Definition of Risk Certainty , Uncertainty and Risk Types of Risk or Sources of Risk:a) Interest rate riskb) Exchange riskc) Liquidity riskd) Internal business riske) External business riskf) Financial riskg) Events of Godh) Market riski) Marketing riskj) Credit riskk) Other risks i.e. personnel/environmental/production risks

Risk avoidance

Loss control

Diversification

Separation

Risk transfer

Risk retention

Risk sharing

Mere survival Peace of mind Lower risk management costs and thus higher profits Fairly stable earnings Little or no interruption of operations Continued growth Satisfaction of the firm’s sense for a good image Fulfillment of social responsibility

Determining objectives Identifying risks Risk evaluation Development of policy Development of strategy Implementation Review

INSURANCE

DERIVATIVES:

Forwards Futures Options Swaps

PROPERTY RISK

LEGAL LIABILITY RISK

OTHER RISKS

HUGE POTENTIAL LOSSES

PURE RISKS ARE CONTROLLABLE

INSURABILITY

LOWER PROBABILITY

NOT ASSOCIATED WITH OFFSETTING GAINS

EXPECTED COST OF LOSSES

COST OF LOSS CONTROL

COST OF LOSS FINANCING

COST OF INTERNAL RISK REDUCTION METHODS

COST OF RESIDUAL UNCERTAINTY

LOSS CONTROL

RISK FINANCING

INTERNAL RISK REDUCTION

( A ) IDENTIFICATION OF EXPECTED LOSSES: PROPERTY LOSSES LIABILITY LOSSES LOSSES TO HUMAN RESOURCES LOSSES FROM EXTERNAL FORCES( B ) MEASUREMENT OF EXPECTED LOSSES: PROBABILITY DISTRIBUTION EXPECTED VALUE STANDARD DEVIATION FREQUENCY OF LOSSES SEVERITY OF LOSS

FIRE ACCIDENT TO PROPERTY PROBABILITY ESTIMATED LOSS

MAJOR .04 RS. 25 LACSMINOR .06 RS. 5 LACSNO ACCIDENT .90 RS. 0 LACS TOTAL : 1 EXPECTED LOSS = 25 ( .04 ) + 5 ( .06 ) + 0 (0.9 ) = 1.3 LACSVARIANCES = (25 – 1.3) (0.04 ) + ( 5 – 1.3 ) ( 0.06 ) + ( 0 – 1.3 ) ( 0. 9 ) = 22. 47 + 0. 82 + 0 = 23.29

STANDARD DEVIATION = RS. 4.83 LACS

INSURER’S SERVICES

AVOIDS RAISING COSTLY EXTERNAL FUNDS

AVOIDS FINANCIAL DISTRESS

REDUCES TAX PAYMENTS

LIFE INSURANCE GENERAL INSURANCE SOCIAL INSURANCE PROPERTY INSURANCE :

Marine Insurance Fire insurance Miscellaneous insurance

Insurable interest Utmost good faith Indemnity Subrogation Warranties Proximate cause Assignment and nomination

Transformation of insurance industry in India Insurance sector reforms Insurance regulatory and development authority ( IRDA ) Players in the insurance markets Insurance market : new dimensions ( I ) Re-insurance ( ii ) Banc assurance ( iii ) Alternative risk transfer (ART )

WHOLE LIFE POLICY ENDOWMENT ASURANCE POLICY MONEY BACK POLICY TERM POLICY JOINT LIFE INSURANCE POLICY CHILDREN’S POLICY GROUP INSURANCE PLAN

Derivatives are contracts whose pay-offs depend upon the value of an ‘underlying’. The underlying can be a commodity , a stock , a stock index , a currency , or interest rate , or literally anything – not necessarily an asset.

When the values of underlying assets change, so do the values of derivatives based on them.

The transactions in the derivatives are settled by the offsetting/squaring transactions in the same derivatives. The difference in value of the derivatives is cash settled.

It is easier to take short position in derivatives than in other assets. Exchange traded derivatives are liquid and have low transaction cost. It is possible to construct the portfolio which is exactly needed ,

without having the underlying assets. Some derivatives are traded on organized exchanges while others are

traded only in OTC markets. Exchange traded derivatives have standardized features and are not

tailored to the needs of buyers and sellers .

COMMODITY DERIVATIVES AND FINANCIAL DERIVATIVES

BASIC DERIVATIVES AND COMPLEX DERIVATIVES

EXCHANGE TRADED AND OTC DERIVATIVES

RISK MANAGEMENT

PRICE DISCOVERY

TRANSACTIONAL EFFICIENCY

FINANCIAL ENGINEERING

Hedgers

Speculators

Arbitrageurs

FORWARDS

FUTUTERS

OPTIONS

FINANCIAL SWAPS

A forward contract is an agreement between two parties to buy or sell an asset at a future date at a price agreed today.

In India, the forward contract have been quite common in agriculture produce. With globalization effect, the forward market for foreign currencies has also come up fast.

Forward contracts are generally tailor- made and non-transferable.

FCs can be used to hedge or lock-in-the price of purchase or sale of the asset at a future date.

In case of FCs, no initial margin or premium is payable, so these can used without any cash outflow.

FCs have a counter party risk and in case of default by other party, the aggrieved party may have to suffer a loss.

Generally, squaring off of a FC is not possible and it compulsorily ends in delivery.

A futures contract, or simply called futures, is a contract to buy or sell a stated quantity of a commodity or a financial claim at a specified price at a future specified date.

Futures are traded in organized exchange and the terms of the futures are standardized by the exchange with reference to quantity, date, units of price quotations etc.

Both the parties to the futures have a right to transfer the contract by entering into an offsetting futures contract. If not transferred until the settlement / specified date, then they have obligations to fulfill the terms and conditions of the contract.

The exchange provides the counter party guarantee through its clearing house and different types of margin system.

Futures are marked to market at the end of each trading day.

DIFFERNCE BETWEEN FUTURES AND FORWARD TYPES OF FUTURES : A foreign currency say Euro, Yen ,Swiss franc

etc. An interest-earning asset say a debenture An index ( usually a stock index ) A physical commodity ( say, wheat , corn etc ) Futures on individual stock

The asset The price The contract size Delivery arrangements Delivery months Limits on daily price movements Trading units

BUYER CLEARINGHOUSE

SELLER

price price

Underlyingassets

Underlyingassets

Ensuring adherence to system and procedures for smooth trading.

Minimizing credit risk by being a counterparty to all trades.

Accounting for all the gains/losses on daily basis Monitoring the speculation margins Ensuring delivery or payment for the assets on the

maturity date for all the outstanding contracts.

MARGINING MECHANISM

SETTLEMENT MECHANISM

HOW TO READ FUTURE PRICES

Symbol : SBIN Expiry date: 29-Dec-05 No. of contracts traded: 16420 Contract Value(Rs. lakh) : 76155.96 Last traded price(Rs) : 931.45 % change from previous close: 1.59 Open interest: 5806500 Value of underlying: 925.8

THIS REPRESENTS THE NUMBER OF OUTSTANDING FUTURESCONTRACT :PERIOD TRADER-A TRADER-B TRADER-C OPEN INTEREST 0 - - - 0 1 SELLS BUYS - 1 2 BUYS - SELLS 1 3 - SELLS BUYS 0

Suppose A,B,C,D,E and F are different investors. ‘+’ refersTo buying a futures contract and a ‘-’ refers to selling of afutures contract on the same underlying asset. Different Cases of transactions and calculations of open interest

(OI)Have shown below:Case-1 case-2 case-3 case-4 case-5 case-6 +A, -B +A, -B +A, -B +A, -B +A, -B +A, -B +C, -D +C,-A +B, -A +C, -D +C, -D +E, -F +E, -C OI=1 OI=2 OI=1 OI=0 OI=3 OI=2

Market order Market if touched ( MIT ) Limit order Market on close ( MOC ) Stop loss order Time orders : Day orders Good till cancelled ( GTC ) Good this week ( GTW ) / this month ( GTM ) Good through date ( GTD )

Gold futures contract : size = 100 grams

Investor buys one December gold futures contract on 1st November at Rs. 400/ per gram.

Value of contract : Rs. 400 x 100 gm = Rs. 40,000/-

Initial margin ( say ) ; 10% = Rs.4000/-

Maintenance margin (say): 75% of initial margin = Rs.3000/-

DAY Closing price of Daily Cumulative Margin Variation gold/ gram gain ( loss) gain (loss) balance marginNov 1 400 --- ----- 4000 -------Nov 2 403 300 300 4300 Nov 3 398 (500) (200) 3800Nov 4 390 ( 800 ) (1000) 3000Nov 5 392 200 (800) 3200Nov 6 387 ( 500 ) ( 1300 ) 2700 1300Nov 7 394 700 (600) 4700Nov 8 401 700 100 5400Nov 9 405 400 500 5800Nov 10 410 500 1000 6300

On Nov.10 the margin balance is Rs.6300/- which represents a profit of Rs.1000( Rs.6300 –Rs.5300 deposited as initial and variation margin) as the price of gold is higher by Rs. 10/- compared to buying price.

DELIVERY OR CASH SETTLEMENT

OFFSETTING

EXCHANGE OF FUTURES FOR PHYSICAL(EFP)

Basis = Current cash price – futures price , normally should be negative.

Basis risk spreads The cost of carry model of determining futures prices Contango Backwardation

COST OF CARRY MEANS STORAGE, INSURANCE, TRANSPORTATION & FINANCING COST.Ft, T = Ct + Ct x St, T x T-t / 365 + Gt, T

Where, Ft, T = The future price at time t, which is to be delivered at time period T.Ct = Cash price at time t

St, T = Annualized interest rate on borrowingsT-t = Time periodGt, T = Storage costs

The price of silver was $ 7.511 per ounce in the New York market on

April 27, 2008. At the close of trading on the same day, the settlement

Price of December 2008 silver futures contracts was $ 8.456. The Annualized borrowing rate on April 27, 2008 was 11%. The cost ofStoring silver is negligible, as the quantity stored is very small.You are required to calculate the following:A. The cost-of-carry price relationship between the cash price of

silverand the futures price of silver.B. Show how an arbitrage gain can be made with the conclusion derived by you in ‘A’ above.

A. Ft, T = Ct + Ct x St, T x T-t / 12 + Gt, T

= 7.511 + 7.511 x 0.11 x 8/12 + 0 = $ 8.061 per ounceB. Futures are now priced at $ 8.456 per ounce. But the fair price

is only $ 8.061 per ounce, so the futures is overpriced.So, the strategy should be : sell futures and buy spot.And in the process the net arbitrage profit will be 8.456 – 8.061 = $ 0.395/ ounce

For Long investor: profit = Spot Price at Maturity – Futures price Loss = Futures price – Spot price at maturity

0K = Strike price

Profit (Rs)

Loss (Rs)

Spot price At maturity

Pay off

For Short investor : Profit = Futures price – spot price at maturity Loss = spot price at maturity – futures price

0

Profit

Loss

kSpot priceAt maturity

Pay off

A stock index is an indicator of the general level of stock prices. It is calculated by taking into consideration the prices of a representative

group of stocks traded in the stock market. Such a stock market index can be used as an underlying asset to create a future contract known as index futures.

Future contracts are available on many stock indices across the globe for example S & P 100 in USA , Nikkei 225 in Japan , DAX in Germany and Nifty in India.

The value of a particular stock index futures contract depends upon the sum of money allotted per index point . The sum of money allotted per index point in the case of Nifty is Rs. 1/- , when Nifty stands at 1990 , the value of a future contracts on Nifty would be Rs.1990/-.

The index futures contracts are cash settled. When an investor goes long in the index future contract, he will

receive a cash settlement on the expiration date, if the closing price exceeds the contract price, otherwise he will have to pay.

Since index futures contracts are listed and traded on future exchanges, the investor can offset his position on any day prior to the expiration day.

The performance of all index futures contacts are guaranteed by the exchange clearinghouse as its become the counterparty to both the buyer and the seller.

The index future carries the margin requirements that are applicable to both buyer and the seller.

The settlement price of sensex futures contract on a particular day was Rs.4600. The Initial margin is set at Rs. 10.000 , while the maintenance margin is fixed at Rs.8000 .The multiple of each contract is 50 . The settlement prices on the following five days

are As follows : DAY SETTLEMENT PRICE RS. 1 4700 2 4500 3 4650 4 4750 5 4700Calculate the mark-to-market cash flows and the daily closing balances in the accounts

ofa) An investor who has gone long , and b) An investor who has gone short at Rs. 4,600.Calculate net profit ( loss ) on each of the contracts .

DAY SETTLEMENT PRICE OPENING MARK-TO MARGIN CLOSING BALANCE MARKET CALL BALANCE 1 4700 10000 5000 -- 15000 2 4500 15000 (-)10000 5000 10000 3 4650 10000 7500 -- 17500 4 4750 17500 5000 --- 22500 5 4700 22500 (-) 2500 ---- 20000

Net profit ( loss) on the contract : 5000 – 10000 + 7500 + 5000 – 2500 = Rs. 5000

Answer for ( b ) loss is Rs. 5000 . Margin call for day 1 is 5000 and day 4 is 2500.

Let us consider an investor who wants to hold a portfolio which is identical to the composition of a stock market index for a period of one year. During the course of the year, he will receive dividends and at the end of the year, the principal value would have changed in line with the change in the index. If we denote the current index value as, I0 , the expiration day index value as It , and the dividends received as Dt , the rupee return earned by the investor is given by the equation : (It - I0 ) + Dt …….. EQ.1

If the investor decided to invest in an index futures contract as an alternative to investing in the underlying portfolio, he will buy the index futures contract and invest all his money in risk free treasury bills or fixed deposits. If we denote the current price of the index futures contract as F0 , the expiration day price as Ft , and the interest earned as Rf , the rupee return earned by investor is :

(Ft - F0 ) + Rf …………. EQ.2

If the investor has to be indifferent between the two alternatives then (It – I0 ) + Dt = ( Ft – F0) + Rf …………. EQ.3

Since Ft = It i.e the final settlement price of the index futures contract is

Set equal to the spot index value, EQ.3 can be simplified as F0 = I0 + (Rf – Dt ) ………….. EQ.4

EQ.4 states that the current index futures price must be equal to the Index value plus the difference between the risk free interest and Dividends obtainable over the life of the contract. The differenceBetween Rf and Dt is referred to as the cost – of – carry and we can

Say that the futures contract must be priced to reflect the cost of carry.

STOCK INDEX ARBRITAGE : If the price of the index futures contract is out of line with the theoretical price suggested by EQ.4, then an arbitrageur can earn abnormal risk less profits by trading simultaneously in the spot (cash) and futures markets. This process is called the stock index arbitrage or basis trading or program trading. The following example illustrates the mechanics involved.

EXAMPLE: The current value of sensex is 4500 and the annualized dividend yield on the index is 4%. A three month futures contract on the sensex can be purchased for a price of Rs.4,600, the risk free rate of interest is 10%. Futures contracts are trading on the sensex at multiples of 50. Can an investor earn an abnormal ( risk free) rate of return by resorting to stock index arbitrage? Assume that 50% of the stocks included in the index will pay dividends during the next three months. Ignore margin requirements, transaction costs and taxes.

The fair price of the index futures contract is given by the equation: F0 = 4500 + ( 4500 X 0.10 X 0.25 ) – ( 4500 X 0.04 X 0.50 )

= 4500 + 112.5 – 90 = 4522.5The index futures is obviously overpriced. The arbitrageurs can exploitThis opportunity by :A. Buying a portfolio which is identical to the index.B. Going short on the index futures contract.The following calculations will show that the arbitrageurs can earn an abnormal rate of return irrespective of the outcome on the expiration Date.

If the sensex closed at 4200 on the expiration date, the arbitrageursProfit will be as under:A. Profit from short sale of futures ( 4600-4200)x50 = 20,000B. Cash dividend received on the portfolio ( 4500 x 0.04 x 0.5 x 50 ) = 4500C. Loss on sale of underlying portfolio(4500-4200)x50 = (-) 15000D. Interest foregone ( 4500 x 0.10 x 0.25 x 50 ) = (-)

5625

NET ARBRITAGE PROFIT = 3875

On the other hand if the sensex closed at 4800 on the expiration date

The arbitrageurs profit can be calculated as follows:

A. Profit on sale of the underlying portfolio(4800-4500)x50 = 15000

B. Cash dividend received on the portfolio(4500x0.04x0.5x50)= 4500

C. Loss on short sale of futures ( 4800 – 4500) x 50 = (-)10000

D. Interest foregone ( 4500 x 0.10 x 0.25 x 50 ) = (-) 5625

NET ARBITRAGE PROFIT = 3875

As more and more arbitrageurs start buying the portfolio of stocks and

selling the index futures contracts, the price of the index futures

Contracts will decline and the mispricing will disappear.

An option is a contract in which the seller of the contract grants the buyer, the right to purchase from the seller a designated instrument or an asset at a specific price which is agreed upon at the time of entering into the contract.

It is important to note that the option buyer has the right but not an obligation to buy or sell.

But if the buyer decides to exercise his right the seller of the option has an obligation to deliver or take delivery of the underlying assets at the price agreed upon.

The seller of the option is also called the writer of the option. CALL OPTION: An option contract is called a “call option “, if the writer

gives the buyer of the option the right to purchase from him the underlying asset.

PUT OPTION: An option contract is said to be a “ put option “,if the writer gives the buyer the right to sell the underlying asset.

EXERCISE DATE : The date at which the contract matures. STRIKE PRICE : At the time of entering into the contract , the

parties agree upon a price at which the underlying asset may be bought or sold. This price is referred to as the exercise price or striking price. This is regardless of the market price of the asset at the time of exercising.

EXPIRATION PERIOD : At the time of introducing an option contract the exchange specifies the period ( not more than 9 months from the date of introduction of the contract in the exchange ) during which the option can be exercised or traded. This period is referred to as the Expiration period. An option can be exercised even on the last day of the expiration period. Beyond this date the option contract expires.

Such options , which can be exercised on any day during the expiration period are called American options.

Such options , which can be exercised only on the last day of the expiration period are called European options.

Depending on the expiration period an option can be short term or long term in nature.

Warrants and convertibles belong to the latter category. In India Reliance petroleum ltd had converted it’s warrants

issued as a part of triple optional convertibles debentures into fully paid equity shares.

This is the amount which the buyer of the option ( call or put ) has to pay to the

option writer to induce him to accept the risk associated with the contract. It

Can also be viewed as the price paid to buy the option.Now look the following terms of stock options of Sat yam computer traded at NSE.Instrument type : OPTSTIKUnderlying : SATYAMCOMPExpiry date : 30 OCT 2008Option type : CA / PAStrike price : 300High price : 13Low price : 10.9Pre. Close : 11.35

Last price : 11.95Number of contracts traded : 146Turnover in Rs. Lakh : 546.83Underlying value : 293.50

AT THE MONEY : An option whose exercise price is equal to the current spot price is said to be at - the – money .

IN – THE – MONEY : A call option is in – the – money when the strike price is below the current spot price of the underlying asset ; a put option is in- the – money when the strike is above the current spot price of the underlying asset .

OUT – OF – THE MONEY : A call option is said to be out – of – the – money when the strike price is above the spot price of the underlying asset or a put option is said to be out – of – the – money when the strike price is below the current spot price of the underlying asset . The buyer makes a loss if he exercises the option out – of – the – money .

NEAR – THE – MONEY : An option is near the money if the current price of the underlying asset price is close to the strike price .

INTRINSIC VALUE of an option is the value of the profits that are likely from the option. It consists of the profit that will accrue, if the option is exercised today ( in the case of American ) or the present value of the profit ( in the case of an European option ).

The Intrinsic value is also the value of an option takes when it is in the money. For a call it is max.( 0 , S – K ) and for a put it is

max ( 0 , K – S ) where S and K are spot price and strike price of the underlying asset respectively .

TIME VALUE is the difference between the option premium and intrinsic value.

PAY- OFF OF AN OPTION is the profit / loss that arise by way of exercise / non –exercise of the option.

COVERED CALL WRITING : An option contract is said to be a covered call option , when the option is covered or protected by the writer by depositing the shares of the company on which the option is written in an escrow account with the brokerage firm. Therefore , the writer of a call option does not have to deposit any cash as such and whenever an exercise notice is received from the clearing house , the shares are delivered .

In case , the option expires or if the writer enters into an offsetting transaction he can withdraw the stocks deposited .

NAKED CALL WRITING : If a trader writes a call option without owning the underlying stock , it is called as Naked call writing .

When the writer does not own the underlying stock , he has to deposit the necessary amount of margin with the brokerage firm who in turn deposits it with the exchange . Sometimes , the deposit required by the broker may be higher than the deposit required by the exchange.

A call option is a contract that gives the owner the right , but not the obligation , to buy something at a specified price on or before a specified date .

Let us , therefore , see when the owner of a call option on shares would prefer to exercise his option and what benefit he get out of it.

Let us specify certain notations : Exercise price or strike price = K Spot price of underlying asset = S Expiry date of an option = T Call option premium or price = C Current time( i.e. today ) = O Any time between today and expiration date = t

Let us consider an investor who has purchased a call option on satyam with exercise price at Rs. 280 for a premium of Rs. 10.

If the price of the sat yam rises above 290 at any time before the expiry date , the investor will exercise his option and will make a profit by selling the share in spot market.

Let us assume that the current market price is 350 then the investor will make a gross profit of 70 ( 350 – 280 ) and a net profit of 60 ( 70 – 10 ) .

Hence , it would be profitable for the investor of the call option to exercise his option if S > ( K + C ) . As there is no limit to the increase in share price , the profit potential of the investor is limitless.

The owner of option will not exercise his option if K > S . But his loss will be restricted up to call premium amount .

The maximum profit available to a call writer is limited to the option premium , while loss may be limitless .

The gross loss of the writer would be equal to ( S – K ) and net loss would be equal to ( S – K – C )

Option trading is a zero sum game . The gain of the call owner or buyer is the loss of the call writer ; the loss of the call owner is the gain of the call writer.

The ultimate economic function of financial derivatives ( forwards , futures , swaps and options ) is to provide means of risk reduction . Someone who is at risk from a price change can use options to offset that risk . That means options can be used as hedging instruments .

Speculators are attracted to the options due to it’s leverage feature and they used it to make speculative gains .

Options can be used to hedging the anticipated purchase by portfolio managers of Investment companies .

A put option can be used to hedge the value of an existing stockholding An investor holding a particular stock faces the risk of reduction in the value of his stockholding due to a decline in the price of the stock . The Risk can be effectively hedged with a put option .Let us consider an investor who has 500 shares of a company whose Current market price is Rs. 356. The value of his stockholding is Rs. 1,78,000.If there is any fall in share prices the value of his stock holding will Decline .Let us assume that put option on the stock with exercise price of Rs.350 is available for a premium of Rs. 14.

ACTION : The investor can buy 500 put options on the stock by paying The premium Rs. 7000 ( 14 x 500 ) .EFFECT : Let us assume that share price has declined to Rs 296 . The intrinsic value of the put option purchased by the investor would now be Rs. 54 ( 350 – 296 ) i.e. K – S .If there is more time to the expiration date , the put option would have A time value also . Let us assume that there are 10 days to expirationAnd the time value of the put option is Rs. 10 ; then the premium on

the Put option purchased by the investor would be Rs. 64 ( 54 + 10 ) , the sum of the intrinsic value and the time value.As the price of the share has come down to 296 from 356 , there is a Decline in value of shareholding to the extent of Rs. 30000( 60x500)

There are two choices before the investor who has a put option on the Stock with Rs. 350 exercise price. He may either exercise his put Option or close out his long position by selling the put option . If he exercises his right under the put option to sell the shares at Rs. 350 per share, he would receive Rs 1,75,000 ( 500 x 350 ) . TheReduction in value is only 3000. As he has already paid a premium of Rs 7000 to buy the put option , his total loss is Rs. 10000. If he had not Hedged risk his loss would have been 30000.The second alternative before the investor with the put option is to sellThe option at it’s current premium of Rs. 64. He would receive a cash flow of Rs. 32,000 , i.e. 500x64 . The profit would be 25000 after Deducting premium of 7000. Here the investor retains the share.

The investor can choose the course of action which is more advantageous to him.

If on the contrary , the share price has increased instead of declining , the value of his stockholding would increase accordingly . The put option will not be exercised .

However , the premium paid represents a loss to the investor which may be compensated by the increase in the value of the stockholding .

Suppose you contemplate to buy a call option with strikePrice Rs. 42 / $ as you expect the following spot rates withTheir probabilities :

Rs./ $ 40.00 41.50 43.00 44.50 46.00 Probability 0.15 0.25 0.30 0.20 0.10

What should be the option premium to enable you to break even ?

Let the option premium be ‘ C’ . Then the pay-off table for the optionWould be as follows ;Probability spot rate option exercised/not profit 0.15 40 NO - C 0.25 41.5 NO - C 0.30 43 YES -C + ( 43 – 42)= -

C+1 0.20 44.5 YES - C + 2.5 0.10 46 YES - C + 4To break even , expected profit should be zero:-C( 0.15 ) – C( 0.25) + ( -C +1) 0.3 + ( - C + 2.5 ) 0.2 + ( -C + 4 )

0.1= 0OR C = 1.2

Ms. Geeta established the following spread on the Delta Corporation’s

Stock :i. Purchased one 3 – month call option with a premium of Rs 30

and an exercise price of Rs 550.ii. Purchased one 3 – month put option with a premium of Rs 5

and an exercise price of Rs. 450 .The current price of Delta corporation’s stock is Rs 500.

Determine Ms.Geeta’s profit or loss if the lot is 100 : a) The price of D. C. stays at Rs. 500 after 3 monthsb) The price of D. C. falls to Rs. 350 after 3 monthsc) The price of D.C. rises to Rs. 600.

( a ) Total premium paid on purchasing a call and put option = ( 30 x 100 ) + ( 5 x 100 ) = 3500In this case Ms. Geeta will not exercise any option because both will result in loss . So, the net loss will be 3500.( b ) Since the price of the stock is below the exercise price of call,

the call will not be exercised. Only call option is valuable and is exercised.

Ending value = - 3500 + ( 450 – 350 ) x 100 = 6500 i.e. NET GAIN( c ) In this case put is worthless only call is valuable.Ending value = - 3500 + ( 600 – 500 ) x 100 = 1,500 ( NET GAIN )

The FRA is an agreement between two parties which determines the interest rate that will apply to a notional future loan / deposit of an agreed amount for a specified period .

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 up-front premium payable . Simpler to administer than futures since there is no margining

requirement . The underlying principal amount is purely notional and no

actual exchange take place . The notional principal amount ( NPA ) is used for calculation of settlement amount to be exchanged between parties.

FORWARD RATE AGREEMENT ( FRAs )

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 . Quotes for various periods can be given in a number of ways

such as : 3 x 6 , 3 – 6 , 3 vs. 6 . Such quotes signify that the FRA rate is being quoted for a

period starting 3 months from now and ending 6 months from now . The first figure is known as the settlement / starting date . The second figure is known as the maturity / expiry date.

The prices for various periods are quoted two- way ( bid – offer quotes ). For instances , if a 3 – 6 FRA is being quoted as 4.35 – 4.40 percent . It signify that the quoting bank is willing to accept a notional deposit , for a period starting 3 months from now and ending 6 months from now at 4.35 percent .

And is wiling to lend a notional deposit at 4.40 % for the same period. In other words , the quoting bank is a notional borrower ( for 3 to 6 month period ) at 4.35 % .

It is , therefore , essential to appreciate that a FRA quotation is an interest rate , and not a price as in the case of futures contracts .

The n – year zero rate is the rate of interest earned on an investment that starts today and lasts for n years . All the interest and principal is realized at the end of n years . There are no intermediate payments . The n – year zero rate is also referred as the n – year spot rate .

A forward interest rate is the interest rate implied by current zero rates for a specified future time period . It is basically a compound rate. Suppose , on a principal amount of 100 the zero –rate is 10%, on the end of the 1st year it will become 110 , now at the end of 2nd year , the interest portion will be 11 , that means forward rate on original sum is 11%.

FRAs can be used by any institution when it is exposed to a single period interest rate risk

For example ING bank which has funded a one year US $ 5 million floating rate loan on 6 – month loan ‘ LIBOR + ‘ basis is exposed to interest rate risk from the 6th to the 12th month .

As the LIBOR for the first 6 month is already fixed at the time of sanction of the loan , the bank would have already locked itself into a spread . Its main cause of concern would be that at the end of the first 6 months period , its spread would be adversely affected , if the LIBOR were to go down .

If, 6 – 12 FRA is being quoted say , 5.25 – 5.35 percent , the bank has to sell FRA at 5.25 % , since it is seeking protection against a fall of interest .

If the actual LIBOR settles at 5.15 % on the settlement date ( i.e. 6 months from now ) then the notional buyer / borrower ( that is quoting bank ) has to compensate the ING bank for the difference in interest rate on the notional principal amount of US $ 5 million .

EXAMPLE : There are two parties X and Y who are interested in raising funds . Other details are as follows :FIRM OBJECTIVE FIXED RATE FLOATING INT. RATE X fixed rate 10.75 % LIBOR + 0.50 % Y Floating rate 10.00 % LIBOR + 0.25 %In the above table , we can see that the cost of borrowing for Y is

lower Than that of X in both the markets. This difference is called quality Spread , which can be quantified for both fixed and floating rate markets as follows : Fixed market 10.75 % - 10.00 % = 0.75 %Floating market LIBOR + 0.50% - LIBOR + 0.25 % = 0.25 %

From the above table it is clear that Y has an absolute advantages in both fixed and floating rate market .

But it is also clear that X has a comparative advantage in floating rate market i.e.( higher by only 25 bp ) than 75 bp in fixed market.

Now , there objectives are X should borrow in fixed rate and Y should borrow in floating rate market .

Considering , the comparative advantage enjoyed by X it is possible to reduce the cost of funds to both X and Y if they borrow in the markets where they enjoy comparative advantages and then swap the borrowing .

The reduction in the cost depends on the quality spreads which is 50 bp ( 0.75 % - 0. 25 % ) .

Assume that both the firms want to share the benefit equally between them – under the swap arrangement :

Y – borrows funds in fixed rate market and lends to X . X – borrows funds in floating rate market and lends to Y .Let us assume that X lends to Y at LIBOR and Y lends to X at 10 % .EFFECT : That means funds are available to Y at LIBOR as against LIBOR + 0.25 and X at 10.50 instead of 10.75% . Thus , swap

enables Reduction in cost for both parties .DIFNITION : Financial swaps are private contractual agreements between two parties to exchange cash flows in the future according To specified terms and conditions .

Financial swaps are broadly classified into interest rate swaps and currency swaps .

SWAP BROKER : He is an economic agent who helps in identifying the potential counterparties to a swap transaction . He charge a fee for the services provided and he is not a party to the swap contract he is also called a market maker .

SWAP DEALER : Swap dealers bear the financial risk associated with the deal he is arranging in addition to the functions of a swap broker and becomes an actual party to the transaction . He serves as a financial intermediary , earning profits by helping complete , the swap transactions . The swap dealer faces two main problems :

Pricing of swaps Managing of default risk of the counterparty .

It is difficult to identify a counterparty to take the opposite side of the transaction once a party has approached the swap dealer with his /her requirements .

The swap deal cannot be terminated without the agreement of the parties involved in the transaction.

Existence of inherent default risk . Underdeveloped secondary markets for swaps, mainly as a

result of very slow development of standardized documentation. This clearly shows that swaps are not easily tradable.