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FINANCIAL DERIVATIVES

14MBAFM411

Subject Code: 14MBAFM411


No. of Lecture Hours / Week: 04
Total Number of Lecture Hours: 56
Practical Component: 01 Hour / Week

IA Marks: 50
Exam Hours: 03
Exam Marks: 100

Syllabus
Module I
Financial Derivatives - Introduction, economic benefits of derivatives - Types of financial
derivatives - Features of derivatives market - Factors contributing to the growth of derivatives functions of derivative markets - Exchange traded versus OTC derivatives - traders in derivatives
markets - Derivatives market in India
Module II
Futures and forwards - differences-valuation of futures, valuation of long and short forward
contract. Mechanics of buying & selling futures, Margins, Hedging using futures - specification
of futures - Commodity futures, Index futures, interest rate futures arbitrage opportunities.
Module III
Financial Swaps - features and uses of swaps - Mechanics of interest rate swaps valuation of
interest rate swaps currency swaps valuation of currency swaps.
Module IV
Options: Types of options, option pricing, factors affecting option pricing call and put options
on dividend and non-dividend paying stocks put-call parity - mechanics of options - stock
options - options on stock index - options on futures interest rate options. Concept of exotic
option. Hedging & Trading strategies involving options, valuation of option: basic model, one
step binomial model, Black and Scholes Model, option Greeks. Arbitrage profits in options.
Module V
Commodity derivatives: commodity futures market-exchanges for commodity futures in India,
Forward markets, commissions and regulation-commodities traded trading and settlements
physical delivery of commodities.
Module VI
Interest rate markets-Type of rates, Zero rates, Bond pricing, Determining Zero rates, Forward
rules, Forward rate agreements (FRA), Treasury bond & Treasury note futures, Interest rate
derivatives (Black model).
Module VII
Credit risk-Bond prices and the probability of default, Historical default experience,
Reducing exposure to Credit risk, Credit default swaps, and Total return swaps, and Credit
spread options, Collateralized debt obligation.
Module VIII
Credit risk - Bond prices and the probability of default, Historical default experience, reducing
exposure to Credit risk, Credit default swaps, Total return swaps, Credit spread options,
Collateralized debt obligation.
Value at Risk (VAR)-Measure, Historical simulation, Model building approach, linear
approach, Quadratic model, Monte Carlo simulation, stress testing and back testing.

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Table of content
MODULES

CONTENT

PAGE NUMBER

Financial Derivatives

03-08

Futures and forwards

09-12

Financial Swaps

13-15

Options

16-26

Commodity derivatives

27-35

Interest rate markets

36-43

Credit risk & Value at


Risk (VAR)

44-49

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Module 1
Financial Derivatives
Introduction
Financial derivatives are financial instruments that are linked to a specific financial instrument or
indicator or commodity, and through which specific financial risks can be traded in financial
markets in their own right. Transactions in financial derivatives should be treated as separate
transactions rather than as integral parts of the value of underlying transactions to which they
may be linked. The value of a financial derivative derives from the price of an underlying item,
such as an asset or index. Unlike debt instruments, no principal amount is advanced to be repaid
and no investment income accrues. Financial derivatives are used for a number of purposes
including risk management, hedging, arbitrage between markets, and speculation.
Financial derivatives enable parties to trade specific financial risks (such as interest rate risk,
currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more
willing, or better suited, to take or manage these riskstypically, but not always, without trading
in a primary asset or commodity. The risk embodied in a derivatives contract can be traded either
by trading the contract itself, such as with options, or by creating a new contract which embodies
risk characteristics that match, in a countervailing manner, those of the existing contract owned.
This latter is termed offsetability, and occurs in forward markets. Offsetability means that it will
often be possible to eliminate the risk associated with the derivative by creating a new, but
"reverse", contract that has characteristics that countervail the risk of the first derivative. Buying
the new derivative is the functional equivalent of selling the first derivative, as the result is the
elimination of risk. The ability to replace the risk on the market is therefore considered the
equivalent of tradability in demonstrating value. The outlay that would be required to replace the
existing derivative contract represents its valueactual offsetting is not required to demonstrate
value.
Financial derivatives contracts are usually settled by net payments of cash. This often occurs
before maturity for exchange traded contracts such as commodity futures. Cash settlement is a
logical consequence of the use of financial derivatives to trade risk independently of ownership
of an underlying item. However, some financial derivative contracts, particularly involving
foreign currency, are associated with transactions in the underlying item.

Economic benefits of derivatives


1. Price Discovery
Futures market prices depend on a continuous flow of information from around the world and
require a high degree of transparency. A broad range of factors (climatic conditions, political
situations, debt default, refugee displacement, land reclamation and environmental health, for
example) impact supply and demand of assets (commodities in particular) - and thus the current
and future prices of the underlying asset on which the derivative contract is based. This kind of
information and the way people absorb it constantly changes the price of a commodity. This
process is known as price discovery.
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With some futures markets, the underlying assets can be geographically dispersed, having
many spot (or current) prices in existence. The price of the contract with the shortest time to
expiration often serves as a proxy for the underlying asset.
Second, the price of all future contracts serve as prices that can be accepted by those who
trade the contracts in lieu of facing the risk of uncertain future prices.
Options also aid in price discovery, not in absolute price terms, but in the way the market
participants view the volatility of the markets. This is because options are a different form of
hedging in that they protect investors against losses while allowing them to participate in the
asset's gains.

2. Risk Management
This could be the most important purpose of the derivatives market. Risk management is the
process of identifying the desired level of risk, identifying the actual level of risk and altering the
latter to equal the former. This process can fall into the categories of hedging and speculation.
Hedging has traditionally been defined as a strategy for reducing the risk in holding a market
position while speculation referred to taking a position in the way the markets will move. Today,
hedging and speculation strategies, along with derivatives, are useful tools or techniques that
enable companies to more effectively manage risk.
3. They Improve Market Efficiency for the Underlying Asset
For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fund
or replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either of these
methods will give them exposure to the index without the expense of purchasing all the
underlying assets in the S&P 500. If the cost of implementing these two strategies is the same,
investors will be neutral as to which they choose. If there is a discrepancy between the prices,
investors will sell the richer asset and buy the cheaper one until prices reach equilibrium. In this
context, derivatives create market efficiency.
4. Derivatives Also Help Reduce Market Transaction Costs
Because derivatives are a form of insurance or risk management, the cost of trading in them has
to be low or investors will not find it economically sound to purchase such "insurance" for their
positions

Types of financial derivatives.


1. Forward - This is a form of contract wherein two parties agree on buying or selling an asset at
an agreed price. The actual exchange then happens on a future date, thus the term forwards. The
contract happens among the parties themselves without an outside party interfering. The contract
in a forward type of financial derivative is non-standardized. It is subject to the choices of the
parties engaged in a forward contract.

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2. Futures - A futures contract is similar in some manner to the forward type. It also involves an
agreement on sales of an asset on a future time. However, financial derivatives contracts of this
category have a standardized contract form. The terms and conditions of the contract are
arranged by a third party called a clearing house.
3. Options - This type of contract allow the person involved to have the option of exercising his
right on the assets. Transactions start at a specified price called a strike price. A maturity date is
then set for the owner to exercise his option of buying or selling the asset. The owner has the
option of using his right on the exact date of maturity and not before in a European option. The
American option allows the owner to exercise his right on or before the maturity date.
4. Swaps - Contracts involving swaps allow transactions to occur before a future date. Like all
financial derivative types, swaps derive their financial value based on the underlying asset.

Factors driving the growth of Derivatives

Increased volatility in asset prices in financial markets


Increased integration of national financial markets with the international markets.
Marked improvement in communication facilities and sharp decline in their costs,
Development of more sophisticated risk management tools, providing economic agents
A wider choice of risk management strategies, and
Innovations in the derivatives markets, which optimally combine the risks and returns
Over a large number of financial assets leading to higher returns, reduced risk as well.
Transactions costs as compared to individual financial assets.

Functions of derivative markets


1.
Prices in an organized derivatives market reflect the perception of market participants
about the future and lead the prices of underlying to the perceived future level. The prices of
derivatives converge with the prices of the underlying at the expiration of the derivative contract.
Thus derivatives help in discovery of future as well as current prices.
2. The derivatives market helps to transfer risks from
but may not like them to those who have an appetite for them.

those who have them

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses higher trading volumes because of
participation by more players who would not otherwise participate for lack of an arrangement to
transfer
risk.
4. Speculative trades shift to a more controlled environment of derivatives market. In the absence
of an organized derivatives market, speculators trade in the underlying cash markets. Margining,
monitoring and surveillance of the activities of various participants become extremely difficult in
these kind of mixed markets.
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5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst
for new entrepreneurial activity. The derivatives have a history of attracting many bright,
creative, well-educated people with an entrepreneurial attitude. They often energize others to
create new businesses, new products and new employment opportunities, the benefit of which
are immense.

Exchange traded versus OTC derivatives

The Difference between Exchange trading & Over-The-Counter trading (OTC Trading).
Many financial markets around the world, such as stock markets, do their trading through
exchange. However, forex trading does not operate on an exchange basis, but trades as OverThe-Counter markets (OTC). The stocks, bonds and other instruments traded on these
exchanges are known as listed securities. Over the counter, or OTC, traded securities encompass
all other financial securities. Understanding the differences between listed and an OTC
transaction is crucial whether you want to trade shares or sell your firms shares to investors.

Difference between Exchange Trading & OTC Trading:


1. Centralization of Market: In a market that operates with exchange trading, transactions are
completed through a centralized source. In other words, one party acts as the mediator
connecting buyers and sellers. There is a specified number of traders that will trade on that
single centralized system. On the other hand, over-the counter markets are generally
decentralized. Here, there are many mediators who compete to link buyers to sellers. The
advantage to this is that it ensures that costs for intermediary services are as low as possible.

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2. Standardization: An Exchange Trade is a standard contract wherein Stock exchange acts as


a guarantor for all the trades. But, OTC contracts are customized as there is no specified
guarantor and hence the risk increases a lot.
3. Counterparty Risk: When you buy or sell something OTC in a private transaction, there is
always the risk of not getting what you bargained for. The other party might not be able to
deliver the stock, bond or other security within the agreed upon time frame. It might also
deliver a different kind of stock or bond than promised. These risks are broadly referred to as
counterparty risk. In an exchange, however, counterpart risk is not an issue. The trading
occurs through brokers who are closely monitored by both the exchange and the Securities
and Exchange Commission. Investors buy exchange traded securities with greater confidence
and therefore pay more for such stocks. Because of this, businesses are better off selling
shares through an exchange rather than in a private transaction.
4. Visibility: As Exchange market is an open market wherein there is a clear visibility for
prices, start date, expiration dates & counterparties involved in a deal etc. But, this is not the
case with OTC market as all the terms & conditions associated with any deal is between the
counterparties only.
5. Parties Involved: In exchange traded markets, the exchange is the counterparty to all of the
trades. Additionally, there is price standardization and execution. One negative these
exchanges involves less price competition. OTC, or over the counter markets, have no
centralized trading facility. This promotes heavy competition between counterparties and
lower transaction costs. The lack of regulation can introduce fraudulent firms and transaction
execution quality may decrease.

Traders in derivatives markets


There are three types of traders in the derivatives market:
1. Hedger
2. Speculator
3. Arbitrageur
Hedger: A hedge is a position taken in order to offset the risk associated with some other
position. A hedger is someone who faces risk associated with price movement of an asset and
who uses derivatives as a means of reducing that risk. A hedger is a trader who enters the futures
market to reduce a pre-existing risk.
Speculators: While hedgers are interested in reducing or eliminating risk, speculators buy and
sell derivatives to make profit and not to reduce risk. Speculators willingly take increased risks.
Speculators wish to take a position in the market by betting on the future price movements of an
asset. Futures and options contracts can increase both the potential gains and losses in a
speculative venture. Speculators are important to derivatives markets as they facilitate hedging
provide liquidity ensure accurate pricing, and help to maintain price stability. It is the speculators
who keep the market going because they bear risks which no one else is willing to bear.
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Arbitrageur: An arbitrageur is a person who simultaneously enters into transactions in two or


more markets to take advantage of discrepancy between prices in these markets For example, if
the futures price of an asset is very high relative to the cash price, an arbitrageur will make profit
by buying the asset and simultaneously selling futures. Hence, arbitrage involves making profits
from relative mispricing. Arbitrageurs also help to make markets liquid, ensure accurate and
uniform pricing, and enhance price stability.
All three types of trades and investors are required for a healthy functioning of the derivatives
market. Hedgers and investors provide economic substance to this market, and without them the
markets would become mere tools of gambling. Speculators provide liquidity and depth to the
market. Arbitrageurs help in bringing about price uniformity and price discovery. The presence
of Hedgers, speculators and arbitrageurs, not only enables the smooth functioning of the
derivatives market but also helps in increasing the liquidity of the market.

Derivatives Market in India:


In India, commodity futures date back to 1875. The government banned futures trading in many
of the commodities in the sixties and seventies. Forward trading was banned in the 1960s by the
government despite the fact that India had a long tradition of forward markets. Derivatives were
not referred to as options and futures but as tezi-mandi.
In exercise of the power conferred on it under section 16 of the Securities Contracts (Regulation)
Act, the government by its notification issued in 1969 prohibited all forward trading in securities.
However, the forward contracts in the rupee dollar exchange rates (foreign exchange market) are
allowed by the Reserve Bank and used on a fairly large scale. Futures trading is permitted in 41
commodities. There are 18 commodity exchanges in India. The Forward Markets Commission
under the Ministry of Food and Consumer Affairs acts as a regulator.
In the case of capital markets, the indigenous 125 year old badla system was very popular among
the broking and investor community. The advent of foreign institutional investors in the nineties
and a large number of scams led to a ban on badla. The foreign institutional investors (FIIs) were
not comfortable with this system and they insisted on adequate risk-management tools. Hence,
the Securities and Exchange Board of India (SEBI) decided to introduce financial derivatives in
India. However, there were many legal hurdles which had to be overcome before introducing
financial derivatives. The preamble of the Securities Contract (Regulation) Act, states that the
Act was to prevent undesirable transactions in Securities by regulating business of dealing
therein, by prohibiting options, and by providing for certain other matters connected therewith.
Section 20 of the Act explicitly prohibits all options in securities. The first step therefore was to
withdraw all these prohibitions and make necessary amendments in the Act.

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Module II
Futures and forwards
Forwards are the simplest of the derivative instruments. A forward contract is an agreement to
buy, or sell, an asset at a certain time for a certain price.
Features of Forwards
Forwards are transactions involving delivery of an asset or a financial instrument at a
future date, and therefore, are over-the-counter (OTC) contracts.
OTC products are customized contracts which are written across the counter or struck on
telephone, fax or any other mode of communication by financial institutions to suit the
needs of their customers.
Both the buyer and seller are committed to the contracts. They have to take delivery and
deliver respectively, the underlying asset on which the forward contract was entered into.
They are bilateral contracts & hence, exposed to counter party risk.
One of the parties to the contract assumes a long position (buying of a security such as
stock, commodity or currency, with the expectation that the asset will rise in value) &
agrees to buy the underlying asset on a certain specified date, for a certain specified price.
The other party assumes a short position & agrees to sell the asset on the same date for
the same price.
Forward contracts are normally traded outside the stock exchange.
They are very useful in hedging & speculation.
The contract price is generally not available on public demand.
Each contract is customer designed & hence, is unique in terms of contract size,
expiration date & the asset type & quality.

FUTURE CONTRACTS
Future markets are designed to solve the problems that exist in forward markets.
Futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price.
It is an agreement to deliver (sell) or take delivery (buy) of a standardized quantity of an
underlying commodity/instrument, at a pre-established price agreed on a regulated
exchange at a specified future date.

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Features of Future Contract


1. Future contracts are standardized & stock exchange traded.
2. The standardized items in a future contracts are:
Quality of the underlying
Quantity of the underlying
The date/month of delivery
The units of price quotation & minimum price change
Location of settlement
3. Both the parties pay a margin to the clearing association. This is used as a performance bond
by contracting parties.
4. Each futures contract has an association month which represents the month of contract
delivery or final settlement. For example, a September T-bill, a March Euro etc.
VALUING FUTURES AND FORWARD CONTRACTS
In finance, a futures contract (more colloquially, futures) is a standardized contract between two
parties to buy or sell a specified asset of standardized quantity and quality for a price agreed
upon today (the futures price or strike price) with delivery and payment occurring at a specified
future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as
an intermediary between the two parties. The party agreeing to buy the underlying asset in the
future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in
the future, the "seller" of the contract, is said to be "short"
Valuation of long and short forward contract
a forward contract or simply a forward is a non-standardized contract between two parties to buy
or to sell an asset at a specified future time at a price agreed upon today.[1] This is in contrast to a
spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the
underlying asset in the future assumes a long position, and the party agreeing to sell the asset in
the future assumes a short position. The price agreed upon is called the delivery price, which is
equal to the forward price at the time the contract is entered into
Mechanics of buying & selling futures
Before you decide to buy and/or write (sell) options, you should understand the other costs
involved in the transactioncommissions and fees. Commission is the amount of money, per
option purchased or written, that is paid to the brokerage firm for its services, including the
execution of the order on the trading floor of the exchange. The commission charge increases the
cost of purchasing an option and reduces the sum of money received from writing an option. In
both cases, the premium and the commission should be stated separately.
Each firm is free to set its own commission charges, but the charges must be fully disclosed in a
manner that is not misleading. In considering an option investment, you should be aware that:
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can be charged on a per trade or a round-turn basis, covering both the purchase
and sale.
charges can differ significantly from one brokerage firm to another.
Some firms have fixed commission charges (so much per option transaction) and others
charge a percentage of the option premium, usually subject to a certain minimum charge.
charges based on a percentage of the premium can be substantial, particularly if
the option is one that has a high premium.
charges can have a major impact on your chances of making a profit. A high
commission charge reduces your potential profit and increases your potential loss.
Margins
Margin Trading: Introduction
Imagine this: you're sitting at the blackjack table and the dealer throws you an ace. You'd love to
increase your bet, but you're a little short on cash. Luckily, your friend offers to spot you $50 and
says you can pay him back later. Tempting, isn't it? If the cards are dealt right, you can win big
and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you
be down your original bet, but you'll still owe your friend $50. Borrowing money at the casino is
like gambling on steroids: the stakes are high and your potential for profit is dramatically
increased. Conversely, your risk is also increased.
Margin Trading: What Is Buying On Margin?
The
Basics
Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a
loan from your brokerage. Margin trading allows you to buy more stock than you'd be able to
normally. To trade on margin, you need a margin account. This is different from a regular cash
account, in which you trade using the money in the account. By law, your broker is required to
obtain your signature to open a margin account.
You are more likely to lose lots of money (or make lots of money) when you invest on margin.
Now let's recap other key points in this tutorial:

Buying on margin is borrowing money from a broker to purchase stock.


Margin increases your buying power.
An initial investment of at least $2,000 is required (minimum margin).
You can borrow up to 50% of the purchase price of a stock (initial margin).
You are required to keep a minimum amount of equity in your margin account that can
range from 25% - 40% (maintenance margin).
Marginable securities act as collateral for the loan.
Like any loan, you have to pay interest on the amount you borrow.
Not all stocks qualify to be bought on margin.

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You must read the margin agreement and understand its implications.
If the equity in your account falls below the maintenance margin, the brokerage will issue
a margin call.
Margin calls can result in you having to liquidate stocks or add more cash to the account.
Brokers may be able to sell your securities without consulting you.
Margin means leverage.
The advantage of margin is that if you pick right, you win big.
The downside of margin is that you can lose more money than you originally invested.
Buying on margin is definitely not for everybody.
Margin trading is extremely risky.

Hedging using futures:


Long & Short Hedges
A long futures hedge is appropriate when you know you will purchase an asset in the
future and want to lock in the price
A short futures hedge is appropriate when you know you will sell an asset in the future &
want to lock in the price
Commodity futures
An agreement to buy or sell a set amount of a commodity at a predetermined price and date.
Buyers use these to avoid the risks associated with the price fluctuations of the product or raw
material, while sellers try to lock in a price for their products. Like in all financial markets,
others use such contracts to gamble on price movements.
Index futures
A futures contract on a stock or financial index. For each index there may be a different multiple
for determining the price of the futures contract
Interest rates futures
Interest rates vary between countries based on their economic health, which creates an
opportunity for investors. By purchasing a foreign currency and depositing it abroad, investors
can effectively capitalize on the difference in interest rates in some cases. While these bets are no
longer as popular as they used to be, they are still widely used in the financial markets.
Risks with Interest Rate Arbitrage
Despite the impeccable logic, interest rate arbitrage isn't without risk. The foreign exchange
markets are fraught with risk, due to the lack of cohesive regulation and tax agreements. In fact,
some economists argue that covered interest rate arbitrage is no longer a profitable business
unless transaction costs can be reduced to below market rates.

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MODULE-3
SWAPS

The word swap literally means an exchange.


A financial swap may be defined as a contract whereby two parties, exchange two streams of
cash flows over a defined period of time, usually through an intermediary like a financial
institution.
Types of Swaps
There are two major types of swap structures (I) Interest-rate swaps and (ii) currency swaps.
Interest-rate swaps
An interest rate swap (IRS) is a contractual agreement between counter-parties to exchange a
series of interest payments for a stated period of time. The payments in a swap are similar to
interest payments on a borrowing. A typical IRS involves exchanging fixed and floating interest
payments in the same currency.
Features of IRS
There is no exchange of principal
Only the interest payments are exchanged. They are usually netted on the settlement dates
and only the net value is exchanged between counter parties.
Any underlying loan or deposit is not affected by the swap. The swap is a separate
transaction.
(ii) Currency Swap
A currency swap is a contractual agreement between counter parties in which one
party makes payments in one currency and other party makes payments in a different currency
for a stated period of time.
Commodity Swap
A commodity swap is a contractual agreement between counter parties, wherein at least one set
of payments involved is set by the price of the commodity or by the price of a commodity index.
Equity index Swap
An equity swap or an equity index swap is a contractual agreement between counter
parties, wherein at least one party agrees to pay the other a rate of return based on a stock index
during the life of the swap.

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Mechanics of Interest Rate Swaps


The most common type of a financial swap is an interest-rate swap. In this, one party, B,
agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on a
notional principal for a number of years.
At the same time, party A agrees to pay party B cash flows equal to interest at a floating
rate on the same notional principal for the same period of time. The currencies of the two sets
interest cash flows are the same. The life of the swap can range from two years to over 15 years.
LIBOR
The floating rate in many interest rate swap agreements is the London Inter-bank Offer
Rate (LIBOR). LIBOR is the rate of interest offered by banks on deposits from other banks in
Eurocurrency markets. LIBOR rates are determined by trading between banks and change
frequently so that the supply of funds in the inter-bank market equals the demand for the funds in
that market.
MIBOR- Mumbai Inter-Bank Offer Rate

II. Currency Swap


A currency swap is a foreign-exchange agreement between two institutions to exchange aspects
(namely the principal and/or interest payments) of a loan in one currency for equivalent aspects
of an equal in net present value loan in another currency; see foreign exchange derivative.
Currency swaps are motivated by comparative advantage. A currency swap should be
distinguished from a central bank liquidity swap.
Valuation of Interest Rate Swaps
Value of the swap is the difference between the value of fixed rate bond
underlying the swap (Bfix) and value of floating rate bond underlying the swap (Bfl).
Thus, Vswap = Bfl-Bfix
Bfix = Ke-r1t1 + Pe-rntn
Where, r1= appropriate zero rate for a maturity t1
t1= time when ith payment are exchaned
K = fixed receipt (payment) on each payment date
P = Notional principal amount.

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Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps.
However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.
There are three different ways in which currency swaps can exchange loans
The simplest currency swap structure is to exchange only the principal with the counterparty at a
specified point in the future at a rate agreed now. Such an agreement performs a function
equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or
through an intermediary), and drawing up an agreement with them, makes swaps more expensive
than alternative derivatives (and thus rarely used) as a method to fix shorter term forward
exchange rates. However for the longer term future, commonly up to 10 years, where spreads are
wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective
way to fix forward rates. This type of currency swap is also known as an FX-swap.

Valuation of Currency Swaps


A currency swap can be decomposed into a position in two bonds: foreign bonds and
domestic currency bond. If Vs represents the value of swaps where foreign currency is received
and domestic currency is paid.
Vs=EOBF-BD
Where BF is the value, measured in the foreign currency, of the foreign denominated
bond underlying the swap; BD is the value in rupees of the INR bond underlying the swap; and
EO is the current spot exchange rate (expressed as no. of rupees per unit of foreign currency). The
value of a swap where the domestic currency is received and foreign currency is paid
Vs = BD EOBF
Prob:1 Suppose the term structure of LIBOR interest rates is flat in both India and United States.
The US rates is 4% per annum and the rate is 9% per annum in India (both with continuous
compounding). A financial institution has entered into a currency swap where it receives 5% per
annum in dollar and pays 8% per annum in rupees once a year. The principals in the two
currencies are rupees 10 million and $2.5 million. The swap will last for another 3 years and the
currency exchange rate is $1=Rs.39.5. What is the value of the swap

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Module 4

Options
Introduction
The trading in options began in Europe and the US as early the 18th century. It was only
in the early 1900s that a group of firms set up, what was known as the Put and Call Brokers and
Dealers Association, with the aim of providing a mechanism for bringing buyers and sellers
together.
Suddenly the options market got a big boost in the year 1973 mainly for two reasons.
First, Fisher Black and Myron Scholes developed an options valuation model which forms the
basis for pricing of options. Second, in April 1973, CBOE (Chicago Board Options Exchange)
was set up specifically for the purpose of trading in options.
In India, NSE introduced trading in index options and options on individual securities on
June 4, 2001 and July 2, 2001 respectively.

Meaning
Options contract is a type of derivatives contract which gives the buyer or holder of the
contract the right (but not the obligation) to buy or sell the underlying asset at a predetermined
price within or at the end of a specified period.
The buyer or holder of the option purchases the right from the seller or writer for a
consideration which is called the premium. The seller or writer of an option is obliged to settle
the option as per the terms of the contract when the buyer or holder exercises his right. The
underlying asset could include securities, an index of prices of securities, currency, etc.

Definition
Under Securities Contracts (Regulations) Act 1956, option on securities has been defined
as option in securities means a contract for the purchase or sale of a right to buy or sell, or a
right to buy and sell, securities in futures.
The NSE and BSE have introduced index based options and stock options which facilitate
hedging of risk exposures and speculations with high leverage.

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Parties in Options Trading


There are three parties involved in the options trading:
The option seller or option writer
The option buyer
The broker
The Option Seller (writer) is a person who grants someone else the option to buy or sell.
He receives a premium (option price) in return. The option writer is usually a skilled
market player with an in-depth knowledge of the market. He is willing to take unlimited
risk in return for a limited profit. The premium paid by the buyer of option is his limited
income, but loss is unlimited.
The Option Buyer pays a price to the option writer to induce him to write the option. The
trade between options writer and buyer is a zero-sum game. Writers profit is buyers
loss.
The securities broker acts as an agent to find the option buyer and the seller, and receives
a commission or fee for it.

Players in the Option Market

Hedgers: The objective of many players in the options market is to reduce the risk. They are
not in the options market to make profits. They want to safeguard their existing positions.
Speculators: These are the traders whose objective is to make profits. They are willing to
take risks and they bet upon whether the markets would go up or come down.
Arbitrageurs: Risk-less profit making is the prime goal of arbitrageurs. Buying in one
market and selling in another market. They could be making profits even without putting in
their own money and such opportunities often come up in the market but they last for very
short time frames.

Types of Options

Exercise Style
A European Option contract may be exercised only on the contracts expiration date.(If the
option is exercised by the holder)
An American Option contract can be exercised at any time prior to the contracts expiration
date, at the holders discretion. Thus, the exercise date of an American option can be
different from its expiration date. In India, except stock index options, rest of the options are
American type options.

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II. Structure

Call Options: The option to buy an asset is known as a call option


Put Options: The option to sell an asset is called a put option.

The put or call options can further be categorized into equity options, index options,
foreign currency options, option on futures and interest rate options.
1. Equity Options: The best known options are those that give their owner the right to buy or sell
shares of stock. These are stock options, also commonly called equity options. With exchange
traded options, the underlying asset is 100 shares of the stock. A person who buys a call option
on the stock of a particular company, he is purchasing the right to buy 100 shares of stock.
2. Index Options: Where the underlying asset of an option is some market measure like the
NIFTY 50 Index, such an option is called index option. While these are similar to equity options
in most respects, one important difference is that they are cash-settled.
3. Future Option: The underlying asset is a futures contract. An option on a futures contract is
like other exchange traded options, except that holders acquire the right to buy or sell a futures
contract on an underlying asset, rather than the asset itself. When the holders of a call option
exercise, they acquire from the writers a long position in the underlying futures contract. When
the holders of a put option exercise, they acquire a short position in the underlying futures
contract.
4. Currency Option: It gives the buyer the right to buy or sell a fixed quantity of a specified
currency in exchange for a specific quantity of another currency, in a ratio determined by the
strike price of the option.
5. Interest Rate Option: They are the instruments whose payoffs are dependent in some way on
the level of interest rates. They are used to hedge interest rate risk exposure.

III. Standard
Standard Options: They are traded on recognized stock exchanges world over and their volume
is growing at an astronomical rate.
Exotic Options: Besides trading options on the exchanges, it is also possible to enter into private
option arrangements with brokerage firms or other dealers. It is also called OTC option.

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Basic Option Positions


CALL

PUT

BUY

Right to buy

Right to sell

WRITE

Obligation to sell

Obligation to buy

Payoff Profile for Buyer of Call Options:


A call option gives the buyer the right to buy the underlying asset at a strike price
specified in the option. The profit/loss that the buyer makes on the option depends on the spot
price of the underlying.
If upon expiration the spot price exceeds the strike price, he makes a profit.
Higher the spot price, more is the profit he makes. On the other hand, If the spot price of the
underlying is less than the strike price, he lets his option expire un-exercised.
His loss in this case is the premium paid for buying the option.
For example, if an investor bought 1 month (March) HPCL stock call option with
a strike price of Rs.500 on March 12 at a premium of Rs.16, the payoff profile for the buyer of
call option is below:

Factors Affecting Option Prices


Factors Affecting Call Prices
1. The current share price
The higher the current (spot) share price, the greater is the probability that the share price will
increase above the exercise price in future, and therefore the higher the call price. If the current
share price is low, the exercise price also will be low.
2. The exercise price
The higher the exercise price, the lower the option price I.e. the lower is the probability that the
share price will increase above the exercise price. For example, on Oct 20, the Nov-360 has a
option price of Rs.18, whereas the Nov-370 has a option price of only Rs.15.65.

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Prices of selected call options on Maruthi shares on Oct 20, 2004


Expiry Month Exercise
Price (Rs.)

Type of Option

Price (Rs.)

October

350

American call 1

7.40

October

360

American call

9.35

November

360

American call 1

8.00

November

370

American call

15.65

3. The term to expiry


The longer the term to expiry, the greater is the probability that share price will
increase above the exercise price. Therefore, the longer the term to expiry, the greater is the call
price. For example, on October 20, the Oct-360 American call price is 9.35, whereas the Nov
360 American Call price is 18.
4. The Volatility of the Share
The volatility of a share is the variability of the price over time. Consider a high volatility
share, H, whose current price is Rs.5 and a low volatility share, L, whose current price is also
Rs.5. Consider call options on H and L, the expected values of the calls on shares H and L are:
E (call on H) = (0.2) (0.50) + (0.2) (1.00)
= Rs.0.30
E (call on L) = (0.16) (0.50) + (0.04) (1.00)
= Rs.0.12
The call on the low volatility share is less valuable than the call on the high-volatility share.
5. The risk-free interest rate
The buyer of a call option can defer paying for the shares. Because interest rates are
positive, money has a time value, so the right to defer payment is valuable. The higher the
interest rate, the more valuable is this right. Therefore, it is plausible to suggest that the higher
the risk-free interest rate, the higher is the price of a call.
6. Expected dividend
If a company pays a dividend to its ordinary shareholders the share price will fall on the
ex-dividend date. The price of a call will decrease if the price of the underlying share decreases.

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The calls on shares that pay high dividends during the life of the call are worth less than
calls on shares that pay low dividends during the life of the call.
To summarize, other things being equal, call option prices should higher:
The higher the current share price
The lower the exercise price.
The longer the term to expiry
The more volatile the underlying share
The higher the risk-free interest rate and
The lower the expected dividend to be paid following an ex-dividend date that occurs during the
term of the call.
Factors Affecting Put Option Price
The buyer of the put option obtains the right to sell shares at the exercise price. The higher the
exercise price, the buyer of the put option stands to gain. For example, the buyer of the put
option will prefer to sell, if the exercise price is Rs.100 than Rs.90. Therefore, for put options,
the higher the exercise price, the higher the price of the option.
The buyer of the put option is willing the current share price should be low comparing with the
exercise price. Then the option Price will go up. For example, the current market price is Rs.90
and the exercise price is Rs.100. The current market price lower than the exercise price. So, the
price of the put option will be high.
If the term of the put option is shorter, the price of the put option will be high. For example, Nov
350, American put option price is 8.00 but Dec 350 American put option price is 2.65.
Higher volatility implies a greater chance of large increases and large decreases in the share
price. From the put holders viewpoint, share price increases are bad news, while decreases are
good news. So, a put holder has a favorable view of share price volatility.
A higher interest rate reduces the present value of whatever future cash inflow received by the
put option holder. If interest rate is low, the option price will be high.
Finally, dividend payments reduce share price, which benefits put holders, so higher expected
dividend payments increase put prices.

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Estimation of Equity Option Price


European Call Option Non-Dividend paying stocks
CE = SO-Ke-rT
Where CE = Price of Call option
SO= Stock price
K= Strike price
r= Risk free rate of interest
T= Maturity period
European Call Option Dividend paying stocks
CE = SO-De-rT -Ke-rT
De-rT = Present value of dividends
European Put Option Non-Dividend paying stocks
Formula: PE = Ke-rT - SO
Put-Call Parity
Put-call parity establishes that European call and put options values are identical. This means
that:

CE + Ke-rT = PE + SO
It shows that the value of European call with a certain exercise price and exercise date is
equal to the value of a European put with the same exercise price and date.
Alternatively European call option price should be equal to the price of a put option with
the same strike price and expiration date plus a sum equal to the current price of the underlying
asset minus the present value of the options strike price.

CE = PE + SO - Ke-rT
If call prices are too high relative to put prices, an arbitrageur can lock in a risk less profit
by selling a call and simultaneously buying a put, borrowing the amount equal to Ke-rT at the
risk-free interest rate and buying the underlying asset.

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Exotic option
An exotic option is an option which has features making it more complex than commonly traded vanilla
options. Like the more general exotic derivatives they may have several triggers relating to determination
of payoff. An exotic option may also include non-standard underlying instrument, developed for a
particular client or for a particular market. Exotic options are more complex than options that trade on an
exchange, and are generally traded over the counter (OTC).

Valuation of option:
Binomial options pricing model
The binomial options pricing model (BOPM) provides a generalizable numerical method for the
valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein in
1979. Essentially, the model uses a discrete-time (lattice based) model of the varying price
over time of the underlying financial instrument. In general, binomial options pricing models do
not have closed-form solutions.
The Binomial options pricing model approach is widely used as it is able to handle a variety of
conditions for which other models cannot easily be applied. This is largely because the BOPM is
based on the description of an underlying instrument over a period of time rather than a single
point. As a consequence, it is used to value American options that are exercisable at any time in a
given interval as well as Bermudan options that are exercisable at specific instances of time.
Being relatively simple, the model is readily implementable in computer software (including a
spreadsheet).
The BlackScholes
BlackScholesMerton model is a mathematical model of a financial market containing certain
derivative investment instruments. From the model, one can deduce the BlackScholes formula,
which gives a theoretical estimate of the price of European-style options. The formula led to a
boom in options trading and legitimised scientifically the activities of the Chicago Board Options
Exchange and other options markets around the world. lt is widely used, although often with
adjustments and corrections, by options market participants. Many empirical tests have shown
that the BlackScholes price is "fairly close" to the observed prices, although there are wellknown discrepancies such as the "option smile".
The BlackScholes was first published by Fischer Black and Myron Scholes in their 1973 paper,
"The Pricing of Options and Corporate Liabilities", published in the Journal of Political
Economy. They derived a stochastic partial differential equation, now called the BlackScholes
equation, which estimates the price of the option over time. The key idea behind the model is to
hedge the option by buying and selling the underlying asset in just the right way and, as a
consequence, to eliminate risk. This type of hedge is called delta hedging and is the basis of
more complicated hedging strategies such as those engaged in by investment banks and hedge
funds.

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Option Greeks
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of
derivatives such as options to a change in underlying parameters on which the value of an
instrument or portfolio of financial instruments is dependent. The name is used because the most
common of these sensitivities are often denoted by Greek letters. Collectively these have also
been called the risk sensitivities, risk measures or hedge parameters.
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the value
of a portfolio to a small change in a given underlying parameter, so that component risks may be
treated in isolation, and the portfolio rebalanced accordingly to achieve a desired exposure; see
for example delta hedging.
The Greeks in the BlackScholes model are relatively easy to calculate, a desirable property of
financial models, and are very useful for derivatives traders, especially those who seek to hedge
their portfolios from adverse changes in market conditions. For this reason, those Greeks which
are particularly useful for hedging delta, theta, and vega are well-defined for measuring changes
in Price, Time and Volatility. Although rho is a primary input into the BlackScholes model, the
overall impact on the value of an option corresponding to changes in the risk-free interest rate is
generally insignificant and therefore higher-order derivatives involving the risk-free interest rate
are not common.
The most common of the Greeks are the first order derivatives: Delta, Vega, Theta and Rho as
well as Gamma, a second-order derivative of the value function. The remaining sensitivities in
this list are common enough that they have common names, but this list is by no means
exhaustive
Delta

Delta, , measures the rate of change of option value with respect to changes in the underlying
asset's price. Delta is the first derivative of the value of the option with respect to the
underlying instrument's price .
Vega

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Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to
the volatility of the underlying asset.
Vega is not the name of any Greek letter. However, the glyph used is the Greek letter nu ( ).
Presumably the name vega was adopted because the Greek letter nu looked like a Latin vee, and
vega was derived from vee by analogy with how beta, eta, and theta are pronounced in American
English. Another possibility is that it is named after Joseph De La Vega, famous for Confusion of
Confusions, a book about stock markets and which discusses trading operations that were
complex, involving both options and forward trades.
The symbol kappa, , is sometimes used (by academics) instead of vega (as is tau ( ) or capital
Lambda ( ), though these are rare).
Vega is typically expressed as the amount of money per underlying share that the option's value
will gain or lose as volatility rises or falls by 1%.
Vega can be an important Greek to monitor for an option trader, especially in volatile markets,
since the value of some option strategies can be particularly sensitive to changes in volatility.
The value of an option straddle, for example, is extremely dependent on changes to volatility.

Theta

Theta, , measures the sensitivity of the value of the derivative to the passage of time (see
Option time value): the "time decay."
The mathematical result of the formula for theta (see below) is expressed in value per
year. By convention, it is usual to divide the result by the number of days in a year, to arrive at
the amount of money per share of the underlying that the option loses in one day. Theta is almost
always negative for long calls and puts and positive for short (or written) calls and puts. An
exception is a deep in-the-money European put. The total theta for a portfolio of options can be
determined by summing the thetas for each individual position.
The value of an option can be analysed into two parts: the intrinsic value and the time
value. The intrinsic value is the amount of money you would gain if you exercised the option
immediately, so a call with strike $50 on a stock with price $60 would have intrinsic value of
$10, whereas the corresponding put would have zero intrinsic value. The time value is the value
of having the option of waiting longer before deciding to exercise. Even a deeply out of the
money put will be worth something, as there is some chance the stock price will fall below the
strike before the expiry date. However, as time approaches maturity, there is less chance of this
happening, so the time value of an option is decreasing with time.
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Rho

Rho, , measures sensitivity to the interest rate: it is the derivative of the option value with
respect to the risk free interest rate (for the relevant outstanding term).
Except under extreme circumstances, the value of an option is less sensitive to changes in the
risk free interest rate than to changes in other parameters. For this reason, rho is the least used of
the first-order Greeks.
Rho is typically expressed as the amount of money, per share of the underlying, that the value of
the option will gain or lose as the risk free interest rate rises or falls by 1.0% per annum (100
basis points).

Lambda

Lambda, , omega, , or elasticity is the percentage change in option value per percentage
change in the underlying price, a measure of leverage, sometimes called gearing.
Arbitrage profits in options
Options arbitrage trades are commonly performed by floor traders in the options market to earn
small profits with very little or zero risk.
Traders perform conversions when options are relatively overpriced by purchasing stock and
selling the equivalent options position. When the options are relatively underpriced, traders will
do reverse conversions or reversals. In practice, actionable option arbitrage opportunities have
decreased with the advent of automated trading strategies.

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Module V
Commodity derivatives
The Forward Markets Commission (FMC) is the chief regulator of forwards and futures
markets in India. As of March 2009, it regulates Rs 52 Trillion worth of commodity trade in
India. It is headquartered in Mumbai and is overseen by the Ministry of Consumer Affairs, Food
and Public Distribution, Government of India.
History
Established in 1953 under the provisions of the Forward Contracts (Regulation) Act, 1952, it
consists of two to four members, all appointed by the Indian Government. Currently, the
Commission allows commodity trading in 22 exchanges in India, of which three are national.
Uniquely the FMC falls under the Ministry of Consumer Affairs, Food and Public Distribution
and not the finance ministry as in most countries. This is because futures, traded in India, are
traditionally on food commodities. However, this has been changing and there have been calls
for change in the industry and in regulation. One proposal is the merging the commodities
derivatives and securities regulation by including the Forward Market Commission within the
Securities and Exchange Board of India (SEBI), the primary securities regulator in India.
However as of 2003 there is no clear consensus for this move.
Development of the Industry
India has a long history of trading commodities and considered the pioneer in some forms of
derivatives trading. The first derivative market was set up in 1875 in Mumbai, where cotton
futures was traded. This was followed by establishment of futures markets in edible oilseeds
complex, raw jute and jute goods and bullion. This became an active industry with volumes
reported to be large.
However, in 1935 a law was passed allowing the government to in part restrict and directly
control food production (Defence of India Act, 1935). This included the ability to restrict or ban
the trading in derivatives on those food commodities. Post independence, in the 1950s, India
continued to struggle with feeding its population and the government increasingly restricting
trading in food commodities. Just at the time the FMC was established, the government felt that
derivative markets increased speculation which led to increased costs and price instabilities. And
in 1953 finally prohibited options and futures trading altogether.
The industry was pushed underground and the prohibition meant that development and
expansion came to a halt. In the 1970 as futures and options markets began to develop in the rest
of the world, Indian derivatives markets were left behind. The apprehensions about the role of
speculation, particularly in the conditions of scarcity, prompted the Government to continue the
prohibition well into the 1980s.
This left the India with a large number of small and isolated regional futures markets. The
futures markets are dispersed and fragmented, with separate trading communities in different
regions with little contact with one another. The exchanges generally have yet to embrace
modern technology or modern business practices.

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Next to the officially approved exchanges, there are many havala markets. Most of these
unofficial commodity exchanges have operated for many decades. Some unofficial markets trade
20-30 times the volume of the "official" futures exchanges. They offer not only futures, but also
option contracts. Transaction costs are low, and they attract many speculators and the smaller
hedgers. Absence of regulation and proper clearing arrangements, however, mean that these
markets are mostly "regulated" by the reputation of the main players.
Responsibilities and functions
The functions of the Forward Markets Commission are as follows:

To advise the Central Government in respect of the recognition or the withdrawal of


recognition from any association or in respect of any other matter arising out of the
administration of the Forward Contracts (Regulation) Act 1952.

To keep forward markets under observation and to take such action in relation to them, as
it may consider necessary, in exercise of the powers assigned to it by or under the Act.

To collect and whenever the Commission thinks it necessary, to publish information


regarding the trading conditions in respect of goods to which any of the provisions of the
act is made applicable, including information regarding supply, demand and prices, and
to submit to the Central Government, periodical reports on the working of forward
markets relating to such goods;

To make recommendations generally with a view to improving the organization and


working of forward markets;

To undertake the inspection of the accounts and other documents of any recognized
association or registered association or any member of such association whenever it
considers it necessary.

It allows futures trading in 23 Fibers and Manufacturers,15 spices, 44 edible oils, 6 pulses, 4
energy products, single vegetable, 20 metal futures, 33 others Futures.

FUTURES TRADING IN COMMODITY EXCHANGES AND FORWARD MARKETS


COMMISSION
1. Futures trading perform two important functions of price discovery and price risk management
with reference to the given commodity. It is useful to all segments of the economy. It is useful to
the producer because he can get an idea of the price likely to prevail at a future point of time and
therefore can decide between various competing commodities, the best that suits him. It enables
the consumer in that he gets an idea of the price at which the commodity would be available at a
future point of time. He can do proper costing and also cover his purchases by making forward
contracts.

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2. Forward/futures trading involves a passage of time between entering into a contract and its
performance making thereby the contracts susceptible to risks uncertainties, etc. Hence the need
for the regulatory functions to be exercised by the Forward Markets Commission (FMC), which
is the Regulator established under the provisions of Forward Contracts (Regulation) Act, 1952.
3. At present, futures trading are permitted in 103 commodities (Annexure-I). Apart from the
three national level Exchanges, there are 21 other regional Exchanges recognized for commodity
futures trading (Annexure-II). The trading volume and value in the past two years have increased
manifold. During 2005-06, permission to trade in furnace oil, crude oil, menthe oil, PVC,
polypropylene and natural gas was granted. Onion has also been notified for futures trading on
26.4.2006.
4. Overall growth during 2005-06, the total value of commodity futures trade was Rs. 21.34 lakh
crore as compared to Rs. 5.71 lakh crore during 2004-05 showing an increase of 274%. The
volume of trade has also gone up to 6685 lakh tonnes during 2005-06 as compared to 1942 lakh
tonnes during 2004-05. The trade volume has also gone up by 244% during 2005-2006.
5. The trading volume and value have increased manifold after the three national level
Exchanges were set up. Department of Consumer Affairs granted recognition to these Exchanges
as indicated below:National Multi-Commodity Exchange of India, Ahmedabad (NMCE), started
trading in November 2002 and the other two national Exchanges viz. Multi Commodity
Exchange of India Ltd., Mumbai (MCX) and National Commodity and Derivatives Exchange
Ltd., Mumbai (NCDEX) started trading in November 2003. The following table shows the
increase in volume and value of trading in commodity futures since the setting up of these
national Exchanges.
Commodity Futures Trading Value and Volume since 2001-02

Volume of
Trading (in lakh
tonnes)
Value of
trading (Rs. in
crore)

Dept. of MBA- SJBIT

2002-03

2003-04

2004-05

2005-06

314.4

492.9

1,942.1

6,685.09

(44.4)*

(57.7)*

(294)*

(244)*

66,530

1,29,363

5,71,759

21,34,471

(92.8)*

(94.4)*

(341.9)*

(274)*

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6. The commodity futures market is regulated under the provisions of the Forward Contracts
(Regulation) Act, 1952. In order to include some new features that are in tune with the latest
developments in the commodity futures market, this Department has proposed amendments in
the Forward Contracts (Regulation) Act, 1952. Accordingly, Forward Contracts (Regulation)
Amendment Bill, 2006 has been introduced in the Lok Sabha on 21.03.2006. The Bill, inter-alia,
seeks to make the following amendments :-- increase the maximum number of members of FMC
from four to nine out of which three to be whole time members and a Chairman; confer power
upon the FMC to levy fees; provide for constitution of FMC General Fund to which all grants,
fees and all sums received by the FMC shall be credited except penalty and apply the funds for
meeting the expenses of the Commission; make provisions for corporatization and
demutualization of recognized associations in accordance with the scheme to be approved by the
FMC; make provisions for registration of members and intermediaries; allow trading in options;
make provision for investigation, enforcement and penalty in case of contravention of the
provisions of the FCR Act, 1952;
7. Future prospect
Future prospect of commodity derivative trading is upbeat. Futures market size (both
commodities and securities) relative to Gross Domestic Product (GDP at current prices) in the
US is about 90%, in China about 85%, and in Brazil about 200%. Commodities derivatives trade
value relative to GDP (at current price) in India was 5.81 % in 2003-04, 20.14% in 2004-05 and
it has gone up to 66 % during 2005-06. The commodity futures trade has taken a big leap in the
past two years. Likely participation of Banks, Mutual Funds and Foreign Institutional Investors
along with introduction of options trading after amendments to FCR

Exchanges and Commodities in which futures contracts are traded.

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FINANCIAL DERIVATIVES
No.
1.

2.

3.

4.

Exchange
India Pepper & Spice Trade Association, Kochi (IPSTA)
Vijai Beopar Chambers Ltd.,
Muzaffarnagar
Rajdhani Oils & Oilseeds Exchange Ltd., Delhi
Bhatinda Om & Oil Exchange Ltd.,
Bhatinda

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COMMODITY
Pepper (both domestic and international
contracts)
Gur, Mustard seed

Gur, Mustard seed its oil & oilcake

Gur

5.

The Chamber of Commerce, Hapur

Gur , Potatoes and Mustard seed

6.

The Meerut Agro Commodities Exchange Ltd., Meerut

Gur
Oilseed Complex

7.

The Bombay Commodity Exchange Ltd., Mumbai


* Castor oil international contracts
Castor seed, Groundnut, its oil & cake,

8.

Rajkot Seeds, Oil & Bullion Merchants Association, Rajkot

cottonseed, its oil & cake, cotton (kapas) and


RBD palmolein.

9.

The Ahmedabad Commodity Exchange, Ahmedabad

Castorseed, cottonseed, its oil and oilcake

10.

The East India Jute & Hessian Exchange Ltd., Calcutta

Hessian & Sacking

11.

The East India Cotton Association Ltd., Mumbai

Cotton

12.

The Spices & Oilseeds Exchange Ltd., Sangli.

Turmeric

13.

National Board of Trade, Indore

Soya seed, Soyaoil and Soya meals.


Rapeseed/Mustardseed its oil and
oilcake and RBD Palmolien

14.

The First Commodities Exchange of India Ltd., Kochi

Copra/coconut, its oil & oilcake

15.

Central India Commercial Exchange Ltd., Gwalior

Gur and Mustard seed

16.

E-sugar India Ltd., Mumbai

Sugar

**17

National Multi-Commodity Exchange of India Ltd., Ahmedabad

18

Surendranagar Cotton Oil & Oilseeds , Surendranagar

Dept. of MBA- SJBIT

Several Commodities (Please see the site of


the Exchange at www.nmce.com)

Cotton, Cottonseed, Kapas

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19

E-Commodities Ltd., New Delhi

Sugar (trading yet to commence)

20**

National Commodity & Derivatives Exchange Ltd., Mumbai site of the Exchange at

Several Commodities (Please see the

www.ncdex.com)
Several Commodities (Please see the
21**

Multi Commodity Exchange Ltd., Mumbai

site of the Exchange at


www.mcxindia.com)
Mustard seed its oil & oilcake, Gram.

22

Bikaner commodity Exchange Ltd., Bikaner

23

Haryana Commodities Ltd., Hissar

Mustard seed complex

24

Bullion Association Ltd., Jaipur

Mustard seed Complex

Guar seed. Guar Gum

Commodity Derivatives Market in India:


Development Regulation and Future Prospects
Introduction
The Indian economy is witnessing a mini revolution in commodity derivatives and risk management.
Commodity options trading and cash settlement of commodity futures had been banned since 1952 and
until 2002 commodity derivatives market was virtually non-existent, except some negligible activity on
an OTC basis. Now in September 2005, the country has 3 national level electronic exchanges and 21
regional exchanges for trading commodity derivatives. As many as eighty (80) commodities have been
allowed for derivatives trading. The value of trading has been booming and is likely to cross the $ 1
Trillion mark in 2006 and, if all goes well, seems to be set to touch $5 Trillion in a few years. This paper
analyses questions such as: how did India pull it off in such a short time since 2002? Is this progress
sustainable and what are the obstacles that need urgent attention if the market is to realize its full
potential? Why are commodity derivatives important and what could other emerging economies learn
from the Indian mistakes and experience

Why are Commodity Derivatives Required?


India is among the top-5 producers of most of the commodities, in addition to being a major
consumer of bullion and energy products. Agriculture contributes about 22% to the GDP of the
Indian economy. It employees around 57% of the labor force on a total of 163 million hectares
of land. Agriculture sector is an important factor in achieving a GDP growth of 8-10%. All this
indicates that India can be promoted as a major center for trading of commodity derivatives. It is
unfortunate that the policies of FMC during the most of 1950s to 1980s suppressed the very
markets it was supposed to encourage and nurture to grow with times. It was a mistake other
emerging economies of the world would want to avoid.

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However, it is not in India alone that derivatives were suspected of creating too much speculation
that would be to the detriment of the healthy growth of the markets and the farmers. Such
suspicions might normally arise due to a misunderstanding of the characteristics and role of
derivative product.
It is important to understand why commodity derivatives are required and the role they can play
in risk management. It is common knowledge that prices of commodities, metals, shares and
currencies fluctuate over time. The possibility of adverse price changes in future creates risk for
businesses.
Derivatives are used to reduce or eliminate price risk arising from unforeseen price changes. A
derivative is a financial contract whose price depends on, or is derived from, the price of another
asset.
Two important derivatives are futures and options.
(i) Commodity Futures Contracts: A futures contract is an agreement for buying or selling a
commodity for a predetermined delivery price at a specific future time. Futures are standardized
contracts that are traded on organized futures exchanges that ensure performance of the contracts
and thus remove the default risk. The commodity futures have existed since the Chicago Board
of Trade (CBOT, www.cbot.com) was established in 1848 to bring farmers and merchants
together. The major function of futures markets is to transfer price risk from hedgers to
speculators. For example, suppose a farmer is expecting his crop of wheat to be ready in two
months time, but is worried that the price of wheat may decline in this period. In order to
minimize his risk, he can enter into a futures contract to sell his crop in two months time at a
price determined now. This way he is able to hedge his risk arising from a possible adverse
change in the price of his commodity.
(ii) Commodity Options contracts: Like futures, options are also financial instruments used for
hedging and speculation. The commodity option holder has the right, but not the obligation, to
buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date.
Option contracts involve two parties the seller of the option writes the option in favour of the
buyer (holder) who pays a certain premium to the seller as a price for the option. There are two
types of commodity options: a call option gives the holder a right to buy a commodity at an
agreed price, while a put option gives the holder a right to sell a commodity at an agreed price
on or before a specified date (called expiry date).
The option holder will exercise the option only if it is beneficial to him; otherwise he will let the
option lapse. For example, suppose a farmer buys a put option to sell 100 Quintals of wheat at a
price of $25 per quintal and pays a premium of $0.5 per quintal (or a total of $50). If the price
of wheat declines to say $20 before expiry, the farmer will exercise his option and sell his wheat
at the agreed price of $25 per quintal. However, if the market price of wheat increases to say $30
per quintal, it would be advantageous for the farmer to sell it directly in the open market at the
spot price, rather than exercise his option to sell at $25 per quintal.

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Futures and options trading therefore helps in hedging the price risk and also provide investment
opportunity to speculators who are willing to assume risk for a possible return. Further, futures
trading and the ensuing discovery of price can help farmers in deciding which crops to grow.
They can also help in building a competitive edge and enable businesses to smoothen their
earnings because nonhedging of the risk would increase the volatility of their quarterly earnings.
Thus futures and options markets perform important functions that can not be ignored in modern
business environment. At the same time, it is true that too much speculative activity in essential
commodities would destabilize the markets and therefore, these markets are normally regulated
as per the laws of the country.
To make up for the loss of growth and development during the four decades of restrictive government
policies, FMC and the Government encouraged setting up of the commodity exchanges using the most
modern systems and practices in the world. Some of the main regulatory measures imposed by the FMC
include daily mark to market system of margins, creation of trade guarantee fund, back-office
computerization for the existing single commodity Exchanges, online trading for the new Exchanges,
demutualization for the new Exchanges, and one-third representation of independent Directors on the
Boards of existing Exchanges etc. Responding positively to the favorable policy changes, several Nationwide Multi-Commodity Exchanges (NMCE) have been set up since 2002, using modern practices such as
electronic trading and clearing.

Multi-Commodity Exchange of India Limited (MCX)


MCX an independent and de-mutulised multi commodity exchange has permanent recognition
from Government of India for facilitating online trading, clearing and settlement operations for
commodity futures markets across the country. Key shareholders of MCX are Financial
Technologies (India) Ltd.,
State Bank of India, NABARD, NSE, HDFC Bank, State Bank of Indore, State Bank of
Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank
Of India, Bank Of Baroda, Canara Bank, Corporation Bank.
Headquartered in Mumbai, MCX is led by an expert management team with deep domain
knowledge of the commodity futures markets. Through the integration of dedicated resources,
robust technology and scalable infrastructure, since inception MCX has recorded many first to its
credit.
Inaugurated in November 2003 by Shri Mukesh Ambani, Chairman & Managing Director,
Reliance Industries Ltd, MCX offers futures trading in the following commodity categories: Agri
Commodities, Bullion, Metals- Ferrous & Non-ferrous, Pulses, Oils & Oilseeds, Energy,
Plantations, Spices and other soft commodities.
MCX has built strategic alliances with some of the largest players in commodities eco-system,
namely, Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors' Association
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of India, Pulses Importers Association, Shetkari Sanghatana, United Planters Association of


India and India Pepper and Spice Trade Association.
Today MCX is offering spectacular growth opportunities and advantages to a large cross section
of the participants including Producers / Processors, Traders, Corporate, Regional Trading
Centers, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being
nation-wide commodity exchange, offering multiple commodities for trading with wide reach
and penetration and robust infrastructure, is well placed to tap this vast potential.

National Commodity & Derivatives Exchange Limited (NCDEX)


National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed
online multi commodity exchange promoted by ICICI Bank Limited (ICICI Bank), Life
Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development
(NABARD) and National Stock Exchange of India Limited (NSE). Punjab National Bank
(PNB), CRISIL Limited (formerly the Credit Rating Information Services of India Limited),
Indian Farmers Fertiliser Cooperative Limited
(IFFCO) and Canara Bank by subscribing to the equity shares have joined the initial promoters
as shareholders of the Exchange. NCDEX is the only commodity exchange in the country
promoted by national level institutions. This unique parentage enables it to offer a bouquet of
benefits, which are currently in short supply in the commodity markets.
The institutional promoters of NCDEX are prominent players in their respective fields and bring
with them institutional building experience, trust, nationwide reach, technology and risk
management skills.
NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act,
1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It has
commenced its operations on December 15, 2003.
NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an
independent Board of Directors and professionals not having any vested interest in commodity
markets. It is committed to provide a world-class commodity exchange platform for market
participants to trade in a wide spectrum of commodity derivatives driven by best global
practices, professionalism and transparency.
NCDEX is regulated by Forward Market Commission in respect of futures trading in
commodities

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MODULE-6

Interest Rates Markets


Interest Rates
An interest rate in a particular situation defines the amount of money a borrower promises to pay
the lender. For any given currency, many different types of interest rates are regularly quoted.
These include mortgage rates, deposit rates, prime borrowing rates and so on. The higher the
credit risk, the higher the interest rate that is promised by the borrower.
Types of Rates
Treasury rates
LIBOR rates
Repo rates

Treasury Rates
Treasury rates are the rates an investor earns on treasury bills and treasury bonds. These
are the instruments used by a government to borrow in its own currency.
Treasury rates are important because they are used to price treasury bonds and are
sometimes used to define the payoff from a derivative.
Treasury rates are therefore totally risk-free rates in the sense that an investor who buys a
treasury bill or treasury bond is certain that interest and principal payments will be made as
promised.
LIBOR Rates
LIBOR is London Inter-bank Offer Rate. A LIBOR quote by a particular bank is
the rate of interest at which the bank is prepared to make a large wholesale deposit with other
banks. Large banks and other financial institutions quote 1 month, 3 month, 6 month and 12
month LIBOR in all major currencies.
Repo Rates
Sometimes trading activities are funded with a repo or repurchase agreement. This
is a contract where an investment dealer who owns securities agrees to sell them to another
company now and buy them back later at a slightly higher price. The other company is providing
a loan to the investment dealer.

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The difference between the price at which the securities are sold and the price at
which they are repurchased is the interest it earns. The interest rate is referred to as the repo rate.
Zero Rates
A zero rate (sometimes referred to as the n-year zero), is the rate of interest earned on an
investment that starts today and lasts for n years.
Suppose a 5-year zero rates with continuous compounding is quoted at 5% per annum. This
means that $100, if invested for 5 years, grows to
100 * e0.05 * 5 = 128.40
Bond Pricing
The theoretical price of a bond can be calculated as the present value of all the cash flows
that will be received by the owner of the bond.
To calculate the cash price of a bond we discount each cash flow at the appropriate zero
rate
Consider the zero rates given in the table. Suppose that a 2 year treasury bond with a
principal of $100 provides a coupon rate of 6% per annum semiannually. To calculate
the PV of the first coupon rate i.e., 6/2 = $3, we discount it as under.
Example

Maturity
(years)
0.5

Zero Rate
(% cont comp)
5.0

1.0

5.8

1.5

6.4

2.0

6.8

3e 0.050.5 3e 0.0581.0 3e 0.0641.5


103e 0.0682.0 98.39

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Bond Yield
The bond yield is the discount rate that makes the present value of the cash flows on the
bond equal to the market price of the bond
Suppose that the market price of the bond in our example equals its theoretical price of
98.39
The bond yield (continuously compounded) is given by solving through trial & error
method to get y=0.0676 or 6.76%.

3e y0.5 3e y1.0 3e y1.5 103e y2.0 98.39


Par Yield
The par yield for a certain maturity is the coupon rate that causes the bond price to equal
its face value.
Determining Treasury Zero Rates

Bond Principal (Rs.) Time to maturity (Years) Annual coupon (Rs.)


100
0.25
0
100
0.50
0
100
1
0
100
1.5
8
100
2
12
Half the stated coupon is assumed to be paid every 6 months

Bond cash price (Rs.)


97.5
94.9
90
96
101.6

The Bootstrap Method


An amount 2.5 i.e., (100 97.5) can be earned on 97.5 during 3 months.
The 3-month rate is (4 * 2.5)/97.5 or 10.256% with quarterly compounding
This is 10.127% with continuous compounding
4 Ln ( 1+ 0.1256 / 4) = 0.10127 or 10.127%
Similarly the 6 month and 1 year rates are 10.469% and 10.536% with continuous
compounding
To calculate the 1.5 year rate we solve

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4e 0.104690.5 4e 0.105361.0 104e R1.5 96


E 1.5 R = 0.85196
To get R = -ln(0.85196) / 1.5 = 0.10681 or 10.681%
Similarly the two-year rate is 10.808%
Zero Curve Calculated from the Data
12

Zero
Rates (%)
11

10

10.46
9

10.12
7

10.68
1

10.5
36

10.8
08

Maturity (yrs)
9
0

0.5

1.5

2.5

Forward Rates
The forward rate is the future zero rate implied by todays term structure of interest rates
Suppose that the zero rates for time periods T1 and T2 are R1 and R2 with both rates
continuously compounded.
The forward rate for the period between times T1 and T2 is
R2T2 R1T1
T2 T1

Forward Rate Agreement


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A forward rate agreement (FRA) is an OTC agreement that a certain rate will apply to
either borrowing or lending a certain principal during a certain future time period.
The assumption underlying the contract is that the borrowing or lending would normally
be done at LIBOR.
Characteristics
It is an OTC Product
It is predominantly used as an inter-bank tool for hedging of short term interest rate risk.
There is no upfront premium payable.
Simpler to administer than futures since there is no margining requirement.
The underlying principal amount is purely notional and no actual exchange takes place.
Notional principal amount is used for calculation of settlement amount to be exchanged
between parties.
Most liquid and frequently traded FRAs are for 3 to 6 months.
FRAs are available for periods extending to 2 years.
FRAs are available in currencies where there are no futures.
o Using FRAs Compensating Amount is calculated as under:
o (Difference in Interest Rates)*(notional Principal) * (Number of days of the
contract).
o PV of Compensation = (L-R)*D*P *100 D*L
Where L = Settlement Rate
R = Contract Reference Rate
D = Days in contract period
B = Days Basis (360 or 365)
P = Notional Principal.

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Treasury bond Futures


One of the long term interest rate futures contracts traded on Chicago Board of Trade. In this
contract, any government bond that has more than 15 years to maturity on the first day of the
delivery month and is not callable within 15 years form that day can be delivered.
When a particular bond is delivered, a parameter known as its conversion factor defines
the price received by the party with the short position and is given by
(Settlement price * Conversion facto) + Accrued Interest
Cost of purchasing a bond is
Quoted bond price + Accrued Interest
The cheapest-to-deliver bond is the one for which
Quoted bond price (Settlement price * Conversion factor)

Blacks Model
Similar to the model proposed by Fischer Black for valuing options on futures
Assumes that the value of an interest rate, a bond price, or some other variable at a
particular time T in the future has a lognormal distribution
The mean of the probability distribution is the forward value of the variable
The standard deviation of the probability distribution of the log of the variable is

T
Where SD is the volatility
The expected payoff is discounted at the T-maturity rate observed today

c P (0, T )[ F0 N ( d1 ) KN ( d 2 )]
p P (0, T )[ KN ( d 2 ) F0 N ( d1 )]
ln( F0 / K ) 2T / 2
d1
; d 2 d1 T
T

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K : strike price
F : forward value of variable today

P(0, T) : Price at time 0 of a zero coupon bond paying $1 at time T

Blacks Model: Delayed Payoff

c P (0, T * )[ F0 N ( d1 ) KN ( d 2 )]
p P (0, T * )[ KN ( d 2 ) F0 N ( d1 )]
ln( F0 / K ) 2T / 2
d1
; d 2 d1
T

K : strike price
F0 : forward value of variable
s : volatility of F
T : time when
variable is observed
T * : time of payoff

Validity of Blacks Model


Two assumptions:
1. The expected value of the underlying variable is its forward price
2. We can discount expected payoffs at rate observed in the market today
It turns out that these assumptions offset each other in the applications of Blacks model
that we will consider

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Blacks Model for European Bond Options


Assume that the future bond price is lognormal
c P (0, T )[ FB N ( d1 ) KN ( d 2 )]
p P (0, T )[ KN ( d 2 ) FB N ( d1 )]
d1

ln( FB / K ) B2T / 2
; d 2 d1 B
B T

FB = B0 I / P(0, T)
Both the bond price and the strike price should be cash prices not quoted prices
Caps and Floors
A cap is a portfolio of call options on LIBOR. It has the effect of guaranteeing that the
interest rate in each of a number of future periods will not rise above a certain level
Payoff at time tk+1 is Ldk max(Rk-RK, 0) where L is the principal, dk =tk+1-tk , RK is the cap
rate, and Rk is the rate at time tk for the period between tk and tk+1
A floor is similarly a portfolio of put options on LIBOR. Payoff at time tk+1 is Ldk max(RK
-Rk , 0)
Caplets
A cap is a portfolio of caplets
Each caplet is a call option on a future LIBOR rate with the payoff occurring in arrears
When using Blacks model we assume that the interest rate underlying each caplet is
lognormal

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Module 7
Credit risk

Credit risk & historical default experience


Credit risk arises from the possibility that borrowers and counter parties in derivatives
transactions may default.
Rating agencies such as Moodys, S&P are in the business of providing ratings describing the
credit worthiness of corporate bonds.
For investment grade bond, the probability of default in a year tends to be an increasing function
over time. This is because the bond issuer is initially considered to be credit worthy, and more
the time elapses, the greater the possibility that its financial health will decline.
For bonds with a poor credit rating, the probability of default is often a decreasing function of
time. Reason being, for a bond with poor credit rating, the next year or two may be critical. If
the issuer survives this period, its financial health is likely to have improved.

Estimating Default Probabilities


The probability of default for a company can be estimated from the prices of bonds it has issued.
The usual assumption is that the only reason a corporate bond sells for less than a similar risk
free bond is the probability of default.
h = s / 1 R, Where, h = default intensity per year, s = spread of the corporate bond yield over
the risk free rate, and R = expected recovery rate.
Credit Default Swap
A credit default swap (CDS) is a bilateral contract in which one party (the protection buyer or the
seller of the credit risk) pays a periodic, fixed premium to another (the protection seller or buyer
of the credit risk) for protection related to credit events On an underlying reference entity or
obligation.
Usually the premium is paid quarterly and expressed in basis points per annum of the swaps
notional. If a credit event occurs, the protection seller is obliged to make a payment to the
protection buyer in order to compensate him for any losses that he might otherwise incur. Thus
the credit risk of the reference entity or obligation is transferred from the protection buyer to the
protection seller.
A CDS is therefore similar to an insurance contract or a financial guarantee i.e. of unfunded
nature. Alternatively it can be thought of as an unfunded FRN (which also largely excludes the
interest rate risk), with the premium similar to the credit spread over Libor.

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CREDIT SPREAD OPTION


A financial derivative contract that transfers credit risk from one party to another. An initial
premium is paid by the buyer in exchange for potential cash flows if a given credit spread
changes from its current level.
The buyer of a credit spread option will receive cash flows if the credit spread between two
specific benchmarks widens or narrows. Credit spread options come in the form of both calls and
puts, allowing both long and short credit positions.
Credit spread options can be issued by holders of a specific company's debt to hedge against the
risk of a negative credit event. The buyer of the credit spread option (call) assumes all or a
portion of the risk of default, and will pay the option seller if the spread between the company's
debt and a benchmark level (such as LIBOR) grows.
Options and other derivatives based on credit spreads are vital tools for managing the risks
associated with lower-rated bonds and debt.

COLLATERALIZED DEBT OBLIGATION


A CDO is a way of creating securities with widely different risk characteristics from a portfolio
of debt instruments.
Merits & Demerits of CDOs
Merits:
Different Trenches allow Investors to customize their Credit Risk exposure
Efficient Mechanism for taking Diversified Credit Exposure
Attractive Spreads relative to similarly rated Assets

De-Merits:
Pricing is based on Rating Agency assigned default probabilities which may not
reflect True Underlying Risk
Expenses Origination & Management Fees reduce the economics to Investors
In this four types of securities are created from a portfolio of bonds. The first Tranche has 5% of
the total bond principal and absorbs all credit losses from the portfolio during the life of the CDO
until they have reached 5% of the total bond principal.
The second Tranche has 10% of the principal and absorbs all losses during the life of the CDO in
excess of 5% of the principal up to a maximum of 15% of the principal.
The third Tranche has 10% of the principal and absorbs all losses in excess of 15% of the
principal and up to a maximum of 25% of the principal.
The fourth Tranche has 75% of the principal absorbs losses in excess of 25% of the principal.

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Value at Risk (VaR)


Meaning
Value at risk (VaR) is an attempt to provide a single number summarizing the total risk in
a portfolio of financial assets for senior management. It has widely used by corporate treasurers
and fund managers as well as by financial institutions.
When using the value at risk measure, the manager of a portfolio of financial instruments
is interested in making a statement of the following form:
we are X percent certain that we will not lose more than V rupees in the next N days
The variable V is the VaR of the portfolio. It is a function of two parameters: N is the
time horizon and X is the confidential level. It is the loss level over N days that the manager is X
% certain will not be exceeded.
In calculating a banks capital for market risk, regulators use N=10 days, X=99%. This
means that they focus on the loss level over a 10-day period that is expected to be exceeded only
1% of the time. The capital they require the bank to keep is at least three times this VaR
measures.
N-day VaR = 1-day VaR*N
10-day VaR = 3 * 10 = 9.49 times the 1-day 99% VaR.
Daily Volatilities
In option pricing we measure volatility per year
In VaR calculations we measure volatility per day
Measures of VaR
Approaches that are available to measure Value at risk are:
1. Historical Simulation Approach
2. Model Building Approach
3. Linear Model
4. Quadratic Model
5. Monte Carlo Simulation

Measures of VaR
1. Historical Simulation Approach
Historical simulation is one popular way of estimating VaR. It involves using past data in
a very direct way as a guide to what might happen in the future. Suppose that we wish to
calculate VaR for a portfolio using a one-day time horizon, a 99% confidence level, and 500
days of data. The first step is to identify the market variables affecting the portfolio. These will
typically be exchange rates, equity rates, interest rates etc. We then collect data on the
movements in these market variables over the most recent 500 days. This provides us with 500
alternative scenarios for what can happen between today and tomorrow. Scenario I is where the
percentage changes in the values of all variables are the same as they were on the first day for
which we have collected data; scenario 2 is where they are the same as on the second day for
which we have data and so on.
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Define Vi as the value of a market portfolio on Day I and suppose that today is Day m.
The i th scenario assumes that the value of the market variable tomorrow will be:
Vm * (Vi / Vi-1)
Suppose m= 500. For the first variable, the value today, V500, is 25.85. Also V0 = 20.33
and V1=20.78. So the value of the first market variable in the first scenario is 25.85* (20.78 /
20.33) = 26.42
After finding 500 scenarios, we have to find expected portfolio values using computer
programming for 500 scenarios. The we have to find value at risk for 501st day.

2. Model Building Approach


Model building approach is also called as variance-covariance approach. Before getting
into the details of this approach, it is appropriate to mention one issue concerned with the units
for measuring volatility.
Daily Volatilities
In option pricing we usually measure time in years, and the volatility of an asset is
usually quoted as a volatility per year. When using model building approach to calculate VaR,
we usually measure time in days and the volatility of an asset is usually quoted as a volatility
per day
Standard deviation of the continuously compounded return on the asset in one year or in
one day is
year= day N
day= year/ N
Single-Asset Case
Consider a portfolio consists of USD 10 million in shares of Wipro.
Suppose the daily volatility of Wipro is 2% (approximately 32% per year).
N=10 days and X = 99%. 10-days 99% VaR is
The standard deviation of the change in the value of portfolio in one day is 10,000,000 * 0.02 =
Rs.2,00,000
Normal distribution for N(-2.33) is =0.01. This means that there is a 1% probability that a
normally distributed variable will decrease in value by more than 2.33 standard deviation.
The 1-day 99% VaR for our portfolio consisting of a Rs.10,000,000 position in Wipro is
2.33*2,00,000 = Rs.4,66,000
The 10-day 99% of VaR is
= 4,66,000* 10 = Rs.14,73,621.

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3. LINEAR MODEL
Suppose that we have a portfolio worth P consisting of n assets with an amount ai being invested
in asset I (1<=i<=n). We define Dxi as the return on assets I in 1 day.
DP = ai Dxi
Where DP is the dollar change in the value of whole portfolio in 1 day.
To calculate the standard deviation of DP, we define i as the daily volatility of the ith asset and
ij as the coefficient of correlation between returns on asset I and asset j. Thus the variance of
DP, which will be denoted by 2p = ai2 2i + 2 ij ai aj i j
In the example considered in the previous slide, $10 Million was invested in the first asset
(Wipro) and $5 million in AT&T. Thus
DP = 10Dx1+ 5Dx2
if i= 0.02, j= 0.01 and ij=0.3 then
2p = ai2 2i + 2 ij ai aj i j
=102*0.022+52*0.012+2*0.3*10*5*0.02*0.01
= 0.0485 and p = 0.0485 = 0.220
Thus the 10 day 99% VaR is 2.33*0.220* 10 = $1.623 million.
Example
Consider an investment in options on Microsoft and AT&T. Suppose the stock prices are 120
and 30 respectively and the deltas of the portfolio with respect to the two stock prices are 1,000
and 20,000 respectively as an approximation.

4. QUADRATIC MODEL
For a portfolio dependent on a single stock price it is approximately true that
1
P S (S ) 2
2

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5. MONTE CARLO SIMULATION


As an alternative to the approaches described so far, we can implement the model
building approach using Monte Carlo Simulation to generate the probability distribution
for DP. Suppose we wish to calculate a 1-day VaR for a portfolio, the procedure is as
follows:
Value of the portfolio today in the usual way using the current values of market
variables.
Sample once from the multivariate normal probability distribution of the Dx1
use the values of the Dx1 that are sampled to determine the value of each market
variable at the end of the day.
Revalue the portfolio at the end of the day in the usual way.
Subtract the value calculated in step 1 from value in step 4 to determine sample
DP.
Repeat steps 2 to 5 many times to build up a probability distribution for DP.

Stress Testing & Back Testing


Stress Testing
In addition to calculating a VaR, many companies carry out what is known as a stress test
of their portfolio. Stress testing involves estimating how the portfolio would have performed
under some of the most extreme market moves seen in the last 10 to 20 years.
Back Testing
It involves testing how well the VaR estimates would have performed in the past.
Suppose that we are calculating a 1-day 99% VaR. Back testing would involve looking at how
often the loss in a day exceeded the 1-day 99% VaR calculated for that day.

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