10), 676) (8D)

HIGHER EDUCATION

SECOND EDITION
 Digitized by the Internet Archive
in 2022 with funding from
Kahle/Austin Foundation

https://archive.org/details/derivativesriskmOO00Osriv
 DERIVATIVES AND
RISK MANAGEMENT
SECOND EDITION

Rajiv Srivastava
rofessor, Finance
Indian Institute of Foreign Trade, New Delhi

OXFORD
UNIVERSITY PRESS
 OXFORD
UNIVERSITY PRESS

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Published in India by
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© Oxford University Press 2010, 2014

The moral rights of the author/s have been asserted.

First Edition published in 2010

Second Edition published in 2014

All rights reserved. No part of this publication may be reproduced, stored in

a retrieval system, or transmitted, in any form or by any means, without the
prior permission in writing of Oxford University Press, or as expressly permitted
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above should be sent to the Rights Department, Oxford University Press, at the
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and you must impose this same condition on any acquirer.

ISBN-13: 978-0-19-808915-5
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by Oxford University Press in good faith and for information only.
Oxford University Press disclaims any responsibility for the material contained therein.
 Dedicated to my parents
Jai Behari Lal and Kailash
 Foreword
Globalization has helped the world become more competitive than ever. Where businesses have
expanded astronomically during the past two decades, financial markets have also grown alongside.
This has encouraged people to invest in various financial instruments with underlying in the form
of stocks, indices, currencies, commodities, etc. With increased financial integration of the world,
the stock market in India and in various allied sectors such as financial services, mutual funds, and
investment consultancies has offered a wider menu of investments to investors. However, all of these
are subject to a variety of risks, and thus investors need to be aware of how to measure as well as
minimize risks. The subject of derivatives is concerned with these financial markets, risk measure-
ment, and risk minimization.
In the light of the fact that more and more people are taking positions in derivatives like futures
and options and are trading in both capital and commodity markets, there is an imperative need for
practitioners, academicians, and students alike to learn about these markets, mechanisms, instruments,
processes, phenomena, and strategies to minimize risks associated with derivatives of various kinds.
Increased interest in derivatives has prompted most management institutions across the world to
include courses on derivatives and risk management that go beyond the traditional domain of corpo-
rate finance. Derivatives and risk management has become the foremost subject for management stu-
dents and has found popularity among them. The demand for management graduates with knowledge
and insight into derivatives, capital and commodity markets, and techniques of risk management has
steadily risen over the years. The trend is likely to continue in future, with increased emphasis.
Unlike most courses in finance and management, derivatives and risk management is a rather
highly technical subject demanding considerable mathematical insight. This volume starts with an
introduction to the world of derivatives, and graduates to advanced topics such as credit risk,
secu-
ritization and credit derivatives, accounting for derivatives, weather and energy derivatives,
and real
options. The book also dwells on complicated areas of option pricing, option-trading
strategies, and
exotic options very widely used in the corporate world. The theoretical construct is well
supported by
real-life examples and solved problems besides tables, figures, screenshots, and schematic
diagrams,
and also throws light on cases referred as ‘derivative disasters’ that focusses on the dangerous
side
of derivatives, the study of which provides critical learning outcomes. Various pedagogical
features
such as sideboxes and business snippets in the form of ‘derivatives in practice’ highlight
real-world
applications of derivatives. All these features make the book easy to read and comprehend
, and apply
concepts 1n practice.
It is indeed a great pleasure reading this book and I am confident it will fill any
gap in the literature
on this subject. I would like to place my appreciation for the author for having
put in quality time and
sincere effort to come out with such an excellent and comprehensive book,
which I consider to be a
must read for anyone associated with derivatives.

Pratip Chaudhuri
Chairman
State Bank of India
Preface to the Second Edition
Derivatives and risk management is a subject that has always eluded the grasp of most people. With
the growth and proliferation of financial and commodity markets, the importance of derivatives as
a tool of risk management has increased manifold. The importance of the knowledge of this subject
is alike for both practitioners and students. The dynamics of stock, commodity, currency, and other
markets has grown at an astronomical pace because of more and more investments being made in
mutual funds and other financial instruments. This has necessitated the world to find ways of manag-
ing increased risk and, hence, the need to study the subject and develop a keen understanding of the
various markets. With increased investments, the natural propensity to manage risks is also the need
of the hour.
India’s inclusion among the top economies of the world in recent years has helped the stock market
to soar higher than ever. People are therefore taking keen interest in investing in stocks and other
financial markets as well as various derivatives. Stock market enthusiasts are no longer restricted to
buying and selling stocks and shares but have broadened their purview of dealings to various deriva-
tives such as futures, options, and commodities.
Financial instruments are subject to market risks and volatility. The causes of volatility in the mar-
kets are numerous and sometimes it becomes difficult to establish a cause-effect relationship. India
losing a game of cricket can be a reason assigned to fall in the financial markets. Even the rumour
of Lord Ganesha drinking milk had the stock market soaring by a few hundred points! In the light
of these characteristics as well as the fact that investing involves high risks, it is imperative that one
develops a keen understanding of the various concepts of derivatives and risk management. Thus,
the mainstream management courses with finance SMS have included derivatives and risk
management as one of their primary electives.

About the book

Derivatives and Risk Management, Second Edition, is a book that caters to the syllabi requirements of
postgraduate students specializing in finance. Since the publication of the first edition of this text, I
have been receiving encouraging feedback about the book from students as well as faculty members.
This second edition further improves the coverage of the original edition, making the text much more
comprehensive and better structured. I hope that it will further aid students in understanding the basic
principles of this subject. The following are the key features and additions in the second edition:

Key Features
e Explores new issues in derivatives and risk management such as volatility and value at risk,
options on bonds, options on swaps—swaptions,.and structured credit derivatives,
e Examines corporate securities such as debt and equity as options,
Provides examples and boxed exhibits for illustrating the key applications of derivatives.
Includes case studies from various organizations on derivatives that led to disasters, to provide
some learnings.
 vi __ Preface to the Second Edition

_New to the Second Edition

e Four new chapters on corporate securities and derivatives, real options, volatility and value at
risk, and derivatives disasters
e New sections on topics such as futures contract on T-bills in India, Monte Carlo simulation,
various exotic options such as lookback option, gap options, pay-later options, and so on
e Fresh discussions on recovery rates, default rates, credit value at risk, and valuation of CDS—
Merton model
e A new feature called derivatives in practice to acquaint students with real-life situations
e Five new real-life cases on derivatives disasters in the last chapter along with lessons learnt from
them

Online Resources
The following resources are available to support the faculty using the text:

e Instructor’s Manual
@ PowerPoint Slides

The following resources are available to support the students using the text:

e Multiple Choice Questions

Extended Chapter Material

e Forward rate agreements (FRAs) (Chapter 6)

e Future contracts on T-bills in India (Chapter 7)

¢ Monte Carlo simulation (Chapter 11)

¢ Volatility and value at risk is a completely new chapter (Chapter 14)

@ Naked call (Chapter 16)

e Recovery rates, default rates, credit value at risk, valuation of CDS—Me
rton model, securitiza-
tion, and structured credit derivatives (Chapter 20)
© Corporate securities and derivatives is a completely new chapter (Chapter
21)
¢ Real options is a completely new chapter (Chapter 22)
e Derivatives disasters is a completely new chapter (Chapter 25)

Coverage and Structure

With its expanded coverage, the book now contains 25 chapters.
Chapter | introduces readers to the
world of derivatives and the risks involved.
Chapter 2 discusses the concepts of forwards and futures in detail;
thereby, touching upon topics such
as futures contract, pricing and value of futures and forward
contracts, and convergence.
 Preface to the Second Edition Vili

Chapter 3 deals with commodity futures and delves deep into developing an understanding of topics
such as long and short positions, long and short hedges, hedge ratio, and spread strategies.
Chapter 4 deals with stock and index futures, while Chapter 5 describes currency forward and futures,
thereby discussing concepts such as foreign exchange preliminaries, non-deliverable forwards, and
arbitrage with currency futures.
Concepts such as interest rate markets and forward rate agreements are described in Chapter 6. This
chapter includes sections on repo and reverse repo transactions, term structures of interest rates,
bootstrapping method, and continuous compounding.
Chapter 7 explains interest rate futures on T-bills, Euro Dollar futures, treasury bond futures. The key
concepts of interest rate swaps, currency swaps, valuation of swaps, and other swaps are discussed
in Chapter 8.
Chapter 9 introduces readers to the fundamentals of options. Chapter 10 delves deeper into the vari-
ous concepts of option pricing. Chapter 11 delves further into the concepts of options pricing and
discusses the Binomial model in detail.
Chapter 12 describes the Black Scholes model in options pricing. The chapter discusses concepts
such as factors affecting options prices, Logarithmic distribution, mean and standard distributions,
-and Merton model for valuing options on dividend paying stock. Options Greeks—sensitivities are
discussed in chapter 13. Concepts such as Delta and Delta hedging, Theta, Gamma and Gamma neu-
trality, and other Greeks such as Vega are discussed in this chapter at length.

Chapter 14 is a completely new chapter that discusses volatility and value at risk. Concepts such as
measures of risk, exponential weighted moving average method, GARCH (1, 1) model, historical
simulation, and stress testing. Concepts on hedging with options are discussed in chapter 15. Topics
such as hedging with stock options, hedging portfolios with index options, hedging with currency
options, and range forward-zero cost structures are discussed in detail in this chapter.
Chapter 16 explains options trading strategies and concepts such as income generation with options,
straddle, strangle, straps and strips, and synthetic positions are discussed at length with real life data.
Chapter 17 describes exotic options within which concepts such as path dependent options like barrier
and Asian options, lookback options, and other exotic options are explained.
Chapter 18 covers concepts on interest rate options and discussed topics such as cap, floor, collar,
and options on bonds. Chapter 19 discusses options on futures and swaps, and Chapter 20 explains
credit risk, securitization, and credit derivatives. New sections on recovery and default rates, credit
value at risk, value of CDS — Merton model, and structured credit derivatives have been included.

Chapter 21 is a completely new chapter that delves deep into the concepts of corporate securities and
derivatives. Chapter 22, also a new inclusion in this edition, explains options on real assets such as
option to delay, expand, and abandon.

Chapter 23 takes us through the concepts of weather and energy derivatives. Chapter 24 is about
accounting for derivatives and discusses concepts such as types of financial instruments, fair value,
hedge accounting, types of hedges, fair value and cash flow hedges. Chapter 25, the concluding
 Vili Preface to the Second Edition

chapter, throws light on derivatives disasters and mentions five organizations whose investments in
derivatives have gone awry.

Acknowledgements
As in the first edition, the motivation to undertake the much-improved second edition came from my
students of this subject who constantly demanded more and more coverage and depth to the topics.
This resulted in reorganization of the book and addition of new topics and extended the number of
chapters from 16 to 25. Indeed, I am thankful to my students for enlarging the content and scope of
the book, thus making it more comprehensive than before.
I am also thankful to the management and faculty of the Indian Institute of Foreign Trade, New
Delhi, which has continued to provide an extremely conducive atmosphere and the encouragement
to undertake the endeavour in this rather relatively new field, especially for India where books on the
subject and those that deal with the Indian environment are lacking. The literature and the books avail-
able in the library of the Indian Institute of Foreign Trade have been an immense source of knowledge
and information. I have enriched greatly from these books and literature and the academic interactions
that I have had with my faculty colleagues.
I continue to be particularly thankful to Dr Anil Misra, Associate Professor at Management Devel-
opment Institute, Gurgaon, for having graciously agreed to allow me to use some part of the contents
of my earlier book titled Financial Management in which he is the co-author.
I sincerely appreciate the reviewers for their constructive criticism and useful inputs. I would like
to thank the editorial team at Oxford University Press, India, for enabling several improvements
in
the contents and presentation of this book.
I am also grateful to my wife, Anita Srivastava, for her endurance, encouragement, and
support
throughout the preparation of this work.
While extensive use of the information from a large number of books, research papers,
and other
publications has been made, I remain solely responsible for the errors and omissions
in the book. Any
feedback or correction could be sent either directly to [email protected] or
through Oxford
University Press and would be highly appreciated.

Rajiv Srivastava
Preface to the First Edition
Derivatives have been in use for a long time but they still remain mystical for a vast majority. While
commodity derivatives solely occupied the spectrum for a long time, its proliferation commenced in
the 1970s when derivatives were introduced gradually on a large number of underlying assets. These
were instruments used by corporations to reduce their exposure to a variety of risks.
Derivatives in the Indian markets, whether over-the-counter or exchange-traded, are gaining
momentum day by day by involving popular products such as options and futures on stocks and indi-
ces. Specific over-the-counter products for the corporate world such as barrier options on currencies
and derivatives on interest rates are also available today. Beginning June 2000, the financial markets
in India have witnessed a rising interest in advanced financial products such as derivatives, index and
stock futures and options. Thus, we have witnessed an introduction of a new line of derivatives on a
regular basis.
Exchange-traded derivatives on commodities, currencies, interest rates, etc. all have evolved over
a short period of time. The pace of development and the increased level of interest in derivatives in
Indian markets make one believe that India would soon be one of the major markets in the world,
both in terms of volume and product range. The popularity of exchange-traded derivatives can be
measured from the fact that the turnover in derivatives has surpassed the turnover in capital markets
in less than five years of its commencement.

About the Book

There are numerous complexities attached with the conceptual comprehension of pricing and the
working of derivatives. A better understanding of the applications of derivatives to provide a desired
risk return profile to match individual needs would further widen its usage and increase its popu-
larity. Clarifying such doubts and apprehensions was the major motivating factor while developing
the contents of this book. The aim of this book is to present the subject in a simple language while
minimizing the use of complex mathematics. This not only makes the subject interesting, but also
enables a better understanding of the subject. Further, by providing adequate knowledge regarding
the purpose of derivatives, i.e. risk management, and fair price discovery, all the other topics covered
would dispel the common belief that derivatives are pure speculative products.
Apart from the theoretical concepts, the book discusses some important issues such as the increased
volatility in the prices of commodities, stocks, and financial products. Such volatility is enhanced due
to the increased integration of the economies all over the world, which has also increased the need for
understanding and use of the various techniques of risk management. The number of variables that
impact the prices of commodities and financial assets has expanded and so the need for understanding
the inter-linkages of these variables have also increased.

Pedagogical Features
Each chapter lists the learning objectives followed by an introduction and discussion of the relevant
topics. To facilitate understanding and learning, the following has been included in the book.
x Preface to the First Edition

e A large number of numerical examples to illustrate usage of derivatives and applications

e A section of solved problems at the end of each chapter to elaborate on the different concepts
and applications discussed within
e A number of side bars that highlight the crux of key concepts discussed in each section
e A comprehensive summary and a list of key terms at the end of each chapter

Some of the key features of the book are as follows:

¢ Commodity derivatives along with financial derivatives
@ Non-deliverable forward (NDF) market
¢ Complete coverage of Accounting for Derivatives in the Indian perspective by incorporating the
essence of Accounting Standard AS 30 which is applicable in India
e Detailed discussion on currency futures and interest rate futures

Acknowledgements
The motivation to undertake this project has been provided by the students whom I have tried to train
in the area of derivatives and risk management. Their thoughtprovoking questions have prompted me
to answer some of them in the form of this book. I am indeed thankful to these students.
I am also thankful to the management and faculty of Indian Institute of Foreign Trade, New Delhi
which has provided an extremely conducive atmosphere and the encouragement to undertake the
endeavour in this rather relatively new field, especially for India which lacks books on the subject
that deals with the Indian environment.
The literature and the books available in the library of Indian Institute of Foreign Trade have been
an immense source of knowledge and information. I have been enriched greatly from these books
and literature.
I am particularly thankful to Dr Anil Misra, Associate Professor at Management Development
Institute, Gurgaon for having graciously agreed to allow me to use some part of the contents of my
earlier book titled Financial Management in which he is the co-author.
I sincerely appreciate reviewers for their constructive criticism and useful inputs. I would like to
thank the editorial team at Oxford University Press, India for enabling several improvements in the
contents and presentation of this book.
I am also thankful to my wife, Anita Srivastava, for her endurance, encouragement, and support
during the preparation of this work.
While extensive use of the information contained in large number of books and research papers
and other publications has been made, I remain solely responsible for the errors and omissions in the
book.

Rajiv Srivastava
_ [email protected]
Brief Contents
Foreword iv
Preface to the Second Edition v
Preface to the First Edition ix
Detailed Contents — xii

— Introduction
Forwards and Futures
Commodity Futures
Stock and Index Futures
Currency Forwards and Futures
Interest Rate and Forwards
Interest Rate Futures
Swaps, Interest Rate, and Currency
fy Options—Basics
Go)
cree
“foe
fo
we
Option Pricing—Basics
Option Pricing—Binomial Model
Option Pricing—Black—-Scholes Model
Option Greeks—The Sensitivities
Volatility and Value at Risk
Hedging with Options
Options Trading Strategies
Exotic Options
Interest Rate Options
Options on Futures and Swaps
Credit Risk, Securitization, and Credit Derivatives
Corporate Securities and Derivatives
Real Options
Weather and Energy Derivatives
Accounting for Derivatives
Derivatives Disasters
Index 671
Detailed Contents
Foreword iv Futures Exchange, An Intermediary
Preface to the Second Edition v Standardized Contract/Product
Specification of aFutures Contract
Preface to the First Edition ix Settlement and Delivery
Brief Contents xi Delivery Logic
Open Interest
1. Introduction 1 Cash Flows Under Forward and
Introduction—Risk Management ] Futures Contracts
Managing Risk 2 Margin Requirements
Types of Business Risk 3 Minimum Margin and Margin Call
Price Risk 3 Pricing a Forward/Futures Contract
Exchange Rate Risk 4 Cash-and-Carry Arbitrage
Interest Rate Risk 4 Reverse Cash-and-Carry Arbitrage
Derivatives 4 Pricing Investment Assets
Distinguishing Features of Hedging Pricing Consumption Assets
with Derivatives 5 Value of a Forward Contract
Derivative s Hedge and Diversification 6 Convergence
Derivative 's Hedge and Insurance 7p Normal Market and Inverted Market
Derivative s Hedge and Strategic Relationship Between Futures
Risk Management & and Forward Prices
Derivative Products 9) Relationship of Futures Price and
Types of Derivatives 9 Expected Spot Price
Classification Based on Product 9 Normal Backwardation Hypothesis
Classification Based on Underlying Asset 10 Contango
Classification Based on Trading a Expectation Hypothesis
Participants in Derivative Markets 13 Expectancy Theory of Futures Pricing
Hedgers M3} Types of Futures
Speculators 14
Arbitrageurs 14 Commodity Futures
Evolution of Derivatives 15 Introduction
Commodities 15 Benefits of Commodity Futures 56
Financial Derivatives 16 On Price and Volatility
Currency LH On Market Structure
Functions of Derivative Markets 19 On National Economy
Price Discovery 19 Commodity Futures and Financial Futures
Transfer of Risk 20 Pricing Commodity Futures
Leveraging 20 Hedging with Commodity Futures
Consequences of Derivative Markets 20 Long and Short Positions
Misuses and Criticism of Derivatives 21 Short Hedge
Increased Volatility 21 Long Hedge
Increased Bankruptcies 22 Perfect and Imperfect Hedge
Burden of Increased Regulation 22 Mismatch of Asset and Quality
Mismatch of Quantities
2. Forwards and Futures 24 Mismatch of Maturities
Introduction 24 Basis and Basis Risk
Forward Contract 2S Basis Risk and Hedging
Motive for Forward Contract 25 Hedge Ratio
Features of Forward Contract 26 Hedging for Changes in Volume
Settlement of Forward Contracts PY Hedging for Gross Profit Margin
Futures Contract 28 Strategic Implications of Futures
Counterparty Risk 28 Speculation with Commodity Futures
 Detailed Contents xili

Spread Strategies with Futures ve Currency Futures mm

Pricing Currency Futures and Forwards 143
Stock and Index Futures Hedging Through Currency Futures 146
Introduction Hedge for Importer—Long Hedge 146
Index Futures Hedging for Exporter—Short Hedge 147
Forward Contracts on Stocks Speculation with Currency Futures 148
Futures Contract on Indices and Arbitrage with Currency Futures 148
Individual Stocks
Features and Specifications of 6. Interest Rate and Forwards 155
Stock/Index Futures Introduction 155
Margining System Interest Rate 156
Pricing Stock and Index Futures Desirable Features of Interest Rates 156
Applications of Index Futures Repo and Reverse Repo Rates 156
Hedging Through Index Futures Treasury Rates 157
Hedging Existing Portfolio Interbank Transactions 158
Hedge Ratio Term Structure of Interest
Hedging Short Position of Portfolio Rates/Yield Curve 160
Insulating Against Market Risk Bootstrapping: Obtaining Zero
Controlling Risk of Stock Portfolio Rates from YTMs of Bonds 162
Speculation with Stock Index Futures 104 Forward Contracts on Interest Rates—FRAs 165
Arbitrage with Stock Index Futures 105 Forward Rate Agreement—The Product 166
Calendar Spreads 107 Borrower's FRA 167
Other Applications of Index Futures 108 Investor sFRA 168
Settlement of FRAs 169
Currency Forwards and Futures 116 Pricing an FRA 169
Introduction 116 Hedging with FRAs 172
Hedging Against Rising Interest Rates 173
wea Foreign Exchange Preliminaries me Hedging Against Falling Interest Rates 174
Foreign Exchange Risk Gy
Speculation with FRAs 175
Foreign Exchange Markets 118
Arbitrage with FRAs IS
Foreign Exchange Rates 118
Bid Rate vs Ask Rate 118
119
7. Interest Rate Futures 176
Spot Rate vs Forward Rate
Introduction 178
Forward Premium/Discount 119
Arbitrage and Foreign Exchange Rates 121 veg Interest Rate Futures on T-Bills se
Treasury Bills 180
vé@m Currency Forwards we Futures Contract on T-bills 181
Foreign Exchange Transactions 123
Pricing of T-bills 181
Spot and Forward Transaction 123
_ Price Quotation on T-bill Futures 182
Swap Transaction 124
Futures Contract on T-bills in India 183
Outright Forward vs Swap 125
Hedging with T-Bill Futures 185
Option Forwards M2
Hedging Against Falling Yields (Long Hedge) 185
Hedging Through Forward Contracts 128
Hedging Against Rising Interest (Short Hedge) 188
Hedging Receivables (by Exporter)
Speculation with T-bill Futures 189
with Forward Contract 128
Arbitrage with T-Bill Futures 190
Hedging Payable (by Importers)
Implied Repo Rate 190
with Forward Contract 129
Cost of Forward Hedge 132 ee EKurodollar Futures ee
Speculation with Forward Contracts 133 Eurodollars 195
Arbitrage with Forward Contract iteks) Futures Contracts on Eurodollars 195
Determining Forward Rates 134 Pricing of and Hedging
with Eurodollars Futures 196
va Non-deliverable Forwards we
Non-deliverable Forward Contracts 135 wa Treasury Bond Futures we
Evolution and Growth of NDF 136 Treasury Bonds 198
Features of NDFs 136 Pricing T-bonds 198
How NDFs works? yy Futures Contract on T-bonds 199
NDF and Interest Rate Parity 1S Pricing of T-bond Futures 200
Are NDFs Desirable? 138 Conversion Factor 201
XIV__— Detailed Contents

Finding Conversion Factors 203 Margins in Options 269

Cheapest-to-deliver Bond 204 Adjusting for Corporate Actions
Interest Rate Futures in India 205 on Stock Options 270
Hedging with Interest Rate Futures 206 Options Other than Stocks/Indices 271
Hedge Ratio 207 Differences Between Options and
Duration and Modified Duration 207 Forwards/Futures Pipi
Optimal Hedge Ratio:
Duration-based Hedging 209 10. Option Pricing—Basics 277
Introduction 277
8. Swaps, Interest Rate, and Currency 215 Intrinsic Value and Time Value 277
Introduction 215 Boundary Conditions for Option Pricing 279
wa Interest Rate Swaps me
Call Option 279
Features of Interest Rate Swap 21g)
Put Option 281
Need for Swap Intermediary: Effects of Dividend on Lower Bounds 283
Swap Dealer/Bank 218
Lower Bounds for Currency Options 284
Applications of Interest Rate Swaps 220
Lower Bounds for Options on Stock Indices 285
Transforming Nature of Liabilities 220
Arbitrage-based Relationship of Option Pricing 285
Transforming Nature of Assets Put—Call Parity 288
Hedging with Swaps Put-Call Parity for American Options 292
Reducing Cost of Funds Put—Call Parity for Dividend Paying Stock 293
Rationale for Swap—Comparative Put—Call Relationship for Currency Options 293
Advantage
Types of Interest Rate Swaps 11. Option Pricing—Binomial Model 298
Introduction 298
v@m Currency Swaps mez
World Bank-IBM Currency Swap ga Binomial Option Pricing Model me:
Hedging Against Exchange Rate Resolving the Dilemma 302
Risk with Currency Swap Risk-neutral Valuation 303
Reducing Cost of Funds with Currency Swaps Finding Risk-free Portfolio 305
Distinguishing Features of Currency Swaps Equivalent Portfolio Approach
for Option Valuation 306
“Valuation of Swaps mz Binomial Model for Put Pricing 307
Valuing Interest Rate Swaps Multi-period Binomial Model 309
Swap Quotes and Initial Pricing Valuing American Options 312
Counterparty Risk and Swaps Valuing European Call 312
Valuing Currency Swaps Valuing American Call 314
a Other Swaps we Valuing European Put 5y/(5)
Commodity Swaps Valuing American Put 316
Equity Swaps Valuing Options on Dividend
Conclusion Paying Stock Se
European and American Calls
9. Options—Basics on Dividend Paying Stock 320
Introduction European and American Puts
Terminology of Options on Dividend Paying Stock 325
Call Option Binomial Solution for Multi-periods 324
Put Option Binomial Model for Index Options 325
Who Benefits? Valuing Currency Options 326
Moneyness of Options Binomial Model in Practice:
In-the-money, At-the-money, Constructing Binomial Tree Sou,
and Out-of-the-money Options Monte Carlo Simulation 328
Types of Options Conclusion Soil
Nature of Exercise: American vs European
Nature of Markets: Over-the-counter vs 12. Option Pricing—Black-Scholes Model 336
Exchange-traded Introduction 336
Nature of Underlying Assets Factors Affecting Option Price 33
Understanding Options Quotations Black-Scholes Option Pricing Model 339
Trading and Settlement Stock Returns have Log-normal
Assignment Distribution 340
 Detailed Contents XV

Mean and Standard Deviation Measures of Risk 38)

of Ln R are Proportional to Time Volatility 393
Ln R has Normal Distribution: Exponential Weighted Moving Average 394
Central Limit Theorem Correlation and Covariance 396
Time Value of At-the-money Option is Highest Garch (1, 1) Model 397
Applying BSM Volatility Index Boy
Assumptions of BSM
Interpreting the BSM ve, Computation of India VIX a
Forward Price, F 401
Put Pricing using BSM
Finding ATM Option, Xo 401
Merton Model for Valuing
Time to Expiry, T 401
Options on Dividend Paying Stock
Risk-free Rate, r 401
Valuing Options on Indices
Option Values, Q; 401
Valuing Options on Currencies
Valuing American Options Option Interval, Ax 401
American Call vs European Call
gga Value at Risk we
on Non-dividend Paying Asset
Features and Concerns of the Financial Sector 405
American Call on Dividend paying Asset
Definition and Meaning of VaR 405
Pseudo-pricing of American Call
VaR with Normal Distribution 405
Exact Pricing of American Option
Portfolio Effect on VaR 408
Volatilty
Decisions in VaR 408
Measuring Historical Volatility
Selection of Confidence Level 409
Implied Volatility
Selection of Time Horizon 409
Estimating Implied Volatility
Methods of Calculating VaR 409
Valuation 410
13. Option Greeks— The Sensitivities Estimation of Volatility 410
Introduction
Historical Simulation 411
v@a Delta and Delta Hedging se Monte Carlo Simulation 416
Computing Delta Limitations 416
Meaning of and Limits on Value of Delta Stress Testing 416
Assumption of Linearity
Behaviour of Delta 15. Hedging with Options 420
Delta and Time to Maturity Introduction
Additivity of Delta: Portfolio Delta Hedging with Stock Options
: Deltas of Other Derivatives Hedging Long Position in Stock
Delta Hedging with Put Option
Delta Neutrality Hedging Short Position in Stock
with Call Option
aa) heta wz Hedging Portfolios with Index Options
Computing Theta
Hedging Long Portfolio with
Meaning ofTheta
Put on Index
Theta and Time
Hedging Short Portfolio with
Theta for Put Option
Call on Index ;
Portfolio Theta
Hedging with Currency Options
veg Gamma and Gamma Neutrality me Hedging Foreign Currency
Computing Gamma Receivable with Put Option
Behaviour of Gamma with Hedging Foreign Currency
Spot Price and Time Payable with Call Option
Meaning of Gamma Range Forward—Zero Cost Collar
Portfolio Gamma
Gamma Neutrality 16. Options Trading Strategies
Introduction
vega Other Greeks we
Vega ma Income Generation with Options me
Rho Naked Call and Covered Call
Writing Put
14. Volatility and Value at Risk Speculation with Single Option
Introduction Arbitrage with Options
 XVi__—Detailed Contents

wa Option Trading Strategies m a \nterest Rate Options a

Long and Short Straddle 45] Cap 518
Strangle 453 Hedging with Cap 518
Straps and Strips 455 Valuation of Cap 521
Bull Spread 456 Floor 524
Bear Spread 458 Valuation of Floor 525
Debit and Credit Spreads 458 Collar 526
BT OE, Ratio 460 ma Options on Bonds me:
Butterfly Spread aoe Valuation of Options on Bonds
Condor Spread 462 229

ee pee
iagonal Spreads poo rig, Options on Futures and Swaps 533
466 ;
Spreads on Different Assets 466 gat ae
Bae Sa y 467 Futures Options he
p 233.
é
Factors Affecting Spreads 468 ei, , 234
Need for Options on Futures 535
wa Synthesizing Instruments and Positions & Put—Call Parity for Options on Futures 536
Synthetic Long Position in Stock 469 P*“omial Model for Pricing Futures Options 53,
Synthetic Short Position in Stock 470 Valuation of Futures Options—Black’s Model 539
Other Synthetic Positions 471 Option on Swaps—Swaptions 540
Payoff on Swaption 541
17. Exotic Options 479 Swaptions and Options on Bond 542
Introduction 479 Valuation of Swaptions 543
Forward Start Option 480
Valuation 480 20. Credit Risk, Securitization,
Applications 481 and Credit Derivatives
Binary or Digital Option 482 Introduction
550
550
Applications 482
Valuation 483 coma Credit Risk me
Chooser Option 484 Probability of Default 551
Valuation 485 Recovery Rates 554
Shout Option 486 Default Rates 555)
Valuation 487 Transition Rates 556
Exchange Option 487 Credit VaR 556
oe Pe pe waa Credit Derivatives me:
; Credit Derivative 560
Gap Option 489 Types of Credit Risks
Cp aes 0 Credit Default Swaps
S61
aESDIOW® 562
420 Cash Flows of CDS 563
Pay-later Option 492 Settlement of CDS 564
Applications 493 Variants of CDS 566
Valuation ’ 493 Applications of CDS
Compound Options 496 Valuation of CDS—Merton Model
567

Case fe 568
vad Total Return Swap 573
; 4 Features of TRSs 574
Barrier Options 499
Valuation Total Return Swaps vs Swaps and CDS IS)
500
Asian Options 504 saat. Securitization me:
Applications 504 Risk in Securitization 578
Valuation 505
; as >
em Structured Credit Derivatives c
ee
me
eee ri Credit-linked Notes _ 579
ia is Collateralized Debt Obligations 581
; 21. Corporate Securities and Derivatives
18. Interest Rate Options 517 introduetibn 586
Introduction
586
SF
 Detailed Contents XVii

Equity Shares—Common Stock 587 Electricity

Agency Cost of Debt 588 Natural Gas
Debt as Options 590
Subordinated Debt 59] 24. Accounting for Derivatives
Callable and Puttable Bonds 592 Introduction
Convertible Bonds 593 Accounting Definition of Derivatives
Warrants 594 Types of Financial Instruments
Fair Value
22; Real Options 997 Measurement of Fair Value
Introduction a7) Hedge Accounting
Kinds of Real Options 598 Types of Hedges
Option to Delay - 598 Steps for Hedge Accounting
Option to Expand 598 Hedged Item
Option to Abandon 599 Hedging Instrument
Differences Between Financial Hedging Relationship
and Real Options aye) Accounting for Derivatives
Real Assets are Not Traded 600 Derivative Held for Trading
Variance of Real Options is Derivative as Fair Value Hedge
Difficult to Estimate 600 Derivative as Cash Flow Hedge
Exercise of Real Options is Conclusion
Time Consuming 600
Terms of Exercise of Real 25. Derivatives Disasters
Options are Not Clearly Defined 600 Introduction
Option to Delay—Timing Decision 601
Evaluating Timing Decision with DCF 601 vem Metallgesellschaft AG: mz
An Intelligent Programme That Went Awry
Valuing Option to Delay
The Contract
with Binomial Model 603
Hedging Programme
Discounted Cash Flow and
Problems
Binomial Option Valuation 604
Size of the Exposure
Using Black Scholes Model
Hedge Ratio and Mismatch
for Investment Timing 605
of Positions and Timings
Option to Expand 607
Marked-to-market and Cash
DCF Valuation 608
Flow Mismatch
Valuing Option to Expand
From Backwardation to Contango
with Binomial Method 609
US and German Accounting Methodologies
Valuing Option to Expand
The outcome
using BSM 611
Option to Abandon 612
DCF Valuation 612 vem Barings Ple: mex
DCF Valuation without the Put Option 613 The Earthquake That Crumbled the Old Strong Edifice
DCF Valuation with Option to Abandon 614 Dual Role
Valuing Put Option with Binomial Method 614 Switching
Value of Put with BSM 615 Unauthorised Trading and
Misrepresenting Accounts
618 The Trap of Losses
23. Weather and Energy Derivatives
The Straddle
Introduction 618
Kobe Earthquake
va Weather Derivatives mm The Exposure
Temperature 619 Funding MTM Losses
Derivative Products on Temperature 620 The Outcome
Pricing Weather Derivatives 620 Analysis
Emission Trading 621
Distinctive Features of Weather Derivatives 623 am LT CM: wee
The Risk Management Models That Crashed
wma Energy Derivatives me Hedge Funds
Crude Oil 625 Growth of LTCM
XViil_ ~——Detailed Contents

The Strategy 658 The Outcome 663

Digression from Practice 3
and Beyond Frontiers 659 _ a ee

Me Bonds toes enc ed Overconfidence ofLeader 664

ce ona Trade and DET atives 659 Concentration of Mane 664
Bpceviation of Corporate Activities 660 The Outeonis 665
Volatility Trades 660
Events 660 “@Procter and Gamble: a
Asian Financial Crisis 660 The Gamble That Didn’t Pay Off
Russian Default and Brazils Devaluation 661 Markets are Supreme 666
Salomon Brothers’ Withdrawal 661 Models Do Not Work Always 666
Failure of Risk Models 661 Complacency and Lack of Supervision 667
Volatility 661 Star Status 667
Coline 661 Concentration of Power and Responsibilities 668
Normal Distribution 662 Complexity of Long Term and Short Term 668
Value at Risk 662 Systemic Risk 668
Liquidity 662 Need vs Greed 669
Leverage 662 Absence of Legal Framework 669
Convergence 663

Index 671
INTRODUCTION—RISK MANAGEMENT © “Learning Objectives
Risk is inherent in all the activities we undertake in our day-to- _ After going through this chapter,
day lives, and is a constant concern for all of us. Risk can be readers should be familiar with
defined as deviation of the actual results from the expected. -
different kinds of risks and ways of
While we would prefer to eliminate this risk altogether and live managing them
in a world of certainty, complete elimination of risk is not pos- ® diversification and transfer of risk
sible. However, steps can be taken to mitigate the risk to a con- e types of business risk—price,
siderable extent. In our personal lives, when we buy an insurance exchange rate, and interest rate
policy against theft in the house or for a vehicle, we are trying ° derivatives and derivative products
to minimize the potential loss that we may incur upon occur- ° functions, uses, and misuses of
rence of the rather unlikely event of theft. derivatives -
The impact or magnitude of risk is normally estimated from ® classification of derivatives
Bick can be clasaified _ the following two factors: * roles of hedgers, speculators, and
arbitrageurs as participants in the
in two ways: (a) risk of e the probability of an adverse event markets
small losses with fre- happening, and
quent occurrence and (b) rts 7 ' th :
risk of large losses with in case the event occurs, the magni-
infrequent occurrence. tude of the loss it may cause

The measurement of risk is deter-

mined by the combined impact of the probability and magnitude
of loss, that is, the product of the two. From the perspective of its
management, risk can be viewed in two ways: (a) risk of small
losses with high probability and (b) risk of large losses with low
probability.
The first category of small losses with high probability
includes events such as changes in the stock prices, commodity
prices, exchange rates, etc., where the changes are small but
occur frequently and almost continuously. In the second cate-
gory, we have events such as earthquakes, tsunami, thefts, road
accidents, etc., which cause large losses but the probability of
their occurrence remains low. Even though the expected loss in
 2 Derivatives and Risk Management

the two categories may be the same, the strategies for managing the two different types of
risk differ significantly.
In business enterprises, the management of risk is mainly confined to the events of small
losses with high probability. Firms are exposed to changes in prices of commodities, exchange
rates, interest rates, etc. The management of the second type of risk, involving large losses
with low probability, is more strategic in nature such as from domains of capital budgeting,
capital structure, etc. The tools for handling such risks form a different subject altogether.
With derivatives, we focus on the management of the risks that emanate from the conduct of
normal operations of the business, that is, risk of small losses with a rather high probability
of change.

MANAGING RISK @
There are various ways in which people manage different kinds of risk. Insurance policies are
a classic example of a method of managing risk. All the tools of risk management focus
on
control of the damage the changes can cause and insulate the operations of a business
enter-
prise from adversities. Those who are able to manage the risk better are likely to outperform
competitors.
One may choose to avoid risk by not undertaking an activity at all. There are people who
abstain from air travel because they foresee too great a risk in travelling by air.
Likewise,
some people do not invest in the stocks because of the risk associated with the
stock mar-
ket; they prefer to invest in safer avenues. While certain activities can be avoided
purely on
grounds of high risk (e.g., one can do without investing in the stock market),
it may not be
possible to abstain from some mandatory activities. Not entering a business
in order to avoid
business risk is not a solution to the problem. Rather, it is a problem in itself.
One has to find
better solutions to manage risk rather than avoiding the activity altogether.
The other option is to manage risk—to control the potential damage.
For example, once
we decideto own a vehicle as a means of transport, we observe speed control
and traffic rules
to avoid loss of life and property. Furthermore, we buy an accident
insurance policy. Simi-
larly, firms can protect themselves against potential loss by buying
suitable ‘loss of profit’
insurance.
Another way of managing risk is by diffusing the risk across
sources. Many call centres
prefer to have multi-location operations to protect against natural
disasters. This is referred to
as disaster management. Similarly, most network operators maintai
n redundancy by having
alternative routes available in case one of the communication
channels breaks down.
We are familiar with diversification of risk through portfol
io management. Investors
prefer to invest in different types of securities in order
to protect themselves against fall
in expected return from a single investment. The risk
Different ways tomanage : of failure of all
y :
risk include controlling 3 Investments simult chives
aneously is lower than the risk of failure of ere a single
potential damage and Ss Investment. Likewise, firms do not prefer to have a single supplier
or
diffusing, diversifying, _ Single customer to manage the business well. They prefer
to have many
and transferring riskto. = suppliers/customers as all the suppliers are less likely
those who are willing to to fail to deliver
acco simultaneously and all customers cannot be wooed away by competitors
at the same time.
 Introduction 3

One can also manage tisk by transferring to another party who is willing to assume it.
Insurance companies do not help to reduce the risk per se; they merely assume risk on your
behalf. They have no means of controlling the thefts, floods, earthquakes, riots, etc., but offer
insurance against these risks. It is the business of the insurance company to assume such
risks, as it earns an income by offering such products. Similarly, there are people who are
willing to assume risks of other kinds in return for compensation. Risk as such does not and
cannot vanish from the environment but gets transferred from those who want to avoid it to
those who are willing to bear that risk for a price.
Here, we are concerned with various kinds of risks that a business enterprise is likely
to face and ways of managing the same. There exist a wide array of financial markets and
instruments that enable business enterprises to contain risks inherent in their day-to-day
operations. Here, we focus on the risks of small losses with high probability and ignore the
other type of risk. Non-financial risks (such as financial loss due to a key employee leaving
an organization, failure of the research and development department to develop a product,
breakdown of production machinery, losses due to the vagaries of nature, etc.) are not within
the scope of the subject of derivatives. Although there could be some mechanism to control
or mitigate such risks, there does not exist a free market where the instruments providing
protection from risk can be freely traded amongst the market participants, and hence the free
determination of price of risk.
Management of risk through derivatives is commonly referred to as hedging. It helps in
offsetting substantial losses likely to be suffered by an individual or an organization. Hedging
is fundamentally the transfer of risk from those who prefer to avoid risk to
Hedging refers to the _ those who are willing :
to take it. Risk per se has negative connotations. It is
ee ;
management of risk perceived as something undesirable. However, if risk is perceived as an oppor-
through transfer from _ tunity, it can convert potential pitfalls into gains. Some people perceive risk as
those who prefertoavoid ==ay opportunity that provides higher returns. Derivatives help to develop a bet-
it to those who are willing
oe _ ter perspective or understanding of risk, although there is also a huge scope of
misunderstanding them purely as an opportunity to reap profits quickly.

TYPES OF BUSINESS RISK Be

With a focus on the day-to-day risks that have high probabilities of producing small losses,
_ some risks that business enterprises face and for which suitable financial
Business risks are _ : a
‘characterized by small instruments and deep markets exist are as follows:
losses and high prob- e Price risk
ability and are concerned e Exchange rate risk
with changes in prices,
e Interest rate risk
exchange rates, and
Interest rates. These risks are described briefly as follows:

Price Risk
All markets, whether commodities, stocks, or materials, are dynamic in nature. From the well-
established economic principle, the price is determined by quantity demanded and quantity
supplied. The forces affecting demand and supply vary continuously. Though striving for
4 Derivatives and Risk Management

equilibrium, the prices are never stable. The prices of commodities, shares, industrial prod-
ucts, etc., are subject to continuous change. These changes in the price render instability to
revenue, cost, and profit of a business enterprise, which is a cause for concern for managers
of the firm. The investors also face the same situation when they invest in financial securities,
the prices of which vary continuously, causing uncertainty of returns. The risk of change in
the prices can be mitigated or kept within acceptable limits with the help of financial instru-
ments specifically devised for the purpose.

Exchange Rate Risk

Exchange rate risk emanates from the transactions denominated in foreign currency, where a
firm or individual faces uncertainty regarding the exchange rate at which the foreign currency
will be converted in the domestic currency or vice-versa. As an example, consider a firm
selling goods on credit and realizing the sales proceeds in foreign currency. Even though the
price in foreign currency is fixed today, the firm faces an uncertainty regarding the amount
that will be realized in domestic currency, which depends upon the rate prevailing at the
time of realization of sales and its conversion to domestic currency. Similarly, an importer
who has to make payment in foreign currency at a later date would be uncertain about the .
actual amount to be paid in domestic currency. The risks of variation in the exchange rates
are managed through specific financial instruments such as futures, options, and swaps on
foreign currency.

Interest Rate Risk

Interest rates change similar to prices and exchange rates, depending upon various national
and international macro-economic factors.
All the firms that need capital resort to borrowing, while those with surplus invest funds.
Both the borrowers and lenders face the risk of changes in the interest rates subsequent to the
transaction. In fact, interest rate risk is far broader than price risk and exchange rate risk. In
fact origin of exchange rate risk can be traced to changes in interest rates. Certain industries
such as infrastructure and banking are extremely sensitive to changes in interest rates while
some others are not as sensitive. The risks emanating from changes in the interest rates
can
be hedged through standard products or tailor-made instruments.

DERIVATIVES
Three kinds of risks described in the preceding section can be managed
through specially
designed products. These products are called derivatives. They are best
suited to manage
the risk of small losses with high probability. Derivatives are instrume
nts
Derivatives are products that derive their value on the basis of prices of some other asset, called
the
that derive their value underlying asset. These underlying assets can be physical commodi
ties or
from some other asset financial securities or may be notional that are devoid of physical
substance
called
eset the underlying but have financial implications. The following example illustrates the
meaning of a derivative product.
 Introduction 5

Consider that an Indian exporter is expecting to realize $1000 in six months’ time from
now. The exporter had priced his product with a profit target of $2000 based on the cur-
rent market price of dollar at %45. The actual amount that will be realized by him in
Indian rupees will depend upon the exchange rate prevailing six months later. This rate
is not known today. The exporter expects 45,000 but he might end up getting 44,000 if
the exchange rate falls to %44/$ after six months, or if fortunate enough, he might realize
%46,000 if the exchange rate rises to %46/$. If the rate falls to 44, his profit will stand
reduced by 71000. Although he cannot control the price of dollar in the currency market
or his profit, he can take protective measures to reduce the uncertainty of the exchange rate
and consequential profit.
One of the ways he can reduce the uncertainty is to sell dollars to a party who needs them
six months later and negotiate the exchange rate today. By doing so, he would be assuring
himself of definite cash flow in Indian rupees and profit. Such a contract will be called a
forward contract, where the actual exchange of currency will take place later but at a price
that is determined today. Of course, the price at which this forward contract will be negoti-
ated depends upon the current exchange rate of the dollar, known as the spot price. Since the
price of the forward contract is determined by or derived from the spot price in the foreign
currency markets, such a contract is classified as a derivative. Here, the spot price of foreign
exchange, on the basis of which the forward contract price will be negotiated, is called the
underlying asset. Besides the price of the underlying asset, there will be other factors too that
can influence the price of the forward contract. In the case of a foreign exchange forward
contract, the other factors influencing the price would be the interest rates of the currencies
involved in the transaction.
Similarly, a forward contract can be negotiated for any commodity, subject to legal con-
straints and feasibility. For example, a wheat farmer can sell his crop before harvesting, at a
predetermined price to a buyer. The price is negotiated today but the physical delivery of the
crop and exchange of cash will take place on the due date of the contract. Selling the crop
in advance at a price known today will help the farmer concentrate on his work rather than
worrying about the price that would prevail when he harvests the crop. Here, the underlying
asset is the crop of wheat, whose current price will govern the price of the forward contract.
Other factors determining the price of the crop will be the expected demand and supply sce-
nario at the time of harvest, interest rates prevailing now and expected in the near future, etc.

DISTINGUISHING FEATURES OF HEDGING WITH DERIVATIVES

A derivative is a contract whose value is derived from the price of the underlying asset but
_ in all other respects remains distinctly independent from the underlying
es _ asset. This underlying asset is traded in the spot market or the physical mar-
from the price ofthe un- ket. Hence, there exist two markets for the same commodity—the spot mar-
derlying asset, but in all ket and the derivative market. The price in the derivative market is derived
other respects remains —_— from the spot market as shown in Fig. 1.1. Normally, if the price in the spot
distinctly independent = market goes up, it will lead to an increase in price in the derivative market
: from the underlying as well. The spot market and the derivative market are strongly correlated
Asse
with each other.
 6 Derivatives and Risk Management

Spot/physical market Price from spot market Derivatives market

|Ae

Fig
EEE”
~ Spot market and derivative market—the relationship

If the prices in the two markets follow the same or a similar pattern, then why have two
different markets for the same commodity, as one can always fulfil commodity needs from the
spot market? This is because there are two important differences between the two concepts—
the independent nature of the two markets, and the timeline. It must be stated that with the
exception of linkage in the prices, the mechanisms of the two markets are independent
of
each other. The commitments made in the spot market are to be fulfilled independently
from
those in the derivative market and vice versa. The commitments in the two markets
are also
different in terms of timeline. While the commitments in the spot are fulfilled
on ‘here-
and-now’ basis, the derivative market is a promise for future delivery. The commitment
s in
derivatives are fulfilled at a later date.
The independent nature of the two markets results in an interesting possibili
ty—it makes
hedging feasible. Since the commitments made in the two markets are independ
ent and have
to be satisfied separately, one can take opposite positions in the two markets,
that is, be a
buyer in one market and seller in the other. The Opposite positions in
the two markets would
have compensating effect on the price. For example, one can buy wheat
in the spot market
and sell the same quantity in the derivative market for future delivery.
Between now and the
_ future date, the price would change. If the price decreases, there
The independent nature is a loss in
of spot and derivatives. the spot position while there would be gain in the derivative position
. If the
market enables one to price increases, the outcome is reverse. In either case, the loss
in one market
take offsetting positions would be compensated by an equal gain in the other. Since
in the two, thus rendering
losses are offset
by profits, the net price paid/realized would remain unaffected.
Stability to the price. The objective
MMMM of hedging—stability of price—would thus be met.

Derivative’s Hedge and Diversification

As stated, derivatives are apt instruments for hedging against
the business risk emanating from
the environment. Under portfolio management, risk is
managed using the popular strategy of
diversification. In order to ensure stable portfolio returns,
the investors are advised to diversify
their portfolio. Diversification eliminates the risk arising
from returns of a single security
assuming that the other securities in the portfolio would
make up for the potential loss, ren-
dering consistent performance of the portfolio under
a wide range of economic conditions.
Though the principle of offsetting the losses of one
with the profit of another in the strat-
egy of diversification seems to be same as that
of derivatives, there is a fundamental differ-
ence in the risk management between the
two. While diversification eliminates the
company-specific risk, that is, unsystematic risk,
the market risk called the systematic risk
 Introduction vi

Risk management with remains. A diversified portfolio carries the systematic risk, measured by the
~ derivatives and that beta of the portfolio, as professed under the capital asset pricing model.
_by diversification are Since risk management with derivatives involves opposite positions in the
complementary and two markets that bear the same characteristics and are subjected to the same
a for each risks, both systematic as well as unsystematic, besides loss/gain, all the risks
too would be offset by opposite positions. However, if the positions in the
spot markets and derivative markets are not on the identical assets (e.g., own-
ing a stock while selling a future on it) but on similar assets (e.g., a portfolio of stock with
derivative position on index), the derivatives hedge would nullify the systematic risk that is
common to both spot markets and derivatives markets. The unsystematic risk would continue
to remain in the hedged position to the same level as it was under the unhedged position. It is
evident that strategies of diversification and hedging with derivatives do not substitute each
other but are complementary. While diversification reduces or smoothens the unsystematic
risk, derivatives can eliminate the systematic risk.
In the context of portfolio returns, deploying simultaneous strategies of risk management by
diversification followed by derivatives makes the portfolio risk-free. While the unsystematic risk
is eliminated by diversification, the systematic risk vanishes by an Bees position in deriva-
trves. Such a portfolio would become entirely risk free.
According to the capital asset pricing model, the investor must get a reward on the portfolio
commensurate with risk. Then, the question arises as to whether one must deploy a derivatives
hedge for a well-diversified portfolio. The natural response would be negative, because if one
were to use diversification followed by a derivatives hedge, ending up in the risk-free port-
folio, the need for creating a portfolio in the first place is not justified. One creates a diversi-
fied portfolio to earn more than the risk-free rate of return commensurate with the market
risk. The extent and nature of diversification by selecting securities would be governed by the
risk appetite of the investor. Taking a hedged position in derivatives subsequent to diversifica-
tion would erode the desired returns to the level of risk-free rate. Should the strategy of
diversification be followed by derivatives hedge? Clearly the answer is no as the investors are
not aiming for risk-free rate of return. A better option of investing directly in risk-free assets
such as government securities, fixed deposits with banks, etc., is always available to them.
Thus, it is apparent that strategies of diversification and hedging with
A derivatives hedge for a
derivatives cannot run concurrently for all time. Risk management with
well-diversified portfolio
can be used only for _ derivatives for a well-diversified portfolio makes sense only for a short
the short term and not period of time where the investors feel threatened in the short term with the
for extended periods of risk exceeding their risk appetite. To control the level of risk and manage it
time. Such a combination within the bounds of the risk appetite, one can resort to derivatives hedge for
would give only risk-free
_ a well-diversified portfolio only for temporary periods of extreme uncertain-
returns.
ties and not perennially.

Derivative’s Hedge and Insurance

Risk management with derivatives ensures a fixed price for the underlying asset. Hence,
it can be said that derivatives in a way provide an insurance against the declining value
of an asset. Is risk management with derivatives different from risk management with
8 Derivatives and Risk Management

insurance? The following are the differences in risk management with derivatives and
with insurance:
e Insurance requires payment of some premium upfront, which is not necessary for hedg-
ing with derivatives. In some hedges with derivatives (options hedge), an upfront pay-
ment is required, which is akin to insurance premium, but not all derivatives need to be
paid for.
e Insurance protects the value of the asset only in case of occurrence of certain events,
such as earthquake, flood, accident, theft, etc. These events are rare and the premium is
determined by actuarial science. Under the derivatives hedge, the actual happening of
the event leading to deterioration in value need not take place. The probability of occur-
rence of an adverse situation is extremely high. In cases where the upfront premium is
involved, its calculation is based on past and likely future behaviour of asset prices.
e Under insurance, in order to get compensated for the loss, two things are mandatory: (a)
the event (theft or accident) must have occurred, and (b) the loss due to occurrence of
the event must be proved. One cannot get a claim that results into profit.
While insurance manag- Under the derivatives hedge, the payoff is neither dependent upon occurrence
es event risk, depending
on occurrence of event of the event nor 1s the actual loss required to be proved. The payoff under the
and the losses caused derivatives hedge is automatic, without ascertaining the happening of the
by it, derivatives protect _ event or the occurrence of the loss. The market bears the payoff.
against the price risk and
é As such, insurance covers event risk, while derivatives cover the market
provide automatic payoff.
risk due to inherent volatility in the prices of the assets.

Derivative’s Hedge and Strategic Risk Management

There are several ways in which the risk can be managed, for example, diversification and
insurance. Yet another distinction one can make in the management of risk is its strategic
nature. We know that marketing managers are fond of product diversification/differentiation
and market segmentation. Attempts to develop different brands for different markets can be
viewed as efforts to reduce the risk a single product or a single market poses to the cash flows
of the firm. By having several brands of the same product, a firm renders stability to the cash
flows of the firm just as an investor makes a portfolio of several stocks to stabilize returns.
Similarly, the production function prefers to produce at several locations to avoid the risk
of disasters. Besides saving in the transportation cost, the firm, by having several plants at
different locations, manages several risks such as natural disasters, riots, strikes, etc. Simi-
larly, the purchase function prefers to develop multiple vendors for supply of inputs to elim-
inate or reduce risks from the supply side.
All these measures are strategic in nature and require substantial investment, time, and
A de cties hedoe fort. Further, they are mostly
_ effort. stly 1
irreversible.
isa method of tactical «How is risk management with derivatives different from strategic risk man-
risk management. It _ agement? The fundamental difference is that ‘management of risk through
is economical, quick, _ derivatives can be regarded as tactical, at best. Strategic risk management, such
reversible, and provides : as a decision to launch a new product or set up another plant, involves con-
protection in the short
_ siderable deliberation, data input, and time. Besides, these decisions involve
term
_ Substantial cost outlay and are often irreversible. Most deliberations regarding
 Introduction 9

risk are subjective rather than quantitative and are focused on the long-term survival of the
firm. In contrast to strategic risk management, the decision to use derivatives for risk manage-
ment is quick, economical, reversible, and a short-term measure providing protection from
temporary uncertainties. Hedging with derivatives can be done at very nominal costs and can
be lifted when the risk scenario seems to be within the acceptable levels. The time horizon of
managing risk through derivatives, in most cases, is confined to a few days, weeks, or months.

DERIVATIVE PRODUCTS
Forwards are the oldest form of derivative contracts. Several financial innovations have taken

The field of derivatives place, especially during and5 after the 1970s, and a host of derivative products
is full of innovations with have come into existence since then. Innovations continue unabated, making
avastrange of standard products more and more complex and difficult to comprehend. The growth,
as well as tailor-made both in terms of innovations and the volume of trading in derivatives, has
products, which serve a been enormous. Innovations in the derivatives markets have made financial
variety of needs.
instruments so complex that understanding them requires special aptitude
and knowledge. Without a reasonable background in mathematics and statis-
tics, it is difficult to interpret some of the instruments and their pricing mechanisms, although
the applications remain simple enough to attract a large number of investors of all kinds.
The prolific growth in derivatives trading has also occurred due to the vast number of
business applications that the investors and academicians have devised. These applications
cover a wide array of situations, ranging from speculation and hedging to profiting from
mispricing. Due to a wide variety of applications, the interest of investors is ever increasing.
Forwards, futures, options, and swaps are some basic derivative products. There are some
complex variants of these as well, such as options on futures, swaptions, and so on. Each of
these products has been discussed in chapters specifically devoted to them. Besides, we also
have some strange derivatives on underlying assets such as temperature, rainfall, etc.

There is a wide range of instruments available as derivatives. Each of the instruments is dif-
ferent in some respect or the other, conceptually, operationally, or applica-
Four broad types of _ tion-wise. Derivative products are continuously evolving and can be
derivatives are forwards, categorized in various ways. We describe three ways of classifying deriva-
futures, options, and tives based on product features, underlying assets, and manner of trading.
- These classifications are briefly discussed here.

Classification Based on Product

There are mainly four basic products—forwards, futures, options, and swaps.
Forwards Forwards are contracts where the buyer and the seller agree to exchange the asset
and its price, at a future date, but at a price fixed in advance. The underlying asset could
be a stock, a foreign currency, a commodity, an interest rate, or any other. The buyer of the
forward contract is called the ‘long’ and the seller of forward contract is called the ‘short’.
10 Derivatives and Risk Management

Both the parties mutually decide the forward contract’s terms and conditions, such as when
and where the delivery will take place, and the quantity and quality of the underlying asset.
Due to these features, forward contacts are known as customized private contracts. In forward
contracts, each party is subject to default risk, that is, the party with a loss on the contract
can possibly default as there is no guarantee against loss.
Futures A futures contract is an extension of the forward contract. It has the same concept
and pricing mechanism, but some additional characteristics clearly differentiate it from a
forward contract. Unlike forward contracts, futures are traded on an exchange. A futures
contract can also be defined as an exchange-traded forward contract. The features of futures
contracts are standardized in terms of quantity, delivery dates, delivery places, quality of
the product, etc., which facilitate exchange-based trading, unlike forward contracts. These
features and differences will be discussed in later chapters.
Options Options are contracts for delivery in future, like forwards and futures, except that
one of the two parties involved holds the option to withdraw from the contract, while the
other party is obligated to perform at the behest of the first party. An option is a right without
an obligation to buy or sell an asset at a predetermined price within a specified time interval.
The option that gives the right to buy is known as a call option; an option that gives right to
sell is known as a put option.
Swaps Swaps are agreements between two parties to exchange a set of future cash flows
according to a predetermined method. For example, one party may pay a fixed rate of inter-
est in exchange for receiving a variable rate of interest on a notional principal amount for
specified intervals of time.
More complex derivatives involve combination of these products such as forward swap,
swap options, options on futures, etc.

Classification Based on Underlying Asset

Derivatives can also be classified on the basis ofthe vast range of underlying assets on
which
they are traded. One can have derivative contracts on any asset, financial or non-financ
ial.
These assets can be physical or hypothetical. It is the compulsion of delivery of the underly-
ing assets that makes the price of derivatives linked to the spot price of the
Derivatives can be classi: asset. However, in some cases, the underlying asset can be hypothetical such
fied onthe basis of defini- : as index futures where the delivery of the underlying
asset is not possible,
eee’ | yet one can trade in them for beneficial outcome.
and trading mechanism, 1 e re Rin
_ e a ;
Derivatives can be classified on the basis of the underlying asset, as follows:
Commodities The commodities on which derivative contracts exist are the following:
e Agricultural products such as rice, wheat, cotton, oils, soya, tea,
coffee, rubber, and
pulses, etc.
¢ Metals such as copper, tin, gold, silver, and aluminium, ete.
e Energy derivatives such as crude oil, natural gas, and heating oil,
etc.
Currencies Derivatives can be based on the exchange rates of various currenci
es, such
as US dollar, Canadian dollar, euro, yen, and Mexican peso.
All the basic derivatives of
 Introduction 11

forwards, futures, options, and swaps based on exchange rates are actively traded. Currency
derivatives are extensively used by banks and corporations to mitigate foreign exchange risk.
US dollar dominates currency derivatives trade for historical reasons.

Interest Rates Derivatives can also have interest rates as the underlying asset. Interna-
tionally LIBOR (London Inter Bank Offer Rate) is the most common interest rate used in
derivative contracts. LIBOR is the interest rate at which one London bank lends dollars to
another London bank. Interest rate derivatives can also be based on instruments whose value
is dependent upon yields on treasury bills (T-bills) and treasury bonds. In India, interest rate
derivatives are best represented by MIBOR (Mumbai Inter Bank Offer Rate) which is akin
to LIBOR.

Equity Shares The most popular underlying assets of derivatives are stocks. In spite of
the forward contracts’ popularity in the past, futures and options on stocks are traded more
actively in India these days.

Indices Derivatives on various indices in the stock markets are possibly the most sought-
after products because of their ability to provide protection against market risk. Futures and
options on stock indices exist all over the world in all major stock exchanges.

Credit Credit derivative is the most stimulating innovation in the derivatives market. These
contracts are based on the credit rating or credit risk of cash flows such as instalment on loans
and other forms of receivables. Credit default swaps are the most common derivatives in this
category, where the value of the derivative is a function of default risk. Credit derivatives are
actively used by banks and financial institutions subject to default risk.

Weather Weather derivatives are the latest type of derivatives. The objective of weather
derivatives is to make natural phenomena as underlying assets, so that the vagaries of weather
can be evened out. Derivatives based on the temperature of specific locations are already
being traded abroad, while those based on rain are in the offing in India. Industries such as
agriculture, utilities, and so on, can use weather derivatives as a hedging tool, as the earnings
of such industries are subject to weather conditions.
While derivatives on commodities and weather form a separate class, the other derivatives
discussed so far are often collectively referred to as financial derivatives because the underly-
ing assets are financial instruments or products.

Classification Based on Trading

Derivatives can-also be classified based on the way they are traded. In this sense, the deriva-
tives can be of the following two types:
e Over-the-counter contracts
Exchange-traded deriva- =e Exchange-traded contracts .
tives are standardized
contracts with low trans- Over-the-Counter Contracts The contracts that are directly entered into
action costs, no counter- between two mutually consenting parties known to each other with matching
party risk, and easy entry needs are called over-the-counter (OTC) products/contracts. These contracts
and exit mechanisms.
are specific to the parties involved and are not traded in the market. These
12 Derivatives and Risk Management

market. These contracts are customized to the requirements of counterparties and are often
settled by delivery of underlying assets, though there is a possibility of exiting the obliga-
tions by entering into a subsequent contract opposite to the initial contract. The price of these
contracts is settled between the parties concerned and may remain confidential.
Forward contracts are OTC products that dominate the foreign exchange markets. Swaps
are also OTC products. The OTC products give rise to another risk called counterparty risk
concerned with the failure of one of the parties to the contract to honour the obligations
undertaken. These products also suffer from the disadvantages of finding matching parties
and skewed pricing, as the two parties may not be equally strong. This disparity will make
the exit difficult for the weaker party.
Exchange-traded Contracts The second category of derivatives, namely the exchange-
traded products, is traded on the organized exchanges where the buyer and seller need not
know each other. The exchange serves as counterparty for both the buyer and the seller.
Exchange-traded derivatives are standard products whose specifications are designed by the
exchange authorities, taking into consideration the characteristics of the underlying assets.

F054

~~@-—- Over the counter contracts

Trillions
—t— Exchange-traded contracts
604

$US

principal
Notional
trillions
in

0 + T | em as + — =: T T T t a >
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

CLL
LLL EL Le A iene

Fig. 1.2 Total notional amounts outstanding ofThdarivind cone

ae in OTC and exchange-traded
markets from end-June 1998 to June 2011
Source: BIS Quarterly Review, June 2012, www.bis.org.
 Introduction 13

Exchange-traded derivatives are practically free from counterparty risk. The transaction
cost in exchange-traded products is transparent and nominal, while in the case of OTC prod-
ucts, the transaction costs are included in pricing.
Exchange-traded products are traded continuously with prices in the public domain; this
enables investors to conveniently enter or exit derivative positions.
Futures are traded only on exchange, while options can be traded on both exchange as well
as OTC. Options on stocks and indices are mostly exchange-traded while options on foreign
exchange rates are mostly traded OTC. Swap is also an OTC product.
Size of OTC and Exchange-traded Product Markets Over-the-counter and exchange-
traded contract markets have grown immensely over the past decade. The OTC market is
bigger than that for exchange-traded contracts. The size of both the markets is best measured
by the notional principal. The notional principal represents the total amount of underlying
assets covered by a derivative contract. The OTC contract is difficult to measure as the
transactions are private and unregulated. Bank of International Settlements conducts surveys
semi-annually to provide a measure of size of derivatives market. All the data is published
in its semi-annual report. The total size of the market can also be measured by the market
value of the contracts, but market value is subject to estimation errors. Therefore, the notional
amount is considered as a more reliable measure in comparison to market value. Figure 1.2
depicts the total notional amounts outstanding of underlying assets in OTC and exchange-
traded markets from end-June 1998 to June 2011.

PARTICIPANTS IN DERIVATIVE MARKETS ©"

_ The participants in the derivative markets can be broadly classified into three
_ Participants in the , fi
derivatives markets have categories, depending upon their motives, as follows:
vee Cioran motives: © Hedgers
hedging, speculation,
and arbitrage. Each activ- e Speculators
ity has a role in efficient e Arbitrageurs
functioning of the market.
We discuss their roles and functions here.

Hedgers
Hedgers are those who enter into a derivative contract with the objective of covering risk.
A farmer growing wheat faces uncertainty about the price of his produce at the time of the
harvest. Similarly, a flour mill that requires wheat also faces uncertainty of price of input.
The farmer and the flour mill can enter into a forward contract, where the farmer agrees to
sell harvested wheat at a predetermined price to the flour mill. The farmer is apprehensive
of a price fall while the flour mill fears price rise. Both the parties face price risk. A forward
contract would eliminate price risk for both the parties. A forward contract is entered with
the objective of hedging against the price risk that is faced by the farmer as well as the flour
mill. Such participants in the derivatives markets are called hedgers. Hedgers would like to
conclude the contract with the delivery of the underlying asset. In the example, the contract
would be settled when the farmer delivers wheat to the flour mill on the agreed date at a
predetermined price. Both the farmer and the flour mill have avoided price risk.
14 Derivatives and Risk Management

Speculators
Speculators are those who enter into a derivative contract to make profit by assuming risk.
The derivative price reflects the expected price of the asset in future. Speculators have an
independent view of the future price of the underlying asset and take appropriate position in
derivatives with the intention of making profit later. For example, assume the forward price
in US dollars for a contract maturing in three months is %48.00. If the speculator believes
that the price of the US dollar would be %50 three months later, he/she would buy a US dollar
forward today and sell later in the spot market. On the contrary, if the speculator believes that
the US dollar would depreciate to ¥46.00 in three months, he/she would sell now and buy
later. Note that the intention here is not to take delivery of the underlying asset but instead
gain from the differential in price. Speculators have a different view on the price of the asset
than the one reflected in the price of the derivative.
If only hedgers were to operate in the derivatives market, the number of participants in the
market would have been extremely limited. A farmer would find it difficult to locate a flour
mill with perfectly matched and complementary requirements in terms of quantity, quality, and
timing of the delivery of the asset (wheat in this case). Similarly, a flour mill will also find it
difficult to locate a suitable farmer to supply the exact requirements. If speculators are permit-
ted to operate, the hedgers need not look for an exact match, and instead they can deal with the
middlemen who would buy the produce from the farmer in advance, anticipating a hike in wheat
price in future at the time of harvest. Such middlemen speculate on the future price and bid on
the current price in a manner that is likely to result in a profitable position for them. By entering
into a contract on the derivatives, the speculators are assuming the risk of price in future.
Speculators perform an extremely important function. They render liquidity to the market.
Without speculators in the market, not only will the hedgers face difficulties in finding suitable
Speculators facilitate L parties but also the hedge is likely to be far from being efficient. The presence
smoother and easier _ of speculators makes the markets competitive, reduces the transaction costs.
hedging through _ and expands the market size. More importantly, speculators are the ones who
increased liquidity and re- assume risk and serve the needs of hedgers who wish to avoid risk. Because
duced transaction costs, _ ©
_. ... speculators, hedgers find counterparties conveniently.

Arbitrageurs
It would seem that hedgers and speculators would complete the market, But this is just a
fallacy because we assume that markets are efficient by themselves and they operate in tan-
dem. We describe derivatives as contracts that derive their value from the underlying asset.
Structurally, the markets for derivatives and the underlying asset are separate. For example,
agricultural products would be bought and sold in the mandis, while futures on the same
products are traded at the commodity exchanges. Ideally, there should be complete harmony
between the prices in mandis and at the commodity exchanges. There cannot be any disparity
in the prices in the physical market (mandis) and the commodity exchange. The existence of
disparity in prices may give rise to arbitrage opportunities.
Arbitrageurs is the third category of participants in the derivatives market. An arbitrageur
performs the function of making the prices in different markets converge and be in tandem with
each other. While hedgers and speculators want to eliminate and assume risk, respectively, the
 Introduction 15

_ Arbitrageurs perform the _ arbitrageurs take riskless positions and yet earn profit. Arbitrageurs constantly
_ economic functions of monitor the prices of different assets in different markets and identify oppor-
_ making markets efficient tunities to make profits that emanate from mispriced assets in two markets. The
by taking riskless posi- most common example of arbitrage is the price difference that may be prevail-
_tions in different markets. _ ing in different stock markets. For example, if the share price of Hindustan
Unilever is 175 at the National Stock Exchange (NSE) and %177 at the Mum-
bai Stock Exchange (BSE), an arbitrageur would buy at NSE and sell at BSE simultaneously
and pocket the difference of %2 per share.
An arbitrageur takes a riskless position and makes profits because markets are imperfect.
Naturally, these imperfections are extremely short lived. An arbitrageur cashes upon these
short-lived opportunities. Such actions restore the balance in prices and remove distortions
in the pricing of assets.
Fundamentally, the speculators and arbitrageurs fall in the same category as long as they
are not looking at owning or disowning the underlying asset by delivery (like hedgers).
Both speculators and arbitrageurs also try to render competitiveness to the market, thereby
helping the price discovery process. The difference between the two participants lies in the
amount of risk they assume. While speculators have their opinion about the future price of
the underlying asset by making investment, the arbitrageur concentrates on the mispricing
in different markets by taking riskless positions with no investment of his/her own. By his/
her actions, an arbitrageur restores the balance and consistency among different markets,
while speculators only hope for a desirable movement in prices. Arbitrageurs also help in
prohibiting speculators from overbidding or underbidding in the derivatives as compared to
the physical markets.

EVOLUTION OF DERIVATIVES ©
The markets for derivatives have been growing at a phenomenal pace. The variety of deriva-
tives in terms of nature of products as well as underlying asset has expanded greatly. The
developments relating to commodity and financial derivatives including those on currency
are briefly discussed here.

Commodities
Derivatives emerged as hedging products out of the need to control price risk. Forward con-
tracts have been in vogue for several centuries. Earlier, commodity prices were almost the
sole concern of the business community, and, therefore, it was natural that derivatives on
commodities were the first ones to emerge. Traders were entering into firm price contracts
for future delivery to eliminate price uncertainty. Naturally, derivatives on commodities were
the first amongst all classes of derivatives.
Possibly the first organized attempt was undertaken by the Chicago Board of Trade
(CBOT). It provided the initial platform for buyers and sellers to enter into forward contracts
in1864 and overcome the credit risk in the forward contracts. These exchange-traded forward
contracts later came to be known as futures. Started with trading in pits, today CBOT oper-
ates round-the-clock and is present virtually across the globe. With the advent of information
16 Derivatives and Risk Management

technology and fast computers, CBOT has moved from an open outcry pit-based system to
an all pervasive electronic trading system since 1992.
The CBOT has been a pioneer in the development of most derivative products—both on
derivatives such as futures, options, and swaps and on vastly different asset classes such as
commodities, energy, weather, exchange rates, indices, and interest rates. Now merged with
the Chicago Mercantile Exchange (CME), it handles more than | billion contracts per year,
valued at around US $1000 trillion!.
Contrary to general notions and the fact that India is a less developed economy, the devel-
opment of derivatives in India started several decades ago. Bombay Cotton Trade Association
Ltd was set up in 1875 for futures trading in cotton. Later, in 1893, Bombay Cotton Exchange
Ltd was established for the same purpose. Several regional associations came into existence
for commodity-specific trading in futures contracts. In 1900, with the establishment of the
Gujarati Vyapari Mandali, futures trading in groundnut, castor seed, and cotton commenced.
Futures trading in wheat was also done at several places in Punjab and Uttar Pradesh. But the
most notable futures exchange for wheat was the Chamber of Commerce at Hapur, set up in
1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian Exchange Ltd
was established in 1919 for futures trading in raw jute and jute goods. But organized futures
trading in raw jute began only in 1927 with the establishment of East Indian Jute Association
Ltd. These two associations amalgamated in 1945 to form East India Jute & Hessian Ltd to
conduct organized trade in both raw jute and jute goods’.
Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards Markets Com-
mission (FMC) was established in 1953. In due course, several other exchanges were created
in the country to trade in diverse commodities such as coffee and rubber.
A major change in the commodities derivatives environment resulted after the recommen-
dations of the Kabra Committee report, preceded by three other committees, namely, Shroff,
Dantewalla, and Khusro. Since 2003, trading in futures on commodities is permitted, while
options contracts on commodities still remain out of bounds. Today, four major national level
commodity exchanges, namely, Multi-commodity Exchange (MCX), National Commodities
and Derivatives Exchange (NCDEX), National Multi-commodity Exchange (NMCE), and
National Board of Trade (NBOT), trade futures contracts on a large number of commodities.
Besides, several regional exchanges for specific commodities also continue to exist. The trad-
ing has also moved from localized centres to the national level, through electronic means.

Financial Derivatives
Financial derivatives became popular only after 1970s when there was an increasing integra-
tion of the world economy. Increased globalization caused firms to expand business beyond
their national boundaries. Besides, the competitive environment too became global, increas-
ing complexities for business and resultant uncertainties. Further, increasing deregulation of
economies and freer movement of capital across geographies caused stock prices and interest
rates to become increasingly important for investment and financing decisions. Today, finan-
cial derivatives constitute the largest segment in derivatives.

' www.cmegroup.com, accessed on 12 July 2009.

° Commodity Derivatives by NSE, pp. 24, 25.
 Introduction 17

The CBOT, now merged with CME, remains the largest exchange in the world for financial
derivatives, both in terms of volume and value of derivatives contracts. In India, derivatives
trading is mostly performed at the NSE, which is among the top 10 exchanges in the world
in terms of number of contracts traded.
Forward trading in stocks was extremely popular in India at the BSE, which was estab-
lished in 1875 and is one of the oldest stock exchanges in the world. These forward contracts
were exchange-traded but lacked the financial discipline of marking-to-market and other
risk-containment measures. Due to several reasons such as difficulties in settlements, lack
of financial discipline, dominance of a few in the trade, and lack of control and regulatory
measures, these forward transactions in shares had to be discontinued and were ultimately
replaced by other derivatives on stocks and indices (such as futures and options) in the year
2000.
The Securities Contracts (Regulation) Act (SCRA) was amended in 1999 to include
derivatives as securities, thus paving the way for their trading. In 1996, the Securities and
Exchange Board of India (SEBI) appointed a committee with Dr L.C. Gupta as chairman
to develop a regulatory framework for derivatives trading. It submitted the report in March
1998. Soon after, trading in derivatives commenced in futures and options on index and indi-
vidual securities. Index futures took off in June 2000, while options on index began a year
later in June 2001. Futures and options on individual stocks followed in July and November
2001, respectively.
The growth of trading in derivatives in India has been quite phenomenal. In a short span
of time, the turnover at NSE increased from a mere %2365 crore (US $207 million) in 2000—
2001 to a mammoth %1,57,58,592 crore (US $3.50 trillion) in 2011-2012?. It signifies a
tremendous interest in stock and index derivatives at the retail level and is reflective of the
potential that derivatives have, both as hedging and speculative instruments. It would not be
wrong to say that within a short span of time, derivatives have achieved the completeness of
a market and made significant contributions in making the financial markets more efficient.
In September 2010, NSE was rated among the top two Asia-Pacific derivatives exchanges
for recording the highest volumes oftrading in financial derivatives. Figure 1.3 shows clearly
that the trading in derivatives has grown exponentially since inception.

Currency
Currency derivatives came into existence only after 1972 when the fixed exchange rate regime
under the Bretton Woods system came to an end. Post Bretton Woods, most currencies were
floating and the volatility in the exchange rate markets started resembling that of stocks.
One of the major developments of the abandonment of Bretton Woods system of exchange
rate was the migration of the world economy from fixed to flexible exchange rates. As firms
started doing more and more business globally, the concerns for exchange rate fluctuations
increased and, hence, the need for hedging against foreign exchange rates became a necessity.
The CBOT commenced derivative trading in currencies in 1972 and today it trades in all
major currencies that are fully or partially convertible. As of 2011, it had products on 19 such
currencies.

3 Indian Securities Market—A Review, Vol. XIV 2011, National Stock Exchange.
18 Derivatives and Risk Management

25,000 4

—e— Index Futures

20,000 4 —wi— Stock Futures

—~ Index Options

15,000 4 —— Stock Options

Total

10,000 4

billions
in
contracts
of
No.

5,000 4

0 - + r aa ci +, es ae
2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13

Year
CLE LEE

Fig. 1.3 Growth in derivatives trading at NSE

There are two distinguishing features of foreign exchange derivatives markets: (a) domi-
nance of US dollar in foreign exchange transactions and (b) dominance of OTC products
rather than exchange-traded products. Foreign exchange trading in spot as well as derivatives
remains dominated by the US dollar because of its legacy (it was the anchor currency in the
fixed exchange rate system under Bretton Woods). Prior to 1973, all currencies were allowed
to denominate their values in terms of the US dollar, and hence it served as a vehicle currency
in determining most cross-currency rates even when the Bretton Woods era came to an end.
Today, free and market-based exchange rates prevail, making the forecast of exchange rates
a challenge as they are determined by local as well as global factors.
However, most foreign exchange transactions in the spot and derivatives segments remain
OTC and proportions of exchange-traded products remain negligible in comparison to the
total foreign exchange markets. Dominance of OTC products in foreign exchange is evident
from the datat shown as follows:
Average daily turnover in April 2010, in billions of US dollars
Year 2004 2007 2010
Total foreign exchange
instruments 1,934 3,324 3,981

Spot transactions 631 1,005 1,490

Exchange-traded derivatives 26 80 168

Source: http://www.bis.org/publ/rpfxft Ot.htm.

* Adapted from Triennial Central Bank Survey ofForeign Exchange and Derivatives Market Activity in 2010—Final Results,
Bank for International Settlements.
 Introduction 19

Foreign exchange derivatives showed 72% growth from 2004 to 2007 and a mere 20%
growth from 2007 to 2010.
Despite a three-fold increase in the foreign exchange derivatives from 2004 to 2007, the
futures contracts comprise less than 2% of the total foreign exchange turnover. Another inter-
esting feature of currency futures has been that futures on currencies are settled by deliveries
(99.77% during January—September 2007 at CBOT). While futures in most other underlying
assets are normally cash-settled by entering into an opposite contract, the participants seem
to overwhelmingly favour physical settlement in case of futures on currencies. Most contracts
on currencies that are not fully convertible are cash-settled due to non-convertibility of the
currencies for fear of increased volatility if settlement by delivery is permitted. However, the
proportion of futures contracts on the currencies that are not fully convertible also remains
extremely small.
Realizing the dominance of the US dollar and partial convertibility of the Indian rupee,
India commenced cash-settled futures trading in August 2008 with monthly contracts of the
rather small size of US $1000, with the aim of providing a convenient platform for trading to
retail and small exporters and importers. The objectives of such trading in currency futures
include alternative avenues for hedging currency exposures and a gradual move towards full
convertibility. After USD-INR, other currency pairs in British pound, euro, and Japanese yen
were introduced.
Following the trends in other parts of the world, the Indian market in currency derivatives
also remains dominated by OTC products rather than exchange-traded ones. The daily turn-
over in foreign exchange has increased from US $23.7 billion in March 2006 to US $33.0 in
March 2007.
In India, trading in derivatives outside the exchange is classified as illegal as per the SCRA
1956. However, the Reserve Bank of India (Amendment) Act, 2006, overrides the SCRA and
makes derivative transactions legal if one of the parties to such derivative trade transactions
happens to be a bank.

FUNCTIONS OF DERIVATIVE MARKETS ©

Derivatives perform the Derivatives were invented to fulfil the need for hedging against price risk.
important functions of They enable the transfer of risk from those wanting to avoid it to those will-
_ efficient price discovery, ing to assume it. Besides hedging, derivatives perform three other important
transfer of risk, and functions. These have led to many advantages at broader level making mar-
_eaany, ket more competitive, informative, deeper, and more efficient.

Price Discovery
First, derivatives markets increase the competitiveness of the spot market as they encour-
age more participants with varying objectives of hedging, speculation, and arbitraging. With
broadening of the market, the changes in the price of the product are observed by many,
regardless of any significant reason. Even a minor variation in price prompts action on the
part of the speculators. Active participation by a large number of buyers and sellers ensures
fair price. The derivative markets therefore facilitate price discovery of assets due to increased
participants, high volumes, and increased sensitivity of participants to react to the smallest of
20 Derivatives and Risk Management

price changes. Increased depth in the derivatives market and fast and smooth dissemination
of information among participants have made the process of price discovery more efficient.

Transfer of Risk
Hedgers could eliminate risk amongst themselves if two parties face risk from the opposite
movement of price. A wheat farmer who wants to sell his produce faces a risk from the fall
in price while the flour mill trying to buy wheat is worried about the rise in price. Since risk
arises from opposite directions of price movement, the convergence of the needs of the two
parties is possible. If both the farmer and the flour mill want to hedge against price rise, the
needs of two would not meet. When speculators enter the market, they discharge an impor-
tant function and help transfer of risk from those wanting to eliminate to those willing to
assume risk.

Leveraging
Taking a position in derivatives involves only a fractional outlay of capital when compared
with the position in the underlying asset in the spot market. Suppose a speculator is con-
vinced that the price of wheat will be 716 per kg in six months and a farmer agrees to sell
at $15.50 per kg. To take advantage, the speculator will have to pay the full price of 715.50
now and realize 16.00 six months later. Instead, if a mechanism is available by which he/she
can absolve himself of making the full payment, he/she will be glad to enter into a contract
and perhaps take a much larger position. Derivatives provide such an exit route by letting the
speculator first enter into a contract and then permitting him/her to neutralize his/her position
by booking an opposite contract at a later date. This magnifies the profit manifold with the
same resource base. This also helps build volumes of trade, thus helping the price discovery
process further.

CONSEQUENCES OF DERIVATIVE MARKETS |

Efficient price discovery, ability to transfer risk and property of leverage have rendered many
benefits. Some of them are descended as follows.
Efficient Portfolio Management The functions of leveraging and transfer of risk help in
efficient portfolio management. With smaller funds at one’s disposal, better diversification
can be achieved with allocation of part of the fund to derivative assets. Derivatives provide
a much wider menu to portfolio managers who constantly seek better risk—return trade-off.
The range of choices would be far more restricted in the absence of derivatives.

Lower Transaction Costs and Prompt Information Dissemination Since a very large
number of participants become active in the market (due to leveraging), the transaction costs
become relatively low in derivatives markets. Derivatives provide various tools of managing
risk; they are used as a form of insurance. No one will be interested in buying insurance if
the costs are too high relative to the value of the asset. In this sense, derivatives may become
a better substitute as they have low transaction costs. Shrinking transaction cost, reflected
 Introduction 21

in the spread of sell and buy prices, is a sure sign of free market economy and, therefore,
efficient allocation of resources. Faster and efficient dissemination of information also helps
in removing price disparities across geographies.

Smoothening Seasonal Variations Derivatives can be extremely useful in smoothening

out the seasonal variations in the prices of the underlying assets. Hoarding is viewed as
social stigma. Hoarding used for speculative purposes requires scanty trading with large
price variation among financially powerful persons acting in concert. Derivatives can help
curb hoarding by continuous trading and increasing participation as it requires little capital
outlay, leaving the field open to large number of participants, thus reducing the financial
muscle power of the few engaged in hoarding.

MISUSES AND CRITICISM OF DERIVATIVES ©

Derivatives act like a double-edged sword. When used properly and conservatively, they are
highly effective but when used with indiscretion, they are capable of causing miseries of
- unimaginable proportions. Some of the disasters due to derivatives are dis-
:
Derivatives are often said _ cussed in ; eat
the last chapter. Unfortunately, there is no pragmatic way to distin-
to be causing increased i ; : Apes : Mer :
volatility in the prices guish discretion and indiscretion. Derivatives are misunderstood as a form of
leading to numerous legalized gambling. There is a very fine line that separates calculated risk and
bankruptcies; hence, the | gambling. Derivatives often extend benefits across the society by making
need for close regulation = financial markets function in a more organized way. However, gambling
and monitoring.g . ; ; ; ‘ its
involves social costs. The following are often cited as demerits of derivatives:

Increased Volatility
Since derivatives offer extremely leveraged positions, a large number of participants are
attracted towards the market with the nominal capital available to them. Giving rise to specu-
lative tendencies, derivative markets are often blamed for causing extreme volatilities in the
prices, which are also seen in the spot markets. However, it remains to be seen whether such
volatility in the prices would be absent in the spot markets if derivatives did not exist.
There are several instances in India, especially in commodities, where the trading in deriv-
atives has been banned. The reason cited for the ban is often the wide and unexplainable
divergence between the prices in the spot market (for the underlying asset) and derivatives
market. In such circumstances, it is often propagated that it is the derivatives markets that
influence the prices in the spot market. The notion that the derivatives markets can influence
the price in the physical markets is at best misplaced and lacks conviction. In fact, trading
in derivatives should be seen as a precursor to what may happen in the spot market. With a
highly leveraged position, it is natural that the volatility in prices would be more than in the
spot market, but it would be wrong to state that volatility in derivatives will get transferred
to the physical markets due to provisions for delivery-based settlements. In fact, volatility in
markets is inherently caused by the mismatch of more fundamental factors governing demand
and supply. Derivatives serve a social cause to provide an advance indication about the events
that are likely to unfold in the future.
 22 ~~ Derivatives and Risk Management

Increased Bankruptcies
Inherent leverage in derivatives may easily cause bankruptcies when one assumes a position
in derivatives that is totally out of sync with the financial position. Since positions in the
financial markets are taken sequentially, one default may trigger a chain of defaults and can
cause market failure. Such risk is termed as systemic risk and very often has been cited as the
reason for bail-out involving huge public funds to rescue some organizations who engaged
in misadventure.

Burden of Increased Regulation

With increasing derivative activity, it is opined that there in an increasing need for regulation
to check misuses. Since derivatives allow accumulation of large positions with little capital,
the disclosure of identities and positions taken is imperative. Most derivative transactions
escape accounting and make audit difficult. In addition, there is a need to discourage overly
speculative positions to prevent bankruptcies and a chain of defaults. Disclosure require-
ments and the need to control has placed onerous responsibilities on the monitoring and
regulating agencies. Such requirements and control mechanisms are often disliked by some
of the participants in the market because they are seen as impediments in the development
of free markets.
The failure of some financial leaders in the United States of America in 2008 and 2009 and
several other disasters (discussed in Chapter 25), due to excessive and innovative derivative
positions by some investment and commercial banks, has emphasized the need for govern-
ment intervention. It may be noted that the positions of these financial institutions was in
OTC derivatives that did not warrant any disclosures in financial statements. These positions
surfaced only when they assumed disastrous proportions. The actions of governments to bail-
out these institutions are criticized for extreme burden on society as they are essentially seen
as “privatizing profit and socializing losses’.

SUMMARY seitecaxnen
Risk is all pervasive: no one can escape it. However, risk can the offsetting of gains and losses. This renders stability to price
be managed. From the perspective of management, risk can be and achieves the objective of hedging.
classified as (a) small losses with high probability of occurrence Hedging with derivatives is different from managing risk
and (b) large losses with low probability of occurrence. Business through diversification. While diversification eliminates unsys-
risk predominantly emanates from changes in price, exchange tematic risk, derivatives would deal with systematic risk. Price
fates, and interest rates. protection with derivatives is also different from insurance. Insur-
Derivatives are defined as instruments that derive their value ance covers event risk while derivatives hedge against changes
from some other asset called the underlying asset. They serve in the price of the assets.
the purpose of managing the risks involving small losses with high Hedging with derivatives is a tactical decision that is economi-
probability rather than risks having potentially large. losses. with cal, reversible, and quick in contrast to strategic risk management,
small probability. The business environment is full of risks involv- which is focused on long-term survival and growth, involving large
ing small losses with relatively large probabilities. outlays, substantial time, and irreversible changes.
The basic principle of hedging with derivatives involves taking Basic derivatives are forward contracts, futures, options,
opposite positions in the spot and derivatives markets. Since and swap, though there can be large number of variants and
the prices in the derivatives market are dependent upon those combinations available. They are available on various assets
in the spot market, opposite positions in the two wouldsresult in called underlying assets. They include commodities, curren-
 Introduction 23

- cies, stocks, interest rates, indices, and weather. Some of these profit. This causes the imbalance in the markets, if any, to vanish.
assets are physical and deliverable but some are hypothetical Derivatives perform several economic functions such as
and are not deliverable (such as indices, interest rates, and “enabling price discovery, facilitating transfer of risk, and provid-
weather). Derivatives can be traded on an exchange like shares ing leverage. These further enable efficient portfolio manage-
(called exchange-traded derivatives) or negotiated across the ment, asset allocation, and faster and efficient dissemination of
table between the parties (called OTC derivatives). information, removing imperfections in the markets.
There are three different participants in the derivatives mar- One of the criticisms of derivatives is that they encourage
ket—hedgers, speculators, and arbitrageurs. Hedgers are those excessive speculation leading to excessive volatility. Further,
who would like to eliminate risk while speculators are those who this volatility causes volatility in the prices of the underlying asset
like to assume risk for earning a reward. Speculators facilitate in the physical markets. Leveraging also leads to increased
hedging. Arbitrageurs perform the balancing function by ensuring bankruptcies, warranting increased need for monitoring and
that the prices in different markets and for different instruments regulation.
are not out of line. They take positions that enable them to make -

Arbitrageurs Arbitrageurs assume riskless positions with no Over-the-counter product When a contract is directly entered
net investment in different markets and instruments, so as to into between two mutually consenting parties known to each
make a profit due to mispricing in different markets. other with matching needs, it is called an OTC product.
Exchange rate risk Risk emanating from changes in the for- Price risk Business loss resulting from change in the prices
eign exchange markets. of inputs and outputs.
Forwards Forwards are contracts where both buyer and seller Risk It is a variance of the actual result from the expected.
agree to exchange the asset and its price at a future date, but at Risk diversification It is a risk reduction strategy by taking
a price fixed in advance. positions in several alternative markets and instruments.
Futures Forward contracts traded on exchanges. Risk transfer Risk transfer refers to the passing of risk from
Hedgers Those who enter into a derivatives contract with the those unwilling to take it to those willing to assume it.
objective of covering risk. Speculators Those who enter into a derivatives contract to
Interest rate risk Risk emanating from changes in the inter- make profit by assuming risk.
est rate. Swaps These are agreements between two parties to
Options It is a right without an obligation to buy or sell an exchange a set of cash flows according to a predetermined
asset at a predetermined price within a specified time interval. method.

QUESTIONS weexm=comene

1.1 What do you understand by risk and what are the different 1.6 Define four different types of derivative products.
ways of classifying and managing them? 1.7 What are the differences between exchange-traded and
1.2 What are the various kinds of business risks? OTC derivatives?
1.3 What is a derivative? Define. 1.8 What are the different underlying assets on which deriva-
1.4 How is risk managed with diversification and derivatives? tives exist?
1.5 What are the advantages of risk management with deriva- 1.9 What are the functions of derivatives? What are their disad-
tives in contrast to strategic risk management? vantages?
INTRODUCTION
Learning Objectives
As described in Chapter 1, derivatives are contracts that derive After going through this chapter,
their value from the price of an underlying asset. The underlying readers should be familiar with
asset can be commodities (wheat, rice, silver, tin, etc.), financial forward contracts and their
products (stocks, currencies, etc.), or hypothetical assets (inter- operational mechanism
est rates, indices, etc.) features of forward contracts and
their settlement
For example, one may agree to sell foreign currency (say
futures contracts and their benefits
US $1000) three months later with the price decided today (say over forward contracts
at ¥48/$). Clearly, the other party would agree to buy US $1000 e the concept of counterparty risk
at ¥48/$ three months later. Such a contract between the buyer the specifications of a futures
and the seller of US dollars would be a forward contract. Under contract
a forward contract, the price of the underlying asset, foreign the difference between ope n
interest and volume
currency in this case, is fixed beforehand.
margins and marking-to-market
Forwards and futures are the most common forms of deriva- °
the pricing of forward or futures
tives. These are contracts that specify the price of an asset today, contracts
but are settled at a later date. The extinguishment of obligations °
the principle of convergence
undertaken at the time of initiating the contract is referred to s cash-and-carry and reverse cash-
and-carry arbitrage
as settlement. How do we determine the price of an asset that
the relationship of the futures price
is to be delivered at a later date? Naturally, this price would be
with the interest rate and th e future
dependent upon the price of the asset that is prevailing today, spot rate
called the spot price for the underlying asset. Hence, a forward
or a futures contract derives its price inter alia from the price of
the underlying asset prevailing today (spot price). The value of
a derivative fluctuates, as does the value of the underlying asset
in the spot market. The underlying asset can be a commodity,
metal, stock, currency, bond, index, T-bills, a reference interest
rate, or any other real or hypothetical asset.
We shall now discuss the concept and distinguishing features
of a forward contract and a futures contract.
 Forwards and Futures 25

FORWARD CONTRACT
Forward contracts are all pervasive. Knowingly or unknowingly, we all enter into forward
contracts. In most cases, we acquire assets and pay the consideration for the
A forward contract is _ same simultaneously. All transactions of cash are made on the spot. However,
an agreement to buy or in some cases, we book a purchase in advance and execute the delivery and
sell an asset at a price payment of its consideration at a later point of time. Booking a movie ticket
determined today, with
settlement scheduled for
over the phone is an example. It is a sort of forward contract, because we
a later, predetermined buy the ticket now (though there is no formal written contract) and pay its
date. price only after reaching the cinema hall. Similarly, most automobiles are
booked with a token advance, and the full price is paid only upon physical
delivery of the vehicles. This, too, is like a forward contract, where an asset and its purchase
consideration are exchanged at a later date.
A typical forward contract that extends for a considerable time is a rental agreement for a
house/flat, where a fixed amount of rent is determined for a specific period of time, usually a
year. The fixed amount of rent the tenant pays the landlord every month is determined today.
The essence of the forward contract lies in the fixing of the price in advance, while the asset
and its consideration are settled at a later date.
Besides unconscious agreements that resemble forward contracts, here are a few examples
of forward contracts that are consciously entered into by firms and individuals in business
situations:
e An exporter expecting to receive €10,000 after six months may agree to sell the same
to a bank at the exchange rate of %66/€ that is decided today, with the foreign exchange
to be delivered only after six months.
e In November, a farmer may agree to sell 20 tons of wheat at a price of %20 per kg toa
rolling mill. The wheat is to be delivered at €20/kg in April.
e A stock market investor may want to sell 10,000 shares of Reliance Industries Ltd today,
to be delivered two weeks later at a price of $2500 per share that is negotiated today.
Here, the forward prices of the assets, i.e., ¥66/€, %20/kg of wheat, or ¥2500 per share of
Reliance, respectively, in the three examples, are fixed now and derived on the basis of the
prices prevailing for these assets in the spot foreign exchange (euro), commodity (wheat),
and stock (Reliance) markets.

Motive for Forward Contract

One might reasonably ask what the need is for entering into a contract that decides the price
in advance. The necessity for entering into a forward contract for both buyer and seller arises
from both parties’ need to eliminate price risks. For example, PepsiCo, producer of potato
chips, may enter into a contract with potato-growing farmers to deliver their harvests later,
at a price determined today. By entering into a forward contract, both PepsiCo and the farm-
ers are assured of the transaction prices, i.e., the farmers know what price their crop would
fetch, and PepsiCo knows what it would have to pay to get the required potatoes. Therefore,
PepsiCo is able to plan profits better. Without the forward contract, both PepsiCo and the
26 Derivatives and Risk Management

farmers would have to wait till the harvest time to know the price that would prevail then,
which exposes both the parties to price risk. Forward contract would eliminate such price
risk.

Features of Forward Contract

The forward contracts mentioned earlier have the distinguishing features described as
follows:
(a) Two parties Like any contract, a forward contract too involves a minimum of two
parties, a buyer and a seller of the asset. In the nomenclature of derivatives, the buyer of
the contract is referred to as having taken a Jong position, while the seller is referred to
as having taken a short position.
(b) Over-the-counter product In an over-the-counter (OTC) product, all the relevant
aspects of the contract such as the asset, its quantity and quality, the price, and the
delivery date and venue are fixed on a one-to-one basis, customized to the needs of the
parties involved. The buyer and the seller are in direct touch with each other, although
the existence of brokers 1s not ruled out.
(c) Price is determined today The price at which the exchange of the asset will be done
is negotiated in advance and is called the forward price. Both the buyer and the seller
attempt to avoid price risk by locking-in a price today, thus rendering irrelevant the price
that will prevail at the time of maturity of the contract.
(d — Mutual obligation to perform On the due date of the contract, the seller makes the
delivery of the asset and the buyer pays the price. There is a mutual obligation to per-
form on both buyer and seller. The seller is committed to make delivery, and the buyer
is obligated to pay the consideration, on the due date.
(e) Counterparty risk Both the buyer and the seller who are parties to the contract assume
risk, referred to as counterparty risk. The seller may fail to deliver the asset, and the
buyer may fail to make the payment on the agreed date. When entering into a forward
contract, both the contracting parties are aware of the possibility of default by the other
party, and take adequate precautions to prevent such default. It is worthwhile to mention
here that upon maturity of the forward contract, only one party would be in an advanta-
geous position. The party in the losing situation is more likely to default.
(f) Mutual consent for cancellation Once a forward contract is booked, both parties are
obliged to perform. Cancellation can only be done through mutual consent at any time
prior to the maturity of the contract. The feasibility and the terms and conditions of
cancellation too may be decided in advance.
(g) No upfront payment No exchange of money is made at the time of execution of the
forward contract, though either party can insist on an initial deposit, adjustable against
price or delivery, to mitigate counterparty risk.
It may be noted that these features of the forward contract are neither essential nor exhaus-
tive. As a forward contract is an OTC product, the buyer and seller are free to modify it to suit
their specific needs. Some of the features described here may be missing from the contract,
while some features not described here may be included. However, the essence of a forward
contract lies in fixing the price today for settlement at a later date.
 Forwards and Futures 27

Settlement of Forward Contracts

Settlement refers to the extinguishment of the obligations created under a forward contract.
A forward contract is Nor- _ On the due date of the‘ forward contract, i.e., upon maturity, there are two
_ mally settled by delivery possible ways of settling these obligations:
_of the asset, though it
_is possible to annul the By Delivery of the Asset and the Consideration For example, if an
contract by entering into exporter had sold €10,000 to a bank 6-m forward at, say, t66/€, then at
~ acontract opposite to the maturity, the contract would be settled by delivery of €10,000 by the exporter
original. _ to the bank, who would pay the exporter %6,60,000.

By Entering into an Offsetting Contract Opposite to the Original Contract at Maturity

or Earlier, at a Price Prevailing then For example, the exporter, having sold €10,000
6-m forward at a price of 66 per euro, may, after three months, decide to buy €10,000 3-m
forward at %67 per euro. Of course, this is subject to acceptance by the bank.
Settlement by delivery is depicted in Fig. 2.1, where upon maturity of the contract period,
the buyer and the seller discharge their mutual obligations.
Settlement by cancellation is done by entering into a new contract that reverses the initial
contract. The buyer in the initial contract can sell the asset at a new price P’ at any time prior
to maturity, or upon maturity, to another party or the original seller. Similarly, the seller in
the initial contract can buy the asset from any party prior to, or upon maturity, at a new price.
However, the obligations entered into in the first contract would still have to be discharged
upon maturity. By mutual adjustment, the exchange then reduces to the differential of the
prices in the original and the offsetting contracts. This is depicted in Fig. 2.2.
Settlement by cancellation may not be feasible for several reasons. Applicable law may
make delivery essential, or in case the underlying asset is not tradable, cancellation may
become almost impossible.
Forward contracts are very common in foreign exchange markets. Exporters expecting to
receive money in foreign currency can sell it forward, while importers can buy foreign cur-
rency forward to meet future liabilities. Banks offer forward contracts on various currencies
to importers and exporters. Banks also offer facilities for cancellation prior to maturity.

Att=0 Att=T
Initiating forward contract Settlement of contract

Buyer B buys asset forward at price P > Buyer. 8

!
Seller S sells asset forward at price P a aaa ioe Seller S

SS
pees LE EEE

Fig. 24 ‘Settlement of forward contract by delivery

28 Derivatives and Risk Management

Att=0 Att=T Att= 7

Initiating forward contract B offsets contract Settlement
Buyer B’ buys asset
forward at P’ with Buyer B’
maturity at T

Buyer B buys asset

forward at price P Buyer B: Gain (P—P)

i
obligations

Seller S sells asset

forward at price P Seller S

Fig. 2.2 Settlement of forward contract by cancellation

The futures contract is a relatively newer instrument than the forward contract, and is the next
generation of derivatives. A futures contract is a modified version of a forward contract with
the same fundamentals, i.e., promising settlement on expiry at a price fixed now. Operation-
ally, however, there are substantial differences between forward and futures contracts.

Counterparty Risk
Futures contracts came into existence to overcome the problems associated with forward
contracts. In a forward contract, there is a very strong possibility that at least one of the par-
ties will default in fulfilling its commitment to the other party, depending upon the price
scenario for the underlying asset at the time of settlement. Consider an exporter booking a
6-m forward contract to sell $10,000 at, say, 45 per dollar. As per the contract, the exporter
stands committed six months later, to deliver $10,000 and receive a predetermined amount
of %4,50,000. If the dollar appreciates to, say, 47 by the time the contract matures, the
exporter will be strongly inclined to back out from the contract, as he/she can now get
%4,70,000 for his/her dollars by selling them in the market. The exporter
Forward contracts are would look for all possible excuses not to honour the commitment made in
;
subject to high defautt +‘ the forward contract. On the contrary, if the dollar depreciates to %43, the
risk, as the price scenario exporter would be too pleased to offer his/her receivable, while the buying
at maturity can favour _ party would hesitate to execute the contract. Therefore, the risk of default is
only one party. Futures, : very high, since the price scenario at the time of settlement would favour
being exchange-traded,
_ only one party to the contract. Only when the spot price at maturity happens
nullify default risk.
to be identical to the forward price would the two parties stay indifferent. The
 Forwards and Futures 29

chances that the spot rate would turn out to be identical to the forward contract price are
remote.
One way of eliminating counterparty risk is to involve another party in the transaction as
the intervening party to guarantee settlement. The forward contract is executed on a one-to-
one basis and the two parties assume the counterparty risk. It is not hard to realize that one
default may trigger a chain reaction, resulting in the collapse of the whole market.
This raises the issue of credibility of the parties involved in a forward contract. Unless both
the parties are convinced of each other’s credibility, the forward contract will not fructify. This
kind of failure will seriously limit the volumes of trade in the forward markets. When volumes
are inadequate, prices cannot be said to be driven competitively. As a solution, the two par-
ties in a forward contract could involve a third party to assure performance of the contract.
However, locating a third party acceptable to both buyer and seller is.another onerous task.

Futures Exchange, an Intermediary

The issue of counterparty risk can be solved if the transaction is done at an exchange that
__ serves as counterparty to both buyer and seller. Rather than conducting busi-
Futures contracts have : ;
io be standardized # _ ness on a one-to-one basis, they route their business through the exchange.
they are tobe exchange. | Both buyer and seller become liable to the exchange, which in turn makes
traded and meets commitments to both parties. In case of default by one party, the
exchange meets its commitment from alternate sources. To protect itself, the
exchange can develop suitable risk containment measures. With the exchange serving as
guarantor to both buyer and seller, contract performance is assured, as depicted in Fig. 2.3.
This also eliminates the need for the parties to establish credibility with each other before
undertaking a forward deal.

Ce CMLL LLL MOO LOLOL EOS LLL LED LEI ES SEMEN ETT LENDS SELEY PLIEE EEE

Fig. es 3 Role of clearing house

The role of the guarantor, to ensure a default-free execution, can be performed by an orga-
nized body, i.e., an exchange. Rather than settling the transaction, both the buyer and seller
can make good on their promises to an exchange, obviating the need for the buyer and seller
to know each other. Futures exchange is similar to stock exchanges where shares are traded.

Standardized Contract/Product
However, if the trade has to take place on an exchange, the product cannot be tailor-made
to the specific needs of the two parties, and, instead, would have to be standardized. The
30 Derivatives and Risk Management

The standardization of
exchange cannot commit itself: to any quantity, a ee
quality, and timing of the
futures is in terms of size, asset as per the specific requirements of individual buyers and sellers. If
quality, delivery time, _ the exchange has to serve as counterparty, it has to deal in standardized
delivery centres, and ?P products in terms of asset q quantity,y, q quality, and delivery timing and centres.
price quotation. _ For example, the exchange may find it difficult to comply with contracts
involving an exporter selling $10,254 forward for delivery on 26 December
and another selling $11,999 for delivery on 29 December. Instead, it will be easier for the
exchange to deal in standard contracts of, say, $10,000 for one particular delivery date in the
month of December. Therefore, individual buyers and sellers would have to adjust their own
requirements and decide on the best possible course of action offered by the menu of standard
products available on an exchange.
The introduction of exchanges to facilitate transactions has other advantages, too. While
_ most forward contracts are settled with delivery, forward markets would limit
ee : participation to actual users. Speculators and arbitrageurs not interested in
forward contracts are (a) actual delivery of the underlying assets may desist from participation in for-
the elimination of coun- += ward markets. Since exchanges would provide an alternative route for exiting
terparty risk, (b) flexibility contracts through an offsetting contract, futures would invite participation by
of entry and exit anytime,
_ speculators and arbitrageurs, thereby increasing size and liquidity in the mar-
at cS | ket. This, in turn, would enable better price discovery.

Specification of a Futures Contract

Thus, the need to eliminate counterparty risk causes intervention by an exchange, which
in turn forces standardization of the contracts that can be traded. A futures contract may
be defined as a standardized forward contract that is traded on an exchange, where a seller
agrees to deliver a specified quantity of an asset of defined quality at a predetermined date
at a price contracted in advance with the buyer.
Each exchange lays down contract specifications in great detail, to ensure complete and
_ unambiguous understanding of the product being dealt in and to prevent
Specifications of futures
; _ conflicts. It is not necessary that two exchanges dealing in futures in the same
contracts are determined = : ° :
by the exchanges where kind of underlying assets should have the same specifications. However, they
they are traded, andmay | Can attempt to have common specifications.
vary fromexchangeto = Standardization of the contract pertains to the asset, size, time, place and pro-
exchange. _ cedure of delivery, quality of underlying asset, price adjustment for variations
ve
NLM
~ in quality of the asset being delivered, ete. It is the prerogative of the exchange
to determine the specifications of the futures contract. Details of futures contracts on gold, as
traded on the National Multi-commodity Exchange of India (NMCEB), are presented in Table 2.1.
Explained here are a few of the terms used in futures contracts:
(a) Underlying asset Futures, being derivatives, are priced according to the assets on which
they are written. Contracts are normally specified by the name of the underlying asset,
and the month and year of the expiry of the contract. For example, a futures contract in
rice at Multi-commodity Exchange (MCX) will be denoted as RICE DEC12, implying
that the underlying asset is rice and the contract is due for delivery in December 2012.
(b) Contract expiry Contract expiry refers to the time at which the contract comes
to
an end. Mutual obligations must be settled on or before the expiry of the contract. The
 Forwards and Futures 31

Table 2.1 Futures contract on gold at NMCE

Asset code GOLD

Unit of trading 100 g of fineness 0.999
Delivery unit Gold bars of 100 g serially numbered and of fineness 0.999
Quotation/base value 10 g of fineness 0.999
|
Tick size ca
Quality specification The gold delivered under the contract must be bars weighing 100 g each and
assaying not less than 0.999 fineness, bearing a serial number, and identifying
the origin of the refiner/brander.
No. of delivery contracts ina Maximum 12 monthly or minimum 2 monthly contracts running concurrently
year
Delivery centres Central Warehousing Corporation, Cochin
Opening of contracts | Trading in any contract month will open on the 16th day of the month, 12
| months prior to the contract month
Due date The 15th day of the delivery months; if the 15th happens to be a holiday, then
the previous working day
Closing of contract Squaring up of positions will be permitted between the 12th and 15th of the
delivery month. No fresh position building will be allowed. From the 12th to the
15th of the delivery month, the seller can tender warehouse receipt for settle-
| ment, which will be accepted at the closing price of the previous day.
Delivery Logic Compulsory deli

ource: Www.nmce.com; last accessed on 18 May 2012.

exchange specifies when the contracts for delivery in a particular month will come into
force and when they will close for trading. For example, gold contracts will open for
trading 12 months prior to the delivery month. The opening date and last day of trading
will be specified by the exchange. Unlike a forward contract, where delivery is in accor-
dance with the contract between two parties, the delivery date is fixed by the exchange
in a futures contract.
This has important implications in terms of the period for which hedging can be done
or a speculative position can be taken. For example, in the case of gold, at any point of
time there are 12 contracts available corresponding to the next 12 months, implying that
hedging is possible for the next 12 months.
(c) Contract size Contract size or trading unit refers to the standard contract size that will
be traded on-the exchange. Each futures contract for gold on the NMCE is for 100 g.

Price quotation The quotation is the basis on which the contract price, i.e., the value of the
futures contract, is set. The price quotation for the product generally follows the convention
of price quotations in the spot/physical markets. For example, the price quotation for a futures
contract on rice is in terms of rupees per quintal. Hence, a quotation for $550 would mean
~550 per quintal, and the contract value would be %55,000 (the value of 10 MT). Similarly,
for contracts in gold, the price is quoted for 10 g (as in the spot market), while the contract
size 1s 100 g at the NMCE. Similarly, futures on oil would be quoted on a per barrel basis, a
practice followed in the spot market for oil.
32 Derivatives and Risk Management

price quotation.
Tick size Tick size is the minimum change that will be recognized in the
is not possible. The tick size
For rice contracts, it is 1. Hence, a price quotation of $551.50
will be 100
for the contract (the minimum by which the value of the contract changes)
(1 per quintal over 10 MT).
Figure 2.4 depicts the futures prices of select commodities at National Commodities and
Derivatives Exchange (NCDEX) in India, with expiry dates of contracts on commodities,
opens, highs/lows, and last traded prices, and compares them with spot prices. It also pro-
vides open interest figures.

Productame , ExpBt , Open, High, Low, Close, LIP, Cho, (h)Chg , SpotP. , 2. LY

18 Way 2612 | 4370 y 1387 | 1412 i) 2.24 142055 |2

Se:

20 Jun 2012 | 4443 137 4255 | WMH

wag [147354| 245 son
45 vans | 780
wis |ts4| 2 49
sos |345— | 37 | 188 | res | 2590 | §
asa | 45 | 143 | 30168 |2570 | F

astor Seed aus | aug [sas | ss | 18 ]

pat _ a #85 4193 sar | atsets | otto | f

20jui20r2 | 4320 |445 |4277 |4342 1a | atsass |oreo | §

inodex.com; last accessed on 18May 2012.
Fig. 2.4 Futures prices

Settlement and Delivery

Forward contracts are either settled by delivery or by closing out of the position at the expiry
with an opposite contract (with the consent of the counterparty). Settlement of futures con-
tracts can be done in three possible ways:
e Offsetting By entering into an offsetting contract prior to the expiry of the futures
contract
e Delivery based By opting for delivery of the underlying asset
e Close-out By close-out at expiry of the futures contract at a price determined by the
exchange

The first option of settlement, by entering into an offsetting contract, is an effective way of
hedging, due to convergence of the futures price with the spot price. Entering into an offset-
ting contract (sell if bought earlier, or buy if sold earlier) nullifies the delivery requirements
of the underlying asset. What remains to be settled is the price difference between the initial
and offsetting contracts. Offsetting is also called squaring up of the position. This is by far
the most preferred option for speculators and hedgers alike.
The second option to reach settlement is by making delivery. At the NMCE, contracts are
delivered during the last three days prior to the expiry date. No one is allowed to enter any
 Forwards and Futures 33

Exchange looks over the commodities to be delivered from the open positions of members

Five days prior

to the end of Open short position Open long position
the contract sellers buyers
month

Exchange gives notice of delivery with

details of lots to be delivered

Matching of open
positions between
buyers and sellers

On T+3 Seller has to tender warehouse

B has to keep th d
day receipt to the exchange
rats la NQLAeIg 25

Pay-in
Pay-out
Position transfer takes
place

On delivery After completion of pay-in and pay-out process, warehouse receipts received
day from the seller are sent to the buyer

Source: www.ncdex.com; last accessed on 18 May 2012.

Fig. 2.5 Settlement by delivery

fresh position in contracts that is about to expire in three days. Figure 2.5 shows the various
steps involved in settlement of contracts by delivery.
The third option is settlement by close-out. This option is resorted to by the exchange upon
expiry of open futures contracts that are not squared up by the investor, if the exchange rules
clearly state that futures contracts are necessarily cash-settled. The necessity for cash settle-
ments arises in the case of futures contracts based on (a) hypothetical assets such as those
on indices or (b) assets that are not permitted to be delivered due to laws of the land, such
as futures on foreign currency in India. The contract specifies whether an exchange would
resort to a close-out or not.
Settlement mechanisms in the futures markets essentially must provide for delivery, to
maintain efficient price discovery and strong linkages between the spot and futures markets.
Absence of settlement by delivery may give rise to a doubt that futures prices
‘There are three ways to _ are not driven by spot market. A healthy and vibrant spot market for the
underlying asset is a prerequisite for futures trade. Delivery becomes crucial
in case the underlying asset is an essential commodity such as wheat, rice,
or sugar, with great political appeal and economic significance. Various types
of delivery systems are referred to as ‘delivery logic’ discussed next.
34 Derivatives and Risk Management

Delivery Logic
As long as competitive markets for the underlying asset exist, provision for settlement by
delivery is welcome. There are various options available to the exchanges to settle by deliv-
ery. They are specified as delivery logic in futures contracts. The following delivery logic
types are available:

(a) Compulsory Under the compulsory delivery logic, all open futures contracts on expiry
would necessarily have to be settled by delivery. Since there is always an equal number of —
long and short positions, the deliveries would match. On expiry, all sellers are required to
fulfil obligations of futures contracts by delivery of the underlying asset, and buyers are
required to accept delivery and pay. An important implication of compulsory logic is that
traders not interested in physical delivery of asset are expected to cancel their positions
before expiry by offsetting contracts. This leaves only those who are likely hedgers and
wish to make/accept delivery. Compulsory logic thus eliminates speculative traders. The
provision of close-out does not exist in the case of compulsory delivery logic.
(b) Both options In some futures contracts, the traders are given both options, 1.e., settle-
ment either by delivery or by close-out. On the expiry of the futures contract, the buyer
and seller can exercise delivery options. The quantities offered for delivery may be more
than the buyers are willing to accept, or vice versa. Only the lesser of the quantities
offered for delivery and accepted can be matched. The remaining quantity must be paid
for in cash at a rate referred to as due date rate (DDR). The DDR would be derived from
the spot market rates.
Select provisions of delivery-based settlement for crude oil contracts at MCX in India
under both options are shown in Box 2.1.
(c) Option of buyer or seller Another delivery logic available is at the option of either
the seller or the buyer. If the seller exercises the delivery option, then buyers would have
to be identified from those still having open long positions. Similarly, if the delivery
option is with the buyer, sellers would be identified for making deliveries. The inten-
tions to deliver the underlying asset are notified in advance, and before the expiry of the
relevant futures contracts. Under such delivery logic, the party that opts for delivery has
voluntarily surrendered the right to square up the position, but the party that is allocated
the delivery is forced to have delivery-based settlement, and loses the chance to square
up the contract. The assigned buyer/seller would have to settle by physical delivery.
(d) Assignment Where the option of delivery-based settlement is restricted to one party,
the counterparty for settlement would have to be identified. The procedure for allocating
the delivery is called assignment. The exchange decides the rule of assignment. It may
be random, willing party, or longest outstanding contract. Under compulsory delivery,
there is no assignment. Under the delivery logic of ’both options’ and ’option of the
buyer/seller’, the exchange would have to frame rules of assignment of
Assignment refers tothe delivery.
method of finding the uae
counterparty for delivery - Provisions for compulsory delivery are necessary to some extent, other-
when either the buyer or wise futures markets become purely speculative. Lack of delivery may influ-
the seller of futureshas ence the prices in the markets for the underlying asset.
opted io) bellemen by | The objectives of hedgers and speculators trading in the futures market
_...,,,.. differ substantially from each other. However, exchanges in India do not
 Forwards and Futures 35

Delivery logic _ Both option

-Both buyers and sellers can express intention to takeand make Halerh ofcrude oll‘Ina way, traders have the option|
to have either delivery-based settlement or cash settlement. Contracts not declaring intentions for delivery would b
settled in cash.

Dhes pee _——s«|sUpto two working days after expir

of futures contract (T + 2
Delivery has to be made good within two days of the expiry of the futures contract.

Intentions for delivery — On the day of expiry of contrac

Buyers and sellers must notify the exchange of delivery-based settlement to enable the exchange to take appropriate :
steps to allocate delivery.
Matching delivery — _. ____ Assigning delivery to buyer
and seller
The exchange matches the delivery nuanitties for ee and sellers. As the quantities notified by the sellers and buy
ers in most cases would not match, the exchange would allocate buyers and sellers, and surplus quantities would b
settled in cash at the DDR.

Delivery period margin | | 25%

Against the usual initial margin of 5%, both buyers and sellers with intentions of delivery have to deposit the enhance
margin to ensure that commitment of delivery is met. Sellers exercising the delivery option are exempt from delivery
margin upon submission of documentary proof of delivery (warehouse receipt).

Due date rate | For cash settlemen

This is the ex-Mumbai price exclusive of all taxes in US dollars, converted into Indian rupees at the exchange rat
prevailing on the day

distinguish between a hedger and speculator, as they apply a uniform margin for both. Con-
trarily, some markets in the world do waive or reduce margins for hedgers who provide
evidence of delivery or underlying trade transaction.
Selection of delivery logic is dependent upon several factors. The availability of goods
of similar nature in the spot market, desire to prevent over-speculation, competitiveness in
the spot markets, warehousing infrastructure, availability of quality assayers, a reasonable
formula for price adjustment of different grades of the same commodity, etc., are some of
the factors that would dictate the selection of delivery logic.

Open Interest -
An important parameter in the futures markets is open interest. The number of contracts out-
standing (not squared up) at any point of time is called open interest. As a new contract is
introduced, investors start taking a view on the market of the underlying asset and assume an
exposure on the futures contract. For every buyer of a contract, there is a seller. Under normal
circumstances, the open interest rises with time as more and more investors start evincing inter-
est in the new contract. They either buy or sell a contract depending upon their respective
opinions. But as the maturity of the contract approaches, investors tend to reduce their exposures
36 Derivatives and Risk Management

— interest is the num-and unwind the initial position. Those who went long initially would unwind
Open : } 9 Ae
ber of futures contracts by selling their contracts, and those who took short positions initially would
outstanding. Itreducesto cover themselves by buying contracts. Hence, the open interest starts declining
zero upon maturity ofthe as maturity approaches. It signifies reduced investor interest in the contracts
oT that have a short time left to expire.
) Ultimately, on the expiry of the contract, all positions would be squared up.
The positions that are left open by investors are compulsorily settled by the exchange either
by delivery or close-out. Where positions are settled by close-out, the difference between
the closing price and the price of initial contract would be paid or received by the exchange.
Open Interest and Volume Open interest and volumes are often thought to be the same.
However, they are different. ‘Volume’ refers to the number of contracts traded in a day. Cumu-
latively, it would always increase. ‘Open interest’ is the number of new contracts opened in
the day. Contracts that offset initial positions do not add to the open interest, but they do add
to the volume. Table 2.2 highlights the differences between open interest and volume.

Table 2.2 Open interest and volume

Day — a _ ___~—Actions ~— Open interest |Volume for day 7

A goes long; B goes short 50 '
C goes long; D goes short 100 Le i
E goes long; F goes short 100
e | (Two new parties add to open interest) a a
B goes long; H goes short 50
3 (One party offsetting and second party opening 250 50
keeps open interest unchanged)
C goes short; D goes long : 100
150 100
(Both parties closing initial position reduces open interest)

CASH FLOWS UNDER FORWARD AND FUTURES CONTRACTS

As we have seen, the principle and purpose of the forward contract and the futures contract
are the same. However, there are key differences with cash flow implications that must be
understood.
Besides standardization, and as exchange-traded products, the cash flow of futures differs
in two substantial ways from that of forward contracts, as follows:
e Initial and variation margin
e Marking-to-market margin

Margin Requirements
The exchange serves as counterparty to both buyers and sellers of futures contracts. Delivery
of the underlying assets and cash flow are the two essential ingredients of futures contracts.
Despite the fact that most contracts are neutralized prior to delivery, the link between delivery
and the resultant cash flow cannot be broken. The exchange works to eliminate counterparty
 Forwards and Futures 37

risk, and, therefore, it has to assure itself of the financial standing of the participating mem-
bers. Further, the exchange needs to curb members’ overtrading tendencies.
To assure itself of the financial credibility of participants and to check speculative tenden-
cies, the exchange prescribes the margin to be deposited with it. The margin
is a percentage of the contract value and is prescribed by the exchange
depending on the volatility in price of the underlying asset. An initial margin
is required to be deposited to open a short or long position in the futures, and
is normally set equivalent to the maximum loss that the position can suffer
in a day. Both buyer and seller are liable to pay margins.

Minimum margin and margin call

If an initial margin of 4% is stipulated by the exchange, it implies that the loss would not
normally exceed 4% in a day. Suppose a trader buys one contract for 10 MT of rice valued
at %55,000, i.e., $550 per quintal. He will be required to deposit 4%, i.e., $2200 as initial
deposit. While the position remains open, the trader can incur loss or profit as the price
changes. If the price falls to $535 the next day, the trader has incurred a loss of 1500 and
his margin now stands reduced to %700 (%2200 — %1500). This may make the exchange
uncomfortable and insecure, as any further decline in price will wipe out the entire margin.
The exchange, therefore, prescribes a minimum level below which the margin should not fall.
If it does, the exchange asks the trader to immediately replenish the margin to the original
level of 4% (known as margin call).
The initial margin is intended to cover potential loss in an open position for the next day.
However, the loss that is already incurred during the day has to be compensated for at the
end of the day. It is the practice of exchanges to settle price differences on a daily basis. This
daily settlement is referred to as marking to market. The difference of initial and final margin
represents profit or loss. Example 2.2 illustrates the mechanism of marking to market.

EXAMPLE 2.1. Margin and margin call

An investor buys five futures contracts on gold at the MCX of India. Each contract is for 100 g. The price quotation is £15,550 per
10 g. The tick size is 21. Initial margin is set at 4%, while the minimum margin is 90% of the initial margin. Find out the following:

(a) What is the minimum change in value of a contract?

(b) What is the amount of initial margin the investor has to deposit with the exchange?
(c) At what price level would the investor get a margin call?
(d) If the investor sold the contract, what price level would trigger a margin call?
Solution

(a) The minimum change in the price quotation is 1 per 10 g. The contract size is 100 g. Therefore, the minimum change in
the value of the contract would be 1 x 100/10= 210.
(b) Initial margin =Value of contract x margin% x no. of contracts= 100/10 x 15,550 x 4% x 5 = %31,100
(c) The minimum margin is 90% of the initial margin. Therefore, till the loss reaches %3110 (%622 per contract), the investor
would not get a margin call. When the price falls by more than %62.20 per 10 g, the margin would fall below the minimum
required. Any price below 715,487.80 would warrant a margin call.
(d) For initial short position, the price rise would erode the margin. Price rise by more than %62.20 to $15,562.20 (15,500 +
62.20) would trigger margin call.
38 Derivatives and Risk Management

Assume an investor has bought a futures contract on the stock of Maruti Udyog at the
National Stock Exchange (NSE) at a price of 7410. As each contract consists of 400 shares,
the exposure is worth %1,64,000. There is no cash flow from the buyer to the seller at the
time of entering the contract. The initial margin payable by both the buyer and the seller to
the exchange is ignored for the purpose of this illustration. If the investor holds this position
till day 4 and closes out by selling the contract when the price is 440, the ultimate profit is
~ 12,000 from the transaction (a gain of %30 per share for 400 shares).
However, what happens to the price during the intervening period is to be accounted for
in the futures contract. At the end of each day, the profit or loss on the position is calculated,
and the loss, if any, is made good to the exchange by the investor. Likewise, any profit at the
end of each day is credited to the account of the investor. Profit or loss is settled at the end
of each day as if the investor were closing out the position. If at the end of day | the clos-
ing price increased to €420, the investor’s account will be credited with the profit of $4000.
Similarly, if at the end of day 2 the price fell to 400, the investor will have to a loss of 78000
with the exchange. This way, the position is marked daily to the end-of-the-day price. The
net impact on profit or loss remains the same as the difference between buying and selling
price, as would be the case under a forward contract. But with futures, the net profit/loss is
represented as a series of cash flows on a daily basis, as can be seen from Table 2.3.
Table 2.3 Marking to market

Day Price (?) Cash flow (2) Remarks +}

Day 1: 410 Mane A long position opened for one contract
Opening a contract (400 shares) valued at 1,64,000

Close of Day 1 -420 (420 — 410) x 400 = +4,000 | Investor receives $4,000

Close of Day 2 400 (400 — 420) x 400 = —8,000 | Investor pays %8,000

Close of Day 3 390 (390 — 400) x 400 = —4,000 | Investor pays 4,000
Day 4: . Position closed out with contract value of
Closing the contract 440 = i
(00S 200) os 400 20,000 %1,76,000. Investor gets $20,000
Net profit (440 — 410) x 400 = 12,000

The final profit given by the difference between the selling and the buying prices of
~12,000 is a series of cash flows of +4000, —8000, —4000, and +20,000.
Besides the margin and marking to market, there are other differences between forward
and futures contracts. For convenierice, these differences are summarized in Table 2.4.

PRICING A FORWARD/FUTURES CONTRACT

We now attempt to understand how the price of a forward/futures contract is decided.
As
defined, the value of derivative contracts depends upon the spot price of the underlyin
g asset.
The price of forward contract or futures contract is determined using the same
principle, as fun-
damentally it is the same contract that specifies the price today for future delivery
of the asset.
 Forwards and Futures 39

EXAMPLE 2.2 Marking to Market

For the contract specified in Example 2.1, find out the gain or loss on a daily basis for short and long positions in five contracts
of gold if the clearing piices for the next 10 days are as given:

Oye
Pye
y es
|Price (%) | 15,340 | 15,600 | 15,630 | 15,670 |15,870
Indicate the position of the margin account and margins calls, if any, on a daily basis when the contracts are marked to market. »
Assuming that investors square off their positions at a price of ¥15,870 on the 10th day, find out the gains and losses of the long |
and short positions in futures. Confirm the same from the margin account cash flows. D
' Solution
The investors have opened their positions at a price of 15,550 by depositing a margin of ¥31,100, calculated at 4% of the initial
outlay. The minimum margin requirement at 90% works out to 27,990 (0.90 < 31,100). The margin accounts of investors would
be credited with any profit and debited with any loss. For long and short positions, the amount of profit and loss would be equal
with a changed sign. On the basis of daily clearing prices, the daily profit and loss position, the margin account position, and
margin call would be as follows:

ear Profit/loss for day (=) Margin account (%) Margin call (<)
Day aieete Short Long Short Long Short
| position position position position position position
0 15,550
1 15,520 1,500 29,600 32,600
2 15005 —10,750 10,750 18,850 43,350 12,250
3 15,410 5,250 = y4a\0) 36,350 38,100
4 15,220 —9,500 9,500 26,850 47,600 4,250
5 15,440 11,000 —11,000 42,100 36,600
6 15,340 —5,000 5,000 37,100 41,600
15,600 13,000 | —13,000 50,100 28,600
8 15,630 1,500 =| 151010 51,600 27,100 4,000 |
2,000 —2,000 53,600 29,100
10,000 | —10,000 63,600 19,100 12,000
Closing position of margin account 63,600 31,100
Margin calls paid 16,500 16,000

Profit and loss is calculated from the clearing price of the previous day. The aggregate profit and loss can be found by the differ-
ence between the closing and opening prices as follows:
Opening price = %15,550 Closing price = 15,870
Profit for long position = (15,870 — 15,550) x 100/10 x 5 = 16,000
Profit for short position = (15,550 — 15,870) x 100/10 x 5 = —%16,000
The aggregate profit or loss would be the sum of the daily profits and losses over 10 days. It can also be obtained from the cash
flow in the margin account. The profit or loss from the margin account position is given by
Profit/loss = Final margin position — initial margin position — margin call paid
For long position: Profit = 63,600 — 31,100 — 16,500 = .%16,000
For short position: Profit = 31,100 — 31,100 — 16,000 = —%16,000
This confirms the profit and loss calculated directly from the opening and closing prices.
40 Derivatives and Risk Management

Table 2.4 Comparison between forward and futures contracts

Features Futures Forwards

Location Exchange Over the counter
Unknown to each other, exchange serves :
: Counterparties are known to each other |
ao as counterparty : -
Counterparty risk Minimal Considerable
Initial cash flow | Initial and variation margins required None
Explicit cost Brokerage to be paid No intermediary and no cost
Settlement implicitly daily by marking to the market No marking to the market
Final settlement By delivery or cash By delivery
1-4-4 4 | Possible by entering an opposite contract to |Generally not possible unless both the
ae ‘square up the position parties agree |
Quantity specification | Fixed standard size/lot Any quantity :
i... 2... Any time mutually decided by the parties |
| Time of oy : On ne dates ee :

Cost of hedging Very nominal High

Period ofhedging _| Contracts available for a limited period Unlimited

The futures price is As a simplest case, let us consider an asset that provides no income to the
based on spot price and owner of the asset during the period of the forward contract. Let the asset be
the cost of carry for the 100 g of gold. Let the current price of gold, Sp, be $7000 per 10 g in the
period less benefits of physical market. The owner of the asset sells the asset 12-m forward at price
ownership.
F. Once the contract period is over, ownership will get transferred to the
buyer upon payment of the contracted price F;. Purely from a financial per-
spective, the buyer of the contract has owned the asset on deferred payment basis, while the
seller of the asset will receive payment only after the end of the contract period. The seller
is deemed to hold the asset till the end of the forward period on behalf of the buyer.
The new buyer has saved the cost of interest. Since there is a certainty of delivery and cash
payment, we can safely assume that the buyer saved the interest cost r, applicable for risk-free
investment. Let us assume r = 10%. If the contracted price was F; he must have F,/(1 + r)
today so as to mature to F' at the expiry of the contract period. Hence, the current price of
the asset, So, must be less than or equal to F\/(1 + 7), or else he or she would not enter into
a forward contract. Mathematically,

So = Fly) or Fy = She =r) (251)

From the viewpoint of the current owner of the gold, if he had sold the asset on the spot at
the current price and invested the proceeds at a risk-free rate, his wealth would have grown
to a minimum of Sy x (1 + r). Therefore, the forward contract price F, must exceed or equal
Sp X (1 + r) to motivate him to enter a forward deal. Mathematically,

Pesiseoecl ear) (22)

 Forwards and Futures 41

The only way the two inequalities of Eqs 2.1 and 2.2 can be satisfied is by equating both
equations. The forward deal will take place only when the buyer and the seller of the asset
feel indifferent to the price. Therefore, the forward contract will take place if and only if both
inequalities (Eqs 2.1 and 2.2) are satisfied, that is,
FP, = So x (1 =a r) (273)

Here, we have assumed annual compounding of interest. If the compounding period is

made infinitesimally small (continuous compounding), Eq. 2.3 can be represented as follows:

Pie Sg Xe" (2.4a)

For compounding at periodic intervals (n times p.a.) and time ¢ expressed in years, the
forward price is given by
F = So x (1 te rin)” (2.4b)

where, r is referred to as the cost of carry.

Arbitrage Argument Equation 2.4 is a necessary condition for the forward price. Any
other price will give rise to arbitrage opportunity. Let us see how arbitrage as a process will
derive the price of the asset as given by Eq. 2.4. Assume the current spot price of 10 g gold
to be %7000, the risk-free rate to be 10% p.a., and the forward contract period of one year.
Using simple compounding, the 12-m forward price of gold should be $7700 (7000 + 10%
interest).
Any other price gives rise to arbitrage. Let us examine how arbitrage works for the assumed
forward prices of (a) ¥8000 and (b) ¢7300.

Cash-and-carry Arbitrage
When forward is overpriced at ¥8000
If the forward price of gold is ¥8000 (i.e., more than the spot price plus
When a futures contract = aost of carry), an arbitrageur can take the following actions simultaneously
is overpriced, cash-and- today at t = 0:
carry arbitrage can be
_ executed by selling the e Borrow 77000
futures now and buying
_ the underlying asset to ° Buy gold spot
deriveariskless profit. e Sell forward contract at $8000
Note that this is a riskless and investment-free position created because
no owned funds are involved and no risk is assumed. The arbitrageur has borrowed funds at
a definite rate and the forward contract is covered by having the underlying asset now. The
arbitrageur would own and therefore be able to deliver the underlying asset one year later,
realize the forward price, and pay back the loan along with interest thereon. The following
cash flow would result after one year:

Realize cash from forward contract by delivery of gold | +8,000

Pay back the borrowed money and interest thereon —%7,700
%300
42 Derivatives and Risk Management

Since all the cash flows are known at ¢ = 0 with no uncertainty about them at maturity,
the profit of £300 represents arbitrage. This is referred to as cash-and-carry arbitrage.

Reverse Cash-and-carry Arbitrage

When forward is underpriced at ¥7300
Whena futures contract _ On the contrary, if the price is ¥7300 (1.e., ; less than the spot price plus cost
is underpriced, reverse _ of carry) an arbitrageur can take the following actions today:
cash-and-carry arbitrage
can be executed by buy- Borrow gold
ing the futures now and * Sell gold spot at $7000
selling short in spot to e Lend at a risk-free rate of 10%
derive riskless profit. e Buy a forward contract at %7300
Note that this is again a riskless position created with no investment, because it is set up
with borrowed gold, and its future delivery is covered through a forward buy contract. One
year later, the following cash flow will result:
Realize cash from lending activity +%7,700
Pay for the forward contract and return borrowed gold —%7,300

Profit
This is known as reverse cash-and-carry arbitrage.
To arrive at a price that does not allow arbitrage either by cash and carry or reverse cash
and carry, the profit must vanish in both the cases. It is not difficult to see that if the price of
the forward contract is ¥7700, it will ensure no profit from arbitrage.

EXAMPLE 2.3 Cash-and-carry arbitrage

The price of Suzlon shares at the NSE is % 85, while a three-month futures contract on Suzlon is being traded at € 90. If
one can
borrow at 12% and Suzlon is not paying any dividend in the next three months, is there an arbitrage opportunity
available in the |
prices ruling in the spot market and futures market? If so, how can a profit be made? Assume the size of the
futures contract to
be 1000 shares. a
Solution
The cost of carry is 1% per month. For three months, the cost of carry is 3% of the spot price of 85.00.
Accordingly, the 3-m
forward price should be 1.03 x 85 = % 87.55. Futures contract trading at % 90.00 is overpriced
and, hence, cash-and-carry
arbitrage can be executed. An investor can take the following actions simultaneously today at t =
0:
* Borrow & 85,000.
* Buy 1000 shares of Suzlon at a spot price of = 85.
* — Sell one futures contract at % 90 with exposure of = 90,000.
Three months later, the investor would deliver the underlying asset against the futures
contract, realize the contracted price of
~90,000, and pay back the borrowing along with interest with the following cash flow:

Realize cash from futures contract +2 90,000

Pay back the borrowed money and interest thereon =< 07,000
|Profit
Since all the cash flows are known at t = 0 with no uncertainty of the cash flows
at maturity, the profit of ¥2450 represents
arbitrage profit obtained through cash-and-carry.
 Forwards and Futures 43

Pricing Investment Assets

For pricing a forward contract, we used the principle of arbitrage. For pricing futures, the
same principle of arbitrage applies as in Eq. 2.4, albeit with some caution. For pricing a
futures contract, we need to consider the characteristics of the underlying asset. The under-
lying asset can be differentiated as (a) carry type or investment asset and (b) non-carry type
or consumption asset.
Investment assets such as gold, silver, stocks, and currencies need adjustment of the fol-
lowing two factors:
e Benefits that accrue to the owner of the asset till it is delivered
° Cost of storage and carry to be incurred by the owner till the delivery is made
The benefits of ownership do not accrue to the buyer of a futures contract. Instead, they go to
the seller, who is physically holding the asset during the intervening period. For example, if the
underlying asset involved was a stock, the dividend on it will accrue to the owner of the physical
asset and not to the owner of the futures contract. Ideally, this benefit must be passed on to the
buyer of the futures contract. This benefit must, therefore, be deducted from the futures price.
If the present value of the benefit is D, then the futures price will be as per Eq. 2.5.
F = (8S) - D) xe (2.5)
Note that the spot price is decreased to the extent of the present value of the benefit.
Similarly, till the asset is delivered, the owner of the physical asset will have to incur storage
cost, which the buyer of the futures contract avoids. This has an impact opposite to that of the
benefits. Since the seller of the contract is holding the asset on behalf of the buyer, he is entitled
to recover the cost from the buyer. The spot price needs to be revised upwards by the present
value of the storage cost s. Therefore, the futures price is calculated as given in Eq. 2.6.
F = (Sp — D +s) x e& (2.6)

If the benefits and costs are proportional to the futures price, then they can be adjusted
against the cost of carry, not in the spot price of the asset. Therefore, the future price now is
expressed by Eq. 2.7.
F=S)x e-Pt (2.7)

Pricing Consumption Assets

While pricing futures on consumption assets, the principle of arbitrage may not be applicable
because of the utility of consumption, referred to as convenience yield. Deriving profit from
the asset no longer remains the motive when an item is required for consumption. Consuim-
able assets incur no income, but they normally have carrying cost, which is treated as nega-
tive income. Hence, with carrying costs, the arbitrage profit can be computed as follows:
1fi-= (Sy s)e7 then
e borrow (S + s) at r to buy commodity and fund storage cost;
e sell the futures contract; and
e at maturity, derive profit = F — (Sp + s)e™.
44 Derivatives and Risk Management

EXAMPLE 2.4 Upper bound on the futures price of consumption asset

A jute processing unit requires raw jute as input to its operations. The spot price of jute is ¥ 1900 per quintal and the 6-m
futures for raw jute at MCX is traded at € 2080. If the cost of funds for the jute processing unit is 10% p.a. and storage costs
are 2% p.a., find out the upper limit on the futures price. If the actual price exceeds the upper bound, how can the firm profit
from such a situation?
Solution
The upper limit on futures price is given by Eq. 2.8.

F=S e*S! of Fs 1900 x 6-'22x6 or F= 2017.49

At a price greater than % 2017.50, cash-and-carry arbitrage can be executed by (a) borrowing (b) buying jute in the spot market,
and (c) selling the futures now. At the expiry of the futures contract, the commitment of delivery of jute may be made good on 7
receiving the futures price. G

IfF = (Sp + s)e” then

e sell the commodity, save storage cost, and invest at r;

e buy the futures contract; and
e at maturity, derive profit = (Sy + s)e” — F.

The consumption value associated with commodities tests arbitrage arguments. For a con-
sumption asset, only the strategy of cash-and-carry can be implemented, but the strategy
of reverse cash-and-carry is not possible. One cannot sell a commodity that is required for
consumption purposes and buy a futures contract instead. Physical holding of the asset and
futures on the same are not equivalent due to the consumption value attached to the com-
modity. For an oil producer, buying oil futures and selling in the physical market leaves no
stock of oil required for production. Due to the consumption value of the asset, we only have
an upper bound to the futures price (refer to solved problem SP 2.2). Hence,

Fo = (Spots) (2.8)
The owner of the assets may feel that holding the asset in a physical form will provide
benefits that cannot be obtained by investing in future contracts.
Convenience yield refers to the benefits enjoyed by the owner of the asset due to its pos-
session and consumption. It is extremely difficult to objectively measure convenience yield,
as it is specific to individuals. In rare situations where an estimate of convenience yield can
be made, the futures price can be given by:

fs) ee
where c is convenience yield measured as a proportion of the price in annual terms.

VALUE OF A FORWARD CONTRACT

When one enters a forward contract, its value must be zero. Assume that an investor
holds
10 g of gold and enters a 6-m forward contract to sell the gold at 15,000. It implies that he
would receive 715,000 after six months and deliver the gold. Since there is no cash flow
at the
 Forwards and Futures 45

time of the forward contract and the delivery price is fixed, the seller of the forward contract is
indifferent to selling the gold today at the spot price or 6-m later at the forward price. Follow-
ing the same logic, we may say that the buyer of the forward contract is indifferent to buying
gold now at the spot price or paying the delivery price under the forward contract six months
later. Hence, the present value of the forward price must be equal to the spot price. The value
of the forward contract at inception is zero.
If F, is the forward price, Sp is the spot price, and 7 is the maturity of the forward contract,
then at inception,
Value of the forward contract, f= (Sy — F))e’7 = 0
At any other time, ¢, a long forward contract f plus present value of the forward price in
cash must be equal to the spot price of the asset, or
fF, x ec = Sp (2.9)
After having entered the forward contract at =15,000 for 10 g of gold, the value of the
forward contract would not be zero because the forward price would change. If the price
changes to F, immediately after the long position in the forward contract, what is the value
of the initial forward contract? The best way to find this out is to enter the opposite contract
maturing at t = T. If the initial contract is long, the subsequent contract is short and vice
versa. For an initial long contract and a subsequent short contract, both maturing at the same
time, 7, the cash flow at maturity would be

Cash flowatt=T |
Pay under initial long contract
Receive under subsequent short contract
Net cash flow

Value of the forward contract, f= (F) — F)) x e"? (2.10)

Therefore, the value of the forward contract already entered at F', at any time subsequently
is the present value of the difference between the current forward price F and F).

EXAMPLE 2.5 Value of forward contract

The current price of Bharti’s share is & 800. An investor A is ready to buy one share of Bharti at = 900 for future delivery after six
months. A goes long with the contract. After one month, another investor, B, offers to buy Bharti’s share at % 925 for delivery after
five months. If the risk-free interest rate is 9% p.a., what is the value of the forward contract that investor A is holding?
Solution
As of now, five months are left for the expiry of the forward contract that investor A is holding. He is committed to paying a price
of = 900 to get delivery of one share of Bharti.
If investor A goes short with a five-month forward contract, he/she would receive % 925 from investor B for delivery of one
2.10 is
share of Bharti, which he would receive under the initial contract. Therefore the value of the forward contract, f, using Eq.

f = present value of the difference of current price and original contract price
= (925 — 900) x 7 909 x 5/12 — % 24.08
46 Derivatives and Risk Management

As per the cost of carry model discussed, the difference between the futures price and the spot
price represents the cost of carry for the remaining period before the expiry of the contract.
Accordingly, a futures contract with longer maturity will be priced higher than a contract
with shorter maturity because of the time value of money. As maturity nears, the difference
between the futures price and spot price shrinks and on the day of maturity, the two prices
must necessarily be identical, as shown in Fig. 2.6.

A
Price
Futures
mares

—-.- a * ok me —

Net cost of carry . + see Maturity

Spot
=|

Fig. 2.6 Convergence of spot and futures price

This happens due to compulsion of delivery attached with the futures contract. Note that
delivery is not obligatory in the futures contract, and one nullifies the open position by enter-
ing into a contract with terms opposite to those of the original one and exchanging the price
difference. This is the most common method followed by investors to square up their positions
in futures contracts.
Even though settlement of a futures contract is rarely done through delivery, the futures
price cannot be different from the one prevailing in the physical market. The mere possibility
of either buyer or seller forcing the delivery is a sufficient reason for prices in the physical
and the financial markets to converge with time. The difference between the futures price and
the spot price represents the costof carry for the remaining period of the
The difference between ‘utures contract. As time elapses, the cost of carry would reduce, being
futures price and spot directly proportional to the time remaining; on the day of the maturity, the
price is called basis. As cost of carry would be zero.
lime progresses, basis | ‘If the provision for delivery is withdrawn, a futures contract will be
eo ened reduced to a purely speculative instrument, and the very purpose for which
spot and futures prices - futures contracts were conceived would be defeated. On the date of delivery,
converge. the prices in the physical and financial markets must essentially converge; if
they do not, arbitrage will drive them to a single common value.

Normal Market and Inverted Market

A market where the futures price exceeds the spot price is referred to as a normal
market, as
the cost of carry is positive. The difference is the cost of carry. However, there are
instances
where the futures price is less than the spot price. This can happen due to changing
demand
and supply positions of the underlying asset. For example, spot prices of wheat
may be high
 Forwards and Futures 47

due to short supply of wheat now but when the crop matures in future, supplies will be
abundant and hence the price of futures contract may fall. Markets where the futures price is
lower than the spot price are known as inverted markets.
In both cases (normal and inverted markets), the principle of convergence of price applies.
In either case, the futures price must converge to the spot price as maturity approaches, as all
cost of carry, benefits of ownership, storage costs, convenience yields, etc., tend to become
zero on the day of the delivery of the futures contract.

RELATIONSHIP BETWEEN FUTURES AND FORWARD PRICES _.

In efficient and perfect markets, the forward price and the futures price must be identical,
_ both contracts being the same fundamentally. However, from the point of
The prices of futures and
forward are identical in view of cash flow, there are two major differences between forward and
perfect markets, where futures contracts, as discussed earlier: forward contracts are not subject to
the interest rates are (a) initial margin requirement and (b) marking to the market. The cash flows
constant; otherwise, from a forward contract and a futures contract may be different, though the
they would be marginally
net position at the end would be the same. Both forward and futures prices
different depending upon
the correlation of the should yield the same profit at the end of the contract period, except for
prices with interest rates. the interest on resettlement payments. A gain of £100 in the forwards mar-
ket may mean a gain of $300 on day | and a loss of $200 on day 2 in the
futures market.
The relationship of spot prices with interest rates determines the difference in pricing of
futures and forwards. If there were no correlation between the spot price and the interest rate,
the cash inflows and outflows arising out of the process of marking to market would tend to
cancel out each other. In such a case, there is no reason to believe that futures and forward
prices would be different.
When spot prices are positively correlated with interest rates, a long position in futures
will be better than in the forward, as it will provide interim cash inflows that may be invested.
Hence, the futures price will exceed the forward price. With a negative correlation between
spot prices and interest rates, the forward prices will be higher than the futures prices, as
there would be cash outflows in futures contract. The relationship is summarized as follows:

Correlation of spot and interest Relationship of futures and forward price

Positive correlation Futures price > forward price
Negative correlation Futures price < forward price
No correlation Futures price = forward price |

RELATIONSHIP OF FUTURES PRICE AND EXPECTED SPOT PRICE &

We have seen that on the maturity date, irrespective of whether the market is normal or
inverted, the futures price and the spot price must converge. Does this mean that we can
take today’s futures price to be the expected spot price, S;, on the date of maturity? There
are three theories that attempt to establish the relationship between the futures price and
expected spot price.
48 Derivatives and Risk Management

Normal Backwardation Hypothesis

Propounded by the famous economist Lord Keynes, the normal backwardation hypothesis
states that the current future price is a downward biased indicator of the future spot price.
Consider the following paragraph:
‘A wheat farmer doing plantation today does not know what wheat price will prevail at the
time of harvest. However, he can lock-in a price by selling a future contract for delivery
around harvest time at a rate determined today. If farmers are taking the short position (sell
futures) to hedge, some group (speculators) must take the long position (buy futures). If the
price at the time of harvest happens to be the same at which the futures contract was made,
then the speculator has provided an assurance of the same price much in advance, without
any compensation. To provide compensation for the risk assumed by the speculators, the
spot price at the time of maturity of futures contract must be higher than the price of the
futures contract. Therefore, the futures price must underestimate the future spot price’.
The premise of Keynes is based on the assumption that hedgers are net short and specula-
tors are net long and if this is true, the backwardation hypothesis holds.

Contango
Contango assumes the opposite of the Keynes’ hypothesis. If hedgers are net long and specu-
lators are net short, then the future price must overestimate the spot price. This is known as
contango. This can happen because it is assumed that speculators are better informed about
the conditions and inefficiencies of the market and, therefore, they become enthusiastic about
buying and pulling up the prices. Hence, the futures price is an overestimate of the expected
spot price. Though lacking rationale, contango can result due to inefficient market conditions.
When the futures price is less than the expected future spot price, it is referred to as normal
backwardation, while the situation when the futures price is more than the expected future
spot price is referred to as contango. However, in common usage, contango and normal back-
wardation are used in the context of the current spot price, So. When the futures price exceeds
the current spot price, it is called contango; when it is less than the current spot price, it is
called backwardation. Figure 2.7 shows the futures price behaviour.

Price Price in Contango

Expected future price

Price in backwardation

Maturity
LE REEL et

Fig. 2.7 Futures price behaviour

 Forwards and Futures 49

Expectation Hypothesis
Expectation hypothesis assumes that the futures price is an unbiased indicator of the expected
spot price. This would be the case when markets are efficient and hedgers and speculators
correctly read the minds of each other. One group cannot outsmart the other group. Under
efficient market conditions, all the factors determining the futures price, such as the cost of
storage, insurance, carrying costs, and convenience yield are well known. Since there is no
element of surprise, the futures price must genuinely reflect the future spot price.
The normal backwardation hypothesis seems to be strong because irrespective of the level
of efficiency of the market, hedgers must be willing to accept a lower than expected future
spot price for their peace of mind. This is like paying insurance premium for a firm price in
the future, even though it may be slightly lower than the price the hedgers could obtain if
they were unhedged.

EXPECTANCY THEORY OF FUTURES PRICING 7" LLCO

In case of consumption assets or non-carry type assets, the cost of carry model cannot work
properly. According to the cost of carry model, the futures price must exceed the spot price
by the cost of carry for the period remaining before maturity of the futures contract. This is
referred to as full cost of carry. In case the futures contract is not at full cost of carry to the
spot, then the process of arbitrage sets in. In some cases, we often find that the futures price
is not only at full cost of carry but at a discount to the spot price or at a partial cost of carry.
Clearly, the process of arbitrage appears to be failing here. In such cases, either arbitrage
cannot be executed or the gains are too little to offset the transaction and delivery costs. The
expectancy theory of futures pricing states that the futures price is a reflection of the future
spot price. It represents a view of what the spot price is likely to be at the maturity of the
futures period, considering the demand and supply situation expected to prevail then. The
expectancy model suggests that the relationship is between the futures price and the future
spot price and not between the futures price and the current spot price. If that be the case,
futures contracts would defy the basic definition of derivative.
However, we cannot ignore the fact that sometimes, even for the carry type of financial
assets, we find futures at a discount to the spot price. The expectancy model relates to the
expected direction of the price in the futures. If the futures trades lower than the spot, it
suggests that the price is expected to be lower in future. It can be easily justified in case of
agricultural commodities. For example, at the time of harvest, the supply of wheat would
be large and while the current prices may be high, in the future wheat may be available at a
much lower price. Naturally, the futures price in this case would be lower than the current
spot price. For agricultural commodities, reverse cash-and-carry arbitrage is constrained as
they have consumption value (convenience yield).

Types of Futures
Futures can be classified on the basis of the underlying asset. As stated earlier, there can be
a host of assets on which a futures contract can be created. It is a matter of standardization
of the contract. Broadly, futures fall into either of the two categories—commodity futures
and financial futures.
50 ‘Derivatives and Risk Management

Derivatives in Practice
Futures trade points to stable prices
The futures price is expected to reflect the future spot price. After taking into account the large number of factors that govern price
determination, the futures trade is expected to reflect the potential price in the spot market. It is the best estimate of the market.
No amount of economic modelling perhaps can match and replace the collective wisdom of millions of traders speculating on the
futures price of the underlying commodity.
The price data in this table for September futures expiring 20 Sept 2011 reflect the possibility that in case of wheat, sugar,
and soya oil, the prices are likely to decline in about 25 days’ time. In case of the gram, the price is expected to go up in
September. That seems alright. But what about prices in December? The market seems to ignore the fact that a fresh crop
would be available between September and December. Higher price for December indicates a further rise in price. Is this pure
speculation or a grim reminder to policy makers that despite a fresh crop hitting the market, the supply would be far less than
the expected demand? Should the government be proactive in taking corrective measures right now to import gram or remain
reactive, only to act when the prices actually increase (as the futures forewarned), much to the discomfort of the people?
In the past, futures trading was blamed for rise in prices; this was considered a good enough reason to ban futures trades in
several commodities, taking away the vital market information that such markets provide.
Source: Based on The Times of India, 2September 2011.

Soya Oil
Source: NCDEX data as published in The Times of India, 2 September 2011.

Commodity Futures Commodity futures are those where the underlying asset is a com-
_ modity. Contracts are available in India on agricultural commodities such as
Futures are broadlyof 5 % :
to pes commen: wheat, rice, soya, coffee, sugar, tea, Jeera, pepper, edible oils, cotton, and
ityfutures and financial coconut. Contracts on metals (gold and silver) are also available. Futures
futures, depending upon Contracts on copper, aluminium, etc., also fall under the commodity category.
the underlying asset.
_ Financial Futures Financial futures are those futures where the underlying
asset 1s a financial product. They can be further divided into four sub-categories:
¢ Currency futures have underlying assets as currencies. Futures contracts on various cur-
rencies are available in major centres such as Chicago, London, and Singapore. They
are also available in India at several exchanges.
¢ Stock futures have stocks as underlying assets. Stock futures were introduced in 1982
by the Kansas City Board of Trade. Stock futures were introduced in India on 12 June
2000 for indices and on 9 November 2001 on select individual securities at NSE.
e Interest rate futures have interest rate as the underlying asset. In India, interest rate
futures were launched on 24 June 2003 at NSE. This attempt was not successful, and
they were relaunched on 31 August 2009 with modifications in the underlying assets
and other contract features.
 Forwards and Futures 51

e Index futures are those futures where the underlying assets are stock indices, such as
the BSE SENSEX or Nifty.

Another system of classification can be based on the deliverability of the underlying assets.
Certain futures contracts are made on hypothetical assets, which do not exist in the physical
form. Futures contracts on indices and freight are non-deliverable. Futures on foreign curren-
cies are also non-deliverable in India due to the partial convertibility of the Indian Rupee.
Having discussed the common features of futures and forwards on all underlying assets,
we shall discuss each type of forward and futures contracts in detail with respect to their
applications in the subsequent chapters.

SOLVED PROBLEMS
SP 2.1 REVERSE CASH-AND-CARRY ARBITRAGE
The price of the Suzlon share at the NSE is 85 while a 3-m futures contract on Suzlon is being traded at %86. If one can borrow at
12%, and Suzlon is not paying any dividend in the next three months, is there an arbitrage opportunity available in the prices ruling
in the spot market and futures market? If so, how can profit be made? Assume the size of the futures contract to be 1000 shares.
Solution
The cost of carry is 1% per month. For three months, the cost of carry is 3% of the spot price of $85.00. Accordingly, the 3-m forward
price should be 1.03 x 85 = 87.55. The 3-m futures contract trading at %86 is clearly underpriced, and reverse cash-and-carry
arbitrage can be executed as follows.
The investor can take the following actions simultaneously today at t = 0:
(a) Short 1000 shares of Suzlon at %85 and realize ¥85,000.
(b) Invest €85,000 for three months at 12%.
(c) Buy one futures contract at €86 with exposure of ¥86,000.
Three months later, the investor would obtain the underlying asset against the futures contract, i.e., shares of Suzlon to be deliv-
ered back to the lender of the shares, realize the lent amount with interest, aggregating to 87,550, and make good the payment
liability of 86,000 towards the futures contract. The following cash flow would result after three months:
Realize cash from lending activity +%87,550
Pay against the futures contract —%86,000
Profit %1550
Since all the cash flows have no uncertainty about them at maturity, the profit of 1550 represents arbitrage profit obtained through
reverse cash-and-carry.
SP 2.2 FUTURES ON A CONSUMPTION ASSET
A refinery uses crude oil as a major input. The current price of crude oil is 3000 per barrel. Futures contracts on crude oil for 100
barrels each are being traded at €3100 per barrel with three months to delivery. The cost of capital for the refinery is 12%, while for
storage of the oil, it incurs an annual cost of 3%.
(a) Do you find the futures market and the spot market prices to be consistent so as to offer no arbitrage profit possibility?
(b) Is there any arbitrage opportunity? If yes, how can the arbitrage be executed?
(c) Up to what price is this arbitrage feasible?
(d) What might constrain the refinery from executing the arbitrage?
(e) How would you interpret the inability of the refinery to execute the arbitrage?
Assume annual compounding for your analysis.
Solution
(a) The cost of carry, including storage, is 15% p.a. For a 3-m futures contract, the price should be 3000 x (1 + 0.15 x 3/12) =
%3112.50. The futures of crude oil is underpriced by €12.50 at €3100. Therefore, an arbitrage possibility by the reverse cash-
and-carry process exists.
52 Derivatives and Risk Management

(b) The arbitrage can be executed by selling crude oil from stock, investing the proceeds, saving the storage costs, and simultane-
ously buying a 3-m futures contract. The stock of oil can be regained after three months on maturity of the futures contract, as
shown here:
Reverse cash-and-carry arbitrage
The refinery could do the following now: z
Sell 100 barrels of crude oil in the spot market (¥3000 100) = 3,00,000
Invest proceeds for three months and save storage cost = —3,00,000
Buy one 3-m futures contract at 3100 =
After three months

Pay for the futures and take delivery of 100 barrels of crude oil = —3,10,000
Receive invested cash = €3,00,000 x 1.03 = +3,09,000
Save storage cost = $3,00,000 x 0.0075 = +2250
Saved amount = 1250
Saved amount per barrel 12.50
The upper bound on the futures price = 3100 + 12.50 = 3112.50
The constraining factor for the refinery is the inability to execute reverse cash-and-carry arbitrage. It would have to go without
the level of stock of crude oil required for production purposes. Selling crude oil implies closure of the refinery.
If the refinery is unable to execute the arbitrage, this implies that it is in no position to sell the crude oil and be out of stock. The
implied convenience yield for the refinery for holding oil in inventory can be taken as a minimum of %12.50 per barrel.

SP 2.3 PRICING FORWARD CONTRACT

The price of a Reliance share at the NSE is 1980. The risk-free borrowing rate in the market is 10% p.a.
(a) If a 6-m forward contract for delivery of 100 shares is available at 2100, can you take advantage of the situation?
(b) If a 6-m forward contract for delivery of 100 shares is available at 2000, can you take advantage of the situation?
(c) Assume that you have gone long on 6-m forward contract for Reliance at 2000. After three months, a 3-m contract is available at
~2050. What is the value of the contract in hand?

Assume no dividend by Reliance in the next six months and annual compounding of interest.
Solution

(a) The cost of carry is 5% for a period of six months. Therefore, a forward contract for delivery after six months must be priced at
1.05 x %1980 = 2079. The forward contract at ¥2100 is overpriced by 21, and as such, a profit of $2100 can be made for
100 shares as follows:
zt
Buy spot 100 shares at 1980 —1,98,000
Borrow at 10% +1,98,000
Sell 100 shares forward at $2100 oF
Net Investment 0
After six months
Deliver 100 shares and receive forward price +2,10,000
Pay borrowing with interest (%1,98,000 x 1.05) —2,07,900
Profit 2100
If 6-m forward is ¥2000, the process can be reversed to make arbitrage gains. One can borrow 100 shares
of Reliance and sell
them at spot price to realize %1,98,000, invest the money at 10% for six months, and buy 100 shares six months’
forward. At
the end of six months, the amount received for the invested money would be €2,07,900 and the forward price payable would
be
%2,00,000, providing a gain of ¥7900.
;
The value of the forward buy contract after three months would be the present value of the difference between
the price of the
original buy contract, i.¢., 2000 and the price prevailing, i.e., 2050. The value of the forward contract for 100 shares
(assuming
simple compounding) is
(%2050 — %2000) x 100/1.025 = 4878
 Forwards and Futures 53

SUMMARY ©
_ Forwards and futures are two very similar derivative products that _ The pricing principle for forwards and futures is the same.
can exist on a variety of underlying assets. The underlying asset The cost of carry model is used to price a forward or a futures
could be commodities, stocks, indices, currencies, interest rates, contract. It essentially uses arbitrage arguments to state that the
etc. Forward contracts are so pervasive that one does not realize fair price of a forward or a futures contract would be spot price
that they are being entered into. They are part and parcel of our plus cost of carry for the forward period. If futures are not fairly
day-to-day life. In business situations, most forward contracts are priced, cash-and-carry arbitrage or reverse cash-and-carry arbi-
executed in the foreign currency markets, The motive for entering trage would make the price fair. Cash-and-carry arbitrage can
into a forward contract is to remove price uncertainties. be executed with relative ease but it may be difficult to execute
Forward contracts are executed between at least two parties, — reverse cash-and-carry arbitrage, as it requires short selling of
directly negotiating the terms of the contract, including fixing the asset. In case of assets that have convenience yield, such
price today. Settlement is done at a future date. The drawback of as commodities, reverse cash-and-carry arbitrage is not execut-
such a contract would be that the counterparties assume risk on able. This places an upper bound on the price of the futures
each other, and consent of the other party would be necessary if contracts for assets that are of the non-carry type. For carry-type
one party wants to cancel the contract. The advantages of a for- assets, arbitrage is executable either way.
ward contract include the ability to tailor it as per specific needs, One of the most important concepts in pricing of futures is
with no upfront payment. Most forward contracts are settled by the convergence of the futures price and the spot price at the
delivery, though one can enter an offsetting contract at any time maturity of the futures contract. The requirement of delivery
prior to or on maturity. would force the futures price to be the same as the spot price
Futures contracts are the same as forward contracts, but are on maturity. Further, since the cost of carry is proportional to time
exchange-traded. Due to the involvement of exchanges, (a) the to maturity, the gap between the spot price and the futures price
product is standardized, (b) entry and exit are extremely conve- must reduce. With no time to maturity, the cost of carry tends to
nient, and (c) counterparty risk is virtually eliminated. Elaborate be zero, and, hence, the futures price would be the same as the
specifications are required for futures contract to make them trad- spot price on maturity.
able on exchanges. Exchange authorities decide on these speci- There would be no difference in futures prices and forward
fications. The settlement of futures contracts can be done in three prices if interest rates remain constant. Since there are intermit-
ways: physical, offsetting, and close-out. Settlement is mostly tent cash flows in a futures position in the margin account, any
done by entering into an offsetting contract, unlike forwards, surplus would be invested, and the shortfall would be borrowed.
where the popular mode is physical settlement. There are vati- Hence, there would be a marginal difference between the prices
ous types of settlement delivery options, decided by the exchange of futures and forward contracts.
authorities. The problem of assignment refers to situations where A futures price for an asset is assumed to be an unbiased
a counterparty has to be found when either the buyer or the seller indicator of the futures spot price for that asset. The normal
opts for physical settlement with no matching counterparty. One of backwardation hypothesis states that the futures price would be
the observed parameters of futures trading is open interest, which underestimating the future spot price so as to build the cost of
refers to the number of open contracts at any point of time. hedging.
From the perspective of cash flow, futures are different from Futures can be broadly classified into two categories—com-
forwards on two counts—margins and marking to market. Mar- modity and financial. Financial futures can further be divided into
gins are required to be deposited with the exchange as guaran- four sub-categories—currency, stock interest rates, and index
tee of settlement. Marking to market implies that profit or loss on futures, each of which is discussed in the following chapters.
all open positions issettled on a daily basis.

KEY TERMS sexs

Backwardation A situation where the futures price is less than Contango A situation where the futures price is more than
the expected future spot price. In common use, it refers to a situ- the expected future spot price. In common use, it refers to a
ation where the futures price is less than the current spot price. situation where the futures price is more than the current spot
Cash-and-carry arbitrage A risk-free profit-making situation price.
where one could buy an asset by borrowing and then selling a Convergence Convergence refers to the fact that on the day
future contract. of maturity of the futures contract, its price must converge with
Commodity futures Futures that have commodities as under- the spot price.
lying assets.
 54 Derivatives and Risk Management

Cost of carry The cost that one would incur if a physical asset on the position of derivatives, as if the position in derivatives is
is possessed and carried for a period of time, i.e., till the time of closed out.
maturity of the futures/forward contract. Open interest The number of futures contracts still outstand-
Counterparty risk The risk for one party to a contract that the ing, awaiting settlement either by delivery or by an offsetting
other party would not perform its commitments on the due date contract.
of the forward contract. Over-the-counter A direct contract between two parties,
Financial futures Futures that have financial assets as under- addressing their specific needs and getting settled between them
lying assets. at maturity.
Forward contract An agreement to buy or sell an asset at a Reverse cash-and-carry arbitrage A risk-free profit-making
price determined today, though the contract is settled later at a situation where one could sell an asset and lend the proceeds,
predetermined date. and then buy a future contract.
Futures contract A forward contract that is traded on an Settlement It is the fulfilment of obligations under a forward
exchange. contract (derivative) of delivery of the asset and cash consider-
Margin The amount of money required to be deposited with ation (or cash differential), or extinguishing of the claims of the
the exchange for taking a long, short, or combination of futures counterparties on the agreed date.
contracts for covering potential loss. Tick size The minimum change in the price that would be rec-
Margin call The replenishment of margins in case of mark- ognized in the price quotation of the futures contract.
to-market losses exceeding the prescribed minimum level of Underlying asset The asset on which the price of the deriva-
margin. tive (forward or futures) is based.
Mark to market The daily settlement of profit or loss incurred

QUESTIONS
2.1. What do you understand by a forward contract? Illustrate 2.6 What are the key specification parameters of a futures
with an example. contract?
2.2 What are the merits and demerits of forward contracts? 2.7 Whats the difference between open interest and volume?
2.3 How are forward contracts settled? Illustrate, 2.8 Describe marking to market using a suitable example.
2.4 What are the advantages of futures contracts over forward 2.9 Explain cash-and-carry and reverse cash-and-carry arbi-
contracts? trage.
2.5 What are possible modes of settlement of futures con- 2.10 How would you value a forward contract once it is entered?
tracts? 2.14 What is convergence?
2.12 Explain backwardation and contango.

PROBLEMS
P 2.1 Understanding a forward contract P 2.3 Cash-and-carry arbitrage with futures
A conductor manufacturing company has entered into a forward Refer to Problem 2.2. Assume that a futures contract on alu-
contract to buy 2000 kg of aluminium after six months at 7100 minium is selling for ¥103.20. How can you take advantage of
per kg. What is the gain/loss for the manufacturing company if
the situation in the futures market scenario?
at the end of six months the price of aluminium turns out to be
(a) $105 per kg and (b) 98 per kg? P 2.4 Reverse cash-and-carry arbitrage with futures
A stockbroker is holding 1000 shares of Reliance Industries Ltd,
P 2.2 Pricing a forward contract
each selling currently at ¥1800. A futures contract expiring in
Assume that the current spot price of aluminium is 294 per kg.
one month is trading at 1808. Each futures contract is for 100
What should be the price of a 6-m forward contract on aluminium
shares. If the stockbroker can borrow/invest at 12% p.a., can
if risk-free interest rate in the market is 12% p.a., with quarterly he
or she take advantage of the situation? Assume annual com-
compounding, and cost of insurance is 4% p.a., with annual
pounding of interest rates.
compounding?
INTRODUCTION |
Learning Objectives
Commodity futures are standardized contracts to buy or sell a After going through this chapter,
commodity at a specified price at a predetermined date in the readers should be familiar with
future. Commodity futures derive their value from the spot price e commodity futures and their
of the commodity that is the underlying asset. There are a large relevance for the economy
number of commodities on which futurescontracts are available. differences between commodity and
Underlying assets for futures contracts can range from agricul- financial futures
pricing of commodity futures
tural/cereal products (wheat, rice, sugar, etc.) to metals (gold,
using commodity futures for
silver, etc.) to plantation products (rubber, coffee, etc.) to energy hedging
products (oil, furnace oil, etc.). « along position against fall in
Trading in forwards and futures on commodities is not new. commodity prices and
_ It has been in vogue for more than « a short position against rise in
Commodity futures have Nis: commodity prices
“commodities as underly- 100 years. Trading in agricultural com- basis and basis risk
ing assets. modities started at the Chicago Board perfect and imperfect hedge
of Trade in 1865. During the late 1800s, cross-hedge and hedge ratio
the Buenos Aires exchange-traded futures in grain. The Bombay how to speculate and arbitrage with
Cotton Exchange came into existence as early as 1921. commodity futures
hedging for gross profit margin
With increased globalization and removal of international using futures
trade barriers, futures markets on commodities have gained prom- hedging for quantity variations
inence as tools of risk management. The cost of managing the risk
and volatility in the prices of commodities, when controlled by a
government using subsidies, is normally borne by the public in
the form of increased taxation. Market-based activity on futures
exchanges induces willingness in participants to perform the role
of price discovery, relieving the government of this onus.
Futures on given commodities help mitigate price risks on
those commodities. Futures exchanges facilitate easy entry and
exit into and from futures contracts at all points of time, provid-
ing an opportunity to maximize benefits such as efficient price
discovery and faster dissemination of relevant information.
Functioning of futures exchange is governed by the rules
framed by the exchange, and supervised by national regulator.
56 Derivatives and Risk Management

The functioning of commodity exchanges in India is regulated by the Forward Markets

Commission.

BENEFITS OF COMMODITY FUTURES 1

Commodities offer great utility value to the society; the government always endeavours to
provide commodities at reasonable prices. The usual tools for assuring supplies, such as
adequate buffer stocks, controlled and phased release of commodities, and minimum sup-
port prices have either failed or proved too expensive for the economy to control volatility
in commodity prices. No method can replace the market-based control mechanism of price
negotiation. Stability in commodity prices can be achieved by futures and forward trading
in commodities, in such a way that the market bears the cost, reducing the burden on the
public exchequer.
There has been considerable debate on the need for futures contracts on commodities.
Futures contracts on commodities of basic nature are often considered as unwarranted and a
disservice to the nation, due to their speculative potential. However, some important benefits
of futures on commodities, which may help dispel these notions, are discussed here under
broad heads of price and volatility, market structure, and national economy.

On Price and Volatility

Price discovery The availability of various futures contracts enables farmers, industries, and
all other users of these commodities to hedge against price risk as well as to help discover the
right price by providing increased transparency. This facilitates managerial decision making for
scheduling production, adequate inventory, and marketing.

Seasonal volatility Uneven supply of commodities coinciding with even consumption

results in demand-supply mismatch, thereby necessitating storage of commodities. It is
_ believed that with efficient futures markets, the risk premium associated with
Commodity futures / storage costs tends to reduce. A futures market would help reduce seasonal
result in price discovery,
reduced seasonal varia-
volatility in the prices of commodities. Speculators would be ready to take
tions, efficient dissemi-. POSitions in volatile markets and even out seasonal variations to a great
nation of information, _ extent. In the absence of a futures market, hoarders would have an increased
reduced cost ofcredit, and arbitrary premium on the storage function due to financial muscle power.
and more efficient physi- _ Excessive control over the supply chain can be damaging. Commodity
cal markets
futures help prevent monopolistic control over supply chains.

On Market Structure
Faster dissemination of information Further, an efficient futures market helps faster dis-
seminate information to the public. Increased participation makes pricing information avail-
able on a continuous basis to a wider geographical area. In the absence of futures markets
on commodities, producers and farmers, who remain geographically apart, would have little
information. A futures market creates greater awareness and helps informed decision mak-
ing due to the ready availability of prices on the exchanges as futures prices are available in
public domain on continuous basis.
 Commodity Futures 57

Derivatives in Practice
Price discovery, seasonal variations, and futures —
In January 2005, after two years of trading in rubber futures, the volumes of trading in three commodity exchanges that trade in rubber
futures started falling. Experts were of the opinion that this is a normal trend when prices in the spot market stabilize. Daily volumes
_in the first fortnight of January 2005 never crossed the 1500 tonne mark in any of the three exchanges. During the period 1-15
January 2005, the largest volume on a particular day at the National Multi-commodity Exchange (NMCE) was 1327 tonnes, while at
Multi-commodity Exchange (MCX) and National Commodity and Derivatives Exchange (NCDEX), it was 645 tonnes and 702 tonnes,
respectively. The daily volume during this period was in the range of 600-1000 tonnes at NMCE. As against this, the daily volume
averaged about 2000 tonnes in March 2004. _
The reason attributed to the declining interest in futures is the stability of rubber prices in the spot markets. Since the introduction
of futures, the tendency of rubber prices to fluctuate wildly came down, dampening the enthusiasm of speculators. Speculators
moved to other commodities where the price volatility is high. Natural rubber prices had skyrocketed during June-July 2004, boost-
_ Ing the interest of speculators in the futures markets. Subsequently, prices fell, and stabilized at around ¢52 per kg. The volatility
in January was 2005 confined to €2 per kg, leaving no room for speculation in futures. In case the volatility increases, activity in
the futures market should pick up.
Even though the volumes thinned in rubber futures, the participation of retail traders increased, as evidenced by the fact that delivery-
based transactions were around 7-8%, as against the global average of 0.5%.

Source: Based on an article by Mr Vipin V. Nair in Business Line, 20 January 2005.

More efficient physical markets Futures markets should have a positive impact on the
functioning of physical markets and make them more efficient—a desirable characteristic for
a growing and maturing economy. Continuous quotations of prices at various centres would
make the prices converge in different locations in the physical markets. They can only dif-
fer in terms of delivery costs. The prerequisite of delivery in futures contracts has improved
warehousing facilities in India without the involvement of public funds.
Abhijit Sen’s Committee Report of 2008!, in examining the impact of futures trading on
the prices of agricultural products, has specified the following conditions for efficient and
effective functioning of the futures markets.
e Vibrant spot market The commodity should have suitable demand and supply condi-
tions, i.e., volume and marketable surplus should be large.
e Volatility in prices Prices should be volatile to necessitate hedging through futures
trading. Entities with a spot market commitment face price risks. As a result, there
would be a demand for hedging facilities.
e Absence of regulation The commodity should be free from substantial control arising
from government (or other authority) regulations that impose restrictions on supply,
distribution,-and prices of the commodity.
e Homogeneity The commodity should be homogenous or, alternately, it must be possible
to specify a standard grade and to measure deviations from that grade. This condition
is necessary for futures exchanges to deal in standardized contracts.
e Storability The commodity should be storable. In the absence of this condition, arbi-
trage would not be possible, and there would be no relationship between spot and
futures markets.

'Report of the expert committee to study the impact of futures trading on agricultural commodity prices, Ministry of Con-
sumer Affairs, Food and Public Distribution, Government of India, 2008.
58 Derivatives and Risk Management

There is a school of thought that holds that trading in futures in essential commodities
encourages speculation. Here, it is pertinent to mention that without speculators, there would
be no one to assume the risk from those who want to eliminate it. The presence of specula-
tors should be seen as a necessity rather than as an evil, as without them, the market would
be extremely shallow and the process of price discovery would be severely constrained.
However, due to the sensitivity of the general population towards the prices of essential com-
modities, the commodity futures markets should be more regulated than derivatives markets
for financial instruments.

On National Economy
Commodity futures trading in a developing country can contribute a lot to the stability of
fiscal management, increasing the effectiveness of price protection at a national level, and
improving the efficiency of social programmes and pricing of credit.
Stability to Government’s Revenue At a macro level, in the case of developing econo-
_ mies such as India, commodity futures offer great potential to cover price
Commodity futures trad-
ing helps smooth out the risks. Many developing countries in Africa, Asia, and Latin America depend
variability in government heavily on exports of commodities. Government budgets, developmental
revenue, transfers, and expenditure, and balance of payment positions crucially depend upon prices
_ price risk management
of commodities. Volatility in commodity prices causes volatility in budget-
from the government to
private participants. _ ary provisions and government’s developmental expenditure. Therefore, at
-amacro level, volatility in commodity prices needs to be reduced. Contain-
ing the volatility of commodity prices should thereby contain the volatility
of the fiscal imbalances.
Due to government ownership of natural resources like oil, the revenues of governments in
developing nations are highly dependent upon the prices of these commodities, especially oil.
For instance, in Mexico, oil contributed to 10% of exports, but constituted 40% of govern-
ment revenue? in 1998. A fall of $1 per barrel would have caused a reduction in government
revenue of $800 million. Targeting a price of $21 per barrel, the market saw a price decline
of $4.40 per barrel, adversely affecting the expenditure programme. C ommodity futures and
derivatives provide great opportunities for developing nations to make the government rev-
enue stable and bring about smooth development as government would be able to hedge
through commodity futures market.
Eliminating Minimum Price Support and Subsidies A common policy in developing
nations is to provide assurance of prices of sensitive commodities to farmers: the under-
privileged. By implementing a minimum support price (MSP), governments try to stabilize
prices by making the MSP a floor price. Another mechanism to protect the prices of com-
modities is by resorting to various types of subsidies. The MSP and subsidies are a topic of
hot debate because they are politically motivated but economically imprudent, and thus these
programmes cause a heavy drain on government resources and place the burden on the public,
willing or unwilling. These programmes are supported by direct and indirect taxes imposed
by the government. Such MSP programmes not only encourage inefficiency in the form of
*Commodity Risk Management and Development, Donald F. Larson, Panos Varangis, Nanae
Yabuki: Paper for roundtable dis-
cussion on New Approaches to Commodity Price Risk Management in Developing Countries,
Washington DC, 28 April 1998,
 Commodity Futures 59

low yields, but also burden the users of these products. The MSP of sugarcane, where sugar
producers and consumers directly bear the cost of the minimum price of sugarcane offered
to farmers is one illustration. Similarly, minimum procurement price programmes in many
commodities, aimed at helping a select category of people, create a burden on taxpayers.
Without doubting the noble intentions of governments to provide support to a section of
the society, there is the additional aspect of inefficiency in the administration of such pro-
grammes. These inefficiencies limit the quantum of benefits actually reaching the segments
of societies at whom such programmes are aimed. Trading in commodity futures would help
remove or reduce subsidies, and also dismantle inefficient administration, saving funds for
implementing newer developmental plans.
With commodity derivatives, price risk can easily be managed through market-determined
forces, with risk mitigation provided by those willing to assume risk. Due to commodity
futures, price risk can be managed without government intervention. There is no need for a
government to provide price protection when people in the market are willing to absorb such
risks. Healthy and competitive commodity exchanges, therefore, serve the economy better,
and help reduce taxes. In fact, futures in commodities are highly efficient mechanisms for
providing the much-needed price protection and shift responsibility from the state to private
parties.
Reducing Cost of Credit Since commodity futures make hedging possible, they also serve
the extremely useful purpose of making credit available at a lower cost. Because of the rela-
tive certainty of the price of the commodity, financial institutions and banks can confidently
offer loan on reasonable interest rates to farmers and producers. This enables even credit flow
across the various sectors of the economy. In this sense, a futures market reduces the need
for selective credit control on the part of regulatory bodies. A futures market must also help
in preventing misuse of credit for purposes of hoarding.

COMMODITY FUTURES AND FINANCIAL FUTURES !

Apart from the difference in the underlying assets, financial futures and commodity futures
_ are substantially different from each other in the following respects:
- Commodities futures ,
_ differ significantly from Valuation Financial futures are easier to understand as the cost of carry
financial futures in terms model applies for their valuation. The argument of arbitrage also holds
_ of quality specifications because of the absence of convenience yield in financial futures. Financial
_ and delivery mecha- futures involve financial instruments that have an investment value but no
_ nisms.
consumption value. Consumption value makes the valuation of futures con-
tracts on commodities difficult. Due to the non-feasibility of reverse cash-
and-carry arbitrage, the lower bound of the futures price would be hazy.
Delivery and Settlement The provisions of delivery are equally applicable to both com-
modity futures and financial futures. In case of financial futures, delivery of the underlying
assets is prompt and hassle-free, and so is the settlement. Further, there are very nominal costs
of transportation, storage, or insurance, etc., involved in financial futures. For futures on finan-
cial assets, price adjustment on account of discrepancy in quality between what was contracted
and what is being delivered is not required. The quality of the underlying asset is immaterial
in the case of financial products, whereas there is ample scope for controversy over quality in
60 ‘Derivatives and Risk Management

the case of commodity futures. In the case of futures on indices or intangibles, the underlying
asset is non-deliverable, and futures contracts on them are necessarily settled in cash.
Contract Features and Life Commodity futures are governed by seasons and the possible
perishable nature of the underlying assets. Delivery is linked to availability and therefore
contract specifications have to consider the physical characteristics of the underlying asset.
The maturity period for futures contracts on commodities normally does not exceed 90 days,
while there is no such limitation on financial futures. Financial futures can have a much lon-
ger life, though generally the maturity of many financial futures is kept at 90 days.
Supply and Consumption Patterns In the case of financial products such as stocks,
indices, and foreign exchange, supply can be considered as unlimited and independent of
weather and seasons. It also does not suffer from the vagaries of nature. The supply of
commodities depends upon factors over which people have no control. The total supply is
dependent upon weather, storage capacity, shelf life, etc. Further, the supply of most com-
modities (agricultural products) is confined to the harvesting period, while consumption is
uniform throughout the year. Deterioration in the value of commodities with time is another
phenomenon that does not affect futures on financial products.

Quality Constraints Futures contracts on commodities have some features similar to those
of any other futures contracts on financial assets. A contract on gold is presented in Table 2.1
in Chapter 2. Significant differences arise in commodity futures in two areas, i.e., (a) the
extremely elaborate descriptions of the quality attributes of the commodity and (b) the proce-
dure for settlement by delivery, deliverable quality, place of delivery, etc. Such complexities
do not arise in the case of futures contracts on financial assets.
Futures contracts on commodities have specific quality requirements. The price may need
to be adjusted to account for any difference in the quality specified in the contract and the
quality delivered. For example, there is a significant difference in the prices of basmati rice
and ordinary rice. What is deliverable against a futures contract needs to be specified.

Delivery Notice Period Besides, the exchange also has to provide for a reasonable time
for both the buyer and the seller to arrange for giving/taking delivery of the underlying asset.
Usually, futures contracts on commodities provide for a delivery notice period, when the par-
ties are required to disclose the intentions of settlement by delivery.
Modes of Settlement and Assignment Futures contracts on commodities can be settled in
any of the three ways described in Chapter 2, i.e., by physical delivery, cash settlement, or
closing out. Settlement by closing out or by cash has the same form in commodities as is in
financial assets. However, unlike futures contracts on financial assets, the settlement of
futures contracts on commodities by delivery requires special treatment. Settlement of com-
modity futures by delivery is cumbersome. Financial assets are either non- deliverable (such
as an index) or do not have very elaborate quality/time limitations.
In the case of settlement by delivery, the exchange has to provide for
The pricing of commodity
futures cannot use the -—=«-@SCertainment of the quality and price adjustment, location of the delivery,
‘no arbitrage’ argument’ adjustment of taxes and freight, the option for the delivery logic (seller/
due to the convenience = buyer/both), and assignment. All these issues are dealt with extensively in the
yield attached with com- _ Specifications of futures contracts. This makes the task of designing futures
modities.
_ contracts on commodities more onerous and complex.
 Commodity Futures 61

Assignment refers to the matching of short and long positions. For example, if the delivery
is at the option of the seller, the exchange has to find a willing buyer and devise rules for
assigning the delivery to a specific buyer. If the delivery logic is compulsory (all open posi-
tions at the expiry of futures contracts are to be settled by delivery), the problem of assign-
ment does not arise, as there is a matching long position for each short position.

PRICING COMMODITY FUTURES ©” yD

We discussed pricing of forwards and futures in Chapter 2 using the argument of arbitrage
with the cost of carry model. It must be reiterated here that we can categorize commodities
as investment commodities or consumption commodities. It is hard to find a commodity that
has only investment value and not consumption value; but commodities such as gold and
silver are regarded more as investment assets rather than as consumption assets.
From the perspective of pricing, it is essential to have such categorization because con-
sumption assets have a consumption value called convenience yield. People hold such assets
to satisfy consumption needs. Wheat, rice, pulses, and edible oils are consumed by one and
all. Similarly, crude oil, tin, copper, jute, etc., form raw material for many manufacturing
concerns. Therefore, the motive of holding or trading in such assets is essentially attributable
to the consumption value, rather than to the possibility of obtaining returns by trading in them.
Under the cost of carry model, the futures price is given by the spot price plus the cost
_ of carry till the expiry of the futures contract. This price would satisfy the
if the upper bound is
violated, then cash-and- ‘no arbitrage’ condition for cash-and-carry as well as reverse cash-and-
carry arbitrage can be carry arbitrage. This should apply to investment assets. For discrete (com-
_ executed to correct the pounding n-times per year) and continuous compounding, the fair price of
Loe price. futures is given by Eqs 3.1 and 3.2, respectively.
~yiy Pre S80 (1 erin)” (3.1)
F, = Sp X e” (3.2)
For cash-and-carry arbitrage, the following must hold good:
FS (So se" . (33)

For no cash-and-carry arbitrage, we must have

Foe (Sp osje™ (3.4)

where S 1s storage cost.

Jao.
EXAMPLE 3.1 Pricing futures on investment asset
Assume that the spot price of gold is 14,000 per tola (1 tola = 10 g). If the financing cost is 12% p.a. with continuous Prati
ing, warehousing and insurance costs with continuous compounding are placed at 3%. What would be the value of 2-m futures
contract on gold with and without warehousing and insurance cost?

Solution
The fair value of a futures contract with financing cost only is given by Eq. 3.2.
Fe S, < e* = 14,000) <2 ~ 212 te < 1428282 per 10g
Warehousing and insurance cost would be added to the financing cost for determining the fair value of the futures, as given by Eq. 3.6.
Fa or = 14.000 Eo ae 714,354.41 per 10 g
62 Derivatives and Risk Management

Due to the consumption value of the asset, reverse cash-and-carry arbitrage (implying
short sale of the asset and buying futures) may not be executable. Since futures contracts
cannot substitute the consumption value of the commodity, the contract can remain under-
priced. Therefore, we only have an upper bound to the futures price, as specified in Eq. 3.4.
_ Incase storage cost and benefits are associated with possession of the com-
Since reverse cash-
and-carry arbitrage is modity, with s and D being present values, respectively, the futures price is
not executable in case T=" (So Daas) een (3.5)
of commodity futures
due to convenience If both storage and benefits are continuous, the fair price of the futures
yield, futures can remain would be
underpriced.
FH So x el” ra ON (3.6)

EXAMPLE 3.2 Pricing futures on consumption asset

Assume that the spot price of cardamom is %714 per kg. If the financing cost is 10% p.a., with continuous compounding, what
should be the price of a 3-m futures contract on cardamom? If warehousing and insurance costs are placed at 1%, what would
be the fair value of the 3-m futures contract inclusive of warehousing and insurance cost?
Solution
Only an upper bound is given to the fair value of a futures contract, as per Eq. 3.4 with S = 0.
FaelOn Ce dee 1) le < 732.07 per kg
Warehousing and insurance cost would be added to the financing cost for determining the upper bound of the fair value of the 4
futures, as given by Eq. 3.4 with S > 0.
Fy = SX es 714 & ell x aie = 2733.91 per kg

HEDGING WITH COMMODITY FUTURES #@

Like all futures, com- _ Hedging strategies with futures revolve around compensating anticipated
modity futures too have losses in the spot market with equivalent gains in the futures market. This is
three major applications: = done by taking a position on the futures market that is opposite of the posi-
hedging, speculation, and ee
arbitrage. tion in the spot market.

Long and Short Positions

When a party holds the underlying asset, it is said to be long on the spot market. For example,
a jeweller holding gold or silver is long on the underlying asset. A wheat farmer is long on
wheat when he sows the crop. A long position gains with price rise and loses with price fall.
Similarly, a party that requires the underlying asset in the future is said to be short on the
underlying asset. For example, a tea exporter who needs a stock of tea to execute a pending
order is short on tea, the underlying commodity/asset. A wheat flour mill needing wheat in
the
future is short on wheat. A short position gains with a fall in price and loses with a rise
in price.
Similarly, in the futures market, one who buys a futures contract is said to
be long, and
one who sells a futures contract is said to be short on futures. Here, too, the long
position
would gain while the short position would lose with a rise in price.
To execute a hedge, the following steps are taken:
¢ One who is long on the underlying asset, goes short on the futures market,
and one who
is short on the underlying asset, goes long in the futures market.
 Commodity Futures 63

e At an appropriate time, one can neutralize the position in the futures market, i.e., go
long on futures if one was originally short and go short on futures if one was originally
long, and receive/pay the difference in prices of futures.
e One can access the physical market for meeting the needs of the underlying asset.

Short Hedge
A short hedge means a short position in futures. It is used by those who are long on the
underlying asset that faces the risk of a fall in price. To hedge the long position on an asset,
it is necessary to take a short position in the futures market. When one takes a short position
in futures, the hedge is referred to as a short hedge.
Consider, for example, a sugar mill in Uttar Pradesh. It is expected to produce 100 MT
of sugar in the month of April. The price in the month of February is ¥22 per kg. An April
futures contract in sugar, due on 20" April, is trading at 25 per kg. The sugar mill appre-
hends that a price less than %25 per kg will prevail in April due to excessive supply. How can
the sugar mill hedge its position against the anticipated decline in sugar prices in April?
To execute the hedging strategy, the sugar mill has to take a position in futures opposite
When one takes a _ to that of physical position in spot. The sugar mill is long on sugar because
short position in futures it gains with price rise. Therefore, it needs to sell the futures contract today.
hedges, it is referred to The number of contracts that needs to be sold is dependent upon the extent
as a short hedge of exposure in the physical asset and the value to be covered. Assuming that
a 100% cover is desired, we can find the number of contracts to be sold.
Assuming each contract for sugar is for 10 MT, the number of futures contracts to be sold is
10 for a physical position of 100 MT.
Number of contracts to be sold
Quantity to be hedged/quantity in each futures contract
100 MT/10 MT = 10
The sugar mill goes short on futures in February. Prior to April, before the future contract
expires, the sugar mill buys the futures contract to nullify its position in the futures market.
The underlying asset, i.e., sugar, is sold in the spot market. The price realized by the sugar
mill in two different scenarios—decline or rise in sugar prices—using the principle of con-
vergence of price on the due date of the contract, is worked out as follows:

When the price falls to ¥22 per kg When the price rises to €26 per kg
SituationA : Situation B
In the futures market : Inthe futures market
Cash flow, ®/kg Cash flow, ®/kg
Sold futures contract in February + 25.00 Sold futures contract in February +25,00
Bought futures contract in April — 22.00 Bought futures contract in April 26.00.
Gain in the futures market 2 +3.00 Gain in the futures market —1,00
Price realized in the spot market +22.00 Price realized in the spot market +26.00
Effective price realized %25.00 per kg Effective price realized %25.00 per kg
Here, the loss of €3 (€25—€22) in the spot market is Here, the gain of <1 (26—€25) in the spot market is
made up by an equal gain in the futures market. offset by the equal loss in the futures market.
64 Derivatives and Risk Management

a
The fact that the prices of sugar in the spot market and futures market must converge,
fixed price of %25 per kg is realized by the sugar mill. The loss/gain in the spot market 1s
fully compensated by a gain/loss in the futures market.

Long Hedge
A long hedge implies taking a long position in futures. It is used by those who are short on
the asset and need protection against a rise in price.
For example, consider a petrochemical plant that needs to process 10,000 barrels of oil in
three months’ time. To hedge against the possibility of a price rise, the plant needs to go long
ona futures contract for crude oil. The spot price of crude oil is ¥1950 per barrel, while a futures
contract expiring three months from now is selling for ¥2200 per barrel. By going long on the
futures, the petrochemical plant can lock-in procurement at ¥2200 per barrel. Assuming a size

EXAMPLE 3.3 Long hedge

Today is 24 March. A refinery needs 1075 barrels of crude oil in the month of September. The current price of crude oil is 3000
per barrel. September futures contracts at MCX are trading at 3200. The firm expects the price to go up further, and even beyond
%3200 in September. It has the option of buying the stock now. Alternatively, it can hedge through a futures contract. The size
of futures contract is 100 barrels.
(a) If the cost of capital, insurance, and storage is 15% p.a., examine whether it is beneficial for the firm to buy now.
(b) Instead, if the upper limit to buying price is €3200, what strategy can the firm adopt?
(c) If the firm decides to hedge through futures, find out the effective price it would pay for crude oil if at the time of lifting the
hedge the spot and futures prices are (i) 2900 and %2910, respectively, (ii) €3300 and %3315, respectively.
Solution
(a) If the cost of carry (including interest, insurance, and storage) is 15%, the fair price of the futures contract is
Sp e = 3000 ef? * 95 = %3233.65. It implies that if the firm buys crude oil today to be used after six months, it would
effectively cost $3233.65 per barrel.
(b) Since futures are trading at ¥3200, it can lock-in the price of around ¥3200 through a long hedge. Under a long hedge, the
firm would buy the futures on crude oil today and sell it six months later, while simultaneously meeting the physical require-
ments from the market at the price prevailing at that time. Irrespective of the price six months later, the firm would end up
paying a price of around €3200.
(c) If the firm adopts the strategy mentioned in (b), the effective price to be paid by the firm in the two cases of rise and fall in
spot values is calculated as follows:

Quantity of crude oil to be hedged = 1,075 barrels

Size of one futures contract = 100 barrels
Number of futures contracts bought = 1,075/100 = 11 contracts
Futures price = %3,200
Value of futures bought = 3,200 * 11 x 100 = %35,20,000
Six months later, the firm would unwind its futures position and buy its requirement from the spot market.

gt x
Futures sold at price 2,910 BaD
Value of futures sold 32,01,000 36,46,500
Gain/Loss on futures —3,19,000 1,26,500
Spot price 2,900 3,300
Actual cost of buying 1,075 barrels 31,17,500 35,47,500
Effective cost of buying 34,36,500 34,21,000
Effective price 3,197 3,182
 Commodity Futures 65

Being short on the asset _ of 100 barrels for a futures contract, the firm buys 100 futures to cover its
means that one needs exposure of 10,000 barrels.
to take a long position Let us examine the price that would be payable under two scenarios—rise
infutures tohedge. This in price to $2400 or fall in price to 1800 per barrel after three months.
is referred to as a long
hedge. (Figures in </barre!)
Situation
Price fall Price rise
Price after three months 1,800 2,400
Actual purchase price 1,800 2,400
Gain/loss on futures
Bought futures at 2,200 2,200
Sold futures at 1,800 2,400
Profit/loss on futures —400 +200
Effective price 2200 | 2 00
Here again, we observe that the loss in the physical position is offset by the gain in the
futures position, and vice versa. This results in an effective price that is equal to the price of
the futures at the time of setting up the hedge.
The strategies of short hedge and long hedge are depicted in Fig. 3.1. By adopting a short
or long hedge, the price locked in would be equal to the futures price of the initial contract,
and is shown in Fig. 3.2.

Hedged
position

(a) (b) RS
SIRT
SIS
SESS

Fig. 3.1 Hedging with futures (a) short hedge (b) long hedge

Att=0 Att=T The outcome /

+ Long/short ; * Cancel short/long * The loss in physical |
position in position in futures position would be
commodity for by buying/selling it compensated by equal |
¥ tonnes Seli/buy asset in gain in the futures and
- Go short/long on the spot market at’ ee
futures with prevailing price * The value would be |
equal positon close to that of the initial
(X tonnes) futures contract, Fo i
at price Fo |
EISELE EERSTE APE eee peer AN

Fig.
3.2 “Hedging with futures: process at
andoutcome
66. _—Derivatives and Risk Management

PERFECT AND IMPERFECT HEDGE liiiiiiisieieanniseanunaen

In the earlier examples of short and long hedges by a sugar mill and a petrochemical plant,
_ respectively, the hedging strategy of the sugar mill resulted in an exact offset-
A forward contract offers
ting of gains and losses in the futures and the physical market. Such a hedge
a perfect hedge, whereas
a futures contract is is called a perfect hedge. In a hedge, the positions in the physical market
rarely a perfect hedge and the futures market are opposite, and therefore the gains or losses with
changing prices would also be opposite. The hedge where a loss in the physi-
cal market is exactly offset by a gain in the position in the futures market (or vice versa) is
known as a perfect hedge, as depicted in Fig. 3.3.

A ~..Short on underlying pee

Gain A ae
Seine ea é Long on futures
physical ! Se :
market \y ae
:
° oi Price
-
‘ PA ® =
Loss in Target rea
futures price
market _»
Y

Fig. 3.3 Perfect hedge

A forward contract is a perfect hedge because the price under the forward contract is firm.
A hedge in the futures market is rarely perfect. The effective price under a futures hedge
would be close to the futures contract price when the initial position is set up. The gains/
losses in the futures do not exactly offset those in the physical market because of the follow-
ing reasons:

futures hedge isoO imper- _° Th e€ exposure in the underlying

i asset and futures market is not on identical
identi
fect due to a mismatch of assets of the same quality, and therefore changes in the prices in the two
(a) quality of assets, markets are not identical,
(b) sizes of exposure, _ © The values of exposure in the underlying asset and the futures do not
and (c) ae oo match exactly, because the size of the futures contract is standardized.
exposure
ane filuicsin eoctions
the physical | The time of SR maturity of the futures
. contract may not coincide
a with the
a -_ time of exposure in the physical position, because maturities of futures
contracts are specific.

Mismatch of Asset and Quality

It is not certain that a futures contract on an underlying asset will always be available so that
price risk is covered fully. For example, a sugarcane grower cannot cover price risk on his
produce if futures contracts on sugarcane are not available. However, it does not mean that
hedging is impossible under situations of non-availability of futures contracts on the com-
modity. One has to find a commodity that is available through futures, and has a positive/
negative correlation with the prices of the commodity to be hedged. The effectiveness of the
 Commodity Futures 67

hedge will depend upon the degree of correlation in the prices of the commodity and the
futures contracts. If the correlation between the two commodities is perfect, the hedge could
be as effective as the one carried with a futures contract on the same underlying asset.
In the case of the sugarcane grower, a hedge is possible through futures contracts avail-
able on sugar, as prices of sugarcane and sugar go hand-in-hand. A hedge executed through
a futures contract on an asset different from, but related to, the underlying asset is referred
to as a cross hedge.
The mismatch in the assets scenario also covers variances in the quality of a commodity.
Different qualities of sugar are sold at different prices, and futures contracts on all these
qualities may not be available. However, an effective hedge can still be set up as long as there
is a correlation of prices and there is nothing else to worry about.

Mismatch of Quantities
Another reason for deviations from a perfect hedge is the inability to cover the exact quantity
of the asset in the hedge with futures contracts as they are standardized in terms of quantity.
For example, one standard contract of sugar futures is of 10 MT. A quantity that is not a
multiple of 10 MT cannot be hedged exactly. If a sugar mill wanted to hedge 95 MT, it would
have a choice of booking either 9 (90 MT) or 10 (100 MT) contracts for hedging. It would
either be under-hedged or over-hedged. Even if the price changes are identical, the hedge
may be sub-optimal because the exposures in the two markets do not match. The gain or loss
in physical position would be on 95 MT while futures position would offset either 90 MT or
100 MT, as the case may be.

Mismatch of Maturities
Since futures contracts are standardized with respect to delivery dates, the exact matching
of the period to a hedge cannot be achieved except by coincidence. For example, if a sugar
mill wanted to hedge against price risk till 30" April, it would not be able to do so because
April. contracts expire on 20" April. The sugar mill may have the choice of booking a futures
contract for April or May, which would expire on 20" May. If it books an April contract, the
position is covered till 20" April, and is exposed from then onwards till 30 April. Alterna-
tively, by booking a May contract, the period of exposure in the assets is covered, but while
exiting the May contract on 30" April, convergence of prices in the physical and financial
markets would not happen, leaving unequal losses and gains in the two markets. Further,
if one keeps the futures position open beyond the date of liquidation of asset, 30" April, it
would amount to speculation for a period of 20 days.
Despite imperfect hedges in futures and perfect hedges in forwards, it is not necessary
that a forward hedge is preferred over a futures hedge. The evaluation needs to be based
on the costs and benefits offered by each of the contracts. The transaction cost in futures
is extremely nominal and transparent in comparison to forward contracts. A future contract
offers easy flexibility of entry and exit at any time. On the contrary, a forward contract
incurs a larger transaction cost in the form of bid—ask spread. Further, the contract price is
not transparent, as it changes from customer to customer. Besides, forward contracts do not
offer convenient entry and exit from the hedge, as do the exchange-traded futures.
68 Derivatives and Risk Management

BASIS AND BASIS RISK

The principle of convergence of price states that the futures price and the spot price must
converge on the date of maturity. If this happens at the time of maturity of
ae
between the futures the underlying asset, a perfect hedge is possible. However, the efficiency
price and the spot price, of the hedge depends on convergence and the correlation between the
and declines astimeto futures price and the spot price. This aspect can be understood through
maturity approaches. = = basis, which is defined as the difference between the futures price and the
spot price. If today the futures price and the spot price are Fo, and Sp,
respectively, the basis is
Bo = Faso (3.7)
Note that in a normal market, the basis will be positive, while in an inverted market, it
will be negative. The principle of convergence assumes that basis shall become zero on the
maturity date, with futures and spot prices being equal. At the time of setting up a hedge by
going long/short on futures, the basis is known.
During the period of the hedge, spot prices as well as futures prices change with time and
are unknown. At the end of the period of the hedge (when one squares up the position in the
futures market, or the underlying position is liquidated), if the futures and spot prices are F|
and S,, respectively, then the basis at the end of hedge period is
B = F, aS (3.8)

Let us look at the gain or loss of the hedger in the spot market and the futures market
separately. If the hedger went long on the underlying asset valued at Sp today, then at the end
of the period of hedge his payoff in the spot market will be:
Gain/loss in the spot market = S; — Sp

The basis risk: physical settlement and delivery

In August 2010, in the futures trading of pepper contracts traded on the National Commodity and Derivatives Exchange Ltd.
(NCDEX), a controversy broke. out over the quality of pepper delivered, with buyers complaining of inferior quality of pepper
resulting in increased processing cost for buyers. This happened on 20 August 2010, when delivery of about 1400 tonnes of
pepper was due.
It was alleged that the exchange-approved warehouse at Kozhikode stored pepper inferior in quality to the one specified in
the futures contract. The same was the case with another approved warehouse at Kochi. The warehouse at Kozhikode was
opened for delivery of pepper coming from nearby locations. The pepper cultivated in the area was considered to be of inferior
quality to the pepper from the areas around Kochi. As on 5 August, 2011 there were 4279 tonnes of pepper deposited at the
two accredited warehouses in Kochi and Kozhikode.
NCDEX claimed that goods deposited in the accredited warehouses were accepted only after quality certification by assayers
appointed to do the sampling and testing. Besides certification, the assayers also conducted periodic audits and ascertained ifthe
quality of goods was in conformity with contract specifications. Besides, the exchange authorities also conducted random quality
audits. NCDEX also claimed that in case the buyers suspected inferior quality, they were free to ask for resampling and testing in
the presence of their representatives.
The problem arose when the goods were stored for a long time. Material once deposited upon certification cannot be rejected
upon revalidation after three months unless justified. The traders alleged that when the certification is done by the same person on
both occasions, the deposited inferior material becomes valid for delivery.
Source: Based on an article by G.K, Nair in Business Line, 24 August 2011.
 Commodity Futures 69

Hedging price risk with

The hedger went : short on the futures market at F) and bought back at F at
futures is not perfect. the end of the period of hedge. His payoff on the futures market is:
Price risks can get
Gain/loss in the futures market = Fy — F
replaced by much smaller
risk, called basis risk The total gain/loss on the combined position in the spot and futures markets 1s
Net gain/loss = S; iG teltg ly = (Fy — So) — son)

= Difference between basis at the start and at the end of the hedge

For a perfect hedge, the net gain/loss must be zero, and, hence, the hedge will be perfect if
the difference in basis is zero. The hedger will achieve his/her objective if he/she minimizes the
differential of the basis. If he/she remains unhedged, then the price risk will be
Price risk = S; — So (3.10)

With hedging, the hedger’s risk is limited to the difference in basis, which is expected to
be much smaller than the price risk. The difference in the basis is referred to as basis risk,
being the risk borne by the hedger. By hedging, the larger price risk is replaced by a much
smaller basis risk. Basis risk arises due to mismatch of positions in the physical and futures
markets, as discussed earlier.
Besides quantity and quality of the asset, basis risk may also arise due to difference in
the time of maturity of the futures contract and the period for which the underlying asset is
to be hedged. As an example, consider a sugarcane trader who would like to get rid of his
stock on a particular date in April, whereas future contracts expire on, say, 25 April. Since the
exposure on the asset owned and the time of square-up of the futures contract will not be the
same, the sugarcane trader would either be over-hedged (when the futures position is open
and the position in the physical asset is closed) or under-hedged (when the futures position

EXAMPLE 3.4 Basis risk

From the data of Example 3.3, the effective price worked out to 3197 and %3182 as against the target price of ¥3200. Wha
are the reasons for variation in the actual price paid and the target price, and how much variation would you attribute to each
reason?
Solution
The difference between the target price and the price actually paid is due to basis, which is attributable to (a) mismatch of assets,
(b) mismatch of timing, and (c) mismatch of quantity in the futures market and the spot market.
Mismatch ofasset quality There is no mismatch of assets, as a futures contract on crude oil was available and the same was
required in the spot market. Therefore, there is no mismatch of quality of the asset in the spot market and the futures market.
Mismatch of timing _If the futures contract was maturing and the asset was to be bought in the physical market at the same time,
then the prices in the spot and the futures would have been identical, i.e., basis would then have been zero. Due to mismatch of |
timing, the prices would differ by the amount of basis at the end of the hedge. The price differential due to mismatch of timing is: |
Effective price paid = S; + Fy — F, = Fo — (Fy; — Sp) = Fo — basis when hedge is lifted
When price declined = 3,200 — (2,910 — 2,900) = $3,190 per barrel
When price increased = 3,200 — (3,315 — 3,300) = €3,185 per barrel

Mismatch of quantity The remaining difference between the spot and forwards prices is attributable to mismatch of quantity. The :
actual requirement of quantity was 1075 barrels, whereas the position taken in the futures was 1100 barrels, i.e., 11 contracts L
of 100 barrels each. L
TEE TO OEE FFF
70 ~—_—sdDerivatives and Risk Management

is closed prior to closure of the position in the asset) with respect to time. This implies that
the convergence of futures pride to spot would not take place. Some element of the basis risk
will remain, although the basis reduces as contract approaches maturity.

Basis Risk and Hedging

As we know, hedging with futures replaces price risk (difference in the spot prices, Le.,
S; — So) with basis risk (the basis at the end, i.e., F; — S;). Due to convergence of the
futures price with futures, the basis risk is expected to be much smaller than the price risk.
Therefore, it makes sense to hedge the commodity price risk with commodity futures. In
case of convergence of futures and spot prices, the basis risk would be zero. The lesser the
basis risk, the more attractive is hedging through futures. Whether or not convergence of
futures and spot prices is achieved is dependent upon the efficiency of the futures markets
and the spot markets. Prices in the spot markets are governed by more fundamental factors
affecting demand and supply, while futures prices are greatly dependent upon how well and
‘quickly the information is absorbed by the futures markets. If the futures market is efficient
in discounting the price information, the impact on spot prices would be smoother, reducing
volatility in spot prices.
In a study conducted 2-3 years after the introduction of futures in July 2004, it was
revealed that the basis risk was larger than the price risk on 14 out of 26 occasions in the
case of wheat and 13 out of 26 occasions in the case of sugar’. Far from being negligible,
the basis risk was in fact greater than the price risk. This clearly indicates several short-
comings. It reflects that either the futures market was poorly informed, did not transfer
information to the spot markets, or was dominated purely by speculative activity. Probably
the process of arbitrage (cash-and-carry and reverse cash-and-carry) that establishes the
link between futures and spot markets and achieves convergence was constrained. If the
basis risk is larger than the price risk, hedging with futures becomes redundant. However,
it may be appreciated that markets cannot become efficient immediately after coming into
existence. The participants in the market need time to go through the learning curve and
understand intricacies of the process.
There is a strong perception in the minds of politicians and economists that large players
are capable of manipulating prices in the futures market and causing spot prices to rise to
the detriment of users and the general public. On that pretext, trading in futures for essential
commodities, which is perceived to cause unwarranted inflation, is banned repeatedly.
Rather than banning the trade and making hedging avenues unavailable, there are many
intermediate options available. Unduly large basis risks may be indicative of structural
defi-
ciencies rather than the influence and dominance of a select few in the market. Unavail-
ability of adequate and suitable warehousing facilities, lack of education and knowledge
on the part of hedgers, unavailability of credit for physical delivery, regulation of
prices in
physical markets by governments, etc., are some of the reasons that do not allow
integration
of futures markets with spot markets. Integrating markets to make them more attractive
for
hedgers should be one side of the coin; introduction of a separate regulatory
framework to
contain speculative activity should be the other side. Speculative activity could
be contained
*Report of the expert committee to study the impact of futures trading on
agricultural commodity prices, Ministry of
Consumer Affairs, Food and Public Distribution, Government of India, 2008.
 Commodity Futures 71

by devising futures contracts with reduced daily price movement limits, compulsory delivery
logic, smaller exposure limits, etc. Though it may be hard to explain the benefits of futures
markets to comparatively illiterate farmers, intermediaries who are educated enough, espe-
cially those in regulatory and government bodies involved in procurement and distribution
of essential agricultural commodities, must be encouraged to use futures markets. As these
agencies generally deal in large volumes, their participation should substantially increase
hedging and strengthen the linkage between physical and futures markets.

Hedge Ratio
With the presence of basis risk, a hedge is likely to be imperfect. This imperfection results due
_ to mismatches of assets, maturity dates, and quantities. Though the larger
The hedge ratio is
the number of futures price risk is replaced by a much smaller basis risk, it cannot be eliminated
contracts having the altogether. The objective is then to minimize the risk if it cannot be eliminated.
minimum risk possible. It The hedge ratio is defined as the ratio of the value of a futures contract to
depends upon the risks in the value of the underlying asset. The optimum hedge ratio is the ratio that
the spot prices and in the
eliminates or minimizes the price risk. While hedging through an identical
futures prices, as well as
the coefficient of correla- asset underlying the number of contracts that are booked to cover long/short
tion between the two. positions, the hedge ratio is equal to the exposure in the underlying asset. In
such a case, we implicitly set the hedge ratio as being equal to one, which
is regarded as optimum.
By definition, the hedge ratio is given by
Ny
i
Na
where N, is the value of the underlying assets and Ny is the value of the hedged contracts.
The optimum hedge ratio (value of a futures contract to the value of the underlying asset)
is dependent upon the degree of correlation between the spot and futures prices. If a change
of 1% in the spot prices causes an equal change in the futures price in the same direction,
the coefficient of correlation is +1. For a hedge through futures, the optimum hedge ratio is
the ratio that minimizes the risk of the combined portfolio of the underlying and futures.
If hf is the number of futures contracts booked, then the risk of the combined portfolio of
underlying assets and the futures is given by the variance of the return from the portfolio so
constructed.
Return from the portfolio = h (F; — Fo) — (S; — So) = h AF — AS Gat)
Variance ofthe portfolio V = Var(h AF — AS)
Ye heer go. 2 i Ord,
In order to find out the optimal hedge ratio, we need to minimize the variance of the port-
folio, by setting the first partial derivative equal to zero.
rahe af +o7—-—2hp OfOs
dV :
ee Oy ap OF,
dh
dV
By setting Th = 0, we get the following equation:
72 ~~ Derivatives and Risk Management

2(h*)of =) pro, = 0
2(h*)a? = 2p a7Oy

b= p= (342)

where h* = optimum hedge ratio

p = correlation coefficient of spot and futures prices
O,, 0, = standard deviations of spot price and futures price, respectively.
The hedge ratio given by Eq. 3.12 minimizes the total risk of the combined portfolio ofthe
underlying asset and the futures contacts. Any deviation from this ratio will be sub-optimal,
as can be seen from Fig. 3.4.
Correlation of spot prices and futures prices can be obtained through a regression. If p
= | and o, = oy then h* = 1. This is likely to be the case where hedging is done through

Variance

1
'
1
'
!

Optimal h* Hedge ratio

Fig. 3.4 Risk and hedge ratio

The hedge ratio is gener- the same asset. If a 1% change causes a 2% change in the futures price,
ally 1 for commodities the most efficient hedge will be obtained from the futures contracts of half
where futures contracts the value of the underlying asset. If the future prices move by only 0.5%
are easily available. with a 1% change in the spot price, the optimal hedge required for exposure
For a cross-hedge, the
in the futures contracts should be twice the value of the underlying asset
hedge assumes special
significance. for minimization of risk. The hedge ratio becomes an extremely important
variable while using a cross hedge. This is illustrated in Example 3.5 and
Example 3.6.
Forward Rolling of the Hedge Another problem faced by hedgers arises when futures
contracts are not available for the period of hedge. For example, when a hedge is required
for 12 months and futures contracts are available for a maximum period of six months, the
hedger faces the problem of remaining exposed for the period that the futures contracts do not
cover. Under such circumstances, the hedger has to roll futures contracts covering the entire
period of the hedge. If ahedger is long on an asset for 12 months and futures are available
for a maximum of six months, he/she can take the following actions:
¢ Initially execute a short hedge for six months
e Six months later, unwind the position of the original contract by going long, and take
_ a fresh short position in a new contract for the next six months
e After 12 months, unwind the position in the second futures contract
 Commodity Futures 73

EXAMPLE 3.5 Cross hedge and hedge ratio g

A sugarcane trader is expecting a stock of 200 MT from various farmers to be available to him after three months, next April. In 1
the normal course, the prices of sugarcane in the month of April remain at $80 per quintal (¥800/MT). As a bumper sugarcane |
crop is anticipated, he is worried about a fall in prices. Futures contracts in sugarcane are not available. However, futures in
sugar are available, and 3-m contracts of 10 MT each are selling for $800 per quintal (%8000/MT). How can the trader hedge his
position using futures contracts in sugar, assuming the prices of sugar and sugarcane are perfectly and positively correlated?
Solution TE
Hedging strategy y
Futures contracts in sugarcane are not available. Hence, the trader has to hedge his position by using a cross hedge. He can |SSS
hedge by taking an opposite position in futures. Since the trader is long on the asset, he has to go short on futures. Therefore, the |
trader sells the 3-m futures contracts on sugar now and buys the same contracts back after three months, just prior to maturity. |
The number of contracts to be traded will depend upon the hedge ratio or the sensitivity of prices of the asset to be hedged to |
the prices of the futures contract. L
When the prices of sugarcane and sugar change equally, then
Valueto be hedged i 200 = 800 _
Number of contracts to be sold =
Value of future contract 10 x 8,000 L
The prices of sugarcane and sugar are perfectly positively correlated. Changes in sugarcane prices will be just as much as L
changes in sugar prices. The price of sugarcane, therefore, must be a0of sugar, i.e., 88 per quintal (880 per tonne)/ 72 per L
quintal (%720 per tonne) for a 10% change in the price of sugar. The hedging outcome for 10% increase/decrease in prices is ]
as below:
Prices rise by 10%, ~ | Prices fall by 10%, %
Value of futures contracts sold 1,60,000 1,60,000
Value of futures contracts bought 1,76,000 1,44,000 L
Profit/loss on the futures market — 16,000 +16,000 L
Spot sale of sugarcane (quantity < price) = 200 x 880 1,76,000 |
= 200. X720—— | 1,44,000
Total value realized 1,60,000 1,60,000
pore ETT ETT TTT TT EO OSE DE: a

Even if futures are available for extended time periods, the rolling over of the hedge is
considered a better option because near futures have greater liquidity and are more fairly
priced than distant futures, which suffer from poor liquidity.

HEDGING FOR CHANGES IN VOLUME! #

So far, we have considered situations relating to uncertainty about the price and how it could
be hedged through futures. Sometimes, uncertainties can prevail over the quantity of future
contracts. Most of the time, farmers face uncertainty about the quantity of the
Cae meZee _ erop that they would be reaping at the end of the season. Under such circum-
quantity uncertainties, as Stances, this interesting question pops up: can such a situation be hedged with
price and quantityhave a position in futures?
an inverse relationship. Since price and quantity are inversely related, one may believe that there
sia ~~ is a negative correlation between price and quantity. Ideally, in order to hedge
against quantity risk, we must adopt a strategy that is the opposite of the strategy used to protect
against price risks.
4For a detailed discussion, refer to The Futures Market—Arbitrage, Risk Management and Portfolio Strategies by Daniel R.
Siegel and Diane F. Siegel, Probus Publishing Company, Chicago.
74 Derivatives and Risk Management

EXAMPLE 3.6 Cross hedge and hedge ratio

Refer to Example 3.5. How would the hedging strategy change if (a) the price of sugarcane changes by half as much as that of
sugar, and (b) the price of sugarcane changes by twice as much as that of sugar?
How can the trader immunize himself from the changes in price?

Solution
(a) Hedging strategy:
When the price of sugarcane changes by half of that of sugar
0.5 x value to be hedged 5
No. of contracts to be sold =
Value of future contract
0.5 x 200 x 800 a
10 < 8,000 J
The prices of sugarcane and sugar are positively correlated. The change in the sugarcane price will be half as much as the |
change in the sugar price. The price of sugarcane, therefore, must be 5% more/less than expected, i.e., $84 per quintal (¥840
per tonne)/ €76 per quintal (%760 per tonne) for a 10% change in the price of sugar. The hedging out come is as below:

Prices rise by 10%, % | Prices fall by 10%, =

Value of futures contracts sold 80,000 80,000
Value of futures contracts bought 88,000 72,000
Profit/loss on the futures market
Spot sale of sugarcane (quantity < price) = 200 x 840 1,68,000
= 200 < 760 1,52,000
Total value realized 1,60,000 | 1,60,000
(b) When the price of sugarcane is twice that of sugar
2 X value to be hedged or
No. of contracts to be sold =
Value of future contract
2 X 200 x 800 |
10 X 8,000
The prices of sugarcane and sugar are positively correlated. The change in the sugarcane price will be twice as much
as the change in the sugar price. The price of sugarcane, therefore, must be 20% more/less than expected, i.e., 96 per
quintal (960 per tonne)/ %64 per quintal (%640 per tonne) for a 10% change in the price of sugar. The hedging out com
is as below: a

Prices rise by 10%, ~ —_Prices fall by 10%, =

Value of futures contracts sold 1,60,000 1,60,000
Value of futures contracts bought 1,76,000 1,44,000
Profit/loss on the futures market
Spot sale of sugarcane (quantity x price) = 200 x 880
= 200 Xx 720 1,44,000
Total value realized 1,60,000
Note that when sugarcane price change only half as much as that of sugar the hedge ratio dropped
to half from two
contracts to one contract. When sugarcane price changed twice as much, the hedge ratio doubled
from two to four.

Practically speaking, though, this is not exactly true. When the quantity is known for
cer-
tain, the revenue/cost is proportional to the price. Hedging actions are aimed at
protecting
against falling revenue or rising cost. When price and quantity become related,
the focus must
change to revenue and cost, i.e. the product of quantity and price.
Uncertainty about quantities primarily arises due to poor weather condition
s that affect
the aggregate output. If production is more, the price is lower and if producti
on is less, the
 Commodity Futures 75

price is higher. Let us assume that a farmer faces uncertainty about the quantity and price of
his wheat crop under the following possible scenarios:
Probability Price of wheat, </kg Quantity, kg
0.6 20.00 40,000 8,00,000
0.4 30.00 30,000 9,00,000
The expected price of wheat is 0.6 X 20 + 0.4 X 30 = 224 per kg.
Since futures prices are supposed to be unbiased indicators of the expected prices, it is
fair to assume that wheat futures would be selling for 24.00. Further, in order to hedge, the
farmer would go short on wheat futures for the expected quantity of 36,000 kg (0.6 * 40,000
+ 0.4 X 30,000). If the farmer does so, the resultant position under two possible scenarios
of price would be as under:
Price, %/kg Gain/loss on futures, < Revenue from crop, = Total revenue, <
(24 — 20) x 36,000 = 1,44,000 8,00,000 9,44,000
(24 — 30) x 36,000 = —2,16,000 9,00,000 6,84,000
It may be seen that contrary to the expectation of reducing the variability of revenue, the
position in futures has resulted in increased volatility. In fact, the position taken in futures is
inappropriate. One need not hedge for the expected quantity of 36,000 kg, because the impact
of reduced quantity is partially offset by increased price (and vice versa), due to the negative
relationship between price and.quantity. The quantity that would render stability to the revenue
would be dependent upon the covariance of revenue with the price, and is given by Eq. 3.13.
Covariance of revenue with price
UCIT Ol CAC 2 ee a (3313)
: Variance of price
The hedge ratio for Using Eq. 3.13, we find out the optimum position that needs to be taken
quantity hedging in futures to hedge against the risk of changing revenue due to combined
depends upon the ratio. | volume and price changes. The expected revenue is 0.6 X 8 + 0.4 X 9 =
of covariance of revenue
and variance of price. :
zg4 Jakh and the expected price is 0.6 X 20 + 0.4 X 30 = %24/kg. The
: :
. _ variance of price and its covariance with revenue are shown below:

Probability | Price, 7/kg | Revenue, *’000 Variance of price Covariance of revenue and price, %’000
0.6 800 —4x —4 x 0.6 = 9.60 —0.4 x —4 x 0.6 = 9.6
0.4 900 6 X 6 x 0.4 = 14.40 6 x 6 X 0.4 = 144
| 24.00 240
Covariance of revenue with price — 2,40,000
Quantity for hedging = —_ = = 10,000 kg
ss, Variance of price 24
Since protection is required for declining revenue, we go short on futures (for rising costs
we would go long on futures) to the extent of 10,000 kg of wheat and not 36,000 kg, as stated
earlier. The hedging outcome with shorting futures worth 10,000 kg results in stable total
revenue at %8,40,000 and is evaluated below:
Price, ukg Gain/loss on futures, < | Revenue from crop, < Total revenue, <
(24 — 20) x 10,000 = 40,000 8,00,000 8,40,000
(24 — 30) x 10,000 = —60,000 9,00,000 8,40,000
76 ‘Derivatives and Risk Management

HEDGING FOR GROSS PROFIT MARGIN’

Most business situations involve related inputs and outputs. The prices of finished products
Spread strategies canbe ae dependent upon the prices of raw materials. For example, sugar prices
used for protectingthe + depend heavily on the price of sugarcane. Similarly, rolling mills price their
gross profit margin where — products depending upon the prices of ingots. The prices of petroleum prod-
futures are available on = cts are heavily dependent upon the prices of crude oil. For most agricultural
inputs ae ote O28 ' products, the prices are linked to the prices of inputs.
se St Firms normally tend to pass on any increase in raw material prices to the
finished product to maintain gross profit margins, and finally the risk of price
is borne by consumers. However, despite strong correlation between the prices of inputs and
outputs, it may not always be feasible, for strategic reasons, for firms to adopt the strategy of
passing on changes in prices of inputs to consumers, even at the risk of a fluctuating gross
profit margin. Further, this philosophy of passing on the entire changes in prices to consum-
ers would become impractical when changes in prices are temporary and too frequent. Firms
have to offer fixed prices, generally valid for some time. As a marketing strategy to preserve
reputation and credibility, the prices of end-products cannot be changed too frequently. At
the same time, firms cannot afford to put their profit margins at risk.
Futures markets can serve the useful purpose of protecting the gross profit margin in the
short run against small and frequent changes in the prices of inputs and outputs. Let us con-
sider an example to highlight the utility of futures in preserving gross profit margin.
Sugar mills use sugarcane as a major input for producing sugar. For simplicity of exposi-
tion, assume that 100 kg of sugarcane yields 9 kg of sugar besides many by-products, and it
takes about one month for converting sugarcane into sugar. Therefore, the gross profit of the
sugar mill is given by:
Gross profit = (Quantity of sugar X price of sugar X 0.09)
— (quantity of sugarcane X price of sugarcane)
The sugar mill needs to sell sugar and buy sugarcane. It is long on sugar (the finished prod-
uct) and short on sugarcane (the raw material). Exposure in sugar can be hedged by going short
on futures contracts on sugar, while the prices of input can be hedged by going long on future
contracts on sugarcane. Therefore, in order to hedge the gross profit margin, the sugar mill
would take simultaneous positions of (a) long on futures contract on sugarcane, and (b) short
on futures contracts on sugar. The time and quantities, too, need to be matched. If the sugar
mill needs to plan two months in advance, it has to take actions, as depicted in Fig. 3.5.

Buy Buy Sell

2-m sugarcane futures Sugarcane Sugar
Sell Sell Buy
3-m sugar futures Sugarcane futures Sugar futures
equal to 9% of exposure in
sugarcane futures

Fig. 3.5 Hedging for gross profit: Sugar mill

 Commodity Futures rei

We consider a simple example of how gross profit margin can be protected

~ Going long on futures of
raw material and short on by a sugar mill°, as depicted in Fig. 3.5. We know that the sugar mill has
_ futures on finished goods a yield of 9%. One quintal (1 quintal = 100 kg) of sugarcane yields 9 kg
provides a tactical way _ of sugar, with a processing time of one month. The mill needs to plan two
of protecting gross profit _ months in advance, and, hence, would need to buy a 2-m futures contract
margin, making strategic
_ on sugarcane and sell a 3-m futures contract on sugar equal to 9% of the
policies more stable
quantity of sugarcane. Consider the following scenario relating to the futures
price today:
2-m futures on sugarcane > %180/quintal
3-m futures contract on sugar : 25/kg
With a futures contract, the price realized/paid is equal to the futures price now less the
basis at the end. Assuming the basis for sugarcane is zero at the end of two months and zero
at the end of three months for sugarcane to keep the exposition simple, the gross profit margin
per quintal of sugarcane is proportional to €45, as can be seen here:
Gross profit = Price of 9 kg sugar — cost of 1 quintal of sugarcane
=9 XK 25 — 180 = %45
It may be realized that the protection of gross profit margin is a combination of inter-
commodity spread using futures on sugarcane and sugar, and calendar spread using 2-m and
3-m futures (discussed in the next section).
Having taken a long position in futures of sugarcane and short position in futures of sugar,
the sugar mill would hedge against fluctuating gross profit margin. Table 3.1 demonstrates

Table 3.1 Hedging for gross profit: Sugar mill

Price scenario
Sugarcane %190/quintal =170/quintal
Sugar %22/kg <27/kg
Sugarcane futures
Bought at %180 =180
Sold at 190 2170
(a) Profit/loss on sugarcane futures 710 <0
Sugar futures
Sold at %25 25
Bought at %22 %27

(b) Profit/loss on sugar futures 9X 3 = &2/ 9x -2- 18

(c) Profit on futures contracts (a + b) %37 <2

Spot position
Price realized for suger 9 X 22 = %198 9 X 27 = %243
Price paid for sugercane %190 =170

(d) Gross profit on spot position %8 873

Aggregate profit (c + d) %45 %45

5Based on Crack Spread at NYMEX for futures on crude oil for input and futures on gasoline and heating oil for output.
78 Derivatives and Risk Management

hedging for profit for two different sugarcane and sugar price scenarios. Profit and loss in
the spot position would be compensated by loss and profit in the futures position. We have
assumed the convergence of prices at the end of the hedge, matching with actual buying of
sugarcane and selling of sugar. Barring basis risk, the actual profit margin would differ mar-
ginally from the targeted figure of €45 per quintal of sugarcane.
We can clearly see that futures can protect day-to-day fluctuations in the gross profit mar-
gin, obviating the need for frequent adjustment of prices of finished goods in accordance with
changes in the raw material prices.

STRATEGIC IMPLICATIONS OF FUTURES 99

The preceding examples of hedging against quantity risk and hedging to protect gross profit
Futures can be viewed as demonstrate the capability of futures as a tool for handling a variety of situ-
a strategic product rather ations. Despite the limitations of imperfect hedges with futures, there are
than a mere tactical prod- other benefits that are possibly difficult to evaluate in financial terms. Futures
uct capable of providing = should not be seen merely as financial products capable of providing an
hedging of routine day-to- effective hedge against price changes. The futures market in commodities
sactions. : :
oy — throws up many more managerial options, and can be used as strategic tool
rather than a tactical tool for hedging transactions.
e With regard to pricing, consider, for example, a wheat grower expecting to reap a
harvest in six months’ time. He can continuously monitor the price of futures for the
next six months and trade at the most favourable price that he finds. A range of prices
prevailing over an extended period of time is not available to him in the absence of a
futures exchange. Futures markets thus compliment marketing strategies.
e Ona similar note, we can say that purchasing strategies also have much wider choices
with access to a vibrant futures market.
e With respect to inventory management, futures are of tremendous use in protecting the
value of closing stock. At an appropriate target price, futures can be traded to have the
values of inventory protected.
¢ From a strategic viewpoint, steady cash flows enable the investor to command a better
valuation of stock prices when borrowing from lenders, etc., and can help to bring down
the cost of capital.

SPECULATION WITH COMMODITY FUTURES |

Just as with forward contracts, commodity futures can be used for purely speculative gains.
As smaller payments (initial margins) are required to book futures contracts than to take
an
equivalent position in the cash/spot market, futures provide highly leveraged positions.
This
magnifies the potential profit as well as the potential loss.
Futures can be used ____ To speculate on the prices of the commodity in the physical market, one
for speculation if the requires huge resources to first buy and store goods till the desired price is
estimate offuture spet_ =» reached, and then sell at higher prices at a later date. Note that that no short
price is different than the
futures price, sale is p possible in the commoditieses m market. : Speculating
i He
on the commodities
_ markets is tantamount to hoarding, which is generally regarded as a social
evil.
 Commodity Futures 79

Rather than using cash or the physical market, one can speculate on futures to achieve the same
objective, with the advantage of a much smaller capital outlay. Speculation in the commodities
markets through futures also saves the speculator from the social stigma attached with specula-
tion (hoarding) in the physical markets. To speculate on the prices of commodities, one has to
do one of the following:
¢ Ifa trader expects a price fall, he/she simply has to sell a futures contract today and
buy it later. For example, in September 2010, futures contracts of silver for delivery in
December 2010 are quoted at 710,921 per kg. A trader in silver believes that the price
in December will not be more than ~10,000 per kg. The trader can take a speculative
position in futures by selling them today and square up later by buying the same any
time prior to December 2010, presumably at a price lower than the selling price; thus,
the trader makes a speculative profit.
e If a trader anticipates a rise in prices, he/she simply has to buy futures today and
sell later. For example, in September 2010, futures contracts of pepper for delivery in
January 2011 are quoted at ¥6627 per quintal. A trader in pepper believes that the price
in January will be not less than %7300 per quintal. The trader can take a speculative
position in futures by buying them today and square up by selling the same any time
prior to January 2011, presumably at a price higher than the buying price; thus, the
trader makes a speculative profit.

SPREAD STRATEGIES WITH FUTURES *

The use of single futures contracts with speculative motive is referred to as open position trad-
ing, where one speculates on favourable price movement. Many traders perceive this to be too
risky a proposition and prefer to monitor basis (the difference between futures and spot prices)
rather than price. The speculation on basis is referred to as spread trading. Spread trading is
speculation on the price differential between two contracts, and involves buying one futures
contract while selling another. Spreads can be categorized into three types:
e Inter-commodity spread
e Inter-market spread
e Intra-commodity spread (also known as time/calendar spread)

Inter-commodity spreads These are derived from buying a futures contract in one com-
modity and selling another in a related commodity. For example, a trader may buy gold
futures and sell silver futures of the same maturity if he/she feels that gold is underpriced
as compared to silver today, and that by the time the futures contracts mature, the markets
will have restored the balance between gold and silver prices. Similarly, a trader may buy
_ tea futures and sell coffee futures if he/she believes that coffee futures are
epee sietees _ overpriced as compared to tea, and that the aberration in the prices of these
eal related commodities will not last long. He/she expects either tea prices to go
futures contracts (a) in up, coffee prices to fall, or both. Speculation with spreads is in fact equivalent
_ two assets, (b) in two to two open positions: a long position in one commodity and a short posi-
_ markets, or (c) of two tion in ancther related commodity. However, a spread position may involve
: aferent maluinies. a smaller outlay in terms of initial margin than the sum of two independent
80 ‘Derivatives and Risk Management

open positions, if the commodities are on the same exchange, subject to its bye-laws. In case
the expectations of the trader fall apart, the losses of the trader will be proportionately large.
Here, the relative valuation is of significance rather than speculation on the absolute price of
one commodity, considered riskier than bets on relative prices. Refer solved problems SP3e2
for comprising spot and futures position for speculative gain.
Inter-market spreads These involve opposite positions in the same commodity, but at differ-
ent markets/exchanges. The price differential in two exchanges for the same commodity may
exist because of transportation costs involved, or two exchanges may specify different delivery
locations/centres. For example on 28 September 2005, jeera futures for December delivery at
NCDEX and MCX were quoted at 76698 and %6783 per kg, respectively®. One may buy jeera
futures at the cheaper location, NCDEX, and sell at the more expensive location, MCX, to book
a profit. This implies two independent positions in two different locations in the same commod-
ity, with the intentions of pure arbitrage. This arbitrage is, of course, subject to transportation
costs and any other differences in the contract features. The apparent disparity in prices may
not actually be there, because the two locations may specify different delivery centres.
Time spreads These involve opposite positions in the same commodity on the same
exchange, but with different maturity dates. Consider the prices of jeera futures at NCDEX
as on 28 September 2005 for October, November, and December deliveries as 6345, $6528,
and 6698’, respectively. The price differential between November and October is 2183
(6698 —6528) while the differential between the December and November contracts is ~170
(6698—6528) only. If cost of carry is assumed to be proportional to the time, a trader may
believe that an equivalent differential is appropriate. However, at a differential of $183 per
month, the December futures seem underpriced as compared to the November futures. Hence,
the trader may go long on the December futures and short on the November futures. Subse-
quently, if the differential of %183 becomes a reality, the trader gains on the spread created
earlier. Solved problem SP3.2 illustrates application of calender spread.

SOLVED PROBLEMS ©»
SP 3.1: Short hedge with commodity futures
A jute packaging unit has planned production of 4300 kg of jute to be sold six months later. The spot price of jute is 1900 per kg
and a 6-m futures on the same is trading at 1850 per kg. The prices are expected to fall as low as %1700/kg six months later.
What can the jute packaging unit do to mitigate its risk of reduced profit? If it decides to make use of the futures market, what
would the effective realized price for the sale of jute be when the spot and futures prices were €1750 and &1755, respectively?
Assume size of futures contract as 200 kgs.
Solution
In order to hedge, the firm would go short on futures at the current futures price of 1850. By doing so the firm ensures a price
realization of around %1850 per kg irrespective of the spot price prevailing at the end of six months.
Quantity of jute to be hedged 4300 kg
Size of one futures contract 200 kg
No. of futures contracts sold 4300/200 ~ 22 contracts
Futures price = %1850
Value of futures sold 1850 x 22 x 200 = %81,40,000

°£7 Source: Business Line, 29 September 2005.

 Commodity Futures 81

Six months later, the firm would unwind its futures position by buying the futures contract back and selling the goods in the spot
market.
z
Futures bought at price 1755
Amount bought for 22 contracts 77,22,000
Gain/loss on futures 418,000
Spot price 1750
Actual cost of selling 4300 kg 75,25,000
Effective cost of buying 79,43,000
Effective price realised 1847

SP 3.2: Speculation with commodity futures

A trader in sugar is extremely bullish with the current price at ¥25 per kg. A futures contract on sugar with three months to maturity is
trading at 28 per kg. One contract in sugar is for 1000 kg, with a 10% margin.
(a) With funds of %1,00,000 available, what could the strategy of the trader be ifthe price is expected to rise by 20% in three months?
(b) At what minimum expected price after three months of taking a position in futures would the strategy be more profitable?
(c) What happens if the price of sugar actually fell to €24 per kg?

Solution
Since the prices of sugar are likely to go up, the trader has two options—(a) buy sugar in the spot market, store, and sell after three
months at a higher price, (b) buy sugar futures now and sell them three months later.
(a) Price now: Spot = %25.00 Futures = %28.00
Price three months later Spot = ¥30.00 Futures = spot = ~30.00
Dealing in the spot market:
Amount of stock of sugar that can be bought = 1,00,000/25 = 4000 kg
Profit at the end of three months = 20% X 1,00,000 = 20,000
Dealing with futures market:
Value of one contract = 28 x 1000 | = %28,000
Margin required = 0.10 X 28,000 = %2800
No. of contracts that can be bought = 1,00,000/2800 = 35 (rounded off)
Exposure in sugar = 35,000 kg
Profit on 35 contracts with price rise of 20% = (30 — 28) x 35 x 1000 = 70,000
b) With the same amount of funds, the cash position is 4000 kg at ¥25 while a futures position is 35,000 kg at €28. With cash and
futures price equal at the end of three months at X, for the profit in futures position to exceed the cash position, the following
must hold:
(X — 28) x 35,000 = (X — 25) x 4000
X = %28.39
For a speculative position to be more profitable, the expected price must exceed %28.39/kg.
c) If the price actually fell to ¥24
Loss in cash position = 1 x 4000 = ~4000
Loss in futures position = 4 X 35,000 = %1,60,000

SP 3.3: Calendar spread with commodity futures

The spot price of crude oil is 3000 per barrel. In the futures market, 3-m and 6-m contracts are trading at €3125 and %3200,
respectively. The cost of carry, inclusive of storage and insurance, is 15% p.a. If the cost of carry model applies, find the following:
(a) Fair price of the futures contracts for three months and six months. What action can an arbitrageur take in this situation?
(b) If at the end of three months the spot price were ¥3500 and the futures market stood corrected, what would the profit to the
arbitrageur be?
(c) If at the end of three months the spot price were %2700 and the futures market stood corrected, what would the profit to the
arbitrageur be?
 82. Derivatives and Risk Management

Solution |
(a) The fair price of 3-m and 6-m futures with cost of carry of 15% and spot value of ¥3000 is
F,= Sp X et= 3000 x e915 * 92 = 3114.64 Actual price= %3125
Fe= Sy X et = 3000 x 6°15x612 — %3233.65 Actual price= %3200
An arbitrageur would act as follows:
(i) The 3-m futures are overvalued and must be sold.
(ii) The 6-m futures are undervalued and must be bought.
(b) If at the end of three months the spot price increased to €3500 and the future prices stand corrected, then the fair values of
futures would be 3500 and %3634, at which the arbitrageur squares off. His position would be
Original 3-m futures
Sold at %3125 Bought at 3500 Profitloss —%375
Original 6-m futures
Bought at %3200 Sold at %3634 Profitloss +%434
Net profit on the calendar spread X59
(c) If at the end of three months the spot price decreased to ¥2700 and the future prices stand corrected, then the fair values of
futures would be ¥2700 and %2803, at which the investor squares off. The position of the investor would be:
Original 3-m futures
Sold at %3125 Bought at 2700 Profit/loss +2425
Original 6-m futures
Bought at %3200 Sold at %2803 Profit/loss Soul
Net profit on the calendar spread %28

SUMMARY
Commodity futures are perhaps the oldest futures with com- cial assets, cannot be used as very effective logic while pricing
modities as underlying assets. With increased globalization and commodity futures. While a one-way arbitrage of cash-and-carry
integration, volatility in prices of commodities such as crude oil is possible, the arbitrage of reverse cash-and-carry is not execut-
is governed not only by local factors but also by international able, as most commodities have consumption value, and are not
economic and political conditions. Hence, there is a greater need held as investment assets. This places an upper bound to the
for protecting prices in a competitive atmosphere, for efficient prices of futures on commodities.
dissemination of information, and for constant monitoring. Com- - Hedging with commodity futures can be classified as (a) short _
modity futures help in price discovery, reduction of seasonal vol- hedge and (b) long hedge. Hedging with futures is done by taking
__atilities, faster flow of information, reduced cost of credit due to a position in futures that is opposite to the position in the physical :
certainty of price, and creation of more efficient physical markets. asset. If one is long on the asset, protection is required against _
At the macro-level, a commodity futures market serves the any fall in price. To hedge, one takes a short position (sells) in
extremely useful purpose of making fiscal management prag- futures. This called a short hedge. A short position in commodi-
matic and independent of volatility in the prices of commodities. It ties needs to be protected against price rise. Here, the hedger _
helps to reduce budgetary burdens involving MSP programmes buys a futures contract (goes long on futures). This iscalled a
and subsidies by transterring the function of price management long hedge. :
to private bodies and individuals ready to provide risk reduction. A hedge with futures is rarely perfect, unlike a forward hedge, —
In aggregate, it makes the whole structure most efficient. which is perfect. Since futures are cash-settled with the hope of
There are major differences between commodity and financial offsetting the gains/losses in the physical market, the offsetting _
futures. The specifications of contracts on commodities face sev- is rarely complete. This happens because of mismatch of qual-
eral constraints that contracts on financials do not. Commodities ity, mismatch of quantities, and mismatch of timing|
betwee the
are characterized by limited shelf life, seasonal variations, elabo- futures and physical positions. _
rate delivery requirements and quality differentials, etc. None of Any difference between the futures price and the snot price
these constraints are present in financial futures. is called basis. The imperfect hedge results because of varying
The pricing of commodity futures is not as simple as the pric- basis. If the basis were constant, offsetting would be complete.
ing of financial futures. The argument of no arbitrage, which However, any change in the basis is far smaller than any change _
forms a fundamentally sound basis for futures pricing for finan- in price due to the correlation between futures and spot pices
 Commodity Futures 83

ard opresitepostions Therefore, in“futures, hedge price risk buy futures now and sell later. In case prices are expected to
gets replaced by a much smaller basis risk. decline, the strategy would be to go short now and square up
_ More offen than not, only price risks of commodities are later, Arbitrage is executed in case one finds prices in the physi-
hedged with: futures. However, hedging can also be to cover cal market and the futures market are out of sync. One would
k against uncertain quantities. Fluctuations in revenue due to _ buy in the cheaper market, sell in the more expensive market,
certainties in quantity are hedged by fixing the hedge ratio and nullify positions in both when the price disparity disappears.
sed on the covariance of revenue and variance of price. _ Arbitrage can also be executed in the futures market alone when —
Effectiveness of the hedge as measured from the degree of the prices of futures maturing at different times are not consis-
offsetting is dependent upon the correlation of prices of futures tent. Arbitrage is executed by taking simultaneous and opposite
with those of the spot/physical market. The optimum hedge ratio positions in two futures contracts and exiting when the prices of
is defined as the number of futures contracts that are required the two contracts become consistent.
for minimum risk in the combined portfolio of asset and futures. The same philosophy of taking simultaneous opposite posi-
itdepends upon the volatilities of the spot and futures prices and
tions of long on futures contracts for input and short on futures
the coefficient of correlation between the two. contracts for output with different maturities would protect the
_ Apart from hedging, futures can also be used for speculation gross profit margin, without frequent adjustment to me prices of —
and arbitrage. When one expects prices to increase, one has to — output or input.

KEY TERMS
Basis The difference between the futures price and the spot Investment assets Assets primarily held for investment pur-
price. poses.
Basis risk The possibility that the basis would not be equal Long hedge _A long position in futures in order to hedge the
at the inception and termination of the hedge, resulting in an short position in the cash market.
imperfect hedge. Optimum hedge ratio The ratio of positions in the futures and
Commodity futures Futures whose underlying assets are spot markets that minimizes risk is optimum hedge ratio.
commodities. Perfect hedge In a perfect hedge, gain/losses in the cash
Consumption assets Assets primarily held for consumption market are fully offset by losses/gains in the derivative market.
and not for investment purposes Rollover hedge Under rollover hedge, position in near month
Cross hedge When an exposure in an asset is covered by a contracts is squared up at maturity and new position opened to
position in futures not in the same asset but in another strongly cover the entire hedging period.
correlated asset for hedging. It is referred as cross hedge. Short hedge A short position in futures in order to hedge the
Hedge ratio The ratio of positions taken in the futures and long position in the cash market.
spot markets in the hedge. Spread The difference in the prices of futures for different
Imperfect hedge In an imperfect hedge, gain/losses in the assets, different markets, or different maturities.
cash market are only partially offset by losses/gains in the deriv-
ative market.

QUESTIONS
3.1 What do you understand by commodity futures? 3.5 What are the possible modes of speculation with commodity
3.2 What are the benefits of commodity futures at national futures?
level? : 3.6 How is pricing of commodity futures different from that of
3.3 What are the differences between commodity and financial financial futures?
futures? 3.7 What is a calendar spread? Explain with an example.
3.4 What do you understand by (a) long hedge and (b) short
hedge? Illustrate.

PROBLEMS
P 3.1 Basis and price—short hedge 100 g on gold is 15,400 per 10 g. In order to protect against any
A trader in gold holds stock of 1 kg valued at £15 lakh at the spot fall in value of the gold, the trader decides to sell 10 contracts
price of $15,000 per 10 g. A 3-m futures contract with a size of in gold for 3-m delivery. However, after one month, the trader is
84 Derivatives and Risk Management

required to sell the stock of gold at 14,500, and therefore also would be optimal?
cancels his position in futures at 714,700. Find out the price the P 3.4 Cross hedge
trader realized. An industrial firm uses tin as raw material and has a requirement
P 3.2 Basis and price—long hedge for 400 kg of tin to be procured six months from now. The prices
Assume in P 3.1 that the trader had planned to buy gold and thus of tin are expected to rise substantially. The firm needs to hedge
went short on the futures on gold. After one month, the trader against price rise. There are no derivative contracts available on —
bought gold and lifted the hedge. What price did the trader end tin, but futures contracts on aluminium are popular.
up paying? The prices of aluminium and tin are strongly correlated. A
P 3.3 Hedge ratio study has revealed that standard deviations of prices of tin and
The risk of spot prices on gold as measured from its standard aluminium are 21% and 20% of their current prices of ¥720 per
deviation is placed at $120. Similarly, the price risk of a 3-m kg and 90 per kg, respectively. The coefficient of correlation is
futures contract on gold is estimated to be %150. The coeffi- placed at 0.95. One futures contract on aluminium is for 1000 kg.
cient of correlation between the two is placed at 0.85. In order How can the firm hedge?
to hedge a spot position on gold, what ratio of futures contract
 Stock and Index Futures

INTRODUCTION Learning Objectives

All of us have heard about the terms SENSEX and NIFTY. After going through this chapter,
Besides other applications and indica- readers should be familiar with
_ An index is a represen- tions of indices, they are devised by ® various terms associated with
tative sample used for futures contracts on indices and
ae vea cote of stock exchanges to measure the day-to-
the stock markets and_ day movement of stock prices. Indices individual stocks
the margining system used in
the economy. were developed to enable a bird’s eye futures contracts
view of the state of the financial mar- e use of futures contracts for hedging
kets. For example, changes in the consumer price index or the « along position in a portfolio
wholesale price index reflect the rate of inflation; similarly, against fall in price
changes in the stock indices measure the state of the financial » ashort position in a portfolio
against rise in price
markets at any given point of time, and will reflect growth in the applications of index futures to
value of stocks. In general, stock indices are regarded as barom- = eliminate market risk in a
eters of the state of the economy. portfolio, and
There is a huge number of shares listed on each stock exchange, + control the beta of a portfolio
speculation and identification of
and changes in the price of each of the stocks will indicate the
e

arbitrage opportunities in the futures

state of the market. It would be a difficult task indeed to moni- market
tor the changes in value of all the stocks listed on an exchange. other applications of index futures
In order to make qualitative and quantitative judgements of the
activities going on in the market, one has to develop a repre-
sentative sample, just as we develop a basket of goods that are
included in the consumer price index to measure inflation. Since
indices are developed to include all sectors of the economy and
all prominent stocks in each sector, the changes in the value of
the index are regarded as a fair indicator of market risk.
A stock index is supposed to reflect the state of the financial
markets and provide a bird’s eye view. Inflation rates and inter-
est rates are indicators of the economic state of a nation, and,
similarly, the index is an aggregate single measure that reflects
the mood and sentiments of the stock market, and serves as a
proxy for the state of the economy.
86 _ Derivatives and Risk Management

Futures on indices or stocks serve the same purpose as futures on commodities or any
other products. Stock and index futures are the most widely traded of all futures contracts.
They were first introduced in 1982 by the Kansas City Board of Trade. Today, there are
index futures available in almost all the stock exchanges of the world. A large number of
exchanges worldwide provide futures contracts on (a) broad-based indices, (b) somewhat
narrower sector-based indices, and (c) individual stocks. While broad-based indices provide
information on the state of the whole economy, sector-based indices reflect upon the potential
of particular sectors. Indices and futures for a given sector enable one to get an overall view
of that sector as a whole. Moving further down and narrowing the scope, one can have futures
contract on an individual stock, which enable taking a position or a view on a particular firm.
Futures on broad-based indices, sector-based indices, and individual stocks present a vast
choice of instruments to a large number of investors to hedge, speculate, or arbitrage. Futures
on indices and on individual stocks make financial markets complete.

INDEX FUTURES | _...__..si_m=d_.6§-.

Stock index futures can be defined as a commitment to buy or sell at a future date a portfolio
_ of stocks comprising the index. Construction of a stock index involves select
ee ae o shares, their prices, and the number of outstanding shares. As the prices of
a. ee _ the stocks change, the value of the index also changes. To attach value to
accois index futures, each point is assigned a monetary value. If each index point is
LL
equal to 1, as is the case with the National Stock Exchange (NSE)’s NIFTY
or the Bombay Stock Exchange (BSE)’s SENSEX, then an index of 4400 would be equal to
a monetary value of %4400.
A stock index is a hypothetical product and does not have a physical form, which makes
it a non-deliverable asset in practice; theoretically, though, it is possible to have an index as
a portfolio of stocks comprising the index in the same proportions that make up the index
construction. Unlike commodities and currency futures, where delivery can be enforced,
stock indices cannot be delivered. In theory, an index may be deliverable, and the delivery
will consist of shares included in the stock index in their relative proportions. However, for
all practical purposes, we can deem the stock index to be a non-deliverable asset.
As we have learnt before, the delivery of an underlying asset is essential in derivative
transactions for them to be true indicators of future spot prices, and to serve as effective
instruments of hedging. However, index futures are cash-settled by an offsetting contract that
iS Opposite to the original contract. Since the delivery of an index is impractical, contracts
in stock index futures are necessarily cash-settled. Cash settlement implies the exchange of
differences in the prices upon cancellation of the original contract. Stock exchanges deem
all outstanding open positions as squared up at the prices prevailing of the day of closing of
the relevant futures contracts.

FORWARD CONTRACTS ON STOCKS

Stock index futures were introduced in India in mid-2000 after some legal hurdles were
overcome. The act governing securities, i.e., the Securities Contracts Regulation Act (SCRA)
had prohibited dealing in futures and options. With the passing of the derivative bill by the
 Stock and Index Futures 87

parliament, stock index trading began at the BSE on 9 June 2000 and at the NSE on 12 June
2000, with trading on SENSEX futures and NIFTY futures, respectively. Though several
other indices and futures on them have come into existence since then, futures on the NSE
NIFTY-50 remains the most popular.
Prior to the introduction of futures on the Indian financial markets, a somewhat similar
_ product called badla had been in vogue in the market for a long time. Badla
Forward contracts in
stocks have been al- enabled forward trading in stocks and provided a tool for speculation in stock
lowed in India for a long prices. In the olden days, when suitable technology was not available, the
time, even prior to the stock market had settlements on a fortnightly basis and, later, on a weekly
introduction of futures. basis. Netting of positions was allowed over the settlement period. For exam-
The system of badia, ple, if one bought 100 shares of Reliance Industries Ltd (RIL) on Monday
perhaps unique to India,
enabled speculation in and sold them the next Wednesday, the net delivery position would be zero.
Indian stock exchanges. Today, this settlement period stands reduced to one day, where the netting is
allowed over a single day rather than a week or a fortnight. The term day
traders has become associated with investors who believe in zero outstanding positions at the
end of the day.
Besides netting over the settlement period, trading in stocks on Indian stock exchanges
also allowed carry forward of the trade to the next settlement period. Assume that an investor
bought 100 shares of RIL at a cost of ¥500 per share on Monday with weekly settlement; the
investor faced the following three options on Friday, the settlement day:
e Settle by delivery Pay %50,000 and take delivery of 100 shares of RIL.
e Square up Sell the shares at the clearing price of Friday, say ¥600, and receive 7100
x 100 = $10,000. If the price was %450, then the investor would pay %5000 (%50
100). One could do so prior to the settlement also.
e Carry forward the transaction Neither settle by delivery nor square up, but defer the
commitment to pay the contract value of ¥50,000 and carry forward the transaction
involving cash and delivery of shares to the next settlement period, due the next Friday.
This carry forward is referred to as badla.

While the first two options are straightforward, the bad/a transaction may need some elab-
oration. To carry forward to the next settlement period, one has to pay a carry forward charge.
In essence, a carry forward defers payment, and the buyer must pay the equivalent interest
for this deferment. Charges for carrying forward transactions are fixed by the exchange and
reflect the interest rates prevailing, as also the technical position of demand and supply of the
security in question. The difference between the contracted price and the settlement price is
paid/received by another party called a badla financier, who takes delivery of the shares at
the settlement price in one settlement period and passes them on to the original investor in
the next settlement.
For speculative investors, bad/a enables deferment of delivery. One could repeat the posi-
tion on the next settlement, and, therefore, while the price of the share remains fixed at $500
as originally contracted, delivery is deferred by paying the carry forward charges, a feature
that a forward contract or a futures contract offers today. Badla charges were proportional to
the interest rates prevailing then and reflected cost of carry. While bad/a meant payment of ©
cost of carry, the differential between settlement and contracted prices was paid or received
by the badla financier and can be termed analogous to marking to market (MTM).
88 Derivatives and Risk Management

the buyers
When sellers instead of buyers sought deferment of delivery, they had to pay
on
to agree to defer delivery; this payment was called ulta badla. The system depended
whether those who were willing to accept delivery on settlemen t day were more in number
than those who were interested in giving delivery. It is analogous to backwardation, or nega-
tive cost of carry.
In today’s market, two alternatives for taking delivery and squaring up are still available,
with the settlement period reduced to a single day. As mentioned earlier in this chapter, those
who square up on the same day are referred to as day traders. However, the third option of
carrying forward a trade is not available in stock markets today. If one does not intend to
deliver or square up on the scheduled day, one has to conduct operations in the futures market,
different from the spot market.
In earlier days, the intention of delivery or carry forward was not required to be disclosed
on the day of opening of trade. Spot deals and forward deals could be conducted in the same
market, except that the carry forward facility was limited to a few active stocks. A decision
with regard to delivery or carry forward could be taken on the settlement day, as the markets
for spot and forward were integrated then. Today, separate markets exist for spot and future
deliveries. The markets or segments meant for future delivery are referred to as derivatives
market.
For several reasons, such as a number of payment crises, operational difficulties, misuse
of the system by a select few, etc., the system of forward trading or badla was banned, rein-
troduced, and then banned again from the market. An alternative to speculators was made
available in the form of another product called futures, which inter alia served the objective
of speculation, but was better regulated, with systems for initial margins, MTM and settle-
ment procedures. An added advantage with futures was that the product could be applied to
the index, while badla was confined to select individual stocks. Badla was a relatively simple
and conceptually strong product that did not suffer from major fundamental deficiencies. It
was banned because it had operational and implementation problems. The system of badla
stands abolished today, and has been superseded by futures and options on stocks and indi-
ces, with elaborate margining and control mechanisms. We now discuss futures on indices
and stocks.

FUTURES CONTRACT ON INDICES AND INDIVIDUAL STOCKS

As we already know, a futures contract means delivery of the underlying asset at a future
date at a price fixed today. While the forward contract could be tailor-made to the require-
ments of the buyer and the seller, the futures contract needs standardization with the inter-
vention of an exchange between the buyer and the seller. Note that badla, too, required
intervention of an exchange, yet we call it a forward contract, as it lacked the level of
standardization that is conventional with futures.
Stock exchanges define the characteristics of futures contracts, such as
Besides futures onindi- the underlying indices, market lots, and the maturity dates of the contracts.
ces, we also have futures : Futures contracts are available for trading from introduction to expiry date.
a stocksin = The NSE and BSE in India offer futures contracts on several indices such
as NIFTY and NIFTY Junior, and indices for sectors such as information
 Stock and Index Futures 89

Quote As on Sep 25, 2012 12:15:51 IST & All prices in &

S&P CNX Nifty - NIFTY . iindex Watch }Option Chain

® index Derivatives (> Stock Derivatives (> Currency Derivatives

Instrument Type: Symbol : Expiry Date : Option Type: Strike Price :

Index Futures NIFTY ie 250072012 |» | Se OL

5 702.00 Prev.Close Open High

~ 080 001% (570280 571000 572295 5688.00

Fundamentals Historical Data

Print Order

Traded Volume (contracts} 74.678 a orient

Traded Value (lacs} 213,104.87 Buy Qty. BuyPrice SellPrice Sell Qty.
VAP 5 707.30 200 «SG70175 5,702.00 950
Underlying value 5,867.70 200 «5701.25 «5,702.25 50
farket Lot ep 50 S701.00 5,702.45 4,000
Open interest 08,19
ae & 580 5,700.95 5,702.95 350
Change in Open Interest TF AN4
200 5,700.90 5,703.00 400
% Change in Open Interest 44 5
217,750 TotalQuantity | 2,238,900
implied otatiity
= Gost of Carry

Beat Buy Best Sell Last Price

§, 701.75 5,702.00 6,702.00
7.25 7.34 7.34

Source: www.nseindia.com, accessed on 25 September 2012.

Fig. 4.1 Price information of futures contracts on index (NIFTY) at NSE

technology (IT)-and banking, besides on many individual stocks. Figure 4.1 depicts the price
information on futures contracts on the popular NIFTY index. Figure 4.2 depicts the price
information for futures contracts on the stock of ITC Ltd.
A stock exchange acts as a market maker by offering two-way quotes. It also functions
as a clearing house, and each member signs a separate agreement with it. Though futures
contracts can be offered for long-term maturities by stock exchanges, exchanges in India have
introduced monthly contracts maturing on each of the next three months. For example, in
the month of January, three contracts, referred to as January, February, and March contracts,
would be available. The day of settlement has been fixed as the last Thursday of each month.
The next month’s contract would be introduced on the following Friday.
90 Derivatives and Risk Management

Quote As on Sep 25, 2012 12:20:21 st © All prices in &

imi Get Underlying Quote | Option Chain
ITC Limited - ITC se

>) Index Derivatives ‘@ Stock Derivatives “ Currency Derivatives

Instrument Type: Symbol: Expiry Date ; Option Type : Strike Price :

ITC [we] 250CT2012 [iw] Select Select

259.70 Prev.Close Open High

305 1.19% 256.65 256.25 259.80
Fundamentals Historical Data

Print Siar: inelee-chary — =

Traded Volume (contracts) 3,932

Traded Value (lacs) 10,159.11 Buy Qty. Buy Price Sell Price
VAP 258.37 1,000 259 60 259.80
Underlying value 259.05 4,000 259.55 259.85
Market Lot 1O00 4000 259.50 259.90
Open interest 2,06,02,000 1,000 259.45 259.95
Change in Open interest ~5, 76,000 5,000 259.40 260.00

% Change in Open interest ~2.72 3,75,000 Total Quantity

Imphed Votatilty
ei = Cost of Carry

Best Buy Best Sell Last Price

Price 259.60 258.80 258.70
Cost of Carry 38.74 52.76 45.73

Source: www.nseindia.com, accessed on 25 September 2012.

Fig. 4.2 Price information of futures contracts on ITC Ltd at NSE

FEATURES AND SPECIFICATIONS OF STOCK/INDEX FUTURES

Standardization aspects of futures contracts currently available in Indian stock exchanges,
with indices as underlying, relate to lot size, tick size, price quotation, settlement date, etc.
Explanations of the details of futures contracts on indices and individual stocks are as follows:
Contract size The minimum contract value is set to be close to 22 lakh at the time of
introduction. The minimum lot for the BSE SENSEX was fixed at 50, while for NIFTY it
was 200, initially. Today, the size of lots in NIFTY futures contracts is also set at 50.
Contract value Each point is considered to be equivalent to 1. If NIFTY has a value of
5050, the contract size would be 5050 X 50 X 1 = %2,52,500.
 Stock and Index Futures 91

Tick size Tick size indicates the minimum change that is allowed in the price quotation. It
is fixed at 0.05 points for both SENSEX and NIFTY. Hence, the minimum change in value
of aNIFTY contract will be 50 X 0.05 = 2.50.

Margins Futures have an elaborate margining system. Whether for a buy or a sell transac-
tion, the margin (percentage of contract value) determined by the exchange needs to be com-
pulsorily deposited with the exchange before executing the trade. It is called the initial margin.
Besides the initial margin, profit/loss adjustments on a daily basis (MTM) are also required.

Number of contracts At any point of time, three monthly contracts are available. There- _
fore, the period of hedge or speculation is confined to the next three months. The contract
expiring first is referred to as the near-month contract, and the contract expiring last is called
the far-month contract.

Maturity/expiry Each contract expires on the last Thursday of the delivery month. A new
series comes into existence on the following Friday.

Settlement As indices are non-deliverable, a futures contract is cash-settled. However,

obligations under futures contracts can be liquidated by entering into a contract opposite to
the original contract before expiry. If not closed by the last day of trading, the open position
is automatically closed on that day at a price determined by the exchange, called the final
settlement price.
Besides index futures, we have futures contracts on individual stocks in India. One such
contract is depicted in Fig. 4.2. Stock futures are financial contracts, where the underlying
assets are individual stocks. These contracts have standardized specifications too. In India,
the amount of each futures contract is determined by the respective stock exchange and was
fixed initially at around %2 lakh. Thus, the number of shares in each stock futures contract
depends upon the prevailing value of the stock.
Unlike index futures, the delivery of stock futures is possible, as the stock in question can
be delivered. However, for the sake of uniformity, stock futures are only cash-settled at pres-
ent, and there is no requirement for delivery. The final settlement is done at the final settle-
ment price on the last day of the contract.
All over the world, futures contracts on indices are preferred, as they are used for hedging
diversified portfolios held by financial institutions. Futures on individual stocks do not exist
in all countries. However, they are gaining acceptance with time, as futures on individual
stocks are being introduced in several countries. Futures on individual stocks are not encour-
aged for the following reasons:

e Institutional investors and large equity holders use futures for hedging fairly diversified
portfolios supposed to carry only market risk. Index futures serve that objective well.
e Price volatility in individual stocks is much higher than in the index com-
“Indexfuturesareof =-«§—SC«épr'isiing them.
_ greater utility than stock e Due to higher volatility, futures on individual stocks carry more risk of
futures because they are clearing, and for investors, they require higher margins.
_Used forte diversi- e The prices of stock indices are more difficult to manipulate as compared
to those of individual stocks.
92 Derivatives and Risk Management

MARGINING SYSTEM
s that
As stated in the features of the futures contracts, trading is facilitated by exchange
face the onus of settlement of all contracts on their due dates. In order to contain the risk
g of
of default, exchanges stipulate margins, which are held as an assurance of honourin
contracts. Both buyers and sellers are required to deposit margins with the exchange while
initiating their positions. These margins are specified in terms of percentages of values of the
contracts, and represent the magnitude of potential loss that a position in futures can incur
on any given day. The margins are linked with volatility of the price of the underlying asset.
Since prices of individual securities are considered more volatile than the index, the margin
requirement for futures on individual stocks is higher.
With the initial margin covering the potential loss on any given day, the loss for the day
that has just gone by must be made good to the exchange if the position is carried forward
to the next day. Similarly, profit, if any, on the outstanding position would be paid by the
exchange to the investor. The exchange deems all positions closed at the end of the day. The
amount of profit or loss that would have accrued if the investors were to close out their posi-
tions at the end of the day is called the MTM margin. All outstanding positions are brought
to a common value called clearing or settlement price.
For example, an investor buys one contract of futures on NIFTY at 3170. With a contract
size of 50 and an initial margin of 12%, the investor needs to deposit ¥19,020 (3170 X 50
x 12%). At the end of the day, assume that NIFTY closes at 3180, with a clearing price of
3185 (clearing price is normally a weighted average price of the last 30 minutes of trade,
and, hence, may differ from the last traded price). MTM would result in a gain of $750 (15
< 50), resulting in cash inflow to the investor. Similarly, on the next day, if the clearing price
was 3150, the loss would be $1750 (35 X 50), and the investor would pay this amount to the
exchange. The MTM process would continue till such time the investor closes out by offset-
ting his contract. If the investor does not close out till the last trading day, then the exchange
clears all the positions on the clearing price of the last trading day, called the final settlement
price. The process of MTM does not alter the overall profit, but splits the profit/loss on a
daily basis. The overall profit/loss of the investor remains the same, that is, the difference of
his buying and selling prices.

PRICING STOCK AND INDEX FUTURES

Pricing of futures on a stock or an index follows the cost of carry model. The cost of carry
is rather easy to determine in case of financial assets. The absence of convenience yield in
financial assets further simplifies the determination of price. In case of financial futures, the
cost of carry comprises only the interest cost adjusted for dividend yield on the index. It
represents the cost of funds that would be incurred if a similar position were taken in the cash
market and carried till maturity of the futures contract, less any income,
Index futures are based
_ typically dividends accruing on the stocks comprising the index. Therefore,
on non-deliverable as-
sets, yet we can use the Futures price = spot price + cost of carry r — benefits of ownership d
cost of carry model for Cost of carry = financing cost in case of stock index futures/financial
pricing Index futures.
__ asset.
 Stock and Index Futures 93

For discrete compounding:

F = S(1 + r/my™
For continous compounding:
(4.1)
F = Se’ ~
where r is the annual interest rate, m is the number of compounding intervals in a year, d is
dividend yield, and ¢ is time to maturity in years.
The theoretical value or the fair value of the index future, F, as given by Eq. 4.1, depends
upon the cost of carry and the benefits of dividend accruing during the period. The cost of
the carry model is based on the arbitrage argument. Example 4.1 illustrates the application
of the cost of the carry model for pricing index futures.

EXAMPLE 4.1 Fair price of index futures

The following data as on 29 December 2008 are available:
NSE NIFTY = 2500, 1-m futures on NIFTY, maturing 29 January 2009 = 2,568.

(a) Find the value of one contract on NIFTY assuming a size of 50 indices.
(b) Find the fair value of the futures contract, assuming the interest rate to be 12% p.a.
(c) Is there an opportunity to profit from the above calculation? If yes, how can this opportunity be realized?
Solution

(a) Value of 50 futures contracts on NIFTY = 50 x 2568 = %1,28,400

(b) Fair value of the futures contract
= current price of underlying + cost of carry (taken for 1 month) -
= 2500 + 25 = 2525 (assuming a financing cost of 12% p.a., i.e., the cost of carry is 1% of 2500)
(c) Yes, there is an opportunity to make profit, since the actual price 2568 is above the fair value. Hence, the futures contract is
overpriced. One must sell futures in the hope that it would correct to fair value and converge to the spot for the underlying
NIFTY on the day of delivery. When that happens, the investor would buy back futures contract to make a profit.

Consider the present value of NIFTY index to be 3150. The 3-m interest rate is 12% p.a.,
while the dividend yield on the index is estimated to be 6%. Based on the data given, the fair
value of the index futures with 90 days remaining for maturity is,
Fair value of the index future
= value of index + cost of carry for 90 days — dividend benefit for 90 days
=o 50st ot 02 6% 90365 — 3150 K 6% X 90/365
= 3150 + 93.20 — 46.60 = 3196.60
If a futures contract sells for anything other than the fair price, it offers an arbitrage
opportunity. Consider a futures contract on index that is selling for 3210. Clearly, the index
futures contract is overpriced and cash-and-carry arbitrage is possible. An investor can
_ execute the arbitrage by taking the simultaneous steps of:
Stock index futures offer
arbitrage opportunities ie selling the futures at 3210;
‘ifthe actual price is differ- © buying the underlying assets (this may be done through basket buying/
ent from the theoretical
cee programme trading) at the current value of the index of 3150; and
e borrow the required amount at 12%.
94 Derivatives and Risk Management

This will ensure profit to the investor upon closing out of the position just prior to the
maturity of the futures contract, irrespective of the value of the index at that point of time.
Because of the convergence, the index and the futures contracts would be at the same price
on the closing day. Upon maturity of the futures contract, the investor would do the following:
e Buy back the futures
e Sell the underlying stocks
e Pay the borrowing along with interest
Table 4.1 gives the profit for the investor at two different closing levels of the index: 3100
and 3300. In both cases, the profit is 13.40; the difference between the actual price and the
fair price at t = 0 (3210.00 — 3196.60). If the index goes down, the profit from the index
futures exceeds the loss on the underlying stocks; and if the index goes up, the loss in the
futures is lesser than the gain on the underlying asset.
Table 4.1 Fair price of futures and arbitrage
Cash flow in& |
Index closing 3,100.00 3,300.00 a
E
Initial position
Sell futures at 3,210 a=
Borrow funds 3,150.00 —3,150.00
Buy underlying stocks — 3,150.00 +3,150.00

Closing position: a
Buy futures 3,100.00 3,300.00 a
(a) Profit/loss on futures +110.00 —90.00 :
Sell underlying stocks +3,100.00 +3,300.00 a
Interest payment —93.20 —93.20
Dividend received + 46.60 +46.60
Pay borrowings —3,150.00 —3,150.00

(b) Net cash flow on borrowing and underlying —96.60 +103.40

stocks
Profit of portfolio of futures and underlying 13.40 13.40
stocks (a + b)

When the futures is underpriced, reverse cash-and-carry arbitrage is executed by buying

the futures, selling the underlying asset, and lending the funds realized till the maturity date
of the futures contract. These actions would not imply any initial cash flow. On the date of
maturity, when the futures price converges to the spot value of the underlying asset, the initial
actions are reversed. One would offset the long position in futures, buy the underlying asset
back, and realize the funds lent along with interest. This would result in a positive cash flow,
irrespective of whether the spot price moved up or down.
The actual value may vary from the theoretical value depending on demand and supply of
the underlying at present and expectations about the future. Under normal market conditions,
futures contracts are priced above the spot price due to positive cost of carry. Sometimes, the
futures price may possibly be below the spot price. Such a situation is known as backwardation.
 Stock and Index Futures 95

The fair value as per the cost of carry model states the value of the futures under ideal condi-
tions, but in reality, the price may deviate from the fair value. If this be the case, the divergence
from fair value represents an opportunity for arbitrage, as explained here.

APPLICATIONS OF INDEX FUTURES

Stock/index futures are used in the same way as any other futures contract is used: for (a)
hedging, (b) speculation, and (c) arbitrage. A-few other applications of convenience are also
discussed. We illustrate each one of them.

EXAMPLE 4.2 Fair priceof stock futures with dividend

A stock is trading at 600 today. What would be the fair value of a futures contract on the stock maturing after 90 days if risk-free |
interest rate is 12%, and after 45 days, the stock is expected to give a dividend of ¥30? What would the fair value of the futures
contract be if there were no dividend? Assume annual compounding.

rZ = = %29.56
Dy =

il 46 === 45)
ms (+ ——
0.12 X
( 365 365 *
Solution
The present value of the dividend is,
Therefore, the ex-dividend price at today’s value = 600.00 — 29.56 = %570.44
The fair value of the futures contract
= current price of the underlying + cost of carry (taken for 90 days)
= 570.44 + 570.44 x 0.12 x 90/365 = %587.32 ‘
If there were no dividend, then the fair value of the futures with 90 days to expiry would be,
= current price of the underlying + cost of carry (taken for 90 days)
600 + 600 X 0.12 x 90/365 = %617.75

HEDGING THROUGH INDEX FUTURES

Portfolio can be hedged using index futures. We discuss hedging long and short portfolios
with respect to fall and rise in prices.

Hedging Existing Portfolio

Investors long on their portfolios or their stocks fear a decline in the value of the assets in
__ case the price declines. They need to protect the value of their existing port-
Stock index futures can
_ folios against fall in price. They can do so by going short on the index
_ be used for hedging a
long position in a portfolio futures. This is known as a short hedge.
For example, consider a mutual fund that fears a fall in the value of the
- portfolio in the near future. While owning the portfolio and expecting the
market to fall, it has the following three options:
Do nothing With faith in the long-term, fundamentals, the mutual fund may decide to
remain invested and do nothing about the temporary fall in value expected. In such a case,
the portfolio faces the risk of a temporary fall becoming permanent and losing value over the
long-term. Here, the fund decides to carry the risk of fall in the market.
96 _ Derivatives and Risk Management

o now and buy back later

Sell and buy back Alternatively, the fund can sell the portfoli
drawbacks:
when the prices have fallen. Such a strategy suffers from the following
result in transac-
Transaction costs First selling and then buying back the portfolio would
tion costs, reducing the returns.
panic selling by
Impact cost If it is a large mutual fund, the action of selling may trigger
the stock,
others, causing prices to fall more than normal. Similarly, while repurchasing
buying
prices may go up. Besides transactions costs, the mere action of first selling and then
unfavoura bly, bringing down the returns. The
back the stocks may cause prices to change
effect on price due to the size of the order in the actions of selling and buying and vice versa
is known as impact cost. This cost accrues over and above the transactions costs of broker-
agen taxes) etc,
Risk proves illusory If the threat of decline in prices actually does not materialize, and if
the markets were to rise instead, it would cost more to reacquire the portfolio. Besides, the
fund will unnecessarily incur transactions cost and impact cost.
Hedge with futures Hedging with futures would involve taking a short position in futures
hoping to compensate any fall in the value of the portfolio with gain in the position of the
futures when unwound. Such a strategy would provide protection of the value of the portfolio,
while avoiding repurchase cost, transaction costs, and impact cost.
Let us consider the mechanics of the third alternative of hedging with futures. The fund
is long on the asset and in order to protect the value against a fall in the price, it must go
short on futures. The fund must sell futures now and buy later, keeping the portfolio intact.
As stated earlier in this chapter, such a strategy will save transaction cost as well as impact
cost, and, besides, will keep the intention confidential.
Assume that the fund holds a portfolio worth %1 crore at current spot prices. A fall in price
is expected, and therefore, a protection of the value is imperative. Assume that a futures con-
tract on NIFTY maturing three months from now is trading at 2650. With each point valued
at 1 and a contract size of 50, the value of one contract on NIFTY futures is €1,32,500 (2650
x 50 X 1). The number of contracts required to be sold to cover the exposure of €1 crore is
75.47 (rounded to 75). At the end of the hedging period of three months, 75 contracts have
to be bought back. Let us now consider the position after three months under two contrasting
scenarios of fall and rise in the prices.
If the market falls as expected, the value of the portfolio would decline, but the position
in futures would result in a profit, compensating for the loss in the value of the portfolio.
However, if the markets appreciated instead, the value of the portfolio would increase, but
this would be offset by the loss in the futures position. Table 4.2 presents the position in two
cases: a 10% decline and a 10% rise.
We note that the value of a portfolio comprising long positions on stocks and futures con-
tracts remains almost the same irrespective of what happens to the market. If the market falls by
Hedging with index fu: -:[0%, the physical portfolio would decline by 710 lakh, but the loss would be
tures is the most efficient | marginal at ¥6250. Instead, if the market gains 10%, the value of the aggregate
way of handling risk as it portfolio would have a marginally improved position at %6250. Note that the
ee ae costs _ hedge through futures is not a perfect one, because the position taken in futures
. Q —........ of %99,37,500 did not exactly match the value of the portfolio of %1 crore.
 Stock and Index Futures 97

Table 4.2 Hedging with futures

Cash flow in is

Index value 2,385 (10% decline) 2,915 (10% rise)

Futures position
Sold 75 futures contracts at 2,650 +99,37,500 +99,37,500
Bought 75 futures contracts —89,43,750 —1,09,31,250
Profit/loss on futures _ +9,93,750 —9,93,750
Portfolio position
Initial value 1,00,00,000 1,00,00,000
Final value 90,00,000 1,10,00,000
Profit/loss on portfolio —10,00,000 +10,00,000
A iti io and futures at the end of 3 months —6,250 +6,250 7
Hedge Ratio
In the preceding analysis, it was assumed that the portfolio would decline in the same pro-
portion as the market, i.e., a 10% change in the index would also mean a 10% change in the
portfolio. What if the proportionate change in value of the portfolio is not the same as the
proportionate change in the market index on which the futures position was taken? In such a
case, the number of contracts would have to be adjusted such that the profit/loss on futures
equals the loss/profit on the portfolio.
We know that the sensitivity of the portfolio to changes in the market is given by the beta
of the portfolio. In the preceding analysis, the beta of the portfolio was assumed as 1.00, and,
hence, the exposure of the short position in futures was equal to the value of the long position
in stocks. If the beta of the portfolio were 1.1, the decline in value would be 11% as a con-
sequence of a 10% fall in the market. Therefore, one would need to short 83 (1.1 X 75.47 =
83.02) contracts to compensate for the extra fall. Similarly, if the beta of the
Any change in value ofa portfolio were 0.85, 64 contracts need to be sold (0.85 X 75.47 = 64.14).
portfolio is determined by : The hedge ratio (the number of futures contracts to be traded) in the case
its beta. The positionin of index futures is equal to the beta of the stock/portfolio. Recall that the
futures should be equal = optimum hedge ratio is given by:
to beta times the portfolio
value. h* = po = B by definition
‘4

Hedging Short Posi

It is difficult to conceive of a short position in stocks. However, consider the position of an
individual who will be superannuated soon, and who intends to invest his/her retirement
funds in stocks, or an investment fund awaiting research findings before deployment of the
proceeds of the new public offer. These instances of proposed or planned acquisition of a
portfolio are regarded as short positions in stocks/portfolio. These positions would lose if
prices rise in the interim period between contemplated and actual purchase of stocks.
A short position in the portfolio can be hedged against any likely rise in the value of stocks
by assuming a long position in futures. Such a hedge is called a Jong hedge. The mechanics
of the long hedge would be similar to the one explained for the short hedge.
98 Derivatives and Risk Management

With a long position in futures, the rise in the market would result in a profit, which could
be used to fund the extra cost of acquisition of stocks. In case the market fell, the cost of the
acquisition of the portfolio would be less but at the same time, there would be a loss in the
futures. In any case, the investor would lock in the cost of acquisition of the contemplated
portfolio at current prices.
While ensuring a fixed price for acquiring the portfolio, one forgoes the benefit of any
price decline in the future.
The hedge ratio for a long hedge remains the same as explained for the short hedge.

Insulating Against Market Risk

We highlighted the aspect of hedging the value of a portfolio using futures. This was under the
assumption that the portfolio was well diversified and did not contain any risk other than market
risk. The risk for a small non-diversified portfolio or a single stock is somewhat different from
the risk for a well-diversified portfolio. Changes in the price of a given stock may not only be

EXAMPLE 4.3 Short hedge—hedging long position of portfolio of stocks

Consider a mutual fund having a huge portfolio of $100 crore. Today is 2 February, and the expectation of a general budget this |
28 February is not very realistic. The current value of the BSE SENSEX is 6500. February and March futures maturing on 25th 7
February and 25th March, consisting of 50 SENSEX, are selling at 6525 and 6600 respectively. How can the fund be protected |
against the uncertainty of the budget? ;

Solution
The hedging strategy:
The fund is long on the asset and must go short on futures. It must sell futures contracts for March, as uncertainty over the |
budget will last till February 28, and cannot be covered by selling February contracts expiring prior to that date. To cover the ;
risk fully, the fund must sell March futures contracts. Alternatively, it can be protected by selling February futures contracts, ,
which would leave the fund exposed for the period between the dates of expiration of the futures and the date of the budget.
No. of contracts to be traded
Value of one BSE SENSEX contract = 50 X 6600 = 3.30 lakh
Value of the portfolio to be hedged = $10,000 lakh
No. of contracts to be sold = 10,000/3.30 = 3030 contracts.
(assuming the fund is diversified enough, and that a 1% change in the market causes the same degree of change in portfolio value)
The fund buys back the index at an appropriate time after 28 February.
If the market goes down by 5% as anticipated:
The value of the portfolio stands reduced by %5 crore to 95 crore. The March futures falls from 6600 to 6260 when the fund
squares up its position
Gain on futures = (6600 — 6270) x 50 x 3030 = %499.95 lakh
Therefore, the fund more or less compensates itself for the loss incurred on the portfolio value. Remember that futures cannot
provide permanent protection, and if market sentiments become bearish, the fund will have to resort to other methods, including
rolling over of the hedge. A longer period of uncertainty can be covered by closing out the position in March futures and opening
a new position by going short on, say, June futures.
If the market goes up by 5% against expectations:
The value of the portfolio stands increased by &5 crore to $105 crore. The price of March futures rises from 6600 to 6900
when the fund squares up its position.
Loss on futures = (6600 — 6930) x 50 x 3030 = 499.95 lakh
Therefore, the increase in portfolio value is offset more or less by the loss incurred on the futures contracts, keeping the value
of the portfolio almost constant. Note that hedging through futures does not mean protecting against loss while preserving gain. It
only ensures a constant value of the portfolio.
 Stock and Index Futures 99

Index futures canonly due to changes in the market but may also be due to internal factors in the
Seb :
be used to
insulate _ organization that floated the stock. According : :
to the portfolio theory, the risk
against
themarket risk of of a non-diversified portfolio consists of
_ individual stocks.
¢ unsystematic risk (stock-specific risk); and
¢ systematic risk (market risk).

An exposure to a single stock (or a non-diversified portfolio) means a risk exposure of

both types. For example, an investor buys stock of Infosys worth 710 lakh on the expectation
of good news. By doing so the investor is assuming the following:

e Unsystematic risk The risk that his assessment of the potential of the company may
prove to be wrong.
e Systematic risk The risk that his assessment of the potential of the stock may be
correct, and, yet, his investment provides poor returns because the market, in general,
falls.

The total risk as measured by the variance of returns is the sum of the two components, i.e.,
systematic risk (market risk) and unsystematic risk (stock-specific risk). This is expressed as

er 7 Bion + 0; (4.2)

where o= Standard deviation of the security/portfolio

B = beta of the portfolio/stock
0, = standard deviation of the market
oO; = standard deviation of the security/portfolio due to itself

Futures can help to éliminate the market risk of the portfolio/security by taking a posi-
tion in futures opposite to that of the underlying market, and the value of the index futures
changes according to the overall market. The risk in the index futures is o”,,. Since the posi-
tion of the index futures is beta times the position in the physical market, its risk would be
B°o,,°. The aggregate risk of the portfolio of physical and futures positions would, therefore,
only be the unsystematic risk of the stock, o7;. Therefore, hedging with index futures can
cancel out market risks while stock-specific risks still remain.
The stock-specific risk is assumed to be a small component of the total risk. As we enlarge
the portfolio, the amount of unsystematic risk diminishes, and can be deemed negligible for
a portfolio consisting of a large number of stocks. A large portfolio would face only market
risk, called systematic risk, and index futures become an effective tool for managing this risk.
While unsystematic risk is taken care of by diversification, the systematic risk is offset by a
position in index futures.
Example 4.4 demonstrates the use of futures as tool for reduction of market risk.

Controlling Risk of Stock Portfolio

With a diversified portfolio of stocks, unsystematic risk is eliminated, while the risk that can-
not be eliminated is systematic risk. With changing market conditions, the portfolio returns
become sensitive to the market risk alone. A portfolio manager or any intelligent investor
would like to beat the market. The strategy that is often employed by investors to outperform
100 Derivatives and Risk Management

EXAMPLE 4.4 Hedge against market risk

very strong fundamentals. However, the
An investor wants to buy stock in Hindustan Lever Ltd (HLL) worth %20 lakh due to its
HLL is 1.2, and the current value of
market in general is considered to remain weak for about three more months. The beta of
NIFTY is 2250. A 3-m index futures contract is selling at 2310. Answer the following:

(a) How can the investor hedge himself against the expected fall in the market?
(b) Analyse his position (i) if the market falls by 10% in three months and HLL drops to 178 from %200, and (ii) if the market
to 215 from %200. L
registers a rise of 6% and HLL rises
market and HLL as 12% and 18%, respectively, what is the risk faced by the unhedged L
(c) Given the standard deviations of the
L
and hedged portfolios
Solution
(a) One option for the investor was to wait for three months and then buy. He runs the risk of a rise in the price of the HLL 7
share after three months. With stock index futures available, he does not need to defer the purchase and take the risk /
of a rise in prices. A better strategy would be to buy the shares now and protect against the risk of a falling market by
taking a short position in 3-m futures. Since the beta of HLL is 1.2, the futures position must be 1.2 times the position in |
the physical market. Therefore, the investor 2

* — buys stock worth 20 lakh due to strong fundamentals; and

¢ — sells 3-m futures worth %24 lakh (1.2 < 20 lakh) to insulate oneself against market risk
No. of shares of HLL = 20,00,000/200 = 10,000
No. of futures contract sold = value to be hedged/value of one futures contract
= 24,00,000/(200 x 2310) ~ 5.19 (say 5 contracts)

(b) (i) The market falls by 10% to 2025 from 2250 and HLL share falls to 178:
Selling price of futures = 2310
Purchase price of futures = 2.025
Gain in futures market = 285
Gain on position of futures = 5 X 200 X 285 = %2,85,000
Loss on 10,000 HLL shares = (200 — 178) x 10,000 = ¥2,20,000
Net gain = %65,000
If the investor was unhedged, his/her loss would have been %2,20,000

(ii) The market rises falls by 6% to 2385 from 2250 and HLL share rises to %215:
Selling price of futures = 2310
Purchase price of futures = 2385
Gain in futures market = 75
Loss in on position of futures = 5-x 200 X 75 = £75,000
Gain on HLL 10,000 shares = (215 — 200) x 10,000 = %1,50,000
Net gain = 75,000
If the investor was unhedged, his/her gain would have been *1,50,000

(c) If the investor remained unhedged, he/she would carry the entire risk of HLL shares of 18%. With a hedged position in
futures, the amount of variance reduction is
B°Om? = 1.22 x 12? = 207.36 of standard deviation of 14.4%
Residual variance = 18° — B%o,,? = 18° — 1.28 x 12? = 116.64 equivalent to 10.8%
A hedged portfolio will reduce the risk of the asset from 18% to 10.8%
 Stock and Index Futures I101

the market is (a) to increase the beta of the portfolio to more than | when a price rise is
expected, to ensure greater portfolio returns than the market, and (b) to reduce the beta of
the portfolio to less than | if a fall in prices is expected, to ensure a smaller decline in the
value of the portfolio than the market. Therefore, a need to change the beta of the portfolio
arises whenever a change in the trend of the market is anticipated. There are many ways to
alter the beta of the portfolio, as discussed here.
Portfolio balancing Portfolio balancing is done to achieve the desired level of beta by
constantly adjusting the portfolio. If the beta needs to be increased, the portfolio manager
may replace some low-beta securities with high-beta ones. Similarly when the beta is to be
reduced, securities with higher betas are replaced by securities with lower betas. Portfolio
balancing requires frequent buying and selling of stocks, with increased costs of transac-
tions as well as equity research. This also sends unwarranted and avoidable signals about the
changing perception of the fund manager. If the size of the portfolio is large, impact costs
would also reduce the returns.
Resort to lending and borrowing Another way to adjust the beta is to switch the portfolio
between capital markets and debt markets. For reduction of beta, the portfolio manager can
divest a suitable proportion from equity markets for reinvestment in debt markets. Remember
that the beta of the bonds/fixed income instruments portfolio would be close to zero. The
portfolio’s beta. would fall if some funds are invested in bonds. To increase the beta of the
portfolio, one may resort to borrowing and investing the borrowed funds in stocks.
This change in beta is achieved by making use of the additive properties of beta, 1.e., the
beta of the portfolio is the weighted average of the betas of the individual assets comprising
the portfolio. Refer to Example 4.5. Like portfolio balancing, the strategy of switching of
portfolio between capital and debt markets will involve transaction costs. The amount to be
invested in the debt markets requires liquidation of the same proportion of existing invest-
ments in the portfolio, to leave the beta of the portfolio untouched.
The beta of the portfolio of two assets, | and 2, 1s given by Eq. 4.3.

Wie CMa a beGp (4.3)

where f, and f, respectively, are the proportions of money invested in assets | and 2, with |
betas of B, and pp.
For example, consider an aggressive investor with €25 lakh invested in a portfolio having
a beta of 1.50. He fears a decline in the market. The investor wants to reduce the beta of
the portfolio to a conservative figure of 0.75. To do so, the investor can retain fractionf, in
the portfolio and sell (1 — f;) to invest in T-bills (beta = 0). Using Eq. 4.3, we can find the
proportion of wealth that must continue to remain in the portfolio, or the wealth that must be
divested from the portfolio and invested in T-bills.
Desired beta, 0.75 =f, X 15 + —/f{) xX 0
Or f, = desired beta/portfolio beta = 0.75/1.5 = 0.5

This implies that the investor must sell, (1 — |) = 50% of his portfolio and invest the
proceeds in T-bills.
102 _ Derivatives and Risk Management

Similarly, if the investor wants to increase the beta to 2.0, the proportion that must be
invested in the portfolio will be
or f; = new beta/portfolio beta = 2.0/1.5 = 1.33

This implies that the investor must borrow 33% of the amount already in the portfolio and
_ make further investments in the same portfolio. Note that while selling or
Stock index futures
provide a cost-effective buying, all the portfolio stocks that are bought/sold must be in the same
way of controlling the _ proportion so as have the beta of the portfolio unchanged.
beta of the portfolio by
eliminating the transac-
Using futures to adjust the beta of the portfolio Yet another way of
tion costs and impact adjusting the risk of the portfolio is to switch the exposures between the
costs associated with equity markets and derivatives markets. The beta of the portfolio can readily
other methods. be adjusted by using index futures. Any index has a beta equal to 1.

EXAMPLE 4.5 Finding the beta of the portfolio

An aggressive fund ‘A’ has a portfolio aggregating to €202.75 lakh, comprising the following 10 stocks.

State Bank of India 2,500

Pie ®) |vaie
930 23,25,000 1.10
HLL 6,000 180 10,80,000 125
ITC 8,000 140 11,20,000 1.40
Reliance 2,000 530 10,60,000 1.30
Bharti 7,000 350 24,50,000 1.70
Larsen & Toubro 2,000 1,500 30,00,000 125
Tata Steel 6,000 340 20,40,000 e05
Maruti 4,000 550 22,00,000 1.25
Infosys 25,00,000
Ranbax 25,00,000
Total value of the portfolio

Find out the beta of the portfolio.

Solution
The beta of the portfolio using additive property is computed as follows:

SCRIP___| No. of shares

State Bank of India 2,500 930 23,25,000 1.10 0.13
HLL 6,000 180 10,80,000 125 0.07
In 8,000 140 11,20,000 1.40 0.08
Reliance 2,000 530 10,60,000 1.30 0.07
Bharti 7,000 50 24,50,000 1.70 0.21
L&T 2,000 1,500 30,00,000 1.25 0.18
Tata Steel 6,000 340 20,40,000 1.05 0.11
Maruti 4,000 550 22,00,000 1.25 0.14
Infosys 1,000 2,500 25,00,000 1.40 0.17
Ranbaxy 5,000 500 25,00,000 0.80 0.10
Total value of the portfolio 2,02,75,000 oy
Beta of the portfolio
 Stock and Index Futures 103

EXAMPLE 4.6 Portfolio balancing

4
Refer to Example 4.5. How much reduction in beta can be achieved by divesting in stock of beta higher than 1.40, and vesting
the proceeds in low-beta Ranbaxy stock?
Solution
Portfolio balancing:
If the investor wants to reduce the beta, he/she can divest the high-beta stocks of ITC, Bharti, and Infosys and reinvest the 4
proceeds in the low-beta Ranbaxy stock. We can achieve a beta of around 1, as shown here 7

State Bank of India 2,500 930 23,25,000 1.10 0.13

HLL 6,000 180 10,80,000 p25 0.07
ITC ~ 140 - 1.40 -
Reliance 2,000 530 10,60,000 1.30 0.07
Bharti - 350 - 1.70 -
L&T 2,000 1,500 30,00,000 1.25 0.18
Tata Steel 6,000 340 20,40,000 1.05 0.11
Maruti 4,000 550 22,00,000 1.25 0.14
Infosys - 2,500 - 1.40 -
Ranbax 17,140 500 85,70,000 0.80 0.34
Total value of the portfolio 2,02,75,000
Beta of the portfolio

Due to the leveraging offered by futures, the. desired beta can be achieved by trading in
futures by using the following strategy:

e Sell futures to reduce beta

e Buy futures to increase beta

If the value of the portfolio is P, having a beta of 8, and the investor goes short on futures
of the value of F, then the beta of his/her combined position £,, is

Pp Py I

The value of futures to be sold (+)/bought (—) = +P x (B, — B,,)

Example 4.7 illustrates the strategies of adjusting beta using debt markets and futures mar-
kets.
The advantages of the strategy of adjusting beta through futures over the strategies of
portfolio balancing and switching to and from the debt markets are easy to see:
e Avoids frequent buying or selling of equities from the portfolio
e Saves transaction costs, and yet adjusts the beta on a regular basis to the desired level
of risk
e Avoids sending unnecessary signals to the market by avoiding constant buy and sell
orders
e Avoids impact costs if the volumes of trade are large
104 Derivatives and Risk Management

EXAMPLE 4.7 Adjusting the risk of the portfolio

Refer to Examples 4.5 and 4.6. What would you do to achieve a beta of 0.8 using (a) debt markets and (b) using index futures
3-m index future is selling at 2675.
Solution
(a) Using debt market: . . non:
The investor can divest the portfolio and invest in T-bills to achieve the desired beta of 0.8. If f; is the fraction retained in the
portfolio, then
OB < 1.24 45 [ah <0 2
or f, = 0.8/1.24 = 64.5% to be retained in the portfolio. The fund must sell portfolio stocks worth 35.5% (%69.95 lakh) and |
invest in T-bills. After three months, when the uncertainty is over, the fund can be divested of the T-bills and reinvested in the
same portfolio.
(b) Using futures:
The investor can sell futures to lower the beta to 0.8. Exposure in the futures market must be equal to F, given by:
F = P x (old beta — new beta) = P x (1.24 — 0.8) = 202.75 x 0.44 = %89.21 lakh
Price of 3-m futures = 2675
Value of one contract = 200 X 2675 = £5.35 lakh
No. of contracts to be sold = 89.21/5.35 = 16.67 (say 17 contracts).
The fund can buy back the contracts to nullify its position any time prior to the expiry of the futures. In this strategy, the fund |
leaves the portfolio untouched. The fund needs
LTO LOPE

SPECULATION WITH STOCK INDEX FUTURES

Hitherto, we looked at the hedging applications of index futures. It will not be wrong to say
that derivatives markets were designed for the purpose of hedging against risk. Ironically,
the same derivative markets can serve the opposite purpose, and may be used to create or
magnify risk. The risk is increased when a participant in the market does not have any posi-
tion in the underlying cash/physical asset. The risk arising from absence of position in the
physical market can be compounded by the fact that a financial outlay is not required in the
derivatives markets. A position in futures requires only the deposit of the initial margin with
the exchange, and MTM provision as long as the position remains open.
A futures position provides an opportunity to take a view on the market. It is a leveraging
mechanism that enables increased returns. As a simple strategy to benefit from an expected
move in the market, one can buy or sell futures, rather than take a position in the cash market
that would involve a large cash outlay. The following are the leveraging strategies:
e Ifthe markets are expected to go up, buy futures now and sell later; and
e Ifthe markets are expected to go down, sell futures now and buy later.
Using futures involves an outlay only in the form of initial margins. If the margin require-
ment is 10%, the investor can take a position 10 times larger than a corre-
Stock index (lures are sponding position in the cash market. Accordingly the returns, positive or
used to take speculative negative, will be magnified 10 times, even if the margin, which actually takes
positions and make way —— the form ofa security deposit, is considered to be an investment.
for magnified returns, with | Assume that an investor has €10 lakh
equally magnified risk. vestor has akh toto invest.
i i currently bull -
3 He/she is
ish about the market. The current level of the index he/she is considering is
 Stock and Index Futures 105

6500, and a 3-m futures contract of 50 indices is trading at 6650. The margin requirement is
20%. The investor has the option of buying a balanced portfolio from a mutual fund. How-
ever, he/she is highly optimistic about the rise of the market, and expects the level of the
index, at a minimum, to be 10% higher in three months’ time. How can he/she benefit from
his/her optimistic forecast?
As one alternative, the investor can buy a balanced portfolio in the cash market. If the
market goes up by 10%, the profit will be 10% of the investment in the cash market, i.e.,
%1,00,000. In case the market falls by 5%, the loss will be %50,000.
Alternatively, if the investor is extremely confident of his/her forecast, he/she can take a
larger risky position in futures by buying 15 contracts on index futures needing margin of
~9,97,500, leaving a cash balance of ¥2500, which is ignored.
Value of 3-m futures = 50 X 6650 = 3,32,500
Margin required per contract = %66,500
No. of contracts that can be bought = §10,00,000/66,500 = 15
The investor subsequently sells these contracts at a higher price.
If the market goes up by 10%
The selling price of the contract = 7150
Purchase price = 6650
Profit per contract = 500
Total profit = 15 X 50 X 500 = £3,75,000
If the market falls by 5%
The selling price of the contract = 6175
Purchase price = 6650
Loss per contract ; = 475
Total loss = 15 X 50 X 475 = &3,56,250
Hence, with futures, the gains as well as the losses are magnified, as compared to a posi-
tion in cash. While the gain on investment can be as high as 37.50% with only a 10% rise in
the market, the loss would be equally high, at more than 35% with a 5% fall in the market.
Here we are considering margin as investment which indeed is not correct because margin is
required by exchange to cover settlement risk.
Futures can also be used in falling markets. An investor can benefit from a predicted fall
in the prices of stocks by selling futures. As the prices of the futures fall in line with the
underlying stocks in the index, the investor will make a greater positive return.

ARBITRAGE WITH STOCK INDEX FUTURES -

_ We explained arbitrage with futures if the price of a futures contract 1s not
When there is mispric-
same as its fair value. This may be used as a tool for enhancing the yield of
ing of futures, arbitrage
with stock index futures _ the portfolio.
is an excellent tool for A portfolio consisting of stock index futures and T-bills produces the
enhancing yields on the same returns as a stock portfolio replicating the index, if there is no mis-
portfolio. pricing of futures. If the theoretical price and actual price differ suffi-
106 Derivatives and Risk Management

EXAMPLE 4.8 Arbitrage with futures: Yield enhancement

An investor has 210 lakh available for investment. The spot value of the index he/she is considering is 6650, while a futures
contract on the index maturing after 60 days is trading at 6670. The risk-free rate is 8%, while the dividend yield on the index is
4%, The investor is considering investment in a market portfolio to capitalize on the potential of an increase in the value of the
securities and earn some dividend yield.

(a) Find out the true value of a 2-m futures contract.

(b) Is there a strategy you can suggest to make the investor earn more than what he/she can through investment in a portfolio
of index stocks?
Solution

(a) Fair value of the 2-m futures contract:

F= Spe!” = aT/365 — 6670e(8% — 4%)(60/365) — 6693.87

The actual price of the futures is 6670, which is lower than its fair value. Hence, futures are underpriced. 7
(b) Rather than buying a portfolio in the physical market, the investor can replicate a portfolio by buying futures contracts and 7
investing in T-bills. The strategy will have the same risk as that of a portfolio in the physical market. A comparison of the L
payoffs under the two strategies is presented as follows: :

Strategy |: invest in a portfolio of index stocks

Amount invested in securities 10,00,000
Strategy II: Invest in T-bills and go long on futures
Amount invested in T-bills 10,00,000 D
No. of futures bought ]
Current value of a 2-m futures 6,670 ;
No. of indices in a futures contract 50
Value of one futures contract 3,33,500
No. of contracts bought 3

The payoffs of the strategies are analysed for three different scenarios: a 10% increase, no change, and a 10% decrease in 7
the market from the current level of 6650.

Increase by 10% No change | Decrease by 10%

Strategy | Have a portfolio of 10 lakh
Value of the portfolio 11,00,000 10,00,000 9,00,000
Dividend yield at 4% on 10 lakh for two months 6,667 6,667 6,667
Total value of investment
Strategy II Invest in T-bills & buy 3-m futures
11,06,667 10,06,667
Value of T-bills 10,00,000 10,00,000 10,00,000
Interest on T-bills 18,333 13,333 13,333
Position on futures
Selling price of futures troll 6,650 5,985
Purchase price of futures 6,670 6,670 6,670
Profit/loss on index points 645 320 —685
Profit/loss on futures 96,750 —3,000 —1,02,750
Total value of investment 11,10,083 10,10,333 9,10,583
As can be noticed Strategy || is always superior to Strategy | and hence in case of mispricing of futures the yields can be
improved by investing in futures and T-bills.
TEE OTE:
 Stock and Index Futures 107

ciently, then arbitrage opportunities that result in increased yield are created. One can
adopt the following strategies in case there is mispricing of futures:
e Ifthe actual price is less than the theoretical price, buy futures.
e If the actual price is more than the theoretical price, sell futures.
Example 4.8 illustrates an arbitrage opportunity that enhances the yield of a portfolio.
When futures are overpriced, a reverse strategy can be used as follows:
e Sell futures
e Borrow at a risk-free rate
e Invest in the cash market, buying securities consisting of index stocks

Calendar Spreads
A calendar spread is created by simultaneous opposite positions in the same contract expiring
at different times. For example, a long position in futures expiring in the month of May, when
combined with a short position in the contract expiring in the month of June, will be termed
calendar spread. There are two legs to a spread. A spread position is closed by reversal of both
the legs simultaneously. The reversal of the long position in May futures would be selling May
futures, while simultaneously buying June futures. In India, for index and stock futures, con-
tracts for each of the next three months are available at any time. Hence calender spread can
be created for next three months.
The risk profile of the calendar spread is substantially different from that of a single posi-
tion. One leg of the spread is opposite to the other leg. If one leg is bearish, the other leg is
bullish, and vice versa. Therefore, the risk in a spread position is much smaller, attracting
lesser margins compared to the margins applicable for two independent stand-alone contracts.
The margin on calendar spread is calculated on the basis of the delta of a portfolio consist-
ing of futures contracts for each month. The delta represents the rate of change of the value
of the derivative with respect to change in the price of the underlying asset. Delta of futures
is given by e’’. For long position on 1-m future, the delta would be 1.0084 at 10% risk-free
rate. For short position on 2-m future delta would be — 1.0168. Thus, a portfolio consisting of
a near-month contract with a delta of 100.84 and a far-month contract with a delta of — 101.68
will attract a margin equal to the spread charge for a portfolio that has long 100 near-month
futures and short 100 far-month futures. The spread charge is specified as 0.50% per month
for the difference between the two legs of the spread, subject to a minimum of 1% and a
maximum of 3%, as specified in the J.R. Varma committee report.!
Investors engaging in spread transactions are basically taking a position on
oread | ; : : ‘
Acalendar spread is the interest rate scenario. Futures prices are based on interest rates and are
used for taking advan-
tage of mispricing of subject to change as perceptions of future interest rates change. A spread trader
two futures expiring at is essentially looking at the differential in prices of two futures contracts as
_ different times by simulta- =compared with interest rates. As the interest rate goes up, the far-month futures
neous and opposite will rise more than the near-month futures. Further, far-month futures are more
ee _ volatile than near-month futures, as the delivery time is farther away, adding to

"As per BSE rules

108 Derivatives and Risk Management

Calendar spreads have uncertainty. This gives rise to arbitrage opportunities, as mispricing between
much lower margins be- ‘the futures of near months and far months is likely. , |
cause of two contrasting If an investor believes that interest rates are expected to rise, he/she might
positions and are usedto buy far-month futures and sell near-month futures. If interest rates do rise as
bet against future interest ax nected, then the far-month futures would appreciate more, and the investor
ae _ makes a profit. Similarly, if he believes that interest rates are expected to fall,
“ai he/she will buy near-month futures and sell far-month futures.

OTHER APPLICATIONS OF INDEX FUTURES ©

Apart from the three universal applications of derivatives, i.e., hedging, speculation, and
arbitrage, there are a few more uses of futures that investors can adopt. These are discussed
in the following paragraphs.
Opportunity for naive investors Investment in the stock markets is often considered to be
a strategy meant for sophisticated, learned, and financially savvy investors who are expected
to understand the nuances of the capital markets. An investment in futures provides a conve-
nient way for naive investors to capture market-based returns, rather than remaining confined
to safer investments like bank deposits offering moderate returns. The myth that invest-
ing in stocks requires considerable expertise and thorough understanding of the vagaries of
the stock markets stands somewhat demolished with the avenue of investment provided by
futures contracts. The prerequisite for investing in the stock market is not knowledge but
orientation towards risk.
The only possible shortcoming with investments in futures is the inflexibility of the invest-
ment horizon. Investment in index futures is constrained by the limited life
Besides hedging, specu- of such contracts. At present, we find that the life of futures contracts is
aa limited to three months, which could be a deterrent to investors with long-
for naive investors, such ‘etm Commitments. The limited maturity of futures contracts leads to a belief
as elimination of research that futures are appropriate only for investors with short-term speculative
and tracking of errors. motives. However, this belief seems to be unfounded, as investors with longer
OE time horizons of investment can adopt the strategy of rolling over from one
futures contract to another, once the earlier futures contract matures.

Avoiding equity research Apart from the opportunities given to naive investors, futures
also provide considerable benefits to more sophisticated investors. Futures impart the abil-
ity to capitalize on bearish or bullish markets without undertaking equity research, which
is time consuming and costly. Making an investment choice requires time, effort, and cost.
Sophisticated and learned investors like mutual funds can simply take an appropriate position
in futures without having to identify specific securities and save much cost, effort, and time.
This is one reason that index funds have gained tremendous popularity.

Eliminating tracking errors Index mutual funds are mandated to provide market returns by
replication of index by investing funds in the spot market in the same securities and the same
proportions as that of the index. Therefore, the physical portfolio is supposed to track the index
and thereby provide index returns to subscribers. Due to the continuous movement of prices,
 Stock and Index Futures 109

impact costs, and transaction costs involved, it is indeed difficult to provide returns equal to
the index. They often fall short of the index returns due to the compulsion to hold back some
liquidity to meet redemption pressures, administrative overheads, transaction costs, periodic
changes in index construction, and the inability to reinvest dividends immediately on receipt.
Any deviation of portfolio returns from index returns is referred to as a tracking error. The
lesser the tracking error, the better managed is the fund. Every fund likes to keep tracking error
to the minimum. Futures can reduce such tracking errors due to the absence of impact costs
and to lower transaction costs, as well as the enhancing of returns due to leveraging features.
If funds invest some part of the corpus in futures, shortfall in returns can be pripgpeties for.
Tracking errors would be minimised.
Facilitating asset allocation Portfolio managers often need to switch among debt, equity,
and derivative markets to match the risk profile of their clientele. Changing the mix of stocks
and bonds in a portfolio involves significant costs as well as discontinuity in operations.

Derivatives in Practice
India launches derivatives on DJIA and S&P 500
With effect from 29 August 2011, the NSE introduced derivatives contracts on indices of US stock markets, i.e., the Dow Jones
Industrial Average (DJIA) and S&P 500, the most popular indices the world over. It is supposed to be the first instance across the
world that a listing is granted for US indices outside the USA. It was perhaps a reciprocal arrangement to the listing of an Indian
index, i.e., NIFTY, on the Chicago Mercantile Exchange (CME), after NIFTY was denominated in US dollars in July 2011. Besides
CME, NIFTY has also been traded in the Singapore Stock Exchange since September 2000, while BSE SENSEX is also listed
on the Eurex exchange, enabling traders to take a view on the Indian economy through its indices.
While S&P 500 offers futures and options through NSE, DJIA offers only futures contracts. The contract specifications are as
given in the table below.
Select contract specifications on US indices

Contract size
Contracts available 3 monthly contracts followed by 3 quarterly contracts for January, March, September, and December
rexpiy -—~«|___ The thirdFriday ofthe expiry month: incase that dayisaholiday, the preceding day
Mode of settlement Cash settlement in Indian rupee
Quantity freeze : _ 15,000
Such contracts are aimed at providing an opportunity to resident Indians to participate in US stocks and indices. Trading in
these contracts is not allowed for non-resident Indians and foreign institutional investors, as they have other avenues available.
As per current guidelines, Indians are allowed to participate in the US spot markets to the extent of US $2,00,000 every year,
but are allowed no positions in derivatives deemed inherently speculative in nature. Rupee-based cash settlement opens up the
avenues for Indian investors who hitherto were not allowed to participate in exchanges abroad by the Reserve Bank of India.
With cash settlement in Indian rupees, Indian investors can take a view on US stocks and trade accordingly. All of this is possible
without their being exposed to any kind of currency risk.
This has important implications for hedging too, as now Indians can have a global portfolio, thereby reducing systematic risk,
measured by beta of the portfolio. According to the portfolio theory, a portfolio with global stocks poses a smaller systematic risk
than a portfolio comprising stocks from one nation alone. Though this move is not expected to draw strong interest from investors
and traders, it is without any doubt a very promising beginning and attempt to integrate Indian capital markets with the world.
110 ‘Derivatives and Risk Management

Rather than liquidating one asset in one market and then investing funds in another market,
portfolio managers can trade in futures to achieve the risk profiles desired by clients. They
can sell stock futures to decrease risk in stocks, and buy interest rate futures to increase
exposure in bonds, and vice versa, with much lower transaction costs.
Assuming only company-specific risk Owning stock and selling futures eliminates market
risk and leaves the investor with company-specific risk. With futures available on individual
securities, investors can leverage positions. Investors do not need a position in the cash
market. Instead, they can go long on the futures of individual stock and, simultaneously, sell
index futures to have company-specific risk in the portfolio with the effect of leverage. For
example, if bullish on Wipro stock, an investor may like to buy futures on Wipro and short
index futures. This eliminates systematic risk but retains the unsystematic risk of Wipro.
Integrating financial markets across the world Investment in financial assets by non-
residents is regulated by the government. From the viewpoint of economic efficiencies, such
denial or restriction is undesirable as it handicaps the determination of true value of the
stocks. The wider and larger the investor base, the truer would be the value of the firm.
Though restrictions on direct participation in equities by non-residents may still have some
merit due to foreign currency and reserve implications or capital flight considerations, their
investments in futures or derivative should be viewed positively. Since futures can always be
settled in cash in local currency, they are safer bets. Trading in the futures of stock indices of
a foreign country would provide an opportunity to investors abroad to take a view on other
economies, increasing market efficiency—something that must be beneficial.

SOLVED PROBLEMS setviseseesesnsssns

SP 4.1: Understanding stock/index futures quotations
From Fig. SP 4.1, answer the following:
a) Name of the underlying asset and its current value
b) Market lot and expiry
c) Value of the contract traded during the day
d) Latest value of the underlying asset
e) Open interest at the end of today and the previous day
f) Cost of carry
g) Number of contracts squared up today
h) Volatility of the index for one day and one year.
Solution
(a) Name of the underlying asset and its current value: NIFTY index futures, 4905.00
(b) Market lot and expiry: 50, 31 May 2012
(c) Value of the contract traded during the day %9,83,785.10 lakh
(d) Latest value of the underlying asset, i.e., NIFTY, 4891.45
(e) Open interest on 17 and 18 May
No. of contracts open as at the end of 18 May = 2,07,61,850
Change in the open interest during the day = —7,19,200
Open interest the previous day, i.e., 17 May 2012 = 2,00,42,650
(f) Cost of carry: 7.77% calculated as follows:
_ Futures price — Spot value % 365 4905.00 — 4891.45 _ 365
Cost of carry (%)
Spot value ~~ days to maturity A 4,891.45 X aq X 100 = 7.77%
 Stock and Index Futures 111

[Quote x on May 12, 2012 18-30-21 IST & All prives in T

iS&P CNX Nifty - NIFTY index Waich Minton Chan

@ index Derivatives ©) Steck Derivatives <> Currency Derivatives

instrument Type: Symbol: Expiry Gate - Option Type : Strke Price

index Futures >| NIFTY Lx BIMAY2012) ” e

4,905.00 Prey, Close Open High Low «Close

eS
& SAFO 1.00% 4 BE2 30 4,778.00 4808.30 | 4 PaT AS | 4888.95
Fundamentals | Weatorcst bata
Print
Book intraday
Traded Volume (contracts) £07 SAS
Traded Value face} BBA 785 10 Buy Oty, Buy Price Sel Price Seti Oty.
VEAP 4,B27 BH 200 «490375 490500 3,950
Underhing value 4,894 96 200 «$503.60 «4,905.45 50
Market Lot 50 #00 «480340 «4,908.58 150
Open interest Z2BT BABSB 5 «$903.30 44,805.85 5g
Change m Open interest -*, 49,206: #0 «490320 «4g0590 © 13,400
trnphed Valatiny “4514000 TotalQuantity | 685.500

Gther information
2 Cost of Carry
Setlement Price 4,988.95
Gauity Voisiiity 4.40 BestBuy & eat Sell Last Prine
Arnualived Volatility 24.04 Briggs 4,303.75 4,905.00 3,305SH
Chent Wise Position Limits 258,44, 587
Cost of Cary 74 8.44 $44
HWarvet Wide Pasition Limits

Source: www.nseindia.com, accessed on 19 May 2012.

Fig.SP 4.1 Snapshot of index futures quote as on 18 May 2012
(g) Number of contracts not squared up till the previous day: 7,19,200/50 = 14,384
(h) One-day volatility of futures is 1.10% and annual volatility is 365 « 1.10 = 21.01%
SP 4.2: Understanding stock/index futures quotations
From Fig. 4.2 in the text, answer the following questions:
(a) Name of the underlying asset and its current value
(b) Market lot and expiry
(c) Latest price and value of the contract
(d) Cost of carry
(e) Number of contracts not squared up till the previous day
(f) Number of contracts squared up on the day
Solution
Name of the underlying asset and its current value: |. T. C Ltd, $259.05
Market lot and expiry: 1000; 25 Oct 2012.
Latest price and value of the contract: %259.70; %2,59,700
Cost of carry:
_ Futures price — Spot value 365 259.70 — 259.05 365
Cost of carry (%) x 100= X = X 100 = 3.05%
Spot value days to maturity 259.05 30
Number of contracts not squared up till the previous day: (2,06,02,0000 + 5,76,000)/1000 = 21,178
Number of contracts squared today: 5,76,000/1000 = 576
112 Derivatives and Risk Management

SP 4.3: Marking-to-market and initial margin

31 December, 1 January, and
Consider the data of Example 4.1. Assume that the clearing values of the index as on 30 December,
out by buying the contract at 2501. With
2 January are 2593, 2692, 2601, and 2550, respectively. On 3 January, the investor closes
an initial margin of 12%, solve the following:

(a) The amount of margin to be paid by the investor on 30 December while selling the futures contract.
(b) What would be the cash flow of the investor on account of MTM?
(c) What is the profit of the investor on the futures contract transaction?
(d) How does the MTM margin affect the profit?
(e) How does the initial margin affect the profit?
Solution:
(a) The amount of initial margin to be deposited with the exchange is 2568 x 20 X 12% = %15,408
(b) The cash flow due to MTM for four days is as follows: Contract size = 50
MTM cash flow (%) = (profit/loss) x contract size

LD Date Action Price eS cash flow @)|

30 December Open position—sell 2,568
30 December | Clearing 2,593 | 25 = 4|PKi0

31 December Clearing 2,692 —99 li —4,950 |

1 January | Clearing 2,610 +82 +4,100
ee a a Clearing er Tal 2,550 T +60 | +3,000
3 January | Close position—buy | 2,501 [ +49 +2,450

(c) Profit = (Selling price — buying price) x contract size = (2568 — 2501) x 50 = ¥3350
(d) Profit as per MTM = —1250 — 4950 + 4100 + 3000 + 2450 = %3350
The MTM margin does not affect the profit. The MTM profit does not change because it depends only upon the opening and
the closing prices of a position, regardless of the movements in price during the days in between the opening position and the
closing position. In fact, the profit is the sum of all MTM cash flows.
(e) The initial margin is only a security provided by the client through the clearing member to the exchange. It can be withdrawn in
full after the position is closed. Therefore, it does not affect the calculation of profit or loss.
SP 4.4: Hedging short portfolio—long hedge
A bureaucrat retiring in three months’ time is planning to invest €20 lakh from his superannuation benefits in an equity portfolio. He
has identified the portfolio at current market prices as given in table below:

Stock No. | Price (%) | Value (%) | Beta

Hind Unilever 230 2,30,000 | 1.10
Infosys 1,700 1,70,000 irae
Indian Hotels 60 3,00,000 0.90
DLF Ltd 175 3,50,000 1.40

Fi | 00 | 1,900 | 9,50,000 | 1.15 _

Total yee: : =i) 20,00,000 |

The market as measured by the index is 4060. The market is expected to rise, as reflected in the 3-m futures trading at 55 points’
premium over spot at 4115. The index is likely to go up by 10% by the end of three months. Having chosen an aggressive portfolio,
the bureaucrat is worried that he/she would have to spend more than 110% to acquire the same portfolio or else reduce the number
 Stock and Index Futures 113

of shares accordingly. What strategy can be suggested to the bureaucrat to hedge? Demonstrate that hedging would enable him
to
acquire the same number of shares by staying within his/her target investment amount of £20 lakh even at increased prices.
Solution
The market, currently trading at 4060, is expected to rise by 10% to 4466 (1.1 x 4060). However, the value of the proposed portfolio
would rise by beta times the market rise. The beta of the portfolio is 1.159, computed as below table.

Stock | No. | Price(%)| Value(z) | Beta |Wtbeta’|

Hind Unilever | 1,000 | 230 | 2300001 1.10 | 0.127
Infosys 100 | 1,700 | 1,70,000 | 1.25 | 0.106
Indian Hotels 5,000 60 | 3,00,000 | 0.90 | 0.135
DLF Ltd 2,000 | 175 | 350,000! 140 | 0.245
RIL | 500 | 1,900 | 9,50,000| 1.15 | 0.546
Total | 20,00,000 1.159

Wt Beta* = Value of particular stock

< Beta of stock
Total value of portfolio
Hedging can be achieved by going long on the index futures, currently trading at 4115. The number of futures to be bought is
computed as follows:
Current value of the portfolio = ¥20,00,000
Beta of the portfolio = 1.159
Exposure to be covered by index futures = 1.159 x 20,00,000 = %23,18,000
Current market price of index futures = 4115
Value of one futures contract = 50 x 4060 = %2,03,000
No. of contracts bought and adjusted for basis: = 23,18,000/2,03,000 4115/4060 = 12 (rounded)
At the end of three months, if the markets indeed went up by 10%, the long position in futures may be squared up by selling the
futures, registering a gain that can be utilized for acquisition of the portfolio. If the market index is at 4466, then the position of the
futures and the proposed portfolio would be: i
Gain in the position of the index futures = (4466 — 4115) x 12 x 50 = %2,10,600
Increase in the value of the portfolio = 10% X 1.159 x 20,00,000 = §2,31,800

The increased cost of acquiring the portfolio, ¥2,31,800, is compensated considerably by the gain of %2,10,600. The bureaucrat
would need an extra ¥21,200 only. In the absence of any hedge with the futures, the increased cost of the proposed portfolio at
€2,31,800 would have to be funded fully, or it can be reduced by reducing the number of shares of each stock.
SP 4.5: Arbitrage when futures are overpriced
The current value of NIFTY is 1990, with a dividend yield of 4%. A 3-m futures contract is selling at 2030 and the risk-free interest
rate is 10%. Half of the stocks in the index will pay dividend in the next three months.
(a) Spell out a strategy that yields risk-less profit
(b) Evaluate gains if the index, after three months, is at (a) 1900, and (b) 2080.
Solution
(a) The fair value of a 3-m index futures = Spot value + cost of carry — dividend
= 1990 + 1990 x 0.10/4 — 1990 x .04/2
= 1990 + 49.75 — 39.80 = 1999.95 ~ 2000
The futures at 2030 are overpriced. The strategy that yields profit would be to:
* sell the futures, borrow funds at 10%, and invest in index securities; and
* after an appropriate time, buy back futures, sell the securities, and refund the loan with interest.
114 Derivatives and Risk Management

(b) The payoff under two different scenarios will be given as follows:
r
|
index at 1,900 |Index at 2,080 |
Position in futures
Selling price 2,030 2,030
Buying price 1,900 2,080
Gain/loss 130 —50

Position on index
Buying price 1,990 1,990
Selling price 1,900 2,080
Gain/loss —90 90
Dividend received 39.80 39.80

Interest paid AO —49.75 |

Profit | 30.05 30.05

SUMMARY
© =
Index futures and stock futures are perhaps the simplest, most carry model is used in determining the fair prices of futures.
talked-about, and popular instruments of investment, speculation, Index and stock futures do not have storage costs, but have
and hedging. Stock exchanges all over the world have huge num- dividends attached to them, which may be accounted for in the
bers of stocks listed with them and have developed an index to cost of carry model when pricing them.
provide a comprehensive and realistic view of the ongoing activ- Index futures, besides having the basic applications of hedg-
ity. An index is a representative sample of activity in the market ing, speculation, and arbitrage, are useful in many other ways.
and is also supposed to be a barometer of the economic situation. Hedgers can use index futures to cover the exposures of long
There are contracts for future delivery based on index values. and short positions in their portfolios. Index futures can also be
An index, comprising of proportions of select stocks, is a non- used for controlling the sensitivity of the portfolio, which may
deliverable product. A futures contract on an index necessarily require frequent adjustments in changing scenarios. They are
has to be cash-settled, i.e., by offsetting the initial contract and also useful in eliminating the systematic risk of an individual
exchanging the price difference. Similarly, there are futures on stock. Like any other futures, index and stock futures also pro-
specific stocks, called stock futures. They, too, can be cash- vide tremendous leverage to speculators to take an advanta-
settled. India is amongst the few countries that have futures on geous view of forthcoming situations.
individual stocks, possibly because of the long-standing practice Besides, they can be used by naive investors for investment
of forward trading in stocks prevalent in India prior to the intro- on a broad-based portfolio. Index futures can also be used for —
duction cf futures. Index and stock futures too are standardized minimizing the systematic risk of portfolios. They are very useful
contracts, like any other futures. in providing a cost-effective solution to equity research, which is
Index and stock futures are subject to cash-and-carry and a costly proposition indeed, with no certainty of outcome.
reverse cash-and-carry arbitrage, and, therefore, the cost of

KEY TERMS
Beta A measure of systematic risk, and specifies the change in Index futures Futures whose underlying assets are indices.
the value of the stock or portfolio with a 1% change in the market. Stock futures Futures whose underlying assets are stocks.
Clearing price The weighted average price for the last trading Systematic risk The change in price of a stock or portfolio
slab at which all outstanding contracts at the end of the day are attributable to market factors.
marked to market. Tracking error The difference between the actual returns
Impact cost The difference in price caused by a change in of an index-based portfolio or fund attempting to replicate the
size of the buy/sell order. returns of the index and the actual returns of the index.
Index Arepresentative sample of the stocks/assets that fairly Unsystematic risk The change in price of a stock or portfolio
represents the whole and is used for gauging the state of the attributable to factors specific to the stock or portfolio.
market and the economy.
 Stock and Index Futures 115

QUESTIONS
4.1 What do you understand by index and index futures? What are the other ways of doing so and what is the advan-
4.2 What are the benefits of index futures overstock futures? tage of adjusting beta with index futures?
4.3 How would you hedge a long position in a portfolio of stocks 4.5 What risk can be reduced with index futures if used in con-
with index futures? Explain with an example. junction with an individual stock?
4.4 How would you control the beta of a portfolio with futures? 4.6 Explain calendar spread in index futures with an example.

PROBLEMS °
P 4.1 Pricing a forward contract P 4.7 Hedging a short position in stock
Suppose a 6-m forward contract on shares of ITC Ltd is avail- Upon his retirement in three months’ time, Gyan Prakash would
able. The current market price of ITC is 180. If the risk-free receive %24 lakh as superannuation benefits, 50% of which he
interest is 6% per annum, what should the price of the 6-m for- intends to invest in shares of State Bank of India (SBI). The cur-
ward contract be? rent market price of the SBI share is =1200, with a beta of 1.05.
P 4.2 Pricing a forward contract with dividend The market is currently rising and is expected to remain upbeat.
In P 4.1, what would be the value of the forward contract if The current level of the market is 4200, while a 3-m futures con-
(a) the interest rate was continuously compounded, and (b) ITC tract on NIFTY sells for 4260, with a lot size of 50. Gyan Prakash
declared a dividend of ¥2 payable after two months. is worried that he would only be able to buy a much smaller
number of shares when he actually gets the funds, compared to
P 4.3 Pricing a futures contract on an index
what he can hope to buy now. What strategy can you suggest
The spot value of NIFTY is 4800. With the risk-free interest rate
to Gyan Prakash? Examine your recommended strategy if the
at 8% and dividend yield on the 50 shares comprising NIFTY
market rises by 10% in three months’ time.
at 4%, what should be the fair value of futures on NIFTY with
(a) one month, (b) two months, and (c) three months to maturity? P 4.8 Price and basis
Examine P 4.7. Do you find that after hedging through futures,
P 4.4 Arbitrage with index futures
Gyan Prakash would be in a position to buy the contemplated
Refer to P 4.3. NIFTY futures with 1-m, 2-m, and 3-m maturity
1000 SBI shares after a rise in the price of SBI stock? What
are trading at 4820, 4825, and 4855, respectively. What strate-
could the reason for the shortfall be?
gies can you adopt with each of the futures contract to profit?
P 4.9 Decreasing the beta of the portfolio
P 4.5 Hedging market risk with index futures
Dynamic Funds Limited (DFL) owns a well-diversified portfolio
An investor holds shares of Suzlon worth €20 lakh, which have
valued at ¥10 crore with an aggressive beta of 1.2. The market
a standard deviation of returns at 25%, with a beta of 1.5. The
scenario in the coming few months is expected to remain bear-
Standard deviation of market returns is 16%. Index futures on
ish, and, therefore, the fund needs to reduce the beta of the
NIFTY are priced at 4000, with a contract size of 50. If an inves-
portfolio to a defensive 0.9. Find out what the managers of DFL
tor hedges with the NIFTY futures, find out what position he/
should do if they want to (a) divest part of the portfolio to treasury
she must take. Also find what risk the investor would face with
bills, and (b) control the beta through a position in index futures.
a hedged portfolio.
P 4.10 Increasing the beta of a portfolio
P 4.6 Hedging a long position in stock
Refer to P 4.9. Assume that the market scenario is changed
An investor is holding 2000 shares of RIL, currently trading at
and sentiments have turned bullish. DFL now want to be more
%1800. The beta of RIL is 1.2. Though there is no adverse news
aggressive and wishes to increase the beta from the existing
regarding RIL, market sentiments are expected to turn weak for
1.20 to 1.50. Examine how this can be achieved (a) through the
the next three months. The investor decides to hedge his position
government securities market, and (b) in the derivatives market.
through 3-m futures on NIFTY, a broad-based index of 50 shares
Assume that DFL does not want to change the composition of
currently at 4200. One contract on NIFTY futures is worth €50
the existing portfolio.
times the index value. How can the investor hedge against risk?
 ee WHO

Currency
Forwards and Futures

INTRODUCTION Learning Objectives

Globalization of business is the theme of almost all firms in the After going through this chapter,
world. As economies grow and become more and more open by readers should be familiar with
relaxation of regulations concerning international trade, firms are _ + foreign exchange rates, markets,
expanding businesses from local markets in domestic currencies and transactions
to global markets in multiple currencies. International markets * how forward contracts on
currencies work
present several different challenges in finance in terms of the
on ; : : : « hedging foreign currency exposures
additional understanding required, due to the added dimension of importers and exporters through
of choosing the currency of trade and for finance. As the world forward contracts
economy becomes more and more integrated, a finance manager « speculation and arbitrage with
is required to make additional decisions with respect to strategic forward contracts
¢ non-deliverable forward contracts;
issues such as the currency of borrowing, impact of globaliza-
their evolution, need, and relevance
tion on capital structure, and tactical issues (such as the currency * currency futures
of invoicing). These new dimensions have added complexities to + hedging with currency futures for
trade. The dynamics of derivatives markets, too, has witnessed importers and exporters
major changes ever since the onset of globalization. * speculation and arbitrage with
; of currency for finance and trade,
Apart from the selection rency ffutures
currency
another important dimension that fig-
When multi-currency ures prominently on the agenda of
options
areavailable, the finance managers is the exposure to
evaluation of all finance on ; vn : :
avenues is notas simple additional risk arising from deals in
as it is with a single _ currencies other than the domestic cur-
currency. _ rency. Apart from broadening the con-

interest rate structures followed in various countries and finan-

cial assets denominated in foreign currency, the finance manager
has the onerous task of gathering, assimilating, and analysing
the vast information that is generated all over the world. In this
way, an international firm, referred to as a multinational corpo-
ration (MNC), becomes different from a purely domestic firm
dealing in a single currency.
 Currency Forwards and Futures 117

One may argue that the concepts of corporate finance must remain the same irrespective
of the currency being evaluated. All the three major decisions in finance—the investment
decision, the financing decision, and the dividend decision—should be independent of the
currency being considered. The argument is valid, but the presence of multiple currencies
makes each of these decisions more complicated, as the number of options available increases
significantly. Numerically, it is simple multiplication involving exchange rates to convert one
currency into another, but the decision-making framework changes drastically with regard
to international business, as managerial inputs are significantly larger, more complex, and
different.

____ FOREIGN EXCHANGE PRELIMINARIES

From the perspective of risk, dealing in foreign currencies adds a new type of risk, called
exchange rate risk. To understand exchange rate risk, it is essential to understand the basic
structure of foreign exchange markets, their terminologies, and their practices. This section
is aimed at providing the necessary background for all of this.

FOREIGN EXCHANGE RISK -

An additional dimension for transactions denominated in currencies other than the domestic
one is exposure to the risk of conversion of currency. Since foreign exchange rates change in
the same way as stock prices change in the stock markets, all transactions denominated in a
foreign currency face exchange rate risk. The MNCs deal in and possess assets and liabilities
denominated in various currencies. They need to bring down all these transactions, assets,
and liabilities to a common single currency—the domestic currency of the country where
the MNC’s headquarter is located.
Basically, all firms that have transactions, assets, or liabilities denominated in foreign
currency face the risk of changes in the position of assets or liabilities and/or cash flows.
The amount of foreign currency outstanding either as payables or receivables is referred to
as currency exposure. If the rate of exchange moves in an unfavourable direction, the
impact on the balance sheet or the income statement is termed exchange rate risk. For
example, if an export firm has sold goods worth US $1000 on credit of 60 days, the trans-
action would be completed only after 60 days, upon receipt of the payment of US $1000.
If from the date of invoicing to the date of realization, the US dollar depreciates, the
exporter realizes a lesser sum in Indian rupees than what he/she envisaged at the time of
_ invoicing. However, an appreciation in the US dollar would be favourable
MNCs and firms dealing _ to the exporter, as he/she will realize more than expected. Similarly, an
in foreign currencies
face the additional risk
importer needing to pay an outstanding in some foreign currency is worried
of exchange rates, and about its appreciation during the intervening period between creation of
need to understand liability and its actual liquidation. In contradiction to an exporter, an
_ the nuances of foreign importer would welcome depreciation of the foreign currency to which he/
exchange markets. she is exposed.
EE
118 _—Derivatives and Risk Management

FOREIGN EXCHANGE MARKETS (9

Foreign exchange markets mainly consist of banks, called authorized dealers in India, These
markets are of the over-the-counter (OTC) type, where individuals and cor-
Despite foreign exchange porate traders come with their requirements for either buying or selling
markets being OTC, : specific currencies. There is no organized exchange where foreign exchange
prices behave muchin can be traded, in the manner of the various stock exchanges where custom-
ne sabe Wey ts 8108 7 ers can place their orders for buying and/or selling stocks in the physical or
Information gathering and
electronic market. Despite the fact that foreign exchange markets are OTC
negotiation skills become
predominant. in nature, the price behaviour of currencies is akin to that of stocks. This
oor implies that different rates of exchange would prevail in the market for dif-
ferent currencies. The OTC nature of foreign currency markets places an additional burden
on corporate finance managers exploring various avenues and possibilities to determine the
most cost-effective solutions to their problems. These analyses not only are time consuming
but also require deep understanding and good negotiation skills.
Further, foreign exchange markets are operative round the clock. There is no specific
time for opening or closing. Foreign exchange rates fluctuate all the time. Banks and foreign
exchange dealers quote foreign exchange rates depending upon the demand and supply posi-
tion they are facing. Normally, banking hours govern trading in foreign exchange.

FOREIGN EXCHANGE RATES (0

Trading in foreign currency, unlike trading in shares and other financial assets, is not done in
any organized exchange. For exchange-traded assets, a single price in the public domain is
available. The buyer and seller both pay brokerage. With a brokerage of 1% ona share priced
at ¥200, a buyer would pay %202, and the seller would receive $198, with €4 being the total
transaction cost for buyer and seller and the income for the brokers. There are many foreign
exchange rates, briefly described in the following paragraphs.

Bid Rate vs Ask Rate

Foreign exchange markets are OTC markets, with various banks quoting rates in bid and ask
pairs—one for buying and the other for selling foreign currency. Bid and ask rates are defined
as follows:
Bid rate: The rate at which a bank buys foreign currency.
Ask rate; The rate at which a bank sells foreign currency.
To make a profit in foreign exchange transactions, banks must buy currencies at a lower
rate and sell them at a higher rate. Therefore, the ask rate is always higher than the bid rate.
While quoting rates, the convention is to specify the bid rate first. The dif-
Foreign exchange rates. ~~ ference between the ask rate and the bid rate is the profit for the bank from
are always two-way _ a round transaction involving the buying and selling of one unit of foreign
quotes, one for buying : ce oer : ;
foreign curency--the bid | currency; this difference is known as the spread. Percentage spread is defined
rate, and otherfor sell- : as follows:
Ce ask ao % Spread = Ask rate — Bid rate x% 100 5.1)
Mid rate
 Currency Forwards and Futures 119

Spot Rate vs Forward Rate

Transactions in foreign exchange may be carried out for settlement either now or at a
later date. Spot transactions in foreign exchange require settlement of contracts within
two business days. Transactions in foreign exchange involve at least two countries, which
hinders the immediate settlement of contracts. Therefore, a provision of two business days
is made to facilitate movement of currencies (by debits and credits) for settlement of spot
transactions.
Forward contracts in foreign exchange, like any other forward contract, fix the exchange rate
today for settlement at some future date. Settlement refers to the actual exchange of currencies.
Since various economic and political factors impact exchange rates on a continuous basis,
spot rates change with time, as do stock prices. The exchange rate, therefore, is dependent
upon the time of delivery of the currencies. This makes for different spot and forward rates.
What is valid today cannot be valid tomorrow. Except by coincidence, the spot and forward
rate would not be identical. Essentially, the exchange rates are dependent upon the tonne of
the settlement of the transaction.
Some people may believe that the forward rate would always be higher than the spot rate
at any point of time. However, it is not true. Forward rates, though dependent upon the spot
rate, can be lower than, equal to, or higher than the spot rate. We shall address this issue in
the section on pricing of forward contracts in foreign exchange in this chapter.

FORWARD PREMIUM/DISCOUNT 7
There are two ways of quoting exchange rates, direct and indirect. Under the direct rate
convention, the value of foreign currency is stated in terms of number of units of domestic
currency per unit of foreign currency, e.g., 47 per US dollar in India. The system of direct
rate prevails across the world, except for a few countries. Under the direct rate convention,
a forward rate that is higher than the spot rate means that the foreign currency will be more
expensive in the future than it is today, when it is said to be at premium. Similarly, a forward
rate that is lower than the spot rate implies that the foreign currency will be cheaper in the
future than it is today, when it is said to be at a discount.
How expensive or cheap the foreign currency will be, is stated conventionally on an annual
basis. Forward rates are available for varying contract periods ranging from
Foreign currency at _ one to six months and sometimes up to 12 months. As the foreign exchange
ee cane a _ market is an OTC market, one can get foreign exchange rates for any forward
rate is higher/ lower than | period on demand, but it is more common to find forward rates available at
the spot rate. _ monthly intervals. The annual premium or discount on the foreign currency
8 can be computed by using the forward rate, as follows:
Annualized forward premium/discount (%)
_ Forward rate,,iq — Spot ratenig 5 ee! 00
Spot rate nig Forward period (in months)
Here mid refers to the average of the bid and ask rates. Since foreign exchange rates are
quoted in pairs of bid and ask rates, the premium or discount is calculated using the average
of the two, called the mid rate.
120 ‘Derivatives and Risk Management

EXAMPLE 5.1 Calculating forward premium/discount

Consider the following rates of foreign exchange for euro:
Spot (rupees per euro) 57.90 58.10
1-m forward (rupees per euro) 57.50 57.80

(a) Find whether the euro is at a premium or discount.

(b) Calculate the annualized premium or discount for euro.
(c) What interpretation do you give to the figure arrived at in (b)?
(d) What do you think would be the average (mid) rate for 3-m, 6-m, and 12-m forward contracts, assuming bid-ask spreads of
%0.50, 0.80, and 1.00, respectively?

Solution

(a) Since 1-m forward rates are lower than the spot rates, the foreign currency, i.e., the euro, is at a discount to rupee.
(b) The amount of discount is:
Annualized Forward Premium/Discount (%)

Forward raténig — Spot ratenig 12 _ 57.65 — 58.00 pe ge

* Spot ratenig Forward period (in months) NE 58.00 x 12 x 100 7.24%
(c) A discount of 7.24% means that the euro is likely to depreciate by 7.24% in a year with respect to the rupee. ;
(d) Assuming that the premium/discount calculated using the 1-m forward rate is a fair representative of forward rates for the 2
whole year, the likely forward rates for 3, 6, and 12 months are as follows: 7
3-m forward rate (mid) = 58.00 x (1 — 0.0724/4) = %56.95/euro
6-m forward rate (mid) = 58.00 x (1 — 0.0724/2) = €55.90/euro
12-m forward rate (mid) = 58.00 x (1 — 0.0724) = %53.80/euro
Assuming even distribution of spread from the mid-rates, the forward bid and ask rates are:
3-m forward rate (rupees per euro) —: 56.70 57.20
6-m forward rate (rupees per euro): 55.50 56.30
12-m forward rate (rupees per euro): 53.30 54.30

Since forward rates are available for different maturities, one faces a dilemma as to which
of the forward periods is most appropriate for calculating the annualized premium/discount.
Purely on consideration that trading thins down as the forward period extends in time, it is
most appropriate to estimate the annualized premium or discount on the foreign currency on
the basis of the nearest forward contract, i.e., the 1-m forward rate rather than the forward
rate for any other forward contract period. This approach is based on the presumption that
contracts with near maturity are traded the most. Greater liquidity implies truer representa-
tion of fair prices.
Another important feature of forward rates is that the spread in forward rates is larger
than the spread in spot rates. Since forward transactions have a greater risk, dealers
demand a greater spread. Given the increased risk, banks would expect a greater reward,
which is derived from the spread (the difference between the ask and bid rates). By the
same logic, the spread increases as the maturity of the forward contract extends, i.e., the
spread in a 6-m forward contract is likely to be higher than the spreads in 3-m and 1-m
forward rates.
 Currency Forwards and Futures 121

ARBITRAGE AND FOREIGN EXCHANGE RATES

Having discussed the various rates, the question of whether different dealers in foreign
exchange would quote the same rates for a currency remains. Basically, the main question
is: what is the process involved in determining and quoting rates?
_The process of determination of rates is analogous to the process behind stock market
_ quotations. Without concern for the fair value of a financial asset like stocks
Arbitrage is a process or bonds, we all appreciate the fact that an asset cannot have two prices.
that makes prices
Having two prices provides an opportunity to investors to make immediate
converge in different mar-
kets. It is not concerned profits without investing or assuming risk. The costs of shares of Reliance
with whether the prices Industries Ltd in various stock exchanges across India at any given point of
are fair or not. time necessarily have to be identical. In case the prices are not the same, the
- situation gives rise to arbitrage opportunities; traders may earn profits by
buying the stock in a market where the price is low and simultaneously selling the stock in
a market where the price is high, pocketing the difference between the two prices. This profit
is earned without making any investment and without taking any risk.
The process of arbitrage would make the prices converge and helps to eliminate such
profit opportunities very quickly. The visibility of an arbitrage opportunity is extremely high
in cases where trading in financial assets takes place on exchanges that display prices all the
time. The same process of arbitrage makes foreign exchange rates converge across different
traders and banks.
However, arbitrage opportunities in the foreign exchange markets are not as visible as
with stocks and bonds. The primary reasons for this difference are: first, foreign exchange
markets are OTC markets where the rates are not displayed for viewing, and, therefore, fewer
investors are aware of the rates and the existence of discrepancies, if any. Second, foreign
exchange quotations are two-way quotes, with one price for buying and the other for selling.
Identification of arbitrage opportunities is relatively difficult in foreign exchange markets,
compared to products that are exchange-traded. Apart from these reasons, foreign exchange
markets may place restrictions on trading and prohibit taking of speculative positions, unlike
stock markets, where such restrictions are almost non-existent.
Let us consider a simple example where two banks, Bank A and Bank B, (assuming both
are American banks and follow the convention of direct rates) have offered the following
rates:

Amount of US dollars per euro Bid Ask

Bank A 1.3160 1.3260
Bank B 1.3280 1.3380
For arbitrage-free foreign
_ The rates of Bank A mean that it would buy euro at $1.3160 and sell euro at
exchange rates, the bid
price of one trader must _ $1.3260. This means that customérs can sell one euro and get $1.3160 (the
be less than the ask price bid rate) and if they wish to buy one euro, they will have to pay $1.3260 (the
of another, with both the - ask rate). Similarly, at Bank B customers can sell one euro to get $1.3280 and
quotes expressed in a pay $1.3380 to get one euro. A customer sells the foreign currency at the bid
similar fashion.
rate and buys foreign currency at the ask rate.
122 Derivatives and Risk Management

To derive profit, one needs to ‘sell high and buy low’. In the foreign exchange markets,
if the ask rate of one bank is higher than the bid rate of another, it would offer an arbitrage
opportunity, such that the difference between the ask of one and the bid of the other can
be earned as profit. The condition for arbitrage is exhibited in Fig. 5.1, and can be simply
expressed as,

For arbitrage: Bid, > Ask,

With the given rates, traders would buy euros from Bank A at the ask rate of $1.3260 and
sell the same amount of euros to Bank B to receive the bid rate of $1.3280, making a profit
of $0.0020 per euro without making any investment or carrying any risk.

ee Le

Fig. 5.1 Condition for arbitrage

Obviously, the rates that offer arbitrage cannot exist for long in the market. Arbitrage
opportunities have to vanish very quickly. Bank A would face a great demand for euro, indi-
cating thatitcan increase the ask rate. Continuing with the same rate would also result in the
fast depletion of its stock of euro. Similarly, Bank B would face a situation where everybody
would be selling euro at $1.3280. This indicates that it can revise its quote downwards, and
also prevents unnecessary build-up of euro. Arbitrageurs would signal an upward revision of
ask rate of Bank A and a downward revision of bid rate of Bank B. The inventory of foreign
currency at hand would tell the bank which rate to revise as well as its direction.
If the quotes of Bank A and Bank B overlap (the ask of one is greater than the bid of
another), the arbitrage opportunity would vanish. For example, the banks could revise the
rates in the following way:

Amount of US dollars per euro

The condition for no arbitrage to exist is depicted in Fig. 5.2, where the rates of the two
banks overlap. This may also be stated as

For no arbitrage: Bid) < Ask,

In competitive and well-informed markets, such arbitrage opportunities do not exist at all,
and if they do, then they vanish as quickly as they are spotted.
 Currency Forwards and Futures 123

“
CC

Fig. 5.2 Condition for noarbitrage

CURRENCY FORWARDS.
FOREIGN EXCHANGE TRANSACTIONS ——"
Having understood the various rates quoted in foreign exchange markets, we now turn to an
understanding of the nature of transactions. For better understanding of the applications of
hedging, speculation, and arbitrage, a brief background of various transactions in the foreign
currency markets is discussed in this section.

Spot and Forward Transaction

Transactions in foreign exchange can either be spot or forward, depending upon the time of
settlement. For all buy or sell currency transactions, the actual exchange of cash (debit or
credit to the respective accounts) in the two currencies takes place later, and is referred to as
settlement. If a transaction is to be settled immediately, it is termed a spot transaction, and
- the rates applicable for such a transaction are known as spot rates. In foreign exchange trade,
spot transactions are to be settled within two business days of the transaction to allow for
clearance and confirmation on the communication network.
Transactions in foreign currency can also be made for settlement at a later date. Such
transactions, where the rate is fixed now but the delivery of currencies is delayed, are known
as forward contracts. For example a 1-m forward contract for buying dollars executed by an
Indian importer at $45.00 per dollar implies that physical exchange of dollars and rupees
would take place one month after the date of transaction, but the rate of £45 per dollar has -
been fixed today. It further provides for two business days for settlement. It does not matter
_ what exchange rate prevails one month later, on the day of settlement.
Forward contracts are Banks usually quote rates for delivery in months, and standard contracts
settled at a later date,
for one, two, three, six, and nine-months are generally available. However,
but at rates negotiated
in advance. These rates banks can also quote rates for forward periods that are not exact multiples of
are usually available in a month. Traders can book contracts for any number of days forward. Such
advance for time periods = contracts are called broken date or odd date contracts.
comprising months as Spot and forward rates, as quoted by the State Bank of India (SBI), are shown
ae in Table 5.1. Note that the forward rates are quoted in unbroken months.
124 Derivatives and Risk Management

Table 5.1 Spot and forward foreign exchange rates

As on 16 September 2005 as quoted by the SBI 7
Export
Currency Spot

US dollar 43,83
54.57 54.22 54.01 53.87 Euro 53.69
79.71 76.56 79.65 79.61 Pound Sterling 79.34
35.41 35.07 34.85 34.72 Swiss franc 34.61
7.32 V2 7.24 UL Danish kroner 7.20
33.68 33.74 33.83 33.81 Australian dollar 33.69 L
37.46 37.31 37.21 37.14 Canadian dollar 37.01 1

| __tperuntotoign rer |
Source: Business Line, 17 September 2005.

Swap Transaction
A swap transaction is a combination of spot and forward transactions. The spot and forward
legs of the swap are opposite and equal in value. On a given day, for example, a bank may buy
$10,000 spot from another bank and simultaneously enter into a 1-m forward contract to sell
$10,000 to the same bank. The rates for buying spot and selling forward would be different, but
are known on that day itself. This called a swap transaction. With both buying and selling rates
known, the bank is not exposed to any risk of fluctuation in exchange rates. Buying foreign
currency today and selling later, or selling today and buying later, is a composite contract in
the swap deal. However, the same position is obtainable with two independent but opposite and
equal contracts—one spot and the other forward. An independent forward contract is called
outright forward contract. Two independent contracts—one spot and the other outright for-
ward—are more expensive than a single swap contract.
Composite swap contracts are of great utility to banks, as they enable avoidance of risk
and the problem of finding an exact matching counterparty. A swap can do this by having
offsetting positions in a single contract. Banks usually do trading on behalf of customers who
are exporters and importers. The transactions of a bank with its customers are normally on
an outright basis, while with other banks, the deals are on a swap basis.
Assume a bank buys a 1-m forward contract of $10,000 at %46 per dollar on an outright
basis from an exporter. The contract means that after one month, the exporter would deliver
$10,000 to the bank and receive %4,60,000 from it. After paying %4,60,000 to the exporter,
the bank would end up with $10,000. While the rupee amount payable by the bank is known
today, it does not know what amount of local currency $10,000 would fetch
Aswapisacomposite | later. Depending upon the rate prevailing at that point of time, the bank may
contract consisting of two Tealize an amount more than, equal to, or less than the %4,60,000 it paid.
legs, with the secondleg = Thus by buying dollars from an exporter, the risk of exchange rate fluctua-
being opposite and equal —_tions passed from the exporter to the bank. The bank must find a buyer (an
to the first leg, but settled
_ importer-customer) who needs exactly the same amount at exactly the same
only after the first leg is
settled. _ time. Though a transaction like this is theoretically possible, in practice it is
“© Cifficult proposition to fulfil.
 Currency Forwards and Futures 125

- Most inter-bank deals are Bankers would not accept such a position since it is not a bank’s business
_ swap deals, which help to assume risk on behalf of its customers, and, hence, the bank in this posi-
eliminate the exchange _ tion would in turn book a contract with another bank to sell $10,000 1-m
rate risk. _ forward. Such a step would mean that the bank, after receiving dollars from
its customer, would sell them to another bank at a rate known today. While
buying dollars forward, the second bank would sell an equal amount of dollars on spot basis
to the first bank. The dollars so received can be sold in the market at the prevailing spot price.
By doing so, the timings of the cash flows in foreign currency are matched with spot buying
and selling and forward buying and selling. Further, all the exchange rate risk is eliminated.
Figure 5.3 depicts the flow of foreign currency (dollars) for Bank A under a swap deal.
Note that cash flows on a spot basis as well as a forward basis in the foreign currency
are matched with all the rates known today, eliminating any uncertainty about the foreign
exchange rates.

Fig. 5.3 A swap transaction for joa A

Outright Forward vs Swap

We described a swap transaction as either of the following:
e Buy foreign currency spot and sell forward
e Sell foreign currency spot and buy forward
A swap 1s a composite deal that has two equal legs, one the spot and the other the forward,
which is equal and opposite to the spot!. The exposure to foreign currency is nullified at the
end of the swap period. As both legs are equal and opposite, the net flow of foreign exchange
is zero. A swap contract merely changes the timings of the inflow of cash and the outflow of
foreign currency. Since the rate for the forward leg is predetermined, the risk of changes in
the foreign currency rates is eliminated. As the deal is composite, the foreign exchange rates
in the spot and the forward transactions are linked with each other.
Swap deals are quoted in a different fashion. Two rates are required for a swap deal: one
for the spot leg and another for the forward leg. While spot rates are readily available, the
rates for the forward leg are quoted in terms of swap points, instead of explicit rates. The spot
rates, together with the swap points, are used to arrive at the rate applicable for the forward
leg. This system can best be explained with an example. Assume a dealer wants to buy euro

'It is not necessary to have the first leg as a spot under the swap. One can buy (sell) a 1-m forward contract and sell (buy)
a 2-m forward contract of equal amount. Such a swap is called a forward—forward swap.
126 Derivatives and Risk Management

- now and sell euro one month later. This is a swap transaction, where the spot
Forward rates under
swap are arrived at by _ leg is a buy and the forward leg is a sell for the dealer. Further, assume that
adding or subtracting a bank quotes the following rates:
the swap poinis. When
the aa aL arelowl Spot (rupees per euro) 58.5800 — 58.6000
high, they are added to Swap points? 1-m 500/700
the spot rate, and when
they are high/low, they The dealer can achieve the same outcome as that of a swap by entering into
are subtracted fromthe two independent contracts; buy euros spot and sell the same quantity 1-m
spot rate. : forward. The rates for the 1-m forward deal on an outright basis are derived
from the swap points using the following rules:

e When the swap points are low/high The foreign currency is at a premium, and the rate
for the forward deal is arrived at by adding the swap points to the spot rates.
e When the swap points are high/low The foreign currency is at a discount, and the rate
for the forward deal is arrived at by subtracting the swap points from the spot rates.

Using this rule, the rate for the outright forward contract in our example is derived as follows:

Spot (rupees per euro) 58.5800 — 58.6000

Swap points |-m 500/700
1-m forward rate 58.6300 — 58.6700
(Swap points being low/high are added to the spot rates)

The dealer can buy euro spot at 58.6000 (the ask rate for a spot deal) and sell euro 1-m
forward on an outright basis at 58.6300 (the bid rate for the forward deal).
Instead of booking two independent contracts, the dealer can book a composite swap con-
tract. Here, the spot transaction would be executed at the same rate (the ask rate at which the
dealer buys and the bank sells euro) of 58.6000 per euro. However, the rate for the forward
leg would differ and is calculated as follows:

¢ The rate for the spot leg becomes the reference rate to/from which the relevant swap
points are either added or subtracted.
e Ifthe swap points are low/high, they would be added to the spot rate and if they are
high/low, they would be subtracted from the spot rate.
e Ifthe forward leg is ‘buy’ for the bank, the bid points are relevant, and if it is ‘sell’,
then the ask points are relevant.

Here, the reference rate is $58.6000 and the forward leg is ‘sell’ for the dealer and ‘buy’
for the bank; therefore, the bid points become relevant. Further, since the swap points are
low/high, they would be added to the reference rate for the forward leg. The
A swap deal is always forward rate would therefore be 58.6000 + 0.0500 = %58.6500, yielding a
Sone _ profit of 0.05 per euro for the dealer. Note that the profit for the dealer was
q P lower at 0.03 per euro if he had booked two independent contracts for spot
contracts.
buy and |-m outright forward sell.
“In inter-bank quotations, rates are quoted up to four decimal places. The first two decimal places are called basis
points,
abbreviated as ‘bp’ and the last two decimal places are referred to as points-in-points abbreviated as ‘PIPs’. Swap
points
are quoted in PIPs.
 Currency Forwards and Futures 127

A composite swap contract is always cheaper than the combination of two independent
contracts consisting of a spot deal followed by an outright forward contract.

Option Forwards
Parties to forward contracts are committed to settling their individual obligations on the due
date. A forward contract is a firm contract that has to be settled on a specific date. While
banks are in a better position to meet these commitments exactly on the specific date, it is
a rather difficult proposition for merchants dealing in exports and imports. For example, an
exporter expecting a payment in one month’s time from his customer may decide to sell the
foreign currency 1-m forward to his bank. Though the commitment has been made to sell the
foreign currency to the bank, the exporter may not realize his payment as expected. In sucha
case, the exporter would default, as he is not ready with the foreign currency to be delivered
to the bank on the scheduled date. A similar instance may happen with an importer who may
not be in a position to buy foreign currency on the date fixed in a forward contract booked
by him. These circumstances certainly do not imply that the merchants defaulted on their
contracted commitments intentionally. Prevailing business circumstances might be a reason
for not honouring commitments on the dates decided.
Some flexibility in the timing of maturity of forward contracts is desired by merchants, as
_ they can predict their cash flows only in an approximate basis due to the
Option forward contracts
: nature of their businesses. When the exact timing of the cash inflow/outflow
are not fixed-date
contracts, but instead _ is uncertain, a forward contract can be booked for delivery within a given
provide flexibility to time period, called the option period, rather than on a specific date. For exam-
deliver foreign exchange _ ple, an exporter expecting payment anytime between two to three months
over a period, called the _ would like the kind of flexibility where he can deliver the foreign exchange
option period.
any time between two and three months of booking a forward contract. Such
a contract is called an option forward contract, and is depicted in Fig. 5.4.
Under the option forward contract, a merchant who has booked a forward contract at t = 0,
has an option period for delivery between two dates: the earliest date and the last date, rather
than one fixed date.
The rates offered by banks in option forward contracts are based on the principle of least
risk and maximum gain. These rates would depend upon (a) whether the bank is buying
or selling the foreign currency forward, and (b) whether the currency is at a premium or
discount. For example, if the bank is dealing with an exporter who wants to tender foreign
currency anytime between two and three months forward, and the currency is at a premium,
the bank would use the 2-m forward rate rather than the 3-m alternative for quoting rates to
the customer. Since the foreign currency is at a premium, it is advantageous for the bank to

Fig. 5.4 Option forward contract

128 Derivatives and Risk Management

e to the bank can be

buy it earlier, as it becomes more expensive at a later date. The advantag
forward rates:
maximized if the bank adopts the following strategy for quoting the option
Foreign currency state Buy Sell
Premium Earliest Latest

Discount Latest Earliest

Though rates based on this strategy would be expensive for the customer, the customer
must be prepared to pay an extra price for having the flexibility of timing when buying or
selling, and, therefore, must not feel too aggrieved.

HEDGING THROUGH FORWARD CONTRACTS (9 "

A forward contract in foreign exchange can be used to remove uncertainty over exchange
rates in the future by buying and selling forward at rates fixed now.
Exporters who expect to realize sales in a given foreign currency face the risk of a fall in
the price of that foreign currency. They need protection against any reduction in the value of
the asset, the account receivable. If the foreign currency appreciates, the exporters welcome
this rise, because it will increase the value of the asset. As it is an unfavourable movement,
deprecation of foreign currency is a cause for concern here. This concern may be mitigated
by selling the anticipated receipts in foreign currency by entering into a forward contract with
a bank, whereby the exporter promises to deliver the foreign currency in exchange for the
domestic currency at a rate fixed now.
Similarly, importers who have to make a definite payment in foreign currency at a future
date are apprehensive about any increase in the price of»that foreign currency. They con-
_ sider that any increase in the value of the payable must be confined to an
A currency forward is _ acceptable level. In order to eliminate the risks changes in exchange rates,
an agreement to give or
_ an exporter can freeze the exchange rate prevailing now, by entering into a
take delivery of foreign
currency in exchange forward contract to sell foreign currency, whereas an importer would obtain
for domestic currencyat the requisite foreign currency later in exchange for domestic currency at an
a future date, atanex- = exchange rate known and accepted today.
change rate determined Two examples demonstrating how hedging for receivables and payables
today.
_ can be done are presented here.

Hedging Receivables (by Exporter) with Forward Contract

Exporters need to guard against the effects of appreciation of their local currencies, as they
realize lesser amounts of the domestic currency against foreign currency payments to be
received by them in the future. Assume an exporter, EXPressive Ltd, has sold merchandise
worth £1,00,000 to a customer in England. EXPressive expects to receive the
Exporters can sell foreign
currency forward at a _ money three months from now. The spot price of the pound is ¥79.34. The
price determined today, ¢Xporter is expecting the pound to depreciate over the next three months to
eliminating any risk of fall = &79.00. What can EXPressive do to protect itself from the risk posed by the
in the value ofthe asset. = decreasing value of the pound?
due to a decline in the ; A 3-m forward contract from a bank for buying pounds is available at
exchange rate.
¥79.27. If the firm thinks that in three months’ time the rupee would not
 Currency Forwards and Futures 129

depreciate as much as the forward rate indicates, then it can sell receivable 3-m forward. A
forward contract for selling £100,000 may be booked with the bank.
At maturity of the forward contract three months later, settlement will be done as follows:

EXPressive will deliver to the bank: £1,00,000

The bank will pay to EXPressive: ~79,27,000
By booking the forward contract, EXPressive has mitigated any anticipated loss and has
assured itself of a firm level of cash flow in local currency. If the forward contract was
not booked, EXPressive would have to sell its pounds at the spot price prevailing three
months later. If the rate falls to $79.00 as anticipated, EXPressive would have realized only
~79,00,000. Through the forward sale of pounds, EXPressive ensured it would not lose prof-
its to the extent of 27,000. On the other hand, if the pound appreciates to 779.50, the local
currency collection would be more ¥79,50,000. Here, the spot market would give 23,000
more than what could be realized from a forward contract. Note that a forward contract fixes
cash flow in the domestic currency. Forward contracts are used to protect future cash flows,
not to maximize the value of those cash flows.
Actions and decisions for hedging receivables in foreign currency are shown in Fig. 5.5.

Asset in foreign currency is created at t= 0 maturing

ai time t= T

Compare the expected spot rate at 7, S; with the

forward rate, F
If S;< F Sell Forward

At t= T deliver foreign currency and receive local -

currency at fixed rate, F :

Hedging Payable (by Importers) with Forward Contract

While exporters do not face any risk from appreciating foreign currency, importers do. In
fact, exporters welcome appreciation of foreign currency, as their receivables appreciate in
value, and importers welcome depreciation of foreign currency, as their pay-
An importer booksa _ ables fall in value.
as ee 0 Let us consider how importers can hedge payables against any rise in
at a price determined
eee th e price
i of f the the forei
foreign currency
ne req uired. : Assume an importer,
p 3 IMPressive
today, eliminating risk Ltd, has purchased a machine from a supplier in Germany for €10,000,
_ associated with a rise in with the payment due in six months. The spot price of the euro is $53.84.
the value of the liability The importer is expecting the euro to appreciate to a level of $55.00 in six
due to an increase in the
months’ time, and is worried about the rising value of the euro. What can the
importer do to safeguard its interests?
130 Derivatives and Risk Management

The importer is expecting a cash outflow of €5,50,000 based on its fore-:

Forward contracts on
currency are OTC, cast for the exchange rate six months later. A forward contract for the euro 1s
settled with delivery, available at £54.57. To safeguard its position, [MPressive may buy €10,000
independent of underly- from the bank six months forward. At the time of maturity of the forward
ing contracts, andhave = contract, coinciding with the payment in euro after six months,
counterparty risk.
~ The bank will provide IMPressive with: €10,000
IMPressive will pay to the bank: %5,45,700

By booking a forward contract to buy the foreign currency at a predetermined price,

IMPressive has ensured that it pays exactly 754.57 per euro. Whether or not the importer
benefits economically from sucha deal will be known only at the expiry of the forward
contract, i.e., from the spot rate at the time of settlement of the forward contract. If the euro
appreciates to a level higher than ¢54.57, then IMPressive benefits from the forward contract.
On the other hand, if the price of the euro remains below 754.57 IMPressive would have been
better off without a forward contract.
Actions and decisions for hedging payables in foreign currency are shown in Fig. 5.6.

Liability in foreign currency is created at t= 0 maturing

at time t= T

Compare the expected spot rate at 7, S; with the

forward rate, F
If S;> F Buy Forward

At t= T deliver local currency and receive foreign

currency at fixed rate, F

Fig. 5.6 Hedging payable with currency forward

The following points need to be reinforced about forward contracts as hedge tools for
exporters and importers:
e A forward contract is a derivative product, which derives its price from the spot price
of the foreign exchange that is the underlying asset. All forward prices mentioned in
Table 5.1 were derived from the spot price of the concerned currency. If the spot price
changes, the forward price will also change.
e The contracts were OTC, as they were tailor-made to the requirements of customers in
terms of quantity of the underlying asset and time of delivery. If required, banks could
quote prices for any forward period depending upon the requirements of their customers.
e A forward contract is settled with delivery on the due date, when both the bank and the
customer honour their commitments to each other for delivery of foreign currency and
local currency.
\
 Currency Forwards and Futures 131

e The obligations undertaken within a forward contract are independent of the underly-
ing contract. Whether or not the exporter actually receives money from its customer or
whether the importer actually made the required payment to its supplier is immaterial.
Irrespective of this situation, the commitment made to the bank under the forward con-
tract must be honoured. The underlying receivable or payable and the forward contract
thereon are independent of each other.
e There is no front-end payment involved at the time of booking a forward contract. There
are no interim cash flows either. Only at maturity is the actual exchange of currencies
done.
e Default by customers is possible (we do not expect a bank to fail in its commitment),
and thus, counterparty risk is present to that extent.

One common misconception about hedging is that it improves profitability/cash flow and
can compensate for the losses anticipated. It needs to be clarified that a forward hedge cannot
provide the desired price. In fact, the spot price, Sp, of an asset is market determined, and no
one can alter it.
Forward contracts ensure a price for the hedger irrespective of the future spot price of
the currency, S;. The forward price, F, is also market-determined and also cannot be
changed.
An exporter, while booking a forward contract, realizes the forward price
A forward contract is
a firm-price contract,
F, that is fixed in advance for his receivables, irrespective of the price pre-
providing protection from vailing at the time of realization. When he/she is unhedged, the amount real-
any downsides in return ized will depend upon the spot price S; prevailing at the time of receiving
for forgoing potential from the foreign currency, as shown in Fig. 5.7. The case would be similar as of
any upsides. an importer buying a forward contract for foreign currency.

EXAMPLE 5.2 Hedging payables with forward contracts

Ultra Films Ltd (UFL) has imported raw materials worth US $2 million for which the payment is due after three months. The fol-
lowing rates are quoted by a bank:
Spot (rupees per US dollar) 47.00 47.45
3-m forward 47.50 48.00
The firm is expecting appreciation of the US dollar by more than 5% in three months’ time.

(a) Should UFL hedge its payable?

(b) What rate would be paid by UFL if it decides to hedge?
(c) What would be the gain or loss if the actual spot rates after three months turn out to be (a) *46.50-%47.00, and (b)
%49.30-F49.85?
Solution

(a) The forward rates indicate an appreciation of the dollar of about 1% in three months’ time, while the firm expects a 5%
appreciation. It should go for hedging in order to save about 4% by buying US dollars forward.
(b) The forward ask rate is $48.00, at which rate UFL can buy US $2 million.
(c) If the spot rates at the end of three months were ¥46.50-%47.00, UFL would have fulfilled its requirement at %47.00. As |
compared to the forward, the firm loses 1 per US dollar. Hence, the loss is €2 million. |
If the spot rates at the end of three months were %49.30-%49.85, UFL could fulfil its requirement at 49.85. As compared to |
the forward, the firm gained €1.85 per US dollar. Hence, the gain would be €1.85 x 2 million = €3.70 million.
132 Derivatives and Risk Management

Fig. 5.7 Payoff of a forward hedge

An important feature of the forward contract is that it provides an assured rate of exchange,
protecting against downside risk. However, while the rate of exchange is assured, one also
forgoes the potential upside gain that one could get if the exchange rates were to move in a
favourable direction.
Further, it should be noted that by hedging through a forward contract, the risk was com-
pletely eliminated for the exporter and the importer, though it did not vanish from the envi-
ronment. It merely got transferred from the customers to the bank. Banks cover the risk in
many other ways, including a swap transaction with another bank, as described earlier.

Cost of Forward Hedge

Through a forward contract the exporter and the importer have assured themselves of fixed
prices, thus removing uncertainties. This price guarantee cannot come free of cost. We need
to know what cost is borne by hedgers while booking a forward contract.
Traditionally, the cost of a forward hedge is measured in terms of premium or discount
over the spot price. When a foreign currency futures is more expensive in than the spot,
i.e., F, > So, it is said to be at a premium and when it is cheaper than the spot, i.e., F, <
So, it is at a discount. The cost of a forward hedge is measured as a percentage premium or
discount over the current spot price, as shown here:

Cost of hedging = premium or discount (+) = (F, — So)/So G4,

In fact, the efficacy of the forward hedge can be measured only after the forward contract
period is over. The real cost or benefit of the forward hedge must be measured not when it was
set up but when it ended. The cost of the forward at the time of setup only reflects what premium
_ or discount is available. The real measure of effectiveness of a forward hedge
oes _ comes from the spot price, S;, at the end of the period of hedge, which tells
premium/discount of the the story about whether the hedger actually benefited from the forward hedge
forward rates over the or not. The real cost of hedging 1s as follows:
spot rates.
Real cost of forward hedge = (F, — S,)/Sp (333)
 Currency Forwards and Futures 133

SPECULATION WITH FORWARD CONTRACTS 9

While hedging, exporters and importers cover their risks on assets/liabilities owned. The
_ exporter holds a foreign currency receivable and the importer holds a fixed
Forward contracts can
also be used for specula- amount of domestic currency for a foreign currency denominated payable.
tion in the currency ex- Hence, they book forward contracts with the purpose of hedging their receiv-
change rate markets by able and payable, respectively, and have all intentions of honouring their
holding a view contrary to commitments.
_ the market and taking a
In contrast to the actions of EXPressive and IMPressive, consider a finan-
position,
cial firm, BETTERS Ltd, which does not need to buy or sell foreign currency.
BETTERS researches foreign exchange movements and forecast rates, and
whenever it finds forward rates attractive, bets on them with the sole objective of making a
profit.
As per Table 5.1, the spot price of the US dollar is 43.83 and a 6-m forward price is
%43.92 at an annualized premium of a mere 0.41%. BETTERS feels that the US dollar is
undervalued and should command a better premium than that indicated by the forward rate.
Therefore, BETTERS buys a US dollars 6-m forward at $43.92. It keeps a continuous watch
on exchange rate movements, specifically of the US dollar. It is convinced that in six months’
time, the US dollar will command a higher price. It can do either of the following:
e Whenever the forward price of the US dollar crosses %43.92, it can neutralize its posi-
tion by booking a sell contract such that the maturity of the new sell contract coincides
with the maturity of the original buy contract. Suppose that three months later, a 3-m
forward contract is available at 44.00. BETTERS can book a 3-m forward contract to
sell dollars at $44.00 and earn a profit of 0.08 for each dollar. Note that the delivery
dates of both the first and the second contracts coincide, although it is not at all neces-
sary to match maturity dates to take a speculative position.
e Alternatively, BETTERS can wait till the contract matures, when it will be required to
take delivery of the dollars by paying at the equivalent rate of ¥43.92, the contracted
rate. Rather than taking delivery, BETTERS sells the dollars at spot price, booking
either a profit or a loss depending upon the spot price prevailing then.

The actions of BETTERS Ltd are termed speculative, since the firm held a view con-
trary to the one indicated by forward rates, and was prepared to assume a position on its
own regarding the future movement of the prices of US dollars. In fact, BETTERS was not
attempting to cover any risk, as it did not have the foreign currency, nor needed it in future;
instead, it was taking a risk by opening the first forward contract in the hope of neutralizing
the exposure subsequently. In case the likely movement was not in its favour, it would lose
some value.

ARBITRAGE WITH FORWARD CONTRACT !

As defined earlier, the process of arbitrage requires setting up of a riskless position, in con-
trast to speculative actions, which set up an initial position and wait for an opportune time
to square up the initial position. It is not possible to find an opportunity to make arbitrage
profit from the same source, as the rates offered by the same bank will be such that they
134 Derivatives and Risk Management

_ result in profit for the bank, and, hence, loss for the customer. However, it
ee ae : is possible to find another bank that offers rates such that a smart and aware
rates for the same _ investor can buy from one source at a cheaper rate and sell to the other at a
currency, which may higher rate simultaneously.
also provide arbitrage = In Table 5.1, we note that the State Bank of India (SBI) offers the follow-
— _ ing rates for the Swiss france (CHF):
Exchange rates of SBI (¢ per CHF)

pe bot
| em | am | ‘tm | Spot :
35.41 35.07 34.85 34.72 CHF
Hypothetically, let us assume that Citibank offers the following exchange rates at the same
time for the Swiss franc:

An arbitrageur spots an opportunity to make a profit from the rates available from the
banks. The arbitrageur can sell Swiss francs 6-m forward at 734.90 to the SBI, and simulta-
neously buy Swiss francs 6-m forward from Citibank at %34.41.
Note that by buying from one and selling to the other, the arbitrageur has assured himself
of a profit of 0.49 for each Swiss franc transacted, without involving any capital or entering
into a promise to perform that cannot be fulfilled. His position stands nullified, as he buys
the Swiss francs from Citibank and simultaneously sells the same amount to the SBI, with
identical maturities.
Execution of arbitrage in the foreign currency markets through forwards is an extremely
unlikely situation. This is because the bid—ask spreads of different banks are not in the public
domain. The rates are obtained on demand only.

DETERMINING FORWARD RATES ®

Determination of forward rates that do not permit arbitrage is linked to the spot rates and the
interest rates prevailing for two currencies. Arbitrage in two different markets is dependent
upon the rates prevailing in the two markets. Arbitrage in the spot and the forward market
for the same underlying asset is governed by borrowing and investing. We borrow in one
currency and invest in another, depending upon the interest rates, spot rates, and the forward
rates. Because of the bid—ask spread and the borrowing—lending spread, there is a range of
forward rates that are feasible without any arbitrage opportunities.
No arbitrage condition places between (a) the lower bound for the ask rate and (b) the
upper bound for the bid rate. Within these bounds, any forward rates could be quoted.
In
Example 5.3, it can be noticed from the upper and lower bounds that many different sets
of
rates are possible with no arbitrage condition satisfied. Different banks can offer different
rates because of the vast range of feasible forward rates that are available. Transactio
n costs
would prohibit arbitrage.
 Currency Forwards and Futures 135

EXAMPLE 5.3 Bounds to forward rates

The following spot and interest rates prevail in the market:
Spot rate (rupees per euro) 60.00 61.00
Interest rate rupee: 8.00% 8.50%
euro: 5.00% 5.50%

Find out (a) the lower bound to the 6-m forward ask rate
(b) the upper bound to the 6-m forward bid rate
Solution

(a) To find the lower bound to the ask rate, we do as follows:

(i) Borrow foreign currency (euros) at the borrowing rate
(ii) Convert spot into local currency (rupees) at the bid rate
(iil) Invest the local currency at the lending rate for the period of the forward
(iv) Sell the matured amount at the forward ask rate to reconvert into foreign currency
For no arbitrage, the matured amount through the forward must be less than the borrowing.
Borrow €1.00 at 5.50% for six months: Amount to repay = 1.0275
Convert to rupees at the spot bid rate and get = %60.00
Invest for six months at 8% and get €1.04 x 60 = 762.40
Sell at the forward ask rate F, to get = 62.40/F,
For no arbitrage, we must have: 62.40/F, = 1.0275 or, F, = %60.7299

(b) To find the upper bound on the bid rate, we do as follows:

(i) Borrow local currency (rupees) at the borrowing rate
(ii) Convert spot into local currency (euros) at the ask rate
(iii) Invest the foreign currency at the lending rate for the period of the forward
(iv) Sell the matured amount at the forward bid rate to reconvert to local currency
For no arbitrage, the matured amount through the forward must be less than the borrowing
Borrow 1.00 at 8.50% for six months: Amount to repay = %1.0425
Convert to euro at the spot ask rate and get €1/61.00 = 0.0164
Invest for six months at 5% and get 1.025 x 1/61 = 0.0168
Sell at the forward bid rate F, to get F, < 0.0168
For no arbitrage, we must have: Fy x 0.0168 = 1.0425 or,F, = %62.0415

NON-DELIVERABLE FORWARDS

NON-DELIVERABLE FORWARD CONTRACTS Le

There exists a product, typical to the foreign exchange markets, which is neither a for-
ward contract nor a future contact. This product is known as the non-deliverable forward
(NDF) contract. An NDF contract, as the name suggests, is a forward contract where the
delivery of the underlying asset, mostly a currency or a commodity, is not required. The
need for such a contract arises from the impossibility of delivery of the underlying asset.
It is most prevalent in the foreign exchange markets in respect of currencies that are not
freely convertible. The governments of some nations exercise capital control in order to
prevent volatility in the exchange rates of their currencies, or for any other political or
economic reason.
136 Derivatives and Risk Management

EVOLUTION AND GROWTH OF NDF

The NDFs evolved in the 70s, when the Australian currency was subjected to capital restric-
tions. The NDFs began trading, obviating the requirement of delivery and
The NDFs are forward = et providing an effective means of hedging. They came into existence
oa | because of the increased volatility in interest rates, which made hedging
settled for currencies that difficult with the on-shore banking system through deliverable forward mar-
have capital control. _ kets. Transactions for hedging were conducted in the NDF market, and,
nm" hence, they are also called the hedge markets. In the case of Australia, the
development of the NDF market was on-shore, with settlement in the local currency, the
Australian dollar.
Today, the NDF market primarily consists of six Asian currencies, namely, the Chinese ren-
minbi (RMB), the Indian rupee, the Korean won, the Indonesian rupiah, the Philippine peso, and
the Taiwanese dollar, all of which are subject to governmental capital control in varying degrees.
One of the popular measures to exercise such control is to ban forward trading in the currency
markets. Due to regulations and legal and practical constraints in the free conversion and move-
ment of a currency, an NDF in any currency is normally traded off-shore, 1.e., outside the bounds
of the home country of that currency. For example, if the Indian rupee is subject to non-delivery
outside India, an NDF contract could be traded outside India, say at Dubai or Singapore.
The banking system in a nation may prohibit booking of forward contracts in the absence
of exposure in the underlying currency. Such controls make hedging feasible, but other spec-
ulative and arbitrage activities are denied, restricting the depth of the forward markets.
_. The NDFs provide alternative hedging avenues for non-residents who can-
NDFs provide much
| not participate in the on-shore deliverable market. Further, an on-shore deliv-
needed liquidity and
depth to non-convertible _ erable market may be illiquid too. Capital controls are aimed at restricting
currencies. The rates -~—»=—sShort-term capital flows that are not trade related. The growth in NDFs in the
in NDF are considered 1990s is believed to be related to the Asian currency crisis that led to further
better, as they are market : tightening of the currency controls. The participation by foreign nationals in
eee oe _ the on-shore forward markets is regarded as speculative enough to destabi-
/ _ lize the currency’s value by making the exchange rate extremely volatile.*

FEATURES OF NDFS Sitti

Unlike the Australian dollar, today’s NDF markets are off-shore. The NDFs are generally
quoted and settled in US dollars, though cross rates can be used for NDFs in other currencies
too. Since delivery is not possible due to restrictions on convertibility of the currency dealt
in, the settlement of a forward contract in the currency has to be on the basis of the differ-
ence between the contracted price and the spot price. Further, settlement has to be done in a
currency that is freely acceptable. Most NDFs are cash-settled in US dollars. Such contracts
have a notional principal amount.
NDFs are foreign exchange derivative products traded OTC. On maturity, the parties to an
NDF contract settle the transaction not by delivering the underlying pair of currencies but by

‘Higgins P, and Humpage, O.M. (2005), Non-Deliverable Forwards: Can We Tell Where Renminbi Is Headed, Federal
Reserve Bank of Cleveland, September.
 Currency Forwards and Futures 137

making a net Rammed equal to the difference between the agreed foreign exchange rate and
the spot fixing rate*. The NDF enables hedging by foreign participants who are not allowed
access to on-shore markets for these currencies.

HOW NDF WORKS &

An NDF works in the same manner as a deliverable forward contract from the perspective of
hedging. However, the mechanism is somewhat different. The settlement of an NDF is done
in foreign currency in cash, with the difference between the forward price and the settlement
price over a notional principal, as per Eq. 5.4, which follows:
Settlement amount = (1 — forward rate/settlement rate) X notional principal (5.4)
As an example, consider an exporter in Thailand who has supplied goods to India worth
~4,80,000 and has agreed to accept payment in Indian rupees after six months. However, the
Indian rupee is expected to depreciate from the current spot rate of ¥48 per dollar. Assume
that a 6-m NDF is quoted at US $0.02 per rupee (equivalent to %50 per dollar). The Thai
exporter decides to hedge by selling a 6-m NDF at 0.02. By doing so, the Thai exporter locks
in his receivable in US dollars at US $9600 (%4,80,000 US $0.02 per rupee), based on
the NDF rate of US $0.02 per rupee. The position of the Thai exporter for depreciation and
appreciation of Indian rupee is demonstrated in the following paragraphs.
If the rupee depreciates excessively to spot at US $ 0.0192 per rupee:
Settlement amount receivable under the NDF
= (0.02 — 0.0192) X_4,80,000 =e WS.$384
Realized US dollars from the receivable
= 4,80,000 X 0.0192 = US $9216
Total realization = US $9600

If the rupee appreciates to spot at US $ 0.0217 per rupee:

Settlement amount payable under the NDF
= (0.02 — 0.0217) X 4,80,000 = —US $816
Realized US dollars from the receivable
= 4,80,000 < 0.0217 = US $10,416
Total realization = US $9600

NDF AND INTEREST RATE PARITY Wit

We know that when the capital markets are freely accessible, the forward markets and the
spot markets are linked with interest rate parity (IRP) as follows:
CL sry)"
F = §, (i + 1)" (5.5)
where F,, is the forward rate for n periods, Sp is the spot rate, and r;, and ry are the interest
rates in the home and foreign countries, respectively.

4Guonon Ma, Corrinne Ho, and Robert McCaulay (2004), ‘Markets for Non Deliverable Forwards in Asian Currencies’,
Bank for International Settlement Quarterly Review June.
138 Derivatives and Risk Management

However, when capital account controls exist, lending and borrowing on-shore is restricted
for foreigners, distorting the IRP. This gives rise to the off-shore market. The rate of NDF,
therefore, would imply an interest rate differential that is not the same as the differential
reflected in the deliverable forward markets on-shore. Since NDF is not subject to capital
controls, the validity of the IRP tends to be greater.
Assuming a 12-m NDF contract in Indian rupees is quoted at 42.60 per dollar as against
the spot rate of 42.00, with a 6% interest rate in US dollars, the implied interest rate for the
Indian rupee would be 7.51%:
42.60
(1 ot ‘'NDF) = 1.06 X 42.00 = 1.0751 or INDE — TAL%,

This may be compared with the interest rate prevailing (one measure could be T-bills
yields) that becomes the benchmark for an on-shore forward market. The differential between
the off-shore and the on-shore rates as implied in the NDF rate and the forward rate may be
taken as the measure of effectiveness of capital controls. The larger the differential, the more
effective is the capital control.
An active NDF market and a lower differential between the off-shore and the on-shore
interest rates would be an indicator or precursor of the likely exchange rate markets scenario
if the capital flow controls were to vanish. The NDF would be regarded as a truer reflector of
free market conditions than the conditions prevailing in the on-shore markets for currencies
where controls exist on capital flows.
Where local residents operating in on-shore markets also have access to off-shore mar-
kets, the differential between the off-shore and the on-shore forward rates (or the differential
between the yields) would give rise to arbitrage opportunities. This would make off-shore
and on-shore yields and forward rates stay in close proximity with each other, with a nominal
differential that probably will not exceed the transaction costs in the two markets.
The differential is likely to be greater where interventions by governments in foreign
exchange markets are frequent and large. In situations of fixed exchange rates and restrictions
on local residents that prevent access to off-shore markets, the NDF may suggest the likely
revaluation/devaluation of a given currency.

ARE NDFs DESIRABLE ©

The NDF markets are often viewed with suspicion, as they circumvent the local exchange
control rules and provide easy alternatives to those who cannot access the on-shore deliv-
erable forward markets. However, they must be viewed from a different perspective. The
on-shore deliverable markets in regulated environments provide hedging applications but
they inhibit speculative and arbitrage activities. In contrast, those who need to hedge through
NDF would be few, but an off-shore NDF market would present opportunities for speculators.
Both stand-alone markets would lack depth and only when combined can present a truer and
competitive picture regarding the status of a currency.
Further, it is believed that an NDF market? (a) facilitates smoother transition of an econ-
omy from a controlled regime to full convertibility, as they serve as an intermediate bridge

*Debelle, G., J. Gyntelberg, and M. Plumb (2006), ‘Forward Currency Markets in Asia; Lesson from Australian Experience’,
BIS Quarterly Review, September.
 Currency Forwards and Futures 139

for the interim period, and (b) provide skills and expertise developed in the NDF markets to
be adapted to the deliverable forward market as and when capital controls are lifted or full
convertibility of the currency is achieved.

Currency futures serve the same purpose as currency forward contracts, 1.e., by providing
importers/exporters with a way to cover exchange rate risks with respect to their recetvables/
payables.
Though forward markets have been in existence for long, currency futures markets are
relatively a new development. Internationally, futures contracts on foreign currencies devel-
opedin the early 70s, when the International Monetary Market at the Chicago Mercantile
Exchange (CME) commenced trading on currency futures. Forward and futures markets have
co-existed in foreign currencies.
The cost of hedging through futures, being exchange-traded, is expected to be much
smaller than that of forward contracts. However, forward contracts offer a perfect hedge, as
the exchange rate realized or paid is known with certainty at the time of booking the con-
tracts. The limitations of futures that make a hedge imperfect, i.e., mismatches of quality,
quantity, and timing of the hedge, do not occur in forward contracts, which are OTC products
matching the specific needs of exporters and importers.
In India, there were no futures exchanges until 2008. The National Stock Exchange (NSE)
introduced futures contracts on the US dollar on 28 August 2008, and the Multi-commodity
Exchange-Stock Exchange (MCX-SX) did so on 7 October 2008. The features of the futures
contract on US dollar available in India are as follows.

Derivatives in Practice
One country, two systems, three currencies
HSBC points out that trading in the Chinese currency, RMB, is hardly simple. There are multiple markets—all of which trade
differently—and only a few that foreigners can truly position in, To start with, although the RMB, which is traded both on-shore
in China and off-shore (primarily in Hong Kong), is the same currency, it is traded at different rates. This is by design: as regula-
tion has explicitly kept on-shore and off-shore separated, the respective supply and demand conditions lead to separate market
clearing exchange rates.
Hence came about the emergence of a new currency code, CNH, to represent the exchange rate of RMB that trades off-shore
in Hong Kong. However, it does not end here. There is the traditional off-shore RMB market, the dollar-settled NDF, which itself
trades independently of either on-shore CNY or off-shore CNH, as well as a trade-settlement exchange rate (sometimes called
CNT) to which off-shore corporates have access, just adding to the complexity.
The CNH is effectively a separate currency altogether, a perfect proxy neither for the domestic RMB (on-shore CNY)
nor for the NDF (forward) curve market. The latter is otherwise known as the off-shore dollar-settled NDF market, which is
the traditional domain of off-shore participants. And to add to all of that, in July 2010, the RMB itself became officially
deliverable in Hong Kong—leading to its own rate, sometimes known as CNT. However, this is only available to off-shore corporate
entities.
A diagram from HSBC highlights the different markets for RMB (Fig. |) and Fig. Il shows how the three main markets (CNY,
CNH, and NDF) have diverged in the recent past.
(Contd)
140 Derivatives and Risk Management

(Contd)

Mainland China On-shore “supply”

Capital controls Central bank
ee) swaps
Offshore
RMB Trade L| |”jurisdictions
Settlement

Offshore
On-shore CNY . Demand

Market
Resident purchases

Central bank swaps

On-shore demand ji RMB Trade Settlement market

> <> S|" a

Key: €> I] Flow a )
a Source of naa a S—
Jurisdiction Market Supply/Demand Fixing Regulatory restrictions

Fig.1 The different markets for RMB

Source: HSBC

"The three markets, similar, but not identical

ha ae ee ee ee ee AS eS

Oe) =
NJ
6.45 | lis T T
14-Jul-10 1-Aug-10 1-Sep-10 11-Oct-10 1-Nov-10
USD-CNY USD-CNH 1m NDF

Fig. 11 The three markets (CNY, CNH, NDF); similar but not identical
Source; Bloomberg, Reuters, HSBC

What about arbitrage? That is the whole point: there is no arbitrage. However, the off-shore RMB market was created explic-
itly to allow the RMB to start developing internationalization characteristics, while at the same time keeping domestic markets
sequestered from global markets. By deliberately separating on-shore from off-shore liquidity, the CNY and CNH are designed
not to be arbitraged and, hence, will naturally have distinct market equilibriums.

Source: http://ftalphaville.ft.com/ posted by Izabella Kaminska on 12 December 2010.

Contract Specifications The contract on US dollar futures at MCX-SX is specified in

Table 5.2. Specifications are identical with the contract introduced by NSE.
Currency futures are _ Standard contracts with a size of US $1000 are available for the next 12 months,
derivatives based on _ providing hedging period of a maximum of one year. Each contract expires on
exchange rates that are ‘the last working day of the month on which spot transaction would be settled.
exchange-traded and are For example, the January 2012 contract expired on 27 January 2012, which
a substitute for forward
was the last day of settlement for spot transactions (two business days prior to
contracts,
_ the last working day of the month).
 Currency Forwards and Futures 141

Table 5.2 Details of contract specification of dollar/rupee futures at MCX-SX

Unit of trading 1 (1 unit denotes US $1000)

Underlying The exchange rate is in units of Indian rupees for a unit of the US dollar

Tick size 25 paise or €0.0025

Last trading day Two working days prior to the last business day of the expiry month at 12 noon.
| The last working day (excluding Saturdays) of the expiry month. |
Final settlement day
The last working day will be the same as that for interbank settlements in Mumbai. |
Quantity Freeze Above 10,000
Base price Theoretical price on the first day of the contract. On all other days, DSP of the contract |
|
Tenure greater than six months L
Tenure up to six months
Price operating range
+3 % of base price +5% of base price
Minimum initial margin 1.75% on day 1, 1% thereafter
x

Extreme loss margin 1% of the MTM value of the open position

spc

Calendar spreads
3%400/-
months,
a spread of 1 month, ¢500/- for a spread of 2 months, ¢800/- for a spread of
for and 1000/- for a spread of 4 months or more
Settiement Daily settlement:T + 1 Final settlement: T + 2
Mode of settlement Cash settled in Indian rupees
DSP Calculated on the basis of the last half an hour’s weighted average price.
The RBI oe rate

Source: —WWW.mcx-sx.com, socesced on 25

Perera 2012.

Trading One can start trading in currency futures by initiating a long/short position in
foreign currency through the members of the exchange dealing in currency futures. An
initial margin is payable as prescribed by the exchange (1.75% in case of MCX-SX), and
is released when the position closes. The initial margin is a performance bond used by the
exchange as a risk-containment measure in order to cover potential loss over a time period.
As such, no cash flow on account of the contract is involved while initiating a buy/sell
futures contract.
Daily marking to the market (MTM) is done with daily settlement prices (DSPs) worked
out on the basis of the average of the last 30 minutes’ trades. The final settlement is done
with the RBI reference rate on the last working day of the expiry month.
The price quotation is rupees per unit of foreign currency (per 100 units in the case of
Japanese yen), with a tick size of 0.0025 (25 paise). The minimum price change for a con-
tract would be €2.50 (%0.0025 x 1000).

Settlement Participants in futures contracts are expected to nullify their positions before
the last day of trading for the contract. However, if any position is outstanding, it is treated
as closed at the final settlement price (FSP), with any difference between the prices of the
opening and the closing contracts paid or received, as the case may be. All futures contracts
are cash-settled, and no delivery is asked for. As is true with any futures contract, settlement
by delivery is rarely chosen, even on underlying assets where allowed.
142 Derivatives and Risk Management

In contrast with the currency futures at NSE or MCX-SX, CME deals in various curren-
cies with different lot sizes. Contract sizes are much larger than US $1000, and only four
quarterly contracts are available. At CME, different currencies are quoted in terms of the
number of US dollars per unit of any other currency, with
e tick size of $0.01;
e delivery standardized in March, June, September, and December; and
e standard lots of Australian $10,000; Canadian $100,000; Sterling pounds 62,500; Yen
12,500,000; and CHF 125,000.

Figure 5.8 depicts trading information for US dollar futures in terms of Indian rupees on
the MCX-SX. It provides information for 12 monthly futures contracts. The product is speci-
fied as USDINR with maturity date. Price information for best buy quantity and price as well
as best sell quantity and price is displayed. It also gives information about the Jast traded
price (LTP), volume, and open interest in terms of the number of contracts (each contract is
for US $1000), and the value of the contracts is in crores of rupees.
The differences between forward and futures contracts are many, and have already been
discussed in Chapter 2. Forward markets in foreign currency are available worldwide, with

09 USOINR 281012 ER + Bil 4

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12 2h 68.9625 63.9700 i 0.0075 68.9625 16849 17633 116.50 3401 a ff. \
V7 63.1700 69,1825 10 UO125 69.1700 3694 9366 «(25.61 and
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|GBPINR 274412 3 87.1450 87.3975 10 0.2525 . 600

LIPYINR 260912 68.7250 63.7300 2 0.0050 68,7350 $856 9748 (67.76 2691 Sail
A20i012 1 68,9100 63.9450 i 0.0350 68.9300 2897 3867 19.9764
R 278112 9 69.0550 69.3350 25 0.2800 71.3500 100 181 «a7 ‘ a HP2 —— OT —— NOV
As on: 25 Sep 2012 12:35:58 : * Notional Turney As on: 25Seo 2022 f23600

SALMALAALIASLLARORLAPLONALELLLAALLLDRLOSAIADUILELIpDSipLULsbtibuisaabbesestanebanicttiiisedsistisibiebtssén “RBI ReferenceRate

Fig. 5.8 Trading information of currency futures on MCX-SX
Source: www.mex-sx.com, accessed on 25 September 2012.
 Currency Forwards and Futures 143,

no specified time of operation. In contrast, futures markets operate for specified hours.
Delivery in forward markets is tailor-made, while futures have a specified maturity date.
Despite the emergence of futures market in currencies, the forward market continues to
dominate trading in foreign exchange, possibly because of the comfort level banks provide
to traders and users.

PRICING CURRENCY FUTURES AND FORWARDS 2"

The pricing of foreign currency futures will depend upon the interest rates of the currencies
involved in the contract. The concepts of IRP and covered interest arbitrage are central to the
determination of forward rates of various currencies. Under conditions of free trade policies
and free flow of capital across international borders, interest rates in the two currencies must
determine future exchange rates.
As a standard concept of economics, the price of any commodity is determined by the
factors that affect the demand and supply of the commodity. Foreign currency is no differ-
ent from any commodity. The demand for foreign currency emanates from importers, and
supply sources predominantly comprise exporters who enter transactions involving goods
and services abroad in currencies other than the domestic one. Apart from the usual risks of
trade, importers and exporters face the additional risk of currency exchange rate fluctuations.
Importers and exporters have a genuine need to hedge the foreign currency transactions they
enter into.
Besides hedgers (importers and exporters), who constitute the demand and supply com-
ponents of foreign exchange, there are speculators and arbitrageurs operating in the foreign
exchange markets, subject to the exchange control regulations in place in any economy. All
over the world, speculators and arbitrageurs constitute a majority of transactions. In fact,
transactions that are being hedged actually form a miniscule 3-4% of the volumes in foreign
exchange markets. Irrespective of speculation or hedging, the pricing of forward contracts is
based on conditions that satisfy a no-arbitrage condition.
To examine how arbitrage works in determining forward exchange rates, let us consider
an example. Assume that a trader has €10 lakh today, available for one year. He/she has a
choice of either (a) investing in rupees, or (b) converting these rupees into US dollars at
today’s spot rate, investing the US dollars and reconverting the US dollars back into rupees
one year later. In an efficient market, the two strategies of investment must yield the same
reward. Further, the outcome of both the strategies must be certain. Therefore, we assume
that the investment must be made in risk-free securities in either market.
If the spot price is $50.00 per dollar and the risk-free interest rates for rupees and US dollars
are 5% and 3%, respectively, then the two strategies that can be followed are as follows:
e Invest in domestic markets:

ee a » Invest 10,00,000 at 5% for a year and get €10,50,000 after a year.

upon the spot price and Here, 5% is the return from risk-free investments such as T-bills.
the differential between e Invest in markets abroad:
interest rates in two dif- » Convert rupees into US dollars at the current spot rate of US $1 =
ferent currencies. 750.00 and get US $20,000.
144 ‘Derivatives and Risk Management

year. Again, the

=» Invest for one year at 3% to yield US $20,600 at maturity after one
investment is in risk-free securities such as T-bills in the USA.
ng after a
=» Obtain Indian rupees back by selling the dollars at the spot rate prevaili
year, 5}.
Here, the final amount of Indian rupees that the investor would get is dependent upon the
s
exchange rate prevailing at the end of the investment window. Both the investment strategie
are depicted in Fig. 5.9.

Today ; # One year later

%10,00,000 710,50,000

Today bs One year later

US $20,000 ee US $20,600

Fig. 5.9 Determination of forward exchange rate

For either strategy, the investor must be indifferent in terms of value in both the markets,
ie., the Indian and the US financial markets. If this has to happen, the spot exchange rate
one year later, $,, must be such that US $20,600 is equal to 10,50,000. This implies a spot
exchange rate of ¥50.97 per US dollar one year later.
In symbolic terms, if the spot rates today and one year later are Sy and S|, and domestic
and foreign interest rates are r; and ry, respectively, the relationship of the two spot rates is
given by Eq. 5.6 as follows:
Cl al ra)
Si = OG. os (1 ay r)
(5.6)
In this argument, we ignored the aspect of risk. There are two sources of risk:
e Rates of interest for making investment
e Spot exchange rate one year later
To be at equal levels of risk in both the markets, we may assume investment at risk-free
rates in both rupee and dollar markets. However, the second source of risk remains as it is.
While converting the matured amount to rupees, the investor is not aware of the future spot
rate S,. If the investor knew today exactly what rate he would get after a year for the US dollars
invested today, the risk of exchange rate fluctuation too would have been covered. Cover for
risk relating to the future spot rate can be easily achieved using the forward markets. If the
investor sells US dollars forward, the risk is covered. The actions would now be as follows:
e Step 1 Invest in domestic markets:
= Invest €10,00,000 at 5% for a year and get %10,50,000 after a year; for one unit of
home currency we get (1 + rj,).
 Currency Forwards and Futures 145

e Step 2 Invest abroad:

= Convert rupees into US dollars at the spot rate of %50.00 per dollar and get US
$20,000.
= Invest for one year at 3% to yield US $20,600 after one year at maturity; for one unit
of home currency, we get (1/S)) X (1 + rf).
= Book a forward contract for selling the maturity value at F, to get back rupees; for
one unit of home currency, we get (F\/Sp) X (1 + ry).
For no arbitrage, the maturity value in step 1 and the sum under the third action under step 2
must be equal. This gives the following relationship between the forward rate and the spot rate:
a2 (1 =F ra)
F, = So X ier) (550)
With continuous compounding, Eq. 5.7 gets modified to

Fy = Sp X e'a~ "pt (5.8)

The relationship expressed by Eqs 5.7 and 5.8 is known as the IRP, which relates the for-
ward markets with the money markets and the spot markets. The price of a forward contract
is governed by the interest rates for the two currencies in the transaction and the spot rates
prevailing.
Therefore, forward/futures price F (direct) = S X (1 + rg/(Q1 + ry)

Reconciling IRP and Cost of Carry Models The price of a futures/forward contract
arrived at through IRP and the no-arbitrage argument in fact is the same as the price calcu-
lated using the cost of carry model.
Under the cost of carry model, spot and Fame prices are related by the cost of carry for
the period of contract. In the case of a currency, this happens to be the risk-free rate of inter-
est. The future value of an asset is given by Sp X e’d’. However, the exchanged asset would
have earned risk-free interest in the foreign currency, which is like the value of benefits of
owning the asset. Therefore, the net cost of carry is the differential of interest rates between

EXAMPLE 5.4 Fair value of currency futures

At MCX-SX, currency futures in US dollar are traded. Today is 12 December and January futures would expire on 28 January.
Spot rate in the exchange market for dollar is 45.45. The yields in the T-bills markets of India and USA are 5.90% and 2.40%,
respectively.

(a) At what price January futures would be traded?

(b) What would be the price of February futures if its expiry is on 24 February?
Solution

(a) The fair value of futures is given by Eq. 5.8.

Here Sp = 45.45, ry = 5.90%, = 2.40%, and t = 57 days (From 12 December to 28 January)
F, = Sy X ella At = 45.45 x @(0.059 - 0.024)57'865 — 45.6991
(b) For February futures, the time to expiry would be 57 + 27 = 84 days. The price of February futures would be:

F, = Sy X eld 1H = 45.45 x (059 - oo2djeaia6s — 245.8176 :

146 Derivatives and Risk Management

the two currencies. If ry is less than rj, it becomes a case of negative cost of carry, as the
dividends on the asset are higher than the cost of carrying in local currency.

HEDGING THROUGH CURRENCY FUTURES

Hedging currency exchange rate fluctuations with currency futures is no different than hedg-
ing price risks through commodity futures or currency forwards. We use the same principle of
taking a position in the futures market opposite to that of the physical market. Subsequently,
we enter into another futures contract that offsets the initial contract. In the case of commodi-
ties, we strive to nullify gain/loss in the physical market with loss/gain in the futures market
in order to achieve a target price as close as possible to the initial futures contract price, with
as much certainty as possible.
One must remember that the target price should not be construed as a profitable price.
The target price in case of a forward contract is fixed, and is governed by the forward rates
available. One cannot desire an exchange rate that is out of line with market conditions. The
ultimate price realized in a hedge through futures is dependent upon the prices of futures
at the times of initiating the contract and cancelling the contracts, and on the ultimate price
prevailing in the spot market.
The following two examples illustrate the mechanics of hedging through futures for the
importer and the exporter, they known as long hedge and short hedge, respectively.

Hedge for Importer—Long Hedge

A hedge that involves taking a long position on futures contract is known as a /ong hedge. It
is appropriate when one has to purchase certain assets in the future and needs to lock-in the
price now. Consider the following situation:
An importer is short on In June 2008, an Indian importer buys a machine at US $50,000. Pay-
foreign currency. To ment is due after six months in December 2008. The spot exchange rate
hedge against appreciat- is €45.5625, while December futures are trading at %46.6500, indicat-
ing foreign currency, he ing an appreciation of the dollar by about 2.4% over six months. The
goes long on a futures
importer feels that the dollar will appreciate much more. What should he
contract.
do? Assume that the size of the futures contract available is US $1000.

Hedging strategy As a hedging strategy, the importer buys a futures contract now, trading
at ¥46.6500, and sells the same close to the delivery date before December. The importer
knows the exact amount of dollars to be covered, and, therefore, he/she buys 50 contracts on
MCX-SX.
Exposure amount _ 50000 ~
Number of contracts bought by importer =
Value of one contract 1000 Hs
Having bought 50 futures, the importer would cancel his/her position in the futures by
selling the futures at a date close to the actual date of payment in December.
Let us examine two different exchange rates scenarios when the payment falls due in
December.
 Currency Forwards and Futures 147

When the US dollar appreciates to 47.5600 and a futures contract sells for 47.5700
The importer exits the futures contract at 47.5700 and buys foreign currency in the spot
market at the prevailing spot rate.
Figures in &
Buy $50,000 at spot rate;
Cost = 50,000 x 47.5600 = 23,78,000
Sell 50 future contracts booked earlier at 747.5700;
Net gain on futures (47.5700 — 46.6500) x 50,000 I 46,000
Net rupee amount paid = 23,32,000
Effective exchange rate (23,32,000/50,000) = 46.6400
As against the spot price of 47.5600, the importer ends up buying dollars at 746.6400.
When the US dollar depreciates to ¥44.5625 and a futures contract sells for 44.5700
Figures in &
Buy $50,000 at the spot rate;
Cost = 50,000 < 44.5625 = 22,28,125
Sell 50 future contracts at €44.5700; ;
Net loss on futures (46.6500 — 44.5700) X 50,000 = 1,04,000
Net rupee amount paid 3327125
Effective exchange rate (23,32,125/50,000) = 46.6425
As against the spot price of 744.5625, the importer ends up buying dollars at 746.6425.
It may be observed that irrespective of appreciation or depreciation of the US dollar, the
effective cost of buying dollars remains close to the opening futures price, i.e., ¥46.6500.
The difference between the actual cost and the futures price is on account of the differential
between the spot price and the futures price when the hedge was lifted, referred to as basis
risk (discussed in Chapter 3).

_ Hedging for Exporter—Short Hedge

Exporters are long on the asset, and to cover risk through the future, they have to take an oppo-
_ site position in futures, 1.e., go short on the futures. This strategy is appropriate
An exporter is long on
foreign currency. To : when one has to sell a certain asset in the future and needs to lock-in the price.
hedge against depreciat- _ _ Assume that it is December now. A British exporter is expecting to receive
ing foreign currency, he US $5 million in six months’ time, in June. He is expecting the dollar to
goes short on a futures depreciate and the pound to appreciate, as is reflected in the following spot
contract, and futures rates at CME:
Spot: $1.5530 per pound, and June futures: $1.5600 per pound
Hedging strategy The hedging strategy would involve selling the futures now and covering
later. The exporter is facing a loss on his receivable, and he/she is long on US dollars in the
physical market. Therefore, he must go short in the futures market, 1.e., buy pounds and sell dol-
lars. A standard contract at CME is for £62,500. The number of contracts to be purchased = $5
million/1.5530/62,500 = 51.51. The actual number of contracts purchased = 52 (rounded off).
148 Derivatives and Risk Management

Say that in June, prior to the settlement date, the following rates are prevailing ($/£)
Spot: 1.6250, and June futures: 1.6275

The exporter squares up and sells the futures contract.

Gain on the futures market = (1.6275 — 1.5600) X 52 X 62,500 = $2,19,375
This is equivalent to £1,35,000 (using the spot price of $1.6250 per pound)
Loss on the receivable = (1/1.5530 — 1/1.6250) X 5 million = £1,42,652
Net lossi=-£1,42,6525—5 £1 ,35,000r = sb1.052

If the exporter had not hedged, he/she would have received £30,72,196 (50,00,000/1.6275).
With hedging, he/she receives £1,35,000 extra from the futures contract, at a realization rate
of $1.5590/£.

Like forwards in currencies and futures in stocks, indices, and commodities, foreign currency
futures too can be used for taking speculative positions on exchange rate movements. This
is also referred to as open position trading. When speculation is made on the movement of
price of a futures contract that is not consistent with the opinion held by the speculator on
the future spot exchange rates, one may take a position in futures and hope that the opinion
held proves correct. Consider the following prices of US dollar:

These rates imply that the Singapore dollar (SG $) will appreciate against the US dollar.
A speculator does not agree and believes that the Singapore dollar would depreciate or will
not appreciate much. Therefore, he/she sells the September futures contract at 0.5220.
However, the Singapore dollar does appreciate to a small extent. The rates (US$/SGD) on
1 September are as follows:

Spot: 0.5150 and futures

September: 0.5158

The speculator squares up his/her position by buying a September contract and gains
(0.5220 — 0.5158) = $0.0062 per Singapore dollar or $775 per contract (SG $1,25,000),
ignoring the transaction cost and marking-to-market. If the Singapore dollar had depreciated
instead, the gain of the speculator would have been even larger.

ARBITRAGE WITH CURRENCY FUTURES |

Arbitrage with futures can be executed in case the futures trade at a value other than fair
value. If the futures are overpriced, then one can sell them and if they are underpriced, one
can buy them. An equivalent position can be created from borrowing/lending and the spot
market. The following steps ensure arbitrage:
 Currency Forwards and Futures 149

:EXAMPLE 5.5 Arbitrage with currency futures

The following data from the financial markets is available
Spot exchange rate (rupees per dollar) 49.5000
180-day futures 50.4000
Rupee interest rate (T-bill yield) 10%
Dollar interest rate (T-bill yield) 5%
Based on the above data, find out the fair price of a futures contract. Is there any arbitrage opportunity? If yes, how can the
arbitrage be executed?
Solution
The fair price of the futures, using simple interest rates, is given by;

(+ Rupee interest rate ae (1+ 0.10 222)

180
ali iCO OR ULES SOL 5
days
(1+ Dollar interest rate 8) [r+ 00s122)
(1+ 0.05 365
= 50.6912

The actual futures trading, at 50.40 as against the fair price of $50.69, is underpriced. Therefore, we need to buy dollar
futures. Hence, we borrow dollars now and do as follows:
OO —————————
. Cash flows
> os
Now
Borrow US dollar 1,000.00 _
Convert to rupee using spot market — 1,000.00 49 500.00
Invest rupee at 10% for 180 days —49 500.00
Buy dollar in futures maturing after 180 days
Worth %51,941
Total 0.00 0.00
At maturity
Receive invested rupee 51,941.00
Deliver rupee against futures —51,941.00
Receive dollars against futures (51,941/50.40) 1,030.58
Pay dollar borrowed at 5% — 1,024.66
Total 5.92 _

At the maturity of the futures contract, the arbitrageur can make a profit of $5.92 for every 1000 dollars borrowed.
LET:

When futures are overpriced

At maturity of futures
Borrow local currency for the period till the futures mature Deliver foreign currency against the futures sold

Convert to foreign currency using the spot market Receive local currency against the futures sold

Invest in foreign currency for the period of the futures Pay for the borrowed local currency

Sell futures equal to the matured foreign currency investment

Since the futures are overpriced, the amount of local currency received would exceed the
liability of the borrowing.
 150 ‘Derivatives and Risk Management

When future is underpriced

Now At maturity of futures

Borrow foreign currency till the futures mature Deliver local currency against the futures sold

Convert to local currency using the spot market Receive foreign currency against the futures bought

Invest in local currency for the period of the futures Pay for the borrowed foreign currency

Buy futures equal to the matured local currency investment

Since the futures are underpriced, the amount of foreign currency received would exceed
the liability of the borrowing.

SOLVED PROBLEMS #49

SP 5.1: Forward premium/discount and forward rates
The following spot rates for the US dollar prevail in the foreign exchange markets:

Spot (rupee per dollar) 47.90 48.10

(a) If the US dollar is at an annualized premium of 5%, find the forward bid rates and the ask rates for 3, 6, and 12 months.
(b) Ifthe US dollarisat an annualized discount of 8%, find the forward bid rates and ask rates for 3, 6, and 12 months.

Assume that in each quarter, the bid-ask spread increases by 20 basis points (bps) for the forward period.
Solution
The spot mid rate is 48.00. We can find the forward mid rates for 3, 6, and 12 months using the following equation:
(a) When the US dollar is at 5% premium

Forward Mid rate = Spot mid rate x (1+ Annualized % Premium *< Forward months
100 x 12
3-m Forward Mid rate = 48.00 x (= 0:05 x 3 = 48.60

6-m Forward Mid rate = 48.00 x (+ 0.05 x 4 = 49,20

12-m Forward Mid rate = 48.00 x (1+ 0.05 x 13)= 50.40
With the bid-ask spread increasing at 20 bps for each quarter, the following would be the forward rates:

Bid Ask
3-M forward 48.40 48.80
6-m forward 48.90 49.50
| 12m forward 50.00 50.80

(6) When the US dollar is at a discount of 8%

3-m Forward Mid rate = 48,00 x (1~ 0.08 x 3 = 47.04

6-m Forward Mid rate = 48,00 x (1— 0.08 x 5 = 46.08
12-m Forward Mid rate = 48.00 x (1~ 0.08 x ¥) = 44.16
With the bid-ask spread increasing at 20 bps for each quarter, the following would be the forward rates:
 Currency Forwards and Futures 151

Ask
3-m forward 46.84 47.24
6-m forward 45.78 46.38
12-m forward 43.76 44.56

SP 5.2: Hedging receivables with forwards

Multiplex Ltd has exported copper castings worth US $1 million for which payment is due after six months. The firm has projected
profits assuming the current spot rate of $45 per dollar. Though the US dollar has been steady for the last year; the firm anticipates
a decline in its value in the coming days. The following rates are quoted by the bank:
Spot (rupee/dollar) 45.00 45.35
6-m Forward 45.50 46.00
(a) Should Multiplex Ltd hedge its receivable?
(b) What realization could be made in Indian rupees it if it decides to hedge?
Solution:
(a) Since the market is expecting a decline in the value of the US dollar, it would be better if Multiplex Ltd books a forward contract
for selling its receivable, especially when the firm has projected its profit at 45.00. Hedging receivable with forward contracts
may help reap high profits.
(b) The forward bid rate is $45.50, at which the firm can sell US $1 million, ensuring a rupee cash inflow of 455.00 lakh.
SP 5.3: Bounds to forward rates
In the inter-bank markets of New York, the prevailing spot rates and interest with respect to the euro are:

Spot rate (dollar per euro) 1.1200 1.1250

Interest rate dollar 5.00% 5.30%
euro 4.00% 4.20%
Find out (a) the lower bound to the 3-m forward ask rate
(b) the upper bound to the 3-m forward bid rate
Solution

(a) To find the lower bound on the ask rate, we (a) borrow €1.00 at 4.20% for three months (to repay €1.0105 after three months)
(b) convert spot into US dollars at the bid rate to get $1.1200, (c) invest at 5% for three months to get $1.1340 after three months,
and (d) the sell matured dollars forward to get euro to pay for the borrowing.
The matured amount of US dollar is sold to get euros at the forward ask rate. For no arbitrage, the matured amount through
forwards must be less than €1.0105.
Alternatively, for no arbitrage, we must have 1.1340/F, = 1.0105 orF, = $1.1222
Loyet
—= To find out the upper bound on the bid rate we (a) borrow $1.00 at 5.30% for three months (to repay $1.01325 after three
months), (b) convert spot into euro at the ask rate to get €0.8889, (c) invest at 4% for three months to get €0.8978 after three
months, and (d) sell matured euro forward to get dollar to pay for the borrowing.
The matured amount of euro is sold to get euro at the forward bid rate. For no arbitrage, the matured amount through the forward
must be less than $1.01325. -
Alternatively, for no arbitrage, we musthave 0.8978 x F, =<1.01325 orF, = $1.1286
SP 5.4: Settlement of NDF
In Singapore, foreign exchange NDFs are quoted in RMB for settlement in US dollar. An exporter based in Hong Kong has RMB
1 million receivable after three months. The RMB is likely to depreciate. The NDF Is being offered at RMB 8.20 per dollar, which
the exporter books. What amount would the exporter pay/receive if on the settlement date, the fixing rate is RMB 8.30 per dollar?
Solution
- The exporter sells RMB (buys US dollars) at an exchange rate of RMB 8.20 per dollar. Therefore, the notional principal is US
$10,00,000/8.20 = $1,21,991.20.
152 _—Derivatives and Risk Management

On settlement, the fixing rate is 8.30. The exporter would receive from the bank what is necessary to cover the shortfall he would
have on RMB receivables when converted to US dollars at spot rate.
ae NDF ae
Settement amount = Notional principal
—— ye
(1 crane
a
a

Settement amount = 1,21,91.20 x (= 520 = $1469.29

SP 5.5: Speculation with currency futures

Dollar futures with expiry in 60 days from now at MCX-SX are trading at %48.65. In the spot market, the rate is 47.75. Risk-free
rates in the USA are estimated to be 9% and 5%. If the estimates are assumed correct, what action would you take to earn profit?
Solution
The fair value of the futures is

F= Syx eld = 4775 x elm 0 eta =< A8 0650

The future is overpriced. Therefore, it must be sold.
SP 5.6: Arbitrage with currency futures
The following data is available from the financial markets:
Spot exchange rate (rupee per dollar) 49.7500
90-day futures 51.4000
Rupee interest rate (T-bill yield) 12%
Dollar interest rate (T-bill yield) 8%

Based on these data, find out the fair price of the futures contract. Is there any arbitrage opportunity? If yes, how can the arbitrage
be executed?
Solution
The fair price of the futures using simple interest rates is given by

(1+ Rupee interest rate ai f see =|

Fair price of futures = Spot x ae = 49.75 x nes %50.2312
(1+ Dollar interest rate 25) (1+ 0.08 =

The actual future trading at $51.40, as against the fair price of ¥50.23, is overpriced. Therefore, we need to sell dollar futures.
Hence, we borrow rupees now and make arbitrage profit as demonstrated below.

Cash flows
Se
|
Now
Borrow rupees = 1,000.00
Convert to dollars using the spot market 20.1005 — 1,000.00
Invest the dollars at 8% for 90 days — 20.1005 —
Sell the dollars in futures maturing after 90 days worth %51,941
Total 0.00 0.00
At maturity
Receive invested dollars 20.2970 —
Deliver dollars against futures —20.2970 =
Receive rupees against futures (20.1005 x 51.40) 1RO58:55
Pay rupee borrowed at 12% — 1,029.59
Total

At the maturity of the futures contract, the arbitrageur can make a profit of 23.96 for every £1000 borrowed.
 Currency Forwards and Futures 153

SUMMARY
ith increased globalization and liberalization of trade, an addi- They are popular instruments in currencies that have capital
tional dimension of risk is added to the menu of finance manag- flow controls. Forward contracts, being OTC, offer flexibility with
ers. Beside business risks, firms that trade internationally face respect to delivery of foreign exchange, by allowing a period
the risk of fluctuating exchange rates for exports and imports. rather than a specific date. Such contracts are called option for-
A risks related to foreign exchange is somewhat different, as it wards.
involves consideration of global factors that are not only hard to The rates offered in various locations by various banks are
comprehend, but are time consuming and too divergent. They different and yet competitive, and it is difficult to capture arbitrage
require more managerial time than would be needed to handle opportunities in foreign exchange markets, because these vary-
other kind of risks. ing rates are not in the public domain.
Foreign exchange markets are intricate and function quite dif- Hedging in foreign exchange rates can be done on the same
ferently in terms of rates. Foreign exchange rates for buying and principle of taking a position in forwards and/or futures opposite
selling are different, and are known as the bid rate and the ask to that of the physical markets. An exporter is long on foreign
rate, respectively. Further, foreign exchange markets are OTC. currency, and, therefore, he/she sells a futures contract. It is a
Transactions in spot are settled within two business days, time short hedge. On the contrary, an importer, who needs foreign
given to allow for the logistics of exchange of one currency into currency, has to go long in the futures market to hedge. This also
another, which involves a chain of banks and nations. remains the position in case of hedging with forward contracts.
Forward contracts are more popular as hedging, speculative While speculation on a forward contract is possible, arbitrage is
instruments, and futures contracts. There also exist NDF con- a near impossibility, as forward rates are OTC. Arbitrage and
_ tracts, which are mostly handled off-shore and are cash-settled. speculation in futures do not suffer from such disadvantages.

KEY TERMS ~~
Ask rate The rate at which a bank sells foreign currency. Non-deliverable forward An off-shore forward contract in for-
Bid rate The rate at which a bank buys foreign currency. eign currency where no delivery is required, and the contract is
Currency futures A forward contract in foreign exchange that necessarily cash-settled on maturity.
is traded on an exchange. Option forward A contract that allows flexibility of settlement
Forward premium or discount The annualized percentage date by specifying a period rather than a specific date.
variation of the forward rate with respect to the spot rate. A for- Spot transaction The transactions in foreign exchange that
ward rate higher than the spot rate means the foreign currency are settled in two business days.
is at a premium. Swap transaction A transaction consisting of two equal and
Forward transaction A transaction that needs to be settled at opposite legs, to be completed at two different points of time.
a future date, at a rate specified now.
Interest rate parity The condition that implies that the forward
rate is determined by the equality of returns in different currencies.

QUESTIONS
5.1 What are the typical features of foreign exchange markets 5.6 Explain hedging of payables and receivables with a forward
as compared to markets for other financial assets? contract.
5.2 Differentiate between (a) bid rate and ask rate, and (b) spot 5.7 What is an NDF? Explain its utility and operation.
rates and forward rates. 5.8 How are currency futures different from currency forwards?
5.3 What do you understand by premium or discount in foreign 5.9 How are currency futures and forwards priced?
exchange? How it is calculated? Show with an example. 5.10 Describe the hedging strategy for payables and receivables
5.4 What is a swap transaction and why is it popular in inter- using currency futures.
bank markets? 5.11 Explain with an example the operation of arbitrage when
5.5 What are option forwards and how are they beneficial? futures are not correctly priced.
154 Derivatives and Risk Management

PROBLEMS ©
P5.1 Triangular arbitrage from now. The spot price of the US dollar is 50.00 while a
Assume that a bank in India has offered exchange rates for the 3-m futures contract at the NSE is trading at %49.30, indicating
US dollar and the euro at ¥48.00 and 78.00 for a 2-m forward depreciation of the US dollar. Under what circumstances would
contract, respectively. An American bank has quoted a 2-m for- you like to hedge? What would be the hedging strategy?
ward rate of US $1.70 per euro. If you are allowed to book any P 5.6 Hedging a Jong position with futures and effective
contract, can you take advantage of the rates offered by the bank exchange rates
in India and the bank in America? Refer to P 5.5. Assume that the exporter hedges with the futures
P 5.2 Arbitrage in futures and forward market contract. One futures contract at NSE is for US $1000, and it is
A futures contract expiring on 28 October in US dollars at the cash-settled. Find out the exchange rate realized by the exporter
NSE is selling for ¥48.6800. Your bank has offered a forward when prior to maturity (a) the spot rate is ¥50.50 and the futures
contract for delivery on 28 October at €48.9000. How can you is selling for ¥50.42 and (b) the spot rate is ¥48.40 and the
take advantage of the disparity in the futures and the forward futures is selling for $48.48.
markets? How do you think the position would correct itself? P 5.7 Hedging a short position with futures and effective
P 5.3 Pricing futures contracts exchange rates
The risk-free continuously compounded interest rates in the USA Impex Ltd has to make a payment of US $25,000 after three
and Japan are estimated at 8% and 3% respectively for 3-m months. The spot exchange rate is €46, and it has been increas-
maturity. If the spot rate in Japan is Japanese yen 102 per dollar, ing in the recent past. The appreciation of the collar is expected
what is the likely price for a 3-m futures contract? to continue, as reflected in the 3-m futures quotation of ¥47.50.
P 5.4 Fair price of futures and interest rates The management of Impex Ltd believes that the US dollar is
The spot exchange rate in Germany is €1.25 per pound. A 6-m expected to go beyond €47.50 in three months’ time.
futures contract in Sterling pounds is quoted at €1.27 per pound. (a) How can Impex Ltd hedge its foreign currency exposure?
With returns of 6% in German government securities for maturi- (b) Assume that Impex Ltd takes position in futures and after 3
ties of six months and assuming that the futures are correctly months, at the time of making payment, it unwinds position in
priced, what risk-free rate would you expect in England? futures. Find out the effective exchange rate paid by Impex
P5.5 Hedging strategy for receivables with currency futures Ltd when (i) spot rate is €49.10 and futures price is 49.20,
As an exporter, you expect to receive US $20,000 three months and (ii) spot rate is 46.75 and futures price is 746.80.
 Interest Rate
and Forwards
INTRODUCTION 72
Learning Objectives
_ Interest rates in an economy occupy a central position because After going through this chapter,
they are regarded as one consolidated parameter that displays readers should be familiar with
the progress and condition of an economy. In derivatives, the e various kinds of interest rates
use of interest rates is of special significance because most valu- * desirable features of interest rates
ations in derivatives require interest rates as one of the critical to be used
distinction between yield to maturity
inputs. Valuation of futures contracts with any underlying asset
(YTM) and zero rates
such as commodity, stock, index, or foreign exchange is not pos- arriving at zeros from YTMs through
sible without knowing the relevant interest rates. booistrapping
In real world situations, many types of interest rates prevail in interest rate risk
_ an economy. In India, like in most other forward rate agreements (FRAS) as
Different rates prevail for a hedging product
nations of the world, interest rates are a
different transactions. borrower's FRA and investor's FRA
They can be direct, such function of the nature of transaction settlement of FRA
being funded, counterparties to the
as bank loans, or indirect, pricing FRA
implied in the market transactions, currency, place, duration hedging with FRAs
prices of securities. of funding, etc. For example, the central = against rising interest rates
= against falling interest rates
bank of a country would lend/borrow
speculation with FRAs
money from banks in its country at certain rates; the banks would
lend to borrowers at other different rates; public debt in the econ-
omy would be mobilized at different rates, and so on. As such,
different measures of interest rates, such as repo (repurchase)
rates, reverse repo rates, yields on T-bills, Prime Lending Rate
(PLR), etc., prevail at the same time. Even though these rates are
all interlinked in some way or the other, the exact relationship is
hard to find.
For the purpose of valuation and the risks emanating from
the changes, interest rates occupy a special place in the study of
derivatives and also for devising derivative products to manage
interest rate risks. We take a look at the desirable features of
interest rates that are used in the study of derivatives.
156 Derivatives and Risk Management

Ze

Markets for interest rates are supposed to reflect the interest rate structure-based yields
on instruments whose values are predominantly determined by changes in the interest rate
scenario. They comprise transactions that resemble each other so much that yields on any
of them can be easily construed as indicators of prevailing interest rates. Therefore, the
question of what represents true interest rates needs to be answered through examination of
these transactions, their nature, and the constraints present in the environment.

Desirable Features of Interest Rates

The interest rate needed for valuation of derivatives and other uses must essentially satisfy a
_ few features that seem to be unavailable in any single transaction. The most
The interest rate desired
useful and commonly desired features of interest rates must have certain
for derivatives must be
free from default risk and characteristics that are discussed in this section.
market determined. First, the interest rate should be devoid of credit risk. Normally, when two
parties engage in a borrowing/lending transaction, the interest rate decided
between them incorporates the counterparty risk or default risk. Ideally, no lending trans-
action can be said to be completely free from default risk. Second, the interest rates must
demonstrate that they are determined by free market forces and are not constrained by legal,
environmental, and economic/financial factors, or by compulsions influencing the demand
and supply of such instruments. Third, the measurement of interest rates must be done in
such a manner that changes in values of the underlying assets may be attributed exclusively
or substantially to changes in the interest rate structure and to no other factor. Thus, in a
nutshell, any interest rates to be used for valuation of derivatives and for the purpose of
designing a suitable instrument for hedging against interest rate risk should be (a) free from
default risk, (b) market determined and free from legal compulsions influencing commercial
needs, and (c) truly reflective of the changes in the value of the securities dependent on those
interest rates alone.

Repo and Reverse Repo Rates

The repo rate applies to borrowing and lending transactions between the central bank of a
country and other banks, where the banks borrow/lend on the strength of extremely safe and
liquid securities. The difference between the selling rate of the securities and their repurchase
price after a predetermined time represents the effective interest rate prevailing at the time
of entering a repurchase agreement. It is a pure lending transaction involving extremely
safe instruments between two highly creditworthy parties, and, therefore, can be said to be
devoid of default risk. In case the repurchase is not honoured, the lending bank keeps/sells
the securities.
Valuation, as reflected in the differential between the selling price and the repurchase
price, is a pure function of the borrowing rate prevailing in the country. However, there are
some important dimensions concerning its appropriateness to serve as a benchmark for risk-
free rates. The repo rate is regulated by the central bank, and is also used as an important
tool of monetary policy to alter the money supply in the country and achieve wider policy
 Interest Rate and Forwards 157

objectives. The repo rate is also influenced by economic conditions and desired growth rates
and complements fiscal policy. It is used to-alter the interest rate structure rather than repre-
sent it. However, it cannot be said to be a true representative of market-determined risk-free
interest because only a limited number of participants comprise the market. Though the
volumes could be high, the market lacks depth.
Further, changes in the repo rate are not continuous but intermittent. We expect the rates
to change as the expectations of return for investors keep changing almost continuously. The
change is effected only when the central bank deems it necessary to achieve some monetary
and fiscal objectives upon periodic review of its policies. At best, repo rate can be one deter-
minant of risk-free interest rates but cannot be said to be freely market determined.

Treasury Rates
Another set of instruments that invites wider and deeper participation than repo transac-
tions is treasury bills (T-bills) and bonds. Treasury bills and bonds are issued by the central
bank for a variety of reasons, among which the need to fund government expenditure is
predominant. Repayment is virtually assured because of the unique position of the issuer
providing the central bank the authority to print money as a last resort. This virtually
eliminates default risk. The issuer would always redeem the securities or pay interest on
due dates, though defaults have taken place in history, such as those by Argentina, Mexico,
and Russia.
The securities issued by a central bank are normally auctioned and, hence, their pricing is
governed by market forces prevailing at the time of the issue. Further after issuance, being
transferable and negotiable, these securities are also traded in the secondary markets, where
the current prices would reflect the yields expected by the investors. These yields would
change on a continuous basis and reflect the current economic conditions and the investors’
expectations of return. Note that under a repo transaction, the same securities form the basis
of borrowing and lending. However, yields in the secondary market would be different from
the repo rate because of wider participation and lesser constraints placed on participants.
However, neither the primary markets (despite processes of auction determining prices/
yields) nor the secondary markets can be said to be free markets. Hence, such prices can-
not be assumed to be freely market-determined interest rates. In the primary markets, auc-
tions are constrained by the compulsions of banks, the major participants, to subscribe to
these securities to meet statutory liquidity ratio (SLR) requirements, whereby they must
maintain certain proportions of their total deposits with the central bank. Subscription to
these securities cannot be deemed voluntary subscriptions purely guided by financial and
economic considerations. These compulsions of SLR are also carried forward to secondary
_ market transactions, casting doubts on whether the yield would be the same
Repo, reverse repo, and
_if secondary market transactions were to be undertaken out of the free will
treasure rates are consid-
ered to free from default of participants to buy and sell-securities guided purely by the commercial
tisk but are subject to _ motive of earning higher returns. Besides legal compulsions, initial subscrip-
legal considerations tion and subsequent trading in secondary markets are also influenced by
that may influence their some tax rebates, reduced provisioning, and escaping marking-to-the-market
requirements for held-to-maturity securities, etc.
158 Derivatives and Risk Management

%per
annum

Note: From Oct 2009 to Mar 2011, the yields are based on 182-day T-bills
LLL LLL LLL TEL
Source: Reserve Bank of !ndia Bulletins
Fig.6.1 91-day T-bill yields on auction

Figure 6.1 depicts monthly T-bill yields on auctions from January 2008 to December 2011,
based on the first auction of each month. Note that these auctions take place every Wednes-
day, with payment on Fridays, according to a pre-announced calendar notifying the amount
of each auction.

Interbank Transactions
Interbank trades constitute a large proportion of trade in financial claims. These trades are
done on the basis of bid and ask rates offered by competing banks to each other for accepting
deposits and lending funds. Internationally, these rates are determined in London in major
currencies for terms up to 12 months. Bid rates are rates to accept deposit while offer rates
are rates for lending. These are known as LIBID (London interbank bid rate) and LIBOR
(London interbank offer rate), respectively.
On similar lines, the National Stock Exchange (NSE) along with Fixed Income Money
Market and Derivative Association of India (FIMMDA), in an effort to develop debt markets,
launched MIBID (Mumbai interbank bid rates) and MIBOR (Mumbai interbank offer rates)
for overnight rates in June 1998. Later, they expanded the list to 14-day rates and then for
I-m and 3-m deposits and lending. These rates have gained wide acceptance for benchmark-
ing various banking and derivative products.
The MIBID/MIBOR rates are used as benchmark rates for a majority of deals struck
for interest rate swaps, forward rate agreements (FRAs), floating rate debentures, and term
deposits. These rates are considered the best for these market-oriented products because they
are (a) unbiased, as they are determined by professionals with no vested interest, (b) transpar-
ent and market-oriented, because these are based on polling by 32 large banks, (c) reliable,
since actual deals do take place on these rates, and (d) scientifically determined on the basis
of polling and bootstrapping, eliminating cartelization, noise, and extreme values. Further,
the default risk is minimal, since banks are not expected to default on the principal and inter-
est repayment of obligations.
 Interest Rate and Forwards 159

These rates are deemed

Interbank rates satisfy : iteas market determined
z because
j they are quoted
: out
the requirements of being Of free will by the participants who engage in lending and borrowing trans-
(a) free from default risk actions. Further, despite the fact that there remains an element of counter-
and [ market deter- party risk, it is considered negligible due to the high credibility of the banks
mined.
involved in the process of determining these rates. Unlike repo transactions
or trading in treasury securities, where the trading is governed by factors
other than complete willingness, the transactions on interbank rates are governed by pure
commercial and business considerations. Hence, interbank rates are considered a better proxy
for risk-free interest rates, as compared to repo rates or yield on treasury instruments.
Figure 6.2 depicts the trend in 3-m MIBOR rates from January 2008 to December 2011.
Though these rates are announced every day, the rates on the first working day of the month
are used in the graphical depiction. The similarities and dissimilarities in the trends and val-
ues between 3-m MIBOR and yields on 91-day T-bills (in Fig. 6.1) may be seen in this figure.
Trends in 3-m MIBOR since 1998 are depicted in Fig. 6.3.

(%)
MIBOR
3-m

Source: www.nseindia.com, accessed on 30 August 2012

Fig. 6.2 3-m MIBOR from January 2008 to December 2011

MIBOR,
(%
3-m
p.a.)

Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10

Month

Source: www.nseindia.com, accessed on 30 August 2012

Fig.6.3 3-m MIBOR since 1998
160 _—Derivatives and Risk Management

Determining market-oriented benchmark risk-free rates MIBID and MIBOR

banks and dealers
The determination of interbank rates to serve as benchmarks set by the NSE and the FIMMDA includes large
from the public sector such as Bank of Baroda, Canara Bank, Central Bank of India, Punjab National Bank, and State Bank of
India, as well as private sector banks including Axis Bank, HDFC Bank, Kotak Mahindra, and, ICIC| Bank. Foreign banks include
Bank of America, CitiBank, Deutsche Bank, HSBC, and Standard Chartered Bank. Amongst primary dealers, participants include
State Bank of India, DFHI, ICICI Securities, PNB Gilts, etc.
FIMMDA-NSE MIBID MIBOR rates are broadcast immediately on release through the NEAT-WDM trading system. The NSE
website carries the daily rates as well as historical data on the FIMMDA-NSE MIBID MIBOR. The FIMMDA also disseminates
the FIMMDA-NSE MIBID MIBOR rates through its website and through other means.
In addition, leading information vendors such as Reuters, Knight Ridder, and Bloomberg carry these rates on a daily basis.
-FIMMDA-NSE MIBID MIBOR rates are also carried by all leading financial dailies, including Economic Times, Financial Express,
Business Standard, and Business Line. \n addition, FIMMDA-NSE MIBID MIBOR rates are released to contributors and users
through e-mail.
Since MIBOR rates exhibit features such as transparency, reliability, and quick and wide dissemination, several products are
designed on this benchmark rate. The products that are linked to MIBID and/or MIBOR include floating rate notes (GE Capital),
corporate debentures (L&T, GE Capital), term deposits (ICICI bank), interest rate swaps (Standard Chartered Bank, HSBC, HDFC
Bank, ABN AMRO, Deutsche Bank, ICICI, and Reliance Industries), and FRAs (HSBC).

Source: http:/Awww.nse-india.com/, accessed on 24 February 2012.

TERM STRUCTURE OF INTEREST RATES/YIELD CURVE |

The returns expected by investors are dependent upon several factors, as mentioned earlier.
One ofthese factors is the investment horizon, 1.e., the duration for which
The return expectation
_ the investment is being made. Investors demand varying returns for vary-
with respectto different ~—s ie ; i ;
maturities isknownas ‘1M maturities. A bond maturing after three years is not the same as a bond
term structure of interest. | with a maturity period of | year or 15 years. Their yields would differ.
rates oryield curve. _ Investors do have a variety of instruments available to choose from to
make an investment, and these instruments trade at different prices, reflect-
ing different yields.
The return expectation with respect to different maturities is known as term structure of
interest rates or yield curve. Consider a simple example of an investor willing to make a
deposit in his bank. The return expectation of the investor depends upon the duration for
which he/she invests. Assume that expectations of return are 8% for a l-year deposit, 9%
for a 2-year deposit, and 10% for a 3-year deposit. The yield curve would be as shown in
Fig. 6.4.
One may find the term structure based on the yields to maturity (YTMs) of the government
securities traded in the secondary markets. The features of government securities are that they
are (a) risk-free, (b) issued by the same counterparty, and (c) readily available as compared to
any other source in an economy. The value of fixed income securities is primarily dependent
upon the maturity and the quality of the issuer. The prices and, therefore, the yields include a
premium towards default risk. Prices of government securities would not include any premium
for default, and, hence, differences in the yields can be assumed only to be exclusively on
account ofdiffering maturities. Though considered safe, interbank rates are normally available
 Interest Rate and Forwards 161

V4
10

(%)
Yield

To)
00)
~~)
©)
GT

Term of investment (years)

Fig. 6.4 Term structure of interest rates

(%)
YTM
caste x —= _Jun-11

wwe SEp-1 1 coors DOCH

Years to maturity

Source: Based on YTMs for Dated Securities Transactions as per RBI Bulletin 13 February 2012
Fig.6.5 YTMs for different maturities

for maturity terms only up to 12 months. Hence, they cannot be used for yield curves that
stretch beyond 12 months.
Figure 6.5 depicts a yield curve up to 15 years in March, June, September, and December
2011, based on secondary market trades in government securities. The curve is based on
YTMs of securities traded for different maturities.
Treasury Zero Rates Understanding the term structure of interest rates is easy but cal-
culating them poses many practical difficulties. The price of a bond implies a YTM, which
is regarded as the average rate of return over the life of the bond. It is erroneous to regard
YTMs of bonds with different maturities as term structure of interest rates, because usually
bonds are composite instruments representing cash flows spread over their lives that occur
at different points of time but are treated as one security. To arrive at the correct yield curve
reflecting investor preferences for yields only on account of differing maturities, we need to
have securities that pay a single cash flow at different maturities. As such, these securities
have no interim coupon payments till maturity and, therefore, are referred to as zeros.
162 Derivatives and Risk Management

Table 6.1 Price and yields of treasury securities (T-bills)

Equivalent continuous
instrument Price (%) Face value (%) Annual return (%) compounding rate (%)
3-m T-bill 98.00 100 8.1633
6-m T-bill 95.90 100 8.5506
12-m T-bill 91.80 100 8.9325 aes

The price of zeros would correctly reflect the yield curve, i.e., return expectations of inves-
tors for different maturities. Generally, zero rates are not available for extended maturities
because zero coupon bonds for longer maturities are generally not issued; if they are avail-
able, they are not liquid enough. Even if such securities are available, they may suffer from
the drawback of lack of volumes, constraining free and true price determination and, hence,
the yield curve.
Most governments issue T-bills for up to a period of one year (364 days). Obtaining a yield
curve up to an investment horizon of one year, therefore, is easy. Consider the price data for
T-bills as shown in Table 6.1.
Continuous Compounding Rate From the price data given in Table 6.1, we observe that a
T-bill with three months to expiry is available at $98.00. After three months, it would mature
to £100, thereby providing a gain of %2, or 2/98 = 2.0408%, annualized as 4 X 2.0408 =
8.1633%. This was based on quarterly compounding. In the practice of derivatives, we assume
continuous compounding. The return needs to be converted into an equivalent return as if
compounding were continuous. This means that the continuous compounding rate, which
would equate the maturity amounts with discrete compounding, can be expressed as follows:

e’’ = maturity amount

where r is the continuously compounded return for the maturity period of f years.
Therefore, for the compounding rate R with the compounding number of periods in a year
n, the maturity amount can be given as follows:

et = (1 + Riny™
For quarterly compounding, the continuous compounding rate for the given data for T-bills
maturing in three months in Table 6.1 is given by

r= 4 In(1 + 0.020408) = 0.080811, or 8.0811%

On similar lines, the equivalent continuous compounding rates for T-bills are

6 months r II 2 In(1 + 0.085506/2) = 0.083728, or 8.3728%

12 months r 1 In(1 + 0.089325) = 0.085558, or 8.5558%

Bootstrapping: Obtaining Zero Rates from YTMs of Bonds

The compounding rates in the aforementioned calculations are zero rates, as the instru-
ments used have no interim coupons. For maturities beyond one year, there normally would
 Interest Rate and Forwards 163

Table 6.2 YTMs for different maturities

Figures in®)
Maturity 1-year bond | 2-year bond 2’/-year bond 3-year bond — 7
Coupon rate,% 10 si 12 12 ) 12
Time (months from now) Cash flows
Current market price 101.00 104.00 104.00 104.00
6 5.00 6.00 6.00 6.00
12 5.00 6.00 6.00 6.00
18 105.00 | 6.00 _ oo 6.00
24 106.00 6.00 6.00

30 Sse 106.00 6.00

36 106.00
YTM (semi-annual), % 4.6353 4.8752 5.0742 5.2067
YTM (annual), % 10.4059 10.6845

be interim coupon payments, and the prices of these securities include the values of these
interim coupon payments. Assuming that an investor would hold the security till its maturity,
yields on these instruments are quoted on the basis of YTM. The valuation assumes that
YTM is the single discount rate that equates the futures cash flow of the instrument with its
current price.
Therefore, while finding the YTMs of the bond, we discount each coupon payment and
_ principal payment at the same rate, irrespective of the timing, rather than the
When zeroes are not : rate as per the term structure applicable for various timings in the cash flow.
available, YTMs of bonds
can be used to arrive The YTMs of coupon paying bonds with maturities from 1% to 3 years
at a yield curve by the with semi-annual cash flows are shown in Table 6.2.
bootstrapping method Do these YTMs truly reflect the return expectations with different terms
~ to maturities of investment? Yes, they do, but these YTMs are approximate
values only. To find the true yield curve, we use the bootstrapping approach, where we suc-
cessively find appropriate yields for progressively increasing maturities.
We already know the true yield curve for maturities of 3, 6, and 12 months. These yields
would help us find the appropriate yield for 18 months, through the market price of the bond
maturing at that time. Assume that a 12-year bond that pays a 10% coupon semi-annually
sells for $101. This bond has three cash flows: (a) €5.00 at the end of six months, (b) %5.00
at the end of 12 months, and (c) $105.00 at the end of 18 months. The market price must be
equal to the present values of these cash flows discounted at a rate appropriate to the timing
of each cash flow. The rates for 6 and 12 months are already known to us. With the current
price already known, we can arrive at the appropriate discount rate for 18 months as follows:
Se e 0-083728 x 0.5 A. FS PSY e 0-085558 SUNY aie 105 oe LS) 101

ns D161 5G

ear i® ARs C= Seat at = (,090910 = 9.0910%

164 Derivatives and Risk Management

EXAMPLE 6.1 Finding the yield curve by bootstrapping

prices prevail
Based on the zero rates given in Table 6.3, find out the zero rates applicable for 42 and 48 months if the following
for government securities:
Maturity Coupon Periodicity Market price (%)
42 months 14% Semi-annual
48 months 16% Semi-annual

Solution
Zero rates up to 36 months are given in Table 6.3. From the price of a bond maturing after 42 months, we can find the zero rate ]
applicable for the term of 42 months. The price of the bond would be calculated as follows: :
e 0.083729 x 0.5 46 7) SZ @ 9.085558 x 1.0 aL 9) 3K e 9.090910 X15 4 Wk e 0.095884 x 2.0 4 Tox e 9.100015 x25 4 ex
7x

ge0.102768 x $0 4107 x eX 3.5 = 109

F 73.3806
For 42 months, r = Se = 0.107763 = 10.7763%
Similarly, after obtaining the zeros’ rate for 42 months, we can find the zeros’ rate for 48 months using the price of bond '
maturing after 48 months. The price of this bond is given by 4
8x e 0.083729 x05 4 8x @ 9.085558 x 1.0 4 8x e7 9.090910 x15 4 8x e 0.095884 x20 4 8x e— 0.100015 x25 4 8x
ge 0.102768 x 3.0 4 8X @ 9.107763 x35 4 108 x e'x 40 = 116

in 09-8057
For 48 months, r = Sati = 0.109104 = 10.9104%
TT TTT SiR CSG LI

Using the yield investment horizon of 18 months, we can now find out the appropriate rate
for a term of two years on similar lines. Therefore, calculation of the appropriate discount
rate for 24 months is as follows:
6 X e70.083728 X 0.5 4 6 % e~0.085558 X 1.0 4 6 y¢ 9 0.090910 X 1.5 4 196 x er X20 = 104
| 87.5029
e106
For 24 months += ST ee 0.095884 = 9.5884%

Similarly, for 2/2 and 3 years, we find the discount rates using the prices of the bond
maturing at 2’2 and 3 years.
6Xe = 0.083728
9 0.5 +6Xe = 0.085558 2 X 1.0 U6 ae aa0.090910 X 4 1.5 das Hud e 0.095884d x 2.0 + 106

ocr a104
In
84.5499
1060
For 30 months, r= — 75 = 0.100015 10.0015%

6 Xe —0.083728 x
ig983728 X05 -
0.5 4. 6 & e—0.085558 : X 1.04 6 x e = 9090910 X15 46 x e = 0:095884 x 2.0 4 6 X
e 9.100015 2.5 4 106 X e "* 3.00 104

In TUG

For 36 months, r = = = 0.102768 I 10.2768%

Now we can have yield curves for periods up to three years at 6-month intervals. The YTM
and zero rates based on continuous compounding computed by using the bootstrapping method
are consolidated in Table 6.3, and the yield curve based on YTMs and zeros is presented in
Fig. 6.6. Note that there is almost a parallel shift in the yields beyond a term of one year.
 Interest Rate and Forwards 165

Table 6.3. Term structure

Yo p.a. |
[ Years YTM-based Zero-based 7
0.5 8.3729 8.3729
io. 8.5558 8.5558
15 9.4855 9.0910 ]
2.0 9.9881 | 9.5864
2.5 10.4059 10.0015
0.6845 Wee.

(%)
Yield

8.00 beteee pean Lot cere en ee aa

0.5 1.0 135 2.0 2.5 3.0

Time (years)

Fig.6.6 Yield curve

While finding zero rates, we assume that bonds with exact maturities are available, which
in general is not true in practice. One may use linear interpolation to arrive at the prices of
two bonds to find an approximate yield for the desired term.

FORWARD CONTRACTS ON INTEREST RATES—FRAs ©

We know that the price risk for various assets can be covered by using forward or futures con-
tracts. When the risk is related to commodities, we use futures on commodities; when the risk
is related to currency, we use currency forwards and futures; and when it is related to stocks,
stock futures are appropriate to cover the risk of changes in the prices of stocks. Similarly, in
order to cover risk on interest rates, we use derivatives on interest rates. A Forward Rate Agree-
ment (FRA) is the forward contract on interest rates and is the basic instrument that covers risk
associated with fluctuations in interest rates.

Interest Rate Risk Most organizations borrow funds from banks and other financial institu-
tions to meet their capital requirements. For firms with borrowed funds, the interest rate
constitutes a cost, whereas for banks and investing firms, the interest rate provides income.
In either case, the risk of changing interest rates is assumed by the firms, as
_ Derivatives oninterest _ it impacts profitability, just like the changing prices of commodities, foreign
used forcover- exchange, and stocks pose a risk. Interest is nothing but the price of capital,
a critical resource every firm uses, and, therefore, it is equally important to
manage this price risk for capital just as it is done for other assets.
166 Derivatives and Risk Management

Though for manufacturing enterprises, the proportion of interest in the overall cost may
be relatively small, in the case of financial enterprises such as banks, investment companies,
and financial institutions, the value is primarily dependent upon the interest rate scenario. The
survival and growth of the firms in financial sector are critically dependent upon the level of
interest rates, just as the survival of manufacturing firms depends upon the prices of inputs and
outputs being produced by them. For banks, capital is the feedstock and the interest rate risk is
akin to price risk, interest being the price of capital. This makes management of risk emanating
from changing interest rates vital for firms in the financial sector. The value of firms in financial
sector is more sensitive to interest rates changes than that for firms in the manufacturing sector.
Volatility in the interest rates is a matter of considerable concern to all enterprises. The
expanding range of interest rates in terms of their nature of fixed and floating, their bench-
marks, currencies, time horizon of exposure, etc., has added to the confusion. We often come
across terms such as T-bills yields, repo rates, 3-m LIBOR, 6-m MIBOR, Eurodollar deposit
rates, and prime lending rates, all representing a variety of interest rates prevailing across
the globe. The plethora of interest rates has increased the degree of analysis and the need for
managing the interest rate risk on the part of firms, especially those having a global presence.
From the perspective of investors, certain sectors are considered more prone to changes in
interest rates. These include real estate, infrastructure, and automobiles, as demand for these
products is a function of prevailing interest rates: end-users usually borrow funds to purchase
them. Likewise, infrastructure firms have high gearing ratios, which imply that these firms
are highly dependent on borrowed funds. Hence, their performance in terms of returns on
stock becomes extremely sensitive to changes in interest rates.

FORWARD RATE AGREEMENT—THE PRODUCT

Uncertainty about the prices of inputs can be effectively managed by forward contracts, in
which the prices of inputs can be fixed in advance. For managing changes in
FRA is a contract to
interest rates, the FRA performs the same function as a forward contract on
deposit or borrowa i
notional sum in future for COMmodities, currency exchange rates, etc. The prices of commoditi2”es and
a specified maturity at an exchange rates can be settled in advance through a forward contract and,
interest rate fixed now, similarly, the rates for borrowing and deposits can be fixed in advance before
~ actually availing of the loan or making a deposit.
An FRA can be defined as a forward contract for agreeing to advance a loan
or accept
a deposit at an interest rate fixed now for a notional amount of principal. A typical
FRA is
quoted as depicted in Fig. 6.7.

3/9 months _

Fig.6.7 Quotation for FRA

 Interest Rate and Forwards 167

This quotation for an FRA means that the bank is prepared to accept a deposit or extend
lending in Indian rupees starting three months from now and ending nine months from now,
paying 6.00% on deposit or charging 6.50% on lending. In a way, this-is a 3-m forward quote
of interest rates for deposit/lending for a tenure of six months. Like any other forward quote,
the FRA has two rates—the bid rate and the ask rate, and the difference between the two
represents the spread for the bank.

Borrower’s FRA
A buyer of an FRA (a borrowing company) agrees to take a loan in Indian rupees at 6.50%,
_ commencing three months from now for the next six months, while the seller
-Aborrowers FRA pro-
tects against rising cost
of the FRA (a bank) agrees to provide such a loan at 6.50%. Such an FRA
of borrowing. would enable the borrower to lock-in the borrowing rate three months in advance
for a 6-m loan. The amount of the principal agreed upon need not be exchanged
either at the commencement or at the termination, and, instead, only the difference between the
actual rate and the settlement rate on the notional amount is exchanged between the buyer and
the seller of the FRA. The following illustration helps to understand the concept better.

EXAMPLE 6.2 Borrower’s FRA

Capital Constructions is expecting to receive an order to build a bridge, for which it would require working capital of 215 crore for
the next six months. The current rate of borrowing for the firm is PLR + 3%, with PLR currently at 10%. The liquidity situation in
the banking circle indicates that PLR would rise in the next three months. Another bank has offered a 3/9 FRA at 9.00%, based |
on the 6-m MIBOR, which is closely linked with the PLR of banks. How can Capital Constructions hedge against rising interest |
cost? Find out the effective cost of borrowing if (a) MIBOR rises to 11%, and (b) MIBOR falls to 8%. Assume equal changes in |
MIBOR and PLR, and also assume 180 days in six months and 360 days a year.
Solution
For a notional principal of €15 crore, Capital Constructions buys an FRA at 9.00%. It would lock-in the rate of borrowing prevailing |
now at 13%. The differential between the actual MIBOR and 9% discounted at MIBOR would be paid/received by Capital Construc-
tions after three months.

(a) If the 6-m MIBOR rises to 11% and PLR rises to 12%
After three months, Capital Constructions would receive 2% (actual rate — FRA rate) for six months discounted at MIBOR
1 180
Cash flow (% crore) = (+ 0.11 X 160/360) x (0.11 — 0.09) x 360 x 15 crore = 14.218 lakh
The firm borrows at 15% (PLR + 3%). The net cost of interest would be: L

Interest paid = 1500 x 0.15/2 = %112.50 lakh L

Interest earned from FRA = 14.218 x (1 + 0.11/2) = $15.00 lakh L
Net interest paid = 297.50 lakh L
Effective cost of borrowing = 97.50/1500 =< 360/180 = 0.13 = 13.00%
(b) /f the 6-m MIBOR falls to 8% and PLR falls to 9%
After three months, Capital construction would pay 1% (actual rate — FRA rate) for six months discounted at MIBOR
1 180
Cash flow (® crore) = (1 + 0.08 x 180/360) x (0.08(0.8 —— 0.09)
0.9) x 360
— x 15 crore = —%7.21 lakh
a
The firm borrows at 15% (PLR + 3%). The net cost of interest would be:

Interest paid = 1500 x 0.12/2 = %90.00 lakh

Interest earned from FRA = 7.21 X (1 + 0.08/2) = 27.50 lakh
Net interest paid = $97.50 lakh
Effective cost of borrowing 97.50/1500 x 360/180 = 0.13 = 13.00%
168 Derivatives and Risk Management

the
Assume that an exporting firm, EXPO Ltd, has bagged an export order. To execute
six months.
order, it needs a working capital of €1 crore three months from now for the next
firm would
The need for borrowing is limited to six months, by the end of which period the
have realized its dues from its customer. The current borrowin g rate for EXPO Ltd 1s 6.25%,
and is likely to go up sharply in the coming days. Consider Fig. 6.7 as a quotation from
EXIM Bank. In order to lock-in the borrowing rate, the firm buys a 3/9-m FRA at 6.50%
from EXIM Bank. On the settlement of the FRA i.e. three months later, the following cash
flow could take place.
If the settlement rate is, say, 7% against the FRAS contracted rate of 6.50%
The bank would pay the differential between the actual rate and the contracted rate (TOO
6.50 = 0.50%) to EXPO Ltd on the notional principal of =1 crore for six months. EXPO
Ltd would borrow at 7%, but would get 0.5% back from EXIM Bank, making the effective
cost of borrowing as 6.50%.
Ifthe settlemet rate is, say, 6% against the FRA’ contracted rate of 6.50%
The bank would demand the differential between the contracted rate and settlement rate
(6.50 — 6.00 = 0.50%) from EXPO Ltd on the notional principal of 1 crore for six
months. EXPO Ltd would borrow at 6%, but would pay 0.5% more to EXIM Bank, mak-
ing the effective cost of borrowing as 6.50%.

Investor’s FRA
_ Like in a borrower’s FRA where the rate of borrowing is locked in at times
Investor's FRA provides
_ of rising interest rates, an investor’s FRA enables locking in of the deposit
protection against falling
interest rates. _ rate when future interest rates are expected to fall.
~~ Assume that an exporting firm EXPO Ltd would have a temporary surplus
of %1 crore three months from now for the next six months. They need to invest the surplus.
The current investing rate for EXPO Ltd is 6.25%, and is likely to fall sharply in the coming
days. In order to lock-in the investing rate, the firm buys a 3/9-m FRA at 6.00% from EXIM
Bank. On the settlement of the FRA i.e. three months later, the following cash flow could
take place.
If the settlement rate is, say, 5.50% against the FRA’ contracted rate of 6.00%
The bank would pay the differential between the contracted rate and settlement rate (6.00
— 5.50 = 0.50%) to EXPO Ltd on the notional principal of €1 crore for six months. EXPO
~ Ltd would place its deposit at 5.50%, but would get 0.5% more from EXIM Bank, making
its effective income from the investment as 6.00%.
If the settlement rate is, say, 6.50% against the FRAS contracted rate of 6.00%
The bank would demand the differential between the settlement rate and contracted rate
(6.50 — 6.00 = 0.50%) from EXPO Ltd on the notional principal of €1 crore for six
- months. EXPO Ltd would now invest at 6.50%, but would pay 0.5% more to EXIM Bank,
again making its effective return on the investment as 6.00%.
It may be noted that the FRA is a product by itself, independent of the actual borrowing
or lending. The principal amount remains notional, and the actual borrowing or deposit need
not be made; if made, it may not be with the same bank with which the FRA is executed.
The actual rate of deposit or borrowing needs to be ascertained for determination of the cash
 Interest Rate and Forwards 169

flow. Delinking of the actual deposit or borrowing makes the FRA a hedging as well as a
speculative product, as the underlying transaction is not mandatory.

Settlement of FRAs
Obligations under an FRA become known at the commencement time for borrowing or lend-
__ ing, when the actual interest rate becomes known. In our example, the FRA
Settlement of FRA is
would come to an end after three months, when EXPO Ltd and EXIM Bank
done by exchanging the
differential cash flow of would know the actual interest rate. The commitment made in the FRA can
contracted interest rate be satisfied after three months, as all determinants of the cash flow are
and the actual bench- known. One need not wait for the conclusion of the borrowing/deposit period.
mark on the notional Therefore, in the context of our example, the cash flow between the two par-
_ principal. . ties to the FRA could be exchanged at the end of three months, rather than
at the end of nine months.
Settlement of an FRA at the start of the contract period requires adjustment to the cash
flow. Since interest on a loan or deposit is payable on maturity, the cash flow should be pay-
able at the end of the contract period. Alternatively, if settled now, the cash flow needs to be
discounted at the current rate of interest. The amount of cash flow (for the buyer) in a bor-
rower’s FRA and an investor’s FRA are, respectively, calculated in Eqs 6.1 i Oe

Cash flow (Borrower’s FRA) = =f) PR (6.1)

(lx q/365) es
l d
Cash flow (Investor’s FRA) = eens x (f-nxX=—=xXP
(AD) 365 (6.2)

where =r = settlement rate; the observed actual rate

f = FRA rate; the contracted rate
d = No. of days in the FRA contract
P = notional principal amount
The amount to be received by EXPO Ltd in the borrower’s FRA for national principal of
~1 crore when the interest rate happens to be 7% would be %2,40,907, as follows:
‘ cn l = 182
Amount to be received = (1 + 0.07 X 182/365) m= (0.07 =0.065)x 265 x 1,00,00,000

BA SLD ren
EET ace =2,40,907

Pricing an FRA
Once forward interest rates are known through an FRA, the buyers of that FRA can lock-in
the rate expressed in it. But how does the FRA seller offer an interest rate in advance? The
rates quoted in the forward contract are considered to be unbiased predictors of future prices.
In the context of an FRA, the interest rate mentioned is most likely to prevail
The term structure of
__at the time when the FRA is settled. In our example, the 6-m interest rates
interest rate implies after three months are likely to be between 6.00% and 6.50%. How do we
forward interest rates and estimate this figure?
forms the basis of pricing “One way of finding the forward interest rate is based on the term struc-
_of an FRA.
ture of interest rates. The term structure of interest rates provides the rate of
170 ~——Derivatives and Risk Management

FRA—Indian practices
An FRA is a financial contract between two parties to exchange interest payments for a ‘notional principal’ amount on the settlement
date, for a specified period from the start date to maturity date. Accordingly, cash payments based on the contract (fixed) and the
settlement rate are made by the parties to one another on the settlement date. The settlement rate is the agreed bench-mark/refer-
ence rate prevailing on the settlement date.
An over-the-counter (OTC) product does not have inflexible specifications; however, market practices in India include the fol-
lowing aspects:
The minimum notional principal amount for which market makers stand committed to their two-way quote is ¥25 crore.
e — {Interest rate computation in FRAs will follow the same day count convention as that applicable to the underlying benchmark
(floating) rate.
e The benchmark for the FRA can be any Indian rupee interest rate benchmark. However, it should be clearly defined, widely
disseminated, and acceptable to the market.
e Unless otherwise stated, the modified following business day convention will be followed for settlement.
e No fixing of rates and compounding of interest will be done on a Saturday.
e It is recommended that regardless of the centre where the deal is transacted, the benchmark and the holiday calendar for
the purposes of computation of interest streams be the same as those in Mumbai.
e The computation of interest on the fixed leg would be done assuming that the fixed rate quoted is a nominal rate. Interest
computation on the floating rate would be as per the convention used by the underlying benchmark.
e The settlement of an FRA will be on the date the FRA comes into effect.
For example, consider a case where Bank A and X Ltd enter into a 3/6 FRA. X Ltd pays an FRA rate of 9.00%. Bank A pays
a benchmark rate based on the FIMMDA Moneyline Telerate 90 Day CP Benchmark.
Additional details are:
Notional principal amount %1 crore
FRA trade date 3 January 2002
FRA start/settlement date 3 April 2002
FRA maturity date 3 July 2002
FRA fixing date 2 April 2002
Assume that the FIMMDA Moneyline Telerate 90 Day CP Benchmark on the fixing date (2 April 2002) is 8.50%. If so, interest
payable by X Ltd would be:

%1,00,00,000 x 0.09 x 91/365 %1,00,00,000 x 0.085 x 91/365

= %224 384 = §211,918
Therefore, a net interest amount of €12466 is receivable by Bank A on the maturity date, i.e., 3 July 2002. However, the
settlement of the amount is to be done on 3 April 2002 on the discounted value, i.e.,
12466
i 0085 x 9 oe
365
X Ltd will pay Bank A %12207 on 3 April 2002.
FIMMDA guidelines are intended to bring uniformity and standardization to the market. They are not
intended to restrict the
- freedom of parties to bilaterally decide terms and conditions different from those suggested at the beginning
of this text box.

Source: FIMMDA Handbook of Market Practices

 Interest Rate and Forwards 171

return based on the maturity of investment. It reflects the investors’ expectations of returns
with the maturity of investment. For example, consider the following term structure of inter-
est rates from 3 to 12 months in 3-m steps, given below:
Investment horizon (months)
Yields (%-annualized)

The yield for a 3-m investment is 5%, while for a 6-m investment the desired return is
5.30%. It is derived from the prices of different financial securities at any given point of
time. Here, the term structure, also known as yield curve, is a rising one, indicating rising
yields (annualized) with increasing maturities. This pattern is depicted in Fig. 6.8.
The yield curve contains the expectations of future interest rates. From the data in the
table, we can find the expectations of interest rates three months from now for an investment
horizon lasting 12 months. From the data, we can find the expected interest rate after three
months for a 3-m investment, i.e., 376. By equivalency, (a) a direct investment for six months
at a rate of 5.30%, o/¢, with (b) initial investment for three months at 93, and then a rollover
for another three months at 374, helps us to find the 3-m interest rate expected to prevail after
three months. Such a rate could be used as a guide to quote 3/6 FRA. Mathematically,
ors Mer ate) = arg) (6.3)
or Chast) ah Sra) (Leengry)
In terms of the given yield curve, substituting the values! in Eq. 6.3, we have:
180
ei LDS Wes ares 10265" :

i 0.050 oe
360
gives 3/6 = 0.01383, or equivalent to annualized 375, = 5.53%
The rate of 5.53% can serve as a guide for the mid-rate of a 3/6 FRA. Assuming a spread
of 50 bps’, we can quote a 3/6 FRA at 5.28-5.78%. The rate arrived here is implied in the
current term structure of interest rates, and is assumed to remain constant. Any bank may

Fig.a 8 eh structure of terest rates

'30-day months and 360-day years are used for ease of computation. For accuracy, the exact number of days may be used.
*bps refers to basic points. 100 bps = 1%
172 Derivatives and Risk Management

modulate the same with its own forecast of expected yields and the likely demand and supply
scenario, or use any other model, to quote forward interest rates.
Continuing with the same process of equivalency of direct investment with rollover strate-
gies, we can find 3-m forward rates for investments maturing 9 months and 12 months later.
From the given yield, we may also find 6-m and 9-m forward interest rates for an investment
horizon of up to 12 months. These are shown in Table 6.4.

Table 6.4 Forward rates as implied in term structure

| Maturity from today (months) Le

Forward rate (% annualized)

3 months from now

6 months from now

9 months from now

EXAMPLE 6.3 Determining forward interest rates

Three zero-coupon bonds A, B, and C, each having a face value of 100 maturing after one, two, and three years, respectively, ]
are trading at 95.43, 90.68, and %85.04, respectively.
1. Find out the yield offered by each of the bonds.
2. What forward rates of interest would you expect for (a) a 1-year and a 2-year investment after one year, and (b) a 1-year ]
investment after two years?
Solution

1. The yields offered by bonds A, B, and C for 1, 2, and 3-year investments can be found as follows:
95.43 X (1 + of) = 100 gives of, = 4.79%
90.68 X (1 + ofp)’ = 100 gives of = 5.01%
85.04 X (1 + fs)? = 100 gives org = 5.55%
2. Implied forward rates are calculated as follows:
a) One year later (1 + or) (1 + yf) = (1 + oh)? gives (1 + 4fo) = 1.1028/1.0429 or +fo = 5.24%
(1 + of) (1 + ye)? = (1 + of)? gives (1 + 4f)* = 1.1759/1.0429 or fr, = 5.93%
b) (1 sr oh) (1 = of) — (1 “ts ofa)® Gives (1 ot ols) =a 1.1759/1.1028 or alg oS 6.63%

HEDGING WITH FRAs

The FRAs can be used effectively for protection against fluctuation in interest rates for short-
duration exposures. For covering exposures over the long term, other instru-
An FRA is an indepen- ments are used. The FRAs are OTC products; therefore, one can obtain
dent contract that delinks
forward rates according to one’s needs from the network of banks at hand
the actual investing or
borrowing and serves and book a contract using the most favourable forward rate. An FRA is a
as an effective toolfor contract fixing the price of a loan/deposit in advance, just as any other for-
hedging. _ ward contract, for example on exchange rates.
It would be wrong to believe that FRAs are offered at fixed rates. They can
be obtained in terms offloating rates too. Firms that need protection against fluctuation in inter-
est rates and have floating rate exposures can also get FRAs quoted in terms of a floating rate.
 Interest Rate and Forwards 173

’ Hedging Against Rising Interest Rates

Firms that borrow are always concerned about any rise in the interest rates, as it would
increase the borrowing cost adversely, affecting profitability. Further, those who intend to
borrow in the future also fear a rise in interest rates. They either avail of the loan today and
incur an additional interest burden for the period when the loan is not required, or leave
themselves exposed to the vagaries of financial markets. An FRA is a cost-effective and con-
venient way for them to freeze the borrowing rate in advance. We already demonstrated this
while describing the product. The following example helps to understand the concept better.
Assume that Excel Industries Ltd (EIL), while forecasting their annual cash flow, found
that they would have a shortfall of $500 lakh after six months. The shortfall is expected to last
for six months, when internal accruals would suffice to overcome the financial constraints.
Assume that the bankers to the firm, Commerce Bank (CB), have been extending loans
at MIBOR. With current MIBOR at 9%, the borrowing cost is 9%. The interest rates are
expected to go up in the next six months. EIL buys a MIBOR-based 6/12 FRA from another
bank, Forward Bank (FB), at 9.25% for a notional principal of ¥500 lakh. We present the
position of EIL under two alternative situations after six months: the MIBOR being more
than the FRA contract rate and the MIBOR being less than the FRA contract rate.

When MIBOR increases to 10%, against the FRA contract rate of 9.25%
FB would pay EIL the differential between the current MIBOR and the agreed rate of 9.25%
on a notional principal of $500 lakh for 180 days, discounted at 10%. Using Eq. 6.1, the
amount to be paid by FB is
1 180
Cash flow to firm = (1 + 0.10 X 180/360) x (Q510:—=
(OV. = 0.0925)
() : 360 PS 5,00,00,000
Yaa eee i

+,3:7;5003 5
aa had T185571

With the cash inflow of the FRA and by availing a loan at the current rate, the effective cost
of borrowing can be calculated as follows:
x
Interest cost for loan from CB = 5,00,00,000 < 0.10/2 = 25,00,000
Maturity amount of FRA at 10% = ees ee 05 Soe)
Effective interest amount paid = 23,12,500
Effective borrowing cost = 23,12,500/5,00,00,000 = 0.04625
equivalent to 9.25% p.a.

When MIBOR falls to 8.60%, below the FRA contract rate of 9.25%
In case the benchmark rate falls to 8.60%, EIL would have to pay FB the differential between
the actual and the contracted rate as follows:
l 180
Cash flow to firm = (I + 0.086 X 180/360) x (0.0860
(0. 90,09 25) severe
— 0.0925) 360 22«90-0000
5 000
0,00

162,500
| iree %1,55,800

With cash outflow from the FRA and by availing of a loan at the current rate, the effective
cost of borrowing can be calculated as follows:
174 Derivatives and Risk Management

“4
Interest cost for loan from CB = 5,00,00,000 X 0.086/2 = 21,50,000
Maturity amount of FRA at 10% = 1,55,800 x 1.043 = 1,62,500
Effective interest amount paid = 24 0
Effective borrowing cost = 23,12,500/5,00,00,000 = 0.04625
equivalent to 9.25% p.a.
We may conclude that irrespective of the interest rate prevailing at the time of borrowing,
the effective cost of interest would be fixed at the rate contracted under the borrower’s FRA.,
1.e., 9.25% here. Note that EIL borrows from CB while settling the FRA with FB.

Hedging Against Falling Interest Rates

Like firms that borrow are always concerned about any rise in interest rates, investing firms
_ are concerned about falling interest rates, which decrease income by reduc-
A borrowers FRA is a
_ ing profitability. An investor’s FRA 1s a cost-effective and convenient way to
contract that covers risk
of rising interest rates, _ freeze the investment rate in advance. We again consider an example to illus-
while an investor's FRA trate this application.
protects against falling Assume that Investment Management Ltd (IML) will have a surplus of
interest rates. 500 lakh after six months, to be invested for six months thereafter. The bank-
ers to the firm, CB, have been accepting deposits at MIBOR. With the current
MIBOR at 9%, the return on investment is 9%. Interest rates are expected to fall in the next
six months, threatening IML’s income. This causes IML to buy a MIBOR-based 6/12 FRA
from another bank FB for placing a deposit at 8.75% for a notional principal of 7500 lakh.
We now present the position of IML under two alternative situations after six months: MIBOR
being more than the FRA contract rate and MIBOR being less than the FRA contract rate.
When MIBOR goes up to 10% against the FRA’ contract rate of 8.75%
IML would pay FB the differential between the current MIBOR and the agreed rate of 8.75%
on a notional principal of ¥500 lakh for 180 days, discounted at 10%. Using Eq. 6.2, the
amount to be paid by FB is
| 180
Cash
ash flflow to firm = (1 + 0.10 X 180/360) X (0.087
(0.0875 — 0.10)
0: X ——
360 < 5,00,00,000
p)
See = — %2,97,619
1.05
With cash outflow from the FRA and investment at the current rate, the effective return
can be calculated as follows:

zg
Interest earnings from CB = 5,00,00,000 X 0.10/2 = 25,00,000
Maturity amount of FRA at 10% = 2.97;619 * 1.05 = 3,12,500
Effective interest earned = 21,87,500
Effective return = 21,87,500/5,00,00,000 = 0.04375
equivalent to 8.75% p.a.
When MIBOR falls to 8.10% against the FRA contract rate of 8.75%
In case the benchmark rate falls to 8.10%, IML would receive from FB the differential
between the contracted rate and the actual rate as follows:
 Interest Rate and Forwards 175

180
Amountmount to to bbe paid Semi ee AG
(1 + 0.081 180/360) x (O087S =— O0S10)-x pa
360 x 5,00,00,000

pelo U0 Ie
= pe T1S6,175

With cash outflow from the FRA and by availing of a loan at the current rate, the effective
cost of borrowing can be calculated as follows:
<
Interest earnings from CB = 5,00,00,000 * 0.081/2 = 20,25,000
Maturity amount of FRA at 10% = 1,56,175 xX 1.0405 = 1,62,500
Effective interest amount paid = 21,87,500
Effective borrowing cost = 21,87,500/5,00,00,000 = 0.04375
equivalent to 8.75% p.a.
Thus, with an investor’s FRA, a firm can be assured of effective return of 8.75%—the
contracted rate—in the FRA, irrespective of the prevalent rate at the time of investment. Here
again, IML makes a deposit with bank different from the one with which it books and settles
the FRA.

SPECULATION WITH FRAs ©

When there is no underlying exposure, i.e., need for borrowing or investing, and yet one
books an FRA, it reflects a view that opposes the scenario reflected in the FRA. Anyone who
buys an FRA without any underlying exposure is speculating on the interest rate behaving
against the FRA, thus hoping to make some gains.
If the current interest rate is 8% and an FRA is being offered at 8.80%, it indicates that
interest rates in the future are expected to go up. If, on the contrary, one believes that future
interest rates would fall, or would not rise to the extent of 0.80%, a speculator may book an
investor’s FRA to place a deposit. If the rates fall down or do not rise to 8.80%, the speculator
would gain the differential between 8.80% and the actual rate. Similarly, if another speculator
believes that interest rates are expected to move beyond 8.80%, he may book a borrower’s
FRA for availing of a loan. If the rates go beyond 8.80%, the speculator would benefit from
the differential between the actual borrowing rate and the FRA rate.
Speculation is possible due to delinking of the underlying transaction of lending or bor-
rowing from the FRA, provided laws of the land allow speculation. The presence of an
underlying transaction is not of concern to the bank selling the FRA as a product. The FRA
seller does not commit itself to either accepting the deposit or advancing the loan. It merely
pays or receives the differential between the settlement rate and the contracted rate on the
notional principal for the contracted period.

ARBITRAGE WITH FRAs |

Arbitrage with FRA seems to be a remote possibility. Arbitrage would be possible if two dif-
ferent banks offer different rates in their FRAs, prompting people to sell FRA to one bank
and buy from another. Since the FRA is an OTC product, where rates are not made publicly,
arbitrage would be extremely difficult to execute even if such an opportunity arises.
176 Derivatives and Risk Management

SOLVED PROBLEMS 3 ((000000———————")

SP 6.1: Investor’s FRA

Pro Investment Ltd is expecting a receipt of €10 crore for three months’ investment after three months. The yield for the contemplated
investment is currently at 7%, but is likely to fall. A bank has offered a 3/6 FRA at 7.00%, based on the 3-m MIBOR as a benchmark.
How can Pro Investment Ltd hedge against falling interest rates? Find out the effective return if (a) MIBOR rises to 9%, and (b) MIBOR
falls to 6%. Assume equal changes in MIBOR and investment yields, 90 days in three months and 360 days in a year.
Solution
For a notional principal of £10 crore Pro Investment Ltd can buy an investor FRA at 7.00%. It would lock-in the yield at 7%. The
differential of the actual MIBOR and 7% discounted at MIBOR would be paid/received by Pro Investment after three months, which
is presumed to carry interest at MIBOR.
(a) If the 3-m MIBOR rises to 9%
After three months, Pro Investment would pay 2% (FRA rate — actual rate) for three months discounted at MIBOR.
90
Cash flow (& crore) = (1 +.09x 90/360) x (0.07 — 0.09) x 360 x 10 crore = %4.891 lakh

The firm borrows at 9%. The return would be:

Interest earned = 1000 x 0.09/4 = $22.50 lakh
Interest paid for FRA = —4.89 x (1 + 0.09/4) = $5.00 lakh
Net interest paid %17.50 lakh
Effective return = 17.50/1000 x 360/90 = 0.07 = 7.00%
(b) If 3-m MIBOR falls to 6%
After three months, Capital construction would pay 1% (actual rate — FRA rate) for six months discounted at MIBOR.
Cash flow (& crore) = x (0.07 — 0.06) x ae xX 10 crore = €2.461 lakh
(1 + .06 X 90/360) 360
The firm invests at 6%. The net return would be:
Interest paid = 1000 x 0.06/4 = $15.00 lakh
Interest received from FRA = 2,46 X (1 + 0.06/4) = ¥2.50 lakh
Net interest earned = $17.50 lakh
Effective cost of borrowing = 17.50/1000 x 360/90 = 0.07 = 7.00%
SP 6.2: Determining forward interest rates
A one-year investment with no interim cash flows yields 5.02%, while 2-year zeros are providing a return of 5.52%. What can you tell
about the interest rate after one year for one year investment?
Solution
The yields offered for one-year and one-year investments are 5.02% and 5.52%, respectively. They imply an investment rate for
a one-year horizon after one year. This may be found by the equivalence of (a) direct investment for two years, and (b) investing
for one year and then rolling over the proceeds for another year at a rate prevailing then. Mathematically. the implied forward rate
would be given by:
(1 + of) (1 + 4h) = (1 + of)? — which gives (1 + 4%) = 1.05522/1.0502 or f = 6.02%

SUMMARY »
Interest rate is often viewed as a macro-economic variable that transactions between banks are free from default risk but are
reflects upon the state of the economy. For derivatives, the inter- camouflaged by legal considerations. That is also the case for
est rate is also of great significance because it is needed for their treasury rates. Interbank transactions governed by commercial
valuation. Different rates prevail for different transactions. Some- considerations alone are true indicators of interest rates.
times, interest rates are direct, such as those on bank loans The term structure of interest rates, also called the yieid curve, _
but sometimes interest rates are implied in the market prices of indicates return expectation for a given term of maturity. Itcanbe
securities. The interest rate desired for derivatives must be free arrived at from treasury zero rates. Treasury zeros are securities
from default risk and market determined. Repo and reverse repo that pay no interest but are redeemed with face value and are
 Interest Rate and Forwards 177

__ issued at discounts. The discount is determined by the market advance for a specific time. Banks offer investing and borrowing
__and represents the yield desired. When zeroes are not available, rates in advance for deposits and lending for specific periods
the YTMs of bonds can be used to arrive at the yield curve by of time. A borrower firm locks-in the borrowing rate, while an
using the bootstrapping method. investing firm can fix the investing rateinadvance. The product
__ Interest rate risks are faced by almost all firms whether they is independent of actual borrowing and lending and, therefore,
are borrowing or investing. More predominantly, banks and can serve as a hedging tool as well as a speculative product.
financial institutions are subject to greater interest rates risk as The risk of rising interest rates can be covered with a borrower's
all their assets and liabilities are dependent upon the interest rate FRA, while that of falling interest rates can be covered through —
scenario. an investor's FRA.
The FRAs are forward contracts on interest rates that pay The pricing of FRAs is dependent upon forward interest rates
or receive the differential between the actual rate and the con- implied in the term structure of the interest rates. It can be found
tracted rate. Tailored to specific needs, an FRA is an OTC by using the prices of zeros in the process of bootstrapping.
product that enables fixing of the investing or borrowing rate in

KEY TERM ee

Forward interest rate The expected interest rate that is likely ety of reasons for a fixed maturity, and are virtually free from
to prevail in the future. default risk.
Forward rate agreement A forward agreement to make a Term structure of interest rate Depicts the expected yields
deposit or borrow a sum commencing at a future date for a to investors depending upon the terms to maturity of their
specific period. investments.
T-bills Discount instruments issued by governments for a vari-

P 6.1 Finding the yield curve by bootstrapping Assuming 360 days in a year, annual compounding, and a bid-
Continuing with the zero rates worked out in Example 6.1 and ask spread of 20 basis points, find quotations for (a) 3/6 FRA,
those given in Table 6.3, find out the zero rates applicable for (b) 9/12 FRA, and (c) 6/12 FRA.
54 and 60 months if the following prices prevail for government P 6.3 Payoff for FRA
securities: A borrowing firm books a 6/9 FRA at 7% for notional amount of
Maturity Coupon | Periodicity |Market Price (%) | 210 crore. At the end of 6 months the benchmark rate turns out
54 months 8% | Semi-annual | 89.00 | to be 8%. Calculate the amount the firm would pay/receive under
the FRA. Assume 360 days p.a.
|60 months 10% | Semi-annual | 94.00 |

P 6.2 Pricing FRA

The following is the term structure of interest rates today;
Term to maturity (months) _| 3 | 6 9 12 |
Yield (% p.a.) | 3.40 | 3.55 | 3.65 | 3.95 |
 Interest Rate Futures

INTRODUCTION RS
Learning Objectives
In Chapter 6, we discussed the characteristics of forward con- After going through this chapter,
tracts on interest rates, widely known as forward rate agreements readers should be familiar with
(FRAs). Here, we discuss another derivative product with inter- . treasury bills (T-bills), their pricing,
est rates as the underlying asset, i.e., interest rate futures. As and T-bill futures contracts
explained in the previous chapters on futures on stocks, indices, hedging, speculation, and arbitrage
and currencies, futures contracts and forward contracts are based with T-bill futures
futures on Eurodollar deposits and
on the same concept. Operationally, however, these contracts are
hedging with them
significantly different from each other. Due to these operational treasury bond (T-bond) futures
differences between forwards and futures, market structures of hedging and speculation with.
the two are also significantly different. T-bond futures
Like any other futures contract, interest rate futures can pricing of T-bond futures
implied repo rates
also be called exchange-traded FRAs. The underlying asset
the calculation and meaning of
would be a financial instrument whose value would-be almost conversion factor
solely determined by prevailing interest rates. Such instruments identification of cheapest-to-deliver
include corporate bonds, treasury bills (T-bills), and treasury bonds
bonds (T-bonds). Predominantly, these instruments are invest-
ment assets because investors target financial gain by investing
in these instruments. Financial gain has always been the most
alluring objective for investment in stocks, indices, currencies,
commodities, etc. However, returns on such assets depend more
on factors other than fluctuations in interest rates.
Exchange-traded interest rate contracts are expected to pro-
vide many benefits in comparison to over-the-counter (OTC)
products such as FRAs. The benefits are as follows:
e Exchange-traded interest rate contracts protect against
counterparty risk, whereas FRAs are always subject to
counterparty risk. For each exchange-traded interest rate
contract, an exchange becomes the counterparty, assum-
ing the risk of settlement, thus encouraging more partici-
pation and providing depth to the market.
 Interest Rate Futures 179

_@ Prices quoted on the exchange are all pervasive and, hence, there is
Derivatives
oninter-
_ est rates are used for. greater transparency in futures contracts than in forward contracts nego-
_covering risk arising from — tiated between two parties, with no obligations to disclose the terms of
changing interest rates. the contract.
Futures contracts provide ease of entry and exit at any time, while forward
contracts would most likely be settled by the delivery of the underlying
asset or cancellation of the original contract, necessarily with the consent of the
counter-party.
e Futures contracts on interest rates do not pose the problem of physical settlement that
exchanges dealing in commodities face. These settlement difficulties relate to grading,
price differentials, warehousing, etc., requiring infrastructure and personnel. These dif-
ficulties are absent in financial instruments, and hence, both modes of settlements, 1.e.,
physical and cash, can easily be carried out by the exchange.
Interest rate futures can be divided into categories on the basis of the underlying assets.
While discussing the term structure of interest rates, we discussed the fact that investors have
varying expectations of return, depending upon the term of maturity. Instruments that serve
short-term needs are not suitable for long-term needs. These needs range from speculation
to arbitrage to hedging.
Instruments that usually form underlying assets for interest rate futures are as follows:
e treasury-bills with maturity period of less than one year, referred to as short-term
instruments;
e treasury notes with maturity period between three and seven years, referred to as
medium- or intermediate-term instruments; and
e treasury bonds with maturity period over 10 years, referred to as long-term instruments.
Besides, interest rate futures have also been developed based on a reference rate, such as
LIBOR (London interbank offer rate) and Eurodollar deposits. We now discuss each of them.

~ INTEREST RATE FUTURES ONT-BILLS __

The value of an interest rate futures contract, just like any other derivative contract, changes
when interest rates change. When the underlying instrument matures over a short period of
time, futures on such an underlying asset would be used for short-term protection or specula-
tion. When the underlying matures at a distant time, then futures on such an underlying would
cover the risk of interest rate changes over the long term.
The FRA, discussed in Chapter 6, is an interest rate derivative that offers a perfect hedge
over a short period of time, and is like any other forward contract on a stock, an index, or a
- commodity. Hedging with interest rate futures would rarely be perfect, like
T-bills are instruments
many other futures hedges are.
issued at a discount
by governments. They The most commonly used short-term futures contracts in an economy are
carry no default risk, and based on T-bills, while internationally, futures on Eurodollar deposits are
hence, serve as ideal most common. To understand futures on T-bills, we need to become familiar
enced assets 10) with T-bills and their pricing, and quoting conventions, as discussed in the
futures contracts. _ : ;
_ following sections.
180 Derivatives and Risk Management

TREASURY BILLS
Treasury bills are one of the most important debt instruments issued by the government. A
T-bill is a discount instrument, which implies that its price will be equal to the face value minus
a discount that represents return or interest. The T-bill rate is acknowledged as a policy measure
for managing short-term liquidity, sterilizing foreign exchange interventions and financing to
bridge temporary fiscal deficits. The scope far discussion of why T-bills are issued falls under
the subject of economics. Here, we are concerned with the pricing and valuation of T-bills.
Risks and returns are inseparable, like the two sides of a coin. The T-bills are borrowing
instruments for the issuer, i.e., the government, and subscribers lend money in anticipation
of returns. Any return is governed by the risk associated with it. There are usually two kinds
of risks inherent in lending and borrowing transactions, namely:
e Default risk The risk of default on the repayment of principal and/or interest by the
issuer, and
e Interest rate risk Any change in the interest rate scenarios between the time of mak-
ing the investment and divesting it, fetching a return different from what was expected

In the case of T-bills, the default risk can be presumed to be non-existent because of the
unique position of the issuer, i.e., the government and the nation’s central bank, who control
the money supply in an economy and have the sole authority to print money. This unique
characteristic of T-bills makes them risk-free assets. A subscription to a T-bill and its price
would be based purely on the interest rate risk. The value of such instruments should be
purely determined by the risk premium, commensurate with the interest rate risk. T-bills
would serve as an ideal proxy for interest rates.
Fixed-income securities issued by the corporate sector do not conform to valuation that
is purely governed by changes in interest rates. Unlike T-bills, which carry no default risk,
most debt instruments issued by firms are subject to default risk. As such, their valuation is
determined not purely by interest rates but includes premium for default risk too. Further, the
various corporate bodies that issue fixed income securities vary greatly in their features, caus-
ing valuations to differ substantially. Since futures require standardization of the underlying
asset, Corporate debt securities are not suitable, because debt instruments issued by different
firms carry different risk premiums, and their valuations are not comparable. Further, their
levels of liquidity are not large enough to justify design of exchange-traded products.
The uniqueness of government securities is that they are frequently issued in large num-
bers, providing adequate liquidity and continuity, which is required for fair pricing, and
making delivery process easy. Though default risk premiums too have a role to play in the
determination of pricing of these instruments, the default risk can be assumed to be the same
for different securities issued by the same issuer, i.e., a government. In any case, the default
risk is minimal. Further, frequent trading of government securities in the secondary markets
provides enough liquidity for fair pricing. Liquidity and fair prices are essential pre-requisites
for meaningful derivative markets.
The value of T-bills reflects the yields in the money market that can be considered as
benchmarks and makes them an appropriate underlying asset for futures contracts. The T-bills
with maturities of 91, 180, and 364 days are the most common. T-bills of 91 days are mostly
used as the basis for futures contracts.
 Interest Rate Futures 181

FUTURES CONTRACT ON T-BILLS

Just as futures contracts on commodities require delivery of the underlying commodity on
maturity of the contracts, futures contracts on financial instruments, say T-
On expiry, a futures
bills, would require delivery of the T-bills. Figure 7.1 depicts transactions
contract on T-bills -
_ calls for the delivery of of futures contracts on 91-day T-bills. Note that at the end of the futures
‘T-bills maturing 91 days contract, the contractor is required to deliver a T-bill maturing 91 days there-
_ thereafter. after. However, such a T-bill may or may not actually exist when the futures
contract matures.

t=0 t=T t=T+91 days

Maturity of futures contract hetoineues
+ Initiate a short/long
position in T-bill futures. + A short position delivers _+ A ong position collects
a T-bill that matures 91 days later. the maturity value ofthe
« A long position pays the contracted T-bill, 1e., face value of [100
price to acquire the T-bill. -

Fig. 7.1 Futures contract on T-bills

T-bills are auctioned frequently as per a pre-announced calendar, when market participants
bid for subscriptions. These bids reflect investors’ expectations at the time of issue of T-bills.
Since T-bills are transferable, there is an active secondary market. The price of a T-bill in the
secondary market would change continuously, reflecting changing interest rates. Hence, the
price of a T-bill forms the basis of the value of a futures contract on it.
Future contracts with T-bills issued by the US government as underlying assets are traded
on the Chicago Mercantile Exchange (CME). However, T-bills future contracts today have
in
lost their sheen because of the competition from Eurodollar futures contracts (described
the section on Eurodollars in this chapter) available at the CME. T-bill rates are highly influ-
enced by government policies, budget deficits, and politics. In spite of this relative inactivity,
understanding T-bill futures is essential because the concept of interest rate futures is derived
from futures contracts on T-bills.
In India, the National Stock Exchange (NSE) introduced on 4 July 2011 interest rate

futures contracts with 91-day T-bills as underlying asset.

Pricing of T-bills
at face value.
Treasury bills are issued at a discount to the face value, and are redeemed
between issuance and redemption. The return to the investor
There is no interim payment
by the difference between the redemption value (face value of
in T-bills is provided entirely
Price quotations for T-bills are mentioned in terms of discount
100) and the purchase price.
market convention.-The market specifies the discount yield d,
on the face value, as per the
the amount of discount,
based on the actual/360-day convention. The discount yield, d, and
D, are related, as given by Eq. 7.1.
Yield, d X No. of days to maturity, 7
Discount on T-bills, D = Face value, V x
360
 182 _ Derivatives and Risk Management

Oil
or DiS Vex (7.1)
360
For a discount yield of 6%, the amount of discount, D, on a T-bill that has 90 days remain-
ing to maturity would be as follows:
dial 0.06 * 90
D=V*X
= 360 = 100 x ——_ 360 = <1 50

The purchase price ofa T-bill, P, would therefore be as per Eq. 7.2
Pe =D C4)
The price ofa T-bill with a 6% discount yield with 90 days remaining for maturity would
be 100 — 1.50 = $98.50.
As stated earlier, the annual yield on T-bills is expressed as a percentage of the face value,
_ not as the purchase price. Further, the base for calculation is assumed to be
T-bills are discount in-
struments that are quoted
360 days, rather than the actual 365 or 366 days.
on percentage discount For these two reasons—the number of days and the price base—the actual
; i ;
yield basis. _ yield would be different than the quoted yield. The actual yield realized
ee would be calculated on the basis of the purchase value using 365 days ina
year, as per Eq. 7.3. It is also referred to as bond equivalent yield, y!.
Face value, V — Purchase price, P 365
SEES Purchase price, P No. of days to maturity, T
FietP A365
Actual yield, y = ae xX = (7.3)

For a T-bill with a 6% quoted yield, the purchase price is 98.50, and with 90 days remain-
ing for maturity, the actual yield would be 6.176%, shown as follows:
VS Ee 365 OUD O50 eas
Actual
t yield,y = aa P r — 98.50 Se 90 =)0.06176 == 6.176%
06. %

Price Quotation on T-bill Futures

For futures on T-bills traded on CME, the underlying assets are 13-week T-bills;
they require
delivery of these T-bills of aface value of $1 million on any ofthe three successiv
e days fol-
lowing the last day of trading, specified as the last business day. Because of
this flexibility, |
sellers of these bills can deliver on any of the three days. Therefore, a
deliverable T-bill can
have a maturity of between 90 and 92 days.
Rather than quoting interest rate futures directly on the basis of interest
rates, they are
specified in terms of index, /. A T-bill’s futures price, F, is quoted
in terms of the T-bill’s
yield, /, annualized on the basis of 360 days a year (as is the case with
the underlying asset),
as per Eq. 7.4.
Futures price, F= 100 — J (7.4)
Index-based pricing is the key difference between the way prices
are quoted in interest rate
futures markets and in other futures markets. This is done in
order to be consistent with all
other futures, markets. In all futures markets, a long position
gains with price rise and loses
'For instruments that have more than 182 days to maturity,
the calculation of bond equivalent yield, y, 1s different.
 Interest Rate Futures 183

with price fall. The opposite holds good for short positions. For example, if the price of gold
rises from %26,000 per 10 g to ¥27,000 on expiry of a contract, the initial long position would
gain ~1000 and the initial short position would lose equivalently. Similarly, if the prices were
to fall, the long position would lose and the short position would gain.
This would not hold good if interest rate futures were quoted directly in terms of prevail-
.. __ ing interest rates due to the inverse relationship between prices and interest
Futures on T-bills are Hee on ae ' : ne Pee
pricedonan index rates, icfying the norma convention of making a long position gain with a
basis because ofinverse price rise and lose with a price fall. The most convenient way to become
_ felationship of their price consistent with other futures markets (to make long/short positions gain/lose
withinterest rates andthe — with rising prices of futures contracts and vice versa) is to introduce a nega-
oe Re sign in the pricing of futures contract. This led to the devising of an
tion gaining with price rise a: : ae — ‘
in other futures marvels appropriate index, as given by Eq. 7.4. With index-based pricing, interest rate
futures markets become consistent with other futures markets.
What the futures price imply A quoted price of a futures contract on T-bills of $92 implies
a discount yield of 8%. If in September a December futures contract is being quoted at $92,
it simply implies that the best estimate of the market for a 3-m discount yield that is likely
to prevail in December is 8%. Similarly, if a March futures contract is quoted at $91.50, it
implies that the market estimates the discount yield on T-bills in the forthcoming March to
be 8.50%. Futures prices should not be construed as the prices at which T-bills are traded.
They are simply the way futures on T-bills are quoted.

FUTURES CONTRACT ON T-BILLS IN INDIA 9"

In India, the underlying instrument for interest rate futures is the 91-day T-bill. It was intro-
duced at the NSE on 4 July 2011, with contract specifications given in Table 7.1.
The price of futures on T-bills is quoted on the basis of the discount yield, and for conve-
nience, the actual yield is also displayed. Exhibit 7.2 is a snapshot ofthe trading and pricing
patterns of futures on T-bills. For example, 91DTB270711 in Exhibit 7.2 indicates that the
underlying asset is a 91-day T-bill, and the expiry of the futures contract is 27 July 2011. It
implies that on 27 July 2011, the seller of the futures contract is required to deliver a T-bill
that matures 91 days thereafter.
The futures price is index based. The price of 92.0800 on 4 July 2011 for 91DTB270711
implies a discount yield of 7.9200%. The contract is for an underlying asset of a91-day T-bill,
expiring on 27 July 2011. The discount yield and purchase price of the T-bill are calculated
as follows:
Discount yleld,d = 100 — F = 100 — 92.0800 = 7.9200%.
Therefore, the purchase price of the bill would be,
Price of T-bill = 100 — 7.9200/4-= 100 — 1.98 = %98.0200
The contract size is €2 lakh in face value (2000 bills of €100 each). The contract value,
also known as invoice price, is 2000 X 98.0200 = %1,96,040. The buyer of the contract
on its expiry on 27 July 2011 would pay %1,96,040 and receive T-bills worth ¥2,00,000 in
face value.
184 Derivatives and Risk Management

Table 7.1 Contract specifications of futures contract on T-bills

Underlying Jo-day Government of India T-bill

Contract size 2,000 units (face value €2 lakh)

Quotation 100 — discount yield, d

Tick size ~0.0025

No. of contracts Three monthly contracts followed by three quarterly contracts, e.g., in July 2011 the
contracts are for July, August, and September 2011, followed by three quarterly contracts
maturing in December 2011, March 2012, and June 2012
Contract value 2,000 x (100 — 0.254)
Daily settlement Cash on T + 1 basis
Margins e Initial margin: SPAN?-based, subject to a minimum
e MTM?®: Based on weighted average yield as long as the contract is open
e Extreme loss margin: 0.03%
Final settlement price | Spot value: Weighted average of discount yield from weekly auction of T-bills by RBI
Mode of Settlement Only cash-settled; there is no d elivery-based settlement
LEE

Source: http://www.nse-india.com accessed on 20 Septe mber 2012

The actual yield corresponding to a futures price of 92.08 and a discount yield of 7.92%
is 8.1022%. It is calculated as follows and as shown in Fig. 7.2.
Vo Pi Oars 00 198024 S308
Actual yield, y = —S— x => = =
— x = = 0.081022 = 8.1022%
ie 98.02 9]

Discount yield =7.9200% .

Contract LTP’ @ lla sthi Bestask| Spread Yield OF | Volume j

dl Price (%) | Qty
91DTB 270711 1 92.0800 92.0775 | 92.0800 8.1022 | 12696 5128

91DTB 300811 | 92.0100 92.0100 | 92.0975 8.1753 30 =

91DTB 280911 - 92.0000 ,
91DTB 281211 -
91DTB 281211 -

ETERS een

Source: www.nseindia.com, accessed on 19 July 2011.

Fig. 7.2 Futures contracts on T-bills in India

*Standardized portfolio analysis of risk

$Mark to market
4Last traded price
Open interest
 Interest Rate Futures 185

- EXAMPLE 7.1 Yield on T-bills

The discount yield on a T-bill with 90 days to maturity is quoted at 6.25%. What is the purchase price of the T-bill? What actual
yield would be realized by one who buys such a T-bill? L
Solution D
The purchase price of the T-bill is found by calculating the discount and subtracting it from the face value of the T-bill. The discount L
is calculated as follows:
dein 0.0625 x 90 _
360 100 x aay eee %1.5625 ]
Hence, the purchase price = 100 — 1.5625 = 298.4375. The bill has 90 days remaining for maturity. The actual yield, therefore, |
will be calculated as
Actual Yield, y = te ES 2 = a tae x = = 6.4374%

EXAMPLE 7.2 T-bill futures in India

An interest rate futures contract on Government of India T-bills maturing after 29 days on 30 August 2011 is quoted at ¥91.8800

Contract LTP * : : Spread | Yield Ol Volume

91DTB 300811 500 250 CLOTSOM SSO 4769 200

91DTB 280911
91DTB 251011
91DTB 281211
Source: www.nseindia.com, accessed on 23 August 2011.

(a) What is the discount yield based on LTP?

(b) If the contract size on the interest rate futures is 2,000 T-bills with face value of €100 each, what is the invoice value of one
contract?
(c) .What would be the actual yield realized by an investor who buys the futures contract today?

Solution

(a) Discount yield, yis 100 — price quotation. Hence, y = 100 — 91.8800 = 8.1200%
(b) Invoice price for one contract = 2,000 x (100 — 0.25y) = 2,000 x (100 — 2.03) = %1,95,940
(c) Actual yield, y, is worked out for a T-bill with face value of ¥100 based on the actual number of days and 365 days in a year.
The invoice value for the T-bill would be 100 — 0.25 x 8.12 = %97.9700.
Naa 100 C7
— 97.97 _ 365
Gy =_ 0.083110 == 8.3110%’

HEDGING WITH T-BILL FUTURES |

T-bill futures are used to hedge short-term interest rate risk. Depending upon the prevailing
situation, one may need protection against rising or falling interest rates. We discuss hedging
with T-bills futures now.

Hedging against Falling Yields (Long Hedge)

As a prospective investor, you are subject to the risk of falling interest rates. You have no cash
now, but expect it to come later, when the yields would have fallen, resulting in a rise in the
price of the instrument. Hence, you need to invest more funds to buy the same number of T-bills.
To protect against falling yields, you can buy futures on T-bills. Let us consider an example.
186 Derivatives and Risk Management

It is 12 January today. Assume you have to invest a temporary surplus of <10 crore that
_ you expect to receive from a customer three months from now. It would be
Protection against falling
: a temporary surplus that would be available for three months thereafter. The
interest rates is covered
by buying interest rate current yield on T-bills is an attractive 7.80%, and you would have bought
futures. _ them now if only funds had been available. The yields are likely to fall in the
~ coming days, and therefore, you are facing the risk of a reduced return on
the prospective investment.
Buying T-bills now is ruled out, as you do not have the funds to invest. However, you can buy
a futures contract on them and lock-in the yield of 7.80% that is offered today in T-bill futures.
The current T-bill futures price for a March contract is 92.20, implying a yield of 7.80%.
Assuming a futures contract is based on 91 day T-bills, 360 days count, and that the con-
tract size is 2 lakh, you buy 500 futures contracts. The value® you have committed to pay is
calculated as follows:
_ discount yield x **)
Price of futures contract = Face value < (
360
x
Price of futures contract = 2,00,000 X ( ae 2°)= %1,96,100

Number of contracts bought = 1000 lakh/2 lakh = 500

Amount committed to pay = 500 X 1,96,100 = %9,80,50,000
By buying 500 futures contracts on T-bills, you have undertaken to pay ~9,80,50,000 and
receive T-bills with a total face value of 10 crore (500 contracts < %2 lakh each) at the
expiry of the March contract’.
Table 7.2 Hedging investment return with interest rate futures

Scenario in March Yield falls to 7.00% Yield rises to 8.50%

T-bill futures price %93.00 91.50

Futures contract sold at ~%93.00 %91.50

Implied yield 7.00% 8.50%

0.070 x 90 0.085 x 90
Price of contract sold Te f| B60 | ee iB60 |
= %1,96,500 = $195,750
Value to be received on 500 futures
ee aera %9,82,50,000 %9,78,75,000

Value
on to be ppaid on 500 futures contracts 29,80,50,000 9 80.50.000
g t ¥ s %

Profit (+)/loss (—) on futures contracts %2,00,000 —%1,75,000

Interest earned on actual deployment of 0.07 x 90/360 x 10,00,00,000 0.085 x 90/360 x 10,00,00,000
10 crore in T-bills = %17,50,000 = %21,25,000
Actual earnings after adjusting profit/loss
on T-bill futures (ignoring time value) < 19,50, 000 <19,50,000
Effective yield 7.80% 7.80%

®Called the invoice price.

'If one settles by delivery, the yield would still be 78% calculated on face value of Tbills.
 Interest Rate Futures 187

EXAMPLE 73 Hedging with T-bills (Long hedge)

Based on his cash flow estimates, a corporate treasurer finds that he will have an investible surplus of €20 crore after two months
This surplus is expected to remain with him for three months, after which it would be needed for working capital. The ideal instru- 7
ment for investment would be T-bills, which are currently yielding an extremely attractive 8.20%. However, T-bills futures with L
expiry of two months are trading at €92.40, (discount yield of 7.60%) indicating falling yields in the times to come. :

(a) Describe the ideal hedging strategy for the treasurer.

(b) What rate of return can the treasurer be assured of by the hedging strategy?
(c) Compute the investment return if after two months the discount yield on T-bills is (a) 6.20%, and (b) 8.20%.
Solution

(a) As ahedging strategy, the treasurer must go long on interest rate futures on T-bills expiring two months later at the prevailing
rate of 92.40. The value of the futures contract would be equal to an exposure of €20 crore. With a contract size of €2 lakh, 1
the number of contracts bought is 1000 (20 crore/2 lakh). When funds are actually available after two months, the treasurer |
must sell the futures and invest at the yield offered at that time. ;
(b) By doing so, the treasure would lock-in an investment return of 7.60%, as reflected in the price of T-bills futures.
—PP)~~ If Discount Yield on T-bills Falls to 6.20%

The futures price rises to 93.80, and T-bills quote at a discount yield of 6.20%.
= per %100 of face value of T-bills
Futures on T-bills (bought) 92.40
Futures on T-bills (sold) 93.80
Gain of futures 1.40
Amount to be received on futures contracts = (93.80 — 92.40) x = 0.35

-bills = 1 — discount yield x 90 _ ioe 6.20% x 90 98.45

Price of T-bills 360 360
Net amount invested = 98.45 — 0.35 : 98.10
Annualized discount yield on maturity = Oe x = - 7.60%
If Discount Yield on T-bills Rises to 8.20% F
The futures price falls to 91.80 and T-bills quote at a discount yield of 8.20%.
Futures on T-bills (bought) 92.40
Futures on T-bills (sold) 91.80
Loss of futures 90 0.60
Amount to be received on futures contracts = (93.80 — 92.40) x 360 0.15
7x ee discount yield x 90 __ , _ 8.20% x 90 97.95
Price of T-bills = 1 360 360
Net amount invested = 97.95 + 0.15 98.10
Annualized discount yield on maturity = 100.00 = 98.10 uel: 7.60%
100.00 90

Just before the maturity of the March contract, you would sell 500 contracts at the yield
prevailing at that point of time (You may also choose to make physical delivery of the under-
lying T-bills). If the yield falls as expected, the futures would be selling at a higher price, and
you would receive a higher price than you paid for the initial contract. This would compen-
sate for the loss you would incur by investing in T-bills at reduced yields.
Table 7.2 depicts the position of investment returns when interest rates fall and increase
contrary to expectation. In either case, you lock-in a return of 7.80%—the yield in the initial
futures contract.
188 Derivatives and Risk Management

Hedging against Rising interest (Short Hedge)

As a prospective borrower, you are subject to the risk of rising interest rates. If yields rise
in the future, you would end up paying a higher cost than you would today. One alternative
is to borrow now, but that would imply keeping resources idle, yet paying for them. Let us
again consider an example of how futures on T-bills can hedge against rising interest rate.
Suppose it is 12 January today and that you need to borrow %10 crore for three months in
_ March for execution of an order from your customer. The current yield on
Protection against rising
_ T-bills is attractively low, and your borrowing would be linked to the yields
interest rates is hedged
by selling interest rate in T-bills that prevail at the time of borrowing. The yields are likely to rise,
futures. and so would the borrowing cost. Therefore, you are exposed to the risk of
increased cost of borrowing.
In order to hedge against rising interest rates, you would sell a futures contract on T-bills
now, and buy the same futures contract back later, locking in the cost of borrowing that is
implied today in T-bill futures.
The current T-bill futures price for a March contract is ~92.20, implying a yield of 7.80%.
Assuming the futures contract is based on a 90-day T-bill, 360 days count, and a contract size
of ¥2 lakh, you sell 500 futures contracts. The value that you receive is calculated as follows:
discount yield x 90
Price of contract = Face value X | —
. 360
Price of contract = 2,00,000 x (
_ 0.078 x 9 “= %1,96,100
360
Number of contracts sold = 1000 lakh/2 lakh = 500
Amount to be received = 200 X 1,96,100 = %9,80,50,000

Table 7.3 Hedging borrowing cost with interest rate futures

Scenario in March Yield rises to 8.50% | Yieldfalls to 7.00%

T-bill futures price %91.50 %93.00
Futures contract sold at %91.50 %93.00
Implied yield 8.50% 7.00%

Price of contract bought ee [" = 2 — [: ae |

= %1,95,750 = 71,96,500
Value to be paid on 500 futures contracts bought %9,78,75,000 %9,82,50,000
Value to be received on 500 futures contracts sold %9,80,50,000 €9,80,50,000
Profit (+)/loss (—) on futures contracts %1,75,0000 —%2,00,000
Interest paid on actual borrowing of 10 crore* for 90 0.085 x 90/360 x 10,00,00,000 | 0.07 x 90/360 x 10,00,00,000
days = %21,25,000 = %17,50,000

(rng tae CELLS Reg 95000

Effective cost ae 7,80% 7.80%
"The amount of actual interest payable would be more than the yield on the T-bills, as the borrowing would be done
at higher
rates than the yield on the T-bills.
 Interest Rate Futures 189

By selling 500 futures contracts on T-bills, you have undertaken to deliver T-bills with a
face value of €10 crore (500 contracts < €2 lakh per contract) at the expiry of the March
futures contract.
Before maturity of the March contract, you would buy 500 contracts at a yield prevailing
at that point of time. If the yield had indeed risen, as expected, the futures would be selling at
a lower price, and you would buy at a price lower than that of the initial contracts you sold.
This would compensate for any loss you incur by borrowing at a higher interest rate.
Table 7.3 depicts the position relating to the borrowing cost when interest rates have
indeed increased, and also when they have decreased, contrary to expectation. Here, too, your
borrowing cost would be at 7.80% of the yield implied in futures now.
Hedging strategies with interest rate futures are summarized as follows:

Situation Hedging strategy

Investors expecting falling interest rates Buy interest rate futures now and sell later, and invest at
the market interest rate.
Borrowers expecting rising interest rates | Sell interest rate futures now and buy later, and borrow at
| the market interest rate

SPECULATION WITH T-BILLS FUTURES 9

Taking a position in futures without exposing the underlying asset to risk is called specula-
tion on future interest rates. When an individual whose views do not match with the present
scenario in terms of futures prices takes a position in futures, he/she is said to be speculating.
In contrast, the hedger takes a position on the underlying asset.
For example, consider that the prevailing yield in the market is 8%. A futures contract on
T-bills maturing after a month is trading at $93.00, implying a yield of 7% next month in
anticipation of a fall in interest rates. You believe that the yield would rise to 9% rather than
fall to 7% from the current level, as the price of futures now is not correctly reflecting the
future interest rate. In your opinion, futures are overpriced (they should be at 91.00 rather
than 793.00), and hence, you decide to sell a futures contract (say for 10 lakh) at ¥93.00.
Therefore, on maturity, you are entitled to receive $9,82,500 for delivering a T-bill with a
face value of 10 lakh. The value of the contract is computed as follows:

Price of contract sold = 10,00,000 x ( - eae)

= %9,82,500
360
If your expectations come true, the futures price over the period of time before maturity
would correct to%91.00. You would buy a futures contract to nullify the original short posi-
tion. As a buyer, you would be required to pay the price of $9,77,500, as shown here:

Price of contract bought = 10,00,000 ( = aa a) = <9 7500

Expectations cf a greater
Thus, the total gain will be %5000, which is equivalent to 2% (the differ-
_tise in the interest rate
than is reflected by the ence between the expected interest rate and the yield implied in the futures
- futures price can be contract).
_ speculated upon by If one believes that in the future the interest rate would fall (and the price
_ selling futures now and of the underlying asset, T-bills, would rise) one would initiate a long posi-
apie. tion in futures. With the futures price at $93.00, the speculator would buy
190 Derivatives and Risk Management

the futures contract undertaking to pay the price equivalent to futures price. If the interest
rates actually fall, the futures would go up in value when you square off your initial position,
thus registering a gain.
The strategies of speculators can be summarized thus:
Situation Strategy
When interest rates are expected to go up by more than what the futures market Sell futures now and buy later
suggests, the price of the underlying assets as well as futures on them would fall.
When interest rates are expected to go down by more than what the futures market | Buy futures now and sell later
suggests, the price of the underlying assets as well as futures on them would go up.

ARBITRAGE WITH T-BILL FUTURES

If futures are overpriced in the commodities market, arbitrage can be implemented using the
cash-and-carry strategy, implying the selling of a futures contract and the borrowing of cash
to buy the underlying asset, carry it till maturity, and deliver it against the futures contract
sold, as condensed here:

Cash-and-carry arbitrage
On maturity
e Sell the future. e Deliver asset against the futures contract sold.
e Buy the underlying asset. |e Receive value equal to futures price.
e Borrow equivalent sum. e Repay borrowing along with cost of borrowing.
The gain would be equal to the difference between the futures price and the cost of carry.
Similarly, if futures were underpriced, reverse cash-and-carry arbitrage may be executed by
buying the futures, selling the underlying asset and lending the sale proceeds. On expiry of
the futures, receive delivery of the asset by paying for it from the matured value of the funds
lent. These reverse cash-and-carry steps are summarized here:

Reverse cash-and-carry arbitrage

i Today On maturity
e Buy the future. e Acquire asset against the futures contract bought.
e Sell the underlying asset. e Receive the funds lent with interest.
e Lend equivalent sum. e Pay for the asset as agreed in futures contract.
We may consider arbitrage actions for futures on gold as examples of cash-and-carry and
reverse cash-and-carry arbitrage actions. Assuming the spot (cash) price of
Coo. gold is <12,000 per 10 g, and the cost of carry is 1% per month, the theo-
repo transactions, and retical price of a 3-m futures contract must be 712,360. If the futures sells at
therefore, a futures price © more than theoretical price, say, at 712,460, cash-and-carry arbitrage
is exe-
implies arepo rate. _ cuted, resulting in a profit of 7100; on the other hand, if the futures sells for
less than the theoretical price, say, at $12,210, reverse cash-and-carry arbi-
trage results in a profit of $150. Both these situations are highlighted in Table 7.4.

Implied Repo Rate

Arbitrage opportunities with interest rate futures are not as apparent as they are
with other
futures markets. In order to examine if arbitrages opportunities exist, we need to compare
the
 Interest Rate Futures I91]

Table 7.4 Arbitrage with commodity futures

_ Cash-and-carry arbitrage Reverse cash-and-carry arbitrage

When futures price Is > spot + cost of carry When futures price ls < spot + cost of carry
Action Cash flow (®) Action Cash flow (%) |
Today Today ]
Sell the futures on gold _ Buy the futures on gold -
Buy gold in cash — 12,000 Sell gold in cash + 12,000
Borrow equivalent sum +12,000 Lend equivalent sum | —12,000
Cash flow today - Cash flow today | _
On maturity ah On maturity
Deliver gold and realize futures +12,460 —_| Acquire gold and pay futures 12210
contract value | contract value
Repay borrowing with interest — 12,360 Receive funds lent with interest + 12,360
Cash flow on maturity +100 | Cash flow on maturity +150

market price of the futures contract with the theoretical/fair price, which effectively means
estimation of the cost of carry. The T-bills are pure financing instruments; the yields on them
represent risk-free rates and are used to determine the cost of carry for futures contracts.
Arbitrageurs can opt for either of the following two strategies:
© Cash-and-carry Buy a deliverable T-bill spot, borrow the equivalent sum, and sell a
futures contract. On maturity of the futures contract, deliver the T-bill already in hand in
exchange for the futures price, and pay back the borrowed funds with interest. Examine
if there is any surplus.
¢ Reverse cash-and-carry Sell a T-bill that matures 91 days after expiry of the futures
contract spot, invest the proceeds, and buy a futures contract. On maturity of the futures,
receive the T-bill by paying for it from the funds you had lent out earlier. Examine if
there is any surplus.
Arbitrage would exist if the difference between the futures and the spot prices is not equal
_ to the lending or borrowing rate—the actual repo rate. Selling securities
Ifthe repo rate implied by
_ today and agreeing to buy them back the next day is a 1-day (overnight) repo
a futures price is different
from the actual repo rate, transaction. The difference between the repurchase price and the initial price
it presents an arbitrage is the actual repo rate. The repo rate is the difference between the selling
opportunity either way. price and the repurchase price of government securities in the physical mar-
ket, expressed on an annualized basis. Cash-and-carry or reverse-cash-and-
carry transactions are financed at the repo rate, which represents the actual cost of carry.
The difference between futures prices and spot prices represents the implied cost of carry.
The difference between the price of a futures contract and the spot price of the deliverable
security, referred to as implied repo rate, is calculated as per Eq. 7.5.
Futures price — Spot price ye 360
Implied repo rate = (7.5)
Spot price No. of days remaining for futures
For example, consider a simple situation where T-bill futures sell for ¥90.00 (indicating an
interest rate of 10%) and the contract has exactly 90 days to mature. Assume that a futures
192 Derivatives and Risk Management

Table 7.5 Arbitrage with interest rate futures

Cash-and-carry arbitrage Reverse cash-and-carry arbitrage

When implied repo rate > financing cost, say 4% When implied repo rate < financing cost, say 8%
Action Cash flow (?) Action Cash flow (®)

Today Today
Sell the Interest rate futures = Buy the interest rate futures =

Buy a 180-day T-bill in cash —96.00 Sell a180-day T-bill in cash +96.00

Borrow the equivalent sum +96.00 Lend the equivalent sum —96.00

Cash flow today oe se flow today -

On maturity after 90 days On maturity after 90 days
Deliver T-bill and realize futures +97.50 Acquire T-bill and pay futures
contract value contract value
Repay borrowing with interest —96.96 Receive funds lent with interest
Cash flow on maturity +0.54 Cash flow on maturity

contract on T-bills warrants delivery of T-bills that have 90 days to mature from the expiry
of the futures contract. Therefore, a 180-day T-bill is the deliverable asset and its yield is
relevant for determination of the cost of carry. Assume that the 180-day T-bill is quoted at a
yield of 8%. The prices of the 180-day T-bill and the futures contract would be %96.00 and
~97.50, respectively.
Price of 180-day T-bill 100 — 0.08 X 180/360 = %96.00
Invoice price of futures contract = 100 — 0.10 X 90/360 = 97.50
The implied repo rate for the remaining period before the expiry of the futures contract is
6.25%, using Eq. 7.5 (assuming 360 days a year for computational ease):
i: 97.50)= 96.005360
Implied repo rate = 96.00 x Pies 0.0625 = 6.25%

The implied repo rate of 6.25% represents the cost of carry for futures pricing. If lending/
borrowing is done at a rate different than the implied repo rate, arbitrage can be executed in
the manner shown in Table 7.5.

Pricing of T-bill Futures We just discussed a situation where the financing rate (actual repo
rate) is different from the implied repo rate; this discrepancy in prices may give rise to an arbi-
trage opportunity. For better appreciation of this situation, assume that the spot price of a deliv-
erable security is 92.00 and futures sell for $93.00. By buying today and
selling the futures, you expect to gain $1.00 on maturity of the futures contract.
A ‘no arbitrage’ condition
forces the implied repo If the financing cost for the period for £92.00 is less than %1.00, then your
rate toconverge tothe -—« actual gain would be the difference between the profit and the financing cost.
actual repo rate, and _ Alternatively, if you sell the security and buy futures contract today, you stand
therefore, determines - to lose $1.00. However, if you could invest the amount of $92.00 realized from
the pricing of futures
_ the spot sale and get more than %1 when the futures contract matures, you
contracts on T-bills.
would have an arbitrage opportunity.
 Interest Rate Futures 193

| EXAMPLE 7.4 Arbitrage with T-Bill futures

Interest rate futures on Gol 91-day T-bill with 29 days to maturity is selling at 91.88 indicating a discount yield of 8.12%. In the sp
market, the following rates are prevailing:

Discount yield, %
T-bill maturing after 29 days 91.7000
T-bill maturing after 91 days 91.5000
T-bill maturing after 120 days 91.0000

(a) What is the implied repo rate?

(b) How would an investor execute arbitrage?
(c) Calculate the profit on one contract of T-bills futures if the actual borrowing rate is 9% p.a.
Solution

(a) The implied repo rate is given by the difference between the futures price and the spot price. Here, the underlying asset is
the 120-day T-bill. The price of the 120-day T-bill would be
9 x 120
Invoice value of 120-day (just as in T-bill) T-bill = 100 — = 97.00
360
The implied repo rate is given by
Implied Repo Rate
_ Futures Price — Spot Price _ 97.970097.0000
Spot Price
— 97.0000 _ 0.0100 == 1.00%Ane

(b) The implied repo rate is 1% for 29 days, corresponding to an annual rate of 12.59%. The actual borrowing rate of 9% is less
than the implied repo rate, and, therefore, cash-and-carry arbitrage can be executed by selling the futures and buying the
underlying 120-day T-bill by borrowing the required sum for 29 days at 9%. On maturity of the futures contract after 29 days,
the underlying asset, already in hand, would have exactly 91 days to mature, and, hence, can be delivered. The invoice value
for a 120-day T-bill with a discount yield of 9% would be 2,000 x 97.00 = ¥1,94,000.
The invoice value received would exceed the amount of borrowing and the interest thereon.
(c) An amount of ¥553 per futures contract is derived as profit, as shown in Table E 7.4:
Table E 7.4 Cash-and-carry arbitrage with interest rate futures
Actions now L Cash flow, =
Sell one contract of interest rate futures on T-bills maturing 29 days later at the prevailing price —
of 91.88. With a discount yield of 8.12%, the invoice value is ¥1,95,940
Buy the underlying asset, i.e., the 120-day T-bill at a discount yield of 9%. For one contract of —1,94,000
2,000 T-bills, the invoice value is 2,000 x 97.00 = 1,94,000
Borrow for 29 days at 9% as against 8.30%. As reflected in the discount yield of 8.30%, which +1,94,000
has an invoice value of 99.3314 and an actual yield of 8.4718%.
Net cash flow, net investment
Actions on maturity of futures contract, i.e., after 29 days

1 Receive contract value under the futures contract sold +1,95,940

2 Deliver T-bill already in possession, with 91 days to mature --
3 Pay borrowing ~ 1,94,000
4 Pay interest on borrowing at 9% for 29 days — 1,387
Net cash flow, arbitrage profit + 553
 194 Derivatives and Risk Management

|EXAMPLE 7.5 Theoretical price of T-bills futures, implied repo rate, and arbitrage

Assume that today is 12 January and a March futures contract on T-bill expires on 26 March. This futures contract requires delivery
of T-bills with a face value of 7100, maturing 91 days thereafter. Assume that such T-bills are available in the market, and are
quoted with a discount yield of 9%. The futures contract is valued at $91.75. The repo rate prevailing in the market is 10% for a
period up to 75 days. Assume a 360 days in a year in all calculations. Find the following:

) The price of the T-bills

) The theoretical value of the futures contract
) The invoice price of the futures contract on the settlement day
) The implied repo rate in the futures market
) Examine the feasibility of arbitrage.
Solution

Theoretical price of T-bills futures, implied repo rate & arbitrage

Today 12 Jan
Expiry of interest rate futures on T-bills 25 Mar
No. of days remaining for futures to expire, t 73 days
(a) Finding purchase price of the underlying asset
Face value of the T-bills, V ~100.00
T-bills deliverable must mature after 91 days
Time remaining for deliverable T-bill, T 164 days
Quoted percentage yield on T-bills with 164 days to maturity, d 9.00%
Discount on deliverable bill, D = d x 1/360 4.1000
Buying price of the deliverable T-bill, P= V — D %95.9000
(b) Finding theoretical price of futures
Actual repo rate, r 10.00%
Financing cost for time till expiry of futures, rx P x t/360 %1.9446
Theoretical futures price %97.8446
Finding implied repo rate
Futures price, F 91.7500
(c) Invoice price of futures, /= 100 — (100 — F) x 91/360 %97.9146
(d) Implied repo rate, (! — P)/P x 360/t 10.36%
(e) The future is overpriced. Therefore we sell it.
5 LEU OOS

In order to eliminate arbitrage either way, futures must be priced at the spot rate plus the
actual repo rate. This can be expressed mathematically as follows:
Theoretical futures price = spot price of deliverable security
+ actual repo rate for time remaining of futures contract (7.6)

... . EVRODOLLAR FUTURES =.

~
Futures contracts on Eurodollar started trading on the CME in December
Eurodollars are not subject | 1981. They are also traded on the London International Financial Futures
to controls by the US and Options Exchange (LIFFE). Volumes of futures on Eurodollar depos-
government, andhence, its are constantly growing, because the returns on Eurodollar are deter-
Eurodollar deposit
andend _ mined by free market forces without any legal or operative constraints.
rates are competitively dé- = Fytures on Eurodollar deposits have become more popular than futures
termined by f oo é
a Eon Lhills.
 Interest Rate Futures 195

EURODOLLARS
Another short term interest rate futures contract has underlying asset of
_ Eurodollars are US
- dollars held outside the Eurodollar deposit. Eurodollar deposit is the US dollar deposit held by banks
_ USA, and constitute a that are held outside USA or by non USA banks or foreign branches of US
large supply source. banks. Eurodollar deposits came into existence during the 1950s and 1960s,
when the erstwhile USSR and East European countries parked their US dol-
lar deposits with banks in London, Paris, and other locations outside the USA for fear of their
cold war with the USA turning hot, and the possible consequence of the USA confiscating
these deposits. Since non-US banks held dollar deposits, they started lending in US dollars
to earn the spread. :
Further, in the era of the Bretton Woods exchange rate system, the flow of dollars kept
increasing phenomenally because all nations needed to export to the USA to enable them to
accumulate the maximum possible US dollars. During the Bretton Woods era, the US dollar
was virtually the only currency accepted worldwide.
US dollars outside USA became a very large market over a period of time. Because these
deposits and lending by banks in US dollars were not subject to any kind of regulation and
control by the US government, they became truer representatives of interest rates. Thus,
Eurodollar deposits and lending rates were purely determined by market forces—a perfect
market condition conducive for the development of futures markets.
These Eurodollar deposits bear interest on the basis of LIBOR (London interbank offer
rate), determined in London. The underlying asset in the case of futures on T-bills is the
T-bills. Similarly, LIBOR is the underlying interest rate for the Eurodollar. For the purpose of
settlement of futures contracts on the Eurodollar, LIBOR is determined by polling of rates by
prominent banks in London on daily basis. Of these rates few highest and lowest are rejected
and a mean of the remaining is taken as LIBOR rate. This becomes the LIBOR for settlement
purposes.

FUTURES CONTRACTS ON EURODOLLARS ©

Like futures contracts on T-bills require delivery of T-bills with a face value of US $1 mil-
lion, maturing 91 days thereafter, a futures contract on Eurodollars requires delivery of
a deposit of US $1 million that matures three months thereafter. Delivery of Eurodollar
deposits is not possible, as they are non-transferable. They cannot serve as collateral for
loans. However, this does not hamper conceptually the process of hedging, speculation, and
arbitrage. Eurodollar futures for each of these applications would be used just in the same
way as futures on T-bills.
There are two key differences between futures contracts on T-bills and on Eurodollar
deposits:
e Cash settlement: Eurodollar deposits are “non-transferable, and hence, cannot be
delivered like T-bills. Therefore, futures on Eurodollar deposits necessarily have to be
settled in cash, i.e., by exchanging the difference between the buying and selling prices.
T-bills futures can be settled by delivery, as an alternative to cash settlement.
e Add-on yield: |T-bills are discount instruments that reach face value on maturity, while
the yield on Eurodollar deposit is on an add-on basis. Interest is added to the face value
196 Derivatives and Risk Management

to arrive at the maturity value. The add-on yield is related to the discount yield, as given
by Eq. 7.7:
Discount _ 360
=
Add-on ield
yield = Se x = (cEa8)

With a discount yield of 10%, the current price of a T-bill maturing after 90 days would be
0.10 x 90
Price of T-bill = 100 A
agggd a <97.50

The actual yield would be:

LOO 975 0a G0
i
Actual Yield = 07 50 * 90 = i) 25004 0

A discount yield of 10% means an investment of €97.50 grows to ~100, while an add-on
yield of 10% simply means that an investment of 100, after 90 days, becomes %102.50.
Like all futures, Eurodollar futures are subject to marking-to-market on a daily basis. It is
done on the basis of trades in the Eurodollar futures market. Final settlement is done on the
basis of the 3-m deposit rates offered by reputed banks in London.

PRICING OF AND HEDGING WITH EURODOLLARS FUTURES

Like futures on T-bills, futures on Eurodollar deposits too are quoted on an index basis. The
price of Eurodollar futures is given by Eq. 7.8

Eurodollar futures price, F= 100 — 3-m LIBOR rate (7.8)

With price based on LIBOR, Eurodollar futures contracts are extremely useful for hedging
_ exposures that are LIBOR based. Further, pricing in terms of add-on yield
peas ofmarkettbased ther than discount yield does not create much difference, because Eurodol-
free pricing, futures : k ee :
oontracte on Brodolars lar futures are settled in cash. Therefore, the difference between prices at the
are extremely popular in entry point and the exit point becomes material.
international markets. Since LIBOR-based exposures are managed by entering swap arrange-
oo) ~ ments, which extend for protracted periods of time, Eurodollar futures
are
available for longer terms, extending to 10 years. Eurodollar futures are available for expiry
every quarter, ending in March, June, September, and December, for 10 years. Therefore,
there are 40 contracts available, corresponding to the next 40 quarters. Each Eurodollar con-
tract is for delivery of a deposit of US $1 million.
A hedging application of Eurodollar futures is illustrated in Example 7.6.
The profit/loss on Eurodollar futures for one who goes long on futures is the difference
between the initial buying price, F’, and the exit/settlement price on cash settlement. F, is
given by Eq. 7.9:
Profit/loss on Eurodollar Futures

Foror ea
initial
initial | long tion == $ $1,000,000
Ovib
position x ==
100 —" x 360
FP; 7 Fo 90
(7.9)

For inital short position: = 8 A000 00h ee ae (7.10)

100 360
 Interest Rate Futures 197

EXAMPLE 7.6 Borrower's hedge with Eurodollar futures

Three months from now, Dynamic Forging Limited (DFL) needs to raise a short-term loan of US $2 million for six months. The
current LIBOR rate is 6.50%, and a Eurodollar futures contract with three months’ expiry is quoted at $93.00 (implying an interest |
rate of 7%). DFL expects the interest rate to rise to 8%. How can DFL hedge against rising interest rates? What would be the |
effective cost if the interest rate actually rises to 8%? Further, analyse the interest cost if LIBOR actually falls to 6%.
Solution y
DFL faces the risk of a rising interest rate for its contemplated borrowing of three months. Since a futures contract provides cash L
flow based on three months and the loan required is for six months, compensation would be equal if the exposure in futures is |
for twice the actual borrowing. DFL can, therefore, sell four futures contracts equivalent to $4 million.
if LIBOR rises to 8%, the Eurodollar price would fall to $92.00. The profit on each futures contract would be
Profit/loss on Eurodollar Futures (For Short Position) = $1,000,000 x Fo ae x a
= 93:00;— 92.00 290»
= $1,000,000 x triers x cae $2,500

The borrowing cost for a 6-m loan of $2 million = 2,000,000 x 0.08 x 180/360 = $80,000
Less: Profit earned from 4 Eurodollar futures contracts = 2500 = 4 = $10,000
Effective interest paid = $70,000
70,000 360 _ Leia
Effective Interest Rate =
2,000,000 «180 0"
This is the rate implicit in the futures contract that can be locked-in now.
if LIBOR falls to 6%, the Eurodollar price would rise to $94.00. The loss on each futures contract would be
Profit/loss on Eurodollar Futures (For Short Position) = $1,000,000 x a x
2 93.00 — 94.00 | 90 _
, = $1,000,000 x 700 x 360 ~ $2,500

-The borrowing cost for a 6-m loan of $2 million = 2,000,000 x 0.06 x 180/360 = $60,000
Loss from 4 Eurodollar futures contracts = 2500 x 4 } = $10,000
Effective interest paid = $70,000
70,000
’ 360
x ee! %
Effective Interest Rate =
2,000,000 180 pOU
With a fall in the interest rate, the firm would not benefit. It still has to pay the same cost of 7%—the rate implicit in the futures
contract now.
OEE LEEEEEEEEEEEEEEEEEEE EEL,

If F,; < Fo, then an initial long position would incur a loss, while an initial short position
would make a profit. A prospective borrower is subject to the risk of rising interest rates. In
order to compensate for any loss in the amount of loan, the prospective borrower must go
short on Eurodollar futures.
Similarly, a prospective lender who fears a fall in the interest rates must go long on
Eurodollar futures.
in
Other applications of Eurodollar futures for speculation and arbitrage would be done
the same manner as for futures on T-bills.

“TREASURY BONDFUTURES

risk. How-
T-bills futures and Eurodollar futures cover short-term exposures to interest rate
must have
ever, to cover long-term exposures to interest rate risk, the underlying instruments
to protect against long-term exposure to
a long-term maturity. Futures on T-bonds are used
198 Derivatives and Risk Management

interest rate risk. Treasury bonds futures are more complex than T-bills futures or Eurodollar
futures, due to peculiarities such as the delivery process, delivery of the underlying, and the
invoice price. Various features of T-bonds are as follows.

TREASURY BONDS Ee
As the name suggests, the underlying instruments for the T-bond futures are the long-term
securities issued by the central bank of a country. The central bank issues long-term securi-
ties for a variety of purposes; one of them is to use long-term securities as measures of fiscal
and monetary policies. These securities are known as dated securities or gilts in India and
in several other countries.
Unlike T-bills, T-bonds are issued by central governments with maturity extending for as
long as 50 years. Treasury bonds carry a coupon that is usually payable semi-annually. Like
T-bills, these bonds are also regarded as free from default risk. The face value is paid on
maturity. The coupon rate reflects the interest rate prevailing at the time of issue. The coupon
rate is decided by an auction process, where investors quote a yield. Investors can quote their
yields at par, at a discount, or at a premium. Par-yield refers to the coupon rate for which the
price of a bond is equal to its par value. The coupon rate and the maturity date are specified at
the time of issue. The pricing of these instruments is expressed in relation to their face value.
On maturity, a futures contract on government bonds would require delivery of an equiv-
alent government security by the seller during the delivery period specified by the exchange
dealing with such futures. However, settlement by delivery would not arise
Futures contracts on if the initial contract is negated by an offsetting contract prior to maturity.
T-bonds are used for
Instead, the settlement would be affected by the payment to be made, on the
hedging long-term inter-
est rate risk. basis of the prices of the futures contract at the time of initial booking and
at the time of offsetting the opposite contract.

PRICING T-BONDS 22"

The pricing of T-bonds is similar to the pricing mechanism of a fixed income
security. The
price of a fixed income security is determined by discounting the future cash flows
of the
security at a rate given by the term structure of interest rates. The term structure
of interest
rates specifies the desired returns for different investment horizons. For example,
the term
structure of interest rate could be as follows:

Investment horizon (m) 6 2 18

Yields, % 6.70 | 6.00 | 6.40
Government securities ((gilts or dated securities) have a fixed coupon
rate expressed as a
percentage of the face value, and normally make semi-annual coupon
payments. For example,
a Government of India (Gol) bond with an 8% coupon that has
three years remaining for
maturity would be priced® at the discounted cash flow of the coupons
denoted by C, and the
principal at the end, denoted by R, as given by Eq. 7.11:

POS
uk SeS :
It is known as clean price, as computed on the coupon date. ‘ AL e
It changes only with change in yields, and does not take into
account the interest that accrues in the intervening period between
two coupons. The quoted price ofa bond is a clean price.
 Interest Rate Futures 199

Py= So n (l+n)y
LA
(7.11)
hack Daa
4.00
ee 4.00
4.00 Lee 4.00 RAL NL4.00 Le 4.00 Serres
°= 1.0573 *(060) *Go6a's *(06729 * 06923 * G.07290 —*102.63
The price of the bond can also be equated to its cash flow discounted at the uniform rate,
rather than the rates given by the term structure of interest rates. This uniform discount rate,
at which the price equals the projected cash flow of the bond, is called yield to maturity
(YTM), signifying the yield that would be realized by the investor if he/she buys the bond at
the prevailing price and holds it till maturity. The YTM, denoted by the r of the bond, shall
be given by the following equation:
on .00) 4.00 4.00 4.00 4.00 a 4.00
Po (1 ae ry ( a pe (1 le r)i-5 dl 4s ry? (1 ae Dee él dL nee
= 7102.63
By solving this equation, we get r = 3.51% for a semi-annual period, or 7.02% p.a. It
implies that if an investor buys the bond at $102.63 and holds it till its maturity, the realized
yield would be 7.02%. The value of the bond at any time in terms of YTM is expressed as
shown in Eq. 7.12, with r as YTM for m coupon payments, each denoted by C,
N & R

Po = ». - F ee, ma (712)
n=l ( oF aye d oF ial

For semi-annual compounding of YTM, a convention that is followed in T-bond futures

markets, the value of the bond would be given by Eq. 7.13:
2N
Po = Cc fu R = AS
ft (l¢r/2¥ (l+r)y”

FUTURES CONTRACT ON T-BONDS “7”

A long-term futures contract would have as underlying asset a T-bond whose price would
A fkures contract on _ govern the futures’ price.
T-bonds requires delivery We illustrate the T-bond futures instrument, its pricing, applications, proce-
ofalong-term bondwith dure for settlement, etc., based on the contracts traded on the Chicago Board
minimum specifications of Trade (CBOT). The principles applicable to the futures of US treasury
ne noes bonds/notes’ remain valid for any other similar futures contract having as
underlying asset a long-term debt instrument issued by any other central bank.
The fundamental differences between futures on T-bills and futures on T-bonds are (a) a
longer term to maturity, and (b) the presence of coupons (normally payable semi-annually),
which makes them complex.
A futures contract on T-bills requires delivery of T-bills that have 91 days to maturity as on
the date of expiry of the futures contract. This provision of delivery means that certain other
instruments, such as 182-day T-bills or 364-day T-bills that have 90-92 days remaining for
maturity are also eligible for delivery. On maturity, a futures contract on US T-bonds requires

°The features of US Treasury bonds and notes are same, except that they differ in their terms to maturity at the time of issue.
In the USA, instruments with maturities of less than 10 years at the time of issue are T-notes, while those with maturities
longer than 10 years are referred to as T-bonds.
200 Derivatives and Risk Management

delivery of bonds, with a face value of US $100,000, with more than 15 years remaining for
maturity. Contracts on various T-notes also have a similar range of instruments that can be
delivered. Similarly, LIFFE deals in futures contracts on British T-bonds (called gilts), which
require delivery of gilts maturing between 8.75 years to 13 years later on the first day of the
delivery month.
Futures contracts on CBOT have maturities in March, June, September, and December.

PRICING OF T-BOND FUTURES 2

Similar to the pricing mechanism for other futures contracts, the prices for T-bond futures
are also based on the concept of cost of carry. However, in the case of T-bonds, we also earn
an income in the form of accrued interest. Note that the price quoted is a clean price. The
accrued interest is the interest amount from the date of the last coupon payment to the date
of delivery. To arrive at the price payable, accrued interest is added to the clean price. Money
receivable on coupons for the period from the date of the last coupon payment to the date of
delivery would have to be paid by the buyer to the seller of the bond, because the seller is
entitled to interest for the period of his holding.
Cash-and-carry transactions in the futures market would involve (a) buying a T-bond at
the current market price, S, (b) borrowing the equivalent sum at r, and (c) selling the futures
contract on the T-bond at price F. The bond bought today is available for delivery against a
futures contract, and the sum realized in the futures contract is used to repay the borrowed
sum, together with borrowing cost. Buying the bond would entitle one to the accrued inter-
est on the bond. There would be arbitrage if the sum receivable against the futures contract
exceeds the net cost of borrowing (financing cost less accrued interest).
Consider this underlying asset for a futures contract: a Gol 10-year security with an 8%
coupon and 45 days to maturity, priced at ¥96.50. With 10% financing cost, cash-and-carry
arbitrage can be executed as follows to yield a profit of 0.2760:

zg
Spot price of the bond (at YTM of 8.60%) = 96.0291
Accrued interest for 45 days = 4 X 45/182 = 0.9890
Cost of financing for 45 days = 96.0291 X 0.10 X 45/365 See yalWate1S)
Net amount to be paid = 96.0291 + 1.1839 — 0.9890 = 96.2240
Amount receivable against the futures contract sold = 96.5000
Arbitrage profit = 0.2 /60
For no arbitrage:
Futures price = spot price + cost of financing — accrued interest (7.14)

The futures contract price represents a repo transaction—selling a security and buying
it back after some time at a price determined today. The futures price, therefore, implies
a repo rate that may be compared with the financing rate to know if the futures contract
is correctly priced. Remember that we have to account for accrued interest in the case of
bonds, which is not the case with futures on T-bills, which do not incorporate coupon dis-
counts. Modifying Eq. 7.14, the implied repo rate in the spot and futures prices is 12.33%,
as computed here:
 Interest Rate Futures 201

Implied Repo Rate

_ Futures price — Spot price + Accrued interest 365
Bi Spot price No. of days remaining for futures
_ 96.50: = 96.03 + 0.9890 369 9 1933 = 12.33% (7.14)
96.03 45 Te
Reverse cash-and-carry transactions would involve (a) selling the T-bond for cash, (b)
investing the cash so realized, and (c) buying futures on T-bond.

Conversion Factor
We know that in any financial futures market, a requirement for delivery forces the conver-
gence of the futures price and the spot price. A futures contract on any long-term securities
would warrant a delivery of the underlying asset. However, government securities issued at
various points of time have different coupon rates and maturities, in consideration of prevail-
ing economic conditions and the requirements of the issuer. For futures markets, the underly-
ing product needs to be standardized, and therefore, futures exchanges would need to identify
some government security(ies) on which futures contracts may be traded. This standardized
futures contract on a specific security would not be available for delivery.
Recognizing the need for delivery of the underlying asset, the exchange would have to provide
for some flexibility in delivery of the asset, subject to the fulfilment of some minimum condi-
tions. The CBOT prescribes the delivery of any T-bond that has more than 15 years to maturity
at the time of delivery, thereby making several government securities eligible for delivery. Sim-
ilarly, there has to be a specified time/duration when the asset can be delivered. The CBOT
provides flexibility by allowing delivery on any day in the month of closing of the contract.
Despite having the same face/nominal value, the price of all the securities would not be
the same, as securities issued at different points of times have varying coupon rates and
maturities. We know that the spot price of bonds is dependent upon, inter alia, the coupon
rate and the time remaining for maturity. A bond with a higher coupon is worth more than
a bond with a lower coupon, given that all other features of the two bonds remain the same.
For example, if a futures contract requires delivery of a bond with a 6% coupon, a seller who
chooses to deliver a bond with an 8% coupon would need adjustments to the price for making
the contract good. The seller who delivers a high coupon rate bond needs to be compensated
more than the seller who chooses to deliver the bond with a lower coupon.
The compensation that the seller must get for delivery of the asset is weighed in terms
of the standard contract. Each exchange specifies government securities that are eligible for
delivery against a futures contract and the relative value of each in terms of the standardized
asset underlying the futures contract. For example, Table 7.6 provides a list of British govern-
ment bonds and their price factor adjustments that could have been delivered against LIFFE
futures contracts maturing in June 2009.
Many deliverable bonds
To simplify the pricing of futures contracts, the price factor is com-
_ may be available in the
market, and are adjusted puted on the basis of a 6% coupon rate. If bonds were perpetuities, the
__ for price using conversion _ price factor would simply be the ratio of the coupon rate for the bond that
_ factors decided peri- is being delivered and 6%. If the coupon rate were 8%, the price factor
_ odically by the relevant would be 1.25, as a perpetual bond with an 8% coupon would trade at 1.25
exchanges. imes the value of a 6% bond. Since government securities have definite
202 Derivatives and Risk Management

maturities, any upward or downward adjustment for the price paid is made by the conver-
sion factors.
Table 7.7 presents a list of US T-bonds and the applicable conversion factors that are
deliverable on T-bond futures contracts of CBOT for contracts maturing from March 08 to
June 09.

Table 7.6 Price factors and accrued interest at LIFFE

Long Gilt Contract (6% Coupon) - Price Factors and Accrued Interest Delivery Month: June 2009
Coupon Redemption Daily accrued Initial accrued
5.00 7 Mar 2018 0.9325024 13.586957 1154.891304
4,50 7 Mar 2019 0.8902618 12.228261 1039.402174
4.75 7 Mar 2020 0.9018

Table 7.7. 6% Conversion factors for T-bond futures at CBOT

Coupon | Issuedate | Maturity soe oe

Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09
4%/, 02-15-08 02-15-38 0.7757 0.7765 0.7771 0.7779 0.7786 0.7794
4\. 02-15-06 02-15-36 0.7984 0.7992 0.7998 0.8007 0.8013 0.8022
4% 02-15-07 02-15-37 0.8297 0.8303 0.8308 0.8315 0.8320 0.8327
> 08-15-07 05-15-37 0.8633 0.8637 0.8642 0.8646 0.8652 0.8656
5% 11-16-98 11-15-28 0.9122 0.9127 0.9133 0.9138 0.9145 0.9150
5% 02-16-99 02-15-29 0.9116 0.9122 0.9127 0.9133 0.9138 0.9145
WP 02-15-01 02-15-31 0.9229 0.9234 0.9237 0.9242 0.9245 0.9251
5\e 08-17-98 08-15-28 0.9417 0.9422 0.9425 0.9430 0.9433 0.9438
6 02-15-96 02-15-26 0.9999 1.0000 0.9999 1.0000 0.9999 1.0000
6'/, 11-17-97 11-15-27 1.0143 1.0140 1.0141 1.0138 1.0139 1.0136
6", 08-16-99 08-15-29 1.0148 1.0148 1.0146 1.0146 1.0144 1.0144
6% 08-16-93 08-15-23 1.0246 1.0245
6% 02-15-00 05-15-30 1.0303 1.0300 1.0300 1.0297 1.0296 1.0293
6, 08-15-97 08-15-27 1.0424 1.0422 1.0418 1.0416 1.0411 1.0409
bY 11-15-96 11-15-26 1.0554 1.0549 1.0546 1.0540 1.0537 1.0532
6°/, 02-18-97 02-15-27 1.0697 1.0693 1.0686 1.0682 1.0676 | 1.0671
6% 08-15-96 08-15-26 1.0824 1.0819 1.0814 1.0806 1.0798 1.0792
6//, 08-15-95 08-15-25 1.0931 1.0925 1.0915 | - 1.0909 1.0899 1.0892
7% 08-15-94 11-15-24 1.1557 1.1542 1.1529 deoie 1.1500 1.1484
lar 02-15-95 02-15-25 1.1701 1.1687 1.1671 1.1657 1.1640
Source: www.cbot.com,
last acc
 Interest Rate Futures 203

The conversion factors for deliverable bonds are determined against standard bonds with
a 6% coupon rate; they are greater than 1.00 when the coupon is greater than 6% and less
than 1.00 when the coupon is less than 6%.
The invoice amount is dependent upon the conversion factor and the accrued interest on
the bond till the date of actual delivery. Exchanges normally allow the whole of the named
month for delivery. For example, a June 2009 futures contract may be delivered on any busi-
ness day of June 2009.

Finding Conversion Factors

The conversion factor system exists to enable a level playing field for all bonds.
As stated earlier, the conversion factor for a deliverable bond is its relative value with
respect to the value of the underlying asset of the futures contract. An interest rate futures
contract on T-bonds assumes a coupon of 6%, and, therefore, the conversion factor reflects
the value of the bond at a YTM of 6%. The CBOT provides conversion factors for deliverable
bonds for unit face value as follows:
e For the bonds being delivered, find the completed number of semi-annual periods, N,
and the remaining number of months, m, till maturity from the first day of the delivery
month of the contract.
e Ifthe remaining number of months, m, is less than a quarter (three months), the conver-
sion factor is equal to the value of the bond immediately after the coupon date, which
is equal to:
Conversion factor = price of the bond immediately after coupon, C
= C/2 X PVIFA (3%, N) + PVIF (3%, N)
e If the remaining number of months, m, is more than a quarter (three months), then the
price of the bond is increased by one coupon payment and discounted for one quarter
at 6% (3% semi-annual), less accrued interest for one quarter, Al. Mathematically,
Conversion Factor = aR
tlotee mC 2), = Accrued Iiterest
1.06°°
Calculations for the conversion factors for futures contracts expiring in June, September,
and December 2008 for a deliverable bond 6-1/4 maturing in November 2026 are demon-
strated in Table 7.8.

Table 7.8 Conversion factor for the same bond for three futures contracts at CBOT

aoe Whole-number of Price. P Coupon, Present Accrued Conversion |

periods left, N : C/2 na value interest factor

June 2008 contract 5 1/2 1.0546 0.0325 1.0711 0.0163 1.0549

Sept 2008 contract 2 1/2 1.0546 oe — — 1.0546

Dec 2008 coniract 3 1/2 1.0537 0.0325 imo! .0703 0.0163 1.0540

The following values are used to arrive at the price, P

36 periods ai 35 periods

PVIFA (3%, N) 21.8323 21.4872

PVIF (3%, N) 0.3450 0.3554 /

204 Derivatives and Risk Management

The values may be verified from Table 7.7.

CHEAPEST-TO-DELIVER BOND ©
The price factor (as it is referred to at LIFFE) or conversion factor (as it is referred to at
The prices of bonds _ CBOT) for a specific deliverable bond is an attempt t to adjust the p price dif-
to adjus
and conversion factors ference between the asset being delivered and the asset underlying the futures
normally imply that not all = contract. However, the actual price of the asset in the market may not con-
bonds would be equal. = form to the adjustment of the price or conversion factor as prescribed by the
A seller of futures oe exchange. Given the menu of bonds and their conversion factors, the seller
have to decide which
among the deliverable _ of a futures contract would have the option of choosing amongst the bonds
bonds is cheapest to _ eligible for delivery. The seller would deliver the bond that is cheapest-to-
deliver. _ deliver (CTD), depending upon the actual price prevailing in the market.
ee ~The invoice price for a nominal value of 100 that the seller of a futures
contract would receive is determined such that,
Invoice price = settlement price X conversion factor + accrued interest
The bond the seller chooses to deliver would be acquired in the market at the prevailing
market price, and the cost would be,
Cost of acquiring the bond = current market price of the bond + accrued interest

terest Rate Futures

India: No interest in interest rates
Interest rate derivatives are perhaps the largest segment of traded derivatives the world over. According to an estimate of the
Bank of International Settlement in March 2011, interest rate derivatives comprised about 85% of total derivatives turnover on
organized exchanges, based on notional principal.
For the first time in India, interest-based derivatives, i.e., interest rate futures were launched in 2003 by the NSE. The pricing
of the futures was based on the zero coupon yield curve, a practice unique to India. Though more scientific, it was considered too
complex and non-transparent, and there were apprehensions about modelling errors. The major users of interest rate derivatives,
i.€., the banks under the control of the Reserve Bank of India, were not allowed to trade in interest rate futures. Interest rate
futures provide hedging against the varying yields on debt securities mostly held by banks. Since banks classified such securities
under held-to-maturity (HTM) to avoid capital adequacy problems, they did not face interest rate risk on such securities.
A second attempt was made in 2009 to introduce interest rate futures with a 10-year 7% notional with coupon payable semi-
annually. Consistent with global practice, delivery-based settlement was provided for. Despite the removal of product deficiency
and opening up of the market by allowing financial institutions to participate, trading did not pick up. It was apprehended that
illiquid securities that fulfilled the requirements for deliverability were not really liquid enough. There apparently was a short
squeeze’, a phenomenon where deliverable grades of securities are in short supply. Under physical settlement, there are several
instruments that can be delivered, and the seller has the option to choose the security, based on what is cheapest to deliver.
Though the provision for physical settlement integrates the spot and derivative markets better, success is dependent upon
how
vibrant the spot markets for interest rate products are.
After long deliberation, the third and latest attempt has been made recently to provide a suitable platform for managing interest
rate risk, On 4 July 2011, interest rate futures were introduced with 91 -day T-bills as underlying. Settlement price
would be based
On auction in the spot market, conducted by the Reserve Bank of India, and positions would be settled in cash. It was
hoped that
this time, participants would show more interest. Unfortunately, it has met the same fate as that of two previous attempts.
We need to create much more awareness on the efficacy of interest rate futures as a hedging tool against interest
rate volatil-
ity. More money from retail investors must be canalized to institutions such as mutual funds, insurance companies,
and pension
funds, so that they become much bigger in size.
 Interest Rate Futures 205

If the invoice price to be received by the seller exceeds the cost of acquisition, the seller of
the futures contract stands to gain. Where the profit in doing so is greatest, the seller would
have the choice of selecting one amongst the bonds eligible for delivery. The profit/loss for
the seller choosing to deliver would be
Profit/loss = invoice amount — cost of acquisition
= settlement price X conversion factor — current market price
Though profit is the unfailing guide for determining the CTD bond, there are certain rules
of thumb that help to quickly determine the bond that is CTD. Some of these rules of thumbs
are as follows:
e When the market yield < 6%, deliver short maturity—high coupon
> 6%, deliver high maturity—low coupon
e Ifthe yield > 6%, deliver bond with highest duration
< 6%, deliver bond with lowest duration
e Deliver the bond with least theoretical price
e Deliver the bond with highest implied repo rate

INTEREST RATE FUTURES IN INDIA

Futures contracts on interest rates were introduced in India at the NSE and the Bombay Stock
Exchange in June 2003. The NSE had three contracts with the following underlying assets:
e 3-m T-bills
e 10-year zero coupon
e 10-year government security, 7% semi-annual
Exchange-traded interest rate derivatives are supposed to provide the much-needed depth
to
in the market, eliminating counterparty risk. Trading in these instruments has left much
be desired and has not attracted active participation for several reasons, including the meth-
odology for the settlement price of futures. Some of the major reasons that trading in interest
of the
rate derivatives has not taken off to the desired level include (a) insufficient volume
hold-
instruments available in the government securities debt markets and (b) concentrated
ing amongst a few financial institutions, banks, etc. Further, a significant proportion of these
category investment and
government securities may be classified as held-to-maturity (HTM)
on long
as such do not face any interest rate risk, obviating the need for hedging. Contracts
term did not find markets deep enough.
—
On as 31 August 2009, the NSE in India re-introduced interest rate futures on Gol security
If the
with a notional bond of maturity of 10 years, with a 7% coupon payable semi-annually.
the inverse
price of the bond is equal to 7100, it would denote a market yield of 7%. Given
indicates a yield lesser than
relationship of bond prices with yield, a price greater than 7100
_ 7% and a price of the notional bond of less than 7100 signifies market yields
_Interest rate futures in
in excess of 7%. As of now, there are only two products for interest rate in
- India are based on
_ notional Gol securities the exchanges in India—T-bills futures meant for covering short-term risk
with 10 years to maturity, (discussed earlier) and T-bond futures for covering long-term interest rate
bearing coupons of 7% risk. Yet another class of futures are on reference rates such as LIBOR, JIBOR
_ payable semi-annually. (Jakarta interbank offer rate), etc. They have not yet been introduced in India.
206 ‘Derivatives and Risk Management

Table 7.9 Interest rate futures—contract specifications

Symbol 10YGS7
Unit of trading 1 lot, equal to notional bonds of face value of €2 lakh

10-year notional coupon bearing Gol security (notional coupon 7% with semi-annual
Underlying
compounding)
Tick size 0.0025
Four fixed quarterly contracts for the entire year, ending in March, June, September,
Contract trading cycle
and December
Last trading day Seventh business day preceding the last business day of the delivery month
Quantity freeze 501 lots or greater
Base price Theoretical price of the 1st day of the contract On all other days, DSP of the contract
Price operating range +2% of the base price
Initial margin SPAN-based margin
Extreme loss margin 0.3% of the value of the gross open positions of the futures contract
Daily settlement marking to market. T + 1 in cash
Settlement
Delivery settlement. In the delivery month, i.e., the contract expiry month
Daily settlement price Closing price or theoretical price
Mode of settlement Daily settlement in cash
Deliverabie grade securities Gol securities
The conversion factor would be equal to the price of the deliverable security (per
Conversion factor rupee of principal) on the first calendar day of the delivery month, to yield 7% with
semi-annual compounding
Invoice price Daily settlement price times a conversion factor + accrued interest
Last delivery day Last business day of the delivery month
Intent to deliver
WET HHT OE

The contract specifications for interest rate futures at NSE are given in Table 7.9.

HEDGING WITH INTEREST RATE FUTURES |

Treasury bond futures are mainly used by institutional investors. The hedging principle with
futures on T-bonds remains the same, i.e., taking an Opposite position in the futures to that
of the spot market.
Assume that a portfolio manager is long on a portfolio of bonds. With a rise
Rising yields erode port- in the interest rates, the value of the portfolio would reduce, posing the risk of
folio values; this risk of a loss in market value of the portfolio. He/she could hedge the risk of losing
diminishing value can be _ the value of the portfolio
by taking a short position on futures on government
covered by going short on
bonds. When the interest rates do indeed go up, the value of the portfolio
would fall, and so would the value of the futures contracts. The second leg
 Interest Rate Futures 207

of the transaction, 1.e., buying the futures contract, would result in a gain, partially or fully
offsetting the likely loss in the value of the portfolio of bonds.

‘Hedge Ratio
To what extent the loss in the value of the portfolio would be offset by the gains in the futures
position depends upon the position taken in the futures contracts and the value of the port-
folio; this is best represented by the hedge ratio. The hedge ratio in turn would depend upon
the sensitivities of the portfolio value and the futures contracts to changes in interest rates.
Since portfolios consist of long-term bonds and bear periodic coupons, the risk of interest
rate change effects on the value of a long-term portfolio needs to be matched with futures
contracts based on similar instruments. Futures on T-bills, which are zero coupon instru-
ments, do not suit the requirements of hedging of a portfolio consisting of coupon-bearing
long-term instruments. Where the asset underlying the futures contract and the cash position
is the same, the optimal hedge ratio is one. In the case of a portfolio of bonds, the optimal
hedge ratio would not be equal to 1, due to the different sensitivities of the values of the
assets underlying the futures contract and of those in the cash position.

Duration and Modified Duration

A futures contract, being based on a notional bond, implies that it cannot be satisfied with
_ the delivery of the underlying asset. Instead, the futures contracts could be
The duration of abondis satisfied with the delivery of any permissible bond that meets the require-
the measure of sensitivity _
of its value with respect to | ment of the exchange. The seller of the futures contract has the option of
changes in interest rates. | Choosing the bond to be delivered. Logic dictates that the seller would choose
os ee ~ the CTD bond. Therefore, a position in futures can at best be regarded as a
position in CTD bonds, rather than as a position in a notional bond that is traded.
By what amount does the value of a portfolio of bonds change with changes in the inter-
est rates? The question is answered by a commonly known statistic of bonds called duration.
The duration ofa bond is obtained by dividing the time-weighted discounted cash flow at the
current YTM by the price ofthe bond. It is given by Eq. 7.15.
Zt Xx DEF
Duration of the bond, D = a G15)
0
where f = time of the cash flow of the bond
DCF, = cash flow at t discounted at YTM of the bond
Po = current price of the bond, signifying its YTM
The duration of the bond represents the approximate change in the value of the bond for
a 1% change in the YTM. A better approximation 1s obtained by modified duration (MD),
given by Eq. 7.16. |
D
Modified Duration, MD = ieee

D
For semi - annual payment m = 2 and MD = —
ae otf eo
208 Derivatives and Risk Management

where D = duration of the bond

r = YTM of the bond
m = number of coupon payments in a year (2 for semi-annual payments)
the value of the bond with the YTM,
The negative sign indicates the inverse relationship of
i.e., value of the bond decreases when the YTM rises.
Table 7.10 demonstrates the computation of the bond value, its duration, and the MD for
a bond with a 7% semi-annual coupon and 10 years to maturity ata YTM of 8%.

Table 7.10 Bond price and duration

Derlod. 1 Cash flow of periodic |Present value |Durationofthe bond | New YTM = YTM = 0.1% |
. : coupons and principal () | at YTM of os (Time x DCF) 8.10% - 7.90%

| 3.50 3.3654 1.6827 3.3638 3.3670

@ 3.50 3.2359 3.2359 3.2328 3.2391
3 3.50 3.1115 4.6672 3.1070 3.1160
4 3.50 2.9918 5.9836 2.9861 2.9976
5 3.50 PASAT 7.1919 2.8698 2.8837

6 3.50 2.7661 8.2983 2.7581 2.7741

7 3.50 2.6597 9.3090 2.6508 2.6687
8 300 2.5574 10.2297 2.5476 2.9673
9 3.50 2.4591 11.0657 2.4484 2.4697
10 3.50 2.3645 11.8224 2.3531 2.3759
11 3.50 2.2735 12.5044 2.2615 2.2856
12 3,50 2.1861. 13.1165 PAIRS 2.1987
13 3.50 2.1020 13.6631 2.0889 eos
14 3.50 2.0212 14.1481 2.0076 2.0348
is 3.50 1.9434 14.5757 1.9295 19575
16 3.50 1.8687 14.9494 1.8544 1.8831
17 3.50 1.7968 15.2729 1.7822 1.8116
18 3.50 1.7277 15.5493 1.7128 1.7427
19 3.50 1.6612 15.7819 1.6461 1.6765
20 | 103.50 47.2360 472.3605 46.7841 -47,6925
Value of the bond 93,2048 92,5583
Time x PV of cash flow 675.4082
Duration of the bond 7.2465
MD of the bond 6.9678
New price of the bond based on duration
With 0.1% increase in YTM 92.5554
ith 0.1% decrease in YTM 93.8543
ETT
 Interest Rate Futures 209

| EXAMPLE 7.7. Bond price, duration, and modified duration

AA bond with three years remaining for maturity, bearing a semi-annual coupon of 10%, is trading at a YTM of 12%. Find out the
value of the bond, its duration, and its modified duration (MD).
Solution
With cash flows of the bond for the remaining six coupons, a principal of ¥100 at semi-annual intervals, and a discount factor of
12% (6% semi-annual), the value, duration, and MD are worked out as follows:

Period, t 2 3 4
Cash flow (2) 5.00 5.00 5.00 105.00
Present value at 12%, DCF (®) 4.7170 4.4500 4.1981 3.9605 74.0209 95.0827
tl2 x DCF 2.3085 4.4500 6.2971 7.9209 222.0626 202.4299
KW"...
Value of the bond (%) 95.0827
Duration (years) 2.6548 L
MD (years) 2.5046
The sum of the present values of the cash flows of the bond, i.¢., €95.08, represents the current value of the bond. L
The product of time and the present values divided by the value of the bond is its duration, which is 2.65 years. The MD is 2.50 L
years. L

The last two columns of Table 7.10 also compute the price with a change
The duration ofabondis
computed by dividing the | in the YTM of +0.1%, ie., at 7.9% and 8.1%. The value of the bond could
_ time weighted cash flows also be obtained by MD with a great degree of accuracy for small changes
ofthe bond byitscurent in the YTM. The duration of the bond is 7.2465 years. The MD is 6.9678
a years (7.2465/1.04). The value 6.9678 signifies that if the YTM changes by
1%, the value of the bond changes in the opposite direction by approximately
6.9678%. The smaller the change, the better is the approximation. For a 0.1% change in
the YTM, the value would change by 0.69%. The value of the bond at a new YTM, which
changes by AYTM expressed as a decimal, is given as follows:
New value = value at old YTM X (1 — MD X AYTM)
The values of the bond at the new YTMs of 8.1% and 7.9% work out to 792.56 and $93.85,
respectively, when computed using MD; these values are fairly close to the actual values
worked out on the basis of new YTM the last 2 columns of Table 7.10.

Optimal Hedge Ratio: Duration-based Hedging

While hedging with futures on bonds, the consideration of changes in value has to be viewed
in terms of changes in the value of the bond likely to be delivered against the futures con-
tract. Therefore, one has to make a fair judgement right at the time of the inception of the
hedge as to which bond is likely to be delivered when the hedge gets lifted. Since there are
many deliverable bonds, there exists the additional dimension of the risk of the actual bond
delivered being different from the one perceived at the inception of the hedge. Since this risk
is nominal, it may be ignored in determination of the optimal hedge ratio.
The optimal hedge ratio, i.e., the position in futures on T-bonds, would be one that offsets
the changes in the value of the portfolio of bonds. It is expressed as
Change in value of bond portfolio = 4 < change in value of T-bond futures
210 ‘Derivatives and Risk Management

The change in the value of the bond portfolio is a function of its duration. The property
_ of additivity of duration comes in handy while computing the duration of a
The optimal hedge ratio : portfolio of bonds. The duration of a portfolio of bonds is the weighted
for a position in long-term
futures depends upon the average of the durations of the bonds comprising the portfolio. With this,
durations of the bonds we may treat the portfolio of bonds as a single bond, with duration equal to
in cash position and the the weighted average. If B is the value of the bond ata YTM of rg and MD;
perceived CTD bond in is the MD, then any change in the value of the portfolio is worked out as
the futures contract.
follows:
Change in value of bond portfolio, AB = Value X Arg X MD
; = B X Arg X MD,
= BX Arg X Dzg/(1 + rp/mp)
We analyse the changes in the value of the futures in terms of changes in the values of the
CTD bond that would be delivered in fulfilment of the futures contract. If G is the value of
the CTD bond at a YTM of rg and MDg is the MD, then the change in the value of the CTD
bond is
Change in the value of CTD bond (government security), AG
= value X Arc x MD
= G X Arg X MDg
= G X Arg X Dg/U + rg/me)
In terms of futures contracts on T-bonds, the value of CTD is expressed as
G = futures price, F X conversion factor
Therefore, the change in value of the CTD bond, AG = AF X conversion factor
Change in the value of bond portfolio _ AB
Hedge ratio = Change in value of futures on treasury bonds AF
edge ratio
AF
me
x Conversion factor
~ AG
_ BX Arg X Dz : (1 + r¢/mg)
x Conversion factor
GX Arg X Dg (1 + rp/mp)
Assuming that the change in YTMs of the bonds in the portfolio and the CTD bonds are
equal, i.e., Arg = Arg, and ignoring the differences in frequency of coupon payments, i.e.,
Mg = Mc = 1, we get a hedge ratio as in Eq. 7.18.

(Fe

EXAMPLE 7.8 Hedging with T-bond futures

A mutual fund is holding bonds worth 5.00 crore. The YTMs in the next three months are expected to rise. The portfolio of bonds
has a duration of 6.63 years. Futures contract on notional 10-year, 7% semi-annual Gol security is trading at 104.3425. The CTD
. Gol security is expected to have a duration of 7.72 years. How many contracts should the mutual fund trade to hedge against the
risk of rising yields? Assume that the YTMs of the CTD bond and the bonds in the portfolio are the same.
Solution
Price in the futures market for a bond with a face value of 7100 = %104.3425
Value of one futures contract (bonds with total face value of %2,00,000) = 104.3425 x 2000 = %2,08,685
Therefore, the number of interest rate futures contracts that must be booked as per Eq. 7.18 are:
BX Dg _ (1+ Fe) _ 5,00,00,000 x 6.63
Hedge Ratio = FX De x (1 +1) 208685 X772 ~ 205.766 say 206 contracts
 Interest Rate Futures 211

ey) Deed Lest a)

Hedge Ratio = x Conversion factor (GAWD
Gea Des AU sais)
In terms of the futures price, the hedge ratio becomes
Bax De (ere)
Hedge Ratio = (7.18)
Po Doe. leas)

SOLVED PROBLEMS
SP 7.1: Hedging with T-bills futures
Wood Craft Ltd requires funds of %1 crore for execution of an order. This amount may need to be borrowed after two months. The
requirement of funds will be for a period of three months. The bankers of Wood Craft Ltd would provide the funds at twice the yield
of T-bills prevailing at the time of availing of the loan. The current discount yield in T-bills is 6.70%, but 2-m futures on T-bills are
suggesting a yield of 7.30%. Wood Craft Ltd is concerned about the increasing cost of borrowing. What action can Wood Craft Ltd
initiate to safequard itself? Evaluate the position if after two months the discount yield on the T-bills is (a) 7.00% and (b) 8.00%.
Solution
As a hedging strategy, Wood Craft Ltd must sell interest rate futures on T-bills today, expiring two months later at the prevailing
rate of ¥92.70 (100 — 7.30). The value of the futures contract would be double.the amount required to be borrowed. They must sell
futures worth 2.00 crore. When funds are actually required after two months, the firm must buy the futures back and borrow from
a bank. By doing so, the firm would lock-in a borrowing rate of 14.60% (2 x 7.60%).
If Discount Yield on T-bills are at 7.00%
The futures would be priced at ¥93.00, and T-bills would quote a discount yield of 7.00%, which would govern the actual bor-
rowing rate.
Futures on T-bills—sold 92.70
Futures on T-bills—bought %93.00
Loss of futures : %0.30
Amount to be paid on 2 futures contracts = (92.70 — 93.00) x a x2 0.15
Annualized cost paid on futures = 360/90 x 0.15 %0.60
Borrowing cost = 2 X 7.00% 14.00%
Effective cost of borrowing 14.60%
lf Discount Yield on T-bills Rises to 8.00%
The futures would sell for 92.00, and T-bills would quote a discount yield of 8.00%, causing a borrowing cost that is equal to
16%. A position in futures helps to bring down the cost to 14.60%.
Futures on T-bills—sold %92.70
Futures on T-bills—bought %92.00
Gain of futures 0.70
90
Amount to be paid on 2 futures contracts = (92.70 — 92.00) x 360 x2 0.35
Annualized benefit on futures = 360/90 x 0.35 1.40
Borrowing cost = 2 X 8.00% 16.00%
Effective cost of borrowing 14.60%

SP 7.2: Invesior’s hedge with Eurodollar futures

Three months from now, American Investors Fund (AIF) needs to invest US $5 million for three months. Currently, the LIBOR is
6.50%, and a Eurodollar futures contract with three months to expire is quoted at $94.00 (implying an interest rate of 6%). The AIF
expects the interest rate to fall to 5.50%. How can AIF hedge against falling interest rates? What would be the effective cost if the
interest rate actually fell to 5%? Further, analyse the interest cost if LIBOR actually rose to 7%.
Solution
The AIF faces the risk of falling yields. It can therefore buy five Eurodollar futures contracts of US $1 million each at $94.00 to cover
-the exposure of US $5 million and lock-in a return of 6%.
212 Derivatives and Risk Management

be:
If the LIBOR fell to 5%, the Eurodollar price would rise to $95.00. The profit on each futures contract would
BIR 90
Profit/loss on Eurodollar Futures (For long position) = $1,000,000 x 100 ox 360
\
95.00 — 94.00 | 90 _
= $1,000,000 x 100 He 360 $2500

The return on $5 million = 5,000,000 x 0.05 x 90/360 = $62,500

Add: Profit earned from five Eurodollar futures contracts = 2500 x 5 = $12,500
Effective interest earned = $75,000
acm 75,000 360 _ -
Effective interest rate = 5,000,000 x 90 6.00%

This is the rate implicit in the futures contract that can be locked in now.
if LIBOR rose to 7%, the Eurodollar would sell for $93.00. The loss on each futures contract would be
F, — F 90
Profit/loss on Euro dollar Futures (For long position) = $1,000,000 x es ox 360
—

93.00 — 94.00 90 _
= $1,000,000 x 700 x 360 $2500

The return on $5 million = 5,000,000 x 0.07 x 90/360 = $87,500

Less: Loss from five Eurodollar futures contracts = 2500 x5 = $12,500
Effective interest earned = $75,000
ah _ 75,000 360 -
Effective interest rate = 5,000,000 Xs 90 7 6.00%

SP 7.3: Conversion factor and invoice price

Assume that the seller of an interest rate futures contract decides to deliver a 6.25% Gol security maturing in 2026 against the futures
contract, expiring in December 2009. He/she notifies his/her intentions to deliver on 10 December with the last settlement price of
the futures at 92.5575. The conversion factor for the bond for December 2009 delivery is 0.9230. Each futures contract at NSE is
for ¥2,00,000 (face value of bonds). He would deliver the bonds on 12 December 2009. The coupons for the Gol security chosen for
delivery are paid on 20 November and 20 May each year. What is the invoice price of the bonds?
Solution
The invoice price is given by
Last settlement price of futures < conversion factor + accrued interest
Contract size = bonds with face value of €2,00,000, i.e., 2000 bonds
Accrued interest is computed as follows:
Last coupon payment made = 20 November 2009
Next coupon payment due = 20 May 2010
Number of days between successive coupons = 181
Delivery date for the bond = 12 December 2009
Number of days since last coupon = 22
Amount of coupon per futures contract = 3.125 X 2000 = %6250
Accrued interest = 6250 x 22/181 = 3759.67
Invoice price per contract = 92.5575 X 0.9230 2000 + 759.67
= 1,70,861.15 + 759.67 = %1,71,620.82

SP 7.4: Hedging with T-bond futures

A mutual fund is holding a 15-year 12% bond trading at 107.2675 at a YTM of 11%, with a duration of 7.54 years. To meet its
redemption requirements, three months later, it needs to sell the bonds worth 750 lakh. The yields in the market are expected to
rise, Causing a decline in the market value of the bonds. If this happens, the fund would have to sell more bonds. A 3-m interest rate
futures contract at NSE is trading at ¥77.6150 (equivalent to a YTM of 10.70%). The bond likely to be delivered at the end of the
futures contract is a 12-year 14% bond selling at a YTM of 13%, with a duration of 6.62 years. How can the mutual fund hedge its
position through interest rate futures at NSE? Examine the scenario if the yields go up by 1.50% flat for all maturities.
 Interest Rate Futures 213

Solution
The mutual fund is facing the risk of loss due to rising yields. If the yields indeed go up, the price of the futures contracts would fall.
Therefore, in order to achieve a gain from the futures to offset the likely loss in the portfolio value, the mutual fund must sell the
futures contracts now. The number of futures contracts that needs to be sold is calculated as follows:

Price of futures contract = <77.6150 .

Value of one futures contract (bonds with face value of %2 lakh) = 2000 x 77.6150 = 21,55,230
The number of futures contracts to be sold
BX Dp 50,00,000 x 7.54
(1 + fe) 1.13
Hedge Ratio = rp 37.34 say 37 contracts
FXDe (+i) 1,55,230 x 6.62
If the YTM increases by 1.50% flat across all maturities, the futures price would be %69.9725 (for a YTM of 12.30%) and the bond
price would be €96.6500 (for a YTM of 12.50%).
At the end of the hedging period of three months the mutual fund would buy back the futures. The gain from 37 contracts would be,
(77.6150 — 69.9725) x 2000 x 37 = %5,65,545

For funds of 50 lakh the value to be obtained from selling the bond would now be,
50,00,000 — 5,65,545 = %44,34,455
The number of bonds that need to be sold = 44,34,455/96.65 = 45,882
The mutual fund is hedged in terms of the number of bonds that it needs to sell, as can be seen from the following:
Number of bonds that need to be sold if the YTM stays the same = 50,00,000/107.2675 = 46,613
Number of bond that need to be sold if it remains unhedged = 50,00,000/96.6500 = 51,733

SUMMARY
Interest rate risk is faced by almost all firms, whether they are bor- interest rates reflected in the prices of futures. Arbitrage with
rowing or investing. More predominantly, banks and financial inst!- T-bills futures is based on the implied repo rate, the reflected
tutions are subject to greater interest rate risk, as all their assets “price of T-bills in the spot market and futures on them. A repo
and liabilities are dependent upon the interest rate scenario. transaction is selling and buying back of securities at prices fixed
Besides the forward rate agreement, another instrument to now. If the actual repo rate is lower than the implied repo rate,
cover short-term interest rate risk is the futures contract on then cash-and-carry arbitrage by selling interest rate futures and
T-bills. While the FRA is over the counter, futures on T-bills are later buying them back would yield certain profits. For an actual
exchange-traded, eliminating the counterparty risk and making repo rate higher than the implied repo rate, reverse cash-and-
entry and exit easier for users, Futures contracts are prevalent carry arbitrage can be executed.
on T-bills and not on any other corporate debt instruments, The futures contract on Eurodollars is another short-term
because they are available in plenty, are issued trom the same instrument priced in terms of the LIBOR rate. Eurodollars are
source, and contain no default risk. Though not very popular in deposits of US dollars held outside USA, are free from all kinds
india, they are very widely traded internationally. of regulatory controls, and, thereby, are supposed to reflect free
On maturity, a futures contract on T-bills calls for delivery market yields. Unlike T-bills, the yield on Eurodollars is add-on.
of T-bills maturing 91 days thereafter. The T-bills are discount A futures contract on Eurodollar calls for delivery of a Eurodollar
instruments specified by the discount yield. The actual yield is deposit of $1 million maturing three months thereafter. Hedging,
higher than the discount yields. T-bills on futures are quoted on speculation, and arbitrage are executed in the same manner as
the basis of an index where the price of the futures becomes that of futures on T-bills.
inversely proportional to the interest rate, as is the price of the For covering long-term interest rate risk, futures on T-bonds
underlying instrument. This is primarily set up to be consistent are available. The exchange specifies the deliverable instrument
with all other futures markets, where long positions gain with against the futures on T-bonds. The short position in T-bond
price rise. futures normally has a choice of delivering one amongst the
Hedging against falling interest rates is achieved by taking a many bonds available in the market. All available bonds have
long position on futures on T-bills. For protection against rising price conversion factors attached with them and the seller deliv-
interest rates, the hedger has to take a short position in futures. ers the bond that is the cheapest. Conversion factors are worked
The gains in the futures position are likely to offset the losses out by the exchange concerned.
in the physical position of borrowing and investing. Speculation Hedge ratio for futures on interest rate depends upon the sen-
with futures is carried out if one differs with the view of future sitivity of bond prices with changing yields. Since the sensitivities
 214 Derivatives and Risk Management

of the bonds in the portfolio would be different than the bond liquidity, instruments, and number of participants are some of the
underlying the futures contract, the optimal hedge ratio becomes reasons that explain the lack of interest in interest rate futures. Of
dependent upon durations of the bonds. late, interest rate futures are introduced in India with a notional
The market for interest rate futures in India remains in the Gol security, with 10 years maturity and 7% coupon payable semi-
nascent stage despite their introduction in 2003. Lack of enough annually as well as on Gol T-bills.

KEY TERMS
Conversion factor Adjustment of prices of all deliverable Implied repo rate The rate implied by the spot price and the
bonds against the price of the specified bond in the futures con- futures price on T-bills.
tract is done using the conversion factor. T-bills |These are discount instruments issued by governments
CTD bond The bond that is the cheapest to deliver, amongst for a variety of reasons; they have fixed maturity and are virtually
the many bonds that satisfy the delivery requirement under the free from default risk.
futures contract. T-bill futures These are exchange-traded contracts with
Discount yield The annualized yield on T-bills, in terms of T-bills as underlying asset, calling for delivery of the T-bills on
percentage of the face value of the T-bills. maturity.
Eurodollars The US dollars held outside the USA. Treasury bond futures A futures contract with T-bonds as
Eurodollar futures A futures contract with a Eurodollar underlying asset.
deposit as the underlying asset.

QUESTIONS #
7.1 What are T-bills and why are they appropriate instruments 7.4 How can you arbitrage with T-bill futures if the implied repo
as underlying assets for futures contracts? rate is greater than the actual repo rate?
7.2 How does a futures contract on T-bills help in hedging 7.5 What is the Eurodollar and what is a futures contract on the
against fluctuating interest rates? Eurodollar?
7.3 What is implied repo rate? How do we compute it? 7.6 What are T-bonds and how are T-bond futures specified?

PROBLEMS oe
P 7.1 Invoice price of T-bills futures 10-year Gol security with a 7% coupon payable semi-annually
If the price of futures on T-bills is quoted at $91.45, what would with face value of €100. Find out the value of these futures con-
be the invoice price, assuming a contract size of 10 lakh worth tracts at YTMs of 6%, 7%, and 8%.
of T-bills in face value?
P 7.5 Bond value and duration
P 7.2 Hedging strategy with T-bills futures You are holding a bond with four years to maturity, bearing a
A treasurer is expecting to receive funds of %1.25 crore in the semi-annual coupon of 10%. What is the value of the bond if the
next three months; this amount would be in surplus for three YTM is 6%? Find its duration also.
months thereafter. A 3-m futures contract on T-bills expiring in
P 7.6 Hedging a long position with interest rate futures
90 days is quoted at %89.50, indicating a yield of 10.50%. The
Assume that you are holding 10,000 bonds of the type men-
treasurer is apprehensive about the yield falling in the days to
tioned in Problem 7.5. The yields in the market are expected
come. What can the treasurer do to hedge against falling yields?
to rise uniformly for all maturities. If you wish to hedge against
P 7.3 Yields and T-bills futures the anticipated decline in value of the bond, what would you do
Refer to Problem 7.2. Assume the treasurer books the desired if after three months it is expected that the CTD bond would
number of futures contracts. What yield would the treasurer be a 9-year maturity bond that has a YTM of 7% and duration
realize on the investment if after three months the yield (a) falls of 6.4068 years? The futures contract is trading at 93.2048,
to 9.25%, and (b) rises to 11.00%? implying a YTM of 6%.
P 7.4 Value of a bond
Interest rate futures contracts in India are based on notional
INTRODUCTION 9"
Learning Objectives
‘Necessity is the mother of invention’ is a popular saying, and Atier going through this chapter,
ny the recent evolution of swaps as finan- readers should be familiar with
The swap as 4 financial tgs £ é f
inetrument come ato cial instruments is a classical example the basic concept of swaps, why
existence due to the _ of its validity. There is near unanimity and how swaps evolved, and the
presence ofexchange among financial experts that swaps terminology of swaps
controls that restricted developed out of the constraints and the different types of interest rates
and currency swaps
the movement of capital regulatory controls exercised over ° how to hedge interest rate risk
ete. oe __ cross-border capital flow, faced by large how to hedge exchange rate risk
corporations in the 1970s. When multi- through financial swaps
acca corporations (MNCs) operating in various countries ° swap as a tool for reducing
financing cost and also as a
could not freely remit funds back and forth among their subsid-
hedging tool
iaries due to exchange controls exercised by various govern- ° how to value a swap
ments on capital flows, they came out with the innovation of =» as a pair of bonds and
back-to-back or parallel loans among themselves. Upon removal » as a series of forward contracts
of restrictions on capital flows, these loans developed into a full- other swaps such as commodities
and equity
fledged financial product called swaps. Since then, the market
has grown to volumes as big as US $30.5 trillion in foreign
exchange swaps and US $22.8 trillion in currency swaps! in
December 2011—1in terms of notional principal involved in
swap transactions—and continues to grow at a rapid rate.
Parallel loans involve four parties that agree to re-exchange
currencies at a predetermined exchange rate on a pre-decided
future date. The four parties usually involve two MNCs and a sub-
sidiary each, in two different countries. Imagine IBM as a USA-
based company with a subsidiary in London and British Telecom
as another company with operations in New York. The subsidiary
of British Telecom needs money in US dollars, while the subsid-
iary of IBM in London requires funds in pound sterling. Due to
regulatory controls, neither IBM USA nor British Telecom can

'As per Bank of International Settlement’s data available for the second half of 2011.
216 ~~ Derivatives and Risk Management

fund their subsidiaries. To overcome the problem, British Telecom can arrange funds in pounds
to fund the requirement of IBM’s subsidiary in London. Similarly, IBM USA may raise funds
in US dollars to fund the operations of British Telecom in New York. Such an arrangement 1s
called back-to-back or parallel loan. These amounts would be re-exchanged at maturity at a rate
determined in advance. Besides overcoming regulatory controls, there were other economic
advantages that caused the development of swaps as full-blown financial products that became
popular even after the removal of regulatory controls. By this simple arrangement, each firm
involved in a swap arrangement has access to capital markets in a foreign country, and can
make use of the comparative advantage of borrowing in different capital markets. The growth
of swaps was so phenomenal that in 1984, a need for standardization and uniform practices in
documentation, trading, and settlement was felt, leading to the formation of the International
Swap and Derivatives Association (ISDA).
Back-to-back/parallel loans pose several difficulties: finding matching parties with identi-
_ cal needs in terms of amount of principal, timing, duration of loan, periodic-
Swaps overcame the _ ity, and nature (fixed or variable) of interest payments, etc., all of which must
operational difficulties
match to conclude a successful deal. Solutions to these problems were found
faced in parallel loans,
and developed into an _ by intermediary banks, which later progressed to become dealers in swaps
instrument independent from being mere arrangers of swaps between two parties. Back-to-back loans
ofthe underlying loan were an example of financial swaps, which had their origin in the 1970s. By
the early 1980s, the same principle was adopted to develop another swap
arrangement based on interest rates, known as interest rate swaps.

Swap, in the simplest form, may be defined as an exchange of a series of future cash flows
between two parties as agreed upon in the terms of a mutual contract. The basis of future
cash flows can be the exchange rate for currency/ financial swaps and the interest rate for
interest rate swaps. Apart from interest rates and currency rates, the formula for determina-
tion of periodic cash flows can include equity returns, commodity prices, etc. In essence,
one of the cash flows, called the fixed leg, would be fixed, while the other cash flow, called
the floating leg, would be the variable, depending upon the value of the variable identified
for the swap.
If the exchange of cash flows is done on the basis of interest rates prevalent at the relevant
times, it is known as an interest rate swap. The simplest example of an interest rate swap is a
forward contract where only one payment is involved. In a forward transaction of any com-
modity, the buyer acquires the commodity and incurs an outflow of cash equal to the forward
price, F. If the buyer, after acquiring the commodity, were to sell it for the spot
A swap is a series of ex- price, S, then there would be a cash inflow of S. From the cash flow perspec-
change of cash flows be- _ tive, a forward contract for a buyer is a swap transaction with inflow of S and
tween two parties,based outflow of F’. The seller would have equivalent cash flows in opposite direc-
on terms and conditions tions. Therefore, a forward contract can be regarded as a swap with a single
agreed upon by them. It is
exchange of cash flow or, alternatively, a swap can be viewed as a series of
a tailor-made product.
several forward transactions taking place at different points of time.
 Swaps—Interest Rate and Currency aah

FEATURES OF INTEREST RATE SWAP |

Mostly interest rate swaps involve payment of a fixed rate of interest for receiving a floating
rate of interest. The basis of exchange of cash flows under an interest rate swap is the inter-
est rate. This fixed-for-floating swap is commonly known as the plain vanilla swap, depicted
in Fig. 8.1, where company A agrees to pay company B a fixed interest rate of 8.50% in
exchange for receiving from company B interest at 30 bps (100 bps = 1%) above the float-
ing interest rate MIBOR (Mumbai InterBank Offer Rate), at predetermined intervals of time.

Company A

Fig. 8.1 Plain vanilla interest rate swap

Assume that the swap contract between company A and company B is (a) for a period of
_ three years, (b) with semi-annual exchange of interest, and (c) on a notional
Cash flows under interest
principal of €50 crore. The cash flows for company A for six semi-annual
rate swaps are based
on a notional principal periods for an assumed MIBOR would as per Table 8.1. The amount
and are netted, making received/paid by company A is paid/received by company B.
them independent of the Within the context of this example, the salient features of the swap con-
original loan amounts. tract may be noted as follows:

entering the swap at T = 0, referred to as the effective date.

e Resetting offloating leg cash flow The cash flow for the floating leg of the swap is
determined one period in advance, when the floating rate is known. Thus, at the time
of entering the swap, the first set of cash flows of interest is known. The first receipt of
cash flow at T = 6 months is known at T = 0, and is done at the MIBOR of 8% plus
Table 8.1 Cash flow under swap for company A

Cash flow, Zlakh

Time, months MIBOR, % ee
| ae Fixed leg Floating leg
ie
6
12
18
24
30
36
Note: Cash flow for floating leg is decided oneperiod in advance.
218 Derivatives and Risk Management

30 bps. The date on which the next floating rate payment is decided is called the reser
date. It will come up every six months in swaps with semi-annual payments.
¢ Notional principal No principal amount is exchanged either at the initiation or at the
conclusion of the swap. It remains a notional figure for determination of the amount of
interest applicable to both the legs.
e Exchange differential cash flow The exchange of interest is done on a net basis, as
depicted in the last column ofTable 8.1, with positive signs indicating cash inflows and
negative signs indicating cash outflows for company A. The cash flows for company B
would be opposite to those for company A.
e Different conventions to calculate fixed and floating interests Since a swap is an
over-the-counter (OTC) product, the method of calculation of interest on the two legs
can be defined by the two parties involved. However, the conventions to calculate
interest for each of the two legs are different. Generally, the conventions followed in
money markets are:
for the fixed leg : actual/365
for the floating leg : actual/360

If the actual number of days in a 6-m period are 182, the amount of interest on both the
legs for the first cash flow would be different from the interest rates shown in Table 8-1 and
the exact amount is calculated as follows:

For Fixed Leg: Principal X Interest rate X a

an LS? a
= 50,00,000 X 0.085 X aaa <2,11,918

For Floating Leg: Principal < Interest rate X Nos. orcays

2)

= 50,00,000 x 0.083 x a = 22.09.805

2

For simplicity of exposition in the example we assumed 180 days in each semi-annual
period, with a 360-day year for both the legs.

NEED FOR SWAP INTERMEDIARY: SWAP DEALER/BANK

The illustration in the previous section.assumed perfect matching of the needs of company A
and company B. That brings up this interesting question: how do company A and company B
find each other in this big world? Normally, firms prefer not to disclose their specific needs
in terms of loans, borrowings, and interest rates. Even the importers and exporters are rarely
involved in direct transactions of buying and selling foreign currency in the forward markets.
All of them resort to banks for this purpose.
Apart from difficulties in locating each other, if company A and company B were to set
up a swap arrangement directly, they would most likely face the following problems.
e Both of them would assume default risk (also known as counterparty risk) associated
with the swap on each other, as either party may fail to honour its commitments under
the swap.
 Swaps—Interest Rate and Currency 219

Swap intermediaries e Matching mutual needs in terms of principal amount of borrowing, the
promote market develop- timing, the periodicity of payment of interest, and the final redemption of
ment by filling the gaps the borrowing could indeed be a difficult task.
in terms of matching of
needs, warehousing, and The existence of intermediaries came into play in order to overcome this
assuming of counter- _ sort of problem in swap agreements. Without intermediaries, the swap mar-
party risk. _ ket would remain extremely small. In fact, the growth in swaps is primarily
attributed to the roles banks have played as swap intermediaries. We now
proceed to write about the functions of a swap intermediary.
Facilitating the swap deal Difficulties in finding a matching counterparty can be mitigated
if an intermediary is involved. The intermediary or the swap dealer is normally a bank with
a widespread network. Due to their deep knowledge of financial markets, huge networks of
customers, and exact understanding of client needs, banks are better placed to locate match-
ing counterparties. Many banks offer forward rates to facilitate foreign exchange transac-
tions. Similarly, a few banks act as market makers in swaps and offer a ready market with
opportunities for firms to enter into and exit from swap deals.

Warehousing Banks perform the role of market maker in swaps. One can obtain a quote
on demand for a swap deal from a bank without waiting for a matching counterparty. There
are several requirements that have to be matched. For example, one party may look for an
interest rate swap for ¥100 crore on semi-annual basis for three years, while another party
may want a swap for %80 crore on a quarterly basis for 2’ years only. Here, the bank may
take up exposure of 20 crore in the hope of finding another suitable party for that amount
in the near future. This is called warehousing; where the bank may enter swaps on its own.
The bank carries the risk of interest rate fluctuations till a matching counterparty is found.
The risk of interest rate in the interim is normally covered through interest rate futures.
Hedging through imerest rate futures has to be done only for net exposure in swaps, as banks
are likely to have a portfolio of swaps that can nullify the interest rate risk for a major part
of the exposure.
Assuming counterparty risk Most important of all, banks mitigate counterparty risk for
both the parties to the swap by becoming the counterparty to each of them. In the example
depicted in Fig. 8.1, company A would be far more comfortable if the counterparty was a
bank, rather than company B. The same would be true for company B. When a bank becomes
a counterparty, the overall risk attached to the swap transaction, which normally is large due
to its long-term nature, stands reduced substantially.
Of course, for providing a facilitating role and assuming the counterparty risk, the swap
dealer needs to earn some remuneration. This has to be borne by the two parties to the swap
transaction. However, each of the party stands to gain in terms of having an exact deal, achiev-
ing the desired timing, and reducing the counterparty risk. The benefits are worth the cost.
Figure 8.2 depicts a swap transaction with a bank as an intermediary, charging 5 bps from
each party, as each of them receives 5 bps less than what they would receive without the inter-
mediary (see Fig. 8.1). Company A pays a fixed interest rate, 8.50%, to the bank, which pays
only 8.45% to company B. In exchange, the bank receives a floating interest from company B
at M + 30 bps, but pays 5 bps less to company A at M + 25 bps. The bank hence earns 10 bps.
220 Derivatives and Risk Management

Company A

Fig. 8.2 Plain vanilla interest rate swap with intermediary

APPLICATIONS OF INTEREST RATE SWAPS |

Having explained the mechanism of the swap transaction, let us focus on what swaps can
achieve. Swaps can be used to (a) transform a floating rate liability to a fixed rate liability and
vice versa, (b) transform a floating rate asset to a fixed rate asset and vice versa, (c) hedge
against fluctuating interest rates, and most importantly, (d) reduce the cost of funds. We now
examine each of these factors.

Transforming Nature of Liabilities

Interest rate swaps are generally used for creating synthetic fixed or floating rate liabilities
with a view to hedge against adverse movement of interest rates. Let us consider company A,
which has borrowed from the market on a floating rate basis at MIBOR + 25 bps. It pays to
its lenders at floating rate. Further, it considers that interest rates would rise in the future. In
view of the possibility of rising interest rates, company A would like to have a liability that
is fixed, rather than variable, in nature. Therefore, it decides to enter into a swap with a bank
by paying a fixed 8.50% and receiving MIBOR + 30 bps, as depicted in Fig. 8.3.
Company A pays a fixed interest rate, 8.50%, to the bank. The bank pays M + 30 bps in
return. Company A continues to pay M + 25 bps to its lenders, as originally agreed. What
is the result of this swap? It simply transforms the liability to a fixed rate at 8.45% p.a., as
shown in Fig 8.3.

Payment to lenders MIBOR + 25bps

Less: receipt from bank under swap 8.50%
Payment to bank under swap —(MIBOR + 30 bps)
Net payment, fixed 8.45%

Company A
E

Fig. 8.3 Swap to transform floating rate liability to fixed rate

 Swaps—Interest Rate and Currency jagal

Similarly, company B can transform its. fixed rate liability to a floating rate liability by
entering a swap with a bank paying a floating interest rate and receiving a fixed one. Naturally,
company B would use such a swap when it believes that interest rates are likely to fall in the
future, and locking-in a lower floating rate would prove advantageous. Refer to Example 8.1
for an illustration.

EXAMPLE 8.1 Changing nature of liability from fixed to floating :

Five years ago, Fasteners Ltd had raised loans through a 10-year debenture issue worth 100 crore with a fixed interest rate
of 12%. After the issue, the interest rates remained constant for some time, but have since come down to around 10%, and are
likely to come down further. Fasteners Ltd wishes to contain the cost of funding for the remaining five years. A bank has offered
a swap rate of 9.50-9.60% against MIBOR for a period of five years. Depict the swap arrangement and find out the new nature
of liabilities the firm can have.
Solution
Fasteners Ltd has a liability with a fixed interest rate of 12%. By entering into a swap with the bank, it may transform interest
on the liability from a fixed rate to a floating rate based on MIBOR. Under the swap arrangement, Fasteners Ltd can receive a
fixed rate and pay MIBOR. The bid rate of the swap (9.50%) would be applicable. The swap arrangement is shown as below:

Fasterners Lid | |

The cost of funds for Fasteners Ltd would be 12.00% — 9.50% + MIBOR = MIBOR + 2.50%.
In case the interest rates fall below 9.50%, which is expected, the firm would end up paying less interest than what it is paying now.
The interest rate payable would be market based.
TE OUUUUOUUERTME OOOOOPQRPQl|LlReLLE LEE

Transforming Nature of Assets

Assets provide income to investing firms based on the interest rates. If the interest rates fall,
the income too falls. In circumstance of falling interest rates, firms would like to change
the complexion of assets that are on floating rates to fixed rates. Similarly, in times of rising
interest rates, firms earning fixed rates of interest would like to remain with the market
trend.
Now assume that company A has made an investment by subscribing to bonds carrying a 9%
fixed coupon. The bonds have still some years to mature but the interest rates are showing
a rising trend, which is expected to continue. Company A faces a potential loss of income.
What should company A do to mitigate the risk associated with the rising
Swaps alter the char- : interest rates? Changing its portfolio ofbonds by selling fixed rate bonds and
acteristics of an asset buying floating rate bonds is one solution. An easier way is to enter the swap
-orliability from fixedto depicted in Fig. 8.4, where it receives a floating, MIBOR + 30 bps and pays
floating or floatingto a fixed rate, 8.50%.
fixed, without disturbing By doing so, the nature of income is transformed from a fixed 9.00% to
ecg one a floating MIBOR + 80 bps:
222 Derivatives and Risk Management

Company A

LLL
LLL LLL LLM LLL MLL CO0OO00000000000€000000088 S

Fig. 8.4 Swap to transform fixed rate asset into floating rate

Receipt from investments 9.00%

Less: Payment to bank under swap —8.50%
Receipt from bank under swap MIBOR + 30 bps
Net receipts, floating MIBOR + 80 bps

If MIBOR moves beyond.8.20% in the future, company A would benefit from the situation.
Similarly, one can transform a floating rate income to fixed rate income by entering a swap
receiving fixed and paying floating. Naturally, a firm would use such a swap when it believes
that interest rates are likely to fall in the future.

Hedging with Swaps

These examples of changing the nature of liabilities or assets from fixed to floating and vice
_ versa demonstrate the hedging applications of swaps. The need to change the
The transformable nature
_ complexion of assets and liabilities arises only when the firms stand to gain
of assets and liabilities
(from fixed rate to float- from such an exercise. Swaps can be fruitfully used to hedge against an
ing rate, or vice versa) adverse interest rate situation, as condensed in Table 8.2.
helps hedge against the There are many ways to hedge against adverse situations but sometimes a
adverse movement of swap agreement hedges the anticipated risk more efficiently. For example, a
interest rates.
firm may have borrowed for 10 years on a fixed rate basis. After a few years,
if the interest rates start a downward movement, one possible recourse for
the firm is to approach the lender to change the nature of loan from fixed to floating.
The
lender might resist switching to a floating rate of interest. A better course of
action is to set
up a Swap arrangement with another party. The firm achieves its objective
without involving
the original lender and any of its additional terms and conditions.

Table 8.2 Hedging strategies with swaps

[
2 Assets
|__ Nature Risk Hedging action
Fixed rate Rising interest rates Swap to transform the nature of asset from fixed rate to floating rate
[ Floating rate Falling interest rates Swap to transform the nature of asset from floating rate to fixed rate
Liabilities | :
Fixed rate Falling interest rates Swap to transform the liability from fixed rate to floating rate
Floating rate Rising interest rates Swap to transform the liability form floating rate to fixed rate.
 Swaps—Interest Rate and Currency 223

Derivatives in Practice

Interest rate swaps in India—Overnight swap

: Withthe view of deepening the money market and enabling banks, primary dealers, and all-India financial institutions to hedge interest
_ tate risks, the Reserve Bank of India has allowed scheduled commercial banks, primary dealers, and all-India financial institutions to
_ make markets in interest rate swaps from July 1999. However, the market that has taken off most seriously so far is the one based
_ on overnight index swaps. The benchmarks for tenor beyond overnight have not become popular due to the absence of a vibrant
_ interbank term money market.
_ The National Stock Exchange (NSE) in India publishes MIBOR rates for three other terms, that is, 14 days, one month, and three
months. The other longer-tenor benchmark that is available is the yield based on forex forward premiums. This is called MIFOR
(Mumbai interbank forward offered rate). Reuters’ published 1-m, 3-m, 6-m, and 1-year MIFORs are the market standard for this
benchmark.
The overnight index swap is a rupee interest rate swap where the floating rate is linked to an overnight interbank call money index.
The swap will be flexible in tenor, i.¢., there is no restriction on the tenor of the swap. Interest would be computed on a notional principal
_ amount and settled on a net basis at maturity. On the floating rate side, the interest amounts are compounded on a daily basis, based
_on the index. At the moment, the NSE overnight MIBOR is the most widely used floating rate index, the Reuters’ overnight MIBOR
being the other reference rate used.
For exampie, consider that bank A is a fixed rate receiver for $5 crore for a period of one week at 10%, and bank B is a receiver of
floating rate linked to the overnight index. The NSE MIBOR rates for seven days are taken and settled at the end of the swap period.
At the end of the period of one week, i.e., the eighth day, bank B will have to pay to bank A €95,890 (which is the interest on %5 crore
for seven days at 10%), and has to receive $97,508 from A. The payments are netted and the only payment that takes place is a
payment by A of %1608 (97,508 — 95,890) to B.

1 5,00,00,000 14,041
2 : 5,00,14,041 13,702
3 5,00,27,743 13,363
4 : 5,00,41,107 13,881
5 and6 5,00,54,988 28,113
7 5,00,83,101 14,407
OA = | 5,00,97,508

Similarly, a fund may have subscribed to a portfolio of fixed rate bonds to generate a
desired level of income. If interest rates rise subsequent to the subscription, the fund loses
the opportunity to raise its income. One of the alternatives available is to change the portfo-
lio from fixed rate to floating rate bonds. This may face serious limitations, such as lack of
availability of such bonds and transaction costs associated with change of the portfolio. An
attractive alternative is to enter a swap to transform the nature of assets from fixed to floating,
where the fund receives a cash flow based on floating rates in exchange for paying a fixed
rate. More importantly, the swap transaction remains off the balance sheet, thereby keeping
the much-desired confidentiality.

Reducing Cost of Funds

Perhaps the most important application of swaps, which also seems to be the primary reason
for its popularity and growth, is its potential of saving the cost of financing.
An example will illustrate how swaps can be used to reduce financing cost. Assume that
a highly rated firm, rated AAA, can raise funds in the fixed rate market at 10% and in the
224 Derivatives and Risk Management

_ floating rate market at MIBOR + 100 bps. The current rate of MIBOR(is
One of the major ap-
plications of swaps is 8%. Another firm, comparatively rated lower, at ‘A’, can mobilize capital
to reduce the cost of at 12% and MIBOR + 200 bps in the fixed rate and floating rate markets,
financing. respectively.
Clearly, firm rated AAA has an advantage over firm rated A, both in the
fixed market as well as in the floating market. This advantage can be tabulated as follows:
Firm rated AAA Firm rated A Advantage AAA
Fixed rate 10% 12% 200 bps
Floating rate MIBOR + 100 bps MIBOR + 200 bps 100 bps

We further assume that firm rated AAA is interested in borrowing at a floating rate (at
MIBOR + 100 bps) and firm rated A wants to borrow in the fixed rate market (at 12%).
Notice that for the lower-rated firm, the spread in the fixed rate market is more than for the
higher-rated firm. The two firms can set up a swap as follows:

e Firm rated AAA goes to the fixed rate market and borrows at 10%, rather than tapping
the floating rate market at MIBOR + 100 bps.
e Firm rated A mobilizes funds from the floating rate market at MIBOR + 200 bps, rather
than mobilizing from the fixed rate market at 12%.
e Having accessed different markets by going against their original choice, now the firms
enter a swap where,
=» firm rated AAA pays the firm rated A floating at MIBOR + 200 bps
= firm rated A pays firm AAA fixed at 11.5%

These actions and the resultant impact on the cost of funds for firm rated AAA and firm
rated A are shown in Fig. 8.5.

MIBOR + 2%

Cost of funds for firms

AAA
4. Payment to investors 10% MIBOR + 2%
2. Payment to counterparty MIBOR + 2% 11.5%
|3.Receipt from counterparty 11.5% MIBOR + 2%
Cost of borrowing (1 + 2 — 3) MIBOR + 0.5% 11.5%
Firm can raise funds at MIBOR+0.50%, | Firm can raise funds at 11.5% as
IMPACT as against MIBOR+ 1% without the swap, |against 12% without the swap,
_| gaining 0.50% |gaining 0.50%
LLLEEE EEE
Fig. 8.5 Interest rate swap—reducing cost of fine
 Swaps—Interest Rate and Currency 225

As against a fixed payment of 10% to its original lenders, firm rated AAA pays a floating
rate of MIBOR + 200 bps and receives a fixed rate of 11.5%. This not only transforms the
lability from fixed to floating rate, as the firm wanted in the first place, but also reduces the
cost to MIBOR + 50 bps, as against MIBOR + 100 bps that it would have incurred without
the swap, thereby gaining an advantage of 50 bps. Similarly, firm rated A too can transform
its liability to a fixed rate as it initially desired, and can also reduce the cost of funds to
11.50%, as against the 12.00%, which it would have incurred if it were to go to the market
directly. The swap again gives an advantage of 50 bps.

RATIONALE FOR SWAP—COMPARATIVE ADVANTAGE _

The remarkable characteristic of the swap agreement was its ability to reduce the cost of
funds for both the firms, as shown in Fig. 8.5. Normally, one expects to gain at the expense
of the other, as it is reasonable to assume that derivatives are a zero-sum game. The explana-
tion behind why both the parties in a swap agreement gain lies in the theory of comparative
advantage.
Regardless of the fact that the firm rated AAA held an edge over the firm rated A in
both types of borrowing, comparative advantage played a significant role in the successful
completion of the swap transaction between the two firms. Firm rated AAA had an absolute
advantage of 200 bps in the fixed rate market and 100 bps in the floating rate market. Alter-
natively, we can say that firm rated AAA had a comparative advantage of 100 (difference
between the two absolute advantages) in the fixed rate market. Put another way, firm rated A
had a relative advantage in the floating rate market. The comparative advantage of 100 bps
was available for exploitation by both the firms, at the expense of distortions in the financial
market.
Therefore, it makes sense for the firm rated AAA to access the fixed rate market, where it
had a greater absolute advantage, and then enter into the swap to transform its fixed rate
liability into a floating rate one. Similarly, firm rated A must access the floating rate market
and then enter into the swap to transform its floating rate liability into a fixed rate one. The
total benefit for both the firms would remain fixed at 100 bps, and the amounts of fixed and
floating rates would determine who gets how much of the benefit. Of course, sharing of
benefit would depend upon the negotiating powers of the two firms involved.
The aggregate advantage remains fixed at a comparative advantage of 100 bps. In case of
a direct deal between the firm rated AAA and the firm rated A as depicted in Fig. 8.5, the
benefit was shared equally by both the firms. In case such a deal were to be structured by an
intermediary, such as a bank, serving as counterparty to each, some part of the benefit would
be sacrificed by each of the party. This benefit goes to the bank. One such deal, where the
bank gets 20 bps (10 bps each) is depicted in Fig. 8.6 and Table 8.3.
The exploitation of the comparative advantage by the firms is a clear case
_ Reduction in cost of
_ funding through swaps is of arbitrage on the credit rating. The fixed rate market demanded a greater
_ based on the principle of remium from the lower rated firm than did the floating rate market, forcing
- comparative advantage, — _ the firm to access the floating rate market. The premium demanded by the
_ and isa classical applica- higher rated firm for a fixed rate was lower than the market, making the swap
tion of credit arbitrage.
deal attractive. The question that arises is: how can a competitive market
226 ‘Derivatives and Risk Management

EXAMPLE 8.2 Interest rate swap to reduce funding cost

Two Indian firms, IndoPlas and IndoCar, are contemplating raising finance of 100 crore each. They have been offered the
following loans by a bank.

Fixed rate Floating rate

IndoPlas 12.00% MIBOR + 70 bps
IndoCar 11.00% MIBOR + 30 bps

Another bank, acting as a swap intermediary, is willing to work out a swap arrangement for a fee of 5 bps from each firm. IndoCar
believes that the interest rate would fall and, hence, wants to raise funds on a floating rate basis. IndoPlas feels otherwise, and
wants to raise funds on a fixed interest rate basis. What swap can be arranged between the two parties? What would be the
saving in financing cost for each firm if benefits of swap are shared equally?
Solution
The absolute advantage for IndoCar is 100 bps in the fixed rate market, while it is 40 bps in the floating rate market. Although
IndoCar wants to raise finance at a floating rate, the firm must access the fixed rate market and then enter into a swap deal
with IndoPlas to convert the liability from fixed rate to floating rate. The total benefit to be availed of is 60 bps, the differential
of absolute advantage for IndoCar in the two markets. The bank would charge 10 bps as a fee. The remaining 50 bps may be
shared equally by both the parties through a swap. One such structure is presented as follows:

Interest rate swap: A schematic view with an intermediary

IndoPlas

Cost of borrowing

. Indocar IndoPlas
Payment to investors 11% MIBOR + 0.7%
Payment to bank MIBOR + 0.05% 11.05%
Receipt from bank 11% MIBOR
Cost of borrowing (1 + 2 — 3) MIBOR + 0.05% 11.75%

The aggregate cost of funds for IndoCar would be MIBOR + 5 bps, a saving of 25 bps if it accesses the floating rate
market.
Similarly, IndoPlas obtains funds at 11.75% against 12% without the swap deal, resulting in an advantage of 25 bps.
LD, ELT EE TTT 7

OR MIBOR + 2%
4
10% 0,
AAA

LLEE EEE

Fig. 8.6 Interest rate swap: A schematic view with intermediary

 Swaps—lInterest Rate and Currency 227

Table 8.3 Sharing benefits of swap

Payment to investors 10.00% MIBOR + 2.00%

Payment to bank MIBOR + 2.00% 11.50%
Receipt from bank 11.40% MIBOR + 1.90%
‘Cost of borrowing (1 + 2 — 3) _ MIBOR + 0.60% coe
Cost with direct access to the market MIBOR + 1.00% 12.00%
Savings _ 40 bps 40 bps
Earning for the bank 11.50% — 11.40% + (M + 2.00%) — (M + 1.90%) = 0.20%

allow this aberration to take place? The answer seems to lie in the gap in the information the
market has on firm rated AAA and the firm rated A. Lenders, while lending on a floating rate
basis, have the opportunity to review rates every six months, and for the firm rated higher, the
spread would usually be a smaller one. In the fixed rate market, the spread would be larger
for lower-rated firms. Lenders could rely more on firm rated AAA than they could on firm
rated A. The spread in the two markets are unequal due to unequal rating of the firms. The
differential of spread reflects the differential of likely default by firm rated A relative to firm
rated AAA.
The theory of comparative advantage has been used to structure swap transactions in a
manner that both parties in the swaps are able to reduce their costs of funds. Generally, a
firm with higher credit rating is able to procure funds at lower rates of interest than a firm
with lower credit rating, irrespective of whether the borrowing is on a fixed or a floating
rate basis. The firm with higher credit rating is said to enjoy an absolute advantage over
the firm with lower credit rating in both the fixed rate and the floating rate markets. The
advantage of the higher-rated firm over the lower-rated firm is called the credit quality
spread.
Despite a credit quality spread in both the fixed rate and the floating rate markets, it may be
beneficial for the higher-rated firm to engage in a swap deal with the lower-rated firm due to
the likelihood that the credit spreads in both the markets would not be equal. The differential
of the two absolute advantages measures the comparative advantage, which
in turn forms the basis of the swap deal. This comparative advantage is the
_ Swaps serve as a tool for
-feducing financing cost, aggregate benefit that both parties to the swap deal can share, in proportion
_ because of the credit to the bargaining powers of each.
Swaps are, therefore, a product resulting from arbitrage on credit rating.
The question is, will this credit arbitrage continue? Most likely, the answer
is ‘yes’, as long as gaps in information and credibility remain.

TYPES OF INTEREST RATE SWAPS (7 "

Interest rate swaps can be categorized as follows:
Fixed-to-floating In fixed-to-floating rate swaps, the party pays a fixed rate of interest to
the bank or swap dealer and in exchange, receives a floating rate of interest determined on
228 Derivatives and Risk Management

_ the basis of a reference/benchmark rate at predetermined intervals of time.

ee
payment of interest, both
Such a swap is used by a firm that has a floating rate liability and anticipates
of which may be based a rise in the interest rates. Through the swap, the firm will cancel out the
on different parameters, receipts and payments of the floating rate and have a cash outflow based on
with one legfixedand =the fixed rate of interest.
the other floating, or with Ts
both floating, but on dif- Floating-to-fixed In this kind of swap, the party pays a floating rate of
ferent benchmarks. _ interest to the bank or swap dealer and in exchange, receives a fixed rate of
~ interest at predetermined intervals of time. Such a swap is used by a firm that
has a fixed rate liability and anticipates a fall in the interest rates. Through
the swap, the firm will cancel out the receipts and payments of the fixed rate liability and
have a cash outflow based on the floating rate of interest.
Basis Swap In contrast to the fixed-to-floating or floating-to-fixed swaps, where one leg is
based on the fixed rate of interest, the basis swap involves cash flows of both the legs based
on a floating rate. However, the reference rates for determining the two legs of payment are
different. Basis swaps are used where the parties to the contract are tied to one asset or liabil-
ity based on one reference rate, and want to convert to another reference rate. For example,
if a firm having liabilities based on the T-bills rate wants to convert them to a MIBOR-based
rate, then the firm can enter a basis swap where it pays a MIBOR-based interest to the swap
dealer in exchange for receiving interest based on the T-bills rate.

CURRENCY SWAPS _
In a currency swap, the exchange of cash flows between counterparties takes place in two dif-
ferent currencies on the basis of a predetermined formula of exchange rates. Since two cur-
rencies are involved, currency swaps are different from interest rate swaps in
Currency swaps, also _ their uses, functionality, and administration. The first recorded currency swap
called financial swaps, was initiated in 1981 between IBM and the World Bank.
are exchanges of cash More complex swaps involve two currencies with fixed and floating rates
flows in two different of interest in two currencies. Such swaps are called cocktail swaps—an
currencies, based on
example is a swap where one party pays 4% in US dollar and receives in
exchange rates.
LIBOR-based Swiss franc.

World Bank-IBM Currency Swap

The idea of swap was provided by a historical deal in August 1981 when
the World Bank
entered a swap deal with IBM through Salomon Brothers. The World Bank
and IBM entered
into a deal to exchange, whereby the two exchanged liabilities in US
dollars, Swiss francs,
and Deutsche marks. It was the first ever currency swap that
recognized the cost-saving
potential of the instrument for borrowing by the two parties
involved.
The World Bank was looking for funds at a minimum cost for
onward lending to develop-
ing countries for various projects. The cost consideration was paramo
unt for them because of
their inability to charge higher rates of interest from developing
countries. In August 1981,
the prevailing interest rates for US dollars were around 17%.
In contrast, the interest rates
 Swaps—Interest Rate and Currency 229

in Switzerland and Germany were 8% and 11%, respectively. This interest rate scenario sug-
gested depreciation of the dollar by about 9% against the Swiss franc and 6% against the
Deutsche mark. The World Bank believed that depreciation of the dollar would not be as
much as suggested by the interest rate differentials, and, hence, it would be inexpensive to
borrow in Swiss francs and Deutsche marks.
The World Bank had borrowed its permissible limit in Switzerland and the same was true
of the then West Germany. The World Bank, with a credit rating of AAA and backing by
several nations such as the USA, Germany, and Japan, was well placed to get a lower financ-
ing rate in US dollars at the treasury rate plus 40 bps in the bond market. Another worldwide
corporation, IBM, could mobilize funds in US dollar at treasury plus 55 bps. In the Swiss
market, the World Bank could raise funds at the Swiss treasury rate plus 20 bps. The problem
for the World Bank was that it had exhausted its borrowing capacity in the Swiss and German
markets. Constantly searching for low cost funds, the World Bank had approached Swiss and
German bond markets frequently in the past. Having already borrowed heavily in both the
markets, it had reached saturation levels. Further borrowing was discouraged by lenders. The
discouragement to borrow further was manifested in raised interest rates, as is the practice in
all markets to contain excessive exposures.
In contrast to this, IBM could raise funds in the Swiss market at the best rate. It could
borrow at the Swiss treasury rate and held an advantage of 20 bps over the World Bank, but
had a poor rate if it were to borrow in US dollars. At the same time, IBM believed that the US
dollar would depreciate much beyond the interest rate differentials of the US dollar vis-a-vis
the Swiss franc and the Deutsche mark. It already had loans outstanding in Swiss francs and
Deutsche marks, as given in Table 8.4.
The desire of the World Bank to raise money in Swiss francs and Deutsche marks and
the existing obligations of IBM in these currencies along with its willingness to raise funds
in US dollars created a common meeting ground for the two. The contrasting views of IBM
and the World Bank regarding the expected depreciation of the US dollar (the World Bank
anticipated a lesser depreciation and IBM expected a higher depreciation of the dollar than
reflected by the interest rate differentials) was the main motivation for fruitful engagement
in a swap deal.

Table 8.4 Details of loans of IBM for swap with the World Bank

Swiss franc (CHF) loan |Deutsche mark (DM) loan |

Principal, in millions 200.00 300.00

Due date for bullet repayment of the principal 30 March 1986 30 March 1986
Annual interest outflow due March 30 each year, in millions 22370 30.000
Effective interest rate 6.187% 10.000%
Interest rate prevailing in August 1981 8.00% 11.00%

|Present value of loans in August 1981, in millions 191.37 301.32

Exchange rate prevailing in August 1981, units/dollar 2.18 2.56

lent dollar of present value of loans, in millions 87.78

sees, TTT TTD
117.70 J
230 Derivatives and Risk Management

The loan liabilities of IBM in Swiss franc and Deutsche mark added up to US $205.48
million in present value terms, as shown in Table 8.4. IBM was willing to pay 16% ona US
dollar loan. After adjusting for the issue expenses, the World Bank issued a debt aggregating
to US $210 million with maturity on 31 March 1986, coinciding with IBM’s loans. Subse-
quent to the debt raised by the World Bank, cash flows were exchanged whereby IBM paid
US dollar obligations at 16% for a principal of US $210 million and the World Bank paid
the Swiss franc and Deutsche mark obligations of IBM. A schematic diagram of the swap is
presented in Fig. 8.7. Flows of principal amount from World Bank to IBM and vice versa and
its repayment at the end of the swap were not required. These flows are shown in Fig. 8.7 to
enable an understanding of the mechanism of a swap transaction.

August 1981: Raising loans and exchanging principal

Debt raised __US $205.48 m Existing debt

US $205.48
m | vole Bank CHF87.78 m of CHF and DM
DM117.70 m

March 1982—March 1986: Exchanging interest obligations and re-exchange of principal

|CHF200 m and DM300 m in March 86

US $33.6 m p.a.

World Bank | CHF12.375m p.a

_..0M30.00
m p.a.

US $210 min March 86

Fig. 8.7 Swap transaction of IBM and the World Bank

The advantage of the swap arrangement was that IBM got US dollars
at a lower rate and
at the same time the World Bank also received Swiss franc and Deutsch
e mark loans at lower
rates, capitalizing on the strength of each other in the respective
currencies. Both IBM and
the World Bank got what they wanted. If the World Bank borrowe
d US dollars and lent them
to IBM at US Treasury + 40 bps, it would not incur any loss,
and IBM would get a better
rate. If IBM borrowed Swiss francs and lent them to the World
Bank at Swiss Treasury + 10
bps, IBM would make 10 bps, and so would the World Bank.
If both the loans were raised,
it would have resulted in a profit of 15 bps to IBM and a
profit of 10 bps to the World Bank.
Since IBM and World Bank both borrowed the same amount
of money, there is no need to
exchange the principal since they cancel each other. On each
due date, IBM would pay interest
on the US dollar loan of the World Bank and receive interest
on the Swiss franc and Deutsche
mark loans from the World Bank. However, as the princip
als were not exchanged in the first
place, it was not necessary to re-exchange the princip
al subsequently. Counterparty risk, Lee
risk of default, was almost non-existent, as both the parties
had a sound AAA credit rating.
 Swaps—Interest Rate and Currency 231

Banks and financial intermediaries were quick to seize upon the idea, and soon started
broking swap deals for a fee. The swap had greater appeal in saving borrowing cost rather
than in managing risk. The development of the swaps market has been rapid since the IBM—
World Bank swap. It has grown tremendously. Today, swaps are possibly the largest deriva-
tive in the market. According to the Bank of International Settlement (BIS), there is over
60 trillion dollars of notional value of transactions in the year 2001, out of a market total of
180 trillion dollars. According to the triennial survey of BIS in 2010, the daily average in
foreign currency swaps amounted to US $1745 million out of a total daily turnover of US
$3370 million. This is estimated to be more than 15 times the size of the US public equities
market. In 1987, according to the ISDA, swaps had a total notional value of $865.6 billion.
By mid-2006, this figure exceeded $250 trillion, and in the first half of 2010, it stood at $434
trillion.
Back-to-back/parallel loans posed several difficulties: finding parties with identical needs
in terms of amount of principal, timing and duration of loans, periodicity, and nature (fixed
or variable) of interest payments. All of these parameters must match to conclude a success-
ful deal. Solutions to these problems were found by intermediary banks, which progressed
later to becoming dealers in swaps, from mere arrangers of swaps between two parties. Back-
to-back loans, which originated in the 1970s, are examples of financial swap agreements.
Problems associated with back-to-back loans were overcome by banks, and the intermediary
role played by banks made these loans a very popular financial product.
The underlying principle that underlines the swap is the exploitation of the comparative
advantage of two counterparties, as was done in the World Bank-IBM swap. Although the
first swap was a currency swap between the World Bank and IBM, the swap market has been
mainly driven by the fixed-for-floating interest rate swaps market.

Hedging Against Exchange Rate Risk with Currency Swap

Currency swaps cover different kind of risk. They are one way of converting liabilities or
assets from one currency to another. While in the case of interest rate swaps, assets or liabili-
ties are transformed from fixed interest rates to floating rates or vice versa, providing a hedge
against fluctuating interest rates, currency swaps provide a hedge against exchange rate risks,
as they transform liabilities/assets from one currency to another.
Let us consider an example to see how MNCs face currency risks and how these could be
overcome through a swap deal.
Assume that an Indian firm needs funds for its US operations. The firm raises funds in
Indian rupees and commits itself to serve its interest obligations and the final repayment in
Indian rupees. The funds raised in rupees are converted to US dollars to acquire assets in
the USA. These assets provide income in US dollars. The Indian firm is subject to the risk
of appreciation of the rupee (depreciation of the dollar) value in the currency markets, as it
would then receive lower rupee amounts for fixed returns earned in US dollars.
Similarly, a US firm, which needs to acquire assets in India while it raises dollar funds in
the USA, faces the same risk. Its earnings would be in Indian rupees, and the liabilities need
to be serviced in US dollars. Like the Indian firm, the US firm also faces a risk of shortfall
in the US dollar if it appreciates (and the rupee depreciates).
232 Derivatives and Risk Management

Currency swaps are use-

The vulnerability of both the Indian firm and the US firm is due to the
ful in (a) hedging against uncertainty of exchange rate movement, which may take place in either
exchange rate risk, (b) direction. Depreciation of the dollar harms the Indian firm, while it benefits
transforming an asset the US firm. Risks for both the firms arise because the future movement of
or a liability from one exchange rates cannot be predicted accurately. However, an estimate of the
currency to another, and
_ likely direction of exchange rates is made based on many theories, such as
(c) reducing the financing
cost. purchasing power parity and interest rate parity. In this sub-section, we focus
Bee
~ on the unexpected and adverse movement of exchange rates, as parties factor
in likely movements while making estimates.
The element of risk can be removed if the Indian firm and the US firm enter into a swap
agreement, as depicted in Fig. 8.8. A cursory look would reveal that the Indian firm has
financed its US operations by creating a rupee liability. This liability, to be serviced by the
income generation in US dollars, faces a currency exchange rate risk. Likewise, the US firm,
having funded its Indian operations through a US dollar loan, would be serviced by income
in rupees, and needs to be converted to US dollars for payment of interest and principal in
the future, whenever they fall due.

US asset
Dollar income

y ; Swap transaction

ose Dollar interest >.

Rupee liability / Dollar liability
Liability Indian firm \ >
Rupee interest x Rupee interest ¥ Dollar interest

Rupee income
Indian asset

Fig. 8.8 Currency swap: Converting assetliability from one currency to another

Under the swap transaction, the mismatch of cash inflow and cash outflow in different
currencies for both the firms can be eliminated by (a) the US firm agreeing to pay the rupees
generated out of its Indian operations to the Indian firm, and (b) in exchange, the Indian
firm
agreeing to pay US dollars generated out of its US operations. Thus, the rupee asset income
flows to the Indian firm, facilitating service of its rupee liability. In exchange, US
dollar
asset income flows to the US firm to meet its US dollar obligations. Both the firms
avoid any
conversion of currencies from one to another and thus eliminate exchange rate risks.
Through
the swap, both the firms will have assets and liabilities maintained in the
same currency,
eliminating currency risk.

Reducing Cost of Funds with Currency Swaps

Like interest rate swaps, currency swaps can also be used to reduce funding
cost for MNCs
needing funds in different currencies. Again, the guiding principle is
the theory of com-
parative advantage. In an interest rate swap, the comparative advantage
emanates from the
 Swaps—Interest Rate and Currency 233

:EXAMPLE 8.3 Currency swap to hedge against exchange rate risk

Assume that an Indian software firm, Inso Ltd, wants to acquire a US firm at a cost of $2.00 crore. For this purpose, it raises
the required capital of 90 crore (current exchange rate of %45/dollar) at 12%. The US acquisition is expected to yield a 15% |
return. At the same time, a US engineering firm, USENG Inc., is negotiating a joint venture to contribute US $2.00 crore, which |
promises to yield a 15% return in India. USENG Inc. raises the dollars required at a cost of 8%. Assume that all liabilities need
annual payments.

(a) Examine the risk faced by Inso Ltd and USENG Inc. if the
(i) rupee appreciates to 44, 42, 40, 38, and 36 per dollar for the next five years
(ii) rupee appreciates to 46, 48, 50, 52, and 54 per dollar for the next five years
(b) Show how a swap arrangement between the two can help eliminate the risk of exchange rate fluctuations.

Solution

(a) Inso Ltd is targeting an annual profit of $270 lakh as fol- lows:
Income in US $ = 15% of $200 lakh = $30 lakh p.a.
Equivalent value in rupees = $1350 lakh p.a.
Interest payment = 12% of €9,000 lakh =%1080 lakh p.a.
Anticipated profit = 1,350 — 1,080 = 270 lakh p.a.
lf the Indian rupee appreciates, Inso Ltd, would receive a lesser income than expected, and, hence, carries the risk of reduction
in profit due to appreciation of the rupee, as its liability is fixed in rupees.
Similarly, USENG Inc. is targeting an annual profit of $14 lakh as follows:
Income in rupees = 15% of $9,000 lakh = $1,350 lakh p.a.
Equivalent value in US dollars = $30 lakh p.a.
Interest payment = 8% of $200 lakh = $16 lakh p.a.
Anticipated profit = 30 — 16 = $14 lakh p.a.
If the Indian rupee depreciates, the firm will receive a lesser annual income than expected, and, hence, faces the risk of reduction
in profit to the extent of depreciation in the rupee, as its liability is fixed in US dollars.
While appreciation of the rupee is good for the US firm and detrimental to the Indian firm, the position reverses if the rupee
depreciates. The impact on the spreads of both the firms for the exchange rate scenario is presented as follows:

Scenario
rate (7/$) | Income US $ |Equivalent =| % Spread | Income | Equivalent$ | $ Spread
1,620.00 1,350.00 25.00 9.00 | Favourable to
1,560.00 480.00 | 1,350.00 the Indian firm
1,500.00 420.00 | 1,350.00 11.00 | and unfavour-
1,440.00 360.00 | 1,350.00 12.13 | able to the US
1,380.00 300.00 | 1,350.00 29.35 13.35 firm
1,350.00 270.00 | 1,350.00 30.00 14.00
1,320.00 240.00 | 1,350.00 30.68 14.68 Favourable to
1,260.00 180.00 | 1,350.00 32.14 16.14 | the US firm and
1,200.00 120.00 | 1,350.00 33.75 17.75 | unfavourable to
1,140.00 1,350.00 35.53 19.53 | the Indian firm
1,080.00 1,350.00 37.50 21.50

(b) By entering into a swap arrangement, both the firms elimi- at the current rate of $45 per dollar:
nate volatility in the spread. Under the swap arrangement,
i) The US firm will pay the Indian firm 1,350 lakh annually, earned out of its joint venture in India.
ii) The Indian firm will pay $30 lakh annually, earned out of its acquisition in the USA.
 234 Derivatives and Risk Management

EXAMPLE 8.3 contd

Currency swap: converting asset/liability from one currency to another

US asset
$ 30 lakh. p.a.
|
|. 5 Swap transaction
iabili
Rupee liability Rs. eae:
Otani. " US dollar liability
9,000 lakh p.a. Neen) SOON Saas $ 200 lakh p.a.
s Inso Ltd. ' —
Interest Interest
%1,080 lakh p.a. US $16 lakh p.a.

21,350 lakh p.a.

Indian asset

A schematic diagram of the swap arrangement is shown here. The spread after the swap arrangement becomes fixed for both :
the firms, irrespective of the exchange rate. The US firm will lock-in a return of $16 lakh and the Indian firm will be assured of a |
profit of 270 lakh after the swap arrangement.

Cash flows after swap Figure in lakh p.a.

Inso Ltd
Income earned abroad + $30 sae 1eGoO)
Paid to counterparty — $30 =< 1,350)
Received from counterparty + <4,350 + $30
Interest obligation =< 1,000 — $14 |
Spread Ea + 2270 + $16
Without the swap agreement, income for both the firms in the USA and India was Subject to fluctuations due to currency exchange
rate changes.

differential in pricing in the floating rate and the fixed rate markets. Here, the comparative
advantage results from two distinct and separate markets in different currencies that are gov-
erned by altogether different sets of rules and operate in vastly different economic conditions.
Although the exchange rate mechanism provides a link among these markets and econo-
mies, the link is a frail one compared to the strong linkages the capital and
Currency swaps enable
_ debt markets have in a single economy. The quality spread in domestic mar-
financing in a currency _ kets is based on the credit rating of the parties. In the international markets,
with the lowest interest. the credit rating for a given firm may vary substantially across nations, as
rate. However , a cheaper _ firms are generally better known in their home country than
in foreign coun-
ee ae _ tries. Further, exchange control regulations of a given land may discourage
advantage into exchange borrowing by non-residents by stipulating a higher rate. Therefore, the com-
rate risk, transforming «parative advantage is likely to be more pronounced in two markets in two
the asset or liability from different economies, as compared to similar markets of the same economy
_ one currency to another, for one currency. As such, the credit quality spread is expected to be larger
while reducing the in the markets for different currencies than the credit quality
financing cost. : spread in the
: markets for fixed and floating rates.
 Swaps—Interest Rate and Currency 235

A greater spread in credit quality increases comparative advantage. Increased comparative

advantage opens up more avenues for currency swaps. However, the size of the market may
be limited, as only MNCs will be the beneficiaries of such currency swap transactions.
As a simple example, consider two MNCs, one Indian and one British. Both the firms
enjoy excellent and equivalent credit rating in their countries. However, their funding require-
ments are confined to their own countries. Now they need to raise funds across boundaries
for their ever-increasing expansion needs. In doing so, they can capitalize on any interest rate
differentials that may exist in two currencies.
The costs of capital for the two firms in India and Britain in their respective currencies are
as follows:

Cs Indian Rupee market British Pound market

Indian firm

British firm

Clearly, the Indian firm enjoys an advantage over the British firm in India, and the British
firm commands more credibility in Britain as compared to the Indian firm. Notice that the
absolute advantage may not be in favour of the same firm as in the interest rate swap case.
The comparative advantage here is 6%. If the two firms borrow in the required currencies,
the total cost of funds will be 20%, i.e., the Indian firm borrows pound at 6% and the Brit-
ish firm borrows rupees at 14%. However, if they borrow as per the comparative advantage
theory and exchange each other’s commitment, the total cost of funds can be reduced to 14%,
with the British firm borrowing pounds at 4% and the Indian firm borrowing rupees at 10%.
Both the firms can benefit by 6% in aggregate if they enter into a swap arrangement wherein
the following sequence is followed:
e The Indian firm mobilizes funds in rupees in the Indian market at 10%.
It lends the rupee funds to the British firm at 11%.
The British firm raises funds in the British market in pounds at 4%.
It lends the same funds to the Indian firm at 5%.
The two firms exchange interest payments periodically.
Finally, they exchange the principal amounts upon redemption.
The schematic diagram of the swap arrangement and cost of funds for both the firms is
shown in Fig. 8.9.
We assumed in the example that the Indian firm and the British firm exchanged the princi-
pal amounts of borrowing, and as a natural outcome, would have to exchange the repayment
amounts at the time of redemption. However, it is not essential to do so, as both the firms
can use the spot market for buying and selling the currencies required independent of each
other, both at the time of raising funds and at the time of redemption.
Through the swap the Indian firm is now able to obtain pound funds at 4% as against 6%
in the absence of swaps; a benefit of 2%. Similarly British firm has access to rupee funds
at 10% as against 14%; a benefit of 4%. The aggregate benefit is equal to the comparative
advantage of 6% which may be shared by the two firms depending upon negotiating skills
and strength of the two firms involved.
236 Derivatives and Risk Management

"8 Brincipal
11%
10%

CuSe oe mee CMnCipal mers

Indian firm British firm

1. Payment to investors rupee 10% pound 4%
2, Payment to counterparty pound 5% rupee 11%
3. Receipt from counterparty rupee 11% pound 5%
Cost of borrowing (1 + 2 — 3) pound 4% rupee 10%

Fig. 8.9 Currency swap to reduce cost of funds

DISTINGUISHING FEATURES OF CURRENCY SWAPS |

It may be noticed that the mechanism of a currency swap is similar to that of a parallel loan.
The existence of an intermediary in a swap contract helps to minimize counterparty risk by
locating a suitable counterparty; it makes swaps better than parallel loans.
However, working on the same principle of comparative advantage, currency swaps differ
operationally from interest rate swaps. Under a currency swap, the cash flows are as follows:
e exchange of principal amounts at the time of setting the swap deal at the current spot rate
e exchange of periodic interest payments
* reverse exchange of the principal amounts upon maturity at exchange rates prevailing then
Under an interest rate swap, there is no exchange of principal at the beginning of the
swap
or at its conclusion.
eae ey Currency swaps may be classified as follows.
Swaps are different from
interest rate swaps, _ Fixed-to-fixed In a fixed-to-fixed currency swap, the interest rates in the
ee
amounts, which are in _ two currencies involved
volved are
are fixed.
xed. ForFor example,
example, aaB British
itish fifirm may raise a
different currencies, are loan in pounds and exchange it for US dollars with a US firm. Interest pay-
exchanged both atthe ments may be made by the British firm in dollars, while it receives interest
in
initiation and the conclu- _ pounds from the US firm. The US firm would do the reverse, making
interest
ee ___ payments in pounds and receiving US dollar interest payments. The interest
rates in both the US dollar and the pound are fixed,
Fixed-to-floating Ina fixed-to-floating currency swap, the interest rate on one
of the cur-
rencies is fixed, while it is floating on the other. In
the earlier example in this chapter of
the British and US firms, if the British firm paid interest
in US dollars at a fixed rate while
receiving interest in pounds, based on LIBOR, from
the US firm, such a swap would be a
fixed-to-floating swap. Such swaps not only transform the
nature of the asset/ lability from
 Swaps—Interest Rate and Currency 237

one currency to another but also change it from a fixed rate to a floating rate. They become
complex tools suitable for hedging against currency risks as well as interest rate risks.
Floating-to-floating [na floating-to-floating currency swap, both interest rates are floating,
but in different currencies. In the British firm—US firm example, if the British firm makes
interest payment in US dollars based on the prime rate in the USA while receiving interest
in pounds, based on LIBOR, from the US firms such a swap would be of the floating-to-
floating type.

Swap pricing is important for two reasons. First, as stated earlier in this chapter, banks
function as warehouses of swaps, and are ready to offer swaps to desiring customers. For
this purpose, they are required to quote swap rates for paying or receiving a fixed rate of
interest for receiving or paying the benchmark floating rate. The second reason for valuing
a swap is for the purpose of terminating an existing swap. For reasons of economy, a firm
may like to cancel its obligations under a swap after some time by abandoning the remain-
ing part of obligations undertaken by it, by paying or receiving the value of the swap at that
point of time.

Derivatives inPractice
India and Japan agree to $15 billion currency swap
On 28 December 2011, India and Japan agreed to a dollar swap agreement of US $15 billion. An earlier US $8 billion arrangement
that came into force in 2008 had expired in June 2011. Currency swaps involve an exchange of cash flows in two different currencies.
By their special nature, these instruments are used for hedging risk arising outofvolatility in the foreign exchange markets.
The agreement will enable the two countries to swap currencies for US dollars and tap into each other's foreign exchange reserves
_ to ease any liquidity problems. Under the deal, the two central banks will supply each other with up to $5 billion from their foreign
currency reserves for possible market intervention in the event of financial turmoil.
The genesis of the deal lies in the need to remove volatility in the foreign currency markets. The Indian rupee had fallen more than
15% in a year. The Japanese yen has also been volatile in the wake of an uncertain global outlook.
There were growing concerns about foreign institutional investors (Fils) pulling out of the Indian capital markets due to fears of a
slowdown in the Indian economy. The Fils withdrew almost $600 million from the Indian securities market in November 2011. This
huge capital outflow has hurt the Indian currency, which hit an all-time low against the US dollar. There have also been fears over the
performance of the overall Indian economy due to the protracted sovereign-debt crisis in the global financial markets. A weakening
currency adds to the cost of imported goods. The two nations agreed to support each other in the event of a run on their currencies.
Under the plan, Japan would lend dollars and other currencies, should India find its foreign-exchange reserves declining dispropor-
tionately.
The agreement effectively meant that Japan would accept rupees and give dollars to India up to a stipulated limit, and, similarly,
India will take yen and send dollars to Japan if speculators seek to trash the respective currencies.
Besides containing volatility in the currencies, the swap would help to boost trade between the two countries. The move would
strengthen the Indian central bank's armoury to tackle any liquidity crisis or volatility in the currency market. For India, the swap
arrangement is all the more important, and it might actually draw from the facility, given the situation of net capital outflows, an
exacerbating current account deficit (which climbed to a troublesome 4.9% of GDP for the October-December quarter) and the weak
composition of reserves. India was struggling to meet the projected level of $72 billion in capital inflows till March 2012, and even the
most optimistic forecasts did not put the figure at above $60 billion to $66 billion.
238 Derivatives and Risk Management

Valuing Interest Rate Swaps

As stated earlier in this chapter, an interest rate swap consists of a fixed rate cash flow and
a floating rate cash flow in the opposite direction. At the time of inception of the swap, the
present value of these payments must be equal in the opinions of both the parties to the
swap, or else they would not agree to it. Therefore, at inception, the value of a swap is zero,
implying that the present values of cash inflows and outflows are equal and its aggregate
flow is zero.
However, the circumstances would change after the swap is initiated. The value of an inter-
est rate swap at any time is the net difference between the present values of the payments to
be received and payments to be made. It becomes positive for one party and is equivalently
negative for the other. This tells how much cash the two parties must exchange to nullify the
remaining obligations in the swap.
From the valuation perspective, a swap transaction may be interpreted in at least two ways.
It can be considered either as a pair of bonds or as series of forward agreements. Either
interpretation of a swap helps in its initial pricing as well as its valuation if and when either
or both parties want a premature closure. We take the pricing of swaps by both methods: by
treating the swap as a pair of bonds and as a series of forward agreements.
Swap as Pair of Bonds The most common interpretation of interest rate swaps is to consider
the inflows and outflows of interest at periodical intervals, equivalent to that
An interest rate swa : Sate
can be seen as a pair
[ of bonds. In an interest rate swap, one leg of the transaction is on a fixed rate
’ :
of bonds: one a
floating and the other leg is on a floating rate of interest. We know that the owner of
rate bond and the other a bond receives interest and the issuer of bond pays interest. Therefore, a
a fixed rate bond rep- swap is a composite of these two cash flows:
resenting the two cash
flows, floating and fixed, 1. Cash inflow equivalent to the interest on the bond owned
of the swap. 2. Cash outflow equivalent to payment of the interest on the bond issued
Therefore, a swap is a pair of bonds, one issued and one owned. A swap where one pays
a fixed rate and receives a floating rate can be viewed as a combination of (a) having issued
a fixed rate bond paying the fixed coupon rate, and simultaneously (b) owning a floating
rate
bond receiving a floating rate as per market conditions, as depicted in Fig. 8.10.
While setting up the swap, the coupon rate (the fixed leg receipts/payments) is
fixed in
such a manner that the values of cash inflows and cash outflows are equal and both
the par-
ties to the swap arrangement are in equilibrium; the net present value of the
cash flows is
zero. This forms the basis for fixing the initial price of the swap, determin
ed in terms of a
fixed rate of interest payable or receivable upon exchange of a floating
benchmark rate. For

Fixed 7% > Issue of bond with coupon of 7%

——
FirmA
~e.

Floating MIBOR + 1% ~——— _Owna floating rate bond with

a coupon of MIBOR + 1%

Fig. 8.10 Swap as pair of bonds

 Swaps—Interest Rate and Currency 239

firm A in Fig. 8.10, the equivalent of MIBOR may be taken as 6%, at the time of initiating
the swap.
However, interest rates are dynamic, and the value of cash flows as determined at the start
of a swap will not remain the same as time elapses. The value of the swap will depend upon
the behaviour of bond prices with respect to changes in the interest rates. The following rules
about bond prices may be kept in mind while valuing swaps:
e The value of a fixed rate bond will increase with a fall in the interest rates.
The value of a fixed rate bond will decrease with an increase in the interest rates.
The value of a floating rate bond remains equal to its par value, as the coupon rate is
aligned with market rates on each periodic payment of interest.
e The value of a floating rate bond changes subsequent to each interest payment, if the
interest rate structure has changed since then.
e The value of a floating rate bond gets aligned again to the par value on the next (and
each) date of payment of interest.
Since any change in the value of a floating rate bond will only be nominal and temporary
_ (it changes only during the two interest payment dates), the value of a swap
A swap when seen as
a pair of bond helps in is determined on the basis of the difference between the present values of the
finding the value of the fixed leg and that of the floating leg, and thus is predominantly dependent
swap subsequent to its upon the value of the fixed rate bond.
initiation. The value of The value of the bond with fixed rate payments will be equal to the sum of
- ap Iszerowhen it coupon payments and the notional principal amount discounted at an appropri-
ate rate. The discount rate to be used for each coupon payment is known from
the term structure of interest rates. The value of the fixed leg, V,, is given by:
n

C; 2
Lier >) (1 +,7;,)" ‘i(1 +,r,)" eat)
1
where C; = coupon payment at time 7
r; = discount rate for period i
n = number of periods remaining
P = notional principal amount
Similarly, we can find the value of the floating rate bond, V;, which is equal to the present
value of the next interest payment and the principal. As we know that the value of a floating
rate bond converges to its par value on each payment date, the value of the floating leg can
be expressed as:-
UME PB,
(8.2)
as Chistier)) "7(lesb)
where F', = next payment of interest
r, = discount rate for period |
P =notional principal amount
The value of the swap at any time for the party receiving a fixed rate and paying a floating
rate will be equal to the differential between the fixed leg and floating rate cash flows, given
by Eq. 8.3.
240 Derivatives and Risk Management

Value of swap = PV of fixed coupon bond — PV of floating rate bond or

Ve = Ve +P Vy

ee: P, F P Be
r= 4 er TPN ee (hay ad teme) oy
i

Let us consider a simple example of valuation of aswap, assuming it to be a pair of bonds.

Assume that two years ago, firm A entered a 5-year interest rate swap where it received a
fixed 8% and paid MIBOR + 1%. For simplicity of exposition, we assume annual payments.
There are three remaining annual payments.
Since the time of the swap, interest rates have moved causing the value of the swap to
change. Note that the value of the swap was zero two years ago when it was set up. Assume
that the payment of the floating rate determined one period in advance is at the rate of 9.5%
(MIBOR was at 8.50% then). The term structure of interest rates as on today 1s:
1 year : 10.0%;
2 years : 10.5%; and
3 years : 11.0%
We find the value of the floating rate bond for an assumed principal payment of $100 by
discounting the interest (%9.50) and the principal (%100) at 10%.

The value of the floating rate bond = 109.50/1.10 = %99.545

The value of a fixed rate bond can be found by discounting the three cash flows at the
appropriate discount rate given by the term structure, which would be
8 8 8 100
ie ee s+ :
eae hy hea YI Ge hires
= 13273. + 6,552 er S3849 = a 92708
The value of the swap = PV of inflow — PV of outflow
= 02 OSs .99 545 = oe
The present value of inflow of the fixed leg for firm A is $92.793 and that of the floating
rate outflow is 99.545. The swap can be cancelled if firm A pays %6.752 now to the coun-
terparty.

Swaps as Series of Forward Contracts In a swap, regular payments of interest are made
and received by the counterparties. The next cash flow of interest can be considered as a
forward transaction. Similarly, all subsequent cash flows are regarded as future-dated deliv-
ery commitments. The timing of each cash flow is known in advance, and
An interest rate swap _ hence, a swap can be regarded as a series of forward contracts maturing on
may also be viewed as _ specified dates, with the amounts of respective interest payments as shown
a series of forward con-
_ in Fig. 8.11. .
tracts where the floating
rate cash flows are equiv. 4 SWap is a single contract encompassing several forward contracts. Hence,
alent to the expected _ the objective achieved by a swap can also be achieved by booking several
interest rates implied by forward contracts of interests (known as FRAs, covered in Chapter 8). How-
the term structure of the _ ever, forward contracts are normally not available for far extended dates in
_ future. Even if they are, they suffer from poor liquidity and more expensive
 Swaps—Interest Rate and Currency 241

Each stream of cash flow is equivalent to a forward contract

Stream of fixed interest rate receipts

eee

FIRMA (receiving fixed and paying floating) TIME LINE

Stream of floating interest rate payments |

(Length of arrow varies depending upon the value of the benchmark) F

Fig. 8.11
pricing. Swap quotes and contracts are available for much longer periods as a bundle of sev-
eral forward contracts, and may be cheaper than a series of independent forward contracts.
The valuation of a swap requires computation of the present values of the fixed rate leg
and the floating rate leg. While the interest payments of the fixed rate leg are known for the
entire remaining duration of the swap, the cash flows of the floating rate leg is known for
only the next immediate payment. For all subsequent periods, the cash flows for the floating
rate leg will be determined only one period in advance. Hence, all the payments cannot be
known today. This poses a problem in valuation of a swap when we assume it to be a series
of forward rate agreements.
Treating a swap as a series of forward rate’'agreements, the arrangement of the example
in the previous section can be viewed as follows:

Period ‘t’ | Year‘y’ | Firmreceives% Firm pays %

9.50% fixed at t= 0
Rate to be determined at t= 1; y = 3 say jf

With the given term structure of interest rates, floating rate payments are implied. The term
structure of the interest rate is given here:
One-year yield investment starting today, or} = 10.00%
Two-year yield investment starting today, of? = 10.50%
Three-year yield investment starting today, 013 = 11.00%
where of, implies the interest rate for the investment period starting at 0 and ending at the
nth period.
Forward rates of interests are built according to the term structure of interest rates. The
implied forward rate can be calculated on the argument of equivalence of investment under
two strategies of (a) making direct investment for the planned horizon, and (b) making an
investment now and rolling it over from period to period to cover the entire planned horizon.
From the term structure of interest rates given in the previous paragraph, we may have either
direct investment for 2 years at 10.5%, 1.e., yg”, or investment for one year at 10%, i.e., at
o’;. and then roll over the matured amount for another year at the 1-year rate one year from
242 Derivatives and Risk Management

now, i.€., ;/>. Both the strategies must yield the same end values of the investment. Given
this condition, we have the following relationship:
Caneel Se ea) Hel te ayy
or, L:L0%% (ir 4) = El05-
Or, vo = 11.002%
The present term structure of interest rate implies that the market expects a one-year
investment yield one year later at 11.002%. The investor can invest for a 2-year period at
10.5% and get €1.2210. Alternatively, he can invest for one year at 10% and get $1.10 after
one year. This amount would be reinvested at 1 1.002% for one more year to give an ultimate
wealth of ¢1.2210. Therefore, the second interest payment for the floating rate (to be decided
one year from now) is expected to be 11.002%.
Using the same logic, a 3-year investment should be equivalent to a 2-year investment
rolled over for another year at the rate prevailing for a 1-year investment after two years, i.e.,
>r3, and thus, we have

(Lcheora)? & (1 chor) = Cahora)?

or, (905° 30 ieee alae
or, 93 = 12.007%
With estimated floating rate, payments as derived from term structure of interest rates, we
would estimate the value of the swap-as under;
Amount of fixed leg — Amount of floating leg
Present value of forward cash payment =
(1 + Discount rate)"
Present value of first swap payment JS 00 = 9508
110 1.364
~ ”)
Present value of second swap payment = sara i a = 24s
are
Present value of third swap payment = eu ERY
Cony
The value of the swap comes to — %6.752 as computed with the assumption of the swap
as a pair of bonds.

SWAP QUOTES AND INITIAL PRICING |

Many banks in the international markets play the role of market maker for swaps.
These banks
quote two-way swap rates in terms of a fixed rate of interest for receiving and paying
a float-
ing rate of interest. The bid rate is the fixed rate of interest the bank will
pay to receive a
_ floating rate; and the ask or offer rate is the fixed rate of interest the bank will
Banks play the role of
: receive for paying a floating rate. The average of the two rates is known as
market makers in swaps
by offering two-way the swap rate. At the swap rate, the value of the swap is zero, i.e., the
values
quotes for payingand _—-Of ‘the ‘fixed and floating rates are equal.
receiving a fixed rate of : In order to determine the initial swap rate, we equate the present values of
interest in exchange for _ the cash flows of the fixed rate leg and floating rate leg. The cash flows
a floating benchmark of the
_ fixed leg are known for the entire duration of the swap. The
cash flows per-
taining to the floating leg cannot be determined in straightforward
manner.
 Swaps—Interest Rate and Currency 243

As series of forward contracts How do we price a swap? We again use the term structure
of interest rates to derive the cash flows of the floating rate leg, as they are the best estimates
available for interest rates in future.
Let us consider an example for quoting a 5-year swap with annual exchange of cash flows.
The pricing will be done in the form of percentage interest of the fixed leg to be received/paid
for paying/receiving a benchmarked floating rate of interest. Internationally, the benchmark
is LIBOR. However, here we assume an exchange of MIBOR for the fixed coupon for five
years in terms of Indian rupee.
To equate the present values of the two legs, we need to saiiitaie the cash flows pertaining
to the floating rate bond. The cash flows of the floating rate bonds are normally decided one
period in advance, implying that the next payment is equal to the prevailing MIBOR. The
remaining payments will have to be estimated. The term structure of interest rates provides
the best estimates of the likely payout for the floating leg payments, using equivalence of
direct investment for the planned horizon or rolling over periodically. Therefore, the present
value (PV) of the floating rate leg is given by:
PV of the floating rate leg
=s a 172 2F3 3h4 4l's
(8.4)
(Dir ira) aLactaigt) rp oe rs)ated irtagre)t ay(Ute gra)?
Assuming that X is the fixed payment of interest, the present value of the fixed rate leg is
given by:
PV of the fixed rate leg

re rn a ear pee sey =a Z (8.5)

Glas 1) ere iesmanra eae ( lect gfe i omelet o%4)") (12ers)
For the initial pricing, we equate the cash flows of the fixed and floating rates and solve
for the unknown variable, X.
With the term structure of interest rates, we can arrive at the discount factors and floating
rate payments as implied forward rates, as shown in Table 8.5.

Table 8.5 Finding floating rate payments

_ Year Interest rate Implied forward rate given by |Implied forward rate | Discountfactor |
1 Ne ousye (1 + of) = (1 + oh) of; = 6.500% 0.9390
2 a = 70% (1 + oh) X (1 + am) = 1 + on? i = 7.502% 0.8734
3 Ace cies (1 + ofs)*X (1.4 of)= (1 + om)? oly = 8.507% 0.8050
4 6h, = 80% (1 + om)?x (1 + 9h)=(C1 + on) af = O514% 0.7350
5 ols = 8.5% (1+ ota)4< (1 + gfe)= (1+ of)5 _is==a0, 523% 0.6650

Substituting the values in Eqs 8.4 and 8.5, we get the following value of X:
X (0.9390 + 0.8734 + 0.8050 + 0.7350 + 0.6650)
= 6.500 X 0.9390 + 7.502 X 0.8734 + 8.507 X 0.8050 + 9.514
X 0.7350 + 10.523 X 0.6650)
Or 4.0174 X = 0.3349
X = 0.08338 equivalent to 8.338% = 8.34%
244 Derivatives and Risk Management

The swap rate will be 8.34% for paying or receiving MIBOR. To this equilibrium swap
rate, the dealer/bank will add its spread to cover its administrative cost and counterparty
risk. Assume that the bank wants to add 40 bps for the bid and ask spread; the swap quote
- of the bank would be 8.14% — 8.54%. This means the bank will pay 8.14% fixed for receiv-
ing MIBOR, and receive 8.54% fixed for paying MIBOR. As the tenor of the swap becomes
longer, the spread increases.
Asapair of bonds The same result would be obtained if we treat the swap as a pair involv-
ing one fixed rate and one floating rate bond. The values of the two bonds must be equal at
the inception of the swap, making net present value equal to zero, the cash flows of the two
bonds being opposite to each other.
The value of the fixed rate bond with a coupon of XY would be equal to 4.0174 X for the
term structure used. The value of the principal would, however, be 0.6650 R if R is the
principal. Since the floating rate bond adjusts to the par value at each coupon date, the value
of the floating rate bond would be equal to its par at the inception of the swap. Equating the
two, we get the following expression:
1.00 X 0.6650 + 4.0174 x X=R
If R is taken as $1.00, the value of X, the coupon of the fixed rate bond, would be computed
as follows:
X = (1 — 0.6650)/4.0174 = 0.0834, equivalent to 8.34%
The swap rate then can be written thus:
1 — Last discount factor
Swap Rate = (8.6)
Sum of all discount factors

COUNTERPARTY RISK AND SWAPS

The swap rate can be interpreted as a weighted average of the floating rate payments over
the period of the swap. It is similar to the yield-to-maturity (YTM) of a bond, which equates
all cash flows ofthe bond to its price with a single discount rate. The floating rate payments
are based on the implied forward rates. The two fixed and floating payment legs are not
equal, but the aggregates of these payments become equal at the termination of the swap
deal.
The floating rate payments will be either more or less than the fixed rate payments, depend-
ing upon the direction of the term structure of interest rates.
If the term structure of interest rates is upward sloping, then the floating rate payments will
keep increasing with time. Initially, the floating leg will be smaller than the
The counterparty sekina | fixed leg and as time passes, the floating rate payments start increasing and
swap is dependent upon €XCeed the fixed leg payments. For the rising term structure shown in Table
who pays the fixedrate 8.5, the expected payments are drawn in Fig. 8.12. Similarly, if the term
and who pays the floating structure of interest rates is downward sloping, the floating rate payments
ee _ will be higher than the fixed leg during the initial years of the swap and will
_ : _ reduce subsequently. Assume that from the initial rate of 6.5% now the term
 Swaps—Interest Rate and Currency 245

structure of 6.5%, 6.0%. 5.5%, 5.0%, and 4.5% from years 1—5, the implied forward rates
and discount factor would be as follows:

| Interest rate Implied forward rate given by |Implied forward rate’

| oly = 6.5% (1 + of) = (1 + oh) of = 6.500%
2 glo = 6.0% (1 + of) X G + 1b) = C1 + ot)? _ 4h = 5.502%
3 of3 = 5.5% (1 + of)? X< (1 + of) = (1 + ots)? alg = 4.507%

4 5 (1 + of)? X (1 + af) = (1 + of)" aly = 3.014%

5 ols = 4.5% (1 + ofa)* X (1 + ats) = (1 + ots)? als = 2.524%

11% - :

10% Vo
L
x- 9% |

id ;
|
Bi)
5 8% |
= Likely default by |
|
fixed payer
T% :

is
6%

1 2 3 4 5
Floa ting 6.500 % 7.502% 8.507% | 9.514% | 10.523% |
Fixed 8.338 % 8,33 8% 8.33 8% | 8.338% | 8.338%

Time (years)

Fig. 8.12 Swap payment (Upward sloping term structure)

Note that initially floating payments are higher than fixed and reduce gradually as shown
in Fig. 8.13. In either case of rising or falling term structure the cash payments of two legs
are expected to be equal over the life of the swap. This has important implications for the
counterparty risk in a swap deal.
In case of an upward sloping term structure of interest rates, the fixed rate payer pays more
than what he/she receives in the early part of the swap. There is net cash outflow during the
initial years of the swap deal, and, hence, the fixed rate payer is the only party likely to default
in the initial years. In the later stages of the swap, the floating rate payments exceed the fixed
rate payments, and, hence, the floating rate payer is more likely to be the default party.
The situation reverses if the term structure“of interest rates is downward sloping. The
intermediary faces default risk from the floating rate payer in the initial part of the swap,
while the fixed rate payer is more likely to default in the later stages of the swap deal. The
intermediary must take appropriate steps to contain this risk, as it serves as counterparty to
both the parties to the swap deal.
246 _—Derivatives and Risk Management

7%

6% Likely default
|
:
by floating payer

se (eT
3@ |
ee Likely default | _
z by fixed payer
3% =

2% —
Le Z 3 4 | 5
Floating 6.500% 5.502% 4.507% 3.514% 2.524% |
Fixed 4,588% 4.588% 4.588% 4.588% 4.588%
Time (years) L

Fig. 8.13 Swap payment (Downward sloping term structure)

VALUING CURRENCY SWAPS

We can price a currency swap on the same lines and principle as we use for an interest
rate
swap, 1.e., equating the present value of cash inflows with the present value of cash outflows.
These cash flows are in different currencies, domestic and foreign; and the foreign
currency
needs to be converted to the domestic currency. If the present values of the cash
flows of
the domestic currency and the foreign currency are V, and lV’, respectively,
and the spot rate
is S, then the value of the swap V,, which pays domestic and receives foreign
currency, is
given by:

Vio SG Ki hs
The initial pricing of the swap is set such that the present values
of the foreign and
domestic currency cash flows are equal and the value of the
swap is zero. The most com-
mon currency swaps involve an exchange of principal in the
beginning, periodic payments
of interest at predetermined interest rates and intervals, and
re-exchange of principal at the
end of the swap contract. We have to value these cash flows
to know the worth of the swap
deal at any time subsequent to the contract, as spot rates
as well as risk-free rates of return
change.
Any change in the term structure of interest rates in
either of the currencies involved or
in the exchange rates causes disequilibrium in the cash
flows and imparts value to the swap.
The valuation of a Currency swap can be understood
through a simple example. Let us
assume that firm A has entered into a 5-year swap where
it receives Indian rupees at 8% and
pays US dollars at 4% annually on the exchange of
a principal amount of US $100 lakh when
the exchange rate was %45 per dollar. Assuming a flat-term
structure of interest, the value of
the swap at its initiation is zero, as can be seen from
Table 8.6.
 Swaps—Interest Rate and Currency 247

EXAMPLE 8.4 Value of interest rate swap

Fe
A firm had entered into a swap arrangement for a notional principal of €1 crore with a bank, whereby the bank paid a fixed 9% 7
and received MIBOR semi-annually. It has three more years to go, and has just exchanged the cash flow. The 6-m MIBOR for
the next payment of interest was reset at 8%. The next day, the markets exhibited a fall and the 6-m MIBOR fell to 7%, leading L
the firm to believe that it is overpaying. It wants to cancel the swap arrangement. How much should the firm ask the bank to pay |
to cancel the swap deal? Assume a flat term structure. )
Solution
The value of the swap for the firm is determined on the basis of discounted cash flows (DCFs). Since the rates have changed, |
the discount rate used would be 7% of the prevalent market rate. The value of the cash outflows on a fixed basis discounted at |
7% iS 115.63, as shown here:

Present value of cash flow of the fixed leg

Fixed leg payment — cash outflow
Present 12-month MIBOR
Next interest payment on floating rate

Time (months) DCF (% at 7.00%)

— — 4.50
6 0.50 4.50 4.42
12 1.00 4.50 4,35
18 1.50 4.50 4.27
24 2.00 4.50 4.20
30 2.50 4.50 4.13
36 3,00 104.50 94.25
Present value of fixed leg 115.63
The PV of the inflow at a floating rate would be the next interest payment, decided a period in advance, plus the face value of
%100 discounted at 7%. This amount works out to ¥100.48.

Value of floating leg

Interest to be received after 6 months 4.00
Principal to be received after 6 months 100.00
Total 104.00
Present value at 7% 100.48

The present value of the cash outflow is more by %15.15 for a principal of ¥100. If the bank pays %15.15 lakh for the principal
amount of ¥1 crore, the firm may exit the swap.
TE

The initial value of the swap is zero, as one would expect, because no deal would take
place if either of the party believes it is receiving less and paying more in the given interest
rate and exchange rate scenario. Firms receiving and paying rupees per US
_ dollars must feel equivalence tn both the currencies at the current interest
The valuation ofaswap
is based on the discount’ | tates and exchange rates before they enter a swap deal.
ed cash flow technique; The valuation of a swap can also be done on the basis of treatment of the
the problem arises with payments as a series of forward contracts (Table 8.7). The forward rates can
projection of cost flows of be worked out from the interest rate structure using interest rate parity. The
the unknown floating leg.
cash flow of interest of $4 lakh in years | to 5 and a principal of $100 lakh in
248 Derivatives and Risk Management

Table 8.6 Initial value of swap

(Figures in lakh) |WEY
'
Interest and principal | Interest and principal PV PV
feu (2) (US $) (Z discounted at 8%) | (US$ discounted at 4%)
1 60.00 4.00 833.00 3.85

2 360.00 4.00 308.64 3.70

3 360.00 4.00 285.78 3.56

4 360.00 4.00 264.61 3.42

b) 360.00 4.00 245.01 R329

6 4500.00 100.00 3062.62 82.19
Total 4500.00 100.00
Equivalent domestic currency @ %45/$

year 5 are equivalent to forward contracts of the amounts for each year. Given interest rates
of 8% and 4% for the rupee and the dollar, respectively, a 1-year forward rate using interest
rate parity is,
Paya 1.08
a 5 TC 45 X 1.0385 = %46.73/$
Likewise, one can find out the implied forward rates for all subsequent periods when the
dollar cash flows can be converted into local currency. The differential between the equivalent
of dollar cash flows and the local currency will be the net cash flows of the firm under the
swap. The differential is discounted at the interest rate applicable to the rupee.
Assuming the swap as a series of forward contracts, the value comes to zero in conformity
with calculations based on the assumption of the swap as a pair of bonds.
Let us calculate the value of the swap assuming that the exchange rate has changed from
*45 to ¥50/$ and the domestic interest rate has gone up from 8% to 10%, while the dollar
interest rate remains same at 4%. Note that the absolute values ofthe cash flows pertaining
to

Table 8.7 Currency swap as series of forward contracts

(Figures in lakh) |
< Interest and | $ Interest and | Implied forward fi : a Value of forward | PV of forward
Year Ue oe Equivalent =
principal | __ principal a rate (%/$) contract contract
| 360.00 4.00 46.73 = 186.92 tal 173.08 160.26
2 360.00 4.00 48.53 194.14 165.89 142.22
3 360.00 4.00 50.39 201.58 158.42 125.76
4 360.00 4.00 52.33 209.33 150.67 110.75
5 360.00 4.00 54.35 217.38 142.62 97.06
6 4500.00 | 10000 | 54.95 | S434 56 934.56 | —636.05
Total
TLE EE OTE
0.00
 Swaps—lInterest Rate and Currency 249

the interest and principal, as fixed at the time of setting up of the swap deal, do not change.
With the change in the domestic interest rates, the discounted value of the rupee cash flow
changes, as shown in Table 8.8.

Table 8.8 Value of the swap with change in interest rate

(Figures in lakh)
Ver Interest and principal Interest and principal PV PV 7
(®) (US $) (% discounted at 10%) US$ discounted at 4%) 7
| 360.00 400 / SICT 3.85
2 360.00 4.00 297,52 3./0
3 360.00 4.00 270.47 3.56
4 360.00 4.00 245.88 3.42
5 360.00 4.00 223108 3.29
6 5000.00 100.00 3104.61 82.19
Total 4469.29 100.00
Present value in equivalent rupees 5000.00
Value of swa — 530.71

It is evident from Table 8.8 that with the rise in the interest rates for the rupee, the dis-
counted value of the rupee cash flow falls, and if the firm pays in rupees, the value of the
swap would become %531 lakh. For a firm that receives rupees and pays dollars, the value of
the swap is positive, at $531 lakh. These values can be used to reverse the positions in the
swaps taken earlier. Therefore, the value of the swap is £531 lakh.
The value of the swap is obtained if transactions under the swap are regarded as a series
of forward contracts as shown in Table 8.9. One can summaries actions as follows:
| Calculate the implied forward rates as per interest rate parity
| Convert the foreign currency cash flows to domestic currency at the implied forward rate
| Discount the payment differential at the domestic interest rate

Table 8.9 Value of currency swap as series of forward contracts

(Figures in lakh) |
——
cere eles ae ae
Year Equivalent z|Value of forward |PV of forward |
360.00 4.00 ee oe. 211.54 148.46 13497. |
2 360.00 4.00 55.94 223,74 136.26 11261
3 360.00 4.00 59.16 236.65 123.35 92.67
C3000 4.00 62.58 250.30 109.70 7492 |
5 360.00 4.00 66.19 264,74 95.26 50.15 |
6 5000.00 100.00 66.19 6618.61 1618.61 1005.03 |
Value of the swap —530.71
 250 Derivatives and Risk Management

EXAMPLE 8.5 Value of currency swap

A swap was entered into by an Indian firm with a bank converting its rupee liability into pounds sterling, where the firm received
10% on the rupee and paid 5% on the pound. The amounts of principal involved are 120 million and £1.5 million, fixed atthe then
exchange rate of 780/£. The swap has four semi-annual payments to follow. Assume the next payment Isdue after six months
from now and the term structures in Indian rupee and pound sterling are flat at 9.00% and 5.50%, respectively, for the next two
years. If the current exchange rate is €82.00/£, what is the value of the swap for the Indian firm and the bank?
Solution My .
The semi-annual payment of interest is 0.05 x 120 = %6 million. The final payment would be 126.00 million, including the
principal amount. With a 9% flat term structure on continuous compounding, the PV of the receivable by the firm from the bank
would be:
PV of rupee cash flow = 6.0 x e °° * 05 + 6.0 x @-009X 10 + 6 x @- 0.09% 15 + 196.9 x |@-0.09 x 2.0
= 5.7360 + 5.4836 + 5.2423 + 105.2440 = %121.7059 million
PV of rupee cash flow in pound terms = 121.7059/82.00 = £1.4848 million
= 0,045 x e 0.055 X05 4 0.045 x e— 0.055 10 0.045 « e 0.055 x15 4 1.545 x e 0.055 x 2.0

PV of pound cash flow = 0.0438 + 0.0426 + 0.0414 + 1.3841 = £1.5119 million

PV of pound cast flow in rupee terms = 82.00 x 1.5119 = %123.9735
Value of the swap for Bank
(in millions)
Rupee leg = TAL — 1.4842 +121.71 +1.4842
Pound leg +123.97 +1.5119 23.97, SHES,

A swap implies an interchange. It need not be on interest rates

or currencies alone. The basic
idea of a swap is to have the interchange based on different paramet
ers'so that the complexion
of asset or liability changes from fixed to variable or vice versa,
as may be required.

Commodity Swaps
The prices of commodities change continuously. If the prices
of the output were fixed, the
profit would be variable. By entering into futures contrac
ts, traders can render stable profits.
However, a futures contract as a hedging tool remains
a short-term measure, as the hedging
period is limited to the maximum maturity of the futures
contracts available at any point of
time. Swaps, being OTC products, can ensure hedgin
g of profits for longer periods.
Consider the case of a jeweller who makes orname
nts using gold. Gold prices change
almost continuously, but the prices ofthe finished
product cannot change that often causing
the profit margin of the jeweller to fluctuate. By
entering into a swap where the Jeweller
pays a fixed rate for gold, but receives cash flow
determined on the basis of the current
price of gold, the cost can be fixed. A plain vanilla
swap with monthly cash flows where the
jeweller pays a fixed rate (23,000 per 10 g),
but receives on the basis of a monthly aver-
age price, is depicted in Fig. 8.14. This swap
would provide a hedge against the fluctuatin
price of gold. g
 Swaps—lInterest Rate and Currency 251

Fixed %23,000/10 g of gold >

Fig. 8.14 Plain vanilla commodity swap

Like other swaps, the swap can be done for a notional quantity of gold that need not be
exchanged. The life of the swap contract can also be fixed. More complex swaps can be
executed where the two legs are based on different commodities and different currencies.
Valuation of Commodity Swap _ Just like any other swap, the value of a commodity swap
at the time of its initiation must equal zero, i.e., the likely receipts must cancel out the likely
payments in present value terms. The present value of the fixed leg is easy to obtain, as we
know the amount of the fixed price and the risk-free rate. The risk-free rate may be obtained
from the term structure of interest rates based on ‘zeros’. The floating leg would be based on
forecasts of the price of the commodity. If one can know the forward price, the present value
can be computed using zero rates.
Consider this example. A jeweller wants to receive an average of 6-m prices for gold for
a period of three years every six months. The forecast average price and the term structure
of interest rate are as follows:

Table 8.10 Valuation of commodity swap

Forward price of gold, average over a

period of 6 months (%/10 g)
Yield at the end of period (% p.a.)
Discount factor 5.1728
PV offorward price, % 130,066
Value of fixed leg, = 25,144

To arrive at the fixed payment, we need to find the present values of the floating rate pay-
ments. The initial value of the swap must be zero. Therefore, the present value of fixed leg
payments is equal to the present value of floating leg receipts
Equating the two cash flows, the jeweller must pay a fixed sum of €25,144 at the end of
every six months for the next three years to receive an average gold price.

Equity Swaps
Under an equity swap, one party pays a fixed rate of return and receives a return based
on stock index returns for the preceding period. Stock market returns are variable. For
252 Derivatives and Risk Management

example, consider a mutual fund owning a portfolio of stocks. It is concerned about provid-
ing some minimum returns to the members of the fund. In order to achieve this objective,
it can enter into a swap for part value of the portfolio, where it pays to the swap dealer
returns based on an index, say the Nifty (the index of the NSE), determined at a specified
periodicity, as agreed in the swap, while receiving a fixed rate of return, say 10%. This 1s
shown in Fig. 8.15.

Nifty Returns ?
Mutual fund

LL EEE EEE:

Fig. 8.15 Plain vanilla equity swap

With such a swap, the mutual fund locks in a return of 10% on the value of the swap. The
mutual fund pays returns equal to the percentage gains/losses on the index in exchange for
receiving a fixed 10%, locking-in a 10% return. Part of the portfolio would then be trans-
formed from equity to bonds. Again, we do not exchange the principal, which remains only
notional and serves a purpose in the computation of cash flows. In the event of negative
returns in a period, the mutual fund would in fact receive on both the legs of the swap.
There are two important differences between an interest rate swap and an equity/index
swap. The payments of fixed and floating rates are decided at the beginning of the period in
the interest rate swap. In case of the equity swap, the variable leg is determined at the end
of the period only after knowing the value of the stock/index. Further, in case of negative
returns on the index, the payer of the variable rate must pay the index returns as well as the
fixed payment to the receiver.
To hedge against variability of return, the fund can receive variable and pay fixed. Such a
swap would be useful in bearish market conditions with rising interest rates. In case of bear-
ish conditions with falling interest rates, the fund can enter a swap receiving variable and
paying floating.
A variant to the equity swap can be the exchange of cash flows that are variable, based on
index returns. However, the indices for the two legs would be different. For example, a
fund
in India, having invested in the Indian equity market, is desirous of taking an exposure in the
US markets. Similarly, a fund in the USA is willing to invest in the Indian capital markets.
The two funds can enter a swap whereby the Indian fund receives returns based on the Dow
Jones Industrial Average and the US fund receives returns based on the Nifty index. The
advantage to both the parties is that they are enabled to earn returns from the other
market
without making an additional investment.

Valuation The valuation of an equity/index swap is surprisingly simple. For valuation of an

equity/index swap at any point of time or at the beginning for determination of fixed
coupon
payments, we may use the expectation hypothesis and futures pricing. The forward price
of an
 Swaps—Interest Rate and Currency 253

index is given by the prevailing price of futures contracts: The fair price of a futures contract
is given as its spot price plus the cost of carry computed at a risk-free rate. Hence, the present
value of the index return when discounted at the risk-free rate would be the index value now.
The coupon rate (equivalent to the swap rate) can be found using Eq. 8.6.

CONCLUSION
Innovations in swaps are taking place at a fast pace. Swaptions (options on swaps) are also
becoming popular. A ca// swaption gives one the right to receive a fixed payment of interest
and a put swaption gives the holder the right to pay a fixed rate of interest. In each case, the
holder pays a nominal front-end premium to cover the risk of rising or falling interest rates.
With regard to comparison with other derivatives such as options and futures, a swap is an
OTC product taking into account the specific needs of counterparties, with financial institu-
tions and banks serving as intermediaries. .
The advantages and popularity of swaps rest on the validity of the theory of comparative
advantage of international trade. The theory of comparative advantage would predict the disap-
pearance of swaps as an instrument of reduced financing cost, as with time opportunities for
credit arbitrage should vanish. However, the increasing volumes of swap transactions are defy-
ing this logic. As long as imperfections in the capital markets persist, swaps would continue
to grow. These imperfections have their roots in controls, incentives, and protection measures
exercised by various governments, making access to capital markets discriminatory. Govern-
ments may prohibit non-resident firms from accessing capital markets or may offer subsidized
loans to promote development. Such aberrations based on the domicile of firms are likely to
continue, and would offer scope for swaps, as a tool for reducing financing cost, to take place.

SOLVED PROBLEMS
SP 8-1: Changing nature of asset from floating to fixed income
Cash Rich Ltd (CRL) have invested %50 crore in market-linked securities, providing them with a current return of 8%, with current
MIBOR at 7.50%. Of late, yields in the market have started falling, adversely affecting CRL’s income. They need to protect their
income. Professional Bank Ltd, their banker, has offered a 3-year MIBOR-based swap with rates at 7.30%-7.40%. Should CRL
accept the swap, what income can they lock-in for the next three years? What would be the advantage of the swap? Depict the
swap arrangement.

Solution:
Cash Rich Ltd has a current income at 50 bps above the MIBOR, currently at 7.50%. Since the MIBOR is likely to fall, it is advisable
for CRL to accept the swap with the bank. The swap arrangement is depicted as follows:

- MIBOR + 0.50% Cash Rich Ltd

The income for Cash Rich Ltd would be MIBOR + 0.50% + 7.30% — MIBOR = 7.80%
 254 Derivatives and Risk Management

By entering a swap with the bank, CRL may transform its asset from a floating rate to a fixed rate. In case MIBOR falls to less
than 7.30%, CRL would have the benefit of the swap.
By entering the swap, CRL does not need to alter its investment portfolio.
SP 8-2: Reducing cost of funds with interest rate swap
Company P and Company Q have equal requirement for funds of €50 crore each. They have been offered the following debt rates
in the fixed and floating rate markets for debt:

ee
Company P
ay 10.00%
Floating rate
MIBOR + 50 bps
Company Q 12.00% MIBOR + 150 bps
P wants funds at a floating rate, while Q is happy to raise funds on a fixed rate basis. A bank is willing to act as intermediary,
with 20 bps as its remuneration. Depict a swap sharing the gains equally and find out the cost of funds for P and Q. What would the
saving in financing cost for each firm be?
Solution
The absolute advantage for company P is 200 bps in the fixed rate market, while it is 100 bps in the floating rate market. Therefore,
the comparative advantage is 100 bps, which needs to be shared among the bank, P and Q. With the bank wanting 20 bps, the
remaining 80 bps are shared equally: 40 bps each for P and Q.
Though company P wants to raise finance at a floating rate, the firm must access the fixed rate market and then enter into a
Swap deal with the bank to convert the fixed rate liability into a floating rate liability. Similarly, Q can access the floating rate market
and enter into a swap with the bank to convert its floating rate liability into a fixed rate liability.
One such structure is presented here:

Interest rate swap: A schematic view with intermediary

MIBOR —

| Company Q Company P
1. Payment to investors MIBOR + 1.50% 10.00%
2, Payment to bank 10.10% MIBOR
3. Receipt from bank MIBOR 9.90%
Cost of borrowing (1 + 2 — 3) 1 11.60% MIBOR + 0.10% “

The aggregate cost of funds for P would be MIBOR + 10 bps, a saving of 40 bps on
the cost it would have borne if it had accessed
the floating rate market. Similarly, Q obtains funds at 11.60% against 12% that it would
have otherwise paid without the swap déal,
resulting in an advantage of 40 bps. The bank earns 20 bps in the fixed rate payments
and receipts.
SP 8-3: Reducing cost of funds with currency swap
A British firm and a German firm have fund requirements They have been offered
the following debt rates in the fixed and floating
rate markets:

Fe Pound market Euro market |

Bis firm 5.00% 5.50%
German firm 6.50% 6.00%
The British firm needs euro funding obtainable at 5.50%, and the German
firm requires pounds, available at 6.50%. Demonstrate
how both the firms can reduce their cost of funds by having a swap of cash flows. Assume
equal requirement of funds.
 Swaps—lInterest Rate and Currency 255

Solution
The absolute advantage for the British firm is 150 bps in the pound market, while it is at an advantage of 50 bps in the Euro market.
Therefore, the comparative advantage is 100 bps, which needs to be shared between the German and British firms. With equal
sharing, the advantage to each would be 50 bps.
The British firm must access the pound market and the German firm must borrow in euros; the two firms can then exchange
cash flows in pounds and euros, with each paying interest in the currency of loan of the other and re-exchange the principal cash
flows on maturity. The swap arrangement is shown here:
The cost of funds after the swap deal would be:
For the British firm: £5.00% — £5.00% + €5.00% = €5.00%; a saving of 0.50%
For the German firm: 6.00% — €5.00% + £5.00% = €1.00% + £5.00%, 6%; a saving of 0.50%

< £5.00%
NOTA
£5.00% British firm

SP 8-4: Value of interest rate swap

A firm has a swap under which it pays a fixed interest of 9% and receives floating interest on a semi-annual basis. The swap has
14 months to go, with the next payment falling due after two months. The rate for the floating payment was fixed four months ago at
10.10%. If the term structure for the next 15 months is flat at 10.10%, what is the value of the swap for the firm?
Solution
The value of the fixed leg of the swap would consist of interest payments at 9% (%4.50% semi-annual) after 2, 8, and 14 months.
If considered as a bond, the final payment would also involve repayment of principal of 100.00. The present value discounted at
10.10% (term structure is flat) for all the payments is 101.5161, as shown here:
PV of fixed cash flow = 4.50 x e79:101 x 22 + 459 x 90.101 x 812 + 494.59 x @7 0-101 x 14/12
= 4.4249 + 4.2070 + 92.8842 = 2101.5161

Similarly, payment for the floating leg, determined four months ago at 10.10%, would be %5.50, to be made after two months.
The next payment would be decided then. It implies that the floating rate payment marks itself to par then. Therefore, the value of
the floating leg would be
PV of floating cash flow = 105.50 x e@0101 212 — %403 2965
Therefore the firm paying fixed and receiving floating would have a value of 2.78 (103.30 — 101.52) per £100 of the notional
amount, or 2.78%.

SUMMARY #e
Swaps came into being to overcome the limitations posed by based on a fixed interest rate on a notional principal, while the
regulatory controls over capital flows across borders when MNCs other leg of the cash flow, called the floating leg, is based ona
resorted to mutual parallel loans to fund their operations over- market-based floating rate. No principal is exchanged either at
_ $eas. Later, when capital controls were removed, they devel- the initiation or at the conclusion of the swap. Only the differential
oped into full-blown financial products. of the cash flow is exchanged.
A swap may be defined as an exchange of a series of cash An interest rate swap can alter the complexion of the nature
flows, based on a parameter, at periodic intervals for a fixed of a liability or an asset from a fixed rate to a floating rate or
period. Where the cash flows are based on interest rates, the vice versa, without disturbing the original contract. Interest rate
swap is called an interest rate swap. When the exchange of cash swaps serve as hedging tools against interest rate risks. Faced
flow is based on currency exchange rates, it is called a cur- with rising interest rates, a firm can alter the liability of a loan
rency swap. In an interest rate swap, one leg of the cash flow is from a floating rate to a fixed rate with a swap entered into with
256 Derivatives and Risk Management

a bank, without disturbing the original loan contract. Other than exchanged at the initiation of the swap and re- exchanged upon
working as a tool to hedge against interest rate risk, a swap has its termination. During the swap, the interest rates either fixed or
the potential to save funding cost. This is due to the fact that dif- floating, are exchanged in two different currencies.
ferent firms have unequal credit spreads in the fixed and floating At the initiation of the swap, the value of the swap is always
markets for borrowing. The differential in the spread, referred to zero, as the PVs of the two opposite legs are equal. The value of
as comparative advantage, can be utilized for the benefit of two the swap is determined on the basis of the interest rate scenario
firms to reduce borrowing costs for either one or both. in interest rate swaps. While the cash flow of the fixed leg is
A swap normally requires exact matching of needs of the two known in advance, the payments on the floating leg are decided
counterparties in terms of amount, maturity, timing, and periodic- only one period in advance, and are reset at periodic iniervals.
ity of interest payments—a requirement that is difficult to fulfil and A changing interest rate scenario creates value. For valuation,
can constrain the development of the market. Another drawback a swap may be treated either as a pair of fixed rate and floating
is that a swap gives rise to counterparty risk. Banks, by acting rate bonds or as a series of forward agreements. The value of
as facilitators, provide the much needed depth to swap markets. the swap would be dependent upon the term structure of interest
They also fill gaps in need matching, and act as counterparties to rates.
both parties in a swap transaction. The ready market for swaps Besides interest rate and currency swaps, many other swaps
provided by banks also makes entry and exit from swaps easier. are possible. Where commodity prices decide the cash flows,
Currency swaps have the same applications as those of swaps are called commodity swaps, and where equity returns
interest rate swaps. They can be used to transform assets/ decide the cash flows, they are called equity swaps. innovations
liabilities from one currency to another, hedge against exchange in the field of swaps are continuous, and newer products are
rate risk, and reduce funding cost for MNCs raising funds in being developed from time to time. Being an OTC product, modi-
different currencies. Unlike interest rate swaps, where no prin- fications in the terms and conditions of swaps are aplenty.
cipal is exchanged, in currency swaps the principal amount is

KEY TERMS ©
Basis swap A swap in which both the legs are floating, but Interest rate swap A series of cash inflows and outflows
with different benchmarks. between two parties based on interest rates on a notional principal.
Commodity swap The exchange of cash flows based on the MIBOR Mumbai interbank offer rate, akin to LIBOR
prices of commodities, with one payment fixed and the other Parallel loans The loans made by two parties to each other
variable. to meet requirements that otherwise could not be met by either
Counterparty risk The risk that a counterparty to a contract party by itself.
would default on the promised commitment. Reset date The prior date at which the next polit for the
Equity swap A swap under which one fixed cash flow is floating leg is decided under a swap.
exchanged for another cash flow dependent upon an index. Swap dealer An intermediary—usually a bank—that facilitates
Financial/currency swap A series of cash inflows and out- a swap deal by becoming a counterparty to each of the parties to
flows between two parties based on currency exchange rates the swap, and fills in any gaps in the transaction.
on a notional principal.

QUESTIONS
8.1 What do you understand by parallel loans? Explain with an 8.7 What is a currency swap, and how is it different operation-
example. ally from an interest rate swap?
8.2 Describe the features of an interest rate swap. 8.8 Currency swaps can be used to convert assets/liabilities
8.3 How would you convert a floating rate liability into a fixed from one currency to another. Explain with a suitable
rate liability using a swap? Draw a schematic diagram to example.
explain your answer. 8.9 How are currency swaps and interest rate swaps used for
8.4 If an enterprise has invested funds in securities providing a reducing cost?
floating rate of income, what risk does it faces? How would 8.10 What do you understand by swap rate? What inputs are
you hedge such a risk using an interest rate swap? required in computing the swap rate?
8.5 What are the problems in arranging a swap, and how are 8.11 In what ways can the vaiue of a swap be found? How is
they overcome by a swap intermediary/bank? the value of a swap important?
8.6 Explain hedging of fixed rate and floating rate loans using
swaps.
 Swaps—Interest Rate and Currency 257

PROBLEMS ©
P 8.1 Pricing swap: finding the swap rate rate of 8.50% payable semi-annually on a notional principal of
The following is the term structure of interest rates prevailing ~100 crore. The last payment was made exactly three months
today; : back, when the next floating payment was decided at 10%. The
yield curve has undergone a change since then, and is cur-
Term (months) Yield % p.a.
rently as follows for the remaining 45 months and the next eight
6 4.00 payments:
12 4.20
18 4.40 Lo Time (months) Term structure
24 4.50 3 8.00%
30 4.60 9 8.10%
36 4.80 15 8.20%
42 5.00 21 8.20%
48 5.20 28 8.30%
54 5.40 33 8.50%
60 eae 5.50 ae 39 8.50%
Assuming 360 days in a year, a simpie interest rate, 180 days lene 45 8.70% |
in each semi-annual period, and a spread of 20 basis points, find If the parties are willing to cancel the swap, find out the cash
the swap rate for a 5-year swap with semi-annual payments. flow involved in cancellation of the swap. Assume simple interest
P 8.2 Pricing a forward swap and equal semi-annual periods.
Refer to Problem 8-1. What rate would be quoted for a 3-year P 8.6 Value of a currency swap
swap commencing two years from now? An Indian firm, in order to convert its US dollar loan into a rupee
P 8.3 Hedge against falling yield loan, had entered a swap with a bank, receiving US dollars and
A firm had issued 10-year bonds worth £10 crore at a fixed paying Indian rupees. The swap was fixed for a principal of 100
coupon of 12%, payable semi-annually. The coupon was con- lakh with rupee interest of 6% p.a. payable semi-annually. At the
sistent with the yield prevailing at the time of the issue. Since exchange rate prevailing then of €40.00 per dollar, the equiva-
then, the yield has fallen, and the bond has 5 years remaining lent dollar amount was 2.50 lakh and the interest rate fixed was
for maturity. 3% p.a., payable semi-annually.
The swap rate offered by a bank is 9.00-9.20% against a The yields in the Indian as well as US markets have changed
floating rate based on MIBOR. Depict the swap arrangement of since then. The yields for the remaining four years in rupee and
the firm with the bank, and find out the cost of the bond after the in dollar are as follows:
swap is entered. Time (months) | Yield—rupee | Yield—dollar
P 8.4 Reducing cost of funds with swaps 6 5.00% 3.60%
Firm A and Firm B have identical requirement of funds, and both 12 5.50% 3.70%
are exploring raising of funds either at a fixed rate or at a float- 18 5.60% 3.80%
ing rate. The following rates are offered by the market to both: 24 5.80% 4.00%
Fixed rate market | Floating rate market | 30 6.00% 4.40%
36 6.10% 4.50%
Firm A 10% “MIBOR + 1%
42 6.20% 4.80%
Firm B 11% MIBOR + 3.50%
48 6.30% 5.00% |
Firm A is more interested in raising a fixed rate loan, perceiv-
Assuming a simple interest rate and all semi-annual periods
ing that rates will increase in the future, while firm B believes to
equal, with the next payment due exactly after six months, find
the contrary, and wants to issue floating rate debt instruments.
what value must be paid/received by the Indian firm if it wants to
Show how the cost of funds may be decreased for both the firms
cancel the swap.
if benefits of swap are to be shared equally.
P 8.5 Value of an interest rate swap
An interest rate swap entered into sometime back had a fixed
 "Wii,
yyy,

Options
Basics

INTRODUCTION 9 Learning Objectives

An option is a unique instrument that confers a right without an After going through this chapter,
obligation to buy or sell another asset, called the underlying asset. readers should be familiar with
Like forwards and futures, it is a derivative instrument because the the basic concept of options
value of the right so conferred would depend on the price of the ° the terminology used in describing
underlying asset at that time. As such, options derive their values options
° the basics of call and put options
inter alia from the price of the underlying
and their payoffs
2. _ asset. For easier comprehension of the types of options
rightbul oeaa ee obliga. Concept of an option, an example using the moneyness of options
tion toperform. stocks as the underlying asset is most apt. how to read options quotations
WME
Consider an option on the share of a how options are traded and settled
firm, say ITC Ltd. It would confer a right to the holder to either how options are different from
forward and futures contracts
buy or sell a share of ITC. Naturally, this right would be available
at a price, which is in turn derived from the price of the shares
of ITC. Hence, an option on ITC would be priced according to
the price of ITC shares prevailing in the market. Of course, this
right can be made available at a specific predetermined price and
remains valid for a certain limited period oftime.
The unique feature of the option is that while it confers the
right to buy or sell the underlying asset, the holder is not obli-
gated to perform. The holder, at his/her option, can force the
counterparty to honour the commitment made. Obligations of
the holder would arise only when he/she decides to exercise his/
her right. Therefore, an option may be defined as a contract that
gives the owner the right but not the obligation, to buy or sell an
asset at a predetermined price within a given time frame. It is the
absence of obligation to perform by one of the parties that makes
the option contract a substantially different derivative product
from forwards and futures, which are characterized by equal and
binding obligations on both parties to the contract. This unique
feature of an option makes several applications possible, which
may not be feasible with other derivative products.
 Options—Basics 259

TERMINOLOGY OF OPTIONS
Before we discuss how an option contract works, it would be handy to familiarize ourselves
with the basic terms that are often used in describing and using options. These basic terms
are described as follows:

Call option A right, but no obligation, to buy the underlying asset at a predetermined price
within a specified interval of time is called a call option.
Put option A right, but no obligation, to se// the underlying asset at a predetermined price
within a specified interval of time is called a put option.
Buyer or holder The person who has the right but not an obligation to buy or sell is called
the owner or holder of the option. The holder of an option has to pay a premium to obtain
the right.

Writer or seller The person who confers the right and undertakes the obligation to the
holder is called the seller or writer of an option.

Premium While conferring a right on the holder, who is under no obligation to perform,
the writer is entitled to charge a fee upfront. This upfront amount is called the premium. This
is paid by the holder to the writer, and is also called the price of the option.

Strike price The price predetermined at the time of buying/writing of an option, at which
the option can be exercised, is called the strike price. It is the price at which the holder of an
option buys/sells the asset.

Strike date/maturity date The right to exercise an option is valid for a limited period of
time. The time by when the option must be exercised is called the time to maturity. It is also
referred to as expiry/maturity date.
These terms would become more clear when the two basic options, call and put, are
described in more detail, which we will do now.

CALL OPTION
Assume that the share of ITC is currently trading at 180. An investor, John, believes that
the share is going to rise to at least $220 in the next three months. John does not have ade-
quate funds to buy the share now but is expecting to receive substantial money in the next
three months. He cannot afford to miss an opportunity to own this share. Waiting for three
months implies not only a greater outlay at a later point of time, but also means foregoing of
substantial potential gains. Another investor, Mohammad, holds contrary views and believes
that John’s optimism is exaggerated. He is willing to sell the share.
What can John do under the present circumstances where he cannot buy the shares on an
outright basis? He could possibly borrow to acquire stock in ITC. Amongst
A call option is a right, _ the many alternatives that may be available to John is an instrument called
but not an obligation, to the call option. Instead of buying the share outright from Mohammad, he can
buy an asset at a prede- instead buy a call option (assuming Mohammad is willing to confer such an
termined price withina option) stating that John has a right to buy ITC shares from Mohammad at
specified time.
a price of, say, 190 at any time during the next three months. This would be
260 Derivatives and Risk Management

_acall option (the option to buy). John is the holder of the : option, while
To obtain a right without )
an obligation 1. option Mohammad is the writer/seller of the option. In case John decides to buy the
holder has to paya share (exercise the option) he would pay €190, the strike/exercise price. The
premium price, called = period during which John can exercise this option is three months. Note that
option price, to the entity = John has an option that he may or may not exercise, but Mohammad has no
even ae ______ such choice, and he stands committed to deliver the share by claiming %190
Spier “gies from John, irrespective of the price of ITC share at that time. Naturally,
Mohammad would not provide such a right for free, as he is obligated to perform at the option
of another person. Therefore, Mohammad would charge some fee, called the option premium,
to grant this right to John. This premium is determined inter alia by the price of the underly-
ing asset, the ITC share. We shall discuss later how this premium is decided.
We now discuss the circumstances if John exercises his option. He would use this right
only when the actual price of the ITC share has gone beyond 7190 (the exercise price). Imag-
ine it has moved to 200. By exercising the option, he stands to gain €10 immediately, as he
gets one share from Mohammad by paying *190 and sells it immediately in the market at
¥200. Logically, John would not exercise the option if the price remained below =190. In that
case, his maximum loss is the premium paid. If the price remains below 190, Mohammad
would not be asked to deliver, and the upfront premium he received would be his profit.
We may generalize the outcome of a call option in the following manner:
The holder of a call op-
tion exercises the option As long as the price of the underlying asset, S, remains below the strike
when the price of the price, X, the buyer of the call option will not exercise it, and the loss to the
underlying asset is more — buyer would be limited to the premium paid on the call option, c; if the price
aa the strike price. goes higher than the exercise price, the holder exercises the option and gener-
ates a profit equal to the difference between the two prices, adjusted for the
premium paid. Alternatively, this can be expressed as follows:
When S' <_X buyer lets the call expire loss = premium c
When S = X buyer is indifferent loss = premium c
When S' > X buyer exercises the call option gan=S$-X-e
Mathematically, the value ofthe call is given by Eq. 9.1.
Value ofthe call option = Max (0, § — X) — ec (O21)
A graphical depiction of the payoff of the holder and writer ofthe call option is easier to
comprehend, and is presented in Fig. 9.1 (a) and (b).

Payoff Payoff
A Holder/buyer of A Writer/seller of
call option call option

<I

(a)
LE
tits

Fig. 9.1 Graphical view of payoff of call option (a) for buyer (b) forseller
 Options—Basics 261

PUT OPTION
A put option is similar to a call option, except for the fact that it is an option to sell. We again
take a small example from the stock markets to clarify how a put option
_ Aput option is a right, but
not an obligation, to sell
works.
an asset at a prede- Again, assume that the share of ITC is currently trading at 180. An inves-
_ termined price within a tor, John, who is in possession of the share (it is not necessary to have the
specified time. share to enter into an options contract) believes that it is likely to fall to 150
in the next three months. John is not absolutely sure of a fall, but would
still like to exit from his investment at 175. He is seeking protection against a heavier fall
in the price. Another investor, Mohammad, holds a contrary view and believes that John’s
pessimism is exaggerated. He is willing to buy the share at £175, since he feels that is the
lowest it can go.
John believes that ITC is a good long-term buy but is unsure about when the scrip would
realize its potential. He does not want to exit unnecessarily. Under these circumstances, John
can buy a put option (the right to sell) from Mohammad, stating that he has the right to sell
a share of ITC to Mohammad at a price of %175 at any time during the next three months.
In case John decides to sell the share (exercise the option) he would receive $175, the strike/
exercise price for the next three months. John has the option, which he may or may not exer-
cise, but Mohammad has no such choice, and he stands committed to pay the agreed price
and buy the share from John. Like in the call option, Mohammad would not grant such a right
for free, and charges some fee upfront, the option premium. This premium is determined inter
alia by the price of the underlying asset, the ITC share.
John would exercise his option only when it is profitable to do so. The option would
become profitable when the actual price of the ITC share falls below %175
Leas oe (the exercise price). Imagine that it has moved to $160. By exercising the
when the price of the option, John stands to gain ¥15 immediately by selling the share to Moham-
underlying asset is less mad and realizing ~175 from him, and using the proceeds to acquire a share
than the strike price of ITC from the market at 160. This keeps his earlier position intact and yet
gives him %15 as profit. Logically, John would not exercise the option if the
price remains above ~175. However, under all circumstances, he loses the premium paid.
We may generalize the outcome of a put option in the following manner:
As long as the price of the security remains below the strike price, the buyer of the option
will exercise it because he stands to gain; otherwise, his loss would be limited to the pre-
mium paid on the put option, p. This can be summarized as follows:

When S <_X buyer exercises the option gain =r —"S — p

When S = X buyer is indifferent loss = premium p
When S > X buyer lets the contract expire loss = premium p
Mathematically, the value of the put is given by Eq. 9.2.
Value of the put option = Max (0, ¥ — S) — p (9.2)

The graphical view of the payoff for the put option holder and the writer is shown in
Figs 9.2(a) and (b).
262 Derivatives and Risk Management

Payoff Payoff
A Holder/buyer of A Writer/seller of
put option put option

(Ae oy

Beet =
Price, S
xX

(a) (b)
LLL LEE EE llléddddddddddéssd

Fig. 9.2 Graphical view of payoff of put option

(a) for buyer
(b) for seller

Options have unsymmet- The payoff diagrams for call and put options as depicted in Figs 9.1 and 9.2
rical, non-linear payoff, reveal that the payoff on the options is not linear. While it may be unbounded
unlike forwards and at one end, the other end is limited to a loss/gain equal to the premium on the
futures, because they do option. This unsymmetrical, non-linear payoff results from the feature of ‘right
not create an obligation.
but no obligation’, and makes options different from other derivative products.

Who Benefits?
All options are a zero-sum game; what is gained by the holder of an option exactly the same
amount is lost by the writer. Similarly, the gain of the writer is exactly the
Options are a zero-sum
_ loss of the holder. Table 9.1(a) shows the payoff to the holder and writer of
game; the gain of the
holder is the loss of the the call option at an exercise price of 190 and asset prices ranging from
writer, and we versa. _ %125 to %225. The payoff is governed by the actions ofthe option buyer. If
~ the price of the asset increases beyond the exercise price, the call option
nalder would buy the asset at the exercise price and sell the same asset in the market to derive
a profit. The call option writer would have to obtain the asset from the market, but realizes
only the exercise price. The market price being higher, he/she would incur a loss. If the price
remains below the exercise price, the holder does not exercise the option, and the writer
pockets the premium as a profit.

Table 9.1(a) Payoff of call option X = %190

Bice ot the Payoff—call holder Payoff—call writer

asset (2) Buy from jSell in me Re Sell ,at |Buy from a ge
:
_|__ Writer (%) market tee market (2)
125
150 Holder does not exercise the call option; loses Obligation of writer does not arise; gains premium
premium paid at the time of buying the call option received at the time of writing the call option
is i
200 190
225
 Options—Basics 263

Table 9.1(b) Payoff of put option X = 160

Payoff—put hol owwriter

: Payoff—put
Price of the ayer Pe nelcer
asset (&
set (<)
Sell to writer |Buymarket
y fromthe | Profitfloss |Paytoholder | Sell inthe
(<) Q
y
market (Z) Profit/loss (%)

125 160 125 35 160 125 =e,

150 160 150 | 10 160 150 710 oo|
§@§
SS

175 |
500 Holder does not exercise the put option; loses | Obligation of writer does not arise; gains premium 7
premium paid at the time of buying the put option received at the time of writing the put option iL
225

Table 9.1(b) shows the payoff of the put

option becomes profitable if the price remains below the exercise price, and, therefore, the
holder exercises his/her option. Here, the holder would sell at the exercise price and buy
back the asset from the market. The writer would have to buy from the holder and sell in the
market.

MONEYNESS OF OPTIONS ©"

Moneyness of options refers to the relationship between the price of the underlying asset and
the exercise price. Generally, we use the terms in-the-money (ITM), at-the-money (ATM),
and out-of-the-money (OTM) to explain the relationship between the cash flow of options
upon exercise at any instant of time.

In-the-money, At-the-money, and Out-of-the-money Options

Depending upon their nature, payoffs from options are often referred to as ITM, ATM, or
___, OTM. At any time, ITM options are those that, if exercised, would result in
Moneyness of the option ete ales :
Aéccines the beret _ a positive cash flow to the holder. Similarly, OTM options would result in
the holder gets if he/she : cash outflow if exercised and ATM options would. have no cash flows.
exercises the optionnow. — A call option becomes profitable when the price of the underlying asset
2. ~ exceeds the exercise price. Similarly, a put option is worth exercising only
when the price ofthe asset is less than the exercise price. A call option is called ITM when
the asset price exceeds the exercise price. A put option would be ITM when asset price is
lower than the exercise price.
When the asset price is equal to the exercise price, the option is called an ATM option. It
applies to both call and put options.
Similarly, when the asset price is lower than the exercise price, a call option is OTM,
while a put option would be OTM when the asset price exceeds the exercise price. This table
captures the state of call and put options:

Underlying value, S
Call option
Put option
264 Derivatives and Risk Management

EXAMPLE 9.1 Moneyness of the call options

_Three call options A, B, and C, with exercise prices of 100, €105, and €110 are trading at ¥2, 8, and %14, respectively, while
the underlying stock is trading at ¥105. What is the moneyness of each of the options? What would be the moneyness of each
option if the call prices increased by ¥2 each?
Solution /
The moneyness of the call option is computed from the difference of the spot price, S, and the exercise price, X. It is the money L
the holder of the option would get if he/she exercises the option at the spot price prevailing. The moneyness of each option is |
as follows:

Option A: S— X= 105 — 100 = positive; in-the-money by %5

Option B: S — X = 105 — 105 = zero; at-the-money ie
Option C: S — X = 105 — 110 = negative; out-of-the-money by %5
If the call prices increased by %2 each, there would be no impact on the moneyness of the options because the call price is the
sunk cost.
STE EETEEEEEEOTTTE
CL ee LEE Le Le

TYPES OF OPTIONS "2

Options have several features, certainly more than forwards and futures, thus making several
differentiations possible in the basic products of calls and puts. Based on several consider-
ations, options can be categorized in the following manner:

e Based on the nature of exercise of options

e Based on how they are generated, traded, and settled
e Based on the underlying assets on which the options are created

Nature of Exercise: American vs European

Based on the timing of the exercise, options can be either American or European. American
options can be exercised at any point of time on or before the expiry date ofthe option. while
European options are exercisable only upon maturity.

Nature of Markets: Over-the-counter vs Exchange-traded

Options can also be categorized as over-the-counter (OTC) or exchange-traded,
depending
upon where and how they are created, traded, and settled. Options may be like
forward con-
tracts, which are specific, and are negotiated by two contracting parties through
direct mutual
negotiations, known as OTC, Alternatively, they can be like futures, which
may be bought
and sold at a specific exchange where the two contracting parties may not
be known to each
other, but instead enter into a contract through that exchange.
Such contracts are called
exchange-traded contracts. In exchange-traded options, the contracts need
to
Options can be eithertal- be standardized, while an OTC product is tailor-made to the requirements
lor-made to requirements the parties involved of
or exchange-traded in TI eee :
standardized forme ne standardization of an option contract would be at the discretion of the
exchange and is done in terms of the following:
 Options—Basics 265

© Quantity of underlying asset Only a specific quantity of the underlying asset, which
needs to be predetermined, can be traded on the exchange.
e Strike prices Only specific strike prices can be handled in a standardized product
traded on the exchanges. The OTC products can have any strike price agreed upon by
the two contracting parties.
e Expiration dates Like strike prices, expiration dates too, must be known before trad-
ing can take place in options at the exchanges. Maturity dates too are standardized in
exchange-traded options.
e Nature of exercise of option Traders must also know whether the options they are
entering into are American or European in nature.
e Ways of settlement The mode of settlement can be either cash or physical. Cash settle-
ment at expiry means the exchange of the difference between the exercise price and the
price of the underlying asset, or by facilitating the cancellation of the original contract
by entering into a new contract that is equal and opposite contract to it. Physical settle-
ment would be executed by the delivery of the asset by one party and payment of the
exercise price by the other.

Nature of Underlying Assets

Like forwards and futures, options too can have several assets as underlying. Options on
stocks, indices, commodities, currencies, and interest rates are available either OTC or at
exchanges. Though not available in India as of now, options on commodities are traded inter-
nationally on agricultural products, livestock, food products, energy, and metals.
Options are also available on various currencies, such as US dollar, euro, yen, and pound
in major exchanges in the USA and Europe, as also other parts of the world including India.
The OTC markets dominate options on currencies.
Besides, options are also traded on exchanges on futures contract rates. Options on futures
have a futures contract as the underlying asset, giving the holder a right to buy (call) or sell
(put) the specified futures contract within or at a specified time. Naturally, the expiry of the
futures contract must extend beyond or match the expiry of the option contract.
Similarly, options can also be traded on interest rates, either on cash assets such as treasury
bonds and notes, or on interest rate futures contracts. These options serve the same purposes
as options on stocks and indices. Options on stocks and stock indices are most common.
Several exchanges across the world offer options on indices and stock. The National Stock
Exchange (NSE) in India offers options on several indices such as the Nifty, a broad-based
index of 50 stocks from banking, information technology, infrastructure, etc. Options on
other indices, including foreign indices, are also available.
Presently, these options cover a limited number of exercise prices and periods up to three
months. However, internationally, options for longer periods of up to two or three years are
also available. The NSE attempts to provide two strike prices that are in-the-money, one strike
price that is at-the-money, and two strikes that are out-of-the-money options at any point of
time. Hence, at any point of time, there would be a minimum of 15 call options and 15 put
options (five strike prices with three maturities of one, two, and three months) available for
trading.
266 Derivatives and Risk Management

UNDERSTANDING OPTIONS QUOTATIONS

Options prices are read in the same manner as the prices of any stock. Figure 9.3 presents a
quotation for a call option at the NSE. The last traded price of the call option was ~34.90,
as on 8 October 2012. This is the price for a call option with a Nifty index as the underlying
asset expiring on 25 October 2012, with the exercise price at 5,800, while the current value
of the index is 5,671.80. One contract comprises 50 Nifty indices with the settlement date 25
October 2012. It is a European option that could be exercised only on maturity. The inves-
tor, who was bullish and assumed the position that the index would close above 5,800 on 25
October 2012, had paid %34.90 to the writer of the call.
Apart from stating the last traded price, the template also displays the day’s opening, high,
and low prices, as well as the previous day’s closing price. Other information pertaining to
the current value and volume of the underlying asset and the open interest is also given.
Information on current investors’ interests in terms of the order book is also available during
trading hours.
Options quotations appear in business newspapers daily, giving the prices of the previous
day. Figure 9.4, which depicts how The Economic Times, a business newspaper, displays the
prices of options on a given day, is self-explicit. Options have to be specified in terms of
their nature, expiry date, and strike price. Besides opening, high, low, and closing prices,

Guete Ason Octos,am21s:302716sT & All prices in &

S&P CNX Nifty ime MIE TY | Index ¥Watch [Option Chain

(2 index Derivatives © Stock Dertvetives © Currency Derivatives

Instrument Type: Symbal : Expiry Date - Qetian Type: Strike Price : ES :

Index Cyptions MIF TY ae 250CT2012 cE ~~ S800.0C ha Os cssas

34.90 | Prev.Close Open High Low Close

~ 2550 §119% | (1.50 67.00 87.00 » 34.60 ce

Fundamentals Historical Data

Print Order Intra-day

Traded Volume fcontracts) 364,991 a :
40,67,231 86 Buy Qty. BuyPrice SellPrice Sell Oty. |
arag 200 34.90, es ae “250|
; 5,671.80 ssa 34.85 35.50 9,800),
Market Lot 50 150 3475 | 36.85. 00
pen Interest SO | 34.65 35.65 250
Change in Open Interest Seco) SreU 35.75 oe
Yo Change in Open interest
peliiab aide tenable chal
Implied “y olatilityy
=) Other Information

Settlement Price
Daily Wal atility ast :
Annualised Votatility Pray shes
Client Wise Position Limits _ 2,43, 16,852 |
tiarket Wide Position Limits

ible Source: www.nseindia.com, F&O quote, accessed on 8 October 2012.

Fig. 9.3 Price information of call option on NIFTY
 Options—Basics 267

- DERIVATIVES OPTIONS TRADING AT NSE

Contracts Premium (2) Open int No. of
i igh Low
Underlying Asset:
NEFTY CE-3800-Orct 1935.00 1935.00 1935.00
Contract size: 50 CE-4000-Oct 174400 1682.00 1687.20
CE-4200-Oct 1511.00 1511.00 151100
CE-4306-Oct 1400.00 1400.90 1400.00
CE-4500-Ort 1241.75 1199.45 1209.00
CE-4600-Oct 1139.25 1094.00 1160.06 |
Call Option CE-4700-Oct 1040.00 1631.90 1031.90 p | Volume:
Nature: CE-4800-Oct 940,00 891.10 896.80 | | 3621 Contracts
European CE-4900-Oct 847.70 794.00 805.70 | | Open interest:
Expiry: October Cé- 6006-Oct 751.00 692,90 698.46 | | 928 Contracts
2012 CE-5100-Oct 651.35 594.00 599.10 i
Strike: 5300 CE-§206-Oct $5340 49240 496.10
BINS E-5300-Oct 453,00 395.00 402.85
CE-5406-Oct 361.10 300.60
CE-5500-Oct 268,00 210.00
CE-5600-Oct 190.70
CE-5700-Oct 122,06
CE-5800-Oct 67.06
CE-§906-Oct 32.60
CE-6000-Oct 13.35
CE-6106-Oct 5.35
CE-6200-Oct
Ce-6300-Oct
CE-6400-Oct
CE-6500-Oct
CE-6600-Oct
CE-6700-Ort
CE-6900-Oct
PE-3800-Oct
PE-4000-Oct
PE-4100-Oct
PE-4200-Oct
PE-4300-Oct
Put Option PE-4500- Oct
Nature: PE-4600-Oct
European PE-4700-Oct
Expiry: October PE-4800-Oct
2012 PE-4900-Oct
Strike: 4700 PE-5000-
Oct
PE-5100-Oct
PE-5200-Oct
PE-5300-Oct
PE-5400-Oct
PE-5500-Oct
PE-5600-Oct
PE-5700-Oct
PE-5800-Oct
PE-5900-Oct
PE-6000-Oct
PE-6100-Oct
PE-6200- Oct
PE-6300-Oct
PE-6400-Oct
PE-6500-Oct
PE-6600-Oct

Fig. 9.4 Options quotations The Economic Times, Tuesday, 9 October 2012

information regarding volumes for the day and open interest (number of contracts that are
yet to be settled) at the close of the day is also published.

TRADING AND SETTLEMENT ©

When an options contract is executed, the life of the contract is specified. No right can be
given forever. The number of contracts that are not yet settled is known as the open interest.
All option contracts must come to a close using any one of the three modes: by exercising,
by letting the option expire, or by selling.
268 Derivatives and Risk Management

By Exercising As options are bought with a view to make a profit, there could exist oppor-
tunities to make gains. The holder of an option may decide to exercise the right, and force
the writer to honour the obligation undertaken. The writer has to deliver the underlying asset
under a call, or pay the price for the asset under a put. Note that this applies for the holder of
the option and not for the writer of an option. If the option is American, the exercise can be
done at any time, and if it is European, the exercise can only be done at maturity.

By Letting the Option Expire _ It is not necessary that profitable opportunities arise during
the life of an option. Even if the option 1s profitable, the holder may not exercise the right in
the hope of making larger gains later. If no action is taken by the option holder, the obliga-
tions of the writer would cease to exist automatically upon maturity of the contract.
By Selling Contract Apart from exercising or letting them expire, obligations under an
options contract may be nullified by entering into an offsetting contract that
Prior to expiry, opticns
creates obligations opposite to those of the initial contract. Two points must
can be settled either by
exercising or by selling be noted here. First, the obligations under the initial and subsequent contracts
them. On maturity, they are independent and remain as they are but get nullified only on a net basis.
expire automatically. Second, obligations under call and put options are not opposite and nullify-
ing. An obligation created by writing a call gets nullified by buying a call and
not with a put option.
Consider, for example, a call written (obligation to sell) on an ITC share for a strike price of
~200. It would stand nullified by buying a call (right to buy) on an ITC share with the same strike
price and the same expiry date, and not by buying a put, which is a right to sell. An obligation to
sell/buy stands nullified by a right to buy/sell and not by creating another obligation to buy/sell.

Assignment
In case of OTC options, the buyer and the seller of options enter into a contract directly, and,
therefore, the holder knows whom to approach if and when he/she decides to exercise his/
her right. The writer of the option has to fulfil the obligation.

EXAMPLE 9.2 Understanding option quotations

From Fig. 9.3, answer the following;

(a) What is the name of the underlying asset and what is its current value?
(b) Describe the nature of the option, its strike price, and its expiry.
(c) What is the premium paid by the buyer of one contract?
(d) What is the latest price of the option?
(e) What is the number of contracts that were not added up till the previous day?
(f) What is the number of contracts that were added today?

Solution
(a) Name of the underlying asset and its current value: Nifty, 5,671.80
(6) Nature of the option, its strike price, and its expiry: Call European, 5,800, 25
October, 2012
(c) Premium paid by the buyer of one contract: 734.90 x 50 = %1,745
(d) Latest price of the option: $34.90
(e) Number of contracts not added up up till the previous day: (73,383,900 — 8,78,000)/5
0 = 64,65,900/50 = 1,29,318
y
(f) Number of contracts added
 Options—Basics 269

In an exchange-traded option, the buyer and the seller are unknown to each other, and
enter into a contract through an exchange. To each of them, the counterparty is the exchange.
If the buyer needs to exercise the option, he/she has to advise his/her decision to the exchange
only. In such a case, the exchange has the task of making good the claim made by the holder
of the option. A suitable writer needs to be identified amongst several option sellers.
Suppose you have bought a call option at a strike price of $120. You do not know who
exactly has written the call. If the asset price has moved up to 7125, you stand to gain %5
by exercising the call. Not all the investors decide to exercise their calls. If you decide to
exercise, someone must pay you &5 or deliver the asset. The exchange, therefore, assigns the
liability to one of the several writers of options. The selection of who will be assigned the.
liability arising out of your option exercise is normally done on a random basis. The writer
who is assigned the liability makes the payment and, therefore, loses the opportunity of can-
celling his/her obligation by entering into an opposite contract (buying the call). If the short
position in the option was taken as a hedge, the seller now stands exposed to the same risk
that he/she had presumably covered through the initial position.
In the case of European options, the issue of assignment does not arise, as on the day of
maturity there is an equality of long and short positions. However, American .options are
exercised at any time before or on maturity. The exchange has the responsibility to assign
an exercised option to some option seller. This exercise of assignment is carried out during
non-trading hours. Normally, exchanges allow only cash settlement of options, and, therefore,
only ITM options are allowed to be exercised.

MARGINS IN OPTIONS (7
Options are one-sided contracts where the buyer has no obligations to perform except upon
exercise, and only the writer has obligations. The holder has to deliver either cash equal to
the exercise price, in case of a call option, or the underlying asset, in case of a put option. On
initiating a position, the buyer of the option satisfies his/her obligations by paying a premium.
On the contrary, the writer of the options assumes unlimited risk in case the price of the asset
moves unfavourably. Since an exchange has the responsibility for settlement, it faces the risk
of option sellers failing to meet their obligations. Since positions in options are cash-settled,
it is assumed that the writer of the option would nullify his/her liability by buying the option
back. Thus, his/her obligations would be limited to the premium payable on buying less the
premium received from selling the option.
The credit risk of the exchange can be eliminated if positions of sellers are marked to
market and losses collected, as is done in the case of futures. In the case of futures, marking-
to-market (MTM) losses collected are passed on as MTM profits. This system could also be
followed in the case of options, where MTM losses collected from sellers/losers are passed on
to option buyers/gainers. If such a practice is adopted, the positions of option buyers too would
need to be marked to market and they, too, would be subject to margin calls. Such a practice
is referred to as futures stvle options, where both buyers and sellers are marked to market.
As an alternative, the exchange may decide to keep all MTM losses collected from writers
with itself and not pass them on to the gainers. This is known as premium style options. Most
exchanges follow premium-style options for margining, obviating the need for marking to
market for option buyers. Only writers of options have to make good any MTM losses.
270 Derivatives and Risk Management

ADJUSTING FOR CORPORATE ACTIONS ON STOCK OPTIONS |

Options are contracts that are settled by delivery or in cash with the implicit assumption
that the basic characteristics of the underlying asset do not change during the tenure of the
options. However, stocks issued by firms are subject to corporate actions at any point of time.
Corporate actions such as declaration of dividend, bonus shares, and stock splits change the
value of the stock, and, as such, options on these stocks, too, would change in value. As such,
actions are not a part of the normal process of price determination of an option; they call for
changes in the characteristics of an option.

Adjustment of dividend Options traded on stock exchanges do not provide for adjustment
of dividend. The price of a stock falls by the amount of dividend on the ex-dividend date.
Therefore, the intrinsic value of the ITM call, too, falls by the amount of dividend on the ex-
dividend date. The option premium, dependent upon the value of the underlying stock, would
change on the ex-dividend date. The difference in the option premium must be equal to the
present value of the dividend. Since stock prices are supposed to be the present value of all
expected dividends, there seems to be little logic in adjusting for the payment of cash dividend.
No adjustment to the option features is made with respect to cash dividend on the stock.
However, extraordinary dividends are not anticipated by investors in pricing underlying
assets, or by traders in derivatives. In such cases, adjustments to the option contract can be made
by reducing the strike price appropriately. In the Indian stock markets, a dividend in excess of
10% (subject to change) of the value of the stock prompts adjustment to the strike price.

Adjustment for bonus shares Instead of cash dividends; firms sometimes make bonus
offers by capitalizing their reserves. Though it does not change the aggregate value of the
shares in the hands of the investor, it affects the price of shares substantially, as a larger
number of shares become available for the same value. For example, consider a 3:5 bonus
issue by a firm with a share price of =160. The value of five shares is 7800. After the bonus
issue, the same five shares become eight shares, and in order to keep the value same, the
share must now trade at %100 (800/8). Since aggregate value ofthe underlying asset has not
changed apart from its composition, the value of options contract should also not undergo
any change. For parity of cum-bonus and ex-bonus, the following two adjustments must
be
made to option contracts:
¢ The number of shares in the contract must increase by (1 + bonus ratio).
e The strike price must reduce to 1/(1 + bonus ratio).

If there is an ATM call option at $160 for 100 shares, the contract now must stand
modified
as an option to buy 100 X 1.6 = 160 shares, i.e., the original contract size
X (1 + bonus
ratio), at a strike price of 160/1.6 = 100, ie., the original strike price/(1
+ bonus ratio).
These two adjustments would keep the commitment under the option unchange
d.
Adjustment for stock splits Under stock splits, the number of shares
increases, with the
price reduced proportionately. For example, a 2:1 split doubles the supply
of shares, and that
must reduce the price of the shares by half. Adjustment, as in the case
of a bonus issue, with
respect to the contract size and the exercise price, are made so
that the value of the option
contract, pre-split and post-split, remains the same. Therefore, the
number of shares in the
option contract must double, with the exercise price reduced by half.
 Options—Basics 271

EXAMPLE 9.3 Corporate actions and option contracts

An exchange-traded option contract on a stock has 500 shares with a strike price of 140. How would the option contract change |
if before maturity of the contract, the following actions are taken by the company?
(a) A cash dividend of 5 per share is declared.
(b) Bonus shares in the ratio of 2 for every 5 are announced.
(c) A stock split in the ratio of 4:1 is announced.

Solution

(a) For a cash dividend, no adjustment to the option contract is made.

(b) For a bonus issue, the number of shares in the option contract would become 500 x 1.4 = 700, and the exercise price is |
reduced to 140/1.4 = 100. L
(c) For a stock split, the number of shares in the contract would increase to 500 < 4 = 2000, with the strike price reduced to |
140/4 = %35.

OPTIONS OTHER THAN STOCKS/INDICES ©

The process of trading and settlement of options on other underlying assets that are exchange-
traded essentially remains the same as that for stocks and indices, as explained earlier in the
chapter. In case of OTC options, the issues. of closure of contract, margins, and daily settle-
ments do not arise. They essentially remain contracts between two known parties. Most
options on currencies are OTC contracts. Some exchanges abroad offer options contracts on
several prominent currencies such as US dollar, euro, and pound sterling.
Options are also available with futures contracts as underlying assets, where a buyer of
the option has the right to buy/sell a futures contract. These futures contracts are normally
based on currencies.
Options on interest rates known as caps, floors, and collars are also available, where the
holder of the option has a right to have interest payments, based on the interest rate achieving
a certain level.

DIFFERENCES BETWEEN OPTIONS AND FORWARDS/FUTURES

The basic concept behind forwards/futures and options is distinctly different. Forwards/
futures and options present distinct risk—return profiles. Consider, for example, futures and
options positions on a stock trading at %100. You are bullish on the stock, and consider a long
position in the stock as beneficial. You have two choices: (a) buy a futures contract now and
sell it at maturity or earlier or (b) buy a call option at a strike price of £100, selling at a
premium of <5, and exercise it on maturity or earlier. What would be the risk—return profile
under each of these two situations?
With two opposite scenarios, mcreased and decreased prices, the payoffs
ee
payoff becausebee
they do on a forward strategy and an option ! strategy would be different.
: Under ; a
not create equal obliga. futures contract, you stand to gain or lose equally, depending upon the price
tions on counterparties, of the stock. If the price goes up, you gain the difference in price, and if it
while forwards or futures = moves down, you lose the difference in price. However, under an option con-
nee se _ tract, while you gain proportionately from an upward movement in the price
272 Derivatives and Risk Management

| EXAMPLE 9.4 Option on currency

A call option expiring six months from now on euro has an exercise price of %62, and is priced at 1.25. Depict a long position
on the call. What is the payoff if on expiry, the exchange rate is (a) 61.00, (b) %63.00, and (c) 765.00?
Solution
The payoff on the long position of the call on the euro is depicted as follows:
Long position of call on euro
Payoff
A

x
>=
Exchange rate (/€)
WLS

Payoff of the call at expiration is given by Max(S — X — c, — ¢).

(a) For a price of 61.00, the call expires worthless. The payoff is the lost premium of %1.25.
(b) For a price of %63.00, the call would be exercised, gaining =1.00. The payoff would be —%0.25, recovering most of the
premium paid.
(c) For a price of 65.00 the gain from the exercise is 4.00. Net of premium paid, the payoff is €2.75.

of the asset, you contain your losses when prices move down to the extent of the premium
paid for buying the call option. The payoff under both situations is presented here and is also
depicted in Figs 9.5(a) and (b).

Asset price Long futures position Long call option

80.00 —20.00 —%5.00

120.00 20.00 715.00

Profit/loss Profit/loss

te
>
Asset price
at maturity

OLLI IOI OTE LLL ET LETSEEE EELS ET i ae eee TELSLET

ESE TEES TES HE
Fig. 9.5 Payoffs (a) Long futures/forward position (bb) Long call

As can be seen, the payoffs under a long position in a forward/futures contract are equal
under situations of favourable and unfavourable movements in the price. It is uneven in the
case of an option. While it permits full gains, a position in options limits losses.
 Options—Basics 273

Similarly, one can realize that a short position in futures loses when the price rises and
gains when the price falls. If an investor is bearish, he/she would go short on futures. This
may be compared with the payoff on the put option. A put option permits gains with a decline
in price, while it contains losses due to a rise in price. Comparing a short position in stock
at 7100 with a long put with a strike of $100 and a premium of 25, the following would be
the payoffs when the price at maturity is (a) lesser at €80 and (b) higher at €120:

Asset price | Short futures position | Long put option

%80.00 %20.00 15.00
=120.00 —%20.00 —%5.00

The payofts for a short position in forwards/futures and a long put are shown in Figs 9.6
(a) and (b).

Profit/loss Profit/loss
A A
z z

> oa
100 Asset price Asset price
at maturity at maturity

LLL Z EE ee

Fig. 9.6 Payoffs: (a) Short futures/forward position (b) Long put

A short position in options, i.e., a short call or a short put, is non-descript in terms of for-
ward/futures positions. A short call in terms of futures appears like a short position in futures
with the gain-making area curtailed substantially and all the loss-making positions retained.
Similarly, a short put is like a long position in futures with almost the entire profit-making
region removed and the whole of the loss-making range retained. Short positions in options
do not have a parallel in futures due to the uneven payoff of options and the even payoff of
futures.

Table 9.2 Differences between forwards/futures and options

| :
Forwards/Futures | Options
Payoff j Linear Non-linear

Obligation to perform Both buyer and seller Only on seller of option with a right to the
; buyer
Trading OTC for forwards; exchange-traded for futures | Both OTC and exchange-traded
Vaan None for forwards, which are OTC, and as None if OTC and as per exchange
a2 required by exchanges in the case of futures | requirement if exchange-traded L
Initial payment None Buyer pays premium to seller |
Settlement it for forwards, and daily
Once on maturity i for ily iif exchange-traded;
Daily -traded; 0 once on :
futures maturity if OTC
ULEEEEEE
 274 Derivatives and Risk Management

Other differences between options and futures are that under an options contract, only one
party (the writer) is obligated to perform, while in a futures/forward contract, the obligations
are mutual. There is no upfront payment involved in a futures or forward contract, while a
premium is paid by the buyer of an option to the seller. For easier comprehension, the differ-
ences between forward/futures and options are condensed in Table 9.2.

Options and Insurance

Match abandoned due to rain! Opera show cancelled as artists do not turn up! Conference deferred due to non-avairabiiity of venue!
These are some of the headlines that we often see in newspapers. What happens to the spectators and participants who have
paid for such events, only to learn at the last minute that the scheduled event is not taking place? The public goes on a rampage,
demanding its money back. Do ticket holders truly get reftunds? The answer to this question is, not all the time. That means seldom.
Why do organizers refuse to or are reluctant to refund? Besides commercial reasons, it may be recognized that in the first piace,
they did not sell the ticket with a put option. If they had done so, the spectators would have got the right to sell the tickets back and
the organizers would be under an obligation to buy the tickets back. Naturally, such protection cannot come for free. If organizers
were to sell tickets with a put option, they would have to build in a premium. A ticket with a put option would cost more than the
one without a put option. How many of us would like to pay that extra bit? Perhaps claiming a refund would cost us more than the
original worth of the ticket itself, and, hence, most of us would not like to pay extra.
Even if organizers of events are willing to sell tickets with a put option, great difficulties would arise in valuation of the risk. This
risk is different from market risk, where the risk premium is known. Organizers would not be able to price the risk themselves. The
risk involved here is event risk, and not market risk. Insurance companies are able to price event risks over a large volume and
spread it across policy holders. Not everybody claims insurance, but for refund of tickets all would claim.
The second obstacle to issuing tickets with a put option is that the right to sell must come without any riders with regard to reasons
for claiming refunds—rain or no rain, show or no show. This is in contrast to insurance, where an event must take place before a
claim can be made.

SOLVED PROBLEMS »
SP 9.1: Moneyness of put options
Consider the price data of Example 9.1. Three put options D, E, and F, with strike prices of 100, %105, and %110, are selling at
%2, 5, and %13, respectively.
(a) Find out which of the put options are in-the-money, at-the-money, and out-of-the-money.
(b) If the price of each of the put options increases by =1, would your answer to the moneyness of options change?
(c) If the price of each of the options decreases by %1, what would be the change in the moneyness of each of the options?
Solution
(a) Moneyness of put options is as follows:
Option D: X — S = 100 — 105 = negative; out-of-the-money by %5
Option E: X — S = 105 ~ 105 = zero; at-the-money
Option F: X — S = 110 — 105 = positive: in-the-money by &5
(b) and (c) _ If the price increases or decreases, there would be no change in the moneyness of the options.

SP 9.2: Long position and call option

At NSE, a share of Reliance is trading at $2100, a call option with a strike of $2200 with three months to expiry
is trading at %26,
while a put option with the same strike is valued at 2110. Draw a payoff diagram for a long position in the stock,
a short position in
the stock, a call option, and a put option.
 Options—Basics 275

Solution

Long position in stock Call option holder

Profit/loss Profit/loss :

z z |
2100
r > |]
> 2126 Stock price L
2100 Stock price
2100

LR Re

Short position in stock Put option holder

Profit/loss Profit/loss
A A

a >
2100 Stock price Stock price

TLL LETTE DTT HET TE ELE ITEP UEP EOLSSS OSES eRe oeereae

SP 9.3: Long position and put option

A put option on shares of ITC with a strike price of %180 sells for 10. Draw the
Payoff of put option
payoff of the long position in the put options at maturity. Under what circumstances
would the holder of the option make a profit? At what price would the investor
break even, and what would be the payoff if the stock price at maturity is =160?
Solution
The payoff of the put option is given by Max(X — S — p, — p) where X and Sare
the strike and spot prices, respectively, and p is the premium on the put option. 1 80 Spot price (= —
The payoff diagram is as shown. 40 at Y
The option would be exercised if at maturity the spot price is less than %180.
The holder of the.put option would be making a profit if the stock price is less zeseasonrsenas

than %170. At a spot price of 160, the profit to the investor would be €10, after
adjusting the premium paid for buying the option.

_ Options are somewhat unique instruments that confer a right to A call option is bought when the expectation is for a rise in
one of the parties to buy/sell an asset, while the other party is the asset price, and it is beneficial to exercise when the asset
obligated to perform at the instance of the former. An option to price exceeds the exercise price. A put option is used when one
_ buvis known as a call option and an option to sell is a put option, expects the price to fall; it is exercised when the price falls below
The holder of the option pays a premium to the counterparty, the exercise price. An option is a zero-sum game, where the gain
called writer or seller, to induce hinvher to confer the right. The of the holder is equal to the loss of the writer.
price at which the asset is sold or bought is called the strike price, Options can either be exchange-traded or customized
and the time during which the right can be exercised is called the between two parties. Options on stocks are mostly exchange-
time to expiry. If the option is exercisable only on maturity, itis a traded, while those on currency—the most popular form—are
_ European option; othenwise, it is anAmerican option. OTC. They automatically become null on expiry. Before or on
276 Derivatives and Risk Management

expiry, they can either be exercised or closed out with an oppo- futures. Since options do not have equal obligations on coun-
site contract with cash settlement of the difference in prices terparties, the payoff is uneven. Options protect the downside,
between the opening and the closing contracts. while retaining the potential for the upside, and, therefore, they.
There is a substantial difference between options and the are unique instruments.
positions taken by other derivatives such as forwards and

KEY TERMS #3
American option An option that can be exercised before or Option contract An option contract confers a right, but no
on maturity. obligation, to buy or sell an asset at a given price before or on
Assignment The process of assigning the obligation of maturity of the contract period.
delivery to a specific seller upon exercise by the holder in an Option premium The amount of money paid upfront by the
exchange-traded option. option buyer to the option seller.
Call option A call option confers a right, but no obligation, Put option A put option confers a right, but no obligation, to
to buy an asset at a given price before or on maturity of the sell an asset at a given price before or on maturity of the contract
contract period. - period.
European option An option that can be exercised only on
maturity.

QUESTIONS ~~
9.1 What do you understand by an option contract? Illustrate 9.5 What is the difference in payoff between a long position on
with an example. an asset and a call option on the same?
9.2 Explain the features of an option. 9.6 What are the key specifications and parameters of an
9.3 How are option contracts settled? Illustrate. options contract?
9.4 What are the advantages of options over forward/futures
contracts?

PROBLEMS ~~
P 9.1 Payoff on options rate with a strike price of ¥50/$, charging a premium of 1.00.
Find out the payoffs of the following positions on European op- Find the payoff for various exchange rates ranging from 245 to
tions on a stock whose price at maturity is 100: 55. At what level of exchange rate would you turn from profit
(a) Long A call with an exercise price of 90 to loss?
(b) Short A call with an exercise price of 80 P 9.3 Payoff on long put
(c) Long A put with an exercise price of $110 As an exporter, you are expecting to receive €10,000. You have
(d) Short A put with an exercise price of 110 bought a put option with a strike exchange rate of 760 per euro,
(e) Long A call with an exercise price of 100 and have paid a premium of %1.50. Depict the payoff of a put
(f) Short A put with an exercise price of 7100 option, the receivable, and receivable combined with the put, for
P 9.2 Payoff on short calls in foreign exchange exchange rates between %55 and %65 per euro. Further, deter-
You have written a call on the US dollar to rupee exchange mine and depict the value of receivable for the range.
 Option Pricing
Basics

INTRODUCTION
Learning Objectives
An option is an uneven contract that gives a right to one party, After going through this chapter,
i.e., the holder or the buyer, while it binds the other party, 1.e., readers should be familiar with:
the writer or the seller, to an obligation. Naturally, the buyer can - the intrinsic value and time value of
not enjoy the right free of cost, since that would make it a lop- an option
sided contract. The buyer of the right has to induce the writer to + the boundary conditions of option
pricing
confer such a right on him and undertake an obligation. The
¢ the determinants of an option price
amount paid by the buyer of the option to the writer of the option and its application
is called the premium. Calculation of the premium is also known ¢ arbitrage arguments regarding
as valuation of the option. option pricing
The determination of the option premium has been an area «~ relationships of option prices based
on arbitrage
of widely researched complexities. Fortunately, there exist
+ relationship between call and put
some arbitrage-based relationships that prices—put-call parity
Determination of option
explain a lot about option price behav-
premiums has been a
major area of research. iour. We shall initially examine and
_However, there also achieve a basic understanding of some
exist simple arbitrage- broad conditions and rules that govern
based rules that explain option premiums. Later chapters will
a lot about option price
cover some conceptual mathematical
behaviour.
models that provide a greater under-
standing of the complex ways an option
price is determined. A broader understanding based on the rules
of arbitrage is extremely handy for exploring the various appli-
cations of options. Moreover, arbitrage is easier to comprehend.
Some simple rules about pricing are presented here. Unless other-
wise stated, we shall discuss the pricing of European options only.

INTRINSIC VALUE AND TIME VALUE |

The valuation of an option, i.e., the premium payable by the
holder, is dependent upon several factors that can be viewed in
different ways. One way to examine the situation is to understand
278 Derivatives and Risk Management

what happens if one buys a call now and exercises it immediately. Besides the immediate
exercise of an option, one needs to consider situations where it would be more profitable to
exercise in the future. Stated differently, the two most important factors in determining an
option price would be
e the extent to which the option is in-the-money (ITM); and
e the chances that before expiry, the option will become deeper ITM or will turn into
ITM if it is presently out-of-the-money (OTM).

Therefore, the price of an option has two components, called intrinsic value and time value.

Intrinsic Value The value attached to the option when exercised is called the intrinsic value
of the option. The difference between the spot price and the exercise price will determine this
value. The intrinsic value is as follows:
For a call option: Max {(S — X), 0}
For a put option: Max {(X — S), 0}
The value of an option can never fall below its intrinsic value. For example, a call option
_ with an exercise price of €80 on an underlying stock currently trading at
The option premium con-
sists of two components: ~100 would have an intrinsic value of 20. This-would be the minimum price
intrinsic value and time at which the call would sell. Any price less than 20 presents an opportunity
value. to make immediate profit without taking any risk. If one buys a call at 719
(less than ¥20) and exercises it immediately, the cash outflow would be =99.
Then the holder can sell the acquired stock at 7100, gaining =1 immediately.
The difference between the spot and strike prices would determine the intrinsic value. For
an ITM option, exercising would lead to positive cash inflow to the holder. An at-the-money
(ATM) option does not lead to a cash inflow to the holder if exercised. An OTM option would
cause a negative cash inflow to the holder if exercised. The conditions for ITM, ATM, and
OTM options are listed as follows:

Call Put
In-the-money I ox S<X
At-the-money S=xX S=X
Out-of-the-money $< xX OX.
Time Value The value attached to the chances that the spot price would pierce the strike
. value is
intrnsic : he :_ price
p befor iry
ore expiry is called
is cé i
the time value of an option. i
The time value of
money the holder ofan 2 option can be derived from the observed/actual price and the intrinsic
option would get upon value. It is the difference between the actual price and the intrinsic value. The
exercise. The time _ time value is paid by the buyer for the probability that the option will
turn
value is the excess of _ITM or achieve greater ITM value before expiration. Time value may
the actual value over the be
intrinsic value. _ written as shown in Eq. 10.1.
Time value of an option = actual price — intrinsic value (10.1)
Similar to intrinsic value, time value too cannot be negative. At best
or worst, it can be zero.
Among options, time value is greatest for ATM options. The entire
premium paid for ATM
options is attributable to their time values, as their intrinsi
c values are zero. As the spot price
moves away from the exercise price, the time value starts falling.
For deep OTM options, the
 Option Pricing—Basics 279

EXAMPLE 10.1. Call option prices and payoffs :

A 2-month call option on Infosys shares with a strike price of 2100 is selling for £140 when the share is trading at 2200. Find
out the following:
(a) What is the intrinsic worth of the call option?
(0) Why should one buy the call for a price in excess of the intrinsic worth?
(c) Under what circumstances would the option holder exercise his call?
(d) At what price of the asset would the call option holder break even?
(e) Ifthe price of the Infosys share becomes 2150 (lower than the break-even price) should the option holder exercise the call option?
(f) What is the payoff to the holder and the writer if the price of the Infosys share is $2000, $2250, and $2500 on the date of
expiry of the option?
Solution

(a) The intrinsic worth of the option is (S — X) = 2200 — 2100 = 2100. L

(b) The price of the option is 140, i.e., $40 more than the intrinsic worth. This is the time value of the option, and is paid because L
there are chances that in the next two months, the price of the Infosys share may rise further, and the holder would stand to |
gain more than €100.
c) The option holder would exercise his call if the price of the asset, S exceeds X, the exercise price, i.e., when S > 2100.
(d) The call option holder would break even when the payoff on the call S — X — c = 0, which happens at S = %2240.
(e) If the price of the asset is above the exercise price, the call option must be exercised, irrespective of whether it breaks even
or not. The premium paid is a sunk cost. If the price of the stock is 2150, the option holder stands to gain 50 upon exercise
of the option, which would partly refund the premium paid and contain the losses to €90. If he does not exercise the option,
the loss would be €140.
(f) The payoff to the call holder and the writer at various prices is
Stock price Call option holder Call option writer
Max(S — X — ¢, — c) -MaxiS X-¢- oc
S = 2,000 —140 +140
S = 2,250 +10 =10
S = 2,500 +260 —260

time value approaches zero. Further, for deep ITM options, the time value approaches zero,.
and most of the premium paid is attributable to the intrinsic value of the option. It signifies
that for deep ITM or deep OTM options, the chances that the spot price would pierce the
exercise price are remote.

BOUNDARY CONDITIONS FOR OPTION PRICING &

Before any attempt is made to find the cost of buying an option, we should examine the
boundary conditions and gain some insight into the maximum and minimum values an option
can take, based on simple logic rather than on any mathematical model. The pricing of Euro-
pean options is discussed in the following section.

Call Option
A call option is a right to buy an asset at the exercise price. The maximum value of the call
option, c, cannot exceed the price of the asset itself, as no one would pay more money to
buy a right to have an asset than what it actually costs. Therefore, the price of a call option
is given as follows:
280 Derivatives and Risk Management

Maximum price of a call option, Cma, = Sore =S (10.2)

Similarly, the minimum price that a ca!l option would sell for is dependent upon itsintrin-
sic value. If the option is maturing just at the time of buying, the time value of the option can
_ be assumed to be zero and it must sell for its intrinsic worth. However, if there
The maximum value ofa is some time remaining for maturity, the exercise price would be payable only
es
_ the value of the asset
then.
:
Therefore the minimum value of the option shall be the difference
on which the option is _ between the spot price and the present value (PV) of the exercise price, or

oe Guin eam ce OS NC (10.3)

where Xe" represents the present value of the exercise price.

Arbitrage argument A call option with an exercise price of 80 and a spot value of $100
for the underlying asset must sell for more than $20 (spot value — exercise price). Any price
less than the intrinsic value presents an arbitrage opportunity. Consider the following strat-
egy, assuming the call option sells for £10.
e Buy a call for 10
e Short the stock for 7100
® Generate a cash flow of 790

At expiry, the payoff would be:

Stock price L Value of stock Value of call Total
If S< 80 as _ =
If S> 80 =e S— 80 —80
The cash outflow at maturity is always less than %80, irrespective of the price of the asset,
as against ~90 already generated.
Therefore, a call option’s value will always exceed the difference between the spot price
and the Present value of the exercise price.
In case of an American option, the boundary conditions for pricing of a call will apply.
o _ The condition for the maximum price needs no elaboration. For the mini-
The minimum value ofa
call is given by the spot. «= uM value, the call holder will pay X at the time of exercise
of the option,
price less the PV ofthe and the condition will hold, since S — Ye~ will always be higher than § —
exercise price. _ X. Further, it can be proved that it is sub-optimal to exercise an American
option before maturity for a stock that pays no dividend,
The composition ofthe price of a call option is shown in Biss si:
As an example, consider a call on the stock of Wipro, with an exercise price of $1400
and
a spot price of 71450, which may be selling at 275. It is easy to see that the intrinsic
value of
the call is 50, and the balance is %25; the time value is attributed to the fact
that the price of
Wipro can go further beyond, say, 1500 before the option expires. Naturally,
the time value
of the option cannot be negative.
It may be observed that for a call option, time value is at a maximum
when the spot price
_ is around the exercise price. The further away the spot price is from the
Time values of options
exer-
cise price, the lesser would be the time value. For a spot price that
are the greatest for ATM is far in
excess of the exercise price, the value of a call option will mainly compris
options. e
_ its intrinsic value. Similarly when the spot price is far less than
the exercise
 Option Pricing—Basics 281

Value of call A

Upper bound
Maximum value

Time value

Lower bound
Minimum value

y eee Intrinsic value

Spot price '*h

é'°h
ew
""
SS

=
SE - - ee ese -_ ,— LLL

EXAMPLE 10.2 Lower bound to call premium

A stock is selling for $500. If the risk-free rate of interest is 10% p.a. continuously compounded, then at what minimum price would |
the following call options on the stock sell for?

(a) A call with a strike price of $450 maturing one month later
(b) A call with a strike price of ¥500 maturing two months later
(c) A call with a strike price of $550 maturing three months later
Solution
The lower bound to the call price is given by zero or S— X. eT
Therefore, the minimum value of the calls would be

(a) Call with X = 450 and T = 1 month: 500 — 450. e-®' * "1? = 500.00 — 446.23 = %53.73
(b) Call with X = 500 and T = 2 months: 500 — 500. e~°' **? = 500.00 — 491.74 = %8.26
(c) Call with X = 450 and T = 3 months: 500 — 550. e-°'* 9? = 500.00 — 536.42 = —%36.42 = 0.00

price, the intrinsic value will be zero, and the entire price of the call option is attributable to
its time value. Since the exercise price is high the chances of the spot price exceeding it are
lower as compared to ATM option. Therefore, the time value associated with the probability
of the spot exceeding the exercise would be less.

Put Option
A put option is a right to sell the underlying asset at an exercise price, Y. Therefore, the
maximum value that one would pay to get that right is X if it is to be exercised immediately.
If there is still time remaining for exercise, the value of the put cannot exceed the present
_ value of the exercise price. Hence, irrespective of the price of the asset, the
The maximum value of a
put option cannot sell for more than the present value of the exercise price, or
put option cannot exceed
the exercise price. Dass =i Xe, 4 0F ep = XeV" (10.4)
282 Derivatives and Risk Management

Value of put Maximum value, X

LOSE ADL CLOLUALAA LALLABOLO ELDB LALLA ULLLT ee OLLIE YALULLLLELUI LEED LILALPO

Value of European put

(PV of X— S)

Exercise price X Spot price

_ ,'meng = - . “ .

The minimum value of a The intrinsic value is the amount of profit one would derive if the option is
put is given by the PV of — exercised immediately. If it is to be paid at maturity, the difference between
_the exercise price less the present value of the exercise price and the spot price provides the lower
_the spot price. bound. Therefore, the minimum price that a put option would sell for is its
intrinsic value, i.e.,
Pun =AC”
— Sor ep Sewer (10.5)
The bounds on the prices of a put are depicted in Fig. 10.2.
Like a call option, a put option too will reach its maximum value when it is close to its
ATM condition. Deep ITM and deep OTM put options would have lesser and lesser
time
values, and the option prices would mainly consist of their intrinsic worth.
Arbitrage argument A violation of the conditions expressed by Eqs 10.4 and
10.5 pres-
ents an arbitrage opportunity. For example, if an asset sells for ~100, and the risk-free
rate
is 1% per month, a 6-month put option for an exercise price of %120 must be
priced at more
than $13.21 (120/1.06 — 100).
To illustrate the arbitrage, consider the following portfolio if the put price is 710,
i.e., lesser
than the lower bound of the put price.
“A put at €10, the stock at $100, funded by a borrowing of %110 for six
months at 12%,
with an obligation to pay back 7110 X 1.06 = 2116.60.”
After six months, the payoff from the portfolio would be as follows:
Stock price Value of stock Value of put
IfrSi< 420 S
If S> 120 S &
With an obligation to pay only %116.60, the arbitrageur always
ends up with a profit, as
the value of the portfolio is always greater than 7120. The minim
um profit is 3.40.
In contrast with the call option where an early exercise cannot
be more beneficial than
waiting till maturity, a put option at times can be more profita
ble if exercised early. Since the
 Option Pricing—Basics 283

value of the underlying cannot be negative, it may be optimal to exercise the put in order to
derive maximum gain. Therefore, an American put, which allows for early exercise, may be
more valuable than a European put.
For an American put, early exercise of the option may be preferred. For an ITM option,
the investor realizes a larger amount, (X — S), as against (Ye~" — S). Consider for example
an investor A, holding a 6-m put option at Y = 100 and the underlying share, as against
investor B, holding cash of $94.34 (present value of the exercise price at a 1% risk-free rate,
100/1.06). At any time before maturity, investor A is worth at least 100 (X — S + S) if he/
she exercises his/her put option and sells the stock, as can be seen here:
| Stock price Value of stock
lf S< 100 S
lf S> 100 S
As against this, investor B attains 7100 only after six months. Though the put option,
together with a long position in the stock, provides insurance against any fall in price of the
stock, an earlier exercise of the put option may be desirable to realize the exercise price and
forego the insurance, if the prices are falling.
Since an American put option may be beneficially exercised prior to maturity, the value of
an American put option will be more than the value of a corresponding European put. The
intrinsic value for a deep ITM American put is ¥ — S, representing the minimum bound.
The European put option may sometimes be valued less than its intrinsic value to the extent
of the differentials of the present value of X and_X. This differential would be at a maximum
when the price of the underlying asset is zero.

|EXAMPLE 10.3 Lower bound to put premium

A stock is selling for £500. If the risk-free rate of interest is 10% p.a. continuously compounded, then at what minimum price would
the following put options on the stock sell for?

(a) A put with a strike price of 450 maturing one monih later
(b) A put with a strike price of ¥500 maturing two months later
(c) A put with a strike price of ¥550 maturing three months later
Solution
The lower bound to put price is given by zero or X. eT — S,
Therefore, the minimum value of the calls would be

Put with X = 450 and T = 1 month: 450 . ge0.10.x 12 _ 590.00 = 446.23 — 500.00 = —%53.73; %0.00
Put with X = 500 and T = 2 months: 500 . e~°1° = 2/2 — 500.00 = 491.74 — 500.00 = —%8.26; %0.00
Put with X = 450 and T = 3 months: 550 . e °'° * 9/2 — 500.00 = 536.42 — 500.00 = %36.42

Effects of Dividend on Lower Bounds

Normally, options on stock are for short maturities. In India, exchange-traded options are
available for a period of three months. The effect of dividend on the prices of options can
easily be incorporated by adjusting the spot price for the dividend. In case the dividend is
payable within the expiry of the option, the spot price S of the asset must be replaced by S less
284 Derivatives and Risk Management

the present value of the dividend. Consider, for example, a stock selling for <200. A call with
an exercise price of ¥180 and three months to expiry at a risk-free rate of 10% would have a
minimum value of 4.94. In case the stock is to pay a dividend of %2 after two months, the
present value of the dividend would be %1.97. This must be subtracted from the lower bound
of a call on an asset with no dividend. A call with a dividend paying stock would have the
lower bound of 2.97 (4.94 — 1.97).
Similar adjustments may be made for the lower bounds of put prices, where the present
values would be added to the lower bounds.
Equations 10.3 and 10.5 for the lower bounds of call and put prices maturing at time 7,
respectively, would stand modified for a dividend, D, payable at ¢, as follows:
Lower bound for call on dividend paying stock
C2 S — Xea — Dent (10.6)

Lower bound for put on dividend paying stock

of Ker ipa (10.7)

EXAMPLE 10.4 Lower bound and dividend 5, O

Assume that in Example 10.3, the stock would pay a dividend of 10 atter two months. Recalculate the lower bound of the put price.
Solution
The present value of the dividend is
D.eot = 10.e7 0-10 K2i2) 79.83

This would get added to the lower bound found in Example 9.3:

(a) Put with X = 450 and T = 1 month: It would remain unaffected, as dividend is paid after the expiry of the option
(b) Put with X = 500 and T = 2 months: The lower bound would become positive
500. a9! * 212 — 500.00 + 10, e710 22 = 491.74 — 500.00 + 9.83 = 21.57
(c) Put with X = 450 and T = 3 months:
550. e 01 x 32 _ 500.00 + 10, e910 x 22 —
536.42 — 500.00 + 9.83 = $46.25

Lower Bounds for Currency Options

In case of options on currencies, the underlying asset is a foreign currency. The foreign
currency is like a dividend paying asset, as it can be invested to yield a risk-free return in
foreign currency. As we adjust the spot price with the present value of dividend, the lower
bound for an option on a foreign currency can be adjusted for the risk-free interest rate in
the foreign currency, ry:
The lower bounds for call and put on foreign currencies would be

ca See — itt (10.8)

De Xe So aa (10.9)
Consider, for example, a call option and a put option on the US dollar, with a strike price
of $50 and maturity in three months, with a spot exchange rate of €48. The risk-free
interest
 Option Pricing—Basics 285

rates in the rupee and the US dollar are 6% and 3%, respectively. The lower bounds for calls
and puts, as given by Eqs 10.8 and 10.9, are as follows:
Lower bound for call:
eC NON eA oa ee 5) Rie eAa6 dee. 26° 00
Similarly, the lower bound for the put option would be:
p = Xe T — §. et = 50 X 67906 X 32 — 4g x e003 x 3/12 — 49.26 — 47.64 = 21.62

Lower Bounds for Options on Stock Indices

In case of options on indices, the situation is the same as for an underlying asset paying
dividend. In case of indices, the dividend, referred to as dividend yield, d, is deemed to be
paid continuously, rather that at discrete intervals of time. The lower bounds for call and put
options would be the same as in the case of currency options, as given in Eqs 10.8 and 10.9,
with ry getting replaced by the dividend yield, d.
The lower bounds for call and put on indices are as follows:
Hi ae RE
Cmin = Se Xe
Sk ex =a
Pmin ei Aa Se

ARBITRAGE-BASED RELATIONSHIP OF OPTION PRICING |

We just saw how arbitrage places lower and/or upper bounds to option pricing. Though we
cannot use the same concept for determination of an exact price, we can use such concepts
for the relative prices of different financial assets, such as two calls, two puts, a call and a
put, etc. An exposition of arbitrage-based arguments is expected to improve the understand-
ing of the principles of finance.
The concept of arbitrage is central to price determination in economics and finance, as it
makes the prices of different assets consistent with each other;
establishes relationships between the prices of different assets;
causes prices of the same asset to converge in different markets; and
e helps explain the differential in prices in different markets and for different assets.
Of course, application of arbitrage-free pricing is crucially dependent upon its feasibility.
Sometimes, restrictive legal frameworks in different markets, other restrictive operational
constraints, the presence of differentials in taxes, etc., inhibit execution of arbitrage, causing
sustained price differentials in different markets and for different assets.
Though there is a large number of arbitrage-based price relationships, we examine a few
of them to illustrate the mechanism of arbitrage as applicable for option price determination.

Call option with higher strike price would be priced lower than call option with lower strike price.

Consider the following price information, which contradicts this statement:

Spot price = £100
286 Derivatives and Risk Management

Strike price Call price Strike price Call price

X, = %80 Cy = %25 Xp = %85 Cp = 26

An initial portfolio may be set up as follows:

Cash flow (%)

Write call with X = 85 26
Buy call with X =.80 ASpNS
Net cash flow +1

The final position at maturity would be:

Price condition Portfolio status Profit (=)

Spot < 80 Both calls, bought and written, are worthless | 1
80 < spot < 85 Call bought is in-the-money by S — 80. (S — 80 + 1); always positive
Call written is worthless. because S > 80
Spot > 85 Both calls, bought and written, are exercised, | 1
resulting in cash flow of (S — 80) — (S — 85)

The portfolio always has a positive value, and, therefore, provides an Opportunity to make ©
a profit without risk and investment.

Difference in call or put prices cannot exceed difference in strike prices.

Again, consider the following price information, which contradicts this statement:
Spot price = 7100

Strike price Call price Strike price Call price

X, = 280 C, = 225 H=%5 | m= R19
Initial portfolio may be set up as to yield %6:

Cash flow (%)

Write call with X = 80 25
Buy call with X = 85 =19
Net cash flow +6
The final position would always result in a profit, as follows:

Price condition Portfolio status Profit (%)

Spot < 80 Both calls bought and call written are worthless 6
80 < Spot < 85 Call bought is in-the-money by S — 80. (S — 80 + 6); always positive
Call written is worthless because S > 80
Spot > 85 Both calls bought and written are exercised, 14
[ fesulting in cash flow of (S — 80) — (S — 85)
On similar arguments, we can prove that the differences
between various put prices cannot
exceed the differences between the corresponding strike
prices.
 Option Pricing—Basics 287

EXAMPLE 10.5 Arbitrage with options

A stock is selling for 450. A call with a strike price of %460 is Selling for %5, while a call with a strike price of %475
is selling for 7 |
%6. Both the calls have the same maturity. Do you find the prices of the two calls appropriate? Can you benefit from the situation?
If yes, how would you do so?
Solution
The prices of the call represent an anomaly, in that the call with a higher strike price is selling for more than the call with a lower L
Strike price. By writing a call with a higher strike price, one can earn a premium that is lower than what would be required
for
buying a call with a lower strike price. The liability on account of the call written would always be matched by the asset one
has with the call bought with a lower strike. If the call with a higher strike is exercised, the call with a lower strike too would L
be exercised.
One stands to gain the difference of the call premiums, i.e., 21 (6 — 5) by writing a call with a strike price of $475 and buying ]
a call for <5 for a strike price of 460. The payoff at maturity would be always positive, as shown here:
All figures in &
| callx=400 | Cal X ae inna Total
Spot price < 460 = — | 1
460 < Spot < 475 5 — 460 = 1 5 — 459
Spot > 475 S — 460 ~($ — 475) 1 14

Call with longer time to maturity must be priced higher than call with shorter time to maturity.

The following price information is not consistent with this statement:

| Strike price Call T = 3 months Call T = 6 months

| X, = 280 C, = 225 C = 24
If so, we set up the initial portfolio at ¢ 0, as follows:

|Action Cash flow (%)

Write call with X = 80, T = 3 months 25 =
Buy call with X = 80, T = 6 months —24
Net cash flow ey a Pol mary adit hare i: |

During the first three months, if the price remains below €80, the call written expires. The
call bought still has three months to maturity and can be sold to get an extra profit.
If the price goes above 80 in the next three months and the call written is exercised, then
the liability can be met by exercising the call bought. No cash flow occurs then.

Higher the exercise price, more valuable the put is. -

Assume the following price information that contradicts this statement:

Spot price = 100

Strike price Put price Strike price Put price

Ce ee et I pa
288 Derivatives and Risk Management

We may set up the initial portfolio to yield @1:

[Action Cash flow (%)
Write put with X = 80 2
Buy putwithX=80 | a:
Net cash flow es
The final position would always result in a profit, as follows:
Price condition __|Portfolio status Profit (2)
Spot < 80 Both puts are in-the-money, and, hence, are | 6 (5 + 1)
exercised;
Cash flow would be (85 — S) — (80 — S)
80 < Spot < 85 Put bought is in-the-money by 85 — S, (85 — S + 1); always positive
put written is worthless because S < 80
Spot > 85 Both puts, bought and written, are worthless |1

PUT-CALL PARITY 2
There exists a relationship between the prices of calls and puts known by the name of put—call
__ parity, which is derived from the principle of no arbitrage. For this, we exam-
ae ome ae ne a special combination that is of significance. The combination uses four
price andthe same time instruments, i.e., a stock, a European call option, a European put option, and
to expiry, the call price _a debt/bond. The call and the put have the same underlying asset, maturity,
would exceed the put and strike prices.
eee Let us consider an example where an investor creates a portfolio of the
spot price and the PV of following securities:

7s exeroise price. He/she goes long on a share selling of $100.

He/she writes a call for Y = 100, maturing at time ‘7’ and commanding
a premium of ‘c’.
e He/she buys a put, also for ¥ = 100, maturing at time *7” and selling at
a premium of ‘p’.

After having formed the portfolio, let us examine the position of this portfolio under various
prices for the underlying asset at the time of expiration. Table 10.1 depicts the position of the
portfolio for a price range of %0 to $200.

Table 10.1 Value of the portfolio of stock, short call, and long put at expiration
Figures in |
Stock price 0 50
Long stock

Short call at X = 100

Long put at X = 100
Total value of the
 Option Pricing—Basics 289

From the last row of Table 10.1, it is evident that the value of the portfolio remains
constant at exercise price Y = 100, irrespective of the price of the underlying asset. When
the price falls below %100, the put becomes valuable, and protects against loss on the asset.
When the price goes beyond ¥100, the call holder exercises the option and the asset in hand
gets delivered in exchange for the exercise price of 100, foregoing any gain from the rise
in price.
Payoffs of the individual securities and the combined payoff of the portfolio are depicted
in Fig. 10.3.

Profit/loss
End value of portfolio = X

Long stock

te, Short call

a ~~ Ci

——$-
Stock price

ES ly ea ey ay a
Long put y

SEN

CL L LT UL ELLE LOLOL ELLE LLL area

Fig. 10.3 Put-call parity—A riskless portfolio

With no uncertainty in the value of the portfolio at expiration, we can state the following:

e An investor can borrow an amount equivalent to the present value of the exercise price
to create a portfolio.
e Since the value of the portfolio is certain at the expiration date, lenders would lend
money at risk-free rates.
e This portfolio can be said to be equivalent to a bond that matures to value s, equal to
that of the exercise price, and whose maturity coincides with the expiry of the options.
Since the maturity values of the portfolio and the bond are equal, the law of one price
demands that the initial cost of the portfolio must be equal to the present value of the bond.
Initial cost of the portfolio of long stock, short call, and long put
= amount that can be borrowed at a risk-free rate
present value of the bond maturing to the exercise price
If S is the current price of the share, c is the call premium, and p is the put premium, then

S — € + p = Present value of X = X/(1.+ r)=Xe—™ (for continuous compounding)

(10.10)
290 Derivatives and Risk Management

_ Equation 10.10 is known as put-call parity, establishing a relationship

if put-call parity does
not hold, it presents an _ between the call and put prices of European options. An alternative form of
arbitrage opportunity by put-call parity is that the difference between the call and put prices must be
forming portfolios of call, equal to the difference between the spot price and the Present value of the
put, bond, and stock. _ exercise price. This can be obtained by rearranging Eq. 10.10.
e—p=S—-Xe™ (10.11)

If put—call parity is not true, the situation will offer arbitrage opportunities. A numerical
example will highlight the arbitrage opportunity available.
Assume that a stock has a current price of <100. A call with an exercise price of ¥100, with
two months to maturity, is selling for €12. The risk-free rate is 1% per month, and, therefore,
a bond maturing after two months is selling for 100/1.02 = ¥98.04. We examine this situa-
tion for a put with an exercise price of ¥100 and two months to maturity, with put prices of
(a) 6 and (b) €11.
If the put price is comparatively lower at %6, the investor can do as follows:

If put price = %6 Figures in&

Att=0 | At t = 2 months
Action =| Cashflow Action
Buy the portfolio

oe oe: ~94.00 Sell the portfolio +100.00

Buy put —6
Short sell the bond +98.04 Buy the bond and deliver —100.00
Net cash flow. +4.04 0.00

Since the value of the portfolio is riskless at maturity, an investor buys the portfolio at
~94 and short sells the bond to realize €98.04, having a net cash inflow of 4.04 now. After
two months, the investor can sell the portfolio at $100, buy the bond, and meet the short sale
commitment. Alternatively, he/she could borrow %98.04 at 1% per month now and after two
months, pay the maturity value of the loan of €100 by liquidating the portfolio. Hence, the
initial cash flow of %4.04 is the profit from the riskless position.
In case the put price is higher at 11, the investor can take a reverse position, i.e., sell the
portfolio and buy the bond, and yet profit from arbitrage, as may be seen from the following:

If put price = =11 Figures in&

At t = 2 months
Action Cash flow Action Cash flow
ca
Sell the portfolio
Sell stock +100
Buy call —12 +99.00 Buy the portfolio —100.00
Write put +11
Buy the bond —98.04 Sell the bond +100.00
Net cash flow +0.96 ke 0.00 |
 Option Pricing—Basics 291

acal parity also links Here again, the maturity value of 100 is fixed. The investor can sell the
the equity, bonds, and bond and utilize the proceeds to buy the portfolio back, resulting in no cash
derivatives markets for flow. However, he/she generates a profit of €0.96 at the time of setting up the
any Inconsistent returns risk-less position. As an alternative to the bond, the investor could lend
Cae Ve esc ¥98.04 at a risk-free rate.
balance among the three. 4 : eae ; ; ;
: — The put price that will eliminate arbitrage profit is arrived at by using Eq.
10.10. Accordingly, the equilibrium put price will be
P= Gs a Present valueof
X =< 12)—.100 4--98:046== 2 110.04
In the first case, the put price of %6 was too low, and, therefore, the investor bought the put,
while in the second case, the put was overpriced at 11, inducing the investor to write the put.
Rearranging Eq. 10.10, we can restate the call price as follows:

CES SAE Aap

Call price = lower bound of call price + time value

As the intrinsic value ofthe call, without the exercise of call, is equal to the spot price less
the present value of the exercise price, we may say that the put price reflects the time value
of the call. Since a put cannot sell for less than zero, a call will always have some time value.
For an OTM put, the put premium reflects the time value of the call, as well as the put.
Put-call parity also establishes a link between capital markets, derivative markets, and .
debt markets. While we all know that derivatives are driven by capital markets dealing in
the underlying assets of shares, the link between the derivatives markets and debt markets
was not very apparent. Through put—call parity, we now know that the returns on the bonds
also affect the prices of the derivatives. Therefore, all three markets in an economy must be
maintained efficiently in balance.

EXAMPLE 10.6 Put-call parity

A stock is prevailing at $80.00. A call with a strike of $85 and maturing after two months is selling for €2.00. Find out the price :
of a put with an exercise price of ¥85 and expiry of two months, assuming a risk-free interest rate of 6% and no dividend on the }
stock for the next two months.
Solution
Using Eq. 10.10, we can find the value of the European put option as <6.16.

p=c+xX.e 7 =—S = 2.00 + 85. e 06 X22 — 80.00 = 6.16

The other implication of put—call parity relates to the synthetic creation of an asset. Put—call
parity relates the prices of call, put, stock, and bonds. A bond can be replicated using stock,
call, and put. Likewise, the payoff of stock can be obtained using bonds, call, and put. In fact,
amongst the four assets of call, put, bond, and stock, the profile of one asset
Put-call parity also helps __ can be replicated using the other three. Rearranging Eq. 10.10 will provide a
synthesize any one of combination for synthesising the asset. A synthetic put can be obtained by
these four: stock, call, buying a bond, buying a call, and short-selling a stock. Synthetic creations
put, and bond, with the
_ can help to establish a position in an asset at a lower cost if there is a tempo-
help of the other three.
rary imbalance in the capital markets, derivative markets, and debt markets.
292 Derivatives and Risk Management

Similarly, a call with a bond that matures to the exercise price must equal the put and
stock, as can be seen by rearranging Eq. 10.10.

xX eT |

Cc Bond po Bi : :
Call option maturing Put option oe |
to xX Ly
SSS

Put-Call Parity for American Options

Put-call parity for European options can help to establish relationships for American puts and
calls. American options provide for early exercise of the option. Is this flexibility to exercise
early of some value? Let us examine it.
It is never optimal to Consider an American call as compared to a European call on a non-div-
exercise an American call _ idend paying stock. If the call is exercised early, one gets the intrinsic value
prior to maturity because and no more. Instead, if one sells an American call, one gets the intrinsic
you lose the time value of value as well as the time value. By exercising at any point of time prior to
the call.
_ maturity, one foregoes the time value attached with the remaining life of the

EXAMPLE 10.7 Arbitrage with options

Assume that the put option in Example 10.6 is actually selling for <8. How can you benefit from the situation? How much profit
can you make from the prices prevailing in the market?
Solution
Put-call parity equates the portfolio of call and bond with one each of put and stock. Since the put is overpriced, it must be sold.
As per put-call parity, (a) the put is sold, (b) the stock is sold, and (c) the call is bought. By doing so, the following cash flow
would result:

Action Cash flow (%)

Sold put 8.00
Sold stock 80.00
Bought call —2,00
Net cash flow 86.00
The. cash can be invested at a risk-free rate at 6% for two months, the time left for expiry of the options. It assures a cash
flow of $86.86 (86 x €°°°*"), At the end of two months, the portfolio would be in profit of 1.86, regardless of the situation
by reversing the initial position. Consider the following three positions of stock price: (a) rising to $100, (b) remaining the same
at 80, and (c) falling to 60.

Stock price %100.00 ~80.00 | %60.00

Payoff of put written — —5.00 A500
Bought stock — 100.00 —80.00 —60.00
Payoff of call bought 15.00 = ==
Cash realised 86.86 86.86 86.86
Net cash flow 1.86 1.86 ey 1.86
 Option Pricing—Basics 293

“There are circumstances OPtion. Therefore, it is never optimal to exercise the call prior to maturity.
when it is more beneficial With this argument, it can be stated that the American call too would be
to exercise a put before exercised only on maturity and it is equal to the European call. Therefore,
Maturity. the value of an American call can be written as c, = c, where c, is the value
of the American call.
Can we say the same for an American put? It may be true in most, but not in all, cases. The
minimum value of a European put is given by X e~" — S. The intrinsic value of a put is X — S.
With a positive rate of interest, the minimum value of the put would be less than its intrinsic
worth. For an extreme case of a stock price of zero, the-exercise of the put would result in the
payoff of X. One cannot get a higher payoff than this. If one waits further, one only stands to
lose. Therefore, it may be said that for a sufficiently low price of the stock, it may be optimal
to exercise the put option early. Since it is so, there would be a greater value to the American
put than the European put. Hence, the value of the American put can be written as:
Pa = Pp, where p, 1s the value of the American put.

Using Eq. 10.10, we may say

A= pl ich ee ae Hs aS
Since c, = c, we arrive at the put-call parity for American options in this way:
ee eS (10.12)

Put-Call Parity for Dividend Paying Stock

In case a stock pays a dividend of q, then the put—call parity would stand modified, with the
spot price of the stock adjusted for the present value of the dividend. Since the stock price
falls by the value of dividend in ex-dividend dates, it is analogous to saying that the current
price of the stock must be adjusted for the present value of the dividend. The put—call parity
for a dividend paying stock would, therefore, be:
Put-call parity for a dividend paying stock with a dividend of D at time t would be given by:
erie =p+S—>De™ (10.13)

The put-call parity for a dividend paying stock with a continuous dividend of q would be
given by:
Gee ey eS ee (10.14)

Put-Call Relationship for Currency Options

A put-call relationship rests on the equivalency of the portfolio: (a) a call option and a bond
that matures to X, with (b) a put option and the underlying asset. In case an option is based
on currencies, the underlying asset would be a foreign currency. The underlying asset, the
foreign currency in question, is like a dividend paying asset that yields a risk- free interest rate
in foreign currency, r Therefore, today’s equivalent would be S e~/". Therefore, the put-call
parity for currency options would be
eS (10.15)
 294 Derivatives and Risk Management

SOLVED: PROBLEM S aaseieeneeaeenenene

SP 10.1: Put option prices and payoff

A 3-m put option on Tata Steel with a strike price of €550 is selling for €60, while the share is trading at €500. Find out the following:
(a) What is the intrinsic worth of the put option?
(b) What is the time value of the put option?
(c) What interpretation do you attach to the time value?
(d) At what price of the asset would the put option holder break even?
Solution
(a) The intrinsic worth of the option is (X — S) = 550 — 500 = 250.00
(b) The time value of the put is the option price less its intrinsic worth = 60 — 50 = 10.00
(c) The time value is paid by the buyer of the option since the intrinsic value of the option may rise with a fall in prices. As the price
of the underlying falls, the put option becomes more in-the-money, and, therefore, the holder stands to gain a greater amount.
(d) If the value of Tata Steel shares falls to ¥490, the put option holder would get back the entire premium paid by way of the intrin-
sic worth of the option. However, instead of exercising the option, he/she may like to sell the same, as it would fetch a greater
value—the time value over and above the intrinsic value.
SP 10.2: Lower bound to option premium
The price of a State Bank of India share is ¥1800. If the risk-free rate of interest is 6.00% p.a. continuously compounded, then at
what minimum prices would the following options on the stock of the State Bank of India, each maturing after one month, sell for?
(a) A call and a put with a strike price of 71700
(b) A call and a put with a strike price of 1800
(c) A call and a put with a strike price of 71900
Solution
The lower bound to the call price is given by zero or Sy — X. eT
The lower bound to the put price is given by zero or X. eT — S,
Therefore, the minimum values of the options calls will be given by:

Call | Put
X = 1700 1800.00 — 1691.52 = %108.48 1691.52 — 1800.00 = —%108.48; 0
X = 1800 1800.00 — 1791.02 = %8.98 1791.02 — 1800.00 = —%8.98; 0
X = 1900 1800.00 — 1890,52 = —%90.52: 0 1890,52 — 1800.00 = €90,52

SP 10.3: Arbitrage with options

The put on a stock with a strike price of 2460 is selling for €15, while another put on the same
stock with a strike price of €475 is
selling for 32. Both the puts have the same maturity. Do you find the prices of the two
puts to be appropriate? Can you benefit from
the situation? If yes, how?
Solution
The prices of the puts are inconsistent, as the difference in premiums of the two
puts of 17 (32 — 15) is larger than the difference
between the strike prices of 15 (475 — 460). One can set up arbitrage by selling
a put with a higher strike and buying one with a
lower strike. When the price is lower than the lower strike, both puts are ITM,
and the liability would not exceed the premium earned.
The same would be the case when the spot value is between the two exercise
prices. With a price higher than the higher strike, both
the puts are OTM, and the premium earned is pocketed. This is shown here:

Stock price Put X = 460 eee

Spot price < 460 460 — S$ =(475 = 5) 17 2
460 < Spot < 475 se ~ (475 — §) 17 5 — 458
Spot > 475 _ — 17 i
 Option Pricing—Basics 295

SP 10.4: Put-call parity

A stock is trading at €500. A call option on the same with three months to maturity and an exercise price of 550 is selling for 12.
What should the price of a put option on the stock with three months to expiry and an exercise price of 550 be? Assume a risk-free
interest rate at 8%.
Solution
Using Eq. 10.10, we can find the value of a European put option as 751.11.
p= X.e—-ft— S= 12.00 + 550. e882 — 60000 = 251,11
SP 10.5: Arbitrage with options
Assume that the put option in SP 10.4 is actually selling for 45.00. How can you benefit from the situation? How much profit can
you make from the prices prevailing in the market?
Solution
Put-call parity equates a portfolio of call and bond with put and stock. Since the put is underpriced; it must be bought. Therefore, we
(a) buy the put, (b) buy the stock, (c) write a call and (d) borrow the shortfall. This transaction would result in the following cash flow:

Action Cash flow (2)

Bought put —45.00
Bought stock —500.00
Sold call 12.00
| Borrowed “ 533.00
Net cash flow 0.00
The cash borrowed would have to be paid back together with risk-free interest at 8% for three months at the time of expiry of
options. The matured amount of borrowing is $538.36 (533 = e°°8 < 9/2) At the end of three months, the portfolio would result in a
profit of $11.64, regardless of the situation, by reversing the initial position. Consider the following three positions, where the stock
price rises to €600, remains the same at %500, and falls to €400.

Stock price 600.00 ~500.00 %400.00

Payoff of put bought _ 50.00 150.00
Sold stock 600.00 500.00 400.00
Payoff of call sold —50.00
Borrowing paid — 538.36 —538.36 —538.36
Net cash flow 11.64 11.64 11.64

SUMMARY —
Option premium, i.e., the amount of money that an option buyer which the option may become more in-the-money or the intrin-
must pay to the option writer to. induce him/her to confer the sic value may rise (of course, it may decline too). The difference
right, is an area that has attracted a lot of attention and involved between the actual price and the intrinsic value is the time value
a lot of effort. Though there are mathematically complex models, of the option. This, too, cannot be negative.
a lot of inference about the option premium may be made by The maximum value of a call option is the price of the underly-
understanding simple arbitrage-based relationships. ing asset. One would not pay more than the price of the asset
An option premium consists of two parts—the intrinsic value to buy a right to buy the same. The cost of buying a right to buy
and the time value. The intrinsic value is the money the holder an asset cannot exceed the price of the asset itself. Since the
of the option gets if the option is exercised immediately. The exercise price is payable only on maturity, the minimum value
intrinsic value cannot be negative. The time value of an option is of the call must be the difference between the asset price and
the value attached due to the time remaining for maturity, during the present value of the exercise price. For deep OTM calls, the
296 Derivatives and Risk Management

entire option premium is made up of time value, while for deep to the value of the portfolio. Therefore, it may be equated witha _
ITM calls, almost all the premium is intrinsic value. The time call and a position on a fixed amount of cash. :
value of an option is greatest for ATM calls. Put-call parity only holds for European options. For American
Similarly, the maximum value of a put is the exercise price options, it remains a relationship of inequality in the minimum
itself. The minimum value is given by the difference between the ptice of a put. For American calls, the notion that the flexibility
present value of the exercise price and the spot price. Again, the to exercise a call at any point of time must cause its value to
time value is largest for ATM put options. be more that a European call is wrong. Since by exercising a
For dividend paying assets, the spot price needs to be call option one gets only the intrinsic value and loses the time
adjusted for the present value of the dividend. value, selling the call option is more attractive than exercising
There also exist some relationships in option prices that are it. Therefore, an American call would not be exercised before
based on the principle of no arbitrage. Some of these relation- maturity and hence, its value is the same as that of a European
ships are: (a) a call option with a higher X would cost less than cail. However, the same cannot be true for an American put, as
one with a lower X, (b} the difference in option premium between there are circumstances when exercising a put is more benefi-
calls and puts cannot exceed the difference in exercise prices, cial. Therefore, an American put option is valued higher than a
(c) options with a longer maturity would cost more than options European put option.
with a shorter maturity. Put-call parity provides a link between call and put prices, thus
There also exists an arbitrage-based relationship between linking the spot equity markets and the debt markets. Therefore,
the prices of call and put options, called the put-call parity. A there needs to be consistency in the equity, debt, and derivatives —
portfolio running long on assets, with a short call and a long put markets. Put-call parity also helps in creating synthetic positions
would result in a riskless position at maturity of the options, with of equity, call, put, and bond. Given any three, the fourth may be
assured payoff equal to the exercise price. A long position in a _ synthesized, and therefore, the pricing of a synthetic product and
put coupled with a long position in the stock provides insurance the actual product needs to be the same.

Intrinsic value The money the holder gets upon immediate Time value of option The excess of the actual price of the
@XeICise. option over its intrinsic value.
Put-Call parity The relationship between the call price and
the put price of the same underlying asset, with the same exer-
cise price and the same time to maturity.

QUESTIONS oe
10.1 What do you understand by the intrinsic value and the time happens, how would you benefit? Explain with the help of
value of an option contract? an example.
10.2 Why do you think time value is the maximum for ATM 10.6 What do you understand by put-call parity? Provide some
options? information on the relationship between the call and put
10.3 What are the minimum and maximum bounds on the prices for European options.
prices of call options? Explain. 10.7 Why is it not a good idea to exercise an American call prior
10.4 What are the minimum and maximum bounds on the to its maturity?
prices of put options? Explain. 10.8 What can you say about the relationship between the call
10.5 Why cannot the difference between two call prices and put prices of American options?
exceed the difference between their strike prices? If this

PROBLEMS
P 10.1 Lower bound on currency options P 10.2 Lower bound of option values and dividend
The spot rate for the US dollar in India is 48.00. If risk-free inter- A stock is selling for $75. A call option and a put option with a
est rates in India and the USA are 8% and 5%, respectively, what strike of ¥80 and a maturity of three months are available on
would the minimum prices for 3-m ATM call and put options be? the stock.
 Option Pricing—Basics 297

(a) What should the minimum price of these options be ifthe risk- (a) What would be the price of a put option on the same stock,
free rate of interest is 12% p.a. with monthly compounding? with the same strike and maturity?
(b) Ifthe stock will be returning a dividend of €2.00 in one month’s (b) If the put actually sells for 1, how much profit can you
time, how would it affect the minimum price derived ina)? make, and how would you make it?
P 10.3 Minimum bound of call and arbitrage (c) If the put sells for $2.00, how much profit can you make, and
Hindalco stock is trading at ¥100. A 6-m European call with a “how would you make it?
strike of 80 is available. P 10.5 Put option and dividend
(a) What would the minimum price of the call be if the risk-free Refer to P 10.2. What would the minimum price of the put option
rate is 10% p.a.? be if another dividend of %3.00 is proposed at the end of two
(b) If the call is actually selling for %12.00, what minimum months?
profit can you make? Demonstrate how you would derive P 10.6 Minimum value of put and arbitrage
such profit. lf the put option in P 10.5 is actually selling for %6.00, is there an
P 10.4 Put-call parity and arbitrage arbitrage opportunity? How would you exploit this opportunity?
Refer to P 10.3. If a call option on the stock sells for $15, then
 Option Pricing
Binomial Model

INTRODUCTION ©”
Learning Objectives
In Chapter 10, we discussed some arbitrage-based arguments After going through this chapter,
that placed upper and lower bounds on the prices of options. readers should be familiar with
We also discussed boundary conditions for option premiums, as The behaviour of the prices of
also the relationship between the prices of call and put options assets
by way of put-call parity. Here, we concentrate on the exact using the binomial model for option
valuation of option premium. Determination of the fair price is pricing
important for researchers, practitioners, and traders alike. Inves- what risk-neutral valuation means
the equivalent portfolio approach to
tors must know the actual worth of the asset being acquired. For vaiue options
traders, it is important for speculation and identifying arbitrage the binomial process to value
opportunities. American options
In this chapter and the next, we shall cover two methods incorporating changes in the
of determination of option premium in detail—the binomial binomial approach for
« dividend payments
model and the Black-Scholes model. The binomial option pric-
« valuing options on indices
ing method is a numerical method that estimates the value of « valuing options on currencies
options. It is a very flexible model for valuing options that are making a binomial mode! more
not regularly traded or are specifically negotiated between con- realistic by effecting changes in its
tracting parties. The Black-Scholes model is a standard model parameters
that values conventional options that are regularly traded, though valuation of American options using
the binomial approach
the principle can be extended to value certain exotic options. It
the Monte carlo simulation for
may be noted that the two models are not contradictory but they valuing options
use somewhat different approaches for valuation. It is necessary
to understand the conceptual frameworks of both the models to
grasp the pricing principles on a wide variety of options that
have evolved over time, and would continue to do so.
We discuss the binomial option pricing model now. The bino-
mial model is an extremely simple yet very powerful model that
provides deep insights into option dynamics. Like with all other
models, it is assumed that there are no market distortions
such
as transaction costs and unexploited arbitrage opportunities.
 Option Pricing—Binomial Model 299

One way of valuing an option on a stock is to construct a tree of possible values of the stock
_ price and find the worth of the option at each of the values on all branches
_ The binomial option pric- of the tree. For simplification, we can assume only two possible values and
ing model makes a sim- ‘ % : ; : See
Gified assumption of only a single period at which the option matures at time f = 1. This is known as
two possible values ofan the binomial model, where the future price of an asset can assume only two
underlying asset, oneup —-—-possible values: an upside move or a downside move.
and the other down from To illustrate how the binomial model works, let us assume a stock sells for
the current price a price of Sy = 100. We assume an investment horizon of one year at the end
of which the price S; can either be 25% up, i.e., 7125 or 20% down, 1.e., $80.
Note that it is not essential to have equal movement on both sides. However, we cannot assume
movement of the price in both directions because if it were so the price of the stock would rise
or fall instantly; it has to be either up or down. It would be injudicious to use both movements
in the same direction, though there is |
no such compulsion while using the pas arrest SSS

binomial model for option pricing. i S4 = 125 |

SSNS

We further assume that the option is aterag ta L

European and that the stock pays no So = 100 :
dividend during the option period.
All returns are arrived at. through (=p) f :
capital gains. The end values of the sale
stock for up and down movements ===" enact
fredepiciedan Fig <1, Fig. 11.1 Value of asset under binomial option pricing model
Having assumed this simplistic scenario, let us now attempt to value an at-the-money
(ATM) European call with a strike price, X, of $100 and time to expiry of one year. We know
that the value of the call is Max(S —_X, 0). A call with a strike price at Y = 100 means that
if the price of the stock moves up to 7125, the payoff on the call option would be 125 — 100
= %25, and in case the price moves down to %80, the call option expires without any worth.
We also assume that the yield on risk-free instruments in the capital market is 6% p.a.
One naive way of finding the value of the call is to find the expected value of the stock
and then the expected value of the call at t = 1. Finally, we discount the value ofthe call at
t = 0. To find the expected value of the underlying stock, we need probabilities for both the
branches of the binomial model. Assume that the probability of an upward movement is p.
The probability of a downward movement then automatically becomes (1 — p). By using
this method, we shall analyse three different scenarios for three different investors, A, B, and
C—an optimist, a realist, and a pessimist, respectively.

Situation I for Investor A Investor A, an optimist, supposes the probability of an upside

movement, p, as 0.90 and the probability of a downside movement, (1 — p) as 0.10. There-
fore, the expected value of the stock can be given as follows:

Expected value of stock (at T = 1) = 0.90 x 125 + 0.10 X 80 = %120.80

300 Derivatives and Risk Management

Calculation of the expected value ofthe call is as follows:

Expected value ofthe call (at T = 1)
= Max (expected value of the stock — exercise price, 0)
= Max(120.80 — 100, 0)
Max(20.80, 0)
120.80 — 100.00 = 20.80

To find the value of the call today, we need to discount it by an appropriate rate consistent
with risk-associated discount on the returns on the stock. Any arbitrary selection of a rate
would lead to arbitrary pricing of the call option. Let us assume that investor A is fairly
certain of his/her assessment of the probabilities of up and down movements, and, therefore,
considers the appropriate rate of discount as a risk-free rate of 6%. Therefore, according to
him/her, the present value of the call will be $19.62, as shown here.
Value of the call today = 20.80/1.06 = 19.62
Is the value of the call derived earlier a valid one? The seemingly valid value of the call
offers an arbitrage opportunity. With the value of the call at 19.62, another investor can
become an arbitrageur; he/she can set up a portfolio of five shares and write nine calls. The
initial investment of the arbitrageur would be as follows:

me
Buy five shares =15) >< (00
Cash flow (2)
—500.00
Write nine calls +9 x 19.62 +176.58

The portfolio can be set up by borrowing at 6%. The liability of arbitrageur would be 1.06
: ~ X 323.42 = %342.83 after a-year.
Lees | The end position of the portfolio would be as depicted in Fig. 11.2. With
find the expected value of the price at $125, the value of the holding would be 5 X 125 = 2625. The
an option, because we do Call holder would exercise his/her option and the liability would be %25 on
not know the appropriate each call written. Therefore, the arbitrageur would have to pay 9 x 25 =
_ °225. The net cash inflow for him/her would be 2400.
. When the stock moves down to %80, the value of the stockholding would
be %400, while there would be no liability for the arbitrageur on the calls written
by him/her,
which would be worthless for the holder,

(All figures in®) |

=1 5 shares 9 calls Total
125.00 625.00 —225.00 400.00

100

80.00

Fig. 11.2 Portfolio value atT=1

CL
 Option Pricing—Binomial Model 301

Irrespective of which way the stock moves, the end value of the portfolio remains fixed at
%400. This yields a certain profit for the arbitrageur at $57.17, after providing for interest on
the borrowing, as shown here:
Value of the portfolio at T= 1 = 7400.00
Gain = 400.00 — 342.83 = %57.17
Hence, the vaiue of the call at $19.62 is not valid.

Situation II for Investor B Assume another person, investor B, who is a realist. He/she
views the expected scenario differently from investor A. For investor B, the probability of an
upside movement, p, is 0.5, and the probability of a down movement, (1 — p), is also 0.5.
Therefore, he/she expects the price of the stock at T = 1 to be $102.50.
Expected value of stock at T = 1 = () 5x 125 70) %.80 = §102.50
Expected value of the call at T = 1
= Max(expected value of the stock — exercise price, 0)
= Max(102.50 — 100, 0) = ¥2.50
For investor B, who too is confident of his/her forecast, the discount rate is 6%. The pres-
ent value of the call would be %2.36 as shown here:
Value of the call today = 2.50/1.06 = 22.36
Let us assume that investor B is correct in his/her perception of the probabilities assigned
to the two branches, the future prices of the stock, and, therefore, the call value. If so, this
position, too, would offer an arbitrage opportunity. Another investor can become an arbitra-
geur and can set up a portfolio, selling five shares and buying nine calls. If one call sells for
%2.36, he/she can set up the following portfolio:
Action Cash flow (%)
Short sell five shares +5 x 100 +500.00

Buy nine calls —9 X 2.36 eed

Cash outflow at t = 0 +478.76

The initial portfolio yields a cash flow of ¥478.76, which may be invested at 6%.
The value of the asset at the end of the investment period of one year against the portfolio
created would be:
Invest at 6% and earn interest SOUS Te
Maturity value = §507.48

The liability at maturity of the option would depend upon what happens to the portfolio. If
the stock rises to 7125, the arbitrageur would have to buy the stock at 125, requiring a cash
outflow of %625 for five shares. However, he/she also owns nine call options, each of which
would be worth 225, providing a cash inflow of %225. His/her net liability would be %400.
If the stock moves to %80, the arbitrageur would buy five shares for €400. Of course, his/her
calls are worthless. In either case, his/her outflow would be 400 only, giving a certain profit
of 7107.48.
Hence, the price of the call at $2.36 is not valid either.
 302 Derivatives and Risk Management

Situation III for Investor C We considered two investors with different perceptions ofthe
expected values of the stock and the call option. Yet, there were arbitrage
Assuming a probability opportunities for both of them. At the expense of redundancy, let us consider
for upside and downside = another position, involving investor C, a pessimist who rates the probability
TG OCS aes © of an upside movement, p, at 0.1, and the probability of a downside move-
to arbitrage opportunities.
. =. ment, (1 — p), at 0.9.
Expected value of stock (at f= 1) — Ol x 125 > 09 < 30 =< 6450
Expected value of the call (at T = 1)
= Max(expected value of the stock — exercise price, 0)
= Max(84.50 — 100, 0) = 0.00
According to investor C, the value of the call is zero, and, therefore, he/she would gladly
write a call if someone offers him/her an amount as little as 21. Let us assume he/she is per-
suaded by an arbitrageur to write nine such calls, to earn ®9. The arbitrageur promptly sells
five shares short to set up the following portfolio and have an immediate cash inflow of 2491.

|action | Cash flow (2)

Short sell five shares +5 X 100 +500.00
Buy nine calls | OC 1400 —9.00
Cash outflow at t= 0 3 +491.00
The arbitrageur invests the sum at a risk-free rate to realize 520.46 at the end of one year.
Invest at 6% and earn interest = 29.46
Maturity value = $520.46
What would his/her liability at the end of the investment horizon be? His/her
liability
would again be %400, irrespective of which of the two possible scenarios exists.
If the stock
moves up to ~125, he/she exercises the nine call options and buys
five shares to have a net
outflow of %400. If the price is 80, he/she buys five shares by paying %400,
letting his/her
call options lapse. In any case, he/she stands to gain a whopping ¢120.46.
Hence, the price
of the call cannot be zero either,

Resolving the Dilemma

The positions of investors A, B, and C, assuming different scenari
os depending upon their
risk perceptions (attaching higher/lower chances to price
moving upwards/downwards) of
the stock price in the future would provide different values to
the call options, each of which
does not seem to be valid, as it offers arbitrage. In a competitive
world, an asset cannot com-
mand two prices at the same time, and, if so, the process
of arbitrage itself must lead to an
arbitrage-free single price. The possible ways by which
all the investors agree to single price
of the call option are as follows:
e They use different discount rates (rather than a commo
n 6%), in such a way that it leads
to the same value of the call option.
e They agree on the same future expected value of
the stock, implying that they abandon
their individual estimates of the probabilities of upside
and downside movements of the
stock price.
 Option Pricing—Binomial Model 303

We address these issues in the following section.

RISK-NEUTRAL VALUATION
We saw that each investor, A, B, and C, made an assessment of the expected value of the
asset and therefore, different values of the call opening opportunities for arbitrage. There are
numerous investors such as A, B, and C in the free and competitive market, who would be
forced to review their pricing of the call by arbitrageurs, so that it results in the same value
of the call for all. Arbitrage-free valuation, therefore, would combine the risk preferences of
the entire market, making the risk estimates of the individuals redundant.
If we assume that the binary state of prices is correct, the market as a whole must agree
_ to the same expected price, E(S,), of the stock. To know E(S,), we must know
Under the risk-neutral
_ either the growth rate of the stock price or the probabilities of upside/down-
method, we assume that
the expected value of a side movements. To have a universally acceptable E(S,), the expected returns
_ stock would provide a offered by the stock [E(S,) — So] can be no greater than the risk-free rate of
return equal to the risk- return, 7. Such a proposition is referred to as risk neutrality, i.e., in aggregate,
free rate. the world is indifferent to risk. A risk-free return would imply probabilities
to the upside and downside movement. Under a risk-neutral valuation, we
presume that the underlying asset earns a risk-free rate of return, i.e., E(S;) = (1 +r) X So,
or with continuous compounding E(S,) = e” X Sp.
Alternatively stated, we can value the derivative by finding the risk-neutral probabilities
with which the current market price is nothing, but the expected value of the underlying asset
discounted at a risk-free rate of return. The valuation of the derivative on the asset too can
follow the same method.
Under the binomial approach, if the risk-neutral probability of an upward movement is p
with a gain of u% and the probability of adownward movement is (1 — p) with a loss of d%,
then the expected return must equal the risk-free rate of return. Therefore, we can determine
the value of p using the following equation:
pe uid
p)’x di=ir
_r-d
(11.1)
pps d
In our case, the risk-free rate is given as 6%, with u = 25% and d = —20%. Using Eq.
11.1 implies that the probability of the upside movement, p, is
pred G20 I je F
Ras 20\he 0.5778 = 57.78%
This implies that the market as a whole assigns a probability of 57.78% to an up move, so
as to have a single value of the call option and thus eliminate any arbitrage opportunity. This
is independent of what we may feel about changes in asset price in our indi-
With a risk-free rate of _ vidual capacities. Therefore, the market can be regarded as risk neutral when
return, the two branches we agree that the expected end value would provide returns no greater than
_of a binomial tree would the risk-free rate.
have implied probabilities With the implied probabilities known, we may value a call option as the
for a given change in the
_ expected value of its payoff. Hence, the value of a call at the end of the option
spot price.
_ period would be:
304 Derivatives and Risk Management

Att=0 Att=1 Call payoff |

Y
125 25 |
' 0.5778 i
Y

So = 100 |

0.4222 io ; ;
y
oe

Fig. 11.3 Payoff of call under binomial pricing model

Value of the call

= Probability of upward movement X payoff
+ probability of downward movement payoff
= p <Max(Sy —-X, 0) (1 = p) Mak Spa Xe9)
With the payoff as indicated in Fig. 11.3, the value of the call at the end of one year would be
0.5778 X 25 + 0.4222 x 0 = 214.44
The present value of the call discounted at the risk-free rate is 14.44/1.06 = 13.63.
We may demonstrate that at this price of the call, arbitrage is eliminated.-We take the same
actions as for Investors A, B, and C.

Action L Cash flow (%)

Short sell five shares +5 x 100 +500.00

Buy nine calls 8) 56 Ge! Selec-on

Cash flow at t= 0 | SOMOS

The arbitrageur invests the sum at a risk-free rate of 6% to realize 400.00 at the end of
one year. This would be exactly equal to the value of the portfolio at the end of one year.
Risk-neutral valuation means that while the call option is independent of the probabilities
of price changes, the call premium implies a probability of the stock rising to (1 + uw). A
large number of investors, such as A, B, and C, would make the market risk neutral on an
aggregate basis for the purpose of determination of the option price.
The value of the call as determined earlier in this section provides some very strange
results. The price ofthe call option derived is independent of the probabilities of the future
price, or of the expected value ofthe stock. This seemingly strange conclusion is difficult to
comprehend. Most of us would believe that the greater the likelihood ofthe price of the share
going up, the larger should be the value of the call option. This belief is misplaced, as we
have seen in the three cases involving investors A, B, and C each of whom estimated a call
value that created arbitrage opportunities. As such we do not need any estimate of probabil-
ities of movement of stock price. The reason is that the current price of a
We do not need '
individual estimates of . Stock already discounts the future. The higher the chances of an up move, the
probabilities of price _ greater would be the price today. Assuming efficient markets, the expected
changes; instead, we use —-value and the volatility estimates are already captured in the current price of
risk-neutral probabilities _ the stock. Hence, there is no need to make separate individualistic estimates
to find the value of an
_ of the future direction of movement or of the probabilities. They are already
option.
_ contained in the current price.
 Option Pricing—Binomial Model 305

To summarize, under the risk-neutral approach, we

e found the risk-neutral implied probabilities of up and down moves;
¢ calculated the expected payoff of the option at maturity with implied probabilities; and
e discounted the expected payoff at the risk-free rate to arrive at the current value of the
option.

Using up and down move as ratio of current price Sometimes, it is easier to represent
the up and down move as a ratio of the current price. In the case of a 25% up move, u can be
equal to 1.25, and for a 20% down move, d is equal to 0.80. In that case, the implied prob-
ability of an up move, p, would be given by Eqs 11.2 and 11.3, respectively, for discrete and
continuous compounding.
el ee
utr C1152)
esd
B saree (lta)

Finding Risk-free Portfolio

We demonstrated that with five shares and nine calls, we end up with a fixed value of the
portfolio, irrespective of the asset price. It is interesting to note that despite the extreme
volatility associated with options, we were able to combine them with the asset to replicate
a risk-free portfolio. The ability to replicate a risk-free portfolio enabled us to price the
option.
How did we find a combination of five shares and nine calls to get a risk-free end value
_ of ¥400? We can do this with a little mathematics. Assume that for each
With derivatives, we can / share, we write N call options. We choose the value of N such that the port-
construct a portfolio that
oo _ folio of one long share and N calls short is equal for the two possible price
provides a fixed value, : ; ; ¢
regardless of the prices -—-—« SCeNarios assumed in the binomial model. We can construct a portfolio that,
ofthe asset in the future. _ irrespective of the price scenario at the expiry of the option, yields the same
~~ end value, making it independent of the risk appetite of individual investors.
When thest of the stock is ¥125, the loss on each call written is ¥25, and the portfolio
is worth 125 — 25 N. When the value of stock is €80, the option written does not incur any
liability, and the value of the portfolio is ¥80. Setting them equally would give the desired
value of the number of calls that can be written for each stock bought. Solving the equation
gives this value at 1.80 calls for each share, or nine calls written for five shares bought.
L253 = 20%,
NV = 80
N = 1.80

The value of the portfolio consisting of one share and N calls is depicted in Fig. 11.4.
Value of call option A portfolio of one share and 1.80 calls would have a future value of
- 80 that is certain. Since it is certain to have a value of €80 after one year, investment in such
a portfolio must yield a return commensurate with the risk-free rate, 1.e., 6% in our case.
Therefore, the call price must be governed by Eq. 11.4.!

'For continuous compounding, the equation becomes (100 — 1.80 c) x e°°7 = 80

306 Derivatives and Risk Management

One share and N calls

125 5
PS PS) ON

100

PRL OOOO
XMM OOM M(M MUIMOLM M OE)OSCO” 47
Fig. 11.4 Value of portfolio of one share and N calls

(100— 1.80
X c) X 1.06
= 80 (11.4)

This gives c = $13.63

The value of the call, as determined by Eq. 11.4, does not allow any arbitrage.
Just as the current price of the share does not tell which way the price is going to move in
_ the future, the call price also does not forecast the expected return on the
Value of call is no reflec-
tion on the return on the stock. The expected return remains equal to the risk-free rate. Alternatively
asset. Instead option put, the call price does not say anything about the expected return from the
prices signify volatility. underlying asset. Merely because a call on one asset sells for $10 and on
another at ¥5, this does not imply a greater return. Instead, the higher price
of the call on the same asset, with the same exercise and the same time to maturity, signifies
increased volatility.

Equivalent Portfolio Approach for Option Valuation

An alternative way of presenting the arguments made in the risk-neutral valuation is to con-
struct a portfolio of some shares bought by borrowing, so as to have the same payoff as that
of a call option. Replication of the payoffof an option with a risk-free portfolio by borrowing
would lead to pricing of the option today. The portfolio of the share and borrowing can be
valued easily with the interest rate and the spot prices known. Two portfolios with identical
end values must have the same price today. Setting the values equal, we can price the call
option today, as demonstrated below.
The payoff of the call option with an exercise price of 7100 is as follows:

Share price = £125 Share price = 780

Payoff of call option (%) 25.00 0

Now consider a portfolio of 5/9 shares and a borrowing that matures to 744.44 after a year.
The payoff of this portfolio is identical to the payoff of the call option, as shown here:

| : | Share price = 7125 Share price = %80

Value of 5/9 shares (%) 69.44 44.44
Maturity value of loan (®) —44.44 —44.44
Value of the portfolio at maturity 25.00 0.00
Since the payoff the portfolio of 5/9 shares and borrowing is the same as that of the call
option on maturity, they essentially must have identical present value, i.e.,
 Option Pricing—Binomial Model 307

“Anoption delta isthe .. ~—»-Value of the call option today

change in value of an = value of the 5/9 share today — value of the loan today
- option ae froma = 5/9 X 100 — 44.44/1.06
aA eo 2 = 61363
For the construction of an equivalent portfolio, we need to find the quan-
tity of the shares that are to be purchased for each call, and the amount of borrowing to fund
the shares. In order to compute the number of shares to be bought or sold, we use a very
important parameter called the option delta. Option delta is the change in value of an option
for a change in value of the underlying asset. It is denoted by A, and is expressed as

Change in the value of option

Option Delta, A =
Change in the value of underlying asset
In our case, the stock is the underlying asset; therefore,
we calculate the option delta as a ratio of the spread on the call payoffs to that on the share
prices.

Spread of call option

Option
SR
Delta,
oan
A=
Spread of share price
(11.5)
For our case the option delta is 5/9, computed as follows:

ay le ie
Up movement
Call value (X = 100)

Down movement

Spread
ceil
Onton Dele Spread of call option ~ 25 -.0°"_ 25 5
Spread of share price 125-80 45 9
The traded option must sell for $13.63, or else we can profit from mispricing. Suppose the
call sells for ¥15, then we can construct a portfolio of long five shares and short nine calls. It
would cost us $365 (5 x 100 — 15 X 9), which can be borrowed at 6%. The maturity value
of the borrowing is $386.90 (1.06 X 365), while at maturity of the option, we have ~400 as
the risk-free value of the portfolio. This gives us a profit of 13.10 without taking any risk
or making an investment.

BINOMIAL MODEL FOR PUT PRICING ©

The binomial model works equally well for put pricing either by using implied probabilities
or by creating a portfolio with identical payoffs.’
Using the risk-neutral method, we find the implied probability of an up move and a down
move. They would remain same as that of the call option. The payoff is shown in Fig. 11.5.
The value of the put at the end of the option period would be
2An alternate way of finding the put price, p is to use put—call parity.
6é—p—S — PV otX
p=c—S+ PV of X= 13.63 — 100 + 100/1.06 = 27.97
308 Derivatives and Risk Management

x
<S
Att=0 Att= 1 Put payoff
125 o |
0.5778 |

So = 100 |
y

04222 7 |
80 20 |
XS

Fig. 11.5 Payoff of put under binomial pricing model

Value of the put

= probability of upward movement x payoff
+ probability of downward movement < payoff
= p X Max(X— S;, 0) + (1 — p) X Max(X— Sj, 0)

‘In our case, the value of the put at the end of one year would be:
Value of the put.= 0.5778 X Max (100 — 125, 0) + 0.4222 Max (100 — 80, 0)
= 0.57784 0 + :0:4222 X20
= 8.44

The present value of the put would be 8.44/1.06 = 7.97 (rounded off)
Under the second approach, we set up a portfolio of long on one share and M puts with XY
= 100, and set the value of the end portfolio to be equal under the two stages of the binomial
model. When the price moves to 7125, the put is worthless, with the value of the portfolio
equal to the value of the stock at ¥125, and when the price is 80, the value of the portfolio
would be %80 plus the value ofM puts. This is shown in Fig. 11.6.
Equating the final values, we get 125 = 80 + 20M (TEO)
which gives M = 2.25
Setting this portfolio of one share and 2.25 puts to yield a risk-free return must give the
value of the put, p’(deviating from the usual notation of p being used for the probability of
an upside movement)

(100 + 2.25 X p’) X 1.06 125

p 707

Stock value One stock and M puts i

100

80+ 20x M
she malin — OO
 Option Pricing—Binomuial Model 309

Under the equivalent portfolio approach, we have proceeded as follows: -

e We have calculated the option delta, A.
The option delta helps in
construction of a riskless e We have set up a portfolio of A share and one short A call or A share and
portfolio, and therefore, one long put,
_{s used in the valuation of e We have found the value of the portfolio at the end of the option period
options. and its present value.
_@ We have equated it with the cost of the portfolio to find the value of the
option.

MULTI-PERIOD BINOMIAL MODEL ©

The model discussed in the ‘Binomial Model for Put Pricing’ section had only one period. |
We may extend the logic for a one-year (a single period; the period need not be a full year)
binomial model to find the price of a call expiring two years from now, with two periods,
each lasting for one year. Further, we may adopt the multi-period approach by shortening the
period too. By doing so intuitively, we expect the valuation to become more accurate, since
a higher number of possible scenarios is evaluated. The valuation procedure would now start
from the last set of nodes, from the end values therein, and traverse back in time to reach the
first node. This is referred to as backward induction.
Let us now extend the single period model to two binomial periods. Assuming the same
size of up and down moves of 25% and 20%, respectively, in each period of one year, we
get a tree for valuing a two-year call, as depicted in Fig. 11.7. Now we would have three end
values of the asset at the end of two years, rather than two.
From the values of the stock at 7 = 2, we work out the payoff of the call option at each
preceding node to arrive at the value of the call option using risk-neutral probabilities and a

Values (%)
| | Stock Call X = 100
| | 156.25 ————— 56.25
| +25% 2A |
| 125 |
tA |
+25% | | :
~20%
100 2B; 100.00 —————0.00 |
ye | cL eemee |
~20% | eae : :
‘oe |

| —20% | :
|
| 2c eees 10 0.00 :
| | g

OTL ILL LEI EELS EEE

310 Derivatives and Risk Management

The onomealmedelean | risk-free rate of return. Assuming the interest rate remains constant over the
be extended to multiple _ life of the option with a risk-free rate of return of 6%, a 25% up movement
periods, andto finding and a 20% down movement, the risk-neutral probabilities remain the same
the value of an option : as worked out in Fig. 11.3 at 0.5778 and 0.4222 for up and down movements,
going backwards from respectively. The implied probabilities would change if the risk-free rate
Ady _ changes during the life of the option.
Starting backwards from nodes 24, 2B, and 2C, we go to nodes 14 and
1B and then to OA, and calculate the values of the call option at each node, as depicted in
Fig. 11.8.
Value of call option for node 1A
Expected value of call option at node 1A
="0.5778 X 56.25" 0.4222 K 0 = {3248
Since the return on the position is 6%, the value at T= 1 (at node 1A)
= 32.48/1.06 = %30.65
Value of call option for node 1B
The expected value of the call at ¢ = 1

= 0.5778 X 0. + 0.4232 x 0 =
Hence value for node 1B would be zero
Value of call option for node 0A
From the values at nodes 1A and 1B at ¢ = 1, we trace back to node 04 and get the value
of the call as
EROCOT7S. % 3005 ar 0.4222 pd pool BYay
1.06 Making.

Values (7)
Call X=100 |

2A 56.25

|
|

T=0 T=1 T=2

Fig. 11.8 Valuin
callgoption: two-period binomial tree
 Option Pricing—Binomial Model 311

_ EXAMPLE 11.1. Valuing call using binomial model

Use the data given in Fig. 11.8 for an asset selling at $100, with a 25% up and 20% down movement in price and a risk-free return |
of 12%. Find out the value of a European call with an exercise price of $80 using two periods of six months each. L
Solution
Referring to Fig. 11.8, the value of a call with an exercise price of 80 would stand modified as follows:
y
Node 2A: 276.22 ye

Node 2B: %20.00

Node 2C: 0.00
ye
The value at Node 1A = 0.5778 X 76.22 + 0.4222 x 20.00 = ¥52.48
And the value of the call att = 1 = 52.48/1.06 = 749.51

The value at Node 1B = 0.5778 x 20.00 + 0.4222 x 0 = 211.56

And the value of the call att = 1 = 11.56/1.06 = #10.90

Using the values at Nodes 1A and 1B, we may go to Node 0A.

Value at Node 0A = 0.5778 X 49.51 + 0.4222 x 10.90 = 233.21
Value of call att = SV WAL Ole) = sechl cee)

Using the multi-period binomial option pricing model, we can value the option by adding
a higher number of branches in the binomial tree.
Improving Accuracy The accuracy of the binomial option pricing model can be challenged
_ because of its rather impractical assumption that a price can take only two
The binomial model can
_ possible values. This seems far from reality. We assumed only two possible
be extended to multiple
periods to broaden the values at the end of one year, whereas in real life, numerous values are pos-
range of price changes in sible. However, the option for one year could also be valued using two sets of
a given period of time. branches of six months each, or four sets of branches of three months each,
or even 365 sets of branches of one day each. We can have an infinite number
of small periods to be closer to the reality. Such a process, of increasing the branches by short-
ening the time interval for each branch, would provide numerous end values of the underlying
at the end of one year, moving closer to reality. Such a process, of shortening the period and
increasing the number of binary states, would make the constraint becoming less restrictive in
fair determination of the option value. However, if we increase the number of nodes, we also
increase the computation time. As we reduce the time interval and examine more end values,
the value of the option would move closer to the one obtained by using the Black-Scholes
model of option pricing’; a pricing mode universally accepted as one determining true value.
_ Why Unequal Up and Down Moves? In Example 11.1, we used the 25%
As we increase the num-
_ rise and the 20% fall as the binary states of value of the underlying asset.
ber of trees by shortening ; 3 pac ;
the time interval, an option This caused the price to be equal to the original price after two periods, with
price under the binomial = @ rise In one period followed by a fall in the other, or vice versa. For the
model moves closerand prices to converge to the original value, the return relatives for the rise and
closer to the analytical the fall have to be reciprocal, i.e., 1/1.25 = 0.80 (25% rise and 20% fall). This
model 0} Blank ccnoles. kind of rise and fall selection would lead to recombining symmetrical trees.

3For a detailed discussion on the subject, one may refer to Chapter 21 of Principles of Corporate Finance, 6th Edition, Tata
McGraw Hill, by Brealey & Myers.
312 Derivatives and Risk Management

Use of recombining symmetrical trees facilitates development of a model for reiterative

calculations, but, theoretically, any change can be handled for determination of option value
by the binomial method.
Continuous Compounding In our analysis of option pricing using the binomial method,
we used an annual risk-free return of 6% and found the risk-neutral probabilities of 0.5778
and 0.4222 for a 25% upward and a 20% downward movement, respectively, using Eq. 11.1
as shown here:
ee0 ee tere)
= 0.5778 = 57.78%
~u-d_
25 -(-20)
If the return were to be continuously compounded, the risk-neutral probabilities would be
given by Eq. 11.3, using the size of the up and down movements in the decimal form. If 6%
return were continuously compounded, the risk-neutral probability of an upside movement
would be 0.5819, as calculated here
Cd ee UCL oe GU
= 0.5819 = 58.19%
u-d 1.25 — 0.80

VALUING AMERICAN OPTIONS =m

We may also use binomial trees for valuing American options, which provide for early exer-
cise rather than exercise at maturity only. With no change in the risk-free rate and the upside
and downside movement, the risk-neutral probabilities remain unchanged. However, the
value of the option may change, depending upon whether it is more profitable to exercise the
option before maturity.
Figure 11.9 shows a binomial tree for three periods of four months each for an asset sell-
7) _ ing at $100, which can move 25% up or 20% down in each period. We shall
The binomial model is | :
a pitent Ibo to value _ use the same tree for valuing a European call, a European put, and an Amer-
American options, as it ican put. We shall also demonstrate that an American call would be valued
allows for early exercise equal to a European call, and early exercise of the call on a non-dividend
at each node. paying stock has no value.
os ies Using the backward induction procedure, we now calculate the value of
a call option with expiry period of one year, with a strike price of =75, using the binomial
method with three periods of four months each. First, we find the risk-neutral probability of
an up movement with Eq. 11.3.
el ay 5 e9-06/3 no (0.80

Wigley
10202 080 ghey= 48.93%
Gas = 0.4893
Therefore, the probability of a down movement is 1 — 0.4893 = 0.5107.

Valuing European Call

The value of a European call option at the end of 12, 8, and 4 months are indicated
in the
tree depicted in Fig. 11.10.
At T = 12 months, the call would be exercised, and, therefore, the values of the call
at
various nodes would be equal to the price of the asset less the exercise PLCE e255
mo
 Option Pricing Binomial Model 313

Time

195.3

125.00

100.00

Fig. 11.9 Binary tree for option pricing—asset value

Value of underlying asset with 25% up and 20% down movement

Fig. 11.10 Binary tree for call option pricing—payotfs Fi

Value of call (X 75) on asset with 25% up and 20% down movement
314 Derivatives and Risk Management

The values of the call option at t = 8 months at the three nodes are worked out by arriving
at the expected values using risk-neutral probabilities and then discounting at the risk-free rate
of 2.02% for four months. The values of the call at three nodes of t = 8 months are as follows:
At t = 8 months
20.4893 x 120.31 4 0:5107% 50.00 Es 58.87 + 25.53
At upper node: 1.0202 = 82.73
1.0202
_ 0.4893 * 50.00 + 0.5107 X 5.00 _ 24.47 + 2.55 = 226.48
At middle node: = 1.0202 7 1.0202 ;
_ 9.4893 X-5.00 + 0.5107 X 0.00 — 2.45 + 0 = 72.40
At lower node: = 1.0202 1.0202 ;
Similarly, the value of the call option at t = 4 months at the two nodes can be worked out
by using the call values at the three nodes of t = 8 months. The values of call at two nodes
of t = 4 months are as follows:
At t = 4 months
_ 0.4893 X 82.73 + 0.5107 X 26.48 — 40.48 + 13.52
eee lo ce, 1.0202 1.0202 = %52.93

; = 0.4893 X 26.48 + 0.5107 X 2.40 =_ 12.96 + 1.22 = 713.90

ATI 1.0202 1.0202
Finally, we arrive at the value of the call at t = 0 using the values found for the nodes at
t = 4 months.
VRS ORE 1 O.A8931X552.935420
ova aos 51 O72Xo13
oS lhek 90 25.90.
wAU ae 710
We — 33735
1.0202 1.0202

Valuing American Call

Using the binomial model, we can value an American call rather easily. However, there is no
need to do so because early exercise of a call is no better than waiting till maturity. We already
know that the value of the call consists of two components: the intrinsic value and the time
value. As long as there is some time remaining for expiry, there would be some time value,
howsoever small. If we exercise the call before maturity, what we get is only the intrinsic
worth, which is the excess of the spot price over the exercise price. With an early exercise,
we lose the time value. Instead, if we decide to sell the call, we capture both the intrinsic
and the time values. The holder of the call would like to sell the call rather than exercise it.
Therefore, an American call is no better or worse than a European call.
For the sake of explanation of the procedure, a modification is required in the binomial
method to value an early exercise. The risk-neutral implied probabilities and the risk-free
rate
of return remain the same. Moving backwards, at each node, we compare (a)
the value of the
call as before, and (b) the value upon exercise of the option at each node. We
retain the higher
of the two values. Mathematically, at each node, say j, the value of the call
The American callisno = would be:
better than European |
call. Itcan easily be con- Value of the call = Max(S; — X, ¢))
ine through a binomial = Where S; and c; are the values of the underlying
and the call, respectively, at
node/.
 Option Pricing—Binomial Model 315

Table 11.1. Values of American call with and without exercise at nodes

. . Value of call X = 75
Time Node Asset value (2) =—— :
' - | If not exercised If exercised
w'_
AQ
Upper node
Att=8m Middle node
Lower node

Upper node
Lower node

Start node
Ee

While moving backwards to the preceding node, we use the value retained at the succeed-
ing node. For the European call, same value continues, as no early exercise 1s done because
the value without exercise is always higher.
Table 11.1 compares the value of an American call withXY= 75, with and without exercise
at each node.
It is easily observed that the value of the call, if not exercised, c;, is always greater than the
value if exercised, 1.e., (S; — X). Hence, we retain the value of the call and not the value upon
exercise at each node, making early exercise redundant. Therefore, the value of an American
call would be the same as that of a European call.

Valuing European Put

For the same asset values as in Fig. 11.9, we now demonstrate the valuing of a European put
with an exercise price of ~150. The binomial tree for the payoff of the put at various nodes
is depicted in Fig. 11.11. At T = 12 months, the put would be exercised, and, therefore, the
values of the put at various nodes would equal Max (0, the exercise price less the value of
the: asseimite s 150e=.5);
The values of the put option at ¢ = 8 months at the three nodes are worked out by back-
ward induction in a similar manner as that used for the call, by arriving at expected values
using risk-neutral probabilities and then discounting at the risk-free rates. The values of put
at three nodes of t = 8 months are as follows:
At t = 8 months
=-).4893" x 0.00.4, 0.5107 725.00" 0.00. 12.97
At upper node: 1.0202 10202 = 712.51
: SOAs 2 ON ae USO 0008 2. Mies er o.oo
At middle node: 10202 TAT ee os 247.03

PRU ASS ay O00 sO Tn 8.80) 34.25 DU AOR Sa.

At lower node: = 10202 = 10202 83.03

Similarly, the value of the put at t = 4 months at the two nodes can be worked out by
using the put values at the three nodes of f= 8 months. The values of put at two nodes of
t = 4 months are as follows:
At ¢ = 4 months
0.4893) Xel2.51 sr 0.5107.% 47.035, 6.12.4 24.02
_ At upper node:
1.0202 002 SNe
316 Derivatives and Risk Management

4m y
Time 0 ) 8m a12m Putvalue 2%
y
]
!
i}
! . 0.00
1 be

| !
| | !
|

|
i

! /
; :
1 1 |
| | ;
29.54 | \
! ; g
;
25.00 Z
|
0.4893 ! .
1

46.27; ! 47.03
|
|
:
i

|
!
l ;
|
:

\ \ i
! 0.5107
| : 3
| 70.00 :
! 64.12 |
! i i i 7

| |
| ’
|
| |
| ' ;
|
|
}
| !
1 |
1

! i}
! 98.80
\ ! }

LL LAL
LLL LEE EEE EEE EEE EE EEE EEE neaicoaoses

Fig. 11.11 Binary tree for put option pricing—payoffs

Value of put X = 150 on an asset with 25% up and 20% down movement.

At lower node:
_ 0.4893 X 47.03 + 0.5107 X 83.03 _ 23.01 + 42.40
= %64.12
ic 1.0202 1.0202
Finally, we arrive at the value of the put at ¢ = 0 using the values found for the nodes at
t = 4 months.
_ 9.4893 X 29.54 + 0.5107 X 64.12 2 14:43 38.15
Value of put: = %46.27
1.0202 1.0202

Valuing American Put

What was stated for the equivalency of the values of American and European call is not true
for put options. Unlike the call option, it may be more beneficial to exercise the put early
rather than wait for maturity or sell it. The procedure for the binomial method remains
the
same, except that with each node we find whether exercising the put results in a greater
pay-
off. Examine the three nodes at t = 8 months. At the middle and lower nodes,
the put has a
greater value when exercised. The values of the put when not exercised and when
exercised
are shown in Table 11.2. The retained values at the nodes are highlighted; they become
appro-
priate for valuation of the preceding nodes.
For an American put, each node,/,is evaluated for payoff in terms of intrinsic
value and
total value as follows:

Max’ ~ Sp)
where 5; and p; are the values of the underlying and the put, respectively,
at node jt
The values at the three nodes at f = 8 months for the European and America
n puts are
shown in Figs 11.12(a) and (b), respectively.
 Option Pricing—Binomial Model 317

Table 11.2 Values of put at f= 8 months when exercised and not exercised

Value of call X = 150

Asset value (2)
If not exercised | itexercised =|
Upper node
Att=8m Middle node
Lower node

FEF
Biv’’)"l
BFF
P8TrrnWi
|S
D1
FB
BW
eee
eee
ee
irisesrrenci

Fig,11.412.penne me cn ienarespees:
X = 150 (a) European put, without exercise (b) American put, with exercise

For the American put, the values at the two nodes for ¢ = 4 months are worked out on the
basis of the retained values at the nodes shown in Fig. 11.12(b). These are as follows:
_ 0.4893X 12.51 Daca ET rs) 0008 Onl 25.54
At upper node: . 10202 10202 = %31.03

j pa) A892 50,00) 1805.10) 286,00 58 24 A439,

At lower node: 10202 10202 = %67.04

Again, these values, derived using the risk-neutral method, are replaced by the values that
can be realized by exercising the put if it is greater. For = 4 months, the values are shown
in the Table 11.3.
A comparison of nodal values at time ¢ = 4 months under the binomial method for a
European put and an American put is made in Fig. 11.13.
Now we value the American put option at time f = 0. Again using the Fle neutral prob-
abilities, the price of an American put with an exercise price of 150 comes to %49.92, as
compared to the European put being valued at 46.27, as worked out here:
318 Derivatives and Risk Management /

Table 11.3 Values of put at t= 4 months when exercised and not exercised

OS Upper node 125.00

Value of put X = 150

31.03 25.00
|

European American

29.54 31.03

: |
|
|
|
]
64.12 70.00
e
| e 1 |
e
| , | |
| | i
' 0.5107 ! 83.03 0.5107
86.00
| |
| \

LEE EEE EE
Fig. 11.13 Binary tree for put at intermediate nodes with and without exercise

_ VACIS Aes Uo Ly eed) Eko Deep tS

Value of put:
1.0202 1.0202
A binomial tree with the value of the European and American puts at ¢ = 4 months and
now (t = 0) are shown in Fig. 11.14. The complete tree for the American put is shown in
Fig. 11.15.

European American
0 4m 0 4m
|
|
|
|

46.27 ; 49.92
|
I
|
II
| 70.00
EEL LEE Le
Fig. 11.14 Binary tree for put option pricing at t
 Option Pricing—Binomial Model 319

Time

SEA

SEM

Value of put (X = 150) on asset with 25% up and 20% down movement

VALUING OPTIONS ON DIVIDEND PAYING STOCK

Under the binomial model, we have valued both American and European calls and puts. For
valuing American options, we examined the question of whether an early exercise is more
beneficial at the decision points called nodes. We chose the higher of the two values for the
holder of the option. On similar lines, we can value options on dividend paying assets. We
shall value all four options—European call and put as well as American call and put on an
asset that pays dividend.
Assume the current value ofa stock as 100; it may go up 25% or fall 20% in a period of
six months. The risk-free rate is 5% p.a. (2.5% semi-annual). Assume that six months from
now the stock pays dividend of ¥10. We need to value an option with time to expiry of one
year using the two-stage binomial tree. Under our usual practice, the tree would appear like
the one shown in Fig. 11.16.
The probability of an up move, p, using Eq. 11.2 is 50%, and of adown move, | — p, is
50%, as calculated here:
AEE ales CMP
reRUE eG aa
eae ee aE le,oa
90 SO mice
Starting at 100 at t = 0, the stock can take values of $125 or €80 on the up or down move,
respectively. However, a dividend of %10 is paid. On the ex-dividend date, the price would
fall by $10, either to $115 or to %70, as the case may be. Using the ex-dividend price, we
construct the second branch of the tree. From the upper node at t = 6 months, we can either
go to 7143.75 (for an up move) or to 92.00 (for a down move). Similarly from a lower node
at ¢ = 6 months, we can go up at 87.50 or down at 56.00.
320 Derivatives and Risk Management

| 143.75 (115.00 x 1.25)

125
:
s
e
e

na ! 50% |92.00 (115.00 x 0.8)

noe ; 87.50 (70.00 x 1.25)

50% ae
1 —10
O70
i. ere |86.00(70.00 x 0.80)
t=6m T=12m
LLL OOOO MOL OOOO OOOO: Ze

Fig. 1, 16 Two-period binomial tree for dividend paying stock

Note that the end values of the asset do not converge to the same in case of a first up move
followed by a second down move, and in case of a first down move followed by a second up
move. Where the values converge, it is called a recombining tree. Computationally, it is easier
to solve a recombining tree, though fundamentally, the methodology of the binomial model
can still be applied. For computation convenience, we should have a recombining tree. So far,
we have been considering unequal up and down moves of 25% and 20%, respectively. These
up and down moves made the tree of the recombining type. A recombining tree is obtained
if we choose up and down moves as reciprocals of each other. To have a recombining tree
and an up move of 25%, we must have a down move at 20%, given by 1/1.25 = 0.80.
We overcome the problem of a non-recombining tree arising due to dividend payment by
making a simple modification in the construction of the tree. It does not distort the outcome
in any way. We know that the stock would pay a dividend of %10 after six months, thereby
reducing the price by the same amount at the end of the six months. Rather than adjusting
the price on the date of dividend, we construct the tree by deducing the present value of the
dividend from the current price. After adjusting the current price for dividend, constructing
the tree in the usual way would make the tree recombining.
The present value of the dividend is 10/1.025 = 9.76. The current stock price of 7100
now becomes ¥90.24. At the end of six months, the stock can have a price of $112.80 or
*72.19. Note that this would be ex-dividend price. The cum-dividend price would be greater
by the amount of dividend of 710. The three possible end prices now would be %141.00,
¥90.24, and %57.75, respectively. The middle price of 90.24 would be identical for (a) an
up move followed by a down move and (b) a down move followed by an up move. Based on
these values of the asset, a two-stage binomial tree is shown in Fig. 11.17. Using the tree of
Fig. 11.17, we now value American and European calls and puts.

European and American Calls on Dividend Paying Stock

Using the binomial tree of Fig. 11.17, the payoffs for both European and American calls
with an exercise price of $100 would be 41.00, %0.00, and 70.00, respectively, for the three
possible values of the asset, as shown in Table 11.4.
 Option Pricing—Binomial Model 321

Node at t= 6 months shows ex-dividend and cum-dividend prices.

' 441.00 (112.80 x 1.25)

90.24 (112.80 x 0.80 or 72.19 x 1.25) _

.
82.19 !
50%
! 57.75 (72.29 x 0.80)

Fig. 11.17 Two-period binomial recombining tree for dividend paying stock

Table 11.4 Payoffs against different possible asset values

_ Asset value (2) | PayoffofEuropean and American calls @)

Upper node
IN =i Middle node
Lower node

For the European call, the expected value of the call would be the discounted value of the
sum of the payoffs of the call multiplied by the respective probabilities. For upper and lower
nodes at t = 6 months, the values are worked out as follows:
_ 0.50 X 41.00 + 0.50 X 0.00
At upper node: 1025 = §20.00

At lower node: = 9.307% a ae eu = %0.00

Extending the same procedure, we can find the value of the European call to be ¥9.76.
. pO. 20a 20000 S025 000m 9 76
Value of European call: 1.025

American Call For the American call, the holder may like to own the underlying asset to
capture the dividend if it is more profitable. At = 6 months, the ex-dividend price would be
112.80, and the intrinsic value would be 712.80. The call value is worth €20. However if the
call holder exercises just before the stock becomes ex-dividend, the payoff would be &22.80
(12.80 + 10.00), which is greater than the value of the call. Hence it would be exercised. At
the lower node at t = 6 months, the call is out-of-the-money (OTM), and an exercise would
result in a loss of $17.81. Hence, the investor holds, as shown in Table 11.5.
322 Derivatives and Risk Management

Table 11.5 Actions taken by call holder at intermediate nodes

Value of call X = 100

| Time i: Node Asset value (7)
If not exercised Ifexercised
| Upper node 122.80 20.00
Att=6m
Lower node 82.19 0.00
Chosen action is in bold.

EXAMPLE 11.2 Multi-stage binomial model for a European put

Using a three-stage binomial tree, find out the value of European and American puts with an exercise price of €75, with a 25%
up movement and 20% down movement on the underlying stock, currently selling at 100, with a risk-free rate of return at 6%
with continuous compounding. Use the tree given in Fig. 11.11.
Solution Y
With a 6% return, the probability of an up movement would be 0.4893 and a down movement would be 0.5107, as worked out 7
in Fig. 11.11. The put would be exercised at T = 12 months only at an asset price of $51.20 at the lowest node. Its value would |
be 23.80. -
With the.rest of the nodes having zero values, the price of the put would be
0.5107 < 0.5107 X 0.5107 X 23.80 _ 9.99
1.02028
The complete binomial tree is depicted here:
Time 0 4m 8m 12m
i
|
|
i
|
I
|
I
|
1
i}
|
|
|
0.00
1
| 0.4893
|
|

2.99 i
I
|
i}
|
|
i
0.5107
|
|
|
|
i
|
i}
|
|
|
|
I
|

Fig. Binary tree for European put option pricing

Value of put (X= 75) on an asset with a 25% up and 20% down movement

The value ofan American put would be same as that of a European put because by comparing the values
of the exercise at each
node, we find that they are lesser than those of the European put. The value of an American put at a
lower node at t = 8 would
be %11.00, and at a lower node at t = 4 is 5.00; both figures are lesser than those for the European
put.
ELE EE TEE: TEE
 Option Pricing—Binomial Model 323

The value of the American call would therefore be 711.12 as compared to the value of the
European call at $9.75.
1050 M622 SU 05006 0.00
Value of American call: =< II
1.025 os

European and American Puts on Dividend Paying Stock

Let us now value a 12-m ATM put for the same asset. At maturity, the payoffs on the Euro-
pean and American puts are as shown in Table 11.6:

Table 11.6 Payoffs on European and American puts at maturity

Time Node _ Asset value (%) Payoff of European and American puts (<)
Upper node 141.00 0.00
AtT=12m | Middle node 90.24 9.76
Lower node 57.75 42.25

Proceeding exactly in the same manner as is followed for valuing a call, we get the value
of the European put at t = 6 at two nodes.
00:90. 400.00 50.50.2096
At upper node: 1.025 = 4.76
avigaver wade: 49 50X a8 ae OVE, 27537

With the values at t = 6 months known, we liroine European put at ¢ = 0 at $14.70 as

below.
Value of European put: = MEU Se SUS Ee 14.70
1.025
American Put At ¢ = 6 months for the upper node when the stock price is 7122.80, an
_ exercise results into a loss of 22.80. Hence, the holder would not exercise. At the lower node,
when the ex-dividend price is ¥72.19, exercising the put gives a payoff of $27.81, which is
more than the worth of the put at ¥25.37. Hence, the holder exercises the put, as shown in
Table P1:7.

Table 11.7 Actions taken by put holder at intermediate nodes

Value of American put X = 100 /

Asset value (%) : :
If not exercised

Cc S

Using the right values at the node of tf = 6 months, we get the value of the American put
at t = 0 as £15.89.
Bee 0 0 27 81
Value of American put: = %15.89
1.025
324 Derivatives and Risk Management

BINOMIAL SOLUTION FOR MULTI-PERIODS

For an n-stage binomial tree, the value of a call on a non-dividend paying asset is given by
Eqaliede |

| 5 Lapa”
. j
(1 — p)"~/
ie if
Max(0, wid"bihivey ~ISga =— X)
Co = (11.7)
(AR ae

Equation 11.7 is not as complex as it appears to be. It is extremely logical, and can be
explained in a rather straightforward manner.
For an n-stage model, there would be a total of m price movements. Each node is reached
by certain up moves and down moves. For j up moves, the remaining, n — /, must be down
moves. The value of the asset at each end-node is given by the number of up and down moves
needed to reach that node. For the topmost node, all n price movements must be up. The
probability of all x moves up, which is p”, and asset value would be wu” X S. For the second
highest end-value, there needs to be n — 1 up moves and | down move. The end-value would
be u"~ ) d' X S. Similarly, for the 7” end-value from the top, there have to be / up moves
and n — j down moves, and the end-value would be wd" ~/ X S.
With the exercise price of the call as X, the payoff at any node that requires 7 up moves
and (n — j) down moves is Max(0, u/ d" ~/ S — X). The probability of such a payoff is the
product of the number of paths for reaching the node multiplied by the probability of each
such path. The probability of each path with 7 up moves and the remaining (n — /) down
moves is p(1 — p)"~/. The number of paths available with ; up moves and (n — j) down
moves is "C;. Therefore, the total value of the call at maturity would be the sum of all payoffs
at the end-nodes. To arrive at the value today, the maturity value must be discounted by r for
n periods.

EXAMPLE 11.3 Valuing a call with the binomial model

An asset sells for 100 today. Value a call assuming an up move of 25% and a down move of 20% value, an ATM call for 12
months using Eq. 11.7, with three periods of four months each, and a risk-free rate of 7% per period.
Solution
With the given parameters, the implied probability of an up move is (1.07 — 0.8)/(1.25 — 0.8) = 60% and the probability of a
down move is 1 — 0.60 = 0.4 = 40%. For a three-stage binomial model, n = 3. For values of jfrom 0 to 3, the payoffs are

For 3!
j= 0 3191
0:09X 0.4% x Max (0, 1.25° x 0.88 x 100 — 100) = 0
For j= 1 08! x 0.4? x Max (0, 1.25' x 0.8? x 100 — 100) = 0

For j= 2 Te 0.6? x 0.4' x Max (0, 1.25? x 0.8! x 100 — 100) = 10.80

Otro me 0.69 x 0.4° x Max (0, 1.25% x 0.8° x 100 — 100) = 20.59
Hence, the value of the call today is calculated as under:
0 +0 + 10.80 + 20.59
Value of Call = =< 20102
1.078
 Option Pricing—Binomial Model 325

BINOMIAL MODEL FOR INDEX OPTIONS ©

The binomial approach for valuing options on indices is no different than that for valuation
of options on dividend paying stock. In the case of indices, the dividend is
_ With a small modification
_inthe risk-free rate, a continuously adjusted, and, hence, under a risk-neutral approach, the risk-
_ binomial model can eas- free rate of return must be reduced by the dividend yield on the index. The
_ ily be adapted for valuing risk-neutral implied probability of an up move for indices is computed by
options on indices. modifying Eq. 11.3 for the dividend yield, g, on the index.
Cn a
(11.8)
Pou, Sepested
For working details, refer to Example 11.4 for valuing a European call and a European put
on an index.

EXAMPLE 11.4 Binomial model of index options

The current value of Nifty is 4500. In a period of three months, it can go up or down by 10%. If the risk-free interest rate is 8%
and the dividend yield on the index is 2%, find the value of a call and a put with strikes of 4600, expiring in three months. 4 L
the single-stage binomial model and assume one index point as <1. L

Solution
A European call and a European put with a strike price of 4600 and a maturity of three months can be valued with risk-neutral
valuation, using a net interest rate of 6%. The risk-neutral probabilities using Eq. 11.5 are
—- al’ fo) es el 0-06 alle) a 0.90

ee 65 10.90
= 1.01—51 0.90 _ 9 5756 = 57.56%
0.20
1 — p=1 — 0.5756 = 0.4244

Risk-neutral valuation of index options

(Figures in ®)

T=3m Call Put

Spot X = 4600

4950 350 —

4500

1- p=0.4244
; 4050 — 550
The payoffs of the call option and the put option with a strike of 4600 at the maturity of the options are depicted above. With |
payoffs of the call of 350 and 0 with up and down moves, respectively, we may derive the risk-neutral valuation of the call. L
Value of the call at the end of three months = 350 x 0.5756 + 0 x 0.4244 = 201.45
Value of the call today = 201.45 x @06 * 312 — 901.45 x 0.9851 = 7198.45 :
With the payoffs of the put of 0 and 550 with up and down moves, respectively, we may derive the risk-neutral valuation of |
the put.
Value of the put at the end of 3 months= 0 x 0.5756 + 550 x 0.4244 = 233.42
Value of the put today = 233.42 « @0-6 * 9/12 — 933.42 x 0.9851 = %229.94
LETTE,
326 Derivatives and Risk Management

VALUING CURRENCY OPTIONS

The binomial model can be easily adapted for valuation of currency options. Just as we
_ modified the risk-neutral return by dividend yield in the valuation of index
The binomial model can
options, we modify the return by foreign interest rates in the case of options
be extended to currency
options with small modi- on foreign currencies. While calculating the implied probabilities under risk-
fications in the risk-free neutral valuation, the interest rate must be considered net of any foreign
interest rate. For example, if the domestic interest rate is 10% p.a. and the
risk-free interest rate in foreign currency is 4% p.a., then while computing
the risk-neutral probabilities, the interest rate that must be used is 6% (10% — 4%). Equation
11.3, for finding the probabilities of an up move, would stand modified by the interest rate
on foreign currency, rg as follows:
ee a ts
fe aged
(11.9)
For example, consider the current exchange rate to be €70.00 per euro. Under a bino-
mial situation, the rupee can depreciate or appreciate by 4% over the period of the next two
months. Further risk-free interest rates in the rupee market and the euro market are 6 and 2%,
respectively. For a European call and put with a strike price of 70 per euro and a maturity of
two months, risk-neutral valuation is done with the net interest rate of 4%. The risk-neutral
probabilities using Eq. 11.9 are as follows:
Ca By) d 0.04 DS POD 0.96

e — u-d + 104-096"
1.0067 — 0.96
= 0.08 = 0.5836 = 58.36%
ye) 1 — 0.5836 = 0.4164
A single-stage binomial tree for payoffs of 2-m call and 2-m put options with a strike price
of $70 per euro is depicted in Fig. 11.18.
With the payoffs of the call with up and down moves of %2.80 and 20.00, respectively, we
may have the risk-neutral valuation of the call, shown as follows:

Value ofthe call at the end of two months = 2.80 X 0.5836 + 0.00 X 0.4164 = 31.6341

Value ofthe call today = 1.6341 x e794 x 2/12 = 1 6341 x 0.9934 = 21.6233 ~ 21.62

(Figures in =/€) i
T=2m :
Spot Call Put
72.80 2.80 ae

70.00

1 - p= 0.4164
67.20 — 2.80
LEE op
eaesosapeyeneereerrte

Figure 11.18 Risk-neutral valuation of currency optio

 Option Pricing—Binomial Model O27

Similarly, with the payoff of the put with up and down moves of 70.00 and %2.80, respec-
tively, we may have the risk-neutral valuation of the put.

Value of the put at the end of two months = 0.00 X 0.5836 + 2.80 X 0.4164 = 71.1659

Value ofthe put today = 1.1659 X.e~

9 < 2/12 = 1 1659 X 0.9934 = 71.1582 ~ F1.16

BINOMIAL MODEL IN PRACTICE: CONSTRUCTING BINOMIAL TREE |

The extremely simplified assumption that only two prices of an underlying asset are possible
_ raises doubts about the applicability of the binomial model as an accurate
By increasing the number _ of The assumption :
Gi penchec etic _ method of calculating option price. of only two prices seems
and adjusting the upand ‘© be too unrealistic for determination of fair value. Further, it seems that by
down move according © aSsuming only two prices, the probability distribution of stock prices would
to volatility, the binomial be far from reality. Further, the primary determinant of option value, i.e., the
model can beusedwith = volatility of stock prices, does not figure in the implied probabilities of up
ee aetety (0 : and down moves of the binary states.
arrive at the value of : ‘ pi
_ However, in actual practice, both the objections can be handled very conve-
» niently. The first objection that binomial stages are far from reality and the
general acceptance that stock returns have normal distribution can be overcome by increas-
ing the number of stages in the binomial method. As we increase the number of stages, the
possible outcomes for asset values increase by a multiplication of 2 in each stage. While
valuing options, the binomial approach can be used if the option period is divided into 30
small intervals; with recombining trees, 31 different terminal prices at the end of the option
period can be evaluated. There would be 2°" different paths to achieve these 31 terminal
prices. The two extreme prices could be achieved only in one possible way, i.e., if all 30 are
up or down moves. The probability of the maximum price and the minimum price is 1/2°°.
The next level of prices (one below the maximum or one above the minimum) would consist
of 29 up moves and | down move. Out of 30 binary states, this is possible to achieve in 30
different ways, i.e., >°C, combinations. The probability would be °°C,/2°°. Similarly, we may
find the probability of each of the 31 possible terminal prices. Thus, probability distribution
would be far closer to reality than what one imagines in the binary state.
The way to overcome the second objection, that the binary system ignores volatility in
valuation, is to replace arbitrary selection of up and down moves with selection based on
stock volatility. It is possible to equate an up or a down move based on stock volatility, o.
The up move, uw, in each binomial period of length Ar is set equal to e®’ as per the Cox,
Ross, and Rubinstein method. For example, to value an option of 3 months on an asset with
a volatility of 30% and a 30-stage binomial tree, the parameters under the binomial approach
would be determined as follows:
Option period 3 months
Number of binomial steps 30
Duration of each binomial step, Ar 3 days or 0.008333 years
Stock volatility, 30%
Mince ee 1.02776
Down price d = 1/u 0.97299
328 Derivatives and Risk Management

Risk-free rate, 7 8%
Probability of up move, p 0.5053
je SCS Oa)
= (1.00067 — 0.97299)/(1.02776 — 0:97229)
p = 0.505329
Probability of down move = | — p 0.4947

We all live under uncertain conditions. Each day is a new day, with some new events hap-
pening and some old events repeating. For each event, we behave differently.
~ soe Cale So do the asset prices. The events are independent and drive the values of the
Le assets. Is there a way to replicate these independent events and conclude the
ables by picking random behaviour of prices of assets for the future? In case there exists a relationship
numbers for aknown of prices with different variables, then it is possible to assume some values
probability distribution. of independent variables, and based on the relationship, the price of a depen-
. dent variable can be forecasted.
We can only simulate the conditions that derive the values of the assets. Simulation means
creating conditions artificially and observing the outcome under each condition. If we repeat
this exercise, a sufficiently large number of times, we can make a reasonable estimate of asset
prices. Under simulation, we generate random numbers that follow the likely probability
distribution associated with the variable. For example, assume that the US dollar exchange
rate for 300 observations was found to vary as shown in Table 11.8.
If we know the relationship of foreign institutional investors (FII) inflows for portfolio
investments with exchange rates, then, based on the above distribution in Table 11.8, we can
simulate the US dollar exchange rate for tomorrow and forecast the value of FII inflows. The
changes in the exchange rate are assumed to occur randomly, but would follow the probabil-
ity distribution pattern assumed in Table 11.8. We can pick a random number that would be
associated with a particular change in the exchange rate. We would repeat the exercise many
times by picking one number each time, which would correspond to a specific change in the
exchange rates. The number would be picked randomly, i.e., we do not know what the next

Table 11.8 Probability distribution—300 US dollar exchange rate observations

% Increase No. of times % Decrease No. of times

> 5% 3 Between 0 and 1%
Between 4 and 5% i Between 0 and 1%
Between 3 and 4% 19 Between 2 and 3%
Between 2 and 3% 27 Between 3 and 4%
Between 1 and 2% 46 Between 4 and 5%
Between 0 and 1% 51 > 5%
No change 2 Total
 Option Pricing—Binomial Model 329

number would be, based on the numbers for the previous periods. Such an exercise is called
the Monte Carlo simulation, named after the city of Monte Carlo, famous for its casinos.
The Monte Carlo simulation is another numerical method that can help in valuation of
options. In this simulation, values are sampled at random from the input probability distribu-
tions. Each sample is called an iteration. The outcome from each iteration is recorded. The
Monte Carlo simulation does this hundreds or thousands of times, and the result is a prob-
ability distribution of possible outcomes. In this way, this simulation provides a much more
comprehensive view of what may happen. It tells you not only what could happen but also
how likely it is to happen.
In finance, Monte Carlo methods are used by financial analysts who wish to construct
stochastic’ or probabilistic financial models, as opposed to the traditional static and deter-
ministic models. In valuing an option on equity, the simulation generates several thousand
possible (but random) price paths for the underlying share, with the associated payoff of the
option for each path. These payoffs are then averaged and discounted to find the value of
the option. Similarly, we can value fixed income instruments and interest rate derivatives by
simulating the source of uncertainty, i.e., the interest rate. A similar approach can be used in
valuing swaps and swaptions.
We demonstrate with a small example the application of the Monte Carlo simulation for
pricing a call option. We know the price of European options through the Black-Scholes
formula (discussed in Chapter 12). We can test if the Monte Carlo simulation matches with
the Black-Scholes model.
Table 11.9 presents 20 iterations under the Monte Carlo simulation for determining the
value of an ATM call on a stock with a current price, S, of 100. The expiration period is 90
days, and the risk-free return is 5% p.a. The stock is assumed to have volatility, o, of 30%.
The change in value of stock, AS, is governed by the following equation:
AS = S-r-At+S-o-(RN)-VAt (11.10)
where S = current value of stock = 100, At = time remaining for expiry of option = 90
. days = 0.2466 years, r = risk-free rate of return = 5%, o = volatility of stock price = 30%,
and RN is the random number generated.
A random number has been generated in MS Excel using the RAND function. The RAND
function generates a random number between 0 and | that is uniformly dis-
eee tributed. The principle behind the Monte Carlo simulation is to generate
for uncertain variables, another type of distribution based on the uniform distribution random num-
_we can determine the ber. It requires a transformation from uniform distribution into other distri-
values of dependent vari- butions. A reasonable way of generating approximate normal distribution
ables, find an average, would be to add 12 RAND() functions and subtract six.4
and discount back to the
The first random number is 0.4954, which gives the change in stock price;
present
as per Eq. 11.10, the change in stock price is as follows:

AS = 100 X 0.05 X 0.2466 + 100 X 0.30 X (0.4954) X 0.2466 = €1.8392

4Refer to An Introduction to Derivatives and Risk Management by Don M. Chance and Robert Brookes; 8th ed. p519; South
Western Cengage Learning. The sum of 12 random numbers has been found to have a mean of 6 and a standard deviation
of 1.00. Hence, subtracting 6 from the sum of 12 random numbers would have a mean of zero and a standard deviation of
1, the two properties of normal distribution.
330 Derivatives and Risk Management

Table 11.9 Monte Carlo simulation—example

Change In spot End-value of spot Value of call

S. No. Random number ne $25. ae Max(0, S; — X)
foe
| 0.0407 1.8392 101.8392 1.8392
2 0.3468 6.3991 106.3991 6.3991
3 1.1354 18.1468 118.1468 18.1468
4 ~ 1.5498 — 21.8543 78.1457 -
5 —0.2814 —2.9591 97.0409 -
6 —0.3259 —3.6220 96.3780 -
a 1.6372 25.6221 125.6221 25.6221
8 —0.2018 - 1/130 98.2267 -
9 © 1.1748 18.7263 118.7263 18.7263
10 0.1235 3.0726 103.0726 3.0726
11 nEOtloce 057365 99.2635 -
12 0.5216 9.0031 109.0031 9.0031
is 0.6977 11.6264 111.6264 11.6264
14 — 0.3585 —41077 ~ 95.8923 -
15 0.9811 15.8482 115.8482 15.8482
16 1.5443 24.2382 124.2382 24.2382
ine 0.9812 15.8497 115.8497 15.8497
18 0.0961 2.6645 102.6645 2.6645
19 —0.1918 4 = e246 98.3757 -
20 —1.2106 — 16.8013 83.1987 -
Sum of 20 observations 153.0362
|Callvalue based on 20 observations c. 7.6518

Therefore, the end-value of the asset would be 100.00 + 1.8392 = ~101.8392, and the
payoff on the ATM call is €1.8392, as shown in the last column of Table 11.9.
Similarly, the 11th number is —0.1322, which gives the change in the spot price as follows:

AS = 100 X 0.05 X 0.2466 + 100 x 0.30 X (—0.1322) x \0.2466 = —%0.7365

The final asset value is given as 100 — 0.7365 = 299.2635 and the resultant payoff of the
call is given as zero.
Repeating the exercise for 20 random numbers, we get 20 different values of
the call.
The average comes to %7.6518, which is the call price under the Monte Carlo simulatio
n at
maturity of the option. Under risk neutrality, the value of the option should be e(~9.5 * 0.2466)
* 7.6518 = %7.4259. Of course, the sample of 20 random numbers is extremely
inadequate
to arrive at a reasonably accurate value for the call. Normally, one has to pick
about 10,000
to 20,000 random numbers to have a reasonably accurate value.
 Option Pricing—Binomial Model 331

The requirement for a large number of observations adds to computation time. The com-
plex relationship between input and output would further constrain the computation. The
computational complexity and the requirement for large drawings of random numbers are,
therefore, considered disadvantages of the Monte Carlo simulation.
The advantages of Monte Carlo simulation include giving approximate solutions to many
mathematical problems. The method can be used for both stochastic (involving probability)
and deterministic (without probability) solutions.

CONCLUSION
The binomial approach to valuation of an option is indeed revealing. It demonstrates how
simple representations can solve seemingly complex issues. The risk-neutral valuation high-
lights how probabilities of up and down moves do not play any role in determining option
value—a proposition difficult to digest. This is because of the fact that when a risky asset is
combined with an option, another extremely volatile asset can resuit into a hedged portfolio,
providing an assured return. Indeed, this is the cornerstone of the risk-neutral approach. With
fast computing devices available, the re-iterative process of valuation can easily be executed.
As the number of iterations increases, option pricing by the binomial model would converge
to the one given by analytical models.
Another extremely powerful feature of the binomial model is its ability to incorporate
managerial flexibilities. As the number of branches in a tree increases, the time interval at
each stage shortens. At each stage, nodes can be regarded as decision points. We applied
decisions such as early exercise and dividend payments in the valuation of options. This
kind of flexibility—incorporating human intervention and managerial discretion in decision-
making—1s not possible in analytical models, which work as black boxes to provide outputs
once the inputs are fed in.
Options are both exchange-traded as well as over-the-counter products. The variety avail-
able in over-the-counter options is tremendous, as features of the options are modified by the
parties involved. These are referred to as exotic options, and they constitute a major propor-
tion of the commercial world. Therefore, the need to incorporate this kind of flexibility is of
paramount importance. It is here that the binomial approach becomes very handy, in contrast
to black-box solutions.

SOLVED PROBLEMS =
SP 11.1: Binomial model for call pricing
A stock is currently trading at %50. It can either go up by 20% or fall by 20% in a period of three months. If the risk-free interest rate
is 8% p.a., find the value of a call and a put with an exercise price of 50 and maturity of three months using the risk-neutral method
under the binomial model for a single period. Verify the put-call parity also.
Solution
The implied probability of an up movement with a risk-free rate of 8%, an up move of 20%, and a down move of 20% is 0.5505. The
probability of a down move is 0.4495, as shown here:
p= e@ — (1 = a) _ 1.02020 — (1 = 0.20) _ gerne — 55 yao,
u+d 0.20 + 0.20
1— p=1— 0.505 = 0.4495
332 Derivatives and Risk Management

The payoffs of a call and a put with a strike of 750 at the end of the maturity period of three months are as shown here:

Spot Call Put |

60 10 0 |
0.5505 |
50 :
0.4495 y

40 0 10 1]
NS

Value of the call at maturity =10 X 0.5505 + 0 x 0.4495 = 5.505

Value of the call today = Present value of the call at maturity
= 5.505 X e008 x 3"2 — %5 3960 ~ 5.40
Value of the put at maturity = 0 X 0.5505 + 10 x 0.4495 = 74.495
Value of the put today = Present value of the put at maturity
= 4,495 x ¢ 008x312 = 4.4060 ~ %4.41
Using put-call parity, p =c -S+X X e-"=5.50 — 50 + 50 x e008 X 912 — F444

SP 11.2: Binomial method with equivalent portfolio approach

Refer to the data in SP 11.1 and re-calculate the values of the call and put using the equivalent portfolio approach.
Solution
Option delta of the call
Option Delta = Spread of call option _ 10-0 _ 10 _ 05
Spread of share price rr60-40 20
The value of a portfolio of one long share and two short calls at maturity
Stock price =60 : 60—2x 10= 40
Stock price = 40 : 40-2x0=40
Present value = 40 x e008 x 3/12 — 39 94
Cost of portfolio = 50 — 2 x c = 39.21
c = (50.00 — 39.21)/2 ~ 5.40
Option delta for the put
ofputoption __ 1-10
Option Delta = SPread _ -10_ _o¢
Spread of share price 60 — 40 20
Value of a portfolio of one long share and two long puts at maturity

Stock price =60 : 60+2x0=60

Stock price = 40 : 40+2x 10=60
Present value = 60 x @~ 9.08 x 3/12 — 5g By
Cost of portfolio = 50 + 2 * p = 58.81
p = (58.81 — 55.00)/2 ~ 24.41
SP 11.3: Binomial model for call pricing
A stock is currently trading at 250. It can either go up by 20% or fall by 20% in a period of three months. If the
risk-free interest rate
is 8% p.a., find the value of a call and a put with an exercise price of 745 and maturity of six months using the
risk-neutral method
under the binomial model for two periods.
 Option Pricing—Binomial Model 333

Solution
The implied probability of an up movement with a risk-free rate of 8%, an up move of 20% and a down move of 20% is 0.5505, as
calculated in SP 11.1. A two-stage binomial tree for 6-m call and put options with an exercise price of %45, three months in each
period, and asset price and payoffs of call and put at expiry is shown here:

Two-stage binomial tree

oh At T=6m,
X= 45
j Stock Call Put
i]

| 72 27 0
0.5505
!

0.5505
1

! 0.4495
i} 48 3 0
0.5505
i}
i}
i
i
1

i
i}
i}
1
1
0.4495
32
i}
i}
1

The risk-neutral valuations of the call

At the node with a spot price of 60 att = 3m
Value of the call at maturity = 27 X 0.5505 + 3 X 0.4495 = %16.2120
Value of the call att = 3m = Present value of the call at maturity
NPA lls ee eee
= 16.2120 x 0.9802 = %15.8910
At the node with a spot price of 40 att = 3m
Value of the call at maturity =O 5505 iene a 0,44.950h—axleboilo
Value of the call at t= 3m = Present value of the call at maturity
1.6515 x e 0.08 x 3/12

= 1.6515 x 0.9802 = %1.6188

At the node with a spot price of 50 at t= 0
* Value of the call at f= 3m = 15.8910 x 0.5505 + 1.6188 x 0.4495 = €9.4756
Value of the call at t= 0 = Present value of the call at t= 3m
= 9.4756 x @~ 0.08 x 3/12

= 9.4756 < 0.9802 = %9.2880 ~ <9.29

The risk-neutral valuations of the put
At the node with a spot price of 60 att = 3m
Value of the put at maturity = 0 X 0.5505 + 0 x 0.4495 = %0
Value of the put att = 3m = %0.00
At the node with a spot price of 40 att = 3m
Value of the put at maturity = 0 X 0.5505 + 13 X 0.4495 = %5.5435
Value of the put at f= 3m = Present value of the put at maturity
= 55435 x e 9.08 x 3/12

= 5.5435 x 0.9802 = %5.7278

At the node with a spot price of ¥50 at t= 0
Value of the put at t= 3m = 0 0.5505 + 5.7278 X 0.4495 = 2.5746
Value of the put at tf = 0 = Present value of the put at t= 3m
= 25746 x e 0.08 x 3/12

= 2.5746 X 0.9802 = %2.5256 ~ %2.53

334 Derivatives and Risk Management

SUMMARY
Determination of option premiums has been one of the most The binomial option pricing model is an extremely potent
challenging areas of derivatives. Various methodologies exist to tool, and has the capacity to value American options that can
value options. One of the most powerful, yet simple, approaches be exercised at any time. The binomial method renders flexibility
to value options is the binomial model. in judging whether exercising an option is beneficial at intervals
The binomial model makes the extremely simplified assump- of time. The flexibility of the binomial model makes it useful for
tion that there are only two possible values of an asset, one up valuing several exotic options that are not standard European
and the other down from the current price, at the end of a period. options,
It is possible to construct a portfolio of the stock and the option Increasing the number of binomial steps by shortening the
on it so that it provides a fixed value at the end of the period. If time intervals makes the valuation closer to that of analytical
so, the return on such a portfolio cannot exceed the risk-free rate models. The binomial model can be used for valuing options on
of return, or else it leads to arbitrage. Investors cannot attach dividend-paying stocks, on indices, and on currencies by making
probabilities to changes in price in an arbitrary manner. Instead, minor modifications.
if the returns have to be equal to the risk-free rate, the probabili- Another numerical method available for valuing options is the
ties are implied. Such an approach to option valuation is referred Monte Carlo simulation. Thousands of possible scenarios of the
to as risk-neutral valuation. price of an underlying asset can be generated, and the value of
Options can also be valued by constructing equivalent portfolios an option can be found. Averaging these values and then dis-
based on the delta of the option. The option delta is the change in counting the average to the present should give the value of an
value of the option relative to a change in value of the underlying option. The method is computationally intensive, but offers the
asset. Setting the values of two portfolios to be equal, we may find advantage of handling situations where analytical solutions are
the value of a portfolio that is unknown. This is referred to as the hard to find.
equivalent portfolio approach. Risky stock combined with an option
on it can result in a portfolio that is risk free.

KEY TERMS
Binomial option pricing model An option pricing model that understanding behaviour and pricing.
assumes that there can be only two possible states of value of Option delta The option delta is the rate of change of an
the underlying asset. option value with respect to a change in the value of the under-
Equivalent portfolio approach An approach that assumes lying asset.
that two portfolios that have the same value would be equiva- Risk-neutral probability The probability that equates the
lent—including the pricing of such portfolios—would fetch the return of a portfolio/asset with the risk-free rate of interest.
same value, and command the same price. Risk-neutral valuation Risk-neutral valuation assumes that a
Monte Carlo simulation The method of simulating the portfolio that provides a definite value cannot grow by more than
uncertainties for a given probability distribution by generating the risk-free rate.
thousands of random numbers and analysing the outcomes for

QUESTIONS
11.1 Describe the binomial model of valuation of options. while valuing American options? Explain with the help of
11.2 What do you understand by risk-neutral valuation? an example.
11.3 What is the equivalent portfolio approach to value options 11.5 What factors would you consider while constructing a bino-
and how is it different from risk-neutral valuation? Explain. mial tree? How would you achieve accuracy of results and
11.4 What changes would you make in the binomial method incorporation of volatility?

PROBLEMS
P 11.1 Understanding the binomial tree rate is 8% p.a., with quarterly compounding. The stock can take
You are required to value a 12-m option on an asset currently only two values at the end of each quarter, with either a 10% up
trading at €100 using a four-stage binomial tree. The risk-free or a 10% down. Answer the following:
 Option Pricing—Binomial Model 335

(a) How many end values can the asset have? What would the value of the put in P 11.4 be if it were an Ameri-
(0) Find out all the end-values. can option?
(c) What is the probability of each end-value? P 11.6 Risk neutrality and binomial tree
P 11.2 Risk neutrality and binomial tree A stock is currently trading at $50. Over a period of one month, it
Refer to P 11.1. Under risk-neutral valuation with a binomial tree, can either go up by 10% or fall by 10%. Using the single-period
what would the probabilities of an up move and a down move be? binomial tree, what is the value of a 1-m call and a 1-m put option
P 11.3 Option value with the binomial model with a strike price of $50? Assume a European option and a
For the parameters of P 11.1 and P 11.2, find the value of a 12% risk-free interest rate with monthly compounding. Draw the
European call and a European put with 12 months to maturity binomial tree, indicating the values of the stock and the call and
and a strike price of $120. put at expiry. Further, verify the put-call parity using the call
price found.
P 11.4 Valuing a European put with the binomial tree
For the parameters of P 11.1, depict the 4-stage binomial tree for P 11.7 Risk-neutral valuation
a European put option with a strike price of %120. Value the call and put options of P 11.6 by making a risk free
portfolio.
P 11.5 Valuing an American put with the binomial tree
 Option Pricing
Black-Scholes Model

INTRODUCTION Learning Objectives .

In Chapter 11, we discussed the binomial model and the Monte After going through this chapter,
Carlo simulation, which used a reiterative approach to value readers should be familiar with
options. In this chapter, we discuss an analytical approach to get s ‘how various factors affect option
solution to option pricing, known as the Black—Scholes—Merton prices
model—more popularly known by its first two discoverers, 1.e., valuation of options by the Black—
Scholes model
Fischer Black and Myron Scholes. They discovered the model in
assumptions of option pricing in the
1973 for European options with no dividend till maturity. Robert Black-Scholes model :
Merton later incorporated the dividend payment into the Black— adapting the Black-Scholes formula _
Scholes model (BSM). to value
The BSM was a landmark in financial literature, as it opened « options on dividend paying stocks
» options on indices
up an entirely new field of research. The understanding of BSM
» options on currencies
is extremely important for those concerned with option valua- valuing an American option
tion. It is said that Black and Scholes developed option pricing the meaning of volatility and its
in two different ways—one based on the capital asset pricing measurement
model and the risk-neutral approach, and the other based on a implied volatility
mathematical solution to a differential equation. Only when a
solution derived by both the methods matched was it accepted.
The approach in the mathematical solution to option pricing
involved use of much research and results, worked out by many
physicists and mathematicians.
In contrast, the binomial approach avoided all complex
mathematics. It may be evident that as the number of branches
increases in a binomial tree, the accuracy of the option price
found increases. Further, as we increase the number of trees in
a binomial model by shortening the time interval, the value of
the option not only stabilizes but also oscillates around some
value—now referred to as the BSM value. It is found that by
suitably increasing the number of iterations in the binomial
model, the option price converges to the one obtained by the
BSM formula.
 Option Pricing—Black-Scholes Model 337

The basic difference between the binomial formula and the BSM formula is that while
the former uses discrete steps for price movements, the latter model works for continuous
changes in the asset price to arrive at a black-box solution to the option price. While the
major strength of the binomial model is its ability to incorporate flexibility, the advantage of
black-box solutions such as the BSM formula is to substantially reduce computation time.

FACTORS AFFECTING OPTION PRICE

The BSM requires five inputs (six for options on dividend paying stock) to value European
options. Before we dwell on the mathematical model for determination of the exact option
price, here are some intuitive explanations on the behaviour of determinants and the effect
each of them has on the option premium.
The following are six identifiable factors that affect option premium:
The price of the underlying asset, S
iieexercise price, X
the time left for expiration, T
variability (volatility) in the price of the underlying, o
the risk-free interest rate, r
the benefit that would accrue for holding the asset rather than an option over it, D
Price of the Underlying Asset, S As the price of the asset increases, the value of the call
_ also increases. The value of the call is driven by the differential of S and X
With any increase in the
_ for S> X. The higher the asset price, the higher the differential, and, hence,
price of the underly-
ing asset, a call option the higher is the value of the call. Most investors buy a call option to benefit
increases in value while from price rise, and, therefore, must pay a higher premium if the asset price
aputoption decreases —_ increases. If the call 1s out-of-the-money (OTM) and the spot price increases,
in value. _ the probability that it will touch or cross the strike price also increases. If the
. "call is already in-the-money (ITM), its intrinsic value increases even further
with an increase in the spot price. A call option becomes more expensive as the writer of the
call assumes a greater risk with rising spot prices.
Similarly with an increase in price ofthe asset, the payoffto the put holder declines, as the
intrinsic value of the put is the difference between its exercise price and the spot price, i.e.,
X — S. As the spot price increases, the differential Y — S also decreases, and, therefore, the
value of a put must fall with an increase in the price of the asset. Investors buy put options to
protect themselves against fall in the price. As the price goes up, the put holder is less likely
to exercise his/her option. It is a favourable situation for the writer of the put, and, therefore,
he/she can be induced to write the put option with a smaller premium.
Exercise Price,X The impact of the exercise price on the value of options is opposite to that
of spot prices. The higher the exercise price, the lower is the value of the call option. As the
exercise price goes up, the chances that the share price will exceed it become
With an increasing exer- lesser and lesser. With an increase in the exercise price, the call option becomes
cise price, the value of a more and more out-of-the-money. As stated earlier, the value of a call is driven
call option decreases and by the differential between the spot price and the exercise price. With any
of a put option increases.
increase in the exercise price, the intrinsic value of the call falls.
338 Derivatives and Risk Management

Just as the value of the call decreases with an increase in the exercise price, the value of
the put increases as exercising the put option by the holder becomes more and more lucrative.
Accordingly, the value of a put option must increase with any increase in the exercise price.
Time Left for Expiration, 7 Intuition would tell us that with more time available, there
_ would be a greater probability of achieving the exercise price from either
With more time to matu- _ direction. This general statement must hold true for both call and put options.
rity, the values of calls
and puts increase.
_ The farther the expiration date, the more valuable is the option, irrespective
_ of whether it is a call or a put. There are equallygreater chances of the price
going above _X (for a call option) or falling below X (for a put option). Conversely, lesser time
available will make the options less valuable. Whether it is an option to buy (call) or to sell
(put), the chances that an option will turn in-the-money increase with increased availability
of the time before expiry.
Therefore, a call or a put of three months must cost more than a call or a put with expiry in
one month. The value of a call as well as a put decreases as the time to maturity approaches;
this phenomenon is called time decay.
Variability of Price (risk) of Stock, 0 Volatility of the underlying stock is measured using
__ the standard deviation of returns. The larger the standard deviation, the larger
With increasing volatility _ 1s the volatility. In terms of the shape of the normal distribution curve, it will
of the price of the under-
lying asset, both call and _ become flatter and wider as the standard deviation increases. The expected
put options increase in _ profit from the option, either a call or a put, would increase with an increase
value. _ in the standard deviation. Volatility is not unidirectional, but applies equally
Lunn
to any rise or fall in price. As risk is higher, the price of the asset varies in a
wider range. Hence, it has a greater chance of becoming in-the-money. It will not be wrong
to say that it is the volatility of the price of the asset that imparts value to an option. Call and
put options become more valuable as the volatility of the underlying asset increases.
Interest Rate, r Interest rates also affect the option premium. Their effect is not as appar-
ent as it may be with other determinants of the option premium. To understand the impact of
interest rates on option premiums, one has to look into the timing of the cash flows that are
attached to owning or writing an option. Assuming an intention to exercise the option at or
prior to expiry, we can also assume that the cash flow for the underlying transaction, i.e., the
exercise price, is deferred in the options contract.
In case of a call option, the holder is liable to pay to the call writer the exercise price
and take over the ownership of the asset at the time of exercise. Essentially, the buyer has
deferred the cash flow for owning the asset, and, therefore, can earn interest on the money
set aside for the exercise price over the option period. Payment is made only when the call
is exercised. It is a liability that arises upon exercise. If the interest rate increases, the earn-
ings for the holder of the option would be more, and, hence, he/she would be willing to
pay an additional premium. The other way of ascertaining the direction of change in value
With an increasing rate ae aes Dea call Bee: as te dependent upon the
alineics he vauect | price and the present value (PV) of the exercise
acalideclines andthe Price, i.e.,
ee of a put a c= S—PVox of c= eee (121)
 Option Pricing—Black—Scholes Model 339

An increase in the interest rate means that the present value of X decreases, thereby mak-
ing the call more expensive.
Similarly, holding a put is a deferred potential asset that results in inflow of money only at
the time of exercise. The holder of a put foregoes interest for the option period. The quantum
of this sacrifice of income would be more if interest rates increase. To compensate for the
loss of interest, the holder will be willing to pay a lesser premium if interest rates are higher.
With an increased rate of interest, the present value of the potential asset is less. Therefore,
the value of the put is less when the interest rate is high. Alternatively, with increased inter-
est rates, the difference between the present value of the exercise price and the spot price
decreases, as can be seen from the value of the put:

(SO is (22)
Expected Dividend During Life of Option, D The benefits of ownership (typically divi-
dend) accrue only to the holder of the asset, and not to the person having a derivative expo-
sure. Further, when the dividends are paid, the value of the asset in the market declines by
an equivalent amount. With an expected decline in the spot price, the value of the call must
decrease and that of the put must increase. It would be more beneficial to hold the stock than
to hold the call.
Just as the value of the call decreases with increased dividend, the value of the put increases,
as the holder of the put option retains the ownership of the asset, and all benefits accruing on
it, till its exercise.
Table 12.1 summarizes the impact on option prices of the various factors that determine
these prices: .

Table 12.1 Impact of various factors on option prices

Variable (increasing)
Share price
Strike price
Time for expiration
Volatility
Risk-free rate
Dividends

BLACK-SCHOLES OPTION PRICING MODEL ff

The basic valuation model, developed by Myron Scholes and Fisher Black in 1973 using
complex mathematics, is the single most important development among the
“The Black-Scholes mod- _ theories of finance. This work, for which its inventors received the Nobel
-elisan analyt ical model Prize, forms the backbone of modern option pricing theory. It is in the ana-
oe gees lytical form, providing a formula into which the determinants of option prices
_ options on non-dividend are fed and the final outcomes on the values of options are derived. The
- paying stocks. numerical method of binomial option pricing has already been discussed.
340 Derivatives and Risk Management

The BSM can be implemented using complex calculus and differential equations. Alter-
natively, the BSM can also be derived with the risk-neutral valuation approach, which has
already been discussed under the binomial method in Chapter 11. With some background
in mathematics and risk-neutral valuation, the BSM for valuation of call options on non-
dividend paying stock is described in this section.
We know that an option price consists of intrinsic value and time value. For a call option,
the intrinsic value is the difference between the spot price and the exercise price if the spot
price is more than the exercise price; otherwise, it is worthless. Similarly, for a put option it
is the difference between the exercise price and the spot price. The minimum value of either
option is zero. Options always have values in excess of their intrinsic values. The excess of
the actual value over the intrinsic value is the time value of an option, the value associated
with the chances of an increase in the intrinsic value before the option’s expiry.
While pricing an option, the intrinsic value is always apparent but estimating the time
value of the option poses a problem. The time value attached to an option reflects (a) the
possibility of it becoming more in-the-money and (b) the extent to which it can become in-
the-money before the maturity date. Therefore, it must be dependent upon the chance that
the spot price would exceed the exercise price for a call option, and the chance that the spot
price would be less than the exercise price for a put option.
Alternatively, the BSM can also be derived with the risk-neutral valuation approach, which
has already been discussed under the binomial method in Chapter 11. The basic assumptions
made under the BSM include absence of transaction costs, arbitrage-free perfect market
conditions, and continuous trading. The BSM for a call option on non-dividend paying stock
further makes the following propositions.

Stock Returns Have Log-normal Distribution

For a European call option maturing at time 7 with an exercise price of X, we need to compare
the price of the stock at maturity, ‘7, with the exercise price. If S; exceeds X, the call would
be exercised; otherwise, it expires worthless.
Let us first examine the behaviour of stock prices. For closer and better understanding of
this behaviour, we need to examine how the price changes over an infinitesimal time period
rather than at the end of the period. This is a deviation from the binomial approach. Stock
prices follow a random walk, implying that the next movement of a stock’s price is com-
pletely independent of its past prices. A rise in price is as equally likely as a fall in price. The
present price contains all this information. Though there can be an upwards or downwards
bias in stock prices that may be the subject of pragmatic forecasting over longer time hori-
zons, this would not hold good if the time intervals were infinitesimally small. For very small
periods, such as daily or hourly periods, the returns are purely random and unpredictable.
Returns are measured by the price relative. We concentrate more on the price relative, i.e.,
_ the ratio of the prices at two successive time intervals rather than their absolute
The distribution of stock _ values. The price relative, R;, defined as S{/Sp over an extremely short
interval
prices is assumed to be
of time between 0 and 1, is observed to be identically and independently dis-
log-normal in the BSM.
tributed, where S| and So are prices at time f = 0 and ¢ = 1, respectively. The
 Option Pricing—Black—Scholes Model 341

final price at the end of the option period at time 7 can be broken in terms of very small inter-
ValSOi tine elite wo) take, T, etc., and the return can be stated as in Eq. 12.3.
Diag Ding Oonele be Sr
i= =X ee eee ee tee
Sat htSowy Dds ay? Spat ae
— R, x R> x R; PO ee Oe OCG HOOKS Te x Rr

The relative return at time 7 is defined as Rp = S7/S7_,. Here, it is assumed that there is no
dividend during the period under consideration, and that returns consist purely of the capital
gains arising from price changes.
To measure returns over very small intervals of time, we need to assume continuous com-
pounding. If we take the natural logarithm of the returns and define r; = In k;, Eq. 12.3 can
be written as follows:

le Sty, Stn RY HE Ry Ry 2 + InR; (12.4)

If the price relatives, R;, are identically and independently distributed, their logarithms
too would be identical and independent random variables. It implies that if many samples of
relative returns are taken, then the values and probabilities would be the same in each case.
This also implies that the expected values and standard deviations too would be identical.
A word about why we consider the distribution of the logarithm of the return relative rather
than the distribution of the stock prices. We know for sure that stock prices cannot be negative.
The minimum value of a stock can only be zero, and loss cannot exceed 100%. Stock prices,
if normally distributed, would imply negative prices and loss exceeding 100%, which cannot
be true. Assuming normal distribution for stock prices would then be simply erroneous, a
log-normal distribution fits the description, as it does not permit negative values, by limit-
ing losses to 100%. As an alternative, we may examine the distribution of log returns. If log
returns, Y;, are normally distributed, then the distribution of the stock price, S7, is log-normal.

Mean and Standard Deviation of Ln R are Proportional to Time

If log returns are identical and independent, then the different samples taken must have the
same expected values and variances. For a definite time period of 7, if one sample taken at
interval At, provides a mean and standard deviation of m, and 0), respectively, and another
sample taken at time interval At, with a mean and standard deviation of m and ©, respec-
tively, then
my, x T/At, = Ith) x T/At,

Similarly, variances too would have the same relationship. This implies that over a given
_ period of time, the expected value, m, and the variance, o”, would be propor-
The mean and standard
tional to the time. If the sample mean and variance were m and 07, respec-
_deviationofreturns on
_ a stock are proportional tively, then
to time. . l| m X T and
The expected value, E(Y7)
Variance, Var Yr Geer
342 Derivatives and Risk Management

Ln R has Normal Distribution: Central Limit Theorem

According to the central limit theorem, a sample taken from a population would have normal
ecome _ distribution as the sample size approaches infinity. For a sufficiently large
The naturel logofuns | sample size, the /n of returns, Y7, would have a normal distribution, with a
relative has a normal : : 2
distribution _mean of mT and a variance of o*T.
= Normal distribution is given by Eq. 12.5.
ah pa
e Z
ee sdV 20 cn
where sd is standard deviation.
The general shape of the normal distribution, applicable to the log of return relative and
log-normal distribution as relevant to stock prices is shown in Figs. 12.1 and 12.2, respectively.
With a mean of m7 and a standard deviation of 0,7, the distribution of Y;, n(Y) as a normal
distribution (dropping the subscript 7 for convenience of expression) is represented as Eq. 12.6.
1 a)
BE) ee eS (12.6)

Probability

Log of return relative

MOL

Fig. 12.1. Normal distribution

Stock price
LOL

Fig. 12.2 Log-normal distribution

 Option Pricing—Black-Scholes Model 343

"The expected value of a If Y; is normally distributed, then S; is log-normally distributed. In terms

stock grows atsomecon- Of Y7, the stock price S; is represented as follows:
_stant rate and variance.
_ The variance in a stock
price or its log would be
_ almost the same. If Y; is normally distributed with mean of mT and variance of oT, then
+t 0/2?
© expected value of Y;is e™
ee
Sr = Se) — Se” 7:OT a Spee (ha)

The expected value of S;' would be given by

BS) = f syelncay (12.8)

Therefore, the expected value of the stock at time 7, S; would rise by yw where

p= m-+ 402 (12.9)

The stock price is interpreted to grow with time at uw, a constant rate m, and the variance
o of the sample.
What is the standard deviation of stock prices? We have assumed that the standard devia-
tion of returns relative is o. With extremely small intervals of time, we can take the standard
deviation of log returns to be the same as the standard deviation of stock prices.” The variance
of Y is the same as the variance of S7/Sp.
Under risk-neutral valuation of the option, we may state that the value of the call option now
Co, would be equal to the value of the option at time 7, c; discounted at the risk-free rate, r.

Co=e" Xcr (12.10)

The value of a call option at maturity T is given by the expected value of S; — X condi-
tional on the stock price exceeds the exercise price, X, i.e.,

ES St isn eee 2 (Skype Oe Sea) (12.11)

If S; is assumed to have the distribution f(S;),then the expected values of S; and X, as
required under Eq. 12.11 to value the call option for Sr = X, are given by:

E (S75 Sr = X) = J srASndsr and £ (X; Sr = X) = xf aspas; i242)

- XxX Be
Since we know the distribution in terms of Y; and the values of the standard normal dis-
tribution are well tabulated, we need to convert the expression in Eq. 12.11 in terms of the
standard normal variable z.
The log of the stock price relative, Y;, has a mean of m7 and a standard deviation of ovT.
In terms of the standard normal distribution, z is defined as shown in Eq. 12.13.

'In general, the expected value of any continuous function, x the mean, and variance are given by following expression:
oO c co

Expected value E(x) = f xmas and variance = f encores

The Taylor expansion is given by In(1 + a) = 1 — 4a’ + 1/3a° ... and for small a Var (1 + a) = Var a
344 Derivatives and Risk Management

~~ Yr = Ae InS'r 12.13
Se Where Yr= nS) (12.13)

S; in terms of the standard normal distribution function, z, is

l ars jt
a = eee

‘ oJ/T
or i Dae o Tz + mT (12.14)
InSo

or InSp = InSy + o/7z + mT

S; = X means In S; = In_X, and is equivalent to z = —d, in terms of the standard normal
distribution z, as shown in Eq. 12.15.
InS;= InSp + o/7z + mT =iInxX

or ez

Ss oe Si
fn om in + mm?
Xe x
—— = = —d, (i233
oJ/T oJ/T
Ss
ee Sell
where d> = ey a
Similarly, for Sr = X means InS; S InX
nce mT
apeieieiecay potent ce ard! 12.16
oJT 5 ea
Expected value of S$; when S; = X is equivalent to z = —d, or

E(Sr; Sp 2 X) = E(S7, z = —d)) (ie7)

Substituting the value of S'7 in Eq. 12.17 from oo 12.12, we get

E(S7; Yj —d>) re
= i z)dz = fsven x eovlz n(z \dz

—d —d>
ive)

or ESe a —d,) = ert

ent [oe
oVIz x er 5.dz

bee

or H Sno; = =a) a== eae

I mT
8 oT/2
ee eee
aa JT)?
Ue
20
oe:
Making another substitution ' +4)
of z — oVT = a gives dz = da, and boundary conditions
change to:

For z= —d;; a= —@ onl) ——d,

This gives the expected value of S; when S; = X as follows:
00

1
BSe7 eae we Spent + 2
&t2 fe=p
5a da
TT = Gh
 Option Pricing—Black-Scholes Model 345

Making use of the symmetrical property of normal distribution as described in Fig. 12.3
we get the expected value of S$; when S; = X,as shown in Eq. 12.18.
d,

Se" <= fev da

$1

Tse
=eSve NG) (12.18)
The area under the standard normal distribution curve from — to d represents the prob-
ability of the value of the standard normal variate z being less than or equal to any value; d
is denoted by Md), as depicted in Fig. 12.3 and restated here:
d

P(e < a) = Nid) = f eta:

On similar lines we can find out the value of the second component of Eq. 12.11, 1.e., E(X;
Sr = LO = BX, a=
Ss —d)

E(Xiz= =X- Jroae- ee fn(z)dz = X + N(dy) (12.19)

N(d>) represents the probability ae z would be ess than or equal to d5, which is the
same as stating that the stock price at time 7, $7, would exceed the exercise
Under risk-neutral valua- price _X.
tion, the growth ofa stock ©» Substituting the values obtained in Eqs 12.18 and 12.19 in the value of the
ren ebeciae Et call given by Eqs 12.10 and 12.11, the value of a European call option on a
the risk-free return. : an :
|... =non-dividend paying stock is as follows:

f(z)
A

z
— oo +60 ag} 0 +d

Area under —o to —d, P(z = —d)= Area eas: dto + oo,PZz=)

So

Fig.123.
1 tae distribution: ree nicercurve
346 Derivatives and Risk Management

(Cp = (Cae et ad So et .N(d)) = X.N(d>)

Under risk-neutral valuation, the growth rate of a stock, ~, would be equal to the risk-free
rate, r. Putting w = r, we get the option value as per the BSM, as shown in Eq. 12.20.
Chas So.M(d)) = Xe Ns) (12.20)

_ Black-Scholes Model for Option Price on Non-dividend Paying Stock

c = S.Mad,) — Xe" Mad) (12.21)
p= Xe N-d) — SM-d,) (12.22)
InQX) 7 oa WiS/X) = & — O72)T Se
where d, = or—~—~—~— ;. and d,
Ae Boe OUT 2a a,1 SV

c = Call premium 7 = Time remaining for expiration of the

p = Put premium option in years
S = Spot price of the underlying asset o = Annualized standard deviation of returns
x = Exercise price expressed as decimal
r = Risk-free interest rate (annualized) Md), N(d>) are cumulative normal distribu-
expressed as decimal tion at d, and d>, respectively
In = Natural log

Time Value of At-the-Money Option is Highest

The time value of an option is highest when it is at-the-money (ATM), i.e., the exercise price
There are five determi- _ is equal to the spot price of the underlying asset. It declines as the price
nants of the option price _ moves away from the exercise price in either direction.
for a non-dividend paying An OTM option having no intrinsic value has a lesser time value because it
asset: price ofthe asset, | remains worthless till the price reaches the exercise price, while an ATM option
Ihe oxaicse pie ey _ has already reached that stage. Hence, an option buyer will be prepared to pay
terest rate, volatility, and : i
hein _ more for an ATM option than for an OTM option. Sa :
Similarly, in case of an ITM
- — ~ option, though the threshold for making profit has already been achieved, there is
the likelihood with the passage of time that an erosion of the intrinsic value could take
place. An
ATM option without any intrinsic value does not face the situation of erosion in intrinsic
value.
The entire premium of an ATM option consists of time value. This is true
for an OTM
option too but it lags behind the ATM option in the race to become in-the-m
oney and, there-
fore, it has lesser time value. The ITM option, though ahead of the
ATM option, faces the
risk oflosing its intrinsic value, a risk that the ATM option does not
face and, hence, has less
time value than the ATM option.

Applying BSM
The application of the BSM is rather easy. One simply has to plug
in the values of the vari-
ables to get the call premium. Example 12.1 explains this in detail.
 Option Pricing—Black-Scholes Model 347

EXAMPLE 12.1. Applying BSM: Calloption

Given the following information about a share:
Current market price: 50, annual volatility: 30%, risk-free interest rate: 10%.

1. Find out the value of a 3-m call option with an exercise price of (a) %40, (b) 50, and (c) 60.
2. What will the value of these calls be after one month?
3. What are the intrinsic and time values of the calls?

Solution
As per the BSM, the value of the call is given by
c= Asi — Xe-'T Nd)
S/X) + (r+ 0/2 T _ In(S/X) + (r=07/2)T
Bait an ive Of b= de—oVT

(a) For an exercise price of ¥40

First, we find the values of a, and d,. All values used are annual and in decimal form. We have S = 50, X = 40, r= 0.10
T = 0.25, and o = 0.30. These are plugged in the formula:
a= In(50/40) + (0.10 + 0.30_x 0.30/2) x 0.25 _ 1.7293
0.30 x V 0.25
d = d; — 0.30 X V0.25 = 1.7293 — 0.15 = 1.1593
From the normal distribution tables, or using the Excel function NORMSDIST(d), we find out the area under normal distribu
tion for values less than d, and db.
We get Ma;) = 0.9581 and Md) = 0.9429
Inserting the values in the equation in the cail premium c, we get:
c = SN(d,) — Xe~ N(as) = 50 x 0.9581 — 40 e-91 x 925 x 0.9429
= 47.9050 — 39.0124 x 0.9429 = 11.12
The intrinsic value of the call is 10 (50 — 40), and the remaining %1.12 represents the time value.
—joya For an exercise price of 50
_ In(50/50) + (0.10 + 0.30 x 0.30/2) x 0.25
= 0.2417
0.30 x V0.25
d, = a; — 0.30 K V0.25 = 0.2417 — 0.15 = 0.0917
We get Ma;) = 0.5955 and Mad) = 0.5365
Inserting the values in the equation in the call premium c, we get:
c = SN(d,) — Xe~™ Nc) = 50 X 0.5955 — 50 e081 X 025 x 0.5365
= 29.7750 — 48.7655 x 0.5365 = %3.61
The call is at-the-money, with zero intrinsic value, and the entire call premium of ¥3.61 is the time value.
For an exercise price of €60, we get.
d, = 0.9738, d = 1.1238, Ma;) = 0.1651 and Md») = 0.1305
and call premium c = <0.62
Here, the call is out-of-money, and the entire premium represents the time value; the value attached with the likelihood o
call becoming in-the-money before expiry.
The time value is maximum for an ATM call.
348 Derivatives and Risk Management

ASSUMPTIONS OF BSM
S

The following assumptions were made in the derivation of the BSM.

Prices are Log-normally Distributed The BSM assumes the behaviour of the spot price
of the underlying asset to be random, which implies that the price is log-normally distrib-
uted. Log-normal distribution is similar to normal distribution with the difference that the
random variable can take any positive or negative value under normal distribution, while it is
restricted to positive values under log-normal distribution. The other property of log-normal
distribution is that the natural log of the variable is normally distributed.
No Dividend till Expiration Date of Call Option The BSM assumes that no dividend is
paid during the tenure of the option. In practice, firms declare dividend from time to time,
and in an efficient market the option price falls by the amount of dividend when it becomes
ex-dividend. The BSM will predict the same price for options on two firms that are identical
in all respects, except that one of them pays some dividend before the expiry of the option.
One way of overcoming the problem is to reduce the present value of the dividend from the
spot price of the asset, using continuously compounding rates.
Applies to European-style Options The BSM applies for European options, which can be
exercised only upon maturity. American options can be exercised at any point of time till the
maturity date. One would imagine that the American option, which can be exercised at any
time, should be more valuable than the European option, which offers exercise only at matu-
rity. As stated earlier, it is always more prudent to sell the option rather than to exercise it.
When one exercises an American call option well before maturity, one realizes only the
intrinsic value, and foregoes the time value. The call will always be selling for more than its
intrinsic value. By selling the call option, one realizes both the intrinsic value and the time
value. Since it is always more prudent to sell a call rather than to exercise it, the BSM can
be applied to American calls too without much problem. This is not true in the case of
American puts. Further, it may be prudent to exercise the call very close to its maturity, sac-
rificing the time value remaining as protection against erosion in the intrinsic
The BSM is applicableto — value.
European-style
- options
Other assumptions of BSM include (a) efficient markets, (b) no transac-
tion costs, and (c) constant risk-free interest rates and (d) continuous trading.

INTERPRETING THE BSM

The log-normal distribution of price implies that the natural log is normally distributed, i.e.,
In S'is normally distributed. The mean and standard deviation ofthe natural log of the vari-
able, 1.e., of In S, are given by
Mean =InS + (uz = 07/2) (1223)
Standard deviation = ovT (12.24)
where Sis the current price, is the expected return per annum and cis the annual volatility
of the price ( is the annualized expected return in a short period oftime).
Let us interpret the BSM for each of the terms that are included in the formula for deter-
mining the call price c:
 Option Pricing—Black—Scholes Model 349

¢ = SM(d,)— Xe Nid)
.
ae gp PUSS Ae
In(S/ oe 4
eee =a ovr
The first term SMd,) can be said to be the cash inflow and the second term Xe~"! M(d>)
can be said to be the potential cash outflow of the exercise price.
The term Md) refers to the delta of the option, which represents the fraction of stock
bought for each call written in a hedged portfolio. Hence, the first term is the value of the
fraction of stock owned and 1s an asset.
The expression Xe~"” reflects the present value of the exercise price discounted on a con-
tinuous basis. M(d>) can be interpreted as the probability of the call becoming in the money,
i.e., the spot price exceeding the strike price. And it does entail cash outflow of X, the present
value of which is Xe~"’. The expected value of cash outflow is Xe’? X M(d)).
The call price is the surplus of the asset owned, less any likely liability for the call written.
Hence, the difference between the value of the stock position taken per call and the present
value of the expected liability represents the call value at any point of time.

Put Pricing using BSM

The BSM can also be applied to the pricing of a put option. A put price as per BSM is given by
p = Xe? N(—d,) — SN(—d;) (1225)
In(S/X) + (r + 07/2)T
where daa re ger ree and

In(S/X) + (r — 07/2)T
dy O i=
a OVE
oVT
The formula is similar to that of the call price, with changed signs ofX and S, as also
with d, and d, being replaced by —d, and —d), respectively. We directly apply the BSM for
determination of put prices. Please refer to Example 12.2.

MERTON MODEL FOR VALUING OPTIONS ON DIVIDEND PAYING STOCK &

The BSM can be readily modified to work with dividend paying stocks. Robert Merton
developed a simple extension of the BSM. Assuming a continuous compounded dividend of
q, the BSM can be modified to obtaining the value ofa call option on a dividend paying stock
by (a) modifying the spot value by the present value of the dividend, and (b) modifying the
growth m = r + 07/2 tor — q + 07/2. Adjusting the spot price with the dividend would
result in the substitution of S with S.e-%. Similarly, the calculation of d, and d, would be
adjusted to reflect the dividend, as stated in Egs 12.27 and 12.28.
The rationale for such adjustment is that when a stock pays dividend, the
With alittle modification price falls by the amount of dividend, because a stock that pays dividend
to the stock price, the should provide the. same return as the one that pays no dividend. If a non-
BSMcanbeadaptedfor == dividend paying stock grows by r, then a stock that pays dividend of gwould
veers paying socks: grow by r — q, so that the total return stays the same at r.
350 Derivatives and Risk Management

EXAMPLE 12.2 Application of BSM: Put Premium

Given the following information about a share:
Current market price: €50, annual volatility: 30%, risk-free interest rate: 10%.

1. Find out the value of 3-m put options with exercise prices of (a) ¥40, (b) €50, and (c) 60.
2. What will the value of these puts be after one month?
3. What are the intrinsic and time values of these puts?
Solution
As per the BSM, the value of the put is given by:

p = Xe~'TN(—dh)— SN(—d,)
( X) ( 7/2) ( X) (es /2) 2
where a, = M2 eee and peeglt aes OF b= d= OV)

(a) For an exercise price of €40 7

First, we find the values of a, and a). We have S = 50, X = 40, r= 0.10, T = 0.25, and o = 0.30. These are plugged in '
the formula: . i :
i= In(50/40) + (0.10 + 0.30 x 0.30/2) x 0.25 = 1.7293
0.30 x V0.25
d> = d, — 0.30 X V0.25 = 1.7293 — 0.15 =-1.1593
From the normal distribution tables, or using the Excel function NORMSDIST(d), we find out the area under normal distribu- j
tion for values less than —d, and — ah. 7
We get M—d;) = 0.0419 and N—d)) = 0.0571
Inserting the values in the equation in the put premium, p

p = Xe~'T N(d,) — S N(d,) = 40 e914 X 925 x 0.0571 — 50 x 0.0419

= 2.2267 — 2.0950 = 20.18
The intrinsic value of the put is zero and the entire value of 20.13 represents the time value, the value attached with the
chances that the put would turn ITM before expiry.
(b) For an exercise price of 50
ae In(50/50) (0.10
+ + 0.30 X_0.30/2) x 0.25
= 0.2417
0.30 x V0.25
d = a — 0.30 X V0.25 = 0.2417 — 0.15 = 0,0917
We get M(—d,) = 0.4045 and M—d,) = 0.4635
Inserting the values in the equation in the put premium, p

p = Xe-'TN(—d,) — SN(—d\) = 50 e-1 X 025 x 0.4635 — 50 x 0.4045

= 22.6028 — 20,2250 = 22.38
The put is ATM with zero intrinsic value. The premium of 2.38 belongs to the time value.
c) For an exercise price of 60, we get
d; = 0.9738, db = 1.1238, N(—d,) = 0.8349, and M(—a>) = 0.8695
and put premium, p = %9.14
Here the put is in-the-money with an intrinsic value of 210. The present value of the exercise
price is 58.52, and the mini-
mum value of a European put option would be %8.52. The remaining premium of 70.62 represents
the time value, the value
attached with the likelihood of the put remaining in-the-money before expiry.
Notice that (a) the put can sell for less than its intrinsic value, and (b) the time value
is highest for the ATM option.
 Option Pricing—Black-Scholes Model 351

| Merton Model for Option Priceon Dividend Paying Stock

c¢= Se~.N(d,) — X.e7”7 Md>) (12.26)
p= Xe" N—d) — Se~t N(—d,) (12.27)
: , a ee : Ey)
In(S/X) coe Oo /2)T = and
where d, =

InS/Y)
2° +aoe
& =g - or| db=d,-oVT
|
q = Dividend yield (continuous compounding basis)

In the computation of d, and d>, the spot price S too would be replaced by S$ e~%.
: Senn S
Since In 7 = Iny — qT, r would be replaced by r — g in computing d, and d.

VALUING OPTIONS ON INDICES

Options on indices are the same as options with dividend paying stocks. In the Indian stock
Stock indices are _ market, options on indices are European in nature and as stated earlier, are
assumed to pay a _ cash settled on maturity. The lot size for option contracts is 50, and each
continuous dividend. With point of Nifty is worth %1. For example, if on the last day of trading the
changes in the spot price clearing price of the index stood at 4150, a call option on Nifty with a strike
and the growth rate, the
of 4100 would be cash settled by-payment of ¥2500 [(4150 — 4100) x 50]
BSM applies to options
on indices.
by the call writer to the call holder for each option contract.
— The valuation of such an option would be the same as the valuation of an
Banony ona maeren paying stock, where gq would represent the average dividend yield on
the index during the life of the option. The valuation of call and put options on an index is
explained by way of Example 12.3.

VALUING OPTIONS ON CURRENCIES #

Currency options are traded on exchanges, and-are also available over the counter (OTC) all
over the world. Options on currencies provide protection for receivables and payables against
adverse movements of exchange rates, while retaining the upside potential. They are extremely
useful for firms having assets and liabilities denominated in foreign currencies. Currency
options remain very popular in the OTC market, where banks offer a variety of options for
exporter and importer clients, as compared to exchange-traded options.
_ Options on currencies are virtually the same as options on dividend paying
The BSM applies to op-
tions on currencies with
_ stocks or options on indices. The valuation of options on currencies can be
foreign risk-free interest done by simply replacing the dividend yield on the index with the risk-free
rates, replacing the interest rate on the foreign currency, as given by Eqs 12.28 and 12.29. The
dividend yield in the valu- spot price of the foreign currency must be expressed as a direct rate (number
ation formula of options of units of domestic currency per unit of foreign currency, e.g.,%45 per dollar
on indices
in India).
352 Derivatives and Risk Management

EXAMPLE 12.3 Black-Scholes model for index options

The Nifty is currently at 4500. If the risk-free interest rate is 8% and the continuous dividend yield on Nifty is assumed at 3%,
what would the value of a 3-m call option with an exercise of 4600 be? The volatility of the Nifty is placed at 25% p.a. One Nifty
point is equal to 21.
Solution
As per the BSM, the value of the call on the index is given by
c = Se- N(d,) — Xe~™ Nd,)
In(S/X) + fog orreyT, 2
and d, = In(S/X) + ie
ris a
o/2)T
ee
ody d, = eo
where d, =
Here, S = 4500, X = 4600, r = 0.08, g = 0.03, Tt = 3/12 = 0.25 years, and o = 0.25, which can be used in the Black-
Scholes—Merton formula for valuation of the call.

For an exercise value of index of 4600

First, we find the values of d, and dp. All values used are annual and in decimal form. We have S = 4500, X = 4600, r
0.08, q = 0.03, T = 3 months or 0.25 years, and o = 0.25. These are plugged in the formula.
Aa In(4500/4600) + (0.08 — 0.03 +0.25 x 0.25/2) x 0.25 _ 0.0133
0.25 x V0.25
d = d, — 0.25 x V0.25 = —0.1383
From the normal distribution tables, or using the Excel function NORMSDIST(d), we find out the area under normal distribu-
tion for values less than a; and d>. We get
N(d,) = 0.4947 and Nd.) = 0.4450
Inserting the values in the equation in the call premium c,
c = Se 4% Nd,) — Xe Nad,) = 4466.37 x 0.4947 — 4600 e998 * 925 x 9.4450
= 2209.52 — 2006.47 = $203.05

Option Price on Foreign Currency

e=Se 7 Nd) - Xe" Na) (12.28)
p =X.e" N-d) — Se" M—d)) (12.29)
ee Le In(S/) er =yt a2) a
a) Se 2

oVT
_ In(S/X) + ( -— 7e - P/2)T
d, = a cL d=ad-~oVrT

ry = Risk-free interest rate in foreign currency

Let us consider a 3-m ATM European call and a put on the euro with a spot price of 275
per euro. The risk-free interest rates in rupee and euro are 8% and 4%, respectively. The
volatility of the exchange rate for the euro is 15%.
Heres =) 73.) Xeee 75. 7 = 1.05. re = 0.04, T = 3 months (0.25 years), and o = 0.15.
Putting these values in Eqs 12.28 and 12.29 for valuing the call and the put, respectively, we
get
fs In(75/75) + (0.08 — 0.04 + 0.15 x 0.15/2) X 0.25 _ eens
0.15 X V0.25 a
d) = d, — 0.15 X V0.25 = 0.0958
Nd) = 0.5678 Md) = 0.5382 N(—d,) = 0.4322 N(—d)) = 0.4618
 Option Pricing—Black-Scholes Model 353

The call price,e = Se’ N(d,) — Xe7"T N(dy)

175,002 925 x 0.56789 — G5. 00.08 X9.25 x0,5382
= 42 0967 831 1315.1 O10, 538 2e 247 bn 97
= 22.59
Put price, p = Xe~'T N(—dy) — S eT N(—d,)
= 75 e 908X025 x 9.4618 — 75.00 X e004 x 0.25 x 0.4322
= 73.51 X 0.4618 — 74.25 x 0.4322 = 33.99 — 32.09
= 190

VALUING AMERICAN OPTIONS

We already know that for the same underlying asset and the same time to expiration, Ameri-
can options are like European options in all features except that the American options provide
for an early exercise, as against exercise only at maturity in the case of European options. Is
this flexibility of early exercise worth some extra value? If the extra value can be captured,
then valuation of the American option would be a simple matter of adding this value to the
price of the European option.

American Call vs European Call on Non-dividend Paying Asset

We have seen in Chapters 10 and 11 that for a non-dividend paying asset, it is never optimal to
o _ exercise a call option prior to its maturity because one gets only the intrinsic
Oo anon den _ value of the option at the time of exercising and foregoes the time value
paying asset, the feature hed. Th : i F eh
of early exercise of call is attache - The entire value of a ca option, i.€., the sum 0 FWA tera |
the intrinsic value
worth nothing, _ and the time value, would be captured in the selling price, and, hence, selling
ve ~~~" a call option is always a better proposition than exercising it. In the binomial
model, this may be checked by comparing the exercise value with the market value at each node.
Mathematically, the minimum value of a European call is

c=S—
PV of X or S — Xe"

Upon exercising the option, one gets the intrinsic value, i.e., S — XY. As long as there is
time remaining for maturity and the interest rates are not negative, the minimum price of a
European call, Cyin, would be larger than the intrinsic value, the value obtained by exercising
an American call. Hence, the flexibility to exercise early in case of a call on a non-dividend
paying asset has no extra value. Therefore, an American call should sell for no more than a
European call for an underlying asset paying no dividend.

American Call on Dividend Paying Asset

In the case of a dividend paying stock, there may be a rationale to exercise early, because the
amount of dividend the holder gets may be larger than the value of the call. We all know that
immediately after a dividend (ex-dividend date), the stock price should fall by the amount
of dividend. Therefore, the intrinsic value of the call would fall by the amount of dividend
between the cum-dividend date and the ex-dividend date. Between these two dates, there
354 Derivatives and Risk Management

the dividend payout, even

would not be much loss of the time value of the call option. Hence,
the loss of time value,
though causes some reduction in the intrinsic value, may far exceed
and prompt the holder of the call to exercise early.
date,
As may be guessed, an early exercise is optimal just before the dividend payment
of an unknown dividend,
and not at any other time. This would be applicable only in the case
dividend is
where the call would be priced without adjusting for the dividend. However, if the
maturity,
known prior to the opening of the call position and the payment date falls before its
the option pricing would be adjusted automatically for such anticipat ed and known dividend
in
amount by replacing the asset price with the dividend-adjusted asset price, as was done
valuation using the Merton model.

Pseudo-pricing of American Call

First established by Fisher Black, the pseudo American call pricing model for a dividend-
paying stock is based on the premise that it is optimal to exercise the call
For a dividend paying
asset, it may make sense only just before the dividend payment date and not at any other point of time.
to exercise a call just Based on this, one may find call prices on each dividend date by using the
prior to dividend, and at BSM, suitably adjusting the stock price, the strike price, and the time to
no other time. maturity. A stepwise approach is listed as follows:

Modify the current stock price by subtracting the present values of all dividends until
the expiration date of the option.
2. On each dividend date, subtract the present values of all the dividends remaining to be
paid from the exercise price.
3. Consider each dividend date as a potential exercise date, and find the value of the option
using the BSM with the asset prices as found in the first step in this list and the exercise
price as found in the second step.
4. Compare the call prices computed and choose the one with the maximum value as the
American call price.
We illustrate the procedure with the help of a numerical exercise. Assume that the current
stock price is 100, and we need to value an American call with an exercise price of =100
expiring at the end of nine months from today. The stock is expected to pay dividends of
%2.00, %2.50, and %3.00 at the end of two, five, and eight months from now, respectively. The
volatility of the stock is 20% and the risk-free rate of return is 8%.
As per the pseudo-pricing, we treat the American call asa series of European calls matur-
ing at the end of two, five, and eight months, i.e., the dividend paying dates, and nine months,
i.e., the expiry date, assuming that the American call would be optimal to exercise only on
. these times and at no other time. Therefore, the American call, as a portfolio
An American call ona _ ofa series of European calls, should command a premium equal to the max-
dividend paying asset _ imum of the European calls.
canbeconsidered Now we shall find out the values of four calls maturing at the end of two
eee Gases | five eight, and nine months, making adjustments to the spot and re
European callsoneach “a , : teres S|zee ee
dividend date. _ prices. The spot price as adjusted for the present values of the dividend would
_ remain the same for all the four calls. The present value of all the dividends is:
 Option Pricing—Black—Scholes Model 355

2.00 X e~ 9-98 X 2/12 4.9.59 x e-0.08 X 5/12 4 3 QE X¢ 90.08 x 8/12

no Sone 8) a 844 7 0357

Therefore, the adjusted stock price to be used in the BSM is 100 — 7.2357 = 92.7643.
The calls maturing after two, five, eight, and nine months would have exercise prices X5,
Xs, Xg, and Xo. Each of them would be reduced by the present values of the remaining divi-
dends just before the stock becomes ex-dividend. These are as follows:

X, = 100-0 = 2100
X, = 100 — 3 = %97.00
Xs = 100 — 2.50 — 3 X e~ 8X 3/2 = 100 — 2.50 — 2.9406 = %94.5594
X, = 100 — 2.00 — 2.50 x e798 3/12 — 3 x 9-08 x 6/12
= 100 — 2 — 2.4505 — 2.8824 = %92.6671
Now the inputs for valuing all the four calls maturing at the end of two, five, eight, and
nine months are known as required in the BSM. The spot price remains at 92.7634, with
a standard deviation of 20% and a risk-free rate of 8% for all the four calls. The remaining
inputs of exercise prices and times to maturity change. All figures relevant for the BSM are
shown in Fig. 12.4.
For a standard deviation of 20% and a risk-free rate of 8%, the call prices for maturities
of nine, eight, five, and two months are, respectively, %5.77, 6.42, $5.43, and 73.71. These
are the prices derived for exercises just prior to dividend dates. An investor in the American

Figures in&
Maturity
Time (months) 0 2 5 8 9
Dividend 2.0000 2.5000 3.0000

Total PV of dividend

PV of dividend today TEAS / 1.9735 2.4180 2.8442

PV of remaining 2.8824 2.9406 3.0000 -
dividends on 2.4505 2.5000 - -
dividend dates 2.0000 = - -
Total PV of remaining
dividends ; 7.3329 5.4406 3.0000 0.0000
Adjusted exercise price 92.6671 94.5594 97.0000 100.0000
Adjusted spot price —> 92.7643 <_-.-
Call price today as per BSM SLAIN 5.4254 6.4218 USS
American call price = Max(call prices) 6.4218
Standard deviation = 20% and risk-free rate = 8%
‘Sore
a
ase

all p rlpricing
356 Derivatives and Risk Management

EXAMPLE 12.4 Valuing an American cail

A 12-m American call with an exercise price of 1100 is available on the stock of TCS Ltd. This stock is expected to pay quarterly
dividends of 25.00, %6.00, %6.50, and 7.00 at the end of 1, 4, 7, and 10 months from now. The spot price of TCS is ¥1100.
With a standard deviation of returns on TCS at 20% and a risk-free rate of 10%, find out the values of the inputs for valuing the L
12-m American call on TCS. L
Solution ;
To value a 12-m American call, we need to value five European calls maturing at 1, 4, 7, 10, and 12 months, with spot and a
exercise prices modified by tne dividend amounts. 2
The price of the underlying asset, i.e., the stock of TCS, would remain the same for all the calls, and would be equal to the L
current stock price less the present values of all the dividends expected over the life of the option. The present value of the 2
expected dividends are as follows: 7
= 500 x e@ 9.1 x 1/12 + 6.00 x e@ 01 x 4/12 + 6.50 x e791 * 7H2 ae 7.00 4 e701 x 10/12

= 4.96 + 5.80 + 6.13 + 6.44 = 23.33

The spot price S that would be considered in all the calls would be
= 1100 — 23.33 = 71076.67
The exercise prices for the five calls would be arrived at by subtracting the present value of remaining dividends as on the |
date of respective dividend. These are as follows: /
Call maturing at 12 months, Xj. = ~1100.00
Call maturing at 10 months, Xj, = 1100 — 7.00 = %1093.00
Call maturing at 7 months, X; = 1100 — 7.00 x e-91 x 812 _6 50
= 1100 — 6.83 — 6.50 = $1086.67
Call maturing at 4 months, X, = 1100 — 7.00 x e081 812 6.59 xX g 4 X32 — 600
= 1100 — 6.66 — 6.34 — 6.00 = 1089.00
Call maturing at 1 month, X, = 1100 = 7.00 X 679" 9 6a aie
= 6,00 ter 01% 9125.06
= 1100 — 6.49 — 6.18 — 5.86 — 5.00 = %1076.47
Remaining inputs of standard deviation and risk-free rate would remain the same as given for valuing the 5 European options.
The maximum value of these would be taken as price of an American option.
EE

call can be assumed to be holding a series of four calls with four potential exercising oppor-
tunities available on any of the four cum-dividend dates. As is evident from the calculations
shown in Fig. 12.4, it is optimal to exercise just prior to the third dividend payment, i.e., at
the eighth month from now. Therefore, an American call would sell for 76.42.
In contrast, a 9-m European call with S = 92.76, X = 100.00, T = 9 months, r = 8%, and
o = 20% would sell for ¥5.7624, as given by the BSM option pricing formula.

EXACT PRICING OF AMERICAN OPTION

An exact analytical solution for any American option is possible only for an asset that pays
only a single dividend during the option period. This is known as the Roll, Geske, and
Whaley formula for a dividend of D at time ¢ before the expiry of the option at 7. The valu-
ation is dependent on some critical asset price S* just prior to the dividend date. It is that
price of the asset at which, on the dividend payment date, the intrinsic value is equal to the
call value plus the dividend on that date. The exercise would be made only when the intrinsic
 Option Pricing—Black-Scholes Model 357

value S* — X + D is greater than the call value at that time. The Roll, Geske, and Whaley
formula for American call options on assets with single dividends is given in the box.
When several dividends are anticipated, it is generally believed that it would be optimal
to exercise only on the last dividend date. Under that assumption, such options can also be
treated as options with single dividends. Therefore, the Roll, Geske, and Whaley formula can
be used by reducing the spot price by the present value of all the dividends except the last
one.

| | Valuation of American Call for Single Dividend

e=(8§- De 7Nb)
5Nb)- O- De
+ (Ss - De). a.—),. ae - erat i A
\ ae 7

nS De “|+(r+S)r
where a= s ; acd, 2, VT
VF

S - Dew" o
> | s* Jebs S adh, 7
VT
# Roll, Geske, and Whaley Formula
S = Price of underlying assety N) = Cumulative normal distribution
X = Exercise price : function at x
S* = Critical stock price at dividend payment M(a, b,r) = Value of cumulative bivariate
D_ = Dividend amount at time f normal distribution with first
T = Time for expiration variable less than a and second
t = Time of dividend payment < 7 variable less than 6 with correla-
o = Annualized standard deviation tion of r
r = Risk-free rate of return In = Natural log
le J

VOLATILTY 2
Option price calculation using the BSM formula requires inputs of stock price S, exercise
price X, risk-free rate of return r, time to maturity 7, and volatility of the prices of the stock o.
Of these variables, X and 7 are those characteristics of the option that are defined. The
stock price S is directly observable for traded assets. The remaining two variables, the risk-
free rate and the volatility of the stock price need to be obtained. The risk-free rate r can be
observed from debt markets from the yield on T-bills for a maturity match-
Volatility in spot prices is
ing the life of the option. At present, the life of the options is restricted to
a major driver of option
premium. The more three months in India, for which T-bill returns are readily available. The last
the volatility, the more variable, 1.e., the volatility of stock prices, is not directly observable from the
valuable is the option, traded information. It is required to be estimated. Normally, historical vola-
- irrespective of itbeing a tility of the stock prices 1s used as an input of standard deviation in the BSM
call or a put.
of option valuation.
358 Derivatives and Risk Management

Volatility of the price of We reiterate that volatility of return over time interval T is proportional
an underlying asset is the to the standard deviation of returns measured over a small interval multiplied
non-observed parameter by the square root of the number of time intervals. This means that if daily
in option price determi- prices are observed for finding the standard deviation of daily returns Oggity,
nation. Itneeds tobe ‘then the annual volatility is equal to Oysiy *V250 if we assume 250 to be the
ae number of trading days in a year. Similarly, if weekly data for 52 weeks is
used, then we can approximate the annual volatility aS Oyeely * V52.

MEASURING HISTORICAL VOLATILITY 9

The BSM assumes log-normal distribution of returns on stocks. The volatility of returns
may be derived from past price data. The past price data have to be converted into price re
lative (S,,/S,,.,) and the natural log of the price relative is taken. This natural log is deemed to
have a normal distribution. The historical volatility can be calculated using EXCEL in the
following manner.

1. Feed the price data (daily, weekly, or monthly) for a sufficient number of periods, n.
The number of observations required for estimation of volatility is not easy to deter-
mine. As we increase the observations, the older data lose relevance, and if we reduce
the number of observations, we compromise on accuracy. Data more than one year
old cannot be relied upon.
2. Find out the relative return for a period by dividing the price of the period by that of
the preceding period.
3. Find out the natural log of the relative return, ¥
4. Find out the mean of natural log returns and its variance as follows:
Sum of natural log returns
Mean, X = and
No. of observations, 7
7) ae

Variance, o7 = I (ona)S
an |

5. The standard deviation calculated for the period is not the same for annual returns. This
needs to be converted into an annual measure as shown in Eq. 12.30.
= *
Oannual = Operiod VT (12.30)

where T = number of periods per annum

We know that the variance, 0”, is proportional to time.

The annual standard deviation from the weekly data will be equal to the calculated stan-
dard deviation X 52. This is the volatility that needs to be used in the BSM formula.
Volatility of the stock One such calculation of historical volatility is shown in Table 12.2, where
canbe measured from the weekly closing prices for 52 weeks are taken in column 2. The relative
the past price data. The ‘returns and their natural logs are shown in the next two columns. The mean
measured volatility may is calculated by dividing the sum of the natural logs by 51, the number of
caer colon observations. The weekly variance is calculated by dividing the sum of vari-
_ ance by n — 1, 1.e., 50, and converted into annual variance using Eq. 12.30.
value.
| The weekly standard deviation is 3.17%, which is equivalent to an annual
 Option Pricing—Black—Scholes Model 359

Table 12.2 Calculating historical volatility

Week No. Observed price (=) Relative return cae sae (rane Variance

1 510 alk |
2 525 1.02941 0.02899 0.00084
3 530 1.00952 0.00948 0.00009 |
4 sg 0.92453 0.07847 0.00616 '
5 460 0.93878 ~0.06318 0.00399 :
6 495 1.07609 0.07333 0.00538 /
zi 495 1.00000 0.00000 0.00000
8 478 0.96566 0.03495 0.00122 |
9 468 0.97908 0.02114 0.00045
10 483 1.08205 0.08185 0.00100 ’
1 496 1.02692 0.02656 0.00071 |
12 501 1.01008 0.01003 0.00010
13 515 1.02794 0.02756 0.00076 :
14 513 0.99612 —0,00389 0.00002 /
15 512 0.99805 ~0.00195 0.00000 1
16 505 0.98633 ~0.01377 0.00019 ‘
17 525 1.03960 0.03884 0.00151 '
18 530 1.00952 0.00948 0.00009 ;
19 545 1.02830 0.02791 0.00078 |
20 536 0.98349 0.01665 0.00028 :
ot 533 0.99440 0.00561 0.00003 :
29 541 1.01501 0.01490 0.00022 |;
23 536 0.99076 ~0,00929 0.00009 :
24 528 0.98507 ~0.01504 0.00023 :
25 509 0.96402 ~0.03665 0.00134
26 522 1.02554 0.02522 0.00064
27 516 0.98851 ~0.01156 0.00013 :
28 aie 1.00581 0.00580 0.00003 ‘
29 489 0.94220 ~ 0.05954 0.00355 :
30 493 1.00818 0.00815 0.00007 |
31 496 1.00609 0.00607 0.00004 ’
32 513 1.03427 0.03370 0.00114 |
33 515 1.00390 0.00389 0.00002 1
522 1,01359 0.01350 0.00018 |
34
(Contd a=
360 Derivatives and Risk Management

Table 12.2 contd

Week a Observed price (%) Relative return Nae nate relative | Variance
30 534 1.02299 0.02273 0.00052
36 500 0.93633 —0.06579 0.00433
37 | 495 0.99000 —0.01005 0.00010
38 499 1.00808 0.00805 0.00006
39 490 0.98196 —0.01820 0.00033
40 521 1.06327 0.06134 0.00376
Aq 509 0.97697 —0.02330 0.00054
42 533 1.04715 0.04607 0.00212
43 538 1.00938 0.00934 0.00009
44 546 1.01487 0.01476 0.00022
45 524 0.95971 —0.04113 0.00169
46 520 0.99237 —0.00766 0.00006
47 495 0.95192 —0.04927 0.00243
48 505 1.02020 0.02000 0.00040
49 516 1.02178 0.02155 0.00046
50 511 0.99031 —0.00974 0.00009
51 532 1.04110 0.04027 0.00162
De 525 . 0.98684 —0.01325 ie 0.00018
Sum 0.02899 0.05025
| Mean ce ag 0.00057
Variance (weekly) 0.00101
Standard deviation (weekly) 0.03170
Annual variance 0.05226
Annual standard deviation 0.22861

volatility of 22.86% (3.17 X V52). In case we use the daily prices, the data will provide daily
volatility and in that case, the annual volatility will be calculated by multiplying the com-
puted figure by \250, assuming 250 trading days in a year.
Volatility is dynamic. To produce realistic results, the calculation of volatility has to find
a balance between the number of observations and the age of the observations, For accuracy
and reliability required to produce a reasonable predictor of future volatility, we need to
have
a sufficiently large sample (say about 50) and recent data: both requirements are difficult
to
comply with simultaneously. If we increase the sample size, the data becomes old and
loses
relevance for future usage. If we believe only in relatively recent data, then the
number of
observations becomes limited. Therefore, more often than not, daily data for stock
prices is
used. At most, we can take only weekly closings, which would mean the sample data
is not
more than a year old. Data older than one year cannot be deemed as truly representat
ive of
 Option Pricing—Black-Scholes Model 361

future volatility, as volatility cannot be assumed to be constant for longer periods, especially if
the sectors are evolving and dynamic, such as information technology or telecommunication.
One may be more assured of reliability if the sectors are traditional, such as cement and steel.
Another way of overcoming the limitation in measurement of volatility from past data
is to assign more weight to recent data and less weight to older data. This method, known
as exponential smoothing, is normally followed by stock exchanges in calculating margin
requirements for derivative traders. It is easier to apply this concept than calculating on a
daily basis.

Adjusting Dividend While calculating the relative returns, adjustments for dividend also
need to be made. We all know that in efficient markets, the price of a stock falls by the
amount of dividend on the ex-dividend date. Hence, the returns on the ex-dividend date wiil
stand modified to (S,,., + D)/S,,. The data in Table 12.2 assumes a non-dividend paying stock.
If the stock pays a dividend of 20 and becomes ex-dividend in week 36, then the relative
return of 0.93633 (500/534) for week 36 will stand modified to 0.97378 (520/534). All other
figures remain the same.

Actual vs Trading Days Another issue that needs attention is the number of periods to be
used while converting the period volatility to-annual volatility. The question is whether to use
the actual elapsed time or the number of trading days. It is generally believed that volatility is
caused by the flow of information, which does not depend on trading. In fact, trading depends
upon information flow. In view of the continuous flow of information, it is argued that the
actual number of days should be used for translation into annual volatility. However, it has
been studied that though volatilities are higher in periods with intervening holidays, they are
not proportionate with the lengths of time. Volatility is much higher when trading takes place.
Hence, we use only the number of trading days to arrive at annual volatility.

The volatility used in the BSM is an unobservable statistic. Using historical volatility in the
BSM formula for arriving at option prices may not match with the market prices prevailing
for calls and puts. The reason for the divergence between the theoretical prices as per the
BSM and the actual market prices may lie in the different estimates of volatility used by the
market, which may not conform to the historical volatility used in the BSM formula.
To illustrate, we may calculate the price of a call option as per BSM as 29.36, with S$ =
» 500, X = 500, T = 0.25 years, and r = 10%, using o = 23% as measured
aa cothee ; using historical data. The actual market price happens to be $35.00. How do
a may be dierent _ we explain this divergence in the prices? The only plausible explanation can
than the measured vola- _ lie in the different estimates of volatility used by the market and the BSM,
tility based on historical : as there exists no ambiguity about the other four variables, S, X, 7, andr, that
data. affect the call price.
~ While the BSM used historical volatility in its calculation of the call pre-
mium, the market is more concerned with the future volatility of returns. As long as historical
volatility truly represents future volatility, the actual prices would not deviate from the theo-
retical prices. Since the market price represents the collective wisdom of investors, we have
to accept it as a better estimate of volatility, even though it does not agree with the theory. All
362 Derivatives and Risk Management

theories must explain practice, else they become redundant. Assuming that the market price
of a call is correct, and also that the BSM is valid, the actual call price must reflect a volatility
that is implied in the BSM formula. Hence, given the four parameters of S, X, 7, and r and the
market-determined call price, we can solve the BSM equation for o. This volatility, derived
from the BSM, is implied in the call premium prevailing in the market, and makes the equa-
tion of the option price hold. Implied volatility is that o which makes the BSM formula hold.

Estimating Implied Volatility

There is a repetitive iterative procedure to find implied volatility. It is to compute the price
_ of the option using the BSM with assumed volatility till it matches the actual
The volatility that price of the option prevailing in the market. Unfortunately, there is no direct
matches the Black—Scho-
les price to the actual way to solve for o using market-determined call prices.
market price is called Since a call premium is an increasing function of volatility, the price must
implied volatility. _ rise with increasing volatility and reduce with decreasing volatility. Suppose
~ the market price of a call is 735. We start the iterative process of matching
the theoretical price to the actual price by changing the volatility. As a first guess, we use
o = 23%, and find BSM value of the call. If the BSM value, say $33.00, is less than %35,
we neéd to increase the o, or else decrease it. If the BSM price is equal to the market price,
then our estimate of volatility is correct. We continue this process till we achieve the desired
accuracy in the volatility estimates.
As a first attempt, we increase the value of o from 23% to 30% and calculate the call
premium. Say, we get a value of 36. Since this value is greater than the market price, we
may try the reduced number of 28% as the next approximation. Assume that this time the call
premium comes to 34. Now we can do a linear extrapolation of the two figures of 734 and
36 for volatilities of 28% and 30% (%1.00 per 1%). We conclude that the implied volatility
at the call price of 35 is around 29%.
Does implied volatility mean that historical volatility is of no significance? Certainly not!
Historical volatility provides insight into what has been the general level of risk with the
stock prices. Implied volatility is something that is assigned by the market for the future.
Though the future is not necessarily dependent upon the past, it is not independent of it either.
One must find an explanation for divergence in the estimates of volatility. Historical Volatility
will provide a base for further study of causes of divergence.
Volatility Smiles It is not necessary that implied volatility as reflected in the call premium
of one option is the same for all other calls, even though they are on the same underlying
assets and have the same expiration, though
' with different exercise prices. Using two dif-
ferent calls with different strike prices will
Se | most likely provide different implied vola-
ATM option
_ tilities. The implied volatility of deep ITM
;
. and deep OTM options is expected to be
Implied
volatility Sa arger than for ATM options. As the strike
Exercise price X price moves away from the spot price, vola-
i0 LEE tility is expected to rise. A sample plot of
Fig. 12.5 Volatility smiles implied volatility with an increasing exercise
 Option Pricing—Black-Scholes Model 363

price is shown in Fig. 12.5. It gets the name volatility smile from its shape, resembling a smile.
It is suggested to use the weighted average of all such implied volatilities as a measure of total
volatility of the stock. The weights of different strike prices are left to investors’ discretion.
There may be no fixed formula for the weights due to the varying characteristics of stocks.
Alternatively, one can use the implied volatility of an ATM option, as it is regarded as a truer
representative of price change.

SOLVED PROBLEMS
SP 12.1: Application of the BSM: Call premium
Assume a share is trading at 7100. A dividend of %3 each is expected at the end of 3, 6, 9, and 10 months from now. The risk-free
rate of interest is 6%, and the stock price has volatility of 25%. What is the value of (a) a call option with an exercise price of <110,
with maturity of six months, and (b) a call option with an exercise price of 100, with maturity of 12 months?
Solution
As per the BSM, the value of the call is given by
c = SN(d,) — Xe~'™ Nay)
_ In(S/X)+ (r+ 0/2)T.
h
where d., oVT - and

ne In(S/X) + te= o/2)T

Pe
Side =
= ovVT
ONT
(a) For a6-m call, there would be two dividends at the end of three and six months that are expected to be paid within the option
period. The PV of these dividends is
as D; el te D> ee = 1.50 e 0.08 * 0.25 4 1.50 e 0.08 x 0.50

= 1.50 X 0.9802 + 1.50 x 0.9608

= 1.47 + 1.44 = %2.91

Under the BSM, the spot price would be reduced by the PV of the dividends. The variables in BSM would then be:
S = 100 — 2.91 = 97.09, X = 110, T = 0.50, r= 0.08, and o = 0.25
ie In(97.09/110) + (0.08 — 0.25 x 0.25/2) x 0.5 _ 0.3916
0.25 x V0.5
d, = d, — 0.25 X V0.5 = —0.5683
N(d;) = 0.3477 and N(d,) = 0.2849
Inserting the values in the equation in the call premium c,

c¢ = SN@d,) — Xe~T Nah) = 97.09 x 0.3477 — 110¢7 908025 x 0.2849 — 93.76 — 30.11 = 73.65
(b) For a 12-month call, there would be four dividends at the end of 3, 6, 9, and 12 months that are expected to be paid within
the option period. The PV of these dividends is
=D, e+ D, e+ De® + Die ™
= 1.50 e 0.08 x 0.25 24.50) e 0.08 x 0,50 + 1.50 e 0.08 < 0.75 + 1.50 e 0.08 x 1,00

= 1.50 X 0.9802 + 1.50 x 0.9608 + 1.50 x 0.9418 + 1.50 x 0.9231

= 147 + 1.44 + 1.41 + 1.38 = %5.70

Under the BSM, the spot price would be reduced by the PV of the dividends. The variables in BSM would then be:
S = 100 — 5.70 = 94.30, X = 100, T = 1.00, r= 0.08, and o = 0.25
oe In(94.30/100) + (0.08 + 0.25 x 0.25/2)x1.0 _ 9 5499
0.25 x V1.0
d> = a, — 0.25 X V1.0 = —0.0398
Ndi) = 0.5833 and» Md) = 0.4841
 364 Derivatives and Risk Management

Inserting the values in the equation in the call premium c,

c = SN(d,) — Xe~™ Nd) = 94.30 x 0.5833 — 100 69% X25 x 0.4841 = 55.00 — 44.69 = 10.31
SP 12.2: Black-Scholes model for index options
The Nifty is currently at 4500. If the risk-free interest rate is 8% and the continuous dividend yield on Nifty is assumed at 3%, what
would the value of a 3-m put option with an exercise of 4600 be? The volatility of the Nifty is placed at 25% p.a.
Solution
As per the BSM, the value of the put on the index is given by
p = Xe~T N(—d,) — Se-%7 N(—d,)
DIS sa = os
where ad, = ; and
oVT
TS amtel £8 va
ee een ee eee
oVT
Here S = 4500, X = 4600, r = 0.08, g = 0.03, T = 3/12 = 0.25 years, and o = 0.25, which can be used in the Black-Scholes—
Merton formula for valuation of the call.

For an exercise value of 4600

First we find the values of d, and d,. All values used are annual and in decimal form. We have S = 4500, X = 4600, r = 0.08, q
= 0.03, T = 3 months or 0.25 years, and o = 0.25. These are plugged in the formula as follows:
_ !n(4500/4600) + (0.08 — 0.03 + 0.25 x 0.25/2) x 0.25
= 0.2102
a 0.25 x V0.25
db = d, — 0.25 x V0.25 = —0.1383
N—d;) = 0.5053 and N(—d,) = 0.5550
Inserting the values in the equation in the put premium p
p = Xe“'T Nah) — S e-% N(—d,) = 4600 e- 98 x 925 x 0.5550 — 4466.37 x 0.5053 = 2502.45 — 2256.86= 2245.59
SP 12.3: Currency Option
The exchange rate for the US dollar in India is 49.00. The risk-free interest rate in India and the USA are 4% and 8%, respectively.
The volatility of the exchange rate is 20%. What is the value of a 3-m call with an exercise price of ¥50.00?
Solution
Here S = 49, X = 50, r = 0.04, r = 0.08, T = 3 months (0.25 years), and o = 0.20. Putting these values in Eq. 12.28 for valuing
the call, we get

d, = In(49/50) + (0.04 — 0.08 + 0,20 x 0,20/2) x 0.25

= 0.2520
0.20 x 0.25
d> = d; — 0.20 x V0.25 = 0.3520
Ma;) = 0.4005 and Ma;) = 0.3624
Call price,c = Se ' Nd,) — Xe~'T Nap)
= 49.00 x e008 x 025 9.4005 — 50 @- 0.04 x 0.25 x 9.3694
= 48.03 0.4005 — 49.50 x 0.3624 = 19.24 — 17.94
=< 1,00

SUMMARY
Determination of option premiums has been one of the most the risk-free interest rate, and the dividend. The price of a call
challenging areas. Various methodologies have been used. Two increases and of a put decreases with an increase in the spot
methods of valuation—the binomial model and the BSM—are price. With an increase in the exercise price, the value of the
discussed. put increases and that of the call decreases. With more time to
Six factors that impact the value of options are the spot value maturity and increasing volatility, the value of the call as well as
of the underlying asset, the exercise price of the option, the the put increases. An increased risk-free rate increases the value
maturity of the option, volatility in price of the underlying asset, of the call and decreases the value of the put,
 Option Pricing—Black—Scholes Model 365

The BSM has been one of the landmarks in the history of something. Pseudo-pricing of American options assumes that
financial management. The model applies to European-style the optimal time to exercise can only be just prior to dividend
options on non-dividend paying stocks. It assumes log-normal payment, and prescribes a method based on this principle. An
distribution of stock prices and uses extensive mathematics to American call can be viewed as a portfolio of calls with exercises
provide an analytical solution. Valuations by the BSM are used at each dividend payment date, and the value of the American
by managers and industry analysts alike. call can be said to be the maximum of all the calls. An exact
Merton modified the BSM formula for European options on analytical solution is available for American options on dividend-
stock that pay a dividend. This formula can be modified to apply paying stock that pay only a single dividend over their life spans.
to value options on indices by replacing the dividend by the Volatility in the price of the underlying asset is the key deter-
yield on the index. Similarly, it can also be used, by substituting minant of option prices. Of all the five parameters that affect
the dividend with the foreign risk-free interest rate, for valuing option value, only this one parameter, volatility, is not observ-
options on foreign currencies. able. Using an analytical model requires input of a volatility
An American option is extremely difficult to value, as there - value, which can be measured from past prices. However, option
are innumerable times where the hoider has to make a choice prices are observable and incorporate estimates of future vola-
between exercising or not exercising. For a non-dividend pay- tility. The observed option price would imply volatility. Volatility
ing asset, it is already established that early exercise is worth that equates the value of an option by an analytical model to the
nothing. However, for a dividend paying asset, it may be worth actual price is called implied volatility.

KEY TERMS eo

Historical volatility The standard deviation of returns in the past. Normal distribution A bell-shaped probability distribution that
Implied volatility The volatility at which the fair price of an is completely defined by its mean and variance.
option as determined by the BSM matches the actual market price.

QUESTIONS ewes

12.1 What are the determinants of option prices? How would 12.4 Outline the assumptions under the pseudo American pric-
a Call price change with changes in (a) the spot price,(b) ing method developed by Black.
the exercise price,(c) volatility, and (d) the risk-free interest 12.5 How would you measure volatility of a stock? Describe the
rate? process.
12.2 What are the assumptions of the BSM? 12.6 What are the differences between historical volatility,
12.3 How does the BSM change to incorporate valuation of an future volatility, and implied volatility?
option on (a) dividend paying stock, (b) indices, and (c)
currencies?

PROBLEMS #@
P 12.1 Value of call—the BSM P 12.4 Put options on indices and put-call parity
A stock is trading at $105.00. You are willing to write a call on Find also the value of a put option based on the parameters
the stock, exercisable at the end of three months, with a strike given in P 12.3 using the BSM. Verify your result using put-call
price of 110.00. If the risk-free rate of interest is 12% p.a. and parity.
the stock has exhibited volatility of 30% based on past data, what P 12.5 Black-Scholes valuation for options on currencies
premium would you like to charge for writing the call? The spot rate for the euro is $68.00. A call option with a strike
P 12.2 Put value by the BSM-—put-call parity of £69.00 expiring in three months is available. What would be
Refer to P 12.1. Find out the value of a put having the same the premium on the call option if the risk-free interest rate for the
parameters as the call. Confirm whether put-call parity holds. Indian rupee and the euro are 12% and 8%, respectively, and
P 12.3 Value options on indices with the BSM the volatility of the rupee—-euro exchange rate is 20%? Find also
Find the value of a 3-m call option on the Nifty with a strike of 4900, the value of the put using the same parameters and establish
with the index trading at 4800. The volatility of the index is 10%, put-—call parity for an option on a currency.
and the index provides a yield of 2%. The risk-free rate is 8% p.a.
 eo
mee

Option Greeks
The Sensitivities

INTRODUCTION Learning Objectives

In the previous chapters, we have learnt that option value depends After going through this chapter,
upon five parameters, namely, the spot value of the underlying readers should be familiar with
asset S, the exercise price X, the time remaining for expiration the behaviour and sensitivity of
T, the risk-free rate of return, and the volatility measured by option value with respect to each of
standard deviation o. Once the option has been traded, its value its various determinants
the computation of delta, theta,
keeps changing with any change in each variable, except the
gamma, vega, and rho—the
exercise price. Those holding a portfolio of options, therefore, parameters of sensitivity of option
have to constantly monitor the prices with respect to each vari- value
able. It is easily understood that each determinant would have the importance of delta and delta
the some impact on an option’s price. hedging
the study of gamma
In this chapter, we study the impact of change in each variable
the meaning of delta neutrality
on option price. Variations in option and gamma neutrality, and how to
Option Greeks refer to
value with respect to each determinant achieve them simultaneously
the sensitivity of option
prices with respect tothe of price are denoted by Greek letters the concept of time decay
determinants of price. such as delta, gamma, theta, rho, and
rh vega (an exception, as vega is not a

Greek letter), and, hence, they are also referred to as option

Greeks. Any change in the value of an option with respect to any
variable is found by identifying the partial derivative! of the
price equation with respect to the single determinant of price.
Options Greeks for determinants of price are as follows:
Greek letter Variable/determinant of option price
Delta Change in asset price
Theta Time left for maturity
Gamma Change of change in price
Rho Change in the risk-free rate
| Vega | Change in volatility

'Partial derivative is found by taking differentiation of the function, including many

determinants, with respect to one determinant, assuming the rest of them constant.
 Option Greeks—The Sensitivities 367

__DELTAAND DELTAHEDGING __
While discussing the pricing of a call option under the equivalent portfolio approach, we
defined the term option delta. The option delta represents the sensitivity of the option price
to change in the price of the underlying asset.
The option delta, denoted by A (Greek letter delta) is defined as the first partial derivative
of the price of the option with respect to changes in the spot price. It indicates the magnitude
of change in the option value with the spot price of the underlying asset.
dc
(1321)
Soivas
where dc = change in the value of the call-option, and
OS = change in the spot price of the underlying asset
The price of a European call option as per the Black Scholes model (BSM) for a non-
dividend paying stock using the five determinants is given by

e¢ = SN(d,) — Xe~™* Nd)

where d; and d, are defined as follows:

MMOLE Gamer Oye
d ° Baye!
o VT
WON ge (eA Oe ing: Wet
dy S ovr Or d, = d o VT

Computing Delta
Taking the first partial derivative of the call value with respect to the spot price S, we get the
delta of the call option:
A call delta is positive : A
andlessthant,anda A. = an Nd) (132)
put delta is negative, but S
less than -1. _ Similarly, the value ofthe put is given by
SAC ERATE meester parapet aaa acme ¥ e Yer N a bi SM Dt

and the delta of the put option is found by taking the partial derivative with respect to the
price of the underlying asset S, given by

Aye7 = -M(=d)) = Nd) = (13.3)

Alternatively, the delta of the put option can also be found by using put—call parity, which
states that
c-p=S=>Xe"
The delta of stock is one, and the delta of bonds is zero, providing the relationship between
the deltas of calls and puts as
Ae hn l = Nd) — 1
368 Derivatives and Risk Management

Meaning of and Limits on Value of Delta

Remember from our discussions on call option pricing under the binomial approach that the
delta denoted the number of shares one must have for each call written to
Positive delta implies have the same payoffs at the end of option period.
that any change would be
Since the value of Md,) is between 0 and 1, the delta of a call would
in the same direction as
that of the asset price. It always be = 0 and < 1. For a stock trading at ¥500 with a standard devia-
is also referred to as the : tion of 25% and a risk-free rate of 6%, the value of the delta for a 3-m call
_ option with Y = 500 is 0.5724. An option delta of 0.5724 means that if the
~ value of the underlying asset changes by 1, the value of the option would
change by %0.5724 in the same direction as that of the asset value.
Similarly, the delta of a put option is always between 0 and —1.00. The negative value
of the delta for a put option indicates an inverse relationship of the put value with the price
of the underlying asset. If the delta of the call is 0.55, the delta of the put on the same asset
would be —0.45, and this would mean that an increase in the price of the underlying asset
by =1 would cause the put value to decrease by ¢0.45.
From Eqs. 13.2 and 13.3, we can make out that the sum of the mod (absolute) values of
delta for non-dividend paying European call and put options on the same underlying asset,
with the same time to maturity, and the same strike price, equals one. For American options,
the sum can exceed one, though marginally only.”
The delta is also referred to as the hedge ratio, as it indicates how many units of the under-
lying asset are required to replicate the returns on the option. The delta of a short position in
an option would be the opposite of that for the long position. Ifa call option delta was 0.45,
then the value ofa long position on the call would increase by £0.45 and of a short position
decrease by %0.45 with %1 increase in the price of the underlying asset. While a long position
in a put has a negative delta (the price of the put falls with an increase in the spot price), it
is positive for short positions.

Assumption of Linearity
The expected change in the value of a call option for a given change in the spot value is given by

The option delta is the dc = Acos (13.4)

change in the price of an
The validity of Eq. 13.4 holds only for infinitesimally small changes in the
option with respect to a
small change in the price _ price of the underlying asset. The value of the call option does not change
of the asset. It is not valid linearly with the underlying. The assumption oflinearity holds good only for
for large changes. _ a small range of changes in the value of the underlying asset, as depicted in
Fig. 13.1. This implies that as the value of the asset undergoes more than a
small change, the value of the delta too would change. The estimate of change in the value
of the option based on the delta is at best an approximation. The extent of change in the
value of the delta would depend upon the curvature of the option value with the spot price.
The change in the delta with the change in the spot value is denoted by another Greek letter
called gamma, discussed later.

°Rendleman Jr, Richard J., Applied Derivatives - Options, Futures and Swaps, Blackwell Publishers, 2002, p. 124.
 Option Greeks—The Sensitivities 369

Call value, c

Fig. 13.1 Delta of call option

Behaviour of Delta
The delta of a call option depends upon the moneyness of the option.
For a deep out-of-the-money (OTM) call option, the delta would be close
ee - to zero, signifying that there would hardly be any change in the price with
oe
around 0.5. a change in the price of the underlying. When the call is deep OTM, the put
LLL would be deep in-the-money (ITM), and its delta is close to — 1.00.
For a deep ITM call option, a change in the spot price of the asset would cause an equiva-
lent change in the call option price. For a deep ITM call option, the value is primarily intrinsic,
which increases by the same amount as the price of the underlying does. When a call is deep
in-the-money, its delta is 1. At this price of the asset, the put is deep out-of-the-money, and
its delta is almost zero.
For an at-the-money (ATM) call, the value of the delta is close to 0.5, meaning that the
call value changes by about 50%, signifying that there is an approximately 50% chance of
it becoming in-the-money before the expiry of the option. Under BSM, the likelihood of the
option turning in-the-money at the time of expiry is given by N(d) for the call and M(—d))
for the put, not by M(d,). Yet M(d,) can be taken as an approximate measure of such a prob-
ability, though it may be slightly overstated.*
The summary of the behaviour of the delta is as follows:
- |Moneyness of the call option Value of delta
Deep out-of-the-money close to zero
Deep in-the-money one
At-the-money close to 0.5
Similar observations can be made about the delta of the put option, which has values
between 0 and —1.00. The deltas of the call and the put options are depicted in Figs 13.2(a)
and (b), respectively, for different values of the asset price for an option with XY = 500, T =

Refer to page 170, Derivatives - An Introduction by Robert A. Strong, Thompson South Western.
370 ~~ Derivatives and Risk Management

z
1.00 RO ore ne

0.80 |

«0.80
2 X = 500, o = 25%. t= 0.25 years, r= 6%
0.40
i
0.20 |

T T T a T T ee

380 400 420 440 460 480 500 520 540 560 580 600 620
0.00 T i.e T T T T

Spot Price
(a)

Spot Price
600 620
0.00

0.20

~~ -0.40
2 X = 500, o= 25%. t = 0.25 years, r= 6%
0.60

0.80

= 00 aa ee TEE RL ec MESES Rect naa seta uaa Ue nana Caer ese Sa wee a oe uate owe WEN ais ewes StS Rea ee SY

LLL LLL LOLOLll llliaiapamarantititte

Fig. 13.2 Delta for non-dividend paying isdn )Call option (b) Put option

3 months, r = 6%, and o = 25%. Note that changes in the delta for the call and the put are
similar, as reflected in the shape of the curve. They differ by a constant factor of 1.00, and,
hence, the behaviour of the options delta for calls and puts essentially remains the same.

Delta and Time to Maturity

The value of the delta does not remain constant even if the value of the underlying asset does
not change. The value of the delta also changes with time. Figure 13.3 shows the values of
the delta for ITM, ATM, and OTM call options at r = 6% and o = 25% from time T = 3
months till expiration.
For ITM calls, the value is slightly less than 1.00 initially and approaches 1.00 when it is
close to expiration, representing a change in the option value equal to that
The option delta fallsto of the spot. Close to maturity, the option behaves more like the asset itself.
zero for OTM options _ For ATM options, the value remains at around 0.5, indicating that there is
eee _ as much chance of it turning in-the-money as is for it becoming out-of-
ity. ions, : ; ES aie Sa ;
itapproaches 1. the-money. With more time to expiration, investors tend to assign a greater
_ chance for it to become in-the-money, but close to maturity, the uncertainty is
 Option Greeks—The Sensitivities 371

a ama ee
ee: SUNN RI
: A a ne o
0.023 ee os
In the money r=6%, o= 25% X = 500 |
: [IM S= 500 =
ee ue = = —
0.7 ATM S$=500
OTM S=450

Deltafo) oO b ~ > ® 3 ie) = 0<

0.3

Oe ae ee eS Out of the
0.1 ES ee. Se eee a money
a a OE Me OE re OE once” Se eee
3) Ze) 2 128 1 0.5 0
Time to expiration (months)

Fig. 13.3 Delta as functio n of time to expiration

somewhat heightened. For OTM options, the variations are not significant, as the entire value
consists of time value. As maturity approaches, one can anticipate practically no change in
the value of an OTM option, making its delta close to zero.

Additivity of Delta: Portfolio Delta

An extremely useful property of the delta is its additivity. Additivity implies that the delta of
_ aportfolio is the weighted average of the securities comprising the portfolio.
The delta of a portfolio
_ Mathematically, this is represented as
of assets is the weighted
sum of the deltas of the A= W| A, ae W2 A, a W3 A; ele Tenetrieistetete = =w; A; (13.5)
securities comprising it.
where w,, is the number of nth options and A,, is the delta of an option posi-
tion on the same asset.
As an example, consider a short position of an ATM straddle* for 3 months on a stock with
a spot price of ¥500, a standard deviation of 25%, and a risk-free return of 6%. The value of the
straddle (one call and one put written at ¥ = 500) and its delta would be as given in Table 13.1.
We can see that the writing of the straddle generates an income of %49.84. The delta of the
call written is —0.5724, indicating that a one-rupee change in the spot price would cause the
call price to go up by 0.57. Since the call has been written, the writer would face a loss of

Table 13.1. Value and delta of short straddle

Spot = %500, T = 3 months, r= 6%, and o = 25%)

Value as per BSM Delta
Short call at X = 500 . —O7e4

Short put at X = 500 +0.4276

Income
| Portfolio delta _ 0.1448

4A long (short) straddle is a combination of long (short) call and long (short) put on same asset, with same style and same
time to maturity.
372 Derivatives and Risk Management

|EXAMPLE 13.1 Delta and value of a call

Given the following information about a stock option:

Stock price = %300, Strike price = 300, T = 3 months,
Risk-free return = 8%, Standard deviation of the stock = 30%

Find out the value of a call using the BSM and its delta.
What interpretation do you give to the delta?
If the value of a stock increases by 1%, by what amount should the call value change? What would be the new value of a 7
call using delta and the BSM? |
If the value of a stock instead increasesby 10%, by what amount would the call value change? What would be the new call |
value using delta and the BSM? 7
What explanation can you offer for the difference between the results of (c) and (d)?
Solution
The BSM for determination of the call value is
c = SN(d,) — Xe~™ Nab)
Deer In(S/X) + (r— 07/2)T i=
where a; - ovT ; and d=
ID oVT = or d=d,-—oVT
2 1

Putting the values in the BSM formula, we get

d, = 0.2083, d. = 0.0583, N(d;) = 0.5825, and Nd.) = 0.5233
And call value as €20.87, option delta = N(d;) = 0.5825 :
If the delta of a call is 0.5825, this implies that for a small change in the spot price, the value of the call would change by |
58.25%. ; ;
If the value of the underlying asset increases by 1%, i.e., to ¥303
The value of the call with a 1% increase in the spot value to 303 = delta x 3 = 0.5825 x 3 = £1.75
Therefore, the new value of the call based on the delta = 20.87 + 1.75 = %22.62
The value of the call as per the BSM = $22.67
The error in the estimated value = %0.05 (understated by the delta)
If the value of the underlying asset increases by 10%, i.e., to 330
The value of the call with a 1% increase in the spot value to 330 | = delta x 30 = 0.5825 x 30 = 217.48
Therefore, the new value of the call based on the delta = 20.87 + 17.48 = $38.35
The value of the call as per the BSM is = %41.86
The error in the estimated value = 3.51 (understated by the delta) |
The error in the first case (1% increase) is far less than the error in the second case (10% increase). The error in estimate
using the delta and the value by BSM is due to the assumption of linearity. The value of the call does not increase linearly
with the spot price, which is assumed in calculations by the delta.

%0.57. However, the put written would cause improvement in the position by %0.43, with a unit
increase in the spot price. The delta of the short straddle would be —0.1448, using Eq. 13.5.
Delta of the straddle = no. of calls X delta of calls + no. of puts X delta of puts (3a)
=) — 1X 05724 (1) XX (0.4276). = 0448
The negative delta of the short straddle signifies that with the spot price increasing by
1, the portfolio would deteriorate in value by about %0.14 (the value of the straddle would
increase by %0.14). Table 13.2 examines the change in the position of a short straddle with a
<1 change in the spot price.
Note that an increase in the spot price causes a rise in the value of the straddle, represent-
ing a deterioration on the short position. Further, note that the change in value of the straddle
is not exactly equal but only approximately equal for the same increase or decrease in the
value of the spot due to convexity.
 Option Greeks—The Sensitivities 373

Table 13.2 Change in the value of short straddle with change in spot price as per BSM

Position Spot price = 501 Spot price = <499 L

Short call at X = 500

Short put at X = 500

New value of straddle

Old value of straddle

Deterioration in value

EXAMPLE 13.2 Portfolio Delta

Under the BSM, the value of Md) is 0.75. What would be the delta of portfolios consisting of a) 4 long positions in stock and 4
calls, b) 4 long positions of stock and 4 puts, and c) 4 long calls and 4 long puts? Which of the portfolios has least sensitivity to
the changes in the stock price? L
Solution
The delta of call option on the stock = N(d,) = 0.75
The delta of put option on the stock = Ma;) — 1 = —0.25
Delta of a) 4 long positions each in stock and call = 4x 1.00 + 0.75 x 4 = 7.00
b) 4 long positions each in stock and put = 4x 1.00 — 0.25 x 4 = 3.00
c) 4 long positions each in call and put = 4x 0.75 — 0.25 x 4 = 2.00
The portfolio of four long calls and four long puts is having least delta and therefore would change least with the change in the
price of the underlying asset.

Deltas of Other Derivatives

The delta as a concept tells us about the change in the value of an option with a change in the
value of the underlying asset. Without any explanation, we can say that the delta of stock would
be one. Similarly, the delta of a bond would be close to zero, as the value of the bond does not
change with a change in the value of the stock.
The concept of delta can be extended to other derivatives such as forwards and futures con-
tracts. The delta of a forward contract is the change in the value of the forward contract with
a change in the value of the underlying asset. Assuming that the forward contract at t = 0 is
for Fo, the delivery price, the value of the forward contract would change by as much as the
change in the value of the underlying. Therefore, the delta of the forward contract is 1.00. It
means that after having entered into a forward contract at Fp, one needs to take an equivalent
opposite position in the underlying to neutralize the impact of changes in value.
Since the value of the futures is Se’’, the delta of a futures contract is given by e””. Any
change in the value of the spot (OS) would cause a change in the futures by OSe’". Therefore, a
change in the spot value by %1 would cause the futures value to change by 2,
In case the stock pays dividend (continuously at the rate of q), then the
A long position in stock _ deltas of a call and a put option on it stand modified to e 4” N(d,) and
has a delta of 1, while for _e | N(d,) — 1], respectively. For a futures on a dividend paying stock, the
_ashort position, the delta delta is ce", Similarly, the delta for a forward contract on a stock paying
sc rt—i— dividend is e~%.
374 Derivatives and Risk Management

Table 13.3 Delta for different assets

AP ; For dividend paying @q

Asset For non-dividend paying (continuously compounded)

Call on stock N(d;) e 47 x N(d;)

Put on stock Nd,) — 1 e 47 x [Nd,) — 1]
Bond 0 0
Stock 1 eo
Forward contract on stock | eg
Futures contract on stock i: eT eat
Call option on foreign currency et! x Nd)
Put option on foreign currency et” x [N(d;) — 1]
Call option on futures eT x Nd)

For options on foreign currency, the dividend is the rate of return in foreign currency, rf
It follows from interest rate parity, where the deliverable asset, the foreign currency, earns
an income equal to the foreign interest rate.
The deltas of various instruments are tabulated in Table 13.3 for our understanding.

DELTA HEDGING 2
Options are bought to contain loss and yet retain profit potential. Further, options are sold to
The lower the delta, the _ earn premiums under the expectation that the price of the stock would not
lesser is the change in change enough. Writing options is fraught with the risk of large potential
the value of the portfolio Josses for a small premium. A call option writer assumes significant risk with
with changes in the
upward movements of the spot price and so does a put writer for downward
prices of the underlying
assets movements in the price. The call seller hopes that the spot price does not
~~~ exceed the strike price, and, therefore, expects to pocket the premium earned.
However, if the position taken is large, the option writer needs to cover for the portion of
risk that exceeds the investor’s profile.

Stop-loss Strategy One strategy of containing the potential losses from a call written is to
acquire the asset the moment its price goes above the exercise price, X. In such a case,
the
asset would be ready for delivery on maturity/exercise. Since the asset is acquired
at a price
close to the strike price, the loss would be rather small. Here, a naked call
writer converts to
a covered call writer the moment the option turns in-the-money. However, the option
writer
may sell the underlying stock if the price comes below the strike price, to save
on the cost of
funds. The savings on the cost of funds would have to be weighed against (a)
the transaction
costs and (b) the loss incurred on a buying price higher than X and a selling
price lower than
X. The strategy of acquiring the asset when it just exceeds the exercise price
and selling it
when it just falls below the exercise price is referred to as the stop-loss strategy.
As an alternative to the stop-loss strategy, one can consider the strategy of
not covering the
position as long as the price remains less than_X, buying the asset (cover
the short position)
 Option Greeks—The Sensitivities 375

the moment it crosses X, but not selling when the price falls below _X. Therefore, once covered,
one would always remain covered.

Delta Neutrality
More often than not, the stop-loss strategy is not preferred by large-volume traders in deriva-
tives due to the loss that is made on each transaction of buying and selling of the asset, apart
from the transaction costs. Instead, traders consider a delta-neutral position a better alternative.
Delta neutrality means that a small change in price of the underlying would have no impact
on the value of the portfolio. In terms of Eq. 13.5, which states the delta of the portfolio
to be the weighted sum of the deltas of the individual assets comprising the portfolio, delta
neutrality can be achieved by making the portfolio delta equal to zero.
Consider the short straddle position in Table 13.1. The delta of the short straddle was
computed as —0.1448. A long position of 0.1448 shares in the underlying stock (the long
stock has a delta of 1.00) along with the short straddle would make the portfolio delta very
close to zero. A change in the value of a portfolio consisting of one short straddle and a long
position of 0.145 stocks is depicted in Table 13.4.

Table 13.4 Change in the portfolio value of short straddle and long stock, values as per BSM

| Position Spot price = ¢501 Spot price = €499

Short call at X = 500 %29.22 %28.08
Short put at X = 500 %20.77 721.63
New value of straddle %49.99 - %49.71
Old value of straddle %49.84 %49.84
Deterioration in value of straddle Oils SEO
Value of 0.145 stock 872.65 272.36
Old value of 0.145 stock %72.50 %72.50
Change in long position of stock OS —€0.14
Net impact on portfolio — —"
“Even when the delta of a portfolio is set exactly at zero, an equal increase/decrease in the spot price would not bring about an exact :
identical change due to non-linearity,
LEA LE ELL LL EEE EEE EEE EEE EEE EEE EE EEE EEE EEE

Traders having large positions in options prefer to hold portfolios that are delta neutral
when the risk is presumed to exceed a particular level. With delta neutrality, they achieve
immunization oftheir portfolios to small changes in spot prices.
For example, consider an investor who is long on the stock of Infosys, with 10,000 shares
currently trading at £1250. In order to protect against a fall in value, the investor buys 10,000
put options with a strike of €1150, currently valued at $19.99, with a delta of —0.1915 as per
the BSM (using T = 6 months, r = 6%, and o = 20%). An initial outflow of
Delta neutrality means _ %1,99,900 is required for availing the protection below a spot price of %1150; the
the delta of the portfolio investor decides to write 4-m calls witha strike of %1300, selling at ¥46.77 as per
is zero. Traders with the BSM. The calls have a delta of 0.4567. Assume that the investor sells 4300
large positions in deriva- calls to generate ¥2,01,111. This results in a cash inflow of €1211. The portfolio
tives strive to achieve It.
es
would have a delta of 6121, as shown in Table 13.5 and the following paragraph.
376 ‘Derivatives and Risk Management

Table 13.5 Portfolio delta

Spot = 21,250, r= 6%, and o = 20%)

Position oC Quantity Value as per BSM Delta

Short call at X = 1,300 T= 4m —4,300 %46.77 +0.4567

Long put at X= 1,150 T= 6m 10,000 %19.99 —0.1915

Long stock 10,000 — +1.0000

Portfolio delta 6121

YO? 2D
LT EEEEEEEEEEEEEEEEOOOODROOPODOOOOOORORDEPRERYEPYOPOPOOROEPRORDOD_DRL—DRLDL___DOOOL

The portfolio delta is given as follows:

10,000 X 1.0000 + 10,000 x (—0.1915) — 4300 < 0.4567 = 6121
A portfolio delta of 6121 implies that if the spot value rises by ®1, the portfolio would rise
by %6121. Similarly, a fall of€1 in the stock of Infosys would cause a decline in the portfolio
value of $6121. To make the portfolio insensitive to price changes in the underlying stock,
we need to make the portfolio delta neutral, i.e., make the delta of the portfolio zero.
One possible way of achieving the objective is to go short on futures on Infosys. The delta
of a futures contract is e’”. With r = 6% and using a 6-m futures contract, the delta would be
e X05 = 1.03. For delta neutrality, we need the futures position to have a delta of 6121.
Therefore, the number of futures to be sold (a short position would have a negative delta) is
6121/1.03 = 5943, or, say, 6000.
Since deltas of derivatives change continuously with changes in factors that determine
option premium, such as time to maturity, interest rates, or volatility, delta neutrality does
not hold for long. A trader with substantial exposures needs to review the delta periodically.
The periodicity of review would depend upon the risk appetite of the trader. A portfolio made
delta neutral does not remain so after some time. To keep the portfolio delta neutral, one is
required to adjust it frequently.

The theta is the sensitivity of the option value with respect to time. As we know, the value of
the option consists of two components, i.e., the intrinsic value and the time
The theta represents
time decay in the value value. The intrinsic value would be the value one gets if the option is exer-
of the option as it nears cised, while the time value represents the value attached to the option becom-
maturity, _ ing more in-the-money before it expires. With all other determinants of the
option value remaining constant, the time value diminishes as maturity
approaches, and becomes zero on the day of maturity for call and put options. Mathemati-
cally, the time value of an option can be expressed as

0. = = fora Cdl ean - for a put

The negative sign indicates that with passage of time, time value decreases, since the time
remaining for maturity is reduced. For a non-dividend paying stock, the thetas for calls and
puts are given by
 Option Greeks—The Sensitivities 377

0. =
USvidie
EU
© rXe*? N(d>) (13.6)
SN (d,)o chs
0, = AEG; + rXe~'T M—d>) (13.7)
1 ;
where Ne
7 = e 9.54%

Computing Theta
Note that the value of the theta for a call would always be negative, signifying that time value
decays with the passage of time. For a 3-m ATM call on a stock selling at ¥500 with a risk-
free rate of 6% and a volatility of 25%, the call sells at 28.64, and the value of the theta is
764.49, shown as below:
SN ’'(d,)o
9, = ———— — Xe" ayNd,
EVR pee
500140,3923.-%.0.25
Se
2V0.25 0 92 oe 728
—49.04 — 15.45 = —%64.49

Meaning of Theta
It may seem strange that while the call sells at 28.64, time decay occurs at the rate of 64.49.
Note that the value of the theta is annual, while the call has a maturity period of three months
only. Since most options have a maturity of less than a year, and, further, since traders in
options need to keep abreast of changes almost on a daily basis, it would make better sense
to have the value of the theta expressed on a per day basis. Transforming the annual value of
%64.49, the option would lose a value of ¥0.1767 every day (%64.49/365).
Note that the entire value of the call of $28.64 represents only time value as for an ATM
call the intrinsic value is zero. The decay of ~0.1767 per day implies that the value of the
option would turn to zero in about 162 days (%28.65/0.1767). However, the option lasts only
for three months or 91 days. Is the value of the theta as computed here reasonable? The value
of the theta is true for the moment or the day. The next day, the value of the theta would
change. It increases as time elapses, 1.e., the fall in value is greater on a given day than what
it was the preceding day.

Theta and Time

Call options lose time value at an increasing rate as maturity approaches, i.e., the value of the
theta increases as the option nears maturity. The value of the theta for an option that stood
at 764.49 at the start would increase to $137.03 when only 15 days are left to maturity. The
increasing rate of time decay of a call option is demonstrated in Table 13.6, and is depicted
in Fig. 13.4 for an ATM call.
For OTM and ITM calls, the decay is at an increasing rate as maturity approaches. For
deep OTM calls, neither the time value nor the intrinsic value (which in any case is zero)
plays any significant role. For an ITM call, the decay in the time value would be arrested once
the traders realize that there is only a remote chance of its value declining. Then the intrinsic
value becomes the major constituent of the value of the call.
378 Derivatives and Risk Management

Table 13.6 Increasing rate of time decay for call option

(—sign ignored),
Spot = 500, X = %500 r = 6%, and o = 25%,
Time to maturity, t : : 2.0 m | 15m | 10m | O5m |
Theta (€ p.a.) : 75.80 85.29 101.20 137.03
Theta (% per day) : : 0.2077 0.2337 oe 0.2773 0.3754

|
Time remaining for maturity (months)

Fig. 13.4 Theta of ATM call with time

Theta for Put Option

The value of the theta for put options in most cases would be negative, but for deep ITM
While theta ofacallis European put options, the theta may be positive. For deep ITM puts, the
always negative, there is : value would be approximately equal to the present value (PV) of X less the
a possibility ofincreas- spot price, S, i.e, Ye’? — S. Assuming all else remains the same, and with
ing the value of the put _ time elapsing, the PV ofthe exercise would increase (as lesser time remains
option as it approaches
ey
: for maturity), and, hence, the value of the put would rise. At maturity, the
_ value of the put would be the highest at Y — S. In fact, the theta would be a
nee aysfenmi (a) the time value of the exercise price that causes an increase in the put
price on one hand, and (b) a natural decline in value due to reduced volatility with the passage
of time, on the other hand. From Eq. 13.7, we may say that the theta for a put would be
positive as long as the following is true:

SN’(d
rXe*T N( oo(io)) oe

Portfolio Theta
Like the portfolio delta, Like the delta, the portfolio theta too is the sum of the thetas of the options
the theta too has an addi- + Comprising the portfolio, weighted with the number of options.
The value of
tive property. It is of little |the theta as such does not have much significance for the purpose of hedging,
significance, as positions as one has no control over time. It remains a figure of interest for traders who
cannot be hedged with want to know the amount by which the value of a portfolio would change as
respect to time decay.
coco, One day elapses, all else remaining constant, of course.
 Option Greeks—The Sensitivities 379

i No dividend yield Continuous dividend paying at Q

Call, @, oN Ome ye PONG Og a
oT Xe" Nab) A/T rXe~" Nd) + gSe~ 7 N(di)

Bue Ge
se | xe ™\- a) |27. oO + Xe" —IT N(—a,)
AW AL) — gSe —gT AY—
9’N—d,)

where N’(d;) = ae Qn 0.5ch?

Qn

EXAMPLE 13.3 Computing theta

At what rate will the value of ATM call and put options with six months to expiry decay for an asset selling at €40, with a voatity
of 30%? The risk-free rate is 8%.
Solution
First we find the values of d; and d> for S = 40, X = 40, aa 0.5, r= 8%, and o = 30%
In(S/X) + (r+ o7/2)T_ 0 + (0.08 + 0.09/2)0.50
d= = 0.2946
oVT 0.30V0.50
d> = d, — oVT= 0.2946 — 0.3°V0.50= 0.0825
The normal distribution values are given as under:
N(d;) = 0.6159 Nas) = 0.5329 N—d;) = 0.3841 M-—da,) = 0.4671
We also get N’(d,) = er e 954i? — 0.3819
ms

Call theta = —
SN(de
; = — rXe~'T : N(d,)
40 X 0.3819 X 0.30 _698 5 ggg 008 x 08's 98999
2x V0.50
= —3.2407 — 1.6384 = —4.8791
—%0.0134 per day

Put theta LZ + rXe—"Tye N—d.

rsSNAG)O
2VT ee
_ 0.
40 X 3819 X 0.30 | 9 og y 4gq-0.08 05 x 9.4671
2x V0.50
= —3.2407 + 1.4361 = —1.8046
—%0.0049 per day

The values of theta for a dividend paying asset for call and put options are given in the
table above. These values are computed based on the BSM.

GAMMA AND GAMMA NEUTRALITY _

From the point of view of utility to traders, the second-most important parameter of signifi-
cance is the gamma of the option. The gamma (7) is the rate of change of the
The gamma is the rate delta of the option or of the portfolio of options.
of change of the delta, Mathematically, the delta is the first derivative of option value, and the
_and is a second partial gamma is the second derivative of option value with respect to the spot price.
derivative with respectto Alternatively, the gamma is the derivative of the delta with respect to price.
~~ Spo!price: We may define the gamma as:
380 Derivatives and Risk Management

emOnan A O° OA, ¢ t option

nee cok tae serCENTRE
The rate of change of the delta would depend upon the curvature of the option value with
respect to the spot value.
Since A, = Md) and a = Md,) —1, i.e., they differ only by a constant, the change of
delta obtained by differentiation with respect to S for a call and a put would be identical.
Therefore, the gamma of a call and a put would be the same. In terms of the BSM, the value
of the gamma for calls and puts is given by
Nd)ees
epee (13.8)
So VT
h N’ d ) =
] n 9]

where N (d, ae,a e 0.541"

Computing Gamma
An ATM call with spot = %500, X¥ = %500, r = 6%, T = 3 months (0.25 years), and o =
_ 25% has a gamma of 0.0063.
The gammas
of acalland In(S/X) + (r + 0.502)T
a put are equal and posi- dy = Via
tive for the same value of ih -
X and the same t. : _ In(@) + (0.06 + 0.5 X 0.25 X 0.25) x 0.25 = (). 1825

]
05d" 2 = ]
e9-5X0.1825752 =
SECs Vin
Nd.) = : e 0.3923

Using Eq. 13.8, we get 0.0063 as the value of the gamma, as shown here:
r= N’'(d\) _ 0.3923 2 = 0.0063
0.3923
S Vi © 500% 0.256./0.25 ors
The gamma of a put option with the same determinants would be the same as that of the
call, i.e., 0.0063. The gammas ofthe stock and the forward contract are zero since their deltas
are constant at |.

Behaviour of Gamma with Spot Price and Time

The behaviour of the gamma with respect to the spot value is depicted in Fig. 13.5. The
gamma of an ATM option is at the maximum. As an option turns in-the-money or out-of-the-
money, the gamma tends to approach zero, signifying that for low and high spot values the
curvature of the option value vanishes (refer to Fig. 13.1). The delta for such values of spot
would approach 0 or 1. Though the plot of the gamma looks like a normal distribution, it is
indeed not so. It appears to be normal because ofthe factor N’(d;) appearing in its value, but
for higher values, its tail extends more than normal distribution because of the presence of
the spot value, S, in the denominator in Eq. 13.8.
The behaviour of a gamma with respect to time is depicted in Fig. 13.6 for an ATM call
option. For ITM and OTM options, the variability of the delta is rather low, and its study is
rather unimportant. A look at Fig. 13.6 would reveal that changes in the
The value of the gamma = gamma are extremely small for a considerable time, till it almost reaches
rises very rapidly as Itap- maturity. The value of the gamma rises very rapidly when the option is close
pieacies i— __. to maturity, even though the value of the delta remains in the vicinity of 0.5.
 Option Greeks—The Sensitivities 381

S = 500, X = 500, o = 25%, 7 = 0.25 years, r = 6%

350 375 400 "425, 450 475 500 525 550 575 600 625 650.
Beh value

0.4000 Sa a ag ee |

020002" aia 1
“ i

:
@ 0.2000 ~

3 0.1000 + |
.
0.0000 |
---- ———4 ee ee ee ect :
3. 00 rp:es - 50. "9.35 2.00 ay5 “ihnh 4. 25 1.00 O75) 0/50 0.25 aa 00
Time to maturity (months)

Fig.13.6 ‘Gamma with spot

: iron

From Figs 13.5 and 13.6, one may conclude that the gamma is at its maximum for ATM
options, when they are near maturity.

Meaning of Gamma
The gamma of an option tells the extent to which the value of the delta would change. It is
a measure of the non-linearity of the option value. The more the value of the gamma, the
more is the non-linearity. The value of the delta remains valid only for small changes in price
under the assumption of linearity. In a way, the value of the gamma tells us
_ the extent to which any change in price predicted by the delta could be relied
The gamma represents
non-linearity, and helps upon.
in knowing the frequency In the example of straddle (refer Table 13.1), the value of the call option is
of portfolio balancing. %28.64, with a call delta of 0.5724. The value of the gamma is 0.0063, which
Higher value of gamma means that the change in value of the delta for a unit change in the value of
implies more frequent
the underlying asset would be 0.0063. The value of the gamma implies that
balancing.
if the stock price moves from %500 to %501, the value of the delta would
382 Derivatives and Risk Management

_ increase to 0.5787 (0.5724 + 0.0063), and if the stock price declines to

Small changes in price
This can be verified by
can be estimated with the _ %499, the delta would be 0.5661 (0.5724 — 0.0063).
delta alone. However, for re-computing the delta at spot prices of %499 and ¢501.
large changes, estimates. However, for relatively large changes in the price of the underlying asset, the
must be made with the = Change in the delta as computed from the gamma would be an approximate
delta and the gamma
_ value only. If the stock price were to move from 500 to %510, the new value
together.
oe of the delta as determined through the gamma would be 0.6354 [0.5724 +
(10 X 0.0063)], while the actual value ofthe delta at a spot value of 7510 as per the BSM is
0.6334.
The value of the delta when combined with the gamma enables a better estimate of the
change in the value of the option for comparatively large changes in the value of the under-
lying. For example, consider the value of an ATM call option at 728.54 and a delta of 0.5724.
If the spot changes to 510, the expected value ofthe call would be %34.26 [28.54 + (0.5724
x 10)], as estimated from the delta. However, the theoretical value ofthe call as per the BSM
at a spot of 510 is $34.64. The divergence is due to the fact that the delta is not constant for
relatively large price changes. The new delta corrected with the gamma would be given by:
Old delta + gamma X price change = 0.5724 + (0.0063 X 10) = 0.6354
Therefore, the average delta for the range is (0.5724 + 0.6354)/2 = 0.6039. Now, for a
change of10 in the value ofthe underlying asset, the average delta is 10 X 0.6039 = %6.04.
Therefore, the new value of the call should be 728.54 + 6.04 = $34.58, a much closer figure
to the actual.
Besides predicting the likely value of the delta with changes in the spot price, the gamma
also tells us about the desirability of rebalancing of our portfolio from the perspective of delta
neutrality. Remember that the delta of the portfolio was made zero to achieve delta neutrality
and make the value of the portfolio immune to changes in the value of the underlying. At best,
such delta neutrality remains valid only for a small period of time, and, therefore, is referred
to as static delta hedging.
If nothing else changes, the time to maturity would change. What is delta neutral today
would not be so after some time. In fact, the deltas of the assets and portfolios change
continuously. Though small changes in the delta may be ignored, the portfolio may require
periodic adjustment to maintain delta neutrality if substantial time has elapsed or the value of
the underlying has changed. How often the portfolio needs to be rebalanced with the passage
of time and with changes in the value of the underlying is gauged by the gamma. Higher the
value of the gamma, more often the portfolio needs rebalancing. Adjustment to the portfolio
with the objective of keeping it delta neutral (or to peg it to a specific value of the delta) is
called dynamic hedging.

Portfolio Gamma
Like the delta and the theta, the gamma too has an additive property. The gamma of a
portfolio can be found by adding the gammas of the securities comprising it, weighted by
the number of securities. For example, the gamma of a short straddle (as reproduced from
Table 13.1) would be the sum of the gammas of one short call and one short put. Therefore,
the gamma of the short straddle would be 0.0126. This is shown in Table 13.7.
 Option Greeks—The Sensitivities 383

Table 13.7 Value of delta and gamma of short straddle

Spot = 7500, t = 3 months, r= 6%, and o = 25%)

Position — Valueas per BSM Delta Gamma
Short call at X = 500 22864 "0.5724 0.0063 1
Short put at X= 500 201.20 40.4276 0.0063 |
Total 749.84 ;
Portfolio delta and gamma ~0.1448 0.0126
One can forecast the value of the delta if the price changes by %1. The new values of the
delta of the portfolio would be 0.1448 + .0126 = 0.1574 when the price increases by 21,
and 0.1448 — 0.0126 = 0.1322 when the price decreases by %1.
If the portfolio consists of 7securities with numbers 7), nz, 13 .... with gammas of I, 15,
I; ..., then the portfolio gamma Ij, can be expressed as ;
[,=m XI, +m x I, +n;,x 1; Rioietsiasisteaiste n; X I; (i329)

Gamma Neutrality
It is often considered that once the applications of the delta are understood, the study of the
gamma is futile. We understood the need for making the portfolio delta neutral to immunize
it from changes in the spot value.
Though the stock can be used to achieve delta neutrality, it cannot be used to manage the
_ gamma, which is zero. Inclusion or exclusion of the stock in the portfolio
Gamma petaly means would have no impact on the gamma of the portfolio. In order to influence
the portfolio gamma is ; ue hee
equal to zero, which can the gamma of the portfolio, only a position in derivatives can help. One of
be achieved through its the ways to achieve delta and gamma neutrality simultaneously is to (a) first
additive propert make a portfolio gamma neutral, then (b) compute the delta of the portfolio,
and finally (c) take a position in stock to achieve delta neutrality.
Alternatively, we are required to take positions in at least three derivatives to achieve neutrality
of the delta and the gamma simultaneously. Using two options, we may have delta neutrality
but it would have some gamma. Adding another derivative security to get gamma neutrality
would disturb the delta neutrality achieved earlier, because the new security would have its own
Greeks. To make the portfolio delta and gamma neutral, we need to solve simultaneous equa-
tions. For example, consider three options with price, delta, and gamma, as given in Table 13.8.
Assume that an investor writes 100 puts with a strike of 550. The delta of the portfolio would
be —79.10, and the gamma would be 0.54 for an income of €5206. The investor has identified

Table 13.8 Option values, deltas, and gammas of three select options

Spot = %500, T = 3 months, r= 6%, and o = 25%)

Value as per BSM
Put at X = 550 %52.06
Call at X = 500 28.64
Call at X = 550 %10.25
384 Derivatives and Risk Management

Table 13.9 Values, deltas, and gammas of portfolio of three select options

Spot = 7500, T= 3monthes, r= 6%, and o = 25%)

Individual assets Portfolio
Option Value (%) No. |Cashtlow(%)| Delta | Gamma_|
Put at X = 550 ; : —100 +5,206

Call at X = 500 é : +11,672

Call at X = 550 i é : —5 914

+11,005 :

two calls with strikes of 500 and 550 to achieve delta and gamma neutrality. Assume that the
number of options traded are n, and np, respectively, for the calls at strikes of
The gamma of a stock ; é
is zero, and it is easier 500 and 550. We need to solve the following equations simultaneously:
to se 0.2810 n,; + 0.5724 n) + 71.90 = 0 _ for delta neutrality
ony a ee and 0.0054 n, + 0.0063 ny — 0.54 =0 for gamma neutrality
in stock, as compared to Solving these equations, we get n; = 577.03 (say, 577) and ny = —408.88
achieving itonly through (say, 409). Now the portfolio would comprise (a) 100 puts short, with XY =
derivatives.
550, (b) 577 calls long, with
XY = 500, and (c) 409 calls short, with
Y = 550.
The income, delta, and gamma of this rial are computed in Table 13.9
demonstrating delta and gamma neutrality.
The value of gammas for call and put options for non-dividend paying and dividend-
paying assets are tabulated in the table below:
No dividend yield Continuous dividend paying at q
Call gamma, I; r= Ndi) _ Nae
Put gamma, I, So VT eer
th

Ene 13.4 Gamma: calculation, interpretation, and neutrality

Refer to the data given in Example 13.3.

(a) Find the gamma of a call and a put. If a trader has written 1000 puts on the stock, what would be the gamma of the position?
(b) What does this figure mean?
(c) How could he/she achieve gamma neutrality through calls on the same asset?
Solution

(a) Gamma of call = gamma of put =

N'(d. 0.3819 0.3819
“SovT 400.30 x v050 8.4853.
(b) For the 1000 puts written, the gamma would be = —1000 x 0.0450 = —%45
This implies that if the value of the asset rises by %1 from %40 to $41, the value of delta of his/her position decreases by %45.
Similarly, if the stock fell to €39, the value of delta of his/her position rises by 45. This is consistent with the option price,
as the value of the put increases with the fall in asset price.
(c) To make the gamma of the position zero, the investor would have to buy an equal number of calls on the same asset with
the same strike and maturity. The gamma of the long positioning cail is equal to 0.0450, and 1000 calls bought would give
a cae of %45,
oe the ue of the put position.
WEEE EEE
 Option Greeks—The Sensitivities 385

~ OTHER GREEKS.
Vega
Among the lesser known and lesser used parameters of option price sensitivity is the vari-
_ ability of option value with respect to the volatility of the underlying. It is
The vega is the rate of
_ denoted:by vega, a non-Greek letter; those used to only Greek letters know
change of value of an
option with respect to it by the name of lambda or kappa.
changes in the volatility. The vega is the change of value of the option if the volatility changes.
Itis the same for calls Note that in option pricing, volatility is not an observable statistic. Instead,
it is implied in the option value.
Vega. = x for call; Vega, = Bb for put
The vega is positive for both calls and puts. In fact, it is volatility that drives the prices
of call and put options. Irrespective of the nature of option, an increased volatility means
increased valuation of the option and vice versa. We know that only historical volatility can
be measured, while the estimate of future volatility is implied in the option price. The vega
is a measure of change in the value with any change in the implied volatility.
Vegas for calls and puts are equal. In terms of the BSM, the vega for a call and a put option
on a non-dividend paying stock is given by
Vega = SVTN(d)) (13.10)
For a 3-m ATM call option with a strike of 500 on a stock with o = 25% and r = 6%,
the value of the vega is 0.9844, computed as follows:
_ In(S/X) + (7 + 0507) h
d
AE
_ In) + (0.06 + 0.5 X 0.25
3 x 0.25)
25) 9G:
X 0.25 _ 9 1955
0.25 V0.25
N’
] , 2 ] ¢ 2
d — = e 9-5a1* = ss e7 9.5% 0.1825° = 0.3923
( ) V2n V2n

The computation of the vega using Eq. 13.10 is as follows:

Vega = 500 X 0.3923 X v0.25 = 98.07

The call value is 28.64. The value of the vega of 98.07 suggests that for a 1% increase
or decrease in volatility (with o changing by 1% or 0.01), the value of the option would
change by 0.98 (98.07 X 0.01). As per the BSM, we find the value ofthe call with o = 24%
at $27.66 and with o = 26% at £29.62.
The vega is at its maximum when the option is at-the-money. As the option becomes
in-the-money or out-of-the-money, the value of the vega declines. For deep ITM and deep
OTM options, the value of the vega approaches zero, suggesting the declining importance of
volatility in determination of option values, as the spot price moves away from the exercise
price. Figure 13.7 depicts the behaviour of the vega with respect to the spot price.
The pattern of the vega with the spot value looks extremely similar to normal distribution.
It is because of the term N’(d,) in the computation. However, it gets modulated by multiplica-
tion by the spot price S.
386 Derivatives and Risk Management

Vega

S = 500, X = 500, o = 25%, t= 0.25 years, r,= 6%

500
Spot price

100
S = 500, X = 500, o= 25%, r,=6%

oO
oD)
®
>

3.00 2.50 2.00 1.50 1.00 0.50 0.00

Time to maturity (months)
GLOLLLLLMLLLLLLLLLOLNIOT TIRTEMER NRE PAE RLESEREEREPRE ARPES cee :

Fig. 13.8 Vega with time

With the passage of time, there is reduced scope for volatility to influence the price.
Volatility is directly proportional to the time available. When an ATM option comes into
existence, the importance of volatility is at the maximum, because maximum time is available
for the values to change. At maturity, the value of the option must be determined purely by
its intrinsic worth, as large fluctuations in the price (volatility concerns with changes in the
price) are almost ruled out. The behaviour of the vega with the passage of time is depicted
in Fig. 13.8.
The values of the vega for non-dividend paying and dividend paying assets are given
below:

No dividend yield Continuous dividend paying at q

Call vega, = Put vega SVT N(d) Se" VT N( dh)
 Option Greeks—The Sensitivities 387

Rho
The last of the Greek letters that denote sensitivity of option price is the rho, p, which gives
_ the rate of change of the option price with respect to a change in the risk-free
The rho is the rate of : ;
change of the value of interest rate. The rhos for call and put options are defined as follows:
an option with respect to
De _ &5 for call;ie p, eke 0p
Sr for put
changes in the risk-free
interest rate. The rhos for call and put options for non-dividend paying stock are given
Dyet@sel sal teandels 2: .
For a call option: Po = TXe~"™ N(d,) (13.11)
For a put option: pp — ike Na) (13.12)
The value of the rho is positive for a call and negative for a put. With a rise in the inter-
est rate, the present value of the exercise price would decrease, and therefore, the value of
the call, being proportional to (S — PV of X), would increase. The reverse would apply for
the value of the put, which is proportional to (PV of X — S). For dividend paying stock, the
formula for the rho remains the same as in Eqs 13.11 and 13.12. However, the value of d,
and, hence, M(d>) would change.
In terms of the BSM, M(d>) represents the probability that the option would be exercised.
The value of the rho is the time-weighted present value of the exercise price multiplied by
the probability of the option being exercised.
For options on currency, rho would stand modified by the foreign currency interest rates.
If r, denotes the risk-free rate abroad, then options on foreign currency would have the fol-
lowing rhos:
For a call option: p, = TSe-F Nas)
For a put option: Py = —TSe~'f” N(—dy)
For ATM 3-m call and put options on an asset selling at 500 with a volatility of 25% and
a risk-free rate of 5%, the value of the rhos are worked out as follows:
1; =
In(S/X) + (r
s
+ 0.507)T
VT
_ In) 0
+ (0.06 6ars0 0.5 Sxi0,250.25 38 0.25)
0:25)0%.0.De) AB ans
0.25 V/0.25
d> = d, — ovT =.0.1825 — 0.25v0.25 = 0.0575
and Md>) = 0.5229 N(—d,) = 0.4771

heretore=Osgem =n lee ING,) = 500 & 0.25% 6 88% ">< 0/5229

—a oe OOS x 05229 = 64:39
and Gs = —NXTe~"™ N(—d>) = —500 X 0.25 X e -86% 925 x 0.4771
= 125 X 0.93 x 0477 Ss58.75
The meaning of rhos of 64.39 for a call and —58.75 for a put is that with a 1% increase
in the risk-free rate, the call value would increase by approximately ~0.6439 (0.01 X 64.39)
and the put value would decrease by approximately €0.5875 (0.01 0.5875). The change in
the value of the option would be rather low with a change in the interest rate when compared
with the other determinants of option value.
388 Derivatives and Risk Management

Among the option Greeks, the rho has the least importance since changes in the risk-free
interest rate are neither large enough to impact portfolio values substantially nor frequent
enough to demand portfolio rebalancing. Only in cases of option portfolios with very large
maturities can the rho be of some significance.

SOLVED PROBLEMS
SP 13.1: Delta for call and put
Find the values of the delta for ATM call and put options with 3 months to maturity. The volatility of the asset price is at 30% and
the risk-free interest rate is 6% p.a.
Solution
For an ATM option, S = X and In(S/X) = 0. The value of d, is 0.1750, shown as follows:
In(S/X) + (r+.07/2)T _ 0 + (0.06 + 0.09/2)0.25
d, = = 0.1750
oVT * 0.30.25
Deita of call option = N(d;) = 0.5695
Delta of put option = Md;) — 1 = —0.4305

SP 13.2: Portfolio delta and neutrality

Under the BSM, the value of N(dj) is 0.75. If you have a long position of 120 shares, how can you make it insensitive to small changes
in the prices of the asset using derivatives?
Solution
The delta of stock is 1.00
The delta of a call option on the stock = N(d;) = 0.75
The delta of a put option on the stock = N(d,) — 1 = —0.25
The delta of a 120 long position in stock is 120, meaning that the value of the position would change by *120 if spot price changes
by %1. In order to make the value insensitive to price, we need to have a portfolio delta equal to zero, which can be had from the
delta of a derivative equal to —120. A short position in calls or a long position in puts would have negative delta, and can be used
for neutralizing the delta of the long position in stock.
No. of calls to be short = 120/0.75 = 160 calls
No. of puts to be bought = 120/(—0.25) = 480 puts
Either of the positions would make the portfolio delta equal to zero.
SP 13.3: Gamma of call and put
Find the values of the gamma of a call and a put for the data of the stock in SP 13.1, assuming the value of the stock at 200.
Solution
For an ATM option S = X and In(S/X) = 0. The value of d; is 0.1750, as shown here:

oO} =
In(S/X) + (r+ 07/2)T _ 0 + (0.06 + 7 0.09/2)0.25 = 0.1750
oVT 0.3 V0.25
NG 1
==="0 DRAG
Obays 1
—La¢€ AN.
0.50,1750* 2 — 0.392
(41) Ver Ven
r= N’(dh) = 0.3928 —— — 0.3928 ~ 0.0131
SoVT 200X030 V0.25 30
Gamma of call option = gamma of put option = 0.0131

SP 13.4: All Greeks

An asset is trading at 40 with volatility of 30%. The risk-free rate is 8%.
(a) Find the values of call and put options with an exercise price of 740 and maturity of six months. Further, find the delta, gamma,
theta, vega, and rho of the options.
 Option Greeks—
The Sensitivities 389

(b) Repeat the exercise for call and put options with a strike price of 50-and maturity of six months.
Solution
For S = 240, o = 30%, r = 8%, and T = 0.5 years
(a) For options with X = 40
We already have from Example 13.3
N(d,) = 0.6159 Md) = 0.5329 N(—d,) = 0.3841 NM—d,) = 0.4671
We also get N’(d;) = 7 e 05d? — 0.3819
1
Value of call = § Na) — Xe Nds)
= 40 x 0.6159 — 40 x 0.9608 x 0.5329 = 24.6360 — 20.4802 = 4.1558 ~ %4.16
Value of put = Xe (Nad) — S N—d:)
= 40 x 0.9608 x 0.4671 — 40 x 0.3841 = 17.9514 — 15.3640 = 2.5874 ~ %2.59
Delta of cali = 0.6159 Delta of put = —0.3841
Gamma of call = gamma of put = 0.0450 (Refer Example 13.4)
Theta of call = —0.0134/day
Theta of put = —0.0049/day (Refer Example 13.3)
Vega of call = Vega of put = SVT N’(d,) = 40 X V0.5 X 0.3819 = 10.8023
Rho of call = 0, = TXe™ Nd) = 0.50 x 40 X 0.9608 x 0.5329 = 10.2401
Rho of put = —TXe'™N-—d,) = —0.50 x 40 x 0.9608 x 0.4671 = —8.9757
(b) Option with X = 50
dine In(S/X) + (r+Z 07/2)T _ |n(40/50) + (0.08 + 0.09/2)0.50 _
oo = = —0.7573
oVT 0.30.50
d, = d, — oVT = —0.7573 — 0.3 V0.50 = —0.9694
N(d,) = 0.2244 N(d,) = 0.1662 N(—d,) = 0.7756 N(—d,) = 0.8338
1 _nsdqi2
We also
so g get N’(d,)
(d,) = ——
Von e 95° = 0.2994

Value of call = SNa,) — Xe-7 Na.)

= 40 0.2244 — 50 x 0.9608 x 0.1662 = 8.9760 — 7.9842 = 0.9918 = 0.99
Value of put = Xe~7(N — d,) — S N(d,)
= 50 X 0.9608 x 0.8338 — 40 x 0.7756 = 40.0553 — 31.0240 = 9.0313 = 9.03

Delta of call = Ma) = 0.2244

Delta of put = Md,) — 1= 0.2244 — 1 = — 0.7756
N’(dh) 0.2994 0.2994
f call t= C= = Ss = 0.0353
eee SoVT 40 0.30 V0.50 8.4853
DENIS
== — aX
a Nd,)
pee= 40s 0.2204 0.90 0.08 x 50e
re X 0.1662
ee DEMO. Sue 2 x V0.50
= —2.5407 — 0.6387 = —3.1794
or —<0.0087/day
=——
SN(A)O Xe"
yy N—d,)
_= 40 x 0.2994 x 0.30 + 0.08 x 50e
Pee ere X 0.8338
ae ia eens 2x V0.50
= —3.2407 + 3.2044 = 0.6377
or +%0.0018 per day

Vega of call = vega of put = SvTN‘(d,) = 40 x 40.5 X 0.2994 = 8.4691

Rho of call TXe~™ Nd.) = 0.50 X 50 X 0.9608 x 0.1662 = 3.9921
Rho of put —TXe~™ N(—d,)= —0.50 X 50 X 0.9608 x 0.8338 = —20.0277
 390 Derivatives and Risk Management

Values of all the four options are tabulated here:

The greeks S 40, r= 8%, T= 0.5, o = 30%

ForX = 40 For X = 50
Call ca Put Call Put
Value (%) 4.16 2.59 0.99 9.03
Delta (€) 0.6159 —0.3841 0.2244 —0.7756

Gamma (®) 0.0450 0.0450 0.0353 0.0353

Theta (¢/day) —0.0134 —0.0049 — 0.0087 0.0018
Vega 10.8023 10.8023 8.4691 8.4691
Rho at 10.2401 = O.0/ or 3.9921 20027
SP 13.5: Delta and gamma neutrality
Refer to the data of SP 13.4. If a trader starts with a short position of puts with X = 50, how would you make the portfolio delta and
gamma neutral simultaneously?
Solution
Initial position: short 1000 puts with X = 50
Income = 1000 x 9.03 = %9030
Delta = -0.7756 x —1000 = 775.60
Gamma = 0.0350 x —1000 = —35.30
For gamma neutrality with call at X = 40:
Gamma of call = 0.0450
Long position of calls required to neutralize the gamma = 53.30/0.0450 = 785 calls
For delta neutrality with stock:
Delta of position of 1000 short puts with X = 50, and 785 long calls with X = 40
= —1000 * —0.7756 + 785 x 0.6159 = 775.6 + 483.5 = 1259.1 say %1260
To have delta neutrality, the trader should short 1260 shares.

SUMMARY
The value of an option does not remain constant even if the price the delta is close to 1 for deep ITM calls, close to zero for deep
of the underlying asset does not change. Though the primary OTM calls, and around 0.5 for ATM calls.
determinant of the value of an option is the price of the underly- One property of the delta is that it is additive in nature. The
ing, there are other factors too that cause this to change. Once delta of a portfolio is equal to the delta of the individual securities
an option position is taken, the exercise price remains the same, comprising it, weighted by the number of securities. This helps
while the rest of the parameters, such as Spot price, time to in achieving delta neutrality, i.¢., setting the delta of the portfolio
maturity, volatility, and risk-free interest rate are dynamic. equal to zero, implying immunity of the portfolio value to small
The sensitivity of an option price with respect to each of the changes in the price of the underlying asset.
determinants except the exercise price is denoted by a Greek The theta of the option is the change in the option value with the
letter, and as such, option sensitivities are often referred to as passage of time. The value of the call declines as it approaches
option Greeks. The delta of an option is the change in the option maturity. However, this may not be true for put options. It is an
value with a small change in the spot price. In terms of the BSM, important statistic in the context of options to know by what value
the delta is given by N(d,) for a call and is positive, while for a the call would change each day. However, there is no hedging
put, it is Md,) — 1 and negative. A negative sign represents possible with respect to the theta of an option. The theta is nor-
the inverse relationship of the option value with the price of the mally expressed in terms of per day change in value,
underlying asset. The value of a delta represents the number of The gamma is the rate of change of the delta. It is the second
stock required for each unit of option for a hedging. The value of partial derivative of the option value with respect to Spot prices. It
 Option. Greeks—The Sensitivities 391

is the same for call and put options, and is always positive. The easier to achieve delta neutrality and gamma neutrality simulta-
desired value of delta that is achieved once does not remain the neously by taking a position in the underlying asset itself.
same. The portfolio needs to be re-balanced because the delta The vega is a change in the value of the option with respect to
changes with time. How often a portfolio needs to be re-balanced changes in the volatility of the underlying asset. It is identical and
is judged by the value of the gamma. The higher the value of positive for call and put options. Though said to be deriving the
gamma, the more frequent is the adjustments. Like the delta, the value of the derivative, the changes in volatility are not sudden.
gamma too has an additive property. Therefore, a study of the vega is relatively unimportant. So is the
_ For large positions, delta neutrality as well as gamma neutral- case with the rho, which is the change in value of the option with
ity is desired. This can be achieved by combining at least three respect to changes in the risk-free rate.
different derivatives. Since the gamma of a stock is zero, it is

Delta The rate of change of the value of the option with respect for any small change in the price of the underlying asset for a
to the spot price of the underlying asset. gamma-neutral portfolio.
Delta neutrality A portfolio whose delta is zero is called a Rho The rate of change of the value of the option with respect
delta-neutral portfolio. Its value remains the same for any small to changes in the risk-free interest rate.
change in the price of the underlying asset. Theta The rate of change of the value of the option with
Gamma_ The rate of change of the value of the delta of the respect to the time to maturity.
option with respect to the spot price of the underlying asset. Vega The rate of change of the value of the option with respect
Gamma neutrality A portfolio whose gamma is zero is called to the volatility of the underlying asset.
a gamma-neutral portfolio. The value of a delta remains constant

QUESTIONS ©
13.1 What do you understand by the sensitivities of option 13.4 What do you understand by the term time decay of option?
prices? Describe all the parameters and their importance. 13.5 What is the gamma of an option and why is its study impor-
13.2 What do you understand by the delta of an option? tant?
Describe its behaviour with respect to the spot price 13.6 What is gamma neutrality? What major problem would you
and time to maturity. How is it measured for call and put face in trying to achieve gamma neutrality?
options? 13.7 How would you make a portfolio delta as well as gamma
13.3 How do you find the delta of a portfolio? What are delta neutral? Illustrate with an example.
neutrality and delta hedging? Describe with the help of an 13.8 What do you understand by the vega and rho of an option?
example.

PROBLEMS
P 13.1 Option value and delta months to expire. The volatility of the underlying stock is 40%
The value of a 3-m ATM European call option on an asset whose and the risk-free rate is 8%.
current price is €100 in terms of the BSM is expressed as follows: P 13.3 Gamma of call and put
Call value c = 100 x 0.5678 — 100 x 0.9901 x 0.5382 For a spot price of €100, find the value of the gamma of the call
(a) What is the expected change in the value of the call if the and put option for the data given in P 13.2.
spot value goes up to ~102?
P 13.4 Delta neutrality
(b) What is the expected change in the value of the put if the
Refer to the data in P 13.2. If you are holding 10,000 shares,
spot value moves to $105?
what would you do to make them delta-neutral using (a) only call
P 13.2 Delta of options options and (b) only put options?
Find the value of the delta of ATM call and put options with three
 Lapinae

Volatility
and Value at Risk

INTRODUCTION Learning Objectives

Understanding risk and its management is becoming increas- After going through this chapter,
ingly complex over time. The variables readers should be familiar with
With globalization,
liberalization, and newer that can impact outcomes are becoming * the meaning of volatility
investment products, larger and larger in number as we prog- different ways of measuring
risk factors have grown ress increasingly from isolation to volatility
in number, making risk exponential smoothing and
global integration and liberalization. In
assessment and its man- exponential weighted average
the olden times, the primary concern method of computing volatility
ce ong
»» used to be the prices of commodities, the basics of the GARCH approach
viel ried meemtines due to weather conditions. As time pro- the conveyed volatility index
gressed, investment and savings got channelized into a variety the meaning of value at risk (VaR)
and its description
of instruments that exposed the returns to economic conditions,
methods for finding VaR
interest rates, and exchange rates. With the factors governing the historical simulation approach
risk becoming larger, we made increasing use of derivatives. the need for stress testing
Risk manifestations developed from one factor to another. For
managing price risk, we resorted to the use of derivatives. Soci-
eties prospered more and more, resulting in increased savings
and investments. With horizons expanding, investment portfo-
lios not only increased in terms of newer and newer products,
they also expanded in terms of the number of risk factors that
determined the values of these products, and, hence, of the
investment. The expanding menu of investment products was
accompanied by the derivatives to manage the risks on these
products. Portfolios now consist of basic products and deriva-
tives based on them. Portfolios became sensitive to changes in
spot prices, interest rates, volatility, time remaining for expiry,
etc. For better understanding and management of risk, we
explored sophisticated risk measurement parameters such as
Greek symbols in Chapter 13
 Volatility and Value at Risk 393

MEASURES OF RISK
We have had several measures of risk, depending on the sensitivity of the instruments to
There are different
_ various factors. Not all determinants affect value in the same manner; some
measures of risk for __ affect it more and some are less important. Changes in value with respect to
different investments a dominant risk factor can be evaluated by one measure of risk. A list of
and instruments. These measures of risk and their meanings is presented in Table 14.1.
predict changes in values Besides these measures, we also used techniques such as sensitivity analy-
based on given changes
ses and scenario analyses in corporate finance to improve our understanding
in the value of a critical
determinant. of the risk emanating from the large number of factors that are beyond our
control.

Table 14.1 Different measures of risk and meanings

Measure Meaning
A measure of risk of the changes in the returns of a stock or a portfolio, irrespective of :
Standard deviation, o
whether the changes occur due to unsystematic or systematic factors
Duration/modified duration’ | A measure of risk with respect to the changes in the term structure of interest rates
Macaulay's duration (yield curve) for a bond or a portfolio of bonds
A measure of systemaiic risk (market risk) causing changes in the value of a well-
Systematic risk, B diversified portfolio of stocks under the assumption that unsystematic risk has been
diversified away
A measure of risk quantifying changes in the level of earnings due to the composition
2 ee of cost structure in the firm

A measure of risk of changes to shareholders’ returns due to changes in the capital

Degree of financial leverage | structure of the firm; a measure of shareholders’ returns due to increasing/decreasing
levels of debt
Delta A measure of risk of changes in the value of an option or a portfolio of options due to
change(s) in the value of the underlying asset(s)
Thet A measure of the risk of changes in the value of an option or a portfolio of options due |
wy to the passage of time 3
G A measure of the risk of changes in the value of an option or a portfolio of options due 7
is to changes in the value of the delta ,
V A measure of the risk of changes in the value of an option or a portfolio of options due
la to changes in the volatility of the underlying asset L
Bh A measure of the risk of changes in the value of an option or a portfolio of options due L
: 2 to changes in the value of the risk-free rate of return L

VOLATILITY 2
With our inability to _ Volatility relates to changes in value arising from changes in market vari-
forecast the future, we ables. The source of the change is usually new information that arrives con-
rely on the historical past tinuously, causing changes in the overall market scenarios. Volatility is the
to peep into future events key measure of risk to the value of assets—stocks, commodities, derivatives,
ar Nope Wai stony _ etc. Volatility is said to be the key driver of the value of options. It is mea-
repeats itself. ae
. _ sured by standard deviation.
394 Derivatives and Risk Management

We also discussed implied volatility, which is reflected in the prices of options. Since the
value of options is driven by expected volatility, it was reasonable to peep into the future
through the prices of options. If options trade is healthy, it may be said to be a collective
reflection of the value the market places on volatility. The use of implied volatility, how-
ever, is limited to valuing options that are not being traded heavily. Volatility estimates from
deep in-the-money (ITM) and deep out-of-the-money (OTM) options cannot be relied upon,
because intrinsic value comprises a major component of the price for ITM options, and the
pricing of OTM options is too skewed for measuring volatility.
The standard way to measure volatility, probably arising out of our inability to look into
the future without considering the past, is to rely on historical data and assume that what has
been happening in the past would also happen in the future. Such an approach is appropriate
in situations where the concern is the immediate future, or where the forecast period is small
enough—for example, estimating probable losses over the next one day. As the time period
extends further back, the relevance of the past to the forecast starts decreasing.

EXPONENTIAL WEIGHTED MOVING AVERAGE

When we measured volatility by historical data in Chapter 12, we assigned equal weights to
each observation. For 100 daily returns (101 daily prices), we found the average and the stan-
dard deviation to arrive at the historical variability of returns and formed an opinion about
the probable volatility of returns in the future. A more rational approach would be to assume
that the recent past is more valuable than the distant past. Hence, recent variability in returns
must get more prominence in our forecast for the future, i.e., what happened yesterday is
more important than what happened 10 days back. Similarly, what happened 100 days back
is less important than what happened 10 days back, and even less important than the events
that happened one day back.
One way of assigning relative importance to past data based on its age is called the exponen-
_ tial weighted moving average (EWMA). Decreasing weights can be assigned
The exponential moving
average method to esti: to older data. If weights are exponentially decreasing with the age of the data,
mate volatility uses past -—«'it is called exponential smoothing. The general form of assigning different
data, with importance _ weights to different observations (returns, r) is given by Eq. 14.1.
given in an exponentially n—1
decreasing manner as On Sle dit CGR oa (14.1)
the data gets older. l
where ©; is the weight assigned to the observation i days ago. All o;’s are
positive, and their sum must equal one. Where the weights a decrease exponentially, it
becomes EWMA Model. The EWMA is called a moving average model because every day,
the oldest observation in the data set is replaced by the latest one.
Translated in terms of variance, Eq. 14.1 for the variance of the nth day would become
Eq. 14.2, given here:

Og WAC veal eee (14.2)

Here the variance for the day n is equal to the sum of (a) the variance for the previous
day multiplied by its weight and (b) the square of the most recent return multiplied by
its weight. The sum of the weights of the past variances and the most recent returns must
 Volatility and Value at Risk 395

equal 1. Specifically, if A is the weight of the past variance, then the new variance would
be given by Eq. 14.2.
We compute the variance progressively, i.e., by updating it with each observation, usually
made once a day. This is often referred to as the variance rate. The biggest advantage of
the EWMA is that one does not need to store all past values; only two values are required
to find the volatility—the most recent volatility, o, and the most recent return, 7. Every day,
we need to have the most recent estimate of volatility and return to arrive at the estimate of
volatility for the next day. Volatility estimates based on historical values of volatility would
require storage of all past data to the extent we consider them important for inclusion in our
estimate.
If the daily volatility at the opening of Monday was estimated at 1.5%, and on Monday the
stock registered a gain of 2%, then the estimate of volatility with 2 = 0.90 for the next day,
1.e., Tuesday, would be 1.5572%, which can be estimated by using Eq. 14.2, as shown here:

o? = 0.90 X 0.0152 + 0.10 X 0.922 = 0.0002025 + 0.00004 = 0.0002425

or 0, = 1.5572%
Looking at Eq. 14.2, one may believe that the values on the left hand side are positive,
and, therefore, there would always be an increase in volatility from the past. However, this
is not always true. A previous volatility at 1.5% means that under the random behaviour of
stock prices, the expected return the next day is zero, with a standard deviation of 1.5%. If the
actual returns are less than 1.5%, then there would be a reduction in volatility. If the returns
are more than 1.5%, volatility would increase, and if the returns stay at 1.5%, the volatility
for the next day remains unchanged. Assume that on Monday the return was not 2, but 1%.
In this case, the estimate of volatility for Tuesday would be 1.46% as shown here, again using
Eq. 14.2:

o? = 0.90 X 0.0157 + 0.10 X 0.017 = 0.0002025 + 0.00001 = 0.0002125

or 0, = 1.4577%

One parameter that requires managerial discretion in the EWMA model is the selection
_ of the weight to be assigned to past volatility, A,. A higher value of A would
ee the give greater importance to the past and lesser importance to recent data. A
low quantum ofdata that decreasing value of A would imply that the past is less inmiportant compared
_ to recent changes, A low value of A would make the estimates of volatility
fluctuate more wildly with current returns and there would be less of a
smoothing effect. We need to find the correct balance between the importance of past volatil-
ity and the most recent returns. The A is, therefore, referred to as the smoothing constant.
RiskMetrics® (developed by J.P. Morgan) and its database, made public in 1994, used
a value of A = 0.94 after testing and confirming that this value provided the best results
when measured in terms of estimated variance and actual variances. Therefore, the value of
A = 0.94 is the most widely used in the industry. The variance calculations for the purpose
of determination of margins by the National Stock Exchange (NSE) in India also use the
EWMA method with A = 0.94. The physical significance of A is that with each progressing
day, the weight reduces by the factor of A. If A = 0.94, then the observation on a given day
would have 6% (100 — 94%) weight for the next day. Therefore, A is also referred to as the
396 Derivatives and Risk Management

Margining system with EWMA and VaR

Standard deviation is the central component when it comes to managing risk. Exchanges all around the world assume default risk,
and, therefore, seek to adequately protect themselves. A single default has the potential to cause an avalanche with catastrophic
proportions. Stock exchanges in India (the NSE and the Bombay Stock Exchange, BSE) adopt three layers of margin—initial
margin to cover for potential loss over one day, marking-to-the-market margin to settle daily profits or losses, and extreme joss
margin to cover for situations not covered by the initial margin.
The initial margin is determined by using EWMA with A = 0.94 as follows:
Calculate the log returns A, = In(P,/P,4) on a daily basis for one year.
ENE
Calculate the initial standard deviation of returns as 09 = @ (A A)
j n

After Gp, obtain standard deviation for day 1 as o; = \Aos + (1 — A)RG

This is calculated on a daily basis for each stock listed on the exchanges. For example, on a given day, if the previous volatility
was 3.14% and the stock closed at 360 with the previous closing at €340, then the updated standard deviation would be
0, = \Ao%+ (1 — ARI
= \ 0.94 x 0.0314* + 0.06 x 0.0588* = 0.0337 = 3.37%
The standard deviations for the two indices, i.e., Nifty for NSE, Oyiny, and SENSEX for BSE, Ogensex. are calculated in the
same fashion.
The initial margin is considered a function of (a) the stock volatility, characterized by its standard deviation and (b) its liquidity,
characterized by the frequency of trade and impact cost. The margins for individual stocks are divided in three groups—Group |,
Group II, and Group Ill—and the applicable initial margins are worked out as follows (ois the standard deviation of the shares):

Group | Traded on at least 80% of the days in the last six 3.5 X o, subject to a minimum of 7.5%
months, with an impact cost of less than 1%
Group Il Traded on at least 80% of the days in the last six |V3 X 3 (higher of Gyity aNd Ogensex)
months, but with an impact cost of more than 1% | or 3.5 x o, whichever is higher.
Group Ill All others V3 X 5 (higher Of Onin, aNd Osensey
The extreme loss margin for any security is 5% or 1.5 times the standard deviation of the daily logarithmic returns of the security
price in the last six months, whichever is higher. This computation is done at the end of each month by taking the price data on
a rolling basis for the past six months, and the resulting value is applicable for the next month.

Source: Based on information available at the website of NSE, www.nseindia.com, last accessed on 10 October 2012.

decay rate. There would be an exponential decrease in the value of any observation as time
progresses, 1.e., an observation of the previous day would have a weight of 6 X 0.94 = 5.64%
and an observation for two days earlier would have a weight of 5.30% (5.64% X 0.94).

CORRELATION AND COVARIANCE |

While dealing in multiple assets, not only is variance important but also the relationships
among the assets gain prominence. In a portfolio of large assets, the risk is
The EWMA method can ;
be extended to update dominated more by covariance and not as much by variance, as has been
correlations and cova demonstrated by Harry Markowitz. We can use a similar approach in the
ances. EWMA model for updating volatility and covariance between assets, and,
hence, updating the coefficient ofcorrelation that impacts covariance. Using
 Volatility and Value at Risk 397

nw
EXAMPLE 14.1. Revising volatility
(The volatility of a stock A today is estimated to be 5%. If during the day the stock declines by 3%, what would your estimated volatility,
for tomorrow be under the EWMA method if the decay rate is assumed at 94%? L
Solution
Using Eq. 14.2 of the EWMA for finding the revised volatility estimates, we have L
= Ao, + (1—Ajre_, = 0.94 x 0.05 + 0.06 x 0.03? 7
= 0.00235 + 0.000054 L
= 0.002404
Or o, = v0.002404 = 0.0490 = 4.90%
The volatility has declined from the previous day, because the return of the stock for the day (3%) was less than the previous.
estimate of volatility (5%). y

a logic similar to that used for updating variance, the EWMA method for covariance is given
by Eq. 14.3, replacing variance with covariance.

Cov(x, Yn 7 ACov(x, Ded a a a eig e (14.3)

where Cov(x, y), 1s the new estimate of covariance, Cov(x, y),,—; is the most recent covari-
ance available and x,,_; and y,,_; are the most recent returns of assets X and Y, respectively.
Assume that the correlation, p, between two assets X and Y is 0.7 today. The assets’
volatilities are 2% and 6%, respectively. The covariance today between the two assets is,
therefore, 90,0, = 0.7 X 0.02 X 0.06 = 0.00084.
If today, assets XYand Y registered returns of 2% and 3%, respectively, then the respective
volatility estimates for tomorrow would be (using Eq. 14.2 with A = 0.9) as follows:
ForX, 0% = Ao2_, + (1—A)r2_, = 0.9 X 0.0004 + 0.1 X 0.0004 = 0.00040
Therefore, the new volatility for XYis /0.0004 = 0.02 = 2%

ForY, o2 = Ao2_,
+ (1—A)r2_, = 0.9 X 0.0036 + 0.1 X 0.0009 = 0.00333
The new volatility for Y is 0.00333 = 0.0577 = 5.77%
The revised estimate of covariance between X and Y using Eq. 14.3 is

Cov(x, Y)n o ACov(x, Vn-1 1 Ve Aer

= 0.9 X 0.00084 + 0.1 X 0.02 X 0.03 = 0.000816

Therefore, the new coefficient of correlation would be

COW, Vy 0.000816
Corrs, Yn = Gg,
nn
= 0.02 x 0.0877 » 07071
GARCH (1, 1) MODEL &
Volatility changes over a period of time. A volatility estimate made in the past does not
continue to remain valid in the future. In 1982, Robert Engle measured the time-varying
volatility of inflation rates in the UK. The model used by him was named auto regressive con-
ditional heteroskedasticity (ARCH), which meant that the natural way to revise an estimate
of variance is to average it out with the most recent observed variance. The model assumes
398 Derivatives and Risk Management

EXAMPLE 14.2 Revising covariance and correlation

Along with stock A as described in Example 14.1; consider another stock B, whose volatility estimate for today is 10%. Its correlation}
with stock A is estimated at 0.60. Stock B’s return today is +5%.
What is the new estimate of volatility for tomorrow under the EWMA method if the weight assigned to the past variance is 94%
for stock B?
What is the present covariance and new estimate of covariance for tomorrow after today’s outcomes using the EWMA method,
with the weight assigned to the existing covariance at 94%?
Solution
he present estimate of covariance between A and B, Cov(A, B),_; is 0.60 x 0.05 x 0.10 = 0.003.
Using Eq. 14.2 of the EWMA for finding the revised volatility estimates for stock B, we have
o2 = Ao2_, + (1-Ayr2_, = 0.94 x 0.12 + 0.06 x 0.082
= 0,0094 + 0.00015
= 0.00955
Or 0, = v0.00955 = 0,0977 = 9.77%
The new estimate for covariance would be

COVA, B), = ACOMA, B)n—1 + (1—A)Xn—1Yn—1

= 0.94 x 0.003 + 0.06 x —0.03 x 0.05 = 0.00282 — 0.000090 = 0.00273
The new estimate for the coefficient of correlation is
_ CoA, B), _ _—*0.00273
= 0.5703
Core os Oy, Oy, 0.049 X 0.0977 |
Correlation has reduced because of the opposite movement caused by stocks with A registering a loss of 3% and those with
B showing a gain of 5%. ]
EET.

that volatility evolves over time slowly, as new observations are added. It depends upon the
previous estimate and the most recent squared residual return, which is an unbiased estimate
of variance. The method allows updating of the variance with the previous estimate, and an
unbiased estimate of the new information is obtained.
The important difference between the ARCH and EWMA methods is that ARCH assumes
The exponential moving that variance is mean reverting—it tends to get back to its long-term average.
average is not mean- _ The weight given to the long-term average in the computation of variance
reverting, Itisseen that would be the rate of reversion. The EWMA model is not a mean-reverting
volatility returns to the model. In practice, it is observed that variance tends to revert to a value that
long-term average. The _ can be called a long-term average, and, therefore, the ARCH model is con-
ARCH and GARCH ap-
proaches assume mean _ sidered better than the EWMA.
reversion, and hence, _ Another model, generalised auto regressive conditional heteroskedasticity
are preferred over the (1,1) (GARCH, developed by Robert Engle and Bollerslev) states that vari-
EWMA. _ ance comprises the following three components:
(a) Long-term average variance, V,
(b) The variance in the immediate past, o,,—,
(c) The return in the immediate past, r,,_;

Under GARCH (1, 1), variance at time n would be given by Eq.14.4.

07 = aV, + bo2_, + cr2_,

2
(14.4)
 Volatility and Value at Risk 399

where a, b, and c are the non-negative weights assigned to the long-term average variance,
recent volatility, and recent returns, respectively, and

abe |

The model assumes that variance tends to revert to some mean value given by the long-
term variance. The weight assigned to it, a, signifies the rate of reversion. The variance tends
to be pulled back towards the long-term average. In case the value of a is negative, the vari-
ance would not be mean reverting but mean diverging. Under such a case it is better to use
the EWMA model, which is a special case of the GARCH model. With a = 0, b = A, and
c = | — A, the model reduces to the EWMA model.
The (1,1) signifies that variance estimates include one recent observation each of immedi-
ate variance and immediate returns. Similarly, (2,3) would mean that the variance includes
two recent observations of variance, and three recent observations of returns. The most popu-
lar version used is GARCH (1,1). The GARCH model has been applied extensively for stock
markets, interest rates, and exchange rates.

VOLATILITY INDEX
Volatility measurement from past data is needed to find the value of options. It is one
extremely critical input that is not observable, but options values are heavily dependent on it.
However, the prices of options are observable. The value of an option implies volatility. The
higher the value of the option, the higher is the volatility. Assuming that the Black-Scholes
Model (BSM) correctly assigns values, any divergence in the market value and the BSM
value is attributable to the estimates of volatility. For correctly valuing an option, we need an
estimate of volatility that holds good for the coming days till the expiry of the option. Hence,
the market values of options that imply volatilities for the option period should be reflective
ofthe future, not in isolation but in aggregation. The values of options are higher with higher
expected volatilities and vice versa.
Based on these concepts, an estimate of future volatility on any asset can be derived from
the values of the options traded on those assets. If the underlying is a stock,
The volatility index is _ the option values would reflect its volatility as anticipated for the option period.
an attempt to forecast Tf the underlying is an index, the volatility values would represent general
Bor cite a ; sentiments about market volatilities anticipated in the immediate future, with
on the prices of actively _ a broader measure of risks in the future. Just as we treat inflation as a repre-
traded options. _ sentative of economic performance, and a stock market index as reflective of
the market’s general sentiments, a volatility index (VIX) is used to represent
the general perception of market volatility anticipated for the future. While inflation rates and
stock indices measure performance based on current observations and have historical signifi-
cance, the VIX is not a measure of past volatility but of future volatility and has prospective
significance. [t is because of this fact that option values hide future volatility within themselves.
Volatility measurement based on the prices of options was first introduced by the Chicago
Board Options Exchange (CBOE) in 1993. It was a weighted measure of the implied volatil-
ity of eight S&P 100 at-the-money (ATM) put and call options. It was called the Volatility
Index (VIX*). Ten years later, in 2003, CBOE changed the composition and methodology
 400 Derivatives and Risk Management

of the VIX for a more accurate and robust view of investors expectations on future market
volatility in the following ways:
e The underlying asset was expanded to use options based on a broader index, the S&P -
500 rather than the S&P 100. A broader index meant greater participation of investors.
e It included a wide range of strike prices rather than only ATM options to capture the
whole volatility skew, rather than just the volatility implied by ATM options.
e It calculated volatility directly from index option prices, rather than using an algorithm
that involved finding implied volatilities out of an option pricing model.
The CBOE also introduced products based on VIX, such as futures and options, in 2003.
The original VIX was constructed using the implied volatilities of eight different OEX®
(ticker for American-style options at the CBOE, and XEO®, which represents European-style
options) option series so that, at any given time, it represented the implied volatility of a
hypothetical ATM OEX option with exactly 30 days to expiration.
The VIX measures the market expectation of near-term volatility conveyed by stock index
option prices. VIX values of greater than 30 are generally associated with a large amount
of volatility as a result of investor fear or uncertainty, while values below 20 generally cor-
respond to less stressful or even complacent times in the markets.
The VIX is based on real-time option prices, which reflect investors consensus view of
future expected stock market volatility. During periods of financial stress, which are often
accompanied by steep market declines, option prices—and VIX—tend to rise. The greater
the fear, the higher is the VIX level. As investors’ fear subsides, option prices tend to decline,
which in turn causes VIX to decline.
Most major exchanges, including those in India and Hong Kong, have adopted the VIX
methodology of CBOE to find their own estimates of volatility. Volatility indices for Nifty
in India and Hang Seng in Hong Kong are already using the same methodology, adapted to
local conditions.
The methodology followed by NSE to arrive at the India VIX in a simplified version is
presented in the box, which can be skipped without any loss of continuity.

_COMPUTATION OF INDIA VIX*

. computing the VIX, only OTM options are ooneders When a

_ The VIXin India,
_ put is out-of-the-money, and vice versa. A chain «
computed by the NSE, ent strikes is considered for computation of Inc
is arrived at using prices The India VIX gives the volatility estimate
of the near-month series ssumed to be the next 30-day period. For a lar.
and the next-month , s higher, and the VIX would have a higher va
series of OTM options on
_VIX would be lower. It is expressed as an ¢
SSG

the NIFTY index to cover

the next 30 days. he option prices, as option values are.
volatility. Higher prices of options indi
lectronic order book for options at exchanges
- future volatility.
Volatility and Value at Risk 401
402 Derivatives and Risk Management

Strike Call prices Put prices

price | Bid iC Ask old Bid | Ask
4,500 1.00 1.20 0.000005439
4,600 5.00 | 6.00 es. 0,000026025
4,700 | — Ignored, being ITM options 12.00 | 13.00 0.000056656
4,800 - 33.00 | 35.00 0.000147751
4,900 41.00 | 42.00 : ; 0.000173058
5,000 52. 45.00 | 46.00 0.000193238
5,100 0.000155901
5,200 0 0.000114786
5,300 : Ignored, being ITM options 0.000073070

5,400 00° : 0.000044637

5,500 | 4. 0.000014894
0.001005456

0.081553640
 Volatility and Value at Risk 403

0.000012408
0.000035624
Ignored, being ITM options 0.000061424
0.000170131
0.000205119
60.00 | 63.00 | 61.50 | | | 0,000257301
55.00 | 56.00 0.000214464
34.00 | 35.00 x 0,000128237
22.00 23.00 Ignored, being ITM options 0.000080507
1400 | 1500 | i46¢ 0.000049978
5.00 | 6.00 0.000018274
0.001233467

0.024335978
404 Derivatives and Risk Management

While academicians and practitioners kept investigating risk measurement and management
as products developed, the need was felt to have a rather simplified and yet
VaR is acomprehensive = comprehensive measure of risk. While different risks impact different securi-
ee eee ties, there is a need for tools that enable integrated views on the potential
tells users ifthe lossona EAS
portfolio over aspecified losses that can be made on a portfolio in a given period of time, for the
period would not exceed purposes of examining the adequacy of capital and ensuring the prepared-
it (VaR) with some speci- ness of financial institutions to overcome crisis situations.
fied confidence level. == The value at risk (VaR) approach is one such tool, which has become
sisi eaeaiiaaaiastaiaaailin popular recently. The credit for using VaR as a risk-measurement tool is
attributed to Dennis Weatherstone, CEO of JP Morgan, who wanted a consolidated and com-
prehensive, yet simple and singular measure to understand what deterioration can take place
in the value of a portfolio at the end of each trading day, 1.e., what dollar amount could be lost
over the next day to assess the risk the bank was exposed to. In a way, he sought an answer
to the question “How much worse can things get?”
The portfolio of the bank would consist of a huge variety of investments, and each invest-
ment is sensitive to several macro-economic factors, though we tend to condense the risk
into one or two important measures. A portfolio of stock 1s primarily exposed to market risk
measured by its beta. A portfolio of fixed-income securities is exposed to changes in the
interest rates. If the yields rise, the value of the portfolio falls. Similarly, holding stocks of
various currencies is subject to the risk of changing foreign exchange rates. A loan portfolio
is Subject to credit risk. If the portfolio was global, the situations and risk parameters would
become increasingly complex. For a financial institution such as a bank, the size of the port-
folio is large, which adds to the complexity of risk management. In addition, if derivatives
are also included in the portfolio, several other risk factors are added.
In case a portfolio consists of stocks, bonds, and currencies, the individual measures of
risk such as duration ofbonds, beta of the portfolio, standard deviation of stock, and option
Greeks do not provide for a firm-wide comprehensive assessment of risk. These measures
focus on one variable and the sensitivity of the value due to a single variable. A firm is
exposed to several investments that are predominantly sensitive to one or two variables.
While it is important to understand the implications of changes in the major variables on the
value of a specific investment, it is perceived that since the variables are correlated, a change
in any of the variables is capable of influencing other investments, and, hence, the total port-
folio value. For example, the risk of change in the value of a portfolio of stocks is condensed
in its beta, but changes in the interest rates (predominantly affecting the portfolio of bonds)
also cause changes in the value of the portfolio of stocks, due to changes in market returns,
even though the beta may remain unchanged.
A comprehensive measure of risk becomes extremely important for those who hold a
variety of investments. One such situation is a firm in the financial sector that is exposed
to a variety of risks—deriving from a credit portfolio subject to default risk; investments in
government securities subject to interest rate risk; exposure to foreign currencies subject to
exchange rate fluctuation risk; investment in stocks subject to market risk; and so on.
 Volatility and Value at Risk 405

Features and Concerns of the Financial Sector

The distinguishing features of banks and financial institutions as compared to any conven-
Financial institutions and tional industrial firm are (a) the high degree of leverage and (b) the absence
banks are dierent from _ of tangible and physical assets. Financial institutions operate in a highly
industrial corporations leveraged environment; their depositors lend to them rather than subscribe
with respect to high debt, to the capital, and, hence, these institutions are susceptible to failure. They
_ lack of tangible assets, need to be capitalized adequately to protect their lenders (depositors) by
lack of control by deposi-
providing for potential losses. They should be able to absorb adverse situa-
tors, and the possibility of
a run on the banks. tions with their own financial reserve strength and not by impinging upon
the claims of depositors. Further, financial firms typically have very little
fixed and tangible assets to back them in adverse situations or to provide a sense of security
to their shareholders. Due to high leverage and lack of tangible assets in financial sectors,
the position of shareholders of financial firms such as banks or insurance companies is
extremely precarious. To create shareholder value, the measurement of risk and its manage-
ment assume great significance. Shareholders of financial institutions/firms do not have
much of an ability to diversify the credit or default risk they face from the operations of these
institutions/firms.
The financial sector is also characterized by a run on banks in case of adverse scenarios.
The banking sector and financial institutions remain fragile, and, hence, must handle risk
with utmost care. One way of safeguarding the interest of shareholders as well as creditors
(depositors) is to capitalize the bank adequately, so as to take care of potential losses in most
situations. A comprehensive firm-wide measure of risk is required to manage it. One such
measure is the VaR. ;

DEFINITION AND MEANING OF VaR ©”

The value at risk is defined as the level of potential loss on a portfolio over a period of N days
_ that it would not be exceeded with X% chance, called the confidence level.
VaR is defined in terms
_ Typically, a period of one day is taken for computing VaR, and the confidence
of absolute or percent : : -
value of loss that can _ level is between 99% and 95%. For example, if 1-day VaR with a 95% confi-
take place over
a period dence level is, say, ¥1 crore, it simply means that the bank/firm holding the
of Ndays with X% confi: nortfolio would see a loss on the portfolio of less than 71 crore on 95 out of
dence level. Xand Nare : 100 days. For the remaining five days, the loss would exceed ¥1 crore. This
oo aioe: loss would be on account of market risk, with other risks such as counterparty
_ tisk excluded.
The VaR can be expressed either as an absolute value or as a percentage ofthe value ofthe
portfolio. It is dependent upon the time horizon (number of days) and the confidence level.
All these parameters are user-defined.

VaR with Normal Distribution

To illustrate the concept of VaR, we take recourse to the all familiar bell-shaped curve of
normal distribution. Assume that portfolio returns are normally distributed with a mean of
406 Derivatives and Risk Management

wand a standard deviation of o. In such a case, a 95% 1-day VaR would correspond to the
area under the standard normal distribution curve at 100 — X = 5% cumulative probability.
This typically happens at 4 1.650.
Any portfolio that has a distribution of return as normal can be converted to an equivalent
z-score for standard normal distribution by subtracting the mean and then dividing by the
standard deviation. The z-score in standard normal distribution is given by (x — j1)/o. The
95% confidence interval happens at a z-score of 1.65 and the 99% confidence interval occurs
at 2.33. Therefore, the VaR is given by
VaR with an X % confidence level
= Probability that loss does not exceed (100 — 95)%
=i P(z Ss 100 eX ))

For example, consider a bank that owns stock of Reliance Industries Ltd, with an expected
return of 10% and a standard deviation of 20%. The VaR with a 95% confidence would be
10 — (1.65 X 20) = —23% return. This is depicted in Fig. 14.1.
If the market value of the holding is €10 crore, then there is a 95% chance that any loss on
the value would not exceed —23%, i.e., 2.30 crore over a period of one year. For the purpose
of risk management for a bank, the implications of VaR may be either of the following.

(a) The VaR method provides a summary measure of the risk the bank is exposed to, and
hence, serves as a comprehensive measurement of capital adequacy. Thus, for the bank,
which likes to provide for 95% of possible situations, a capital cushion of €2.30 crore
is required.

seems Probability

soem Cumulative probability

Probability

g g ¢

; setQOOE en i
all a
idles PO rrevecvcererecesnssscbstmcecicnuretoeSunervecmnipreecensceceassteceveserveesi
omen 3 ae AE { i voice
{ } $

-50% 40% -30% '-20% -10% 0% 10% 20% 30% 40% 50% 60% 70%
i

Fig. 14.1. Normal and cumulative normal distributio

 Volatility and Value at Risk 407

(b) The VaR method can serve to arrive at a comprehensive figure that may limit the risk-
weighted assets of financial institutions. If the bank is capitalized to a lesser extent, say
~1.50 crore, and cannot capitalize to the desired level, then it must reduce its exposure
to the stock of Reliance Industries Ltd to 6.52 crore (1.50/0.23). The sale proceeds
of ¥3.48 crore may be invested in risk-free securities. (Remember, though, that these
securities too would not really be free from risk, as they would predominantly carry
interest rate risk.)

Risk and Time Risk compounds with time, but not linearly. If one holds a portfolio for
longer than one year, say for two years, would the risk increase to twice as
The VaR is usually cal! = = much? The risk, as measured by standard deviation, compounds with the
ea 0 he ey ac square root of the period. Our illustration for explaining VaR was based on
then scaled forthe time e ae ; ?
honor the confidence | the annual distribution of returns on the stock of Reliance Industries. Typi-
interval chosen is usually Cally, for the purpose of determining VaR, a period of one day is taken. Under
between 95% and 99%. the assumption of returns being independently and identically distributed
pr normally, the following relationships prove handy in converting the risk mea-
surement of the VaR for the period under consideration.
N-day VaR = 1-day VaR X VN
or 1-day VaR = Annual VaR/VN

EXAMPLE 14.3 Return, risk, and VaR for a single asset

Assume that the stock of ITC has an annual expected return of 25%, with an annual volatility of 15%.

(a) What return and risk do you expect over a period of one 95% and 99% confidence? :
day? (d)a What percentage of value would you provide for losses |
(b) What return and risk do you expect over a period of 10 over one day and 10 days for covering 95% and 99% |
days? outcomes? L
(c) What is the range of returns for one day and 10 days with
ee 250 days in a year.
Solution

(a) One day + 7.99%

The 1-day return on ITC stock = 25/250 = 0.1% (d) Value at risk
The 1-day standard deviation = 15/250 = 0.95% 1-day VaR with 95% confidence = 1.65 x 0.95 =
(b) 10 days 1,5675% :
The 10-day return on ITC stock = 25/25 = 1.00% 1-day VaR with 99% confidence = 2.33 x 0.95 = ]
The 10-day standard deviation = 15/v25 = 3.00% or 2.2135% ,
(0.95110) 10-day VaR with 95% confidence = 1.65 x 3.00 = |
(c) The range of return over one day 4.95% L
With 95% confidence = 0.10 + 1.65 x 0.95; — 1.4675 to 10-day VaR with 99% confidence = 2.33 x 3.00 = |
+ 1.6675% 6.99%
With 99% confidence = 0.10 + 2.33 x 0.95; —2.1135%
to + 2.3125%
Range of return over 10 days
With 95% confidence = 1.00 + 1.65 x 3.00; —3.95% to
+ 5.95%
408 Derivatives and Risk Management

If the 95% VaR in this illustration was —23%, then, based on roughly 250 trading days,
the 1-day VaR would be —23/\250 = —1.46%,i.e.,%14.60 lakh, and the 2-week VaR with 10
trading days would be —1.46 X \10 = —4.62%, i.e.,%46.20 lakh. The daily returns would
have a mean of 10/250 = 0.04%, and a standard deviation of 20/V250 = 1.26%. With normal
distribution, the returns would fluctuate between 0.04 + 1.65 * 1.26 = 2.12% and 0.04 —
1.65 X 1.26 = —2.04% on 95% (about 238 in number) ofthe days.
VaR is usually computed for a 10-day period. The normal way of arriving at this figure
would be to compute the VaR based on 1|-day returns and then find the 10-day VaR as the
1-day VaR X v10.

Portfolio Effect on VaR

Under the portfolio approach, broadly classified as the parametric approach, calculation of
the VaR for a portfolio would be based on the portfolio returns and risk, and would involve
correlation coefficients among the stocks of the portfolio as additional inputs. Assume that a
bank has a portfolio of Reliance and ITC shares with equal investment of 10 crore in each.
Based on a 10-day period, the VaR with a 99% confidence on each of the stocks would be
~163.10 lakh (refer to the table as follows).

Annual volatility 10-day volatility 99% 10-day VaR

Reliance ~1000 lakh 20% 4% 9.32% = €93.20 lakh
ITC %1000 lakh 15% 3% 6.99% = %69.90 lakh

If the correlation of the two is estimated at 0.5, then the portfolio variance would be

Of 0 + fy Ox or LP h01G>
= 0:25 X 400 0:25 < 225 + 205 X 05200 F< 205 15

The standard deviation of the portfolio is 15.21%, and the 10-day standard deviation
would be 3.04%. For a 99% 10-day period, the VaR would be 2.33 X 3.04 = 7.09%.
The VaR would be 7.09% xX 2000 = %141.80 lakh. The VaR stands reduced due to the
portfolio effect.
In practice, loss in a portfolio may not be normally distributed. If so, the actual distribution
of loss over a given period is computed and the probability distribution plotted. For a 95%
VaR, the fifth-percentile loss gives the VaR. For example, if 100 observations are made and
the portfolio loss or profit is tabulated, then the fifth worst loss would correspond to the 95%
VaR. Similarly, for a confidence interval of 99%, the first percentile would give a 99% VaR.

DECISIONS IN VaR
There are two variables in computing VaR that managers have to keep in mind while making
decisions:

@ Selection of confidence level

e Selection of time period
 Volatility and Value at Risk 409

Selection of Confidence Level

The confidence level specifies the frequency of occurrence of maximum loss. A 95% VaR
implies that on 5 out of 100 days, the loss would exceed the VaR estimate. Similarly, a
99.9% VaR assumes that the loss would exceed the VaR estimate on | out of 1000 days, 1.e.,
approximately once in three years.
Providing capital adequacy according to the VaR method would mean increased safety,
with an increased confidence level of VaR. The larger the confidence level, the lower is the
risk of facing capital inadequacy. A 99.9% VaR would be much higher than a VaR based on
a 95% confidence interval. Not only is the provision of capital adequacy large but also it
would be unrealistic, to have a confidence level as high as 99.9%. It is unrealistic because it
is indeed difficult to verify the statistical accuracy of a confidence level that is over-cautious.
Confidence interval selection is based on normal distribution assumptions. It may be
argued that bad events do take place more often than suggested by normal distribution. Fur-
ther, when such events do occur, the magnitude of losses would be much higher because of
the high degree of correlation amongst the variables that determine the returns. For example,
political instability may cause a simultaneous crash of the bonds market, the stock market,
and the exchange rate market. Under extremely adverse conditions, they tend to act together
to the detriment of the value of portfolios. Under normal conditions, these markets may have
a lower correlation with each other, or their relationship can be established through a model.
The model breaks down under extremely adverse conditions.
It is observed that a confidence level of more than 95% tends to lose validity.

Selection of Time Horizon

The other important determinant of VaR is the time horizon. The usual calculation of VaR is
based on the daily returns, and then an appropriate scaling factor is used for the number of
days of safety required, depending upon the organisational needs. Under the assumption of
normal distribution, the scaling factor is the square root of the time period.
A financial institution having a marketable portfolio can unwind its position in a short
period of time and, hence, can use a lower time period. Corporates that do not have a trad-
ing portfolio may choose to opt for longer time horizons, such as a quarter. It may also be
suggested that selection of the time horizon must be based on the liquidity of the assets.
Different assets trade in different markets characterized by asset classes and geographies.
For example, bonds in an emerging market may take longer to unwind than stocks held in a
developed economy. However, more often than not, institutions do not differentiate between
asset classes and markets, and, instead, apply the same scaling factor to the entire portfolio.

METHODS OF CALCULATING VaR

In any method for calculating the VaR, the two inputs required are

e the value of the portfolio; and

e the variability of the market, 1.e., volatility.
410 Derivatives and Risk Management

Valuation
The valuation of a portfolio is easy when the securities comprising the portfolio are traded.
We then have market value and do not need to make any assumptions. For
The method of calculat-
illiquid or non-traded assets in the portfolio, no market data are available.
ing VaR involves two
steps—a valuation _ The approach used most often is cash flow mapping, where the cash flows
approach to value the _ attached with the instrument are broken down in the form of standard prod-
portfolio and estimation = ucts whose valuation is available. For example, a bond that matures after 14
of volatility of market- months can be represented as bonds with maturities of 3, 6, 12, and 18
ee
_ months, whose valuations are readily available as they may be traded. For the
Eprniectce caine of the portfolio, we may either use past values and changes in them or may
have some analytical model that establishes the value based on its determinants.

Estimation of Volatility
Changes in the value of a portfolio occur due to changes in market variables, referred to as
volatility. To estimate volatility, we need (a) specific scenarios and (b) correlations among
market variables. If the value depends upon multiple factors, then the change in value is a
function of (a) volatility of each factor, (b) correlation among factors, and (c) sensitivity of
value with respect to each factor.
Changes in value of the portfolio can be achieved through analytical models, where the
relationship of the value with respect to market variables is established; for example, returns
on a portfolio of stock are given by its beta, changes in the value of a portfolio of bonds are
given by duration, and changes in the value of a portfolio of derivatives are given by the delta.
An analytical approach also requires correlations and variances as inputs; this is sometimes
referred to as the variance-covariance approach. The advantages of such an approach, based
on models, include (a) easier comprehension, (b) lesser data requirement, and (c) fast comput-
ing. Once a valuation model is developed, computations become easy. The disadvantage of the
model building approach is that it ignores historical data that may defy the validity of the pric-
ing model itself. Though the model is built on historical correlations and variances, they may
not hold good in the future. Another disadvantage with such an approach is the non-linearity of
payoffs in case of derivatives like options. Estimates based on the delta would be invalid under
certain conditions, and full valuation methods such as the BSM, may be required to arrive at
true changes in value. For instruments with linear payoffs, the model approach may work fine.
The second approach uses past data for computing VaR. Under simulation, we are not
measuring changes in value; we are re-computing the values of the portfolio afresh, under
different possible scenarios. The issue revolves around how to generate scenarios. There are
two ways of doing it—historical and Monte Carlo simulations.
Under historical simulation, we assume that history can foretell the future. One has to
decide how far back in history one goes to generate as many scenarios as possible. We treat
each past day as one possible scenario and re-value the portfolio for the future, assuming no
specific distribution for the scenarios except what is contained in the history. Under Monte
Carlo simulation, the process remains the same as the historical one, except for the method
of generating different scenarios. Unlike historical simulation, we create different scenarios
based on defined stochastic processes, where we assume specific distributions.
 Volatility and Value at Risk 411

HISTORICAL SIMULATION ©
As mentioned, one way of arriving at the VaR is based on historical data. The value of the
Coercion portfolio is a function of several parameters. These are often broad economic
based on the underlying variables such as the state of the stock markets, interest rates, exchange rate,
assumption that historical + inflation rates, and growth rates. Due to varying degrees of correlations of
changes contain possible —_these variables, it is naive to assume predictability based on model building.
scenarios of market vari- One way of finding the potential impact of changing economic variables
ables, and can form the . sae . a .
without establishing the exact cause-effect relationship is to examine how
basis for future estimate.
the portfolio behaved under different scenarios in the past. Based on the past,
the likely change in the value of the portfolio the next day would give an idea of the potential
loss that can be incurred over a period of one day. The undeflying idea is that for the next
day, the variables can change in any of the ways they changed in the past.
For computing VaR based on historical simulation, we need to undertake the following
actions:

(a) Identify and select the variables that impact the value of the portfolio
(b) Take the actual past values of these variables, /, on a daily basis
(c) Compute the value of the portfolio for each previous day with the corresponding values
of the identified variables |
(d) Replicate the same changes in the values of the variables for the next day and develop
as many scenarios as possible
(e) Re-compute the portfolio values to arrive at the scope of the loss for each of the sce-
narios ?
(f) Find out the fifth percentile worst loss or first percentile worst loss to arrive at the 95%
or 99% 1-day VaR.

Thus, the VaR method does not presume any probability distribution while relying on the
past data. Whatever be the patterns of past, they are translated into as many scenarios, and,
hence, the user determines the number of possible scenarios.
Historical simulation is best explained by way of an example. Assume that today is 14
October and we need to determine the VaR for the next day, 15 October, for a portfolio
aggregating ~10,000 crore today that consists of

(a) a long position in foreign exchange worth 2000 crore, with a sensitivity of 1.00 for
changes in the US dollar exchange rate
(b) along position in a well-diversified stock portfolio worth ¥5000 crore, with a beta of 1.5
(c) a long position in short-term securities worth ~3000 crore, with interest sensitivity
(duration) of —0.6

The list of variables that can cause changes in the value of the portfolio is indeed large but
for the purpose of illustration, the three variables chosen are (a) the US dollar exchange rate,
(b) the value of the Nifty index, and (c) the yield on 91-day T-bills. We list the actual value
of each of the variables over the previous 51 days so as to develop 50 scenarios. A set of
hypothetical data from 1 August to 14 October is shown in Table 14.3. In practice, a sample
of 50 historical values is too small, and a much larger sample is taken.
412 Derivatives and Risk Management

Table 14.3 Historical data for select variables for simulation for VaR calculation
T
One day change in

Date sate Nifty index 8 eB US dollar Nifty index, 91-d T-bill Scenario
rate, z/S yield, % exchange yield, %
%
rate, %
01 Aug 44.05 Sons 8.35 _—

02 Aug 44.23 5457 8.33 0.41

03 Aug 44 38 5405 B35 0.34

04 Aug 44,42 5332 8.05 0.09

05 Aug 44 80 5211 8.34 0.86
08 Aug 44,96 5119 8.21 0.36
09 Aug 45.17 5073 8.28 0.47

10 Aug 45.21 51614 8.10 0.09

11 Aug 45.27 5138 8.30 0.13

12 Aug 45.37 5073 8.05 0.22 Bet)

©O
tO
Bec
NM
Goes
BB
Or
&

16 Aug 45.25 5036 8.20 . —0.26

17 Aug 45,37 5057 8.15 0.27 OC
—-

18Aug 45.61 4944 8.31 0.53

19 Aug 45.95 4846 8.30 0.75

22 Aug 45.69 4899 8.24 U5

23 Aug 45.77 4949 8.30 0.18

24 Aug 46.13 4889 8.29 0.79

25 Aug 46.05 4840 8.04 O17
26 Aug 45.87 4748 8.27 —0.39
29 Aug 46.02 4920 8.32 0.33

30 Aug 45,90 5001 8.22 —0.26

02 Sep 45.94 5040 8.31 0.09

05 Sep 46.13 5017 8.38 0.44

06 Sep 46.02 5064 8.34 —().24

07 Sep 46.18 5125 8.30 0.35

08 Sep 46.38 rayetsee| foils 0.43

09 Sep 46.97 5059 8.35 Wee
12 Sep 47.10 4947 8.17 0.28
13 Sep 47.81 4941 8.33 oi
14 Sep 47 84 5013 8.40 0.06
15 Sep 47.47 5076 8.20 ONG
16 Sep 47.79 5084 8.30 0.67
 Volatility and Value at Risk 413

47.79 5032 8.35 0.00 =4 02

4622 sé 8.32 0.90 2.15
47,89 5133 8.42 —0.68 -0.14
48.82 4924 8,35 1.94 —4.07
49.67 4868 8.25 1.74 = 44
49.62 4835 8.35 —0.10 ~0.68
49.18 4971 8.29 ~0.89 2.81
48,91 4946 8,39 —0.55 —0.50
48.93 5015 8.26 0.04 1.40
48,93 4943 8.34 0.00 144
49.42 4850 8.27 1.00 —1.88
49,23 4772 8.39 —0.38 —1.61
49.19 4751 8.33 —0.08 ~0.44
49.14 4888 8.26 —0.10 2.88
49.07 4980 8.27 =o 14 1.88
49.03 4974 8.39 —0,08 —0.12
49,24 2.51
49.02 —0.41
49.07

Three variables, the US dollar exchange rate, the Nifty index, and 91-day T-bill yield,
indicate a percentage change of +0.41, 1.09, and —0.24, respectively, from | August to 2
August. This gives Scenario |. Similarly, 50 such scenarios can be obtained. For example,
on 8 September (Scenario 25) the changes in the values of the exchange rate, the Nifty and
T-bill yield are +0.43, +0.55, and +5.66%, respectively.
Percentage changes in the values of the variables are analysed, rather than the absolute val-
_ ues, for two reasons. The first is to eliminate the base effect, i.e., the general
Historical data over a
_ level of a selected variable may have changed during the sample period. For
sufficient number of
days back in historyis example, the US dollar exchange rate, which was ataround %44.00 on | August
analysed toknow what —s1 att 49.00 on 14 October. Secondly, the composition of the portfolio would
level of VaR is adequate change through addition or deletion of securities during the sample period.
for a portfolio fora given These percent changes are viewed as possible scenarios for working on
ae a given conf: the current value of the portfolio. The value of the portfolio at the end of
14 October is $10,000 crore. It is assumed that any of the 50 scenarios that
occurred during the sample period immediately preceding the current date,
as detailed in Table 14.1, can occur on 15 October, the next trading day. The value of the port-
folio is assumed to change in accordance with the sensitivity of the portfolio with respect to
each of the variables selected. For example, changes in values of the variables under Scenario
20 are —0.26% in the US dollar exchange rate, + 1.65% in the Nifty index, and —1.20% in
91-day T-bill yield. Therefore, the portfolio value would change as shown here:
414 Derivatives and Risk Management

= crore
Portfolio of foreign exchange = —0.26% X 1.0 x 2000 =.—5.22
Portfolio of stocks = +1.65% X 1.5 * 5000 = +123.47
Portfolio of short-term securities = —1.20% * —0.6 X 3000 = +21.63
Total change in value of portfolio = +139.88

The 95% 1-day VaR is arrived at by looking at the value of the fifth-percentile worst
scenario. For a sample of 50 observations, finding the 95% VaR would be difficult, as it cor-
responds to the worst 2.5 scenarios, but we may find the 98% 1-day VaR by choosing the
second-percentile worst scenarios, i.e., the one worst scenario in a set of 50 observations. In
a sample of 500 observations, the 99% VaR would be the last five worst scenarios and the
95% VaR would be the last 25 worst scenarios.
In the illustration we have just discussed, we may find the 98% VaR by observing the
value of the worst scenario. This happens at Scenario 35, with a loss of 251.57 crore, as
highlighted in Table 14.4.
Table 14.4 Scenarios based on past data for 15 October

One-day change in % for Change in the value of the portfolio, ¢crore

ee ve 91-d T-bill : Foreign Short-term

exchange | Nifty index : Scenario Stocks ee Total
rate, Z/S yield, % exchange securities

0.41 = 108 —0.24 1 8.17 —81.56 4.31 —69.08

0.34 —0,95 0.24 2 6.78 —71.47 — 4,32 —69.01
0.09 = 35. =3.59 3 1.80 — 101.30 64.67 —34.83
0.86 eel 3.60 4 17.11 —170.20 —64.85 —217.94
0.36 = = 1.50 5 7.14 — 132.41 28.06 07.21
0.47 —0.90 0.85 6 9.34 —67.40 15.35 —73.41
0.09 113 Seeulil 7 Tien 130.10 39.13 171.00
0.13 —0.45 2,47 8 2.65 —33.43 —44.44 = (5.22
0.22 a -—3,01 9 4.42 —94.88 54.22 —36.24
—0.26 073 1.86 10 —5,29 et We = 39.54 93.54
0.27 0.42 —0.61 11 5.30 31.28 10.98 47.56
0.53 = 2.20 1.96 12 10.58 = 167.59 35.34 = 192.35
0.75 —1.98 OZ 13 14.91 — 148.67 2.17 131.59
=] 1.09 072 14 11:32 82.03 13.01 5 B372
0.18 102 0.73 15 3.50 76.55 SARE 66.94
0.79 1.21 012 16 15.73 —90.93 elf —73.03
=A aie = 100 = 302 17 —3,47 =F5AT 54.28 — 24.36
0,39 — 1,90 2.86 18 1 8? — 142.56 —51.49 ~ 201.87
0.33 3.62 0.60 19 6.54 271.70 — 10.88 267.36
—0.26 1.65 = 1.20 20 mb22 123.47 21.63 139.88
 Volatility and Value at Risk 415

0.09 0.78 1.09 21 1.74 58.49 =I 40.52

0.44 —0.46 0.84 22 : 8.27 — 34.22 71516 41.11
—0.24 0.94 —0.48 23 —4.77 70.26 8.59 74.08
0.35 1.20 —0.48 24 6.95 90.35 8.63 105.93
0.43 0.55 5.66 25 8.66 40.97 =101,.93 —52.30
a 27 =| 82 —479 26 25.44 — 136.82 86.20 720.18
0.28 acl 2a16 27 5.54 — 166.04 38.80 = 12he70:
1.54 SUZ 1.96 28 30.15 | io 35.20 14.20
0.06 1.46 0.84 Es 1.25 109.29 One 95.41
—U77 1.26 2.38
0.67 0.16 1.22
0.00 = 102 0.60
0.90 2 AO —0.36
—0.68 —0.14 1.20
1.94 —4.07 —0.83
1.74 —1.14 1.20
=e —0.68 12)
=0.89 2.81 O72
=U 55 —0.50 1.21
0.04 1.40 = 1.66
0.00 —1.44 0.97
1.00 = 1.88 —0.84
—0.38 = 1sG4 1.45
—0.08 —0.44 —0.72
SOG 2.88 —0.84
—0.14 1.88 0.12
—0.08 Uli 1.45
0.43 2.51
—0.45 —0.41
0.10 1.06

The advantage of historical simulation is that it requires very few modelling assumptions.
In our illustration, we used the sensitivities of the portfolio values with respect to selected
variables in the economy. It (historical simulation) is essentially driven by the actual distri-
bution of loss, without necessarily assuming that the returns on the portfolio follow normal
distribution.
The disadvantages of historical simulation may emanate from the theoretical arguments
that economic fundamentals do change from one period to another, and, hence, the historical
416 Derivatives and Risk Management

with an identi-
data that form the basis for finding the VaR may not be repeated in the future
predicting
cal effect. Here, we have combined the analytical model with historical data for
the past data. With a purely historical
the values of the portfolio while scenarios are built on
approach, we must have historical values of the portfolio from the past. However, this would
mean that the composition of the portfolio remains the same for the entire past period and
the forthcoming period; this is a difficult proposition indeed.

MONTE CARLO SIMULATION

A similar exercise would be performed under the Monte Carlo approach, except that the
_ distribution of the scenarios would be different. While no specific assump-
The Monte Carlo simula- ; ritere er ee ;
fon is came as ae tion about the probability distribution of market variables was used under the
torical simulation, except ‘historical simulation, the Monte Carlo simulation provides for a distribution
that expected probability pattern that may be expected. The very purpose of estimating VaR is to pro-
distribution is generated ~—= vide for unlikely scenarios, and it is believed that normal distribution does
bydesign, while historical 44 take care of such situations, because adverse events are fat-tailed, 1.e.,
simulation does not Geltrel Ves ;
assume any specific losses would be much larger than computed under normal distribution. His-
probability distribution.torical data would take care of such situations if the period under consider-
a DS ation includes the occurrence of such events. However, if historical data are
devoid of such events, we need to incorporate these by choosing some skewed distribution
pattern under the Monte Carlo approach.

LIMITATIONS
Though VaR as a measure of risk may appear to be comprehensive, it really is not so. In
_ calculating VaR using any of the approaches, it was assumed that future risk
The VaR as a measure
_ can be predicted from the historical distribution of returns. Further, it fails
of risk has been criticized
because of its inability to deal with new asset classes such as exotics, for which neither pricing
to consider
theview that = models nor historical price data are readily available.
under extremely adverse Under the analytical approach, we assumed normal distribution. It does
situations, variables tend == not apply to abnormal situations such as crises that cannot be handled by
tohave strong correla- She ae : ; :
fone normal distribution. Further, it cannot deal with non-linear payoffs.
_............__ Historical simulation assumes no historical fitting of portfolio values. Instead,
it simply assumes historical distribution to be repeated in the future. Ifcrises do not forma part
of the data set, it also fails to give a true picture of possible losses. The approach overestimates
the meaningfulness of historical data, and allocates same weight to every observation.
The Monte Carlo approach addresses fat-tailed problems by allowing a variety of distribu-
tional assumptions. However, volatility, correlation forecasts, and relationships are still based
on historical observations.

STRESS TESTING &

Besides calculating VaR based on normal or past distributions, it is necessary to take care of
some extreme situations that seem to occur more often than one imagines. Under extreme
situations, market variables tend to show unusually high correlations. Steep changes in yields
 Volatility and Value at Risk 417

on bonds in short periods of time and huge depreciation/appreciation of currencies happening

simultaneously occur far more frequently than normal distribution would suggest.
Crises happen more often than any of the distribution patterns predict. Further, crises also
do not exhibit any distribution pattern that can be studied to form the basis
Stress testing comple- _ for future provisioning. The history of global crises suggests that they happen
ments the VaR by
often. For example, in the period from 1990 till date, we have seen many such
analysing past positions
during periods of crises crises, such as the Gulf war, the Mexican debt crisis, the Asian currency
that happened over the crisis, the Russian rouble devaluation, the sub-prime crisis, and the Greek/
last 10-20 years. Euro crisis. Further complexity is added by natural disasters such as tsuna-
mis, earthquakes, floods, and droughts. Events like wars or political coups
have similar threats. Natural disasters, wars, and coups do not have any pattern, and are not
subject to statistical forecasting. All these events can cause systemic risk, where the inability
of one to meet commitments leads to impairment for others in the system. As a result of this,
losses may be of much larger magnitude than what VaR results may prescribe.
VaR bands are dramatically exceeded in such situations, and therefore, it is imperative to
take additional precautionary measures, apart from computing VaR. Many financial institu-
tions carry out stress testing by examining the performance and adequacy of capital under
extreme conditions in crises that occurred over the last 10 to 20 years. Stress testing com-
bined with the VaR method would be a more comprehensive measure of risk.

SOLVED PROBLEMS ssssswssssamnemevsnnanence

SP 14.1: Volatility measurement
At the beginning of the week on Monday, the annual volatility of an index was 24%. On Monday, Tuesday, and Wednesday, the index
registered a return of 1.5%, —2.0%, and 0.5%, respectively. What estimates of volatility would you make for Tuesday, Wednesday,
and Thursday, based on the EWMA approach with a decay factor of 0.90 and 256 trading days in a year?
Solution y
With 256 days in a year and annual volatility of 24%, the daily volatility would be 24/256 = 1. 5%.
The estimate of volatility for Tuesday, Wednesday, and Thursday would be found successively using revised estimates for each
day, based on Eq. 14.1.

For Tuesday o2 = Ao2_, + (1—A)r2_, = 0.90 x 0.0152 + 0.10 x 0.0152

= 0.90 x 0.000225 + 0.1 x 0.000225 = 0.000225
Or on = v0.000225 = 0.015 = 1.50%
For Wednesday o% = Ao*_, + (1—A)r2_,. = 0.90 x 0.015% + 0.10 x 0.022
= 0,90 x 0.000225 + 0.1 x 0.0004 = 0.0002425
Or on = v0.0002425 = 0.01557 = 1.56%
For Thursday 02 = Ao2_, + (1—A)r2_, = 0.90 x 0.01562 + 0.10 x 0.005?
= 0.90 x 0.00024336 + 0.1 x 0.000025 = 0,000221524
Or on = v0.000221524 = 0.01488 = 1.49%

SP 14.2: Historical simulation

Under historical simulation for the last 100 days for a portfolio observation, the following table was created:
Profit (+ )/loss (—) lakh No. of times
More than —220 |
Between —180 and —200 4
Between —160 and —180 5
Between —100 and —160 14
418 Derivatives and Risk Management

Between —50 and —100

Between —50 and —0
Between +0 and +50
Between +50 and +80
Between +80 and +150
Between +150 and +200
What will be (a) the 1-day VaR with 99%, 95%, and 90% confidence levels and (b) the 10-day VaR with 99%, 95%, and 90%
confidence levels?

Solution
For 99%, 95%, and 90%, we have to find the number of occasions (not exceeding 1, 5, and 10, respectively) out of 100 the VaR
level would be the loss incurred.
Therefore, the VaR for

99% confidence = loss occurred no more than 1 time out of 100 = $220 lakh
95% confidence = loss occurred no more than 5 times out of 100 = %180 lakh
99% confidence = loss occurred no more than 10 times out of 100 = 7160 lakh

For a 10-day VaR the levels would be

99% confidence 220 x V10 = %696.70 lakh
95% confidence 180 x V10 = $569.21 lakh
90% confidence 160 < V10 = 7505.96 lakh

The world is integrating, with increased liberalization policies The VIX is a new concept for foretelling general expectations
adopted by different nations. This has made the world a global about the market and is derived from option prices. While option
village. The factors governing risk have multiplied. Risk charac- prices are observable, volatility is not. Since option prices are
terised by standard deviation as a universal measure has been dependent on future volatility, they can be used to derive future
condensed in different ways—beta, delta, gamma, etc. They volatility. The VIX, developed by the CBOE is a method to arrive
measure changes in the value for a given change in the value at the volatility that is widely accepted and adapted by stock
of a determinant perceived to be the most important. In a global exchanges worldwide. The NSE, too, is one such exchange,
environment, such measurement of risk may not be comprehen- which uses the prices of OTM options to derive volatility esti-
sive and true. mates for the next 30 days.
Recognizing the need to rely on past data, the EWMA attempts The VaR measure is considered to be a comprehensive mea-
to forecast volatility on the basis of past trends, giving lesser and sure of risk for portfolios that consist of a variety of instruments
lesser importance to older data and emphasising more recent spread across several nations. It gives an idea of what possible
data. The weight of each past observation decreases exponen- losses can be foreseen with the objective of providing for them
tially in the new estimate of volatility. As per the EWMA, the for continued and healthy operations. Since losses get multiplied
updated volatility is a function of past volatility modulated by the with time and the magnitude of loss depends upon probability
latest returns. The advantage of the EWMA is that estimating distribution, the VaR becomes dependent upon two critical inputs
volatility requires only two sets of data—a single comprehensive to be decided by management—the level of protection required
figure for volatility of the past and the latest returns; this is unlike and the time horizon. A 99% 10-day VaR implies that over a
the historical method, which needs storage of substantial past period of 10 days, the loss exceeding the VaR is expected to —
data. The EWMA approach can be extended to covariance too. occur only once out of 100 days. For this, we continue to assume
Like variance, covariance would also be a function of past volatil- normal distribution for returns on the portfolio.
ity contained in the single figure and the latest covariance. Banks and financial institutions are more concerned about risk
It has been found that variance is mean reverting, i.e., it tries because of (a) high leverage, (b) absence of tangible securities,
to come back to some long-term average. The ARCH/GARCH and (c) lack of control by the major suppliers of funds, i.e., the
approach has been used to incorporate mean reversion. The depositors. :
EWMA, which does not recognize mean reversion, is a special Since a large number of factors influence portfolio value, the
case of GARCH. applicability of the model building approach for valuation is sus-
 Volatility and Value at Risk 419

pect. One possible way to arrive at expected losses is to do a scenarios based on the probability distribution of the variables
Scenario analysis. The usual practice is to find out the 1-day that we expect and re-compute the value of the portfolio.
VaR and then scale up for the desired period. There are two Despite quite exhaustive data analysis, the VaR is found to
ways of generating scenarios—historical or Monte Carlo, Under - be deficient in true measurement of risk, because it is observed
historical simulation, each of the past observations is treated as that under extreme negative outlooks, the correlations amongst
one scenario for the next day. Creating about 200-500 scenarios the determinants become very large and, therefore, capital ade-
would provide a distribution pattern of portfolio values, and with quacy based on the VaR may not suffice. To bolster the VaR, a
the desired confidence levels, we can have a 1-day VaR. No few financial institutions have started stress testing, to see the
Specific distribution is assumed. We repeat the distribution pat- actual performance over the last 10-20 years under extreme
tern of the past. Under the Monte Carlo approach, we develop negative scenarios.

Decay factor The rate at which the importance of past data Standard deviation A measure of volatility as a percentage of
decreases. deviation from average returns.
Exponential smoothing A situation where the weight of past Stress testing An exercise conducted to establish how a portfo-
date decreases exponentially at each new observation. lio/an organisation would withstand a crisis situation on the basis of
GARCH Itis an approach where volatility is assumed to revert analysis of crises that occurred over the last 10-20 years.
to a long-term average. Value at risk A measure of risk that quantifies losses for a
Historical simulation A method of arriving at the VaR using time horizon with a certain confidence level.
past data as source, assuming history can foretell future events. Volatility index An index that reflects on expected volatility
Monte Carlo simulation A method of arriving at the VaR by in the short term.
generating scenarios according to the expected pattern of mar-
ket variables.

QUESTIONS ==
14.1 What are the different measures of risk for different kinds 14.5 Describe what you understand by VaR and its utility.
of assets? Describe their importance and limitations in risk 14.6 What are the different ways of measuring VaR?
measurement. 14.7 Elaborate the steps of historical simulation involved in
14.2 What are the assumptions made in the exponential finding out the VaR and differentiate it from the Monte
weighted average model for updating volatility? Carlo simulation.
14.3 How is the GARCH model different from the EWMA 14.8 What are the limitations of VaR?
model? 14.9 Describe what you understand by stress testing.
14.4 What do you understand by VIX? Briefly describe how VIX
is calculated in India.

PROBLEMS ~~
P 14.1 Updating volatility P 14.3 Value at Risk
Stocks A and B have annual volatilities of 20% and 30%, respec- Assuming normal distribution applies, what would be your esti-
tively. You are updating volatility on a weekly basis. In the past mate of VaR for one month for a portfolio that has an annual
week, the returns of stocks A and B were 3% and —2%, respec- mean return of 20% and an annual standard deviation of 10%,
tively. What is your revised estimate of annual volatility for the with confidence levels of (a) 95% and (b) 98%?
coming week using the EWMA method, with a 95% decay rate P 14.4 VaR and historical simulation
and 52 weeks per annum? Consider the data given in SP 14.2. Find out the VaR with a
P 14.2 Updating correlation 90% confidence level for (a) 1 day, (b) 1 month, and (c) 1 year.
If the coefficient of correlation between stocks A and B is 0.7 in
P 14.1, what would the correlation between them for the coming
week be?
 Hedging with Options

INTRODUCTION Learning Objectives

Options have an impressive and huge array of applications, cer- After going through this chapter,
tainly greater than most other derivatives. Some of these applica- readers should be familiar with
tions are unique to options. The extended applications of options the hedging applications of options
emanate from their distinctive payoffs. While the obligations of the hedging of a long position with
counterparties are mutual and equal in other derivatives, options puts
the hedging of a short position with
have a unique payoff that is unequal. While one party holds the
calls
option and has a right without an obligation, the other party is the hedging of a long/short portfolio
obligated to perform. This unequal payoff, also referred to as a with index put/call options with
non-linear payoff, makes possible several applications that are « beta equal to 1; and
not feasible with other derivatives. » beta equal to a value other than 1
the concept of hedging with
Though options can be used for hedging, speculating, and arbi-
currency options
_ trage, just the same way as other deriva- how to reduce hedging costs with
Due to the non-linear
payoffs, there are many _ tives, the applications seem somewhat options
more applications avail- different due to uneven payoffs. We shall strategies of range forward, ratio
able with optionsthan == discuss the various applications of range forward, and zero cost
structures
with ote! erates _ options under the following four heads:
e Hedging strategies to concentrate on how to use options
to hedge against adverse price movements for a long or a
short position in the underlying asset.
e Income generation strategies to focus on how to use options
to enhance portfolio yields. This is possible because the
writer of an option earns a premium.
e Trading strategies by highlighting different options to
achieve the desired risk and return profiles, depending
upon the perception of the market by the trader.
¢ Synthesizing strategies, demonstrating the power of options
to create synthetic positions of other financial instruments.
The replication of the payoff effectively means lesser
investment without compromising returns enhancing the
return on investment (Rol).
 Hedging with Options 421

We discuss them one by one, covering hedging in this chapter and the remaining strategies
in the next chapter.
Hedging may be defined as an action that protects against the effects of adverse events such
as inflation, adverse price movement of stocks, and errant behaviour of foreign exchange.
Due to their uneven payoffs, options provide hedging opportunities that are somewhat differ-
ent from those provided by forwards and futures.
Options, like eS: are All-pervasive We all encounter options contracts in our every-
_ day lives. These contracts often go unnoticed and are not given much thought
Options are all pervasive
and we hardly recognize or attention. For example, each one of us obtains insurance in some form or
their presence in our day- _ the other. Consider car insurance against theft or house insurance against fire.
to-day lives. _ Each year, we pay an insurance premium to protect against the loss of the
~ asset due to theft or fire. Insurance firms charge a premium and both the
parties hope that the fire or theft will not take place. If it does, you will be able to recover
the loss from the insurance firm. If the fire or theft does not take place, you and the insurance
firm feel good. In any case, the premium paid to the insurance firm is foregone by you. It is
the price for buying peace of mind.
Look at the situation in another way: by taking out an insurance policy on an asset we own,
we hedge against any loss in the value of that asset. If an asset gets stolen or damaged by fire,
its value would reduce substantially, even to zero. In options terminology, buying an insurance
policy is nothing but the equivalent of holding a put option that protects against any loss in the
value of the asset owned. The insurance firm has in fact written a put. You exercise your option
if the fire takes place, when the insurance firm is obligated to compensate you for the loss.
Is insurance different from options? Yes, indeed, because insurance covers against risk
arising from an event, and one is required to prove that a loss, indeed, has occurred. Such is
not the case with options as financial products. Insurance covers a different nature of risk,
called event risk, while options cover price risk. Further, with options, one does not need to
prove that a loss has, indeed, occurred.
As another example, consider the purchase of a real estate property. When buying a prop-
erty, we normally enter into an ‘agreement to buy/sell’, which states the firm price of the
property and provides for a token payment by the prospective buyer to the prospective seller
at the time of the agreement. The balance is to be paid within an agreed time period. Before
the expiry of the agreement, the prospective owner has the right to pay the balance and take
delivery of the property in question. If the prospective buyer does not exercise this option
within the stipulated time, the prospective seller is absolved of the obligation to deliver the
property. This agreement to buy/sell closely resembles a call option that is a right to buy an
asset at an agreed price within a stipulated time frame.
The call option is exercised if the price goes up but not when the price falls. Though most
of us buy property with the intention of taking delivery, if the property is considered to be an
investment, the agreement to sell can be viewed as a call option on the asset. The prospective
buyer would exercise the option if the price of the property has gone up. Instead, if the price
has fallen, the buyer would not seek delivery of the property, and would let the agreement to
sell expire. In either case, the front-end payment made is forfeited, and belongs to the seller.
Such an agreement to sell provides protection to the buyer and is a hedge against any rise in
price of the property.
422 Derivatives and Risk Management

Depending upon the situation, people need protection against changes in price. Some-
times, a fall in value is damaging, as is the case when one buys an insurance policy. Here,
one already owns an asset—called ‘long on asset’ in financial terminology—and needs pro-
tection against a fall in the value of the asset. At other times, a rise in value is adverse to
the interests of the people concerned, as is the case in entering into an ‘agreement to buy’
for buying property, where one does not own the asset—called ‘short on asset’ in financial
terminology—and needs protection against a rise in prices. Both the situations emphasize the
need for hedging.
Financial Markets Provide Easier Comprehension of Options Examples from the finan-
cial market are most apt for explaining and comprehending the concept of hedging. There-
fore, such examples are used here with the belief that similar processes can be adopted for
protecting against adverse price movement for any other asset. When an investor takes a
position in stock (either long or short), he/she faces the risk of losses when prices move in a
direction opposite to the anticipated one. If one has purchased stock, he/she expects to gain
from a rise in the price of the stock. If the price falls instead, he/she incurs a loss. Similarly,
an investor who has taken a short position (a planned acquisition of an asset in the future is
considered a ‘short’ position, till the asset is actually acquired) in stock expects to gain from
a fall in the price. Instead, if the price rises, the investor faces a loss.

HEDGING WITH STOCK OPTIONS

The unique feature of hedging with options is that it protects one from possible losses that
_ could arise from adverse movements in prices, while at the same time retain-
An option is an excellent
instrument to hedge be- ing the potential for gain from the favourable movement of prices. Returns
cause it protects against from the favourable movement are reduced only marginally by the amount
adverse movements in of premium paid to buy the option. In contrast, hedging with forwards or
prices while retaining the futures locks-in a price. Though protecting against loss, they also deny any
potential to gain.
Wis EE
gain from the possible favourable movements of the prices. In case of for-
wards and futures, protection is provided at the expense of foregoing poten-
tial gain.
We now consider hedging for long and short positions in an asset with options. The long
position needs protection against falling prices, and the short position must be protected
against rising prices.

Hedging Long Position in Stock with Put Option

An investor takes a long position in a stock or an asset in the hope that its price would rise.
A long position carries risk if the price falls. If the purchase price of the asset was Sp and
the current price is S, the loss or profit is given by S — So. If.S> So, the investor is happy.
If
S' < So the investor suffers a loss, and this is a situation that he/she needs to safeguard against.
When an investor is holding an asset, he/she has the potential to make an unlimited gain as
well as an unlimited loss (limited to the buying price, since the price cannot fall below
zero)
depending upon the price of the asset at the end of the investment horizon. However,
he/she
needs protection against fall in value of the asset. When an investor buys a put option
(giving
him/her the right to sell at the exercise price) alongside the asset, it forms a portfolio,
called
 Hedging with Options 423

long on asset with a put. A loss in a long position on an asset can be covered by exercise
of the put, in the event of a fall in price below the exercise price. Therefore, it is called a
protective put. The payoff on the protective put, which is shown in Fig. 15.1, emerges from
combinations of the payoffs on a long position in the stock andthe put option.

Payoff

Long stock

Long put fu é Protective put

Price

Le LEE EEE EEE TELE OLEELOLDILLULLLLELEEEELL

EE EEET .\ He

Fig.r5d Protective put

Note that loss in case of a fall in price is contained to the extent of the premium paid for the
ce put. If the price falls below the exercise price, the investor exercises his/her
A long position in an _. ae : :
ascel deterorios wih | right to sell, thereby providing protection against a fall in price below the exer-
a fallin price. Protection Cise price. In case of a rise in price, the put is worthless, and, thus, not exercised.
against the expected loss The long position in the asset gives a profit. However, the profit would stand
is gained by buyingaput. — reduced by the amount of premium paid while buying the put. When S > So,
lf prices move up, tne _ for a long position on the asset, the profit will be S — So, while for an asset
long positioncontinues s. ; ; :
to gain. _ with a put, the profit will be S — S) — p, where p is the put premium.
coe eee An example of a protective put with the stock of Hindustan Unilever Ltd.
(HUD )as ip underlying asset is shown in Exhibit 15.1, which contains the hedging strategy,
a table for the payoff, and a graphical view of the combined position of the asset with a put
option. If the investor does not buy the put—if he/she remains unhedged—his/her loss could
be very large. Buying a put limits the losses to €8, and yet retains the profit potential, except
for the premium paid on the put, as may be seen from the figure in Exhibit 15.1.

Hedging Short Position in Stock with Call Option

_ Now consider an opposite position, with no asset in possession. Many of
A bol position in an
asset deteriorates with a us would wonder what protection one may need on an asset that is not yet
rise in price. Protection owned. Of course, one has nothirig to lose because one does not own the
against the expected asset. However, we must see it in a different way—in terms of a plan to own
loss is gained by buying the asset. Protection is required if one is intending to own the asset in the
a call. If prices go down,
near future, possibly because one does not have funds to acquire the asset
the short position contin-
ues to gain. now. Such a position is considered a short position.
For a short position, a price fall is favourable but a price rise is unfavour-
ables If the:price rises, then owning the asset becomes more expensive in the future. It is
424 Derivatives and Risk Management

EXHIBIT 15.1 Hedging long position—Protective put

Strategy (All figures in %)

e Long position on stock of Hindustan Unilever Ltd (HUL)

e To hedge against fall in price: Buy a put on the same asset for the period of hedge.
Example
The following prices prevail on 21 October 2008, on the National Stock Exchange for a November 2008 put option on HUL:
X = 220; p = 8; current stock price = 220
Protective put
Long position HUL stock
Bought 1 put at X = 220
Initial cost of protective = Put premium paid = 8
Table for payoff for protective put

Graphical view: Protective put—Payoff

Payoff (7) :Break-even point;
~S§ — 228 = 0; S = 228
| Maximum profit:
|When S rises: unlimited
-Maximumloss:
_ When
Sfalls below 228: 8

Price of HUL (®)

precisely here that protection is required. Alternatively, where short selling is allowed, an
investor may short sell the asset, expecting a fall in price, and buy back later. In such a case,
the investor carries a risk if the price rises subsequently.
[f the current price of the asset is Sy and the expected price is S, the loss or profit is given
by S — Sp. IfS < So, the investor gains because he/she executes the purchase at a lower price,
otherwise he/she suffers a loss. To protect against losses due to a rise in the price, the investor
buys an at-the-money (ATM) call option on the stock. If the price indeed rises, the investor
can exercise the call owned and compensate for the losses incurred on the short position in
stock. If the price falls, the investor lets the call expire. The payoff on the combined position
of short stock and long call is shown in Fig. 15.2.
Note that any loss in case of a rise in price is contained to a maximum of the premium
paid for the call c. In case of a fall in price, the profit from the stock stands reduced by the
amount of the premium paid on the call. If the investor were short on the asset, the profit will
 Hedging with Options 425

Payoff

Short stock Long call

Price, S

Fig
LL LL A A LL

g on call

be So — S, but when combined with the call at Y = Sp, the profit will be S) — S — c, where
c is the call premium.
Buying a call option places a maximum limit on the purchase value, consisting of the
strike price, X, plus the call premium, c. Consider, for example, an investor who has bought
a call option at $5, with a strike of ¥100. In case the price remains less than 100, the inves-
tor allows the call option to lapse and acquires the asset at the market price. After adding the
call premium, the cost would be S + c, or S + 5S. If the price of the asset is more than $100,
the investor exercises the call to acquire the asset from the call writer by paying €100. Add
<5, the value of the premium paid earlier, and the maximum cost of the acquisition is thus
pegged at X + c, 1.e., 105. This is shown in Fig. 15.3.

Cost of asset

Fig. 15.3 Cost of acquiring on asset

Similar toa protective put, Exhibit 15.2 depicts the complete strategy for a short position
in the stock of State Bank ofIndia (SBI), trading at 880, with a call option on it with a strike
of €880, selling at $34. With a call option, the investor is assured of getting the stock of SBI
426 Derivatives and Risk Management

EXHIBIT 15.2 Hedging short position in stock with call option

Strategy (All figures in)

e Short position on stock
e To hedge against rise in price: Buy a call on the same asset for the period of hedge.

Example
The following prices (in %) prevail on 21 October 2005, on the National Stock Exchange for a November 2005 option on SBI:
Call with X = 880, c = 34; current stock price = 880
Hedging with Call
Short position in SBI stock
Bought1 call at X = 880; Premium paid = 34
Initial cost of hedging = 34
Payoff of short on asset and long on call

Graphical view: Short stock and long call payoff

Payoff (2)
846

When St
rises above 880: 34

Price of SBI (%)

at a price not exceeding %880. If the price remains below %880, he does not exercise the call,
and instead buys the desired stock at a lower price in the market. The maximum price would
bex -+-'¢; 1.6, 880 + 34 =" 914.

HEDGING PORTFOLIOS WITH INDEX OPTIONS [iui

Stock options are used to cover risk on specific stocks. These risks on stock comprise both
systematic risk and unsystematic risk. Index options are used by investors to cover systematic
risk or market risk. In case of portfolios, unsystematic risk is diversified
Index options are mostly away, while market risk remains. Therefore, options on an index are best
used by mutual fundsto = suited for large funds that already have minimized unsystematic risk by
hedge against systematic
ie _ divec nea
diversificati on. T To protect against
. .
market risk, pean
one can take a position in
. _ index options.
 Hedging with Options 427

Options on an index are cash settled, with the difference between the closing value of the
index, S and the strike value, X, being paid if the option is in-the-money. For call options, it
is Max(S — X, 0), and for puts, it is Max(¥ — S, 0).

Hedging Long Portfolio with Put on Index

We know that buying a put on an individual stock insures against price fall below a particular
level. A long position in stock trading at $140, with a put on the same with a strike of, say,
~120 would protect the value of the stock from falling below %120. Similarly, in case of a port-
folio, protection against a general fall in the market can be had by buying a put on an index.
For example, consider an investor who has a portfolio with a current market value of
~10 lakh. Assume that the beta of the portfolio is the same as that of the market, and the
index is currently at 4000. With a beta of 1, the portfolio moves equivalently with the
market. When the sentiments of the market are weak, and a general fall in equity prices is
expected. The investor needs to protect the value of the portfolio for erosion in value by not
more than 10%.
A simple way to protect against a likely fall of the market is to buy a put with a strike of
_ 10% below the current level ofthe index, 1.e., 3600. If the contract size is 50
A long portfolio position
can be protected against _ indices with %1 as the value of one point, then the value that would be cov-
systematic risk by buying ered by one contract is 50 X 4000 = 22 lakh. The investor needs to buy five
a put on an index. put contracts to cover the exposure. If the index falls by more than 10%, the
a shortfall in the portfolio would be compensated by the payoff on the put. The
position of the investor at the expiry of the option period for two contrasting situations—a
20% fall and a 10% rise in the index—is presented here (ignoring the premium paid for buy-
ing the put).
Figures in&
Put payoff Portfolio value Total value
Exercise put (3600 — 3200) x 50 x 5 8,00,000 9,00,000
Let put lapse 0 11,00,000 11,00,000

When Beta of Portfolio is Other than 1 The hedging value ofa portfolio against a fall in
price with index options involves three decisions: (a) the value of the exposure in the options,
(b) the protection level desired, and (c) the strike price on the put option. In case of a port-
folio with a beta equal to 1.00, all the three decisions were simple. The exposure in options
was equal to the value of the portfolio. Protection desired for a fall of more than 10% fixed
the strike price of the put option at 10% below the current value of the index. Normally, a
well-diversified portfolio would have the same beta as the market.
However, portfolios may at times be either aggressive (beta > 1.0), aiming at higher than
_ market returns under bullish sentiments, or defensive (beta < 1.0) aiming at
When the beta of the _ less than market losses under bearish sentiments. In such cases, while hedg-
oe Gk - ing the value of the exposure in options, their strike prices need to be modi-
tion and its strike needto _ fied. Consider the same portfolio of ¢10 lakh but with a beta of 1.60, with a
be adjusted forthe value desired protection level of 10% over a period of one year. The current value
_ of the beta. of the index is 4000. Would buying a put of 3600 serve the purpose, as it did
- in the earlier case, when the beta of the portfolio was 1.00?
428 Derivatives and Risk Management

The relationship between portfolio protection and market decline has to be viewed in the per-
spective of the capital asset pricing model (CAPM). As per CAPM, portfolio returns in excess
of the risk-free rate would be beta times the index returns in excess of the risk-free rate, 1.e.,
Excess returns of portfolio = B X excess returns on index
If the risk-free rate is 8% and the dividend yields on the portfolio and the index are the
same at 2%, then the strike price of the put to be bought is calculated as follows:
All values on p.a. basis
Acceptable level of decline in portfolio value, the capital loss —10%
Dividend yield on portfolio 2%
Returns net of dividend yield —8%
Returns on portfolio with respect to risk-free rate = —8% — 8% =16%
Beta of the portfolio 1.60
Equivalent excess returns on the index = —16%/1.60 —10%
Return on the index with respect to the risk-free rate = —10% + 8% 26
Dividend yield on the index 2%
Capital loss on index = —2% — 2% —4%
Therefore, the strike price of the put (percentage of the current index value) = 96%
Hence, in order to hedge against a fall beyond 10%, a strike price on the put option below
4% of the current index value is required, as compared to 10% below in the case where the beta
of the portfolio was 1.00. Therefore, to hedge the portfolio of =10 lakh for a minimum value of
_ %9 lakh (10% below), the hedger would buy
To hedge a portfolio with
beta > 1, a higher num- (a) a number of puts equivalent to the beta X the portfolio value
ber of puts with higher = 1.6 X 10,00,000/4000 = 400
strike prices needs to be
: (b) at a strike price of 4% below the current index level
= 0.96 X 4000 = 3840
This implies that when the portfolio beta is more than 1, hedging would be costlier for
two reasons: (a) the need to buy a higher number of puts, and (b) a higher strike price. We
know that a put with a higher strike price costs more.
Now let us assume that the value ofthe portfolio falls by 15% to 8.50 lakh. Is the investor
protected with a level of $9.00 lakh? If the portfolio has fallen by 15%, we find the value of
the index and the payoff from the puts as follows:
Capital loss suffered = —-15%
Return after dividend yield =r 15% 2% = 13%
Return with reference to the risk-free rate eel Bia =—a8% = —-21%
Return on the index with reference to the risk-free rate — 2 1 Or eG = —13.13%
Return on the index = —13.13% + 8% = —5.13%
Capital return on the index after dividend yield = —5.13 — 2% = =7.13%
New value ofthe index = (Cl Sel 3%) e000 ans
Gain from the put = (3840 — 3715)8 400 =2250 000
Value ofthe portfolio after the put = 8,50,000 + 50,000 = %9,00,000
 Hedging with Options 429

Note that in all these analyses, the period of hedging is taken as one year. In case the period
is different, all returns would need to be modified for the contemplated period of hedge.

Hedging Short Portfolio with Call on Index

A short position on a portfolio needs to be protected against price rise. A plan to acquire
_ a portfolio in the future is analogous to a short position in a portfolio. Any
_ Ashort position ina
_ rise of the market in general would be disadvantageous to the prospective
_ portfolio can be protected
against systematic risk by nvestor. This risk of price rise may be covered by buying a call option.
buying a call on an index. Consider an investor who needs to acquire a portfolio worth $10 lakh with
a beta of 1.00. The index is currently at 4000. The investor needs to cap the
cost of acquiring the portfolio at 110%, or $11 lakh. To do so, the investor needs to buy a
call with a strike of 10% above the current level of the index, 1.e., at 4400, worth 10 lakh.
If the index rises by more than 10%, the shortfall in the portfolio would be compensated by
the payoff of the call. Thus the cost would not exceed %11 lakh.
The position of the investor at the expiry of the option period for two assumed scenarios—
a 10% fall and a 20% rise in the index—is presented here (ignoring the premium paid for
buying the call):
Figures in
Call payoff : Portfolio value Total cost
Exercise call (4800 — 4400) x 50 x 5 12,00,000 11,00,000
Let call lapse 0 9,00,000 9,00,000

When Beta of Portfolio is Other than 1 In case the proposed portfolio has a beta other
than 1.00, the analysis for determining the strike price of the call and exposures to the deriva-
tive would have to be done on a similar basis as was done in case of hedging long portfolio
with a put.
Assuming the beta of the proposed portfolio as 2.00, with a current index value of 4000, a
risk-free rate at 8% and dividend yields on the portfolio and the index at 2% each, as before
the calculation ofthe strike price ofthe call, the option for protection beyond 10% rise in the
price is shown as follows:
All values on p.a. basis
Acceptable level of rise in the portfolio value 10%
Dividend yield on the portfolio 2%
Returns after dividend yield 12%
Returns on portfolio with respect to the risk-free rate = 12% — 8% 4%

The beta of the portfolio 2.00

Equivalent excess returns on the index = 4%/2 2%

Return on the index with respect to the risk-free rate = 2% + 8% 10%
Dividend yield on the index 2%
Capital loss on the index = 10% — 2% 8%

Therefore strike price of the call (% of current index value) 108%

430 Derivatives and Risk Management

EXAMPLE 15.1 Hedging long portfolio with put option on index

A mutual fund owns an aggressive portfolio of stocks with a beta of 1.15. Due to political uncertainty, the market is expected to
decline in the near future, for six months, after which the political uncertainty is likely to end. The portfolio is worth ¥10 crore, and
provides a dividend yield of 3%. The current level of the index is 5000, and yield on the index is 4%. The mutual fund needs to
limit its losses to 10% for the next six months. Find out the value of a put option and its strike price for hedging capital losses not |
exceeding 10%. Assume a risk-free rate of return of 6%. 7
Solution
L
To find out what level of decline in the index would cause the portfolio to lose 10% of its value, we use the CAPM, incorporating |
the dividend yields on the portfolio and the index. The CAPM, with returns broken into capital gains and dividend yields, is given by 7
A,r Dy = Fe? BlRn + De > Rp

where A, and D, represent capital gain and dividend yield on the portfolio, respectively, and R,, and D,, are capital gain and |
dividend yield on the index, respectively. R; is the risk-free rate of return.
Substituting the values of the expected decline of 10%, we solve for an equivalent percentage fall in the index.
—{0+15=3+115(R,+2—3)gvesR, =—9%
A fall of 9% in the index would protect loss beyond 10% in the portfolio. The mutual fund must buy put options with a strike price :
of 9% below the market, i.e., 5000 x 9% = 450 points. The strike price of the put, therefore, should be 4550. 7
The value of the put options must be 1.15 x the portfolio value = 1.15 x 10 = 211.5 crore.
11,50,00,000 _
Assuming one rupee equals one index point, the number of puts bought = 000 23,000
If the market falls by 10% to 4500 levels, then the return on the portfolio would be
Ry D,= Ry + B(Am + Dm Ay) = —11.15%
Ap + 15 =3 + 1.15 (—10 + 2 — 3) gives R,
Hence the portfolio would now be worth (1 — 0.115) x 10 = 8.885 crore.
The payoff from each put would be 50(4550 — 4500), and the total payoff is 23,000 x 50 = 211.50 lakh.
Hence, the portfolio wo e.

Hence, in order to hedge against a price rise beyond 10%, a call option above 8% of the
current index value is required. Therefore, to hedge a portfolio worth 710
To hedge a short position —
in aportfolio with beta lakh today for a cost not to exceed 11 lakh (10% , above the value) the pro-
> 1, a higher number _ Spective investor would buy
of calls with lower strike
prices is needed, increas- | (a) Number of calls = beta X portfolio value
ing hedging costs. = 2.0 X 10,00,000/4000 = 500
en ~~ (b) Strike price = 8% above the current index level
= 1.08 xX 4000 = 4320
This implies that when a short position has a beta in excess of 1, the investor needs to
buy more calls with a lesser strike price than if the portfolio beta were 1.00. Again,
such a
hedge would be costlier because (a) more calls are bought, and (b) calls with
lower strikes
cost more.
Now let us check if it works. If the portfolio has risen by 20%, we find the index
level,
and hence, the payoff from the call as follows:
 Hedging with Options 431

The additional cost for acquiring the portfolio = 20%

Return after dividend yield = 20%. + 2% = 22%
Return above the risk-free rate = 22% — 8% = 14%
Return on the index above the risk-free rate = 14%/2 7%
Return on the index = 7% + 8% 15%
Capital return on the index after dividend yield = 15% — 2% 13%
New value of the index = (1 + 13%) X 4000 4520
Gain from the call = (4520 — 4320) X 200 €1,00,000
Effective cost of the portfolio after the call = 12,00,000 — 1,00,000 = €11,00,000

EXAMPLE 15.2 Hedging short portfolio with call option on index

A mutual fund wants to acquire an aggressive portfolio of stocks worth €10 crore, with a beta of 1.5. The market is on the rise, and
funds would be available only after six months. The current level of the index is 5000, and the yields on the index and the proposed
portfolio are identical at 4%. The mutual fund needs to limit its losses to 5% for the next six months. Find out the value of a call
option and its strike price for hedging against any rise in the value of the new portfolio by 5%. Assume a risk-free rate of return of L
8%. All returns and yield are for a 6-m period. Examine the position of the mutual fund if the market rises by 10% in six months. L

ston what level of decline in the index would cause the portfolio to lose 5% of its value, we use CAPM, as given in
Example 15.1.

Bae Da By Blin ck Da fi)

Substituting the values of the expected decline of 5%, we solve for the percentage fall in the index.
bo 2 = 44 1:5(A, + 2 — 4) gives A, = +4%
A rise of 4% in the index would mean a loss of 5% in the portfolio. The mutual fund must buy call options with strike prices
of 4% above the market, i.e., 5000 x 4% = 200 points. Therefore, the strike price of the call should be 5200.
The value of the call option must be 1.5 the portfolio value = 1.5 x 10 = %15 crore.
Assuming one point as one rupee, the number of calls bought
= 15,00,00,000/5000 = 30,000
If the market rises by 10% to the 5500 level, then the capital loss on the portfolio would be 4% as below:
Rpt Do Ay + BlAg: + Dn — Fy 14%
R, +2=4+74.5 (10 + 2 — 4) gives A, =
Hence the portfolio would now cost 1.14 x 10 = <11.4 crore.
The payoff from each call would be 300 (5500-5200) and total payoff is 30,000 x 300 = %0.90 crore.
After the payoff from the call, the portfolio would cost 11.40-0.90 = 10.50 crore, the maximum level, i.e., 5% above the current
value afforded by the mutual fund

HEDGING WITH CURRENCY OPTIONS *

Exposures on a foreign currency can be hedged through options on that foreign currency. The
underlying is the spot exchange rate of the foreign currency. We discuss hedging receivables
and payables with options.
432 Derivatives and Risk Management

Hedging Foreign Currency Receivable with Put Option

Buying put option protects long position in assets. The concept of a protective put can be
_ extended to foreign currency exposures. Exporters who sell their products on
Receivables in a foreign
_ credit face exchange rate risk. Having invoiced in a foreign currency, the
currency can be protect-
ed against depreciation _ position of the exporter is equivalent to having a long position in a foreign
of that foreign currency _ currency equal to the amount of the account receivable in the foreign cur-
by buying a put option. rency. The value of the asset would drop if the foreign currency depreciates.
Like with stock, the position in the receivable too can be protected by buying
put options with the strike price at which protection is desired. Foreign currency options are
mostly available over-the-counter (OTC) with banks.
For example, assume that an exporter has sold goods worth US $10,000 with payment due
in six months’ time. The value of the dollar after six months is uncertain. The exporter has
planned his profit by assuming that his dollar receivable would be paid to him at around <45
per dollar. Realizing more than %45 (the dollar appreciating) would be a pleasing situation,
but anything less than 45 could seriously dent the target profit. The exporter can protect
his/her position by buying a put with a strike price of 745, valid for six months, by paying a
small premium of, say, ¥0.50 per dollar.
Should the exporter hedge his position with a put, the net realization would always be
greater than €44.50 per dollar (the strike exchange rate — the premium). Should the rate hap-
pen to be less than €45, say 743.00, the exporter can exercise his/her put, resulting in a profit
of 2.00 (45 — S). The exporter sells his/her dollars at $43.00 and is short of the target by
%2.00. The shortfall is made good by exercising the put. The realized exchange rate with put
under two different scenarios for the exchange rates at the time of actual receipt of foreign
currency are as follows:

Figures in =
Spot price Position of put Put payoff Asset value Realized price
S < 45.00 Exercise put 45: 00h 7S) = 0150 S 44 50
S > 45.00 Let put lapse —0.50 ‘S) oO 0150
(larger than 44.50)

Value of asset

Unhedged

44.50
“T Hedging with put

X = 4500 Price S

Fig. 15.4 Hedging receivable with put

 Hedging with Options 433

As can be seen from this, hedging a receivable through a put not only protects the value
to some minimum level, but also helps in retaining potential gain if the currency appreciates.
At the time of realization, if the spot price were %48, then the exporter would end up getting
%47.50 for each dollar. Hedging with a put provides a floor to the exporter, as depicted in
Fig. 15.4. The exporter retains the potential to make gains in case of depreciation of the local
currency by paying a small cost of 0.50, simultaneously protecting against downside losses.

Hedging Foreign Currency Payable with Call Option

Payables
inaforeign cur. 4 call option provides an effective hedge for the exposures of importers
rency can be protected who make payments in foreign currency on a deferred basis. Importers who
against appreciation of buy their products on credit also face exchange rate risk. Having accepted
that foreign currency by the obligation to make a certain payment in a foreign currency, they fear
buying
a call option. rie ;
_ Ce appreciation of foreign currency. Their requirement of the foreign currency
in future is analogous to a short position in the foreign currency. The value
of the liability would rise as the foreign currency appreciates. Like a short position on stock,
the payable can be protected by buying a call option with a strike price at the level at which
protection is desired.
For example, assume that an importer has bought goods for US $10,000 for which he/
she has committed payment in six months’ time. The current exchange rate is ¥47.00/$. The
value of the dollar after six months is uncertain. The importer has planned his/her profit by
assuming that the dollar rate for his payable would not exceed %50. Paying more than 750
(the dollar appreciating) would be a disaster for the bottom line. The importer can protect
his/her position by buying a call option with the strike price of %50, valid for six months, by
paying a small premium of, say, 70.50/$.
If the importer hedges his/her position with a call, the maximum payment is capped at
%50.50 (strike exchange rate + premium). Should the rate happen to be less than 50, say
~48.00, the importer can buy the foreign currency at %48.00, limiting the overall cost to
~48.50. However, if the rate happens to be in excess of 50, the importer exercises the call
option to get dollars at €50, limiting the overall cost to 50.50. This is shown in the following
table:

Spot price Position of call Call payoff

S < 50.00 Let call lapse = 0.50 Se 050
(Less than 50.50)
S > 50.00 Exercise call S— 50.00 — 0.50 50.50

Like a put works for a receivable, a call works for a payable. Hedging a payable with a
call not only protects the cost but also helps in retaining the potential for gain if the foreign
currency depreciates. At the time of realization, if the spot price is 48, then the importer
would end up paying ~48.50 for each dollar.
Hedging with a call provides a cap to the importer, as depicted in Fig. 15.5. The importer
retains the potential to make gains in case of appreciation of the local currency by paying
434 Derivatives and Risk Management

Exchange rate
paid (%/$) Unhedged

K+ c= 50.50

50.00 Exchange rate (%/$)

Fig. 15.5 Hedging payable with call

a small cost of ¥0.50. Of course, he/she protects himself/herself against losses arising from
depreciation of the local currency.

Range Forward—Zero Cost Collar

We considered hedging of a long position by buying a put and a short position by buying a
call. Both the strategies required an initial cost equal to the price of the option that must be
paid upfront. While the put assured a minimum value of the underlying asset, the call ensured
the maximum cost of a liability. Hedging through options involves a cost, as buying an option
requires an upfront payment.
The cost of options has always been a consideration for importers and exporters. Remem-
_ ber that the party who sells an option earns the premium. As a cost-saving
To offset the cost of
hedging with options, one strategy, one may consider buying one option while writing another, so that
may sell another option, the initial outlay on the position is minimized. Ifthe strike price of both the
earning a premium but options is the same but notional is different, the position is called a partici-
sacrificing some gain, pating forward. Where the strike prices of the options bought and options
and assuming part of sold are different, the position is called a range forward. For example, to
the risk.
protect against a price fall (for a receivable), one may buy an out-of-the-
money (OTM) put and write an in-the-money (ITM) call. Since the OTM
option would be cheaper than the ITM option, the net initial position can be set up with zero
cost by writing a smaller number of calls than the number of puts bought. The puts would
provide protection against any price falls, while the call would not fully negate the advantages
of price rises. Protection would not be available till the price falls below the strike of the put,
which is OTM. However, some part of the risk would have to be borne by the investor (the
current price and the strike price ofthe put).
In the range, given by the difference between the two strike prices of the options, the
position of the hedger is not covered. For currency options, the following positions con-
stitute a range forward for importers and exporters, as depicted in Fig, 15:6;

Exporters A range forward is created by buying a put with a lower strike price, X;, and
writing a call with a higher strike price, X>. Buying a put is a right to sell, and writing a call
 Hedging with Options 435

Exporter

Importer

Fig. 15.6 “Range forward—pay off

is an obligation to sell. Both positions are consistent as exporters sell foreign currency. They
have a right at one price and an obligation at another. For a spot price below_Xj, the put would
provide protection; between X, and X3, the market price prevails; and above X3, the benefits
of increased realization are foregone, as the obligation under the call written arises.

Importers A range forward is created by buying a call with a higher strike price, X>, and
writing a put with a lower strike price, X,. Buying_a call is a right to buy and writing a put is
an obligation to buy. Both positions are consistent as importers buy foreign currency. They
have a right at one price and an obligation at another. For a spot price above_X5, the call would
provide protection; between X, and X} the market price prevails; and below Xj, the benefits
of a lesser cost are foregone as the put becomes activated.
Depending upon the premiums of the call and the put, the range forward may be set up
at zero cost by adjusting the strike prices of the options bought and sold. The range forward
would have a cost of zero or close to zero. Does this mean that hedging can be done at no
cost? Certainly not. The protection is available only after some losses are borne by the hedger
and potential gains are sacrificed. The guaranteed price is more unfavourable under a zero
cost option than it would be with a single option. Therefore, it is a compromise between the
cost and the objective of hedging.
The payoffs on range forwards for exporters and importers are shown in Fig. 15.6. Long-
term contracts involving cash flows in foreign currency involve range forwards in different
fashions. This is done by incorporating clauses on payment terms based on exchange rates.
Such clauses work like range forwards. However, financial markets provide risk sharing
based on the buying of one option and the selling of another.
As a receivable-related example, consider an Indian exporter who has sent goods to Sin-
_ Atange forwardisa _ gapore invoiced in Singapore dollars (SGD). If the current spot rate is 725/
_ product based on options _ SGD, the exporter may set a range forward by buying a put at the exchange
that helps reduce the rate of %24.50/dollar and selling a call at %25.50/dollar. The payoff on such
costofhedging, =
a position is presented in Table 15.1.
436 Derivatives and Risk Management

Table 15.1 Range forward

Event Exchange rate Value of receivable

SGD appreciates beyond acceptable limit < %24.50/SGD 724 .50/SGD
SGD remains within the acceptable limits 224 50-25.50/SGD Actual rate
SGD depreciates beyond the acceptable limits > ¥25.50/SGD %25.50/S

With a range forward, the exporter is prepared to bear the risk when the exchange rate
remains within the range of ¥24.50 to 25.50. Should the dollar depreciate below $24.50,
the exporter realizes 24.50, and when the dollar appreciates above ‘25.50, he/she realizes
no more than ~25.50 for the receivable.
The value of the receivable would change linearly with the exchange rate in a limited
range. It has a floor (the minimum rate that would be realized) and a cap (the maximum rate
that would be realized), as shown in Fig. 15.7.

Exchange rate

Value of
receivable

Exchange rate

Fig. 15.7 Range forward

As we know, a forward contract has a cost. Further, the buyer of a forward contract
fore-
goes the potential to make a profit in order to protect against losses. A range forward would
be more economical as compared to a forward contract because the buyer of the range for-
ward contract assumes some risk within an acceptable range.
Example 15.3 presents a comparison of hedging strategies with a forward, a put, and
a
range forward. In the range forward, the net cost of the hedging was brought
down from
0.70 for the put option to 70.35 by writing a call at %47.00, thus foregoing any
gain from
an upside movement of the exchange rate beyond 247.00. In order to achieve
a zero cost
 Hedging with Options 437

EXAMPLE 15.3 Hedging strategies with options

Assume that an exporter is expecting to collect some receivables denominated in US dollars three months from now, and is
worried about fluctuations in the foreign exchange markets. He/she wants to analyse hedging benefits available under various
scenarios based on the following information.
The spot exchange rate is 45 per dollar and a 3-m forward contract is offered at 45.50 per dollar. Call and put options at
various strike prices are also available. A put option with a strike price of %45.50/dollar sells at a premium of 0.70 and a call
option with a strike price of €46.50 is selling at £0.35.
Tabulate the payoffs and value of receivables for the exporter for a given range of final exchange rates between %40.00 to
~50.00 at the end of three months if the exporter
(a) decides to remain unhedged
(b) buys a forward contract at $45.50
(c) buys a put with a strike price of €45.
(d) buys a range forward with at market between %45.50 and 46.50
Further, plot the payoffs and values under the given scenarios.
Solution
If the exchange rate at the end is S;, then the exporter is likely to reap the following payoffs and values:
(a) Under an unhedged position, the payoff would be (45.00 - S;), and the total value realized would be equal to the market
rate, Sr.
(b) With a forward contract, the payoff would be (forward rate - S;) and the total value realized would be equal to the forward
rate, irrespective of the value of Sr.
(c) With a put option at a strike of X, and a premium of p, the te would be Max(X, — S; — p, —p) and the total value realized
would be a minimum of %45.30 oie S7 is below %46.00/dollar and (S7 — 0.70) when the exchange rate is above €46.00/
dollar.
(d) With range forward, a call with a strike price, — X,, of 47.00 would be written earning a premium, c, of 0.35 with a put option
at a strike of 46.00 and a ee of 0.70 paid. The net cash outflow would be %0.35. The payoff would be {Max (X, —
S7 — p, —p) - Max(S;— - C, — C)} for exchange rates less than 46.00 and more than 47.00. In between the two, the
realization would be (ST—ee The minimum would be %45.65 and the maximum would be €46.65.

The payoffs and values of realization are shown in the following table:

Payoffs and values under different scenarios (%/$)

Exchange Unhedged With put Range forward

ae
41.00 —4.00 41.00 5.00 46.00 4,30 45.30 4.65 45.65
42.00 —3.00 42.00 4.00 46.00 3.30 45.30 3.65 45.65
43.00 2.30 45.30 2.65 45.65

47.00 2.00 47.00 | —1.00 46.00 | —070 46.30 | —0.35 46.65

48,ame3.00 48.00 | —2.00 46.00 | —0.70 4790 | D8 46.65
49.00 4.00 49.00 46.00 ~0.70 48,30 ~2.35 46.65
50.00| 5.00 —4.00 46.00 | —0.70 49.30 | —3.35 46.65
The payoffs and values of realization are depicted in the following figures: L
Contd
438 Derivatives and Risk Management

Example 5.3 contd

Payoffs under given scenarios

Unhedged
Forward
Put option
Range forw

rate (</$

mene (Jnhedged
- oman FOrward
Put option

structure, one can consider writing two calls rather than one to compensate fully for the cost
of the put option. In such a case, the ratio of calls written to puts bought would exceed 1.
Such a combination for hedging is called a ratio range forward.
We now examine the position of a hedge with a ratio range forward, with the ratio of
calls written to put bought at 2. The payoffs and the value of the receivable are presented in
Table 152, |
Notice that in the ratio range forward, once the exchange rate goes beyond %47.00/dollar,
the receivable starts losing in value because the extra call written turns in-the-money and
creates a liability for the writer. The payoffs are shown in Fig. 15.8 and the values of the
receivable are depicted in Fig. 15.9.
 Hedging with Options 439

Table 15.2 Forward, range forward, and ratio range forward

Exchange rate Forward Range forward 7 Ratio range forward

Payoff | Value _|__ Payoff [Value Payoff Value
40.00 6.00 46.00 5.65 45.65 6.00 46.00
41.00 5.00 46.00 4.65 45.65 5.00 46.00
42.00 4.00 46.00 3.65 45.65 4.00 46.00
43.00 3.00 | 46.00 2.65 45.65 3.00 46.00
44.00 2.00 46.00 1.65 45.65 2.00 46.00
45.00 1 1. 0.65 45.65 1.00 46.00
46.00 SS PA ee 45.65 - 46.00
47.00 = 100 | 46.00 = 0.35 46.65 0.00 | 47.00
48.00 —2.00 46.00 —1.35 46.65 — 2.00 46.00
49.00 —3.00 = 239 46.65 400 | 00
50.00 46.65 —6.00 44:00

et = change rate {F/$}

Meg AB on
* :

neem
ROTWATS

comme Range Forward

venom Ratio Rarige Forwart

Fig. 15.9 Values—forward, range forward, and ratio range forward

440 Derivatives and Risk Management

SOLVED PROBLEMS © ~
SP 15-1: Hedging with stock options
An investor is holding 1000 shares of Reliance Industries Ltd (RIL), currently trading at $2300. A put option on RIL with a strike of
2100 and maturity of one month is available at $50. What purpose would buying the put option serve? Analyse the position after
one month for stock prices of 1800, 2000, and %2200 if the investor buys (a) 500 puts, (b) 1000 puts, and (c) 1500 puts.
Solution
Buying the put option would provide insurance to the value of the stock for prices below 2100. When the stock price falls below
2100, the holder can exercise the put option of selling the asset at $2100. This would happen if the position in the put option is the
same as the position in the underlying stock. In case of overbooking or underbooking of the put, the hedge would not be perfect, as
may be seen from the following table:

SP 15-2: Hedging with index options

Consider the investor in SP 15-1 and assume stock options are not available. Instead, option on index are available for hedging the
position. Further assume that the beta of RIL is 1.00. The current level of the index is 4600. If protection below the price of 2100
is desired, then
(a) What option strategy would you consider for hedging a long position?
(b) What would be the exposure in options?
(c) What would be the strike price of the options?
(d) How is this hedge different from the hedge taken in SP 15-2?
Solution
(a) The exposure of the investor is 1000 x 2300 = %23 lakh.
Protection on the exposure is required below the price of 2100. Therefore, the investor must buy put options.
(b) Since the beta of RIL is 1.00 and the risk is intended to be covered through index options, the position in options must be equal
to the amount of exposure. With the present level of the index at 4600, the number of put options to be bought
— 23,00,000 _ 500
4,600
(c) The strike price of the put option would be2100
=~7 x 4600 = 4200.
(d) The difference in the hedge with options on the index is that the risk of a fall in RIL shares attributable to a general fall in the
market, i.e., only systematic risk, would be covered. Hedging with put options with the RIL stock as the underlying would cover
both systematic and unsystematic risks.
 Hedging with Options 441

SP15-3: Hedging long portfolio with put option on index

Consider Example 15-1 in the chapter. Assuming that the dividend yield and the index yield are the same at 3%, find out the new
strike price of the put and the number of puts to be bought for protection below 10% of the current value of the portfolio. Examine
the value of the portfolio if the market falls by 15%.
Solution
To find out what level of decline in the index would cause the portfolio to lose 10%, again using CAPM with segregated capital gains
and dividend yields,
Pi aie a (ec Dy)
Substituting the values of the expected decline of 5%, we solve for the percentage fall in the index.
i+ to — 3 7 1.101A, + 1.5 — 3) gives AR, = 85%
A fall of 8.5% in the index would cause a loss of 10% in the portfolio. The mutual fund must buy put options with a strike price of
8.5% below the market, i.e., 5000 x 8.5% = 425 points. The strike price of the puts, therefore, should be 4575.
The value of the put options must be 1.15 times the portfolio value = 1.15 x 10 = €11.5 crore.
Assuming one put as one index, the number of puts bought
= 11,50,00,000/5000 = 23,000
If the market falls by 15% to the 4250 level, then the return on the portfolio would be
AyD) Sas oD (Aya Daye)
Byte ded soet 1.to t= 19! 1. bo18) gives.A,.==17.4/5%
Hence the portfolio would now be worth (1 — 0.17475) x 10 = 8.2525 crore.
The payoff from each put would be 100(4575 — 4250) and total payoff is
23,000 X 325 = %74.75 lakhs.
Hence, the portfolio would be insured at a level of €9.00 crore, i.e., 10% less than the existing value as desired in the hedge.

SP 15-4: Hedging with currency option

Opto Electronics Ltd has imported machinery worth €100,000 for which payment is due in six months’ time. The exchange rate
prevailing is ¥85/£. In six months, time, the pound is likely to appreciate to an estimated level of €90/£. A call option and a put option
with a strike exchange rate of €87/£ are available at 1.50 and 3.00. What should Opto Electronics Ltd do to hedge its exposure
in pounds? If it hedges, what would the maximum exchange rate it would pay to liquidate the liability be?
Solution
The firm is facing an appreciating foreign currency. To protect against the rise of the pound to as high a level as %90, the firm must
buy call option with a strike of €87/pound at a price of %1.50. For exchange rates of ¥85 and ~90 per pound, the combined position
of the payable on the due date would be as follows:
Figures in /€
Exchange rate ~ Call option Call cash flow Payable cash flow
85.00 Let call lapse Ane, —85.00 86.50
90.00 - Exercise call +1,50 —90.00

The firm can exercise its call option to buy the currency at a strike of €87/pound. The total cost of the payable would then be
limited to ¥88.50/pound, including the premium for buying the call option.
SP 15-5: Hedging with zero cost structures
Export Experts is an exporting firm that is very conscious of both the exchange rates it realizes on its receivables as well as the costs
of hedging. The current spot rate is €50.50/dollar, and the firm believes that the rupee would be depreciating further. However, it
decides to hedge by buying a put option with a strike of $50.50 at a cost of %0.70. In order to offset the cost, it also writes a call with
442 Derivatives and Risk Management

a strike of 251.50, because it can afford to forego any gains beyond this level. Since it believes that the rupee would be depreciating
only, and in order to recover its cost, it also writes a put option with a strike of $49.50, also selling at %0.35. A
For a range of possible exchange rates at the end from %48.00 to %55.00, find out (a) the payoffs on all the three positions and
(b) the value of the receivables. Further, depict the position graphically.
Solution
The spot exchange rate is 750.00/dollar. The exporter firm decides to buy a put with a strike of 750.50 at a premium of 0.70, assur-
ing itself of a minimum exchange rate of 749.80 (50.50 - 0.70) if it does not engage in any other option. By writing a put at 49.50
and a call at 51.50, it has recovered the premium on the put in full. This would have an impact on the position of the receivable. This
is shown in the following table.
Payoffs and values under zero cost structure
All figures in &
Exchange Put bought Put written Call written © TOTAL
rate (</$) Payoff Value | Payoff Value Payoff Value
48.00 1.80 49.80 1.15 46.85 0.35 48.35 1.00 | 49.00
48.50 1.30 49.80 —0.85 47.85 0.35 48.85 1.00| 49.50
49.00 0.80 49.80 =0.15 48.85 0.35 49.35 1.00 50.00
49.50 030. | 49.80 0.35 49.85| 0.35 49.85 1.00 50.50
50.00 0.20 49.80 0.35 50.35 0.35 50.35 0.50 50.50
50.50 -0.70 | 49.80 0.35 50.85 0.35 50.85 0.00
51.00 =0.70 50.30 0.35 51.35 0.00
51.50 0.70 50.80 0.35 51.85 0.35 51.85 | 0.00 | 51.50 |
52.00 ~0.70 51.30 0.35 52.35 ~0.15 51.85 0.50
52.50 0.70 51.80 0.35 52.85 ~0.65 51.85
53.00 -0.70 52.30 0.35 63.36 -| =145 51.85 ~1.50 51.50
The payoffs per dollar of the three options with the total values of the receivable are shown in the following figures. It may be
observed that for a range between %49.50 and %50.50, the realization is fixed at 50.50, and for a range between €50.50 and £51.50,
the exporter capitalizes on depreciation. However, beyond ~51.50, he/she foregoes the benefit, and the maximum realization is
pegged at %51.50 for an exchange rate beyond %51.50. However, if the rupee starts appreciating beyond 49.50, contrary to expec-
tations, the value of the realization starts falling.

Ne
ee en ares
*
Exchange rate {/$}-
S2 a

LLL
 Hedging with Options 443

Exchange rate (%/5)

EEE LEE EEE EERE ELE EEE EEE EEE EEE

SUMMARY ©
Options, because of their unique non-linear payoffs, offer a options. When the beta of the portfolio is 1 and the dividend yield
broader range of applications than other derivatives. These is the same for the index and the portfolio, then determining the
applications can be categorized in four types—hedging, income appropriate strike price of the option is rather easy. However,
generation, trading, and synthesizing. when the beta of the portfolio is not 1, or the portfolio yield is not
Hedging with options is different from hedging with other the same as the index yield, or when both situations exist, then
derivative instruments in that options protect the downside but we have to apply CAPM to find the appropriate strike price of the
retain the upside potential for gain. Of course, this does not option. The exposure in the options would simply be beta times
come free of cost. Exposures to stocks can be hedged with stock the value of the portfolio. _
options. Market risks for a portfolio can be effectively managed Exporters hedge receivables by buying puts and importers
with index options. Foreign currency exposures are managed by hedge payables by buying calls. Since the cost of buying options
_ options on foreign currency. Long positions in stock, portfolio, or is high sometimes, the exporters and importers strive to reduce
foreign currency are hedged through puts, while short positions the cost by writing some options that fetch a premium and thus
are protected by buying calls. help bring down the cost of hedging, while sacrificing some
_ A long position in stocks can be protected by buying a put potential gains. The selection of strike prices of the options to
at the strike level to which the stock holder can sustain loss. be bought and to be sold is governed by the hedger’s desired
Similarly, a short position in stocks can be covered by buying a outcome as well as the risk profile acceptable to him/her. Many
put. Hedging of a portfolio with index options requires selection such structures, such as range forwards or ratio range forwards,
_ of the appropriate strike price and the amount of exposure in the are available to suit individual needs.

KEY TERMS
Beta The sensitivity of the value of a portfolio with respect to other short—created with the objective of reducing cost and limit-
changes in the market. ing the holder's market risk to a small range.
Protective put A long position in an asset is protected against Ratio range forward Where the numbers of options bought
decline in value by buying a put. and options written are not equal but in a certain ratio.
Range forward A combination of options—one long and the
444 Derivatives and Risk Management

QUESTIONS sessment
15.1. How is an options hedge different from a hedge through 15.4 If the beta of a portfolio is greater than 1, the insurance
forwards/futures? of the portfolio would cost more. Do you agree with this
15.2 What do you understand by a protective put? Describe statement? Explain your answer.
how it protects value. 15.5 Differentiate between (a) a forward and a range forward
15.3 How is hedging through index options different from hedg- and (b) a range forward and a ratio range forward.
ing through stock options? If you hedge a long position in
stock with a stock option, would that protect you to the
desired extent?

PROBLEMS ©
P 15.1 Hedging portfolio with put expecting to receive €10,000 in three months’ time. The euro
A mutual fund is holding a portfolio worth €120 crore, almost rep- is likely to depreciate, and, hence, the exporter wants to lock-in
licating the market portfolio. The current value of the Nifty index the value at 763.00 by buying a put at a strike of $63.00, priced
is 4800. Due to uncertainty about the outcome of the forthcoming at 71.60. The exporter finds it expensive, and, hence, in order
elections, the market is expected to fall for the next three months. to cut costs, is prepared to write a call with a strike of €65.00,
The mutual fund needs protection against likely erosion in the selling at 2.00, and forego any advantage if the spot rate goes
value of the portfolio not exceeding 5%. beyond *65.00.
The yields on the portfolio and index are 4% and 3%, respec- lf the exporter wants to have no initial cost, how many calls
tively, and the risk-free rate is 8%. should he/she write for every put bought? What would be the
Find out the value of his/her receivables at spot exchange rates from ~62.00
(a) strike price of the put option to %68.00?
(b) number of contracts you would buy if each contract is for 50 If the exporter can write one call for every put bought, what
indices and each index point is worth <1 would be the value of his/her receivables at spot exchange rates
from %62.00 to 68.00?
P 15.2 Beta and hedging for long portfolio
Depict the value of the receivables for both the strategies.
What change in the hedging strategy would take place ifthe beta
At what level of exchange rate does the first strategy become
of the portfolio were 2.00, instead of 1.00?
superior to the second strategy?
P 15.3 Range forward and zero cost collar
The spot exchange rate for the euro is 64.00. An exporter is
 Options Trading —
Strategies

INTRODUCTION °
Learning Objectives
We discussed hedging applications of options in Chapter 15. After going through this chapter,
Like other derivatives, options too have speculative and arbi- readers should be familiar with
trage possibilities. In addition to these possibilities, options also s the various applications of options
offer unique applications that no other derivative do, because * using options to enhance income
other derivatives have linear and unidirectional payoffs. Some of » trading in options to obtain desired
returns and risk profiles, including
these applications unique to options are not feasible with other
combinations such as
derivatives. The extended applications of options emanate from « straddle
the non-linear payoff of options. « strangle
We have described various applications of options under the = spreads
following four heads: timing and methods for using
different combinations of options
Due to their non-linear
e Hedging strategies concentrate on synthesizing other financial assets
payoff, there are many
using options to hedge against the using options
more applications avail-
able with options than adverse price movement for a long
with other derivatives. or a short position in the underlying
asset.
e Jncome-generation strategies focus on using options to
enhance yields of the portfolios. This 1s possible because the
writer of options earns a premium.
e Trading strategies highlight different options to achieve
desired risk and return profiles, depending on the perception
of the market by the trader.
e Synthesizing strategies demonstrate the power of options to
create synthetic positions of other financial instruments. The
replication of the payoff effectively means a lesser investment
without compromising on returns, thus enhancing return on
investment.

While hedging has already been discussed, we now describe

the rest of the applications in this chapter. They are also referred
to as trading strategies.
446 Derivatives and Risk Management

_INCOME GENERATION WITH OPTIONS __

Hedging strategies with options, as discussed earlier, entail some cost in the form ofa pre-
mium to get the desired protection from the risks of fluctuating prices while
Bp = ee retaining the upside potential. Options can also be used for enhancing
i - ;
oo pees income. We know writing or selling options entitles the seller to earn an
stagnant. option premium. Writing an option is done with the intention of pocketing
the premium, hoping that the option would not turn in-the-money till expiry.
However, under certain circumstances, options can be used as income-generating tools to
enhance yields, without assuming significantly large risk.

NAKED CALL AND COVERED CALL

Writing options is extremely tempting for investors (read speculators) for their potential
to provide gains, though small in value, on zero investments. In fact, returns on investment
can be made infinite by writing options. To earn premium, an investor may choose to write
a call option hoping that the price will not exceed the exercise price. This would be done by
an investor who is extremely bearish about market conditions. If the expectations come true,
the call will not be in-the-money and it would not be exercised by the holder. The seller can
pocket the premium. However, in case the price exceeds the exercise price, the option holder
will exercise the call, and the seller will have to deliver the underlying asset by buying it at
the current market price. Such a strategy is called naked call writing, 1.e., writing a call on
an asset not owned. Naked call writing is deemed to be an extremely speculative strategy in
nature, since for a very small profit, i.e., the call premium, a call writer assumes the large,
potentially unlimited risk of incurring losses, as shown in Fig. 16.1.
Payoff

Profit

Fig. 16.1 Payoff—naked call writer

In contrast to naked call writing, the strategy behind covered call writing is to write a call
on an asset already in possession. In case the writer of the call already owns the underlying
asset, delivery can be made without going to the market to obtain the asset. This strategy can
be fruitfully deployed to enhance income when markets are dormant. Since not much gain is
foreseen on the asset owned in such market conditions, the holder of the asset may choose
to write a call to earn a premium and enhance return. In the rather unlikely circumstances
 Options Trading Strategies 447

Payoff

Long stock ,+*"

2?

ot S
piSet Covered
Short call ote call

Fig. 16.2 Writing acovered call re

EXHIBIT 16.1 Covered call writing

Strategy
© Longposition on stock
© To generate income, write a call onthe same asset for the hedging period
Example
The following
prices prevail on 21 October 2005 on the National Stock Exchange (NSE) for November 05 calls on Tata Steet:
Cail with X= 80 c= 14

Covered call
Long position in Tata Stee! stock
Sold one call at X = 380 Premium eared = 14
Initial income from the call = 14
Table for payoff on the covered call

Graphical view: Covered call payoff

Break-even points;
S - 366=0; S = 366
Payoff Maximum profit:
S rises above 320: 14
When
Maximum loss:
oi ha i ee
When S falls to 0: 366

Price of Tala Stee (2)

448 Derivatives and Risk Management

can fall back on the asset

of a rise in the price in excess of the exercise price, the call writer
call writing is losing the
already owned for delivery. The worst that can happen with covered
already made a substantial reward on
asset already owned. Perhaps the call writer may have
the asset after having acquired it at a low price.
call writing, gen-
Covered call writing, regarded as a less speculative strategy than naked
ng asset. The
erates income in times of range-bound movements in the prices of the underlyi
payoff on covered call writing is depicted in Fig. 16.2.
is presented
Anexample of covered call writing with a long position in the Tata Steel stock
of the
in Exhibit 16.1. Note that with the call written, the income is enhanced by the amount
premium of %14, as compared to a long position on stock without any call written.
A covered call is exercise price, written with X = 380 for of ¥ 14. When the price goes
_ beyond % 380, the holder would exercise the call and the writer would meet
Writing a call with an
asset in hand is called
his/her obligations without going to the market. If the price remains below
covered call writing. It %380—the expectation with which he/she chose to write the call—the call
enhances income when writer pockets €14 and continues to keep the asset.
markets are not volatile. Writing a call can be used repeatedly to earn frequent premiums, as long
as the markets remain sluggish. Calls are not a hedge against falling prices
while owning stock but provide a cushion in return to the extent of the premium earned on
the calls. Hedging against a fall in price can be achieved by buying a put option on the asset.

WRITING PUT |
The strategy of writing a covered call is used when no upside movement in the price is fore-
cast. Similarly, one can write a put when no downside movement in the asset price is antici-
pated. When an investor is short on stock (and is contemplating buying some) and foresees
no downside movement, he/she may decide to write a put to earn some return in the short
term. Writing a put option, while short on the underlying, is analogous to writing a covered

Payoff

Short put

Combined short stock

and short put

Fig. 16.3 Payoff writing put with short stock

 Options Trading Strategies 449

call. Though the term covered call is prevalent, the term covered put does not exist in usage,
though having cash equivalent to the exercise price amounts to possessing the underlying
asset. If one writes a put, one must buy the stock when required by the put holder at the
exercise price. The writer of the put gets the stock at the exercise price, which can be used
to fulfil the position of short stock.
Despite its income-generating potential, writing a put is seldom used. It may be because
short positions on stock are either not permitted or seldom taken by investors. The payoff on
a combined position (short on stock and short on put), which is similar to writing a call, is
depicted in Fig. 16.3.

Speculation with Single Option

Speculative strategies with options are rather simple—possibly as simple as with futures or
forwards. When the market is bullish, buying futures now and selling them later is appro-
priate, while under bearish conditions, investors would sell futures first and buy them back
later.
Similar speculative positions are possible with options. When the market is bullish, buying
a call option provides a gain of S —_X if the price exceeds the strike price,
As speculation, one buys
a call when the market where S' and X are the spot price at expiration/exercise and the strike price,
_ is bullish, and buys a respectively. Similarly, under bearish conditions, buying a put would provide
put when the market is a gain of X — S if the spot price is less than the strike price of the put.
bearish. Depending upon his/her opinion about future price movement, an investor
can take up the speculative position of buying a call or a put.
Unlike speculation with forwards/futures, speculation with options costs money. Buying
forwards and futures does not require any up front payment, and though there is a require-
ment for margins in futures. It is refundable and is only deposited as a form of security. On
the contrary, taking a long position in options requires payment of premiums. Therefore,
buying options as a speculative strategy must necessarily be done when the potential for gain
is likely to exceed the premium paid. Much is dependent upon the confidence level of the
investor in the direction of future movement.
Since volatility is a double-edged sword, a position in futures is more risky than a posi-
tion in options. Therefore, the levels of volatility must be reasonable when taking specula-
tive positions in futures. When volatility is high, it makes more sense to speculate with
options due to their ability to limit losses on one side of volatility. There is a big difference
between speculation with futures and speculation with options. Speculation with futures is
without protection against adverse price movement, while options do provide this protec-
tion. The maximum possible loss is already paid up as an upfront premium. This is shown
in Fig. 16.4.

Arbitrage with Options

Arbitrage opportunities with options, in the manner that we are familiar with in respect of
futures, are not available. Processes such as cash-and-carry and reverse cash-and-carry arbi-
trage are not possible for implementation with options due to the absence of convergence of
450 Derivatives and Risk Management

Payoff Bullish outlook Payoff Bearish outlook

Buying call Buying put

Fig. 16.4 Speculation with options

the kind that applies in the case of forwards or futures contracts. Options either expire worth-
less or are exercised at maturity depend upon price at maturity and exercise price.
However, arbitrage within options is possible. If two or more options are mispriced, arbi-
trage can be done by buying the underpriced option and selling the overpriced one. A few
such strategies were discussed in Chapter 10.

OPTION TRADING STRATEGIES

A position on a single option provides uneven gains or losses with changes in the price of
the underlying asset. A call option gives unlimited upside gain potential in
By combining options,
exchange for a small premium, while a put option provides potential for large
a wide menu of risk and
return profiles is available gains in falling markets in exchange for a small premium, as depicted in Fig.
for investors to choose 16.4. Due to the non-symmetric profile of risks and returns, options can be
from. __used in various combinations that can generate a vast number of risk—return
~ profiles. Investors can choose from hordes of risk—return profiles to match
their individual risk appetite and return preferences.
These strategies are used for trading as well as for hedging purposes. If options are com-
bined with the objective of risk containment, it is called hedging; when combined to take a
specific or directional view on future prices and risks, it would become a speculation. The
major distinction between hedge and speculation depends on whether the intention behind
the position taken is to reduce risk or to assume risk. Unlike other derivative values, option
values are dependent on many determinants, and the dimensions of risk can be with respect
to any of these parameters. These parameters are maturity, volatility, nature of assets, type of
options, exercise prices, option prices, etc., and form the basis on which many positions can
be formed. With futures and forwards, only long and short positions are possible.
Combinations of options can be done on any one or more of these various parameters, such as,

e the different types of options (calls and puts)

e different exercise prices
e different ratios of calls and puts
 Options Trading Strategies 451

e different expiration dates

e different underlying assets
The risk profile of a combination of options is an aggregation of the risk profiles of the
individual options constituting the combination. Some of the most common and popular
combinations (but certainly not exhaustive), are discussed here. Creativity is boundless, and,
as such, there is no limit to the combinations of options that can be invented by investors,
depending upon the risk—return profiles desired.

LONG AND SHORT STRADDLE

_ A straddle is a combination of simultaneous positions taken in call and put
A long straddle is formed options on the same underlying asset with the same time to expiry. A long
by buying a call and a put
straddle constitutes a long call and a long put, and a short straddle comprises
on the same asset with
the same maturity a short call and a short put. Both the call and the put have identical features.
eee
As both the options are bought, cash is needed to set up a long straddle. A
short straddle would have cash inflow.
If the price remains equal to the exercise price, both the call and the put remain unexer-
cised and the investor loses the premium. However, if the price moves away from the exercise
price, either the call or the put becomes in-the-money, depending on the direction of the price
movement. The long straddle starts recovering the cost incurred in setting up the position.
The short straddle would start losing from drift on either side of the strike price.
If the price goes higher than the exercise price, the call option becomes in-the-money, and
Aha straddle is cutanie | if the price is below the exercise price, the put option is in-the-money. The
when prices are volatile, payoff on a long straddle is depicted in Fig. 16.5 (a). A long straddle is a
while ashort straddle is suitable strategy when one expects volatility in the prices of the underlying
good when prices are asset with no directional bias. An investor with a long straddle gains with
range bound. price movements in either direction. It is suitable at times when a large move-
sii ment in the price is forecast but the direction of the movement is unknown.
A short straddle is formed by simultaneously selling a call and a put on the same asset
with the same strike price and the same expiry. It generates income as premiums on both
the options, i.e., the call and the put written, are received. With any change in the price of
the underlying asset, either the call or the put written becomes in-the-money. A movement

Payoff | Long call Payoff

Short call

®
tie ee P Rh i WR Bh we BE Me RH
e
Long put
| .o* Short put
i
e

'

(a) Long straddle (b) Short straddle

Fig. 16.5 Straddle (a) Long (b) Short

452 Derivatives and Risk Management

a
of the price away from the exercise price is detrimental to the interests of an investor with
nd
short straddle. A short straddle position is suitable for an investor who foresees range-bou
movement of the price around the exercise price, as can be seen from Fig. 16.5 (b).
Note that the combined position of a long and a short straddle results in zero payoff, con-
firming our earlier view that options are a zero-sum game.
An example of the long straddle is shown in Exhibit 16.2, where the investor has bought
a call and a put, both with a strike price of %780 on the same underlying asset, Reliance
stock, with the same expiry dates. In setting up this portfolio, the investor incurs a cost of
225, equal to the sum of the premiums on the call and the put. This would be the maximum

EXHIBIT 16.2 Long straddle

Strategy
e Buy acall for a strike price
e Buy a put for the same strike price on the same asset and with the same expiration
Example
The following prices prevail on 17 October 2005 on the NSE for October 05 options on Reliance:
X= 780 c= 15 p= 10
Long straddle
Bought 1 call at X = 780 Premium paid = 15
Bought 1 put at X = 780 Premium paid = 10
Initial cost of the long straddle spread = 25 + 10 = 35
Table for payoff on the long straddle
(All figures in 2)

Break-even point;
S — 805= 0; S— 805
S +765 =0; S- 765
Maximum profit:
When S falls: 765,
When S rises: Unlimited
Maximum loss
25 for S = 780

Price of the asset (®)

 Options Trading Strategies 453

loss. The investor breaks even with a price of 755 for Reliance stock, when the put comes
in-the-money, and of $805, when the call becomes in-the-money. Thus, a long straddle ends
up in profit with the price of the Reliance stock below %755 or above €805. Within the range
of ¥755 to ¥805, there would be some losses, with peak losses at a price equal to the strike
price of the two options, 1.e., ¥780.
The payoff for the investor in a short straddle, called the writer of the straddle, would be
exactly opposite to that of an investor in a long straddle. His/her peak profit would be %25
when the price of the Reliance share remains static at €780—the strike price of the options
written. Such an investor would incur losses when the price of the Reliance share falls below
755 or goes above %805. However, the break-even would be the same as that of an investor
with a long straddle.
A long straddle is not an appropriate strategy if the price stays within a tight trading range
and does not break out sufficiently before the expiry of the options. The right time to set up a
straddle would be just before the anticipated price breakout. Once the breakout has occurred,
some small amount can be earned by selling the option that has now gone out-of-the-money.
Being a combination of independent call and put options, a long straddle may be created
without an investor, with an equivalent short straddle. Call and put options may be bought
from different persons to have a long straddle. The same principle applies to the creation of
a short straddle, which may be created without a corresponding long straddle. However, few
exchanges offer straddles as an independent and composite product.

LONG AND SHORT STRANGLE

_ A strangle is similar to a straddle, except that in a strangle the exercise
While a long
ischosen withstraddle
ATM prices of the call and put options bought/written are different. A straddle is
options, a long strangle is usually created with ATM options. AS there is No intrinsic worth, the entire
- formed by buying a call at premium consists of time value, which is the highest in case of ATM options.
ahigher strike priceand = If we move away from ATM options towards OTM options, the cost of the
a put at a lower strike. set-up should be less, as OTM options would have no intrinsic value and
iia less time value.
For a long strangle, the exercise price chosen for the put is less than the spot price, while
the call option strike is chosen to be higher than the spot price. Hence, the strike of a put is
lower than that of a call option. If the price remains within the two exercise prices, none of
the options is exercised, and the premium paid on the options is lost. If the price goes above
the strike of the call or goes below that of the put, a long strangle starts, paying off the cost
initially and then resulting in a profit.
For a short strangle, the premiums earned by the investor is the profit if the price remains
within the band of the two exercise prices. The payoff on the short strangle is opposite to that
of the long strangle. The payoffs for long and short strangles are shown in Figs 16.6 (a) and
(b), respectively.
Exhibit 16.3 provides a comprehensive view of a long strangle. Both the call and the put
options are out-of-the-money when the long strangle is set up, as is indicated for the shares
of Reliance, trading at €780. The strangle is created by buying a call at Y = 800 and a put
at X = 760. Within the price range of ¥760—820, both the call and put options are worthless.
454 Derivatives and Risk Management

+ Long call 4
4

Masses
eae eee ee
io’

4
avs Short put

(a) Long strangle (b) Short strangle

Figure 16.6 Payoff of strangle (a) Long strangle (b) Short strangle

EXHIBIT 16.3 Long strangle

Strategy
© Buy a call for a strike price that is preferably higher than that of the long straddle
¢ Buy a put for a strike price that is preferably lower than that of the straddle on the same asset and for the same expiration
Example ©
The following prices prevail on 17 October 2005 on the NSE for October 05 options on Reliance:
X= 8000-6
X= /60p=5
Long straddle
Bought one call at X = 800 Premium paid = 5
Bought one put at X = 760 Premium paid = 5
Initial cost of long strangle spread = 5 + 5 = 10
Table for payoffon the long straddle
(All figures in %)

Graphical view: Long strangle-payoff

Payoff (®)
Break-even point;
750 S-— 810 =0; S— 810
—S + 750 = 0; S— 750
Maximum profit:
When S falls: 750,
When S rises: Unlimited
Maximum loss
25 for 760 < S < 800

ee Price of the asset (%)

 Options Trading Strategies 455

When the price goes below %760, the put becomes valuable and when the price is greater
than %800, the call turns in-the-money.
Like the straddle, the strangle too becomes profitable with a large breakout of the price
in either direction. However, the straddle starts paying earlier than the strangle. The strategy
is fruitful under situations where volatility is expected to be high, with no directional bias.
Some of these situations are described here, as follows:

e One situation arises when stocks are trading in the range with well-identified resistance
and support levels, and when one does not know which of the two would be pierced.
Breakouts are usually significant whenever they occur.
e Another situation favourable for creating a long strangle is at the time of a takeover
attempt. Great uncertainty exists when takeover attempts are made. The situation is
similar when some litigation reaches a point of decision specific to a particular firm.
Depending upon the outcome of the event, prices move rather significantly.
e Yet another time to have a long strangle is when widespread uncertainty prevails at
the time of a major or significant economic or political event, such as presentation of
the budget, announcements of monetary and fiscal policies, and declaration of election
results; these are events that cause large movements in market prices but with direction
unknown.
On the contrary going short on a straddle or a strangle makes sense when the investor
expects stability rather than volatility in prices.
Exhibit 16.3 shows the payoff on a long strangle with puts and calls at strike prices of
%760 and %800, respectively, both selling at $5.each. The investor breaks even at prices of
7650 and %810, and turns into profit with prices less than €750 and more than €810. This
may be compared with the payoff on a straddle in Exhibit 16.2. A strangle costs lesser than
a straddle, as a call with a higher exercise price and a put with a lower exercise price would
cost less. With a lesser cost of strangle, an investor with a long position loses some of the
likely gains from volatility, as compared to a long straddle position. An investor with a long
strangle earns a lesser profit (a) over a broader range of prices, and (b) for every price as
compared to the investor with a long straddle. This is a natural outcome, as a strangle costs
less, thus providing lesser profit and a larger range for loss.

STRAPS AND STRIPS

In a long straddle or strangle, the payoffs from volatility are equal for equal price movements
in either direction. This is due to the equal positions taken in call and put options in terms
of the number of contracts.
The payoffs from changes in price can be made unequal by changing the ratio ofthe call
and put options. For example, if the investor not only expects volatility in prices but also
believes that the likelihood of prices going up is far more than the prices coming down, he/
she can buy more than one call for every put bought. In the case of two calls for one put, the
gains from an upside movement would double, as two calls will become in-the-money. The
gains from an upside movement will be larger than the straddle, but will remain the same for
a downside movement. This combination is known as a strap and is shown in Fig. 16.7.
456 = Derivatives and Risk Management

Similarly in the opposite situation, where volatility is expected to be higher for a down-
side movement as compared to an upside movement, the investor can buy two puts and one
call, When the price goes down, the two puts become in-the-money, and when the prices
go up, only one call becomes in-the-money, making gains unequal for the same degree of
rise or fall in the prices, This combination is known as a strip and its payoff is depicted in
Fig. 16.8, ‘
Strips and straps make sense in markets with high expected volatility, with some direc-
tional bias.

Buying two calls

and one put
Buying two puts
and one call

Fig. 16.7 Payoff of strap

RE
BULL SPREAD © SS
SSSA
ea

The combinations discussed so far were created using two different types of options on the
same asset and the same expiration dates. Spreads are created with positions
A bullspread
issetu_ on the same type of options on the same underlying asset but with different
Se ee exercise prices. Spreads can be created using either calls only or puts only.
the sailing of a callwitha i We discuss bull and bear spreads here.
higher strike, } A bull spread is used by one who is moderately bullish about the market
pp in the near future. One buys a call when a bullish but high premium for the
call becomes a major consideration. When the prospects of a price rise are not as high, then
one can reduce the investment in a single call by writing another call at a higher strike price.
The call with the higher strike would sell for a lower value than the one bought, thereby
offsetting only part of the cost. However, it would result in a better risk—reward ratio.
A call with a higher strike price trades at a lower premium than a call with a lower strike
price. There will be net cash outflow while setting up a bull spread. A spread that results in
cash outflow at the time of set-up is called a debit spread.
If the market does not rise as expected and the price remains lower than both the strike
prices, both calls would expire worthless. The loss will be limited to the dif-
A bull spreadis used . . : ; : :
hen one is moderately ference between the premium paid and received on the call bought and writ-
bullish
about the market. __ ten, respectively. If the spot price is higher than both the strike prices, both
scenario. _ of the calls will be in-the-money, and the payoff shall be equal to the differ-
eee’ ence between the strike prices, less the cost of set-up. An illustration of a bull
spread is shown in Exhibit 16.4.
 Options Trading Strategies 457

EXHIBIT 16.4 Bull spread with calls

Strategy
e Buy a call for a strike price X;
e Sell another call at the strike price Xp > X, on the same asset and for the same expiration
Example
The following prices prevail on 17 October, 2005, on the NSE for October 05 options on the NIFTY:
X= 2600 c= 35, X= 2600 c=7
Bull spread
Bought one call at X = 2500 Premium paid = 35
Sold one call at X = 2600 Premium received = 7
Initial cost of bull spread = 35 - 7 = 28
Table for payoff for bull spread
(All figures in)

Graphical view: Bull spread-payoff

Break-even point;
S — 2528 = 0; S— 2528
Maximum profit:
Payoff (%) When S > 2600: Limited to 72
When S rises: Unlimited
Maximum loss
When S < 2528: Limited to*28

2528 2600 Price of the asset (%)

The maximum profit on a bull spread occurs when the price of the underlying asset is
higher than the higher of the two call strike prices. The maximum profit is given by
Protih— (X59 1X)) = (E> C2)
where X, and_X; are the two strike prices, and X, > X;
c, and c, are the call premiums with strikes of X; and X) respectively

Adverting to the data in Exhibit 16.4, with the investor setting a bull spread by buying a
call at a strike of 2500 and writing another at a strike of 2600, the investment stands reduced
458 Derivatives and Risk Management

from %35 as compared to a single call to 28, which is the maximum loss. His/her profit
would be pegged at %72 because beyond a strike of 2600, the call written offsets the gains
on the call exercised at 2500.
An extremely bullish investor would create a bull spread with both the calls initially out-of-
the-money. It would cost little, since both calls are out-of-the-money, with relatively lower
chances of high payoff. This is termed as aggressive strategy. A rather less aggressive strategy
will have one call in-the-money and the other out-of-the-money. The most conservative bull
spread is created with both calls initially in-the-money.
A bull spread can be created using puts only——buying a put with a lower strike and selling
a put with a higher strike. Such a spread would be a credit spread as it provides a cash inflow
at the time of the set-up, because a put with a higher strike sells for more than one with a
lower strike.

BEAR SPREAD Sitnammmnnesnsucneena

The opposite of a bull spread is a bear spread. An investor who believes that the market will
_ be weak in the near future deploys a bear spread by buying a call with a
A bear spread is set up
with the buying of a call _ higher strike price and simultaneously writing a call with a lower strike price.
with a higher strike and _ The set-up of a bear spread is likely to generate a positive cash flow, since a
the selling of a call with call written with a lower strike earns more than a call bought with a higher
a lower strike. It is used strike price. A bear spread is useful when the market is moderately bearish.
when the investor is mod-
A bear spread with calls is shown in Exhibit 16.5, with the same data
_ used for the bull spread. A call of 2600 is bought and another with a strike
of 2500 is sold, netting 28, which is the maximum profit. When markets
remain weak, both the calls, written and bought, are out-of-the-money. The investor makes a
profit equal to the income generated while setting up the bear spread. However, if the market
behaves contrary to expectations and rises, so as to make both the calls in-the-money, the
investor loses. The loss will be equal to the difference between the strike prices of the two
calls less the income generated in creating the bear spread position.
This strategy is a bearish strategy but not as risky as writing naked calls. It limits losses
to the difference between the strike prices of the calls less the initial cash inflow. Writing
a naked call would be extremely risky, and such a strategy is adopted when the market is
extremely bearish. Under a bear spread, another call with a higher strike is bought to provide
protection against a substantial price rise.

Debit and Credit Spreads

Both bull and bear spreads can also be created using just put options rather than
calls. They
would have almost the same payoff profiles as for calls. However, the differenc
e may lie in
whether a debit or a credit spread is being created. Whether the initial cash
is
A debit/credit bear _ an inflow or an outflow is an important consideration for investors. A debit
spread isone that results _ spread would provide for losses initially and wait for the profit
to accrue. A
es Gast OutlloW _ credit spread would book the profit initially, and then see if erosion takes place.
ee _ However, the payoffs remain the same, and it is a matter of individua
l choice.
 Options Trading Strategies 459

EXHIBIT 16.5 Bear spread with calls

Strategy
© Sell a call for a strike price X
o Buy another call at the strike price X, > X; on the same asset and for the same expiration
Example
The following prices prevail on 17 October 2005 on the NSE for October 05 options on the NIFTY:
X= 2500 C= 25, X= 2600 c= /
Bear spread
Sold one call at X = 2500 Premium received = 35
Bought one call at X = 2600 Premium paid = 7
Initial cost of long bear spread = 35 — 7 = 28 (cash inflow)
Table for payoff on bear spread
(Allfigures in?)

=e
508-200
eee
|6 2 6 +2008
S > 2,600 ~($— 2,500) | (S— 2,600) —2
Graphical view: Bear spread payoff
Payoff (%) Break-even point;
S — 2528 = 0; S— 2528
Maximum profit:
When S < 2600: Limited to 28
Maximum loss
When S > 2528: Limited to 72

Price of the asset (@)

Bull and bear spreads with puts can be created as follows;

For a bull spread Buy a put with exercise price X,, and sell another
put with exercise price X> > X|
For a bear spread : Buy a put with exercise price X>, and
sell a put with exercise price X, < X5
Both bull and bear spreads limit the upside and downside potential, as
Both bull and bear - compared to positions in a single option. Buying a call provides unlimited
spreads can be created upside gain while protecting against downside loss. By writing another call at
with puts alone or with a higher strike price in a bull spread, one reclaims some of the premium paid
me 6 on the first call, sacrificing upside potential. Similarly, writing a call implies
460 Derivatives and Risk Management

unlimited downside loss while earning a premium. By buying another call at a higher strike
price while creating a bear spread, the investor limits downside loss and sacrifices some income.

Risk—-Reward Ratio
Investors trading in spreads are often concerned with the risk—-reward ratio—a ratio that
compares potential gains with potential losses. The examples considered for bull and bear
spreads created with the same options highlight the difference between the two. Under the
bull spread, the potential for gain was 72, with a risk of ¥28. The bear spread results in a
potential gain of ¥28, with a risk of 72. The risk—reward ratio is of the order of approxi-
mately 3, favouring the bull spread. This ratio perhaps is compared with the likelihood
of upside and downside movements. For non-investors in derivatives who are investors in
underlying assets, an important clue about the potential directional movement may be pro-
vided. For example, it may be construed (though it may be wrong) from the risk—reward
ratios of bull and bear spreads that the market is more likely to be bullish, since more inves-
tors would be choosing bull spreads than those opting for bear spreads. The contradictory
interpretation would be that the market is heading for a bearish outlook because there may
be too many bulls now.

BUTTERFLY SPREAD’
A butterfly spread is an interesting combination, and is created by four options with three
_ different strike prices as follows:
A butterfly is created with
one long call at two differ- e One long call with a strike price of X,
ent strike prices and two
e Another long call with a higher strike price, X;
calls written with a strike
price in between the two ¢ Two short calls at a strike price X, that lies between _X, and_X,
bought.
The two calls written at the middle strike, X5, are around the current levels
of price of the underlying asset, to fetch an income with larger time values.
The call at the lower strike price, X), is in-the-money, and commands a larger premium. The

7
¢
Payoff 7
a Long call at Xx;
2 Short calls atX,
A ie i ie ee ee ee |

eeeee Seer ee erccresvcceeuscssencoesoem

Long call at Xx, ‘ :

X
\
OLE
EEE EEE. ee E

Fig. 16.9 Payoff of butterfly spread

 Options Trading Strategies 46]

EXHIBIT 16.6 Butterfly spread with calls

Strategy :
© Buy two calls, with two different strike prices, X, and Xg; and
_@ Two short calls for a strike priceX> in between the strike prices of the calls bought
Example _
Thefollowing prices prevail on 24 June 2004 on the NSE for July call options on infosys:
X= 5100 c = 425: X = 5200 c = 350; X = 5300 c = 280
Butterfly spread
Bought one callatX=5100 Premium paid = 425
Sold two calls atX=5,200 Premium received = 700
Bought —oneccallatX=5300 — Premium paid = 280
Initial cost of long butterfly spread = -425 + 2 x 350 - 280 =5
Payoff for butterfly spread
(All figures in)

Eee
Psiocs<sao | sss | - |
Fsz00<s<saw | s-so [assem] - | -s | -S+5005
Graphical view: Butterfly spread-payoff
Payoff
Break-even point;
S— 5105 = 0; S= 5105
S + 5295 = 0; S = 5295
Maximum profit = 95 at S = 5295
Maximum loss = 5 for S < 5100
and S > 5300

5200
5 be

other call, bought with a higher strike price, X3, 1s out-of-the-money, and has a lower price.
The nominal initial cost of creating a butterfly spread is one of its great attractions.
If the two calls that are bought have the strike prices as X, and X3, the strike price of the
two calls written at Y; is normally chosen as the average of X; and X3. If the price remains
below Xj, all calls are worthless, and expire without exercise. The investor suffers a nominal
loss, equivalent to the set-up cost. If the price exceeds 3, all calls are in-the-money, and are
462 Derivatives and Risk Management

exercised. The two calls bought compensate exactly for the liabilities of the two calls written,
and the investor again ends up with a nominal loss equal to the set-up cost.
When the price is above X; but below X3, only one call bought is in-the-money, and
the investor starts making a profit. He/she has maximum profit when the price reaches X),
beyond which both the calls written become in-the-money and get exercised. The inves-
tor starts losing out on the profit, as he/she pays on two calls and receives from one call.
When the price reaches X3, the second call bought also becomes in-the-money, matching
the aggregate liabilities on the calls written. The payoff on the butterfly spread is depicted
in Fig 16.9,
The strategy generates a profit if the price stays close to the current levels around 5 and
results in modest losses with a large change in price in either direction.
An example of a butterfly spread is shown in Exhibit 16.6, with a nominal cost of %5, with
_ potential to make a profit of 795 with two calls written at ¥ = 5200, one call
A butterfly is an ex-
bought at Y = 5100, and another call bought at Y = 5300 in respect of the
tremely tempting strategy
that involves a low outlay _ shares of Infosys. The risk-reward ratio is 5:95, a very attractive proposition
with potential for a huge _ that limits the losses to %5, with the potential to gain 795.
A butterfly spread can also be created with put options by buying two
separate puts at X, and 3 and selling two puts at the same strike price of
X. There also exist other combinations of calls and puts that may be used in constructing a
butterfly spread.
The butterfly spread can be viewed as a combination of a bull spread immediately followed
by a bear spread. Used with the call options, one would be a credit spread, while with puts
is a debit spread. Writing two options brings down the cost to a nominal level as compared
to bear or bull spread.

The condor spread is a modified version of the strangle. It is less risky than the strangle.
It
uses four strike prices, X;, X>, X3, and_X4, instead of the two used ina strangle,
with X, <_X,
< X3 < X4. A condor spread is created as follows:
¢ Long calls with two outer strike prices, i.e., at Y) and X4
¢ Short calls with strike prices in between, i.e.. X, and X;

The condor spread too can be thought of as a combination of bull and bear
spreads; bull
spreads with lower strike prices and bear spreads with higher strike prices.
Calls with Y, and
X) construct a bull spread, while the other two calls make a bear spread.
Figure 16.10 depicts
the payoff for a long condor created with two calls bought at X, and X,
and two calls written
at X, and_X3.
All calls are out-of-the-money for a price below X;. Between X,
and_X3, the call bought
with the lower price is in-the-money, leading to gain. Between Y3 and_X3,
the call written and
the call bought cancel out, and the other sets of calls have not become
in-the-money as yet.
Between X3 and X4, the second call written is operational and the liability
arises. For a price
beyond X%4, all four calls are in-the-money, but the calls bought and
the calls written cancel
each other out.
 Options Trading Strategies 463

_ Derivatives In Practice
Brokers market ‘Butterfly Spread’ for assured returns
On 24 May 2012, rich investors were advised by their brokers to opt for a conservative options strategy involving four legs to make
limited profits, as the market is expected to move in a range-bound, albeit indecisive, way in the near term.
Called a short butterfly spread, the strategy involves simultaneous selling of a put and a call option of the same strike price and
using part of the money from this to buy a call and a put of different strikes, but with the same expiration. By buying two OTM options,
the trader aims to hedge himself/herself in case the market breaches a forecast range.
in May 2012, most of the activity in options indicated that writers or option sellers expected 4,800 on the NIFTY to be a strong .
support and 5,000 a strong resistance. With a week left for the May series options to expire, brokers were advising clients to sell
4,800 strike (ATM) put and call options and to use part of the sale proceeds to purchase a 4,900 cail and a 4,700 put.
The amount, or premium, received from selling the two 4,800 strike options stood at 150, while the combined purchase of a call
and a put tailed an outflow of 765. The maximum profits accrue when the NIFTY May futures expire at around the middle strike price
(4800). Ifthe series expires at 4,800, the gain (excluding brokerage, etc.) will be 85 (150 — 65) as the OTM options expire worthless.
if NIFTY futures expire at 4,600, the gain will be €16 (66 profit from the OTM put purchased at €34 — 50, the payout for the ATM
put sold). Similarly, if the NIFTY expires at 5,000, the gain will be £19. ‘As we feel the market could move in a narrow range on either
side, the butterfly spread is a good tool to make relatively risk-free returns’, said Sahaj Agarwal, AVP (derivatives research), Kotak
Securities.
The butterfly spread is a safer way to make money in a range-bound and otherwise indecisive market’, agreed Shashank Mehta,
derivatives strategist, Shah Investor's Home.

Based on The Economic Times, 24 May 2012.

Payoff : + 1

i)
!
Short Call X, € '
|
|
'
¢ |
,
%
¢e
X3 , Price

pic re “ \y
eG een em
(es he eee ee

‘het, * , Long Call X, My :

Lé
Ll @ , %,
| Long Call X, “ &
% %

LOLOL LLOLLLLMM LALA MLL LAL ULLAL LIAM IU AU SLNRYEIRA EERE STI HEROIN EE EEG OIE IYER TON ERENT PEPE ESSE RIE ER REIT OEE REY ee
SLOVO

Fig. 16.10 Long Condor Payoff

An example of a condor is presented in Exhibit 16.7. Figure 16.10 and Exhibit 16.7 indicate
that a long condor is a suitable strategy when the markets are expected to remain in a rather
flat range. Under these circumstances, the condor gives the maximum profit.
A condor, created with
The risk—reward ratio is 15:85 for the condor spread depicted in Exhibit 16.7.
two long calls at two
outer strike prices and
As compared to a butterfly spread, the condor would have a larger range of
two short calls with _ prices that yield a profit. A butterfly spread, therefore, is useful when markets
in-between strike prices, are expected to be within a very narrow range, while the condor affords a
has an attractive risk- — Jarger range of prices of the underlying asset. With a larger profit range, it
reward rati
eke costs more.
464 Derivatives and Risk Management

EXHIBIT 16.7 Long condor spread with calls

Strategy
e Buy two calls, at two different strike prices of X, and X,
e Short two calls at different strike prices in between the two strike prices of the calls bought on the same asset and with
the same expiration.
Example
The following prices prevail on 24 June 2004 on the NSE for July call options on Infosys:
X =5100
c = 425; X = 5200 c = 350; X = 5300 c = 280; X = 5400 c = 220
Long condor spread
Bought one call at X = 5100 Premium paid = 425
Sold one call at X = 5200 Premium received = 350
Sold one call at X = 5300 Premium received = 280
Bought one call at X = 5400 Premium paid = 220
The initial cost of the long condor spread = 425 - 350 - 280 + 220 = 15
TABLE: Payoff on the long condor spread

(All figures in 2)
Initial TOTAL

$< 5,100 _. . : = bon 15

5,100<$<5200 $-5,100 = - = =15 S— 5,115
5,200<$<5300 | S-—5100 | —($—5,200) - = —15 +85
5,300<§<5400 | $-5100 | —(S—5,200)-| —($ — 5,300) = —15 —$ + 5,385
S>5400 | $-510 | -(S—5,200) |-(S- 5,300) |S — 5,400 Aas —15
Graphical view: Long condor spread-payoff

Break-even point;
Slee eo ne Kae eaaedoy Soper ene vveees vebxea Canaan
S—5115 =0; S—5115
—S + 5385 = 0; S— 5385
Maximum profit:
85 for 5200 < S < 5300
Maximum loss
15 for S< 5100 and S < 5400

Price of Infosys (%)

19

A condor can also be formed just with puts or from a combination of calls and puts. Refer
to this chapter’s Derivatives in Practice, where a butterfly was made from calls and
puts. If an
investor buys two puts with outer strike prices of X, and X4 and writes two with strike
prices
in between at X4 and _X3, he/she will have the same profile as one created with calls.
A condor can also be formed with a set of calls, long at Y, followed by short at_X5,
and a
set of puts, long at X3 and short at _Y4.
 Options Trading Strategies 465

x < eee TT: Long strangle ?,

~ ¢

Price

ier
Short condor

ELL ELL Wb
l"™l_kb'&h}l.
SG
Wy
w™6°"
©5s
®®
9

rison

A long condor looks like a short strangle with extremes curtailed to the wings. Similarly,
a short condor is similar to a long strangle. The difference, as illustrated in Fig. 16.11, lies in
the risk characteristics of the two. The condor can be deemed to be a less risky version of the
strangle. A long condor can also be seen as a butterfly spread with a flattened top. A strangle
when chipped at the ends forms the condor. The condor costs less, and the compromise is on
curtailing gains at extreme prices. A long condor can also be treated as a combination of a
bull spread (the first half) and a bear spread (the second half). Investors are enabled to choose
the exact risk profiles desired by them.

CALENDAR SPREADS ©”
Calendar spreads are formed by using options on the same asset with the same exercise price
Calendar spreads are : but with different expiration dates. An investor in a calendar spread is aiming
created with options _ to make a profit based on the time value of the options. With the passage of
expiring at different - time, the values must correct to yield gains.
times. They offer an A bullish investor takes a position in a calendar spread on the premise
epportny fe as _ that the price of the asset would not increase enough in the near term but
on temporary mispricings
that are likely to be cor- would exceed a predetermined level in the longer term. Therefore, a bullish
rected over time. _ investor buys a distant call and writes a near call, expecting the distant call
~~ bought to be in-the-money at expiration, while reducing the cost by writing
a near call. Only very experienced investors use such a strategy.
Similarly, a bearish investor may buy a near call but sell a distant call in the hope that
the price would rise enough in the near term to make the near call in-the-money, but will
fall thereafter, making the distant call out-of-the-money. The bearish calendar spread inves-
tor aims to make a profit at the time of set-up, as the distant call written provides a greater
premium than the premium he/she has to pay for the near call.
We know that the value of an option consists of two parts, 1.e., the intrinsic value and the
time value. Unlike other spreads, calendar spreads play on the time value of options. With a
larger time to maturity, the time value declines, but not fast enough. The time value declines
more rapidly as maturity approaches. An investor in a calendar spread capitalizes by writing
options whose time values decline more rapidly.
466 Derivatives and Risk Management

Diagonal spreads are constructed by using different strike prices and different maturities
of options on the same asset. The interpretation and objectives of such spreads are hard to
explain, and, further, are too numerous for tabulation and generalization.
However, as an example, consider an investor who believes that the price of a certain stock
will exceed 780 by November, but remain below 100 till December. The investor can adopt
the following strategy:
Buy a Noy call at X¥ = 80, paying a premium of ¢5
Write a Dec call at ¥ = 100, earning a premium of {10
His payoff is tabulated here:

Bought Dec call at

X = 100
Sold Nov call at
X = 80
Initial income

Max profit

It is apparent that the investor rules out the possibility of a price in excess of %100 at
the end of December, and, hence, the payoff is larger than the strategy of simply buying
a November call at £80, which would give him a maximum of ®15 as a profit. By writing
another call at €100 for the distant future, the investor earns an extra premium of ~10, and
at the same time has an option to square up the Dec call at any time, in case his/her forecast
about the future price appears to be failing.

Spreads on Different Assets

Very rarely do investors construct spreads on different underlying assets. Options on different
underlying assets provide an opportunity to investors to capitalize on the
ce _ relative valuation of the two or more assets in question. Investors have a
“the dowvetve pricingis tendency to value assets in comparative terms, and any divergence may cre-
inconsistent with the rela’ ate an opportunity to make some gains. For example, rather than concentrat-
tive pricing of two assets. ing on the absolute values of Infosys and Wipro, investors may watch the
eee relative valuation of the two. If an investor feels that as
an aberration, Infosys
is overpriced compared to Wipro and that the situation will correct itself with time, he/she
may choose to sell a call option on Infosys and buy a call option on Wipro. With time, as the
relative valuation corrects, the investor squares up by buying a call option on Infosys and
selling a call option on Wipro, negating the earlier position. The major advantage of such a
strategy would be the reduced cost. Buying one call and selling another on different assets
brings down the initial cost.
When asset prices are related, spreads on different assets can be used profitably. Investors
believe that there is large correlation between the prices of gold and silver, and, therefore,
 Options Trading Strategies 467

may like to benefit from their judgment about the price of silver given the price of gold, or
vice versa.

BOX SPREAD
Though options are thought to be risky in nature, their combinations can be remarkably stable.
One can create a tiskless Different options can be combined to obtain a risk-free position. We used this
position using deriva- _ in the valuation of options by forming a risk-free portfolio comprising the
tives. underlying and options on it. From derivatives alone can such risk-free positions
a“ be created. One such position, called the box spread, is depicted in Exhibit 16.8.

EXHIBIT 16.8 Box spread

Strategy
e Buy a call and sell a put with the same strike price
e Once again, buy a call and sell a put with the same strike price, but higher than that of the first set of a call and a put, on
the same asset and with the same
Example
The following prices prevail on 17 October 2005 on the NSE for October 05 options on Hindustan Unilever:
X= 1/0 6= 7 X= 185 c= 1.45 X= 1/00 = 1.30: X= 185 p = 11.55
Box spread
Bought one call at X = 170 Premium paid = 7.00
Sold one call at X = 185 Premium received = 2.05
Sold one put at X = 170 Premium received = 1.95
Bought one put at X = 185 Premium paid = 11.55
Initial cost of box spread = 7.00 - 2.05 - 1.95 + 11.55 = 14.55
Table for payoff on the box spread

‘Initial a
cost*
eUlG-= 3) | (85 §)
- (185 — o)

*Must represent discounted value of the payoff (Difference of strike prices)

Graphical view: Box spread payoff
Graphical view: Box spread payoff

Payoff (%) : Break-even point; None

Maximum profit :15
Maximum loss = i)

Price of the asset (&)

468 Derivatives and Risk Management

A box spread is created by two sets of a call and a put, with each set at different strike
prices. Specifically, a box spread can be created by,
e going long ona call and short on a put at the same strike price
e going short on another call and long on another put, again at the same strike price,
though different from that in the first case.
This combination results in a certain fixed profit equal to the difference between the two
strike prices. This may be used for arbitrage in the pricing of different options as follows:
Cost of box spread > discounted value of the box spread; go short on the box spread
Cost of box spread < discounted value of the box spread; go long on the box spread
A box spread can also be thought of as a synthetic bond providing a certain value equal
to the difference in strike prices over the remaining life of the options. In the example in
Exhibit 16.8. the box spread is like a bond with a maturity value of €15.
The cost will determine the returns, which must be comparable with those prevailing in
the bonds market. This would keep the derivatives market and the bonds market in balance.
If the return on the box spread is higher, investments would flow in the derivatives market
from bonds, increasing the prices, reducing the returns on derivatives, and decreasing bond
prices to increase returns in the bonds market. In the opposite scenario, the reverse would
happen. The existence of such a risk-free position out of derivatives alone makes their pric-
ing accurate, in tandem, and consistent with the capital markets dealing in fixed income
securities.

FACTORS AFFECTING SPREADS -

While trading on independent and single options is rather easy, creating a spread requires
deep thinking and understanding before assuming a position. Though, in general, spreads are
safer, their construction needs prior evaluation in terms of the following factors:
Initial cost of spread Dealing in spreads means trading in multiple options involving
long and short positions. While a short position implies a cash inflow, the long position
means a cash outflow, resulting in an income or a cost at the time of set-up. An investor has
to determine the additional parameter ofthe initial income or cost in setting up the spread.
Further, since a similar risk profile is obtainable in several ways from either puts or calls,
one has to find a way to create a spread at minimum cost or with maximum income. A
complete understanding ofrisk profiles with the prevailing market prices of various options
is required.
Initial margin requirements The margin requirements on options as independent con-
tracts are different from those for specific combinations of options. A buyer
initial cost, margin of options does not need to bring any margins, as he/she is under no obliga-
requirements, andthe ‘tion to perform. His/her obligation towards the contract is met when he/she
desired risk return profile pays the required premium. However, the writer of an option under an obliga-
are the main consid- _ tion to perform is required to deposit a margin with the exchange. Normally,
erations in devising
_ margins for writers of options are larger for independent single contracts
spreads using options.
_ than for spreads, which is a simultaneous position on several options.
 Options Trading Strategies 469

Risk profile and selection of exercise prices. An additional parameter in the construction
of spread is the exact risk profile that needs to be generated, which in turn involves selection
of a particular set of exercise prices out of the many that are available. The liquidity of distant
options and those that are deep in-the-money or deep out-of-the-money is poor compared to
near options and ATM options. Therefore, pricing may be non-competitive for distant and
deep ITM/OTM options. This restricts the choices for spread trading. It is suggested to create
a spread with frequently traded options to obtain competitive pricing and necessary liquidity,
as one may need to unwind (not necessarily) the original spread before the expiration of the
options. It is possible that at around the expiration time, the spread may become illiquid and
difficult to unwind.

_SYNTHESIZIN

We have seen that options can: be combined to form a large array of risk and return profiles.
Options can also be combined to synthesize basic instruments such as risky positions on stocks
and riskless positions on bonds. One can synthesize these basic instruments, as discussed now.

SYNTHETIC LONG POSITION IN STOCK

When an investor is bullish, he/she goes long on the asset now and hopes to sell it later at an
_ increased price to make a gain. A long position in stock can be synthesized
Optionscanbecombined
_ |with
.- :
options. For ? example, consider
ae
a stock Pes .
with the current price of $100.
to synthesize various Th eee ena d for ‘Keonetdelae S100. th
positions in stock, mul e Jes also has call and put OpuOns; and tor a strike price 0 , they
tiplying gains as wellas_ -— are selling for <10 and %6, respectively.
losses. Consider the two alternatives: (a) buy stock at $100 and (b) buy a call and
, write a put, both at XY = 100. Let us now compare the initial investment and
the payoffs under rising and falling price scenarios for the stock:

Payoff
Initial cash flow Price > 100 Price < 100
say ~120 say €80
Buy stock | = 100 $ — 100 =+20 $ — 100 =—20
Portfolio of call and put: |
Call bought 10 S00 ar 6 Worthless
Put written +6 Worthless (100 =$) =4= —18 |
+16 16 |
It is evident that while the payoff on a long position in stock is similar to that on a portfolio
of calls bought and puts written at the current market prices, the investment in the portfolio
of calls and puts is far less at €4, as compared to the investment in the long position in stock
of ~100. A portfolio of long calls and short puts with the same exercise price and maturity
synthesizes the long position in the stock, the underlying asset, at a price equal to the strike
prices of the options, as the payoffs are identical. This portfolio provides great leverage and
enhances returns as well as losses several times (in this case, 25 times).
470 ‘Derivatives and Risk Management

Payoff Payoff
Payoff PS nciter
Call bought Call bought and put written
combined fe

Payoff

Straight
long stock

4
7 synthesized
4 long stock

Fig. 16.12 Synthetic long position and straight long position (mimicking stock)

A synthetic long position with a put written and a call bought with a straight long position is
depicted in Fig. 16.12. Synthetic position in stock with options is also called as mimicking stock.
The payoff on a synthetic long position created with a call and a put is less than on a
straight long position by the amount of the cost of setting up the synthetic long position. The
synthetic long position would cease to exist upon expiry of the options. If the investor wants
to continue with the synthetic position, it can be recreated with a fresh set of options that
come into existence upon expiry of the first set of options.

SYNTHETIC SHORT POSITION IN STOCK

When an investor is bearish, he/she sells the asset short now and hopes to buy it later at a
decreased price to make a gain. This is called a short position. A short position in stock can
also be synthesized with options. To synthesize a short position in a stock with the current
price of $100, we write a call and buy a put at strike prices of $100. Again, assume that the
call and the put are selling for ¥10 and &6, respectively.
Consider the two alternatives: (a) sell the stock short at €100, and (b) write a call and buy
a put, both at ¥ = 100. Let us now compare the initial investment and the payoffs under rising
and falling price scenarios for the stock:

Payoff
Initial Investment Price>100 Price
<100
say %120 say 80
Sell stock short +100 100 S19 = = 20 100 — S= +20
Portfolio of call and put:
Call written +10 —($— 100) + 4 = —16 Worthless
Put bought = Worthless (100 — S) + 4 = +24
Total +4 -16 +24
 Options Trading Strategies 471

Payoff :
A i Call written and put bought
Call written Put bought combined
\
\ \
' 1X XN XxX
_~ >
.
x Price1
; Price \
\
\
v v v
Straight short position
Payotf
\ Synthesized
short stock

It is evident that the payoff on a short position in stock is similar to that on a portfolio
of a call written and a put bought at the current market prices. This would result in a cash
inflow, since the call is priced higher than the put for the same asset, the same exercise price,
and the same expiry. A portfolio of a short call and a long put with the same exercise price.
and maturity synthesizes the short position in stock, the underlying asset, at a price equal to
the strike prices of the options, as the payoffs are identical, as depicted in Fig. 16.13. The
position can be continued if the portfolio is reconstructed upon expiry of the options.

OTHER SYNTHETIC POSITIONS

Recall the put-call parity. It is depicted in Fig. 16.14 in an explanatory form. Put-call parity
establishes a relationship among four assets, i.e., the call option, the put option, the stock,
and the bond. It implies that if put—call parity holds, then any instrument can
Put—call parity relates
_ be synthesized using the other three.;
four instruments—call :
put, stock, and bond, For example, consider a portfolio of a long stock, a short call, and a long
Using any three of these —- pu. Options are available at strike price X and mature after time 7. At matu-
instrument, the fourthcan rity, assuming a stock price of S, the value of the portfolio would be 4, irre-
. hee ___ spective of the price of the stock. This value of the portfolio is the same as

Sy = c + p. =~ Xe

Buy stock at S, Write call at X expiring at T| |Buy put at X expiring at T] |PV of the bond maturing at X at T
Nvoras

Fig. 16.14 Put-call parity—synthetic positions

472 Derivatives and Risk Management

the maturity value of a bond bought at f = 0, which matures to a value equal to the exercise
price ofX at T = t. This may be seen in Table 16.1.
Similarly, synthetic stock calls and puts may be created using the other three instruments,
as shown in Table 16.1.

Table 16.1 Synthetic positions of bond, stock, call, and put

Synthetic bond E

GS yi S : ae) ix
Sey S =( Sa) = x
Synthetic bond L

a. x Z = 5 S :
BS x (S=x) ke S
Synthetic call

cea =¥ == 6 S 0
S>X =X, ~ S S—xX
Synthetic put
Buy bond
Beso Rees

SOLVED PROBLEMS
SP 16.1: Constructing a long straddle
At the NSE, the following were the prices of 1-m call and put options on its index NIFTY on 15 June, 2009, when the NIFTY
was
at 4500.
Exercise price Call option Put option
4,450 165 AS
4,500 125 95
4,550 100 125
(a) How would you construct a straddle at the index value of 45002
(b) Find out its cost, payoff, break-even point, and maximum loss.
(c) What would be the profit/loss if after one month the index value were (a) 4100, and (b) 5000?
Solution
(a) A straddle may be constructed by buying a call and a put option, both at a strike index value of 4500.
(b) The initial cost of a long straddle is $220,
Buy a call with X = 4500 125
Buy a put with X = 4500 %95
Total %220
 Options Trading Strategies 473

The payoff would be

Spot price at maturity Long call Long put Initial cash flow Total
X= 4500 X = 4500 (<)
Sia SDOOWRAI NHLAMAR ht Ihun500° —220 4,280 — §
S > 4,500 S — 4,500 ~ —220

Break-even points: 4280 - S = 0 gives S = 4280 S - 4720 = 0 gives S = 4720

Maximum loss at S = 4500 Loss = Initial cost = 220
(c) Profit at S = 4100 4280 - S = 4280 - 4100 = %180
S = 5000 S - 4720 = 5000 - 4720 = €280
SP 16.2: Constructing a short strangle
From the data of SP 16.1, how would you construct a short strangle with 4500 as the central point?
(a) Find out its cost, payoff, and break-even point.
(b) At what levels would the position result in maximum profit?
(c) What is the profit at a level of (a) 4100 and (b) 5000?
(d) Depict the payoff diagram with all important parameters marked.
Solution
A short strangle can be created by selling a call at a higher strike price and selling a put at a lower strike price than the central point.
Hence, we sell a call at a higher strike of 4550 and sell a put at a lower strike of 4450 for a short strangle.
(a) Initial inflow short strangle
Sell a call with X = 4550 =100
Sell a put with X = 4450 %75
Total RAM
The payoff would be

Spot price at maturity Short call Short put Initial cash flow Total
X = 4,550 X = 4,450 (%)
S < 4,450 —(4,450 — S) a) So AHS
4,450 < $< 4,550 : 2 175 175 |
S> 4,550 —($ — 4,550) = 175 4725-8 |
Break-even point: 4725 - S=0 gives S = 4725 S - 4275 = 0 gives S = 4275
(b) Maximum profit: S Between 4450 and 4550 Profit = Initial cash flow = £175
(c) Profit at S = 4100 S - 4275 = 4100 - 4275 = -2175
S = 5000 4725 — § = 4725 — 5000 = - *275
(d) The short strangle would look as follows:

Short strangle
Payoff

175 |--------------

Spot price

ee
eee
474 Derivatives and Risk Management

SP 16.3: Constructing bull spreads

Use the data from problem SP 16.1 to do the following:
(a) Construct a bull spread using call options and find out its cost, payoff, and break-even point.
(b) Construct a bull spread using put options and find out its cost, payoff, and break-even point.
(c) Depict the bull spreads of a) and b) with different levels of the index at maturity, indicating all relevant points of break-even,
maximum, and minimum levels of profit/loss.
Solution
(a) A bull spread with calls can be created by buying a call at a lower strike price and selling a call at a higher strike price. Hence,
we buy a call at a lower strike of 4450 and sell a call at a higher strike of 4550.
The initial cash flow of the bull spread with calls would be
Buy a call with X = 4450 - 7165
Sell a call with X = 4550 + %100
Total - 765
The payoff would be
Spot price at maturity Long call Short call Initial cash flow Total
X = 4,450 X = 4,550 (%) (2)
S < 4,450 = - =65 —65
4,450 < $< 4,550 S — 4,450 A —65 S — 4,515
S> 4,550 S — 4,450 —($ — 4,550)
Break-even point: S - 4515 = 0 gives $ = 4515
The maximum loss would be %65 for an index below 4450 and the maximum profit would be %35 for an index above 4550.
(b) A bull spread with puts can be created by buying a put at a lower strike price and selling a put at a higher strike price. Hence,
we buy a put at a lower strike of 4450 and sell a put at a higher strike of 4550.
The initial cash flow of the bull spread with puts would be
Buy a put with X = 4450 - %75
Sell a put with X = 4550 + 2125
Total + %50
The payoff would be
Spot price at maturity Long put Short put | tnitial cash flow Total
X = 4,450 X = 4,550 (2) (%)
S < 4,450 4,450 — § — (4,550 — S) 50 —50 |
4,450 < $< 4,550 - = (4,550 =") 50 S — 4,500
| S> 4,550 . = 50 50
Break-even point: S- 4500 =0 S = 4500
Maximum loss would be %50 for index below 4450 and maximum profit would be 250 for index above 4550.
(c) A bull spread using calls and puts is depicted here:

Bull spread

ae With calls Payoff With puts

Ch ee en
ag Me

4515 4550
 Options Trading Strategies 475

SP 16.4: Constructing bear spreads

Use the data from problem SP 16.1 to do the following.
(a) Construct a bear spread using call options and find out its cost, payoff, and break-even point.
(b) Construct a bear spread using put options and find out its cost, payoff, and break-even point.
(c) Depict the bear spreads of a) and b) with different levels of the index at maturity, indicating all relevant points of break-even,
maximum, and minimum levels of profit/loss.

Solution
(a) A bear spread with calls can be created by selling a call at a lower strike price and buying a call at a higher strike price. Hence,
we sell call at a lower strike of 4450 and buy a call at a higher strike of 4550.
The initial cash flow of the bear spread with calls would be
Sell a call with X = 4450 + 165
Buy a call with X = 4550 - 7100
Total + %65
The payoff would be

Spot price at maturity Short call Long call Initial cash flow Total
X = 4,450 X= 4,550 Q)
S < 4,450 —— Es

4,450 < $< 4,550 —(S — 4,450)

S > 4,550 —(S — 4,450) (S — 4,550)
Break-even point: 4515-S=0 S = 4515
The maximum profit would be %65 for an index below 4450 and the maximum loss would be %35 for an index above 4550.
(b) A bear spread with puts can be created by selling a put at a lower strike price and buying a put at a higher strike price. Hence,
we sell a put at lower strike of 4450 and buy a put at a higher strike of 4550.
The initial cash flow of the bear spread with puts would be
Sell a put with X = 4450 +275
Buy a put with X = 4550 — %125
Total - 50
The payoff would be

Spot price at Short put Long put Initial cash flow Total
maturity X = 4,450 X = 4,550 ()
S < 4,450 —(4,450 — S) (4,550 — S)
4,450 < S$ < 4,550 = (4,550 — S) =50 4,500 — $
S > 4,550 : - —50 =50

Break-even point: 4500 - S=0 S = 4500

The maximum profit would be 250 for an index below 4450 and the maximum loss would be %50 for an index above 4550.
(c) A bear spread using calls and puts is depicted here:
476 Derivatives and Risk Management

Bear spread
Payoff Payoff

With calls With puts

CLIT ULLAL erp aearenamemgarancarnunaricncamEE

SP 16.5: Mimicking stock

A stock is currently selling for ¥100. ATM calls and puts on the stock with a maturity of three months are selling for £3 and 2,
respectively.
(a) What would the payoff of a long position on the stock be? Depict the long position.
(b) How can you replicate the payoff of a long position in the stock using call and put options?
(c) What is the difference in payoffs between a) and b)?
Solution
(a) The long position on the stock would have a payoff of S- 100 where Sis the stock price at the end of the investment period. If
it is more than %100, the position would end up in a profit. For a spot price less than =100, there would be a loss. If it remains
the same, the position gives neither a profit nor a loss. This is depicted as folloes:

Payoff of long position in stock

Payoff

Stock price, S

cota
arecesat
etecpteonae
same
ama
pageor
wnt
teppnevonmaseemncat
eraapecanans
cuntnntcornty
marpsegsets
cectase

(b) The long position on the stock can be mimicked with a long call and a short put, both with ATM. The initial
cost of such a position
would be the premium paid for buying the call less the premium earned by selling the put. With 1 as the initial
cost (3 - 2), the
payoff on the position would be as follows:

Spot Short put Long call Initial Total

price X= 100 X= 100 cost payoff
2= 100 =—(700==5) - = C104
S> 100 = o= 100 =H S101
 Options Trading Strategies 477

This is the same as a long position in stock, as depicted here:

Mimicking stock
Payoff
Long call + short put

Stock price

000
02...
0606
0
00S
SOAS

L a nee daceemnmmncnea

(c) The difference would be the initial cost. While taking a long position would entail an investment of €100, the same payoff can
be obtained at a much lesser cost (%1 in this case).

SUMMARY ©
Options, because of their unique non-linear payoffs, offer a much moderately bullish, the investor can sell a call at a higher strike
wider range of applications than other derivatives. These appli- price to reduce cost and sacrifice gains. A bull spread can also
cations can broadly be categorized in four groups—hedging, be created with put options. When the written option is priced
income generation, trading, and synthesizing. higher than the bought option, the spread may result in an initial
Since writing options results in earings, premium investors cash inflow. It is referred to as credit spread, in contrast with
also use options to enhance yields on their portfolios. Without debit spread, which involves an initial cash outflow. Similarly, a
an asset in hand, option writing can be used for pure speculative bear spread is created by selling a call with a higher strike and
gains. Speculation with options can be done otherwise also, by buying a call with a lower strike, and is constructed when the
buying a call when the market is bullish and buying a put when investor is moderately bearish.
the market is bearish. Speculation with options is at a cost, but is There are other combinations, such as butterfly and condor,
safer than other derivatives, as options cap the extent of losses which involve more than two options. Similarly, a risk-less posi-
to the premium paid. tion too can be constructed from options alone, referred to as a
There is a huge array of risk return profiles that can be created box spread. Spreads can be created on the basis of time: these
with options. Among the most popular of them are straddles, are known as calendar spreads. When options on the same
strangles, and spreads. A long straddle is created by buying a asset but with different expiries are combined, it is called a cal-
call and a put at the same strike and the same maturity on the endar spread. Using different assets, different maturities, and dif-
same asset. It is extremely appropriate to have a long straddle ferent strike prices, there are numerous combinations possible,
when volatility is expected but with direction unknown. A strangle and it remains a challenge to obtain the desired characteristics.
is the same as a straddle but the strike prices of the options Options can be used to synthesize various positions, such
are different. It costs less to create a strangle than to create a as stocks and bonds. Put-call parity helps in identifying what
straddle. Accordingly, the profit making range is smaller than instruments can be synthesized, and how they can be synthe-
with a straddle. Ratio spreads can be used when an investor sized. Put-call parity relates four instruments—call, put, stock,
believes somewhat more in either a rise or a fall in price. and bond. With three of them, the fourth may be synthesized.
A bull spread is created when the investor is moderately bull-
ish. If confidently bullish, he/she can buy a call. When he/she is
478 Derivatives and Risk Management

KEY TERMS
Bear spread A bear spread is a combination of a long call/ Credit spread A spread combination that results in initial cash
put with a higher strike and a short call/put with a lower strike. inflow.
Box spread A special combination of options that results in Debit spread A spread combination that results in initial cash
risk-less payoff. outflow.
Bull spread A combination of a long call/put with a lower strike Diagonal spread A diagonal spread is constructed by using
and a short call/put with a higher strike. different strike prices and different maturities of options on the
Butterfly spread A butterfly spread is created by two long same asset.
calls/puts at two different strikes and two short calls/puts at Naked call writing Selling a call without possessing the
the same strike price, in between the strikes of the two long underlying asset, with a view to earning a premium.
positions. Ratio spread A combination consisting of calls and puts on
Calendar Spread A combination of options on the same asset the same asset with the same expiry but in different proportions.
but with different maturities. Straddle A combination consisting of a call and a put on the
Condor spread A condor spread is created by two long calls/ same asset with the same expiry.
puts at two different strikes and two short calls/puts at different Strangle A combination consisting of a call at a higher strike
strike prices, both in between the strikes of the two long posi- price and a put at a lower strike price on the same asset with
tions. the same expiry.
Covered call writing Selling a call while possessing the Strap A ratio spread with more calls than puts.
underlying asset, with a view to earning a premium, but with Strip A ratio spread with more puts than calls.
delivery of the asset in hand.

QUESTIONS
16.1 What is a straddle and when is it appropriate to use it? 16.4 Differentiate between debit spread and credit spread.
16.2 Compare a strangle with a straddle, with suitable exam- 16.5 What is a box spread? Explain with a suitable example
ples. 16.6 How would you synthesize a put option with a call, a stock,
16.3 How would you construct a bull spread with put options? and a bond?

PROBLEMS
P 16.1 Butterfly spread with calls she benefit from the options being traded in the market? What
An investor has the following portfolio of call options on the same maximum profit can be made and what losses are possible?
asset and with the same expiration dates: P 16.3 Ratio spread
Long one call at a strike price of %95, at a premium of %5
Refer to the data in P 16.2. Another investor believes that the
Short two calls at a strike price of 100, at a premium of 27
market would be volatile, with a downward bias. He/she wants
Long one call at a strike price of 105, at a premium of 210
to have twice as much gain from the downside movement as
Graphically depict the payoff and find the following:
compared to an upside movement. What strategy do you sug-
(a) The price of the asset yielding maximum profit, and the gest for him/her? Find out the maximum loss and the range in
extent of profit. which the investor would be making loss. Further, find the payoff
(b) The price of the asset yieling maximum loss, and the extent for the ending index values of 4150 and 4450.
of loss.
P 16.4 Mimicking bond from stocks and derivatives
(c) The price of the asset yielding no profit or loss. A stock is currently trading at ™1000, and ATM call and put
P 16.2 Short straddle options with three months maturity are trading at 275 and 250,
Currently, the value of Nifty is 4500, and ATM call and put respectively. If the stock markets and derivative markets are pric-
options with three months to maturity are selling for ¥120 and ing products competitively, what best estimates can you make
%60, respectively. If an investor believes that the market is going for the risk-free rate of return?
to remain range bound for the coming three months, how can he/
INTRODUCTION @
Eee iu ree

Learning Objectives
Exchange-traded options are plain vanilla products with routine After going through this chapter,
features, as described in earlier chapters. The prices of these readers should be familiar with
options are generally available, as they are regularly traded. * changing the terms of an option to
Apart from regular exchange-traded options, which are con- suit specific needs
ventional in nature, there is a large variety of tailor-made over- + the forward start option, its
the-counter (OTC) products, normally referred to as exotics. valuation, and its use
+ the binary option and its valuation
The valuation of such options is complex, as the Black-Scholes « the chooser option and its valuation
Model (BSM) works only for standardized options that are nor- + the shout option and its working
mally exchange-traded. There have been substantial efforts to « the exchange option and its
find analytical solutions to these options with the BSM as a base. valuation
The reasons and motivations for deviating from the conven- + the gap option and its valuation
+ the pay-later option and its
tional features of options are many. Where standard products valuation
traded on exchanges do not meet specific requirements of users, * compound options
some modifications in the features of the derivatives may be + barrier options, their types, and their
sought. A major reason for seeking modification of the features valuation by the binomial method
+ Asian options and their valuation by
is to meet the specific requirements of traders and hedgers. Some
the binomial method
of these requirements were discussed in options trading, where + lookback options and their valuation
desired risk—return profiles were obtained by combining standard by the binomial approach
exchange-traded options.
One universal motivation that causes improvisation in the fea-
_ tures of options is reduction in the cost
One primary reason for = of hedging. For option buyers, the pre-
ee bees - mium payable has always been a matter
premium for the buyer. of concern, and they are constantly look-
ing for ways and means of reducing the
cost of the options by (a) sacrificing some of the potential gains,
(b) eliminating highly improbable scenarios that are included
in the calculation of the premium, or (c) both. Where an option
buyer considers that the premium payable includes an extremely
unlikely scenario, he/she would like to exclude such a scenario by
480 Derivatives and Risk Management

modifying the terms, and, hence, seeking a reduction in the price. One such product was the
range forward that could be created from standard options. Similarly, various kinds of spreads
and combinations of options were discussed in Chapter 16.
Here, we are not seeking to reduce cost by writing options but by modifying the terms of
the options. Improvisation in the terms of the options can be done along various parameters
that go into determining the option premium. Modifications in the determinants would entail a
change in the price of the option. These modifications are normally related to amending

e the frequency and/or timing of the exercise

e the payoff
e the exercise price
We know that the value of the option is a function of five parameters for a non-dividend
paying underlying—the spot price, the exercise price, the time to expiry, the risk-free rate,
and volatility. Most exotic options play around modification of the manner of exercise, the
frequency of exercise, the behaviour of the spot, shortening or extending of the time to expiry,
adjustment of the exercise price, and so on. There is hardly any role played by the risk-free
rate and volatility that can be altered as per business requirements, as they are broad exoge-
nous variables beyond the control of the parties to an options contract. For the purpose of this
chapter, we shall denote the price of the option as a function of the spot, S, the exercise price,
X, and the time to expiry, 7. These parameters are subject to negotiations between the buyer
and the seller of the option. For convenience, the value of a call option is denoted by c(S, X, T)
and that of a put option as p(S, X, 7), as function of S, X, and T.
Though the range can be tremendous, we discuss some of the exotics in this chapter.

FORWARD START OPTION

Conventional options confer a right at the inception of the option to exercise on or before the
_ maturity. If one wants to acquire the right to exercise the option not at its
in a forward start option
the right is conferred inception but at a later date one has to wait for the appropriate time to arrive.
now, but commences Such a situation is most common for firms that want to confer the right to
some time in the future. _ acquire shares of the firms only after employees have served the firm for
some minimum time. These are commonly called employee stock options.
The firms would like to confer the right to buy shares now, but exercise can take place only
after the employees have served for a minimum period of time. Such options are vested now,
but start at some future date/time, f, and expire at 7; these options are called forward start
options.

Valuation
To value a forward start option, we use the property of homogeneity of option pricing. The
implication of homogeneity in pricing is that a forward option starting after one month and
ending after four months should have the same value as an option starting today, with an
expiry of three months. It is the time remaining for expiry that determines the value of the
 Exotic Options 481

option, and not when that time commences. Of course, the value changes not because it
depends upon when the right commences but because the spot value changes. If the forward
commencement time is ¢ with a spot at S, and the time remaining for maturity is T — ft, then
the value of the call would be denoted as c,(S,, X, T — f). This value should be no different
from the value of the call today that matures at T — ¢, rather than at 7, Co(S9,-X, F — f). From
homogeneity, we may say that

(Site) es Sys Tee 6) (17.1)

Again, using risk neutrality, the value of a forward start option at time ¢ = 0 with a forward
time of ¢, and maturing at 7, F;, is

Pte ic SEX) Se Lac Soe i) (17.2)

For easier comprehension, the valuation of a forward start option is depicted in Fig. 17.1.

Time t=0 t=t t=T

Sport price S, S, Ss,

Ga C, ce
Call value =¢(S,, X, T) Sa, 26 fay = Max(0, S_ — X)

Applications
Consider, for example, a firm making an offer to a senior executive where part of his/her
_ remuneration is in the form of stock options. With a current stock price of
Employee stock options
are like forward start op- _ 2100, the executive is offered an option to acquire the firm’s stock at a strike
tions in that they start at price of $110 (1.e., 10% higher than the current stock price) at the end of two
some time in the future years. However, to ensure his/her commitment towards the firm, the execu-
tive would have to work for at least 12 months (one year). Remember, the
right is being conferred now but would commence only after 12 months. Assuming a risk-free
rate of return at 8% and volatility of the stock at 25%, the value of the call option as per the
BSM, without the condition about working for at least 12 months, is
Co(Sp, X, T) = co(100, 110, 2) = 716.95
However, 1f the option cannot be exercised before 12 months, the value of the option at the
end of 12 months would be c,(S;, 110, 1), where S; is the spot price at the end of 12 months
(one year). From Eq. 17.1, this must be equal to co(100, 110, 1). As per the BSM, the value
is €9.27. Therefore, the value of a forward start option today with a start period of 12 months
and expiry 12 months thereafter, using Eq. 17.2, is
Che ac, MO0mI Ube er. xX.9.07 = 0.9231 x 9.27'= 88.56
482 Derivatives and Risk Management

BINARY OR DIGITAL OPTION __.idi‘i(#§......

The binary option, also called the digital option, has a payoff that has only two possible
_ values. Conventional options have numerous payoffs, depending upon the
ae _ value of the asset at expiry. In a binary option, only two payoffs are possi-
nothing for a orice above _ ble—a fixed cash amount or nothing, depending upon the price of the under-
or below X. Alternatively, lying and the exercise price. For a binary call option, the payoff for the holder
itcould be the asset or would be a fixed sum, Q (rather than S —_X, as in a conventional call option),
_ nothing.
saeco onan etoecinentrcteee
if the spot, S, exceeds the exercise price, X; otherwise, it is nothing. Such an
option is called a cash or nothing option. Alternatively, the payoff can be the
asset or nothing, where the call holder would get the value of the asset, S, if the spot exceeds
X. The payoff on the option does not reflect the exercise price. In case of a call, there would
be no payment of the exercise price to arrive at the payoff, and in case of a put, no payment
would be made by the writer. The exercise price merely determines whether the payoff exists
or not. It does not impact the quantum of payoff.
The payoff on a cash or nothing binary call is O if S > X or 0 if S <_X, and for an asset
or nothing option, it is Sif S > X or 0 if S < X. Table 17.1 summarizes the payoffs for the
holders and writers of cash or nothing and asset or nothing binary call and put options.

Table 17.1 Payoff for holder and writer for binary options

Cash or nothing Sete |

Calloption :

sey
S<xX :
Put option

PER

Applications
Binary options are very popular and widely used, perhaps without many users actually real-
Binary oplionvauaten izing that they are doing so. The options obviate the need for complex com-
is often used in deciding _ putations. The settlement of these options is extremely simple. They may
the collective reward of _ have practical use in the design of incentive schemes for collectively reward-
employees. ing employees. As a motivation tool, firms reward all employees equally if
i ' the performance of the stock exceeds a certain level of expectation. For
example, a manufacturing organization may announce a reward of a bonus equal to one
month’s salary if the production achieves a certain target level. It is a cash or nothing call
option, where the payoff is fixed at one month’s salary or nothing, and is independent of the
extent by which the target is exceeded. Similar incentive schemes are formulated by market-
ing departments that reward sales employees or members of distribution channels with fixed
amounts upon achieving a pre-set sales target. Further, most bets are win-or-lose situations
and are, by nature, cash or nothing options.
 Exotic Options 483

An asset or nothing option is a situation where one is ready to part with the asset if the
value achieves a certain level. For example, if one is ready to offer a share of ITC Ltd should
its price cross %200 at the end of six months, he is writing an asset or nothing call with an
exercise price of 200 and time to expiry of six months. For doing so, he is entitled to a
premium to be paid by the buyer of such an option. Note that the buyer of the binary option
only pays the premium and not the exercise price for acquiring the asset, provided the value
of the share exceeds %200 at the end of six months.

Valuation
The valuation of a binary option is surprisingly easy. Under the BSM, we know that the prob-
ability of a spot exceeding the exercise price is given by N(d>). Under the risk-neutral method,
The value of a binary call option =e ' (payoff X probability of S >_X)
For a fixed payoff of $1, the value is =e? <1 Na)
For a cash or nothing call with a fixed payoff of O, the value would be
=e x 0 XING) (17.3).
Using put—call parity, the value of a binary cash or nothing put option that is paying Q at
maturity is
=e 1.0: N—d,) (17.4)
The value of
a cash or nothing binary option is given by the second term in the BSM, with
The computation of i_
a payoff equal to the exercise price. Since normal distribution is symmetrical,
payoftanebinary option the sum of N(d) and M(—d) is always equal to 1.00. Therefore, having a cash
is extremely simple. _
or nothing call and a cash or nothing put with same features would always
result in a payoff equal to the discounted value of the fixed cash, irrespective
of the value of the underlying at expiration. Mathematically,
Cash or Nothing call + Cash or Nothing put = e-"? X QO X Md») + e7'?- O- M—d))
lege eel
Similarly, for asset or nothing binary options, the value is given by the first term of the
BSM. Using the properties described earlier, the values of asset or nothing options are given
by Eqs 17.5 (a) and (b).
For a call option: So X Md) (17.5)(a)
For a put option: So X NM(—d)) (17.5)(b)
Like cash or nothing options, a position in asset or nothing calls and asset or nothing puts
with identical terms would always be equal to the value of the underlying asset.
Asset or Nothing call + Asset or nothing put = Sy < M(d,) + So X M—d))
=
For a continuous dividend of g on the stock, Sy becomes Sye~@.
From the payoffs on binary options, we may say that a regular European call is equal to a
long position in an asset or nothing call and a short position in a cash or nothing call, with
the cash payoff equal to the exercise price. This helps in valuing asset or nothing options.
Long asset or Nothing call + Short cash or Nothing call = European call
484 Derivatives and Risk Management

Therefor,
Asset or Nothing call = So M(d,)
Similarly, Asset or Nothing put = Sy M(—d)).
A look at Fig. 17.2 (a) and (b) would reveal that short cash or nothing and long asset or
nothing call is same as payoff of standard European call.
The payoffs for a binary call option (cash or nothing and asset or nothing) and a binary put
option (cash or nothing and asset or nothing) are depicted in Figs 17.2 and 17.3, respectively.
Note that long positions in cash or nothing calls and cash or nothing puts would always equal
the fixed payoff at maturity, as can be obtained by adding Figs 17.2(a) and 17.3(a). Similarly,
a position in a call and a put for an asset or nothing option is equal to a position in the asset
itself, as may be obtained by adding Figs 17.2(b) and 17.3(b).

Value

X Spot x Spot
(a) Cash or nothing (b) Asset or nothing

Fig172ree Call Fer

Value

xX Spot Xx Spot
(a) Cash or nothing (b) Asset or nothing

LL

Fig. 17.3 ane put option

CHOOSER OPTION *%
A chooser siento is an option that gives the right to the holder at time ¢ to have either a
A chooser option : call or put option, with an exercise price X and time to maturity 7, where
provides flexibility to _ T >t. The holder has time till ¢ todecide whether he/she would like to have
the holdertochoose _ a call or a put for the remaining period, T — ¢. Since this option allows
pelican ie Cal oF the
put at its maturity
flexibility
if option
to choose between a call and a put, ? it is also called an as 3you like
 Exotic Options ~ 485

A chooser option provides time for uncertainty to settle in the mind of the investor. In situ-
ations where an investor is uncertain about the future behavior of the price of an underlying
asset but believes that the directional uncertainty will resolve in times to follow, a chooser
comes as a handy choice. For example, if certain events such as the presentation of a fiscal
budget, an announcement about election results, etc., make directional forecast difficult prior
to option expiry, this may distract investors, leading them to defer trading in options till the
time of uncertainty passes. Taking positions after the event has occurred would be a compro-
mise on the potential profits as calls or puts may rise in value. An ideal product would be one
that allows holding both calls and puts till the time of the event, and, thereafter, holding either
of them, depending upon the outcome of the event that guides the directional movement of
the price of the underlying asset.
With a straddle or a strangle strategy, the risk of the directional volatility of the price is
neutralized with simultaneous positions in call and put options. A call gives a payoff in case
of a price rise, while a put becomes in-the-money on a decline in the price, thus providing
protection against movements in either direction.

Valuation
A chooser option is like a straddle but should be relatively less expensive. A straddle
comprises simultaneous positions of an at-the-money (ATM) call and an ATM put. With
either option turning into money, a straddle yields a decent payoff if the underlying moves
sufficiently in either direction. However, to take advantage, one would be required to have
both the call and the put with expiry at 7. Therefore, with a straddle, one is required to pay
an option premium equivalent to the time period 2 < 7. Instead, a chooser option is like
holding both a call and a put till t < 7 and, thereafter, holding either a call or a put for the
remaining time, 7 — t. Therefore, for a chooser option expiring at 7, the investor at best can
pay for two options (a call and a put) for time ¢ and either a call or a put for T — t. The cost
of such a chooser option cannot exceed that of a straddle. Hence, the cost of the straddle
places an upper bound to the price of the chooser.
The valuation of a chooser option at time ¢ would depend upon the value of the call and the
put at time ¢. The holder would make a choice in favour of the greater of the two. Therefore,
Value of a chooser at time, t = Max (c;, D,) (17.6)
where c¢,, p; are the values of the call and the put, respectively, at time 1.

The value of the call and the put at time t would be dependent upon the price of the under-
lying asset at ¢, the exercise price X and the time remaining, T — 1, represented as c(S,, X, 7
=fp-and p(s, 471) —* 71), respectively.
Using put-call parity for the value of the put at ¢, we have p, = c, + X a ws,
Substituting the value of the put in Eq. 17.6 at time ¢, we get

Value of chooser at t = Max (c,, p,) = Max (c, ¢, + Xe" 9 — S))

Adding and subtracting c,, we get

Payoff of chooser = Max (c, P;)
On iMax (0.X°e,"4= ).-0S;) (en)
486 Derivatives and Risk Management

Valuation of the chooser

The payoff on the chooser at time f is the sum of the value of the call and the
option is based on the ex- put. The first term in Eq. 17.7, c,, is the value of the call at time ¢. It is a function
pected payoff of the call of the price of the underlying, S,, the exercise price, X, and the time remaining
and the put. The larger of for maturity, 7 — t. The value today would be equal to the value of the call with
the two would determine
the spot price, Sp, the exercise price, X, and the time remaining for maturity, 7.
the value.
CAOpid al 21) cC(Sq, Ask)
The second term in Eq. 17.7 is the value of the put option maturing at time ¢ with an exer-
cise price of Xe" ~ 9. Its value today would be p(Sp, X e-"” ~ , t). Therefore, the value
of the chooser option today would be
Value of chooser = c(Sp, X, T) + p(So, Xe 7 A) (17.8)
One way of interpreting the value of the chooser is that it must comprise the value of the
straddle (value of the call and value of the put) till the time of choosing, and, thereafter, for
the remaining period, it must be the value of either the call or the put, whichever is higher.
For ATM options, the call value is higher than the put value. Stated another way, the value
of the chooser is the sum of (a) the value of the call for the entire period, and (b) the value
of the put for the period till the choice is made.
For example, consider an underlying asset trading at ¥100. The buyer of the option wants
a chooser with an exercise price of %100 for a period of four months with a right to choose
between a call and a put, to be exercised at t = 1 month. The value of the chooser would be equal
to the sum of (a) the value of the call maturing in four months, with Y = 100, and (b) the value
of the put maturing after one month with an exercise price equal to three months’ discounted
value of $100, assuming a risk-free rate of 8% (100 « e~°8 3/12 = %98 02). Therefore,
Value of the chooser = c(100, 100, 4/12) + p(100, e~%%8 x 4 = 112 1909, 1/12)
The value of a call with spot and exercise prices of 100 each, time to maturity of four
months, a risk-free rate of 8%, and volatility of 25% would have d, = 0.2569, dy = 0.1126,
Md;) = 0.6014, and Md>) = 0.5448. This gives a call value of =7.09. A put with same fea-
tures would cost ¥4.46. Hence a 4-month straddle would be at 211.55 (7.09 + 4.46).
The second component of the chooser option would be a put with maturity of one month,
with an exercise price of 98.02. Such a put would cost 71.72. Hence, the chooser would cost
63:51 (7.09 te le72).
The reduction in value as compared to straddle is mainly due to the fact that while with a
straddle chooser, we pay a premium for eight months (four months each for the call and the
put) while with a chooser, we pay a premium for five months, comprising two months
for
holding both the call and the put till the chooser expires and then three months for
the call.
Another small reduction comes from the reduced strike price of the put.

SHOUT OPTION f
A shout option enables _ A shout option is an option where the holder has the option of ‘shouting’ at
the holder to assure _ any time ¢ before maturity, so as to ensure a minimum payoff of S, — X. At
a minimum payoff by _ the end of the option period, the holder of the shout option gets the higher of
permitting booking of the
: (a) the intrinsic value at the time of the shout or (b) the payoff at maturity.
intrinsic value at the time
_ Such an option provides flexibility to the holder, whereby he/she feels that
 Exotic Options 487

the payoff at the time of the shout would be more than the payoff at maturity.
The payoff of
the shout option is given by Eq. 17.9.
Payoff of shout option = Max (0, S,—X, Sp — X) (17.9)
Note that if the call option holder does not shout till maturity, it becomes a regular
European call.

Valuation
Normally the value at the time of the shout would have a positive intrinsic value, 1.e., (S,-X)>0.
Therefore, the term zero in Eq. 17.9 is redundant, and the payoff on the shout option at
maturity,
Cr = Max (S, — X, Sp — X)
= §,—X + Max (0, Sr — S,)
Therefore, the value of the shout at time f is

pram OES) =X)

+ the value of the call at t with a strike of S, and time to maturity of T—t
Value ofthe shout at Per 21 X< (Sh X)are(S Sai 2) (17.10)
This may be priced using the binomial method, in just the way American options are
valued. While valuing an American option, starting backwards from the terminal value, we
compare the payoffs from the succeeding nodes based on risk-neutral probabilities with the
value upon exercise. At each node, we retain the more favourable value of the two. Similarly,
while valuing a shout option, we compare the risk-neutral value at each node with the payoff
given by Eg. 17.10, and retain the most favourable value. The process can be reiterated till
the last node at t = 0, proceeding backwards. Another valuation method can be based on the
Monte Carlo simulation.

EXCHANGE OPTION ©
An exchange option may be defined as the right to exchange one risky asset for another. One
asset is already owned and the other asset is acquired by surrender of the
An exchange option is an
owned asset. Typically in mergers and acquisition markets, an acquiring firm
option to exchange one
risky asset for another offers its shares in exchange for some shares in the target firm. This is like
risky asset, such as one an option to exchange shares of one firm for those of another with both the
share for another share. assets being risky, albeit with different volatilities.
For example, consider Firm A, whose shares trade at €100; this firm is
acquiring Firm B, whose shares trade at $48. Firm A offers one of its own shares for two of
B’s. This situation can be considered as an exchange option held by the shareholders of Firm
B, enabling them to acquire shares in Firm A. This is equal to having a call option (a right
to have the shares of Firm A) with an exercise price, X, of £96 (exchange ratio X current
market price of Firm B, the target firm), because the shareholders of Firm B surrender two
of their shares to obtain one share in Firm A. The value surrendered is equivalent to paying
the exercise price for acquiring one share in Firm A, the underlying asset with a current sell-
ing price, S, of %100. Note that not all merger situations qualify to be exact exchange call
488 Derivatives and Risk Management

options. Since the shares of Firm B are extinguished completely by its delisting consequent
to the merger, it is not a call option in the true sense, as the shareholders of the target firm
have a right but are also under an obligation to surrender their shares. If the target firm is
allowed to exist even after the offer is made, the situation resembles a call option.

Applications
Margrabe, who first published a paper on exchange options in 1978, discussed four spe-
cific applications of exchange options—manager’s incentive fee, margin account, standby
arrangements, and exchange offers. The valuation of an exchange offer is discussed in the
following paragraphs.

Valuation
The valuation of an exchange option could be based on the BSM formula for call option
pricing. Assuming no dividend by either firm till the acquisition is complete, the parameters
for valuation that need modifications are (a) volatility, o, (b) the risk-free rate of return, r,
and (c) the time to maturity, 7. The volatility that needs to be used is the volatility of the
underlying asset after acquisition. This would be dependent upon the volatilities of Firm A
and Firm B, i.e., o, and og, respectively, and their correlation coefficient, p. The new vola-
tility of the surviving firm, A, is now equivalent to the volatility of a long position in the
shares of Firm A and a short position in Firm B. Hence, the relevant volatility that must be
considered would be given by:

o =a + O73 —2por oF (tee)

The risk-free rate to be used must be essentially on a net basis, i.e., the saving of the inter-
est on the exercise price net of the interest earned on the underlying asset. It is analogous to
buying an option on a foreign currency, where the exercise price is reduced by the interest
rate on the domestic currency, while the asset price is adjusted for the interest earned on the
foreign currency, the underlying asset. Here, since the exercise is done by surrender of one
set of shares for another, the two interest rates are the same, and, hence, the risk-free rate
iS
zero on a net basis.

EXHIBIT 17.1 Exchange option price on non-dividend paying stocks

c= S.N(d,) ~ X.N (db) (17.12)

where a, = ISX)
+ F772. 24
oyT

in(S/X) — 02T/2
(ep) oe oe dy = ayT
ay
S = stock price of acquiring firm; X = exercise price exchange ratio x market price of target
T = time remaining for expiration of the option in years: o- = annualized standard
deviation as decimal and is given by
a? =o¢%, + o%, — 20 0, Of

Nd,) and N(d,) are cumulative normal distributi on functions at qd; and d,, respectively
In = natural log
 Exouc Options 489

EXAMPLE 17.1 Exchange option

Assume that Firm A, whose shares trade at =100, is willing to offer its shares to the shareholders of Firm B, whose shares trade
at 748. Firm A is willing to exchange one of its own shares for two of Firm B. The volatility of the shares of Firms A and B are
30% and 20%, respectively, with a coefficient of correlation of 0.50. The exchange can be exercised within three months from |
today. What is the value of exchange for the shareholders of Firm B? |
Solution
Here, the underlying asset is the share of Firm A with the current value, S = €100. The shareholders of Firm B could exercise
by surrendering two of their own shares, providing an exercise price, X, of $96 (48 x 2). The volatility of the underlying asset |
would not be equal to 30%, but would stand modified by the influence of the shares of Firm B. The effective volatility would be L
oa, given by Eq. 17.11. L
o* = 307 + 202 — 2 x 0.5 X 30 X 20 = 700 or o = 26.46%
With r= 0 and T = 0.25 years, we have d, = 0.3747 d> = 0.2424 Nid,) = 0.6461 and Mas) = 0.5958
The value of the exchange option, call value
100 x 0.6461 — 96 x 0.5958 = 64.61 — 57.20 = &7.41

The time remaining for the option can be considered to be equal to the time difference
between the announcement date and its completion of exchange of shares.
With this information, the exchange option can be valued by Eq. 17.12, by making suitable
substitutions in d; and d).

GAP OPTION
Normally, payoffs on options are non-linear, with discontinuity in the payoffs at the exercise
prices. Gap options are options where payoffs are non-linear, and also have gaps in the pay-
offs at the exercise prices. The payoffs of a gap call option and a gap put option are given
in Table 17.3 and depicted in Fig. 17.4. A look at Fig. 17.4 would justify the name given to
the option.
It may seem that gap options are similar to regular options with XY replaced by another
figure, G, but there are two critical differences. As can be seen from Table 17.3,
tion is similar to : :
Aap ophon payoff for regular options
é is a function: of the exercise price, but for gap
a regular option except
that the quantum of options, it is determined by another variable, G. However, the exercise price
payoff is decided inde- continues to determine whether the option is exercised or not. Further, the
pendent of the exercise buyer of regular options exercises only when it is ITM; otherwise, he/she lets
pice it expire. A gap option may or may not be ITM when exercised. It would
Bee
depend upon the value of G.

Table 17.3 Payoffs on gap options at maturity

Asset price at maturity Gap cail option Gap put option =|

When S;< X G— S;
When S;= X 0
Exercise price, G = Ga
 490 Derivatives and Risk Management

Applications
The strategy of using a gap option achieves a balance between a reduction in the cost of hedg-
ing with options and a sacrifice of the potential gains in case G is fixed higher than X for call
option. If G <_X, the potential gain is enhanced, with a commensurate increase in the cost of
the option. For put option the situation is reverse. Therefore, what value of G would be fixed is
predominantly a function of extra costs and extra gains depending upon the likely behaviour of
the asset price. Figure 17.4 clearly compares the payoffs on regular options and on gap options.

Gap call option Gap put option

Payoff G<xX Payoff G<Xx

x Spot price Spot price

Payoff Payoff
G>xXx

G>x

Spot price

: Spot price
——e——= Conventional option ©
Gap option a
Fig. 17.4 Payoff of gap options at maturity wey

Valuation
Valuation of gap options is rather easy. The payoff on a gap
call option at maturity, 7, is
given by
c7( gap) = Sr—-G when S$; > X
0 when S; = X
or Sp X+X=-G when S; > X
0 when S; = X
l

or Sp> Xx “whens =X 1 when S; > X

0 WHEE Stk nee | 0 when
S; > ¥
= Payoff on a regular call at Payoff on a cash or
maturity with exercise ie nothing binary call at
price, X maturity with a fixed
amount, ¥— G
 Exotic Options 491

tO, the value of a gap call at maturity is the same as the value of a regular call and
isao mb | a cash or nothing option with X — G as the payoff, c(CON). The value of the
ion ofa regular option. gap call option before maturity should be the sum of the values of the regu-
labinary option. For lar call and the cash or nothing call, and can be written as!
iging, itisa sacrifice
of the payoll forsaving c(gap)= 1 (X= G) xX (CON) (17.13)
_ Asimilar logic would prove that the value of a gap put option is the sum of
~ the values of a regular put and a cash or nothing put with G — X.
Prgap) = Fe— Sr when S; < X
0 when S; = X
or facemaia when
S; < X
0 when S$; = X
] O

or fee BE when S; < X | |1 when

S; > X
0 when S; = X ee 0 when
S; = X
= Payoff on a regular put at Payoff on a cash or
maturity with exercise +: nothing binary put at
price, X maturity with a fixed
amount, G — X

p(gap) = p + (G —X) X p(CON) (17.14)

The valuation of gap options can also be arrived at by using the BSM with some modi-
fications. The payoffs on a regular call and a gap call are decided by the exercise price and
the gap, respectively. However, the rules regarding exercising the options remain the same in
both the cases. Therefore, the payoffs on the options in terms of the exercise price need to be
replaced from X to G for gap options, as if the exercise price is not XY but G. Incorporating

EXHIBIT 17.2 Valuation of gap call and put options

c(gap) = ¢ + (X — G) x ¢e(CON)
c= Se~%". Nid,) — Xe. Nd) and CON) = e~” xNid.)

- p(gap)=p + (G — X) x p(CON)
p= Xe” Nt) ~ Se-". M—d;) and p(CON = e~™ x N—d,)
_ iS) + rg ole)T.
where and
Oy IT

_ ee
3 Price ofundetyine asset. X = Exercise price G = Gap
_ T= Time remaining for. o = Annualized standard deviation In = Natural log
-freerateofreturn _ q = Dividend yield on the asset
‘) = Cumulative normal distribution function at x

!Wherever the value of the difference between G and_X is negative, it can be deemed to have written an option.
492 Derivatives and Risk Management

ee

EXAMPLE 17.2 Gap option call

Assume that an importing firm has a payment of US $10,000 to make at the end of six months from now. The spot price is £50/$.
The volatility of the dollar exchange rate is estimated to be 20%, and the risk-free rates in the Indian rupee and the US dollar are
10% and 5%, respectively.

(a) What would the maximum cost for the firm be if it decides to hedge with a regular call with a strike of €51.00?
(b) If the firm is willing to sacrifice €1 from its likely gains by hedging with a gap option, what would its maximum cost be?
(c) Under what circumstance would the strategy of a gap call prove better than hedging with a regular call?
Solution
(a) If the importer hedges with regular a call with a strike price of £51.00, the cost of the call option would be given by the Merton
model. .
c= Se~4 N(d,) — Xe~'T .N(d,)
With S = 50, X = 51, r= 10%, q = 5%, T=0.5 years, and 7 = 20%, the values of the intermediate parameters are
d; = 0.1075, d> = —0.0339, N(d;) = 0.5428 N(a>) = 0.4865
And the value of the call = 48.7655 x 0.5428 — 48.5127 x 0.4865
= 26.4699 — 23.6014 = %2.8685/$.
By taking a regular call, the importer ensures that the maximum cost would be frozen at X + C, 1.€., 51.00
+ %2.8685 =
%53.8685/$.
(b) If the importer decides to sacrifice up to 1.00 by fixing the gap, G, at %52, the value of the call would
be reduced by the 5
value of the binary call with the value X — G being negative. The value of the binary call would be
]
(X — G) x e-" X Nd) = —1.00 x 0.9512 x 0.4865 = —20,4628,
7
Therefore, the cost of the gap call is 72.4064. The importer’s maximum cost would be G + c, i.e.,
752.00 + 72.4064 =
%54.4064 per dollar.
(c) Gap call would reduce the cost by %0.4628/dollar. The strategy with gap call would be beneficial if rupee
appreciates rather 7
than depreciating. :
LEED

the change in the payoffs, the value of gap options as modified under the BSM
would be as
follows:
c(gap) = Se~4" - N(d);) — Geo" - Nd>)
p(gap) = Ge~"" - N(—dz) — Se~%" : N(=d,)

PAY-LATER OPTION ees:

As the name signifies, pay-later options allow the payment of the
premium on the option later
rather than upfront, while initiating a position as in a regular option.
For pay-later options,
the premium is adjusted in the payoffs. The payoffs on pay-later
call and put options for the
holder are given in Table 17.4.

Table 17.4 Payoffs on pay-later options at maturity

Asset price at maturity Pay-later call option Pay-later put option

When S;< X
X-A,—8;
When S;= X
0
 Exotic Options 493

Pay-later call option Pay-later put option

Payoff Payoff

Ui

Spot price Spot price

i}

Regular option
Pay-later option

ig. 17.5 Payoff on pay-later options at maturity

The payoffs on the pay-later call and the put options are depicted in Fig. 17.5. A look at
the figure would suggest that the payoffs on the pay-later options look just the same as those
for the gap options when G more than_X. They are strikingly similar. However, there is an
important difference. The premium in the case of the pay-later option is not payable at matu-
rity; the liability arises only if the option ends up ITM. No premium is payable if the option
is out-of-the-money (OTM). Under the gap option the premium is payable upfront.

Applications
As no premium is payable upfront, the pay-later option enables hedging at zero cost. A
pay-later option becomes useful when a large one-way movement in the asset price is fore-
seen. The pay-later call would be useful to importers when the local currency is expected to
depreciate substantially. If that happens, the importer does not mind paying the premium,
but does not want to pay it upfront. If a foreign currency of interest is expected to depreciate
substantially, an exporter could hedge against unfavourable movements through purchase of a
pay-later put option with no initial cost. If the expected forecast comes true, the hedger does
not mind sharing part of payoff with the writer of the option. If the forecast does not come
true, the hedger has no liability to pay.

Valuation
The valuation of pay-later options can be done on similar lines as the valuation of gap
options. However, unlike gap options, where the gap value, G, is a choice of the buyer, with
pay-later options, the amount of decrease/increase in the payoff is decided by the seller of
the option. The valuation of pay-later options is stated here:
c7(PL) = Fe—X- A. when S; > X
0 when S; = X

or Sp—X when S;> X ya [copa

0 when S; = X 0 when S;
> X
494 Derivatives and Risk Management

= Payoff on a regular call at Payoff on a cash or

maturity with exercise = nothing binary call at
Priceek maturity with a fixed
amount, A.

At maturity, the position in the pay-later call is equal to a long position in a regular call
and a short position in a cash or nothing call with a payout of 4.. Therefore, at any point of
time, the value of the pay-later call is equal to the value of the regular call less the value of
the cash or nothing call with 4..
Since the premium on the pay-later call is not to be paid upfront, the value of the pay-later
option at time ¢ = 0 must be zero. Hence, the value of A, essentially has to be a value that
makes the premium of the pay-later call nil. Mathematically, it can be expressed as follows:
EPL) ACN TAO CONVO (17.15)
x Co - Co . Al
os ae COM) eTN(d) (7-16)
For comparison, consider the data in Example 13.2 on a gap call option on the US dollar
exchange rate with S = 50, X¥ = 51, r = 10%, g = 5%, T = 0.5 years, and a = 20%. The
values of the intermediate parameters were
d,; = 0.1075, d) = —0.0339, — Md,) = 0.5428 N(d>) = 0.4865
The value of the regular call was found as 72.8685/dollar. If this premium is not to be paid
by opting to go for a pay-later option, the value of 4. would be fixed by
Pay-later options are _ dividing the call price by the value of the cash or nothing call, ie., e 7.
deceptively attractive for Nd). This comes to 70.4628. Hence, the value of A. is 2.8685/0.4628 =
oeee a 6.1982. For these values, if the ending exchange rate finishes at 754/dollar,
may have tobe exercised the pay-later call would have to be exercised with the payoff as § — T — A.
evenwhennotITMat © = 54.00 — 51.00 — 6.20 = —%3.20/dollar. The payoff would not be positive
expiry. _ till the spot exchange rate on maturity closes above 757.20. Hence, the pay-
ne ~ later option makes sense only when the direction is almost certain and sub-
stantial movement is also foreseen. Until this happens, it may not be worthwhile to go for a
pay-later option just to avoid the upfront premium, as it may land up costing the holder dearly
at the end of the hedging period.
On similar lines, we may value a pay-later put option as shown here:

pre Te when Sp < X

0 when S; = X
or {oe when S; < X ee fish aie
Pp

0 when S;
=X 0 when S;
= XY
= Payoff on a regular put at Payoff on a cash or
maturity with exercise — nothing binary put at
Bplicew a maturity with a fixed
amount, 4,
 Exotic Options 495

EXAMPLE 17.3 Pay-later put option

Assume that an exporting firm has a receivable of US $10,000 at the end of six months from now. The spot exchange rate is €50/ |
dollar. Volatility is estimated to be 20%, and the risk-free rates in the Indian rupee and the US dollar are 10 and 5%, respectively. |

(a) What would the minimum exchange realized by the firm be if it decides to hedge with a regular put option with a strike of ]
51.00?
(b) If the firm is not willing to pay a premium upfront, then what would the equivalent pay-later put option be?

Solution L
(a) If the exporter hedges with a regular put option with a strike price of 751.00, the cost of the put option would be given by the
Merton model.
p = Xe~. N—as) — Se-97. N(— dk)
With S = 50, X = 51, r= 10%, g = 5%, T = 0.5 years and o = 20%, the values of the intermediate parameters would be
d, = 0.1075, d, = —0.0339, N(—a;) = 0.4572, N(= db) = 0.5135
and the value of the put would be = 48.5127 x 0.5135 — 48.7655 x 0.4572
= 24.9113 — 22.2956 = ¥2.6157 per $.
By taking a regular put, the exporter ensures the minimum realization of X — p, i.e., 51.00 — 2.6157 = %48.3843 per dollar.

(b) If the exporter is not willing to pay the premium upfront, he/she would need to buy a pay-later put option with a gap of Ao,
arrived at by dividing the regular put price by the value of the cash or nothing put. The value of the cash or nothing put is p
0.4884. The value of A, would be 2.6157/0.4884 = 5.3557.

EXHIBIT 17.4 Valuation of pay-later call and put options

c(PL) = c — A, x (CON)
c= Se. Nd,) — Xe Nd) and c(CON) = e~ xN(d,)
p(PL) = p — A, xp(CON)
p= Xe"7. M—d,) — Se-97. N—d,) and p(CON) = ex (N— ab)
where
d, = ISM) + (r= a + o7/2)T ; and
O\ if

1 In(S/X) + (r csoo 2 /2)T bead ato

O7* if

S = Price of underlying asset X = Exercise price

A, Ap = Ratio of prices of regular and cash or nothing option while initiating
T = Time remainin g for expiration o = Annualized standard deviation
r = Risk-free rate of return q = Dividend yield on the asset
N(x) = Cumulative normal distributi on function at x In = Natural log

Just as we determined the premium adjustment in case of a pay-later call, the premium for
a pay-later put would be adjusted as follows:

po(PL) = po — Ap X po(CON) = 0 (17.17)

= Sees 17.18
(17.18)
ak CP AENCON) | 2 Na)
496 Derivatives and Risk Management

COMPOUND OPTIONS a
A compound option is an option on an option. The underlying in the regular option is an asset
_ that is conventionally’a stock, a commodity, an index, a foreign currency, an
A compound option is
_ interest rate instrument, etc. In a compound option, the underlying asset is
an option on an option,
another option that gives a right to buy or sell the underlying asset. In a
and is ideal for covering
contingent exposures compound option, there would be two options with two different maturities,
t and 7, and two different exercise prices, x and X. There can be four types
of compound options that are described for a stock.

Call on call A compound option of a call on a call would comprise of two calls, one matur-
ing earlier at ¢ and the other later at 7. When the first call expires at ¢, it gives a right to the
holder to acquire another call by paying the exercise price of the first call, x. On expiry of
the second call at 7, the holder gets a right to buy the underlying asset, say a stock, by pay-
ing its exercise price, X.

Put on call A compound option of a put on a call would comprise of one put maturing
earlier at ¢ and one call maturing later at 7. When the put expires at f, it gives a right to the
holder to sell a call by receiving the exercise price, x. On expiry of the call at T, the holder
gets a right to buy the underlying asset, say a stock, by paying its exercise price, X.

Put on put A compound option of a put on a put would comprise of two puts, one matur-
ing earlier at ¢ and the other later at 7. When the first put expires at f, it gives a right to the
holder to sell another put by receiving the exercise price of the first put, x. On expiry of the
second put at 7, the holder gets a right to sell the underlying asset, say a stock, by receiving
iis /exercise price, 21.

Call on put A compound option of a call on a put would comprise of one call maturing
earlier at ¢ and one put maturing later at 7, When the call expires at ¢, it gives a right to the
holder to buy a put by paying the exercise price, x. On expiry of the put at 7, the holder gets
a right to sell the underlying asset, say a stock, by receiving its exercise price, X.

Applications
Compound options are ideal to cover contingent exposures where forwards do not serve
hedging purposes. Consider the situation of a supply contract for equipment, where a firm
has quoted a price in a foreign currency, say euro. Whether the bid is successful or not would
be known after three months. If the firm bags the order, it would take another three months
to supply and realize payment. The firm expects the euro to depreciate. The firm faces many
alternatives to hedge against the depreciating euro:
¢ One alternative with the firm is to book a 6-m forward contract to sell euro. That could
prove disastrous if the firm does not succeed in getting the order. A forward contract is
a binding commitment, and, therefore, the firm would have to honour the commitment,
irrespective of whether it succeeds in getting the order or not.
e Another alternative would be to buy a plain vanilla put option for six months. Though
not obligatory in nature, the put option would be expensive in terms of the premium.
 Exotic Options 497

Further, it does not allow for the possibility of failing in the tender, as the premium of
put is paid in any case.
e Asa third alternative, the firm can buy a compound option. It would be a call on a put
with the call at the end of three months, giving it a right to sell euro in six months. If
successful, the firm exercises the call to have the put option to sell euro in six months,
otherwise it allows the call to lapse. An additional decision with the firm in this case
would be to fix the exercise price of the call, the first option.
On similar lines, an importer uncertain about procurement being contingent on some event
and apprehending an appreciation in the foreign currency he/she is dealing in may like to have
a call on a call that gives a right to buy the foreign currency at the expiry of the first call. It
may be a more preferable alternative than a forward buy contract or a plain vanilla call.
A put on a call and a put on a put would be appropriate in situations where one wants to
sell either a call or a put, respectively, not now but later. At maturity, a compound option
with the put as the first option would give a right to sell a call (for a put on a call) or sell a
put (for a put on a put). All situations that warrant selling of an option on a deferred basis
are suitable for compound options with a put as the first option.

Valuation
The valuation of a compound option is dependent upon the value of the second option at the
expiry of the first option. In the case of a compound option of call on a call, the holder would
exercise it on maturity only if the value of the second call exceeds the exercise price of the
first call. Similarly, for a compound option of a put on a call, the holder would exercise the
put on its maturity only if the value of second option, 1.e., the call, is less than the strike of
the first option.
The decision to exercise the first option or let it expire is dependent on the payoff at the
expiry of the first option, which in turn is decided by the strike price of the first option and
the value of the second option at that time.
Consider a call on a call. At the expiry of the first call at t, one would like to exercise it
only when the value of the second call (the underlying asset in this case) at that time, c,, is
greater than the exercise price of the first call, x. The payoff is positive. If the value of the
second call is less than the exercise price of the first, the compound option would not be
exercised. Similarly, a compound option of a put on the call is exercised only when the value
of the subsequent call, c,, is less than the strike price of the first put, x. The payoffs on the
four compound options at the expiry of the first are summarized in Table 17.5.

Table 17.5 Payoff on a compound option at maturity of first option, t

At maturity of first
option, t
Exercise when

Do not exercise
where x= exercise price of the first option,
eeand p;= Value of the second clue coals at the ill of the firstsalads at time, t L
498 Derivatives and Risk Management

The value of the second option at the expiry of the first would be governed by not just the
risk-free rate of return and volatility but also the (a) asset price at ¢, S,, (b) exercise price of
the second option, X, and (c) time remaining for maturity, 7 — ¢. With a given and known
X and T — ¢ that are determined initially, the asset price at the time t becomes crucial in the
exercise of the option. The option holder is indifferent to exercising if the value of the second
option is exactly equal to the exercise price of the first. We define S* as that asset price that
equates the value of the option equal to the exercise price of the first, i.e.,

For a call: Cy, = C4S*, XT = 1) =

For a put: D; = pAS*, X, T = 1) =x

An analytical solution to European compound options can be found in terms of the bivari-
ate normal distribution denoted by M(a, 6, p), which represents the bivariate cumulative
probability of the first variable less than or equal to a and the second variable less than or
equal to b, with p as the coefficient of correlation between the two. Analytical solutions to
the valuation of the four compound options are given in Exhibit 17.5 known as Roll, Geske
and Whaley formula.

EXHIBIT 17.5 Valuation of compound options

Cail oncall Ce= Se". (ay Dy, V2) —-Xe'. M4, bo, vz) xe". Nay)

Putoncall Pe= Xe". M(—a, Do, — V2) ~S.e. (a, by, -£) —x-e 7. N—a)

Callonoul Co=X.e 7. M(—a —Do, VE) —~8¢@¢. M(—a, —p,, Vz) —x-eT. M—a)

Puton put Po=S-.e%. (a, —D,, - 4)~X.@. (a — Dp, -,[£) —x-e-T. N—a,)

nfoae ("-G4 =
where Ls: 2
ay ——- and a = a — ot
ayt

nfsss (r-q+ “\r

b= te ond tS a
oy

S= Price ofstock now S* = Critical stock price at expiry of first option at time t
X= Exercise price of first option t= Time of expiration of first option t< T
X = Exercise price of second option T= Time for expiration of second option
a = Annualized standard deviation r= Risk-free rate of return
q = Continuous dividend on asset underlying the second option In = Natural log
M (a, b, p) = Value of cumulative bivariate normal distributi N (x) = Cumulative normal distributi on function at x
on with first variable less than a and second variable less
than b with correlatio n of p

*Roll, Geske, and Whaley Formulae

 Exotic Options 499

BARRIER OPTIONS *
Among the most popular and most traded exotic options are barrier options because they are
cheaper than standard options. Barrier options either come to life or expire at
Barrier options are a specific level, called the barrier price. Plain vanilla options have one refer-
amongst the most
_ ence price, 1.¢., the strike price X, to which the spot is compared when deter-
popular options, as
they reduce the cost of mining the payoff. For barrier options, there is another reference, the barrier B,
hedging which determines if the option is alive or dead. However, when alive, it is like
a standard option. The reference point that determines whether the option is
alive or dead is called the barrier. Barrier options are also known as path-dependent options, as
the value of these options depends not only upon the value of the underlying asset at maturity -
but also on whether the value touched the barrier during the period of the option.
Barrier options can be either knock-in or knock-out. Knock-in options come to life only
when the barrier is touched, otherwise they remain worthless. Knock-out options are those
that may be currently alive but become worthless if the spot touches the barrier. The up or
down direction towards the barrier gives rise to two more possibilities for knock-in or knock-
out options. Whenever alive, these barrier options behave like plain vanilla options.
A knock-in option comes to life if the spot touches the barrier, and, thereafter, becomes a
plain vanilla option. It can be up-and-in, meaning that if the spot goes above the barrier, it
becomes alive. Similarly, down-and-in options would be alive if the spot goes below the barrier.
Knock-out options remain standard options till they expire upon the spot touching the
barrier. They too can be up-and-out or down-and-out. The spot price going above the barrier
makes the option worthless for uwp-and-out. Similarly, a down-and-out option expires when
the spot goes below the barrier. Remember, once out the option is always dead. If during the
life of the option the barrier is never touched, then the knock-out option would always remain
alive, while the knock-in option would never come to life.
For example, consider a call option with %110 as the strike and %120 as the barrier on an
asset trading at $100. An up-and-in option would be an option that remains dead till the spot
touches the barrier of =120. Once the price goes above the barrier, the option comes to life.
It remains alive irrespective of the subsequent price levels. The payoff would be decided as
in the case of a plain vanilla call option. Similarly, if the barrier were $90, a down-and-in
option would remain dead till the spot is above €90 and become alive when the spot goes
below %90. The four types of barrier call options are described in Table 17.6. There would
be another set of four matching combinations of barrier options involving puts.

Barrier Options are Less Expensive Since barrier options are not expected to remain
alive for the entire life of the option, they are less expensive than plain vanilla options. A
bullish trader would buy a call option with a strike 10% higher than the current spot and pay
_ the entire premium. However, bullish sentiments may turn negative if the
Barrier options cost less
spot falls by more than 10%. Therefore, he/she may buy a down-and-out
_than regular options
_ because they remain option and save some cost.
_ alive only for a part of the Some of the barrier options exhibit abrupt behaviour in prices because
option period, depending - they gain or lose value without warning. For example, an up-and-in call
upon the path the final with the spot at 100, the exercise at 110, and the barrier at €120 suddenly
Vv
becomes valuable when the price starts approaching the barrier of 120. If
500 Derivatives and Risk Management

Table 17.6 Barrier call options

Assumed spot = 7100)
Type Exercise Barrier L Description Features
price, x price, B
Knock-in options
Up 110 120 The option comes to life only when | The call option suddenly gains an intrinsic worth
and S goes above the barrier of 120; | of 10 the moment it comes to life.
In otherwise, it is worthless.
Down
and
ce 110 90 corel ee
The option comes to life only when | A call option gets activated only when the spot
S goes below %90; otherwise, itis | falls to the barrier of 90. Thereafter, it behaves
In le i worthless like a regular option.
Knock-out options
Up 110 120 The option is valuable as long as | The call option, gaining in value with any rise in L
and S does not touch %120. It expires | price, suddenly loses the entire intrinsic worth of |
out when S goes above 120. 10 upon touching the barrier.
Down 110 90 if S goes below 90, the option The call option becomes OTM prior to the spot |
and becomes worthless. touching the barrier. The value consists only of |
out time value. The time value becomes zero upon 7
the spot touching the barrier. - 7

the spot value remains between %110 and 120, the option does not become alive, despite
being in-the-money. Naturally, there is loss of value in some price ranges and, hence, this
option would cost less than a vanilla option.
Similarly, an up-and-out call with the spot at ¥100, the strike at 110, and the barrier at
~130 would become in-the-money after the price crosses $110, but would lose its worth (of
at least 20) when the spot crosses $130. It would start falling in value as the asset price
approaches the barrier. This too would cost less than a vanilla option, as it is worthless
beyond a spot price of 130.

Valuation
The valuation of a barrier option needs a high level of mathematical understanding, which
is
beyond the scope of the book. Besides, barrier options can be valued in many ways: by
the
analytical method, by the numerical method, and by simulation.
We may use the binomial method to value barrier options much in the same way
as we
do for valuing American options. At each node, we may examine if the barrier comes
into
action. If it does, we eliminate the node and continue to evaluate the nodes
that are alive.
Let us examine the application of the binomial method to value a barrier option
that not
only illustrates the decision-making process, but also shows how a barrier option
is cheaper
than a regular option. Assume a stock trades at 7100. We value a call with
an exercise price
of 85 and an expiry of 12 months with a barrier at 90, It is a down-and
-out call, imply-
ing that if the stock price falls to ¥90 or below at any time before maturity,
the call option
becomes worthless.
We shall use three-stage binomial tree with each binomial period of
four months for call
expiring after | year. This tree is depicted in Fig. 17.6, with a risk-fre
e rate of 3% per period,
and up and down movements of 10% each.
 Exotic Options 501

Value of underlying asset with 10% up and 10% down movement

Exercise price of call =~85, Barrier price = ¥90. Down-and-out
Risk-free rate = 3% per period

Time 4m 8m 12m Call payoff

48.10

So ro)aq
Barrier = 90 a
ee
or
aen)
se
Se

The risk-neutral probabilities for up and down movements are 0.65 and 0.35, respectively.
As shown in the binomial tree, there are four possible terminal values of the stock. The payoff
on a regular call with ¥ = 85 would be as follows:

End price Call payoff ||

2133.10 £48.10
7108.90 la 223,90
| %89.10 4.10 :
Eee Z
The values of a regular call and a down-and-out call with a barrier of €90 are condensed
in Table 17.4, with irrelevant paths (where the stock has touched or gone below the barrier
of 90) for the barrier option struck out.
There are eight possible paths in the tree. Whenever the stock price is less than ¢90, the
option expires and its value becomes zero.
The end price of 7133.10 is achieved by all the three up movements with the probability
of each at 0.65. With a call payoff of $48.10, the expected value of a regular call would be
(0.65 X 0.65 X 0.65) X 48.10 = %13.21. Since the path to reach the value never crosses the
barrier, it is also included in the pricing of the barrier option.
The end price of 108.90 can be achieved by two up movements and one down movement.
This is possible in three different ways. The expected value of the payoff on the regular call
would be 3 X (0.65 X 0.65 X 0.35) X 23.90 = %10.61. However, ofthe three possible paths
to reach the value of 108.90, one (down—up-up) path on three branches of the binomial tree
502 Derivatives and Risk Management

would cross the barrier, and, hence, is eliminated from computation of the call price with a
barrier. This would reduce the value to ¥7.07 for the call with the barrier.
Similarly, we may value nodes with end prices of ¥89.10 and %72.90. The end price of
~89.10 can be achieved by one up movement and two down movements. This is again pos-
sible in three different ways. The expected value of the payoff on the regular call would be 3
X (0.65 X 0.35 < 0.35) X 4.10 = %0.98. However, since the end value is less than 790, the
value of the call with a barrier would not consider this figure at all. Hence, the entire value
of 0.98 is saved in the call with the barrier. For the end price of 72.90, there is only one
possible way of all the three down moves. The end price is trivial for valuing a regular as
well as a barrier call, being less than both the exercise and the barrier.
Table 17.7 shows that while a regular call would cost %22.48, the downand-out call with
a barrier of £90 costs ¥18.38, indicating a saving of about 18.2%. The barrier option does
not pay for unlikely possibilities.
Another method of valuing barrier options is the BSM. Four formulae
Many methods to value ee : : ; re
fe options exist similar to the BSM are used in valuing barrier options. Exhibit 17.6* gives
each ofwhich is more the various formulae used in the valuation of barrier options. Table 17.8
cumbersome than valu- provides the valuations for all possible combinations of barrier options.
ing a regular option While valuing a barrier option, one property that is very handy is that the
sum of a knock-in and a knock-out option with the same asset, the same
exercise, and the same barrier are nothing but equal to a European option.

Knock-in option + knock-out option = European option (17.19)

Table 17.7 Binomial valuation of barrier option

[ Strike =85 | Barrier = 90 |Nature = down-and-out |

Call Call value at T= 12m :
ne Probabilities |Standard |Barrier |
z
4010 | uu u)| 065 oes o8s |
132
| 1321
1 |
u d u 065 085°: 0.65 1
23,90 u U d 0.65 005.-° 0.35 10.61 7.07
d U u 0.35 065 0.66
u d d 065.7 °0.85* . 0:35
4.10 d u d 0.35 0.65 0,35 0.98 -
d d U 0135.7 20735 7) 0.65
0.00 d d d O35. 035° 0.85 _ ~
Call value at T= 12m 24.80 20.28
Call value today = discounted at 22.48 18.38
Saving with barri tion 3 % per period 18.2%

Adapted from Peter James, Option Theory, John Wiley and

Sons, England, 2003, pp. 180, 181; and Desmond Higham, 4n
Introduction to Financial Option Valuation, Cambridge University
Press, 2004, p. 190.
 Exotic Options 503

Important formulae for valuing barrier options

B: S-Nd;,)
— X-e7'T Nab)
E: SNe)
— X:e-7. Nes)
a. a
BF ;
(2)
oe
B\o
smi (2
— (2) B\e
()
Xet ME
Ba Be

G: Al
(2 oN (92) - (2)
S Xe. N(94)

__ IS) + (r+ o72)T, _ In'SX) + (r— 0 2)T OF bad -—at

ovl

_ In(S/B) + (r+ 0/2)T. _ ISB) + (r— 02)T Or @=6—a\T

oyvl

2 _ 2 .
gle)T. aaa o b=h—ot
ol : :

= (r=oe0%) In SX/BP) pe2 ee.

O*

Table 17.8 Valuation of barrier options

Type Barrier Valuation* - Type Barrier

conditions conditions
Knock-in options ~
Down-and-In X<B B-—E+F Up-and-In X>B
Down-and-In X> cia G Up-and-In X<B
Up-and-In X<B E+F-—G_ | Down-and-In X>B
Up and In X>B Down-and-In Ka
Knock-out a
Down-and-out Ke Up-and-out X>B
Down-and-out iS 18) B-G Up-and-out <8}
Up-and-out X<B B— E-—F+ G| Down-and out X>B
Up-and-out X>B 0 Down-and out X<B

*Refers to ue given in Exhibit 17.6 L

Consider the holder of knock-in and knock-out call options with a spot of €100, an exer-
cise of 110, and a barrier of €90. At the time of creating the position, the knock-in option is
in-the-money but dead. The down-and-out call is alive. If the spot remains above the barrier
of 290, the original position continues till maturity. If the spot falls below the barrier of ¢90,
 504 Derivatives and Risk Management

the knockout call option expires, but the knock-in call becomes alive. Therefore, one of the
options would always be alive and thus, the combination of a knock-in with same barrier and
strike prices and a knock-out is equal to a plain vanilla option.
The application of Eq. 17.19 may be verified in the values of the knock-in and knock-out
options given in Table 17.8. They would add up to B, the BSM value of a European call.

ASIAN OPTIONS & _.

Asian options have a payoff that is not entirely determined by | the price of the underlying
asset at maturity but is based on the average price during the life of the
Asian options provide option. These options are also called average options. Like barriers, they are
payoff depending upon
also path dependent, as their values also depend upon the path the asset val-
the average over option
period, and suit business ues take during the option periods. The payoff on an average option is given
needs by Eqai7.20:
For a call Max(0, S, — X) (17.20)
For a put Max( 025-95.)
where S, is the average of the spot prices during the option period.
Another kind of Asian option is the average strike option, where the strike
price is based
on the average. The payoff on an average strike option is based on
the final price, $7, and the
average price during the period, as given by |
Sra TEA Ge
Por a call Max(0, S; — S.,)
For a put Max(0, S, — Sp) C1727)
where S, is the average of the spot price during the option period
and S; is the price at matu-
rity of the option.
é
Average strike options ensure that the final price during
the period matches the average
during the period.

Applications
Asian options are very popular because of:
Asian options are popular © the practice of judging performance for a given period
based on the aver-
because they provide = age during the period;
hedging based on the averages present a fairer view, as they are more
averages rather than end : difficult to manipulate
values than end-of-the-period prices; and
- ¢ being cheaper than plain vanilla options because
averages have less vola-
tility than end-of-the-period prices.
Due to these reasons, hedging based on average
rather than end-of-the-period values
makes more sense in terms of fairness of comparison
and cost effectiveness.
Asian options are more common in foreign curre
ncy transactions, where exporters and
importers are more interested in the average excha
nge rate during a given period than in one
single value at the end of the period. The underlying
for determining the payoff is the average.
An exporter would like to buy a put option whose
payoff is determined by the average over
 Exotic Options 505

a quarter, rather than the end-of-the-quarter value. Similarly, an importer would buy a call
option with the average over the quarter to compare the actual cost over the period. Invest-
ments in the equity market and financial assets also follow a common strategy of averaging
for purposes of smoothing the investment value. For those who want to avoid extreme views
on the prices of assets, Asian options have tremendous appeal, irrespective of the exposure
in any underlying asset.
Average options are cheaper than regular options. For example, consider, as an alternative
cian options are . to an average option, the buying of 13 weekly options covering the quarter.
cheaper because aver- The payoff in the case of 13 weekly options would be better than the one
ages include all values, quarterly average option. The logic is simple. Of the 13 weekly options, some
and have less volatility of the options would expire worthless when the price is not favourable. In
than spot values the case of put options for exporters, the spot rate could be higher than the
— . strike during some of the weeks. These spot values are not counted. In case
of an average option, none of the values would be ignored, as they are used in calculating the
average. All the values would be included in the average, and, hence, the payoff would be
smaller than the series of independent equivalent options. Further, the average itself is a
smoothing phenomenon and has less volatility. We know that option prices are driven by the
volatility of the underlying asset. This makes average options cheaper than vanilla options
based on end-values.

Valuation
The question of averaging has two dimensions:
e How often will price samples be taken? The options can be daily, weekly, or monthly.
e Which average would be considered? The choices are arithmetic or geometric.
The valuation of Asian options presents problems due to the fact that while the distribu-
tion of stock prices is known to be log-normal, the probability distribution of the average is
unknown. Most average options are based on the arithmetic average. This poses great prob-
lem in valuation because the probability distribution of the arithmetic average is not known,
and, therefore, an analytical solution such as the BSM is not possible. However, it is possible
to have an analytical solution for Asian options that is based on geometric averages, because
geometric averages would have the same probability distribution as prices.

Arithmetic Average, A, = (Sp + Sy + S)......... Syl + D

N
i
alle ] 0 oF
Ciye22)

Geometric Average, Ag = (Sp xS)xS) ......... Sn

Natural log of geometric average, Ag

= fae Btn In S (17.23)

Sper LG é
From Eq. 17.23, it is clear that the geometric average, being the sum of the log-normal
of the spot values, is normally distributed because the log of the stock prices is normally
distributed. Such an inference is not possible for the arithmetic average.
506 ‘Derivatives and Risk Management

The valuation of average options based on the geometric average is possible on the lines
of the BSM with the parameters of drift and volatility changing. The expected value of the
geometric average is given by:
N eyes i
E(Ag) =
ea S
140
* A, y pL eka sal ekseer a)
- = S Vo 17” . E (r) wi th E (7) = mot

ras eee 28, NN + 1)

= Vee cl
qe one Ve mie ie ema

yAN
eee m at, mT
eles
5 (17.24)
Similarly, the variance of the geometric mean is stated as
1 N
Var(A,) = +1? > Var (Hie To whan ee ie)
N
= Taare 2m. VarE(r) with VarE(r) = o7dt

= ————_
1 celine ae
a =
DNC
(Or-
eee
Pe
AGE While eos Paoel cab Ores: 6
Bu CON
ten eae eve
Te ane anne) ts ONE)
oi
= 3 (For large N) (17.25)

From Eqs 17.24 and 17.25, we may state that

e the expected growth of the average, m,, would be half of the growth of the underlying
spot, m; and
e the variance of the average, oe can be approximated to one third of the variance of the
underlying, a7.
With these modifications, we may now apply the BSM for valuing the geometric average
_ options. Under the BSM, the growth, m = r — q — o7/2, would stand mod-
The valuation of Asian
options is extremely ified to Me = Mids Ve (go od yang Og = o/\3, with dividend yield
difficult because the aver- changing to gg = %(r + q + 07/2). The value of the call with geometric
age is not log-normally average 1s given by Eq. 17.18.
distributed, for which an Cy = S.e4? » N(d,;) — X.e7"T - N(d>) (17.26)
analytical model like the a ; “ ?
BSM applies here d, 22 In iS aie Alr 7 ar Or 16) and

dx WUSIX) + Ar = g + o7/6)T
dy = d, — gyT3
ei ayT/3
The value of the average options as given by Eq. 17.26 applies to the geometric average.
In practice, average options are based on the arithmetic average. Since the arithmetic average
and the geometric average are fairly close, the normal approach is to apply a correction fac-
tor to the value of the geometric average option. One such approach is to calculate the first
moment and the second moment of the average in the risk-neutral world, which are given as
M, and M), respectively (with a = r — q), as follows:
gen
Cm |
Deed ge )e §2 952 1 eal

> (a+ 02)(2a + 6) as + ae =]

 Exotic Options 507

Assuming the average as a log-normal distribution, the value of the call can be calculated
by using Black’s model (for future options) by substituting the forward price, Fy, and standard
deviation, o, by the following’:
Fo = M,

ieee
ae Naa ee
en agin
Using the binomial model for valuing Asian options Like with the valuation of barrier
options, the binomial method may be used for valuing options based on averages. Being
path dependent, the interim values become important and are aptly considered in binomial
trees. Consider an ATM Asian call option based on the average for a stock trading at 100.
Let us attempt the valuation of a call option using a three-stage binomial tree. Assume the
risk-free rate at 2% per period and the up and down movements at 10% in each period. The
risk-neutral probability of the up and down movements would be 0.60 and 0.40, respectively.
While valuing a regular call option, we need to find only the end values in the binomial
tree and then determine the payoff on the option with the given strike price. The values in the
intermediate periods have no significance. While valuing an option based on averages, there
is little to do with end values. It is because the payoff is not dependent upon the end value
alone, but also on the path taken to reach the end value. The path decides the average, and,
hence, the payoff. The end value is only one of the values used in calculation of the average.
There are four end valués and eight possible paths, as depicted in the binomial tree in
Fig. 17.7. The valuation of average options by a binomial tree is more complex because for
this kind of valuation, all eight paths need to be evaluated separately. This is because the
average under each path would be different, even though multiple or many paths lead to the
same end value. For binomial valuation of regular options, all paths that lead to the same end
value may be combined.

Fig. 17.7 Binomial valuation of Asian call

3Hull, John C., Options, Futures, and Other Derivatives, 7th Ed, Pearson Education, 2009, p. 557.
508 Derivatives and Risk Management

Consider two in-between values of the tree. They can be achieved by three paths each. For
a regular call, the payoff would be the same for these middle nodes. However, for an Asian
option, there would be three different payoffs at each of the middle nodes because the average
in each path would be different. The average is calculated on the path taken for three prices
in three periods. The payoff is Max(Average — X, 0), which is multiplied by the respective
probabilities to get the expected payoff. This is discounted at the risk-free rate of 2% per
period to get the value of the Asian call option today.
All calculations are shown in Fig. 17.7.
We may check if an Asian option costs less than a regular call. The value of the regular
call may be computed by discounting the expected payoff at the risk-free rate. The payoff
at the four final nodes would be $33.10, $8.90, %0.00, and %0.00, respectively, with a strike
price of $100.00.
The value of the expected payoff at the end = 33.10 X 0.216 + 8.90 X 0.432
= 7.1496 + 3.8448 = %10.9944
Therefore, the value of the call at t = 0 = 10.9944/1.023 = %10.3602 ~ 210.36
(rounded off)
A call based on the average is cheaper than a regular call due to the reduced payoff and
reduced volatility.

LOOKBACK OPTIONS 9"

Lookback options are options that allow the holder to exercise them to (a) buy the asset at
the minimum price over a given past period, for a call, and (b) sell the asset at the maximum
of the prices for a given past period, for a put. The holder is allowed to look back at the price
data for a period and determine the exercise price. The distinctive feature of the lookback
option is that it would not remain unexercised, as there would always be some minimum and
maximum prices during the given preceding period that becomes the exercise price. Look-
backs are also called no-regret options, as one can ensure buying at the lowest price or selling
at the highest price, avoiding the potential to regret having missed an opportunity in the past.
Lookback options have a variable exercise price determined by the minimum and maxi-
mum values of the asset price, respectively, for calls and puts.
For a lookback call, the exercise price would be the minimum achieved during a period
during which the holder of the option can acquire the asset. The payoff from the lookback
call at its maturity is
ST = Sane
Similarly, for a lookback put, the exercise price would be the maximum achieved during
the period during which the asset can be sold. The payoff from a lookback put at its maturity is
Shae. ee
where S7 is the asset price at the expiry of option, and S,,,,. and Smin are the maximum and
minimum prices, respectively, achieved in the lookback window.
Lookback options are path dependent as the payoff is dependent upon the prices achieved
in the past rather than on the ending values alone.
 Exotic Options 509

Applications
Lookback options are very attractive for investors because of their potential to provide large
payoffs. Usually, investment in mutual fund is made by vesting equivalent units at the cur-
rent net asset value (NAV). The units are redeemed at the NAV prevailing at the time of exit.
The NAV changes as the prices of stocks change. The product may be modified and made
attractive for investors by incorporating a feature that enables subscribers to look back at the
NAVs during the investment horizon for the purpose of redemption. For example, a mutual
fund may offer a product where it undertakes to redeem units from subscribers at the maxi-
mum NAV achieved during a pre-specified period. It is kind of lookback put option where
subscribers hold a right to redeem their investments at a highest NAV.

Valuation
In most cases, the payoff from a lookback option would be positive and substantial. It can
at worst be zero. This would happen only when the minimum or maximum happens at the
expiry of the option period. The lookback option, therefore, would not expire worthless and
would necessarily be exercised. Hence, the cost of lookback options would be prohibitively
high as compared to their counterpart plain vanilla options.
The lookback option can be valued using the binomial approach with risk neutrality, in
the similar manner as that used for Asian options.
The payoff on the lookback call at maturity is Sp — S),j,. For a lookback call with maturity
at T, the value at its inception would be the discounted value of its expected payoff. Math-
ematically, this is expressed as
ALB y= Cas E(Sr— oa
mer ORS 6 = Snip)
For risk neutrality, the stock must grow at the risk-free rate. Therefore, E(S7) = e” - So.
The value of the call now is
LB) = S,— € EUS, ) aoa)
The payoff of the lookback put at maturity is S,,. — S7. For a lookback put with maturity
at T, the value at its inception would be the discounted value of its expected payoff. Math-
ematically, this is expressed as
p(LB) y ae. x E Seams i Sr)

= er ESirae) a ere E(Sr)

For risk neutrality the stock must grow at the risk-free rate. Therefore, E(S7) = e”. So. The
value of the put now is
DLBy= eo MES i.) 56 (17.28)
A simple illustration would demonstrate the applicability of the binomial approach.
Assuming that the current price of an asset is 7100, which can change by +10%. With a
risk-free return of 3% per period, the probability of an up move is (1.03 — 0.9)/(1.1 — 0.9)
= 0.65 or 65% and the probability of a down move is | — 0.65 = 0.35 or 35% under the
binomial approach. A two-stage binomial tree is depicted in Fig. 17.8.
510 Derivatives and Risk Management

Path Prob Min Max

121 abd 0.4225 100121

d

abe 0.2275 99 110

99
e ace OFZ275) 90 100

81 Ole 0.1225 8] 100

I ee

Fig. 17.8 Binomial tree for valuation of lookback options

The expected minimum price E(S,,,;,,) would be

E(Smin) = 100 X 0.4225 + 99 X 0.2275 + 90 X 0.2275 +'81 X 0.1225

Se UB ah TO
The present value of the expected minimum price is 95.1700/1.037 = 89.71. Hence, the
value of the lookback call is

c(LB) = Sy — €7'T E(Smin) = 100.00 — 87.71 = 210.29

The expected maximum price E(S,,,,..) would be
E(Simax) =121 X 0.4225 + 110 X 0.2275 + 100 X 0.2275 + 100 X 0.1225
= %111.1475
The present value of the expected minimum price is 111.1475/1.032 = 104.77. Hence the
value of a lookback put is

P(LB) =e il ES! *¥ So = 104.77 — 100.00 = %4.77

Lookback options are more expensive than vanilla options. The values of plain vanilla call
and put options with an exercise price of 100 are worked out as %8.36 and 22.62, respec-
tively, in the following table.

Table 17.9 Valuing regular call and put

Node Probability | Call option Put option

d 0.4225 21.00 | 8.8725 : :

e 0.4550 wa 1.00 f 0.4550
f 0.1225 = & 19.00 2.3275
Expected payoff at maturity, % | 2.7825
Value of the option today, % 262
 Exotic Options 511

EXAMPLE 17.4 Lookback options

An investor observes that a stock has been trading in a narrow range between %90 and 2100, buts likely to break out of the resis- L
tance at ¥100 soon. The investor regrets having missed a buying opportunity at 90. Assuming volatility at 30%, a dividend yield at
5%, and a risk-free rate at 10%, compare the values of a plain vanilla call and a lookback call with expiry of six months from now.
Solution
With S = 3100, Simin = $90, r= 10%, = 5%, T = 0.5 years, and 7 = 30%, the values of the intermediate parameters would be
a, = 0.7209 N(a;) = 0.7645 N(—a,) = 0.2355 L
a = 0.5088 N(a>) = 0.6946 N(—ap) = 0.3054
ay = 0.4851 N(as) = 0.6862 N(—as) = 0.3138
b, = 0.4375 N(b;) = 0.6691 N(—b,) = 0.3309 L
bo = 0.2254 N(bo) = 0.5892 N(—b,) = 0.4108
b;= 0.6733 N(b3) = 0.7496 N(—bs) = 0.2504 7
“Y1 = 0.0117 e”! = 1.0118 L
Y2 = 0.0106 e”? = 1.0107
The value of the lookback call using the formula given in the Exhibit 17.7 comes to %18.89. L
For the same parameters of S = $100, X = 90, r= 10%, g = 5%, T = 0.5 years, and c = 30%, the values of the inter-
mediate parameters for the plain vanilla option would be
d, = —0.2254, d, = —0.4375, N(d;) = 0.4108, N(d>) = 0.3309
(And the value of the call is 12.55 as per the Merton model.

EXHIBIT 17.7 Valuation of lookback options#

ofLB) ) = Se Ma,)
( 1) — Se 7 oy — g) Ma,)( 1) — S$minno" Na
( 2) a(r — Q) e! M-a
( 3)

ford
LB) = —S.e7
p(LB) e Nb.)
(bo) + Se ar —9g).M—(— bo)
by) + S,max en] me
(b;) = a(r— ghe’? .M—b
(— bs)

inlS| [r—g+S}r In (Smas)+ (— + or

ee
where So ee : b = : ~ ee
a\ t ov

a = ay — o\T bp = by — o\T
nee (--a+ 3)? oi Soul (r—q+ S)r
: min 2 by = S _ 2
3 oO"T O*y T

S$ o
info|xar-9+ Fr in [Sas]x ar — g - =)
yo ‘min oe S 2
1 a ae

S = Price of stock now r= Risk-free rate of return

Simin = Minimum stock price before initiating lookback option g = Continuous dividend on asset
Simax = Maximum stock price before initiating lookback option N (x) = Cumulative normal distribution function at x
T = Time for expiration of option In = Natural log
o = Annualized standard deviation

# Goldman, Sosin, and Gatto Formula

512 Derivatives and Risk Management

Analytical solutions for pricing of lookbacks are provided in the box for continuously
observed values of the underlying asset.

Bermudan option The Bermudan option allows exercise at several predetermined times
rather than at any time, as is the case with American option, or only at maturity, as is the
case with European option.

Basket option A basket option is an option whose payoff depends upon several assets
rather than a single asset. These are normally several stocks, indices, or foreign currencies.

SOLVED PROBLEMS mxseuzsnsmssumssnsmmn

SP 17.1: Forward start option
The CEO of a firm has promised the board a 50% increase in performance in three years, as measured by the firm’s stock price.
The board of directors of the firm has offered a stock option plan to the CEO whereby he can acquire shares in the firm at 110%
of the current price at the end of three years. However, they have placed the condition that the option would start only after one
year from today. Assume that the current stock price is 100, the risk-free rate is 8%, and volatility is 25%. What is the value of this
option to the CEO?
Solution
The value of the option at the commencement of the forward period depends upon the price of the stock at the end of one year, S;,
the exercise price of 7110, and the period of two years remaining thereafter. This is equal to the value of the option today with time
to maturity of (3 — 1) = 2 years. Using the BSM, the value of the call, c(100, 110, 2), is $16.95. Discounting the value at the com-
mencement of the exercise arrived at 16.95, the value of the call starting one year forward is 0.9231 x 16.95 = €15.64.
If the CEO were offered the stock options commencing now, the value of the call, c(100,110, 3), is $23.60.
SP 17.2: Valuing the barrier option
Refer to Fig. 17-4, showing a binomial tree used for valuing a down-and-out barrier call option with a strike of 85 and a barrier of
~90. Use the same tree for valuing an up-and-out call option with a strike of $100 and a barrier of $120.
Solution
The up and out option means that any time the price goes above the barrier of 120, the call option becomes worthless. The current
price is 100. For the three-stage binomial tree with a risk-free rate of 3% per period and an up and down movement of 10%, there
would be four end prices with eight possible routes.
The four end prices are $133.10, €108.90, %89.10, and %72.90. With a call strike of 100, there would be a positive payoff only
at the two upper prices. The value of a regular call would be

E End price (%) + Call payoff (2) |; Probability ae Expected payoff (%) |
Le 133.10 33.10 0.65 x 0.65 < 0.65 9.09
108.90 le 890 | 0.65 x 0.65 x 0.35 x 3 3.95
Total expected payoff at maturity | 13.04
Value of the regular call at t= 0 (13.04/1.03°) a 11.93

For valuation of the up and out barrier call, the node with end price of 133.10 becomes worthless, as the price is above the
barrier. There is only one price, ¥108.90, which is above the strike and below the barrier. The end price of 7108.90 can be achieved
by the following three paths, each with a probability of 0.65 x 0,65 x 0.35.

100 > > 110 > —-> 121 —+ — 108.90 The barrier is crossed
100 +~ > 90 77> 99 > > 108.90
100 ~ > 110 > => 99 > —> 108.90
 Exotic Options 513

Therefore, the value of the call would be the payoff times the probability = 8.90 x 0.65 x 0.65 x 0.35 x 2 = %2.63. The
discounted value of the call at the risk-free rate of 3% per period is 2.63/1.039 = %2.41.

Binary tree for barrier option pricing for SP 17.2

Value of underlying asset with 10% up and 10% down movement
Exercise price of call ¥ = 100, Barrier price = = 120. Up and out
Risk-free rate = 3% per period

Time 0 4m 8m 12m _ Call payoff

133.10 33.10

0.35
90.00 89.10 ~

Consider the data in Table 17.4 for valuing an Asian call with a strike of ¥100. Use the same data for valuing an Asian put option
with a strike of $100. Further, find the value of a regular put option with a strike of 100 and compare the values of the regular and
the Asian put options.
Solution
For an option with a risk-free rate of 2% and up and down movement of 10% each, the risk-neutral probabilities of the up and down
movements would be 60% and 40%, respectively. It would lead to four end values, but also eight paths that would have different
averages for the purpose of valuation of the average option. These are shown in the following table, together with the respective
probabilities. The average is calculated at three different points of time.
With a strike price of 100, the expected payoff and its value at the maturity of the put option are shown for each branch. The
value of the Asian put option works out to %3.14.
The value of the regular put option would be independent of the path the end values take. The value of the regular put is calculated
as follows:
End price (?) Put payoff (%) Probability Expected payoff (<) _

Total expected payoff at maturity

|Value of the regular call at t = 0 discounted at 2% per period
 514 Derivatives and Risk Management

u — up; d — down

The term exotic option is used to describe an option that differs option, like the American option, leaves the time of exercise to
from conventional and standard options. Options have many the discretion of the holder but retains the upside gain if at matu-
features that affect their value. Users of options may alter these rity the payoff is greater. A shout option enables locking-in of the
features to accommodate their specific needs. The terms of intrinsic value of the option at any time during its life.
the options are changed with respect to the type of option, the An exchange option is one where one asset is exchanged
exercise price, the frequency and time of exercise, the path for for another. Mergers and acquisitions are instances where the
determination of the payoff, the commencement date, etc. shares of the acquired firm are exchanged for the shares of the
Innovations in changing the terms and conditions of the option acquiring firm. A gap option, as the name implies, has a payoff
are primarily motivated by (a) the specific needs of the users that depicts a gap on exercise. The gap is governed by a figure
and (b) the reduced cost of these products. Some people may different from the strike price, though the strike price continues to
believe that since the terms of exotic options are not standard, decide the exercise. A pay-later option is one where the premium
they would cost more. On the contrary, most exotic options are is payable only at its expiry, when it is exercised. A compound
cheaper because while a standard option charges a premium for option is an option on another option. The exercise of the first
all possible situations, the exotic option rules out some of them. option gives another option to the holder.
That is one of the reasons for its popularity. Barrier options are unique in several ways. Besides the strike
Forward start options start at some time in the future. Start- price, they have another price called the barrier, which is used
ing later means reducing the life of the option, and, hence, the to determine whether the option is dead or alive. The payoff on
premium. They are used mainly in the employee stock option the option is not only dependent on the price at maturity but also
schemes aimed at motivating employees. Another simple option on the path it took in reaching that price. If the option becomes
is the binary or digital option, which is characterized by two dis- alive on reaching the barrier, it is called a knock-in option, and if
crete levels of payoff. It pays a fixed sum: or nothing (called a it becomes dead, it is called a knock-out option. If the price goes
cash or nothing option) or the underlying asset or nothing (called above the barrier and the option becomes alive only then, it is
an asset or nothing option). The payoff is easier to comprehend, called an up and in option, and if it becomes dead, it isan up and
and, hence, so is the valuation. Another interesting exotic option out option. Similarly, a down and in option becomes alive if the
is the chooser option, which permits the holder to have another price goes below the barrier, and a down and out option is dead
_ option at maturity—which can be either a call or a put. A shout if the price goes below the barrier. Valuation of these options is
 Exotic Options 515

_ complex because of an extra element, the barrier price. Under all them out-of-the-money. Second, the volatility of options based
_ circumstances, these options are cheaper than regular options on averages would be less than that of options based on single
_ because they have situations that do not keep them alive for part prices, because the average smoothens out variations. The
_ of the life of the options. valuation of average options is extremely difficult, because the
Another type of path-dependent options is the Asian option, arithmetical average does not follow any known probability dis-
whose payoff is based on the average price during the period tribution.
rather than on the price at expiry. It is a better way of hedging, as _ Lookback options also are path dependent, as they provide an
most business performances are compared against the average. opportunity to the holder to buy (lookback call) the asset at the
_ It makes Asian options extremely popular. Apart from represent- minimum price or sell (lookback put) the asset at the maximum
ing business needs better, Asian options are also cheaper than price observed in the past.
regular options for two reasons. First, for options on average, There are a large number of other exotics that are also avail-
the payoff is smaller than for regular options, as while calculat- able, They are OTC products, essentially leaving the terms and
ing the average, all prices during the period are included, while conditions to be decided upon by the two parties involved.
for regular options, calculations exclude the prices that make

Asian option An option whose payoff depends upon the aver- Exchange option An option where one asset is exchanged
age for the period of the option rather than the terminal value of for another.
the asset price. Forward start option An option on which the commencement
Asset or nothing binary option An option that pays either the date starts some time in the future, and not now.
asset or nothing at maturity. Gap option A gap option has a payoff that is governed by
Barrier option An option whose value depends not only on a figure different from the strike price, though the strike price
the spot and exercise prices but also on another price called continues to decide the exercise.
the barrier. Lookback option A lookback option provides an opportunity
Binary option or digital option Options that have only two to buy the asset at the minimum price or sell the asset at the
states of payoff. maximum price observed in the past.
Cash or nothing binary option An option that pays a fixed Pay-later option A option is one where the premium is pay-
amount of cash or nothing at the maturity. able only at its expiry, and only when it is exercised.
Chooser option A chooser option grants the holder the right Shout option A shout option provides flexibility to the holder
to choose between the call and the put at maturity. to book the minimum of the intrinsic values or the final value at
Compound option An option on another option where exer- the end of the option period.
cise of the first option gives another option to the holder. Up-and-in option An option that comes to life only when the
Down-and-in option An option that comes to life only when price of the underlying asset goes above a pre-specified level,
the price of the underlying asset goes below a pre-specified called the barrier price.
level, called the barrier price. Up-and-out option An option that becomes dead when the
Down-and-out option An option that becomes dead when the price of the underlying asset goes above a pre-specified level,
price of the underlying asset goes below a pre-specified level, called the barrier price.
called the barrier price.

17.1 What are exotic options and why are they popular? 17.6 A shout option allows the holder to lock in the minimum
17.2 What is a forward start option? What could its possible value that he/she thinks is the maximum. Elaborate on
usages be? the statement.
17.3 How does advancing the commencement of a forward 17.7. What difficulties are faced in valuing shout options?
start option affect its price? 17.8 Describe barrier options and distinguish between knock-
Describe how you would value such an option maturing in and knock-out options.
at T but starting at f? 17.9 When do you think you would use (a) up and out barrier
17.4 Describe the payoff on cash or nothing binary call and options, and (b) down and in barrier options? Illustrate
put options. How are they different from asset or nothing with suitable examples.
binary options? 17.10 What are Asian options? Why are they popular and what
17.5 What is a chooser option and how would you value it? are the difficulties faced in valuing them?
516 Derivatives and Risk Management

P 17.1 Forward start option Which of the two schemes, i.e., the fixed amount or the shares,
Executives in the top management of an IT firm have been would you choose?
offered a total of one lakh stock options with an exercise price P 17.4 Chooser option
20% higher than the current stock price of 120. The options The current price of a stock is 120. An investor is uncertain
would come into operation one year from now and would about the likely movement of the stock price but expects lot of
remain valid for another three years. The value of the stock volatility. He/she wants to choose in one month’s time from now
options has to be reflected in the financial statements of the whether to buy an ATM call or put with a maturity of three months
company as employee compensation. If the volatility of the thereafter. The volatility of the stock is 30%, while the risk-free
stock is 20% and the risk-free rate is 8%, what is the amount rate is 8% per annum. What price would you charge for allowing
that would be charged in the financial statement for the options the investor to choose a call or a put after one month?
so granted?
P 17.5 Valuing the Asian option
P 17.2 Binary option The spot value of a stock is ¥200. It can either go up by 20%
A firm has announced that every middle-level manager would get or fall by 20% over a period of four months. Using the 3-stage
a bonus of one month’s salary ifthe performance of the company binomial model with a risk-free rate of 2.50% per period, what
exceeds the expectations of its stockholders. The current stock would the value of a 12-m call option that pays off the excess of
price is ¥1000, and for entitlement to the bonus, the stock price the average over the strike of ¥200 be? Include the initial price
at the end of the year must be €1200 or more. The volatility of in computing the average. Further, value a standard call with a
the stock is placed at 20% and the risk-free rate is 8%. Find out strike of %200.
the value of the option for an executive whose monthly salary
P 17.6 Valuing the barrier option
is 10,000.
Refer to the data in P 17-5. Find out the value of a 12-m down-
P 17.3 Asset or nothing binary option and-In put option with a strike of $55 and a barrier of €45. Fur-
What would the value of the option in P 17.2 be if the firm ther, calculate the value of a 12-m standard put option with a
decided to give five shares instead of a fixed amount of bonus? strike of £55.
INTRODUCTION ~~ Learning Objectives
In this chfapter, we shall discuss some derivatives on interest After going through this chapter,
rates—options on interest rates and options on bonds whose readers shouldbe familiar with
value is primarily dependent upon their interest rates. These + the description of interest rate
derivatives are more complex to value than other options as the options such as cap, floor, and
behaviour of their interest rates is more difficult tounderstand. collar
The main products that are dependent on interest rates are bonds hedging interest rate risk with cap,
floor, and collar
and swaps. Besides options with interest rates as direct underly-
e an introduction to Black's model for
ing assets, we can have options on products such as bonds and valuing options on interest rates
swaps whose values are primarily dependent on interest rates, managing interest rate risk through
and, hence, can serve the purpose of hedging against interest interest rate options
rate fluctuations. options on bonds and the way to
value these options
As usual, we need to highlight that forward contracts on inter-
° valuing options on bonds using
est rates, i.e.,the forward rate agreements (FRAs) discussed ear- Black’s model
lier are obligatory in nature. We also discussed interest rate futures
in earlier chapter. Commitments under FRAs as well as interest
rate futures are binding, irrespective of the outcome at maturity.
Options on interest rates would provide a right without creating
an obligation, just as options on any other assets do. In this chap-
ter, we discuss interest rate options and options on bonds.

___ INTEREST RATE OPTIONS _

We examined the management of interest rate risk through inter-
est rate swaps and interest rate futures. A swap is an Instrument
to transform a fixed rate liability/asset
Interest rate options work «into a floating rate liability/asset, and
inthesame manneras —_—rvice versa. A borrower who has issued
options on other assets. 4 floating rate bond can convert the
They cover Ihe #SKS 0! interest rate liability to a fixed rate lia-
changing interest rates.
bility by entering into a swap when the
 518 Derivatives and Risk Management

interst rates start rising. Futures could be used to lock in the prevailing interest rate implied
in treasury bills (T-bills) or treasury bonds. Under the FRA, one could lock-in interest rates
for borrowings and deposits in advance, and thus, manage the interest rate risk. All these
hedging instruments implied a cost in terms of sacrifice of potential gain from favourable
changes in the interest rates.
In this section, we discuss another tool for managing interest rate risk, 1.e., options. We
can have options based on interest rates like we have options based on any other financial
instrument as the underlying asset. Options that have interest rates as the underlying asset are
referred to as interest rate options. They are called caps, floors, and collars. Unlike swaps
and FRAs, options on interest rates are not firm commitments but are onlyrights for which a
price has to be paid upfront. Options on interest rates are over-the-counter (OTC) products.
Further, many bonds have these options embedded in the product itself.

sa...
Consider, for example, a borrowing firm that has issued bonds with semi-annual coupons
determined on the basis of Mumbai Interbank Offer Rate (MIBOR). Assume
A cap is a series of call
ose
options exercised at that the : firm pays interest to subscribers to the bond at each 6-m interval on
; hs Ses :
those times that provide the basis of the MIBOR that prevailed at the beginning of the period (cou-
a payoff equal to the pons on floating rates are decided one period in advance). If MIBOR goes
difference between the up, the liability of the firm too goes up. Can anything be done to contain the
actual rate and the cap
rising cost of debt?
rate when the actual rate
exceeds the strike. To manage interest rate risk, one usual way is to issue a callable bond. The
~ flexibility of making the bond callable is available only once,i.e.,at the time
of issue, and depends upon the interest rate scenario forecast made then. Further, it is usually
once in a lifetime, before maturity, that the bond may be called. As the tenure of the bond
increases, forecasting the future interest rate scenario becomes increasingly complex and dif-
ficult. One may issue a bond of 10 years with a right to call back at 2110 between three and
five years, at ¥105 between six and eight years, and at 102 anytime thereafter. Subscribers
to
such a bond can be considered to be holders of the bond with a call written. having conferred
a right to the issuer to call back the bond. The issuer is short on the bond but long on the call.
Managing interest rate risk by issuing a callable bond does not offer flexibility and
is based
on perceptions at the time of the issue of the bond. Swaps, FRAs, and interest rate
futures
provide flexibility but forego profitable opportunities.
A cap is a call option on interest rates that gives a right without obligation
to the holder
to exercise the call and provides for flexibility as well as profitable opportunities.
With a cap
on interest rates, when the interest rate exceeds the strike interest rate,
the holder exercises:
otherwise, he/she lets the call expire. The cash flow under a call option
is based on a notional
principal, just as is the case with FRAs and swaps.

Hedging with Cap

Managing interest rate risk with a call provision is indeed difficul
t due to our limited ability
to forecast interest rate scenarios for the distant future. Further, one
needs to offer higher
yields for callable bonds than for plain bonds. Therefore, callable
bonds would trade at a
 Interest Rate Options 519

lower price than comparable non-callable bonds. This implies a higher cost of borrowing for
the firm issuing the callable bonds. As stated in the section titled ‘Cap’, fixing of the call
price can only be done once, and, therefore, interest rate risk management does not remain
flexible.
Alternatively, the borrowing firm can enter into another independent contract where the
counterparty, normally a bank, undertake to compensate if the interest rate goes beyond a
pre-specified level, called the strike. Rather than buying a call option from the subscriber to
the callable bond, the interest rate option can be bought from another party at any time the
issuing firm chooses.
Let us consider a firm that had issued a floating rate bond that has five years remaining
for maturity, with semi-annual interest payments. Assume that the next 10
To contain the cost of bor-
rowing, a firm buys acap _ values of MIBOR will be as given in column 2 ofTable 18.1. The firm would
as a hedge against rising _ Pay interest as per MIBOR. To limit its outflow, the firm may buy a cap from
interest rates. : a bank with a strike of 7.60%. Under this cap, the firm would have a payoff
~ of Max (M — 7.60%, 0) * '4 xX notional principal. In case the MIBOR
exceeds 7.60%, the firm would get the excess over 7.60% from the bank, and,hence, limit the
interest outgo to 7.60%.

Table 18.1 Interest with and without cap

Time MIBOR | Floating, rate Interest with cap

| _(months) | % a interest % %
0 7.00 :
ee 7.25 7.00
it2 8.00 7.25
18 7.50 8.00
24 8.50 7.50
30 7.60 8.50
36 7.80 7.60

7.80 SS
8.20
8.50
7.80

Payoff on Cap A cap is a series of European call options, called caplets, on interest rate.
The buyer of a cap receives the payoff from the cap writer at each exercise date for a speci-
fied number of periods on a notional sum. It is an OTC product that is bought by a floating
rate payer to protect against rising interest rates.
Based on the data in Table 18.1, the cost of borrowing to the firm is depicted in Fig. 18.1,
where the firm limits the maximum outflow to 7.60%, the strike rate of the cap. The payoff
from the cap at each exercise date, called a caplet, is like the payoff from a call option with
the interest rate as underlying, as depicted in Fig. 18.2.
520 Derivatives and Risk Management

9.00

8.50

_ 8.00
xs
3 7.50
g
= 7.00
—e— Interest (MIBOR)
6.50 --#-—- Interest with CAP

6.00
6 12 18 24 30 36 42 48 54 60
Time (Months)
_ SEO EE Re LL aR

Fig. 18.1 Interest under Cap

Fig. 18.2 Payoff of caplet at maturity

The payoff on the cap on each exercise date would depend upon (a) the reference rate,
M,(b) the cap rate, X,(c) the notional loan amount, L,and (d) the number of times per year
interest, m, is paid. The payoff on each exercise date is given by Eq. 18.1.
L
- x Max (M — X, 0) (18.1)
mM
Like the FRA and the swap, the cap is an independent product, and it is immaterial
whether an actual floating rate interest payment liability exists or not.
How Cap Works Let us assume that a firm has three years remaining on
A cap is a series of call
options, called caplets, a floating rate borrowing based on MIBOR. Today (t = 0), it has observed
which pays the excess a rate of MIBOR, Mp. It perceives a rising trend in MIBOR and, therefore,
of the interest cost deter- would like to contain the cost of borrowing to X. Let the amount of bor-
mined now, but paid one rowing be L; it pays coupons semi-annually. The MIBOR observed today
period later.
determines the next coupon payment due six months later.
 Interest Rate Options 521

To hedge against the rising interest rate, the firm can buy a cap with a cap rate of X. The
first payoff on the cap would be decided after six months, when the coupon obligation would
be known, but actual payment would be made at the end of 12 months. Thus, the cap would
consist of a maximum of five payoffs, and the obligations of the cap writer would be deter-
mined at the end of 30 months,while the cash flow obligations would terminate at the end of
36 months from now. This is depicted in Fig. 18.3. Cash flows are crystallized one period in
advance and paid on the due date.

Instant, n 0 1 2 3 4 5 6 |
Time in months 0 6 2 18 24 30 36
Observed MIBOR M, M, f M, M, M,
Interest flow iH ip p iS I. I,
Cash flow from cap ca CF CF. Ce CF CF,

M_ is the observed 6-m MIBOR at time instant n

Cash flow from Cap, CF, (at t= + 1) = L/2 x Max (M.— X, 0); X is the cap rate
alan annie ss
. oe

Fig,18.3 Deena nation of FU atone and cash fw Chet cap

Valuation of Cap
In order to value a cap, we need to value each caplet separately as a call option and aggregate
them to determine the premium that would be paid by the buyer of the cap. In interest rate
options, the underlying asset is the interest rate at maturity. Interest rate derivatives are more
complex than derivatives on stocks, indices, commodities, or foreign exchange because of the
more complex behaviour of interest rates. Further, in the valuation model,we need to discount
the cash flows, and for an interest rate derivative, the underlying asset is the interest rate itself.
The commonly used model for valuing interest rate options has been the binomial model.
However, it is fairly complex. We turn our attention to the analytical model called Black’s
model. The Black-Scholes model (BSM), applicable for non-dividend paying stock, was
extended to fit valuations of other options, such as those on indices and foreign currencies.
It has also been extended for use in valuing interest rate options.
Under the assumption of deterministic interest rates, we can adopt a variation of the BSM
to value interest rate options. In interest rate options, the underlying asset is the value of the
interest rate at the expiration of the option period. The estimate of the interest rate today at
the expiration of the option period would be the forward rate, 1.e., the interest rate expected
today to be applicable after.30 days if the option expiry is 30 days. Therefore, the underlying
asset in an interest rate option becomes the forward interest rate. This rate can be derived by
using the current term structure.
For using a valuation approach based on the BSM, we need the continuous compounding
rate. This can be obtained from the term structure of the interest rates. If the 30-day MIBOR
is 5% and the 120-day MIBOR is 5.2%!, then the continuous compounding 30-day forward
rate for 90-day investments is 5.28%.

IMIBOR follows the 30/360 convention.

522 Derivatives and Risk Management

1 + 0,052 129 :
In| —___360 | x 365 — 9.9528 = 5.28%
1 + 0.050 32 a
360
Each caplet may be valued using Black’s model, given as Eq. 18.2, also known as the
standard market model.
Value of caplet = a
m
c= ert mir Naa — Na) (18.2)
Where L = notional amount of cap,
m = Nos of payments every year,
(2 for semi-annual and 4 for quarterly)
where
(he In(Fo/X ) at oil ae
o\T

ee eke ey)
ees Ruger #3
omen
Here, Fo is the forward interest rate, o is the volatility of the forward rate, X is the cap
rate, J is the expiry of the caplet, and m is the number of annual payments
A cap can be valued as _ (m = 2 in our case). Notice that the value of c is the same as in Black’s
the sum of some caplets, model for finding the value of options on futures, except for the discount-
each of which in turn may
be valued using Black’s
ing period. While for options on futures, discounting is done up to the
model. maturity of the option (refer to Chapter 19), and in the case of options on
interest rates, the time span for discounting is extended by one period
(T + 1/m) due to the delayed payment under each caplet.’
To find the values of the input for Black’s model, we need the term structure for the inter-
est rates, which provides (a) the implied forward rates F for all caplets at time ¢ = 0, and
(b) the price ofzeros (the rate of discount) for all periods. For illustration, consider the data in
Table 18.2, which gives the term structure for three years at half-yearly intervals, the discount
rates applicable, and the forward interest rates implied in the term structure.
To keep the exercise computationally simple, we have used discrete compounding rather
than continuous compounding to find the forward rates from the zeros.

Table 18.2 Term structure for finding zeros and forward rate

Time 1 oo 8 4 5 6
Time in months 6 12 asta a diele 24 30 36
Term structure (%) 3.0000 3.4000 | 4.0000 4.7000 5.4000 6.2000
Price of zeros 0.98522 0.96685 |0.94232 0.91127 | 0.87528 0.83262
Forward rate for
next 6 months (%)
3.000 3,8008 5.2053 6.8144 8.2240 10.2470

°The discount rate to be used here could be split into two periods: the risk-free rate for the period
over which the option is
valid, and the forward rate for the period from maturity of the option to payment under the caplet.
 Interest Rate Options 523

Let us value a caplet with a cap of 4.8% for a coupon payment determined 12 months
from now, and paid six months thereafter. To value this caplet, the inputs to the Black’s model
would be as follows:
¢ The forward rate F is the likely value of the 6-m MIBOR at the end of one year. This is
the investment rate beginning 12 months from now for an investment ending 18 months
from now.
e The volatility of the forward rate is assumed to be 20%.
e The time of maturity of the option, 7, is 12 months.
e The discount rate required is for 18 months, as the cash flow would take place then.
This would be the same as the price of a zero maturing 18 months from now.
e The cap rate, _X, is 4.80%.
The forward interest rate implied by the term structure is found by equating the direct
investment for period n with the rollover of investment by first investing for n—1 periods and
again investing the matured amount for an additional period. We can find the 6-m forward
rate at the end of one year by equating the (a) 18-m direct investment, and (b) the 12-m
investment, and rolling over the matured amount at the forward rate for the next six months.
Mathematically, for the given term structure, we may find the 6-m forward rate at the end of
one year as follows: :
[1re [1acai +o)
2 2 2
This see the 6-m forward rate at the end of one year as 5.2053%. Similarly, all other
- ‘ _ forward rates may be found. The forward rates are calculated in the last row
Among the basic inputs | f Table 18.2.
for Black’s model for Sed '
valuingacapwouldbe © —\=—he term structure at half yearly intervals directly gives the value of the
the term structure, to | Zeros as
forecast the forward rate, _
and the price of zeros. : Price of zero maturing att=7, P= Be tidor
ae (18.3)

D+) 2
where 7 is time in years and r is annual yield.
For the caplet, the cash flow is due 18 months from now but its value is determined 12
months from now. The price of a zero maturing after 18 months is =1/1.027= 0.94232.
Using Eq. 18.2, the value of the caplet may be found as %0.0001213, which is equivalent
to $12.13 per lakh of the notional amount. Using, F' = 5.2053%, as found in Table 18.2, and
X = 4.80, as shown here:
c = 0.9423 [25.2053NM(d,) — 4.8000.M(d>)]
= 0.9423 [25.2053 X 0.0551.48000 x 0.0426] = %0.0001213
For convenience, the value is expressed as $12.13 per lakh. On a semi-annual basis, the
price of the caplet would be %6.065 per lakh of the notional amount.
Likewise, each caplet can be valued. The values of all the caplets are found in Table 18.3.
Five caplets constitute the value of the cap. For a notional principal of ¢1 crore, the value
of the cap is %5,02,105.
The model described here for valuing interest rate options is generally adopted by traders,
despite its limitations. The assumption of constant volatility for interest rates is likely to be
024 Derivatives and Risk Management

Table 18.3 Input for Black’s model finding cap value

Time 1 2 3 4 5 6
Forward rate, Fo(%) 3.8008 5.2053 6.8144 8.2240 | _10.2470 -
re a
Cap rate, X(%) es 4.80 4.80 4.80 4.80 -
Time to expiration, T 6 40 18 DA 30 36
(months)
Variance of forward rate, o 0.04 0.04 0.04 0.04 i 0.04 0.04
d, —1,5797 0.5053 1.5531 2.0451 2.5563
L& —1.7212 0.3053 1.3081 1.7623 2.2401 j
N(d,) 0.0571 0.6933 0.9398 0.9796 0.9947
N(d;) 0.0426 0.6199 0.9046 0.961 0.9875 of
Fx N(d,) 0.00217 0.03609 0.06404 0.08056 010193 |
Xx N(a,) 0.00204 0.02976 0.04342 0.04613 0.04740 |
ee Tacos (29t0 tof
n+
0.96685 0.94232 0.91127 0.87528 | 0.83262 |
yal Neues peo
notional
12.13 596.80 1,879.17 |
3,013.99 4,540.02 |7
Notional principal igs |
amount(<lakh)

Caplet value (%) 606 29,840 93,958 | 1,50,699 | 227,001 |

Cap price %5,02,105
GL TELEEEEA LEE

more untrue than for stocks. Since the values of bonds today and at maturity are known with
certainty, there is no volatility now and at maturity. In between now and maturity,volatility
increases first and then declines. Here, we have assumed a constant figure for o for valuing
each ofthe caplets.

A floor is a series of put options on interest rates, just as a cap is a series of call options. As a cap
A floor is used by invest- _ protects against rising interest rates, a floor protects against falling interest
ing companies to protect rates. It is used by investing firms deriving income from floating rate
against the income going — instruments. As long as the interest rates are increasing,they are beneficial
below a certain minimum _ for the investing firms. However, the firms may need protection when the
level.
interest rates are falling.
Payoff of Floor As stated in the preceding paragraph, a floor is a series of put options on
interest rates. Each option exercisable on its maturity, based on an interest. rate, is called
a floorlet. The payoff on a floorlet would be Max (X — M, 0), where_X is the floor rate
and M is the floating rate on the maturity of the floorlet. When the interest falls below UG
the investing firm receives M from its investment and X¥ — M from the floorlet, ensuring a
minimum aggregate return of X. On each exercise date, the payoff would be determined,
and a guaranteed return, as fixed by the floor value, can be achieved for the desired tenure.
 Interest Rate Options 525

The payoff on a floorlet is depicted in Fig. 18.4, which is similar to a put holder with an
interest rate as underlying. Like the cap, the floor is also independent of the investment
contract. Since the investment and the position in floors can be with different parties, it
is not necessary that the underlying investment asset must exist to have a position on a
floor option.

Pay off

Interest rate

a
EEE TET LEO LCL

Fig. 18.4 Payoff of floorlet at maturity

Valuation of Floor
The valuation of a floor is the same as that of a cap. To find the value of a floor, each of the floorlets
Like the cap, the floor, Must be valued using Black’s model for put pricing. The value of each
00, isaseriesofput _—‘floorlet would be L/m x p, where p is as per Eq. 18.4.
different times, when the /
actual rate falls below the | where
strike. : Hate In(Fo/X) + @TI2 ne

she In(Fo/X) ee Ty)

ss Cale d, — offSs
O\T

Relationship between Cap and Floor A relationship exists between the values of cap and
_ floor. Each caplet is like a call option and each floorlet is like a put option.
The value of the cap
and ic lie ofthe Buying a cap and selling a floor with the same strike is like entering into“a
floor would represent the SWAP with a fixed rate equal to the strike rate. For example, consider buying
value of the swap. _acap and selling a floor, both at a strike of 10%. It always results in a cash
~~ inflow of J, the floating rate, and a cash outflow of 10%, the strike. This is
identical with the cash flows of a swap to receive a floating rate and pay a fixed rate, as shown
here:
Cash flow Interest in % fhe
Sold floor Bought cap Total
When M < 10 —(10—71) — M— 10
When M > 10 = (M—10) M-— 10
Therefore, we may say
Value of cap—value of floor = value of swap
526 Derivatives and Risk Management

EXAMPLE 18.1 Value of floorlet

What would the price of an option that has to commence after 12 months be for an investing company that wants to protect the
interest rate of 9% on its investments? The interest rate expected after 12 months is 8%. The interest rates have shown a volatility
of 20%. The seller of the option would pay his/her liability after three months when it arises. The risk-free rate for all maturities
up to two years Is a flat 7%. Find the value per lakh of the investment amount.
Solution L
The investing company needs to buy a put option on the interest rate with a strike of 9%. The value of the put on the interest rate |
is given by Eq.18.4, with Fo =8%, X= 9%, T= 12 months, o = 20%, r= 7%, and m = 4 (for three months’ deferred payment).
In(Fo/X) + o°7/2)T — In(0.08/009) + 0.2 x 0.2 x 1/2 |
d; = —0.4889 and
or If 0.20 x \1

dp = alte see d, — 0, T= —0,4889 — 0.20 x 1 = 0.6889

O° I

N(—d;) = 0.6875 and N(—d>) = 0.7546

p =e T+ 9) (X.N(= ab) — Fo.M(—d))]

=e 007 x 125 1.09 x 0.7546 — 0.08 x 0.6875] x 1,00,000/.

A collar is a combination of a cap and a floor. A borrowing firm desirous of containing the
_ cost of borrowing may choose to buy a cap. The buying of a cap provides
A collar is a combination
of one option bought and protection from rising interest costs while retaining the benefit of falling
another soldto containthe ‘Interest rates. The holder lets the caplet expire unexercised if the floating
cost of hedging. _ rate is less than the cap rate. Like any other option, buying a cap would
PLLA iolve payment of a premium upfront.
Similarly, a firm, having invested in floating rate instruments, seeks protection
by buying
a floor where the downside risk is covered while retaining the potential gain from
any upside
movement of the interest rates. This, too, costs money upfront.
Like any option, the payoffs on caps and floors for the seller (writer) would
be opposite
to those for the holder. The writer of a cap or a floor earns the premium paid
by the holder.
As a strategy of cost cutting, just as we use range forwards for foreign
exchange risks, a
borrowing firm may buy a cap and simultaneously sell a floor to earn
some premium. This
offsets the cost of the cap either completely or partially. The cap rate and
the floor rate may
be adjusted in such a way that the premium on the cap equals the
premium on the floor for
achieving zero cost. Buying a cap and writing a floor or buying a
floor and writing a cap is
called a collar. The premiums on the cap and the floor depend
upon the strike rate chosen.
Choosing the appropriate strikes for the cap and the floor may
result in a collar with zero
cost. Such a collar is referred to as a zero-cost collar.
To attain zero cost, a borrowing firm buys a cap and sells a floor.
In such a collar, the
borrowing firm would give up some ofthe gains that could
accrue on any downside move-
ment ofthe interest rate. Hedging with a cap, a floor, and a
collar is depicted in Figs 18.5
and 18.6.
 Interest Rate Options 527

Liability Asset
cost income
Interest cost without cap

LESBOS
“ Floored asset
Capeed loan

Income without floor

Floating rate Floating rate

Fig. 18.5 Hedging (a) With cap (b) With floor

Interest income/cost R
Interest income/cost os
without collar fo
Pa

~ Cap rate, X,

interest income/cast
with collar

Floating rate
EEE
EEE EEE EE EEE EE EEE

Fig. 18.6 Interest rate collar

EXAMPLE 18.2 Valuing interest rate collar

An investing firm would have %1 crore to invest after six months. It is expected that the interest rate would be 10% after six months.
The firm wants to lock-in a minimum return of 9%.

(a) What can it do to safeguard against loss of income due to a fall in the interest rate?
(bo) If the firm is willing to sacrifice gains beyond 11.5%, can it reduce the cost of hedging?
Solution
(a) The investing company needs to buy a put option on the interest rate with a strike of 9% to lock-in a minimum return. The
value of the put on the interest rate is given by Eq.18.4, with Fp = 10%, X = 9%, T= 6 months, a = 20%, r= 10%, and m
= 4 (for three months’ deferred payment).
g, — MMFolX) + oFM2 _ In(0.10/0.09) + 0.2 xa 0.2 x 0.5/2 = 0.8157 and
o\T 0.20 x \0.5
hy In(FyiX) = of1 =, — 0\T=0.8157 — 0.20 x \0.5 = 0.6743
O° ip

N(—d,) = 0.2073 and N(— db) = 0.2501

Dosa as NG) — FM 0i)]
528 Derivatives and Risk Management

= e910 x 0.75 19.09 x 0.2501 — 0.010 x 0.2073] x 1,00,000/4

= $41.26 per lakh
Hedging against a fall in the interest rates would cost the firm %41.26 per lakh of investment. For 1 crore, the cost of the
floorlet would be %4126.
(b) To reduce the cost, the firm may sell a caplet. The value of the caplet on the interest rate is given by Eq. 15.11, with Fo =
10%, X = 11.50%, t= 6 months, 0 = 20%, r= 10%, and m= 4.
In(Fo/X) + o77/2 _ |n(0.10/0.115) + 0.2 « 0.2 x 0.5/2 _
= — 0.7621 and
oyT 0.20 x 0.5
g, —= OTe =y _ 5 JF = —0.7621 —0.20x(05 = 0.9036
O71 af

N(d;) = 0.2230 and N(d,) = 0.1831

Cc =en ttt tm) TE Na,) — X.N(ob)]
= 910X075 19.10 x 0.2230 — 0.115 x 0.1831] x 1,00,000/4
= %39.46
The premium that can be earned by the firm by writing a caplet for a principal of €1 crore would be ¥3946. L
The cost of the collar with floor at 9% and cap at 11.5% would be €41.26 — 39.46 = 71.80 per lakh of investment, or $180 only.

The value of a collar would be equal to the difference between the premiums on the cap and
the floor. The values of the cap and the floor may be found using Black’s model.

OPTIONSON BONDS
Callable bonds and puttable bonds have options embedded in them. A callable bond is one
that gives the issuer the right to buy back the bond at a pre-designated price. Thus, the holder
of the bond is a combination of a long position on the bond and a short position on a call
option on the bond. Similarly, puttable bonds give a right to the holder of the bond to seek
early redemption of the bond from the issuer at a designated price. Therefore, the holder of a
puttable bond is equivalent to a long position on the bond and a long put thereon. As stated
earlier, these embedded features are one-time tools for managing interest rate risk.
A portfolio of bonds can be hedged by buying a put with a strike price equal to the level of
protection desired. If a fund owns a portfolio of bonds valued at 7120 crore
p pe tere Bones ca and needs to protect the value at the level of 100 crore, the fund needs to buy
be hedged by buyin ; é
4 sone an: i _ a put option with a strike of €100 crore. The put on the bonds would entitle
bonds. _ the fund to sell the portfolio at $100 crore in case the value of this portfolio
falls below %100 crore. Note that there exists an inverse relationship between
the interest rate and the bond price. A protective put would be required not for falling interest
rates but for interest rates that are likely to rise, resulting in a fall in the value of the bond.

Valuation of Options on Bonds

European options on bonds can be valued using Black’s model in the same way as for pricing
caps and floors. Forward interest rates were used as the underlying assets in valuing caps and
 Interest Rate Options 529

floors. For valuing options on bonds, we replace the forward interest rates with the forward
prices of the bond, Fg. As usual, 7 is the time to maturity of the option and o is the volatility
of the bond prices.* The value of a call and a put option on the bonds can be computed with
Eqs 18.5 and 18.6, respectively.
=e" F,N(d,) — X Na) (18.5)
p =e" [X N(—d)) — Fz N(—d,)] (18.6)
rie In(Fp/X) + @TI2
2
ene
O\T
ie In(FiplX) — O°T/2 _ i Hor
ovT
The forward price of the bond, Fz,can be computed by using the cost of carry model for
_ finding the futures price. For non-dividend paying stock, the futures or for-
The forward price of a : Seger:
bond is the current price _ ward price is given by the spot value plus the cost of carry for the forward
P
less the present value -~—«—period. For a dividend paying stock, the present value (PV) of the dividend
of the coupons payable during the forward period needs to be subtracted from the spot value before
inthe forward period, == adding the cost of carry. Bonds are akin to dividend paying stocks in terms
campoueed rouge 7 of forward pricing. Bonds carry periodic coupons that are equivalent to div-
forward period. -
_ idend. Therefore, the forward price of the bond, Fx, 1s

Fg = current price — PV of coupons in the option period)(1+ the cost of carry)

= (Bo- Io) Kaen

where / is the present value of the coupons till the expiry of the option and r is the risk-free
rate for the period of option maturity. The volatility of the forward price is assumed to be
constant over the option period.
As an example, consider a call option for three years at a strike of €120 on a bond with a
face value of €100, with semi-annual coupons at 12%. The current price of the bond is €145.
The volatility of the price can be taken as 10%. The term structure as reflected in the price
of zeros up to 36 months, is as given below:

[Time (months) | 6 f ae ; | 2a
| Yields (%) 5.00 520 |
To find the value of the call option on the bond, we first need to find the forward price
of the bond at the expiry of the option period, i.e., 36 months. This would be equal to the
current market price less the present value of the coupons with the cost of
Options onbondscan — carry for 36 months. With the given term structure, the present values of
be valued using Black's =the six coupons that would be paid before the option’s expiry are calculated
oo oe _ _ in Table 18.5 with the amount of coupons discounted at the corresponding
. yields given by the zeros, as shown in Table 18.4:

4Volatilities quoted are yield volatilities and not price volatilities. A quoted volatility can be converted to a price volatility
using the concept of duration and formula: Price volatility = D X yo X yield volatility, where D is the modified duration
and yo is the initial forward yield.
530 Derivatives and Risk Management

Table 18.4 Finding forward price

(months)

Coupon 2 | 6 5.20 5.70

Coupon 3 . 6
Coupon 4 6
Coupon 5 | 6

Coupon 6 6
PV of coupons in the option period
Naueotthebond =
Forward price of the bond at cost of carry of 6.50%

The present value of the coupons is 32.52 and the forward price of the bond works out
to €136.70 as follows:
The forward price of the bond, Fp = (145.00 — 32.52) X ¢9.0650 x 3 = %1 36.70.
The values of the determinants of a three-year call on bonds under Black’s model are
jcc IFeKes th0) BOS? AG Pe=Siyears:
PESO and O10 %
Inserting these values, we get
d= 0.8390 Nd) = 0.7993
d> = 0.6658 N(d>) = 0.7472

EXAMPLE 18.3 Valuing put option on bonds

A 10-year bond is trading at 7120, and pays coupons of 10% with face value 100 on a semi-annual
basis. The next coupon F
payment is due exactly after six months. The interest rate up to one year is a flat 8%.
What is the value of a put option on the
bond with a strike of 100 and maturity of one year? The volatility of bond prices
is 10%.
Solution
The present value of the coupon payments would be

5 x e008 X05 + § x 9-008 X 1 = 4.80 + 4.62 = 79.42

The forward price of the bond, Fg = (120.00 — 9.42) x 6908 x 1 = 2449.79
In Black’s model, Fg = 119.79, X= 100, T=1, anda = 0.10
, — I0(FolX) +| 0°12 _In(119.79/100) + 0.1 x 0.1 x 1/2
a\yT
2 = 1.8557 and
0.1 v1

dp = HFN) oT gee. TH er 80 aT SUTSET

O* il

N(—<d,) = 0.0317 and N(—ch) = 0.0396

Put value = e-"{X x N(d;) — Fp x N(—dh)}
= 0.9048 (3.9600 — 3.7974)
= 0.15
 Interest Rate Options 531

Call value =e -"{F, X N(d,) — X X Na>)}

aoe UES 3£136.70 X 0.7993 — 120.00 x 0.7472}
= 0.8228 (109.2660 — 89.6640)
= 16.13
For a put on the same bond with the same strike, the values are
N(—d,) = 0.2007 and N(—d>) = 0.2525
Put value =e "{ X X N(—d>) — F3X M—d,)}
me 1 20100 X10:2525 = 136.70 «0.20073
= 0.8228 (30.3360 — 27.4361)
= §2.39

SOLVED PROBLEM
SP 18.1: Value of caplet
Find the value of the caplet for the data in Example 18.1.
Solution
The value of the caplet on the interest rate is given by Eq.18.1, with Fy = 8%, X = 9%, T = 12 months, o = 20%, r= 7%, and
m= 4 (for three months’ deferred payment).
ee In(Fo/X) + M2 _ In(0.08/0.09) + 0.2 x 0.2 x 1/2 _ 0.4889 and
oT 0.20 x 1
g, = M(FoX)
—o°Tl2 _ 4 _ 5 /T = —0.4889 — 0.20 x 1 = —0.6889
(OMY ip

N(—d,) = 0.3125 and Nd) = 0.2454

c= e@-AT+ Im) [F Nd) — X.N(db)]
= @ 007 x 1-25 (0.08 x 0.3125 — 0.09 x 0.2454] x 1,00,000/4
= %64.29
SP 18.2: Valuing put option on bonds
Refer to Example 18.3. What would the price of the put be if the exercise price is changed to ¥120?
Solution
The present value of the coupon payments and the forward price of the bond would stay the same, and would’be
5X 970.08 X05 4 5 x 90081-4890 + 4.62 = 79.42

The forward price of the bond, Fg = (120.00 — 9.42) « 69% * 1 = %419.79

In Black’s model, Fg = 119.79, X= 120, T= 1, and 0 = 0.10
a, <IN(FolX) + 2
272 In(119.79/120) + 0.1 X04 X V2 _ 4.9595 ang
ovT 0.1 yi

ae “ a
gy SFX) ote Sy = 5.2 0.0325 — 0.1/1 = —0.0675
oyT

N—d,) = 0.4870 and N— dh) = 0.5269

Put value =e {X x M—d)) — Fg X N—d;)}
=e 98 XI 1490.00 x 0.5269 — 119.79 x 0.4870}
= 0.9048 (63.2280 — 58.3377)
= %4.42
 532 Derivatives and Risk Management
fw)

SUMMARY
Interest rate risk is of primary concern to banks and financial money, the strategy to reduce the cost of buying options is to
institutions, whose income and expenses are extremely sensi- write another option at a different strike rate so that the front-end
tive to the interest rate scenario. Firms are also affected if they cost of buying an option is offset either completely or partially.
have significant borrowing or income from investments. Options This combination of buying one option and selling another option
on interest rate provide an excellent means of hedging against is called a collar.
falling or rising interest rates. Long-term exposures to interest Options on long-term bonds cover the risk of fluctuating inter-
rate risk can be managed by caps, floors, and collars. est rates on a portfolio of bonds. One needs to buy a put option
A cap is a series of call options called caplets, each of which on the bonds to protect against a fall in the value of the portfolio
has a common strike called cap rate. A caplet is exercised at due to rising interest rates. These options on bonds can be val-
predetermined intervals of time. It is used to cover against rising ued using Black's model, where the forward price of the bond
interest rate. Similarly, a floor is a series of put options, called would be dependent upon the price of the bond less the present
floorlets, with the same strike, and is exercised at different inter- | value of coupons that would be paid before the expiry of the
vals of time. Each of the caplets or floorlets may be valued with option on the bond. Another caution that is worth mentioning
Black’s model for calls and puts on futures, respectively. The is that the volatility that must be used in Black’s formula is for
basic determinants of caplet or floorlet valuation would be the bond prices, which are not available. The available volatilities are
term structure of interest rate to find the forward price and the on yields that need to be converted to price volatility using the
prices of zeros, besides the normal inputs for valuing option such concept of duration.
as strike, volatility, and time to maturity. Since hedging costs

KEY TERMS -
Cap Acapisa series of call options called caplets, each exer- Floor A floor is a series of put options called floorlets, each
cisable at successive intervals of time, to provide payoff to the exercisable at successive intervals of time, to provide payoff to
excess of the actual rate over the agreed (strike) rate. the excess of the agreed (strike) rate over the actual rate.
Caplet A call option on interest rates that constitutes one Strip Floorlet A put option on interest rates that constitutes one Strip
of a cap and pays the excess of the actual interest rate over the of a floor and pays the excess of the strike rate over the actual
strike rate. interest rate.
Collar A combination of a call and a put, one bought and the Option on bond An option that entitles the holder to buy or
other sold, to contain the cost of hedging. Options sold fetch sell the underlying bond at a specified price within or at any time
premium offset the cost of options bought. before maturity of the option.

QUESTIONS
18.1 What is a cap and how is it used for hedging interest rate 18.3 Describe a caplet and a floorlet. How is each valued?
risks? 18.4 What are options on bonds and how to value them?
18.2 What is a collar and why do investors use it?

PROBLEMS ~
P 18.1 Valuing interest rate options P 18.2 Option on bonds
A firm intends to cap its interest payment liability at 14%, to be The current price of a bond having 2 years to maturity is $130. It
determined six months in advance for two semi-annual instal- pays annual coupons on the face value of 7100 at 12%. Assum-
ments of interest falling due after 12 and 18 months, respec- ing that a coupon has just been paid, find out the value of a
tively, for a principal amount of 2100 crore. The forward interest 2-year call option on the bond with the strike price of £120 if the
rates for 6-m maturity as reflected in the term structure for six risk-free rate is 8% and the volatility of the bond price too is 8%.
and 12 months are 13% and 13.5%, respectively. The volatility of
the forward interest rates is placed at 10%. The risk-free rates for P 18.3 Put option on bonds
From the data in Problem 18.2, find the value of a 2-year put
12 and 18 months are 12 and 12.5%, respectively. All rates are
Option. Further, find the value of the put using put-call parity.
continuously compounded. What is the value of the cap the firm
would pay for a notional principal of 100 crore?
 Options on Futures
and S w a p s
INTRODUCTION Learning Objectives
In this chapter, we shall discuss some advanced options. These After going through this chapter, —
include derivatives on derivatives, such as options on futures and readers should be familiar with
options on swaps. These products are rather recent developments Black’s model for valuing options on
and allow traders to take positions not on the underlying but on futures contracts
the derivatives on the underlying. Traders have started to deal in the differencesbetweenthe binomial
model for derivatives on spot assets
options on futures on commodities rather than option on com- and for futures on the assets
modities themselves, because they are not interested in delivery. swaptions, their uses, and their
They prefer to take a view on price changes. valuation using Black’s model

FUTURES OPTIONS Be
Options on futures are traded on many exchanges. These are a
relatively recent development as they came into existence as late
as 1982 and became popular only after 1987. Currently, no such
contracts are traded in India.
Since futures are essentially exchange-traded contracts, options
on futures are exchange-traded too.
Options on futures are mostly American options that can be
exercised any time by asking for delivery of the underlying asset,
i.e., a futures contract.
Options on spot give a right without obligation to buy or sell
_ the underlying assets. In case of options
Options onfutures give
on futures, the underlying asset is a
the holder the right to
have a long or a short © futures contract. When an option gives
position in a futures a right to buy or sell a futures contract
contract. without an obligation, it is known as an
option on futures or a futures option.
When an option, a derivative, is exercised, it is settled either by
cash or by delivery of the asset. An option on futures is concluded
upon taking a position in the futures contract on the maturity of
 534 Derivatives and Risk Management

the option. We know that a futures contract is a contract for delivery of the underlying in the
future. Therefore, delivery of the physical asset would be made well after the conclusion of the
option contract. It is a derivative on another derivative, like a compound option.

Payoff
A call option on futures gives a right with no obligation to have a long position on the futures
_ contract, while a put option gives a right without obligation to have a short
The payoff on options on
futures would have two : position on the futures contract. Like any other option, it is a right without an
components: (a) the in- : obligation. The value of this option would depend upon the value of the futures
trinsic value in cash, and contract, which in turn depends upon the value of the underlying in the spot
(b) a long position (fora market. The payoff on options on futures would consist of two components:
call) or a short position
(for a put) in the futures e A cash amount equal to the difference between the last settlement price of
_ contract. the futures contract and the exercise price of the option
Dieses

e A long or short position on the underlying futures contract

As an example, consider a call option on futures on the Nifty, the
index of the National
Stock Exchange (NSE). The spot value of Nifty is 3540, and a
futures contract expiring
two months later in November is trading at 3610. The last settleme
nt price of the November
futures on the previous day was 3600. The strike price of the call
option on November futures
on Nifty is 3570. If the holder ofthe call exercises the option,
then
¢ one gets cash equal to its intrinsic worth
= Max (last settlement price — exercise price, 0)
= Max (3600 — 3570, 0) = %30, and
¢ a long position on the November Nifty futures contract
.
The holder may continue with the long position in futures
. However, if the holder wants
to square off the long position immediately, he/she would
do so at the current price of the
futures, i.e., $3610. Thus he/she gains €10 (3610 —
3600). Therefore, the aggregate payoff
would be %40, i.e., the difference between the current
futures price and the exercise price
(3610 — 3570). If one futures contract consists of
50 indices, the call on futures has a value
of 50 X 40 = %2000. This is the intrinsic worth of
the call option on Nifty futures.
The writer of the call futures option would pay
%30 and obtain a short position on the
November Nifty futures.
Similarly, we can explain the put option on future
s. If an investor holds a put option on the
November Nifty futures with a strike price of $3640,
with the last settlement done at 3600,
and decides to exercise, the investor gets

¢ cash equal to its intrinsic worth

= Max (exercise price — last settlement price, 0)
= Max (3640 — 3600, 0) = %40, plus
¢ a short position on the November Nifty future
s contract.
As a holder of a short position, the investor may
continue or square off immediately. If he/
she decides to square off, he/she loses =10
(3610 — 3600). Therefore his/her payoff would
 Options on Futures and Swaps 535

be 30, i.e., the difference between the exercise price and the current price (3640 — 3610).
If one futures contract consists of 50 indices, the put on futures is worth 50 * 30 = 1500.
The writer of the put futures option would pay %40 and obtain a long position on the
November Nifty futures.
Therefore, the payoffs on options on futures would be

For a call option on futures: Nias OME aXe) (19.1)

For a put option on futures: Max (0,4 =F) (19.2)
where F' is the current futures price (i.e., at the time of exercising the option) and X is the
exercise price of the option.
An options contract on futures must have a maturity prior to that of the futures contract,
the underlying asset in this case. If the futures contract matures on the same date as the
option, then by the phenomenon of convergence of the futures price to the spot, the futures
price would be the same as the spot price. The option on futures would then be the same as
an option on the underlying spot. Hence, options on futures are American style and have the
same maturity as that of the underlying futures contract. Options on futures are referred to
using the time at which the underlying futures expires. If a futures contract on index expires
on 25 May, it is called a May futures contract. Then an option on this index futures would
also be called a May option.

Need for Options on Futures

Why should one trade in options on futures rather than in options on underlying assets? We
_ may like to recall the properties of futures and options to understand this. It
Options on futures are
_ becoming increasingly _ may be realized from the examples in the previous section on payoffs, that
popular because of the / options on futures would in most circumstances be cash settled, because a
ready visibility of the _ futures position is almost always settled in cash by entering into an opposite
prices of futures as com- : contract. Therefore, an option on futures makes sense to traders, who are not
pared © those of Spots, really interested in the possession or dispossession of the final underlying
__and the uneven payoff of
options. _ asset.
LEED - If this be the case, one can take a futures position. However, a futures posi-
tion would expose the trader to downside risk too. A long position on futures would gain with
a price rise and lose when the price ofthe underlying falls. In order to have protection on the
downside, one may prefer an option contract to a futures contract. A futures contract provides
leverage but exposes the holder to the downside, while the option contract safeguards against
the downside. Thus, options on futures serve the purpose of providing leverage as well as
protection from the downside.
Another reason that options on futures are becoming increasingly popular is the instant
availability of futures prices. If one needs to take a position in crude oil, knowing the spot
price would be the first prerequisite. It is easier to know the price of futures on crude oil than
the spot price of oil. Hence, rather than trading an option contract on oil, it becomes easier
to trade an option on oil futures, especially when the futures and the options on futures are
being traded at the same platform or exchange.
Since both derivatives are on the same exchange, trading in two derivatives becomes easier
than trading that involves an interaction with the spot market. With options on futures, the
536 Derivatives and Risk Management

futures serve as a better and more convenient proxy for the spot, as futures prices are avail-
able instantly and are transparent.

Put-Call Parity for Options on Futures

We know the relationship between call and put prices for an underlying asset that was derived
by constructing a portfolio of long stock, long put, and short call that created a synthetic
bond. We now examine a similar position using futures, puts, and calls. Let the futures price
be Fo, with the call and put prices denoted as c(Sp, XY, T) and p(So, X, 7), respectively, where
So is the current spot price, X is the exercise price of the options, and 7 is the time to maturity.
All the derivatives expire at the same time 7. We now see the maturity value of the portfolio
consisting of long futures, long puts, and short calls. With the final asset price S;, the payoff
on the portfolio is shown in Table 19.1.
Table 19.1 Put-call parity for futures (forwards)
Portfolio Current value $;=X Sr>X |
- Sr-Fy | Sr-Fo |
Longput pOee eres
Short call — (Sp, X,T)
0 —(S;-X) F

Total | SX T)— AS %T) |XA | XA |

The portfolio matures without any uncertainty to a fixed value—the strike price less the
current futures price (X — Fy)—irrespective of the asset price. A certain outcome must yield
no more than the risk-free rate of return, r, for the period, 7. Therefore, at ¢ = 0,
Xi FG
POGAg P= Cl Stl) lik or
(19.3)
Equation 19.3 can also be obtained from Eq. 10.8 or 10.9 by substitution of S§= Fo/(1 +
r). This is shown in Eq. 19.14 in terms of the Black Scholes Model (BSM).

Payoff Payoff

Long call

Short call Short put

Long put + short call = Short futures Long call + short put =

Fig. 19.1 Put, call, and futures

 Options on Futures and Swaps 537

| EXAMPLE 19,1 Put, call, and futures

Assume that today’s spot price for the Nifty index is $5000. A June futures on the Nifty expiring 45 days from now is trading at |
5075. June call and June put options on futures with strike prices of €5,100 for expiry on the same day as the futures are edo |
at ¥5 and ¥35, respectively. If the risk-free rate of interest is 1.5% for 45 days, find out the following: L

(a) What is the price of the synthetic futures created by a bond, a call, and a put?
(b) Is there an arbitrage opportunity?
(c) If yes, how would you execute the arbitrage?
Solution L
(a) As per Eq. 19.3, using simplified notations, the futures price should be F = X — (1 + 4 (p — c) = 5100 — (1.015) x (35
— 5) = $5069.55
(b) The actual futures price is ¥5075, which as per put-call parity for wide on futures is overpriced, suggesting that an arbitrage SSS
|
SAS
SSS

profit of ¥5.45 can be made.

(c) To execute the arbitrage, one would go short on the futures, and create a synthetic futures by (a) buying a bond that matures
to ¥5,100 after 45 days, (b) buying a call, and (c) going short on the put. The bond is selling for 5100/1.015 = 5024.63, the
call would cost 5.00, and the put would give 35.00 with the total cost of the portfolio at 4,994.63, which can be borrowed at SSSA
SSS

1.5% for 45 days. The long futures and the portfolio would match at maturity. The payable on the borrowing would be 1.015 |
x 4994.63= %5099.55 and the receivablepa tethe short futures would be %5075, yielding a profit of %5.45. L

From Eq. 19.3, we may say that a long position on a put with a short call 1s equal to a short
futures contract, and a short put and a long call make a long futures contract, as they have
identical payoffs. These positions, ignoring the option premiums, are depicted in Fig. 19.1.
The position in the call and the put can be used to create a synthetic futures contract.

Binomial Model for Pricing Futures Options

Let us consider some of the differences between options on the spot and option on futures
with the help of a binomial tree. Recall that under risk neutrality, we set up
ee
futures is without invest-
a hedged portfolio of A long stock and one short call at a cost of ASp — c.
mentascomparedioa With the up and down movement of the stock at uSp and dSo, and respective
position inthe spot,no — call payoffs of c, and cy, the hedged portfolio would have the same value,
growth of the futures _ irrespective of any price change. Equating the portfolio at the upper and the
pice tal) be presumed _ lower nodes would give the value of delta as
in valuing options on ries
futures. / = ——u_ _—d__ (19.4)
| So (u — a)
As the payoff on the portfolio at maturity is certain, it would yield nothing
greater than the risk-free rate. Therefore, the payoff at maturity discounted at the risk-free
rate should be equal to the cost of the portfolio.
Discounted value of the portfolio at the up move: (A uSy — c,Jev? = A Sp —c
Discounted value ofthe portfolio at the down move: (A dSy — cae"? = A Sy —
Putting the value of A would give
Value of the call, c = e~[pc, + (1 — p)cal (19.5)
is Cafe d
where p= ar (19.6)
538 Derivatives and Risk Management

Asset Call on Futures _ Callon |

asset futures

US, C,
ee
UF, i

S, 2 F,
a Selbbe
is
a ae dF,
;

Hedged portfolio Long A stock and short 1 call Long A futures and short 1 call
Set-up cost AS, -C Ane
Delta (C, - C,)/S,(u - d) (f, — f,)/F,(u — d)

Fig. 19.2 Binomial tree for option on spot and futures

We adopt the same approach for valuing the call option on futures. Consider the current
futures price of Fo. The futures does not require an initial outlay for the hedged portfolio
of long A futures, and a short call would be set up at —f, where fis the value of the call on
futures.
With up and down movements of wu and d of the futures, the value of the futures at expiry
of the call option would be uF) and dF», respectively. If the respective values of the call on
futures at the up and down movements are f, and f), then the value of the delta would be

See
=. he oly
(19.7)
In this case too, payoff at maturity would be certain and, thus, it would provide a return
equal to the risk-free rate, and, therefore, we may find the value of the call on futures.

Discounted value of the portfolio at the up move: (A uy —fje" = =f

Discounted value of portfolio at the down move: (A'dFy —fper = —
With A as calculated in Eq. 19.7, the call on futures would be

Value ofthe call on futuresf=

, e~"[pf,, + (1 — p)fj] (19.8)
Lo,
p = LG,
where (195)
The comparative position of the call on stock and the call on futures under the
binomial
approach is depicted in Fig. 19.2.
The risk-neutral probability, p, in case of the call on futures suggests that the
futures price
does not grow as does the stock price at the risk-free rate. It is consistent with
the notion that
if there is no initial investment, as is the case with a position on futures,
the return would
have to be zero under risk neutrality.
Further, the futures price itself represents the expected value of the
spot at the expiry of
the futures.
 Options on Futures and Swaps 539

Valuation of Futures Options—Black’s Model

The valuation of an option on futures can be done by what is referred to as Fisher Black’s
-
heBlack-Scholes model _ model. It is on the same lines as BSM for dividend paying stock or for
or valuation can be indices, where the dividend q is set equal to the risk-free rate. Setting g =
applied to value options r makes the growth equal to zero. The value of the call and put options on
n futures byassuming - futures is stated in Eqs 19.10 and 19.11.
Zero growth or by setting
gen | “ITE. N(d,) — X. NM(a>)] (19.10)
m“TIX.N(—d>) — Fy. M—d))] (19.11)
Note that the valuation of option on futures is same as that for the BSM with simple
substitution of Sp by the equivalent futures price of Fy X e'’. The computation of d, and

:EXAMPLE 19.2 Binomial valuation of call on futures

The spot value of gold is ¥ 14,000 per 10 g. A futures contract on gold for delivery one month later is selling for € 14,150. What
the price of a call on gold spot and gold futures expiring in one month with a strike price of = 14,250? Assume a risk-free interest |
rate of 1% per month, a price movement of +10%, and the last settlement price of the futures as & 14,150.

(a) Draw a single-stage binomial tree.

(b) What would the payoff on the call on futures be if the holder exercises the option?
Solution
(a) With a risk-free interest rate of 1% per month and an up and down movement of 10% each, the risk-neutral probability of an |
up movement, using Eqs 19.6 and 19.9, is
For a call option on spot gold p = (e7 — d)(u — d) = (1.01005 — 0.9)/0.2 = 0.55025
For a call option on futures p = (1 — d)/(u — d) = 0.1/0.2 = 0.50
Binomial tree for option on spot and futures on gold

Call on Futures Call on

Gold gold on gold futures

15,400 1,150 15,565 1 Ske

0.55025 pectin
14,000 14,150
0.44975 wale
12,600 0 VSS 0

Using Eq. 19.5, the value of the call on spot gold, c =e "Ipc, + (1 — p) cd
= e .0119.55025 x 1,150 — 0.44975 x 0]
= 0.99005 x 632.79 = % 626.49
Using Eq. 19.8, the value of the call on futures, f =e" "pf, + (1— p) fy
Ba ONO x 1315 0.5.x. 0)
0.99005 x 657.50 = % 650.96
(b) If the holder of the call wants to exercise his/her option, he/she would get
(i) cash of (14,500 — 14,250) = % 250; and
(ii) a long position on the futures contract on gold.
540 Derivatives and Risk Management

EXAMPLE 19.3 Value call on index futures

The Nifty index is trading at 4500. A 3-m Nifty futures contract is at 4600. The volatility of the futures contract is 25%. What is the
value of a 1-m call option on a 3-m futures contract with a strike of 4600 if the risk-free rate is 12% p.a.?
Solution
The value of the call option on the futures is given by Black’s model
c= e"|Fy.N(d,) — X.N(db)|
The values are Fy = 4600, X = 4600, r= 12% T= 1 month, and o = 25%
In(Fo/X) + o7T/2) — In(1) + 0.25 « 0.25 x 1/24
di = 0.0361 and
_ o\T ‘ 0.25 o\ 1/12
2 = a se
dp ae iy OST oa d; —o\T= 0.0861 — 0.25, 1/12 = —0.361
(Oo. i

N(a,) = 0.5144 and —-N(d,) = 0.4856

Value of the call = e791? * "2/4 600 x 0.5144 — 4,600 Xx 0.4856] = 131.36
Value of one contract = 50 < 131.36 = #6568
LTE ELLE

d,, too, would stand modified. The computation of d; and d, includes the drift of r. For the
futures, the drift can be stated to be equal to zero. The drift on the stock that pays a dividend
of q is equal to r — g. The futures is equivalent to the stock with the dividend yield equal to
r. Therefore, the net drift for the futures would be zero. The modified values of d , and d, for
valuing options on futures are shown in Eqs 19.12 and 19.13.
27/2
dy = In(Fo/X ) ns oT/2 (19.12)
O\T
¢T/2 LX) =
and ppt 9 ES dl ee ee
al
(19.13)
o\T
Without elaboration, we may say that the put-call parity that holds good for
the call and
_ put options on the underlying stock would also hold good for the European
Put-call parity too holds
for options on futures, with _ option on futures. The put—call parity for contracts on the underlying is
the spot price replaced c+X-eTant+S,
by the present value of .
the futures price less the The current futures price, Fy
premium for the buyer, = Spot value + cost of carmyr== Sauk 2%
g Z or So — Fo x a

Replacing Sp with the equivalent futures price F » Xe’, we get the

put—call parity for
options on futures as Equation 19.14.
c+XeT=p+Fi et (19.14)

OPTION ON SWAPS—SWAPTIONS lita Wes

Swap options are options on swaps. They are also called swaptio
ns. Options on swaps give
A swaption gives the right the holder the right, but no obligation, to enter into a swap
contract at some
to the holder to enter into / time in the future on payment
of a premium.
a swap at the expiry of The underlying swap can be fixed payer—floating receive
r (called payer’s
_ swaption) or floating payer—fixed receiver (receiver’s
swaption). The strike
 Options on Futures and Swaps 541

rate in a swaption is the interest rate that would be applicable for the fixed leg of the under-
lying swap. For a payer’s swaption, the holder would pay a fixed interest rate for receiving
the floating rate, and for a receiver’s swaption, the holder receives a fixed rate and pays a
floating rate. A payer’s swaption would be entered by one who expects interest rates to go
up and a receiver’s swaption would be chosen by one who expects interest rates in the future
to come down.
The exercise can be American style or European style. Upon exercise, the underlying swap
contract is entered into. However, swaptions can be cash settled too. The rules of exercise of
swaptions are as follows:

Rate on expiry | Payer’s swaption Receiver’s swaption

When interest > strike Exercise Do not exercise
interest < strike Do not exercise Exercise

Forward Swap and Swaption Let us examine a payer’s swaption with a 3-year swap as
underlying, with a strike rate of 10%. The swaption matures in two years, at which time the
holder gets a right, but no obligation, to enter into the underlying swap by paying a fixed rate
at 10% for receiving a floating rate.
Such an option would be useful for a firm that (a) pays a floating interest rate on its bor-
rowing, (b) anticipates a rise in the interest rates in the future, and (c) believes that the swap,
if entered into after two years, would have a swap rate greater than 10%, the strike rate in the
swaption. This situation can be effectively covered by entering a forward swap with two years
as the forward period and three years as the swap period. However, with a forward swap, it
would be obligatory on the firm to enter into the swap at 10%, which would be disadvanta-
geous if the market rate for the swap happens to be lower than 10%. With a swaption, it is
not obligatory to enter the underlying swap. If the swap rate happens to be less than 10%,
the firm would enter the swap on the market rate rather than exercise the swaption.
Similarly, one can demonstrate that for a receiver’s swaption, the underlying swap would
require paying a floating rate for receiving a fixed rate specified in the strike of the swaption.
This would be exercised when the swap rate on the expiry of the swaption is less than the
strike rate. It would be applicable for a firm expecting to enter into a swap to convert either
an existing liability from a fixed rate to a floating rate, or an existing asset from a floating
rate to a fixed rate.

Payoff on Swaption
The payoff on a swaption may be viewed in terms of the differential between the swap rate,
_ S,,, and the strike rate of the swaption, X. Assume that a European payer’s
fi tion : ; :
ees ne swaption with two years to expiry has a strike rate of 10% for an underlying
the swap rate and the 3-year swap with semi-annual payments. At the end of two years, the holder
_ strike rateatthe end of of the swaption would compare the swap rate, S,,, with the strike rate. The
_ the option period. payoff in terms of percentage would be Max(S,, —_X, 0).
Assume that the swap rate on the expiry of the swaption happens to be
11.90%. Therefore, the gain from exercising the swaption would be (11.90 — 11.00) =
1.90%, or 0.95% of the notional principal amount on each semi-annual payment. Assuming
 542 Derivatives and Risk Management

a notional principal of 7100 lakh, the saving on each semi-annual payment would be 0.95%
xX 100 = ¥0.95 lakh.
To know the aggregate payoff on the swaption, we need to value each semi-annual pay-
ment in present value terms. Assume that the term structure observed at the expiry of the
swaption is as follows:

Time(months) | 6 | 12 | 18 | 24 30 36
Yields (%) 10.50 |10.80
|11.20 |11.50 11.70 | 12.00

From the term structure, one can find the value of the zero, which is the correct discount
factor for cash flows occurring at that point of time. Table 19.2 provides the amount of saving
the holder of swaption would make by exercising the swaption. It comes to %4.7087 lakh for
the notional principal of 7100 lakh.

Table 19.2 Payoff from swaption

; :
Time (months) 6s 9 ep a 18 ay
sek 24 30 a 36
Yields (%) 10.50 10.80 11.20 11.50 11.70 12.00
Price of zeros 0950) 0.9002 7 0.8492 0.7996 = 0.7526 0.7050
Amount saved (% lakh) 0.9500 0.9500 0.9500 0.9500
ees ae
0.9500 0.9500
a] aE aa
Present value (% lakh) 0.9026 | 0.8552 0.8067 0.7596 0.7149 | _ 0.6697
Payoff from swaption
(lakh) EL

The payoff of 74.7087 lakh, signifying the saving from entering into
the underlying swap,
also implies that if a cash settlement of the swaption is made,
then the holder of the swap-
tion should receive %4.7087 lakh. In that case, it is immaterial
whether the underlying swap
is actually entered into or not.

Swaptions and Options on Bond

From the payoff on the swaption shown in Table 19.2. it can
be stated that swaptions are like
options on a bond. A payer’s swaption is like a put option
on a bond with a face value of
* 1 and a coupon at the strike price of the swaption, X.
The value of such a bond is 2 ke
* (Sum of zeros till maturity of bond), where Zy 1s the
value ofthe zeros for the period till
maturity of the bond. From Chapter 18, we know that
a put option on a bond with the exercise
price, X, equal to a face value of 1 with a coupon of
X, would have the following payoff:
Payoff on put option on a bond = Max(1 — value of bond,
0)
The payoff on the payer’s swaption is Max(S\,, —_Y,
0), where S\, is the swap rate. The swap
rate discussed in Chapter 8 is calculated by Eq. 8.6.
In terms of our notations here, it is as
given by Eq. 19.15.

Swap rate = 1 lastdiscountractor: a) l= Zy

Sum of all discount factors (1985)
El
a4]
|
 Options on Futures and Swaps 543

The payoff on the payer’s swaption represented in terms of zeros is given in Eq. 19.16:
hae
Payer swaption payoff = Max
N fal
7; 1
]
N

N
= Mas}(2: a + x52) 0
= Max(1 — value of bond, 0) (19.16)
The payer’s swaption payoff is the same as the payoff on a put option on a bond. On similar
lines, the value of a receiver’s swaption can be shown to be equal to a call option on a bond
with a face value of | and a coupon at the strike price of the swaption: Therefore,
e A payer’s swaption is equal to a put option with an exercise price of 1 on a bond with
_ a face value of <1 and a coupon rate equal to the strike of the swaption.
e A receiver’s swaption is equal to a call option with an exercise price of 71 on a bond
with a face value of 71 and a coupon rate equal to the strike of the swaption.

Valuation of Swaptions
A swaption can be valued using Black’s model by assuming that the swap rate of the under-
aceon ying swap hashas log-
lyin log-norn nal distribution.
We may
distribution.
We ma value
lue thethe p payer’
yer’s swaption
tion,
ee _ where the holder has the right to pay a fixed rate, X, the strike rate of the
caplet or floorlet repeated : swaption, for receiving a floating rate.
_ Payer swaption value,
€— LA [Fo Nad) — XxX N@)) (19 17)
Receiver swaption value,
[SM Es WON Cote be COUN EF 00] (19.18)
where
mses SZ: q, = RIX) + o 7/2 pa ia) oT. mre:
m1 o\T o\T
Z; = Value of zeros (discount factor for i cash flow),
X = Strike interest rate of swaption
m = Number of payments in a year
L = Notional principal
T = Life of swaption, when the underlying swap starts
F’, = Forward price of underlying swap
o = Volatility of forward swap price
Note the difference in valuation of a swaption from that of an interest rate option or an
option on a bond. The value of a swaption includes a discount factor, 4. In the valuation
of an interest rate option, the cash flow is discounted using the discount rate applicable to
the respective cash flows of the option. Each caplet is discounted at the applicable rate (the
value of zero) at the time of the cash flow. In a caplet, there is only one cash flow, but a swap
involves repeated cash flows at each scheduled date. Therefore, the discount factor becomes
an annuity, A, because a swaption is a repeated payoff on the swap rate.
544 Derivatives and Risk Management

We now value a swaption with following parameters:

Strike interest rate, X : 6.50%

Time to expiry, 7 : 2 years
Underlying swap : 3-year swap commencing two years from
now, with the right to pay a fixed rate on a
semi-annual basis
Volatility of swap rate, 7 : 20%
The only unknown parameter under Black’s model for valuing a swaption is the forward
swap rate, F’,, which is arrived at using the term structure or the values of zeros, and is
described in the paragraphs that follow.
_ Calculating forward swap rate The swap rate is the fixed rate of inter-
Swaptions can be valued
using Black’s formula est that would be paid/received in exchange for a floating rate of interest.
with the forward swap The determination of the swap rate is discussed in the valuation of swaps in
rate derived from the Chapter 8. Swap rates are derived from zero rates that are available for the
term structure. period till the cash flows are committed in the swap.
4 , rf 1 — Discount factor for last cash flow _ ‘we a
wap Rate = m X - ees ee Cig
Sum of all discount factors Sz
a4;
1
where Z; = Value of zero (discount factor for i‘ cash flow)
N = Number of swap cash flows
m = Number of cash flows in a year

Table 19.3 demonstrates the calculation of the swap rate for a five-year swap with semi-
annual and annual cash flows for a given term structure (yields for the corresponding

Table 19.3 Finding swap rate

ce flow | Time | Yield(%) | Discount factor
(months) Semi-annual | Annual
| 6 5.00 0.9756
are 5.50 0.9479 0.9479
3 18 | 6.00 0.9174
4 24 6.30 0.8881 0.8881
5 30 6.50 0.8602
6 36 6.80 0.8306 0.8306
a 7.00 0.8032|
8 48 7.20 0.7764 0.7764
a 9 54 7.40
10 ‘le 60 7.60
Sum of all discount factors

Swap rate
 Options on Futures and Swaps 545

periods). The discount factors mentioned are also referred to as values of zeros. The swap
rate is 6.50% for semi-annual payments and 6.61% for annual payments.
For semi-annual, swap rate = 2 X Eee 2 0.0650 or 6.50%
8.4742
Maes 7246
or annual, Ie swap ratete =
For 41676 or 6.61% 0
= 0.06615 or

To find the forward swap rate for a swap starting two years from now for the next three
years with semi-annual fixed rate payments, we need to find the forward discount factors and
the forward swap rate using Eq. 19.19. The forward discount factors are obtained directly
from the values of the zeros. The forward discount factor is arrived at by dividing the discount
factor in the semi-annual period by 0.8881 (the last discount factor prior to the commence-
ment of the forward swap), as shown here:
Forward discount factor for the first payment = 0.8602/0.8881 = 0.9686
Forward discount factor for second payment = 0.8306/0.8881 = 0.9352

Forward discount factor for sixth payment = 0.7246/0.8881 = 0.8159

The forward swap rate may be found using Eq. 19.19.
It is shown to be 6.89% in Table 19.4.
Table 19.4 Finding forward swap rate 2-year forward for 3-year swap
Cash flow Time Yield Discount factor

(montis) |
3 18 6.00 0.9174
4 24 6.30 0.8881

6 36 6.80 0.8306 0.9352

8 48 7.20 0.7764 0.8742

9 7,40 0.7502 0.8447

10 60 7.60 0.7246 0.8159
Sum of all discount factors 5.3431
Forward swap rate (2 year forward, 3 year swap) 6.89%

Value of swaption The inputs for Black’s model for valuing swaptions are: the forward
swap rate, F,, 6.89%,X = 6.50%, m = 2, T = 2 years, and 0 = 20%. For an assumed notional
principal, L = ~ 100, we get
d\ = 0.3472, d, = 0.0644,
N(d,) = 0.6358, N(dz) = 0.5257 and A = 2.6716
546 Derivatives and Risk Management

The value of the payer’s swaption is €2.5744.

For the same underlying, the receiver’s swaption would have
=—d, ==03472, —dy = 0.0644,
N(—d,) = 0.3642, NM(—d>) = 0.4743 and4 = 2.6716
The value of the receiving swaption is %1.5324.

EXAMPLE 19.4 Valuing swaption

ABC Ltd has a floating rate liability for the next six years. It expects interest rates to rise in the future, and, therefore, may have
to enter into a swap for receiving a floating rate and paying a fixed rate. A 1-year swaption is available with a strike of 10.50% for |
paying a fixed rate and receiving a floating rate for five years thereafter. The term structure for the next six years Is

Yer | 1 2 3 4 5 6 1
Interest,% | 9.50 9.75 10.00 10.25 10.50 11.00 ;
If the volatility of the forward swap rate is 20%, what price is appropriate for the firm to pay for the payer's swaption? Assume an
annual payment for the notional principal of 100 under the swap.

se
Term structure
Year | Rate Zeros 1-year Forward zeros
i 9.50% ae 0.91324 ese
2 i 9.75% 0.83022 0.9091 at
3 10.00% 0.75131 0.8227
+——

4 10.25% 0.67684 0.7411

es AL —
5 10.50% | 0.60700 0.6647
sane
6 11.00% | osa4e4 | 0.5854
is r
|
Sum { a
4.31325 3.7230 2)
Swap rate t = 0 10.789%
Forward swap rate t = 1 11.136%
1

The swap rate is found by using Eq. 19.15. The forward swap rate works out to
11.136%. The value of the payer's swaption is
given by Eq. 19.17. We have F, = 11.135%, X = 10.50%, m = 1, T= 1 year, and
o = 20%.
ix
A= => A= 3.7290
m4

of ae In(F/X)
Fa) +eeeo°T/2 an
— In(14.135/10.5) + 0.2 x 0.2 x 1/2
pas = 0.3937 and
oT 0.2/1
dy = d, — oT = 0.3987 — 0.2\1 = 0.1937
N(d,) = 0.6531 and = Mab) = 0.5768
Payer swaption value, c = LA[F;.N(d,) — X.N(d,)]
= 100 x 3.7230[0.1135 x 0.6531 — 0.1050 x 0.5768]
 Options on Futures and Swaps 547

SOLVED PROBLEMS
SP 19.1: Binomial pricing of put on futures
Refer to Example 19.2. What would the values of a put option on spot gold and a futures contract on gold be, with the same strike
of ¥14,250 and one month to expiry? Assume a risk-free interest rate of 1% per month. Draw a single-stage binomial tree.
What would the payoff on a put on the futures be if the holder exercises the option?
Solution
With a risk-free interest rate of 1% per month and up and down movements of 10% each, the risk-neutral probability of up movement,
using Eqs 19.6 and 19.9, is:
For a put option on spot gold = (e" — d)/(u — d) = (1.0105 — 0.9)/0.2 = 0.55025
For a put option on futures = (1 — d)/(u — d) = 0.1/0.2 = 0.50
Using Eq. 19.5 modified for a put (replacing p for c), the value of the call on spot gold,
p =e "[ppy + (1 — p) pal
= e °110.55025 x 0 — 0.44975 x 1650]
=,.99005 x 805.50 = %797.48.

Binomial tree for option on spot and futures on gold

Put on Futures Call on

Gold gold on gold futures

15,400 0 15565 -
0.55025 0.50

14,000 14,150

0.44975 0.50
12,600 1650 12735 1s

Using Eq. 19.8, the value of the put on futures, f = e—rfpf, + (1 — p) fl

= @ 9010.5 x 0+ 0.5 x 1515]
= 0.99005 x 757.50 = 749.96
The value of the call in Example 19.2 was derived at = 650.96. Using put-call parity as given by Eq. 19.3, the value of the put would be
p=c+ Xe"x Foe"
= 650.96 + 0.99005 x 14,250 — 0.99005 x 14,150
= 0.99005 x 757.50 = ¥ 749.96
SP 19.2: Value put on index futures
Use the date in Example 19.3 and find the value of a put option on Nifty of the same parameters as those of the call.
Solution
The value of the put option on futures as given by Black’s model is

p= e"[XN(—db)— Fy x M—d,)]
The values are Fy = 4600, X = 4600, r= 12%, T = 1 month, and a = 25%
ie In(Fy/X) + o°Tle_ In(1) + 0.25 X 0.25 x 124 _ 9 0364 and
ae 0.25 \1/12
dg, =I) = oF 12g =5 T= 0.0361 — 0.281712 = -0.361
(omy 1B

N(—d;) = 0.4846 and N(—d,) = 0.5144

Value of the put = e °'2 x 2/4600 x 0.5144 — 4600 x 0.4856] = % 131.36
Value of one contract = 50 < 131.36 = €6568
 548 Derivatives and Risk Management

SP 19.3: Valuing swaption

XYZ Ltd has a fixed rate liability for the next six years. It expects interest rates to fall in the future, and, therefore, may have to enter
into a swap for receiving a fixed rate and paying a floating rate. A one-year swaption is available with a strike of 9.00% for receiving
a fixed rate and paying a floating rate for five years thereafter. The term structure for the next six years is as follows:

Year
Interest, % 9.50 9.25 10.50 10

If the volatility of the forward swap rate is 20%, what price would be appropriate for the firm to pay for a receiver's swaption?
Assume annual payments under the swap for a principal sum of 100.
Solution
We need to find out the likely swap rate after a year. According to the term structure, the present swap rate must be 8.50% (see
the following table). With an upward sloping term structure, the one-year forward swap rate works out to 8.25%, as shown here:
Term structure
Year Rate Zeros Forward zeros
1 9.50% 0.91324 eau

2 9.25% 0.83783 0.9174

a
3 9.00% 0.77218 0.8455
—- rast
4 8.80% | 0.71365 0.7814

5 8.70% 065805 | 0.7215

6 8.40%
ea 0.61635
El 0.6749
| Sum 4.51220 3.9409
Swap ratete t= 0 “ai
8.503% es
Forward swap rate t= 1 8.250%
The swap rate is calculated by using Eq. 19.15. The forward swap rate works out to 8.25%.The value of the receiver's swaption is
given by Eq. 19.17. We have pe = 8.25%, X = 9.00%, m= 1, T= 1 year, and 0 = 20%

Ava: Sz = 3.9409
m4

d, = In(FJX) +~ 0?72 _ In(8.25/9.00) + 0.2 : x 0.2 x 1/2

= —0.3354 and
avT 0.2 4/1
do = d, — oT = 0.3937 — 0.2\1 = —0.5354
N—d;) = 0.6313 and = N(—d,) = 0.7038
Receiver Swaption Value, p = LA[X.N(—a,) — F,.N(—d,)]
= 100 x 3.9409[0.90 0.7038 — 0.0825 x 0.6313]
= %4.44

SUMMARY
A futures option, or option on futures, gives the right to the Futures options have gained popularity because they combine
holder of the option to have a long or a short position in the the advantages of both options and futures. While an option pro-
futures contract upon exercise or on expiry of the option. A tects the holder from downside risk, it retains the upside potential
call option on futures upon exercise provides cash equal to the gain. A future obviates delivery by rendering flexibility to enter
intrinsic value of the option and a long position on the underly- into an offsetting contract.
ing futures contract. Similarly, a put option on futures provides The valuation of options on futures can be done in a man--
cash equal to the intrinsic worth plus a short position on the ner similar to that used for options on the spot by assuming a —
futures contract. dividend yield equal to the risk-free rate, implying zero growth of
 Options on Futures and Swaps 549

the futures price in the risk-neutral world. Black’s model incorpo- Swaptions provide a hedge for entities that are likely to enter
rates such a modification and can be used for valuing options on into’aswap in the future. The objective can be achieved by a
futures contracts. forward swap too. However, it would be obligatory to enter the
A swaption is an option on swaps. It gives the holder the right swap at the end of the forward period, while with a swaption, it is
to enter into a swap at the end of the option period. Under a pay- an option. The payoff under swaptions is like that for an interest
er’s swaption, the holder pays a fixed rate and receives a floating rate option. With an interest rate option, payment under each
_ fate, and under a receiver's swaption, floating rate payments are caplet or floorlet would be different, while under a swaption, the
made in exchange for receiving fixed rate payments. The holder same payoff would result on each date, till the swap period is
of a swaption compares the strike rate of the option with the over.
. swap rate at the end of the option period. Under a payer's swap- Swaptions canbe valued with Black’s formula for options on
: tion, the holder would like to pay the lesser of the strike or the futures. The forward swap rate can be obtained from the term
swap rate. Hence, ifthe swap rate is higher, the holder exercises structure of interest rates. The remaining determinants can be
__ the option. For a receiver's swaption, the reverse is true. fixed between the buyer and the seller of the swaption.

KEY TERMS ee

Forward swap A swap that commences at a future date with Receiver’s swaption Under a receiver's swaption, the holder
a swap rate fixed now. pays a floating rate in exchange for receiving a fixed rate.
Futures option An option that gives the right to the holder to Swaption An option that gives a right to the holderto enter into
have a long or a short position on a futures contract. a swap at a future date.
Payer’s swaption Under a payer's swaption, the holder pays
a fixed rate for receiving a floating rate.

19.1 Describe Black’s model for valuing options on futures. 19.4 Differentiate between (a) a forward swap and swaption
19.2 Why are options on futures popular despite options on and (b) a payer’s and receiver's swaption.
spot being available?
19.3 Howis a binomial model for valuing futures options differ-
ent from the one for valuing options on spot?

PROBLEMS “ce”

P 19.1 Payoff—options on index futures on Nifty futures with the same strike and time to maturity as
What is the payoff on call and put options on Nifty futures with a the call option. Further, compute the put price using put-call
strike price of % 4800? The last settlement price for Nifty futures parity.
was 24775, and, currently, it is trading at ¥4820. Would the P 19.4 Swaptions—payoff
options be exercised? Determine the payoff on a receiver's swaption with a strike of
P 19.2 Valuation—options on index futures 11% and a payer's swaption with a strike of 10.50%,with a three-
Nifty futures with three months to maturity is currently trading at year semi-annual swap as underlying, when the following term
= 4700. What would be the value of a 2-m call option on Nifty structure was observed at the end of the option period.
futures with an exercise price of € 4650? The risk-free rate is 8% Period(months)| 6 12 | 18 24 | 30 36
and the volatility of the futures price is 20%
Yield (%) 9.00 | 9.50 | 9.90 | 10.20 |10.50 |10.70
P 19.3 Black’s model for put on futures
Refer to the data in P 19-2. Find the value of a put option
 Credit Risk,
Securitization,
and Credit Derivatives

INTRODUCTION
SS

Learning Objectives
This chapter deals with another dimension of risk that, of late, After going through this chapter,
_ has become extremely important— readers should be familiar with
Understanding credit
credit risk. It is also referred to as a credit risk and credit risk
risk is crucial because
it threatens to lead to default risk, and its understanding, measurement
systemic risk and cause measurement, and management have assessment of probability of default,
default rates, and default losses
been gaining prominence, as it gives
finding credit value at risk
rise to systemic risk. Systemic risk credit default swaps and how they
relates to the impairment of the ability of an organization to work
honour its commitments due to the failure of others. Since finan- valuation of credit default swaps
cial markets and institutions are integrated and are mutually using the Merton model
dependent to a great degree, adversity faced by one institution total return swaps and how they
work
has the potential to be transmitted to the others in the system. If
the process of securitization and its
adversity affects several sectors or large parts of the financial benefits
system, it culminates in a global crisis. how securitization creates credit
Under such circumstances, it is not as important to under- derivatives
stand what causes systemic risk as it is to manage it. The roots of credit-linked notes
collateralized debt obligations
default may lie in market factors such as interest rates, commod-
synthetic collateralized debt
ity prices, or exchange rates, which manifest into credit risk, or obligations
may emerge from wrong policies and structural decisions within
an organization, such as an inordinate amount of leverage. In
the context of derivatives, default risk becomes more important
due to the high degree of leverage used. Derivative exposures
also escape getting recorded in the financial statements, making
exposures invisible, and thus avoid scrutiny by regulators and
those who might be affected by these highly leveraged trans-
actions. Most of the exposures in derivatives are contingent in
nature and get crystallized only upon the happening of some
event or the maturity of the derivatives.
We deal with credit risk first, before discussing the derivatives
used for managing it.
 Credit Risk, Securitization, and Credit Derivatives 551

Credit risk is the risk that the counterparty in a transaction would not honour or pay
the obli-
gations undertaken by it. In financial circles, terms such as non-performing assets
(NPAs)
are in common use; the NPA ratio with total credit often serves as an important indicator
of
the quality of business and the creditworthiness of borrowers. It is also taken as a measure
of the effectiveness of due-diligence and post-credit supervision.
All organizations in business are exposed to credit risk. A firm supplying goods or services
_ on credit to its customers always faces the possibility of the customers not
Credit risk is the risk of
paying their full amounts on the due dates. However, their core area lies in
default by the counter-
party to a loan transac-
: making profit through the supply of goods and services, and credit is gener-
tion, and is different from _ ated only out of business necessity. Business organizations largely take mar-
market risk. ket risk and not credit risk. Credit risk primarily affects those who are mainly
in the business of providing credit and generating profit out of assuming
credit risk, such as banks and financial institutions.
Credit risk, as distinct from market risk, is concerned with default by counterparties in
loan transactions. There are ways of assessing market risk, but the same principles used in
measuring market risk cannot be applied to measure credit risk, as borrowers do not pay in
excess of what they owe. A trading portfolio may pay more than expected if the going is
good, while a loan portfolio never pays in excess ofthe interest promised and the principal
due. Therefore, returns from debt cannot be regarded as having a normal distribution. Fur-
ther, a debt is not traded as much as equity and is rather illiquid. A significant part of debt
is mobilized over the counter (OTC), as financial institutions and banks make loans that are
never traded, and, hence, there are no market prices available for loans and debt.
All individuals, firms, financial institutions, and governments can default on their com-
mitments. Credit risk arises out of some credit event, and, therefore, credit risk measurement
is a complex process. It is a function of (a) the probability of default, (b) the loss once the
default has occurred, i.e., loss given default (LGD), or (c) its opposite, the recovery rate.
One of the key determinants of credit risk is the rating. The ratings of bonds and firms are
based on the probability of default. The price of a bond is dependent upon the expected yield, its
maturity, and the default risk associated with rated bonds. Since treasury bonds are presuined
to be free from default risk, the yields on them would purely reflect on the expected returns
of the investors for the given maturity. If a bond trades with higher yields, then the differential
from the yield on treasury bonds can be attributed to default associated with the issuer.

PROBABILITY OF DEFAULT !
The first step to comprehend credit risk is the understanding of the probability of default. The
prices of bonds may throw some light on the probability of default.
The value of a bond issued by a firm when compared with the value of a correspond-
ing treasury bond must reflect the expected losses from the bond issued by the firm. For
ease of computation and understanding, let us deal with zero coupon bonds, called zeros.
Assume that a one-year zero coupon bond issued by ABC is trading at a yield of 6.30%,
552 Derivatives and Risk Management

while one-year treasury zeros are trading at a yield of 6%. To what factor do we associate
all
the difference in yield between the treasury zero and the corporate bond? Given that
other features are identical, the difference in yields of 0.30% must reflect on the ability/
inability of ABC to redeem the bond in a timely fashion. Therefore, the difference in yield
from a risk-free bond is on account of the default risk associated with the firm ABC.
What does the difference in value represent? It must represent the present value of the loss
expected due to a default in the period. The value of the one-year treasury
The probability of default
is factored into the prices. | Ze Coupon bond at 6% yield is 100 x e°° * | = %94.1765, and the value
of bonds. The difference _ of the one-year zeros issued by ABC at 6.30% is 100 * gt EAGER SS)
in price with a risk-free _ The difference in the values of the two, i.e., ¥0.2821, must be the present
bond represents the _ value ofthe loss expected due to default by ABC in one year. As the percent-
Hee . age of the value of the risk-free zeros, this corresponds to a probability of
oe ee
default.
Y default of 0.2996% (0.2821/94.1765) in one year.
a Similarly, if five-year treasury zeros trade at 7.50% and zero coupon bonds
issued by ABC are trading at 8.10%, the values would be %68.7289 and %66.6977, respec-
tively. The difference in value of =2.0312 represents the expected loss due to a default by
ABC over a period of five years, which is equivalent to a cumulative probability of 2.9954%
(2.0312/68.7289), expressed as a percentage of the value ofthe five-year risk-free zero.
The yields and values of zeros issued by the treasury and firm ABC are presented in
Table 20.1, for a period of 10 years. The difference in values represents the present value of
the expected loss till the end of the period. The difference as a percentage of the risk-free
zero is the cumulative probability of default till the end of the period.
From the values of the bonds, it may be said that the probability that ABC would default by
the end of the third year is 1.4889%. The difference in the cumulative probabilities of the two
periods represents the probability of default during the intervening periods. The probability

Table 20.1 Finding probability of default

Maturity Risk-free zeros Zero coupon bonds | Difference in Cumulative Probability of

of ABC value, probability of default in the
Value, zg default, year,
% % of risk-free % of risk-free
zeros ee zeros
1 6.00 94.1765 6.30 , 93.8943 0.2822 0.2997 0.2997
2 88.3380 87.6341 0.7039 0.7968 0.4971
3 6.50 82.2835 7.00 81.0584 1.2251 1.4889 0.6921
4 74.0818 | 1.7995 garth |. ane
5 7.50 68.7289 8.10 66.6977 2.0312 2.9554 0.5839
6 | 780 | 626254 | 850 | 60.0496 2.5758 4.1130
7 7.95 | 57.7238 | 865 | 54.5801 | 3.1437
8 7.90 53.1528 8.80 49.4603 | 3.6925 6.9470 1.5009
9 8.00 48.6752 9.00 44.4858 ane 8.6068 1.6598

[__io [320 | a4.oise | 990 | soassa | 45078 some 10.4166 18008

 Credit Risk, Securitization, and Credit Derivatives 553

"EXAMPLE 20.1 Expected loss and probability of default

Refer to the data presented in Table 20-1 and answer the following:
(a) What is the present value of the loss expected due to default by ABC by the end of year 6?
(b) What is the probability that ABC would default in the next six years?
(c) What is the probability of default by ABC in year 5?
(d) What is the probability of default between the third and the seventh years?
Solution
(a) The present value of the loss expected in the next six years due to default by ABC is the difference between the prices of |
the six-year risk-free zeros and the six-year zeros by ABC, i.e., 2.5758 (62.6254 - 60.0496) /
(b) The cumulative probability that ABC would default in the next six years is 4.1130%. L
(c) The probability that ABC would default in the fifth year is the difference between the cumulative probabilities of defaults in L
the fifth and the fourth year, i.e., 0.5839% (2.9554- 2.3715). :
(d) The probability of default between the third and the seventh years is the difference between the cumulative probabilities of |
default at the end of the seventh and the third iis i.e:, 3.9272%ade 4461 - a 1, AGED):

of default between | to 5 years is 2.9554 — 0.2997 = 2.6557%. The last column ofTable 20.1
is the probability of default in the year.
The data presented in Table 20.1 are valid only if we assume that in case of default, the
value of ABC’s bonds would be zero, i.e., the recovery rate is nil, and the loss is the entire
value of the bonds.
With some recovery rate (R) associated, the probabilities of the default and expected losses
would undergo a change. This may be seen from the following formulation.
Let r and r* be the yields on the risky and the risk-free zero coupon bonds, respectively,
for identical maturity periods, 7, and identical face values of %1.00. The values ofthe bonds
would be as follows:
Risky bond: 1.00 e 7
Risk-free bond: 1.00:e°2
If the probability of default before period 7 is P; and the risky bond has a value of R in
the case of default, then the expected value of the risky bond at maturity is
Under risk neutrality, the
present value of losses PR UL — 7) x 2.00
can be converted intothe =I the risk-neutral world, we can discount the expected value at maturity at
ee . See _ the risk-free rate to arrive at the present value of the bond. Therefore,
Present value of the bond = [P; x R+(1 — Py) x 1.00] x e"*?
The risk-neutral value must be equal to the present value of the bond. Hence,
(Peer ee (StF) si 00) Ye 1.00 e%
Solving for P;, we get
eee re ee aye
ie (20.1)
if oa ee
With recovery rate R = 0, Eq. 20.1 reduces to Eq. 20.2.
Prag lines Vat (20.2)
554 Derivatives and Risk Management

EXAMPLE 20.2 Probability of default and recovery rate

Using the data in Table 20-1 and Eqs 20.1 and 20.2, find out the following:

(a) The probability of default by firm ABC in five years (i) with no recovery, and (ii) with recovery of 50% in the case of default.
(b) The probability of default by firm ABC in 10 years (i) with no recovery, and (ii) with recovery of 30% in case of default.
Solution

(a) The probability of default is governed by the spread in yields over five years. The spread in the yields of the risk-free and
risky bonds is 8.1 - 7.5 = 0.6%. Therefore, using Eq. 20.2, the probability of default with no recovery is
Pr=1- e(l-P)T = 4 — 0.006 x 5

= 1 — 0.970446 = 0.029554 = 2.9554%

The probability of default with expected recovery of 50% using Eq. 20.1 would be.
Py = 2.9554/(1 - 0.5) = 5.9108%
(b) Similarly, the probability of default in ten years is governed by the spread in yields over 10 years. The spread in the yields :
of the risk-free and risky bonds is 9.3 - 8.2 = 1.1%. Therefore, using Eq. 20.2, the probability of default with no recovery is |
Pra et fee ee OlF710
= 1 — 0.895834 = 0.104166 = 10.4166%
The probability of default with expected recovery of 50% using Eq. 20.1 would be
Py= 10.4166/(1 - 0.3) = 14.8806%
LEE EEE EE,

From Eq. 20.2, we may infer that the probability of default is a function of the spread
in yields of the risky and the risk-free bonds, i.e., (x — r*), and not so much of the actual
absolute yields. Refer to Example 20.2.
The outcome in Example 20.2 is subject to some misleading interpretation. We observe
that the probability of default increased with an increased recovery rate. It is truly not so.
With an increasing recovery rate, the probability of default must decline. In the example,
we get increased probability of default with increased recovery rate because we assumed
that the price of the bond of ABC remains the same. With an increased recovery rate, the
value of the bond must increase, indicating a decreasing spread with the risk-free rate.
Despite the increased recovery, if the bond continues to sell for the same price, it implies
that the probability associated with default has indeed increased. For better understanding,
refer to Solved Problem SP 20.1 at the end ofthis chapter.

Recovery Rates
Recovery rate is the estimate of the face value that bondholders expect to receive after
a credit event such as bankruptcy, or restructuring. It is expressed as a percentage of the
face value. Generally, recovery rates are difficult to obtain. The recovery rate is dependent
on several factors. The most important of them are (a) the nature of priority of any claims
over the cash flows of the firm, and (b) the level/kind of security available. Secured debt
would have higher recovery rates in case of default due to the charge over the assets of the
firm, and, hence, would provide lesser returns commensurate with lesser risk.
The preceding section provided an overview of credit risk measurement. We made
extremely simplified assumptions such as (a) availability of the prices of zero coupon
bonds, which is rarely the case, as bonds issued by firms are not large in numbers, and
 Credit Risk, Securitization, and Credit Derivatives 555

most corporate bonds are coupon bearing; (b) default occurs only at the end of
periods,
whereas in practice defaults can take place at any time; (Cc) estimates of recovery
in the
case of default are known; again, a difficult condition to fulfil due to the
extended and
complicated legal procedures of liquidation and the resultant deterioration in the value
of
the assets over the intervening period of time between the default and the actual recovery,
impacting the claims and recovery rates.

Default Rates
One of the ways to assess default rates is to rely on some historical data on defaults. Rating
agencies monitoring firms over long periods of time collect data on defaults, upgrades,
and
downgrades periodically, which can prove to be an invaluable source in the understanding
of credit risk. Figures 20.1 and 20.2 provide the default rates of Indian firms and the his-
torical patterns, respectively, as compiled by CRISIL in their recent default study of 2011.

[ One-, Two-, and Three-year CDRs, between 1988 and 2011 7

CRISILAAA | 11846 0.00% 0.00% 0.00%

L CRISIL AA 24368 | 0.04% 0.40% | 1.09%
|CRISIL A - o5e04 | 0.82% | 350% | 766%
CRISILBBB | 29366 | 1.89% alia
534% 12.27%
CRISIL BB 22685 5.80% 12.52% 24.58%
Ze vie Te
\ CRISIL B | 11489 8.25%
pe 17.89%
L 37.90%
Total 127798 =|

Fig. 20.1 Trends in default rates

Trends in overall annual default rate

GO Agen. <ente, 2e:_ keene

—*@
eee re eee
Overall—CRISIL
ee Pigs rncan oan ee aes
—#—
een,
Overall—S&P
d ee ee wh soe
|

hoger”sa ae)
sy Yer 2)
a a
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 CN CN CN GNI 2007 2008 2009 2010 2011

Source: CRISIL rating

Fig. 20.2 Trends in default rates
556 Derivatives and Risk Management

The data have been compiled over a long period of time, and, therefore,
Historical data about
recovery rates and can be presumed to have incorporated all possible adverse market sce-
default rates canbe used narios. They cover a span of three years and a large number of firms. For
to arrive atthe potential © example, CRISIL A rated firms have defaulted to the extent of 0.82, 3.52,
Joss gue fo detaull and 7.66% in a period of one, two, and three years, respectively. These
ia ct le figures can serve as unbiased benchmarks for predicting the likelihood of
default by firms in the future, as the size of data and period of coverage are sufficiently
large. These historical default rates render objectivity to unbiased default rates. They
should serve as a better estimate than a subjective prediction of likelihood of default.

Transition Rates
Similarly, transition rates relate to the probability of the migration of firms from one rating
to another. In assessing credit risk, not only a default but also a downgrade of rating is a
credit event that throws light on the credit risk. Here again, the period of
Historical data about _ coverage and the size of data are sufficiently large to serve as reasonable
transition rates can be estimates for the probability of upgrade or downgrade to another rating. The
used to determine the transition matrix depicted in Figure 20.3 provides transition probabilities
probability of changes in over a period of one year, the usual horizon for assessing credit risk and
_ estimation of capital adequacy.

One-year average transition rates: between 1988 and 2011 :

Rating | Issuer- | CRISIL | CRISIL | CRISIL | CRISIL | CRISIL | CRISIL

months AAA AA BBB BB B c D 7
CRISIL AAA | 11846 3.21% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% |

CRISIL AA 24368 1.77% 91.87% 5.27% 0.72% 0.26% 0.05% 0.03%

CRISIL A 25694 0.00% 4.00% 85.71% 6.02% 2.84% 0.20% 0.41%

CRISILBBB | 29366 0.00% 0.15% 3,95% [35.78% 6.69% 0.89% 0.65%

CRISIL BB 22685 0.00% 0.11% 0.00% 4.29% 84.58% 3,65% 1.57%

CRISIL B 11489 000% | 0.00% |. 0.05% 0.24% 10.00% 80.43% 1.03% 8.25%
CRISIL C 2350 0.00% 0.00% 0.00% 0.51% 2.47% 15.45% e02zi% | 21 36%
Total 127798 i
A transition rate measures the probability of a change in credit rating over a specified period. Transition rates can be calculated for the entire rated population, or can
refer to a specified rating level.
EERE eseteae eae eteen Beta eee eae Re tees oooaneson ne ataatenat ates

Source: CRISIL Default Study 2011

Fig. 20.3 One-year average transition rates

CREDIT VaR 2
One measure of default or credit risk is the credit spread, i.e., the excess of return over the
risk-free rate. It is instrument specific. In a portfolio of financial securities or loans, the
concern for financial institutions is to examine their ability to meet the risk of default by
providing for a given level of losses through capital adequacy.
 Credit Risk, Securitization, and Credit Derivatives 557

One measure is the credit VaR, i.e., the value of the loss associated with a portfolio of
credit instruments/loans. It is similar to the VaR discussed earlier in Chapter 14. It reflects
the losses over a given period of time for a portfolio of loans or bonds with a certain level of
confidence desired. The losses are not taken into consideration when the bond defaults, but
any deterioration in the value of the loan/bond too is considered while finding the credit VaR.
The rating of loan/bond determines its value and the profit or loss from its current value.
However, the rating of instruments or firms takes place after the event causing deterioration
has taken place. There seems to be no way other than to rely on the historical data about migra-
tion of ratings of a firm over the risk horizon. The usual period of consideration in computing
credit VaR is one year, rather than the few days used for a portfolio of investment assets.
Credit risk is concerned with the deterioration of the quality of assets over time. Surveil-
lance by rating agencies is done to monitor upgrades and downgrades of firms. Credit migra-
tion analyses the probability of moving from one credit rating to another, including default
within a time, usually a year. This may be used as one of the inputs for the determination of
VaR for a credit portfolio.
The credit migration approach computes the forward distribution of values that an asset
_ can take over one year, where changes are related to credit migration alone.
Credit VaR is a com-
prehensive measure
_ Since credit risk can have its source in market risk, we must also capture
of credit risk that helps _ market risk while assessing credit risk. It must be noted that the cause is
plan capital adequacy to irrelevant, but the fact that a downgrade has taken place is relevant.
absorb potential losses. The best way to highlight the determination of credit VaR is by way of an
~ example. For the purpose of illustration, we find the credit VaR on a single
asset or a bond with a maturity of five years and an annual coupon of 15%, redeemable at
par value of %100; the asset is presently rated as CRISIL A.
Transition Matrix The transition matrix serves the purpose of assessing the probability of
moving from one credit rating to another, including default. Based on the historical data in
the transition matrix shown in Fig. 20.3, the probabilities of a CRISIL A-rated bond moving
to another rating or remaining in the same rating over the next one year is as follows:

% | AAA AA | A | BBB OB ee 6 |
A : 4.00 | 85.71] 6.02 204 | 0.20 | o4t | |
0.82
The table shows that an 4-rated bond has an 85.71% chance of remaining in the same
rating after a year; it has a 4% chance of being upgraded to AA, and no chance of being
upgraded two notches above to 444. Similarly, it has a chance of 6.02% of being downgraded
to BBB.
Forward Rates After knowing the probabilities for upgrades and downgrades, we need to
one
know the likely values of the bond after the end of the horizon of the VaR period, 1.e.,
year. The values are required for different grades of ratings after one year.
How do we know what value the bond would have one year from now? The present yield
are
curve helps to forecast future yields. The values of forward yields may be derived, and
called forward rates, as implied in the prices of zeros today. This is dependent upon the rating
of the instrument. We use the forward zero curve to find the forward value of the bond under
as
various rating scenarios. Assume that the forward rates for various graded instruments are
given in Table 20.2.
Derivatives and Risk Management

Table 20.2 Forward interest rates for bonds with different ratings

% 1-year 2-year ‘| 3year 4-year

AAA 360 | 427 4.73 5.12
AA 3.65 4.20 4,78 5.17
A 3,72 4.32 4.93 5.32
BBB 4.10 4.67 5.25 5.63
BB 5.55 6.02 | 6.78 7.27
B 6.05 7.02 8.03 g52 |
ccc [44.03 13.52 |
Revalue bond From the forward rates, we find the value of the bond as seen today. It would
depend upon the likely rating after one year. Assuming that the rating of the bond remains
the same at 4, the value of the bond after one year would be arrived at by discounting the
remaining cash flows at the appropriate discount rates from Table 20.2. The forward value of
the bond, if it stays in the same rating of A, comes to $149.70, as given in Table 20.3.

Table 20.3 One-year forward value of a bond rated A

iYear
Cash flow, =
1
15.00
oe:
15.00
et 3
15.00
4
15.00
——— ——

Discount rate for a rated bond, % oe 4 32

=
Present Value, = ‘Sonam RES 13.7834 12.9835 93.4662
Forward value of bond after 1 year, =

However, if the rating undergoes a change during the year, the value of the bond too would
change. We can arrive at this value today using forward rates applicable to the rating as dis-
count rates on the cash flows ofthe bond. Using the forward rates given in Table 20.2 for the
respective ratings, we can find the value of the bond upon migration in the same manner as
done in Table 20.3. The values of the bond with different ratings are shown in Table 20.4.

Table 20.4 Forward value of bond with different ratings ce

New Tes Present values of cash flows at forward fates Value |
rating ae 9 3 4 5 of bond
oa ec a

AAA 15.0000 | 14.4788 | 13.7966 | 13.0580 |94.1795 | 150.51

AA 15.0000 |
14.4718 |13.8099 |13.0394 |94,0008 |150.32_|
A 15.0000 | 14.4620 | 13.7834 | 12.9835 |93.4662 | 149.70
BBB 15.0000 | 14.4092 | 13.6914 | 12.8654 | 92.3738 | 148.34
BB 15.0000 | 14.2113 | 13.3449 | 12.3203 | 86.8530 | 141.73
B 15.0000 | 14.1443 | 13.0967 | 11.8976 |82.9199 | 137.06
C [1 5.0000 | 13.0378 | 11.3382 | 10.1166 | 69.2482 | 118.74
| Default Assumed recovery at 54% of face value 54.00
ssecccoasc
 Credit Risk, Securitization, and Credit Derivatives 559

The value of the bond is most difficult to work out in case of a default, as no discount rates
can be visualized and recovery varies from case to case. Estimating market
Transition matrices, for-
ward rates, and recovery
_ value is almost impossible, as there is no market for such assets. The recovery
_ rate is dependent upon (a) the seniority of the claim and (b) the security avail-
rates are crucial inputs to
find the credit VaR. able. It becomes increasingly difficult to assess recovery as time elapses, as the
process of recovery is prolonged and stretched. Again, one would rely on past
data to get an idea of the recovery in case of default. Based on recoveries made in the past, one
can estimate the present recovery. Historical data serve as another input here. For illustration,
it is assumed that in case of default, a recovery of 54% of the face value can be made.
With the value of the asset computed and the probabilities of ratings known, we may com-
pute the expected value and standard deviation of the bond value to get an idea of the credit
risk involved. The expected value is $148.48 and the standard deviation is 78.93, as shown
in Table 20.5.

Table 20.5 Mean and variance of bond value

New atng. | Value, < Probability % Expected value, < Variance

AAA 150.51 0.00 0 0

AA 150.32 4.00 6.0128 a 0.1355

A 149.70 85.71 128.3079 1.2765

BBB 148.34 6.02 8.9301 So 0.0012

BB 141.73 2.84 4.0251 te.wll 1.2938
B 137.06 0.20 0.2741 0.2608
coc 118.74 0.41 0.4868 3.6262

Expected value, < 148.4796 |

Variance | 79.7905 |
Standard deviation, Z 8.93 '

Table 20.6 Computing credit value at risk

Probabilty,%. | sropatitty.se | YMG | srmeetedvaluest |

0.00 0.00 150.51 2.03 ;
4.00 4.00 150.32 1.84 L
85.71 89.71 149.70 1.22
6.02 (eas 95.73 148.34 -0.14
2.84 98.57 141.73 -6.75
0.20 98.77 137.06 ~11.42 One-year $9.18%
0.44 99.18 118.74 ile -29.74 confidence
ee 100.00 54.00 TE
94.48 cea (aR 50.4
560 Derivatives and Risk Management

We can now get the credit VaR for the confidence level desired by computing the deviation
from the expected value. For example, if we need a 99% confidence level, then the expected
loss that does not exceed 1% oftime would provide the required figure. A 99.18% one-year
credit VaR is found to be 29.74, as shown in Table 20.6

The latest forms of derivatives that have surfaced and have gained prominence are credit
derivatives. They are devised to cover the risks that are inherent in credit.
Acredit derivative isan ora ; ; :
_ Credit is the essence of modern society, as it enables increased consumption
instrument whose value : .
is dependent upon the over and above what the current income can provide. Thus, with a growing
credit risk of the underly. economy, credit essentially has to grow. Banks perform the function of moving
ing asset. funds from those with surplus capital to those wanting capital. In the discharge
of this function, banks create exposures to their operations. These exposures
contain market risks (predominantly, interest rate risk) and default risk. Default risk is referred
to as credit risk. Similarly, firms too borrow from the capital market by issuing debt instru-
ments called bonds, and investors hold these bonds in anticipation of good return. Besides
market risk, these investors are exposed also to the credit risk inasmuch as the promised pay-
ment of coupons and/or principal may not fructify as per the terms and conditions agreed upon.
Credit derivatives largely remain products confined to the banking sector, which has expo-
sures to various kinds of loans, and, therefore, faces the inherent risk of default or rapid
deterioration in value of these loans. Banks advance these loans to earn a reasonable rate
of return. The reward for assuming credit risk is built-in loan pricing. Credit derivatives are
instruments that provide a hedge against credit risk by segregating the risk premium for credit
risk from the overall pricing. Credit derivatives are also used by large mutual funds, as they
may have made a sizable proportion of their investments in corporate bonds.
Actual default may take place directly or be preceded by some events that signify a gloomy
future. The events that signify a default could be downgrading of the firms and the bonds
issued by them, bankruptcy, etc. The banks face the risk of default on these loans or receiv-
ables. The defaults may be a result of delinquency, losses, failing economies, adverse move-
ment ofinterest rates and exchange rates, etc. At times, such risks may become exceedingly
high for the banks, and they may feel the need to transfer such risks to those willing to take
them in exchange for returns commensurate with the risks.
Credit derivatives came into existence around 1993-1994. As the volumes grow, these
credit derivatives allow participants to increase trade on financial instruments such as loans to
enterprises or the value offirms based on their credit risks. However, credit derivatives remain
OTC products, where the specific needs of participants may be matched in the contract, which
derives its value on the basis ofthe credit-based value of the underlying exposures.

CREDIT DERIVATIVE
Credit derivatives are _ We may broadly define a credit derivative as an asset whose returns are
instruments Lae '0 determined by its credit risk, as assessed by the credit rating or any other
ane ee ous such indicator. The definition of a credit derivative is not easy to find. The
 Credit Risk, Securitization, and Credit Derivatives 561

reason would lie in the fact that there could hardly be any other instrument whose value
depends exclusively on its credibility. One definition is that credit derivative is a class of
financial instruments, the value of which is derived from an underlying market value driven
by the credit risk ofprivate or government entities other than the counterparties to the credit
derivative transaction itself:!
We know that the value of financial instruments depends upon several factors. For exam-
ple, corporate bonds issued by two different firms do not provide the same yield even if all the
conditions and cash flows of the bonds are identical. These yields are expected to compensate
the investor for the various kinds of risk he/she takes. The yields on different bonds can be
viewed as rewards for investment in the risk-free asset and as rewards for taking up credit
risk. The difference in the yields of any two bonds is attributable to the difference in the risk
profiles of the firms issuing those bonds. Yield in excess of the risk-free rate of return is the
reward for taking up credit risk on the bond or on the entity that has issued the bond. Credit
risk primarily refers to the possibility that the bond would not pay its promised cash flow. A
credit derivative would then be an instrument that would derive its value from the spread of the
yield over and above the risk-free rate, rather than from the absolute yield on the instrument.
Normally, credit risk is embedded in the returns. We need to segregate the returns attribut-
able to credit risk from the returns on investment and those bearing other risks. Credit deriva-
tives perform the function of separation and isolation of credit risk, facilitating trading with
the purpose of (a) replicating, (b) transferring, and (c) hedging credit risk. Credit becomes a
separate dimension, where any reward predominantly is a function of credit risk alone.
When an investor acquires an asset, he/she takes up all the risk associated with the asset,
including its credit risk. With credit derivatives, it is feasible to acquire the
Credit derivatives permit pi ; as : say
:
gaining exposure without
_ credit risk without acquiring the asset. This requires replication and transfer
(a) origination, (b) fund- _ of the credit risk. This enables hedging against the credit risk. For a firm
ing, and(c)necessary + assuming a risk, credit derivatives offer many advantages, such as gaining
credit administration _ exposure without (a) originating the asset, (b) locking-in funds, and (c)
_ requiring any kind of credit administration and supervision infrastructure.

Types of Credit Risks

The risk that is covered by the credit derivative instrument is the default risk, offering credit-
related returns. Banks advancing loans to firms face this risk on the asset side of their balance
sheets. All assets are not equally prone to default; some are more prone and some are less
prone. The sub-prime crisis in 2008 is an example of default on the loans made by various
borrowers, where a certain class of borrowers failed to honour the committed repayments.
Likewise, firms also borrow by issuing instruments in the shape of bonds, whereby they com-
mit to pay a coupon value as well as the initial investment on the due dates to the investors. The
cash flows of the firm may deteriorate, causing a default on committed payments. The default
would normally be preceded by a progressive decline in the market values of the instruments.

Credit Risk from Rating All popular instruments of debt are normally subjected to peri-
odic evaluation by independent agencies, called rating firms, with regard to the safety of

\Das, Satyajit, Credit Derivatives, CDOs, and Structured Credit Products, Wiley Finance, 3rd Edition, John Wiley & Sons
(Asia) Pte Ltd, 2005.
562 _—Derivatives and Risk Management

investments. The assessment is generally made in terms of the repayment obligations of a

firm relative to its cash-generating capacity. With time, the cash-generating capacity of the
firm is subject to change. A deteriorating cash flow of the firm results in the downgrading
of the debt instruments or the firm itself. This type of downgrading is normally referred
to as a credit event. A credit derivative instrument may cover such credit events. Similarly,
bankruptcy is another such credit event that could govern the payoff of credit derivative
instruments.
The return on debt instruments is supposed to cover the risk of default as well as the
downgrade. With each downgrade, the market value of the debt instrument declines. Since
low-rated bonds offer substantially higher returns, investment in such assets is a lucrative
proposition because if the investment is upgraded the returns would become phenomenal.
However, when the risk in the instruments exceeds the risk appetite, the investor may like to
prevent excess losses and look for transfer of the risk. Such a transfer could be achieved with
a tailor-made derivative product whose payoff is dependent upon the specified credit events
actually coming to pass.

Credit Risk from [liquidity Unlike corporate bonds, bank loans are not traded and are
subject to credit rating. The risk of default is normally covered in the appraisal process of the
Credit derivatives enable _ bank when they decide the pricing of the loan. Since a loan is reviewed peri-
passing the credit risk of _ odically, it is analogous to the rating review and an increase in the interest
an asset to a third party. rate is analogous to a downgrade of the loan. However, due to the availability
of collateral, the credit risk in bank loans can be considered to be less in
intensity than that associated with bonds issued by firms.
Market Risk and Credit Risk Credit risk in the case of corporate bonds or bank loans
is somewhat different from the risk faced by investors in stocks or bonds that are traded in
larger volumes on a daily basis. Returns on such assets are normally distributed, whereas
returns on credit seem to have larger tails than what they would have if the returns were
normally distributed.” The downside tail in the returns represents a larger probability of a
downside risk.

CREDIT DEFAULT SWAPS "9%

There are broadly two kinds of credit derivatives—funded and unfunded. In an unfunded
credit derivative, the returns are commensurate with credit risk, which is replicated without
acquiring the risky asset. In a funded derivative, there would be part or whole funding of the
asset bearing credit risk.
An unfunded credit derivative permits an investor to replicate the returns of a financial
instrument, a portfolio of assets, or an entity, without directly engaging in the underlying trans-
action of advancing a loan or making an investment in bonds. Under a credit derivative trans-
action, the loan or the investment in the portfolio of risky assets continues to remain with
the
original investor, while the credit risk stands transferred to another party. It is pertinent
to add
here that to engage in the trade of credit derivatives, it is not necessary that either party
has a
“Anson, Mark J. P., Frank J. Fibozzi, Moorad Choudhry, and Ren-Raw Chen, Credit
Derivatives—Instruments, Applications,
and Pricing by, John Wiley & Sons, Inc., 2004, p. 15.
 Credit Risk, Securitization, and Credit Derivatives 563

credit risk exposure, in the same manner that one need not hold the asset while buying a put
option. One can trade a put or a call option with or without a position on the underlying asset.
Probably a credit default swap (CDS) is the only instrument whose payoff is purely gov-
_ erned by events signifying the credit risk. It is the most popular credit deriva-
The a GD
CDSisan arrange
an arenue . tive. CDS is an OTC product contracted between two counterparties—one,
-ment where aprotection _ é ’ 3
buyer pays a periodic called the protection buyer, needing protection against default on an asset or
premium for compensa- an entity (referred to as the reference asset or entity) and the counterparty,
tion of the potential loss called the protection seller, who provides protection for a specified period
from default. _ against the happening of a specified credit event in exchange for receiving a
periodic premium. The pricing of the loan includes the market risk premium
as well as the credit risk premium. Can the credit risk be segregated and traded? Credit default
swaps achieve precisely this. Figure 20.4 depicts a plain vanilla CDS.

Premium

Protection buyer Payment contingent on default Protection seller

of reference obligation/entity

Reference entity or
reference obligation
Dotted lines represent contingent payments

Fig. 20.4 Credit default swap

For example, a bank may have advanced a loan to a corporate entity or may be holding
the bonds of a company, called the reference entity or reference obligation. The loan may be
defaulted, or the bond may deteriorate in value. The bank, the protection buyer, may require
protection/ insurance against credit risk. The protection seller undertakes to compensate the
protection buyer in the event of the happening of a particular event (called the credit event).
It is a de facto insurance for the protection buyer against deterioration in the value of the
asset. The protection buyer passes the credit risk to the protection seller for a fee.
Besides the protection buyer and the protection seller, there is a third party involved in
the CDS, called the reference entity. The reference entity may be a corporate availing a loan,
whose quality is monitored regularly; when its ability to pay back the obligation is jeopar-
dized, the protection seller pays off the protection buyer.

Cash Flows of CDS

A CDS is depicted in Fig. 20.4. Note that while the protection buyer pays a regular premium,
the protection seller makes payment only upon the happening of specific credit events. The
protection payment is typically made in arrears. The premium payment is quoted as a percent-
age, on per annum basis, of the notional principal. For example, if the payment is 240 bps,
it implies a payment of 60 bps every quarter. If fee payments are in arrears, there would be
an accrual payment at the time of the default event. For example, in a CDS involving annual
payment, if default takes place after three years and four months, then the protection buyer
564 Derivatives and Risk Management

would have to pay for the four months (after having paid three annual instalments till then)
on a pro-rata basis.
If no event related to a default occurs during the contract period, no cash flow accrues to
the protection buyer. The liability of the protection seller is contingent. It is
The obligations of a a kind of option to swap the credit asset if there is a default. The option can
protection seller are con-
be exercised only when a default occurs, unlike options on financial assets.
tingent upon the defined
default events actually . Even though the payoff on a CDS is asymmetric and resembles that of
coming to pass. _ options, it is called a swap for the reason that the payoff does not conform
to the characteristics of that on an option. It resembles the swap to a larger
degree. In a swap, one party pays at a fixed rate while receiving a floating rate. The option
premium depends upon the price of the underlying asset. A CDS has an asymmetric payoff,
but its price performance is more like a swap than an option. When a risky bond is the under-
lying asset, the risk-free rate and the credit spread over it determine the value of the bond.
In the case of a CDS, the change in the spread directly affects the price of the transaction,
rather than the price of the bond.
Credit/Default Events The performance of a reference entity is tied to the credit event.
Under a CDS, the events under which the protection seller would compensate the buyer are
spelt out beforehand. These events are normally downgrades, bankruptcies, mergers, and
restructuring of the reference entity/obligation. Upon the occurrence of the default event,
the premium stops.

Settlement of CDS
A CDS concludes on its scheduled termination date or on the happening of the credit event,
whichever is earlier. If the period of swap ends without a credit event happening, there is no
payment from the protection seller to the protection buyer. The premium too ceases to exist.
However, if the credit event occurs, then settlement can take place either in the cash mode
or in the physical mode.
Cash Settlement Under the cash settlement mode, the protection payment is settled in
cash. The value is the difference between the nominal value of the reference
Under a cash settlement
the asset remains with
obligation and its market value at the time of the credit event. The market
the protection buyer, with value of the reference obligation when the credit event happens is extremely
any loss compensated by difficult to ascertain. Normally, an agent, called a calculation agent, is
the protection seller. appointed to calculate the value. Since the value of the asset at the time of
default is likely to be extremely volatile, irrespective of the method of valu-
ation, one may appoint several independent and impartial agents. When the credit event
occurs, the asset may be subjected to extraordinary changes in value, making fair assessment
of value difficult. Usually, a cooling-off period (the time between the credit event and the
actual valuation date, usually about three months) is provided to allow for aberrations in
valuation to settle down and for a rational price of the asset to emerge. A swap that fixes the
amount in case of default irrespective of the assessment of actual loss is called a binary swap.
Under cash settlement, the underlying asset remains with the protection buyer. The protec-
tion seller pays the difference between the face value and the value of the deliverable asset,
as determined by a calculation agent.
 — Credit Risk, Securitization, and Credit Derivatives 565

Greek swap deal classified as ‘Credit Event’

On 9 March 2012, thefinance ministers of 17 Eurozone member nations released the second bailout package of €35 billion to
debt-ridden Greece after the Greek government achieved a landmark deal with its private creditors on a swap that implied a more
than 50% reduction in its debt to them of €107 billion.
The Greek government successfully entered a pact with its lenders, who subscribed to government bonds to write down 53%
of their claims in nominal terms and 74% in real terms by exchanging their bonds with new ones with (a) lesser value, (b) longer
maturity, and (c) lower interest rates. The Eurozone was highly appreciative of the participation by banks, insurance companies,
and other private investors in restructuring Greek debt. Since Greece fulfilled the conditions laid down by the troika—the IMF,
the ECB, and the European Commission—it became eligible for receiving a second bailout package of €130 billion. Remember
that the Greece bond exchange is a package deal with three parts. For every old bond tendered, the holder gets (a) a new Greek
bond, (b) new EFSF (European Finance Stability Fund) bonds, and (c) new warrants linked to the GDP of Greece.
By 8 March 2012, the last date for exchange of debts, bondholders tendered Greek-law bonds worth €152 billion (about86% of
the total) and other foreign law bonds worth €20 billion (about 69%). This enabled the Greek government to activate a collective
action clause (CAC) to achieve full participation, whereby those who did not participate in the debt swap deal would be forced to
tender their old debt instruments for the new ones..
Greece is activating its CACs, and, thus, there will be a credit event for the purposes of its CDSs—as there should be. If one
sold protection on Greek bonds, then he will end up having to pay out roughly 75 cents on the dollar. However, given where the
CDSs have been trading of late, one has almost certainly put up that much money in margins already. So there was nothing
unexpected here, and there will not be any nasty surprises on the CDS front.
Due to the activation of the CAC, the International Swaps and Derivatives Association (ISDA) classified the debt swap deal as
a ‘credit event’, triggering insurance payments likely to run into billions of dollars. Losses on the bonds would have to be paid out
under CDSs. The payment of CDSs is likely to destabilize the financial institutions who sold the credit protection. Recall that in
the past, after 2008 financial crisis, the insurance giant American Insurance Group had to be bailed out by the US government
after it could not meet obligations under CDSs on mortgage debts in the US property markets.

Source: Reuters, Business Standard, and Business Line.

Physical Settlement Under the physical settlement mode, the protection buyer delivers the
asset to the seller in exchange for the nominal value of the swap. In case the
Under
aphysical sette- =©CDS has been entered into with respect to a firm (a reference entity) rather
ie a ae __ than a specific instrument (a reference obligation) and in the event physical
sellerat face value. _ settlement has been agreed upon, the contracts would specify the deliver-
vem ables. If the value of the CDS is a notional %10 crore, then the protection
buyer would deliver acceptable assets with a face value of 10 crore and receive cash from
the protection seller.
Physical settlement obviates the need for determining the market value of the reference
obligation but forces another decision. The protection buyer would have to determine the
cheapest-to-deliver instruments if the CDS is on a reference entity. The deliverable instru-
ments must meet the requirement of seniority and maturity. This situation is similar to that of
futures contracts on T-bonds, where the seller has the option to decide which bonds to deliver.
Under physicai settlement, the asset goes into the hands of the protection seller, who
stands to gain in case the value of the asset increases subsequent to the credit event.
Exhibit 20.1 depicts the standard CDS structure, the associated cash flows and the modes
of settlement.
 566 Derivatives and Risk Management

EXHIBIT 20.1 A credit default swap and its cash flows

Premium
Protection
seller

' Continge payment

2 upondetault

CDS structure

| Payment by
| protection buyer

Assumed cash settlement

Cash settlement
The protection seller and the protection buyer appoint a calculation agent to value the asset.
The protection seller pays the difference between the notional and the market”
value at the time of the credit default event. If the market value is °400, the protection
payment of 600 is made.
Physical settlement
i) _| The protection buyer delivers the asset and receives ‘1000. The protection seller acquires
yyYs the
— vs asset and may sell it at its market value.

Variants of CDS
As the CDS is an OTC product, the terms and conditions of the swap
are mutually decided
upon by the contracting parties. Besides the standard CDS just
discussed, there are many
variants available. Some of these are as follows:

Digital CDS Under a CDS cash settlement, the assessment of market value is indeed
dif-
ficult to make. This leads to uncertainty over the payoff in case of
default. In a digital CDs:
 Credit Risk, Securitization, and Credit Derivatives 567

the value of the payoff is fixed, eliminating the need for calculating the market value of the
asset under a default situation.
Basket CDS_ The standard CDS depicted in Exhibit 20.1 was for a single asset. Where
the protection buyer is looking for protection on a portfolio (holding several bonds or
covering exposure on them), the reference entities would be many. Such a CDS is called
a basket CDS, where the protection payment is made in the event of any of the reference
entities defaulting. The CDS terminates upon the first default. A portfolio of loans or
bonds is viewed as a bundle of credit risk. This portfolio carries the risk that some of the
loans would be defaulted upon, or there is deterioration in value, as signified by a rating
downgrade. The banks or investors in the bonds may bundle them in different tranches,
representing different classes of credit risk. Such a product would be a basket credit
derivative.
Portfolio CDS A basket CDS comes to an end with the first default. Under a portfolio
CDS, many assets are covered but the CDS continues even after the first default. A portfolio
CDS covers a pre-specified sum and till the total represented by all defaults matches this
amount, the CDS continues to be valid.

Applications of CDS
CDS can be viewed in many ways. Some of the uses of CDS are mentioned here.

CDS and Insurance The payment made by the protection seller in case a default event
occurs is called the protection payment. This is similar to an insurance con-
Under CDS, the hap- :
pening of an event éis _ tract. The difference between an insurance contract and a CDS is that under
sufficient reason fora _ the former, a loss that can be ascertained must actually have been incurred,
claim, unlike insurance, and compensation is paid only to the extent of that loss, whereas under a
where the loss needsto § (CDS, the mere happening of the credit event is a sufficient cause for the
Anne _ protection payment to be made; the actual suffering of a loss is immaterial.
CDS and Financial Guarantee Credit derivatives allow hedging with a third party, with-
out the reference obligation performing any role in the transaction. This enables the creditor
to transfer the credit risk without letting the debtor know of it. This is a major difference
between a CDS and a financial guarantee, as the former is bilateral, while the latter is nor-
mally trilateral.

Income Generation for Protection Seller While the protection buyer has insured himself
against any default, the protection seller in a CDS has a synthetic position on the reference
obligation, say a bond. It has, in effect, created a position on the reference asset or entity
without actually owning it. The protection seller has not funded the asset or loan, and yet
receives a return in the form of a premium that is determined on the basis of the credit per-
formance. With respect to default, the protection seller has synthesized the reference asset.
Should there be no default, the protection seller pockets the premium. The motivation for a
protection seller is yield enhancement without increase in financial exposure, similar to of the
motivation for an option writer. Even if a default occurs, the protection seller would acquire
the asset (in case of physical settlement), and hopes to gain in the future from an improved
position of the defaulted asset.
568 Derivatives and Risk Management

Risk-free Position for Protection Buyer The CDS enables a risk-free position for the
protection buyer. Assume an investor has a portfolio of corporate bonds providing, say, 200
bps over risk-free bonds. By entering a CDS to protect against default, the investor may make
200 bps as protection payment. Post the CDS, the investor would earn a risk-free return. By
entering into the CDS, the investor obviated the need for changing his portfolio. He also
gets protection for the desired time. For example, if the portfolio matures in seven years and
doubts about the default are limited up to three years, then the investor can enter a CDS for
three years. Here, the investor would earn risk-free returns for three years and get normal
expected returns for the remaining period.

Diversification of Risk for Buyer and Seller Another interesting application of the CDS is
that it helps achieve diversification. Assume a situation involving two coun-
he terparties that are banks, each involved in specialized financing. One bank
by providing returns and —- does agricultural loans, and the other concentrates on the automobile sector.
exposure to different _ Bank A, which advances farm loans, faces default risk emanating primarily
sectors. from weather conditions. Bank B, which concentrates on auto loans, faces
inti default risk that primarily emanates from economic conditions. Both the
banks can trade their risks by entering into two independent CDSs: (a) Bank A pays a premium
to Bank B for defaults on farm loans and (b) bank B pays a premium to Bank A for default
of auto loans. Thus, with the differential of the premium for the two defaults, both banks can
diversify their credit risks in both the agricultural and the automobile sectors, without either
having to resort to the costly proposition of actual lending in the other’s sector. Besides funds,
the lending to specific sectors requires specialized domain knowledge, acquiring which is
doubtful and time consuming. The synthetic positions of both the banks created by way of
CDSs help achieve safe and rather instantaneous diversification of credit risk at little cost.
Both the banks get the benefits of each other’s expertise in their respective specific fields.

VALUATION OF CREDIT DEFAULT SWAP—MERTON MODEL

One of the most popular methods to price credit risk is the Merton model. It is a model to value
Theyauationtecps |debt with the option pricing model developed by Black and Scholes. It is con-
can be done on the _sidered a structural model, where a firm is replicated in the economic structure.
basis of the option pricing It assumes that a firm defaults when the value of the firm drops to a certain
theory, using the BSM. level, called the default value. For the Merton model, it is necessary to value
the assets and for that reason, it is also referred to as the asset value model.
The underlying idea behind Merton’s model for default on debt by firms is that
a firm
defaults if the value of its assets falls below the value of its debt. The first step in
the process
is the valuation of its assets and liabilities. For ease of comprehension and
expression, we
divide the balance sheet into three elements—equity and debt on one side and
assets on the
other side. Both equity and debt holders have claims on the asset of the firms,
though the
nature of their claims are significantly different.
From accounting, we know that the value of assets and liabilities must be equal
for a bal-
ance sheet to balance. However, Merton speaks of economic values and not
asset values. The
book value needs to be replaced by economic/market values. For a traded firm,
the value of
its equity is easy to obtain. When traded, the value of debt can also be obtained.
However,
 Credit Risk, Securitization, and Credit Derivatives 569

Derivatives in Practice
What do CDS rates mean?
Credit default swap rates are good proxies to understand risk perception and investor appetite for the underlying asset, called
reference entity in CDS parlance.
On 4 October 2011 Moody's downgraded the state-owned State Bank of India (SBI), the largest Indian bank, from C- to D+
due to (a) increased concerns about its mounting proportions of NPAs in its lending portfolio, and (b) inadequacy of Tier | capital.
The ratings of its competitors from the private sector, such as HDFC Bank, ICICI Bank, and Axis Bank remained unchanged. In
the April-June quarter of 2011, the bank had a Tier | capital adequacy ratio of 7.60%, which was lower than the other top local
lenders such as ICICI Bank Ltd, HDFC Bank Ltd, and Axis Bank Ltd.
As per Moody’s, a rating of D implies “modest intrinsic financial strength, potentially requiring some outside support at times”,
while a C rating denotes “adequate intrinsic financial strength’.
Global investors seem to have shared Moody’s concerns about SBI. This is indicated by the rise in CDS rates for investments
in SBI paper. SBI’s five-year CDS rate rose 91% since August 2011. CDS rates for SBI paper widened from 189 basis points in
early August 2011 to 363 basis points on 4 October 2011, as per Bloomberg.
These rates seem to indicate that SBI would have to face a higher cost of borrowing for future funding plans. Interestingly, the
CDS rates on ICICI Bank have also doubled from 238 basis points to 468 basis points during the same period.
In line with the increasing CDS rates, Moody’s downgraded the outlook on India’s banking sector to ‘negative’ from ‘stable’ on
9 November 2011.

Source: Based on a report in the Business Line, 5 October 2011.

the assets of the firm, such as land and building, plant and machinery, loans, creditors, and
debtors are never traded, and it is impossible to find the true economic value of the firm’s
assets in the market place.
The principle of the claims of equity and debt holders 1s that any deterioration in the value
of assets is first absorbed by the equity holders. The equity holders are owners of the residual.
Till such time the drop in value is less than the value of equity, the claim of debt holders does
not get affected. In this context, Merton views debt and equity as options, discussed in a
subsequent chapter.
If the value of the equity is E, the face value of debt is D, and the value of
Oe cas. _ assets is A, then the equity has a payoff of Max (0, A — D) which is a call
viewed as a call option, option with a strike price of D. The debt has a payoff of Min (4, D). This
while debt is seen as a does not correspond to the payoff on any standard option. However, it is a
combination ofabond = combination of a bond that pays the face value of the debt at maturity and a
ane eet ie ie short put with an exercise price of D. It may be seen as below:

— eae Long bond Short put Total 2

A<D | D | -(D-A) Age os
| A>D | eh = oF ae!
The payoffs on the equity and debt of a firm are depicted in Fig. 20.5. The values of the
call and the put would be given by the Black-Scholes Model (BSM) for a non-dividend pay-
ing stock, as described in Eqs 12.25 and 12.26, reproduced here for convenience.
Let us now value debt under the Merton model under the simplified circumstances of a
firm. Let us assume the following values:
570 ‘Derivatives and Risk Management

Till the value of the assets, A, is If the asset value, A, exceeds the
below the level of the debt, D, the value of the debt, D, the payoff to
equity holders do not have any the debt holders is D. They get no
payoff -more than the value of the debt

When the value of the assets, A, If the value of the assets, A, falls
exceeds the value of the debt, below the value of the debt, D, all
D, the excess of A over D is the assets go to satisfy the claims of
.payoff for equity .debt. The shorfall is D- A

i a

Fig. 20.5 Debt and equity as options

Value of assets, A = ~100

Face value of debt, D = %60
Volatility of asset price = 20%
Time to maturity, 7 =) eats
Risk-free rate, r = 3%
In the context of the BSM, the spot price, S, is the value of the assets, 4, while
the exercise
Equity anddebtthatare
price, X, is the value of the debt, D. Volatility would be equal to the asset
° . : : .
considered as options _ prices, with a time to maturity of five years and a risk-free rate of 5%.
can be valued for the __ The value of the firm’s equity, considered as a call option with a strike
option prices by using price of %60 and an asset price of 7100, would be computed by
Eq. 12.25.
ie BSM. The intermediate values are as follows:

d, 1.9249 N(d;) 0.9729 N(-d;) 0.0271

d, 1.4777 N(d,) 0.9303 N(-ds) 0.0697
and the value of equity = Adi) = Dever Nia)
100 x 0.9729 — 46.73 x 0.9303
97.29 — 43.47 = %53.82
 Credit Risk, Securitization, and Credit Derivatives 571

With equity valued as a call option, the remaining value of the firm belongs to debt hold-
ers. Therefore, the value of the debt is
Value of debt = 100.00 — 53.82 = #46.18
Alternatively, the value of the debt is a long position on a bond with a maturity value of
D atter five years with a short position on the put. The value of the put as per the BSM—as
shown in Eq. 12.26—is:
The value of the put = Xe"! - N(—-d) — A - N-d;)
= 46.73 x 0.0697 — 100 x 0.0271
= Oe20 92 jl = <0.55
The value of the risk-free bond = D e7"! = #46.73

The value of the debt = The value of the risk-free bond — the value of the put
= 46.73 — 0.55 = %46.18 (the same as was found using the
call)

Credit Spread “Once the value of the debt is established, we can find the credit spread
(the difference between the yield on the bond and the risk-free rate). The yield on debt, 7; is
given by
60.00 = 46.18 x e > *"
Solving for 7 we get r = 5.236%.
Hence, the credit spread of the yield over the risk-free rate = 5.236% — 5.000%
= 0.236% = 23.6 bps.
Thus, the price of the credit risk of the bond is 23.6 bps. The larger the spread, the more
the likelihood that the firm would default.

Probability of Default under Merton Model Though we calculated the credit spread with
the Merton model, we still do not know what the probability of default is. Though we cannot
get an exact figure, we can have a reasonable estimate of the probability of default. If we
assume a risk-neutral world, i.e., a world where the investor earns sums equal to the risk-free
rate—a concept used. repeatedly in the valuation of derivatives—we can have a fair idea of
the probability of default.
Recall that while explaining the interpretation of terms in the BSM, it was stated that the
The cotaniny ofceeut | probability of the asset price exceeding the exercise price was given by N(d>).
ona debt under option If the asset price is the value of the firm and the exercise price is the face
prices is given by N(-d,), value of the debt (as is the case in the Merton model), then default would
which can be derived _ take place if the asset price is less than the strike price, Y = D. Hence, we
with values of the equity have the probability of the value of the firm being less that of the strike; the
= ae _ face value of the debt would be 1 — N(d>), which is also equal to M(—d)).
= With risk neutrality, the probability of default under Merton’s model is
given by 1 — M(d>) = M(—d)). In the present case, this value is 0.0697 (6.97%) over a period
of five years.

CDS Premium Under a CDS, there are two legs of payment—the premium payments,
which are made as long as no default occurs, and the protection payment, which is made
572 Derivatives and Risk Management

when a default occurs. At the time of entering the CDS, the expected present value ofthese
payments must be equal. Since the present value factor is common on both sides of the pay-
ments, there is no need to discount the cash flows of the CDS payments.
If the probability of default over five years is M(—d), then it can easily be converted into
an equivalent probability over a year, or for any other period like a quarter or half an year,
given that the probability each year remains constant. If the probability of default in each
year for the next five years is constant, g, then the probabilities of ‘default’ and ‘no default’
over the period of the next five years are as follows:
Probability of no default = = gy
Probability of default - teh)
The value of M(—d,) can be converted into an equivalent constant annual probability of
default by following Eq. 20.3.
N(-dy) = 1 — (1 = q)? = 0.0697 (20.3)
Solving Eq. 20.3, we get g = 1.4346%.
The protection buyer makes a fixed premium payment, s, for each period.
With the probabilities of default taken as g and of no default as (1 — q), the expected values
of the cash flows of the premium and protection values can be found. The expected value of
the premium at the end of the mth period (payment in arrears) would be
Expected value of premium
= Premium * Probability of no default = s x (1 — g)”
The protection payment depends on the notional principal and the recovery rate, R. The
notional principal is assumed to be the face value of the debt/bond, D. The expected value
for the nth period would be:
The expected value of protection payment
= D (1 — R) x Probability of default = D (1 — R) x q (1 — q)™!
For a period of five years, these values are shown in Table 20.7.
Table 20.7 Cash flow under CDS

Y Probability of | Probability of | Expected value of | Expected value of protec- |

ear : : L
default | no default premium payment tion payment :
Ie cf Posieetme alleer) $x (1- q) D(1-A)xq
2 g(t - q) (ae sx (1 - qj D(1-R)x
q(t-q)
3 q(t - q)° Cag: sx (1-9) D(1 - R) x q(t - gi?
4 q(1 - 9) (1 - g)' eS sx(1-q D(1- A)xq(t-Q)°
Sa) Gel cain) oe Tiss HANS
The probability of default Equation 20.4 would give the amount of premium for a CDS in case the
canbe usedtofindthe premium is paid in arrears, 1.e., after the end of the period. Note that there is
credit spread, which isa no need to discount the expected cash flows, as they are already measured in
measure of default, and present value terms.

es
is used
ae in pricing credit

Dexa! =D Dxd-R) xg ~g) 204)

Nn ie

| |
 Credit Risk, Securitization, and Credit Derivatives 573

Using the methodology just described, we find the amount of premium in Table 20.8 for
the firm with the face value of debt of %60 and the probability of default over five years 6.97%
as follows:
The probability of default, [1 — M(d,)] = Md) = 0.0697
Annual probability of default, g = 1.4346%
where M(—d>) = 1 — (1 — gq)"
Protection payment = _ Face value a
Recovery rate, R = 40%

Table 20.8 Pricing CDS

Expected value L
Probability of no of premium Expected value of |
Year Probability of default default payment protection payment |
oe 1.4346%
Sioa EE 98.5654%
eel 0.9857
Lea — 0.008607
2 | 1.4140% 97.1514% 0.9715 0.008484
3 1.3937% 95.7577% 0.9576 0.008362
4 1.3737% 94.3840% 0.9438 0.008242
5 1.3540% 93.0300% 0.9303 0.008124
Sum 4.7889 0.041820

Premium per 100 we

87.33 bps

TOTAL RETURN SWAP

A total return swap (TRS) is an arrangement where one party pays a total return on a refer-
ence asset, say, a bond, in exchange for a floating rate of return plus a spread, as depicted in
Fig. 20.6.
The total returns on the reference asset would include the periodic coupon payments, as
well as the gains and losses on the reference asset for the period of swap. For example, if
the coupon rate is 10% payable semi-annually and the swap has been entered for a period
of five years for London Interbank Offer Rate (LIBOR) + 50 bps on a notional principal of
$10 million, then every six months, the payer would pay 5% (the semi-annual coupon) in

Total return

Floating rate + spread

LEER EE FEE EEE EEE EEE EEE EEE EEE EEE EEE EEE

Fig. 20.6 aol return swap

 574 Derivatives and Risk Management

exchange for receiving LIBOR (decided one period prior, as in the case of interest rate swaps)
+ 50 bps. At the end of the swap, the capital gains/losses on the value of the reference asset
would be exchanged. If there is a gain, it shall be paid by the payer, and ifthere is a loss, it
would be compensated for by the receiver. However, if there is a default prior to the expiry
of the bond, the swap is terminated with the difference between the notional amount and the
market value of the reference asset. We can describe the cash flows of the TRS as follows:
On each coupon date The payer pays the coupon value and receives the floating rate
plus the spread. The payer passes the regular return in the form
of the coupon. Capital gains/losses can be paid/received either
at each payment date or at the conclusion of the swap period.
On conclusion of the swap The payer pays capital gain on the value of the asset to the
receiver. If there is a loss, the receiver pays the difference.
This compensates for capital gain/loss on the reference asset
by finding the difference in the market values at the inception
and the conclusion of the swap.
If there is a default during | The swap is terminated with the receiver being compensated for
the swap period the loss on the reference asset due to the default by the receiver.
From the viewpoint of the payer, the TRS can be taken as a fully hedged position, except
Under a TRS, the swap cour for the counterparty risk taken on the receiver. If the reference asset—a
pon as well as capital appre. | Corporate bond—is acquired, the payer would get all the benefits of own-
ciation are passed to the re- ership, which are passed to the receiver, resulting in a neutral position on
ceiver, who also assumes the the asset. The acquisition of the asset can be deemed to be financed at the
SS _ ae ] floating LIBOR rate, which the payer gets from the receiver ina TRS. A
= TRS thus provides the spread over (say 50 bps) the floating rate as a
reward for the payer, as depicted in Fig. 20.7. The spread over the floating rate is compensa-
tion to the payer for assuming the counterparty risk.

Total return Total return

Total return
: _ peyer
_(4-------------- _ Net=S00ps \<-----------------
EEE. eelensesecenantaysepptecaanencneccesasetemmrconectec Seca
nc comme ete te ee Zs

Fig. 20.7 Total return swap—payer’s position

To the receiver, the TRS provides the total return on the reference asset without
owning
it. The receiver pays a fee for receiving the total return on the reference asset.
If the payer is
in a better position to acquire the asset, the advantage is gained by the receiver.
Where the
reference asset is a portfolio consisting of many bonds, a total return is
received in a single
Composite transaction, rather than swaps for each individual bond.
However, the receiver
assumes both the credit risk and the interest rate risk on the reference
asset/portfolio.

Features of TRSs
In essence, a TRS appears like a CDS. Some of their features are
common but some are dif-
ferent. The following are some of the common features:
 Credit Risk, Securitization, and Credit Derivatives 575

Under a TRS, the reference asset is usually a widely quoted and traded bond.
The amount in the transaction is a notional principal, and, as such, no funds are pro-
vided to acquire the asset, as would be the case with a CDS.
The financing for acquiring the asset is provided with assumed funding at the floating
LIBOR rate.
The notional amount reduces in line with the amortization of the underlying bond. The
usual term for a TRS is relatively less, typically between six months and one year.
_¢ Like a CDS, it would terminate on the happening of a credit event.
A TRS is similar to a
CDS except that the e All payments are calculated on a notional principal.
TRS embeds default risk, e A TRS is normally cash-settled. In case of appreciation of the price of
while the CDS has only the bond, the total return receiver receives the price difference. In case of
default risk. depreciation, the total return receiver pays the difference. As an option,
changes in the price can be exchanged periodically rather than on maturity.
e In the case of physical settlement, the total return payer would deliver the asset to
the receiver. The payer would receive a cash payment equal to the notional principal
(adjusted for any amortization) from the receiver. Physical settlement is more practical
where it is difficult to get the price of the asset (illiquid asset, defaulted asset).

Total Return Swaps vs Swaps and CDS

If we compare the TRS with the plain vanilla interest rate swap, we find two critical differ-
ences, as follows:

e Under a conventional interest rate swap, there is a fixed rate payment in exchange for a
floating rate payment. Fixed rate payments are analogous to the fixed coupon payments.
There is no compensation for any gain/loss on the value of the asset.
A default on the reference asset has no implication on the cash flows of the conventional
interest rate swap. It continues as a contract whether or not there has been a default on
the underlying asset. The default risk is passed by the return payer, if he/she owns the
bond/asset, to the return receiver.
The TRS can be compared with the CDS too. The TRS provides a superior protection for
the ‘payer’ in comparison to the protection a CDS provides for the ‘protection buyer’. In a
CDS, there is no compensation for any decline in the value of the reference asset. It only
covers the default risk. In a TRS, the receiver would compensate for any loss on the value of
the reference asset, apart from the default risk. The TRS thus covers the interest rate risk as
well as the default risk of the reference asset. Thus, a TRS can be deemed to be a combina-
tion of an interest rate swap and a CDS.
The motivation to enter into a TRS lies in having exposure to an asset in respect of both
market risk and default risk. The advantage for the receiver is getting returns on the asset
without acquiring it. Only the financing cost is paid on a floating basis. For
ACDS covers oniyde- _ the receiver,
; it also
on obviates the requirement
et of credit administration
wate associ-
fault risk and an interest ated with due diligence and supervision. Hence, the transaction is off balance
rate swap coversinterest sheet. Further, to the total return payer, it is not necessary to acquire the asset,
rate risk only.
A TRS _if he/she so chooses. If the total return payer decides to acquire
it, he/she
covers both.
also has leverage available to do so. Finally, the consent of the issuer is not
576 ‘Derivatives and Risk Management z

required if the total return payer and the receiver opt to exchange the cash flow for a floating
rate and a total return.

___ SECURITIZATION
When banks hold assets to cover loans or receivables, they not only take the risk on the
returns but also expose themselves to the risk of default. These assets may become non-
performing. Further, these loans essentially are non-transferable and lack liquidity. Therefore,
the holder of these loans may convert such non-tradable assets into tradable ones by a process
called securitization and then market them as packaged products to others who chase higher
returns, and, in the process, also assume the risk of credit, i.e., the risk of default. Securitiza-
tion forms the backbone of funded credit derivative transactions. However, securitization is
not essential to credit derivatives.
Securitization is a process of converting rather illiquid cash flows into freely tradable
_ assets that are transferable by endorsement and delivery. It is a financial
Securitization is a pro-
cess of converting illiquid, innovation where a lender finds a way of augmenting financial resources
non-transferable assets for furthering business and, at the same time, for improving liquidity and
into tradable assets the free market price determination of the value of such illiquid claims. Of
whose value is market late, securitization as an innovation in modern finance has been stretched
determined.
too far, and possibly has eclipsed the honest purpose that it came into being
for initially.
Generally speaking, a lender financing property (more popularly called mortgages) col-
lects the instalments covering the principal and interest from the owners of the property over
a long period of time. While there is one large lump sum paid at the initiation of the loan,
causing drainage of financial resources, the recovery of funds is made in small bunches from
a large number of borrowers. To put it in simple words, a firm in the business of granting
housing loans with the repayment stretching to, say, 20 years, would end up exhausting its
initial 100% corpus only to recover 5% each year over a period of 20 years. Apart from suf-
fering from liquidity problems and constrained financial resources, the lender bears the credit
risk of repayment by the borrowers. Further, these receivables are also not tradable.
To overcome these problems, the lender bundles the loan instalments, i.e., the financial
claims into an instrument that is sold to third-party investors at a price. The price is paid
by these new investors to the original lender. Now, the new investors are entitled to receive
the instalments that provide them the required returns. This process enables transfer of the
returns from the original lender to the new investors.
If these instalments are backed by mortgages, the process is called mortgage-based secu-
ritization (MBS), and in case of loan repayment instalments on any other asset, such as
vehicles, it is referred to as asset-based securitization (ABS). Such a process (a) enables the
augmenting of resources for the original lender, (b) provides liquidity, and (c) allows market
determination of the pricing of the instruments, leading to free pricing in case these securi-
ties were listed. The securitization is done without the original borrowers knowing that the
instalments are now actually going to a third party that did not participate in the original loan
transaction.
 Credit Risk, Securitization, and Credit Derivatives 577

Securitization started with

Mortgage-based securitization is said to have had its origin in the 1980s,
mortgage loans, where when government-sponsored agencies in the USA pooled relatively safe and
instruments were issued homogeneous loans and repackaged them into some securities, i.e., the bonds
to investors with loan known as pass through certificates that were sold to investors. The instal-
repayments providing the ments on the loans were designated to service the investors. However, the
returns.
certificates were guaranteed by the government-sponsored agencies against
default. Investors subscribed to these bonds by parting with the initial price
in return for the claims on the cash flows that were to be received from the mortgages. With
these known cash flows, the returns for the investors were fixed. Thus, they assumed the
interest rate risk, and the value of the bonds would now change in accordance with changes
in the interest rate scenario.
Securitization could be with recourse or without recourse. In securitization with
recourse, the original lender who created the MBS guarantees the cash flows to the inves-
tors, thereby retaining the risk of default. In a non-recourse structure, the risk of default
is passed on from the original lenders to the new investors. Hence, both interest rate risk
and credit risk are borne by the new investors in securitized papers.
Figure 20.8 depicts the structures and various participants in securitization. The originator,
the lender in the first place to the borrowers, floats a special purpose vehicle (SPV) with the
intention of making the loan instalments tradable and liquid. The homogeneity of the receiv-
ables is established. The originators sell the claims on the receivables. Pooling of cash flow
is done, and the rating agency divides the pool of receivable into various grades (tranches)
such as A, B, and C or Senior, Mezzanine, and Junior, setting different grades of priorities

Excess
Credit rating and
enhancements

Shortfall

Scheduled payments
principal and interest

Investment
investors
vehicle for Pay through
prepayments

Pay through structure

Fig. 20.8 Securitization structures—pass through and pay through

578 Derivatives and Risk Management

of claims on the cash flows. Cash flows from the asset service the investors in the tranches
in the order of the seniority of the claims. Junior grade claims carry a higher return, with
more risk. The cash flows of the receivables first service the senior grade and then go on to
the lower grades.
Investors subscribe to the graded paper depending upon their risk—return profile. The
junior-most tranche is the first that bears losses or shortfalls in the cash flow; hence, it is
also referred to as equity tranche. Normally, a junior tranche is not sold to investors for com-
mercial and moral reasons. Instead, it is kept by the issuers themselves to indicate that they
are not passing on junk to the investors, and, thus, would themselves be the first sufferers in
case of default. The process of securitization is highlighted in Fig. 20.9.

*A bank grants loans to its «The SPV receives afee *Rating agencies look at the «Investors, depending upon
customers, on which for bundling the receivables quality of receivables and their risk appetite,
instalments are repaid into various categories, obligors. subscribe to the
over a period of time. depending upon the past appropriate paper forj their
*Depending upon the
*The bank becomes an performance of loans a theyare
rating, divide the desired return and risk
originator and floats an from the original receivables into various profile:
SPV to generate additional borrowers, called the tiers, setting priority of *The issuer of the
resources and pledge obligors. claims for the subscribers, certificates receives the
receivables of loan ‘The SPV establishes the called investors. subscription.
instalments. expected cash flows, and *The cash flows would *The SPV passes througn
based il return service the cash flow the receivables in
expectations, advances commitments in the order accordance with the
the funds to the of rating. contractual obligations.
originator.
MALLLD

Fig. 20.9 Securitization—roles of participants

Securitization helps the originators know what value the market attaches to the receiv-
able claims. This enables them to receive immediate cash. To the investors, it opens up
avenues for participation in lending activities and getting better returns. The loan market,
otherwise confined to banks only, now becomes open to general investors with a much
wider base.

Risk in Securitization
The originators of the loans are exposed to interest rate risk. The investors who subscribe
to securitized papers receive the cash flows from the obligors—the original
Securitized papers suffer borrowers. The value of the securitized paper is dependent upon the cash
from the risk of prepay- flows of the instalments. If the interest rate declines, the borrowers
pay
ment, which may arise early because they can refinance the loan at cheaper rates. This impacts the
due to a decline in the returns to the investors. The change in value of the securitized paper due
interest rates.
to early payments is referred to as prepayment risk.
 Credit Risk, Securitization, and Credit Derivatives 579

___ STRUCTURED CREDIT DERIVATIVES _

In the section of Credit Derivatives, we discussed CDS and TRS, which were non-funded
credit derivatives. In’ this section we discuss more credit derivatives which are structured
and funded inst.

CREDIT-LINKED NOTES ©
Ina CDS, there is no cash flow from the protection seller to the protection buyer at the incep-
tion of the swap. A deal like the CDS is said to be non-funded or unfunded. With no invest-
ment, an unfunded derivative instrument synthesizes a position on an instrument. However,
depending upon specific needs, the contract can be converted into a funded product, where
the protection seller may make a full or partial upfront payment to the protection buyer at the
inception of the contract to enable the purchase of the reference obligation. This is usually
achieved by the issue of a note by the protection buyer, which is bought by the protection
seller. Such an instrument is called a credit-linked note (CLN).
In a CLN, the position of the protection seller who buys the note is referred to as the
investor, while that of the protection buyer who issues a note is referred to as the issuer. The
payout on the note issued would bear some resemblance to the performance of the refer-
ence asset, such as an investment grade bond. The market value of the note 1s linked to the
performance of the underlying asset. Initially issued at par, the final payment would depend
upon the happening of any credit events. Thus, a CLN becomes a funding instrument, like a
bond, and provides protection against default or a credit event, like a CDS.
A CLN may be defined as a hybrid instrument that offers investors a synthetic credit
_ exposure to a specified reference entity. The CLN is a combination of fixed
ACLN is a funded prod- _ income security and an embedded credit derivative. The CLNs are designed
Bee ees _ to capture the returns of a bond or its portfolio. The funding given to the
and also transfers the __- iSSuer replicates a direct exposure to a bond/loan, and is a refinance com-
credit risk. _ pounding the credit risk. The investor would be exposed to dual credit
risk—one on the reference entity and the other on the note issuer.
Credit exposure can be gained through a variety of methods like a CDS, a credit spread
swap, a TRS, or as a repackaged note where the issuer passes on the risk of the underlying
credit to the note holder in exchange for an enhanced return. For example, a note may pro-
vide for its principal repayment to be reduced below par in the event a reference obligation
is defaulted upon?.
The motivation behind funding a derivative is to enhance the resources of the issuer for
furtherance of his/her business, apart from using it as a hedge against the credit risk faced
by the issuer. The motivation for the investor is to enhance yield, as CLNs offer attractive
returns.

3 Anson, Mark J.P., Frank J. Fibozzi, Moorad Choudhry, Ren-Raw Chen, Credit Derivatives—Instruments, Applications, and
Pricing, John Wiley & Sons, Inc., 2004, p. 120
580 Derivatives and Risk Management

The CLN is, therefore, a structured product where the coupon/interest payment and princi-
pal are linked to the performance of a reference obligation or reference entity. It is a funded
CDS. It becomes an on-balance sheet product in contrast to the CDS, which is an off-balance
sheet product. For example, consider a bank involved in the issue of credit cards, housing
loans, and automobile finance. All these loans are payable periodically and bear the risk of
default. The bank may pool certain class of assets and issue a note for a specified maturity
that may be bought by an investor at face value. The bank gets funds by issuing the note.
The payout on the note would depend upon the performance of the assets on which the note
is issued. For example, the payment at maturity may be 80% of the par value if any default
within the specified period exceeds a certain proportion of the value of the assets, based on
which the credit note was initially issued. Alternatively, the issuer could have securitized the
loans and issued separate instruments to augment his/her resources; to hedge against credit
risk, he/she could have entered into a CDS. The CLN, as a composite instrument, would help
to achieve these twin objectives. The cash flows of CLNs are shown in Fig. 20.10.

Initial Subsequent
Investor Issuer Issuer
Investor
* Subscrbes to the * Issues the note « Issues the note
* Subscribes to
note issued by linking the returns linking the returns
the note issued
the issuer to the performance by the issuer to the performance
* Pays the face of the underlying *Paysthe face —> of the underlying
value of the * Receives the initial value of the note + Receives the initial
note amount from the amount from the
investor investor

Reference entity Reference entity

* Cash is used to * Cash is used to
acquire the asset, accquire the asset,
normally a bond/loan normally a bond/loan
« Cash flows accrue to * Cash flows accrue to
the issuer the issuer

Fig. 20.10 Credit-linked note—cash flows, initial and subsequent

The investor in the CLN may derive yield in two forms—the regular return and the capital
gains. The investor would subscribe to the CLN as it would offer a larger regular return in the
form of a higher coupon than that on a plain bond from the same issuer, For example, if an
investment grade entity can mobilize at 200 bps above the risk-free rate, the CLN may have
to offer a coupon of, say, 400 bps above the risk-free rate. This regular coupon payment is
expected to cover the return on the investment and the premium for the credit risk. Besides
a regular coupon, the investor can benefit from capital gains too if the CLN is issued below
par and redeemed at par at maturity.
Regular coupon payment can be variable and made proportional to credit performance. For
example, the coupon payment value may increase with any downgrading of the underlyin
g
reference asset.
 Credit Risk, Securitization, and Credit Derivatives 581

These returns would be realized only if the specified credit events do not occur. At the end
of the contracted period, and if no specified credit event has occurred, the original investment,
the par value, must be paid by the issuer (protection buyer) to the investor (protection seller).
However, if any credit event occurs during the tenure of the CLN, then settlement at the
expiry is done at less than par value, transferring the losses to the protection seller (investor).

Collateralized debt obligations (CDOs), first introduced in 1988, are essentially structured
finance products that package risk in different classes, called tranches, as described in the
section on securitization in this chapter.
Securitization forms the backbone of CDOs. Illiquid and non-transferable debt obligations
are converted into a tradable form through securitization, having claims on the debts. It is a
repackaging of the debt obligations that have collateral securities in the form of underlying
assets financed by the loans. The underlying pool of assets can be a portfolio of bonds or a
portfolio of loans. The former is called a collateralized bond obligation (CBO) and the latter
is called a collateralized loan obligation (CLO). If the underlying pool of assets is mortgaged,
it is called a collateralized mortgage obligation (CMO).
Once securitized, the cash flows accrue to the holders of these instruments. The securitized
instruments are categorized according to the risk and returns, called tranches. Each tranche
would have a different priority over the cash flows received from the debt obligations. Each
tranche is sold to investors interested in yield enhancement (while assuming
~ commensurate risk). Each tranche has a different risk—return profile, depen-
Collateralized debt
obligations have catego- _ dent upon the credit performance of the underlying pool of assets.
ries of credit risk, and Figure 20.11 depicts a typical CDO. Assume that a bank, called the origi-
investors choose the risk nator, has a pool of loans, say, for housing, issued to its customers, from
-return profile.
whom regular cash flows are expected. These cash flows are not uniform

= ie ae
> ._ Repayments
cis
~
s

Sale proceeds
Special purpose
Originator vehicle
Asset sale (SPV)

a
a

_7 Repayments
va
we

Note issuance

Fig. 20.11
582 Derivatives and Risk Management

because some of the customers may not be making timely payments, while some are making
pre-payments. The originator, for reasons discussed later, may decide to sell the pool of assets
(the underlying) to an SPV, who makes a payment to the originator and assumes the owner-
ship of the assets that entitles him/her to receive the periodic cash flows generated from the
underlying assets. This is referred to as securitization of the loans by the originator.
In the subsequent stage, the SPV may grade the cash flows into different categories of
risks and issues notes with varying levels of entitlement to receive the cash flows from the
underlying. These notes, with varying returns, are sold to various investors. This transaction
is analogous to a CLN. However, here the underlying asset serves as collateral for these notes,
as they are serviced from the cash flows of the underlying assets.
The notes issued by the SPV do not bear the same claim on the cash flows from the under-
lying. The notes are categorized on the basis of those who are entitled to have prior claims
on the cash flows. The notes that are serviced first are the senior most. Only after satisfying
the obligations to the senior-most notes are the claims of the next level, the mezzanine, met.
There may be several layers of mezzanine notes. After the claims of the mezzanine notes are
settled, the junior-most notes are satisfied. Hence the junior-most notes become most risky.
Since the underlying are subject to credit risk, the Junior-most notes are the first ones to
suffer the initial part of the loss of cash flows from the underlying. They behave more like
equity and are normally subscribed by the originators themselves to show that they are
the
first sufferers of any default and to absorb loss due to non-payment of the debt obligations.
This helps in marketing the remaining tranches by creating confidence in investors that
bad
loans are not being sold off to them.
The notes issued by the SPV are normally rated by rating agencies, with the senior-mo
st
notes accorded the highest rating. The junior-most notes are generally not
rated, and they
behave more like equity, having the last claim on the cash flows. For determina
tion of the
order of servicing the different categories of notes, the adequacy of the cash
flows from the
underlying assets needs to be ascertained, and, therefore. coverage
tests are conducted at
every stage. Generally speaking, the claims for interest payment of the
senior-most notes are
first dealt with. Subject to the adequacy of cash flow from the underlyin
g assets, the liability
for the interest claims of the next level of notes is met.
Figure 20.12 depicts how the cash flows are applied for meeting
commitments toward the
various Classes of notes. It may be observed that interest gets precede
nce over principal for
notes of the same rating, and the principal sums of senior notes
get precedence over the inter-
est claims of notes rated lower.
The junior-most notes are normally not sold, as they are the
first ones to be affected by
the credit risk. As an example, consider the loans by a bank
that through an SPV issues four
classes of credit notes in the order of seniority and rating,
named Tranche 1, Tranche a
Tranche 3, and Tranche 4. These notes are rates, and offer progres
sively increasing yields of
6, 10, 20, and 40%, respectively. Tranche 4, held by an SPV,
is not rated, and
The payments undera absorbs the first 5% loss. The next 10% loss is borne
by Tranche 3 and then
CDO are hierarchical, Tranche 2. The remainder of the loss in excess of 25%, if any,
is passed to the
ee ae of holders of Tranche 1 notes. The larger the yield, the larger
investors depending ! is the credit risk
upon their seniority, ie
assumed. By creating tranches, the risk pts
is redistributed, though the risk on
the underlying does not change merely because tranch
es have been created.
 Credit Risk, Securitization, and Credit Derivatives 583

Cash flow from collateral

Interest on senior notes

Coverage tests

Interest on mezzanine notes Principal to senior notes

Coverage tests

Pass ie ‘
Principal to mezzanine notes AAA
CAAA

Interest on junior note a Principal to junior notes

Fig. 20.12 Priority of cash flow under CDO

A major benefit of a CDO is that it enables the originators to transfer risky debt off their
balance sheets, improve their debt—equity ratios, and raise additional resources for furthering
their businesses.

Synthetic CDO The underlying debt obligations decide the nature of CDOs. The structure
described in the last section is referred to as a cash CDO. Where the underlying asset is a
credit derivative, such as a CDS, the CDO would be called a synthetic CDO. It repackages
the credit derivatives rather than the debt obligations.
Normally, a protection seller in a CDS becomes the issuer in a synthetic CDO. The issuer
takes up the credit risk exposure on a portfolio of CDSs under which credit risk has been
assumed on a portfolio of reference assets or entities. These are converted into tranches of
different risk—return profiles for onward sale to different investors. Since the protection seller
in a CDS would have only nominal cash inflows by way of premium, he/she would have to
acquire fresh assets to support the CDO programme. This achieves twin objectives—first,
these assets can serve as collateral, and, second, they provide the required cash flows to ser-
vice cash flow obligations undertaken in CDOs.
The investors agree to provide funding if losses take place, in return for some premium.
This would be a pure synthetic, 1.e., an unfunded CDO. A prudent investor in an unfunded
CDO would make provisions for payment by investing funds in safe securi-
Synthetic CDOs have. ties, because when several simultaneous defaults take place, there would be
another derivative, i.e., many investors wanting cash that may not be available. As a variant, we may
_ the CDS, as the underly- have a fully or partially funded CDO, where some initial payment is made
ingasset, by the investors to the issuer.
584 Derivatives and Risk Management

SOLVED PROBLEM
SP 20.1 RATING AND RECOVERY RATE
Suppose an unsecured, zero coupon bond of a firm with five years to maturity is trading at a yield of 8.1% against treasury Zeros
yielding 7.5%. The investors of the bond assign no chances of recovery in case of default. The firm decides tocreate security by
creating a charge over some of the unencumbered assets in favour of bond holders, leading to an upgrade in rating by rating agen-
cies. If the price of the bond rises by 1%, what is the new outlook about the recovery rate by the investors?
Solution
The spread is 0.6%. With no recovery, the associated probability of default is given by Eq. 20.1. The probability of default over a
five-year period is 2.9554%.
Risk-free bond yield Tore Price 0.6873
Risky bond yield 8.1% Price 70.6670
With a 1% increase, the new price of the bond Is 0.6737.
New price 20.6737
New yield, % 7.8994
New probability of default, % 1.9772
(an New probability of default _— 1.9772
give R = 33.10%
Old probability of default 2.9554

SUMMARY
Credit risk is the risk of default faced by a lender that his/her Should any of the specified default events actually take place,
borrower would not pay on time, for whatever reason. Crecit risk the CDS terminates. If it is cash-settled, the protection buyer gets
is different from market risk or the risk of a portfolio of traded the difference between the notional value and the market value,
assets, which may provide lower or higher returns than expecied. as determined by a caiculation agent. Under physical settlement,
On the contrary, a loan transaction never pays more than what is the instrument is delivered to the protection seller for payment of
promised under the loan agreement. The assessment of credit the notional value.
risk is not easy, as it cannot be said to follow a distribution on Other than covering default risk, a CDS has many applica-
which models are available. tions, as it is a synthetic exposure on the reference asset.
Some idea of default can be had from the return the asset of a A TRS is another instrument where the returns on an asset
firm provides in excess of the risk-free yield. The difference in the are exchanged for receiving a floating rate. One party, called the
price of the bond with respect to risk-free bonds represents the total return payer, pays regular coupons as well as the capital
present value of the expected losses. The expected losses can appreciation to another party, called the total return receiver. The
be used to oblation the probability of default and the difference TRS is different from the interest rate swap and the CDS, as the
in yields serves as an input for pricing credit derivative products. TRS covers two risks—the interest rate risk and the default risk.
The transition rate indicates the chances of migration of the rat- Interest rate swaps provide hedge against interest rate risks and
ing of a debt instrument over a given period of time. are not concerned with default. A CDS covers only default risk.
One measure of credit risk for financial institutions holding The TRS covers both for the payer in exchange for receiving a
a portfolio of financial instruments is credit VaR. It is similar to floating return plus a spread.
VaR, which gives the potential loss over a chosen period with Securitization is essential for certain credit derivatives. Secu-
a chosen confidence level. It serves as a benchmark for capital ritization is a process of transforming illiquid non-transferable
adequacy and for assessing loss-absorbing capacity, loans into freely tradable marketable securities with features of
A CDS is an arrangement or instrument designed to exclu- ready transferability. It forms the backbone of credit derivatives
sively cover the default risk of an asset, referred to as reference such as CLNs and CDOs.
obligation, or a firm called the reference entity. The premium The CLN is a funded instrument that covers credit risk and
payable by the protection seeker, called the protection buyer, also provides funds to the issuer through a note issued on the
would be proportional to the excess return one gets over and reference entity/obligation. The issuer pays the regular coupon
above the risk-free rate, In return for periodic payment, the pro- based on the credit performance of the reference obligations.
tection buyer covers the risk of default on the reference asset or These coupons could be variable. Thus, the investor in the note
reference entity. : absorbs the credit risk. The note is terminated upon occurrence
 Credit Risk, Securitization, and Credit Derivatives 585

of the default event, with losses absorbed by the investor. If the cash flows from the pool of assets. These claims, providing
no credit event occurs, the funded amount is paid back to the different returns, are satisfied on the basis of adequacy of cash
investor, flows determined periodically, with junior-most claims absorbing
The CDO is a way of segregating the risks of a pool of assets the shortfall in the cash flows.
into different classes, with each class having different claims on

KEY TERMS
Calculation agent An agent who determines the market value Protection seller A protection seller, in exchange for receiving
of an asset after a default event has occurred. a periodic premium, compensates against loss due to default on
Collateralized debt obligation Under collateralized debt obli- an asset upon the happening of some default event.
gation, a pool of assets is categorized under different risk classes Recovery rate The proportion of debt that can be claimed
with varying returns and priorities, set to be subscribed by differ- once a default has occurred.
ent classes of investors, with the cash flow from the underlying Reference entity An entity on whose credit performance pro-
asset serving as collateral. tection is sought under a CDS.
Credit default swap A CDS is an arrangement between two Securitization A process of converting illiquid and non-trans-
parties where one party compensates the other for losses due to ferable cash flows into tradable and marketable securities with
default on the occurrence of defined events, in return for receiv- values determined by market conditions.
ing a premium at periodic intervals. Synthetic CDO The CDO where the underlying asset is a
Credit event A credit event is an event that triggers default on basket of CDSs.
a loan and payment from the protection seller to the protection Total return payer The total return payer pays the total
buyer. returns on an asset by way of regular coupons and end-of-the-
Credit-linked note A funded instrument where the investor period capital gains or losses, and receives a floating rate plus
pays for a note issued on the reference entity and agrees for a the spread.
return based on the credit performance. Total return receiver The total return receiver gets regular
Credit risk The risk of a default by the borrower in a loan coupons as well as capital gains and pays on a floating basis,
transaction. assuming the credit risk as well as the interest rate risk.
Credit VaR The expected loss that can occur due to default Total Return swap An arrangement where one party pays
ona given portfolio over a period of time and with a given con- total returns on an asset for receiving a floating rate plus a
fidence level. spread.
Probability of default The probability of default relates to the Transition rate The probability that a debt instrument may
chances that a debtor would not pay interest and/or the principal undergo a change of its rating over a given period of time.
on the due dates.
Protection buyer A protection buyer seeks protection against
default by a reference entity or an asset owned by paying a pre-
mium.

QUESTIONS
20.1 Describe what credit risk is, and how it is different from 20.5 What is a transition matrix?
market risk. 20.6 How is a TRS different from an interest rate swap and a
20.2 What are CDSs? Illustrate with a diagram, indicating the CDS?
roles of the swap and cash flow participants. 20.7 Explain the process of securitization, its benefits and risks.
20.3 Describe the Merton model for finding credit risk using 20.8 Describe a CLN.
option pricing. 20.9 Illustrate a CDO with a diagram.
20.4 What do you understand by credit VaR?
 Corporate Securities
and Derivatives

INTRODUCTION "=
Learning Objectives
Firms raise funds by issuing different kinds of securities that are After going through this chapter,
claims against their cash flows. The market prices of these secu- readers should be familiar with
rities govern the values of the derivatives on them. Corporate 2
corporate securities’ resemblance
securities that act as underlying assets for derivatives can in fact to combinations of options
be viewed as derivatives themselves. Managers in corporate equity's resemblance to a call
finance may not be very familiar with the terminology or func- option on the firm
tioning of derivatives, but they do have the ingenuity to come debt as a combination of options
out with innovative products to raise resources, by including the application of put-call parity for
features that are practically identical or similar to derivatives. corporate securities
These securities often have embedded derivatives in them. warrants
These embedded derivatives in corporate securities are the valuation of warrants

Corporate securities
_ invented due to the felt need of inves- the differences between the value
often have derivatives tors for inclusion of features that make of a warrant and that of a regular
embedded in them, more instruments more attractive for them. call
because of the felt need For example, firms issue callable bonds
of investors and as a rather than straight bonds to contain the
strategy to attract them,
rather than as a deliber-
cost of capital. Such bonds have call
ate attempt to include : options embedded. The purpose of this
these derivatives. / chapter is to provide an exposition on
corporate securities visualized in terms
of derivatives. If corporate securities can be seen as derivatives, it
would not only enhance our understanding of these securities but
may also prove helpful in their pricing. The ad-hoc approach used
by naive managers in valuing them can be replaced by a techni-
cally more sound approach using option pricing models. Inter-
pretation of corporate securities as derivatives would enhance our
understanding of not only corporate securities but also derivatives.
We have all heard of the popular versions of corporate secu-
rities issued by firms, such as common stock, debt, preference
shares, warrants, convertible bonds, and callable bonds. These
 Corporate Securities and Derivatives 587

instruments have been in use for a long time and are evolving continuously. They came into
existence much before derivatives. Although it is quite natural for one to think of the value of
derivatives as driven by their underlying assets, it is rather strange to see these securities used
as derivatives. A cursory look at the terms and conditions stipulated in these instruments would
reveal that they actually embed a derivative or a combination, and we may use the principles of
valuation of derivatives in the pricing of such instruments.

EQUITY SHARES—COMMON STOCK

The most common method for raising capital is issuing common stock/equity shares. Inves-
tors in the shares of a firm, called shareholders, have a right to manage the assets of the firm.
To maintain the continuity of the firm’s capital, these shares are transferable. If a shareholder
decides not to exercise his/her right or ownership, he/she has another alternative: to sell his/her
shares. If the shares are listed and traded, the objective of selling can be achieved rather easily.
Ownership of Residual However, a shareholder’s right to manage the assets of the firm is
_ not unambiguous. In terms of the priority of claims, the shareholder occupies
The common stock of a :
firm can be considered the last place. Therefore, the shareholder is often said to be the owner of the
as acall option, withthe residual, 1.e., the leftover remaining after the claims of all others who precede
maturity value ofdebtas the shareholders have been settled. In fact, shareholders come last in the list.
the exercise price. _ As long as shareholders satisfy the claims of all others, the right to manage
remains with them. Any failure to meet the claims of others, such as creditors,
workers, lenders, and the government jeopardizes the right of the shareholders to manage.
The total value of a firm is given by the sum total of the value of its debts and the value of
its equity. Since debt holders have priority of claims over shareholders, the value that can be
derived by shareholders is only the remainder after the claims of the debt holders have been
satisfied. In an efficient market, the residual nature of the claim would be recognized in the
market value of the equity. In an all-equity firm, the entire value rests with the shareholders.
At worst, the value of the equity can be zero; it cannot be negative.
The total value of the firm, V, is the sum of the value of its equity, E, and the value of its
debts, D, i.c., V = E + D. The value of all claims is supposed to represent the total value of
the assets of the firm. The market value of the equity is supposed to reflect the residual of
assets that belong to the shareholders.
Limited Liability Another feature of equity is limited liability, 1.e., the maximum loss that
can be incurred by any shareholder is the price he/she paid to acquire his/her equity. In any
case, the price paid to acquire equity has no significance for future decision making, since it
is a sunk cost. At best, it can be a consideration before acquiring equity. It is like paying a
premium to buy an option that loses its significance thereafter for any further
_ decisions, though its recovery remains a consideration. For example, the
Shareholders’ rights to es ;
manage the Lies ofa decision to buy a call or a put option for hedging may be influenced by the
firm with limited liability option’s price, but after the option is acquired, the price paid becomes imma-
canbeexercisedonly —_terial for exercising it, except for the psychological satisfaction or dissatis-
after satisfying all prior faction at the end of the option period of having ended up with a profit or a
«Cla
loss. At worst, the payoff of equity is zero.
588 Derivatives and Risk Management

Payoff of stock
A

Payoff forequity holders

at maturity of debt, V.—X

Face value Value of the firm, V,

of debt, X
LEE
EEE EEE EEE

Fig. 21.1. Common equity as call option

Equity as Call Option When a firm has debts, the value for the shareholder is the excess
of the value of the firm over the value of the debt. Debt claims cannot exceed their maturity
values. More often than not, the maturity value is the same as the face value. If the total
value, V7, of the firm is less than the maturity value of its debt, the shareholder gets nothing.
If the maturity value of the debt is X, then the payoff for the shareholders at maturity, S;, of
the debt is

S7 = Max
(0, V;
— X) (215)
The payoff for shareholders, as given by Eq. 21.1, is identical to that of a call option. Hence,
common stock is regarded as a call option with an exercise price equal to the maturity value of
the debt of the firm, as shown in Fig 21.1. The value of shareholding today, So, is the difference
between the current value of the firm, Yo, and the current value of its debt, D = XYe~’", ice..

So = Ve Ae! (21.2)

Agency Cost of Debt

Exponents of corporate finance often mention the agency cost of debt as a conflict between
debt holders and equity holders. From the payoff for holders of equity as a call option, it
can be surmised that the value of the equity can be increased by increasing the risk.
Risk
can be increased by increasing leverage. Therefore, shareholders. being at the helm
of
decision making, work towards increasing the payoff, tempted to avail of more and
more
debt. There may be a tendency to increase debt to an inordinately high level. If the
risk
pans out, the shareholders gain, while the debt holders get no more than the promised
return. In case the risk fails to pan out, debt holders lose more than the shareholder
s, who
have limited liabilities. Therefore, while approving additional debt beyond a limit,
lenders
often impose restrictive covenants that limit the freedom of shareholders to take
major
policy decisions.
Equity as Put Option From this perspective, shareholding can be viewed in terms of put
option. The position of shareholders can be described as ownership of the
firm with prior
obligation to pay the maturity value to debt holders. Since shareholders
can default on this
 Corporate Securities and Derivatives 589

Essar puts Vodafone on call

Hutchinson Essar Ltd, a joint venture between Hutchinson Telecom International, the Cayman Islands, (HUTCH) and Essar Group of
India (ESSAR), held licences to operate cellular services in 23 circles in India since 1994. HUTCH held 67% of the equity, with the
balance of 33% held by ESSAR.
In 2007, after operating for more than a decade, HUTCH decided to exit by selling its stake to Vodafone NV, Netherlands, (VODA-
FONE) globally ihe largest telecom firm. VODAFONE was desirous of operating in India. In an offshore all-cash deal between the two,
VODAFONE acquired HUTCH’s 67% holding in the Indian venture for US $11.1 billion. The Indian venture was rechristened Vodafone
Essar Ltd.
ESSAR’s 33% holding was split in two tranches—10.97% (a third) held by ESSAR Telecom Holding Pvt. Ltd, a firm incorporated in
India and 22.03% (two thirds) held by ESSAR Communication (Mauritius) Ltd, a foreign entity registered in the tax haven of Mauritius.
At the time of acquisition by VODAFONE, the Indian stakeholder ESSAR did not deem it fit to exit at the pro-rata value of US $5.6
billion, but instead chose to have a put option (a right to sell) for its entire 33% equity for a total of US $5 billion, to be exercised by
May 2011. The agreement gave ESSAR the right to be on the board of the firm, together with veto power, because of its retained
33% holding. The shareholder agreement also provided for part sale of the equity, but at a mutually decided price and not by proration
of US $5 billion. Since the venture was not listed in any of the stock exchanges in India, the part sale would be done on the basis of
valuation to be done by an independent agency.
By March end, i.e., two months prior to the option window closing, ESSAR decided to exercise its put option in respect of its two-third
holding. VODAFONE contended that such an exercise of the put option by ESSAR gave a call option (right to buy) for the remaining
one third too. A part sale would raise the question of valuation, and, hence, a two-third put option for ESSAR without a corresponding
call option for VODAFONE was against the shareholders’ agreement. ESSAR repudiated the claim of a call option for one third by
VODAFONE, and contended that the exercise of the put for a two-third stake was in order.
According to ESSAR, the two tranches could not be valued by the same yardstick, as the two-third share was held by an offshore
firm, while the one-third share was owned by an Indian entity, falling under a separate jurisdiction. What perplexed people the most
was the valuation of the two-third stake held by the offshore entity at US $3.8 billion, and of the one-third stake owned by the Indian
entity at US $1.2 billion. The 50% premium for valuation of the foreign holding over that of the Indian holding was mired in regulatory
controversy, as the Indian valuation for an unlisted firm could only be done on a free cash flow basis by a competent and independent
agency, and was subject to regulatory approval. VODAFONE and ESSAR appointed the likes of Standard Chartered Bank, Goldman
Sachs, and UBS to conduct the valuation. Since the telecom sector had fared badly since 2007, experts feared that the entire 33%
stake could not be valued at more than US $3.00 billion in 2011, as against what was considered to be about US $5 billion in 2007.
Under the circumstances, would the regulatory authorities in India accept vatuation of the Indian stake at less than what was being
paid for the stake held overseas? If the valuation of the offshore two-third stake was considered fair, then the value of the one-third
Indian stake would be higher by about US $700 million, taking it to US $1.9 billion instead of US $1.2 billion.
Mired in controversies, claims, and counterclaims, the issue of the put option value forcing the call valuation continued till July
2011. The issue was put to rest by VODAFONE and ESSAR iy both agreeing to exercise their call and a respectively, and
entering into an agreement to pay US $5.46 billion, comprising!

+ anet payment of US $3.32 billion for the two-third stake, after withholding tax of US $0.88 billion;
* apayment of US $1.26 billion for the remaining one-third stake. This payment will be made by 15 February 2012: and
« the expectation that 1.35%? of the shares will be transferred to an Indian investor to ensure VODAFONE’s continued compli-
ance with Indian foreign direct investment rules.

Consequently, both VODAFONE and ESSAR agreed that all outstanding claims between them were terminated, and that all
future claims were renounced. The parties also agreed to cooperate fully in seeking all regulatory approvals necessary for the
completion of these transactions. ESSAR relinquished all of its board seats in VODAFONE.
The settlement marks the end of a four-year partnership between VODAFONE and ESSAR in India.

Source: www.vodafone.com, accessed on 6 March 2012.

stake of 67%,
2To make a minimum holding of 26% by Indians, as per ihe foreign direct investment policy of the telecom sector in India, Of the original VODAFONE's
about 24.6% was held by entities deemed resident Indians. The foreign holding, Le., VODAFONE’s holding, could not exceed 74%.
590 Derivatives and Risk Management

obligation if the cash flows are not adequate to cover the maturity value of the debts, they
would have to hand over the assets, i.e., the firm, to the debt holder. Therefore, the sharehold-
ers have a put option with an exercise price equal to the maturity value of the debts. This put
option is implicitly written by the debt holders.

DEBT AS OPTIONS |!
Debt has the feature that it cannot provide returns in excess of what has been promised. If
the value of a firm exceeds the value of its debts, the debt holders get their
The position of the debt face values and no more. In case the value of the firm is less than the matu-
peters Are ts rity value of the debts, the holders get only as much as possible given the
equal to having (a) along —
position on bonds with a value of the firm. Hence, the payoff to the debt holders is: capped at the face
maturity value equalto _-—«-vaillue of their respective debts (refer to Fig. 21.2c).
the debt, and(b)ashort This can be seen as a long position on a bond maturing at X¥and a short
position on puts with a _ position on a put with an exercise price of X. The put is written by the debt
ous ne lone vale holders to the shareholders. If the value of the firm is less than the face value
oo of the debts, the shareholders exercise their puts and to that extent, the debt

Long bond Short put

Value of firm, Vr

Value of firm, V+

(a) Long bond (b) Short put

Value of debt

X Value of firm, Vr

(c) Debt

Fig. 21.2 Debt as options (a) Bond and value of firm value of firm (b) Put and value
of firm (c) Debt and value of firm
 Corporate Securities and Derivatives 591

holders lose a part of the value of the long bond that they hold. The position of the debt hold-
ers is depicted in Fig. 21.2, and the payoffis tabulated in Table 21.1.

Table 21.1 Payoff to debt holders

Lex
Short put —(X — Vj)
Long bond
Total

In this context, shareholders can be viewed as holding a combination of

e a long position on the firm;
¢ a short position on bond with the maturity value of the debt; and
e a long position on put, with a strike price equal to the maturity value of the debt.

Earlier, we said that equity can be viewed as a call option. The above combination is no
different from a call option, as put-call parity would imply. Under put—call parity, a call can
be synthesized with a long stock, a long put, and a short bond. This can easily be verified by
the put—call parity discussed in Chapter 10, reproduced here for convenience.
Put—call parity;
Stock + put = bond + call
For shareholders, equity is a call option. Re-arranging put—call parity, we get;
Call = stock + put — bond
Yet another way of looking at the position of debt holders is through the value of the firm.
The value of the firm at maturity is the sum of the maturity values of the debts and the value
of equity. This implies

X = Vr — Sy, or
= Vr — Max (0, V;—-X)
This is equal to a long position on the entire value of the firm, with a short position on a
call option and a strike equal to the face value ofthe debt.

Subordinated Debt
Debts have different levels of seniority in terms of their claims on the cash flows of a firm.
Senior debt has claims that take priority over anyone else. Figure 21.2 depicts the payoff for
only one category of debt holders. Firms normally have several types of creditors who have
different priorities over one another. We now analyse the changes in the claims of equity
holders and debt holders if there is another category called subordinated debt, with claims
superior to the equity holders but inferior to the holders of senior debt.
The position of shareholders remains unaffected because any debt has prior claim over
them. However, the strike price of the call would now include the total value of all the debts,
senior and subordinated. The payoff for any senior debt with face value X), too, remains
unchanged, because to them subordinate debt is like an equity holder. Subordinated debt
592 Derivatives and Risk Management

is sandwiched between senior debt and the shareholders. The payoff for subordinated debt
would appear similar to the payoff for senior debt, with two modifications. First, the claim
would start later than that of senior debt, shifting the strike price to the right. Till the senior
debt is paid off fully (maturity value X,), the claims of subordinated debt do not start. Second,
the payoff would be smaller than for senior debt. This is depicted in Fig. 21.3 for subordi-
nated debt with an amount equal to X, — Xj, the total debt being X).

Value of debt
All debt
Subordinated debt > senior
debt ES ee ee ae
o
o Senior debt

Subordinated debt

Value of firm, V,

Fig. 21.3 Value of subordinated debt

CALLABLE AND PUTTABLE BONDS ©

Firms issuing bonds make commitments to the subscribers of the bonds, which are generally
Callable bonds are
_ not amendable. The commitments, in terms of coupon rates and tenure, are
issued by firms to gain _ decided at the time of issue with other terms contained in the indenture.
protection from falling These terms and conditions cannot be altered without the consent of the bond
yields after the issue of holders. Therefore, an indenture is issued after a lot of deliberation.
debts. __ We know that there is an inverse relationship between price and yield. The
~ higher the yield, the lower is the price, and vice versa. The coupon offered
becomes the cost of debt for the issuing firm. A commitment to pay the coupon lasts for a
longer time horizon. In a dynamic world, the situation may become adverse to the firm if the
interest rate declines after the issue of debt. For example, a firm may have issued a 15-year
debt at an attractive 10% coupon that is consistent with the current expectations of investors.
However, after five years, the economic scenario might change to lower interest rates. This
would adversely affect the competitive position of the issuer, as other competing firms would
be able to raise debt at much cheaper rates.
A convenient way to overcome the problem of falling yields is to build in a clause in the
indenture to call back the bond from the holders at a price that corresponds to the lowest
yield at which the issuer feels it necessary to cut down the cost of debt. Such bonds are
called callable bonds. The price at which the issuer can call back the bond is known as the
call price. As the yield falls, the bond price moves up. It would happen in the case of all
bonds. For a callable bond, though, the rise in price would be capped at the call price, as
shown in Fig. 21.4. Up to a certain fall in the yield, callable and non-callable bonds would
move almost the same way. For a callable bond, the price would not rise above the call price
because investors know that the bond would be called back by the issuer.
 Corporate Securities and Derivatives 593

Price

Call price Bete — Non-call

able

Yield to maturity
LEEDS
EI AEST ES EEE CLL DLE NS MATE

Fig. 21.4
2 ‘Callable and non-callable bonds—price and YTM

In terms of the option, the holder of a callable bond is equivalent to a long position in
a non-callable bond, with a call sold to the issuer at a strike equal to the call price. When
the yield falls to a level corresponding to the call price, the issuer would exercise the call
option by paying the call price to acquire the underlying security, 1.e., the bond. By a simi-
lar logic, the issuer can be deemed as long on a call with a short position on a non-callable
bond.
As issuer, a firm would protect against falling yields by inserting a callable feature. It may
also like to safeguard the interest of its subscribers by offering them an opportunity to sell the
bond back. A bond with such a feature 1s called a puttable bond. The holders of such bonds
would like to exercise the put option when prices fall. In terms of options, the holder of a
puttable bond is equivalent to a long position in a non-puttable bond and a long position in
a put with a strike equal to the put price.

CONVERTIBLE BONDS ©
While callable bonds are issued by firms to protect themselves from falling yields, convert-
ible bonds are issued to induce the subscribers to draw on the charm of equity. The intention
of the issuer is to bring down the coupon rate by offering conversion of part (or the whole)
of the debt into more lucrative equity. The number of shares converted upon extinguishing
the bond is called the conversion ratio. The conversion ratio multiplied by the share price
would give the conversion value. For example, consider a bond with a face value of £100,
with a maturity of five years and coupons of 8%. At the end of two years, the bond offers an
option to convert %60 into two shares of the firm. The bond would have a conversion ratio
of 2 and a conversion value of 60, assuming a stock price of €30. This bond may be seen
as combination of:
e anon-convertible bond of % 100 maturing after two years
e anon-convertible bond of = 40 maturing after five years
e acall option to get two shares at an exercise price of ¢ 60 (¥ 30 per share)
594 Derivatives and Risk Management

Since a call option always sells for more than its intrinsic value, it can safely be concluded
that a convertible bond would always sell for more than its conversion value. It can also be
seen that a convertible bond would sell for more than its equivalent non-convertible bond.

WARRANTS _ tiie

Firms also issue warrants (normally to promoters and their associates) to subscribe to their
shares within a stipulated time, at a price predetermined at the time of the
Warrants are like Ameri- _ issue. This is done by paying (a) some fraction of the price upfront and (b)
can calls, to be exercised the remaining at the time of exercise and within a stipulated time, the expiry
eee aL of the warrant. As is apparent, a warrant is like a call option to acquire the
tween the issue priceand ©Underlying asset, i.e., the stock of the firm at a predetermined price on or
the front-end payment before the some preset date.
However, there are some critical differences between a call and a warrant.
While exercising a warrant, there is a new issue of capital, which does not happen in the
case of a regular call. A call is written or bought with the same number of shares outstand-
ing. Besides, warrants are issued for longer maturities than those usually available for traded
options. Since warrants are issued by a firm, the value enhances by the amount of the exercise
value, and the firm issues the required number of additional shares exercised under the war-
rants.
When one exercises a warrant, the number of shares increase. The capital structure in
terms of the ownership of the firm undergoes a change. Equity increases if warrants are exer-
cised. In order to keep the capital structure unchanged in terms of the debt—equity ratio, the
issuance of warrants is often accompanied by the issuance of bonds. The bonds and warrants
are detachable. They can be traded independent of each other.
Due to the enhanced capital, there is dilution in the payoff on the warrant, as compared to
the payoff on a call. Consider the payoffs in two situations of 25 calls sold and 25 warrants
issued with identical expiry and exercise prices of % 100. Assume that there are 100 shares
outstanding. The payoffs under alternative scenarios for calls and warrants would be as given
inielablewules

Table 21.2 Dilution effect of warrants

ee Call ae Warrant
(a) Price of share before NG 150 150
(b) No. of new shares issued - a 25
(c) Total no. of shares after exercise 100 ie 125
(d) Exercise value accruing to firm - 2500
(25 < 100) %
(e) He after exercise 45,000 | 17500

(f) Share price after exercise, & 150 140

9) Exercise price,=
(h) Payoff,&
 Corporate Securities and Derivatives 595

Call option in warrants

A warrant is a security, entitling its holder to convert it into equity shares at a fixed price within a stipulated date. The current law
governing the issuance of warrants in India is that,
* they can be issued only at the current market price, as governed by a formula;
e the maximum period allowed would not be more than 18 months from the date of issue;
¢ 25% of the price would be paid upfront, to be adjusted against the exercise, i.e., only the remaining 75% is required to be
paid; and
e if not exercised, there is no refund of the money paid upfront.
Promoters of firms issue warrants to themselves, invariably increasing their own stakes in their firms. The motives for issuing
warrants include improving the debt-equity ratio, better control, avoidance of takeover threats, and raising resources for expansion.
Besides these features, warrants are also supposed to have significant information content, as they reflect on the minimum
intrinsic value of the firm as perceived by its management. For shareholders, the conversion price of a warrant is supposed to be
a floor because of the general belief that promoters would allocate shares to themselves at a price that is favourable to them at
the time of conversion of the warrants.
- However, in a large number of cases, this has not come true. The promoters of JSW Steel, the second largest steel producer
in India with a capacity of 10 million tonnes, did not exercise their 1.75 crore warrants, allotted in June 2010 at a price of € 1210
per share and due for conversion in December 2011, because the share price had fallen more than 50% since the allotment
of the warrants. As a result, they had to surrender 25% of the initial deposit of € 529 crore to the firm. Similarly, another firm,
Pantaloon Retail, having allotted themselves 1 crore warrants at € 400, also due for conversion in December 2011, surrendered
the initial deposit of = 100 crore, i.e., 25% of the conversion price when the share was trading in the vicinity of € 150 against the
conversion price of ¥ 400.
This trend is not new. In April 2009, several companies, such as Raymond, Bombay Dyeing, Aditya Birla Nuvo, Usha Martin,
and Jindal Saw also surrendered warrants due to sharp falls in prices from the dates of allotment of the warrants to the dates of
conversion. However, the losses in 2009 were much less because at that time, warrants could be allotted by paying only 10% of
the conversion price. These includents reflect holders not exercising the call option because asset-price falls better exercise price.
Source: Based on infor mation in the Economic Times and the Business Standard of April 2009 and December 2011

If the value of the firm is V with n shares. outstanding prior to the exercise of the calls/
warrants, then for m calls/warrants issued with exercise price X, the payoffs under calls and
warrants are given by
For Call; Payoff per call = eX (21.3)
n
: - ihe oc Be A A Rees
For Warrants; Payoff per warrant = sare X (21.4)
n +m
Since the payoff on the warrants is different from the payoff on the calls due to the issue
of additional shares, the value of one warrant would be less than the value of one normal
traded call. The payoff on the warrant can be expressed in terms of the payoff on a traded
call, as shown in Eq. 21.5.
Warrants imply issue of : Vy
fresh stock, while regular Payoff per warrant = —-——— t = x] (20-3)
calls are traded on n+m \n
already existing stocks. Value of warrant = —/— x Value of traded call (21.5)
Therefore, the value of a n+m
warrant is less than the Equation 21.5 enables us to value the warrant using the Black-Scholes
value of a regular call. _ option pricing model. First, we find the value of a regularly traded call using
 596 Derivatives and Risk Management

the given X, 7, r, and a, and then simply multiply it by the ratio of the number of shares
before and the number of shares after the exercise of the warrants.

SOLVED PROBLEMS
SP 21.1: Value of warrant
The promoters of a listed firm, ABC Ltd, have issued warrants to themselves equivalent to 10% of the present capital, exercisable at
a price of ¥ 200 per share within one year from the date of issue. The current price of the share is ¥ 240. Regular calls on the stock
with a strike price of ¥ 200 and an expiry of one year are trading at % 66. A potential investor has offered to purchase the warrants
from the promoters at € 62. Should the promoters sell the warrants to the investor?
Solution:
The exercise of the warrants would increase the capital of the firm by 10%. Even though the regular call is trading at a premium of
% 66, the value of the warrants is not as much due to the issue of fresh capital. The value of the warrant, as given by Eq. 21.5, is = 60.
Value of warrant = 100/110 x 66 = 60.
Since the investor offers more, the promoters should consider his/her proposal favourably.

SUMMARY
Firms issue various kinds of securities to raise capital. The form position on a bond with a maturity value equal to the face value
of capital issued by these securities provides different kinds of of the debt and a short position on a put.
rights to the holders on the cash flows of the firms. The basic The position of the equity holder can also be analysed in
forms of capital are equity and debt. While debt has a fixed claim terms of put-call parity as a combination of a long position on the
on the cash flow, equity owners have a claim on the residual. firm, a short position on bonds with a maturity value of debt, and
The securities issued by firms can be viewed as combination a long position on puts with a strike price equal to the maturity
of options. The value of a firm can be seen in two ways—one value of the debt.
on the liability side and the other on the asset side. The value of Callable bonds are issued by firms to gain protection from fall-
the firm should be equal to the value of the assets. Ifthe value of ing yields after the issue of debt. The position of bond holders is
the firm is less than the claims of the debt holders, equity holders equivalent to (a) a long position on a non-callable bond and (b)
do not get anything. The excess of value over the value of debt a short position on calls with a strike equal to the call price.
belongs to the shareholders. Hence, a shareholder's position is Warrants are like American calls, to be exercised on or before
considered as a call with a strike price equal to the value of the maturity by paying the difference between the issue price and the
debt at maturity. front-end payment. Warrants imply issue of fresh stock, while
A debt holder gets no more than the face value of the debt regular calls are traded on already existing stocks. Therefore,
provided the value of the firm is in excess of it. If the value is the value of warrants is less than the value of regular calls.
less than the debt, the holder loses. This is equivalent to a long

KEY TERMS
Callable bond A debt issued with a right to the issuer to call Warrants Instruments that give the right to their holders to
back after some time at a pre-specified price. subscribe to the stock of the firm at a pre determined price within
Puttable bond A puttable bond gives the right to the sub- some time upon initial part payment, with remaining payable at
scriber to sell back the bond to the issuer at a pre-specified price the time of exercise,
some time after the issue of the bond.

QUESTIONS “=
21.1 How does the derivative perspective help in understanding 21.3 Debt holders are only holding bonds of the firm. Do you
corporate securities? agree?
21.2 Can you describe the equity of a firm in the terminology of 21.4 How are warrants different from calls? Does a warrant
options, apart from it being considered a call option? have the same value as a regularly traded call?
 Real Options

INTRODUCTION - Learning Objectives

Strategic decisions are not as straightforward as routine capital After going through this chapter,
budgeting decisions. Firms and managers usually have various _ readers should be familiar with
options in terms of investing in real assets. The standard capital the meaning of real options
budgeting problem is solved by discounting cash flows (DCFs) the difference between financial
at an appropriate discount rate to arrive at the net present value options and real options
(NPV). Traditional capital budgeting approaches assume no the three important real options
faced in the corporate world,
action once the project is accepted or rejected on the basis of
namely,
DCFs. The implied assumption is that nothing can be altered » the option to delay
once the decision is taken and all is left to chance. « the option to expand
In real life situations, the problems are not as clearly defined « the option to abandon
as is assumed in capital budgeting exer- the valuation of real options by the
Routine capital budgeting discounted cash flow (DCF) method
cises. There remain substantial ambi-
exercises involving dis- the limitations of the application of
counting of cash flows to guities about the timing of investments, DCF valuation to real options
_find the net present value the gain or loss of competitive advan- application of the binomial model to
is flawed, because the tage as time elapses, and the strategic value real options
value so derived ignores position of the firm in the competitive e application of the Black Scholes
the managerial actions Model to value real options
world. All of these factors vary with
that are available later. reconciliation of different real option
time. Such strategic decisions often values obtained from different
relate to expenditure in research and development, where the methods
outcome of the efforts as well as of the cash flows is totally
unknown. In fact, a firm has the option of whether to invest or
not, and, if yes, when to escalate the capital investment. If the
initial outcome is not on expected lines, the firm has to decide
whether or not to abandon the effort.
Standard techniques assume that all managerial actions are
absent once the cash flow estimates are prepared. Capital budget-
ing decisions are not passive and static. Instead, they are subject
to managerial actions with several options as time progresses.
For example, after having implemented a project, managers have
options to reduce capacity utilization or undertake intensive adver-
tising campaigns if volumes are not picking up. On the contrary, if
 598 Derivatives and Risk Management

the product finds more than expected acceptance, the managers have options such as increasing
production, raising prices, and developing more product variants. The list of available future
courses of actions is endless. Each situation is different, and throws up several possible actions.
In fact, each capital budgeting decision is a complex set of options.
Discounted cash flow-based techniques assume that once an action has been taken, the
possibility of changes in the cash flows due to managerial action does not exist. This holds
good for financial assets like stocks and bonds; once this type of asset is purchased, the inves-
tor does not have any control over the cash flows attributable to it. In the case of real assets,
though, significant managerial leeway is always available to influence the cash flows of the
project, sometimes substantially and sometimes only marginally.

KINDS OF REAL OPTIONS

As distinct from financial options, options on real assets are referred to as real options. Firms
and managers usually have three different kinds of options on projects, as follows:

e The option to delay the project

e The option to expand the project
e The option to abandon the project

Option to Delay
The option to delay a project, also referred to as the option to wait, refers to
timing decisions
_ tegarding commencement of the project. Managers have several choices
The three basic real as
Options are the option to the right time to start a project. Conflicts arise, for example, from the
toss-
to delay, the option to up between the benefits of capitalizing on early bird advantages on the
one
expand, and the option hand and taking a greater risk by starting immediately on the other
to abandon. There are
hand.
Firms may face a choice between starting right away and starting a year
other options, too, that later.
They are mutually exclusive projects. Delaying a project may mean
allow managerial flex- leaving
ibility for adjusting prices, the field open to competitors and foregoing the early bird advantage,
which
volumes, shutting and means capitalizing on the market share acquired in the nascent
stage. The
re-opening, etc. option to delay is a valuable one where there is some kind of
exclusivity
~ about the venture or where the entry barriers are substantial. It
is a meaning-
less option if competitors can start the same project right then
or soon.
In a strategic sense, no project is acceptable merely because
it has a positive NPV now. It
is possible to have a greater NPV ifthe project is delayed. This
may happen due to the greater
certainty of cash flows, reductions in discount rates, expand
ing markets due to increased
awareness, etc., all of which go to increase the NPV. Similar
ly, no project can be permanently
rejected merely because it has a negative NPV then. It may
turn positive later due to reasons
such as greater demand, higher prices, lack of competition,
reduced capital cost, etc.

Option to Expand
The option to expand emanates from a firm’s exploration
of new markets and new products.
Capacity expansion to meet increased demand also provid
es options regarding the size of the
project. The size of the project has a direct effect on the
value of the investment in fixed assets
 Real Options 599

and working capital. This is also referred to as the growth option. A firm also has the option of
starting a pilot project; depending upon the outcome of the pilot project, it may decide to go in
for a full-fledged investment later. Normally the data available for starting of a pilot project are
rather uncertain and inadequate. The pilot project may be having a negative NPV, and, therefore,
may be rejected. Yet, firms do start a pilot project to gain experience. It also provides a com-
petitive edge to the firm and the possibility of expansion at a later stage. Pilot projects provide
an option to grow, and, hence, have value that must be considered before a decision is made.

Option to Abandon
The option to abandon is the option to discontinue operations before the useful life of the
project is over. Normally, cash flows are projected for the entire useful life
The options available add
- value to projects that is _ of the project and rarely do we account for the possibility of making an early
not captured in standard ; exit. Having undertaken a project that shows a promising future, the expected
capital budgeting exer. = cash flows of the project may not fructify. Under such situations, the firm
cises. _ always has the option of abandoning the project and realizing its salvage
~ value available, as doing so may be more beneficial than continuing the busi-
ness and wasting good money over a bad decision.
These embedded options in strategic capital investment add value to the project. This
value must be considered while evaluating capital budgeting. The value of these options
sometimes makes a negative NPV of the project worthy of a favourable consideration. The
strategic value of these options is significant and should not be ignored, as they create future
opportunities for the firm that can be exploited at the right time. Firms that recognize such
values tend to outperform their competition.
The identification and valuation of options is a tricky proposition, since business scenarios
are complex. Several options may be built into a single business situation,
Real options are strategic
in nature, and are difficult __and several real options may run concurrently. For example, assume that an
to value in awell-defined | infrastructure development firm is considering construction of a road, con-
mathematical modelor necting two towns, which reduces the distance and time of travel. However,
framework. _ the level oftraffic between the towns is low, and toll charges are subject to a
“shiny LEE EEE:
ceiling prescribed by the government. These factors give the project a nega-
tive NPV. However, this project may have multiple options embedded in it simultaneously.
The project may offer the options of expanding in scope (from a single lane to double lane),
abandoning it (handing it over to the government at a predetermined price after a few years),
or delaying (deferring it till more traffic is generated or the toll ceiling gets revised upwards).
All ofthese flexibilities will add value to the project. More importantly, they can turn a proj-
ect with negative NPV into one with a positive NPV.

DIFFERENCES BETWEEN FINANCIAL AND REAL OPTIONS!

The principles used in valuing financial options can be extended to value real options. Before
we attempt valuation of real options on the basis of tools used for valuing financial options,

'For a more elaborate discussion refer to Corporate Finance — Theory & Practice by Aswath Damodaran, John Wiley &
Sons Inc.
 600 Derivatives and Risk Management

let us consider the distinguishing features that will help to explain the distortions that may
show up in the results.

Real Assets are Not Traded

The principles used in option pricing theories assume a set-up of equivalent portfolios and
Oe : risk neutrality. A call option can be replicated by borrowing at the risk-free
Se of rate and owning the underlying asset. This replication has the same payoff
models applicable for op- : as that of a call option, and, hence, the two must trade at the same price to
tions on financial assets. | prevent arbitrage. This implies that both the call option and the replicated
However, real options portfolio are widely traded assets. Such an assumption in the case of real
ae Soy aneen _ assets is far from reality as the underlying assets, which are the cash flows
and
pon hence,
ae limit the _ of f the
th project
ject itsel1,
itself, d do notth have many buyers
buyers and sellers, » and,anc as such
uch,
applicability of valuation _ are not easily tradable. Valuing real options as if they are financial options
models. _ demands great care in reaching conclusions.

Variance of Real Options is Difficult to Estimate

Another difficulty with real options is the estimate of volatility of their cash flows. It is
extremely difficult to obtain the variance of projects though techniques such as simulation
and scenario analysis exist. In the case of financial assets, it is far easier to obtain the estimate
of variance because historical price data are available. Option pricing for financial assets
assumes that the variance remains constant over the life of the option. Since financial assets
are short term, the assumption seems valid. For real options, this assumption cannot hold, as
most real options are long term in nature. Even if the variance of the project may be obtain-
able, it cannot be regarded as constant over the life of the option.

Exercise of Real Options is Time Consuming

The exercise of real options is a time-consuming process, unlike the exercise of financial
options, which takes place rather instantaneously. The exercise of a call option on a stock can
be done the moment the stock price exceeds the exercise price, and, otherwise, whenever the
investor desires. In contrast, the exercise of real options, such as setting up additional capac-
ity, will require substantial time. This gestation period means a substantial delay from the
time the decision to exercise is made to the time the exercise is implemented. The benefits of
the exercise of the option accrue much later, once the decision to exercise is made and imple-
mented. Effectively, it means that the option period is less than what it may appear to be.

Terms of Exercise of Real Options are Not Clearly Defined

Further, the terms of exercise of financial options are well defined. In the case of real
options,
the right to exercise is ambiguous. Further, the actual exercise of a real option is doubtful
and
usually gets deferred because of human behaviour patterns. The exercise of financial
options
requires only economic and financial considerations, while the exercise of real options
involves
subjectivity and managerial prudence. The data required to value real options and
the consid-
erations to exercise them are not as well defined as in the case of options on financial
assets.
 Real Options 601

Though valuing real options is complex, we attempt to value some simple looking real
options to provide insights to the valuation process in this chapter.

OPTION TO DELAY—TIMING DECISION

Some high-technology firms engaged in developmental work often face an uncertain situa-
An option fo delay is ; tion regarding timing of the investment. When the product is in the prelimi-
the flexibility of timing ofMary stage, doubts over its commercial viability or its success are rather high.
implementing a project. _ Under such situations, the firm may prefer to wait, since uncertainty reduces
~ as time elapses. Making an investment earlier than warranted exposes the
firm to a greater risk, which can be reduced significantly if the firm waits a while to achieve
clarity in future scenarios.
The apprehensions of the firm about whether to invest now or later may emanate from
any of a number of reasons. Normally, the demand situation is fluid for new products, or the
products are not fully developed and require some refinements. An unrefined product may not
receive an enthusiastic response from customers. The firm may have to make an extra effort
to launch a more refined product later. At the same time, if the product is not launched now,
the firm may be apprehensive about losing business to its competitors, who may take greater
initiatives and show more entrepreneurship. The firm may not want to lose the advantages
normally associated with an early bird presence in the market. Under such circumstances, the
option to delay the investment is ruled out, since competitors would introduce the product
anyway.
However, in some circumstances where the firm has exclusivity by way of a right or a pat-
ent, the option to delay the implementation or timing of the investment is somewhat a matter
of choice that is less subject to pressure.

Evaluating Timing Decision with DCF

One way to value an option to wait is the standard DCF analysis. In the nascent stage, there
_ is a lot of uncertainty about cash flows. In terms of financial management,
Merely because the NPV : deine ; i
a see is positive _ this uncertainty and ambiguity is reflected in the negative NPV at present,
itisnot necessary that : calling for its rejection. Strategically, though, the managers are not inclined
itmustbe implemented to do so. The dilemma arises due to the negative NPV of the project. The
now. By deferring the _ DCF technique uses the decision criteria now or never. If the NPV is nega-
project, one may get a
tive, we do not consider the project. However, the future potential may be
higher NPV.
_ large enough to more than offset the present negative NPV of the project.
Under such situations, another alternative emerges, 1.e., to wait until the
uncertainty about the project reduces to an acceptable level. In terms of the DCF valuation,
we expect the NPV of the project to improve and turn positive either due to improved cash
flows or due to reduction in the discount rates.
The rule: The standard technique in capital budgeting to evaluate the timing issue is to find
out the NPVs ofdifferent timing options and choose the one that has the maximum NPV.

Let us consider a simple example to illustrate the decision-making process.

602 Derivatives and Risk Management

Assume that a software firm SOFTBANK has developed a new banking product and is
uncertain about its demand potential. SOFTBANK expects the life of the product to be four
years, and its launch will cost 7100 lakh today. SOFTBANK knows that there is no com-
petitor presently for the product developed. If the firm faces a good demand for its product,
the annual cash inflows are expected to be %50 lakh. However, if the demand is not good,
the annual cash flows will reduce to 30 lakh. The managers at SOFTBANK estimate equal
likelihoods ofthe ‘good’ and ‘not so good’ demand scenarios. The expected annual cash flow
would be %40 lakh (0.50 x 50 + 0.50 = 30). With a 12% discount rate considered appropriate
for the cash flow risk, the expected NPV of the project if launched now is %21.49 lakh.
NPV = 40 i A) | 40 " 40
— 10 =€21.49 lakh
LQ ei ae eto meres
With a positive NPV, the project must be implemented now. However, some managers of
SOFTBANK feel that it is worthwhile to wait for another year before launching the product,
as the preferences of the customers will be better known next year. The cost of launching
the product a year later will be no different from what it is now. The decision to implement
a year later will depend upon the demand scenario prevailing then. If the demand remains
good, SOFTBANK must go ahead with the launch. Otherwise, it must drop it altogether (this
would be the option to abandon).
This situation can be considered as a choice between two mutually exclusive options, with
The option to delay _ the decision to be based on the rule of the higher NPV.
:
a project (a) helps in Option I: Launch now
reducing the uncertain- Option II: Launch a year later
ties of cash flows, and
(b) provides for learning. Options I and II are mutually exclusive, as selection of one precludes the
Therefore, it adds value other. As a first step, we compute the NPV of the project for immediate
to the project launch. If we considered the NPV of option I, which is positive, we would
have gone ahead with immediate implementation, forgoing option II. We
cannot let option II lapse unless an immediate launch proves a better choice. To know which
of them is better, we need to compare the NPVs of both the options. The expected NPVs of
options I and II are computed in Table 22.1.
Note that the present values that need to be compared must coincide in time. The invest-
ment of €100 lakh in Option II in Year 1 is equivalent to $89.29 lakh as on this day (Year
0).
The expected NPV of option I is ¥21.49 lakh, and that of option II is 23.16 lakh. Since
the
expected NPV of option II is greater, the product must be launched a year later. The
value of
the option to wait for one year, therefore, is the difference between the two
NPVs, i.e., 71.67
lakh. We have assumed the following here:
The firm implements the project if the demand scenario is ‘ good’ in Year |.
:project
ne when
A delayed
oe 2 The firm
irm abandonsthe proje
projectifthe demand cenario
scenarioisis ‘not
‘notso good’ d’inYear
in Year | 1.
indicates that the option ® The initial outlay and the cash flows for the next four years remain the
to wait is valuable. L same.
ner e The discount rate too remains the same at
12%.
While the first two assumptions seem valid, the latter two may be challeng
ed. The annual
cash flows for the life of the project may turn out to be more or less than
€50 lakh. If the
 Real Options 603

Table 22.1 Option to delay for SOFTBANK & lakh

Option I: Launch now L

Discount rate 12%

Year NPV | Probability p |px NPV

Good 2 ]
Cash flow (100.00) 50.00
PV (100.00) 39.86 — 5.8) 0.50 25.93
Not good
Cashflow | (100.00) 30.00
PV (100.00) 23.92 (8.88) 0.50 (4.44)
Expected NPV | 21.49 |
Option Il: Launch a year later L
Discount rate 12%

Year NPY
Good
Cash flow | (100.00)
PV atyear0} (89.29)
Not good
Cash flow

PV

competition catches on, the likely cash flows may reduce; if the demand proves better than
expected, they may increase.
Likewise, if other options of different timings for the investment are available, they may
be analysed utilizing the DCF technique and comparing the expected NPVs to choose the
option with the largest NPV. Based on the calculation of the NPVs for SOFTBANK for both
the options, it is worthwhile to wait for the launch, as the NPV for the delay option is higher.

Valuing Option to Delay with Binomial Model

Since there are only two possibilities, the situation of the timing option for SOFTBANK is
tailor made to apply the binomial model of option pricing. The situation for SOFTBANK is
displayed in Fig. 22.1. The present value in case the demand is high is 170.09 lakh, being the
present value of the annual cash flows of %50 lakh at ¢ = 1 year discounted at 12%. Similarly
the present value of the cash inflows in case the demand is not so good is 102.05 lakh, with
annual cash flows of 30 lakh.
The firm has the option to delay the launch by one year, implying that it implements the
project with an exercise price of 7100 lakh. In case the demand is good, the firm implements
604 Derivatives and Risk Management

PV |
|

at f= 1 year % Return _
170.09 70.09% |
Y

y
100 i
Y

wep ara
l 7

y%
102.05 2.05% i
LE EEE EEE jy

Fig. 22.1 Option to wait: Binary option pricing

a8 _ the project and the payoff is ¥70.09 lakh after a year. In case the demand is
The binomial method . i ape
for valuation of financial ot so good the payoff on the call option is at 2.09 lakh.
options can be applied to - We adopt the risk-neutral method to value the call option. Assuming that the
value real options, too. risk-neutral probability of high demand is p, the expected payoff of the two
_ ~ branches must yield a return equal to the risk-free
rate of 9%. Then
p x 1009% + (1 — p) X (—2.09%) = 9%
p=AVALG
With a probability of 10.21%, the value of the call at the end of option periods computed
at £15.26 lakh.
Value ofthe call today = (0.1021 x 70.09 + 0.8979 x 205)/1.09 = 28.30 lakh
Option pricing through the binomial model suggests that the option to wait is worth $8.30
lakh, as against the NPV of the project at 21.49 lakh if implemented today. Therefore,
SOFTBANK must implement the project now. It is not worth waiting for another year.

Discounted Cash Flow and Binomial Option Valuation

Here, we face a contradiction in the outcomes derived from DCF valuation and the binomial
_ model. Which of them is correct? It is hard to belie the DCF approach,
Due tothe presence of : tee
options, the risk profiles because it has been used q so successfu
fare Sire
ly in financia ki
ecision making.
of cash flows changein However, we must point out the deficiencies of the DCF analysis when
the
each scenario, and there- —_situation involves options. In the DCF approach, we made two vital assump-
fore, the standard DCF tions—the first was regarding the probability of the demand
being good at
aes en a 50%, and the second was regarding the discount rate of 12%. The probabil-
No single rate of discount
can capture the risks of ity assigned to the demand being good was subjective, and each individual
cash flows. _ would assign a different value depending upon his/her perception. The
NPY,
emer therefore, would be different for different persons. In contrast, option
valu-
ation by the binomial method is independent of individuals’ expectat
ions and perceptions. It
is defined for the risk-neutral world.
Second, we assumed a discount rate of 12% for all situations. While
valuing an option,
there are contingent situations, which change the risk of the cash flows.
Here, the option to
wait includes a decision not to implement the project if in the
first year the demand faced
1s not so good. The risk faced in such a situation would be zero.
There cannot be a single
discount rate that captures all the situations and corresponding
risks. We have to necessarily
 Real Options 605

use different rates for discounting the cash flows for different situations. The validity of using
a single discount rate is questionable. The valuation of the option, however, is independent
of individual preferences for probabilities and the discount rates.
Under the risk-neutral assumption in binomial option pricing, we need neither the prob-
abilities of different demand scenarios nor the discount rates. With the binary model taking
contingent situations into account, the use of the DCF method is inappropriate.
Option valuation is dependent upon the current price of the underlying asset. The current
price is assumed to contain the probability estimates. The risk-neutral method implies the
probability of facing an upside demand of 50 lakh per annum of 10.21% as against the
assumed figures of 50% in the DCF method. The other determinant of the option price is the
risk. The risk 1s supposed to be contained in the estimates of volatility. This also means that
the implied volatility in the binary model’ is 53.11%, as against 28.00% in the DCF method,
calculated later in this chapter.

Using Black-Scholes Model for Investment Timing

The binomial model takes care of two possible future values of the underlying asset. We can
also use the Black-Scholes option-pricing model (BSM) to value the option to wait, which
provides further insight to the analysis, as it allows all possible values and continuous com-
pounding. The BSM developed for pricing financial options can be used to value real options
too, though with certain limitations, as stated in the earlier part of this chapter.
Of the five inputs of BSM, the three inputs X, 7, and r are available readily. The exercise
price, X, is 100 lakh. The time to expiry of this option is one year. The risk-free rate can be
obtained from the yield on the government securities. Let us assume this at 9%.
The underlying asset on the option is the cash flow of the delayed project. The expected
present value of the cash inflows of only the project (not the expected NPV, which is the
intrinsic value of the option) will be equivalent to the spot price, S. The spot price of the
underlying asset values can be arrived at as follows:

Present value of inflows—the spot price <= lakh

Discount rate 12%
PV Probability. p

|
Cash flow
PV
Cash flow
PV

The last input required is the variance of the returns. We need to compute the variance of
the expected returns on the option to delay at the time the option expires, 1.e., after one year.
The value of the underlying asset at expiration is as follows:

2The volatility implied in the binary option pricing is given by (1 + u) =e?!

606 Derivatives and Risk Management

Present value of inflows at expiry of the option a

Discount rate 12%
Year PV Probability (p) | px PV
1 rere 2 3 4 | a
Cash flow 50.00 50.00 50.00 50.00
PV 44.64 39.86 35.59 31.78 151.87 0.50 75.93
Cash flow 30.00 30.00 30.00 30.00
PV 26.79 23.92 21.35 19.07 91.12 0.50 45.56
Present value at t = 1 121.49 |

One standard model of Note that the expected value of the asset at the time of expiration is 12%
valuing options is the higher than the values at the beginning of the option period, as the cash flows
Black Scholes option are discounted at a weighted average cost of capital (WACC) of 12%.
pricing formula, devel-
oped for valuing options ES ; Z 5
on financial assets. Calculating variance of option
——- |. Expected Spot 9 ay We
Price att = 1 price Return Probability Return dev2
Good 151.87 108.48 40% 0.50 0.20 0.0392
Not good 91.12 108.48 -16% 0.50 (0.08) 0.0392 |
Expected return 12%
Variance 0.0784
Standard deviation 28.00%

The variance of the call option is 0.0784, equivalent to a standard deviation of 0.28
(28.00%). Now all the inputs for valuing the option are available for using the BSM, appli-
cable for valuing financial options.
The BSM for valuing call options is reproduced as 6 Re

c = SN(d,)—Xe~"* N(dy)
Vin S20 r+ o7/2)T
where d ; and 21)
aul:

ee . 2/2
d, = ESS Foal Cake aE ord, =d, — ovT
owl

The values ofthe input are

Spot price, S %108.48 lakh
Bxercise price, €100.00 lakh
Time to expiry, T | year
Interest rate, 9%
Standard deviation, o 28%
Inserting these values in Eq. 22.1, we find the value of the call option
to be $21.67 lakh.
 Real Options 607

It may be observed that the NPV of the option is just about the same if implemented today
(21.49 lakh). The option pricing method recommends implementation now. The NPV of the
delayed project is computed as $23.16 lakh using the DCF method. It recommends delaying
implementation by a year. How do we reconcile the contradiction?
The answer possibly lies in the assumptions of option pricing not holding good. The stan-
dard deviation of the project is computed with a limited number of scenarios, and, hence,
may not be reflecting the variability truly. Options derive their values from volatility. The
larger the variance, the greater is the value of the option. The implied volatilityof the cash
flow appears to be higher than what is assumed in the option pricing model. However, our
failure to accurately project the variance of the cash flows in real world situations should not
be treated as a deterrent to use of the model. Instead, we must strive for a better estimate of
volatility.

OPTION TO EXPAND |
_ Many strategic situations demand investment in the initial stages despite a
The option to expand
relates to the ability of negative NPV because such an investment provides the firm with an opportu-
firms to improve their nity to make a further investment that is profitable enough to compensate for
cash flows subsequent the loss incurred in the first investment. Firms cannot let go such investment
to implementation by opportunities, simply because they lose a more profitable business opportu-
increasing the price,
nity that arises subsequently, as a consequence to the initial investment. We
increasing the volumes,
and improving the quality shall examine how to value such opportunities to expand the business that is
of products. basically embedded in the first investment.
a Consider a firm called GrowMotors, developing an electric car that
requires no fossil fuel and works on batteries and solar energy. The initial cost of a project
for developing the pilot model is estimated at $200 crore. The product is new, and offers
considerable advantages over normal petrol-driven cars. However, the selling price is rela-
tively high, and the new car suffers from the drawback of low speed. Since the product is
high priced and cannot achieve a speed of more than 50 kmph, its consumer acceptability
is doubtful. Based on estimates for the next three years, the cash flows are projected evenly
at 75 crore annually (assumed for simplicity). The project has a negative NPV of $13.49
crore, as can be seen in Table 22.2, and, therefore, is not worthy of consideration. The dis-
count rate used is 10%, being the risk-adjusted WACC considered appropriate for the risky
electric car venture.

Table 22.2 GrowMotors—launch of electric car—Phase |

(crore) Discount rate 10%

Cash flow (200.00) | 75.00 75.00 700 OF

Present value (200.00) 68.18 61.98 ee
hp
|
G34
608 Derivatives and Risk Management

However, this project has an option to grow embedded in it. GrowMotors is engaged in
continuous and sustained developmental work. It expects to remove the deficiencies of the car
over the next three years. Let this be called Phase IH. It could commence in the third year. It
would cost another €600 crore to launch the improved model in terms of the present value at
Year 3. This is clearly a call option with an exercise price of ¥600 crore that is available only
when Phase I is implemented, and arises only when the present investment of ¥200 crore is
made. Depending upon the experiences gained in the initial launch period, the decision to
introduce Phase II will be made. At present, however, management expects either of the fol-
lowing two scenarios:

¢ There is a 60% probability of facing a good demand with a cash flow of the present
value of $1000 crore, providing an NPV of 400 crore in Year 3.
¢ There is a 40% probability of facing a poor demand with a cash flow of the present
value of $300 crore, providing an NPV of —%300 crore in Year 3.
This is depicted in Fig. 22.2. .
Conventionally evaluated, the expected NPV at Year 3 of the commercial model is

0.60 x 400 + 0.40 x — 300 = €120 crore

Year 3 PV of inflows

Good (0.60) 1,000

—600

Poor (0.40)

300

Fig. 22.2 Option to expand—Growmotors—Phase ||

DCF Valuation
The commercial model in Phase II, as a stand-alone project, has a positive NPV as
on today.
Note that Phase II has considerable uncertainty. However, this is a contingent
project, which
cannot be pursued without the pilot project of Phase I. At the end of Year
3, the option to
expand will be exercised, depending upon the demand scenario. If the demand
is poor, the
investment (exercise of the option) will not be made, and if the demand happens
to be good,
the investment will be made. In such a case, the NPV ofthe project for expansion
would be
0.60 x 400 + 0.40 x 0 = %240 crore
Therefore, the NPV of the electric car project with the option to launch
Phase II will be a
positive $126.32 crore, as shown in Table 22.3 and Pigwe 2.
Notice that under the DCF approach, we have used a risk-free rate of 5%
for discounting
the initial investment of %600 crore because of its certainty. The rest
of the figures that carry
operational risk are discounted at a WACC of 10%. If we go by the standard
capital budgeting
 Real Options 609

Table 22.3 GrowMotors—launch of electric car Phase | and Phase II

Discount rate 10%
Present value with high demand Expand
Cash flow 0 1 2 3 PV atT=0
Phase | (200.00) (200.00)
Investment (200.00)
Inflows 75.00 75.00 75.00 186.51
Phase Il
Investment - - -600 (518.30)*
Inflows By 2 1,000 751.31
Net present value with high demand 219,53
Present value with low demand Do not expand

Phase | 2
Investment (200.00) (200.00)
Inflows 75.00 75.00 75.00 186.51
Phase II
Investment = at = =

Inflows 2 2 = =
Net present value with low demand (13.49)
“Beilig certain aiscounted at oe.

NPV Probability Expected NPV _

219.53 0.60 New

Do not Expand

(13.49) 0.40 (5.39)

jo inihe NPV with Phase | and Phase II 126.32

Fig.2
22.3 NPV GrowMotors—withERG | and phase II (% sees

process in evaluating the pilot Phase I as a standalone project, we would end up rejecting it.
With the option to expand, though, the project becomes viable.
In the appraisal of Phase I, we did not consider the value of the option to expand. We need
to value this option, which is a call option with an exercise price of 600 crore, with time to
expiry of three years.

Valuing Option to Expand with Binomial Method

We shall consider the value of the option to expand using the binomial method, as there are
only two possible demand scenario outcomes. The payoff on the call option at expiry is
610 ‘Derivatives and Risk Management

Figures in ® crore
Demand scenario
Value of the underlying asset 1,000 300°
Exercise price 600 . 600
Payoff from the call option 400 0 |

This time, we value the call option with the equivalent portfolio approach. The equivalent
portfolio can be constructed by owning some fraction of the asset and borrowing in such a
way as to give the same payoff as that of the call option. The delta of the call option is given by
Delta = Spread of payoff of call/spread of value of underlying asset
= (400 — 0)/(1000 — 300) = 400/700 = 4/7
Therefore, we shall buy 4/7 of the underlying asset and borrow in a manner that makes
the payoff equal to the payoff on the call option. The amount of borrowing that will equal the
cash flow of the call option to expand on the expiration date would be 7171.43, which is the
difference between the value of the asset and the payoff on the call (4/7 = value of asset —
payoff on the call option = 571.43 — 171.43 or 171.43 — 0). The value of the portfolio of 4/7
of the asset and the borrowing on the expiry of the option period of three years is identical
to that of the call option, as depicted here:

Figures in& crore

|Demand scenario Good Poor
Value of the asset on expiry 1,000.00 300.00
Value of 4/7th of the underlying asset 571.43 171.43
Repayment of loan and interest 171.43 171.48
| Payoff from the portfolio 400.00 0.00

Since the portfolio and the call option are identical at maturity, they must command
identi-
cal prices today. Hence, we need to find the value ofthe asset and the loan
today. Here, the
underlying asset is the present value of the cash flows from the asset. The
expected value of
the asset at year 3 is

Figures in crore
Demand scenario PV of cash flows Probability p X cash flow |
| Good 1,000 0.60 600
Poor 300 0.40 120
|Expected value % 720

The current value of the underlying asset can be computed by discounting the year
3 value
at a WACC of 10%. The current value ofthe underlying asset is 720/1.103 = 540.95
crore,
and the value of the 4/7 portion is 309.11 crore. The borrowing will be done at
a risk-free
rate of 5%, and the present value of borrowing is 171.43/1.05? = 2148.09 crore.
We arrive
 Real Options 611

at the value of the call by setting it equal to the current value of the equivalent portfolio.
Therefore, the value of the call is

= Value of 4/7 share — present value of borrowing

= 309.11 — 171.43/1.05° = 309.11 — 148.09 = 2161.02 crore
Value of Phase I of the electric car project

= NPV of Phase I + value of the embedded call option

= ht 491.6102 = $147.53 crore.

Valuing Option to Expand using BSM

Amongst the five inputs required to find the value of the call, we already have four: the
exercise price, X, at 600 crore; the risk-free rate, r, at 5%; the time to expiry, 7, of three
years; and the spot price of the underlying asset, S, at ¥540.95 crore (The expected value of
~720 crore at t= 3 years discounted at 10%). The remaining input, the standard deviation of
the underlying asset, o, is calculated in Table 22.4.

Table 22.4 Calculation of standard deviation of returns

ae ae Return relative | Annualreturns(%) | Prob ee Variance i

540.95 1000 1.85 CPs 0.60 13.64 158.01

540.95 300 : 0.55 (17.84) 0.40 ~7.14 237.02
Expected return (%) 6.50
Variance 395.03
UREA SL i) L 19.88

With all the inputs known, GrowMotors’ option to expand can be valued using the BSM
with the following values:
Exercise price, X 600.00 crore
Spot price, S 540.95 crore
Standard deviation, o 19.88%
Annual interest, rf 5.00%
Time for expiration, f 3.00 years
Inserting the input values in the BSM, we get the value of the call as
c = Md) x S— N(d>) x PV ofX
c = 0.6205 x 540.95 — 0.4851 x 516.42 = $85.16 crore

The value of the call option is ¥85.16 crore.

Note that the delta of the option under the binomial method and the BSM 1s 0.5714 and
0.6205, respectively, which is one source of variation in the value of the call. The other source
of variation between the values of the call derived by the binomial method and the BSM is
rooted in the volatility calculated by the two models.
 612 Derivatives and Risk Management

OPTION TO ABANDON
All projects are subject to constant review by the managers of the firm, taking into consider-
ation the latest happenings and the future potential. One of the possible sce-
An option to abandon
relates to a situation _ narios relates to discontinuationve of the project under circumstances where the
where afirm can take _ managers face adverse conditions that no longer generate the expected cash
adecision toexitsome flows. In such conditions, the managers may estimate that the project will be
activity to reduce or avoid better off if its assets are disposed off, rather than put to continued use. Such
cash losses.
a right to abandon or make an exit is valuable, as it may release financial
resources for exploring new, more profitable business avenues, or may sim-
ply help contain the future losses that may arise as a result of continuation of the project.
Such an option is analogous to a put option where the holder has the option to sell at a pre-
determined price within a predetermined time period.
Consider the example of Ganga Toll Bridge Company (GANGA), which is contemplating
participating in a tender to build a bridge across a river. The tender stipulates the maximum
toil fee that can be charged. The terms and conditions of the tender also specify that the
bridge must be made toll free after 25 years. The cost of building the bridge is 10 crore.
Based on the present level and future estimates of traffic, GANGA has estimated that it
would be able to generate a cash flow of €1 crore evenly for the next 25 years. The present
value of the cash inflows of €1 crore for next 25 years at a WACC of 12% works out to 27.843
crore, and the NPV is a negative 2.157 crore.
NPV = PV of annuity of %1.00 crore for 25 years at 12% — %10 crore
= 7.843 — 10.000 = =%2.157 crore
Since the project has a negative NPV, GANGA is not keen on pursuing it.
GANGA rejects the proposal, but the tender authorities then offer the following additional
information:
¢ The local government is also planning to develop an amusement park and a
township
on the other side of the river, which are likely to enhance the traffic on the bridge.
The
estimated time to complete the development is five years.
e In view of its developmental objective, the local government has also
offered to buy
back the bridge at the end of five years at 26 crore from GANGA. if it finds
the bridge
non-remunerative at that time.

DCF Valuation
Under the revised scenario, GANGA faces the following situation:
¢ [timplements the project now and expects cash flows of 21 crore for
the next five years,
when it would be time to take another decision.
e At the end of five years, GANGA faces two possible traffic scenarios
:
= If traffic volume is high, it gives an annual cash flow of 22.50
crore for 20 years,
which if valued at 12% has a present value of 318.674 crore. GANGA
continues the
project. The chances of such a situation coming to be are estimat
ed at 60%.
 Real Options 613

= If traffic volume is low (for which the chances would be 40%), it gives an annual
cash flow of 0.50 crore for 20 years, which if valued at 12%, has a present value
of %3.735 crore. GANGA abandons the project and realizes %6.00 crore from the
government, because the asset is worth less than the put option.

The new scenario is presented in Fig. 22.4.

Time (years)

%2.50 crore/annum for 20 years at 12%

PV (at t= 5 yrs) = ¥18.674 crore Continue ]
71.00 crore for 5 years High = 0.6

Low = 0.4
~0.50 crore/annum for 20 years at 12%
PV (at t= 5 yrs) = %3.735 crore Abandon —

Fig.220.4 caer toenon Scaretoll

ee

DCF Valuation without the Put Option

Without the additional new information, the NPV of the project was negative at ¥2.16 crore.
With the changed scenario of traffic from year 6 onwards, we revalue the project assuming
(a) annual cash flows of %1 crore for the first five years, and (b) the expected value of two
possible traffic scenarios—high traffic and low traffic—with probabilities of 0.6 and 0.4,
respectively, for the next 20 years. All the cash flows are discounted at 12%, considered
appropriate for the risk associated with the project. The expected value of the cash flows at
t= 5 years is ¥12.698 crore.
This is further discounted at 12% for five years to give a present value of ¢7.205 crore.
We add the present value of the cash flows of %1 crore for five years to provide an NPV of
%0.81 crore. This makes the project marginally acceptable, even without the exercise of the
put option. This is depicted in Fig. 22.5.

PV (t = 5)
High 18.674 x 0.6 = 11.204
0.6
1 crore, 5 yrs, 12%

3.735 x 0.4 = 1.494

PV (t = 0)
3.605
2.205, =
<a 12.698 |
10.810 NPV= 10.810
— 10.000 = 0.810 Z

ah Bain”
2. 5 Peteyvallear NPVPalthout
Fig. (% crore)
 614 Derivatives and Risk Management

DCF Valuation with Option to Abandon

The offer of the local government is a put option for GANGA, with an exercise price of %6
crore and time to expiry of five years. At the end of five years, GANGA can exercise the
option depending upon the situation at that time. This changes the cash flow for the low traf-
fic scenario from %3.735 crore to %6 crore because GANGA exercises the option to abandon
the project. This would enhance the value of the project. Here again, we have discounted all
the cash flows at a WACC of 12%. This may be challenged because the cash flow with low
traffic is certain, while the cash flow with high demand carries the usual business risk. If the
cash flow of the low traffic demand is discounted at the risk-free rate of 6%, the NPV of the
project increases to 1.755 crore.
.
The value of the project with a put option is shown in Fig. 22.6. Clearly, the put option
adds value to the capital budgeting exercise.

PV (t = 0) i
High 18.674 x 0.6 = 11.204

1 crore, 5 yrs, 12%

6.000 x 0.4 = 2.400

PV (t = 0)

Fig. 22.6 Expected value and NPV with put option (%crore)

Valuing Put Option with Binomial Method

Since GANGA faces only two possible traffic situations, we
may use the binomial method to
value the put option. The underlying asset is the present value
of the cash flows of the bridge
that are likely from the sixth year onwards. Note that the cash
flows of the first five years do
not form part ofthe underlying asset.
To apply the risk-neutral method, we need to compute the
return on the underlying asset
at the time of expiry of the put option. The current value
of the underlying asset is 7.205
crore, as computed in Fig. 22.7. As can be seen in this
figure, at the end of five years, the

Asset value,t=5 Returnrelavive %Annualreturn ©

High, p 18.674 2.592 159.2%
7.205

ce. 3.735 0.518

CLLR pr crane

Fig. 22.7 Risk-neutral valuation of put option—Ganga toll bridge

(crore)
 Real Options 615

asset has a value of 18.674-crore with high traffic, providing a return of 159.2%, and %3.735
crore with low traffic, providing a return of —48.2% over five years.
Assuming risk neutrality with probability of the high traffic as p, we must have

{(1.06)° -1} = p x 159.2% + (1 — p) x (48.2%)

Solving this equation for p, we get the implied probability as 39.55%.
Bye Oreo Uy. 82,02
639.5576.
159.20 + 48.20 204.40
The value of the put at maturity of the option p would be the expected value of the payoff
on the put option with the implied probabilities of high and low traffic. Therefore,
Value of the put at expiry

= p x payoff with high traffic + (1 — p) x payoff with low traffic

= 0.3955 x 0 + 0.6045 x 2.265 = 71.369 crore
The current price of the put would be the present value of the put at expiry discounted at
the risk-free rate of 6%. Therefore, the value of the put option is €1.023 crore.

The value ofthe put today= 1.369/1.06°= %1.023 crore

Value of Put with BSM

Amongst the five inputs required to find the value of the put, we already have four: the exer-
cise price, X, at 6.00 crore; the risk-free rate, r, at 6%; the time to expiry, 7, of five years;
and the spot price of the underlying asset, S, at ¥7.205 crore. The remaining input, the stan-
dard deviation of the underlying asset, o, can be found from the variability of the returns on
the underlying asset. The return when the traffic scenario is high is 159.5%, which is equal
to an annualized return of 20.98%. Similarly, the annualized return when the traffic scenario
is low is —12.33%. The scenario relating to the expected returns on an annualized basis is
depicted in Fig. 22.8.

|
Asset valuet=5 Returnrelative % Annual return

High, p 18.674 2.592 20.98% :

7205
2 eee
i
Tes 3735 0.518 Bio 20 :
ea ae oy Os

Ae22.8 paeareee return for BSM valuation of put option—GANGA toll bridge (®crore)

The calculation of standard deviation of the annualized returns on the underlying asset
is shown in Table 22.5. It is 16.31%.
Now we may compute the value of the put option using the BSM.
With these inputs we find

d, = —1.5067 and _N(-d,) = 0.0659

dy=-01.1420 and M-d,)=0.1267
 616 Derivatives and Risk Management

Table 22.5 Standard deviation of returns on underlying asset

Annual cash flow Annual return Probability | Expected return Poe

(crore) (%) (%)
aicavtanic 2.50 0.60 12.59
Low traffic 0.50 12.32 0.40 -4,93
Expected return 7.66% _—
Variance 0.026613
Standard deviation tab | 16.31% |
TEE

Inserting the input values in the BSM, we get the value of the put as €0.089 crore.
The option to sell back the bridge to the government is valuable, as can be seen from
visualizing what happens after the fifth year. The put option works as insurance for GANGA
in the event that the demand keeps low due to non-development of the amusement park and
the new township. GANGA can also use this valuation to renegotiate the buyback price to
upwards of %6 crore to accept the project.
The difference in the valuation of the put with the binomial model and the BSM is due to
the difference in the volatility used. In the BSM, the annual volatility is taken as 16.31%. For
a five-year period, this volatility is equivalent to o f= 16.31V5 = 36.49%. As against this, the
volatility in the binomial method for the five-year period is 101.60%, as shown in Table 22.6.
This is equivalent to an annual standard deviation of o /Vt = 101.66/V5S= 45.43%. Using the
value of o as 45.43%, we get a put value of =1.108 crore.

Table 22.6 Standard deviation of returns on underlying asset under binomial method

es Annual cash flow | Annual return | Probability | Expectedreturn | Variance

(= crore) (%) cb (%)
High traffic 2.50 159.20 0.60 95.92 0.412942
Low traffic 0.50 ic ~48.20 0.40 -19.28 | 0.619412
|Expected return 16.24% =
|Variance 1.032354
Standard deviation

SUMMARY
Capital budgeting decisions are strategic in nature, where man- on real assets. We are familiar with options on financial assets.
agement has the flexibility to make decisions subsequent to Options on real assets are normally of three types—the option
implementation of a project. These decisions have an implica- to delay, the option to expand, and the option to abandon.
tion on the cash flows of the project. These cash flows, once The option to delay refers to decisions regarding timing of the
projected, are assumed constant over the life of the project. implementation of a project. An option to expand is the flexibility
Decisions can be made on the basis of these static cash flows, to increase production, increase prices, or add product lines to
The standard capital budgeting exercise ignores the strategic enhance the cash flows of the project later, depending upon the
value of these decisions. experiences gained in the initial phases. It is like a call option that
The flexibility of management and its ability to change the has an exercise price equal to the cost of the additional invest-
cash flows of a project subsequently is referred to as an option ment required at a later date. The option to abandon refers to
 Real Options 617

_ the flexibility of management to exit a project after having imple- the decision tree using DCFs are the elimination of the require-
_ mented it and realize the salvage value. It is the equivalent of a ments for knowing (a) the probabilities of the various scenarios
~ put option that is exercised when the cash flows of the project and (b) the discount rate. The current price of the asset and its
_ fail to meet expectations, with the exercise price equal to the volatility are assumed to contain the expected value. The esti-
salvage value. mates of probabilities for the likely future price are extremely
A standard capital budgeting analysis on the basis of DCFs subjective. The process of valuation of an option by the binomial
treats the situation as now or never. If the NPV of the project is method is independent of an individual's risk preferences. While
positive, we implement the project; otherwise, we drop it. The this remains true for financial assets, which are traded, it may
_ feal options approach suggests that there exists the possibil- not be applied to real assets, because they are not traded. This
ity of increasing value by deferring implementation. It is like a makes the price of options independent of individual choice. It is
call option, because there is no compulsion to implementing a risk-neutral valuation.
the project earlier or later. The option to delay can be valued in The valuation of real options on the basis of the model devel-
-many ways. The DCF approach compares the NPVs of differ- oped for options on financial assets suffers from the limitations
ent options by changing the timing of implementation. Since an imposed by (a) the non-tradability of real options, (b) the fact that
option to implement now and an option to implement later are option exercise is not instantaneous, (c) the problem of estimat-
two mutually exclusive projects, we choose the implementation ing the volatility of the cash flows, and (d) the inability to clearly
timing that provides the largest NPV. define the option.
Many real options situations are apt for valuation using the
binomial method. The advantages of the binomial method over

KEY TERMS
Option to abandon It is a decision to exit a project and realize Option to expand An option to expand refers to the flexibility
the salvage value in case the cash flows happen to be lesser to start a project at a lower scale and then expand it as time
than expected. It is equivalent to a put option. progresses and uncertainties get resolved.
Option to delay An option to delay allows the decision on Real option Options on real assets as distinct from financial
when to implement a project to rest with management. It is also assets.
referred to as an option to wait for a timing decision.

QUESTIONS
22.1 What are real options and how do they add value to capital 22.4. Why do you think that DCF analysis is not an appropriate
budgeting proposals? tool for evaluating capital budgeting proposals involving
22.2 What are the different kinds of real options? Define all of real options?
them.
22.3 What are the differences between real options and finan-
cial options?
 ney y
we

Weather and Energy

Derivatives

INTRODUCTION 9277"
Learning Objectives
In this chapter, we will discuss some of the unusual underly-
After going through this chapter,
ing assets on which derivatives have been developed. The most readers should be familiar with
recent innovation in the derivative market is that of derivatives
¢ weather derivatives
on weather and energy. They are briefly described in this chap-
+ carbon credits and its trading
ter, along with some insights on hedging with such derivatives. * energy derivatives
« how weather derivatives are
different from others

All of us are familiar with the vagaries of weather. Though the

weather is not as unpredictable as stock prices, the havoc it can
cause is far more damaging than a stock market meltdown. Like
derivatives can effectively manage the risk of stock prices, there
can be derivatives whose payoff would depend upon weather con-
ditions. While extreme conditions of weather, such as floods and
droughts, may be the subject matter of insurance, as they deal
with large losses with small probabilities, derivatives can effec-
tively deal with the risk of small losses with large probabilities.
In India, timely rain is one important factor that not only
affects the day-to-day life of the masses
Weather derivatives are
but also causes a lot of concern to
ated vain industries, primarily those that are
hedge against business 4
losses due to weather + dependent upon agricultural products.
conditions. _ Industries such as sugar, fertilizers,
ommend breweries and food processine Kaye.
direct relationship with weather conditions. Adverse weather
also affects the tourism industry. Besides, general economic
conditions and purchasing power are crucially dependent upon
timely rain, which governs rural demand patterns. It is believed
that industries such as consumer durables, automobiles, and
consumer products are also affected. Further, winter fog in
the
 Weather and Energy Derivatives 619

northern parts of India affects the aviation industry. Likewise, cold waves during winter or
heat waves during summer cause dips in tourism and adversely affect the hospitality industry.
In some way or the other, life is dependent on the weather. Some things are extremely sus-
ceptible to weather, while some others are less so.
While large changes in the weather are predictable, small changes are not. For example,
in India, we do not expect freezing temperatures in the summers or sweaty heat during the
winters. However, small changes in temperatures are always unpredictable, and more often
than not, any attempted predictions become a laughing stock. When we talk of weather
derivatives, it is the damage of risk or potential loss due to small changes that we are trying
to cover. With the increased usage of technology and the availability of past data, weather
has become measurable and quantifiable in respect of heat or cold, rainfall, humidity, etc.
Derivatives were invented and designed for assets that we can own. Therefore, we feel the
need to cover any risk that may arise in relation to those assets. Weather, though itcannot be
owned, is a source of risk to many businesses, predominantly agriculture. Through deriva-
tives, we can manage the risk of several industries whose performance is weather dependent,
especially when it is measurable.

Temperature
In Western countries, including the USA, weather extremities are related to temperature con-
ditions rather than rain. Though weather-related contracts would remain specific to the parties
concerned, the scope exists for exchange-traded productsto have greater liquidity. Started
as an over-the-counter (OTC) product, temperature was conceived as a tradable commodity
by Chicago Mercantile Exchange (CME) in September 1999, when it introduced weather
derivatives based on temperature, trade in weather futures, and options on weather futures.
The contracts of CME are based on heating degree day (HDD) or cooling degree day
(CDD), which effectively states that heating or cooling energy requirements are directly
related to the deviations from a base temperature taken at 65°F (18.33 °C). For European
cities, the reference is 18°C.
The HDD is defined as Max (0, 65 — A) and the CDD as Max (0, A — 65), where A is
the average temperature for the day for a specific location.
If the average temperature of a location is, say, 85°F (mean of the highest of 95°F
and the lowest of 75°F) then the values of HDD and CDD would be 0 and 20, respectively.
This implies that the day has been hotter than normal, and, hence, energy requirement is for
cooling. Similarly, if the average temperature is 55°F, the day would be cooler than normal,
and energy is consumed for heating homes. The measurement of average temperature at a
given location has to be transparent, prompt, and free from ambiguities. The CME offers
_ temperature-related futures and options for about 42 locations! in the USA
In the USA, derivatives
based on the tempera- _ and other parts of the world such as Europe, Japan, Canada, and Australia.
tures at various locations The payoff on a contract can be decided by taking the cumulative HDD
are in place to serve the or CDD for a specific period, and attaching a monetary value to each degree.
hedging needs of energy- Most derivatives are based on accumulated HDD or CDD over a month or a
producing firms.
season. A greater value for CDD means hotter days and greater requirements

'www.cmegroup.com, accessed on 14 May 2009.

620 Derivatives and Risk Management

for cooling. Similarly, higher HDD values mean lower temperatures, and, hence, a greater
need for heating. This becomes directly relevant to energy-producing firms.

Derivative Products on Temperature

Most contracts on weather are call or put options on the cumulative HDD or CDD. Assume
that HDDs have aggregated to 750 for a month. Now for a call option on CDD with a strike
of 700 and each degree worth US $1000, the payoff would be 1000 = Max (0, Cum HDD
— 700) = 50 * 1000 = $50,000, hopefully compensating the energy producer with the cost
required to produce extra electricity for air conditioning. Cum HDD is the number of cumu-
lative HDDs in a specified period per month. Of course, the buyer of the option would have
to pay a premium for having this potential payoff. Similarly, a put option on an HDD would
have a payoff 1000 X Max (0, 700 — Cum HDD).
Options with a CDD can be similarly stated.
Normally, the payoff on calls and puts on an HDD or a CDD is capped at a certain level.
If in the example of a HDD in this section, the cap was fixed at US $30,000, the holder of
the call would not get $50,000, but only $30,000.
The other product based on weather is the swap. It is a combination of a long call and a
short put. Swaps are contracts where two parties agree to exchange the risks. This will pro-
duce a more stable cash flow when weather conditions are volatile. In simple terms, one party
agrees to pay the other if the contracted index settles above a certain level, while the other
agrees to pay if the index settles below that level. Swaps have no premium, but provide protec-
tion from adverse weather in return for giving up some of the upside of favourable weather.

Pricing Weather Derivatives

Though trading in weather derivatives has started, there is no robust model that can value a
derivative on weather. In the absence of any such model, some experts are using the Black-
Scholes Model (BSM) to value weather derivatives.
It is clearly a compromise because the non-applicability of BSM for weather derivatives
is well known. The assumptions of normal distribution and random walk of the prices of
the
asset do not hold good for weather. Temperature seems to follow a pattern, and cannot
have any
value for the same time of the year at a particular location, unlike stock prices, which
can vary
wildly. Further, weather is a mean reverting phenomenon, as it is observed that temperatu
re
tends to revert to the average in two or three days, whereas under a random
walk, no mean
reversion is assumed,
One solution to value weather derivatives may lie in performing the Monte
Carlo simula-
tion, incorporating the probability distribution and mean reversion in the process
of genera-
tion of random numbers.
Derivatives on Rain The weather element that affects life the most in India is rain, rather
than temperature, and, therefore, derivatives based on the quantum of
rain at different geo-
graphical locations may have a larger market and greater appeal for all those
wanting to hedge
against an excess or a shortfall of rain. Some banks in India have already
made a beginning
in terms of providing weather-based derivative products. In 2005, the
NCDEX in India, for
 Weather and Energy Derivatives 621

Like derivatives based on information purpose only, defined a rain day as a 24-hour period during which
temperature, derivatives precipitation was in excess of a reference of 20 mm and an index for Mumbai
based on rainfall, too, cumulating the number of rain days between June | and September 30. This is
can be developed that probably a preparatory exercise before the launch of exchange-traded deriva-
would better suit the
tive products on weather in India. The users could be agriculturalists and the
hedging needs in India.
food processing industry. A brief on rain indexes is presented as follows.

Rainfall indices
The rainfall indexes RAINDEXMUM, RAINDEXIDR, and RAINDEXJAI record rainfall at Mumbai (Colaba), Indore, and Jaipur,
respectively. They are designed in such a way that they also consider the normal historical rainfall in Mumbai, Indore, and Jaipur,
respectively. All historical and current data have been taken from the Indian Meteorological Department (IMD).
These indexes are computed on the basis of historical annual cumulative rainfall, and are adjusted for the net surplus or deficit of
actual cumulative rainfall on a given day. The adjustment factor takes into account the impact of historical and actual rainfall during
the period. The normal index values for Mumbai, Indore, and Jaipur are 1950, 950, and 350, respectively. A cap is adopted on the
maximum daily rainfall to reduce the impact on the index at times of unprecedented rainfall on a single day (e.g., 26 July 2005). The
rainfall index values are posted on a daily basis on the index websites during the monsoon season (June to October) every year.

Source: www.mexindia.com, accessed on 14 May 2009.

EMISSION TRADING Sault

Concerned with the increasing environmental hazard due to rapid industrialization causing
long-term climate changes disturbing the ecological balance, an effort was made to regulate
the dangerous emissions of gases. Industries such as steel, power, cement, fertilizer, metals,
and so on, emit hazardous gases that have long-term adverse implications on climate changes.
United Nations Framework Convention on Climate Change (UNFCCC) with the objective of
stabilizing the concentration of greenhouse gases (GHGs) placed obligations on industrialized
nations to reduce emissions of four gases, 1.e., carbon dioxide, methane, nitrous oxide, and sulphur
hexafluoride, collectively referred as greenhouse gases, and two more gases, 1.e., hydrofluorocar-
bons and perfluorocarbons. These gases trap infra-red energy and induce climate changes.
The treaty referred as Kyoto Protocol signed in Kyoto, Japan, set emisston reduction tar-
gets for 37 industrialized nations to reduce emission levels by 5.2% (later revised to 4.2%
due to withdrawal of USA) from the base year of 1990 in a period from 2008 to 2012. These
emission reduction levels were translated in terms of carbon dioxide equivalent (CO2e).
Under the second phase conducted at Doha, nations have agreed to bring down emissions
in another eight years commencing | January 2013 to 31 December 2020 by 18% from the
base level emissions of 1990.
In order to meet the objectives of the protocol, the nations were mandated to follow
policies and adopt measures for the reduction of GHGs in their respective countries. These
emissions were measured as Assigned Amount Units (AAUs). In addition, they are required
to increase the absorption of these gases and utilize all mechanisms available. A national
authority is appointed to take inventory of GHGs and also decide which projects are fit for
accreditation for earning credits.
622 Derivatives and Risk Management

The interesting feature of the protocol was that it provided for three flexible mechanisms
within the industrialized nations and other developing nations to trade in the emission levels
with the objective of reducing cost and contain emission of GHGs according to the protocol.
These mechanisms were a) Joint Implementation (JI), b) Clean Development Mechanism
(CDM), and c) International Emission Trading (IET).
Joint implementation allows one developed country with high emissions to help set up
projects in another developed country with low emissions. Clean development mechanisms
provides for a developed country to sponsor a GHG reduction project in a developing country
that has low emission levels and get credit for reduction of GHG emissions. The benefit to the
developing nations is that it receives desired capital investment. International emission trading
allows a nation with low emissions to sell its surplus AAUs to the nation that has high AAUs.
These three mechanisms place a financial cost on reduction of emissions and allow for pur-
chasing of emission reduction credits by deficit nations from other surplus nations through a
financial exchange. The JI and CDM are credit generation tools for emission reduction while
IET allows exchanging shortfall and excess to strike a balance among nations.

_ MCX India contract on carbon credit

Symbol _| CFI ai
Description _| CFIMMMYY
Contracts available for trading
December 08 contract 1 January to 15 December of the contract year Re
|December 09 contract "7 January to 15 December of the contract year
December 10 contract 1 January to 15 December of the contract year biel
| December 11 contract 1 January to 15 December of the contract year
December 12 contract | 1 January to 15 December of the contract year
Ee Trading
Trading period Mondays through Saturdays
Trading unit 200 tonnes of carbon credits (carbon emission allowances)
Quotation/base value “f~ per tonne
|Maximum order size _| 10,000 tonnes as
Tick size (minimum price movement) | 50 paise per tonne
Initial margin |6% a
Delivery
|Delivery unit |200 tonnes of carbon credits (carbon emission allowances)
Quality specifications Carbon credits (CO, emission allowance). Each CQ, emission allowance
being an entitlement to emit one tonne of CO, equivalent gases.
Source: www.mexindia.com, accessed on 14 May 2009,
The rationale for providing the flexible mechanisms in the KP was to enable
industrialized
countries to reduce the cost of reducing emissions. With financial values
assigned by the trad-
ing mechanism, it is expected that nations would strive for reduction
of emissions realizing
the cost implications determined by market forces. Such an approach
is expected to reduce the
aggregate cost of reducing emissions. This is also expected to create
incentives for producers
and consumers to significantly invest in low GHG products, technolo
gies, and processes.
 Weather and Energy Derivatives 623

Emission reductions projects are given credit in the form of carbon credit, called Certified
Emission Reductions (CERs). Under CDM, projects could be registered in the first phase
ending 2012 to earn carbon credits. The CDM was expected to produce substantial COe in
emission reductions. Most of these reductions are through renewable energy, energy effi-
ciency, and fuel switching. China and India are expected to be leading producers of CERs.
With trading among the industrialized nations, some were deficit and some were surplus.
Major surplus countries are Latvia, Estonia, Czech Republic, and Poland.
The trading was to be done in the form of carbon credit. 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 GHG with a CO;e, equivalent to one tonne of carbon dioxide.
The trading of carbon credit can be done at an exchange or over the counter.
Climate exchanges have been established to provide a spot market in allowances, as well as
futures and options market to help discover a market price and maintain liquidity. Currently
there are five exchanges trading in carbon allowances
Carbon trading is expected to be one of the largest markets. As the use of energy grows,
the demand for CERs would rise substantially with time. Firms needing to buy these credits
would increase while those generating would decrease. With great mismatch of demand and
supply, the prices are expected to move up. High price of carbon credit is expected to induce
behavioural changes in production and consumption of energy substituting high emission
fuels such as coal and oil with low emission fuels such as natural gas and nuclear energy.
High price would also motivate invention of energy-saving devices.
Carbon credits create a market for reducing GHG emissions by giving a monetary value
to the cost of polluting the air. Emissions become an internal cost of doing business and are
visible on the financial statements. For example, consider a project that emits 10,000 tonnes
of GHG emissions in a year. Due to commitments made to reduce emission, the government
limits the emissions to say 8000 tonnes per year. Here, the firm is now required to reduce
emissions to the prescribed level by investing in environmental-friendly technology or buy-
ing carbon credits from open markets. The decision to buy or to invest in technology would
now be compared financially because the cost of buying carbon credit would be known. The
seller of carbon credit would receive cash flows to reduce cost of production. The price may
be more likely to be perceived as fair by those paying it while the sellers would have more
control over their own costs.
Carbon emissions trading has been steadily increasing in recent years. According to the
World Bank’s Carbon Finance Unit, 374 million metric tonnes of CO e were exchanged
through projects in 2005, a 240% increase relative to 2004 (110 mt CO;e), which was itself
a 41% increase relative to 2003 (78 mt CO,e). In terms of dollars, the World Bank has esti-
mated that the size of the carbon credit market was 11 billion USD in 2005, 30 billion USD in
2006, and 64 billion in 2007. In 2008, Barclays Capital predicted that the new carbon credit
market would be worth $70 billion worldwide that ‘year.

Distinctive Features of Weather Derivatives

The following distinct features of weather derivatives must be noted:
e From their name, it appears that weather derivatives provide insurance against adverse
weather conditions. However, there are some vital differences between weather deriva-
624 Derivatives and Risk Management

Weather derivatives are

tives and insurance. While insurance would take care of extremities in~
not insurance products. _ weather, compensation for small changes in weather conditions 1s not pos-
They are non-deliverable, : sible. There does not seem to be a way to compensate for the ‘loss of business
free from manipulation, or profit’ due to adverse weather conditions. Further, in case of insurance,
and do not require com- 1.5 due to adverse weather conditions would have to be proved before any
plex valuation models.
compensation is awarded. In the case of weather derivatives, proof of having
incurred a loss is not required.
e Weather derivatives would be contracts where the underlying is non-deliverable. One can
neither buy nor sell rain, snow, or temperature. Therefore, contracts on weather are neces-
sarily cash-settled. Hedging can only be done by initiating a position and then having an
offsetting contract, unlike hedging in other commodities and products, where derivatives
can be combined with positions in the underlying assets to have an effective hedge.
e The weather is a natural phenomenon and is not subject to manipulation by anyone.
Weather riskis also unique toa location. Itcannotbe controlled and despite great advances
in meteorological sciences, it still cannot be predicted precisely and consistently.
e The pricing of weather derivatives, fortunately, does not require complex mathemat-
ics or any analytical formulation such as the BSM. Weather can be priced based on
historical data and the forecast. One can use past data on temperature or rain to find a
probability distribution that can be used to determine derivative payoffs.

"ENERGY DERIVATI
VES
We consume energy in various forms, such as fossil fuel for transportation; electricity for lighting
houses and factories producing industrial goods, and temperature control; and gas for cooking and
running turbines. The maximum energy is produced from fossil fuel, coal, and the sun.
The market for energy derivatives can trace its roots back to 1983, when crude oil futures were
first traded on the New York Mercantile Exchange (NYMEX). Since then, oil and other energy
market derivatives have also been traded on the Tokyo Commodities Exchange (TOCOM), the
Energy Market Exchange (EMEX), and the newly opened Dubai Mercantile Exchange.
Like other derivative products, energy derivatives can be used as a form of insurance to
protect against the often-volatile changes in energy prices.
Energy derivatives are chiefly traded through two different financial instruments—swaps
and futures.
An energy swap is a transaction that trades on the prices two parties pay for an energy
commodity. For example, a company purchasing oil at a variable rate can participate in a
Swap so that it can purchase oil at a fixed rate for a certain amount of time. In a swap transac-
tion, there is no transfer ofoil, only a transfer of the prices paid for oil. In contrast, a futures
contract is an agreement for one part to deliver or receive the energy commodity at a certain
price for a specified period of time.
Hedgers are usually large energy providers or purchasers who use energy derivatives to
protect themselves from the volatile nature of energy prices. An energy producer, for example,
would use energy futures to guarantee a selling price of energy so that it would be protected
from a sudden drop in prices and, thus, from a decrease in profits. Large consumers of energy,
such as transportation service companies and city and state governments, use energy futures to
lock-in a low price of energy so that they are not subject to the risk of rising energy costs.
 Weather and Energy Derivatives 625

The airline industry is a huge hedge player in the energy derivatives market. Each year,
airlines compete to purchase energy futures contracts in an attempt to lessen their fuel costs,
which often take up more than 20% of their annual budgets.
The other part of the energy derivative market is composed of speculators—entities who
do not produce or purchase energy but simply make investments by betting on the price of
energy. Energy speculators have made a significantly higher number of trades than energy
hedgers—that is, more trading of energy derivatives was concerned with essentially betting
on the price of energy than with protection from volatile price changes.
Products covered by energy derivatives include crude oil, heating oil, natural gas, electric-
ity, jet fuel, and kerosene.

Crude Oil
Crude oil has become a commodity that impacts economies the world over in ways that pos-
sibly no other commodity does. With rising consumption and shrinking supply of this natural
resource, oil has become the most sought after commodity in the world. It will remain so
until alternative sources of energy are developed.
Crude oil price risk was perceived as more serious in the 1970s, when the need to manage
the price risk emanating from changes in crude oil prices gathered momentum and products
to manage crude oil price risk were developed.
India is among the 10 largest consumers of crude oil in the world, and almost 70-75% of
the requirements are met by imports. Thus, India faces relatively very large risk from chang-
ing crude oil prices. Volatility in the prices is much high, and so is the risk. Further, since
the prices of end products from crude oil are still administered in India, price fluctuations in
the international crude oil markets cannot be transferred to consumers readily. Crude oil also
happens to be a major revenue earner commodity by way of customs duty and cess for the
Government of India, constraining the developmental public expenditure. On a broader scale,
therefore, crude oil prices impact the economy in much larger ways than most of us would
imagine. Unlike most commodities and financial assets, the crude oil industry is dominated
by the actions of a cartel, namely, the Organization of the Petroleum Exporting Countries
(OPEC), whose actions and decisions with respect to production and supply hugely impact
crude oil prices worldwide. :

MCX India contract on crude oil

Symbol CRUIDEOIL
Description CRUIDEOILMMMYY
Contracts available for trading
January contract 20 July of the previous year to 19 January of the contract year
need contract 20 August of the previous year to 21 February of the contract year
March contract 21 September of the previous year to 21 March of the contract year
April contract 20 October of the previous year to 18 April of the contract year
May contract 19 Nevember of the previous year to 19 May of the contract year
June contract 18 December of the previous year to 20 June of the contract year
 626 Derivatives and Risk Management

ee MCX India contract on crude oil A

July contract 20 January to 19 July of the contract year
August contract 22 February to 19 August of the contract year
September contract 22 March to 19 September of the contract year
| October contract 19 April to 19 October of the contract year
November contract 20 May to 17 November of the contract year
December contract 21 June to 19 December of the contract year
Le . a Trading
Trading period Mondays through Saturdays
Trading unit 100 barrels
Quotation/base value < per barrel 4
Maximum order size 10,000 barrels a
Tick size (minimum price movement) | =1
|initial margin AL: [5%

Delivery unit
_ Delivery
50,000 barrels with + 2% tolerance unit
|
Quality specifications Light sweet crude oil conforming to the foliowing quality specification is
deliverable:
Sulphur 0.42% by weight or loss
API gravity: between 37-42 degrees zy
Source: www.mexindia.com, accessed on 17 September 2012.

The Multi-commodity Exchange (MCX) in India has futures contracts on crude oil, Brent
The world is critically _ crude oil, and air turbine fuel, thus providing opportunities for hedging to
dependent on energy _ crude oil users such as refineries, airlines, crude oil exploration firms, and
thatis limited andnon- ther petro-based industries. Contracts on crude oil are among the most traded
pO ae Fat the MCX. Since érude oil is traded globally, the
international price and the
on crude ollaretraded : :
worldwide _ local price must be the same when quoted in the same currency. Internation al
—mm-nmuunwumeus prices are quoted in terms of US dollar per barrel and contracts at the MCX
are denominated in Indian rupees. Hedgers must understand the movements of crude oil
prices
as well as exchange rates. However, there is no need to consider exchange rate risk separately.

Electricity
The electricity market in India is characterized by government regulatio
n. With increased
deregulation, the need for hedging against electricity production and revenue
would surely
mount. The MCX has weekly as well as monthly contracts with electricity as
the underlying.
The contract size is 1 MW X 24 hours with prices quoted in terms of per
MWH and a tick
size of @1. Contract duration is eight weeks, and eight weekly contracts are
available at any
point of time. The delivery unit is MWH X 24 h X calendar days in the
week. The contract
is for even delivery of 1 MWH of electricity.
 Weather and Energy Derivatives 627

Natural Gas
Another important natural source of energy is natural gas. Futures contracts on natural gas
came into being in 1990. NYMEX launched option contracts on natural gas in October 1992.
Subsequently, Canada and the United Kingdom have also launched derivative contracts on
natural gas. The growth of derivative contracts in gas has been phenomenal.
Natural gas in various forms such as liquefied (LNG), compressed (CNG), and piped
(PNG) natural gas has a vast amount of uses and users. Natural gas is used as feedstock in the
fertilizer industry, petrochemicals, automobile fuels, domestic cooking, solvents, and chemi-
cals. Besides the fertilizer industry, users include the transportation industry and electricity
producers, apart from domestic consumers. As the economy grows, there will be more and
more consumption of natural gas, as it is environment friendly.
The MCX has introduced futures contracts in India with contract sizes of 500 mmBtu and
delivery in multiples of 10,000 mmBtu. The price quotation is in terms of rupees per mmBtu,
with a tick size of %0.10.
Energy price behaviour is characterized by mean reversion and truncated distribution with
seasonality in both prices and volatility. Products have been developed with payoff based on
energy prices. These products include energy commodity-linked bonds and treasury notes
where the coupons are decided on the basis of energy prices.

SUMMARY “=
A recent development in the derivatives market is the introduc- based on rainfall. Carbon credits are already being traded in
tion of weather derivatives aimed at covering risks emanating India. For pricing weather derivatives, complex models such as
from the weather. This should not be construed to indicate that the BSM are not required.
extreme weather conditions can be hedged with these deriva- Energy derivatives such as those on crude oil, electricity,
tives. Extreme losses due to unforeseen and extreme weather and natural gas, also have gained popularity because of the
_conditions remain in the domain of insurance. The derivatives overdependence of the world economy on very limited and non-
already in use in the USA are aimed at covering energy losses renewable sources of energy. There are derivatives on varieties
due to hot or cold weather conditions. These derivatives are of crude oil, electricity, and natural gas being traded all over the
cash-settled, and are based on the temperature conditions world.
during a period. In India, efforts are on to introduce derivatives

CDD Cooling degree days, defined as Max(0, A - 65). HDD Heating degree days, defined as Max(0, 65 - A).

QUESTIONS sensenusscmenmenmane
23.1 Describe weather derivatives on temperatures. 23.4 How are weather derivatives different from derivatives on
23.2 Why do you think that derivatives on temperatures are not other underlying assets?
useful in India?
23.3 What problems do you see in pricing of weather deriva-
tives using standard valuation methods?
 Accounting for
Derivatives

INTRODUCTION (9
Learning Objectives
For several reasons, accounting for derivatives has always been After going through this chapter,
a complex issue. The definition and readers should be familiar with
Accounting for deriva-
tives is complex because financial implication of derivatives the differences of derivatives from
they require no/very little are difficult to comprehend from the other financial instruments in terms
initial investment, and accounting perspective. One prominent of accounting
obligations under deriva- reason has been that positions in deriva- fair value and fair value accounting
tives are contingent in the measurement of fair value
tives involve no/nominal cash outlay, as hedged items, hedging instruments,
nature.
compared to the outlay required in the and hedging relationships
acquisition of the underlying financial hedge accounting
assets or creation of liabilities. A second reason is that derivative differences in hedge accounting
contracts are contingent in nature, and more often than not, are as compared to other accounting
practices
settled in cash. The cash inflows or outflows occur on a net basis,
fair value hedges and cash flow
when the original position is squared up. hedges
Accounting for any transaction is done only when finan- the difference between a fair value
cial implications of the contract materialize fully. Just like no hedge and a cash flow hedge
accounting entries are passed when a firm only anticipates a accounting for derivatives in
different circumstances
big order, there is no recognition at the inception of a deriva-
tive contract when there is no cash flow. Futuristic positions
cannot be recorded and accounted for beforehand. Account-
ing has the convention of recording transactions only after they
have occurred. A position in derivatives may have zero cost or
no initial cash flow, and, therefore, goes unrecorded. When an
actual cash flow takes place upon settlement, the obligations are
over. However, at the same time, non-reporting of the financial
obligations assumed by initiating positions in derivatives would
not represent the true picture of the financial commitments an
organization makes. Due to the natural leverage in derivatives,
a seemingly small commitment has massive and extremely dis-
proportionate financial implications. The accounting perspective
has to be transformed to record firm commitments that have not
yet crystallized.
 Accounting for Derivatives 629

Recording transactions only after they have occurred implies that the value shown is based
on historical cost. After recording the asset or liability, if the value changes, the asset or
liability remains stated at the original historical value. The value of the derivative changes as
the value of the underlying changes: While the underlying remains stated at one value, the
derivative position as a hedge would lead to an accounting anomaly. Stating the underlying
at its historical value and the derivative at its market value would be conceptually inconsis-
tent. Changes in the value of the derivative would not be accompanied by changes in the value
of the underlying. It would not reflect the true nature of hedging. Therefore, accounting for
derivatives demands radical changes in accounting approaches.
These extremely complicated and basic issues of accounting for derivatives have been
__addressed by the Accounting Standard AS 30 (Financial Instruments: Rec-
Conventional accounting
is based on historical
ognition and Measurement) issued by the Institute of Chartered Accountants
cost, while derivatives of India. Internationally, accounting for derivatives is prominently governed
need to be recorded at by the IAS 39 (Financial Instruments: Recognition and Measurement)
fair value. The AS 30 _ issued by the International Accounting Standard Board, and the FAS 133
Ly : (Accounting for Derivatives and Hedging Activities) issued by the Financial
wlomational practices. _ Accounting Standards Board. There is no material difference between the
... AS 30 and the IAS 39. Each of these standards is too massive for compre-
hension me yet there were lacunae and complexities that have surfaced subsequently. These
complexities have possibly arisen due to the attempts by issuing bodies to generalize rather
than treat each derivative separately. A simplified discussion of the AS 30 follows.

ACCOUNTING DEFINITION OF DERIVATIVES © *

The AS 30 and all other international standards governing accounting for derivatives define
derivatives in a generic way; there is no instrument-specific definition. Since newer and newer
instruments are evolving in the field of derivatives, the generic definition is expected to take
care of the long-term future and obviate the need for revision from time to time.
As per the AS 30, a derivative is a financial instrument with the following three charac-
_ teristics:
As per AS 30, a
derivative is a financial § e |ts value changes with the interest rate, the price of the instrument, the
instrument that changes = foreign exchange rate, the index, its credit rating, ete.
is value based on the
_ © It requires no/very little net initial investment.
underlying, requires no/
marginal investment and _ e It is settled at a future date.

oe Cane oe ~The definition of derivatives involves (a) risk, (b) futurity, (c) origination,
The term derivative ex-
cludes bank guarantees and (d) investment. Insurance and bank guarantees do have risk and futurity
and insurance contracts. but their originations are based on past events, and, therefore, are excluded.
. ~~ The IAS 39 has a similar definition for derivatives. Embedded derivatives
are defined separately. An example of an embedded derivative would be a callable bond.
Some part of the values or cash flows of the instrument behaves in the same manner as that
of derivatives. Due to the difference in the method of recording, the derivative needs to be
separated from the host instrument; otherwise, it leads to an accounting anomaly. To enable
recording the host instrument at its historical cost and the embedded derivative at its fair
 630 Derivatives and Risk Management

value, the derivative needs to be separated from the host contract. Segregation of the deriva-
tive and the host contract is extremely complex, and no amount of explanation is enough to
resolve the issue. Seemingly simple terms of business contract such as the pricing of long-
term contracts based on exchange rates could be seen as embedding options. To simplify, sev-
eral conditions are laid down for segregating the embedded derivative from the host contract.

TYPES OF FINANCIAL INSTRUMENTS 2 ~

In order to identify what principles must be followed for recording assets and liabilities, the
AS 30, like other international accounting standards, classifies financial instruments into four
broad categories. We are already aware that cash or a promise to pay or receive cash repre-
_ Sents the basis of recognizing, measuring, and recording financial assets and
The AS 30 has four
categories for financial liabilities. Besides financial assets, there are non-financial assets that do not
instruments: (a) financial give rise to cash transactions, such as warranties and prepaid expenses in the
instruments at fair value financial statements. The AS 30 classifies financial instruments in the follow-
through profit and loss, ing four categories:
(b) held to maturity
investments, (c) loans A financial asset or liability at fair value through profit or loss
and advances, and (d) Held-to-maturity (HTM) investments
available-for-sale.
Loans and receivables
e Available-for-sale
Financial assets or liabilities at fair value (FaFV) through profit
and loss are instruments
that are

e held for trading; and

¢ initially recognized at their fair values.
All financial derivatives, unless held for hedging purpos
es, would fall in this class. Almost
all positions in derivatives are essentially short term
in nature, and are held with the motive of
_ making speculative profit. All instruments held for
FaFV instruments are : at fair value. trading must be recorded
recorded at fair value,
and gains/losses are The HTM investments are non-derivative financ
ial assets with fixed and
routed to the profit _ determinable payments at fixed maturities. Furthe
r, there must be a clearly
and loss account upon _ demonstrated intention and ability to hold the inves
tment till maturity. Items
re-measurement. HTM _ that are classified as FaFV. loans and receivables,
investments are held till and available-for-sale are
maturity, and mostly are exclude d. Th The firm must demonstrate
xcluded. ¢ :
that it has the intentions of holding the
not subject to hedging, --@8Set till maturity. Naturally, equity cannot be
classified as HTM as it has no
. wev~were ‘tixed payment or term to maturi
ty.
Loans and receivables are non-derivative financ
ial assets and liabilities with fixed or
determinable payments that are not quoted
in an active market, other than those classi
as HTM, FaFV etc. This definition is intended fied
to include accounts receivable and accounts
payable.
Available-for-sale financial instruments are
those non-derivative financial assets that are
not classified in any of the first three categ
ories. These assets are, therefore, a resid
category. ual
 Accounting for Derivatives 631

This classification is meant for disclosure requirements as well as to gain knowledge of

the values at which such instruments would be recorded in financial statements upon acqui-
sition, and how subsequent gains/losses would be treated in financial statements. Table 24.1
oe _ summarizes the treatment to be accorded to measurement in the balance
Derivatives are recorded == sheet and treatment of gains/losses as provided for in the AS 30.
at fairvalue and would With ee (ee is Pahoa : is
be MTM. Changes in fair WIth specific reference to erivatives, the classification can be made in two
value would be routed ss tees held for trading and those designated as hedging instruments.
through the profit and _ The accounting with respect to derivatives held for trading would be
loss account. When the
derivative is used in a © to recognize the initial position at cost, with the transaction cost expensed
hedge, the MTM changes _ out; and
would be clubbed with e re-measure the fair value at each reporting date, recognize the gains or
ee a the hedged item. losses in the profit and loss account, and record the difference from the
initial fair value recorded as a liability or an asset in the balance sheet.
Derivatives designated as hedging instruments would be subject to hedge accounting.

Table 24.1 Recognition of financial instruments and gains/losses

Financial assets and liabilities [Initial measurement __—_| Treatment ofgains/losses |
FaFV Fair value on date of acquisition | Profit and loss account
Short-term receivables and payables Invoice amount -
Other financial assets and liabilities Fair value + transaction cost
HTM investments Amortized cost.
Derivatives designated as hedge instrument Hedge accounting
Available-for-sale Fair value Reserves; to be transferred to
the profit and loss account on
derecognition
eres anussical At cost Profit and loss account

FAIR VALUE
Derivatives are financial instruments whose value can be determined accurately by the
_ observed prices that are quoted in exchanges or over the counter (OTC) in
The fair value is the
amount at which the as- domestic
at and international
sabia markets, and, thus, the practice
Pane is to
whe value deriva-
set could be exchanged tive instruments at their fair values rather than at their historical costs. Easy
between knowledgeable entry and exit at market prices makes accounting possible at fair values, and
and willing parties. It historical costs lose relevance.
excludes forced and Hitherto, Indian accounting standards prescribed the historical cost as the
distress sale situations
basis for recording transactions, including those of financial instruments.
Short-term investments are stated at cost or market value, whichever is
lesser, whereas long-term investments are recorded at cost. With the introduction of the AS
30, fair value accounting has gained acceptance, and become consistent with international
practices.
632 Derivatives and Risk Management

Fair value is defined as be the amount for which an asset could be exchanged or a liability
settled between knowledgeable and willing parties in an arm’s length transaction.

Measurement of Fair Value

Fair value is determined on the basis of continuing operations, and eliminates prices in forced
transactions, involuntary liquidations, and distress sales. The following are possible methods
for measurement of fair value.

When Active Market Exists When an active market for the instrument and hedged item
exists, the quoted prices form the basis of fair value. The quoted prices that can be used are:
e the bid price for an asset held or a liability to be issued;
ie re erent e the ask price for an asset to be acquired or a liability to be held;
based on valuation tech. ¢ the mid price for an asset and a liability with offsetting risk, and then
niquesmocels, making = apply bid or ask price for the net position; and
maxmmum
USE OFMAMKEE Fs the most recent prices with suitable adjustments when the bid and ask
determined inputs.
prices are not available.
When No Active Market Exists When no active market exists or the quoted price is not
available, then valuation techniques need to be used. The valuation principle includes:
the use of the most recent arm’s length price between knowledgeable and willing par-
ties, if it is available;
the fair value of another instrument that is substantially the same as the instrument in
question;
a discounted cash flow (DCF) analysis; and
option pricing models.
The valuation technique or model must (a) use the maximum inputs from the market, (b)
reasonably reflect the risk-return factors just as the market would, and (c) be applied consis-
tently.
The following are some of the useful rules for establishing fair value:

While arriving at the discount rate, the time value of money is needed for determining
the risk-free rate. It must be derived from the observed prices of government bonds
and the yield curves for different time horizons. Market-based rates such as LIBOR or
MIBOR are not regarded as risk-free rates, because they incorporate credit risk. If these
rates are used, the adjustment for the benchmark rate and the hedging instrument/item
must be made for the credit risk.
Credit risk premiums must be based on observable market prices of traded instruments
of a similar risk class.
Foreign currency, commodity, and equity prices must be used as they are quoted
in the
respective markets.
Volatility measurement must be based on observed historical data. or the
volatility
implied in the price.
Prepayment and surrender risks must be gauged from historical data.
ns
5

Accounting for Derivatives 633

HEDGE ACCOUNTING ?
A position in derivatives can either be speculative or constitute a hedge. When it is part of
a hedge, the intention of the hedger is to protect against any unfavourable movement in the
value of the asset or liability by having an offsetting position in derivatives, implying that any
profit/loss on the asset or liability is compensated fully or substantially by loss/profit on the
derivative position. Therefore, when used as a hedge, the profit or loss needs to be assessed
on an aggregate basis, rather than separately on the asset/liability and the derivative position.
When the position is accounted for in an isolated manner, the principle of conservatism
of ‘providing for unrealized loss and not recognising the unrealized gain’ causes a distorted
view of the financial positions and makes profits volatile. Though this could be classified as a
correct representation, it is not a fair view of profit till the position in the derivative is closed.
For example, consider that a firm invests 720 lakh in the shares of another company
by eo aivese. t (10,000 shares at 200) on 28 February. To protect against any decline in the
the combined position ] value of his/her investment, the investor takes a short position on index
_ futures expiring on 25 April, worth 720 lakh (assuming a beta of 1.00) at an
index value of 5000 involving 400 indices. The financial position of the
_ investing firm on the date of acquisition would be:
Equity 20,00,000 Investment 20,00,000
On 31 March, the day of reporting, the investment, and the futures posi-
_ tion thereon must be re-assessed. Assume that the value of the shares fell to
nere 7180 (a decline of 10%) while the index came down to 4600 (a fall of 8%).
Ss

How would the investing firm present its financial position on 31 March?
If the position on index futures is deemed squared up (marked-to-market—MTM), it
would entail a gain of 71,60,000 (400 * 400), which is unrealized, and under conservative
reporting or prudence, would not be recognized. However, an unrealized loss of €2,00,000
(10,000 shares X %20) on the investment, again on prudence, would be recorded.
Equity 20,00,000 Investment 18,00,000
Loss (2,00,000)
Instead, if the markets moved up, a loss on the futures would be recorded, while a gain
on the investment asset would go unrecorded with prudent accounting. This also follows the
accounting principle that investments must be recorded at cost or market price, whichever is
less. Hence, any gain in financial assets would not be recognized. Note that both gains and
losses are unrealized. In either case, recognizing losses but not profits is a fallacious view.
Instead, the fair view would be to understand that the position in futures was taken to
hedge and make value of the asset stable. When a comprehensive view is taken, there is an
unrealized loss of 740,000 (a loss of %2,00,000 on the value of the asset less a gain on the
futures position of %1,60,000). If so, the true finaricial position on 31 March would be as
follows:
Equity 20,00.000 Investment 18,00,000

Loss (40,000) Receivable from 1,60,000

the futures
634 Derivatives and Risk Management

If the investor had squared up on 31 March, the receivable would translate into cash from
the exchange.
This was an example where the asset already existed in the books. The issue becomes far
more complex ifthe asset/liability does not exist but a hedging position is taken on the basis
of forecast cash flows. Consider, for example, an exporter aiming at exports worth 7120
lakh, evenly spaced over 12 months, to be denominated in euros. Anticipating depreciation
of the euro, the exporter sells 12-m forward contracts worth %10 lakh at %60/euro (assuming
the same forward rate for all the 12 contracts, for simplicity). After two months when the
performance needs to be recorded, there would be 10 forward contracts worth 7100 Jakh still
outstanding. These would have to be valued for loss or gain as per the exchange rate prevail-
ing then. If the euro had instead appreciated by 10%, there would be a loss of 710 lakh (10%
of 100 lakh) that needs to be accounted for, making the results volatile, because there is no
receivable existing in the books that would have a value higher by the same amount, annul-
ling the loss in the derivative position. The purpose of the forward contracts was the exactly
opposite, i.e., rendering stability to the cash flows and profits.
Hedge accounting relates to the combined effect of changes in the values of the asset/
liability that is being hedged and of the derivative instrument used for such purpose against
the risk of adverse movement of market variables such as interest rate, price, credit rating,
and prepayment. This necessitates valuation of the asset or liability as well as of the hedging
instrument at fair value. Therefore, concepts of historical cost and accounting based on past
transactions need to be changed.

TYPES OF HEDGES 6
Recognizing the need for a comprehensive view on the hedged position, the
rules for hedge
_ accounting are laid down. The AS 30 classifies hedges into three types:
There are basically two
types of hedges—the fair e Fair value hedge
value hedges that protect ¢ Cash flow hedge
the fair value of the
_ © Net investment in foreign operations
recorded asset, and the
cash flow hedge to pro- : However, from the perspective of accounting, there are basicall
y only two
lect the cashflow froma different types of hedges, i.e., the fair value hedge and the cash flow hedge.
forecast transaction. For-
eign currency exposures Fair Value Hedge A fair value hedge is intended to protect
the fair value.
may be hedged by either _ The values of assets and liabilities are Subject to change due
to changing
~ economic and market conditions. A fair value hedge is aimed
at protecting
the fair values of the recognized assets/liabilities. Apart from
recorded assets
and liabilities, the AS 30 also permits hedging of unrecognized
firm commitments (such as
pending supply against a firm order).

Cash Flow Hedge A cash flow hedge is used for protect

ion against variability in the antici-
pated cash flows that are subject to a particular risk associa
ted with a recognized asset/liability
or a possible forecast transaction. Obviously, such variabi
lity could affect the profit/loss. An
example befitting a cash flow hedge could be a repayment
of debt on a variable interest rate
that can be covered with a swap for paying a fixed rate in exchan
ge for receiving a floating rate.
 Accounting for Derivatives 635

From the definitions of the fair value hedge and the cash flow hedge, it is clear that an
account payable or an account receivable in foreign currency could be classified as either of
the two.
The third type of hedge, i.e., net investment in foreign operations, is equivalent to a cash
flow hedge from the accounting perspective.

STEPS FOR HEDGE ACCOUNTING ©

In order to prevent misuse and arbitrariness in hedge accounting, there are prerequisites that
need to be established before exposures in assets/liabilities and positions in
_ For hedge accounting, _ derivatives become eligible for hedge accounting. The various requirements
the basic requirements and steps that need to be followed are as follows:
include (a) identification
of the hedged item, (b) a e Identification of the asset, liability, or firm commitment, referred to as the
hedging instrument, hedged item, that needs to be hedged
and (c) a relationship
e Identification of the risk parameters that cause changes in the fair value
between the two, demon-
strating offsetting effects — and/or cash flow
against a particular risk. e Identification of the derivative instrument intended to offset the changes
in fair value or cash flow of the hedged item against risk parameters,
referred to as the hedging instrument
e Establishment of a relationship between the hedged item and the hedging instrument,
called the hedging relationship
e Determination of the criterion for measuring the effectiveness of the hedge (applicable
for a cash flow hedge only), i.e., the extent to which the hedging instrument has been
able to offset the changes in the fair value or cash flow of the hedged item

Hedged Item
The first question that arises in hedging is: What is the asset or liability that is being hedged?
An asset or liability that is exposed to the risk of changes in its fair value or its cash flows,
including a highly probable forecast transaction, can be designated as a hedged item. The
hedged item may not be an individual item; instead, it can be a group of assets or liabilities
permitting the adoption of a portfolio approach.
The AS 30 categorizes the following as possible hedged items:
e Recognized assets or liabilities
Recognized financial _e Unrecognized firm commitments
assets and liabilities and :
highly probable forecast For those items that are eligible for hedging, the relevant risk factors must
_ transactions can be be identified, and changes in the fair value or cash flows caused by such
categorized as hedged identified factors are to be included in the hedge accounting. Any excluded
items. However, assets
portion of the asset cannot form a part of the hedge accounting, and such
and liabilities cannot be
netted.
excluded portions must be accounted for separately in the profit and loss
~ account.
Held-to-maturity investments cannot be a qualifying hedge item with respect to inter-
est rate risks or prepayment risks, because designating an investment as HTM implies the
636 ‘Derivatives and Risk Management

An HTM investment
intention to hold it till maturity without regard; to changes 1n
ae
the fair value
cannot be classified as a _ or the cash flow all through. Therefore, the interest rate risk is presumed
hedged item for covering to be absorbed while designating an item as HTM. However, an HTM
interest rates or prepay- investment can be qualified as a hedged item with respect to the risk from
HS . _ changes in foreign exchange rates and credit risks.
Normally, only transactions with external parties are covered in hedged
items. Hedge accounting for transactions within the group can be considered only for hedged
items in a stand-alone financial statement, not those in the consolidated financial statement.
However, foreign currency transactions within the group (payables and receivables) may
qualify as hedged items even if they are in consolidated financial statements, if they can result
in gains/losses that are not fully offset upon consolidation.

Hedging Instrument
The next issue in the determination of a hedge is the identification of the derivative that is
planned for hedging the exposure. This is referred to as the hedging instrument in the AS 30.
The standard does not confine hedging instruments only to derivative products. Even a non-
derivative may be designated as a hedging instrument for hedging foreign currency risks.
As long as the relationship demonstrates an offsetting effect, it can be classified as a
_ hedging instrument. A designated derivative or a designated non-derivative
Writing options is
contrary to the hedging financial asset/liability whose fair value or cash flows are expected to offset
principle because of the : changes in the fair value of the cash flow of the hedged item can be termed
significantly larger risk _ asa hedging instrument.
for a small premium. As _ However, the AS 30 specifically precludes short positions in options (writing
such, an option written
_ options) from being classified as hedging instruments. Since writing options
cannot be a hedging y ; ; :
instrument unlessasa_-—=«CTeSults in a small inflow of premium with potentially disproportionate losses,
means of offsetting the they cannot constitute effective hedges. Thus, written options do not qualify
premium paid for a long __ as hedging instruments unless the hedging is done to offset the price of the
position. option bought, including the one that is embedded (writing a call to hedge
a callable liability). Buying options entails little cost but has the potential to
provide substantially large gains. Therefore, options bought qualify as hedging instrumen
ts.
Part of exposure in derivative instruments that can be attributed to hedging
can be clas-
sified as ‘hedging instrument’ while the remainder could be treated as speculati
ve and is
subject to normal accounting. For example, one may book a forward contract
of US $20 mil-
lion against an exposure of US $10 million and designate 50% of the amount
of the forward
contract as a hedging instrument.
Similarly, more than one instrument may be designated as a hedging instrume
nt. A com-
bination of derivatives (or their proportions) may also be designated as
hedging instruments,
because risks arising from one derivative may be offset by another derivativ
e. Several deriva-
tives may be combined and jointly designated as a hedging instrume
nt.
However, a derivative combination that involves a written option such
as an interest rate
collar cannot be classified as a hedging instrument if it is a net written
option providing an
option premium. Any written option or a net written option does
not qualify to be designated
as a hedging instrument,
 Accounting for Derivatives 637

The factors that affect the value of derivatives are co-dependent. Therefore, a hedging
relationship is designated in its entirety, except (a) when separating the intrinsic and time
values of an option and designating only the intrinsic value, while excluding the time value,
as part of the hedge relationship, and (b) separating the interest element and the spot price of
the forward contract. The intrinsic value of an option and the premium on a forward contract
are measured separately.
Self-owned equity cannot be designated as a hedging instrument. An investment in an
unquoted equity instrument and a derivative thereon that needs to be settled by delivery of
the unquoted instrument cannot be designated as a hedging instrument.

Hedging Relationship
_ A hedging relationship between the hedged item and the hedging instrument
eee _ needs to be established for accounting treatment. A prior designation of the
have to be established hedging instrument, the hedged item, and their relationship is essential to
at the inception of a eliminate subjective interpretation of the hedging.
hedge, and need to be According to AS 30, all the following conditions must be satisfied:
ae es e At inception, a formal designation of the hedged item and the hedging
ary misuse of hedge instrument must be made, and documentation stating the objective, the
accounting. hedging strategy, the transaction, etc., must be prepared.
It must be established that the hedge is expected to be highly effective in
offsetting changes in the value of the hedged item and the hedging instru-
ment. Hedging effectiveness is determined on the basis of the ability of
the hedging instrument and the hedged item to offset each other’s gains
and losses.
e Hedging effectiveness: A hedge is regarded as highly effective only if both the follow-
ing conditions are met:
« At inception and later, the hedge is expected to offset changes in fair
pine bee aise: value or cash flow for the period of the hedge. The hedge ratio may be
tive if changes in the
values of the hedged adjusted based on past statistical data.
item and the hedging in- » The actual result of the hedge is within 80% to 125%, 1.e., the offset-
struments are within 80% ting changes must result in a loss no greater than 80% on the hedged
item/hedging instrument with a gain of 100% on the hedging instru-
ment/hedged item.
e For a cash flow hedge, a forecast transaction must be prepared.
e A reliable measurement of the effectiveness and determination of changes in the cash
flows or fair value must be specified.
e The hedge must be assessed on an ongoing basis for the hedge period.
Once the designations of the hedged item and the hedging instrument and their relation-
ship are completed, the nature of hedge must be ascertained.
Accounting for fair value hedges differs from accounting for cash flow hedges, as tabu-
lated in Table 24.2. While a fair value hedge recognizes the combined effect of changes in
the fair values of the hedged item and the hedging instrument through the profit and loss
account, the cash flow hedge does so through a designated reserve equity account.
 638 Derivatives and Risk Management

Table 24.2 Hedge accounting

Hedging instrument
[Farv aivet _‘([adge ashowteage
Gain/loss on re-measuring the —_|The portion of effective hedge
instrument at a fair value must be |must be recognized directly in
recognized in the profit and loss | an appropriate equity account
statement | (hedging reserve account) and
| the remaining in the profit and
loss account
Gain or loss should adjust
the carrying amount and be
recognized in the profit and loss
statement

In the case of a cash flow hedge, there is the additional dimension of effectiveness of the
hedge. We all know that a perfect correlation between the hedged item and the hedging
instrument does not exist, meaning that the gains or losses in one would not be completely
iy offset by the losses or gains in the other. Therefore, while the intentions of
i baienbor ert _ the hedge would be to achieve such perfect offsetting, the actual position
fairvalue of thehedged _ when the hedge is lifted would be somewhat different.
item and the hedging ___ Foracash flow hedge, the appropriate hedging account associated with the
mstuments trough the | ~hedged item must be adjusted to the lesser of the following:
the cash flow hedge ~® Cumulative gain loss on the hedged instrument
fOutes Bf the equity © Cumulative change in fair value of the expected future cash flows on the
account,
hedged item
Any remaining amount is to be adjusted in the profit and loss account.

ACCOUNTING FOR DERIVATIVES & See

If there is a hedging relationship between the hedged instrument
and the hedged item, then —s
accounting for gain or loss on both the hedging instrument
and the hedged item must follow
hedge accounting. An example each for a stand-alone derivati
ve, a fair value hedge, and a
cash flow hedge follows. e
LL

Derivative Held for Trading

Assume that in January, an oil company is expecting
a rise in the prices of crude oil. Futures
on crude oil are quoted on the exchange. Let the crude
oil futures price for a
Derivatives held for July contract be $3000 per barrel, with a contract size
of 100 barrels.
tradare ingMTM at Expecting a rise in oil prices, the firm goes long
on the July futures
each reporting interval, | on crude oil at $3000 for
one contract ot 100 barrels, Let us examine the
ety eal see accounting for such a position at inception, at some
intervening reporting
Ha tiineteaaat date when the position in the derivative is outsta
nding and at the expiry/
closing of the derivative position. rs
=ET
G
A

e
 Accounting for Derivatives 639

On Initiation of Long Position No accounting entries are passed, assuming no margin and
no transaction cost. Transaction cost may be expensed out and margin money would create
a receivable in the margin account, with an equivalent decline in the cash position. The fair
value of the derivative position is the cost of acquiring the position.
On Reporting Date Let 31 March be the reporting date. As per the AS 30, the futures must
be marked to market. The fair value would be recalculated and shown in the balance sheet,
and any profit or loss would be recognized in the income statement. Assume that the closing
price of crude oil futures on 31 March is $3200.
Marking to market would lead to a gain of 20,000 for one contract of 100 barrels, 1.e.,
100 X (3200 — 3000). This amount would be due from the exchange. This would be recorded
as follows:

Dr Derivative account 200 * 100 20,000

Cr Profit and loss account 200 X 100 20,000

On Closing of Position The firm must close out its long position in the oil futures prior
to the expiry of the contract. Assume that the futures price has declined to 3100 when the
firm sells the contract to nullify the original position.
Since the derivative was marked to market on 31 March at 3200, there would be a loss
of 2100. In fact, the firm made a profit of 710,000 on the futures position, having bought
them at 73000 and sold them at 73100. Since a profit of ¥20,000 was already recognized in
the preceding reporting period, the current period would have to recognize a loss of 710,000.
This brings the total gain to 10,000.
The firm would receive the net profit of 10,000 from the exchange, book a loss of $10,000
and derecognize the asset with the following accounting entries:

Dr Profit and loss account 100 * 100 10,000

Dr Bank 100 X 100 10.000
Cr Derivative Account 200 * 100 20,000

Derivative as Fair Value Hedge

Now let us examine how hedge accounting would be carried out if the position in futures
were taken for the purpose of a hedge. Consider the following situation:

e In January, an inventory of 100 barrels of crude oil exists with the firm. The current
value is 2,90,000 at a spot price of ¥2900 per barrel.
The inventory is expected to be sold in July.
Prices are expected to fall by July.
A July futures in crude oil is trading at ¥3000 per barrel.
The firm sells a July futures contract at 73000 to hedge against any fall in the oil price
by July.
e The inventory of oil is designated as the hedged item and the futures contract is desig-
nated as the hedging instrument.
640 Derivatives and Risk Management

e Since the value of the inventory is being protected with a short position in the futures
contract, it qualifies for hedge accounting, and is a fair value hedge.
On Initiation of Short Position No entries would be passed for assuming a short posi-
tion in oil futures. The margin and transaction cost are ignored. Any transaction cost may be
expensed out and the margin money would create a receivable in the margin account, with
an equivalent decline in the cash position. The fair value of the derivative position is the cost
of acquiring the position.
On Intervening Reporting Date On 31 March, the fair value would be re-assessed and
shown in the balance sheet, and any profit or loss would be recognized in the income state-
ment. The oil inventory is being hedged, and, therefore, it needs to be recorded at fair value.
Assume that the futures contract trades at $3200, while the spot price of oil is 73050.
There would be a loss of $20,000 on the derivative, which is MTM, and a gain of 715,000
on the asset, whose fair value in the book of accounts has gone from the initial spot price of
~2900 to the present spot price of 3050. In aggregate, the loss would be %5000, as can be
seen from the following entries:
Dr Profit and loss account 200 X 100 20,000
Cr Derivative account 200 X 100 20,000

Dr Inventory account 156 X 100 15,000

Cr Profit and loss account 150 x 100 15,000
The fair value of the inventory would rise by the difference between the
spot price of oil
on the day of initiating the hedge and that on the reporting date, i.e., $150
per barrel. Note
that the value of the inventory would not change if historical cost
valuation was followed.
Under hedge accounting, the asset too would have to be recorded at
fair value. The position
in the derivative too would be marked to market on the reporting
date. The short position
when marked to market would show a loss of ~20,000, being
the difference in the present
futures price from that on the date of inception of the hedge.
The net impact of such accounting would be recognition
of the MTM loss of %5000,
comprising an increase in the liability of 20,000 and an increas
e in the value ofthe asset of
~15,000. Now, the derivative position stands at %3200 per barrel
and inventory valuation is
~3050 per barrel.
On the Day of Square-up or Disposal of Inventory
The hedge would be lifted in case
the position in the futures is squared up (no hedging
instrument would exist), or when the
inventory is disposed off (no hedging item would exist).
Assuming a futures price of 3180
and a spot price of ¥3150 when the futures is squared
up (with the inventory still existing),
the following accounting entries would result:

Dr _ Derivative account 200 X 100 20,000

Dr Inventory account 100 X 100 10,000
Cr Profit and loss account 120 X 100 12,000
Cr Bank 180 X 100 18,000
 Accounting for Derivatives 641

The fair value of the inventory would rise by another ¥10,000 because of an increase in
the valuation rate from $3050 to 3150. The liability on account of the futures position would
be extinguished with payment to the exchange of 718,000, being the difference between the
sold position at the rate of $3000 and the bought position at $3180 per barrel for 100 barrels.
There would be a profit of ¥12,000.
With hedge accounting, the position of the oil inventory and the oil futures would be split
into two reporting periods. The overall impact would remain the same, as highlighted in
Table 24.3.

Table 24.3 Impact of fair value hedge Figures in

Hedged item Aggregate In the current Inthe previous =|
Jinstrument accounting year accounting year
On inventory of oil 25,000 10,000 15,000
100 x (3,150 — 2,900) | 100 x (3,150 — 3,050) | 100 x (3,050 — 2,900)
On futures position — 18,000 2000 — 20,000
100 x (3,180 — 3,000) | 100 x (3,200 — 3,180) | 100 x (3,200 — 3,000)
TOTAL 7,000 12,000 —5,000

Derivative as Cash Flow Hedge

To see how a cash flow hedge works and is accounted for, let us consider the following
situation:
e In January, the firm estimates that 100 barrels of crude oil would be required in July.
At current prices, the value would be %2,90,000, with a spot price of ¥2900 per barrel.
e The inventory is expected to be purchased in July. Prices in July are expected to be more
than €2900.
e A July futures contract for crude oil is trading at $3000 per barrel.
e The firm buys a July futures contract at ¥3000 to hedge against any fall in the oil price
by July, and locks-in a price of ¥3000.
e The inventory of oil is designated as the hedged item andthe futures contract is desig-
nated as the hedging instrument.
e Since the future cash flow for acquisition of the asset (inventory) is being protected
with a position in a futures contract, it qualifies for hedge accounting, and is a cash flow
hedge.

On Initiation of Long Position Upon initiation of a long position in futures again, no

entries would be passed, assuming no margin and no transaction cost. Any transaction cost
may be expensed out, and the margin money would create a receivable in the margin account,
with an equivalent decline in the cash position. The fair value of the derivative position is the
cost of acquiring the position.

On Intervening Reporting Date On 31 March, the fair value would be reassessed and
shown in the balance sheet, and any profit or loss would be recognized in the income state-
ment. Assume that the futures price is ¥3200 and the spot price has risen to $3050. The fol-
lowing entries would result on 31 March:
642 Derivatives and Risk Management

Dr Derivative account 200 < 100 20,000

Cr Hedging reserve account 200 X 100 20,000

There is no asset that is being hedged, and, therefore, there would be no accounting for the
prospective asset. It is a future transaction only that is being hedged. Only a long position on
the futures contract when marked to market would show a receivable and increase in reserve
of 20,000, each being the difference between the futures prices on the date of inception
of the hedge and on the date of reporting. Note that any change in the fair value is routed
through the equity account in a cash flow hedge and not through the profit and loss account.

On the Day of Square-up or Acquisition of Inventory The hedge would be lifted in case
the position in the futures is squared up (no hedging instrument would exist) or when the
inventory is acquired (no hedging item would exist). In case further protection of the inven-
tory is felt necessary, a fair value hedge can be initiated afresh. Assuming a futures price of
~3180 and a spot price of $3150 when the futures is squared up and the inventory acquired,
the following accounting entries would result:
For extinguishing the asset created by the derivative position, by receipt of cash:

Dr Hedging reserve account 200 X 100 2.000

Dr Bank 180 X 100 18,000
Cr Derivative account 200 X 100. 20,000

Here, the hedging reserve account is debited rather than the income
statement, since the
hedge is determined to be effective. The change in value of the hedging instrume
nt is 718,000
and the change in value of the forecast transaction is ~15,000 (the
difference between the
expected price of ¥3000 and the actual price of 33150 for 100 barrels),
which is within 80%
of one and 125% of the other. Had this not been true, the excess
amount would have been
debited to the profit and loss account.
For acquiring inventory (the forecast transaction) by actual flow
of cash:

Dr Inventory SLO) LOO 1 5-000

Cr — Bank 3,150 X 100 3,15,000
For valuing inventory at the hedged amount by actual flow
of cash:

Dr Hedging reserve account 18,000 3.15.000

Cr Inventory 18,000 3,15,000
The value of the inventory upon acquisition would be
%2,97,000. If the hedge were per-
fect, the value would have been ~3,00,000. The differe
nce has occurred due to the basis risk
inherent in futures.
The hedging reserve account is adjusted to the lesser of
the following absolute amounts:
e The cumulative gain/ioss on the hedging instrument
from the inception of the hedge
_ © The cumulative change in present value of the
forecast cash flow on the hedged item
 Accounting for Derivatives 643

The liability on account of the futures position would be extinguished with payment to the
exchange of 18,000, which is the difference between the sold position at a rate of $3000 and
the bought position at $3180 per barrel for 100 barrels.

CONCLUSION
The AS 30 has ushered in a new era in accounting. It is an attempt to reconcile the account-
ing process to the conceptual approach of finance. The accounting standard has far reaching
implications, and would require several modifications in the accounting standards issued in
the past. They relate to the rules for recognizing assets and liabilities in the books of accounts,
their measurement, and the treatment of profit and loss on transactions relating to financial
assets and liabilities. It may warrant significant changes in accounting practices, so much so
that some parts of the accounting standard may have to be re-written. It involves changes to
old practices that are firmly rooted in traditional accounting concepts.
Besides causing a rethink of past accounting practices, the AS 30 in itself (as well as IAS
39 and FAS 33) is too complex and leaves many holes. For example, can barrier options
form a hedging instrument? A knock-in option for which a premium has been paid has not
become alive because the barrier has not been touched. Similarly, a knock-out option may
expire upon reaching the barrier, and the hedge becomes ineffective. All the issues starting
from the definition of assets, the designations of hedging instruments and hedged items, the
establishment of a hedge relationship, and the measurement of hedge effectiveness leave suf-
ficient scope for ambiguities, convenience of interpretation, and use of discretion.

SUMMARY ©
Accounting for derivatives is not as simple as for other routine invoice value. All remaining assets are classified as available for
business transactions of sale, purchase, and expense. Deriva- sale.
tive contracts are different in nature because they require no/ Derivatives would be recorded at fair value, and the account-
marginal cash flows, and commitments are large and contingent ing treatment for gains/losses would depend upon whether they
in nature because more often than not the contracts are cash are held for trading or are used for hedging. The fair value is the
settled. Accounting recognizes transactions that have already amount that an asset or liability would be exchanged for between
occurred, and does not recognize forecast transactions. The AS knowledgeable and willing parties. In either case (trading or
30, issued by the Institute of Chartered Accountants of India, hedging), they would be marked to market on each reporting
which has come into vogue, prescribes accounting treatment for date. If held for trading, MTM gains/losses would be recognized
derivatives. Its prescriptions are on the same lines as the inter- in the profit and loss account. If they form part of a hedge, then
national practices contained in IAS 39 and FAS 133. the MTM item would be clubbed with the hedged item.
The AS 30 defines derivatives on the basis of futurity, origi- When an active market exists, the measurement of fair value
nation, and investment, It also categorizes financial instruments is easy. In the absence of active markets, alternative methods
in four classes—FaFV, HTM investments, loans and advances, of arm’s length price, discounted cash flow techniques, or other
and those available for sale. This classification is done for valuation models may be used. Even in these measurements,
prescribing the values at which financial instruments would be the most reliance must be placed on inputs that are market deter-
recorded, and for how profits and losses would be accounted for. mined.
Further, it facilitates decisions on what can be hedged and what Hedge accounting is central to the AS 30. It is concemed
cannot. The FaFV are recorded at fair value and gains/losses on with presenting cumulative changes in the fair values of hedging
instruments, derivatives, and hedged items. Hedge accounting
revaluation are routed through the profit and loss account. The
HTM investments are intended to be held till maturity. Loans and would depend upon the type of hedge. There are two types of
advances have fixed and determinable cash flows that are not hedge—the fair value hedge and the cash flow hedge. Foreign
currency exposures are classified and can be treated as either of
quoted, such as payables and receivables, and are recorded at
 644 Derivatives and Risk Management

the two. Under a fair value hedge, the changes in the fair values writing option assumes an extremely risky position for earn-
of derivatives and hedged instruments are cumulated and routed ing a small premium. A long position in options is a hedging
through the profit and loss account. Under a cash flow hedge, instrument. A combination of derivatives can be designated as
the cumulated changes in the fair value are adjusted in an equity a hedging instrument because the risk in one derivative may be
account to the extent of the effective portion, while the ineffective annulled by another. A hedging relationship and hedging effec-
portion is charged to the revenue account. tiveness have to be demonstrated at the inception of the hedge.
The basic prerequisites to qualify for hedge accounting are A fair value hedge takes a comprehensive view of gains and
very onerous and involve establishing a hedging relationship losses on the designated hedged item and hedging instrument,
between the item being hedged and the hedging instrument both of which are recorded at fair value and market to market,
being used, There are rules regarding what instruments can be The net position of gains and losses in fair value is charged to
designated as hedging instruments and what can be hedged the profit and loss account. For a cash flow hedge, the changes
items. Further, in the case of a cash flow hedge, the measure- in the cash flow have to be segregated into two—the effective
ment of effectiveness of the hedge too has to be documented. portion and remaining ineffective portion. The effective portion is
The HTM investment cannot be categorized as hedged items accounted for in the equity account, while the ineffective portion
for interest rates or prepayment risks, A writing option or a net is charged to the profit and loss account.
written position cannot be a hedging instrument because the

Cash flow hedge A hedge that protects against changes in Financial instrument at fair value through profit and
the cash flows attributable to a particular risk of a recognized
loss Instruments that are held for trading and initially recog-
asset/liability or a highly probable forecast transaction.
nized at their fair values.
Derivative A derivative is a financial instrument
Hedge accounting Hedge accounting permits clubbing of
* whose value changes with the interest rate, the price of the
gains/losses of fair values or cash flows of hedged items and
financial instrument, the foreign exchange rate, the index, its
designated hedge instruments. .
credit rating, etc.; Held for trading Financial instruments that are held for
* that requires no/very little net initial investment; and the
purpose of making speculative profits through changes in
* that is settled at a future date. the
values of these instruments.
Fair value The amount at which an asset could be exchange
d Held-to-maturity Investment It is a non-derivative financial
or a liability settled between knowledgeable, willing parties in
an asset with fixed and determinable payments at fixed maturity
arm’s length transaction. .
Net written option A combination of options at
Fair value hedge A hedge that protects against changes inception
in involving a sold position, in such a way that it results
the fair value that are attributable to a particular risk. in a cash
inflow.

QUESTIONS
24.1 What is the definition of derivatives as per the AS
30, and 24.6 What is the reason that a short position in option
why do you think they have been defined in a generic cannot
be designated as a hedging instrument?
way?
24.7 Illustrate with an example how you would accoun
24.2 What do you understand by hedge accounting? t for a
derivative when it is used as (a) a speculation
24.3 Describe a fair value hedge and a cash flow hedge. product,
(b) a fair value hedge, and (c) a cash flow hedge.
24.4 What is the basic difference between a fair value
hedge 24.8 What radical changes in the AS 30 have been
and a cash flow hedge? made with
regard to the recognition of financial assets and
24.5 What do you understand by (a) a hedged item, (b) liabilities
a hedg- in the balance sheet and the treatment of gains/losses
ing instrument, and (c) a hedging relationship? in
values?
INTRODUCTION Learning Outcomes
In this chapter, we look at some of the most publicized cases - howderivative transactions remain
involving huge losses in derivative transactions. These cases help unreported
to understand the complex nature of the subject. Transactions in + why controls and reporting
of derivative transactions are
derivatives do not become a matter of common knowledge or
important
come into the public domain, partly because of the tendency of - how supervisors ignore day-to-day
people to not disclose actual positions when they are fraught actions of subordinates that could Ss

with risk and partly because of the fact that they avoid conven- be threatening
tional accounting. Cash transactions, even when they are not
disclosed publicly, come to light when financial statements are
prepared, presented, and made public.
Success stories in derivative trading do not come into the
limelight because of the confidentiality maintained. Of late,
there has been increasing concern about the proportion of ’other
income’ in the profits of various firms. This income is suspected
to be emanating from derivative trading, albeit in the name of
hedging. However, they do not make headlines. On the contrary,
when firms make huge losses that seemingly are not related to
their core activities, they make headlines for the wrong reasons.
Though there are many instances of huge losses in derivative
trading in history, the actual processes leading to these losses are
rarely disclosed. People often wonder how such huge losses sud-
denly come to light one single day, and why such losses never
got reported as they were accumulating. This phenomenon is
due to the basic nature of derivatives, where exposures only
remain notional and liabilities remain contingent. Only when
the contingent liabilities get crystallized do they become topics
of public debate and scrutiny. Since notional transactions remain
pro-
under wraps, very little becomes known about the actual
their
cesses behind such mishaps. It is left to analysts, who use
wild imagination to speculate on these processe s.
 646 Derivatives and Risk Management

We shall discuss five cases here that have been widely debated, researched, and published.
However, complete accuracy and truthfulness in how the events unfolded cannot be guaran-
teed, nor can the financial implications of the managerial actions. Further, the observations
of researchers and practitioners are in retrospect only, and may appear to be sound, but are
devoid of the exact reproduction of actions that were perhaps taken in actual situations.
All
these cases relate to disasters and none to overwhelming successes, for the reasons cited
in
the preceding paragraphs.

££ £698.Baas
____An intelligent Hedging Programme That Went Awry
Metallgesellschaft AG, (MG), a German conglomerate is owned largely
by Deutsche Bank
AG, Dresdner Bank AG, Daimler-Benz, Allianz, and the Kuwait
Investment Authority. It was
amongst the largest corporations in Germany in 1993. Founded in
1883, MG had 58,000
employees and 251 subsidiaries across the world. Its business
es were related to mining,
metal, and energy.
In 1993 and early 1994, MG incurred losses of $1.3 billion
on futures trading equal to
about 50% of its capital at that time. It was saved by a bailout
package of $1.9 billion raised
by a consortium of banks that were its house banks. Only
the massive rescue operation of
this large banking consortium kept MG from bankruptcy.
Metallgesellschaft Refining and Marketing Inc. (MGRM
) was a US subsidiary of MG in
charge of refining and marketing petroleum products in
the USA. MGRM’s expanded venture
into the derivatives world began in 1991 with the hiring
of Mr Arthur Benson from Louis
Dreyfus Energy.
In December 1993, MG was effectively bankrupt
after huge losses in the oil business that
was conducted in MGRM, its New York-based subsid
iary.

THE CONTRACT ieee

The roots ofthe crises lay in the marketing strate
gy of MGRM.
In 1992, MGRM began implementing an aggre
ssive marketing programme in which it
offered long-term price guarantees on deliveries
of gasoline, heating oil, and diesel fuels for
up to five or ten years to its customers, both
wholesalers and retailers. The same price
offered without considering the time value of was
the credit. The scheme had two novel contracts
—a ‘firm-fixed’ programme, under which
a customer agreed to take monthly deliveries
fixed quantities at fixed prices, and a ’firm-flexib of
le’ contract that did specify a fixed price
the total volume of future deliveries and also and
gave the customer some flexibility in settin
delivery schedules, g
Under the firm-flexible system, a customer
could request 20% of its contracted volu
for any one year with a 45-day notice. By me
September 1993, MGRM had committed
forward the equivalent of over 150 million to sell
barrels of oil for delivery at fixed prices,
most contracts for terms of 10 years. These with
contracts also contained an ‘option’ that enabl
the counterparties to terminate the contracts ed
early if the front month futures contract
of the
 Derivatives Disasters 647

New York Mercantile Exchange (NYMEX) was greater than the fixed price at which MGRM
was selling the oil products. If the buyer exercised this option, MGRM would be required to
pay in cash one half of the difference between the futures price and the fixed price multiplied
by the total volume remaining to be delivered under the contract. Under the firm-flexible
contract, the compensation was 100% of the price difference.
The MGRM provided its customers with a means that enabled them to shift or eliminate
some of their oil price risks. These contracts initially proved to be very successful since they
guaranteed a price over the spot price, and the sales of MGRM tripled.

HEDGING PROGRAMME ©
With a short position in the forward contracts, MG was exposed to the risk of rising prices
of oil. If prices rose, MG would incur a loss on the forward deliveries committed under the
contracts.
The short position is offset by a long position in futures. MGRM°s hedge strategy to man-
age the spot price risk was to use the front-end month futures contracts of NYMEX. Since the
liquidity of distant futures contracts is poor, MGRM chose to cover the risk by taking a long
position in stacks of short-dated futures and then rolling them for the next stack of futures. This
would be done repeatedly. Such a strategy is referred to as a stack-and-roll hedging strategy.
Covering for the entire deliverable quantity in the future, the rollover would stand reduced
by the deliveries already made. Each rollover for a month would be lessened by the amount
of deliveries already made during the month.
The MGRM also entered into over-the-counter (OTC) energy swap agreements to receive
floating and pay fixed energy prices. According to the NYMEX, MGRM held futures posi-
tions on the equivalent of 55 million barrels of oil in different oil products such as gasoline,
crude oil, and heating oil. The futures contracts MGRM used to hedge were those on unleaded
gasoline and the No. 2 heating oil. Of the total commitment of about 160 million barrels
(assuming that MGRM hedged fully), their swap positions may have accounted for as much
as 110 million barrels to completely hedge their commitments under the forward contracts.
MGRM’°s hedges adequately transferred its market risk. When oil prices dropped, they
lost money on their hedge positions but the value oftheir forward contracts increased. If oil
prices increased, they would gain on the futures and compensate for losses in the forward
delivery-based contracts.

PROBLEMS ="
What appeared to be safe and sound promotional programmes bolstered by a seemingly fool-
proof hedging strategy, had many deficiencies. We address them one by one as they surfaced
over time:

Size of the Exposure

The sheer size of the positions both in forward and futures contracts created an enormous
amount of risk. The assumption of economies of scale was mistaken. According to an esti-
mate, this position was the equivalent of 85 days’ worth of the entire oil output of Kuwait. If
648 Derivatives and Risk Management

oil prices were to drop, MGRM would lose money on their hedge positions and would receive
huge margin calls on their enormous futures positions. The positions of MGRM in futures
included about 55,000 contracts, against a daily market volume of 15,000—30,000 contracts.
To liquidate its futures positions completely, MGRM would require anywhere between 30
and 45 days. The liquidation of the huge number of positions in itself would have been a big
problem, in case such a need did arise. In essence, MGRM was a market maker rather than a
small market participant, and failed to recognize that its impact cost would be too high and
would defy the normal behaviour of prices.

Hedge Ratio and Mismatch of Positions and Timings

The MGRM employed a naive hedge ratio of 1:1 without concern for deliveries under its
forward contracts. Against a future supply of 150-160 million barrels spread over a period
of 10 years, monthly deliveries were of the order of 1.2—1.3 million barrels. This entailed a
mismatched maturity and quantity structure.
- Under futures, hedge price risk gets replaced by a much smaller basis risk. The basis risk
is the difference between the price of the instrument and the price of the underlying asset
being hedged. Hedgers in the futures market are said to be ‘speculators on basis’. In terms
of aggregate delivery, the sizes in the forwards and the futures did match, but considered
from the viewpoint of monthly delivery schedules, the positions in futures were 120 times
the forward positions. Thus, MGRM was exposed to an excessive quantum of basis
risk
(about 120 times its physical positions). Therefore, variations in the value ofthe short-dated
futures positions were not compensated by equal and opposite variations in the value
of
the long-dated delivery contracts because of the one-for-one hedges entailed. One
barrel of
oil for delivery in one month is simply not equal in present value to one barrel
of oil for
delivery in 10 years, and the values of two obligations of different dates do not
move in lock
step.

Marked-to-market and Cash Flow Mismatch

Another problem MGRM encountered was the timing of cash flows required
to maintain
the hedge. Over the entire life of the hedge, these cash flows would
have balanced out. Due
to the mismatch of delivery positions in the forward and the futures,
the profit/loss in the
futures would be 120 times the loss/profit in the forwards, even though
they tended to cancel
out over the entire period of 10 years. MG’s problem was the
lack of the necessary funds
needed, to maintain their position in futures that are marked-to-mark
et (MTM) in case oil
prices dropped. If prices increased, the futures would have a positive
cash flow for MG that
would far exceed the losses in the forwards. However, if prices
declined, the negative cash
flow would be massive, and would far outweigh the gains in the
forwards.
Given the fact that-this risk management strategy did play
a key role in acquiring busi-
hess pursuant to their corporate objectives, the management should
have obtained a complete
understanding of the strategy. The MGRM followed a textboo
k hedging strategy that was not
properly understood by its supervisory board and house banks.
The MGRM placed the entire
hedge in short-dated delivery months rather than spreading
this amount over many, longer-
dated delivery months, because the call options were tied to front-m
onth futures contracts at
 Derivatives Disasters 649

the NYMEX. Studies have demonstrated the effectiveness of using stacked hedging. MGRM’s
strategy was sound from an economic standpoint.
A rolling stack of short-dated futures initially increases the variance of the cash flows.
This occurs because movements in the price of oil within a month create losses or gains for
the entire stack of contracts. These losses or gains must be settled by the end of the month,
while compensations for gains or losses on deliveries are realized only gradually over the
remaining part of the 10-year tenure of the delivery contract. When cash flows matter, the
rolling stack may be worse than no hedge at all. It was the realized losses through MTM
against the unrealized gains in forwards that caused a massive fund outflow that was beyond
the means of MG.

From Backwardation to Contango

Oil prices decreased and futures went in contango because the Organization of the Petroleum
Exporting Countries (OPEC) had problems in holding its quota. Oil prices started falling
and fell about 33% in 1993. In the particular case of crude oil, the backwardation can be
considered the market’s judgement that OPEC’s cartel pricing was unsustainable over the
long run, and prices would someday collapse. AsOPEC managers became deadlocked on
reaching production quotas in late 1993, the spot price tumbled in accordance with the
expectations reflected in the inverted market, and oil markets moved from backwardation
to a strong carry.
In the oil futures market, the spot price is normally greater than the futures price due
to convenience yield. When this occurs, the market is said to be in backwardation. When
futures markets are in backwardation, the rolling over of a long hedge would result in cash
inflow. The rollover of a long position into a new contract would come at a lesser value than
the contract just settled. However, if the market is in contango, the rollover would result in
a cash outflow. The issue of contango compounded MG’s crisis. Since MGRM was long on
futures with its stack-and-roll strategy, the contango market created rollover losses that were
indeed unrecoverable. The MGRM entered into ‘stacked’ futures positions in the front-month
contracts and then rolled its position forward at the expiration of each contract.
In the contango market, the spot price decreased more than the futures prices. As long
as the market stayed in contango, MGRM continued to lose on the rollover. The contango
market compounded MGRM'°s problem, but their real problem was created by their inability
to handle the cash flow problems created by the drop in oil prices, in conjunction with the
huge volume of futures contracts that they entered into.
The fall in price meant losses in the long futures position, while the market turning from
backwardation to contango meant losses on the rollovers. It was the fall in price that caused
the cash flow crisis, and the contango markets compounded it. If the market had stayed in
normal backwardation, MGRM would actually have picked up a gain on the rollover of their
hedge positions. MGRM’s rollover gains turned into rollover losses. The rollover loss that
resulted from the contango market was the only real economic loss suffered by MGRM. By
this, we mean that the rollover loss was unrecoverable and was not offset by another position.
The rollover risk that the oil market might go into contango should have been factored
into the price of the call options within MGRM'°s forward fixed-rate contracts. The contango
650 Derivatives and Risk Management

market simply meant that the market was at full carry. The contango market did not make
their hedge a bad hedge. It simply compounded their cash flow crunch.

US and German Accounting Methodologies

Accounting also created some problems for MG, which was a German firm, and MGRM,
which was incorporated in the USA. They were governed by different sets of accounting
rules and practices. German accounting standards compounded MG’s problems, while US
accounting permitted hedge accounting. German standards followed the rules of lower of cost
or market (LCM) accounting. In the USA, MGRM met the requirements of ahedge and used
permitted hedge accounting, under which forwards and futures positions could be combined.
Therefore, in the USA, MGRM actually showed the net position of its short forwards and
its long futures. It could be a minor loss or a minor profit because of netting. Their hedge
losses were deferred because they could offset the gains of their forward fixed rate positions.
Using LCM in Germany, MG was required to book its current losses but could not recognize
gains on their fixed-rate forward positions until they were realized. Since German account-
ing standards did not allow for the netting of positions, MG’s income statement in Germany
presented a dismal picture and bleak outlook. As such, their credit rating came under scrutiny,
and the financial community speculated on the demise of MG.
This drastically changed the market arena for MGRM. Their swap counterparties required
additional capital to maintain their swap positions. On the contrary, NYMEX imposed super-
margin requirements on MGRM, more than doubling their performance bond requirement.
This further constrained the cash position. MG would have to either meet its MTM require-
ments through an additional drain on its financial resources or liquidate its futures positions.
If hedge accounting were acceptable in Germany, MGRM°s positions would not have
alarmed
the market place, and they might have been able to reduce their positions in the
OTC market
without getting their eyeballs pulled out.
The timing of margin calls could not have been worse. MG in Germany was passing
through
a bad phase in business, and was forced to sell some assets and reduce manpowe
r to meet its
liquidity crisis. As it is, the company planned to skip any dividend issue
too. Without adequate
funding in case of immediate margin calls, this seemingly sound strategy
becomes reckless.
In view of the huge cash drain on account of MTM, MG had no option
but to lift the
futures hedge. Now the forward position was unhedged, and was prone
to the risk of price
rise. Unfortunately this is precisely what happened. All the ground
lost in 1993 was made up
for in the next year. Had MGRM continued with the futures hedge,
it would have paid back
the cash flows lost in MTM. To make things worse, it was now its
turn to lose on the forward
contracts.
The MGRM accounted for sucha great percentage of the total open
interest on the NYMEX
that liquidation of their position was problematic. MGRM’°s
hedge adequately transferred its
market risk. When oil prices dropped, they lost money on their
hedge positions but the value
of their forward contracts increased. The MGRM exposed itself
to funding risk by entering
into these positions. In that sense, they were speculating. They
were speculating by entering
into medium-term fixed-rate forward positions totaling approxi
mately 160 million barrels of
oil. The sheer size ofthis position created an enormous amount
ofrisk.
 Derivatives Disasters 651

THE OUTCOME
MG’s losses in the futures and swaps markets have raised questions about whether MG was
really hedging or speculating. The hedging strategy of MG has been widely debated. On the
one hand, it is repeatedly argued that the 1:1 hedge strategy of MGRM was a basically sound
strategy. On the other hand, Edwards and Canter, Mello and Parsons, and Ross argue that a
1:1 hedge strategy was significantly oversized, given MGRM’s underlying oil business.
When news of MG’s losses began to leak to the public, it was rumoured that the company
had speculated, betting that oil prices would rise. If it was hedging, as initially reported in the
press, it would be indifferent to changes in the prices. The MGRM was not indifferent to the
direction of oil price movements because it was engaged in an indirect hedge of its forward
positions. The enormous losses it incurred did not result from its naked futures positions, in
which MGRM gambled that the price of oil would rise. The position was more complex than
that. MGRM’s futures and swaps positions were hedges of the medium-term fixed-rate oil
products they had sold forward. The hedge scenarios were as follows: if oil prices dropped,
the hedge lost money and the fixed-rate positions increased in value. If oil prices rose, the
hedge gains offset the fixed-rate position losses. A hedge is supposed to transfer market risk,
not increase it. If this were a hedge, as we have proposed, we must answer the question: how
did MG lose over $1 billion?
While a financial crisis of MG’s magnitude is rare, the nature of their losses is becoming
more frequent in the financial marketplace. Are derivatives the cause of these unexpected
losses that seem to commonly blindside companies? Every few weeks, we hear about a new
company that lost money either speculating in the derivatives market or lacking an under-
standing of a hedge position they entered into. As the derivatives markets continue to grow,
we will continue to hear of losses.
MG’s disaster in the oil markets should be seen as a reminder to the corporate community
to understand the nature of positions in the financial markets and to understand the ramifica-
tions of market movements on financial positions.
At the same time, it should not be seen as a warning sign to corporate CFO’s to stay away
from the derivatives markets. These markets provide tremendous value to their users. The
swaps and futures markets provided MGRM with an opportunity to transfer its market risk. It
successfully did this, but failed, however, to accurately estimate the funding risk of its hedge
position.
Critics assert that MGRM’s strategy exposed it to three significant and related risks:
rollover risk, funding risk, and credit risk, because of the maturity mismatch between the
hedge and the delivery contracts and other features. It was exposed to rollover risk because
of uncertainty about whether it would sustain gains or losses when rolling its derivative posi-
tions forward. It was exposed to funding risk because of the MTM conventions that applied to
its short-dated derivative positions. It was exposed to credit risk because its forward delivery
counterparties might default on their long-dated obligations to purchase oil at fixed prices. If
energy prices fell, this risk is expected to increase because of the increase in the difference
between contractual prices and prevailing spot prices. To minimize the credit risk, MGRM
limited the annual volume supplied-under a contract to no more than 20% of the customer’s
in
needs, and included in the contracts a cash-out option. It could, however, be a factor
MGRM+¥ ability to raise funds against the collateral of these contracts.
 652 Derivatives and Risk Management

By January, the firm was close to declaring bankruptcy and its future was unclear. The MG
eventually negotiated a $1.9 billion bailout from its bankers in tandem with a plan to shed
assets such as its auto parts manufacturing business, its tin mining operations, its recently
acquired heating equipment, and others. The price of MG shares fell by half between Novem-
ber 1993 and February 1994 as a consequence. The MGRM exposed itselfto funding risk by
entering into these positions.

BARINGSPLC: =
‘The Earthquake That Crumblethe
d Old Strong Edifice
Another highly publicized case of derivatives-linked losses relates to Barings PLC, largely
due to a single person named Nick Leeson, who unmindfully carried on with unauthorized
loss-making trades in derivatives and succeeded in fooling the bank’s management by inge-
nious accounting methods to convert those losses into profits.
Barings PLC was one of the oldest merchant banks in Great Britain. Founded in 1762,
the
bank had a long and distinguished history. Barings had helped a fledgling USA arrange
the
financing for the Louisiana Purchase in 1803. It had also helped Britain finance
the Napo-
leonic Wars, a feat that prompted the British government to bestow five noble titles
on the
Baring family. Despite not being in the list of largest banks, with equity of
only £440 mil-
lion, it was an extremely respected and reputed bank that enjoyed the patronage
of an elite
clientele, including the royal family of England.
Barings had long enjoyed a reputation as a conservatively run instituti
on. However, that
reputation was shattered on 24 February 1995, when Peter Baring,
the bank’s chairman, con-
tacted the Bank of England to explain that a trader in the firm’s Singapor
e futures subsidiary
had lost huge sums of money speculating on NIKKEI 225 stock index
futures and options. In
the days that followed, investigators found that the bank’s total losses
exceeded US $1 billion,
a sum large enough to bankrupt the institution. !
Barings had almost failed once before in 1890. after losing millions
in loans to Argentina,
but it was rescued then by a consortium led by the Bank of
England. A similar effort was
mounted in February 1995 but the attempt failed when
no immediate buyer could be found,
and the Bank of England refused to assume liability for
Barings’ losses. On the evening of
Sunday, 26 February 1995, the Bank of England took action
to place Barings in administra-
tion, a legal proceeding resembling the Chapter 11 bankrup
tcy-court proceedings in the USA.
The crisis brought about by Barings’ insolvency ended
just over one week later when a large
Dutch financial conglomerate, the Internationale Nederlanden Groep (ING), assumed the
assets and liabilities of the failed merchant bank for a token
sum of£1.

Dual Role
In 1992, Barings sent Nicholas Leeson, a clerk from
its London office, to manage the back-
office accounting and settlement operations at its
Singapore futures subsidiary, Baring
‘Anatoli Kuprianoy Federal, Derivatives Debacles;
Case Studies of Large Losses in Derivatives Markets
of Richmond Economic Quarterly Volume 81/4 Fall 1995. by Reserve Bank
 Derivatives Disasters 653

Futures (Singapore) (BFS). Soon, Leeson passed Singapore International Monetary Exchange
(SIMEX) examinations that made him eligible to trade on the floor of the exchange. Leeson
was made the general manager and head trader of BFS.
Nick Leeson now had a dual role to discharge—one as the in-charge of potlemient opera-
tions; reporting to Gordon Bowser and Mike Killian, Head Global Futures and Options sales
in London, and the other as floor manager on SIMEX, reporting to the Singapore office to its
Managing Director, and Simon Jones, Director Finance. This dual reporting led to disinterest
in his superiors in exercising supervisory control over the activities of Nick Leeson.
Though supposed to trade NIKKEI 225 futures on behalf of Barings’ clients on SIMEX,
he was also allowed to conduct proprietary trades for Barings. The NIKKEI 225 futures con-
tract is a bundle of stocks that are equal in proportion to the stocks that make up the Tokyo
Stock Exchange’s NIKKEI 225 stock average. The value of futures is derived from the NIK-
KEI 225 average.

Switching
The NIKKEI 225 was traded on SIMEX and the Osaka Stock Exchange (OSE). At times,
price discrepancies existed on the two exchanges, and in order to take advantage, Barings
would allow arbitrage transactions that were hedged. If the NIKKEI 225 futures traded at a
higher price at the OSE than at the SIMEX, the arbitrage transaction would comprise selling
NIKKEI 225 at the OSE and buying it at the SIMEX. When the prices corrected, Barings
would unwind its positions in the two exchanges. This strategy, referred to as switching, gave
assured but limited profit. Barings had been using the conservative approach in line with its
tradition of undertaking hedged transactions only on its own account.
Nick Leeson was allowed to avail of arbitrage opportunities on NIKKEI futures listed in
Tokyo, the OSE, and the SIMEX. The strategy of switching was to hedge a position in one
exchange with an opposite position in another in respect of all proprietary positions to contain
risk. Unhedged trades were allowed for Leeson to the very limited extent of the following levels:
1. 200 NIKKEI futures contracts
2. 100 Japanese bond contracts
3. 500 euroyen futures contracts

Unauthorised Trading and Misrepresenting Accounts

Leeson, however, embarked upon a much riskier trading strategy. Rather than remaining
confined to switching, as Barings’ management had permitted, he began placing bets on the
direction of price movements on the Tokyo stock exchange. From the beginning itself, the
bets proved wrong, and Leeson started making losses.
On 3 July 1992, an account with the number 88888 was created as an error account. Lee-
son asked his technical computer personnel to modify the software so that trades, prices, and
positions were not reported to the London office, and only margin balances were reported.
Having worked in London, Leeson knew that only the trade and prices of positions were
downloaded in the internal reporting system of Barings, and margin balances were ignored
by the London office.
 654 Derivatives and Risk Management

The London office had allotted code 99002 as the account for the Singapore trades, but
Leeson kept on trading in 88888. For cross trades, i.e., buy and sell transactions from the
- same firms, the London office allotted account 92000 (Barings Securities [Japan] Govt
Bond Arbitrage account); account 98007 (Barings Securities [London] Govt Bond Arbitrage
account); account 98008 (euroyen arbitrage) to satisfy the requirement of the SIMEX. Leeson
would ask the staff to break down transactions in many lots and record them in the Barings
accounts at prices higher than those he had paid on SIMEX, hence showing profits. Gains in
these three accounts also resulted in losses that were buried in 88888.
Leeson ignored hedging/switching tactics, and went long on both the OSE and the SIMEX.
By doing so, he was exposed to twice the risk he would have faced in being hedged if the
markets fell.

The Trap of Losses

By the end of 1992, i.e., just a few months after he began trading, Leeson had accumulated a
hidden loss of £2 million. He used his position in the back office to hide the losses. In Sep-
tember 1992, he debited money from a Barings receivables account at Citibank and credited
it to 88888 to hide the trading losses in that account. The loss figure remained unchanged
until October 1993, when his losses again began to rise sharply. He lost another £21 million
in 1993 and £185 million in 1994. The cumulative losses at the end of 1994 stood at £208
million.
However, his reported trading profits were spectacular. The bank’s senior management
regarded him as a star performer. In fact, the loss of £208 million was slightly larger than
the
£205 million profit reported by the Barings Group as a whole, before accounting for
taxes
and for £102 million in scheduled bonuses.
Sometime in 1994, Leeson began selling large numbers of option straddles, a strategy
that
involved the simultaneous sale of calls and puts on the NIKKEI 225. The seller
of an option
straddle earns a profit only when the markets remain range bound, which Leeson
thought
would be so. The NIKKEI 225 had been trading in a very narrow range in
the past. He was
perhaps motivated to write options to earn some money to meet his large losses,
as also the
margin calls for the MTM losses on the futures position. Once Leeson lost,
he kept doubling
down to extricate himself from the situation. He did not hedge because
to cover up the losses,
he had to follow the first in first out (FIFO) principle in account 88888.

The Straddle
By | January 1995, Leeson was short on 37,925 NIKKEI calls and
on 32,967 NIKKEI puts.
He also held a long position of just over 1000 contracts in NIKKEI
stock index futures,
which would gain in value if the stock market were to rise. He
sold straddles on the NIK-
KEI, hoping for range bound movements between 19,000 and
19,500. With a double long
position in futures in the OSE and the SIMEX and the straddles,
he was hoping that if the
NIKKEI remained flat, he would pocket the straddle premium
. If the index increased, the
futures would give profits. He was already down £ 208 million
by the end of 1994, It seemed
to him to be the only way to recover. The only risk was if the
NIKKEI moved down, when
the futures and the straddles would both lose.
 Derivatives Disasters 655

Kobe Earthquake
That was precisely what happened. Disaster struck on 17 January, when news of a violent
earthquake in Kobe, Japan, sent the Japanese stock market into a tailspin. The NIKKEI went
down to 18,950, making puts in-the-money. Over the next five days, the NIKKEI index fell
over 1500 points, and Leeson’s options positions sustained a loss of £68 million. The long
futures positions lost, as did the put options. After the Kobe earthquake, Leeson believed the
NIKKEI had over-reacted and was undervalued. Hence, he went additionally long on 10,814
NIKKEI futures contracts on 20 January to break even or even to make profits. On 20 January
at the OSE, the NIKKEI lost 220 points and at the SIMEX, it lost 195. If Leeson were short
on the SIMEX and long on the OSE, the loss would have been only 25 points. If it were the
other way round, there would have been a profit of 25 points. With long positions in both the
exchanges, however, the loss was 415 points.
This strategy seemed to work for a short time. By 6 February, the Japanese stock market
had recovered by over 1000 points, making it possible for Leeson to recoup most of the losses
resulting from the market’s reaction to the earthquake. However, within days, the market
began falling again, and Leeson’s losses began to multiply. The NIKKEI went below 18,000
in mid-February 1995. He also placed a side bet on Japanese interest rates, selling Japanese
government bond (JGB) futures by the thousands in the expectation of rising interest rates
sent
and falling bond prices. Market risk got coupled with event risk: the Kobe earthquake
the NIKKEI down. It also increased volatility in the equity markets. The increase in volatility
increased option prices.
He could not have squared up on the short straddles too. Even if he wanted to hedge, he
not
could not do so. If he used official accounts, he had to establish huge positions. He could
the FIFO rule applied. One hedging strategy would be to liquidate
hedge in 88888 because of
turn to
all NIKKEI long and JGB and euroyen short. In that case, the unrealized loss would
realized loss.

The Exposure
his exposure
Leeson did not believe that prices would crash further. He continued to increase
bought over 61,000 NIKKEI futures
as the market kept falling. By 23 February, Leeson had
NIKKEI futures
contracts, representing 49% of the total open interest in the March 1995
in JGB futures
contracts, and 24% of the open interest in the June contracts. His position
ing 88% of the open interest in the
totalled up to just over 26,000 contracts sold, represent
He began 1995 with
June 1995 contracts. Leeson also took on positions in euroyen futures.
fall), but then
long positions in euroyen contracts (a bet that Japanese interest rates would
he had accumula ted a short position in
switched to selling the contracts. By 23 February,
1995 contracts and 1% of
euroyen futures, equivalent to 5% of the open interest in the June
the open interest in both the September and December contracts.

Funding MTM Losses

how were the margin
The question that now arises is: with the futures showing MTM losses,
re because he convinced
calls made good? Leeson was able to meet margin calls in Singapo
purported difficulties
the London office to provide him easy access to funds, in view of the
 656 Derivatives and Risk Management

in raising money from Japanese banks in Singapore. The London office thought that though
there were losses at the SIMEX, they were covered by the profits in the OSE, because they
always believed that Leeson was doing switching. Possibly, given the compulsions of meeting
margins coupled with the observation that the NIKKEI was range bound, Leeson decided
to write straddles. Till February 1995, Nick Leeson was able to receive funds from London
without being questioned about his ability to meet margin calls.

The Outcome
Barings faced massive margin calls as Leeson’s losses mounted. While these margin
calls
raised eyebrows at the bank’s London and Tokyo offices, they did not prompt an
immediate
inquiry into Leeson’s activities. It was not until 6 February that the Barings
group’s trea-
surer, Tony Hawes, flew to Singapore to investigate irregularities in the
accounts at BFS.
Under the impression that liabilities in the SIMEX were matched by correspo
nding assets
at the OSE, he assured the SIMEX that there would be no problem
in meeting the huge
liabilities. Only later was it learnt that Leeson had stand-alone positions,
and no switching
was done.
On 24-25 February, Leeson left Singapore with his wife and faxed
his resignation to the
Barings London office from a hotel in Kuala Lumpur, stating,
in part, "My sincere apolo-
gies for the predicament I have left you in. It was neither my
intention nor aim for this to
happen’. Leeson was later detained by authorities at the
airport in Frankfort, Germany, and
was extradited to Singapore the following November. In
Singapore, Leeson pleaded guilty to
charges of fraud, and was sentenced to a 6 1/2-year prison
term.
The payment to be made to the SIMEX was $835 million
(Barings had a capital of $615
million) led to bankruptcy. Accounts could not be reconci
led, and it was discovered later that
Leeson had lost astronomical sums of money.
Peter Baring, the bank’s chairman, was forced to call
the Bank of England to ask for assis-
tance when he learnt of the bank’s difficulties. Most
of the cost of the Barings debacle was
borne by its shareholders and by ING, the financial
institution that bought Barings. Barings
was a privately held firm; most of its equity was
held by the Baring Foundation, a charity
registered in the United Kingdom. Although ING
was able to buy the failed merchant bank
for a token amount of £1, it had to pay £660
million to recapitalize the firm. The SIMEX
subsequently reported that the funds Barings had
on deposit with the exchange were suffi-
cient to meet the costs incurred in liquidating
its positions. It is not known whether the OSE
suffered any losses as a result ofthe Barings
collapse.

Analysis
Several studies have been made analysing the
causes of the debacle. Almost all of them
converge with the opinion that lack of super
vision largely contributed to the debacle
of the world’s oldest and most respected at one
banks. Dual control created ambiguity in
vision between the London headquarters and super -
the subsidiary in Singapore, a situation that
Leeson seems to have taken great advantage
of. Normally, the functions of trading and
ments are kept separate within an organizati settle-
on, as the head of settlements is expected
vide independent verification of the records to pro-
of trading activity, However, Leeson was
never
 Derivatives Disasters 657

relieved of his authority over the subsidiary’s back-office operations when his responsibilities
were expanded to include trading.
After Barings failed, however, investigators found that Leeson’s reported profits had been
fictitious from the start. His duties included the supervision of both trading and settlement
activities for the Singapore subsidiary, and, therefore, Leeson was able to manufacture ficti-
tious reports concerning his trading activities.
Some observers have also remarked that at the SIMEX and the OSE, which were fierce
competitors, there were relaxations such as the position limits granted to Barings, the largest
customer. Though exemptions on margins are granted on hedged positions and to esteemed
customers, there was no effort by the SIMEX to crosscheck the offsetting positions with its
rival exchange.

LONG TERM CAPITAL MANAGEMEN

The Risk Management Models That Crashed
Long Term Capital Management (LTCM) was a Connecticut-based hedge fund founded by
John Meriwether—erstwhile Salomon Brothers executive—that started operations in 1994.
Meriwether believed in strong analytics and academicians, and put together a management
team that included Robert Merton and Myron Scholes, the Nobel laureate of the famous
Black-Scholes Model (BSM), and David Mullins, who as vice chairman of the US Federal
Reserve had helped to write the famous Brady report, which had investigated the 1987 stock
market crash.

HEDGE FUNDS _
Hedge funds are investment vehicles for wealthy investors that are largely unregulated, since
they do not mobilize funds from the public like other financial institutions, pension funds,
and mutual funds. Their investors are presumed to be sophisticated enough not to require the
same protection as an average investor needs.
Hedge funds can invest in anything that is legal, with no limits on the amount of risk. The
fees charged are high, and the managers of a successful fund are very well paid. However,
the principals normally invest a substantial amount of their own wealth in their fund to align
incentives, on the premise that the managers’ incentives are better aligned when the fund
managers are investors, too.
The first hedge fund was set up in 1949 by Alfred Winslow Jones. He used a strategy of
selling short stocks that he considered to be overvalued and using the proceeds to buy stocks
that he thought were cheap. A portfolio constructed in this manner would not be adversely
affected by broad market movements, because losses on one side would be offset by profits
on the other. In this way, the portfolio would be protected or hedged, hence the name *hedge
fund’.
Hedge funds operate without much publicity till they deliver noteworthy performance,
good or bad. The only time they are in the news is when a large fund is involved in something
dramatic, such as the case under study.
658 Derivatives and Risk Management

Another feature of hedge funds is the extraordinary leverage they have, and their extensive
use of derivatives. The leverage multiplies gains as well as losses. In general, any investment
restrictions are self-imposed. Hedge fund returns do not always move exactly the same way
as those of the market as a whole, and this feature can be attractive to investors seeking
additional diversification. Hedge funds also provide benefits to the financial system. Hedge
funds are in the business of taking risk, and they can absorb the risks that other market par-
ticipants wish to shed. Paradoxically, the very features of hedge funds that are beneficial to
the system can be dangerous if taken to excess, to the extent that the stability of an entire
financial system is threatened, leading to systemic risk due to the huge positions taken.

GROWTH OF LTCM °
The stellar reputations of the firm’s principals made it much easier for LTCM to raise money
than if it was just another hedge fund. The LTCM was able to obtain cash from quasi-gov-
ernmental agencies, and even the central bank of Italy invested US $250 million. LTCM had
the target of raising US $2.5 billion in initial capital. The firm was able to raise US $1.25
billion, which was an unprecedented corpus in a new hedge fund.
Hedge fund charges are based on performance incentives as well as fees on asset size. As
against the performance-based benchmark of 20% of the profit, LTCM’s incentive was 25%,
with an annual fee of 2% of the asset size, as against the industry norm of 1%.
The LTCM promised annual returns in excess of 30% to its investors, after adjusting
for
incentives and fees. For the first three years of its operations, the fund lived up to
this prom-
ise. Its returns, net of fees and management charges, were around 40% for the
two years 1995
and 1996, and slightly less than 20% in 1997,

THE STRATEGY i
Hedge funds do not have any restrictions on the way they operate.
They can adopt any
profit-making strategy on offer in the market place. The key
issues are risk appetite and
the size of operations. They take advantage of global economic
developments, capitalizing
on event-driven opportunities like mergers and acquisitions, reorgani
zation, and bankrupt-
cies, and engage in relative value trading. The LTCM initially
was focussed on this kind
of trading.
Relative value trading is basically identifying temporary price
discrepancies and exploit-
ing these opportunities to make profits. If two bonds were mispric
ed relative to each other,
the fund would buy the cheaper one and sell the dearer one
until the prices came back into
line with one another. Bonds necessarily have to converge
to face value at their maturity. The
initial strategy of LTCM typically involved the buying
and selling of two US T-bonds with
very similar maturities, whose prices were slightly out
of line, and holding them till their
prices fell in line. The fund bought the cheaper bond and
sold the same amount of the dearer
bond. This is called convergence trade. Under relative
value trade, there is no guarantee that
the prices would converge but there is strong expectation
that the difference would shrink.
The LTCM did active relative value trading on bonds—
taking long positions on undervalued
bonds and short positions on overvalued bonds of
the same maturities but different issue
dates. They must sell at the same yield, but do not.
Based on the convergence of prices
 Derivatives Disasters 659

brought about by taking offsetting positions in two related products, the strategy worked well
in 1995, providing a 43% return; in 1996, it yielded 41%.
The LTCM used its models and trading expertise to take calculated risks that were very
profitable in the fund’s first few years. It was able to identify and exploit even small price dis-
crepancies between bonds of differing maturities or of different types. For example, if LTCM
noticed that the spread between the yields on corporate bonds and T-bonds was higher than
the historical spread, it would buy the corporate bonds and sell T-bonds in the hope that the
spread would return to its normal and historical level. If that happened, LTCM would make
money, but if the spread persisted, or if it widened, then the trade would lose money.
Due to its highly leveraged position, the fund made very profitable trades on Japanese con-
vertible bonds, junk bonds, interest rate swaps, and Italian bonds. It was also able to exploit
a spread between French bonds and German bonds that seemed unsustainable. The reason
LTCM focused on bonds was that very robust models on interest rates are available.
Successful strategies are susceptible to imitation. By the end of 1996, the opportunities for
profitable trades in this area were diminishing. This was partly because of competition from
other institutions. By 1997, other firms started following LTCM, reducing opportunities for
LTCM in the bonds markets. The LTCM struggled to get a mere 17% return in 1997.

Digression from Practice and Beyond Frontiers

The lack of opportunities due to imitation forced LTCM to expand its activities in order
to achieve higher returns. The firm moved from bonds to riskier equity avenues. They also
expanded to markets beyond the USA, including emerging markets, while continuing to
employ the relative value trading concept.

From Bonds to Equity

The LTCM set up a trade of this type based on the shares of two oil companies—Shell Trans-
port (listed in London) and Royal Dutch Petroleum (listed on the Amsterdam exchange)—on
the assumption that the prices would converge. This was risk arbitrage. The idea of paired
share trade involved finding a stock that is listed on two exchanges whose value represents
for
roughly the same claim on the firm’s assets. The prices of the pair should be equal, but
persist. Royal Dutch Petroleum and
institutional reasons, price discrepancies can open up and
Histori-
Shell Transport derived their income from the same asset, which they jointly owned.
Accord-
cally, the shares of the English company traded below those of the Dutch company.
markets became more integrated; and
ing to LTCM, the spread would contract as European
with a position
the firm proceeded to go long on Shell and short on Royal Dutch Petroleum,
the earlier
of at least a billion dollars in each stock. This was a riskier strategy than some of
prices was less assured. The sheer size of
bond plays because the convergence of the stock
quickly at
the trade meant that LTCM’s positions in these two stocks could not be unwound
current market prices.

Directional Trade and Derivatives

based on its
The LTCM also engaged in directional trades, where it would take a position
, reflecting a
view of the future. For example, when the value of index stock options increased
 660 Derivatives and Risk Management

higher degree of uncertainty about the future than normal, LTCM took up positions in index
options. The portfolio of LTCM expanded to bonds and derivatives in developed nations such
as Canada, France, Germany, Italy, Japan, and the UK. The fund also invested in equities and
corporate bonds, as well as in emerging markets. It made extensive use of both exchange-
traded and OTC derivatives, because this afforded a cheap way to gain exposure to differ-
ent markets and increase leverage. In particular, it took significant positions in equity index
futures and interest rate futures in a number of countries. It was also extremely active in the
OTC derivatives markets, and had a very large portfolio of swaps with a number of different
counterparties.

Speculation of Corporate Activities

The LTCM also entered a riskier arena by speculating in mergers and acquisitions outcomes
.
This involved buying stocks of companies that were potential takeover targets
and profiting
from the price rise that would occur when the takeover was announced. This
trade is a form of
risk arbitrage that requires considerable research to be profitable, as so
many imponderables
are involved. One such trade involved the stocks of a communication
company based in
Chicago, called Tellabs, which had planned to acquire another telecomm
unications company
called Ciena Corporation. This trade was information sensitive.
The LTCM took a position
worth US $300 million in Ciena’s stock. The acquisition was announce
d on 3 June 1998 but
was unexpectedly withdrawn on 21 August 1998. This caused
Ciena’s stock price to drop by
45% and LTCM lost about US $50 million.

Volatility Trades
Another of LTCM’s strategies was to take positions based
on volatility. As is well known,
high volatility means high option prices. Based on
the BSM, LTCM worked out implied
volatilities. It took the view that when the implied
volatility in the market reached 20%, it
would eventually revert to more normal levels of
13-15%, under the assumption of mean
reversion, and when that happened, the option prices
would fall. In 1997, LTCM began to
sell five-year options on the S&P 500 Index. expect
ing to buy the options back at a lower
price when volatility returned to normal levels. This
was LTCM’s plan but implied volatility
remained high throughout 1998, which resulted
in the firm losing money.

There were a number of events that occurred aroun

d the same time that failed to live up to
the theories and principles applied by LTCM
.

Asian Financial Crisis

The Asian crisis also affected global equity
markets, culminating in a severe fall in Octo-
ber 1997. Investors became more frightened,
and the levels of implied volatility in equi-
ties increased. Seeing an opportunity to make
money, LTCM began to take on large optio
positions based on the assumption that the n
implied volatility levels would fall. The bets
volatility went awry. on
 Derivatives Disasters 661

Russian Default and Brazil’s Devaluation

On 17 August 1998, Russia declared a moratorium on its domestic dollar debt, and this trig-
gered a flight to US government debt, which meant that the price of US bonds rose. LTCM
was long on Russian debt, to the extent of about 8% of its portfolio, and it was also short on
US bonds. The hedge fund lost money on both these positions. On 21 August, LTCM lost US
$553 million. Many of the hedge funds’ trades were losing heavily at this time, and the coun-
terparties on the other side of these transactions were requiring cash payments from LTCM
to protect their own interests. The devaluations saw funds withdraw from these markets in
search of safer markets. Prices in more stable markets increased, while they fell in emerging
markets, once again causing divergence to increase.

Salomon Brothers’ Withdrawal

The risk arbitrage group at Salomon, Meriwether’s former group, had been using some of the
same types of strategies as LTCM, and was also facing the same sorts of difficulties. In 1998,
Salomon’s risk arbitrage group began to scale back its operations and decrease its leverage.
In June 1998, the Travelers Group, which had acquired Salomon in 1997, made a decision to
close down its risk arbitrage operations. In September, Travelers reported that Salomon lost
US $360 million in July and August because of the ‘extreme volatility’ in global markets.
The swap positions that Salomon and other firms were unwinding this time were similar to
those held by LTCM, and so, as these trades came to the market, they put downward pressure
on market prices.
There were a number of factors that led to the collapse of theLTCM fund in 1998. LTCM’s
financial position was very sensitive to market movements because of its highly leveraged
positions.

FAILURE OF RISK MODELS #

The strategy of LTCM was heavily dependent upon models of determining arbitrage opportu-
nities and risk management. They believed that money management was a quantifiable science
rather than an art. Initially, success prompted increased and more sophisticated modelling.

Volatility
In 1998, the bets on volatility were based on market volatility and the assumption that it
would decline back to its historical average level. By mid-September 1998, equity volatil-
ity was up to 33%, with each point increase costing the fund $40 million. Against a normal
volatility of 1% per day, it became 9%.

Correlations
The LTCM also assumed low correlation in market variables across the globe. However, all
factors became strongly correlated in 1998. Their portfolio consisting of Danish mortgages,
US T-bonds, Russian bonds, US stocks, mortgage bonds, Latin American bonds, UK bonds,
and US swaps was assumed to be highly diversified, with low correlation coefficients. On
662 Derivatives and Risk Management

17 August 1998, Russia defaulted on bonds; the interest rate surged to 200%. On 21 August
1998, the Dow fell 280 points; in US swap deals, the spread rose to 20 points (200 bps) and
mortgage rates climbed.

Normal Distribution
The LTCM relied too heavily on the bell-shaped normal distribution. As per normal distribu-
tion, bad events are remote, but they happened several times in August 1998. When a firm
has to sell in a market without buyers, prices run to the extremes, beyond the bell curve.

Value at Risk
For LTCM, a 95% 1-m VaR was $448 million. With $4.7 billion as capital, it was more than
adequately covered for an assumed volatility of 20%. Risk was thought to be within man-
ageable limits. LTCM’s objective was to have volatility not exceeding 20%. Till April 1998,
volatility measured below 11.5%. The LTCM used VaR based on historical data. It studied
various markets in various countries. When the relationship diverged, it placed bets that the
relationship would return to historical levels. The market factors became correlated with the
Russian default, capital outflows from Brazil, the inability to unwind positions, etc. It made
the VaR look irrelevant to risk measurement and management. As per the VaR, LTCM was
not likely to lose more than $40 million on any given day. In August 1998, it lost $500 million
in a day. It lost the same amount in September, and kept losing day after day.

Liquidity
The LTCM assumed that market risk remains the same, irrespective of the leverage used by
a firm. This is true if liquidity is good. However, when the trader becomes a
market maker,
liquidity is not guaranteed. The LTCM possibly ignored the fact that
it was not a small part
of the market but formed a substantial chunk of it. It assumed that its
positions could be
Squared up if the risk exceeded the target level. This did not happen, and
LTCM could not
liquidate due to its huge positions.

Leverage
At the end of 1997, LTCM had assets on its balance sheet worth
$130 billion, with its equity
at $4.7 billion, providing a leverage of 28:1. Besides these, it
had off-balance sheet exposures
in derivatives ofa notional value of $1.4 trillion (including $500
billion in futures and $750
billion in OTC derivatives). From the perspective of leverage
, both on and off the balance
sheet, LTCM matched larger investment houses such as Goldma
n Sachs (34:1 and 3.41 tril-
lion), Lehman Brothers (28:1 and 2.4 trillion), Merrill
Lynch (30:1 and 3.47 trillion), and
Morgan Stanley (22:1 and 2.86 trillion).
LTCM’s increased leverage was partly due to the high reputat
ion of its management team.
In OTC and swap deals with non-banking firms, the practic
e is to insist on collateral at the
time of initiating contracts: This practice was diluted by
bankers in Wall Street due to the high
*Gallati, Reto R., Risk Management and Capital Adequacy
, McGraw Hill, 2003, p. 470.
 Derivatives Disasters 663

reputation of the principals of LTCM, thus providing them with infinite leverage. Partly, the
increased leverage also resulted from the decision of LTCM to return $2.7 billion (182%) as
dividend to its investors in 1997 to gain market reputation and credentials, showing little con-
cern for leverage. The capital came down suddenly from $4.67 billion in the beginning of 1998
to $2.9 billion. Now, the leverage was 55 times, apart from the exposures in derivatives. An
investment of $1 in 1994 grew to $4 at the end of 1997, but shrank to 50 cents by mid-1998.

Convergence
One of the fundamental strategies was relative value trading, based on the convergence or
reduction of divergence of value over a period of time for similar assets. In August 1998,
the situation changed when Russia defaulted on its debts and devalued the rouble. Devalua-
tion of the rouble caused a global margin call. The currencies and values of bonds declined
simultaneously and sharply.
In July 1998, Salomon Brothers decided to disband its bond arbitrage unit. Interest rate
spread, on the US T-bills and bonds increased. The LTCM counted on the spread closing on
low-liquid and high-liquid treasuries. Salomon was selling positions that increased diver-
gence rather than convergence. The LTCM assumed that divergence between swap rates
and T-bonds would narrow. Every five basis points were equal to $2.8 million. For five such
adverse jumps, the loss could only be 5 X 2.8 = US $14 million. It was not so. On 21 Sep-
tember, the fund lost $553 million.
As per the LTCM models, it was a once in a lifetime occurrence. The LTCM lost 15% of
its capital, while according to the model they were not supposed to lose more than $35 mil-
lion on a single day. It was more than 10 times the daily volatility. By the month end, LTCM
lost 15% of its capital. The spread between corporate and government debt securities also
increased. The Russian crisis forced investors to invest in more liquid US treasuries, increas-
ing divergence further.
The convergence theory of LTCM was not working. The LTCM lost 44% of its capital in
August alone (52% for the year). It put itself into the position that it could fail before conver-
gence happened. It needed more collateral to cover for margin calls, which was unavailable.
Non-convergence is due to a variety of reasons such as restrictions on free trade or a minor
difference in the characteristics of seemingly identical assets. The differential in price may
persist for a longer time than one would expect.
For example, we find that in India, Tata Motors have voting and non-voting shares, with
the latter providing extra dividend. The price differential between the two (apparently on
account of the control of the firm) persists at 40%, despite the fact that both values are driven
by the same cash flow. The same was the case with Nestle’s registered and bearer shares in
Switzerland for a long time, before they became one in 1988.

THE OUTCOME
During the last week of August, the firm’s partners tried in vain to raise the US $1.5 billion
in additional capital needed to keep the fund afloat. This proved to be impossible and by
mid-September, a collapse was inevitable. The excessive leverage and market-maker posi-
tion of LTCM posed the hazard of systemic risk. Defaults by LTCM could lead to a chain
 664 Derivatives and Risk Management

of defaults in the financial system, and could lead to the collapse of others. Fourteen leading
banks decided to invest US $3.65 billion and obtain a 90% stake in LTCM. The margin calls
for LTCM was answered by a bail-out package.
The fall of LTCM was highly publicized, and it was subsequently analysed in a number of
reports. The near collapse of the huge hedge fund renewed fears about the vulnerability of the
entire financial system to systemic risk. Questions were raised concerning the role of hedge
funds in the economy and the extent to which the trading practices of LTCM contributed
to the crisis. In the aftermath of the fall, questions were raised about the risk management
practices of not only LTCM but also the institutions that had lent it so much money.

Sumitomo was a large Japanese bank with specific interests in copper trading. They had $50
billion worth of assets globally and controlled about 8% of the world’s copper supplies and
markets. With more than 200 years of experience and expertise in metals, they bought and
sold roughly 8,00,000 tonnes of copper every year around the world, selling primarily in
Southeast Asia. The key person handling the global purchases was Yasuo Hamanaka.
.
With its dominance in the copper market, the actions of Sumitomo were important clues
for traders in copper. With huge positions in copper, the prices could not remain aloof to
Sumitomo’s actions.

Overconfidence of Leader
Due to the small size of the global copper market as compared to other metals
and the sig-
nificant proportions held by Sumitomo, Yasuo Hamanaka believed that he could
influence, if
not control, the prices of copper. This very belief of his caused a loss of about
US $2.6 billion
to Sumitomo in June 1996, when Hamanaka miscalculated and ruled
out the possibility of
copper prices falling; he made an all-out attempt to cause the prices
to go up.
The strategy of Yasuo Hamanaka was to corner all the copper stored
in the warehouses
of the London Metal Exchange (LME). He would create long position
s in physical copper,
pay for them, and hoard the copper at the warehouses of the LME.
Large positions in copper
were thought to be genuine requirements of Sumitomo in view
of their huge trading interests
in the past.

Concentration of Authority
With an increasing physical copper inventory, supplies were
drying up, causing an upward
pressure on Copper prices. Yasuo Hamanaka operated with
reputed banks and trading houses
of the calibre of Merrill Lynch, JP Morgan, Chase Manhat
tan, etc. He was given a power of
attorney by the management of Sumitomo to trade, which
in turn he passed on to the broking
houses. The banks and trading houses conducted trades
in copper with the world and all
markets knowing that the operations were acting on behalf
of Sumitomo. All these operations
were neither checked nor monitored at the apex level
 Derivatives Disasters 665

Due to the confidence that he could drive the prices up, Hamanaka started writing put
options to earn a premium. With prices going up, the puts would not be exercised and the
premium would be pocketed. As long as prices remained up and rising, writing puts would
remain a profit-making strategy.
The freedom given to Hamanaka possibly developed an attitude of carelessness, even
though Hamanaka could not make a profit every time. Trading in physical copper and futures
caused losses too. To hide losses, he prepared duplicate sets of accounts, which showed prof-
its to the management.

THE OUTCOME = ies

In December 1995, copper prices rose close to $2800 per tonne on the LME, when events
started happening rapidly. Suspecting a price manipulation in copper, the US Commodity
Futures Trading Commission (CFTC) and Britain’s Securities and Investments Board (SIB)
asked Sumitomo to cooperate. The prices remained in the band of $2500 to 2600 till about
mid-April 1996. Then they shot up to $2800 again by May 1996.
Sumitomo discovered Hamanaka’s actions, and he was relegated to a junior position. The
positions in physical copper held by Sumitomo were substantially out of proportion to its
business needs. Apart from the physical positions, Sumitomo also had significant long posi-
tions in copper futures. These large positions in physical copper and futures were considered
to be speculative and motivated by profit, through artificial manipulation of the price of
copper. The market suspected something amiss, and investors started off-loading their long
positions, hoping that Sumitomo would do the same. Prices fell abruptly by about 15% in
four days and by the third week of June, copper was ruling close to US $1800 per tonne at
the LME.
Hamanaka’s folly was that he could not accept that even the most successful market
manipulator must face unfavourable situations. Rather than selling copper in the downward
market, he thought he could still drive the prices up. He kept picking short sales in order to
raise the prices. He thought that he could still do it in the falling markets. Hamanaka failed
to minimize the downside risk of the falling copper prices. With huge physical long positions,
Sumitomo was extremely vulnerable to declining prices. He also financed his long positions
through credit lines and prepayment of swaps with major banks.
Sumitomo was able to unwind some of its positions at a huge loss, and suffered a penalty
of US $150 million for being guilty of price manipulation. The total estimated loss was to
the order of US $2.6 billion. Hamanaka was fired, arrested, and jailed.

" PROCTERANDGAMBLE =——t™”

Thl
The Gamb e n't Pay Off —_
at Did
Another classic case of derivatives being put to misuse is that of Procter and Gamble (P&G).
Procter and Gamble entered an exotic swap deal with Bankers Trust in November 1993 for
a period of five years, with semi-annual exchange of cash flows, wherein Bankers Trust paid
a fixed 5.30 % and P&G paid the 30-day commercial paper rate less 75 bps plus a spread.
 666 Derivatives and Risk Management

The spread was the differential between the prices of five-year treasury notes and a specified
30-year T-bond. This is often referred to as a ‘5/30’ swap. Procter and Gamble hoped that
the spread would be zero, and it would lock-in a financing rate of 75 bps less than the com-
mercial paper rate. The swap, therefore, would transform the fixed rate obligations of 5.30%
into floating rate obligations, as they expected the interest rates to remain low.
Procter and Gamble entered into another swap deal with Bankers Trust, linked to the
exchange rates of the Deutsche mark. Both parties paid each other based on German interest
rates. Procter and Gamble hoped that swap rates in the Deutsche mark would remain within
the 4.05—-6.10% band, when they would receive higher coupons. Both the swap deals were
bets that the US interest rate as well as the German interest rate would not rise.
The bets went wrong and barely six months after the swaps, P&G disclosed a loss of US
$157 million. The cost of borrowing went as high as 1400 bps above the commercial paper
rate. When P&G wanted to unwind the position, they had to depend upon the pricing of
Bankers Trust based on their proprietary model.
Procter and Gamble sued Bankers Trust, who argued that P&G had sufficient knowledge
of derivatives in view of their successful experience of hedging with derivatives, and that
P&G fully understood the complex nature of the swap deals they had entered into. Procter
and Gamble alleged that they were misled by the advisers, i.e., Bankers Trust. Ultimately,
even though optimistic of a favourable outcome to the legal case, Bankers Trust
chose to
settle the dispute with P&G by paying US $80 million in May-June 1996,

RNINGS FROM THE CASES

The cases described in this chapter offer many points of learning. Some
of these are not
unique to management. They simply reinforce the validity of the fundamen
tal principles that
are applicable to any discipline of management. These principles
also apply to derivatives,
which are no exception. Some of these points of learning are specific
to the area of derivatives
in view oftheir special characteristics. These are highlighted in
this section.

Markets are Supreme

Many investors, not only in derivatives but in all forms of markets
, seem to believe that they
know the market too well. They assume that they have
been in the markets long enough to
have seen several up and down cycles, and, therefore, can
predict the market moves. Experi-
ence in the market is a good thing to have, but to believe
that it imparts a complete under-
standing is bad. This presumption leads to rising stakes,
and that proves detrimental to the
investor when the market behaves unfavourably. It must
be said that the markets have the
capacity to surprise one and all. Markets do not care
for reputation (Barings), size (Sumi-
tomo), needs (MG), or superlative knowledge (LTCM)
.

Models Do Not Work Always

We have seen several models of pricing and theoreticall
y strong arguments for arbitrage. These
models do make some simple underlying assumptions,
which are sometimes forgotten or
 Derivatives Disasters 667

overlooked. These assumptions place limitations on the applicability of models. One of the
limitations that practically every model faces is the normal conditions in the markets. Howso-
ever robust a model is, it tends to fail when the markets are abnormal. The episode of LTCM
is a case in point. When abnormality in the market persists for some time, defying all logic,
several assumptions fall flat. This is an important realization for all researchers, academicians,
and practitioners alike.

Complacency and Lack of Supervision

Another important lesson to be learned from the cases highlighted in this chapter is the
importance of supervision in all business activities. In the case of derivatives, supervision
assumes much greater significance due to two additional facts that are generally not present
in other business situations. One, derivative transactions involve much greater value than
suggested by the cash outlay. For taking a futures position, one has to put in the margins
only. For forwards, there is no cash flow and for options, there may be an inflow if one has
written them. Little do we know of about the mammoth exposure in the value underwritten.
Two, derivatives escape accounting treatment for a long time till they are settled; the profit
and loss becomes known only at maturity. By then, all control over the situation has been lost.
Since there in no accounting, derivative transactions escape scrutiny by auditors, supervisors,
and management.
The leveraged nature of derivatives and the absence of accounting demand that an organi-
zation develops adequate and extra control mechanisms outside the routine accounting-based
controls. This may be by way of special detailed reports that must be analysed comprehen-
sively. Organizations do have several reports, but the tendency is to give them only a cursory
look.

Star Status
The lack of supervision is also partly due to the fact that we are all prone to hero worship.
An individual who has delivered is seen as a star performer. This dilutes the supervision and
also discourages people from pointing out shortcomings, if any. We see this happening time
and again. Nick Leeson’s contribution to the profits made him a star at Barings. Furthermore,
he was too important for SIMEX. People with star status not only get heard by all but also
get what they desire, even if it means bending of the rules. Special treatment makes the star
increasingly important and, possibly, unmanageable and uncontrollable. Star status helps in
hiding some crucial actions that have the potential for causing huge damage. Similarly, Rob-
ert Citron operated Orange County, California (case not discussed), solely on the basis of
his past reputation, resulting in a $1.6 billion loss to one of the richest counties in the USA.
Similarly, Yasuo Hamanaka was too important to be questioned till events reached massive
negative proportions.
Organizations tend to relax controls and grant greater discretionary powers to such people.
This was the case with Yasuo Hamanaka in Sumitomo, when he was granted extraordinary
power to execute deals; in turn, he transferred this power to the brokerage firms. As long as
discretion is used pragmatically, the situation remains healthy. However, when discretion 1s
misused, it results in extremely embarrassing situations for the organization.
 668 Derivatives and Risk Management

How else can one justify the overlooking ofthe high levels of funding requested by Lee-
son? Barings provided Leeson with huge sums to meet margin calls without questioning him.
Leeson purportedly asked for margins on account of customers’ positions. This was acceded
and accepted without any verification, and with the full knowledge that the SIMEX prohibits
funding of customers by brokerage houses. Leeson was a star performer, and his contribu-
tions to the overall profit were never scrutinized to ascertain if he really was engaged in a
conservative switching strategy.

Concentration of Power and Responsibilities

One of the reasons attributed to the Barings and Sumitomo cases is operational risk. In ©
both the cases, there was organizational failure to detect malafide activities or the overstep-
ping of designated authority levels. Segregation of operations and controls is a fundamental
principle of management. In the case of Barings, the Operations and settlement activities
were entrusted to the same person, permitting Leeson to hide his losses for a long time. In
the case of Sumitomo, Hamanaka was entrusted with absolute power to deal, without any
requirement for approvals. He operated with complete freedom. In the case of derivatives,
such concessions are obtained on the pretext of fast-changing scenarios and the need
for
immediate action on the spot, without the delays that are an unavoidable part of sanction
and approval procedures.

Complexity of Long Term and Short Term

The cases of MG and P&G tend to highlight the time perspective. Derivativ
es are essentially
sets of instruments whose pricing is governed by short-term changes. Whether
they were
the appropriate instruments for hedging on a long-term basis remains a
debatable point.
Metallgesellschaft attempted to hedge long-term risks spanning 10 years
of forward contracts
with its futures position, while P&G attempted to play on the differenti
al between 5-year
and 30-year yields. This seems to be a case of drilling a hole with a needle.
Derivatives are
characterized by their nature in terms of (a) their short-term
lives, (b) their tactical aspects,
(c) their economical aspects, and (d) their reversibility, as highlight
ed in Chapter 1. If one
needs to hedge for the long term, other strategic tools in marketin
g and production functions
are available. Perhaps, firms are motivated to hedge with financial
products because such
hedges are perceived to be cheap. However, they become expensiv
e if the markets behave in
directions that are opposite to the anticipated directions, as the
MG and P&G cases highlight.

Systemic Risk
Speculators provide the all-important function of providing
liquidity that helps in price dis-
covery on a continuous basis. Speculators are driven by
leverage. Since markets are domi-
nated by speculators who deploy massive leverage to magnif
y gains, it becomes extremely
important for regulators to monitor developments. In cash
or physical markets, control over
leverage is automatic, since commitments have to be
met in cash, borrowed or otherwise.
Thus, one can take speculative positions depending upon
the borrowing capacity available.
Derivatives by themselves are instruments of leverage,
and comprise a’ market that works
only on promises. Therefore, exposure in derivatives
is always in terms of notional amounts.
 Derivatives Disasters 669

This poses great risk to entire systems as one default tends to trigger a chain of defaults,
causing entire markets to collapse. The fear of failure gives rise to the loss of confidence in
market mechanisms, and, therefore, it becomes a primary concern for society, regulators, and
other participants. The need to act and bail out in the public interest is paramount, lest people
lose faith in the markets. The fear of systemic failure was the reason for the massive bailout
of LTCM. Systemic failure was also a concern for the SIMEX in the case of Barings. The
exposure of MG too was considered huge enough to cause a systemic failure. Time and again,
the International Monetary Fund (IMF) has considered bail-out plans for nations. Mexico
and Thailand in the past and more recently, Greece, Ireland, etc., are cases in point. Though
the IMF has been criticized for ’privatising profit and socialising losses’, these attempts were
made to avoid systemic failures.

Need vs Greed
Almost all transactions in derivatives are initially motivated by the need for hedging. When
they become successful, the participants get encouraged. Due to the leverage effect, the
derivatives have another side too. They hold tremendous potential to magnify losses as well
as gains. In case an initial transaction fails to deliver the expected outcome, one tends to
blame it on adverse market conditions and wrong forecasts. Expecting that adversity does
not last long and forecasts do not go consistently wrong, there is a tendency to make up for
earlier losses by doubling the stakes in the next venture. It is like a gambler on a losing streak;
he keeps doubling the stakes in each round, hoping for good times to appear and for recovery
of past losses in a single stroke. At such a juncture, it becomes difficult to determine whether
the actions are motivated by need or by greed. Perhaps this was one bit of the psychology
that dominated the thinking of Nick Leeson, when in order to recover losses he kept boost-
ing the stakes. The times never favoured him, and the result was a doubling of losses, rather
than a recovery of the past losses. Perhaps for Nick Leeson in Barings and Yasuo Hamanaka
in Sumitomo, when the need morphed into greed may never be known.

Absence of Legal Framework

Legal risk poses special problems for the derivatives markets. Though the legal systems are
fairly well developed for cash-based contracts, the innovations in derivatives, especially those
that are OTC, present many novel ideas that are not foreseen by legal systems; hence, there
is an absence of legal remedies. The novelty of many derivatives makes them susceptible to
legal risk because of the uncertainty that exists over the applicability of existing laws and
regulations to such contracts.
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 Index
3-m MIBOR 159 hedging 70 interpretation of 571
3-m Mumbai Interbank Offer Basis swap 228 interpreting 348
Rate 159 Basis 68 put premium 350
convergence 68 put pricing 349
A Basket CDS 567 Black-Scholes option pricing
Accounting standard AS 30 629 Basket option 512 model 339
Add-on yield 195 Bear spread 458-460, 467, 475, Bombay Cotton Exchange 16, 55
Agency cost of debt 588 476 Bombay Stock Exchange/BSE 86,
debt as options 590 calls 459 205, 396
American call 356, 357 with calls 476 Bond equivalent yield 182
valuation 357 with puts 476 Bond price 205, 208-209
valuing 356 Bermudan option 512 and duration 208
American options 284 Beta 102, 103 and modified duration 207, 209
valuing call 310, 311 Bid rate 118 duration 209
valuing put 530, 531, 614 Binary options 482, 483 Bootstrapping 162
Arbitrageurs 10 application 482 Borrower’s FRA 167, 168
Arch 397 call 482 Box spread 467-468
As you like it options 484 payoff for 482 Brazil’s devaluation 661
AS 30 630 put 482 Broken date 123
Asian financial crisis 660 valuation 483 BSM 347, 363
Asian options 504 Binomial method 332 call 347, 363
applications 504 Binomial model 298, 307-312, currency option 364
binomial valuation 507, 513, 5, SAM Doh, B32 index options 364
514, 539 American call 314 Bull spread 456-458, 474, 478
Asian options 504, 513 call on futures 534 calls 457
applications 504 call pricing 331, 332 Business risk 3
binomial model 507 currency options 326 Butterfly spread 460-463
binomial valuation 513 equivalent portfolio calls 461
valuation 505 approach 306, 334 payoff of 460
Ask rate 118 European call 312
Asset allocation 109 European put 315 C
Asset-based securitization 576 index options 325 Calendar spread 77, 79, 107, 465
Assignment 269, 277 multi-period/stage 309, 322, 324 arbitrage 661
At-the-money option 346 put pricing 307, 309 Call on call 496
Average option 504 valuing call 311 Call on put 496
valuing a call 324 Call option 259-261, 264, 279,
B ~ Binomial option pricing model 299 280, 305
Back-to-back/parallel loans 216, Binomial pricing model 304 lower bound 281]
payoff 304 moneyness 264
231
Backward induction 309 Black’s model SD, Soy Se payoff 260, 261, 263, 279
Black-Scholes model 336,346, premium 260, 305
Badla_ 87, 88
352, 605 value 281, 305
Barings ple 652
Barrier option 499-504, 512, 515 assumptions of 348 Callable bonds 592
call pricing 354-355 non-callable bonds 593
binomial tree 507
currency option 351, 431 price and YTM 593
valuation 500, 505, 509
index futures 540, 547 Cap 518-524, 527
valuing the 512
index options 352, 364 cash flows 521
Basis risk 68-73
 672 Index

hedging with 518, 527 calendar spread 81 Crack spread 77

payoff 519 cost of credit 59 Credit default swap/CDS 568
valuation of 521 financial futures 59 mean 569
Caplei 195 520),531 government’s revenue 58 Merton model 568
value 531 hedging 62 valuation 568
Carbon credit 553, 622 national economy 58 Credit default swaps 562-569
Cash flow hedge 634, 635, 638, pricing 61 and financial guarantee 567
641, 642 speculation 78, 81 and insurance 567
Cash flow mapping 410 spread strategies 79 applications 562
Cash flows 574 subsidies 58 cash flows 563
Cash-and-carry arbitrage 41-43, volatility 56 credit/default events 564
53, 190, 193 Commodity futures Sk Bish Soh Stop settlement of 564
Cash-and-carry 70 59-61 Credit derivative 550, 560
EDO Mss benefits of 56 Credit-linked notes 579-581
cash flow 583 calendar spread 77, 107 Credit quality spread 227
synthetic 583 financial futures 54 Credit risk 551, 561, 562
CDS premium 571 hedging with 62 market risk 562
CDSmO4on2 pricing of 60 rating 561
applications of 567 speculation with 78 types 561
cash flow 572 Commodity swap 251 Credit spreads 458, 571
cash flows 566 valuation of 251 Credit value at risk 559|
credit event 565 Commodity swaps 250 computing 559
financial guarantee 567 Common stock 587 Credit VaR 556
insurance 567 Compound option 496-498 Credit-linked note 580
settlement 566 applications 496 cash flows 580
settlement of 564 payoff 497 GRISTESS>
variants 566 valuation 497, 498 Cross hedge 67, 72-74
Central limit theorem 342 Condor spread 462-465 Currency futures 50, 139-143, 145.
Certified emission reductions/ Condor 463, 465 146, 148, 149, 152, 153
CERs 623 payoff 463 arbitrage 148, 149, 152
Cheapest-to-deliver bond 204, 205 Consumption assets 43 contract specifications 140
Chicago Board of Trade/CBOT 15, Contango 48, 649 fair value 145
SS, OE Continuous compounding rate 162 hedging 146
Chicago Mercantile Exchange/ Continuous compounding 312 pricing 143-146
CME 16, 109, 139, 181, 619 Contract size 90 settlement 168
Chooser option 484-486 Contract value 90 speculation with 149, 152
valuation 485 Convenience yield 44 trading 14]
Clearing 92 Convergence 53, 663, 664 Currency option 284, 285, 294, 44]
Close-out 32 Conversion factor 201-203, 212. hedging with 431-439
Clean price 198, 200 214 lower bounds 284, 285
Collar 518, 526-528 invoice price 212 payoff 299
valuing 527 Convertible bonds 593 Currency swap 228-237, 246, 248,
Collateralized bond obligation/ Converting asset/liability from one 250, 254
Ch Omos|| currency to another 234 converting asset/liability from one
Collateralized debt obligations/ Cooling degree day 619 currency to another 232, 234
CDO 581-583 Correlation 396, 398 cost of funds 232
Collateralized loan obligation/
Correlations 661 exchange rate risk 233
CLOM ssi Cost of carry model 59, 145 features of 236
Collateralized mortgage obligation/ TRP 145 fixed-to-fixed 236
CMO 581 Counterparty risk 26, 28, 54, 219, fixed-to-floating 236
Commodity futures 50, 191 244, 256 floating-to-floating 237
arbitrage 191 Covariance 396, 398 hedging against exchange rate
benefits of 56 Covered call 446, 478 risk 23]
 Index 673

reducing cost of funds 232, 254 strategic risk management 8 Expectation hypothesis 49
series of forward contracts 248 types of 9 Exponential smoothing 394
value 250 Diagonal spreads 466, 467 Exponential weighted moving
value of 246 Digital CDS 566 average 394
valuing 246 Digital option 482
valuation 483 F
Directional trade 659 Fair value hedge 634, 635, 638, 639
D
Day traders 88 Discount on T-bills 181 Fair value 631-633
Debit spread 456 Discount 150 features of 574
Debit spreads 458 Down-and-in option 499, 515 measurement 632

Debt 590 Down-and-out option 499, 515 Features 136

as options 590 Down-and-out 499 Financial assets or liabilities at fair
Due date rate(DDR) 34 value 630
value of firm 590
Duration 207, 208 Financial derivatives 16
Default events 564
bond price 208 Financial futures 50
Default rates 555
Duration/modified duration/ commodity futures 59
Default risk 180, 550
Degree of financial leverage 393 Macaulay’s duration 393 Floor 524-527
Degree of operating leverage 393 Duration-based hedging 209 payoff 524
Dynamic hedging 382 valuation of 525
~ Delivery logic
Floorlet 524-526
compulsory 34
E Foreign exchange markets 118
option of buyer 34
Electricity derivatives 627 Foreign exchange rates 118-119,
option of seller 34
Emission trading 621 121
Delivery notice period 60
Energy derivatives 10, 618, arbitrage 121
Delta hedging 367, 374, 382
624-627 condition for arbitrage 122
Delta 366-375, 388, 393
contract on crude oil 625 condition for no arbitrage 122
additivity of 371
crude oil 625 Foreign exchange risk 117
and gamma neutrality 379
electricity 626 Forward and futures contracts 40
and time to maturity 370
natural gas 627 Forward contract 5, 25-27, 44, 45,
behaviour of 369
Entity 563 86, 128, 133
call 388
Equity shares 587 arbitrage with 133
call option 367
Equity swaps 251, 252 cancellation 26
computing 367
valuation 252 features of 26, 136
limits on value 368
Equivalent portfolio approach 306 hedging 128-132
meaning of 368
Eurodollar futures 194-197 motive for 25
neutrality 375
borrower’s hedge 197 offsetting 27
put 388
hedging with 196 on stocks 86-88
put option 367
investor’s hedge 211 pricing 38, 39
value of the call 372
pricing of 196 settlement of 27
Deltas 373
Eurodollars 194, 195 speculation with 133
derivative as 640
European options 265 value of 44, 45
other derivatives 373
European put 315 Forward contracts 86, 123, 128,
Derivatives 4, 5, 9, 566
valuing 315 133
accounting definition of 630
Event risk 8 hedging receivables 128
accounting for 539
Evolution 136 Forward discount 119, 120
classification of 1
Exchange option 487, 488 Forward exchange rate 144
criticism 21
applications 488 determination 144
diversification 6
valuation 488 Forward hedge 132
evolution of 15-19
Exchange rate risk 4 cost of 132
functions of 19
Exchange-traded derivatives 11 Forward interest rates 169, 171,
insurance 7
Exchange-traded options 265 UWB SENS
misuses 21
Exchange-traded 11, 12, 264 determining 173, 176
participants in 13
Expectancy theory 49 term structure 177
products 9
 674 Index

Forward interest rates 172, 176 specification of 30 call 490, 492

determining 172, 176 T-bills 181 payoffs 489
Forward premium 119, 120, 150 T-bonds 199 put 490
Forward premium/discount 199, Futures exchange 29 valuation 490
120, 150, 153 Futures market 78 Garch (1, 1) model 397
Forward price Futures options 533, 539
obligation to 26 binomial model 537
Forward rate agreement 166 binomial valuation 539 Heating degree day 619
Forward rate agreements/ Black’s model 539 Hedge accounting 633, 634, 636,
BRAS 156-1 65924 bsg, payoff 534 639
arbitrage with 175 put-call parity 536 steps for 636
hedging with 184 value 540 types of hedges 634
settlement of 179 valuation of 539 Hedge funds 657
Forward rate 119, 151 Futures price 33, 39 Hedge ratio 71-74, 83, 84, 97,
bounds 151 and expected spot price 47 207, 648
Forward rates 134, 557 expectancy theory 49 conversion factor 201
bounds 135 upper bound 44 Hedge 72, 100
determining 134 Futures pricing 49
Forward start option 480, 512 forward rolling 72
Futures style options 269
market risk 100
applications 481 lunes.) 10), DR AWG. NS} Hedged item 635, 636, 638
valuation 480 arbitrage 113
Forward rolling of the hedge Hedgers 13
73 forward 33, 46 Hedging effectiveness 637, 638
Forward start option 480, 512
on consumption asset 62 Hedging for 73
application 481 on investment asset 61
valuation 483 gross profit 77
Spread strategies 76, 79 Hedging instrument
Forward swap rate 544 635-638
types of 49
Forward swap 544 Hedging payable. 129
yield enhancement 106
Forward transaction Hedging payables 131
123 Futures/forward position 272, 273
Forward/futures contract Hedging relationship 635, 637-645
36, 39 payoffs 272, 273
Forward-forward swap Hedging with futures 97
125 Futures/forwards 273 Hedging 3, 62, 73, 76, 173, 174,
Forwards hedging 15] options 273
receivables 151 185, 188, 211, 422, 423, 427,
Futures: yield enhancement 106
Forwards 9, 143 429-433, 44]
arbitrage 106 against falling interest rates
Forwards/futures 271 174
options 27] against falling yield 185
G against rising interest
BRAT 67175" 176 172, 188
Gamma neutrality 379 against rising interest rates
arbitrage 175 172
Gamma 366, 379-384, 388. 393
borrower’s 167 basis risk 70
behaviour 380 call on index 429
hedging 172
calculation 384 call option 423
Indian practices 170 call 388
investor’s 168, 176 call option on 431
call option 387 currency option 44]
pricing 169
computing 380 exchange rate risk 231, 233
settlement 169
interpretation 384 falling interest rates
speculation 175 174|
meaning of 381 falling yields
Futures contract 28-36, 195, 199 185
neutrality 383, 384
and forward 47 for gross profit margin 76
portfolio 382 foreign currency payable 432
comparison 38
put 388 foreign currency receivable 432
convergence 46
put option 387 gross profit margin 76
eurodollars 195
spot price 380 long position in stock
indices 88 115, 422
time 380 payable with call option 433
individual stocks 88 Gap option 489, 492
pricing 38 portfolio 97, 99, 100
applications 490
put on index 427
 Index 675

put option 422 reduce funding 226 M

put option on index 430, 441 reducing cost of funds 254 Margin call 37, 54
receivable with put option 432 value of 247, 248, 255 Margin requirements 36
rising interest 188 Interest rate swaps 220, 223, 227, Margining system 92
rising interest rates 173 238 Market risk 98-100
volume 73 applications 220 Marking-to-market 369 37)39,,40,
with futures 65, 96 fixed-to-floating 227 Ne
with index futures 96 in India 223 Maturity date 259
with index options 426, 440 reducing cost of funds 223 MCX-SX 139-142
with T-bills 181, 187, 211, 214 valuing 238 Merton model 349, 357, 568, 571
Held-to-maturity/HTM 630 Interest rates 156 Metallgesellschaftag 646
investments 636, 645 desirable features 156 MIBID 158, 160
Historical simulation 411 Inter-market spreads 80 Mimicking stock 470, 476, 477
Historical volatility 358-385 International Swaps and Derivatives Minimum margin 37
Association (ISDA) 565 Minimum support price 58
I In-the-money 263 Modified duration 207
Imperfect hedge 66 Intrinsic value 277-279 Moneyness of options 264
Implied repo rate 190-194, 201 Inverted market 46 Monte Carlo simulation 416, 328
Implied volatility 361-365 Investment assets 43 limitations 416
estimating 362 Investor’s FRA 168, 176 Mortgage-based securitization 576
Index future Invoice price 186, 192, 204 Mortgages 576
specifications 90 Mumbai Inter Bank Offer Rate/
Index futures 85, 86, 93, 95 MIBOR_ 11, 158-160, 217,
K
applications 95 218, 221-228
Kansas City Board of Trade 50, 86
fair price of 93,94
Knock-in option 499, 500, 503
hedging 95 N
Knock-out option 499, 500, 503 Naked call 446
hedging with 96 Kyoto Protocol 621
price 93 National Multi-commodity Exchange
pricing 92 of India/NMCE 16, 30, 37
specifications 90 L National Stock Exchange/NSE 15,
Index options 325 Leveraging 20 7. SOS Om Ls OMS 85 223
India VIX 400 LIBID 158 Nifty 51, 85-91
LIFFE 195, 200, 204 Non-deliverable forward/NDF 135-
computation 400
Initial margin 37, 47, 78, 112 Log-normal distribution 340 By, 164
Interbank transactions 158 London Inter Bank Offer Rate/ and interest rate parity 137
Inter-commodity spreads 77, 79 LIBOR 11, 158, 166, 179, features of 136
Interest rate futures 50, 178, 179, 195-197, 574 settlement 137, 151
186, 188, 192, 193, 205, 206 Long butterfly spread 461 Normal backwardation
arbitrage 192 Long condor spread 464 hypothesis 48
Long hedge 64, 97, 112, 146, 185, Normal distribution 340, 342, 345,
borrowing 188
cash-and-carry arbitrage 193 187 662
contract specifications 206 importer 146
hedging 186, 206 Long hedge 65, 83, 422 O
in India 205 Long position 276 Odd date 123
on T-bills 179 synthetic 469 Offsetting 32
specifications 199 Long positions 62 Oil derivatives 625
Interest rate options 517 Long put 273 Open interest and
Interest rate parity 137, 153 Long-term capital management 657 volume 36
Interest rate risk 4, 165, 180 Lookback options 508, 510, 511 Open interest 35
Interest rate swap 4, 165, 180, applications 509 Open position trading 79
216-223, 226, 247, 254, 255 binomial 510 Optimal hedge ratio 209
cost of funds 224 valuation 509-511 duration based 209
features 217 Loss given default 551 Optimum hedge ratio 71
 676 Index

Option delta 307, 334, 367 Options 9, 10-23, 259, 263, 264, Position trading 79
behaviour 369 26632695271) 273) 2045287, Premium style options 269
call value 372 292, 294, 295, 449 Premium 259
computing 367 American 264 Prepayment risk 578
meaning 368 arbitrage with 105, 106, 133, Price discovery 19, 56, 57
portfolio delta 371 148, 149, 175, 287, 292, 294, Price quotation 31]
short straddle 371 295 Price risk 3
time to maturity 370 binomial valuation 502 Price 92, 194
value 368 European 264 Pricing forward contract 52
Option forwards 127, 129 futures/forwards 271-273 Pricing futures
Option on bonds 530-532 insurance 274 investment asset 61
valuing 530, 531 margins in 269, 270 Pricing T-bonds 198
Option on swaps—swaptions 540 moneyness 274 Probability of default 551-554,
forward swap 541 moneyness of 263 571
payotf 54] quotations 266-269, 288 expected loss 553
Option premium/pricing 260, 295 settlement 267, 268 finding 552
arbitrage 28] terminology 259, 260 Merton model 571
boundary conditions 280 trading 267, 268 recovery rate 554
lower bound 282-285 types of 264, 265 Procter and Gamble 665
Option price 337 Out-of-the-money options 264 Protection buyer 563, 568, 585
factors affecting 337 Out-of-the-money 263 Protection seller 563, 567, 585
Option pricing 279, 285 Outright forward 125 Protective put 423, 424, 443
arbitrage 285 Overnight swap 223 Pseudo-pricing of American
boundary conditions 279 Over-the-counter 11, 264 call 354
Option to abandon 599, 612
Put—call parity 288, 289, 291-295,
binomial method 614 P 471
BSM 615 Par-yield 198 American options 292, 293
DCF valuation 612, 614 Pass through certificates 577 currency options 293, 294
Option to delay 598, 601, 603
Pass through 577 dividend paying stock 293, 319
binomial model 603 Pay-later call option 493 synthetic positions 471
Option to expand 598, 607, 609, call 493 Put on call 496
611 Pay-later call 495 Put on put 496
binomial method 609 valuation 495 Put option 10, 259-262, 277, 281.
BSM 611 Pay-later option 492 282, 294
DCF valuation 608 applications 493 payotf 262-264, 294
Option 268, 272, 294, 449 payoffs 492 lower bound 283
arbitrage 449 valuation 493 value of 282
currency 272 Pay-later 495 Put
speculation put 495 pay-later option 493
Options on bonds 528 Pay through 577 Puttable bonds 592, 593
Options on currencies 351 Payer swaption 543
Options on futures 533-540
Perfect hedge 66 R
binomial model 537 Plain vanilla interest rate swap 220
need 535 Rain derivatives 620
Plain vanilla swap 217 Range forward 435, 436
payoff 54]
Points-in-points/PIPs 126 pay off 435
Options on indices 351, 365
Portfolio balancing 101, 103 Range forward—zero cost
Options on stock indices 286
Portfolio beta 101, 102, 428, 430
Options valuing 351 collar 434
Portfolio CDS 567 Real options 598
currencies 35] Portfolio delta 371, 373
dividend paying stock 319 kinds 598
Portfolio gamma 382 Receiver swaption
indices 35] 548
Portfolio theta 378 Recombining symmetrical 311
 Index 677

Recovery rate 551, 584 fair price 95 floating-to-fixed 228

Recovery rates 554 pricing 92 hedging strategies 222
Reference asset 563 specifications 90 hedging with 222
Reference entity 579 Stock index futures 86, 90, 104, pricing 242
Repo rate 156, 190 105 rationale 225
Reverse cash-and-carry arbitrage with 105 term structure 245, 246
speculation with 104, 133, 149 the comparative advantage 225
arbitrage 42, 51, 52, 54, 190
Reverse cash-and-carry 51, 70 Stock index option valuation of 237
Reverse repo rates 156 lower bounds 285 transforming nature of
Rho 366) 387s 5915 393) Stock options 270, 271, 422 assets 220, 221
and dividend 270, 285, 297 Swap—comparative advantage 225
Risk diversification 23
Risk neutral valuation 303, 325, and stock splits 270, 271 Swaption/Swaptions 540-547
333, 334 bonus shares 270. binomial 547
Risk of the portfolio 103 hedging with 470, 422, 431 options on bond 542
Stock/index futures 90, 110, 111 payoff of 524
Risk transfer 23
Stop-loss strategy 374 value 547
Risk
diffusing the risk 2 Straddle 451-453, 472, 654 value of 545
long 451, 452, 472 valuing 546, 548, 603, 609
diversification of risk 2
payoff onalong 451 valuation 543
non-financial risks 3
transferring 3 short 451 Switching 653
Strangle 453, 454, 465, 473, 478 Synthetic long stock 469
Risk-neutral valuation 303, 325
long 453, 454 Synthetic short stock 470
Risk-neutral valuations 333
payoff 454 Systematic risk 6, 99, 114, 393
callgns3s
short 453, 473 Systemic risk 550, 668
put 333
Risk—reward ratio 460 Strap 456
Russian default 661 payoff 456 T
Straps 455 T-bill futures 182, 185, 189, 190,
Strike date/maturity date 260 192-194, 211
S
Strike price 259, 260, 266 arbitrage 190, 193, 194
SCRAw 17, 19) 86
Strips 455 price quotation 182
Securitization 576, 578
Sumitomo 664 pricing of 192
participants 578
Swap dealer 218 hedging 187, 211
risk in 578
counterparty risk 219 hedging strategy 189
SENSEX 51, 85-87, 90
Swap dealer/bank 218 implied repo rate 194
Settlement and delivery 32
need for 218 price 194
Settlement 91, 123
Swap for 217 speculation 189
Short hedge 63, 65, 80, 83, 95, 98,
cash flow 217 T-bills futurs contract
147, 188
Swap points 126 specifications 184
exporter 147
Swap quotes 242 T-bills 181, 183, 185
Short positions 62
Swap rate 244 futures contract 181
Shout option 486
Swap transaction 124, 153 futures contract in India 183
valuation 487
Swap/Swaps 9, 10, 23, 124, 125, pricing of 181
Speculators 14, 123
Ps PS), OMY, Py II) yield on 185
Spot price 24
and forward contract 133 T-bond futures 200, 210, 212
Spot rate 79,119
applications of 220 hedging 210,212
Spot rates 123
as pair of bonds 238, 244 pricing 200
Spot 123
as series of forward Term structure of interest
Spread trading 79
contracts 240, 243, 248 rates 160, 161, 171
Stack-and-roll strategy 649
counterparty risk 244, 256 Theta 366, 376-378, 393
Standard deviation 393
exchange rate risk 23, 233 computing 377
Standard market model 522
features of 217 portfolio 378
Stock futures 50, 95, 114
 678 Index

time 377 Up-and-out option 515 call option 595

Tick size 32, 54,91 dilution effect 594
Time spreads 80 Vv payoff 595
Time value 277-279 Value at risk 404, 408, 409, 662 value of 595
Total return payer 573, 576, 585 calculating 409 Weather derivatives 11, 618, 620,
Total return receiver 573-575, 585 confidence level 408 621
Total return swap 573, 575 limitations 416 features 623
CDSaoi> Valuing options 319 pricing 620
swaps 575 VaR 405, 408 rainfall 621
Tracking errors 108 definition and meaning 405 temperature 619, 620
Transfer of risk 20 normal distribution 405 World Bank-IBM currency
Transition matrix 557 portfolio effect 408 swap 228
Transition rates 556 Variance—covariance 410
Treasury bills 180 Vega 366, 385, 393 Y
Treasury bond futures 197-204 Volatility index 399 Yield curve by bootstrapping 164
Treasury bonds 198 Volatility smiles 362 Yield curve 160
pricing of 200 Volatility trades 660 Yield curve, also term structure of
Treasury rates 157 Volatility 21, 56, 357, 358, 393, interest rates 160
Treasury zero rates 161 410, 661 Yield on T-bills 185
RS Seow4 estimation 410 Yield-to-maturity/YTM 244
features of 574 historical 358
measuring 358 LZ
U
Zero cost collar 434, 444.526
Ultabadla 88 Ww Zero rates 162
Unsystematic risk 6, 99, 114 Warehousing 219, 229
Up-and-in option 499, 515
Warrants 594, 595
 DERIVATIVES AND RISK MANAGEMENT seconp epition
Derivatives and Risk Management, 2e, is a very comprehensive textbook designed to cater to the syllabi requirements
i
of financial management students. The text provides extensive and intensive coverage of all the basic principles
of ae
derivatives and risk management. Furthermore, advanced topics such as credit risk, securitization,
and credit derivatives
are also covered in detail. It also includes corporate finance-related topics such as corporate securities
seen as derivatives
and real options.
The focus of this particular edition is to provide a better and more organized coverage of
the subject. In addition to
covering regular subject material, the text covers weather and energy derivatives and accounting
for derivatives. A few
cases that throw light on the dangerous side of derivatives are also discussed. Other than
providing an extensive coverage
of the core concepts of the subject, it includes numerous solved examples and graphical
illustrations to provide the
students with a practical orientation towards derivatives.
KEY FEATURES
e Explores new issues in derivatives such as volatility and value at risk, credit risk, and
also relatively complex products
such as option on bonds, options on swaps—swaptions, etc.
e Provides examples and boxed exhibits for illustrating the key applications
of derivatives and risk management
e Includes case studies on derivatives used by various organizations that
led to disasters
NEW TOTHIS EDITION o
¢ Four new chapters on co rporate securities and derivatives, real options, volatility
and value at risk, and derivatives
disasters a ae :
e New sections on topics such as futures contract on T-bills in India; Monte
Carlo simulation; exotic options such as gap
options, pay-later option, lookback option, and so on; credit risk-relat
ed topics such as recovery rates, default rates,
credit value at risk, and valuation of CDS including Merton model
e New feature called Derivatives in Practice to acquaint students with
real-life situations
° Five real-life cases on derivatives that led to disasters along with
lessons learnt from these incidents
Rajiv Srivastava is currently Professor, Finance, at the Indian Ins
titute of Foreign Trade, New Delhi. An engineer and dual-
MBA by qualification, he possesses a vast experience of 35 years
in corporate finance, having worked at senior and top
positions with various corporates such as Uflex Ltd, CMC Ltd, an
d Rajasthan Breweries Ltd. Prior to that, he worked with
the State Bank of India for a long span of 14 years where he was
involved with credit appraisal, consultancy, and training
a

of industrialists and bankers, Prof. Srivastava is the co-author

of Financial Management2e (OUP, 2011).
a

ONLINE RESOURCES

The fol ble to help the

faculty rf i = it:
For Fac wal ws idents
@ Insti Fa [a] \Itiple Choice ‘
e Pow a". estions 4
— 792-BAC-494
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OXFORD
UNIVERSITY PRESS
ISBN 0-19-808915-5

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9 "780198"089155
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