Financial Derivatives Notes

Financial Derivatives 20MBAFM402
Module-1 Financial Derivatives 5 hours

Meaning, benefits, types (both exchange traded, and OTC traded) and features of financial
derivatives-Factors causing growth of derivatives-functions of derivatives market-Derivative
market players (Hedgers, speculators and arbitragers)-Derivatives market in India. (Theory).
Introduction
The objective of an investment decision is to get required rate of return with minimum risk. To
achieve this objective, various instruments, practices and strategies have been devised and
developed in the recent past. With the opening of boundaries for international trade and
business, the world trade gained momentum in the last decade, the world has entered into a
new phase of global integration and liberalisation. The integration of capital markets world-
wide has given rise to increased financial risk with the frequent changes in the interest rates,
currency exchange rate and stock prices. To overcome the risk arising out of these fluctuating
variables and increased dependence of capital markets of one set of countries to the others, risk
management practices have also been reshaped by inventing such instruments as can mitigate
the risk element. These new popular instruments are known as financial derivatives which, not
only reduce financial risk but also open us new opportunity for high-risk takers.
Derivatives
‘Derivatives are the financial instruments whose value depends on the value of an underlying
asset’. Since they derive their value from an underlying asset. Derivatives are useful to reduce
the risk due to fluctuation in prices. Financial derivatives are financial instruments that are
linked to a specific financial instrument or indicator or commodity, and through which specific
financial risks can be traded in financial markets in their own right. Transactions in financial
derivatives should be treated as separate transactions rather than as integral parts of the value
of underlying transactions to which they may be linked. The value of a financial derivative
derives from the price of an underlying item, such as an asset or index. Unlike debt instruments,
no principal amount is advanced to be repaid and no investment income accrues. Financial
derivatives are used for a number of purposes including risk management, hedging, arbitrage
between markets, and speculation.
Prof. Rajimol K P, Assistant Professor, ACME 1

Financial derivatives contracts are usually settled by net payments of cash. This often occurs
before maturity for exchange traded contracts such as commodity futures. Cash settlement is a
logical consequence of the use of financial derivatives to trade risk independently of ownership
of an underlying item. However, some financial derivative contracts, particularly involving
foreign currency, are associated with transactions in the underlying item.
Features of financial derivatives
1. It is a contract: Derivative is defined as the future contract between two parties. It means
there must be a contract-binding on the underlying parties and the same to be fulfilled in future.
The future period may be short or long depending upon the nature of contract, for example,
short term interest rate futures and long term interest rate futures contract.
2. Derives value from underlying asset: Normally, the derivative instruments have the value
which is derived from the values of other underlying assets, such as agricultural commodities,
metals, financial assets, intangible assets, etc. Value of derivatives depends upon the value of
underlying instrument and which changes as per the changes in the underlying assets, and
sometimes, it may be nil or zero. Hence, they are closely related.
3. Specified obligation: In general, the counter parties have specified obligation under the
derivative contract. Obviously, the nature of the obligation would bedifferent as per the type of
the instrument of a derivative. For example, the obligation of the counter parties, under the
different derivatives, such as forward contract, future contract, option contract and swap
contract would be different.
4. Direct or exchange traded: The derivatives contracts can be undertaken directly between
the two parties or through the particular exchange like financial futures contracts. The
exchange-traded derivatives are quite liquid and have low transaction costs in comparison to
tailor-made contracts.
5. Secondary market instruments: Derivatives are mostly secondary market instruments and
have little usefulness in mobilizing fresh capital by the corporate world, however, warrants and
convertibles are exception in this respect.
6. Exposure to risk: Although in the market, the standardized, general and exchange-traded
derivatives are being increasingly evolved, however, still there are so many privately negotiated
customized, over the counter (OTC) traded derivatives are in existence. They expose

the trading parties to operational risk, counter-party risk and legal risk. Further, there may also
be uncertainty about the regulatory status of such derivatives.
Advantages of Derivatives
➢ They help in transferring risks from risk adverse people to risk oriented people.
➢ They help in the discovery of future as well as current prices.
➢ They catalyse entrepreneurial activity.
➢ They increase the volume traded in markets because of participation of risk
adverse people in greater numbers.
➢ They increase savings and investment in the long run.
Disadvantages of Derivatives
1. High volatility:
Since the value of derivatives is based on certain underlying things such as commodities, metals
and stocks etc., they are exposed to high risk. Most of the derivatives are traded on open market.
And the prices of these commodities metals and stocks will be continuously changing in nature.
So the risk that one may lose their value is very high.
2. Requires expertise:
In case of mutual funds or shares one can manage with even a limited knowledge pertaining to
his sector of trading. But in case of derivatives, it is very difficult to sustain in the market
without expert knowledge in the field.
3. Contract life:
The main problem with the derivative contracts is their limited life. As the time passes the
value of the derivatives will decline and so on. So one may even have chances of losing
completely within that agreed time frame.
Types of Derivatives
Forward - It is an agreement between two parties to exchange an agreed quantity of an asset
for cash at a certain date, at a predetermined price. The contract happens among the parties
themselves without an outside party interfering. The contract in a forward type of financial
derivative is non-standardized. It is subject to the choices of the parties engaged in a forward
contract.

Futures - A futures contract is similar in some manner to the forward type. Future contract is
a standardized forward contract. It is legally enforceable & it is always traded on an organized
exchange. Future contract is an agreement between two parties to exchange any asset for cash
at a future date at an agreed price. The terms and conditions of the contract are arranged by a
third party called a clearing house.
Options -This type of contract allow the person involved to have the option of exercising his
right on the assets. Transactions start at a specified price called a strike price. A maturity date
is then set for the owner to exercise his option of buying or selling the asset.
Types of option: -
i) Call option - call option is one which gives the option holder the right to buy an underlying
asset. At a predetermined price called “Strike price or Exercise price on or before future date
ii) Put option- A put option is one which gives the option holder the right to sell an underlying
asset at a predetermined price on or before specified date.
Swaps - It is an agreement between the parties to exchange their risks. A swap contract involves
mutual exchange of the underlying assets between the parties. A swap can either be an interest
rate swap or a currency rate swap. Interest rate swap involves exchange of fixed rate
commitment for that of floating rate interest commitment and vice versa. A currency swap
involves exchange of currency between two parties
EXCHANGE TRADED CONTRACT

Exchange traded contracts trade on a derivatives facility that is organized and referred to as an
exchange. These contracts have standard features and terms, with no customization allowed
and are backed by a clearinghouse.
OVER THE COUNTER CONTRACT

Over the counter (OTC) contracts are those transactions that are created by both buyers and
sellers anywhere else. Such contracts are unregulated and may carry the default risk for the
contract owner.

Difference between Exchange Trading & OTC Trading
Centralization
Exchange regulated markets are centralized. Here, a single party mediates and thereby connects
buyers with the sellers. All the transactions are therefore completed through a centralized
source. On the other hand, Over the Counter trading is completely de-centralized.
Standardized transactions
In a regulated exchange market, all the transactions are standardized. In other words, The
SEBI or the Stock Exchange Board of India acts as the guarantor for all transactions. In an
OTC, there is no specific guarantee or agreement and the contracts are customized as per the
requirement. Hence, the level of risk increases manifold in an OTC market.
Level of counter-party risk that is involved
When you buy or sell something through OTC market and via a private transaction, you are
generally not assured of getting, what you had ideally bargained for. The other party may also
not be able to deliver the desired stock, bond or any other security within the stipulated time
frame. You may get a different share or bond from what you had asked for; and, this risk is
broadly referred to as a counter-party risk.
Visibility
An exchange market is more of an open market. Here the prices of currencies, start date,
expiration date and parties involved are clearly transparent or rather highly visible. On the
other hand, in an OTC market, all terms and conditions involved with a transaction are held
within counter parties only.
Parties Involved
In a regulated exchange market, it is the governing body that is the counter party to all
transactions which are traded within the domain. While in a de-centralized or rather OTC
market, there are several brokers or mediators facilitating buying and selling of equities or
shares. Though the competition is high, the transaction costs are relatively lower in an OTC
market.

Benefits of Derivatives
Derivatives are supposed to provide the following services:
• Risk aversion tools: One of the most important services provided by the derivatives
is to control, avoid, shift and manage efficiently different types of risks through various
strategies like hedging, arbitraging, spreading, etc. Derivatives assist the holders to
shift or modify suitably the risk characteristics of their portfolios. These are
specifically useful in highly volatile financial market conditions like erratic trading,
highly flexible interest rates, volatile exchange rates and monetary chaos.
• Prediction of future prices: Derivatives serve as barometers of the future trends in
prices which result in the discovery of new prices both on the spot and futures markets.
Further, they help in disseminating different information regarding the futures markets
trading of various commodities and securities to the society which enable to discover
or form suitable or correct or true equilibrium prices in the markets. As a result, they
assist in appropriate and superior allocation of resources in the society.
• Enhance liquidity: As we see that in derivatives trading no immediate full amount of
the transaction is required since most of them are based on margin trading. As a result,
large number of traders, speculators arbitrageurs operate in such markets. So,

derivatives trading enhance liquidity and reduce transaction costs in the markets for
underlying assets
• Assist investors: The derivatives assist the investors, traders and managers of large
pools of funds to devise such strategies so that they may make proper asset allocation
increase their yields and achieve other investment goals.
• Integration of price structure: It has been observed from the derivatives trading in
the market that the derivatives have smoothen out price fluctuations, squeeze the price
spread, integrate price structure at different points of time and remove gluts and
shortages in the markets.
• Catalyse growth of financial markets: The derivatives trading encourage the
competitive trading in the markets, different risk taking preference of the market
operators like speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in
trading volume in the country. They also attract young investors, professionals and
other experts who will act as catalysts to the growth of financial markets.
• Brings perfection in market: Lastly, it is observed that derivatives trading develop

the market towards ‘complete markets’. Complete market concept refers to that
situation where no particular investors can be better off than others, or patterns of
returns of all additional securities are spanned by the already existing securities in it,
or there is no further scope of additional security.
Factors contributing to the growth of Derivatives

Factors contributing to the explosive growth of derivatives are price volatility, globalization of
the markets, technological developments and advances in the financial theories.
• Price Volatility - A price is what one pays to acquire or use something of value. The
objects having value maybe commodities, local currency or foreign currencies. The
concept of price is clear to almost everybody when we discuss commodities. There is a
price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays
for use of a unit of another persons money is called interest rate. And the price one pays
in one’s own currency for a unit of another currency is called as an exchange rate.
• Globalization of the Markets - Earlier, managers had to deal with domestic economic
concerns; what happened in other part of the world was mostly irrelevant. Now
globalization has increased the size of markets and as greatly enhanced competition .it
has benefited consumers who cannot obtain better quality goods at a lower cost. It has

also exposed the modern business to significant risks and, in many cases, led to cut
profit margins
• Technological Advances - A significant growth of derivative instruments has been
driven by technological breakthrough. Advances in this area include the development
of high speed processors, network systems and enhanced method of data entry. Closely
related to advances in computer technology are advances in telecommunications.
Improvement in communications allow for instantaneous worldwide conferencing,
Data transmission by satellite. At the same time there were significant advances in
software programmed without which computer and telecommunication advances would
be meaningless. These facilitated the more rapid movement of information and
consequently its instantaneous impact on market price.
• Advances in Financial Theories - Advances in financial theories gave birth to
derivatives. Initially forward contracts in its traditional form, was the only hedging tool
available. Option pricing models developed by Black and Scholes in 1973 were used to
determine prices of call and put options. In late 1970’s, work of Lewis Edeington
extended the early work of Johnson and started the hedging of financial price risks with
financial futures. The work of economic theorists gave rise to new products for risk
management which led to the growth of derivatives in financial markets.
• Development of sophisticated risk management tools- In certain derivative trading,
a typical type of risk is emerged. To manage this, sophisticated tools have been
developed. This “solution to derivative problems” add further growth in derivative
market.
Functions of Derivative Markets

Risk Management
As derivative prices are related to the underlying spot market goods (assets), they can be used
to reduce or increase the risk of owing the spot items. For example, buying the spot item and
selling a futures contract or call option reduces the investor’s risk. If the goods price falls, the
price of the futures or options contract will also fall. The investor can then repurchase the
contract at the lower price, affecting a gain that can at least partially offset the loss on the spot
item. All investors however want/need to keep their investments at an acceptable risk level.
Derivative markets enable those wishing to reduce their risk to transfer it to those wishing to
increase it, whom we call speculators

Price discovery
Forward and futures markets are an important source of information about prices. Futures
markets in particular are considered a primary means for determining the spot price of an asset.
Futures and forwards prices also contain information about what people expect future spot
prices to be. In most cases the futures price is more active hence, information taken from it is
considered more reliable than spot market information. Therefore futures and forward market
are said to provide price discovery. Option markets do not directly provide forecasts of future
spot prices. They do, however provide valuable information about the volatility and hence the
risk of the underlying spot asset.
Operational advantages
Derivative markets offer several operational advantages, such as:
1. They entail lower transaction costs. This means that commission and other trading
costs lower for traders in these markets.
2. Derivative markets, particularly the futures and exchanges have greater liquidity than
the spot markets.
3. The derivative markets allow investors to sell short more easily.
Securities markets impose several restrictions designed to limit or discourage short if not
applied to derivative transactions. Consequently, many investors sell short in these markets in
lieu of selling short the underlying securities.
Market efficiently
Spot markets for securities probably would be efficient even if there were no derivative
markets. There are important linkages among spot and derivative prices. The ease and low cost
of transacting in these markets facilitate the arbitrage trading and rapid price adjustments that
quickly eradicate these opportunities. Society benefits because the prices of the underlying
goods more accurately reflect the goods true economic value. Therefore, the derivative markets
provide a means of managing risk, discovering prices, reducing costs, improving liquidity,
selling short and making the market more efficient.
Liquidity

Since the derivative market involves margin system, the traders can execute the orders in large
quantity than in a spot market which in turn increases market liquidity
Financing Function
The derivative market provides the finance function in the sense that the transaction in
derivative market are based on margin system wherein the buyers and sellers are required to
deposit only small portion of the contract value ranging from 5-10% of the contract value.
Players in Derivative Market
Hedger: A hedge is a position taken in order to offset the risk associated with some other
position. A hedger is someone who faces risk associated with price movement of an asset and
who uses derivatives as a means of reducing that risk. A hedger is a trader who enters the
futures market to reduce a pre-existing risk.
Speculators: While hedgers are interested in reducing or eliminating risk, speculators buy and
sell derivatives to make profit and not to reduce risk. Speculators willingly take increased risks.
Speculators wish to take a position in the market by betting on the future price movements of
an asset. Futures and options contracts can increase both the potential gains and losses in a
speculative venture. Speculators are important to derivatives markets as they facilitate hedging
provide liquidity ensure accurate pricing and help to maintain price stability. It is the
speculators who keep the market going because they bear risks which no one else is willing to
bear.
Arbitrageur: An arbitrageur is a person who simultaneously enters into transactions in two or
more markets to take advantage of discrepancy between prices in these markets For example,
if the futures price of an asset is very high relative to the cash price, an arbitrageur will make
profit by buying the asset and simultaneously selling futures. Hence, arbitrage involves making

profits from relative mispricing. Arbitrageurs also help to make markets liquid, ensure accurate
and uniform pricing, and enhance price stability.
All three types of trades and investors are required for a healthy functioning of the derivatives
market. Hedgers and investors provide economic substance to this market, and without them
the markets would become mere tools of gambling. Speculators provide liquidity and depth to
the market. Arbitrageurs help in bringing about price uniformity and price discovery. The
presence of Hedgers, speculators and arbitrageurs, not only enables the smooth functioning of
the derivatives market but also helps in increasing the liquidity of the market.
Derivatives market in India

In India, commodity futures date back to 1875. The government banned futures trading in many
of the commodities in the sixties and seventies. Forward trading was banned in the 1960s by
the government despite the fact that India had a long tradition of forward markets. Derivatives
were not referred to as options and futures but as “tezi-mandi”. In exercise of the power
conferred on it under section 16 of the Securities Contracts (Regulation) Act, the government
by its notification issued in 1969 prohibited all forward trading in securities. However, the
forward contracts in the rupee dollar exchange rates (foreign exchange market) are allowed by
the Reserve Bank and used on a fairly large scale. Futures trading is permitted in 41
commodities. There are 18 commodity exchanges in India. The Forward Markets Commission
under the Ministry of Food and Consumer Affairs acts as a regulator. In the case of capital
markets, the indigenous 125 year old badla system was very popular among the broking and
investor community. The advent of foreign institutional investors in the nineties and a large
number of scams led to a ban on badla. The foreign institutional investors (FIIs) were not
comfortable with this system and they insisted on adequate risk-management tools. Hence, the
Securities and Exchange Board of India (SEBI) decided to introduce financial derivatives in
India. However, there were many legal hurdles which had to be overcome before introducing
financial derivatives. The preamble of the Securities Contract (Regulation) Act, states that the
Act was to prevent undesirable transactions in Securities by regulating business of dealing
therein, by prohibiting options, and by providing for certain other matters connected therewith.
Section 20 of the Act explicitly prohibits all options in securities. The first step therefore was
to withdraw all these prohibitions and make necessary amendments in the Act.
• Derivatives market in India has a history dating back in 1875. The Bombay Cotton
Trading Association started future trading in this year.

• However, after independence in 1952, the government of India officially put a ban on
cash settlement and options trading. In 1993, the National stocks Exchange, an
electronics-based trading exchange came into existence.
• SEBI granted its final approval for the introduction of derivative contracts in May 2000.
*******End of Unit 1*******

Module -2 Futures and Forwards 7 hours
Futures and Forwards: Meaning, features and types of futures/forwards-Futures vs Forwards-

Mechanics of buying and selling futures/forwards-Hedging through futures/forwards-Marking-
to-market process-contract specifications of stock, index and commodity futures–valuation of
futures/forwards using cost of carry model-Arbitrage process-Interest Rate Futures & options.
(Numerical problems on MTM and valuation of futures/forwards). (Theory and Problems).
FORWARD CONTARCT:
Forwards are the simplest of the derivative instruments. A forward contract is an agreement to
buy, or sell, an underlying asset at a certain time for a certain price in the future date.
Features of Forwards
• Forwards are transactions involving delivery of an asset or a financial instrument at a

future date, and therefore, are over-the-counter (OTC) contracts.
• OTC products are customized contracts which are written across the counter or struck
on telephone, fax or any other mode of communication by financial institutions to suit
the needs of their customers.
• Both the buyer and seller are committed to the contracts. They have to take delivery
and deliver respectively, the underlying asset on which the forward contract was entered
into.
• They are bilateral contracts & hence, exposed to counter party risk.
• One of the parties to the contract assumes a long position (buying of a security such as
stock, commodity or currency, with the expectation that the asset will rise in value) &
agrees to buy the underlying asset on a certain specified date, for a certain specified
price.
• The other party assumes a short position & agrees to sell the asset on the same date for
the same price.
• Forward contracts are normally traded outside the stock exchange.
• They are very useful in hedging & speculation.
• The contract price is generally not available on public demand.

• Each contract is customer designed & hence, is unique in terms of contract size,
expiration date & the asset type & quality.
FUTURES CONTRACT:

A futures contract is a legal agreement to buy or sell a particular commodity asset, or securityat a
predetermined price at a specified time in the future. Futures contracts are standardized forquality
and quantity to facilitate trading on a futures exchange. The buyer of a futures contractis taking on
the obligation to buy and receive the underlying asset when the futures contract expires. The seller
of the futures contract is taking on the obligation to provide and deliver theunderlying asset at the
expiration date.
Features of Futures
1. Organised Exchanges: Unlike forward contracts which are traded in an over-the-counter

market, futures are traded on organised exchanges with a designated physical location where
trading takes place. This provides a ready, liquid market in which futures can be bought and
sold at any time like in a stock market.
2. Standardisation: In the case of forward currency contracts, the amount of commodity to be

delivered and the maturity date are negotiated between the buyer and seller and can be tailor-
made to buyer’s requirements. In a futures contract, both these are standardised by the
exchange on which the contract is traded.
3. Clearing House: The exchange acts as a clearing house to all contracts struck on the trading
floor. For instance, a contract is struck between A and B. Upon entering into the records of the
exchange, this is immediately replaced by two contracts, one between A and the clearing house
and another between B and the clearing house.
4. Margins: Like all exchanges, only members are allowed to trade in futures contracts on the
exchange. Others can use the services of the members as brokers to use this instrument. Thus,
an exchange member can trade on his own account as well as on behalf of a client. A subset of
the members is the “clearing members” or members of the clearing house and non- clearing
members must clear all their transactions through a clearing member.
5. Marking to Market: The exchange uses a system called marking to market where, at the
end of each trading session, all outstanding contracts are reprised at the settlement price of that
trading session. This would mean that some participants would make a loss while others would
stand to gain. The exchange adjusts this by debiting the margin accounts of those members
who made a loss and crediting the accounts of those members who have gained.
Advantages of futures

1. Opens the Markets to Investors: Futures contracts are useful for risk-tolerant
investors. Investors get to participate in markets they would otherwise not have access
to.
2. Stable Margin Requirements Margin requirements for most of the commodities

and currencies are well- established in the futures market. Thus, a trader knows how
much margin he should put up in a contract.
3. No Time Decay Involved In options, the value of assets declines over time and
severely reduces the profitability for the trader. This is known as time decay. A futures
trader does not have to worry about time decay.
4. High Liquidity Most of the futures markets offer high liquidity, especially in case
of currencies, indexes, and commonly traded commodities. This allows traders to enter
and exit the market when they wish to.
5. Simple Pricing Unlike the extremely difficult Black-Scholes Model-based options

pricing, futures pricing is quite easy to understand. It's usually based on the cost-of-
carry model, under which the futures price is determined by adding the cost of carrying
to the spot price of the asset.
6. Protection Against Price Fluctuations Forward contracts are used as a hedging tool
in industries with high level of price fluctuations. For example, farmers use these
contracts to protect themselves against the risk of drop in crop prices.
7. Hedging Against Future Risks Many people enter into forward contracts for better
risk management. Companies often use these contracts to limit risk that may arise from
foreign currency exchange.
The Disadvantages of Futures Contracts
1. No Control Over Future

Events One common drawback of investing in futures trading is that you don't have any
control over future events. Natural disasters, unexpected weather conditions, political
issues, etc. can completely disrupt the estimated demand-supply equilibrium.
2. Leverage Issues

High leverage can result in rapid fluctuations of futures prices. The prices can go up
and down daily or even within minutes.
3. Expiration Dates
Future contracts involve a certain expiration date. The contracted prices for the given
assets can become less attractive as the expiration date comes nearer. Due to this,
sometimes, a futures contract may even expire as a worthless investment.
Futures Terminology
1. Commodity Futures Market – a physical or electronic marketplace where traders buy and
sell commodity futures contracts.
2. Commodity Futures Contracts – purchase and sales agreements having standardized

terms, including quantities, grades, delivery periods, price basis, and delivery methods of a
particular commodity.
3. Long Position - a buyer of futures contracts. A long position is the number of purchase
contracts held by the buyer.
4. Short Position - a seller of futures contracts. A short position is the number of sales contracts
held by the seller.
5. Trade Volume – the number of transactions executed for a particular time period. The
purchase by the buyer and sale by the seller of one futures contract equals a volume of ONE
(Purchases and sales are not double counted.)
6. Open interest – the number of futures contracts that exist on the book of the Clearinghouse.
One purchase and sale, involving two transacting parties – constitutes an open interest of ONE.
The number of purchase and sale contracts is always equal.
7. Closing Price – the fair value price trading near the end of the trading session, as determined
by the exchange.
8. Futures Delivery – the transfer of commodity ownership from the short (the seller) to the
long (the buyer) during the delivery period. Ownership is transferred by the surrender of
warehouse receipts or some other negotiable instrument specified by the contract.
9. Futures Expiration– the last trading day of futures contract.

10.Volatility – the variability of prices over time (historical) or projected (Implied) as

determined by a formula.
Trading process
The trading process of futures involves the following steps
1. Select brokerage
2. Opening a trading account
3. Choose a commodity or financial instrument to trade
4. Study different contract, the costs and goods
5. Develop a trading strategy 6. Purchase the futures contract
Future trading mechanism
1. Placing an order
2. Role of the clearing house
3. Daily settlement
4. Settlement
Role of clearing house
A clearing house acts as an intermediary between a buyer and seller and seeks to ensure that
the process from trade inception to settlement is smooth. Its main role is to make certain that
the buyer and seller honor their contract obligations. Responsibilities include settling trading
accounts, clearing trades, collecting and maintaining margin monies, regulating delivery of the
bought/sold instrument, and reporting trading data. Clearing houses act as third parties to all
futures and options contracts, as buyers to every clearing member seller, and as sellers to every
clearing member buyer. The clearing house enters the picture after a buyer and seller have
executed a trade. Its role is to consolidate the steps that lead to settlement of the transaction. In
acting as the middleman, a clearing house provides the security and efficiency that is integral
for financial market stability. Clearing houses take the opposite position of each side of a trade
which greatly reduces the cost and risk of settling multiple transactions among multiple parties.
While their mandate is to reduce risk, the fact that they have to be both buyer and seller at trade

inception means that they are subject to default risk from both parties. To mitigate this, clearing
houses impose margin (initial and maintenance) requirements.
Functions of clearing house
A clearing house is basically the mediator between two transacting parties. However, there is
also more to what clearing houses do. Let’s take a look at some of their functions in more detail.
1. The clearing house guarantees that the transactions will occur smoothly and that both
parties will receive what is due to them. This is done by checking the financial
capabilities of both parties to enter into a legal transaction, regardless of whether they
are an individual or an organization.
2. The clearing firm makes sure that the parties involved respect the system and follow
the proper procedures for a successful transaction. The facilitation of smooth
transactions leads to a more liquid market.
3. . It is the clearing house firm that provides a level playing field for both parties, where
they can agree on the terms of their negotiation. This includes having the responsibility
for setting the price, quality, quantity, and maturity of the contract.
4. The clearing house makes sure that the right goods are delivered to the buyer, in terms
of both quantity and quality, so that at the end of the transaction there are no complaints
nor arbitration necessary.
Margin system
In futures contract, the clearing house undertakes the default risk. To protect itself from this
risk, the clearing house requires the participants to keep margin money. Thus margins are
amounts required to be paid by dealers in respect of their futures position to ensure that both
parties will perform their contract obligations.
Types of margin
1. Initial Margin Initial Margin is the capital sum which an investor needs to park with his
broker as a down payment in its account to initiate trades. This acts as a collateral. An investor
can offer cash and securities or other collateral like open ended Mutual fund as collateral to
enter into a trade. In most cases, especially for equity securities, the initial margin requirement

is 30 % or exchange defined margin whichever is higher, but this may vary. And yes, both
buyers and sellers must put up a payment to enter into a trade.
2. Maintenance Margin After purchasing the stocks, a minimum balance called as

maintenance margin needs to be parked with the broker. In case the margin drops below the
limit, your broker will make a margin call and can also liquidate the position if you do not make
up for the requirement amount. Maintenance Margin varies between 20-30% subject to
minimum exchange charged margin and may change depending on a position an investor wants
to hold in a stock market.
3. Variation Margin Variation margin is the additional amount of cash you are required to
deposit in your trading account to bring it up to the initial margin after you have incurred
sufficient losses to bring it below the "Maintenance Margin". Variation Margin = Initial Margin
- Margin Balance.
Marking to Market Meaning
Marking to Market (MTM) means valuing the security at the current trading price. Therefore,
it results in the traders’ daily settlement of profits and losses due to the changes in its market
value.
• Suppose on a particular trading day, the value of the security rises. In that case, the
trader taking a long position (buyer) will collect the money equal to the security’s
change in value from the trader holding the short position (seller).
• On the other hand, if the security value falls, the selling trader will collect money from
the buyer. The money is equal to the change in the value of the security. It should be
noted that the value at maturity does not change much. However, the parties involved
in the contract pay gains and losses to each other at the end of every trading day.

Steps to Calculate Mark to Market in Futures
Mark to market in futures involves below two steps:
1. Determining Settlement Price
Various assets will have different ways of determining the settlement price, but
generally, it will involve averaging a few traded prices for the day. Within this, the last
few transactions of the day are considered since it accounts for considerable activities
of the day.
The closing price is not considered as it can be manipulated by unscrupulous traders to
drift the prices in a particular direction. The average price helps in reducing the
probability of such manipulations.
2. Realization of the Profit/Loss
The realization of profit and loss depends on the average price taken as the settlement
price and pre-agreed upon contract price.
Benefits of Marking to Market in Futures Contract
• Daily marketing to the market reduces counterparty risk for investors in Futures
contracts. This settlement takes place until the contract expires.
• Reduces administrative overhead for the exchange;
• It ensures that when the daily settlements have been made at the end of any trading day,
there will not be any outstanding obligations, which indirectly reduce credit risk.

Drawbacks of Mark to Market in Futures
• It requires continuous monitoring systems, which are very costly and can be afforded
only by large institutions.
• It can cause concern during uncertainty as the value of assets can swing dramatically
due to the unpredictable entry and exit of buyers and sellers.
SPECIFICATIONS OF A FUTURES CONTRACT
Following are the specifications required of a futures contract:
1. Expiration
Expiration (also known as maturity or expiry date) refers to the last trading day of the
futures contract. After the expiry of a futures contract, final settlement and delivery is
made according to the rules laid down by the exchange in the contract specifications
document.
2. Contract Size
Contract size, or lot size, is the minimum tradable size of a contract. It is often one unit
of the defined contract. For example, current contract size of PMEX sugar contract is
10 Tons. This implies that trading one contract creates a position of 10 tons of sugar.
PMEX rice contract has a contract size of 25 tons.
3. Initial Margin
Initial margin is the minimum collateral required by the exchange before a trader is
allowed to take a position. Initial margins can be paid in various forms as laid down by
the exchange and varies from commodity to commodity as well as from time to time.
The level of initial margin is dependent on the price volatility of the contract. More
volatile commodities generally have higher margin requirements.
4. Price Quotation
Price Quotation is the units in which the traded price of a contract is displayed. It can
be different from the trading size of a contract and is often based on industry practices
and conventions. While the contract size of PMEX sugar contract is 10 tons, its price is

quoted in Rupees per 100 kgs. PMEX Palm Oil contract has a size of 25 tons but its
price quotation follows local trade practices and is displayed as Rupees per maund.
5. Tick Size
Tick Size is the minimum movement allowed by the exchange in Price Quotation. For
example, the tick size of PMEX 100gms gold futures contract is Re. 1, whereas it is
$0.01 or 1cent for the PMEX 10oz gold futures contract.
6. Tick Value
Tick Value refers to the minimum profit or loss that can arise from holding a position
of one contract. Tick value depends on the size of the contract and its tick size. While
it is often explicitly mentioned in contract specifications, it can be calculated by the
formula:
Tick Value = Contract Size x Tick Size
7. Mark to Market
Mark to market refers to the process by which the exchange calculates and values all
open positions according to pre-defined rules and regulations. Mark-to-market is an
essential feature of exchange-traded futures contracts whereby the exchange ensures
that all profit and losses are recognized by pricing them according to accurate market
conditions. It is also an important feature for the risk management of positions of
participants.
8. Delivery Date
Delivery date or delivery period refers to the time specified by the exchange during or
by which the seller has to make delivery according to contract specifications and
regulations. Delivery date is often later than expiry date of a contract, especially in case
of physically delivered commodities.
9. Daily Settlement
Daily settlement refers to the process whereby the exchange debits and credits all
accounts with daily profits and losses as calculated by the mark-to-market process.

Daily settlement is necessary in order to recover losses and pay profits to respective
accounts.
VALUATION OF FORWARD AND FUTURES
The forward and futures pricing are based on the cost of carry model. The cost of carry model
is based on the premise that the future price of an asset is the spot price plus the cost of carry.
The cost of carry is an absolute number, but cost of carry model presents it in percentage terms.
The forward or future price will be higher than the current spot rate when the cost of carry is
positive and vice versa. The cost of carry or carry cost refers to the holding costs such as
insurance, storage and obsolescence cost including the interest cost on borrowing to buy the
assets. The cost of carry model does not apply to non-carry type commodities. The
commodities which are meant primarily for consumption purpose are known as non-carry type
commodities.
The calculation of forward and future price is based on the concept of continuous
compounding which is calculated as shown below.
r = (1+R/c)c
r = Continuously compounded rate of interest
R = Annual Rate of Interest
C= Compounding Factor
Assumptions of Cost of Carry Model
1. The market is assumed to be perfect.

2. Market participants have no influence on price.
3. There are no Transaction cost and tax
4. All assets are invisibly divisible.
5. No restriction for borrowing and lending and done at the same rate of interest.
6. There are no restrictions on short selling or shorting. (Selling an assets that is
not owned)
****************End of Unit 2******************

Module -3 Option Contracts 7 hours

Option Contracts: Meaning, features and types of option contracts-Options vs
futures/forwards-Mechanics of buying and selling option contracts-contract specifications of
stock, index and commodity options-Option pricing-factors affecting option pricing-Valuation
of option contracts using Black Scholes model and Binomial model-Put-call parity theory-
Option Greeks-Option Trading strategies-Interest rate options-Exotic options. (Numerical
problems on all aspects except exotic options). (Theory and Problems).
Meaning
Options contract is a type of derivatives contract which gives the buyer or holder of the contract the
right (but not the obligation) to buy or sell the underlying asset at a predetermined price within or at the
end of a specified period.
The buyer or holder of the option purchases the right from the seller or writer for a consideration which
is called the premium. The seller or writer of an option is obliged to settle the option as per the terms of
the contract when the buyer or holder exercises his right. The underlying asset could include securities,
an index of prices of securities, currency, etc.
Features of an option contract

Premium or down payment:
The holder of this type of contract must pay a certain amount called the ‘premium’ for having the right
to exercise an options trade. In case the holder does not exercise it, s/he loses the premium amount.
Usually, the premium is deducted from the total payoff, and the investor receives the balance.
Strike price:
This refers to the rate at which the owner of the option can buy or sell the underlying security if s/he
decides to exercise the contract. The strike price is fixed and does not change during the entire period
of the validity of the contract. It is important to remember that the strike price is different from the
market price. The latter changes during the life of the contract.
Contract size:
The contract size is the deliverable quantity of an underlying asset in an options contract. These
quantities are fixed for an asset. If the contract is for 100 shares, then when a holder exercises one
option contract, there will be a buying or selling of 100 shares.

Expiration date:
Every contract comes with a defined expiry date. This remains unchanged until the validity of the
contract. If the option is not exercised within this date, it expires.
Intrinsic value:
An intrinsic value is the strike price minus the current price of the underlying security. Money call
options have an intrinsic value.
Settlement of an option:
There is no buying, selling or exchange of securities when an options contract is written. The contract
is settled when the holder exercises his/her right to trade. In case the holder does not exercise his/her
right till maturity, the contract will lapse on its own, and no settlement will be required.
No obligation to buy or sell:

In case of option contracts, the investor has the option to buy or sell the underlying asset by the
expiration date. But he is under no obligation to purchase or sell. If an option holder does not buy or
sell, the option lapses.
Parties in Options Trading
There are three parties involved in the options trading:
➢ The option seller or option writer
➢ The option buyer
➢ The broker
➢ The Option Seller (writer) is a person who grants someone else the option to buy or sell. He
receives a premium (option price) in return. The option writer is usually a skilled market player
with an in-depth knowledge of the market. He is willing to take unlimited risk in return for a
limited profit. The premium paid by the buyer of option is his limited income, but loss is unlimited.
➢ The Option Buyer pays a price to the option writer to induce him to write the option. The trade
between options writer and buyer is a zero-sum game. Writer’s profit is buyer’s loss.
➢ The securities broker acts as an agent to find the option buyer and the seller, and receives a
commission or fee for it.

Players in the Option Market

• Hedgers: The objective of many players in the options market is to reduce the risk. They are
not in the options market to make profits. They want to safeguard their existing positions.
• Speculators: These are the traders whose objective is to make profits. They are willing to
take risks and they bet upon whether the markets would go up or come down.
• Arbitrageurs: Risk-less profit making is the prime goal of arbitrageurs. Buying in one
market and selling in another market. They could be making profits even without putting in
their own money and such opportunities often come up in the market but they last for very
short time frames.
Types of Options
I. Exercise Style
✓ American option: - It is an option where, it is can be exercised at any time on or before Expiry
date.
✓ European Option: - The option which can be exercised only at the time of maturity is termed as
European option.
II. Structure
✓ Call option: - A call option is one which gives the option holder the right to buy a underlying
asset. At a predetermined price called “Strike price or Exercise price on or before future date.
Call options are further of 2 types
In the money call option: In this case, the strike price is less than the current market price of the
security.
Out of the money call option: When the strike price is more than the current market price of the
security, a call option is considered as an out of the money call option.
✓ Put Option: - A put option is one which gives the option holder the right to sell an underlying
asset at a predetermined price on or before specified date.

Like call options, put options can further be divided into in the money put options and out of the
money put options.
In the money put options: A put option is considered in the money when the strike price is more than
the current price of the security.
Out of the money put options: A put option is out of the money if the strike price is less than the
current market price.
The put or call options can further be categorized into equity options, index options, foreign currency
options, option on futures and interest rate options.
1. Equity Options: The best known options are those that give their owner the right to buy or sell shares
of stock. These are stock options, also commonly called equity options. With exchange traded options,
the underlying asset is 100 shares of the stock. A person who buys a call option on the stock of a
particular company, he is purchasing the right to buy 100 shares of stock.
2. Index Options: Where the underlying asset of an option is some market measure like the NIFTY 50
Index, such an option is called index option. While these are similar to equity options in most respects,
one important difference is that they are cash-settled.
3. Future Option: The underlying asset is a futures contract. An option on a futures contract is like
other exchange traded options, except that holder acquire the right to buy or sell a futures contract on
an underlying asset, rather than the asset itself. When the holders of a call option exercise, they acquire
from the writers a long position in the underlying futures contract. When the holders of a put option
exercise, they acquire a short position in the underlying futures contract.
4. Currency Option: It gives the buyer the right to buy or sell a fixed quantity of a specified currency
in exchange for a specific quantity of another currency, in a ratio determined by the strike price of the
option.
5. Interest Rate Option: They are the instruments whose payoffs are dependent in some way on the
level of interest rates. They are used to hedge interest rate risk exposure.
III. Standard
•Standard Options: They are traded on recognized stock exchanges world over and their volume is
growing at an astronomical rate.

•Exotic Options: Besides trading options on the exchanges, it is also possible to enter into private option
arrangements with brokerage firms or other dealers. It is also called OTC option.
Basic Option Positions CALL PUT
BUY Right to buy Right to sell

WRITE Obligation to sell Obligation to buy
Payoff Profile for Buyer of Call Options:

A call option gives the buyer the right to buy the underlying asset at a strike price specified in the option.
The profit/loss that the buyer makes on the option depends on the spot price of the underlying.
If upon expiration the spot price exceeds the strike price, he makes a profit. Higher the spot price, more
is the profit he makes. On the other hand, if the spot price of the underlying is less than the strike price,
he lets his option expire un-exercised.
Factors Affecting Option Prices

Factors Affecting Call Prices
1. The current share price
The higher the current (spot) share price, the greater is the probability that the share price will increase
above the exercise price in future, and therefore the higher the call price. If the current share price is
low, the exercise price also will be low.
2. The exercise price
The higher the exercise price, the lower the option price i.e. the lower is the probability that the share
price will increase above the exercise price. For example, on Oct 20, the Nov-360 has an option price
of Rs.18, whereas the Nov-370 has an option price of only Rs.15.65.
3. The term to expiry
The longer the term to expiry, the greater is the probability that share price will increase above the
exercise price. Therefore, the longer the term to expiry, the greater is the call price. For example, on
October 20, the Oct-360 American call price is 9.35, whereas the Nov 360 American Call price is 18.
4. The Volatility of the Share
The volatility of a share is the variability of the price over time. Consider a high volatility share, H,
whose current price is Rs.5 and a low volatility share, L, whose current price is also Rs.5. Consider call
options on H and L, the expected values of the calls on shares H and L are:
E (call on H) = (0.2) (0.50) + (0.2) (1.00)

= Rs.0.30
E (call on L) = (0.16) (0.50) + (0.04) (1.00)
= Rs.0.12
The call on the low volatility share is less valuable than the call on the high-volatility share.
5. The risk-free interest rate

The buyer of a call option can defer paying for the shares. Because interest rates are positive, money
has a time value, so the right to defer payment is valuable. The higher the interest rate, the more valuable
is this right. Therefore, it is plausible to suggest that the higher the risk-free interest rate, the higher is
the price of a call.
6. Expected dividend
If a company pays a dividend to its ordinary shareholders the share price will fall on the ex-dividend
date. The price of a call will decrease if the price of the underlying share decreases. The calls on shares
that pay high dividends during the life of the call are worth less than calls on shares that pay low
dividends during the life of the call.
Factors Affecting Put Option Price

The buyer of the put option obtains the right to sell shares at the exercise price. The higher the exercise
price, the buyer of the put option stands to gain. For example, the buyer of the put option will prefer to
sell, if the exercise price is Rs.100 than Rs.90. Therefore, for put options, the higher the exercise price,
the higher the price of the option.
The buyer of the put option is willing the current share price should be low comparing with the exercise
price. Then the option Price will go up. For example, the current market price is Rs.90 and the exercise
price is Rs.100. The current market price lower than the exercise price. So, the price of the put option
will be high.
If the term of the put option is shorter, the price of the put option will be high. For example, Nov 350,
American put option price is 8.00 but Dec 350 American put option price is 2.65.
Higher volatility implies a greater chance of large increases and large decreases in the share price. From
the put holder’s viewpoint, share price increases are bad news, while decreases are good news. So, a put
holder has a favorable view of share price volatility.
A higher interest rate reduces the present value of whatever future cash inflow received by the put option
holder. If interest rate is low, the option price will be high.
Finally, dividend payments reduce share price, which benefits put holders, so higher expected dividend
payments increase put prices.

Exotic option
An exotic option is an option which has features making it more complex than commonly traded vanilla
options. Like the more general exotic derivatives they may have several triggers relating to
determination of payoff. An exotic option may also include non-standard underlying instrument,
developed for a particular client or for a particular market. Exotic options are more complex than options
that trade on an exchange, and are generally traded over the counter (OTC).
Valuation of option:
Binomial options pricing model
The binomial options pricing model (BOPM) provides a generalizable numerical method for the
valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein in 1979.
Essentially, the model uses a “discrete-time” (lattice based) model of the varying price over time of the
underlying financial instrument. In general, binomial options pricing models do not have closed-form
solutions.
The Binomial options pricing model approach is widely used as it is able to handle a variety of conditions
for which other models cannot easily be applied. This is largely because the BOPM is based on the
description of an underlying instrument over a period of time rather than a single point. As a
consequence, it is used to value American options that are exercisable at any time in a given interval
as well as Bermudan options that are exercisable at specific instances of time. Being relatively simple,
the model is readily implementable in computer software (including a spreadsheet).
The Black–Scholes Model

Black–Scholes–Merton model is a mathematical model of a financial market containing certain
derivative investment instruments. From the model, one can deduce the Black–Scholes formula, which
gives a theoretical estimate of the price of European-style options. The formula led to a boom in options
trading and legitimized scientifically the activities of the Chicago Board Options Exchange and other
options markets around the world. lt is widely used, although often with adjustments and corrections,
by options market participants. Many empirical tests have shown that the Black–Scholes price is "fairly
close" to the observed prices, although there are well-known discrepancies such as the "option smile".
The Black–Scholes was first published by Fischer Black and Myron Scholes in their 1973 paper, "The
Pricing of Options and Corporate Liabilities", published in the Journal of Political Economy. They
derived a stochastic partial differential equation, now called the Black–Scholes equation, which
estimates the price of the option over time. The key idea behind the model is to hedge the option by
buying and selling the underlying asset in just the right way and, as a consequence, to eliminate risk.
This type of hedge is called delta hedging and is the basis of more complicated hedging strategies such
as those engaged in by investment banks and hedge funds.
Assumptions of the Black-Scholes-Merton Model
Lognormal distribution: The Black-Scholes-Merton model assumes that stock prices follow a
lognormal distribution based on the principle that asset prices cannot take a negative value; they are
bounded by zero.
No dividends: The BSM model assumes that the stocks do not pay any dividends or returns.
Expiration date: The model assumes that the options can only be exercised on its expiration or maturity
date. Hence, it does not accurately price American options. It is extensively used in the European options
market.
Random walk: The stock market is a highly volatile one, and hence, a state of random walk is assumed
as the market direction can never truly be predicted.
Frictionless market: No transaction costs, including commission and brokerage, is assumed in the BSM
model.
Risk-free interest rate: The interest rates are assumed to be constant, hence making the underlying
asset a risk-free one.
Normal distribution: Stock returns are normally distributed. It implies that the volatility of the market
is constant over time.
No arbitrage: There is no arbitrage. It avoids the opportunity of making a riskless profit.
What Is Put-Call Parity?

The term "put-call" parity refers to a principle that defines the relationship between the price of European
put and call options of the same class. Put simply, this concept highlights the consistencies of these same
classes. Put and call options must have the same underlying asset, strike price, and expiration date in
order to be in the same class. The put-call parity, which only applies to European options, can be
determined by a set equation.
Put-call parity shows the relationship that has to exist between European put and call options that have
the same underlying asset, expiration, and strike prices.
This concept says the price of a call option implies a certain fair price for the corresponding put option
with the same strike price and expiration and vice versa.
Put-call parity doesn't apply to American options because you can exercise them before the expiry date.
If the put-call parity is violated, then arbitrage opportunities arise.

Option Greeks
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of
derivatives such as options to a change in underlying parameters on which the value of an instrument or
portfolio of financial instruments is dependent. The name is used because the most common of these
sensitivities are often denoted by Greek letters. Collectively these have also been called the risk
sensitivities, risk measures or hedge parameters.
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the value of a
portfolio to a small change in a given underlying parameter, so that component risks may be treated in
isolation, and the portfolio rebalanced accordingly to achieve a desired exposure; see for example delta
hedging.
The Greeks in the Black–Scholes model are relatively easy to calculate, a desirable property of financial
models, and are very useful for derivatives traders, especially those who seek to hedge their portfolios
from adverse changes in market conditions. For this reason, those Greeks which are particularly useful
for hedging delta, theta, and vega are well-defined for measuring changes in Price, Time and Volatility.
Although rho is a primary input into the Black–Scholes model, the overall impact on the value of an
option corresponding to changes in the risk-free interest rate is generally insignificant and therefore
higher-order derivatives involving the risk-free interest rate are not common.
The most common of the Greeks are the first order derivatives: Delta, Vega, Theta and Rho as well as
Gamma, a second-order derivative of the value function. The remaining sensitivities in this list are
common enough that they have common names, but this list is by no means exhaustive
Delta
Delta, , measures the rate of change of option value with respect to changes in the underlying asset's
price. Delta is the first derivative of the value of the option with respect to the underlying instrument's
price .
Vega
Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to the
volatility of the underlying asset.
Vega is not the name of any Greek letter. However, the glyph used is the Greek letter nu (). Presumably
the name vega was adopted because the Greek letter nu looked like a Latin vee, and vega was derived
from vee by analogy with how beta, eta, and theta are pronounced in American English. Another
possibility is that it is named after Joseph De La Vega, famous for Confusion of Confusions, a book
about stock markets and which discusses trading operations that were complex, involving both options

and forward trades.
Theta
Theta, , measures the sensitivity of the value of the derivative to the passage of time (see Option time
value): the "time decay."
The mathematical result of the formula for theta (see below) is expressed in value per year. By
convention, it is usual to divide the result by the number of days in a year, to arrive at the amount of
money per share of the underlying that the option loses in one day. Theta is almost always negative for
long calls and puts and positive for short (or written) calls and puts. An exception is a deep in-the-money
European put. The total theta for a portfolio of options can be determined by summing the thetas for
each individual position.
Rho
Rho, , measures sensitivity to the interest rate: it is the derivative of the option value with respect to the
risk free interest rate (for the relevant outstanding term).
Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free
interest rate than to changes in other parameters. For this reason, rho is the least used of the first-order
Greeks.
Rho is typically expressed as the amount of money, per share of the underlying, that the value of the
option will gain or lose as the risk free interest rate rises or falls by 1.0% per annum (100 basis points).
Lambda
Lambda, , omega, , or elasticity is the percentage change in option value per percentage change in the
underlying price, a measure of leverage, sometimes called gearing.
Arbitrage profits in options

Options arbitrage trades are commonly performed by floor traders in the options market to earn small
profits with very little or zero risk.
Traders perform conversions when options are relatively overpriced by purchasing stock and selling the
equivalent options position. When the options are relatively underpriced, traders will do reverse
conversions or reversals. In practice, actionable option arbitrage opportunities have decreased with the
advent of automated trading strategies.

Option Trading Strategies
Investors and speculators makes strategies to generate profit from price fluctuations in the financial
asset. the options trading strategies are broadly classified into 2 categories these are Spreads and
Combinations
Spread strategy
Spread strategy consists of taking a position in 2 options of the identical class that is either only in call
and only in put option. Spread strategy maybe design vertically which involves simultaneously buying
and selling of options on the same underlying asset for the same expiry month but different strike
price. Bull spread, Bear spread and Butterfly spread are belongs to this category
Combination Strategy
The combination strategies involves taking position in both the call and put option on the same
underlying assets. Combination strategies are straddle, strangle, box strategy strip and strap.
Bull Spread
Bull spread strategy can be constructed using either call option only or put option only under this
strategy one call is bored and one cold is sold on the same underlying asset with the same expiry date
but with a higher strike price if the spot rate is greater than the exercise price both option will be ITM
A bull spread is a bullish options strategy using either two puts, or two calls with the same underlying
asset and expiration. Bull Spread is a strategy that option traders use when they try to make profit from
an expected rise in the price of the underlying asset. It can be created by using both puts and calls at
different strike prices.
Bear Spread
A bear put spread consists of one long put with a higher strike price and one short put with a
lower strike price. Both puts have the same underlying stock and the same expiration date. A bear put
spread is established for a net debit (or net cost) and profits as the underlying stock declines in price.
A bear call spread is a bearish options strategy used to profit from a decline in the underlying asset
price but with reduced risk.

Butterfly Spread
The term butterfly spread refers to an options strategy that combines bull and bear spreads with a
fixed risk and capped profit. These spreads are intended as a market-neutral strategy and pay off the
most if the underlying asset does not move prior to option expiration. The butterfly spread is a neutral
strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options
strategy.
A condor spread is a non-directional options strategy that limits both gains and losses while seeking
to profit from either low or high volatility. There are two types of condor spreads. A long condor seeks
to profit from low volatility and little to no movement in the underlying asset.
Straddle
A straddle is an options strategy involving the purchase of both a put and call option for the same
expiration date and strike price on the same underlying security. The strategy is profitable only
when the stock either rises or falls from the strike price by more than the total premium paid. An options
straddle involves buying (or selling) both a call and a put with the same strike price and expiration on
the same underlying asset. A long – or purchased – straddle is the strategy of choice when the forecast
is for a big stock price change but the direction of the change is uncertain.
Strangles
A strangle is a popular options strategy that involves holding both a call and a put on the same
underlying asset. A strangle covers investors who think an asset will move dramatically but are unsure
of the direction. A strangle is profitable only if the underlying asset does swing sharply in price.
Box Spread
A box spread is an options arbitrage strategy that combines buying a bull call spread with a matching
bear put spread. A box spread's ultimate payoff will always be the difference between the two strike
prices. The longer the time to expiration, the lower the market price of the box spread today.
Strips and straps
Strips and straps are two options strategies applied to increase the returns from an investment. Both
strips and straps are related to options where market movements are compared with the underlying
stock’s prices. As profits can be made from both upward and downward direction of the stock’s value,
adding one or more options to increase the profit is the underlying concept in the case of strip and strap
option strategies.
Strip Options
Strips mean buying two put options and one call option at the same time where the expiry date, strike
price, and the underlying assets are identical. This is also considered as adding one more put option to
a straddle.
Strap Options
Straps strategy includes buying one more call option to a straddle. That is, there are two call options
and a put option in a strap. Adding the call option means investors are bullish about the movement of
their underlying stock.
************************* End of Unit 3**********************

Module -4 Financial Swaps 7 hours

Meaning, features and advantages of financial swaps-Types of financial swaps (Interest rate
swap, currency swap, equity swap and commodity swap)-Mechanics of interest rate swaps–
Triangular swap (Numerical problems only on interest rate swap including triangular swap)-
valuation of interest rate swaps- Only theory. (Theory and Problems).
Meaning:
The word ‘swap’ literally means an exchange. It is an agreement between the parties to
exchange their risks. A swap contract involves mutual exchange of the underlying assets
between the parties. A swap can either be an interest rate swap or a currency rate swap. Interest
rate swap involves exchange of fixed rate commitment for that of floating rate interest
commitment and vice versa. A currency swap involves exchange of currency between two
parties
A financial swap may be defined as a contract whereby two parties, exchange two streams of
cash flows over a defined period of time, usually through an intermediary like a financial
institution.
Swap refers to an exchange of one financial instrument for another between the parties
concerned. This exchange takes place at a predetermined time, as specified in the contract. A
swap in simple terms can be explained as a transaction to exchange one thing for another or
‘barter’. In financial markets the two parties to a swap transaction contract to exchange cash
flows. A swap is a custom tailored bilateral agreement in which cash flows are determined by
applying a prearranged formula on a notional principal. Swap is an instrument used for the
exchange of stream of cash flows to reduce risk.
Features of Swap
• Basically, a swap has to be entered between at least two parties. It means more than two
parties are possible when a third person is involved as an intermediary.
• Both the parties will have similar exposure in the market.
• One of the parties has an absolute advantage in one market, which the other party does
not have.
• In case of unequal exposures, the banks charge nominal fees to make the exposure
equal.
• The end result of the swap will be financial savings as compared to normal operations
for both the entities. This happens in most cases.

• Each party needs to manage their debt issues and are exposed to funding cost. Each
party wants to reduce their funding cost.

The advantages of swaps are as follows:

1) Swap is generally cheaper. There is no upfront premium and it reduces transactions
costs.
2) Swap can be used to hedge risk, and long time period hedge is possible.
3) It provides flexible and maintains informational advantages.
4) It has longer term than futures or options. Swaps will run for years, whereas
forwards and futures are for the relatively short term.
5) Using swaps can give companies a better match between their liabilities and
revenues.
The disadvantages of swaps are:
1) Early termination of swap before maturity may incur a breakage cost.
2) Lack of liquidity.
3) It is subject to default risk.
Types of Swaps
(I) Interest-rate swaps
Interest-rate swaps An interest rate swap (IRS) is a contractual agreement between counter-
parties to exchange a series of interest payments for a stated period of time. The payments in a
swap are similar to interest payments on a borrowing. A typical IRS involves exchanging fixed
and floating interest payments in the same currency.
Features of IRS
• There is no exchange of principal

• Only the interest payments are exchanged. They are usually netted on the settlement
dates and only the net value is exchanged between counter parties.
• Any underlying loan or deposit is not affected by the swap. The swap is a separate
transaction
Types of Interest Rate Swaps:

1. A Plain Vanilla Swap:
This is the simplest form of Interest rate swaps where a fixed rate is exchanged for a
floating rate or vice versa on a given notional principal at pre-agreed intervals during the
life of the contract.
2. A Basis Swap:
In a floating to floating swap, it is possible to exchange the floating rates based on different
benchmark rates. For example, we may agree to exchange 3m Mibor for 91 days T Bills rate.
Such a swap is called a Basis Swap.
3. An Amortising swap:
As the name suggests, swaps that provide for reduction in notional principal amount
corresponding to the amortisation of a loan, are called amortising swaps.
4. Step-up Swap:
This is the opposite of an amortising swap. In this variety the notional principal increases as
per a pre- agreed schedule.
5. Extendable Swap:
When one of the counter parties has the right to extend the maturity of the swap beyond its
original life, the swap is said to be an extendable swap.
6. Delayed Start Swaps/Deferred Swaps/ Forward Swaps:
When it is agreed between the counter parties that the swap will come into effect on a future
date, it is termed as a delayed start swap or deferred swap or a forward swap.
7. Differential Swaps:
Interest rate swaps which are structured in such a way that one leg of the swap provides for
payment of interest at a rate pertaining to a currency other than the currency of the underlying
principal amount. The other leg provides for payment of interest at the rate and
currency of the underlying principal.

II) Currency Swaps
Cross currency swaps are agreements between counter-parties to exchange interest and
principal payments in different currencies. Like a forward, a cross currency swap consists of
the exchange of principal amounts (based on today’s spot rate) and interest payments between
counter-parties. It is considered to be a foreign exchange transaction and is not required by law
to be shown on the balance sheet. In a currency swap, these streams of cash flows consist of a
stream of interest and principal payments in one currency exchanged for a stream, of interest
and principal payments of the same maturity in another currency. Because of the exchange and
re-exchange of notional principal amounts, the currency swap generates a larger credit
exposure than the interest rate swap.
Currency swaps give companies extra flexibility to exploit their comparative advantage in their
respective borrowing markets. Currency swaps allow companies to exploit advantages across
a matrix of currencies and maturities. Currency swaps were originally done to get around
exchange controls and hedge the risk on currency rate movements. It also helps in Reducing
costs and risks associated with currency exchange. They are often combined with interest rate
swaps. For example, one company would seek to swap a cash flow for their fixed rate debt
denominated in US dollars for a floating-rate debt denominated in Euro. This is especially
common in Europe where companies shop for the cheapest debt regardless of its denomination
and then seek to exchange it for the debt in desired currency
Features of Currency Swap
• They allow companies to exploit the global capital markets more efficiently because
they are an integral arbitrage link between the interest rates of different developed
countries
• Currency swaps give companies extra flexibility to exploit their comparative advantage
in their respective borrowing markets.
• They also provide a chance to exploit advantages across a network of currencies and
maturities.
• Currency swaps generate a larger credit exposure than interest rate swaps because of
the exchange and re-exchange of notional principal amounts.

• Currency swaps are priced or valued in the same way as interest rate swaps – using a
discounted cash flow analysis having obtained the zero coupon version of the swap
curves.
III) Commodity Swaps
A commodity swap helps producers manage their exposure to fluctuations in their products’
prices, and although they can be risky, these swaps are important for energy, chemical and
agricultural companies. The speculators who buy and sell these commodities through various
types of swaps are a crucial part of the market and play a key role in pricing these commodities.
Commodities are physical assets such as precious and base metals, energy stores (natural gas
or crude oil) and food (including wheat, pork bellies and cattle). These can be swapped for cash
flows under what’s called a commodity swap, through markets that involve two kinds of agents:
end-users (hedgers) and investors (speculators).
Types of Commodity Swaps
There are two types of commodity swaps: fixed-floating and commodity-for-interest. Fixed-
floating swaps are just like the fixed-floating swaps in the interest rate swap market, but they
involve commodity-based indices. General market indices in the commodities market like the
Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board Index
(CRB) place different weights on the various commodities, so they’ll be used according to the
swap agent’s requirements. Commodity-for-interest swaps are similar to the equity swap in that
a total return on the commodity in question is exchanged for some money market rate (plusor
minus a spread).
Valuing a Commodity Swap
In pricing a commodity swap, it’s helpful to think of the swap as a strip of forward contracts,
each priced at inception with zero market value (in a present value sense). Thinking of a swap
as a strip of at-the-money forwards is also a useful and intuitive way of interpreting interest
rate swaps or equity swaps.
A commodity swap is characterized by some idiosyncratic peculiarities that we should take

into account. These include:
1. The cost of hedging
2. The institutional structure of the particular commodity market in question

3. The liquidity of the underlying commodity market
4. Seasonality and its effects on the underlying commodity market
5. The variability of the futures bid/offer spread
6. Brokerage fees
7. Credit risk, capital costs and administrative costs
Some of these factors must be extended to the pricing and hedging of interest rate swaps,
currency swaps and equity swaps as well. The idiosyncratic nature of the commodity markets
refers more to the often-limited number of participants in these markets (naturally begging
questions of liquidity and market information), the unique factors driving these markets, the
inter-relations with cognate markets and the individual participants in these markets.
IV) Equity index Swap

An equity swap or an equity index swap is a contractual agreement between counter parties,
wherein at least one party agrees to pay the other a rate of return based on a stock index during
the life of the swap. An equity swap where one party periodically pays a fixed amount and
receives an amount based on the performance of a basket of shares or a stock index. In other
words, this swap involves the payment of periodic cash flows based on the change (positive or
negative) in the value of an equity index in return for a fixed or a floating rate of interest applied
to the notional principal.
The outstanding performance of equity markets in the 1980s and the 1990s, have brought in
some technological innovations that have made widespread participation in the equity market
more feasible and more marketable and the demographic imperative of baby-boomer saving
has generated significant interest in equity derivatives. In addition to the listed equity options
on individual stocks and individual indices, a burgeoning over the counter (OTC) market has
evolved in the distribution and utilization of equity swaps.
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. An exchange of the potential appreciation of equity’s value
and dividends for a guaranteed return plus any decrease in the value of the equity. An equity
swap permits an equity holder a guaranteed return but demands the holder give up all rights to
appreciation and dividend income. 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
stockholders do have. Equity swaps make the index trading strategy even easier. Besides
diversification and tax benefits, equity swaps also allow large institutions to hedge specific
assets or positions in their portfolios
Mechanics of Interest Rate Swaps
The most common type of a financial swap is an interest-rate swap. In this, one party, B,
agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on
a notional principal for a number of years. At the same time, party A agrees to pay party B cash
flows equal to interest at a floating rate on the same notional principal for the same period of
time. The currencies of the two sets interest cash flows are the same. The life of the swap can
range from two years to over 15 years.
LIBOR
The floating rate in many interest rate swap agreements is the London Inter-bank Offer Rate
(LIBOR). LIBOR is the rate of interest offered by banks on deposits from other banks in
Eurocurrency markets. LIBOR rates are determined by trading between banks and change
frequently so that the supply of funds in the inter-bank market equals the demand for the funds
in that market.
MIBOR- Mumbai Inter-Bank Offer Rate
The Mumbai Inter-Bank Offered Rate (MIBOR) is the interest rate benchmark at which banks
borrow unsecured funds from one another in the Indian interbank market. It is currently used
as a reference rate for corporate debentures, term deposits, forward rate agreements, interest
rate swaps, and floating-rate notes. The rate is only offered to first-class borrowers and lending
institutions, and it is calculated daily by the National Stock Exchange of India, the Fixed
Income Money Market, and the Derivative Association of India. It is determined by taking the
weighted average of the lending rates of all major banks or groups of banks throughout India.
*************** End of Unit 4****************

Module -5 Commodity Derivative Market 7 hours
Commodity Derivative Market: Meaning of commodity derivatives-Commodity derivative

exchanges (with commodities traded) in India-Trading and settlement system of commodity
derivatives-SEBI Guidelines for commodity market-commodities traded. (Theory).
Introduction
A commodity is generally defined as a group of items or assets that can be traded or exchanged.
It should, however, be noted that all goods except for money and claims can be bought and
sold.
Commodity derivatives are financial instruments that allow investors to profit from
commodities without actually owning them, according to the definition. A derivatives contract
entails the right to exchange a commodity at a later date for a specified price.
Meaning of Commodity Derivative Market:
Commodity Derivative is Market is a place, where the investor can directly incest in
Commodities, rather than investing in those companies that trade in these commodities. In other
words, Commodity Derivative markets are the market, where the trade is undertaken through
a future/options/swap contract. Under these contracts, as the name suggest, transaction is
completed at a future date. Commodity Derivatives markets are a good source of critical
information and indicator of market sentiments. Since commodities are frequently used as input
in the production of goods or services, uncertainty and volatility in commodity prices and raw
materials makes the business environment erratic, unpredictable and subject to unforeseeable
risks.
Commodity Derivative Contract:
A derivative contract, which has a commodity as its underlying, is known as a ‘commodity

derivatives’ contract. According to clause (bc) of section 2 of the SCRA, commodity
derivative” means a contract: (i) for the delivery of such goods, as may be notified by the
Central Government in the Official Gazette, and which is not a ready delivery contract; or (ii)
for differences, which derives its value from prices or indices of prices of such underlying
goods or activities, services, rights, interests and events, as may be notified by the Central

Government, in consultation with the Board, but does not include securities as referred to in
sub-clauses (A) and (B) in the definition of Derivatives.
Types of Derivative Contracts:
There are 4 types of derivative contracts are involved in the commodity market :
• Forwards – Private agreements where the buyer commits to buy, and the seller
commits to sell.
• Futures – Standardized forms of forwards that trade on exchanges.
• Options – Give the holder the right to buy or sell the underlying asset on a fixed
date in the future.
• Swaps – Contracts through which two parties exchange streams of cash flows.
Advantages of commodity derivatives markets
Commodity derivatives market provides various direct and indirect benefits to commodity
value chain participants. The key benefits of Commodity derivatives market are as follows:
(a) Price Discovery: Provides a nationwide platform for discovery of prices and enabling
physical market participants to hedge their price
(b) Hedging Price Risk: In the absence of Derivatives, various value chain participants like
small producers and end users lose an invaluable tool for hedging their price risk, getting
advance price signals of the commodity and for making informed decision on cropping, timing
of sales
(c) Investment Opportunity: A successful derivative contract in any commodity catalyzes the
development of marketing infrastructure like warehousing, assaying facilities which in turn
facilitates pledge financing through warehousing and banks
(d) Diversification: Commodity prices are prone to supply-demand dynamics, weather

conditions, geo-political tensions and natural disasters. Accordingly, commodities are an
independent asset class, and can prove to be an effective means of diversification in one’s
investment portfolio.
Disadvantages of commodity derivatives markets
Despite the benefits that derivatives bring to the commodity markets, the derivative contracts
come with some significant drawbacks;

(i) High risk The high volatility of derivatives exposes them to potentially huge losses.
The sophisticated design of the contracts makes the valuation extremely
complicated or even impossible. Thus, they bear a high inherent risk.
(ii) Speculative features Derivatives are widely regarded as a tool of speculation. Due
to the extremely risky nature of derivatives and their unpredictable behavior,
unreasonable speculation may lead to huge losses.
(iii) Counter-party risk Although derivatives traded on the exchanges generally go
through a thorough due diligence process, some of the contracts traded over-the-
counter do not include a benchmark for due diligence. Thus, there is a possibility of
counter-party default.
Features of Commodity Derivative Markets
The followings are the features of commodity Derivative Market;
(a) Complement to investment in Companies that use commodities.
(b) Defines pattern of Country’s Production and Consumption.
(c) Gains are in the forms of Price increases, not dividends.
Players in the commodity derivatives market
1. Risk givers or hedgers refer to those who have a risk due to physical exposure to the
commodity and are looking to pass on their risk by taking a sell or buy position on
Stock Exchange.
2. Risk takers or investors refer to those who do not have physical exposure to the
commodity, but who are willing to take a buy or sell position or risk with the aim of
making gains from inequalities in the market. Financial investors and arbitrageurs are
the investors in this market.

Commodity Exchanges in India

The commodity exchanges in India are
regulated by the Securities and Exchange
Board of India (SEBI) since 2015, which is
also the regulatory authority for equity
markets. Prior to this, the FMC or Forwards
Market Commission, overseen by the
Ministry of Consumer Affairs regulated the
Indian commodity exchanges.
Commodity market in India:

India is one among the top-5 producers of most of the commodities and to being a major
consumer of bullion and energy products. Agriculture contributes about for about 22%
to the GDP of the Indian economy. It employees for about 57% of the labor force on a
total of 163 million hectares of land. Agriculture sector is a significant factor in
achieving a GDP growth of 8-10%. All this point out that India can be promoted as a
main centre for trading of commodity derivatives.
It is regrettable that the policies of FMC during the most of 1950s to 1980s suppressed
the markets. But in fact it was supposed to encourage and nurture to grow with times.
It was a mistake and other emerging economies of the world would want to avoid such
instance. However, it is not in India alone those derivatives were suspected of creating
too much speculation that would be damaging the healthy growth of the markets and
the farmers. Such suspicions may generally arise due to a misunderstanding of the
characteristics and role of derivative product. It is significant to understand why
commodity derivatives are necessary and the role they can play in risk management. It
is general knowledge that prices of commodities, metals, shares and currencies fluctuate
over time. The opportunity of adverse price changes in future creates risk for
businesses. Derivatives are used to diminish or eliminate price risk arising from
unforeseen price changes. A derivative is a financial contract whose price depends on,
or is resultant from, the price of another asset.

Two important types of Commodity Derivatives

Commodity Futures Contracts
A futures contract is a contract for buying or selling a commodity for a predetermined
delivery price at a specific future time. Futures are standardized agreements that are
traded on organized futures exchanges that ensure performance of the contracts and
therefore eliminate the default risk. The commodity futures had existed ever since the
Chicago Board of Trade (CBOT) was established in 1848, in view to bring farmers and
merchants together. The main function of futures markets is to transfer price risk from
hedgers to speculators. For instance, suppose a farmer is expecting his crop of wheat to
be ready in two months time, but is worried that the price of wheat may turn down in
this period. In order to minimize his risk, he can penetrate into a futures contract to sell
his crop in two months’ time at a price determined now. In this way he is able to hedge
his risk arising from a probable adverse change in the price of his commodity.
Commodity Options contracts
options are also financial instruments like hedges, which are used for hedging and
speculation. The commodity option holder has the right, except he don’t have the
obligation, to buy (or sell) a specific quantity of a commodity at a specified price on or
before a specified date. Option agreements involve two parties, namely the seller of the
option writes the option in favor of the buyer (holder) who pays a certain premium to
the seller as a price for the option. There are two kinds of commodity options. First one
is a ‘call’ option gives the holder a right to buy a commodity at an agreed price and the
other one is ‘put’ option gives the holder a right to sell a commodity at an agreed price
on or before a specified date (called expiry date).
COMMODITY DERIVATIVE EXCHANGE

A commodities exchange is an exchange, or market, where various commodities are
traded.
MULTI COMMODITY EXCHANGE OF INDIA LTD (MCX)
Multi Commodity Exchange of India Ltd (MCX) is an independent commodity
exchange based in India. It was established in 2003 and is based in Mumbai. It is India's
largest commodity derivatives exchange where the clearance and settlements of the
exchange happen and the turnover of the exchange for the quarter ended September
2018 was 1.78 billion rupees. MCX offers options trading in gold and futures trading

in non-ferrous metals, bullion, energy, and a number of agricultural commodities

(mentha oil, cardamom, crude palm oil, cotton, and others).
In 2016, MCX was seventh among the global commodity exchanges in terms of the
number of futures contracts trade, the latest yearly data from Futures Industry
Association (FIA) showed. In 2017 MCX partnered with Thomson Reuters to develop
India’s first co-branded commodity index series, the I COMDEX. I COMDEX series
consists of I COMDEX Composite, I COMDEX Base Metals, I COMDEX Bullion, I
COMDEX Gold, I COMDEX Copper and I COMDEX Crude Oil. Recently, the
exchange has set up a web-based application "ComRIS" (Commodity Receipts
Information System) in order to maintain an electronic record of commodities deposited
at the Exchange accredited warehouses and ensure flow of real time information from
the warehouses.
In February 2012, MCX had come out with a public issue of 6,427,378 Equity Shares
of Rs. 10 face value in the price band of Rs. 860 to Rs. 1032 per equity share to raise
around $134 million. It was the first-ever IPO by an Indian exchange and made MCX
India’s only publicly listed exchange. From 28 September 2015, MCX is being
regulated by the Securities and Exchange Board of India (SEBI). Earlier MCX was
regulated by the Forward Markets Commission (FMC), which got merged with the
SEBI on 28 September 2015.
Commodities traded include

➢ Metal - Aluminum, Copper, Lead, Nickel, Zinc, Brass(futures)
➢ Bullion - Gold, Gold Mini, Gold Guinea, Gold Petal, Gold Petal (New Delhi),
Gold Global, Silver, Silver Mini, Silver Micro, Silver 1000.
➢ Agro Commodities - Cardamom, Cotton, Crude Palm Oil, Kapas, Mentha Oil,
and Castorseed, RBD Palmolien, Black Pepper.
➢ Energy - Crude Oil, Natural Gas.

NATIONAL COMMODITY & DERIVATIVES EXCHANGE LIMITED (NCDEX)
National Commodity & Derivatives Exchange Limited (NCDEX) is an online commodity

exchange based in India. It has an independent board of directors and provides a commodity
exchange platform for market participants to trade in commodity derivatives. It is a public
limited company, incorporated on 23 April 2003 under the Companies Act, 1956 and obtained
its Certificate for Commencement of Business on 9 May 2003. It commenced operations on 15
December 2003.As of 31 July 2013, NCDEX has 848 registered members and client base of
about 20 Lakhs and offers trading on more than 49,000 terminals across 1,000 centers in India.
It facilitates deliveries of commodities through a network of over 594 accredited warehouses
through eight warehouse service providers, with holding capacity of around 1.5 million tonnes
and offers average deliveries of 1 lakh MT at every contract expiry. NCDEX has offices in
Mumbai, Delhi, Ahmedabad, Indore, Hyderabad, Jaipur, and Kolkata
Products traded on NCDEX:
• Cereals and pulses: Barley, chana, maize kharif, maize rabi, wheat, moong, paddy
(basmati)
• Fibres: Kapas and 29 mm cotton.
• Guar complex: Guar seed and guar gum.
• Oil and oil seeds: castor seed, cotton seed oil cake, soy bean, refined soy oil, mustard
seed and crude palm oil.
• Sugar.
THE NATIONAL MULTI COMMODITY EXCHANGE OF INDIA LTD. (NMCE)
The National Multi Commodity Exchange of India Ltd. (NMCE) was launched on
November26, 2002 as India's first online, demutualized commodity exchange by a group of
Indian commodity-based corporations and public agencies, and listed its first contracts on 24
commodities in November 2002.As of July 2016, the NMCE listed futures contracts on a total
of 13 different commodities, ranging from oils and oil seeds, to rubber, sacking, raw jute,
coffee, Isabgul seed, chana, pepper and cardamom. India's commodities market space received
a fourth exchange competitor named the Indian Commodity Exchange (ICEX) in 2009 but it
closed in 2014. NMCE and ICEX agreed to merge in July 2017 and were to close the deal by
December 2017. The merger was forged in part by an Indian regulatory requirement that the
exchange meet a Rs 100-core minimum net worth for commodity exchanges. At the time of

the merger, the NMCE's net worth was Rs 76 core, while ICEX's net worth was Rs 100 core.
ICEX was given regulatory approval in July 2017 to restart its operations
INDIAN COMMODITY EXCHANGE LIMITED (ICEX)
Indian Commodity Exchange Limited (ICEX) is SEBI regulated online Commodity Derivative
Exchange. Headquartered at Mumbai, the Exchange provide nationwide trading platform
through its appointed brokers. Some of Prominent shareholders are MMTC Ltd, Central
Warehousing Corporation, Indian Potash Ltd, KRIBHCO, Punjab National Bank, IDFC Bank
Ltd, Gujarat Agro Industries Corporation, Reliance Exchange next Ltd, Bajaj Holdings &
Investment Ltd, Gujarat State Agricultural Marketing Board, NAFED and India bulls Housing
Finance Ltd The Exchange launched world’s first ever Diamond derivative contracts. ICEX
aims to provide futures trading products in India’s all economically relevant commodity. At
present it offers futures contract in Diamond. Providing desired price risk hedging solution to
the trade through innovative contract designing forms core value of ICEX. This Exchange is
ideally positioned to leverage the huge potential of commodities market and encourage
participation of actual users to benefit from the opportunities of hedging, risk management and
supply chain management in the commodities markets. ICEX is the first Exchange in India to
adopt global hi-tech platform that ensures automatic and seamless switch-over from its Data
Center (DC) to the Disaster Recovery (DR) site with zero data loss in case of exigencies. The
technology platform has highly optimized processing techniques, which enables the system to
handle very large orders with latencies under 300 microseconds
AHMEDABAD COMMODITY EXCHANGE, (ACE DERIVATIVES AND

COMMODITY EXCHANGE)
Ahmedabad Commodity Exchange, also known as ACE Derivatives and Commodity

Exchange is India's fifth national commodities exchange, was launched on October 26, 2010.
The exchange opened, offering contracts on soybeans, soy oil, rape mustard seed, castor seed
and chickpeas with plans to offer other contracts such as energies, metals and spices. ACE's
launch was the first time a regional Indian market was upgraded to a national market. The all-
electronic market is 51 percent owned by Kotak Mahindra Group, an Indian banking and
financial services firm. Other investors include The Haryana State Cooperative Supply &
Marketing Federation Ltd. (HAFED), a state cooperative service and marketing organization.
Other investors include: Bank of Baroda, Corporation Bank and Union Bank. The exchange
opened with 230 registered members. The exchange joins other Indian commodity exchanges:

National Multi-Commodity Exchange (NMCE), National Commodity and Derivatives

Exchange (NCDEX), Multi Commodity Exchange of India (MCX), and Indian Commodity
Exchange (ICEX).The exchange lists a host of commodity products, some of which are offered,
others which are planned for launch. ACE's agriculture contracts include: castor seed, mustard
seed, soybeans, refined soy oil, mustard seed and chickpeas or chana and sugar. It also lists
turmeric, a staple spice used in India. Among the non-agricultural contracts announced by the
exchange are: gold, silver, copper, zinc, nickel, crude oil and natural gas.
The nature of Commodities that can be trades in the Commodity Derivative Market
The following features should exist in Commodities, to be eligible for Derivatives Trading-
1. Storage and Durability: Commodity should be durable with storage possibilities, since it
provides a hedge against Price Risk for the carrier of Stocks.
2. Homogeneous: Units must be homogeneous, so that the commodities are actually delivered
in the Derivative Market.
3. Price Fluctuation: The Commodity must be subject to frequent price fluctuations with wide
amplitude, supply and demand must be large, since it creates greater avenues for trading in
Commodity Derivatives.
4. Cash Market Risk: Supply must flow naturally to market and there must be breakdowns in
an existing pattern of forward contracting. This indicates that, the Cash Market Risk must be
present, for Commodity Derivative Market to came into existence. If the Price fluctuations are
eliminated using a Cash Forward Contract, the Commodity Derivatives Market would be of
limited use.
Commodity Trading in India
The Securities and Exchange Board of India (SEBI) regulates commodity trading in India.
While the Commodity Derivatives Market Regulation Department (CDMRD) looks after its
day-to-day operations. Recently, SEBI allowed mutual funds and PMSs to trade in the
commodities derivatives segment. Commodity exchange in India trades from Monday to
Friday. The trade timings are IST 9:00 A.M. to 05:00 P.M. for agricultural commodities.
For non-agricultural commodities like metals, crude oil, etc., the trade timing is IST 10:00
A.M. to 11:55 P.M.
How to Invest in Commodities?

Commodity trading isn’t the only means of investing in commodities. You can also invest in
stocks of companies that produce commodities. Or you could invest in exchange-traded funds
(ETFs) or mutual funds that track these commodities. Here are five basic ways to invest in
commodities.
1. Physical Commodity: Investors can buy actual physical commodities like gold and other
precious metals and sell it at a profit in the future. But the biggest issue with physical
commodity trading is the high logistics cost and expensive insurance which eats into the returns
generated by the asset.
2. Commodity ETFs: Commodity exchange traded funds are passively managed and invest in
physical commodity and futures contracts which are traded on the exchange on real-time basis.
They help investors benefit from price appreciation of the commodities without the hassle and
liquidity issues of physical commodity trading.
3. Commodity Mutual Funds: These are actively managed mutual funds which in turn invest
in commodity ETFs. They offer the benefit of diversification and issues of liquidity in
commodity ETFs are eliminated with commodity mutual funds. Since lakhs of investors invest
collectively in commodity mutual funds, economies of scale are also achieved.
4. Commodity Options: Investors can also take exposure to commodities using commodity
options contracts. In a commodity options contract, the buyer has the right but not the
obligation to buy or sell the underlying commodity in the future at a particular strike price.
Commodity options are better than futures contract as the buyer has no obligation to
compulsorily buy or sell the underlying asset.
MCX offers commodity options contracts in Gold, Silver, Crude Oil and Zinc.
NCDEX offers commodity options contracts in Soya bean, soya refined oil, guar seed, guar
gum, Chana etc.

5. Commodity Futures: This is a contract between two parties to buy and sell the underlying
commodity at a fixed price and date in the future. Irrespective of the price on the settlement,
both parties have to honour their futures contract. Commodity futures contract are available on
Petroleum, Gold, Silver, Natural Gas, Wheat, Cotton etc. They are generally used by
commodity producers to hedge against adverse price movements.
HOW TO TRADE IN COMMODITY FUTURES
2. The trader deposits the margin amount with the broker
3. He places the order
4. The buyers and sellers are matched on the exchange platform electronically
5. The exchange determines a 'settlement price' for each commodity when the market closes.
Depending on how the price has moved, the difference is credited to or debited from the trader’s
account
6. The trader pays the margin shortfall (if any)
7. The trader closes his position before the contract expires. He may also choose to opt for the
delivery option that requires a separate documentation process.
BENEFITS OF COMMODITY TRADING
Diversification - Commodity returns have a low correlation to returns from other assets. As an
individual asset class, commodities can be considered to diversify your investment portfolio.
Inflation safeguard - Commodities are considered a good hedge against inflation as their
prices tend to rise during periods of high inflation. This helps maintain the purchasing power
parity.
Hedge against event risk - Supply disruptions during a natural disaster, an economic crisis, or
war could push up the prices of commodities. However, the trading of commodities could help
you guard against loss by leveraging strategically on price swings. For instance, to lock inthe
input price of a raw material, a consumer could take a long hedge by buying a Futures contract
based on the commodities price today. Meanwhile, a producer that is aiming for a highsale price
could choose a short hedge by selling a Futures contract.

**********************End of Unit 5**********************
Module -6 Credit Derivatives and VaR 7 hours
Credit Derivatives-Total Return Swap (TRS)-Credit Default Swap (CDS)-Types of CDS-Asset

Backed Securities (ABS)-Collateralized Debt Obligation (CDO)-Sub-Prime Crisis-2007-
Credit Spread Options-Probability of Default- Forward Rate Agreement (FRA)-Interest Rate
Caps/Floors/Collars-Types of Interest Rates-Zero Rate Forward Rate-Value-at-Risk-Meaning,
VaR Models-Stress testing and back testing. (Numerical problems only on VaR, Zero Rate and
Forward rate). (Theory and Problems).
Credit Derivatives
A credit derivative is a financial asset in the form of a privately held bilateral contract between parties
in a creditor/debtor relationship. A credit derivative allows the creditor to transfer the risk of the
debtor's default to a third party, paying it a fee to do so.
A credit derivative is a contract whose value depends on the creditworthiness or a credit event
experienced by the entity referenced in the contract.
Credit derivatives (CDs) are derivative contracts that enable a lender to transfer a debt instrument’s
credit risk to a third party in exchange for a payment. However, there is no actual transfer of
ownership of the instrument. They protect the lender against the loss associated with the risk of default
by the borrower.
Features of CDs
• Credit derivatives (CDs) are a type of derivatives instrument that allows the transfer of credit
risk from a lender to a third party against payment of a fee.
• Credit risk is the risk of loan or debt default.
• There are three parties to a credit derivative contract: borrower (reference entity), lender
(protection buyer), and third party (protection seller).

• Credit derivatives may be funded or unfunded. They include credit default swap, credit spread
option, credit linked note, and collateral debt obligation.
• CDs are the buffer against economic volatility.
The Credit derivatives refers to the financial instruments which are designed to transfer the credit risk
from one person to another person the lenders can mitigate the credit risk by using various techniques
such as
• Netting of payments
• Collateralisation and
• Downward triggers
Netting: Settling the net payments after adjusting the receipts to be received from the same party
to which the payments are to be made is called netting. For instance, assume that the firm a has
to pay ₹5,000,000 to the firm B and the firm B has to pay ₹18,000,000 to firm A. As per netting,
the firm B has to pay 13,000,000 that is (18 – 5) to the firm A and the firm A need not to pay
anything to the firm B. Thus, the netting eliminates counter payments and avoid transaction costs
and currency conversion costs in case of international receipts and payments. Netting has
become standard in OTC market and substantially reduce credit risk of business firm or financial
institutions.
Collateralization: Collateral is a property or asset offered as a security by the borrower to the

lender and if the borrower defaults the payment of interest or repayment of principal, the lender
can seize the asset to recover the due. Under collateralisation agreement the financial institutions
will specify the threshold level and contracts will be periodically valued. If value of the contract
is above the threshold level, the company has to bring in additional collateral to bridge the gap
between the value of the contract to the financial institution and the threshold level. In the event
of a default by the company to post collateral as required the existing collateral can be seized by
the financial institutions and close out the contract.
Downgrade trigger: Under downgrade trigger the financial institutions will set a minimum level

of credit rating and if credit rating of the counterparty falls below the level the contract will be
closed out however the counterparty is not benefited from the increase in the credit rating
Types of Credit Derivatives

There are two broad categories of credit derivatives:
• Unfunded credit derivatives are instruments where the seller (lender) does not guarantee any
payments to the buyers. The buyer gets paid only when the seller receives the loan repayments
from borrowers. The buyer bears the entire credit risk.
• Funded credit derivatives are instruments where the seller makes an initial payment to cover
any future credit defaults. Therefore, the buyer is not exposed to the credit risk.
1. Credit default Swap (CDS):

The most popular form of unfunded credit derivative is Credit Default Swap (CDS). In a credit default
swap, the seller negotiates an upfront or continuous fee, in order to compensate the buyer when a
specified event, such as default or failure to make a payment occurs. The benefit to the buyer and the
seller in CDS is that the buyers can remove risky entities from their balance sheets without having to
selling them while the sellers can gain higher returns from investments by entering markets which are

otherwise difficult for them to get into.

Credit default swap is an OTC traded financial swap agreement wherein the seller of the CDS will
compensate the buyer in the event of a loan default by the borrower. In other words it is an agreement
between 2 parties where in the buyer of CDS will make series of payments in exchange for receiving a
pay off in the event of a loan default by the borrower.
Types of CDS
1. Credit default swaps on single entities:

In this form, the swap is on a single entity. It is a financial contract which allows a seller of credit
protection to transfer the credit risk of a single issuer to a buyer of credit protection without
transferring ownership of an underlying asset.
2. Credit default swaps on a basket of entities:
In this the swap is on a bunch of entities combined. It is similar to a single entities default swaps
except that the underlying is a basket of entities rather than one single entity. The popular ones are
first-to-default, nth-to-default, all-to-default.
3. Credit default index swaps:
This includes a portfolio of single entity swaps. It is a credit derivative used to hedge credit risk or to
take a position on a basket of credit entities. It is a benchmarks for protecting investors against the
default.
4. First-loss and tranche-loss credit default swaps:
In this type, the buyer is compensated for any losses from the credit events unlike that in the first loss
credit default swap which only compensates the loss from the first credit event
Another version of CDS are

1. Digital CDS
The greatest difficulty of non-digital CDs calculation of market value which results into
uncertainty on the calculation of settlement amount required on the event of default. In the light
of this problem digital CDS was emerged in which the value of payoff is fixed and does not
consider the market value of the asset on default.
2. Basket CDS
Basket CDS the protection buyer wants to protect the entire portfolio of bond or loans instead of
single bond or loan. The portfolio is considered as a bundle of credit risk and the basket CDS
will terminated on the first default.

3. Portfolio CDS
Portfolio CDS is similar to basket CDs except for the difference that the basket CDs is terminated
on first default while portfolio CDS continue even after first default.
2. Credit default swap option
It is a contract that offers its buyer a right, without obligation, to enter into a CDS agreement on a future
date at a specific strike price. A credit default swap (CDS) is a contract between two parties in which
one party purchases protection from another party against losses from the default of a borrower for a
defined period of time. A credit default swap (CDS) option, or credit default swaption, is a contract that
provides the holder with the right, but not the obligation, to enter into a credit default swap in the future.
CDS options can either be payer swaptions or receiver swaptions. If a payer swaption, the option holder
has the right to enter into a CDS where they pay premiums; and, if a receiver swaption, the option holder
receives premiums.
.
3. Credit spread option
This type of CD involves simultaneously buying and selling an option of the same class (with the same
underlying asset and expiry date) at a different strike price. The difference in the strike prices yields
profit. A credit spread, or net credit spread, involves a purchase of one option and a sale of another
option in the same class and expiration but different strike prices. Investors receive a net credit for
entering the position, and want the spreads to narrow or expire for profit.
A financial derivative contract that transfers credit risk from one party to another. An initial premium is
paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current
level.
The buyer of a credit spread option will receive cash flows if the credit spread between two specific
benchmarks widens or narrows. Credit spread options come in the form of both calls and puts, allowing
both long and short credit positions.
Credit spread options can be issued by holders of a specific company's debt to hedge against the risk of
a negative credit event. The buyer of the credit spread option (call) assumes all or a portion of the risk
of default, and will pay the option seller if the spread between the company's debt and a benchmark
level (such as LIBOR) grows.

Options and other derivatives based on credit spreads are vital tools for managing the risks associated
with lower-rated bonds and debt.
4. Total-rate-of-return swap
It involves the transfer of both credit and interest rate risks associated with the underlying financial asset
to a third party. Here also, the transfer of risk is without the transfer of the ownership of the underlying
asset. It is defined as the total transfer of both the credit risk and market risk of the underlying asset. The
assets commonly are bonds, loans and equities.
1. Credit linked note (CLN):

It is structured as a security with an embedded CDS allowing the issuer to transfer a specific credit risk
to credit investors. In this case the issuer is not obligated to repay the debt if a specified event occurs.
The ultimate purpose of the CLN is to pass on the risk of specific default to the investors who are willing
to bear the risk in return for higher yield.
2. Constant Proportion Debt Obligation (CPDO):
CPDO is a complex financial instrument, invented in 2006 by ABN Amro and designed to pay the same
high interest rate as a risky junk bond while offering the highest possible credit rating. It is defined as a
type of synthetic collateralized debt instrument that is backed by a debt security index. These are credit
derivatives for the investors who are willing to take exposure to credit risk.
3. Collateralized debt obligation (CDO):
It is a type of structured asset backed security (ABS). The CDO is divided into tranches through which
the flow of payments is controlled. The payments and interest rates vary with the tranches with the most
senior one paying the lowest rates and the lowest tranche paying the highest rates to compensate for the
default risk. Synthetic CDOS are credit derivatives that are synthesized through basic CDs like CDSs
and CLNs. These are divided into credit tranches based on the level of credit risk.
It is a type of structured asset backed security (ABS). The CDO is divided into tranches through which
the flow of payments is controlled. The payments and interest rates vary with the tranches with the most
senior one paying the lowest rates and the lowest tranche paying the highest rates to compensate for the
default risk. Synthetic CDOS are credit derivatives that are synthesized through basic CDs like CDSs
and CLNs. These are divided into credit tranches based on the level of credit risk.
A CDO is a way of creating securities with widely different risk characteristics from a portfolio of debt
instruments.
Merits & Demerits of CDOs

Merits:
– Different Trenches allow Investors to customize their Credit Risk exposure
– Efficient Mechanism for taking Diversified Credit Exposure
– Attractive Spreads relative to similarly rated Assets
De-Merits:
– Pricing is based on Rating Agency assigned default probabilities which may not reflect True
Underlying Risk
– Expenses – Origination & Management Fees reduce the economics to Investors
Benefits & Risks of Credit Derivatives
Benefits of Credit derivatives

1. Enable the lenders / investors to take the credit risk as per capacity
2. Help in enhancing the market efficiency and liquidity
3. They act as financial shock absorbers for the economy
4. Creates macroeconomic and financial stability
Risks of Credit Derivatives

1. It could lead to increased leverage and risk taking by investors
2. Markets need to be liquid to manage risk through CDs
3. It may not always channel risk to those who best understand / handle it
4. New instruments keep appearing constantly and are not always tested
Uses of Credit Derivatives

➢ Credit derivatives allow banks to diversify their credit portfolios without venturing outside their
usual client
➢ Credit derivatives enable their buyers to protect themselves from the risk of counterparty default.
With the set of pros and cons involved in credit derivatives, investors should measure and manage
counterparty risks, correlations and liquidity. Building a strong financial shock absorber is a key
element for ensuring financial stability.
Asset-Backed Security (ABS)
An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying

pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card
balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set
amount of time, until maturity. For income-oriented investors, asset-backed securities can be an
alternative to other debt instruments, like corporate bonds or bond funds.
• Asset-backed securities (ABSs) are financial securities backed by income-generating assets such
as credit card receivables, home equity loans, student loans, and auto loans.
• ABSs are created when a company sells its loans or other debts to an issuer, a financial institution
that then packages them into a portfolio to sell to investors.
• Pooling assets into an ABS is a process called securitization.
• ABSs appeal to income-oriented investors, as they pay a steady stream of interest, like bonds.
• Mortgage-backed securities and collateralized debt obligations can be considered types of ABS.
Types of Asset Backed Securities

The asset backed securities can be mainly divided into three different types based on the type of
underlying assets. They are:
• Residential mortgage-backed securities
• Commercial mortgage-backed securities
• Collateralized debt obligations
• Residential mortgage-backed securities: In this type of securities, the underlying assets that
generate cash flow are residential mortgages. These securities are exposed to both default risk
and prepayment risk. However, the default risk is quite low as residential mortgage backed
securities are backed by houses as collateral.
• Commercial mortgage backed securities: These type of securities are backed by commercial
real estate loans, such as factories, warehouses, hotels, office buildings, apartment complexes,
shopping malls, etc. Typically, these securities are very complex owing to the inherent nature of
the underlying assets. In the case of commercial mortgage backed securities, the risk of
prepayment risk is quite low because of lockout provision and significant prepayment penalties.
• Collateralized Debt Obligations: In these types of securities, the underlying assets include a
wide range of assets, such as a residential mortgage, corporate debt, credit card receivables, etc.
All types of assets are pooled together and repackaged into discrete tranches on the basis of the
riskiness of the underlying assets.
Risks of Asset Backed Securities

The investors of the asset backed securities remain exposed two major risks: credit risk and
prepayment risk.
• Credit Risk: It refers to the risk that the issuer of the asset backed securities may default on
its payments. The risk of default is usually managed by dividing the entire portfolio into
different credit tranches, each tranche with a different level of credit risk exposure. Tranches
with higher credit rating indicate a lower risk of default and vice versa.
• Prepayment Risk: It refers to the risk that the borrowers of the underlying assets may prepay
their mortgages in a low interest environment, which will impact the regular cash inflow of
the investors. The risk of prepayment is usually managed by creating different tranches
according to the maturities of the underlying assets resulting in different prepayment risk
exposure for each tranche.
Advantages of ABS
• For Lenders
1. The potentially risky loans are taken off from the balance sheet and sold to other investors
through securitization.
2. By selling these securities, the lenders are able to gain access to a new source of funding that
can be used for issuing more loans.
• For Investors
1. These securities provide interested investors with alternative investment opportunities that can
generate higher yields than government bonds.
2. It also offers the benefit of portfolio diversification through investment in other markets.
Disadvantages
1. The prepayment of the underlying assets results in a lower yield for the investors.
2. During the economic downturn, these securities may be exposed to widespread defaults.
So, it can be seen that asset backed securities can be advantageous to both issuers and investors.
However, their mixed history tainted with instances of the large volume of defaults suggests that the
investors should be very cautious before putting their money into these securities.
Financial crisis of 2007–08 / Sub Prime Crisis

Financial crisis of 2007–08, also called subprime mortgage crisis, severe contraction of liquidity in
global financial markets that originated in the United States as a result of the collapse of the U.S. housing
market. It threatened to destroy the international financial system; caused the failure (or near-failure) of
several major investment and commercial banks, mortgage lenders, insurance companies, and savings
and loan associations and precipitated the Great Recession (2007–09).
Causes of the crisis
Although the exact causes of the financial crisis are a matter of dispute among economists, there is
general agreement regarding the factors that played a role (experts disagree about their relative

importance).
First, the Federal Reserve (Fed), the central bank of the United States, having anticipated a mild
recession that began in 2001, reduced the federal funds rate (the interest rate that banks charge each
other for overnight loans of federal funds—i.e., balances held at a Federal Reserve bank) 11 times
between May 2000 and December 2001, from 6.5 percent to 1.75 percent. That significant decrease
enabled banks to extend consumer credit at a lower prime rate (the interest rate that banks charge to their
“prime,” or low-risk, customers, generally three percentage points above the federal funds rate) and
encouraged them to lend even to “subprime,” or high-risk, customers, though at higher interest rates
(see subprime lending). Consumers took advantage of the cheap credit to purchase durable goods such
as appliances, automobiles, and especially houses. The result was the creation in the late 1990s of a
“housing bubble” (a rapid increase in home prices to levels well beyond their fundamental, or intrinsic,
value, driven by excessive speculation).
Second, owing to changes in banking laws beginning in the 1980s, banks were able to offer to subprime
customers mortgage loans that were structured with balloon payments (unusually large payments that
are due at or near the end of a loan period) or adjustable interest rates (rates that remain fixed at relatively
low levels for an initial period and float, generally with the federal funds rate, thereafter). As long as
home prices continued to increase, subprime borrowers could protect themselves against high mortgage
payments by refinancing, borrowing against the increased value of their homes, or selling their homes
at a profit and paying off their mortgages. In the case of default, banks could repossess the property and
sell it for more than the amount of the original loan. Subprime lending thus represented a lucrative
investment for many banks. Accordingly, many banks aggressively marketed subprime loans to
customers with poor credit or few assets, knowing that those borrowers could not afford to repay the
loans and often misleading them about the risks involved. As a result, the share of subprime mortgages
among all home loans increased from about 2.5 percent to nearly 15 percent per year from the late 1990s
to 2004–07.
Third, contributing to the growth of subprime lending was the widespread practice of securitization,
whereby banks bundled together hundreds or even thousands of subprime mortgages and other, less-
risky forms of consumer debt and sold them (or pieces of them) in capital markets as securities (bonds)
to other banks and investors, including hedge funds and pension funds. Bonds consisting primarily of
mortgages became known as mortgage-backed securities, or MBSs, which entitled their purchasers to a
share of the interest and principal payments on the underlying loans. Selling subprime mortgages as
MBSs was considered a good way for banks to increase their liquidity and reduce their exposure to risky
loans, while purchasing MBSs was viewed as a good way for banks and investors to diversify their

portfolios and earn money. As home prices continued their meteoric rise through the early 2000s, MBSs
became widely popular, and their prices in capital markets increased accordingly.
Fourth, in 1999 the Depression-era Glass-Steagall Act (1933) was partially repealed, allowing banks,
securities firms, and insurance companies to enter each other’s markets and to merge, resulting in the
formation of banks that were “too big to fail” (i.e., so big that their failure would threaten to undermine
the entire financial system). In addition, in 2004 the Securities and Exchange Commission (SEC)
weakened the net-capital requirement (the ratio of capital, or assets, to debt, or liabilities, that banks are
required to maintain as a safeguard against insolvency), which encouraged banks to invest even more
money into MBSs. Although the SEC’s decision resulted in enormous profits for banks, it also exposed
their portfolios to significant risk, because the asset value of MBSs was implicitly premised on the
continuation of the housing bubble.
Fifth, and finally, the long period of global economic stability and growth that immediately preceded
the crisis, beginning in the mid- to late 1980s and since known as the “Great Moderation,” had convinced
many U.S. banking executives, government officials, and economists that extreme economic volatility
was a thing of the past. That confident attitude—together with an ideological climate emphasizing
deregulation and the ability of financial firms to police themselves—led almost all of them to ignore or
discount clear signs of an impending crisis and, in the case of bankers, to continue reckless lending,
borrowing, and securitization practices.
Probability of Default
The probability of default (PD) is the probability of a borrower or debtor defaulting on loan repayments.
Within financial markets, an asset’s probability of default is the probability that the asset yields no return
to its holder over its lifetime and the asset price goes to zero. Investors use the probability of default to
calculate the expected loss from an investment.
Default probability, or probability of default (PD), is the likelihood that a borrower will fail to pay back
a debt. For individuals, a CIBIL score is used to gauge credit risk. For businesses, probability of default
is reflected in credit ratings.
Forward Rate Agreement

Forward Rate Agreement, popularly known as FRA, refers to customized financial contracts that are
traded Over the Counter (OTC) and allow the counterparties, which are primarily large banks, corporate
to predefine interest rates for contracts which are going to start at a future date.
There are two parties involved in a Forward Rate Agreement, namely the Buyer and Seller. The Buyer
of such contract fixes in the borrowing rate at the inception of the contract, and the seller fixes in the
lending rate. At the inception of an FRA, both parties have no profit/loss.
However, as time passes, the Buyer of the FRA benefits if Interest Rates increases than the rate fixed at
the inception, and the Seller Benefits if the interest rates fall than the rate fixed at the inception. In short,
the Forward Rate Agreement is Zero-sum games where the gain of one is a loss for the other.
A forward rate agreement (FRA) is an OTC agreement between two parties to lend or to borrow funds
on a future date at a pre-determined interest rates. The assumption underlying the contract is that the
borrowing or lending would normally be done at LIBOR.
Characteristics
• It is an OTC Product
• It is predominantly used as an inter-bank tool for hedging of short term interest rate risk.
• There is no upfront premium payable.
• Simpler to administer than futures since there is no margining requirement.
• The underlying principal amount is purely notional and no actual exchange takes place.
Notional principal amount is used for calculation of settlement amount to be exchanged
between parties.
• Most liquid and frequently traded FRA’s are for 3 to 6 months.
• FRA’s are available for periods extending to 2 years.
• FRA’s are available in currencies where there are no futures.
Interest Rate Caps, Floors and Collars

Interest Rate Caps, Floors and Collars are option-based Interest Rate Risk Management products.
These option products can be used to establish maximum (cap) or minimum (floor) rates or a
combination of the two which is referred to as a collar structure. These products are used by investors
and borrowers alike to hedge against adverse interest rate movements.
A Cap provides variable rate borrowers with protection against rising interest rates while also retaining
the advantages of lower or falling interest rates.
Interest Rate Caps:

An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end
of each period in which the interest exceeds the agreed strike price. An interest rate cap actually consists
of a series of European call options on interest rates
• Caps are frequently purchased by issuers of floating rate debt who wish to protect themselves
from increased financing costs that would result from a rise in interest rates
• Investors use caps to hedge against the risk associated with floating interest rate
Variable rate borrowers are the typical users of Interest Rate Caps. They use Caps to obtain certainty
for their business and budgeting process by setting the maximum interest rate they will pay on their
borrowings. By implementing this type of financial management, variable rate borrowers obtain peace
of mind from rising interest rates but retain the ability to benefit from any favourable interest rate
movements.
An Interest Rate Cap ensures that you will not pay any more than a pre-determined level of interest on
your loan. An Interest Rate Cap enables variable rate borrowers to retain the advantages of their variable
rate facility while obtaining the additional benefits of a maximum interest rate.
The cost of the Cap is referred to as the premium. The premium for an Interest Rate Cap depends on the
Cap rate you want to achieve when compared to current market interest rates. For example, if current
market rates are 6%, you would pay more for a Cap at 7% than a Cap at 8.5%. The premium for an
Interest Rate Cap also depends on the rollover frequency and how you make your premium payments.
An Interest Rate Cap can be purchased for a minimum term of 90 days and a maximum term of five
years. When the Actual Interest Rate rises above the Cap Strike Rate the Bank will reimburse the extra
interest to the customer.
Interest Rate Floors:

Is an option strategy that protects the investor in a floating rate instrument from a fall in interest rates at
the time when the floating coupon is being reset, whilst allowing the enjoyment of rising interest rates.
As for caps a floor is made of a series of individual options, known as floorlets. Variable rate investors
are the typical users of Interest Rate Floors. They use Floors to obtain certainty for their investments
and budgeting process by setting the minimum interest rate they will receive on their investments. By
implementing this type of financial management, variable rate investors obtain peace of mind from
falling interest rates and the freedom to concentrate on other aspects of their business/investments.
An Interest Rate Floor ensures that you will not receive any less than a pre-determined level of interest
on your investment. The Bank will reimburse you the extra interest incurred should interest rates fall
below the level of the Floor.
An Interest Rate Floor enables variable rate investors to retain the upside advantages of their variable
rate investment while obtaining the comfort of a known minimum interest rate.
The cost of the Floor is referred to as the premium. The premium for an Interest Rate Floor depends on
the Floor rate you want to achieve when compared to current market interest rates. For example, if
current markets rates are 6%, you would pay more for a Floor at 5% than a Floor at 4.5%.
The premium for an Interest Rate Floor also depends on the rollover frequency and how you make your
premium payments.
Interest Rate Collars:

An interest rate collar is an investment strategy that uses derivatives to hedge an investor's exposure to
interest rate fluctuations. An interest rate collar protects a borrower against rising interest rates while
setting a floor on declining interest rates.
Interest rate collar strategy protects the investor by capping the maximum interest rate paid at the collar's
ceiling, but sacrifices the profitability of interest rate drops.
Interest rate collar Provides protections against interest rate increase and gain from interest rate decrease.
It can be used as a form of short term interest rate protection in times of uncertainty. An Interest Rate
Collar ensures that you will not pay any more than a pre-determined level of interest on your borrowings.
The cost of the Collar is referred to as the premium. The premium for an Interest Rate Collar depends
on the rate parameters you want to achieve when compared to current market interest rates. For example,
as a borrower with current market rates at 6%, you would pay more for an Interest Rate Collar with a
4% Floor and a 7% Cap than a Collar with a 5% Floor and a 8.5% Cap.
The premium for an Interest Rate Collar also depends on the rollover frequency and how you make your
premium payments. An Interest Rate Collar can be purchased for a minimum term of 90 days and a
maximum term of five years.
Interest Rates
An interest rate in a particular situation defines the amount of money a borrower promises to pay the
lender. For any given currency, many different types of interest rates are regularly quoted. These include
mortgage rates, deposit rates, prime borrowing rates and so on. The higher the credit risk, the higher the
interest rate that is promised by the borrower.
Types of Interest Rate:
Zero Rates
A zero rate (sometimes referred to as the n-year zero), is the rate of interest earned on an investment
that starts today and lasts for n years.
Suppose a 5-year zero rates with continuous compounding is quoted at 5% per annum. This means that
$100, if invested for 5 years, grows to
100 * e0.05 * 5 = 128.40
Forward Rates
The forward rate is the future zero rate implied by today’s term structure of interest rates. A forward
rate is an interest rate applicable to a financial transaction that will take place in the future
Value at risk (VaR)

Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of
investments might lose (with a given probability), given normal market conditions, in a set time period
such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the
amount of assets needed to cover possible losses.
Value at risk (VaR) is an attempt to provide a single number summarizing the total risk in a portfolio
of financial assets for senior management. It has widely used by corporate treasurers and fund
managers as well as by financial institutions
VaR Models
Stress Testing
In addition to calculating a VaR, many companies carry out what is known as a stress test of their
portfolio. Stress testing involves estimating how the portfolio would have performed under some of
the most extreme market moves seen in the last 10 to 20 years.
Back Testing
It involves testing how well the VaR estimates would have performed in the past. Suppose that we are
calculating a 1-day 99% VaR. Back testing would involve looking at how often the loss in a day
exceeded the 1-day 99% VaR calculated for that day.

****************** End of Unit 6***********************

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Financial Derivatives 20MBAFM402

Module-1 Financial Derivatives 5 hours

Prof. Rajimol K P, Assistant Professor, ACME 1

Features of financial derivatives

Prof. Rajimol K P, Assistant Professor, ACME 2

Prof. Rajimol K P, Assistant Professor, ACME 3

EXCHANGE TRADED CONTRACT

OVER THE COUNTER CONTRACT

Prof. Rajimol K P, Assistant Professor, ACME 4

Difference between Exchange Trading & OTC Trading

Prof. Rajimol K P, Assistant Professor, ACME 5

Prof. Rajimol K P, Assistant Professor, ACME 6

• Brings perfection in market: Lastly, it is observed that derivatives trading develop

Factors contributing to the growth of Derivatives

Prof. Rajimol K P, Assistant Professor, ACME 7

Functions of Derivative Markets

Prof. Rajimol K P, Assistant Professor, ACME 8

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Players in Derivative Market

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Derivatives market in India

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*******End of Unit 1*******

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Module -2 Futures and Forwards 7 hours

Futures and Forwards: Meaning, features and types of futures/forwards-Futures vs Forwards-

• Forwards are transactions involving delivery of an asset or a financial instrument at a

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1. Organised Exchanges: Unlike forward contracts which are traded in an over-the-counter

2. Standardisation: In the case of forward currency contracts, the amount of commodity to be

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2. Stable Margin Requirements Margin requirements for most of the commodities

5. Simple Pricing Unlike the extremely difficult Black-Scholes Model-based options

The Disadvantages of Futures Contracts

1. No Control Over Future

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2. Commodity Futures Contracts – purchase and sales agreements having standardized

9. Futures Expiration– the last trading day of futures contract.

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10.Volatility – the variability of prices over time (historical) or projected (Implied) as

The trading process of futures involves the following steps

Future trading mechanism

2. Role of the clearing house

Role of clearing house

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Functions of clearing house

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2. Maintenance Margin After purchasing the stocks, a minimum balance called as

Marking to Market Meaning

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Steps to Calculate Mark to Market in Futures

Mark to market in futures involves below two steps:

1. Determining Settlement Price

2. Realization of the Profit/Loss

Benefits of Marking to Market in Futures Contract

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Drawbacks of Mark to Market in Futures

SPECIFICATIONS OF A FUTURES CONTRACT

Following are the specifications required of a futures contract:

End of Unit 1

*** End of Unit 3