FRM Notes

Financial Risk Management
Whether we like it or not, mankind now has a completely integrated, international financial and
informational marketplace capable of moving money and ideas to any place on this planet in
minutes.
Believe me the secret of reaping the greatest fruitfulness and the greatest enjoyment
from life is to live dangerously
Friedrich Wilhelm Nietzsche
Financial Engineering
Computational finance, also called financial engineering, is a cross-disciplinary field which
relies on computational intelligence, mathematical finance, numerical methods and computer
simulations to make trading, hedging and investment decisions, as well as facilitating the risk
management of those decisions. Utilizing various methods, practitioners of computational
finance aim to precisely determine the financial risk that certain financial instruments create.
To be alive at all involve some Risk

(Harold Macmillan)
Khurasan Institute of Higher Education

Jalalabad, Afghanistan.
By Imran Khan MBA (Finance), CIA, CQC

2012-13
What Is Risk?
Risk is the chance of financial loss, or more formally the variability of returns associated with a given
asset. Risk provides the basis for opportunity. The terms risk and exposure have slight differences in
their meaning. Risk refers to the probability of loss, while exposure (experience, contact) is the
possibility of loss, although they are often used interchangeably. Risk arises as a result of exposure.
Exposure to financial markets affects most organizations, either directly or indirectly. When an
organization has financial market exposure, there is a possibility of loss but also an opportunity for
gain or profit. Financial market exposure may provide strategic or competitive benefits.
Risk is the likelihood of losses resulting from events such as changes in market prices. Events with a
low probability of occurring, but that may result in a high loss, are particularly troublesome because
they are often not anticipated. Put another way, risk is the probable variability of returns.
Potential Size of Loss Probability of Loss
Potential for Large Loss High Probability of Occurrence
Potential for Small Loss Low Probability of Occurrence
Since it is not always possible or desirable to eliminate risk, understanding it is an important step
in determining how to manage it. Identifying exposures and risks forms the basis for an
appropriate financial risk management strategy.
Investment
A commitment of funds made in the expectation of the positive rate of returns.
Returns: investment is made with the aim of returns.
Returns= yield +capital appreciations.
Risk
Its inherent
May be capital loss
Or not receiving the interest payments or dividends.
Longer maturity higher risk
Credit worthiness of the firm
Risk varies with nature of investment.
Return
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Return can be defined as the total gain or loss experienced on an investment over a given period of
time.
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Risk in Investment
Investors like return and dislike risk
Risk in holding securities is generally associated with the possibility that realized returns will be less
than the returns that were expected.
Risk is the variability of the in returns of a security
How Does Financial Risk Arise?
Financial risk arises through countless transactions of a financial nature, including sales and
purchases, investments and loans, and various other business activities. It can arise as a result of legal
transactions, new projects, mergers and acquisitions, debt financing, the energy component of costs,
or through the activities of management, stakeholders, competitors, foreign governments, or weather.
When financial prices change dramatically, it can increase costs, reduce revenues, or otherwise
adversely impact the profitability of an organization. Financial fluctuations may make it more
difficult to plan and budget, price goods and services, and allocate capital.
There are three main sources of financial risk:
1. Financial risks arising from an organizations exposure to changes in market prices, such as
interest rates, exchange rates, and commodity prices.
2. Financial risks arising from the actions of, and transactions with, other organizations such as
vendors, customers, and counterparties in derivatives transactions
3. Financial risks resulting from internal actions or failures of the organization, particularly people,
processes, and systems. These are discussed in more detail in subsequent chapters.
What Is Financial Risk Management?
Financial risk management is a process to deal with the uncertainties resulting from financial
markets. It involves assessing the financial risks facing an organization and developing management
strategies consistent with internal priorities and policies. Addressing financial risks proactively
may provide an organization with a competitive advantage. It also ensures that management,
operational staff, stakeholders, and the board of directors are in agreement on key issues of risk.
Managing financial risk necessitates making organizational decisions about risks that are acceptable
versus those that are not. The passive strategy of taking no action is the acceptance of all risks by
default.
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Organizations manage financial risk using a variety of strategies and products. It is important to
understand how these products and strategies work to reduce risk within the context of the
organizations risk tolerance (acceptance) and objectives.
Strategies for risk management often involve derivatives. Derivatives are traded widely among financial
institutions and on organized exchanges. The value of derivatives contracts, such as futures, forwards,
options, and swaps, is derived from the price of the underlying asset. Derivatives trade on interest
rates, exchange rates, commodities, equity and fixed income securities, credit, and even weather.
The products and strategies used by market participants to manage financial risk are the same ones
used by speculators to increase leverage and risk. Although it can be argued that widespread use of
derivatives increases risk, the existence of derivatives enables those who wish to reduce risk to pass it
along to those who seek risk and its associated opportunities.
The ability to estimate the possibility of a financial loss is highly desirable. However, standard theories of
probability often fail in the analysis of financial markets. Risks usually do not exist in isolation, and the
interactions of several exposures may have to be considered in developing an understanding of how
financial risk arises. Sometimes, these interactions are difficult to forecast, since they ultimately
depend on human behavior.
The process of financial risk management is an ongoing one. Strategies need to be implemented and
refined as the market and requirements change. Refinements may reflect changing expectations
about market rates, changes to the business environment, or changing international political
conditions, for example. In general, the process can be summarized as follows:
Identify and prioritize key financial risks.
Determine an appropriate level of risk tolerance.
Implement risk management strategy in accordance with policy.
Measure, report, monitor, and refine as needed.
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Risk Classification
TYPES OF RISK:
Thus far, our discussion has concerned the total risk of an asset, which is one important
consideration in investment analysis. However, modern investment analysis categorizes the
traditional sources of risk identified previously as .causing variability in returns into two
General types: those that are pervasive in nature, such as market risk or interest rate risk, and those
that are specific to a particular security issue, such as business or financial risk. Therefore,
we must consider these two categories of total risk.
Dividing total risk into its two components, a general (market) component and a
specific (issuer) component, we have systematic risk and nonsystematic risk, which are
additive:
Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk
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A. Systematic Risk
Systematic (Market) Risk, (Non-diversifiable Risk):
Risk attributable to broad macro factors affecting all securities.

Acting according to a fixed plan or system
Systematic risk is caused by system wide factors that affect the entire community.
Change in economic conditions
Change in political system
Change in social system
The effect of such system wide factors which are beyond the control of individual, business
establishments and which affect all the business establishments in the system called Systematic
Risk.
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Systematic Risk is an investor can construct a diversified portfolio and eliminate pan of the total
risk, the diversifiable or non-market part. What is left is the non-diversifiable portion or the
market risk. Variability in a security's total returns that is directly associated with overall
movements in the general market or economy is called systematic (market) risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because
systematic risk directly encompasses the interest rate, market, and inflation risks. The
investor cannot escape this part of the risk, because no matter how well he or she
diversifies, the risk of the overall market cannot be avoided. If the stock market declines
sharply, most stocks will be adversely affected; if it rises strongly, as in the last few months of
1982, most stocks will appreciate in value. These movements occur regardless of what any
single investor does. Clearly, market risk is critical to all investors.
1. Market Risk
This arises out of changes in demand and supply pressures in the markets, following the changing
flow of information or expectations.
The totality of investor perception and subjective factors influence the events in the market which are
unpredictable and give rise to risk, which is not controllable.
The basis for the reaction is a set of real, tangible events political, social or economic
Intangible events are related to market psychology
2. Interest Rate Risk

The return on an investment depends on the interest rate promised on it and changes in market rates of
interest from time to time.
The cost of funds borrowed by companies or stockbrokers depends on interest rates.
The market activity and investor perception change with the changes in interest rates.
Lower interest rates make it easier for people to borrow in order to buy cars and homes. Purchases of
homes, in turn, increase the demand for other items, such as furniture and appliances, thus providing
an additional boost to the economy.
Lower interest rates mean that consumers spend less on interest costs, leaving them with more of their
income to spend on goods and services.
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3. Purchasing Power Risk
It is also known as inflation risk
This risk is arises out of change in the prices of goods and services and technically it covers both
inflation and deflation periods
Inflation: Rising prices on goods and services
Deflation: Falling prices on goods and services
Purchasing power risk= Inflation + Deflation
B. Unsystematic Risk
Nonsystematic (Non-market) Risk, (Diversifiable Risk):

Risk attributable to factors unique to the security
Nonsystematic Risk is the variability in a security's total returns not related to overall
market variability is called the nonsystematic (non-market) risk. This risk 1s unique to a
particular security and is associated with such factors as business and financial risk as well as
liquidity risk. Although all securities tend to have some nonsystematic risk, it is generally
connected with common stocks.
Unsystematic risk emerges out of the known and controllable factors, internal to issuer of the
securities or companies.
Factors such as management capability, consumer preferences and labor strikes can cause
unsystematic variability of returns for a companys stock.
The uncertainty surrounding the ability of the issuer to make payments on securities stops from two
sources:
1. The operating environment of the business- Business Risk
2. The financing of the firm- Financial risk
1 Business Risk
This relates to the variability of the business, sales, income, profits etc. which in turn depend on the
market conditions for the product mix, input supplies, strength of competitors, etc.
This Business risk is sometimes external to the company due to changes in govt. policy or strategies
of competitors or unforeseen market conditions
They may be internal due to fall in production, labor problems, raw material problems or inadequate
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supply of electricity etc.
The internal business risk leads to fall in revenues and in profit of the company, but can be corrected
by certain changes in the companys policies.
2. Financial Risk
This relates to the method of financing, adopted by the company, high leverage leading to larger debt
servicing problems or short-term liquidity problems due to bad debts, delayed receivables and fall in
current assets or rise in current liabilities.
These problems could no doubt be solved, but they may lead to fluctuations in earnings, profits and
dividends to shareholders.
Sometimes, if the company runs into losses or reduced profits, these may lead to fall in returns to
investors or negative returns.
Proper financial planning and other financial adjustments can be used to correct this risk and as such it
is controllable.
Risk management: Nature & Importance

Risk Management The entire process of identifying, evaluating, controlling and reviewing risks, to
make sure that the organization is exposed to only those risks that it needs to take to achieve its
primary objectives.
Risk management is Proactive (practical) process, As different markets, different types of risks so, the
risk management procedures and techniques vary in their application ways but target is same; putting
the risks under control and accomplishing the mission as expected.
Ways to Conduct Risk Management

There can be three approaches or sets of actions and within them the various instruments that are
available to firms for risk management.
Eliminate/Avoid
A firm can decide to eliminate certain risks that are not consistent with its desired financial
characteristics or not essential to a financial asset created.
Moreover, the firm like a bank can use portfolio diversification in order to eliminate specific risk.
Additionally, it can decide to buy insurance, for event risks. Furthermore, the firm can choose to avoid
certain risk types up front by setting certain business practices/policies (e.g., underwriting standards,
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process control) to reduce the chances of certain losses and/or to eliminate certain risks ex ante. If the
firm has no comparative advantage in managing a specific kind of risk, there is no reason to absorb
and/or manage such a risk.
Absorb/Manage
Some risks must or should be absorbed and managed at the firm level, because they have one or more
of the following characteristics:
They cannot be traded or hedged easily
They have a complex, illiquid, or proprietary structure that is difficult, expensive, or
impossible to reveal to others
They are a business necessity. Some risks play a central role in the banks business purpose
and should therefore not be eliminated or transferred
Transfer
The transfer of risks to other market participants is decided on the basis of whether or not the firm has
a competitive advantage in a specific (risk) segment. Any element of the systematic risk that is not
required or desired can be either shed;
by selling it in the spot market or
hedged by using derivative instruments such as futures, forwards, or swaps
In all such circumstances, the bank needs to actively manage these risks by using one of the following
instruments:
Diversification: The bank is supposed to have superior skills (competitive advantages),
because it can provide diversification more efficiently/at a lower cost than individual investors
could do on their own. This might be the case in illiquid areas where shareholders cannot
hedge on their own. Management of their credit portfolio is necessary, because the
performance of a credit portfolio is determined not only by exogenous factors but also by
endogenous factors such as superior ex ante screening capabilities and ex post monitoring
skills. Diversification, typically, reduces the frequency of both worst-case and best-case
outcomes, which generally reduces the banks probability of failure.
Holding capital:
For all other risks that cannot be diversified away or insured internally and which the bank decides to
absorb, it has to make sure that it holds a sufficient amount of capital in order to ensure that its
probability of default is kept at a sufficiently low level.
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Note that equity finance is costly
The cost of economic capital and the decision of not eliminating risk provide a trade-off
Both risk and return need to be monitored
In dealing with the challenge of risk management, the following interrelated guidelines should be
considered;
Understanding the firms strategic exposure
Employing a mix of real and financial tools
Proactively managing uncertainty
Aligning risk management with corporate strategy
Learning when it is worth reducing risk
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Risk Management Process
The process of financial risk management comprises strategies that enable an organization to
manage the risks associated with financial markets. Risk management is a dynamic process that
should evolve with an organization and its business. It involves and impacts many parts of an
organization including treasury, sales, marketing, legal, tax, commodity, and corporate finance.
The risk management process involves both internal and external analysis. The first part of the
process involves identifying and prioritizing the financial risks facing an organization and
understanding their relevance. It may be necessary to examine the organization and its products,
management, customers, suppliers, competitors, pricing, industry trends, balance sheet structure, and
position in the industry. It is also necessary to consider stakeholders and their objectives and tolerance
for risk.
Once a clear understanding of the risks emerges, appropriate strategies can be implemented in
conjunction with risk management policy. For example, it might be possible to change where and how
business is done, thereby reducing the organizations exposure and risk. Alternatively, existing exposures
may be managed with derivatives. Another strategy for managing risk is to accept all risks and the
possibility of losses.
There are three broad alternatives for managing risk:
Do nothing and actively, or passively by default, accept all risks.
Hedge a portion of exposures by determining which exposures can and should be hedged.
Hedge all exposures possible.
Measurement and reporting of risks provides decision makers with information to execute decisions
and monitor outcomes, both before and after strategies are taken to mitigate them. Since the risk
management process is ongoing, reporting and feedback can be used to refine the system by
modifying or improving strategies.
An active decision-making process is an important component of risk management. Decisions about
potential loss and risk reduction provide a forum for discussion of important issues and the varying
perspectives of stakeholders.
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Factors that Impact Financial Rates and Prices
Financial rates and prices are affected by a number of factors. It is essential to understand the factors
that impact markets because those factors, in turn, impact the potential risk of an organization.
A Factors that Affect Interest Rates
Interest rates are a key component in many market prices and an important economic barometer.
They are comprised of the real rate plus a component for expected inflation, since inflation reduces
the purchasing power of a lenders assets. The greater the term to maturity, the greater the
uncertainty. Interest rates are also reflective of supply and demand for funds and credit risk.
Interest rates are particularly important to companies and governments because they are the key
ingredient in the cost of capital. Most companies and governments require debt financing for
expansion and capital projects. When interest rates increase, the impact can be significant on
borrowers. Interest rates also affect prices in other financial markets, so their impact is far-
reaching.
Other components to the interest rate may include a risk premium to reflect the creditworthiness of a
borrower. For example, the threat of political or sovereign risk can cause interest rates to rise,
sometimes substantially, as investors demand additional compensation for the increased risk of default.
Factors that influence the level of market interest rates include:
Expected levels of inflation
General economic conditions
Monetary policy and the stance of the central bank
Foreign investor demand for debt securities
Levels of sovereign debt outstanding
Financial and political stability
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B Factors that Affect Foreign Exchange Rates
Foreign exchange rates are determined by supply and demand for currencies. Supply and demand,
in turn, are influenced by factors in the economy, foreign trade, and the activities of international
investors. Capital flows, given their size and mobility, are of great importance in determining
exchange rates.
Factors that influence the level of interest rates also influence exchange rates among floating or
market-determined currencies. Currencies are very sensitive to changes or anticipated changes in
interest rates and to sovereign risk factors. Some of the key drivers that affect exchange rates
include:
Interest rate differentials net of expected inflation
Trading activity in other currencies
International capital and trade flows
International institutional investor sentiment
Financial and political stability
Monetary policy and the central bank
Domestic debt levels (e.g., debt-to-GDP ratio)
Economic fundamentals
C Factors that Affect Commodity Prices
Physical commodity prices are influenced by supply and demand. Unlike financial assets, the value of
commodities is also affected by attributes such as physical quality and location.
Commodity supply is a function of production. Supply may be reduced if problems with
production or delivery occur, such as crop failures or labor disputes. In some commodities,
seasonal variations of supply and demand are usual and shortages are not uncommon.
Demand for commodities may be affected if final consumers are able to obtain substitutes at a
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lower cost. There may also be major shifts in consumer taste over the long term if there are supply or
cost issues.
Commodity traders are sensitive to the inclination of certain commodity prices to vary according to
the stage of the economic cycle. For example, base metals prices may rise late in the economic
cycle as a result of increased economic demand and expansion. Prices of these commodities are
monitored as a form of leading indicator.
Commodity prices may be affected by a number of factors, including:
Expected levels of inflation, particularly for precious metals
Interest rates
Exchange rates, depending on how prices are determined
General economic conditions
Costs of production and ability to deliver to buyers
Availability of substitutes and shifts in taste and consumption patterns
Weather, particularly for agricultural commodities and energy
Political stability, particularly for energy and precious metals
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Calculation of Return
We are going to assess risk on the basis of variability of return, we need to be certain we know what
return is and how to measure it. The return is the total gain or loss experienced on an investment
over a given period of time. It is commonly measure as cash distributions during the period plus the
change in value expressed as a percentage of the beginning of period investment value. The
expression for calculating the rate of return earned on any asset over period, commonly defined as:
i = C + PC - PB
PB
where:
i = rate of return
C = cash flow received from the investment
PB = price (value) of asset at beginning
PC = price (value) of asset after changes
Example: Mr. Moody wishes to determine the return of two video machines, C and D. C was
purchased 1 year ago for $ 20,000 and currently has a market value of $ 21,500. During the year it
generated $ 800 of after tax cash receipts. D was purchased 4 years ago, its value in the year just
completed declined from m$ 12,000 to $ 11,800. During the year it generated $ 1,700 of after tax
cash receipts.
We can calculate the annual rate of return i for each video machine.
For video machine C
i = C + PC - PB
PB
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i = 800 + 21,500 - 20,000
20,000
i = 2,300
20,000
i = 11.5%
For video machine D
i = C + PC - PB
PB
i = 1,700 + 11,800 - 12,000
12,000
i = 1,500
12,000
i = 12.5%
Although the market value of D declined during the year, its cash flow caused it to earn higher rate
of return than C earned during the same period. Clearly the combined impact of cash flow changes
in value as measured by the rate of return is important.
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Risk Preferences
Feelings about risk differ among managers and firms. Thus it is important to specify a generally
acceptable level of risk. The three basic risk preference behaviors risk averse, risk indifferent and
risk seeking are explained below:
A Risk Indifferent
Risk Indifferent is the attitude toward risk in which no change in return would be required for an
increase risk. For the risk indifferent manager the required return does not change as risk goes from
x1 to x2. In essence no change in return would be required for the increase in risk.
B Risk Averse
It is the attitude toward risk in which increased return would be required for an increase in risk. For
the risk averse manager the required return increases for an increase in risk. Because they shy away
from risk, these managers require expected returns to compensate them for taking greater risk.
C Risk Seeking
Risk seeking is the attitude toward risk in which a decreased return would be accepted for an
increase in risk. For the risk seeking manager, the required return decreases for an increase in risk.
Theoretically because they enjoy risk these managers are willing to give up some return to take
more risk. However such behavior would not be likely to benefit the firm.
Most managers are risk averse; for a given increase in risk they require an increase in return. They
generally tend to be conservative rather than aggressive hen accepting risk for their firm.
Accordingly a risk averse financial manager requiring higher returns for greater risk is assumed
throughout this text.
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Risk of a single asset
The concept of risk can be developed by first considering a single asset held in isolation. We can
look at expected return behaviors to assess risk, and statistics can be used to measure it.
Risk Assessment
Sensitivity analysis and probability distributions can be used to assess the general level of risk
embodied in a given asset.
Sensitivity analysis
An approach for assessing risk that uses several possible return estimates to obtain a sense of the
variability among outcomes. Sensitivity analysis uses several possible return estimates to obtain a
sense of the variability among outcomes. One common method involve s making pessimistic worst,
most likely expected and optimistic best estimates of the returns associated with a given asset. In
this case the assets risk can be measured by the range of returns. The range is found by subtracting
the pessimistic outcome from the optimistic outcome. The greater the range the more variability or
risk the asset is said to have.
Example
Norman company a golf equipment manufacturer, wants to choose the better two investments, A
and B. each requires an initial outlay of Rs. 10,000 and each has a most likely annual rate of return
of 15%. Management has made pessimistic an optimistic estimates of the returns associated with
each. The three estimates for each asset along with its range are given below:
Assets A and B
Asset A Asset B
Initial Investment Rs 100,000 Rs 100,000
Annual rate of return
Pessimistic 13% 7%
Most likely 15% 15%
Optimistic 17% 23%
Range 4% 16%
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Asset A appears to be less risky than asset B, its range of 4 percent (17% - 13%) is less than the
range of 16% (23% - 7%) for asset B. the risk averse decision maker would prefer asset A over asset
B, because A offers the same most likely return as B 15% with lower risk smaller range.
Although the use of sensitivity analysis and the range is rather crude, it does give the decision maker
a feel for the behavior of returns, which can be used to estimate the risk involved.
Probability Distributions
Probability means the chance that a given outcome will occur. Probability distributions provide a
more quantitative insight into an assets risk. The probability of a given outcome is its chance of
occurring. An outcome with an 80% probability of occurrence would be expected to occur 8 out of
10 times. An outcome with a probability of 100 percent is certain to occur. Outcomes with a
probability of zero will never occur.
A probability distribution is a model that relates probabilities to the associated outcomes. The
simplest type of probability distribution is the bar chart, which shows only a limited number of
outcome probability coordinates. The bar charts for Norman companys assets A and B are show in
the following figure. Although both assets have the same most likely return, the range of return is
much greater or more dispersed for asset B than for asset A- 16 percent versus 4 percent.
Bar charts for asset As and Bs returns
Continuous probability distribution
A probability distribution showing all the possible outcomes and associated probabilities for a given
event. If we knew all the possible outcomes and associated probabilities, we could develop a
continuous probability distribution. This type of distribution can be thought of as a bar chart for a
very large number of outcomes. Following figure represents continuous probability distributions for
assets A and B. note that although assets A and B have the same most likely return 15%, the
distribution of returns for asset B has much greater dispersion than the distribution for asset A.
clearly asset B is more risky than asset A.
Risk of a Portfolio
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In real world situations, the risk of any single investment would not be viewed independently of
other assets. We did so for teaching purposes. New investments must be considered in light of their
impact on the risk and return of the portfolio of assets. The financial managers goal is to create an
efficient portfolio, one that maximizes return for a given level of risk or minimizes risk for a given
level of return. We therefore need a way to measure the return and the standard deviation of a
portfolio of assets. Once we can do that we will look at the statistical concept of correlation, which
underlies the process of diversification that is used to develop an efficient portfolio.
Efficient portfolio
A portfolio that maximizes return for a given level of risk or minimizes risk for a given level of
return.
Correlation
A statistical measure of the relationship between any two series of numbers representing data of any
kind. The numbers may represent data of any kind from returns to test scores.
Positively correlated
If two series move in the same direction they are positively correlated. Or describes two series that
move in the same direction.
Negatively correlated
If the series move in opposite directions they are negatively correlated. Or describes two series that
move in opposite directions.
Hedging and Correlation

Hedging is the business of seeking assets or events that offset, or have weak or negative
correlation to, an organizations financial exposures.
Correlation measures the tendency of two assets to move, or not move, together. This tendency is
quantified by a coefficient between -1 and +1. Correlation of +1.0 signifies perfect positive
correlation and means that two assets can be expected to move together. Correlation of -1.0 signifies
perfect negative correlation, which means that two assets can be expected to move together but in
opposite directions.
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The concept of negative correlation is central to hedging and risk management. Risk management
involves pairing a financial exposure with an instrument or strategy that is negatively correlated to
the exposure.
A long futures contract used to hedge a short underlying exposure employs the concept of negative
correlation. If the price of the underlying (short) exposure begins to rise, the value of the (long)
futures contract will also increase, offsetting some or all of the losses that occur. The extent of
the protection offered by the hedge depends on the degree of negative correlation between the
two.
Derivatives
Definition of Derivatives
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One of the most significant events in the securities markets has been the development and
expansion of financial derivatives. The term derivatives is used to refer to financial
instruments which derive their value from some underlying assets. The underlying assets could
be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various
assets, such as the Nifty 50 Index. Derivatives derive their names from their respective
underlying asset. Thus if a derivatives underlying asset is equity, it is called equity derivative
and so on. Derivatives can be traded either on a regulated exchange, such as the NSE or off the
exchanges, i.e., directly between the different parties, which is called over-the-counter (OTC)
trading. The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of
the asset prices) from one party to another; they facilitate the allocation of risk to those who are
willing to take it. In so doing, derivatives help mitigate the risk arising from the future
uncertainty of prices. For example, on November 1, 2009 a rice farmer may wish to sell his
harvest at a future date (say January 1, 2010) for a pre-determined fixed price to eliminate the
risk of change in prices by that date. Such a transaction is an example of a derivatives contract.
The price of this derivative is driven by the spot price of rice which is the "underlying".
Origin of derivatives
While trading in derivatives products has grown tremendously in recent times, the earliest
evidence of these types of instruments can be traced back to ancient Greece. Even though
derivatives have been in existence in some form or the other since ancient times, the advent of
modern day derivatives contracts is attributed to farmers need to protect themselves against a
decline in crop prices due to various economic and environmental factors. Thus, derivatives
contracts initially developed in commodities. The first futures contracts can be traced to the
Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of rice prices falling
in the future at the time of harvesting. To lock in a price (that is, to sell the rice at a
predetermined fixed price in the future), the farmers entered into contracts with the buyers. These
were evidently standardized contracts, much like todays futures contracts. In 1848, the Chicago
Board of Trade (CBOT) was established to facilitate trading of forward contracts on various
commodities. From then on, futures contracts on commodities have remained more or less in the
same form, as we know them today. While the basics of derivatives are the same for all assets
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such as equities, bonds, currencies, and commodities, we will focus on derivatives in the equity
markets and all examples that we discuss will use stocks and index (basket of stocks).
Two important terms
Before discussing derivatives, it would be useful to be familiar with two terminologies relating to
the underlying markets. These are as follows:
Spot Market
In the context of securities, the spot market or cash market is a securities market in which
securities are sold for cash and delivered immediately. The delivery happens after the settlement
period. Let us describe this in the context of India. The NSEs cash market segment is known as
the Capital Market (CM) Segment.
Index
Stock prices fluctuate continuously during any given period. Prices of some stocks might move
up while that of others may move down. In such a situation, what can we say about the stock
market as a whole? Has the market moved up or has it moved down during a given period?
Similarly, have stocks of a particular sector moved up or down? To identify the general trend in
the market (or any given sector of the market such as banking), it is important to have a reference
barometer which can be monitored. Market participants use various indices for this purpose. An
index is a basket of identified stocks, and its value is computed by taking the weighted average
of the prices of the constituent stocks of the index. A market index for example consists of a
group of top stocks traded in the market and its value changes as the prices of its constituent
stocks change.
Definitions of Basic Derivatives
There are various types of derivatives traded on exchanges across the world. They range from the
very simple to the most complex products. The following are the three basic forms of derivatives,
which are the building blocks for many complex derivatives instruments (the latter are beyond
the scope of this book):
Forwards
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Futures
Options
Swaps
Knowledge of these instruments is necessary in order to understand the basics of derivatives.
We shall now discuss each of them in detail.
A Forwards
A forward contract or simply a forward is a contract between two parties to buy or sell an asset at
a certain future date for a certain price that is pre-decided on the date of the contract. The future
date is referred to as expiry date and the pre-decided price is referred to as Forward Price. It may
be noted that Forwards are private contracts and their terms are determined by the parties
involved.
A forward contract is a particularly simple derivative. It is an agreement to buy or sell an

asset at a certain future time at a certain price.
It can be contrasted with a spot contract, which is an agreement to buy or sell an asset
today.
A forward contract is traded in the over-the-counter market, usually between two
nancial institutions or between a nancial institution and one of its clients.
One of the parties to a forward contract assumes a long position and agrees to buy the
underlying asset on a certain specied future date for a certain specied price. The other
party assumes a short position and agrees to sell the underlying asset on the same for the
same price.
The price in a forward contract is known as the delivery price.
Forward contracts are commonly used to hedge foreign currency risk.
A forward is thus an agreement between two parties in which one party, the buyer, enters into an
agreement with the other party, the seller that he would buy from the seller an underlying asset
on the expiry date at the forward price. Therefore, it is a commitment by both the parties to
engage in a transaction at a later date with the price set in advance. This is different from a spot
market contract, which involves immediate payment and immediate transfer of asset. The party
that agrees to buy the asset on a future date is referred to as a long investor and is said to have a
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long position. Similarly the party that agrees to sell the asset in a future date is referred to as a
short investor and is said to have a short position. The price agreed upon is called the delivery
price or the Forward Price. Forward contracts are traded only in Over the Counter (OTC) market
and not in stock exchanges. OTC market is a private market where individuals/institutions can
trade through negotiations on a one to one basis.
Example 1: (Hedging Currency Risk with a Forward Contract)
Suppose it is April 5 of a certain year and the treasurer of a U.S. Corporation knows that the
corporation will receive 1 million EUROs in three months (on July 5th), and wants to hedge
against the exchange rate moves. The treasurer could contact a bank, and nd out that the
exchange rate for a 3-month forward contract on EURO is $1.25, and agree to sell 1 million
EUROs. In this case, the corporation takes a short forward position (agrees to sell), whereas the
bank assumes a long forward position (agrees to buy). This forward contract eliminates all
exchange rate risk, since the corporation will receive $1.25 million no matter what happens to
the Euro currency rate in the course of the next three months.
Settlement of forward contracts
When a forward contract expires, there are two alternate arrangements possible to settle the
obligation of the parties: physical settlement and cash settlement. Both types of settlements
happen on the expiry date and are given below.
Physical Settlement
A forward contract can be settled by the physical delivery of the underlying asset by a short
investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed
forward price by the buyer to the seller on the agreed settlement date. The following example
will help us understand the physical settlement process.
Example II
Consider two parties (A and B) enter into a forward contract on 1 August, 2009 where, A agrees
to deliver 1000 stocks of Unitech to B, at a price of Rs. 100 per share, on 29 the August, 2009
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(the expiry date). In this contract, A, who has committed to sell 1000 stocks of Unitech at Rs.
100 per share on 29 the August, 2009 has a short position and B, who has committed to buy 1000
stocks at Rs. 100 per share is said to have a long position.
In case of physical settlement, on 29th August, 2009 (expiry date), A has to actually deliver 1000
Unitech shares to B and B has to pay the price (1000 * Rs. 100 = Rs. 10,000) to A. Incase A does
not have 1000 shares to deliver on 29th August, 2009, he has to purchase it from the spot market
and then deliver the stocks to B.
On the expiry date the profit/loss for each party depends on the settlement price, that is, the
closing price in the spot market on 29 August, 2009. The closing price on any given day is the
weighted average price of the underlying during the last half an hour of trading in that day.
Depending on the closing price, three different scenarios of profit/loss are possible for each
party. They are as follows:
Scenario I Closing spot price on 29 August, 2009 (S T) is greater than the Forward price
(FT) Assume that the closing price of Unitech on the settlement date 29 August, 2009 is Rs. 105.
Since the short investor has sold Unitech at Rs. 100 in the Forward market on 1 August, 2009, he
can buy 1000 Unitech shares at Rs. 105 from the market and deliver them to the long investor.
Therefore the person who has a short position makes a loss of (100 105) X 1000 = Rs. 5000. If
the long investor sells the shares in the spot market immediately after receiving them, he would
make an equivalent profit of (105 100) X 1000 = Rs. 5000.
Scenario II Closing Spot price on 29 August (S T), 2009 is the same as the Forward price
(FT) The short seller will buy the stock from the market at Rs. 100 and give it to the long
investor. As the settlement price is same as the Forward price, neither party will gain or lose
anything.
Scenario III Closing Spot price (S T) on 29 August is less than t he futures price (F T) Assume
that the closing price of Unitech on 29 August, 2009 is Rs. 95. The short investor, who has sold
Unitech at Rs. 100 in the Forward market on 1 August, 2009, will buy the stock from the market
at Rs. 95 and deliver it to the long investor. Therefore the person who has a short position would
make a profit of (100 95) X 1000 = Rs. 5000 and the person who has long position in the
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contract will lose an equivalent amount (Rs. 5000), if he sells the shares in the spot market
immediately after receiving them.
The main disadvantage of physical settlement is that it results in huge transaction costs in terms
of actual purchase of securities by the party holding a short position (in this case A) and transfer
of the security to the party in the long position (in this case B). Further, if the party in the long
position is actually not interested in holding the security, then she will have to incur further
transaction cost in disposing off the security. An alternative way of settlement, which helps in
minimizing this cost, is through cash settlement.
Cash Settlement
Cash settlement does not involve actual delivery or receipt of the security. Each party either pays
(receives) cash equal to the net loss (profit) arising out of their respective position in the contract.
So, in case of Scenario I mentioned above, where the spot price at the expiry date (ST) was
greater than the forward price (FT), the party with the short position will have to pay an amount
equivalent to the net loss to the part y at the long position. In our example, A will simply pay Rs.
5000 to B on the expiry date. The opposite is the case in Scenario (III), when ST < FT. The long
party will be at a loss and have to pay an amount equivalent to the net loss to the short party. In
our example, B will have to pay Rs. 5000 to A on the expiry date. In case of Scenario (II) where
S T = FT, there is no need for any party to pay anything to the other party. Please note that the
profit and loss position in case of physical settlement and cash settlement is the same except for
the transaction costs which is involved in the physical settlement.
Default risk in forward contracts
A drawback of forward contracts is that they are subject to default risk. Regardless of whether
the contract is for physical or cash settlement, there exists a potential for one party to default, i.e.
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not honor the contract. It could be either the buyer or the seller. This results in the other party
suffering a loss.
This risk of making losses due to any of the two parties defaulting is known as counter party risk.
The main reason behind such risk is the absence of any mediator between the parties, who could
have undertaken the task of ensuring that both the parties fulfill their obligations arising out of
the contract. Default risk is also referred to as counter party risk or credit risk.
Forward Prices and Arbitrage
Arbitrage involves locking in a prot by simultaneously entering into transactions in two or more
markets to exploit a pricing anomaly. Such opportunities to make riskless prots are quite rare,
since when the traders start moving to exploit them the prices adjust accordingly so that the
arbitrage opportunity disappears.
Example III (Arbitrage with a Forward Contract on Gold).
This example illustrates the possibility of arbitrage when the delivery price on a forward contract
is too high or too low. Consider a trader who owns one ounce of gold today. Suppose the spot
prices for gold is such that in the spot market traders can buy an ounce of gold at PB = $100 and
sell at PS = $95. Furthermore, suppose that the 1-year borrowing and lending rates are such that
traders can borrow at RB = 5% and lend at RL = 4% a year.
Suppose rst that the delivery price for a one year forward contract on gold is F = $107. In this
case, the following arbitrage strategy yields a riskless prot.
Borrow $100 at 5%, buy one ounce of gold in the spot market and take a short position in the
forward contract.
To see why, note that at time of delivery for the forward, the trader will sell the gold she bought
for $107, whereas she has to pay back the loan at $100(1+0.05) = $105, which leaves her with
$107 $105 = $2 prots.
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Note that once traders start exploiting this arbitrage opportunity by taking short forward
positions, there will be an excess supply to deliver gold at $107, which will drive the 1-year gold
forward delivery price down.
For the arbitrage opportunity to disappear, the delivery price F should be less than
F < PB (1 + RB) = $100(1 + 0.05) = $105
F < $105.
Example III (continued)
Suppose now that the delivery price for a one year forward contract on gold is F = $96. In this
case, the following arbitrage strategy yields a riskless prot (recall that our trader own one ounce
of gold to begin with).
Sell the gold today at PS = $95, lend the proceeds at RL = 4%, and take a LONG position in the
forward contract.
To see why, note that at time of delivery for the forward contract, the trader will BUY the gold at
F = $96, whereas she will receive $95(1 + 0.04) = $98.8 (for the funds she invested at 4%),
which leaves her with $98.8 $96 = $2.8 prots.
Note that once traders start exploiting this arbitrage opportunity by taking long forward
positions, there will be an excess demand to be delivered gold at $96, which will drive the 1-year
gold forward delivery price up. For the arbitrage opportunity to disappear, the delivery price
F should be more than
F > PS (1 + RL) = $95(1 + 0.04) = $98.8
F > $98.8
Practice Problems
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Problem 1 A U.S. Company expects to pay 1 million Euros in six months. How can they use
forward contracts to hedge against the exchange rate risk?
Problem 2 The price of gold is currently $500 per ounce. The forward price for delivery in
one year is $700. An arbitrage trader can borrow money at 10% per annum. Identify an arbitrage
strategy.
Problem 3 A traders owns one unit of gold. The trader can buy gold at $50 per ounce and sell
it at $40 per ounce in the spot market. She can borrow money at 6% per year and can invest
money at 5% per year. For what range of one-year gold forward price F does this trader have no
arbitrage opportunities?
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B Futures
Like a forward contract, a futures contract is an agreement between two parties in which the
buyer agrees to buy an underlying asset from the seller, at a future date at a price that is agreed
upon today. However, unlike a forward contract, a futures contract is not a private transaction but
gets traded on a recognized stock exchange. In addition, a futures contract is standardized by the
exchange. All the terms, other than the price, are set by the stock exchange (rather than by
individual parties as in the case of a forward contract). Also, both buyer and seller of the futures
contracts are protected against the counter party risk by an entity called the Clearing
Corporation. The Clearing Corporation provides this guarantee to ensure that the buyer or the
seller of a futures contract does not suffer as a result of the counter party defaulting on its
obligation. In case one of the parties defaults, the Clearing Corporation steps in to fulfill the
obligation of this party, so that the other party does not suffer due to non-fulfillment of the
contract. To be able to guarantee the fulfillment of the obligations under the contract, the
Clearing Corporation holds an amount as a security from both the parties. This amount is called
the Margin money and can be in the form of cash or other financial assets. Also, since the futures
contracts are traded on the stock exchanges, the parties have the flexibility of closing out the
contract prior to the maturity by squaring off the transactions in the market. The basic flow of a
transaction between three parties, namely Buyer, Seller and Clearing Corporation is depicted in
the diagram below:
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What is the difference between forward and futures contracts?
Fundamentally, forward and futures contracts have the same function: both types of contracts
allow people to buy or sell a specific type of asset at a specific time at a given price.
Forwards Futures
Privately negotiated contracts Traded on an exchange
Not standardized Standardized contracts
Settlement dates can be set by the parties Fixed settlement dates as declared by the
exchange
High counter party risk Almost no counter party risk
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C Options
Like forwards and futures, options are derivative instruments that provide the opportunity to buy
or sell an underlying asset on a future date. An option is a derivative contract between a buyer
and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but
not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a
specific day at an agreed -upon price. In return for granting the option, the party granting the
option collects a payment from the other party. This payment collected is called the premium
or price of the option. The right to buy or sell is held by the option buyer (also called the
option holder); the party granting the right is t he option seller or option writer. Unlike
forwards and futures contracts, options require a cash payment (called the premium) upfront
from the option buyer to the option seller. This payment is called option premium or option price.
Options can be traded either on the stock exchange or in over the counter (OTC) markets.
Options traded on the exchanges are backed by the Clearing Corporation thereby minimizing the
risk arising due to default by the counter parties involved.
There are two types of options, call options and put options, which are explained below:
Call option
A call option is an option granting the right to the buyer of the option to buy the underlying asset
on a specific day at an agreed upon price, but not the obligation to do so. It is the seller who
grants this right to the buyer of the option. It may be noted that the person who has the right to
buy the underlying asset is known as the buyer of the call option. The price at which the buyer
has the right to buy the asset is agreed upon at the time of entering the contract. This price is
known as the strike price of the contract (call option strike price in this case). Since the buyer of
the call option has the right (but no obligation) to buy the underlying asset, he will exercise his
right to buy the underlying asset if and only if the price of the underlying asset in the market is
more than the strike price on or before the expiry date of the contract. The buyer of the call
option does not have an obligation to buy if he does not want to.
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Put option
A put option is a contract granting the right to the buyer of the option to sell the underlying asset
on or before a specific day at an agreed upon price, but not the obligation to do so. It is the seller
who grants this right to the buyer of the option. The person who has the right to sell the
underlying asset is known as the buyer of the put option. The price at which the buyer has the
right to sell the asset is agreed upon at the time of entering the contract. This price is known as
the strike price of the contract (put option strike price in this case). Since the buyer of the put
option has the right (but not the obligation) to sell the underlying asset, he will exercise his right
to sell the underlying asset if and only if the price of the underlying asset in the market is less
than the strike price on or before the expiry date of the contract. The buyer of the put option does
not have the obligation to sell if he does not want to.
Illustration
Suppose A has bought a call option of 2000 shares of Unilever at a strike price of Rs 260 per
share at a premium of Rs 10. This option gives A, the buyer of the option, the right to buy 2000
shares of Unilever from the seller of the option, on or before August 27, 2009 (expiry date of the
option). The seller of the option has the obligation to sell 2000 shares of Unilever at Rs 260 per
share on or before August 27, 2009 (i.e. whenever asked by the buyer of the option).
Suppose instead of buying a call, A has sold a put option on 100 Reliance Industries (RIL)
shares at a strike price of Rs 2000 at a premium of Rs 8. This option is an obligation to A to buy
100 shares of Reliance Industries (RIL) at a price of Rs 2000 per share on or before August 27
(expiry date of the option) i.e., as and when asked by the buyer of the put option. It depends on
the option buyer as to when he exercises the option. As stated earlier, the buyer does not have the
obligation to exercise the option.
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Differences between futures and options:
Terminology of Derivatives
In this section we explain the general terms and concepts related to derivatives.
Spot price (ST)
Spot price of an underlying asset is the price that is quoted for immediate delivery of the asset.
For example, at the National Stock Exchange of India (NSE), the spot price of Reliance Ltd. at
any given time is the price at which Reliance Ltd. shares are being traded at that time in the Cash
Market Segment of the NSE. Spot price is also referred to as cash price sometimes.
Forward price or futures price (F)
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Forward price or futures price is the price that is agreed upon at the date of the contract for the
delivery of an asset at a specific future date. These prices are dependent on the spot price, the
prevailing interest rate and the expiry date of the contract.
Strike price (K)
The price at which the buyer of an option can buy the stock (in the case of a call option) or sell
the stock (in the case of a put option) on or before the expiry date of option contracts is called
strike price. It is the price at which the stock will be bought or sold when the option is exercised.
Strike price is used in the case of options only; it is not used for futures or forwards.
Expiration date (T)
In the case of Futures, Forwards and Index Options, Expiration Date is the only date on which
settlement takes place. In case of stock options, on the other hand, Expiration date (or simply
expiry), is the last date on which the option can be exercised. It is also called the final settlement
date.
Contract size
As futures and options are standardized contracts traded on an exchange, they have a fixed
contract size. One contract of a derivatives instrument represents a certain number of shares of
the underlying asset. For example, if one contract of BHEL consists of 300 shares of BHEL, then
if one buys one futures contract of BHEL, then for every Re 1 increase in BHELs futures price,
the buyer will make a profit of 300 X 1 = Rs 300 and for every Re 1 fall in BHELs futures price,
he will lose Rs 300.
Contract Value
Contract value is notional value of the transaction in case one contract is bought or sold. It is the
contract size multiplied but the price of the futures. Contract value is used to calculate margins
etc. for contracts. In the example above if BHEL futures are trading at Rs. 2000 the contract
value would be Rs. 2000 x 300 = Rs. 6 lacs.
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Margins
In the spot market, the buyer of a stock has to pay the entire transaction amount (for purchasing
the stock) to the seller. For example, if Infosys is trading at Rs. 2000 a share and an investor
wants to buy 100 Infosys shares, then he has to pay Rs. 2000 X 100 = Rs. 2,00,000 to the seller.
The settlement will take place on T+2 basis; that is, two days after the transaction date.
In a derivatives contract, a person enters into a trade today (buy or sell) but the settlement
happens on a future date. Because of this, there is a high possibility of default by any of the
parties. Futures and option contracts are traded through exchanges and the counter party risk is
taken care of by the clearing corporation. In order to prevent any of the parties from defaulting
on his trade commitment, the clearing corporation levies a margin on the buyer as well as seller
of the futures and option contracts. This margin is a percentage (approximately 20%) of the total
contract value. Thus, for the aforementioned example, if a person wants to buy 100 Infosys
futures, then he will have to pay 20% of the contract value of Rs 2,00,000 = Rs 40,000 as a
margin to the clearing corporation. This margin is applicable to both, the buyer and the seller of a
futures contract.
Moneyness of an Option
Moneyness of an option indicates whether an option is worth exercising or not i.e. if the option
is exercised by the buyer of the option whether he will receive money or not.
Moneyness of an option at any given time depends on where the spot price of the underlying is
at that point of time relative to the strike price. The premium paid is not taken into consideration
while calculating moneyness of an Option, since the premium once paid is a sunk cost and the
profitability from exercising the option does not depend on the size of the premium. Therefore,
the decision (of the buyer of the option) whether to exercise the option or not is not affected by
the size of the premium. The following three terms are used to define the moneyness of an
option.
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In-the-money option
An option is said to be in-the-money if on exercising the option, it would produce a cash inflow
for the buyer. Thus, Call Options are in-the-money when the value of spot price of the underlying
exceeds the strike price. On the other hand, Put Opt ions are in-the- money when the spot price
of the underlying is lower than the strike price. Moneyness of an option should not be confused
with the profit and loss arising from holding an option contract. It should be noted that while
moneyness of an option does not depend on the premium paid, profit/loss do. Thus a holder of an
in-the-money option need not always make profit as the profitability also depends on the
premium paid.
Out-of- the-money option
An out-of-the-money option is an opposite of an in-the-money option. An option-holder will not

exercise the option when it is out-of-the-money. A Call option is out-of-the-money when its
strike price is greater than the spot price of the underlying and a Put option is out-of-the-money
when the spot price of the underlying is greater than the options strike price.
At- the-money option
An at-the-money-option is one in which the spot price of the underlying is equal to the strike
price. It is at the stage where with any movement in the spot price of the underlying, the option
will either become in-the-money or out-of-the-money.
Illustration
Consider some Call and Put options on stock XYZ. As on 13 August, 2009, XYZ is trading at Rs
116.25. The table below gives the information on closing prices of four options, expiring in
September and December, and with strike prices of Rs. 115 and Rs. 117.50.
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Moneyness of call and put options
Suppose the spot price of the underlying (closing share price) as at end of September is Rs. 116
and at end of December is Rs. 118. On the basis of the rules stated above, which options is in-
the-money and which ones is out-of-the-money are given in the following table.
Moneyness of call and put options
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It may be noted that an option which is in-the-money at a particular instance may turn into out-
of-the money (and vice versa) at another instance due to change in the price of the underlying
asset.
Applications of Derivatives
We look at the participants in the derivatives markets and how they use derivatives contracts.
Participants in the Derivatives Market
As equity markets developed, different categories of investors started participating in the

market. Equity market participants currently include retail investors, corporate investors, mutual
funds, banks, foreign institutional investors etc. Each of these investor categories uses the
derivatives market to as a part of risk management, investment strategy or speculation. Based on
the applications that derivatives are put to, these investors can be broadly classified into three
groups:
Hedgers
Speculators, and
Arbitrageurs
We shall now look at each of these categories in detail.
1 Hedgers
These investors have a position (i.e., have bought stocks) in the underlying market but are
worried about a potential loss arising out of a change in the asset price in the future. Hedgers
participate in the derivatives market to lock the prices at which they will be able to transact in the
future. Thus, they try to avoid price risk through holding a position in the derivatives market.
Different hedgers take different positions in the derivatives market based on their exposure in the
underlying market. A hedger normally takes an opposite position in the derivatives market to
what he has in the underlying market. Hedging in futures market can be done through two
positions, viz. short hedge and long hedge.
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Short Hedge
A short hedge involves taking a short position in the futures market. Short hedge position is
taken by someone who already owns the underlying asset or is expecting a future receipt of the
underlying asset.
For example, an investor holding Reliance shares may be worried about adverse future price
movements and may want to hedge the price risk. He can do so by holding a short position in the
derivatives market. The investor can go short in Reliance futures at the NSE. This protects him
from price movements in Reliance stock. In case the price of Reliance shares falls, the investor
will lose money in the shares but will make up for this loss by the gain made in Reliance Futures.
Note that a short position holder in a futures contract makes a profit if the price of the underlying
asset falls in the future. In this way, futures contract allows an investor to manage his price risk.
Similarly, a sugar manufacturing company could hedge against any probable loss in the future
due to a fall in the prices of sugar by holding a short position i n the futures/ forwards market. If
the prices of sugar fall, the company may lose on the sugar sale but the loss will be offset by
profit made in the futures contract.
Long Hedge
A long hedge involves holding a long position in the futures market. A Long position holder
agrees to buy the underlying asset at the expiry date by paying the agreed futures/ forward price.
This strategy is used by those who will need to acquire the underlying asset in the future.
For example, a chocolate manufacturer who needs to acquire sugar in the future will be worried
about any loss that may arise if the price of sugar increases in the future. To hedge against this
risk, the chocolate manufacturer can hold a long position in the sugar futures. If the price of
sugar rises, the chocolate manufacture may have to pay more to acquire sugar in the normal
market, but he will be compensated against this loss through a profit that will arise in the futures
market. Note that a long position holder in a futures contract makes a profit if the price of the
underlying asset increases in the future. Long hedge strategy can also be used by those investors
who desire to purchase the underlying asset at a future date (that is, when he acquires the cash to
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purchase the asset) but wants to lock the prevailing price in the market. This may be because he
thinks that the prevailing price is very low.
For example, suppose the current spot price of Wipro Ltd. is Rs. 250 per stock. An investor is
expecting to have Rs. 250 at the end of the month. The investor feels that Wipro Ltd. is at a very
attractive level and he may miss the opportunity to buy the stock if he waits till the end of the
month. In such a case, he can buy Wipro Ltd. in the futures market. By doing so, he can lock in
the price of the stock. Assuming that he buys Wipro Ltd. in the futures market at Rs. 250 (this
becomes his locked-in price), there can be three probable scenarios:
Scenario I: Price of Wipro Ltd. in the cash market on expiry date is Rs. 300. As futures price
is equal to the spot price on the expiry day, the futures price of Wipro would be at Rs. 300 on
expiry day. The investor can sell Wipro Ltd in the futures market at Rs. 300. By doing this, he
has made a profit of 300 250 = Rs. 50 in the futures trade. He can now buy Wipro Ltd in the
spot market at Rs. 300. Therefore, his total investment cost for buying one share of Wipro Ltd
equals Rs.300 (price in spot market) 50 (profit in futures market) = Rs.250. This is the amount
of money he was expecting to have at the end of the month. If the investor had not bought Wipro
Ltd futures, he would have had only Rs. 250 and would have been unable to buy Wipro Ltd
shares in the cash market. The futures contract helped him to lock in a price for the shares at Rs.
250.
Scenario II: Price of Wipro Ltd in the cash market on expiry day is Rs. 250. As futures price
tracks spot price, futures price would also be at Rs. 250 on expiry day. The investor will sell
Wipro Ltd in the futures market at Rs. 250. By doing this, he has made Rs. 0 in the futures trade.
He can buy Wipro Ltd in the spot market at Rs. 250. His total investment cost for buying one
share of Wipro will be = Rs. 250 (price in spot market) + 0 (loss in futures market) = Rs. 250.
Scenario III: Price of Wipro Ltd in the cash market on expiry day is Rs. 200. As futures price
tracks spot price, futures price would also be at Rs. 200 on expiry day. The investor will sell
Wipro Ltd in the futures market at Rs. 200. By doing this, he has made a loss of 200 250 = Rs.
50 in the futures trade. He can buy Wipro in the spot market at Rs. 200. Therefore, his total
investment cost for buying one share of Wipro Ltd will be = 200 (price in spot market) + 50 (loss
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in futures market) = Rs. 250. Thus, in all the three scenarios, he has to pay only Rs. 250. This is
an example of a Long Hedge.
2 Speculators
A Speculator is one who bets on the derivatives market based on his views on the potential
movement of the underlying stock price. Speculators take large, calculated risks as they trade
based on anticipated future price movements. They hope to make quick, large gains; but may not
always be successful. They normally have shorter holding time for their positions as compared to
hedgers. If the price of the underlying moves as per their expectation they can make large profits.
However, if the price moves in the opposite direction of their assessment, the losses can also be
enormous.
Illustration
Currently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market and also at Rs.
500 in the futures market (assumed values for the example only). A speculator feels that post the
RBIs policy announcement, the share price of ICICI will go up. The speculator can buy the
stock in the spot market or in the derivatives market. If the derivatives contract size of ICICI is
1000 and if the speculator buys one futures contract of ICICI, he is buying ICICI futures worth
Rs 500 X 1000 = Rs. 5,00,000. For this he will have to pay a margin of say 20% of the contract
value to the exchange. The margin that the speculator needs to pay to the exchange is 20% of Rs.
5,00,000 = Rs. 1,00,000. This Rs. 1,00,000 is his total investment for the futures contract. If the
speculator would have invested Rs. 1,00,000 in the spot market, he could purchase only 1,00,000
/ 500 = 200 shares. Let us assume that post RBI announcement price of ICICI share moves to Rs.
520. With one lakh investment each in the futures and the cash market, the profits would be:
(520 500) X 1,000 = Rs. 20,000 in case of futures market and
(520 500) X 200 = Rs. 4000 in the case of cash market.
It should be noted that the opposite will result in case of adverse movement in stock prices,
wherein the speculator will be losing more in the futures market than in the spot market. This is
because the speculator can hold a larger position in the futures market where he has to pay only
the margin money.
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3 Arbitrageurs
Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous
trades that offset each other and captures a risk-free profit. An arbitrageur may also seek to make
profit in case there is price discrepancy between the stock price in the cash and the derivatives
markets.
For example, if on 1st August, 2009 the SBI share is trading at Rs. 1780 in the cash market and
the futures contract of SBI is trading at Rs. 1790, the arbitrageur would buy the SBI shares (i.e.
make an investment of Rs. 1780) in the spot market and sell the same number of SBI futures
contracts. On expiry day (say 24 August, 2009), the price of SBI futures contracts will close at
the price at which SBI closes in the spot market. In other words, the settlement of the futures
contract will happen at the closing price of the SBI shares and that is why the futures and spot pr
ices are said to converge on the expiry day. On expiry day, the arbitrageur will sell the SBI stock
in the spot market and buy the futures contract, both of which will happen at the closing price of
SBI in the spot market. Since the arbitrageur has entered into off-setting positions, he will be
able to earn Rs. 10 irrespective of the prevailing market price on the expiry date. There are three
possible price scenarios at which SBI can close on expiry day. Let us calculate the profit/ loss of
the arbitrageur in each of the scenarios where he had initially (1 August) purchased SBI shares in
the spot market at Rs 1780 and sold the futures contract of SBI at Rs. 1790:
Scenario I: SBI shares closes at a price greater than 1780 (say Rs. 2000) in the spot market
on expiry day (24 August 2009) SBI futures will close at the same price as SBI in spot market on
the expiry day i.e., SBI futures will also close at Rs. 2000. The arbitrageur reverses his previous
transaction entered into on 1 August 2009.
Profit/ Loss () in spot market = 2000 1780 = Rs. 220
Profit/ Loss () in futures market = 1790 2000 = Rs. () 210
Net profit/ Loss () on both transactions combined = 220 210 = Rs. 10 profit.
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Scenario II: SBI shares close at Rs 1780 in the spot market on expiry day (24 August 2009)
SBI futures will close at the same price as SBI in spot market on expiry day i.e., SBI futures will
also close at Rs 1780. The arbitrageur reverses his previous transaction entered into on 1 August
2009.
Profit/ Loss () in spot market = 1780 1780 = Rs 0
Profit/ Loss () in futures market = 1790 1780 = Rs. 10
Net profit/ Loss () on both transactions combined = 0 + 10 = Rs. 10 profit.
Scenario III: SBI shares close at Rs. 1500 in the spot market on expiry day (24 August 2009),
Here also, SBI futures will close at Rs. 1500. The arbitrageur reverses his previous transaction
entered into on 1 August 2009.
Profit/ Loss () in spot market = 1500 1780 = Rs. () 280
Profit/ Loss () in futures market = 1790 1500 = Rs. 290
Net profit/ Loss () on both transactions combined = () 280 + 290 = Rs. 10 profit.
Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, which was the difference
between the spot price of SBI and futures price of SBI, when the transaction was entered into.
This is called a risk less profit since once the transaction is entered into on 1 August, 2009 (due
to the price difference between spot and futures), the profit is locked.
Irrespective of where the underlying share price closes on the expiry date of the contract, a profit
of Rs. 10 is assured. The investment made by the arbitrageur is Rs. 1780 (when he buys SBI in
the spot market). He makes this investment on 1 August 2009 and gets a return of Rs. 10 on this
investment in 23 days (24 August). This means a return of 0.56% in 23 days. If we annualize
this, it is a return of nearly 9% per annum. One should also note that this opportunity to make a
risk-less return of 9% per annum will not always remain. The difference between the spot and
futures price arose due to some inefficiency (in the market), which was exploited by the
arbitrageur by buying shares in spot and selling futures. As more and more such arbitrage trades
take place, the difference between spot and futures prices would narrow thereby reducing the
attractiveness of further arbitrage.
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Uses of Derivatives
1 Risk management
The most important purpose of the derivatives market is risk management. Risk management for
an investor comprises of the following three processes:
Identifying the desired level of risk that the investor is willing to take on his investments;
Identifying and measuring the actual level of risk that the investor is carrying; and
Making arrangements which may include trading (buying/selling) of derivatives contracts
that allow him to match the actual and desired levels of risk.
The example of hedging discussed above illustrates the process of risk management through
futures.
2 Market efficiency
Efficient markets are fair and competitive and do not allow an investor to make risk free profits.
Derivatives assist in improving the efficiency of the markets, by providing a self-correcting
mechanism. Arbitrageurs are one section of market participants who trade whenever there is an
opportunity to make risk free profits till the opportunity ceases to exist. Risk free profits are not
easy to make in more efficient markets. When trading occurs, there is a possibility that some
amount of mispricing might occur in the markets. The arbitrageurs step in to take advantage of
this mispricing by buying from the cheaper market and selling in the higher market. Their actions
quickly narrow the prices and thereby reducing the inefficiencies.
3 Price discovery
One of the primary functions of derivatives markets is price discovery. They provide valuable
information about the prices and expected price fluctuations of the underlying assets in two
ways:
First, many of these assets are traded in markets in different geographical locations. Because of
this, assets may be traded at different prices in different markets. In derivatives markets, the price
of the contract often serves as a proxy for the price of the underlying asset. For example, gold
may trade at different prices in Mumbai and Delhi but a derivatives contract on gold would have
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one value and so traders in Mumbai and Delhi can validate the prices of spot markets in their
respective location to see if it is cheap or expensive and trade accordingly.
Second, the prices of the futures contracts serve as prices that can be used to get a sense of the
market expectation of future prices. For example, say there is a company that produces sugar and
expects that the production of sugar will take two months from today. As sugar prices fluctuate
daily, the company does not know if after two months the price of sugar will be higher or lower
than it is today. How does it predict where the price of sugar will be in future? It can do this by
monitoring prices of derivatives contract on sugar (say a Sugar Forward contract). If the forward
price of sugar is trading higher than the spot price that means that the market is expecting the
sugar spot price to go up in future. If there were no derivatives price, it would have to wait for
two months before knowing the market price of sugar on that day. Based on derivatives price the
management of the sugar company can make strategic and tactical decisions of how much sugar
to produce and when.
Trading Options
In this chapter we will discuss pay -outs for various strategies using options and strategies which
can be used to improve returns by using options.
Option Payout
There are two sides to every option contract. On the one side is the option buyer who has taken a
long position (i.e., has bought the option). On the other side is the option seller who has taken a
short position (i.e., has sold the option). The seller of the option receives a premium from the
buyer of the option. It may be noted that while computing profit and loss, premium has to be
taken into consideration. Also, when a buyer makes profit, the seller makes a loss of equal
magnitude and vice versa. In this section, we will discuss payouts for various strategies using
options.
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A long position in a call option
In this strategy, the investor has the right to buy the asset in the future at a predetermined strike
price i.e., strike price (K) and the option seller has the obligation to sell the asset at the strike
price (K). If the settlement price (underlying stock closing price) of the asset is above the strike
price, then the call option buyer will exercise his option and buy the stock at the strike price (K).
If the settlement price (underlying stock closing price) is lower than the strike price, the option
buyer will not exercise the option as he can buy the same stock from the market at a price lower
than the strike price.
A long position in a put option
In this strategy, the investor has bought the right to sell the underlying asset in the future at a
predetermined strike price (K). If the settlement price (underlying stock closing price) at maturity
is lower than the strike price, then the put option holder will exercise his option and sell the stock
at the strike price (K). If the settlement price (underlying stock closing price) is higher than the
strike price, the option buyer will not exercise the option as he can sell the same stock in the
market at a price higher than the strike price.
A short position in a call option
In this strategy, the option seller has an obligation to sell the asset at a predetermined strike price
(K) if the buyer of the option chooses to exercise the option. The buyer of the option will
exercise the option if the spot price at maturity is any value higher than (K). If the spot price is
lower than (K), the buyer of the option will not exercise his/her option.
A short position in a put option
In this strategy, the option seller has an obligation to buy the asset at a predetermined strike price
(K) if the buyer of the option chooses to exercise his/her option. The buyer of the option will
exercise his option to sell at (K) if the spot price at maturity is lower than (K). If the spot price is
higher than (K), then the option buyer will not exercise his/her option.
Explanation of pay-offs for long options
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The buyers profit is equal to the sellers loss. Therefore, in the above table the sellers loss is S T
K for a short call option if the spot price closes at a value above the strike price of the option
and is K S T for a short put option if the spot price closes at a value lower than the strike price
of the option. The above four positions and their pay-offs are depicted in the figure below:
Pay -off for a buyer of a call option
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The figure shows the profits/losses for a buyer of a three-month Nifty 2250 call option. As can be
seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes
above the strike of 2250, the buyer would exercise his option and profit to the extent of the
difference between the Nifty-close and the strike price. The profits possible on this option are
potentially unlimited. However, if Nifty falls below the strike of 2250, the buyer lets the option
expire. His losses are limited to the extent of the premium that he paid for buying the option.
Pay-off for a seller of option
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The figure shows the profits/losses for a seller of a three-month Nifty 2250 call option. As the
spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon
expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the
writer who would suffer a loss to the extent of the difference between the Nifty-close and the
strike price. The loss that can be incurred by the writer of the option is potentially unlimited,
whereas the maximum profit is limited to the extent of the upfront option premium charged by
him.
Pay-off for a buyer of a put option
The figure shows the profits/losses for a buyer of a three-month Nifty 2250 put option. As can be
seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes
below the strike of 2250, the buyer would exercise his option and profit to the extent of the
difference between the strike price and Nifty-close. The profits possible on this option can be as
high as the strike price. However, if Nifty rises above the strike of 2250, he lets the option
expire. His losses are limited to the extent of the premium he paid for buying the option.
Pay-off for a seller of a put option
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The figure shows the profits/losses for a seller of a three-month Nifty 2250 put option. As the
spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon
expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the
writer who would suffer a loss to the extent of the difference between the strike price and Nifty-
close. The loss that can be incurred by the writer of the option is a maximum extent of the strike
price (since the worst that can happen is that the asset price can fall to zero) whereas the
maximum profit is limited to the extent of the upfront option premium of charged by him.
Option Strategies
An option strategy is implemented to try and make gains from the movement in the underlying
price of an asset. As discussed above, options are derivatives that give the buyer the right to
exercise the option at a future date. Unlike futures and forwards which have linear pay -offs and
do not require an initial outlay (upfront payment), options have non linear pay-offs and do
require an initial outlay (or premium). In this section we discuss various strategies which can be
used to maximize returns by using options.
A Long option strategy
A long option strategy is a strategy of buying an option according to the view on future price
movement of the underlying. A person with a bullish opinion on the underlying will buy a call
option on that asset/security, while a person with a bearish opinion on the underlying will buy a
put option on that asset/security. An important characteristic of long option strategies is limited
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risk and unlimited profit potential. An option buyer can only lose the amount paid for the option
premium. At the same time, theoretically, the profit potential is unlimited.
Calls
An investor having a bullish opinion on underlying can expect to have positive returns by buying
a call option on that asset/security. When a call option is purchased, the call option holder is
exposed to the stock performance in the spot market without actually possessing the stock and
does so for a fraction of the cost involved i n purchasing the stock in the spot market. The cost
incurred by the call option holder is the option premium. Thus, he can take advantage of a
smaller investment and maximize his profits.
Consider the purchase of a call option at the price (premium) c. We take
S T = Spot price at time T
K = Strike price
The payout in two scenarios is as follows:
Profit/Loss = c , if S T = K
Profit/Loss = (S T - K ) c if S T = K
Let us explain this with some examples. Mr. A buys a Call on an index (such as Nifty 50) with a
strike price of Rs. 2000 for premium of Rs. 81. Consider the values of the index at expiration as
1800, 1900, 2100, and 2200.
For S T = 1800, Profit/Loss = 0 81 = 81 (maximum loss = premium paid)
For S T = 1900, Profit/Loss = 0 81 = 81 (maximum loss = premium paid)
For S T = 2100, Profit/Loss = 2100 2000 81 = 19
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As we can see from the example, the maximum loss suffered by the buyer of the Call option is
Rs. 81, which is the premium that he paid t o buy the option. His maximum profits are unlimited
and they depend on where the underlying price moves.
Puts
An investor having a bearish opinion on the underlying can expect to have positive returns by
buying a put option on that asset/security. When a put option is purchased, the put option buyer
has the right to sell the stock at the strike price on or before the expiry date depending on where
the underlying price is.
Consider the purchase of a put option at price (premium) p. We take
S T = Spot price a t time T
K = exercise price
Profit/Loss = (K S T ) p if S T = K
Profit/Loss = p if S T = K
Let us explain this with some examples. Mr. X buys a put at a strike price of Rs. 2000 for a
premium of Rs. 79. Consider the values of the index at expiration at 1800, 1900, 2100, and 2200.
For S T = 2100, Profit/Loss = 79 (maximum loss is the premium paid)
For S T = 2200, Profit/Loss = 79 (maximum loss is the premium paid)
As we can see from the example, the maximum loss suffered by the buyer of the Put option is Rs.
79, which is the premium that he paid to buy the option. His maximum profits are unlimited and
depend o n where the underlying price moves.
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B Short options strategy
A short options strategy is a strategy where options are sold to make money upfront with a view
that the options will expire out of money at the expiry date (i.e., the buyer of the option will not
exercise the same and the seller can keep the premium). As opposed to a long options strategy,
here a person with a bullish opinion on the underlying will sell a put option in the hope that
prices will rise and the buyer will not exercise the option leading to profit for the seller. On the
other hand, a person with a bearish view on the underlying will sell a call option in the hope that
prices will fall and the buyer will not exercise the option leading to profit for the seller. As
opposed to a long options strategy where the downside was limited to the price paid for the
option, here the downside is unlimited and the profit is limited to the price of selling the option
(the premium).
Calls
An investor with a bearish opinion on the underlying can take advantage of falling stock prices
by selling a call option on the asset/security. If the stock price falls, the profit to the seller will be
the premium earned by selling the option. He will lose in case the stock price increases above the
strike price.
Consider the selling of a call option at the price (premium) c. We take
K = exercise price
Profit/Loss = c if S T = K
Profit/Loss = c (S T K) if S T = K
Now consider this example: A sells a call at a strike price of Rs 2000 for a premium of Rs 81.
Consider values of index at expiration at 1800, 1900, 2100, and 2200.
For S T = 1800, Profit/Loss = 81 (maximum profit = premium received)
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For S T = 2100, Profit/Loss = 81 (2100 2000) = 1 9
For S T =2200, Profit/Loss = 81 (2100 2200) = 119
As we can see from the example above, the maximum loss suffered by the seller of the Call
option is unlimited (this is the reverse of the buyers gains). His maximum profits are limited to
the premium received.
Puts
An investor with a bullish opinion on the underlying can take advantage of rising prices by
selling a put option on the asset/security. If the stock price rises, the profit to the seller will be the
premium earned by selling the option. He will lose in case the stock price falls below the strike
price.
Consider the sale of a put option at the price (premium) p . We take:
K = exercise price
Profit/Loss = p (K ST) if S T = K
Profit/Loss = p if S T = K
We sell a put at a strike price of Rs. 2000 for Rs. 79. Consider values of index at expiration as
1800, 1900, 2100, and 2200.
For S T = 1800, Profit/Loss = 79 (2000 1800) = ( ) 121
For S T = 1900, Profit/Loss = 79 (2000 1900) = ( ) 21
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As we can see from the example above the maximum loss suffered by the seller of the Put option
is unlimited (this is the reverse of the buyers gains). His maximum profits are limited to the
premium received.
Determination of option prices
Like in case of any traded good, the price of any option is determined by the demand for and
supply of that option. This price has two components: intrinsic value and time value.
Intrinsic value and time value
Intrinsic value of an option: Intrinsic value of an option at a given time is the amount the holder
of the option will get if he exercises the option at that time. In other words, the intrinsic value of
an option is the amount the option is in-the-money (ITM). If the option is out -of- the-money
(OTM), its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0,
(S t K)] which means that the intrinsic value of a call is the greater of 0 or (St K).
Similarly, the intrinsic value of a put is Max [0, K S t] i.e., the greater of 0 or (K S t) where
K is the strike price and S t is the spot price.
Time value of an option
In addition to the intrinsic value, the seller charges a time value from the buyers of the option.
This is because the more time there is for the contract to expire, the greater the chance that the
exercise of the contract will become more profitable for the buyer. This is a risk for the seller and
he seeks compensation for it by demanding a time value.
The time value of an option can be obtained by taking the difference between its premium and its
intrinsic value. Both calls and puts have time value. An option that is Out-of-the-money (OTM)
or At-the-money (ATM) has only time value and no intrinsic value. Usually, the maximum time
value exists when the option is ATM. The longer the time to expiration, the greater is an options
time value, all else being equal. At expiration, an option has no time value.
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Illustration
In the following two tables, five different examples are given for call option and put option
respectively. As stated earlier, premium is determined by demand and supply. The examples
show how intrinsic value and time value vary depending on underlying price, strike price and
premium.
Intrinsic and Time Value for Call Options: Examples
Intrinsic and Time Value for Put Options: Examples
Factors impacting option prices
The supply and demand of options and hence their prices are influenced by the following factors:
The underlying price,

The strike price,
The time to expiration,
The underlying assets volatility,
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Risk free rate
Underlying Prices
Each of the five parameters has a different impact on the option pricing of a Call and a Put. The
underlying price: Call and Put options react differently to the movement in the underlying price.
As the underlying price increases, intrinsic value of a call increases and value of a put decreases.
Thus, in the case of a Call option, the higher the price of the underlying asset from strike price,
the higher is the value (premium) of the call option. On the other hand, in case of a put option,
the higher the price of the underlying asset, the lower is the value of the put option.
The strike price
The strike price is specified in the option contract and does not change over time. The higher the
strike price, the smaller is the intrinsic value of a call option and the greater is the intrinsic value
of a put option. Everything else remaining constant, as the strike price increases, the value of a
call option decreases and the value of a put option increases. Similarly, as the strike price
decreases, the price of the call option increases while that of a put option decreases.
Time to expiration
Time to expiration is the time remaining for the option to expire. Obviously, the time remaining
in an options life moves constantly towards zero. Even if the underlying price is constant, the
option price will still change since time reduces constantly and the time for which the risk is
remaining is reducing. The time value of both call as well as put option decreases to zero (and
hence, the price of the option falls to its intrinsic value) as the time to expiration approaches
zero. As time passes and a call option approaches maturity, its value declines, all other
parameters remaining constant. Similarly, the value of a put option also decreases as we
approach maturity. This is called time-decay.
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Volatility
Volatility is an important factor in the price of an option. Volatility is defined as the uncertainty
of returns. The more volatile the underlying higher is the price of the option on the underlying.
Whether we are discussing a call or a put, this relationship remains the same.
Risk free rate
Risk free rate of return is the theoretical rate of return of an investment which has no risk (zero
risk). Government securities are considered to be risk free since their return is assured by the
Government. Risk free rate is the amount of return which an investor is guaranteed to get over
the life time of an option without taking any risk. As we increase the risk free rate the price of the
call option increases marginally whereas the price of the put option decreases marginally. It may
however be noted that option prices do not change much with changes in the risk free rate.
The impact of all the parameters which affect the price of an option is given in the table below:
Even though option prices are determined by market demand and supply, there are various
models of getting a fair value of the options, the most popular of which is the Black Scholes
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Merton Model. In this model, the theoretical value of the options is obtained by inputting into
formula values of the above-mentioned five factors. It may be noted that the prices arrived at by
using this model are only indicative.
Real Options
An alternative or choice that becomes available with a business investment opportunity. Real
options can include opportunities to expand and cease projects if certain conditions arise,
amongst other options. They are referred to as "real" because they usually pertain to tangible
assets such as capital equipment, rather than financial instruments. Taking into account real
options can greatly affect the valuation of potential investments. Oftentimes, however, valuation
methods, such as NPV, do not include the benefits that real options provide.
Note that this kind of option is not a derivative instrument, but an actual option (in the sense of
"choice") that a business may gain by undertaking certain endeavors. For example, by investing
in a particular project, a company may have the real option of expanding, downsizing or
abandoning other projects in the future. Other examples of real options may be opportunities for
R&D, M&A and licensing.
Real Options Valuation (ROV) is revolutionizing corporate strategy and bridging the gap
between finance and strategic planning. Just as an option gives its owner the right - but not the
obligation - to take a particular course of action at some time in the future, flexibility embedded
in capital investment projects and company strategies allows managers to take a staged approach
to corporate strategy and react to changes in the business environment, so they can limit
downside losses while fully capitalizing on upside potential opportunities.
Real Options - Some Examples
Defer - Investing now eliminates the option to defer (learning)
Expand - An option to defer part of the scale of investment
Contract - The flexibility to reduce the rate of output
Abandon - Stop investing, and liquidate existing assets
Staging - Substitute a series of small investments for one large
Switching - Re-deploy resources or change inputs
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Techniques for Reasoning Through Decision Trees
1. Focus on the most important decisions.
2. Reason forward to construct the tree.
3. Track certainties and uncertainties at each decision point.
4. Calculate backward to evaluate choices.
5. Select the tree branch with the highest expected value.
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Decision Tree Example Assumptions
Consider an investment project where there is uncertainty about the state of the world. Suppose it
can be either good or bad and it's as likely to be one as the other. The market research provides
us the following data that:
Demand may be high (30%), medium (50%), low (20%).
Cost of large restaurant is $750,000.
Cost of small restaurant is $600,000.
Entrepreneur will invest $400,000, outside investor provides the rest.
Investor requires 1% of equity for each $10,000 invested.
If demand is high - PV large is $1,500,000, PV small is $800,000.
If demand is medium - PV large is $800,000, PV small is $800,000.
If demand is low - PV large is $300,000, PV small is $400,000.
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Accept/reject Decision to Invest in Restaurant Business
Evaluation of Accept/Reject Alternatives
Large-scale entry:
NPV conditional on high demand = $575,000
NPV conditional on intermediate demand = $120,000
NPV conditional on low demand = ($205,000)
NPV = .3 x $575,000 + .5 x $120,000 .2 x $205,000
= $191,500
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Small-scale entry:
NPV conditional on low demand = ($ 80,000)
NPV = .3 x $240,000 + .5 x $240,000 - .2 x $80,000
= $176,000
Do not enter:
NPV = $0
Restaurant Business Investment with an Option to Delay Investing
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Evaluation of Option to Delay
Large-scale entry strategy: NPV = $191,500
Delay until uncertainty is resolved:
High demand
Build large restaurant
Intermediate demand
Build small restaurant
Low demand
Do not enter
NPV conditional on low demand = $0
NPV of delay strategy:
= .3 x $445,000 + .5 x $160,000 + .2 x $0
= $213,500
Value of Option to Delay = $213,500 - 191,500
= $22,000
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Restaurant Business Investment with an Option to Expand Initial Investment
Evaluation of Option to Expand
Delay until uncertainty is resolved: NPV = $213,500
Build small, with Option to Expand:
Conditional on High demand:
NPV if Expand = $580,000
NPV if Remain Small = $240,000
Conclusion: Expand if demand is high
Conditional on Intermediate demand:
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NPV of Remaining Small = $240,000
Conditional on Low demand:
NPV of Remaining Small = ($80,000)
NPV of Small-scale entry with Option to Expand
= .3 x $580,000 + .5 x $240,000 - .2 x $80,000
= $278,000
Value of Expansion Option = $86,500
Incremental value over Delay Option = $64,500
The Options are Mutually Exclusive
Evaluation of Option to Abandon
Large-scale entry with Abandonment option:
Convert to office with $600,000 value
NPV of converting for entrepreneur = ($10,000)
NPV with Abandonment Option:
= .3 x $575,000 + .5 x $120,000 - .2 x $10,000 = $230,500
Would pay up to $39,000 extra for location that is convertible
Small-scale entry with Expansion and Abandonment Options:
Convert to office with $300,000 value
NPV of converting for entrepreneur = ($160,000)
NPV with Abandonment Option:
= .3 x $580,000 + .5 x $240,000 - .2 x $160,000 = $262,000
Abandonment has negative value for the small restaurant
A result of discreteness of the analysis
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Conclusion: Build small with Expansion Option
NPV = $278,000
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Value-at-Risk
History of Value-at-Risk
VaR was pioneered by major U.S. banks in the 80s, as the derivative markets developed. The
birth of derivatives represented a new challenge for risk management because traditional
measures of exposure were clearly inadequate. For example, two derivative contracts with the
same notional value could have very different risks. With VaR, banks had developed a general
measure of economic loss that could equate risk across products and aggregate risk on a port-
folio basis.
The value of a portfolio of financial assets is subject to many risks: credit risks, market risks, etc.
Value at Risk, VaR, is a statistical estimate of the market risk of a portfolio. VaR attempts to
answer the following question. Given a certain confidence level and a specified time horizon,
what is the maximum potential loss of the portfolio?
Definition of VaR
The value at risk (VaR) indicates the maximum percentage value of our multiple trading systems
portfolio that could be lost during a fixed period (e.g. one day) within a certain confidence level
(e.g. 95%).
VaR is defined as the predicted worst-case loss at a specific confidence level (e.g., 95%) over a
certain period of time (e.g., 1 day).
For example, every afternoon, J.P. Morgan takes a snapshot of its global trading positions to
estimate its Daily-Earnings-at-Risk (DEaR), which is a VaR measure that Morgan defines as the
95% confidence worst-case loss over the next 24 hours due to adverse market movements.
One the major advantage of VaR Method is that it works across different asset classes such as
bonds and stocks. The elegance of the VaR solution is that it works on multiple levels, from the
position-specific micro level to the portfolio-based macro level. VaR has become a common
language for communication about aggregate risk taking, both within an organization and outside
(e.g., with analysts, regulators, rating agencies, and shareholders).
Virtually all major financial institutions have adopted VaR as a cornerstone of day-to-day risk
measurement. Now with the VaR method it is possible to measure the aggregated risk on a
portfolio level. But there are some limitations of VaR model that is it can only be achieved under
normal market condition. Three approaches for VaR calculation:
Risk Metrics
Historical simulation
Monte Carlo simulation
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Risk Metrics
The RiskMetrics variance model (also known as exponential smoother) was first established in
1989, when Sir Dennis Weather stones, the new chairman of J.P. Morgan, asked for a daily
report measuring and explaining the risks of his firm. Nearly four years later in 1992, J.P.
Morgan launched the RiskMetrics methodology to the marketplace, making the substantive
research and analysis that satisfied Sir Dennis Weather stones request freely available to all
market participants.
Risk metrics by definition is a set of financial models used by investors to determine portfolio
risk.
Risk measurement process
Portfolio risk measurement can be broken down into steps. The first is modeling the market that
drives changes in the portfolio's value. The market model must be sufficiently specified so that
the portfolio can be revalued using information from the market model. The risk measurements
are then extracted from the probability distribution of the changes in portfolio value. The change
in value of the portfolio is typically referred to by portfolio managers as profit and loss, or P&L.
Market models
RiskMetrics describes two models for modeling the risk factors that define financial markets.
Historical Simulation
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Historical Simulation
HS involves using past data as a guide to what will happen in the future
Suppose we want to calculate VaR for a portfolio using 1-day horizon, a 99% confidence level,
and 500 days of data. Collect data on the daily movements in the given market variables.Conduct
500 trials assuming as if todays prices will change at a past rate of change in each of the 500
days
0 This way forecasted value for tomorrow will be:

v
vn i
vi 1
Where Vn is todays value of the variable
Vi is the variable value in past days
Vi-1 is the variable value one-day before the vi value
After that, calculate the value of portfolio based on the trial values of each variable and find the
difference between the forecasted values and todays value of the portfolio in all 500 trials. Find
the given percentile of these differences, and that will be the VaR estimate.
The 1st percentile in 500 observations means the 5th worst loss in all 500 observations
In Excel, we do this by: =percentile (range, .01) if it is for 1st percentile.
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Risk analysis is part of every decision we make. We are constantly faced with uncertainty,
ambiguity, and variability. And even though we have unprecedented access to information, we
cant accurately predict the future. Monte Carlo simulation (also known as the Monte Carlo
Method) lets you see all the possible outcomes of your decisions and assess the impact of risk,
allowing for better decision making under uncertainty.
Monte Carlo simulation furnishes the decision-maker with a range of possible outcomes and the
probabilities they will occur for any choice of action. It shows the extreme possibilitiesthe
outcomes of going for out of business and for the most conservative decisionalong with all
possible consequences for middle-of-the-road decisions.
Monte Carlo simulation is a computerized mathematical technique that allows people to account
for risk in quantitative analysis and decision making.
How Monte Carlo simulation works:
Monte Carlo simulation performs risk analysis by building models of possible results by
substituting a range of valuesa probability distributionfor any factor that has inherent
uncertainty. It then calculates results over and over, each time using a different set of random
values from the probability functions. Depending upon the number of uncertainties and the
ranges specified for them, a Monte Carlo simulation could involve thousands or tens of
thousands of recalculations before it is complete. Monte Carlo simulation produces distributions
of possible outcome values.
During a Monte Carlo simulation, values are sampled at random from the input probability
distributions. Each set of samples is called iteration, and the resulting outcome from that sample
is recorded. Monte Carlo simulation does this hundreds or thousands of times, and the result is a
probability distribution of possible outcomes. In this way, Monte Carlo simulation provides a
much more comprehensive view of what may happen. It tells you not only what could happen,
but how likely it is to happen.
Advantages
Monte Carlo simulation provides a number of advantages over single-point estimate analysis:
Probabilistic Results. Results show not only what could happen, but how likely each
outcome is.
Graphical Results. Because of the data a Monte Carlo simulation generates, its easy to
create graphs of different outcomes and their chances of occurrence. This is important
for communicating findings to other stakeholders.
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Sensitivity Analysis. With just a few cases, deterministic analysis makes it difficult to see
which variables impact the outcome the most. In Monte Carlo simulation, its easy to see
which inputs had the biggest effect on bottom-line results.
Scenario Analysis: In deterministic models, its very difficult to model different
combinations of values for different inputs to see the effects of truly different scenarios.
Using Monte Carlo simulation, analysts can see exactly which inputs had which values
together when certain outcomes occurred. This is very useful for pursuing further
analysis.
Who uses Monte Carlo simulation?
Many companies use Monte Carlo simulation as an important tool for decision-making. Here are
some examples.
General Motors, Procter and Gamble, and Eli Lilly use simulation to estimate both the average
return and the riskiness of new products. At GM, this information is used by CEO Rick
Waggoner to determine the products that come to market.
GM uses simulation for activities such as forecasting net income for the corporation, predicting
structural costs and purchasing costs, determining its susceptibility to different kinds of risk
(such as interest rate changes and exchange rate fluctuations).
Lilly uses simulation to determine the optimal plant capacity that should be built for each drug.
Wall Street firms use simulation to price complex financial derivatives and determine the Value
at RISK (VAR) of their investment portfolios.
Procter and Gamble uses simulation to model and optimally hedge foreign exchange risk.
Sears uses simulation to determine how many units of each product line should be ordered from
suppliers for example, how many pairs of Dockers should be ordered this year.
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Financial Risk Management

Friedrich Wilhelm Nietzsche

To be alive at all involve some Risk

Khurasan Institute of Higher Education

By Imran Khan MBA (Finance), CIA, CQC

How Does Financial Risk Arise?

There are three main sources of financial risk:

What Is Financial Risk Management?

Identify and prioritize key financial risks.

Determine an appropriate level of risk tolerance.

Implement risk management strategy in accordance with policy.

Measure, report, monitor, and refine as needed.

Total risk = General risk + Specific risk

= Market risk + Issuer risk

= Systematic risk + Nonsystematic risk

Systematic (Market) Risk, (Non-diversifiable Risk):

Risk attributable to broad macro factors affecting all securities.

2. Interest Rate Risk

Nonsystematic (Non-market) Risk, (Diversifiable Risk):

Risk management: Nature & Importance

Ways to Conduct Risk Management

Do nothing and actively, or passively by default, accept all risks.

Hedge all exposures possible.

A Factors that Affect Interest Rates

Expected levels of inflation

General economic conditions

Monetary policy and the stance of the central bank

Foreign investor demand for debt securities

Levels of sovereign debt outstanding

Financial and political stability

Interest rate differentials net of expected inflation

Trading activity in other currencies

International capital and trade flows

International institutional investor sentiment

Financial and political stability

Monetary policy and the central bank

Domestic debt levels (e.g., debt-to-GDP ratio)

C Factors that Affect Commodity Prices

Expected levels of inflation, particularly for precious metals

Exchange rates, depending on how prices are determined

General economic conditions

Costs of production and ability to deliver to buyers

Availability of substitutes and shifts in taste and consumption patterns

Weather, particularly for agricultural commodities and energy

Political stability, particularly for energy and precious metals

C = cash flow received from the investment

PB = price (value) of asset at beginning

PC = price (value) of asset after changes

For video machine C

For video machine D

i = 1,700 + 11,800 - 12,000

Bar charts for asset As and Bs returns

Continuous probability distribution

Hedging and Correlation

Two important terms

Definitions of Basic Derivatives

Knowledge of these instruments is necessary in order to understand the basics of derivatives.

We shall now discuss each of them in detail.

A forward contract is a particularly simple derivative. It is an agreement to buy or sell an

Example 1: (Hedging Currency Risk with a Forward Contract)

Settlement of forward contracts

Default risk in forward contracts

Forward Prices and Arbitrage