V.S.B.

ENGINEERING COLLEGE, KARUR

DEPARTMENT OF MANAGEMENT STUDIES
INTERNAL TEST- I
DERIVATIVES MANAGEMENT
PART-A Answer ALL Quest!ns "#$%&'( M)r*s+
1. Bring out the differences between speculation and arbitrage.
Speculation involves assimilation of available information about a security and assessing
the rise or fall of its price. Arbitrage implies obtaining risk-free profits by simultaneously
buying and selling identical or similar instruments in different markets.
2. What is meant by !" derivatives instruments#
!" $erivative instruments are those instruments which are traded through telephone%
tele& etc as opposed to screen based trading. Although a great fle&ibility of product
design may be available% the lack of transparency is of course a point of doubt.
'. $efine (orward "ontract.
(orward contract may be defined as two parties sign this type of deferred contract where
they agree to buy and sell an asset at some point of time in future under mutually
acceptable terms and conditions. "ompared to futures contract% forward contracts are
neither standardi)ed nor regulated by any authority.
*. What do you mean by ptions "ontract#
ption contract may be defined as a contract through which the buyer buys the right to
buy or sell an asset by paying the option premium. But the seller% by getting the option
premium takes the obligation to sell or buy the asset at a specified price on or before a
predetermined future date.
+. $ifferentiate between American and ,uropean ption.
American option is an option which can be e&ercised at any time between the purchase
date and the e&piration date. ,uropean option is an option that can be e&ercised only on
the e&piration date.
PART-B
-. .a/ ,&plain the term 0$erivatives1. What are its important features# ,&plain with
Suitable e&amples.
a/ $erivative are of three kinds future or forward contract% options and swaps and
underlying assets can be foreign e&change% e2uity% commodities markets or financial
bearing assets.
b/ As all transactions in derivatives takes place in future specific dates it is easier to short
sell then doing the same in cash markets because an individual can take of markets and
take the position accordingly because one has more time in derivatives.
c/ Since derivatives have standardi)ed terms due to which it has low counterparty risk% also
transactions costs are low in derivative market and hence they tend to be more li2uid and
one can take large positions in derivative markets 2uite easily.
d/ When value of underlying assets change then value of derivatives also changes and hence
one can construct portfolio which is needed by one and that too without having the
underlying asset. So for e&ample if one want to buy some stock and short the market then
he can buy the future of a stock and at the same time short sell the market without having
to buy or sell the underlying assets.
-. .b/ De,ne O-t!ns. E$-.)n t/e ,e)tures !, 0,,erent t1-es !, !-t!ns.
An ption is the contract in which the seller .also called the writer/ gives the buyer the
right but not obligation to purchase from a designated asset at a specific price which is
agreed upon at the time of entering into the contract. 3t is important to note that the option
buyer has the right but not an obligation to buy or sell. But if the buyer decides to
e&ercise his right% the seller of the option has an obligation to deliver or take delivery of
the underlying asset at the agreed price. !he underlying assets for options range from
everyday products like Wheat and cotton to precious items like gold% silver% petroleum to
financial assets like stocks% bonds% indices and currencies.
!ypes of options4
ption can be classified into many ways4
n the basis of underlying asset4
1. "ommodity ptions
"ommodity options are financial options with the underlying asset being a
specific commodity. !hose investing in these products buy a right to sell or buy
a commodity at a certain price. !here are two basic types of commodity
options4 a call option and a put option. !he call option gives the holder the
right% but not the obligation to buy the underlying commodity from the option
writer at a specified price on or before the option5s e&piration date. !his option
helps the buyer when price escalates. !he put option give the holder the right%
but not the obligation to sell the underlying commodity to the option writer at a
specified price on or before the option5s e&piration date. !his option helps the
seller when price declines.
2. "urrency ptions4
!he interbank market is an ma6or component of currency option market some
of the stock e&changes list currency options also. A currency call is similar to a
call on a stock that give the holder the right to buy a fi&ed amount of foreign
currency at a fi&ed e&change rate on or before the option5s e&piration date. A
currency put gives the holder the right to sell a fi&ed amount of foreign
currency at a fi&ed e&change rate on or before the option5s e&piration date.
"urrency options are identified by the five parameters vi).% time to e&piration%
currency pair% option type% strike and face value. !he e&change rates are 2uoted
as A7B when you buy a call option on "urrency A. 3t is also the same as a put
option on currency B.
'. 3nde& ptions
3nde& options allow investors to gain e&posure to the market as a whole or
to specific segments of the market with one trading decision and
fre2uently with one transaction. 3n order to obtain the same level of
diversification using individual stock issues or individual e2uity option
classes% numerous decisions and transactions would be re2uired.
,mploying inde& options can clear both the costs and comple&ities
involved in doing so.
*. 3nterest rate options
An interest rate option holder gets the right to buy or sell the underlying
cash instrument or the financial futures contract. !he treasurer may use
these options to protect his position from rising interest rates or falling
interest rates by buying put options or call options respectively. Borrowers
options and lenders options are over the counter call and put options on
short term loans and deposits respectively. !hese are called interest rate
guarantees because it helps one to fi& the ma&imum borrowing rate or the
minimum lending rate.
+. Stock ption4
ne contract gives the holder the right to buy or sell 188 shares at the
specified strike price. !his contract si)e is convenient as the shares
themselves are usually traded in lots of 188.
n the basis of transactions
1. "all ption
3t is an option which gives the buyer of an option the right to purchase from the
seller the underlying asset at the e&ercise price mentioned in the contract. But the seller
has to bear the obligation to sell the same at the above price. (or e&ample% an option to
purchase a !"S stock for 9s.1288 is a call option.
2. :ut option
A put option is an option by which the holder gets the right to sell the underlying
asset at a specified price on or before its maturity% while the writer is obliged to buy it as
so. (or e&ample% an option to sell a !"S stock for 9s.12+8 is a put option.
n the basis of e&ercise style4
1. American ption4
American option is an option which can be e&ercised at any time between the
purchase date and the e&piration date.
2. ,uropean ption4
,uropean option is an option that can be e&ercised only on the e&piration date.
;. .a/ $iscuss the types and functions of the futures "ontract. <ow do future contract and
forward contract differ from each other#

T1-es !, Futures C!ntr)2t3
"ommodity (utures3
A commodity futures contract is a tradable standardi)ed contract% whose terms are set in
advance by the commodity e&change arranging for trading on it. "ommodities such as "orn%
Soybeans% sugar% cotton% coffee seeds which form a part of daily consumption% are traded on the
futures e&change. !hough all of them form a part of agricultural commodities% they are further
segregated into grain% soft commodities and meat futures. 9ed beans% corn% wheat% soybeans and
soybean meal etc form a part of grains whereas commodities like cocoa% coffee% dried cocoon%
cotton yarn and raw sugar% etc form a part of soft commodities. Animal products like live hogs%
live cattle% pork bellies% eggs and poultry products form a part of meat futures.
"urrency (utures4
All developed countries started importing a plethora of foreign goods% which in turn created a
demand for foreign currencies. !hus huge volumes of international transactions led to the
development of foreign currency markets% which in turn created the necessity for foreign
currency futures. "urrency futures can be defined as 0a binding obligation to buy or sell a
particular currency against another at a designated rate of e&change on a specified future date.
(oreign currency futures contracts need to specify a trading unit .such as British :ound% ,uro% A
Swiss (ranc etc/ 2uotations .such as =S > per pound% =S > per (ranc% etc/% minimum price
change% contract months% =S > value of currency as the on the day and the delivery date.
3nde& (utures4
!he first inde& futures contract was introduced in 1?@2 at the Aansas "ity Board of !rade and
today% inde& futures are one of the most popular types of futures as far as trading is concerned.
All inde& futures contract is basically an obligation to deliver at settlement% an amount e2ual to &
times the difference between the stock inde& value on the e&piration date of the contract and the
price at which the contract was originally struck. !he value of & % which is referred to as the
multiple% is predetermined for each stock market inde&.
3nterest 9ate (utures
All interest rate futures contract is an agreement to buy or sell a standard 2uantity of specific
interest bearing instruments% at a predetermined future date and at a price agreed upon between
the parties. 3t is known fact that money lenders stand to lose if the interest rates go down in
future and the money borrowers stand to lose if the interest rates go up in future. !he dislike of
these two sections of the society to uncertainty in interest rate fluctuation has led to the
innovation of techni2ues to hedge such risks.
Stock (utures
Stock futures may be defined as a binding obligation to buy or sell an e2uity stock at a
designated rate of e&change on a specified futures date.
Fun2t!ns !, Futures C!ntr)2t "T/s 4uest!n 0!es n!t /)5e ) 0stn2t )nswer. 6!u 2)n
wrte t/e ,un2t!ns !, Der5)t5e nstru7ents )s )nswer ,!r t/s 4uest!n+
:rice $iscovery
:rice discovery symboli)es the process of providing e2uilibrium prices that reflect
current and prospective demands on current and prospective supplies and making these prices
visible to all.
As such% derivative markets not only play a significant role in terms of actual trading% but
also provide guidance to the rest of the economy to optimal production and consumption
decisions.
(orwards and futures markets are significant sources of information about prices. (utures
markets are often considered as primary means of information for determining the sport price
of the asset.
<igh degree of correlation e&ists between forward 7 future prices and the price which
people e&pect to prevail for the commodity7asset at the delivery date specified in the futures
contract.
By using the information available in the forward 7 futures price today% market observers
try to estimate the price of a given commodity 7 asset at a certain time in future.
(or e&ample% let us consider the price of copper. !he price of copper twelve months from
today cannot be said with certainty. <owever% the future price can be determined by using
forward 7 futures market. !he price that is 2uoted on the market today for a copper forward 7
futures contract e&piring in twelve months is very essential in estimating the future price.
!hus a futures or forward price reflects a price which a market participant can lock in
today in lieu of accepting the uncertainty of future spot price.
<edging
<edging attempts to reduce price risk. 3t can be defined as a transaction in which an
investor seeks to protect a position or anticipated position in the spot market by using an
opposite position in derivatives.
A person who hedges is called hedger. !hese are people who are e&posed to risks due to
the normal business operations and would like to eliminate or minimi)e or reduce the risk.
Bet us consider an illustration to understand how futures market is used for hedging.
Suppose in August 2811% Cr A% a manufacturer of bedcovers% is in need of 18 million pounds
of cotton in $ecember 2812 and is of the opinion that the price would rise. n Culti
"ommodity ,&change% the $ecember "otton Do 2 futures are trading at 9s. 188 per lot. Cr A
entered into a futures contract for a 18 million lot% for which he needs to buy 28 contracts .as
minimum contract si)e is a +8888 lot on C"E/ and locks his pric eat 9s.188 per lot .i.e. his
total outflow in $ecember will be 9s.2888/.
Assume that in $ecember% the cash market price of cotton is 9s.128 per lot% Cr A will
have to pay the supplier 9s.2288 to procure cotton. <owever the e&tra cost of 9s.28 per pound
which Cr A will have to pay for procuring cotton will b offset by a profit of 9s.28 per lot when
the futures contract bought at 9s.188 and sold at 9s.128 per lot.
3n other words% the hedge provides insurance against an increase in the price. <owever%
had the price of cotton declined instead of rising% Cr A would have incurred a loss on his
futures position but this would have been offset by the lower cost of ac2uiring cotton in cash
market.
<edging is done mainly for the following reasons4
o !o protect a purchase against price decline
o !o protect a sale against price increase.
o !o protect an anticipated purchase against a price increase
o !o protect an anticipated sale against a price decline.
!he result of a hedge can be 6udged as the net effect of the gain or loss on the physical
position plus the gain or loss on the hedging tool.
!wo types of hedging are available% namely short hedging and long hedging. Short
hedging is also known as selling hedge and it happens when the futures are sold in
order to hedge the cash commodity against declining prices. Bong hedging is also
known as buying hedge and it happen when the futures are purchased to hedge against
the increase in the prices of commodity to be ac2uired either in the spot or futures
market.
$epending on the e&tent of minimi)ation of basis risks% there are four outcomes
possible4
o Short hedge without basis risk
o Short hedge with basis risk
o Bong hedge without basis risk
o Bong hedge with basis risk
S-e2u.)t!n
Speculation involves assimilation of available information about a security and
assessing the rise or fall of its price. A person engaged in speculation is called
speculator. !hese people voluntarily accept what hedgers wish to avoid. Based on the
forecast% the speculator would like to make gains by taking long and short positions on
the derivatives.
Suppose spot rate between F 7 9s. -+. !he speculator may believe that 3D9 .3ndian
9upee/ will be strengthened on the coming days. So he will buy 3ndian 9upees by
selling :ounds in his portfolio. Say% he sold F 1 million in the market and he received
9s.-+ million back. After ?8 days% 3D9 gets strengthened. So spot rate becomes .9s. 7
F/ -*. <e will convert back 9s.-+ million into :ound. <e will add F1.81+ million into
his portfolio. Dow the margin is F 8.81+ million. <ere the risk is if 3D9 does not get
strengthened as per his predictions he may lose. 3f spot rate becomes 9s.--% !hen he
will get back F8.?@+ million only. So he loses 8.81+ million.
Speculators perform a valuable economic function by feeding information and analysis
about a company into the derivatives markets. A market that rapidly translates
company knowledge into stock price is an efficient market. Speculation makes a market
efficient.
!he speed at which the information gets assimilated into the market depends on the
speed at which the speculators act on the information. !herefore the market efficiency
can be brought only through the actions of speculators. Core the number of speculators%
better the efficiency of the market. A successful speculator correctly buys when the
stock is undervalued and sells when it is overvalued. !his transaction when done by a
reasonably large number of speculators corrects the value of the stock.
$ S
1
,&p b a
(2 d
(1 $
1
$
11
S
3n the above figure% we can see that when the futures prices fall below the e&pected spot prices%
long speculators enter the market and purchase futures contracts pulling the line $$
1
to the
position $$
11
. !his implies that the demand for futures for speculative purposes increases in
futures prices and reduces in comparison to spot prices.
Re.)t!ns/- 8etween F!rw)r0, Future )n0 S-!t -r2es
Forward Futures
!raded on over-the-counter market !raded on an e&change
Dot standardi)ed Standardi)ed contract
=sually one specified delivery date 9ange of delivery dates
Settled at end of contract Settled daily
$elivery or final cash settlement usually takes place "ontract is usually closed out
prior to maturity.
;. .b/ ,&plain elaborately how the settlement system works in (utures market. .1-/
3n futures market% transactions can be settled on daily basis or at the time of delivery on cash
basis.
$aily settlement4
$aily settlement is a significant feature of futures market and is the ma6or difference
between futures and forward markets.
,very futures contract involves initial margin and maintenance margin. !he amount
re2uired to be deposited in the margin account at the time of entering the contract is called
initial margin. Generally the initial margin is set between +H and 1+H of the total value of the
contract. 3t covers losses arising because of price fluctuations. n closure of position or at time
of maturity of futures contract% the initial margin is released again.
!he margin account is read6usted at the end of each trading day to reflect the investor5s
gain or loss on its open position. !he amount that is maintained everyday thereafter is called
maintenance margin. Sometimes% additional funds called variation funds might be re2uired to
be deposited immediately whenever notified.
At the close of each day% a committee comprising clearing house officials determines a
settlement price. =sually% settlement price is an average of the prices of the last few trades of
the day. =sing this settlement price% each account is marked to market.
Carked to market is a uni2ue feature of futures contract wherein the positions of both
buyers and sellers of the contracts are ad6usted everyday for the change in the market price that
day. 3n other words% the profits or losses related with price movements are either credited or
debited from an investors account even if he does not trade.
Any difference in the current settlement price and the previous day5 settlement price is
determined and it the difference is positive because of increase in settlement price% then the
rupee amount is credited to the margin account of the buyer. 3f the difference is negative
because of decrease in the settlement price% then the amount is credited to the margin account
of the seller.
$elivery and "ash Settlement4
All the contracts e&pire at some or the other time. ,very contract has a delivery month and
the delivery procedure differs from one contract to the other.
While some contracts can be delivered on any business day of the delivery month% others
can be delivered only after the contract is traded for the last day.
!his last day also varies from contract to contract. 3n the case of contracts that are cash
settled there is no delivery at all. (or e&ample% for stock inde& futures the settlement price
on the last trading day is determined at the closing spot price of the underlying
instrument.
All the contracts are marked to market on that day and the positions are considered to be
closed.
(or non cash settled financial futures% the clearing member firms inform the clearing
house about their customers who hold long positions. !wo business days prior to the
intended delivery day% the holder of the short position willing to make delivery notifies
the same to the clearing house. !his day is known as I:osition day5. !he ne&t business
day is known as Inotice of intention day5. n this day% the e&change selects the holder of
the oldest long position to receive the delivery.
n the third day or the delivery day% delivery takes place and the holder of long position
will pay the holder of short position. =sually traders close out their positions prior to
contract e&piration. Such process is called offsetting.
@.a..ii/Write a short note on long position and short position. .*/
Bong position means buying the derivative instrument to buy or sell the underlying asset.
Short position means selling the derivative instrument to buy or sell the underlying asset.
Bong position is taken by predicting the increase in prices and short position is taken based
on the prediction of declining prices.
INTERNAL TEST II 9 Answer Ke1
DERIVATIVES MANAGEMENT
PART-A
1. What is "urrency Swap#
"urrency swap is defined as the agreement between two parties to e&change a future
series of cash flows J interest and principal% where one party pays in one currency and the
other party in a different currency. !he e&change rate is generally assumed as fi&ed over
the tenure of the swap.
2. $efine "redit 9isk.
"redit risk is defined as :ossibility of the failure of a counterparty to a contract to fulfill
his contractual obligation specially in case of a swap deal due to bankruptcy or some
other reason.
'. $ifferentiate between long put option and short put options contract.
Bong position in put option means buying the option to sell the underlying asset. Short
position in put option means selling the option to sell the underlying asset.
*. What is (9D#
(loating 9ate Dote is a note issued by a borrower with a promise to pay the interest on
floating rate basis. !hese are also known as floaters.
+. $efine !ime value.
!ime value is the amount of premium that investors are willing to pay for an option under
the e&pectation that with the passage of time changes in the underlying asset will make
the option increase in value. 3n other words% it is the difference between the total value
and the intrinsic value of an option.
PART-B Answer ALL Quest!ns ":;'<;'<&=( M)r*s+
6. .a/ ,&plain various types of options contracts with illustrations. .@/
.3t is already discussed in 3nternal !est 3 /
.b/ ,numerate the assumptions of Black Scholes option pricing model. .@/
Assu7-t!ns !, B.)2* S2/!.es O-t!n Pr2n> M!0e.
Assu7-t!n '3 T/e un0er.1n> -r2e s .!>n!r7)..1 0str8ute0
(irst assumption is that the logarithm of the price is normally distributed such that it has a
trend and a volatility that we can specify. !his enables us to predict what the e&pected value of
the stock price will be and it also makes the model mathematically tractable. =se of normal
distribution makes it easier to find a closed-from solution to the problem. A closed form solution
is simply an e2uation that we can use to determine the price of the option. 3t is to be noted that
this means that volatility for the underlying price is constant and the same for all maturities.
Assu7-t!n %3 T/e s/!rt se..n> !, se2urtes wt/ t/e ,u.. use !, -r!2ee0s s -er7tte0.
We assume that we could buy and sell stock against our options position in order to capture
the effects of a volatile underlying price% thereby paying for the option premium over the life of
the instrument. 3n order to sell stock% there can be no restriction of short sales.
Assu7-t!n ?3 T/ere )re n! tr)ns)2t!ns 2!sts !r t)$es. A.. se2urtes )re -er,e2t.1
0esr)8.e.
!ransactions costs such as brokerage and ta&es would distort the simple problem of trying to
understand how to price an option. 3n practice% the investor or the options professional accounts
for these factors in the course of doing business.
Assu7-t!n =3 T/ere )re n! 050en0s 0urn> t/e .,e !, 0er5)t5e se2urt1
Again we ignore dividends in the derivation of the Black Scholes model because of the
distortionary effects they can have on our hedging decision. 3f we buy a call option and need to
delta hedge it by short selling of securities% we may be hesitant to short sell securities that pay a
dividend.
Assu7-t!n #3 T/ere )re n! rs*.ess )r8tr)>e !--!rtuntes
!his is an assumption of efficient markets theory. An arbitrage opportunity e&ists when one
can buy and sell the same instrument .or virtually the same instrument/ simultaneously for
different prices% thereby locking in a price. Because the transaction is instantaneous% there is no
risk to the individual. A market may be said to be efficient if there are no such opportunities.
Assu7-t!n <3 Se2urt1 tr)0n> s 2!ntnu!us.
By assuming that prices can trade in a mathematically continuous fashion% the model is
mathematically more tractable.
Assu7-t!n @3 T/e rs* ,ree r)te !, nterest, r, s 2!nst)nt )n0 t/e s)7e ,!r )..
7)turtes
!his is a big assumption. 3t states that the government yield curve is flat. We know that is not
true% 6ust from common sense. But in order to solve the model for wasting asset% it is important
model rates as constant.

7. .a/ Write short notes on 3nterest rate swap% KS$% 3ntrinsic value. .@/

Interest R)te Sw)-
3nterest rate swap is defined as an agreement between two or more counterparties who
agree to e&change interest rate payments over a specific time period on agreed terms. !he
rate of interest agreed upon may be fi&ed or floating.
!he floating rate in many interest rate swap agreements is the Bondon 3nterbank ffer 9ate
.B3B9/. B3B9 is the rate of interest offered by banks on deposits from other banks in
,urocurrency markets. ne-month B3B9 is the rate offered on one month deposits% three-
month B3B9 is the rate offered on three-month deposits% and so on. B3B9 rates are
determined by trading between banks and change fre2uently so that the supply of funds in the
interbank market e2uals the demand for funds in that market. Bikewise if the interest rate is
3ndian% then it is called C3B9. .Cumbai 3nter Bank offered rate/.
"onsider a three year hypothetical interest rate swap between !ata and 9eliance on Lanuary 1%
288?. 3n which% !ata agreed to pay 9eliance a fi&ed interest rate of 18H whereas 9eliance will
pay !ata C3B9 in return. .Cumbai 3nter Bank offered rate% better known as call money rate
between 3ndian banks/. Dotional principal is 9s.188 "rores. Dow every si& months% !hey will
e&change the interest payment or they will pay the net amount. (or e&ample during the first
payment on Luly 1% 288?% if C3B9 .the rate on Lanuary 1% 288? is applicable i.e. 18.+H/% !ata
will pay reliance 18H i.e. .9s.+ crore i.e. half yearly payment of interest of 18H on 9s.188
"rores/. And 9eliance will pay in return 18.+H i.e. 9s.+.2+ "rores i.e. half yearly payment of
interest of 18.+H on 9s.188 "rore.
(i&ed
C3B9
!he cash flows for !ata are as follows
$ate - month
C3B9 rate
(loating cash flow
received .9s. 3n "rore/
(i&ed cash flow paid
.9s in crore/
Det "ash
flow
Lan 1% 288@ 18.+H
Luly 1% 288@ 18.;+H +.2+ + 8.2+
Lan 1% 288? 11H +.';+ + 8.';+
Lul 1% 288? 11.+H +.+ + 8.+
Lan 1% 2818 12H +.;+ + 8.;+
Lul 1% 2818 12.+H -.2+ + 1.2+
Lan 1% 2811 12.@H -.* + 1.*
Dow !ata can transform its floating rate loan into fi&ed rate loan in order to avoid the interest
rate risk. 3t receives C3B9 interest rate from 9eliance. Dow it can borrow funds in the market
at the interest rate C3B9 M 18 BAS3S :3D!S. .1 basis point is 17188
th
of 1H interest rate.
!herefore% 18 basis points e2uals to 8.1H/. Dow !ata has a three set of cash flows
1. 3t pays C3B9 M 8.1H to the lender in the market.
2. 3t receives C3B9 from 9eliance
'. 3t pays 18H fi&ed interest rate to 9eliance.
So by netting% it pays 18.1H fi&ed interest rate. By offering premium of 8.1H interest rate% it
avoids the interest rate risk.
!ata 9eliance
Suppose 9eliance may feel that fi&ed rate loan also has interest rate risk in case of raising
scenario. So it may hedge the risk by converting fi&ed rate loan into floating rate loan. 3t may
raise the loan in the market by paying fi&ed interest rate of 18.2H. Dow it has ' sets of cash
flows
1. 3t pays 18.2H fi&ed interest rate to the lender in the market.
2. 3t receives 18H from !ata
'. 3t pays C3B9 to !ata.
By netting% it pays C3B9M8.2H interest rate.
C3B9M8.1H (i&ed 18H 18.2H
C3B9
R!.e !, Fn)n2). Inter7e0)r1
=sually two nonfinancial companies such as !ata and 9eliance do not get in touch directly to
arrange a swap in the way indicated in the figures. !hey each deal with a financial intermediary
such as a bank or other financial institution. N:lain vanillaN fi&ed-for-floating swaps on 3ndian
interest rates are usually structured so that the financial institution earns about ' or * basis points
.8.8' to 8.8*H/ on a pair of offsetting transactions.
!he financial institution enters into two offsetting swap transactions with !ata and 9eliance.
Assuming that neither defaults% the financial institution is certain to make a profit of 8.8'H .'
basis points/ per year multiplied by the notional principal of 9s.188 crore. .!his amounts to
9s.'88%888 per year for the three-year period./ !ata ends up borrowing at 18.2+H .instead of
18.1H% as in (igure/. 9eliance ends up borrowing at C3B9 plus '+ basis points .instead of at
C3B9 plus 28 basis points% as in figure/.
C3B9 M8.1H (i&ed 18.1+H (i&ed ?.@+H 18.2H
C3B9 C3B9
<ere State Bank of 3ndia enters into two contracts4 one with !ata and another with 9eliance. 3n
most cases% !ata will not even know that State Bank of 3ndia has entered into an offsetting
transaction with 9eliance and vice versa. 3f one of the companies default% still State Bank of
3ndia has to honour with the other company.
Qu).t1 S-re)0 D,,erent).3
Kuality Spread $ifferential is the difference between the default risk premium differential
on the fi&ed rate debt and the default risk premium differential on the floating rate debt.
!ata 9eliance
!ata 9eliance SB3
"onsider a three year hypothetical interest rate swap between !ata and 9eliance on
Lanuary 1% 288?. 3n which% !ata agreed to pay 9eliance a fi&ed interest rate of 18H or
C3B9. 9eliance will pay 11.2+H fi&ed interest rate to !ata or C3B9M8.+H in
return. .C3B9 is Cumbai 3nter Bank offered rate% better known as call money rate
between 3ndian banks/.
"alculation of Kuality Spread $ifferential
R)te Re.)n2e T)t) D,,erent).
F$e0 Interest R)te 11.2+H 18.88H 1.2+H
F.!)tn> Interest R)te C3B9
M8.+H
C3B9 8.+H
Qu).t1 S-re)0 D,,erent). "QSD+ (.@#A
Intrns2 V).ue
!he option premium can be broken down into two components - intrinsic value and time value.
!he intrinsic value of a call is the amount the option is in the Coney i.e. the difference between
the strike price and spot price% if it is 3n !he Coney. 3f the call is !C% its intrinsic value is )ero.
:utting it another way% the intrinsic value of a call is Max[0, (St K)] which means the intrinsic
value of a call is the greater of 8 or (St K). Similarly% the intrinsic value of a put is Max[0, K
O StP%i.e. the greater of 8 or (K St). A is the strike price and St is the spot price.
(or e&ample% consider a call option and put option on a stock4
a. !he call option has an e&ercise price of 9s.;8
b. !he put option has an e&ercise price of 9s.;8
"ompute the intrinsic value option when the stock prices are 9s.-+% 9s.;+ and 9s.;8.
a. When the stock price is 9s.-+% S-EQ-+-;8Q Rma&%.8-+/P Q 8S
When stock price is 9s.;+% S JE Q ;+ -;8 Q +
When stock price is 9s.;8% S-E Q ;8-;8Q8
b. When stock price is 9s.-+% E-SQ;8--+Q9s.+
When stock price is 9s.;+% E-S Q ;8-;+ Q Rma&.8%-+/Q8
When stock price is 9s.;8% E-SQ;8-;8Q8
;. ,&plain various uses and advantages of swap contracts. .18/
1. Swaps can be used to transfer assets or liabilities to the benefit of the
owner.
2. Swap can be done for simultaneous purchase and sale of currency for
different maturities or vice versa.
'. With the help of a swap% a floating rate liability .loan/ can be converted
into a fi&ed rate liability .loan/% ensuring that the volatility in the interest rate does not
increase the burden of payments or else% vice versa convert a fi&ed rate liability .loan/
into a floating rate liability.loan/ when the interest rates fall steeply in the market.
*. Similarly an asset can be changed to convert a floating rate earning asset
into a fi&ed rate earning asset or vice versa according to the re2uirements of the holder.
+. Swaps are possible for various terms of maturity. Swaps can be divided
into short term% medium term and long term swaps. While short term swaps have
maturity periods of less than three years% medium term swaps mature between three and
five years and long term swaps have a life e&tending beyond five years.
-. !hrough commodity swaps% the future market price of the commodity can
be determined and price loss can be averted. 3n a commodity swap% the counter parties
make payments based on the price of a fi&ed amount of a certain commodity in which
one party pays a fi&ed price for the good and the other party pays a market rate over the
swap period.
;. "urrency swap is a mutual understanding of parties for e&change of
interest payments %either fi&ed or floating% on loan in one currency to an e2uivalent loan
in another currency. Since currency swap is not a loan% it does not appear as a liability on
the contracted party balance sheet unlike other loans.
@. "urrency swaps give greater li2uidity. $ue to this many banks agree to
take risk in swap transaction.
?. 3n the back to back and parallel loans% the documentation is cumbersome
and counterparties have to find others with mirror currency re2uirement. "hanges in
interest rates and foreign e&change rates during the life of the structures also cause
difficulties. "urrency swaps do not involve foreign currency loans like their
predecessors. 3nstead one party agrees to make periodic payments% based on either fi&ed
or floating interest rates% to a counter party who in turn makes period payments to the
other in a different currency. !he payments are based on principal amounts which are
fi&ed at the initiation of the swap.
18. An e2uity swap means an e&change of dividends earned and capital gains
on a portfolio% which is based on a stock inde& against period interest payments. 3t is
similar to interest rate swap% in that it has a fi&ed period% a fi&ed rate payer and a floating
rate payer. ,2uity swap reduced the capital market risk.
11. !he simple interest rate swaps are popularly called :lain Tanilla Swaps.
!here are many variants on the plain vanilla swaps. !hese swap variants are the ma6or
possible outcomes in the swap market and are tailored to suit different needs of different
customers.
;. b. $ifferentiate between Stock option and inde& option. .-/
1. =nderlying Asset4
An e2uity inde& option is an option whose underlying instrument is intangible an e2uity
inde&. !he underlying instrument of an e2uity option is a number of shares of a specific
stock% usually 188 shares.
2. :rice
!he price of an e2uity option tends to rise and fall in relation to the underlying shares. !he
price of an inde& option will rise and fall in relation to the inde&. !he price of an inde& call
will generally increase as the level of it underlying inde& increases and the price of an inde&
put will generally increase as the level of its underlying inde& decreases.
'. :ricing factors
Generally the factors that affect the price of an inde& option are the same as those affecting
the price of an e2uity option4 Talue of the underlying instrument% strike price% volatility% time
until e&piration% interest rates and dividends paid by the component securities.
*. Tolatility
3nde&es by their nature are less volatile than their individual component stocks. !he up and
down movements of component stock prices tend to cancel one another out% lessening the
volatility of the inde& as a whole. <owever the volatility of an inde& can be influenced by
factors more general than those which affect individual e2uities such as investors5
e&pectations of changes in inflation% unemployment% interest rates or other economic
indicators issued by the Government and political or military situations.
+. 9isk
As with an e2uity option% an inde& option buyer5s risk is limited to the amount of the
premium paid for the option. !he premium received and kept by the inde& option writer is
the ma&imum profit% a writer can reali)e from the sale of the option. <owever the loss
potential from writing an uncovered inde& option is generally unlimited. Any investor
considering writing inde& options should recogni)e that there are significant risks involved.
-. "ash Settlement4
When an inde& option is e&ercised by its holder% the amount e2uivalent to the difference of
value of inde& on the date of e&piration and the value of inde& specified in the inde& option
will be paid in cash. Where as in e2uity option% the e2uity share are paid for settlement in
some cases.
;. :urchasing rights
:urchasing an inde& option does not give the investor the right to purchase or sell all of the
stocks that are contained in the underlying inde&% because an inde& is simply an intangible%
representative number. An investor purchasing an inde& option obtains right to demand and
receive a specified amount of cash from the writer of the contract with the same terms.
Whereas e2uity option will give the holder the right to buy the specified number of e2uity
shares from the writer.
@. ption "lasses
Available strike prices% e&piration months and the last trading day can vary with each inde&
option class% a term for all option contracts of the same type .call or put/ and
style.American% ,uropean or "apped/ that cover the same underlying asset.
?. Strike :rices
!he strike price or e&ercise price of a cash settled option is the basis for determining the
amount of cash% if any% that the option holder is entitled to receive upon e&ercise.
18. ,&ercise and Assignment
!he e&ercise settlement value is an inde& value used to calculate how much money will
change hands% the e&ercise settlement amount% when a given inde& option is e&ercised either
before or at e&piration. !he value of every inde& underlying an option% including the
e&ercise settlement value% is the value of the inde& as determined by the reporting authority
designated by the market where option is traded.
11. "losing !ransactions
As with e2uity options% an inde& option writer wishing to close out his position buys a
contract with the same terms in the market place. 3n order to avoid assignment and its
inherent obligations% the option writer must buy this contract before the close of the market
on any given day to avoid notification of assignment on the ne&t business day.

INTERNAL TEST III 9 Answer Ke1
DERIVATIVES MANAGEMENT
1. What is currency swap#
"urrency swap is the agreement between two parties to e&change a future series of cash
flows- interest and principal% where one party pays in one currency and the other party in
a different currency. !he e&change rate is generally assumed as fi&ed over the tenure of
the swap.
2. $efine credit risk.
"redit risk is the possibility of the failure of a counterparty to a contract to fulfill his
contractual obligation specially in case of a swap deal due to bankruptcy or some other
reason.
'. $ifferentiate between (9A and 3nterest rate swap.
(orward 9ate Agreement .(9A/ is a forward contract on interest rate on the basis of a
fi&ed notional principal where cash is settled based on the difference between the contract
rate and the reference rate e&isting on the closing date. !he final settlement is done on the
cash basis.
*. What is (9D#
(loating 9ate Dote .(9D/ is a note issued by a borrower with a promise to pay the
interest on floating rate basis. !hese are also known as floaters.
+. $efine time value.
!he amount by which the option premium e&ceeds the intrinsic value of an option is
referred to as time value of an option. !he time value is the amount above the intrinsic
value which is investor ready to pay with an e&pectation that the value may increase due
to the favorable movement in the price of the underlying asset. !he longer the time to
e&piration% the greater is the time value of an option
PART-B Answer ALL Quest!ns ":;'<;'<&=( M)r*s+
-. a. ,&plain various terminologies used in DS, regarding futures.
C!ntr)2t s-e2,2)t!ns ,!r n0e$ 8)se0 ,utures
3nde& futures are futures contracts on an inde&% like the Difty. !he underlying asset in case of
inde& futures is the inde& itself. (or e&ample% Difty futures traded in DS, track spot Difty
returns. 3f the Difty inde& rises% so does the pay off of the long position in Difty futures. Apart
from Difty other indices such as "DE 3!% Bank Difty etc. are also traded on the DS,. !hey have
one-month% two-month% and three-month e&piry cycle4 a one-month Difty futures contract
would e&pire in the current month% a two-month contract the ne&t month% and a three-month
contract the month after. All contracts e&pire on the last !hursday of every month% or the
previous trading day if the last !hursday is a trading holiday. !hus% a September 288? contract
would e&pire on the last !hursday of September 288?% which would be the final settlement date
of the contract. !able -.1 summari)es contract specifications for SU: Difty 3nde& (utures.
C!ntr)2t s-e2,2)t!ns ,!r st!2* 8)se0 ,uturesStock based futures are futures based on
individual stocks. !he underlying on these futures are the individual company stocks traded on
the ,&change. !he e&piration cycle of the stock futures is same as that of inde& futures. !able -.'
summari)es the contract Specification for Stock (utures.
1. b. ,numerate the evolution of derivative markets in 3ndia. .@/
3n 3ndia% derivatives markets have been functioning since the nineteenth century% with
rgani)ed trading in cotton through the establishment of the "otton !rade Association in 1@;+.
$erivatives% as e&change traded financial instruments were introduced in 3ndia in Lune
2888.
!he Dational Stock ,&change .DS,/ is the largest e&change in 3ndia in derivatives%
trading in various derivatives contracts.
!he first contract to be launched on DS, was the Difty +8 inde& futures contract. 3n a
span of one and a half years after the introduction of inde& futures% inde& options% stock
options and stock futures were also introduced in the derivatives segment for trading.
DS,5s e2uity derivatives segment is called the (utures U ptions Segment or (U
Segment. DS, also trades in "urrency and 3nterest 9ate (utures contracts under a
separate segment.
A series of reforms in the financial markets paved way for the development of e&change-
traded e2uity derivatives markets in 3ndia. 3n 1??'% the DS, was established as an
electronic% national e&change and it started operations in 1??*.
3t improved the efficiency and transparency of the stock markets by offering a fully
automated screen-based trading system with real-time price dissemination.
A report on e&change traded derivatives% by the B.". Gupta "ommittee% set up by the
Securities and ,&change Board of 3ndia .S,B3/% recommended a phased introduction of
derivatives instruments with bi-level regulation .i.e.% self-regulation by e&changes% with
S,B3 providing the overall regulatory and supervisory role/.
Another report% by the L.9. Tarma "ommittee in 1??@% worked out the various operational
details such as margining and risk management systems for these instruments.
3n 1???% the Securities "ontracts .9egulation/ Act of 1?+-% or S".9/A% was amended so
that derivatives could be declared as 0securities1. !his allowed the regulatory framework
for trading securities% to be e&tended to derivatives.
!he Act considers derivatives on e2uities to be legal and valid% but only if they are traded
on e&changes. !he Securities "ontracts .9egulation/ Act% 1?+- defines NderivativesN to
include4
1. A security derived from a debt instrument% share% loan whether secured or unsecured%
risk instrument% or contract for differences or any other form of security.
2. A contract which derives its value from the prices% or inde& of prices% of underlying
securities.
@.b. ii/ $ifferentiate between commodity futures and commodity options. .-/
"T/s )nswer 2)n 8e wrtten ,!r 0,,eren2e 8etween )n1 t1-e !, ,utures )n0 !-t!ns+
C!77!0t1 Futures C!77!0t1 O-t!ns
,&change traded% with novation Same as futures.
,&change defines the product Same as futures.
:rice is )ero% strike price moves Strike price is fi&ed% price moves.
:rice is )ero :rice is always positive.
Binear payoff Donlinear payoff.
Both long and short at risk nly short at risk.
IMPROVEMENT TEST 9 Answer Ke1
DERIVATIVES MANAGEMENT
1. $efine swap.
Swap is the agreement through which a series of e&changes of periodic payments .both
interest and principal/ is done with a counterparty.
2. $ifferentiate between interest rate swap and currency swap.
3nterest rate swap is a contract between two entities where a series of interest payments
are e&changed against the same notional principal denominated in the same currency.
"urrency swap is the agreement between two parties to e&change a future series of cash
flows J interest and principal% where one party pays in one currency and the other party in
a different currency. !he e&change rate is generally assumed as fi&ed over the tenure of
the swap.
'. What is D,A!#
National Exchange for Automated Trading)
DS, is the first e&change in the world to use satellite communication technology for
trading. 3ts trading system% called Dational ,&change for Automated !rading .D,A!/% is a
state of-the-art client server based application. At the server end all trading information is
stored in an inmemory database to achieve minimum response time and ma&imum system
availability for users. 3t has uptime record of ??.;H. (or all trades entered into D,A!
system% there is uniform response time of less than one second.
*. What is warehousing swap#
A practice whereby an intermediary enters into one side of the swap transaction% such as
fi&ed rate payer .or floating rate payer/ to a client who wishes to be a floating rate payer
.or a fi&ed rate payer/. !hen the intermediary waits for a matching counterparty and
offloads the swap thereto. 3n other words% swap warehousing involves holding a portfolio
of swaps usually by a swap dealer without seeking to offset each swap with an identical
mirror swap. 3n this sense% the swap dealer becomes counterparty to every swap held in
its portfolio. !he dealer earns% for its services as a dealer% a pay-receive spread .bid-ask
spread/ which is e2ual to the difference between the swap coupon the dealer pays and
swap coupon the dealer receives.
+. $escribe netting.
Detting means allowing a positive value and a negative value to set off and partially or
entirely cancel each other out. 3n the conte&t of credit risk% there are at least three specific
type of netting4
"lose out Detting4 All transactions or all of a given type are netted at market value.
Detting by Dovation4 !he legal obligations of the parties to make re2uired payments
under one or more series of related transactions are cancelled and a new obligation to
make only the net payments is created.
Settlements or payment netting4 (or cash settled trades% this can be applied either
bilaterally or multilaterally and on related or unrelated transactions.
(inally netting decreases credit e&posure% increases the business with e&isting
counterparties% and reduces both operational and settlement risks and operational costs.
-.a/ ,&plain the role of financial intermediary in detail .@/
R!.e !, Fn)n2). Inter7e0)r1
=sually two nonfinancial companies such as !ata and 9eliance do not get in touch directly to
arrange a swap in the way indicated in the figures. !hey each deal with a financial intermediary
such as a bank or other financial institution. N:lain vanillaN fi&ed-for-floating swaps on 3ndian
interest rates are usually structured so that the financial institution earns about ' or * basis points
.8.8' to 8.8*H/ on a pair of offsetting transactions.
!he financial institution enters into two offsetting swap transactions with !ata and 9eliance.
Assuming that neither defaults% the financial institution is certain to make a profit of 8.8'H .'
basis points/ per year multiplied by the notional principal of 9s.188 crore. .!his amounts to
9s.'88%888 per year for the three-year period./ !ata ends up borrowing at 18.2+H .instead of
18.1H% as in (igure/. 9eliance ends up borrowing at C3B9 plus 21.+ basis points .instead of at
C3B9 plus 28 basis points% as in figure/.
C3B9 M8.1H (i&ed 18.1+H (i&ed ?.@+H 18.2H
C3B9 C3B9
<ere State Bank of 3ndia enters into two contracts4 one with !ata and another with 9eliance. 3n
most cases% !ata will not even know that State Bank of 3ndia has entered into an offsetting
transaction with 9eliance and vice versa. 3f one of the companies defaults% still State Bank of
3ndia has to honor with the other company.
!ata 9eliance SB3
-.b.Bist various terminologies used in DS, regarding options. .@/
C!ntr)2t s-e2,2)t!ns ,!r n0e$ 8)se0 !-t!ns
3nde& based options are similar to inde& based futures as far as the underlying is concerned
i.e.% in both the cases the underlying security is an 3nde&. As the value of the inde& increases%
the value of the call option on inde& increases% while put option value reduces. All inde& based
options traded on DS, are ,uropean type options and e&pire on the last !hursday of the e&piry
month. !hey have e&piries of one month or two months% or three months. Bonger dated e&piry
contracts with e&piries up to '.+ years have also been introduced for trading. !able -.2
summari)es contract specifications for SU: Difty 3nde& ptions.
C!ntr)2t s-e2,2)t!ns ,!r st!2* 8)se0 !-t!ns
Stock based options are options for which the underlying is individual stocks. A ll the stock
based options at the DS, have ,uropean style settlement. !able -.* summari)es the contract
specification for Stock ptions.
;.a. i/Write short notes on ,&change traded derivatives in 3ndia. .@/
M)r*et Des>n
nly two e&changes in 3ndia have been permitted to trade in derivatives contracts% the DS, and
the BS,. DS,5s contribution to the total turnover in the market is nearly ??H. <ence% the market
design enumerated in this section is the derivative segment of DS, .hereafter referred to as the
(U segment/. !he different aspects of market design for (U segment of the e&changes can
be summari)ed as follows4
Tr)0n> Me2/)ns7
D,A!-(U system4 a fully automated screen-based% anonymous order driven trading system for
derivatives on a nationwide basis.
a. !here are four entities in the trading system4
1. !rading members who can trade either on their own account or on behalf of their clients
including participants.
2. "learing members who are members of DS""B and carry out risk management activities and
conV rmation7in2uiry of trades through the trading system. !hese clearing members are also
trading members and clear trades for themselves and7or others.
'. :rofessional clearing members are clearing members who are not trading members. !ypically%
banks and custodians become :"Cs and clear and settle for their trading members.
*. :articipants who are client of trading members like V nancial institutions. !hese clients may
trade through multiple trading members% but settle their trades through a single clearing
member only.
Me78ers/-
!he members are admitted by DS, for its (U segment in accordance with the rules and
regulations of the ,&change and the norms speciV ed by the S,B3. !he eligibility criteria for
membership on (U segment has been mentioned in "hapter * Secondary Carket J !rading. At
the end of Lune 288?% there were 1828 members in the "C and (U segment taken together.
C!ntr)2ts )5).)8.e
W 3nde& futures and inde& options contracts on DS, are based on Difty +8 3nde&% "DE 3! 3nde&%
Bank Difty 3nde&% and Difty Cidcap +8 inde&.
W Stock (utures and options% based on 1@8 individual securities.
C/)r>es
!ransaction charges payable to the e&change by the trading member for the trades e&ecuted by
him on the (U segment were V &ed at 9s. 2 per lakh of turnover .8.882H/ sub6ect to a
minimum of 9s. 1%88%888 per year. <owever for the transactions in the options sub-segment the
transaction charges are levied on the premium value at the rate of 8.8+H .each side/ instead of on
the strike price as levied earlier.
!he DS, reviewed these transaction charges and further reduced the transaction charges for
trades done in the (utures segment from its present level to a slab based structure as given below
.w.e.f. ctober 1% 288?/ J
!otal !raded Talue in a month 9evised !ransaction "harges
.9s. per lakh of !raded Talue/
=p to (irst 9s. 2+88 cores 9s. 1.?8 each side
Core than 9s. 2+88 crores up to 9s. ;+88 crores
.on incremental volume/ 9s. 1.@+ each side
Core than 9s. ;+88 crores up to 9s. 1+888 crores
.on incremental volume/ 9s. 1.@8 each side
,&ceeding 9s.1+888 crores
.on incremental volume/ 9s. 1.;+ each side
Se2urtes Tr)ns)2t!n T)$
!he trading members are also re2uired to pay securities transaction ta& .S!!/ on non-delivery
transactions at the rate of 8.81; .payable by the seller/ for derivatives w. e. f Lune 1% 288@.
!a&able securities transaction 9ate .H/ !a&able Talue :ayable by
Sale of an option in securities 8.81; ption premium Seller
Sale of an option in securities%
where option is e&ercised 8.12+ Settlement :rice :urchaser
Sale of a futures in securities 8.81; Sale :rice Seller
Talue of ta&able securities transaction relating to an 0option in securities1 will be the option
premium% in case of sale of an option in securities.
Talue of ta&able securities transaction relating to an 0option in securities1 will be the settlement
price% in case of sale of an option in securities% where option is e&ercised.
C!ntr8ut!n t! In5est!r Pr!te2t!n Fun0
!he trading members contribute to 3nvestor :rotection (und of (U segment at the rate of
9e.17- per 9s. 188 crore of the traded value .each side/ in case of (utures segment and 9s.17- per
9s. 188 crore of the premium amount .each side/ in case of ptions segment.
C.e)rn> )n0 Sett.e7ent
W Dational Securities "learing "orporation Bimited .DS""B/ undertakes clearing and settlement
of all trades e&ecuted on the futures and options .(U/ segment of the DS,.
W 3nde& as well as stock options and futures are settled in cash.
;.b.What are the different types of swap contracts prevail in the market# ,&plain in detail. .@/
"urrency swaps
A currency swap is a mutual understanding of parties for e&change of interest payments .either
fi&ed or floating/ on loan in one currency to an e2uivalent loan in another currency. !his may or
may not involve initial e&change of principal. A plain vanilla currency swap is a fi&ed-fi&ed
currency swap in which each party pays a fi&ed payment on the loan taken by them.
With the rate in interest rate swaps% the currency swaps market also rose from the earlier
parallel and back to back loan structures which were developed and designed in the =nited
Aingdom as a means of circumventing foreign e&change controls and to prevent an outflow of
British capital. 3n the 1?;8s% the British Government imposed ta&es on foreign e&change
transactions that involved its currency. $ue to this% the parallel loan became a widely accepted
transaction by which these ta&es could be avoided.
"urrency swaps effectively decreased the use of these loans due to the following advantages4
1/ 3n currency swaps% termination of contract can be done if one party defaults the other
party and can claim damages.
2/ Since currency swap is not a loan% it does not appear as a liability on the contracted party
balance sheet unlike other loans.
'/ "urrency swaps give greater li2uidity. $ue to this many banks agree to take risk in swap
transaction.
=nlike interest rate swaps% where no e&change of principal takes place% in a currency swap the
principal amount is generally e&changed at the beginning of the transaction and re e&changed
upon maturity.
,&change of :rincipals
,&change of 3nterest instalments
9e e&change of 3nitial :rincipal
3nterest rate swaps
An interest rate swap is defined as an agreement between two or more counterparties who agree
to e&change interest payments over a specific period on agreed terms. !he rate of interest agreed
upon may be fi&ed or floating.
!he simple interest rate swaps are popularly called :lain Tanilla Swaps. !here are many variants
on the plain vanilla swaps. !hese swap variants are the ma6or possible outcomes in the swap
market and are tailored to suit different needs of different customers. Suppose if there is an
e&change of interest obligation then it is termed a liability swap and if there is an e&change of
interest income then it is an asset swap. !he basic swap techni2ues can be e&plained using plain
vanilla swap concept. !he plain vanilla swaps are those swaps where fi&ed rate obligations are
e&changed for floating rate obligations over a specific period of time or a notional principal.
!hey are also called coupon swaps or generic swaps.
,2uity Swaps4
An e2uity swap means an e&change of dividends earned and capital gains on a portfolio% which is
based on a stock inde& against periodic interest payments. 3t is similar to an interest rate swap% in
that it has a fi&ed period% a fi&ed rate payer and a floating rate payer.
"ommodity swaps
(irm A (irm B
3n a commodity swap% the counterparties make payments based on the price of a fi&ed amount of
a certain commodity in which one party a fi&ed price for the good and the other party pays a
market rate over the swap period.
ther Swaps
ther types of swaps include power swaps% weather swaps etc. !he swaps that are privately
negotiated financial contracts that allow two parties to e&change specific weather risk e&posures
over a predetermined period of time are called weather swpas.
INTERNAL TEST I - RETEST 9 Answer Ke1
DERIVATIVES MANAGEMENT
1. $efine $erivatives.
$erivatives can be defined as financial instruments whose values are derived from the
underlying assets such as stock% commodity% bond% inde& etc. 3n other words% their
performance depends on the movement of underlying assets such commodities% shares%
indices% e&change rates% interest rates and so on.
2. What is meant by Speculation#
Speculation involves assimilation of available information about a security and assessing
the rise or fall of its price. A person engaged in speculation is called as speculator. Based
on the forecast% the speculator would like to make gains by taking long and short
positions on the derivatives.
'. Bist any two differences between forward contracts and futures contracts.
Forward Futures
!raded on over-the-counter market !raded on an e&change
Dot standardi)ed Standardi)ed contract
=sually one specified delivery date 9ange of delivery dates
Settled at end of contract Settled daily
$elivery or final cash settlement usually takes place . "ontract is usually closed out
prior to maturity.
*. $ifferentiate between inde& future and e2uity future.
3nde& futures are those futures contracts traded in the organi)ed stock e&changes on the
basis of future value of stock indices. Such contracts are finally settled through cash on
the closing day by converging the inde& futures value with that of the spot inde& value.
,2uity futures are those futures contracts traded in the organi)ed stock e&changes on the
basis of future value of e2uity shares. Such contracts are finally settled through either
delivering the e2uity shares or through cash.
+. "all ption price is 9s.8.+8 per unit. Strike price is 9s.'.88. n maturity date% spot price
is 9s.2.-8. 3f an investor takes a long position% find the investor5s gain 7 loss.
Since market price on the maturity date is lower than the strike price% he will not e&ercise
the call option. So his loss would be the option price i.e. 9.8.+8 per unit.
-. .a/ Bist the advantages of $erivatives "ontract. .@/
1. :rice $iscovery
:rice discovery symboli)es the process of providing e2uilibrium prices that reflect
current and prospective demands on current and prospective supplies and making these prices
visible to all.
As such% derivative markets not only play a significant role in terms of actual trading% but
also provide guidance to the rest of the economy to optimal production and consumption
decisions.
(orwards and futures markets are significant sources of information about prices. (utures
markets are often considered as primary means of information for determining the sport price
of the asset.
<igh degree of correlation e&ists between forward 7 future prices and the price which
people e&pect to prevail for the commodity7asset at the delivery date specified in the futures
contract.
By using the information available in the forward 7 futures price today% market observers
try to estimate the price of a given commodity 7 asset at a certain time in future.
(or e&ample% let us consider the price of copper. !he price of copper twelve months from
today cannot be said with certainty. <owever% the future price can be determined by using
forward 7 futures market. !he price that is 2uoted on the market today for a copper forward 7
futures contract e&piring in twelve months is very essential in estimating the future price.
!hus a futures or forward price reflects a price which a market participant can lock in
today in lieu of accepting the uncertainty of future spot price.
2. <edging
<edging attempts to reduce price risk. 3t can be defined as a transaction in which an
investor seeks to protect a position or anticipated position in the spot market by using an
opposite position in derivatives.
A person who hedges is called hedger. !hese are people who are e&posed to risks due to
the normal business operations and would like to eliminate or minimi)e or reduce the risk.
Bet us consider an illustration to understand how futures market is used for hedging.
Suppose in August 2811% Cr A% a manufacturer of bedcovers% is in need of 18 million pounds
of cotton in $ecember 2812 and is of the opinion that the price would rise. n Culti
"ommodity ,&change% the $ecember "otton Do 2 futures are trading at 9s. 188 per lot. Cr A
entered into a futures contract for a 18 million lot% for which he needs to buy 28 contracts .as
minimum contract si)e is a +8888 lot on C"E/ and locks his pric eat 9s.188 per lot .i.e. his
total outflow in $ecember will be 9s.2888/.
Assume that in $ecember% the cash market price of cotton is 9s.128 per lot% Cr A will
have to pay the supplier 9s.2288 to procure cotton. <owever the e&tra cost of 9s.28 per pound
which Cr A will have to pay for procuring cotton will b offset by a profit of 9s.28 per lot when
the futures contract bought at 9s.188 and sold at 9s.128 per lot.
3n other words% the hedge provides insurance against an increase in the price. <owever%
had the price of cotton declined instead of rising% Cr A would have incurred a loss on his
futures position but this would have been offset by the lower cost of ac2uiring cotton in cash
market.
<edging is done mainly for the following reasons4
o !o protect a purchase against price decline
o !o protect a sale against price increase.
o !o protect an anticipated purchase against a price increase
o !o protect an anticipated sale against a price decline.
!he result of a hedge can be 6udged as the net effect of the gain or loss on the physical
position plus the gain or loss on the hedging tool.
!wo types of hedging are available% namely short hedging and long hedging. Short
hedging is also known as selling hedge and it happens when the futures are sold in
order to hedge the cash commodity against declining prices. Bong hedging is also
known as buying hedge and it happen when the futures are purchased to hedge against
the increase in the prices of commodity to be ac2uired either in the spot or futures
market.
$epending on the e&tent of minimi)ation of basis risks% there are four outcomes
possible4
o Short hedge without basis risk
o Short hedge with basis risk
o Bong hedge without basis risk
o Bong hedge with basis risk
?+ S-e2u.)t!n
Speculation involves assimilation of available information about a security and
assessing the rise or fall of its price. A person engaged in speculation is called
speculator. !hese people voluntarily accept what hedgers wish to avoid. Based on the
forecast% the speculator would like to make gains by taking long and short positions on
the derivatives.
Suppose spot rate between F 7 9s. -+. !he speculator may believe that 3D9 .3ndian
9upee/ will be strengthened on the coming days. So he will buy 3ndian 9upees by
selling :ounds in his portfolio. Say% he sold F 1 million in the market and he received
9s.-+ million back. After ?8 days% 3D9 gets strengthened. So spot rate becomes .9s. 7
F/ -*. <e will convert back 9s.-+ million into :ound. <e will add F1.81+ million into
his portfolio. Dow the margin is F 8.81+ million. <ere the risk is if 3D9 does not get
strengthened as per his predictions he may lose. 3f spot rate becomes 9s.--% !hen he
will get back F8.?@+ million only. So he loses 8.81+ million.
Speculators perform a valuable economic function by feeding information and analysis
about a company into the derivatives markets. A market that rapidly translates
company knowledge into stock price is an efficient market. Speculation makes a market
efficient.
!he speed at which the information gets assimilated into the market depends on the
speed at which the speculators act on the information. !herefore the market efficiency
can be brought only through the actions of speculators. Core the number of speculators%
better the efficiency of the market. A successful speculator correctly buys when the
stock is undervalued and sells when it is overvalued. !his transaction when done by a
reasonably large number of speculators corrects the value of the stock.
*. Cost companies are in the business of manufacturing or retailing or wholesaling or providing
a service. !hey have no particular skills or e&pertise in predicting variables such as interest
rates% e&change rates% and commodity prices. 3t makes sense for them to hedge the risks
associated with these variables as they arise. !he companies can then focus on their main
activitiesOin which <edging Strategies =sing (utures presumably they do have particular
skills and e&pertise. By hedging% they avoid unpleasant surprises such as sharp rises in the
price of a commodity. 3n practice% many risks are left unhedged. 3n the rest of this section we
will e&plore some of the reasons.
+. <edging and Shareholders ne argument sometimes put forward is that the shareholders can%
if they wish% do the hedging themselves. !hey do not need the company to do it for them.
!his argument is% however% open to 2uestion. 3t assumes that shareholders have as much
information about the risks faced by a company as does the companyXs management.
-. "ompetitive pressures within the industry may be such that the prices of the goods and
services produced by the industry fluctuate to reflect raw material costs% interest rates%
e&change rates% and so on. A company that does not hedge can e&pect its profit margins to be
roughly constant. <owever% a company that does hedge can e&pect its profit margins to
fluctuateY
;. 3t is important to reali)e that a hedge using futures contracts can result in a decrease or an
increase in a companyXs profits relative to the position it would be in with no hedging.
-.b.,&plain carefully the difference between hedging% speculation and arbitrage. .@/
Be0>n>, S-e2u.)t!n 9 see t/e -re5!us )nswer
Ar8tr)>e
Arbitrage is creating a profit by dealing in two or more markets simultaneously. Suppose !"S
share is traded at 9s.1288 in BS, and 9s.1218 in DS,. So an arbitrageur may buy !"S share in
BS, and sell in DS, and he may gain 9S.18 per share. <ere the main concern is the transaction
cost involved. 3f the transaction cost nullifies the gain% then it will not be a real gain. So an
arbitrageur will ensure there should be ade2uate gain even after deducting the transaction cost
involved.
;. .a/ .i/ "lassify the futures market elaborately. .12/
"ommodity (utures3
A commodity futures contract is a tradable standardi)ed contract% whose terms are
set in advance by the commodity e&change arranging for trading on it. "ommodities such
as "orn% Soybeans% sugar% cotton% coffee seeds which form a part of daily consumption%
are traded on the futures e&change. !hough all of them form a part of agricultural
commodities% they are further segregated into grain% soft commodities and meat futures.
9ed beans% corn% wheat% soybeans and soybean meal etc form a part of grains whereas
commodities like cocoa% coffee% dried cocoon% cotton yarn and raw sugar% etc form a part
of soft commodities. Animal products like live hogs% live cattle% pork bellies% eggs and
poultry products form a part of meat futures.
"urrency (utures4
All developed countries started importing a plethora of foreign goods% which in turn
created a demand for foreign currencies. !hus huge volumes of international transactions
led to the development of foreign currency markets% which in turn created the necessity
for foreign currency futures. "urrency futures can be defined as 0a binding obligation to
buy or sell a particular currency against another at a designated rate of e&change on a
specified future date. (oreign currency futures contracts need to specify a trading unit
.such as British :ound% ,uro% A Swiss (ranc etc/ 2uotations .such as =S > per pound% =S
> per (ranc% etc/% minimum price change% contract months% =S > value of currency as the
on the day and the delivery date.
3nde& (utures4
!he first inde& futures contract was introduced in 1?@2 at the Aansas "ity Board of !rade
and today% inde& futures are one of the most popular types of futures as far as trading is
concerned. All inde& futures contract is basically an obligation to deliver at settlement% an
amount e2ual to & times the difference between the stock inde& value on the e&piration
date of the contract and the price at which the contract was originally struck. !he value of
& % which is referred to as the multiple% is predetermined for each stock market inde&.
3nterest 9ate (utures
All interest rate futures contract is an agreement to buy or sell a standard 2uantity of
specific interest bearing instruments% at a predetermined future date and at a price agreed
upon between the parties. 3t is known fact that money lenders stand to lose if the interest
rates go down in future and the money borrowers stand to lose if the interest rates go up
in future. !he dislike of these two sections of the society to uncertainty in interest rate
fluctuation has led to the innovation of techni2ues to hedge such risks.
Stock (utures
Stock futures may be defined as a binding obligation to buy or sell an e2uity stock at a
designated rate of e&change on a specified futures date.
.ii/ What is the difference between long forward and short forward position# .*/
Bong forward position means making the forward contract for buying the underlying
asset e&pecting that price of underlying assets will increase in the future. Short forward position
indicate making the forward contract for selling the underlying asset e&pecting that price of
underlying asset will fall further.
;. .a/ .i/ $erivatives is a basket full of risk. ,&plain. .12/
.ii/ Bist and brief the four positions in options market .*/
$erivatives is a basket full of risk.
'. Issuer 0e,)u.t rs*
3n the event that a derivative product issuer becomes insolvent and defaults on their listed
securities% investors will be considered as unsecured creditors and will have no preferential
claims to any assets held by the issuer. 3nvestors should therefore pay close attention to the
financial strength and credit worthiness of derivative product issuers.

%. Un2!..)ter).Ce0 -r!0u2t rs*
=ncollaterali)ed derivative products are not asset backed. 3n the event of issuer bankruptcy%
investors can lose their entire investment. 3nvestors should read the listing documents to
determine if a product is uncollaterali)ed.
?. Ge)rn> rs*
$erivative products such as derivative warrants and callable bull7bear contracts ."BB"s/ are
leveraged and can change in value rapidly according to the gearing ratio relative to the
underlying assets. 3nvestors should be aware that the value of a derivative product may fall to
)ero resulting in a total loss of the initial investment.
=. E$-r1 2!ns0er)t!ns
$erivative products have an e&piry date after which the issue may become worthless. 3nvestors
should be aware of the e&piry time hori)on and choose a product with an appropriate lifespan for
their trading strategy.
#. E$tr)!r0n)r1 -r2e 7!5e7ents
!he price of a derivative product may not match its theoretical price due to outside influences
such as market supply and demand factors. As a result% actual traded prices can be higher or
lower than the theoretical price.
<. F!re>n e$2/)n>e rs*
3nvestors trading derivative products with underlying assets not denominated in domestic
currency are also e&posed to e&change rate risk. "urrency rate fluctuations can adversely affect
the underlying asset value% also affecting the derivative product price.
@. L4u0t1 rs*
!he ,&change re2uires all derivative product issuers to appoint a li2uidity provider for each
individual issue. !he role of li2uidity providers is to provide two way 2uotes to facilitate trading
of their products. 3n the event that a li2uidity provider defaults or ceases to fulfill its role%
investors may not be able to buy or sell the product until a new li2uidity provider has been
assigned.
:. M)r*et rs*
$erivative :roducts may also be e&posed to the economic% political% currency% legal and other
risks of a specific sector or market related to the single stock% basket of stocks% inde&% currency%
commodity or futures contract that it is tracking.
?. T7e 0e2)1 rs*
All things being e2ual% the value of a derivatives will decay over time as it approaches its
e&piry date. $erivative warrants should therefore not be viewed as long term investments.
18. V!.)t.t1 rs*
:rices of derivative can increase or decrease in line with the implied volatility of underlying
asset price. 3nvestors should be aware of the underlying asset volatility.
Bist and brief the four positions in options market .*/
!here are four types of option positions4 a long position in a call% a long position in a put% a short
position in a call% and a short position in a put. A long position in a call option means buying the
option instrument for buying the underlying asset. A long position in a put option means buying
the option instrument for selling the underlying asset. A short position in a call means selling the
option instrument for buying the underlying asset. A short position in a put means selling the
option instrument for selling the underlying asset.
1. $efine swap.
A swap is the agreement through which a series of e&changes of periodic payments both
interest and principal is done with a counterparty.
2. $ifferentiate between long call option and short call option.
ption :osition Buyer5s :ay-off ,&planation
Bong "all ption Ca& .S! J A% 8/ 3f the closing spot price on any day
J:remium on or before e&piry is at a value
above the strike price of the option%
then the option buyer can make
profit e2ual to the difference
between the spot price and strike
priceS else he makes )ero profit
Bong :ut ption Ca& .A J S!% 8/ J 3f the closing spot price on any day
:remium on or before e&piry is at a value
lower than the strike price of the
option% then the option buyer makes
profit e2ual to the difference
between the strike and spot priceS
else he make )ero profit
'. What is swaption#
Swaption is an option on a swap where the buyer of the swaption J like the option holder is
entitled to perform a specific swap deal for a defined period of time.
*. What is warehousing swap#
+. A practice whereby an intermediary enters into one side of the swap transaction% such as
fi&ed rate payer .or floating rate payer/ to a client who wishes to be a floating rate payer .or a
fi&ed rate payer/. !hen the intermediary waits for a matching counterparty and offloads the
swap thereto. 3n other words% swap warehousing involves holding a portfolio of swaps
usually by a swap dealer without seeking to offset each swap with an identical mirror swap.
3n this sense% the swap dealer becomes counterparty to every swap held in its portfolio. !he
dealer earns% for its services as a dealer% a pay-receive spread .bid-ask spread/ which is e2ual
to the difference between the swap coupon the dealer pays and swap coupon the dealer
receives.
+. $escribe intrinsic value.
!he option premium can be broken down into two components - intrinsic value and time value.
!he intrinsic value of a call is the amount the option is in the Coney i.e. the difference between
the strike price and spot price% if it is 3n !he Coney. 3f the call is !C% its intrinsic value is )ero.
:utting it another way% the intrinsic value of a call is Max[0, (St K)] which means the intrinsic
value of a call is the greater of 8 or (St K). Similarly% the intrinsic value of a put is Max[0, K
O StP%i.e. the greater of 8 or (K St). A is the strike price and St is the spot price.
-. .a/ ,&plain the role of financial intermediary in detail .@/
Already discussed.
-. .b/ $ifferentiate between futures and options. .@/
Futures O-t!ns
,&change traded% with novation Same as futures.
,&change defines the product Same as futures.
:rice is )ero% strike price moves Strike price is fi&ed% price moves.
:rice is )ero :rice is always positive.
Binear payoff Donlinear payoff.
Both long and short at risk nly short at risk.
;. .a/ i. Write short notes on ,&change traded options. .@/
ii. What are the different types of swap contracts prevail in the market# ,&plain in detail..@/
B!< A9, AB9,A$Z $3S"=SS,$
An ption gives the buyer the right but not the obligation while the
seller has an obligation to comply with the contract. 3n the case of a
futures contract% there is an obligation on the part of both the buyer
and the seller. When you purchase call or put ptions you have the
right to let your ption lapse but if you choose to e&ercise it% the
counter-party .seller/ must comply. A futures contract% on the other
hand% is binding on both counter-parties as both parties have to settle
on or before the e&piry date.
:urchasing a futures contract re2uires an up front margin and normally
involves a larger outflow of cash than in the case of ptions% which re2uire
only the payment of premium.
A futures contract carries unlimited profit and loss potential whereas the
buyer of a "all or :ut ptionXs loss is limited but the profit potential is
unlimited.
(utures are a favourite with speculators and arbitrageurs whereas ptions are
widely used by hedgers.