Financial Risk Management

1 Introduction 1
Learning Objectives 1
1.1 What Are Derivatives? 2
1.2 Derivatives Markets 3
1.3 Forward Contracts 3
1.4 Futures Contracts 4
1.5 Options Contracts 4
1.6 Swap Contracts 5
1.7 Uses of Derivatives 5
1.8 What is Risk? 6
1.8.1 Operating or Business Risk 6
1.8.2 Event Risk 6
1.8.3 Price Risk 6
1.9 R isk Management 7
1.10 A Brief History of Risk Management 8
1.11 Implications for Hedging 8
1.12 Upside and Downside Risks 9
1.13 Commodity Price Risk 9
1.13.1 Volatility 10
1.13.2 Liquidity 10
1.14 Interest Rate Risk 10
1.14.1 Deregulation and Interest Rate as a Tool for Developing
Monetary Policy 10
1.14.2 Floating Rate Loans 11
1.14.3 Interest Rates and Inflation 12
1.14.4 Components of Interest Rate Risk 13
1.15 C urrency Risk 13
1.16 Approaches to Risk Management 15
1.17 R isks in Derivatives Trading 15
Chap ter Summary 16
Multiple-Choice questions 16
R eview Questions 17
SELF-ASSESMENT TEST 18
Case Study 18

2 T he Derivatives Market in India 19

Learning Objectives 19
2.1 T he International Derivatives Market 20
2.2 Derivatives in India 21
2.3 Operations of Derivatives Exchanges 22
2.4 T he Trading System 22
2.4.1 Types of Orders 24
2.4.2 Order-matching Rules 25
2.4.3 Order Conditions 25
2.5 T he Clearing and Settlement System 25
2.5.1 The Members of the Clearing House 26
2.5.2 The Clearing Mechanism 26
2.5.3 Margin and Margin Accounts 27
2.5.4 The Settlement System 27
2.5.5 Risk Management 28
2.6 T he Trading Process 28
2.7 Online Trading 29
2.8 T he OTC Derivatives Market 29
2.9 T he Regulation of Derivatives Trading in India 29
Chap ter Summary 30
Multiple-Choice questions 30
R eview Questions 31
3 Forward Contracts 33
Learning Objectives 33
3.1 What is a Forward Contract? 34
3.2 T he Purpose of Forward Contracts 35
3.3 Advantages of Forward Contracts 35
3.4 Problems with Forward Contracts 35
3.4.1 Parties with Matching Needs 35
3.4.2 Non-performance 36
3.4.3 Non-transferability 36
3.5 T he Pricing of Commodity Forward Contracts 37
3.6 C urrency Forward Contracts 38
3.6.1 The Operation of the Currency Forward Market 40
3.6.2 Characteristics of Currency Forward Contracts 40
3.6.3 The Pricing of Currency Forward Contracts 40
3.6.4 Covered Interest Arbitrage 43
3.6.5 Rolling Over Currency Forward Contracts 46
3.7 Interest Rate Forwards 47
3.7.1 Mechanics of FRAs 50
3.7.2 The FRA Payment Amount 51
3.7.3 An Alternative View of an FRA and the Settlement Amount 53
3.7.4 Uses of FRAs 54
3.8 N on-deliverable Forwards 56
Chap ter Summary 58
Multiple-Choice questions 58

eview Questions 59
SELF-ASSESMENT TEST 59
Cas e Study 60

4 Futures Contracts 63
Learning Objectives 63
4.1 What Is a Futures Contract? 64
4.2 Futures Contracts Versus Forward Contracts 64
4.2.1 Negotiability 64
4.2.2 Standardization 65
4.2.3 Liquidity 65
4.2.4 Performance 65
4.2.5 Cash Needs 65
4.2.6 Ability to Reduce Losses 65
4.3 Participants in Futures Markets 66
4.3.1 Hedgers 66
4.3.2 Speculators 67
4.3.3 Arbitragers 68
4.4 Specifications of Futures Contracts 68
4.4.1 The Underlying Asset 68
4.4.2 The Contract Size 69
4.4.3 Delivery Arrangements: Location 69
4.4.4 Delivery Arrangements: Alternative Grade 69
4.4.5 Delivery Month 70
4.4.6 Delivery Notification 70
4.4.7 Daily Price Movement Limits 70
4.4.8 Position Limits 71
4.5 C losing out the Positions 71
4.6 Arbitrage Between the Futures Market and the Spot Market 72
4.7 Performance of Contracts 73
4.8 T he Clearinghouse 73
4.9 Margins and Marking-to-Market 75
4.10 Price Quotes 79
4.11 Settlement Price 81
4.12 Open Interest 81
4.13 T he Pattern of Prices 83
4.14 T he Relation Between Futures Price and Spot Price 83
4.15 Delivery 83
4.16 C ash Settlement 84
4.17 T ypes of Orders 84
4.17.1 Market Orders 84
4.17.2 Limit Orders 84
4.17.3 Stop Orders 84
4.17.4 Stop–Limit Orders 84
4.17.5 Other Orders 84
4.18 How to Trade in Futures? 85
4.19 Pricing of Futures Contracts 86
Chap ter Summary 86
Multiple-Choice questions 87

eview Questions 87
SELF-ASSESMENT TEST 88
Cas e Study 89

5 Hedging Strategies Using Futures 91

Learning Objectives 91
5.1 T he Principles of Hedging 91
5.2 Long Hedges 92
5.3 Short Hedges 93
5.4 Should Hedging be Undertaken? 97
5.5 R isks in Hedging 98
5.6 B asis Risk 98
5.7 Factors Affecting Basis Risk 99
5.8 T he Hedge Ratio 102
5.9 Static and Dynamic Hedging 105
5.10 Strip Hedges and Stack Rolling Hedges 105
5.11 Losses from Hedging Using Futures 106
Chap ter Summary 107
Multiple-Choice questions 107
Review Questions 108
SELF-ASSESMENT TEST 109
Case Study 109

6 Swaps 111
Learning Objectives 111
6.1 What are Swaps? 111
6.2 T ypes of Swaps 112
6.3 T erminologies in Swaps 112
6.4 Interest Rate Swaps 113
6.5 Swap Rates 114
6.6 R ationale for Swap Arrangements 114
6.7 Swap with Intermediaries 115
6.8 Forward Swaps 116
6.9 Swaptions 118
6.10 Uses of Interest Rate Swaps 119
6.11 V aluation of Interest Rate Swaps 119
6.12 C urrency Swaps 121
6.12.1 Differences Between an Interest Rate Swap and a Currency Swap 121
6.12.2 Basic Structure of Currency Swaps 121
6.13 C urrency Risk in Currency Swaps 123
6.14 C omparative Advantages of Currency Swaps 123
6.15 Uses of Currency Swaps 124

6.16 T he Valuation of a Currency Swap 124

6.17 E quity Swaps 125
6.18 T he Valuation of an Equity Swap 126
6.19 C ommodity Swaps 127
6.20 R isks While Entering into Interest Rate Swaps 127
Chap ter Summary 129
Multiple-Choice questions 129
R eview Questions 130
SELF-ASSESMENT TEST 130
Cas e Study 131

7 Fundamentals of Options 133

Learning Objectives 133
7.1 Options Issued by Corporations 134
7.1.1 Warrants 134
7.1.2 Employee Stock Options 135
7.1.3 Convertible Bonds 136
7.1.4 Callable Bonds 137
7.1.5 Put Bonds 138
7.1.6 Rights 139
7.2 Options Contracts Between Private Parties 140
7.3 E xchange-traded Options 140
7.4 Options Contracts: An Example 140
7.5 What Is an Options Contract? 141
7.6 Options Terminologies 141
7.6.1 The Underlying Asset 141
7.6.2 Call and Put Options 142
7.6.3 The Option Premium 142
7.6.4 Exercising Options 143
7.6.5 The Exercise Price or the Strike Price 143
7.6.6 The Exercise Date or the Strike Date 143
7.6.7 American and European Options 143
7.6.8 Buyers and Writers of Options 144
7.6.9 The Contract Size 144
7.6.10 In-the-money, At-the-money and Out-of-money Options 144
7.7 E xchange-traded and OTC Options: A Comparison 145
7.7.1 Guarantee of Performance in Exchange-traded Options 145
7.7.2 Margin Requirements 146
7.7.3 Margin Calculation 146
7.7.4 Standardization of Contracts 149
7.7.5 Exercise Dates 150
7.7.6 Exercise Prices 150
7.7.7 Options Classes and Options Series 151
7.8 T rading of Options 151
7.8.1 Types of Orders 152
7.8.2 Offsetting Orders 153
7.9 Price Quotes 153
7.10 Protection Against Corporate Actions 153
Chap ter Summary 157
Multiple-Choice questions 157

eview Questions 158

SELF-ASSESMENT TEST 158
Cas e Study 160

8 C all and Put Options 161

Learning Objectives 161
8.1 What Are Call Options? 161
8.2 T he Terminal Value of a Call Option 164
8.3 G ains and Losses from Purchasing Call Options 166
8.4 V alue of a Call Option Before Maturity 167
8.5 Minimum and Maximum Values of a Call 168
8.6 When to Exercise an American Call Option 169
8.7 From a Call Option Writer’s Point of View 170
8.7.1 The Terminal Value of a Written Call 170
8.7.2 Gains and Losses for a Call Writer 171
8.8 C omparison Between the Gains Made by a Call Buyer
and a Call Writer 173
8.9 When to Buy and When to Write a Call Option? 174
8.10 Put Options 175
8.10.1 What Are Put Options? 175
8.10.2 Rationale for Put Options 175
8.11 T he Terminal Value of a Put Option 177
8.12 Gains and Losses from Purchasing Put Options 178
8.13 V alue of a Put Option Before Maturity 180
8.14 Minimum and Maximum Values of Put 180
8.15 When to Exercise a Put Option 181
8.16 From a Put Option Writer’s Point of View 182
8.16.1 The Terminal Value of a Written Put 182
8.16.2 Gains and Losses for a Put Writer 183
8.17 Comparison Between the Gains Made by
a Put Buyer and a Put Writer 185
8.18 When to Buy and When to Write a Put Option 185
8.19 Comparison Between Calls and Puts 187
Chap ter Summary 192
Multiple-Choice questions 193
R eview Questions 193
SELF-ASSESMENT TEST 194
Case Study 195

9 Combinations of Options: Trading Strategies 197

Learning Objectives 197
9.1 Naked or Uncovered Positions 198
9.1.1 Naked Long Stock Positions 198
9.1.2 Naked Short Stock Positions 199
9.1.3 Naked Bought Calls 200

9.1.4 Naked Written Calls 201

9.1.5 Naked Bought Puts 202
9.1.6 Naked Written Puts 204
9.2 Hedge or Covered Positions 205
9.2.1 Covered Call Writing 206
9.2.2 Reverse Hedges 207
9.2.3 Protective Puts 208
9.2.4 Short Stocks and Short Puts 210
9.2.5 Partial Hedges 211
9.2.6 Summary of Hedged Positions 212
9.3 Spread Positions 213
9.3.1 Money Spread Using Calls 213
9.3.2 Money Spreads Using Puts 216
9.3.3 Box Spreads 219
9.3.4 Butterfly Spreads 220
9.3.5 Calendar Spreads 224
9.3.6 Iron Condor Spreads 226
9.4 C ombinations of Puts and Calls 228
9.4.1 Straddles 228
9.4.2 Strips 230
9.4.3 Straps 233
9.4.4 Strangles 234
9.4.5 Other Pay-offs 235
9.5 Losses from Options Trading 236
9.6 Strategies Using Options, a Risk-free Security
and Underlying Assets 237
9.6.1 Combination of Call Options and Risk-free Securities 238
9.6.2 Combination of Long Stocks and Long Puts 239
9.7 T he Put–Call Relationship 240
Chap ter Summary 241
Multiple-Choice questions 242
Review Questions 243
SELF-ASSESMENT TEST 243
Case Study 245

10 The Binomial Options Pricing Model 247

Learning Objectives 247
10.1 T he Binomial Options Pricing Model for Call Options 248
10.2 T he Binomial Options Pricing Model for Put Options 252
10.3 T he Relation Between the Hedge Ratios for Call and Put Options 255
10.4 T he No-arbitrage Pricing Argument 255
10.5 T he Derivation of the Binomial Options Pricing Model 256
10.6 T he Single-period Binomial Options Pricing Model 257
10.7 T he Two-period Binomial Options Pricing Model 259
10.8 T he Multi-period Binomial Options Pricing Model 262
10.9 T he Determination of u and d 264
10.10 T he Valuation of a European Call Paying a Given
Dividend Amount 265

10.11 T he Valuation of an American Call Paying a Given Dividend Amount 266

10.12 T he Binomial Put Options Pricing Model 267
Chap ter Summary 270
Multiple-Choice questions 271
R eview Questions 271
SELF-ASSESMENT TEST 272
Cas e Study 273

11 The Black–Scholes Options Pricing Model 275

Learning Objectives 275
11.1 T he History of Options Pricing Research 276
11.2 Stock Price Behaviour 276
11.2.1 Lognormal Distribution 276
11.2.2 The Valuation of Options 277
11.3 T he Assumptions in the Black–Scholes Options Pricing Model 277
11.4 T he Black–Scholes Model for Pricing Call Options 278
11.5 T he Black–Scholes Model for Pricing Put Options 280
11.6 Determinants of Options Prices 281
11.6.1 The Current Price of the Underlying Asset 282
11.6.2 The Exercise Price 283
11.6.3 The Time to Expiration 284
11.6.4 Volatility of the Underlying Asset 285
11.6.5 The Risk-free Rate 286
11.7 T he Options Pricing Model for Securities that
Pay Known Dividends 288
11.8 Volatility 290
11.9 Implied Volatility 292
11.10 V olatility Smile 292
Chap ter Summary 294
Multiple-Choice questions 294
Review Questions 295
SELF-ASSESMENT TEST 295
Case Study 296

12 Greeks in Options 297

Learning Objectives 297
12.1 R isks in Options Trading 297
12.2 C haracteristics of Options Hedging 298
12.2.1 The Naked Position 299
12.2.2 The Covered Position 299
12.2.3 Hedging Through the Cap 299
12.3 G reeks in Options Hedging 299
12.4 Delta 300
12.4.1 The Use of Futures in Delta Hedging 303
12.4.2 The Delta of a Portfolio 304

12.5 Gamma 306

12.5.1 Making a Portfolio Gamma-neutral 306
12.5.2 Calculating Gamma 307
12.6 Theta 308
12.7 T he Relationship Between Delta, Gamma and Theta 309
12.8 Vega 310
12.9 Rho 311
12.10 Creating Portfolio Insurance Using Synthetic Puts 313
12.11 Hedging Options Positions in Practice 316
Chapter Summary 316
Multiple-Choice questions 317
Review Questions 318
SELF-ASSESMENT TEST 318
Case Study 319