Futures and Options For CMA Exam

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1. DERIVATIES
Question 1: What are derivatives? Answer: Derivatives are financial instruments whose values depend on the value of the underlying assets
Question 2: What is forwards contract? Answer: Forward Contract is a simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price. A forward contract is traded in the over-the-counter market usually between a financial institution and of its client. Forward contracts are widely used in foreign exchange.
Question 3: What is future contract? Answer: Future Contract like a forward contract, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, Future contracts are normally traded on an exchange with pre-standardized lot. At the expiry of the contract, the future-contract price tends to future spot price of the underlying asset. Otherwise there is no profit or loss on settlement date. A futures contract has a) The date on which the contract is being executed b) The name of the underlying asset c) The quantity of the asset d) The contract price e) The period of the contract.
Question 4: Differentiate between Futures and Forwards. Answer: Futures 1 2 3 4 5 6 Trade in Contract term Liquidity Margin payment Settlement Risk of default organized exchange Standardized More Requires Daily Taken by clearing corporation Forwards OTC Customized Less Nil At the end of period Borne the client.
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Question 5: How to determine theoretical futures price? Answer: Formula Spot price Add Cost of carry Cost of finance Storage cost Insurance Cost Others Less Returns Future value of dividend2 Future Price [Fair Value]
Financial futures
Commodity futures Not Applicable
or S ( ) S S Rate of Storage
Not Applicable Not Applicable
or ( )
Where: S = Spot rate, r = rate of interest, t = time, e = constant for continuous compounding, d = rate of dividend, FV = Face Value of share, D = Dividend per share, dy = dividend yield, cy = Convenience Yield
Question 6: What is an index future? Answer: An index future is a derivative whose value is dependent on the value of the underlying asset (e.g. BSE Sensex, S&P CNX Nifty). In index futures, an investor buys and sells a basket of securities comprising an index in their relative weights.
Practical Problems
Question 1: The following quotes were observed by Mr. X on Mar 11, 2005 in the Economic Times. Contracts 1 2 SBI MAR 05 FUT NIFTY MAY 05 FUT Open 735 2800 High 740 2830 Low 735 2800 Close 738 2830 Open Interest 433 1016 Traded quantity 138000 102400 Number of Contracts 92 512
Required: Explain the details that are displayed against the futures. Answer: Column 1 2 3
1 2
Particulars Contracts Open High
Meaning Row 2 SBI stock future expires on Mar 2005 Days open-rate of SBI-stock future Days high-rate of SBI-stock future
Cost of finance is calculated using simple interest rate [ ] or continuous compound interest rate [ ] Return is in absolute numbers for shares and in dividend yield (dy) % for index future 6.2
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4 5 6 7 8 Note: Number of shares per contract [Lot size] = = Positions outstanding = = 2 Details of Nifty Index is also as similar as the above
1,38,000 92
Low Close Open Interest Traded quantity Number of contracts
Days low-rate of SBI-stock future Days close-rate of SBI-stock future Pending future contract Number of shares traded in the day Number of contracts traded in the day
= 1,500
Open interest Lot size = 433 1,500 6,49,500 shares
FUTURES PRICING & ARBITRAGE Question 2: Calculate the price of 3-month RIL futures and find the chance of arbitrage if any, if RIL (Face Value 10) quotes at 520 on NSE, and the 3 month futures price quotes at 542, and the one month borrowing rate is given as 15% p.a. and the expected annual dividend yield is Nil p.a. payable before expiry. Answer: Formula Spot price Add Cost of finance Future Price [Fair Value] 520
15 100
Calculation
520.00
3 12
19.50 539.50
Analysis: The fair value of Futures price [539.50] is lesser than the quote in the exchange [542]. Hence the Futures are overvalued in the market. Hence Arbitrageurs would buy stocks in cash market and sell the Futures.
Question 3: Calculate the price of 3-month M&M futures and find the chance of arbitrage if any, if M&M (Face Value 10) quotes at 520 on NSE, and the 3 month futures price quotes at 532, and the one month borrowing rate is given as 15% p.a. and the expected annual rate of dividend is 25% p.a. payable before expiry. Answer: Formula Spot price Add Cost of finance 520 100 12
15 3
Calculation
520.00 19.50
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Less Dividend Future Price [Fair Value] FV 10 100
25
2.50 337.00
Analysis: The fair value of Futures price [537] is lesser than the quote in the exchange [532]. Hence the Futures are undervalued in the market. Hence Arbitrageurs would sell stocks in cash market and buy the Futures.
[CA FINAL] Question 4: The following data relates to ABC Ltds share prices: 180 195
Current price per share Price per share in the 6 months futures market
It is possible to borrow money in the market for securities transactions at the rate of 12% p.a. Required: a. Calculate the theoretical minimum price of a 6-month futures contract
b. Explain if any arbitrage opportunities exist Answer: (a) Spot price Add Cost of finance Future Price [Fair Value] 180 100 12
12 6
Formula
Calculation
180.00 10.80 190.80
(b) Analysis: The fair value of Futures price [190.80] is lesser than the quote in the exchange [195]. Hence the Futures are overvalued in the market. Hence Arbitrageurs would buy stocks in cash market and sell the Futures.
Cash-flow Borrow for 6 months at an interest rate of 12% Less Add Less Buy share spot in cash market with the borrowings Sell Future Repay the borrowing together with interest 180 +1800.120.5 Net Cash Flow [Arbitragers surplus per share] Note: We have ignored transaction costs like commission, margin, etc. 180.00 (180).00 195.00 (190.80) 4.20
Question 5: Consider a 3 month expiry futures contract on a non-dividend paying stock. The underlying stock is available for 70 (Face Value 10). With continuously compounded Risk free rate (CCRRI) of 8% p.a.
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1. Find the price of futures. 2. If the stock pays a dividend yield of 5%, find the price of the futures. 3. If the stock pays a dividend of 1.50 in 3 months time, find the price of the futures. 4. If the stock pays a dividend of 1.50 in 1 months time, find the price of the futures. 5. If the stock pays a dividend of 2 today, find the price of the futures. 6. If the stock pays a dividend of 10% today, find the price of the futures.
Answer: Formula Spot price Add Cost of finance S ( ) S D or (FV ) 1 70.00 1.41 2 70.00 0.53 3 70.00 1.41 4 70.00 1.41 5 70.00 1.41 6 70.00 1.41
Less Future value of dividend Future Price
Nil Nil 1.50 1.52 2.04 1.02 71.41 70.53 69.91 69.89 69.37 70.39
Question 6: A stock index currently stands at 3500. The risk free interest rate is 8% per annum and the dividend yield on the index is 4% per annum. Expiry is in 4 months. What should the Index futures price be if it has continuously compounded rate? Answer: Formula Spot price Add Cost of finance Future Price S ( ) S 3,500
0.08 0.04 0.33
Calculation
Index 3,500.00 3,500 46.97 3,546.97
Question 7: Assume that the risk-free interest rate is 9% per annum with continuous compounding and that the dividend yield on a stock index varies throughout the year. In August and November dividends are paid at a rate of 5% per annum, in September at a rate of 6% per annum and in October at a rate of 2% per annum. Suppose the value of an index on July end is 3000. What is the futures price for a contract deliverable on November end? Answer: Formula for finding the future value = S e(r-dy)t 3000e(0.09 - 0.05)*(1/12) 3010.017e
(0.09 - 0.06)*(1/12)
The August Futures Price The September Futures Price The October Futures Price The November Future Price
= = = =
3010.017 3017.551 3035.205 3045.339 3045.339
3017.551e(0.09 - 0.02)*(1/12) 3035.205e(0.09 - 0.05)*(1/12)
Therefore the Novembers Futures Price as at July end
Question 8: Current value of stock index is 4500 and the annualized dividend yield is 4%. A three month futures contract on the SENSEX can be purchased for a price of 4600. The risk free rate of return is 10%. Can the investor earn abnormal risk free rate of return by resorting to Arbitrage?
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Assume that 50% of the stocks in the index will pay dividends during the next three months. Ignore transaction costs, margin requirements and taxes.
Answer: The fair value of Index Futures contract is Formula Spot price Add Cost of finance Future Price S ( ) S 4,500
0.10.0450% 0.25
Calculation
Index 4,500.00 4,500 90.90 4,590.90
The value of current index future is 4600 is overpriced. The arbitrageur can exploit the opportunity by buying in cash market and sell the future.
Cash-flow Borrow for 3 months at an interest rate of 10% Less Add Less Buy index in cash market with the borrowings Sell Future Repay the borrowing together with net interest 4,500 Net Cash Flow [Arbitragers surplus per lot]
0.10.0450% 0.25
4,500.00 4,500.00 4,600.00 4,590.90 9.10
Question 9: You have entered into a sale of one gold futures contract in Multi Commodity Exchange, to sell 1 kg of gold at 960,000 per kg. The contract now still has 6 months to expiry. Gold is trading now at 9350 per 10 gms (1 Futures Contract = 1 Kg.) and the six-month storage and risk-free rate are 0.2% & 5% with continuous compounding, respectively. What is the fair value of the contract? [Assume storage cost is paid in advance] Answer: Formula Spot price Add Cost of carry Cost of finance Future value storage cost Future Price S S S Rate of Storage
9,35,000
9,35,000 (0.050.5) 9,35,000 9,35,0000.002
(0.050.5)
23,667
1,917
9,60,584
Question 10: The current price of wheat is 900 per bushel. The storage costs are 145 per bushel per year payable in advance. Assuming that interest rates are 10% per annum with continuous compounding for all maturities and this year an expected convenience yield of 2% is observed. Calculate one year futures price of wheat.
Derivatives
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Answer: Formula Spot price Add Add Cost of finance Future Value of Storage cost Future Price [Fair Value] S
( )
Calculation
900.00
S
( )
900
(0.10.02)1
900
74.95 157.08
Storage Cost
145
(0.10.02)1
1,132.03
Question 11: The current price of Cotton is 400 per bale. The storage costs are 100 per bale per year payable in arrears. Assuming that, the interest rates are 10% per annum with continuous compounding for all maturities. Calculate one year futures price of 500 bales of Cotton. Answer: Formula Spot price Add Cost of carry Cost of finance Future value of Storage cost Future Price [Fair Value] S ( ) S Storage Cost 2,00,000 0.11 2,00,000 21,031.89 50,000.00 Calculation 2,00,000.00
2,71,031.89
Question 12: Consider a 6 month gold futures contract of 100 grams. If the spot price is 480 per gram and that it costs 3 per gram for the period to store gold and that the cost is incurred at the end of the period. a. If the continuously compounded Risk free rate (CCRRI) of 10% per annum, compute futures price. b. If futures are available at 520 per gram what action would be suggested? If futures are available at 490 per gram what action would be suggested? Answer: (a) Spot price Add Add Cost of finance Future value of Storage cost Future Price [Fair Value] (b) Actual Value of Futures = 52,000 Actual Value of Futures = 49,000 Fair Value < Actual Value Fair Value > Actual Value Sell Futures, Buy Gold in Spot Market Buy Futures, Sell Gold in Spot Market S S Storage Cost 48,000 0.10.5 48,000 3100 Formula Calculation 48,000.00 2,460.75 300.00
50,760.75
Question 7: Explain the concept of margin in F&O. Answer: Initial margin 1. Meaning: Initial margin, a sum of money, is deposited by both the buyer and the seller. 2. Purpose: To assure the execution of the contract.
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3. When to deposit: At the time of entering into the futures contract. 4. How much: Minimum margins are set by the Exchange and are usually about 10% of the total value of the contract. 5. How to calculate: An initial margin is calculated based on the concept of Value-at-Risk (VAR). 6. Why: The initial margin deposit is large enough to cover a one-days loss that can be encountered in 99% of the days.
Maintenance Margin: Maintenance Margin is the minimum margin required to hold a position. Maintenance margin should be sufficient to support the daily settlement process called mark-to- market, where by losses that have already occurred are collected. Initial margin, on the other hand seeks to safeguard against potential losses on outstanding positions. Maintenance margin is the margin required to be kept by the investor in the equity account equal to more than the specified percentage of the amount kept as initial margin. Normally this is 75% to 80% of the initial margin. In case this requirement is not met, the investor is advised to deposit cash to make up for the shortfall. If the investor does not respond, then the broker would close out the investors position by entering a reverse trade in the investors account. If the customer selects to liquidate open positions in order to meet a maintenance margin call, such liquidations are completed immediately. Any profits over the margin requirement can be withdrawn or used for other futures contracts.
Variation Margin: Variation margin is simply the running profit or loss on positions paid out or received on a daily basis. If a margin call is made and the money is deposited by the trader / investor, to bring the account to the level of initial margin, then the amount that is deposited is called as the variation margin. Variation margin is the amount needed to restore the initial margin once a margin call has been issued. The variation margin may change depending on how far the margin account has fallen below the maintenance margin level.
MARGINS
Question 13: Nifty Index is currently quoting at 1329.78. Each lot is 250 units. X purchases a March contract at 1364. He has been asked to pay 10% initial margin. What is the amount of initial margin? Nifty futures rise to 1370. What is the percentage gain? Answer: Particulars The initial margin deposited Profit or Loss Profit % Formula Value of Contract Initial Margin% (Latest price earlier price) Units

Calculation 1,3642500.10 (1,370 1,364)250

1,500 34,100
34,100 1,500 4.4%
Question 14: Suppose that X bought 1 contract of Andhra Bank Futures (each underlying 2300 equity shares) for 62.80 per share. The initial margin is 50%. The maintenance margin is 40%. Suppose that the stock price drops to 50 per share. a. Does X need to put additional fund to his account?
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b. What is the break-even price Andhra Bank can fall before X receives a margin call? c. Suppose that the price rises to 70. What is Xs rate of return on his investment? Particulars Initial margin Maintenance margin (a) Profit or Loss Formula Value of Contract Initial Margin% Value of Contract Maintenance Margin% (Latest price earlier price) Units Calculation 2,30062.800.50 2,30062.800.40 (5062.8)2,300 72,220 29,440 72,220 57,776 -29,440 42,780 29,440
72,220 57,776 2,300
Answer:
Balance in margin after loss Balance falls below maintenance margin, hence deposit required to bring his account to initial margin level (b) (c) Break-even price Return on investment Price

62.8
56.52 22.93%
70 62.8 62.80.5
[CMA FINAL] Question 15: On August 2nd, Mr. Tandon buys 5 contracts of December Reliance futures at 840. Each contract covers 50 shares. Initial margin was set at 2400 per contract while maintenance margin was fixed at 2000 per contract. Daily settlement prices are as follows:
August 2 August 3 August 4 August 5
818 866 830 846
Mr. Tandon meets all margin calls. Whenever he is allowed to withdraw money from the Margin Account, he withdraws half the maximum amount allowed. Compute for each day: 1. Margin call; 2. Profit & (Loss) on the contracts and mark-to-market 3. The balance in the Account at the end of the day. Assume that Mr. Tilak sells the same 5 contracts at the same price. If the same margins and same conditions are applicable, what are the margin calls, profit and loss and balance in the account for Mr. Tilak? Verify buyers gain is sellers loss i.e. prove futures are zero sum games. Answer: MARGIN ACCOUNT STATEMENT FOR TANDON & TILAK Particulars The initial margin The maintenance margin Formula Number of Contracts Initial Margin Number of Contract Maintenance Margin Calculation 2,4005 2,0005 12,000 10,000
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Tandon Aug 2 +/Details Initial Margin Paid Profit / (Loss) [mark-to-market] Closing Balance Deposit / (Drawings) Closing Balance 2 +/Opening Balance Profit / (Loss) [mark-to-market] Closing Balance Deposit / (Drawings) Closing Balance 4 Profit / (Loss) [mark-to-market] Closing Balance Deposit / (Drawings) Closing Balance 5 Profit / (Loss) [mark-to-market] Closing Balance Deposit / (Drawings) Closing Balance (846 830)250 shares Balance before withdrawals Half of (16,000 12,000) Balance after Margin Call (830 866)250 shares Balance before Margin Call Balance after Margin Call From previous day (866 818)250 shares Balance before Withdrawals (818 840)250 shares Balance before Margin Call [Long 5] 12,000 (5,500) 6,500 5,500 12,000 12,000 12,000 24,000 6,000 18,000 (9,000) 9,000 3,000 12,000 4,000 16,000 2,000 14,000 Tilak [Short 5] 12,000 5,500 17,500 (2,750) 14,750 14,750 (12,000) 2,750 9,250 12,000 9,000 21,000 4,500 16,500 4,000 12,000 250.00 12,250.00
Net gain or loss Mr. Tandons gain Mr. Tilaks loss
Closing Balance Initial Margin Variation margin Paid + Profit Withdrawn 14000 12000 [3000 + 5500] + [2000 + 6000] 12250 12000 [9250] + [250 + 4500 + 2750] Net position of the two 1,500 -1,500 0
Question 16: Nifty Index is currently quoting at 1300. Each lot is 250. Mr. X purchases a March contract at 1300. He has been asked to pay 10% initial margin. What is the amount of initial margin? To what level Nifty futures should rise to get a percentage gain of 5%. Answer: Particulars 1 2 The initial margin Nifty rise to gain 5% Formula Value of Contract Initial Margin% Price +
Deposit ROI
Calculation 1,3002500.10 1,300 +

32,5000.05 250
32,500 1,306.50
Question 17: A futures contract is available on a company that pays an annual dividend of 5 and whose stock is currently priced at 200. Each futures contract calls for delivery of 1,000 shares of stock in one
6.10
Derivatives
year, daily marking to market, an initial margin of 10% and a maintenance margin of 5%. The current Treasury bill rate is 8%. a. Given the above information, what should the price of one futures contract be?
b. If the company stock decreases by 7%, what will be, if any, the change in the futures price? c. As a result of the company stock decrease, will an investor that has long position in one futures contract of this company realize a gain or a loss? Why? What will be the amount of this gain or loss?
d. What must the initial balance in the margin account be? Following the stock decrease, what will be, if any, the change in the margin account? Will the investor need to top up the margin account? If yes, by how much and why? e. Given the company stock decrease, what is the percentage return on the investors position? Is it higher, equal or lower than the 7% company stock decrease? Why? (a) (b) 7% price fall Spot price Add Less Cost of finance Dividend Future Price [Fair Value] 200
8 100
Answer: Formula Calculation
200.00 1 16.00
186.00 14.88
5.00 211.00
5.00
195.88
(c) (d)
Loss because of price fall Initial Margin required for 1000 shares Balance after loss Maintenance Margin required for 1000 shares Value of shares Maintenance Margin% Value of shares Initial Margin%
1,000 (211195.88) 2111,00010%
15,120 21,100 5,980
2111,0005%
10,550 15,120 -71.7%
Balance after loss is less than maintenance margin hence he has to invest to bring his balance equal to initial margin else his position will be closed out by the broker (e) Return percent

15,120 21,100
The loss is 10 times higher than the actual decrease in the stock price. The 10-to-1 ratio of percentage changes reflects the leverage inherent in the futures contract position.
Question: What is the Hedging? Answer: Hedging is taking an equal and opposite position in another market so that loss that may arise in one market would be compensated by a gain in another market. The extent of hedging (hedge ratio) is determined by the beta of a security. If the beta is greater than one (i.e. hedge ratio is greater than one) then the position hedged would be higher than the underlying position and would be proportionate to the beta of the security.
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Question: What is the Hedge Ratio? Answer: The hedge ratio is the ratio between future position and underlying asset position. The hedge ratio allows the hedger to determine the number of contracts that must be employed in order to minimize the risk of the combined cash-futures position.

Hedge Ratio =
As explained earlier, for a perfect hedge, in case of a stock / portfolio position hedged with an index futures position, the hedge ratio is the beta of stock or portfolio. Else, if a stock is hedged using the same stock futures position, the hedge ratio is one. If the hedger wants to hedge his stock / portfolio position partially, then the hedge ratio would be less than one. On the hand if his future hedge position is more than that of his current position, we say that the hedge ratio is more than one. FUTURES HEDGING
Question 18: Identify the hedging strategies that would be required using the index futures under following circumstances: Stock RIL Satyam RIL Satyam Infosys Position Long Long Short Short Long Beta 1.2 0.8 1.2 0.8 1.0 Number of Shares 1000 1000 1000 1000 1000 Price 500 350 500 500 1700 Hedge Needed Full Full Full 80% 120%
Answer: Future position = Beta Number of Shares Price % Hedging required Stock Original Position Beta No. of Shares Price Hedge Needed Hedge Position Future position Futures Strategy [lacs] RIL Satyam RIL Satyam Infosys Long Long Short Short Long 1.2 0.8 1.2 0.8 1.0 1000 1000 1000 1000 1000 500 350 500 500 1700 Full Full Full 80% 120% Short Short Long Long Short 1.210005001.0 0.810003501.0 1.210005001.0 0.810005000.8 1.0100017001.2 Short 6 Short 2.8 Long 6 Long 3.2 Short 20.4
[CA FINAL] Question 19: Which position on the Index future gives a speculator a complete hedge against the following transactions? 1. The share of Right Ltd. is going to rise. He has a long position on the cash market on 50 lakhs on the Right Ltd. The beta of the Right Ltd. is 1.25.
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2. The share of Wrong Ltd. is going to depreciate. He has a short position on the cash market of 25 lacs on the Wrong Ltd. The beta of the wrong Ltd. is 0.9 3. The share of Fair Ltd is going to stagnate. He has a short position on the cash market of 20 lacs of Fair Ltd. The beta of the Fair Ltd. is 0.75 Answer: Future position = Beta Value of Investment Stock Original Position Right Ltd Wrong Ltd Fair Ltd Long Short Short 1.25 0.9 0.75 50 25 20 Beta Value Hedge Position Short Long Long [Optional] Future position 1.2550 0.925 0.7520 Futures Strategy [lacs] Short 62.5 Long 22.5 Long 15
[CA FINAL] Question 20: Ram buys 10,000 shares of X Ltd. at 22 and obtains a complete hedge of shorting 400 NIFTIES at 1,100 each. He closes out his position at the closing price of the next day at which point the share of X Ltd. has dropped 2% and the Nifty future has dropped 1.5%. What is the overall profit or loss of this set of transaction? Answer: The gain or loss incurred by Ram can be estimated as follows:
Value of Bought Shares Todays Valuation Next Days Valuation* Gain / (Loss) 2210,000 21.5610,000 2.2 Lakhs 2.156 lakhs (0.044) lakhs
Value of Short Futures 4001100 4001083.5 4.4 lakhs 4.334 lakhs 0.066 lakhs
*When share price drops by 2% and Futures drop by 1.5% Net Gain = 0.066 lakhs 0.044 lakhs = 0.022 lakhs = 2200
ALTER THE BETA OF PORTFOLIO Question 21: A portfolio manager manages a large portfolio of 300 million with a beta of 1.6 (90% of total portfolio consists of stock and rest 10% is cash) He expects the market to be volatile in the near future and contemplates to reduce his portfolio beta to 1.0. How he can accomplish his goal using stock index futures? (Assume the current index to be quoting at 1000 with a market lot of 100). Answer: Equity Cash Total portfolio 0.9 0.1 1.0 270 million 30 million 300 million
The fund manager has to sell index futures to reduce the beta. He would sell N contracts so that the following equation is satisfied:
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(270 million1.6) (1000100N) = 300 million1.0 Solving the above equation gives N = 1320 The fund manager would sell 1320 contracts i.e. 13201000100 = 132 million of Index futures and accomplish his goal of reducing the beta to 1.0 Question 22: A portfolio manager manages a large portfolio of 200 million with a beta of 1.0 (80% of total portfolio consists of stock and rest 20% is cash) He expects the market to rally in the near future and contemplates to increase his portfolio beta to 1.5. How he can accomplish his goal using stock index futures? (Assume the current index to be quoting at 1000 with a market lot of 100). Answer: Equity Cash Total portfolio 0.8 0.2 1.0 160 million 40 million 200 million
The fund manager has to buy index futures to increase the beta. He would Buy N contracts so that the following equation is satisfied: (160 million1.6) + (1000100N) = 200 million1.5 Solving the above equation gives N = 1400 The fund manager would buy 1400 contracts i.e. 14001000140 = 140 million of Index futures and accomplish his goal of increasing the beta to 1.5
Question 23: Let us consider a portfolio held by Mr. X. Portfolio Beta () 0.983
Portfolio Characteristics 20 Stocks
Total Cost in Lakhs 1520.87
Market Value in Lakhs 1767.59
Mr. X believes that the portfolio performance since the day it was constructed has been good. He has clocked a return of 16.22% over a three month period. However, now he is getting worries whether the out performance would continue next month. He wants to protect his portfolio by using 1 month S&P CNX Nifty Futures which is quoting at 2189.05, Each Nifty contract is 200 units. Explain the use of hedging by Index Futures. Also explain how much overall gain / loss he would witness (a) if the market rises by 10% (b) if the market falls by 10%. Answer: As given Mr. X has decided to use S&P CNX Nifty futures for hedging. One Nifty contract represents 2002189.05 = 437,810. Mr. X has to first have the beta of the portfolio. Which we know: p = 0.983. Now, we calculate the number of futures he has to sell. This is equal to 0.9831767.59100000/437810 = 397 contracts approximately. Thus, Mr. X will have to sell 397 contracts of 1 month Nifty futures to hedge the portfolio equivalent to 2189.05200397 = 1738 lakhs. Let us estimate what happens when the nifty futures moves up or down. We also know that the index too would track similar movement. [We omit interest cost on initial margin, since no information is provided]
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Derivatives
Portfolio Value Market up 10% Market down 10% 1767.59 1.1 = 1944.35 lakhs 1767.59 0.9 = 1590.83 lakhs Nifty Futures * 3972002189.051.1 = 1911.92 lakhs 3972002189.050.9 = 1564.30 lakhs Gain / Loss (1944.35 1767.59) (1911.92 1738) = 2.84 lakhs (1590.83 1767.59) (1564.30 1738) = -3.06 lakhs
It can be seen that in the first case, when the market rose, X made a small profit and incurred a little loss of (3.06 / 1767.59) = 0.17% only when the market fell. As against a 10% loss which he would have incurred had we not hedged, X incurred a minimal acceptable loss. Obviously the gains were also clipped to (2.84 / 1767.59) = 0.16% as against 10% rise of market. Thus hedging does not aim to make profits or reduce losses; it aims to lock a portfolio value i.e. it aims to reduce the uncertainty that may arise while managing the portfolio.
Question 24: Suppose you own a grove of Apple trees. The harvest is still two months away but you are concerned about price risk. You want to guarantee that you will receive 10.00 per KG in two months regardless of what the spot price is at that time. You are selling 25,000 Kgs. a. If you short sell apples at 10 per Kg., show the economics of a short transaction in the forward market if the spot price on delivery date is 7.50 per Kg, 10.00 per Kg, or 12.50 per Kg.
b. What would have happened to you if you had not entered the hedge and each scenario is equally likely? c. What is the variability of your receipts after the hedge is in place?
Answer: a) Apple Growers Transaction Proceeds from sale of Apple Cash flow from futures contract Total receipts 7.50 / Kg 10.00 / Kg 187,500 +62,500 250,000 250,000 0 250,000 12.50 / Kg 312,500 -62,500 250,000
b) You would have had a 1/3 chance each of paying out 187500 (less than expected), 250000 (the same as expected) or 312500 (more than expected) i.e. 250000 c) No variability. Receipts are always equal to 250000. Question 25: Suppose in six months time the cost of 1 Kg of Mentha oil will either be 480 or 520. The current futures price is 500 per Kg. How can two parties (seller & buyer) use the Mentha oil futures market to reduce their risks and lock in a price of 500 per Kg.? Assume each contract is for 360 Kgs and they each need to hedge 720 Kgs. Can you say that each party has been made better off? Why or why not?
Derivatives
6.15
Answer: (a) Formula Mentha Oil [S6 / kg] Gain (Loss) Net Value S6 = Spot price at the end of 6th month (b) Even though it appears that in each scenario one party has benefited at the expense of the other, both have really benefited because both parties were able to lock in a price of 500 per Kg. and eliminate all risk. (S6 X)720 kg Buyer 480 (14,400) 3,60,000 520 14,400 3,60,000 (X S6)720 kg Formula Seller 480 14,400 3,60,000 520 / Kg. (14,400) 3,60,000
Question 26: Suppose you are a CFO of Hotels ITC and you purchase a large quantity of coffee each month. You are concerned about the price of coffee one month from now. You want to guarantee that you will not pay more than 100 per Kg. of Coffee A for 15,000 Kgs. You do not want to pay for insurance but you do want to lock in a current price of 100 per Kg for 15,000 Kgs. a. Show the economics of a futures transaction if the spot price on the delivery date is 75, 100, or 125. If at the time of delivery coffee is 75 per Kg, should you have forgone entering into the futures contract? Why or why not?
b. What is the variability of Hotels ITCs total outlays under the fut ures contract? c.
Answer: (a) CFO would sell Coffee A futures entailing 15,000 Kgs. at the prevailing price of 100 / Kg CFO Hotels Transaction Cost of coffee purchased from supplier Cash flow from futures contract Total outlay Outlays are fixed at 1500000. 75/Kg 1125000 +375000 1500000 100/Kg 1500000 0 1500000 125/Kg 1875000 (375000) 1500000
a.
b. Regardless of the outcome of the price of coffee at the delivery date, the Treasurer did the right transaction if he wanted to lock in a price of 100 per Kg. Although he gave up any opportunity to pay a lower price, he also guaranteed that he would never pay more than 100 per Kg. A hedge transaction is only useful if one does not know the future price of some item, hence the need to hedge the risk of uncertainty.
Derivatives
6.16
OPTIONS BASICS
Question 1: Write a note on options. Answer: There are two types of options, calls and puts. Call option: gives the buyer of the call option the right, but not the obligation, to buy shares of the underlying security or index at a specific price for a specified time. The seller of a call option (writer) has the obligation to sell the underlying share if the buyer exercises the option. Put option: gives the buyer of the put option the right, but not the obligation, to sell shares of the underlying security or index at a specific price for a specified time. The seller of a put option (writer) has the obligation to buy the underlying share if the buyer exercises the option.
Question 2: Explain At-the-money option, In-the-money option and Out-of-the money option. Answer: Term In-the-money At-the-money Out-of-the-money Meaning Profit position in option Break-even in option Loss position in option Call option Market price > Strike price Market Price = Strike Price Market Price < Strike Price Put option Market Price < Strike Price Market Price = Strike Price Market price > Strike price
Question 3: Explain intrinsic value and time value Answer: Intrinsic Value = Gain when the option is in-the-money or 0 when the option is out-of-the-money Extrinsic Value or Time Value = Premium Intrinsic Value
Question 4: Write a note on long and short. Answer: Long is buy position and short is sell position Long Call & Short Call: Long call is buy position of call and Short call is sell position of call Long Put & Short Put: Long put is buy position of put and Short put is sell position of put
Question 5: What are the variables of a call option? Answer: 1. Price of the underlying asset 2. Exercise price 3. Variability of return 4. Time left to expiration 5. Risk-free interest
Derivatives
6.17
PRACTICAL PROBLEMS
Question 1: The following quotes were observed by Hari on March 11, 2005 in the Economic Times.
Contracts CE-1950March 2005 PE-2100March 2005
Open 191.05 19.50
High 205 26
Low 191.05 18.65
Close 204.90 19.9
Open Interest 41,000 26,47,000
Traded quantity 1,600 13,69,000
Number of Contracts 8 6845
Underlying NIFTY NIFTY
Explain what these quotes indicate. Answer: Column 1 Particulars Contracts Meaning Row 2 Call European of NIFTY with strike price 1,950 and expires on March 2005 2 3 4 5 6 7 8 Open High Low Close Open Interest Traded quantity Number of contracts Days open-premium-rate of NIFTY call European Days high-premium-rate of NIFTY call European Days low-premium-rate of NIFTY call European Days close-premium-rate of NIFTY call European Pending contracts Number of NIFTY index traded in the day Number of contracts traded in the day
Each Nifty is 1600 / 8 = 200 units of the underlying.
Question 2: The following quotes were observed by Sanjay on Mar 11, 2005 in the Economic Times. Contracts CA-370-Mar 2005 PA-135-Mar 2005 Open 7.35 3.00 High 9.60 3.10 Low Close 7.35 1.75 8.75 1.90 Open Interest 649,500 203200 Traded quantity 138,000 102,400 Number of Contracts 92 64 Underlying ACC MTNL
Explain what these quotes indicate. Answer: CA Call American, PA Put American. Other than CA and PA, the explanations for the other columns are the same as earlier problem.
Question 3: For the following identify the nature of the option Mr. X holds: a) The option gives him the right to purchase equity shares of Satyam at 725 on or before March 28, 2006.
6.18
Derivatives
b) The option gives him the right to sell equity shares of Sesa Goa at 1025 on or before March 28, 2006. Answer: Nature of option (a) (b) Option to purchase Satyam at 725 Option to sell of Sesa Goa 1,025 Call option Put option
Question 4: Mr. Ramesh purchases the following European Call options on Reliance. He also purchases the following European put options on ACC. What decision he would take on expiry, if Reliance (RIL) closes at 835 and ACC closes at 565? Ignore premium paid. 1. RIL 830 Call 2. RIL 840 Call 3. ACC 510 Put 4. ACC 580 Put Answer: X (a) (b) (c) (d) Call Option to purchase RIL Call Option to purchase RIL Put option to sell ACC Put option to sell ACC 830 840 510 580 835 835 565 565 Position Exercise Do not exercise Do not exercise Exercise Profit 5 0 0 15
Question 5: Identify which of the following options is In-The-Money (ITM), At-The-Money (ATM) or Out-of-The-Money (OTM) for the buyer of option. Which of these options would be exercised? Treat each case individually. 1. RIL 840 CALL when the price on expiry is 855 2. RIL 830 CALL when the price on expiry is 840 3. RIL 800 CALL when the price on expiry is 765 4. ACC 510 PUT when the price on expiry is 510 5. ACC 520 PUT when the price on expiry is 500 6. ACC 540 PUT when the price on expiry is 555 Answer: X 855 840 765 510 500 ITM / OTM / ATM Position Profit= Max [S X, 0] 1 2 3 4 5 RIL Call Option RIL Call Option RIL Call Option ACC Put Option ACC Put Option 840 830 800 510 520 In the money In the money Out of the money At the money In the money Exercise Exercise Lapse Lapse Exercise 15 10 0 0 20
Derivatives
6.19
6 ACC Put Option 540 555 Out of the money Lapse 0
For Call Option: ITM: S > X, OTM: S < X & ATM: S = X For Put Option: ITM: S < X, OTM: S > X & ATM: S = X
Question 6: For each of the following options, find out the Intrinsic Value and the Time Value. The premium paid by the buyer is given in brackets. Details of options purchased are given. Treat each case individually. 1. HLL 180 PUT (9) 2. L&T 1510 PUT (7) 3. ACC 540 PUT (39) 4. HLL 205 CALL (2) 5. L&T 1500 CALL (12) 6. RIL 800 CALL (37) On the day of expiry the prices of stocks were: HLL 200; L&T 1510; RIL 825 & ACC 515. Answer: X 1 2 3 4 5 6 HLL Put Option L&T Put Option ACC Put Option HLL Call Option L&T Call Option RIL Call Option 180 1,510 540 205 1,500 800 200 1,510 515 200 1,510 825 Premium Paid 9 7 39 2 12 37 OTM ATM ITM OTM ITM ITM Position Lapse Lapse Exercise Lapse Exercise Exercise Intrinsic Value 0 0 25 0 10 25
1
Time Value2 9 7 12 2 2 12
Question 7: The call option of X with a 25 strike price is available. The following table contains historical values for this option at different stock prices:
Stock Price 25 30 35 40 45 50
Call Option Price 3.00 7.50 12.00 16.50 21.00 25.50
1 2
Intrinsic Value [Profit]= Max [S X, 0] Time Value = Premium Intrinsic Value 6.20
Derivatives
Create a table which shows: a) c) e) Answer: Call Option X 1 2 3 4 5 6 25 25 25 25 25 25 25 30 35 40 45 50 Premium Paid 3.00 7.50 12.00 16.50 21.00 25.50 ATM ITM ITM ITM ITM ITM Position Lapse Exercise Exercise Exercise Exercise Exercise Intrinsic Value 0 5 10 15 20 25
1
Stock price Intrinsic value, The time value.
b) d)
Strike price, Option price,
Time Value2 3 2.50 2 1.50 1 0.50
Question 8: What is the Intrinsic Value and time value in the following cases? Price of Stock (S) 25 30 45 20 45 50 Answer: Option X 25 35 25 25 55 50 25 30 45 20 45 50 Premium Paid 13.00 17.50 22.00 16.50 12.00 20.50 ATM ITM OTM OTM ITM ATM Position Lapse Exercise Lapse Lapse Exercise Lapse Intrinsic Value 0 5 0 0 10 0
3
Strike Price (X) 25 35 25 25 55 50
Premium 13.00 17.50 22.00 16.50 12.00 20.50
Nature of Option Call Put Put Call Put Put
Time Value4 13.00 12.50 22.00 16.50 2.00 20.50
1 2 3 4 5 6 [CA FINAL]
Call Put Put Call Put Put
Question 9: An investor has the following position on options of CIPLA.

1 2 3 4
Intrinsic Value [Profit]= Max [S X, 0] Time Value = Premium Intrinsic Value Intrinsic Value [Profit]= Max [S X, 0] Time Value = Premium Intrinsic Value 6.21
Derivatives
1. Long one call option with a premium of 25 per stock at an exercise price of 400. 2. Long one put option with a premium of 5 per stock at an exercise price of 300. 3. The prevailing market price of the CIPLA stock is 350. 4. Options are European options with expiration period of 3 months. You are required to find out the profit or loss to the investor in the following market situations: 1. At expiration if the price of the CIPLA remained at present level. 2. At expiration if the price of the CIPLA rises to 500. 3. At expiration if the price of the CIPLA falls to 250. Answer: Long Call X = 400, CP =25 1 2 3 350 500 250 Long Put X = 300, PP=5 Total Profit
(Max ( X, 0) CP) (Max (X , 0) PP) 25 75 25 5 5 45 30 70 20
OPTION GREEKS
Questions: What are Greeks? Answer: Greeks measure the sensitivity of option price. Long Call 1 2 3 4 Delta [ ] Gamma [] Vega [Lambda][] Theta[]

Short Call
Long Put + +
Short Put + +
+ + + +
Note 1: the maximum value of a delta [ ] for a call option is 1 [ 1 for put option], because the option premium does not change beyond the price change of underlying stock Note 2: Assign + for long position and [ for short position] Note 3: Vega lies between 0 to , and maximum for at-the- money option. High Vega is attractive. Assign + for long position and [ for short position]
Question 1: Find delta of the following individual positions of a stock X, given that delta of call = +1 and of put = 1 4 long calls
Derivatives
6.22
3 short puts 6 long puts 5 short calls 4 long puts and 4 shares 30 short calls and 3 shares. Answer: Position 4 Long Calls 3 short puts 6 long puts 5 short calls 4 long puts & 4 shares 30 short calls and 3 shares Details Delta of Call Positive, Delta of Long Position Positive Delta of Put Negative, Delta of Short Position Negative Delta of Put Negative, Delta of Long Position Positive Delta of Call Positive, Delta of Short Position Negative Delta of: Put Negative; Long Position Positive; Underlying Positive Delta of: Call Positive; Short Position Negative; Underlying Positive 30+3=27 Net Delta +4+1 = +4 31 = +3 +61 = 6 5+1 = 5 4 +4 = 0
Question 2: Calculate the Net Delta of the following individual contracts. Also calculate the Net delta if these contracts form a single portfolio. 1. Short 2 Calls with a delta of 0.5 2. Long 1 Puts with a delta of 0.3 3. Long 5 Calls with a delta of 0.2 Answer: We know that Delta of Long Calls & Short Puts is positive and that of Short Calls and Long Puts are negative. Position 1 2 3 4 Short 2 Calls with a delta of 0.5 Delta Long 1 Puts with a delta of 0.3 Delta Long 5 Calls with a delta of 0.2 Delta Portfolio [Total] Calculation 20.5 10.3 +50.2 Net Delta 1.0 0.3 +1.0 0.3
Question 3: Mr. A decides to purchase Two RIL 840 call options which have a delta of 0.75 each. He also plans to simultaneously hedge by buying Four RIL 900 Put options which has a delta of 0.375. What is the net delta of each position? What is the net delta of overall position? Is he fully hedged? Answer: Position 1 2 3 Delta of RIL Call position Delta of RIL Put position Net Delta of entire position Calculation (+2)(+0.75) (+4)0.75 +1.51.5 Net Delta +1.5 1.5 0
Since net delta of the entire position is zero, Mr. A is perfectly hedged.
Derivatives
6.23
Question 4: Given that Vega of a call is 0.098 and Vega of a put is 0.076, find out position Vega of Long 3 calls and Short 5 Puts. Answer: Vega of entire position = +3 0.098 + (5) 0.076 = 0.086
Question 5: Given the following portfolio position comprised of stock X and various options on stock X. Currently stock X quotes at 25.
Short 45 X Short 100 X April 25 calls Long 50 X April 30 Calls Long 130 X July 30 Calls
1.00 0.89 0.76 0.70
0.00 0.01 0.03 0.02
Find position Delta and Position Gamma. If X moves up by 1 point, how much will the delta move? And if, X moves down by 1 point, by how much will the delta move? [Each call has underlying 1 share of X] Answer: Option Position Short 45 X Short 100 X April 25 calls Long 50 X April 30 Calls Long 130 X July 30 Calls Total Delta 1.00 0.89 0.76 0.70 Position Delta Calculation 451 100(+0.89) +50(+0.76) +130(0.70) 4589 + 38 + 91 45 89 38 91 5 Option Gamma 0.00 0.01 0.03 0.02 Position Gamma Calculation 450 100(+0.01) +50(+0.03) +130(0.02) 01+1.5+2.6 0 1 1.5 2.6 3.1
If X moves up by one point, delta of entire position would move by (Current Delta + Gamma i.e. 5 + 3.1) 1.9 i.e. the entire position would depict short 1.9 shares for every rise of 1 in stock X. And if X moves down by one point, delta of entire position would move by (Current Delta Gamma i.e. -5 3.1) 8.1 i.e. the entire position would depict short 8.1 shares for every fall of 1 stock X.
Question 6: Given the following portfolio position: Position Short 2000 X Short 100 X May 25 calls Long 50 X May 30 Calls Long 10 X August 30 Calls Option Delta 1.00 0.89 0.76 0.74 Option Gamma 0.00 0.01 0.03 0.02 Option Vega 0.00 0.02 0.05 0.07
Find position Delta, Position Gamma and Position Vega. (Assume each contract of all options to be comprising of 100 shares of the underlying). To make it gamma neutral, what strategy need to be adopted? Establish a suitable position to make the above position both gamma and delta neutral. What will be the overall gain / loss subject to increase in 1% implied volatility?
Derivatives
6.24
Answer: Position Delta Short 2000 X Short 100 X May 25 calls Long 50 X May 30 Calls Long 10 X August 30 Calls Total 1.00 0.89 0.76 0.74 Individual Gamma 0.00 0.01 0.03 0.02 Vega 0.00 0.02 0.05 0.07 Delta 2000 8900 +3800 +740 6360 Position Gamma 0 100 +150 +20 +70 Vega 0 200 +250 +70 +120
The Gamma of the current position is +70. To make it neutral we short 70 more X May 25 calls. In that case the new position Gamma would be = -1701000.01 + 501000.03 + 101000.02 = 0. Now our entire position is gamma neutral. But by selling 70 more May 25 Calls, our position delta would have changed. The delta of this new position would be = -2000 1701000.89 + 501000.76 + 101000.74 = -12590. The earlier position delta has increased significantly to 12590. This can be made neutral only by going long 12590 shares. Since we are already short 2000 shares, the net will be long 10590 shares of the underlying. Thus the new position would be depicted as under.
Position Delta Long 10590 X Short 170 X May 25 calls Long 50 X May 30 Calls Long 10 X August 30 Calls Total 1.00 0.89 0.76 0.74
Individual Gamma 0.00 0.01 0.03 0.02 Vega 0.00 0.02 0.05 0.07
Position Delta +10590 15130 +3800 +740 0 Gamma 0 170 +150 +20 0 Vega 0 340 +250 +70 20
We can see that after the portfolio has been converted to delta and gamma neutral, the position Vega is just 20. This implies that an increase in implied volatility by 1% our profits would reduce by 20 on the overall position. Obviously, we would make 20 for every fall in implied volatility of 1%.
Question 7: X holds 100 contracts each of the following options. Each contract has 100 shares of the underlying. The theta of the options is as follows:
Option July 30 call July 30 put (a) What is the position theta? (b) How much X will lose or gain per day?
Theta 0.03 0.03
(c) How much a seller of this position will lose or gain per day?
Derivatives
6.25
Answer: (a) Calculation of position theta: Option Position Long 100 Long 100 July 30 call July 30 put Theta 0.03 0.03 Position Theta 300 300 600
(b) Theta is always given as a negative number. A long position holder would witness time decay. In this case, Xs overall position would lose 600 per day. (c) Theta (time decay of an option) always favors the seller. Hence the seller of this position would gain 600 daily from this position. Question 8: We have stock P whose price if 480. With three months to expiration, we have the following calls available. April 500 call and April 600 call. Each contract has 100 shares of the underlying. Given the following data Option April 500 Call April 600 Call Delta 0.373 0.095 Gamma 0.009 0.002 Vega 0.006 0.004
A spreader desires to make a profit of approximately 50 for each one percentage decrease in volatility. Contract a strategy using mathematical approach assuming that he wants his position delta and gamma neutral. i.e., how many options should be spread to achieve the desired result? Answer: Our aim is first to make the portfolio gamma neutral. Then make it delta neutral and finally ensure that position Vega is 50. This would ensure that the entire position would give us 5000 for every decrease of 1% in implied volatility. Let X represent the number of April 500 Calls we buy and y represent the number of April 600 calls we buy. First we make the portfolio gamma neutral i.e. ensure that the weighted average of gamma of both these calls is zero. 0.009x + 0.002y = 0 [1] We construct a second equation of Vega to give us the desired 50 i.e. o.5 (50/100) on every contract of 100 shares. 0.006x + 0.004y = -0.5 [2]
Multiplying equation [1] by 0.006 & equation [2] by 0.009 and then subtracting [2] from [1], we get (0.0000Q0.000036) y = -0.0045 Therefore y = -187.5 Solving these two simultaneously we get: Y = -188 and X= +42
Derivatives
6.26
This means that we need to sell 188 contracts of April 600 Calls & we need to buy 42 contracts of April 500 calls to make 50 for every fall in 1%. This would however change our net delta, which we need to neutralize. The delta of the position would be calculated as follows: -1881000.095 + 421000.373 = -219 Since this is equivalent to short 219 shares, we make it neutral by going long 219 shares.
Valuation of Options
Question: What are the methods of valuation of option? Binomial Model for Option Valuation: the value of a call option as per the binomial model is equal to the hedge portfolio (consisting of equity and borrowing) that has a payoff identical to that of the call option. Assumptions for the binomial model: The stock, currently selling for S, can take two possible values next year, uS or dS An amount of B can be borrowed or lent at a rate of r the risk-free rate. The value of r is greater than d but smaller than u. This condition ensures that there is no risk-free arbitrage opportunity. The exercise price is E
The value of call option If the stock price goes up to uS [Cu]= Max (uS E, 0) If the stock price goes down to dS [Cd]= Max (dS E, 0)
Portfolio of shares and B rupees of borrowing (1) Stock price rises, Cu = uS RB (2) Stock price falls, Cd = dS RB From (1) and (2), = ( ) =

B = (1+ )( ) Since the portfolio (consisting of shares and B debt) has the same payoff as that of a call option, the value of the call option is C = (S B) Risk-Neutral Valuation: Current value of call option is present value of the expected future value of the option Question 1: Calculate the value of call option from the following data S E r 200 220 10% u d 1.4, 0.9
Derivatives
6.27
Answer: The value of call option under option equivalent method [one-step binomial model] Formula 1 2 3 4 5 Cu Cd B C Max (uS E, 0) Calculation Max (1.4 200 220, 0)
60 0 200(1.40.9) 0.9(60 0) 1.1(1.40.9)
60 0 0.6 98.18 21.82
Max (dS E, 0) Max (0.9 200 220, 0)

( ) (1+ )( )
S B
0.6200 98.18
The value of call option under Risk-Neutral Valuation Particulars Expected return Probability of rise [Pr] Future value of call option Current value of call option Formula Pr(u 1)+(1Pr)(d 1) = 0.1 From the above formula PrCu + (1 Pr)Cd
1+
Calculation
0.4 0.460 + (10.4)0

24 1+0.1
24 21.82
Question: Explain Black Scholes Model of pricing an option. Answer: Fischer Black and Myron Scholes published a paper in 1973 for the pricing of options and corporate liabilities that is now known as the Black-Scholes model. It is the standard method of pricing a European call option. Variables used in the model are stock price expiration date risk-free return standard deviation (volatility) of the stocks return. Black-Scholes formula for pricing call option = C = S N(d1) Xe-rT N(d2) d1 d2 Where Variables C S X r T N() Meaning Price of the Call option Spot price of the underlying stock Option eXercise price Risk-free interest rate Time to expiration area under the Normal curve = =
In ( ) + (r +
2 )T 2
d1
Derivatives
6.28
A comparison between binomial model and black-scholes model Option Position 1 Buy Call Option Binomial Model Borrow B Buy shares 2 Sell Call Option Lend B Sell shares 3 Buy Put Option Lend B Sell shares 4 Sell Put Option Borrow B Buy shares Black-Scholes Model Borrow Xe-rT N(d2) Buy N(d1) shares Lend Xe-rT N(d2) Sell N(d1) shares Lend Xe-rT (1 N(d2)) Sell 1 N(d1) shares Borrow Xe-rT (1 N(d2)) Buy (1 N(d1)) shares
Adjustment for Dividends Short-term options, Adjusted stock price = S = S

1+
Long-term options, where dividend yield (y) expected is stable Black-Scholes formula for pricing call option = C = S N(d1) Xe-rT N(d2)
2 )T 2
d1 d2
= =
In ( ) + (r y +
d1
Question 2: Calculate the value of a put option from the following date S E R Answer: Formula 1 2 3 4 d1 d2 C P
In ( ) + (r +
2 )T 2 60 50
60 50 8%
3 months 0.4
Calculation
In ( ) +(0.08 +
0.04 2 0.25 ) 2
1.1115 0.9115 11.87 0.88
0.4 0.25
d1 S N(d1) Xe-rT N(d2) 0 0 +
1.1115 0.4 0.25 60 N(1.1115) 50e-0.080.25 N(0.9115) 11.87 60 + 0.080.25

50
PUT CALL PARITY Question 3: What would be the price of a call, if Value of a Put=5, Strike Price = 100, Current price = 100, Rate of interest = 6%, Time Period = 2 months. Answer:
Derivatives
6.29
Formula 0 0 + 0
Calculation 100 + 5
100
0.06 2 12
Question 4: The common share of a company is selling at 90. A 26 week call is selling at 8. The calls exercise price is 100. The risk free rate is 10% p.a. What should be the price of a 26 week put of 100? Answer: Formula 0 0 0 + Calculation 8 90 + 100 0.1.5 6
Question 5: Mr. Narendra holds an American put option on Delta Airlines a non-dividend paying stock. The strike price of the put is 40, and Delta Airlines stock is currently selling for 35 per share. The current market price of the put is 4.50. Is this option correctly priced? If not, should Mr. Narendra buy or sell the option in order to take advantage of the mispricing? Answer: the option pricing is mispriced, that leads to arbitrage gain as follows Strategy 1 2 3 Buy put option Buy stock Exercise put option Arbitrage Profit Cash Flow 4.50 35.00 +40.00 +0.50
Therefore, Mr. Narendra should buy the option for 4.50, buy the stock for 35, and immediately exercise the put option to receive its strike price of 40. This strategy yields a risk less, arbitrage profit of 0.50 (=5 4.50)
Question 6: GESCO has both European call and put options traded on NSE. Both options have same exercise price of 40 and both expire in one year. GESCO does not pay any dividends. The call and the put are currently selling for 8 & 2 respectively. The risk free rate of interest is 10% p.a. What should the stock price of GESCO trade in order to prevent arbitrage? Answer: Formula 0 0 = 0 0 + Calculation 2 = 8 0 + 0.1
40
42.36
[CS FINAL] Question 7: The following quotes are available for 3-months options in respect of a share currently traded at 31: Strike price Call option 30 3
Derivatives
6.30
Put options 2
An investor devises a strategy of buying a call and selling the share and a put option. What is his profit / loss profile if it is given that the rate of interest is 10% per annum? What would be the position if the strategy adopted is selling a call and buying the put and the share? Answer: Formula 0 + 0 = 0 + Calculation 31 + 2 = 3 + 30 0.10.25 33 = 32.27 LHS RHS, Hence arbitrage exist
Arbitrage strategy: Buying a call & Selling a put & spot leading a profit of LHS RHS [3332.27=0.73] Cash Flow < E, = 25 Buy a call Sell a put and spot Net Investment @ 10% Withdraw investment Call [Exercise | Lapse] Put [Exercise | Lapse] Buy stock to cover short Net Flow 3 33 30 30.75 Lapse 5 25 0.75 = E = 30 3 33 30 30.75 Lapse Lapse 30 0.75 > E = 35 3 33 30 30.75 30 Lapse 0 0.75
Similar strategy if developed by selling the call and buying the share and put would result in an initial out flow of 0.73, and hence not advisable.
Risk-neutral approach Question 8: We provided with the following information: Stock price = 88; Risk free rate = 3%; In 3 months time the stock could either go up to 95 or down to 82. The strike price is 90. Compute the value of put option using risk neutral probability. Answer: Particulars Expected return Probability of rise [Pr] Future value of call option Current value of call option Formula Pr(u 1)+(1Pr)(d 1) = 0.0075 From the above formula PrCu + (1 Pr)Cd
1+
Calculation
0.5123 0.51230 + (10.513)8

3.896 1+0.0075
3.896 3.867
Derivatives
6.31
Question 9: We are provided with the following information: Stock price = 88; Risk free rate = 3%; In 3 months time the stock could either go up to 95 or down to 82. The strike price is 90. Compute the value of call option using risk neutral probability. Using the answer of the previous problem, verify whether Put Call parity holds. Answer: Particulars Expected return Probability of rise [Pr] Future value of call option Current value of call option Formula Pr(u 1)+(1Pr)(d 1) = 0.0075 From the above formula PrCu + (1 Pr)Cd
1+
Calculation
0.5123 0.51235+(10.513)0
2.5615 1+0.0075
2.5615 2.54
Formula 0 + 0 = 0 +
Calculation 88 + 3.87 = 2.54 + 90 0.0075 91.87 = 91.87 LHS = RHS, Put-call parity exists
Question 10: We have a stock which is quoted at 80. Its beta is 1.2. In 2 months time the stock market can either go up by 20% or fall by 10% from the current price. Mr. X wishes to find the price of call option of strike price = 80, on this stock using risk less hedge approach. The risk free rate is given as 12%. Explain how hedge can be created using these call options if Mr. X holds 1,000 shares of the stock. It is given that each call option underlies 1,000 shares of the stock. Answer: u = market u beta = 20%1.2 = 24% [1 + 24% = 1.24] d = market d beta = 10% 1.2 = 12% [1 12% = 0.88] Formula 1 2 3 4 5 Cu Cd B C Max (uS E, 0) Max (dS E, 0)
( ) (1+ )( ) (1+
Calculation Max (1.2480 80, 0) Max (0.8880 80, 0)

19.2 0 80(1.24 0.88) 0.8819.20
0.12 2)(1.24 0.88) 12
19.2 0 0.667 46.01 7.35
S B
0.66780 46.01
Two-step binomial model Question 11: Consider a stock which is quoted at 84. A put option on this available at a strike price of 87.50. The stock can take values of 89 or 79 in 3 months. If it takes a value of 89, it can go to either 94 or 84 in another 3 months. And if it takes the value of 79 after 3 months, it can go to either 84 or 74 in another 3 months. The stock is not expected to pay any dividend. It is given that the risk free rate is 4%. Find the price of the put option using binomial model.
Derivatives
6.32
Answer: Formula u d 1 2 3 4 5 Pu Pd B P Max (uS E, 0) Max (dS E, 0)
( ) (1+ )( )
Calculation
94 89 84 89
Pu 1.0562 0.9438 0 3.5018 -0.3501 32.57 1.42
Calculation
84 79 74 79
Pd 1.0633 0.9367 3.5 13.5 -1 86.625 7.625
Max (87.5 1.056289, 0) Max (87.5 0.943889, 0)

0 3.5018 89 1.0562 0.9438 0.943800.3501 (1+0.01)(1.0562 0.9438 )
Max (87.5 1.063379, 0) Max (87.5 0.936779, 0)

00 79(1.0633 0.9367 ) 0.9367 00 1+0.01 1.0633 0.9367
S B
0.3501 89 32.57 Formula u d 1 2 3 B P

( ) (1+ )( )
1 79 86.625
Calculation
89 84 79 84 1.42 7.625 89 79 0.94053.7873 0 1+0.01 1.0595 0.9405
1.0595 0.9405 -0.6205 56.08 3.97
S B
-0.6205 84 56.08
Question 12: Consider a stock which is quoted at 84. A call option on this available at a strike price of 87.50. The stock can take values of 89 or 79 in 3 months. If it takes a value of 89, it can go to either 94 or 84 in another 3 months. And if it takes the value of 79 after 3 months, it can go to either 84 or 74 in another 3 months. The stock is not expected to pay any dividend. It is given that the risk free rate is 4%. Find the price of the call option using binomial model. Using the value of put option; verify the put call parity theorem. Answer: Formula u d 1 2 3 4 5 Cu Cd B C Max (uS E, 0) Max (dS E, 0)
( ) (1+ )( )
Calculation
94 89 84 89
Cu 1.0562 0.9438 6.5018 0 0.6499 54.0538 3.7873
Calculation
84 79 74 79
Cd 1.0633 0.9367 0 0 0 0 0
Max (1.056289 87.5, 0) Max (0.943889 87.5, 0)

6.5018 0 89 1.0562 0.9438 0.94386.5018 0 (1+0.01)(1.0562 0.9438 )
Max (1.063379 87.5, 0) Max (0.936779 87.5, 0)

00 79(1.0633 0.9367 ) 0.9367 00 1+0.01 1.0633 0.9367
S B
0.6499 89 54.0538
Derivatives
6.33
Formula u d 1 2 3 B C
( ) (1+ )( )
Calculation
89 84 79 84 3.7873 0 8979 0.94053.7873 0 1+0.01 1.0595 0.9405
1.0595 0.9405 0.3787 29.6339 2.1769
S B
0.3787 84 29.6339
Formula 0 + 0 = 0 +
Calculation 84 + 3.97 = 2.1769 + 87.50 0.040.5 87.97 = 87.97 LHS = RHS, Put-call parity exists
[CS FINAL] Question 13: The current market price of the equity shares of Bharat Bank Ltd. is 190 per share. It may be either 250 or 140 after a year. A call option with a strike price of 180 (time 1 year) is available. The rate of interest applicable to the investor is 9%. Rahul wants to create a replicating portfolio in order to maintain his pay off on the call option for 100 shares. Find out (i) hedge ratio; (ii) amount of borrowing; (iii) fair value of the call; and (iv) his cash flow position after a year. Answer: Formula u d 1 2 3 4 5 Cu Cd B C Max (uS E, 0) Calculation
250 190 140 190
Cu 1.3158 0.7368 70.002 0 0.6363 81.725 39.172
Max (1.3158190 180, 0)
Max (dS E, 0) Max (0.7389190 180, 0)

( ) (1+ )( ) 70.002 0 190 1.3158 0.7368 0.7368 70.002 0 (1+0.09)(1.3158 0.7368 )
S B
0.6363 190 81.725
Question 14: Suppose Anns stock price is currently 25, In the next six months it will either fall to 15 or rise to 40. What is the current value of a sixmonth call option with an exercise price of 20? The sixmonth risk-free interest rate is 5% (periodic rate). [Use risk-neutral valuation] Answer: u=
40 25 15 25
= 1.6, d =
= 0.6
Derivatives
6.34
Particulars Expected return Probability of rise [Pr] Future value of call option Current value of call option Formula Pr(u 1)+(1Pr)(d 1) = 0.05 From the above formula PrCu + (1 Pr)Cd
1+
Calculation
Question 15: Kim is interested in buying a European call option on Nalco a non-dividend paying stock, with strike price of 110 and one year until expiration. Currently Nalco sells for 100 per share. In one year Kim knows that Nalco would either trade at 120 or 80 per share. Kim is able to borrow and lend at risk free rate of 2.5% per annum, (assume simple interest). How much Kim should pay for this call option? Use risk neutral argument. Answer: Particulars Expected return Probability of rise [Pr] Future value of call option Current value of call option Formula Pr(u 1)+(1Pr)(d 1) = 0.05 From the above formula PrCu + (1 Pr)Cd
1+
Calculation
Question 16: What is the value of the following call option according to the Black Scholes Option Pricing Model? Stock Price Exercise Price Time to Expiration Risk-Free Rate Stock Return Variance 27.00 25.00 6 Months 6.0% 0.11
Answer: Black Scholes Model Formula 1 2 3 4 d1 d2 C P

In ( ) + (r +
2 )T 2
Calculation
In ( ) +(0.06 +
27 25 0.11 0.5 ) 2
0.5736 0.3391 4.0036 1.2754
0.3317 0.5
d1 S N(d1) Xe-rT N(d2) 0 0 +
0.5736 0.3317 0.5 27 N(0.5736) 25e-0.060.5 N(0.3391) 4.0036 27 + 0.060.5

25
Question 17: The share of APAR Ltd. is currently priced at 415 and call option exercisable in 3 months time has an exercise rate of 400. Risk free interest is 5% p.a. and standard deviation (volatility) of share price is 22%.
Derivatives
6.35
(a) Based on the assumption that APAR Ltd. is not going to declare any dividend over the next three months, is the option worth buying for 25? (b) Calculate value of aforesaid call option based on Block Scholes valuation model if the current price is considered as 380. (c) What would be the worth of put option if a current price is considered 380? (d) If APAR ltd. share price at present is taken as 408 and a dividend of 10 is expected to be paid in the two months time, then calculate value of the all options. Answer: (a) Formula 1 2 3 4 d1 d2 C P
In ( ) + (r +
2 )T 2
Calculation
In (
415 ) +(0.05 400
0.22 2 0.25 ) 2
0.5033 0.3933
0.22 0.25
d1 S N(d1) Xe-rT N(d2) 0 0 +

0.5033 0.22 0.25

50
415 N(0.5033) 400e-0.050.25 N(0.3966) 27.58 11.87 60 + 0.080.25 0.88
Since market price of 25 is less than 27.58 (Black Scholes Valuation model). This indicates that the option is under priced, hence worth buying. (b) If the current price is taken as 380 the computations are as follows: Formula 1 2 3 (c) d1 d2 C P
In ( ) + (r +
2 )T 2
Calculation
In (
380 ) +(0.05 400
0.22 2 0.25 ) 2
-0.2976 -0.4077 7.10 22.16
0.22 0.25
d1 S N(d1) Xe-rT N(d2) 0 0 +
-0.2976 0.22 0.25 380 N(-0.2976) 400e-0.050.25 N(-0.4077) 7.10 380 + 0.050.25
400
(d) Since dividend is expected to be paid in two months time we have to adjust the share price and then use Block Scholes model to value the option. Adjusted S = S Present Value of Dividend = 408 10 (0.0512 ) = 398.08
2
Formula 1 2 3 (c) d1 d2 C P
In ( ) + (r +
2 2
Calculation
)T In (
398 .08 ) +(0.05 400
0.22 2 0.25 ) 2
0.125 0.015 18.98
0.22 0.25
d1 S N(d1) Xe-rT N(d2) 0 0 +
-0.2976 0.22 0.25 398.08 N(0.125) 400e-0.050.25 N(0.015) 18.98 398.08 + 0.050.25
400
Derivatives
6.36
OPTION STRATEGIES
Question: What is option spreads? Answer: Option spread means taking position in two or more options of the same type (i.e. calls or puts) on the same underlying assets. 1. Vertical spread is an option spread, which has different strike prices but the same expiration date. 2. Horizontal spread is the spread, which has different expiration dates but the same strike price . This spread is also called time spread or calendar spread. 3. Diagonal spread is the spread in which two legs of the spread have different strike prices and different expiration dates. This position has features of both vertical and horizontal spreads and so may be called a hybrid product.
Question: Write a note on option strategies. Answer: 1. Bull call spread: A bull call spread involves the purchase and sale of call options at different exercise prices but with the same expiry date. The purchased calls should have a lower exercise price than the written calls. 2. Bull put spread: A bull put spread involves the purchase and sale of put options at different exercise prices but with the same expiry date. The purchase puts should have a lower exercise price than the written puts. 3. Bear call spread: A bear call spread involves the purchase and sale of call option at different exercise prices and the same expiry date. But the purchased calls have a higher exercise price than the written calls. 4. Bear put spread: A bear put spread involves the purchase and sale of put option at different exercise prices and the same expiry date. But this time purchased puts have a higher exercise price than the written puts.
Question: Write a note on straddle and strangle. Answer: Straddle & Strangle: Straddle & Strangle are strategies tailor made for volatile situations. Long straddle: Purchase a call option and a put option with the same exercise price. Short straddle: Sell a call option and a put option with the same exercise price. Long strangle: Purchase a call and a put with different exercise prices Short strangle: Sell a call and a put with different exercise prices
Question: Explain Butterfly Spread. Answer: A Butterfly Spread is an option strategy combining a bull and bear spread. It uses three strike prices. The lower two strike prices are used in the bull spread, and the higher strike price in the bear spread. Both puts and calls can be used. A butterfly spread consists of either all calls or all puts and all options expire at the same time. Long butterfly spread: A long butterfly spread can be created by buying one option at each of the outside exercise prices and selling two options at the inside exercise price.
Derivatives
6.37
Short butterfly spread: A short butterfly spread can be created by selling one option at each of the outside exercise prices and buying two options at the inside exercise price. The butterfly spread is a neutral options strategy position used when the underlying security is not too volatile by expiration. Both risk and profit are limited and commission costs are high. The maximum profit is realized if the stock price expires at the strike price.
General concept of using options and futures Bullish Perspective Futures Call options Put options Buy Futures Buy options Sell options Bearish Perspective Sell Futures Sell options Buy options
Strategies with Individual Stock Option Protective Put: protect against potential losses beyond a level [invest in stock and purchase put] Payoff X Stock Add Put Total X- X 0 X
Covered Call: Invest in stock and short call in the same stock Payoff X Stock Add Call Total 0 X -( ) X
Payoff of a Straddle X Payoff of a call Add Call Total Payoff of a Spread < Payoff of a call, X = Add Payoff of call, X = Total 0 -0 0 < < ( ) -0 ( ) > ( ) -( ) (2 1 ) 0 ( ) ( ) X ( ) 0 ( )
Derivatives
6.38
Collar: limits the value of a portfolio held within two bounds by buying put and writing call at relatively same X for both options. The premium paid for long put is offset with premium received for short call
Question 1: Mr. Eswar sold 10 BILT put options and bought 5 BILT call options. Both options have same exercise price of 80 and the same expiration date. Draw the payoff diagram with respect to various prices BILT may take at expiration. Answer: X = 80 S CE PE Payoff p.c. Max(S-X, 0) Max (X-S, 0) Total c. 5 10 50 0 -300 -300 55 0 60 0 65 0 -150 -150 70 0 -100 -100 75 0 -50 -50 80 0 0 0 85 25 0 25 90 50 0 50 95 75 0 75 100 100 0 100 105 125 0 125 110 150 0 150
-250 -200 -250 -200
Question 2: Suggest what strategies an investor could adopt on Reliance Industries in the options market in each of the following, if: (a) Investor is strongly bullish. (b) Investor believes the bullish trend would continue but is not very bullish. (c) Investor believes that the chance of market going up is more than the chance of market going down. (d) Investor believes that the chance of market going up is more than the chance of market going down and wants to earn income. (e) What is common in all the above strategies? Answer: (a) It is without doubt, that when an investor is bullish, he would buy a call option on Reliance Industries. His loss is limited to premium paid. It is generally adopted when the option is undervalued and volatility is increasing. (b) When an investor believes the bullish trend would continue but is not very bullish, he may sale a put option on Reliance Industries. Selling a put is a neutral-bullish position. Here his profit is limited to premium received. It is generally adopted when the options volatility is increasing. (c) When an investor believes that the chance of market going up is more than the chance of market going down, he may buy Call & Sell call of higher strike price, or Reliance industries. This is a buying a Bull Call Spread strategy. This transaction would provide a range bound payoff, both on the upside and the downside and maximum loss is limited to the net debit of the position. (d) When an investor believes that the chance of market going up is more than the chance of market going down and wants to earn income, he would sell Put & but Put of lower strike price, of Reliance Industries. This is a selling Bear Put Spread strategy. In this case the loss is limited to strike price difference premium received. This would be used when the overall position derives a good income. (e) All the strategies explained above are adopted when the view on the stock / market is bullish.
Question 3: Suggest what strategies an investor could adopt on Reliance Industries in the options market in each of the following if: (a) Investor is strongly bearish. (b) Investor believes the bearish trend would continue but is not very bearish.
Derivatives
6.39
(c) Investor believes that the chance of market going down is more than the chance of market going up. (d) Investor believes that the chance of market going down is more than the chance of market going up and wants to earn income. (e) What is common in all the above strategies? Answer: (a) It is without doubt, that when an investor is bearish, he would buy a put option on Reliance Industries. His loss limited to premium paid. It is generally adopted when the option is undervalued and volatility is increasing. (b) When an investor believes the bearish trend would continue but is not very bearish, he may sell a call option on Reliance Industries. Selling a call is a neutral-bearish position. Here his profit limited to premium received. It is generally adopted when the option is overvalued and market trend is flat to bearish. (c) When an investor believes that the chance of market going down is more than the chance of market going up, he may buy Put & Sell of higher strike price, of Reliance Industries. This is a buying Bear Put Spread strategy. This transaction would provide a range bound payoff, both on the upside and the downside and maximum loss is limited to the net debit of the position. (d) When an investor believes that the chance of market going down is more than the chance of market going up and wants to earn income, he would sell Call & buy Call of higher strike price, of Reliance Industries. This is selling Bear Call Spread strategy. In this case the loss is limited to strike price difference credit. (e) All the strategies explained above are adopted when the view on the stock / market is bearish.
Bull Call Spread Question 4: X is moderately bullish on the market and wants to capitalize on a modest advance in price of the L&T. He is not very bullish on L&T. He has a discomfort with the cost of purchasing and holding the long call alone. On 1 st November, the share price of L&T is 204. Suggest a suitable strategy if call options on L&T with strike prices of 200 & 220 are available for 16 & 8 respectively. Explain with the help of payoff table and diagram, what strategy he would adopt. Answer: X = 200 and 220, Apply Bull Call Spread [purchase call at lower X, and sell call at higher X] X CE CE B S 200 220 P 16 8 S Max (S-X, 0) Max (S-X, 0) Payoff 150 -16 8 -8 170 -16 8 -8 190 -16 8 -8 200 -16 8 -8 208 -8 8 0 210 -6 8 2 216 0 8 8 220 4 8 12 240 24 -12 12 260 44 -32 12
Bull Put Spread Question 5: X is moderately bearish on the market and wants to capitalize on a modest decrease in price of the L&T. He is not very bearish on L&T. He has a discomfort with the cost of purchasing and holding the long put alone. He needs a small income on the spread. On 1 November, the share price of L&T is 204. Suggest a suitable strategy if put options on L&T with strike prices of 200 & 220 are available for 7 & 18 respectively. Explain with the help of payoff table and diagram, what strategy he would adopt.
Derivatives
6.40
Answer: X = 200 and 220, Apply Bull Put Spread [purchase put at lower X, and sell put at higher X] X PE PE B S 200 220 P 7 14 S Max (X-S, 0) Max (X-S, 0) Payoff 150 43 -52 -9 170 23 -32 -9 190 3 -12 -9 200 -7 -2 -9 208 -7 6 -1 209 -7 7 0 210 -7 8 1 216 -7 14 7 220 -7 18 11 240 -7 18 11 260 -7 18 11
Bear Call Spread Question 6: Tata Tea is trading at 228. X an investor is moderately bearish on the stock and wants to create a spread using calls that would earn him little income. Call options on Tata Tea are available with strike prices of 240 & 220 priced at 9 & 20 respectively. Explain with the h elp of payoff table for all prices, what strategy he would adopt. Answer: X = 240 and 220, Apply Bear Call Spread [purchase call at higher X, and sell call at lower X] X CE CE B S 240 220 P 9 20 S Max (X-S, 0) Max (X-S, 0) Payoff 190 -9 20 11 200 -9 20 11 210 -9 20 11 220 -9 20 11 230 -9 10 11 231 -9 9 0 240 -9 0 -9 250 260 270
1
-10 -9
11
-20 -9
21
-30 -9
Bear Put Spread Question 7: Tata Tea is trading at 228. X an investor is moderately bullish on the stock and wants to create a spread using puts. Put options on Tata Tea are available with strike prices of 240 & 220 priced at 16 & 7 respectively. Explain with the help of payoff table for all prices, what strategy he would adopt. Answer: X = 240 and 220, Apply Bear Put Spread [purchase put at higher X, and sell put at lower X] X PE PE B S 240 220 P 16 7 S Max (X-S, 0) Max (X-S, 0) Payoff 190 34 -23 11 200 210 220 230 231 240 250 260 270
24
-13 11
14
-3 11
4
7 11
-6
7 1
-7
7 0
-16
7 -9
-16
7 -9
-16
7 -9
-16
7 -9
Question 8: Over the coming year the common stock of Dabur, will either halve to 50 from its current level of 100, or rise to 200. The 1-year risk-free interest rate is 5%. What is the delta of a one-year call option on Dabur stock with a strike price of 170? How an investor can hedge 1000 shares of Dabur which he holds, if each call option underlies 100 shares of Dabur? Answer: Formula The delta is [] Short Call

Calculation
30 0 200 50
0.2 200 shares (or) 2 call options
No. of Shares
0.21,000
Derivatives
6.41
Question 9: We have put options on a stock available with strike prices of 30 and 35. While the 30 Put costs 2, the 35 put costs 5. Explain how can we form a bull spread and a bear spread? Also tabulate the values at expiry for various values of stock ST. Answer: X = 30 and 35, Apply Bull Put Spread [purchase put at lower X, and sell put at higher X] X PE PE B S 30 35 P 2 5 S Max (X-S, 0) Max (X-S, 0) Payoff 35+ -2 5 3 30-35 -2 Max (S-35, 0) + 5 S-32 30Max (30-S, 0) 2 Max (S-35, 0) + 5 -2
X = 30 and 35, Apply Bear Put Spread [purchase put at higher X, and sell put at lower X] X PE PE S B 30 35 P 2 5 S Max (X-S, 0) Max (X-S, 0) Payoff 35+ 30-35 30-
Butterfly Spread Question 10: We have put options on a stock available with strike prices of 55, 60 and 65 and they cost 3, 5 & 8 respectively. Explain how we can form a butterfly spread using these puts. Also tabulate the values at expiry for various values of stock ST. Answer: X = 55, 60 and 65, Butterfly Spread [purchase put at the lowest and highest X each one, and sell 2 puts at mid X] X PE PE 2PE B B S 55 65 60 P 3 8 5 S Max (X-S, 0) Max (X-S, 0) Max (X-S, 0) Payoff 50 2 7 -10 -1 55 56 60 64 65 70
-3 2
0 -1
-3 1
2 0
-3 -3
10 4
-3 -7
10 0
-3 -8
10 -1
-3 -8
10 -1
The butterfly leads to a loss then the final stock price is greater than 64 or less then 56.
Butterfly Spread Question 11: Construct a Butterfly Spread using XYZ November 90 call (priced at 6.50), XYZ November 100 calls (priced at 3.50) and XYZ November 110 call (priced at 2). Draw the payoff diagram for range or prices at expiry (70 130). What specific consideration if anyone needs to take before setting up this spread? Answer: X = 90, 100 and 110, Butterfly Spread [purchase calls at the lowest and highest X each one, and sell 2 calls at mid X]
Derivatives
6.42
X CE CE 2CE B B S 90 110 100 P 6.5 2 3.5 S Max (S-X, 0) Max (S-X, 0) Max (X-S, 0) Payoff 70 -6.5 -2 7 -1.5 80 90 95 100 105 110 120 130
-6.5 -6.5 -1.5 -2

7 -1.5
3.5 -2
7 8.5
8.5 -2
-3 3.5
13.5 23.5 33.5 -2

-13 -1.5
-2
7 -1.5
-2
7 3.5
8
-33 -1.5
18
53 -1.5
Maximum loss in the butterfly spread is 1.5 Maximum gain in the butterfly spread is 8.5 This strategy involves enter in to 4 options, which leads to high cost of commission. The profit from the spread may be eroded by the cost of the commission. Hence care should be taken before the construction of butterfly spread.
Long Straddle Question 12: We have call and put options on a stock available with a strike price of 60. While the call options costs 6, the put options cost 4. Explain how we can form a straddle. Also tabulate the values at expiry for various values of stock ST. Answer: X = 60, Straddle [purchase call and put at the same X] X CE PE B B 60 60 P 6 4 S Max (X-S, 0) Max (X-S, 0) Payoff 45 -6 11 5 50 55 60 65 70 75
-6 6
0
-6 1
-5
-6 -4
-10
-1 -4
-5
4 -4
0
9 -4
5
There is a loss with this strategy if the final stock price is between 50 and 70.
Long Straddle Question 13: Assume you can buy or sell either the call or the put options, with a strike price of 35. The call option has a premium of 3, and the put option has a premium of 2. Which of these option contracts can be used to form a long straddle? What is the payoff if the stock price closes at 38 on the op tion expiration date? What is the payoff if the stock price closes at 28 on the option expiration date? Answer: X = 35, Long Straddle [purchase call and put at the same X] X CE PE B B 35 35 P 3 2 S Max (X-S, 0) Max (X-S, 0) Payoff 38 0 -2 -2 28
-3 5
2
Short Straddle Question 14: Assume you can buy or sell either the call or the put options, with a strike price of 35. The call option has a premium of 3, and the put option has a premium of 2. Which of these option contracts
Derivatives
6.43
can be used to form a short straddle? What is the payoff if the stock price closes at 38 on the option expiration date? What is the payoff if the stock price closes at 28 on the option expiration date? Answer: X = 35, Short Straddle [sell call and put at the same X] X CE PE S S 35 35 P 3 2 S Max (X-S, 0) Max (X-S, 0) Payoff 38 0 2 2 28
3 -5
-2
[CS FINAL] Question 15: An investor purchased Reliance November Future (600 shares Tick size) at 542 and wrote a 580 November call option at a premium of 6 (600 shares Tick size). As on November 20, the spot prices rose and so also the future prices and the call premiums. Future price rises to 575 and call premium rises to 12. Find out profit / loss of the investor, if he [she] settles the transaction on that date and at stated prices. Brokerage is 0.05% for the transaction value of futures and strike price net of call premium for option. (a) Why the investor did write a call? Why did he [she] buy a call subsequently? (b) Do you think the strategy taken by investor was logical? Answer: Original Transaction Original purchase price of Futures @ 542 Add: Brokerage Paid Total Outflow Premium received by writing call @ 6 Less: Brokerage Paid Total Inflow Net Outflow:[325362.60 3427.80] 325,200.00 162.60 325,362.00 3,600.00 172.20 3,427.80 321,934.80
Offsetting Transactions: Sale of Futures @ 575 Less: Brokerage Paid Total Inflow Squaring off written call @ 12 (Buy) Add: Brokerage Paid Total Outflow: Net Inflow: [344827.50 7370.40] Total Inflow arising out of all transactions: 345,000.00 172.50 344,827.50 7,200.00 170.40 7,370.40 337,457.10 15,522.30
Derivatives
6.44
(a) The investor it appears has hedged his long future position by selling calls. Any rise in futures would be offset by writing calls (though not fully). He bought the call to square off the written call. (b) The strategy was to hedge that may arise out of future position by writing calls. The strategy may not be termed logical owing to the meager compensation provided by the written calls. Question 16: Mr. Ashok holds 10000 shares of IOB bought at 35. He is of the opinion that his portfolio needs protection on the downside. He has the following options short listed: (a) To write covered calls at a strike price of 45 (January Expiry) which are priced at 3 per share (each contract underlies 1000 shares of IOB). (b) To buy protective puts at a strike price of 35 (January Expiry) which are priced at 3 per share (each contract underlies 1000 shares of IOB). (c) To establish a Collar with these call & put. (d) Which of these would be advised to Mr. Ashok? How you rank them? Answer: (a) By writing covered call options, Ashok collects premium income of 30000. If the price of the stock in January is less than or equal to 45, he will have his stock plus the premium income. The stock will be called away from him if its price exceeds 45. The payoff structure is:
Stock price Less than 45 More than 45
Portfolio value 10,000 times stock price + 30000 450000 + 30000 = 480000
(b) By buying put options with a 35 exercise price, Ashok will be paying 30000 in premiums to insure a minimum level of 3510,000 30000 = 320000. This strategy allows for upside gain, but exposes Ashok to the possibility of a moderate loss equal to the cost of the puts. The payoff structure is:
Stock price Less than 35 More than 35
Portfolio value 350000 30000 = 320000 10,000 times stock price - 30000
(c) A collar can be established by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock. In other words, one collar equals one long put and one written call along with owing in 100 shares of the underlying stock. The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside. In the present case the net cost of the collar is zero. (This is because, the income received by writing a call will be used to pay premium of the put option). The value of the portfolio will be as follows:
Stock price Less than 35
Portfolio value 350000
Derivatives
6.45
Between 35 and 45 More than 45 10,000 times stock price 450000
If the stock price is less than or equal to 35, the collar preserves the 350000 in principal. If the price exceeds 45 Ashok gains up to a cap of 450000. In between, his proceeds equal 10000 times the stock price.
(d) The best strategy in this case would be (c) since it satisfies the two requirements of preserving the 350000 in principal while offering a chance of getting 450000. Strategy (a) seems ruled out since it leaves Ashok exposed to the risk of substantial loss of principal. The ranking would be (c) (b) and (a), in that order.
Protective Put Question 17: Ram and Shyam purchase an Index at 1200. However, they decide to seek downside protection by buying put option of different strike prices. Whereas, Ram prefers at the money Put option costing 60, Shyam buys In-the-Money Put option with a strike price of 1170, costing 45. Compare and contrast their profits of the respective protective puts they have purchased. Answer: Rams strategy Initial cost Payoff S 1200 Stock Index Put option (X = 1200) Total Profit = Payoff 1260 Break Even Point = 1260 1200 60 1260 S 1200 S 1200 1200 1260 = -60 S > 1200 S 0 S S 1260
Shyams strategy Initial cost Payoff S 1170 Stock Index Put option (X = 1170) Total Profit = Payoff 1245 Break Even Point = 1245 1200 60 1245 S 1170 S 1170 1170-1245= -75 S > 1170 S 0 S S 1245
Shyam does better when the stock price is high, but worse when the stock price is low. Both Ram &Shyam incur same losses of 60, at the break-even point of S = 1185. Shyams strategy has greater systematic risk. Profits are more sensitive to the value of the stock index.
Derivatives
6.46
[Value of a Warrant] Question 18: Consider the following data Number of share outstanding Current stock price Ratio of warrants issued to the number of outstanding share Exercise price Standard deviation of continuously compounded annual returns Time to expiration of warrants Risk-free interest rate per year 80 million 80 0.05 84 0.30 3 months 8%
What is the value of a warrant? Ignore the complication arising from dividends and / or dilution. Answer: The value of the warrant (call option using Black-Scholes) is calculated below: Formula 1 d1 d2 C
In ( ) + (r +
2 T ) 2
Calculation
In
80 84
+ 0.08 +
0.3 2 2
0.25
-0.117
0.3 0.25
2 3
d1 S N(d1) Xe-rT N(d2)
-0.117 0.3 0.25 80 N(-0.117) 84e-0.080.25 N(-0.267)
-0.267 3.77
Derivatives
6.47

Futures and Options For CMA Exam

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Commodity futures Not Applicable

Not Applicable Not Applicable

Particulars Contracts Open High

Low Close Open Interest Traded quantity Number of contracts

Open interest Lot size = 433 1,500 6,49,500 shares

180.00 10.80 190.80

Less Future value of dividend Future Price

Index 3,500.00 3,500 46.97 3,546.97

3010.017 3017.551 3035.205 3045.339 3045.339

3017.551e(0.09 - 0.02)*(1/12) 3035.205e(0.09 - 0.05)*(1/12)

Therefore the Novembers Futures Price as at July end

Index 4,500.00 4,500 90.90 4,590.90

4,500.00 4,500.00 4,600.00 4,590.90 9.10

Calculation 1,3642500.10 (1,370 1,364)250

34,100 1,500 4.4%

August 2 August 3 August 4 August 5

818 866 830 846

Net gain or loss Mr. Tandons gain Mr. Tilaks loss

Calculation 1,3002500.10 1,300 +

Answer: Formula Calculation

1,000 (211195.88) 2111,00010%

15,120 21,100 5,980

10,550 15,120 -71.7%

Portfolio Characteristics 20 Stocks

Total Cost in Lakhs 1520.87

Market Value in Lakhs 1767.59

Contracts CE-1950March 2005 PE-2100March 2005

Open 191.05 19.50

Low 191.05 18.65

Close 204.90 19.9

Open Interest 41,000 26,47,000

Traded quantity 1,600 13,69,000

Number of Contracts 8 6845

Underlying NIFTY NIFTY

Each Nifty is 1600 / 8 = 200 units of the underlying.

Call Option Price 3.00 7.50 12.00 16.50 21.00 25.50

Stock price Intrinsic value, The time value.

Strike price, Option price,

Time Value2 3 2.50 2 1.50 1 0.50

Strike Price (X) 25 35 25 25 55 50

Premium 13.00 17.50 22.00 16.50 12.00 20.50

Nature of Option Call Put Put Call Put Put

Time Value4 13.00 12.50 22.00 16.50 2.00 20.50

Call Put Put Call Put Put

Question 9: An investor has the following position on options of CIPLA.

(Max ( X, 0) CP) (Max (X , 0) PP) 25 75 25 5 5 45 30 70 20

1.00 0.89 0.76 0.70

0.00 0.01 0.03 0.02

Theta 0.03 0.03

60 0 0.6 98.18 21.82

Max (dS E, 0) Max (0.9 200 220, 0)

0.4 0.460 + (10.4)0

Adjustment for Dividends Short-term options, Adjusted stock price = S = S

1.1115 0.9115 11.87 0.88

d1 S N(d1) Xe-rT N(d2) 0 0 +

1.1115 0.4 0.25 60 N(1.1115) 50e-0.080.25 N(0.9115) 11.87 60 + 0.080.25

0.5123 0.51230 + (10.513)8

Calculation Max (1.2480 80, 0) Max (0.8880 80, 0)

19.2 0 0.667 46.01 7.35

Pu 1.0562 0.9438 0 3.5018 -0.3501 32.57 1.42

Pd 1.0633 0.9367 3.5 13.5 -1 86.625 7.625

3017.551e(0.09 - 0.02)(1/12) 3035.205e(0.09 - 0.05)(1/12)