Buying and Selling Stock:

Long Position

Profit

E
0 MP (T)
400

(-) 400
Loss
 Buying and Selling Stock:
Short Position

Profit
240

240
0 MP (T)
E

Loss
 Derivative Instruments
They derive their value from the value
of an underlying asset. The underlying
asset could be a Stock, a Commodity, a
Rate or a Price, an Index etc.

Derivatives include Options, Futures,

Forwards and Swaps.
 Use of Derivatives

 They provide investors additional

investment avenues by helping them
achieve unique return and risk
profiles.

 They are used for Managing Risk.

 Options

Call Option: gives the holder a right to buy

the underlying asset at a fixed price at any
time before its expiration.

Put Option: gives the holder a right to sell

the underlying asset at a fixed price at any
time before its expiration.
 Call Option
Pay-off Diagram:
Net payoff
on call

Strike
Price

Price of underlying
asset
 Put Option
Pay-off Diagram:
Net payoff
on put

Strike
Price

Price of underlying asset

Options other than Calls and Puts

 Convertible bonds: purchaser buys a

straight bond and a call option.
 Callable bonds: purchaser buys a
straight bond and sells a call option
to issuer.
 American Versus European
Options

European options can only be exercised

on expiration day whereas American
options can be exercised on or prior to
expiration day.

The possibility of early exercise makes

American options more valuable than
otherwise similar European options.
 Monieness and Options
Relationship Calls Puts
A>S in-the-money out-of-the-money
A=S at-the-money at-the-money
A<S out-of-the- in-the-money
money

‘A’ denotes the current price of the underlying asset

‘S’ denotes the strike price of the option
 Value of an Option

The two components are,

 Intrinsic Value: of call = Max [A-S, 0]
of put = Max [S-A, 0]
 Time value: It is the value in excess of
the intrinsic value and indicates option’s
potential to become more valuable before
it expires. It decays with passage of time
 Factors Determining Option
Value

 Relating to the underlying asset

 Relating to option characteristics
 Relating to financial markets
Relating to the Underlying Asset

 Its Current Value

 Variance of its value – higher
variance leading to higher potential
to earn
 Dividends paid on the asset during
the life of the option
 Relating to Option
Characteristics

 Strike Price of the Option

 Time to Expiration of the Option
Relating to Financial Markets

Risk less rate of interest

corresponding to the life of the
option.
 Summary of Effects
Factor Call Value Put Value

Increase in asset value Increase Decrease

Increase in strike price Decrease Increase

Increase in variance of Increase Increase

underlying asset
Increase in time to Increase Increase
expiration
Increase in interest rate Increase Decrease

Increase in dividend paid Decrease Increase

 Investment Strategies

 Elementary
- Involving a single option
 Complex
- Combining positions in stocks & options
- Combining elementary positions
 Elementary Investment
Strategies

 Long Call
 Short Call
 Long Put
 Short Put
 Long Call
Profit
This refers to the purchase of a call

400 E
0 MP (T)
440
(-) 40

These are cash flows when a bullish

Loss
Investor buys a 3-month call on the
Stock with an exercise price of Rs.400
Per share by paying a premium of Rs.40
 Short Call
This involves writing a call without owning the
underlying asset
Profit

(+) 40
440
0 MP (T)
400 E

Loss These cash flows relate to writing a

3-month call on a stock at an exercise
price of Rs.400 per share
by receiving a premium of Rs.40.
 Long Put
This involves buying a put – the right to sell the
Underlying asset at a specified price
Profit
(+) 216

E 240
0 MP (T)
216
(-) 24

Loss These cash flows relate to a bearish investor

Buying 3-month put with a exercise price of
Rs.240 per share by paying a premium of Rs.24
 Short Put
This involves writing a put
Profit

E
0 MP (T)
216 240

(-) 216
Loss
These cash flows relate to a bullish investor
Writing a put at an exercise price of Rs.240
Per share receiving a premium of Rs.24.
Complex Investment Strategies

 Covered Call Writing

 Protective Put
 Straddles
 Strangles
 Spreads
 Covered Call Writing
It involves buying the stock and writing call on that.
Profit

(+)48

E
302 350 MP (T)

These are cash flows when we buy

(-)302
100 shares @310 and write a Dec
350 call for Rs.8 so that initial
Investment is Rs.302
 Covered Call Writing:
CF0 = (-)Rs.302

MP (T) At Time T NCF

Sell Stock Buy Call CF(T)
270 270 0 270 -32
290 290 0 290 -12
310 310 0 310 8
330 330 0 330 28
350 350 0 350 48
370 370 -20 350 48
 Protective Put
It involves buying the stock and buying put on that.

Profit

E
MP (T)
270 312
(-)42
These are cash flows when buy
100 shares @ Rs.310 and buy a
Jan 270 put for Rs.2 so that initial
Loss Investment is Rs.312
 Long Straddle
Involves buying a put and a call, each with same exercise
price
and same time to expiration.
Profit
247

E1 E2 MP (T)
247 373

(-)63
310

Buying a Jan 310 call for Rs.21

Loss
And Jan 310 put for Rs.42 per
Share. Initial investment Rs63.
 Short Straddle
Involves selling a put and a call, each with same exercise price
and same time to expiration.

Profit

(63)
E1 E2
MP (T)
247 310 373

Loss
(-)247
 Long Strangle
Involves buying a call and a put on the same underlying asset
for same expiration period at different exercise prices

Profit
247

E1 270 310 E2 MP (T)

247 333
-23

Buy Jan 310 call for Rs.21 and Jan 270

Put for Rs. 2. Initial investment Rs.23.
Loss Usually one in-the-money and another
Out-of-the-money. Initial investment
Can be less than straddle
 Vertical Spread (Across Strike Prices)
Involves buying an option of and selling another option of the
same type and time to expiration but with different exercise price

Profit

+ 30
E
MP (T)
270 320 350

- 50

Bullish vertical spread using calls wherein we

Buy Mar 270 calls for Rs.58 and sell Mar 350
Loss Calls for Rs.8 i.e. buy lower strike price and
Sell higher strike price calls.
 Vertical Spread
Involves buying an option of and selling another option of the
same type and time to expiration but with different exercise price

Profit

+ 68

E
MP (T)
270 282 350
- 12

Bullish vertical spread using puts wherein

We buy Mar270 put for Rs.2 and sell
Loss Mar 350 put for Rs.70.
 Vertical Spread
.

Profit

+59

E
MP (T)
270 329 350

-21

Bearish vertical spread wherein Sell

Loss Jun 270 call for Rs.71 and buy
Jun 350 call for Rs.12.
 Vertical Spread
.

Bearish vertical spread using

Profit Puts wherein Buy Mar 350 put
for Rs.70 and sell Mar 270 put
for Rs.2
+12

E
MP (T)
270 282 350

-68

Loss
 Horizontal Spreads (Across Expiration Months)

 Involve buying an option and selling another of

same type with same exercise price but with
different expiration time.
 In a horizontal bull spread, we buy back month
and sell the front month. In a horizontal bear
spread, we buy front month and sell back month.
 Horizontal bull spread has similar pay-off as that
of a short straddle and horizontal bear spread has
similar payoff as that of a long straddle.
 Diagonal Spreads

They are vertical and horizontal at

the same time i.e. the are across
both strike price and expiration
month.
 Butterfly Spread
 Involves four options, all calls or all puts.
 All have same expiration month and same
underlying asset.
 One option has high strike price, one has
low strike price and two have same strike
price which is between those of high strike
and low strike.
 Two middle strike price are sold and the
two end options are purchased.
Reverse Butterfly or Sandwich Spreads

 This is strategy reverse of the

butterfly spread.
 The two middle strike price options
are purchase and the two end strike
price options are sold.
 Evaluation of the Strategies
 Transaction costs have not been considered
and should be kept in mind.
 Bid-ask spreads may affect payoffs.
 They are dividend protected.
 Margin requirements are applicable to option
writing.
 Possibility of early exercise may pose new
risks.
 Timing of cash flows can make a difference.
 Forwards

A forward is a contract between two

parties requiring deferred delivery
of underlying asset (at a contracted
price and date) or a final cash
settlement. Both parties are obliged
to perform and fulfill he terms.
Cash Flows on Forwards
Pay-off Diagram:
Buyer’s pay-offs

Futures
Price

Spot price of
underlying assets

Seller’s pay-offs
 Futures

A standardized forward contract is

called a Futures Contract.
 Why Forwards?
They are customized contracts unlike
Futures and they are:
 Tailor-made and more suited for certain
purposes
 Useful when futures do not exist for
commodities and financials being
considered
 Useful in cases futures’ standard may be
different from the actual
 Futures & Forwards
Distinguished
FUTURES FORWARDS
They trade on exchanges Trade in OTC markets
Are standardized Are customized
Identity of counterparties is Identity is relevant
irrelevant
Regulated Not regulated
Marked to market No marking to market
Easy to terminate Difficult to terminate
Less costly More costly
 Futures vs. Options:
Performance
 Option purchasers do not post margins since they
have no obligations
 An option clearing house serves the similar
functions as those of clearing associations in
futures trading
 Option writers have to post margins to clearing
houses
 Options are also OTC and dealers may require
margins or guarantees.
 Index Futures Contract
It is an obligation to deliver at
settlement an amount equal to ‘x’
times the difference between the
stock index value on expiration date
and the contracted value
On the last day of trading session the
final settlement price is set equal to
the spot index price
 Illustration
The settlement price of an index futures contract on
a particular day was 1100. The multiple associated
is 150. The maximum realistic change that can be
expected is 50 points per day. Therefore, the initial
margin is 50×150 = Rs.7500. The maintenance
margin is set at Rs.6000. The settlement prices are
on day 1,2,3 and 4 are 1125, 1095, 1100 and 1140
respectively. Calculate mark-to-market cash flows
and daily closing balance in the account of investor
who has gone long and the one who has gone short
at 1100. Also calculate net profit/(loss) on each
contract.
 Illustration
Long Position:
Day Sett. Price Op. Bal. M-T-M CF Margin Call Cl. Bal
1 1125 7500 + 3750 - 11250
2 1095 11250 - 4500 - 6750
3 1100 6750 + 750 - 7500
4 1140 7500 + 6000 - 13500
Net Profit/(loss) = 3750-4500+750+6000 = Rs. 6000

Short Position:
Day Sett. Price Op. Bal. M-T-M CF Margin Call Cl. Bal
1 1125 7500 - 3750 2250 6000
2 1095 6000 + 4500 - 10500
3 1100 10500 - 750 - 9750
4 1140 9750 - 6000 2250 6000
Net Profit/(loss) = -3750+4500-750-6000 = (-) Rs. 6000
Pricing of Index Futures Contracts

Assuming that an investor buys a portfolio

consisting of stocks in the index, rupee
returns are:
RI = (IE – IC) + D, where
RI = Rupee returns on portfolio
IE = Index value on expiration
IC = Current index value
D = Dividend received during the
year
 Pricing of Index Futures Contracts

If he invests in index futures and invest

money in risk free asset, then
RIF = (FE – FC) + RF, where

RIF = Rupee return on alternative investment

FE = Futures value on expiry
FC = Current futures value
RF = Return on risk-free investment
Pricing of Index Futures Contracts

If investor is indifferent between the two

options, then

RI = RIF
i.e. (IE-IC) + D = (FE-FC) + RF
Since IE = FE
FC = IC + (RF – D)
(RF – D) is known as the ‘cost of carry’ or
‘basis’ and the futures contract must be
priced to reflect ‘cost of carry’
 Stock Index Arbitrage
When index futures price is out of
sync with the theoretical price, the
an investor can earn abnormal risk-
less profits by trading simultaneously
in spot and futures market. This
process is called stock index
arbitrage or basis trading or program
trading.
 Stock Index Arbitrage: Illustration
Current price of an index = 1150
Annualized dividend yield on index = 4%
6-month futures contract price = 1195
Risk-free rate of return = 10% p.a.
Assume that 50% of stocks in the index will
pay dividends in next 6 months. Ignore
margin, transaction costs and taxes. Assume a
multiple of 100. Is there a possibility of stock
Index arbitrage?
 Stock Index Arbitrage: Illustration
Fair price of index future
FC = IC + (RF – D)
= 1150 + [(1150×0.10×0.5)-(1150×0.04×0.5)]
= 1150 + 34.5 = 1184.5 (hence it is overpriced)
Investor can buy a portfolio identical to index and
short-sell futures on index.
If index closes at 850 on expiration date, then
A. Profit on short sale of futures (1195-850) ×100 = Rs.34,500
B. Cash Div recd on port. (1150 × 0.04 × 0.5 × 100 = Rs. 2,300
C. Loss on sale of port. (1150-850) ×100 = (-) Rs.30,000
D. Net Profit = 34,500 +2,300 – 30,000 = Rs.6,800
E. Half yearly return = 6800/1150×100=0.0591 = 5.91%
F. Annual return (1.0591)2 – 1 = 0.1217 = 12.17%
Stock Index Arbitrage: Illustration

If index closes at 1300,

A. = (-) 10,500
B. = 2,300
C. = 15,000
D. = 6,800 = 12.17% p.a.
 Application of Index Futures
In passive Portfolio Management:
An investor willing to invest Rs.10 lakhs can buy
futures contracts instead of a portfolio, which
mimics the index.
Number of contracts (if Nifty is 1000)
= 10,00,000/1000 ×150 = 6.67 = 7 contracts
Advantages:
 Periodic rebalancing will not be required.
 Potential tracking errors can be avoided.
 Transaction costs are less.
 Application of Index Futures
In Beta Management:
In a bullish market beta should be high and in a
bearish market beta should be low i.e. market
timing and stock selection.
Consider a portfolio and rising market forecast.
Equity : Rs.150 millions
Cash Equivalent : Rs.50 millions
Total : Rs.200 millions
Assume a beta of 0.8 and desired beta 1.2
 Application of Index Futures
The Beta can be raised by,
a. Selling low beta stocks and buying high beta
stocks and also maintain 3:1 ratio.
b. ‘x’ contracts in the following equation can be
purchased:
150 × 0.8 + 0.15 × X = 200 × 1.2
i.e. X = (200 × 1.2 – 150 × 0.8) / 0.15
= 800 contracts, assuming Nifty
future available at Rs.1000 and
multiple of 150, and beta of
contract as 1.
 Interest Rate Caps

A cap writer pays the holder each

time when the reference rate is
above the contract’s ceiling rate on a
settlement date and full premium is
usually paid in advance
 Participating Cap

Purchaser pays the dealer a portion

of difference between reference rate
and ceiling if reference rate is below
the ceiling. Dealer pays the
purchaser full when reference rate is
above the ceiling rate.
 Caption

A firm in eventual need for interest

rate cap may buy an option on cap in
the lag period and decide later to buy
cap or not to buy it.
 Swaps

Swaps involve exchange of one set

of financial obligations with another
e.g. fixed rate of interests with
floating rate of interest, one currency
obligation to another, a floating price
of a commodity to fixed price etc.
 History of Swaps
First currency swap was engineered in
London in 1979, but the next deal
structured by Salomon Brothers in 1981 in
London involving organizations of the
stature of World bank and IBM, not only
ended the 2-year obscurity but also gave
credibility to the instrument, so necessary
for its extremely fast growth. Was
introduced in the US in 1982 by Student
Loan Marketing Association (Sallie Mae).
.
Initial Exchange of Notionals
(Optional)

Notionals Notionals
Swap
Counterparty A Counterparty B
Dealer
Notional Notionals
 Periodic Usage or Purchase
Payments (Required)
.

Fixed Price Fixed Price

Swap
Counterparty A Counterparty B
Dealer
Floating Floating
Price Price
.
Re-exchange of Notionals
(Optional)

Notionals Notionals
Swap
Counterparty A Counterparty B
Dealer
Notionals Notionals
 Interest Rate Swap
.
CASH MARKET TRANSACTIONS

Debt market
(Floating Rate)

Debt Market
(Fixed Rate)

Swap
Counterparty A Counterparty B
Dealer

SWAP
 Interest Rate Swap
.
CASH MARKET TRANSACTIONS

Debt market
6-M LIBOR +50bps
(Floating Rate)

Debt Market
(Fixed Rate) 10.25% (sa)

10.50% (sa) 10.40% (sa)

Swap
Counterparty A Counterparty B
Dealer
6-M LIBOR 6-M LIBOR

SWAP
 Currency Swap
.
CASH MARKET TRANSACTIONS

Debt market
9%
(DM)

Debt Market
($) LIBOR

9.45% 9.55%
Swap
Counterparty A Counterparty B
Dealer
LIBOR LIBOR

SWAP
 Commodity Swap
.
CASH MARKET TRANSACTIONS

Spot
Actuals Oil Actuals
Market
Spot Price Spot Price

$15.20/barrel $15.30/barrel
Swap
Counterparty A Counterparty B
Dealer
Spot Price Spot Price
(average) (average)
Oil Producer Refiner
SWAP
 Swaption

When a firm doesn’t want a swap

now but can lock-in the terms of
swap now by buying an option on
swap called Swaption.