PORTFOLIO

AND
DERIVATIVES
 PORTFOLIO
• In finance, a portfolio is a collection of investments held by an institution
or an individual.
• Holding a portfolio is a part of an investment and risk-limiting strategy
called diversification. By owning several assets, certain types of risk (in
particular specific risk) can be reduced. The assets in the portfolio
could include bank accounts, stocks, bonds, options, warrants,
gold certificates, real estate, futures contracts, production facilities, or
any other item that is expected to retain its value.
• Portfolio management involves deciding what assets to include in the
portfolio, given the goals and risk tolerance of the portfolio owner.
Selection involves deciding which assets to acquire/divest, how many
to acquire/divest, and when to acquire/divest them. These decisions
always involve some sort of performance measurement, most typically
the expected return on the portfolio, and the risk associated with this
return (e.g., the expected standard deviation of the expected return).
 PORTFOLIO ANALYSIS
• In financial terms , ‘portfolio analysis’ is a study of the performance of
specific portfolios under different circumstances. It includes the efforts
made to achieve the best trade-off between risk tolerance and returns.
The analysis of portfolio can be conducted either by a professional or
an investor who may utilize specialized software to do so.
• Portfolio analysis is broadly carried out for each asset at two levels:
• Risk aversion: This method analyzes the portfolio composition while
considering the risk appetite of an investor. Some of the investors may
prefer to play safe and accept low profits rather than invest in risky
assets generating high returns.
• Analyzing returns: While performing portfolio analysis, prospective
returns are calculated through the average and compound return
methods. An average return is simply the arithmetic average of returns
from individual assets. However, compound return is the arithmetic
mean that considers the cumulative effect on overall returns.
 PORTFOLIO SELECTION
THEPROCESS OF SELECTING a portfolio may be divided into two stages.
The first stage starts with observation and experience and ends with beliefs
about the future performances of available securities. The
second stage starts with the relevant beliefs about future performances and

ends with the choice of portfolio.

INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse

economic agents to guard themselves against uncertainties arising out of

fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use of derivative

products, it is possible to partially or fully transfer price risks by locking-in

asset prices. As instruments of risk management, these generally do not

influence the fluctuations in the underlying asset prices. However, by locking in

asset prices, derivative products minimize the impact of fluctuations in

asset prices on the profitability and cash flow situation of risk-averse

investors.
 DERIVATIVES DEFINED
Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a
contractual manner. The underlying asset can be equity, forex, commodity or any
other asset.
In the Indian context the Securities Contracts (Regulation) Act, 1956

(SC(R)A) defines "derivative" to include-

1. A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form

of security.

2. A contract which derives its value from the prices, or index of prices, of

underlying securities.
For example, wheat farmers may wish to sell their harvest at
a future date to eliminate the risk of a change in prices by that

date. Such a transaction is an example of a derivative. The

price of this derivative is driven by the spot price of wheat
which is the "underlying".
• Table 1.1 Milestones in the development of Indian derivative market
• November 18, 1996 L.C. Gupta Committee set up to draft a policy
• framework for introducing derivatives
• May 11, 1998 L.C. Gupta committee submits its report on the policy
• framework
• May 25, 2000 SEBI allows exchanges to trade in index futures
• June 12, 2000 Trading on Nifty futures commences on the NSE
• June 4, 2001 Trading for Nifty options commences o n the NSE
• July 2, 2001 Trading on Stock options commences on the NSE
• November 9, 2001 Trading on Stock futures commences on the NSE
• August 29, 2008 Currency derivatives trading commences on the NSE
• August 31, 2009Interest rate derivatives trading commences on the
• NSE
FACTORS DRIVING THE GROWTH OF
DERIVATIVES
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international

markets,

3. Marked improvement in communication facilities and sharp decline in their

costs,

4. Development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and

returns over a large number of financial assets leading to higher returns,

reduced risk as well as transactions costs as compared to individual

financial assets.
 TYPES OF DERIVATIVES
• The overall derivatives market has five major classes of
underlying asset:
• interest rate derivatives
• foreign exchange derivatives
• credit derivatives
• equity derivatives
• commodity derivatives
•
 DERIVATIVE PRODUCTS

 Forwards
 Futures
 Options
 Warrants :Options generally have lives of up to one year, the majority of
options traded on options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally traded

over-the-counter.

• Leaps: The acronym LEAPS means Long-Term Equity Anticipation

Securities. These are options having a maturity of up to three years.
• Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity

index options are a form of basket options.

• Swaps
• . Swaptions: Swaptions are options to buy or sell a swap that will become
 operative at the expiry of the options. Thus a swaption is an option on a
forward swap. Rather than have calls and puts, the swaptions market has
receiver swaptions and payer swaptions. A receiver swaption is an option
to receive fixed and pay floating. A payer swaption is an option to pay
fixed and receive floating
•
 FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date
for a specified price. One of the parties to the contract assumes a long

position and agrees to buy the underlying asset on a certain specified future

date for a certain specified price e. The other party assumes a short position

and agrees to sell the asset on the same date for the same price. Other

contract details like delivery date, price and quantity are negotiated bilaterally

by the parties to the contract.

 The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are:
• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of

contract size, expiration date and the asset type and quality.

• The contract price is generally not available in public domain.

• On the expiration date, the contract has to be settled by delivery of

the asset.
• If the party wishes to reverse the contract, it has to compulsorily go

to the same counter-party, which often results in high prices being

charged.

 Forward markets world-wide are afflicted by several

problems:
 • Lack of centralization of trading,
 • Illiquidity, and
 • Counterparty risk
 FUTURES
Futures markets were designed to solve the problems that exist
in forward markets. A futures contract is an agreement
between two parties to buy or sell an asset at a certain time
in the future at a certain price. But unlike forward contracts,
the futures contracts are standardized and exchange traded.
To facilitate liquidity in the futures contracts, the exchange
specifies certain standard features of the contract.
A futures contract may be offset prior to maturity by entering

into an equal and opposite transaction. More than 99% of

futures transactions are offset this way.
The standardized items in a futures contract are:


 · Quantity of the underlying

 · Quality of the underlying
 · The date and the month of delivery
 · The units of price quotation and minimum price change
 · Location of settlement
 OPTIONS
In this section, we look at the next derivative product to be traded on the
NSE, namely options. Options are fundamentally different from forward and

futures contracts. An option gives the holder of the option the right to do

something. The holder does not have to exercise this right. In contrast, in a

forward or futures contract, the two parties have committed themselves to

doing something. Whereas it costs nothing (except margin requirements) to

enter into a futures contract, the purchase of an option requires an up-front

payment.
 Two basic types of options
 Call option
 · Put option
 Call option
 A call option gives the holder the right but not the obligation to
buy an asset by a certain date for a certain price.
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.
 Put option
A put option gives the holder the right but not the obligation to
sell an asset by a certain date for a certain price.
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.
Suppose A has “bought a call option” of 2000 shares of Hindustan Unilever
Limited (HLL) 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
HLL 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 HLL 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.
 DISTINCTION BETWEEN FUTURES AND
OPTIONS CONTRACTS
Futures Options
Exchange traded, with notation Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
 Black–Scholes model
• The Black–Scholes model is a mathematical description of financial markets and
derivative investment instruments. The model develops
partial differential equations whose solution, the Black–Scholes formula, is
widely used in the pricing of European-style options.
• The model was first articulated by Fischer Black and Myron Scholes in their
1973 paper, "The Pricing of Options and Corporate Liabilities." The
foundation for their research relied on work developed by scholars such as
Jack L. Treynor, Paul Samuelson, A. James Boness, Sheen T. Kassouf, and
Edward O. Thorp.The fundamental insight of Black-Scholes is that the option
is implicitly priced if the stock is traded. Robert C. Merton was the first to
publish a paper expanding the mathematical understanding of the options
pricing model and coined the term Black–Scholes options pricing model.
•
 Model assumptions
• The Black–Scholes model of the market for a particular equity makes the
following explicit assumptions:
• It is possible to borrow and lend cash at a known constant risk-free interest rate.
• The stock price follows a geometric Brownian motion with constant drift and
volatility.
• There are no transaction costs, taxes or bid-ask spread.
• The underlying security does not pay a dividend.
• All securities are infinitely divisible (i.e., it is possible to buy any fraction of a
share).
• There are no restrictions on short selling.
• There is no arbitrage opportunity.
•
 The Model

C = SN (d1 ) − Ke − RT N (d 2 )
where
S  σ2 
ln  +  R + T
K  2 
d1 =
σ T
and
d 2 = d1 − σ T

28
The Model (cont’d)
• Variable definitions:
 S = current stock price
 K = option strike price
 e = base of natural logarithms
 R = riskless interest rate
 T = time until option expiration
  = standard deviation (sigma) of
returns on the underlying
security
 ln = natural logarithm
 N(d1) and
 N(d2) = cumulative standard normal
distribution functions


29
 Intuition Into the Black-
Scholes Model (cont’d)

− RT
C = SN (d1 ) − Ke N (d 2 )

Cash Inflow Cash Outflow

30
 Swaps
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts.
For example, in the case of a swap involving two bonds, the benefits in question can

be the periodic interest (or coupon) payments associated with the bonds.
Specifically, the two counterparties agree to exchange one stream of cash flows
against another stream. These streams are called the legs of the swap. The swap
agreement defines the dates when the cash flows are to be paid and the way they
are calculated. Usually at the time when the contract is initiated at least one of
these series of cash flows is determined by a random or uncertain variable such
as an interest rate, foreign exchange rate, equity price or commodity price
 Types of swaps
• Interest rate swaps: These entail swapping only the interest
related cash flows between the parties in the same
currency.
• Currency swaps: These entail swapping both principal and
interest between the parties, with the cash flows in one
direction being in a different currency than those in the
opposite direction.
• Commodity swaps: A commodity swap is an agreement
whereby a floating (or market or spot) price is exchanged
for a fixed price over a specified period. The vast majority
of commodity swaps involve crude oil.
•
•
• Equity Swap: An equity swap is a special type of total return
swap, where the underlying asset is a stock, a basket of
stocks, or a stock index. Compared to actually owning the
stock, in this case you do not have to pay anything up
front, but you do not have any voting or other rights that
stock holders do.
• Credit default swaps: A credit default swap (CDS) is a
swap contract in which the buyer of the CDS makes a
series of payments to the seller and, in exchange,
receives a payoff if a credit instrument - typically a bond or
loan - goes into default (fails to pay). Less commonly, the
credit event that triggers the payoff can be a company
undergoing restructuring, bankruptcy or even just having
its credit rating downgraded.
•
 GLOBAL PERSPECTIVE
• While FIIs have undoubtedly hastened the process of integration
of Indian stock markets with the global markets, Indian
companies have also been on the move, particularly in the last
four to five years, to tap the global markets. Securities of
several Indian companies are currently listed as GDRs on
London, Euro next and Dublin Stock Exchanges and as ADRs
on NASDAQ and New York Stock Exchange. The easier entry
norms offered by the Alternate Investment Market of London
Stock Exchange has drawn a large number of Indian companies
into its listing fold. Besides, acquisition of foreign companies
by the Indian companies has been on the increase. Indian
Mutual funds have also started acquiring foreign securities.
•