Chapter -4

DERIVATIVES ANALYSIS &

VALUATION Contents
1. INTRODUCTION TO DERIVATIVE ............................................................................................................. 3
UNIT-I
FUTURE CONTRACT
2. INTRODUCTION TO FUTURE CONTRACT ............................................................................................... 3
(A) BUY CONTRACT ........................................................................................................................................................................... 4
(B) SALE CONTRACT ......................................................................................................................................................................... 4
3. RELATIONSHIP BETWEEN CASH PRICE AND FUTURE PRICE ......................................................... 5
4. MARGIN REQUIREMENT.............................................................................................................................. 5
(A) INITIAL MARGIN ......................................................................................................................................................................... 5
(B) MINIMUM MAINTENANCE MARGIN ..................................................................................................................................... 5
(C) MARK TO MARKET MARGIN .................................................................................................................................................... 5
(D) MARGIN CALL .............................................................................................................................................................................. 5
5. SQUARE OFF OF FUTURE CONTRACT OR EXIT FROM CONTRACT BEFORE EXPIRY ................ 6
6. LOT SIZE OF FUTURE CONTRACT ............................................................................................................. 7
7. OPEN INTEREST OF FUTURE ..................................................................................................................... 7
(A) INCREASE IN OPEN INTEREST .............................................................................................................................................. 7
(B) NO CHANGE IN OPEN INTEREST .......................................................................................................................................... 8
(C) DECREASE IN OPEN INTEREST ............................................................................................................................................. 8
8. DELIVERY OF UNDERLYING UNDER FUTURE CONTRACT (MOST IMPORTANT) ...................... 8
9. EFFECT OF DIVIDEND ON PRICE .............................................................................................................. 9
10. EFFECT OF DIVIDEND ON INDEX PRICE (NIFTY) ............................................................................. 10
11. FAIR FUTURE VALUE / THEORETICAL FUTURE VALUE................................................................. 10
12. USE OF INDEX FUTURE ............................................................................................................................. 11
13. ARBITRAGE IN FUTURE CONTRACT ..................................................................................................... 13
(A) WHEN ACTUAL FUTURE PRICE IS LOWER THAN FAIR FUTURE PRICE ................................................................ 13
(B) WHEN ACTUAL FUTURE IS HIGHER THAN FAIR FUTURE ......................................................................................... 14
14. LOG FUNCTION ............................................................................................................................................ 14
15. HEDGE RATIO .............................................................................................................................................. 15
UNIT-II
OPTION CONTRACT
16. INTRODUCTION TO OPTION CONTRACT............................................................................................. 15
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 DERIVATIVES Page 4.2

17. CALL OPTION ............................................................................................................................................... 16

18. PAYOFF GRAPH OF CALL OPTION ......................................................................................................... 17
19. PUT OPTION ................................................................................................................................................. 18
20. PAYOFF GRAPH OF PUT OPTION............................................................................................................ 19
21. EUROPEAN OPTION AND AMERICAN OPTION: ................................................................................. 20
22. SQUARE OFF OF THE OPTION (EXIT BEFORE EXPIRY) ................................................................... 20
23. INVESTMENT REQUIRED FOR OPTION TRADING ............................................................................ 20
24. STATUS OF THE OPTION .......................................................................................................................... 20
IN THE MONEY OPTION (ITM) .................................................................................................................................................... 20
AT THE MONEY OPTION (ATM) .................................................................................................................................................. 20
OUT OF THE MONEY OPTION (OTM) ........................................................................................................................................ 20
25. INTRINSIC VALUE AND TIME VALUE OF MONEY ............................................................................. 21
26. STRATEGY IN OPTION ............................................................................................................................... 22
CALL OPTION STRATEGY .............................................................................................................................................................. 22
PUT OPTION STARATEGY ............................................................................................................................................................. 22
STRANGLE STRATEGY ................................................................................................................................................................... 23
STRADDLE STRATEGY ................................................................................................................................................................... 24
BULLISH CALL SPREAD STRATEGY ........................................................................................................................................... 25
BUTTERFLY STRATEGY ................................................................................................................................................................. 26
27. VALUE OF OPTION (GENERAL METHOD) ............................................................................................ 27
28. VALUATION OF OPTION IN SPECIFIC CONDITION ........................................................................... 28
(A) PUT CALL PARITY METHOD ................................................................................................................................................. 28
(B1) BINOMIAL MODEL ................................................................................................................................................................. 29
(I) RISK NEUTRALIZATION METHOD ................................................................................................................................................. 29
(II) RISK LESS HEDGE PORTFOLIO OR REPLICATING PORTFOLIO METHOD .................................................................. 30
(B2) TWO PERIODS BINOMIAL MODEL ................................................................................................................................... 31
(A) EUROPEAN OPTION ............................................................................................................................................................................. 32
(B) AMERICAN OPTION ............................................................................................................................................................................. 33
29. NORMAL DISTRIBUTION TABLE ............................................................................................................ 33
AREA UNDER NORMAL DISTRIBUTION CURVE (Z) ............................................................................................................. 33
(A) STANDARD NORMAL DISTRIBUTION TABLE ................................................................................................................. 34
(B) ONE TAIL NORMAL DISTRIBUTION TABLE ..................................................................................................................... 34
(C) TWO TAIL NORMAL DISTRIBUTION TABLE .................................................................................................................... 34
(D) CUMULATIVE STANDARD NORMAL DISTRIBUTION TABLE ..................................................................................... 34
30. BLACK-SCHOLES MODEL .......................................................................................................................... 35
(A) FOR STOCK OPTION ................................................................................................................................................................ 35
(B) FOR INDEX OPTION ................................................................................................................................................................. 35
31. ARBITRAGE OPPORTUNITY UNDER OPTION CONTRACT .............................................................. 36
CALCULATION OF ARBITRAGE AMOUNT [FOR ALL ABOVE SITUATION] .................................................................... 36
UNIT-III
CURRENCY FUTURE AND CURRENCY OPTION
32. INTRODUCTION TO CURRENCY OPTION AND CURRENCY FUTURE ........................................... 38
33. USE OF OPTION AND FUTURE TO HEDGE RISK ................................................................................. 38
SITUATION 1: .................................................................................................................................................................................... 38
SITUATION 2: .................................................................................................................................................................................... 38
34. IDENTIFICATION OF UNDERLYING CURRENCY: ............................................................................... 39
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 Page 4.3 SFM (CONCEPT SUMMARY)

INTRODUCTION TO DERIVATIVE
Derivative is a contract whose value depends upon performance of underlying (i.e. stock, index, currency,
commodity, interest rate etc.)
Derivative contract may be traded on exchange or OTC (Over the counter)
Exchange: where price negotiation is made publicly among various parties. E.g. NSE, BSE, MVX, NCDEX etc.
OTC (Over The Counter): where price negotiation is made privately between two parties. E.g. Contract with Bank.
Refer Interest Rate
Derivative Contract
Risk Management

Exchange Traded OTC Traded

Future Option For

For Currency
Contract Contract } Interest Rate

Forward Currency Caps, Floor

FRA IRS Swaption
Contract swap & Collar

UNIT-I
FUTURE CONTRACT

INTRODUCTION TO FUTURE CONTRACT

 FUTURE CONTRACT is a contract to buy/sell underlying on expiry date at agreed price.

1 Jan (Now) 31 March Expiry date

Contract Expiry Date

Mr. A agrees to buy 1000
share of ABC Ltd. and Mr. B
agrees to sell 1000 share of It does not matter
ABC Ltd. on 31 st March what will be the price
of ABC share on 31 st
March, Contract will
Contract Price negotiated at
be executed at ₹500
500
On the basis of Bidding (i.e. Contracted Price)

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 DERIVATIVES Page 4.4

On 31st March
CASE-I [Price 510] CASE-II [Price 492]
On expiry, Price of Share increased to ₹510 and hence On expiry Price of Share decreased to ₹492 and hence
future price also increased to ₹510 future price also decreased to ₹492
Mr. A (Buyer) Mr. A (Buyer)
Buy share at ₹500 (i.e Contracted Price) even market Buy share at ₹500 (i.e Contracted Price) even market
price is ₹510. price is ₹492.
As delivery is not possible, Mr. A receives ₹10 (per As delivery is not possible, Mr. A has to pay ₹8 (Per
share) from Mr. B Share) to Mr. B
Mr. B (Seller) Mr. B (Seller)
Sale share at ₹500 but share price is ₹510. Sale share at ₹500 but share price is ₹492.
As delivery is not possible, Mr. B has to pay ₹10 (per As delivery is not possible, Mr. B will receive ₹8 from
Share) to Mr. A. Mr. A (per share)
Note: Derivative trade is zero sum game.
Gain of one party = Loss to another party

Summary:
Delivery of underlying is not possible under F&O segment (or FNO segment). Hence, we can say that Future
contract is contact to receive upside difference or pay downside difference and contract to receive downside
difference or pay upside difference.

(A) BUY CONTRACT

 Contract to receive upside difference or pay downside difference.
 Buy position is also termed as Long Position.

(B) SALE CONTRACT

 Contract to receive downside difference or pay upside difference.
 Sale position is also termed as Short Position.

DIAGRAMMATICAL PRESENTATION OF LOSS/GAIN:

Market Price on Expiry

(510)
(Mr. A) Buyer Gain 10
(Mr. B) Seller  Loss 10
Agreed Future Price
(500)
(Mr. A) Buyer  Loss 8
(Mr. B) Seller  Gain 8
Market Price on Expiry
(492)

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 Page 4.5 SFM (CONCEPT SUMMARY)

RELATIONSHIP BETWEEN CASH PRICE AND FUTURE PRICE

 Future Contract price depends upon cash segment Price.
 Future Contract price = [Cash Price or Spot Price + Time Value]

1 Jan 1 Feb 31 March Expiry date

Cash Price 500 Cash Price 510 Cash Price 520

Future Price Future Price Future Price

=500+3M TV =510+2M TV =520 (Almost Same)

Where, TV = Time value of money

MARGIN REQUIREMENT
 Buyer and seller of future contracts are required to deposit the initial margin in a margin account which is
fixed by exchange on the basis of contract value. Simply, Security money payable by trader (Buyer & seller) of
future contract to exchange & broker is margin money and it is payable at the time of entering into contact.
 This amount will be refunded on the expiry or at the time of square off of contract (i.e. exit before expiry).
 Margin money depends upon the volatility of the price of the underlying which differs from stock to stock,
broker to broker & time to time.
(A) INITIAL MARGIN
Initial margin is calculated by using following formula:
Initial Margin (Index) = [Average daily absolute change in the contract value + (3 x σ)]
Initial Margin (Stock) = [Average daily absolute change in the contract value + (3.5 x σ)]
OR
Initial Margin = Contract value × % of Initial Margin (If question provides initial Margin percentage)

Where,
σ (Read as Sigma) = Standard deviation of stock/Index
Recent Update:
Exchange increased margin on future contract which is calculated using Two days absolute change instead of one
day. However, students are advised to calculate margin using one day absolute change and write notes regarding
recent updates.

(B) MINIMUM MAINTENANCE MARGIN

Minimum balance of margin account that is to be maintained at every time during the contract period.

(C) MARK TO MARKET MARGIN

Balance in margin account after adjustment of loss/gain.
Mark to market margin= Opening balance ± Profit/Loss

(D) MARGIN CALL

When mark to market margin (i.e. margin account balance after adjustment of loss/gain) falls below minimum
maintenance margin then trader has to add that much additional amount in margin account which will
increase balance of margin account to initial margin. This additional amount is known as margin call. If margin
balance is higher than initial margin then trader can withdraw extra amount from margin balance.
(Note: Practically margin is calculated on real time and it differs from above theoretical concept bu t follow
above theory in question.)

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 DERIVATIVES Page 4.6

SQUARE OFF OF FUTURE CONTRACT OR EXIT FROM CONTRACT BEFORE EXPIRY

The second transaction/contract opposite to first contract entered to exit from market is known as square off.

Entry Contract (First Contract) Exit Contract (Square off)

Future Buy Sale same future at any time on or before Expiry.
Future Sale Buy same future at any time on or before Expiry
Same future means: Same underlying & Same expiry date

Loss or gain from Future Contract = Difference between buy & Sale Value (i.e. Sale value – Buy value)
Example:
(i) At 9:20 AM (1 Jan)
Price of ABC Share = ₹500; Price of ABC march future = ₹510 [Approx. 3 months’ time value]
(Approx. 3M Future) ⟶ 3M Time Value
Buy @510 Sale @₹510
Mr. A NSE Mr. B
March future of ABC March future of ABC
Assume Lot size = 1000
Both Paid margin = 86700 each (17% on Contract Value. Online rate from NSE)

(ii) At 10:40 AM (5-Feb)

Price of ABC share = ₹520; Price of ABC March Fut = ₹527 [Approx. 2M Time Value]
Mr. A wants to exit from market by booking Profit (i.e. Sale March Future)
Sale @₹527 Buy @₹527
Mr. A NSE Mr. C
March future of ABC March future of ABC
Profit to Mr. A:
Sale Price ₹527
Buy Price ₹510
Gain per share ₹17

Total Profit = 17 × 1000 = ₹17000

17000
Return on investment = × 100 = 19.61%
86700
Total cost involved in this trade is approx. ₹130 [Visit Zerodha]

(iii) On expiry (31 March)

Price of ABC closed at ₹505; Price of ABC March Future ₹505 [No time value. Hence, Cash Price = Future Price]
Mr. B Position:
Sale Price ₹510
Buy Price ₹505
Gain per share ₹5
OR
Downside difference is profit to seller of contract = ₹5
Total Profit = 5 × 1000 = ₹5000
Total Cost around = ₹125 (Visit Zerodha)
Mr. C Position:

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 Page 4.7 SFM (CONCEPT SUMMARY)
Sale Price (Notional) ₹505
Buy Price ₹527
Gain per share -₹22
OR
Downside difference is loss to buyer.
Total loss = ₹22 × 1000 = ₹22000
Total transaction cost around ₹125
Net Position:
Mr. A +17000
Mr. B +5000
Mr. C -22000
Zero

LOT SIZE OF FUTURE CONTRACT

 Future contract can be traded only in bundle of quantities (Lot).
 Lot size of different underlying may be different. It is decided by exchange.
 Currently, lot size of future is calculated for contract value approximately 6,00,000.
 Online example:
NIFTY Lot size = 75
NIFTY Bank Lot size = 20
MRF Lot Size = 10
SBI Lot size = 3000
 Lot size changes time to time on the basis of contract value.
 Exchange (NSE) adjusts outstanding contract lot size in following situations:
(a) Bonus Issue
(For 1:1 bonus lot size increases to 2 times on Ex-date i.e One day before record date)
(b) Split off of face value
(c) Right issue
(d) Dividend more than 10%

OPEN INTEREST OF FUTURE

It indicates outstanding quantity of a particular future contract at particular time.
(A) INCREASE IN OPEN INTEREST
When buyer and seller take entry in a contract.

Example (a) At 9:30 AM

Buy Sale
Mr. A NSE Mr. B
1 Lot [75 units] 1 Lot [75 units]
NIFTY March FUT
Open Interest (OI) at 9:30 AM = 75

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 DERIVATIVES Page 4.8

Example (b) At 10:00 AM

Buy Sale
Mr. C NSE Mr. D
2 Lot [150 units] 2 Lots [150 units]
NIFTY March FUT
Open Interest (OI) at 10:00 AM = 75 + 150 = 225

Buyer Seller
A = 75 B = 75
C = 150 D = 150
225 225

(B) NO CHANGE IN OPEN INTEREST

When one trader exit from a contract and another trader enters into the contact.

Example (c) At 12:30 PM

Sale Buy
Mr. C NSE Mr. E
1 Lot [75 Units] 1 Lot [75 Units]
NIFTY March FUT
Open Interest (OI) at 12:30 AM = 225

Buyer Seller
A = 75 B = 75
C = 150 -75=75 D = 150
E =75
225 225

(C) DECREASE IN OPEN INTEREST

When both existing buyer & seller exit from a contract.
Example (d) At 1:00 PM

Sale Buy
Mr. C NSE Mr. D
1 Lot [75 Units] 1 Lot [75 Units]
NIFTY March FUT
Open Interest (OI) at 1:00 PM = 225-75 = 150

Buyer Seller
A = 75 B = 75
E = 75 D = 75
150 150

Note: We cannot predict expected movement on the basis of open interest of future because both parties are equally
strong.

DELIVERY OF UNDERLYING UNDER FUTURE CONTRACT (MOST IMPORTANT)

Sometimes trader wants to take delivery of underlying but it is not possible in F&O segment as exchange doesn’t
allow it.
In this situation trader has to take following two actions:
(i) Settle Future with difference [Either hold till expiry or square off before expiry as the case may be].
(ii) Deliver underlying in cash segment
 Net off of the above two is inflow to sale underlying or outflow to buy underlying.

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 Page 4.9 SFM (CONCEPT SUMMARY)
EXPLANATION:
Let us suppose Mr. Ram wants to buy 160 gm Gold on 10th Aug for his marriage and he expects that price of
gold to rise up. Today is 1 st July.
In this case he can hedge this transaction by purchasing Gold Aug Future today.
Contract detail from MCX: 1 Unit = 10 gm & 1 Lot = 10 Units i.e. 100 gm

1 July (Now) 10 Aug Aug End

(Now)
9Ncskcc Now1
Now per unit July Expiry of future
Spot Price: 30200 Spot Price: 32000 per unit (Assumed)
1 July Contract
Now Now1
Aug Fut 1Price:
July 30450 per unit JulyPrice = 32083 per unit
Gold Future
Real time price from MCX Assumed, fair price prevails in market
32083−30450
(It is approx. 5% p.a. TV for 60 [SP+20 Day TV (i.e. ×20 = 83)]
60
days) [i.e. SP+60 days TV]

Buy gold Aug Future @30450 ACTIONS Cash Flow

to hedge risk Square off of Future [Gain in 2 lot] +32660
16
No of Contracts = = 1.6 [(32083-30450) × 10] ×2
10 Slightly lesser
[Either 1 Lot or 2 Lots; Buy gold for delivery [32000×16 unit] -512000 than contracted
Say, Bought 2 Lots] Net outflow [512000-32660] -479340 Price 30450 due
to 2 Lots
Effective cost per unit [479340÷16] 29958.75

Note:
If number of contracts is a whole number and spot price & future price on delivery date are same then effective
cost to buy underlying must be contracted future price.
Suppose, 1 lot = 16gm, then NO of contracts = 10 (whole number); and
Future price on 10th Aug = 32,000 (Equal to Cash price)
In this case effective cost to buy Gold must be agreed future price 30450.

EFFECT OF DIVIDEND ON PRICE

 On dividend announcement date, there is no effect on price.
 Before record date, shares are traded at cum- dividend price.
 After record date, shares are traded at Ex- dividend price.
Announcement Date Ex- Date Record Date
4444

Share Price=500 Practically, share price Dividend of ₹ 25 is payable

decreases by ₹25 in to those shareholders who
Announced: Dividend of pre-opening session hold share on record date.
₹25 (After announcement due to T+2days (i.e. Bought 1 day before Ex-
₹500 price is known as settlement. (Share price date @ ₹ 500)
cum- dividend price.) decreases to ₹475)

Note:
 Ex- date is one day before record date. If we assume there is no time value of money & no movement in share
price due to other factors then share will be traded at ₹475 after Ex- date. (i.e. Ex- dividend price)
 Due to dividend, shareholder’s wealth does not change if there is no movement in price due to other factors.
Verification:
On 1 day before Ex-date: Bought at ₹500
On record date: Received dividend of ₹25 and
Holding share worth ₹475
(i.e. Total worth = ₹500; equal to buy price)

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 DERIVATIVES Page 4.10

EFFECT OF DIVIDEND ON INDEX PRICE (NIFTY)

Index cannot declare dividend as index is nothing but portfolio of some stocks. However, it is affected by
dividend.
Now Record Date Expiry Date

Company Share Price Comp 1 Comp 4 Comp 5 Company Share Price

Comp 1 100(Cum) Div =5 Div =10 Div =20 Comp 1 95 (Ex)
Comp 2 200 Comp 2 200
Comp 3 80 Comp 3 80
Assume total dividend declared by
Comp 4 140 (Cum) Comp 4 130 (Ex)
group companies is ₹ 1,00,000 Cr.
Comp 5 500(Cum) Comp 5 480 (Ex)
--------- ----- --------- -----
--------- ----- Total Market cap of NIFTY is --------- -----
Comp 50 400 ₹80,00,000 Cr Comp 50 400
NIFTY 11000 (Actual data as on Jan 2019) NIFTY XXXXX

NIFTY point as on today is Hence, Dividend Yield of NIFTY This NIFTY point must be Ex-
Cum-Dividend due to cum =
1,00,000 𝐶𝑟
×100 dividend due to ex-dividend
dividend share price of group 80,00,000 𝐶𝑟 shares price of group
companies. =1.25% companies.

It means spot price 11,000 is 101.25% including 1.25 % dividend. Hence, Ex-Dividend spot price of index
𝐶𝑢𝑚 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐼𝑛𝑑𝑒𝑥 11000
should be : (i.e. = ₹10864.20)
1+ % 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 1+0.0125
𝑆𝑃
Formula: EDSP= (1+𝑃𝐷𝑌)
𝒐𝒓 𝑒 𝐷𝑌.𝑡
Where,
EDSP = Ex- Dividend Spot Price
SP= Spot price
PDY = Periodic dividend yield
DY= Dividend yield (annual) ; t= Time (in year)

FAIR FUTURE VALUE / THEORETICAL FUTURE VALUE

Fair Future Price (FFP)

Stock Future Index Future Currency future Commodity Future

(i) FFP* (i) FFP (i) FFP = EDSP × (1+PIR)n (i) FFP
= EDSP × [(1+PIR) n = EDSP × [(1+PIR) n or 𝑒 𝑟𝑡 ] = (SP + PV of SC) ×
or 𝑒 𝑟𝑡 ] or 𝑒 𝑟𝑡 ] [(1+ PIR)n or 𝑒 𝑟𝑡 ]
Or, Or, f
(ii) FFP# (ii) FFP Where, Where,
= SP× [(1+PIR) n or = SP × 𝑒 (𝑟−𝐷𝑌)𝑡 ] EDSP (Ex-Div Spot Price) PV of SC = PV of storage
𝑒 𝑟𝑡 ] – FV of Div 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒 Cost
=
[1+𝑃𝐼𝑅($)]
Where, Where, It means,
𝑆𝑃
EDSP (Ex-Div. Spot EDSP= FFP=
𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒
× [1+ PIR()]
price)
(1+𝑃𝐷𝑌)𝑛 𝒐𝒓 𝑒 𝐷𝑌 × 𝑡 [1+𝑃𝐼𝑅($)] Convenience Yield
PDY = Periodic Dividend [1+𝑃𝐼𝑅()] = [Actual Future Price
= SP- PV of Expected = SP of $ ×
Dividend Yield on Index [1+𝑃𝐼𝑅($)] – Fair Future Price]
* (See Explanation 1) DY = Dividend Yield on
Index (Annual) Same formula as
# (See Explanation 2) Interest Rate Parity Theory

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 Page 4.11 SFM (CONCEPT SUMMARY)
EXPLANATION 1:
0 Year 1 Month 2 Month

Spot Share Price Dividend Received

Less: PV of Dividend

Ex-Div Spot Price Fair Future Price

EXPLANATION 2:

0 Year 1 Month 2 Month

Spot Share Price Dividend Received

FV of Spot Price

Less: FV of Dividend

Fair Future Price

USE OF INDEX FUTURE

Index future can be used for following:
INDEX Future

For Speculation To Hedge risk of Equity Portfolio To increase/decrease Beta of Port.

Expected Existing Risk Action Existing Action Beta

Market Action position in to position
Condition equity hedge Short Short Increase
Move up Buy portfolio risk Long Long Increase
Move down Sale Long Downside Short Short Long Decrease
If market is expected to Short Upside long Long Short Decrease
move up Value of Index future to be Value of Index future to be
Buy NIFTY future sold/bought sold/bought
Profit = Upside difference = [Value of Portfolio ×Beta of Port.] = [Value of Portfolio × Change in Beta
If market is expected to (SEE EXPLANATION-1) of Portfolio]
move down No of contract of Index future to Where,
Change in Beta of Portfolio
Sale NIFTY future be sold/Bought=
𝑉𝑎𝑙𝑢 𝑜𝑓 𝐼𝑛𝑑𝑒𝑥 𝑓𝑢𝑡𝑢𝑟𝑒
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑛𝑒 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 =Difference in New desired beta and
Profit = Downside Old beta
Difference
Note: At perfect hedge position, new (SEE EXPLANATION-3)
beta of portfolio should be “Zero”.
(SEE EXPLANATION-2)

Note: Practically Short position in equity (Cash Segment) is possible in intraday only due to “T+2days” delivery
settlement.

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 DERIVATIVES Page 4.12

EXPLANATION-1:
Mr. X is holding the portfolio worth ₹ 2,00,000. Due to bad news, market is expected to move down.
He wants to hedge portfolio using NIFTY future. Assume, Beta of portfolio = 2.5 times. He wants perfect hedge
position (i.e. 100% hedging) using NIFTY future.
β = 2.5 times
Portfolio value
NIFTY
₹ 2,00,000

Portfolio Value is expected to move In this case NIFTY will move down
down by 5% by 2% (i.e. 5%/2% = 2.5 times)
Loss from port.=₹2,00,000×5% For perfect hedging, Mr. X has to
=₹ 10,000 (Expected) earn profit of ₹ 10,000 by taking
action on NIFTY.

Assume, value of NIFTY future to be sold = X

X × 2% = ₹ 10000 or, X = ₹ 5,00,000
Derivation (Value of INDEX future):
10000 200000 ×5% 5%
Value of NIFTY Future = = = 200000 ×
2% 2% 2%

=Value of portfolio × Beta of portfolio

EXPLANTION-2 (At perfect hedge position, Beta portfolio = “Zero”)

(i) Existing value of a portfolio = ₹ 2,00,000
(ii) Value of portfolio after taking position in NIFTY future (if NIFTY drop by 2 %, Assumed)
Share portfolio value (old) 2,00,000

Less: Loss from portfolio (10,000)

(200000×5%)
Add: Gain from NIFTY Future 10,000
(500000×2%)
New Value ₹ 2,00,000/-
200000−200000
Change in port. value = × 100 = 0%
200000
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 0%
New Beta = = = 0%
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝐼𝐹𝑇𝑌 2%

EXPLANTION-3:
Objective to increase beta
Trader wants to increase beta when price is expected to move in favor of trader position (i.e. to increase profit)
Objective to decrease beta
Trader want to decrease beta when price is expected to move adversely (i.e. to reduce loss)
Action to increase/decrease beta of existing portfolio
Entering into same position on index future as portfolio increases the beta of portfolio and taking inverse
position decreases the beta of the portfolio.
In above example suppose Mr. X wants to increase beta to 4 times using NIFTY future.
Assume, NIFTY is expected to increase by 2%.
Portfolio value = 200000 (long), Existing Beta = 2.5 times
In this case portfolio will increase by 5% (i.e. 2% × 2.5)
Action: As beta is to be increased, buy NIFTY future.
Value = value of portfolio × change in beta = 200000 × (4 – 2.5)
= ₹300000

// CA NAGENDRA SAH // WWW.FMGURU.ORG

 Page 4.13 SFM (CONCEPT SUMMARY)
Verification:
(i) Existing value of portfolio = ₹ 200,000
(ii) Value of New portfolio after taking position in NIFTY future when NIFTY increase by 2% and portfolio by 5%.
Share portfolio value (old) 2,00,000

Add: Gain from portfolio (2,00,000×5%) 10,000

Add: Gain from NIFTY Future (3,00,000×2%) 6,000
New Value ₹ 2,16,000/-
2,16,000−2,00,000
Change in port. value = × 100 = 8%
2,00,000
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 8%
New Beta = = = 4 times (Hence, Objective achieved)
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝐼𝐹𝑇𝑌 2%

ARBITRAGE IN FUTURE CONTRACT

Arbitrage is an act to earn risk free profit.
Arbitrage in Future is possible when: Fair future value ≠ Actual future value
Conditions Actions Reasons
Actual future price < Fair future price (i) Buy Future & Future is underpriced in market
(ii) Sale share in cash market Because underlying is to be
[Arbitrageur must have shares in his DP bought on expiry under future
(Demat A/C) and his intension is to hold contract
it for long period]
Actual future price > Fair future price (i) Sale Future & Future is Overpriced in market.
Because underlying is to be sold
(ii) Buy share in cash market
on expiry under future contract.

PROCEDURE FOR EARNING ARBITRAGE PROFIT IN FUTURE CONTRACT

(A) WHEN ACTUAL FUTURE PRICE IS LOWER THAN FAIR FUTURE PRICE
For arbitrage gain Buy Share under Future contract and sale share in Cash market.
0 period Maturity date

1. Enter Future contract

today to buy share.

2. Sale the share in cash

market at spot rate.
(Assume, Arbitrageur has
1 share today.)
4. Withdraw deposit
3. Deposit the sale proceeds Arbitrage gain
at risk free rate for 5. Buy share (Outflow =(4)–(5)
specific period (i.e. future must be contracted
contract period) price)

Note: If company pays dividend before maturity, then it is opportunity loss to arbitrageur as he sold share. Hence,
consider it as outflow in calculation of arbitrage.
Arbitrage = Withdrawal – Outflow – Dividend foregone (i.e. opportunity loss)

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 DERIVATIVES Page 4.14

(B) WHEN ACTUAL FUTURE IS HIGHER THAN FAIR FUTURE

For arbitrage gain Sale Share under Future contract and Buy share in Cash market.

0 period Maturity date

1. Enter Future contract

today to sale share. 3. Sale share (Inflow
must be contracted
price) Arbitrage gain
2. Borrow the amount at
=(3)–(4)
risk free rate and buy
share from cash market. 4. Repay borrowing

Note: If company pays dividend before maturity, then it is gain to arbitrageur as he bought share. Hence, consider it
as inflow in calculation of arbitrage.
Arbitrage = Withdrawal – Repayment of Borrowing + Dividend Received

LOG FUNCTION
Log is a mathematical function useful for some complex calculation.
Let us suppose an equation, 𝑎𝑏 = 𝑦,
this equation using log function is written as: log 𝑎 (𝑦) = b
Where, a is base of logarithmic function.
Log Function

Log with base 10 Log with base e

𝐋𝐨𝐠 𝟏𝟎 (𝒙) 𝐋𝐨𝐠 𝒆 (𝒙)OR 𝐋𝐧(𝒙)

Formula for both Log:
Log(a×b)= Log(a) + Log(b)
𝑎
Log( ) = Log (a) - Log (b)
𝑏
Log(𝑎𝑏 ) = 𝑏 𝐿𝑜𝑔(𝑎)
Use of Calculator to calculate value of Logarithmic Function:
Log 𝑒 (𝑥) or Ln(𝑥)=? ; Log10 (𝑥) =?
Where x = Any number whose Log is to be calculated

AC Base √ √ √ 12 Times
----------
− 1 M+
𝒙 √ √ √ 12 Times
----------
− 1 ÷ MRC =

Conversion of Annual Compounded rate into Continuous compounding:

At effective interest rate future value of different compounding remains same .
Hence, 𝑒 𝑟𝑡 = (1 + 𝑃𝐼𝑅)𝑛
𝑒 𝑟 = (1 + 𝑃𝐼𝑅)
By taking log both sides:
Ln (𝑒 𝑟 ) = Ln (1 + PIR)
r Ln (e) = Ln (1+ PIR) Where, Ln (e) = 1
Hence, r = Ln (1+ PIR)

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 Page 4.15 SFM (CONCEPT SUMMARY)

HEDGE RATIO
Beta of a portfolio is also known as hedge ratio.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑑𝑒𝑥 𝑓𝑢𝑡𝑢𝑟𝑒
Beta of a portfolio or Hedge ratio =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝜎𝐴× 𝑟 (𝐴,𝑚)
Beta of a security A (β A) = [Refer portfolio chapter]
𝜎𝑚
Where, A= Security A
M= Market/ Index

UNIT-II
OPTION CONTRACT

INTRODUCTION TO OPTION CONTRACT

 OPTION COONTRACT is a type of derivative contract which provides right to buy/sell underlying at agreed
rate on agreed future date.
 There are two parties to option contract. One is buyer of option (or Holder of option) and another is seller of
option (or Writer of option)
 The person who gets right to buy or sale an underlying at agreed rate is called Buyer of option (i.e. Holder of
option).
 The person who has the obligation to sale or buy an underlying at agreed rate is called seller of option (i.e.
Writer of option)
 The options are of two types:

Option

Call Option Put Option

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 DERIVATIVES Page 4.16

CALL OPTION
The contract which provides right to holder of option to buy an underlying, is known as Call option. However,
writer of option (Opposite party) has obligation to sell underlying.

Mr. W receives Premium from Mr. H for

Mr. H (HOLDER) selling call option (Say, ₹ 10) Mr. W (WRITER)
Buyer of Call option Seller of Call option

Mr. H has right to Mr. W has

buy share of ABC Call Option obligation to sale
at 600 at 3- share of ABC at
month time. If you desire, you 600 at
Lot Size
may buy 1000 3-month time, if
Strike Price (K) shares of ABC at Underlying buyer approach
Exercise price (X) to do so.
₹ 600 at 3- Months
Execution Price (X)
time Exercise date or Expiry date

 If at 3-month time (i.e. on expiry date) price of a share is more than 600 then buyer exercise his right and
seller is bound to sell share at 600 (i.e. at strike price) even actual market price is higher.
 If at 3-month time (i.e. on expiry date) price of a share is less than 600 then right lapses (i.e. buyer does not
exercise his right).

ACTION OF CALL AND SETTLEMENT ON EXPIRY

Market Price on Expiry

(650) CASE-1
Mr.H Exercises right &
Buy share at ₹600
H
₹50 W 
Payoff
Strike Price
(600)
Option Lapses
NIL
H W
Payoff
Market Price on Expiry
(572) CASE-2

CASE-1: (On Expiry Price = ₹650)

Mr. H  Profit/Loss (Net payoff) = Payoff received – premium paid = ₹50 - ₹10 = ₹40
Mr. W  Profit/Loss(Net payoff) = Premium Received – Payoff Paid = ₹10- ₹50 = - ₹40

CASE-2: (On Expiry Price = ₹572)

Mr. H  Profit/Loss (Net payoff) = Payoff received – premium paid = ₹0 - ₹ 10 = - ₹10
Mr. W  Profit/Loss (Net payoff)= Premium Received – Payoff Paid = ₹10- ₹0 = ₹10

// CA NAGENDRA SAH // WWW.FMGURU.ORG

 Page 4.17 SFM (CONCEPT SUMMARY)

PAYOFF GRAPH OF CALL OPTION

Assuming, Strike price of Call = ₹600 and Premium = ₹10

SITUATIONS I II III IV V VI VII VIII

MP on expiry
₹580 ₹590 ₹600 ₹610 ₹620 ₹630 ₹640 ₹650
Strike Price (K)
₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600
Action
Lapse Lapse Lapse Exercise Exercise Exercise Exercise Exercise
Payoff
0 0 0 ₹10 ₹20 ₹30 ₹40 ₹50
Premium
₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10
Net Profit/Loss (₹)
-10 -10 -10 0 10 20 30 40
( Call Holder)
Net Profit/Loss (₹)
10 10 10 0 -10 -20 -30 -40
(Call Writer)

NET PAYOFF GRAPH OF CALL OPTION FOR BOTH HOLDER AND WRITER
50

40

30

20 Profit (H)
High Probability
Net Profit/Loss

10 Low Probability
Profit (W)
0
₹ 580 ₹ 590 ₹ 600.0 610 ₹ 620 ₹ 630 ₹ 640 ₹ 650
Loss (H)
-10 (BEP)
Loss (W)
High Probability
-20 Low Probability

-30
H  HOLDER
-40
W  WRITER
-50
Price of share on Expiry

Analysis of Call Option

For Holder of call For Writer of call
It provides right to receive upside difference It provides obligation to pay upside difference
Earns profit when price moves up Earns profit when price moves down or remains stable
Premium  Outflow at beginning. Premium  Inflow at beginning.
Payoff  Inflow at expiry (If exercise) Payoff  Outflow at expiry (If exercise)
Payoff (Inflow) = (MP-K) Payoff (Outflow) = (MP-K)
Net P/L (Net payoff)= Payoff-Premium Net P/L (Net payoff) = Premium-Payoff
BEP = Strike price + Premium BEP = Premium + Strike price
Maximum Gain = Unlimited Maximum Gain = Premium
Maximum Loss = Premium Maximum Loss = Unlimited

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 DERIVATIVES Page 4.18

PUT OPTION
The contract which provides right to sell an underlying, is known as Put Option.
In other words, Put Option provides right to receive downside difference.

Mr. W receives Premium from Mr. H for

Mr. H (HOLDER) buying put option. (Say, ₹ 10) Mr. W (WRITER)
Buyer of Put option Seller of put option

Mr. H has right Mr. W has

to sell share of Put Option obligation to buy
ABC at 600 at share of ABC at
If you desire, you
3-month time. 600 at 3-month
may sell 1000 Lot Size
Underlying time, if seller
shares of ABC at
approach to do
Strike Price (K) ₹ 600 at so.
Exercise price (X) 3- Months time
Execution Price (X) Exercise date or Expiry date

 If at 3-month time (i.e. on Expiry date) price of a share is less than 600 then buyer of put option exercise his
right and seller of put option is bound to buy share at 600 (i.e. at strike price) even actual market price is less.
 If at 3-month time (i.e. on Expiry date) price of a share is higher than 600 then option lapses

ACTION OF PUT AND SETTLEMENT ON EXPIRY

Market Price on Expiry

(650) CASE-1
Option Lapses
NIL
Payoff
Strike Price
Mr.H Exercises right & (600)
Sell share at ₹600
H
₹40
W 
Payoff Market Price on Expiry
(560) CASE-2

CASE-1: (On Expiry Price = ₹650)

Mr. H  Profit/Loss (Net payoff) = Payoff Received – Premium paid = ₹0 - ₹10 = - ₹10
Mr. W  Profit/Loss(Net payoff) = Premium Received – Payoff Paid = ₹10- ₹0 = ₹10

CASE-2: (On Expiry Price = ₹560)

Mr. H  Profit/Loss (Net payoff) = Payoff Received – Premium paid = ₹40 - ₹ 10 = ₹30
Mr. W  Profit/Loss (Net payoff) = Premium Received – Payoff Paid = ₹10- ₹40 = - ₹30

// CA NAGENDRA SAH // WWW.FMGURU.ORG

 Page 4.19 SFM (CONCEPT SUMMARY)

PAYOFF GRAPH OF PUT OPTION

Assuming, Strike price of Put = ₹600 and Premium = ₹10

SITUATIONS I II III IV V VI VII VIII

MP on expiry
₹550 ₹560 ₹570 ₹580 ₹590 ₹600 ₹610 ₹620
Strike Price (K)
₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600 ₹600
Action
Exercise Exercise Exercise Exercise Exercise Lapse Lapse Lapse
Payoff
₹50 ₹40 ₹30 ₹20 ₹10 0 0 0
Premium
₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10 ₹10
Net Profit/Loss (₹)
40 30 20 10 0 -10 -10 -10
( Put Holder)
Net Profit/Loss (₹)
-40 -30 -20 -10 0 10 10 10
(Put Writer)

NET PAYOFF GRAPH OF PUT OPTION FOR BOTH HOLDER & WRITER
50

40

30

20
Profit (H) High Probability
Net Profit/Loss

10 Low Probability
Profit (W)
0
₹ 550.00 ₹ 560 ₹ 570 ₹ 580.0 590 ₹ 600 ₹ 610 ₹ 620
(BEP) Loss (H)
-10
Loss (W) High Probability
-20 Low Probability

-30
H  HOLDER
-40
W  WRITER
-50
Price of share on Expiry

ANALYSIS OF PUT OPTION

For Holder of Put For Writer of Put
It provides right to receive downside difference It provides obligation to pay downside difference
Earns profit when price moves down Earns profit when price moves up or remains stable.
Premium  Outflow at beginning. Premium  Inflow at beginning.
Payoff  Inflow at expiry (If exercise) Payoff  Outflow at expiry (If exercise)
Payoff (Inflow) = (K-MP) Payoff (Outflow) = (K-MP)
Net P/L (Net payoff) = Payoff-Premium Net P/L (Net payoff) = Premium-Payoff
BEP = Strike price – Premium BEP = Strike price - Premium
Max. Gain = Unlimited up to Zero price of Underlying Max. Gain = Premium
Max. Loss = Premium Max. Loss = Unlimited up to Zero price of Underlying

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 DERIVATIVES Page 4.20

EUROPEAN OPTION AND AMERICAN OPTION:

0 Year Exercise Date

American Option European Option

If option can be exercised If option can be exercised
at any time on or before only at expiry date then it
expiry date then it is is called European option.
called American option
Note:
 Premium charged by seller of an American option may be greater than that of European option because seller
of option feel more risk than that of European option.
 Unless otherwise stated all option are assumed to be European option.

SQUARE OFF OF THE OPTION (EXIT BEFORE EXPIRY)

Trader can exit from contract any time on or before expiry by taking opposite position.

Entry Contract Exit Contract (Square off)

Buy Call Option Sale same call option any time on or before expiry.
Buy Put Option Sale same put option any time on or before expiry.
Write Call Option Buy same call option any time on or before expiry.
Write Put Option Buy same put option any time on or before expiry.
Same call/put Option means  Same underlying
 Same expiry date
 Same strike price

INVESTMENT REQUIRED FOR OPTION TRADING

 Buy Option [Call & put both]
Fund Required = Total Option premium + Brokerage on entry
 Write Option [Call & put both]
Fund Required = Margin Money + Brokerage on entry
Margin money is approximately equal to margin of future. However, it also varies according to strike price.

STATUS OF THE OPTION

Status of the Option Meaning
IN THE MONEY OPTION (ITM) Favorable strike price option.
For call option  K < SP
For put option  K > SP
AT THE MONEY OPTION (ATM) Strike price equal to spot price.
For call option  K = SP
For put option  K= SP

OUT OF THE MONEY OPTION (OTM) Unfavorable strike price option.

For call option  K > SP
For put option  K< SP

Note:
[In the money option premium >At the money option premium> Out-of-the-money option premium]

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 Page 4.21 SFM (CONCEPT SUMMARY)

INTRINSIC VALUE AND TIME VALUE OF MONEY

(A) INTRINSIC VALUE
Normally, intrinsic value means fair value. But this normal meaning is applicable for valuation of securities
other than option.
In option, Intrinsic value of call is today’s upside difference and intrinsic value of put is toda y’s downside
difference.
Example 1:
SP = 10300 (NIFTY)
Strike = 10200
Intrinsic value of call = (10300 – 10200) = 100
Intrinsic value of put = NIL

Example 2:
SP = 10300 (NIFTY)
Strike = 10450
Intrinsic value of call = NIL
Intrinsic value of put = 150

(B) TIME VALUE OF OPTION

Difference between intrinsic value and actual premium is time value of option.
Longer period of option = More time value (i.e. Expiry period is longer)
Shorter time value = Less time value
On expiry at 3:30 PM
Time value = NIL
Example:
SP = 10300 [Time to expiration = 2 week]
K = 10200
Premium of call = 154 & Time value = (154 – 100) = 54
Suppose, it is 3:30 PM on expiry
SP = 10300; K = 10200
Premium of call must be 100
Time value = NIL

Note:
On expiry at 3: 30PM
Intrinsic Value = Premium = Payoff

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 DERIVATIVES Page 4.22

STRATEGY IN OPTION

CALL OPTION STRATEGY

LONG CALL STRATEGY: Buying call option is also termed as long call strategy.
It is beneficial when price moves up.
Payoff (Inflow) = Upside difference = (MP- K)
Net Profit/loss = Payoff received – premium
BEP = K + Premium
SHORT CALL STRATEGY: Writing call option is also termed as short call strategy.
It is beneficial when price moves down or remain stable.
Payoff (Outflow) = Upside difference = (MP- K)
Net Profit/loss = Premium – Payoff paid
BEP = K + Premium
PROFIT/LOSS RANGE:

Profit: Long Call

Low Probability Loss: Short Call

BEP
High Probability Profit: Short Call
Loss: Long Call
Call Strike Price

PUT OPTION STARATEGY

LONG PUT STRATEGY: Buying put option is also termed as long put option strategy.
It is beneficial when price moves down.
Payoff (Inflow) = downside difference = (K – MP)
Net Profit/Loss = Payoff – premium
BEP = [K - Premium]
SHORT PUT STATEGY: Writing put option is also termed as short put strategy.
It is beneficial when price move up or remain stable.
Payoff (Outflow) = downside difference = (K – MP)
Net Profit/Loss = Premium – Payoff paid
BEP = [K - Premium]
PROFIT/LOSS RANGE:
Put Strike Price
Profit: Short Put
High Probability
Loss: Long Put
BEP
Low Probability Profit: Long Put
Loss: Short Put

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 Page 4.23 SFM (CONCEPT SUMMARY)

STRANGLE STRATEGY
LONG STRANGLE Portfolio of
(i) 1 Long call at high strike price
(ii) 1 Long put at low strike price
for same underlying and same expiry date is known as long strangle strategy.
 In fact, it is a combination of out of the money call and put.
(Logic to buy out of the money (OTM) call and put option is to reduce the cost of
contract)
 Beneficial when there is high movement either up or down. ( High volitality)
 Followings are some events which increases volatility:
Budget, Election, Monetary policy, Quarter result, etc.
 Outflow at beginning = Call premium + Put premium
 Inflow at expiry = Either call payoff or put payoff
 Net profit/loss = [Inflow – Outflow]
 BEP-1 [for up movement] = Call strike + Total premium
 BEP-2 [for down movement] = Put strike - Total premium
SHORT STRANGLE Portfolio of
(i) 1 short call at high strike price
(ii) 1 short put at low strike price
for same underlying and same expiry date is known as short strangle strategy.
 It is also a combination of out of the money (OTM) call and put.
 Beneficial when there is low movement either up or down. (Range bound
trade.)
 Inflow at beginning = Call premium + Put premium
 Outflow at expiry = Either call payoff or put payoff
 Net profit/loss = [Inflow - Outflow]
 BEP-1 [for up movement] = Call strike + Total premium
 BEP-2[ for down movement] = Put strike - Total premium
PROFIT/LOSS RANGE
IN STRANGLE: Profit: Long Strangle
Loss: Short Strangle

BEP-1

Strike price Call

Profit: Short Strangle

Loss: Long Strangle
Strike price Put

BEP-2
Profit: Long Strangle
Loss: Short Strangle

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 DERIVATIVES Page 4.24

STRADDLE STRATEGY
LONG STRADDLE Portfolio of
STRATEGY (i) 1 Long call
(ii) 1 Long put
at same strike Price for same underlying and same expiry date is known as long
straddle strategy.
 It is a combination of At-the-money (ATM) call and put or near ATM Call &Put
Due to high premium it is more expensive than long strangle strategy.
 Beneficial when there is high movement either up or down. (High volatility)
 Meanwhile both long strangle and long straddle are beneficial in same situation but
the only difference is in cost.
 Outflow at beginning = Call premium + Put premium
 Inflow at expiry = Either call payoff or put payoff
 Net profit/loss = [Inflow – Outflow]
 BEP-1 [for up movement] = Call/Put strike + Total premium
 BEP-2 [for down movement] = Call/Put strike - Total premium

SHORT STRADDLE Portfolio of

STRATEGY (i) 1 short call
(ii) 1 short put
With same strike price for same underlying and same expiry date is known as short
straddle strategy.
 It is also a combination of at the money (ATM) call and put or near ATM Call & Put
 Beneficial when there is low movement either up or down. (Range bound trade)
 Inflow at beginning = Call premium + Put premium
 Outflow on expiry = Either call payoff or put payoff
 Net profit/loss = [Inflow - Outflow]
 BEP-1 [for up movement] = Strike Price+ Total premium
 BEP-2[ for down movement] = Strike Price - Total premium

PROFIT/LOSS
RANGE IN
STRADDLE Profit: Long Straddle
STRATEGY Loss: Short Straddle
BEP-1

Profit: Short Straddle

Strike price Call/Put
Loss: Long Straddle

BEP- 2
Profit: Long Straddle
Loss: Short Straddle

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 Page 4.25 SFM (CONCEPT SUMMARY)

BULLISH CALL SPREAD STRATEGY

Portfolio of
(i) 1 Short Call at high strike price
(ii) 1 Long Call at low strike Price
for same underlying and same expiry date is known as Bullish call spread strategy.
 Beneficial when price moves up (even low up-movement)
 This is limited loss and limited profit strategy.
 Net cost at beginning = Premium paid on long call - Premium received on short call.
 Inflow at expiry = Payoff received in long call – payoff paid on short call
 Net profit/loss = [Inflow – Outflow]
 Maximum payoff of this strategy = Difference in K (Strike price)
 Maximum profit = Difference in strike price – Net Outflow
 BEP =[Low Strike price + Net Premium]

High Strike price (Short Call) Receive low Prem.

Profit
BEP
Loss
Low Strike price (Long Call) Pay high Prem.

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 DERIVATIVES Page 4.26

BUTTERFLY STRATEGY
LONG Portfolio of
BUTTERFLY (i) 1 Long call at high strike price
STRATEGY:
(ii) 2 Short call at mid strike price
(iii) 1 Long Call at low strike Price
for same underlying and same expiry date is known as Long butterfly strategy.
 Beneficial when price remains within a range. (i.e. Low movement)
 Outflow at beginning = Premium on Long calls – Premium on short calls
 Inflow at expiry = Payoff received on Long call – Payoff paid on short call
 Net profit/loss = [Inflow – Outflow]
 BEP 1 =[High Strike price - Net Premium]
 BEP 2= [Low Strike price + Net Premium]
SHORT Portfolio of
BUTTERFLY (i) 1 Short call at high strike price
STRATEGY:
(ii) 2 Long call at mid strike price
(iii) 1 Short Call at low strike Price and
for same underlying and same expiry date is known as Long butterfly strategy.
 Outflow of strategy = Premium on Long call – Premium on short call
 Inflow of strategy = Payoff received on Long call – Payoff paid on short call
 Net profit/loss = [Inflow – Outflows]
 BEP-1 =[High Strike price - Net Premium]
 BEP-2=[Low Strike price + Net Premium]
PROFIT/LOSS
RANGE IN Profit: Short Butterfly
BUTTERFLY Loss : Long Butterfly
High K Long Call
STRATEGY

BEP - 1

Profit: Long Butterfly

Mid K Short Call
Loss : Short Butterfly

BEP - 2
Low K Long Call
Profit: Short Butterfly
Loss : Long Butterfly

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 Page 4.27 SFM (CONCEPT SUMMARY)

VALUE OF OPTION (GENERAL METHOD)

Calculation of Fair price of option is also known as valuation of option.
Fair premium is that premium which buyer wants to pay and seller/writer wants to receive.
If question is silent calculate price/premium for current date.
Fair price of any instrument depends upon future inflow and required return.
It means:
Value of Option

When one or more Expected market Price of When Expected market Price of underlying
underlying is/are given is Not given

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐏𝐚𝐲𝐨𝐟𝐟 C0 = 𝐄𝐃𝐒𝐏 – 𝐏𝐕 𝐨𝐟 𝐒𝐭𝐫𝐢𝐤𝐞 𝐩𝐫𝐢𝐜𝐞 OR

C 0 / P0 = (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕 P0 = PV of Strike Price - EDSP
Calculation of expected Payoff When expected price of underlying is not
CASE 1: Expected payoff of Call = EMP – K given, calculate fair expected price using
When only Expected payoff of Put = K – EMP following formula:
one expected Where, = EDSP × [(1+PIR) n or 𝑒 𝑟.𝑡 ]
price of EMP = Expected MP on expiry  [It is fair future price.]
underlying is K = Strike price 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐩𝐚𝐲𝐨𝐟𝐟 𝐄𝐌𝐏−𝐤
given C0 = (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕
= (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕
𝑬𝑫𝑺𝑷 ×[(𝟏+𝐏𝐈𝐑)𝐧 𝐨𝐫 𝒆𝒓.𝒕 ] 𝑲
CASE 2: First calculate payoff at each price = (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕
− (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕
When more and then do average using = EDSP – PV of K
than one probabilities.
expected price Expected payoff = ∑ (Payoff × Prob.)
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐩𝐚𝐲𝐨𝐟𝐟 𝐊−𝑬𝑫𝑺𝑷 ×[(𝟏+𝐏𝐈𝐑)𝐧 𝐨𝐫 𝒆𝒓.𝒕 ]
of underlying P0 = =
are given along Where, (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆 𝒓.𝒕 (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕

with C0 = Call Premium as on today

𝑲 𝑬𝑫𝑺𝑷 ×[(𝟏+𝐏𝐈𝐑)𝐧 𝐨𝐫 𝒆𝒓.𝒕 ]
probabilities P0 = Put Premium as on today = (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕 − (𝟏+𝐏𝐈𝐑) 𝒐𝒓 𝒆𝒓.𝒕
= PV of strike price - EDSP

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 DERIVATIVES Page 4.28

VALUATION OF OPTION IN SPECIFIC CONDITION

Valuation of Option

General Method Put Call Parity Method Binomial Model Black Scholes Model

Risk Neutralization Risk less hedge

Method portfolio method
Applicability of different methods in different situation
Application of Methods of valuation

Normal Method 1 Put Call Parity 2 Binomial Model 3 Black-Scholes Model

When other methods i.e. When underlying, It is useful when It is useful for option
strike & expiry of both expected price of valuation when expected
1 2 & 3 call and put are same underlying has only price of the underlying is
are not applicable use and call premium to be two possibility on not given but standard
Normal Method calculated when put expiry (i.e. either deviation of price is given.
premium is given or high price or low
vice versa. price.)

(A) PUT CALL PARITY METHOD

Put call parity (PCP) Method can be used for option valuation when
(i) underlying, strike price and expiry of both call & put are same and
(ii) Call Premium is to be calculated when put premium is given
OR
Put premium to be calculated when call premium is given.
Formula:
C0 = (EDSP – PV of Strike) + Put premium
P0 = (PV of Strike– EDSP) + Call Premium

Explanation:
PCP Method is derived by keeping in mind arbitrage where arbitrageur has to take delivery of underlying.
At PCP,

Outflow of call holder as Outflow of call holder as

on today if settles call with = on today if settles put with
delivery of underlying delivery of underlying

Call Premium + PV of strike Price = Put Premium + Spot Price of share.

Put option provides

right to sell
From above, underlying on expiry.
Call Premium = [Put premium + spot Price – PV of strike] Hence put holder has
Call Premium = [Spot Price – PV of strike) + Put premium to buy share today.
Hence it is outflow.
Similarly,
Put Premium + SP = Call Prem + PV of strike
Put Premium = [PV of strike – SP] + Call Premium

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 Page 4.29 SFM (CONCEPT SUMMARY)
(B1) BINOMIAL MODEL
Binomial model can be used for option valuation when price of underlying has only two possibilities on expiry
date (i.e High Price or Low Price).
Condition for applicability of Binomial model

Today Expiry

High price
Spot Share

Low Price

In this situation, we can use any one of following two methods to calculate call/put Premium.
(A) Risk Neutralization Method
(B) Risk Less Hedge Portfolio Method

(I) RISK NEUTRALIZATION METHOD

Calculation of option value/premium is same as general method. In addition, we have to calculate probability
of attaining high price and low price under this method.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑎𝑦𝑜𝑓𝑓
C0/P0 = [ ]
(1+𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡
Where
Expected payoff = (Payoff at HP ×Prob. Of HP) + (Payoff at LP × Prob of LP)
For calculation of Probability of attaining HP and LP see below:
(a) Probability of attaining High Price:
We can any one of following two formula to calculate probability of attaining High Price .
(i) Probability of high price (P H) =
𝑆𝑃 ×[(1+𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡 ]−𝐿𝑃
𝐻𝑃−𝐿𝑃

(ii) Probability of high price (PH) =

R−d
U−d
In our Example, Where,
6
R = ( 1 + 0.12 × 12 ) = R = (1 + 𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡
1.06
d = (1 -0.1) = 0.9 d = (1 - % down movement in decimal)
U = ( 1 + 0.20 ) = 1.20
U = ( 1+ % up movement in decimal )

(b) Probability of attaining Low Price

(i) Probability of low price (P L) = (1-PH)
Explanation/ Derivation of above formula of Probability
Investor’s risk will be neutral when investment value of risky investment and risk -free investment remains
same on expiry dare.
Suppose, Mr. X has ₹200 today. He can invest it at 12% p.a risk-free rate for 6 month or buy share worth ₹200
for 6 months. Share price may rise to ₹240 and fall to ₹180 on 6 months’ time.
Risk free investment value:
Now 6 Month

Future Value
Invest
@12% p.a for 6 M = 200 × (1 + .12 × 0.5)
₹200
= 212

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 DERIVATIVES Page 4.30

Risk investment value:

It should be 212 (i.e equal to risk Free)
Now 6 Month

HP = ₹240 Prob. x
SP = 200
LP = ₹180 Prob. (1- x)

Expected Value = 212

Expected Value = ( 240 × x) + 180 (1-x)
Or, 240x – 180 x = 212 – 180
212 − 180
X = LP
240 − 180
HP
SP (1 + PIR) n

𝑺𝑷 ×[(𝟏+𝑷𝑰𝑹)𝒏 𝑶𝑹 𝒆𝒓.𝒕 ]−𝑳𝑷

Prob. Of HP =
𝑯𝑷−𝑳𝑷

(II) RISK LESS HEDGE PORTFOLIO OR REPLICATING PORTFOLIO METHOD

 It is valuation from writer’s point of view.
 It does not matter, valuation is made from buyer’s point of view or writer’s point of view, fair price is
correct price for both and writer.
 Value of option calculated using risk neutralization method and risk less hedge portfolio methods remains
same.
Let us consider following example to understand entire concept of this method:

Now 6M

HP = ₹240
SP = 200
LP = ₹180
Strike Price of call = ₹216
STEP 1: Create risk less hedge portfolio by purchasing underlying.
Diffence in payoff
Hedge ratio (Option Delta) =
Diffence In share price
In our example,
Payoff at HP−Payoff at LP
Hedge ratio =
HP−LP
24 − 0
= = 0.40
240−180
It means writer has to buy 0.40 shares for each 1 call option.
Explanation / Derivation of Formula:
Riskless Hedge Portfolio is combination of share and call where portfolio value remains equal at
both high price and low price.
Assume number of shares = X

Portfolio: Buy x share and write 1 call value on expiry:

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 Page 4.31 SFM (CONCEPT SUMMARY)

HP = 240 LP = 180
Value of x share 240 X 180 X
Less: Payoff (24) 0
Portfolio Value 240x -24 180x- 0
At perfect hedge,
(240x -24) = (180x – 0)
24 − 0 Difference if Payoff
0r x =  [Hence, Derived]
240−180 Difference in Price

STEP 2: Calculate value of Hedged portfolio on expiry.

HP = 240 LP = 180
Value of .4 share 240 × .4 180 × .4
Less: Payoff (24) 0
Portfolio Value 72 72
STEP 3: Calculate PV of Hedged portfolio value
72
PV of Hedged Portfolio = = 67.92
(1+ .012 ×0.5)
It means, if writer invests ₹67.92 today to create portfolio then he is at perfect hedge position.
STEP 4: Fund required to buy 0.40 share today
= (200 × 0.40 ) = ₹80
Hence, Premium to be charged from buyer = 80 – 67.92 = ₹12.08

COMPARISON WITH RISK NEUTRALIZATION METHOD

Alternatively, Using formula
𝑺𝑷 ×[(𝟏+𝑷𝑰𝑹)𝒏 𝑶𝑹 𝒆𝒓.𝒕 ]−𝑳𝑷
Probability of HP =
𝑯𝑷−𝑳𝑷
𝟐𝟎𝟎 ×[(𝟏+𝟎.𝟎𝟔)𝟏 ]−𝟏𝟖𝟎
= = 0.5333
𝟐𝟒𝟎−𝟏𝟖𝟎
Probability of LP = (1 – 0.5333) = 0.467
Expected payoff = (24 × .533) + (0 × .467)
= 12.792
𝟏𝟐.𝟕𝟗𝟐
Call premium = = ₹12.07 (Same as above, hence verified)
(𝟏+𝟎.𝟎𝟔)

(B2) TWO PERIODS BINOMIAL MODEL

Conditions for applicability of two periods binomial model:

0 Period 1 Period 2 Period

HP
HP
LP
SP

HP
L LP

LP

To calculate value of option under two period binomial model we may use Risk neutralization method or
Replicating portfolio method (Risk less hedge portfolio Method)
However, Risk neutralization method is less time consuming.

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 DERIVATIVES Page 4.32

(A) Probability of attaining High Price: [Refer Analysis]

We can use any one of following two formula to calculate probability of attaining High Price
(i) Probability of high price (P H) =
𝑆𝑃 ×[(1+𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡 ]−𝐿𝑃
𝐻𝑃−𝐿𝑃

(ii) Probability of high price (P H) =

R−d
U−d

(B) Probability of attaining L ow Price

(i) Probability of low price (PL) = (1-PH)

Analysis for selecting formula to save time in (A)

As there are three different high prices, we have to calculate probabilities separately for all if we use first
formula and hence consumes more time.
In second formula we use % up movement and % down movement. If % up movement in both periods are same
and also % down movement in both periods are same then probability of all high prices remain same. Similarly,
probability of all low prices also remain same.
Hence, do single calculation of prob. Of all High prices using second formula and it wil l save time.

CALCULATION OF OPTION VALUE UNDER TWO PERIOD BINOMIAL MODEL

0 Period 1 Period 2 Period

B
E
A
F
C

(A) EUROPEAN OPTION

 European option can be exercised only at expiry date (i.e. 2 nd period end)
 Calculate payoff of node D, E, F and G using same concept as studied earlier.
MP > K  Exercise call Otherwise lapse  Call Payoff = MP – K
MP < K  Exercise put Otherwise lapse  Put Payoff = K- MP

Option value of node B =

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝐷 & 𝐸
[(1+𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡 ]

Option value of node C =

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝐹 & 𝐺
[(1 + 𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡 ]
Option value of node A (As on Today) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝐵 & 𝐶
[(1+𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡 ]

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 Page 4.33 SFM (CONCEPT SUMMARY)

(B) AMERICAN OPTION

 American option can be exercised any time on or before expiry. It means, it can be exercised at 1 st period
end or 2 nd period end.
 Payoff node D, E, F & G (If option is exercised at 2nd period end) are calculated using same concept of
European option as studied earlier.
MP > K Exercise call otherwise lapse  Call Payoff = MP - K
MP < K Exercise put otherwise lapse  Put Payoff = K - MP
Option value of node B Higher of following two is option value of node B.
(i) Payoff at High price if option is exercised at 1 period end.
(ii) Discounted value of expected payoff (average payoff) if option is
exercised at 2 period end.
Option value of node C Higher of following two is option value of node B.
(i) Payoff at High price if option is exercised at 1 period end.
(ii) Discounted value of expected payoff (average payoff) if option
is exercised at 2 period end.
Option value of node A (As on Today) 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑝𝑡𝑖𝑜𝑛 (𝑎𝑣𝑒𝑟𝑎𝑔𝑒)𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵 & 𝐶
(1 + 𝑃𝐼𝑅)𝑛 𝑂𝑅 𝑒 𝑟.𝑡

NORMAL DISTRIBUTION TABLE

Normal distribution table is useful for calculation of probability of range of data.
Examples:
(i) Probability of price of NIFTY higher than 10500 Here, Range: 10500 to ∞

(ii)Probability of NPV (Net Present Value) being negative  Here, range is 0 to -∞

(ii)Probability of price of NIFTY remains within a range 10500 to 11500  Here, range is 10500 to 11500

AREA UNDER NORMAL DISTRIBUTION CURVE (Z)

Z is a number of standard deviations from mean.
Area under normal distribution curve is measured by “Z”.
It can be calculated using following formula:
(𝑥−x̄ ) (𝑥−x̄ )
Z= or | |
σ σ
Where, x = desired data
x̄ = mean
σ = Standard deviation
(x- x̄ ) = Range of data from mean.

TYPES OF NORMAL DISTRIBUTION TABLE

There are four types of table of Normal Distribution table.
(A) Standard Normal Distribution Table
(B) One Tail Normal Distribution Table
(C) Two Tail Normal Distribution Table
(D) Cumulative Standard Normal Distribution Table

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 DERIVATIVES Page 4.34

(A) STANDARD NORMAL DISTRIBUTION TABLE

This table provides probability of area “0 to z”

This table provides Prob. of this area

z OR -∞ z
-∞ 0 +∞ 0 +∞
For +ve Z For -ve Z

(B) ONE TAIL NORMAL DISTRIBUTION TABLE

One tail table provides probability of area “z to +∞” or “z to -∞”

This table provides Prob. of this area

OR
-∞ 0 z +∞ -∞ z 0 +∞
For +ve Z For -ve Z

(C) TWO TAIL NORMAL DISTRIBUTION TABLE

-∞ 0 z +∞ -∞ z 0 +∞
For +ve Z For -ve Z

This table provides prob. of this area This table provides prob. of this area

(D) CUMULATIVE STANDARD NORMAL DISTRIBUTION TABLE

This table provides probability of area “-∞ to z”

z
-∞ 0 z +∞ -∞ z 0 +∞

For +ve Z For -ve Z

This table provides prob. of this area This table provides prob. of this area

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 Page 4.35 SFM (CONCEPT SUMMARY)

BLACK-SCHOLES MODEL
Black-Scholes have given a model for valuation of European option. It is also referred as Black-Scholes –Merton
Model. Black Scholes model is used for option valuation when expected price of underlying is not given but
Standard deviation is given.

Black Scholes Model

(A) FOR STOCK OPTION (B) FOR INDEX OPTION

⦿ C0 = [EDSP × N(d1)] – [PV of K × N(d2)] ⦿ C0  Same

⦿ P0 = [PV of K × {1-N(d2)}] – [EDSP × {1-N(d1)}] ⦿ P0  Same
OR (PV of K – EDSP) + C0
𝑆𝑃
⦿ EDSP = SP – PV of K ⦿ EDSP =
𝑒 𝐷𝑌.𝑡
𝐾
⦿ PV of K = ⦿ PV of K =
𝐾
𝑒 𝑟𝑡 𝑒 𝑟𝑡
𝐸𝐷𝑆𝑃 σ2
𝐿𝑛ቂ 𝐾 ቃ + ൬𝑅𝐹 + 2 ൰ × 𝑇 𝑬𝑫𝑺𝑷 σ2 𝑺𝑷 σ2
𝐿𝑛ቂ 𝐾 ቃ+൬ 𝑅𝐹 + 2 ൰× 𝑇 𝐿𝑛ቂ 𝐾 ቃ + [ (𝑅𝐹 −DY) + 2 ]×𝑇
⦿ d1 = ⦿ d1 = OR
σ × ξ𝑇 σ × ξ𝑇 σ × ξ𝑇
R F = Risk Free rate in decimal (Annual)
K = Strike Price d1 Calculated from both formulae remains same.
σ =Standard deviation (Percentage decimal) Hence, we can use anyone of above two.
σ2 = Variance
T = Time (in year)
⦿ d2 = d1 − [(𝛔 × ඥT] ) ⦿ d2  Same
⦿ N(d1) = Cumulative prob. of area (-∞ to d1) ⦿ N(d1)  Same
⦿ N(d2) = Cumulative prob. of area (-∞ to d2) ⦿ N(d2)  Same
Note: Always assume continuous compounding in Black-Scholes Formula.
CALCULATION OF N(D1) AND N(D2)
Institute may provide any one of following four tables. In this case, we have to do following adjustment for
calculation of N(d1) & N(d2)
FOR +VE Z FOR -VE Z

Table

z
-∞ 0 z +∞ -∞ z 0 +∞
(i) Standard N(d1) / N(d 2) = [Table Value + 0.5] N(d1) / N(d2) = [ 0.5 – Time Value]
Normal table
(ii) One tail table N(d1) / N(d 2) = 1 – Table value N(d1) / N(d2) = Table value
(iii) Two tail table N(d1) / N(d 2) = First calculate one tail N(d1) / N(d2) = First calculate one tail value
value by dividing by 2 and by dividing by 2 and do
do same adjustment as one same adjustment as one tail
tail
(iv) Cumulative N(d1) / N(d 2) = Table value N(d1) / N(d2) = Table value
table

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 DERIVATIVES Page 4.36

ARBITRAGE OPPORTUNITY UNDER OPTION CONTRACT

Act to earn risk free profit is known as Arbitrage.

Arbitrage
By comparing actual option premium with fair option By comparing actual option premium with fair option
premium calculated using general method. premium calculated using PCP method.
Situation – 1 Situation-1
Actual Call Premium < Fair Call Premium Actual Call Premium > Fair call Premium
Actions: In this case, there must be:
(i) Buy call Option Actual Put premium > Fair put premium
(ii) Sale share in cash market Actions:
Situation- 2 (i) Buy call option
Actual Call Premium > Fair Call Premium (ii) Write Put option
Arbitrage is not possible as writer cannot earn risk (iii) Sale share in cash Market
free profit.
Situation – 3 Situation-2
Actual Put Premium < Fair Put Premium Actual Put Premium < Fair Put Premium
Actions: In this case there must be:
(i) Buy put option Actual Call Premium > Fair Call Premium
(ii) Buy share in cash market. Actions:
Situation- 4 (i) Buy Put option
Actual Put Premium > Fair Put Premium (ii) Write Call Option
Arbitrage is not possible as writer cannot earn risk (iii) Buy share in Cash Market
free profit.

TECHNIQUE TO REMEMBER ABOVE ACTION

Now Expiry

Sale share today in Cash market CASE-1

If buy underlying on expiry

Buy Share today in cash market CASE-2

If sale underlying on expiry
Assume, arbitrageur has share
today in his DP and his intention
is to hold it for long period.

 Same technique is useful for arbitrage in future also.

CALCULATION OF ARBITRAGE AMOUNT [FOR ALL ABOVE SITUATION]

(i) Calculate net cash flows as on today in above actions.
Case (I) : If inflow (When sale share today) Deposit at risk free rate
Case (b): If Outflow (When buy share today)  Borrow at risk free rate
On expiry
(ii) withdraw deposit or repay borrowing.
(iii) Buy share if sold at 0–Year or Sale share if bought at 0-Year
Price of underlying may be higher than strike price or lower than str ike price but outflow to buy share / inflow
from sell of share must be exercise price [For Logic refer excel sheet]
(iv) Arbitrage = Difference in (ii)& (iii)

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Page 4.37 SFM (CONCEPT SUMMARY)

UNIT – III

CURRENCY FUTURE &

CURRENCY OPTION

// CA NAGENDRA SAH // WWW.FMGURU.ORG

 DERIVATIVES Page 4.38

INTRODUCTION TO CURRENCY OPTION AND CURRENCY FUTURE

Option and future whose underlying is currency ($, €, ¥ & £) is known as currency option & currency future.
Currency future contract of currency is available for maximum 1 year period.
Delivery of currency is not possible under derivative contract but we can hedge foreign c urrency transaction
using currency option and currency future with the help of cash market.

USE OF OPTION AND FUTURE TO HEDGE RISK

SITUATION 1:
Export $100
Mr. India Mr. USA
At 6 month $100

In NSE: Where underlying currency is $ currency

 $ ⦿ Sale $ future or
⦿ Buy put option of $ [Because Put provides right to sell
Exchange underlying (i.e $) and Mr.India has to sell $.]
NSE/NYSE

In NYSE: Where underlying currency is  currency

⦿ Sale  future or
⦿ Buy call option of  [Because call provides right to buy underlying (i.e₹) and
Mr.India has to buy ₹.]

Where,
NSE: National Stock Exchange (India)
NYSE: New York Stock Exchange (USA)

SITUATION 2:
Import $100

Mr. India Mr. USA

At 6 month $100

In NSE: Where underlying currency is $ currency

 $ ⦿ Buy $ future or
⦿ Buy call option of $ [Because call provides right to
buy underlying (i.e.$) and Mr. India has to buy $.]
Exchange
NSE/NYSE

In NYSE: Where underlying currency is  currency

⦿ Sale  future or
⦿ Buy put option of  [Because call provides right to buy underlying (i.e.) and
Mr. India has to buy .]

// CA NAGENDRA SAH // WWW.FMGURU.ORG

 Page 4.39 SFM (CONCEPT SUMMARY)

IDENTIFICATION OF UNDERLYING CURRENCY:

(A) FOR FUTURE
 Lot size currency is underlying currency
 If lot size is not given, assume that currency as underlying currency which is quoted in per unit term
E.g. €1= $1.30 [ 3 m future price] Here, € is an underlying currency.

(B) FOR OPTION

 Lot size currency is underlying currency.
 Premium currency is other than underlying currency.
 If lot size and premium are not given then assume that currency a s underlying currency which is quoted in
per unit term.
E.g. Strike price £1 = €1.12
Premium of call = €0.02
Lot size = £1000 Here, £ is an underlying currency

// CA NAGENDRA SAH // WWW.FMGURU.ORG