Financial Engineering

Introduction
Need of a New System/ Instrument:

Q. Why do we need a new instrument/

system???

Example
1. In an informal financial system, there
was a greater credit risk. To mitigate
this risk, the need of a formal
financial system was felt.
2. The basic forms of sources of funds
(???) were not fulfilling the need of
entrepreneurs and hence, there was
need
of
development
of
new
instruments to raise funds e.g: Hybrid
instruments (FCCB, ECB etc.)

Definition
Financial

engineering

involves

the

design, the development and the

implementation

of

innovative

financial instruments and processes

and

the

formulation

of

creative

solutions to problems in finance.

Price Chart of NTPC

Q. You are a fund manager and have taken shares of

NTPC in your portfolio. Share prices of NTPC are
falling. What possible actions will you take ? (Before

Functions
Functions of financial engineers:
Functions are not limited to the listed
ones. Few of them are:
1. Investment and Money Management:
Mutual Funds, Money Market Funds,
Repo market etc.
2. Security and Derivative Products
Trading:
To take advantage of
arbitrage, innovation of program
trading (??).

Continue
3. Corporate Finance: formulation of new
instruments to raise funds, pay-off
debts etc.
4. Investment Banks: IPO management,
M&A
( Pricing methods of IPO, Innovative
ideas to handle M&A like: issuance of
junk bond, Leverage Buy-outs (LBO)
etc.).
5. Risk Management: Development of

Case 1

You are a financial engineer and

standing at a time when only Debt,
Equity and F.D are the sources of
investment. Mr. X is having Rs. 10 lakh
to invest but his risk appetite is not
high. At the same time, he would like to
take exposure in both equity as well as
debt and short-term F.Ds. What type of
instrument can you design/ suggest
him to invest in??

Tools of F.Es

F.E.

Concept
ual Tools
Accounting
Relationship,
Valuation Theory,
Portfolio Theory,
hedging Theory etc.

Physical
Tools
Instruments like: Equities,
Derivatives, Bonds etc.
Processes: Electronic
Securities Trading, IPO,
Private placements etc.

Risk
Define it ???

Price Risk
Risk is any deviation in expected value
of a security/ portfolio/ asset class.

Ex: Share price of NTPC is Rs.130 per

share today. But, What about tomorrows
price??

Types of Financial Risk

The term "financial risk" covers the
range of risks affecting financial
outcomes, faced by a firm.
Financial risk is essentially of two
kinds: systematic and unsystematic.

Systematic Risk
Business risk is the risk of fluctuations in sales
revenue. It arises from macroeconomic factors
such as economic swings and deregulation, and
demand factors such as seasonality of demand.
This risk is not totally systematic, however, and
some of it can be reduced by diversification of
the firm's operations.

Financing risk arises from leverage. It is

possible to minimise it by restricting the amount
of debt in the firm, even though there may be
tax advantages to borrowing.

Continue..

Inflation risk arises from unanticipated

inflation
Marketability, or liquidity risk: When it is
difficult to buy or sell a financial instrument
at its market price. This risk is undiversifiable and also completely systematic.
Political risk can be both domestic and
foreign; it is particularly high when operating
in some politically unstable economy. This
risk is highly systematic and unavoidable.

Unsystematic Risk
Interest rate risk arises both from
fixed
and
floating
rate
debt.
Unanticipated changes in floating
interest rates can cause costs to rise.
Floating-rate debt offers a long-run
hedge against inflation risk.
At the same time, a fixed rate debt can
cause financial difficulties in case interest
rates drop. This is therefore a major risk
faced by almost all companies. It can be
hedged against in many ways.

Continue
Currency (or foreign exchange)
risk arises when cash inflows or
outflows take place in foreign currency.
This risk can be either diversified or
hedged.
Commodity price risk arises from
unanticipated changes in commodity
prices and can be hedged.

Calculation of Risk

Systematic Risk:
Unsystematic Risk
Total Risk
Diversification
What is beta ??

Future & Forward

Why do we need it??

Forward Market
A forward contract is a contract between two
parties to exchange assets or services at a
specified time in the future at a price agreed
upon at the time of the contract.
How do you the future price today ???
What is risk here ??

Forward contact is non-standardized.

Traded on OTC (Over the Counter).

Future Market

A futures contract is a contract

between two parties to exchange
assets or services at a specified time in
the future at a price agreed upon at the
time of the contract.
It is standardized.
It is traded on Exchanges.

Continue

An exchange acts as an intermediary and

guarantor, and also standardizes and
regulates how the contract is created and
traded

Pay-off Diagram of Future

Strike
Price
Delivery
(K)
Price

ST

Continue

Pay-off from
Long position in future/ Forward = ST -K
Where ST = Spot price of asset at maturity
K = Strike Price (Delivery price)
- Short position in future/ Forward = K - ST

Pay-off of Nifty Future (long)Strike Price 8200

Symbol

NIFTY
NIFTY
NIFTY
NIFTY

Date
18-Dec14
19-Dec14
22-Dec14
23-Dec14
24-Dec-

Settle
Expiry
Price

Underly
ing
Value

24-Dec14 8,180.80 8,324.00

24-Dec14 8,239.85 8,267.00
24-Dec14 8,334.20 8,225.20
24-Dec14 8,271.55 8,159.30
24-Dec-

Pay-off
124.00
67.00
25.20
40.70

Pay-off Diagram
140.00

Pay-of
120.00
100.00

Pay-Off

80.00
60.00
40.00
Pay-off
20.00
0.00
8159.3

8174.1

8225.2000000000007

8267

8324

-20.00
-40.00
-60.00

Spot Price of
Nifty

Margin Calculation
Settlement is made on daily basis in future
market while,
In Forward market, it is done at the end of
the contract period. ( Why ???)
Task:
Take an index future or stock future of your
interest and calculate profit/loss in last 1
week.

One more Observation

NSE - National Stock Exchange of India Ltd..
htm
http://www.nseindia.com/live_market/dynaCo
ntent/live_watch/derivative_stock_watch.ht
m
Normal Market: When the future prices of
the underlying increases as the time to
maturity
increases.
(also
known
as
Contango).
Inverted Market: If the future price of the
underlying decreases as the time to maturity
increases. (also known as Backwardation).

Purpose of Future Markets

To Hedge
Minimize or manage risks
Have position in spot market with the goal to
offset risk

To Speculate
Take a position with the goal of profiting from
expected changes in the contracts price
No position in underlying asset

Marking to Market

One of the unique features of futures contracts

is that the positions of both buyers and sellers
of the contracts are adjusted every day for the
change in the market price that day.
In other words, the profits or losses associated
with price movements are credited or debited
from an investors account even if he or she
does not trade. This process is called marking
to market.
Excel file

VaR (Value at Risk)

My Financial advisor made a portfolio
of Rs. 10 lakh for me by investing in
different asset class in 2006 when
market was in boom.
Now, My heart-beat started increasing
looking at the market condition.
What is the most I can lose on this
investment?

Continue

Value at Risk measures the potential loss in

value of a risky asset or portfolio over a
defined period for a given confidence
interval.
Ex:
VaR on an asset is $ 100 million at a oneweek, 95% confidence level. i.e
There is a only a 5% chance that the value of
the asset will drop more than $ 100 million
over any given week

Continue..
The VaR can be specified for an
individual asset, a portfolio of assets or
for an entire firm.
Task:
Take a security (Share of any company).
Collect data of last one week-trading
price and calculate VaR assuming that
you knew this can be the lowest price of
share in one-week.

Basis Risk

Basis is the difference between the

spot price of an asset and its future
price.
Basis = Spot price of hedged asset Futures price of contract
Where is risk ??
Hint: What should be basis at
Maturity ?

Hedge Ratio
The ratio of the size of the position taken in future
contract to the size of the position taken in spot is known
as Hedge Ratio.
Hedge Ratio =
Number of future contract/ Number of spot position .

Number of future required =

(Beta of portfolio * Value of
portfolio)/value of one index future contract
Mr. X buys three future contracts of company ABC ltd. to hedge the
risk of 6 number of bought shares of ABC ltd. What is hedge
ratio? ( Is there anything wrong in this strategy??).

Stop and Think for a

moment !!
Why Mr. X is taking position in future
market ?
Which type of risk does he want to
mitigate?
How does it work?

Calculation of number of futures

Mr. X is having a portfolio of Rs. 660
lakhs and he wants to hedge his
portfolio using NIFTY Index Future.
The strike price of future contract is
Rs. 6600 and beta of his portfolio is
0.8. NIFTY index future trade in
multiples of 50. Find number of
future contract that he should buy or
sell to hedge his portfolio.

Rolling Hedge

Continue
If Mr. X wants to buy future of Month
May in India on 1-Feb. (Can he buy??)
The possible strategy he could have:
Buy future of April month
At the expiration of April month contract
buy contract of next1 month

Task
Buy 50 shares of SBI at todays price. Find
beta of SBI. Hedge this asset using NIFTY
Index future.
Buy 50 shares of MARUTI and 50 shares
of SBI. Find beta of SBI and MARUTI.
Calculate beta of the portfolio and hedge
this portfolio using NIFTY index futures.

Interest Rate Future

interest rate futures suggests that the
underlying is interest rate.
It is actually bonds that form the underlying
instruments.
An important point to note is that the
underlying bond in India is a notional
government bond which may not exist in
reality.
In India, the RBI and the SEBI have defined
the characteristics of this bond: maturity
period of 10 years and coupon rate of 7%
p.a

Continue
One other salient feature of the
interest rate futures is that they have
to be physically settled
Unlike the equity derivatives which are
cash settled in India.
Physical settlement entails actual
delivery of a bond by the seller to the
buyer

Trading Strategy

If an investor is of the view that interest

rates will go up, he would sell the IRF.
This is so, because interest rates are
inversely related to prices of bonds, which
form the underlying of IRF. So, expecting a
rise in interest rates is same as expecting a
fall in bond prices.
Similarly, if an investor expects a decline in
interest rates (equivalently, a rise in bond
prices), he would buy interest rate futures.

Lot Size in IRF

Lot size: The minimum amount that can
be traded on the exchange is called the
lot size.
All trades have to be a multiple of the lot
size.
The interest rate futures contract can be
entered for a minimum lot size of 2000
bonds at the rate of Rs. 100 per bond
(Face Value) leading to a contract value
of Rs. 200,000.

Continue
At any given time, a maximum of four
contracts can be allowed for trading on
the exchange (Viz., March, June,
September and December contracts).

Currently, at NSE only three contracts

are allowed to be traded

Settlement

Mark-To-Market
Settlement
Physical settlement:

and

For IRF, settlement is done at two

levels:
1. Mark-to-market (MTM) settlement which
is done on a daily basis and
2. Physical delivery which happens on any
day in the expiry month

Application of IRF

Asset-liability management
Banks typically have lots of government bonds
and other long term assets (loans given to
corporate) in their portfolio.
while their liabilities are predominantly shortterm (deposits made by individuals range
from 1 to 5 years).
To address this risk (Where is the risk???)

Continue

The risk resulting from the asset-liability

mismatch, they generally sell IRF and
thereby, hedge the interest rate risk.
On the other hand, for the insurance
companies and several big corporates,
the tenure of their liabilities is longer
than that of their assets.
So, they buy IRF to hedge the interest
rate risk.

Continue
2.
Investment
management:

portfolio

Mutual funds and similar asset classes

having a portfolio of bonds can use IR
futures to manage their interest rate
exposure in turbulent times.

Questions for Practice

What do you mean by derivative?
What are differences between Future and
Forward contracts?
What is Index future?
What is stock future?
What is IRF ?
What is Forward Agreement?
What is future agreement?
Why the underlying bond in IRF is a notional
bond?

Continue

A hypothetical banks is having more short

term asset and more long-term liabilities. Using
the concept of IRF explain, which type of
hedging strategy the bank should use?

A company has taken loan from a bank of 20

years term and have fixed deposits in banks of
tenure 5 years. The interest rates on both
( loan as well as F.D.) are floating. Suggest
which type of strategy the company should
follow to hedge Interest rate risk. Also explain
how interest rate fluctuation can bring risk in
its portfolio if not hedged?

Foreign Currency Future

What is foreign exchange rate?
Value of a foreign currency relative to
domestic currency.
The participants in this markets are: banks,
exporters, importers etc.
Foreign exchange deal is always done in
currency pairs. Ex:
US-INR :
US dollar & Rs.
GBP-INR :
British pound & INR
JPY-CHF:
Japanese Yen and Swiss-Franc.

Continue
In a currency pair, first currency is called
base currency and second currency is
called Counter/ term/Quote currency.
Ex: USD-INR = 62.45
The price fluctuation in currency market
is
expressed
as
appreciation/
depreciation
or
strengthening/
weakening of a currency with respect to
other.
Ex: a change of US-INR from 35 to 36
indicates that US dollar has ????

Continue..

USD is the most widely traded currency and is

referred as Vehicle currency.
Why Vehicle currency ??
A vehicle currency helps a market in reducing
the number of quotes at any point of time.
Any quote not against the USD is termed as
Cross.
Ex: Cross Quote for GBP-CHF can be arrived
through GBP-USD USD-CHF Quote.
Therefore the availability of USD quote helps in
finding cross quote for any other currency.

Task
From NSE collect last days data of
exchange rate of following:
USD-INR
EUR-INR
GBP-INR
&
JPY-INR
And calculate the following:
1. USD-EUR exchange rate.
2. EUR-GBP exchange rate
3. GBP-JPY exchange rate
Verify your answer with real data of these
exchange rates from other sources and find
reason of deviation, if any.

Pricing Currency Futures

Continue

Long-Short Concept clarity

Q1. If I would like to own an asset in

future, I should take ..position?
Q2. If I would like to sell an asset in
future, I should take ..position?
Q3. If I have taken a liability and I want
to hedge it, I will take .position?
Q4. If I have an asset and I want to
hedge it, I will take .position?

Options

Options are fundamentally different

from forward and futures contracts.
An option gives the holder of the
option the right to do something, but
the holder does not have to exercise
this right.
By contrast, in a forward or futures
contract,
the
two
parties
have
committed themselves to some action.

Types of Options

Call Option: gives the holder of the option

the right to buy an asset by a certain date for
a certain price.
Put Option: gives the holder the right to sell
an asset by a certain date for a certain price.
The date specified in the contract is known
as the expiration date or the maturity date.
The price specified in the contract is known
as the exercise price or the strike price.

Continue..

Options can be either American or

European, a distinction that has
nothing to do with geographical
location.
American options can be exercised at
any time up to the expiration date,
whereas European options can be
exercised only on the expiration date
itself.

Profit Diagram of ??

1. Option price =??

2. Strike Price = ??
3. Call / Put ?
4. European/ American ??

Task
From NSE site identify the periods for
which options are available?
Note strike price corresponding to
each period. Do analysis by taking
volume also into consideration.
Which option is most active option?

Test 1

Q1. In forward market credit risk is not present ?

(True/ False)
Q2. In a forward market daily settlement is
done?
(True/ False)
Q3. In mark-to-market concept, the profit/loss for
the day is settled on the same day. (True/
False)
Q4. If I have a share, which type of hedging
strategy should I use? (Long Future/ Short
Future)
Q5. If I hedge a share using NIFTY Future, which
risk am I hedging. (Systematic/ Unsystematic)

Q6. Total risk of the portfolio cant be

mitigated. (True/ False).
Q7. beta measures unsystematic risk of
the portfolio. (True/ False)
Q8. Forward and futures are obligatory
contracts. (True/ False).
Q9. We take opposite position in future
market than spot market. (True/ False).
Q10. VaR measures the minimum loss that
my portfolio will make. (True/ False).
Q11. beta of market is always 1.5? (True/
False)

Q12. VaR on an asset is $ 100 million at a

one-week, 95% confidence level. Meaning
of this is my portfolio will lose a value of
$100 million with 95% confidence? (True/
False).
Q13. An American option can be excised
only at the expiration. (True/ False)
Q14. If I want to buy share of NTPC in
March, I will take position in Option
Market today. ( Long Call/ Long Put)
Q15. Higher the beta lower is the risk.
(true/ False)

I dont understand this

subject at all.

Q16.

(True/ False).

Option Positions
Two parties on each Option: Buyer &
Seller
Call Option: Buyer as well as Seller
(Writer)
Put Option : Buyer as well as Seller
The writer of an option receives cash
upfront but have potential liabilities.
The profit/ loss of writer is the reverse
of that of buyers.

Continue

Parties in contract:
1.Long Call
&
2. Long Put
&

Short Call
Short Put

Identify the strategy

How does Option protect Us

Stock Vs Options : Draw Graph of stock
price change and Option price change.

Pay-off (Intrinsic Value)

Long Call: Max(ST-K,0)

Short Call: - Max(ST-K,0) = Min(K-ST,0)
Long Put: Max(K-ST,0)
Short Put: - Max(K-ST,0) = Min(ST-K,0)

Options are referred to as in the money, at

the money, or out of the money.
If S is the stock price and K is the strike price, a
call option is in the money when S > K, at the
money when S =K, and out of the money when
S < K.

Numerical

An investor buys a European put on

a share for $3. The stock price is $42
and the strike price is $40. Under
what
circumstances
does
the
investor make a profit? Under what
circumstances will the option be
exercised? Draw a diagram showing
the variation of the investors profit
with the stock price at the maturity
of the option.

Answer the following

Q1. If you expect prices of asset can increase, you
will take:
a). Long call b). Short call C) Long put d) Short put
Q2. If you expect prices of asset can decrease, you
will take:
a). Long call b). Short call C) Long put d) Short put
Q3. I have share of NHPC trading at Rs. 18 per
share. I want to sell this share @ Rs. 22 per share
but am nervous about any fall in prices. What
strategy should I follow?

Other Strategies
One share and a short position in one
call option.
Two shares and a short position in one
call option.
One share and a short position in two
calls.
One share and a short position in four
calls.

Option Pricing

Binomial Model

Assumptions:
Two price points up/down are known with
certainty.
There is no arbitrage opportunity.
No transaction cost.

Task

Find value of an option with following

details:
52

50
49

50

48
56

45

Strike price =

Rf = 8%, 3 months

Black Scholes Model

The Black-Scholes model is used to price European
options
( Which assumes that they must be held to expiration).
It takes into account that you have the option of
investing in an asset earning the risk-free interest rate.
It acknowledges that the option price is purely a
function of the volatility of the stock's price (the
higher the volatility the higher the premium on the
option).
Black-Scholes treats a call option as a forward contract
to deliver stock at a contractual price, which is, of
course, the strike price.

Formula

Numerical on Black-Scholes Model

The stock price 6 months from
expiration of an option is $42,
exercise price of the option is $40,
risk-free interest rate is 10%
annum, and the volatility is 20%
annum.

the
the
the
per
per

Solution

Option Revisited
There are two types of options:.
There are four types of option
strategies..
American option can be exercised at any
time before expiration. (True/ False)
Draw profit-loss diagram of :
(i) One long call and one short call
(ii) A share and a short call.
() What is a Binomial option Model?
() What is Black-Scholes Model?

Swap
A
swap
is
an
over-the-counter
agreement between two companies to
exchange cash flows in the future.
The agreement defines the dates when
the cash flows are to be paid and the
way in which they are to be calculated.
Usually the calculation of the cash flows
involves the future value of an interest
rate, an exchange rate.

Example:
Consider a hypothetical 3-year swap initiated on March 5, 2012, between
Microsoft and Intel.
We suppose Microsoft agrees to pay Intel an interest rate of 5% per annum on a
principal of $100 million, and in return Intel agrees to pay Microsoft the 6-month
LIBOR rate on the same principal.

Cash Flow in IRS

Comparison of Forward and Swap

A forward contract can be viewed as a simple
example of a swap.
Suppose it is March 1, 2012, and a company
enters into a forward contract to buy 100 ounces
of gold for $1,200 per ounce in 1 year.
The company can sell the gold in 1 year as soon
as it is received.
The forward contract is therefore equivalent to a
swap where the company agrees that on March 1,
2012, it will pay $120,000 and receive 100S,
where S is the market price of 1 ounce of gold on
that date.
Buyer

Seller

Continue
Whereas
a
forward
contract
is
equivalent to the exchange of cash
flows on just one future date, swaps
typically lead to cash flow exchanges
on several future dates.

Application of Swap
1. To Transform a Liability:
Suppose that Microsoft has arranged to borrow $100 million
at LIBOR plus 10 basis points.
a. For Microsoft the risk is : ??
How to mitigate this risk ??
. After Microsoft has entered into the swap, it has the following three
sets of cash flows:
1. It pays LIBOR plus 0.1% to its outside lenders.
2. It receives LIBOR under the terms of the swap.
3. It pays 5% under the terms of the swap.
LIBOR+0.1%

Continue

For Intel, the swap could have the effect of transforming a fixed-rate
loan into a floating-rate loan.
Suppose that Intel has a 3-year $100 million loan outstanding on
which it pays 5.2%.
After it has entered into the swap, it has the following three sets of
cash flows:
1. It pays 5.2% to its outside lenders.
2. It pays LIBOR under the terms of the swap.
3. It receives 5% under the terms of the swap.
5.2%

Thus, for Intel, the swap could have the effect of transforming
borrowings at a fixed rate of 5.2% into borrowings at a floating rate
of LIBOR plus 20 basis points.

Continue
2. To Transform an Asset:

Comparative Advantage Argument

AAA is credit Rating of AAA Corp and BBB is that of

BBBCorp.
We assume that BBBCorp wants to borrow at a fixed rate
of interest, whereas AAACorp wants to borrow at a
floating rate of interest linked to 6-month LIBOR.
In what condition AAAcorp is at advantage and what
condition BBBCorp is at advantage (Floating/ Fixed)?
ANS????
BBBCorp is at advantage at floating rate while AAAcorp at

Swap Design

Role of Financial Intermediary

Usually two nonfinancial companies such as Intel and Microsoft do not get in
touch directly to arrange a swap.

financial institution has two separate contracts: one with Intel and the other with
Microsoft.
In most instances, Intel will not even know that the financial institution has entered
into an offsetting swap with Microsoft, and vice versa.
If one of the companies defaults, the financial institution still has to honor its
agreement with the other company. The 3-basis-point spread earned by the
financial institution is partly to compensate it for the risk that one of the two
companies will default on the swap payments.

Continue..

Problem

Swap Revisited

What is a Swap?
How does Swap help to mitigate risk?
Different types of Swaps?

Other
Types
of
Swaps
Currency Swap
Amortizing swap: the principal reduces in a
predetermined way.
Step-up swap: the principal increases in a
predetermined way.
An equity swap : is an agreement to exchange the total
return (dividends and capital gains) realized on an equity
index for either a fixed or a floating rate of interest.
For example, the total return on the S&P 500 in
successive 6-month periods might be exchanged for
LIBOR, with both being applied to the same principal.
Equity swaps can be used by portfolio managers to
convert returns from a fixed or floating investment to the
returns from investing in an equity index, and vice versa.

Credit Rating
Rating agencies, such as Moodys, S&P, and Fitch,
are in the business of providing ratings describing
the creditworthiness of corporate bonds.
The best rating assigned by Moodys is Aaa.
Bonds with this rating are considered to have
almost no chance of defaulting.
The next best rating is Aa. Following that comes
A, Baa, Ba, B, Caa, Ca, and C.
Only bonds with ratings of Baa or above are
considered to be investment grade.
The S&P and Fitch ratings corresponding to
Moodys Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C
are AAA, AA, A, BBB, BB, B, CCC, CC, and C,
respectively.

Default Rates

Observations:
1.

For investment-grade bonds, the probability of default in a year tends to be an

increasing function of time.
Reason: the bond issuer is initially considered to be creditworthy,
and the more time that elapses, the greater the possibility that its
financial health will decline
2.

For bonds with a poor credit rating, the probability of default is often a

decreasing function of time.

Reason: The longer the issuer survives, the greater the chance that

Hazard Rates
Hazard Rate is the probability that bond will
default in a particular year on a condition that it
will not default on no earlier year.
The probability of a bond rated Caa or below
defaulting during the third year as 38.682
29.384 = 9.298%.
The probability that the bond will survive until the
end of year 2 is 100 -29.384 =70.616%.
The probability that it will default during the third
year conditional on no earlier default is therefore
0.09298/0.70616 = 13.17%. (This is Hazard
Rate)
Note: This is similar to conditional probability
P(A/B)= Probability of event A, when B has already occurred.

ESTIMATING DEFAULT PROBABILITIES FROM

BOND PRICES
Why Does a Corporate Bond trade at a price lower
than a G-Bond?

possibility of default

I his the average hazard rate (default

intensity) per year,

S: Spread of the corporate bond yield over the
risk-free rate, and
R is the expected recovery rate

Problem
If a bond yields 200 basis points more than a similar
risk-free bond and that the expected recovery rate
in the event of a default is 40%; find default
probability (Hazard Rate)?

Conclusion:

1. Higher the spread, more is the risk i.e. higher is the

probability of default.
2. Lower is the recovery rate, higher is the Prob. Of
default.

Exotic Option
Exotic Options are non-standardized options created by
financial engineers to fulfill the gap in the traditional
option instruments.
Traditional Option instruments are standardized and
hence, sometime dont meet the requirements of
participants.
Some of Exotic Options are:
1. Rainbow Options: It is an option written on more than
one underlying asset.
For example: a put option may specify that you have the
option to deliver one from a range of different assets.
Clearly if the exercise price is the same for all assets
specified, and if you decide to exercise your option to
sell, you will choose to deliver that asset with the lowest
current price

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2. Non-Standard American Option:

1. Bermudan option: Early exercise may be
restricted to certain dates.
2. Early exercise may be allowed during only part
of the life of the option. For example, there may
be an initial lock out period with no early
exercise.
3. The strike price may change during the life of the
option.
. 3. Chooser Option:
A chooser option (sometimes referred to as an as
you like it option) has the feature that, after a
specified period of time, the holder can choose
whether the option is a call or a put

Direct Hedge
A form of derivatives hedge in which the
cash market instrument being hedged is
hedged by an options or futures contract
on the same underlying instrument.
For example, a 91-day U.S. Treasury bill
hedged with a Treasury bill future

Cross Hedge
A form of derivatives hedge in which
the cash market instrument being
hedged is hedged by an options or
futures contract on other underlying
instrument.
For example, a 91-day U.S. Treasury
bill hedged with a 3-Month Stock
future.

Hybrid Securities
SWAP-Options: SWAPTIONs.
I.R. Swap options, or swaptions, are options
on interest rate swaps.
(They give the holder the right to enter into
a certain interest rate swap at a certain time
in the future).
consider a company that knows that in 6
months it will enter into a 5-year floatingrate loan agreement and knows that it will
wish to swap the floating interest payments
for fixed interest payments to convert the
loan into a fixed-rate loan

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At a cost, the company could enter into a swaption

giving it the right to receive 6-month LIBOR and
pay a certain fixed rate of interest, say 8% per
annum, for a 5-year period starting in 6 months.
If the fixed rate exchanged for floating on a regular
5-year swap in 6 months turns out to be less than
8% per annum, the company will choose not to
exercise the swaption and will enter into a swap
agreement in the usual way.
However, if it turns out to be greater than 8% per
annum, the company will choose to exercise the
swaption and will obtain a swap at more favorable
terms than those available in the market.

Synthetic Instrument
Synthetic financial instruments are artificially
created
instruments
intended
to
meet
requirements not met by existing, conventional
instruments.
They are designed to reducerisk, increase
diversification or offer a higher return.
an asset with the same risks and rewards as the
underlying sharecan be created by the purchase
of acall optionand the simultaneous sale of aput
optionon the same share.
Or
A synthetic floating rate instrument can be
produced by combining a fixed-ratebondand
aninterest rate swap.