Module 1

Risk is defined as an uncertainty concerning the occurrence of a loss .ex: the loss of being killed by a speeding vehicle. Under risk mgmt risk is identified with life or property being insured. So we hear such statements as the building is unacceptable risk or the driver is poor risk. Objective risk :-( degree of risk) is defined as the relative !"iation of actual loss from the expected loss. #his decreases as the number of exposures increase. $t !"ies inversely with the s%uare root of the number of cases under observation. Suppose &'(''' houses are built and &) of these are to burn per year. #hat means &'' are to burn. #hat does not mean that &'' houses will exactly be burnt. $t may !"y plus or minus. *b+ective risk may be calculated by using some statistical measure like sd,cv. because ob+ -risk can be measured it is an extremely useful concept for an insurer as the number of exposures increases an insurer can predict its future loss more accurately The law of large numbers state that as the number of exposures unit increases the more closely the actual loss experience will approach the expected loss experience. 2. Subjective risk:- this is the uncertainty based on a mental condition or state of mind of a person. -x:- a person in a drunken state might drive home. .e is uncertain whether he will reach home safely or would be caught by the police. #he mental uncertainty is called as sub+ective risk. #wo different may alter their course of action like taking an auto home instead of driving. /hance of loss is closely related to the concept of risk. $t is defined as the probability that an event will occur. like risk probability has both ob+ective and sub+ective aspects. Objective robabilit!:" it refers to the long run relative fre%uency of an event based on the assumption of an infinite number of observations and of no change in the underlying conditions Objective robabilit! can be determined in two wa!s:&. #hey can be determined by deductive reasoning. #hese are also call-ed as priori probabilities. (toss of a coin where the answer is 0. !lso in case of a dice where the probability is &,1. 2. *b+ective probabilities can be determined by inductive reasoning rather than by deductive reasoning. -x:- probability that a person will die before 23 when his age is 2& years cannot be

logically deduced. 4ut if current mortality rates are seen then an insurance policy can be sold for people aged 2& years. #hance of loss. Subjective robabilit!

$t is the individual personal estimate of the chance of loss. #his need not coincide with ob+ective probability. -x:- people buying lottery tickets on their birthday expecting luck. 5actors affecting sub+ective probabilities are age( gender( intelligence( education( beliefs( use of alcohol etc. #hance of loss distinguished from risk. /hance of loss is the probability that an event that causes a loss will occur. ob+ective risk is the relative !"iation of actual loss from expected loss. the chance of loss may be identical for two different groups but ob+ective risk may be %uite different. ex:- chances of accidents in 2 towns. $erils and ha%ards 6erils are the cause of loss. ex:- fire( lightening( floods( earth%uake etc .a7ards are conditions that creates or increases the chance of loss. #here are 8 types of ha7ards:&. 6hysical. 2. 9oral :. 9orale. 8. ;egal ha7ards. &a%ards. &. 6hysical ha7ards:- these are the physical conditions that increases the chance of loss (bad roads) 2. 9oral ha7ards:- dishonesty or character defects in an individual like faking in+ury or making fraudulent claims. :. 9orale ha7ards:- these are carelessness because of the existence of insurance. #hese increase the chances of loss. 8. ;egal ha7ards:-these are the characteristics of the legal system or the regulatory environment. -x:- adverse +ury verdict( <ovt. schemes of insurance giving undue benefits

#ategories of risk. 1. $ure and s eculative risk. 2. 'undamental and articular risk. (. )nter rise risk. $ure risk is defined as situation in which there are only the possibilities of loss or no loss. #he only possible outcomes are adverse or neutral (no loss) S eculative risk is a situation in which either profit or loss is possible. =ifferences:&. 6rivate insurers underwrite only pure risk. 2. #he law of large numbers applies to pure risk only. :. Society may benefit from speculative risk even though loss occurs. -xample new technology used benefits some. $S"* rockets 6rogramme helps some. 'undamental risk affects the whole economy like famine( natural disasters( terrorist attacks etc. 6articular risk affects only the individuals like theft( robberies. )nter rise risk is the ma+or risk faced by a business firm like pure risk( financial risk( speculative etc. T! es of ure risk

#ausing financial insecurit! &. 6ersonal risk:- premature death( insufficient income during retirement( poor health( unemployment. 2. 6roperty losses like direct loss( indirect losses( (loss of customers). :. ;iability risk:- (bodily in+ury because of accidents). *nsurance. #he !merican risk and insurance association has defined insurance as follows:- it is the pooling of fortuitous losses by transfer of such risks to insurers who agree indemnify insured for such losses to provide other pecuniary benefits on their occurrence or to render services connected with the risk. *nsurance:" basic characteristics &. 6ooling of losses. 2. 6ayments of fortuitous losses. :. "isk transfer. 8. $ndemnification of losses.

6ooling of losses:-this is the spreading of losses incurred by the few over the entire group so that in the process average loss is substituted for actual loss. $t involves grouping of a large number of exposure units so that the law of large numbers can operate to provide a substantially accurate prediction of future losses. $deally there should be a large number of similar but not necessarily identical exposure units that are sub+ect to the same peril. 2. $a!ment of fortuitous loss ! fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. #hat means the loss must be accidental and occur randomly. $nsurance policies cover only accidental losses and not intentional losses. (.risk transfer "isk transfer means that a pure risk is transferred from the insured to the insurer who typically is in a stronger financial position to pay the loss than insured. 5rom the point of an individual pure risk are premature deaths( poor health( destruction of property personal lawsuits etc. +. *ndemnification $ndemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of loss. #his is feasible only in case of non life insurance like fire( marine and other non life policies. Meaning of Risk Mgmt $t is a process that identifies loss exposures faced by an organi7ation and selects the most appropriate techni%ues for treating such exposures. "isk as a term is very ambiguous so using the term loss exposure is considered more appropriate. ;oss exposure is any situation or circumstance in which a loss is possible( regardless of whether a loss occurs. here risk managers consider only pure risk exposures faced by the firm .of late even speculative loss exposures are being considered. Risk management"objectives 1. $re loss objectives. 2. $ost loss objectives.

$re loss objectives:- the important ob+ectives before a loss occurs include economy( reduction of anxiety and meeting legal obligations. $re loss objectives &. #he firm should be prepared for potential losses in the most economical way. this preparation involves an analysis of the cost of safety programs( premiums paid and the cost handling losses. 2. "eduction of the anxiety of the risk manager and the key executives.(catastrophic law suit :. #o meet any legal obligations:#his may be asking the firm to install safety devices( pollution controlling devices( waste disposal etc. #he insurance manager must try to ensure that these are provided. $ost loss objectives "isk management also has certain ob+ectives after a loss occurs:&. Survival of the firm. (resume operations in a short time) 2. /ontinue to operate.(competitors would take up the business) :. Stability of earnings. 8. <rowth of the firm. 3. 9inimi7e the effects of loss to the others,society. Risk management rocess 1. *dentif! the loss e, osures:" .ere we identify all ma+or and minor loss exposures. #his involves analysis of all potential losses. !) 6roperty loss exposure 4) ;iability loss exposures. /) 4usiness income losses. =) /rime loss. -) 5oreign loss exposures f) reputation loss 2. -nal!%e the loss e, osures:" a) ;oss fre%uency (probable no. *f losses in a time period) b) ;oss severity (si7e of the loss) #hese are done for each type of exposure. when done it helps in finding out the techni%ues for handling the exposures,estimating the max possible losses. (. Selecting the a ro riate techni.ue for treating the loss e, osure a) "isk control b) risk financing. Risk control:-this is a techni%ue for controlling the severity of loss. 1. -voidance:" /dangerous drugs0 2. 1oss revention./ using measures0 (. 1oss reduction:- these are the measures to avoid the severity of a loss after it occurs. (5uture) uses the sprinklers for fire prevention( having decentrali7ed stores( limiting of the amount of cash so that the

chances of theft are avoided( safety programs being implemented in the premises. Risk financing:"this is the funding the losses after the loss have occurred. 1. Retention: this is retaining the part or all of the losses that can result from a given loss. this may be active,passive. !ctive is the retention when the firm is aware of its acts and passive when the firm neglects its acts like forgetting to act ( failure to act( failure to identify the loss exposure. "isk retention level:- a firm has to determine its risk retention level. ! strong firm can retain a higher amount of risk than a weaker firm. .ere a firm can estimate the maxi-mum level of risk it can absorb without insuring like ) of annual earnings or ) of working capital. $f the risk is retained then the firm should think of how it would finance the risk:a) /urrent net income. b) 5unded reserve. c) Unfunded reserve (book entries) d) /redit line with bankers using borrowed funds. 2.non insurance transfers:- these are methods used in which the pure risk and its financial conse%uences are transferred to some other firm like leased transfers( contracts( agreements( annual maintenance contracts etc. (. #ommercial insurance contracts on !earl! basis.

Module 2
Risk management 'utures and forwards a derivative instrument is a financial contract whose payoff structure is determined by the value of an under-lying commodity( security( interest rate( share price index exchange( oil price and like. so a derivative instrument derives its value from some underlying !"iable. a derivative instrument promises to convey ownership. 2erivatives !ll derivatives are based on some cash products. it includes commodities( metals( foreign exchange( bonds( short term debt securities such as t- bills( over the counter money market products like loan or deposits. the purposes for which derivatives are used are:&. "eduction of funding costs. 2. -nhancing the yield on assets. :. 9odifying the payments structure of assets to correspond to the investors market view. but the most important use of derivatives is in transferring market risk called as hedging which is protection of losses . .edging is protection against losses resulting from unforeseen price or volatility changes. So hedging is a very important tool of risk management. there are many kinds of derivatives: futures( options( interest rate swaps and mortgage derivatives. 'orward contracts a deal for the purchase or sale of a commodity security or other asset can be in the spot or forward markets. a spot or cash market is most commonly used for trading. in a forward contract the buyer agrees to pay cash at a later date when the seller delivers goods. Usually no money changes hands when forward contracts are made. >ormally one of the parties may ask for some initial good faith deposit to ensure that the contract is honored. .ere the price at which the contract is entered is decided at the time of entering into the contract. #he essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. So one is assured of the price at

which one can buy,sell goods or other assets. so the risk of price moving adversely is avoided. !t the maturity of a contract if the market price is greater than the agreed price the buyer gains. 5orward contracts have been in existence for some time. #he formal start to it happened in &?8? when the /hicago board of trade was established as a commodities exchange. ! forward contract is a good means of avoiding price risk. -ach party faces the risk of default. *nce a position of buy,sell is taken an investor cannot retreat with-out the consent of the other party or by taking a reverse posit-ion of the earlier contract. #hese are contracts entered on a one to one basis and with no standardi7ation. #he problems of credit risk and no li%uidity led to the formation of futures contracts. futures contracts. a futures contract represents an improvement over the forward contracts in terms of &. Standardi7ation( 2. performance and :. ;i%uidity. a futures contract is a standardi7ed contract between two parties where one of the parties commits to sell and the other to buy . #his is done for a stipulated %uantity( %uality of a commodity( currency( security( index or some other specified item at an agreed price on a given date in the future. the future contracts are standardi7ed ones so that :&. #he %uantity of the commodity could be transferred or would form a basis of gain,loss on maturity of contract. 2. #he %uality of a commodity( and the place of its delivery would be made. :. #he date and month of delivery. 8. #he units of price %uotation. 3. #he minimum amount by which the price would change and the price limits for days operations are specified. 5utures contracts are traded on commodity or other future exchanges. 6eople buy and sell futures as like other commodities. when an investor buys a futures contract ( he takes a long position) on an organi7ed exchange he is in fact assuming the right and obligation of taking the delivery of the item on the specified date. @hen an investor takes a short position one assumes the right and obligation to make delivery of the underlying asset. #here is no risk of non performance in the case of trading in futures contract. #his is because of the clearing house which plays a pivotal role in the clearing.

! clearing house takes the opposite position in each trade( so that it becomes a buyer to a seller and a seller to a buyer. @hen a party takes a short position it is obliged to sell the commodity at the stipulated price to the clearing house on the maturity of the contract. the clearing house guarantees the performance of the futures contracts( the parties in the contracts are re%uired to keep margins with it. #he margins are taken to ensure that each party to a contract performs it. #he margins are ad+usted on a daily basis to account for gains and losses. this depends on the price at which the futures contracts are being traded in the market. #his is known as marking to the market and involves giving a credit to the buyer of the contract if the price of the contract rises and debiting the sellerAs account by an e%ual amount. Similarly the buyers balance is reduced when the contract price declines and the sellers account is accordingly updated. in effect the profit,loss on a futures contract is settled daily and not on maturity of the contract as for a forward contract. it is not necessary to hold on to a futures contract until maturity and one can easily close out a position. -ither of the parties may reverse their position by initiating a reverse trade so that the original buyer of a contract can sell an identical contract at a later date canceling the earlier. the fact that the buyer as well the seller of a futures contract are free to transfer their interest in the contract to another party makes such contracts essentially marketable instruments. 5utures contracts are highly li%uid in nature. here a small number of contracts are held for delivery 2ifferences forwards and futures contracts: &. standardi7ation:a forward contract is made by the seller and the buyer where the terms are settled mutually. in a futures contract the transaction as regards %uantity , %uality , place etc are standardi7ed. *nly the price is negotiated. 2. ;i%uidity:#here are no secondary markets for forward contracts while the futures are traded on organi7ed exchanges. so futures contracts are more li%uid than the forward contracts. :. /onclusion of contract:a forward contract is generally concluded with a delivery of the asset in %uestion whereas a futures contract is concluded either with delivery of goods or by paying up of price differences. #his has to be done

before the conclusion of the maturity of the first contract and is called as offsetting a trade. 8. 9argins:a forward contract has 7ero value for both the parties as no collateral is re%uired. 4ut in a futures contract a third party called clearing corp. is also involved with which margin is re%uired to be kept by both parties. 3. profit,loss settlement:#he settlement of a forward contract takes place on the date of maturity so that profit,loss is booked on maturity. 5utures contracts are marked to daily so that the profits or losses are settled daily. #lassification of derivatives based on features &. nature of contracts:a) 5orward rate contracts and futures. b) *ptions. c) Swaps. #he nature of the contract sets upon the rights and obligations of both the position to the contract. 2. Underlying asset:- there can be a contract which is similar in all aspects except for the underlying asset. a) 5oreign exchange. b) -%uities. c) $nterest bearing financial assets. d) /ommodities. -x:- options in currency,stock. :. 9arket mechanism:a) *#/ products. b) -xchange traded products. role of a clearing house:- it performs two critical functions. &. *ffsetting customerAs dealings. 2. !ssuring the financial integrity of the transactions in exchange. *m ortant features of derivatives. =erivatives became very popular because of their uni%ue nature. #hey offer a combination of characteristics which are not found in other assets. #here are four important features that distinguish derivatives from the underlying assets and make them useful for a !"iety of purposes. &. "elation between the values of derivatives and their underlying assets:@hen the value of underlying assets change so do the value of derivatives based on them. -x:- if the product price changes the

instrument price also changes. in a currency future contract price to be paid is fixed by the future contract. #his is done by depending on the movement of the underlying currency. the relation between values of the underlying assets and options are more complicated but the values of the option and the underlying assets are still to be related so derivatives appear similar to real commodities. 2. $t is easier to take short position in derivatives than in other assets: - as all transactions in derivatives take place in future specific date it is easy for the investor to sell the underlying assets. .e can take view of the market ,product which is not possible in any other assets. :. exchange traded derivatives are li%uid and have low transaction cost: - this is because of standardi7ed terms and low credit risk. #ransaction cost is low because of high volume of trade and due to high competition. !lso margin re%uirements in exchange traded derivatives are very low so risk associated is very low. 8. it is possible to construct a portfolio which is exactly needed without having the underlying assets:- ex:- a person with a floating rate of interest can limit his exposure by buying interest rate cap. #his derivative pays the firm the difference between the floating rate and predetermined max cap rate whenever the rate increases exceeding the cap.

artici ants in derivatives market. the participants can be banks( 5$As( brokers( corporate( individuals etc. the participants are:&. hedgers:a transaction in which an investor seeks to protect a position in the spot market by using an opposite position in the derivatives is known as hedge. #hese are people who want to reduce risk or eliminate risk. #hese are people exposed to risk in normal business operations and try to eliminate risk. 2. Speculators: - a person who trades expecting to make profit out of price changes. #hese are people who voluntarily accept what hedgers want to avoid. .e has a view on the market and based on the forecast he takes a long ,short position in the derivatives. :. !rbitrageurs:- arbitrage means obtaining risk free profits by simultaneously buying and selling identical instruments in different markets. #hey consistently keep track of the different markets. @henever there is any chance of getting profit without any risk they will take the position and make risk less profits.

$artici ants in derivatives market. #hey perform a very valuable economic function by keeping the derivatives prices and current underlying assets price closely consistent. !rbitrageurs are in the same class as that of speculators to the extent that they have no risk to hedge. #hey make money out of changes in price in different markets. 2erivative market in *ndia in =ecember the securities contract regulation act was amended to include derivatives within the sphere of securities and the regulatory framework was developed for governing derivatives trading. #he act also specified that derivatives shall be legal and valid only when traded on recogni7ed stock exchanges. =erivatives trading commenced in $ndia in Bune 2''' after the grant of final approval by S-4$ to this effect in may 2'''. S-4$ permitted the derivatives segments of two stock exchanges: - >S- and 4S- and their clearing houses to commence trading and settlement in approved derivatives contracts. $nitially S-4$ approved trading in index futures contracts based on SC6 />D >$5#E and 4S--:'(S->S-D) index. #his was followed by approval for trading in options based on these two indexes and options on individual securities. the trading in S->S-D options and trading in options on individual securities started Bune 2''&. =erivatives trading on >S- started with SC6 />D >$5#E index futures in Bune 2'''.futures contracts on individual stocks were launched in >ovember 2''& while the trading in index options commenced in Bune 2''& and trading in options on individual securities began in Buly 2''&. #ypes of derivative instruments available in $ndia:&. forwards.a forward contract is a contract between two parties to buy or sell an underlying asset at todayAs pre-agreed price on a specified date in the future. 2erivative market instrument in *ndia 5orward contracts in $ndia can be booked by companies( firms and any person having authentic foreign exchange exposures only to the extent and in the manner allowed by "4$. 5oreign exchange brokers are not allowed to book the contract. 2. 5utures. :. *ptions. 8. Swaps:#hese are derivative products which are traded between two parties as a private agreement and not on exchanges. #hese are traded between dealers. #he swaps normally dealt are currency swaps and interest rate swaps.

Mechanism of futures markets 5utures contracts are traded in auction markets where the prices are order driven. $n these markets each broker and trader can buy at the lowest offered price and sell at the highest bid price and the li%uidity is maintained by the participation of these buyers and sellers. Some of these buyers and sellers are hedgers seeking to protect their investments( some are speculators who are risk-takers seeking to trade in pursuit of profit incidentally keep bid and ask prices close together and to provide efficient trading in the system. 5utures contracts are designed in such a way so that their prices should always reflect the prices of the underlying cash market. #he activities of speculators and arbitrageurs also bring in price alignment. $n Fcalendar spreadingG traders sell the current delivery month contract and buy a later delivery month contract. #his reduces the price !"iance between the futures contracts. !rbitrage also helps keep the cash and futures prices aligned. -x: futures contracts seem to be overpriced in relation to the underlying commodity( arbitrageurs will sell the futures contract and simultaneously buy the commodity making profit. &istor! of futures markets #his was originally established to meet the needs of the farmers and merchants. 5armers have to face risk of prices and this depends on the vagaries of !"ious kinds. #he companies who buy grain also face the uncertainty and price risk. #his is on account of over supply and scarcity in the market. $t makes sense to make some sort of futures contracts. #he contracts provide a way for each side to eliminate the risk it faces because of the uncertain future price of grain. in &?8? the /hicago board of trade was established to bring farmers and merchants together. #his was done to standardi7e the %uantity and %uality of trade. #hicago board of trade @ithin a few years the first futures type contract was established and called as Fto arriveG contract. Speculators became interested in contract and found trading the contract to be a better alternative than trading in the grains. #he /hicago board of trade now offers futures contracts on other underlying assets including Soya products and treasury bonds and notes. The #hicago mercantile e,change: $n &?H8 the /hicago produce exchange was established providing a market for butter( egg( poultry( and other perishable agricultural

product. $n &I&I it was renamed as the /hicago mercantile exchange and was reorgani7ed for futures trading. Since then it has taken care of !"ious products and in &I?2 it introduced futures on SC6 3'' S#*/J index. #raditionally futures have been traded by Fopen outcryG system. #his involves using a complicated system of hand symbols for physical trading on the floor. $n &I?& /9- introduced -urodollar future which gave way to futures on stock indexes and option products. in &II2 it went electronic. Other e,changes 9any other exchanges throughout the world trade futures contracts. !mong them the popular exchanges are &. ;ondon $nternational 5inancial 5utures -xchanges (;$55-) #*JE* $nternational 5inancial 5utures -xchange (#$55-)( Singapore $nternational 9onetary -xchange (S$9-D)( Sydney 5utures -xchange (S5-). #learing house. ! clearing house is an institution that clears all the transaction undertaken by a futures exchange. $t could be part of the same exchange or a separate entity. $t computes the daily settlement amount due to or from each of the members and from other clearing houses and match the same. 9embers who execute trade on the exchange floor are of two types. &. 5loor brokers: - these brokers will execute the orders on others account. #hese people are normal-ly self employed individual member of the exchange. 2. 5loor traders: - these traders execute trades on their own account. Some also execute the orders for the account of others. 'loor traders #his mechanism is known as dual trading and such traders are known as dual traders. Some of the floor traders are classified as KscalpersA. ! scalper is a person who stands ready either to buy or sell. #hey add to the li%uidity to the market as they are market makers. #hey are also called as Kposition tradersA they tend to carry the positions for longer period of time thereby adding li%uidity to the market. #ontract s ecification for the futures. ! futures contract between the two parties should specify in some detail the exact nature of the asset( price( contract si7e( delivery arrangements( delivery months( tick si7e( limits on daily price fluctuation and the trading unit.

&. #he asset:-the delivery of the asset needs to be specified at the time of entering into a contract. $f the underlying asset is a commodity there may be !"iations in the %uality and grade. 2. 6rice:#he price agreeable to the buyer and seller at the time of delivery of the contract is specified at the time of agreement. #he futures prices if %uoted are convenient and easy to understand :. #he contract si7e:$t specifies the amount of asset to be delivered under one contract. $f the si7e is too large many investors cannot use it for hedging, speculation as the risk involved is too large. $f it is too small then the coat of trading is too much. 8. =elivery arrangements:#he place of delivery is very import-ant when transport cost is significant. 3. =elivery months:! futures contract is referred to by its delivery month. the period !"ies from item to item. 5or example Buly corn( means that the contract is for delivery in Buly. 5or certain contracts the delivery period runs throughout the month. #he date on which the contract ceases to trade is specified by the exchange. 1. #ick si7e:the contract also specifies the minimum price fluctuation or tick si7e. 5or example in soybean con-tract( one tick is L cent per bushel as the minimum si7e of contract for soybean is 3''' bushel. H. ;imits on daily price movements:#he daily price movementsA limits are specified by the exchange. $f the price moves up by a limit it is referred to as limit up and vice versa. #he prime purpose of the daily price limit is to prevent large price fluctuations and to safeguard the interest of genuine traders. 3asis: #he basis is the relationship between the cash price of a good and the futures price of that good. $t represents the difference between the cash price and future price of a single commodity. 4asisMcurrent price-futures price. #he futures market can portray a pattern of either normal,inverted. $f the prices for more distant futures are higher than the nearby futures it is referred to as KnormalA market condition. $n an Kinverted marketA the distant futures are lower than the prices that are near to expiration. @hen the future contract is at expiration

the futures price and spot price of a commodity is the same. So the basis must be 7ero #his behavior pattern of the basis over a period of time is referred to as KconvergenceA. $f the current price lies above the futures price and as the time elapses and future contract is nearing maturity( the basis narrows and at the time of maturity the futures price should be e%uivalent to cash price. #hus basis would be 7ero leading to no arbitrage situation. 3asis risk: $f the hedge can eliminate the full risk it is a situation known as perfect hedging( but as some uncertainty is associated always with the future and the difference between the spot prices and future prices may change( there are chances of basis risk. so basis risk may arise because of imperfect hedging between spot price of the asset and the futures price of the contract used. S reads: ! spread is the difference between two futures prices. 5or the same underlying good if there are two different prices on two different expiration dates the underlying spread is known Kintra commodityA spread.(or time spread)if the spread is between two different but related products then it is known as inter-commodity spread. #once t of cost of carr! : #he extent to which the futures price exceeds the cash price at one point of time is determined by the concept of cost of carry that refers to the carrying charges. #he carrying charges can be further classified into storage( insurance( transportation and financing cost. /arrying cost plays a crucial role in determining pricing relationships between spot and futures #onvenience !ield4 contango and backwardation #he shortage of the physical commodity is probably one of the reason for having additional cost other than cost of carrying. @hen there is a shortage in a commodity there is an implied yield (return) by holding the commodity. #his yield is referred to as convenience yield. $f the futures prices obtained by full carry relationship (cost of carry i.e. the estimated cost of futures prices) are accurately pro+ected the basis is negative as the future prices are higher than the cash prices. #his condition is referred to as KcontangoA market (which means the prices of futures market are determined by cost of carry). #his sort of market is featured by progressively rising future prices as the time to delivery becomes more distant. if the futures price is less

than the cash price the basis is positive. #his condition prevails only if the futures prices are determined by some other factors other than cost of carrying. @hen the future prices are lower than the cash prices it is known as backwardation. $t is featured by lower futures prices as delivery becomes more distant ), ectation rinci le #his theory postulates that the expected basis would be e%ual to 7ero. #his is based on the argument that futures prices are an unbiased estimate of expected future spot prices as would be expected in an efficient market. #hus there is no room for any excess returns for either the hedgers,speculator &edging using futures .edging is the process of reducing exposure to risk. .edge is any act that reduces the price risk of a certain position in the cash market. Similarly exports and imports are exposed to currency risk. #his exposure can be hedged through derivatives like futures( options etc. &edging with currenc! futures 5utures are one of the derivatives where an exporter and importer can hedge their positions by selling,buying futures. as the futures market does not re%uire upfront premium for entering into contract as in the case of options it provides an a cost effective way for hedging the exchange risk. /urrency futures provide a means to hedge the tradersA position who wishes to lock in exchange rates on future currency transactions. 4y purchasing (long hedge) or selling (short hedge) foreign exchange futures a corporate or individual can fix the incoming and outgoing cash flows in one currency with another. !ny one who is dealing with a foreign currency is faced with an exchange risk since the cash flows in terms of domestic currency are known only at the time of conversion. ! person who is long or is expected to go long in a foreign currency will have to sell the same on a given day. ! hedge can be obtained now by selling futures in that currency against a domestic currency. Similarly a person who is short or is expected to go short in a foreign currency will have to go long on the same on a given day. ! hedge may be obtained by buying futures in that currency against a domes-tic currency instead of buying the currency later in the spot market.

2etermining the effective rice using futures ;et sp& be the spot price at time t&. Sp2 be the spot price at time t2. 5t& be the futures price at time t&. 5t2 be the futures price at time t2. Sp& N ft&M basis at t& Sp2 N ft2 Mbasis at t2. ;et us assume that a transaction took place at t& and closed at t2. 6rofits made in futures market by closing out position at t2M ft&- ft2. 6rice received for asset while selling in the spot market Msp2. Msp2O(ft&-ft2) Mft&O(sp2-ft2) Mft&Ob2P.. @here b2 represents basis at t2. !s b2 is unknown the futures transaction is exposed to basis risk. $f b2Mb& then the effective price at currency sold will be :5t& Osp& N ft& Msp&. .edge ratio:-a hedger has to determine the number of futures contracts that provide best hedge for his risk return profile. $t allows the hedger to determine the number of contracts that must be employed to minimi7e the risk of the combined cash,futures position. #hat means the hedger has to take a futures position i.e. #he number of the futures contracts times the %uantity represented by each contract which will result in the maximum reduction in the !"iability of the value of his total hedged position. in simple form the hedge ratio hr is the ratio of si7e of the position taken in futures contracts to the si7e of the exposure. &edge ratio #he general definition of hedge ratio is:.rM futures position M %f cash market position %s where hr is the hedging ratio( %f is %uantity (units) of the asset represented by futures position and %s is %uantity of spot cash asset that is being hedged. The basic long and short hedges .edging refers to by taking a posit-ion in the futures that is opposite to a position taken in the cash market or to a future cash obligation that one has or will incur. .edging can be classified into two categories:&. Short hedge. 2. ;ong hedge.

Short and long hedge. Short hedge: - (selling hedge)$s a hedge that involves taking a short position in futures contract. $n other words it occurs when a trader plans to purchase or produce a cash commodity sells future to hedge the cash position. $t means having a sold position. $t is a commitment to deliver. #he main ob+ective is to protect the value of the cash position against a decline in cash prices. ! short hedge is appropriate when the hedger already owns an asset and expects to sell it at some time in the futures. *nce the short futures are established it is expected that a decrease (increase) in the value of the cash position will be fully or partially compensated by a gain (loss) in short futures position. 1ong hedge: ! long hedge (or a buying hedge) involves taking a long position in the futures contract. #he basic ob+ective here is to protect itself against a price increase in the underlying asset prior to purchasing it in either the spot ,forward market. ! long hedge is appropriate when a firm has to purchase a certain asset in futures and wants to lock in a price now. $t is also called as Kbeing longA or having a net bought position or an holding of the asset. $t is also known as inventory hedge because the firm already holds the asset in inventory. #he terms KlongA and KshortA apply to both the spot and futures market and are widely used in the futures trading. ! person who holds stocks of an asset is obviously regarded as Kbeing longA in the spot market but it is not necessary to actually hold stock. Similarly it is in the case of KshortA where one who has made a forward sale regarded as Kbeing shortA on the spot market. Sometimes it is seen that the firms wish to hedge against a particular asset but no futures contract are available. #his situation is called as asset mismatch. 5urther in many cases same futures period on a particular asset is not available( it is called as maturity mismatch. "eferring to different situations as could be seen there is still a possibility to hedge against a price risk in related assets (commodities or securities) or by using futures contracts that expire on dates other than those on which hedges are lifted. Such hedges are called as cross hedges. $n actual practice and in real business world it will be rare for all factors to match so well. #hus a cross hedge is a hedge in which the characteristics of the spot and futures positions do not match perfectly( either in %uantity( %uality( maturity( or physical assets change between spot and futures markets.

#urrenc! futures $n &IH2 /hicago mercantile exchange was the first exchange to introduce the financial futures contracts. !ll developed countries started importing a plethora of foreign goods which in turn created a demand for foreign currencies. So huge international transactions led to the development of foreign currency markets and futures. #he foreign currency futures contracts need to specify a trading unit (dollar( pound etc)( %uotation (say( USQ per pound)( minimum price change( contract months( usQ value of currency as on a day( and the delivery date. 6resently -uro( Een( Swiss 5ranc( 4ritish 6ound /anadian 6ound and !ustralian =ollar !re #raded *n /9-. /urrency futures can be defined as Fa binding obligation to buy or sell a particular currency against another at a designated rate of exchange on a specified future date. G#he contract si7e specifications for the few currencies traded in the /9- are as follows:&. 4ritish pound- 12(3'' as minimum trading %ty. 2. /anadian dollars- &(''(''' minimum :. Bapanese yen-&2(3''(''' as minimum 8. Swiss francs-&( 23(''' as minimum. 3. !ustralian dollar- &(''(''' as min *nvestment and consum tion assets: $nvestment asset is an asset that is held for investment purposes by significant number of investors. <old( silver( stocks and bonds are examples. ! consumption asset is held purely for consumption. -x:copper( food articles etc. @e can determine forward and futures prices for an investment asset for both spot and other !"iables. Short selling Short selling or shorting involves selling as asset that is not owned. $t is something that is possible for some but not for all investment assets. #his is done by borrowing from another or investor. !t some stage the investor has to purchase the share to close the deal. #his is replaced with borrow-ed shares and profit is made if price falls. Short selling and short s.uee%ed $f at any time while the contract is open the broker runs out of shares to borrow the investor is short s%uee7ed and is forced to close out the position immediately even if not ready to do so. !n investor with a short position must pay to the broker any income such as dividend,interest that would normally be received on the securities that have been shorted. 2etermination of forward rices "-6* rate: - it refers to the risk free rate of interest for many arbitrageurs operating in the futures market. "epurchase agreement

refers to the agreement where the owner of the securities agrees to sell them to a financial institution and buy the same back later. #he repurchase price is slightly higher than the #reasury bill rate -ssum tions and notations &. #here are no transaction costs. 2. Same tax rate for all trading p,l. :. ;ending,borrowing at risk free interest rate. 8. #raders are ready to take advantage of arbitrage opportunities as and when arise. #hese assumptions are e%ually available for all market participants (large,small. 3. #Mtime remained up to delivery date in the contract. 1. SM spot market,cash market. H. JM delivery price at time t. ?. 5M forward,future price today. I. 5 M value of long forward today. &'. " M risk free rate of interest. &&. # M current or present period. The forward rice @e consider three situations:&. $nvestment assets providing no income. 2. $nvestment assets providing known income. :. $nvestment assets providing known yield,income (dividends.) 8. !sset that provides no income. #his is the easiest forward contra-ct to value because such assets do not give any income to the holder. #hese are usually non-dividend paying e%uity shares and discount bonds. -x: - consider a long forward contract to purchase a share (non div paying) in three months. !ssume that the current stock price is "s &''. 'orward rice 5 of an asset roviding no income #he three month risk free rate of interest is 1)p.a. !ssume that the three month forward price is "s &'3:- the arbitrageur can borrow "s &'' R 1) for : months( buy one share at "s &'' and short a forward contract for "s &'3( the sum of money re%uired to pay off the loan is &''e '.'1S'.23 M&'&.3' #his way he will book a profit of "s :.3' i.e. &'3-&'&.3'.we can generali7e as :5 M S-"# @here 5M forward price of stock( SM spot price( #M maturity period( and "M risk free rate( eM expiration period.

$f 5 T S-"# then the arbitrageur can buy the asset and wil go for a short forward contract on the asset. $f 5 U S-"# then he can short and go for long forward contract on it. 'orward rices that rovides known cash income #hese are for coupon bearing bonds( treasury securities etc:/onsider a long forward to purchase a coupon bond whose current price is "s I'' maturing in 3 years. @e assume that the forward contract matures in one year so that the forward contract is to purchase a four year bond in one year. !ssume that the coupon payments are "s 8'( 1monthly and &2monthly. !lso 1monthly and &2 monthly risk free interest is I) and &'). @e assume that the forward price is high at "s I:'. $n this case the arbitrageur can borrow "s I'' to buy the bond and short a forward contract. #hen the first coupon payment has a present value of:8'e-'.'IS'.3 M "sM :?.28. So the balance amount "s ?1&.H1 (I'':?.28) is borrow-ed R &') for year. the amount owing at the end of the year is:?1&.H1e '.&S& MI32.:I. #he second coup-on provides "s 8' towards this amount and "s I:' is received for the bond under the terms of the forward contract .the arbitrageur will earn ("s 8' O I:') -I32.:I M &H.1& So it can be generali7ed that for such assets where the income is known the forward price would be 5 M (s N i) ert. $f fT(s-i)ert the investor can earn the profit by buying the asset and shorting the asset forward and taking a long position in a forward contract and vice versa. 'orward rice where the income is a known dividend !ield

! known dividend yield means that when income expressed as a percentage of the asset life is known. .ere we assume that dividend yield is paid continuously as a constant annual rate at % then the forward price for a asset would be: - f M se (r- %) t ;et us consider a 1-month forward contract on a security where 8) p.a. /ontinuous div is expected. #he risk free return is &')( the current price is "s 23. #he forward price is fMse(r-%)t fMse ('.&-.'8)S'.3 M23.H1. $f the forward price is T than the spot price then he can buy the asset and enter into a short forward contract to enter a lock in a risk less profit and vice versa.

6aluing forward contract #he value of a forward contract at the time of its writing is 7ero. .owever at a later date it may prove to be a Ove , -ve value. $t may be determined as follows:f M (f-k) e-rt where fMvalue of forward contract. 5M forward price and k M delivery price of the asset( t M time to maturity and rM risk free return,risk free rate of interest. @e compare a long forward contract that has a delivery price of KfA with an otherwise identical long forward contract with a delivery price of KkA. we know that the for-ward price is changing with the passage of time and that is why later on f and k may not be e%ual which were otherwise e%ual at the time of entrance of contract. #he difference between the two is only in the amount that will be paid for the security at the time KtA under the first contract this amount is KfA( and under the second contract it is KkA. ! cash outflow difference of f-t at the time t translates to a difference of (f-t)e-rt today. #herefore the contract with a delivery price of f is less valuable than the contract with a delivery price of k by an amount of (f-k)e-rt. #he value of contract that has a delivery price of f is by definition 7ero. Similarly the value of a short forward contract with the delivery price k is fM(k-f)e rt. /onsider a six month long contract of a non income paying security. #he risk free rate of interest is 1) p.a. #he stock price is "s :' and the delivery price is "s 2?. /ompute the value of the forward contract. 5orward price fM:'e '.'1S.'3 Mrs:'.I' alue of forward contractM 5M (f-k)e-rt (:'.I'-2?)e -'.'1S.3 M2.I-'.'IM 2.?& app. *r fM:'-2? -'.'1S'.3 M2.?8 app. @e can show the value of long forward contract as:&. !sset with no income MfMs-ke-rt 2. !sset with known income:fMs-i-ke-rt. :. !sset with known dividend yield. at the rate %:- fMse-%t Nke-rt .so in each case the forward price f is the value of k which makes f e%ual to 7ero. 7ain on long and short osition er contract #he concept of the forward price for a forward contract is +ust like the future price for a future contract. ! contractAs current forward price is the delivery price that would apply if the contract were negotiated today. #he forward price is the delivery price which would make that contract to 7ero value. that means the forward price and the delivery price are e%ual at the time the contract is written.

.owever in practice as the time passes the forward price is liable to change whereas the delivery price remains same. $t means the forward price and delivery price may not be e%ual at any time after the start of the contract except by chance. in fact the forward price at any given time !"ies with the maturity of the contract #he forward price of a contract usually depends upon the spot and foreign exchange %uotations given by !"ious banks. !s the for-ward rates are normally %uoted for a year and available in forward exchange market the trader can easily make the ad+ustments in their forward rates. 7ains on long and s ot ositions er contract >otations:&. 5t tMforward price at time t of a contract that expires at time t. 2. St Mspot price at t (enter period). :. St M future spot price at t 8. J M delivery price. #he profit and loss on a forward contract is determined by future spot rate st. 7ains on long and short osition er contract. #hose holding long forward positions( the profit will arise on the futures spot price is higher than the delivery price. (assume that the forward price and delivery price are the same) since the mark-et price of the asset is higher than the price at which the buyers (long) have contracted to buy. <ains on long position per contract Mno of unitsS(future spot price N forward price or delivery price.) M no of units Vst-k(or ft t)W @here the no of units is per contract. (#hose holding short forward positions the gain will incur to them of the futures spot price falls below the forward price.) <ains on short position per contra-ct:M no of unitsS(forward price-futures spot price) Mno of units S Vft t(or k) NstW @here the number of units is per contract. Theories of futures rices #here are two important theories which have made efforts to explain the relationship between spot and futures prices. #hey are:&. #he cost of carry approach. 2. #he expectation approach

1. The cost of carr! a roach #op economists like Jeynes and hicks have argued that futures prices essentially reflect the carrying cost of the underlying assets. #he interrelationship between the spot and futures prices reflect the carrying costs i.e. #he amount to be paid to store the asset from the present time to the future maturity time, date. /arrying costs are of several types: &. Storage costs. 2. $nsurance costs. :. #ransportation costs. 8. 5inancing costs. &. Storage costs:- these are costs of storing and maintaining the asset in safe custody. "ent( pilferage( deterioration in %uality etc. 2 insurance costs:- amount incurred on safety of assets against fire( damage( accidents etc. the premium paid is called as insurance costs. :. #ransportation costs:- when the futures contract matures then the delivery is to be given at a particular place and time at !"ious locations. 8. /ost of financing the underlying asset:-if gold costs "s 3(''' per &' grams and the cost of financing is &) per month then "s 3' is the financing charge. !part from the carrying cost we may also have the possibility of earning a yield on storing the asset called as convenience yield. #he marginal cost of carrying of an asset is:ct M cgt - yt where:/t M net cost of carrying the asset. /gt M gross carrying cost of that %uantity. Et M convenience yield. #he cost of carry model in perfect market:5uture priceM spot price Ocarrying cost. /onditions of a perfect market:>o transaction cost( unlimited capacity to borrow,lend( borrowing rates are same( no credit risk( no margin for trading( no taxes( and goods can be stored without loss in %uality. The e, ectation a roach #he economists argued that the futures prices as the market expectation of the price at the futures date. #raders who use the futures market to hedge would like to study how todays futures prices are related to market expectations about futures prices. -xpected futures profit M expected futures price N initial future price any ma+or deviation of the futures prices from the expected prices will be corrected by speculative activity. 6rofit seeking traders will trade

as long as the futures price is sufficiently far away from the expected futures spot price. Stock inde, futures ! stock index or stock market index is a portfolio consisting of a collection of different stocks. #hat means a stock index is +ust like a portfolio consisting of a collection of different securities proportions traded on a particular stock exchange like >$5#E SC6 />D( traded on >S-( the SC6 3'' index is composed of 3'' common stocks. #hese indices provide summary measure of changes in the value of a particular segments of the stock markets which is covered by the specific index. #his means that a change in a particular index reflects the change in the average value of the stocks included in the index. #he number of stocks included in a particular index may depend upon its ob+ectives and thus the si7e !"ies index to index. 5or example the S->S-D has :' stocks whereas 3'' stocks are covered under standards and 6**"AS 3''. /ommon features:&. ! stock index covers a specific no of stocks like :'( 3'( &''( 3'' etc. 2. Selection of a base period on which index is based. Starting value of base is &''( &''' etc. :. #he method or rule of selection of a stock for inclusion in the index to determine the value of the index. 8. #here are !"ious methods used to calculate like arithmetic mean etc 3. #here are three types of index constructions like price weighted( return weighted and market capitali7ation weighted index. 1. ! stock index represents the change in the value of a set of stocks which constitute the index. H. #he index should represent the market and be able to represent the returns obtained by a typical portfolio of that market. ?. ! stock index also acts as the barometer for market behavior( a benchmark for the portfolio performance. $t also reflects the changing expectations of the market. I. #he index components should be highly li%uid( professionally maintained and accurately calculated. ! stock index futures contract is a future is a contract to buy,sell the face value of a stock index. #he most actively traded index is the !merican SC6 3'' index.

MO281) (
Risk management using swa s #he term swap means to barter or to give in exchange or to exchange one for another. so swaps are private agreements between the two parties to exchange cash flows in the future according to a prearranged formula. So swaps are an agreement to exchange payments of two different kinds in the future. $n the context of financial markets the term swap has two meaning:&. $t is a purchase and simultaneous forward sale or vice versa. 2. $t is defined as the agreed exchange of future cash flows possibly but not necessarily with a spot exchange of cash flows. #he second definition of swap is most commonly used stating as an agreement to the future exchange of cash flows. #hese can be regarded as series or portfolios of forward contract. Such a currency swap is similar to a succession of forward foreign exchange contracts with relatively distant maturity basis. #he study of swap is thus a natural extension of forward and future contract. 5inancial swap is a specific funding techni%ue which permits a borrower to access one market and then exchange the liability for another type of liability. Swaps can be helpful to change the nature of liability accrued on a particular instrument with the others. $t means that swaps are not a funding instrument rather +ust like a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. 4asically swaps involve the exchange of interest or currency exposures or a combination of both by borrowers. #hey may not necessarily involve the legal swapping of actual debts but an agreement is executed to meet certain cash flows under the loan or lease agreements. Swap market exist because different companies have specific access to !"ious financial markets and they have different needs. Some companies have better access to Bapanese markets than others where-as otherAs may have good reputation in us markets. Some need floating rate of payments. So swap is a private agreement between the two parties to exchange predetermined amount of cash flows in future as per desired formula along with others terms. )volution of swa market ;ike most new products,instruments in international finance swaps are not executed in a physical market. 6articipants and dealers in the swap

market are many and !"ied in their location( character and motives. Swaps originated in early &IH'As when many countries imposed foreign exchange restrictions Some are of the opinion that swaps owe their origin to the exchange rate instability that followed the demise of the 4retton @oods system during the mid &IH'As. $n &I?' a few countries liberali7ed their foreign exchange regime as a result some of the treasurers structured their portfolioAs and brought a new product called swaps. #hey replaced their back to back loans with swap deals which found them more flexible and simpler due to simpler documentation. $t also lowered financing cost and tax differences in comparison to the earlier contracts. !lso 9>/As started directly interacting instead of banks. ! ma+or dramatic change in the swap market has been the emergence of large banks and performed as aggressive market makers in dollar interest rate swaps. #hey offered bid ,offer %uotes for both interest rate and currency swaps. 4anks also found a counter party who exactly re%uired the same to hedge the transaction. $n &I?8 the international swap dealers association was formed to speed up the growth in the swap markets by standardi7ing the documents. in &I?3 the first swap code was devised. $n &I?H it formed a standard forms agreement. #hese contracts are structured as master agreements. 'eatures of swa s. &. /ounter parties:- all swaps involve the exchange of a series of periodic payments between at least 2 parties.(example :interest rate fixed,floating) 2. 5acilitators: - swap agreements are usually arranged through an intermediary financial institution like a banker. 4rokers and swap dealer are two categories of facilitators. a) 4rokers bring parties to a swap deal. #heir basic idea is to initiate the /ounter parties to finali7e a deal. b) Swap dealers: - they themselves become the counter parties and takeover risk. #hey have to price the swap( and manage the portfolio. :. /ash flows:-here we have 2 different cash flows. $t is a deal where we exchange two financial obligations in the future. so we examine the present value of future cash streams. 8. =ocumentations:- formalities are lesser as compared to a loan( less time consuming and simpler. 3. #ransaction costs:-they are very low at almost 0) of the total sum of the contract. 1. 4enefits to parties:- these deals are needed as long as both parties are happy and find it profitable.

H. #ermination: both parties need to terminate the contract and not one party. ?. =efault risk:-as they are bilateral agreements there are possibilities of default risk by both the party. #ypes of swaps:-the basic purpose of swaps is to hedge the risk as desired by both the parties. #he ma+or risks are interest rate( currency( commodity( e%uity - debt( credit( climate( etc. *nterest rate swa s:" $t is a financial agreement between two parties who wish to change the interest payments or receipts in the same currency on assets or liabilities to a different basis. #here is no exchange of the principal amount in this swap. $t is an exchange of interest payments for a specific maturity on a agreed upon notional amount. #he term notional refers to the theoretical principal underlying the swap. it is used only to calculate the interest to be exchanged under the interest rate swap. #he example of exchanging a fixed to floating rate of interest in the same currency is called as the plain vanilla swap. $t involves credit differentials between two borrowers which generate sufficient cost savings for both the parties. 'eatures of interest rate swa s &. >otional principal:- in the interest rate swap agreement the interest amount whether fixed or floating is calculated on a specified amount borrowed or lent. $t is the notional because the parties do not exchange this amount at any time. $t remains constant at all times. $t is used to compute the se%uence of payments of cash flow 2. 5ixed rate:-this is the rate which is used to calculate the si7e of the fixed payment. 4anks or the other financial $nstitutions who make the market in interest rate swaps %uote the fixed rate they are willing to pay if they are fixed rate payers in a swap (bid swap rates)( they are willing to receive if they are floating rate payers in a swap(ask swap rate). -x:- a bank might %uote a us Q floating to fixed 3-year swap rate:#reasuriesO2'bp,treasuriesO8'bp vs 1 month ;$4*". #he %uote indicates the following:&. #he said bank is willing to make fixed payment at a rate e%ual to the current yield on a 3 year treasury notes O2' basis points (.2')) in return for receiving floating payments at 1 months ;$4*". 2. #he bank has offered to accept at a rate e%ual to 3 year treasury notes plus 8' basis points in return for payment of 1 months ;$4*". 5loating rate:- it is defined as one in the market index like ;$4*" treasury bill rate etc on which basis the floating interest rate is

determined in the swap agreement. #he maturity of the underlying index e%uals the interval between payment dates. #rade date( effective date( reset date( and payment date:!ll the above mentioned dates are important terms in the swap deal: #he fixed rate payments are normally paid semi annually,yearly. #he trade date may be defined as such date on which the swap deal is concluded. -ffective date is that date from which the first fixed,floating payment starts to accrue. for ex:- a 3 year swap is traded on :'-'?-2''2 the effective date may be '&-'I-2''2 and ten payments dates from &-':2'': to '&-'I-2''H.the floating rate payments in swaps are set in advance and paid in arrears. "elevant dates for the floating payment:&) =(s) 2.d(&) and :.d(2). @here d(s) is setting date on which floating rate applicable for the next payment is set. =(&)Mthat date from which the next floating payment starts to accrue. =(2)M payment is due. T! es of interest rate swa s 1. $lain vanilla swa :- it is also known as fixed for floating swap. .ere one party with a floating interest rate liability is exchanged with fixed rate liability. Usually swap period ranges from 2 to &3 years for a predetermined notional principal amount. 9ost of the deals occur within 8 years period. 2. 9ero cou on to floating:-the holders of 7ero-coupon bonds get the full amount of loan and interest accrued at the maturity of the bond. .ence in this swap the fixed rate player makes a bullet payment at the end and the floating rate player makes the periodic payment throughout the swap period. (. -lternative floating rate:- in this type of swap the floating reference can be switched to other alter-natives as per the re%uirement of the counter party. #hese alternatives include : month libor(& month commercial paper( t-bills rate etc. #hat means alternative floating interest rates are charged in order to meet the exposure of others. +. 'loating to floating :- in this swap one counter party pays one floating rate say ;$4*" while the other counter party pays another say prime for a specified time period. #hese swap deals are mainly used by non us banks to manage their dollar exposure.

:. 'orward swa s:-this swap involves an exchange of interest rate payment that does not begin until a specified future point of time. it is also kind of swap involving fixed for floating interest rate. ;. ).uit! swa :-the e%uity swap involves the exchange of interest payments linked to the change of stock index. <. Swa tions:- these are combination of options and swaps. #he buyer of swaption has the right to enter into an interest rate swap agreement by some specified date in the future. the buyer of a swaption will specify whether the buyer will be a fixed rate receiver or a fixed rate payer. 6aluation of interest rate swa !ssuming no default risk an interest rate swap can be valued either as a long position in one bond combined with short in another bond or as a portfolio of forward contracts. $n other words interest rate swap (fixed or floating) can be valued by treating the fixed rate payments as being e%uivalent to a floating rate note (frn). !ssuming no default risk an interest rate swap can be valued either as a long position in one bond combined with a short in another bond or as a portfolio of forward contracts. $nterest rate swap (fixed or floating) can be valued by treating the fixed rate payments as being e%uivalent to the cash flows of a conventional bond and the floating rate payments as being e%uivalent to a floating rate note. (frn) in a interest rate swap the principal amount is not exchanged and further amount is paid in the same currency. #hus the value of swap could be expressed as the value of fixed rate bond and value of floating rate underlying the swap. $t may be expressed as:- v M b&- b2 where vMvalue of swap(b& M the value of fixed rate bond underlying the swap and b2Mvalue of floating rate bond underlying the swap. #urrenc! swa s ! swap deal can also be arranged across currencies. $n this swap the two payment streams being exchanged are denominated in two different currencies. 5or ex a firm which has borrowed yen at a fixed interest rate can swap away the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate of return for Q at either at fixed ,floating int. #he currency swap is like interest rate swap( also two party transaction involving two counter parties with different but complimentary needs being bought by a bank. .ere three steps are involved:&. $nitial exchange of principal amount.

2. *ngoing exchange of interest. :. "e-exchange of principal amount on maturity. #he first step is the initial exchange of the principal amount at an agreed rate of exchange. #his rate is usually based on the spot rate. #his exchange can be on a notional basis i.e. >o physical exchange of principal amount. #he counter parties simply convert principal amount into the re%uired currency-via the spot market. #he second step is related with ongoing exchange of interest. !fter establishing the principal amount the counter parties exchange interest payment on a agreed date based on the o,s principal amount at the fixed interest rates at the outset of the transaction. #he third step is the re-exchange of principal to principal amount. !greements on this enable the counter parties to re-exchange the principal sums at the maturity date. #he structure of a currency swap differs from interest rate swaps in a !"iety of ways. T! es of currenc! swa s #he ma+or difference is that in a currency swap there is always an exchange of principal amounts at maturity at a predetermined exchange rate. #hus the swap contract behaves like a long dated forward( is forward exchange contract where the forward is the current spot rate. #he currency swaps can be of different types based on their structure such as:1. fi,ed to fi,ed currenc! swa :" .ere the currencies are exchanged at fixed rate. *ne party raises a fixed rate liability in Q and the other a fixed rate funding in pound. #he principal amount is e%uivalent at current market exchange rate. $n a swap deal the first party gets pound whereas the second party gets Q. ;ater on the first party gets to make periodic payments in pound to the second in turn gets Q computed at interest at a fixed rate on the respective principal amount of both currencies. at maturity the Q and pound principal are re-exchanged. 2. 'loating to floating swa :-here the counter parties will have payments at floating rate in different currencies. (. 'i,ed to floating currenc! swa s : this swap is a combination of a fixed to fixed currency swap and floating swap. here one party makes the payment at a fixed rate in currency say x while the other party makes the payment at a floating rate in currency y. /ontracts without the exchange and re-exchange of principals do exist. $n most cases a financial intermediary (a swap bank) structures the

swap deals and routes the payments from one party to other party. the most important currencies in the currency swaps market are:#urrenc! swa s"uses USQ( S@$SS 5"!>/( =-U#S/.- 9!"J( -U"* 6*U>= S#-";$><( /!>!=$!> Q C E->. #he currency swap is an important tool to manage currency exposure and cost benefits at the same time. #hese are often used to provide long term financing in foreign currencies. #his is because in many countries fin markets are not well developed. 6aluation of currenc! swa .ere the swaps are valued as the difference between the current values of two conventional bonds. #he value of a foreign currency bond and the corresponding value of a domestic currency bond are taken. MsbfNbd where vMvalue of swap( sMcurrent exchange rate expressed in no of units of domestic currency( bfMvalue of a fr /urrency bond( and bd Mlocal currency bond

MO281) +
Risk management using o tions !n option is a particular type of a contract between two parties where one person gives the other the right to buy or sell a specific price within a specific time period. #he option is a specific derivative instrument under which one party gets the right but no obligation to buy ,sell a specific %uantity of an asset at an agreed price on or before a particular date. #he buyer will exercise the option only when he expects to gain. $n case of losses he will not exercise the option. nowadays options are traded on a !"iety of instrument like commodities( financial assets( treasury bills( stocks( stock index food grains( petroleum( metals etc. O tions terminologies 1. $arties in a o tion deal: @e have two parties the buyer (holder) and seller (writer). #he writer grants the buyer the right to buy or sell a particular asset in exchange for a certain sum of money for the obligation taken by him in the option contract. 2. ),ercise rice:#he price at which the underlying asset may be sold or purchased by the option buyer from the option writer is called as exercise or strike price. at this price the buyer can exercise his option. (. ), iration date and e,ercise date: #he date on which an option contract expires is called as expiration date or maturity date. #he option holder has the right to exercise his option on any date before the expiration date. -xercise date is date upon which the option is actually exercised. +. O tion remium:- the price at which the option holder buys the right from the option writer is called as option premium ,price. #his is the consideration paid by the buyer to the seller and it remained with the seller whether the option is exercised or not. this is fixed and paid at the time of writing the option deal. :. O tion =in>4 =out> and at the mone! :@hen the underlying futures price is greater than the strike price, exercise price( the option is in the money( and the futures price is

lesser than the strike price it will be called as out of money call option( and if the futures price is e%ual to the strike price it is at the money. O tion terminologies 6ay off profile of option $n the money !t the money *ut of money /all opt futT str futMstr fut U str put opt futU str futMstr futTstr

1. #he break even price:$t is that price of the stock where the gain on the option is +ust e%u-al to the option premium. #he break even price level is determined by adding the strike price and the premium paid together. Since there is 7ero sum game the profit from selling a call is the mirror image of the profit from buying the call. T! es of o tions *ptions can be classified into:1. #all and ut o tions. 2. -merican and )uro ean o tions. (. ),change traded and OT# traded o tions. #all and ut o tions:"

@hen an option grants the buyer the right to purchase the underlying asset from the writer (seller) a particular %uantity at a specified price within a specified expiration date it is called Fcall optionG. #he call option holder pays the premium to the writer. ! put option is an option where the option buyer has the right to sell the underlying asset to the writer at a specified price at or prior to the optionKs maturity date. $t is also called simply as KputG. So if we buy a put option to on S4$ stock we have gained the right to sell the shares of S4$ to the writer at a specified price on or before the expiration date. T! es of o tions"on the basis of timing ! -uropean option can be exercised only at the expiration date whereas the !merican option can be exercised at any time up to and including the expiration date. 9ost of the options dealt are !merican until actually clarified as -uropean. #he names are merely conventional not geographic.

-x change traded option contracts are standardi7ed and are traded on the recogni7ed exchanges. *#/ options are tailor made agreement sold directly by the dealer. the terms and conditions of these contracts are negotiated by the parties to the contract. 2ifferences " e,change traded and OT# o tions &. -xchange traded are standardi7ed and traded on recogni7ed stock exchanges. *#/ options are written on the counters of commercial C investment bankers. 2. -xchange traded options have certain specified norms relating to %uantity( %uality( dates etc. Under *#/( norms are negotiated and mutually determined by buyers and sellers :. 4eing standardi7ed in nature an option contract traded through the recogni7ed exchange has uniform underlying asset( limited no of strike prices ltd expiration dates etc. but in case of options through *#/ the contracts are tailor made as per the re%uirements of the buyers and sellers. 8. exchange traded options are performed and cleared through a clearing house which acts as a third party. So risk of default is eliminated. 4ut in *#/ traded contracts the risk of default is higher as there are only two parties and if the option writer defaults there is no guarantee. 3. *n buying a options contract from a exchange the obligation can be fulfilled as follows: a) #he buyer may not exercise the option. he may allow it to expire. b) $n the case of an !merican option he may exercise his option on or before the expiration date( letting the seller adhere to contract and keep the premium. /) -ither of the parties can execute an offsetting transaction to eliminate the future obligation. 4ut under an *#/ option no such facilities exist they are tailor made and un-standardi7ed in nature. so the %uestion of offset-ting does not exist. 1. under the writers are expected to deposit margins as they are expos-ed to considerable risk. Under *#/ no such margins exist. H. Under the exchange traded options transactions cost are lower but the *#/ options depend upon the creditworthiness of the buyer ?. $n *#/ traded options market( large investment banking firms and commercial banks normally operates as principals as well as brokers. #hat is why they are less li%uid in comparison to the exchange traded options. 5urther they take them as part of an asset liability management in which they intend to hold them to expiration.

2istinction"o tions and futures &. Under options one party (buyer) is not obligated to transact the contract at a later date( only the seller is under the obligation to perform the option contract and only if the buyer desires. Under futures both the parties are under the obligation to perform the contract. 2. Under the options the buyer of the option has to pay the option premium to the seller and this is forfeited irrespective of completion of the contract. in futures no cash is transferred to either party. :. Under futures contract the buyer of the contract reali7es the gain in cash when the price of the futures contract increases and losses in case of fall in the prices. Under options such symmetric risk,reward relationship does not arise. #he most the buyer can loose is the option premium. 8. *ptions contracts are brought into existence by being traded( if none is traded none exists( also there is no limit on number of option contracts that can be in existence at any time. however in case of future contract there is a process of closing out position which causes contracts to cease. O tions valuation &. $ntrinsic value: - it is the gain to the holder of an option on immediate exercise. Since the investor cannot exercise the option before maturity in -uropean option( so the value is only notional. Under the !merican option it can be exercised at any time before the expiration date. #hat means this value for a call is nothing more than the difference between the market price and strike price of the underlying asset. 5or a call option:- max X(st Nx)('Y where st is current stock price( x is strike price of the asset. if st T x it is positive intrinsic value. it cannot be Nve as buyer will not exercise the option. so the value cannot fall below 7ero. 5or a put option:$ntrinsic value is:9ax X(x Nst)('Y $f xTst the value is Ove( xMst the value is 7ero . 2. Time value of the o tion:#he value of an !merican option at any time prior to expiration must be at least to its intrinsic value. $n general it will be larger. #his is

because there is a possibility that the stock price will move further in favor of the option holder. #he difference between the value of an option at the particular time t and its intrinsic value at the time is called the time value of an option. #his does not hold good to a -uropean option. 9a+or factors that influence the time value are the expected volatility of the stock price( length of the period to expiry( the extent to which the option is in or out of money. $t is observed that out of money options have less time value than at the money options since the stock price has further to move before intrinsic value is ac%uired. Similarly in the money options have less time value than at the money options reason being that their prices contain intrinsic value which is vulnerable to fall in stock price. further the more time remains until expiry the higher the time value tends to be. O tion ositions $n every option contract there are two sides:- &. #he investor who takes the long position ( i.e. .e has purchased the option) 2. *pposite to this is the investor who takes the short position (i.e. .e has sold or writ-ten the option). So if one takes long position then the other short. #here are 8 types of options:&.a long position in a call option. 2.a long position in a put option. :.a short position in a call option. 8.a short position in a put option. >aked (uncovered):- these are options which do not have offsetting positions and are more risky. @here the writer has a corresponding offsetting position in the asset it is a covered option. ?aked and covered o tions @riting a simple uncovered call option indicates toward exposure of the option writer to unlimited potential losses. #he aim is to earn premium. in period of stable,falling prices call options writing may result in attractive profits by capturing the time value of an option. @riting an uncovered option shows the investor tolerance for risk. #overed@uncovered o tions ! covered option position involves the purchase or sale of an option in combination with an offsetting (or opposite) position in the asset which underlies the option. the writer of an call option incurs losses when stock prices rise and put writers incur losses when the prices fall.

$n such a situation the writer can cover the short put with a short position and short call with a long position in the underlying asset. this can be stated as:/overed call saleMshort call Olong futures. /overed put saleM short putO short futures. S!nthetic futures and o tions Synthetic futures positions are created by combining two options positions such that the resulting pay off remains same or nearly same as that of an outright futures position. Synthetic long position is created by combining long call option with short put option having the same strike price. Synthetic short futures are created by combining long put with short call option having the same strike price. #herefore:Syn long futuresMlong call Oshort put. Syn short futuresM long put O short call. Similarly we have synthetic options. The underl!ing assets in e,change traded o tions !"ious assets which are actively traded on the recogni7ed exchanges are stock( stock indices( foreign currencies and futures contracts. &. Stock options:- options on individual shares of common stock have been traded for many years Stock o tions Stock options on a number of over the counter stocks are also available. @hile the strike prices are not because of cash dividends paid to common stock holders the strike price is ad+usted to stock splits( stock dividends( and reorgani7ations etc( which affect the value of the underlying stock. Stock options are most popular assets traded all over the world. 'oreign currenc! o tions #his is another important asset traded on !"ious stock exchanges. 9a+or currencies traded are UsQ( !us Q(4ritish 6ound( /an Q(<er 9ark( 5rench 5ranc( Bap Een( Swiss 5r. #he si7e of the contract differs from currency to currency. @e shall see these under currency options. *nde, o tions 9any different index options are currently traded on different exchanges. $n $ndia trading is undertaken on >S-( and 4S-. ;ike stock option( index optionAs strike price is the index value at which the buyer of the option can buy and sell the underlying stock index.

#he strike index is converted into dollar (rupee) value by multiplying the strike index by the multiple for the contract. if the buyer of the stock index option intends to exercise the option then the stock must be delivered. it would be complicated to settle a stock index option by delivering all stocks that make up the index. So index options are cash settlement contracts. $f the option is exercised the exchange assigned option writer pays cash to the option buyer and there will be no delivery of any share. #he money value of the stock index underlying an index option is e%ual to the current cash index value multiplied by contracts multiple. "upee value of the underlying index M cash index valueScontract multiples. 5or example:- the contract multiple for the SC6 &'' is Q&''. !ssume that cash index value for the SC6 &'' is H3' then the dollar value of SC6 &'' contracts is H3'S&'' M QH3('''

Module :
)lementar! investment strategies #he use of options enables an investor to achieve uni%ue risk-return patterns which cannot be achieved by taking investment positions only in the underlying assets. #his is in fact the economic rationale for the existence of options. #he two investment strategies well known are long and short position. *nvestment strategies 1. 1ong osition:- a position created by a person by buying an asset without taking any off setting position. #he above buyer will gain when the price rises and lose due to the fall in price. on the other hand if the stock price remains unchanged or declines the invest-or makes no profit or incurs a loss (ignoring transaction 2. Short osition:a short position involves selling the asset first (without actually owning it) and buying it back later. #he investor who short sells hopes that the price will decline during the time he is short. (. 1ong call:long call refers to the purchase of a call. #he similarity between the long position in the underlying asset and long call position is that the investor concerned must be bullish on the underlying asset. +. Short call:#he strategy involves writing a call without owning the underlying asset. #he call writer makes a profit if the option expires worthless on the expiration date. :. 1ong ut:#his strategy involves buying a put- right to sell the underlying asset at a specified price. #he put buyer anticipates a decline in the price of an underlying asset. ;. Short ut:#his is a strategy of writing a put. $n contrast to the put buyer the put writer is bullish on the underlying asset and earns an income (in

the form of put premium) by speculating on his prediction. .e is also prepared to accept ownership should the put owner decide to exercise. #a s4 'loors -nd #ollars /aps (interest rate caps):- a cap is a series of interest rate options( which guarantees a fixed rate payable on a borrowing over a specific time period at specific future dates. $f interest rates rise above the agreed cap rate then the seller pays the difference between the cap rate and the interest rate to the purchaser. ! cap is usually bought to hedge against a rise in interest rate and yet is not a part of the loan agreement and may be bought from a completely different bank,writer. $n a cap usually an upfront fee is to be paid to the bank,writer. the cap guarantees that the rate charged on a loan will never exceed the current existing rates. 5loors:- a floor is an agreement where the seller agrees to compensate the buyer if interest rates fall below the agreed up to a on floor rate. $t is similar to a cap but ensures that if the interest rate falls below a certain agreed floor limit interest rate will be paid. /ollars:a collar is a combination of a cap and a floor where you sell a floor at a lower strike rate and buy a cap at a higher strike rate. #hus they provide protection against a rise in interest rates and some benefit from a fall in interest rates.

Straddle ! straddle involves a call and a put option with the same exercise price and the same expiration date. ! straddle buyer buys a call and a put option and the seller sells a call and a put option at the same exercise

price and the same expiration date. #he maximum loss associated with the long straddle is the premium paid ,cost of option 6rofit potential is unlimited when the prices of the underlying asset rise significantly and limited when it falls significantly. it is a case when investor purchasing a straddle makes profit at prices which are significantly lower, higher than the prevailing market price. #his strategy will appeal to an investor who wants to take a position in an underlying asset that is volatile but does not have a clue whether it will rise or fall in the short run. the investor however only anticipates a sharp movement in the price of the asset.

#he graph has been drawn connecting the daily high-low prices. the triangular formation reveals that there has to be a break out either upwards or downwards. it is difficult to predict the direction in which the stock will move because the successive tops are lower than the preceding tops which is a bearish signal. !lso the successive lows are higher than the preceding low which is a bullish signal. if the investor knows that the stock is a volatile 7 tock he can profit from this scenario by buying a straddle on the stock. *bviously the writer of a straddle anticipates no ma+or fluctuation in the prices of assets Strangle $t is a combination of a call and a put with the same expiration date and different strike prices. $f the strike prices of the call and the put options are x& and x2 then a strangle is chosen in such a way that x&Tx2. !ssume that we buy a call and put option on a particular stock with strike prices Q:3 C Q:'. ;et the cost of call and put option be Q: and Q 3 respectively. our initial out flow is Q?. $f we have to benefit the total payoff should

exceed Q?.we will exercise the call option only when the price of the stock at expiration goes above Q:?.similarly put option only if price is below Q23. #o break even the stockAs price at expiration should be below Q22 'r above Q8:. $f the price falls between Q22 and Q8: then we do not benefit from the strategy by having a loss. *utside this range we have a profit potential. So profit and loss on a short position in a strangle is reverse of that of the long position.

Stri s and stra s ! strip consists of a long position in one call and two puts with the same exercise price and expiration date. #he buyer of a strip believes that there will be a big stock price move but the stock price is more likely to fall than it is to rise. ! strap consists of a long position in two calls and one put with the same strike price and expiration date. ! strap is like a strip that is skewed in the opposite direction. #he buyer of a strap expects bullish and bearish possibilities for the optioned security with a price rise being more likely.

S read strategies #hese are employed for exploiting moderately bullish or bearish beliefs about the market. #hey involve use of options. &. ertical spreads or price spreads: #hese involve buying an option and selling another option of the same type and time to expiration but with different exercise price 2. .ori7ontal spread (time) involves buying an option and selling another option of the same type with same exercise price but with a different time of expiration. :. =iagonal spread involves buying an option and selling another of the same type with a different exercise price and different time to expiration. 3ulls and bear s read $f we wish to buy a bull spread using calls then we buy a call with a lower strike price and sell a call at a higher strike price. #his strategy is called a spread because it involves buying an option and selling a related option to limit the risk. this strategy also limits the profit potential. #he cost of a bull spread is cost of the option bought less the cost of the option sold.

3o, s read $t is a combination of bull and bear spreads with calls and puts respectively with the same set of exercise prices. if x& and x2 are strike prices available with calls and puts then a box spread involves

buying and selling a put with strike prices x2 and x&.for a risk averse investor this strategy is ideal as it gives a payoff of the difference between the higher and the lower strike prices i.e. D2-x&.

3utterfl! s read ! butterfly spread can be executed by using four identical options with the same underlying stock but with different exercise prices. ! trader who is long on the butterfly spread buys a call with a low exercise price( buys a call with a high exercise price and sells two calls at intermediate exercise price

O tion

ricing model

=eterminants of option prices:#he following are the important factors which influence the option pricing. &. /urrent price of the option: the option price will change as the stock price changes. #he option price increases if the stock price increases and vice versa. 2. Strike price of the options:#he strike price is fixed for the life of the option. *ther things remaining same in case of call option the lower the strike price the higher will be the option price and vice versa. :. #ime to expiration of the option:*ptions are wasting assets. !s it has a fixed time period. #he longer the time period to expiration the higher is the option price. #his is because as the time to maturity decreases lesser time remains for the stock price to fall,increase. 8. -xpected stock price volatility:5luctuations in stock prices in future is a ma+or factor to influence the option price as greater the expected volatility of the price of the stock the more an investor would be willing to pay for the option and more premium the writer would demand. 3. "isk free interest rate:- interest rate is an important factor which creates impact on the option price. #he higher the interest rate (short term risk free) the greater the cost of buying the underlying and carrying it to the expiration date of the call option. .ence the higher the interest rate the greater the price of the call option. 1. !nticipated cash payments on the stock:-it tends to decrease the price of a call option because the cash payments make it more attractive to hold stock than to hold the option. on the other hand for put option cash payments on the stock tend to increase the price. $arameters e, laining behavior of stock rices &. -xpected return from the stock:-this is the annuali7ed average return earned by the investors in a short period denoted by u. #he expected return desired by invest-ors from stock depends on the riskiness of the stock. .igher the risk higher the return( and the market interest rate.

2. olatility: - the volatility of stock( Z is a measure of uncertainty about the returns provided by the stock. olatilities are expressed in ) per annum. it is defined as F the volatility of a stock price is the standard deviation of the return provided by the stock in one year when the return is expressed using continuous compoundingG. #he sd of the proportional change in stock price in timeKtA:- assume Z on a stock is :')pa.to find the change in six months then Z M:'['.3 M2&.2) and for : months it is :'['.23 M&3).so sd will increase as the period lengthen. <raphically the curve becomes flatter and wider. Models of valuation of o tions &. 4inomial option pricing model:#his model was developed by /ox( "oss and "ubinstein in &IHI.this model assumes that the prices change in follow a binomial distribution. $t follows the -uropean call options. $t solves the problem numerically rather than analytically. 3inomial ricing model 5assum tions &. #here are no transaction costs( no bid,ask spread (no margin re%uirements( no restriction on short sales( no taxes 2. #here is no risk of default by the other party in the contract. :. 9arkets are competitive( i.e. 9arket participants act as price takers and not makers. 8. #here are no arbitrage opportunities. 6rices have ad+usted in such a way so that there are no arbitrage opportunities in the market. 3. #here is no interest rate uncertainty. #his is assumed to reduce the complexity of the pricing problems. The binomial model #he model is based on the assumption that if a share price is observed at the start and end of a period of time it will take one of the two values at the end of that period i.e the model assumes that the share price would move up or down to a predetermined level. One ste binomial model /onsider a situation where a stock price is currently rs 2' and it is known that after : months it may be either rs 22 or rs &?. @e also assume a -uropean call option to buy the stock for rs 2& in : months in this option we are estimating two values i.e. "s 22 and rs &?( if the value turns up to 22 the option value will be re & and if &? it is '. #he situationM So M initial stock price rs 2'

S& M stock price after period U' M up factor =' M down factor S& M u'(s') when stock price M22 and s& M d'(s') when stock price M &?. @hen the initial stock price M2'( uo M 22-2'M2,2'( &.&' and the down fact-or doM 2'-&?M2,2'( '.I'. #hese are called as price relatives. #he assumption that the stock price can take only one of the two possible values at the end of each interval is referred as the binomial model. /onsider a portfolio consisting of a long position in \shares of the stock an a short position in call option. @e can find out the value of portfolio which is riskless. $f the share price moves up from 2' to 22 the value of shares will be 22\ and the value of the option will be & i.e. 22-2&. #he total value of the option will be 22 \ N &. $f the price falls to &? the value of the shares is &? \ and the value of the option is 7ero so that the total value of the port-folio is &? \O' M &?\. #he portfolio is riskless if the value of \ is chosen so that the final value of the portfolio is the same for both of the alternative stock prices. #his means 22\ N &M&?\ 8 \ M &( \M '.23 ! riskless portfolio is( therefore:;ong: '.23( short: & option. $f the stock price moves upward to 22 the value of the portfolio will be 22S'.23-& M8.3. $f the stock prices moves downward to &? the value is &?S'.23 M 8.3. So irrespective of whether the stock price moves up or down( the value of the portfolio is always 8.3 at the end of the life of the option. !naly7ing the risk free portfolio must earn risk free interest. !ssuming risk free interest R &2)pa( the value of the portfolio today must be the present value of 8.3 or 8.3e-'.&2So.23 M8.:1H #he current price of the stock is 2'( assuming option price denoted by f the value of the portfolio today is 2'S'.23 N f M 3 N f. $t follows that 3 N f M8.:1H or fM '.1::. #his means that current value of option must be '.1::. $f the value of the option were more than '.1:: the portfolio would cost less than 8.:1H to set up and would earn more than the risk free rate and vice versa. 3lack and scholes o tion ricing model #his is the most commonly used option pricing model in finance. it was developed in &IH: by fisher black and myron scholes and was designed to price -uropean options on non-dividend paying stocks. ;ater it was modified for !merican options( options on dividend paying stock( and for future contracts.

&. $t assumes that the expected return and standard deviation are constant. (u and Z are constant) 2. #here are no taxes and transaction costs. :. !ll securities,stocks are perfect-ly divisible. 8. >o dividend payments on stock during the life of the option. 3. #here is no risk less arbitrage opportunities. 1. Stock trading is continuous. H. $nvestors can borrow or lend at the same risk free rate of interest ?. #he short term risk free interest rate KrA is constant. #he foundation of the model is the construction of a hypothetical risk free portfolio( consisting of long call options and short positions in the underlying stock on which an investor earns the risk less return. it is analogous to the no arbitrage analysis. #he reason why a risk less portfolio can be set up is because the stock price and the option price are both affected by the same underlying source of uncertainties and factors. $n short period the stock price is perfectly correlated with the option price and the price of a put option is perfectly negatively correlated with the price of the underlying stock. $n this way in both cases when an appropriate portfolio of the stock and option is created( profit and loss from stock position will offset the profit and loss from option position so that the overall value of the portfolio at the end of the short period of time is known with certainty. /Msn(d&)-ke-rt n(d2) (call option) -rt 6M ke n(-d2) N sn(-d&) (put option) =& M ln(s,k) O rt O '.3Z[t Z[t =2 M ln(s,k) O rt - '.3Z[t Z[t or d2Md&- Z[t /M call option( pMput option( sM stock price( kM strike price( eM exponential ( constant value 2.H&?2?&?)( rMrisk free interest rate annual( tM time to expiry in years( ZMsd of returns (volatility) as a decimal( e-rt is present value of a future sum of money( lnM natural log(nd& is the area under the distribution to the left of d& and nd2 is left of d2. &edging with o tions .edging through financial derivatives is an important strategy of financial institutions( traders( and other dealers. #he ultimate economic function of financial derivatives is to provide means of risk

reduction. !s seen earlier hedgers using futures basically attempt to lock in a specific price. $n case of options hedgers seek to set a specific floor or ceiling price. 5or ex:- an option hedger can establish a floor price for a long put position and in case of a long call position a ceiling price is established. So options can be regarded as means of insurance against adverse price movements !nyone who is at a risk from a price change can use options to offset that risk. 5or ex:- a call option can be used as a means of ensuring a maximum purchase price in which if the market price exceeds the strike price then the option can be exercised in order to buy at the strike price and vice versa. The conce t of fi,ed hedge @hen the si7e of the option being hedged matches the amount of the underlying covered by the options the hedge is referred to as a fixed hedge. ! fixed hedge with option retains an exposure and entails a cost. while protection is obtained from a stock price movement in one direction exposure is retained to a movement in other direction. #his profit potential is paid for in the form of option premium. So it should be decided whether hedging is really desirable. $f so whether options constitute the appropriate hedging instrument. 4ecause if there is no intention to sell then there is no need to hedge. ?aked and covered osition *ne strategy open to the hedger is to do nothing. #his involves what is known as a naked option. ! naked call option is also termed as a call option that is not used for hedging an existing exposure. !n alternative is covered position. #his involves buying the stock as soon as the option has been sold. $f the option is exercised this strategy works well. $f the option is not exercised the covered position could price to be expensive. .owever neither a naked position nor a covered position provides a satisfactory hedge. - sto " loss strateg! #his is an interesting hedging strategy where the stocks are purchased and sold against writing a call or put option. for ex:- a firm which has a call option with exercise price of x to buy one unit of stock. #he hedging strategy is to buy the stock as soon as the prices rise over x and sell at fall. #he ob+ective of this strategy is to hold a naked position whenever the stock price is less than x and covered position if the stock price is higher than x. #he strategy is designed to ensure that the firm owns

the stock when the option is in the money and does not own it if the option is out of the money. 9ero"cost o tion strateg! #his strategy involves when an opt-ion is purchased at a particular premium and at the same time( selling an option which gives same si7e to the receipt of premium. $t means paying the premium on one option and receiving the premium on the other option and thus bearing 7ero cost on the option. ]ero cost options are instruments which can be broken down into:&.participting forwards:- all the constituents have the same strike price. 5or hedging against price fall a purchase of out of the money puts could be financed by the sale of a smaller number of in the money calls. $n this strategy put options will fully cover against the price fall whereas the call option would not fully negate the benefits of a price rise. So in this situation net effect is that of a forward contract that allows some participation in the benefits of a price rise. 2. "ange forwards:- this is also call-ed as cylinder or split synthetic. $n these techni%ue constituents options have different strike prices. ex:in case of falling prices( hedging can be by buying a put option with a strike price below the stock price and financing the same by writing a call option with a strike price above stock price. !s a result there will be advantage of allowing some profit from a rise in the stock price( but at the cost of having no protection against a price fall until the stock price reaches the strike price of the put option. 2elta hedging =elta hedging is the strategy used to immuni7e portfolios from small changes in the prices of the under-lying asset in the futures small interval of time. #he delta of an option is the ratio of the change. $f the delta is '.3' it means that the option premium will change by 3') for the change in the price of stock. $f an option with a delta of '.3' is used a hedge then two options must be held for every unit of the asset in order to e%uate both the option and asset portfolios. #he minimum !"iance hedge ratio is the reciprocal of the option delta if delta is '.3' then the hedge rat-io is 2.as an option delta changes the hedge ratio will be changed ^ M \c, \s where \ is delta( \c is change in call price( \s is change in asset (stock) price. ! delta e%ual to '.H for a call option implies that for a one unit change in the stock price or index the option would move '.H points. !lso a \M -'.? for a put option means that the put option premium will decline by ?o paise if the stock rises by re &.

$n terms of the b-s model for a call option the delta is given by n(d&)( while for a put option it is e%ual to n(d&)-&.ex if n(d&) M '.188: the delta for call option is '.188:-& M '.:33H. So if the price of the asset rises by re & the price of the call option will rise by 18 paise while the price of put option will fall by :3 paise. -vidently the call delta would always be greater than 7ero and less than one. =eep in the money call options would have delta close to unity while deep in the money put options would show a delta neari-ng -&.options that are far out of the money have delta values close to 7ero. Theta A *ption values increase with the length of time to maturity. #he expected change in the option premium from a small change in the time to expiration is termed as theta( i.e. $t is a rate of change in the option portfolio value as time passes. it is also called as time delay of the portfolio. #heta is calculated as the change in the option premium over the change in time. _ M \ premium, \ time #he option premiums deteriorate at an increasing rate as they approach expiration. $t is also observed that most of the option premiums depending on the individual option is lost in the final :' days to expiration. #hat is why theta is based on s%uare root of time. #his exponential relationship between option premium and time is seen in the ratio of option value between the four month and the one month at the money maturities. $t will be:- premium of 8 months premium of & month M [8,[& M2,& M 2 times. 7amma #he gamma of the portfolio of opt-ions on an underlying asset may be defined as the rate of change of the portfolioAs delta with respect to the price of the underlying instrument. in other words it is the change in delta per unit change in the price of the asset. $f the gamma is small and not significant it means that the delta changes very slowly then ad+ustments for keeping delta neutral need relatively infre%uently. $f gamma is very high which means that delta is highly sensitive to stock price then the ad+ustment to make delta neutral is needed.

6ega /v0 $t may be defined as the rate of change of the value of the portfolio of the options with respect to change (volatility) of the underlying asset. olatility is stated in percentage per annum. it is the sd of daily percentage changes in the underlying stock price. $.e. #he value of an option is liable to change because of movements in stock prices over the passage of time. $f vega is high in absolute terms the portfolio value is very sensitive to changes in volatility. $f the stockAs volatility rising then the risk of the optionAs being exercised is increasing( the optionAs premium would also be increasing. vega M \ premium, \ volatility. Rho and hi #he rho of a portfolio of options may be defined as the rate of change in the value of the portfolio option with respect to the interest rate. $.e. #he expected change in the option premium from a small change in the domestic interest rate. "ho M \ premium , \ domestic interest rate. $n case of currency options we have domestic interest rate and foreign interest rate. @hen the change in the option value is due to foreign interest rate it is called as phi. phi M \ in option premium,\ foreign interest rate.

MO281) ";
*nterest Rate Markets $nterest rate futures are the most popular and successful financial derivative instrument today in the global fin. 9arkets. 4oth the borrowers and lenders face interest rate risk. $f both dislike risk and uncertainty then they will seek such instruments through which they can reduce such risk. *nterest Rate 'utures $nterest rate futures are such financial derivatives( which assist in reducing the interest rate risk of such persons. $nterest rate futures are such financial derivatives that are written on fixed income (return) securities or instruments here interest and principal are payable on predetermined dates. $nterest rate futures are such financial derivatives( which assist in reducing the interest rate risk of such persons. $nterest rate future is such financial derivatives that are written on fixed income (return) securities or instruments here interest and principal are payable on predetermined dates. $n the financial markets these debt obligations are often arbitrarily separated into short term(money market) and long term(capital market) instruments. 9oney market instruments are those financial assets having initial maturity of one year or less and capital market more than one year. !n interest rate futures contract is a futures contract on an asset whose price is dependent solely on the level of interest rates. $nterest rate futures are more complicated than other types of futures because it re%uires description of both level of interest rates and maturity of interest rates. T! es of interest rates 1. Treasur! rates: it is the rate of interest applicable to borrowing by a own country. -x: - $ndian govt. can borrow in $ndian treasury rates prescribed. #reasury rates are also regarded rate of interest. govt. in its rupees on as risk free

2. 1ibor rate: - ;ondon inter bank offer rate is the rate at which international banks are willing to lend money to another international bank. ;$4*" rates change as per the economic conditions( %uantum of money flows( market position of funds re%uirements etc. ;$4*" is higher than treasury rates. (. Re o rate: -it is a contract where the owner of the funds agrees to sell the to a counter party now and buy them back later at a slightly higher rate. so the counter party is giving a loan to other party. #he difference between the selling price and the repurchase price is called as interest earned or repo. +. 9ero rate@ s ot rate:-it is the rate of interest earned on an investment that starts today and lasts for n years. $t is called as n year 7ero rate( n-year 7ero or n spot rate. !ll the amounts of accrued interest and principal are reali7ed at the end of n years. #here are no intermediate payments #he underlying markets #here are a number of money markets operating in different segment collectively called as parallel markets. $t comprises of :&. #he inter bank rate. 2. #he cdAs and cp markets. :. #he local govt. securities market. &. $nter bank market:- it involves the borrowing and lending among banks and large entities like corp( govt. bodies( central banks( imf. $t is a wholesale market where one single transaction is usually in millions. *ften money passes through many banks between original lender and the ultimate borrower. #he inter bank interest rate has become the benchmark for other interest rates. both the bid and offer rates are available here. #he difference between offer and bid rate is known as spread which is usually &,? ). 2. /dAs and cp market:-the cdAs are bearer certificates acknowledging a deposit for a period( such as : or 1 months. it is a negotiable instrument which can be bought and sold between the date of issue and maturity. the market is dominated by banks and usually the discount houses operate market makers in this market. #he cpAs are issued by the corporate borrowers. /orporate firms directly approach the investors and can borrow at rates e%ual to or even perhaps lower than the interest rates charged by the banks from them.

:. <overnment borrowing:- govt. issues different instruments like treasury notes( treasury bills and bonds for financing their spending and budget deficits. #he local govt. authorities may find it cheaper to take deposits directly rather than borrow from the banks and other fin. $nstitution. #he term structure of interest rates #he volatility of a debt instrument price is dependent on its maturity( the longer the maturity the greater the price volatility. Since the maturity of a bond is referred as its term to maturity or simply term the relationship between yield and maturity is referred to as the term structure of interest rates. it is also called as yield curve. &. Upward sloping yield: -yield rises as maturity increases. this is referred as positive yield curve. 2. =ownward sloping yield: - where yield decreases as maturity increases. :. 5lat yield: - yield remains the same irrespective of changes in maturity. 'orward rate agreements /'R-s0

#hese are also known as future rate agreements. #hese refer to a techni%ue for locking in future short term interest rates. #hese are agreements that a certain interest rate will apply to a certain principal amount for a certain period in the future. &edging the 'R5"! can also be used to manage the risk by entering a notional agreement to lend or borrow in the futures at a rate of interest determined in the present. ! set of bid-offer spreads is published showing rates of interest for different futures time periods. #he customer and the banker may agree that the compensation will pass between them in respect of any deviation of interest rates between the two dates. Treasur! bill futures #reasury bill is ma+or short-term interest rate securities and normally issued I' days &?' days respectively. #he I'-day t-bills are most popular instrument. #he t-bill futures market is the most li%uid and contracts are widely traded. #reasury bill yield are %uoted on a discount basis with relation to the face value. !s such the difference between the purchase price and the redemption value is the interest earned by the buyer. #he discount on the face value is always as a percentage of the face value. #- bills have

maturity of less than one year. #he difference between the purchase price and its face value determines the interest earned by the buyer. #he discount on the face value is always as a percentage of the face value. 6rice %uotation for t-bill futures are on an index basis i.e. #he index is &'' minus the annuali7ed discount rate. $f discount is say H) then index price will be I:. #he minimum price change allowed is one basis point( which amounts to Q23 (Q&'(''('''S.'&)S:,&2) per contract. (Si7e of us #reasury bill M &'(''(''' dollars) #he t-bill purchase price is: 5ace valueS (& N ) discount) S days to maturity) &'' :1' $f discount is H) the corresponding price paid for a I' day t- bills M Q&'(''('''V &-'.'H S(I',:1')W M QI(?2(3'' @e can calculate the return on purchase of I' day t-bill i.e. face value - issue price S :1' issue price days to maturity &'(''(''' - I?2(3'' S :1' I(?2(3'' I' M H.&:). )uro dollar futures -uro dollar is another most popular short-term instrument in the money markets. -uro dollar deposits are us Q deposits held in a commercial bank outside the US!. #hese banks may be either foreign banks or foreign branches of us based banks. #he deposits are nontransferable and they cannot be used as collateral security -uro dollar futures contracts are non-negotiable( :-month time deposits in dollars at banks located outside the US mainly in -urope with particular presence in ;ondon. ;ondon dominates the euro dollar deposit market so ;$4*" has become the benchmark short-term interest rate for the traders. #he ;$4*" is %uoted as an Fadd- on yieldG basis( which means that it is a percentage of the time deposit purchase amount. it is an annuali7ed rate based on a :1' day a year. -x:- if the : month ;$4*" is &')( the interest on Q& million M ('.&')(I',:1')(Q& million) M Q23('''. 'actors for the s eed! growth of euro B futures &. 9ost of the banks in the world depend on euro dollar market for short-term loans. 2. 9any corporate depend heavily on euro dollar market for their borrowing re%uirements.

:. -uroQ futures are traded in Singapore( ;ondon and /hicago and can be used globally on 28 hours. Ted s read #ed spread is the difference between the price of a : month t-bill futures contract and a : month euro dollar time deposit futures contract both expiring at the same day. <iven that the t-bills are less risky than euro dollars the ted spread !"ies considerably over the life of the futures contracts. #he t-bills being guaranteed by the US govt. are less risky than the guarantee given by the commercial banks issuing the euro dollar time deposits. therefore the t-bills carry a lower rate of return than the euro dollars. so the treasury bills future prices are higher than the euro dollar deposit futures &edging interest rate with the interest rate futures &. .edging a rise in interest rate for borrowing decisions or short term hedging. 2. .edging a fall in interest rate for investing decisions or long term hedging. #here are two popular hedging strategies in futures used by investors to ensure the surety of their earnings for a longer period of time. Two strategies for securit! &. Strip hedging: -it involves buying !"ious futures contracts with different delivery times( which are matching the investor`s exposure dates. #he basis risk is less here. 2. Stack hedging: buying !"ious futures contracts( which are concentrated in the nearby delivery months. .ere the basis risk is more the li%uidity position is far superior to strip hedging. Treasur! bond futures #he most popular long-term interest rate futures contract is the #reasury bond futures contract traded on the /hicago board of trade. #he underlying instrument is a Q&(''(''' par value hypothetic-al bond for a 2' year period. #he notional coupon rate is at present 1) . #he #reasury bond futures price is %uoted at par of &''. auotes are in :2nds of &). So a %uote of I8-&1 means I8 and &1,:2 or I8.3'. So a buyer is prepared to accept delivery at I8.3') of par value. Since the par value is Q&(''(''' the hypothetical t-bond price is QI8(3'' for buyer and seller. the minimum price fluctuation is &,:2nd of &) i.e Q:&.23 for Q&(''(''' par value.

Treasur! bills4 notes and bonds. #-bills:- these are short term gilt edged securities sold by us treasury at a discount. #-notes:- these are medium term coupons bearing gilt edged securities sold through periodic auctions. #-bonds:-these are long term coupons bearing gilt edged securities sold at periodic auctions.

MO281) 5<
#redit risk and derivatives /redit derivatives are the financial instruments designed to transfer the credit risk of one counterpart to another. /redit risk arises main-ly due to the default of the debt-or or due to the deterioration of the credit %uality of the debtor. =ue to the incidence of such risk the creditor can only receive the amount that the debtor provides. $t is related to the offsetting of credit risk to be incurred in a firm. #he concept of derivative is to create a contract that derives from an original contract or asset. ! credit derivative is a contract that involves a contract between parties in relation to a return from the credit asset. @ithout transferring the asset. #redit derivatives #here are such instruments which transfer either specific or all the inherent risks of a credit position from one party to the other. .ere the risk seller transfers its risk to the risk buyer against payment of a premium. #hese contracts are private and confidential which allow the user to manage their exposure to credit risk. #hey are also termed as off balance sheet financial instruments which permit one party (beneficiary) to transfer credit risk of a reference asset owned by it to another party (guarantor) without actually selling the asset. ! credit derivative is a specific financial product designed to mitigate or to assume specific forms of credit risk by hedgers and speculators. #he credit derivatives generally hedge directly to a particular debtor. #he credit risk is typically debtor specific. .ere the focus is placed on individual solutions specifically designed to fulfill customer specific desires with an eye on their balance sheet. the solutions are customer specific with no secondary market.

#redit derivatives" features &. $t is a bilateral contract comprising two parties. *ne is the credit risk protection buyer or beneficiary and the other is the credit risk protection seller or guarantor. 2. #hese are traded on *#/ market. *#/ products are dealt with outside the regulated exchanges so they permit maximum flexibility in designing the contract as per the needs of parties. :. $n credit derivatives contract the beneficiary(protection buyer) pays a fee called premium as in insurance business to the guarantor (protection seller) i.e. a party which wants to protect itself from the future credit risk will pay fee to the other party which takes such risk. 8. #he reference asset for which credit risk protection is purchased and sold is predetermined. -x:-a bank loan( corporate bonds( debentures( trade receivables etc. 3. #he protection from credit risk regarding reference asset is arisen due to !"ious causes which are known as credit events. -x:bankruptcy( insolvency( payment default( price decline( ratings. 1. !"ious instruments are being used in the credit-derivatives market like credit-default swaps( total return swaps( credit option( etc. H. #he settlement between the counter-parties in such contract on the credit event is settled on cash or in terms of physical financial assets (loan,bond). $f the guarantor is not satisfied with the pricing or valuation he has a right to ask for physical settlement ?.in general credit derivatives guidelines are issued by international swaps and derivatives association known as master agreement and the legal format of a derivative contract. /redit derivatives are the most important financial innovations which assist credit managers to reali7e their credit exposures and then to act optimally to hedge and replicate credit risk. #redit risk"conce t "isk may be of two types:&. 9arket risk. 2. 5irm specific risk. 9arket risk arises due to movements in interest rates( exchange rates( stock prices( commodity prices( trade restrictions( economic sanctions( govt. policies etc in adverse directions creating an effect on the firms. 5irm specific risk refers to the possibility that an individual borrowers circumstances change for the worse resulting in failing to make obligated payments. #he market risk is managed by entering into offsetting or hedging transaction but in the preview of firm specific risk common called as credit risk.

/redit risk refers to the possibility that a borrower will fail to service or repay a debt on time. $t is also defined as the possibility of losses associated with diminution in the credit %uality of borrower or counter parties. 5or ex in a bank the party may refuse outright commitments( settlements etc. #redit risk" forms &. =irect lending:- principal, interest may not be repaid. 2. $n case of guarantee,letter of credit funds may not be coming. :. 5unds settlement may not be effected in securities trading. 8. in case of cross border exposure free transfer of funds may cease or be restricted by governments. #redit derivatives instruments #he basic feature of credit derivative instruments is that they separate the credit risk from the total risk allowing the trading of credit risk with the purpose of replicating credit risk( transferring credit risk and hedging credit risk. the important instruments of credit derivatives are:&. /redit default swaps:- (cds) is a bilateral derivative contract where one party agrees to pay another party periodic fixed payments in exchange for receiving Fcredit event protectionG in the form of payment for any adverse credit event over a pre agreed period. #redit derivatives instruments /cds0 #he typical credit events are bankruptcy( failure to pay( restructuring( failure to pay( repudiation, moratorium. 5eatures:&. $t is a bilateral contract between protection buyer and seller. 2. #he protection buyer pays a fee to the protection seller for receiving the credit event protection. $t is expressed in annuali7ed basis points of a transactions nominal amount. :. #he third party and the specific obligation if any on which even protection is concurrently bought and sold are referred to as the reference entity and reference obligation. 8. "eference credit is the contingent amount which will be paid by the seller in case adverse event occur. 3. #he reference credit must be nominated under the default swap contract. !lso the reference credit asset must also be specified in the default swap contract. !lso to be mentioned is the asset value.

1. #he credit event triggers the obligation of the provider of default protection to make payment either in cash or the underlying asset. 3asket linked credit swa s $n this type of swap contract credit default is based on a basket of underlying assets with different issuers. 5or ex a usQ&'' million transaction may comprise four underlying credit assets N a five year <erman bond( a five year /anadian bond( a five year 5rench bond and 3 year Swiss bonds. .ere the default provider provides protection on any 8 assets up to a face value of usQ&'' million on a first to default basis is providing protection of usQ8'' million of credit assets. #he important point in this concept is first to default of any credit assets included in the basket of credits. 2. #otal return swaps:- (trs) these are bilateral contracts designed to replicate the economic returns arising of underlying asset or a portfolio of assets for a pre-specified time. here one party pays the total return ( interest O capital appreciation) of a asset and in return the other pays floating rate payments (;$4*" O spread). #hese floating payments represents a funding cost of the trs payer. ! trs contract allows the trs receiver to obtain the economic returns of an asset without funding thereon its balance sheet. So trs is primarily off balance sheet financial vehicle. #otal return payers are typically such lenders and other investors who want to reduce their exposure to an asset without removing it from their balance sheet. *ther return receivers are typically such institutions who want to invest funds on a leverage basis to diversify their portfolios or intend to higher return by taking on risk exposure. #redit s reads $t represents the margin between the risk free rate of return designated to compensate the investor for the risk undertaken on default of the underlying asset. $t is the difference between return of the underlying security and the return on the corresponding risk free security. $t is to understand the relative credit value changes in contract to changes in the interest rates( credit spread expectation( and the term structure of credit spread. #his is re%uired to design credit option derivatives which would be the natural extension of financial markets to unbundled risk.

#redit o tions $t gives the option holder the right to sell a bond to the other party (investor) at a certain strike price expressed in terms of a spread over a benchmark. *n the expiration if the actual spread is lower than the strike price then the bond holder will not exercise the option( thereby the option is worthless. $f the actual spread is higher than the strike price then the bond holder will deliver the bond and the investor pays the price whose yield spread over the bench mark e%uals the strike spread. credit option may be put and call options. 6ut options are &. 6rice options 2. Spread options. $n the price put options the option writer agrees to compensate the option buyer for a decline in value of the underlying asset below the strike price. Upon the exercise of the credit option the payoff is determined by subtracting the market price from the strike price of the asset. Strike price is usually determined by taking the present value of the assetAs cash flow discounted at the risk free rate plus the strike credit spread. #he spread put options are based upon the spread between the bond yield and the corresponding treasury yield. Second type of credit options are referred to as call options which are based on the credit spread. #hese are structured in such a way that the option is in the money when the credit spread exceeds the specified (strike) spread level. #redit linked notes #his instrument enables the invest-or to purchase an asset with a return linked to the credit risk of the asset itself and the additional credit risk transferred by way of credit derivative between the parties. it is a combination of a regular note (bond) and a credit option. 4eing a regular note with coupon( maturity and redemption it is an on balance sheet instrument +ust like credit default swap. the price or coupon of the note is based on the performance of a reference asset. $t means the investor receives a coupon and redemption at par value unless there has been credit event by a reference credit. $f there is a credit event in that case the amount will be redeemed at par value minus a contingent payment to the investor. the issuer receives a premium for taking exposure to the reference credit. #he premium forms part of the coupon that is paid to the investor.

Mechanism of credit linked notes /;>As are created through a trust or special purpose vehicle (spv) which is collaterali7ed with !!! rated securities. $t is a credit swap between a bank and the issuer. $t can also be issued by a >45/ or a bank directly. if the issuer is a trust it enters into a default swap with a deal arranger (:rd party) in return for a premium. $n case of a default the trust pays the dealer par amount the recovery rate in exchange for an annual fee. this annual fee is passed on to the investors in the form of higher coupon on the notes. #he investors purchase the securities from the issuer which pays a floating or fixed coupon during the life. /oupon reflects risk of issuer and the credit swap. !t the time of maturity the investors receive the par amount if no credit event occurs (referenced credit defaults) or declares bankruptcy. $f the credit event occurs the principal at par minus contingent payment will be paid to investors. #he investor is selling the credit protection in exchange for higher yield in terms of coupon on the note.

MO281) 5 C
6alue at risk /6-R0 measure $t is a statistical measure of the maximum potential loss from uncertain events in the normal business over a particular time hori7on. $t is measured in units of currency through a probability level. $t is the loss measurement consistent with a confidence limit such as II) on a probability distribution. $t implies that this is the measurement of a loss which has a chance of only &) of being exceeded. #hat means if a trader mis hedges a deal it is a must to know the chances of loss before they occur. !" is defined as the maximum loss a portfolio of securities can face over a specified time period with a specified level of probability. -x:- a !" of Q& million for a day at a probability of 3) means that the portfolio traded securities would expect to loose at Q& million in one day with a probability of 3). !lternatively there is I3) probability that the loss from the portfolio in one day should not exceed Q& million. So losses may occur once in 2' trading days. !" actually assigns a probability to a dollar amount of happening of the loss. it is not the maximum loss that could occur but only a loss amount that could expect to exceed only at some percentage of time. #he actual loss that may occur could be much higher than at !". - roaches to com uting 6-R #here are various approaches to computing ones are:the ariance co- ariance approach historical simulation approach 9onte /arlo simulation approach !"( the most important

6-R"6ariance covariance a roach #his allows an estimate to be made of the potential future losses of a portfolio through using statistics on volatility of risk factors in the past and correlations between changes in their values. olatilities and correlation risk factors are calculated for a selected period of holding the portfolio. #his is done using historical data. !" is computed as multiplying expected volatility of the portfolio by a factor that is selected based on the desired confidence level. #his is based on the assumption that the underlying market factors follow a multivariate normal distribution.

!s the portfolio return is a linear combination of normal ariables it is also normally distributed. #he normal !" is easy to handle because the !" multiple of the portfolio std deviation and the portfolio std dev is the linear function of individual volatilities and covariance. #he following facts are to be consi-dered.&.movements in market prices do not always follow a normal distribution they sometime exhibit heavy tails( which means a tendency to have a relatively more fre%uent occurrence of extreme values than following a normal distribution. 2. 9odels may not appropriately depict market risk arising from extraordinary events. :. #he past is not always a good guide to the future for example correlation forecast may not hold true. 6-R" historical simulation a roach #his approach uses historical data of actual price movements to determine the actual portfolio distribution. $n this way the correlations and volatilities are implicitly handled. the advantage here is that the fat tailed nature of securityAs distribution is preserved. 5at tails refer to the fact that the large market moves occur more fre%uently than what would occur if the market returns was normally distributed. in using historical simulation changes that have been seen in relevant market prices and the risk factors are analy7ed over & to 3 years time. #he portfolio under examination is then valued using changes in the risk factors derived from the historical data to create the distribution of the portfolio returns. we then assume that this historical distribution of returns is also a good proxy for the distribution of returns of the portfolio over the next holding period. #he relevant percentile from the distribution of historical returns leads to the expected !" for the current portfolio. *f course if asset returns are normally distributed the !" obtained under the historical simulation approach should be the same as that under ariance covariance approach. Monte #arlo simulation a roach #o apply this approach first we have to calculate the correlation and volatility matrix for the risk factors. #hen these correlations and volatilities are used to drive a random number generator to compute changes in the underlying risk factors. #he resulting values are used to re-price each portfolio position and determine trial gain or loss. #his process is repeated for each random number generation and repriced for each random number generation and reprised for each trial.

the results are then ordered such that the loss corresponding to the desired confidence level can be determined. 9onte /arlo simulation can be viewed as a hybrid of the ariance covariance approach and the historical simulation approach. $t uses the ariance covariance matrix to drive a simulation. this simulation works similar to the historical simulation but rather than simply using history it creates the history (known as path). $t is based on the ariance covariance matrix devised from the actual historic market data. #he greatest benefit of the 9onte /arlo simulation !" is the ability to use pricing models to revalue nonlinear securities for each trial. $n this way the non linear effects of option that were missed in the ariance covariance !" can be captured in this approach. 9onte /arlo simulation having its roots in random number generation is exposed to sampling error. #here is the risk of running too few simulations to ade%uately capture the distribution and this could result in an inferior answer. .owever methods exist to estimate how far off a simulation is so that we can decide whether to run or not to run trials.