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DERIVATIVES AND MARKETS

Assignment -1

Submitted to:
DR. Shaista Anwar

Submitted by:
Mohammad Arsalan, AUD 1372
Submission date: 20 th May 2015

AMITY UNIVERSITY, DUBAI.


Q1.Which of the followings cannot mitigate credit risk? Explain briefly.

(A) Collateralization
(B) Bank letters
(C) Haircut
(D) Hedging
(E) No answer is given in (A), (B), (C), and (D)
ANSWER (D) Hedging, because hedging mitigate market risk not credit risk.

Q2. What are the needs of derivatives and who are the participants of Derivatives market?
ANSWERToday's sophisticated international markets have helped foster the rapid growth in derivative
instruments. In the hands of knowledgeable investors, derivatives can derive profit from:

Changes in interest rates and equity markets around the world.

Currency exchange rate shifts.

Changes in global supply and demand for commodities such as


agricultural products, precious and industrial metals, and energy products such as
oil and natural gas.

Adding some of the wide variety of derivative instruments available to a traditional portfolio of
investments can provide global diversification in financial instruments and currencies, help
hedge against inflation and deflation, and generate returns that are not correlated with more
traditional investments. The two most widely recognized benefits attributed to derivative
instruments are price discovery and risk management.
Participants of derivatives market-The derivatives market is similar to any other financial
market and has following three broad categories of participants:
HEDGERS:
These are investors with a present or anticipated exposure to the underlying asset which is
subject to price risks. Hedgers use the derivatives markets primarily for price risk management
of assets and portfolios.
SPECULATORS:

These are individuals who take a view on the future direction of the markets. They take a view
whether prices would rise or fall in future and accordingly buy or sell futures and options to try
and make a profit from the future price movements of the underlying asset.
ARBITRAGEURS:
They take positions in financial markets to earn riskless profits. The arbitrageurs take short and
long positions in the same or different contracts at the same time to create a position which can
generate a riskless profit.
Q3. An investor has done the following two spread trades in Sensex futures contracts. What is
her profit (+) or loss(-)? Bought 10 Jan-Feb Spread [Sold Jan @ 3660; Bought Feb @ 3662],
Sold 10 Jan-Feb Spread [ Bought Jan @ 3700 ; Sold Feb @ 3717]
a) Rs.375000
b) Rs.150
c) Rs.7500
d) None of these

ANSWER- (c ) Rs. 7500.


Because when an investor Bought 10 futures @ Spread [Sold Jan @ 3660; Bought Feb @
3662], he will be in loss of Rs.20 =(2*10), but when he Sold 10 futures @ Spread [Bought
Jan @ 3700 ; Sold Feb @ 3717], he will be in profit of Rs.170=(17*10).
So overall his profit is Rs.150=(170-20).
150*50=7500

Q4. You have bought Satyam Put strike price Rs. 260 at a premium of Rs.45. Lot size is 1,200.
What is your profit (+) or loss(-) if you sell the Put at Rs 18?
a) Rs 32,400

b) Rs -31,400
c) Rs -33,400
d) None of these
ANSWER- (a) i,e Rs-32400.
Bought Put at strike price Rs.260 @ premium of 45.
Total price of Put is Rs.54000 (45*1200).
But sold @ premium of 18.
Money received Rs.21600. So, there is a loss of Rs.32400 = (bought @ 54000- sold @ 21600).

Q5. Why might the increased protection provided to individual traders by the derivatives market
increase the risk of the whole financial system running into difficulties?
ANSWER-

Most witnesses and commentators took the view that derivatives were involved in, but did not
cause, the financial crisis of 2008, although some witnesses argued that CDS in particular played
a very significant role. Lord Myners, financial services Secretary to the Treasury, told us
however that although derivatives represented a significant part of the financial infrastructure "it
is difficult to argue that the financial crisis was caused by derivatives".
The Commission argued in the first Communication that
the crisis had shown "that the characteristics of OTC derivative marketsthe private
nature of contracting with limited public information, the complex web of mutual
dependence, the difficulties of understanding the nature and level of risksincrease
uncertainty in times of market stress and accordingly pose risks to financial stability." It
noted that while the difficulties experienced by Bear Stearns, Lehman Brothers and AIG during
the crisis originated outside the derivatives market, the involvement of all three institutions in the
OTC derivatives market, and in particular CDS contracts, spread those difficulties across the
world economy.
It is argued that the opacity of the market increased mistrust among participants which
resulted in reduced liquidity. This opacity also prevented regulators from spotting the
build-up of risk in the financial system, which increased the consequences that the default
of one of these companies would have for the financial system.
Other witnesses pointed to the involvement of derivatives in the collapse of
Lehmann Brothers and AIG, both of which, in effect, were insuring banks against the default of
their borrowers. More specifically, Deutsche Bank explained that AIG had taken on a large
number of bespoke CDS, which were often too complex to be centrally cleared. As the value of
the underlying asset declined with the bursting of the sub-prime mortgage bubble, AIG was
forced to make significant payments to its counterparties and subsequently required financial
support provided by the US Government to prevent its collapse.

Q6. Discuss interest rate swap and currency swap.


ANSWERInterest Rate Swap-

An agreement between two parties (known as counterparties) where one stream of future interest
payments is exchanged for another based on a specified principal amount. Interest rate swaps
often exchange a fixed payment for a floating payment that is linked to an interest rate (most
often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure
to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have
been able to get without the swap.
Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate
specifications) for another. Because they trade OTC, they are really just contracts set up
between two or more parties, and thus can be customized in any number of ways.

Currency SwapA swap that involves the exchange of principal and interest in one currency for the same in
another currency. It is considered to be a foreign exchange transaction and is not required
by law to be shown on a company's balance sheet.
For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based
company needs to acquire U.S. dollars. These two companies could arrange to swap currencies
by establishing an interest rate, an agreed upon amount and a common maturity date for the
exchange. Currency swap maturities are negotiable for at least 10 years, making them a very
flexible method of foreign exchange.

Q7.What is future market and discuss about the mechanics of future market?
ANSWERFuture market- Futures markets are places (exchanges) to buy and sell futures contracts. There
are several futures exchanges.

In UAE- DME (Dubai Merchantile Exchange),


DGCX( Dubai Gold & Commodity Exchange),
ADX(Abu Dhabi Securities Exchange).
Mechanics of future market1. Day traders-short-term movements do not hold positions overnight.
2. Scalpers- gain profit from small changes in contract prices, hold positions for just a
few minutes.
3. Position traders- hold position for longer periods of time looking for long term
movements.
4. Settlement price-price established at the end of each trading day.
5. Marked to market- adjusting each margin account by changes in the settlement
price each day.
6. Limit up/down-maximum amount by which futures prices can change during a
trading day.

Q8. What do you understand by forward contract and what are the features of forward contract?
A customized contract between two parties to buy or sell an asset at a specified price on a
future date. A forward contract can be used for hedging or speculation, although its nonstandardized nature makes it particularly apt for hedging. Unlike standard futures contracts,

a forward contract can be customized to any commodity, amount and delivery date. A forward
contract settlement can occur on a cash or delivery basis. Forward contracts do not trade on a
centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While
their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also
gives rise to a higher degree of default risk. As a result, forward contracts are not as easily
available to the retail investor as futures contracts.
Features1. Futures contracts are traded on an exchange while forward contracts are privately
traded.
2. Since they are traded on exchange, futures contracts are highly standardized.
Forward contracts, on the other hand, are customized as per the requirements of the
counterparties.
3. A single clearinghouse acts as the counterparty for all futures contracts. This means
that the clearinghouse is the buyer for every seller and seller for every buyer. This
eliminates the risk of default, and also allows traders to reverse their positions at a
future date.
4. Futures contracts require a margin to be posted at the contract initiation, which
fluctuates as the futures prices fluctuate. There is no such margin requirement in a
forward contract.
5. The government regulates futures market while the forward market is not
regulated.

Q9. What are the benefits of trading in index futures compared to any other security?
ANSWERAn investor can trade the entire stock market by buying index futures instead of buying
individual securities with the efficiency of a mutual fund.

The benefits of trading in Index Futures are:


1. The contracts are highly liquid
2. Index Futures provide higher leverage than any other stocks
3. It requires low initial capital requirement
4. It has lower risk than buying and holding stocks
5. It is just as easy to trade the short side as the long side
6. Only have to study one index instead of 100s of stocks

Q10.What is the contract cycle for equity based products in NSE?


ANSWERFutures and Options contracts have a maximum of 3-month trading cycle -the near month
(one), the next month (two) and the far month (three), except for the Long dated Options
contracts.
New contracts are introduced on the trading day following the expiry of the near month
contracts. The new contracts are introduced for a three month duration. This way, at any
point in time, there will be 3 contracts available for trading in the market (for each security) i.e.,
one near month, one mid month and one far month duration respectively. For example on
January 26,2008 there would be three month contracts i.e. Contracts expiring on January
31,2008, February 28, 2008 and March 27, 2008. On expiration date i.e January 31,2008, new
contracts having maturity of April 24,2008 would be introduced for trading.

Q11. Consider the following statement: A speculator who felt that interest rates were likely to
rise or a currencys value decline would go short in the relevant asset by selling a futures
contract.
(a)Why would a speculator go short rather than long in these two cases?
(b) What does going short in interest rates mean?

(c) How does selling a futures contract allow one to go short?


ANSWER(a)- A speculator should go short in these two cases rather than long in these two case
because whenever interest rates are likely to be rise and currencies values decline in future,
in both the cases , holder of the long position will be suffered and hence he/she will be in
loss, so its better to go for short.
(b)- A speculator go short in these cases because interest rates were likely to be rise so, it
will also increase the futures price so its better to sell at low interest earlier in order to pay
less in future.

Q12. Differentiate between Investment Assets with Consumption Assets.


ANSWER-

Investment assetsAn asset or item that is purchased with the hope that it will generate income or appreciate
in the future. In an economic sense, an investment is the purchase of goods that are not
consumed today but are used in the future to create wealth. In finance, an investment is a
monetary asset purchased with the idea that the asset will provide income in the future or
appreciate and be sold at a higher price.

Consumption assetsConsumption assets are typically raw material commodities which are used as a source of
energy or in a production process, for example-crude oil or iron ore. Users of these
consumption commodities may feel that there is a benefit from physically holding the asset in
inventory as opposed to holding a forward on the asset. These benefits include the ability to
profit from temporary shortages and the ability to keep a production process running and
are referred to as the convenience yield.
Q13. What do you understand Rainbow Option?
ANSWERA single option linked to two or more underlying assets. In order for the option to pay
off, all the underlying assets must move in the intended direction.

The underlying securities can have different characteristics, such as expiry date and strike
price, but all must move in the way the option holder has bet they will.
Here's a sports-betting analogy that demonstrates a rainbow option: suppose you're at a baseball
tournament with three fields backing one another. One game is halfway through, a second is just
starting and a third starts in an hour. A type of bet that's analogous to a rainbow option is one that
earns you a profit if you pick all three winners, but gets you nothing if any one team you pick is a
loser.

Q14. You are given that the ABC Stock price is traded at $45 now and the 3-month forward price
is $46.80. Which of the following is true about outright purchase of this stock and the forward
contract?
.

(A) If the spot price is $45 after 3 months, the profit for outright purchase and long
forward contract is the same

(B) If the spot price is $46.80 after 3 months, the profit for outright purchase and long
forward contract is the same.

(C) If the ABC Stock pays a dividend of $0.50 after 1 month and is traded at $46.80 after
3 months, purchasing the stock outright makes a profit of $2.30.

(D) If the ABC stock pays a dividend of $0.50 after 1 month and is traded at $46.80 after
3 months, the profit of long forward is $0.

(E) The answer is not given in (A), (B), (C), and (D).

ANSWER(D) If the ABC stock pays a dividend of $0.50 after 1 month and is traded at $46.80 after 3
months, the profit of long forward is $0.

Q15. The current price of the Lucky Company Stock is $50, and the 6-month forward price is
$52. What is the amount of money that needs to be lent today to mimic the profit of outright
purchase after 6 months? Assume that the annual continuously compounded risk free rate is 5%.
.

(A) $50.00

(B) $50.20

(C) $50.70

(D) $51.20

ANSWER- (C) $ 50.70


PV= FV/(1+r)^t
PV=52/(1+0.05)^0.5
PV=50.78
50.78 have to be lend in order to mimic the profit of outright purchase after 6 months.
Q16. A dealer has just entered into a short forward position. The underlying asset is currently
traded at $100 and the 1-year forward price is $105. Assuming an annual effective rate of 3%,
find the number of 100 zero-coupon bonds that the dealer has to buy to hedge his position.
.

(A) 0.00000

(B) 0.19417

(C) 0.98058

(D) 1.019417

(E) 2.00000

ANSWER- (D) 1.019417


Given 1 year forward price is $105
Spot price- $100
Rate of return-3% = 0.03
Forward rate= 100+(100*0.03*1)= $ 103.
103/105=0.98095
To hedge his position dealer has to buy 0.98095 times 100 zero coupon bond.
Q17. Which of the following is false?
.

(A) Entering into a long forward contract with a purchased zero-coupon bond maturing at
the expiration date of forward mimics the payoff of an outright purchase of stock

(B) Purchasing a stock and borrowing the present value of forward price replicate a long
forward contract

(C) Entering into a long forward contract, selling a stock and buying a bond are always
making a negative profit, since there is transaction cost.

(D) Selling a stock and lending money at certain risk free rate earns the same payoff as a
short forward contract

(E) Forward contracts are the only derivative that has no credit risk involved

ANSWER- (E) false because derivatives instrument are meant to be mitigate market risk
not the credit risk.

Q18. An investor has open position of 10 contract long and 20 contract short in Sensex future
March and April series respectively. What are her open positions in March series after
considering the spread position?
a) 0
b) 10
c) 20
d) None of these
ANSWER- (b) 10 open positions remains after considering the spread position because
There are total 30 contracts in which there are 10 long and 20 short, while taking spread
position same amount of contract is sold or bought in order to hedge the price risk, so there
is only 10 short contract remains, after taking the spread position.

Q19.An investor has open position of 10 contracts long, and 10 contract short in Sensex future
March, April and May series respectively. What are her spreads across March-April?
a) 0
b) 10
c) 20
d) None of these.

ANSWER- (a) 0.
Q20.An investor has an open position of 10 contracts short and 23 contracts long in March and
April Series respectively. How many contracts are covered under calendar spread?
a) 23
b) 13
c) 10
d) None of these
ANSWER- (c) 10.
Q21.You have taken a short position of one contract on the June Sensex futures at a price of
3,000. You desire to make a profit of Rs 10,000. Which of the following actions will enable to
generate your profit? You may ignore brokerage costs.
a) Buying 2 June Sensex futures contracts at 2900
b) Buying 1 September Sensex futures contract at 2700.
c) Buying 1 June Sensex futures contract at 2800.
d) Selling 1 June Sensex futures contract at 3200.
ANSWER- (c) Buying 1 june sensex futures contract @ 2800.
Desirable profit is Rs.10000.
Profit =(3000-2800)=200
Total profit =( 200*50)= Rs.10000.

Q22. At a Sensex futures price level of 3000, what will be the value of one Sensex futures
contract?
a) Rs.3000
b) Rs.300000
c) Rs.150000
d) None of these
ANSWER- (c) Rs.150000

Lot size =50


Price = 3000
Value of the sensex future contract= (3000*50) = Rs.150000.

Q23.If you have bought a Sensex future at 3200 and sold at 3600 .what is your profit/loss?
a) loss Rs.18,000
b) gain Rs.20,000
c) gain Rs.18,000
d) loss Rs.20,000
ANSWER- (b) Gain Rs.20000.
Purchase Price : Rs. 3,200
Sales Price : Rs. 3,600
Profit per unit : Rs. 400
Lot Size : 50
Total profit = (400*50) = Rs.20000.

Q24.If you have short sold a Sensex future at 3000 and bought it at 3100, what is your gain /
loss?
a) A loss of Rs. 5000
b) A gain of Rs. 500
c) A gain of Rs. 5000
d) A loss of Rs. 500
ANSWER- (a) A loss of Rs.5000.

Purchase Price : Rs. 3,100Sale Price : Rs. 3,000


Loss per unit : Rs. 100

Lot Size : 50

Total Loss = (3,100- 3,000) x 50 = Rs.5,000.

Q25. Calculate Short Hedge and Long Hedge on information given below
Short hedge: Today is March 1st A US company expects to get 50 million Japanese yen at the
end of July. Contract size is 14.5 million yen; future price (September) on March 1 is
0.8000cents/yen. Company enters September future. In July when the yen is received the spot
and future price are 0.7500 and 0.7550 cents/yen respectively. Calculate payoff?
ANSWERPortfolio =50 million yen.
Assume contract size is 12.5 million yen
Short 4 contract
F1= Initial futures price. (0.8000 cents/yen).
F2= Final futures price. (0.7550 cents/yen).
S2= Final assets price. (0.7500 cents/yen).
Price realized= S2+(F1-F2)= 0.7500+(0.8000-0.7550)=0.7950
Basis= S2-F2= 0.7500-0.7550= -0.0050
F1+b2(basis)= 0.8000-0.0050=0.7950 (cents/yen).
Long hedge: In June company wants to purchase 20,000 barrels of crude in Oct./Nov. contract
size is 1000 barrels. On June 8, December contract future price is $ 20.00 per Barrel Company
buys 20 contracts long. On November 10 company decide to purchase the crude oil. The spot and
future prices are $ 22.00 and $ 19.10 per barrel respectively, calculate payoff.
ANSWERPortfolio = 20000 barrels
Contract size is 1000 barrels
Long 20 contract

F1= Initial futures price.($20.00).


F2= Final futures price.($19.10).
S2= Final assets price.($22.00).
Cost of assets=S2-(F2-F1)=F1+(S2-F2)
22-(19.10-20.00)=22.90
Basis= S2-F2= 22.00-19.10= 2.90
F1+b2(basis)= 20.00+2.90= $22.90 per barrel.