Escolar Documentos
Profissional Documentos
Cultura Documentos
Forecasting and Planning Treasury Relationships Foreign Exchange Management Liquidity Debt Forex Interest Rate Exposure Operational Risk
Managing Treasury Related Risks Treasury controls and identifying treasury related risks
Concept of hedging
Concept of hedging Financial Markets and instruments Forex Markets Commodities Markets
Syllabus
Quantitative Techniques Pricing and valuations Translation Risk Derivatives and speculation
Instruments
Hedging
Hedging is a means of defense against probability of loss from a business transaction. It is a carefully planned and organized effort aimed at protecting specific exposures both currency and commodity,in the market so as to ensure stability of cash flows. Hedging is essentially buying protection for unforeseen events similar to insurance. It is purely a safety driven approach
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Hedging vs Insurance
Although hedging is akin to insurance, the following points of difference are important:
Sl no Hedging Insurance
This is a means of protection of physical and financial assets against market volatilities This is not intended to reduce risk but only to transfer risk
This is a means of protection of people against risk of life/loss or destruction of physical assets This is intended for risk reduction.
Hedging vs Insurance
Sl no Hedging Insurance
The basic principle of insurance is sharing or distributing risk over the entire group of policy holders Insurance claims are generally predictable There is no minimum or maximum period
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The risks hedged are not predictable This covers risks on physical/family assets for periods ranging from 6 months to 2 years
Hedging vs Speculation Hedging is risk transfer to avoid loss, while speculation is risk acceptance in expectation of profit out of future movement of prices. In market risk management, both Hedging and speculation are necessary, since interplay of risk aversion and risk perversion is generally obvious.
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Hedging vs Speculation
The functional role of hedging and speculation is tabulated Below:
Sl no Hedging Speculation
This is risk transfer/ reduction hence safety driven, This is possible only when specific exposures need protection
This is risk assumption in expectation of profithence, expectation driven. This is possible when market opportunities open up
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Hedging vs Speculation
Sl no Hedging Speculation
This is aimed at neutralizing market movements. This tends to stabilize cash flows and cost of capital Short selling transaction does not arise
This is aimed at making the best use of favorable market movements This has the objective of profit and profit only Short selling with a view to earning profits from the same assets is the core of speculation.
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ICICIPru Life Insurance Co Ltd proposes to invest Rs 432 cr in G-secs for 5 years at the current yield 8.17% out of funds receivable within a fortnight. The CIO believes interest rate are likely to be softened in coming days. Is there an option available?
Types of hedging
Long Hedge Contracts entered before the investor buys the actual securities, so as to generate a desired yield before the securities are actually purchased ie a transaction when a position in the cash market is hedged by going long in the futures market
Types of Hedging
Short Hedge
Immediate sale until the actual securities are sold in the cash market and is intended to protect the risk of falling prices. The hedge is accomplished by going short in the futures market.
Cross Hedge
When a futures contract is not available on an asset, market participants look forward to an asset that is closely associated with their underlying and trades in the futures market, for the purposes of hedging. It is a process of minimizing risk through a contract transaction between the 10 spot and future markets
BEML Limited, the Public Sector Mini Ratna Company under the Ministry of Defence manufacturing Metro Cars, submitted a global tender for the prestigious Jaipur Metro order valuing to Rs 318 Crores. By this Order, BEML will have to manufacture, supply,test and commission 10 train sets of 4-Car each, totaling 40 Cars to Jaipur Metro Project. BEML had estimated the cost of the major imports from US and Europe at US$ = Rs50. The order envisges import of equipment from US and Europe aggregating US $ 55mln @ US =Rs 50.The company expects to make a profit of Rs 17 crores.
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Cost of imported equipment US$55mln @ Rs 50 Local manufacturing costs + operative expenses incl interest Order Rs318 cr Should US$/Inr rate move to Rs 54.00 US$ 55 mln costs Rs 297.00 cr Local costs Rs 26.00cr Rs 323.00cr
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Hedge net economic exposure Too many hedging programmers target the nominal risks of siloed business rather than a companys net economic exposure. This siloed approach is a problem especially In large multinational organizations.
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At a large international industrial company , one business unit decided to hedge its forex exposure from sale of US$700 mln in goods to Brazil, inadvertently increasing the companys net exposure to fluctuations in foreign currency. The unit Manager had not known that a second business unit was at the same time sourcing about US$500 mln of goods from Brazil.
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Calculate total costs and benefits Estimated costs of hedging Direct costs Oppurtunity and marginal costs Other costs ,if any
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Functions of Treasury
Forecasting and Planning Treasury Relationships Foreign Exchange Management Liquidity Debt Forex Interest Rate Exposure Operational Risk
Wednesday February,2012
Managing Treasury Related Risks Treasury controls and identifying treasury related risks
Concept of hedging
Concept of hedging Financial Markets and instruments Forex Markets Commodities Markets
Syllabus
Quantitative Techniques Pricing and valuations Translation Risk Derivatives and speculation
Instruments
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. Derivatives
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Spot
Forward Futures
Swap Spot
FRA Options
Forward Contracts A forward contract is an agreement to buy or sell an asset, incl currency, on specified future date for a specified price. Forward contract is a bilateral transaction. It is tailored to suit the needs of the customer. It is an OTC product
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Recap
Forward Contract
Currencies/ Commodities
A transaction in which the exchange of currencies takes place at a specified future date, subsequent to the spot date, is known as a forward transaction The forward transaction can be for delivery one month or two months or three months and more. Forward contract for 3 months means the exchange of currencies takes place after 3 months from the date of contract
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Recap
Forward contract The difference between the forward rate and the spot rate is known as the forward margin. Forward margin may be either at premium or discount The forward margin is called a premium on the currency whose forward rate is more expensive than the spot rate and, a discount where the forward rate is cheaper
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Recap
Purchase/sale Purchase/sale
Purchase/sale Purchase/sale
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Recap
Forward Margin
Spot US$ = 52.00 00 / 1000 Fwd Feb 2000 / 2100* Fwd March 3500 / 3600
Sometimes, annualized and quoted in % terms 0.2000/.2100
Where forward margin for a month is given in ascending order as in the quotation above, it indicates that forward currency is at premium. The out right rates are arrived at by adding the forward margin to the spot rates
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Recap
Forward contract
Under direct quotation, premium is added to spot rate to arrive at the forward rate. This is done for both purchase and sale transactions. Discount is deducted from the spot rate to arrive at the forward rate
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Recap
Forward Margin
The difference in the rate of interest prevailing at the home centre and the concerned foreign centre determines the forward margin. If the rate of interest at the foreign centre is higher than prevailing at the home centre, the forward margin would be at discount Conversely, if the rate of interest at the foreign centre is lower than that at the home centre ,the forward margin would be at premium.
US Int rate 3m 0.30% India Tbill 91d 8.15%
Forward 25 Margin Premium
Recap
Forward Margin
Spot rate for US$ is Rs 52.00/52.10 Interest rate Rate for 3 mon Fwd ?
Mumbai 8%pa New York 5%pa Purchase $ and US$100000 Borrow Rs 52.10 lacs Invest for 3mon Pay int Rs 1.042lacs receive interest 1250 $101250 Rs 53.142lacs Rate 53.142lacs/101250 Rs 52.49 Forward Premium Rs00.39
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Recap
Forward Margin
Spot rate x Forward period x Int differential
Forward Margin
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Recap
In India, inter-bank trades, forwards for two different maturity patterns; - X months from spot maturity - the last working day of the month When an inter-bank quote for a specific maturity date desired by the client is not available, it is derived by straight line interpolation between the two nearest available dates
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Recap
The system of option contracts is prevalent in the Indian market. This refers to choosing the value date within an agreed period
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Forward contracts
Forward contract suffers from ; i . Liquidity risk ii. Counter party or credit risk A forward contract does not allow the parties to derive any gain from favorable price movement or to unwind the transaction once the contract is made Futures came into existence to address the issues of illiquidity and counterparty risks
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Futures contracts
Futures contracts are standardized forward contracts settled through a clearing agency of the exchanges. In other words , Futures contract is an agreement to buy or sell a standard quantity and quality of a given underlying on a future date thru the medium of an exchange house at price which is pre determined. Though the above definition looks similar to a forward contract differences between the two are many
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Financial Futures
Currency futures
Financial Futures Financial futures are used by market players to protect their assets against adverse price movements
Financial futures contract
Buy long to protect against Fall in interest rate Rise in currency value Rise in index value
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Interest rate
Currency
Equity index
The price of the currency is determined in the same manner as currency forwards are priced
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Mon 6 th February,2012
Sell short to protect against Rise in interest rate Fall in currency Fall in equity index value
Buy long to protect against Fall in interest rate Rise in currency value Rise in index value
Financial Futures
Currency futures
Operational nuances
To trade in Futures contracts one has to become a Member of the Exchange by paying an initial margin that is based on the price volatility of the underlying instrument. The variable margin account has to be maintained with the Exchange so that the daily profit or loss on the outstanding position on account of marking to market may be accounted for
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Operational nuances The contracts are for 3 months and expires on the last Thursday of the month.
The size and maturity of the contract are standardized. As Futures contracts are entered into basically for hedging purposes, physical delivery of the underlying instrument between the buyer and seller rarely takes place.
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Liabilities
Rs cr
Assets
Rs cr
Share Capital Reserves & sur Minority interest Deposits Borrowings Liab on Policies in force Other Liabilities
27850.27
Treasury liabilities
Total
Contingent Liabilities**
489347.29
Rs 820519.93 cr
Treasury assets
489347.29 41
ICICI Bank Ltd Mumbai has in its investment portfolio fixed income securities aggregating Rs167000cr. The Duration of the portfolio is 4.6 years and modified duration is at 4.0%.The market is agog with rumors that interest rates may go up soon by 1% to curb inflationary trends. In tandem,the BSE sensex may fall by 1000 points from its present level. INR may weaken vis a vis US$ to Rs 52.00
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Amount Rs cr 167000.00
Impact of Market developments Duration 4.6yrs Modified Duration 4.00% 1 % increase in general interest rates reduces value of investments by Rs 6680cr Incl
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Available options: - Do nothing -Sale of securities -Shuffle investments for reduction in maturity Duration and Mod Duration - Hedge the risk ?
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Swaps
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A Swap is a barter - exchange of one thing for another. In financial markets, the two parties to a swap transaction contract to exchange cash flows, at specified future times according to certain specified rules.
Fixed Maturity US $
Party A
1 2 3 4
1 2 3 4
Party B
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A Swap transaction is the simultaneous buying and selling of a similar underlying asset or obligation of equivalent capital amount where the exchange of financial arrangements provides both parties to the transaction with more than favorable conditions they would otherwise expect
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Types of Swaps
Interest Rate Swap Where cash flows at a fixed rate of interest are exchanged for those referenced to a floating rate
Currency swap
Where cash flows in one currency are exchanged for cash flows in another currency
Basis swap
Where cash flows on both legs of the swap are referenced to different floating rates 48
An interest rate swap is a contractual agreement to exchange a series of cash flows. One leg of cash flow is based on a fixed interest rate and the other leg is based on a floating interest rate over a period of time There is no exchange of principal.
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Mico Bosch is a multinational corporation with a credit rating of BBB. Mico Bosch needs to borrow US$ 50mio for 5 years.
Treasury prefers
In order to predict future funding costs. In other words Mico Bosch wants to hedge 51 its interest rate exposure
Treasury prefers
MICO can manage to raise the loan on floating rate @ Libor +1%
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Treasury prefers
MICO can manage to raise the loan on floating rate @ Libor +1% Alternate strategy would be to issue debt instrument with a high coupon of 10 % 53
Deutsche Bank AG is an international bank with AAA credit rating. Deutsche Bank need to raise US$50mio for 5 years
Treasury prefers
Reason control its profit margins on an interest rate gap In other words the bank too wants to hedge its interest rate exposure
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Treasury prefers
Because of its credit rating, Deutsche Bank Ag can borrow at a fixed rate of 8.25 % or at floating rate of LIBOR
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Plain vanilla IRS Rates Fixed @ Floating @ Requirement Mico Bosch can borrow 10 % Libor +1 % Fixed Deutsche Bank can borrow 8.25 % Libor Floating
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Mico Bosch and Deutsche Bank Ag obtain funds which are favorable to them and then swap the interest rate payments
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Swap between Mico Bosch and Deutsche BankAg will reduce interest rate payments on both sides The result of swapping interest rate payments is that both parties should pay interest at net rates lower than otherwise available to them
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Mico Bosch borrows @ a floating rate of libor + 1 % Deutsche Bank Ag borrows @ a fixed rate of 8.25 % Mico Bosch and Deutsche Bank Ag enter into an IRS for a notional principal amount of $50 mio for 5 years Mico Bosch makes fixed rate payments of 9.75 % to Deutsche Bank Ag Deutsche Bank Ag makes floating rate payments of Libor +1% to Mico Bosch Pays higher fixed rate @11/2@+%
to compensate the bank for doing 59 the swap
Mico Bosch
Deutsche Bank Ag
Pays to lender Libor+1% & Pays 9.75% to Deutsche Bank Libor +1%+9.75%
Pays fixed rate of 8.25% to lender Pays Libor +1% to Mico Bosch Libor+1%+8.25%
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Rates
Pay out Receive in Payments With out swap costs Savings Another way of Considering the swap is
Mico Bosch
9.75%+Libor+1% Libor + 1 % 9.75% 10 % 0.25% Without swap both parties pay a total of 10 % +Libor
Deutsche Bank
8.25 %+Libor+1% 9.75% Libor - 0.5% [-] Libor 0.50% With swap they pay 9.25 %+Libor
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Forward Rate Agreement is a contract between two parties by which they agree to settle between them the interest differential on a notional principal on a future settlement date for a specified future period
FRA is a financial contract to exchange interest payments based on a fixed interest rate with payments based on floating interest rate like 6 m Libor / 3m Mibor
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The exchange of payments is based on a notional principal of the FRA. There is no commitment on either side of the counter parties to lend or borrow the principal amount
There are two legs in a FRA the fixed leg and the floating leg.
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Parties to FRA
Pays a particular fixed rate Buyer of FRA Receives a floating rate
Seller
Pays a particular floating rate
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Parties to FRA
Pays a particular fixed rate Buyer of FRA Receives a floating rate Buyer expects interest rates to go up
Seller
Pays a particular floating rate
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an example
A corporate wants to borrow Rs one crore for a period of six months but starting three months from today reason ,six months interest rates may rise in three months time FRA is quoted in the market as 3 Vs 6 , 3 Vs 9. or 6 Vs 9 and so forth. A 3 Vs 9 FRA means seeking protection for a six month borrowing or lending commitment starting 3 months from today The Corporate picks up the quote for 3 Vs 9
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Prices are quoted 2 ways in the market. like 6.25/6.50; 7.00/7.30 For a 3vs 9, the price is 6.25 / 6.50
The Corporate buys at the higher of the two quotes ie @ 6.50 % If on the date of settlement, which is the date three months from today when the borrowing commitment has to be met , the bench mark rate settles at 7%. The Corporates view has come true and it receives from the seller Rs 1crore x0.05x181 --------------------------- x 36500 1 ------------------------[1+0.07x181/365]
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Pricing a FRA
Money market rates for various months as on the 12thMay,2009 are as follows; 1 mon 3.10 / 3.20% 6 mon 3.60 / 3.75 % 2 mon 3.50 / 3.60% 9 mon 3.78 / 3.88 % 3 mon 3.45 / 3.65% 12mon 3.95/ 4.00 % Price a 3vs12 FRA?
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A 3vs 12 FRA is equivalent to a commitment to either lend or borrow a sum of money for a period of 9 months starting 3 months from say today. If we have to lend money for 9 months starting 3 months from today, we may have to borrow the money for 12 months and invest it for the first 3 months. On completion of 3 months ,the investment will mature and it can be lent for 9 months.
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We can borrow money for 12 months from the market @4.00% and repayment amount after 12 months would be [1+0.0400] The amount borrowed can be invested for 3 mon@3.45% And this investment on maturity can be invested at unknown forward rate for 9 mon at r % The compounded value of the 2 cash flows would be [1+0.0345x91/365][1+rx274/365]
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The two cash flows should be equal for us to break even in terms of interest cost [1+0.0400] = [1+0.0345X91/365][1+rX274/365] r =4.15% Similarly ,if we borrow money for 3 m at 3.65% and renew this borrowing for 9 mat the end of 3 months and we lend the money at one go for 12 m at 3.95% we arrive at [1+0.0395]= [1+0.0365X91/365][1+rX274/365] r= 4.63% The range is ;4.63%-4.15% Price the FRA , based on our perception of the counter party
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Options
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Option Contract An option is a contract, which gives the buyer the right ,but not the obligation ,to buy or sell specified quantity of the underlying assets, at a specified price on or before a specified time The underlying may be physical commodity like wheat/ gold or financial instruments like equity stocks/bonds /currency
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Banks, Developmental institutions, Mutual Funds, Domestic & Foreign Institutional Investors, Brokers, Retail Participants
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Option Products
Stock Index Options Options on Individual Stocks Interest Rate Options , Currency Options.
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Concepts
Premium
The price of an option
Strike Price
Expiry Date
The date on which the option expires. On expiration date, either the option is exercised or it expires worthless
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Concepts
Total number of option contracts outstanding in the market at any given point
Open interest
Option holder
One who is obligated to buy or sell the underlying asset in case the buyer of the option decides to exercise the option
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Call options
Put options
Buyer
Buys the right to buy the underlying asset at the specified price
Seller
Has the obligation to Has the obligation to sell the underlying asset sell the underlying asset at the specified price at the specified price
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Types of options
OTC Options
Option exercisable at any time until expiry Listed on exchanges, Chicago IMM, NSE
Options on individual securities available at NSE are American type of options S&P CNX NIFTY and CNX IT options at NSE are European type options 80
Characteristics of options
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Characteristics of options
positive cash flow to the holder if it were exercised immediately. A call option is said to be in the money when the current price stands at a level higher than the strike price. If the spot price is much higher than the strike price, a call is said to be in deep money. In case of a put , the put is in the money if the spot price is below the strike price.
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Characteristics of options
At the money option is an option that would lead to zero cash flow if it were exercised immediately. An option on index is said to be at the money when the current price equals the strike price
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Characteristics of options
Out of money option is an option that would lead to a negative cash flow if it were exercised immediately. A call option is out of money when the current price stands at a level which is less than the strike price . If the current price is much lower than the strike price the call is said to be deep out of the money. In case of a put ,the put is said to be out of money if the current price is above the strike price
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In the money Strike price < Spot price Strike price > Spot price At the money Strike price = Spot price Strike price = Spot price Out of the money Strike price > Spot price Strike price < Spot price ---- Of underlying asset ----
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Shri Rakesh Jhunjhunwala of Kolkata buys call option on1000 shares of SBI from NSE Mumbai, at a strike price of Rs 1275 Pays option premium Rs 225 Threshold price Rs 1500 It is an American type option; ie option is exercisable
at any time before expiry of the contract
Expiry 28 th May,2009 Price of SBI Share on the13th May was Rs 1268 What should he have done on the 13th May,2009 in the light of the subsequent developments?
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Rakesh Jhunjhunwala
It is a call option. Strike Price is Rs1275. Pays option price of Rs 225. The threshold price of the option is Rs 1500. RJ has the right to exercise his call option at any time before expiry of the contract and buy the Option. The option will be in the money when the scrip price exceeds Rs1500
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+
Option premium Rs225
Rs1268
[13thmay,09]
Threshold price
Rs1500
Expiry;26thMay2009 88
The price of the scrip in the market on the 13th May,2009 was Rs 1268. Though the option is exercisable at any time it is not advantageous to exercise it on the 13th May,2009 as RJ would otherwise be loosing Rs 232 on each scrip. RJ has to wait and see the movement of the price of the scrip to Rs 1500 when he can exercise his option Otherwise ,he should allow the option to expire
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Covered and naked calls A call option position that is covered by an opposite position in the underlying instrument is called a covered call . Writing covered calls involves writing call options when the shares that might have to be delivered are already owned, eg a writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock
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Covered calls are less risky than naked calls since the worst that can happen is that the investor is required to sell shares already owned at below their market value. When a physical delivery of a naked call is exercised, the writer will have to purchase the underlying asset at market rates to meet the call ,which may be a costly proposition
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Factors affecting the value of an option Quantifiable Factors Underlying stock prices Strike price of the option Volatility of the underlying stock Time to expiration Risk free interest rate
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