Financial engineering

Section A

Definition of financial engineering: involves designing, development and

implementation of innovative financial instruments and processes, and the formulation
of creative solutions to problem] ms in finance.

Financial engineering is the application of mathematical methods to the solutions of

problems in finance.

Financial engineering involves utilization of mathematical techniques in solving

financial problems. This process uses tools and knowledge from the fields of
economics, statistics, applied mathematics and computer science. These tools not only
assist in solving the prevailing financial issues but also help in devising innovative
financial products. Financial engineering is also known as quantitative analysis.
Investment banks, commercial banks and insurance agencies use this technique.

HOW FINANCIAL ENGINEERING WORKS?

Financial engineers create, design and implement new financial models and processes
in order to find solutions for problems. They always seek new financial opportunities.
Preparing such models requires a great deal of research and they rely on in-depth data
analysis, simulations, risk analysis and stochastics. Financial engineers possess
knowledge in fields such as economics, statistics and corporate finance. These
engineers work in banking, consulting agencies, securities and financial management.

Tools Required for Financial Engineering:

In relation to tools requirement of financial engineering process, basically, two types

of tools are used named

Conceptual Tools

Physical Tools

Conceptual Tools:
This category involves the combination of concepts and ideas that can be used in
finance studies and are considered as formal disciplines. Mostly these types of tools
are taught in business programs especially at graduation level. For instance,
accounting relationships, hedging theory, valuation of theory, and portfolio theory are
considered in curriculum.

Physical Tools:

Special process and instruments that are used by Financial Engineers in combination
to gain a specific task or purpose are called as physical tools. The examples include
variants, securities, futures, swaps, options, and equities.

Factors Influencing Financial Engineering:

Just like tools, two types of factors contribute to the growth process of financial
engineering; environmental factors and intra firm factors

Environmental Factors:

The factors which are not controllable by any firm and are part of external
environment are included in this category. Though they are external to business but
they have direct impact on your business. Usually, PEST analysis is used to evaluate
these factors and impact on any business. Most common examples are
competitiveness, technological advancements, and new inventions, political and
economical changes. Some environmental factors are:

 Price volatility: Interaction of demands by consumers and supplies by producers

ultimately decides market clearing price and quantities. If the demands and the supplies
for a thing change rapidly over short period of time then market clearing price can change
dramatically. This is referred to as Price Volatility.

Consider four scenarios of Price Volatility:

 If demand increases and supply remains unchanged then price increases.

 If demand decreases and supply remains the same then the price decreases.
 If supply increases and demand remains unchanged the price decreases.
 If supply decreases and demand remains the same even then price increases.

In today’s financial world the financial information is readily available about any given
company and its current and future investments projects and this keeps changing hence
the price of stock remains volatile.
  Globalization of the markets:

 Currency exchange rate: companies operating on global basis selling their goods
and services in various economies face of risk of ultimate profits because of
currency volatilities i.e. when profits in one economy are converted back to mother
currency then devaluation or accretion happens because of exchange rate
volatilities.
 Debt capital markets: different economies offer different interest rates on debt and
hence the loan taken in one economy to fund operations in another economy can
create a risk of interest rate loss/gain as well as currency exchange loss/gain.
 Equity risk factor for companies operating in many countries would be difficult to
judge as in different economies the cost of equity would be different .

 Tax asymmetries: some industries are granted special tax exemption to

encourage their development and growth, different countries charge different
tax rates and more importantly some countries charge domestic and foreign
firms differently.
 Technological advancement: the development of technology in terms of
computers, networks, internet, spreadsheets, various models, data bases and
enhanced methods of data entry and analysis.

 Advance in financial theories: various financial theories of different scholars

such as markwitz port folio theory, William sharpe and jhon lintner capital
asset pricing theory, option pricing model by fischer black and Myron schools
etc had contributed to financial engineering.
 Regulatory change
 increased competition:
 Transaction Costs: Enormous technological development decreased the cost of
information, on which many transactions feed. Thus, the cost of transacting itself,
declined significantly during the decade of 1980’s.

Intra Firm Factors:

All those factors of the company which can directly progress the financial engineering
process are included in intra firm factors. Likewise, agency costs, accounting policies,
risk aversion and liquidity needs are included in this type.

 Liquidity needs: The degree to which an asset or security can be bought or sold
in the market without affecting the asset's price. Liquidity is characterized by a
high level of trading activity. Assets that can by easily bought or sold, are
 known as liquid assets. The ability to convert an asset to cash quickly. Also
known as "marketability".

Degree of liquidity can be determined by using various financial engineering

tools like Markov Chain Monte Carlo methods.

 Risk aversion: description of an investor who, when faced with two investments with a
similar expected return (but different risks), will prefer the one with the lower risk. With
the advancement of technology new methods of determining risk and volatility are
developed. These methods are advanced computer software based and can be easily used
to perform extensive analysis. Some of these methods are GARCH, ARCH, FARIMA
and ARIMA.

 Management training: With the birth of software like SAS, Matlab, Mathematica it has
become relatively much easier to perform the most complex analysis is least possible
time. Moreover it doesn’t require a manager to understand whole fundamental theories
behind the modeling and all the manager is required to understand are relevant
assumptions and interpret results.
[

 Agency Costs: type of internal cost that arises from, or must be paid to, an agent acting
on behalf of a principal. Agency costs arise because of core problems such as conflicts of
interest between shareholders and management. Shareholders wish for management to
run the company in a way that increases shareholder value. But management may wish to
grow the company in ways that maximize their personal power and wealth that may not
be in the best interests of shareholders. The biggest example of Agency Cost analysis is
EVA Model which uses financial engineering fundamentals to come up with concept of
shareholder value maximization.

Financial engineering strategies:

1. Assets and liability management strategy: Asset-liability management is all about

matching liabilities to assets. This means we need to understand how cash flows of any
given company vary over time. Holding the appropriate combination of assets and
liabilities to meet firm’s objectives and simultaneously minimizing the firm’s risk. Assets
and liability management is the art and science of choosing the best mix for assets and
liabilities portfolio. Following are some factors that play an important role in
assets/liabilities management strategies:
 Liquidity
 Interest rate sensitivity
  Default risk: it is the risk when debtor is unable to repay the principal and/or interest.

2. Hedging and related risk management strategies:

3. Corporate restructuring: it refers to any kind of change in operations, capital structure or

and/or ownership.

Corporate restructuring involves 3 different but related activities:

 Expansion: in the form of merger, acquisition, joint venture etc

 Contraction: in the form of sell off, liquidation etc
 Ownership and control: including stock repurchase, going private etc.

4. Arbitrage: the simultaneous buying and selling of securities, currency, or commodities in

different markets or in derivative forms in order to take advantage of differing prices for
the same asset.
5. Asset allocation strategy: it is the allocation of investment funds across various classes of
assets.

What Is a Relative Valuation Model?

A relative valuation model is a business valuation method that compares a company's value to
that of its competitors or industry peers to assess the firm's financial worth.

One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is
calculated by dividing stock price by earnings per share (EPS), and is expressed as a company's
share price as a multiple of its earnings. A company with a high P/E ratio is trading at a higher
price than its peers and is considered overvalued. Likewise, a company with a low P/E ratio is
trading at a lower price and is considered undervalued.

Steps in relative valuation model:

Step I. Select the Universe of Comparable Companies: The selection of a universe of comparable
companies for the target is the foundation for performing trading comps.

In order to identify companies with similar business and financial characteristics, it is first
necessary to gain a sound understanding of the target. At its base, the methodology for
determining comparable companies is relatively intuitive. Companies in the same sector (or,
preferably, “sub-sector”) with similar size tend to serve as good comparables.

Key Characteristics of the Target for Comparison Purposes

 Sector: Sector refers to the industry or markets in which a company operates (e.g., chemicals,
consumer products, healthcare, industrials, and technology). A company’s sector can be
further divided into sub-sectors, which facilitates the identification of the target’s closest
comparable.

Within the industrials sector, for example, there are numerous sub-sectors, such as aerospace
and defense, automotive, building products, metals and mining, and paper and packaging.
For companies with distinct business divisions, the segmenting of comparable companies by
sub-sector may be critical for valuation

 Products and services: A company’s products and services are at the core of its business
model. Accordingly, companies that produce similar products or provide similar services
typically serve as good comparables. Products are commodities or value-added goods that a
company creates, produces, or refines.
 Customers and End Markets:

Customers: A company’s customers refer to the purchasers of its products and services.
Companies with a similar customer base tend to share similar opportunities and risks. For
example, companies supplying automobile manufacturers abide by certain manufacturing and
distribution requirements, and are subject to the automobile purchasing cycles and trends.

End Markets: A company’s end markets refer to the broad underlying markets into which it
sells its products and services. For example, a plastics manufacturer may sell into several end
markets, including automotive, construction, consumer products, medical devices, and
packaging. End markets need to be distinguished from customers. For example, a company
may sell into the housing end market, but to retailers or suppliers as opposed to homebuilders

 Distribution Channels: Distribution channels are the avenues through which a company sells
its products and services to the end user.

 Geography / location

 Size: Size is typically measured in terms of market valuation (e.g., equity value and
enterprise value), as well as key financial statistics (e.g., sales, gross profit, EBITDA, EBIT,
and net income). Companies of similar size in a given sector are more likely to have similar
multiples than companies with significant size discrepancies.

For example, companies with under $5 billion in equity value (or enterprise value, sales) may
be placed in one group and those with greater than $5 billion in a separate group. This
tiering, of course, assumes a sufficient number of comparables to justify organizing the
universe into sub-groups.

 Growth profile:
  Return on investment
 Credit profile

Step II. Locate the Necessary Financial Information:

Step III. Spread Key Statistics, Ratios, and Trading Multiples.

Step IV. Benchmark the Comparable Companies.

Step V. Determine Valuation.

Section B

Credit analysis

Credit risk: Credit risk analysis is assessing the possibility of the borrower’s repayment failure
and the loss caused to the financer when the borrower does not for any reason repay the
contractual loan obligations.

Who Needs Credit-Risk Analysis

Banks, financial institutions and NBFCs offer mortgages, loans, credit cards etc and need to
exercise utmost caution in credit risk analysis. Similarly, companies that offer credit, bond
issuers, insurance companies, and even investors need to know the techniques of effective risk
analysis.

The 5 C’s of Credit analysis

Character: Lenders need to know the borrower and guarantors are honest and have integrity.
Additionally, the lender needs to be confident the applicant has the background, education,
industry knowledge and experience required to successfully operate the business.

 Capacity (Cash flow): The lender wants to know that your business is able to repay the loan.
The business should have sufficient cash flow to support its business expenses and debts
comfortably while also providing principals’ salaries sufficient to support personal expenses
and debts. Examining the payment history of current loans and expenses is an indicator of the
borrower’s reliability to make loan payments.
 Condition: The lender will need to understand the condition of the business, the industry, and
the economy, which is why it is important to work with a lender who understands the WCB
industry. The lender will want to know if the current conditions of the business will continue,
improve or deteriorate.
 Capital: Your lender will ask what personal investment you plan to make in the business. Not
only does injecting capital decrease the chance of default, but contributing personal assets also
 indicates that you are willing to take a personal risk for the sake of your business; it shows that
you have ‘skin in the game.’
 Collateral: A lender will consider the value of the business’ assets and the personal assets of the
guarantors as a secondary source of repayment. Collateral is an important consideration, but its
significance varies depending on the type of loan.

Sovereign and country risks: Sovereign Risk also known as Country Risk is the risk of default in
meeting the debt obligation by a Country. It is the broadest measure of credit risk and
includes country risk, political risk, and transfer risk. Country risk refers to the uncertainty
associated with investing in a particular country, and more specifically the degree to which that
uncertainty could lead to losses for investors. This uncertainty can come from any number of
factors including political, economic, exchange-rate, or technological influences. In a broader
sense, country risk is the degree to which political and economic unrest affect the securities of
issuers doing business in a particular country. such as political instability can affect the
investments in a given country Thus, when analysts look at sovereign debt, they will examine the
business fundamentals—what is happening in politics, economics, general health of the society,
and so forth—of the country that is issuing the debt.

A country's risk can generally be divided into two groups:

 Economic risk: Risk associated with a country's financial condition and ability to repay
its debts. For instance, a country with a high debt-to-GDP ratio may not be able to raise money
as easily to support itself, which puts its domestic economy at risk.
 Political risk: Risk associated with a country's politicians and the impact of their decisions on
investments.

Following are part of sovereign and country risks:

 Regulatory framework
 Tariffs
 Fiscal policy (income taxes)
 Monetary policy
 Foreign currency control
 Political and legal risks

Methods used to assess country risk can be grouped into two categories:

 Quantitative analysis: The use of ratios and statistics to determine risks, such as the debt-to-
GDP ratio or the beta coefficient of the MSCI index for a given country. International investors
can find this information in reports from rating agencies, magazines like the Economist, and
through various other online sources.
 Qualitative analysis: The use of subjective analysis to determine risks, such as breaking political
news/opinion or realistic market rumors. International investors can find this information in
financial publications like the Economist and the Wall Street Journal, as well as by searching on
international news aggregators like Google News.

Most common way that investors assess country risk is through sovereign ratings.

Richard Cantor and Frank Packer used a regression analysis to narrow the process down to six
critical factors that explain more than 90% of the variation in credit ratings.

1. Per capita income comes into play since a larger tax base increases a government's ability
to repay debt, while it can also serve as a proxy for a country's political stability.
2. Strong GDP Growth makes a country's existing debt easier to service over time, since
that growth typically results in higher tax revenues and an improved fiscal balance.
3. High inflation can not only signal problems with a country's finances, but also cause
political instability over time.
4. A country's external debt can be a problem if it becomes unmanageable.
5. Countries with a history of defaulting are perceived to have a higher credit risk.
6. More economically-developed countries are seen has less likely to default.

Conclusion: Better sovereign ratings can reduce inflation risk, ensure political stability, and
make it cheaper to borrow money when needed

Management factor in credit risk analysis

 credit policies
 interest rates
 lending practices
 Analyzing the possibility of loan repayment
 Recovery process

Financial Risk

This risk is the danger or possibility that shareholders, investors, or other financial stakeholders
will lose money. Financial risk is a type of danger that can result in the loss of capital to
interested parties.

The Basics of Financial Risk

 For governments, this can mean they are unable to control monetary policy and default
on bonds or other debt issues.
  Corporations also face the possibility of default on debt they undertake but may also
experience failure in an undertaking the causes a financial burden on the business.
 Individuals face financial risk when they are not able to pay a debt they have assumed.
 Financial markets face financial risk due to various macroeconomic forces, changes to
the market interest rate, and the possibility of default by sectors or large corporations.

Forms of financial risk:

 Loan risk
 Equity risk
 Foreign investment risk
 Currency risk
 Liquidity risk
 Equity risk
 Market risk: the movement of prices in the market

Credit Rating

A credit rating is a quantified assessment of the creditworthiness of a borrower in general terms

or with respect to a particular debt or financial obligation. A credit rating can be assigned to any
entity that seeks to borrow money—an individual, corporation, state or provincial authority, or
sovereign government.

A credit rating is an evaluation of the credit risk of a prospective debtor (an individual,
a business, company or a government), predicting their ability to pay back the debt, and an
implicit forecast of the likelihood of the debtor defaulting.The credit rating represents an
evaluation of a credit rating agency of the qualitative and quantitative information for the
prospective debtor, including information provided by the prospective debtor and other non-
public information obtained by the credit rating agency's analysts.

Importance of credit rating:

For The Money Lenders

1. Better Investment Decision: No bank or money lender companies would like to give
money to a risky customer. With credit rating, they get an idea about the credit
worthiness of an individual or company (who is borrowing the money) and the risk factor
attached with them. By evaluating this, they can make a better investment decision.
2. Safety Assured: High credit rating means an assurance about the safety of the money and
that it will be paid back with interest on time.

For Borrowers
 1. Easy Loan Approval: With high credit rating, you will be seen as low/no risk customer.
Therefore, banks will approve your loan application easily.
2. Considerate Rate of Interest: You must be aware of the fact every bank offers loan at a
particular range of interest rates. One of the major factors that determine the rate of
interest on the loan you take is your credit history. Higher the credit rating, lower will the
rate of interest.

Process of credit rating

 Request from issuer and analysis: The first step to credit rating is that the enterprise applies to
the rating agency for the rating of a particular instrument. Thereafter, an expert team interacts
with the firm’s those charged with governance and acquires relevant data. Factors which are
considered includes:
 Historical performance
 Financial Policies
 Business Risk profile
 Competitive Position, etc.
 Rating Committee: Based on the information gathered and evaluation performance, the
presentation of the report is made by the expert’s team to the Rating Committee, in which the
issuer is not permitted to take part.
 Communication to management and appeal: The decision of the rating is shared with the
issuer and if he/she does not agree with the decision, then an opportunity of being heard is
given. The issuer is required to provide material information, so as to appeal against the
decision. The decision is reviewed by the committee, but that does not make any change in the
ratings.
 Pronouncement of the rating: When the issuer agrees to the rating decision, the agency make a
public announcement, of the rating.
 Monitoring of the assigned rating: The agency which rates the issue, overlooks the
performance of the issuer and the business environment in which it operates.
 Rating Watch: On the basis of continuous critical observation undertaken by the rating
agency, it may place a rated security on Rating Watch.
 Rating Scores: Rating scores are given by the credit rating agencies like CRISIL, ICRA,
CARE, FITCH.
Credit Rating is of great help, not just in investors protection but to the entire industry, as it
directly mobilizes savings of the individuals.

Credit Spread
The credit spread is the difference between the yield (return) of two different debt instruments
with the same maturity but different credit ratings. In other words, the spread is the difference in
returns due to different credit qualities.

For example, if a 5-year Treasury bond is trading at a yield of 3% and a 5-year corporate bond is
trading at a yield of 5%, the credit spread is 2% (5% – 3%).

Interest coverage ratio and its effect on industries classification

The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a
company can pay interest on its outstanding debt. The interest coverage ratio may be calculated
by dividing a company's earnings before interest and taxes (EBIT) during a given period by the
company's interest payments due within the same period.

Interest coverage ratio = EBIT/interest expense

The interest coverage ratio measures how many times a company can cover its current interest
payment with its available earnings. In other words, it measures the margin of safety a company
has for paying interest on its debt during a given period. When a company's interest coverage
ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

Optimal Interest Coverage Ratio

What constitutes a good interest coverage varies not only between industries but also between
companies in the same industry. Generally, an interest coverage ratio of at least two (2) is
considered the minimum acceptable amount for a company that has solid, consistent revenues.
Analysts prefer to see a coverage ratio of three (3) or better. In contrast, a coverage ratio below
one (1) indicates a company cannot meet its current interest payment obligations and, therefore,
is not in good financial health.

Effect of sovereign and country risk, industry risk and financial risk on credit analysis?

Sovereign risk: Sovereign is one of many risks that an investor faces when holding forex
contracts. Foreign exchange traders and investors face the risk that a foreign central bank will
change its monetary policy so that it affects currency trades. Sovereign risk also impacts personal
investors. There is always risk to owning a financial security if the issuer resides in a foreign
country. For example, an American investor faces sovereign risk when he invests in a South
American-based company. A situation can arise if that South American country decides to
nationalize the business or the entire industry, thus making the investment worthless.

Section C

Options

Option are financial instruments whose value is derived from other underlying assets (such as
stock, bond, currency etc) and give the right but not the obligation to the holder to buy/sell the
asset at stated price within specific time period.

Call Options: A call option gives you the right to buy within a specified time period at a
specified price
The owner of the option pays a cash premium to the option seller in exchange for the right to buy

Put Options: A put option gives you the right to sell within a specified time period at a specified
price. It is not necessary to own the asset before acquiring the right to sell it

In-the-Money Option – One that would lead to positive cash flows to the holder if it were
exercised immediately

At-the-Money Option – One that would lead to zero cash flows to the holder if it were exercised
immediately

Out-of-Money Option – One that would lead to negative cash flows to the holder if it were
exercised immediately

In-Money Calls and Puts –

 Call is in the money if strike price is lesser than the current stock price
Strike price < stock price

 Put is in the money if strike price is above the current stock price

Strike price > current stock price

Out of Money Calls and Puts –

 Call is out of money if strike price is more than the current stock price
Strike price > stock price
 Put is out of money if Strike price is less than the current stock price
Strike price < current stock price
 Factors affecting option value
Striking price
For a call option, the lower the striking price, the higher the option premium

Time to expiration
For both calls and puts, the longer the time to expiration, the higher the option premium

Current stock price

The higher the stock price, the higher the call option premium and the lower the put option
premium

Volatility of the underlying stock: The greater the volatility, the higher the call and put option
premium

Dividend yield on the underlying stock

Companies with high dividend yields have a smaller call option premium than companies with
low dividend yields

Risk-free interest rate

The higher the risk free rate, the higher the call option premium

Types of options

 American options: can be exercised any moment prior to maturity.

 European options: can be exercised only at expiration time.

 Bermudan options: can be exercised on “FEW Specific Dates” prior to expiration

Binomial Option Pricing Model

Binomial option pricing model is very simple model that is used to price options. When to
compared to Black Scholes model and other complex models, binomial option pricing model is
mathematically simple and easy to use. This model is based on the concept of no arbitrage.
Binomial Option pricing model is an important topic as far as FRM Part 1 exam is concerned.
There are both conceptual and numerical questions in exams to test this topic. In this article, I
will talk about various concepts related to binomial option pricing model.

Assumptions in Binomial Option Pricing Model

The assumptions in binomial option pricing models are as follows

1. There are only two possible prices for the underlying asset on the next day. From this
assumption, this model has got its name as Binomial option pricing model (Bi means two)

2. The two possible prices are the up-price and down-price

3. The underlying asset does not pay any dividends

4. The rate of interest (r) is constant throughout the life of the option

5. Markets are frictionless i.e. there are no taxes and no transaction cost

6. Investors are risk neutral i.e. investors are indifferent towards risk

Binomial option model building process

Let us consider that we have a share of a company whose current value is S 0. Now in the next
month, the price of this share is going to increase by u% (up state) or it is going to go down by
d% (down state). No other outcome of price is possible for this stock in next month. Let p be the
probability of up state. Therefore the probability of down state is 1-p.

Now let us assume that call option exist for this stock which matures at the end of the month. Let
the strike price of the call option be X. Now in case, the option holder decides to exercise the call
option at the end of month, what will be the payoffs?

The payoffs are given the below diagram

Now, the expected payoff using the probabilities of up state and down state. From the above
diagram, the expected value of payoff is

Once the expected value of the payoff is calculated, this expected value of payoff has to be
discounted by risk free rate to get the arbitrage free price of call option. Use continuous
discounting for discounting the expected value of the payoff. FRM Part 1 uses continuous
compounding and discounting for all numerical problems on derivatives. In some questions, the
probability of up state is not given. In such case, probability of up state can be calculated with
the formula

Where;

p = up state probability r = risk free rate D = Down state factor

u = Up state factor

Using the above the model building process, similar model can be build for multi period options
and also for put options.

Advantages of Binomial Option Pricing Model

1. Binomial option pricing models are mathematically simple to use.

2. Binomial option pricing model is useful for valuing American options in which the option
owner has the right to exercise the option any time up till expiration.

3. Binomial option model is also useful for pricing Bermudan options which can be exercised at
various points during the life of the option.

Limitations of Binomial Option Pricing Model

One major limitation of binomial option pricing model is its slow speed. Computation
complexity increases in multi period binomial option pricing model
 Black-scholes Model'

Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or
a put option based on several variables such as volatility, type of option, underlying stock price,
time, strike price, and risk-free rate.
The model is used to determine the price of a European call option, which simply means that the
option can only be exercised on the expiration date.

Assumptions:
 The Stock Pays No Dividends during the Option’s Life

 European Exercise Terms

 Markets are Efficient

 No Commissions

 Constant Interest Rates

 Lognormal Returns

Black-Scholes pricing model is largely used by option traders who buy options that are priced
under the formula calculated value, and sell options that are priced higher than the Black-Schole
calculated value.
 Cash flow charts of long call, long put, short call and short put

Credit Rating

Credit Rating is an assessment of the borrower (be it an individual, group or company) that
determines whether the borrower will be able to pay the loan back on time, as per the loan
agreement.
It is a rating given to a particular entity based on the credentials and the extent to which the
financial statements of the entity are sound, in terms of borrowing and lending that has been
done in the past.

The rating is given to entities by the credit rating agencies after analysing their business and
finance risk. The agencies prepare a detailed report after taking into consideration some
additional factors such as the ability to repay the debt. Banks and lenders use a credit rating as
one of the factors to determine whether to lend money.

Principles of options

 Diversify. Take at least two or three positions and try to always own both calls and puts. With
the recent swings in the market, playing both sides will improve your chances in the long run.
Don't forget this.
 Minimize your risk. Pay as little as possible for each option and always be ready to cut your
losses.
 be patient. Don't invest everything right away. Decide how much you want to risk in options
during the next twelve months and spread your purchases over that time frame.
 Plan before you play. If you do not have a game plan that tells you when to take profits and when
to cut losses you will have a very difficult time making a profit.
 Maximize your leverage. Try to buy options that will increase in value by at least 100%. Buying
cheap options is the first step in this strategy.
 Buy options on high volatility stocks.
 In general, buy out-of-the-money options. These options normally have lower prices, and less
risk.

Option based hedging Strategies

Bullish strategies: Bullish options trading strategies are used when options trader expects the
underlying assets to rise. It is very important to determine how much the underlying price will
move higher and the timeframe in which the rally will occur in order to select the best options
strategy. Following are the most popular bullish strategies that can be used depend upon different
scenarios.

 Long call

 Short put

 Covered Call

 Protective Put

 Call Bull Spread

 Put Bull Spread

 Straps

1. Long call: Long call is best used when you expect the underlying asset to increase
significantly in a relatively short period of time. It would still benefit if you expect the
underlying asset to rise slowly.
Breakeven at expiry = Strike price + Premium paid
Risk = limited to premium paid
Reward = unlimited
2. Short put: This option trading strategy has a low profit potential if the stock trades above the
strike price and exposed to high risk if stock goes down. A short put is best used when you
expect the underlying asset to rise moderately. It would still benefit if the underlying asset
remains at the same level
 Break even = strike price – premium received
 Risk = unlimited
 Reward = limited to premium, received

3. Covered call: Covered Call portfolio is generated by long position on asset and short call
options.
 Break even = stock price paid – premium received
 Maximum risk = unlimited
 Reward = limited
4. Protective Put: Protective Put is achieved by Long position on stock and long position on Put
option. The pay off is limited to the premium paid for the option.
 Maximum loss is limited to Premium Paid on Put Option.
 Maximum gain: Unlimited as market rallies

Options Spread Strategy: Options spread strategy stands for taking a position in two or more
options of the same stock type be it call or put.
 Vertical Spread---option spread created by combination of options (either call or put)
having different strike prices but the same time to expiration.
 Horizontal Spread---option spread created by having options of same strike prices but
different time to maturity.
 Diagonal Spread---option spread created by having options of different strike prices and
different time to maturity.

There are 3 types of Bull Spreads:

 Both calls out of the money.
 One call initially in the money and one call initially out of the money.
 Both calls initially in the money.

5. Call Bull Spread: The call bull spread is created by long one call option with a low strike price
and one short call with a higher strike price. Both options have same time to maturity.
 6. Put bull spread: The put bull spread is created by long one put option with a low strike
price and one short put with a higher strike price.

7. Straps: Strap strategy implemented when investor expects that the probability of stock
price increase is relatively higher then the probability of stock price decrease.
Strap consists of long position in two calls and one put with same Exercise Price and
Expiration price.

net profit/loss
200
150
100
50 net profit/loss
0
0 50 100 150 200 250
-50
-100

Bearish options strategies

Bearish options strategies are employed when the options trader expects the underlying stock
price to move downwards. It is necessary to assess how low the stock price can go and the time
frame in which the decline will happen in order to select the optimum trading strategy.
1. Short call

2. Long put:

3. Call Bear Spread: When we anticipate that the market will go down then we create Call
Bear Spread. Call Bear Spread is created by Shorting one call option with a low strike
price and long one call option with higher strike price.

4. Put Bear Spread: The put bear spread is created by short one put option at lower strike
price and long one put option at higher strike price.
 5. Strips: When we anticipate that the probability of market going down is relatively higher
than the probability of market going up. Strip is combination of one long call option and
two long put options with same Exercise price and date of Expiration.

net profit/loss
200
150
100
50 net profit/loss
0
0 50 100 150 200 250
-50
-100

Neutral Strategies

Neutral strategies in options trading are employed when the options trader does not know
whether the underlying stock price will rise or fall.

1. Long call butterfly: Formed by short two AT THE MONEY call options and long one IN THE
MONEY cal option and long one OUT OF THE MONEY CALL Option.

 Maximum Gain: Limited to the net premium received from the spread.

 Maximum Loss: Limited to the ATM strike less the ITM strike less the net premium paid
for the spread.
3. Short call butterfly: Long two ATM call options, short one ITM call option and short one
OTM call option.
 Maximum Loss: Limited to the net difference between the ATM strike less the ITM
strike less the premium received for the position.
 Maximum Gain: Limited to the net premium received for the option spread.

4. Long put butterfly: Long two ATM put options, short one ITM put option and short one
OTM put option.
 Maximum Loss: Limited to the net difference between the ATM strike less the ITM
strike less the premium received for the position.
 Maximum Gain: Limited to the net premium received for the option spread.

5. Short put butterfly: Long two ATM put options, short one ITM put option and short one OTM
put option.
 Maximum Loss: Limited to the net difference between the ATM strike less the ITM
strike less the premium received for the position.
 Maximum Gain: Limited to the net premium received for the option spread.
 Interest rate options

The definition of option remains same. The options on interest rate will have interest rate as
underlying asset just like stock options and currency options.

An Interest rate option is a specific financial derivative contract whose value is based on interest
rates. Its value is tied to an underlying interest rate, such as the yield on 10 year treasury notes.

Similar to equity options, there are two types of contracts: calls and puts. A call gives the bearer
the right, but not the obligation, to benefit off a rise in interest rates. A put gives the bearer the
right, but not the obligation, to profit from a decrease in interest rates.

The options including long call, short call, long put and short put have same payoff structure

LONG INTEREST RATE CALLS:

Profitability from Long call on interest rate =

Notional Principal × Max (0, LIBOR – EXERCISE STRIKE RATE) × (Days/365)
SHORT INTEREST RATE CALL

LONG INTEREST RATE PUT

Profitability from Long put on interest rate =
Notional Principal × Max (0, EXERCISE STRIKE RATE - LIBOR) × (Days/365)
 SHORT INTEREST RATE PUT

Caps, floors and collar

An interest rate cap is a type of interest rate derivative in which the buyer receives payments at
the end of each period in which the interest rate exceeds the agreed strike price. An example of a
cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

Similarly an interest rate floor is a derivative contract in which the buyer receives payments at
the end of each period in which the interest rate is below the agreed strike price.

Collar is a combination of cap and floor. OLLAR is the simultaneous purchase of an interest rate
cap and sale of an interest rate floor on the same index for the same maturity and notional
principal amount.

Swaps

A swap is a derivative contract through which two parties exchange the cash flows or liabilities
from two different financial instruments.
1. Interest rate swaps: Counterparties agree to exchange one stream of future interest payments
for another, based on a predetermined notional principal amount. Generally, interest rate swaps
involve the exchange of a fixed interest rate for a floating interest rate.

Structure of interest rate swaps

Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice
versa it includes:

1. Fixed to floating
2. Floating to fix
3. Floating to floating

 Fixed to float: Let's walk through an example of a plain vanilla swap, which is simply an
interest rate swap in which one party pays a fixed interest rate and the other pays a floating
interest rate.

The party paying the floating rate "leg" of the swap believes that interest rates will go down. If
they do, the party's interest payments will go down as well.

The party paying the fixed rate "leg" of the swap doesn't want to take the chance that rates will
increase, so they lock in their interest payments with a fixed rate.

Company XYZ issues $10 million in 15-year corporate bonds with a variable interest rate
of LIBOR + 150 basis points. LIBOR is currently 3%, so Company XYZ
pays bondholders 4.5%.

After selling the bonds, an analyst at Company XYZ decides there's reason to believe LIBOR
will increase in the near term. Company XYZ doesn't want to be exposed to an increase in
LIBOR, so it enters into a swap agreement with Investor ABC.

Company XYZ agrees to pay Investor ABC 4.58% on $10,000,000 each year for 15 years.
Investor ABC agrees to pay Company XYZ LIBOR + 1.5% on $10,000,000 per year for 15
years. Note that the floating rate payments that XYZ receives from ABC will always match the
payments they need to make to their bondholders.

Investor ABC thinks that interest rates are going to go down. He is willing to accept fixed rates
from Company XYZ

To do this, Company XYZ structures a swap of the future interest payments with an investor
willing to buy the stream of interest payments at this variable rate and pay a fixed amount for
each period. At the time of the swap, the amount to be paid over the life of the debt is the same.

 Float to fixed: opposite to the above.

 Float to Float: Companies sometimes enter into a swap to change the type or tenor of
the floating rate index that they pay; this is known as a basis swap. A company can swap from
three-month LIBOR to six-month LIBOR, for example, either because the rate is more
attractive or it matches other payment flows.

Currency swaps

A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of

interest – and sometimes of principal – in one currency for the same in another currency. Interest
payments are exchanged at fixed dates through the life of the contract. It is considered to be
a foreign exchange transaction and is not required by law to be shown on a company's balance
sheet.

Example: Assume an Australian company is setting up a business in the UK and needs GBP 10
million. Assuming the AUD/GBP exchange rate at 0.5, the total comes to AUD 20 million.
Similarly, a UK-based company wants to set up a plant in Australia and needs AUD 20 million.
The cost of a loan in the UK is 10% for foreigners and 6% for locals, while in Australia it's 9%
for foreigners and 5% for locals. Apart from the high loan cost for foreign companies, it might be
difficult to get the loan easily due to procedural difficulties. Both companies have a competitive
advantage in their domestic loan markets. The Australian firm can take a low-cost loan of AUD
20 million in Australia, while the English firm can take a low-cost loan of GBP 10 million in the
UK. Assume both loans need six monthly repayments.

Both companies then execute a currency swap agreement. At the start, the Australian firm gives
AUD 20 million to the English firm and receives GBP 10 million, enabling both firms to start a
business in their respective foreign lands. Every six months, the Australian firm pays the English
firm the interest payment for the English loan = (notional GBP amount * interest rate * period) =
(10 million * 6% * 0.5) = GBP 300,000 while the English firm pays the Australian firm the
interest payment for the Australian loan = (notional AUD amount * interest rate * period) = (20
million * 5% * 0.5) = AUD 500,000. Interest payments continue until the end of the swap
agreement, at which time the original notional forex amounts will be exchanged back to each
other.

Types of currency swaps

1. Fixed Rate Currency Swap/ Fixed vs. fixed: A fixed rate currency, swap consists of the
exchange between two counterparties of fixed rate interest in one currency in return for fixed
rate interest in another currency. A fixed-for-fixed swap refers to a type of foreign currency
swap in which two parties exchange currencies with one another. In this agreement, both parties
pay each other a fixed interest rate on the principal amount. A fixed-for-fixed swap can be used
to take advantage of situations where interest rates in other countries are cheaper.
2. Currency Coupon Swap/ Fixed vs. float: A currency swap in which one side is a fixed rate
currency and the other a floating rate payment (such as U.S dollar LIBOR). This type of swap
combines the features of a currency swap and an interest rate swap. In currency coupon swaps,
a loan denominated in one currency and effected at a fixed rate is typically swapped for a
floating rate loan denominated in another currency. The currency coupon swap is a combination
of the interest rate swap and the fixed-rate currency swap. The transaction follows the three
basic steps described for the fixed-rate currency swap with the exception that fixed-rate interest
in one currency is exchanged for floating rate interest in another currency.

3. Basis Rate Swap/ Float vs. float: The float vs. float swap is commonly referred to as basis
swap. In a basis swap, both swaps’ legs represent floating interest payments.

Section D

Forwards and Futures

Forward contracts: A forward contract is a contract made today for delivery of an asset at a pre-
specified time in the future at a price agreed (fixed in advance) when the contract is entered into. A
forward contract is a customized contract between two parties to buy or sell an asset at a specified
price on a future date. A forward contract can be used for hedging or speculation, although its non-
standardized nature

In other words: A forward contract or simply a forward is a non-standardized contract between two
parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion
of the contract.

• The forward contract has two counterparties including buyer and seller.

• The buyer of a forward contract agrees to take delivery of an underlying asset in future time at
price agreed when a contract is entered into.

• The seller agrees to deliver the underlying asset at a future time at a price agreed when a
contract is entered into..

Features of forward contracts:

 Counter parties
 Specific price
 Specific future date
 Non standardized
 Forward contract is customizable to any commodity, amount and delivery date
  Default risk exist: seller may not deliver the product or buyer my not pay the price etc.

Advantages:

 Hedging risk
 No premium
 Customizable

Disadvantages:

 Default risk
 Non standardized
 Uncertain

Nature of Forward contract

Long and short forward pay offs

 Hedging with forward contracts

• Forward contracts are used to hedge any unperceived risk involved in future value of
underlying assets.

• As the party gets into a future contract it knows the price at which products will be
available to it at desired date. This can make company operate and plan future strategy.

• By using series of forward contracts the parties can achieve optimal capital structure.

Future contracts

A futures contract is a legal agreement to buy or sell a particular commodity or asset at a

predetermined price at a specified time in the future. Futures contracts are standardized for
quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is
taking on the obligation to buy the underlying asset when the futures contract expires. The seller
of the futures contract is taking on the obligation to provide the underlying asset at the expiration
date.

For example, if you plan to grow 500 bushels of wheat next year, you could either grow the
wheat and then sell it for whatever the price is when you harvest it, or you could lock in a price
now by selling a futures contract that obligates you to sell 500 bushels of wheat after the harvest
for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On
the other hand, if the season is terrible and the supply of wheat falls, prices will probably rise
later -- but you will get only what your contract entitled you to. If you are a bread manufacturer,
you might want to purchase a wheat futures contract to lock in prices and control your costs.
However, you might end up overpaying or (hopefully) underpaying for the wheat depending on
where prices actually are when you take delivery of the wheat.

Speculators are usually not interested in taking possession of the underlying assets. They
essentially place bets on the future prices of certain commodities. Thus, if you disagree with the
consensus that wheat prices are going to fall, you might buy a futures contract. If your prediction
is right and wheat prices increase, you could make money by selling the futures contract (which
is now worth a lot more) before it expires

Primary areas of trading include:

• Agricultural Commodities

• Metals and Petroleum

 • Financial assets like stocks, bonds, interest rate and currency.

Types of Futures Contracts

• Financial futures (interest rate, currency, indexes, stocks)….they are not deliverable.

• Commodity futures

Features of future contracts

 Standardized
 Specific price
 Expiration: Expiration (also known as maturity or expiry date) refers to the last trading
day of the futures contract. After the expiry of a futures contract, final settlement and
delivery is made according to the rules laid down by the exchange in the contract
specifications document.
 Contract Size: Contract size, or lot size, is the minimum tradable size of a contract. It is
often one unit of the defined contract. For example, current contract size of PMEX sugar
contract is 10 Tons. This implies that trading one contract creates a position of 10 tons of
sugar. PMEX rice contract has a contract size of 25 tons.
 Initial Margin: Initial margin is the minimum collateral required by the exchange before
a trader is allowed to take a position. Initial margins can be paid in various forms as laid
down by the exchange and varies from commodity to commodity as well as from time to
time. The level of initial margin is dependent on the price volatility of the contract. More
volatile commodities generally have higher margin requirements.
 Price Quotation: Price Quotation is the units in which the traded price of a contract is
displayed. It can be different from the trading size of a contract and is often based on
industry practices and conventions. While the contract size of PMEX sugar contract is 10
tons, its price is quoted in Rupees per 100 kgs. PMEX Palm Oil contract has a size of 25
tons but its price quotation follows local trade practices and is displayed as Rupees per
maund.
 Delivery Date: Delivery date or delivery period refers to the time specified by the
exchange during or by which the seller has to make delivery according to contract
specifications and regulations. Delivery date is often later than expiry date of a contract,
especially in case of physically delivered commodities.
 BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON

Meaning Forward Contract is an A contract in which the parties

agreement between parties
to buy and sell the
underlying asset at a
specified date and agreed
rate in future.
agree to exchange the asset for
cash at a fixed price and at a
future specified date, is known
as future contract.

What is it? It is a tailor made contract. It is a standardized contract.

Traded on Over the counter, i.e. there Organized stock exchange.

is no secondary market.

Settlement On maturity date. On a daily basis.

Risk High Low

Default As they are private No such probability.

agreement, the chances of
default are relatively high.

Size of contract Depends on the contract Fixed

terms.

Collateral Not required Initial margin required.

Maturity As per the terms of Predetermined date

contract.
 BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON

Regulation Self regulated By stock exchange

Liquidity Low High

Valuation of Futures/forward contracts

Value of futures/forward contracts,

F = So × ert

So ……………………is the spot price of an Asset

r………………………is the risk free rate of return

t………………………is the time to maturity in years (note time should be in years)

Some underlying assets likes stocks gives dividends then the value of forward or future is

F = So × e (r – d) × t

Here d is the continuous dividend rate.

The valuation of forward/futures contracts on commodities should include the storage cost of
storing the underlying asset. Also it should include convenience yield

Value of futures/forward contracts, F = So × e (r + c - y) × t

So ……………………is the spot price of an Asset

r………………………is the risk free rate of return

c…………………….is the continuous dividend rate

t………………………is the time to maturity in years (note time should be in years)

y……………………..is the convenience yield.

 Hedging with futures

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a
hedge consists of taking an offsetting position in a related security. Hedging is done to minimize
or offset the chance that your assets will lose value. It also limits your loss to a known amount if
the asset does lose value.

Short Hedging:

• A short hedge means to hedge by going short in the futures market.

• A hedge who holds the commodity/asset and is concerned about the decrease in its price
might consider hedging with short position in futures.

• If the spot price and futures price move together, the hedge will reduce some of the risk. For
example, if the spot price decreases, the futures price also will decrease. Since the hedger is
short the futures contract, the futures transaction produces a profit that at least partially offsets
the loss on the spot position. This is called short hedge because hedger is short in futures.

• Another type of short hedge can be used in anticipation of future sale of asset. For example
you want to sell wheat in the market and anticipate that its price may go down in the near
future (when wheat is ready to be sold) and so for this you can take short hedge position in
futures contract so as to hedge the risk of fall in price of wheat.
Long Hedging:

• A long hedge means to hedge by going long in the futures market.

• An anticipatory hedge which involves an individual who plans to purchase a

commodity/asset at a later date. Fearing an increase in the commodity/asset price, the
investor might a buy a futures contract. Then if the price of the commodity increases, the
futures price also will increase and produce a profit on the futures position. The
generated profit from futures contract will partially offset the higher cost of purchasing
the commodity.

• Another type of long hedge can be when we short the asset and fear that in near future
that the market will go up. Rather than close out the short position, one might buy a
futures contract and earn a profit on the long position in futures contract that will at least
partially offset the loss on the short position in the stock.
 Basis
In the futures market, the difference between the cash price of the commodity and the futures
price is the basis. Basis is defined as the difference between cash and futures prices. Basis can be
either be positive or negative. Basis may change its sign several times during the life of the
contract. Basis converges to zero at maturity of the futures contract i.e. both cash and futures
prices converge at maturity. The uncertainty regarding how the basis will change is called
BASIS RISK.

• basis = spot price – futures price.

• Profit (short hedge) = (St – So) + (Fo – Ft) = bt – bo

basis bo = So – Fo, basis bt = St - Ft

• Profit ( long hedge) = So – St + Ft – Fo = -bt + bo

basis bo = So – Fo, basis bt = St – Ft

St is the price of stock at time t, So is the price of stock at time Zero, Ft is the futures price at
time t and Fo is the futures price at time Zero.

If the spot price increase more than the futures price then the basis will increase and is called
strengthening the basis and vice versa.

Hedging Strategies using futures

Going long - Buy futures contract

• when an investor anticipates that the asset price will go up in the market.

• Market perception: When the outlook of the market is Bullish and so price of underlying
asset is expected to increase.

• Risk: Unlimited as assets price and so futures price can fall to zero.

• Profit: unlimited depending on the upward moment o asset.

• Break-even: the price of asset (at maturity) equals the price o futures contract price.

Going Short—Sell futures

• A futures contract where by investor agrees to sell and deliver the underlying asset at a
set price and is anticipating to make profits from declining price of asset.
 • Situation: bearish outlook for the market. Price of asset expected to fall.

• Risk: unlimited as the asset and futures price can increase.

• Profit: unlimited as it depends upon the downward moment until the price of asset
reaches zero.

• Breakeven: the price of asset equals the price of futures contract.

Long hedging---short spot and long futures

• This strategy is appropriate when a company has shorted an asset and anticipates that it
might incur losses due to rise in asset price.

• Situation: bullish outlook and prices expected to rise.

• Profit: no loss/profits. The loss and profit will be offset by gain/loss in asset price and
futures price.

Short hedging--- long spot and short futures

• A short hedge is appropriate when we own the asset and expect to sell it sometime in
future. It can also be done when hedger anticipates to buy asset in the future.

• Situation: bearish outlook and prices expected to fall. Protection needed against falling
prices.

• Profit: no profit/loss. The gain/loss in long asset and short futures will be offset by
fluctuating prices of both.

Credit derivatives
Credit derivatives are financial instruments that transfer credit risk of an underlying portfolio of
securities from one party to another party without transferring the underlying portfolio. When a
lender lends money to a borrower, the lender is faced with the risk that the borrower won't pay
that money back. This is called the credit risk. A credit derivative is a financial contract in which
the underlying is a credit asset (debt or fixed-income instrument). The value of credit derivatives
is derived from the credit risk on an underlying bond, loan or any other financial asset. The
purpose of a credit derivative is to transfer credit risk without transferring the asset itself. The
credit risk is on an entity other than the counterparties to the transaction itself. This entity is
known as the reference entity and may be a corporate, a sovereign or any other form of legal
entity which has incurred debt.
 To illustrate, suppose XYZ Bank lends $10k to Bob over 10 years. Determining that Bob carries
significant default risk as a borrower, XYZ Bank enters into a credit derivative with ABC Bank.
The terms of the agreement state that in the event Bob defaults and is unable to repay the loan,
ABC Bank will compensate XYZ Bank for the remaining interest and principal in return for an
annual fee of $100 through the end of the 10-year term. If Bob does not default on the loan, ABC
bank may keep the $100 annual fee as a gain.

 Credit default swap: Credit default swaps (CDS) are a type of insurance against default risk by
a particular company. The company is called the reference entity and the default is called credit
event. It is a contract between two parties, called protection buyer and protection seller. Under
the contract, the protection buyer is compensated for any loss emanating from a credit event in a
reference instrument. In return, the protection buyer makes periodic payments to the protection
seller. In the event of a default, the buyer receives the face value of the bond or loan from the
protection seller. From the seller’s perspective, CDS provides a source of easy money if there is
no credit event.

Assume that two parties A and B enter in a five-year CDS. In this, A is the protection buyer and
B is the protection seller. Let’s assume that the notional principal is Rs 50 crore and the
protection buyer agrees to pay 100 basis points annually to the protection seller. If the reference
entity does not default, the protection buyer keeps on paying 100bps of Rs 50 crore, which is Rs
50 lakh, to the protection seller every year. On the contrary, if a credit event occurs, the
protection buyer will be compensated fully by the protection seller.
• Total Return Swap: A Total Return Swap is a contract between two parties who exchange the
return from a financial asset between them. These parties are called total return payer (TRP) or
protection buyer and total return receiver (TRR) or protection seller. In this agreement TRP
agrees to pay total return on particular reference asset to TRR and agrees to receive a rate such as
LIBOR + Spread. Reference assets can be bonds, equity interest loan etc.

In a TRS contract, the party receiving the total return gets any income generated by the financial
asset without actually owning it. The receiving party benefits from any price increases in the
value of the assets during the lifetime of the contract. The receiver must then pay the asset owner
the base interest rate during the life of the TRS. The asset owner forfeits the risk associated with
the asset but absorbs the credit exposure risk that the asset is subjected to. For example, if the
asset price falls during the lifetime of the TRS, the receiver will pay the asset owner a sum equal
to the amount of the asset price decline.