Futures PDF

CA –FINAL STRATEGIC FINANCIAL MANAGEMENT
INDIAN CAPITAL MARKET
Financial
Markets
Capital Money Debt

Market Market Market
Primary Secondary
Market Market
Place where
Place where
exisitng
new issues
securities
are made
are traded
Basics of derivatives:
❖ A derivative contract is a financial instrument whose payoff structure is derived
from the value of the underlying asset
Example: Ticket Price of IPL match is Rs.1,000 but the same is fully sold out. A reference
letter is given to buy 3 tickets by paying the price of the ticket
Day Grey Market Price Value
T – 7 1,250
T – 5 750
T – 3 1,500
T – 1 1,600
T 1,800
T+1
❖ The letter is a derivative instrument. It gives you the right to buy the tickets
❖ The underlying asset is the ticket
❖ The letter does not constitute ownership
❖ It is a promise to convey ownership
❖ The value of the letter changes with the value of the ticket
What can be an underlying asset?

❖ Stock (Equity)
❖ Commodity (Cotton)
❖ Precious metals (Gold)
❖ Foreign currency ($)
❖ Interest rate
❖ Market index (Sensex/Nifty)
Types of derivative contracts:
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Types of derivative contracts
Forward Futures
Options Swaps
Contract Contract
Forward contract:
Meaning: Features:
A forward contract is an ❖ Unique – No transfer can be made
agreement entered today under ❖ Performance obligation – Both parties obliged to
which one party agrees to buy perform
and the other party agrees to sell ❖ Price risk is eliminated
an asset on a specified future date ❖ No margins
at an agreed price ❖ Default risk ~ There is no guarantee of
performance
❖ Illiquid – FC cannot be traded
Futures contract:
Meaning: Features:
A futures contract is a standardized contract between two ❖ Standardized
parties where one of the parties commits to sell and the other quantity
permits to buy a specified quantity of a specified asset at an ❖ Deal with clearing
agreed price on a given date in the future house
❖ Market to Market
Options Contract:
Meaning: Features:
A contract between two parties under which the “buyer of the ❖ Standardized
option” buys on payment of a price (premium) the right and quantity
not the obligation to sell (put option), a standardized quantity ❖ Deal with clearing
(contract size) of a financial instrument (underlying asset) at or house
before a pre-determined date (expiry date) at a predetermined ❖ Market to market
price (exercise price or strike price).
Why derivative instruments:

❖ A derivative market is a market for derivative instruments. We need a derivative
market because they perform three useful economic functions.
1. Different Players and 2. Price 3. Risk transfer:
different objectives: Discovery: ❖ Like an insurance
Each player in the market has ❖ Low company
different objectives. Following are transaction ❖ Redistributes the risk
the objectives of the different cost to market players
players: ❖ High return ❖ Premium is the
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❖ Hedger – To protect ❖ Price changes protection against
against the adverse price are first adverse price
changes reflected in movement
❖ Arbitrageur – Looks for this market
prospects in 2 different
markets for riskless gains
❖ Speculator – Take risk in
order to make profit
during adverse market
movement
Futures:
Key concepts:
1. Continuous compounding:
❖ 12% rate of interest has a different effective annual rate if it is compounded at
different frequencies as show below:
Compounding frequency Effective rate
Annually
Half-yearly
Quarterly
Monthly
Continuous compounding
❖ As the frequency of compounding increases the effective annual rate goes up
❖ The effective rate is maximum when compounding is continuous
❖ The future value of continuous compounding is got from eX table and the present
value of continuous discounting is got from e-X table
❖ eX values can be arrived using the following formula 1 + (X/1!) +
(X2/2!) + (X3/3!) + (Xn/n!)
2. Arbitrage through futures:
❖ Compute fair futures price
❖ Compare fair futures price with actual futures price to take decision
Relationship Valuation Futures Spot Action
AFP > FFP
FFP < AFP
Computation of fair futures price:

Situation 1: Non-dividend paying stock:
❖ The underlying asset (stock) does not generate any income for the investor.
Fair futures price = Spot rate * eX
Where X = r * t; r = rate per annum; t = time in years
Situation 2: Dividend paying stock:

❖ This refer to assets (stock) which generate income or dividend during the period of
the futures contract
❖ In this case the spot price should be adjusted with the present value of the income
Fair futures price = Adjusted Spot rate * eX
Where Adjusted spot rate = Spot rate – PV of dividend income
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Situation 3: Known yield
❖ At times the income is expressed as a % of spot price. This is called yield
❖ Since this is a %, it must be deducted from r
Fair futures price = Adjusted Spot rate * e (r-y)t
Where r = risk free rate; y = known yield ; t = time in years
Situation 4: Storage costs:

❖ In respect of physical assets like Gold there is no intervening income. There are only
intervening costs namely storage costs
❖ If the storage cost is expressed in rupees the adjusted spot price will be normal spot
price + PV of storage cost
❖ If the storage cost is expressed as a percentage, then storage cost percentage is added
to r
o FFP = Spot price * e (r+S)t
Convenience yield:
❖ It is an implied return on holding inventories. It is an adjustment to the cost of carry
in the non-arbitrage pricing formula for forward prices.
❖ This is the amount of benefit that is associated with physically owning a particular
good
❖ Fair Futures Price = Spot Price + Cost to Carry – Convenience yield
Hedging with futures:

❖ To hedge (protect against price risk) we must take a position in the futures market,
which is opposite of the position taken in the spot market
o If we are long in the spot market, we must go short in the futures market
o If we are short in the spot market, we must go long in the futures market
❖ If we seek only partial protection, the value of the position to be taken in the futures
market is as under:
Value of futures position = Spot position * Protection needed (%)
❖ If the stock for which hedging is required is not traded in the futures market, we can
create a cross hedge by taking a position in index futures. Position to be taken is as
under:
Value of futures position = Spot position * Protection needed (%) * Beta
Hedging through index futures:
No. of contracts = Beta * Value of units requiring hedging

Value of one futures contract
Example:
X Limited has a beta of 0.8. Mr. A holds 5000 shares of X Limited whose CMP is Rs.300 per
share. Index future is 30000 points and has a multiplier of Rs.30. What action should be
taken in order to hedge?
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Impact of hedging:
❖ If we are long in one market and price goes up we gain
❖ If we are short in one market and price goes up we lose
❖ If we are long in one market and price falls we lose
❖ If we are short in one market and price falls we gain
Position Price Impact
Long Up Gain
Long Down Lose
Short Up Lose
Short Down Gain
How to compute Hedge ratio (Beta)

❖ Beta measures the sensitivity of a stock to a broad based index. Beta of 2 times would
indicate that a 1 percent change in index will lead to a 2 percent change in stock price
(concept of Beta is explained in detail in portfolio management)
Beta = Change in spot prices * Co-relation coefficient
Change in future prices
How to alter risk in portfolio:

Situation 1: Reducing risk Situation 2: Increasing risk
Method 1: Sell portfolio and buy risk free Method 1: Borrow money and buy
investment securities
❖ Step 1: Let weight of the stock in the ❖ Step 1: Let weight of the stock in
new portfolio is W1. So weight of risk the new portfolio is W1. So weight
free investment is 1 – W1 of borrowings is 1 – W1
❖ Step 2: Compute weighted average of ❖ Step 2: Compute weighted
step 1 and equate the same to the new average of step 1 and equate the
desired beta same to the new desired beta
❖ Step 3: The proportion of (1-W1) of old ❖ Step 3: The proportion of (1-W1)
portfolio will be sold and be replaced of old portfolio will be borrowed
with risk free investment to buy additional stocks
❖ Step 4: All stocks in the portfolio will be ❖ Step 4: The same old stocks will
sold for the value identified in step 3 in be bought in the proportion in
the proportion in which they were held which they were originally held
in the original portfolio
Method 2: Keep portfolio intact, buy
Method 2: Keep portfolio intact, sell stock stock index futures
index futures
No. of contracts to be dealt =
No. of contracts to be dealt = Portfolio value * [Desired Beta –
Portfolio value * [Desired Beta – Existing Beta] Existing Beta]
Value of one futures contract Value of one futures contract
Note: If the result is (-) it means sell and if the Note: If the result is (-) it means sell and if
result is (+) it means buy the result is (+) it means buy
Concept of Mark to Market and margin account:
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❖ The stock exchange wants the derivative players to maintain the margin accounts to
safeguard against the risk of default
❖ The initial margin to be maintained is equal to average daily absolute change + 3
(Standard deviation)
❖ The margin balance will change with daily profits/losses being credited/recovered
from the margin account. This concept is also known as mark to market wherein the
company’s derivatives are valued daily at the closing price
❖ The margin balance cannot fall below a specified limit which is also knows as
maintenance margin. In case the margin account drops below the maintenance
margin then the derivative player is required to replenish the account to the level of
initial margin
❖ The derivative player can withdraw the balance from the margin account in case the
balance is above initial margin. However the maximum withdrawal will be upto to
the point of initial margin
Open Interest:
❖ Open interest is the total number of open or outstanding (not closed or delivered)
options and/or futures contract that exist on a given day
❖ Open interest is commonly associated with futures and options markets, where the
number of existing contracts changes from day to day unlike the stock market
wherein the number of shares remain constant unless new issues are made
❖ Open interest is a measure of flow of money into a futures or options market.
Increasing open interest represents new or additional money coming into the market,
while decreasing open interest indicates money flowing out of the market
❖ An increase in open interest is typically interpreted as a bullish signal while
decreasing open interest is interpreted as a bearish signal
Basics of option contract:

Term Meaning
Holder Buyer of the “Right to buy” or “Right to sell”
Writer Person who sells the “Right to buy” or “Right to sell”
Exercise price / strike price Price at which the underlying asset will be bought or sold
Expiry date The date by which the option has to be exercised
Call option This gives the buyer the right to buy
Put option This gives the buyer the right to sell
Underlying asset Asset against which the derivative instrument option is traded
American option Right can be exercised at any time before the expiry date
European option Right can be exercised only at the expiry date
When to exercise an option:

Relationship Call option Put option
Exercise price > Market price
Exercise price = Market price
Exercise price < Market price
Note:
❖ Only buyer can exercise an option
❖ Option premium is irrelevant because the same is a sunk cost
In the money (ITM) / Out the money (OTM) and At the money (ATM):
❖ An option is in the money if exercising the option at that point would give a gain
❖ An option is out the money if exercising the option at that point would lead to a loss
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❖ An option is at the money if exercising the option at that point would lead to neither
profits nor losses
❖ In all the above cases, the option premium being a sunk cost is irrelevant
Relationship Status for call Status for Put
Exercise price > Market price
Exercise price = Market price
Exercise price < Market price
❖ The phrase ITM, OTM and ATM are used in relation to the buyer. Therefore while in
the money is good for the buyer, it is bad for the writer
❖ Similarly OTM is bad for the buyer it is good for the writer
Taking stance:
❖ Whether a derivative player want to be a buyer (holder) or a writer would depend
on his ability to take risk
o Maximum risk = Writer
o Minimum risk = Holder
❖ A buyer would prefer that option which lead to him an exercise on the maturity date
❖ A writer would prefer that option which would lead to lapse on the maturity date
❖ In order to take a stance we need to compare the exercise price with expected market
price
Bullish and Bearish Market:

❖ A bullish market is one where the expected MP is greater than the exercise price
❖ A bearish market is one where the expected MP is lesser than the exercise price
Party EMP > EP EMP < EP

Call Buyer
Call Writer
Put Buyer
Put Writer
Note:
❖ Favourable means making money and adverse means losing money. For a buyer the
position is favourable if it is exercisable and for a writer the position is favourable if
it lapses
Intrinsic value and time value:

❖ Intrinsic value is the extent to which the option is in the money if it ITM
❖ Time value is the difference between option premium and intrinsic value
Option Strategies:
Payoff table and Payoff graph:
❖ The payoff table captures the net profit at various expected MP on expiry date
❖ Such tables are drawn for call buyer, call writer, put buyer and put writer
❖ When an option is exercised, the buyer gains and the writer lose at gross payoff level
❖ Gain or loss at the net payoff level will depend on the extent of premium
❖ When an option in lapsed, neither the holder nor the writer gain or lose at the gross
payoff level
❖ A payoff graph is a graphical representation of the payoff table with market price on
X-axis and net payoff on Y-axis
Which option what premium?

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❖ The option with the lowest exercise price is called E1. The one with the higher EP is
called E2
❖ Example: EP of 90, 110 & 98. Then E1 = 90, E2 = 98 & E3 = 110
❖ The call with a lower EP has a greater probability of being exercised and therefore
command a higher premium
❖ A put with a higher exercise price has a greater probability of being exercised and
therefore command a higher premium
Strategies
Sprea
Combination
ds
Deals in options of one Deal in option of both

type only types
Butter
Bull Bear Strips Straps Strangle Straddle
fly
Call Put Call Put
Note:
❖ The term type would mean call option or put option
❖ The term position would mean Buyer or writer
❖ Derivative strategies are normally created by entering into two or more transactions
❖ If both transaction involve the same type of option the strategy is called a spread
❖ If one transaction involve a call and another transaction involve a put it is called
combination
Bull spread strategy:

There are two ways of creating a bull spread:
❖ Buying a call at E1 and writing a call at E2
❖ Buying a put at E1 and writing a put at E2
E1 E2
Call Buy Write
Put Buy Write
Steps in derivative strategy:

Step 1: Prepare relationship table
❖ If there are “n” options then there will be “n+1” relationships
❖ The various columns in table and their computation is as follows
Column Column Explanation
reference Name
1 Relationship Refer point above
2 E1 Identify action on expiry date and calculation gross
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payoff
3 E2 Same as above
4 GPO Column 2 + Column 3
5 Premium Income (+) for writer and expense (-) for buyer
6 NPO GPO ± Premium
7 BEP Equate NPO to zero
Step 2: Breakeven table:

The breakeven table summarizes the outcome of the relationship table with reference to the
net pay off column
❖ If a relationship has no BEP then it will have only one class interval
❖ If a relationship has BEP then it will have 3 columns. One before, one at and one after
BEP
Step 3: Draw strategy graph:

❖ Strategy graph convert the BEP table into graph. Draw break even table on a graph
with expected MP on x-axis and net payoff on y-axis
Bear Spread Strategy:

There are two ways of creating a bear spread:
❖ Writing a call at E1 and buying a call at E2
❖ Writing a put at E1 and buying a put at E2
E1 E2
Call Write Buy
Put Write Buy
Butterfly spread strategy:

❖ A butterfly spread involves dealing in 4 transactions and 3 exercise prices
❖ You deal either with calls or puts
Way Option E1 E2 E3
1 Call Buy 2 Write Buy
2 Call Write 2 Buy Write
3 Put Buy 2 Write Buy
4 Put Write 2 Buy Write
Combination strategies:
Particulars Strip Strap Strangle Straddle
No of calls 1 2 1 1
No of puts 2 1 1 1
Exercise price Same Same Different Same
Call will have higher EP &
Put will have lower EP
Note:
❖ If the person buys calls and puts then it is called long strategy and in case he sells
calls and puts then it is called short strategy
❖ For example a long straddle would involve buying one call and one put with same
exercise price whereas a short straddle would involve selling one call and one put
with same exercise price
Pricing options:
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❖ Valuation of options means finding out the fair option price
Option
valuation
models
Put call Portfolio Black

Risk Neutral Binomial
parity replication Scholes
Model Model
theory model Model
Stock Option
equivalent equivalent
approach approach
Model 1: Put call parity theory (PCPT)
Share + Put = Call + Present value of exercise price

The formula indicate that the payoff from the following two strategies will always be
identical
❖ Buying a share and buying a put
❖ Buying a call & making an investment equal to present value of exercise price
The above formula can be spun around as follows:
❖ Put = Call + Present value of exercise price – Share
❖ Call = Share + Put – Present value of exercise price
❖ Share = Call + Present value of exercise price – Put
Note: (+) would indicate buy/invest & (-) would indicate sell/borrow
Note:
❖ For all option valuation models the share price will get replaced with adjusted share
price in case dividends are expected to be paid during tenor of option.
❖ Adjusted spot price = Spot Price – PV of dividend income
Model 2: Portfolio Replication Model

Assumptions:
❖ The investor can make only two judgements of market prices on expiry date
❖ He cannot make judgements of “MP before expiry date”
❖ That only 2 judgements of MP are made doesn’t mean that their probabilities are
50/50
Stock equivalent approach: Option equivalent approach:

❖ Compute intrinsic value at two ❖ Compute intrinsic value at two
judgement prices judgement prices
❖ Compute no.of calls to be bought using ❖ Compute the no. of shares to be bought
o No of calls = Spread in stock price using
Spread in IV o No of shares = Spread in IV
❖ Compute risk free investment = Present Spread in Stock price
value of (Lower JP – IV at JP 1) ❖ Compute amount of borrowing using the
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❖ Compute value of calls using following formula
o S0 = C0 * No of calls + Rf investment o Borrowing = PV of [(No. of shares *
❖ Compute value of put using PCPT Lower JP) – IV at JP1]
❖ Compute value of call using
o Call = share value bought –
borrowing
❖ Compute value of put using PCPT
Model 3: Risk Neutral Model:

Assumptions:
❖ Investors are indifferent to risk
❖ Investors can make only two judgement prices “MP of stock on expiry date”
❖ It is possible to make an estimate of probabilities of upside price & downside price
Steps:
❖ Step 1: Compute the intrinsic value at 2 judgement prices
❖ Step 2: Compute upside probability and downside probability by equating the
weighted average return with the return from the risk free asset
❖ Step 3: Expected value of call on expiry date is the weighted average of the values in
step 1 with probability computed in step 2 being the assigned weights
❖ Step 4: Compute the PV of expected value of step 3 by discounting at risk free rate.
This gives the value of call
❖ Step 5: Use PCPT model to value the put
Formula to calculate Probability:
Upside Probability = ert – d
u-d
Where
r = rate of interest per annum; t = time period in years
d = JP 1 / Current Price ; u = JP 2 / Current Price
Model 4: Binomial model:
❖ Step 1: Draw decision diagram
❖ Step 2: Identify market price on expiry dates
❖ Step 3: Write intrinsic value at various judgement price on expiry date
❖ Step 4: Taking into account the previous probabilities roll back the IV to the base.
This is the fair value of the option
❖ Step 5: Discount the value of step 4 to identify the fair value of option on day 0
Binomial model and American Option:

❖ Step 1: Draw decision diagram
❖ Step 2: Identify market price on expiry dates
❖ Step 3: Write intrinsic value at various judgement price on expiry date
❖ Step 4: The value of each previous node is higher of the following
o Value of immediate exercise
o Value of later exercise
❖ Step 5: Roll back to get the option value at base node
❖ Step 6: Discount the value of step 4 to identify the fair value of option on day 0
Model 5: Black – Scholes Model:

Assumptions:
❖ Applicable only for European options
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❖ Risk free rate of return is known and is constant over the life of the option
❖ The volatility of the underlying asset is known and is constant over the life of the
option
❖ The underlying asset’s CCRFI is known and follows normal distribution pattern
❖ The prices of underlying assets cannot be negative
❖ No transaction charges & tax
C0 = [ {S0 * N(d1) } – {PVEP * N(d2) }]
Where d1 = [Naturallog [S0/E)] + [{r+0.5SD2}t]
SD√t
Where d2 = [Naturallog [S0/E)] + [{r-0.5SD2}t]
SD√t
Or d2 = d1 - SD√t
S0=CMP; r =risk free rate per year; t =time in years and E =Exercise Price
Valuation of Put
P0 = [{PVEP * N(-d2) }{S0 * N(-d1) }]
Delta of an option:
❖ Delta is a ratio comparing the change in the price of an asset to the corresponding
change in the price of the derivative instrument.
❖ It is similar to beta of a stock which measures the percentage change in share price
for a corresponding change in market
❖ Example: A stock option having beta of 0.7 would mean that if price of share
increased by 1 rupee then the price of the option will increase by Rs.0.7
❖ Delta values can be positive or negative depending on the type of option. Call option
will have positive delta values as the increase in share price will lead to increase in
call value. However put option will have negative delta values as the increase in
share price will lead to decrease in put value
❖ Call option can have delta closer to 1 for deep in the money options whereas it will
have delta value closer to 0 for deep out of the money options
Delta = Change in option Price
Change in stock price
(or)
Delta of call option = N(D1) of Black Scholes Model
Delta of put option = Call delta -1
Delta values with dividend:
❖ In case the dividend is given in rupees then the current market price of the share is to
be replaced with CMP – PV of dividend income
❖ In case the dividend is given as % then delta is as under
o Call delta = N (d1) * e^-yt
o Put delta = Call delta - 1
Where y = Annualized dividend yield in %; Also additionally r is to be replaced with r-y
while calculating d1
Delta Hedging:
❖ Creating a riskless hedge using options and underlying stock is called as Delta
Hedging
❖ The investor should aim to make the delta adjusted value of the portfolio as zero to
have a delta neutral portfolio
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Topic 14: Valuation of Futures
1. Pricing future – Non-dividend paying stock

The stock of Y Limited, a non-dividend paying stock, is today selling at Rs.72. You wish to
enter into a futures contract on this stock maturing in 6 months’ time.
i. If the risk free rate of return is 12 percent per annum continuously compounded
what would be the futures price to be?
ii. If the price of futures contract is Rs.75, what action would you take?
iii. In case it is priced at Rs.77 will your decision change?
2. Calculation of today’s price

The 6-months forward price of a security is Rs.208.18. The borrowing rate is 8% per annum
payable with monthly rests. What should be the spot price? Rework if the borrowing rate
has quarterly compounding, half-yearly compounding and continuous compounding?
3. Pricing future –Dividend paying stock

Calculate the price of a 6 months futures contract on a share that is currently priced at Rs.75.
The share is expected to pay a Rs.2 dividend four months from today. The continuously
compounded risk free rate is 12 percent per annum. The contract size is 100. If the contract
value is Rs.7400 what action would follow? In case it is Rs.7800 what would you do?
4. Price future – Dividend paying stock

Consider a 3-months futures contract on New Gen Bank Ltd. quoting at Rs.1100. The
continuously compounded risk free rate of return is 12 percent per annum and the
continuously yield on the share is 4 percent per annum.
i. Find the value of the futures contract?
ii. What action would follow if futures are available at 1110?
iii. Will your position change if futures are available at 1150?
5. Pricing future – Storage costs

Gold futures have been opened up in India recently. A 3-month gold futures is available at
Rs.800 per gram. Suppose the current price of gold is Rs.775 per gram and that it costs Rs.5
per gram in arrears for the 3-monthly period to store gold.
i. What is the fair price if the CCRFI is 8% per annum?
ii. If the rental is 4 percent per annum instead of Rs.5 per gram and the CCRFI is 8% per
annum, what is the fair price of gold futures?
iii. If the futures price of Rs.770 per gram is to be considered as fair then what is the
implicit convenience yield
6. Arbitrage opportunity:
Spot price of Gold : Rs.30,000
Interest rate : 6%/10%
Transaction cost on buy or sell : 3%
❖ Define the no arbitrage boundary for a futures contract expiring in one year
❖ Rework the no arbitrage boundary if on short sell the trader can receive a fraction
amount of 80% from the broker
7. Pricing future
The following data relate to Anand Ltd.’s share price:
Current price per share Rs.1800
6 months future’s price/share Rs.1950
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Assuming it is possible to borrow money in the market for transactions in securities at 12%
per annum, you are expected:
❖ To calculate the theoretical minimum price of a 6-months forward purchase and
❖ To explain arbitrage opportunity
8. Pricing future [May 2012 RTP]

On 31-8-2011, the value of stock index was Rs.2,200. The risk free rate of return has been 8%
per annum. The dividend yield on this stock index is as under:
Month Dividend Paid p.a.
January 3%
February 4%
March 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 4%
November 3%
December 3%
Assuming that interest is compounded daily, find out the future price of contract deliverable
on 31-12-2011. Given e0.01583 = 1.01593
9. Calculation of fair futures price:

Suppose that there is a future contract on a share presently trading at Rs.1000. The life of
future contract is 90 days and during this time the company will pay dividends of Rs.7.50 in
30 days, Rs.8.50 in 60 days and Rs.9.00 in 90 days. Assuming that the CCRFI is 12%, you are
required to find out:
❖ Fair value of the contract if no arbitrage opportunity exists
❖ Value of cost to carry
10. Calculation of fair futures price:

Nifty futures trade on NSE as one, two and three months contracts. Spot nifty stands at 1200.
BSAF which currently trades at Rs.120 has a weight of 5% in Nifty. It is expected to declare a
dividend of Rs.20 per share after 15 days of purchasing the contract. The cost of borrowing is
15% per annum. What will be the price of new two month futures contract on Nifty?
11. Calculation of interest rate

Suppose current price of an index is Rs.13,800 and yield on index is 4.8% (p.a.). A 6-
month future contract on index is trading at Rs.14,340. Assuming that Risk Free Rate of
Interest is 12%, show how Mr. X (an arbitrageur) can earn an abnormal rate of return
irrespective of outcome after 6 months. You can assume that after 6 months index closes
at Rs. 10,200 and Rs. 15,600 and 50% of stock included in index shall pay dividend in
next 6 months. Also calculate implied risk free rate.
12. Calculation of profit/loss:

Mr. X bought NIFTY futures of Rs.10,00,000 on January 1, 2017 for delivery on March 31,
2017. The nifty lot size is 200. Calculate the profit/loss if NIFTY future on maturity date is:
❖ 6,000
❖ 4,500
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13. Arbitrage through futures

Mr. X, is a Senior Portfolio Manager at ABC Asset Management Company. He expects to
purchase a portfolio of shares in 90 days. However he is worried about the expected price
increase in shares in coming day and to hedge against this potential price increase he
decides to take a position on a 90-day forward contract on the Index. The index is currently
trading at 2290. Assuming that the continuously compounded dividend yield is 1.75% and
risk free rate of interest is 4.16%, you are required to determine:
❖ Calculate the justified forward price on this contract.
❖ Suppose after 28 days of the purchase of the contract the index value stands at 2450
then determine gain/ loss on the above long position.
❖ If at expiration of 90 days the Index Value is 2470 then what will be gain on long
position.
Note: Take 365 days in a year and value of e0.005942 = 1.005960 & e0.001849 = 1.001851
14. Pricing future and arbitrage opportunity
Calculate the price of 3 months PQR futures, if PQR (FV Rs.10) quotes Rs.220 on NSE
and the three months future price quotes at Rs.230 and the one month borrowing rate
is given as 15 percent and the expected annual dividend yield is 25 percent per
annum payable before expiry. Also examine arbitrage opportunities.
15. Pricing future and arbitrage opportunity

The share of X Ltd. is currently selling for Rs.300. Risk free interest rate is 0.8% per
month. A three months futures contract is selling for Rs.312. Develop an arbitrage
strategy and show what your riskless profit will be 3 month hence assuming that X Ltd.
will not pay any dividend in the next three months.
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Topic 15: Hedging with Futures
1. Hedging with futures

BSE 5000
Value of portfolio Rs.10,10,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5
We assume that a future contract on the BSE index with four months maturity is used to
hedge the value of portfolio over next three months. One future contract is for delivery of 50
times the index. Based on the above information calculate:
❖ Price of future contract.
❖ The gain on short futures position if index turns out to be 4,500 in three months.

A Mutual Fund is holding the following assets
Investments in diversified equity shares Rs.90 Crores
Cash and Bank Balances Rs.10 Crores
The Beta of the portfolio is 1.1. The index future is selling at 4300 level. The Fund
Manager apprehends that the index will fall at the most by 10%. How many index
futures he should short for perfect hedging? One index future consists of 50 units.
Substantiate your answer assuming the Fund Manager's apprehension will materialize.

A trader is having in its portfolio shares worth Rs.85 lakhs at current price and cash
Rs.15 lakhs. The beta of share portfolio is 1.6. After 3 months the price of shares dropped
by 3.2%. Determine:
❖ Current portfolio beta
❖ Portfolio beta after 3 months if the trader on current date goes for long
position on Rs. 100 lakhs Nifty futures.

Identify the action to be taken in respect of the following situations?
Stock beta Stock Position Stock value (Rs. lakh) Hedge needed
0.8 Long 2 Full
1.2 Long 5 Full
0.9 Short 1 Full
1.0 Long 2 50%
1.3 Short 4 110%
5. Hedge ratio
A company is long on 10 MT of Rs. 474 per kg (spot) and intends to remain so for the
ensuing quarter. The standard deviation of changes of its spot and future prices are
4% and 6% respectively, having correlation coefficient of 0.75. What is its hedge ratio?
What is the amount of the Rs future it should short to achieve a perfect hedge?
6. Residual risk
The beta of ABC Limited is 1.3 and the total risk of ABC Limited is 9. The daily SD of Nifty
is 1.6. Once complete hedging is done, how much risk is left with?
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On January 1, 2013 an investor has a portfolio of 5 shares as given below:
Security Price No.of Shares β
A 349.30 5,000 1.15
B 480.50 7,000 0.40
C 593.52 8,000 0.90
D 734.70 10,000 0.95
E 824.85 2,000 0.85
The cost of capital to the investor is 10.5% per annum. You are required to calculate.
I. The beta of his portfolio.
II. The theoretical value of the NIFTY futures for February 2013.
III. The number of contracts of NIFTY the investors needs to sell to get a full hedge until
February for his portfolio if the current value of NIFTY is 5900 and NIFTY futures are
trading lot requirement of 200 units. Assume that the futures are trading at their fair
value.
IV. The number of future contracts the investor should trade if he desire to reduce the
beta of his portfolios to 0.6
(No. of days in a year be treated as 365. Given: in (1.105) = 0.0998 e (0.015858) =1.01598)

On April 1, 2015, an investor has portfolio consisting of eight securities as shown below:
Security Price No. of shares β
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of capital for the investor is given to be 20% per annum. The investor fears a fall in
the prices of the shares in the near future. Accordingly, he approaches you for advice. You
can make use of the following information/assumptions:
❖ The current S&P CNX Nifty value is 8500.
❖ S&P CNX Nifty futures can be traded in units of 25 only.
❖ The May futures are currently quoted at 8700 and the June Futures are being quoted
at 8850.
You are required to:

I. Calculate the beta of his portfolio.
II. Calculate the theoretical value of the futures contracts according the investor for
contracts expiring in (1) May, (2) June. [Given e0.03 = 1.03045; e0.04 = 1.04081; e0.05 =
1.05127]
III. Calculate the number of units of S&P CNX Nifty that he would have to sell if he
desires to hedge until June (1) his total portfolio, (2) 90% of his portfolio and (3) 120%
of his portfolio.
IV. Determine the number of futures contracts the investor should trade if he desires to
reduce the beta of his portfolio to 0.9.
9. Stock hedging – long position
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You have bought 2045 shares of LP Limited. LP has a beta of 1.1 with the sensex. Each
sensex contract is equal to 50 units. LP now quotes at Rs.100 and the sensex futures is
available at 4500 index points. Required:
i. How many futures contracts will you have to take?
ii. If the price of the spot market drops by 12 percent how are you protected?
iii. If the price in the spot market jumps up by 5 percent, what happens?
iv. Calculate the profit if LP limited falls to 97 and sensex falls to 4410
10. Stock hedging – short position

Consider the following data relating to KM stock. KM has a beta of 0.7 with NIFTY. Each
Nifty contract is equal to 200 units. KM now quotes at Rs.150 and the Nifty futures is 1400
Index points. You expect prices to fall and have gone short on 8000 shares of KM in the spot
market.
i. How many futures contracts will you have to take?
ii. Suppose the price in the spot market drops by 10 percent, how are you protected?
iii. Suppose the price in the spot market jumps up by 5 percent, what happens?
iv. Calculate the profit if KM stock increases to 160 and nifty increases to 1600.

A portfolio manager has the following five stocks in his portfolio
Security No of shares Price/share Beta
A 10000 50 1.2
B 5000 20 2.0
C 8000 25 0.7
D 1000 100 1.0
E 500 200 1.3
i. Compute portfolio beta?
ii. If the manager wants to reduce the beta to 0.8, how much risk free investment would
he bring in? What will be the new portfolio?
iii. If the manager wants to increase the beta to 1.4, how much of risk free investment
should he sell? What will be the new portfolio?
iv. Suppose Nifty spot is 1200 points and Nifty futures is 1250 points and futures have a
contract multiplier of 200, how can he obtain the same position as in (ii) by dealing in
Nifty futures?
v. How can he obtain the same position as in (iii) by dealing in Nifty futures?

Which position on the index future gives a speculator, a complete hedge against the
following transactions:
❖ The share of Right Limited is going to rise. He has a long position on the cash
market of Rs. 50 lakhs on the Right Limited. The beta of the Right Limited is 1.25.
❖ The share of Wrong Limited is going to depreciate. He has a short position on
the cash market of Rs. 25 lakhs on the Wrong Limited. The beta of the Wrong
Limited is 0.90.
❖ The share of Fair Limited is going to stagnant. He has a short position on
the cash market of Rs. 20 lakhs of the Fair Limited. The beta of the Fair Limited is
0.75.

Ram buys 10,000 shares of X Ltd. at a price of Rs. 22 per share whose beta value is 1.5
and sells 5,000 shares of A Ltd. at a price of Rs. 40 per share. He obtains a complete
104 | P a g e
hedge by Nifty futures at Rs. 1,000 each. He closes out his position at the closing
price of the next day when the share of X Ltd. dropped by 2%, share of A Ltd.
appreciated by 3% and Nifty futures dropped by 1.5%. What is the Beta of A Limited if the
overall loss of the investor is Rs.11,450?
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Topic 16: Maintenance Margin and Open Interest
1. Maintenance of margin – Mark to Market

On November 15 when the spot price of Telco is Rs.473/share, Mr. X buys 15 contracts of
July Telco Futures at 491. Assume that the initial margin for Telco Futures is Rs.800 per
contract, and the maintenance margin is Rs.600 per contract. Given that each contract is for
50 shares. Daily settlement prices for the next few days are as follows:
❖ November 15 – Rs.496
Assume that Mr. X withdraws profits from his margin account only once on November 16th
when he withdraws half the maximum amount allowed. Compute the balance in the
account at the end of each of these 5 days
2. Maintenance of margin – Mark to Market

Sensex futures are traded at a multiple of 50. Consider the following quotations of sensex
futures in the 10 trading days during February, 2017:
Day High Low Closing
4-2-09 3306.4 3290.0 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60
You have bought one sensex futures contract on February 04. The average daily absolute
change in the value of the contract is Rs.10,000 and standard deviation of these changes is
Rs.2,000. The maintenance margin is 75% of initial margin. You are required to determine
the daily balances in the margin account and payment of margin calls, if any.
3. Concept of open interest

Day Transaction No of contracts
1 A (long) with B (short) 100 contracts
X (long) with Y (short) 50 contracts
2 A (short) with X (long) 50 contracts
B (short) with Y (long) 100 contracts
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Topic 17: Basics of Option
1. Spot the option terms

The Infosys stock is selling at Rs.5,000. Mr.X has a negative view about the stock. He decides
to go through the option route to take advantage of the situation. He buys an option from
Mr.A which will entitle him to sell 100 shares on or before 30th December at Rs.4,500 per
share for which has to pay Rs.20 per share today. Identify:
i. Type of option
ii. Exercise price
iii. Expiry date
iv. Option premium
v. Buyer of the option
vi. Writer of the option
vii. Underlying asset and
viii. Current market price
2. Spot the option terms

The WIPRO stock is selling at Rs.700. Mr.Z thinks that the stock price will rise. He decides to
go through the option route to take advantage of the situation. He buys an option from Mr.K
which will entitle him to buy 100 shares on or before 30th December at Rs.725 per share for
which has to pay Rs.10 per share today. Identify type of option, exercise price, expiry date,
option premium, buyer of the option, writer of the option, underlying asset and the current
market price?
3. Option status
State whether each one of the following is in the money, at the money or out of the money
Option Exercise Price Stock Price Status
Call 60 55
Call 50 50
Call 110 105
Call 30 35
Put 110 100
Put 105 105
Put 12 15
Put 25 20
4. Taking position
The strike price and the expected price on expiry are given in columns 1 and 2 respectively.
The option expires 3 months down the road. What position would you take? The actual
price on the expiry date is given in column 3. What action will be taken on maturity date?
Exercise Price Expected price on expiry Actual price on expiry
180 160 180
125 125 130
160 175 155
170 155 160
150 160 150
110 110 100
150 155 165
170 160 180
95 95 95
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5. Intrinsic value
Consider the data relating to a stock contained in the following table. Determine both the
intrinsic value and the time value in each of the cases.
Option Exercise Asset Price Option Price Intrinsic value Time value
Call 90 100 5
Call 110 100 2
Put 200 100 65
Put 90 100 4
Put 150 125 30
Call 150 125 30
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Topic 18: Option Strategies
1. Payoff for call option

The September option on AB corp stock at a strike price of Rs.130 is available at a call option
price of Rs.10. The contract size is 100 shares. The price of the stock today in 15 June is
Rs.140. A range of prices beginning from 110 and ending with 160 with intervals of 10 is
possible as at the expiry date.
i. What is the payoff for the call holder on expiration?
ii. Draw the payoff graph
iii. What is the call writer’s payoff on expiration
iv. Draw the payoff table and the payoff graph
2. Payoff for put option

The September put option on JB Ltd stock at a strike price of Rs.110 is available at a price of
Rs.10. The contract size is 100 shares. The price of the stock today on 15 June is Rs.115. A
range of prices beginning from 90 and ending with 140 with intervals of 10 is possible as at
the expiry date.
i. What is the payoff for the put holder on expiration
ii. Draw the payoff graph
iii. What is the put writer’s payoff on expiration?
iv. Draw the payoff table and the payoff graph
3. Application of option strategy:

Mr. A is considering writing a 30-day option on ABC Limited which is currently trading at
Rs.60 per share. The exercise price of the share is also Rs.60 and the premium received on the
option will be Rs.3.75. At what share prices will he make money, at what price will he start
to lose money and at what prices will he lose Rs.5 and Rs.10 on each option that is written?
4. Payoff for option strategy

The equity share of VCC Ltd. is quoted at Rs. 210. A 3-month call option is
available at a premium of Rs. 6 per share and a 3-month put option is available at a
premium of Rs. 5 per share. Ascertain the net payoffs to the optionholder of a call option
and a put option.
❖ the strike price in both cases in Rs. 220; and
❖ the share price on the exercise day is Rs. 200,210,220,230,240.
Also indicate the price range at which the call and the put options may be gainfully
exercised.
5. Payoff for option strategy

A call and put exist on the same stock each of which is exercisable at Rs. 60. They now trade
for:
Market price of Stock or stock index Rs.55
Market price of call Rs.9
Market price of put Rs.1
Calculate the expiration date cash flow, investment value, and net profit from:
a) Buy 1.0 call
b) Write 1.0 call
c) Buy 1.0 put
d) Write 1.0 put
for expiration date stock prices of Rs. 50, Rs. 55, Rs. 60, Rs. 65, Rs. 70.
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6. Option strategies:
Consider a call and put option on the same underlying stock. Both options have an exercise
price of Rs.75. The call costs Rs.5 and the put costs Rs.4. The stock price is expected to be in
the range of Rs.50 to Rs.90. Prepare a payoff table and payoff graph for:
❖ Long straddle
❖ Short straddle
7. Option strategies:
Consider a call and put option on the same underlying stock. The call has an exercise price
of Rs.100 and put has an exercise price of Rs.90. The call costs Rs.20 and the put costs Rs.12.
The stock price is expected to be in the range of Rs.50 to Rs.150. Prepare a payoff table and
payoff graph for:
❖ Long strangle
❖ Short strangle
8. Bull and bear spread

For each of the following cases, name the strategy adopted and calculate the profit/loss of
different price range of the stock. Also compute the break-even price. Draw the payoff table
and the payoff graph.
Type of Exercise price of Exercise price of Premium on Premium on
option option bought option sold option bought option sold
Call 60 70 9 4
Call 80 75 2 6
Put 70 65 9 5
Put 50 60 4 11
9. Butterfly spread
A stock is selling at 62. An investor observes the market price of 3-month calls and notes the
following:
Exercise Price Call Price
55 10
60 7
65 5
The investor chooses to go long on two calls (55 and 65) and writes two calls with an
exercise price of Rs.60. Name the strategy adopted. Determine his payoff function for
different levels of stock prices. Also, find his profit or loss when the stock price at maturity is
❖ 52
❖ 57
❖ 64 and
❖ 70
10. Payoff for option

The market received rumour about ABC corporation’s tie-up with a multinational
company. This has induced the market price to move up. If the rumour is false, the
ABC corporation stock price will probably fall dramatically. To protect from this an
investor has bought the call and put options. He purchased one 3 months call with a
striking price of Rs.42 for Rs.2 premium, and paid Re.1 per share premium for a 3
months put with a striking price of Rs.40.
❖ Determine the Investor’s position if the tie up offer bids the price of ABC
Corporation’s stock up to Rs.43 in 3 months.
❖ Determine the Investor’s ending position, if the tie up programme fails and the
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price of the stocks falls to Rs. 36 in 3 months.
11. Strangle
A call option on a stock with an exercise price of Rs.70 is available for Rs.6 while a put
option on the same stock with the same expiration date with an exercise price of Rs.60 is
selling for Rs.8. How can a strangle be created by using these options? Draw the payoff table
and the payoff graph.
12. Option strategy

Mr. X established the following spread on the Delta Corporation’s stock :
Purchased one 3-month call option with a premium of Rs. 30 and an exercise price
of Rs. 550. Purchased one 3-month put option with a premium of Rs. 5 and an exercise
price of Rs. 450. Corporation’s stock is currently selling at Rs. 500. Determine profit or
loss, if the price of Delta Corporation’s :
❖ remains at Rs.500 after 3 months.
❖ falls at Rs.350 after 3 months.
❖ rises to Rs.600.
Assume the size option is 100 shares of Delta Corporation.
13. Option strategy

The current spot price of share of ABC Ltd. is Rs. 121.00 with strike price Rs. 125.00
and Rs. 130.00 are trading at a premium of Rs. 3.30 and Rs. 1.80 respectively. Mr. X, a
speculator is bullish about the share price over next six months. However, he is also
of belief that share price could also go down. He approaches to you for advice, you are
required to:
❖ Suggest a strategy that Mr. X can adopt which puts limit on his gain and loss.
❖ How much is maximum possible profit.
❖ Draw out a rough diagram of the strategy adopted.
❖ What will be break-even price of the share?
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Topic 19: Option Valuation
1. Setting up Put
X Limited is quoting at Rs.85. A three-month call can be written at Rs.7. The exercise price is
Rs.90. CCRFI is 10 percent per annum. Required:
i. If puts on X Limited are not traded but you want to create the same, how would you
do it? In case the market is not favorable, how are you protected?
ii. If puts are traded, what would it quote?
2. Put call parity

Three month call and three month put are available on Multan Ltd’s stock. The exercise
price is Rs.100. The CCRFI is 12% p.a.
i. If the put rules at Rs.5, and the share is worth Rs.95, Compute the value of the call.
ii. If the put quotes Rs.3 and the call is worth Rs.4 what is the share worth?
iii. If the market price of the call is Rs.8 and the market price of the share is Rs.102, what
is the value of the put?
iv. Rework the above three scenarios in case dividend of Rs.1 is to be paid at the end of
first month.
3. Put call parity theory – arbitrage opportunity:

Consider the following data:
Exercise price of option : Rs.50
Share price : Rs.60
Call option price : Rs.16
Put option price : Rs.2
Time to expiration of both options is 3 months and the risk free rate is 12%.
❖ Determine if the put-call parity is working?
❖ Is there any arbitrage opportunity existing? If so how an investor could gain from it
❖ Rework if the put option was quoting at Rs.8.
❖ Rework the problem if dividend of Rs.2 per share is expected at the end of month 2.
4. Portfolio replication model

From the following data compute the value of the call option using replicating model. First
use the stock equivalent approach and then the option equivalent approach. Are the results
different? Also find value of put.
Upper price 90
Lower price 70
Time 1 year
CMP 75
Exercise price 65
T bill rate (p.a.) 4%
5. Portfolio replication model

In one year’s time R Ltd’s stock will either halve in value to Rs.50 or it will rise to Rs.200.
The one-year interest rate is 10%. Assume exercise price as Rs.100.
i. Use the stock equivalent approach to value this call
ii. Use the option equivalent approach to value this call
iii. Are the results different?
iv. Find the value of put?
6. Risk Neutral model

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The current market price of an equity share of Penchant Ltd is Rs.420. Within a
period of 3 months, the maximum and minimum price of it is expected to be Rs. 500 and
Rs. 400 respectively. If the risk free rate of interest be 8% p.a., what should be the value
of a 3 months Call option under the “Risk Neutral” method at the strike rate of Rs. 450 ?
Given e0.02 = 1.0202
7. Calculation of probability of price rise

Sumana wanted to buy shares of ElL which has a range of Rs.411 to Rs.592 a month
later. The present price per share is Rs.421. Her broker informs her that the price of this
share can sore up to Rs. 522 within a month or so, so that she should buy a one month
CALL of ElL. In order to be prudent in buying the call, the share price should be
more than or at least Rs. 522 the assurance of which could not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the
probability of attaining the share price Rs. 592 so that buying of a one month CALL of
EIL at the execution price of Rs. 522 is justified. Advice her. Take the one-month risk
free interest to be 3.60% and e 0.036 = 1.037
8. Binomial model
The current share price is Rs.20 and share price volatility has been estimated to be either 10%
up or down. The risk free interest rate is 12% p.a. Using two period binomial, estimated the
fair price of 6 months call option with a strike price of Rs.21.
9. Binomial model
A stock is currently priced at Rs.50. It is known that in the first 6 months of current year
from now prices will either rise by 20% or go down by 20%, further in the later half of the
year prices may again up by 20% or go down by 20%. Suppose risk free rate is 5%
continuous compounded and strike rate is Rs.52. Calculate value of European Put option?
Also calculate the value of European call option
10. Binomial model

ABC Limited is a newly listed company and its price today is Rs.200. Analysts expect the
price of ABC Limited to either rise by 40% every half year or fall by 20% every half year, for
the next one year, weightage being 40% for every increase and 60% for every fall. If a one
year option carries an exercise price of Rs.260, you are required to compute the following
under binomial model
❖ Risk free rate of return
❖ Future and Present Value of call
❖ Future and Present Value of Put
11. Binomial model

A stock index is at 5000 points. There is a 50% probability that it will change either up by 20
points or down by 10 points in each month. Consider an American call option on this index
with an exercise price of 5020, which will expire in three months.
i. Find the value of the American call if risk free rate is 8%?
ii. If the actual price of the call were Rs.12, what strategy would you adopt?
iii. If the actual price of the call were Rs.8, what strategy would you adopt?
12. Binomial model

A stock index is at 5000 points. There is a 50% probability that it will change either up by 20
points or down by 10 points in each month. Consider an American put option on this index
with an exercise price of 5020, which will expire in three months.
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i. Find the value of the American put?
ii. If the actual price of the put were Rs.12, what strategy would you adopt?
iii. If the actual price of the put were Rs.28, what strategy would you adopt?
13. Binomial model

Consider a two year American call option with a strike price of Rs. 50 on a stock the
current price of which is also Rs. 50. Assume that there are two time periods of one
year and in each year the stock price can move up or down by equal percentage of
20%. The risk free interest rate is 6%. Using binominal option model, calculate the
probability of price moving up and down. Also draw a two step binomial tree showing
prices and payoffs at each node.
14. Valuation of option:

Ramesh owns a plot of land on which he intends to construct apartment units for sale. No. of
apartment units to be constructed may be either 10 or 15. Total construction costs for these
alternatives are estimated to be Rs. 600 lakhs or Rs. 1025 lakhs respectively. Current market
price for each apartment unit is Rs. 80 lakhs. The market price after a year for apartment
units will depend upon the conditions of market. If the market is buoyant, each apartment
unit will be sold for Rs. 91 lakhs, if it is sluggish, the sale price for the same will be Rs. 75
lakhs. Determine the current value of vacant plot of land. Should Ramesh start construction
now or keep the land vacant? The yearly rental per apartment unit is Rs. 7 lakhs and the risk
free interest rate is 10% p.a. Assume that the construction cost will remain unchanged.
15. Valuation of option

IPL already in production of Fertilizer is considering a proposal of building a new plant to
produce pesticides. Suppose, the PVof proposal is Rs. 100 crore without the abandonment
option. However, it market conditions for pesticide turns out to be favourable the PV of
proposal shall increase by 30%. On the other hand market conditions remain sluggish the
PV of the proposal shall be reduced by 40%. In case company is not interested in
continuation of the project it can be disposed off for Rs. 80 crore. If the risk free rate of
interest is 8% than what will be value of abandonment option
16. Black-scholes model

Following information is available for X Ltd's shares:
Current share price 185
Option exercise price 170
Risk free interest rate 7%
Time of the expiry of option 3 years
Standard deviation 0.18
Calculate the value of the option using Black-Scholes formula. Rework the problem if
dividend of Rs.2 is expected at end of year 1, 2 & 3.
17. Black-scholes model
From the following details find the value of call option
Current share price 80
Option exercise price 75
Risk free interest rate 12%
Maturity period 6 months
Standard deviation 0.40
Given:
Number of SD from mean Area of the left or right (one tail)

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0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
e0.06 = 1.062 In 1.0667 = 0.0646
18. Miscellaneous – Expected value

You as an investor had purchased a 4 month call option on the equity shares of X Ltd. of
Rs.10, of which the current market price is Rs. 132 and the exercise price Rs. 150. You
expect the price to range between Rs. 120 to Rs. 190. The expected share price of X Ltd.
and related probability is given below:
Expected Price 120 140 160 180 190
Probability 0.05 0.20 0.50 0.10 0.15
Compute the following:
❖ Expected Share price at the end of 4 months.
❖ Value of Call Option at the end of 4 months, if the exercise price prevails.
❖ In case the option is held to its maturity, what will be the expected value of
the call option?
19. Option valuation

Mr.Dayal is interested in purchasing equity shares of ABC Ltd. which are currently selling
at Rs. 600 each. He expects that price of share may go upto Rs. 780 or may go down to
Rs. 480 in three months. The chances of occurring such variations are 60% and 40%
respectively. A call option on the shares of ABC Ltd. can be exercised at the end of
three months with a strike price of Rs. 630.
❖ What combination of share and option should Mr. Dayal select if he wants a
perfect hedge?
❖ What should be the value of option today (the risk free rate is 10% p.a.)?
❖ What is the expected rate of return on the option?
115 | P a g e
Topic 20: Delta Hedging
1. Delta Hedging:
A trader sold 20 option contracts (2000 options) on a certain stock. The option price is USD
10, the stock price is USD 100 and option delta is 0.6.
❖ Suggest a hedge strategy to make the portfolio delta neutral
❖ Suppose due to share price increase, the delta changes to 0.65, under a dynamic
hedge strategy, what should the trader do?
2. Delta Hedging:
Find the delta of the following individual positions of a stock X given the delta of call = +1
and of put = -1
❖ 4 long calls
❖ 2 short puts
❖ 6 long puts and long 4 shares
❖ 5 short calls and short 5 shares
❖ 4 long puts and short 4 shares
❖ 3 long calls and long 3 shares
3. Delta computation:
Calculate delta of an at-the-money six month European call option for a non-dividend
paying stock when the risk free rate is 10% per annum and the stock price volatility is 25%.
What should be the delta if this is a European put option? Recalculate the delta of the
European call and put option if the dividend yield is 4% for the aforesaid stock
4. Portfolio delta hedging:

Consider a financial institution that has the following positions in USD options:
Option Position Strike Price Expiration Delta
1 lacs call Long USD 0.55 3 months 0.533
2 lacs call Short USD 0.56 5 months 0.468
50000 put Short USD 0.56 2 months -0.508
Make the portfolio delta neutral. How is hedging portfolio cheaper than hedging individual
stocks?
116 | P a g e
Topic 21: Interest rate futures and options
1. Interest rate caps and floors
Suppose that a 1-year cap has a cap rate of 8% and a notional amount of Rs.100 Crores. The
frequency of settlement is quarterly and the reference rate is 3-months MIBOR. Assume that
3-month MIBOR for the next four quarters is shown below:
Quarters 3-months MIBOR
1 8.70
2 8.00
3 7.80
4 8.20
You are required to compute payoff for each quarter

Suppose that a 1-year floor has a floor rate of 4% and a notional amount of Rs.100 Crores.
The frequency of settlement is quarterly and the reference rate is 3-months MIBOR. Assume
that 3-month MIBOR for the next four quarters is shown below:
Quarters 3-months MIBOR
1 4.70
2 4.40
3 3.80
4 3.40
You are required to compute payoff for each quarter

XYZ Limited issues a GBP 10 million floating rate loan on July 1, 2013 with resetting of
coupon rate every 6 months equal to LIBOR + 0.50%. XYZ is interested in a collar strategy by
selling a floor and buying a cap. XYZ buys 3 years cap and sell 3 years floor as per the
following details on July 1, 2013.
❖ Notional principal amount : USD 10 million
❖ Reference rate : 6 months LIBOR
❖ Strike rate : 4% for floor and 7% for cap
❖ Premium : 0 as premium paid on cap is
compensated by premium receive on floor
Using the following data you are required to determine:

❖ Effective interest rate paid out at each reset date
❖ The average overall effective rate of interest
Reset Date LIBOR (%)
31-12-2013 6.00
30-06-2014 7.00
31-12-2014 5.00
30-06-2015 3.75
31-12-2015 3.25
30-06-2016 4.25
4. Caps
XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period
of 24 months. The company anticipates a rise in LIBOR, hence it proposes to buy a
Cap Option from its Bankers at the strike rate of 8.00%. The lump sum premium
is 1.00% for the entire reset periods and the fixed rate of interest is 7.00% per
117 | P a g e
annum. The actual position of LIBOR during the forthcoming reset period is as under:
Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%
You are required to show how far interest rate risk is hedged through Cap Option.
For calculation, work out figures at each stage up to four decimal points and amount
nearest to £. It should be part of working notes.
5. Collar
a) A company has decided to take a 3 –year floating rate loan of $25 million to finance a
project. The loan is indexed to a 6 month LIBOR with a spread of 100 BP. The current
level of LIBOR is 5.75%. The company thinks that the projected cash flows from the
project will enable it to service the loan as long as the interest cost did not exceed
8.5%. A 3 year interest rate cap with a face value of $25 million and a strike rate of 7%
is available for a premium of 3.75 %. Calculate the effective cost of the capped loan
for the following scenario of LIBORs on the next 5 roll over dates: 5.50%, 6.00%,
6.25%, 6.50%,& 6.75( use a rate of 7% to amortize the premium).
b) The above company is offered an interest rate collar with strike rates of 5.75% and
6.5% respectively for a net premium of 2%. Under this, the company has to
compensate the seller of the collar if LIBOR falls below 5.75%, while the seller
compensates the company if LIBOR rises above 6.5%. Compute the effective cost of
the loan under the same scenario?
6. Interest rate futures
In two months time, ABC Limited will receive Rs.3.9 million which it wants to deposit in
money market for three months. ABC Limited at present can deposit at 8% per annum, but
the treasurer fears a decrease in interest rate after two months and hence wishes to hedge
using interest rate futures. Three months futures are currently priced at 93. The standard
contract size in the futures market is 0.5 million.
❖ What strategy should the treasurer adopt to hedge the interest rate risk?
❖ If after two months, the futures are priced at 90.75 and interest rate increases to
10.5%, what would be the effective interest income earned by ABC Limited due to
adoption of this strategy? Also calculate the hedge efficiency?
❖ If after two months, the futures are priced at 94.25 and interest rate falls to 6.5%,
what would be the effective interest income earned by ABC Limited due to adoption
of this strategy? Also calculate the hedge efficiency?
7. Interest rate futures

The monthly cash budget of ABC Limited shows that the company is likely to need Rs.18
million in two month’s time for a period of four months. Financial markets have recently
been volatile, and the finance director fears that short term interest rates could rise by as
much as 150 ticks (1.5%). LIBOR is currently 6.5% and ABC can borrow at LIBOR + 0.75%.
The 3 months futures prices (contract size = Rs.5,00,000) are as follows:

❖ December 93.40
❖ March 93.10
❖ June 92.75
Assume that it is now 1 December and that exchange traded futures contracts expire at the
end of the month. You are required to estimate the result of undertaking an interest rate
futures hedge if LIBOR increases by 150 ticks (1.5%) and March future increases by 130 ticks
(1.3%).
118 | P a g e
Topic 22: Forward Rate Agreements
1. FRA
M/s. Parker & Co. is contemplating to borrow an amount of Rs.60 crores for a
period of 3 months in the coming 6 month's time from now. The current rate of
interest is 9% p.a., but it may go up in 6 month’s time. The company wants to hedge
itself against the likely increase in interest rate. The Company's Bankers quoted an FRA
(Forward Rate Agreement) at 9.30% p.a. What will be the effect of FRA and actual rate of
interest cost to the company, if the actual rate of interest after 6 months happens to be (i)
9.60% p.a. and (ii) 8.80% p.a.?
2. Forward loan arrangement versus FRA

ABC Limited estimates that it would need Rs.50 lacs in two months time for a six month
period. The current 6 months money market interest rate is 5.50%-6.00%. But it feels that
over the next two months, interest rates will rise. The other details obtained from the money
market are as follows:
Two months 5.25% - 5.75%
Six months 5.5% - 6.00%
Eight months 5.625% - 6.1255%
❖ Explain how ABC Limited could hedge its interest rate exposure by means of
forward loan
❖ If ABC Limited wants to enter into an agreement with the bank for FRA, what will be
the forward interest rate that would be quoted by the Bank
❖ If on the date of borrowing the actual interest rate becomes 8%, explain how the FRA
will be given effect?
❖ If on the date of borrowing the actual interest rate becomes 5%, explain how the FRA
will be given effect?
3. FRA
The following market data is available:
Spot USD/JPY 116.00
Deposit rates p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward Rate Agreement (FRA) for Yen is 0.25%.
a) What should be 3 months FRA rate at 3 months forward?
b) The 6 & 12 months LIBORS are 5% and 6.5% respectively. A bank is quoting 6/12
USD FRA at 6.50 – 6.75%. Is any arbitrage opportunity available?
4. FRA
Two companies ABC Limited and XYZ Limited approach DEF Bank for FRA (Forward Rate
Agreement). They want to borrow Rs.100 Crores after 2 years for a period of 1 year. Bank
has calculated yield curve of both companies as follows:
Year XYZ Limited ABC Limited
1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
❖ You are required to calculate the rate of interest DEF Bank would quote under 2v3
FRA, using the company’s yield information as quoted above
119 | P a g e
❖ Suppose bank offers Interest rate guarantee for a premium of 0.1% of the amount of
loan, you are required to calculate the interest payable by XYZ Limited if interest in 2
years turns out to be
o 4.50%
o 5.50%
5. FRA
Electraspace is consumer electronics wholesaler. The business of the firm is highly
seasonal in nature. In 6 months of a year, firm has a huge cash deposits and especially near
Christmas time and other 6 months firm cash crunch, leading to borrowing of money to
cover up its exposures for running the business. It is expected that firm shall borrow a sum
of €50 million for the entire period of slack season in about 3 months.
A Bank has given the following quotations:
❖ Spot 5.50% - 5.75%
❖ 3 × 6 FRA 5.59% - 5.82%
❖ 3 × 9 FRA 5.64% - 5.94%
3 month €50,000 future contract maturing in a period of 3 months is quoted at 94.15 (5.85%).
You are required to determine:
❖ How a FRA, shall be useful if the actual interest rate after 6 months turnout to be:
o 4.5%
o 6.5%
❖ How 3 months Future contract shall be useful for company if interest rate turns out
as mentioned in part (a) above.
120 | P a g e
Topic 23: Interest Rate Swaps
1. Mechanism of Interest rate swap

A and B Limited have entered into a three year swap on March 5, 2010 wherein A agrees to
pay a fixed rate of interest of 5 percent per annum and B agrees to pay LIBOR on a notional
principal of 100 million USD. The agreement specifies the payment to be arranged every six
months. The floating rate of interest on various reset dates happened to be as follows:
Date Floating rate
5/3/10 4.2
5/9/10 4.8
5/3/11 5.3
5/9/11 5.5
5/3/12 5.6
5/9/12 5.9
5/3/13 6.4
❖ Calculate the net cash flow to A and B from the swap arrangement
❖ Comment upon A and B regarding their view on interest rates
❖ A Limited has borrowed money at a floating rate of LIBOR + 0.10% and B Limited
has borrowed at fixed rate of 5.2%. A Limited wants to transform its floating rate
loan into fixed rate and B Limited wants to transform its fixed rate to floating rate.
Illustrate how swap has been structured and what is the effective borrowing cost
post swap arrangement.
2. Interest rate swap

Madagascar Limited is an Indian company. They are in the process of raising a US dollar
loan and are negotiating the rates with a foreign bank. The company has been offered a fixed
rate of 8 percent with a proviso that they should opt for a floating rate, the interest rate is
likely to be linked to the bench mark rate of 60 basis points over 10 year US T Bill rate with
interest refixation on a three-monthly basis. The expectations of Madagascar Limited are
that the Dollar interest rates will fall and are inclined to have a flexible mechanism built into
their interest rates. On enquiry they find that they could go for a swap arrangement with
Syndicate India Limited who have been offered a floating rate of 120 basis points over 10
year T Bill rate as against a fixed rate of 9.20 percent. Describe the swap on the assumptions
that
• The swap differential is shared between the two equally or
• The swap differential is shared between Madagascar and Syndicate in the ratio of 3:1
• The swap banker charges 0.1% as charges and swap benefits are shared equally

There are two firms A and B. Firm A has invested USD 100 million in fixed rate bonds
yielding 8.5 percent. Firm A is not a highly rated firm and it has raised its loan for funding
its assets through floating rate loan from bank at an interest rate of LIBOR + 0.50%. Firm B
has invested USD 100 million in floating rate bond yielding LIBOR + 0.75% and it has raised
its loan for funding its assets through fixed rate loan from bank at 6%. There is a big bank
which offers interest rate swap with a spread of 0.10% as follows:
❖ Swap Bid = 6.4% for LIBOR
❖ Swap Ask = 6.5% for LIBOR
a) Explain how the two companies can reduce the interest rate risk
b) Calculate the companies locked in spread
121 | P a g e
4. Interest rate swap:
ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR +
0.25% for Rs.200 million for 5 years. The bank is able to swap into a fixed rate at 7.5% versus
six months LIBOR treating six months as exactly half a year.
❖ What will be the all in cost funds to ABC Bank?
❖ Another instrument being considered is the issue of a hybrid instrument which pays
7.5% for first three years and LIBOR – 0.25% of remaining two years. Given a three
year swap rate of 8%, suggest the method by which the bank could achieve fixed rate
funding.

Grades Limited enjoys a high credit rating and is capable of raising term funds either at a
fixed rate of 10% p.a. or at a floating rate of 40 basis points over MIBOR. Level Limited
enjoys a relatively lower credit rating and is able to borrow either at 80 basis points over
MIBOR or at affixed rate of 10.5%. Level limited wants to borrow at fixed rate whereas
Grades would like to enjoy a floating rate. Structure a swap arrangement such that Grades
gains 2/3rd of the total gain. Assume that there are no intermediaries. What action would
follow if Grades apprehends that interest rates will harden while Level believes that interest
rates will soften?

The following details are related to the borrowing requirements of ABC Limited and DEF
Limited.
Company Requirement Fixed rate Floating rate
ABC Limited Fixed rate 4.5% PLR + 2%
DEF Limited Floating rate 5.0% PLR + 3%
Both companies are in need of Rs.2,50,00,000 for a period of 5 years. The interest rates on the
floating rate loans are reset annually. The current PLR for various maturities are as follows:
Maturity (years) PLR (%)
1 2.75
2 3.00
3 3.20
4 3.30
5 3.375
DEF Limited has bought an interest rate cap at 5.625% at an upfront premium payment of
0.25%. You are required to exhibit how these two companies can reduce their borrowing cost
by adopting a swap assuming that gains resulting from swap shall be shared equally among
them. Further calculate cost of funding to these two companies assuming that expectation
theory holds good for the 4 years.

Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six months LIBOR flat.
If the notion principal amount of swap is Rs.5,00,000.
• Calculate semi-annual fixed payment
• Find the first floating rate payment for above if the six month period from the
effective date of swap to the settlement date comprise of 181 days and that the
corresponding LIBOR was 6% on the effective date of swap
• In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer would
pay to the floating rate payer? Generic swap is based on 30/360 days basis.
122 | P a g e
8. Evaluation of interest swap arrangement:
NoBank offers a variety of services to both individuals as well as corporate customers.
NoBank generates funds for lending by accepting deposits from customers who are paid
interest at PLR which keeps on changing.
NoBank is also in the business of acting as intermediary for interest rate swaps. Since it is
difficult to identify matching client, NoBank acts counterparty to any party of swap.
Sleepless approaches NoBank who already have Rs. 50 crore outstanding and paying
interest @PLR+80bp p.a. The duration of loan left is 4 years. Since Sleepless is expecting
increase in PLR in coming year, he asked NoBank for arrangement of interest of interest rate
swap that will give a fixed rate of interest.
As per the terms of agreement of swap NoBank will borrow Rs.50 crore from Sleepless at
PLR+80bp per annuam and will lend Rs. 50 crore to Sleepless at fixed rate of 10% p.a. The
settlement shall be made at the net amount due from each other. For this services NoBank
will charge commission @0.2% p.a. if the loan amount. The present PLR is 8.2%.
You as a financial consultant of NoBank have been asked to carry out scenario analysis of
this arrangement. Three possible scenarios of interest rates expected to remain in coming 4
years are as follows:
Year 1 Year 2 Year 3 Year 4
Scenario 1 10.25 10.50 10.75 11.00
Scenario 2 8.75 8.85 8.85 8.85
Scenario 3 7.20 7.40 7.60 7.70
Assuming that cost of capital is 10%, whether this arrangement should be accepted or not.
9. Calculation of interest expenditure:

Principal USD 100 million
Interest 8% p.a.
Coupon March 1 and September 1
Calculate interest from March 1 to July 3 under following day count conventions:
❖ 30/360 (coupon bonds)
❖ Actual days / 360 (money market instruments)
❖ Actual days / reference period days (treasury days)
10. Calculation of interest rate (May 2012 RTP)

Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index
Swap) on a principal of Rs. 10 crores and agreed to receive MIBOR overnight
floating rate for a fixed payment on the principal. The swap was entered into on
Monday, 2 August, 2010 and was to commence on 3 August, 2010 and run for a period
of 7 days. Respective MIBOR rates for Tuesday to Monday were:
7.75%,8.15%,8.12%,7.95%,7.98%,8.15%.
If Derivative Bank received Rs. 317 net on settlement, calculate Fixed rate and interest
under both legs.
Notes:
❖ Sunday is Holiday.
❖ Work in rounded rupees and avoid decimal working.
123 | P a g e
11. Calculation of fixed rate
TMC corporation entered into 3.5 million Euros notional principal interest rate swap
agreement. As per the agreement TMC is to pay a fixed rate and to receive a floating rate of
LIBOR. The payment will be made at the interval of 90 days for one year and it will be based
on the adjustment factor 90/360. The term structure LIBOR on the date of agreement is as
follows:
Days Rate (%)
90 7.00
180 7.25
270 7.45
360 7.55
You are required to calculate fixed rate on the swap and first net payment on the swap. Also
calculate the swap bid and offer rate for the above transaction if the financial institution
dealing in this swap wants a dealer’s margin of 0.20%
12. Valuation of swap

A financial institution has agreed to pay six months LIBOR and receive 8% per annum semi
annual fixed interest on the notional principal of USD 100 million. The swap has a remaining
life of 1.25 years. The LIBOR rates for 3 months, 9 months and 15 months maturities are 10%,
10.5% and 11%. The 6 month LIBOR rate on the last payment date was 10.2%. Calculate the
value of the swap
124 | P a g e

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CA –FINAL STRATEGIC FINANCIAL MANAGEMENT

INDIAN CAPITAL MARKET

Capital Money Debt

What can be an underlying asset?

Types of derivative contracts:

Types of derivative contracts

Why derivative instruments:

Computation of fair futures price:

Situation 2: Dividend paying stock:

Situation 4: Storage costs:

Hedging with futures:

Hedging through index futures:

No. of contracts = Beta * Value of units requiring hedging

How to compute Hedge ratio (Beta)

How to alter risk in portfolio:

Concept of Mark to Market and margin account:

Basics of option contract:

When to exercise an option:

Bullish and Bearish Market:

Party EMP > EP EMP < EP

Intrinsic value and time value:

Which option what premium?

Deals in options of one Deal in option of both

Call Put Call Put

Bull spread strategy:

Steps in derivative strategy:

Step 2: Breakeven table:

Step 3: Draw strategy graph:

Bear Spread Strategy:

Butterfly spread strategy:

Put call Portfolio Black

Model 1: Put call parity theory (PCPT)

Share + Put = Call + Present value of exercise price

Model 2: Portfolio Replication Model

Stock equivalent approach: Option equivalent approach:

Model 3: Risk Neutral Model:

Binomial model and American Option:

Model 5: Black – Scholes Model:

1. Pricing future – Non-dividend paying stock

2. Calculation of today’s price

3. Pricing future –Dividend paying stock

4. Price future – Dividend paying stock

5. Pricing future – Storage costs

8. Pricing future [May 2012 RTP]

9. Calculation of fair futures price:

10. Calculation of fair futures price:

11. Calculation of interest rate

12. Calculation of profit/loss:

13. Arbitrage through futures

15. Pricing future and arbitrage opportunity

1. Hedging with futures

2. Hedging with futures

3. Hedging with futures

4. Hedging with futures

8. Hedging with futures

You are required to:

9. Stock hedging – long position

10. Stock hedging – short position