Derivatives: Chapter - 1

DERIVATIVES
CHAPTER – 1
DERIVATIVES
Concept Of Derivatives
 Derivative is a financial instrument which derives its value from an

underlying asset.
 Underlying asset means share, stock, bonds, currency, commodity, stock
index etc.
 Derivative is an instrument for betting.
 We will discuss this chapter in two parts.
Part I – Option Contract
Part II – Forward & Future Contract
Part I : Option Contract
We will discuss option contract in three points

I – Basics
II – Valuation of Option
III – Option Strategy
I - Basics :
1) Option contract is a contract in which option holder has right but not
obligation to buy or sell an underlying asset at predetermine price
(Exercise price or strike price) on maturity. An option premium is to be
paid in advance & such premium is transferred to option writer by
stock exchange.
2) There are two parties in option contract

Option Holder or Option Buyer Option Writer or Option Seller
1) Right but not obligation 1) Obligation but not right
2) An option premium to be 2) Margin money is required

paid in advance. to be deposited at stock
exchange.
3) Unlimited profit & 3) Unlimited loss & maximum
maximum loss premium profit is premium amount.
amount.
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DERIVATIVES
4) Hates Volatility.
4) Loves volatility.
3) There are two types of options

(i) Call Option
 Right to buy
 Expected to price rise
(ii) Put Option

 Right to sell
 Expected to price fall
4) Types of options on the basis of cash flows

(i) European Option
European option can be exercised only on maturity.
(ii) American Option
American option can be exercised on or before maturity. Premium

amount of American option is more than European
Example 1
Mr. E is interested in buying a share of I.T.C. He is however afraid that the
price of the share may move down. Hence, he does not purchase a share but
buys a call option on 1 share of I.T.C. at a strike price of ₹ 300 by paying an
option premium of ₹ 35.
Required:-
(i) Determine the breakeven point price of Mr. E.

(ii) Determine the Profit/Loss if the price on maturity is: - 250, 270, 290,
300, 320, 340, 350.
(iii) Draw pay off for call option holder.
(iv) Draw pay off for call option writer.
Solution:
(i) Calculation of breakeven point.

BEP = EP + Premium
= ₹ 300 + 35
= ₹ 335
DERIVATIVES
(ii) Calculation of Profit/Loss (Net pay off).

Market Exercise Gross Premium Net
Price or not Pay off Pay off
250 No 0 (35) (35)
270 No 0 (35) (35)
290 No 0 (35) (35)
300 No 0 (35) (35)
320 Yes 20 (35) (15)
340 Yes 40 (35) 5
350 Yes 50 (35) 15
(iii) Pay off for option Holder.
Unlimited
Profit Profit
BEP
0
300 335
Loss EP BEP
(35) Maximum
Loss = ₹ 35
(iv) Pay off for option Writer.
(35) Maximum Loss

Profit
= Premium Amt
EP BEP
0
(300) (335)
Loss
Unlimited
Loss
DERIVATIVES
Example 2
Mr. G is hoping that the price of a share of ACC is going to fall. He purchases a
put option at an exercise price of ₹ 480. He pays a premium of ₹ 40.
Required:-
(i) Determine the breakeven point to Mr. G

(ii) Compute Profit/Loss for Mr. G if the price on maturity is- ₹ 400, 420,
440, 480, 490, 500, 530.
(iii) Draw pay off put option holder.
(iv) Draw pay off put option writer.
Solution:
(i) Calculation of breakeven point.

BEP = EP – Premium
= ₹ 480 - ₹ 40
= ₹ 440
(ii) Calculation of Profit/Loss (Net pay off).

Market Exercise Gross Premium Net
Price or not Pay off Pay off
400 Yes 80 (40) 40
420 Yes 60 (40) 20
440 Yes 40 (40) 0
480 No 0 (40) (40)
490 No 0 (40) (40)
500 No 0 (40) (40)
530 No 0 (40) (40)
(iii) Pay off for option Holder.
Unlimited
Profit
Profit
BEP EP
0
440 480
Loss
(40)
Maximum Loss
= Premium
DERIVATIVES
(iv) Pay off for option Writer.
Maximum Profit
(40)
Profit = Premium
BEP EP
0
440 480
Loss
Unlimited
Loss
Question 1
The equity share of VCC Ltd. is quoted at ₹ 210. A 3-month call option is
available at a premium of ₹ 6 per share and a 3-month put option is available
at a premium of ₹ 5 per share. Ascertain the net payoffs to the option holder of
a call option and a put option.
The strike price in both cases in ₹ 220; and

The share price on the exercise day is ₹ 200,210,220,230,240.
Also, indicate the price range at which the call and the put options may be
gainfully exercised.
Answer
Net payout for the holder of the call option
(₹)
Share price on exercise day 200 210 220 230 240
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 220 220
Out flow (premium) 6 6 6 6 6
Total Outflow 6 6 6 226 226
Less inflow (Sales proceeds) - - - 230 240
Net payoff -6 -6 -6 4 14
Net payoff for the holder of the put option
(₹)
Share price on exercise day 200 210 220 230 240
Option exercise Yes Yes No No No
Inflow (Strike price) 220 220 Nil Nil Nil
DERIVATIVES
Less outflow (purchase price) 200 210 - - -

Less outflow (premium) 5 5 5 5 5
Net Payoff 15 5 -5 -5 -5
The call option can be exercised gainfully for any price above ₹ 226
(₹ 220 + ₹ 6) and put option for any price below ₹ 215 (₹ 220 - ₹ 5).
5) In the money , At the money, Out of the Money, Intrinsic value &
Time value
 In the money (ITM), At the money ( ATM ), Out of the money (OTM)
EP < CMP EP = CMP EP > CMP
Call ITM ATM OTM
Put OTM ATM ITM
 Intrinsic value & Time value (Volatility premium)

There are two parts of option premium
(i) Intrinsic value : If option is in the money, then difference
between CMP & EP is called Intrinsic value. If option is out
of the money & At the money than Intrinsic value will be
zero.
(ii) Time value or Volatility premium : If option is in the money

then Time value = premium amount – Intrinsic value If
option is Out of the money & At the money then whole of the
premium amount is time value.
Example 3
Consider the data relating to a stock contained in the following table.
Determine both the intrinsic value and the time value in each of the cases.
Option Strike price Asset price Option premium
Call 90 100 15
Call 110 100 2
Put 200 100 135
DERIVATIVES
Put 90 100 4
Put 150 125 30
Call 150 120 22
Solution:
Option Strike Asset Option Intrinsic Time

Price Price Premium Value Value
Call 90 100 15 10 5
Call 110 100 2 - 2
Put 200 100 135 100 35
Put 90 100 4 - 4
Put 150 125 30 25 5
Call 150 120 22 - 22
6) Participants in Derivative Market
There are three participants or players in Derivative Market.
(i) Hedgers
 Existing Exposure
 To avoid risk
 Take Long or short position
(ii) Speculators
 No existing exposure
 For making profit on the basis of price expectation.
 Take long or short position
 They may loose
(iii) Arbitrageurs
 No existing exposure
 For making profit on the basis of mispricing
 They are sophisticated investors & use skill to make profit
 Take long & short position simultaneously
 Loss is not possible
7) Short selling (Stock lending & Borrowing Scheme)

(i) Definition :
DERIVATIVES
Short selling is a speculative activity is designed to make

profit on the basis of bearish price expectation.
(ii) Explanation :
In short selling, short seller borrow stock from stock lender
& sell it at current market price with a view to buy later on
at lower price & return to stock lender.
(iii) Sources of Return :

 Price depreciation
 Interest on selling amount
(iv) Sources of Risk :

 Price Appreciation
 Dividend (Short seller compensates dividend amount to
stock lender)
 Stock lending charges
(v) Legal Status :
Short selling is prohibited in some Countries. In some Countries

like US & India allow short selling with some restriction.
In India stock Lending & Borrowing scheme (SLBS) of SEBI

regulates short selling activities.
8) Expected value of Option

 Expected price of share
= ∑ Price x probability
 Expected value of option
= ∑ Gross payoff + probability
Or
∑ Intrinsic value x probability
Question 2
You as an investor had purchased a 4 month call option on the equity shares
of X Ltd. of ₹ 10, of which the current market price is ₹ 132 and the exercise
price ₹ 150. You expect the price to range between ₹ 120 to ₹ 190. The expected
share price of X Ltd. and related probability is given below:
DERIVATIVES
Expected Price 120 140 160 180 190
Probability .05 .20 .50 .10 .15
Compute the following:
(1) Expected Share price at the end of 4 months.
(2) Value of Call Option at the end of 4 months, if the exercise price prevails.
(3) In case the option is held to its maturity, what will be the expected value
of the call option?
Answer
(1) Expected Share Price
= ₹120×0.05 + ₹140×0.20 + ₹160×0.50 + ₹180×0.10 + ₹190×0.15

= ₹6 + ₹28 + ₹80 + ₹18 + ₹28.50 = ₹160.50
(2) Value of Call Option
= ₹150 − ₹150 = Nil
(3) If the option is held till maturity the expected Value of Call Option
Expected price (X) Value of call (C) Probability (P) CP

₹ 120 0 0.05 0
₹ 140 0 0.20 0
₹ 160 ₹ 10 0.50 ₹5
₹ 180 ₹ 30 0.10 ₹3
₹ 190 ₹ 40 0.15 ₹6
Total ₹ 14
Alternatively, it can also be calculated as follows:
Expected Value of Option
(120 – 150) × 0.1 Not Exercised*
(140 – 150) × 0.2 Not Exercised*
(160 – 150) × 0.5 5
(180 – 150) × 0.1 3
DERIVATIVES
(190 – 150) × 0.15 6
14
* If the strike price goes below ₹ 150, option is not exercised at all.
II - Valuation of option or option pricing :
In this topic, we calculate value of option & compare with market price of
option i.e. premium & decide whether option should be purchased or
not?
 Premium Amt. > Value of option Overpriced Not buy

 Premium Amt. < Value of option Underpriced Buy
There are three methods to calculate value of option.
1. Binomial Model
 Risk neutral probability approach
 Delta hedging or Risk free portfolio approach
 Replicating portfolio approach
2. Put call parity theorem (PCPT)

3. Black – Scholes Model (BSM)
Binomial Model :
(i) Risk Neutral Probability Approach

As per Binomial Model (Name Suggested), Only two possible price
of stock on maturity i.e.
 Maximum price or upper price of stock (us)
 Minimum price or lower price of stock (ds)
(ii) Following step are applied to calculate value of option
Step – 1 Standard notation or given

Step – 2 Calculate risk neutral probability
R−d
𝑃=
𝑢−𝑑
Step – 3 Binomial Three

Step – 4 Calculate value of option
DERIVATIVES
 Value of call
Cup +Cd (1−P)
Co =
R
 Value of put
PuP +Pd (1−P)
Po =
R
(iii) How to Calculate Risk Neutral Probability
500 x 1.10=(500 x 1.20 x P)+(500 x 0.8)(1-P)

SR=(us x P)+ds(1-P)
500 x 1.10=(500 x 1.20 x P)+500 x 0.8-500 x 0.08 x P
SR= us x P + ds – dsP
500 x 1.10 - 500 x 0.8 = 500 x 1.20 x P - 500 x 0.8 x P
500 x 1.10 - 500 x 0.8 = [(500 x 1.20) – 500 x 0.08] P SR-ds = us x P – dsP
500 × 1.10 − 500 × 0.8

𝑃=
500 × 1.20 − 500 × 0.8 SR – ds = P (us – ds)
500 (1.10 − 0.8) 𝑆𝑅 − 𝑑𝑠

𝑃= 𝑃=
500 (1.20 − 0.8) 𝑢𝑠 − 𝑑𝑠
1.10 − 0.8 𝑆 (𝑅 − 𝑑)
𝑃= 𝑃=
1.20 − 0.8 𝑆 (𝑢 − 𝑑)
𝑅−𝑑
𝑃=
𝑢−𝑑
Question 3
The current market price of an equity share of Penchant Ltd is ₹420. Within a
period of 3 months, the maximum and minimum price of it is expected to be ₹
500 and ₹ 400 respectively. If the risk free rate of interest be 8% p.a., what
should be the value of a 3 months Call option under the “Risk Neutral” method
at the strike rate of ₹ 450? Given e0.02 = 1.0202
Answer
Let the probability of attaining the maximum price be p
DERIVATIVES
(500 − 420) × p + (400 − 420) × (1−p) = 420 × (e0.02-1)
or, 80p − 20(1 − p) = 420 × 0.0202
or, 80p – 20 + 20p = 8.48
or, 100p = 28.48
p = 0.2848
0.2848 ×(500 450)

The value of Call Option in ₹ =
1.0202
0.2848 ×50 0.7152 0

= = 13.96
1.0202
Question 4
Sumana wanted to buy shares of ELL which has a range of ₹ 411 to ₹ 592 a
month later. The present price per share is ₹ 421. Her broker informs her that
the price of this share can sure up to ₹ 522 within a month or so, so that she
should buy a one month CALL of ELL. In order to be prudent in buying the
call, the share price should be more than or at least ₹ 522 the assurance of
which could not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the
probability of attaining the share price ₹ 592 so that buying of a one month
CALL of EIL at the execution price of ₹ 522 is justified.
Advice her. Take the risk free interest to be 3.60% and e0.036 = 1.037.
Answer
e rt −d
p =
u−d
ert = e0.036
d = 411/421 = 0.976
u = 592/421 = 1.406
e 0.036 −0.976 1.037−0.976 0.061
p = = = = 0.1418
1.406−0.976 0.43 0.43
Thus probability of rise in price 0.1418
DERIVATIVES
Question 5
Consider a two year American call option with a strike price of ₹ 50 on a
stock the current price of which is also ₹ 50. Assume that there are two
time periods of one year and in each year the stock price can move up or
down by equal percentage of 20%. The risk free interest rate is 6%. Using
binominal option model, calculate the probability of price moving up and
down. Also draw a two step binomial tree showing prices and payoffs at
each node.
Answer
Stock prices in the two step Binominal tree
Using the single period model, the probability of price increase is
R−d 1.06−0.80 0.26

P= = = = 0.65
u−d 1.20−0.80 0.40
Therefore the p of price decrease = 1−0.65 = 0.35
The two step Binominal tree showing price and pay off
DERIVATIVES
The value of an American call option at nodes D, E and F will be equal to the
value of European option at these nodes and accordingly the call values at
nodes D, E and F will be 22, 0 and 0 using the single period binomial model
the value of call option at node B is
Cup +Cd (1−p) 22×0.65+0×0.35

C= = = 13.49
R 1.06
The value of option at node „A‟ is
13.49×0.65+0×0.35
= 8.272
1.06
Question 6
Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are
currently selling at ₹600 each. He expects that price of share may go upto ₹780
or may go down to ₹480 in three months. The chances of occurring such
variations are 60% and 40% respectively. A call option on the shares of ABC
Ltd. can be exercised at the end of three months with a strike price of ₹630.
(i) What combination of share and option should Mr. Dayal select if he
wants a perfect hedge?
(ii) What should be the value of option today (the risk free rate is 10%
p.a.)?
(iii) What is the expected rate of return on the option?
Answer
(i) To compute perfect hedge we shall compute Hedge Ratio (Δ) as follows:
C 1 −C 2 150−0 150
∆= = = = 0.50
S 1 −S 2 780−480 300
Mr. Dayal should purchase 0.50 share for every 1 call option.
(ii) Value of Option today

If price of share comes out to be ₹780 then value of purchased share
will be:
Sale Proceeds of Investment (0.50×₹780) ₹390 Loss
on account of Short Position (₹780 – ₹630) ₹150
₹240
DERIVATIVES
If price of share comes out to be ₹480 then value of purchased share

will be:
Sale Proceeds of Investment (0.50×₹480) ₹240
Accordingly, Premium say P shall be computed as follows:
(₹300 – P) 1.025 = ₹240

P = ₹65.85
(iii) Expected Return on the Option

Expected Option Value = (₹780– ₹630) × 0.60 + ₹0 × 0.40
= ₹90
90−65.85
Expected Rate of Return = × 100 = 36.67%
65.85
Black Sholes Model (BSM)
As per BSM, value of call option is calculated as under
E
Co = So × n(d1) − rt × n(d2)
e
Where,
So = Current Market Price
E = Exercise Price
r = Rate of Interest [ Always Continuously Compounding ]
n = Normal Distribution Table (Z Table)
d1 = Delta of call or probability of stock price is more than exercise

price
d2 = Probability of option exercise
S σ2
Ln o + r+ t
E 2
d1 =
σ t
d2 = d1 − σ t
DERIVATIVES
Question 7
From the following data for certain stock, find the value of a call option:
Price of stock now = ₹80
Exercise price = ₹75
Standard deviation of continuously compounded
annual return = 0.40
Maturity period = 6 months
Annual interest rate = 12%
Given
Number of S.D. from Mean,(z) Area of the left or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
𝑒 0.12×0.5 = 1.062
In 1.0667 = 0.0646
Answer
Applying the Black Sholes Formula,
Value of the Call option now:
The Formula C = SN(d1)-Ke(-rt) N(d2)
S σ2
In + r+ t
K 2
d1 =
σ t
d2 = 𝑑1 − 𝜎 𝑡
Where,
C = Theoretical call premium
S = Current stock price
t = time until option expiration
K = option striking price
r = risk-free interest rate
N = Cumulative standard normal distribution
e = exponential term
σ = Standard deviation of continuously compounded annual return.
In = natural logarithm
DERIVATIVES
In 1.0667 + 12%+0.08 0.5

d1 =
0.40 0.5
0.0646 + 0.2 0.5 0.1646

= = = 0.5820
0.40×0.7071 0.2828
d2 = 0.5820 – 0.2828 = 0.2992

N(d1) = N (0.5820)
N(d2) = N (0.2992)
Price = SN(d1)−Ke(-rt)N(d2)
= 80 × N(d1) − (75/1.062) × N(d2)
Value of option
75
= 80 N(d1) − × N(d2)
1.062
N(d1) = N (0.5820) = 0.7197
N(d2) = N(0.2992) = 0.6176
75
Price = 80 × 0.7197 − × 0.6176
1.062
= 57.57 – 70.62 × 0.6176
= 57.57 – 43.61
= ₹13.96
Option Strategies
1. Straddles & Strangles

2. Straps & Strips
3. Bull & Bearish
4. Butterfly
(1) Straddles & Strangles
Straddles
 An Investor expects that wide Volatility in price of underlying asset in

future but he is not sure about movement i.e. price goes up & goes down
hence he creates straddles strategy.
 In straddles, we buy one call option & one put option at same strike
price, on same asset for same maturity period. (Long straddles)
 If price will rise then we will exercise Call option & Put option will lapse.
DERIVATIVES
 If price will fall then we will exercise Put option & Call option will lapse.
Strangles
 An investor expect wide volatility in price of share but he is not sure

about direction i.e. price rise or price fall, hence he creates strangles
strategy.
 In strangles, we buy one call option & one put option at different strike
price, on same asset for same maturity period.
 If price will rise then we will exercise call option & put option will lapse.
 If price will fall then we will exercise put option & call option will lapse.
 Cost of strangles strategy is less than cost of straddles strategy.
 In strangles, Call option is bought at higher EP & Put option is lower EP.
Question 8
Mr. X established the following spread on the Delta Corporation‟s stock:
(i) Purchased one 3-month call option with a premium of ₹ 30 and an

exercise price of ₹ 550.
(ii) Purchased one 3-month put option with a premium of ₹ 5 and an
exercise price of ₹ 450.
Delta Corporation‟s stock is currently selling at ₹ 500. Determine profit or loss,
if the price of Delta Corporation‟s:
(i) Remains at ₹500 after 3 months.

(ii) Falls at ₹350 after 3 months.
(iii) Rises to ₹600.
Assume the size option is 100 shares of Delta Corporation.
Answer
(i) Total premium paid on purchasing a call and put option

= (₹30 per share × 100) + (₹5 per share × 100).
= 3,000 + 500 = ₹3,500
In this case, X exercises neither the call option nor the put option as
both will result in a loss for him.
Ending value = − ₹3,500 + zero gain
= − ₹3,500
i.e Net loss = ₹3,500
(ii) Since the price of the stock is below the exercise price of the call, the
call will not be exercised. Only put is valuable and is exercised.
DERIVATIVES
Total premium paid = ₹3,500

Ending value = – ₹3,500 + ₹ [(450 – 350) × 100]
= – ₹3,500 + ₹ 10,000 = ₹6,500
∴ Net gain = ₹6,500
(iii) In this situation, the put is worthless, since the price of the stock
exceeds the put‟s exercise price. Only call option is valuable and is
exercised.
Total premium paid = ₹3,500
Ending value = −3,500 + [(600 – 550) × 100]
Net Gain = −3,500 + 5,000 = ₹1,500
Part II : Forward & Future
1. Forward Contract
 Forward contract is a contract between two parties to buy or
sell an underlying asset at predetermine price (forward Rate) in
future delivery.
 In forward contract forward buyer is obligated to buy & forward
seller is obligated to sell such underlying asset.
 Forward contract is over the counter (OTC) contract.
2. Future Contract
Future contract is
 Standardized forward contract
 Traded at stock exchange
 With margin requirement
 No counter party default risk
3. There are Two parties in future contract
 Future Buyer
 Contract to buy
 Upside betting
 Long position
 Future Seller
 Contract to sell
 Downside betting
 Short position
DERIVATIVES
4. Forward contract V/S Future contract

Forward Contract Future Contract
(i) Over the counter contract (i) Exchange traded
(ii) Customized (ii) Standardized
(iii) No margin requirement (iii) Margin requirement
(iv) Counter party default risk (iv) No counter party default risk
(v) Settlement only on (v) Daily settlement in margin
maturity balance (Mark to Market
settlement )
(vi) Loss Liquidity (vi) High liquidity
(vii) Less regulations (vii) More regulations
(viii) Generally used by hedgers (viii) Generally used by
speculators .
5. Stock index future

 Stock index future means future contract on stock index i.e. Nifty
& Sensex et.
 It could be on sector wise i.e. Bank nifty, IT index et. Or it could be
on overall market i.e. Nifty, Senses etc.
 It is settled only in cash, No physical delivery is possible. It is more
liquid than stock future.
 It is difficult to manipulate.
NUMERICALS
 Margin A/c
 Valuation of future
 Beta management or Hedging through future
 Commodity future
I. Margin
There are three types of margin
(i) Initial Margin : Initial margin means margin amount is required
at the time of execution of contract
(ii) Maintenance Margin : Maintenance margin is minimum margin
amount. If initial margin is below maintenance margin than
investor has to bring out extra margin.
(iii) Variation Margin : If initial margin is less than maintenance
margin then investor has to bring extra amount of margin & such
extra amount is called variation margin.
Important Notes
DERIVATIVES
(i) Margin amount can be withdrawn if margin money is more than

initial margin. If question is silent then assume no withdraws.
(ii) Whenever contract is squared off than balance amount of margin is
refunded .
(iii) If initial margin is not given in question then it is calculated as
under.
Initial Margin = µ + 3𝜎
µ = Average daily absolute change in price
𝜎 = Standard deviation in price
QUESTION 9
Sensex futures are traded at a multiple of 50. Consider the following quotations
of Sensex futures in the 10 trading days during February, 2009:
Day High Low Closing
4-2-09 3306.40 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60
Abhishek bought one sensex futures contract on February, 04. The average
daily absolute change in the value of contract is ₹ 10,000 and standard
deviation of these changes is ₹ 2,000. The maintenance margin is 75% of initial
margin.
You are required to determine the daily balances in the margin account and
payment on margin calls, if any.
DERIVATIVES
Answer
Initial Margin = µ + 3σ
Where µ = Daily Absolute Change
σ = Standard Deviation
Accordingly
Initial Margin= ₹10,000 + ₹6,000 = ₹16,000
Maintenance margin = ₹16,000 × 0.75 = ₹12,000
Day Changes in Future Values (₹) Margin Call

A/c (₹) Money (₹)
04/02/09 - 16000 -
05/02/09 50 × (3294.40 − 3296.50) = −105 15895 -
06/02/09 50 × (3230.40 − 3294.40)= −3200 12695 -
07/02/09 50 × (3212.30 − 3230.40)= −905 16000 4210
10/02/09 50 × (3267.50 − 3212.30)= 2760 18760 -
11/02/09 50 × (3263.80 − 3267.50)= −185 18575 -
12/02/09 50 × (3292 − 3263.80) =1410 19985 -
14/02/09 50 × (3309.30 − 3292)=865 20850 -
17/02/09 50 × (3257.80 − 3309.30)= −2575 18275 -
18/02/09 50 × (3102.60 − 3257.80)= −7760 16000 5485
II. Theoretical future price [Cost of carry model]

 As per cost of carry model, Theoretical future price or fair value
of future is calculated as under
f = Spot price + Interest saved – Dividend forgone
If
Actual future price > Value of future -: Future is overpriced
Actual future price < Value of future -: Future is
underpriced
Supposed
Spot price = ₹ 500
Rate of Intt. = 10% p.a.
Period = 1 year
Expected dividend = ₹ 40
DERIVATIVES
(i) Calculate theoretical future price

f = Spot price + Intt saved – Dividend forgone
= 500 + 50 – 40
= 510
f = S(1+R)-D
f = 500(1.10)-40 = ₹ 510
(ii) If actual price ₹ 510 : Since actual future price is more than
theoretical future hence future is overpriced.
(iii) If actual future price ₹ 505 : Since actual future price is less than
theoretical future price hence future is under price.
Arbitrage with future

(i) No dividend paying stock
(ii) Dividend paying stocks
(iii) Stock index future
Question 10
The following data relate to Anand Ltd.'s share price:
Current price per share ₹ 1,800
6 months future's price/share ₹ 1,950
Assuming it is possible to borrow money in the market for transactions in

securities at 12% per annum, you are required:
(i) to calculate the theoretical minimum price of a 6-months forward

purchase; and
(ii) To explain arbitrate opportunity.
Answer
Anand Ltd
(i) Calculation of theoretical minimum price of a 6 months forward

contract Theoretical minimum price
= ₹1,800 + (₹1,800×12/100×6/12) = ₹1,908
DERIVATIVES
(ii) Arbitrage Opportunity The arbitrageur can borrow money @ 12 % for

6 months and buy the shares at ₹1,800. At the same time he can sell
the shares in the futures market at ₹1,950. On the expiry date 6
months later, he could deliver the share and collect ₹1,950 pay off
₹1,908 and record a profit of ₹42 (₹1,950 – ₹1,908
Question 11
The share of X Ltd. is currently selling for ₹ 300. Risk-free interest rate is 0.8%
per month. A three months futures contract is selling for ₹ 312. Develop an
arbitrage strategy and show what your riskless profit will be 3-month hence
assuming that X Ltd. will not pay any dividend in the next three months.
Answer
The appropriate value of the 3 months futures contract is –
Fo = ₹300(1.008)3 = ₹307.26
Since the futures price exceeds its appropriate value it pays to do the
following:-
Action Initial Cash flow at time T

Cash Flow (3 months)
Borrow ₹300 now and repay with + ₹300 −₹300(1.008)3
interest after 3 months = − ₹307.26
Buy a share − ₹300 ST
Sell a futures contract (Fo = 312/-) 0 ₹312 – ST
Total ₹0 ₹4.74
Such an action would produce a risk less profit of ₹4.74.
Question 12
On 31-8-2011, the value of stock index was ₹ 2,200. The risk free rate of return
has been 8% per annum. The dividend yield on this Stock Index is as under:
Month Dividend Paid

P.A.
January 3%
DERIVATIVES
February 4%
March 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 3%
November 4%
December 3%
Assuming that interest is continuously compounded daily, find out the future
price of contract deliverable on 31-12-2011. Given: e0.01583 = 1.01593
Answer
The duration of future contract is 4 months. The average yield during this
period will be:
3%+3%+4%+3%
= 3.25%
4
As per Cost to Carry model the future price will be
F = Se(rf-D)t
Where S = Spot Price
rf = Risk Free interest
D = Dividend Yield
t = Time Period
Accordingly, future price will be
= ₹2,200 𝑒 (0.08−0.0325)×4/12) = ₹2,200 e0.01583

= ₹2,200 × 1.01593 = ₹2235.05
DERIVATIVES
Question 13
The NSE-50 Index futures are traded with rupee value being ₹100 per index
point. On 15th September, the index closed at 1195, and December futures
(last trading day December 15) were trading at 1225. The historical dividend
yield on the index has been 3% per annum and the borrowing rate was 9.5%
per annum.
(i)
Determine whether on September 15, the December futures were
under-priced or overpriced?
(ii) What arbitrage transaction is possible to gain out this mispricing?
(iii) Calculate the gains and losses if the index on 15thDecember closes at
(a) 1260 (b) 1175.
Assume 365 days in a year for your calculations
Answer
(i) Current price of the December Future
91
= ₹ 100[1195+1195(0.095−0.03) ]
365
= ₹ 100[1195+19.37]
= ₹ 1,21,437
Since the current market price of December – 15 is ₹ 1,22,500 (₹

100×1225) it is overpriced.
(ii) Since the actual future is overpriced, the cash and carry arbitrage is
possible i.e. sell the future contract and borrow to buy the stock.
(iii) September 15
Transaction Cash Flow

Buy (1195 × ₹100) = ₹ 1,19,500 worth of stock −₹1,19,500.00
Borrow ₹ 1,19,500 @ 9.50% for 91 days +₹1,19,500.00
Sell a future contract @ 1225 0
Total 0
(a) If on December 15, the index closes at 1260
Transaction Cash Flow

(₹)
Repay ₹1,19,500 @ 9.50% for 91 days −1,22,330.35
DERIVATIVES
Cancellation of Future Contract (1,22,500−1,26,000) −3,500.00

Sell 1,19,500 worth of stocks @ 1,260 +1,26,000.00
1260
× 1,19,500
1195
Dividend Earned @ 3% +893.79
91
× 1,19,500 × 3%
365
Gain due to Arbitrage +1,063.44
(b) If on December 15, the index closes at 1175
Transaction Cash Flow (₹)

Repay ₹1,19,500 @ 9.50% for 91 days −1,22,330.35
Cancellation of Future Contract (1,22,500−1,17,500) +5,000.00
Sell 1,19,500 worth of stocks @ 1,175 +1,17,500.00
1,175
× 1,19,500
1,195
Dividend Earned @ 3% +893.79
91
× 1,19,500 × 3%
365
Gain due to arbitrage +1,063.44
Question 14
Suppose current price of an index is ₹ 13,800 and yield on index is 4.8% (p.a.).
A 6 months future contract on index is trading at ₹ 14,340.
Assuming that risk free rate of interest is 12%. Show Mr. X (an arbitrageur) can
earn an abnormal rate of return irrespective of outcome after 6 months . You
can assume that after 6 months index closes at ₹ 10,200 and ₹ 15,600 and
50% of stock included in index shall pay dividend in next 6 months. Also
Calculate implied risk free rate
Answer
(i) Theoretical Future Price
F = S (1+r) – D
= 13800 (1.06) – 165.60
= ₹ 14462.40
DERIVATIVES
Since actual future price (14340) is less than theoretical future price
(14462.40) it means future under price, hence “Sell Spot & Buy Future.”
6
D = 13800 × 4.8% × × 50%
12
= 165.60
Arbitrage Process
Today
- Short sell at ₹ 13800
- Invest ₹ 13800 @ 12% p.a. for 6 months
- Buy future at ₹ 14340 [Long Position]
On Maturity
Price Price
10200 15600
Buy share & return to stock lender (10200) (15600)
Investment 13800(1.06) 14628 14628
Profit/Loss on long position of future (4140) 1260
Dividend compensates to stock lender (165.60) (165.60)

Arbitrage Gain 122.40 122.40
122.40 12
Implied RT Rate = × 100 × = 1.77%
13800 6
Question 15
Mr. SG sold five 4-Month Nifty Futures on 1st February 2020 for ₹9,00,000. At
the time of closing of trading on the last Thursday of May 2020 (expiry), Index
turned out to be 2100. The contract multiplier is 75.
Based on the above information calculate:
(i) The price of one Future Contract on 1stFebruary 2020.
DERIVATIVES
(ii)
Approximate Nifty Sensex on 1st February 2020 if the Price of Future
Contract on same date was theoretically correct. On the same day
Risk Free Rate of Interest and Dividend Yield on Index was 9% and
6% p.a. respectively.
(iii) The maximum Contango/ Backwardation.
(iv) The pay-off of the transaction.
Note: Carry out calculation on month basis.
Answer
(i) The price of one future contract
Let X be the price of future contract. Accordingly,
₹9,00,000
5=
X
X (Price of One Future Contract) = ₹ 1,80,000
₹1,80,000
(ii) Current future price of the index = = 2400
75
Let Y be the current Nifty Index (on 1st February 2020) then
Accordingly,
4
Y+Y (0.09 – 0.06) = 2400
12
2400
And Y = = 2376.24
1.01
Hence Nifty Index on 1st February 2020 shall be approximately 2376.
(iii) To determine whether the market is in Contango/Backwardation first we

shall compute basis as follows:
Basis = Spot price – Future price
If basis is negative the market is said to be in contango and when it is

positive the market is said to be Backwardation.
Since current spot price is 2400 and Nifty index is 2376. The basis is
negative and hence there is Contango market and maximum Contango
shall be 24(2400−2376).
DERIVATIVES
(iv) Pay off on the future transaction shall be [(2400-2100)×375] ₹112500
The future seller gains if the Spot price is less than futures contract price
as position shall be reversed at same Spot price. Therefore, Mr. SG has
gained ₹ 1,12,500/- on the short position taken.
Part III : Beta Management or Hedging through stock index future

1. What is Beta?
 Beta is measurement of systematic risk which represent
relationship between change in stock return & change in
market return.
Change in stock ′ s return
Beta =
change in market return
Suppose, change in stock return is = 20% & change in market
return is 10%
20%
Hence Beta of stock = =2
10%
Higher Beta means higher volatility i.e. higher risk.
2. What is portfolio Beta?

 Portfolio beta means weighted overage beta of individual stocks.
 Suppose, we invest in following stock.

Stocks Investment Amount Beta
A 3,00,000 2
B 2,00,000 1.5
C 5,00,000 1
VP = 1,00,000
Method I : Calculation of Beta of portfolio
3,00,000×2 + 2,00,000×1.5 +(5,00,000×1)

BP =
10,00,000
= 1.4
Method II : Beta of Portfolio
Stocks Amount Weights Beta W×B
DERIVATIVES
A 3,00,000 0.30 2 0.6

B 2,00,000 0.20 1.5 0.3
C 5,00,000 0.50 1 0.5
1,00,000 1.00 BP 1.4
Bp 1.4 means if index changes by 10% then value of portfolio will change
by 14%.
3. Beta Management or Hedging

 We know that beta is a relationship between stock & market.
 Suppose we hold stock of RIL at ₹ 5,00,000(Portfolio = ₹ 5,00,000)
& Beta = 1 & we expect that portfolio will rise but it may possible
that market will fall. We afraid from market falling & we want to
hedge the risk of decrease in value of portfolio.
 In order to hedge risk, we have to decrease beta of portfolio & we
take short position on stock index future ( Downside betting)
 Suppose market will fall in future then we loose on long position of
portfolio but, make profit on short position of stock index future.
 No. of contracts to be bought or sold of stock index future is
calculated as under
V p × B t −B p
x=
f×M×B f
x = No. of contracts
Bt = Target Beta (If not given in question, assume “0”)[perfect
hedge]
Bp = Beta of portfolio
F = Future price of stock index
m = Multiplier (Lot size)
Bf = Beta of future (If not given in question , assume 1)
Question 16
Which position on the index future gives a speculator, a complete hedge
against the following transactions:
(i) The share of Right Limited is going to rise. He has a long position on
the cash market of ₹ 50 lakh on the Right limited. The beta of the
Right Limited is 1.25.
DERIVATIVES
(ii) The share of Wrong Limited is going to depreciate. He has a short

position on the cash market of ₹ 20 lakh of the Wrong Limited. The
beta of the Wrong Limited is 0.90.
(iii) The share of Fair Limited is going to stagnant. He has a short position
on the cash market of ₹ 20 lakh of the Fair Limited. The beta of the
Fair Limited is 0.75.
Answer
Sl. No. Company Trend (3) Amount Beta (₹) (6) [(4) Position
(1) Name (2) (₹) (4) (5) × (5)] (7)
1 Right Ltd. Rise 50 lakh 1.25 62,50,000 Short
2 Wrong Ltd. Depreciate 25 lakh 0.90 22,50,000 Long
3 Fair Ltd. Stagnant 20 lakh 0.75 15,00,000 Long
25,00,000 Short
Question 17
Ram buys 10,000 shares of X Ltd. at a price of ₹ 22 per share whose beta value
is 1.5 and, sells 5,000 shares of A Ltd. at a price of ₹ 40 per share having a
beta value of 2. He obtains a complete hedge by Nifty futures at ₹ 1,000 each.
He closes out his position at the closing price of the next day when the share of
X Ltd. dropped by 2%, share of A Ltd. appreciated by 3% and Nifty futures
dropped by 1.5%.
What is the overall profit/loss to Ram?
Answer
No. of the Future Contract to be obtained to get a complete hedge
10,000×₹22×1.5−5,000×₹40×2
=
₹1,000
₹3,30,000−₹4,00,000
= = 70 contracts
₹1,000
Thus, by purchasing 70 Nifty future contracts to be long to obtain a

complete hedge.
Cash Outlay
= 10000 × ₹22 – 5000 × ₹40 + 70 × ₹1,000
DERIVATIVES
= ₹2,20,000 – ₹2,00,000 + ₹70,000 = ₹90,000
Cash Inflow at Close Out
= 10000 × ₹22 × 0.98 – 5000 × ₹40 × 1.03 + 70 × ₹1,000 × 0.985
= ₹2,15,600 – ₹2,06,000 + ₹68,950 = ₹78,550
Gain/ Loss
= ₹78,550 – ₹90,000 = − ₹11,450 (Loss)
Question 18
On April 1, 2015, an investor has a portfolio consisting of eight securities as
shown below:
Security Market Price No. of Shares Value
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of capital for the investor is 20% p.a. continuously compounded. The
investor fear a fall in the prices of the shares in the near future. Accordingly, he
approaches you for the advice to protect the interest of his portfolio.
You can make use of the following information:
(i) The current NIFTY value is 8500.

(ii) NIFTY futures can be traded in units of 25 only.
(iii)Futures for May are currently quoted at 8700 and Futures for June
are being quoted at 8850.
You are required to calculate:
DERIVATIVES
(i) the beta of his portfolio.

(ii) the theoretical value of the futures contract for contracts expiring in
May and June.
Given (e0.03 =1.03045, e0.04 = 1.04081, e0.05 =1.05127)
(iii) The number of NIFTY contracts that he would have to sell if he desires
to hedge until June in each of the following cases:
(A) His total portfolio
(B) 50% of his portfolio
(C) 120% of his portfolio
Answer
(i) Beta of the Portfolio

Security Market No. of Value β Value × β
Price Shares
A 29.40 400 11760 0.59 6938.40
B 318.70 800 254960 1.32 336547.20
C 660.20 150 99030 0.87 86156.10
D 5.20 300 1560 0.35 546.00
E 281.90 400 112760 1.16 130801.60
F 275.40 750 206550 1.24 256122.00
G 514.60 300 154380 1.05 162099.00
H 170.50 900 153450 0.76 116622.00
994450 1095832.30
10,95,832.30
Portfolio Beta = = 1.102
9,94,450
(ii) Theoretical Value of Future Contract Expiring in May and June
F = Sert
2
FMay = 8,500 × e0.20×(12 ) = 8500 × e0.0333
e0.0333 shall be computed using Interpolation Formula as follows:

e0.03 = 1.03045
e0.04 = 1.04081
e0.01 = 0.01036
e0.0033 = 0.00342
e0.0067 = 0.00694
e0.0333 = 1.03045 + 0.00342 = 1.03387
DERIVATIVES
or 1.04081 – 0.00694 = 1.03387
According the price of the May Contract
8500 × 1.03387 = ₹8788
Price of the June Contract

3
F May = 8,500 × e0.20×(12 )
= 8,500 × e0.05
= 8500 ×1.05127 = 8935.80
(iii) No. of NIFTY Contracts required to sell to hedge until June

Value of position to be hedged
= ×β
Value of future contract
(A) Total portfolio

9,94,450
× 1.102 = 4.953 say 5 contracts
8,850×25
(B) 50% of Portfolio

9,94,450 × 0.50
× 1.102 = 2.47 say 3 contracts
8,850×25
(C) 120% of Portfolio

9,94,450 × 1.20
× 1.102 = 5.94 say 6 contracts
8,850×25
Question 19
A Mutual Fund is holding the following assets in ₹Crores:
Investments in diversified equity shares 90.00
Cash and Bank Balances 10.00
100.00
The Beta of the portfolio is 1.1. The index future is selling at 4300 level. The
Fund Manager apprehends that the index will fall at the most by 10%. How
many index futures he should short for perfect hedging? One index future
DERIVATIVES
consists of 50 units. Substantiate your answer assuming the Fund Manager's

apprehension will materialize.
Answer
Number of index future to be sold by the Fund Manager is:
1.1 × 90,00,00,000
= 4,605
4,300 × 50
Justification of the answer: Loss in the value of the portfolio if the index falls
11
by 10% is ₹ × 90 Cr. = ₹9.90 Cr.
100
Gain by short covering of index future is:
0.1×4,300×50×4,605
= ₹9.90 Cr.
1,00,00,000
This justifies the answer. Further, cash is not a part of the portfolio.
Question 20
A trader is having in its portfolio shares worth ₹ 85 lakhs at current price and
cash ₹ 15 lakhs.
The beta of share portfolio is 1.6. After 3 months the price of shares dropped by
3.2%.
Determine:
(i) Current portfolio beta

(ii) Portfolio beta after 3 months if the trader on current date goes for
long position on ₹ 100 lakhs Nifty futures.
Answer
(i) Current Portfolio Beta

Current Beta for share portfolio = 1.6
Beta for cash =0
Current portfolio beta = 0.85×1.6+0×0.15 = 1.36
(ii) Portfolio beta after 3 months:

Beta for portfolio of shares
DERIVATIVES
Change in value of portfolio of share

=
Change in value of market portfolio (Index )
0.032
1.6 =
Change in value of market portfolio (Index )
Change in value of market portfolio (Index)
= (0.032 / 1.6) × 100 = 2%
Position taken on 100 lakh Nifty futures : Long
Value of index after 3 months = ₹100 lakh×(1.00 − 0.02)
= ₹98 lakh
Mark-to-market paid = ₹2 lakh
Cash balance after payment of mark-to-market = ₹13 lakh
Value of portfolio after 3 months = ₹85 lakh×(1-0.032)+₹13lakh
= ₹95.28 lakh
₹100 lakh − ₹95.28 lakh

Change in value of portfolio =
₹100 lakh
= 4.72%
Portfolio Beta = 0.0472/0.02 = 2.36
Question 21
BSE 5000
Value of portfolio ₹ 10,10,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5
DERIVATIVES
We assume that a future contract on the BSE index with four months maturity
is used to hedge the value of portfolio over next three months. One future
contract is for delivery of 50 times the index.
Based on the above information calculate:
(i) Price of future contract.

(ii) The gain on short futures position if index turns out to be 4,500 in
three months.
Answer
(i) Current future price of the index

4
= 5000 + 5000 (0.09-0.06) = 5000 + 50= 5,050
12
∴ Price of the future contract

= ₹50 × 5,050 = ₹2,52,500
10,10,000
(ii) Hedge ratio = × 1.5 = 6 contracts
2,52,500
Index after there months turns out to be 4,500
1
Future price will be = 4,500 + 4,500(0.09−0.06)× = 4,511.25
12
Therefore, Gain from the short futures position is
= 6×(5050 – 4511.25) × 50
= ₹1,61,625
Note: Alternatively we can also use daily compounding (exponential)formula.
4. Commodity future : Commodity future means future contra t on

commodity like gold, steel, oil etc.
(i) Margin
(ii) Theoretical future price
(iii) Beta management
Question 21
The following information about copper scrap is given:
(i) Spot price : $10,000 per ton
DERIVATIVES
(ii) Futures price : $10,800 for a one year contract

(iii) Interest rate : 12 %
(iv) PV (storage costs) : $500 per year
What is the PV (convenience yield) of copper scrap?
Answer
Futures price
= Spot price + Present value of − Present value of
1+Risk −Free Rate 1
storage costs convenience yield
10,800
= 10,000 + 500 – Present value of convenience yield
1.12 1
Hence the present value of convenience yield is $857.14 per ton.
Question 22
A company is long on 10 MT of copper @ ₹ 474 per kg (spot) and intends to
remain so for the ensuing quarter. The standard deviation of changes of its
spot and future prices are 4% and 6% respectively, having correlation
coefficient of 0.75.
What is its hedge ratio? What is the amount of the copper future it should
short to achieve a perfect hedge?
Answer
The optional hedge ratio to minimize the variance of Hedger‟s position is given
by:
σS
H= ρ σF
Where
σS = Standard deviation of ΔS
σF = Standard deviation of ΔF
ρ = coefficient of correlation between ΔS and ΔF
H = Hedge Ratio
ΔS = change in Spot price.
DERIVATIVES
ΔF = change in Future price.
Accordingly
0.04
H = 0.75 × = 0.5
0.06
No. of contract to be short = 10 × 0.5 = 5
Amount = 5,000 × ₹474 = ₹23,70,000

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DERIVATIVES

 Derivative is a financial instrument which derives its value from an

Part I : Option Contract

We will discuss option contract in three points

2) There are two parties in option contract

1) Right but not obligation 1) Obligation but not right

2) An option premium to be 2) Margin money is required

3) There are two types of options

(ii) Put Option

4) Types of options on the basis of cash flows

(ii) American Option

American option can be exercised on or before maturity. Premium

(i) Determine the breakeven point price of Mr. E.

(i) Calculation of breakeven point.

(ii) Calculation of Profit/Loss (Net pay off).

(iii) Pay off for option Holder.

(iv) Pay off for option Writer.

(35) Maximum Loss

(i) Determine the breakeven point to Mr. G

(i) Calculation of breakeven point.

(ii) Calculation of Profit/Loss (Net pay off).

(iii) Pay off for option Holder.

(iv) Pay off for option Writer.

The strike price in both cases in ₹ 220; and

Net payout for the holder of the call option

Net payoff for the holder of the put option

Less outflow (purchase price) 200 210 - - -

 Intrinsic value & Time value (Volatility premium)

(ii) Time value or Volatility premium : If option is in the money

Option Strike price Asset price Option premium

Call 110 100 2

Put 200 100 135

Put 150 125 30

Call 150 120 22

Option Strike Asset Option Intrinsic Time

6) Participants in Derivative Market

There are three participants or players in Derivative Market.

7) Short selling (Stock lending & Borrowing Scheme)

Short selling is a speculative activity is designed to make

(iii) Sources of Return :

(iv) Sources of Risk :

(v) Legal Status :

Short selling is prohibited in some Countries. In some Countries

In India stock Lending & Borrowing scheme (SLBS) of SEBI

8) Expected value of Option

∑ Intrinsic value x probability

Expected Price 120 140 160 180 190

Probability .05 .20 .50 .10 .15

Compute the following:

(1) Expected Share price at the end of 4 months.

(1) Expected Share Price

= ₹120×0.05 + ₹140×0.20 + ₹160×0.50 + ₹180×0.10 + ₹190×0.15

(2) Value of Call Option

= ₹150 − ₹150 = Nil

Expected price (X) Value of call (C) Probability (P) CP

Alternatively, it can also be calculated as follows:

Expected Value of Option

(120 – 150) × 0.1 Not Exercised*

(140 – 150) × 0.2 Not Exercised*