Hedging Using Futures

HEDGING
STRATEGIES
USING
FORWARDS AND
FUTURES
PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

Long & Short Hedges
■ Long hedge
– Taking a long position in the forward/futures contract
– To lock the price of an asset to be acquired sometime in
future
■ Short Hedge
– Taking a short position in the forward/futures contract
– To lock in the price of an asset expected to be sold
sometime in future
– Asset may already be owned or expected to be owned
PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

Dhamija
Hedging Using Currency
Forward Contracts
■ Contract to exchange a certain amount of one
currency for a certain amount of another
currency at a future date
■ Exchange rate at which one party can buy/sell
a fixed amount of specified currency at a
future date
■ May be settled in cash or by delivery
PGDM / Financial Derivatives / Forwards and Futures/ Sanjay Dhamija

Illustration I
■ $10 million to be paid after 6 months towards

import of the machine
■ Current Spot Price = 65.80
■ 6 Months forward = 66.20
■ What is the gain or loss if dollar goes up to
67.50 or declines to 65.00 six months hence?

Long Hedge
$ = 67.50 $ 65.00
Gain on spot market = 65.80 – 67.50 = - Gain of Spot Market = 65.80 – 65.00 =
1.70 0.80
Gain on Forward = 67.50 – 66.20 = 1.30 Gain on Forward = 65.00 – 66.20 =
-1.20
Net Gain or Loss = -1.70 + 1.30 = Net Gain or Loss = 0.80 + -1.20 =
-0.40 -0.40
Effective Price= 65.80 + 0.40 = 66.20 Effective Price= 65.80 + 0.40 = 66.20
Alternatively 67.50 – 1.30 = 66.20 Alternatively 65.00 + 1.20 = 66.20

Illustration II
■ $10 million to be received after 6 months

towards exports of services
■ Current Spot Price = 65.30
■ 6 Months forward = 65.90
■ What is the gain or loss if dollar goes up to
67.20 or declines to 64.70 six months hence?

Short Hedge
$ = 67.20 $ 64.70
Gain on spot market = 67.20 – 65.30 = Gain on spot market = 64.70 – 65.30 = -
1.90 0.60
Gain on Forward = 65.90 – 67.20 = Gain on Forward = 65.90 – 64.70 = 1.20
-1.30
Net Gain or Loss = +1.90 - 1.30 = 0.60 Net Gain or Loss = -0.60 + 1.20 = 0.60
Effective Price= 65.30 + 0.60 = 65.90 Effective Price= 65.30 + 0.60 = 65.90
Alternatively 67.20 – 1.30 = 65.90 Alternatively 64.70 + 1.20 = 65.90

Dhamija
Forward Rate Agreement
■ A forward rate agreement (FRA) is an OTC
agreement that a certain rate will apply to a
certain principal during a certain future time
period
■ An FRA is equivalent to an agreement where
interest at a predetermined rate, RK is
exchanged for interest at the market rate
■ May be used to hedge against rise or fall in
interest rate
PGDM / Financial Derivatives / Forwards and Futures/ Sanjay

Dhamija
■ RK = Rate of interest agreed to in FRA

■ RM = Actual interest rate observed in the market at time T1
for the period between times T1 and T2
■ L = The principal underlying the contract
■ Gain or Loss
 Seller /Lender = L( RK  RM )(T2  T1 )
 Buyer/Borrower = L( RM  RK )(T2  T1 )

■ FRA often denoted as 3 x 6 or 3 vs.6
■ Market Practice is to settle at the beginning of a
borrowing or lending commitment
■ Pay off is the present value of the gain or loss
L( RK  RM )(T2  T1 )
1  RM (T2  T1 )
 days in loan term 
(
 K R  R )( )
■ Or L
M
365
days in loan term 
 1  RM ( ) 
 365 

Illustration III
■ Notional principal :10 million

■ Period : 3 x 12
■ Counterparty Quotes : 6.25/ 6.5%
■ MIBOR (Settlement date) : 7%
■ What is the payoff for the buyer of FRA?
■ What is the payoff for the buyer of FRA if the
MIBOR on the date of settlement is 6%?

Dhamija
Illustration III
■ MIBOR at 7%
L( RM  RK )(T2  T1 ) 10(.07  .065)(1  .25)
Pay off = =
1  RM (T2  T1 ) 1  .07(1  .25)
= Rs.35629.45
■ MIBOR at 6%
Payoff = 10(.06  .065)(1  .25)
1  .06(1  .25)
= (- Rs.35,885.2)

Dhamija
Hedging Using Futures
■ Hedgers use futures market to reduce a

particular risk that they face.
■ A perfect hedge is one that completely
eliminates the risk.
– In practice, these are rare.
■ The objective is usually to take a position that
neutralizes the risk as far as possible.

Key Questions
■ What kind of hedge
– To buy or sell forward or future
■ Which expiration
– Given the period of exposure
– Basis Risk
■ Which underlying asset
– Cross hedging
■ Number of contracts

Arguments in Favor of
Hedging
■ Companies should focus on the main
business they are in and take steps to
minimize risks arising from interest
rates, exchange rates, and other market
variables
■ If competitors are hedging, so do you

Dhamija
Arguments against Hedging
■ Shareholders are usually well diversified and

can make their own hedging decisions
■ It may increase risk to hedge when
competitors do not
■ Explaining a situation where there is a loss on
the hedge and a gain on the underlying can be
difficult

Imperfections in hedging
■ Timing Mismatch
– Date when the asset is to be bought or sold may not
match with the expiry date of the future contract
– Future contracts may have to be closed out before the
delivery month
■ Assets mismatch
– Asset to be hedged may not exactly be the same as
underlying asset in a future contract
– Cross hedging

Basis Risk
■ Basis is usually defined as the spot price

minus the futures price
– Basis = Spot Price – Future Price
■ Basis risk arises because of the uncertainty
about the basis when the hedge is closed
out
■ On maturity spot and future prices converge
and basis is zero

Long Hedge for Purchase of an Asset
■ Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased
S1 : Asset price at time hedge is set up
S2 : Asset price at time of purchase
b1 : Basis at time of hedge is set up = S1 - F1
b2 : Basis at time of purchase = S2 – F2
Cost of asset S2
Gain on Futures F2 −F1
Net amount paid S2 − (F2 −F1) =F1 + b2

Dhamija
Short Hedge for Sale of an Asset
■ Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased
S1 : Asset price at time hedge is set up
S2 : Asset price at time of purchase
b1 : Basis at time of hedge is set up = S1 - F1
b2 : Basis at time of purchase = S2 – F2
Price of asset S2
Gain on Futures F1 −F2
Net amount paid S2 + (F1 −F2) =F1 + b2

Dhamija
Basis and Hedging
Profitability
Hedge Benefits from When Occurs
Long Weakening basis Spot price rises less than future price
Or
Spot price falls more than future price
Or
Spot price falls and future price rises
Short Strengthening basis Spot price rises more than future price
Or
Spot price falls less than future price
Or
Spot price rises and future price falls

Illustration IV
March 30
■ Spot price of Gold : $1387.15
■ Gold Future (June) : $ 1388.60
Expiration (June)
■ Spot price of Gold : $1408.50
Closed prior to expiration
■ Spot Price of Gold : $ 1377.52
■ Gold Future (June) : $1378.63

Dhamija
Long Hedge – Held till
expiration
■ Gain on spot market = 1387.15 – 1408.50 = - 21.35
■ Gain on Forward = 1408.50 – 1388.60 = 19.90
■ Net Gain or Loss = -21.35 + 19.90 = -1.45
■ Effective Price= 1387.15+ 1.45 = 1388.60
■ Alternatively 1408.50 – 19.90 = 1388.60
■ b1 = 1387.15 -1388.60 = -1.45
■ b2 = 0
■ Gain = b1 – b2 = -1.45 – 0 = -1.45

Dhamija
Long Hedge – closed prior to
expiration
■ Gain on spot market = 1387.15 – 1377.52 = 9.63

■ Gain on Forward = 1378.63 – 1388.60 = -9.97
■ Net Gain or Loss = 9.63-9.97 = -0.34
■ Effective Price= 1387.15+ 0.34 = 1387.49
■ Alternatively 1377.52 + 9.97 = 1387.49
■ b1 = 1387.15 -1388.60 = -1.45
■ b2 = 1377.52 – 1378.63 = -1.11
■ Gain = b1 – b2 = -1.45 – (-1.11) = -0.34
PGDM/Financial Derivatives / Hedging Using Futures /

Sanjay Dhamija
Short Hedge– Held till
expiration
■ Gain on spot market = 1408.50 - 1387.15 = 21.35
■ Gain on Forward = 1388.60 - 1408.50 = -19.90
■ Net Gain or Loss = 21.35 - 19.90 = 1.45
■ Effective Realization = 1387.15+ 1.45 = 1388.60
■ Alternatively 1408.50 – 19.90 = 1388.60
■ b1 = 1387.15 -1388.60 = -1.45
■ b2 = 0
■ Gain = b2 – b1 = 0 – (-1.45) = 1.45

Dhamija
Short Hedge – closed prior to
expiration
■ Gain on spot market = 1377.52 -1387.15 = - 9.63

■ Gain on Forward = 1388.60 -1378.63 = 9.97
■ Net Gain or Loss = -9.63+9.97 = 0.34
■ Effective Realization= 1387.15+ 0.34 = 1387.49
■ Alternatively 1377.52 + 9.97 = 1387.49
■ b1 = 1387.15 -1388.60 = -1.45
■ b2 = 1377.52 – 1378.63 = -1.11
■ Gain =b2 - b1 = -1.11 – (-1.45) = 0.34

Dhamija
Choice of Contract
■ Choose a delivery month that is as close as

possible to, but later than, the end of the life
of the hedge

Cross Hedging
■ Asset being hedged and asset
underlying the future contract are
different
– There is no futures contract on the asset
being hedged, or the future contract is not
liquid
– Choose the contract whose futures price is
most highly correlated with the asset price

Optimal hedge ratio
■ Hedge ratio represents the ratio of the size of the position taken
in futures contracts to the size of the exposure.
■ Optimal hedge ratio may differ from 1.
■ The optimal hedge ratio (h*) is given as
S
h 
*
F
– S = Standard deviation of change in spot price
– F = Standard deviation of change in futures price
–  = Correlation coefficient between spot price and futures price
■ Optimal hedge ratio is also termed as Minimum variance hedge
ratio.
Optimal hedge ratio
■ Optimal number of futures contracts is given as
thus:
*
h NA
N 
*
QF
– NA = Size of the position being hedged (units)
– QF = Size of the futures contracts (units)
– N* = Optimal number of futures contracts for hedging
Illustration V
■ The standard deviation of monthly changes in the spot

price of commodity A is 1.2. The standard deviation
of monthly changes in the future prices of commodity
B is 1.4. The correlation between the two is 0.7. The
manufacturer is committed to buy 200,000 Kgs of A
on August 2016 and wants to use December futures of
B to hedge its risk. Each contract is for delivery of
40,000 Kg of B.
■ What strategy should be followed?

Illustration V

Illustration VI
■ Airline will purchase 2 million gallons of jet

fuel in one month and hedges using heating
oil futures
■ From historical data F =0.0313, S =0.0263,
and = 0.928
* 0.0263
h  0.928   0.7777
0.0313

Dhamija
Illustration VI
■ The size of one heating oil contract is 42,000 gallons
■ The spot price is 1.94 and the futures price is 1.99 (both
dollars per gallon) so that
V A  1.94  2,000,000  3,880,000
V F  1.99  42,000  83,580
■ Optimal number of contracts assuming no daily settlement

 0.7777
■ Optimal number  2,000
of contracts ,000
after 42,000  37.03
tailing
 0.7777  3,880,000 83,580  36.10

Hedging Using Index Futures
■ If the portfolio mirrors the index, a hedge ratio of 1.0 is
appropriate.
 To hedge the risk in a portfolio the number of contracts
that should be shorted is
VA

VF
 where VA is the value of the portfolio, is its beta, and
VF is the value of one futures contract

Dhamija
Illustration VII
• INDEX Spot : 7,900
• INDEX Futures : 8,000
• Contract Size : 50
• Value of Portfolio : Rs.50 million
• Beta of portfolio : 1.5
What position in futures contracts on the INDEX is necessary to
hedge the portfolio?
VA
N 
*
= 1.5 50,000,000 = 187.5 or say 188
VF 8,000 X 50
Short 188 INDEX Futures @8,000

Dhamija
Illustration VII
10% increase in 10% decline in market
market
Index 8,690 7,110

Index Return 10% -10%
Portfolio Return 14.00% -16.00%
Gain on Portfolio 7,000,000 (8,000,000)
Gain on Future
Contract (690) 890
Gain on Futures (6,486,000) 8,366,000
Total Gain 514,000 366,000
Gain without Hedging 7,000,000 (8,000,000)
Value of Portfolio 50,514,000 50,366,000
Dhamija
Changing β
■ Portfolio managers adjust their portfolio betas to reflect
changes in the perceived market risk and return
– Bullish expectation  increase beta (increase the exposure to
the market)
– Bearish expectation  decrease beta (decrease the exposure
to the market)
■ How to adjust beta?
– Reduce beta by selling part of an equity portfolio and buy risk
less securities
– Increase beta make additional investments on risky equity
portfolio through borrowing/selling risk less securities

Changing Beta
■ Futures can be used to change the Beta of the portfolio
■ Short future to reduce β to β*
VA
(   ) *
VF
■ Long future to increase β to β*
VA
(   )
*
VF

Dhamija
Illustration VIII
■ INDEX : 8000
■ INDEX FUTURE : 8200
■ Size of Contract : 50
■ Value of Portfolio : 5,000,000
■ Beta of Portfolio : 1.2
– A) What position is necessary to reduce the β of the
portfolio to 0.75?
– B) What position is necessary to increase the β of the
portfolio to 2.0?

Illustration VIII
■ No of Contracts to be shorted to reduce β to 0.75
5,000,000
(1.2  0.75)
410,000
5.48 or say 5
■ No of Contracts to go long to increase β to 2.00
5,000,000
(2.0  1.2)
410,000
= 9.756 or say 10

Dhamija
Why Hedge Equity Returns
■ Avoids the costs of selling and repurchasing the

portfolio
■ Suppose stocks in your portfolio have an average beta
of 1.0, but you feel they have been chosen well and
will outperform the market in both good and bad
times. Hedging ensures that the return you earn is the
risk-free return plus the excess return of your
portfolio over the market.

Stack and Roll
■ Rolling Over
■ We can roll futures contracts forward to hedge
future exposures
■ Initially we enter into futures contracts to
hedge exposures up to a time horizon
■ Just before maturity we close them out an
replace them with new contract reflect the new
exposure etc

Rolling The Hedge Forward
■ If there are futures contracts 1, 2, 3, …, n (not all necessarily
in existence at the present time) with progressively later
delivery dates, a company wishing to hedge an equity
portfolio can use the following strategy:
Time t1: Short futures contract 1

Time t2: Close out futures contract 1
Short futures contract 2
Time t3: Close out futures contract 2
Short futures contract 3
Time tn: Close out futures contract n – 1
Short futures contract n
Time T: Close out futures contract n
Key Learnings
■ Hedging
– Long Hedges and Short Hedges
■ Basis Risk
■ Cross Hedging
– Optimal Hedge Ratio
■ Hedging Using Index Futures
– Changing β of a portfolio
■ Stack and Roll

Dhamija
SWAPS
Chapter 11: Chance, Brooks and Dhamija
PGDM/Financial Derivatives/Swaps/Sanjay Dhamija

Nature of Swaps
■ A swap is an agreement to
exchange cash flows at specified
future times according to certain
specified rules
– Interest Rate Swap
– Currency Swap

Interest Rate Swap
■ Agreement to pay interest at a fixed

rate in return of floating rate interest

Interest Rate Swap
■ Converting a ■ Converting an
liability from investment from
– fixed rate to – fixed rate to
floating rate floating rate
– floating rate to – floating rate to
fixed rate fixed rate
Illustration I
■ X Ltd borrowed 1000 Millions @

MIBOR+1%. Y Limited borrowed 1000
Millions @ 7%. Y agree to pay
MIBOR+1%, in return X agrees to pay
7% per annum. MIBOR at the
beginning of each year are at:
5.5%, 7.0%, 6.5%,

Transform a Liability
7%
7%
X Y
MIBOR+1%
MIBOR+1%

Financial Institution is Involved
6.985% 7.015%
7%
X F.I. Y
MIBOR+1%
MIBOR+1% MIBOR +1%
• Financial Institution has two offsetting

swaps

Illustration II : Comparative
Advantage Argument
• AAA Corp wants to borrow floating
• BBB Corp wants to borrow fixed
• AAA has advantage in both markets but in Fixed it has higher comparative advantage
• Potential Gain = (8.2%-7.0%) – (0.6%-0.1%) = 0.7%; to be shared
Fixed Floating
AAA Corp 7.0% 6 month MIBOR + 0.1%
BBB Corp 8.2% 6 month MIBOR + 0.6%

The Swap
7.25%
7%
AAACorp BBBCorp
MIBOR+0.6%
MIBOR

The Swap when a Financial Institution
is Involved
7.23% 7.27%
7%
AAACorp BBBCorp
F.I
. MIBOR+0.6%
MIBOR MIBOR

Quotes By a Swap Market Maker
Maturity Bid (%) Offer (%) Swap Rate (%)

2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850

Currency Swap
■ Exchanging principal and interest

payments in one currency for principal
and interest payments in another
– An agreement to pay 5% on a sterling principal
of £10,000,000 & receive 6% on a US$ principal
of $18,000,000 every year for 5 years

Exchange of Principal
■ In an interest rate swap the principal is not

exchanged
■ In a currency swap the principal is
exchanged at the beginning and the end of
the swap’s life

Typical Uses of a Currency
Swap
■ Convert a liability in one currency to a

liability in another currency
■ Convert an investment in one currency
to an investment in another currency

Comparative Advantage
■ General Electric wants to borrow AUD

■ Quantas wants to borrow USD
■ 1 AUD = 0.9 USD
■ Cost after adjusting for the differential impact of
taxes
USD AUD
General Electric 5.0% 7.6%
Quantas 7.0% 8.0%

Swap
AUD 6.9% AUD 8.0%
Swap
USD 5% GE Qantas AUD 8.0%
Dealer
USD 5% USD 6.3%
GE= -USD5% - AUD 6.9% + USD5% = -AUD 6.9%
Qantas = -AUD8% - USD6.3% + AUD 8% = -USD6.3%

Valuation of Interest Rate
Swaps
■ Initially interest rate swaps are worth close to
zero
■ Each exchange of payments in an interest rate
swap is an FRA
■ The FRAs can be valued on the assumption
that today’s forward rates are realized

Illustration III
■ 3 months ago, a financial institution agreed to receive six-

month LIBOR and pay 3% (s.a. compounding) on a
principal of $100 million
■ Remaining life 1.25 years
■ LIBOR rates for 3-months, 9-months and 15-months are
2.8%, 3.2% and 3.4% (cont comp)
■ 6-month LIBOR on last payment date was 2.9% (semi
annual compounding)
■ Determine the value of SWAP?

Valuation of Currency Swaps
Currency swaps can be valued either as

the difference between 2 bonds or as a
portfolio of forward contracts

Illustration IV
■ Japanese interest rates - 4%

■ USD interest rates - 9%
■ 5% is received in yen; 8% is paid in dollars.
Payments are made annually
■ Principals are $10 million and 1,200 million yen
■ Swap will last for 3 more years
■ Current exchange rate is 110 yen per dollar

Valuation in Terms of Bonds
Time Cash Flows ($) PV ($) Cash flows (yen) PV (yen)

1 0.8 0.7311 60 57.65
2 0.8 0.6682 60 55.39
3 0.8 0.6107 60 53.22
3 10.0 7.6338 1,200 1,064.30
Total 9.6439 1,230.55
Value of Swap = 1230.55/110 − 9.6439 = 1.5430

Valuation in Terms of
Forwards
Time $ cash Yen cash Forward Yen cash Net Cash Flow Present value
flow flow Exchange rate flow in $
1 -0.8 60 0.009557 0.5734 -0.2266 -0.2071

2 -0.8 60 0.010047 0.6028 -0.1972 -0.1647
3 -0.8 60 0.010562 0.6337 -0.1663 -0.1269
3 -10.0 1200 0.010562 12.6746 +2.6746 2.0417
Total 1.5430

Learnings
■ Swaps
– Exchange of one stream of future cash flows with an
alternative stream of cash flows
■ Interest Rate Swaps
– To covert the floating rate assets/liabilities to fixed
rate assets/liabilities and vice versa
■ Currency Swaps
– To covert investments/liabilities in one currency to
investments/liabilities in another currency

Things to do..
■ https://www.hdfcbank.com/wholesale/fit/financial_institutions/d
erivatives_desk/derivatives_desk.htm

MECHANICS OF
OPTIONS
MARKETS
Chapter 3 : Chance, Brooks and Dhamija
PGDM/Financial Derivatives/ Option Markets/ Sanjay Dhamija

Option Terminology
■ Option
– Right but not the obligation to buy or sell a specified quantity of
the underlying asset at a fixed exercise price on or before
expiration date
■ Call Option
– The right to buy
■ Put Option
– The right to sell

Option Terminology
■ Option Writer
– Option seller – has an obligation to perform according to the
contract
– Also called as the `short position’
■ Option Holder
– Option buyer – buys the rights (but not obligation) conveyed by
the option
– Also called as the `long position’

Option Terminology
■ Exercise Price
– Price at which the contract is settled
– Also referred to as `strike price’
■ Expiration Date
– The date on which the option expires
– The option holder would have no right after the expiration
date
– Also referred to as `maturity’

Option Terminology
■ Premium
– Price that the holder of the option pays and the writer of an
option receives for the rights conveyed by the option
– Premium is market determined
– Key factors
■ Spot Price of underlying, exercise price, volatility, volatility,
time remaining till expiration, interest rate etc.

Option Terminology
■ Style of Option – time at which the option is

exercisable
– American Style – can be exercised any time before
expiration
– European Style – can be exercised only on the expiration
date
PGDM/Financial Derivatives/ Option Markets/ Sanjay

Dhamija
Option Terminology
■ Opening Transaction
– A purchase or sale transaction by which a person
establishes or increases a position
■ Closing Transaction
– A transaction by which a person reduces or cancels out
previous position

In the Money, At the Money and Out of
Money Options
■ What is the pay-off for the option holder if it is exercised
now
■ Depends upon the Current Spot Price (S) and Strike Price
(K)
– At the money – S=T
– In the money
■ Call Option : S > K
■ Put Option : S < K
– Out of the Money
■ Call Option : S < K
■ Put Option : S > K

Intrinsic Value and Time
Value
■ The premium of the option consists of two components
– Intrinsic Value
– Time Value
■ Intrinsic Value
– By which amount the option is `in the money’
■ Time Value
– Difference between option premium and the intrinsic value

Long Call
Profit from buying one European call option: option price
= $5, strike price = $100, option life = 2 months
30 Profit ($)
20
10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130

Dhamija
Short Call
Profit from writing one European call option: option price
= $5, strike price = $100
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)
-20
-30

Dhamija
Long Put
Profit from buying a European put option: option price =
$7, strike price = $70
30 Profit ($)
20
10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7

Short Put
Profit from writing a European put option: option price =
$7, strike price = $70
Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10
-20
-30

Dhamija
Illustration I
■ Spot Price :Rs.580

■ Strike Price : Rs.600
■ Option Premium : Rs.50
– Calculate the pay off for the Buyer and Seller of Call and Put
(Price range Rs.580 – Rs. 710, increment Rs.10)
– Whether the options are in the money, at the money, out of the
money?
– What is the intrinsic value and time value of the options?
– What is the break even point for the call option and put
option?
– What action would you suggest to the buyer of call/put?

Dhamija
Learnings
■ Type of Options
■ Options’ Payoff
– Long Call
– Short Call
– Long Put
– Short Put
■ Market Mechanism

Dhamija
PROPERTIES OF
STOCK OPTIONS
PGDM/Financial Derivatives/Option Properties/ Sanjay Dhamija

Upper bounds for call option
■ Call option
– European : c  S0;
■ If not True
– Sell call option and buy stock to make riskless profit

Upper bounds for put option
■ Put option
– European : p  Ke –rT;
■ If not True
– Sell put option and invest the proceeds of sale at risk free
rate of interst

Lower Bound for European Call
Option Prices; No Dividends
c  S0 –Ke -rT
• If not true, buy call and short

stock to make riskless profit

Illustration I
■ Details regarding a stock and call option are given below:
c = Rs. 70 S0 = Rs. 1000

T = 3 months r = 10%
K = Rs. 940 D=0
■ Is there an arbitrage opportunity?
■ If yes, how to take advantage?

Illustration I
■ c  S0 –Ke –rT
■ = Rs. 83.21
■ As Call option is mispriced in market, buy call option and sell
stock to take advantage of the mispricing

Lower Bound for European Put
Prices; No Dividends
p  Ke -rT–S0
• If not true, buy put and buy stock
to make riskless profit

Illustration II
■ Suppose that
p= 10 S0 = 1000
T = 2 Months r =10%
K = 1040 D =0
■ Is there an arbitrage opportunity?

Illustration II
■ p  Ke –rT -S0
■ = Rs. 22.81
■ As Put option is mispriced in market, buy put and stock to take
advantage of the mispricing at a total outflow of Rs.1010.

Lower and Upper Bonds -
European Option
Upper Bound Lower Bound
Call Option c  So c  max (S0 –Ke –rt,0)
Put Option p  Ke –rT; p  max (Ke -rT–S0 ,0)

Put-Call Parity: No Dividends
■ Value of a European Call with a certain exercise price and exercise date
can be deduced from the value of European put with the same exercise
price and exercise date and vice versa.
– c + Ke -rT = p + S0

Put-Call Parity: No Dividends
■ Consider the following 2 portfolios:
– Portfolio A: European call on a stock +
zero-coupon bond that pays K at time T
– Portfolio C: European put on the stock +
the stock

Values of Portfolios
ST > K ST < K
Portfolio A Call option ST − K 0
Zero-coupon bond K K
Total ST K
Portfolio C Put Option 0 K− ST
Share ST ST
Total ST K

The Put-Call Parity Result
■ Both are worth max(ST , K ) at the maturity of the

options
■ They must therefore be worth the same today. This
means that
■ c + Ke -rT = p + S0
PGDM/Financial Derivatives/Option Properties/ Sanjay

Dhamija
Illustration III
■ Suppose that
c= 3 S0= 31
T = 0.25 r = 10%
K =30 D=0
■ What are the arbitrage possibilities when:
a) p = 2.25 ?
b) p = 1.00 ?

Dhamija
The Impact of Dividends
 rT
c  S 0  D  Ke
 rT
p  D  Ke  S0
c + D+ Ke -rT = p + S0
D is the present value of dividends during the life of
the option
Dhamija
Learning
■ Lower and Upper bounds of call and put

options
■ Put –call parity
– c + Ke -rT = p + S0

Dhamija

Hedging Using Futures

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HEDGING

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

PGDM / Financial Derivatives / Forwards and Futures/ Sanjay Dhamija

■ $10 million to be paid after 6 months towards

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

Alternatively 67.50 – 1.30 = 66.20 Alternatively 65.00 + 1.20 = 66.20

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

■ $10 million to be received after 6 months

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

Alternatively 67.20 – 1.30 = 65.90 Alternatively 64.70 + 1.20 = 65.90

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

PGDM / Financial Derivatives / Forwards and Futures/ Sanjay

■ RK = Rate of interest agreed to in FRA

PGDM / Financial Derivatives / Forwards and Futures/ Sanjay Dhamija

PGDM / Financial Derivatives / Forwards and Futures/ Sanjay Dhamija

■ Notional principal :10 million

PGDM / Financial Derivatives / Forwards and Futures/ Sanjay

PGDM / Financial Derivatives / Forwards and Futures/ Sanjay

■ Hedgers use futures market to reduce a

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

■ Shareholders are usually well diversified and

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

■ Basis is usually defined as the spot price

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

■ Gain on spot market = 1387.15 – 1377.52 = 9.63

PGDM/Financial Derivatives / Hedging Using Futures /

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

■ Gain on spot market = 1377.52 -1387.15 = - 9.63

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

■ Choose a delivery month that is as close as

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

■ The standard deviation of monthly changes in the spot

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

■ Airline will purchase 2 million gallons of jet

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

■ Optimal number of contracts assuming no daily settlement

 0.7777  3,880,000 83,580  36.10

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

Short 188 INDEX Futures @8,000

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

Index 8,690 7,110

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

■ No of Contracts to be shorted to reduce β to 0.75

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay

■ Avoids the costs of selling and repurchasing the

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay Dhamija

Time t1: Short futures contract 1

PGDM/Financial Derivatives / Hedging Using Futures / Sanjay