Q. How options are used as a tool for hedging?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. The two types of options are calls and puts. a) Call Options b) Put Options A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the expires. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Options can be used as arbitrary, speculation or hedging tools. Hedging is generally a finance transaction as a safeguard against risks such as exchange rate fluctuations or changes of commodity prices. The person or company who wants to hedge a transaction, also called the Hedger, is doing another transaction which is directly linked to the underlying transaction. One instrument to do this is the so called Option. Options belong to the group of derivatives. An Option gives you the right to buy or to sell the underlying at or before a future date for an agreed price. This price is called the strike price and the future date is called expiration date or maturity. The underlying can be a stock, a bond, a currency or another security such as a future contract and they can be traded at an exchange or over-the counter. Options are a special type of future contracts and that is why they are also called conditional future contracts. If you buy the underlying it is called a Call and if you sell the underlying it is called a Put. It has to be emphasized that the Option gives the owner the right to do something but he doesn`t have to exercise this right. This is basically the biggest difference to Forwards and Futures where you have to perform. That is why the buyer of an Option has to pay a premium to the seller (writer). This value of an option can be determined with several methods such as the Black and Scholes model. Generally you can distinguish two types of Options. On the one hand you have the American Options which can be exercised at any point of time until the expiration date and which are the most traded Options at the exchanges and on the other hand you have the European

Options which can be exercised only at maturity. The biggest exchange for Options is the Chicago Board Options Exchange (CBOE). Example:- If you buy 1,000 RIL shares at Rs. 1,000 each. After three months, the stock price goes up to Rs. 1,300. This means you make a notional gain (since you are not booking profits) of Rs. 300 per share, or Rs. 3 lakh, overall. Now, if you think the price will go down from this level but dont want to sell, you can hedge the notional loss by buying put options. You buy four put options (with 250 units each) at a strike price of Rs. 1,300 at a premium of Rs. 80your total outgo is Rs. 80,000. If the stock price goes down to Rs. 1,100 and the premium goes up to Rs. 150 (the premium goes up in put option when stock price plummets), the gain you make on each share is Rs. 70Rs. 70,000 in all. On the other hand, the notional loss you make on 1,000 RIL shares is Rs. 2 lakh. Since you gained Rs.70,000 through the put option, your net notional loss comes down to Rs. 1.30 lakh.

Q. What are SWAPS and how they are used by Investors?

SWAPS:Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps. If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.

Investment and commercial banks with strong credit ratings are swap market-makers, offering both fixed and floating-rate cash flows to their clients. The counterparties in a typical swap transaction are a corporation, a bank or an investor on one side (the bank client) and an investment or commercial bank on the other side. After a bank executes a swap, it usually offsets the swap through an interdealer broker and retains a fee for setting up the original swap. If a swap transaction is large, the interdealer broker may arrange to sell it to a number of counterparties, and the risk of the swap becomes more widely dispersed. This is how banks that provide swaps routinely shed the risk, or interest-rate exposure, associated with them. Uses For SWAPS:-

Interest rate swaps became an essential tool for many types of investors, as well as corporate treasurers, risk managers and banks, because they have so many potential uses. These include:
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Portfolio management. Interest rate swaps allow portfolio managers to add or subtract duration, adjust interest rate exposure, and offset the risks posed by interest rate volatility. By increasing or decreasing interest rate exposure in various parts of the yield curve using swaps, managers can either ramp-up or neutralize their exposure to changes in the shape of the curve, and can also express views on credit spreads. Swaps can also act as substitutes for other, less liquid fixed income instruments. Moreover, long-dated interest rate swaps can increase the duration of a portfolio, making them an effective tool in Liability Driven Investing, where managers aim to match the duration of assets with that of long-term liabilities. Speculation. Because swaps require little capital up front, they give fixed-income traders a way to speculate on movements in interest rates while potentially avoiding the cost of long and short positions in Treasuries. For example, to speculate that five-year rates will fall using cash in the Treasury market, a trader must invest cash or borrowed capital to buy a five-year Treasury note. Instead, the trader could receive fixed in a five-year swap transaction, which offers a similar speculative bet on falling rates, but does not require significant capital up front. Corporate finance. Firms with floating rate liabilities, such as loans linked to LIBOR, can enter into swaps where they pay fixed and receive floating, as noted earlier. Companies might also set up swaps to pay floating and receive fixed as a hedge against falling interest rates, or if floating rates more closely match their assets or income stream. Risk management. Banks and other financial institutions are involved in a huge number of transactions involving loans, derivatives contracts and other investments. The bulk of fixed and floating interest rate exposures typically cancel each other out, but any remaining interest rate risk can be offset with interest rate swaps. Rate-locks on bond issuance. When corporations decide to issue fixed-rate bonds, they usually lock in the current interest rate by entering into swap contracts. That gives them time to go out and find investors for the bonds. Once they actually sell the bonds, they exit the swap contracts. If rates have gone up since the decision to sell bonds, the swap contracts will be worth more, offsetting the increased financing cost.

ASSIGNMENT
ON

DERIVATIVES AND RISK MANAGEMENT

Submitted To:Dr. Bhavesh Joshi AIMT Greater Noida

Submitted By:PRASHANT KUMAR Roll No:- DM10132 Sec A AIMT (2010-12)