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Rough Note:
Bullish: Daam Badega
Bearish: Daam Girega
Options both OTC and exchange traded
22 August 2016
Class 1(Introduction)
We divide the entire topic into the following parts: 1. Introduction 2. Forward
Rate Agreement (FRA) 3. Financial Swap 4. Futures 5. Options 6. Other types of
Derivatives
1.
Introduction
1.
Definition: It is a financial contract which derives its value from
some underlying asset, reference rate(LIBOR), Index(Nifty), etc.
It is an instrument designed for betting
1.
Types of Derivatives:
Forward Commitment
-Both sided betting (Ex Forward, future, financial Swap)
A.
Contingent Claims
- One sided betting (Ex: Opt
Cap& Floor)
Types of Derivatives
Forward Contract: Both sided Betting, Long Position (F+) will gain if
the price rises, Short Position (F-) will gain if the price falls, OTC traded,
Normally no Margin Requirement, not repriced
Futures Contract: Similar to forward contract but they are exchange
traded. Strict Margin Requirement, Mark to market
Financial Swap: It is a portfolio of forward contract.
Call Option: Upside Betting, C+(Call Buyer) : Right to buy(Right to
enjoy the upside without paying the downside) C-(Call Seller) : Obligation to
sell (Obligation to pay the upside without enjoying downside), Obviously C+
will pay to C- an upfront call premium(Hak ka daam)
Put Option: Downside Betting. P+ : (Put Buyer)Right to sell (Right to
enjoy the downside without paying the upside) P-(Put Seller): Obligation to
buy ( Obligation to pay the downside without receiving the upside)
Obviously P+ will pay to P- an upfront put premium.
Ex: You bought a put option on a stock at a strike price of 500, for a premium of
60. What would be your payoff and profit if on maturity : a) S=590 b) S=430
Ans) a: Put lapses i.e. payoff = nil and loss=60, initial premium paid
b: Put exercised in our favour. Therefore payoff=70, Profit = 70-60=10
Ex 2. You sold a call option(C-) on a stock at a strike price or exercise price of 800
for a premium of 90. What would be you payoff and profit if on maturity
a)S=1000
s=500
Ans) a: Call exercised against us. Therefore payoff = -200 and loss = 20090=110
b: Call lapses, payoff=nil, Profit = 90
Food for thought: Option buyer (C+ or P+ )runs a high probability of losing a
small amount with a very low probability of winning a huge amount.
A.
1.
Types of Derivatives
Exchange Traded: Standardized, Futures, Strict Margin Requirement,
Virtually no counterparty default risk, Marked to market everyday wit the
difference being adjusted in the margin so there is daily settlement of gains
and losses, Highly Regulated, Highly Liquid (ability to enter and exit as
many times) , more suitable for speculation, this are generally squared off
prior to maturity, ex: futures
2.
Over the Counter: Customized, Counterparty Risk, Normally no
Margin Requirement, there is no re-pricing so gains and looses gets
accumulated, less regulated, Lack of liquidity, favourable for hedging
(specialization is required), this are generally settled on maturity, ex:
forward & swaps
1.
Players in the derivative markets:
Hedgers
Speculators
They take up a long or shot position They take a long or short position in the derivative
in the derivative to reduce the
to profit from their price belief Knowing fully well
exposure.
that they can lose.
Ex: A bank quotes a 2x7 FRA at 9%/11%. You sell this FRA on a notional
principle of $800 Million. What would be your profit or loss if after 2 months,
the 5 month LIBOR turns out to be (a) 7% (b) 13%
Solution: We have F- at 9%
1.
L= 7<9 so the customer wins and will receive PV of the difference
i.e. {(9-7)% x 800 x 5/12}/(1+.07x5/12)
$6.48 Million
1.
L=13>9 so the customer losses and will have to pay PV of the
difference i.e. {(13-9)% x 800 x 5/12}/(1+0.13x5/12)
$12.65 Million (approx.)
1.
2.
5
%
Step1: Borrow $500 Million at 6 Months LIBOR Therefore outflow after 6
Months = 500x1.055=527.5
Step 2: Contract to Borrow $527.5 Million through FRA after 6 months for 3
months.
A.
Show the Process of Arbitrage if the actual Quote for 6x9 FRA is
15%/16%
Ans) Since the actual quote is greater than 13.27%, FRA is overpriced and we
should sell (Contract to invest)
Financial Swaps
3ML(month
Libor)
1/1/12
1/4/12
1/7/12
1/10/12
9%
13%
8%
15%
On 20th July Thursday X ltd entered into a 6 day OIS with a bank for
a notional principle of Rs. 800 Lakhs. The fixed rate of the swap was 11%
The following taable shows the MIBOR for each day
20/07
21/07
22/07
24/07
25/07
Thursda
y
Friday
Saturday
Monday
Tuesday
12%
11.5%
10%
13%
12.5%
Compute the net payment at the end of the swap(Assume X Ltd. is the fixed
rate receiver )
Payment for the fixed leg=11% of 800 x 6/365 = Rs. 1.45 Lakhs
In an OIS MIBOR is subject to daily compounding
Therefore Effective MIBOR for six days = (1+0.12/365)x (1+
0.115/365)x{1+(2x.1/365)}x(1+.13/365)(1+0.125/365)-1
=(1.000329X1.000315X1.000548X1.000356X1.000
342)-1
= 0.19%
Therefore payment for the floating leg = 0.19% of 800
= Rs.1.52 Lakhs
Net Payment to be made by X = 1.52-1.45=Rs 0.07 Lakhs
1.
1.
Ans) Firm A wants to borrow fixed rate funds (13%). Since this rate is too high,
we advice firm A to borrow floating rate funds (L+1.2). It should then convert
floating rate funding into fixed rate funding via a swap in which it receives
LIBOR and paays fixed i.e. 10.6%.
Therefore effective cost = Outflow-Inflow
= LIBOR+1.2+10.6-LIBOR
= 11.8% which is less then 13%
The swap is structured as shown below:
A.
Class 3
FRA Homework
A.
B: Profit=1845.02
A.
Ans)
Given 3 Month LIBOR is 9% and 9 Month LIBOR is 12% find out the
price of 3x9 FRA
A.
A.
What if 3x9 FRA is quoted at 9%/10%. Show the arbitrage
Ans) Buy the FRA
A.
What if 3x9 FRA is quoted at 13%/14%. Show the arbitrage
Ans) No arbitrage
SWAP Homework
Note:
LIBOR is the rate of borrowings between large multinational banks and it changes
every moment.