Risk Management 2023 Short Notes

Module-F
Unit-34 DERIVATIVES AND RISK MANAGEMENT
Definition of Derivatives: Derivatives are financial OTC derivatives are not standardized and can be
instruments that derive their value from an underlying customized to the needs of the parties.
asset. They transfer risks from one party to another.
Examples of derivatives include options, futures, and Exchange Traded Derivatives: These have
swaps. The underlying asset may include equities, standardized terms, facilitating liquidity and enabling
fixed-income securities, currencies, commodities, and a streamlined clearing and settlement process.
others. Exchanges also provide a credit guarantee to ensure
the completion of transactions. However, they come
Features of Derivatives: Derivatives are legal
with a trade-off of less privacy and flexibility due to
contracts between two parties, the buyer and the
transparency and regulatory oversight.
seller, with defined rights and obligations. They specify
a future price for selling an underlying asset. There are Over-The-Counter Derivatives:
two general classes of derivatives: forward
commitments (like forward contracts, futures • They are private contracts between parties with
contracts, and swaps) and contingent claims (like terms mutually agreed upon.
options). • Brokers often facilitate these contracts by
connecting potential parties.
Role of Derivatives Clearinghouse: A derivatives
clearinghouse typically facilitates transactions and • They can be beneficial for trading large quantities
helps manage credit risk. It acts as the buyer to all or customized claims and executing multiple
sellers and the seller to all buyers, in a process known transactions at once.
as novation. • Less regulated and less transparent than
exchange-traded derivatives.
Benefits of Derivatives: Derivatives markets create
new opportunities for trading and risk management
strategies. They also involve high leverage, meaning
small movements in the underlying can lead to
significant gains or losses. They generally trade at
lower transaction costs and offer a simple, effective,
and low-cost way to transfer risk. By Praveen Rana
ADDA247
Over the Counter vs Exchange Traded Derivative:
Derivatives can be traded either over-the-counter
(OTC) or on an exchange. Exchange-traded derivatives
are standardized contracts traded on a market, while

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Uses of Derivatives: Options:

Risk management: Used to hedge against risks • Contract giving the buyer the right, not obligation,
associated with fluctuations in underlying asset prices. to buy (call option) or sell (put option) an asset at
a fixed price on/before a future date.
Speculation: Attempt to profit by anticipating changes • The buyer pays the seller an option premium.
in market prices. • Can be standardized or customized.
• If options are not exercised, the purchaser loses
Reduced transaction costs: Using derivatives can be
the premium paid.
less costly than trading the underlying asset.
Swap:
Arbitrage: Exploiting mispricing in the market to lock
in riskless profit. • OTC contract where two parties agree to exchange
a series of cash flows.
Misuse of Derivatives: • Cash flows could be based on fixed or floating
interest rates.
• They can permit legalized gambling, as they are
• Terms of the swap (identity of the underlying,
attractive to speculators who accept the risks that
payment dates, payment procedure) are
others want to avoid. negotiated and written into the contract.
• Excessive speculative trading can potentially • Subject to default risk like other OTC contracts.
destabilize the market due to large amounts of
Long and Short Positions:
leverage.
• Complex nature of derivatives can lead to • Long position: Buying securities, stocks, currency,
misunderstanding and mismanagement, adding to or commodities with the expectation of earning
their riskiness. profit.
• Short position: Selling securities or commodities
Forwards: with the intention of repurchasing them later at a
lower rate.
• Over-the-counter (OTC) derivative contract with
fixed price for future asset sale/purchase. Long Position:
• No exchange of value at contract initiation. • When a person owns the security or asset.
• Short-term and non-negotiable. • Profit potential is unlimited as the holder can sell
• Can settle by an exchange of cash (non-deliverable the asset when its price increases.
forwards). • Example: Buying 1000 shares of stock in a
• A default can lead to legal proceedings. company at $1700 per share, and then selling
them a year later at $1750 per share, yielding a
Futures: profit of $50,000.
• Standardized derivative contracts traded on Short Position:
futures exchanges.
• When a person sells an asset that he/she does not
• Daily settling of gains and losses with a credit own.
guarantee by the futures exchange. • Profit is made when the price of the asset falls.
• Either party can transfer contract obligation before • Example: A manufacturer holding an inventory of
expiry. aluminum sells futures short to protect against a
• Can be written on real assets (commodity futures) potential price drop. If the price falls, he/she
or financial assets (financial futures). makes a profit from the short position.

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Long Position vs Short Position: • Currency futures contracts were introduced in BSE
and NSE in August 2008 and in MCX in October
• Long position means owning the shares of a stock,
2008. Additional futures on Japanese yen, British
while short position means owing stocks to
pound, and euro were introduced in 2010.
someone else.
• For options, holding/buying a put or call option is OTC Derivatives:
a long position, whereas writing a call or selling a
• RBI allowed trading of interest rate swaps,
put option is considered a short position.
currency swaps, and forward rate agreements on
• Long positions are considered less complicated
July 7, 1999. Originally for resident Indians, but
compared to short positions.
later expanded to include non-resident Indians
Derivatives in India: and non-resident financial institutions.

• Derivatives are traded on organized exchanges and Credit Derivatives:

on OTC markets.
• Since 2003, the RBI has been exploring the
• Financial securities derivatives were introduced in
introduction of credit derivatives.
NSE and BSE in 2000.
• On May 17, 2007, it allowed banks to enter into
• Commodity derivatives were introduced in 2003
single-entity credit default swaps.
with the establishment of MCX, NMCE, and the
National Commodity in 2009. Market Popularity:

Types of Derivatives: • The derivative markets are becoming more

popular due to the advent of technology and the
• Futures on 10-year government bonds were
availability of a diverse range of derivatives.
introduced, but trading volumes remain low.

Unit-35 FORWARD CONTRACT

• The future date is known as the "expiration date"
Origin of Forward Contracts:
and the price at which the asset is purchased is
• Forward contracts date back over 2000 years and called the "forward price."
were used by farmers and merchants to mitigate
Advantage of Forward Contracts:
price risks.
• Since 1973, forward contracts on currency and Forward contracts are used to avoid price uncertainty
interest rates exist in India. and lock in a price for a future transaction.
They eliminate price uncertainty for both parties and
Definition and Characteristics of Forward Contracts:
are flexible with respect to the amount, quality, and
• A forward contract is an agreement to buy or sell delivery details of the asset.
an asset at a future date for a predetermined
Problems Associated with Forward Contracts:
price.
• It involves two parties, referred to as the "long • Requires two parties with matching needs in terms
position" or "long forward," and the "short of quantity, quality, and time of delivery.
position" or "short forward." • Non-performance or counterparty risk is a
• The asset is known as the "underlying asset" and significant issue, where one party fails to fulfill the
could be any asset like stocks, bonds, currencies, contract, causing the other party to be unable to
or commodities. hedge the price risk.

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Examples: Pay-off Equation:

• The examples given highlight the workings of a Long forward payoff = Underlying asset price on the
forward contract and the potential gains, losses, expiration date - Forward price.
and risks associated with them.
Short Forward Payoff:
• A farmer and a merchant use a forward contract to
secure a price for a future rice sale, regardless of • The short forward (seller) is obliged to sell the
how the market price changes. This mitigates price asset at expiration, for which it receives the
uncertainty but introduces the risk of non- forward price.
fulfillment of the contract by one party. • The payoff is the forward price received minus the
Pay-off on a Forward Contract: price of the asset delivered.
• Payoff can be positive (if forward price > asset
• The pay-off is the value of the contract at
price), negative (if forward price < asset price), or
expiration.
zero (if forward price = asset price).
• It is calculated by the long forward (buyer) paying
the agreed forward price at expiration. Short Forward Profit and Loss (P&L):
• The pay-off decides the price for future data at the
• P&L is the difference between cash flows at
time of entering into the contract.
initiation and expiration. For short forward, this is
Calculation of Pay-off: equal to the payoff, as the only cash flow occurs at
expiration.
• At time t = 0, the spot price of the asset is S0, and
at expiration (time t = T), it is ST. The agreed • Profit: If forward price received is greater than the
forward price is F. asset price delivered.
• If the price of the asset at expiration (ST) is greater • Loss: If forward price received is less than the asset
than the forward price (F), the contract pays off ST price delivered.
- F to the long position. This is considered a • Breakeven: If forward price received is equal to the
positive payoff. asset price delivered.
• If ST is less than F, the payoff for the long position • Short Forward Breakeven Point:
is still ST - F, but it will be a negative value. • It is identical to the long forward’s breakeven
point.
Pay-off for the Short Position:
Example:
• The short position (seller) delivers the asset worth
ST and accepts an amount F. • Initiation: May 21
• The contract has a payoff for them of F - ST, which • Expiration: June 3
could be negative. • Forward price: ` 5000
Possible Pay-off Outcomes for the Long Position: • Underlying asset price on June 3: ` 4500
• Short forward’s P&L = F - ST = 5000 - 4500 = ` 500
• Positive payoff: When the asset price received (ST)
• Zero-sum Game:
is greater than the forward price paid (F).
• Negative payoff: When the asset price received • Forwards are zero-sum games, meaning the profit
(ST) is less than the forward price paid (F). one party gains is equal to the loss the other party
• Zero payoff: When the asset price received (ST) incurs. This reflects in the P&L of long and short
equals the forward price paid (F). forwards.

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 Computation of Forward Value:

• The value of any financial security is the present

value of its expected cash flow. For instance, a
bond's value is the present value of its expected
future coupons and face value, while a stock's
Pricing the Underlying: value is the present value of its expected future
dividends and its market value (price).
• The price of a financial asset is often determined • A forward contract is designed to have zero value
using a present value of future cash flows at initiation with a "fair" forward price that is
approach. agreeable to both counterparties.
• Forward premiums are competitive and require • After initiation, the forward value may change due
market intelligence for accurate pricing. to determinants such as underlying asset price,
• Benefits and Costs of Holding Assets: forward price, time to expiration, and risk-free
• Assets generate both monetary and nonmonetary interest rate. This change can either benefit or
benefits and costs. harm one of the counterparties, resulting in the
• Benefits include dividends, coupon interest, and forward value becoming positive (asset) or
convenience yields (nonmonetary advantage for negative (liability).
commodities). Time Value of Money:
• Costs include storage, protection, and opportunity
costs. The net of these is called 'carry' or 'cost of • This concept highlights that the value of a financial
carry'. security is the present value of its expected cash
flow.
The Concept of Price and Value of a Forward
• For instance, the value of a bond or a stock is the
Contract:
present value of their expected future dividends
The 'price' is the agreed transaction cost, while the and market value.
'value' is the worth of holding a position. • Forward and option values are also calculated
Forward Price: The price agreed at initiation for the using the present value of their expected future
asset to be transacted at expiration. dividends and market value.
Forward Value: The value of holding a position in a
forward at a given time during the life of the forward. Example:
At expiration, the value equals the payoff from the • A forward obligates a long forward to purchase an
contract. underlying asset from a short forward in three
Example: months for `105. At initiation, the forward value is
A forward contract to buy a car in one year for zero for both the long and short positions. The
`2,00,000. long forward’s value may either increase above or
At the end of the year, the same car is worth `3,00,000 decrease below zero as the determinants of value
in the market. change.
The value of the forward contract is 1,00,000 Determinants of Forward Value:
(3,00,000 - 2,00,000), showing a benefit to the buyer.
If the buyer were the seller, the value would be - The underlying asset price on the valuation date.
1,00,000. If the market price was below `2,00,000, the The forward price.
contract would have negative value to the buyer and The risk-free interest rate on the valuation date.
positive value to the seller. The time to expiration.

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Calculation Example: 'notional principal' amount on a settlement date
for a specified period. This agreement serves as a
Given: The forward has 0.25 years remaining until
risk mitigant due to varying risk perceptions
expiration, the monthly compounded risk-free interest
among buyers and sellers.
rate is 6%, the forward price is 1000, and the
underlying asset price is 920. • The settlement rate is the agreed
The task is to calculate the forward value and benchmark/reference rate prevailing on the
determine if the forward is an asset or a liability. settlement date.

Computation of Forward Price: Features of a Forward Rate Contract:

• At the initiation of a forward contract, neither An FRA is a forward contract based on interest rates.
party pays anything, making the contract neither
• Two counterparties agree to a notional principal
an asset nor a liability, thus its initial value is zero.
amount which serves as a reference figure in
• The forward price agreed upon at the initiation
determining cash flows. By Praveen Rana
ensures zero value of the contract, prohibiting
ADDA247
arbitrage. This price is such that, at the horizon
• The buyer of the FRA agrees to pay a fixed-rate
date, the buyer is ensured ownership of the asset
without having committed the initial money that interest payment and receive a floating-rate
would have otherwise accrued interest. payment against the notional principal at some
specified future date. The seller agrees to the
Investment with Known Income: opposite.
• This pertains to a forward contract on an • The exercise rate is typically set equal to the
investment yielding perfectly predictable cash forward rate from the prevailing yield curve
flows, such as coupon bonds or dividend-paying reflecting the expected future interest rate.
stocks. When such an investment provides • The buyer of the FRA will receive (pay) cash when
income with a present value of I during the the actual interest rate at contract settlement is
contract's life, this income influences the forward greater (less) than the exercise rate set at
price. origination. The seller will experience the
opposite.
Forward Rate Agreement (FRA): • FRAs are cash-settled at the settlement date with
• An FRA is an over-the-counter contract where two no interim cash flows. They are not marked-to-
parties agree to exchange interest payments for a market nor require margining.

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Calculation of Settlement Amount under FRA:

Usages of Forward Rate Agreement (FRA):

Notation and Quoting FRA
The format in which FRAs are noted is the term to Hedging: FRAs can be used to hedge future borrowing
settlement date and term to maturity date, both or lending activities against adverse movements in
expressed in months and usually separated by the interest rates. By fixing an interest rate today, market
letter “x” participants can secure themselves against
3 × 6 FRA: An FRA having 3 months waiting period unpredictable changes in the future.
(forward) and a 3 month contract period.
Trading: FRAs can also be used for trading purposes. A
6 × 12 FRA: An FRA having a 6 month waiting period
market participant may wish to profit from their
(forward) and a 6 month contract period.
predictions about future interest rates.

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Arbitrage: Finally, FRAs can be employed in arbitrage clearinghouse to guarantee performance, nor is there
strategies where a market participant attempts to take daily marking to market or posted collateral. Because
advantage of price differences between FRAs and of this, parties to these contracts must perform due
other interest rate instruments. diligence to ensure their counterparty is financially
sound and can fulfill their contractual obligations.
Weaknesses of FRA:
Difficulty in Matching Counterparties: It can be
Default Risk: The primary drawback of forward
challenging to find a specific counterparty willing to
contracts, including FRAs, is their susceptibility to
take exactly the opposite position. This could limit the
default risk or counterparty risk. There's no
ease of entering into a FRA and its effectiveness.

Unit-36 FUTURES
Loss Reduction: With a futures contract, parties can
A futures contract is a derivative contract
mitigate losses by taking offsetting positions if the
standardized and traded on a futures exchange, where
asset price moves unfavorably. In a forward contract,
two parties agree to transact an underlying asset at a
parties are obliged to fulfill the contract even if it
specified future date and at an agreed price. These
results in a loss.
contracts are marked-to-market daily, and a credit
guarantee is provided by the futures exchange Regulation: Futures markets are heavily regulated at a
through its clearinghouse. national level, resulting in higher transparency and
security for market participants compared to forward
Futures Contract vs. Forward Contract:
markets.
Negotiability: Futures contracts are negotiable,
Clearing House:
meaning parties can enter into offsetting contracts
before maturity to close out their positions, whereas The clearinghouse is an entity associated with a
forward contracts are not, obliging both parties to futures exchange that acts as an intermediary in all
uphold their contractual obligations regardless of transactions. Clearing members (CMs) carry out
changes in circumstances. trades through the clearinghouse, which maintains
track of all transactions and calculates the net
Standardization: Futures contracts are standardized
positions of each CM. Each CM is required to maintain
by the exchange, which covers aspects like contract
a margin account with the clearinghouse to guarantee
size, asset type, delivery arrangements, delivery
the performance of their trades, enhancing the overall
months, price quotes, and price limits. This makes
stability and reliability of the futures market.
them less flexible than forward contracts, which can
be custom-tailored to the parties' needs, but it does Margin accounts and the process of marking-to-
improve liquidity and reduce counterparty risk. market are essential aspects of trading in futures
contracts. Here's how it works:
Liquidity: Because futures contracts are standardized
and traded on an exchange, they are more liquid than Margin Account: A margin account is an account a
forwards. This ease of trading reduces transaction trader must maintain with a broker when trading
costs and increases market depth. futures contracts. It serves as collateral to cover
potential losses.
Performance: The possibility of non-compliance is
minimized in futures contracts due to the oversight of Initial Margin: At the outset of a futures contract, the
the exchange and its clearinghouse. Forward trader deposits an initial margin into the account. By
contracts, in contrast, are more prone to default risk. Praveen Rana ADDA247

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Marking-to-Market: Each day, the futures contract is Spot price and Futures price: The futures price tends
marked-to-market, meaning the account is adjusted to converge with the spot price as the contract nears
to reflect the contract's daily profit or loss. Gains are expiration. This is due to market efficiency and the
added to the account balance, and losses are elimination of arbitrage opportunities.
deducted.
Delivery: Very few futures contracts lead to actual
Variation Margin/Maintenance Margin: This is the
delivery of the asset because most are closed before
minimum amount that must be maintained in the
maturity. The details of the delivery are decided by the
margin account. If the account balance falls below this
amount, a margin call is issued. exchange and the party with the short position in the
contract.
Margin Call: A margin call is a demand from a broker
for a trader to deposit additional money into the Cash Settlement: In contracts like stock index futures,
margin account to meet the minimum margin cash settlement is used instead of actual delivery. At
requirement. If a trader fails to meet a margin call, the the end of the last trading day, all positions are
broker has the right to close out the trader's position declared closed and the settlement price is the closing
and adjust the account balance accordingly. spot price of the underlying asset.
Settlement Price: The settlement price is the price
Pricing of Future Contracts: Pricing for futures is
used to calculate daily gains and losses for marking-to-
similar to forwards, and is primarily based on the cost
market. It is typically the average of the prices at which
the contract was traded just before the end of the of carry model. However, the actual price can also be
trading day. influenced by demand and supply for the contract on
the exchanges.
Closing Out: Most futures contracts do not result in
delivery of the underlying asset. Instead, traders Contango vs Normal Backwardation: Contango refers
usually close out their positions before the contract's to the situation where the futures price is above the
delivery date. This involves entering into an offsetting expected future spot price, while normal
trade (a long position selling the contract or a short backwardation is when the futures price is below the
position buying the contract). Once the position is expected future spot price. Over time, the futures
closed, any remaining balance in the margin account
price will converge with the spot price to avoid
is returned to the trader. By adda247
arbitrage opportunities.
• In futures markets, most participants are looking
to profit from price movements in the underlying Interest Rate Future: Interest rate futures are
asset rather than taking delivery of it. It is contracts to exchange a financial instrument at a
important for traders to accurately estimate future date for a predetermined price. These contracts
market trends, as this will determine whether they are standardized, and the clearing house acts as the
make a profit or incur a loss. guarantor of performance. Traders can take a long
position (buying a futures contract) or a short position
• The information provided here is detailed and
fairly complete with respect to the concepts of (selling a futures contract). Profits and losses in these
futures trading, the relationship between spot contracts depend on the difference between the cash
price and futures price, delivery and cash and future contract prices.
settlement, pricing of futures contracts, contango
and normal backwardation, and interest rate
future. Below, I'll provide a brief summary for each
topic.

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Interest Rate Futures in India: Hedging Strategy:
• Interest Rate Futures (IRFs) are derivative Hedging strategies can vary depending on the
contracts between buyer and seller where the expected movements in interest rates.
underlying asset is based on the interest-bearing
securities. The National Stock Exchange (NSE) Short Hedging: If a bank expects interest rates to rise
introduced interest rate futures in 2003, offering (and thus bond prices to fall), they can sell futures
products under NBF II (NSE Bond Futures II), contracts to hedge against this risk.
including 6 yr, 10 yr, and 13 yr GOI Securities.
Long Hedging: If participants find the current yield
• IRFs provide a valuable tool for risk management, attractive and wish to lock in that yield, but do not
as they allow parties to hedge against the risk of have the funds to invest immediately, they can go long
changing interest rates. Banks and other financial on futures contracts. Adda247
institutions use these futures contracts to reduce
their exposure to fluctuations in interest rates, Changing Portfolio Duration Using Interest Rate
thereby stabilizing their potential returns. Future:
Hedging with Interest Rate Futures: Interest rate futures can also be used to adjust the
Hedging is essentially a risk management strategy duration of a portfolio. If a portfolio manager expects
used to offset potential losses that may be incurred interest rates to rise, they may wish to decrease the
due to fluctuations in interest rates. For instance, a duration of their portfolio because long-term bonds
bank with a large portfolio of bonds would lose money will decrease in value more than short-term bonds. By
if interest rates were to rise, because the bonds would selling futures contracts, they can effectively reduce
decrease in value. By taking a short position in interest the duration of their portfolio. Conversely, if they
rate futures, the bank can mitigate this risk. If interest expect interest rates to fall, they can increase the
rates rise, the short futures position will gain in value, duration of their portfolio by buying futures contracts.
offsetting the loss on the bond portfolio.

Unit-37 OPTIONS
Underlying Price: The price at which the underlying
History of Options Market: Options have been
asset trades in the spot market.
available since the 1920s, initially as Over-The-
Call and Put Option: A call option gives the buyer the
Counter (OTC) trades on commodities. Options on
right to buy the underlying asset at a fixed price in the
equities began trading in 1972 on the Chicago Board
Options Exchange (CBOE), and options on currencies future, while a put option gives them the right to sell.
and bonds began in the late 1970s. Option Premium: The money paid by the option buyer
to the option seller/writer.
Definition: Options are contracts between two parties Exercise Price: The fixed price at which the asset will
giving the buyer the right (but not the obligation) to be traded under the options contract.
buy or sell a specific asset at a predetermined price
Exercising an Option Contract: Claiming the right to
within a set time period. They are more flexible than
buy/sell the options contract at the end of the expiry.
other derivatives, such as futures and forwards.
Exercise Date: The fixed maturity date of an options
Terminology: contract.
Underlying: The asset on which the option is written, American and European Option: A European option
such as commodities, individual stocks, stock indexes, can be exercised only on the exercise date, while an
foreign currencies, futures contracts, bonds, interest American option can be exercised at any time until the
rates, or credit. exercise date.

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Buyers and Writers of an Option: The buyer holds the price, the option will not be exercised and the payoff
option long, while the seller (or writer) has sold the will be zero.
option short.
In-the-money, At-the-money, Out-of-money: An
option is "in-the-money" if exercising it will provide a
gain; it's "out-of-money" if exercising it is likely to
result in a loss; and it's "at-the-money" if the price of
the underlying asset is very close to the exercise price.

A Call Option gives the holder the right, but not the
obligation, to buy an asset at a predetermined price
(known as the strike price) within a specific time
Short Call Payoff: The seller (or writer) of the call
period. You've correctly outlined the key elements of
option, also known as the short call, has an obligation
a Call Option, including:
to sell the underlying asset if the buyer (or holder) of
Counterparties: A Call Option involves two parties - the call option decides to exercise the option. The
the buyer (or holder) of the option and the seller (or short call's payoff can either be zero (if the option is
writer) of the option. not exercised by the buyer) or negative (if the option
Right to Purchase: The buyer of the Call Option has is exercised by the buyer and the market price of the
the right to buy the underlying asset at a fixed price asset is higher than the strike price).
(the strike price) on or before a specific date. However,
P&L Diagram: A profit and loss (P&L) diagram
they are not obliged to exercise this right.
graphically shows the potential profit and loss of a
Premium: For having this right, the buyer pays the position. For a long call, the P&L diagram would show
seller a fee called the premium. that losses are limited to the premium paid, while
Exercise Styles: Call options can be either European or potential profits are unlimited if the price of the
American style. European options can only be underlying asset rises significantly.
exercised on the expiration date, while American
options can be exercised anytime on or before the
expiration date.
Underlying Asset: The asset that can be bought using
the option can be various types, such as stocks, bonds,
commodities, etc.
Payoff: If the price of the underlying asset is higher
than the strike price at expiration, the buyer will
exercise the option and the payoff will be the
difference between the asset's market price and the
strike price. If the asset's price is lower than the strike

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Zero-Sum Game: This term indicates that the gain of Long Put Payoff: The payoff to the holder of a put
one participant is exactly balanced by the loss of the option if they exercise their option is the difference
other participant. In the context of options, any profit between the strike price and the price of the
made by the buyer of the option is exactly equal to the underlying asset (if the strike price is higher). If the
loss incurred by the seller, and vice versa. holder does not exercise the option, the payoff is zero
because no transaction takes place.
Moneyness of an Option: This term describes the
relationship between the market price of the
underlying asset and the strike price of the option. An
option can be "in the money" (ITM), "out of the
money" (OTM), or "at the money" (ATM).

ITM: A call option is in the money when the market

price of the underlying asset is higher than the strike
price.

OTM: A call option is out of the money when the Short Put Payoff: As you mentioned, the short put is
market price of the underlying asset is lower than the obligated to buy the asset if the long put decides to
strike price. exercise the option. If the underlying asset price is less
than the strike price, the long put will likely exercise,
ATM: A call option is at the money when the market leading to a negative payoff for the short put. On the
price of the underlying asset is equal to the strike contrary, if the underlying asset price is greater than
price. the strike price, the long put will likely not exercise,
Put Option: This is a contract that gives its holder the leading to a zero payoff for the short put.
right, but not the obligation, to sell a specified amount
Put Option Moneyness: This describes the
of an underlying asset at a specified price (the strike relationship between the market price of an
price) within a certain time frame. underlying asset and the strike price of the put option.
Long Put/Short Put: The buyer of a put option is As you correctly stated, a put option is in-the-money
(ITM) when the underlying asset price is below the
referred to as the "long," and the seller is referred to
strike price; out-of-the-money (OTM) when the
as the "short." The long has the right to sell the asset,
underlying asset price is above the strike price; and at-
while the short has the obligation to buy it if the long
the-money (ATM) when the underlying asset price and
chooses to exercise their right. the strike price are equal.
Strike Price: This is the predetermined price at which Option Pricing (Black-Scholes-Merton model): The
the underlying asset can be bought or sold. Black-Scholes-Merton model is indeed a crucial tool
for valuing options. However, it makes a number of
Premium: This is the fee paid by the long to the short
important assumptions that may not always hold true
for the right to sell the asset. It is paid at the initiation
in reality, such as the constant volatility of returns and
of the contract. the absence of transaction costs or taxes. In real
American-style/European-style: These terms refer to markets, these assumptions are often violated, which
when the option can be exercised. An American-style can lead to deviations between the model's
option can be exercised at any time up to its expiry predictions and observed prices. Despite this, the
model remains a fundamental tool in financial
date. In contrast, a European-style option can only be
economics, providing a useful benchmark for option
exercised at expiry. By Praveen Rana adda247
pricing.

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Interest Rate Calls and Puts: These are options where exchange for the right to receive a payout if the
the underlying asset is related to the interest rate. interest rate exceeds a specified level (the cap
Buying an interest rate call option implies the rate). By Praveen Rana ADDA247
expectation that interest rates will rise, which
• An Interest Rate Floor is the opposite of a cap. It
increases the value of the call position. Conversely,
provides a minimum interest rate for the
purchasing an interest rate put option suggests an
247holder, limiting their exposure to falling
anticipation of a decrease in interest rates, which
interest rates. By ADDA247
would boost the value of the put position.
• An Interest Rate Collar is a combination of a cap
Interest Rate Caps, Collars, and Floors: These are
and a floor, providing a band within which the
more complex types of options and are typically
interest rate can fluctuate. This can be useful for
traded in over-the-counter markets. They are
managing both upside and downside interest rate
primarily used to manage the risk of fluctuating
risk.
interest rates for floating-rate loans.
• A Reverse Collar involves buying an interest rate
• An Interest Rate Cap is an agreement that limits
floor and simultaneously selling an interest rate
the buyer's exposure to rising interest rates. The
cap. This setup aims to protect the buyer from
buyer of a cap pays a premium to the seller in
falling interest rates.

Unit-38 SWAP
iv. Both the long and short position do not pay or
Swaps are Over-the-Counter (OTC) contracts, private
receive a premium at the initiation of the swap,
agreements between two parties, which allow the
exchange of one stream of future cash flows for meaning it is designed to have zero value at its
another. This could be based on variables such as inception.
interest rate, exchange rate, equity price, or
v. To ensure the swap has zero value at initiation, a
commodity price.
"fair" fixed rate is established that makes neither
An interest rate swap is a type of swap where two counterparty's position an asset or a liability at the
parties agree to exchange fixed and floating interest start.
rates over a certain period of time. The party that
agrees to receive the floating rate and pay the fixed Swap Terminology
rate is the long position, and the party that agrees to i. Interest rate swap: As stated above, an interest
receive the fixed rate and pay the floating rate is the rate swap is an agreement in which two
short position.
counterparties agree to periodically exchange
Some important characteristics of swaps include: fixed and floating rates of interest over a number
i. The fixed rate, determined at the initiation of the of periods of time.
swap, does not change during its lifetime. ii. Buyer/Seller: By convention, the buyer of the IRS
agrees to periodically receive a floating rate and
ii. The floating rate, often linked to a benchmark like
pay a fixed rate. He assumes the long position in
the London Interbank Offered Rate (LIBOR) or the new
ARR (Alternative Reference Rates), fluctuates over the contract. The other swap counterparty, known
time. as the seller, agrees to periodically receive a fixed
rate and pay a floating rate. He takes a short
iii. The "tenor" of the swap, or its duration, is mutually
interest rate swap position.
decided by the two parties involved.

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 iii. Notional Principal: A monetary figure that is used iv. Equity Swaps: The underlying asset in an equity
as a part of the calculation to determine the swap could be a single stock, a basket of stocks,
payment amounts. The minimum notional or a stock index. One leg of the swap would
principal amount for which market makers in India involve cash flows based on the performance of
stand committed to their two-way quote is ` 5 the underlying equity, while the other leg could
crores. be based on a floating interest rate.
iv. Tenor: The length of time for which these v. An Interest Rate Swap (IRS) is a popular type of
payments will be exchanged is known as the tenor, financial derivative used to manage interest rate
term, maturity, or expiration of the swap. The exposure. Here's a further elaboration on your
tenor is determined by agreement between the description:
two parties. A rupee interest rate swap follows a
• An IRS is a contract between two parties to
day count basis of Actual/365.
exchange (or 'swap') interest payments, typically
v. Swap Facilitators: They are specialists in the swap
one fixed rate for one floating rate, over a set
market who help clients find ways, via the swap
period. The parties to the swap do not exchange
market, to alter or avoid unwanted risks. They are
the underlying principal amount (or 'notional
like financial engineers who design swaps to solve
principal') upon which these interest payments are
client problems.
calculated; they only exchange the interest
vi. Swap Brokers: Swap brokers bring swap
payments.
counterparties together so that a swap can be
• The fixed rate is determined at the initiation of the
arranged between them. By Praveen Rana
swap and does not change during the swap's life.
ADDA247
The floating rate, commonly linked to a
vii. Swap Dealers: Swap dealers, in addition to acting
benchmark such as the ARR (Alternative Reference
as facilitators or brokers, also enter into swaps on
Rates) or MIBOR (Mumbai Interbank Offered Rate)
their own behalf as one of the parties to the swap.
in India, fluctuates over time.
viii. The intermediaries in the swap product will be
• There is no premium paid or received at the
critical in enabling better risk management. Swap
is the medium of exchanging fund flows of one initiation of the swap, indicating it's designed to
have zero value for both parties at the start. A
entity with another that benefits both. The swap
"fair" fixed rate is established to ensure this, so
charges are nominal in relation to the risk that it is
neither counterparty's position is an asset nor a
able to manage.
liability at the initiation.
TYPES OF SWAP • The net present value (NPV) of the two streams of
i. Interest Rate Swaps: In interest swaps, one party interest payments should be the same at the start.
agrees to exchange interest payments based on This is easier to calculate for the fixed rate bond,
a fixed rate with another party for interest but more challenging for the floating rate bond as
payments based on a floating rate. it's linked to a changeable benchmark.
ii. Currency Swaps: In a currency swap, one party • As benchmark rates like MIBOR change after
agrees to exchange payments based on one initiation, one counterparty will benefit, and the
currency with another party for payments based other will be negatively impacted. Therefore, the
on another currency. value of the interest rate swap will no longer be
iii. Commodity Swaps: In a commodity swap, the zero for both parties:
floating market price is exchanged for a fixed • It becomes an asset for the counterparty that
price over a certain period. benefits from the benchmark rate change.

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• It becomes a liability for the counterparty that is Bringing a Swap into Place When Hedging Becomes
negatively impacted by the benchmark rate Necessary: If a borrower is uncertain about the future
change. direction of interest rates or unsure if they will need
• Hence, while IRS can help manage interest rate funds in the future, they might purchase a swaption.
risk, it also introduces counterparty risk as the In this case, if rates increase, they can exercise the
benchmark rate change can benefit or harm the swaption and lock in the previously agreed upon,
counterparties. lower rate. If the rates decrease, they can let the
swaption expire worthless and benefit from the lower
USES OF INTEREST RATE SWAP: interest rates in the market.
Reduction of Borrowing Cost: Companies with Removing an Existing Swap When It Becomes
different credit ratings can borrow at different rates in Unattractive: If a company has entered into a swap
different markets. The use of IRS can help these agreement but believes that market rates might
companies lower their overall borrowing costs. In the decrease in the future, they can purchase a swaption
scenario you described, Company A and Company B that allows them to exit the existing swap. If the rates
can take advantage of their different credit ratings and indeed decrease, they can exercise the swaption to
preferred markets to enter into an IRS. Company A, cancel the existing swap and take advantage of the
which has a comparative advantage in the floating- lower interest rates.
rate market, borrows at a floating rate, and Company
B, which has a comparative advantage in the fixed-rate Enhancing the Yield on an Underlying Position by
market, borrows at a fixed rate. They then swap these Selling a Swaption: Companies can sell swaptions to
interest payments, resulting in lower effective interest earn premium income, essentially betting that the
rates for both parties. This reduction of borrowing swaption will not be exercised by the buyer. This can
costs benefits both parties by exploiting their enhance the yield on the company's existing
comparative advantages in different markets. investments.

Gap Management by IRS: Banks frequently use IRS to Obtaining Access to a Swap When Borrowers Are
Uncertain of the Funding That Will Be Required:
manage their duration gap. A duration gap is the
When borrowers are unsure of their future funding
difference between the durations of a bank's assets
needs, they can use a swaption to secure the right to
and liabilities. Banks typically have assets with longer
enter into a swap agreement at a future date. If the
durations (loans) and liabilities with shorter durations
funding becomes necessary, they can exercise the
(deposits). Interest rate changes can affect the value
swaption and enter into the swap agreement. If the
of these assets and liabilities differently, creating a
funding is not needed, they can let the swaption
potential risk for the bank. By using IRS, banks can
expire.
effectively transform short-duration liabilities into
long-duration liabilities, thus matching the duration of
SWAP KEY POINTS
their assets. This helps to minimize the bank's
• Swaps were developed for the purposes of
exposure to interest rate changes.
hedging risks.
Swaptions indeed provide flexibility and control in the • In comparison to forwards and futures, swap
management of interest rate risks, as they offer the contracts have longer maturity.
right, but not the obligation, to enter into a swap • Swaps are over-the-counter contracts between
agreement in the future. Let's delve into the ways private parties. These are facilitated by swap
swaptions can be used: intermediaries.

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• In an interest rate swap, one party agrees to • A forward swap and swap futures are contracts to
exchange interest payments based on a fixed enter into a swap at a future time.
interest rate with another party for interest • A swaption is an options contract to enter into a
payments based on a floating rate. swap contract in the future. A swaption can also
• In a currency swap, one party agrees to exchange be used to remove an existing swap.
payments based on one currency with another • Interest rate swaps and currency swaps can be
party for payments based in another currency. valued on the basis of the principle that any swap
Currency swaps are interest rate swaps, where the contract can be considered as a series of forward
interest rates are based on the currencies of the contracts. The value of the swap at any time
two countries. would then be the sum of the value of each such
• The swap rate is the rate at which the party that forward contract for periodic payment.
has a fixed- interest-rate obligation pays the party
that has a floating-rate obligation, and vice versa.
There is an active swap market, and the swap
rates are determined in the market.
• The major reason for the use of interest rate swaps
and currency swaps is the comparative advantage
whereby one party has an advantage over the
other party in arranging a particular loan. The two
parties then share this comparative advantage
through a swap so that they can get a lower
interest rate through the swap agreement.

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