Derivatives and Risk Management

By Rajiv Srivastava

P 2-1

Understanding Forward Contract

A conductor manufacturing company has entered into a forward contract to buy 2,000
Kgs of aluminium after 6 months at Rs 100 per Kg. What is the gain/loss for the
manufacturing company if at the end of 6 months the price of aluminium turns out to be a)
Rs 105 per Kg and b) Rs 98 per Kg?
Solution
The conductor manufacturing company has bought aluminium at Rs 100 per Kg. It is a firm
contract and his profit or loss would be judged from the spot price at the end of six months.

Profit or loss from the forward contract is

Spot price at the end of six months
less: Forward contract price
Profit or loss from the forward contract
Profit/loss from forward contract =
When spot price is Rs 105; Profit
When spot price is Rs 98; Loss
P 2-2

Rs/Kg
=
=
=

105
100
5

98
100
-2

Quantity x ( Spot price - Forward price)

= 2,000 x (105 - 100) = Rs 10,000
= 2,000 x (98 - 100) = - Rs 4,000

Pricing Forward Contract

Assume that the current spot price of aluminium is Rs 94 per Kg. What should be the price of
the 6-m forward contract on aluminium if risk free interest rate in the market is 12% per
annum with quarterly compounding and cost of insurance is placed at 4% per annum with
annual compounding?
Solution
The price of the forward contract is based on the savings made by buying aluminium
forward rather than spot.
By buying aluminium forward the user makes following savings:
a) Interest cost saved for six months
=
1.032 - 1 = 0 .0609 = 6.09%
b) Insurance cost saved for six months
=
2%
Therefore price of the forward contract
=
(1+8.09%) x 94 = Rs 101.60

Solution to Unsolved Problems

Chapter 2

Derivatives and Risk Management

By Rajiv Srivastava

P 2-3

Cash-N-Carry Arbitrage with Futures

Refer to Problem 2-2. Assume that futures contract on aluminium is selling for Rs 103.20. How
can you take advantage of the situation in the futures market scenario?
Solution
With annual compounding the cost of futures contract should be:
Futures price = Spot price + Cost of financing + Cost of storage
6-m futures price = 1.0809 x 94 = 101.60
Futures is selling for price greater than the fair price and hence must be sold.
Cash-and-carry arbitrage is possible by taking following actions:
ACTION
Cash flow (Rs)
Borrow Rs 94 at 12% per annum
94.00
Buy 1 Kg of aluminium in the spot market
-94.00
Sell futures contract for 1 kg of aluminium*
After 6 months following action are taken
Pay the borrowed money with interest
-99.72
Pay for the insurance @ 2%
-1.88
Deliver 1 kg of aluminium against futures and realise
103.20
Profit from cash-and-carry arbitrage
1.60
* Figure may be adjusted for the size of the futures contract on aluminium.

P 2-4

Reverse Cash-N-Carry Arbitrage with Futures

A stock broker is holding 1,000 shares of Reliance Industries Limited (RIL) selling currently at
Rs 1,800. The futures contract expiring in one month is trading Rs 1,808. Each futures
contract is for 100 shares of RIL. If the stock broker can borrow/invest at 12% per annum
can he take advantage of the situation. Assume annual compounding of interest rates.
Solution
With annual compounding the price of futures contract should be:
Futures price = Spot price + Cost of financing
1-m futures price = 1.01 x 1,800= 1,818
Futures is selling for price lower than the fair price and hence must be bought.
Reverse Cash-and-carry arbitrage is possible by taking following actions:
ACTION
Cash flow (Rs lacs)
Sell 1,000 shares of RIL in the spot market
18.00
Lend the funds so realised at 12% p.a.
-18.00
Buy 10 futures contract for 1,000 shares of RIL
After 1 month following action are taken
Receive the money lent with interest
18.18
Receive delivery of 1,000 shares against futures and pay
-18.08
Profit from cash-and-carry arbitrage
0.10

Solution to Unsolved Problems

Chapter 2

Derivatives and Risk Management

By Rajiv Srivastava

P 3-1

Hedge Ratio
The risk of spot prices on gold as measured from its standard deviation is placed at Rs 120.
Similarly the price risk of the 3-m futures contract on gold is estimated to be Rs 150. The coefficient of correlation between the two is placed at 0.85. In order to hedge spot position
on gold what ratio of futures contract would be optimal?
Solution
The optimal hedge ratio is given by
Optimal hedge ratio =

O p t im a lH e d g e R a t io= x

s
f

0.85 x 120/150 = 0.68

In order to hedge the spot position in gold one would take opposite position in gold futures
to the extent of 68% of the value in spot.
P 3-2

Basis and Price - Short Hedge

A trader in gold hold stock of 1 Kg valued at Rs 15 lacs at the spot price of Rs 15,000 per 10
gms. The 3-m futures contract for size of 100 gms on gold is Rs 15,400 per 10 gms. In order to
protect against the fall in value of the gold the trader decides to sell 10 contracts in gold
for 3-m delivery. However after one month the trader is required to sell the stock of gold at
Rs 14,500 and therefore also cancels his position in futures at Rs 14,700. Find out the price
the trader realised.
Solution
The gain made by the trader on the futures position is Rs 700 per 10 gms
Selling price
=
Rs 15,400
Buying price
=
Rs 14,700
Profit
=
Rs 700
Spot price realised
=
14,500
Effective price realised =
15,200 per 10 gms
The effective price can also be computed from the futures price and the basis at the end.
Initial futures price
=
Rs 15400
Basis when the hedge was lifted
=
Rs 200
Final price realised = Initial futures price - basis at end = 15,400 - 200 = Rs 15,200

Solutions to Unsolved Problems

Chapter 3

Derivatives and Risk Management

By Rajiv Srivastava

P 3-3

Basis and Price - Long Hedge

Assume in Problem 3-2 the trader had planned to buy gold and thus went short on the
futures on gold. After one month the trader bought gold and lifted the hedge. What price
did trader ended up paying?
Solution
The loss made by the trader on the futures position is Rs 700 per 10 gms
Buying price
=
Rs 15,400
Selling price
=
Rs 14,700
Loss on futures
=
Rs 700
Spot price paid
=
Rs 14,500
Effective price paid
=
Rs 15,200 per 10 gms
The effective price can also be computed from the futures price and the basis at the end.
Initial futures price
=
Rs 15,400
Basis when the hedge was lifted
=
Rs 200
Final price paid = Initial futures price - basis at end = 15,400 - 200 = Rs 15,200

P 3-4

Cross Hedge
An industrial firm uses tin as raw material and has a requirement of 400 kgs of tin to be
procured 6 months from now. The prices of tin are expected to rise substantially. The firm
needs to hedge against the price rise. There are no derivative contracts available on tin
but futures contract on aluminium are popular.
The prices of aluminium and tin are strongly correlated. A study has revealed that standard
deviations of prices of tin and aluminium are 21% and 20% of their current prices of Rs 720
per Kg and Rs 90 per Kg respectively. The coefficient of correlation is placed at 0.95. One
futures contract on aluminium is for 1,000 Kg. How can the firm hedge?

Solution
Standard deviation of spot prices of tin 21% of 720 =
Standard deviation of futures prices of aluminium 20% of 90 =
Coefficient of correlation between tin and aluminium prices =
Optimal hedge ratio =

151.20
18.00
0.95

0.95 x 151.2/18 = 7.98

Quantity of tin to be hedged

Size of futures contract on aluminium
Nos of futures contract on aluminium to be bought =

500 Kgs
1,000 Kgs
7.98 x 500/1000
3.99 say 4

Solutions to Unsolved Problems

Chapter 3

Derivatives and Risk Management

By Rajiv Srivastava

P 4-1

Pricing a Forward Contract

Suppose a 6-m forward contract on shares of ITC Limited is available. The current market
price of ITC is Rs 180. If the risk free interest is s 6% per annum what should be the price of
the 6 month forward contract?
Solution
The value of the forward contract = Spot value + Cost of carry for forward period
F=
1.03 x 180 = Rs 185.40

P 4-2

Pricing a Forward Contract with Dividend

In Problem 4-1 what would be the value of the forward contract if a) the interest rate were
continuously compounded, and b) ITC declared dividend of Rs 2.00 payable after 2
months.
Solution
For continuous compounding the value of the forward contract = S x ert
0.06x0.5

F = 180 x e
= 185.48
Forward price would have to be adjusted for dividend if paid in the forward period.
The holder of the forward contract is not entitled for dividend. The benefit accrues to the
holder of the physical position in the stock.
Therefore,

The present value of dividend = D x e-rt = 2 x e - .06 x 2/12

D0
=
1.98
Value of the forward contract when dividend is paid = (S - D0) x ert
=
=
P 4-3

(180.00 - 1.98) x e.06x0.5

183.44

Pricing a Futures Contract on Index

The spot value of NIFTY is 4,800. With risk free interest rate at 8% and dividend yield on the
50 shares consisting NIFTY at 4% what should be the fair value of futures on NIFTY with a) 1
month b) 2 months and c) 3 months to maturity?
Solution
The value of futures on index is given by S0e(r-y)t where r is risk free rate and y is the dividend
yield.
Here r - y = 8% - 4% = 4%
The fair value of futures on NIFTY is
a) For 1 month; 4,800 x e 0.04 x 1/12 =

4,816.03

b) For 2 months; 4,800 x e

0.04 x 2/12

4,832.11

c) For 3 months; 4,800 x e

0.04 x 3/12

4,848.24

Solutions to Unsolved Problems

Chapter 4

Derivatives and Risk Management

By Rajiv Srivastava

P 4-4

Arbitrage with Index Futures

Refer to Problem 4-3. NIFTY futures with 1-month, 2-months and 3-months maturity are
trading at 4,820, 4,825 and 4,855 respectively. What strategies can you adopt with each of
the futures contract to profit?
Solution
When futures price is greater than the fair price the contract is overpriced and must be
sold. When actual price is less than far price the futures contract must be bought as it is
undervalued. The position must be reversed when market corrects the futures price to the
fair price.
Following strategies may be adopted to benefit from the existing condition:
Contract
Actual Price
Fair Price
Result
Strategy
1-month
4,820.00
4,816.03
Overpriced
Sell now buy later
2-months
4,825.00
4,832.11
Underpriced Buy now sell later
3-months
4,855.00
4,848.24
Overpriced
Sell now buy later

P 4-5

Hedging Market Risk with Index Futures

An investor holds shares of Suzlon worth Rs 20 lacs which has standard deviation of returns
at 25% with beta of 1.5. The standard deviation of market returns is 16%. Index futures on
NIFTY is price at 4,000 with contract size of 50. If investor hedges with the futures find out
what position he must take in NIFTY futures. Also find what risk the investor would face in the
hedged portfolio.
Solution
The variance of the Suzlon shares = 0.252 = 0.0625
By taking a short position in index futures the market risk of long position in shares would be
eliminated.
Position to be taken in index futures = beta x value of long position
= 1.50 x 20 = Rs 30 lacs
Nos. of index futures to be sold
= Value to be hedged/ Value of one index futures contract
= 30,00,000/4,000 x 50 = 15 contracts
The variance of stock consists of systematic risk of (m)2 = (1.5 x 0.16)2 = 0.0576
The remaining is unsystematic risk = 0.0625 - 0.0576 = .0049
equivalent to 7%
By short position in index futures the unsystematic risk cannot be eliminated.

Solutions to Unsolved Problems

Chapter 4

Derivatives and Risk Management

By Rajiv Srivastava

P 4-6

Hedging a Long Position in Stock

An investor is holding 2,000 shares of Reliance Industries Limited (RIL) currently trading at Rs
1,800. The beta of RIL is 1.2. Though there is no adverse news regarding RIL but market
sentiments are expected to turn weak for the next three months. The investor decides to
hedge his position through 3-m futures on NIFTY, a broad based index of 50 shares currently
at 4,200. One contract on NIFTY futures is worth Rs 50 times the index value. How can the
investor hedge against the risk?
Solution
The investor is long on the stock and hence faces the risk of falling prices. By taking the
opposite position in NIFTY futures i.e. selling the futures the investor can protect against the
fall in price attributed to market risk.
Rs/Kg
The exposure of the investor at current market value is = Nos. of shares x Current price
Spot price at the end of six months
=
2,000 x 1,800 = Rs 36,00,000
Beta of the stock
=
1.2
Amount of short position in futures
=
Beta x Value of stock
=
1.2 x 36 = Rs 43.20 lacs
Value of one futures contract
=
4,200 x 50 = Rs 2.10 lacs
Nos. of futures contracts to short
=
43.20/2.10 = 20.57
say 21 contracts

P 4-7

Hedging a Short Position in Stock

Upon his retirement in 3 months time Gyan Prakash would receive Rs 24 lacs as
superannuation benefits and 50% of which he intends to invest in shares of State Bank of
India (SBI). The current market price of SBI is Rs 1,200 with beta of 1.05. The market is
currently rising and is expected to remain upbeat. The current level of market is 4,200 while
3-m futures contract on NIFTY sells for 4,260 with lot size of 50. Gyan Prakash is worried that
he would be able to buy much lesser number of shares when he actually would have the
funds, than what he can hope to buy now. What strategy you can suggest to Gyan
Prakash. Examine your recommended strategy if the market rises by 10% in three months
time.
Solution
Gyan Prakash is short on stock and fears rise in price. He can protect his position by going
long on futures on NIFTY hoping to compensate the extra cost in buying of SBI shares by the
gains in the futures position if the market indeed rose.
Value of short position stock of SBI
Value that needs to be covered by futures
Value of one futures contract in NIFTY
Nos. of futures contract to be bought

=
=
=
=
=

Rs 12,00,000
Beta x 12 lacs
1.05 x 12 = Rs 12.60 lacs
50 x 4,260 = Rs 2.13 lacs
12.60/2.13 = 5.91 say 6

When market rises the long position in futures would gain. The share of SBI too would rise
and the increased cost of acquiring the stock can partially be met by profit on the futures
position.
The profit from the position in futures when the market rises by 10%
Value of index at maturity
=
1.10 x 4,200 = 4,620
Value of futures
=
4,620 (due to convergence)
Solutions to Unsolved Problems
Chapter 4

Derivatives and Risk Management

By Rajiv Srivastava

(assumed expiry on the same day)

Profit on 6 futures contracts
Funds available for buying shares
Expected price of SBI shares
Nos. of shares that can be bought
P 4-8

=
=
=
=

(4,620 - 4,260) x 50 x 6 = Rs 1,08,000

12,00,000 + 1,08,000 = Rs 13,08,000
1.105 x 1,200 = Rs 1,326
13,08,000/1,326 = 986 shares

Price and Basis

Examine Problem 4-7. Do you find that after hedging through futures would Gyan Prakash
be in a position to buy contemplated 1,000 shares after the rise in the price of stock of SBI.
What could be the reason for the shortfall?
Solution
The compensation from position in futures would not be adequate to suffice the shortfall in
number of shares because of the basis in the futures and spot value at the time of the
setting up of the futures hedge. While futures price at maturity would be same as spot due
to phenomena of convergence while setting the futures hedge the basis is 60. Therefore
gain in futures position would be less by 60 as compared to spot.
The amount of shortfall
Nos. of shares of SBI with increased price

P 4-9

=
=

60 x 50 x 6 = Rs 18,000
18,000/1,320 = 13.63; say 14

Decreasing Beta of the Portfolio

Dynamic Funds Limited (DFL) owns a well diversified portfolio value at Rs 10 crore with an
aggressive beta of 1.20. The market scenario in coming few months is expected to remain
bearish and therefore the fund needs to reduce beta of the portfolio to a defensive 0.9.
Find out what the managers of Dynamic Funds should do if a) they like to divest part of the
portfolio to treasury bills b) they like to control beta through position in index futures.

Solution
DFL can adjust the beta of the portfolio by divesting the part of it in treasury bills. Fixed
income securities have a beta of zero.
If X is the proportion of portfolio is divested to treasury bills the portfolio beta is given by
w1 1 + w2 2 = 1.20 (1 - X) + X .0 = 0.9
This gives X =
25%
Therefore 25% of the portfolio i.e. Rs 10 x 0.25 = Rs 2.50 crore may be divested from the
portfolio and invested in treasury bill.

DFL can reduce the beta of the portfolio by going short on index futures.
The beta of index futures is 1 and it involves no investment. Therefore with position of X in
index futures the beta of the portfolio would be:
w1 1 + w2 2 = 1.20 x 1 + 1 x X = 0.9
This gives X = - 0.3 implying short position in index futures equivalent to 30% of exposure in
the portfolio.
DFL should short index futures worth 30% of Rs 10 crore = Rs 3.00 crore.

Solutions to Unsolved Problems

Chapter 4

Derivatives and Risk Management

By Rajiv Srivastava

P 4-10 Increasing Beta of Portfolio

Refer to Problem 4-9. Assume that market scenario is changed and sentiments have turned
bullish. DFL now want to be more aggressive and wish to increase the beta from existing
1.20 to 1.50. Examine how this can be achieved through a) the government securities
market and b) in derivatives market. Assume that DFL does not want to change the
composition of the existing portfolio.
Solution
Since DFL now want to increase the beta of the portfolio it will have to borrow say X% of its
exposure and invest the borrowed funds in the existing portfolio. This may be found as
below:
w1 1 + w2 2 = 1.20 (1 + X) + X .0 = 1.50
This gives X = 0.25 implying that DFL must borrow 25% of the portfolio value i.e. Rs 25 crore
and invest in the existing portfolio.
Through the derivatives market the beta of the portfolio can be increased by buying
futures. Assume that DFL takes a long position in futures equivalent to X% of the portfolio.
The beta of the position would then be:
w1 1 + w2 2 = 1.20 x 1 + 1 x X = 1.50
This gives X = 0.30 implying that DFL must take long position in index futures to the extent of
30% of the portfolio value i.e. Rs 30 crore worth of futures.

Solutions to Unsolved Problems

Chapter 4

Derivatives and Risk Management

By Rajiv Srivastava

P 5-1

Triangular Arbitrage
Assume that a bank in India has offered exchange rate for US dollar and Euro at Rs 48.00
and 78.00 for a 2 month forward contract respectively. An American bank has quoted 2-m
forward rate of US $ 1.70 per Euro. If you are allowed to book any contract can you take
advantage of the rates offered by bank in India and the American bank?

Solution
Exchange rate

Rs/US $
48.00
Rs/Euro
78.00
Synthetic rate from Indian bank
US $ 1.625/Euro
Direct rate from American bank
US $ 1.700/Euro

Using Indian rupee as vehicle we can get US $ 1.625 per Euro from the rates quoted by
Indian bank, while from American bank one can get US $ 1.70 per Euro. Therefore one must
buy Euro from Indian bank, sell them for dollars to American bank and finally convert
dollars to Indian rupee from Indian bank. Profit would be Rs 3.60/ as below:
Pay Rs 78 and get Euro 1 from Indian bank
Sell Euro 1 and get US $ 1.70 from American bank
Sell US $ 1.70 and get 1.70 x 48 = Rs 81.60 from Indian bank
Profit per Euro bought = 81.60 - 78.00 = Rs 3.60
P 5-2

Arbitrage in Futures and Forward Market

Futures contract expiring on 28 October in US dollar at National Stock Exchange is selling
for Rs 48.6800. Your bank has offered a forward contract for delivery on 28 October at Rs
48.9000. How can you take advantage of the disparity in the futures and forward market?
How do of think the position would correct?
Solution
In the futures market US dollar is cheap compared to the forward market. Therefore one
can go long in the futures market and sell dollar to bank in the forward market locking in a
profit of Rs 0.22/$. At maturity the profit is worked out for two possible opposite scenarios of
exchange rates.
Today
At maturity spot exchange rate
48.00
49.00
Buy $ futures at NSE
48.68
Profit/loss on futures
(0.68)
0.32
Sell $ forward to bank
48.90
Profit/loss on forward
0.90
(0.10)
Net profit/loss per $
0.22
0.22
The arbitrage has to vanish. Forward market being over the counter and futures being
exchange traded, the exchange rate by the bank essentially has to converge to the
exchange rate in the futures. If actual price of futures is JY 103 what would you do?

Solutions to Unsolved Problems

Chapter 5

Derivatives and Risk Management

By Rajiv Srivastava

P 5-3

Pricing Futures Contract

The risk free continuously compounded interest rates in USA and Japan are estimated at
8% and 3% respectively for 3 month maturity. If the spot rate in Japan is JY 102/$, what is
the likely price for 3-m futures contract?
Solution
The fair price of futures is given by F = S e(rd - rf) x t
-0.05x0.24

F = 102 e
F = 100.73
If futures contract is selling for JY 103 one must sell futures contract.
P 5-4

Fair Price of Futures and Interest Rates

The spot exchange rate in Germany is 1.25/. 6-m Futures contract in sterling pound is
quoted at 1.27/. With returns of 6% in German government securities for maturities of 6
months and assuming that futures are correctly priced what risk free rate you expect in
England?
Solution
Assuming simple interest rate 6-m futures price is given by

F = 1.27 = S

1+ rg
1+ re

= 1.25

gives x = (1+ re ) =

1.03
x

1.25x1.03
= 1.0138
1.27

where rg and re are interest rate for 6 months in Germany and England respectively.
This gives re = 0.0138 or 2.76% p.a.
P 5-5

Hedging Strategy for Receivables with Currency Futures

As an exporter you expect to receive 3 months from now US $ 20,000. The spot price of US $
is Rs 50.00 while 3-m futures at NSE is trading at Rs 49.30 indicating depreciation of US dollar.
Under what circumstances would you like to hedge? What would be the hedging
strategy?
Solution
If as exporter one believe that in 3 months' time US dollar would depreciate below the
futures price of Rs 49.30 one must hedge else not.
For hedging with futures market the exporter being long on the underlying asset would go
short on futures. Close to expiry of futures when exporter receives the funds he would buy
back the futures contract hoping to nullify the gains/losses and realise close to target rate
of Rs 49.30

Solutions to Unsolved Problems

Chapter 5

Derivatives and Risk Management

By Rajiv Srivastava

P 5-6

Hedging Long Position with Futures and Effective Exchange Rate

Refer to Problem 5-5. Assume that the exporter hedges with the futures contract. One
futures contract at NSE is for US $ 1,000 and it is cash settled. Find out the exchange rate
realised by the exporter when prior to maturity a) spot rate is Rs 50.50 and futures is selling
for Rs 50.42 b) spot rate Rs 48.40 and futures is selling for Rs 48.48.
Solution
The exporter has receivable of US $ 20,000. With contract size of US $ 1,000 the exposure
shorts 20 futures contract at Rs 49.30 now and buys back later. He sells the foreign currency
in the spot market.
The effective exchange rate realised by the exporter under two different scenarios is
worked out as below:
Scenario "a"
Scenario "b"
Futures contract sold at
49.30
49.30
Futures contract bought at
50.42
48.48
Profit/loss in cash from futures position
(1.12)
0.82
Spot rate realised
50.50
48.40
Effective exchange rate realised
49.38
49.22
Effective price can also be found by adding basis at the end to the futures price.
Futures price at inception
49.30
49.30
Basis at end
0.08
(0.08)
Effective exchange rate realised
49.38
49.22

Solutions to Unsolved Problems

Chapter 5

Derivatives and Risk Management

By Rajiv Srivastava

P 5-7

Hedging Short Position with Futures and Effective Exchange Rate

Impex Limited has to make a payment of US $ 25,000 after 3 months. The spot exchange
rate is Rs 46 and it has been increasing in the recent past. The appreciation of dollar is
expected to continue as reflected in the 3-m futures quotation of Rs 47.50. The
management of Impex Limited believes that US dollar is expected to go beyond Rs 47.50 in
3 months' time.
1. How can Impex Limited hedge its foreign currency exposure?
2. Assume that Impex Limited takes position in futures and at the time of making payment
after 3 months it unwinds the position in futures. Find out the effective exchange rate paid
by them if a) spot rate is Rs 49.10 and futures price is Rs 49.20, and b) spot price is Rs 46.75
and futures price is Rs 46.80.
Solution
Impex limited has payable of US $ 25,000. With contract size of US $ 1,000 they buy 25
futures contract at Rs 47.50 now and sell the futures later. Impex Limited fulfils the foreign
exchange requirement from the spot market.
The effective exchange rate paid by Impex Limited under two different scenarios is worked
out as below:
Scenario "a"
Scenario "b"
Futures contract bought at
47.50
47.50
Futures contract sold at
49.20
46.80
Profit/loss in cash from futures position
1.70
(0.70)
Spot rate paid
49.10
46.75
Effective exchange rate paid
47.40
47.45
Effective price can also be found by adding basis at the end to the futures price.
Futures price at inception
47.50
47.50
Basis at end
(0.10)
(0.05)
Effective exchange rate paid
47.40
47.45

Solutions to Unsolved Problems

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Derivatives and Risk Management

By Rajiv Srivastava

P 6-1

Pricing FRA
Following is the term structures of interest rates as on today;
Term to maturity (months)
Yield % p.a.

3
3.40

6
3.55

9
3.65

12
3.95

Assuming 360 days in a year, annual compounding and bid ask spread of 20 basis points
find the quotation of a) 3/6 FRA b) 9/12 FRA and c) 6/12 FRA.
Solution
a) 3-m forward interest rate for next 3 months of investment is worked out as below:
180
360 = 1.01775 = 1.009172;
(1+ 3 r6 ) =
90
1.0085
1+ 0.0340 x
360
giv es 3 r6 = 0.009172, or equiv alent to annualised
1+ 0.0355 x

3 r6

= 3.67%

Therefore the 3/6 FRA quote would be 3.57% - 3.77%

b) 9-m forward interest rate for next 3 months of investment is worked out as below:
360
360 = 1.0395 = 1.01180;
(1+ 9 r12 ) =
270
1.027375
1+ 0.0365 x
360
giv es 9 r12 = 0.01180, or equiv alent to annualised
1+ 0.0395 x

9 r12

= 4.72%

Therefore the 9/12 FRA quote would be 4.62% - 4.82%

c) 6-m forward interest rate for next 6 months of investment is worked out as below:
360
360 = 1.0395 = 1.02137;
(1+ 6 r12 ) =
180
1.01775
1+ 0.0355 x
360
giv es 6 r12 = 0.02137, or equiv alent to annualised
1+ 0.0395 x

6 r12

= 4.27%

Therefore the 6/12 FRA quote would be 4.17% - 4.37%

Solutions to Unsolved Problems

Chapter 6

Derivatives and Risk Management

By Rajiv Srivastava

P 6-2

Invoice Price of T-Bills Futures

If the price of futures on T-bills is quoted at 91.45 what would be the invoice price assuming
a contract size of Rs 10 lacs worth of T-bill in face value?
Solution
In the futures market US dollar is cheap compared to the forward market. Therefore one
can go long in the futures market and sell dollar to bank in the forward market locking in a
profit of Rs 0.22/$. At maturity the profit is worked out for two possible opposite scenarios of
exchange rates.
The discount yield on the futures = 100 - 91.45 = 8.55%
The discount would be = 0.0855 x90/360 = 0.021375
With contract of Rs 10 lac the discount = 10,00,000 x .021375 = Rs 21,375
The invoice price = 10,00,000 - 21,375 = Rs 9,78,625

P 6-3

Hedging Strategy with T-bills Futures

A treasurer is expecting to receive funds of Rs 1.25crore in next three months which would
be surplus for next three months. 3-m futures contract on T-bills expiring in 90 days is quoted
at Rs 89.50 indicating the yield of 10.50% likely to prevail for the 90-day T bills. Treasurer is
apprehensive about yield falling in the times to come. What can treasurer do to hedge
against falling yields?
Solution
The treasurer can go long on the T-bills future contracts. If the size of the contract is treasury
bill with face value of Rs 10 lacs then the invoice price of each contract would be:
The invoice price of T-bills futures =
10,00,000 x (1 - 0.105/4) = Rs 9,73,750
Nos of futures contract to be bought =
1,25,00,000/9,73,750 = 12.83 say 13 contracts
By going long on futures the treasurer can lock-in the approximately the same yield that is
reflected in the T-bills futures i.e. 10.50%

P 6-4

Yields and T-bills Futures

Refer to Problem 6-3. Assume the treasurer books the desired number of futures contracts.
What yield would the treasurer realise on the investment if after 3 months the yield a) falls
to 9.25%, and b) rises to 11.00%
Solution
The position of the treasurer for the two scenario is analysed below:
New yield after 3 months, %
9.25
Futures price after 3 months
90.75
Invoice price for futures sold
Rs. 9,76,875
Invoice price for futures bought
Rs. 9,73,750
Profit/loss per futures contract
Rs. 3,125
Profit/loss for 13 futures contract
Rs. 40,625
Interest on the investment of Rs 1.25 crore
Rs. 2,89,063
Net interest including futures contracts
Rs. 3,29,688
Annualised yield
10.55%

11.00
89.00
Rs. 9,72,500
Rs. 9,73,750
Rs. -1,250
Rs. -16,250
Rs. 3,43,750
Rs. 3,27,500
10.48%

Solutions to Unsolved Problems

Chapter 6

Derivatives and Risk Management

By Rajiv Srivastava

P 6-5

Value of the Bond and Duration

Interest rate futures contract in India are based on 1 notional 10-year Government on India
security with 7% coupon payable semi-annually. Find out the value of the futures contract
at YTMs of 6%, 7% and 8%.
Solution
The value of the bond at 7% YTM would be same as its face value of Rs 100 because it
bears the same coupon. At 6% the value would be more than Rs 100 while at 8% it would
be les than Rs 100. These can be found by discounting 20 semi-annual cash flows of the
bond at these rate and adding them up, as shown below:
Periods
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Value of the bond

P 6-6

YTM
6%
3.3981
3.2991
3.2030
3.1097
3.0191
2.9312
2.8458
2.7629
2.6825
2.6043
2.5285
2.4548
2.3833
2.3139
2.2465
2.1811
2.1176
2.0559
1.9960
57.3054
107.4387

Cash flow
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
3.50
103.50

YTM
8%
3.3654
3.2359
3.1115
2.9918
2.8767
2.7661
2.6597
2.5574
2.4591
2.3645
2.2735
2.1861
2.1020
2.0212
1.9434
1.8687
1.7968
1.7277
1.6612
47.2360
93.2048

Bond Value and Duration

You are holding a bond with 4 years to maturity bearing semi-annual coupon of 10%. What
is the value of the bond if the YTM is 6%. Also find its duration.
Solution
The computation of the value and duration of the bond is as below:
Period, t
Cash flow
DCF at 6%
t/2 x DCF
Duration

1
5.00
4.85
2.43

2
5.00
4.71
4.71

3
5.00
4.58
6.86

4
5.00
4.44
8.88

5
5.00
4.31
10.78

6
5.00
4.19
12.56

7
8 Value
5.00 105.00
4.07 82.89 114.04
14.23 331.55 392.01
3.4375

Solutions to Unsolved Problems

Chapter 6

Derivatives and Risk Management

By Rajiv Srivastava

P 6-7

Hedging Long Position with Interest Rate Futures

Assume that you are holding 10,000 bonds mentioned in Problem 6-6. The yields in the
market are expected to rise uniformly for all maturities. If you wish to hedge against the
anticipated decline in value of the bond what would you do if after 3 months it is
expected that cheapest-to-deliver bond would be a 9 year maturity bond that has YTM of
7% and duration of 6.4068 years. The futures contract is trading at Rs 93.2048 implying YTM
of 6%.
Solution
Since a rise in YTM is expected the fall in value of the bond could be hedged by going
short on interest rate futures hoping to compensate the expected loss from the gain in the
futures position.
Value of the bond
Duration of the bond
YTM of the bond

= 10,000 x 114.04 =
= 3.4375 years
= 6.00%

Price of the futures contract

Value of the futures contract
Duration of the CTD bond
YTM of CTD bond

= Rs. 93.2048
= Rs. 1,86,410
= 6.4068
= 7.00%

Nos. of futures contracts to be sold =

Rs. 1,14,03,938

at YTM of

8.00%

1,14 ,03 ,938

3.4375
1.07
x
x
1,86 ,410
6.4068
1.06

= 33.134

say

33 contracts

Solutions to Unsolved Problems

Chapter 6

Derivatives and Risk Management

By Rajiv Srivastava

P 7-1

Pricing Swap; Finding Swap Rate

Following is the term structures of interest rates as on today;
Term (months)
Yield % p.a.

6
4.00

12
4.20

18
4.40

24
4.50

30
4.60

36
4.80

42
5.00

48
5.20

54
5.40

60
5.50

Assuming 360 days in a year, simple interest rate and 180 days in each semi-annual period
and a spread of 20 basis points find the swap rate for a five year swap with semi-annual
payments.
Solution
3-m forward interest rate for next 3 months of investment is worked out as below:
Term (months)
6
12
18
24
30
36
42
48
54
60
Yield % p.a.
4.00
4.20
4.40
4.50
4.60
4.80
5.00
5.20
5.40
5.50
Discount
0.9804 0.9597 0.9381 0.9174 0.8969 0.8741 0.8511 0.8278 0.8045 0.7843
factor
Sum of discount factors
8.8343
The swap rate is
0.0244
Annual rate
4.88%

Sw a p R a te=

1 La st d iscou n tfa ctor

1 0 .7 8 4 3
=
= 0 .0 2 4 4
Su m of a ll d iscou n tfa ctors
8 .8 3 4 3

With the spread of 20 bps the swap rate would be 4.78% - 4.98%.
P 7-2

Pricing Forward Swap

Refer to Problem 7-1. What rate would be quoted for a 3-year swap commencing 2 years
from now?
Solution
Term (months)
6
12
18
24
30
36
42
48
54
60
Yield % p.a.
4.00
4.20
4.40
4.50
4.60
4.80
5.00
5.20
5.40
5.50
Discount
0.9804 0.9597 0.9381 0.9174 0.8969 0.8741 0.8511 0.8278 0.8045 0.7843
factor
Forward
discount
factor
Sum of forward discount factors
The swap rate is
Annual rate

Sw a p R a te=

0.9776 0.9528 0.9277 0.9023 0.8769 0.8549

5.4922
0.0264
5.28%

1 La st d iscou n tfa ctor

1 0 .8 5 4 9
=
= 0 .0 2 6 4
Su m of a ll d iscou n tfa ctors
5 .4 9 2 2

With same spread of 20 bps, the forward swap rate would be 5.18% - 5.38%.

Solutions to Unsolved Problems

Chapter 7

Derivatives and Risk Management

By Rajiv Srivastava

P 7-3

Hedge Against Falling Yield

A firm had issued 10-year bonds worth Rs 10 crore at fixed coupon of 12% payable semiannually. The coupon was consistent wit the yield prevailing at the time of the issue. Since
then the yield has fallen and the bond has 5 years remaining for maturity.
Swap rate offered by the bank is 9.00% - 9.20% against floating rate based on MIBOR.
Depict the swap arrangement of the firm with the bank and find out the cost of the bond
after the swap is entered.
Solution
Since yield is expected to decline the firm can enter the swap with the bank for receiving
fixed 9% and paying floating. The swap arrangement is depicted below:

12% Fixed Bond

Floating M

FIRM

Fixed 9.00%

B
A
N
K

After entering the swap with the bank the cost of funds would be M + 3%:
Payment to bond holders
Payment to Bank
Receipt from bank
Net cost of funds

12%
M
-9%
M + 3%

Solutions to Unsolved Problems

Chapter 7

Derivatives and Risk Management

By Rajiv Srivastava

P 7-4

Reducing Cost of Funds With Swap

Firm A and Firm B have identical requirement of funds and both are exploring raising of
fund either at fixed or floating rate. Following rates are offered by the market to both:
Fixed rate market
Floating rate market
Firm A
10%
MIBOR + 1%
Firm B
11%
MIBOR + 3.50%
Firm A is more interested in raising a fixed rate loan perceiving increased rates in future
while Firm B believes to the contrary and wants to issue floating rate debt instruments. Show
how the cost of funds may be decreased for both the firms.
Solution
The absolute advantage of the Firm A in the fixed rate market is 100 bps and that in the
floating rate market is 250 bps. Therefore, the comparative advantage of Firm A is 150 bps.
This may be shared by both the firms in the ratio of 2:1 in favour of Firm A
Firm A has greater advantage in floating rate market and hence must access the same at
MIBOR + 1%. Firm B must access the fixed rate market and mobilise funds at 11%. Both the
firms now can enter into the swap and share the benefit by 100 bps to Firm A and 50 bps to
Firm B. One such arrangement is shown below:
M +1%

FIRM A

M + 1%

11%

FIRM B

9.50%
Cost of funds for Firm A and Firm B
Cash flows for the firms
To subscribers
To Counterparty
From Counterparty
Cost without the swap
Saving

FIRM A
- (M+1%)
- 9.0%
(M+1%)
-9.0%
-10.0%
100 bps

FIRM B
-11%
- (M+1%)
9.0%
-(M+3%)
-(M+3.5%)
50 bps

Solutions to Unsolved Problems

Chapter 7

Derivatives and Risk Management

By Rajiv Srivastava

P 7-5

Value of Interest Rate Swap

An interest rate swap entered sometime back had fixed rate of 8.50% payable semiannually on a notional principal of Rs 100 crore. The last payment was made exactly 3
months back when the next floating payment was decided at 10%. The yield curve has
undergone a change since then is currently as below for the remaining 45 months for the
next 8 payments:
Time (months)
Term structure

3
8.00%

9
8.10%

15
8.20%

21
8.20%

27
8.30%

33
8.50%

39
8.50%

45
8.70%

If the parties are willing to cancel the swap find out the cash flow involved in cancellation
of the swap. Assume simple interest and equal semi-annual periods.
Solution
With the given term structure we can find the present value of the cash flow attached with
the fixed leg of the swap with the notional principal payment at the end of the swap, as
shown below:
Interest on fixed leg
Time (months)
Term structure
Discount Factor
Rupee Interest
Value of fixed cash
flows

3
9
8.00% 8.10%
0.9804 0.9427
4.25
4.25
4.17

4.01

8.50%

3.85

3.72

Rs in crore
15
21
27
33
39
45 Total
8.20% 8.20% 8.30% 8.50% 8.50% 8.70%
0.907 0.8745 0.8426 0.8105 0.7835 0.754
4.25
4.25
4.25
4.25
4.25 104.25

Value of the fixed leg of the swap

=
Value of the floating leg of the swap
PV of next interest due 3 months from now =
The value of remaining floating payments and
principal 3 months from now =
Value of the floating leg of the swap
Value of the swap

3.58

3.44

3.33

78.61 104.71

Rs. 104.71 crore

Rs. 4.90 crore
Rs. 100.00 crore
Rs. 104.90 crore
Rs. 0.20 crore

Value of the floating leg is higher than value of the fixed leg. If the floating leg receiver is
paid Rs 20 lacs by the counter party the swap may be cancelled.

Solutions to Unsolved Problems

Chapter 7

Derivatives and Risk Management

By Rajiv Srivastava

P 7-6

Value of the Currency Swap

An Indian firm in order to convert its US dollar loan into rupee loan had entered a swap
with a bank receiving US dollar and paying Indian rupee. The swap was fixed for a
principal of Rs 100 lacs with rupee interest of 6% p.a. payable semi-annually. At an
exchange rate prevailing then at Rs 40.00 per dollar the equivalent dollar were 2.50 lacs
and the interest rate fixed was 3% p.a. payable semi-annually.
The yields in the Indian as well as US markets have changed since then. The yields for the
remaining 4 years in rupee and dollar are as below:
Time (months)
Yield - Rupee
Yield - Dollar

6
5.00%
3.60%

12
5.50%
3.70%

18
5.60%
3.80%

24
5.80%
4.00%

30
6.00%
4.40%

36
6.10%
4.50%

42
6.20%
4.80%

48
6.30%
5.00%

Assuming simple interest rate and all semi-annual period equal and next payments due
exactly after 6 months find what value must be paid/received by the Indian firm if it wants
to cancel the swap.
Solution
To arrive at the value o the swap we need to find the present value o rupee cash flows
and US dollar cash flows fro the next 4 years.
Exchange rate at inception
Cash flows of the swap:
Rupee Principal
100
Dollar Principal
2.5
Time (months)
Term structure
Discount Factor
(Rupee)
Rupee Interest
Value

Rs
Interest Rate
Interest Rate

40.00 per $
6.00%
3.00%

6
12
18
24
30
36
Value of the cash flow of Indian rupee
5.00% 5.50% 5.60% 5.80% 6.00% 6.10%

42
6.20%

48 Total
6.30%

0.9756 0.9479 0.9225 0.8961 0.8696 0.8453 0.8217 0.7987

3
3
3
3
3
3
3
103
2.93
2.84
2.77
2.69
2.61
2.54
2.47 82.27 101.10
Value of the cash flow of US dollar
3.60% 3.70% 3.80% 4.00% 4.40% 4.50% 4.80% 5.00%

Term structure
Discount Factor
(Dollar)
0.9823 0.9643 0.9461 0.9259 0.9009 0.8811 0.8562 0.8333
Dollar Interest
0.075 0.075 0.075 0.075 0.075 0.075 0.075 2.575
Value
0.07
0.07
0.07
0.07
0.07
0.07
0.06
2.15
2.63
Value o dollar cash flow at current spot rate of Rs
40.50 per $
106.52
Value of the swap for party receiving US dollar cash flows
5.41
If bank pays Rs 5.41 lacs to the Indian firm now the swap may be cancelled.

Solutions to Unsolved Problems

Chapter 7

Derivatives and Risk Management

By Rajiv Srivastava

P 8-1

Payoff of Options
Find out the payoffs of the following positions on European options on a stock whose price
at maturity is Rs 100:
a. Long call with exercise price of Rs 90
b. Short call with exercise price of Rs 80
c. Long put with exercise price of Rs 110
d. Short put with exercise price of Rs 110
e. Long call with exercise price of Rs 100
f. Short put with exercise price of Rs 100
Solution
a.
b.
c.
d.
e.
f.

Long call with exercise price of Rs 90

Short call with exercise price of Rs 80
Long put with exercise price of Rs 110
Short put with exercise price of Rs 110
Long call with exercise price of Rs 100
Short put with exercise price of Rs 100

Payoffs
max(S - X, 0)
- max(S - X, 0)
max(X - S, 0)
- max(X - S, 0)
max(S - X, 0)
- max(X - S, 0)

Amount
0
0
10
-10
0
0

Solutions to Unsolved Problems

Chapter 8

Derivatives and Risk Management

By Rajiv Srivastava

P 8-2

Payoff Short Call - Foreign Exchange

You have written a call on exchange rate of US dollar with Rupee with the strike price of Rs
50/$ charging a premium of Rs 1.00. Find the payoff at various exchange rates ranging
from Rs 45 to 55. At what levels of exchange rate you would turn from profit to loss?

Solution
Exchange Rate
45
46
47
48
49
50
51
52
53
54
55

Payoff
0
0
0
0
0
0
-1
-2
-3
-4
-5

Payoff net of premium

1
1
1
1
1
1
0
-1
-2
-3
-4

Inclusive of premium the position would be profitable as long as exchange rate

remains below Rs 51.
PAYOFF OF SHORT CALL

Payoff (Rs)
2
1

Exchange Rate Rs/$

0
-1

45

46

47

48

49

50

51

52

53

54

55

-2
-3
-4

Call w/o premium

Call with premium

-5
-6

Solutions to Unsolved Problems

Chapter 8

Derivatives and Risk Management

By Rajiv Srivastava

P 8-3

Payoff of Long Put

As an exporter you are expecting to receive euro 10,000. You have bought a put option
with strike exchange rate of Rs 60 per euro and have paid a premium of Rs 1.50. Depict the
payoff of put option, receivable and receivable combined with the put from exchange
rate of Rs 55 to Rs 65 per Euro. Also determine and depict the value of receivable for the
range.
Solution
Exchange
Rate
55
56
57
58
59
60
61
62
63
64
65

Payoff from
put
3.5
2.5
1.5
0.5
-0.5
-1.5
-1.5
-1.5
-1.5
-1.5
-1.5

Payoff Receivable
-5
-4
-3
-2
-1
0
1
2
3
4
5

Value of receivable
w/o put
With put

Total
-1.5
-1.5
-1.5
-1.5
-1.5
-1.5
-0.5
0.5
1.5
2.5
3.5

55
56
57
58
59
60
61
62
63
64
65

58.5
58.5
58.5
58.5
58.5
58.5
59.5
60.5
61.5
62.5
63.5

Payoff - Receivable with Put

Payoff Rs
6
4
2
0
-2

55

56

57

58

59

60

61

62

63

64

65

Exchange Rate Rs/Euro

-4

Put Option

Receivable Payoff

Combined

-6

Value of
Receivable
(Rs)
66

Value of Receivable

64
62
60
58
56

Receivable w/o put

Receivable with put

54

Exchange Rate (Rs/Euro)

52
55

56

57

58

59

60

61

62

63

64

65

Solutions to Unsolved Problems

Chapter 8

Derivatives and Risk Management

By Rajiv Srivastava

e
=

1
u
m

L
a
o
f

s
t
a

d
l
l

i
s
c
o
u
n
t
f
a
c
t
o
r
d
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s
c
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t
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=
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4

8
9

5
2

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9
=

Solutions to Unsolved Problems

Chapter 8