Derivatives

Question 123
A is an investor and having in its Portfolio Shares worth ` 1,20,00,000 at current
price and Cash ` 10,00,000. The Beta of Share Portfolio is 1.4. After four months the
price of shares dropped by 1.8%.
You are required to determine:
1. Current Portfolio Beta and
2. Beta after four months-if A on current date goes for long position on ` 1,30,00,000
Nifty futures.
Show calculations in ` Lakhs with four decimal points.
(May 17, 5 Marks)

Solution
Current Portfolio ₹
Shares (Current Price) 1,20,00,000
Cash 10,00,000
1,30,00,000

β share = 1.4
β cash = 0
Current Portfolio Beta:
βp = β share. Wshare + β cash + Wcash

1,20,00,000 10,00,000
= 1.4 = + 0
1,30,00,000 1,30,00,000

 βp = 1.2923

WN.1: After 4 months share price dropped by 18% β share = 1.4

% Decrease in Nifty Futures =
% decrease in share price
 % Decrease in Nifty Futures =
β share
1.8%
= = 1.2857 %
1.4
WN.2: Revised Portfolio (After 4 months)

Shares [1,20,00000 – 1.8 %] 1,1,7,84,000

Cash
Opening Balance 10,00,000
Loss on Nifty Futures (167,141)
[1, 30, 00,000 – (1, 30, 00,000 – 1.285 %)] 8,32,859
1,2616859

Portfolio Beta (after 4 months)

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1,17,84,000 832,859
 βp = 1.4 + 0
1,2616,859 12,616,859
 βp = 1.3076

Question 124
Ram Chemical is in production Line of Chemicals and considering a proposal of
building new plant to produce pesticides. The Present Value (PV) of new proposal is
` 150 crores (After considering scrap value at the end of life of project). Since this is a
new product market, survey indicates following variation in Present Value (PV):
Condition Favourable in first year PV will increase 30% from original estimate
Condition sluggish in first year PV will decrease by 40% from original
Figures

In addition Rama Chemical has a option to abandon the project at the end of Year and
dispose it at ` 100 crores. If risk free rate of interest is 8%, what will be present value
of put option?
(May 17, 5 Marks)

Solution
Decision Tree showing pay off
Year 0 Year 1 Pay off
195 0
150
90 100 – 90 = 10

First of all, we shall calculate probability of high demand (P) using risk neutral
method as follows:
8% = p X 30% + (1-p) X (-40%)
0.08 = 0.30 p - 0.40 + 0.40p
0.48
p= = 0.6857 say 0.686
0.70
The value of abandonment option will be as follows:
Expected Payoff at Year 1
= p X 0 + [(1-p) X 10]
= 0.686 X 0 + [0.314 X 10] = ` 3.14 crore
Since expected pay off at year 1 is 3.14 crore, present value of expected pay off will
be:
3.14
= 2.907 crore
1.08
This is the value of abandonment option (Put Option).

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Question 125
A call option on gold with exercise price ` 26,000 per ten gram and three months to
expire is being traded at a premium of ` 1,010 per ten gram. It is expected that in three
months time the spot price might change to ` 27,300 or 24,700 per ten gram. At
present this option is at-the-money and the rate of interest with simple compounding
is 12% per annum. Is the current premium for the option justified? Evaluate the
option and comments.
(Nov 17, 5 Marks)
Solution
To determine whether premium is justified we shall compute the value of option by
using any of the following models:
By use of Binomial Model
Decision Tree showing pay off
Year 0 3 Months Pay off
27,300 1,300
26,000
24,700 0

The Delta (Δ) Ratio

1300 – 0
Δ= = 0.50
27300 – 24700
Replicating portfolio Buy 5 gram of gold and sell one call option.
The pay off if price goes up = 0.50 X ` 27300 – ` 1,300 = ` 12,350
The pay off if price goes down = 0.50 X ` 24,700 = ` 12,350
12,350
Present Value of Pay-off = = ` 11,990
1.03
Current Investment = ` 26,000 X 0.50 = ` 13,000
Value of Option = ` 13,000 – ` 11,990 = ` 1,010
Thus the price of option is justified.
Alternatively, by using Risk Neutral Model:
First of all we shall calculate probability of high demand (P) using risk neutral method
as follows:
3% = p X 5% + (1-p) X (-5%)
0.03 = 0.05 p - 0.05 + 0.05p
0.08
p= = 0.80
0.10
1300 X 0.8 + 0 X 0.2
The value of Call Option = = ` 1,009.71 say ` 1,010
1.03
Thus, the price of option is justified.

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 Incito Academy – Final CA – Strategic Financial Management
Question 126
Bharat Bank Ltd. has entered into a plain vanilla swap through on Overnight Index
Swap (OIS) on a principal of ` 1 crore and agreed to receive MIBOR overnight floating
rate for a fixed payment on the principal. The swap was entered into on Monday, 10th
July 2017 and was to commence on and from 11th July 2017 and run for a period of 7
days.

Respective MIBOR rates for Tuesday to Monday were: 8.75%, 9.15%, 9.12%, 8.95%,
8.98% and 9.15%.

If Bharat Bank Ltd. received ` 417 net on settlement, calculate fixed rate and interest
under both legs.
Notes:
1. Sunday is a holiday
2. Work in rounded rupee and avoid decimal working
3. Consider 365 days in a year.
(Nov 17, 8 Marks)

Solution
Day Principal (`) Mibor (%) Interest (`)
Tuesday 1,00,00,000 8.75 2,397
Wednesday 1,00,02,397 9.15 2,507
Thursday 1,00,04,904 9.12 2,500
Friday 1,00,07,404 8.95 2,454
Saturday & Sunday (*) 1,00,09,858 8.98 4,925
Monday 1,00,14,783 9.15 2,511
Total Interest @ Floating 17,294
Less: Net Received 417
Expected Interest @ fixed 16,877**
Thus Fixed Rate of Interest 0.0880015
Approx. 8.80%

(*) i.e. interest for two days.

(**) 1 crore X ‘X’/100 X 7/365 = 16,877

16877 X 365 X 100

Hence, X = = 8.8%
1 cr. X 7

Question 127
A textile manufacturer has taken floating interest rate loan of ` 40,00,000 on 1st April,
2012. The rate of interest at the inception of loan is 8.5% p.a. interest is to be paid
every year on 31st arch, and the duration of loan is four years. In the month of October
2012, the Central bank of the country releases following projections about the interest
rates likely to prevail in future.

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(i) On 31st March, 2013, at 8.75%; on 31st March, 2014 at 10% on 31st March, 201? at
10.5% and on 31st March, 2016 at 7.75%. Show how this borrowing can hedge the
risk arising out of expected rise in the rate of interest when he wants to peg his
interest cost at 8.50% p.a.
(ii) Assume that the premium negotiated by both the parties is 0.75% to be paid on 1st
October, 2012 and the actual rate of interest on the respective due dates happens
to be as: on 31st March, 2013 at 10.2%; on 31st March, 2014 at 11.5%; on 31st
March, 2015 at 9.25%; on 31st March, 2016 at 9.0% and 8.25%. Show how the
settlement will be executed on the perspective interest due dates.
(Nov 17, 8 Marks)

Solution
As borrower does not want to pay more than 8.5% p.a., on this loan where the rate of
interest is likely to rise beyond this, hence, he has hedge the risk by entering into an
agreement to buy interest rate caps with the following parameters:
• National Principal: ` 40,00,000
• Strike rate: 8.5% p.a.
• Reference rate: the rate of interest applicable to this loan
• Calculation and settlement date: 31st March every year
• Duration of the caps: till 31st March 2016
• Premium for caps: negotiable between both the parties
To purchase the caps this borrower is required to pay the premium upfront at the
time of buying caps. The payment of such premium will entitle him with right to
receive the compensation from the seller of the caps as soon as the rate of interest on
this loan rises above 8.5%. The compensation will be at the rate of the difference
between the rate of none of the cases the cost of this loan will rise above 8.5%
calculated on ` 40,00,000. This implies that in none of the cases the cost of this loan
will rise above 8.5%. This hedging benefit is received at the respective interest due
dates at the cost of premium to be paid only once.
The premium to be paid on 1st October 2012 is 30,000 (` 40,00,000 X 0.75/100). The
payment of this premium will entitle the buyer of the caps to receive the
compensation from the seller of the caps whereas the buyer will not have obligation.
The compensation received by the buyer of caps will be as follows:
On 31st March 2013
The buyer of the caps will receive the compensation at the rate of 1.70% (10.20 - 8.50)
to be calculated on ` 40,00,000, the amount of compensation will be ` 68000 (40,00,000
X 1.70/100)
On 31st March 2014
The buyer of the caps will receive the compensation at the rate of 3.00% (11.50 – 8.50)
to be calculated on ` 40,00,000, the amount of compensation will be ` 120000
(40,00,000 X 3.00/100).
On 31st March 2015
The buyer of the caps will receive the compensation at the rate of 0.75% (9.25 – 8.50)
to be calculated on ` 40,00,000, the amount of compensation will be ` 30,000
(40,00,000 X 0.75/100).
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 Incito Academy – Final CA – Strategic Financial Management

On 31st March 2016

The buyer of the caps will not receive the compensation as the actual rate of interest
is 8.25% whereas strike rate of caps is 8.5%. Hence, his interest liability shall not
exceed 8.50%.
Thus, by paying the premium upfront buyer of the caps gets the compensation on the
respective interest due dates without any obligations.

Question 128
Mr. KK purchased a 3 – month call option for 100 shares in PQR Ltd. at a premium of
` 40 per share, with an exercise price of ` 560. He also purchased a 3 – month put
option for 100 shares of the same company at a premium of ` 10 per share with an
exercise price of ` 460. The market price of the share on the date of Mr. KK's purchase
of options, is ` 500.
Compute the profit or loss that Mr. KK would make assuming that the market price
falls to ` 360 at the end of 3 months.
(May 18, 4 Marks)

Solution
Since the market price at the end of 3 months falls to ` 360 which is below the exercise
price under the call option, the call option will not be exercised. Only put option
becomes viable.

`
The gain will be:
Gain per share (`460 – ` 360) 100
Total gain per 100 shares 10,000
Cost or premium paid (` 40 X 100) + (` 10 X 100) 5,000
Net Gain 5,000

Question 129
Punjab Bank has entered into a plain vanilla swap through on Overnight Index Swap
(OIS) on a principal of ` 2 crore and agreed to receive MIBOR overnight floating rate
for a fixed payment on the principal. The swap was entered into on Monday, 24th July,
2017 and was to commence on 25th July, 2017 and run for a period of 7 days.

Respective MIBOR rates for Tuesday to Monday were:

8.70%, 9.10%, 9.12%, 8.95%, 8.98% and 9.10%.
If Punjab Bank received ` 507 net on settlement, calculate Fixed rate and interest under
both legs.
Notes:
1. Sunday is a Holiday.

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2. Workout in rounded rupees and avoid decimal working.
3. Consider a year consists of 365 days.
(May 18, 8 Marks)

Solution
Day Principal (`) MIBOR (%) Interest (`)
Tuesday 2,00,00,000 8.70 4,767
Wednesday 2,00,04,767 9.10 4,987
Thursday 2,00,09,754 9.12 5,000
Friday 2,00,14,754 8.95 4,908
Saturday & Sunday (*) 2,00,19,662 8.98 9,851
Monday 2,00,29,513 9.10 4,994
Total Interest @ Floating 34,507
Less: Net Received 507
Expected Interest @ fixed 34,000
Thus, Fixed Rate of Interest 0.0886428
Approx. 8.86%
(*) i.e. interest for two days.

Question 130
The equity share of SSC Ltd. is quoted at ` 310. A three months call option is available
at a premium of ` 8 per share and a three months put option is available at a premium
of ` 7 per share.

Ascertain the net payoffs to the option holder of a call option and a put option,
considering that:
1. the strike price in both cases is ` 320; and
2. the share price on the exercise day is ` 300, 310, 320, 330 and 340.
Also indicate the price range at which the call and the put options may be gainfully
exercised.
(Nov 18, 8 Marks)

Solution
Net payoff for the holder of the call option
`
Share price on exercise day 300 310 320 330 340
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 320 320
Out flow (premium) 8 8 8 8 8
Total Outflow 8 8 8 328 328
Less inflow (Sales proceeds) - - - 330 340
Net payoff -8 -8 -8 2 12

Net payoff for the holder of the put option

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Share price on exercise day 300 310 320 330 340
Option exercise Yes Yes No No No
Inflow (strike price) 320 320 Nil Nil Nil
Less outflow (purchase price) 300 310 - - -
Less outflow (premium) 7 7 7 7 7
Net Payoff 13 3 -7 -7 -7

The Call Option can be exercised gainfully for any price above ` 328 and Put Option
for any Price below ` 313.

Question 131
A dealer quotes 'All-in-cost' for a generic swap at 6% against six months LIBOR flat.
If the notional principal amount of swap is ` 8,00,000:
1. Calculate semi-annual fixed payment.
2. Find the first floating rate payment for (i) above if the six months period from the
effective date of swap to the settlement date comprises 181 days and that the
corresponding LIBOR was 5% on the effective date of swap.
3. In (ii) above, if the settlement is on 'Net' basis, how much the fixed rate payer
would pay to the floating rate payer? Generic swap is based on 30/360 days basis.
(4 Marks)

Solution
1. Semi-annual fixed payment
= (N) (AIC) (Period)

Where,
N = Notional Principal amount = `8,00,000
AIC = All-in-cost = 6% = 0.06
180
= 8,00,000 X 0.06
360
= 8,00,000 X 0.06 (0.5)
= ` 24,000

2. Floating Rate Payment

dt
= N (LIBOR)
360
181
= 8,00,000 X 0.05 `
360
= ` 24,000

3. Net Amount
= (i) – (ii)
= ` 24,000 – ` 20,111 = ` 3,889
Or = ` 24,000 – ` 20,120 = ` 3,880

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Question 132
Mr. John established the following spread on the TTK Ltd.'s stock:
1. Purchased one 3 – month put option with a premium of ` 15 and an exercise price
of ` 900.
2. Purchased one 3 – month call option with a premium of ` 90 and an exercise price
of ` 1,100.

TTK Ltd.'s stock is currently selling) at ` 1,000. Calculate gain or loss, if the price of
stock of TTK Ltd.
1. Remains at ` 1,000 after 3 months.
2. Falls to ` 700 after 3 months.
3. Raises to ` 1,200 after 3 months.
Assume the size of option is 200 shares of TTK Ltd.
(May 19, 8 Marks)

Solution
1. Total premium paid on purchasing a call and put option
= (` 15 per share ` 200) + (` 90 per share ` 200).
= ` 3,000 + ` 18,000 = ` 21,000
In this case, Mr. John exercises neither the call option nor the put option as both
will result in a loss for him.
Ending value = – ` 21,000 + 0 = – ` 21,000
i.e. Net loss = ` 21,000

2. Since the price of the stock is below the exercise price of the call, the call will not
be exercised. Only put is valuable and is exercised.
Net Gain = (Exercise Price – Current Price) X No of Shares – Premium Paid
Total premium paid = ` 21,000
Ending value = – ` 21,000 + ` [(900 – 700) X 200]
∴ Net gain = ` 19,000

3. In this situation, the put is worthless, since the price of the stock exceeds the put’s
exercise price. Only call option is valuable and is exercised.
Total premium paid = ` 21,000
Ending value = – ` 21,000 + ` [(1,200 – 1,,100) X 200] = – ` 1,000
∴ Net gain = ` 1,000

Question 133
A Rice Trader has planned to sell 22,000 kg of Rice after 3 months from now. The spot
price of the Rice is ` 60 per kg and 3 months future on the same is trading at ` 59 per
kg. Size of the contract is 1,000 kg. The price is expected to fall as low as ` 56 per kg, 3
months hence. What the trader can do to mitigate its risk of reduced profit? If he
decides to make use of future market, what would be the effective realized price for

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its sale when after 3 months, spot price is ` 57 per kg and future contract price for 3
months is ` 58 per kg?
(May 19, 8 Marks)
Solution
In order to hedge its position trader would go short on future at current future price
of ` 59/kg. This will help the trade to realize sure ` 59 per kg. after 3 months.
Particulars
a. Quantity of Rice to be hedged 22,000 kg.
b. Contract Size 1,000 kg.
c. No. of Contracts to be sold (a/b) 22
d. Future Price ` 59/kg.
e. Exposure in the future market (a X d) ` 12,98,000

After 3 months, trader would cancel its position in the future by buying a future
contract of same quantity and will sell Rice in the spot market and position shall be as
follows:

Particulars `
a. Price of Future Contract 58/kg.
b. Amount bought = 22,000 X 58 12,76,000
Gain (Loss) on future position (12,98,000 –
c. 22,000
12,76,000)
d. Spot Price ` 57/kg.
Amount realized by selling in the spot
e. ` 12,54,000
market (22000 X 57)
f. Effective Selling Amount (c + e) ` 12,76,000
g. Effective Selling Price (12,76,000/22,000) 58/kg.

Question 134
Sun Limited, an Indian company will need $ 5,00,000 in 90 days. In this connection,
following information is given below:
Spot Rate – $1 = ` 71
90 days forward rate of $1 as of today = ` 73
Interest Rates are as follows:
Particulars US India
90 days Deposit Rate 2.50% 4.00%
90 days Borrowing Rate 4.00% 6.00%

A call option on $ that expires in 90 days has an exercise price of ` 74 and a premium
of Re. 0.10. Sun Limited has forecasted the spot rates for 90 days as below:
Future Rate Probability
` 72.50 25%
` 73.00 50%
` 74.50 25%

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Which of the following strategies would be the most preferable to Sun Limited:
1. A Forward Contract;
2. A Money Market hedge;
3. An Option Contract; (iv) No Hedging.
Show your calculations in each case.
(May 19, 8 Marks)

Solution
1. Forward contract:
Rupees needed in 90 days = $5,00,000 X ` 73 = ` 3,65,00,000
2. Money market hedge:
Amount in $ to be invested = 5,00,000/1.0250 = ` 4,87,805
Amount of ` needed to convert into $ = 4,87,805 X 71 = ` 3,46,34,155
Interest and principal on ` loan after 90 days
= ` 3,46,34,155 X 1.06 = ` 3,67,12,204

3. Call option:
Expected Prem. Exercise Total Total price for Prob. Pixi
Spot rate /unit Option price $ 5,00,000 X (4) Pi (5) X (6)
per unit
(1) (2) (3) (4) = (5) (6) (7)
72.50 0.10 No 72.60 3,63,00,000 0.25 90,75,000
73.00 0.10 No 73.10 3,65,50,000 0.50 1,82,75,000
74.50 0.10 Yes 74.10 3,70,50,000 0.25 92,62,500
3,66,12,500
Add: Interest on Premium @ 6% (50,000 X 6%) 3,000
3,66,15,500
* (` 74 + ` 0.10)
4. No hedge option:
Expected Future spot rate ` needed Xi Prob. Pi Pi xi
72.50 3,62,50,000 0.25 90,62,500
73.00 3,65,00,000 0.50 1,82,50,000
74.50 3,72,50,000 0.25 93,12,500

Decision: Forward Contract Strategy is most preferable strategy because it requires

the least amount to arrange $5,00,000.

Question 135
P Ltd. is contemplating to borrow an amount of ` 50 crores for a period of 3 months
in the coming 6 months’ time from now. The current rate of interest is 8% per annum
but it may go up in 6 months’ time. The company wants to hedge itself against the
likely increase in interest rate. The Company’s bankers quoted an FRA (Forward Rate
Agreement) at 8.30% per annum. Compute the effect of FRA and actual rate of interest

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cost to the company, if the actual rate of interest during considering period happens
to be (i) 8.60% p.a., or (ii) 7.80% p.a. (Show your working on the basis of months)
(Nov 19, 8 Marks)

Solution
Final settlement amount shall be computed by using formula:
(N)(RR - FR)(dtm / DY)
=
[1+ RR(dtm / DY)]
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on the
contract settlement date;
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in Months
DY = Applicable basis of months

Accordingly,
If actual rate of interest after 6 months happens to be 8.60%
(` 50 crore) (0.086-0.083) (3/12)
= [1 + 0.086(3/12)]
(` 50 crore) (0.003) (0.25)
=
1.0215
3,75,000
= = 3,67,107
1.0215
Thus, banker will pay a sum of ` 3,67,107 to P Ltd. and actual interest rate for P Ltd.
shall be as follows:

Interest on loan @ 8.60% for 3 months ` 1,07,50,000

Less: Amount Received from the bank ` 3,67,107
Net Amount ` 1,03,82,893

Effective Interest Rate

` 1,03,82,893 12
= X X 100
` 50 crore 3
= 8.31%

If actual rate of interest after 6 months happens to be 7.80%

(` 50 crore) (0.0780 – 0.0830) (3/12)
= [1 + 0.0780(3/12)]
(` 50 crore) (-0.005) (0.25)
=
1.0195
- 6,25,000
= = ` 6,13,046
1.0195

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Thus P Ltd. will pay banker a sum of ` 6,13,046 and actual interest rate for P Ltd. shall
be as follows:
Interest on loan @7.80% for 3 months ` 97,50,000
Add: Amount paid to bank ` 6,13,046
Net Amount ` 1,03,63,046

Effective Interest Rate

` 1,03,63,046 12
= X X 100 = 8.29%
` 50 crore 3

Question 136
A future contract is available on R Ltd. that pays an annual dividend of ` 4 and whose
stock is currently priced at ` 125. Each future contract calls for delivery of 1,000 shares
to stock in one-year, daily marking to market. The corporate treasury bill rate is 8%.

Required:
1. Given the above information, what should the price of one future contract be?
2. If the company stock price decreases by 6%, what will be the price of one futures
contract?
3. As a result, the company stock price decrease, will an investor that has a long
position in one futures contract of R Ltd. realises a gain or loss? What will be the
amount of his gain or loss?
(Ignore margin and taxation if any)
(Nov 19, 6 Marks)

Solution
1. Future Price = Spot + Cost of Carry – Dividend
= ` 125 + (` 125 X 0.08) – 4 = ` 131

Price of one future contract

= 1000 share X ` 131= ` 1,31,000

2. Price decrease by 6 %
Market Price: = 125 X 94% = 117.50

Then, price of one future contract

= ` 117.50 + (` 117.50 X 0.08) – 4 = ` 122.90
= ` 122.90 X 1000 = ` 1,22,900

3. If the investor has taken a long position, decrease in price will result in loss for the
investor.
Amount of loss will be:
= ` 1, 31,000 - ` 1,22,900 = ` 8,100

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Question 137
AB Ltd.’s equity shares are presently selling at a price of ` 500 each. An investor is
interested in purchasing AB Ltd.’s shares. The investor expects that there is a 70%
chance that the price will go up to ` 650 or a 30% chance that it will go down to ` 450,
three months from now. There is a call option on the shares of the firm that can be
exercised only at the end of three months at an exercise price of ` 550.
Calculate the following:
1. If the investor wants a perfect hedge, what combination of the share and option
should be select?
2. Explain how the investor will be able to maintain identical position regardless of
the share price.
3. If the risk-free rate of return is 5% for the three months period, what is the value
of the option at the beginning of the period?
4. What is the expected return on the option?
(Nov 19, 8 Marks)

Solution
1. To compute perfect hedge, we shall compute Hedge Ratio (Δ) as follows:
C1 – C2 100 – 0 100
Δ = = = = 0.50
S1 – S2 650 - 450 200

The investor should purchase 0.50 share for every 1 call option Or, the investor
should purchase 1 share for every 2 Call Option.

2. How the investor will be able to maintain his position if he purchases 0.50 share
for 1 call option written.
a) If price of share goes upto ` 650 then value of purchased share will be:
Sale Proceeds of Investment (0.50 X ` 650) ` 325
Loss on account of Short Position (` 650 – ` 550) ` 100
` 225

b) If price of share comes down to ` 450 then value of purchased share will be:
Sale Proceeds of Investment (0.50 X ` 450) = ` 225

3. The Value of Option, say, P at the beginning of the period shall be computed
as follows:
(` 250 – P) 1.05 = ` 225
` 262.50 – 1.05P = ` 225
` 37.5 = 1.05P
P = ` 35.71

4. Expected Return on the Option

Expected Option Value
= (` 650 – ` 550) X 0.70 + ` 0 X 0.30 = `70

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Expected Rate of Return
70 – 35.71
= X 100 = 96.02%
35.71

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