Financial Engineering

C.A Nikhil Jand

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ALL About Derivatives

Every derivative is just an agreement between future buyer and future seller.

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Why they are called Derivatives

A financial Instrument whose value is defined from something else.

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Financial Instrument
Its just a standard type of agreement or contract that gives you certain financial rights and responsibilities to its parties .
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Simple Example
A Wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of changes in price by that date . This price would obviously depend on the current spot price of wheat . Such transaction would take place in the wheat forward market

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 Here the Wheat Forward is the derivative and wheat on the spot price is the underlying.

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Four Basic Derivatives

A forward Contract A Futures Contract A Swap Contract An Option contract

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Why derivatives are used

Hedging Speculation
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Derivatives are financial weapons of mass destruction .

Warren Buffet
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Define Derivatives
A financial Instrument whose value depends on value of other , more basic , underlying variables.

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Underlying Asset may be

Commodities Bonds Stocks Foreign exchange

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Features Forward / Future Contracts Operational Mechanism

Forward Contract

Future Contract

Not traded on exchange

Traded on exchange

Contract Specifications

Differs from trade to trade.

Contracts are standardised contracts.

Counterparty Risk

Exists

Exists, but assumed by Clearing Corporation/ house.

Liquidation Profile

Poor Liquidity as contracts are tailor maid contracts.

Very high Liquidity as contracts are standardised contracts.

Price Discovery

Poor; as markets are fragmented.

Better; as fragmented markets are brought to the common platform.

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Futures Market
Like most other financial instruments , future contracts are traded on recognized stock exchanges . In India , the both the NSE and BSE Have introduced the S&P CNX NIFTY and BSE SENSEX.

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1$ = 45.5 46

Buy / Bid price

Sell or ask or offer rate

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 An Importer imports goods worth $ 100,000 from USA and 3 months forward rate quoted by the bank is 1$= 45.4 45.7. He expects that in 3 months time the spot rate at the end of three months is most likely to be above Rs 46 per dollar Advise whether he should cover himself by entering into forward contract .

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What is arbitrage or Who are abitrageurs

Arbitrage means Riskless Gain Arbitrage means taking advantage of discrepancy of prices of an asset existing in various markets

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US 1$ = Rs 50 in India Rs 1 = US $ .019 in USA How can a Dealer arbitrage from the above situation?
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Buying and Selling Stock Index Futures

When an investor opens a future position he or she does not pay the entire amount of the equity underlying the futures contract . The Investor is required to put only a small amount of money known as the Margin .

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Index futures are usually subject to two kinds of margins

Initial Margin Maintenance Margin

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Initial Margin
Margin is the money deposited by both the buyer and the seller to assure the integrity of the contract . Initial Margin is the amount of money , which a buyer or a seller must deposit in his account when he establishes a future position. Minimum margins set by the exchange and are usually about 10 % of the value of contract .
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The Following are the quotes were observed by Mr. XYZ on March 11,2009 in the Economic Times a) SBI MAR 09 FUT 720.50 b)HUL APR 09 FUT 144.30 c)NIFTY MAY 09 FUT 2140 If the Initial margin is 10% and Mr. XYZ wants to buy 100 of each how much margin he has to deposit individually?

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Ans
7205 1443 21400

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Maintenance Margin
Minimum margin required to hold a position . Maintenance margin is normally 75% to 80% of the initial margin Maintenance margin should be sufficient to support the daily settlement process called mark to market.

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Mark to market
Once a future is bought/sold and a contract is issued , its value in respect of future fluctuates on daily basis . At the end of every trading day , the contract is marked to its closing market price of the futures contract . Each account is debited or credited to the SETTLEMENT PRICE on daily basis . This is known as mark to market .
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Trading Cycle
S&P CNX Nifty Futures contracts have a maximum of 3 month trading cycle . Expiry date : S&P CNX Nifty contracts expire on the last Thursday of every expiry month . Permitted Size : S&P CNX Nifty futures contact is 200 and multiples thereof

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Concept of Present Value

FV = PV (1 + rt ) FV = Future Value PV = Present Value r = rate of interest t = time in years

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Continuous Compounding
rt

FV = PV* e
- rt

PV = FV * e

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Formula
Future Price= Spot Price + Cost of carry - dividend

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Lets solve
The Following data relates to ABC limited share prices Current price per share Rs. 180 Price per share in the future market 6 months Rs. 195 It is possible to borrow money in the market for securities @12% p.a. Required Calculate the theoretical minimum price of a 6 month contract. Explain the arbitrage opportunities exist.
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Answer
= 180 + 180*12%*6/12- NIL =190.80 Actual price is different from fair price hence arbitrage is possible .Actual price is more than fair price hence arbitrageur should sell future He will sell in future and buy spot.

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Option
The option is an instrument which gives right to the buyer of option , to exercise option at expiration date at exercise price . There are two parties buyer and seller

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Strike price or Exercise price

The price at which a call holder may buy or put holder may sell is known as the strike price or exercise price
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The parties of option

Seller or short party or writer

Buyer or long party or holder

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Types of options

Call option

Put option
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On Basis of expiration date

American Option On and Before European option - On

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Call option

The buyer of the call option purchases it from seller of the option. The buyer pays premium to the seller of the option.
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Value of the call option

Value of the call option at expiration date = Market price of assets exercise price for assets

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Example
Mr. A purchases a call option from B. B writes a call and gives right to Mr. A to buy Reliance share on exercise date (say March 10 ) at exercise price Rs. 450. Mr A has right to purchase share at Rs. 450 or ignore the option, the price of share in the market is Rs. 570.

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 Value of the option = market price exercise price = 570 450 = Rs. 120

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Solve

If the market price of share on March 10 is Rs 410. The exercise price is Rs. 450.
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Answer
Value of option = Market price exercise price = 410 -450 = Rs -40

The option has no value hence the buyer will not exercise the option.

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Lets Solve
Mr X purchases a call option from Mrs Y . This option provides buyer X right to buy TATA share@ Rs 410, on exercise date May 25 . The actual market price of TATAs share is on may 25 is 475 410 315 Find the value of option
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Put option

The put option provides buyer of put option- Right to sell an asset at expiration date at exercise price to the seller of put option .
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Market Price

Exercise Price

MP- EX price

Value of call

Action

475

410

=475-410=65

65

Exercise the option

410

410

= 410-410

Normally Ignored

315

410

=315-410

Ignore the option

Example
Strike price Rs 300 Type of option Call Option Premium Rs 35 Required Determine the break even point of call buyer Determine the profit and loss to the call buyer if the price on maturity is Rs 250 ,270 , 290,300,320 ,340, 350 . Draw the pay off diagram of the call buyer
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Value of the PUT option

Value of put at expiration date = Exercise price - Market price

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Example
Mr. A Sells put option to Mr. B . This put option gives Mr. B right to sell the reliance share to Mr A on 15th March @Rs 640 . On 15th march price of share is Rs. 510

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Topics for presentation

If I were to choose my person of the millennium Elections in U.P What suggestions will you give to the finance minister ? European debt crisis How Credit rating is done? Cloud computing Carbon Credits Rupee fluctuation
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Swaps

Swap is an agreement between two companies to exchange cash flows in future.

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 The First swap involving an indian counterparty took place as early as 1984 when ONGC entered into a swap contract with a consortium of foreign banks

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Types of Swaps
Interest rate swaps Currency swaps Commodity swaps Credit default swaps

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LIBOR
London Interbank offer rate The Libor is the average interest rate that leading banks in london charge when lending to other banks Its a benchmark for finance all over the world

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Strategy in options

Straddle strategy
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Straddle strategy

An investor who is hoping wide fluctuations in an asset but who is unsure as to where the movement can be can create a straddle strategy.
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Straddle strategy involves buying a put and a call option with same maturity but same strike prices .
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A straddle is a put and a call option brought by an investor at the same strike price and with the same maturity. If the price goes up he will exercise his call option and if the price goes down he will exercise his put option.

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Lets solve
An investor expects wide fluctuations in one share of R.I.L but he is unsure where the movement will be ,hence he buys one put and one call at a strike price of Rs 700 after paying a premium of a Rs 35 for put and Rs 45 for call, having maturity of 2 months each Required Name the strategy Determine Break even points and also compute the cost of strategy Determine the profit /loss if the price on maturity is :550,6000,650,700,750,800,850 Determine the pay-off of the strategy
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 1) Straggle strategy 2) cost = 35+45=Rs 80 3)BEP for call option= strike price + cost of strategy =700+80= 780 put option = Strike price cost of strategy = 700-80 = 620 4)Maturity Price = 550 600 650 700 750 800 850 profit /loss 70 20 (30) (80) (30) 20 70
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Strangle Strategy
An investor who is betting that there will be a wide fluctuation in the price of the share but is unsure, where the movement is likely to be , may create a strangle strategy.
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Strangle is a strategy involves buying a put and a call option with same maturity but different strike prices.

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Example
Suppose a RIL share is currently selling for Rs 110. The exercise prices for the telco put and call are respectively , Rs 100 and Rs 105. What will be your payoff if the price of the RIL share increases to 120 in three months What will be your payoff if the price of the RIL share falls to Rs 95 in three months

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 Mr G is expecting wide fluctuations in stock of RIL . He buys one call option at a strike price of Rs 700 by paying Rs 45 along with a put option at a strike price of Rs 650 by paying a premium of Rs 20. Required Name of the strategy Compute the cost of the strategy and break even points Compute the profit / loss if the price on maturity is 500,550,600,650,680,700,750,800,850 Draw the payoff of G strategy
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Answer
Strangle Strategy Cost of the strategy = 45 +20= 65 Break Even point for put option = Strike price cost of strategy = 650 -65= 585 for call option = Strike price + Cost of Strategy = 700 + 65 = 765 Profit /loss = 85 ,35,-15,-65,-65,-65,-65 ,-15 ,35 ,85
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Classification of option on the basis of Cash Flows

In the money option At the money option Out of the money option

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Find the Value of the option

Share A B C Option Call Put Call Exercise Price 50 60 45 Market Price 70 75 40

D
E F

Call
Put Put

80
75 90

80
62 90
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Value of the option when different probabilities are given

Find the Value of the option in normal way for various market price To calculate the expected value of option at expiration date = Sum of (Value of option into the probabilty)

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Lets Solve
A company has a receivable of $ 100 million in three months . A bank has offered him a put option with exercise price of Rs 37/$ . The premium payable is Rs 1 /$. The probability of exchange rate after 3 months is
Prob. .20 Exchange 35 Rate .30 35.5. .30 36 .20 36.5

In your Opinion should company purchase put option ?

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Answer
MP EP EP- MP Value of PUT 2
1.5 1 .5

Prob.
.20 .30 .30 .20

Value *prob .4
.45 .30 .10 1.25
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Classification of Options on the Basis of CASH FLOWS

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In the money option

An option is said to be in the money option if it would lead to positive cash flow if it were exercised immediately . In other words a call option shall be said to be in the money option if the spot price of the underlying asset is more than the exercise price

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At the money option

Both put and call option are said to be at the money if the exercise price and the current market value are equal . In other words an option is said to be ATM if it results in NIL cash flows .

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Out of the money Option

An option that would lead to negative cash flow if it were exercised immediately is termed as out of the money option. Therefore In call option if the exercise price is greater than the current market price .

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Intrinsic Value of option

Intrinsic Value of option is NIL in case of an option is ATM or OTM . Intrinsic Value in case option is INM is the difference between current market value and strike price of an underlying asset.

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Time Value of option

If an option is OTM/ATM the value of option i.e. option premium constitutes only the time value of money . However if an option is ITM, the time value of money is the difference between total option premium and the intrinsic Value

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 OTM/ATM

Option Premium

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 ITM

Total Option Premium Intrinsic Value

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Example
Type Premium Strike Price Current Price Type Intrinsic Value Time Value

Call
Call Call Put Put Put

30
10 90 20 4 76

500
550 600 200 200 200

500
550 650 200 250 150
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Example
Type Premium Strike Price Current Price Type Intrinsic Value Time Value

Call
Call Call Put Put Put

30
10 90 20 4 76

500
550 600 200 200 200

500
550 650 200 250 150

ATM
OTM ITM ATM OTM ITM

0
0 50 0 0 50

30
10 40 20 4 26
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Pricing of options
Binomial Model Black scholes model of pricing an option

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Binomial Model
The Binomial option pricing model is based upon a simple formulation for the asset price process in which the asset , in any time period can move to one of the two possible prices. The general formulation of a stock price process that follows is called the binomial

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S 20 X 21 U 1.1 D .9 R .12 T .25

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