Introduction to Derivatives

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 Black-Scholes Model
Non-Dividend Paying Stock

Value of call = S N (d1) - K e-rt N(d2)

Value of put = K e-rt (1-N(d2)) – S e-yt (1-N (d1))
S = Current value of the underlying asset S σ2 t
K = Strike price of the option ln + (r + )
t = Life to expiration of the option measured in years K 2
r = Riskless interest rate corresponding to the life of the d1 =
option, should be continues compounding, eg: 12% = σ t
ln(1.12)=0.1133
σ2 = Variance in the ln(value) of the underlying asset, d2 = d1 - σ √t
annualized SD of continuously compounded returns on
underlying
σ2annual = σ2daily x square root of no. trading days per year
N( ) = cumulative normal distribution
N(d1) = delta of option, measures the change in price of
the option with respect to change in the price of the
underlying asset
N(d1) and N(d2) = probabilities estimated by using
cumulative standardized normal distribution
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Option delta = number of units of the underlying asset that are needed to create the replicating Portfolio
 Black-Scholes Model
(Adjusted for Dividends)

C = S e-yt N(d1) - K e-rt N(d2) S  2

ln + (r - y + )t
d1 = K 2
 t

d2 = d1 - σ √t

Dividend yield (y = dividends/ Current value of the asset) of the

underlying asset is expected to remain unchanged during the life
of the option
Adjustments:
Value of the asset is discounted back to the present at the dividend yield to take into
account the expected drop in asset value
Interest rate is offset by the dividend yield to reflect the lower carrying cost from holding
the asset
Other dividend adjustment options
Estimate the pv of expected dividend and subtract it from the current value of the asset 4
to use as S in the model
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Elements of Derivatives

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 Derivatives
OTC European style Cash settled Standardized contracts
Exchange traded American style Deliverable Unstandardized contract

Short term contracts

Forwards
Contractual obligation
Long term contracts Futures Rights /choice
Options
Stock
Index
Swap Limited loss
Unlimited profit
Currency
Commodities
Services Hedging Plain contracts
Weather… Speculation Compound and complex contract
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Arbitrage trading
Other Types of Derivatives

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Participants

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Functions of Derivatives

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Eccentric Types

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Eccentric Types

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Factors Causing Development of
Exchange Traded Derivatives

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OTC Derivatives

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Forward Contracts

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Forward Contracts

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Forward Price

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Forward vs. Futures

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Short Selling

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Short Selling

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Forward Price

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Known Yield

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Valuing Forward Contracts

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Valuing Forward Contract

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Is Forward Price = Futures Price?
• If rf is constant and same for all maturities; forward
price for a contract with a certain delivery date is the
same as the futures price for a contract with that
delivery date
• When price S is strongly positively (negatively)
correlated with interest rates, futures prices will be
higher (lower) than forward prices
• Increase in S, investors with long futures get immediate gain,
because of daily settlement procedures – gain can be invested for
higher interest rates
• Decrease in S, investors with long futures get immediate loss,
because of daily settlement procedures – loss can be financed
with lower interest rates

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 Is Forward Price = Futures Price?
• The real world factors causing the differences are…
• Taxes
• Transaction costs
• Margin treatments
• Risk of default
• Liquidity (tradability) of the contract
• As the life of a futures contract increase, the
difference between forward and futures contracts
are significant

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 Forward Contracts on Foreign
Currencies
• The foreign currency is regarded as an investment asset
paying a known yield
• Yield is the risk free rate of interest in foreign currency
• Fo = Soe(r-rf)T
• Its interest rate parity relationship
• rf = foreign risk free interest rate when money is invested for time T
• r > rf
• F0 is always less than S0
• F0 decreases as the time to maturity of the contract, T increases
• r > rf
• F0 is always greater than S0
• F0 increases as the time to maturity of the contract, T increases

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 Theories of Term Structure
• Expectations theory
• Segmentation theory
• Liquidity preference theory

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 Futures
• An agreement
• Exchange traded
• Standardized
• Standard underlying – quality, quantity
• Standard timing of settlement
• Standard location of settlement
• Contract cycle..
• Expires on the last Thursday of the month
• Friday following the last Thursday, a new contract having a
three month expiry is introduced for trading

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 Futures
• Expiry date – last trading day of the contract
• Contract size – amount asset
• Basis = futures price – spot price
• Normal market basis = futures price > spot price
• Cost of carry = storage cost + interest to be paid on
financial asset – income earned on asset
• Initial margin
• Maintenance margin
• Marking-to-market

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 Future Contracts
• Traded on exchange
• Guaranteed by a financial intermediary
• Underlying…
• Financial assets – stock indices, currencies, treasury bonds,
• Commodities – pork bellies, live cattle, sugar, wool, lumber,
copper, aluminum, tin, and gold
• American style
• Specifies – product specification, delivery time and
location

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 Future Contracts
• Margin requirements
• Daily settlement procedures
• Delivery procedures – clearing houses

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 Trading Futures Contracts
• Majority of futures contract leads to squaring
off before maturity

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Specifications of the Futures Contract
• Nature of agreement between two parties
• Assets
• Contract size
• Amount of the asset that has to be delivered under one contract
• Depends on likely users
• Delivery arrangements
• Where and when delivery
• Alternatives of assets that can be delivered
• Party with short position will file a notice of intention to delivery
• Transportation costs

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Specifications of the Futures Contract

• Delivery months
• Delivery can be the whole of delivery month
• At any time contracts trade for closest delivery month and a
number of subsequent delivery months
• Trading generally cease (if deliverable) few days before the last
day on which delivery can be made
• Price quotes is consistent with the way in which the
minimum price movement can occur
• Delivery price movement limits
• Trading cease once the contract is limit up or limit down
• Prevents large price movements
• Artificial barrier to trading not allowing the futures to reflect the
underlying volatility
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Specifications of the Futures Contract
• Position limits
• Maximum no. of contract a speculator may hold
• Bonafide hedgers are not affected by position limits
• To prevent speculators from exercising undue influence
on the market

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 Convergence of Futures Price to Spot
Price
• On expiry of the contract the futures price
converges to the spot price of the underlying
asset
• Its to fulfill the no arbitrage principle of the
futures – spot market

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 Margins
• Marking to market
• Initial margin
• Maintenance margin
• Trade is first MTM on the close of the first trading
day, subsequently MTM at the close of every day
• Margin call received (for variation margin) when
margin money falls below maintenance margin
• If variation margin not provided, broker closes out
the position by selling the contract

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 Margins
• Brokers may allow an investor to earn interest on
balance in a margin account
• Investors may provide securities as margin…
• Treasury bill (accepted in lieu of cash at about 90% of their face
value)
• Shares (accepted in lieu of cash at about 50% of their face value)
• Contracts are settled every day and rewritten for
next day
margins are set by the exchange

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 Margins
• Margin levels are determined by the variability of the
price of the underlying asset
• Maintenance of margin = 75% on initial margin
• Margin requirements also depends on objectives of
the investors
• Margin are same for long and short positions

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 Clearing House
• Acts as an intermediary
• Guarantees the performance of parties
• CM has to maintain clearing margin with CH

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 Futures Quotes
• Settlement price = average of the prices at
which the contract traded towards closing
• Settlement prices is used to calculate daily
profit/losses and margins
• Open interest = no. of contracts outstanding
• No. of contracts outstanding = no. of long
positions = no. of short positions

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 Futures Price will be above the
Expected Future Spot Price
• If hedgers tend to hold short positions and
speculators tend to hold long positions;
futures price < expected future spot price,
because….
• Speculators require compensation for the risks they are
bearing, will trade only if they can expect to make
money on average
• Hedger will loose money, they are ready accept loss
because futures reduce their risks

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Future Price vs. Expected Future Spot
Price
• Normal backwardation; future price <
expected future spot price
• Contango; future price > expected future spot
price

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 Delivery
• Decision of when to deliver is made by the party
with short position
• Party with short position issues notice of
intention to deliver
• Exchange chooses a party with oldest outstanding
long position to delivery
• Parties with long position have to accept the
deliver, if transferable, it can be transferred in
short span of time ( ½ hr)
• Delivery = acceptance of warehouse receipt

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 Delivery
• After delivery, party delivery will incure all warehousing
costs
• Price paid = settlement price immediately preceding the
date of the notice of intention to deliver
• Delivery procedure takes two to three days
• Cycle days of contract…
• First notice day
• First day on which the notice intention to delivery can be made
• To avoid risk of taking delivery an investor with long position should
close out his or her contract prior to first notice
• Last notice day
• Last day on which the notice intention to delivery can be made
• Last trading day
• Few days before the last notice day
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 Cash Settlement
• Settlement price on last trading day = spot
price of the underlying asset at close of
trading on that day

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 Trading Irregularities

• Method..
• Cornering the commodity market and then…
» As the maturity of the futures contract is approached,
investor group does not close out its position so that the
number of outstanding futures contracts may exceed the
amount of the commodity available for delivery
» Parties with short try to close out the position due to non-
availability of commodities for delivery
• Result: large rise in both futures and spot prices
• Regulation..
• Increasing margin requirements
• Imposing stricter position limits
• Prohibiting trades that increase a speculator’s open position
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• Forcing market participants to close out the positions
 Trading Irregularities
• Overcharging customers
• Not paying the customers the full proceeds of
sales
• Traders using their knowledge of customer
orders to trade first for themselves

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 Accounting
• Hedge accounting
• Allows profit/loss from a hedging instrument to be
recognized at the same time as the profit /loss from the
item being hedged
• All derivatives to be included in the balance sheet at
fair market value
• Hedging instrument should be highly effective in
offsetting exposure and the effectiveness of the is to
assessed every three months

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 Stock Index Futures
• Index tracks the capital gain/loss from investing in
portfolio
• Weights assigned to individual stocks in a portfolio
do not remain fixed; if one stock price moves sharply
than other, it gets the more weight
• Index constructed on market capitalization weights
automatically adjusts to reflect…
• Stock splits
• Stock dividends
• New equity issues

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 Futures Prices of Stock Indices
• Assumed that dividend on portfolio provides a
known yield than known cash income…
• Fo = Soe(r-q)T
• q = average yield per annum on an asset during the life of a
futures contract
• Dividend used for estimating q should be those for which the ex-
dividend date is during the life of the futures contract
• If index futures price increases with maturities of of
the futures contract; rf exceeds dividend yield

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 Index Arbitrage
• Fo > Soe(r-q)T
• Buying spot the stock underlying index and shorting futures
contracts
• Done by corporation holding short-term money market investments
• Fo < Soe(r-q)T
• Shorting or selling the stock underlying the index and taking a long
position in futures contract
• Done by pension funds
• Index can be proxy through a portfolio which moves very
close with index, though having very few stocks
• Is implemented through program trading
• The spot price underlying the futures price should be the
price of an asset that can be traded by investors

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 Futures on Commodities
• In absence of storage costs…
• Fo = SoerT
• In presence of storage cost…
• Fo = (So+U)erT
» U = present value of all the storage costs that will be incurred
during the life of a forward contract
» Storage costs can be regarded as negative income
• Fo > (So+U)erT ; long underlying commodity and short commodity
futures contracts to lock in a profit
• Fo > (So+U)erT ; short underlying commodity and long commodity
futures contracts to lock in a profit

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 Futures on Commodities
• If storage cost incurred at any time are
proportional to price of the commodity
• Fo = Soe (r+u)T
– u = storage costs per annum as proportion of the spot price
– Storage cost is regarded as the negative yield

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Futures on Consumption Commodities
• Fo > (So+U)erT
• Borrow an amount So+U at the risk-free rate and use it to purchase
one unit of the commodity and pay storage costs
• Short a futures contract on one unit of the commodity
• Above leads to a profit of Fo - (So+U)erT at time T
• Fo < (So+U)erT
• Sell the commodity, save the storage costs, and invest the
proceeds at the risk-free interest rate
• Long a futures contract on one unit of the commodity
• Above leads to a profit of (So+U)erT - Fo at time T

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Futures on Consumption Commodities
• Commodities in inventory are kept (long) so
because of its consumption value and not
because of investment value
• Futures contracts cannot be consumed
• Therefore..
• Fo < (So+U)erT
• Fo < (So+U)e (r+u)T ; if storage costs are expressed as a proportion u
of the spot price

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 Contract Specifications for Index
Futures
• Cycles of contract = one-month, two month, and
three month contracts
• All contracts expire on last Thursday of every month
• Friday following last Thursday a new three months
contract will be introduced
• Each futures contract has separate limit order book
• Single move in the index value would imply a
resultant gain or loss of Rs.10 (0.05*200 units) on an
open position of 200 units

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 Convenience Yields
• Benefits from holding the physical asset
• Fo eyT = (So+U)erT
» y = convenience yield
• If the storage costs per unit are constant proportion u of spot
price…
• Fo eyT = Soe(r+u)T
• Fo = Soe(r+u-y)T
• For investment assets the convenience yield is zero
• y > (y+u)
• Futures prices of some of the commodities (sugar) decrease as the
time to maturity of the contract increases

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 Convenience Yields
• Reflects the market’s expectations concerning
the future availability of the commodity
• Greater the possibility the storage will occur;
higher the y
• Low inventories leads to high convenience
yields

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 Cost of Carry
• = storage costs + interest paid – income earned from
assets
• Cost of carry for…
• Non-dividend paying stock its r
• Stock index its r-q, because income is earned at rate q on the assets
• Currency its r-rf
• Commodity with storage cost proportion u of the price is r+u
• For invetsment assets
• Fo = SoecT
• For consumption assets
• Fo = Soe(c-y)T

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 Delivery Alternatives
• c>y
• Futures price is an increasing function of the time to maturity
• Benefits from holding the asset are less than the risk-free rate
• Party with short position has to deliver as early as possible
• Interest earned on the cash received out weighs the benefit of holding
the asset
• Futures price has to be computed as if the delivery will take place at the
beginning of the delivery period
• c<y
• Futures price is an decreasing function of the time to maturity
• Benefits from holding the asset are more than the risk-free rate
• Party with short position has to deliver as late as possible
• Interest earned on the cash received under weighs the benefit of holding
the asset
• Futures price has to be computed as if the delivery will take place at the
end of the delivery period

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 Futures Prices and Expected Future
Spot Price
• If more speculators are long than short
• Futures price < expected future spot price
• If more speculators are short than long
• Futures price > expected future spot price
• Present value of the investment to a speculator
• = -Fo e-rT + E(ST)e-kT
» k = discount rate appropriate for the investment
» Value of k depends on the systematic risk of the investment
» E = expected value
• Assuming all the investments opportunities in
securities market have zero NPV…
• Fo e-rT + E(ST)e-kT = 0
• Fo = E(ST)e(r-k)T
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 Futures Prices and Expected Future
Spot Price
• If systematic risk is zero; k = r
• Fo = E(ST)

• If ST is positively correlated with stock market;

k>r
• Fo < E(ST)

• If ST is negatively correlated with stock market;

k<r
• Fo > E(ST)

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Proof that Forward and Futures Prices are Equal
when Interest Rates are Constant
• Page Hull 90-91

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 Hedging Strategies using Futures
• Perfect hedge
• Completely eliminates the risk
• Are rare
• Hedge-and-forget strategies
• No attempt is made to adjust the hedge once it has been put in
place
• Hedger takes the future position at the beginning of the life of the
hedge and closes out the position at the end of the life of the
hedge
• Dynamic hedge
• Hedge is monitored very closely and frequent adjustments are
made

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 Short Hedges
• Short position in futures
• Appropriate
• Already owns an asset and expects to sell it at some
time in the future
» Example: Farmers owning hogs and ready for sale after
two months
• Asset will be owned at some time in the futures
» Example: Exporter expecting foreign currencies in the
future
• Offset an existing long position

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 Long Hedges
• Long position in futures
• Appropriate
• Wants to purchase an asset in future and wants to lock
in a price now
» Example: Copper manufacturing company
• Offset an existing short position

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 Arguments For and Against Hedging
• Avoids unpleasant surprises
• Hedging by shareholders instead of company
• Very expensive
• Size of futures makes the hedging impossible by an individual
• Can easily diversify than by a company
• All the implications of price changes on a company’s
profitability should be taken into account in the
design of a hedging strategy to protect against the
price changes

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 Issues in Hedging
• Asset whose price is to be hedged may not be
exactly the same as the asset underlying the
futures contract
• Uncertainty as to the exact date when the
asset will be bought or sold
• Hedge may require the futures contract to be
closed out well before its expiration date

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 Basis Risk
• Basis = spot price of asset to be hedge – future price
of contract used
• At expiration of contract ‘Basis = 0’ if..
• Assets to be hedged = underlying asset
• At expiration of contract ‘Basis <0’ if..
• Underlying asset is a low-interest-rate currency, gold, silver
• At expiration of contract ‘Basis >0’ if..
• Underlying asset is a high-interest-rate currency, gold, silver and
many commodities

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 Basis Risk
• b1 = S1 – F1
• b2 = S2 – F2
• Profit on futures position is F1 – F2
• Effective price obtained with hedging is
• S2 + F1 – F2 = F1 +b2
» Value of F1 is known at time t1, If b2 were also known at
this time, a perfect hedge would result

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 Basis Risk
• Basis risk of investment assets..
• Tends to be much lower than consumption
commodities
• Arises from uncertainty as to the level of risk-free
interest rate in the future
• Basis risk of consumption commodity..
• Caused by large variance in convenience yield because
of…
» Imbalance between demand and supply
» Difficulties in storing the commodity

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 Basis Risk
• Basis risk is higher when asset that give’s
exposure is different from underlying asset
• Price to be paid for the asset is…
• = S2 + F 1 – F 2
• = F1 + (S*2 – F2) +(S2 –S*2)
» S*2 – F2 = basis that would exist if the asset being
hedged were the same as the asset underlying the
futures contract
» S2 –S*2 = basis arising from the difference between
the two assets

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 Basis Risk
• Short hedge
• If the basis strengthens unexpectedly, hedger’s position
improves
• If the basis weakens unexpectedly, hedger’s position
worsens
• Long hedge
• If the basis strengthens unexpectedly, hedger’s position
worsens
• If the basis weakens unexpectedly, hedger’s position
improves

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 Choice of Futures Contract for Hedging
• Choice of the asset underlying the futures contract
• Prices of futures contracts has to be closely correlated with the
price of the asset being hedged
• Choice of the delivery month
• Contract with later delivery month is usually chosen because
futures prices are in some instances quite erratic during the
delivery month
• Long position has the risk of having to take delivery for the
physical assets if the contract is held during the delivery month
• Basis risk increase as the time difference between the hedge
expiration and the delivery month increase
• Choose a delivery month that is as close as possible to, but later
than, the expiration of the hedge
• In practice, liquidity tends to be greatest in short maturity futures
contracts
• May use short maturity contracts and roll them forward 76
 Hedge Ratio
• Ratio of the size of the position taken in futures
contracts to the size of the exposure
• h* = ρ(σS/ σF)
» δS = change in spot price, S during a period of time equal to the
life of the hedge
» δF = change in futures price, F, during a period of time equal to
the life of the hedge
» σS = standard deviation of δS
» σF = standard deviation of δF
» ρ = coefficient of correlation between δS and δF
» h* = hedge ratio that minimizes the variance of the hedger’s
position

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 Hedge Ratio
• h* = 1
• If ρ = 1 and σS = σF
• Futures price mirrors the spot price perfectly
• Optimal h*
• Slope of the best fit line when δS is regressed against δF
• h* to correspond to the ratio of changes in δS to changes in δF
• Hedge effectiveness
• Proportion of variance that is eliminated by hedging is = ρ2 = h*2 =
ρ(σ2S/ σ2F)

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 Hedge Ratio
• Procedure..
• Value of δS and δF for each of the intervals are
observed
• Length of each time interval is the same as the length
of the time interval for which the hedge is in effect

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 Optimal No. of Contracts
• Futures contracts used should have a face
value of h*NA
• N* = (h*NA / QF)
» NA = size of position being hedged (units)
» QF = size of one futures contract (units)
» N* = Optimal no. of futures contracts for hedging

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 Stock Index Futures
• Used to hedge an equity portfolio
• N* = β(P/A)
• P = current value of the portfolio
• A = current value of the stock underlying one futures contract
• N* = futures contracts to be shorted
• β = slope of the best fit line obtained when excess return on the
portfolio over the risk-free rate is regressed against the excess
return of the market over the risk-free rate
• Formula assumes that the maturity of the futures contract is close
to the maturity of the hedge and ignores the daily settlement of
the futures contract

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 Reasons for Hedging an Equity
Portfolio
• Why the hedger should go to the trouble of using
future contracts to earn the risk-free interest rate,
the hedger can simply sell the portfolio and invest
the proceeds in treasury bills?
• Hedging using index futures removes the portfolio
exposure to the overall market movements, this
could…
• Hedger can earn abnormal return form the well constructed
portfolio with very good stocks
• Helps protecting the portfolio for short period of time, likely to
held for longer period

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 Changing Beta
• Stock index futures contracts are used to
change the portfolio beta
• Change the portfolio beta from β to β*
• If β > β*; short position were (β- β*)*(P/A)
• If β < β*; long position were (β*- β)*(P/A)

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 Exposures to the Price of an Individual
Stock
• Page Hull:107

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 Rolling the Hedge Forward
• Occurs when the expiration date of the hedge
is later than the delivery dates of all the
futures contracts that can be used
• Hedges can be rolled forward many times

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 Treasury Bond Futures
• Deliverable bond: Govt. bond having more than 15 years to
maturity on the first day of delivery month and that’s not
callable within 15 years from that day can be cancelled
• Prices are quoted in the same way as the treasury bond
prices
• Delivery can take place at any time during the delivery
month
• Conversion factor defines the price received by the party
with the short position
• Quoted price applicable to delivery = conversion factor x quoted
futures price
• Cash received = (conversion factor x quoted futures price) + accrued
interest

86
 Treasury Bond Futures
• Conversion factor = value of bond per dollar of principal on
the first day of delivery month on the assumption that the
interest rate for all maturities equals 6% p.a. with semiannual
compounding
• Bond maturity and the times to the coupon payment dates
are rounded down to the nearest three months for the
purposes of computation
• Party with short can decide the bond to be delivered
• Party with short position receives = (quoted futures price x
conversion factor) + accrued interest

87
 Treasury Bond Futures
• Cost of purchasing a bond = quoted price +
accrued interest
• Cheapest-to-deliver bond is for one which the
given below is least…
• = quoted price – (quoted futures price x conversion factor)
• If bond yield > 6%
» Conversion factor system tends to favor the delivery of low-
coupon, long maturity bonds
• If bond yield < 6%
» Conversion factor system tends to favor the delivery of
high-coupon, short maturity bonds
• When the yield curve is upward sloping
» Tendency for bonds with a long term maturity to be favored
• When the yield curve is downward sloping
» Tendency for bonds with a short time to maturity to be
delivered

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Determining the Quoted Futures Price
• Assuming that cheapest-to-deliver bond and the
delivery date are known
• F0 = (S0 – I)erT
» I = present value of coupons during the life of the futures
contract
» T = time until the futures contract matures
» r = risk free interest rate applicable to a time period of length T
• Treasury bond futures contract is a futures contract
on a security providing the holder with known
income

89
 Eurodollar Futures
• Eurodollar interest rate = interest earned on
eurodollar deposit
• Settled in cash
• Final marking to market set Q equal to 100-R,
where R is the actual three-month Eurodollar
interest on that day, expressed with quarterly
compounding and an actual/360 day count
convention

90
Forward vs. Futures Interest Rates
• For short maturities forward interest rates = futures
interest rates
• Convexity adjustment to convert Eurodollar futures
rates to forward interest rates
• Forward rate = futures rate – 1/2σ2t1t2
» t1= time to maturity of the futures contract
» t2 = time to maturity of the rate underlying the future contract
» σ = standard deviation of the change in the short-term interest
rate in one year, both rates are expressed in continuous
compounding

91
 LIBOR Zero Curve
• Also called Swap Zero Curve
• Used as risk-free zero curve when derivatives are
valued
• Spot LIBOR rates are used to determine very short-
term LIBOR zero rates
• Uses bootstrap procedure to determine zero rates
• Fi = (Ri+1Ti+1-RiTi)/(Ti+1-Ti)
• Ri+1 = [Fi(Ti+1-Ti) + RiTi ]/Ti+1
» Fi = forward rate calculated from the ith Eurodollar future
contract
» Ri = zero rate for a maturity T

92
 Duration

• Measures of how long on average the holder of the

bond has to wait before receiving cash payments
• Zero-coupon bond; term = duration
• Coupon bond; duration < term

93
 Duration
n
B=∑ c i e (minus) yt i

i=1

c i = cash flows
t i = time
B = bond price
y = yield

∑
n (min us ) yt
t c
i=1 i i
e i

D=
B
(min us ) yt i
n
cie
D = ∑ti
i=1 B

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 Duration
• A weighted average of the times when payments are
made, with the weight applied to time ti, being equal
to the proportion of the bond’s total present value
provided by the cash flow at time ti
• Sum of the weights is 1
yD
(-Dy
• The % change in a bond price is approx. = Duration x
size of the parallel shift in the yield curve

95
 Modified Duration
• Dy)/(1+y/m)]
• D* = D / (1+y/m)
• D* = Bond’s modified duration
• m = compounding frequency
• Duration relationship simplified to…
• D*y
» y = expressed with a compounding frequency of m times
per year
• Modified duration improves accuracy

96
 Bond Portfolios
• Portfolio duration = weighted average duration
• Assumes that yields of all bonds will change by the
same amount
• Its possible only when there is parallel shift in yield
curve
• Convexity measures the curvature of the price yield
relationship
• Can be used to improve the price predictability of
duration

97
 Hedging Portfolios of Assets and
Liabilities using Duration
• Duration matching
• Also called portfolio immunization
• Average assets’ duration = average duration of liabilities
• Does not immunize a portfolio against the nonparallel shifts in the
yield curve
• Gap management
• Segmenting the portfolio based maturities and managing the
duration as per segment can be a good strategies for managing
non parallel shifts in yield curve

98
Duration based Hedging Strategies
• Duration-based hedge ratio
• Also called price sensitive hedge ratio
• If assumed that yield curve shift parallely, then…
» P = -PDPy
• Its also true that…
» FC = -FCDFy
• No. of contracts required to hedge against an uncertain
y is…
» N* = (PDP / FCDF)

99
Duration based Hedging Strategies
• Interest rates and future price move in opposite
direction
• Company losing money if interest rates drop = long futures
• Company losing money if interest rates moves up = short futures
• Choose futures were duration of the underlying will
be as close as to the duration of the asset being
hedged
• Eurodollar futures used for exposure to short term
interest rates, treasury bonds and treasury note
futures contracts are used for exposures to longer-
term rates

100
Convexity and Duration based Hedging
Strategies
• Convexity is considered when there is large parallel shifts in yield
• Relationship between percentage change in value and change in yield
• Change in yield = y
• Measure of convexity…
• C = (1/B)*(y2ni=1cit2ie-yti)/B
• Convexity of a bond portfolio tends to be greatest when the portfolio
provides payment evenly over a long period of time
• Dy+1/2C(y)2
• By matching convexity as well as duration, a company can make itself
immune to relatively large parallel shift in the zero curve, but still exposed
to nonparallel shifts

101
Contract Specifications for Index
Futures

102
Contract Specifications for Index
Futures

103
Long Nifty Futures
(Payoff Diagram)

104
Short Nifty Futures
(Payoff Diagram)

105
 Pricing Futures
• Futures price based on discrete compounding…
• Futures price = Spot price + Holding costs or carry costs
• F=S+C
• Carrying cost = cost of financing
• F = S (1+r)T
• T = time till expiration
• Arbitrage opportunities exists if…
» F < S(1+r)T
» F > S(1+r)T

106
 Pricing of Futures
• Futures price based on continuous
compounding…
• F = SerT
• Components of holding cost
• Commodity futures = cost of financing + cost of storage
+ insurance purchased
• Equity futures = cost of financing – dividends return

107
 Pricing Equity Index Futures
• Cash settled
• Great impact on the world’s securities market
• Made the world stock market more volatile
• Dividend stream…
• Negative cost – long the stock
• Positive cost – short the stock
• Requires accurate forecasting of dividends
• Carrying cost = cost of financing – present value of
dividends obtained from stock in the index

108
 Pricing Equity Index Futures
• F = S (1+r-q)T
• q = expected dividend yield
• As time to expiration of contract reduces; basis
reduces = futures price converges to spot price
• Closing price of futures contract on the last day =
closing value of Nifty
• Cost of carry related arbitrage derives the behavior
of futures prices
• Market discovered price is different form theoretical
price of a futures contract

109
 Pricing Equity Index Futures
Example…

• Page 52

110
 Pricing Stock Futures
• Cash settled
• No costs of storage
• Dividend stream = negative cost
• Cost of carry = financing cost – dividends
• Requires an accurate forecasting of dividends

111
 Pricing Stock Futures
Example…

• Page 54

112
 Using Index Futures
• Hedging
• Long security, short Nifty futures
• Short security, long Nifty futures
• Have portfolio, short Nifty futures
• Have funds, long Nifty futures
• Speculation
• Bullish index, long Nifty futures
• Bearish index, short Nifty futures
• Arbitrage
• Have funds, lend them to the market
• Have securities, lend them to the market

113
 Long Security, Short Nifty Futures
• Risks faced in buying under valued stock…
• Valuation may be wrong
• Entire market might move against the investor’s opinion
• Every buy position on a security is a simultaneously a
buy position on Nifty
• Index is an incidental baggage to a security
• Long security in security = Long security + β times
Long Nifty
• Long in security demand speculation in index

114
 Long Security, Short Nifty Futures
• Value of security without any extra risk from market
fluctuations
• Hedges away the unwanted index exposure
• Hedge position will make less profits than unhedged
position
• Size of position in index futures market = β * amount
invested in stock
• Immune to Nifty fluctuation
• Returns on futures position = movements of nifty

115
 Long Security, Short Nifty Futures
• Works even for a security out of index
• Risk reduction range varies from security to security
• Variance of hedged position = i2m2
• Basis of selecting the available index futures
contract…
• Liquidity (one with the tightest bid-ask spread)
• Expiration date – based required speculative position
• Potential mispricing

116
 Long Security, Short Nifty Futures
Example

• Page 61

117
 Short Security, Long Nifty Futures
• Risks faced in buying overvalued stock…
• Valuation may be wrong
• Entire market might move against the investor’s opinion
• Every sell position on a security is a simultaneously a
sell position on Nifty
• Index is an incidental baggage to a security
• Short in security = short security + β times short Nifty
• Short in security demand speculation in index

118
 Short Security, Long Nifty Futures
• Value of security without any extra risk from market
fluctuations
• Hedges away the unwanted index exposure
• Hedge position will make less profits than unhedged
position
• Size of position in index futures market = β * amount
invested in stock
• Immune to Nifty fluctuation
• Returns on futures position = movements of nifty

119
 Short Security, Long Nifty Futures
• Works even for a security out of index
• Risk reduction range varies from security to security
• Variance of hedged position = i2m2
• Basis of selecting the available index futures
contract…
• Liquidity (one with the tightest bid-ask spread)
• Expiration date – based required speculative position
• Potential mispricing

120
 Short Security, Long Nifty Futures
Example

• Page 66

121
Have Portfolio, Short Nifty Futures
• Used when market is seen very volatile for
few days
• Most of the portfolio return is affected by
index
• Doesn't make sense to use this strategy for
long periods of time
• Used for rapid adjustments
• Partial hedging is appropriate

122
Have Portfolio, Short Nifty Futures
Example…

• Page 70

123
 Have Funds, Buy Nifty Futures
• Expecting funds in the future, but Nifty futures and
take the benefits of up movements
• Used by newly raised funds in MFs before deciding
on investment strategies
• Avoid impact costs in cash market by gradually
acquiring shares in the cash market, since you are
protected by futures for any surprise benefits

124
 Have Funds, Buy Nifty Futures
Example…

• Page 74

125
 Bullish Index, Long Nifty Futures
• Longer dated contracts – long term forecast
• Shorter date contracts – short term forecasts
• Shorter dated futures tends to be more liquid

126
 Bullish Index, Long Nifty Futures
Example…

• Page 77

127
 Bearish Index, Short Nifty Futures
• Longer dated contracts – long term forecast
Shorter date contracts – short term forecasts
Shorter dated futures tends to be more liquid

128
 Bearish Index, Short Nifty Futures
Example…

• Page 79

129
Have Funds, Lend them to the Market
• No price risk
• No credit risk
• Works like repo
• Perfectly hedged position
• Done by ‘long on stock and short on futures’
• Requires an attractive ‘basis’ (very high)
• As lender gains also through dividend and loses
through transaction costs
• Can also go for ‘early unwind’ once the gain is reaped
when future prices decrease

130
Have Funds, Lend them to the Market
Example…

• Page 82

131
 Having Securities, Lend them to the
Market
• No price risk
• No credit risk
• Works like reverse repo (by lending stock)
• Perfectly hedged position
• Done by ‘short on stock and long on futures’
• Requires an attractive ‘basis’ (very low)
• Can also go for ‘early unwind’ once the gain is reaped
when future prices increases
• Total return = interest – basis – transaction costs

132
 Having Securities, Lend them to the
Market
Example…

• Page 84

133
 Spot the Mispricing
• Based on cost-of-carry logic
• Cash and carry arbitrage if; F > S(1+r)T
• Reverse cash and carry arbitrage if; F < S(1+r)T
• Based on fair value and market value of
futures
• Buy the cheaper sell the expensive

134
 Spot the Mispricing
Example…

Fair Value vs. Market Prices for various Futures

Month Quantity Bid Ask Quantity Fair Remarks Action
Value
(at 12% pa)
Nov. 1000 1009 1010.5 1000 1009.50

Dec. 200 1022 1025 400 1019.00 FV < Bid Overpriced

(Sell at bid)
Jan. 400 1028 1032 200 1028.70

Note: On 1st Nov. Nifty stands at 1000

If FV > Ask; underpriced
135
 Spot the Mispricing
Example…

Fair Value vs. Market Prices for various Futures

Month Quantity Bid Ask Quantity Fair Remarks Action
Value
(at 12% pa)
Nov. 1000 1006.5 1007 1000 1009.50 FV>Ask Underpriced
(Buy at Ask)
Dec. 200 1018 1025 400 1019.00

Jan. 400 1028 1032 200 1028.70

Note: On 1st Nov. Nifty stands at 1000

136
 Spot the Mispricing
Example…

Fair Values Basis Spread

Nov. 1010 10
Dec. 1020 20 10
Jan. 1030 30 10

Note: On 1st Nov. Nifty stands at 1000

Arbitrage opportunity exist when ‘basis’ or ‘spread’ is indifferent

If the ‘market spread’< ‘fair spread’; buy the far month contract
and sell the near month contract
If the ‘market spread’> ‘fair spread’; sell the far month contract
and buy the near month contract 137
 Mispricing of Basis and Spreads on
Various Futures contracts
Example…

• Page 89

138
 Bid-Ask on Various Contracts at Time
T1 and Time T2
Example…

• Page 90

139
 Futures on Individual Securities
• Trading stock futures no different from
trading stock itself
• Short sales on security can only be executed
on an up-tick?????
• Do not represent ownership of stock

140
 Contract Specifications for Stock
Futures
• Cash settled on T+1 basis

141
Contract Specifications for Stock
Futures

142
 Long Security, Sell Futures
• Uncomfortable with market movements in
short run
• Minimize the price risk

143
 Bullish Security, Buy Futures
• Leverage the buying

144
Bearish Security, Sell Futures

145
 Overpriced Futures: Buy Spot, Sell
Futures
• Also called cash-and-carry arbitrage
• Arbitrage opportunities arise when futures
price deviate from its fair value
• Sensible if…
• Cost of borrowing funds < arbitrage profit
• Involves trading on spot and futures market, which
requires transaction cost

146
Underpriced Futures: Buy Futures, Sell
Spot
• Also called reverse-cash-and-carry arbitrage
• Arbitrage opportunities arise when futures
price deviate from its fair value
• Sensible if…
• Return from investing in risk free assets < arbitrage
profit
• Involves trading on spot and futures market, which
requires transaction cost

147
 Settlement of Futures Contracts
• Two types of settlement…
• MTM settlement
» Happens at end of each day
• Final settlement
» Happens on the last trading day of the futures contract

148
 Settlement of Futures Contracts
MTM Settlement
• Profit/loss is computed as…
• Contracts executed during the day but not squared up
» Profit/loss = trade price – day’s settlement price
• Brought forward contracts
» Profit/loss = previous day’s settlement price – current da
y’s settlement price
• Contracts executed during the day and squared up
» Profit/loss = buy price – sell price

149
 Settlement of Futures Contracts
MTM Settlement
• CMs responsible to collect and settle daily MTM by
TMs and their clients
• TMs are responsible to collect and pay MTM to their
clients on next day
• Pay-in and Pay-out MTM settlement are effected on
the day following trade day
• Daily settlement price = last ½ hrs weighted average
or closing price of respective futures contract

150
 Settlement of Futures Contracts
MTM Settlement
• If futures contract not traded last ½ hr
theoretical settlement price is computed…
• F=SerT
» F = theoretical futures price
S = value of the underlying index
» r = cost of financing (using continuously compounded
interest rate) or rate of interest (MIBOR)
» T = time till expiration
» e = 2.71828

151
Settlement of Futures Contracts
MTM Settlement

152
 Settlement of Futures Contracts
Final Settlement
• Done after the expiry after the close of trading
hours
• Settled through clearing bank to CMs by
NSCCL
• Final settlement price = last ½ hrs weighted
average or closing price of underlying on the
last trading day of the contract

153
Options

154
 Options
• Call + put
• American + European
• Exchanges traded options are American
• OTC traded options are European
• Right to buy or sell
• Premium to be paid – an up-front fee
• Call option should be always exercised at
expiration date if the stock price is above the
strike price
• Provides insurance

155
 Option Payoff

European European American American

Call Option Put Option Call Put Option
Option
Long Max (ST-K, 0) Max (K-ST, 0)

Short or Write - Max (ST-K, 0) - Max (K-ST, 0)

156
 Using Options
• Due to leverage benefit, option is many time
profitable than buying stock
• Option also rise to a greater potential loss
• Options magnifies the financial
consequences…
• Good outcomes becomes very good
• Bad outcomes becomes very bad

157
 Options
• Right to sell or buy
• Up-front payment = premium = option price
• American vs. European
• Index options = European + American
• Cash settled
• Stock options
• Writer of an option
• Expiration date = exercise date = strike date =
maturity
• Exercise price = strike price

158
 Option
• Right to buy or sell….
• specified quantity of an underlying asset
• at a fixed price (called a strike price or an exercise price)
• at or before the expiration date of the option.
• Holder can choose not to exercise the right and allow
the option to expire.
• Types of options
• Call options (right to buy)
• Put options (right to sell)
• European Option
• American Option

159
 Call Option
• Right to buy the underlying asset at a strike price or K
• Any time prior to the expiration date of the option
• Buyer pays a price for this right
• At expiration,
– If the value of the underlying asset (S) > Strike Price(K)
• Buyer makes the difference: S - K
– If the value of the underlying asset (S) < Strike Price (K)
• Buyer does not exercise
• More generally,
– the value of a call increases as the value of the underlying asset increases
– the value of a call decreases as the value of the underlying asset decreases

160
 Put Option
• Right to sell the underlying asset at a fixed price
• Any time prior to the expiration date of the option
• Buyer pays a price for this right. Net Payoff
on Call
• At expiration,
– If the value of the underlying asset (S) < Strike Price(K)
• Buyer makes the difference: K-S
– If the value of the underlying asset (S) > Strike Price (K)
• Buyer does not exercise
• More generally,
– the value of a put decreases as the value of the underlying asset increases
Strike
– the value of a put increases as the value of the underlying asset decreases
Price

Price of underlying asset

161
 American vs. European Options
• An American option can be exercised at any time prior to its expiration,
while a European option can be exercised only at expiration.
– American options more valuable than European options.
– Time premium associated with the remaining life of an option makes early
exercise sub-optimal.
• While early exercise is generally not optimal, there are two exceptions:
– Underlying asset pays large dividends
– Call options may be exercised just before an ex-dividend date
– Investor holding both the underlying asset and deep in-the-money puts on
that asset, when interest rates are high. The time premium on the put may be
less than the potential gain from exercising the put early and earning interest
on the exercise price.

162
 Options

Call Option Put Option

In-the-money Spot price > strike Spot price < strike
price price
At-the-money Spot price = strike Spot price = strike
price price

Out-of-the- Spot price < strike Spot price > strike

money price price

163
 Options
• Option premium = intrinsic value + time value
• Intrinsic value = amount the option is in-the-
money
• Intrinsic Value
• Call option = Max {0, (St - K)}
• Put Option = Max {0, (K - St)}
• Maximum time value exist on ATM

164
 Index Derivatives
• Derive value from underlying index
• Index futures and index options
• Popular in world wide markets
• Cash settled
• Importance…
• Facilitates portfolio hedging
• Cost-effective measure of managing risk
• Pension funds uses stock index futures
• Helps in hedging any type of portfolio
• Difficulty to manipulate the prices
• Lower capital adequacy and margin requirements

165
 Index Derivatives
• Requirements…
• Well diversified liquid index
• Clearing corporation with settlement guarantee
• Strong surveillance mechanism
• Professional intermediaries

166
 Contract Specification for Index
Options
• Expiry cycles: one month, two months, three months
• Five different strikes
• Given point in time there will be 3x5x2 = 30 options
products
• Contract specification…
• Date-Expiry month – Year – Call / Put – American / European –
Strike
• 28 JUN 2001 1040 CE

167
 Contract Specification for Index
Options
• Each option product has its own order book
and its own prices
• Cash settled
• Expiry on the last Thursday of the month
• Trading is in minimum market lot size of 100
units
• Minimum tick size: 0.05 paise

168
Contract Specification for Index
Options

169
Long Nifty Index
(Payoff Diagram)

170
Short Nifty Index
(Payoff Diagram)

171
Long Nifty Call Option
(Payoff Diagram)

172
Short Nifty Call Option
(Payoff Diagram)

173
Long Nifty Put Option
(Payoff Diagram)

174
Short Nifty Put Option
(Payoff Diagram)

175
 Determinants of Option Value
• Variables Relating to Underlying Asset
• Value of Underlying Asset
• Variance in that value
• Expected dividends on the asset
• Variables Relating to Option
• Strike Price of Options;
– the right to buy (sell) at a fixed price becomes more (less) valuable at a lower
price.
• Life of the Option;
– both calls and puts benefit from a longer life.
• Level of Interest Rates
• as rates increase, the right to buy (sell) at a fixed price in the future
becomes more (less) valuable.

176
 Determinants of Option Value

Factor Call Value Put Value

Increase in Stock Price Increases Decreases
Increase in Strike Price Decreases Increases
Increase in variance of under. asset Increases Increases
Increase in time to expiration Increases Increases
Increase in interest rates Increases Decreases
Increase in dividends paid Decreases Increases

177
Effect on the Price of a Stock Option of Increasing One
Variable While Keeping all Others Fixed

Variable European European American American

Call Put Call Put
Current stock + - + -
price
Strike price - + - +
Time to expiration ? ? + +
Volatility + + + +
Risk-free rate + - + -
Dividends - + - +
178
 Option Pricing
• Price of an option = f{market demand, market
supply}
• Separate order book for each option
• Arbitrage opportunity if; market price of option is
not equal to options theoretical price
• Various option pricing models are the variants of the
‘celebrated’ Black-Scholes model for pricing
European option

179
 Binomial Tree
• is the possible paths that might be followed by the
stock price over the life of the option
• Assumptions…
• No arbitrage opportunities exist
• Set up a portfolio of the stock and option in such a way that there
is no uncertainty about the value of the portfolio at the end of
the three months
• Portfolio earns risk free interest rate, since it has no risk
• Only two securities and two possible outcome
• Portfolio consisting of a long position in Δ shares of
the stock + short position in one call option
• Calculate value of Δ that make the portfolio risk less

180
 Binomial Tree
• Value of portfolio at the end of the life of the option…
• If up movement in stock price = S0uΔ - fu
• If down movement in stock price = S0dΔ – fd
• S0uΔ – fu = S0dΔ – fd
• Δ = (fu – fd) / (S0u - S0d)
» Δ = ratio of change in the option price to the change in the stock price as we move between
nodes
» S0 = stock price
» f = stock option price
» T = option lasts for time T
» During the life of the option…
» Stock price S0 may move up to S0u
» Stock price S0 may move down to S0d
» Where u > 1 and d < 1
» Proportional increase in up movement in stock price is u – 1
» Proportional increase in up movement in stock price is 1- d
» fu = price of option if stock moves up to S 0u
» fd = price of option if stock moves down to S 0d
» Portfolio consisting of a long position in Δ shares of the stock + short position in one option

181
 Binomial Tree
• Present value of the portfolio = (S0uΔ – fu)e-rT
• Cost of setting up the portfolio = S0Δ – f
• That…S0Δ – f = (S0uΔ – fu)e-rT
• f = S0Δ - (S0uΔ – fu)e-rT….. Substitute Δ = (fu – fd) / (S0u - S0d)
• Then f = e-rT[pfu + (1 – p)fd]
• p = (e-rT – d) / (u – d)

182
 Binomial Tree
• Irrelevance of stock’s expected return…
• Does not involve the probabilities of the stock price
moving up or down because the option is not valued in
terms of absolute terms, value is calculated in terms of
the price of the underlying stock
• Probabilities of up or down movements are already
incorporated into the price of the stock

183
 Binomial Tree
S uu 0

S0u
p
fu S0ud
S0
f 1-p S0d
S0dd
fd

S0 =current stock price

Value of Value
S0u = price movement upward
Position of call
S0d = price movement downward
p = probability Stock price = S0u S0u - $B(1+r) Cu

Stock price = S0d S0d - $B(1+r) Cd

= Number of units of the underlying asset bought

 = (Cu – Cd) / (Su – Sd)
Value of call = Current value of underlying asset x Option Delta – Borrowing needed to
184
replicate the option
 Risk Neutral Valuation
• Expected payoff from option
• = pfu + (1 – p)fd
» p = probability of an up movement in the stock price
» 1 - p = probability of an down movement in the stock price
• Value of the option today is its expected future value discounted at risk-
free rate
• Expected stock price at time T is…
• E(ST) = pS0u + (1 - p)S0d
• E(ST) = pS0(u – d) + S0d
• E(ST) = S0ert
» Stock price grows on average at the risk free rate
• Setting the probability of the up movement equal to p is therefore
equivalent to assuming that the return on stock equals the risk-free rate
• p can be defined as the upward movement in the stock price in a risk
neutral world

185
 Risk Neutral Valuation
• All individuals are indifferent to risk
• Investors require no compensation for risk, and the
expected return on all securities is the risk-free
interest rate
• Value of option = expected payoff in a risk neutral
world discounted at risk-free rate
• Risk neutral valuation
• Important option pricing principle
• Assumes an risk neutral world when pricing an option
• Its also correct in a real world as well
• Gives the same answer as no-arbitrage arguments

186
 Two-Step Binomial Trees
• Calculate the option price at the initial node of
the tree
• Option prices at the final nodes of the tree are
easily calculated
• They are the payoffs from the option

187
 Two-Step Binomial Tree
• Initial stock price is S0
• fu = e-rδt[pfuu + (1-p)fud]
• fd = e-rδt[pfud + (1-p)fdd]
• f = e-rδt[pfu + (1-p)fd]
• So there fore the value of option is
• f = e-2rδt[p2fuu + 2p(1- p)fud + (1-p)2 fdd]
• p = risk neutral probability
• P2, 2p(1-p), and (1-p)2 = probabilities that the upper, middle, and
lower final nodes will be reached
• Option price = expected payoff in a risk-neutral world discounted
at the risk-free interest rate

188
Binomial Model and American Options
• Work back through the tree from the end to the
beginning, testing at each node to see whether early
exercise is optimal
• Option value at the final node is the same as for the
European option
• At earlier nodes the values of the option is the
greater of…
• The value given by option
• The payoff from early exercise

189
 Delta
• An important parameter in pricing and hedging of options
• Is the ratio of the change in the price of the stock option to the change in
the price of the underlying stock
• No. of units of stock should hold for each option shorted in order to
create a riskless hedge
• Its same as Δ
• Construction of a riskless hedge is sometimes referred as delta hedging
• Delta of a call option is positive
• Delta of a put option is negative
• In order to maintain a riskless hedge using an option and the underlying
stock, need to adjust holdings in the tock periodically

190
 Matching Volatility with u and d
• Parameters u and d to match the volatility of the
stock price
• Expected return on a stock = μ
• Volatility = σ
• Length of the step = δt
• Stock price moves up (down) by a proportional
amount = u or d
• Probability of an up movement in real world is
assumed to be q

191
 Matching Volatility with u and d
• Expected stock price at the end of the first time step = S0eμδt
• The expected stock price on the binomial tree is..
• qS0u + (1 – q)S0d
• To match the expected return on the stock with the tree’s
parameters, we must therefore have…
• qS0u + (1 – q)S0d = S0eμδt
• q = (eμδt-d)/(u-d)
• σδt = standard deviation of the return on the stock price in a
short period of time of length δt
• Variance of the return is σδt

192
 Matching Volatility with u and d
• Variance of the stock price return is…
• qu2 + (1 – q)d2 – [qu + (1 – q)d]2
• To match the stock price volatility with tree’s
parameters, have
• qu2 + (1 – q)d2 – [qu + (1 – q)d]2 = σ2δt
• We get…
• eμδt(u+d) – ud – e2μδt = σ2δt
• When terms in δt2 and higher powers of δt are ignored, one
solution to this equation is
• u = e σδt
• d = e-σδt

193
 Matching Volatility with u and d
• Probability of a up movement is p, and then behave
as though the world is risk neutral
• p = (e σδt – d) / (u - d)
• It’s the risk neutral probability of an up movement
• Expected stock price at the end of the time step is S0erδt
• The variance of the stock price return is…
• pu2 + (1 - p)d2 – [pu + (1 – p)d]2 = [erδt (u+d) – ud – e2rδt]
• When we move from real world to risk-neutral world the
expected return on the stock changes, but its volatility
remains the same

194
 Binomial Trees in Practice
• Unrealistically simple
• Provides only an rough approximation to an
option price
• Page hull 234

195
 Binomial Model
• Discrete-time model for asset price movements, with a time
interval (t) between price movements.
• The stock can jump to only one of two points in each time
interval, and the option value is estimated iteratively.
• As the time interval is shortened, the limiting distribution, as t
-> 0, can take one of two forms.
– If as t -> 0, price changes become smaller, the limiting distribution is
the normal distribution and the price process is a continuous one.
– If as t->0, price changes remain large, the limiting distribution is the
poisson distribution, i.e., a distribution that allows for price jumps.

196
 Binomial Model
Suu
Su
p
Sud
S
1-p Sd
Sdd

S =current stock price

Su = price movement upward Value of Value
Sd = price movement downward Position of call
p = probability Stock price = Su Su - $B(1+r) Cu

Stock price = Sd Sd - $B(1+r) Cd

= Number of units of the underlying asset bought

 = (Cu – Cd) / (Su – Sd)
Value of call = Current value of underlying asset x Option Delta – Borrowing needed to
197
replicate the option
 Stochastic Process
• Any variable who values changes over time in
uncertain way
• Can be classified as…
• Discrete-time stochastic process
» Value of the variable can change only at certain fixed points in
time
• Continuous-time stochastic process
» Value of the variable can change at any time
• Continuous-variable stochastic process
» Underlying variable can take any value within a certain range
• Discrete-variable stochastic process
» Underlying variable can take one any discrete value

198
Stochastic Process and Stock Prices
• Stock price is assumed to be continuous-
variable, and continuous-time stochastic
process
• In practice stock price is a discrete variable,
and changes can be observed only when the
exchange is open

199
 Markov Property
• Type of stochastic process where only the present value of a
variable is relevant for predicting the future
• Past history of the variable and the way the present have
emerged from the past are irrelevant
• Stock prices are assumed to follow a Markov process
• Predicting for future are uncertain and must be expressed in terms of
probability distributions
• Probability distribution of the price at any time is not dependent on the
particular path followed by the price in the past
• Consistent with the weak form of efficiency
• Present prices of stock price impounds all the information contained in a
record of past prices

200
Continuous-Time Stochastic Processes

• Current value of a variable is 10

• Change in its value during one year is Φ(0, 1)
» Φ(µ, σ) = Φ(0, 1)
» denotes a probability distribution that is normally distributed
with mean µ and standard deviation σ
» Strictly speaking standard deviation of 1 year should be
referred as 1 per square root of years
• Change in two years = sum total of two normal distributions,
each with a mean of 0, and standard deviation of 1
• Two probability distributions are independent
• Resulted normal distribution will have…
» Mean = sum of means, i.e., 0
» Variance = sum of variances, i,e., 2
» Change in variable over two year is = Φ(0, 2 )
201
» Change in variable during six months is = Φ(0, 0.5 )
Continuous-Time Stochastic Processes
• Change during any time period of length T is
• Change during a short time period of length t
is Φ(0, T )
• When Markov process are considered,
Φ(0, δt )
variance of changes in successive time periods
are additive
• Standard deviations of the changes in
successive time periods are not additive

202
 Wiener Processes
• Why uncertainty is often referred to as being
proportional to the square root of time?
• A type of Markov stochastic process with a mean
change of zero and a variance rate of 1 per year
• Also called Brownian Motion
• Used in physics to describe the motion of a particle
that is subject to a large number of small molecular
shocks

203
 Wiener Processes
• Variable z follows Wiener process if it has the following
properties…
– The change z during a small period of time t is
– random drawing from a standardized normal distribution
δz = εΦ(0,δ1)
t
– The values of z for any two different short intervals of time t are
independent
• It follows from the first property that z itself has a normal distribution
with…
» Mean of z = 0
» Standard deviation of z =
» Variance of z = t δt
• Second property implies that z follows Markov process

204
 Wiener Processes
• Increase in value of z during a relatively long period of time T
is denoted by z(T) – z(0)
• Can be regarded as sum of the increase in z in N small time
intervals of length t, where…

T
N=
δt
N
z( T ) z(0) = ∑ ε i δt
i=1

ε i (i = 1,2,3,......, N) are random drawings from Φ(0,1)

From second property of Wiener processes, the ε i is independent of each other
z(T) - z(0) is normally distriobuted with
Mean of [z(T) - z(0)] = 0
Variance of [z(T) - z(0)] = Nδt = T
S tan dard Deviation of [z(T) - z(0)] = T

205
 Wiener Processes
Uncertaini ty about the value of the variable at a certain time in the future
as measured by its standard deviation, increases as the sqaure root of how
for we are looking ahead
In calculus its usual to proceed from small changes to the limit as teh small changes become closer to zero
Thus δy / δx becomes dy / dx in eth limit
Weiner Process is the limit as δt → 0 of the process described above for z
Path followed by z as the limit δt → 0 is approached....
Path is quite ' jagged' , because teh size of a movement in z in time δt is proportion al to δt and, when δt is small
δt is much bigger than δt.

206
 Wiener Processes
• The properties of Weiner processes related to
property are…
• δExpected
t length of the path followed by z in any time
interval, is infinite
• Expected no. of time z equals any particular value in
any time interval is infinite

207
 Generalized Wiener Process
• A generalized Weiner process for a variable x can
be defined in terms of dz as…
• dx = a dt + b dz
» a and b are constants
» a dt = x has an expected drift rate of a per unit of time
– Without b dz the equation is…
• dx = a dt
• (dx/ dt) = a
• Integrating with respect to time, its
• x = x0 + at
» x0 is the value of x at time zero
• In a period of time of length T, the value of x increases by an
amount aT
• b dz = regarded as adding noise or variability to the path
followed by x
208
 Generalized Wiener Process
• Amount of noise or variability is b times a wiener process
• Weiner process has a standard deviation of 1
• b times a weiner process has a standard deviation of b
• In a small time interval t, the change x in the value of x is given by
equation as…

δx = aδt + b δt
• random drawing from a standardized normal distribution
• x has a normal distribution with
• Mean of x = a t
• Standard deviation of change in x =
• Variance of x = b2 t b δt

209
 Generalized Wiener Process
• Change in the value of x in any time interval T
is normally distributed with..
• Mean of change in x = aT
• Standard deviation of change in x =
• Variance of change in x = b2T b T

• Generalized wiener process has an expected

drift rate of a and a variance rate of b2

210
 ItÔ Process
• Is a generalized Wiener process
• Parameters a and b are functions of the value of the underlying variable x
and time t
• ItÔ process can be written as…
• dx = a(x, t)dt + b(x, t)dz
» Expected drift rate and variance rate of an ItÔ process liable to change over time
• In a small interval between t and t+t, the variable changes from x to x+x
, where…

• Assumes that driftδxand=variance

a( x, t )rate
δt of
+ xbremain
( x , t )constant,
ε δt equal to a(x, t)
and b(x,t)2, respectively between t and t+t

211
 Process for Stock Prices
• Its unrealistic to say that stock price follows generalized
wiener process because…
• Expected % return by investors are independent of stock’s price
• Constant expected drift rate
• Constant variance rate
• S = μSt
• In the limit as δt → o
• dS = μSdt or (dS/S) = μdt
• Integrating between time zero and time T…
• ST = S0eμt
» S = stock price at time t
» μS = assumed expected drift rate in S for some constant parameter
μ
» μ = expected rate of return on the stock, expressed in decimal form
» In a short interval of time, t, the expected increase in S is μSt
» S0 and ST are stock price at time Zero and T
» When variance rate is zero, stock price grows at a continuously
compounded arte of μ per unit of time
212
 Process for Stock Prices
• In practice, stock price does exhibit volatility
• Reasonable assumption is…
• Percentage return in a short period of time, t, is the same
regardless of the stock price
» Eg: an investors is just as uncertain of the percentage return
when the stock price is $50 as when it is $10
• Standard deviation of the change in a a short period
of time t should be proportional to the stock price
• The most widely used model (geometric Brownian
motion) of stock price behavior is…
• dS = μSt + Sdz or (dS/S) = μdt + dz
» volatility of stock price
» μ = expected rate of return

213
 Discrete-Time Version Model
• S = change in the stock price S in small time interval t
•  random drawing from a standardized normal distribution (i.e., a
normal distribution with a mean of zero and standard deviation of 1)
•  = expected rate of return per unit of time from the stock
• volatility of the stock price
• and= assumed constant
• S/S) = return provided by the stock in a short period of time t
• t = expected value of return
• stochastic component of the return
• 2t = variance of the stochastic component
• S/S) is normally distributed with mean t and standard deviation

214
 Monte Carlo Simulation
• Procedure for sampling random outcomes for the process
• Path for stock price can be simulated by sampling repeatedly
for from Φ(0,1)
• Samples for should be independent of each other
• Different random sample leads to different price movements
• Any small time interval t can be used in the simulation
• In the limit as t 0, a perfect description of stochastic
process is obtained
• By repeatedly simulating movements in stock price, a
complete probability of the stock price at the end of this time
is obtained

215
 Parameters and
• 
• Is the expected continuously compounded return
earned by an investor per year
• Should depend on risk of return from the stock
• Should also depends on the level of interest rates in the
economy, higher the interest higher the expected
return required
• Value of a derivative dependent on a stock is
independent of 

216
 Parameters and
• 
• Stock price volatility
• Important to the determination of the value of most derivatives
• Typical value of  for a stock are in range of 20% to 50%
• Standard deviation of the proportional change in the stock price in
a small interval of time t is
• Standard deviation of the proportional σchangeδt in the stock price
over a relatively long period of time T is
• Volatility can be interpreted as the standard deviation
σ T of the
change in eth stock price in one year
• Volatility of a stock price is exactly equal to the standard deviation
of the continuously compounded return provided by the stock in
one year

217
 ItÔ’s Lemma
• Stock option price = f(underlying stock’s price, time)
• Price of any derivative is a function of the stochastic
variables underlying the derivatives and time
• Discovered by mathematician Kiyosi ItÔ in 1951
• dx = a(x,t)dt + b(x,t)dz
» dz = Wiener process
» a and b = are functions of x and t
» x = has drift of a and a variance rate of b2

218
 ItÔ’s Lemma
• A function G of x and t follows the process

∂G ∂G 1 ∂ G 2
∂G
dG = ( a+ + b )dt + bdz
2

• dz isthe Wiener ∂ x process

∂t 2∂x ∂x
2

• G follows an ItÔ process has a drift rate

∂G ∂G 1 ∂ G 2

a+ + b 2

∂x ∂t 2 ∂x 2

and the var iance rate of

∂G
( )b
2 2

∂x 219
 ItÔ’s Lemma
• Lemma can be viewed as an extension of well-known results
in differential calculus…
• dS = Sdt + Sdz
•  and  constant, is a reasonable model fo stock price
movements
• From ItÔ’s lemma, it follows that the process followed by a
function G of S and t is …

∂G ∂G 1 ∂ G
2
∂G
dG = ( μS + + σ S )dt +
2 2
σSdz
∂S ∂ t 2 ∂S 2
∂S
• Both S and G are affected by the same underlying sources of
uncertainty, dz. This proves to be very important in eth
derivation of the Black-Scholes results
220
Application of ItÔ’s Lemma in Forward
Contracts
• F0 = S0erT
• r = risk-free rate of interest which is constant and equal to for all
maturities
• F0 = forward price at time zero
• S0 = spot price at time zero
• T = time to maturity of the forward contract
• Relationship between F (forward price) and S (stock
price) at a general time t, with t<T…
• F = Ser(T-t)

221
Application of ItÔ’s Lemma in Forward
Contracts
• ItÔ’s lemma to determine the process for F

∂F
=e r(T - t)

∂S
∂ F
2

=0
∂S 2

∂F
= - rSe r( T - t)

∂t
• dF = [er(T-t)S-rSer(T-t)]dt+er(T-t)Sdz
• Substituting F = Ser(T-t)….
• dF=(-r)F dt + F dz
• Like stock price S the forward price F follows geometric Brownian motion
• F has an growth rate of -r rather than 
• Growth rate in F is the excess return of S over the risk-free rate

222
 Lognormal Property
• Uisng ItÔ’s lemma to derive the process followed by ln S when S
follows the process..,
• G = ln S
• Because..
∂G 1 ∂ G
2
1 ∂G
= , =- , =0
∂S S ∂S 2
S 2
∂t
σ2

dG = (
•  and are constantμ - )dt + σdz
2
• G = ln S follows a generalized Wiener process
• Constant drift rate = m – 2/2
• Constant variance rate = 2
• Change in ln S between time zero and come future time, T, is therefore
normally distributed with…
• Mean = ( - (2/2))T
• Variance = 2T

223
 Lognormal Property
σ2
ln S T - ln S 0 ~ Φ [(μ - )T , σ T ]
2
or
σ2
ln S T ~ Φ [ ln S 0 + (μ - )T , σ T ]
2
ST = stock price at a future time T
S0 = stock price at time zero
m,s) = normal distribution with mean m and standard deviation s
ln ST is normally distributed
• A variable has a lognormal distribution if the natural
logarithm of the variable is normally distributed
• Standard deviation of the logarithm of the stock price is .
σ T
Its proportional to the square root of how far ahead we are
looking

224
 Black-Scholes Model
• By Fischer Black, Myron Scholes, and Robert
Merton
• In early 1970s
• Made a huge influence on the way the traders
price and hedge options
• In 1997 Myron Scholes and Robert Merton
were awarded the noble prize
• Fischer Black died in 1995

225
 Lognormal Property of Stock Prices
• Percentage changes in the stock price in a short
period of time are normally distributed

δS
~ Φ(μδt, σ δt )
 = expected
S return on stock
 = volatility of the stock price
Mean of the percentage change in time t, is t
Standard deviation of the percentage change is
S = change in stock price S in time t σ δt
(,) = denotes a normal distribution with mean m and standard
deviation s

226
Lognormal Property of Stock Prices
σ 2

ln S - ln S ~ Φ[(μ - )T, σ T ]
T 0
2
S σ 2

ln T
~ Φ[(μ - )T, σ T ]
S
0
2
σ 2

ln S ~ Φ[ln S + (μ - )T, σ T ]
T 0
2
» ST = stock price at future time T
» S0 = stock price at time zero
» ln ST is normally distributed
» ST has a lognormal distribution
» Variable that has a lognormal distribution can take any
value between zero and infinity
» Expected value of ST is E(ST) = S0eT
» Var(ST) = S02e2T(e(^2)T-1)

227
 Distribution of the Rate of Return
• Lognormal property of stock prices can be used to
provide information on the probability distribution of
the continuously compounded rate of return earned
on a stock between times zero and T
• ST = S0e
continuously compounded rate of return per annum realized
between times zero and T

1 ST
η= ln
T S0
σ2 σ
η ~ Φ(μ - , )
2 T
» continuously compounded rate of return per annum is normally
distributed with mean 2/2 and standard deviation of

σ
T 228
 Expected Return
• Expected return () required by investors depends on…
• Riskiness of the stock
• Level of interest rates in the economy
• Value of stock option when expressed in terms of the value of
the underlying stock, does not depend on  at all
• t
• Expected % change in the stock price in a very short period of time t
• m is the expected continuously compounded return on the stock over a
relatively long period of time
• Continuously compounded return realized over T years is…
• (1/T)ln(ST/S0)

229
 Expected Return
• E(ST) = S0eT
• Taking logarithms…
• ln[E(ST)] = ln(S0)+T
• So..
• ln[E(ST)] = E[ln(ST)]
• So that…
• E[ln(ST)]-ln(S0) = T or E[ln(ST / S0) = T
• Average returns on the stock in each interval is close to 
•  is close to the arithmetic mean of the Si/Si
• Expected returns over the whole period covered by the data,
expressed with a compounding period of t, is close to 2/2

230
 Volatility
• Measure of uncertainty about the returns provided by the stock
• Stock typically have a volatility between 20% and 50%
• Volatility of a stock price is the standard deviation of the return provided
by eth stock in one year when the return is expressed using continuous
compounding
• When T is small, is approximately equal to the standard deviation of
the percentage changeσ T in eth stock price in time T
• Uncertainty about a future stock price, as measured by its standard
deviation, increases – at least approximately – with the square root of
how far ahead we are looking
• Standard deviation of the stock price in four weeks is approximately twice
the standard deviations in one week

231
 Estimating Volatility from Historical
Data
• Stock price is observed at fixed intervals of time – every day, week, month..
• ui = ln(Si/Si-1)
» N+1: No. of observations
» Si: Stock price at end of ith (i = 0,1,..,n) interval
» length of time interval in years
» for i = 1, 2,…,n

• Standard deviation s of ui is…

1
s= ∑ni=1 ( u i - u) 2
n -1
1 1
s= ∑ni=1 u 2i - ( ∑ni=1 u i ) 2
n -1 n(n - 1)
S tan dard deviation of the u i ' s is σ τ
Variable s is therefore an estimate of σ τ
It follows that σ itself can be estimated as σ̂ , where
s
σ̂ =
τ
S tan dard error of this estimate cen be shown to be approximately σ̂/ 2n 232
 Estimating Volatility from Historical
Data
• Choosing an appropriate value for n is not easy
• More data lead to more accuracy but…
•  does change over time and data that are too old may not be
relevant for predicting the future
• Use closing prices from daily data over the most
recent 90 to 180 days
• Set n equal to the no. of days (trading days should be
used) to which the volatility is to be applied

233
 Concepts Underlying the Black-Scholes-Merton
Differential Equation
• Price of derivative dependent on a non-dividend-paying stock
• No-arbitrage arguments
• Setting up a riskless portfolio consisting of a position in
derivative and a position in stock
• Return from portfolio must be risk-free interest rate r
• Price of derivative is perfectly correlated with the price of the
underlying stock

234
 Concepts Underlying the Black-Scholes-Merton
Differential Equation
• Portfolio at the end of the short period of time is known with certainty
– c = 0.4s
• 0.4 = slope of the line representing the relationship between c and S
• Riskless portfolio would consist of…
» Long position in 0.4 share
» Short position in one call option
• Position in stock and derivative is riskless only for a very short period of
time, to remain riskless, it must be adjusted, or rebalanced, frequently
• Return from riskless portfolio in any very short period of time must be
risk-free interest rate

235
 Black-Scholes Formulae
Basic Principles and Underlying Intuition

• Disproves that expected growth of underlying ought to affect

the option price
• It tells what’s good and what’s not
• Prices option within the framework of assumptions
• Uses well know simple equation – Geometric Brownian
Motion, which implies….
• Stock returns are lognormal distribution
• Two variables are allowed to change; time and underlying stock price
• Other factors are not allowed to change; volatility, exercise price, risk free
rate

236
 Black-Scholes Formulae
Basic Principles and Underlying Intuition

• Delta Hedging…
• Portfolio of ‘long stock + short calls’ eliminates stock’s
risk
• Setting the ‘No. of shares of stock = Approx. change in
call price for a change in stock price’
• Its requires continues revising

237
 Black-Scholes Formulae
Basic Principles and Underlying Intuition

• Uses stochastic calculus, which defines…

• Δ option price = f{Δ stock price, Δ time to expiration}
• Using partial differential equation defines….
• Hedged combination of options and stock should grow in value at
the risk-free rate
• Solution found through ‘boundary condition’ on the
model; option price converge to the exercise value at
expiration

238
 Black-Scholes Model
• By Fischer Black and Myron Scholes
• Applies when the limiting distribution is the
normal distribution

239
 Assumptions of Black-Scholes Model
• Time is continuous, requires continuous compounding
• Price process is continuous
• Stock price follows the process with  and  constant
• Price changes become smaller as time period gets shorter
• No jumps in asset prices
• Value European options
• Dividend-protected
• Option price does not affect the value of the underlying asset
• Short selling of securities with full use of proceeds is
permitted

240
 Assumptions of Black-Scholes Model
• No transaction costs
• No taxes
• All securities are perfectly divisible
• There no dividend during the life of the derivative
• No riskless arbitrage opportunities
• Security trading is continuous
• Risk free rate r is constant and the same for all maturities
•  and r can be a known function of t

241
 Derivation of the Black-Scholes-
Merton Differential Equation

dS = μSdt + σSdz
∂f ∂ f 1 ∂ 2f 2 2 ∂f
df = ( μS + + 2
σ S )dt + σSdz
∂S ∂t 2 ∂S ∂S
f = price of a call option or other derivative contingent on S
Variable f must be some function of S and t
δ S = μS δ t + σ S δ z
∂f ∂ f 1 ∂ 2f 2 2 ∂f
δf = ( μS + + 2
σ S )δt + σSδ z
∂S ∂t 2 ∂S ∂S
δS and δf are the cahneg in S and f in a small time interval δt
Wiener process underlying the S and f are the same 242
 Derivation of the Black-Scholes-Merton
Differential Equation
Appropriat e portfolio is...
- 1 : derivative
∂f
+ : shares
∂S
Holder of this portfolio is short one derivative and long an amount ∂ f/∂ S of shares
∂f
∏ = -f + S
∂S
∏ = value of portfolio
Change δ ∏ in the value of teh portfolio in teh tiem interval δt is given by
∂f
δ ∏ = - δf + δS
∂S
∂ f 1 ∂ 2f 2 2
δ∏ = ( - σ S )δt
∂ t 2 ∂ S2
Equation does not involve δz, portfolio must be riskless during time δt
Portfolio must instantaneously earn the saem rate of return as otehr short - term risk - free securities
δ ∏ = r ∏ δt
r = risk - free interest rate
243
 Derivation of the Black-Scholes-Merton
Differential Equation
∂ f 1 ∂ 2f 2 2 ∂f
( + 2
σ S )δ t = r ( f - S)δt
∂t 2 ∂S ∂S
∂f ∂ f 1 2 2 ∂2 f
+ rS + σ S 2
= rf
∂t ∂S 2 ∂S
is the Black - Scholes - Merton differenti al equation
depends on the boundary conditions that are used
In European call option, the key boundary condition is...
f = max(S - K, 0) when t = T
In European call option, the key boundary condition is...
f = max(K - S, 0) when t = T
As S and t change, ∂ f / ∂ S also changes
To keep teh portfolio riskless, it is therefore necessary to frequently
change the relative proportion s of teh derivative s and teh stock in the portfolio
244
 Derivation of the Black-Scholes-Merton
Differential Equation on Forward Contract

f = S - Ke -r(T- t)
2
∂f ∂f ∂ f
= - rKe -r(T - t) , =1 , =0
∂t ∂S ∂ S2
rKe - r(T - t) + rS
f = value of forward contract
t = time
S = stock price
245
 Prices of Tradeable Derivatives

2
e (σ - 2r)(T - t)

S
The price of a tradeable security is the derivative that paysoff 1/S T at time T

246
Risk-Neutral Valuation

247
 Black-Scholes Model
Non-Dividend Paying Stock

Value of call = S N (d1) - K e-rt N(d2)

Value of put = K e-rt (1-N(d2)) – S e-yt (1-N (d1))
S = Current value of the underlying asset S σ2 t
K = Strike price of the option ln + (r + )
t = Life to expiration of the option measured in years K 2
r = Riskless interest rate corresponding to the life of the d1 =
option, should be continues compounding, eg: 12% = σ t
ln(1.12)=0.1133
σ2 = Variance in the ln(value) of the underlying asset, d2 = d1 - σ √t
annualized SD of continuously compounded returns on
underlying
σ2annual = σ2daily x square root of no. trading days per year
N( ) = cumulative normal distribution
N(d1) = delta of option, measures the change in price of
the option with respect to change in the price of the
underlying asset
N(d1) and N(d2) = probabilities estimated by using
cumulative standardized normal distribution
248
Option delta = number of units of the underlying asset that are needed to create the replicating Portfolio
 Black-Scholes Model
(Adjusted for Dividends)

C = S e-yt N(d1) - K e-rt N(d2) S  2

ln + (r - y + )t
d1 = K 2
 t

d2 = d1 - σ √t

Dividend yield (y = dividends/ Current value of the asset) of the

underlying asset is expected to remain unchanged during the life
of the option
Adjustments:
Value of the asset is discounted back to the present at the dividend yield to take into
account the expected drop in asset value
Interest rate is offset by the dividend yield to reflect the lower carrying cost from holding
the asset
Other dividend adjustment options
Estimate the pv of expected dividend and subtract it from the current value of the asset 249
to use as S in the model
250
 Pricing Index Options
• Valued in the same way like security option
• On smooth dividend payments, replace.. K with Ke-yt
• Assumptions
• Costless purchase at exact amount necessary to replicate index
• Stocks are infinitely divisible
• Index follows diffusion process
• Continuously compounded returns distribution of the index in
normally distributed

251
 Pricing Index Options
Example…

• Page 101

252
 Black-Scholes Option Pricing Model to
Price American Option
• Its never optimal to exercise a call option on a non-dividend paying stock
before expiration??????
• Its easy to use the formula, since it looks like an European option
• If dividend expected..some time its optimal to exercise the option just
before ex-dividend
• Two exercise possibilities…
– Just before ex-dividend date
• Like short-term option
• Required adjustment in the model
– Assume that the option will be exercised just before ex-dividend date, use unadjusted
stock price in the model
– Shorten the time of expiry to time of ex-dividend date
– At expiration of the contract
• Like longer-term option
• Required adjustment in the model….
– Deduct the pv of dividends from the stock price
– Option value = highest of the two valuation

253
Black-Scholes Option Pricing Model to
Price American Option
Example…

• Page 103

254
 Issues in Option Valuation
• Early exercise
• Use unadjusted BS model; regard the value as a floor or
conservative estimate of the true value
• Value the option to each potential exercise date –
choose the maximum of the estimated call values
• Use a modified version of the binomial model to
consider the possibility of early exercise
• Dilution

255
 Put-Call Parity
• Deriving value of put from a value of call with same
strike price and expiration date
• C – P = S – Ke-rt
• Deviation in parity creates arbitrage
Position Payoffs at ‘t’ if Payoffs at ‘t’ if
S* > K S* < K
Sell call -(S*-K) 0
Buy put 0 K-S*
Buy stock S* S*
Total K K 256
 Value of Put Option
Value of put = K e-rt (1-N(d2)) – S e-yt (1-N (d1))
 S 2
ln  + (r - y + )t
K 2
d1 = 
 t
d2 = d1 - σ √t
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
σ2 = Variance in the ln(value) of the underlying asset
N(d1) and N(d2) = probabilities estimated by using cumulative standardized normal distributio

257
 Black-Scholes Model
Value of call = S N (d1) - K e-rt N(d2)

S  2
ln + (r + )t
K  2
d1 =
 t
d2 = d1 - σ √t
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
σ2 = Variance in the ln(value) of the underlying asset
N(d1) and N(d2) = probabilities estimated by using cumulative standardized normal distribu

Option delta = number of units of the underlying asset that are needed to create the replicating
258
Portfolio
 Using Index Options
• Hedging
• Have portfolio: buy puts
• Speculation
• Bullish index: buy Nifty calls or sell Nifty puts
• Bearish index: sell Nifty calls or buy Nifty puts
• Anticipate volatility: buy a call and a put at same strike
• Bull spreads: buy a call and sell another
• Bear spreads: sell a call and buy another
• Arbitrage
• Put-call parity with spot-options arbitrage
• Arbitrage beyond option price bounds

259
 Have Portfolio: Buy Puts
• Used when short term prices are expected to fall
• It insures the potential drop in the market due to any
negative information to the market
• Right no. of puts with right price
• Generally used by mutual funds
• No. of put to buy = (portfolio value x portfolio beta) /
Index
• Protective puts with required expiration and strikes
are often not available in the market

260
Gamma Effect

261
 Bullish Index: Buy Nifty Calls or Sell
Nifty Puts
• Used when short term prices are expected to increase
• It supports to bet on the potential increase in the market due
to any positive information to the market
• Right no. of calls or puts with right price has to be selected
• Selection of put are call will be based on…
• How strongly feel about the market movement
• How much you are willing to loose
• Also sell or write put
• Has limited upside and unlimited downside
• Can earn only the premium

262
 Bullish Index: Buy Nifty Calls or Sell
Nifty Puts
Example…

Nifty Strike Price Call Premium Put Premium Remarks Remarks

of Option (Rs.) (Rs.) (Call) (Put)
1250 1200 80.10 18.15 In-the-money Out-of-the-money
1250 1225 63.65 26.50 In-the-money Out-of-the-money
1250 1250 49.45 37.00 At-the-money At-the-money
1250 1275 37.50 49.80 Out-of-the-money In-the-money
1250 1300 27.50 64.80 Out-of-the-money In-the-money
Risk free rate = 12% p.a. Index volatility = 30%

What call to buy? What put to sell?

263
Bullish Index: Buy Nifty Calls Example…

264
Bullish Index: Sell Nifty Puts
Example…

265
 Bearish Index: Sell Nifty Calls or Buy
Nifty Puts
• Used when short term prices are expected to decrease
• It supports to bet on the potential decrease in the market due
to any negative information to the market
• Right no. of calls or puts with right price has to be selected
• Selection of put are call will be based on…
• How strongly feel about the market movement
• How much you are willing to loose
• Also sell or write calls
• Has limited upside and unlimited downside
• Can earn only the premium

266
 Bearish Index: Sell Nifty Calls or Buy
Nifty Puts
Example…

Nifty Strike Price Call Premium Put Premium Remarks Remarks

of Option (Rs.) (Rs.) (Call) (Put)
1250 1200 80.10 18.15 In-the-money Out-of-the-money
1250 1225 63.65 26.50 In-the-money Out-of-the-money
1250 1250 49.45 37.00 At-the-money At-the-money
1250 1275 37.50 49.80 Out-of-the-money In-the-money
1250 1300 27.50 64.80 Out-of-the-money In-the-money
Risk free rate = 12% p.a. Index volatility = 30%

What call to sell? What put to buy?

267
Bearish Index: Sell Nifty Calls
Example…

268
Bearish Index: Buy Nifty Puts
Example…

269
 Anticipate Volatility: Buy a Call and a
Put
• Expecting a market swing but not aware of the
direction of swing
• Combination of call and put
• Also called ‘Straddle’
• Buy call and put at ‘same strike price’
• Note: Investors beliefs about the market movement
should be different from the other market
participants, if market believes the same way then
this reflect in the prices of the options

270
 Anticipate Volatility: Buy a Call and a
Put
Example…
Call and put have same strike and expiration
Current index value: 1252
Profit Strike price: 1250
Time: 3 months
Call price: Rs.95.00
Put price: Rs. 57.00

1345
1193
1098 1402
1250

57.00 Nifty
95.00

152.00

On expiration if index closes between 1098 and 1402; loss: Rs. 152.00
Loss
271
 Straddle
Payoff

Range of Payoff from Payoff from Total Payoff

Stock Call Put
Price
ST < K 0 K – ST K – ST
ST > K ST – K 0 ST – K

272
 Strip
• Consists of a long position in one call and two
puts with the same strike price and expiration
date
• Investors is betting that there will be a big
stock price move and considers a decrease in
the stock price to be more likely than an
increase

273
 Strip
Profit Pattern

Profit

ST

274
 Strap
• Consists of a long position in two calls and one
put with the same strike price and expiration
date
• Investors is betting that there will be a big
stock price move, an increase in the stock
price is considered to be more likely than a
decrease

275
 Strap
Profit Pattern

Profit

ST

276
 Strangle
• Also called bottom vertical combination
• Investor buys a put and a call with the same expiration date
and different strike prices
• Call strike price (K2) > put strike price (K1)
• Investor is betting that there will be a large price move, but is
uncertain whether it will be an increase or a decrease
• Stock price has to move farther in a strangle than in a straddle
for the investor to make a profit
• Downside risk if the stock price ends up at a central value is
less with a strangle

277
 Strangle
• Profit depends on how close together the strike
prices are. Farther they are apart, the less the
downside risk and the farther the stock price has to
move for a profit to be realized
• Sale of strangle sometime refer as a ‘top vertical
combination’
• Appropriate for an investor who feels that large
stock price moves are unlikely
• A risky strategy involving unlimited potential loss to
the investor

278
 Strangle
Payoff

Range of Payoff Payoff Total

Stock Price from Call from Put Payoff
ST < K1 0 K1- ST K1- ST
K1 < ST < K2 0 0 0
ST > K2 ST - K2 0 ST - K2

279
 Strangle

Profit

K1 K2

ST

280
 Trading Strategies Involving Options
• Writing a covered call
• Long position in a stock + short position in a call option
• Protective put strategy
• Buying a put option + stock itself
• [Long position in a put + long position in the stock] =
[long call position + certain amount (=Ke-rT + D) of
cash
• [long position in a stock + short position in a call] =
[short put position + certain amount (=Ke-rT + D) of
cash

281
 Long Position in a Stock + Short
Position in a Call

Profit

K ST

282
Short Position in a Stock Combined with
Long Position in a Call

Profit
Long call

ST

Short stock
283
Long Position in a Put + Long Position in a
Stock

Profit Long stock

ST

Long Put

284
Short Position in a Put + Short Position in a
Stock
Profit

K ST

285
 Bull Spreads: Buy a Call and Sell
another
• Expecting the market to increase, but limiting the downside, if
market not increasing
• Spread is taking a position in two or more options of the same
type
• Bull spread: profits if the price go up
• Two calls with same expiration dates but different strike price
• Buying call with strike price below current level
• Selling a call with the strike price above current level
• Requires initial investment
• Limits the trader’s risk and also limits the potential profit

286
 Bull Spreads: Buy a Call and Sell
another
• Cost of bull spread = cost of option bought – cost of option
sold
• Value of option sold < value of option bought
• Types of bull spread…
• Both calls initially out of the money – very aggressive but costs very
less –most aggressive type
• One call initially in-the-money and one call initially out-of-the-money
• Both calls initially in-the-money – more conservative
• Selection of any one spread from above spread is based on how much
you are willing to loose
• Cost of setting spread = call premium received – call
premium paid
• Can be also created by buying a put with low strike price
and selling a put with high strike price 287
 Bull Spreads: Buy a Call and Sell
another
Example… Call and put have same strike and expiration
but different strike
Profit
Current index value: 1252
Strike price: 1260, and 1350
51.35 Time: 3 months
1298.65 Buy call price: Rs.76.50
1350
Sell call price: Rs. 37.85
37.85
1387.85 Cost of setting spread =
1260 76.50 – 37.85 = 38.65
0
Nifty
1336.50

38.65
Max. loss = 38.65
Max profit: 51.35
76.50
Payoff obtained is the sum off the two payoffs, payoff lies between –38.85 to 51.35
Profit is made when index moves above 1260
Loss Beyond 1350 any profit made on long call will be cancelled by losses on short call
288
 Bull Spread: Buy a Put and Sell Put
Profit

K1
K2 ST

289
 Bull Spreads: Buy a Call and Sell another
Payoff

Stock Price Payoff from Long Payoff from Short Total

Range Call Option Call Option Payoff
S T > K2 ST – K1 K2 – S T K2 – K 1

K1 < S T < K 2 ST – K1 0 ST – K 1

S T < K1 0 0 0

K1 = strike price of call option bought

K2 = strike price of call option sold

290
 Bull Spreads: Buy a Call and Sell
another
Example

• Page 127

291
 Bear Spread: Sell a Call and Buy
Another
• Expecting the market to decrease, but limiting the downside,
if market not decreasing
• Bear spread: profits if the price falls down
• Two calls same expiration dates but different strike price
• Buying call with strike price above current level
• Selling a call with the strike price below current level
• Strike price of option purchased > strike price of option sold
• Price of call sold > price of call purchased
• Limits the trader’s risk and also limits the potential profit

292
 Bear Spread: Sell a Call and Buy
Another
• Cost of bear spread = cost of option bought – cost of
option sold
• Types of bear spread…
• Both calls initially out of the money – very aggressive but costs very
less
• One call initially in-the-money and one call initially out-of-the-money
• Both calls initially in-the-money
– Selection of any one spread from above spread is based on how much you are
willing to loose
• Can be also created by buying a put with a high strike
price and selling a put with a low strike price, this requires
an initial investment
• Limits the investor’s upside as well as downside risk

293
 Bear Spread: Sell a Call and Buy
Another
Example… Call and put have same strike and expiration
but different strike
Current index value: 1252
Profit
Strike price: 1350, and 1260
Time: 3 months
76.50 Buy call price: Rs.37.85
Sell call price: Rs. 76.50
Cost of setting spread =
38.65 76.50 – 37.85 = 38.65
1350

1260 1298.65 1336.50 1387.85

0
Nifty
Max. loss = 51.35
37.85 Max profit: 38.65
51.35

Loss Payoff obtained is the sum off the two payoffs, payoff lies between –38.85 to 51.35
Profit is made when index moves above 1260
Beyond 1350 any profit made on long call will be cancelled by losses on short call 294
Bear Spreads: Buy Put and Sell Put
Example…

Profit

K1 K2
ST

295
 Bear Spread: Sell a Call and Buy
Another
Example…

• Page 131

296
Bear Spread: Sell a Call and Buy Another
Payoff

Stock Price Payoff from Long Payoff from Short Total

Range Call Option Call Option Payoff
ST > K2 S T – K2 K1 – S T -(K2 – K1)

K1 < S T < K 2 0 K1 – S T -(ST – K1)

ST < K1 0 0 0

Strike prices are K1 and K2, with K1<K2

297
 Butterfly Spreads
• Involves positions in options with three
different strike prices
• Can be created by…
• Buying a call option with a relatively low strike price K1
• Buying a call option with a relatively high strike price K3
• Selling two call options with a strike price K2, half way
between K1 and K3
• Generally K2, is close to the current stock price

298
 Butterfly Spreads
• Leads to a profit if the stock prices stay close
to K2, but gives rise to a small loss if there is a
significant stock price move in either direction
• Appropriate if investor feels that large stock
price moves are unlikely
• Requires a small investment initially

299
 Butterfly Spreads
• Can be created using put options
• Buy a put with a low strike price, buy a put
with a high strike price, and sell two puts with
an intermediate strike price
• Use of put options results in exactly the same
spread a steh use of call options

300
 Butterfly Spreads
Payoff

Stock Price Payoff from Payoff from Payoff Total

Range First Long Second Long from Payoff
Call Call Short Calls
S T < K1 0 0 0 0
K1 < S T < K 2 ST - K1 0 0 ST – K1

K2 < S T < K 3 ST – K1 0 -2(ST – K2) K3 – ST

S T > K3 ST - K1 ST – K3 -2(ST – K2) 0

The payoffs are calculated using the relationship K 2 = 0.5(K1 + K3)

301
Butterfly Spread using Call Options

Profit

K1
K2 K3

ST

302
Butterfly Spread using Put Options

Profit

K1
K2 K3

ST

303
 Calendar Spreads
• Options have same strike price and different expiration dates
• Created by…
• Selling a call option with a certain strike price +
• Buying a longer maturity call option with the same strike price
• Longer the maturity of an option, more expensive it usually is
• Usually requires an initial investment
• Investor makes a profit if the stock price at the expiration of the
short-maturity options is close to the strike price of the short-
maturity option
• Loss is incurred when the stock price is significantly above or
below the strike price

304
 Calendar Spreads

• If stock price is very low when the short maturity

option expires….
• Short-maturity option is worthless
• Value of long maturity option is close to zero
• Incurs a loss that is close ot the cost of setting up the spread
initially
• Can be created with put options as well as call
options
• Investor buys a long-maturity put option and sells a short-maturity
put option
• Profit is similar to that obtained from using calls

305
 Calendar Spreads
• Reverse calendar spread
• Investor buys a short maturity option and sells a long-
maturity option
• Small profit arises is the stock price at the expiration of
the short-maturity option is well above or well below
the strike price of the short maturity option
• Significant loss results if it is close to the strike price

306
Calendar Spread Created Using Two
Calls
Profit

K ST

307
Calendar Spread Created Using Two
Calls
Profit

K ST

308
 Diagonal Spread
• Both the expiration date and the strike price
of the calls are different
• Increases the range of profit patterns that are
possible

309
 Put-Call Parity
• Two portfolios
• Portfolio A: one European call option + an amount of cash equal to
Ke-rT
• Portfolio B: one European put option + one share
» Both are worth max (ST, K) at expiration of options
» Portfolio must have identical values today
» c + Ke-rT = p + S0
• Value of a European call with a certain exercise price and exercise
date can be deducted from the value of a European put with the
same exercise price and exercise date, and vice versa
• Put-call parity on American options
» S0 – K < C – P < S0 – Ke-rT

310
 Put-Call Parity
• Put and call prices are related by put-call parity
condition
• Buy an asset on spot, paying S
• Buy a put at X, paying P, so downside below X is
taken care of (if S<X, exercise the put)
• Sell a call at X, earning C, so if S>X, counterpart will
exercise, upside beyond X is gone

311
 Put-Call Parity
• Portfolio S+P-C = Zero-coupon bond which pays X on date T
• S+P-C = X / (1+r)T
• S = Current index level
• X = Exercise price of option
• T = Time of expiration
• C = Price of call option
• P = Price of put option
• r = risk-free rate of interest
• The value of European call with a certain exercise price and
exercise date can be deducted from the value of a European
put with the same exercise price and date and vice versa

312
 Put-Call Parity
• Payoff from holding a call plus an amount of
cash equal to X/(1+r)T is the same as that of
holding a put option plus the index

313
 Put-Call Parity Violation
Example

• Page 133

314
 Put-Call Parity Violation
Example

• Page 134

315
Upper and Lower Bounds for Option
Prices
• Upper bounds on an American or European call
option
• Option can never be worth more than the stock
• Stock price is an upper bound to the option price
• C<S0
• Upper bounds on an American or European put
option
• Option can never be worth more than K
• P<K
• At maturity the option cannot be worth more than K
• It cannot be worth more than the present value of K
• P = Ke-rT

316
 Upper and Lower Bounds for Option
Prices
• Lower bounds on an European call option on a
non-dividend-paying stock
• S0 – Ke-rT
• Lower bounds on an European put option on a
non-dividend-paying stock
• Ke-rT – S0

317
 Beyond Option Price Bounds
• Factors affecting the option value set general
boundaries for possible option prices
• Arbitrage possibility if…
• Option price < lower bound
• Option price > upper bound
• Upper bounds for calls and puts
• Call option price < Index
• Put option price < Strike price
• Lower bounds for calls and puts
• S-K(1+r)-T<C
• K(1+r)-T-S<P

318
 Beyond Option Price Bounds
Example…

• Page 135

319
 Using Stock Options
• Hedge an open position in the stock
• Speculate on the underlying stock price as
well as underlying stock volatility

320
 Having Stock, Buy Puts
• Simplest was to hedge
• Limited downside and unlimited upside
• Enable to take leveraged position on stock

321
Bullish Stock, Buy Calls or Sell Puts
• Losses = strike price – (spot price + premium)
• Limited upside and an unlimited downside

322
Bearish Stock, Buy Puts or Sell Calls

323
 Combination Positions using Stock
Futures and Stock Options
• Hedge or speculative position using
combination of option and futures
• Types…
• Long stock futures + long at-the-money stock put
• Long stock futures + long at-the-money nifty put + long
out-of-the-money stock put

324
 Long Stock Futures + Long At-The-
Money Stock Put
• Limited downside, unlimited upside
• If security price moves up: long futures makes money
• If security price moves down: long put goes in-the-
money
• Profits on put are offset by losses on long futures
• It’s a synthetic call
• Used when at-the-money puts are underpriced

325
Long Stock Futures + Long At-The-Money Nifty Put + Long
Out-of-The-Money Stock Put

• Long stock futures…

• Gives exposure to security
• If security price goes up, generates profits
• ATM Nifty put
• Hedges away index exposure
• OTM stock put
• Limits overall loss on the combination
• If security price falls below strike of OTM security
put, any losses on long futures position will be
offset by the profits on the long put position

326
Early Exercise of Calls on Non-Dividend
Paying Stock
• Reasons for buying calls on non-dividend paying
stock…
• Acquire the underlying stock and hold it beyond the life of the
option
• Acquire the stock and sell it off if/when it is overpriced
• Never optimal to exercise a call option on a non-
dividend paying stock before expiration date…
• Exercise at maturity, earn interest on the cash for that period
• Exercising on maturity may bring down the stock price further
• Exercising option get you only intrinsic value, but by selling the
option you also gain time value

327
Early Exercise of Puts on Non-Dividend
Paying Stock

328
Early Exercise of Calls on Dividend
Paying Stock

329
Early Exercise of Puts on Dividend
Paying Stock

330
 Implied Volatility
• Estimated future volatility
• Methods of estimation…
• Predicting future movement of underlying using the historical
volatility over a certain period
• Entering all parameters into an option pricing model and then
solving for volatility
• It’s a market estimate of how volatile the underlying
will be from the present until the option’s expiration
• It can be biased due to thinly traded options in the
market

331
 Order Types and Conditions
• Time conditions
• Day order
• Good till cancelled (GTC) order
• Good till days/date (GTD) order
• Immediate or cancel (IOC) order
• Price conditions
• Stop-loss order
• Other conditions
• Market price order
• Trigger price order
• Limit price order
• Pro order
• Cli order

332
 Placing Orders on the Trading System
• Identify order as proprietary or client order
• Open interest in futures
• Total number of outstanding contracts (long/short) at
point in time
• Good indicator of liquidity in every contract
• Is maximum in near month equity contracts

333
 Market Spread / Combination Order
Entry
• Enables to enter or two or three orders
simultaneously into the market
• Conditional orders
• They will be traded only if they find a countermarch
for the whole batch of orders
• Facilitates spread and combination trading strategies
• Basket trading…
• System automatically works out the quantity of each security to
be bought or sold in proportion to their weights in the portfolio

334
 Contract Specifications for Stock Options

• Are American style

• Minimum of 5 strike prices for every option
type

335
Contract Specifications for Stock Options

336
 Criteria for Stock Eligible for Options
Trading
• Should be amongst top 200 scrip on basis of average daily volume
• Average market capitalization during last 6 months
• Average free float market capitalization should not be less than Rs.750
crore
• Non-promoter holding in the company should be at least 30%
• Average daily volume should not be less than Rs.5 crore in the underlying
cash market
• Should be traded on atleast 90% of the trading days in the last 6 months
• Ratio of the daily volatility of the stock vis-à-vis the daily volatility of the
index should not be more than 4, at any time during the previous six
months

337
 Charges
• Max. brokerage chargeable by a trading member…
• Index futures and stock futures: 2.5% of the contract value
• Index options and stock options: 2.5% of notional value of the
contract [(strike price + premium)*quantity] exclusive of statutory
levies
• Transaction charges payable by trading member for
the trades executed by him…
• Rs. 2 per lakh of turnover (0.002%)subject to
minimum of Rs. 1,00,000 per year

338
 Charges
• Transactions on the options sub-segment the
transaction charges are levied on premium value at
the rate of 0.05% (each side) instead of on strike
price as levied earlier
• Trading members contribute Rs. 10 per crore of
turnover (0.0001%) to investor protection fund
• Trading members are advised to charge brokerage
from their client on the premium price (traded price)
rather than strike price

339
 Clearing Entities
• Clearing members
• Self clearing members
» Clear and settle own trades and trades of the clients
• Trading member-cum-clearing member
» Clear and settle trades of own trades and trades of TM
• Professional clearing members
» Clear and settle trades of TMs

• Clearing banks

340
 Clearing Mechanism
• Exposure and daily margin is based on open position
and obligations of CMs
• CMs open position = TMs open position + Custodial
participants open position
• TMs open position = proprietary open position +
clients open long positions + clients open short
position
• Proprietary position = net basis (buy-sell) for each contract
• Clients position = sum of net (buy-sell) positions of each individual
client

341
Clearing Mechanism

342
Clearing Mechanism

343
Clearing Mechanism

344
 Settlement of Options Contracts
• Types of settlement…
• Daily premium settlement
• Exercise settlement
• Interim exercise settlement

345
 Settlement of Options Contracts
Daily Premium Settlement
• Net premium payable or receivable amount
for each client for each option contract =
premium payable amount – premium
receivable amount

346
 Settlement of Options Contracts
Exercise Settlement
• Always a possibility an option seller being
assigned an exercise
• Once assigned option seller is bound to fulfill
his obligation even though he may not yet
have been notified of the assignment

347
 Settlement of Options Contracts
Interim Exercise Settlement
• Only for option contracts on securities (American
options)
• Investors can exercise his ATM options any time
during trading hours through TMs
• Settlement is effected at the close of the trading
hours, on the day of exercise
• Valid exercised options are assigned to short
positions in the option contract with the same series,
on random basis, at the client level

348
 Settlement of Options Contracts
Final Exercise Settlement
• Effected for all open long ATM options
existing at the close of trading hours on the
last trading day
• Are exercised and automatically assigned to
short positions on random basis

349
 Settlement of Options Contracts
Exercise Process
• On ATM options on the last trading day the exercise
is automatic
• On interim exercise, buyer must direct through the
TM to exercise option before the cut-off time for
accepting exercise instruction for that day
• Different TMs have different cut-off time
• Once an exercise instruction is given from CM to
NSCCL it cannot be ordinarily revoked

350
 Settlement of Options Contracts
Exercise Process
• Exercises notices given by buyers are
processed (for validity) by NSCCL after the
close of trading hours on that day
• Validity checks are done for…
• Open by position of the exercising client/TM
• If option contract is in-the-money
• Only valid contracts are assigned

351
 Settlement of Options Contracts
Assignment Process
• Assigned in standardized market lot at the
client level
• Are made at the end of trading the day
• Possible that an option seller may not receive
notification from TMs that an exercise has
been assigned until the next day following the
date of assignment to CM by NSCCL

352
 Settlement of Options Contracts
Exercise Settlement Computation
• Exercise settlement price = closing price of the
underlying on the exercise day or the expiry day
• Settlement value….
• Call option; settlement value = closing price of the underlying on
the day of exercise – strike price
• Put option; settlement value = strike price - closing price of the
underlying on the day of exercise
• Exercise settlement by NSCCL done on 3rd day
following the day of exercise
• Members may ask for the clients who have been
assigned to pay the exercise settlement earlier

353
 Settlement of Options Contracts
Special Facility for Settlement of Institutional Deals

• Institutions / FIIs / MFs can execute trade through

any TMs cleared by won CMs called custodial
participants
• CP is required to register with NSCCL through his CM
• A unique CP code is allotted by NSCCL
• Trading is done using CP code
• FIIs can trade in all derivatives after complying…
• Position limits
• Prescribed procedures for settlement and reporting

354
 Risk Management
• Stringent capital adequacy (net worth, security
deposits) for members
• Upfront initial margin for all open position of CM
• NSCCL daily specifies the initial margin for CMs
• VaR based margin through SPAN
• CM in turn collects initial margin from TMs and their
respective clients
• MTM based on contracts settlement price for each
contract
• Difference in MTM is settled in cash on a T+1 basis

355
 Risk Management
• On-line position monitoring system
• Limits for each CM based on capital deposits
• Generating alerts when position limit is
reached
• Monitoring for MTM value violations
• TMs are monitored for contract-wise position
limit violations

356
 Risk Management
• CMs are provided terminal to monitor the position
limits of TMs
• CM may set a exposure limits to TMs
• When ever a TM exceeds limits, it stops that
particular TM for further trading
• Members are alerted to adjust exposure limit or
bring in additional capital
• Position violations result in withdrawal of trading
facility for all TMs of a CM in case a violation by the
CM

357
 Risk Management
• Separate settlement guarantee fund created out of
the capital of members
• Actual position monitoring and margining system is
carried out online through ‘Parallel Risk
Management System’ (PRISM)
• PRISM use SPAN for computing on-line margins,
based on parameters defined by SEBI

358
 NSE-SPAN
• Identifies overall risk in a portfolio of all
futures and options contracts for each
member
• It treats…
• Futures and option contracts uniformly
• Recognizes the unique exposure associated with option
portfolio, like deeply OTM short positions and inter-
month risk

359
 NSE-SPAN
• Measures the largest loss that a portfolio might reasonably be
expected to suffer from one day to the next day based on
99% VaR methodology
• Considers uniqueness of option portfolios
• Constructs scenarios of probable changes in underlying prices
and volatilities in order to identify the largest loss a portfolio
might suffer from one day to the next
• Sets the margin requirements to cover this one day loss
• Complex calculation in SPAN are executed by NSCCL

360
 NSE-SPAN
• Risk arrays and other necessary data inputs for
margin calculations are provided to members daily in
a file called SPAN risk parameter file
• Members can apply the data contained in risk
parameter files, to their specific portfolios of futures
and options contracts, to determine the SPAN
margin requirements
• SPAN has ability to estimate risk for combined
futures and options portfolios, and also re-value the
same under various scenarios of changing market
conditions
361
 Margin
• Types of Margins…
• Initial margin
• Premium margin
• Assignment margin
• Client margins

362
 Initial Margin
• Computed by NSCCL up to client level for open positions of
CMs/TMs
• Paid up-front on…
• gross basis at individual client level for client positions
• Net basis for proprietary positions
• NSCCL collect margin on all open position of CMs computed
based on NSE-SPAN
• CM required ensure adequate collection of initial margin from
TMs up-front
• TMs required to collect adequate initial margin up-front from
clients

363
 Premium Margin
• Charged at client level
• Required to be paid by a buyer of an option till
the premium settlement is complete

364
 Assignment Margin
• Paid on assigned positions of CMs towards
interim or final exercise settlement obligations
for option contracts on individual securities,
till such obligations are fulfilled
• Charged on net exercise settlement value
payable by CM towards interim and final
exercise settlement

365
 Client Margins
• NSCCL intimates all members of the margin
liability of each of their client
• Members are also required to report details of
margins collected from clients to NSCCL

366
Margin / Position Limit Violations

367
Initial Margin Violations

368
Member-wise Position Limit Violations

369
Exposure Limit Violations

370
Market-wide Position Limit Violation for Futures
and Options on Securities

371
Client-wise Position Limit Violation

372
Position Limits for FIIs

373
Securities Contracts (regulation) Act, 1956

374
Securities and Exchange Board of India Act,
1992

375
SEBI (Stock brokers and sub-brokers)
Regulations, 1992

376
Regulation for Derivatives Trading

377
Regulation for Clearing and Settlement

378
Regulation for Membership

379
Regulation for Risk Management

380
Accounting for Futures

381
Accounting for Equity Index Options and
Equity Stock Options

382
Taxation Issues

383
 Futures Options
• Also called options on futures
• Underlying asset is future contract
• Futures contract normally matures shortly after the
expiration of the options
• When call option is exercised, holder acquires from the writer a
long position in the underlying futures contract + a cash amount
equal to excess of futures price over the strike price
• When a put option is exercised, holder acquires from the seller a
short position in the underlying futures contract + a cash amount
equal to excess of strike price over the futures price

384
 Specification of Stock Options
• American style
• Long term (expiration dates upto three years) option are
known as long-term equity anticipation securities (LEAPS)
• Stock splits and stock dividend leads to substandard strike
prices
• When a new expiration date is introduced, the two or three
strike prices closest to the current stock prices are usually
selected by the exchange
• If stock prices move outside the range, trading usually
introduced in an option with a new strike price

385
 Specification of Stock Options
• Any given asset at any given time may have different
option contracts trading
• Option class
• All options of same type
• Ex: calls
• Option series
• Consists of all options of a given class with same expiration date
and strike price
• Refers to a particular contract that is traded
• Ex: IBM 50 October calls

386
 Specification of Stock Options
• Time value
• Part of option’s value that derives the possibility of future
favorable movement in stock price
• Will be zero once it reached maturity
• Optimal to exercise the options immediately
• Flex options
• Options were the traders on the floor of the exchange agree to
nonstandard terms
• Involves a strike price or an expiration date that is different from
what is usually offered by the exchange
• Involve option being European rather than American

387
 Specification of Stock Options
• Exchange-traded options are not generally adjusted
for cash dividends
• Exchange traded options are adjusted for…
• Stock-splits
» Strike price reduced to m/n of its previous value
» No. of shares covered by one contract is increased to n/m of its
previous value
• Stock dividends
• Rights issues
» Calculating theoretical price of the rights and reducing the strike
price by this amount

388
 Specification of Stock Options
• Position limit
• Max. no. of option contracts that an investor can hold
on one side of the market
• Long calls and short puts are considered to be on the
same side of market
• Exercise limit
• Position limit
• Max. no. of contracts that can be exercised by any
individual in any period of five consecutive business
days

389
 Specification of Stock Options
• Market makers add liquidity to the market
• An investor who has written an option can close out
the position by issuing as offsetting order to buy the
same option
• Hidden cots in option trading is the market maker’s
bid-offer spread
• Initial margin = 50% of the value of shares
• Maintenance margin = 25% of the value of shares
• An investor who writes options is required to to
maintain funds in a margin account

390
 Writing Naked Options
• Option that’s not combined with an offsetting position in the underlying
stock
• Initial margin for a written naked call option is the greater of the
following…
• Total of 100% of the proceeds of the sales + 20% of the underlying share price –
amount if any by which the option is the out of the money
• Total of 100% of the option proceeds + 10% of the underlying share price
• Initial margin for a written naked put option is the greater of the
following…
• Total of 100% of the proceeds of the sales + 20% of the underlying share price –
amount if any by which the option is the out of the money
• Total of 100% of the option proceeds + 10% of the exercise price

391
 Writing Covered Calls
• Involves writing call options when the shares
that might have to be delivered are already
owned
• Far less risky
• No margin required if call options are out of
the money

392
 Properties of Stock Options
• Early exercise of an American put option on a stock
can be optimal
• Call option payoff = stock price – strike price
• Risk-free rate affects the price of an option in a less
clear-cut way
• In practice, when interest rates rise (fall), stock prices
tend to fall (rise)
• Risk-free rate is the nominal rate of interest

393
 Early Exercise: Calls on a Non-
Dividend-Paying Stock
• Page Hull 197

394
Early Exercise: Put on a Non-Dividend-
Paying Stock
• Page Hull 199

395
 Effect of Dividends
• Page Hull 200

396
Strategies Involving a Single Option
and a Stock

397
Spreads

398
Combinations

399
Other Payoffs

400
Swaps

401
 Mechanics of Interest Rate Swaps
• Company agrees to…
• Pay cash flows equal to interest at a predetermined fixed rate on a notional
principal for a no. of years
• Receives floating rate interest (LIBOR) on the same notional principal for the same
period of time
• LIBOR is a reference rate of interest for loans in international financial
markets
• Floating rate payment on a payment date are calculated using the six-
month LIBOR rate prevailing six months before the payment date
• One side remits the difference between the two payments to the other
side
• Principal is not exchanged
• Regarded as exchange of fixed-rate bond for a floating-rate bond

402
 Using Swaps

• Transform liability
• Used to transform a floating-rate loan into a fixed rate
loan
• Transform an asset
• Used to transform the nature of an asset
• Used to transform a floating-rate asset into a fixed rate
asset

403
Role of Financial Intermediary in Swap
• Financial intermediary: bank or financial
institutions
• Enters into two offsetting swap transactions
with two parties in a swap agreement
• Needs to bare the defaults
• Spread earned by financial institutions will
partly compensate for bearing default risk

404
 Market Maker
• Financial institutions act as market makers for
swaps
• Taking the position of counter party
• Used for hedging by market makers

405
 Day Count Conventions
• LIBOR based floating rate = LRn/360
• L = principal
• R = relevant LIBOR rate
• n = number of days since the last payment date
• Fixed payment may not be exactly equal on each
payment date because…fixed rate in a swap
transaction is similarly quoted with a particular day
count basis being specified
• Fixed rate is quoted as actual/365 or 30/360

406
 Confirmations
• Legal agreement underlying a swap and is signed by representatives of the two
parties
• Its describes the details like…
• Basic details
• Trade date
• Effective date
• Business day convention (all dates)
• Holiday calendar
• Termination date
• Fixed amounts
• Fixed-rate payer
• Fixed-rate notional principal •Floating amounts
• Fixed rate •Floating-rate payer
• Fixed rate day count convention •Floating -rate notional principal
• Fixed rate payment dates •Floating rate
•Floating rate day count convention
•Floating rate payment dates

407
 Comparative Advantage
• Companies may have comparative advantage
in fixed or floating rate markets
• It makes sense of companies to borrow from
market were it has comparative advantage
• Company borrow fixed when it want floating
and vice versa

408
 Comparative Advantage
• Difference between fixed rate > difference between floating rate
• Comparative advantage
• AAA Corp. = fixed-rate market
• BBB Corp. = floating-rate market
• Swap agreement ensuring AAA Corp. with floating and BBB Corp. with
fixed

Fixed Floating
AAA Corp. 10.0 6-month LIBOR +
% 0.3%
BBB Corp. 11.2 6-month LIBOR + 409
Comparative Fixed Floating
AAA Corp. 10.0 6-month LIBOR +
Advantage % 0.3%
BBB Corp. 11.2 6-month LIBOR +
• Swap improves position of both%the parties
1.0% by 0.25%
p.a.
• Total gain from swap arrangement = a – b
• a = fixed rate difference
• b = floating rate difference
• Total gain is 0.5% p.a. [i.e., (11.2%-10%) – (1%-0.3%)]
• Both parties pay some portion of their gains (a+b) to
financial intermediary

410
 Comparative Advantage
• Reasons for comparative advantages to exit…
• Nature of contracts available to companies in fixed and
floating markets
• Floating rates are short term, while fixed rates are long
term, this makes the lender to expect a liquidity
premium on fixed rate lending
• Likeliness of default, it will be assumed highly risky to
lend a firm with low rating in fixed for long term

411
 Swap Value
• Value of the swap to a company receiving
floating and paying fixed
• Vswap = Bfl – Bfix
• Value of the swap to a company receiving
fixed and paying floating
• Vswap = Bfix – Bfl
» Bfix = value of fixed-rate bond underlying the swap
» Bfl = value of floating-rate bond underlying the swap

412
 Swap Rate
• Market makers quote for a no.of different
maturities and a no. of different currencies, a bid
and an offer for the fixed rate they will exchange
for floating
• Bid is the fixed rate in a contract where the
market maker will pay fixed and receive floating
• Offer is the fixed rate in a contract where the
market maker will receive fixed and pay floating
• Swap rate = average of bid and offer fixed rates

413
 Swap Rate
• In a new swap; fixed rate = swap rate, value of swap
is zero
• Bfl = Bfix
• Banks and FIs use LIBOR rate as discounting rate
• Floating-rate under swap also pays LIBOR
» Bfl equals swap principal
» Value of fixed bond also equals principal because B fl = Bfix
• Swap rate is a LIBOR par yield
• Coupon rate on the LIBOR bond that causes it to be worth par

414
 LIBOR Zero Curve
• Also called swap zero curve
• Is the zero curve for interbank borrowings in a world where
the a bank’s interest rate roll-over risk is zero
• Swap rate also plays an important role in determining LIBOR
zero rates
• Defines a series of LIBOR par yield bonds
• Swap rates can be used to bootstrap a LIBOR zero curve in the
same way that treasury bonds are used to bootstrap the
treasury zero curve
• Swap rates are used to calculate zero curve for longer
maturities

415
 Valuation of Interest Rate Swaps
• On initiation; interest rate swap value = 0
• Method of valuation..
• Regarding swap either as a long position in one bond
combined with a short-position in another bond
• Portfolio of FRAs
• Use LIBOR zero rates for discounting

416
Valuation of Interest Rate Swaps in
Terms of Bond Prices
n (minus) ri t i

B fix = ∑ ke + Le (minus) rn t n

i=1

ti = time until ith (1 < i < n) payments are exchanged

L = notional principal in swap agreement
ri = LIBOR zero rate corresponding to maturity ti
k = fixed payment made on each payment date

• The cash flows from the bond are k at time ti (1 < i <
n) and L at time tn

417
 Valuation of Interest Rate Swaps in
Terms of Bond Prices
• Immediately after a payment date the value of fixed
rate bond is identical to a newly issued floating rate
bond
• Immediately after payment date Bfl = L
• Immediately;y before next payment date..
• Bfl = L+k*
» k* = floating rate payment that will be made on next payment
date
• Bfl = (L+k*)e-r1t1
» t1 = time until the next payment date
» Value of swap today = value h=just before the next payment
date discounted at rate r1 for time ti

418
 Valuation of Interest Rate Swaps in
Terms of Bond Prices
• Value of the swap to a company receiving
floating and paying fixed
• Vswap = Bfl – Bfix
• Value of the swap to a company receiving
fixed and paying floating
• Vswap = Bfix – Bfl
» Bfix = value of fixed-rate bond underlying the swap
» Bfl = value of floating-rate bond underlying the swap

419
 Valuation of Interest Rate Swaps in
Terms of FRAs
• FRA …
• Agreement that a certain predetermined interest rate will apply to
a certain principal for a certain period of time in the future
• An agreement were interest at the predetermined arte is
exchanged for interest at the market rate of interest for the
period in question
• Interest rate swap = portfolio of FRAs
• First exchange is known at the time the swap is
negotiated and other exchanges can be regarded as
FRAs

420
 Valuation of Interest Rate Swaps in
Terms of FRAs
• FRAs can be valued by assuming that forward
interest rates are realized
• A plain vanilla interest rate swaps can also be valued by assuming
that forward interest rates are realized
• Procedure…
• Calculate forward rates for each of the LIBOR rates that will
determine swap cash flows
• Calculate swap cash flows assuming that the LIBOR rates will equal
the forward rates
• Set the swap value equal to the present value of these cash flows

421
 Valuation of Interest Rate Swaps in
Terms of FRAs
• Fixed rate in an interest rate swap is chosen so
that the swap is worth zero initially; sum of
the value of the FRAs underlying the swap is
zero
• Value of FRA to financial institution < 0 when forward
rates > fixed rate received
• Value of FRA to financial institution = 0 when forward
rates = fixed rate received
• Value of FRA to financial institution > 0 when forward
rates < fixed rate received

422
 Valuation of Interest Rate Swaps in
Terms of FRAs
• Term structure of interest rates is upward
sloping at the time the swap is negotiated
• Early FRAs are positive and latter FRAs are negative
• Term structure of interest rates is downward
sloping at the time the swap is negotiated
• Early FRAs are negative and latter FRAs are positive

423
 Currency Swaps
• Exchanging principal and interest payments in
one currency for principal and interest
payments in another currency
• Principal amount…
• To be specified in each of two currencies
• Is exchanged at the beginning and at the end of the life
of swap
• Are approx. equivalent using the exchange rate at the
swap’s initiation

424
 Using Currency Swaps to Transform
Loans and Assets
• Borrowing in one currency transformed to
another currency
• Used to transform assets
• Transforming investment in one country to
another countries investment

425
 Currency Swap and Comparative
Advantage
• Possible sources of comparative advantage is tax
• Borrowing in the market were the comparative
advantage is

USD AUD
General Motors 5.0% 12.6%
Quanta Airway 7.0% 13.0%
Quoted rates have been adjusted to reflect the differential impact of taxes

426
 Valuation of Currency Swaps in
Terms of Bond Prices
• Value in domestic currency of a swap where
domestic currency are received and a foreign
currency is paid
• Vswap = BD – S0BF
» BF = value in foreign currency of the foreign denominated
bond underlying swap
» BD = value of the domestic currency bond underlying the
swap
» S0 = spot exchange rate
• Value in domestic currency of a swap where
foreign currency are received and a domestic
currency is paid
• Vswap = S0BF - BD

427
Valuation of Currency Swaps in Terms
of FRAs
• At initiation if two principals are worth same then
swap value is zero
• If interest rates in two currencies are significantly
different
• Payer of low-interest rate currency is in the position where the
forward contracts corresponding to early exchanges of cash flows
have positive value and forward contract corresponding to final
exchange of principals has a negative expected value
• Payer of high-interest rate currency is in the position where the
forward contracts corresponding to early exchanges of cash flows
have negative value and forward contract corresponding to final
exchange of principals has a positive expected value

428
Valuation of Currency Swaps in Terms
of FRAs
• For the payer of low-interest-rate currency,
swap will tend to have a negative value during
most of its life
• For the payer of high-interest-rate currency,
swap will tend to have a positive value during
most of its life

429
 Credit Risk
• FIs find third party to take the credit risk for an
agreed payment
• Presence of credit-exposure in a swap is, only when
the value of the swap to the financial institution is
positive
• Potential loss on swap is very small
• Potential loss on currency swap is big, since it also
involves exchange of principal
• Currency swap van have a greater value than a
interest rate swap

430