Professional Documents
Culture Documents
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4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. 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 as trans-actions costs as compared to individual financial assets.
Source: www.nse-india.com
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Futures: A 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. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
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calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.2
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businesses, new products and new employment opportunities, the benefit of which are immense. Sixth, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Derivatives thus promote economic development to the extent the later depends on the rate of savings and investment.
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three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, etc.3 Table 1.1 The global derivatives industry: Outstanding contracts, (in $ billion) 1995 Exchange traded instruments 9283 Interest rate futures and options 8618 Currency futures and options 154 Stock Index futures and options 511 Some OTC instruments 17713 Interest rate swaps and options 16515 Currency swaps and options 1197 Other instruments Total 26996 1996 10018 9257 171 591 25453 23894 1560 35471 1997 12403 11221 161 1021 29035 27211 1824 41438 1998 13932 12643 81 1208 80317 44259 5948 30110 94249 1999 13522 11669 59 1793 88201 53316 4751 30134 101723
Table 1.2 Chronology of instruments 1874 Commodity futures 1972 Foreign currency futures 1973 Equity options 1975 Treasury bond futures 1981 Currency swaps 1982 Interest rate swaps, T note futures, Eurodollar futures, Equity index futures, 1983 1985 1987 1989 1990 1991 1993 1994 Options on T bond futures, Exchange listed currency options Options on equity index, Options on T-note futures, Options on currency futures, Options on equity index futures, interest rate caps and floors Eurodollar options, Swap options OTC compound options, OTC average options Futures on interest rate swaps, Quanto options Equity index swaps Differential swaps Captions, exchange listed FLEX options Credit default options
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have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures.
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When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter-party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal.
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process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India Table 2.1 Chronology of instruments 1991 Liberalisation process initiated 14 December 1995 NSE asked SEBI for permission to trade index futures. 18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 25 September 2000 2 June 2001 index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Nifty futures trading commenced at SGX. Individual Stock Options & Derivatives
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followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place.
2.2.1 Derivatives increase speculation and do not serve any economic purpose While the fact is... Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices, or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock
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index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance.4
Table 2.2 PRE-REQUISITES Large market Capitalisation INDIAN SCENARIO India is one of the largest market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores. The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the countrys Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying. The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL).
Trade guarantee
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NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing. A Strong Depository National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country. In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
2.2.3 Disasters prove that derivatives are very risky and highly leveraged instruments While the fact is... Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are not necessarily due to dealing in derivatives, but derivatives make headlines... Here I have tried to explain some of the important issues involved in disasters related to derivatives. Careful observation will tell us that these disasters have occurred due to lack of internal controls and/or outright fraud either by the employees or promoters. Barings Collapse 1. 233 year old British bank goes bankrupt on 26th February 1995 2. Downfall attributed to a single trader, 28 year old Nicholas Leeson 3. Loss arose due to large exposure to the Japanese futures market 4. Leeson, chief trader for Barings futures in Singapore, takes huge position in index futures of Nikkei 225 5. Market falls by more than 15% in the first two months of 95 and Barings suffers huge losses 6. Bank looses $1.3 billion from derivative trading 7. Loss wipes out the entire equity capital of Barings The reasons for the collapse:
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Leeson was supposed to be arbitraging between Osaka Securities Exchange and SIMEX -- a risk less strategy, while in truth it was an unhedged position. Leeson was heading both settlement and trading desk -- at most other banks the functions are segregated, this helped Leeson to cover his losses -- Leeson was unsupervised.
Lack of independent risk management unit, again a deviation from prudential norms. There were no proper internal control mechanisms leading to the discrepancies going unnoticed Internal audit report which warned of "excessive concentration of power in Leesons hands" was ignored by the top management.
The conclusion as summarised by Wall Street Journal article " Bank of England officials said they did not regard the problem in this case as one peculiar to derivatives. In a case where a trader is taking unauthorised positions, they said, the real question is the strength of an investment houses internal controls and the external monitoring done by Exchanges and Regulators. " Metallgesellschaft 1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billion Germanys 14th largest industrial group nearly goes bankrupt from losses suffered through its American subsidiary - MGRM 2. MGRM offered long term contracts to supply 180 million barrels of oil products to its clients -- commitments were quite large, equivalent to 85 days of Kuwaits oil output 3. MGRM created a hedge position for these long term contracts with short term futures market through rolling hedge --, As there was no viable long term contracts available 4. Company was exposed to basis risk -- risk of short term oil prices temporarily deviating from long term prices. 5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in cash. The Company was faced with temporary funds crunch. 6. New management team decides to liquidate the remaining contracts, leading to a loss of 1.3 billion.
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7. Liquidation has been criticised, as the losses could have decreased over time. Auditors report claims that the losses were caused by the size of the trading exposure. Reasons for the losses: The transactions carried out by the company were mainly OTC in nature and hence lacked transparency and risk management system employed by a derivative exchange Large exposure Temporary funds crunch Lack of matching long-term contracts, which necessitated the company to use rolling short term hedge -- problem arising from the hedging strategy Basis risk leading to short term loss
2.2.4 Derivatives are complex and exotic instruments that Indian investors will have difficulty in understanding While the fact is... Trading in standard derivatives such as forwards, futures and options is already prevalent in India and has a long history. Reserve Bank of India allows forward trading in RupeeDollar forward contracts, which has become a liquid market. Reserve Bank of India also allows Cross Currency options trading. Forward Markets Commission has allowed trading in Commodity Forwards on Commodities Exchanges, which are, called Futures in international markets. Commodities futures in India are available in turmeric, black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures exchanges in Soya bean oil as also in Cotton. International markets have also been allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India also allows, the users to hedge their portfolios through derivatives exchanges abroad. Detailed guidelines have been prescribed by the RBI for the purpose of getting approvals to hedge the users exposure in international markets.
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Derivatives in commodities markets have a long history. The first commodity futures exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 196368). A clearinghouse for clearing and settlement of these trades was set up in 1918. In oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market was set up in Mumbai in 1920. History and existence of markets along with setting up of new markets prove that the concept of derivatives is not alien to India. In commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign exchange markets. Government of India has also been facilitating the setting up and operations of these markets in India by providing approvals and defining appropriate regulatory frameworks for their operations. Approval for new exchanges in last six months by the Government of India also indicates that Government of India does not consider this type of trading to be harmful albeit within proper regulatory framework. This amply proves that the concept of options and futures has been well ingrained in the Indian equities market for a long time and is not alien as it is made out to be. Even today, complex strategies of options are being traded in many exchanges which are called tejimandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,1998) In that sense, the derivatives are not new to India and are also currently prevalent in various markets including equities markets. 2.2.5 Is the existing capital market more safer than Derivatives? While the fact is... World over, the spot markets in equities are operated on a principle of rolling settlement. In this kind of trading, if you trade on a particular day (T), you have to settle these trades on the third working day from the date of trading (T+3).
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Futures market allow you to trade for a period of say 1 month or 3 months and allow you to net the transaction taken place during the period for the settlement at the end of the period. In India, most of the stock exchanges allow the participants to trade during oneweek period for settlement in the following week. The trades are netted for the settlement for the entire one-week period. In that sense, the Indian markets are already operating the futures style settlement rather than cash markets prevalent internationally. In this system, additionally, many exchanges also allow the forward trading called badla in Gujarati and Contango in English, which was prevalent in UK. This system is prevalent currently in France in their monthly settlement markets. It allowed one to even further increase the time to settle for almost 3 months under the earlier regulations. This way, a curious mix of futures style settlement with facility to carry the settlement obligations forward creates discrepancies. The more efficient way from the regulatory perspective will be to separate out the derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at the same time allow futures and options to trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants. In addition, the existing system although futures style, does not ask for any margins from the clients. Given the volatility of the equities market in India, this system has become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a period of three days. At the same time, the Barings Bank failed on Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000 crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although, the exposure was so high and even the loss was also very big compared to the total exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins that they did not stop trading for a single minute.
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Speculators
Existing Approach &Prize
1) Deliver based Trading, margin trading& carry
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New Peril
1)Maximum loss possible to premium
Source: Mr. Rajesh Gajra Senior writer- Intelligent Investor (rgajra@iinvestor.com) Source: Invest Monitor (Magazine) July 2001
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Advantages
Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time. Figure 2.2
Arbitrageurs
Existing Approach &Prize SYSTEM Peril &Prize Approach New Peril
1) Buying Stocks in 1) Make money one and selling in whichever way the another exchange. Market moves. forward transactions. 2) If Future Contract more or less than Fair price Fair Price = Cash Price + Cost of Carry.
1) B Group more 1) Risk free promising as still game. in weekly settlement 2) Cash &Carry arbitrage continues
Figure 2.3
Hedgers
Existing Approach &Prize SYSTEM Peril &Prize Approach New Peril
1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional offload holding available risk latter by paying premium. cost is only during adverse reward dependant 2)For Long, buy ATM Put premium. market conditions on market prices Option. If market goes up,
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Advantages
Figure 2.4 Availability of Leverage
Small Investors
Existing Approach &Prize
1) If Bullish buy stocks else sell it.
New Peril
1) Downside remains protected & upside unlimited.
1) Buy Call/Put options based on market outlook 2) Hedge position if holding underlying stock
Advantages
3.0 SWAPS
Losses Protected.
A contract between two parties, referred to as counter parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counter parties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.
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on behalf of the counter parties to keep the anonymity of the parties involved. By doing so, if the swap transaction falls through, counter parties are free of any risks associated with releasing their financial information. Brokers receive commissions for their services.
Credit risk 7
Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates. Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counter parties for long duration swaps, specially so in India Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference. Yield on 91 day T. Bill - 9.5% Cost of fund (e.g.- Repo rate) 10% The transaction cost in this case would involve 0.5% Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating. Swap Market Participations
Source: www.appliederivatives.com
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Since swaps are privately negotiated products, there is no restriction on who can use the market. However, parties with low credit quality have difficulty entering the market. This is due to fact that they cannot be matched with counter parties who are willing to take on their risks. In the U.S. many parties require their counter parties to have minimum assets of $10 million. This requirement has become a standardized representation of "eligible swap participants".
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A Forward Rate Agreement (FRA) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed benchmark/reference rate prevailing on the settlement date. An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount of multiple occasions on specified periods. Accordingly, on each payment date that occurs during the swap period-Cash payments based on fixed/floating and floating rates are made by the parties to one another. Currency swaps can be defined as a legal agreement between two or more parties to exchange interest obligation or interest receipts between two different currencies. It involves three steps: Initial exchange of principal between the counter parties at an agreed upon rate of exchange which is usually based on spot exchange rate. This exchange is optional and its sole objective is to establish the quantum of the respective principal amounts for the purpose for calculating the ongoing payments of interest and to establish the principal amount to be re-exchanged at the maturity of the swap. Ongoing exchange of interest at the rates agreed upon at the outset of the transaction. Re-exchange of principal amount on maturity at the initial rate of exchange.
This straight forward, three step process results in the effective transformation of the debt raised in one currency into a fully hedged liability in other currency. Participants Schedule commercial banks. Primary dealers All India financial institutions
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RBI in its slack season credit policy '97 allowed the authorized dealers to arrange currency swap without its prior approval. This was to enable those requiring long-term forward cover to hedge themselves without altering the external liability of the country. Prior to this policy RBI had been approving rupee foreign currency swaps between corporates on a case basis, but no such swaps were taking place. RBI in its process of making the Indian corporates globally competitive has simplified their access to this instrument by making changes in its credit policy. But despite an easing regulation, swaps have not hit the market in a big way. India has a strong dollar-rupee forward market with contracts being traded for one, two, six-month expiration. Daily trading volume on this forward market is around $500 million a day. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets. Outside India, there is a small market for cash settled forward contracts on the dollar rupee exchange rate. While studying swaps in the Indian context, the counter parties involved are Indian corporates and the swap dealers are the Authorized dealers of foreign exchange, i.e., the banks allowed by RBI to carry out the swaps. These banks form the counterparty to the corporates on both sides of the swap and keep a spread between the interest rates to be received and offered. One of the currencies involved is the Indian rupee and the other could be any foreign currency. The interest rate on the rupee is most likely to be fixed, and on foreign currency it could be either fixed or floating. 3.5.1 The Players Swaps are instruments, which allow the user to hedge - that are to offset risk or to take risk deliberately in the expectation of making profit. The user in this case would be any corporate having a foreign exchange exposure/ a risk. A foreign exchange exposure will arise out of the mismatch between the currency of inflow and outflow. The outflow being considered here is the interest and the principal payment on the borrowings of the corporates. Corporates having such currency mismatches would be of the following types
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Mainly the exporters would fall in this category. Corporates with foreign subsidiaries would also be having forex revenues but due to cheaper availability of funds abroad, it is unlikely that these subsidiaries would be funded by a rupee loan. Thus the main players meeting this criterion would be the exporters. The main players in the Indian market are Tata Exports, Hindustan Levers Ltd., ITC Ltd., and Nestle Indian Ltd. among the others. 3.5.3 Corporates with forex loan and rupee revenue The corporates having foreign currency loan could further be classified into two groups. One which have net imports and thus may have raised loans to meet their import requirements, for example Bharat Heavy Electricals Ltd., Apollo Tyres Ltd., Tata Power Co. Ltd. Two, which do not have net imports but have raised foreign currency loan for funding requirements, for example Arvind Mills Ltd., Ballarpur Industries etc. 3.5.4 Corporates with no foreign exposure There may be corporates with no existing exposure but willing to take up an exposure in an expectation of making profit out of this transaction. Thus they would be willing to swap their rupee loan with forex loan and book in forward cover or make the payments on spot basis on the day of disbursements. These corporates may also consider the option of raising new loans in foreign currency and swap a rupee loan if it turns out to be cheaper option. Thus many corporates would fall under this category. 3.5.5 Banks Banks act as the authorized dealers and are instrumental in arranging swaps. They have to take the swaps on their books. A bank would enter into swap with a party and then try to find another with opposite requirement to hedge itself against any fluctuation in exchange rates. They would normally keep a spread between the offer and bid rate thus make profit from transaction. They also take up the credit risk of counterparties.
3.6 The needs of the players and how currency swaps help meet these needs
3.6.1 To manage the exchange rate risk
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Since the international trade implies returns and payments in a variety of currencies whose relative values may fluctuate it involves taking foreign exchange risk. The players mentioned above are facing this risk. A key question facing the players then is whether these exchange risks are so large as to affect their business. A related question is what, if any, special strategies should be followed to reduce the impact of foreign exchange risk. One-way to minimize the long-term risk of one currency being worth more or less in the future is to offset the particular cash flow stream with an opposite flow in the same currency. The currency swap helps to achieve this without raising new funds; instead it changes existing cash flows. 3.6.2 To lower financing cost Currency swaps can be used to reduce the cost of loan. The following example deals with such a case. Consider two Indian corporates A & B. Corporate A is an exporter with a rupee loan at 14% fixed rate. B has a dollar loan at LIBOR + 0.25% floating rate. Due to difference in the credit rating of the two companies, the rates at which the loans are available to them are different. A has access to 14% rupee loan and dollar loan at LIBOR + 0.25%. A would like to convert its rupee loan into a dollar loan, to reverse its revenue in dollars and B would like to convert the dollar loan into a fixed rupee loan thus crystallizing its cost of borrowing. They can enter into a swap and reduce the cost compared to what it would have been if they had taken a direct loan in the desired currencies. Comparative advantage Company B Options: Borrow ruppe at 14.5% Borrow dollars at LIBOR +200 bps
Company A Exporter Options: Borrow ruppe at 13% Borrow dollars at LIBOR +100 bps
Company A has an absolute advantage over B in both the markets/ rates. The advantage in terms of rupee funds is 150 bps while it is 100 bps in case of dollar rates. Thus B has a comparative advantage in terms of dollar rates.
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Now as A is an exporter he would be more interested in a dollar denominated loan to offset his future receivables. Therefore it would be advantageous if A would borrow at rupee rates and B borrows at LIBOR rates. Then they may go in for a currency swap. The net gain arising out of such a swap will be 50 bps, which may be shared between the parties. The swap will thus result in A paying B a floating rate of LIBOR + 75 bps in return for a 13% fixed rupee rate. The swap will take place on a notional principal basis. The effective cost for A is LIBOR + 75 bps and for B it is 14.25%. The effective cost for A is 12.75%. This results into a net saving of 25 bps for both the parties. Figure 3.1 LIBOR +75 bps Company A 12.75% in INR 13% in INR To access restricted markets Libor +200 bps Company B
Many countries have restrictions on the type of borrowers that can raise funds in their bond markets. Foe example an Indian firm exporting goods to Japan may wish to issue bonds in yen to form a natural hedge by reversing their cash flows. To issue a yen bond, the borrower must qualify for a single A credit rating. If the company does not qualify in this regard it would fail to issue yen denominated bond. By issuing bonds in the rupee market and then entering into a currency swap, the firm can meet its expectation of raising a yen denominated loan. 3.6.3 Swaps for reducing the cost of borrowing With the introduction of rupee derivatives the Indian corporates can attempt to reduce their cost of borrowing and thereby add value. A typical Indian case would be a corporate with a high fixed rate obligation. Eg.
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Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of 18.5%. Today a 364-day T. bill is yielding 10.25%, as the interest rates have come down. The 3-month MIBOR is quoting at 10%. Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month MIBOR. The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next one year. The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75 %. Figure 3.2 Fixed 10.75 Mehta Ltd 3 Months MIBOR 18.75%s MIBOR Counter Party
The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75 = 7.75 + MIBOR At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75% The gain for the firm is (18.5 - 17.75) = 0.75 % The risks involved for the firm are - Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments.
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- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond 10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firm hold a strong view that MIBOR shall remain below 10.75%. This will require continuous monitoring on the path of the firm. How does the bank benefit out of this transaction? The bank either goes for another swap to offset this obligation and in the process earn a spread. The bank may also use this swap as an opportunity to hedge its own floating liability. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%. Taking advantage of future views/ speculation If a bank holds a view that interest rate is likely to increase and in such a case the return on fixed rate assets will not increase, it will prefer to swap it with a floating rate interest. It may also swap floating rate liabilities with a fixed rate.
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Since currency swaps include exchange of interest payments, the interest rates also need to be traced. By keeping an eye on the yield curve of long term bonds and the macro economic variables of different countries, the interest rates can be estimated. Amount of cover to be taken Having estimated the amount of exposure, the expected exchange rates and the interest rates, the parties can determine the risks involved and can decide upon the amount of cover to be taken. This shall depend on the management policy whether they believe in minimizing the risk for a given level of return or maximizing the gain for a given level of risk. The risk taking capability of a corporate will depend upon the financial backup to absorb the losses, if any, the availability of time and resources to monitor the forex market.
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infructuous. Rates like LIBOR, Fed Funds Rate/ T.Bill Rate are those at which banks are prepared to lend and borrow in any currency. In India too, such a market does exist for the rupee- the call money market. Banks borrow/lend at market determined rates. But where the Indian money market differs from other major financial centers is that, in the latter money is available for periods ranging from 1 or 7 days to 3, 6 and 12 months, whereas in India, rupee is available for a day or two, up to a maximum period of 13 days, as a general rule. The reason being the fortnightly reserve requirements. Another deficiency is the lack of integration with the foreign exchange (FX) markets. In order to protect and control the exchange rate of the rupee, strong silos have been created. Forward premium between the rupee and another foreign currency does not reflect the interest rate differential. If anything, it reflects the estimated risk of depreciation of the local unit against the dollar. This gives rise to significant arbitrage opportunities between the two markets, which are protected through the RBI diktat. At present, the tenors available in the IRS market are short and the benchmark limited to only one, the Mumbai Inter-bank Offer Rate (MIBOR).
Source: www.economictimes.com
- 32 -
VYSYA Bank and Larsen & Toubro have entered into an overnight index swap (OIS) transaction for Rs 10 crore. The one-year swap has Vysya Bank paying 8.75 per cent against the compounded NSE Mibor to L&T. The deal, brokered by eMecklai, was done over the internet. The verification of the swap differences will be carried out quarterly with settlement at maturity. 17 FEBRUARY Jet swaps $340-m floating loan with Credit Lyonnais George Cherian CREDIT Lyonnais and Jet Airways have concluded the largest interest rate swap in the country. A total of $340m of the air tax operators outstanding foreign currency floating rate loans has been swapped to fixed/ floating via a structured interest rate swap spread over four years. It will insulate Jet Airways against rising interest rates. It will also give Jet Airways the opportunity to take advantage of falling interest rates in later years. The swap, which has been executed in two tranches of $200m and $140m, is the largest ever derivatives transaction in the domestic market
- 33 -
If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.
In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non-tradable.
- 34 -
Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when for-ward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.
- 35 -
Futures Trade on an organized exchange Standardized contract terms Hence more liquid Requires margin payments
Forwards OTC in nature Customised contract terms Hence less liquid No margin payment
4.4
Futures Terminology
Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts
on the NSE have one-month, two-months and three-months expiry cycles, which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.
Expiry date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.
Contract size: The amount of asset that has to be delivered under one contract. For
in-stance, the contract size on NSEs futures market is 200 Nifties.
Basis: In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
Initial margin: The amount that must be deposited in the margin account at the time
a futures contract is first entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin
ac-count is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket.
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Maintenance margin: This is somewhat lower than the initial margin. This is set to
ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
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April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early 80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.
Stock options: Stock options are options on individual stocks. Options currently
trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.
Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
Option price: Option price is the price which the option buyer pays to the option
seller.
Expiration date: The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price
or the exercise price.
American options: American options are options that can be exercised at any time
upto the expiration date. Most exchange-traded options are American.
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European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.
Intrinsic value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call isNP which means the intrinsic value of a call is Max [0, (St K)] which means the intrinsic value of a call is the (St K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or (K - St ). K is the strike price and St is the spot price.
Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. A call that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the
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time to expiration, the greater is a calls time value, all else equal. At expiration, a call should have no time value. 11
Futures Exchange traded, with novation Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Both long and short at risk
Options Same as futures. Same as futures. Strike price is fixed, price moves. Price is always positive. Nonlinear payoff. Only short at risk.
11
Source: www.derivativesindia.com
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Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty.
Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates.
The L.C.Gupta committee which was setup for developing a regulatory framework for derivatives trading in India had suggested a phased introduction of derivative products in the following order: 1. Index futures 2. Index options 3. Options on individual stocks
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With all the above infrastructure in place, trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively.
5.1.1 Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Figure 5.1 shows the payoff diagram for the buyer of a futures contract. 5.1.2 Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially
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unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses. Figure 5.2 shows the payoff diagram for the seller of a futures contract. Figure 5.1 Payoff for a buyer of Nifty futures The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 1220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses. Profit
1220 0 Nifty
Loss Figure 5.2 Payoff for a seller of Nifty futures The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 1220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses. Profit
1220 0 Nifty
Loss
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profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. 5.2.1 Payoff profile of buyer of asset: Long asset In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price,S4 it is purchased, the investor is said to be long the asset. Figure 5.3 shows the payoff for a long position on the Nifty.12 Figure 5.3 Payoff for investor who went Long Nifty at 1220 The figure shows the profits/losses from a long position on the index. The investor bought the index at 1220. If the index goes up, he profits. If the index falls he looses. Profit +60 0 -60 Loss 5.2.2 Payoff profile for seller of asset: Short asset In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and buys it back at a future date at an unknown price S4 Once it is sold, the investor is said to be short the asset. Figure 5.4 shows the payoff for a short position on the Nifty. 1160 1220 1280 Nifty
Figure 5.4 Payoff for investor who went Short Nifty at 1220
12
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The figure shows the profits/losses from a short position on the index. The investor sold the index at 1220. If the index falls, he profits. If the index rises, he looses. Profit +60 0 -60 Loss 5.2.3 Payoff profile for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the 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. 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 he paid for buying the option. Figure 5.5 gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 1250 bought at a premium of 86.60. 5.2.4 Payoff profile for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyers profit is the sellers loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 5.6 gives the payoff for the writer of a three month call option (often referred to as short call) with a strike of 1250 sold at a premium of 86.60. 1160 1220 1280 Nifty
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The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. Profit 1250 0 86.60 Loss Figure 5.6 Payoff for writer of call option The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him. Profit 86.60 1250 0 Nifty Nifty
Loss 5.2.5 Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the
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spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 5.7 gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 1250 bought at a premium of 61.70. Figure 5.7 Payoff for buyer of put option The figure shows the profits/losses for the buyer of a three-month Nifty 1250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. Profit 1250 0 61.70 Nifty
Loss
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5.8 gives the payoff for the writer of a three-month put option (often referred to as short put) with a strike of 1250 sold at a premium of 61.70. Figure 5.8 Payoff for writer of put option The figure shows the profits/losses for the seller of a three-month Nifty 1250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses . If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price(Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him. Profit 61.70 1250 0 Nifty
Loss
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futures price moves away from the fair value, there would be chances for arbitrage. We know what the spot and future prices are, but what are the components of holding cost? The components of holding cost vary with contracts on different assets. At times the holding cost may even be negative. In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance purchased etc. In the case of equity futures, the holding cost is the cost of financing minus the dividends returns. Note: In the futures pricing examples worked out in this book, we are using the concept of discrete compounding, where interest rates are compounded at discrete intervals, for example, annually or semiannually. Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates. Most books on derivatives use continuous compounding for pricing futures too. However, we have used discrete compounding as it is more intuitive and simpler to work with. Had we to use the concept of continuous compounding, the above equation would have been expressed as: F= Se rT Where: r: Cost of financing (using continuously compounded interest rate) T: Time till expiration e: 2.71828 5.3.2 Pricing futures contracts on commodities
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Let us take an example of a futures contract on a commodity and work out the price of the contract. The spot price of silver is Rs.7000/kg. If the cost of financing is 15% annually, what should be the futures price of 100 gms of silver one month down the line ? Let us assume that were on 1st January 2001. How would we compute the price of a silver futures contract expiring on 30th January? From the discussion above we know that the futures price is nothing but the spot price plus the cost-of-carry. Let us first try to work out the components of the cost-of-carry model. 1. What is the spot price of silver? The spot price of silver, S= Rs.7000/kg. 2. What is the cost of financing for a month? (1+0.15) 30/365 3. What are the holding costs? Let us assume that the storage cost = 0. In this case the fair value of the futures price, works out to be = Rs.708. F=s (1+r) T + C = 700(1.15) 30/365 =Rs. 708 If the contract was for 3 month period i.e. expiring 30th March the cost of financing would increase the futures price. Therefore, the futures price would be C = 700(1.15)
90/365
Rs.724.5. On the other hand, if the one-month contract was for 10,000 kg. Of silver instead of 100 gms, then it would involve a non-zero storage cost, and the price of the future contract would be Rs. 708 +the cost of storage.
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The main differences between commodity and equity index futures are that: There are no costs of storage involved in holding equity.
Equity comes with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends Thus, a crucial aspect of dealing with equity futures as opposed to commodity futures is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, the better is the estimate of the futures price.
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7. Thus, futures price F = 1200(1.15) 60/365 {120*10(1.15) 45/365 /200} =Rs. 1221.80
As the date of expiration comes near, the basis reduces - there is a convergence of the
futures price towards the spot price. On the date of expiration, the basis is zero. If it is not, then there is an arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference between spot and futures price) or the spreads (difference between prices of two futures contracts) during the life of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities can be exploited.
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There is nothing but cost-of-carry related arbitrage that drives the behavior of the
futures price.
- 53 -
1450
79
1500
48
1550
27
1600
13
3 mth 154 119 90 67 48 Puts 1 mth 8 19 38 66 102 3 mth 25 39 59 84 114 Assumptions: Nifty spot is 1500, Nifty volatility is 25% annualized, interest rate is 10%, and Nifty dividend yield is 1.5%. produce the exact prices that show up in the market, but definitely does a remarkable job of pricing options within the framework of assumptions of the model. Virtually all option pricing models, even the most complex ones, have much in common with the Black Scholes model. Black and Scholes start by specifying a simple and wellknown equation that models the way in which stock prices fluctuate. This equation called Geometric Brownian Motion, implies that stock returns will have a lognormal distribution, meaning that the logarithm of the stocks re-turn will follow the normal (bell shaped) distribution. Black and Scholes then propose that the options price is determined by only two variables that are allowed to change: time and the underlying stock price. The other factors - the volatility, the exercise price, and the riskfree rate do affect the options price but they are not allowed
- 54 -
to change. By forming a portfolio consisting of a long position in stock and a short position in calls, the risk of the stock is eliminated. This hedged portfolio is obtained by setting the number of shares of stock equal to the approximate change in the call price for a change in the stock price. This mix of stock and calls must be revised continuously, a process known as delta hedging. Black and Scholes then turn to a littleknown result in a specialized field of probability known as stochastic calculus. This result defines how the option price changes in terms of the change in the stock price and time to expiration. They then reason that this hedged combination of options and stock should grow in value at the riskfree rate. The result then is a partial differential equation. The solution is found by forcing a condition called a boundary condition on the model that requires the option price to converge to the exercise value at expiration. The end result is the Black and Scholes model.
C = SN(d1) Xe-rT N(d2) P = Xe-rT N(-d2)- SN(-d1) Where d1 = [ ln s/x +(r+2/2)T ]/ T And d2 = d1 T The Black Scholes equation is done in continuous time. This requires continuous
compounding. The r that in this is ln(1+r). E.g. if the interest rate per annum is 12%, you need to use ln1.12 or 0.1133, which is continuously compounded equivalent of 12% per annum.
N () is the cumulative normal distribution. N(d1 ) is called the delta of the option
which is a measure of change in option in option price with respect to change in the price of the underlying asset.
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annual = daily * number of trading days per year. On a average there are 250 trading
days in a year. X is the exercise price, S is the spot price and T the time to expiration.
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Hedging
H1 Long stock, short Nifty futures H2 Short stock, long Nifty futures H3 Have portfolio, short Nifty futures H4 Have funds, long Nifty futures
Speculation
Source: NSE Derivatives Module & www.rediff/money/derivatives.htm & www.erivativesreview.com
13
- 57 -
Arbitrage
A1 Have funds, lend them to the market A2 Have securities, lend them to the market
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Those who are bullish about INFOSYS do wrong by carrying along a long position
on Nifty as well. There is a simple way out. Every time you adopt a long position on a stock, you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every longstock position. Once this is done, you will have a position, which is purely about the performance of the stock. The position LONG INFOSYS + SHORT NIFTY is a pure play on the value of INFOSYS, without any extra risk from fluctuations of the market index. When this is done, the stockpicker has hedged away his index exposure. Warning: Hedging does not remove losses. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profits than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk. How do we actually do this? 1. We need to know the beta of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take WIPRO, whose beta is 1.2, and suppose we have a LONG WIPRO position of Rs.200,000. 2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 *200,000, i.e. Rs.240,000. 3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To sell Rs.240,000 of Nifty we need to sell one market lot. 4. We sell one market lot of Nifty (200 nifties) to get the position: LONG WIPRO Rs.200,000, SHORT WIPRO Rs.240,000 This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.
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position is not a
SHORT RELIANCE, SHORT
focused play on the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental baggage. The stockpicker may be thinking he wants to be
RELIANCE + SHORT NIFTY.
Those who are bearish about the index should just sell nifty futures; they need not trade individual stocks. Those who are bearish about RELIANCE do wrong by carrying along a short position on Nifty as well.
There is a simple way out. Every time you adopt a short position on a stock, you should buy some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every shortstock position. Once this is done, you will have a position which is purely about the performance of the stock. The position SHORT RELIANCE + LONG NIFTY is a pure
- 60 -
play on the value of RELIANCE, without any extra risk from fluctuations of the market index. How do we actually do this? 1. We need to know the beta of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take WIPRO, where the beta is 1.2, and suppose we have a position of Rs.200,000. 2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 * 200,000, i.e. Rs.240,000.
SHORT WIPRO
3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To long Rs.240,000 of Nifty we need to buy one market lot. 4. We buy one market lot of Nifty (200 nifties) to get the position:
SHORT WIPRO Rs.200,
This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.
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1 Sell shares immediately. This sentiment generates panic selling which is rarely optimal for the investor. 2 Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to do something when stock prices fall. In addition, with the index futures market, a third and remarkable alternative becomes available: 3 Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without panic selling of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk. The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index stocks or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual stocks, where only 3060% of the stock risk is accounted for by index fluctuations). Hence a position
LONG PORTFOLIO
SHORT NIFTY
tenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures. Warning: Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profit than the unhedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk. The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable, or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops. It does not make sense to use this strategy for long periods of time if a twoyear hedging is
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desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments. Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate. The complete hedge may require selling Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, twothirds of his portfolio is hedged and onethird ofthe portfolio is held unhedged. The exact degree of hedging chosen depends upon the appetite for risk that the investor has.
Getting invested in equity ought to be easy but there are three problems: 1. A person may need time to research stocks, and carefully pick stocks that are expected to do well. This process takes time. For that time, the investor is partly invested in cash and partly invested in stocks. During this time, he is exposed to the risk of missing out if the overall market index goes up. 2. A person may have made up his mind on what portfolio he seeks to buy, but going to the market and placing market orders would generate large impact costs. The execution would be improved substantially if he could instead place limit orders and gradually accumulate the portfolio at favor-able prices. This takes time, and during this time, he is exposed to the risk of missing out if the Nifty goes up.
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3. In some cases, such as the land sale above, the person may simply not have cash to immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises. So far, in India, we have had exactly two alternative strategies which an investor can adopt: to buy liquid stocks in a hurry, or to suffer the risk of staying in cash. With Nifty futures, a third alternative becomes available:
The investor would obtain the desired equity exposure by buying index futures,
immediately. A person who expects to obtain Rs.5 million by selling land would immediately enter into a position LONG NIFTY worth Rs.5 million. Similarly, a closed end fund which has just finished its initial public offering and has cash which is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity. The index futures market is likely to be more liquid than individual stocks so it is possible to take extremely large positions at a low impact cost.
Later, the investor/closed-end fund can gradually acquire stocks (either based on
detailed research and/or based on aggressive limit orders). As and when shares are obtained, one would scale down the LONG NIFTY position correspondingly. No matter how slowly stocks are purchased, this strategy would fully capture a rise in Nifty, so there is no risk of missing out on a broad rise in the stock market while this process is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing stocks and placing aggressive limit orders. Hedging is often thought of as a technique that is used in the context of equity exposure. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty. Holding money in hand, when you want to be invested in shares, is a risk because Nifty may rise. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty! Table 6.1 Gradual acquisition of stocks, hedged
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On 17 Feb, Iqbal purchased 5000 nifties to obtain a position of Rs.5 million. From 18 Feb onwards, on each day, Iqbal purchased one security worth Rs.357,000 (at 17 Feb prices) and sold off a similar value of futures thus shrinking his futures position. For this example, we deliberately use nonindex small stocks; hedging using index futures works for all portfolios regardless of what stocks go into them. Nifty rose sharply on 27 February and 28 February, so his outstanding futures position generated an infusion of cash for him on these days. This inflow paid for the higher stock prices that he suffered. Date Futures position Stock purchase Futur es sold 17 Feb 18 Feb 19 Feb 20 Feb 23 Feb 24 Feb 25 Feb 26 Feb 27 Feb 02 Mar 03 Mar 04 Mar 05 Mar 06 Mar 09 Mar Total +5,000,000 4,597,074 4,190,807 3,786,330 3,375,976 2,964,000 2,648,488 2,330,165 2,007,454 1,673,850 1,350,948 1,019,453 690,853 362,993 29,828 2700 shares of ASIANHOTL 2800 shares of BATAINDIA 5400 shares of BOMDYEING 55500 shares of SAIL 6050 shares of ESCORTS 1600 shares of DABUR 500 shares of CIPLA 1150 shares of CADBURY 4700 shares of APOLLOTYRE 5100 shares of ICICIBK 2150 shares of ITCHOTEL 2100 shares of LAKME 700 shares of PFIZER 6300 shares of TITAN 4,982,538 400 400 400 400 400 300 300 300 300 300 300 300 300 300 MTM profit/loss (In Rs.) -17,042 38,430 18,801 55,828 13,795 65,300 25,290 35,112 76,248 -64,214 42,968 -11,582 -2,220 10,611 249,724
How do we actually do this? 1. Mr.Mehta obtained Rs.5 million on 17 Feb 1998. He made a list of 14 stocks to buy, at 17 Feb prices, totaling Rs.5 million. 2. At that time Nifty was at 991.70. He entered into a LONG NIFTY MARCH FUTURES position for 5000 nifties, i.e. his long position was worth 5,053,600. 3. From 18 Feb 1998 to 09 March 1998 he gradually acquired the stocks (see Table 5.2). On each day, he purchased one stock and sold off a corresponding amount of futures.
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On each day, the stocks purchased were at a changed price (as compared to the price prevalent on 17 Feb). On each day, he obtained or paid the marktomarket margin on his outstanding futures position, thus capturing the gains on the index. 4. By 09 Mar 1998 he had fully invested in all the shares that he wanted (as of 17 Feb) and had no futures position left. 5. The same sequencing of purchases, without the umbrella of protection of the LONG NIFTY MARCH FUTURES position, would have cost Rs.249,724 more.
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Longer dated futures go well with longterm forecasts about the movement of the index. Shorter dated futures tend to be more liquid.
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Would you like to lend funds into the stock market, without suffering the slightest risk? Traditional methods of loaning money into the stock market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party. What is new about the index futures market is that it supplies a technology to lend money into the market without suffering any exposure to Nifty, and without bearing any credit risk. The basic idea is simple. The lender buys all 50 stocks of Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo. There is no price risk since the position is perfectly hedged. There is no credit risk since the counterparty on both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle for entities which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries. How do we actually do this? 1. Calculate a portfolio which buys all the 50 stocks in Nifty in correct proportion, i.e. where the money invested in each stock is proportional to its market capitalization. 2. Round off the number of shares in each stock. 3. Using the NEAT software, a single keystroke can fire off these 50 orders in rapid succession into the NSE trading system. This gives you the buy position. 4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do not affect you. 5. A few days later, you will have to take delivery of the 50 stocks and pay for them. This is the point at which you are loaning money to the market. 6. Some days later (anytime you want), you will unwind the entire transaction. 7. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 stocks. 8. A moment later, reverse the futures position. Now your position is down to 0. 9. A few days later, you will have to make delivery of the 50 stocks and receive money for them. This is the point at which your money is repaid to you.
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What is the interest rate that you will receive? We will use one specific case, where you will unwind the transaction on the expiration date of the futures. In this case, the difference between the futures price and the cash Nifty is the return to the moneylender, with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them, and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades. On 1 July 1998, if the Nifty spot is 942.25, and the Nifty July 1998 futures are at 956.5 then the difference (1.5% for 30 days) is the return that the moneylender obtains. Example On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. Ashish wants to earn this return (30/1200 for 27 days). 1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 1204. 2. He sells Rs.3 million of the futures at 1230. The futures market is extremely liquid so the market order for Rs.3 million goes through at nearzero impact cost. 3. He takes delivery of the shares and waits. 4. While waiting, a few dividends come into his hands. The dividends work out to Rs.7,000. 5. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty portfolio, putting 50 market orders to sell off all the shares. Nifty happens to have closed at 1210 and his sell orders (which suffer impact cost) goes through at 1207. 6. The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last day is always equal to the Nifty spot). 7. Ashish has gained Rs.3 (0.25%) on the spot Nifty and Rs.20 (1.63%) on the futures for a return of near 1.88%. In addition, he has gained Rs.70,000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free. It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the
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return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days. This is very close to the actual number.
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When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spotfutures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.2% per month, this stocklending could be profitable. It is easy to approximate the return obtained in stock lending. To do this, we assume that transactions costs account for 0.4%. Suppose the spotfutures basis is x% and suppose the rate at which funds can be invested is y% Then the total return is y-x-0.4%, over the time that the position is held. This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spotfutures basis is somewhat wider. Example Suppose the Nifty spot is 1100 and the twomonth futures are trading at 1110. Hence the spot futures basis (1110/1100) is 0.9%. Suppose cash can be risklessly invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over the two month period. Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs.4 million of the Nifty portfolio which he would like to lend to the market. 1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098. 2. A moment later, Akash puts in a market order to buy Rs.4 million of the Nifty futures. The order executes at 1110. At this point, he is completely hedged.
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3. A few days later, Akash makes delivery of shares and receives Rs.3.99 million (assuming an impact cost of 2/1100). 4. Suppose Akash lends this out at 1% per month for two months. 5. At the end of two months, he get back Rs.4,072,981. Translated in terms of Nifty, this is 1098*1.012 or 1120. 6. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying back, but the difference is exactly offset by profits on the futures contract. When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25, 400. Table 6.2 Market watch showing bid and ask for various futures contracts
Hedging
H5 Have portfolio, buy puts
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Arbitrage
A3 Put-call parity with spot-options arbitrage A4 Arbitrage beyond option price bounds14
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We need to know the beta of the portfolio. We look at two cases, case one where the portfolio has a beta of 1 and case two where the portfolio beta is not equal to 1. Portfolio insurance when portfolio beta is 1.0 1. Assume we have a well-diversified portfolio with a beta of 1.0, which we would like to insure against a fall in the market. 2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want to play. Assume that the spot Nifty is 1250 and you decide to buy puts with a strike of 1125. This will insure your portfolio against an index fall lower than 1125. 3. When the portfolio beta is one, the number of puts to buy is simply equal to the portfolio value divided by the spot index. Now let us look at the outcome. We have just bought twomonth Nifty puts at a strike of 1125. This is designed to ensure that the value of our portfolio does not decline below Rs.0.90 million. (For a portfolio with a beta of 1, a 10% fall in the index directly translates into a 10% fall in the portfolio value). During the twomonth period, suppose the Nifty drops to 1080. This is a 13.6% fall in the index. The portfolio value too falls at the same rate and declines to Rs.0.864 million. However the options provide a payoff of (1125-1080)*4*200 which is equal to Rs.36,000. This is the amount needed to bring the value of the portfolio back to Rs.0.90 million. Portfolio insurance when portfolio beta is not 1.0 1. Assume we have a portfolio with beta equal to 1.2 which we would like to insure against a fall in the market. 2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want to play. Assume that the spot Nifty is 1200 and we decide to buy puts with a strike of 1140. This will insure our portfolio against an index fall lower than 1140. 3. For a portfolio with a non-unit beta, the number of puts to buy equals (portfolio value * portfolio beta)/Index. Assume our portfolio is worth Rs.1 million with a beta of 1.2. Hence the number of puts we need to buy to protect our portfolio from a downside is
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(10,00,000 *1.2)/1200 which works out to 1000. At a market lot of 200, it means that we will have to buy 5 market lots of two month puts with a strike of 1140. Now let us look at the outcome. We have just bought two month Nifty puts at a strike of 1140. This is designed to ensure the value of our portfolio does not decline below Rs.0.94 million. (For a portfolio with a beta of 1.2, an index fall of 5% translates into a 6% fall in the portfolio value). During the two-month period, suppose the Nifty drops to 1080. The portfolio value has declined to Rs.0.88 million. (Again, for a portfolio with a beta of 1.2, a 10% fall in the index translates into a 12% fall in the portfolio value). However the options provide a payoff of (1140-1080)*5*200 which is equal to Rs.60,0000. This is the amount needed to bring the value of the portfolio back to Rs.0.94 million.
7.2 S3: Bullish index, buy Nifty calls or sell Nifty puts
Do you sometimes think that the market index is going to rise? That you could make a profit by adopting a position on the index? How does one implement a trading strategy to benefit from an upward movement in the index? Today, using options you have two choices: 1. Buy call options on the index; or, 2. Sell put options on the index We have already seen the payoff of a call option. The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Having decided to buy a call, which one should you buy? Table 7.1 gives the premia for one-month calls and puts with different strikes. Given that there are a number of one month calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current index level is 1250, risk-free rate is 12% per year and index volatility is 30%. The following options are available: 1. A one month call on the Nifty with a strike of 1200.
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Which of these options you choose largely depends on how strongly you feel about the likelihood of the upward movement in the market index, and how much you are willing to lose should this upward movement not come about. There are five onemonth calls and five onemonth puts trading in the market. Table 7.1 One-month calls and puts trading at different strikes The spot Nifty level is 1250. There are five one-month calls and five one-month puts trading in the market. Figure 7.1 shows the payoffs from buying calls at different strikes. Figure 7.2 shows the payoffs from writing puts at different strikes.
As a person who wants to speculate on the hunch that the market index may rise, you can also do so by selling or writing puts. As the writer of puts, you face a limited upside and an unlimited downside. Having decided to write a put, which one should you write? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose ? This largely depends on how strongly you feel about the likelihood of the upward movement in the market index. In the example in Figure 7.2, at a Nifty level of 1250, one option is inthemoney and one is outofthemoney. As expected, the inthemoney option fetches the highest premium of Rs.64.80 whereas the outofthemoney option has the lowest premium of Rs.18.15. Figure 7.1 Payoff for buyer of call options at various strikes The figure shows the profits/losses for a buyer of Nifty calls at various strikes. The in themoney option with a strike of 1200 has the highest premium of Rs.80.10 whereas the outofthemoney option with a strike of 1300 has the lowest premium of Rs.27.50.
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1200
1250 1280.10
1300 1299.45
1327.50 Nifty
27.50 49.45 80.10 Loss Figure 7.2 Payoff for writer of put options at various strikes The figure shows the profits/losses for a writer of Nifty puts at various strikes. The in themoney option with a strike of 1300 fetches the highest premium of Rs.64.80 whereas the outofthemoney option with a strike of 1200 has the lowest premium of Rs.18.15.
Profit 64.80 37.00 18.15 1200 1981.85 1213 1250 1235.20 1300 Nifty
Loss
7.3 S4: Bearish index: sell Nifty calls or buy Nifty puts
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Do you sometimes think that the market index is going to drop? That you could make a profit by adopting a position on the index? How does one implement a trading strategy to benefit from a downward movement in the index? Today, using options, you have two choices: 1. Sell call options on the index; or, 2. Buy put options on the index We have already seen the payoff of a call option. The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Having decided to write a call, which one should you write? Table 7.2 gives the premiums for one month calls and puts with different strikes. Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose ? Let us take a look at call options with different strike prices. Assume that the current index level is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write the following options : 1. A one month call on the Nifty with a strike of 1200. 2. A one month call on the Nifty with a strike of 1225. 3. A one month call on the Nifty with a strike of 1250. 4. A one month call on the Nifty with a strike of 1275. 5. A one month call on the Nifty with a strike of 1300. Which of this options you write largely depends on how strongly you feel about the likelihood of the downward movement in the market index and how much you are willing to lose should this downward movement not come about. Table 7.2 One month calls and puts trading at different strikes The spot Nifty level is 1250. There are five one-month calls and five one-month puts trading in the market. Figure 7.3 shows payoff for seller of various calls at different strikes. Figure 7.4 shows the payoffs from buying puts at different strikes.
Nifty 1250 1250 1250 1250 Strike price of option 1200 1225 1250 1275 Call Premium (Rs.) 80.10 63.65 49.45 37.50 Put Premium (Rs.) 18.15 26.50 37.00 49.80
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As a person who wants to speculate on the hunch that the market index may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the index does fall, you profit to the extent the index falls below the strike of the put purchased by you. Having decided to buy a put, which one should you buy? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the downward movement in the market index. Figure 7.3 Payoff for seller of call option at various strikes The figure shows the profits/losses for a seller of Nifty calls at various strike prices. The inthemoney option has the highest premium of Rs.80.10 whereas the atthemoney option has the lowest premium of Rs.27.50. Profit 80.10 1327.5 49.45 27.50 1200 1250 1300 Nifty
Loss
1280.10 1299.45
Figure 7.4 Payoff for buyer of put options at various strikes The figure shows the profits/losses for a buyer of Nifty puts at various strike prices. The inthemoney option has the highest premium of Rs.64.80 whereas the atthemoney option has the lowest premium of Rs.18.50. Profit
- 79 Nifty
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view is that there will be a large jump in the index, this will reflect in the prices of the options. Figure 7.5 Payoff for buyer of three-month call and put options at strikes of 1250 The figure shows the profits/losses for a combination of a long call and a long put at the same strike and expiration. The investor has bought both a call and a put on the Nifty index. If on the expiration date, the index closes between 1098 and 1402, he losses a maximum of Rs.152. If however, his expectation of high volatility does come true, his profits are potentially unlimited. If for instance the index jumps to 1420, he makes a neat profit of Rs.18 i.e. (1420-1250)-152. The effectiveness of this combination depends how different is the investors belief about market movement from that of most other participants. The higher the cost of setting up this combination, the more the index would have to move for it to be profitable.
Profit
1193 |
1250 |
1345 |
1402 |
Loss
Table 7.3 Three-month calls and puts trading at different strikes Given below are the three-month call and put option premia on the S&P CNX Nifty. An investor who decides to play on the volatility of the market must decide at what strike to
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generate the straddle. In this case he has three three-month option contracts to choose from.
Nifty 1248 1248 1248 Strike price of option 1250 1245 1230 Call Premium (Rs.) 48 50.65 59.05 Put Premium (Rs.) 38.30 35.95 29.50
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Rs.51.35. Beyond an index level of 1350, any profits made on the long call position will be cancelled by losses made on the short call position, effectively limiting the profit on the combination.
Nifty Buy Call Jan 1260 Sell Jan Call 1350 Cash Flow Profit (Rs.) & Loss
1245 1255 1265 1275 1285 1295 1305 1315 1325 1335 1345 1355 1365
0 0 +5 +15 +25 +35 +45 +55 +65 +75 +85 +95 +105
0 0 0 0 0 0 0 0 0 0 0 -5 -15
0 0 5 15 25 35 45 55 65 75 85 90 90
-38.95 -38.65 -33.65 -23.656 -13.65 -3.65 +6.35 +16.35 +26.35 +36.35 +46.35 +51.35 +51.35
Figure 7.6 Payoff for a bull spread created using call options The figure shows the profits/losses for a bull spread.As the index moves above 1260, the position starts making profits (cutting losses) until the spot reaches 1350. Beyond 1350, the profits made on the long call position get offset by the losses made on the short call position and hence the maximum profit on this spread is made if the index on the expiration day closes at 1350. Hence the payoff on this spread lies between 38.85 to 51.35. Profit 51.35
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difference between the call premium received and the call premium paid. The upside on the position is limited to this amount. Hence the payoff on this spread lies between +38.85 to -51.35.
Profit 76.50
Loss Table 7.5 Expiration day cash flows for a Bear spread using two-month calls
The table shows possible expiration day profit for a bear spread created by selling one market lot of calls at a strike of 1260 and buying a market lot of calls at a strike of 1350. Nifty Buy Call Jan 1350 Sell Jan Call 1260 Cash Flow Profit (Rs.) & Loss
1245 1255 1265 1275 1285 1295 1305 1315 1325 1335 1345
0 0 0 0 0 0 0 0 0 0 0
+38.95 +38.65 +33.65 +23.656 +13.65 +3.65 -6.35 -16.35 -26.35 -36.35 -46.35
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The above expression shows that the value of a European call with a certain exercise price and exercise date can be deduced from the value of a European put with the same exercise price and date and vice versa. It basically means that the payoff from holding a call plus an amount of cash equal to X / (1+r) T is the same as that of holding a put option plus the index. Case 1 Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty 1260 call is Rs.96.50 and the price of a three month Nifty 1260 put is Rs.60. In this case we can see that S + P C (not equal to) X / (1+r) T 1325 > 1321.30 What does this mean? If we think of index plus put as portfolio A and the call plus cash as portfolio B, clearly portfolio A is overpriced relative to portfolio B. What would be the arbitrage strategy in this case? Sell the securities in portfolio A and buy those in portfolio B. This involves shorting the index and a put on the index and buying a call. How would one short the index? One way to do it would be to actually sell off all 50 Nifty stocks in the proportions in which they exist in the index. Another easier way to do this would be to sell units of Index funds instead of the actual index stocks. This would achieve a similar outcome. This entire set of transactions generates an up-front cash-flow of (1265 + 60 - 96.50) = Rs.1228.50. When invested at the riskfree rate of 12%, this amount grows to Rs.1265.35. At expiration, if the index is higher than 1260, you will exercise the call. If the index is lower than 1260, the buyer of the put will exercise on you. In either case, the investor ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is Rs.5.35 (i.e. 1265.35-1260). How do we actually do this? 1. Sell off all 50 index shares on the cash market in the proportion in which they exist in the index. This can be done using a single keystroke using the NEAT software.
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4. You will receive the money for the stocks and the put sold and have to make delivery of the 50 shares. 5. Invest this money at the riskless interest rate. In three months Rs.1228.50 will grow to Rs.1265.35. 6. On the exercise date at 3:15 PM, if the Nifty is above 1260, exercise the call. If the Nifty is below 1260, the put will be exercised on you. 7. Either way, you end up buying the index at Rs.1260. 8. The riskless profit on the transaction works out to be Rs.5.35. Case 2: Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty 1260 call is Rs.96 and the price of a three month Nifty 1260 put is 51.50. In this case, we can see that S + P C (not equal to) X / (1+r) T 1316.50 < 1320.80 What does this mean? If we think of index plus put as portfolio A and the call plus cash as portfolio B, clearly portfolio B is overpriced relative to portfolio A. What would be the arbitrage strategy in this case? Buy the securities in portfolio A and sell those in portfolio B. This involves buying the index and a put on the index and selling a call. How would one buy the index? One way to do it would be to actually buy all 50 Nifty stocks in the proportions in which they exist in the index. An easier way to do this would be to buy units of Index funds instead of the actual index stocks. This would achieve a similar outcome. This entire set of transactions involves an initial investment of Rs.1220.50(i.e. 1265 - 51.50 + 96) When financed at the riskfree rate of 12%, the repayment required at the end of three months is Rs.1257. At expiration if the index is lower than 1260, you will exercise the put. If the index is higher than 1260, the buyer of the call will exercise on you. In either case, the investor
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ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is Rs.3 (1260 - 1257). How do we actually do this? 1. Buy all 50 index shares on the cash market in the proportion in which they exist in the index. This can be done using a single keystroke using the NEAT software. 2. Buy a three month Nifty 1260 put. 3. Sell a three month Nifty 1260 call. 4. You will have to pay for the shares and the put, and will receive the call premium. The entire set of transactions will require an initial outflow of Rs.1221.20. 5. Finance this money at the riskless interest rate. The repayment at the end of three months works out to Rs.1257. 6. On the exercise date at 3:15 PM, if the Nifty is below 1260, exercise the put. If the Nifty is above 1260, the call will be exercised on you. 7. Either way, you end up selling the index at Rs.1260. 8. The riskless profit on the transaction works out to be Rs.3.
Dividends expected during the life of the option These factors set general boundaries for possible option prices. If the option price is above the upper bound or below the lower bound, there are profitable arbitrage opportunities. We shall try to get an intuitive understanding about these bounds. Upper bounds for calls and puts
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A call option gives the holder the right to buy the index for a certain price. No matter what happens, the option can never be worth more than the index. Hence the index level is an upper bound to the option price. C (less than equal to) I If this relationship is not true, an arbitrageur can easily make a riskless profit by buying the index and selling the call option. As we know a put option gives the holder the right to sell the index for X. No matter how low the index becomes, the option can never be worth more than X. Hence, P (less than equal to) X If this is not true, an arbitrageur would make profit by writing puts. Lower bounds for calls and puts The lower bound for the price of a call option is given by S-X (1+r) T The price of a call must be worth at least this much else, it will be possible to make risk less profit S-X (1+r) T < C Consider an example. Suppose the exercise price for a three-month Nifty call option is 1260. The spot index stands at 1386 and the risk-free rate of interest is 12% per annum. In this case, he lower bound for the option price is 1386-1260 (1+1.2)
0.25
i.e. 161.20
Suppose the call is available at a premium of Rs.150 which is less than the theoretical minimum of Rs. 163.20. An arbitrageur can buy a call and short the index. This provides a cashflow of 1386-150 = 1236. If invested for three months at 12% per annum, the Rs.1236 grows to Rs.1273. At the end of three months, the option expires. At this point, the following could happen: 1. The index is above 1260, in which case the arbitrageur exercises his option and buys back the index at 1260 making a profit of Rs.1273 - 1260 = Rs.13. 2. The index is below 1260 at say 1235, in which case the arbitrageur buys back the index at the market price. He makes an even greater profit of 1273 - 1235 = Rs.38.
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The lower bound for the price of a put option is given by X (1+r) -T S. The price of a put must be worth at least this much else, it will be possible to make riskless profits. X (1+r) -T S. < P Consider an Example. Suppose exercise price for three- month Nifty put option is 1260. The spot index stands at 1165 and the risk-free rate of interest is 12% per annum. In this case the lower bound for the option price is Rs.59.80. Suppose the put is available at a premium of Rs.45 which is less than the theoretical minimum of Rs.59.80. An arbitrageur can borrow Rs.1210 for three months to buy both the put and the index. At the end of the three months, the arbitrageur will be required to pay Rs.1246.3. Three months later the option expires. At this point, the following could happen: 1. The index is below 1260, in which case the arbitrageur exercises his option, sells the index at Rs.1260, repays the loan amount of Rs.1246.3 and makes a profit of Rs.13.7. 2. The index is above 1260 at say 1275, in which case the arbitrageur discards the option, sells the index at 1275, repays the loan amount of Rs.1246.3 and makes an even greater profit of 1275 - 1246.3 = Rs.28.7.
Bibliography
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Books
1. Options Futures, and other Derivatives by John C Hull 2. Derivatives FAQ by Ajay Shah 3. NSEs Certification in Financial Markets: - Derivatives Core module 4. Investment Monitor Magazine July 2001
Reports
1. Regulatory framework for financial derivatives in India by Dr. L.C.Gupta 2. Risk containment in the derivatives markets by Prof.J.R.Verma
Websites
www.derivativesindia.com www.nse-india.com www.sebi.gov.in www.rediff/money/derivatives.htm www.igidr.ac.in/~ajayshah www.iinvestor.com www.appliederivatives.com www.erivativesreview.com www.economictimes.com www.cboe.com (Chicago Board of Exchange) www.adtading.com
www.numa.org