Derivatives and financial innovations 9780070620827, 0070620822

Table of contents :
Half Title
About the Authors
Title Page
Copyright
Dedication
Preface
Foreword
Contents
PART 1: FUTURES
1. Introduction to Derivatives
Derivatives in India
Generic Derivative Products
Summary
Questions
2. Trading Mechanism of Futures Contracts
Maturity of Futures Contracts
Contract Size and Contract Multiplier
Tick Size
Contract Specifications
What Makes a Contract Successful
Positions in Derivatives Market
Open Interest and Volume
Convergence of Cash and Futures Prices
Settlement of Futures Contracts
Initial and Variation Margins
Additional Margins
Final Settlement of Futures Contracts
Appendix 2.1: Index Concepts
Summary
Questions
3. Uses of Futures
Risk Traded in Index Futures Market
Other Risks in Financial Markets
Role of Different Players in the Futures Market
Risk Management using Futures (Hedging)
Important Terms in Hedging
Speculation in the Futures Market
Arbitrage Opportunities in the Futures Market
Summary
Questions
4. Futures Pricing
Cash and Carry Model for Futures Pricing
Cost of Transaction and Non-arbitrage Bound
Extension of Cash and Carry Model to Assets, Generating Returns
Assumptions in the Cash and Carry Model
Convenience Yield
Expectancy Model of Futures Pricing
Summary
Questions
PART 2: OPTIONS
5. Basics of Options
Option Contract
Terminology used in Options Market
Risk and Return Profile of Option Contracts
Relationship between Strike Price of an Option and Market Price of the Underlying Asset
Option Premium
Relationship of Time Value with Time
Comparison of Futures and Options Positions
Risk Management in the Options Market
Introduction of New Option Contracts
Settlement of Option Contracts
Exercise of Options
Assignment of Options
Appendix 5.1: Risk Management Using SPAN
Summary
Questions
6. Synthetic Positions and their Management
Synthetic Positions
Purpose of Synthetic Positions
Creation of Synthetic Positions
Summary
Questions
7. Basics of Options Pricing and Option Greeks
Basic Determinants of Options Pricing
Binomial Model for Options Pricing
Black–Scholes Model for Options Pricing
Upper and Lower Bounds of Option Premium
Option Greeks—Measuring Price Sensitivity of Options
Option Positions vis-a-vis Underlying Positions
Summary
Questions
8. Perspectives in Options Trading
Perspectives of Futures and Options Traders
Choice of Strike Price
Analysis of Call Options
Analysis of Put Options
Summary
Questions
9. Option Spreads
Vertical Spread Positions
Horizontal/Calendar/Time Spreads
Diagonal Spreads
Vertical Ratio Spreads
Summary
Questions
10. Other Option Trading Strategies
Straddle
Strangle
Protective Put Buying
Protective Call Buying
Covered Call Writing
Collar
Covered Put Writing
Reverse Collar
Butterfly Spread
Condor
Strip
Strap
Summary
Questions
11. Summary of Trading Strategies on the Basis of Market Outlook
Market Outlook
PART 3: FINANCIAL INNOVATIONS
12. Introduction to Some Innovative Financial Products
Some Innovative Financial Products across the Globe
Some Innovative Financial Products in India
Summary
13. Understanding Convertibles
Global Convertible Market: Salient Features
Bond with Warrants
Convertible Equity
Buy Back of Shares in Kind
Exchangeable
Broad Dimension of Convertibles
Summary
14. Covered Warrants
Warrants
Covered Warrants
Difference between Covered Warrants and Covered Calls
Difference between Call Warrants as Sweeteners and Covered Warrants
Put Warrants
Summary
15. Fresh Perspective on Existing Financial Products
Fixed Deposits and Options
Pre-payment Choice and Option
Bank Guarantee and Option
Underwriting and Option
Right Issue and Option
Buy Back of Shares and Option
Equity and Option
Collateralised Loans and Option
Restructuring the Collateralised Loan Transaction
Summary
16. Interest Rate Products
Genesis of Floaters
Risk Management of Floating Rate Instruments
Some Innovative Structures in the Debt Market
Summary
17. Securitisation
Process of Securitisation
Types of Securitisation
What can be Securitised?
Instruments in Securitisation
Benefits of Securitisation
Difference Between Collateralised Loans and Securitisation
Summary
18. Other Innovative Ideas
Real Estate Funds
Exchange Traded Funds (ETFs)
Foreign Currency Denominated Bonds
Foreign Bonds and Euro Bonds
Dual Currency Bonds
American Depository Receipts (ADRs) and Global Depository Receipts (GDRs)
Indian Depository Receipts (IDRs)
Options on Futures Contracts
Options on Option Contracts
Commodity Linked Securities
Weather Derivatives
Weather Insurance
Summary
19. Case Studies
Case 1—Unleashing Values from Rights
Case 2—Put Warrants Approach to Fixed Price Buy Back/Takeover Offers
Case 3—Creative Use of Options in Designing Contracts
Case 4—Collateralised Mortgage Obligations
Case 5—Protection of Bondholders through Put Option
Case 6—Buy Back of Shares for Other than the Cash
Case 7—Buy Back of Shares for Treasury Purpose
Case 8—The Barings Episode: Learning for the Market
Conclusion
Glossary
Index
Authors’ Profiles

Citation preview

Derivatives and Financial Innovations

This book touches all dimensions of futures and options trading starting from basic concepts to sophisticated trading strategies in a simple and lucid manner. I am sure that after going through this work, market participants would have a great understanding of this complex subject. DR M T RAJU Director (In-Charge) Indian Institute of Capital Markets, Mumbai

This is a comprehensive work on derivatives encompassing almost all segments of the financial market—commodities, equities, currencies and interest rates. One can read this book like a novel, which is interesting, informative, educative and fun because it focuses on conceptual issues and thought provoking ideas on derivatives without involving mathematical web. DR CHIRAGRA CHAKRABARTY Head—Research & Development & Training Multi Commodity Exchange, Mumbai

Authors Manish Bansal and Navneet Bansal are actively associated with derivatives revolution in the country. Both of them have contributed phenomenally in this area through their continuous educational and training efforts along with their successful stints with their respective organizations. This book is a great contribution from both of them to the Indian Financial Market. C VASUDEVAN General Manager—Knowledge Management Head—BSE Training Institute, Mumbai

Derivatives and Financial Innovations

MANISH BANSAL Vice President Citigroup Mumbai

NAVNEET BANSAL Director Equity Risk Management UBS AG Hong Kong

Tata McGrawH - ill lbuP ishing oC apm ny Limited NEW DELHI McGraw-Hill Ofices New Delhi New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal San auJ n Santiago Singaop re Sydney Tokoy Toronto

Published by Tata McGraw-Hill Publishing Company Limited, 7 West Patel Nagar, New Delhi 110 008. Copyright © 2007, by Tata McGraw-Hill Publishing Company Limited No part of this publication may be reproduced or distributed in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval system without the prior written permission of the publishers. The program listings (if any) may be entered, stored and executed in a computer system, but they may not be reproduced for publication. This edition can be exported from India only by the publishers, Tata McGraw-Hill Publishing Company Limited. ISBN 0-07-062082-2 Head—Professional and Healthcare: Roystan La’Porte Publishing Manager: R. Chandra Sekhar Editorial Executive: Souvik Mukherjee Senior Copy Editor: Sandhya Iyer Product Manager: Ajit K. Sharma Asst. General Manager—Production: B.L. Dogra Junior Manager—Production: Sohan Gaur

Information contained in this work has been obtained by Tata McGraw-Hill, from sources believed to be reliable. However, neither Tata McGraw-Hill nor its authors guarantee the accuracy or completeness of any information published herein, and neither Tata McGraw-Hill nor its authors shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that Tata McGraw-Hill and its authors are supplying information but are not attempting to render professional services. If such services are required, the assistance of an appropriate professional should be sought.

Typeset at Le Studio Graphique, Guru Shivir, 12, Sector 14, Gurgaon 122 001, and printed at Rashtriya Printers, M-135 Panchsheel Garden, Naveen Shahdara, Delhi 110 032 Cover Design: Kapil Gupta RCXYCDDKRBAXA

To Our Parents

Foreword Financial markets in India have undergone significant changes over the last several years. Both, the chemistry of change and its pace, have become unprecedented and unpredictable. Innovation in products, processes and procedures has become almost ubiquitous. The entry of derivatives into different segments of the Indian market—be they equity, commodity, currency or interest rate—is one such example of change. These products serve the vitally important economic functions of price discovery and risk management. India joined the league of exchange traded derivatives with the introduction of equity derivatives Index Futures in June 2000. Subsequently, expansion of the product portfolio to include Index options, individual stock options and individual stock futures gave the equity derivatives market its required impetus. Today, the market clocks an average daily volume of $ 8–10 billion. The introduction of commodity derivatives at the end of 2003 marked another beginning for the country. Today, we trade futures on various commodities including energy, bullion, base metals and agricultural commodities. This market has also shown remarkable growth over time, with a daily average volume of $ 2–3 billion. There is also a significant amount of derivatives business on foreign exchange and interest rate products. An exposure to derivatives has thus become an imperative for a successful stint in the financial services world. This book is a comprehensive work on the subject, presenting the complicated

viii

Foreword

terminology of derivatives in a simplified manner. The issues have been worked out thoroughly and knowledgeably, especially in the Indian context, and I sincerely believe the book is a meaningful contribution to the Indian financial market. MANOJ VAISH President & CEO—India Dun & Bradstreet Information Services India Pvt. Ltd.

Preface India today is undergoing the demolition of its rigid structures, cumbersome rules and procedural aspects, and building a higher degree of integration with the rest of the world. This integration, unequivocally, brings in new opportunities by extending trade beyond the geographical boundaries of the nation. At the same time, it presents risks. This risk management demands new set of products and competencies. The economic rationale behind the introduction of derivatives in any economy is risk management and efficient price discovery. Fundamentally, derivatives are risk management products. Worldwide, these markets are reflecting unprecedented growth in volumes. In fact, in many countries, volumes in the derivatives markets are many times the volumes in the underlying cash markets. The exploitation of these products’ value generating capabilities by the market participants requires sound understanding of product nuances and their strategic use. This work will hopefully help readers accomplish that. This book is the product of our interaction with thousands of market participants during our seminars and training programmes. No words are sufficient to thank the many friends and colleagues to whom we owe a great deal of the credit for this work. We would like to extend our sincere thanks to Harsh Nahata and Vikram Sampat, who helped us with a part of the book. We would also like to acknowledge our sincere thanks for

x

Preface

the patient and diligent work done by the editorial team that spent nights editing the material. In conclusion, we invite readers’ suggestions and feedback, if any, as it would offer us an opportunity to enrich this work further. MANISH BANSAL [email protected]

NAVNEET BANSAL [email protected]

Contents Foreword

vii

Preface

ix

PART I: FUTURES 1. Introduction to Derivatives

3

Derivatives in India Generic Derivative Products Summary Questions

5 13 27 30

2. Trading Mechanism of Futures Contracts Maturity of Futures Contracts Contract Size and Contract Multiplier Tick Size Contract Specifications What Makes a Contract Successful Positions in Derivatives Market Open Interest and Volume Convergence of Cash and Futures Prices Settlement of Futures Contracts Initial and Variation Margins Additional Margins Final Settlement of Futures Contracts

33 34 35 43 44 50 52 55 56 57 63 69 70

xii

Contents

Appendix 2.1: Index Concepts Summary Questions

3. Uses of Futures

71 76 79

85

Risk Traded in Index Futures Market Other Risks in Financial Markets Role of Different Players in the Futures Market Risk Management using Futures (Hedging) Important Terms in Hedging Speculation in the Futures Market Arbitrage Opportunities in the Futures Market Summary Questions

4. Futures Pricing

86 87 89 92 99 102 104 112 115

121

Cash and Carry Model for Futures Pricing Cost of Transaction and Non-arbitrage Bound Extension of Cash and Carry Model to Assets, Generating Returns Assumptions in the Cash and Carry Model Convenience Yield Expectancy Model of Futures Pricing Summary Questions

122 124 125 127 129 130 133 135

PART 2: OPTIONS 5. Basics of Options

139

Option Contract

140

Contents

xiii

Terminology used in Options Market Risk and Return Profile of Option Contracts Relationship between Strike Price of an Option and Market Price of the Underlying Asset Option Premium Relationship of Time Value with Time Comparison of Futures and Options Positions Risk Management in the Options Market Introduction of New Option Contracts Settlement of Option Contracts Exercise of Options Assignment of Options Appendix 5.1: Risk Management Using SPAN Summary Questions

145 146 150 152 153 154 155 156 156 164 175 179

6. Synthetic Positions and their Management

184

Synthetic Positions Purpose of Synthetic Positions Creation of Synthetic Positions Summary Questions

141 142

186 187 189 198 200

7. Basics of Options Pricing and Option Greeks

203

Basic Determinants of Options Pricing Binomial Model for Options Pricing Black–Scholes Model for Options Pricing Upper and Lower Bounds of Option Premium Option Greeks—Measuring Price Sensitivity of Options

203 207 212 218 220

xiv

Contents

Option Positions vis-a-vis Underlying Positions Summary Questions

8. Perspectives in Options Trading Perspectives of Futures and Options Traders Choice of Strike Price Analysis of Call Options Analysis of Put Options Summary Questions

9. Option Spreads Vertical Spread Positions Horizontal/Calendar/Time Spreads Diagonal Spreads Vertical Ratio Spreads Summary Questions

10. Other Option Trading Strategies Straddle Strangle Protective Put Buying Protective Call Buying Covered Call Writing Collar Covered Put Writing Reverse Collar Butterfly Spread

224 226 229

235 236 237 238 244 249 250

254 255 274 275 275 285 287

291 291 295 299 300 301 306 309 311 313

xv

Contents

Condor Strip Strap Summary Questions

11. Summary of Trading Strategies on the Basis of Market Outlook Market Outlook

317 321 324 326 329

333 334

PART 3: FINANCIAL INNOVATIONS 12. Introduction to Some Innovative Financial Products Some Innovative Financial Products across the Globe Some Innovative Financial Products in India Summary

13. Understanding Convertibles Global Convertible Market: Salient Features Bond with Warrants Convertible Equity Buy Back of Shares in Kind Exchangeable Broad Dimension of Convertibles Summary

14. Covered Warrants Warrants

341 342 347 351

353 358 361 362 365 366 367 368

370 371

xvi

Contents

Covered Warrants Difference between Covered Warrants and Covered Calls Difference between Call Warrants as Sweeteners and Covered Warrants Put Warrants Summary

15. Fresh Perspective on Existing Financial Products Fixed Deposits and Options Pre-payment Choice and Option Bank Guarantee and Option Underwriting and Option Right Issue and Option Buy Back of Shares and Option Equity and Option Collateralised Loans and Option Restructuring the Collateralised Loan Transaction Summary

16. Interest Rate Products Genesis of Floaters Risk Management of Floating Rate Instruments Some Innovative Structures in the Debt Market Summary

17. Securitisation Process of Securitisation Types of Securitisation

372 376 377 378 379

380 380 381 382 383 384 385 386 387 388 388

391 392 396 407 415

418 420 422

Contents

What can be Securitised? Instruments in Securitisation Benefits of Securitisation Difference Between Collateralised Loans and Securitisation Summary

18. Other Innovative Ideas Real Estate Funds Exchange Traded Funds (ETFs) Foreign Currency Denominated Bonds Foreign Bonds and Euro Bonds Dual Currency Bonds American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) Indian Depository Receipts (IDRs) Options on Futures Contracts Options on Option Contracts Commodity Linked Securities Weather Derivatives Weather Insurance Summary

19. Case Studies Case 1—Unleashing Values from Rights Case 2—Put Warrants Approach to Fixed Price Buy Back/Takeover Offers Case 3—Creative Use of Options in Designing Contracts Case 4—Collateralised Mortgage Obligations

xvii

425 425 426 428 429

431 431 432 434 435 437 438 439 440 441 442 443 444 446

449 449 452 462 465

xviii

Contents

Case 5—Protection of Bondholders through Put Option Case 6—Buy Back of Shares for Other than the Cash Case 7—Buy Back of Shares for Treasury Purpose Case 8—The Barings Episode: Learning for the Market Conclusion

468 475 477 479 485

Glossary

486

Index

507

Authors’ Profiles

513

PART 1

FUTURES

Chapter 1

Introduction to Derivatives Welcome to the fascinating world of Derivatives! Someone said that, “Well begun is half done.” To ensure we begin right, this chapter is designed to lay down the foundations of derivatives in a lucid manner. Examples across various asset classes—securities, commodities, bullion, currency, livestock, etc.—communicate that once the concepts are learnt they can be leveraged upon to create values in any business segment. In other words, the basic characteristics of these contracts do not alter with changes in the underlying asset. This chapter also covers in detail the distinction between exchange-traded and overthe-counter (OTC) derivatives.

The chapter presents a bird’s eye view of growth of the derivatives market in India and its future potential. It then analyses the fundamentals of three generic derivative products—Forward, Futures, and Options. Without getting into the mathematical web, it elaborates concepts in a simple, understandable manner. An in-depth study of this chapter will create a strong foundation for meaningful interpretation of the complex derivative structures and innovations, on which the later chapters focus. The term derivative indicates that the product/contract has no independent value, i.e. it derives its value from some

4

Derivatives and Financial Innovations

underlying asset. These underlying assets can be securities, commodities, bullion, currency, livestock, and so forth. In other words, derivative is a product/contract of predetermined, fixed duration, linked for the purpose of contract fulfilment to the value of a specified asset or an index. Derivative contracts are primarily of two kinds—contracts that are traded on the exchanges and contracts that are traded outside the exchanges. Products/contracts that are traded on the exchanges are called Exchange-traded derivatives. Products/ contracts traded outside the exchanges are called Over-the-counter derivatives. The generic term used for the market outside the exchanges is over-the-counter market. Worldwide, large volume is traded in both exchange-traded and OTC derivative products. India also trades in both exchange-traded and OTC derivative products on different asset classes. Although, commodity derivatives (forward, futures, and options) have been in existence for a long time, derivatives on financial assets like securities, currencies, etc. are a relatively new phenomenon in global markets. The first derivative on financial asset was traded on currencies (currency futures) in the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME), U.S., in 1972. Since then, the growth of derivatives on financial assets has been unprecedented. Beginning with currency futures in 1972, stock options in 1973 at Chicago Board Options Exchange (CBOE), U.S., and interest rate futures in 1975, the derivatives market has come a long way. Swaps, which started in 1981–82, accounts today for a trillion dollar business opportunity at the international level.

Introduction to Derivatives

5

Derivatives in India At present, the Indian market trades in both exchange-traded and over-the-counter derivatives on various asset classes including securities—both equity and debt—commodities, currencies, etc. The evolution of the derivatives market in the said asset classes, is as follows.

Equity Derivatives India joined the league of exchange-traded equity derivatives in June 2000, when futures contracts were introduced at its two major exchanges, viz. the Stock Exchange, Mumbai (BSE) and National Stock Exchange (NSE). The BSE sensitive index, popularly known as the SENSEX (comprising 30 scrips), and S&P CNX Nifty index (comprising 50 scrips), commenced trade in futures on June 9, 2000 and June 12, 2000 respectively. Index options and individual stock options on 31 selected stocks were subsequently added to the derivatives basket, in 2001. November 2001 witnessed the introduction of single stock futures in the Indian market. This list of stocks was selected, based on a predefined eligibility criterion linked to the market capitalisation of stocks, floating stock, liquidity, etc. As on July 26, 2006, the NSE’s Futures and Options Segment (F&O Segment) trades futures and options on 118 stocks and the Derivatives Segment of BSE, trades in 77 stocks. This differentiation in the number of stocks at the BSE and the NSE is because the eligibility criterion for a stock to figure in the derivatives list is linked to various measures at the respective exchanges. It is important to note that most of the derivatives business is concentrated in

6

Derivatives and Financial Innovations

the NSE, which accounts for almost 100 per cent of the equity derivatives business. The growth of the equity derivatives business on Indian bourses has been an unprecedented one. A modest start of an average daily volume of Rs 10 crores has developed into a business opportunity of Rs 30,000 crores per day. Figure 1.1 depicts the growth of the market since its initial years. Interestingly, over a period of time, there has also been a shift in the market share of various competing products (index futures, index options, single stock futures, and single stock options) available for trading. Today, the most preferred product on the exchanges is single stock futures, which accounts for around 55 per cent of total volumes. Nifty futures are the second most traded product, with a business share of around 35 per cent. Options account for approximately 10 per cent of the total business with almost 2/3rd in index options and 1/3rd in single stock options. The dynamics of the equity derivatives business in the country are reflected in Fig. 1.2. There seems to be a lack of clarity among market participants about OTC products on equity. Some market participants hold that OTC equity derivatives are illegal. Others believe that they are not illegal but that they are not legally enforceable in the country as per the existing regulatory infrastructure. Due to this lack of clarity, OTC equity derivatives do not exist in the market today. At the time of writing this book, some market participants are in the process of seeking legal opinion as to whether OTC equity derivatives can be offered in the Indian jurisdiction and if so, how can it be done.

200,000

400,000

600,000

800,000

1,000,000

Dec-03

Oct-03

Aug-03

Jun-03

Feb-03 Apr-03

Total no. of contracts

Aug-05

Oct-05

Jun-05

Feb-05

Apr-05

Aug-04

Oct-04

Jun-04

Average daily turnover (Rs cr)

Dec-04

Feb-04 Apr-04

Dec-02

Aug-02 Oct-02

Jun-02

Apr-02

Fig. 1.1: Equity derivatives growth on NSE—Source: Bloomberg

No. of contracts traded (Daily average)

1,200,000

Equity Derivatives growth on NSE (April 2002–July 2006)

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

Introduction to Derivatives 7

Average daily turnover (Rs cr) Jun-06

Feb-06

Apr-06

Dec-05

8

Derivatives and Financial Innovations

Break-up of NSE Derivatives Volumes (April 2002–Jun 2006) 100% 90% 80% 70% 60% 50% 40% 30% 20%

Index Fut

Stock Fut

Index Options

Apr–Jun ’06

Jan–Mar ’06

Oct–Dec ’05

Jul–Sep ’05

Apr–Jun ’05

Jan–Mar ’05

Oct–Dec ’04

Jul–Sep ’04

Apr–Jun ’04

Jan–Mar ’04

Oct–Dec ’03

Jul–Sep ’03

Apr–Jun ’03

Jan–Mar ’03

Oct–Dec ’02

Jul–Sep ’02

0%

Apr–Jun ’02

10%

Stock Options

Fig. 1.2: Break-up of NSE Derivatives volume product wise—Source: Bloomberg

Commodity Derivatives The Forward Contract Regulation Act (FCRA) governs commodity derivatives in the country. The FCRA specifically prohibits OTC commodity derivatives. Accordingly, at this point in time, we have only exchange-traded commodity derivatives. Furthermore, FCRA does not even allow options on commodities. Therefore, at present, India trades only exchangetraded commodity futures. Though commodity derivatives in the country have existed for a long time, trading has been regionally concentrated due to

9

Introduction to Derivatives

the regional nature of the commodity exchanges. Further, all these exchanges offered only a single product. For example, pepper exchange in Cochin trades only pepper, Soya exchange in Indore trades only soya. Recently however, India began trading in commodity derivatives through two nation-wide, online commodity exchanges—the National Commodities and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange (MCX). They started functioning in the last quarter of 2003 with the introduction of futures contracts on various assets such as gold, silver, rubber, steel, mustard seed, etc. Major banks and financial institutions in the country (SBI, ICICI, Canara Bank, NABARD, NSE, LIC, etc.) have promoted both these exchanges. Business on these exchanges has increased remarkably over the short period of time. Volume growth at NCDEX and MCX are shown in Figures 1.3 and 1.4 respectively. NCDEX Monthly Volumes (Rs cr) 160000

Monthly Volume (Rs cr)

140000 120000 100000 80000 60000 40000

0

Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06

20000

Fig. 1.3: Volume growth on NCDEX—Source: NCDEX website

10

Derivatives and Financial Innovations

Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06

Monthly Volume (Rs cr)

MCX Monthly Volumes (Rs cr) 220000 200000 180000 160000 140000 120000 100000 80000 60000 40000 20000 0

Fig. 1.4: Volume growth on MCX—Source: MCX website

It is important to mention here that both exchanges are developing a niche for themselves. For instance, bullion and energy products contribute around 75–80 per cent of MCX business. On the other hand, the primary source of business for the NCDEX is agri-products, which contribute around 80 per cent of the total volume of this exchange. Figures 1.5 and 1.6 provide an overview of the major products traded on both the exchanges. It is interesting to note that the growth in volume of commodity derivatives has been achieved without institutional participation in the market. At present, banks, financial institutions, mutual funds, pension funds, insurance companies and FIIs are not allowed to participate in the commodities market. However, the subject is under consideration by the respective regulators. Furthermore, both exchanges are now focusing their attention on addressing issues like collateral management, warehouse accreditation, quality and quantity certification of

11

Introduction to Derivatives

commodities, settlement price, methodology, etc. Substantial progress has been made on these issues by the exchanges. For example, warehousing receipts have been made electronic with the help of depositories—National Securities Depository Ltd (NSDL) and Central Depository Services Ltd (CDSL). Break-up of NCDEX Derivatives Volumes Silver 3%

Soyoil-refined 2%

Pepper 5%

Others 14%

Chana 22%

Chilli 2% Guar Gum 2%

Jeera 3%

Gold 7%

Guar Seeds 40%

Fig.1.5: Break-up of NCDEX Derivatives Volume—Source: NCDEX website

The commodity exchanges are also concentrating on the introduction of: l

l l

l

l

Options on various agricultural, energy, metal and bullion products, whenever this is permitted by the government Futures and options on various commodity indices Introduction of exchange-traded funds (ETFs) linked to commodities Carbon credit derivatives (in association with Chicago Climate Exchange) Weather derivatives

12

Derivatives and Financial Innovations

Break-up of MCX Derivatives Volume Copper 11%

Crude Oil 2%

Natural Gas 2%

Others 2%

Refind Soya Oil 1% Zinc 1%

Silver 21%

Gold 60%

Fig.1.6: Break-up of MCX Derivatives Volume—Source: MCX website

Currency Derivatives India has been trading forward contracts in currency, for the last several years. Recently, the central bank viz. the Reserve Bank of India (RBI) has also allowed options in the over-thecounter market. The OTC currency market in the country is considerably large and well-developed. However, the business is concentrated with a limited number of market participants, mainly banks—both international and local as the corporates deal with these banks for derivative contracts on various currencies. Some market participants are making a case for trading currency derivatives (futures and options) on the exchanges. Generally speaking, business in currency derivatives is expected to grow in the near future.

Introduction to Derivatives

13

Interest Rate Derivatives There has also been significant progress in interest rate derivatives in the Indian over-the-counter market. The National Stock Exchange (NSE) introduced trading in cash settled interest rate futures in the year 2003. However, due to some structural issues the product did not attract market participants. A new version of the product, designed in consultation with market participants, is likely to be launched soon.

Other Derivatives Indian market participants have also shown some interest in credit and weather derivatives. Slowly but surely, these products too are making strides in the Indian financial markets. Securitisation and exchange-traded funds (ETFs) linked to currencies and bullion are being widely discussed. To summarise, the derivatives market—both OTC and exchange-traded, is continuously expanding in India on various asset classes and this phenomenon is expected to continue in the future.

Generic Derivative Products The emergence of a market for derivative products can be traced to the requirement of risk-averse economic agents, to guard themselves against uncertainties arising out of fluctuations in asset prices. It is possible to create certainty by partially or fully transferring the price risk in assets from one entity to another, through the use of derivative products. As instruments of risk management, derivative products minimise the impact of

14

Derivatives and Financial Innovations

fluctuations in asset prices on the profitability and cash flow situations of risk-averse market participants. The following factors have driven the growth of financial derivatives in India: 1. Increased volatility in asset prices in the financial markets 2. Increased integration of domestic financial markets with global markets 3. Development of more sophisticated risk management tools, which provide economic agents with a wider choice of risk management strategies 4. Innovations in the derivatives markets which optimally combine the risks and returns over a large number of financial assets. This leads to higher returns and reduced risk, as well as low transaction costs when compared to individual financial assets. 5. A marked improvement in communication facilities with a sharp decline in cost Today, international markets trade innumerable derivative products on all kinds of underlying assets, both tangible and intangible. Without getting into the complexities of derivatives at this level, it is important to understand the following three generic derivative products/contracts in detail: 1. Forward contract 2. Futures contract 3. Option contract It is necessary here, to state that an in-depth understanding of these concepts will create a strong foundation for a meaningful interpretation of complex derivative structures and innovations. The later part of the book focuses on this. Forward, futures and

Introduction to Derivatives

15

option contracts must be understood as concepts, without limiting their thinking to a specific asset. Once the concepts are understood clearly, they may be applied to any asset class. In other words, characteristics of these contracts do not alter with change in the underlying asset.

Forward Contract A Forward contract is a one-to-one, bipartite/tripartite contract, which is to be performed mutually by the contracting parties, in future, at the terms decided upon, on the contract date. In other words, a forward contract is an agreement to buy or sell an asset on a specified future date for a specified price. One of the parties to the contract assumes a long position, i.e. agrees to buy the underlying asset while the other assumes a short position, i.e. agrees to sell the asset. As this contract is traded off the exchange and settled mutually by the contracting parties, it is called an over-the-counter product. As mentioned before, overthe-counter (OTC) is a generic term used for a product/market, which is off the exchange. This concept can be better understood with the help of an illustration. Assume that there are two parties—Mr A (buyer) and Mr B (seller)—who enter into a contract to buy and sell 100 units of asset X at Rs 350 per unit, at a predetermined time of two months from the date of contract. In this case, the product (asset X), the quantity (100 units), the product price (Rs 350 per unit) and the time of delivery (2 months from the date of contract) have been determined and well understood, in advance, by both the contracting parties. Delivery and payment (settlement of transaction) will take place as per the terms of the contract on the designated date and place. This is a simple example of a forward contract.

16

Derivatives and Financial Innovations

Forward contracts are extensively used in India in the foreign exchange market. Forward contracts are negotiated by the contracting parties on a one-to-one basis and hence offer tremendous flexibility in terms of determining contract terms such as price, quantity, quality (in case of commodities), delivery time and place. The parties may freely decide upon all these terms, based on their circumstances and negotiation powers. They may also carry out subsequent alterations in the contract terms, by mutual consent. Like other over-the-counter products, forward contracts offer tremendous flexibility to the contracting parties. However, as they are customised, they suffer from poor liquidity. Furthermore, as these contracts are mutually settled and generally not guaranteed by any third party, the counter party risk/default risk/credit risk is considerable in such contracts. These features of forward contracts need to be understood in detail.

Liquidity Risk Liquidity is generally defined as the ability of a market participant to buy or sell the desired quantity of an asset, at any time. As forward contracts are traded on a one-to-one basis, they are tailormade contracts and cater to the specific needs of the contracting parties. Therefore, others may not be interested in these contracts. Further, as these contracts are not listed and traded on the exchanges, other market participants do not have easy access to either the contracts or to the contracting parties. Their tailormade feature and non-availability on the exchanges, which make them inaccessible to a large set of market participants, create illiquidity in the contracts. In other words, it is very difficult for the contracting parties to withdraw from a forward contract before the contract matures. Hence, the liquidity in these contracts is poor.

Introduction to Derivatives

17

Interestingly, in order to address the issue of poor illiquidity of forward contracts, contracting parties have started listing forward contacts on the exchanges in some international markets. This display of products on the exchanges creates visibility and accessibility of products to other market participants. Thus, an interested party may trade the product with the contracting parties.

Default Risk/Credit Risk/Counter Party Risk Forward contracts, as defined, are transacted on a one-to-one basis. Each party is, therefore, exposed to the counter party’s credit risk, i.e. the risk of default. It may be appreciated that in the case of a movement in the price of the asset, either of the parties is exposed to the risk and this may result in default by the affected party. For instance, if the price of the asset goes up during the life of the forward contract, the seller may default as he will benefit by selling his asset in the market at the prevailing price, which is higher than the contracted forward price. On the other hand, if the asset price goes down, the buyer may default, as he will benefit by purchasing the asset in the cash market at a price lower than the contracted forward price. To illustrate the risk of default, let us refer to the example given earlier, where Mr A and Mr B enter into a contract to buy and sell 100 units of asset X @ Rs 350 per unit after two months from the date of contract. If the price of asset X goes up substantially after two months, Mr B (the seller) may prefer to sell his asset in the market rather than sell it to Mr A as contracted, because the cash market would fetch him a better price. Therefore, he may default on his obligation to the contract, i.e. not deliver the asset. Similarly, in the event that the price of asset X goes down, Mr A (the buyer) may choose to default as he

18

Derivatives and Financial Innovations

will find it more attractive to buy the asset from the market at a lower price, rather than honour the contract. This way, both Mr A and Mr B are exposed to the risk of default by each other. The important point to understand regarding default is that the contracting parties are likely to default only when there is an incentive to do so. As defined in the example, neither Mr A nor Mr B will default unless they stand to benefit by dishonouring the contract. Market participants across the globe are trying to address this issue of counter party risk in forward contracts. One option chosen by market participants is the third party guarantee to these contracts. For instance, having entered into a forward contract, the contracting parties may go to a third party who will immunise their positions, through a guarantee. This third party—essentially a risk taker (such as a clearing corporation)— may collect some margin from both the parties and immunise them against the risk of default by each other. Indeed, this is being done in India as well. For instance, Clearing Corporation of India Ltd (CCIL) is guaranteeing the settlement of OTC traded government securities contracts.

Futures Contract In view of the preceding points, one may say that although forward contracts provide a great deal of flexibility to the contracting parties, they suffer from two important problems— illiquidity and counter party risk. These two issues concerning forward contracts have offered the exchanges a tremendous business opportunity and they have started trading these forward contracts; but with a difference. In order to make the contracts attractive to a large set of market participants, they have

Introduction to Derivatives

19

standardised these contracts. To further generate liquidity in these contracts by engendering confidence among market participants, exchanges have persuaded their clearing corporations to guarantee these trades. Trading of forward contracts on the exchanges was considered a means for addressing the issues in the forward contracts. Further, in order to differentiate between the exchange-traded forward and the OTC forward, the market renamed the exchange-traded forwards as Futures contract. Hence, futures contracts are essentially standardised forward contracts, which are traded on the exchanges and settled through the clearing agency of the exchanges. The clearing agency also guarantees the settlement of these trades. In other words, futures contracts are standardised forward contracts or the futures market is simply an extension of the forward market. As futures contracts are organised/standardised, they cater to a wide range of market participants. Furthermore, their availability on the exchanges makes them accessible to market participants scattered throughout the country and perhaps, the world. Therefore, the liquidity problem, which persists in the forward market, does not exist in the futures market. The clearing agency of the exchange becomes the counter party to all the trades or provides the unconditional guarantee for their settlement, i.e. assumes the financial integrity of the entire system. Hence, the market participants are not exposed to counter party risk. This point can be elaborated on by going back to the earlier example where Mr A and Mr B enter into a forward contract to buy and sell asset X. It is now assumed that this contract is entered into through the exchange, traded on the exchange and the settlement is guaranteed by a clearing agency. It would then be

20

Derivatives and Financial Innovations

called a futures contract. Today, India trades futures on various underlying assets including commodities and securities—both equity and debt (interest rates). These contracts are discussed in subsequent chapters.

Differences between Forward and Futures Contracts 1. The contracting parties negotiate forward contracts, on a one-to-one basis. This offers tremendous flexibility in articulating the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place. Futures contracts do not have this flexibility as such contracts have standard terms, viz. quantity, quality (in case of commodities), delivery time and place, which are decided by the exchanges. 2. In the forward market, one party may be at an absolute disadvantage due to non-availability of information regarding the underlying factors. A typical example of this may be the exploitation of poor farmers in remote areas. One of the most important reasons, why poor farmers are continuously poor, is that they do not have current information on their commodities. Farmers generally sell their produce in advance to the zamindar. They thus, enter into a forward contract, at a price that is substantially lower than the expected cash price of the produce at the time of its availability in the market. In the futures market, geographically segmented areas are integrated, as futures provide a common platform to all market participants. It consolidates all orders through a common order book and reflects a better price, as price is the result of interaction of the collective

21

Introduction to Derivatives

wisdom of a large number of market participants. Therefore, in the case of futures, every bit of price relevant information is quickly reflected on the prices of assets. This results in elimination of the nonavailability of information risk, which exists in the forward market. 3. Another problem in forward contracts is that of the final settlement, which becomes quite cumbersome if forward contracts are traded subsequently. To understand the concept, let us go back to the earlier example. Assume, that after 15 days, Mr A enters into a fresh transaction to sell asset X to Mr C on the same delivery date. Mr B is a stranger to the transaction between Mr A and Mr C. On settlement, Mr A will take delivery of asset X from Mr B and give it to Mr C and then take the money from Mr C to pay Mr B. Similarly, Mr B may enter into a contract with another party, Mr D, which will be unknown to Mr A. Now, assume a situation when there are 4–5 subsequent deals during the life of the contract. Each of these subsequent deals will complicate the final settlement of the trade.

A

C

B

D Money Asset X

Fig. 1.7: Settlement of forward contract with 1 original and 2 subsequent transactions

22

Derivatives and Financial Innovations

In the futures markets, the clearing agency maintains the accounts of all participants on the exchange. Hence, on the last trading day of the contract, it is in a position to declare which of the two entities are the counter parties to each other. It thus provides the solution to the settlement problem, which is very acute in the case of the forward market. Indeed, at any point in time, the clearing agency is in a position to indicate which participants in the market have open positions, i.e. outstanding/ unsettled long (buy) or short (sell) positions. Operational risks generated through human error, fraud, systems failure, etc. exist in both the forward and futures markets. These cannot be addressed in any way other than by training, competence building, proper monitoring and insurance. Based on the preceding, we may summarise the finer points of differentiation between forward and futures contracts as follows: Feature

Forward contracts

Futures contracts

Operational mechanism

Traded directly between contracting parties (not traded on the exchanges)

Traded on the exchanges

Contract specifications

Differ from trade to trade

Contracts are standardised contracts

Counter party risk

Exists. But, sometimes jettisoned to a guarantor

Exists. But, assumed by the clearing agency, which becomes the counter party to all trades or unconditionally guarantees their settlement

Liquidation profile

Low, as contracts are tailor-made contracts catering to the needs of the parties involved

High, as contracts are standardised exchange-traded contracts

Contd

23

Introduction to Derivatives

Box Contd Feature

Forward contracts

Futures contracts

Further, they are not easily accessible to other market participants Price discovery

Not efficient, as markets are scattered

Efficient, as markets are centralised and all buyers and sellers come to a common platform to discover the price through a common order book

Quality of information and its dissemination

Quality of information may be poor. Speed of information dissemination is weak

As futures are traded on a nation-wide basis, every bit of decision-related information gets disseminated very fast

Examples

Currency market in India

Commodities futures, index futures and individual stock futures in India

Option Contracts In both forward and futures contracts, the contracting parties undertake an obligation to perform in accordance with the contract. Thus, for the buyer of the contract, profit is generated if the price of the underlying asset goes up. On the other hand, for the seller of the contract, the profit proposition requires a fall in the price of the underlying asset. However, unfavourable movements in the price of the underlying asset will create losses for the contracting parties. Now, consider another situation. Assume that Mr X needs to honour an obligation of a million U.S. dollars after three months from a given date. There are a number of ways in which he can deal with this obligation. His first choice may be to do nothing at present and buy the dollars after three months, at the time when payment is due. The second option may be to

24

Derivatives and Financial Innovations

buy the dollars right away and keep them in safe custody. Thirdly, he can buy the dollars in the forward or futures market for delivery in 3 months. If he buys 1 million dollars at Rs 47 per dollar (prevailing forward market prices) in the forward market for 3 months, he is obviously locked in to buy the dollars at the contracted price. At the time of maturity of the contract, if the dollar trades at a price higher than Rs 47, he will gain as he will pay the contracted price of Rs 47 per dollar. However, if the price of the dollar, after 3 months is less than Rs 47, Mr X will have lost the opportunity to buy the dollars at a lower price. The transaction here is simple and is not complicated with issues like transaction cost, marking to market, etc. This situation leads to another thought. Is it possible to design a contract, which offers Mr X an opportunity to buy the underlying asset only if he desires, with no compulsion whatsoever? This essentially means that the contract needs to confer a right on Mr X to buy the asset (US$ in the instant example) with no obligation, to ensure that he is free to decide on buying the underlying asset. A similar concept may be thought of on the sell side, wherein the seller may just need a right, rather than an obligation to sell the underlying asset. As a whole, this contract must offer the position takers an opportunity to exercise the right (buy or sell the underlying asset) only if it is favourable to them, or else, they may let the right expire. These contracts are called Options. As in any other contract, the market also needs the sellers of these rights. One may then ask the question, “Why should someone sell these rights?” The answer to the question is that this is done “in pursuit of money.” Fundamentally, the seller of these rights has an obligation under the contract and so will want compensation in monetary terms, from the buyer of the

Introduction to Derivatives

25

rights. As long as there is a counter party who is prepared to pay the seller of the rights/options, there will be a market for options. Thus, one can say that an option is a right given by the option writer/seller to the option buyer/holder to buy or sell an underlying asset at a predetermined price, within or at the end of a specified period. The option buyer, who is also called long on option, long premium or holder of the option, has the right but no obligation. On the other hand, the option seller/writer, who is also called the short on option or short on premium, has an obligation but no right, with regard to buying or selling of the underlying asset. The option buyer may or may not exercise the option given. However if he decides to exercise the option, the option seller/writer is bound to honour the contract. Options can be categorised as Call and Put options. An option, which gives the buyer a right to buy the underlying asset, is called a Call option and an option, which gives the buyer a right to sell the underlying asset, is called a Put option. Further, an option, which is exercisable any time on or before the expiry date/day, is called an American option and an option, which is exercisable only on its expiry, is called an European option. The price at which the option is exercisable is called the Strike price or Exercise price. The date/day on which the option expires is called the Expiration date/day. The expiration date/ day is the date/day on which the contract ceases to exist. The date/day on which the option is exercised is called the Exercise date/day of option. It may be noted that the expiration date/day and the exercise date/day may differ in case of an American option but will be the same in case of an European option, in the event that the option is exercised at all, by the option buyer. When an option writer gives a right to the option buyer, he will charge for that right. The price that the option buyer pays

26

Derivatives and Financial Innovations

to the option seller for this option/right is called the Option premium. The option premium is the inflow to the option writer irrespective of whether the option holder exercises his option or not. The options terminology is better understood with the help of a simple example. Assume that Mr A goes shopping and likes a painting that costs Rs 15,000. As he does not have the money required to make the full down payment, he offers the shopkeeper Rs 2,000, with a proposal to take delivery within 2 days, on payment of the balance amount. Further, assume that the shopkeeper makes it clear that if the painting was not bought within 2 days, the contract would expire. This is a typical example of a forward contract. As the shopkeeper is not confident about the counter party, he takes some money in advance and this is treated as collateral or a good faith deposit. It is also clear that if Mr A does not return in 2 days, the shopkeeper will have the right to sell the painting to someone else but would refund the advance payment made by Mr A. Another way to structure the deal is for Mr A to offer the shopkeeper Rs 200 and reserve the painting for two days. If Mr A wishes, he may pay the full price and purchase the painting during these two days. Otherwise, he will lose the right to buy it. In this case, Mr A is the option buyer and the shopkeeper is the option seller. As an option buyer, Mr A has a right to buy the painting but no obligation. If he finds another shop selling the same painting at a price lower than Rs 15,000, he has the option to ignore the first shop and buy the painting from the second shop. In other words, Mr A may let his right expire if he finds it unattractive to exercise his option. It must be understood however, that even if Mr A does not exercise his right, the Rs 200, which he paid as the price for reserving the painting for 2 days will not be refunded. This money, viz. Rs 200 may be called the

Introduction to Derivatives

27

cost of the right or price of option. In option terminology, this price is known as the Option premium. It is worth noting that no difference in nomenclature exists for options in the OTC market and the exchange-traded market, as it does for forward and futures (forward contract is an OTC product but futures is an exchange-traded product). Options are traded both on exchanges and in the OTC market and market participants simply call them exchange-traded options and OTC options. The second part of this book deals with options in detail. This may be referred to for an in-depth understanding of options and options markets.

Summary 1. The term Derivative indicates that the product/contract has no independent value, i.e. it derives its value from some underlying asset. This may be securities, commodities, bullion, currency, livestock, and so forth. 2. Products/contracts that are traded on the exchanges are called exchange-traded derivatives. Products/contracts traded outside the exchanges are called over-the-counter products/contracts. The generic term used for the market outside the exchanges is OTC market. 3. Although, commodity derivatives (forward, futures and options) have been in existence for long, derivatives on financial assets such as securities, currencies, etc. is a relatively new phenomenon in global markets.

28

Derivatives and Financial Innovations

4. In June 2000, India’s two major stock exchanges—the BSE and the NSE introduced futures contracts on BSE SENSEX (comprising 30 scrips) and S&P CNX Nifty index (comprising 50 scrips) respectively. India added index options and individual stock options to the derivatives basket, in 2001. November 2001 witnessed the introduction of single stock futures in the Indian market. The growth in the equity derivatives business on Indian bourses has been an unprecedented one. 5. India started trading commodity derivatives through two major nation-wide commodity exchanges—National Commodities and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX) on various assets such as gold, silver, rubber, steel, mustard seed, etc. in the last quarter of 2003. Business on these exchanges has shown remarkable growth over a short period of time. On July 2006, the combined average daily volume on these two exchanges was around INR 15,000 crores. 6. There are only three generic derivative products/ contracts—forward, futures and option contracts. 7. A forward contract is a one-to-one bipartite/tripartite contract, which is to be performed mutually by the contracting parties, in the future, at the terms decided on the contract date. In other words, a forward contract is an agreement to buy or sell an asset on a specified future date for a specified price. One of the parties to the contract assumes a long position, i.e. agrees to buy the underlying asset and the other party assumes a short position, i.e. agrees to sell the asset. A forward contract is an OTC product.

Introduction to Derivatives

29

8. Forward contracts, despite having a great deal of flexibility in terms of structuring the contract to customised needs of individual players, suffer from two main risks— illiquidity (lack of sufficient volumes for trading) and counter party or credit/default risk. 9. Futures came into existence in order to address the issues of illiquidity and counter party risk in forward contracts. Basically, futures contracts are standardised forward contracts traded on the exchanges and settled through a clearing agency of the exchanges. The clearing agency also guarantees the settlement of these trades. 10. In both forward and futures contracts, the contracting parties undertake an obligation to perform the contract. So, for the buyer of the contract, profit is generated if the price of the underlying asset goes up and for the seller of the contract, the profit proposition requires a fall in the price of the underlying asset. However, unfavourable movements in the price of the underlying asset will create losses for the contracting parties. 11. An option is a right given by the option writer/seller to the option buyer/holder to buy or sell an underlying asset at a predetermined price within or at the end of a specified period. Therefore, an option is a contract that offers the buyers an opportunity to exercise the right (buy or sell the underlying) only if it is favourable to them. Otherwise, they may let the right expire. 12. Options can be categorised as call and put options. An option, which gives the buyer a right to buy the underlying asset, is called a call option and an option, which gives the buyer a right to sell the underlying asset, is called a

30

Derivatives and Financial Innovations

put option. Further, an option, which is exercisable at any time on or before the expiry date/day, is called an American option and the option, which is exercisable only on its expiry, is called an European option. 13. The price at which the option is exercisable is called the strike price or exercise price. The date/day on which the option expires is called the expiration date/day. The date/ day on which the option is exercised is called the exercise date/day of the option.

Questions 1. What is a Derivative? (a) A product, which derives its value from some underlying asset. (b) Essentially traded on the exchanges. (c) A contract to be performed sometime in the future at the terms decided today. (d) Both (a) and (c). (e) All three—(a), (b) and (c). 2. Which of the following is/are true about forward contracts? (a) Forward contracts are tailor-made contracts. (b) Default risk does not exist in a forward contract. (c) Liquidity profile of these contracts is high. (d) Both (a) and (b).

Introduction to Derivatives

31

(e) Both (b) and (c). 3. Which of the following important problems of forward contracts do futures address? (a) The liquidity problem. (b) Credit risk. (c) The settlement problem. (d) Both (a) and (c). (e) All—(a), (b) and (c). 4. Which of the following can default risk also be defined as? (a) Credit risk. (b) Counter party risk. (c) Liquidity risk. (d) Both (a) and (b). (e) All—(a), (b) and (c). 5. Which of the following is/are true about the futures contracts? (a) Futures contracts are standardised contracts. (b) Default risk is assumed by clearing corporation/house. (c) Price discovery in the contracts is efficient. (d) Both (a) and (b). (e) All—(a), (b) and (c). 6. What does long futures position mean? (a) A right, but not the obligation to purchase the underlying asset.

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Derivatives and Financial Innovations

(b) An obligation to purchase the underlying asset. (c) It is the same as buying a forward contract. (d) It is the same as selling an option. 7. Which of the following is true if the price of the underlying asset rises sharply after the initiation of a futures contract? (a) The value of a long position in the futures contract becomes positive. (b) The value of a long position in the futures contract becomes negative. (c) The value of a short position in the futures contract becomes positive. (d) The value of a short position in the futures contract becomes negative. (e) Both (a) and (d). Answers to the Questions 1. (d)

2. (a)

3. (e)

4. (d)

5. (e)

6. (b)

7. (e)

Chapter 2

Trading Mechanism of Futures Contracts This chapter deals with the nuances of the futures market, which include the trading mechanism and terminologies involved in futures contracts. Practical illustrations explain each term that may be encountered in the market place. The chapter highlights the important idea of the convergence of futures and spot prices when the futures contract matures. Details related to the settlement of futures contracts, margin requirements, marking to market process, etc. are dealt with in a very simple and lucid manner. The chapter ends with an appendix on index concepts, which elucidates the processes of index construction, maintenance and revision.

Futures contract, as defined in the previous chapter is a legally enforceable, exchange-traded, standardised contract that represents an agreement to buy or sell a specific quantity of asset at a predetermined price and delivery date. Currently, India trades in index futures, single stock futures, interest rate futures and commodity futures. Since interest rate futures are a virtual non-starter with no trade, this chapter focuses primarily on securities futures and commodity futures.

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Derivatives and Financial Innovations

Index futures are the futures contracts where the underlying asset is a cash market index. For instance, The Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE), trade futures contracts on the BSE sensitive index (comprising 30 scrips) and the S&P CNX Nifty index (comprising 50 scrips) respectively. The NSE also trades sectoral indices such as the IT Index and Banking Index. Similarly, Single stock futures are futures contracts with individual stocks as the underlying asset. As on July 26, 2006, stock futures are available only on 118 stocks on the NSE and 77 stocks on the BSE. In keeping with global practice, Interest rate futures are traded on the NSE with a notional/imaginary bond (both coupon and discount) as the underlying asset. Commodity futures are available on a large number of commodities including gold, silver, rubber, edible oils, steel, etc. on the National Commodities and Derivatives Exchange Ltd (NCDEX) and Multi Commodity Exchange (MCX). Though these futures contracts may differ in their product design depending on the underlying asset, primary characteristics of these contracts remains the same. The basic features of futures contracts are dealt with in this chapter.

Maturity of Futures Contracts The Exchanges trade simultaneously in futures with different maturities. For instance, the NSE trades three contracts with one, two and three month maturity for all Index and Equity derivatives. The commodity exchanges, i.e. the NCDEX and the MCX also run different maturity cycles for different underlying assets. Each of these contracts has a unique code for the purpose of representation on the system.

Trading Mechanism of Futures Contracts

35

The month in which a particular contract expires is called the Contract month. For example, a contract expiring in January 200X will be termed as a January 200X contract. It may be noted that a futures contract is identified by its contract month only. Exchanges specify the maturity of derivative products based on the maximum maturity stipulated by regulators, if any. For example, in the securities market, the Securities and Exchange Board of India (SEBI) has stipulated one year as the maximum maturity of futures contracts. All these contracts expire on a specific day/date of the month. For instance, both the BSE and NSE trade futures contracts, which expire on the last Thursday of the month (if the last Thursday is a holiday, contracts expire on the previous business day). In the commodities market, the expiry day/date of contracts is different on both the major exchanges. On the NCDEX, majority of futures contracts expire on the 20th of each month and on the MCX, majority of contracts expire on the 15th of the month. As soon as the “near month” contract expires on the exchange, a new “far contract” begins on the next business day. Therefore, at every point of time, market participants have the choice of a couple of contracts, which trade simultaneously on the exchanges.

Contract Size and Contract Multiplier Index futures contracts are traded in terms of index points. Consider for instance, a January 200X Nifty contract (a contract maturing in Jan. 200X) trading at an index level of 3000. The

36

Derivatives and Financial Innovations

value of the contract (contract size), can be determined by multiplying this index by a number called the Contract multiplier. The contract multiplier is standardised for an index futures contract and is defined by the exchanges in the contract specification, before trading in the contract begins. For instance, the NSE has selected Rs 100 as the contract multiplier for its Nifty index futures contract. Thus the contract size at the index level of 3000 would be Rs 300,000, i.e. index level of 3000 multiplied by the contract multiplier of Rs 100. In the case of index futures contracts therefore, the contract multiplier may be viewed as the price per index point. Different indices may have different contract multipliers. For instance, while the contract multiplier for Nifty index futures contracts is Rs 100, the BSE trades in Sensex with a contract multiplier of Rs 50. Furthermore, an index may trade with different multipliers, i.e. two contracts on the same index may appear on the exchange with different contract sizes (a change in the multiplier, results in different contract sizes at the same index level). Single stock futures trade in terms of price and the multiplier is determined based on the number of underlying shares. For instance, Reliance has a multiplier of 600 shares and Infosys has a multiplier of 200 shares. Thus, if the Infosys future is trading at Rs 1650, the value of the contract will be Rs 330,000 (1650 * 200). Similarly, Reliance futures trading at Rs 1000 will have a contract value of Rs 600,000 (1000 * 600). A comprehensive list of all the individual stocks with contract multipliers is as follows.

Trading Mechanism of Futures Contracts

37

Table 2.1: Contract multipliers of Indices and Single stocks Underlying security

NSE lot size

BSE lot size

Index Derivatives S&P CNX Nifty

100

N.A.

CNX IT

100

N.A.

BANK Nifty

100

N.A.

BSE SENSEX

N.A.

50

BSE TECK

N.A.

125

BSE BANKEX

N.A.

50

BSE Oil & Gas

N.A.

75

BSE PSU

N.A.

50

BSE Metal

N.A.

50

BSE FMCG

N.A.

175

ABB Ltd

200

N.A.

Associated Cement Co. Ltd

750

750

Allahabad Bank

2450

2450

Alok Industries Ltd

3350

3350

Andhra Bank

2300

2300

Arvind Mills Ltd

2150

2150

Ashok Leyland Ltd

9550

9550

Aurobindo Pharma Ltd

700

N.A.

Bajaj Auto Ltd

200

200

Bank of Baroda

1400

1400

Bank of India

1900

1900

550

N.A.

Bharat Forge Co Ltd

1000

N.A.

Bharti Tele-Ventures Ltd

1000

1000

Derivatives on Individual Securities

Bharat Electronics Ltd

Bharat Heavy Electricals Ltd

300

300 Contd

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Derivatives and Financial Innovations

Table 2.1 Contd Underlying security

NSE lot size

BSE lot size

Ballarpur Industries Ltd

1900

N.A.

Bongaigaon Refinery Ltd

2250

2250

550

550

1600

1600

850

850

CESC Ltd

1100

N.A.

Chambal Fertilizers Ltd

6900

N.A.

950

N.A.

Cipla Ltd

2500

2500

Kochi Refineries Ltd

1300

N.A.

Colgate Palmolive (I) Ltd

1050

N.A.

600

N.A.

Cummins India Ltd

1900

N.A.

Dabur India Ltd

3600

N.A.

Divi’s Laboratories Ltd

250

N.A.

Dr Reddy’s Laboratories Ltd

400

400

Escorts India Ltd

2400

N.A.

Essar Oil Ltd

5650

N.A.

Federal Bank Ltd

1300

N.A.

GAIL (India) Ltd

1500

1500

Great Eastern Shipping Co. Ltd

1350

1350

300

N.A.

2950

2950

175

175

4125

550

HCL Technologies Ltd

650

650

Housing Development Finance Corporation Ltd

300

300

Bharat Petroleum Corporation Ltd Canara Bank Century Textiles Ltd

Chennai Petroleum Corp Ltd

Corporation Bank

Glaxosmithkline Pharma Ltd Gujarat Narmada Fertilizer Co. Ltd Grasim Industries Ltd Gujarat Ambuja Cement Ltd

Contd

Trading Mechanism of Futures Contracts

39

Table 2.1 Contd Underlying security

NSE lot size

BSE lot size

HDFC Bank Ltd

400

400

Hero Honda Motors Ltd

400

400

Hindalco Industries Ltd

1595

150

Hindustan Lever Ltd

2000

2000

Hindustan Petroleum Corporation Ltd

650

650

ICICI Bank Ltd

700

700

I-FLEX Solutions Ltd

600

600

Industrial Development Bank of India Ltd

2400

2400

Infrastructure Development Finance Company Ltd

5900

5900

15750

N.A.

350

N.A.

India Cements Ltd

2900

2900

Indusind Bank Ltd

3850

3850

200

200

Indian Petrochemicals Corpn. Ltd

2200

2200

Indian Overseas Bank

2950

2950

600

600

ITC Ltd

2250

2250

IVRCL Infrastructure and Projects Ltd

2000

N.A.

J & K Bank Ltd

600

N.A.

Jet Airways (India) Ltd

200

200

Jindal Steel & Power Ltd

250

250

Jaiprakash Hydro-Power Ltd

6250

6250

Jindal Stainless Ltd

2000

N.A.

The Karnataka Bank Ltd

2500

N.A.

LIC Housing Finance Ltd

850

850

1250

625

IFCI Ltd Indian Hotels Co. Ltd

Infosys Technologies Ltd

Indian Oil Corporation Ltd

Mahindra & Mahindra Ltd

Contd

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Derivatives and Financial Innovations

Table 2.1 Contd Underlying security Maharashtra Seamless Ltd

NSE lot size

BSE lot size

1200

N.A.

800

800

Matrix Laboratories Ltd

1250

N.A.

Mphasis BFL Ltd

1600

N.A.

Mangalore Refinery and Petrochemicals Ltd

4450

N.A.

Mahanagar Telephone Nigam Ltd

1600

1600

14000

N.A.

National Aluminium Co. Ltd

1150

1150

NDTV Ltd

1100

N.A.

Neyveli Lignite Corporation Ltd

2950

N.A.

Nicolas Piramal India Ltd

1045

950

National Thermal Power Corporation Ltd

3250

3250

300

300

1050

700

Oriental Bank of Commerce

600

600

Punj Lloyd Ltd

300

300

Patni Computer Syst Ltd

650

N.A.

Punjab National Bank

600

600

Polaris Software Lab Ltd

2800

2800

Ranbaxy Laboratories Ltd

400

200

Reliance Energy Ltd

550

550

Reliance Petroleum Ltd

3350

3350

Reliance Capital Ltd

1100

1100

Reliance Industries Ltd

600

600

Satyam Computer Services Ltd

600

600

State Bank of India

500

500

1600

1600

Maruti Udyog Ltd

Nagarjuna Fertiliser & Chemicals Ltd

Oil & Natural Gas Corp. Ltd Orchid Chemicals Ltd

Shipping Corporation of India Ltd

Contd

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41

Table 2.1 Contd Underlying security

NSE lot size

Siemens Ltd

BSE lot size

750

750

1500

N.A.

850

N.A.

1750

1750

Sun Pharmaceuticals India Ltd

450

N.A.

Sun TV Ltd

250

250

Suzlon Energy Ltd

400

N.A.

Syndicate Bank

3800

N.A.

Tata Chemicals Ltd

1350

1350

Tata Consultancy Services Ltd

250

250

Tata Motors Ltd

825

825

Tata Power Co. Ltd

800

800

Tata Steel Ltd

675

675

Tata Tea Ltd

550

550

Titan Industries Ltd

822

N.A.

TVS Motor Company Ltd

2950

N.A.

Union Bank of India

2100

2100

900

900

Vijaya Bank

3450

N.A.

Videsh Sanchar Nigam Ltd

1050

N.A.

Wipro Ltd

600

300

Wockhardt Ltd

600

N.A.

SRF Ltd Strides Arcolab Ltd Sterlite Industries (I) Ltd

UTI Bank Ltd

Source : NSE & BSE websites. N.A.—Not available for trading. The table shows the lot size statistics as on July 26, 2006.

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Contracts in the commodities market also have a contract multiplier in order to determine the contract size. Table 2.2 provides details of the contract multipliers for some of the contracts on the NCDEX. As an example, Table 2.2 indicates that in order to determine the contract size for mini gold futures, the price quoted is to be multiplied by 10. Thus, if gold futures are trading at approximately Rs 9,900 (which is the price of 10 gm gold), the contract size would be Rs 99,000 (i.e. 9900 * 10). Similarly, if mini silver is trading at Rs 14,000/kg, the contract size of a futures contract would be Rs 70,000, as the lot size is 5 kg. Table 2.2: Contract multipliers for some NCDEX contracts Symbol

Commodity

City

Price quote unit

Market lot

GLDPURMUM

Pure gold

Mumbai

Rs/10 gm

1 kg

SLVPURDEL

Pure silver

Delhi

Rs/kg

5 kg

SYBEANIDR

Soybean

Indore

Rs/quintal

1 MT

SYOREFIDR

Refined soya oil

Indore

Rs/10 kg

1 MT

RMSEEDJPR

Rapeseed mustard seed

Jaipur

Rs/20 kg

1 MT

RMOEXPJPR

Expeller rapeseed mustard oil

Jaipur

Rs/10 kg

1 MT

RBDPLNKAK

RBD palm olien

Kakinada

Rs/10 kg

1 MT

CRDPOLKDL

Crude palm oil

Kandla

Rs/10 kg

1 MT

COTJ34BTD

J34 medium staple cotton

Bhatinda

Rs/quintal

11 bales

COTSO6ABD

S06 L S cotton

Ahmedabad

Rs/quintal

11 bales

Source: NCDEX website.

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Tick Size Tick size is the minimum difference between two quotes of a similar nature (two buy or two sell quotes). This is determined by the exchange and communicated to the market. As indices trade in index points, the tick size in this market is defined in terms of index points. However, this can always be converted into rupees. The NSE has selected 0.05 index point as the tick size for trading in Nifty index futures. As each index point is priced at Rs 100, an index point of 0.05 is equivalent to Rs 5. Thus one may say that, the tick size for trading in Nifty index futures is 0.05 index point, or Rs 5. This means that if one wants to improve upon an existing best buy quote of, for example, 3000 (contract size Rs 3,00,000), the minimum quote that the system will accept is 3000.05 (contract size of Rs 3,00,005) and not 3000.02 or 3000.03. The tick size for single stock futures is the same as the cash market tick size, i.e. 5 paise. Exchanges in the commodities market have determined different tick sizes for different products. The NCDEX and MCX have different tick sizes, even for the same product. Table 2.3 indicates the tick sizes of some of the products on the NCDEX and MCX. Table 2.3: Tick sizes of some products on the NCDEX and MCX Sl. No.

Product

NCDEX

MCX

1

Gold

Rs 1

Rs 1

2

Silver

Rs 1

Rs 1

3

RBD

5 paise

10 paise

4

Soya oil

5 paise

10 paise

Source: NCDEX & MCX websites.

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Contract Specifications Contract specifications essentially mean the salient features of a derivative contract and include information on contract maturity, contract multiplier (lot size), contract size, tick size, etc. The contract specifications for some futures contracts can be seen in Table 2.4. Table 2.4: Contract specifications for index futures contracts on the BSE and NSE Features

BSE Index Futures Contracts

NSE Index Futures Contracts

Underlying index

BSE Sensitive index (Sensex)

S&P CNX Nifty

Contract multiplier

50

100

Tick size or minimum price difference

0.1 index point or Rs 5

0.05 index point or Rs 5

Last trading day/ Expiration day

Last Thursday of the expiration month. If this happens to be a holiday, the contract will expire on the previous business day

Last Thursday of the expiration month. If this happens to be a holiday, the contract will expire on the previous business day

Contract months

3 contracts of 1, 2 and 3 month maturity. At the expiry of the nearest month contract, a new contract with 3 months maturity will start. Thus, at any point of time, there will be 3 contracts available for trading

3 contracts of 1, 2 and 3 month maturity. At the expiry of the nearest month contract, a new contract with 3 months maturity will start. Thus, at any point of time, there will be 3 contracts available for trading

Daily settlement price

Settlement price of the futures contract

Settlement price of the futures contract

Final settlement price

Settlement price of the cash index on the expiry date of the futures contract

Settlement price of the cash index on the expiry date of the futures contract

Source: NSE & BSE websites.

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Contract specifications of gold and silver contracts on NCDEX are indicated in Table 2.5 and Table 2.6, respectively. Table 2.5: Gold futures contracts on NCDEX Type of Contact

Futures Contract Specifications

Name of Commodity

Gold

Ticker symbol

GLDPURMUMK

Trading system

NCDEX’s Trading System

Basis

Ex-Mumbai inclusive of Customer Duty and Octroi, excluding Sales Tax

Unit of trading

1 kg

Delivery unit

1 kg

Quotation/base value

Rs per 10 Grams of Gold with 999.9 fineness

Tick size

Re 1

Quality specification

Not less than 995 fineness bearing a serial number and identifying stamp of a refiner approved by the Exchange. List of approved refiners: www.ncdex.com\downloads\refiners_gold.pdf

Quantity variation

None

Delivery center

Mumbai

Additional delivery centres

Ahmedabad

Trading hours

As per directions of the Forward Markets Commission from time to time, currently Mondays through Fridays 10:00 am to 11:30 pm Saturdays 10:00 am to 2:00 pm On the expiry date, contracts expiring on that day will not be available for trading after 5 pm. The Exchange may very the above timing with due notice.

Due date/Expiry date

20th day of the delivery month. If 20th happens to be a holiday, a Saturday or a Sunday then the due date shall be immediately preceding trading day of the Exchange. Contd

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Table 2.5 Contd Type of Contact

Futures Contract Specifications

Delivery specification

Upon expiry of the contracts all the outstanding positions should result in compulsory delivery. A penalty of minimum 5% (of final settlement price) would be imposed on longs and shorts if they fail to meet their delivery obligation.

Closing of Contracts

Upon the expiry of the contract all the outstanding open position should result in compulsory delivery.

Opening of Contracts

Trading in any contract month may open on the 21st day of the month. If the 21st happens to be a non-trading day, contracts would open on the next trading day.

No. of active contracts

Minimum 2 contracts with a maximum of 12 contracts running concurrently

Price limit

Daily price fluctuation limit is (+/–) 4%. If the trade hits the prescribed daily price limit there will be a cooling off period for 15 minutes. Trade will be allowed during this cooling off period within the price band. Thereafter the price band would be raised by another 50% of the existing limit, i.e. (+/–) 2% and trade will be resumed. If the price hits the revised price band (6%) again during the day, trade will only be allowed within the revised price band. No trade/order shall be permitted during the day beyond the revised limit of (+/–) 6%.

Position limits

For a member, the position limit will be 20% of market wide open position or 16 MT, whichever is higher Client-wise—4 MT. The above limits will not apply to bonafide hedgers. For bonafide hedgers, the Exchange will, on a case to case basis, decide the hedge limits.

Quality allowance (for Delivery)

Gold bars of 999.9/995 fineness. The discount will be given for a fineness below 999.9. The settlement price for less than 999.9 fineness will be calculated at (Actual fineness/999.0) * Final Settlement Price.

Special Margin

In case of additional volatility, a special margin of at such other percentage, as deemed fit, will be imposed immediately on both buy and sell side in respect of all outstanding positions, which will remain in force for next 2 days, after which the special margin will be relaxed.

Source: NCDEX website.

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Table 2.6: Silver futures contracts on NCDEX Type of Contract

Futures Contract Specifications

Name of Commodity

Silver

Ticker symbol

SLVPURDEL

Trading system

NCDEX Trading System

Basis

Ex-New Delhi inclusive of Customs Duty, exclusive of local sales tax

Unit of trading

30 kg

Delivery unit

30 kg

Quotation/Base value

Rs per kg of Silver with 999 fineness

Tick size

Re 1

Quality specification

Not less than 999 fineness bearing a serial number and identifying stamp of a refiner approved by the Exchange. List of approved refiners: www.ncdex.com\downloads\refiners_silver.pdf

Quantity variation

+/– 6 per cent

Delivery center

New Delhi

Additional delivery centres

Ahmedabad

Trading hours

As per directions of the Forward Markets Commission from time to time, currently— Mondays through Fridays: 10:00 am to 11:30 pm Saturdays 10:00 am to 2:00 pm On the expiry date, contracts expiring on that day will not be available for trading after 5 pm. The Exchange may vary the above timing with due notice.

Due date/Expiry Date

20th day of the delivery month. If 20th happens to be a holiday, a Saturday or a Sunday then the due date shall be the immediately preceding trading day of the Exchange.

Delivery specification

Upon expiry of the contracts all the outstanding open position should result in compulsory delivery. A penalty of minimum 5% (of settlement price) would be imposed on all longs and shorts if they fail to meet their delivery obligation. Contd

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Derivatives and Financial Innovations

Table 2.6 Contd Type of Contract

Futures Contract Specifications

Closing of Contracts

Upon the expiry of the contract all the outstanding open position should result in compulsory delivery.

Opening of Contracts

Trading in any contract month may open on 21st day of the month. If the 21st day happens to be a non-trading day, contracts would open on the next trading day.

No. of active contracts

Minimum 2 contracts with a maximum of 12 contracts running concurrently.

Price band

Daily price fluctuation limit is (+/–) 6%. If the trade hits the prescribed daily price limit there will be a cooling off period for 15 minutes. Trade will be allowed during this cooling off period within the price band. Thereafter the price band would be raised by another 50% of the existing limit, i.e. (+/–) 3% and trade will be resumed. If the price hits the revised price band (9%) again during the day, trade will only be allowed within the revised price band. No trade/order shall be permitted during the day beyond the revised limit of (+/–) 9%.

Position limits

For a member, the position limit will be 20% of market-wide open position or 200 MT, whichever is higher, Client-wise–50 MT. The above limits will not apply to bonafide hedgers. For bonafide hedgers, the Exchange will, on a case to case basis, decide the hedge limits.

Quality allowance (for Delivery)

Silver bars of 999 fineness. No premium/discount.

Special Margin

In case of additional volatility, a special margin of at such other percentage, as deemed fit, will be imposed immediately on both buy and sell side in respect of all outstanding positions, which will remain in force for next 2 days, after which the special margin will be relaxed.

Source : NCDEX website.

Terms such as unit of trading, price band, due date, etc. that are used in contract specifications are explained here. Others such as delivery centres, delivery quantity, quality specifications,

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49

delivery unit and premium/discount, etc. need to be understood from the perspective of delivery and are therefore explained in the section on settlement of futures contracts through physical delivery.

Unit of Trading Unit of trading implies the size of a contract in terms of quantity. For instance in the case of mini silver contract on MCX, although prices are quoted in Rs per kg, the size of a contract is 5 kg silver. This essentially means that if silver is quoted at Rs 14,000, one contract is equivalent to Rs 70,000 (5 kg * Rs 14,000).

Price Band On a specific trading day the price of a contract is not allowed to exceed a particular price band. This band is called the Price band and is viewed in relation to the price of the particular stock at the close of trading on the previous day. This band is decided upon, based on the closing price of the underlying asset in the cash market on the first trading day of the contract. All the terms of the price band are clearly defined in the contract specifications so that they are available to all market participants, in advance. Exchanges sometimes use their discretion and allow these bands to be expanded. However, this is done with specific trading halts (e.g. trading may be stopped for approximately ½ an hr) and increased margins.

Due Date Due date is the expiry date or last trading date of a derivatives contract. Majority of contracts on the NCDEX have 20th of

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Derivatives and Financial Innovations

the contract month as due date. Majority of MCX contracts expire on the 15th of the contract month.

Position Limits Position limits are limits that are imposed on the positions of the individual clients or member brokers in order to avoid any concentration of business in the market place.

What Makes a Contract Successful Several innovative derivative contracts are introduced in the global markets from time to time. However, only a few of these survive and succeed. It may therefore interesting to consider what it is that “makes a specific derivative product/contract effective?” It is important to determine “what really is the measure of success of a derivative product?” The answer is Liquidity and this is considered to be the only true test for the success of a derivative product. As Liquidity is a function of the interest of market participants in a product, the most important success factor for a contract therefore, is that it must appeal to a large set of market participants including hedgers, speculators and arbitragers. Hedging interest in a product arises only if the price of the underlying asset is volatile and carries an element of risk. Speculators are attracted to a product only if there is an opportunity to generate money and this, in turn, arises from the volatility in the price of the underlying asset. Therefore, the existence of risk in the underlying market is a prerequisite for the success of a derivative product.

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A right contract size is another important requirement for the success of a derivative contract. This means that the contract size should not be too big. Although the definition of “too big” is debatable, a very large contract may make it too difficult even for medium-sized market players to participate in the product. This may create liquidity constraints and deter the success of the product. The existence of a well-laid regulatory framework is another important requisite for the success of a contract. This engenders confidence among market players by the creation of an equal, fair, competitive and efficient market place. The prevalence of right margin regulations is also very important if a product is to succeed. Regulators may be tempted to prescribe higher margins in order to provide extra protection for the market. However, every rupee locked in as a margin, imposes additional costs on the market participants. It is equally true that a lower margin requirement may also pose a substantial threat to the very existence of the market place. Therefore, it is important to strike an intelligent balance between margins and safety of the market. It is pertinent here to consider the result of concentration of volume in a product on one exchange, especially when similar products are launched at two competing exchanges. Ultimately, the choice of trading platform lies with the market participants. However, when trading volume builds up on an exchange, it attracts further volume and this makes it difficult for another exchange to attract better volume. Market participants prefer to trade where there is higher volume because this makes entry and exit from the market easier. Greater liquidity reduces the risk of execution for market participants. The Indian example substantiates this point. The BSE and the NSE started trading with similar derivative products, in 2000. Initially, both the exchanges were at par, with each generating approximately

52

Derivatives and Financial Innovations

50 per cent of the volume traded. Subsequently however, concentration built up on the NSE and the BSE lost heavily. Today, the NSE attracts most of the volumes (almost 100 per cent) in equity derivatives. Similarly, in the commodity market, the two major exchanges in the country—the NCDEX and the MCX—have introduced similar contracts on underlying assets such as gold and silver. Within a span of 2 years, there has been a clear concentration of volume in these two products on MCX. On the other hand, volumes in agri-products are concentrated on NCDEX.

Positions in Derivatives Market Market participants necessarily need to be familiar with terms such as long, short and open positions in the market.

Long Position A buy position in a contract that is outstanding/unsettled is called the Long position. For instance, if Mr A buys 5 contracts on Infosys futures, he will be called long on 5 contracts on Infosys. If Mr B buys 4 contracts on pepper futures, he would be called long on 4 contracts on pepper.

Short Position An outstanding/unsettled sell position in a contract is called the Short position. For instance, if Mr A sells 5 contracts on Infosys futures, he would be called short on 5 contracts on Infosys. If

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53

Mr B sells 4 contracts on pepper futures, he would be called short on 4 contracts on pepper.

Open Position A Long (buy) or short (sell) position that is outstanding/unsettled in various derivative contracts, is called an Open position. For instance, if Mr A sells 5 contracts on Infosys futures and buys 3 contracts on Reliance futures, he would be termed as having an open position, which is equivalent to being short on 5 contracts on Infosys and long on 3 contracts of Reliance. If he then buys 2 Infosys contracts with the same maturity, his open position would be short on 3 Infosys contracts and long on 3 Reliance contracts.

Naked and Calendar Spread Positions A Naked position in the futures market implies a long or short position in any futures contract without having any cash position in the underlying asset. A Calendar spread position implies a position in futures, in one maturity contract, which is hedged by an offsetting position in a different maturity contract. Only opposite positions can offset each other. For instance, a short position in a one-month contract coupled with a long position in a two months contract is a calendar spread position. Such a position is always computed with respect to the near month series and becomes an open position when the near month contract expires or when either of the offsetting positions is closed. It is important to remember that the underlying asset is the same for different contracts in a calendar spread position.

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Derivatives and Financial Innovations

A calendar spread is always defined with regard to the relevant months, i.e. the spread between 1 and 2 months, 1 and 3 months or 2 and 3 months.

Opening a Position Opening a position implies either buying or selling of a contract, which increases the client’s open position (long or short). In other words, if a client is long on a contract, buying more of this contract would amount to opening a contract. Similarly, if he is short on a contract, then selling more of this contract would also amount to opening a position.

Closing a Position Closing a position means either buying or selling a contract, which essentially results in a reduction of the client’s open position (long or short). In other words, if a client is long on a contract, selling this contract would amount to closing a position and if he is short on a contract, then buying this contract would amount to closing a position.

Position Calculations The clearing agency of the exchanges works as an accountant who monitors the positions of all the market participants. The clients of an exchange can be identified by the clearing agency through their unique identification numbers (IDs). In a contract, all long and short positions of a client are netted, in order to determine his open position at a given point in time. However, the positions of one client are not set-off against the positions of

Trading Mechanism of Futures Contracts

55

other client/clients, while determining the open position of a member broker. Thus, the open position of a member broker is the gross open position, of the net open positions of his clients. For instance, a member broker M has two clients A and B. On a particular day, if client A buys 10 contracts and sells 5 of them, his open position at the end of the day is long 5 contracts. Similarly, if client B buys 5 contracts and sells 10 of them, his open position at the end of the day is short 5 contracts. While calculating the open position of member broker M, the open positions of clients A and B will not be netted. Therefore, the open position of the member broker is calculated as 5 long and 5 short contracts. Calculation of open positions is important from the perspective of risk management through margining. This concept is elaborated upon later.

Open Interest and Volume Open interest, is a crucial and dynamic measure of the derivatives market. It is computed as the number of outstanding/unsettled positions in a contract, at a specific point of time, in the market as a whole. This is a contract specific measure and is therefore provided separately for different contracts. The total number of long positions in a contract will always be equal to the total number of short positions. Hence, only one side of the contract is counted for the purpose of calculating the open interest. From the perspective of market participants, the combined open interest in the various contracts of an underlying asset, and the market-wide combined open interest across all the contracts, is a very relevant measure. Both these open interests are generally defined in monetary terms. For example, the average daily market-wide open interest across all the contracts, in the Indian

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Derivatives and Financial Innovations

securities market, is around Rs 30,000 crores and the average daily market-wide open interest in the commodities market is around Rs 9,000 crores. Volume relates to the trading activity in the market. It provides a static picture of the market activity with regard to a specific contract, over a period of time, e.g. a day, a week or during the entire life of a contract. Worldwide, different markets define volume in different ways—in terms of the number of contracts traded during a specific period of time or in terms of the value of the contracts traded. Further, some exchanges take into account the volume of both the legs of the contract (i.e. buy and sell) while others consider only one aspect. It is therefore important, to clarify this while reflecting on the numbers relating to volume.

Convergence of Cash and Futures Prices What do futures prices really indicate? For instance, what is indicated if a Nifty January 200X index futures contract is trading currently (i.e. in December), at 3050? As the contract is trading for settlement on the last Thursday of January 200X, the trading level of 3050 indicates that at the close of market on that day (i.e. the last trading day of the contract), the market expects the cash index to settle at 3050. Every market participant seeks to predict the cash index level at a single point in time, i.e. at the closure of the market on the last trading day of the contract, which in this case is Thursday. This results in a price discovery of the cash index at a specific point in time. Futures prices are essentially the expected cash prices of the underlying asset, at

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57

the maturity of the futures contract. Accordingly, both futures and cash prices converge on the maturity of the futures contract since there cannot be any difference between these two prices at that point in time. That is why on expiry, all futures contracts are settled at the underlying cash market settlement price. This principal remains the same for all the underlying assets. Price

Futures price

Spot price

Time t1

t2

T

Fig. 2.1: Convergence of prices on maturity of futures contracts

Settlement of Futures Contracts Settlement relates to the manner in which the obligation in a contract is honoured. Some derivative contracts are settled only in cash, i.e. settlement of these contracts takes place only through settlement of the difference between the buy/sell price and the final settlement price. Other contracts are settled in physical form, i.e. by delivery and payment for the underlying asset. Settlement characteristics—i.e. whether a contract will be a cash or a physically settled contract—depends upon several factors.

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1. The first consideration is whether delivery of the underlying asset is possible. In the event that this is not possible, the derivative contract will necessarily have to be cash settled. For instance, all weather derivatives are cash settled, as delivery in the underlying is not possible. Sometimes, delivery of the underlying asset may be possible, but this may be very cumbersome. In such cases also, the contract is designed as a cash settled contract. For instance, in the case of index-based derivatives, delivery of an index may be a very cumbersome process. Hence, all index-based derivatives, in India and across the globe, are cash settled. 2. The second point is whether exchanges are willing to be involved in the delivery process. If they are not interested in doing so, they may make the contract a cash settled one. 3. The third consideration is whether the exchanges have the infrastructure required to handle the delivery. For instance, in the case of commodities, it is important for exchanges to have proper warehousing facilities in the period between pay in and pay out. Pay in refers to the time of delivery of the underlying asset to the exchange, by the seller and pay out refers to the time of its delivery by the exchange, to the buyer. If exchanges do not have this facility, they may not be in a position to introduce delivery-based products, even though they may be quite willing to do so. 4. Another important factor to consider is whether there are any regulatory requirements with regard to physical or cash settled contracts. In some markets, regulators require derivative contracts to be essentially cash settled,

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in order to avoid price manipulation and short squeeze situations. In India, regulators have stipulated that all equity derivatives must be cash settled contracts. On the other hand, the law requires that all commodity derivatives be physically settled. The settlement of a cash settled contract is quite simple as the difference between the buy/sell price and the final settlement price is settled between the buyer and seller. In the case of physically settled contracts, the exchange defines the mechanism for the settlement of contracts. The delivery process in the case of commodity derivatives is governed by several factors.

Settlement of Commodity Futures In commodities market, at present, three kinds of contracts are traded—compulsory delivery contracts, intention matching contracts and seller’s option contracts. In case of compulsory delivery contracts, all open positions at the maturity are essentially settled through delivery and payment. Example of compulsory delivery contract is gold. In case of intention matching contract, for delivery to take place, both buyer and seller have to give intention for delivery. In other words in an intention matching contract, the delivery will take place only when both buyer and seller are agreeable for delivery. Example of intention matching contract is crude oil contract. In case of seller’s option contracts, the seller has a choice to deliver underlying commodity at the maturity of the contract. If he desires so, the buyer will be forced to take delivery. Most of the agri-contracts are having seller’s option. In a contract, delivery is made only during a specific time, towards the end of the contract, called the Delivery period. For

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instance, on NCDEX, the delivery period starts three days prior to maturity and on MCX, it begins five days prior to maturity. During this period, sellers and buyers make known their intention to either make or take delivery to the exchanges. On the maturity of the contract, the exchanges compare these declared intentions and settle contracts based on their respective rules as mentioned earlier (compulsory delivery, intention matching and seller’s option). Delivery of the commodity is made at a designated warehouse/warehouses at the delivery centers. This is predetermined by the exchange and communicated to market participants in advance. There are different centers for the different commodities, and also for different exchanges. For instance, in the case of NCDEX, delivery in gold is accepted only in Mumbai, while MCX accepts gold deliveries at different centers such as Mumbai, Delhi, Ahmedabad, etc. The quality and quantity of the commodity is certified by a certifying agency appointed by the exchange. When the commodity is delivered to the designated warehouse, the seller is provided with a warehouse receipt, which may be in either physical or electronic form. This warehouse receipt is the proof of ownership of the quantity and quality of a stated commodity, by the beneficial owner or the holder of the certified warehouse receipt. In order to complete the delivery process, the seller must send this warehouse receipt along with delivery notice to the clearing house/corporation of the exchange. The clearing house/ corporation randomly allocates this delivery notice to a buyer. In the commodity market, there is also a concept of Delivery unit which represents the minimum quantity that can be delivered by a seller. There are different delivery units for different underlying assets. For example, in the case of gold on NCDEX, the delivery unit is 1 kg where as in the case of silver, it is 30 kgs.

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The contracts, which do not result in delivery units, are essentially settled in cash. The quality of commodities delivered in the market is a matter of grave concern and therefore needs careful consideration. The exchanges clearly define the basic quality of commodities that are traded in the market. Sellers are however, permitted to deliver commodities of a better or poorer quality, within a given range of this basic quality. This range is called the Deliverable grade/ quality. The seller receives a premium for delivery of a better quality product whereas a discount is applied on the payment made to the seller, for delivery of a product of poorer quality. It may be mentioned, that the choice of the quality of the product that is delivered, lies with the seller and this is part of the contract specification. Similarly, in terms of quantity also, the basic quantity and the deliverable quantity is defined by the exchange. For instance, in case of a flat steel contract on MCX, even if the basic quantity of the contract is 25 metric tonnes, the seller may deliver any quantity within a range of 23.5 and 26.5 tonnes. This means that if the seller delivers between 23.5 MT to 26.5 MT, it will be considered that he has adequately discharged his obligation of delivering 25 MT. However, he will be paid only the value of the actual quantity of goods delivered. In the commodities market, both the exchanges clear and settle their trades independently. While MCX has an in-house department to clear and settle trades, NCDEX has outsourced this activity to the National Securities Clearing Corporation Ltd (NSCCL). Further, both exchanges guarantee the settlement of all the transactions and have a trade guarantee fund/settlement guarantee fund, in order to meet the contingency requirement in case of default by the brokers.

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Settlement of Equity Futures All equity futures contracts in Indian securities market are cleared and settled through the clearing corporation/house of the exchange. Thus, it becomes the counter-party to all the trades or gives an unconditional guarantee for their settlement. The counter-party risk involved in trading is therefore, assumed by the clearing corporation/house of the exchange. For this purpose, the exchanges have created a separate trade/settlement guarantee fund, which is independent of the cash market. In order to protect the interest of the investors in the derivatives market, they have also set up an investors’ protection fund for the derivative segment, which too is independent of the cash segment. Trading is being commoditised across the globe as well as in India and hence the values have migrated from trading to clearing and settlement functions. As the clearing agency provides the facility of clearing and settlement of trades as well as standing guarantee for them, it has become the centrepiece in the derivatives market. The clearing corporation/house manages its risk on the guaranteed transactions by margining the positions of all market participants on the exchange. It collects margins from its member brokers who are called clearing members/ trading-cum-clearing members. In turn, the clearing members collect margins from their associated trading members and trading-cum-clearing members collect it from their clients. In the cash market, the exchanges confer trading and clearing rights on the members, simultaneously, i.e. a member with a trading right always has the clearing right as well. However, in the derivatives market, trading and clearing rights are segregated. Thus, broker members may have only a trading right (become trading members—TM) or only a clearing right (become clearing

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members—CM), or they may have both trading and clearing rights (become trading-cum-clearing Members—TCM). Trading members are dependent on clearing members for clearance of their trades. The clearing corporation/house lays down the criteria for clearing membership including the net worth requirements. However, the exchanges determine the criteria for trading membership. Clearing members place deposits with the clearing corporation/house in the form of assets, which include cash or fixed deposits, bank guarantees, treasury bills, government securities or de-materialised securities (with suitable haircuts). These are pledged in favour of the exchange/clearing corporation and work as margins. The exposure that the clearing corporation/ house provides to the member brokers is linked to this margin. The margins in the futures market are as follows.

Initial and Variation Margins Theoretically, it appears that settlement is a simple task since at the end of the contract life, the clearing corporation/house takes the losses from the losers and gives them to the gainers. However, what happens in the event that one or more losers in the market do not fulfil their obligations at maturity due to large movement in the prices of the underlying assets. How does the clearing agency honour its commitment to counter-parties in such a situation? The clearing corporation considered dividing the risk into smaller pieces—equivalent to the days in a contract life— and spreading it over the life of the contract. This means that, the clearing agency will collect the losses at the end of each day (or before the market opens on the next day) and give them to the gainers. In this process, if a member does not pay the clearing

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agency the losses, the clearing agency can square off the members’ position at the opening of the market next day. Thus, the clearing agency will be exposed to only one day’s risk on the part of the broker members. However, the agency will still have to cover itself against possible one day loss. This situation can be addressed if the clearing agency obtains some money in advance from the broker members. This may be treated as a good faith deposit with the clearing agency and represent a financial commitment on part of the clients, towards their obligations in the market. If at the end of each day, the broker members do not meet their obligations, this money may be used by the clearing agency to honour their transactions. This is how the market operates today. An advance deposit, which allows members to take a position, either on their own behalf or on behalf of their clients, is collected by the clearing agency. This is popularly known as Initial margin. In a rough sense, this may imply that by charging an initial margin, the clearing agency assumes that every one in the market will default on their position at the end of the day. However, it must be distinctly understood that the initial margin is invoked by the clearing agency only in the event that position holders default on their obligations. Thus, the initial margin (IM) is a good faith deposit, i.e. the advance money collected by the clearing agency both from buyers and sellers before they commit to any position in the market. This raises the issue as to what the quantum of IM must be. Fundamentally, the quantum of IM must be equivalent to the potential losses on positions of both buyers and sellers. This in turn raises the issue of the period of time over which these potential losses are likely to occur. In practical terms, the clearing corporation must decide the period of potential loss—a day, a week or any other period—it sees fit. However, this decision is dependent upon marking to market exercise, if any, and the

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time taken by the market participants to deposit mark to market margins with the clearing agency. Marking to market is the process of virtually settling all open positions in the market, at a price (called settlement price), at a specific point in time. This exercise is performed by all major exchanges at the end of each trading day. This implies the assumption, that all open positions in the market, whether long or short, have been settled on a daily basis at the daily settlement price. Collection of losses and payments of profits, as the case may be, is done by the exchange and/or clearing corporation/ house on a daily basis. After the settlement with the clearing corporation/house, such positions are deemed open, on the subsequent trading day, at the previous day’s settlement price. This daily settlement obligation, called the daily margin or marking to market margin or variation margin, is payable only in cash. Pay in and pay out in the futures market are on a T + 1 basis, i.e. all the losses are payable and profits are receivable on T + 1 basis. If collection of this daily or mark to market margin takes t number of days, the clearing corporation needs to charge the initial margin as potential loss for t number of days. For instance, if the collection of daily margin takes place on a dayto-day basis before the markets open for trading on the subsequent trading day, the clearing agency needs to take an initial margin to cover the potential loss only for one day. Naturally, the margin required for 2 days would be higher. Let us understand daily margining with the help of an example. Suppose Mr A has bought a futures contract when the Nifty index level was 3000. At the end of the day, this index settles/closes at 2950. This means that, Mr A has lost money equivalent to 50 points on the Nifty, i.e. Rs 5,000 (50 * 100). This money is to be deposited by Mr A, in cash, with his broker. Now, the next day, Mr A’s position is treated as open at 2950.

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If in the preceding example, instead of the market going down, it goes up by 25 points and closes on 3025, Mr A would receive Rs 2,500 (25 * 100) and next day his position would be treated as open at 3025. This process is called marking to market or daily settlement of all open contracts. For the purpose of administrative convenience, broker members may maintain a daily settlement margin balance up to a pre-agreed level with clients in order to avoid collection and payment of daily settlement amounts on a day-to-day basis. Brokers retain this amount in a separate account, called clients’ account. The broker member is not permitted to make payment for any transaction in which he has a position as principal, from the clients’ account. Further, the broker cannot utilise the funds of one client either for or on behalf of another client/clients, except on specific authorisation from the client whose funds are being utilised. A broker may open a single account for all his clients or maintain separate accounts for each one of them. It is necessary to consider what the t days potential loss is and how the clearing agency can confidently say that it is safe, if it charges the client for this potential loss. In other words how can the margins collected by it, absorb the losses on positions. This issue is slightly technical and can best be addressed with the help of Value at Risk (VAR) model. Value at risk model requires the clearing agency to decide on the confidence level and the time frame over which it wants to cover the risk. One may achieve a confidence level of 99 per cent over a day, if the market is able to collect the MTM margin on a day-to-day basis. In the worst case this VAR would represent one day’s potential losses on a client’s position, assuming that the daily margins/ marking to market margins are collected by the clearing agency from clients before trading begins on the very next day. A 99 per cent confidence level implies that the clearing corporation can

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state with 99 per cent surety that the margin collected will cover the potential losses. In other words, the clearing corporation will be safe for 99 per cent of the trading days, if it charges VAR at 99 per cent confidence over a period of time t. Minimum initial margins on different positions are prescribed by the clearing corporation/house, based on the specified risk algorithm using Standard Portfolio Analysis of Risk (SPAN), which is detailed as annexure to the chapter number 5. It is also possible that the confidence level may be reduced to around 95 per cent. Mathematically, this would mean that the exchange is safe for 95 per cent of the trading days with the margin charged at that level. It should be clear that with a decreasing confidence level, the margin requirement would also decrease. Brokers may charge more than the minimum requirement outlined by the clearing corporation/house, based on its risk perception, in dealing with their clients. Clients deposit Money/ securities as initial margin, with the broker. He inturn deposits this with the clearing corporation/house, which keeps this in a trust on behalf of the client. Initial margin can be paid in the form of cash, fixed deposit receipts, bank guarantees, government securities and other de-materialised securities (equity and/or debt) with certain haircuts. Some clearing agencies also accept gold as part of an initial margin portfolio. As initial margin is computed in order to cover the MTM risk for a specific period of time, the timely collection of MTM margins is essential for the safety of the clearing agency. If the clearing agency does not receive the MTM on time, it runs the risk on a clearing member, as the IM charged may not be sufficient to cover the accumulated MTM losses of additional days. Accordingly, the clearing agency reserves the right to

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liquidate a clearing members’ position, in case the MTM is not paid in time. In such cases, the clearing member is liable for losses, if any, on such closing out of his positions. Similarly, if a client fails to submit his daily margin to the broker by a given deadline, the broker may liquidate either a part or all of the client’s position in order to cover his risk and the client would bear the losses, if any. Let us discuss an interesting perspective here. The initial margin (IM) is the money taken as a deposit by the clearing corporation in order to make the transaction good, in the event that the client does not pay the MTM. In other words, the IM is the advance MTM. One may therefore say that there is only one kind of margin in the derivatives market and that is the MTM margin. The initial margin requirement in the derivatives market is different for the naked long and short positions and for the calendar spread positions. In case of the latter as both the legs of the transaction move in opposite directions, risk is significantly low and hence the margin requirement is also low. It may be seen that a calendar spread assumes a naked position in the farther month contract, as the expiry of the near month contract approaches. In some markets, the effect of a spread position turning naked is taken on the margin at one time while in other markets, it is spread over a certain number of last trading days of the nearer month contract. For instance, in the Indian market, this change is effected three days prior to the expiry of the near month contract. Accordingly, all the positions in the market are considered as open positions in the farther month series after that day. Currently, commodity markets in India are at a very nascent stage. At this point in time, for the purpose of margining, the

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two aspects of spread positions are treated as independent positions and 50 per cent benefit on both the legs are given to the position takers. However, with increasing volumes and interest in the market, it is definitely likely to move towards greater sophistication on the margining front.

Additional Margins Globally, regulators set the minimum margins that the clearing agency/agencies are required to charge. This is done in order to ensure that competing clearing agencies do not dilute their standards and create risks for the financial market, in pursuit of business opportunities. Accordingly, in India, SEBI has provided exchanges with VAR based methodology to calculate initial margins. In the commodities market, FMC has set up a risk management group under the leadership of Prof. J.R. Verma of the Indian Institute of Management (IIM), with a mandate to recommend uniform risk management practices across the exchanges. However, over and above the minimum margins prescribed by the regulators, clearing agencies may charge additional margins based upon their risk perception with regard to a clearing member. Similarly, broker members may take margins over and above the minimum required depending upon their relationship with their clients. Furthermore, in order to deal with any adverse situation in the market, clearing agencies may impose additional margins at any time. For instance, in the event of excessive volatility, clearing agencies generally ask for additional margins from brokers in order to protect their risk.

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Final Settlement of Futures Contracts As described earlier, final settlement of derivative contracts may take place either in cash or in physical form, i.e. through delivery and receipt of the underlying asset. In India, all derivative contracts on the equity side are cash settled. However, commodity contracts are deliverable contracts, i.e. they are physically settled contracts. While settling in cash, all open futures positions in the market are marked to market, to the closing value of the underlying asset (final settlement price of the contract) on the maturity day of the contract. The resulting losses/profits are settled in cash. In practical terms, the final settlement of a futures contract is similar to the mark to market process/daily settlement process, except for the settlement price used for this purpose. The settlement price for a futures contract is the same as its closing price until the second last day. However, on the last day, the settlement price of the futures contract is the settlement price of the underlying asset in the cash market. While settling through delivery, actual delivery takes place between the buyer and seller within a specific time after expiry of the contact. The price paid by the buyer is the futures settlement price on the day previous to the expiry day. This happens because the buyer/seller has already settled all gains and losses up to this day—i.e. the day before the expiry day— over the life of the contract, in the form of MTM gains/losses.

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Appendix 2.1: Index Concepts A large number of derivative products are globally, based on indices and the Indian securities market also started trading derivatives with index based derivative products—Index futures—in June 2000. A preliminary knowledge of indices is essential in order to understand index-based derivatives and accordingly, this appendix discusses the basics of indices.

Stock Index A Stock index is a well-diversified portfolio, created to represent the market sentiments. An index captures the overall behaviour of the market and reflects the changing expectations of the market regarding the future performance of the corporate sector/ economy. A rising index reflects optimistic expectations and a falling index indicates pessimistic expectations from the market. A good index is highly liquid, has a high hedging effectiveness against a wide variety of portfolios and is difficult to manipulate. Mathematically, an index measures how much a variable changes over a period of time and is calculated by finding the ratio of the current value to a base value. For example, BSE Sensex is a portfolio of 30 liquid and fundamentally strong companies. These scrips are leaders in their respective industry or sector. Any significant change in the economic scenario of any industry will be reflected directly in the index through movements in the prices of these representative companies.

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Index Management (Index Construction, Maintenance and Revision) Index construction, maintenance and revision are specialised jobs and generally performed by specialised agencies. For instance, all NSE indices are managed by a separate company called India Index Services and Products Ltd (IISL), which is a joint venture between Standard and Poor (S&P), National Stock Exchange (NSE) and CRISIL Ltd (Now a part of Standard and Poor). The Stock Exchange, Mumbai (BSE) manages its own indices through its index cell. Index construction deals with choosing the index scrips and deciding on the index calculation methodology. Maintenance means adjusting the index for corporate actions like bonus issues, rights issues, stock splits, consolidation, mergers, etc. Revision of index deals with changes in the composition of the index, i.e. replacing some existing scrips with new ones because of changes in the trading paradigm of the scrips/interest of market participants.

Index Construction Scrips in the index are chosen based on certain predetermined qualitative and quantitative parameters, laid down by the index construction managers. A scrip is eligible for inclusion in the index when it satisfies the eligibility criterion. Generally, the final decision regarding the inclusion or removal of a security from the index is taken by a specialised committee known as the index committee. Having decided on the scrips, the following methods are primarily used to construct indices. (a) Market capitalisation weighted method: The market capitalisation of a company is calculated by multiplying

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the outstanding number of its shares by its share price. In this method of index construction, each stock in the index is given a weight, which is proportional to its market capitalisation. A simple weighted average of current prices of stocks in the index is calculated in order to arrive at the present price level of a portfolio. This is divided by the base year price of the portfolio in order to determine the current index level. Popular examples under this category are S&P 500, NYSE Composite Index, Nasdaq Composite Index, S&P CNX Nifty 50, etc. (b) Price weighted method: Price weighted indices differ from market capitalisation weighted indices only on one score, viz. weights used for calculation of the present price level of a portfolio. In case of price-weighted indices, each stock in the index is given a weight proportional to its market price. Popular examples of price-weighted indices are the Dow Jones Industrial Average, Nikkei 225, etc. (c) Equal weighted method: In an equal weighted index, each stock in the index is equally weighted, while all other characteristics of index calculation remain intact. (d) Modified market capitalisation weighted method: Some market participants argue that while calculating a capitalisation weighted Index, only free-float, i.e. nonpromoters shareholding should be considered rather than the entire market capitalisation. Accordingly, some markets have constructed a free-float capitalisation weighted index called a modified market capitalisation weighted index. Popular examples from global markets are the Nasdaq 100 and BSE Sensex. All the popular indices in the Indian securities market, viz. NSE’s S&P CNX Nifty, Nifty Junior, BSE 100, BSE 200, etc.

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are market capitalisation weighted indices. However, BSE Sensex is a free-float market capitalisation weighted index.

Index Maintenance and Index Revision Maintenance and revision of the indices are done with the help of mathematical formulae, which ensure that the pre and post corporate action/revision indices are comparable. While the index maintenance issue is triggered by a corporate action, index revision is an unabated phenomenon to ensure that the index captures the most vibrant lot of securities in the market and continues to reflect the market sentiments.

Uses of Indices Traditionally, indices have been used as a measure to understand the overall direction of the market. However, over a period of time, various direct and indirect applications of indices have emerged in the investment field, major ones being index funds and index derivatives. Worldwide, Index-based applications are now expected to be a multi-trillion dollar industry.

Index Funds Index funds are funds, which invest in a specific index (replicate the index) with an objective to generate returns equivalent to the return on index. In index funds, investment is made in all the index scrips in proportion to their weight in the index, based on market capitalisation. For instance, Nifty Fund of UTI is an Index fund, which has invested the issue proceeds in Nifty stocks in proportion to their weight in the index, based on market capitalisation. This is a passive form of portfolio management.

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Index Derivatives Index derivatives are derivative products for which the underlying asset in the cash market is the index. For instance, futures and options on indices are index derivatives. Today, Index derivatives are significantly used to hedge against the market risk. Hedging, using the index derivatives, has become a central part of risk management in modern economies.

Market Risk Management Price risk, in a scrip, results from the volatility in its price. This volatility in price may be attributed to company and/or industry related factors (good/poor performance of company/industry) and economy related factors (social, economical and political factors). Price risk due to company related factors is called specific/unsystematic risk and is inseparable from the investment in the scrips. Price risk due to general factors of the economy is called the market/systematic risk. This component of price risk is separable from the investment and can be traded in the market with the help of index based derivative products. Today, markets are also trying to trade the industry risk through industry/sectoral indices.

Exchange Traded Funds Exchange traded funds (ETFs) are innovative products that provide exposure to an index or a basket of securities, while trading on exchanges, like a single stock. Practically speaking, ETFs provide market participants the facility to trade the index

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itself in the cash market as an alternative to the index funds. ETF units are listed and traded like any other stock on the exchange. So, market participants can conduct intra-day transactions. Furthermore, ETFs have competitive advantages over basket trading in terms of smaller denomination and low transaction cost. The first ETF in the Indian securities market was the NiftyBeES, introduced by the Benchmark Mutual Fund in December 2001. Prudential ICICI Mutual Fund introduced SPICE in January 2003, which was the first ETF on Sensex.

Summary 1. Futures contracts are legally enforceable, exchange-traded, standardised contracts that represent an agreement to buy or sell a specific quantity of asset at a predetermined price and delivery date. 2. Terminology used in the futures market are: (a) Contract month—The month in which a contract expires (b) Expiration day—The last trading day of the contract (c) Contract size—Value of a derivative contract (d) Tick size—Minimum difference between two quotes of a similar nature (e) Contract specifications—Salient features of a derivative contract. Information regarding contract maturity, contract multiplier (lot size), contract size, tick size, etc.

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(f ) Price band—The band, beyond which the price of a contract is not allowed to go during a specific trading day (g) Due date—The expiry date or last trading date of a derivative contract (h) Position limits—The limits on the positions of the individual clients/broker members. They are imposed to avoid the concentration of business in the market 3. Liquidity is the hallmark for success of any derivative contract. Risk in the underlying market, right contract size and a well laid down regulatory framework are essential ingredients for a contract to succeed. 4. Market participants may take the following positions in the derivatives market: (a) Long position—Outstanding/unsettled buy position in a contract (b) Short position—Outstanding/unsettled sell position in a contract (c) Open position—Outstanding/unsettled either long (buy) or short (sell) position in various derivative contracts (d) Naked position—Long or short position in any futures contract without having any cash position in the underlying asset (e) Calendar spread position—A position in futures with one maturity contract, which is hedged by an offsetting position in a different maturity contract. Only opposite positions can offset each other

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5. Opening a position means either buying or selling a contract, which increases an existing open position (long or short). 6. Closing a position means either buying or selling a contract, which results in reduction of an existing open position (long or short). 7. Open interest means the number of outstanding/unsettled positions in a contract, in the market as a whole, at a specific point in time. This is a dynamic phenomenon, i.e. open interest changes on a continuous basis in the market place. 8. Volume relates to the trading activity in the market. It provides a static picture of the market activity with regard to a specific contract, over a period of time—during a day, a week or the life of a contract. 9. Futures price is essentially expected cash price of an underlying asset, at the maturity of the futures contract. Accordingly, both futures and cash prices converge at the maturity of a futures contract as at that point in time there cannot be any difference between these two prices. This principal remains the same for all the underlying assets. 10. Some derivative contracts are settled only in cash, i.e. settlement of these contracts takes place only through settlement of the difference between the buy/sell price and the final settlement price and some contracts are settled in physical form, i.e. through delivery of underlying and payment for the same. 11. Initial margin is collected by the clearing agency for allowing members to take positions on their own behalf

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or on behalf of their clients. In a rough sense, a clearing agency assumes that every one in the market is going to default on his/her position at the end of the day. Initial margin is invoked by the clearing agency only in case of default by the client/clients on their MTM obligations. 12. Marking to market is the process of virtually settling all open positions in the market, at a price called the settlement price, at a specific point in time. This exercise is performed by all major exchanges at the end of each trading day. It means that, it is assumed that all open positions in the market, whether long or short, are settled on a daily basis at the daily settlement price. Collection of losses and payments of profits, as the case may be, is done by the exchange and/or clearing corporation/house on a daily basis.

Questions 1. Index futures were introduced in the Indian capital market in: (a) July 1998 (b) September 1999 (c) June 2000 (d) None of the above

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2. According to Dr L.C. Gupta Committee report, the maximum maturity of futures contracts in the Indian capital market may be: (a) 3 months (b) 6 months (c) 9 months (d) 12 months (e) 18 months 3. If the futures contract expires on the last Thursday of January 200X, which incidentally happens to be a trading holiday, the contract would expire on: (a) The last Wednesday of January 200X (b) The last Friday of January 200X (c) The second last Thursday of January 200X (d) The first Thursday of February 200X (e) None of the above 4. Contract multiplier, in case of index futures is: (a) The price per index point (b) The contract size for index futures when multiplied with the index value (c) Both (a) and (b) (d) None of the above 5. Contract size is calculated as: (a) Futures index level × tick size (b) Futures index level × contract multiplier

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(c) Futures index level × contract multiplier × tick size (d) None of the above 6. Tick size is: (a) The maximum permissible difference between buy and sell quotes (b) The minimum permissible difference between two buy quotes (c) The minimum permissible difference between two sell quotes (d) Either (b) or (c) (e) None of the above 7. In an Index futures contract, if the tick size is 0.05 index point and each index point is valued at Rs 100, the tick is valued at: (a) Rs 0.05 (b) Rs 5,000 (c) Rs 5 (d) Rs 25 (e) Rs 2,500 8. At the expiry of the futures contract, theoretically: (a) Cash market should be higher than the futures market (b) Cash market should be lower than the futures market (c) Cash market should be at the same level as the futures market (d) Cash and futures prices should converge

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(e) Both (c) and (d) 9. Which of the following is false with regard to futures transactions in India? (a) Clearing corporation/house gives the unconditional guarantee for settlement of all the trades (b) Derivatives segments of the exchanges have a separate settlement guarantee funds, independent of that of cash segments (c) Derivatives segments of the exchanges have investors’ protection funds, independent of that of cash segments (d) All the trades in futures are settled through physical delivery of the underlying stocks (e) None of the above 10. Which of the following is true with regard to futures contracts? (a) Futures provide flexibility of designing the contract according to one’s requirements (b) The long and short are dependent on each other for fulfilment of the contract (c) Futures contracts can be squared off any time during the life of the contract (d) Once a position is taken, the trader is required to carry the position till the maturity (e) None of the above 11. BSE Sensitive index (Sensex) is a portfolio: (a) Consisting of 30 scrips, which are equally weighted

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(b) Consisting of 30 scrips weighted by their free-float market capitalisation (c) Consisting of 30 scrips, which are weighted by the number of outstanding shares of these companies (d) Consisting of 100 scrips weighted by their market capitalisation 12. Which of the following is false? (a) BSE sensitive index is managed by BSE (b) S&P CNX Nifty is managed by NSE (c) Market risk is also called systematic risk (d) Option on index is an example of index derivatives 13. BSE Sensitive Index is used to: (a) Indicate the market movements (b) Provide the benchmark for funds’ performance (c) Provide index based derivatives products (d) All of the above 14. The base year for the BSE Sensitive Index is: (a) 1985–86 (b) 1978–79 (c) 1982–83 (d) 1991–92 15. Market risk reflects the risk arising due to: (a) Company specific factors (b) Industry specific factors

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(c) Economy specific factors (d) None of the above Answers to the Questions 1. (c)

2. (d)

8. (e)

9. (d) 10. (c) 11. (b) 12. (b) 13. (d) 14. (b)

15. (c)

3. (a)

4. (c)

5. (b)

6. (d)

7. (c)

Chapter 3

Uses of Futures This chapter outlines the uses of futures contract as an effective instrument for managing risk. It begins with an analysis of what risk is, enumerates its components and highlights the idea that the derivatives market is essentially a place where the risk is traded. It also analyses the role of the main players in the market— hedgers, speculators and arbitragers. Different trading strategies for hedging, speculation and arbitrage are also covered with the help of simple mathematics.

In economic terms, the introduction of derivatives is a mechanism that enables market participants to hedge against undesirable/unwanted risks on their asset portfolios. In other words, derivatives essentially, facilitate the transfer of risk/risks from one set of market participants, who do not want to carry it (hedgers), to another set of market participants, who are intentionally prepared to take it (speculators). Different products in the derivatives market trade different kinds of risks. For instance, in the case of individual stock futures and options, the entire price risk in underlying securities is transferred by hedgers to speculators. In the case of index-based products (index futures and index options), only a component of price risk, called the market risk is traded. Commodity derivatives trade commodity price risk and credit derivatives facilitate transfer of credit risk.

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Thus, fundamentally, the derivatives market is a market where the risk is traded.

Risk Traded in Index Futures Market As mentioned earlier, index futures facilitate trading of a component of price risk, which accompanies investment in securities. Price risk is the risk of price movement of an asset held by a market participant, in an unfavourable direction. This risk is divided into two components—specific or unsystematic risk and market or systematic risk.

Specific or Unsystematic Risk This is the component of price risk, which is generated by the specific events in the company and the industry. This risk is inseparable from investments in securities and can be reduced to a certain extent by taking well-informed investment decisions based upon research. Further, as the price risk of a portfolio is less than that of a single stock, diversification may be another way of reducing this risk.

Market or Systematic Risk This is the component of price risk, which is generated by factors other than company and industry related factors, e.g. economic and political events. Every scrip/portfolio is exposed to market risk. This risk is separable from investment and can be traded in the market with the help of index-based derivatives, i.e. index futures and options. When this risk is hedged perfectly with the

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help of index-based derivatives, only the specific risk of the portfolio remains. One may therefore conclude that, the total price risk in investment in securities is the sum of the systematic or market risk and unsystematic or specific risk. Similarly, commodity markets may trade some commodity indices in order to provide market participants with a mechanism for hedging their risk on commodity price movements in general. On the other hand, commodity specific contracts can cater to the need of price risk protection against specific commodities.

Other Risks in Financial Markets Price risk is the major risk in all financial markets. However, in addition to price risk, there are several other risks related to the market, which market participants must understand.

Default or Credit Risk Default or credit risk implies the possibility that any of the counter-parties to a contract may not honour its obligation. This risk is also called the counter-party risk. In an exchange driven environment, this risk is generally assumed by the clearing corporation/house of the exchange, which provides an unconditional guarantee for settlement of all trades conducted on the exchange. For instance, BOI shareholding and NSCCL provide guarantees for the settlement of all trade on the BSE and NSE, respectively. Similarly, commodity exchanges, i.e. NCDEX and MCX, provide settlement guarantees backed by

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their settlement guarantee fund for all the trades on these commodities exchanges.

Liquidity Risk This is the risk that is related to poor tradability/liquidity of securities/contracts in the market. Liquidity is the main factor which determines the interest of market participants in a product/contract, and varies from product to product as all securities/contracts available for trading in any market are not equally liquid. Business in futures contracts comes from three streams of activity—hedging, speculation and arbitrage. These contracts are quite liquid due to wider participation from market participants as well as competitive advantages over cash market transactions, such as lower transaction cost, lower securities transaction tax (STT) and their leveraged nature. Liquidity is very high in the Indian securities market particularly in the Nifty futures and 70–75 per cent of the single stock futures. In the case of commodities also, volumes in the futures market show good liquidity. However, it may be mentioned here that the success of a futures contract is essentially a market function. If it is to succeed in the long term, the product must attract all kinds of market players, i.e. hedgers, speculators and arbitragers. If it fails to do this, it may not survive in the market place.

Operational Risks These are risks that originate from factors like human error, fraud, systems failures, etc. These risks exist uniformly in all

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markets and can not be hedged by any mechanism other than by training, competence building, proper monitoring and insurance. It is thus clear that different mechanisms are designed to take care of different risks in the securities business. In order to manage the systematic risk/market risk, market participants use index-based products such as futures and options on indices, the exchange/clearing corporation assumes credit risk and operational risk management needs insurance providers.

Role of Different Players in the Futures Market As mentioned before, there are three major players in the derivatives market—hedgers, speculators and arbitragers. Hedgers basically hedge their risk of the existing underlying positions, speculators take the risk jettisoned by hedgers and arbitragers establish an efficient link between different markets. The reason why speculators take risks and arbitragers link different markets is simple, to make money. Speculators generally accept risks, in pursuit of profit. This is a highly specialised business and the success of a speculator is dependent on his ability to forecast correctly, the future prices of commodities or financial assets. Speculators take naked positions in the futures market, i.e. they go long or short in the various futures contracts available in the market, without having any stake in the underlying asset/assets. Speculators are one of the important pillars of the derivatives market as the capacity of the derivatives market to absorb buying/selling by hedgers, is

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directly dependent upon the prevalence of speculators. They act as a counter-party to hedgers, who will not be in a position to hedge if there are no speculators in the system. Therefore, the presence of both hedgers and speculators is essential if the futures market is to operate successfully. Consider for example, that a farmer is interested in hedging the price risk on his wheat produce, which will be ready in 3 months. The farmer believes that when the actual produce is available, the spot price of wheat may fall below the forward/ futures rate prevalent at present. He therefore, prefers to lock himself at the current forward/futures price and sells the futures contracts on the expected quantity of produce. However, in order to sell the futures contract he needs a buyer—someone who needs wheat after three months, or perhaps a flour-mill. However, very often there is a demand–supply mismatch in the market and speculators fill this gap between demand and supply. Thus, the view of the speculator, who is the counter-party to the farmer, is contrary to that of the farmer’s, as he will buy the contract only if he believes that after three months, the actual price of wheat will be higher than the contract price. If this happens, the speculator will make money, otherwise he will lose. Thus, if no one in the market is prepared to speculate, a hedger will not be able to hedge his risk. This is similar to an insurance contract, where the market needs both, insurance providers as well as insurance seekers. Thus, insurance providers assume the risk on behalf of insurance seekers. In addition to hedgers and speculators, a third party called arbitragers is required in order to establish a link between various markets such as cash and derivatives market. Arbitragers continuously look for profit opportunities across the markets and products, and avail of these by executing trades in different

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markets and products simultaneously (going long in one market/ product and short in another market/product, depending on the relative advantages). These activities facilitate the alignment of prices of various assets across the board. Importantly, arbitragers generally lock in their profits, unlike speculators who trade naked contracts. Assume for instance that, security X is available for Rs 500 in the cash market. If the cost of carrying this security up to the maturity of the futures contract is Rs 10, theoretically, the futures on this security should trade at Rs 510. However, if the future is trading at Rs 515 in the futures market, it will trigger arbitrage, i.e. market participants will start buying the security in the cash market and selling it in the futures market. This trading will result in a profit of Rs 5 to the arbitrager. As more and more people arbitrage and seize the so-called risk free profit, buying pressure in the cash market will increase the cash market price of the security and selling pressure in the futures market will reduce its futures price. This, in turn, will result in alignment of the cash and futures prices. It is appropriate here, to consider the risks that arbitragers carry. As seen earlier, arbitragers execute positions in two or more markets/products simultaneously. Even if the systems are seamless and electronic, and both legs of the transaction are liquid, there is still a possibility of some gap between execution of the two orders. If either leg of the transaction is illiquid, then the risk on the arbitrage deal is considerable as only one leg may be executed; thus leaving the arbitrager open to the naked exposure of a position. Similarly, if contracts are cash settled in either both or one of the markets, it will need a reversal of trades in the respective markets. This, in turn, will result in an additional risk on the unwinding position with regard to the simultaneous execution of the trades.

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Profit hungry speculators and arbitragers bring enormous liquidity to the products traded on the exchanges. This liquidity in turn, results in better price discovery, reduced cost of transaction and lesser manipulation of the market.

Risk Management using Futures (Hedging) Use of Index Futures As mentioned earlier, it is possible to manage only the systematic/ market risk component of the price risk using index-based derivative products. Prior to looking at market risk management with the help of index futures, an important concept in risk management must be considered, Beta. Beta is a measure of systematic risk but, it is not the systematic risk itself. It measures the sensitivity of a scrip/portfolio vis-avis index movement. Thus, a scrip with beta 2 will indicate a return of 20 per cent, when the index generates a return of 10 per cent. Similarly, if the index falls by 10 per cent, the scrip will also fall by 20 per cent. This indicates that the scrip is more volatile/risky than the index. Scrips/portfolios with beta in excess of 1 are called aggressive and with beta lower than 1 are called conservative scrips/portfolios. The beta of a scrip is index specific, i.e. the beta of a particular scrip vis-a-vis Sensex will be different from the beta value of the same scrip vis-a-vis Nifty. However, this difference will be marginal, as both Sensex and Nifty themselves enjoy a very high correlation. Beta is also a time-frame specific value, i.e. the beta

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of a scrip vis-a-vis Sensex based on the historical data of the previous 6 months, will be different from the beta value for the data over the last one year, keeping all other parameters constant. Similarly, beta is also a variable of the frequency of returns, i.e. daily returns, weekly returns, etc. Assuming that the index and the time frame for the data is the same, the beta of a scrip over daily returns will be different from the beta value over weekly returns. Therefore, it is important for anyone using beta to know its underlying calculation parameters. Beta values of individual scrips are used while calculating the beta values of the portfolios. Quite simply, this is calculated as the weighted average of betas of individual scrips in the portfolio based on their investment proportion. This means that if there are four scrips in a portfolio, with betas of 0.75, 0.90, 1.20 and 1.50 having weightages of 25 per cent, 35 per cent, 30 per cent and 10 per cent respectively, the beta of this portfolio would be 1.0125 (0.75 * 0.25 + 0.90 * 0.35 + 1.20 * 0.30 + 1.50 * 0.10). Information on the beta of scrips is available in various financial newspapers, magazines, exchange websites and information vending networks such as Bloomberg, Reuters, etc. As mentioned, beta is calculated on the basis of historic data and is used as an estimate of the future price movement of the scrips/portfolios vis-a-vis index. However, this method has lately been challenged in many empirical studies. Let us now consider how the concept of beta is used for the purpose of hedging. Assume that Mr X has a well diversified portfolio of Rs 400,000 with a beta value of 1.5 vis-a-vis Nifty and expects the market in general, to fall during next one month. He has two choices: 1. He can sell his portfolio in the cash market and buy it again after the prices fall.

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2. As he is already protected against unsystematic risk as a result of diversification, he can use index futures to protect the value of his portfolio from the expected fall in the market (systematic risk). If he chooses to hedge his downside risk on the portfolio through the second option, i.e. by using index futures, Mr X will have to sell or go short in the index futures market (calculation of required number of contracts is defined in the next paragraph). If, as he expects, the market does go down, he will lose on his cash position (long position) but gain on his futures position (short position). Therefore, his losses on the cash position will be compensated partly or fully, depending upon his position in the futures market, by the profits on his futures position. It is necessary here to know exactly how many contracts Mr X must sell and what the net impact of his combined position in the cash and futures markets will be. Fundamentally, although there are ways to calculate how many contracts he should trade in order to be absolutely immunised against market risk, the final choice of the specific number of contracts, lies with Mr X. Indeed, the number of contracts he trades will also determine the extent to which he is hedged and/or unhedged. The following formula will help to determine the number of contracts Mr X should trade, in order to achieve a perfect hedge against the systematic risk using index futures. This number is called the Hedge ratio. Number of contracts for perfect hedge = V p * b

V p —Value of the portfolio b

p

—Beta of the portfolio

Vi —Value of index futures contract

p

/Vi

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(The value of the index futures contract or contract size is equal to the futures index level * contract multiplier. In order to simplify this, the beta of futures index vis–a-vis the cash index is taken as 1). Assuming that a one month Nifty futures trading at 3000, is used to hedge the value of Mr X’s portfolio, the hedge ratio is 400,000 * 1.5/3000 * 100 which is equal to 2 contracts. This means that, to be protected fully against the market risk, Mr X must sell 2 contracts of Nifty futures. For the sake of simplicity, numbers have been taken hypothetically in order to ensure that the hedge ratio appears as an integer. In a real life situation however, it would rarely be an integer and may be a fraction, e.g. 3.45 or 3.80. In such cases, a hedger can enter into contracts that are equivalent either to the lower or upper integer of the fraction and therefore he will either be slightly over-hedged or under-hedged. Having calculated the hedge ratio in practical terms, it is up to a hedger to decide the number of contracts he will trade in. He may always consciously choose to only partly hedge his position, e.g. hedge by going short in 1 contract, rather than in 2. To explain the concept further, let us assume that Mr X decides to go short in two futures contracts at the 3000 level, in order to hedge his systematic risk completely. If after 20 days the index comes down to 2700 (goes down by 10 per cent) as he expects it will, his position will be as follows: Loss on cash position—Rs 60,000, i.e. 15% of 400,000 (The beta of portfolio being 1.5, the portfolio will lose 15%) Profit on the futures position—Rs 60,000 (10% of 300,000, i.e. Rs 30,000 on each contract or Rs 60,000 on two contracts)

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Therefore, the losses on Mr X’s cash position are compensated by the profits on his futures position. It is important to understand that the cash position may move higher or lower than 15 per cent due to some company/industry specific news on the scrips in the portfolio and this may result in some mismatch between the loss on one position and the profit on another. (Readers may note that the numbers taken in the example are hypothetical and a perfect hedge, as defined, rarely exists in practical life.) A hedge against the systematic risk depends to a large extent on the relationship between the portfolio and the index, which is measured by beta. As a portfolio may have different relationships with different indices, the hedge ratio will change with any alternation in the index used to hedge through. Further, the assumption that the past relationship between the movement of the scrip/portfolio and the index measured through beta will continue in the future, is a limitation of the model and may result in some difference between actual and expected outcome. Is it then, possible to manage this risk through the cash market itself? The answer is in the affirmative since there is choice of selling the portfolio now in order to buy it later when the price falls. However, the impact cost (i.e. the difference between the average price of execution of a deal and the best buy/sell quotes) and the cost of transaction make this option highly uneconomical. The same objective can be accomplished much faster and more economically with the help of index futures, since they offer the competitive advantages of lower cost, leverage and faster execution, as compared to cash market. Another interesting aspect is that, by selling index futures in order to protect the value of the portfolio, Mr X is actually

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expanding his portfolio by adding a short position to this. Since this short position is equally strong and opposite in nature to his existing portfolio, his net risk, after addition of the futures position, goes down drastically. Similarly, single stock futures may be used to manage the risk of equity investments. For instance, use of single stock futures will hedge a market participant against the complete risk in equity investment, because these futures are comparable with underlying positions. The only difference between an underlying position and single stock futures is in relation to settlement—in the case of cash transactions, settlement takes place immediately and in the case of single stock futures contracts, settlement is deferred. There are many instances where hedging is done with the help of index futures, so it will be meaningful to consider two specific cases of hedging in case of a mutual fund. (i) Reduction of equity exposure in a mutual fund scheme : Suppose, that the fund manager of a balanced mutual fund scheme decides to reduce his equity exposure from, around 60 per cent to 45 per cent of the corpus for a short period. This objective can be achieved by selling the equity holdings, but such selling entails three issues. Firstly, this is likely to depress equity prices to the disadvantage of the scheme (if the fund is large, impact cost may be high) if markets are not liquid. Secondly, it may not be possible to achieve this quickly and may take some time if the corpus is large and liquidity is poor. Thirdly, it is a costly procedure due to the prevalence of higher transaction charges. The same objective can be achieved through index futures at a considerably lower cost and with lesser impact on the

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cash market. For instance, the fund manager may sell index futures immediately and the sale of equity holdings may be done gradually, depending on market conditions, so as to realise the best possible prices. As the unloading of holdings progresses, the index futures position may also be unwound by an opposite transaction, to the same extent. (ii) Investment of funds raised by a mutual fund in a new scheme : When a new scheme is floated by a mutual fund, the money raised is not fully invested for a considerable period of time. This may be due to several reasons such as delay in making investment decisions or nonavailability of suitable securities in sufficient quantity at reasonable prices. The rush to invest the entire sum may drive up prices, and this will be disadvantageous to the scheme if markets are not very liquid. Thus, the timing of investment is very important. If a scheme is launched in order to take advantage of low equity prices, the advantage may actually be lost due to delay in acquiring suitable securities, since the market situation may change over a period of time. In such a situation, index futures may be used in order to deal with the issue. Mutual funds may buy index futures for a targeted amount of the mutual fund scheme. Having collected funds from the market, it may gradually invest in the market itself, and while investments are made, the futures position in the corresponding notional amount may be unwound by the mutual fund. Even if the mutual fund invests in the cash market at the higher price due to the upward movement of the market in general, it will be compensated by the profit on its futures position. It may be noted that as a mutual fund has a long position in

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the index futures, an upward movement of the market would create a profit on its position. Hedgers must appreciate that hedging is not free and entails various types of costs. These costs may be in the form of direct cost, opportunity cost and cost in terms of creation of other risks. Direct cost is the money paid as premium on options, or the interest lost on the margins paid for futures. Opportunity cost may be in the form of lost opportunity due to favourable price movement, i.e. the opportunity to buy an underlying asset at the lower price, or sell it at a higher price in the case of futures, as the price is fixed. However, in the case of options, this cost does not exist because if the price movement of the underlying is favourable, the hedger will not exercise the options. Sometimes, other risks are also generated, when one enters into a hedge transaction. For instance, when a farmer hedges the price risk on his crop by entering into a forward/futures contract on his expected produce, he creates a quantity risk. This means that, the farmer has sold a certain quantity of produce in the forward/ futures market, and if the produce does not occur in the expected quantity, then he will suffer on account of the quantity risk.

Important Terms in Hedging Long Hedge Long hedge is a transaction where a position in the cash market is hedged by going long in the futures market. For example, assume a situation where one is likely to receive some funds in the near future and would want to invest these funds in the securities market, but has not determined the securities in which

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to invest. The market is expected to go up in the near future, as a result of which, the price of the securities will be higher at the time of investment. This risk can be hedged by buying index futures, today. On receipt of the money, it can be invested in securities and the corresponding futures positions can be unwound. Any loss due to acquisition of the securities at higher price, resulting from upward movement in the market over the intermediate period, will thus be partially or fully compensated for by the profit on index futures position. Further, it is also possible that at the time of investment, suitable securities in sufficient quantity may not be available at reasonable prices and investing all the money together is likely to disadvantageously push up the prices. This situation can also be taken care of by use of futures, by gradually investing money in the cash market and unwinding corresponding futures positions. Similarly, in the commodity market, if a flour-mill owner expects the price of wheat to increase in the near future, he may buy wheat in the forward/futures market today. By doing this, he can protect himself against the upward movement in the price of wheat as well as create certainty on its procurement price of wheat. This is an example of long hedge in relation to commodities.

Short Hedge Short hedge is the hedge that is accomplished by going short in the futures market. For instance, if a portfolio is to be liquidated in near future, it may need to be protected against the disadvantage that a fall in prices of the scrips may cause. This can be achieved by selling index futures of an equivalent amount

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now, so that there is no adverse effect if the market goes down. The losses realised on the cash market transactions, resulting from downward movement of the market, get compensated fully or partially by the profits on the futures positions. Short hedges are also possible in the currency market. For example, Company C is in the import-export business and expects an inflow of dollars after 6 months. The finance director of the company anticipates a depreciation in the dollar vis-a-vis the local currency during this period, in which case the company will receive less local currency per dollar. To protect against this risk of adverse movement in the currency exchange rate, the company may sell dollars in the forward/futures market and thus protect itself from the depreciation of the dollar in relation to local currency.

Cross Hedge For the purposes of hedging, when futures contract on an asset is not available, market participants generally look forward to an asset that is closely associated with their underlying and trades in the futures market. They may trade in futures in this asset, in order to protect the value of their asset in the cash market. This is called Cross hedge. For instance, while futures contracts on jet fuel are not available in the international market, the contracts are available on other energy products such as crude oil, heating oil or gasoline. As the prices of these commodities are closely associated with that of jet fuel, market participants take positions in crude oil, heating oil or gasoline futures contracts in order to hedge the price risk of jet fuel. This is an example of cross hedge.

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Similarly, bauxite miners and traders use aluminium contracts to hedge their risk in bauxite prices because derivatives on bauxite are not available. It may be noted that bauxite is an input for aluminium and the prices of both these products move in tandem. Therefore, in using index futures to hedge against the market risk on a portfolio, a cross hedge is established since the exact underlying is not used in order to hedge the risk.

Hedge Contract Month Hedge contract month is the maturity month of the contract through which the position is hedged. For instance, if a January 200X contract is used to hedge the market risk of the portfolio, the hedge contract month will be January 200X. Similarly, if risk on crude oil price is hedged with the help of March 200Y, the hedge contract month will be March 200Y.

Speculation in the Futures Market In order to make profits, speculators often take positions in the futures market without having a position in the underlying cash market based upon their expectations regarding the price movement of underlying assets. These may be either naked positions or spread positions. A naked position is either a long (bought) or short (sold) position in any of the futures contracts. In case of a spread, two opposite positions (one long and one short) are taken in either two contracts with the same maturity on different products or in two contracts with different maturities on the same product.

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The former is called Inter-commodity or inter-product spread and the latter is called calendar spread/time spread or horizontal spread. Exchanges need to provide the system with the required inputs for it to recognise any kind of spread. At present, in the equity market, the system only recognises calendar spreads. In the commodities market, along with calendar spread, system also recognises inter-commodity spreads between specific commodities like gold and silver; soyabean, soyabean meal, soyabean oil, etc. A calendar spread may be established as a short position in a one month contract coupled with a long position in a two months’ contract. As contracts are available for different months, a calendar spread position is always computed with respect to the near month series. For instance, if Mr X has 3 contracts short in a one month futures contract, 2 contracts long in a two months futures contract and 3 contracts long in a three months futures contract, one may say that he has 2 calendar spreads between the first and second month and 1 calendar spread between the first and third month. Further, his position in the three months contract in relation to the remaining 2 contracts will be treated as naked. A calendar spread becomes a naked/ open position, when the near month contract expires or when either of the legs of the spread is closed. As spread positions are to a large extent hedged because they are combinations of two opposite positions, they are treated as conservatively speculative positions. A speculator will take a naked long position when he expects the market to go up and will make money by reversing the position at a higher price later. Similarly, he will take a short position when he expects the market to go down and will book profit by reversing his position at a lower price in the future.

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For instance, if during one month, Nifty index futures is trading at the 3100 level and a speculator believes that the cash index at the maturity will settle at a level higher than this, he will take a long position in index futures at a level of 3100. If his expectation comes true and on maturity the index settles above 3100, he will gain to the extent of the difference between the buy and the sell/settlement price of the index. Speculators may also take long or short positions in single stock futures depending on whether they expect the market to go up or down. Similarly, if one wants to speculate in commodities, one may take a long or short position depending upon whether the expectation from the market is upward or downward. If the market moves as expected, the speculator will make a profit, but if it does not, the speculator may end up incurring a loss. Because, a position is equally exposed to loss as well as profit, it is called a speculative position.

Arbitrage Opportunities in the Futures Market Arbitrage is the simultaneous purchase and sale of an asset or replicating an asset in the market in an attempt to profit from discrepancies in its price. Arbitrage involves activity on one or several instruments/assets in one or different markets, simultaneously. It is important to understand that in an efficient market, arbitrage opportunities can exist only for a very short time because the moment an arbitrager spots an opportunity, he will initiate the arbitrage and thus, eliminate the arbitrage opportunity.

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Arbitrage occupies a prominent position in the futures world and is the mechanism that keeps the prices of futures contracts aligned properly with the prices of underlying assets. Arbitragers’ aim to make profits without risk, but the complexity of arbitrage activity is such that it may also result in losses. Accordingly, well-informed and experienced professional traders, who are equipped with powerful calculating and data processing tools, generally undertake it. In practical terms, an arbitrager faces several key important issues the first of which is the implementation risk. As arbitrage entails the simultaneous purchase and sale of the same or a replicating asset, market participants interpret the word ‘simultaneous’ with varying degrees of precision. However, in reality, there is a time lag between the execution of any two trades. As markets today are electronic, order driven markets, they move swiftly within seconds. Therefore, even if there is difference of a couple of seconds in the execution of different positions in an arbitrage transaction, there is some element of risk. This is called the execution risk. The cost of transaction is the second key issue. Transaction costs involved in different instruments and markets are generally different and it is important for an arbitrager to understand them clearly before committing to any position. The third important issue is the handling of an arbitrage once it is established. Suppose that Mr X has bought an asset in the cash market for Rs 560 and he sold December futures on the asset for Rs 565. What must be his next course of action? Should he hold his positions to delivery or should he try to trade out when the opportunity arises? The answer to this question is difficult and there cannot be any definite generalisation on the subject, although many traders prefer to trade out a position

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rather than holding it until maturity. The ability to hold positions to delivery is normally viewed as a safety net that ensures a minimum profit, if the arbitrager is unable to trade out a position prior to maturity. Typically, there may be three types of arbitrage in the futures market: 1. Cash and carry arbitrage: Cost and carry arbitrage refers to a long position in the cash or underlying market and a short position in the futures market. 2. Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to a long position in the futures market and a short position in the underlying or cash market. 3. Inter-exchange arbitrage: This arbitrage entails two positions on the same contract in two different markets. These three positions are explained with the help of examples. In order to keep the calculations simple, it is assumed that there are no frictions like transaction costs, impact cost, taxes, etc. although in reality, arbitrage may not be as easy and cost efficient. It is also assumed that the company does not pay any dividend during the life of futures contract. In a simplified situation, actual futures prices should be equal to the fair price or the theoretical price, which is the cash price plus cost of carry. In simple mathematical terms, the Fair futures price, F = S + C, where, S stands for spot price and C stands for holding costs/carrying costs. If cost of carry is defined in percentage terms, the formula may be redefined as, F = S ** (1 + r)T where r is the carrying cost in percentage form and T is the time to expiration.

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If continuous compounding is used for computation of the cost, the same formula reduces to, F = Se rT. If the actual futures prices are higher than the fair/theoretical price, there will exist a profitable, no risk, cash and carry arbitrage opportunity. Thus, unless there are obstacles to such arbitrage, the activities of arbitragers will cause cash futures price relationships to conform to the cost of carry formula. On rare occasions, there may be an arbitrage opportunity that exists for some time but in practical terms, an arbitrage is feasible and will be undertaken only if it provides net cash inflow after cost of capital, transaction costs, viz. brokerage, securities transaction tax, service tax, etc. The cost of carry in equity market has major cost components like transaction costs, custodial charges, financing costs, taxes, etc. In case of commodities, it also includes costs such as warehousing cost, insurance cost, etc. As these cost components may be different for different market participants, practically, there may be as many theoretical prices as participants, in the market. Indeed, all these costs together create non-arbitrage bound across the cash prices, within which arbitrage may not be economical.

Illustrations of Cash and Carry Arbitrage The following data is available on stock S as on December 1, 200X. Cash market price

Rs 4,555

December futures

Rs 4,600

Contract multiplier for stock

100 shares

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An assumed implied cost of carry of 8 per cent p.a., i.e. 0.75 per cent per month. Theoretically, the fair price of December futures is 4590 (4555 * exp.0075), and therefore one may say that December futures on stock S are overvalued. To benefit from this differentiation, an arbitrager may buy 100 shares of stock S and sell 1 futures contract on that, at the given prices. This would result in an arbitrage profit of Rs 1,000 (100 * 10), which is the difference between the actual and fair price for 100 shares. The position of the arbitrager in various scenarios of stock price would be as follows: Case I: The stock rises to Rs 4,800 Profit on underlying = (4800 – 4555) × 100 = Rs 24,500 Loss on futures = (4800 – 4600) × 100 = Rs 20,000 Gain on arbitrage = Rs 4,500 Cost of arbitrage in terms of financing (Rs 35 for 100 shares) = Rs 3,500 Net gain from the arbitrage = Rs 1,000 Case II: The stock falls to Rs 4,200 Loss on underlying = (4555 – 4200) × 100 = Rs 35,500 Profit on futures = (4600 – 4200) × 100 = Rs 40,000 Gain on arbitrage = Rs 4,500 Cost of arbitrage in terms of financing (Rs 35 for 100 shares) = Rs 3,500 Net gain from the arbitrage = Rs 1,000 Note: Transaction costs and execution errors have not been taken into consideration, and in a real life situation, these may render this arbitrage unattractive.

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Illustration of Reverse Cash and Carry Arbitrage Reverse cash and carry arbitrage is done when the futures are trading at a discount to the cash market price. For example, the data on stock K on December 1 is: Cash market price

Rs 600

December futures price

Rs 590

The prices being traded in the market reflect a negative cost of carry, which offers traders an opportunity to execute reverse cash and carry arbitrage, as the cost of carry should reverse to positive at some point during the life of the contract. Even otherwise, if the trader carries his position till the expiry of the contract, it will yield him an arbitrage profit. The assumption in implementing this arbitrage opportunity is that the arbitrager has the stock to sell in the cash market, which will be bought back at the time of reversing the position. If the stock is not available, the arbitrager has to borrow the stock in order to implement the arbitrage. In that case, while analysing the profitability from the transaction, the cost of borrowing the stock will also be taken into account. Assuming that the contract multiplier for the futures contract on stock K is 400 shares, the arbitrager will buy one December futures @ 590 and sell 400 stock K @ 600 in the cash market in order to execute the reverse cost and carry. This will result in the arbitrage profit of Rs 4,000 (400 * 10). The position of the arbitrager in various scenarios of stock price would be as follows: Case I: The stock rises to Rs 650 Loss on underlying = (650 – 600) × 400 = Rs 20,000 Profit on futures = (650 – 590) × 400 = Rs 24,000

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Net gain from the arbitrage = Rs 4,000 Case II: The stock falls to Rs 550 Profit on underlying = (600 – 550) × 400 = Rs 20,000 Loss on futures = (590 – 550) × 400 = Rs 16,000 Net gain from the arbitrage = Rs 4,000 A crucial assumption in the previous example is that on maturity, futures prices converge with the cash prices of the underlying and the arbitrager is in a position to buy the stock back at the closing price/settlement price of the day. Here again, transaction cost and execution error, which in a real situation may make this arbitrage unattractive, have not been taken into consideration. It is also assumed that the company does not pay any dividend during the life of futures contract. The assumption in the preceding examples is that if the positions (cash and futures) are held until maturity, one can always square off one’s positions before the expiry of the contracts, when market prices are favourable. Thus, if in the example of reverse cost and carry, the cash price of stock K is Rs 630 and December futures are at 635, on any day prior to the maturity date in the month of December, the arbitrager can reverse both his positions, i.e. buy the stock at Rs 630 and sell the futures at Rs 635. This will result in the following position: Loss on underlying = (630 – 600) × 400 = Rs 12,000 Profit on futures = (635 – 590) × 400 = Rs 18,000 Net gain from arbitrage = Rs 6,000 The preceding example on reverse cash and carry arbitrage can also be expanded to include the interest income generated

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by investing the sale proceeds of the stock and/or the borrowing cost for the stock.

Inter-market Arbitrage This arbitrage opportunity arises because of some price difference existing in same underlying at two different exchanges. If December futures on stock Y is trading at Rs 276.50 at the NSE and Rs 277.50 at the BSE, a trader can buy a contract at the NSE and sell it at the BSE. These positions may be reversed over a period of time, when the difference between the price of stock futures on Y reduces or reverses at both the exchanges. This would result in a profit to arbitrager. Here also, the cost of transaction and other incidental costs involved in the deal must be analysed properly by the arbitrager before entering into any transaction. One may thus conclude that derivatives provide market participants with a quick and less expensive mode alongwith leverage facility to alter their portfolio composition in order to arrive at the desired level of risk. As they can be used either to add or reduce the risk of the existing portfolios, they are essentially risk management and portfolio restructuring tools. One may wonder why derivatives are considered risky, if they are so useful. This is essentially due to their leveraged nature. Leverage means the ability of market participants to take a position in the market in multiples of their financial resources. As positions in the derivatives market can be taken with payment of a small margin, they provide a high degree of leverage. Due to this high leverage, market participants may take positions beyond their risk appetite and in case of any adverse movement of the market, they may end up booking huge losses. Nevertheless,

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this may be viewed as the problem of market participants and not of derivatives. In other words, derivatives may serve either purpose, depending on how they are used by market participants. In conclusion therefore, one may say that although risks exist everywhere and in various products and processes, the focus must be to explore the means to deal with these risks, efficiently and effectively. Accordingly, in relation to derivatives, the focus has largely been on the development of human resource competence and on augmenting their operational risk management capabilities.

Summary 1. The derivatives market is a market, where the risk is traded. Derivatives facilitate the transfer of risk/risks from one set of market participants, who do not want to carry it (hedgers) to another set of market participants, who intentionally take it on (speculators). 2. Price risk is the risk of price movement of an asset, held by a market participant, in an unfavourable direction. This risk is divided into two components—specific or unsystematic risk and market or systematic risk. 3. Specific or unsystematic risk is the component of price risk that is generated by the specific events of the company and industry. This risk is inseparable from investment in securities. This risk can be reduced to a certain extent by taking well-informed investment decisions based upon research.

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4. Market or systematic risk is the component of the price risk, which is generated by factors other than those related to the company and industry. This risk is separable from the investment and is tradable in market with the help of index-based derivatives 5. Default risk, liquidity and operational risks are other risks that investors may encounter in the securities market. 6. Default or credit risk means a possibility that one of the parties to a contract may not honour his/her obligation. 7. Liquidity risk relates to poor tradability/liquidity of securities/contracts in the market. 8. Operational risks are the risks that originate from factors such as human error, fraud, system failures, etc. 9. There are three major players in the derivatives market— hedgers, speculators, and arbitragers. Hedgers operate in order to reduce their risk, speculators take on the risk jettisoned by hedgers and arbitragers establish an efficient link between different markets. Each one of them plays a role that is important for the market to survive. Hedgers will not be able to hedge their positions if there are no speculators in the system. For the futures market to succeed, the presence of both hedgers and speculators is essential. 10. Beta is a measure of systematic risk (it is not itself the systematic risk). It measures the sensitivity of a scrip/ portfolio vis-a-vis index movement. The beta of a scrip is index specific. Betas of individual scrips are used while calculating beta of the portfolio. It is simply calculated as the weighted average of betas of individual scrips in the portfolio based on the proportion of their investment.

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11. If a trader wants perfect hedge against the systematic risk with the use of index futures, he can make use of the beta to calculate what is called hedge ratio – Number of contracts for perfect hedge = V p * b p /Vi

V p —Value of the portfolio b

p

—Beta of the portfolio

Vi —Value of index futures contract 12. Hedge terminology: (a) Long hedge—A transaction when a position in the cash market is hedged by going long in the futures market. (b) Short hedge—A hedge accomplished by going short in the futures market. (c) Cross hedge—Generally, when a futures contract is not available on an asset, market participants look forward to an asset that is closely associated with their underlying and trades in the futures market, for the purpose of hedging. (d) Hedge contract month—The maturity month of the contract through which the position is hedged. 13. Speculators take positions in the futures market without having a position in the underlying cash market. They take either naked positions or spread positions. 14. A naked position is either a long (bought) or short (sold) position in any of the futures contracts. In case of a spread, two opposite positions (one long and one short) are taken either in two contracts with the same maturity on different products or in two contracts with different maturities on

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the same product. The former is called inter-commodity or inter-product spread and latter is called calendar spread/ time spread or horizontal spread.

Questions 1. Systematic risk is: (a) The market risk (b) The diversifiable risk (c) Managed by the futures on indices (d) Both (a) and (c) (e) Both (b) and (c) 2. Who are the players in the futures market? (a) Speculators (b) Hedgers (c) Arbitragers (d) Only (a) and (b) (e) (a), (b) and (c) 3. Which of the following is false with regard to speculators in the futures market? (a) The presence of speculators is essential in the system (b) They contribute towards higher liquidity in the market (c) They contribute towards bringing down the cost of transactions in the system

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(d) They contribute towards better price discovery in the market (e) None of the above 4. A portfolio consists of three scrips with weightages of 0.25, 0.50 and 0.25, respectively. The betas of individual scrips are 2.00, 1.20 and 0.80 respectively. The beta of the portfolio is, therefore: (a) 1.40 (b) 0.90 (c) 1.30 (d) 2.00 (e) None of the above 5. The portfolio in the above question will be called: (a) An aggressive portfolio (b) A conservative portfolio (c) An index portfolio (d) None of the above 6. The beta of an equally weighted portfolio is 2. There are 5 scrips in the portfolio. Beta values of 4 scrips are 1.30, 2.10, 1.80 and 2.50 respectively. Therefore, the beta of the 5th scrip is: (a) 1.70 (b) 2.30 (c) 2.50 (d) 3.00 (e) None of the above

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7. The beta of a portfolio vis-a-vis the BSE Sensex is 4.0. One month futures contract on the BSE Sensex is trading at 10000. Find the value of the portfolio, if the hedge is to be a perfect one (assume that holder of the portfolio enters into two contracts in index futures and the contract multiplier for the BSE Sensex futures contract is 50): (a) Rs 150,000 (b) Rs 200,000 (c) Rs 250,000 (d) Rs 300,000 (e) Rs 350,000 8. A trader has Rs 30,000 with which he buys scrips, with beta value of 1.2. Another option open to him is to buy one Nifty futures contract at a level of 2900 using the same Rs 30,000 as margin. If the market goes up by 10 per cent, what is the difference between the profit he will make in the cash and futures markets (assume that the futures index has beta 1 vis–a-vis the cash index and the contract multiplier for the Nifty futures contract is 100)? (a) Rs 15,600 (b) Rs 18,800 (c) Rs 25,400 (d) Rs 29,000 (e) Rs 32,600 9. The beta of Cipla is 1.5 vis-a-vis the Nifty. A trader has a long position in Cipla worth Rs 600,000, coupled with a short Nifty position of Rs 600,000. Which of the following is true for the trader:

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(a) He has a partial hedge against the market risk in Cipla (b) He has a complete hedge against the market risk in Cipla (c) He is over-hedged 10. An investor expects that the rupee will depreciate and hence the profit of export-oriented information technology companies will go up. He is long on Infosys to the extent of Rs 20 lacs. The beta of Infosys is 1.35 vis-a-vis the Nifty. He wants to remove the effect of market movements from his holding. He can remove his market risk by: (a) Shorting Nifty futures worth Rs 27 lacs (b) Shorting Nifty futures worth Rs 13.5 lacs (c) Shorting Nifty futures worth Rs 20 lacs (d) Taking a long position in Nifty futures worth Rs 27 lacs 11. Mr X buys 1000 shares of HLL at Rs 250 each and obtains a complete hedge by shorting one Nifty futures contract at 3000 (multiplier Rs 100). Both his positions are closed on the next day; HLL has gone down by 2 per cent and the Nifty has gone up by 1 per cent. What is his overall profit/ loss? (a) Profit of Rs 8,000 (b) Loss of Rs 8,000 (c) Loss of Rs 2,000 (d) Profit of Rs 2,000 12. On July 1, 2006, an investor has a portfolio worth Rs 20 lacs, which has a beta of 0.5 vis-a-vis the Nifty. There is a marriage in the family at the end of September 2006,

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so he wants to totally eliminate his market risk. What is the correct hedging strategy? (a) Buy futures worth Rs 20 lacs for September 2006 expiration (b) Short futures worth Rs 10 lacs for September 2006 expiration (c) Short futures worth Rs 20 lacs for September 2006 expiration (d) Do nothing and keep the portfolio intact to sell, when the money is needed, in September 2006 13. The risk(s) faced by a derivatives trader on an exchange are: (a) Operational risk (b) Credit risk (c) Market risk (d) Both (a) and (c) (e) Both (b) and (c) 14. Short hedge through futures means: (a) Hedging short position of cash market by long futures position (b) Hedging long position of cash market by short futures position (c) Hedging long position of cash market by long futures position (d) Hedging short position of cash market by short futures position

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15. Hedging a long position in jet fuel by a short position in crude oil, is an example of: (a) Long hedge (b) Short hedge (c) Cross hedge (d) None of the above Answers to the Questions 1. (d)

2. (e)

8. (c)

9. (a) 10. (a) 11. (b) 12. (b) 13. (d) 14. (b)

15. (c)

3. (e)

4. (c)

5. (a)

6. (b)

7. (c)

Chapter 4

Futures Pricing Pricing of futures contracts is quite simple. This chapter explains the fundamentals of futures pricing through two popular models—cash and carry model and expectancy model. Since the pricing of futures is heavily dependent on the characteristics of the underlying asset, these models must be adjusted to fit in the specific requirements of the underlying asset.

The pricing of futures contracts is heavily dependent upon the characteristics of the underlying asset. Different assets have different demand and supply patterns, different characteristics with regard to their carriability (some are carriable and some are not) and cash flow patterns (some generate returns and some don’t). Hence, there is no single way of pricing futures contracts. In practice, market participants use different models for pricing futures on different assets. Two popular models of futures pricing discussed here are the cash and carry model and expectancy model.

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Cash and Carry Model for Futures Pricing This topic was introduced in the previous chapter, while discussing arbitrage opportunities in the futures market. The cash and carry model for pricing futures is also known as nonarbitrage model for futures pricing and assumes that arbitrage opportunities cannot exist in an efficient market. In other words, arbitrage opportunities in an efficient market can at the best be momentary viz. the moment there is an opportunity to make profit in the markets due to mis-pricing of an asset and its replicas, arbitragers will start trading in order to eliminate these opportunities. This trading will continue until the prices are aligned across the products/markets for replicating assets. This concept can be elaborated with the help of an illustration. Practically speaking, there are two ways to create a forward/futures position in a stock. 1. Enter into a forward/futures contract, or 2. Create a synthetic forward/futures position by buying in the spot market and carrying the asset to a future date. The price of acquiring the asset on a future date through either of the modes should be the same i.e. the cost of synthetic forward/futures contract (spot price + cost of carrying the asset from present to the future date) should be equal to the price of readymade forward/futures contract. If it is not, it will trigger arbitrage that will continue until the prices in both the markets are aligned. The cost of creating synthetic futures position may be called the fair price of futures contract. Thus, fair price of futures

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contract is equal to the spot price of the underlying asset plus the cost of carrying the asset from present to the future date. Different kinds of costs such as transaction cost, custodial charges, financing cost, taxes, etc. may be included in the cost of carrying the asset to the future date. In case of commodities, it will also include costs such as warehousing cost, insurance cost, etc. Consider, for example, a situation in the bullion market where gold is available in the cash market at Rs 9,000 per 10 grams and cost of financing, storage and insurance for carrying the gold for three months is Rs 100 per 10 gram. Thus, one may say that the value of gold (synthetic futures value or fair value of futures) at the end of three months will be Rs 9,100 per 10 gram. It is further assumed that a 3 months futures contract on gold is trading at Rs 9,150 per 10 gram. One must attempt to exploit the arbitrage opportunity that exists in the gold market by buying gold in the cash market and selling it in the futures market, simultaneously. It is therefore necessary to borrow money in order to take delivery of gold in the cash market, hold the gold for three months and then deliver it in the futures market to honour the futures contract. The money received on the performance of futures contract will be used to repay the financer of the gold. This will result in a profit of Rs 50 per 10 gram of gold, assuming that there is no other cost involved in the transaction. If many people purchase gold in the cash market and sell it in the futures market, price of gold will rise in the cash market and fall in the futures market. This arbitrage on gold between the cash and futures markets will continue until the prices between the cash and futures markets are aligned.

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Therefore, if the futures price is more than the future fair price of asset/synthetic futures price, it will trigger cash and carry arbitrage, which will continue until the prices in both the markets are aligned. Similarly, if the futures price is less than the future fair price of asset/synthetic futures price, it will trigger reverse cash and carry arbitrage i.e. people will sell gold in the cash market and buy it in the futures market. In this situation, they will borrow the gold, deliver it to honour the contract in the cash market, invest the proceeds of the cash market sale to earn a return and give the gold back to the lender on receipt of the same in the futures market, after three months. This reverse arbitrage will result in reduction of the cash price of gold and an increase of its price in futures, until these prices are aligned with each other.

Cost of Transaction and Non-arbitrage Bound The cost components of futures transaction such as margins, transaction costs (commissions), taxes, etc. generally create distortions and upset the equilibrium of the markets and may also create a non-arbitrage bound in the market. This means that if the futures price is within this bound around the future fair value/synthetic futures value, the arbitrage will not take place. In other words to trigger arbitrage, due to the frictions in the market, it is necessary for futures prices to fall beyond the nonarbitrage bound in either direction.

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Fair price

Non-arbitrage bound

Fig. 4.1: Illustration of a non-arbitrage bound

Practically speaking, every component of carrying cost contributes towards widening the non-arbitrage bound and wider the non-arbitrage bound, farther away from equilibrium the markets are. In other words, in order for markets to be efficient, different costs related to operating in the markets should be as low as possible. Lower costs will narrow down the non-arbitrage bound, which in turn will ensure efficient price alignment across the markets. Furthermore, as the various cost components are not the same for different market participants, the non-arbitrage bound also differs among them.

Extension of Cash and Carry Model to Assets, Generating Returns The concept of cash and carry can be further extended by adding the inflows on holding assets. For instance, if the underlying asset is securities (equity or bonds), there may be certain inflows (dividend on equity and interest on debt instruments) during the holding period. In order to adjust this factor, it is necessary

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to slightly modify the formula of future fair price or synthetic futures price as follows: Fair price = Cash price + Cost of carry – Inflows In mathematical terms, Fair Price F = S (1 + r – q)T, where q is the expected return during the holding period and T and r are the time to maturity and the interest rate. If continuous compounding is used, the formula may be rewritten as F = Se(r – q) * T This formula can be applied to the index futures market in order to determine the synthetic futures price/future fair price of an index. Assume, that index in the cash market is bought at a level of 2960 (all the scrips constituting the index in the same proportion as they are in the index), cost of financing is 12 per cent and the return on index is 4 per cent per annum (spread uniformly over the year). Based on this, fair price of the index after three months should be: Spot price + Spot price (cost of financing – holding period return) * time to expiration/365 = 2960 + 2960 (0.12–0.04) * 90/365 = 3018.38 (Alternatively, the exponential form for calculating the futures value may be used i.e. Se(r – q) * T. In this case, the value will be 2960 * e((.12 – .04) * 90/365), i.e. 3018.97]. Based on these calculations, if the index futures for three months maturity are trading at a level above 3018.38, one can buy cash index and simultaneously sell index futures to lock the gains equivalent to the difference between the futures price and the future fair price (the cost of transaction, taxes, margins etc. are not taken into consideration while calculating the future fair value).

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It is important to note that as the cost of borrowing funds and securities, return expectations on the held asset etc. are not same for different market participants, there can be as many fair values of futures as there are market participants in the market. Perhaps, the market moves on a continuous basis only as a result of the difference among the fair values of futures contracts and non-arbitrage bound for the various market participants.

Assumptions in the Cash and Carry Model The cash and carry model of futures pricing works under certain assumptions. The important ones are as follows: l

l

l

The underlying asset is available in abundance in cash market There is no seasonal demand and supply in the underlying asset The storability of the underlying asset is not a problem i.e. the asset is carriable

l

The underlying asset can be sold short

l

No transaction costs are applicable

l

No taxes are applicable

l

There are no margin requirements

Note: This is not an exhaustive list of the assumptions of the model.

The assumption that an underlying asset is available in the cash market in abundance i.e. as much underlying asset as wanted

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can be bought and/or sold does not work in many cases, particularly when there is a seasonal pattern of demand and supply in the underlying asset. The prices of these seasonal assets (specially commodities) vary drastically in different demandsupply zones. When supplies arrive in the market, prices are generally low and immediately prior to supplies, prices are generally high. Furthermore, if the underlying asset is not storable, it cannot be carried to the future and therefore, it is not possible to follow the cash and carry model of futures pricing. The cash and carry model is thus not effective in the case of this type of underlying asset. Similarly, in many cases the underlying may not be sold short and this is particularly true in relation to seasonal commodities. Although this simple form of cash and carry model does not discount for transaction cost, taxes etc. the formula can be upgraded to reflect the impact of these factors in the model. Further, this model does not take margins into consideration while delivering the fair value/synthetic futures value and that is why it is more suitable for pricing forward contracts rather than futures contracts. No generalisation can therefore be made with regard to the use of cash and carry model for pricing futures contracts. In other words, one needs to decide whether a specific asset can be priced with the help of this model or not based on the assumptions of the model and characteristics of the underlying asset. In addition, suitable adjustments need to be made in the model in order to fit in the specific requirements of the underlying assets.

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Convenience Yield An important concept related to the concept of pricing in the futures market is convenience yield. As discussed earlier, the formula for determining the fair price of futures contract is, Fair price of futures contract = Cash price + Cost of carry – Inflows While generally inflows are in the form of dividend (in case of equity) and interest (in case of debt), they may sometimes also be in the form of intangibles. Essentially, intangible inflows are the values that market participants perceive in holding the physical asset. These values may be in the form of convenience or the perceived mental comfort of holding the asset. For instance, in any period of crisis there is a rush to hoard essential commodities such as grains, vegetables and energy products (e.g. heating oil) etc. This inflates the demand and creates paucity of assets in the cash market and thus pushes up the prices of assets. In such a situation, people essentially derive convenience merely by holding the asset. This is termed as convenience return or convenience yield. The convenience return for a commodity is likely to vary for different people, based upon its utility value to them and may change over a period of time. In fact, convenience yield/ return is a subjective issue and therefore very difficult to price although there are ways of doing this. Sometimes, the inflow in terms of convenience yield may be more predominant than the cost of carry and hence, futures may trade at a discount to the cash market. In this case, reverse arbitrage is also not possible because no one is prepared to lend

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speculators the assets to enable them to sell short in the cash market. In such a situation, the cash and carry model breaks down and cannot be applied for pricing the underlying assets.

Expectancy Model of Futures Pricing As seen earlier, cash and carry model of futures pricing cannot work if the underlying asset is not carriable. This is particularly true in the case of agricultural commodities where it is quite common for the futures prices of underlying assets to be at a discount to the cash prices. For instance, the price of an underlying asset in the cash market may be at a premium to the futures price just before the crop season, but it is not really possible to short the asset. In such situations, there is no link between the cash and futures prices and they are governed purely by the demand and supply factors during the prevailing times. If futures do trade on these assets, how can they be correctly priced?” The expectancy model for futures pricing provides the answer to this question. The model is based on the philosophy that it is the relationship between expected spot and futures prices rather than that of cash and futures prices which move the market, especially in cases when the asset cannot be sold short or cannot be stored. In other words, the expectancy model states that the futures price is nothing other than the expected spot price of an asset in the future and therefore market participants will price the futures based upon their estimates of the future spot prices of the underlying assets. According to this model, first point is that futures can either be at a premium or at a discount to the cash prices of the underlying asset. Secondly, futures prices give market participants

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an indication of the direction in which the cash prices are likely to move in the future. Thus, if futures are trading above the cash price for an asset, market participants may expect the cash price of this asset to go up in the future. This anticipated rising market is called contango market. Similarly, if futures are trading below the cash price for an asset, market participants may expect the cash price of this asset to go down in the future. This expected falling market is called backwardation market. It is vital at this point to understand an important term of the futures market, which is called basis. Basis is defined as the difference between the cash and futures prices i.e.: Basis = Cash price – Futures price If futures price of an asset is higher than its cash price, basis for the asset is negative. In contrast, if cash price of an asset is higher than its futures price, basis for the asset is positive. For example, if cash Nifty index is at the 3000 level and 2 months futures on the Nifty is trading at 3020, the basis is 20 points negative. Similarly, if futures index is trading at 2985, the basis is 15 points positive. Hence, a negative basis reflects the upward expectations about the market and positive basis shows the downward expectations about the market. In other words, a contango market has a negative basis and a backwardation market has a positive basis. Importantly, the basis for one month contract will be different from the basis for two or three month contracts. Therefore, the definition of basis is incomplete until we define the basis vis-avis a futures contract i.e. basis for one month contract, two months contract etc. It is also important to understand that the difference in the basis between a one month and a two months futures contract should essentially be equal to the cost of carrying

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the underlying asset for the period between the first and second month. Indeed, this is the fundamental of linking together various futures and underlying cash market prices. Due to changes in the expectations of the market, a futures contract, which is trading at a discount, may turn into a premium or vice versa. Thus, a positive basis may become negative or a negative basis may become positive during the life of the contract, as a result of changes in the expectations of the market. Further, whether the basis is positive or negative, it becomes zero on maturity of the futures contract i.e. there cannot be any difference between one month futures price and the cash index at the time of maturity/expiry of this one month contract. This happens because final settlement of futures contracts on the last trading day takes place at the closing price of the underlying asset. This phenomenon may be depicted as follows:

Positive basis B A S I S

At maturity

Time

Negative basis

Fig. 4.2: Basis movement with time to maturity

This issue may also be considered from a different point of view. For example, when the current price of January 200X Nifty futures contract is 2950, it means that the market expects the cash index to settle at 2950 at the closure of the market on the last Thursday of January 200X (last trading day of the contract). In other words, every market participant tries to predict the cash index at a single point i.e. at the closure of the market on

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the last trading day of the contract and that level is 2950 in the instant case. Since the futures price is the expected cash price, both futures and cash indices converge at maturity/expiry of the futures contract. Indeed, on the last day of trading of the futures contract, closing cash market prices are taken as settlement prices in order to close/settle all open positions in futures at the maturity/expiry of the contract.

Summary 1. Pricing of futures contracts is heavily dependent on the characteristics of the underlying asset. As different assets have different demand and supply patterns, different characteristics with regard to their carriability (some are carriable and some are not) and cash flow patterns (some generate returns and some do not), there is no single method of pricing futures contracts. Two popular models of pricing futures contracts are cash and carry model and expectancy model. 2. Cash and carry or non-arbitrage model for futures pricing assumes that in an efficient market, arbitrage opportunities cannot exist. In other words, arbitrage opportunities in an efficient market can at the best be momentary. 3. The fair price of a futures contract will be the sum of the spot price of the underlying asset and the cost of carrying the asset from the present to a future date (Fair price F = cash price + cost of carry). Cost of carrying the asset up to the future date entails different kinds of costs such as transaction cost, custodial charges, financing cost, taxes, etc. In the case of commodities, it also includes costs such as warehousing cost, insurance cost, etc.

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4. If the concept of cash and carry is extended to assets like securities (equity or bonds), there may be certain inflows (dividend on equity and interest on debt instruments) during the holding period. To adjust this factor, the formula of future fair price or synthetic futures price is modified as follows: (a) Fair price = Cash price + Cost of carry – Inflows (b) Mathematically, Fair Price F = S (1 + r – q)T where, q is the expected return during holding period, and T and r is cost of carry. (c) Using continuous compounding, fair price may be written as F = Se(r – q) * T 5. There are many assumptions behind the cost and carry model. Some of them are—the underlying asset is available in abundance in cash market, there is no seasonal demand and supply in the underlying asset, storability of underlying asset is not a problem, the underlying asset can be sold short, there are no transaction costs, taxes, margin requirements, etc. Indeed, there are many more assumptions in the model. We may upgrade above formula for futures pricing for adjusting various issues. 6. Intangible inflows essentially mean values that are perceived by the market participants just by holding the physical asset. These values may be in the form of convenience or perceived mental comfort. In financial terms, this is called convenience return or convenience yield. 7. The philosophy behind the expectancy model for futures pricing is that it is not the relationship between cash and

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futures prices but the expected spot and futures prices which moves the market, especially in cases when the asset cannot be sold short or stored. In other words, expectancy model states that futures price is merely the expected spot price of an asset in the future. Therefore, market participants price the futures based on their estimates of the future spot prices of the underlying assets. 8. Futures can be either at a premium or at a discount to the cash prices of underlying assets. Futures prices give market participants an indication of the direction in which the cash prices are likely to move in the future. 9. Basis is defined as the difference between cash and futures prices. A negative basis reflects the upward expectations regarding the market and a positive basis indicates the downward expectations regarding the market. Thus, a contango market has a negative basis and a backwardation market has a positive basis. Further, whether the basis is positive or negative, it turns to zero at the maturity of the futures contract.

Questions 1. What should be the value of a 6 months forward contract of a share if it is quoting in the cash market at Rs 100? The share is expected to declare a dividend of Rs 4 after three months. Assume the interest rate in the economy as 10 per cent. (a) Approx. Rs 99 (b) Approx. Rs 103

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(c) Approx. Rs 101 (d) Approx. Rs 105 (e) Approx. Rs 108 2. The current value of Nifty is 3167. The interest rate in the economy for borrowing for 3 months is 12 per cent per annum. The dividend yield on the Nifty is expected to be 3 per cent per annum. The value of the futures contract which has 3 months to expiration should be: (a) 3238.25 (b) 3167.06 (c) 3312.74 (d) 3179.81 (e) 3215.37 3. Which of the following is not an assumption in a cost and carry model of futures pricing? (a) No seasonal demand and supply in the underlying asset (b) The asset is carriable (c) The underlying asset can not be sold short (d) No transaction cost (e) The underlying asset is available in abundance Answers to the Questions 1. (c)

2. (a)

3. (c)

PART 2

OPTIONS

Chapter 5

Basics of Options This chapter introduces readers to the exotic world of options. Options are fundamentally different from forward and futures contracts. While in a forward or futures contract both the contracting parties have an obligation to honour the contract, in case of options, the seller has an obligation and the buyer has a right in the contract, which he may or may not exercise. The chapter discusses the different technical aspects of options and explains these with the help of illustrations. It also elaborates extensively the risk management and margining product, Specific Portfolio Analysis of Risk (SPAN), designed by the Chicago Mercantile Exchange (CME), which both exchanges in India, Mumbai Stock Exchange (BSE) and National Stock Exchange (NSE) use under license from the CME.

India joined the league of countries that trade options on exchanges, in the year 2001 with the introduction of options on securities indices. Subsequently, in 2002 it added options trading on individual stocks. Although it may be difficult to track the origin of options trading in the country, it is believed that they have been in existence in different dimensions of the economy for a long time. Today, India also trades currency options in the OTC market.

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Worldwide, options are traded on a wide range of underlying assets, viz. commodities, securities, currencies, indices, etc. An active over-the-counter-market (OTC market) in options on securities has been in existence in the US for more than a century but they were first traded on an organised exchange in 1973, when the Chicago Board Options Exchange (CBOE) came into existence. CBOE began trading in options with call options on 18 stocks. Since then, worldwide growth of options on securities in both organised as well as unorganised markets has been unprecedented. Prior to the CBOE, options were traded in the OTC market under the auspices of the “Put and Call Dealers Association.”

Option Contract An option is a right that the option seller gives to the option buyer to buy or sell an underlying asset at a predetermined price, within or at the end of a specified period. The party taking a long position, i.e. buying the option is called the buyer/holder of the option and the party taking a short position, i.e. selling the option is called the seller/writer of the option. The option buyer who is also called long on option, or long premium or holder of option, has the right and no obligation with regard to buying or selling the underlying asset while the option seller/writer who is also called short on option or short on premium, has the obligation but no right, in the contract. In other words, the option buyer may or may not exercise his option but if he decides to exercise it the option seller/writer is legally bound to honour the contract. It is important to note that although the term “writer of option” is widely used in the options market, no physical document is

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created on the exchanges and all transactions are recorded electronically by the exchange/clearing corporation/house. Practically speaking, the term “writer” is pertinent in the OTC market where a physical document is signed by the seller and given to the buyer as proof of his obligation under the contract.

Terminology used in Options Market Options can be categorised as call or put options depending upon the right conferred on the buyer. An option, which gives the buyer a right to buy the underlying asset, is called a call option and the option, which gives the buyer a right to sell the underlying asset is called put option. Further, an option that can be exercised at any time on or before the expiry date/day is called an American option and the option which can be exercised only on its expiry, is called a European option. The price at which an option is exercised is called the strike price or the exercise price. The date/day on which an option expires or the contract ceases to exist is called the expiration date/day of the option. The date/ day on which an option is exercised is called the exercise date/day of the option. The expiration date/day and the exercise date/ day may differ in case of an American option but will be the same in case of a European option, in the event that the option buyer exercises the option. Option writer has an obligation and option buyer has a right under the contract and when the option writer gives this right to the option buyer, he charges him for it. The price that the option buyer pays the option seller for this option/right is called the option premium. An option premium is the inflow to the option writer irrespective of whether the option holder exercises his option or not.

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Although options have been defined here in very simple terms, at present, a wide variety of options are available both in India and in markets around the globe.

Risk and Return Profile of Option Contracts As discussed, option buyer has a right but no obligation in an options contract and he will exercise this right only when he is likely to benefit by doing so. For example, if he holds a call option on a particular stock he will exercise his option only when the market price of that stock is higher than the strike price so that he profits from the difference between the market price and the strike price. Thus, the profit potential of option buyer is unlimited as there is no cap on stock prices. If however, the market price is lower than the strike price option buyer will let his option expire without exercising it, in which case he will lose a limited amount of the option premium. Therefore, an option buyer bears a limited amount of risk (his maximum loss is the premium paid to the option writer) but his profit potential is unlimited. Conversely, as the profit/ loss of an option buyer reflects the loss/profit of an option seller, the seller carries an unlimited risk with a limited return potential (his maximum gain is the premium received from option buyer). Thus, the risk and return profile of an option contracts is asymmetric unlike that of a futures contract. The concept is better understood with the help of an example. Assume that Mr A gives Mr B a right/option to buy (call option) one share of stock S at Rs 7,000 (strike price) for settlement after one month. The right/option can be exercised any

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time during the life of the contract and hence the option is an American option. The current market price of stock S is also Rs 7,000 (cash price). Assume, that Mr A has charged Mr B Rs 300 (option premium) as the price for purchasing this option/right. Mr B will not exercise his option as long as the cash price of stock at time t, St is less than Rs 7,000 because by doing so he will incur the loss equivalent to 7000 – St . He may decide to exercise his option any time during the currency of contract if market price of the stock is above Rs 7000. However, if market price of the stock is between Rs 7,000 and Rs 7,300 when he decides to exercise the option, he will incur a loss equivalent to the difference between Rs 7,300 (strike price + option premium) and the prevailing market price of the stock. For instance, if market price of the stock at that time is Rs 7,200 his loss will be Rs 100 (7,200 – 7,000 – 300) because his total outflow is Rs 7,300 and the inflow from the sale of the share will be Rs 7,200. He will breakeven at the stock market price of Rs 7,300 and if the market price is above Rs 7,300 at the time of exercise of the option, he will make a profit. Thus, if the market price at that time is Rs 7,400 Mr B will make a profit of Rs 100 (7,400 – 7,000 – 300). The pay-off profiles of the buyer and seller of such a call option are shown in Figures 5.1 and 5.2 respectively.

Profit zone Profit/ loss to option buyer (Rs)

7000 Asset price 7300

300

Fig. 5.1: Pay-off profile of a call option buyer

Loss zone

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In view of the preceding, one can say that a call option holder will make profit from an option only if price of the underlying asset rises above the exercise/strike price plus the option premium at the maturity of the contract or time of exercise of the option. As the pay-off profile for a call option seller is the mirror image of that of a call option buyer, he will make profit only if stock price is less than the strike price plus the option premium. In other words, he will lose money only if the price of the underlying asset rises above the exercise/strike price plus the option premium. Profit zone

300 Profit/ loss to option buyer (Rs)

7300 7000

Asset price

Loss zone

Fig. 5.2: Pay-off profile of a call option seller

Similarly, in the case of a put option (option to sell) if Mr X buys a put option on the same stock with a strike price of Rs 7,000 at a premium of Rs 300 he will make profit only if the price of the stock goes below Rs 6,700 (strike price – option premium) at the maturity or time of exercise of the contract. On the other hand, a put option seller will lose money if the stock price is below Rs 6,700. The pay-off profiles for a put option buyer and seller are shown in Figures 5.3 and 5.4, respectively.

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Profit zone Profit/ loss to option buyer (Rs)

6700 7000 Asset price Loss

300

Fig. 5.3: Pay-off profile of a put option buyer Profit zone

300 Profit/ loss to option seller (Rs)

6700

7000

Asset price Loss

Fig. 5.4: Pay-off profile of a put option seller

Relationship between Strike Price of an Option and Market Price of the Underlying Asset An option contract, where the strike price is better than the market price of the underlying asset, is called in-the-money option (ITM). Therefore, a call option is in-the-money when market price of the underlying asset is more than the strike price and a put option is in-the-money when market price of the underlying asset is less than the strike price.

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An option contract, where the strike price is worse than the market price of the underlying asset, is called out-of-the-money option (OTM). A call option is out-of-the-money when market price of the underlying asset is less than the strike price and a put option is out-of-the-money when market price of the underlying asset is more than the strike price. An option contract where the strike price and market price of the underlying asset are equal is called at-the-money option (ATM) and an option is called near-the-money option (NTM) when strike price is very close to the market price of the underlying asset. The relationship between strike price of an option and market price of the underlying asset is summarised as follows: Market Scenario

Call Option

Put Option

Market price > Strike price

in-the-money

out-of-the-money

Market price < Strike price

out-of-the-money

in-the-money

Market price = Strike price

at-the-money

at-the-money

Market price @ Strike price

near-the-money

near-the-money

Option Premium As mentioned earlier, option buyer pays some amount to the option seller in order to acquire the right either to buy (call option) or to sell (put option) the underlying asset. This amount is called option premium and primarily consists of two components—intrinsic value and time value. Hence, Option price/premium = Intrinsic value of option + Time value of option

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The intrinsic value of an option is equal to the amount by which the option is in-the-money i.e. the amount an option buyer will realize make (the option seller will lose), before adjusting the premium, if he exercises the option instantly. Therefore, only in-the-money options have intrinsic value and all out-of-the-money or at-the-money options have zero intrinsic value. It may be noted that the intrinsic value of an option can never be negative. In notation terms, the intrinsic value of a call option at time t is Max. (0, St, – K ), where St is the market price of the underlying asset at time t and K is the strike price of the option. Hence, a call option will be in-the-money or will have intrinsic value only if its strike price is lower than the current market price of the underlying asset. Similarly, the intrinsic value of a put option at time t is Max. (0, K – St ), where St is the market price of the underlying asset at time t and K is the strike price. Hence, a put option will have intrinsic value or will be in-the-money only if its strike price is higher than the current market price of the underlying asset. Mathematically, if the cash price of an asset is Rs 50, any call option with a strike price less than Rs 50 will be in-themoney or will have intrinsic value. But, any put option with a strike price less than Rs 50 will be out-of-the-money or will not have any intrinsic value. On the other hand, any call option with a strike price that is more than Rs 50 will not have any intrinsic value but a put option with a strike price higher than Rs 50 will be in-the-money or will have intrinsic value. The time value of an option, which is also called extrinsic value of the option is the component of option premium which takes care of future risk for seller of the option. It can be defined as the quantification of probability of an out-of-the-money or

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at-the-money option going in-the-money, or an existing in-themoney option going deeper in-the-money during validity of the contract. This value depends on time to expiration of the option and volatility in the prices of the underlying asset. Mathematically, time value of an option is equal to the difference between the option premium and its intrinsic value. Hence, it is clear that in case of out-of-the-money option or at-the-money option, the entire premium paid by the option buyer to the option seller is time value of the option. Time value of an option also cannot be negative. The time value of an option also depends upon whether option is in-the-money, at-the-money or out-of-the-money. It is the maximum for at-the-money options due to the high uncertainty about the future movement of the price of underlying asset. As the option goes deeper in-the-money or out-of-themoney, as a result of lesser uncertainty with regard to the price of underlying asset, the time value of option diminishes. This is shown diagrammatically in Figs 5.5 and 5.6. Strike price

in-the-money

at-the-money

out-of-the-money

Fig. 5.5: Time value of options

The call option price curve in Fig. 5.6 indicates that on expiry of an option premium is a straight dotted line while during the

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life of option premium is a smooth curve. On maturity, option has no time value as there is no uncertainty about the price of underlying asset. In other words, at maturity, option has only intrinsic value. Figure 5.6 also indicates that the option has zero intrinsic value until the price of underlying asset reaches Rs 50 and as it increases above Rs 50 option begins to gain intrinsic value. Furthermore, time value of the option is maximum when stock price and strike price are the same i.e. the option is at-the-money. This happens because there is maximum uncertainty for the option seller at this point as the price of underlying asset may go either up or down with equal probability. The figure also shows that when stock price is far above or below the strike price i.e. the option is either deep-in-the-money or deep-outof-the-money, it sells for a price that is closest to its intrinsic value. Intrinsic value Call option price curve Premium (Rs)

Maximum time value premium Strike price

10 5

40

45

50

Asset price (Rs)

Fig. 5.6: Example of a call option price curve

55

60

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Relationship of Time Value with Time Figure 5.7 shows the relationship of call option value with time and indicates that as the time to maturity increases, total value of the call option also increases. This happens because risk to the option seller increases with lengthening time frame and consequently he demands compensation for that. However, lengthening maturity does not affect the intrinsic value of the option. In summary therefore, lengthening maturity of an option is reflected on the option premium in the form of increased time value.

9 months curve

Premium (Rs)

3 months curve

6 months curve

Strike price

Asset price

Fig. 5.7: Relationship of call option value with time

The time value of an option decreases as the option approaches maturity as illustrated in Fig. 5.8. It may be observed that the rate of decay of option time value is not linear over the life of option. It decreases at an accelerated rate as the option approaches maturity. Mathematically, rate of decay in time value

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of an option is related to the square root of time remaining to expiration. Thus, time value of a three months option decays at twice the rate of a nine months option (square root of 9 is 3) and similarly time value of a two months option decays at twice the rate of that of a four months option.

Time value premium (Rs) 3

2

1

0 Time to maturity

Fig. 5.8: Behavior of time value of an option

To conclude, some of the facts regarding option premiums may be re-stated as follows: 1. The value of an option at its maturity is equal to its intrinsic value. 2. The time value of an option is maximum for at-themoney options. 3. The time value of an option decreases at an accelerated pace during the last phase of its life. 4. When stock price is far above or below the strike price i.e. option is either deep-in-the-money or deep-out-ofthe-money, it sells for a price nearest to its intrinsic value.

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Comparison of Futures and Options Positions The salient features of futures and options contracts (both call and put) are as follows: Alternative Futures positions contract buyer

Futures contract seller

Call option buyer

Call option seller

Put option buyer

Trader’s rights

–

Buy underlying at strike price

–

Sell – underlying at strike price

–

Put option seller

Trader’s Accept obligations underlying at contracted price/Pay settlement difference

Deliver None underlying at contracted price/Pay settlement difference

Sell None underlying at strike price

Buy underlying at strike price

Premium paid or received

–

–

Paid

Received

Paid

Received

Margin requirement

Yes

Yes

No

Yes

No

Yes

Risk profile

Unlimited*, when prices go down

Unlimited, when prices go up

Limited to the extent of premium paid

Unlimited, if prices go up

Limited, to the extent of the premium paid

Unlimited**, if prices go down

Contd

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Box Contd Alternative Futures positions contract buyer

Futures contract seller

Call option buyer

Call option seller

Put option buyer

Put option seller

Profit potential

Unlimited*, if prices go down

Unlimited, if prices go up

Limited to the extent of the premium received

Unlimited**, if prices go down

Limited to the extent of the premium received

Unlimited, if prices go up

* Practically, risk of a futures buyer and profit of a futures seller are limited, as price of the asset cannot go below zero. ** In practice, risk of a put option seller and profit of a put option buyer are limited, as price of the asset cannot go below zero.

Risk Management in the Options Market As discussed in the section on futures, clearing corporation/house of the exchange handles the risk management of exchange-traded options by margining the positions of market participants. However, margining of positions in the OTC market is a matter of choice between the contracting parties who may in some cases, approach a third party to guarantee the transactions. In the course of risk management, clearing corporation/house of an exchange faces considerable risk from the market participants. Since an option buyer buys a right on an underlying asset and pays the premium upfront there is no risk to the system with regard to his position. An option seller on the other hand, carries an obligation till the maturity/exercise of contract and if the option buyer chooses to exercise his option it is possible that

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the option seller may default. Therefore, the exchange and/or clearing corporation/house imposes a margin only on the sellers’ positions. Consequently, only short option positions attract margins in the options market. There are two types of options that are traded worldwide— futures style options and premium style options. In the case of futures style options, the clearing corporation/house collects mark to market (MTM) losses and passes them to the gainer on a daily basis but in the case of premium style options it retains all the MTM losses collected. As MTM gains are passed on to the option buyers in the case of futures style options, adverse price movements will result in margin call to them, which will expose the clearing corporation/house to their credit risk. Hence, in the case of futures style options the clearing corporation/house also margins the positions of the option buyers. Most countries in the world trade premium style options rather than futures style options. A detailed note on the margining of option contracts is given as Annexure A to this chapter.

Introduction of New Option Contracts Current regulations require that the exchanges introduce an option on any underlying stock/Index with a minimum of seven strike prices—one at-the-money, three in-the-money and three out-of-the-money. This is required by the regulators in order to ensure that at any point in time, strikes are available both above and below the cash market price. Accordingly, any significant movement in the price of underlying asset triggers the introduction of new option contracts i.e. contracts with new strike prices but with the same maturity.

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Assume for instance that seven call option contracts are introduced—three in-the-money (strikes Rs 85, 90 and 95), one at-the-money (strike Rs 100) and three out-of-the-money (strikes Rs 105, 110 and 115)—on product X which is trading at Rs 100 in the cash market. If during the life of the contract cash price of X moves from Rs 100 to Rs 101, the call option with strike Rs 100 becomes near-the-money. As the market price moves up beyond 102.50, Rs 105 call option becomes nearthe-money and only two out-of-the-money strikes remain available. In this case, the exchange will introduce a new strike of Rs 120 to offer three out-of-the-money choices to the market participants. Currently, exchanges introduce new strikes only after trading hours i.e. if the market price of stock moves beyond 102.50 intra-day, 120 strike will not be introduced during the day. However, a new strike of 120 will be available for trading on the next day. Another important point is that the strike price interval (difference between two strike prices) varies from one stock to another depending on its market price and what is considered to be a significant movement in the price in relation to its market price. For example, strike price interval in case of Infosys is Rs 50 whereas in case of Tisco it is only Rs 10. Hence, strikes are available on TCS as 1800, 1830, 1860, etc. and in Tisco as 480, 490, 500, etc. This is generally determined by the exchanges based on the price of underlying at the time of introduction of option contracts.

Settlement of Option Contracts Settlement of option contracts varies from one contract to another; for instance, some option contracts are delivery-based

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contracts while others are non-delivery based. These non-delivery based contracts are designated as cash settled contracts i.e. their settlement takes place by settlement of the difference between the buy/sell price and the final settlement value of the contract. Currently, all option contracts (index as well as stocks) available on Indian securities exchanges are cash settled contracts.

Exercise of Options At present, buyers can exercise options only after trading hours i.e. the clearing corporation/house of the exchanges does not permit intra-day exercise of options. An option exercise session is held for a specific period of time on the exchange after normal trading hours, wherein market participants who wish to exercise their options can participate and do so. All options are exercised with respect to the settlement value/closing price of the stock.

Assignment of Options Assignment of options means the allocation of exercised options to one or more option sellers. The issue of assignment of options does not arise in the case of European options since these options are exercised if in-the-money, only on expiry of the contract/ contracts. Furthermore, in such a case there is a clear match between outstanding buyers and sellers. However, in case of American options where a buyer can exercise his option at any point in time, there is an issue about who should be asked to honour the contract as a counter-party i.e. who (seller) should be assigned the exercised option. The practices followed in

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international markets vary; while some exchanges practice the system of random assignment of options others follow the first in first out (FIFO) principle for assigning options. In the Indian market, the system of random assignment has been adopted for the purpose of assignment of options. The process of assignment as given in the notice issued by The Stock Exchange, Mumbai on July 4, 2001 is as follows. 1. System will find the total of open long positions (say A) and total exercised positions (say B) for each expiring options series. 2. It will compare positions A and B and if the total exercised position is equal to the total long positions i.e. all the long options are exercised, then system will assign the position equal to their short position to all the sellers; i.e. For all sellers: Assigned Position = Short Position. 3. If exercised position (B) is less than total of long position (A) then following algorithm will be applied: 3.1 Select at random one seller id from the list of portfolios with short position where no position is assigned. 3.2 Find the short position for this seller id (say C). 3.3 Compare C with B. 3.4 If C is less than B, assign that seller id the full position (C) else assign that seller id, position equal to C – B. 3.5 Reduce B by the amount assigned in Step 3.4. 3.6 Repeat this cycle till B is greater than zero.

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The concept is elaborated with the following examples using hypothetical figures. Example 1: Assume that there are 6 buyers and 9 sellers and each of the 6 buyers has exercised their options fully. The options will be assigned to the sellers in the following manner. Buyer

Open Position

Exercised Position

Seller

Short Position

Assigned Position

A

20

20

1. P

50

50

B

30

30

2. Q

15

15

C

50

50

3. R

30

30

D

10

10

4. S

20

20

E

100

100

5. T

25

25

F

40

40

6. U

5

5

7. V

40

40

8. W

30

30

9. X

35

35

250

250

Total

250

250

Example 2: Assume that some of the buyers decide not to exercise their option positions or to exercise it only partially. The options will be assigned to the 9 sellers in the following manner. 1. Position to exercise = 160, assigned position = 0. 2. The system will generate a random number between 1 and 9 e.g. number 6. The short position of 6U is 5 which is less than position to exercise (160) and therefore, 5 options are assigned to 6U. Hence, after assignment of 5 positions the position to exercise remains 155 and the assigned positions are 5.

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Buyer

Open Position

Exercised Position

Seller

Short Position

A

20

20

1. P

50

–

B

30

10

2. Q

15

–

C

50

25

3. R

30

–

D

10

0

4. S

20

–

E

100

75

5. T

25

–

F

40

30

6. U

5

5

7. V

40

–

8. W

30

–

9. X

35

–

155

5

Total

250

160

Assigned Position

3. After assignment of 5 positions, the system will again generate a random number out of the remaining 8 for example the number 1, in order to assign the remaining 155 positions. The short position of 1P is 50, which is less than position to exercise (155) and therefore, 50 options are assigned to 1P. Hence, after assignment of 50 positions, the position to exercise remains 105 and assigned positions are 55. Buyer

Open Position

Exercised Position

Seller

Short Position

Assigned Position

A

20

20

1. P

50

50

B

30

10

2. Q

15

–

C

50

25

3. R

30

–

D

10

0

4. S

20

–

E

100

75

5. T

25

– Contd

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Box Contd Buyer

Open Position

Exercised Position

Seller

Short Position

F

40

30

6. V

40

–

7. W

30

–

8. X

35

–

U

5

5

105

55

Total

250

160

Assigned Position

4. After assignment of 50 positions the system will again generate a random number out of the remaining 7 e.g. number 6 in order to assign the remaining 105 positions. The short position of 6W is 30, which is less than position to exercise (105) and therefore, 30 options are assigned to 6W. Hence, after assignment of 30 positions, position to exercise remains 75 and assigned positions are 85. Buyer

Open Position

Exercised Position

Seller

Short Position

A

20

20

1. Q

15

–

B

30

10

2. R

30

–

C

50

25

3. S

20

–

D

10

0

4. T

25

–

E

100

75

5. V

40

–

F

40

30

6. W

30

30

7. X

35

–

U

5

5

P

50

50

75

85

Total

250

160

Assigned Position

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5. After assignment of another 30 positions the system will again generate a random number out of the remaining 6 so that the remaining 75 positions may be assigned. Assume that the number generated is 2. The short position of 2R is 30, which is less than position to exercise (75) and accordingly 30 options are assigned to 2R. Hence, after assignment of 30 positions, position to exercise remains 45 and assigned positions are 115. Buyer

Open Position

Exercised Position

Seller

Short Position

A

20

20

1. Q

15

–

B

30

10

2. R

30

30

C

50

25

3. S

20

–

D

10

0

4. T

25

–

E

100

75

5. V

40

–

F

40

30

6. X

35

–

W

30

30

U

5

5

P

50

50

45

115

Total

250

160

Assigned Position

6. Now, after assignment of another 30 positions a random number will again be generated from the remaining 5 numbers e.g. the number 4 in order to assign a further 45 positions. As the short position of 4V is 40, which is less than position to exercise (45), 40 options are assigned to 4V. Hence, after another assignment of 40 positions, position to exercise remains 5 and assigned positions are 155.

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Buyer

Open Position

Exercised Position

Seller

Short Position

A

20

20

1. Q

15

–

B

30

10

2. S

20

–

C

50

25

3. T

25

–

D

10

0

4. V

40

40

E

100

75

5. X

35

–

F

40

30 R

30

30

W

30

30

U

5

5

P

50

50

5

155

Total

250

160

Assigned Position

7. Now after assignment of these 40 positions, in order to assign the remaining 5 positions the system will once again generate a random number out of the remaining 4 e.g. the number 4. The short position of 4X is greater than the position to exercise (5) and therefore only 5 options are assigned to 4X. Hence, after the remaining 5 positions are assigned the position to exercise remains 0 and assigned positions are 160. Buyer

Open Position

Exercised Position

Seller

Short Position

Assigned Position

A

20

20

1. Q

15

–

B

30

10

2. S

20

–

C

50

25

3. T

30

–

D

10

0

4. X

35

5 Contd

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Box Contd Buyer

Open Position

Exercised Position

E

100

75

F

40

30

Total

250

Seller

Short Position

Assigned Position

V

40

40

R

30

30

W

30

30

U

5

5

P

50

50

0

160

160

Thus, the final assignment of 160 exercised positions of options out of 250 open positions will be as follows: Buyer

Open Position

Exercised Position

Seller

Short Position

Assigned Position

A

20

20

P

50

50

B

30

10

Q

15

0

C

50

25

R

30

30

D

10

0

S

20

0

E

100

75

T

30

0

F

40

30

U

5

5

V

40

40

W

30

30

X

35

5

250

160

Total 1

250

160

Positions in bold are fully assigned. Positions in normal are not assigned. Positions in normal italics are partially assigned.

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Appendix 5.1: Risk Management Using SPAN In order to manage risk efficiently in the Indian securities market, exchanges have adopted SPAN (Standard Portfolio Analysis of Risk), a risk management and margining product designed by Chicago Mercantile Exchange (CME), Chicago, USA. This software was developed and implemented by CME in 1988, for calculating initial margins (performance bond requirements) on the various positions of market participants. SPAN was the first ever derivatives industry performance bond system to calculate margin requirements on the basis of overall portfolio risk. Over a period of time SPAN has become the industry standard; the program is now the official performance bond mechanism of virtually every registered derivatives exchange and clearing agency in the world.

Kinds of Instruments that SPAN can Handle Although SPAN was originally designed to measure the risk associated with futures and futures options (options on futures), it can handle options on virtually any underlying asset including equity and commodity because the basic philosophy of options remains the same. Indeed, SPAN can margin any derivative or non-derivative financial instrument.

The Basic Objective behind SPAN The objective of SPAN is to identify overall potential risk in a portfolio. The program treats futures and options uniformly,

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while recognising the unique exposures associated with options portfolios. The program also recognises both intra-commodity and inter-commodity risk relationships. Intra-commodity refers to different positions in one underlying and inter-commodity implies different positions in different underlying assets. Since SPAN is used to determine initial margins/performance bond requirements on various positions, its basic objective is to determine the largest possible loss that a portfolio might reasonably be expected to suffer from one day to the next. It then sets the initial margin/performance bond requirement at a level, which is sufficient to cover this one-day potential loss. Exchanges and clearing agencies using SPAN are responsible for determining a “reasonable” one-day loss and for setting the basic SPAN parameters accordingly. For example, an exchange/ clearing agency may set SPAN parameters in such a way that it covers the largest loss on a portfolio for 99 per cent or 95 per cent of the trading days.

Mechanics of SPAN The mechanism of calculating margins with the SPAN system is quite simple and can be elaborated in a pictorial form as shown in Fig. 5.9. As it is impossible to ascertain future loss on a position with certainty, SPAN is based on 16 possible risk scenarios called risk arrays. Potential risk on a position is calculated by the SPAN in all the 16 scenarios and then the worst-case loss is captured. The steps taken while calculating margins are as follows. 1. The first step is that the exchanges/clearing agencies provide inputs to the SPAN system in the form of

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important risk parameters such as price scan range, volatility scan range, intra-commodity spread, intercommodity spread, short option minimum charge, etc. These terms are explained subsequently. Inputs by exchanges/ clearing agencies: 1. Price scan range 2. Volatility scan range 3. Intra-commodity spread 4. Inter-commodity spread 5. Short option minimum charge 6. Any other margin parameter

3

1

SPAN at exchange/ clearing agency

2

4 Risk parameter file—market snap shot at a point in time

STEP 1

5 Position file

Risk arrays for each specified product

5

PC span at the end of broker members (users)

6

Span risk-margins (performance bond requirement) FINAL OUTPUT

Fig. 5.9: Calculation of margins with the SPAN system

2. SPAN uses these inputs along with the current underlying prices and generates 16 possible risk scenarios called risk arrays. Risk arrays are calculated separately for separate underlying assets. 3. Risk arrays along with other inputs are used by SPAN to calculate and create a file called SPAN risk parameter file. The SPAN risk parameter file presents a static snapshot of the market at a point in time. This file becomes the base for calculation of margins/performance bond requirement on the final position of market participants. Calculation of risk arrays by exchanges and clearing agencies using SPAN and the packaging of these

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into the SPAN risk parameter file is sometimes referred to as the SPAN front end. 4. This risk parameter file is transmitted to broker members (users) on a daily basis or even more frequently. In the Indian scene, this file is sent 5 times during a typical trading day. 5. Broker members use data contained in the risk parameter file along with their specific portfolios to determine their initial margins/performance bond requirements. This simple process is referred to as the SPAN back end. SPAN offers exchanges and clearing agencies tremendous flexibility to tailor the system to their requirements through the inputs at the first step. As SPAN also assumes responsibility of revaluation of all the instruments, exchanges and clearing agencies using SPAN, are able to ensure that margin requirements calculated for their products are uniform. This means that margins do not deviate across users of the system and fully reflect the stated performance bond policies of the exchange/clearing agency, in view of the current market environment. The system has established its credibility by consistently demonstrating good results under various scenarios of changing market conditions across the world. The concept of SPAN risk array is at the heart of SPAN as it represents the extent to which a specific derivative instrument will gain or lose value from the present time to a specific point in time in the near future (called the look-ahead time), over a specific set of market conditions. The look-ahead time is typically set to one trading day i.e. through the use of SPAN the maximum likely loss, which may reasonably occur over one trading day is being evaluated.

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The specific set of market conditions that are evaluated are called the risk scenarios and these are defined in terms of (a) how much the price of the underlying instrument is expected to change over the look-ahead time, and (b) how much the volatility of that underlying price is expected to change over the lookahead time. The results of the calculation for each risk scenario— the amount by which the specific derivative instrument will gain or lose value over the look-ahead time under that risk scenario— is called the risk array value for that scenario. The set of risk array values for a particular instrument under the full set of risk scenarios constitutes the risk array. Conventionally, since SPAN is interested in potential losses rather than in potential gains, losses are represented as positive values and gains as negative values. Risk array values are typically represented in the performance bond currency in which the specific contract is denominated. Since its inception, SPAN has used a standardised definition of the risk scenario in terms of the underlying price scan range (possibility of price change over look-ahead period) and the underlying price volatility scan range (possibility of volatility change over look ahead period). These two values are often simply referred to as the price scan range and the volatility scan range. The system generates 16 standard risk scenarios that reflect different combinations of price and volatility scan range as shown in Fig. 5.10.

Scanning Risk Charge As demonstrated in Fig. 5.10, SPAN starts at the current underlying market settlement price and scans up and down three even intervals of price changes (price scan range) and two extreme movements, which are defined as double the price scan range.

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However, because price changes of these extreme magnitudes (double the price scan range) are rare, the program covers only a fraction of the resulting losses (35 per cent) in these situations. At each underlying market price, the program also scans up and down a range from the underlying market’s current volatility (volatility scan range). The exchanges and clearing agencies, using SPAN, determine the magnitude of these scan ranges for each underlying instrument. In India, the Securities and Exchange Board of India (SEBI), which is the regulator for the market specifies these scan ranges.

U/L cash

2 PSR (+ve), 35% of the loss +1 V PSR –1 V +1 V 2/3 PSR –1 V +1 V 1/3 PSR –1 V Unch +1 V 1/3 PSR –1 V +1 V 2/3 PSR –1 V +1 V PSR –1 V

+1 V –1 V

2 PSR (–ve), 35% of the loss

Fig. 5.10: Price and volatility scan range

For the Indian market, the price scan range for index products is set at 3 times the daily standard deviation and for stock products it is 3.5 times the daily standard deviation. Volatility scan range is taken as 4 per cent for index products and 10 per cent for stock products. After SPAN has scanned 16 different scenarios of underlying market price and volatility changes it calculates potential losses for a position in all these scenarios. A similar exercise is conducted separately for each position on an underlying asset and the system then adds up the losses in the 16 scenarios horizontally and

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selects the largest loss (worst-case loss/largest reasonable loss) from among these observations. This “largest reasonable loss” is the scanning risk charge for all positions on an underlying instrument and is also called the combined commodity portfolio. A similar exercise is also carried out for different underlying assets and the scanning risk charge of different underlyings is then added in order to arrive at the total scanning risk charge on a portfolio.

Intra-commodity (Inter-month) Charge As SPAN scans future prices within a single underlying instrument it assumes that price moves correlate perfectly across contract months. Since price moves across contract months do not generally exhibit perfect correlation, SPAN adds an intracommodity spread charge (previously called the inter-month spread charge) to the scanning risk charge associated with each underlying instrument. In other words, intra-commodity spread charge covers the calendar (inter-month, etc.) basis risk that may exist for portfolios containing futures and options with different expirations. SPAN also uses delta information in order to form spreads. Delta measures the change in the value of a futures or option contract with one unit change in the value of the underlying instrument. Futures deltas are always 1.0 while options deltas range from –1.0 to +1.0. Moreover, options deltas are dynamic i.e. any change in the price of the underlying instrument will affect not only the price of the option but also its delta statistic. In the interest of simplicity, SPAN employs only one delta value per contract/position called composite delta. This is derived as the weighted average of the deltas associated with each underlying price scan point. The weights associated with each

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171

scan point are based upon the probability of the associated price movement with higher weights assigned to the prices that are more likely to change and lower weights given to the prices that are less likely to change. The composite delta for an option contract can be considered to be the best estimate of what the contract’s delta will be after the look-ahead time has passed i.e. after one trading day is over. Like the risk arrays, the composite delta for each contract is calculated by the clearing organisation of the exchange, using SPAN and is transmitted daily to users along with the risk arrays and the SPAN risk parameter file. SPAN identifies the delta value for each position in a portfolio and then forms spreads using these delta values according to patterns specified in the SPAN risk parameter file. For example, SPAN can form spreads between all equity futures contract months with net long delta and all contract months with net short delta. Having established the spreads, SPAN also keeps track of each combination in the spread and is completely flexible in establishing spreads based upon given parameters. For each spread that is formed, SPAN assesses a charge based on the specified charge rate for the spread. The total of all the charges for a particular combined commodity constitutes the intra-commodity spread charge for that combined commodity. This is added to the scanning risk charge calculated earlier to arrive at the final initial margin/performance bond requirement on a portfolio.

Inter-commodity Spread Credits Price movements tend to correlate fairly well between related underlying instruments, especially as the prices of related

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instruments tend to move in tandem. As a result, gains from positions in one instrument will sometimes offset losses in another related instrument. Thus, in order to recognize the risk reducing aspects of portfolios containing positions in related instruments, SPAN forms inter-commodity spreads for positions properly configured across all these instruments. These spreads produce credits, which may reduce the overall performance bond requirement. Like the futures price scan ranges themselves, the policies which govern the recognition of inter-commodity spreads within SPAN are set by the exchanges/clearing agencies including the universe of recognised spreads, the magnitude of the credit offered for each such spread and the order in which SPAN should attempt to form these spreads. All this information is contained in the daily SPAN risk parameter files. SPAN identifies the net delta for each contract month and for the underlying instrument as a whole (the combined commodity) and then processes the inter-commodity spread data contained in the risk parameter file to form spreads between the combined commodities. It is possible to form a multitude of inter-commodity spreads for some portfolios. Clearing organisations and exchanges that use SPAN, generally place the highest priority on those spreads that generate the largest monetary value savings and give the lowest priority to those which generate the smallest savings. Each spread formed by SPAN generates a percentage saving from the total outright performance bond requirement for the related underlying instruments. SPAN applies the percentages to these outright requirements and in most cases derives a lower net requirement for the instruments in question. The more the delta of a portfolio that is allocated to spreads the greater is the

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spread credit for the underlying instruments. For example, spreads involving deep-in-the-money options and futures positions may generate the greatest inter-commodity spread credit savings. As indicated earlier, SPAN uses delta information to form spreads. Since delta exclusively measures the sensitivity of a contract to changes in the price of its underlying instrument, the credits generated by the program are applied strictly to the underlying price risk of the instrument. In contrast, volatility risk and time risk (the other key factors which affect the value of an option) are not measured by the delta statistic and SPAN does not use spread information to adjust either of these components of risk calculation. As a result, delta-neutral positions within a portfolio may generate low magnitude intercommodity spread credits, if any.

Short Option Minimum Charge Short option positions in extremely deep-out-of-the-money strikes may appear to have little or no risk across the entire scanning range. However, in the event that underlying market conditions change significantly, these options may move intothe-money thereby generating large losses for the holders of short positions in these options. To cover the risks associated with deep-out-of-the-money short option positions, SPAN uses the concept of short option minimum charge for each short option contained in the portfolio. These short option minimum charges are set by the exchanges and clearing organisations that subscribe to SPAN and serve as a lower bound to the risk requirement on the portfolio level for each underlying instrument. In other words, risk requirement for the instrument in question cannot fall below

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this level. In India, the short option minimum charge is set at 5 per cent for index products and 7.5 per cent for stock products.

Putting it all Together—The Overall Portfolio Risk Requirement The different pieces in SPAN calculation are put together to calculate the total margin/performance bond requirement for a customer as follows. SPAN adds up scanning risk charges and intra-commodity spread charges for each underlying instrument (each combined commodity) in which a portfolio has positions. The program then subtracts inter-commodity spread credits, if any, in a portfolio. SPAN then compares this figure to the short option minimum charge for the combined commodity, selects the larger of these two values and multiplies the result by the maintenance requirement adjustment factor (typically set to one.) The result is the maintenance risk requirement for the combined commodity. This value is then multiplied by the initial to maintenance ratio for this combined commodity in order to yield the initial risk requirement. The adjustment factors and initial to maintenance ratios are set by the exchange or clearing organisation for each type of customer account—member, hedger, and speculator— and are contained in the SPAN risk parameter file. The adjustment factors and the initial to maintenance ratios are usually one, except in the case of speculative public customers for whom they may be greater than one. The maintenance risk requirements for all the combined commodities in the portfolio are then converted to a common currency and consolidated as the initial risk requirements. These

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values are then compared to the net liquidating value of the total portfolio including the current net value of all premiumstyle options, in order to determine if a performance bond excess or deficiency exists. Sometimes the term total performance bond requirement is used to refer to the SPAN risk requirement less the net value (net option value) of all premium-style options in the portfolio. If the total performance bond requirement is calculated in this way, it is compared to the total equity—that is, everything that constitutes the net liquidating value except the net option value. It is sometimes said that the total performance bond requirement has two components, namely the risk component—in other words, the SPAN risk requirement and the equity component. Whether one compares the SPAN risk requirement to the portfolio net liquidating value or the total requirement to the total equity, the result is the same; the difference only lies in which side of the comparison the net option value is placed. It is important to note that SPAN is done when the portfolio SPAN risk requirement has been calculated. All other aspects of the performance bond calculation process, the determination of whether a performance bond excess or deficiency exists and any call for more performance bond collateral or release of excess collateral, are outside the scope of SPAN.

Summary 1. An option is a right given by the option seller to the option buyer to buy or sell an underlying asset at a predetermined price, within or at the end of a specified period. The party taking a long position i.e. buying the option is called the

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buyer/holder of the option and the party taking a short position i.e. selling the option is called the seller/writer of the option. 2. While the option buyer who is also called long on option or long premium or holder of option has the right and no obligation with regard to buying or selling the underlying asset, the option seller/writer who is also called short on option or short on premium has the obligation but no right in the contract. 3. Options terminologies: (a) Call option—An option which gives the buyer a right to buy the underlying asset. (b) Put option—An option which gives the buyer a right to sell the underlying asset. (c) American option—An option which is exercisable any time on or before the expiry date/day. (d) European option—An option which is exercisable only on its expiry. (e) Strike price or exercise price—The price at which the option is exercisable. (f ) Expiration date/day of the option—The date/day on which the option expires or contract ceases to exist. (g) Exercise date/day of option—The date/day on which the option is exercised. (h) Option premium—The price that the option buyer pays to the option seller for the option/right. The option premium is the inflow to the option writer

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irrespective of whether the option holder exercises his option or not. (i) In-the-money option (ITM)—An option contract, where the strike price of the underlying asset is better than its market price. (j) Out-of-the-money option (OTM)—An option contract, where the strike price is lower than the market price of the underlying asset. (k) At-the-money—An option contract where the strike price and market price of underlying asset are equal. (l) Near-the-money—An option where the strike price is very close to the market price of the underlying asset. 4. A call option is in-the-money when market price of the underlying asset is more than the strike price and a put option is in-the-money when market price of the underlying asset is less than the strike price. 5. A call option is out-of-the-money when market price of the underlying asset is less than the strike price and a put option is out-of-the-money when market price of the underlying asset is more than the strike price. 6. Option price/premium = Intrinsic value of option + Time value of option (a) The intrinsic value of an option is equal to the amount by which option is in-the-money. Therefore, all outof-the-money or at-the-money options have zero intrinsic value. The intrinsic value of an option can never be negative.

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(b) The time value of an option which is also called extrinsic value of an option is the component of the option premium, which takes care of future risk for the seller of the option. It can be defined as the quantification of probability of an out-of-the-money or at-the-money option going in-the-money or an already in-the-money option going deeper in-themoney during the validity of the contract. This value depends on the time to expiration of the option and the volatility of the underlying asset’s prices. Mathematically, time value of an option is equal to the difference between option premium and its intrinsic value. 7. Some facts about the option premium are as follows: (a) The value of an option at its maturity is equal to its intrinsic value. (b) The time value of an option is maximum for at-themoney options. (c) The time value of an option decreases at an accelerated pace during the last phase of the option’s life. (d) When the stock price is far above or below the strike price i.e. the option is either deep-in-the-money or deep-out-of-the-money it sells for an amount that is closest to its intrinsic value. 8. Settlement of option contracts varies from one contract to another. For instance, some option contracts are delivery-based contracts while others are non-delivery based. These non-delivery based contracts are designated

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as cash settled contracts i.e. their settlement takes place through settlement of the difference between buy/sell price and the final settlement value of the contract. 9. Both the exchanges in India—BSE and NSE use SPAN (Standard Portfolio Analysis of Risk) for risk management and margining of derivative positions.

Questions 1. A call option buyer has: (a) The right to purchase the underlying asset (b) The right to sell the underlying asset (c) The obligation to buy the underlying asset (d) The obligation to sell the underlying asset (e) None of the above 2. A put option seller: (a) Has the right to buy the underlying asset (b) Has the obligation to sell the underlying asset (c) Has the right to sell the underlying asset (d) Has the obligation to buy the underlying asset (e) None of the above 3. A European option: (a) Can be exercised anytime during the life of the option

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(b) Can be exercised only at maturity (c) Is traded only on the European exchanges (d) Is the option to buy Euro vis-a-vis USD (e) None of the above 4. In case of an American option: (a) The exercise date is same as the expiration date (b) The exercise date and expiration date may differ (c) There is no exercise date (d) There is no expiration date (e) None of the above 5. If the market price of the underlying asset is higher than the strike price: (a) The put option on the asset will be called in-the-money (b) The call option on the asset will be called out-of-themoney (c) The put option on the asset will be called at-the-money (d) The call option on the asset will be called at-the-money (e) None of the above 6. In case of in-the-money call option: (a) The intrinsic value is nil (b) The intrinsic value is positive (c) The intrinsic value is negative (d) The time value is nil (e) Both (b) and (d)

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7. The time value of: (a) In-the-money option is nil (b) At-the-money option is nil (c) Out-of-the-money option is nil (d) Decreases with the time to maturity. (e) Both (a) and (d) 8. Which of the following is false? (a) The intrinsic value of out-of-the-money option is nil (b) The time value is the maximum when the option is atthe-money (c) The time value can be calculated by deducting intrinsic value from the option premium (d) The time value can be calculated by adding intrinsic value to the option premium (e) Time value decreases at an accelerated pace towards the maturity of the option 9. Time decay of the option works: (a) To the benefit of the option buyer (b) To the benefit of the option seller (c) Against the option buyer (d) Against the option seller (e) Both (b) and (c) 10. If on a stock with a market price of Rs 270, a call option is purchased with a premium of Rs 29 and a strike price of Rs 270, the intrinsic value of the option is:

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(a) Nil (b) Rs 29 (c) Rs 241 (d) Rs 270 (e) None of the above 11. If on a stock with a market price of Rs 270, a call option is purchased with a premium of Rs 29 and a strike price of Rs 270, the time value of the option is: (a) Nil (b) Rs 29 (c) Rs 241 (d) Rs 270 (e) None of the above 12. If a call option on a share is bought at a strike price of Rs 160, market price of Rs 150, expiry in 3 months and a premium of Rs 12, the maximum gain on expiry of this position will be: (a) Rs 2 (b) Rs 10 (c) Rs 12 (d) Rs 148 (e) Unlimited 13. If a put option on a share is written with a strike price of Rs 160, market price of Rs 150, expiry in 3 months and a premium of Rs 12, the maximum loss on expiry of this position may be:

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(a) Rs 2 (b) Rs 10 (c) Rs 12 (d) Rs 148 (e) Unlimited 14. In case of stock/premium style options: (a) Both the buyer as well as writer have to pay mark to market margins (b) Only the buyer has to pay mark to market margin (c) Only the writer has to pay mark to market margin (d) Neither buyer nor seller has to pay mark to market margin (e) None of the above 15. The problem regarding the assignment of an option during the life of the contract occurs: (a) Only in case of American options (b) Only in case of European options (c) In case of both American as well as European options (d) Only in case of call options (e) Only in case of put options Answers to the Questions 1. (a)

2. (d)

8. (d)

9. (e) 10. (a) 11. (b) 12. (e) 13. (d) 14. (c)

15. (a)

3. (b)

4. (b)

5. (e)

6. (b)

7. (d)

Chapter 6

Synthetic Positions and their Management This chapter introduces a world of innovative thinking in the form of synthetic products or positions, which market participants create by operating in different products/markets simultaneously, in order to generate the pay-offs they desire. It combines the conventional concepts of futures and options to generate an interesting array of synthetic products to suit specific market needs and demands. The key value drivers of synthetic products are nonavailability of readymade products, trading flexibility and their ability to facilitate the alignment of prices of various products across different markets through the mechanism of arbitrage.

Most of the basic fundamentals of futures and options have been discussed in the previous chapters. This chapter covers the creation and management of synthetic futures and options positions, which lay down the foundation for trading strategies and the pricing of options and are therefore important to understand. In the field of finance, there are only six generic products/ pay-off profiles viz. long underlying/forward/futures, short underlying/forward/futures, long call, short call, long put and

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short put. All other products/positions are product innovations resulting from combination of these six positions. Underlying, forward and futures are put together since they have the same pay-off profile i.e. in all these situations the buyer profits if price of the underlying asset goes up and suffers a loss when price of the underlying asset goes down. Similarly, the seller gains if price of the underlying asset falls and loses when price of the underlying asset rises. These six products/positions provide market participants with tremendous flexibility and they can be used to devise innumerable products/trading strategies. The pay-off profiles of these six positions are illustrated in Figures 6.1, 6.2 and 6.3. Long on underlying/ forward/futures

Short on underlying/ forward/futures

Profit zone

Asset price Contracted price

Loss zone

Fig. 6.1: Pay-off profile of underlying/forward/futures contract

Profit zone Long on call option Asset price Short on call option Strike price

Fig. 6.2: Pay-off profile of call option

Loss zone

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Profit zone Short on Put option Asset price

Strike price

Long on Put option Loss zone

Fig. 6.3: Pay-off profile of put option Note : These charts are not drawn to scale and are merely diagrammatic representations of these products/positions.

The illustrations of call and put options demonstrate the pay-off profiles of long and short positions at maturity of the contract. During the life of the contract these pay-off lines are smooth curves as described in the previous chapter.

Synthetic Positions What is the meaning of “synthetic derivative positions”? Fundamentally, a synthetic position is the position created by market participants to generate a desired pay-off by operating simultaneously in different products/markets. For instance, creating pay-off profile of a call option through combination of underlying asset/futures and put options would be a synthetic call position. Similarly, a combination of futures/underlying assets and call option positions will create a synthetic put position i.e. a put option pay-off. There are innumerable ways in which the earlier mentioned basic pay-offs (long on forward futures or

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underlying, short on forward futures or underlying, long call, long put, short call and short put) can be combined to create desired pay-offs or synthetic positions.

Purpose of Synthetic Positions The fundamental question here is, “why are these synthetic positions created”? There are several reasons for this and some of them are: l

Non-availability of readymade products

l

Flexibility offered by synthetic products

l

Synthetic products create the base for pricing of various products across different markets and align them through the arbitrage mechanism.

Non-availability of Readymade Products When stock options were first listed and traded on an organised stock exchange—Chicago Board of Options Exchange (CBOE), US in 1973, only call options were offered on 18 individual stocks and trading in put options began only in 1977. In the meanwhile, market participants developed their own way of creating the pay-off profile of put options by using a combination of call options and positions in underlying stocks. Similarly, single stock futures i.e. futures contract on individual stocks started trading in the US in the year 2003 after a waiting period of nearly 20 years. Talks on single stock futures had been initiated in the US in the early 1980s but due

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to unresolved conflicts regarding regulatory control over the product both, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) entered into a contract and decided to look into the product later. In the meanwhile, market participants developed their own way of trading futures synthetically through a combination of call and put options. Simultaneously, they continued to persuade US authorities to introduce single stock futures on the ground that if single stock futures could easily be created through a combination of options (call and put) then it would be better to provide the market with a readymade product, instead. Another issue was that creating any product synthetically is also more expensive and difficult. Persistent pressure by market participants led the US to introduce the product in 2003 but interestingly now also, both the CFTC and SEC regulate the product jointly. Synthetic positions thus emerged out of necessity and nonavailability of readymade products to the market participants.

Flexibility Offered by Synthetic Products Synthetic positions provide market participants with higher flexibility than readymade products. If one trades futures that are readymade there is only one price to trade at. However, if futures pay-off profile is created synthetically by a combination of call and put options there may be many prices to trade the futures but these different prices will be available at different costs (buying options will cost in terms of option premium). Further, in the case of a standard futures position, one can either have a position or close it but in the case of a synthetic position, one may choose to close one leg and continue with the other. This provides market participants with enormous flexibility regarding the management of synthetic positions.

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Synthetic Products are the Foundation for Price Alignment Across the Markets The third issue is the requirement of synthetic positions for pricing options and price alignment of equivalent assets across the markets. The non-arbitrage theory of pricing products including financial instruments is based upon replicating assets being priced rationally by an efficient market. The cost of acquiring replicating assets through different means/markets should be the same. If it were not true, it would trigger arbitrage in order to align the prices of equivalent assets across different markets. In fact, in the absence of replication different markets will begin to operate in isolation and this will make the markets grossly inefficient.

Creation of Synthetic Positions It is clear therefore that there is a need for synthetic positions and that they play an important role in aligning prices of equivalent assets across the markets. How then are different synthetic positions created? Before discussing this concept it is necessary to differentiate between gross and net pay-off profiles of different positions. While net pay-off profile means the payoff profile of a position including the premium paid or received, in the case of gross pay-off profile the premium is not taken into consideration. As an example, assume that Mr X buys a European call option on stock S at a strike price of Rs 300 by payment of a premium of Rs 10 per share. He will exercise this option only if on expiry of the option the market price of the stock is higher than Rs 300.

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It is also clear that Mr X will not make a profit unless price of the stock in the cash market is above Rs 310. If price of the stock on maturity of contract is between Rs 300 and Rs 310, Mr X will exercise this option in order to reduce his losses (it may be noted that the option premium of Rs 10 is the sunk cost for Mr X and irrespective of whether or not he exercises the option premium will be retained by the option seller). Gross and net pay-off profiles for the position of Mr X may be shown as follows: Net pay-off profile for call option Profit zone Profit/ loss Asset price Maximum loss Rs 10

300

310

Loss zone

Gross pay-off profile for call option

Profit zone

Profit/ loss

300

Asset price

Loss zone

Fig. 6.4: Net and gross pay-off profile for a call option

Figure 6.4 indicates that in case of gross pay-off profile, profit zone starts from the strike price itself since the premium is not taken into consideration. On the other hand, in case of net

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pay-off profile, profit zone begins from the break-even point i.e. after adjustment of premium with the strike price. Note: In order to keep the explanations simple and easy to understand gross pay-off profiles of different positions are used in this chapter and all options are assumed to be European options. In addition, all illustrations of pay-off profiles of different generic positions are schematic diagrams (diagrams without any specific data).

Synthetic Long Futures Position Figure 6.5 illustrates the pay-off profile of a long futures position. It is clear from this schematic pay-off profile that if price of the underlying asset on maturity is higher than the contracted futures price the position will generate profit. Conversely, a decrease in price of the underlying asset will result in a loss to the holder of a long futures position. In other words, pay-off profile of a long futures position reveals that there is profit potential on the upward side (if price of underlying asset goes up) and risk of loss on the downward side (if price of underlying asset goes down). Profit zone

Profit/ loss

Asset price Contracted futures price

Loss zone

Fig. 6.5: Gross pay-off profile of a long futures position

The objective of crafting a synthetic long futures position is to create the same pay-off profile by a combination of products in other markets such as the cash or options market.

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A long call option position has an upside profit potential and no downside risk as shown in Fig. 6.6.

Profit zone

Profit/ loss

Asset price Strike price Loss zone

Fig. 6.6: Gross pay-off profile for a long call option position

If this long call position is combined with a position on a downside risk it will generate a pay-off profile similar to that of a standard/readymade long futures position. It is possible to achieve this through the sale of one put option. Figure 6.7 depicts the gross pay-off profile of a sold put option. Profit zone

Profit/ loss

Asset price

Strike price

Loss zone

Fig. 6.7: Gross pay-off profile for a short put option position

It may be noted that in order to create synthetic futures both the option positions (call and put) must be taken on the same strike price (preferably at-the-money, as the premium credit/debit will be minimal). Combined pay-off profile of the call and put options is given in Fig. 6.8.

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Strike price

Profit zone Long call leg

Profit/ loss

Asset price Short put leg

Loss zone

Fig. 6.8: Gross pay-off profile of a combined long call and short put option

In the combination of long call and short put as shown in Fig. 6.8, call option generates the upward profit potential and put option creates the downside risk and the combination thus delivers a result that is equivalent to long futures position as shown in Fig. 6.1.

Synthetic Short Futures Position In case of a short futures position, the position holder will make a profit if price of the underlying asset goes below the contracted futures price at maturity of the contract but he also bears the risk if price of the asset goes up. In other words, a short futures position has a downside profit potential and upside risk as can be seen in Fig. 6.9. Pay-off profile similar to that of short futures can be created by using a combination of call and put options. One may buy a put option to create a downside profit potential and sell a call option to create an upside risk. However, both these positions must be taken at the same strike price (preferably at-the-money, as the premium credit/debit will be minimal). Independent profiles of long put and short call options along with the combined profile are shown in Fig. 6.10.

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Contracted futures price

Profit/ loss

Profit zone

Asset price Loss zone

Fig. 6.9: Gross pay-off profile of short futures

Gross pay-off of long put option

Gross pay-off of short call option

Profit zone

Profit zone Strike price

Strike price Profit/ loss

Asset price

Asset price

Profit/ loss

Loss zone

Loss zone

Gross pay-off of the combination of long put and short call Profit zone Long put leg Profit/ loss

Asset price Strike price

Short call leg Loss zone

Fig. 6.10: Pay-off profiles of long put, short call and their combined position

It may be seen that a combination of long put and short call options generates a pay-off profile that is similar to that of a readymade/standard short futures position as shown in Fig. 6.9.

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Synthetic Long Call Options The pay-off profile of a long call option is shown in Fig. 6.11. Strike price

Profit/ loss

Profit zone

Asset price

Loss zone

Fig. 6.11: Gross pay-off profile of a long call option

Figure 6.11 shows that a long call position will have an unlimited upside profit potential without having any downside risk (except to the extent of the premium paid). A similar payoff profile can be created with the help of other products such as futures, cash market and put options. To create an unlimited upside profit potential one can go long on futures but this position will come along with a risk on the downside. If however, this position can be combined with another position which counters this downside risk one will achieve a profile that is similar to that of a long call option. This downside risk can be contained with the help of a long put option. Pay-off profiles of long futures position, long put option position and a combination of the two are given in Fig. 6.12. In order to create this position strike price of the put option and contracted futures price should be the same. It is apparent from Fig. 6.12 that pay-off profile of the combination of long futures and long put option results in the pay-off profile of a long call option as shown in Fig. 6.11.

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Gross pay-off of long futures position Contracted futures price

Profit/ loss

Gross pay-off of long put position

Profit zone

Asset price

Profit zone

Profit/ loss

Loss zone

Asset price Strike price

Loss zone

Gross pay-off for the combination of long futures and long put Profit zone

Profit/ loss

Asset price

Loss zone

Fig. 6.12: Pay-off profiles of long futures, long put option and a combined position

Synthetic Short Call Options Similarly, by combining short futures and short put option, one may create the pay-off profile of a short call option. Fundamentally, short futures will have a downside profit potential and an upside risk. Although the upside risk of short futures is required in order to create a short call pay-off profile the downside profit potential must be eliminated. This can be done by selling a put option. Creation of the required pay-off diagrams for this synthetic position has been left to the readers as an exercise.

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Synthetic Long Put Options A long put option position generates profit on the downside with no upside risk (except for the premium paid). This is illustrated in Fig. 6.13.

Profit zone Strike price

Profit/ loss

Asset price Loss zone

Fig. 6.13: Gross pay-off of a long put option

To create the similar pay-off profile, one may take short position in futures, which offers downside profit potential and upside risk. Upside risk needs to be contained in order to create the pay-off profile of a long put option. This can be done by buying a call option. The combination of a short position in futures and a long position on a call option thus creates a payoff profile that is similar to that of a long put option. This is shown in Fig. 6.14.

Synthetic Short Put Options Similarly by combining a long position in futures and a short position on a call option, a synthetic short position in a put option, which has only a downside risk, can be created. A long position in futures has a downside risk but it also has an upside profit potential and to create a pay-off profile equivalent to that

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of a short put option this upside profit potential must be eliminated. This can be done by selling a call option. The combination of long on futures and short on call option thus gives pay-off profile of a short put option. Pay-off diagrams for this synthetic position have been left to the readers as an exercise. Gross pay-off for short futures Contracted futures price

Gross pay-off for long call

Strike price

Asset price

Profit/ loss

Profit zone

Profit zone

Asset price

Profit/ loss

Loss zone

Loss zone

Gross pay-off for the combination of short futures and long call Profit zone

Profit/ loss

Asset price Loss zone

Fig. 6.14: Gross pay-off profiles of short futures long call and a combined position

Summary 1. A synthetic position is the position created by market participants to generate the desired pay-off by operating in different products/markets simultaneously.

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2. There are several reasons behind the creation of synthetic positions and some of them are as follows: l

Non-availability of readymade products

l

Flexibility offered by synthetic products

l

Synthetic products create the base for the pricing of various products across different markets and align them through the arbitrage mechanism.

3. While net pay-off profile means the pay-off profile of a position including the premium paid or received, in case of gross pay-off profile premium is not taken into consideration. 4. Combination of long call and short put options at the same strike creates a synthetic long futures position. 5. Combination of long put and short call options at the same strike creates a synthetic short futures position. 6. Combination of long futures and long put option creates a synthetic long call option position. 7. Combination of short futures and short put option creates a synthetic short call option position. 8. Combination of short futures and long call option creates a synthetic long put option position. 9. Combination of long futures and short call option creates a synthetic short put option position.

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Questions 1. Which of the following is not a reason to create a synthetic product: (a) The readymade product is not available in the market (b) The synthetic products provide more flexibility as compared to readymade products (c) The synthetic products maximise the profit potential and minimise the loss potential (d) The synthetic products provide a base for the pricing of the readymade products (e) Both (b) and (c) 2. The pay-off profile of a long futures position can be drawn synthetically by a combination of: (a) Short call and long put (b) Short call and short put (c) Long call and short put (d) Long call and long put (e) Either (b) or (c) 3. The pay-off profile of a short futures position can be drawn synthetically by a combination of: (a) Short call and long put (b) Short call and short put (c) Long call and short put. (d) Long call and long put (e) None of the above

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4. The pay-off profile of a long call position can be drawn synthetically by a combination of: (a) Short futures and long put (b) Short futures and short put (c) Long futures and short put (d) Long futures and long put (e) Long futures and short call 5. The pay-off profile of a short call position can be drawn synthetically by a combination of: (a) Short futures and long put (b) Short futures and short put (c) Long futures and short put (d) Long futures and long put (e) Short futures and long call 6. The pay-off profile of a long put position can be drawn synthetically by a combination of: (a) Short futures and long call (b) Short futures and short call (c) Long futures and short call (d) Long futures and long call (e) Long futures and short put 7. The pay-off profile of a short put position can be drawn synthetically by a combination of: (a) Short futures and long call (b) Short futures and short call

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(c) Long futures and short call (d) Long futures and long call (e) Short futures and long put Answers to the Questions 1. (c)

2. (c)

3. (a)

4. (d)

5. (b)

6. (a)

7. (c)

Chapter 7

Basics of Options Pricing and Option Greeks This chapter forms the core of understanding options and the manner in which they are priced. It elucidates various factors that affect the price of an option and gives an overview of Binomial and Black–Scholes option pricing models in simple mathematical terms. The chapter ends with a discussion on Option Greeks.

As discussed in the previous chapter, the price that an option buyer pays to the option seller for buying an option is called option premium. Since the strike price of options is constant throughout their lives they are quoted in the market on premium basis.

Basic Determinants of Options Pricing Logically, like the price of any other product premium of an option should also be determined by demand and supply factors in the market. However, theoretically as seen earlier, option

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premium is a combination of intrinsic value and time value. Intrinsic value in turn is a function of the difference between strike price and cash market price of the underlying asset and time value is a function of volatility of the price of underlying asset, time to expiration of the option and prevailing interest rate in the economy. Therefore fundamentally, there are following five basic determinants of options pricing: (a) Cash price of asset (St ) (b) Strike price (K ) (c) Volatility of underlying asset’s prices (s ) (d) Time to expiration (T ) (e) Interest rates (r) These factors affect the premium/price of both American and European options in several ways.

Effect of Current Asset Price on Option Premium Keeping all other factors constant, if cash market price of underlying asset goes up value of the call option increases but value of the put option diminishes. For instance, call option with strike price Rs 100 would worth more when cash market price of stock is Rs 110 than in the situation when cash market price of stock is Rs 100. This point may be derived from the intrinsic value concept, which maintains that keeping the strike price constant an increase in the market price of underlying asset results in an increase in intrinsic value of call option. Similarly, value of a put option decreases with an increase in market price of underlying asset due to decrease in the intrinsic value of this option.

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Effect of Strike Price on Option Premium If all other factors remain constant but the strike price of option increases, intrinsic value of the call option will decrease and hence its value will also begin to decrease. On the other hand, with all other factors remaining constant, increase in strike price will increase the intrinsic value of the put option and it will therefore become dearer.

Effect of Volatility in Price of an Underlying on Option Premium Volatility in the price of underlying asset affects both call and put options in the same way. As higher volatility escalates the chances of an option going in-the-money at any point in time during the life of the contract it increases the risk to the option seller and consequently makes the option, both call and put, more expensive.

Effect of Time to Expiration on Option Premium The effect of time to expiration on both call and put options is similar to that of volatility on option premiums. The longer the maturity of the option the greater is the uncertainty and hence the prices of both call and put options are higher, keeping all other factors constant. Therefore, longer maturity options are always more expensive than shorter maturity options.

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Effect of Interest Rates on Option Premium The effect of interest rates on options is slightly complicated mainly because interest rates affect different options, differently. For instance, options on individual scrips and indices are greatly influenced by interest rates while options on futures are not. In simple terms one may say that a higher interest rate has the same effect as lowering the strike price (consider the present value concept), and therefore as seen, higher interest rate will result in an increase in the value of a call option and a decrease in the value of a put option. Another way of looking at the impact of interest rate on option premium is through replica method. Call option may be treated as a variant to buying an underlying asset in the spot market and carrying it to the future. Therefore, by means of a call option the buyer postpones buying the underlying asset and earns interest on his money. The higher the interest rate, higher is the interest component to him and therefore, cost of buying the call option must also be higher. Similarly, in case of a put option the buyer postpones sale of the underlying asset and thus postpones his inflow. Therefore, if interest rates are high, he is losing more money in terms of loss of interest on his inflow and hence, he must be compensated by a lower put option price. Thus, higher interest rates result in increasing the price of a call option and lowering the price of a put option. The effect of these determinants of the value of options is summarised as follows:

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Effect of an increase in each pricing factor on the option value keeping other factors constant Sl. no.

Pricing factors

Call option

Put option

1.

Cash price of asset (St )

Increase

Decrease

2.

Strike price (K )

Decrease

Increase

3.

Volatility of underlying price (s )

Increase

Increase

4.

Time to expiration (T )

Increase

Increase

5.

Interest rate (r)

Increase

Decrease

Binomial Model for Options Pricing The binomial model has proved over time to be the most flexible, intuitive and popular approach to option pricing. It is based on the simple fact that over a single period (of possibly very short duration) an underlying asset can move from its current price to only two possible levels. Among other virtues the model embodies the assumptions of no risk free arbitrage opportunities and perfect markets as well as the risk-neutral valuation principle, which can be used to shortcut the valuation of European options. All pricing models consider that the cash flow from a derivative is a direct function of price of the underlying security. The pricing of option can therefore be done relative to the price of the underlying security. In order to price options it is necessary to make assumptions about the probability distribution of movements of the underlying security. To begin with, this is considered in a particularly simple framework, which is the

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binomial assumption. The price of underlying is currently So and it can take only two values Su and Sd in the next period, as shown in Fig. 7.1. Su

S0

Sd

Fig. 7.1: Possible movements of asset price

If one can find all possible future states along with their probabilities then one can value a security by first finding the expected values of the underlying security at each of these terminal points and then discounting them at a risk free interest rate. The binomial framework is particularly simple since there are only two possible states. Thus, if the probability q of one state is known then the probability of the other is also known as (1 – q). The following equation demonstrates the calculation for the underlying security. So = Exp (–r) * [q * Su + (1 – q) * Sd] Any derivative security based on this underlying security can now be priced using the same probability q. To find the value of, for example, a call option, one has to find the expected value of the option at each terminal node and then discount it at risk free rate in order to find the present value of the option. A valuation can be done by introducing constants u and d, implicitly defined by Su = u * So and Sd = d * So and thereby getting a process as illustrated in Fig. 7.2. This is called a Binomial tree.

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u S0

S0

d S0

Fig. 7.2: Possible movements of asset price

The price of a one-period call option in a binomial framework may thus be arrived at as follows: Value of call option on up tick Cu = Max (0, Su – K) Value of call option on down tick Cd = Max (0, Sd – K) Value of call option, today Co = e–r * (q * Cu + (1 – q) * Cd) Su = u * So and Sd = d * So are the possible values of the underlying security in the next period, u and d are constants and K is the call option exercise price. In the binomial model, probability q is based on the assumption that there are no arbitrage opportunities in the market. In algebraic terms, q can be expressed as the function of up and down movements (u and d ) as q = (er – d )/(u – d ). This raises the question as to how u and d are determined. U and d, also called up and down ticks are essentially factors of volatility of the underlying asset and time to the next period. They are calculated as u = s (t )^(1/2) and d = – s (t )^(1/ 2). This is a simplistic assumption of a single period binomial tree but it can be extended over many periods (two possible outcomes next date) to get a multi period binomial tree as shown in Fig. 7.3.

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u (u St) = uu St

u St

d (u St) = u (d St) = ud St

St

d St

d (d St) = dd St

Fig. 7.3: A two period binomial tree

If this is repeated several times, with increasing terminal states a more realistic distribution of future prices of the underlying at the terminal date is achieved. It is however important to note that in order to get a picture like this it is crucial that the factors u and d are the same on each date. In a setting like this pricing is done by working backwards from the terminal date since all possible values of the underlying security at each terminal node are known at this point. For each of these nodes, pay-offs are calculated from the derivative. Given these prices, option price one period before terminal date is calculated and this continues to be worked down to the root of the tree where the option price is determined as the derivative price in the first node. This is calculated algebraically assuming a two-step binomial tree with the exercise price K, as shown in Fig. 7.4.

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uu S0

u S0

ud S0

S0

d S0

dd S0

Fig. 7.4: A two period binomial tree

First step: Find terminal pay offs of the derivative Cuu = max. (0, uu S0 – K )

Cu

Cud = max. (0, ud S0 – K )

C0

Cd

Cdd = max. (0, dd S0 – K )

Second step: Find the two possible call prices at time 1: Cu = e–r * [q * Cuu + (1 – q) * Cud) Cd = e–r * [q * Cud + (1 – q) * Cdd) Third step: Using these two possible payoffs at time 1, option value at time 0 can be determined: Co = e–r * [q * Cu + (1 – q) * Cd)

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Thus, by working backwards option prices can be calculated for any number of periods. However, as number of periods increase, tree becomes more and more difficult to manage.

Black–Scholes Model for Options Pricing Among the various models prevalent for pricing options the Black–Scholes model for pricing European options published by Fischer Black and Myron Scholes in 1973 is by far the most popular. As most calculators and spreadsheets have built-in the Black–Scholes option formulae it is no longer necessary to memorize the formulae. However, a brief look at the profound mathematics behind it (without getting into the depth of mathematical jugglery or long formulae) will help to appreciate the idea better. Black and Scholes start by specifying a simple and wellknown equation that models the manner in which stock prices fluctuate. This equation called Geometric Brownian Motion implies that stock returns will have a lognormal distribution i.e. the logarithm of the stock’s return will follow the normal (bell shaped) distribution. Black and Scholes then propose that the price of option is determined by the only two variables that are allowed to change—time and the underlying stock price. While other factors such as volatility, exercise price and risk free rate do affect the price of the option they are not allowed to change. They also maintain that by forming a portfolio consisting of long position in stock and a short position in calls the risk of the short option is eliminated. This hedged portfolio is obtained

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by setting the number of shares in such a manner that the change in value of shares (long position) is equal to approximate change in the price of call option (short position) for each move in stock price. This mix of stock and calls must be revised continuously and this process is known as delta hedging. Black and Scholes then turn to a little known result in a specialized field of probability called stochastic calculus. This result defines how the option price changes in terms of change in the stock price and time to expiration. They then explain how this hedged combination of options and stock will grow in value at the risk free rate (The technique used to solve the model is the celebrated Ito’s Lemma). The result is a partial differential equation and the solution is found by forcing a condition called boundary condition on the model that requires the option price to converge to the exercise value at expiration. The end result is the Black and Scholes model. The main assumptions behind the model are as follows. 1. The stock pays no dividends during the option’s life Most companies pay dividends to their shareholders so this might appear to be a serious limitation of the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model to cover this situation is to subtract the discounted value of a future dividend from the stock price. 2. European exercise terms are used European exercise terms dictate that the option can only be exercised on the expiration date. An American exercise term allows the option to be exercised at any time during the life of the option. However, this limitation of

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European options is not a major concern because very few calls are ever exercised. This is true because when a call is exercised early, the remaining time value on the call is foregone and only intrinsic value is collected by the holder of option. 3. Markets are efficient This assumption suggests that no one can consistently predict the direction of the market or an individual stock. The market operates constantly with share prices following a continuous process called an Ito process. An Ito process is simply a continuous Markov process, which states that ‘the observation in time period t, depends only on the preceding observation.’ 4. No commissions are charged Usually market participants pay a commission when buying or selling options, which can often distort the output of the model. 5. Interest rates remain constant and known The Black and Scholes model uses the risk free rate (GSec. rates) to represent interest rates that are constant and known. In reality there is no such thing as the risk free rate. Further, interest rates may change over the life of option, thereby violating one of the assumptions of the model. 6. Returns are log-normally distributed This assumption suggests that returns on the underlying stock are log-normally distributed, which is a reasonable assumption for most assets.

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The Black–Scholes model for call option price may be stated as follows: The Model: C = SN(d1) – Ke(–rt) N(d2) C = Theoretical call premium S = Current Stock price t = Time until option expiration K = Option's strike price r = Risk-free interest rate N = Cumulative standard normal distribution E = Exponential term (2.7183)

d1 =

ln(S /K ) + (r+ s t

d2 = d1-

( s 2/2))t

s t

s = Standard deviation of stock returns ln = Natural logarithm The first part in formula SN (d1) derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price S by change in the call premium with respect to a change in the underlying stock price [N (d1)]. The second part of the model Ke^(–rt) N (d2) gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated as the difference between these two parts. Take for example a situation where a three-month call option on a stock with a strike price of Rs 1,180 is available for trading.

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The stock stands at Rs 1,150 and has a volatility rate of 30 per cent per annum. The annual risk-free rate is 12 per cent. The price of a 1,180 strike option can be calculated by using the Black–Scholes option pricing formula where T = 0.25, S = 1150, K = 1180, r = 12%, and the std deviation s = 0.3. Substituting these values in the formula, a call price of Rs 70.15 is obtained. Put option price can be obtained using put call parity as: e + Ke–rt = S + P 70.15 + 1180 × e–rt = 1150 + P and P = 67.19 The Black and Scholes option pricing formula can also be used to price American calls and puts on stocks with some adjustments. Pricing American options becomes a little difficult because unlike European options they can be exercised at any time prior to expiration. Though, it is never optimal to exercise a call option on a non-dividend paying stock before expiration, when dividends are expected it is sometimes optimal to exercise the option just before the underlying stock goes ex-dividend. Hence, when valuing American options on dividend paying stock, one must consider two different times when the option may be exercised—either just before the underlying stock goes ex-dividend or at the expiration of the option contract. Therefore, owning an option on a dividend paying stock is like owning two options, one that is a long maturity option with a time to maturity from the present until the expiration day, and the other that is a short maturity option with a time to maturity from the present until just before the stock goes ex-dividend. Some adjustments need to be made before the Black and Scholes formula is used for a dividend paying stock and the first step is to value the option on assumption that it will be exercised at expiry. Thus, the present value of dividends is deducted from the stock price and adjusted value Sd is used in the Black and

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Scholes model. The next step is to assume that the option will be exercised just before the ex-dividend date in which case the un-adjusted stock price is used and time to expiry is shortened to the period up to the ex-dividend date. The Black and Scholes model is applied only after these adjustments are made and the higher of the two valuations is taken as the actual value of the option. Assume for example that the price of a stock is Rs 50, exercise price of option is Rs 45, risk free rate of interest is 6 per cent per annum, tenor of option is 6 months and an ex-dividend adjustment of 2.5 will occur 0.166 years hence. The volatility of the stock is 20 per cent. There are thus two call options—a long maturity call option with a maturity of 0.25 years which can be exercised on the expiration date and a short maturity call option with a maturity of 0.166 years which can be exercised just before the ex-dividend date. These options are valued as follows. Solution: The details of the longer maturity option are: T = 0.25, r = 0.06, D = 2.5, S = 50, K = 45 and Sd = S – D/(1 + r)T = 47.52. The stock price to be used in Black and Scholes option pricing formula is Sd which is the adjusted price of the stock after deducting the present value of the dividends. Using these values the price of the option is Rs 3.84. The details of the shorter maturity option are: T = 0.166, r = 0.06, D = 2.5, S = 50 and K = 45. Since the option is exercised just before the stock goes ex-dividend the unadjusted stock price of Rs 50 is used in this case. Using these values the price obtained for the option is Rs 5.56.

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Thus, using the given approximation, an American option on the dividend paying stock will be valued at the higher of the two options, i.e. at Rs 5.58. Since 1973, the original Black and Scholes option pricing model has been the subject of great attention and many financial scholars have expanded upon the original work. In 1973, Robert Merton relaxed the assumption of no dividends and in 1976 Jonathan Ingerson went one step further and relaxed the assumption of no taxes or transaction costs. In 1976, Merton responded by removing the restriction of constant interest rates. The result of all of this work is alarmingly accurate valuation models for stock options. The same underlying assumptions regarding stock prices underpin both the binomial and Black–Scholes models, i.e. stock prices follow a stochastic process described by the geometric Brownian motion. Consequently, for European options the binomial model converges with the Black–Scholes formula as the number of binomial calculation steps increase. In fact, the Black–Scholes model for European options is really a special case of the binomial model where there are an infinite number of binomial steps. In other words, the binomial model provides discrete approximations to the continuous process underlying the Black–Scholes model.

Upper and Lower Bounds of Option Premium Let us now consider the maximum and minimum values (upper and lower bounds) of option prices. An upper bound is essentially the maximum price that the buyer of an option is prepared to

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pay. On the other hand, lower bound is the minimum price that the seller of an option is prepared to accept. These upper and lower bounds for European and American call and put options are as follows. l

l

l

l

l

Upper bound for call option, both European and American is S0. The maximum price a buyer of a call option is willing to pay for the option is the cash price of the underlying itself. If option trades at a price higher than the cash market price of the underlying the buyer of option would be better off buying the asset itself rather than the option. Upper bound for an American put option is K. The maximum price that the buyer of an American put option will be willing to pay for option is his receipt from the transaction, i.e. the strike price of the option. Upper bound for a European put option is K * Exp. (–r * t)— The maximum price that the buyer of a European put option will be willing to pay for option is the present value of his receipt from the transaction, i.e. the present value of the strike price of the option. Lower bound of American call and put options is the intrinsic value—As American options can be exercised immediately the minimum price that the seller of an option is prepared to accept is the intrinsic value of the option. If an American option trades at a price that is lower than its intrinsic value, it will trigger arbitrage. Lower bound of a European call option is S0 – K. Exp. (–r * t)—The minimum price that the seller of an option is willing to accept is the intrinsic value of the option adjusted for time value of the strike price. If a European

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call option trades at a price lower than this value, it will trigger arbitrage. l

Lower bound of a European put option is K. Exp. (–r * t) – S0—The minimum price that the seller of an option will be willing to accept is the intrinsic value of the option adjusted for time value of the strike price. If a European put option trades at a price lower than this value, it will trigger arbitrage.

Option Greeks—Measuring Price Sensitivity of Options Option premiums change with changes in the factors that determine options pricing, i.e. option premiums are sensitivity to pricing factors such as strike price, volatility, term to maturity etc. In financial terminology, measures of option price sensitivity are called option Greeks. The major option Greeks are delta, gamma, lambda (vega) and theta. Delta: Delta measures change in the price of an option with respect to unit change in market price of the underlying asset. In other words: Delta = Change in price of option/ unit change in price of the underlying asset. Delta may be viewed as the speed with which an option moves with respect to price of the underlying asset. The maximum speed is 100 per cent for very deep in-the-money options (both call and put) and the minimum speed is zero for very far out-of-the-money options (both call and put).

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Delta for a call option buyer varies between 0 (for far outof-the-money options) and 1/100 (for deep in-the-money options; some markets use 1 and some use 100). Zero delta/ near zero delta means that change in price of the underlying will have very little or negligible effect on the option premium and 1/100 delta means that prices of both option and underlying asset will move almost in tandem. In case of deep in-the-money options a major part of the option price is the intrinsic value and for at-the-money and outof-the-money options, the price is only its time value (no intrinsic value). Delta values for a call option seller will be the same in magnitude but with the opposite sign, i.e. if a call option buyer has a delta position 0.5/50, the position of the option seller will be delta –0.5/–50. The delta for a put option buyer varies between 0 and –1/–100. In case of deep out-of-the-money put options it is 0 and for deep in-the-money put options it is –1/–100. The delta value for a put option seller is of the same magnitude but with an opposite sign, i.e. if the put option buyer has a delta of –0.7/–70, the seller of this option will have a delta position of 0.7/70. As the expiry of option contract draws near the delta converges to zero for out-of-the-money options (both call and put). However, for in-the-money options it converges to 1/100 (in the case of call options) and –1/–100 (in the case of put options). It may also be noted that if delta of a position is positive then a rise in the price of underlying asset is desired. On the contrary, if delta of a position is negative a fall in the price of underlying asset is desirable.

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Knowledge of delta is of vital importance for option traders because this parameter is extensively used in margining and risk management strategies. While margining option positions, the SPAN (Standard Portfolio Analysis of Risk) system regularly uses delta. Furthermore, delta is of significant use when the number of options needed to equate some underlying market positions are to be determined. Delta may also be considered as the probability of option expiring in-the-money. For instance, if delta of an option is 0.5/–0.5 (at/near-the-money option) it has almost 50 per cent chance of expiring in-the-money. Gamma: Gamma measures change in delta with respect to change in price of the underlying asset. Since delta itself measures the change in the price of an option with regard to price of the underlying, gamma is called the second derivative of option premium with respect to price of the underlying asset. It is calculated as the ratio of change in delta for a unit change in market price of the underlying asset as follows: Gamma = Change in option delta/ unit change in price of the underlying asset Gamma works as an acceleration of the delta, i.e. it signifies the speed with which an option will go either in-the-money or out-of-the-money due to a change in price of the underlying asset. High gamma values reflect that an option will go in-themoney faster and out-of-the-money at a slower speed. Therefore, high gamma operates against the option seller and in favor of the option buyer. Option buyers are said to have a positive gamma position and option sellers have a negative gamma position. Options that are both at-the-money and close to the expiration have the highest gamma values. Vega (Lambda): Vega, which is also called lambda of an option, measures sensitivity of the option price with regard to volatility

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of prices of the underlying. It is calculated as a change in the option premium for unit change in volatility of prices of the underlying asset. Vega lies between zero and infinity for both call and put options. Vega is the maximum for at-the-money options with long term to expiration. High vega reflects greater chances of an option going in-themoney at any point in time during currency of the contract and therefore options with high vega are preferred by option buyers. Vega is positive for option buyers and negative for option sellers. Theta: Theta measures the sensitivity of option price in relation to its time to expiration. It generally measures change in the value of an option for a days change in time to expiration of the option. The theta for both call and put options lies between 0 and total value of the option. As the option approaches expiration the theta increases in value, i.e. the time value of the option erodes faster in last few days of option’s life. As time decay is always in favour of the option writer high theta options are attractive to sellers and low theta options are attractive to buyers. The theta is negative for option buyers and positive for option sellers. The option Greeks are summarised as follows: Position

Delta

Long futures

Positive

Short futures

Gamma

Vega

Theta

0

0

0

Negative

0

0

0

Long call

Positive

Positive

Positive

Negative

Short call

Negative

Negative

Negative

Positive

Long put

Negative

Positive

Positive

Negative

Short put

Positive

Negative

Negative

Positive

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One can conclude from the table that delta of all bullish positions is positive and for all bearish positions it is negative (long futures, long call and short put are bullish positions and short futures, short call and long put are bearish positions). Gamma is positive for long option positions and negative for short option positions. Similarly, vega is positive for long option positions and negative for short option positions. Theta on the other hand, is negative for long option positions and positive for short option positions. When calculating delta, gamma, vega and theta values for a portfolio values of the individual positions are simply added together. For example, if delta of a position is 0.4 and delta of another position is 0.5, delta of the portfolio with these two positions will be 0.9. Calculation of these Greeks for portfolios is the basis for delta neutral position, which is one of the most widely discussed strategies in options. This position is constructed by combining two equal and opposite delta positions in a portfolio. For instance, buying an underlying asset in the cash market will have delta 1/100 and selling two at/near-the-money call options (each at/nearthe-money option will have delta –0.5/–50) will have delta –1/ –100. This portfolio will therefore have delta position of almost 0. There are many other measures of options sensitivity such as rho, epsilon, zeta etc. but they are beyond the scope of this book.

Option Positions vis-a-vis Underlying Positions Having considered the basic determinants of options pricing and their movement with respect to the underlying asset prices,

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one must examine whether option positions are riskier than underlying cash market positions, i.e. whether: l

l

l

l

Long call option position is riskier than the equivalent long underlying position. Long put option position is riskier than the equivalent short underlying position. Short call option position is riskier than the equivalent short underlying position. Short put option position is riskier than the equivalent long underlying position.

It is apparent that long underlying and short underlying positions may result in huge losses if market turns unfavourable to the position holder. But, in case of long call and long put, option holder will not exercise the option if price of the underlying asset is unfavourable for him and his loss will be limited to the premium paid for buying the options. Therefore, long option positions are certainly less risky than long or short positions in the underlying asset itself. Furthermore, one-to-one change in the option price with respect to the underlying takes place only when the option is deep in-the-money, i.e. its delta is near 1/100 (for call options) or –1/–100 (for put options). Otherwise, option prices generally move at a pace that is slower than the price change in the underlying asset. Therefore, we may say that short positions in deep in-the-money call/put options are as risky as short/long underlying positions and short positions in at/near-the-money and/or out-of-the-money call/put options are less risky than the short/long underlying positions themselves.

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Summary 1. There are five basic determinants of options pricing. These are: (a) Cash price of asset (St ) (b) Strike price (K ) (c) Volatility of the price of the underlying asset (s ) (d) Time to expiration (T ) (e) Interest rates (r) 2. The binomial model has proved over time to be the most flexible, intuitive and popular approach to option pricing. It involves both a single period and multi period binomial tree models. 3. The price of a one-period call option in a binomial framework is worked out as Cu = Max (0, Su – K ) Cd = Max (0, Sd – K ) Co = e–r * (q * Cu + (1 – q) * Cd ) Where q = (er – d )/(u –d ) Su = u * So and Sd = d * So are the possible values of the underlying security in the next period, u and d are constants, r is the continuously compounded risk-free interest rate and K is the call option exercise price. The same logic can also be extended to a multi period binomial tree.

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4. Among the various models that are prevalent to price options is the celebrated Black–Scholes model for pricing European options published by Fischer Black and Myron Scholes in 1973. 5. The main assumptions behind the Black–Scholes model are: (a) The stock pays no dividends during the option’s life (b) European exercise terms are used (c) Markets are efficient (d) No commissions are charged (e) Interest rates remain constant and known (f ) Returns are lognormally distributed The Model: C = SN(d1) – Ke(–rt) N(d2) C = Theoretical call premium S = Current Stock price t = Time until option expiration K = Option’s strike price r = Risk-free interest rate N = Cumulative standard normal distribution E = Exponential term (2.7183)

d1 =

ln(S /K ) + (r – ( s 2/2))t s t

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d2 = d1-

s t

s = Standard deviation of stock returns ln = Natural logarithm 6. Option prices have the following bounds: l

Upper bound for call option both European and American is S0

l

Upper bound for American put option is K

l

Upper bound for European put option is: K Exp. (–r * t)

l

l

Lower bound of American call and put options is the intrinsic value Lower bound of European call option is: S0 – K. Exp. (–r * t)

l

Lower bound of European put option is: K Exp. (–r * t) – S0

7. Sensitivity of option’s premium with regard to various pricing factors is measured through option Greeks. Major option Greeks are delta, gamma, lambda (vega) and theta. (a) Delta measures the change in the price of an option with respect to unit change in market price of the underlying asset. (b) Gamma measures change in delta with respect to change in price of the underlying asset. Because, delta itself measures the change in price of the option with respect to price of the underlying, gamma is called

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the second derivative of option premium with respect to price of the underlying. (c) Vega, which is also called lambda of the option, measures the sensitivity of option price with regard to volatility of prices of the underlying. It is calculated as change in the option premium for unit change in volatility of prices of the underlying asset. Vega lies between zero and infinity for both call and put options. (d) Theta measures the sensitivity of option price with respect to its time to expiration. It generally measures change in value of the option for a day’s change in option’s time to expiration. Theta for both call and put options lies between 0 and total value of the option.

Questions 1. With the market price of the underlying going up: (a) The value of the call option goes up (b) The value of the call option goes down (c) The value of the put option goes up (d) The value of the put option goes down (e) Both (a) and (d) 2. If the interest rates in the economy go up: (a) The value of call option goes up and the value of put option goes down

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(b) The value of call option goes down and the value of put option goes up (c) The value of call as well as put options goes up (d) The value of call as well as put options goes down (e) The value of call as well as put options remains unchanged 3. If the volatility in the price of the underlying goes down: (a) The value of call option goes up and the value of put option goes down (b) The value of call option goes down and the value of put option goes up (c) The value of call as well as put options goes up (d) The value of call as well as put options goes down (e) The value of call as well as put options remains unchanged 4. Delta is a measure of: (a) Change in option’s value for a given change in the market price of the underlying (b) Change in option’s value for a given change in the strike price of the option (c) Change in option’s value for a given change in the volatility of the underlying’s price (d) Change in option’s value for a given change in the time to expiry of the option (e) Change in option’s value for a given change in the interest rate in the economy

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5. Which is the ratio of change in premium for a unit change in time? (a) Vega (b) Rho (c) Delta (d) Theta (e) Gamma 6. Theta is the second derivative of: (a) The interest rates in the market (b) The time to option expiry (c) The underlying asset price (d) The strike price of the option (e) None of the above 7. An option has a delta of 0.5. If there is a Rs 4 change in the price of the underlying share, the change in the price of the option would be: (a) Rs 2 (b) Rs 4 (c) Rs 8 (d) No Change in the price (e) None of the above 8. If a call option buyer has a delta 0.5, it means that: (a) The option is in-the-money (b) The option is out-of-the-money

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(c) The option is at-the-money (d) The option will yield value to the buyer if exercised immediately (e) None of the above 9. Which of the following is true? (a) Delta for call option buyer varies between 0 and –1 (b) Delta for put option buyer varies between 0 and –1 (c) Delta for call option buyer varies between –1 and 1 (d) Delta for put option buyer varies between –1 and 1 (e) Delta for put option buyer varies between 0 and 1 10. A deep out-of-the-money put option buyer will have a delta of: (a) Close to 1 (b) Close to –1 (c) Close to 0 (d) Close to 0.5 (e) Close to –0.5 11. A deep in-the-money call option seller will have a delta of: (a) Close to 1 (b) Close to –1 (c) Close to 0 (d) Close to 0.5 (e) Close to –0.5

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12. The gamma value is the highest in magnitude in case of: (a) In-the-money options (b) At-the-money options (c) Out-of-the-money options (d) Near-the-money options (e) Same in case of all the options 13. A high vega value option indicates that: (a) The option has higher chances of going in-the-money (b) The option has higher chances of going out-of-themoney (c) The option is attractive for the option buyer (d) The option is attractive for the option seller (e) Both (a) and (c) 14. An investor has two option positions, one with delta of –0.4 and other with the delta of 0.9. What is the delta of his portfolio? (a) 1.3 (b) 0.9 (c) 0.5 (d) –0.4 (e) None of the above 15. Which of the following is true? (a) Delta for all the bullish positions is positive (b) Delta for all the bullish positions is negative

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(c) Delta for all long positions is positive (d) Delta for all short positions is positive (e) None of the above 16. If daily volatility of Nifty is 1.92, standard deviation figure, sigma or s used in the Black–Scholes formula should be (a) 30% (b) 1.92% (c) 1.38% (d) 35% Answers to the Questions 1. (e)

2. (a)

8. (c)

9. (b) 10. (c) 11. (b) 12. (b) 13. (e) 14. (c)

15. (a) 16. (a)

3. (d)

4. (a)

5. (d)

6. (e)

7. (a)

Chapter 8

Perspectives in Options Trading This chapter analyses basic option positions from the perspective of both buyers and sellers. It includes an explanation of pay-off profiles and a complete analysis of various positions and also examines the optimal way of trading/hedging after consideration of different alternatives available in the market place.

A trader buys a forward/futures contract when he expects the price of underlying asset to move upwards. If prices go up as expected, his profit potential is unlimited (there is no limit to increase in the prices) but he also carries a downside risk on this position, i.e. if contrary to his expectations prices fall, he will incur losses. Theoretically, the risk of loss in long forward/futures positions is unlimited but practically it is limited as price of an asset cannot go below zero (maximum loss is the price of the forward/futures itself). When a hedger hedges his position with the help of a forward/futures contract, he basically locks himself at a price that leaves him with no opportunity of taking advantage of a favourable movement in price of the underlying asset (both buyers and sellers have obligations to honour the contract). For example, a wheat producer sells his wheat in the futures market

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at Rs 10 per kg with belief that the wheat price will go down. If at the maturity of futures contract, cash market price of wheat is Rs 13 per kg he will not be in a position to take advantage of favourable movement in price of wheat. Similarly, if a company (earning in rupees) has already hedged its outstanding position payables in dollars by buying dollars in the forward/futures market, it will be unable to take advantage of any subsequent full in dollar prices. Options address this basic issue by providing hedgers an opportunity to take advantage of favourable movements in the prices of underlying asset. Options act as insurance for a hedger, i.e. they provide a hedger at a small cost without completely locking hedger at a fixed price (Options provide the buyer with a right but no obligation in the contract). Thus, the basic difference between futures and option contracts is that while in futures contracts both the contracting parties (buyers and sellers) have an obligation to fulfil, in case of options only the seller has an obligation (buyer has a right with regard to the contract). Let us now analyse trading in futures and option contracts from a trader’s perspective.

Perspectives of Futures and Options Traders A trader will take a long position in futures market when he is bullish and a short position if he is bearish on the underlying asset. Similarly, a trader will take long position in a call option when he is bullish on the underlying asset because the exercise of this option will give him a long position in the underlying

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asset. On the other hand, position of a call option seller will result in an obligation to deliver the underlying if option buyer decides to exercise his option. Hence, position of a call option seller is similar to that of a seller of the underlying. Therefore, option seller believes that price of the underlying asset will either remain stable or go down, i.e. he has a neutral to bearish perspective. In case of a put option the option buyer is buying a right to sell the underlying asset, i.e. he has a bearish perspective about the underlying. On the other hand, a put option seller is taking the obligation of buying the underlying asset with a view that price of the underlying asset will either remain stable or go up, i.e. he has a stable to bullish perspective.

Choice of Strike Price A crucial decision that an option trader must take is which option he should trade in—in-the-money, at-the-money or out-of-themoney? This dilemma does not arise in case of futures where there is only one price available for trading the futures at any given point in time. An options trader must consider the premium components of these three options in order to make an educated decision. As discussed earlier there are two components in the option premium—intrinsic value and time value. If the option is deeply in-the-money the intrinsic value will be higher and so will the option premium/price. In case of at-the-money and out-of-themoney options the intrinsic value is nil and the premium is only its time value. Hence, these options are cheaper when compared to in-the-money options. As a rule, out-of-the-money

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options are cheaper than at/near-the-money options and at/nearthe-money options are cheaper than in-the-money options. Therefore, if an option buyer buys in-the-money option he has to pay a higher premium compared to the premium on at/nearthe-money or out-of-the-money options and thus the cost factor largely influences the decision of an option buyer.

Analysis of Call Options Analysis of Call Option Trading from a Buyer’s Perspective Assume that cash price of XYZ stock is Rs 100 and call options are available on three strike prices—Rs 90 (in-the-money option), Rs 100 (at-the-money option) and Rs 110 (out-of-themoney option). Assume further that these options are trading at Rs 12, Rs 5 and Rs 2 respectively (this is the premium/price of these options). The pay-off profiles of long call positions for these three strikes at different cash asset price levels, at the expiry of the options, are indicated in Table 8.1. Table 8.1 shows that the option with strike price Rs 90 has a break-even point at XYZ share cash price of Rs 102, the option with strike price Rs 100 breaks even at Rs 105 and the breakeven point of option with strike price Rs 110 is Rs 112. Therefore, it is apparent that Rs 90 strike price option is the least risky (it has the lowest break-even point) and Rs 110 strike option is the most risky (it has the highest breakeven point) from the perspective of a buyer. The contents of Table 8.1 are further analysed as follows.

Value of option at the expiry*

0 0 0 0 0 5 10 12 15 20 22

Cash price of XYZ at the expiry of the option (Rs)

70

75

80

85

90

95

100

102

105

110

112

–12

–12

–12

–12

–12

–12

–12

–12

–12

–12

–12

Premium paid

10

8

3

0

–2

–7

–12

–12

–12

–12

–12

Total Profit/ Loss**

Call with strike price Rs 90

12

10

5

2

0

0

0

0

0

0

0

Value of option at the expiry*

–5

–5

–5

–5

–5

–5

–5

–5

–5

–5

–5

Premium paid

7

5

0

–3

–5

–5

–5

–5

–5

–5

–5

Total Profit/ Loss**

Call with strike price Rs 100

Table 8.1: Pay-off profiles of long call options at different cash asset price levels

2

0

0

0

0

0

0

0

0

0

0

Value of option at the expiry*

–2

–2

–2

–2

–2

–2

–2

–2

–2

–2

–2

0

–2

–2

–2

–2

–2

–2

–2

–2

–2

–2

Contd

Premium Total paid Profit/ Loss**

Call with strike price Rs 110

Perspectives in Options Trading 239

25 30 35 40 45

115

120

125

130

135

–12

–12

–12

–12

–12

Premium paid

33

28

23

18

13

Total Profit/ Loss**

35

30

25

20

15

Value of option at the expiry*

–5

–5

–5

–5

–5

Premium paid

30

25

20

15

10

Total Profit/ Loss**

Call with strike price Rs 100

25

20

15

10

5

Value of option at the expiry*

–2

–2

–2

–2

–2

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign.

23

18

13

8

3

Premium Total paid Profit/ Loss**

Call with strike price Rs 110

* Value of option at the expiry would be equal to its intrinsic value, i.e. (cash price of the asset – strike price of call option)

Value of option at the expiry*

Call with strike price Rs 90

Cash price of XYZ at the expiry of the option (Rs)

Table 8.1 Contd

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241

Case I—What happens if XYZ cash price ends at a price below Rs 90 on maturity of the options In this situation, all the three options will expire out-of-themoney, i.e. they will be worthless. The greatest loss will be incurred on the option with strike price Rs 90 (Rs 12) and the least loss will be incurred on strike Rs 110 option (Rs 2). In this case, probably the decision to purchase the call options itself was wrong since in reality cash price of XYZ share has fallen by more than Rs 10 rather than going up, in contrary to our expectations. Case II—What happens if XYZ cash price ends between Rs 90 and Rs 100 In the event that cash price of share XYZ closes between Rs 90 and Rs 100, options with strike prices of Rs 100 and Rs 110 would expire worthless. The option with strike price of Rs 90 will have some value depending upon the actual cash market price of XYZ. For example (as shown in Table 8.1), at XYZ cash price of Rs 95 the option will be worth Rs 5 but the buyer of strike Rs 90 option will suffer a net loss of Rs 7 as his breakeven point is Rs 102. Case III—What happens if XYZ cash price ends between Rs 100 and Rs 110 The option with strike of Rs 110 will expire worthless if cash price of XYZ share ends between Rs 100 and Rs 110. The option with strike of Rs 100 will profit only if cash price of XYZ is more than Rs 105 (break-even price for this strike). The option with strike Rs 90 will profit if cash price of XYZ is more than Rs 102 (break-even price for this strike). The actual amount of profit loss on various options at the different cash price levels of XYZ share are shown in Table 8.1.

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Case IV—What happens if XYZ cash price goes above Rs 110 If cash price of XYZ share ends above Rs 110 options with strikes Rs 90 and Rs 100 will profit. However, option with strike of Rs 110 will generate a profit only if cash price of XYZ is above Rs 112. In view of this, it is apparent that even a mild escalation in cash price of XYZ (more than Rs 2) will result in a profit for Rs 90 strike price option (profit at any price above Rs 102), but in order to make a profit from Rs 110 strike option cash price of XYZ will have to go up by more than Rs 12 (profit at any price above Rs 112). Therefore, there is a higher probability of losing low premium of Rs 2 on strike Rs 110 option (out-of-the-money) and a lower probability of losing high premium of Rs 12 on Rs 90 strike option (in-the-money). This means that if one is mildly bullish on an stock, deep in-the-money option must be selected even though it is costlier. If one is moderately bullish one should trade in at-the-money or near-the-money options and if one is strongly bullish one should opt for deep out-ofthe-money options. This choice of option may also be analysed from the viewpoint of return on investment (ROI). In case of options, ROI may be defined as net profit as a percentage of premium paid by the option buyer. Clearly, trader will acquire the maximum return from deep out-of-the-money options if price of the underlying shoots up considerably. For example, if price of XYZ stock goes up to Rs 130 at maturity of the options out-of-the-money option will generate a massive 900 per cent return to the investor. This is calculated as follows: Profit on strike Rs 90 option = 130 – 90 – 12 = 28

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243

Return on investment = 28/12 * 100 = 233% Profit on strike Rs 100 option = 130 – 100 – 5 = 25 Return on investment = 25/5 * 100 = 500% Profit on strike Rs 110 option = 130 – 110 – 2 = 18 Return on investment = 18/2 * 100 = 900% The ROI for different options at different prices of underlying XYZ, at maturity of option contracts, may be calculated similarly.

Analysis of Call Option Trading from a Seller’s Perspective As discussed, in-the-money call options begin to generate value for option buyers on a mild upward movement in price of the underlying asset. Since profit/loss of call option buyers implies loss/profit for call option sellers, one may say that in-the-money options start generating losses for option sellers on a mild upward movement in the underlying’s price. Therefore, in-the-money call options are more risky for call option sellers compared to at/near-the-money options or out-of-the-money options. This concept is also clarified in Table 8.1. A call option seller generally has a neutral to bearish perspective regarding the underlying’s price and if this is strong neutral to bearish perspective he should sell deep in-the-money call options, as they will fetch him the highest premium. If he has a moderate neutral to bearish perspective it will be prudent for him to sell at/near-the-money call options and with a mild neutral to bearish perspective he will be better off selling deep

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out-of-the-money call options. Further, for this kind of option seller there is a high probability of making little money by selling deep out-of-the-money options and lesser probability of making a large amount of money by selling deep in-the-money options.

Analysis of Put Options Analysis of Put Option Trading from a Buyer’s Perspective To understand the position of a put option buyer, assume that cash price of XYZ stock is Rs 100 and put options are available on three strike prices, viz. Rs 90 (out-of-the-money), Rs 100 (at-the-money) and Rs 110 (in-the-money). Assume also that these options are trading at Rs 2, Rs 5 and Rs 12 respectively (this is the premium/price of these options). The pay-off profiles of long put positions on these three strikes at different cash asset price levels, at expiry of the options, are shown in Table 8.2. It is apparent from Table 8.2 that option with strike price Rs 90 has break-even point at XYZ share cash price of Rs 88, option with strike Rs 100 has break-even at Rs 95 and option with strike of Rs 110 breaks even at Rs 98. Therefore, it can be observed that among the three, Rs 110 strike price option is the least risky and Rs 90 strike option presents the greatest risk for the buyer from the break-even point perspective. The contents of Table 8.2 are further analysed as follows.

Value of option at the expiry*

20 15 12 10 5 2 0 0 0 0 0

Cash price of XYZ at the expiry of the option (Rs)

70

75

78

80

85

88

90

95

98

100

105

–2

–2

–2

–2

–2

–2

–2

–2

–2

–2

–2

Premium paid

–2

–2

–2

–2

–2

0

3

8

10

13

18

Total Profit/ Loss**

Put with strike price Rs 90

0

0

2

5

10

12

15

20

22

25

30

Value of option at the expiry*

–5

–5

–5

–5

–5

–5

–5

–5

–5

–5

–5

Premium paid

–5

–5

–3

0

5

7

10

15

17

20

25

Total Profit/ Loss**

Put with strike price Rs 100

Table 8.2: Pay-off profiles of long put options at different cash asset price levels

5

10

12

15

20

22

25

30

32

35

40

Value of option at the expiry*

–12

–12

–12

–12

–12

–12

–12

–12

–12

–12

–12

–7

–2

0

3

8

10

13

18

20

23

28

Contd

Premium Total paid Profit/ Loss**

Put with strike price Rs 110

Perspectives in Options Trading 245

0 0 0 0 0 0

110

115

120

125

130

135

–2

–2

–2

–2

–2

–2

Premium paid

–2

–2

–2

–2

–2

–2

Total Profit/ Loss**

0

0

0

0

0

0

Value of option at the expiry*

–5

–5

–5

–5

–5

–5

Premium paid

–5

–5

–5

–5

–5

–5

Total Profit/ Loss**

Put with strike price Rs 100

0

0

0

0

0

0

Value of option at the expiry*

–12

–12

–12

–12

–12

–12

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign.

–12

–12

–12

–12

–12

–12

Premium Total paid Profit/ Loss**

Put with strike price Rs 110

* Value of option at the expiry would be equal to its intrinsic value, i.e. (strike price of put option –cash price of the asset).

Value of option at the expiry*

Put with strike price Rs 90

Cash price of XYZ at the expiry of the option (Rs)

Table 8.2 Contd

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Perspectives in Options Trading

247

Case I—What happens if XYZ cash price ends lower than Rs 90 on maturity of the options In such a case, all the three options will be exercised. In absolute number sense, the highest gain will occur on Rs 110 strike option and the lowest gain will occur on strike Rs 90 option. Case II—What happens if XYZ cash price ends between Rs 90 and Rs 100 The option with strike Rs 90 will expire worthless if at maturity, cash price of the share is between Rs 90 and Rs 100. Options with strike prices Rs 100 and Rs 110 will have some value depending on actual cash market price of XYZ share. For example, as shown in Table 8.2 at XYZ share cash price of Rs 95 the option with strike Rs 110 will be worth Rs 15 and the profit on this position would be Rs 3 after adjustment of the premium paid. Case III—What happens if XYZ cash price ends between Rs 100 and Rs 110 In this situation, options with strikes Rs 90 and Rs 100 will expire worthless and the option with strike Rs 110 will be exercised in order to curtail the loss of the premium paid. Case IV—What happens if XYZ cash price ends above Rs 110 If cash price of the share ends above Rs 110 all the three options will expire worthless and the highest loss will occur on option with strike Rs 110 (Rs 12) while the lowest loss will occur on option with strike Rs 90 (Rs 2). It is thus apparent that even a small fall in cash price of XYZ (more than Rs 2) will result in a profit for Rs 110 strike option (profit at any price below Rs 98). However, to make a profit from Rs 90 strike option cash price of XYZ will have to come down by more than Rs 12 (profit at any price below Rs 88).

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Derivatives and Financial Innovations

Therefore, for buyer of the option there is a high probability of losing a low premium of Rs 2 on Rs 90 strike option (out-ofthe-money) and a low probability of losing high premium of Rs 12 on Rs 110 strike option (in-the-money). This means that if one is mildly bearish, deep in-the-money put options must be chosen even though they are costlier. If one is moderately bearish one should trade at-the-money or near-the-money put options and in case of strongly bearish perspective one should select deep out-of-the-money put options. In terms of ROI criteria buyer of deep out-of-the-money options will gain the maximum return if price of the underlying falls drastically. For example, if price of XYZ stock falls to Rs 70 at maturity of the options, out-of-the-money option will generate a huge 900 per cent return to the investors. This is calculated as follows: Profit on strike Rs 90 option = 90 – 70 – 2 = 18 Return on investment = 18/2 * 100 = 900% Profit on strike Rs 100 option = 100 – 70 – 5 = 25 Return on investment = 25/5 * 100 = 500% Profit on strike Rs 110 option = 110 – 70 – 12 = 28 Return on investment = 28/12 * 100 =233% Similarly, ROI for different options at different price levels of the underlying asset XYZ, at maturity of the option contracts, can be calculated.

Analysis of Put Option Trading from a Seller’s Perspective As in case of call option sellers, from a put option seller’s perspective it is more risky to sell deep in-the-money put options

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249

even though they fetch higher returns in terms of option premiums. On the other hand, selling deep out-of-the-money put options are less risky but they come with low premium.

Summary Trading perspectives while operating in futures and options market may be summarized as follows: Futures

Buy futures Bullish perspective

Sell futures Bearish perspective

Call Options

Buy options Bullish perspective

Sell options Neutral to bearish perspective

Put Options

Strongly Moderately Mildly Strongly Bullish Bullish Bullish Neutral to perspective perspective perspective bearish perspective

Moderately Neutral to bearish perspective

Mildly Neutral to bearish perspective

Buy deep Buy at or out-of-the- near-themoney money

Sell at or near-themoney

Sell deep out-of-themoney

Buy deep in-themoney

Sell deep in-themoney

Buy options Bearish perspective

Sell options Neutral to bullish perspective

Strongly Moderately Mildly Strongly Bearish Bearish Bearish Neutral to perspective perspective perspective bullish perspective

Moderately Neutral to bullish perspective

Mildly Neutral to bullish perspective

Buy deep Buy at or out-of-the- near-themoney money

Sell at or near-themoney

Sell deep out-of-themoney

Buy deep in-themoney

Sell deep in-themoney

From a buyer’s perspective, deep in-the-money options are less risky as compared to at/near-the-money options or deep out-of-the-money options.

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From a seller’s perspective, deep in-the-money options are more risky as compared to at/near-the-money options or deep out-of-the-money options.

Questions 1. Once a trader has hedged his position using futures/forward contracts: (a) He has eliminated his price risk arising from the movement of the market as a whole (b) He has maximised his profit (c) He has minimised his losses (d) He can not take advantage of the favourable price movements in the underlying asset (e) Both (a) and (d) 2. Which of the following is true with regard to futures contracts? (a) There is an obligation for both buyer and seller for performance of the contract (b) There is a right for both buyer and seller for performance of the contract (c) There is an obligation only for the buyer for performance of the contract (d) There is an obligation only for the seller for performance of the contract (e) None of the above

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251

3. The seller of a call option expects: (a) Increase in the price of the underlying asset (b) Decrease in the price of underlying asset (c) No change in the price of the underlying asset (d) Either (b) or (c) (e) None of the above 4. A decline in the market price of an underlying asset will result in: (a) Value of call option going up (b) Value of call option going down (c) Value of put option going up (d) Value of put option going down (e) Both (b) and (c) 5. Which of the following is the most risky strategy in the options market if the market is expected to increase substantially before the maturity of the option? (a) Writing call (b) Writing put (c) Buying call (d) Buying put (e) All are equally risky 6. Which of the options will fetch maximum premium to the writer? (a) In-the-money option (b) At-the-money option

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(c) Near-the-money option (d) Out-of-the-money option (e) All of the above would fetch him the same premium 7. If the writer of an option has a strongly bearish perspective, he should write a: (a) Deep in-the-money put option (b) Deep in-the-money call option (c) Deep out-of-the-money put option (d) Deep out-of-the-money call option (e) Either at-the-money call or put option 8. If the buyer of an option has a very mildly bullish perspective, he should buy a: (a) Deep in-the-money put option (b) Deep in-the-money call option (c) Deep out-of-the-money put option (d) Deep out-of-the-money call option (e) Either at-the-money call or put option 9. If the buyer of an option has a moderately bearish perspective, he should buy a: (a) Deep in-the-money put option (b) Deep in-the-money call option (c) Deep out-of-the-money put or call option (d) At-the-money put option (e) At-the-money call option

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253

10. If a trader has a mildly neutral to bearish perspective, he should: (a) Write deep out-of-the-money call option (b) Write deep out-of-the-money put option (c) Buy deep in-the-money call option (d) Buy deep in-the-money put option (e) Either (a) or (c) Answers to the Questions 1. (e)

2. (a)

3. (d)

8. (b)

9. (d) 10. (a)

4. (e)

5. (a)

6. (a)

7. (b)

Chapter 9

Option Spreads This chapter deals with various spread strategies that can be deployed in order to exploit a moderately bullish or a moderately bearish perspective on the market. These are discussed with special reference to horizontal spreads, vertical spreads and diagonal spreads and each of these strategies are considered both from bullish as well as bearish perspectives. Thus, the chapter presents a comprehensive description of various combinations of spread strategies that an option trader can adopt in the market.

Option spreads are combinations of two or more opposite positions in options of the same type (i.e. calls or puts) on the same underlying. These spread positions may be categorised as follows: l

Vertical spread

l

Horizontal spread

l

Diagonal spread

Vertical spread is a spread position in which two legs of the spread have different strike prices but the same expiration date. For instance, one may buy a December call option on scrip X with strike price Rs 100 and sell another December call option on scrip X with strike price Rs 110. This will amount to establishing a vertical option spread.

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255

Horizontal spread is a spread in which two legs of the spread have different expiration dates but the same strike price. For instance, one may sell a December call option on scrip X with strike price Rs 100 and buy a January call option on scrip X with strike Rs 100. This will result in establishing a horizontal option spread. This spread is also called time spread or calendar spread. Diagonal spread is a spread in which two legs of the spread have different strike prices and different expiration dates. For instance, one may sell a December call option on scrip X with strike Rs 110 and buy a January call option on scrip X with strike Rs 100. This will establish a diagonal option spread. This position has features of both vertical and horizontal spreads and may therefore be called a hybrid product. These spread positions can be established either synthetically or through readymade spread products available on some of the exchanges.

Vertical Spread Positions Traders generally use vertical spread positions when they have a mild view on the stock. These spreads can be used for both bullish and bearish perspectives, i.e. one may create a bullish vertical spread or a bearish vertical spread. Furthermore, these bullish and bearish vertical spreads can be created with use of either call options or put options.

Bullish Vertical Spreads A bullish vertical spread is a position where a trader has a positive view on the stock. Since the perspective is bullish the first position

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Derivatives and Financial Innovations

trader will take is long call or short put. However, as the trader does not have a very aggressive view he will try to reduce his cost/risk by adding a counter position. While establishing bullish spreads trader always buys lower strike price options and sells higher strike price options irrespective of options type (calls or puts). Bullish option spreads have a positive delta.

Bullish vertical spread using calls To establish bullish vertical spread with call options one would buy a lower strike price call option and sell a higher strike price call option. As lower strike price call option is more expensive than higher strike price call option this spread would result in an outflow of money in terms of net premium and is therefore called net debit strategy. Note: Net debit and net credit are terms used in the options market to define whether the net premium is payable or receivable by the trader.

As an example, assume that cash market price of scrip X is Rs 100 and one buys a December call option on scrip X with strike price Rs 100 (at-the-money option) after paying a premium of Rs 5 and sells a December call option on scrip X with strike price Rs 110 (out-of-the-money option) by receiving a premium of Rs 2 (buy lower strike price option and sell higher strike price option). This will result in a net outflow of Rs 3 at the time that the spread is established. The pay-off profile of this spread position with the price of scrip X at different levels, at expiry of the options, is shown in Table 9.1.

Premium (Rs)

–5 –5 –5 –5 –5 –5 –5 –5 –5

X’s Price at the expiry of the options (Rs)

80

85

90

95

100

103

105

110

112

12

10

5

3

0

0

0

0

0

Value of option (Rs)*

Long call with strike Rs 100

7

5

0

–2

–5

–5

–5

–5

–5

Total profit/loss (Rs)**

2

2

2

2

2

2

2

2

2

Premium (Rs)

–2

0

0

0

0

0

0

0

0

Value of option (Rs)*

Short call with strike Rs 110

Table 9.1: Pay-off profile of a bullish vertical spread using calls

0

2

2

2

2

2

2

2

2

Total profit/loss (Rs)**

7

7

2

0

–3

–3

–3

–3

–3

Contd

Net profit/loss (Rs)***

Option Spreads 257

–5 –5

115

120

20

15

Value of option (Rs)*

15

10

Total profit/loss (Rs)**

2

2

Premium (Rs)

–10

–5

Value of option (Rs)*

Short call with strike Rs 110

–8

–3

Total profit/loss (Rs)**

7

7

Net profit/loss (Rs)***

*** Net profit/loss on the position is the combined value of total profit/loss of both the option contracts in the spread. Negative values show net loss on the position and positive values show net profit on the position.

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign.

* Value of option at the expiry would be equal to its intrinsic value, i.e. cash price of the asset – strike price of call option.

Premium (Rs)

Long call with strike Rs 100

X’s Price at the expiry of the options (Rs)

Table 9.1 Contd

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Derivatives and Financial Innovations

Option Spreads

259

Table 9.1 shows that if price of the underlying is at or below Rs 100, both the options will expire worthless and total loss on the position will be net option premium paid i.e. Rs 3. The break-even point for this spread position is at level of Rs 100 (lower strike price) plus net debit of Rs 3, i.e. at Rs 103. This means that spread position will expire with zero value if price of the underlying asset is Rs 103 at maturity of the options. Further, as long as price of the underlying is lower than Rs 103 the spread position will result in a loss with a maximum loss of Rs 3. If price of the asset is above Rs 103 there will be a profit equal to actual cash price of the asset less the break-even price, i.e. Rs 103 (with maximum profit of Rs 7). If cash price is above Rs 110 both the options will have intrinsic value and will be exercised and profit on the spread will be Rs 7. The pay-off profile of this spread is illustrated in Fig. 9.1. Maximum profit Rs 7

Profit zone

Rs 103

Profit/ loss

Rs 100 Rs 110 Asset price Loss zone

Maximum loss Rs 3

Fig. 9.1: Pay-off profile of bullish vertical spread with calls

It is apparent from Fig. 9.1 that in this spread position, investor is locked in at both the ends (buy and sell side) and his profit potential as well as his loss is limited. Since the position is locked both at buy and sell ends the position taker’s perspective is mildly bullish.

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Derivatives and Financial Innovations

Let us consider the fundamental reason for establishing this position. As this is a primarily bullish strategy the first position established in the spread is a long, at-the-money call option with unlimited profit potential. As the trader does not have a very aggressive view on the stock, he writes an out-of-the-money call to reduce his cost. As a result, net outflow goes down since sold option fetches some premium. Importantly, this reduction in outflow in terms of premium puts a cap on the profit potential from long call as may be seen in Table 9.1 (unlimited profit potential of long call is capped by selling another call at higher strike price). The profit and loss from a spread position will vary depending on the strikes at which an investor chooses to establish the spread position. Based on this it is also possible to establish formulae for maximum profit, maximum loss and break-even point for this spread position as follows: Maximum profit = Higher strike price – Lower strike price – Net premium paid Maximum loss = Net premium paid Break-even price = Lower strike price + Net premium paid Readers are advised to take hypothetical positions themselves and try these formulae.

Bullish vertical spread using puts Similarly, a bullish vertical spread can be created with the help of put options in which case one will buy a lower strike put option and sell a higher strike put option. Since lower strike price put option is cheaper than higher strike price put option,

Option Spreads

261

in this position one will receive some money as the net option premium and hence this strategy is also called net credit strategy. This can be understood with the help of an example. Assume that cash market price of scrip X is Rs 100. If one sells a December put option on scrip X with strike price of Rs 110 (in-the-money option) by receiving a premium of Rs 12 and buys a December put option on scrip X with strike price of Rs 100 (at-the-money option) by paying a premium of Rs 5 (buy lower strike price option and sell higher strike price option) the spread will result in an inflow of Rs 7 at the time of its establishment. The pay-off profile of this spread position at different levels of scrip X ’s price, at expiry of the options, is analysed in Table 9.2. It is clear from the table that for any price of the underlying asset that is either at or above Rs 110 both the options will expire worthless and total profit on the position would be net premium received, i.e. Rs 7. The break-even point for this spread position is at the level of Rs 110 (higher strike price) minus the net credit of Rs 7, i.e. at Rs 103. This means that the spread position will expire with zero value if price of the underlying asset is Rs 103 at maturity of the options. Further, as long as price of the underlying is below Rs 103 the spread position will result in a loss equivalent to the difference between Rs 103 and actual price of the asset (with a maximum loss of Rs 3). If cash price is below Rs 100 both the options will have intrinsic value and be exercised and the spread will result in a loss of Rs 3. The pay-off profile of this spread is seen in Fig. 9.2. Figure 9.2 shows that in this spread position the investor is locked at both the ends (buy and sell side) and his profit potential as well as his loss is limited. As the position is locked at both buy and sell ends perspective of the position taker is considered as mildly bullish.

Premium (Rs)

12 12 12 12 12 12 12 12 12

X’s Price at expiry of the options (Rs)

80

85

90

95

98

100

103

105

110

0

–5

–7

–10

–12

–15

–20

–25

–30

Value of option (Rs)*

Short put with strike Rs 110

12

7

5

2

0

–3

–8

–13

–18

Total profit/loss (Rs)**

–5

–5

–5

–5

–5

–5

–5

–5

–5

Premium (Rs)

0

0

0

0

2

5

10

15

20

Value of option (Rs)*

Long put with strike Rs 100

Table 9.2: Pay-off profile of bullish vertical spread using puts

–5

–5

–5

–5

–3

0

5

10

15

Total profit/loss (Rs)**

7

2

0

–3

–3

–3

–3

–3

–3

Contd

Net profit/loss (Rs)***

262

Derivatives and Financial Innovations

12 12

115

120

0

0

Value of option (Rs)*

12

12

Total profit/loss (Rs)**

–5

–5

Premium (Rs)

0

0

Value of option (Rs)*

Long put with strike Rs 100

–5

–5

Total profit/loss (Rs)**

7

7

Net profit/loss (Rs)***

*** Net profit/loss on the position is the combined value of total profit/loss of both option contracts in the spread. Negative values show net loss on the position and positive values show net profit on the position.

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign.

* Value of option at the expiry would be equal to its intrinsic value, i.e. Strike price of put option – cash price of the stock.

Premium (Rs)

Short put with strike Rs 110

X’s Price at expiry of the options (Rs)

Table 9.2 Contd

Option Spreads 263

Derivatives and Financial Innovations

264

Maximum profit Rs 7

Profit zone Rs 103

Profit/ loss

Rs 100 Rs 110 Asset price

Maximum loss Rs 3

Loss zone

Fig. 9.2: Pay-off profile of bullish vertical spread with puts

Since this is primarily a bullish strategy the first position established in the spread is a short in-the-money put option. However, a short put position carries unlimited risk in the event that price of the underlying asset falls. As the trader does not have a very aggressive view on the stock he takes long position in at-the-money put in order to reduce the unlimited risk associated with short put option. Consequently, the net inflow goes down since long option results in some premium outflow but importantly, this reduction in inflow (in terms of premium) comes with a cap on the downside risk. The profit and loss from such a spread position will vary depending on the strikes at which an investor chooses to establish the spread position. Based on the preceding, formulae for maximum profit, maximum loss and break-even point of this spread position may be established as follows: Maximum profit = Net premium received Maximum loss = Higher strike price – Lower strike price – Net premium received

Option Spreads

265

Break-even price = Higher strike price – Net premium received

Bearish Vertical Spreads A bearish vertical spread is a position where a trader has a negative view on the stock. The first position taken by the trader is a short call or a long put but as he does not have a very aggressive view he tries to reduce the risk/cost by adding a counter position. This spread may be established with the help of either two call options or two put options but, while establishing a bearish spread one must buy a higher strike price option and sell a lower strike price option. Bearish option spreads have negative delta values.

Bearish vertical spread using calls To establish a bearish vertical option spread with calls one will buy a higher strike price call option and sell a lower strike price call option. Since a low strike price call option is more expensive than a higher strike price call option this spread will result in inflow of money in terms of net premium and is therefore called net credit strategy. To take an example, it is assumed that cash market price of scrip X is Rs 100. December call option on scrip X with strike price Rs 100 (at-the-money option) is bought on payment of a premium of Rs 5 and another December call option on scrip X with strike price Rs 90 (in-the-money option) is sold by receiving a premium of Rs 12. This will result in an inflow of Rs 7 at the time the spread is established. Table 9.3 analyses the pay-off profile of this spread position under different scenarios of the price of scrip X, at the expiry of the options.

Premium (Rs)

–5 –5 –5 –5 –5 –5 –5 –5 –5

X’s Price at the expiry of the options (Rs)

80

85

90

95

97

100

102

105

110

10

5

2

0

0

0

0

0

0

Value of option (Rs)*

Long call with strike Rs 100

5

0

–3

–5

–5

–5

–5

–5

–5

Total profit/loss (Rs)**

12

12

12

12

12

12

12

12

12

Premium (Rs)

–20

–15

–12

–10

–7

–5

0

0

0

Value of option (Rs)*

Short call with strike Rs 90

Table 9.3: Pay-off profile of a bearish vertical spread using calls

–8

–3

0

2

5

7

12

12

12

Total profit/loss (Rs)**

–3

–3

–3

–3

0

2

7

7

7

Contd

Net profit/loss (Rs)***

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Derivatives and Financial Innovations

–5 –5

115

120

20

15

Value of option (Rs)*

15

10

Total profit/loss (Rs)**

12

12

Premium (Rs)

–30

–25

Value of option (Rs)*

Short call with strike Rs 90

–18

–13

Total profit/loss (Rs)**

–3

–3

Net profit/loss (Rs)***

*** Net profit loss on the position is combined value of total profit/loss of both the option contracts in the spread. Negative values show net loss on the position and positive values show net profit on the position.

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign.

* Value of option at the expiry would be equal to its intrinsic value, i.e. cash price of the asset – strike price of call option.

Premium (Rs)

Long call with strike Rs 100

X’s Price at the expiry of the options (Rs)

Table 9.3 Contd

Option Spreads 267

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268

It is clear from the table that if price of the underlying is either at or below Rs 90 both the options will expire worthless and the total profit on the position will be the net premium received, i.e. Rs 7. The break-even point for this spread position is at the level of Rs 90 (lower strike price) plus the net credit of Rs 7. This means that the spread position will expire with a zero value, if price of the underlying asset is Rs 97 at maturity of the options. Further, as long as price of the underlying is lower than Rs 97, it will result in a profit equivalent to the difference between Rs 97 and the actual price of the asset (with a maximum profit of Rs 7). If price of the asset is above Rs 97 there will be a loss equivalent to actual cash price of the asset less the break-even price, i.e. Rs 97 (with a maximum loss of Rs 3). If cash price is above Rs 100 both the options would have an intrinsic value and will be exercised and the spread will result in a loss of Rs 3. The pay-off profile of this spread is shown in Fig. 9.3. Maximum profit Rs 7

Profit zone Rs 97

Profit/ loss

Maximum loss Rs 3

Rs 100 Rs 90

Asset price

Loss zone

Fig. 9.3: Pay-off profile of a bearish vertical spread with calls

The preceding pay-off figure illustrates that in this spread position the investor is locked at both ends (buy and sell side) and his profit potential as well as loss is limited. As the position is

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269

locked at both the ends position taker’s perspective is considered to be mildly bearish. As this is a primarily bearish strategy the first position taken in the spread is a short, in-the-money call with a bearish perspective, which results in an inflow of premium. However, a short call position is an unlimited risk position in case price of the underlying stock increases. As trader does not have a very aggressive view on the stock, he buys at-the-money call in order to reduce the upside risk. This purchase results in some outflow in terms of premium payment but limits the risk of the first position and the final position is left with a limited risk and limited profit. Profit and loss from the spread position will vary depending upon the strikes at which an investor chooses to establish the spread position. The maximum profit, maximum loss and break-even point of this bearish vertical spread with calls are as follows: Maximum profit = Net premium received Maximum loss = Higher strike price – Lower strike price – Net premium received Break-even point = Lower strike price + Net premium received

Bearish vertical spread using puts A bearish vertical spread can be created with the help of put options by buying a higher strike price put option and selling a lower strike price put option. This is a net debit strategy since higher strike put option is more expensive than lower strike price put option.

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Consider an example where cash market price of scrip X is assumed to be Rs 100. December put option is bought on scrip X with strike price Rs 100 (at-the-money option) on payment of a premium of Rs 5 and another December put option on scrip X with strike price Rs 90 (out-of-the-money option) is sold on receiving a premium of Rs 2. This would result in an outflow of Rs 3 at the time of establishing the spread. An analysis of the pay-off profile of this spread position at different levels of scrip X ’s price, at expiry of the option, is shown in Table 9.4. The table shows that if price of the underlying is at or above Rs 100 both the options will expire worthless and the total loss on the position will be net option premium paid, i.e. Rs 3. The break-even point for this spread position is at the level of Rs 100 (higher strike price) minus net debit of Rs 3, i.e. at Rs 97. This means that the spread position will expire with zero value if underlying asset’s price is Rs 97 at maturity of the options. Furthermore, as long as price of the underlying is lower than Rs 97 the spread position would result in a profit amounting to the difference between Rs 97 and actual price of the asset (maximum profit of Rs 7). For cash price below Rs 90 both the options will have an intrinsic value and be exercised and the spread position will result in a profit of Rs 7. Figure 9.4 shows the pay-off profile of this position. Figure 9.4 shows that in this spread position the investor is locked at both ends (buy and sell side) and his profit potential as well as loss is limited. One can therefore say that perspective of the position taker is mildly bearish. Since this is a bearish strategy the first position established in the spread is a long at-the-money put option with unlimited profit potential. As the trader does not have a very aggressive

Premium (Rs)

–5 –5 –5 –5 –5 –5 –5 –5 –5

X’s Price at the expiry of the options (Rs)

80

85

88

90

95

97

100

105

110

0

0

0

3

5

10

12

15

20

Value of option (Rs)*

Long put with strike Rs 100

–5

–5

–5

–2

0

5

7

10

15

Total profit/loss (Rs)**

2

2

2

2

2

2

2

2

2

Premium (Rs)

0

0

0

0

0

0

–2

–5

–10

Value of option (Rs)*

Short put with strike Rs 90

Table 9.4: Pay-off profile of a bearish vertical spread using puts

2

2

2

2

2

2

0

–3

–8

Total profit/loss (Rs)**

–3

–3

–3

0

2

7

7

7

7

Contd

Net profit/loss (Rs)***

Option Spreads 271

–5 –5

115

120

0

0

Value of option (Rs)*

–5

–5

Total profit/loss (Rs)**

2

2

Premium (Rs)

0

0

Value of option (Rs)*

Short put with strike Rs 90

2

2

Total profit/loss (Rs)**

–3

–3

Net profit/loss (Rs)***

*** Net profit/loss on the position is the combined value of total profit/loss of both the option contracts in the spread. Negative values show the net loss on the position and positive values show the net profit on the position.

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign.

* Value of option at the expiry would be equal to its intrinsic value, i.e. Strike price of put option – cash price of the asset.

Premium (Rs)

Long put with strike Rs 100

X’s Price at the expiry of the options (Rs)

Table 9.4 Contd

272

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Option Spreads

273

view on the stock, he writes an out-of-the-money put to reduce his cost. As a result, net outflow decreases as sold option fetches some premium for the trader. However, this reduction in outflow in terms of premium puts a cap on the profit potential from long put as may be seen in Table 9.4 (unlimited profit potential of long put is capped by selling another put at lower strike price). Profit and loss from a spread position will vary depending on the strikes at which an investor chooses to establish the spread position. Maximum profit Rs 7

Profit zone Rs 97

Profit/ loss

Rs 100 Rs 90

Asset price

Maximum loss Rs 3

Loss zone

Fig. 9.4: Pay-off profile of bearish vertical spread with puts

Maximum profit, maximum loss and break-even point of this position are as follows: Maximum profit = Higher strike price – Lower strike price – Net premium paid Maximum loss = Net premium paid Break-even point = Higher strike price – Net premium paid

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Horizontal/Calendar/Time Spreads Horizontal/calendar or time spread is established by taking two opposite positions in either two call or two put options at the same strike price, but with different maturities. While taking this position outlook of the position taker is stable, i.e. he expects the market to be more or less stable in the near future. Here, trader is essentially trying to gain from the declining time value of options. The philosophy that time value of an option diminishes at an accelerated pace with reducing maturity works for a calendar spread position taker. As the objective is to make a profit from diminishing time value of options trader sells a short-term option and buys a longterm option with the same strike price. It may be noted that both the options are generally at/near-the-money options. The concept can be better understood with the help of an example. A calendar spread is established with a short December call option on scrip X with strike price Rs 100 by receiving a premium of Rs 5 and a long January call option on scrip X with strike price Rs 100 by paying a premium of Rs 8 (assume that cash price of stock is Rs 100). The net premium paid at the beginning of December would be Rs 3. If as expected, price of the underlying stock does not move at the expiry of the December contract, December option will expire worthless and January option will have a certain price. The time value concept implies that the January option will lose time value at a pace slower than that of the December option. Hence, value of the January option at the end of December will be close to Rs 5. In this case, trader will make a net profit of Rs 2 (inflow from sale of January option at the end of December for Rs 5 – net premium paid). This profit is generated as time value of the option

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275

decreases at an accelerated rate as the option approaches its expiry date.

Diagonal Spreads As defined, diagonal spread is a spread in which two legs of the spread have different strike prices and different expiration dates. Broadly speaking, this position combines the features of both vertical and horizontal spreads. This spread may be used to create a diagonal bullish spread or a diagonal bearish spread and either call options or put options can be used to create these positions. For instance, a diagonal bullish spread may be created on the basis of an optimistic outlook for a stock and to take advantage of the diminishing time value of options. In order to create a diagonal spread trader will take a long call position with longer maturity and a short call position with shorter maturity. Thus, he may sell a December call option on scrip X with strike of Rs 110 and buy a January call option on scrip X with strike of Rs 100. Similarly, a bullish diagonal spread with put options and a bearish diagonal spread with call and put options may be created. Mathematical explanations of these positions have been left to the readers as an exercise.

Vertical Ratio Spreads Ratio spreads are an extension of bullish or bearish spreads. In the case of bullish or bearish spreads one option is bought and

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276

another option is sold, either to reduce the risk or to reduce the cost. In a ratio spread a bullish or bearish spread is taken with an additional position. Ratio spreads are more aggressive positions as compared to normal spread positions and can be created for both bullish as well as bearish perspectives.

Ratio Call Spread Ratio call spread is a position where one is mildly to moderately bullish on a particular stock. Initially a bullish vertical spread is created using calls by buying a lower strike call and selling a higher strike call. However, if market price of the stock is not expected to go beyond the higher strike price, additional call/ calls of the higher strike are sold. This position is called short ratio call spread and can be in the ratio1:2, 1:3 or 3:5, etc. Let us assume that on December 1 market price of XYZ stock is Rs 171 and outlook for the stock is mildly to moderately bullish. One would then take a long position in 170 strike call by paying a premium of Rs 6.10 and in order to reduce the cost Rs one will take a short Rs 180 strike call by receiving Rs 2.55. With these two positions a vertical bullish spread in XYZ is created. However, as the perspective is not very bullish it is believed that XYZ will not go above Rs 180 level before expiry of the series. Hence, one would sell another call of Rs 180 strike by receiving a premium of Rs 2.55 so that net debit for the position is only Re 1. However, this naked short position of Rs 180 carries an additional risk in the event that stock price goes above Rs 180 before expiry of the option. The pay-off profile of this ratio call spread position is: Buy 1 December 170 call @ 6.10 Sell 2 December 180 calls @ 2.55

Option Spreads

277

Net debit:

Re 1

Maximum profit: Rs 9 (at Rs 180) Maximum loss:

Unlimited (above Rs 189) Re 1 (below Rs 170)

The pay-off profile of this short ratio call spread position with price of XYZ stock at different levels, at expiry of the options, is as follows. Maximum profit Rs 9

Profit/ loss

Profit zone

Rs 170 Asset price

Rs 180 Loss Re 1

Rs 171

Rs 189 Loss zone

Fig. 9.5: Pay-off profile of 1:2 ratio call spread seller

As is evident from Fig. 9.5 and Table 9.5, if stock price closes below 170 on expiry, all options will expire worthless and the maximum loss on the position will be net debit, i.e. Re 1. If stock price closes between 170 and 180, Rs 170 strike call will have an intrinsic value and Rs 180 strike calls will expire worthless. In that case, the profit on the position will be actual stock price minus lower strike price and net debit of the position. The maximum profit of Rs 9 will be at stock level of Rs 180. However, if stock price closes above 180 profit will begin to decline as there will be a gain of Re 1 on 170 long call position with every Re 1 increase in the stock price but there will be a

–6.10 –6.10 –6.10 –6.10 –6.10 –6.10 –6.10 –6.10 –6.10 –6.10 –6.10

155

160

165

170

171

175

180

185

189

190

Premium (Rs)

150

XYZ’s Price at the expiry of the options (Rs)

20

19

15

10

5

1

0

0

0

0

0

Value of option (Rs)*

1 Long call with strike Rs 170

13.90

12.90

8.90

3.90

–1.10

–5.10

–6.10

–6.10

–6.10

–6.10

-6.10

Total profit/loss (Rs)**

Table 9.5: Pay-off profile of 1:2 ratio call spread

5.10

5.10

5.10

5.10

5.10

5.10

5.10

5.10

5.10

5.10

5.10

Premium (Rs)

–20

–18

–10

0

0

0

0

0

0

0

0

Value of option (Rs)*

–14.90

–12.90

–4.90

5.10

5.10

5.10

5.10

5.10

5.10

5.10

5.10

Total profit/loss (Rs)**

2 Short calls with strike Rs 180

–1

0

4

9

4

0

–1

–1

–1

–1

–1

Contd

Net profit/loss (Rs)***

278

Derivatives and Financial Innovations

–6.10

200

30

25

Value of option (Rs)*

23.90

18.90

Total profit/loss (Rs)**

5.10

5.10

Premium (Rs)

–40

–30

Value of option (Rs)*

–34.90

–24.90

Total profit/loss (Rs)**

2 Short calls with strike Rs 180

–11

–6

Net profit/loss (Rs)***

*** Net profit/loss on the position is combined value of total profit/loss of both the option contracts in spread. Negative values show net loss on the position and positive values show net profit on the position.

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign.

* Value of option at the expiry would be equal to its intrinsic value, i.e. cash price of the asset – strike price of call option.

–6.10

Premium (Rs)

1 Long call with strike Rs 170

195

XYZ’s Price at the expiry of the options (Rs)

Table 9.5 Contd

Option Spreads 279

Derivatives and Financial Innovations

280

loss of Rs 2 on 2 short 180 call positions. The profit of Rs 9 will evaporate if market price goes up to Rs 189 and at any price above Rs 189 it will begin to suffer a loss, which will be unlimited. Hence, this position is more aggressive than a vertical bullish spread. On the other hand, perspective of a ratio call spread buyer is that XYZ stock may go down but if it goes up it will gain strongly. The trader therefore sells one at-the-money or near-the-money call and buys 2 out-of-the-money calls, thus creating this spread position at a net credit. If market remains stagnant or goes down the trader gains an amount equivalent to the net credit (Re 1) of the position. However, if market goes up sharply the profit potential on his position is unlimited. The pay-off profile of this long 1:2 ratio call spread is seen in Fig. 9.6. Thus, a ratio call spread buyer will gain Re 1 if stock price remains below Rs 170 at expiry of the contract and will make a maximum loss of Rs 9 if stock closes at Rs 180. However, if stock closes above Rs 189 his profit potential will be unlimited.

Profit Re 1

Profit zone Rs 171

Rs 189 Rs 180

Rs 170

Asset price

Profit/ loss Maximum loss Rs 9

Fig. 9.6: Pay-off profile of 1:2 ratio call spread buyer

Loss zone

Option Spreads

281

Ratio Put Spread Ratio put spread is a position that is mildly to moderately bearish on a particular stock. Initially, a bearish vertical spread using puts is created by buying a higher strike put and selling a lower strike put. However, if market price of the stock is not expected to fall below the lower strike price, additional put/puts at the lower strike are sold. This position is called short ratio put spread and can be in the ratio 1:2, 1:3, 3:5, etc. If for example, market price of XYZ stock on December 1 is Rs 181.50 and one is mildly to moderately bearish on the stock, one will take a long position in a 180 strike put by paying a premium of Rs 5.90. Further, in order to reduce the cost of buying 180 strike put one will short a 170 strike put by receiving Rs 2.20. These two positions will create a vertical bearish spread. However, as perspective is not very bearish and it is believed that XYZ stock will not fall below Rs 170 level before expiry of the series, one would sell another put of Rs 170 strike by receiving a premium of Rs 2.20 so that net debit for the position is only Rs 1.5. However, this naked short position of Rs 170 carries an additional risk in the event that stock price does go below Rs 170 before expiry. The pay-off profile of this short 1:2 ratio put spread position is as follows: Buy 1 December 180 put @ 5.90 Sell 2 Dec 170 puts @ 2.20 Net debit:

Rs 1.50

Maximum profit: Rs 8.50 (at Rs 170) Maximum loss:

Unlimited (below Rs 161.50) Rs 1.50 (above Rs 180)

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282

Now, let us analyse the pay-off profile of this short 1:2 ratio put spread position under different scenarios of XYZ prices at the expiry of the options. Maximum profit Rs 8.50

Profit zone

Profit/ loss

Rs 180 Rs 170 Asset price

Loss Rs 1.50

Rs 161.50

Rs 178.50 Loss zone

Fig. 9.7: Pay-off profile of 1:2 ratio put seller

Figure 9.7 and Table 9.6 show that if stock price closes above 180 on expiry all the options will expire worthless and the loss on the position will be a net debit, i.e. Rs 1.50. If stock price closes between 180 and 170, 180 strike put will have intrinsic value and 170 strike put will expire worthless. The profit on the position will be higher strike price minus actual stock price and net debit of the position. The maximum profit point will be Rs 170 at which there will be a gain of Rs 8.5. However, if price closes below 170 the profit will begin to decline since with each Re 1 fall in stock price there will be a gain of Re 1 on a 180 long put position but there will be a loss of Rs 2 on 2 short 170 put positions. The profit of Rs 8.5 will disappear if market price goes to 161.50 and at any price below this one will begin to suffer loss, which will be unlimited. That is why this position is believed to be more aggressive than a vanilla vertical bearish spread. A ratio put spread buyer holds the view that the price of XYZ stock may go up but in the event that it goes down, it will

–5.90 –5.90 –5.90 –5.90 –5.90 –5.90 –5.90 –5.90 –5.90 –5.90 –5.90

155

160

161.50

165

170

175

178.50

180

185

190

Premium (Rs)

150

XYZ’s Price at the expiry of the options (Rs)

0

0

0

1.50

5

10

15

18.50

20

25

30

Value of option (Rs)*

1 Long put with strike Rs 180

–5.90

–5.90

–5.90

–4.40

–0.90

4.10

9.10

12.60

14.10

19.10

24.10

Total profit/loss (Rs)**

4.40

4.40

4.40

4.40

4.40

4.40

4.40

4.40

4.40

4.40

4.40

Premium (Rs)

0

0

0

0

0

0

–10

–17

–20

–30

–40

Value of option (Rs)*

4.40

4.40

4.40

4.40

4.40

4.40

–5.60

–12.60

–15.60

–25.60

–35.60

Total profit/loss (Rs)**

2 Short puts with strike Rs 170

Table 9.6: Pay-off profile of a short 1:2 ratio put spread position

–1.50

–1.50

–1.50

0

3.50

8.50

3.50

0

–1.50

–6.50

–11.50

Contd

Net profit/loss (Rs)***

Option Spreads 283

–5.90

200

0

0

Value of option (Rs)*

–5.90

–5.90

Total profit/loss (Rs)**

4.40

4.40

Premium (Rs)

0

0

Value of option (Rs)*

4.40

4.40

Total profit/loss (Rs)**

2 Short puts with strike Rs 170

–1.50

–1.50

Net profit/loss (Rs)***

*** Net profit/loss on the position is combined value of total profit/loss of both the option contracts in the spread. Negative values show net loss on the position and positive values show net profit on the position.

** Total profit/loss on the position is equal to value of option at the expiry +/– the premium received or paid. Outflows and losses are shown with negative sign while inflows and profits are shown with positive sign

* Value of option at the expiry would be equal to its intrinsic value, i.e. strike price of put option – cash price of the asset.

–5.90

Premium (Rs)

1 Long put with strike Rs 180

195

XYZ’s Price at the expiry of the options (Rs)

Table 9.6 Contd

284

Derivatives and Financial Innovations

Option Spreads

285

lose strongly. The trader therefore sells one at-the-money or nearthe-money put and buys 2 out-of-the-money puts thus creating this spread position at a net credit. If market remains stagnant or goes up he will gain an amount equivalent to the net credit but if market goes down sharply his profit potential is unlimited. The pay-off profile of this long 1:2 ratio put spread position is as follows: Profit zone

Asset price Rs 170 Rs 180

Profit/ loss Rs 161.50

Rs 178.50

Maximum Loss Rs 8.50

Loss zone

Fig. 9.8: Pay-off profile of 1:2 ratio put spread buyer

It is evident from the figure that trader will make a profit of Rs 1.50 if stock price remains above Rs 180 at expiry of the contract and will undergo a maximum loss of Rs 8.50 if stock price closes at Rs 170. However, if stock closes below Rs 161.50 his profit potential can be unlimited.

Summary 1. Option spreads are combinations of two or more opposite positions in options of the same type (i.e. calls or puts) on the same underlying.

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Derivatives and Financial Innovations

2. A vertical spread is a spread position in which two legs of the spread have different strike prices but the same expiration date. 3. A horizontal spread is a spread in which two legs of the spread have different expiration dates but the same strike price. 4. A diagonal spread is a spread in which two legs of the spread have different strike prices and different expiration dates. 5. Spreads can be used for both bullish and bearish perspectives and they can be structured using both calls as well as puts. 6. Traders generally establish spread positions when they have a mild to moderate view on the underlying asset. 7. Spread positions have maximum loss and maximum profit which are very well defined right from the time of creation of the position. 8. To establish a bullish vertical spread with call options, one buys a lower strike call option and sells a higher strike call option. As lower strike call option is more expensive than higher strike call option, this spread results in outflow of money in terms of net premium and is therefore called net debit strategy. 9. To establish a bullish vertical spread with put options, one buys a lower strike put option and sells a higher strike put option. As lower strike price put option is cheaper than higher strike put option, this spread results in an inflow of money as net option premium and is therefore called net credit strategy.

Option Spreads

287

10. To establish a bearish vertical option spread with calls, one buys a higher strike price call option and sells a lower strike call option. As lower strike call option is more expensive than higher strike call option, this spread results in an inflow of money in terms of net premium and is hence called net credit strategy. 11. To establish a bearish vertical spread with put options, one buys a higher strike put option and sells a lower strike put option. This is net debit strategy as higher strike put option is more expensive than lower strike put option. 12. A horizontal/calendar or time spread is established by taking two opposite positions in either two call or two put options at the same strike price, but with different maturities. 13. Ratio spreads are an extension of bullish or bearish spreads. In a ratio spread, a bullish or bearish spread is taken with an additional position. Ratio spreads are more aggressive positions as compared to normal spread positions.

Questions 1. The position, in which two legs of the spread have different expiration dates but the same strike price, is called: (a) Vertical spread (b) Horizontal spread (c) Diagonal spread

Derivatives and Financial Innovations

288

(d) Long spread (e) Short spread 2. Which of the following is an example of a bull spread? (a) Long December maturity call option with Rs 300 strike and short December maturity call option with Rs 320 strike (b) Long December maturity call option with Rs 300 strike and short December maturity call option with Rs 280 strike (c) Long December maturity call option with Rs 300 strike and short January maturity call option with Rs 300 strike (d) Long December maturity put option with Rs 300 strike and short December maturity put option with Rs 280 strike (e) Long December maturity put option with Rs 300 strike and short January maturity put option with Rs 300 strike 3. Which of the following is true? (a) Bullish vertical spread using call options is a net credit strategy (b) Bullish vertical spread using call options is a net debit strategy (c) Bullish vertical spread using put options is a net debit strategy (d) Bullish vertical spread using put options is a net credit strategy

Option Spreads

289

(e) Both (b) and (d) 4. Which of the following is true with regard to bull spread positions? (a) The maximum profit and maximum loss are limited (b) The maximum profit and maximum loss are unlimited (c) The maximum loss is limited but the profit potential is unlimited (d) The profit potential is limited but the downside risk is unlimited (e) As it is a bullish strategy, there can not be any loss in this position 5. Which of the following is an example of bear spread? (a) Long December maturity call option with Rs 300 strike and short December maturity call option with Rs 320 strike (b) Long December maturity call option with Rs 300 strike and short December maturity call option with Rs 280 strike (c) Long December maturity call option with Rs 300 strike and short January maturity call option with Rs 300 strike (d) Long December maturity put option with Rs 300 strike and short December maturity put option with Rs 320 strike (e) Long December maturity put option with Rs 300 strike and short January maturity put option with Rs 300 strike

Derivatives and Financial Innovations

290

6. In case of a horizontal spread position: (a) The trader expects the market to be more or less stable in the near future (b) The objective is to benefit from the diminishing time value of the option (c) The trader generally takes both the positions in at/nearthe-money options (d) Both (a) and (c) (e) All (a), (b) and (c) Answers to the Questions 1. (b)

2. (a)

3. (e)

4. (a)

5. (b)

6. (e)

Chapter 10

Other Option Trading Strategies Previous chapters have covered the versatility of options and the innumerable option trading strategies that can be created by combination of futures, calls and puts. This chapter deals with some of the most popular trading strategies. These strategies focus on profiting from the directional views in the market as well as on scenarios where a trader may have no indicative view but still wants to be in the market. They are designed, bearing in mind factors such as premium outgoings, margin of safety and profit potential and these aspects are discussed in this section.

Options are very versatile in nature and there are virtually innumerable trading strategies that can be crafted by combination of options. This chapter deals with some of the prominent ones.

Straddle Straddle involves buying/selling a combination of one at/nearthe-money call and one at/near-the-money put option with the same maturity. Traders, who are uncertain about movement of the market and its direction usually take this position.

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Derivatives and Financial Innovations

A long position in straddle is established by buying a combination of call and put options with the same strike price (preferably both at-the-money options). Similarly, a short position is established by selling a combination of call and put options with the same strike (preferably both at-the-money options). A long position holder expects that regardless of direction in which the market moves the move will be substantial. This position can generate superior returns to the trader if he creates this position ahead of a price sensitive event. On the other hand, a short straddle holder expects that market will either remain stable or will move marginally in either direction, i.e. it will be range bound. In order to understand the risk return profile of straddle holders with the help of an example let us assume that cash price of scrip X is Rs 100. Mr A is not sure about direction the market price of scrip X is likely to move in but he believes that stock will move substantially in either direction. He is therefore interested in establishing a straddle position. If he buys one call and one put option at strike of Rs 100 on payment of premium of Rs 5 each his total outflow at the time of buying straddle will be Rs 10. Table 10.1 examines what happens if market price of the underlying asset falls below the strike price, remains stable or goes above the strike price. If cash market price of the underlying is lower than the strike at the expiry of options, call leg of straddle will be worthless and put option will command a value depending upon the underlying price and as a result, net profit/loss from the position would vary. For instance, at the underlying price of Rs 85, call option would expire worthless but put option will generate Rs 15 (intrinsic value) and profit to the buyer of straddle will be Rs 5.

Other Option Trading Strategies

293

It may be noted from Table 10.1 that at the underlying’s price of Rs 90, straddle has no profit no loss position. This is called downside break-even point for straddle buyer. At any price of the underlying asset below this break-even point this position will deliver a profit. Table 10.1: Pay-off profile for a straddle buyer Price of scrip X Premium paid Profit/loss on Profit/loss on at the maturity for straddle the call option the put option of options position position position

Total profit/loss on the straddle position

75

–10

0

25

15

80

–10

0

20

10

85

–10

0

15

5

90

–10

0

10

0

95

–10

0

5

–5

100

–10

0

0

–10

105

–10

5

0

–5

110

–10

10

0

0

115

–10

15

0

5

120

–10

20

0

10

125

–10

25

0

15

It may also be noted from the table that if underlying asset closes at cash price of Rs 100 at maturity of the options both the options will expire worthless. This will result in a loss of total premium paid by the straddle buyer, i.e. Rs 10 and this will be his maximum loss position. If underlying asset ends at a price that is above the strike price, put leg of the transaction will expire worthless and call option will command a value depending upon cash price of the

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underlying. For instance, at cash price of Rs 115, put option will expire worthless and call option will be valued at Rs 15 (intrinsic value). In this case, net profit to the straddle buyer will be Rs 5. It may also be noted from the table that if price of the underlying is Rs 110 straddle position has no profit and no loss. This is called upside break-even point for the straddle buyer. If price of the underlying asset is anywhere above this breakeven point the position will deliver a profit. It is thus clear that if price of the underlying asset ends between Rs 90 and Rs 110, straddle buyer would incur a loss depending upon the actual underlying price. Basically, the premium paid (Rs 10) creates a no-profit zone around the strike price and since the premium paid is Rs 10 as long as price of the underlying moves within a range of Rs 10 on either side of the strike straddle buyer would not gain. This may be seen in Fig. 10.1.

Profit zone

No profit zone Break-even points

Profit/ loss Maximum loss Rs 10

Rs 90

Rs 110

Rs 100

Asset price

Loss zone

Fig. 10.1: Pay-off profile of a straddle buyer

In case of a straddle seller there will be a profit as long as cash price of the underlying asset, at expiry of the options, is within a range of Rs 90 and Rs 110. In fact, Rs 90 and Rs 110 are break-even points for straddle seller as well. If asset price

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goes below Rs 90 or above Rs 110 a short straddle position will result in a loss. The maximum profit to the straddle seller will occur if cash price of the stock happens to be the strike price of the option, i.e. Rs 100 at the expiry of the options. This maximum profit will be total premium received for the options, i.e. Rs 10. The pay-off profile of a straddle seller is defined in Fig. 10.2. Profit zone Rs 100

Maximum profit Rs 10 Rs 90

Rs 110 Asset price

Profit/ loss

Break-even points No profit zone

Loss zone

Fig. 10.2: Pay-off profile of a straddle seller

One may therefore conclude that if cash price of the underlying asset, at the expiry of options, remains within the range of strike price +/– the total premium paid, straddle seller will gain otherwise straddle buyer will gain.

Strangle A strangle position is a variant of the straddle position but with a minor difference. The difference lies in the strike prices at which the call and put options are bought or sold. While a straddle buyer buys call and put options at the same strike (both at/near-the-money options) a strangle buyer buys both the

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Derivatives and Financial Innovations

options at different strikes (both out-of-the-money options). It may be noted that the perspective of strangle holder, like that of a straddle holder, is also one of uncertainty about the market direction and he too expects the market to go up or down substantially. In case of a long strangle, trader buys a combination of one call option and one put option at different strike prices with the same maturity. As positions are generally taken in out-of-themoney options, the cost of this position is lower than the cost of a long straddle (out-of-the-money options are cheaper than atthe-money options). In case of a short strangle, trader writes a combination of one out-of-the-money call and one out-of-the-money put. Since selling out-of-the-money options are less risky than writing atthe-money options, selling a strangle position is less aggressive than a short straddle position. However, as this position is less risky the maximum profit potential is also lower when compared to a straddle. To understand the pay-off profile of a strangle buyer let us assume that cash market price of stock X is Rs 100 and that a trader buys a call option of Rs 110 strike at Rs 2 premium and a put option of Rs 90 at a premium of Rs 2. Total cost of establishing this strangle position is Rs 4. Table 10.2 analyses the position if price of the underlying asset falls below the lower strike price, remains stable or goes above the higher strike price. Table 10.2 indicates that strangle buyer will generate money only if cash price of the asset ends below Rs 86 (lower strike price – net premium paid) or above Rs 114 (higher strike price + net premium paid). He will incur the maximum loss of Rs 4 (total premium paid) if cash price ranges between Rs 90 and

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Rs 110 but if it is between 86 and 90 or 110 and 114 his loss will depend on actual price of the asset in the cash market. Table 10.2: Pay-off profile of a strangle buyer Price of scrip X Premium paid Profit/loss on Profit/loss on at the maturity for straddle the call option the put option of options position position position

Total profit/loss on the strangle position

75

–4

0

15

11

80

–4

0

10

6

85

–4

0

5

1

86

–4

0

4

0

90

–4

0

0

–4

95

–4

0

0

–4

100

–4

0

0

–4

105

–4

0

0

–4

110

–4

0

0

–4

114

–4

4

0

0

115

–4

5

0

1

120

–4

10

0

6

125

–4

15

0

11

The pay-off profile of a strangle buyer is illustrated in Fig. 10.3. It is apparent from the preceding that profit potential for a strangle buyer is unlimited but the risk is limited to the extent of the premium paid (occurs between two strike prices). The break-even points are: lower strike price – total premium paid on the downside, and higher strike price + total premium paid on the upside.

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From buyer’s perspective, strangle is more aggressive in nature because of out-of-the-money options that are involved. This position is also much cheaper than a straddle position as out-ofthe-money options are always cheaper than at/near-the-money options. The widening non-profit zone in Fig. 10.3 confirms that strangle position is more aggressive than straddle from a buyer’s perspective, i.e. market price of the underlying asset has to move substantially in either direction before a strangle buyer can begin to make a profit as compared to the straddle buyer.

Profit zone No profit zone Rs 90

Profit/ loss Maximum loss Rs 4

Rs 110 Asset price

Rs 86

Rs 114 Loss zone

Fig. 10.3: Pay-off profile of a strangle buyer

In analysing the strangle seller’s position it is clear that he will profit within the strangle buyer’s non-profit zone, i.e. a loss to the buyer is a profit to the seller. Furthermore, seller’s maximum profit is limited to the premium received by him and will occur within the band of strike prices, i.e. Rs 90 and Rs 110. A strangle seller’s position is presented in Fig. 10.4. If one compares the profit zone of a short strangle position with that of a short straddle position, it is clear that strangle position is more conservative position than a straddle position for an option seller and there is also lesser profit potential for the seller.

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Profit zone Maximum profit Rs 4

Rs 86

Rs 114

Rs 90 Profit/ loss

Rs 110

Asset price

Profit zone Loss zone

Fig. 10.4: Pay-off profile of a strangle seller

Protective Put Buying As discussed in Chapter 3, a portfolio investor might decide to hedge his portfolio using futures if he has a negative view on the market in short term. However, the biggest drawback of this strategy is that once he has hedged himself he is unable to take advantage of any upward movement in price of the underlying stock/stocks. Hedging in the futures market leaves an investor locked in at the price, he has hedged himself. Many investors find this proposition a big risk as it may cause them greatly under performing the market in the event of large unpredictable upward moves in the price of assets. A protective put buying strategy offers a solution to this problem. To protect the value of his portfolio an investor may buy put options on underlying stock/stocks and although this comes at a price (premium for options), it limits the downside risk of the investor while keeping the upside potential open. As an example, assume that an investor has stock X that is currently trading at Rs 100 in the cash market and although he expects the market to go down in short term, the medium term

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outlook is positive. He may therefore, buy a put option of strike price Rs 100 at a premium of Rs 5. In effect, he has bought insurance by paying Rs 5 as the premium. If price of the underlying goes down to Rs 80, put option will protect him as he will still realise a net price of Rs 95. On the other hand, if price goes up to Rs 120, put option will expire worthless but the investor will still enjoy the upside on the stock and realise a net price of Rs 115. Therefore, by buying a put option investor will lock himself at a floor level (Rs 95 in the example) leaving his position open to capitalise on any growth potential. Further analysis of this position indicates that by buying a put option, investor has actually converted his long stock position into a synthetic long call position. As discussed in the chapter on synthetics, a long position in a stock together with a long put is equivalent to a long call. Thus, the investor has effectively put a cap on the downside risk on the stock while continuing to keep the upside.

Protective Call Buying As the name suggests, this strategy involves buying a call option to protect from an unlimited loss situation. Assume that, based on negative outlook on a particular stock a trader shorts the stock futures, which involves an unlimited profit potential but also unlimited risk. To jettison the unlimited loss potential, trader may buy call options which give him an upside protection. However, this insurance comes at a price in terms of the premium for buying the call options. It is apparent that this call option purchase reduces the net realisable gain from a short position (by amount of option

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premium) but importantly, it limits the upward price movement risk on short position while maintaining the full profit potential on the downside. To elucidate this, let us assume that a trader has taken a short position in stock X that is currently trading at Rs 100 in the futures market. Although he expects the market to go down in the short term, he is concerned about the potential unlimited loss arising out of upward movement of the market. He might buy a call option at strike price of Rs 100 with a premium of Rs 5, which in effect means that he has insured himself by paying Rs 5 as premium. Contrary to his expectations, if price of the underlying asset goes up to Rs 120, call option will enable him to come out of this position with a net loss of Rs 5. On the other hand, if price goes down to Rs 80, call option would expire worthless but he would make a net profit of Rs 15 (after making adjustment for the option premium paid) on his short futures position. Therefore, by buying the call option trader has effectively protected himself against an upward movement while keeping the downside profit potential open to capitalise. Further analysis of this position indicates that by buying a call option, trader has converted his short futures position into a synthetic long put position. As discussed earlier, a short position in futures together with a long call is equivalent to a long put. Thus, although trader has effectively capped his upside risk, he has retained the downside profit potential.

Covered Call Writing Terms such as naked option writing and covered option writing are frequently used in the options market. Naked option writing means writing an option without having a position in the

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underlying market or the futures market to support the option position. A covered option writing implies that short option is covered by a position in the cash/futures market. In case of a covered call writing, trader has a long position in cash/futures market and short position in call option. This strategy is used to generate value from the stocks, which a trader holds in his investment portfolio and does not wish to sell, as he is bullish in the medium term although in the short term he expects the prices to remain stable. Covered call writing delivers values in the following two ways: 1. Cost of acquisition of the underlying asset goes down. 2. Generates profit while the trader continues to hold the asset. To understand this concept take example of Mr A, who had bought shares of company X at Rs 50 per share and which have appreciated to Rs 100 per share. Mr A has medium term positive outlook on this stock but expects that it is going to remain stable in the short term. In order to generate a profit from this stable perspective he can write call options on stock X. If he sells corresponding number of call options at strike price of Rs 110 and receives Rs 2 as premium, one may say that this premium has reduced his stock acquisition cost by Rs 2 while he continues to hold the stock. However, this reduction in cost of acquisition imposes a cap on his upside profit potential as he will not be able to enjoy unlimited profit potential of his stock position beyond the strike price of the short call option. The pay-off to Mr A under different price situations is given in Table 10.3.

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Table 10.3: Pay-off profile of a covered call writer Price of scrip X at the maturity of options

Profit/loss on long stock position

Premium adjusted profit/loss on short call option position

Total profit/loss on covered call position

80

–20

2

–18

85

–15

2

–13

90

–10

2

–8

95

–5

2

–3

98

–2

2

0

100

0

2

2

105

5

2

7

110

10

2

12

115

15

–3

12

120

20

–8

12

Table 10.3 shows that if price of the stock falls, Mr A will lose money on his stock position but will retain the premium received on the short call position and therefore his loss on the stock is reduced to the extent of the premium amount. Accordingly, his break-even point reduces to Rs 98 and even if stock closes at the same price of Rs 100 he would generate a profit of Rs 2. If price of the stock closes between Rs 100 and Rs 110, Mr A would enjoy the upside on the stock as well as make a profit on the call option since call would expire worthless. However, if price of the stock goes up significantly beyond Rs 110, Mr A would not be able to draw full benefit from this increase due to his short call position and his profit would be capped at Rs 12. This is the element of risk that is involved in covered call writing.

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Derivatives and Financial Innovations

Another issue regarding the strike in covered calls is that a covered option writer has a choice between writing in-the-money, at/near-the-money or out-of-the-money options. While in-themoney and at/near-the-money options will fetch him a better premium as compared to out-of-the-money options, they would also cap his upward profit potential at a lower level. This position can also be considered from another perspective. For example, if Mr A, who holds stock X, has a target price of Rs 110 for selling the stock, he can generate some additional money without adding any risk to his existing position by writing a Rs 110 strike call. If stock does not reach his targeted selling price, he will retain the premium of Rs 2 and stock goes above the target price of Rs 110, he effectively sells his stock at Rs 112. The advantage of this strategy is that Mr A can continue to sell Rs 110 strike calls month after month until he achieves his target price or decides to exit the stock at a lower level. Covered call writing can also be considered as a bullish strategy. If market price of stock X is Rs 122 and a trader, moderately bullish on the stock, takes a long position in stock X futures at Rs 123, his pay-off profile will be as given in Fig. 10.5. It is apparent that this long futures position holds an unlimited profit as well as unlimited loss potential. If trader’s view is moderately bullish and he does not expect the stock to cross Rs 135 level within a month, he can safely write Rs 135 strike call option. This short position in Rs 135 strike call will fetch the trader an assumed Rs 2 in premium. The pay-off profile of the combined position of long futures and short call position under different price scenarios will be as per Table 10.4.

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Profit zone

Profit/ loss

Asset price Rs 123 Loss zone

Fig. 10.5: Pay-off profile of a futures buyer Table 10.4: Pay-off profile of a covered call writer Price of scrip X at maturity of options

Profit/loss on long futures position

Premium adjusted profit/loss on short call option position

Total profit/loss on covered call position

105

–18

2

–16

110

–13

2

–11

115

–8

2

–6

120

–3

2

–1

121

–2

2

0

125

2

2

4

130

7

2

9

135

12

2

14

140

17

-3

14

145

22

-8

14

It is evident from Table 10.4 that break-even point for the trader has gone down by Rs 2—from Rs 123 to Rs 121. The premium received from short call option acts as a downward cushion for the trader. However, his profit potential is also capped at Rs 135, once he has written a call at 135 strike. In effect,

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trader has taken a bullish futures position at Rs 121 with an upside profit potential up to Rs 135 in mind. If stock goes up to Rs 130, trader makes a profit of Rs 9 in case of a covered call as against Rs 7 he would have made in naked futures position. Similarly, if stock goes to Rs 135 trader will gain Rs 14 in covered call position against Rs 12 in naked futures position. However, if stock goes up to Rs 140, covered call will fetch him only Rs 14 while a naked futures position would have given this position would be as follows: Maximum profit Rs 14

Profit/ loss

Rs 135

Profit zone

Asset price Rs 121 Loss zone

Fig. 10.6: Pay-off profile of a covered call writer

If one looks at the covered call as a bullish strategy it is really just an alternative to the naked long futures/stock position and is also exposed to the same downside risk. However, the premium received from shorting the call serves as a downward cushion for the trader. Hence, covered call is less risky strategy for a trader as compared to naked long futures/stock position.

Collar A covered call writing strategy is a very efficient strategy for generating money on the basis of a stable to moderately positive

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outlook. However, a trader is still exposed to the risk of a downside price movement of the stock. Continuing with the example taken previously, a covered call position is exposed to the risk of downside price movement in stock below Rs 121. If stock goes down to a level of Rs 110 trader stands to lose Rs 11. To cover this downside risk he can buy a put option at a lower strike (at/near-the-money). His position will then have a cap on upside profit potential created by short call and a floor on downside risk potential created by long put. This is called collar strategy. For example, he may buy Rs 120 strike put option trading at Rs 4 in which case the combined position thus created would be called collar. The pay-off profile of combined position of a long futures, a short call and a long put under different price scenarios is shown in Table 10.5. Table 10.5: Pay-off profile of a collar position Price of scrip X at maturity of options

Profit/loss on long futures position

Premium adjusted profit/loss on short call option position

Premium adjusted profit/loss on long put option position

Total profit/loss on collar position

105

–18

2

11

–5

110

–13

2

6

–5

115

–8

2

1

–5

120

–3

2

–4

–5

125

2

2

–4

0

130

7

2

–4

5

135

12

2

–4

10

140

17

–3

–4

10

145

22

–8

–4

10

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It is evident from Table 10.5 that the additional cost of buying a put will have a bearing on the break-even point of the position, which has moved upward from the level of Rs 121 to Rs 125. However, put option comes to the rescue of trader if price of the stock begins to fall contrary to his expectations, as his loss gets capped at Rs 5. The pay-off profile of this collar position is illustrated as in Fig. 10.7. Maximum profit Rs 10 Rs 135

Profit/ loss

Profit zone

Rs 120 Asset price Rs 125

Maximum loss Rs 5

Loss zone

Fig. 10.7: Pay-off profile of a collar position

Collar is a covered position on both the sides and profit and loss potential is very well defined and limited. The pay-off profile of a collar looks similar to that of a bullish spread. As long futures together with long put is equivalent to a long call position synthetically, this position is essentially a combination of long call at lower strike and short call at higher strike (bullish spread created by calls). Alternatively, since long futures with short call is equivalent to a short put position, this position is essentially a combination of long put at lower strike and short put at higher strike (bullish spread created by puts).

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Covered Put Writing As the name suggests, covered put writing involves a short position in futures contract along with a short put option on the underlying asset. A covered put is basically a bearish strategy. If market price of stock XYZ is Rs 858 and a trader who is moderately bearish on the stock takes a short position in XYZ futures at Rs 860, pay-off profile of this short futures position will be as in the following figure.

Profit zone

Profit/ loss

Asset price Rs 860 Loss zone

Fig. 10.8: Pay-off profile of a futures seller

It is clear that this short futures position comes with an unlimited profit and unlimited loss potential. If trader’s view is moderately bearish and he does not expect the stock to fall below say Rs 840 level within a month he can safely write a Rs 840 strike put option. This short put position will fetch the trader an assumed Rs 15 in premium. The pay-off profile of combined position of a short futures and a short put position under different price scenarios will be as in Table 10.6.

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Table 10.6: Pay-off profile of a covered put writer Price of scrip XYZ at maturity of options

Profit/loss on short futures position

Premium adjusted profit/loss on short put option position

Total profit/loss on covered put position

800

60

–25

35

810

50

–15

35

820

40

–5

35

830

30

5

35

840

20

15

35

850

10

15

25

860

0

15

15

870

–10

15

5

875

–15

15

0

880

–20

15

–5

890

–30

15

–15

900

–40

15

–25

Table 10.6 shows that break-even point has gone up by Rs 15 from a level of Rs 860 to Rs 875. The premium received from short put option acts as an upward cushion for the trader. However, once the trader has written put at 840 strike the profit potential also gets capped below Rs 840. The trader has thus taken a bearish futures position at Rs 875 with a downside profit potential up to Rs 840. If stock falls to Rs 850, he gains Rs 25 in case of a covered put against Rs 10, which he would have made in a naked futures position. Similarly, if stock goes down to Rs 840, he makes Rs 35 in case of covered put against Rs 20 in naked futures position. However, if stock falls to Rs 800, covered put will fetch the trader only Rs 35 versus Rs 60, which he would have got in a naked futures position. The pay-off profile of a covered put writer may be presented as in Fig. 10.9.

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Maximum profit Rs 35

311

Rs 840

Profit zone

Asset price

Profit/ loss Rs 875

Loss zone

Fig. 10.9: Pay-off profile of a covered put writer

Effectively, if we look at the covered put as a bearish strategy it is just an alternative to the naked short futures position. This strategy is also exposed to the risk of upward movements in price of the stock, as is a naked short futures position. However, premium received from shorting a put serves as a cushion for the trader and covered put is therefore a less risky strategy as compared to naked short futures position.

Reverse Collar Covered put writing is an excellent strategy to generate money on the basis of a stable to moderately negative outlook. However, a trader is still exposed to the risk of upward price movement in the stock. As seen in the previous example, covered put position is exposed to the risk of upward price movement in the stock above Rs 875. If stock goes up to a level of Rs 910 the trader stands to lose Rs 35. To cover this upside risk, he can buy a call option at a higher strike (at/near-the-money). His position would then have a cap on the downside profit potential created by the short put and a floor on the upside risk potential created by the long call. This is called a reverse collar strategy.

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Thus, if trader buys a Rs 870 strike call option trading at Rs 20, the combined position will now be called a reverse collar. The pay-off profile of combined position of a short futures, a short put and a long call, at different price levels, is given in Table10.7. Table 10.7: Pay-off profile of a reverse collar Price of scrip XYZ at maturity of options

Profit/loss on short futures position

Premium adjusted profit/loss on short put option position

Premium adjusted profit/loss on long call option position

Total profit/loss on reverse collar position

800

60

–25

–20

15

810

50

–15

–20

15

820

40

–5

–20

15

830

30

5

–20

15

840

20

15

-20

15

850

10

15

–20

5

855

5

15

–20

0

860

0

15

–20

–5

870

–10

15

–20

–15

880

–20

15

–10

–15

890

–30

15

0

–15

900

–40

15

10

–15

It is evident from the preceding that additional cost of buying a call option will have a bearing on the break-even point of the position, which has moved downward from level of Rs 875 to Rs 855. However, Rs 870 strike call protects the trader if price of the stock starts to rise contrary to his expectations, as his loss is capped at Rs 15. The pay-off profile of this reverse collar position is illustrated in Fig. 10.10.

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Maximum profit Rs 15

Profit zone Rs 840

Asset price

Profit/ loss Rs 855 Rs 870 Maximum loss Rs 15

Loss zone

Fig. 10.10: Pay-off profile of a reverse collar

A reverse collar position is covered on both sides and the profit and loss potential is very well defined and limited. The pay-off profile of a reverse collar position looks very similar to a bearish spread. In fact, as a short futures position with a long call is equivalent to a long put position, this position is essentially a combination of a long put at higher strike and a short put at lower strike (bearish spread created by puts). Alternatively, one may say that as short futures along with a short put is equivalent to a short call position, this position is essentially a combination of a long call at higher strike and a short call at lower strike (bearish spread created by calls).

Butterfly Spread This is one of the most exotic names of option strategy in practice and is so called because of its pay-off profile, which looks like a butterfly. As discussed earlier, a trader can short a straddle or a strangle on the basis of stable outlook on the market. The perception of

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a butterfly spread buyer is also the same, namely that the market will remain more or less stable till expiration of the options. A butterfly spread can be created through different combinations of call and put options. To establish a butterfly spread, a trader takes positions in four option contracts at three different strike prices. For instance, he may buy calls at the two extreme strike prices K1 and K3 (one contract at each strike) and sell two calls at the middle strike price K2 (K1 < K2 < K3). These four options may be rearranged into two components as follows: l

Buy one call option at K1 and sell one call option at K2

l

Sell one call option at K2 and buy one call option at K3

A careful look at the above two positions reveals that the first position is bullish vertical spread and the second position is bearish vertical spread. In other words, butterfly spread is just a combination of a bullish and a bearish vertical spread. To take an example of a butterfly spread, let us assume that stock X is trading at Rs 100 in the cash market and three call options with strike prices Rs 90, 100 and 110 are trading at Rs 12, 5 and 2, respectively. A trader buys calls of 90 and 110 strikes and sells two calls of 100 strike. The cost of establishing the spread will be Rs 4 (–12 +10 – 2). The value of this spread under different market prices, at the expiry of options, will be as per Table 10.8. We can analyze various scenarios as follows: Case I—What if the underlying stock price turns to be lower than the lowest strike price. In this case, all call options will expire worthless and the loss to the trader will be Rs 4 (net debit for the spread). This is also the maximum loss to the trader.

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Table 10.8: Pay-off profile of a butterfly spread buyer Price of scrip X at maturity of options

Net premium paid for butterfly position

Profit/loss on the lowest strike call option

Profit/loss on two middle strike call options

Profit/loss on the highest strike call option

Total profit/loss on the butterfly position

75

–4

0

0

0

–4

80

–4

0

0

0

–4

85

–4

0

0

0

–4

90

–4

0

0

0

–4

94

–4

4

0

0

0

95

–4

5

0

0

1

100

–4

10

0

0

6

105

–4

15

–10

0

1

106

–4

16

–12

0

0

110

–4

20

–20

0

–4

115

–4

25

–30

5

–4

120

–4

30

–40

10

–4

125

–4

35

–50

15

–4

Case II—What if the underlying stock price turns to be between the lowest and middle strikes. In this case, Rs 90 strike option will command some value as it is in-the-money while Rs 100 and Rs 110 strike options will expire worthless. Total profit/loss on the spread will be equal to the value of Rs 90 strike option less the cost of establishing this spread. For instance, at the spot price of Rs 95, the 90 strike option will be worth Rs 5. After deduction of Rs 4 (the cost of creating the spread), profit at this level will be Re 1. Similarly, profit at the spot level of Rs 98 will be Rs 4.

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Case III—What if the underlying stock price turns to be equal to the middle strike prices. If market price turns to be the middle strike price, Rs 100 and Rs 110 strike call options will expire worthless and Rs 90 strike option will command a value of Rs 10. Net profit to the trader will be Rs 6, which is the maximum profit for this spread. Case IV—What if the underlying stock price turns to be between the middle and the highest strikes. In this case, Rs 110 strike option will expire worthless but Rs 90 and Rs 100 strike price options will command values. The breakeven point on the upside is at the spot level of Rs 106. Case V—What if the underlying stock price turns to be above the highest strike price. In this case, all the three options will expire in-the-money and total loss to the trader will be Rs 4, which is the maximum loss for the spread. The pay-off profile of a butterfly spread trader is shown in Fig. 10.11. Maximum profit Rs 6

Profit zone Rs 100

Profit/ loss

Maximum loss Rs 4

Asset price Break-even points Rs 94 Rs 106 Rs 90

Rs 110

Fig. 10.11: Pay-off profile of a butterfly spread buyer

Loss zone

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It is apparent that risk and return potential of a butterfly spread buyer are limited. Maximum profit is realised if spot price at expiration is equal to the middle strike price. The break-even points of the position are defined as follows: Downside break-even point = Lowest strike + Net debit Upside break-even point = Highest strike –Net debit As seen earlier, it is possible to establish bullish and bearish spreads with the help of calls and puts independently. Therefore, a butterfly spread may be established using only call options, only put options or a combination of call and put options (one spread with calls and one spread with puts). Numerical examples of other butterfly spread combinations have been left to the readers as an exercise. A butterfly spread can also be looked at a little differently. As the trader expects price of the underlying asset to be more or less stable he can short at-the-money straddle. As a short position in straddle will expose him to unlimited loss in both directions, if market prices were to move; he may buy out-of-the-money strangle to cap his losses on both sides. The combined positions of short straddle and long strangle will also be equivalent to a butterfly spread. Readers can try this out taking a numerical example themselves. The position of a butterfly spread seller will be exactly opposite to that of a buyer. He will lose money as long as price of underlying stock remains within the range and gain if they move significantly in either side.

Condor This strategy is a variant to the butterfly spread. The perception of the buyer of a condor is the same as that of a butterfly spread

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buyer, i.e. the market will remain more or less stable till expiration. To establish a condor a trader takes positions in four option contracts at four different strike prices. For instance, he will buy calls at the two extreme strike prices K1 and K4 (one contract at each strike) and sell calls at middle strike prices K2 and K3 (one contract at each strike) (K1 < K2 < K3 < K4). Therefore, net position of trader would be long one call at K1, short one call at K2, short one call at K3 and long one call at K4 (where, K1 < K2 < K3 < K4). It is thus apparent that like a butterfly spread, condor is also a combination of bullish vertical spread and bearish vertical spread. In order to understand this concept better, let us assume that stock X is trading at Rs 105 in the cash market and four call options with strike prices Rs 90, 100, 110 and 120 are trading at Rs 17, 9, 5 and 2 respectively. A trader buys calls at 90 and 120 strikes and sells calls at 100 and 110 strikes. Total cost of establishing this spread will be Rs 5 (–17 + 9 + 5 – 2). The value of this spread under different scenarios of market prices, at the expiry of options, will be as in Table 10.9. We can analyze various scenarios as follows: Case I—What if the underlying stock price turns to be lower than the lowest strike price. In this case, all call options will expire worthless and loss to the trader will be equal to Rs 5 (net debit for the spread). This is also the maximum loss to the trader. Case II—What if the underlying stock price turns to be between the lowest and second lowest strikes. In this case, Rs 90 strike option will command some value and all the other options will expire worthless. Net profit/loss to the

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trader will be the value of Rs 90 strike option less the cost of establishing the spread. For example, at the cash market price of Rs 95, value of Rs 90 strike call will be Rs 5. As the cost of establishing the spread is Rs 5, this will also be the break-even point for the spread. However, if cash market price is assumed to be Rs 98, net gain on the position will be Rs 3. Table 10.9: Pay-off profile of a condor spread buyer Price of scrip X at maturity of options

Net premium paid for condor position

Profit/loss on the lowest strike call option

Profit/loss on second strike call options

Profit/loss on third strike call option

Profit/loss on the highest strike call option

Total profit/loss on the condor position

80

–5

0

0

0

0

–5

85

–5

0

0

0

0

–5

90

–5

0

0

0

0

–5

95

–5

5

0

0

0

0

100

–5

10

0

0

0

5

105

–5

15

–5

0

0

5

110

–5

20

–10

0

0

5

115

–5

25

–15

–5

0

0

120

–5

30

–20

–10

0

–5

125

–5

35

–25

–15

5

–5

130

–5

40

–30

–20

10

–5

Case III—What if the underlying stock price turns to be between the two middle strike prices. If market price of the stock turns to be between Rs 100 and Rs 110, options with strikes at Rs 110 and Rs 120 will expire worthless. Long position in Rs 90 strike will generate a profit and short position in Rs 100 strike will generate a loss. At any

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price between 100 and 110, the spread will generate a net profit of Rs 5. This is the maximum profit of the trader. Case IV—What if the underlying stock price turns to be between the second highest and the highest strikes. In this case, Rs 120 strike option will expire worthless but all the other three options will command values. The break-even point on the upside occurs at the cash market price of Rs 115. Case V—What if the underlying stock price turns to be above the highest strike price. In this case, all the four options will end in-the-money. The position will result in a loss of Rs 5 to the trader. This is the maximum loss for the trader. The pay-off profile of a condor buyer is given in the following figure. Maximum profit Rs 5

Rs 100

Rs 110

Profit/loss

Maximum loss Rs 5

Profit zone

Asset price Break-even points Rs 95 Rs 115 Rs 90 Rs 120

Loss zone

Fig. 10.12: Pay-off profile of a condor buyer

It is apparent from Fig. 10.12 that risk and return potential of a condor buyer are limited. The maximum profit is realised if spot price at expiration is between the two middle strikes. The break-even points of the position are defined as follows:

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Downside break-even point = Lowest strike + Net debit Upside break-even point = Highest strike –Net debit As in the case of butterfly spread, condor position can also be created using a combination of calls and puts. Numerical examples of other condor combinations have been left to the readers as an exercise. A condor can also be viewed as a combination of two strangles. As a trader expects price of the underlying stock to be more or less stable, he can short out-of the-money strangle. As a short position in strangle will bring the trader unlimited loss in both directions, if price of underlying were to move significantly, he may buy a deeper out-of-the-money strangle in order to cap his losses on both the sides. The combined positions of out-ofthe-money short strangle and deep out-of-the-money long strangle will also be equivalent to a condor. Readers can try this out by taking a numerical example themselves.

Strip A strip position is just an extension of straddle position. A straddle buyer expects the market to move significantly but is unsure about the direction it will move in and hence he buys a call as well as a put option. If market moves up, call generates money for him and if market goes down, put generates value for him. If a trader believes that although market may move in either direction, there is a greater probability of a down move rather than an up move, he can buy two put options and one call option to take advantage of the down side move.

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Assume, for example, that cash price of scrip X is Rs 100. Mr A is unsure about the direction of market price movement in scrip X but he believes that there will be a substantial move in the stock in either direction. He also has a view that the chances of a downside move are higher than an upside move. In order to establish a long strip position, he therefore buys one call and two put options at a strike price of Rs 100 on payment of a premium of Rs 5 each, i.e. his total outflow at the time of buying the strip is Rs 15. His pay-offs under different scenarios of scrip X ’s prices, at the maturity, are given in Table 10.10. Table 10.10: Pay-off profile of a strip buyer Price of scrip X at the maturity of options

Premium paid for strip position

Profit/loss on call option position

Profit/loss on Total profit/loss 2 put option on the strip positions position

75

–15

0

50

35

80

–15

0

40

25

85

–15

0

30

15

90

–15

0

20

5

92.5

–15

0

15

0

95

–15

0

10

–5

100

–15

0

0

–15

105

–15

5

0

–10

110

–15

10

0

–5

115

–15

15

0

0

120

–15

20

0

5

125

–15

25

0

10

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323

Table 10.10 indicates that trader will lose money between the levels of 92.50 and 115 (break-even points). He will suffer a maximum loss of Rs 15, if stock closes at Rs 100 on expiry. Clearly, the position is tilted in favour of a downward move in price of the underlying stock as two put options generate values for the trader in this case, whereas in case of an upward move, he has only one call option. The pay-off profile of the strip buyer is shown in the following figure.

Profit zone

No profit zone Break-even points Profit/ loss Maximum loss Rs 15

Rs 92.50

Rs 115

Rs 100

Asset price

Loss zone

Fig. 10.13: Pay-off profile of a strip buyer

Similarly, view of the strip seller is also range bound with higher probability of an upward move rather than a downward move. The strip seller will earn the maximum profit if price of the stock happens to be the strike price of the options, i.e. Rs 100 at expiry of the option. The maximum profit will be equivalent to the total premium received, i.e. Rs 15. The pay-off profile of the strip seller may be defined as in Fig. 10.14.

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Profit zone Rs 100

Maximum profit Rs 15 Rs 92.50

Profit/ loss

Rs 115 Break-even points Profit zone

Asset price

Loss zone

Fig. 10.14: Pay-off profile of a strip seller

Strap Unlike the buyer of a strip position a strap buyer expects the stock to move significantly in either direction with a greater probability of an upward move rather than a downward move. He therefore buys two call options and one put option at the same strike and maturity. For example, cash price of scrip X is Rs 100 and Mr A is unsure about the direction in which the market price is likely to move. However, he believes that there will be substantial movement in price of the stock in either direction. He also has a view that there are greater chances of an upward move than of a downward move. Based on this view he establishes a long strap position, i.e. he buys two call options and one put option at strike of Rs 100 on payment of a premium of Rs 5 each, i.e. his total outflow at the time of buying the strap is Rs 15. The pay-off profile of his position at different levels of the price of scrip X, at maturity, is given in Table 10.11. As can be seen from the table, in this position, trader will lose money between the levels of 85 and 107.50 (break-even

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points) and he will incur the maximum loss of Rs 15, if on expiry stock closes at Rs 100. Table 10.11: Pay-off profile of a strap buyer Price of scrip X at the maturity of options

Premium paid for strap position

Profit/loss on 2 call option positions

Profit/loss on Total profit/loss put option on the strap position position

75

–15

0

25

10

80

–15

0

20

5

85

–15

0

15

0

90

–15

0

10

–5

95

–15

0

5

–10

100

–15

0

0

–15

105

–15

10

0

–5

107.5

–15

15

0

0

110

–15

20

0

5

115

–15

30

0

15

120

–15

40

0

25

125

–15

50

0

35

Clearly, the position is tilted in favour of an upward move in price of the underlying stock as two call options generate values for the trader as compared to only one put option in case of a downward move. The pay-off of the strap buyer is presented in Fig. 10.15. The perspective of a strap seller is also range bound with a higher probability of a downward move rather than an upward move. A strap seller will achieve the maximum profit if price of stock is the same as the strike price, i.e. Rs 100 at the expiry of the options and it will be equivalent of the total premium

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326

received, i.e. Rs 15. The pay-off profile of a strap seller may be defined as in Fig. 10.16.

Profit zone

No profit zone Break-even points

Profit/ loss

Rs 85

Maximum loss Rs 15

Rs 107.5

Rs 100

Asset price

Loss zone

Fig. 10.15: Pay-off profile of a strap buyer

Rs 85 Profit/ loss

Profit zone

Rs 100

Maximum profit Rs 15

Rs 107.5 Asset price Break-even points Profit zone

Loss zone

Fig. 10.16: Pay-off profile of a strap seller

Summary 1. Straddle involves buying/selling a combination of one at/ near-the-money call and one at/near-the-money put option with the same maturity. Traders, who are expecting a big move on either side usually buy a straddle, wherein who expect the market to be range bound sell a straddle.

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2. Strangle involves buying/selling a combination of one outof-the-money call and one out-of-the-money put option with the same maturity. Traders, who are expecting a big move on either side buy a strangle, wherein who expect the market to be range bound sell a strangle. 3. A protective put buying involves buying a put option to protect the value of existing portfolio. Although this comes at a price (premium for options), it limits the downside risk of the investor while keeping the upside potential open. 4. A protective call buying involves buying a call option to protect the value of an existing short position. It is apparent that this call option purchase reduces the net realisable gain from the short position but importantly, it limits the upward price movement risk on short position while maintaining the full profit potential on the downside. 5. Covered call writing involves a long position in cash/ futures market and a short position in call option. This strategy is a very efficient for generating money on the basis of a stable to moderately positive outlook. 6. In covered call writing, trader is still exposed to the risk of downside price movement in the stock. To cover this downside risk, he can buy a put option at lower strike. His position will then have a cap on the upside profit potential created by short call and a floor on the downside risk potential created by long put. This is called collar strategy. 7. Covered put writing involves a short position in cash/ futures market and a short position in put option. This strategy is a very efficient for generating money on the basis of a stable to moderately negative outlook.

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8. In covered put writing, trader is still exposed to the risk of upward price movement in the stock. To cover this upside risk, he can buy a call option at higher strike. His position will then have a cap on the downside profit potential created by short put and a floor on the upside risk potential created by long call. This is also called collar strategy. 9. A butterfly spread can be created through different combinations of call and put options. To establish a butterfly spread, a trader takes positions in four option contracts at three different strike prices. For instance, he may buy calls at two extreme strike prices K1 and K3 (one contract at each strike) and sell two calls at the middle strike price K2 (K1 < K2 < K3). 10. A condor can be created through different combinations of call and put options. To establish a condor, a trader takes positions in four option contracts at four different strike prices. For instance, he will buy calls at two extreme strike prices K1 and K4 (one contract at each strike) and sell calls at middle strike prices K2 and K3 (K1 < K2 < K3 < K4). 11. A strip position is just an extension of straddle position. Strip buying involves buying a combination of one call and two put options with the same maturity and is undertaken by the traders having a volatile view with negative bias. The traders having a range bound view with positive bias usually sell the strip. 12. A strap position is also just an extension of straddle position. Strap buying involves buying a combination of two calls and one put option with the same maturity and is undertaken by the traders having a volatile view with positive bias. The traders having a range bound view with negative bias usually sell the strap.

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Questions 1. In case of long straddle positions: (a) The trader thinks that the market is going to go up significantly (b) The trader thinks that the market is going to go down significantly (c) The trader thinks that the market will move substantially in either direction (d) The trader thinks that the market will remain more or less stable (e) None of the above 2. A trader is not sure about the market movements but expects that the market will remain more or less stable. His friend informs him of an option trading strategy that involves writing, a call option and a put option at the same strike and same maturity. This strategy is known as: (a) Long straddle (b) Short straddle (c) Long strangle (d) Short strangle (e) Butterfly spread 3. In a situation similar to that in the previous question, a trader takes the position in call and put options at different strikes but with same maturity, erroneously. Unknowingly, the trader has entered into a strategy known as: (a) Short straddle

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330

(b) Short strip (c) Short strangle (d) Short strap (e) Butterfly spread 4. Which of the following is true with regard to strangle positions? (a) The seller expects the market to move widely in either direction (b) It involves positions to be taken in a call and a put at same strike (both at-the-money) and for same maturity (c) It involves positions to be taken in a out-of-the-money call and a out-of-the-money put options for same maturity (d) It involves positions to be taken in an in-the-money call and an in-the-money put options for same maturity (e) Both (a) and (c) 5. If an investor writes a call option and takes a long position in the underlying stock, the strategy is called: (a) Writing a naked option (b) Writing a covered call (c) Protective put strategy (d) Strip (e) Strap 6. The strategy of writing 10 call options on an underlying when the trader possess only 4 underlying stocks:

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(a) Is called strip strategy (b) Is called ratio call writing (c) Is a combination of 4 covered call writing and 6 naked call writing (d) Both (a) and (c) (e) Both (b) and (c) 7. The strategy of buying a put option on a stock, that one already owns, is called a: (a) Covered put writing (b) Writing a covered call (c) Strip (d) Protective put strategy (e) Strap 8. A trader buys, June expiry call options each at a strike price of Rs 200 and 220 respectively. Simultaneously, he writes 2, June expiry call options at a strike price of Rs 210. This strategy is called: (a) Butterfly spread (b) Bull spread (c) Bear spread (d) Strip (e) Time spread 9. Which of the following is false with regard to butterfly spread position? (a) The buyer expects the market to be more or less stable

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332

(b) The seller expects the market to move significantly in either direction (c) It is a combination of vertical bullish and vertical bearish strategies (d) Ideally, the middle strike price should be the average of the two extreme strikes (e) The profit for the buyer would be the maximum when the market price is equal to the highest strike price 10. Which of the following is true with regard to strap position? (a) It is also known as strip position (b) The trader is uncertain about the market movement but expects that the chances of the market going up are greater than the chances of its going down (c) The buyer in this strategy takes long position in 2 call and 1 put options with same strike and same maturity (d) Both (b) and (c) (e) All (a), (b) and (c) Answers to the Questions 1. (c)

2. (b)

3. (c)

8. (a)

9. (e) 10. (d)

4. (c)

5. (b)

6. (e)

7. (d)

Chapter 11

Summary of Trading Strategies on the Basis of Market Outlook This chapter presents a consolidated picture of various strategies available to market participants with regard to specific views on price of underlying stocks. It covers different perspectives about the market, viz. bullish, bearish, uncertain and stable and tabulates the strategies available to market traders in relation to each one of them. These strategies take into consideration various influencing factors such as: l

Positions creation

l

Underlying market outlook

l

Risk and return profiles of these positions, and

l

Values in the strategies, i.e. the way they can be used to create values.

For sake of simplicity, only generic and widely known trading strategies are considered here; therefore this is not an exhaustive list and there are many exotic products that are available in highly developed markets. With a complete understanding of these basic trading strategies however, it is possible to develop individual strategies depending on the level of risk desired and pay-off profiles of the expected returns.

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Market Outlook 1. Rising prices Strategy Long futures

Long call

Construction

Market outlook

1. Buy futures 2. Long call + Short put

Strongly bullish price expectation

1. Buy call 2. Long futures + Long put

Bullish price expectation

1. Long call A + Mildly bullish Short call B price (Vertical call expectation spread) 2. Long put A + Short put B (Vertical put spread) Wherein, Strike A < Strike B

Short put

1. Short put 2. Long futures + Short call

Neutral to mildly bullish price expectation

Long futures + Short call

Neutral to mildly bullish price expectation

Collar

n

n

n

n

Bull spread

Covered Call

Potential profit and/or loss

Long futures + Mildly bullish Short call A + price expectation Long put B Wherein Strike A > Strike B

n n

n

n

n

n

n n

Profit is unlimited as prices rise Risk is unlimited as prices decline Profit is unlimited on the upside Risk is limited to the premium paid Profit is limited Risk is limited

Profit is limited to the premium received Risk is unlimited Profit is limited to the premium received Risk is unlimited Profit is limited Risk is limited

Summary of Trading Strategies on the Basis of Market Outlook

335

2. Declining prices Strategy Short futures

Long put Bear spread

Short call Covered Put Reverse Collar

Construction

Market outlook

1. Sell futures 2. Long put + Short call

Strongly bearish price expectation

1. Buy put 2. Short futures + Long call

Bearish price expectation

Potential profit and/or loss n

n

n

n

1. Short call A + Mildly bearish price Long call B expectations (Vertical call spread) 2. Short put A + Long put B (Vertical put spread) Wherein, Strike A < Strike B 1. Sell call 2. Short futures + Short put

Neutral to mildly bearish price expectation

Short futures + Short put

Neutral to mildly bearish price expectation

Short futures + Mildly bearish price Short put A + expectations. Long call B Wherein Strike A < Strike B

n

n

n

n

n

n

n n

Profit is unlimited as prices fall Risk is unlimited as prices rise Profit is unlimited as prices fall Risk is limited as prices rise Profit is limited if prices fall Risk is limited if prices rise

Profit is limited to the premium Risk is received unlimited Profit is limited to the premium Risk is received unlimited Profit is limited Risk is limited

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336

3. Stable prices Strategy

Construction

Market outlook

Short straddle

Short call and short put at the same strike price

Stable price expectations. The trader expects that price will not move significantly in either direction

Short call and short put at different strike prices

Stable price expectations. The trader expects that prices will not move in either direction significantly

Short 1 call and 2 puts at the same strike price

Stable price expectations. But, the trader expects that probability of an up move is higher than that of a down move.

Short 2 calls and 1 put at the same strike price

Stable price expectations. But, the trader expects that probability of a down move is higher than that of an up move.

Short strangle

Short strip

Short strap

Butterfly 1. Long call A + 2 Spread Short calls B + Long call C 2. Long put A + 2 Short puts B + Long put C 3. Long put A + Short put B + Short call B + Long Call C Wherein Strike A < Strike B < Strike C

Stable price expectations. The trader expects that prices will not move in either direction significantly

Potential profit and/or loss n

n

n

n

n

n

n

n

n n

Profit is limited to the net premium received Risk is unlimited, as prices move up or down beyond the two strike prices Profit is limited to the premium received Risk is unlimited if prices move sharply up or down

Profit is limited to the net premium received Risk is unlimited as prices move up or down significantly

Profit is limited to the net premium received.

Risk is unlimited as prices move up or down significantly Profit is limited Risk is limited even if prices moves sharply up or down

Contd

Summary of Trading Strategies on the Basis of Market Outlook

337

Table Contd Strategy

Construction

Market outlook

Condor 1. Long call A + Stable price Short call B + expectations. The Short call C + trader expects that Long call D prices will not move 2. Long put A + in either direction Short put B + significantly Short put C + Long put D 3. Long put A + Short put B + Short call C + Long Call D Wherein Strike A < Strike B < Strike C < Strike D

Potential profit and/or loss n n

Profit is limited Risk is limited even if price moves sharply up or down

4. Uncertain prices Strategy

Construction

Market outlook

Long straddle

Long call and Long put at the same strike price

Uncertain price expectations. But, the trader expects that price would move significantly in either direction

Long call and long put on different prices strike

Uncertain price expectations. The trader expects that price would move significantly in either direction

Long 1 call and 2 puts at the same strike price

Uncertain price expectations. But, the trader expects that the probability of a down move is higher than that of an up move.

Long strangle

Long strip

Potential profit and/or loss n

n

n

n

n

n

Profit is unlimited, if prices move up or down Risk is limited to the premium paid

Profit is unlimited, if prices move up or down Risk is limited to the premium paid

Profit is unlimited, if prices move up or down. Risk is limited to the premium paid

Contd

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338

Table Contd Strategy

Construction

Market outlook

Long strip

Long 2 calls and 1 put at the same strike price

Uncertain price expectations. But, the trader expects that the probability of an up move is higher than that of down move

Potential profit and/or loss n

n

Profit is unlimited, if prices move up or down Risk is limited to the premium paid

PART 3

FINANCIAL INNOVATIONS

Chapter 12

Introduction to Some Innovative Financial Products In the previous two sections, generic derivative products forward/futures and options have been discussed and analysed. Thorough understanding of these generic products will form the basis for clear comprehension of this section on financial innovations, as any innovative financial product would essentially be a combination of the generic products. This section deals with innovative financial products and the process of developing such structures. Accordingly, the section focuses on the process of innovation and illustrates how new financial products come into existence. Based on this information, it will be possible to bifurcate clearly any complex product into its different components and to develop, or participate in developing innovative structures to cater to the specific needs of market participants. The discussion in this section is not confined within the regulatory and legal framework, which currently exists in India and consequently it may not be possible to implement many of the ideas presented here, in the Indian market. Accordingly, it is not limited to the study of only those products, which are practicable at present but also examines those that though not currently feasible in the Indian setting, are popular in other parts of the world. This is done with the strong belief that changes in the economic environment are inevitable and market will then be open for new ideas and innovative products.

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342

Basically, there are only three generic financial products in financial markets. These are: 1. Underlying/Forward/Futures 2. Call options 3. Put options All other products that exist in markets across the globe are a combination of these three generic products. Underlying, forward and futures are placed together and treated as one product as their pay-off profiles are identical (they have the same linear pay-off profiles). The present financial market is very open and receptive to new, innovative products and many such products are continuously being introduced and accepted by market participants. Before examining the basic principles of financial products structuring let us first consider the salient features of some of the innovative ideas on financial products.

Some Innovative Financial Products across the Globe The universe of innovative financial products is unlimited and placing all the prevailing structures together may prove to be an impossible task. Therefore, scope of the discussion here is limited to three products from the global financial market as follows: l

Liquid Yield Option Note (LYON)

l

Equity Linked Note

l

Catastrophic Bond

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343

Liquid Yield Option Note (LYON) The Liquid Yield Option Note (LYON) was launched by Merrill Lynch in 1985. The first company that raised funds through this instrument was Waste Management Inc., US. The salient features of this product were as follows: Issue price: $ 250 Maturity value: $ 1000 Interest rate: Zero Investment Bank: Merrill Lynch Issuer: Waste Management, Inc., US Launch year: 1985 Convertibility clause: Each bond optionally convertible by investors into 4.36 shares of Waste Management, Inc. Options: Both call and put; call to the issuer and put to the investors. It essentially meant that the issuer could call/buy back the note from the investors or investors could put/sell the note back to the issuer, any time during the currency of the bond. Life of the instrument: 16 years (maturity in 2001)

Thus, this instrument was structured as a zero coupon, convertible, callable and putable bond. If the security was not called, converted or redeemed till maturity, it provided a yield to maturity of 9.05 per cent to the investors. After the initial success of the product, several other issuers have used this instrument in order to raise funds. Innumerable variants of this structure exist in the market today since each feature of the product is independent of the other.

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The drivers for this product were as follows. l

l

l

l

Waste management did not want any interest cash outflow during the currency of the contract. Zero coupon bond was, therefore, issued in order to save intermediate cash flows. To compensate investors they were offered equity as a part of the convertibility clause. The convertibility clause gave the bondholders a sense of reassurance that the conversion of debt into equity would offset the loss of interest on their investment. Waste management wanted to keep open its option to redeem the notes anytime. Accordingly, it reserved the option to call back the notes in the form of a call option. To provide investors with the flexibility of exiting the investment at their choice, issuer also offered them a put option on the bond.

Equity Linked Note An Equity Linked Note (ELN), as the name suggests, is an instrument in which the pay-off profile is dependent on the return on a specific equity or equity index. It may also be called a derivative product because it derives its value from some underlying based on equity/equity index. Worldwide, there are innumerable investment products where pay-off profile is linked to a specific equity, portfolio of equities, or an index. For instance, during the Internet boom a large number of people wanted to invest in Internet stocks, which at that time were very highly priced. The risk involved in the stocks was also very high and it was therefore essential to diversify in order to mitigate the risk profile of the investment. Furthermore,

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accessibility of retail participants to good stocks was limited as a considerable portion of new equity was placed among institutions through private placement. Anticipating and appreciating the demand from the market, Smith Barney created a product with its performance linked to the Internet stock index— “Thestreet.com” an index of 20 Internet stocks. The salient features of this instrument were as follows: Issued on: May 25, 1999 Issue price: $ 10 Principal protection: Loss was limited to 10 per cent of the initial investment. In other words, principal was protected at 90 per cent of the initial investment. Profit potential: Profit was limited to 25 per cent a year. Cumulative profit was payable on maturity or call, whichever occurred earlier. Call option on bond: Bonds were callable by issuer during a 30-day period, each year after the first three years. Life of the note: 7 years Amount raised: $ 65 million, mostly from retail investors.

It may be observed from the preceding that this product offered the investors a limited loss along with an annual ceiling on profit. As loss on the investment was limited to 10 per cent of the initial investment, this product was structured in the form of a capital guarantee note (capital guarantee at 90 per cent of the investment value). From the investors’ perspective the product was outstanding, with a limited downside and a sound upward potential. It attracted the attention of a large number of retail investors.

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There is a huge potential to create financial products with their performance linked to commodities/commodity indices, currencies/currency indices, bullion/bullion indices, etc. on lines similar to those of equity linked notes, which track the performance of a specific equity or portfolio of equities. Some of these products are discussed in later part of the book.

Catastrophic Bond (CAT Bond) As the name indicates, catastrophic bonds are bonds which have their performance linked to some catastrophic incident such as a flood, storm, earthquake etc. These instruments are generally issued in the form of fixed income securities and in the event of a catastrophe, investors first lose their interest component and then principal in order to compensate issuers for the loss caused by the catastrophe. But if no calamity occurs during the period of investment, investors reap a return which is better than that offered by competing investment products (same tenure and risk profile). For instance, while setting up the amusement park in Japan, Disney Land issued CAT bonds with their performance linked to earthquakes. This essentially meant that if there were no quakes during the life of the bonds, investors would earn a high return promised to them. But if there were earthquake, investors would lose first their interest and then the principal equivalent to the amount used in repairs of the amusement park. It may be noted that in this product, principal invested is also at stake from the investor’s perspective. Accordingly, though return on bonds is high, risk to the investors is also very high. Electrolux also issued similar catastrophe bonds linked to earthquakes while setting up operations in Japan.

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A detailed look at this product reveals that it is merely a combination of a vanilla bond and an insurance product. Simply speaking, investors are writing an insurance cover to the issuer of the instrument. The insured entity merely collects the insured notional in advance in the form of an investment to avoid having to chase the insurance providers for finances later, in the event of a catastrophe. This investment earns interest at par with prevailing market rates and investors are also eligible for insurance premium, which is paid to them as an additional interest on their investment. The terms of the bond are quite simple—if covered incident does occur, insurers are required to pay and accordingly investors forgo their principal/interest either in part or full to compensate the insured. Otherwise, investors get their investment along with general return plus insurance premium i.e. a return higher than the competing products in the market. From the investors’ perspective this is essentially an investment diversification tool. Return on these bonds in excess of competing products is a function of insurance premium. This is a brilliantly innovative way to buy insurance from a wide range of insurers (investors are essentially insurers in this product). At a very broad level this may be positioned as the securitisation of insurance risk.

Some Innovative Financial Products in India Let us now consider two innovative structures from the Indian securities market.

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l l

Index Bond Indian Corporate Collateralised Debt Obligation Fund (ICCDO Fund)

Index Bond An index bond as the title suggests, is an instrument with the pay-off/performance linked to an index. This instrument was launched by ICICI in 1997 under its umbrella prospectus. The salient features of the product were as follows. Issuer: ICICI Investment banker: J M Morgan Stanley Issued in: 1997 Pay-off profile—Invest Rs 6,000 and receive Rs 22,000 at the end of 12 years, i.e. in 2009, plus an amount equivalent to the numeric value of Rs 2,000 * (Sensex in 2009/Sensex in 1997 on the date of allotment). Sensex as defined in the first section is the Bombay Stock Exchange Sensitive Index, which contains 30 stocks. It essentially means that if index registers a return of 10 per cent, investors would get a return of 10 per cent on the notional value of Rs 2,000. If however, index settles below the initial level at maturity investors would lose a corresponding amount on the notional value of Rs 2,000.

It may be seen that this product is a combination of two instruments—one discount bond (of value Rs 4,000) and one unit (of value Rs 2,000) linked to the index (BSE sensitive index). The discount bond redeems at Rs 22,000 at the end of 12 years and the index linked unit produces a value based on the value

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of index at maturity of the instrument. Both the discount bond and index unit were listed and traded separately. Therefore, the product was a simple one, which was presented to investors in the form of a package. Value drivers for the investors were to earn a fixed return over the life of instrument, while participating in the equity return linked to the index.

Indian Corporate Collateralised Debt Obligation Fund (ICCDO Fund) The ICCDO Fund was the first ever attempt to market a collateralised debt fund in the country. Although it was an innovative idea from the ICICI Investment Management Company Ltd, it did not produce the desired results. This is not because the product was not good; it was a splendid attempt at financial innovation but was not received by the investing community in the right perspective. The concept behind the product was to offer investors a vehicle to access collection of high yielding bonds (high coupon bonds issued at the time of high interest rate regime) from the sellers. Sellers were motivated to book profit on their investment through liquidation of relatively illiquid securities. The use of the mutual fund route to liquidate sellers’ positions in various fixed income instruments was quite an innovative thought. Full profile of the portfolio to be bought from the funds collected under the issue was described in the offer document. The issue was structured in three tranches—A, B and C. The salient features of the product were as follows.

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Type of scheme:—Close ended scheme. Size per unit: Rs 50,00,000 Minimum Investment: Rs 500,00,000 (10 units of Rs 50,00,000 each) Offer price: At par Offer to: Class A to public, Class B to IFC on private placement basis and class C to investors on private placement basis. Rating: Rating by ICRA (Class A—LAAA (SO), Class B—LA+ (SO) and Class C (not rated).) Year of offering: March 2002 Investment portfolio: Fully disclosed in the offer document

Somehow, the product did not sell in the market and some of the reasons cited for this were wrong timings (financial year closure), lack of regulatory clarity and lack of understanding/ awareness of investors. These innovative products provide some idea of what is meant by financial innovation. There are many products that are considerably more imaginative and creative in nature that are not offered to the public or are privately placed. This is because in order to be sold to individual/retail investors, the product needs to be simple. Individual/retail investors have neither the competence to understand nor an interest in complex structures. On the other hand, institutions need specific solutions that are sometimes highly structured in nature. They are also expected to have the competence required to understand and price complex structures.

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The objective behind financial innovation is always to create better values for both issuers and investors alike. The idea is not to win at the cost to the counter party because ultimately, both issuers and investors are dependent on each other on a continuous basis. Furthermore, better values do not necessarily mean better returns. Better values may be in terms of products that fulfil the requirements of investors better in terms of maturity profile, timeliness of funds etc. Flexibility to both issuers and investors in terms of an exit route at any time during the currency of the contract may also be considered a valued feature.

Summary 1. There are only three generic financial products in financial markets: (a) Underlying/Forward/Futures (b) Call options (c) Put options All the remaining products, we see across the globe, are a combination of these three generic products. 2. Equity Linked Note (ELN), as name suggests, is an instrument where the pay-off profile is dependent on the return on a specific equity or equity index. 3. Catastrophic bonds are bonds that have their performance linked to some catastrophic incident. These bonds are combination of a vanilla bond and an insurance product.

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4. Products offered to individual/retail investors are generally simple, as they have neither the competence nor the interest to understand them. On the other hand, institutions need specific solutions, which are sometimes highly structured in nature. 5. Financial innovation is always performed with an objective to create better values—monetary or non-monetary for both issuers and investors.

Chapter 13

Understanding Convertibles Convertibles are one of the most widely discussed products and are equally popular with both retail as well as institutional investors. This chapter will elaborate on basic features of convertibles and then examine the role these features play in terms of creating value for issuers and investors. The chapter will not merely explain what convertibles are but will consider the process of structuring convertibles from the perspective of both investors and issuers and also examine the variants of convertibles with real life examples.

Convertibles are generally considered to mean convertible bonds and as their name indicates they are bonds that may be converted into equity of the company that issues them. In other words, convertibles result in an exchange of equity shares of the company, for bonds. There are several questions related to convertible bonds that need to be considered such as: l

Is conversion compulsory or optional.

l

If it is optional, who holds the option.

l

What is the price at which equity shares will be issued and is this a fixed price or a floating price.

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l

l

If it is a floating price, what is the reference benchmark for determination of the conversion price. When will the conversion take place.

Traditionally, most of the offerings in the market have been fixed price, compulsorily convertible instruments with different time horizons. For example, Dewan Sugars Ltd issued fully convertible debentures (Rs 100 each), which were compulsorily convertible into 10 equity shares of Rs 10 each at the end of 17 months from the date of allotment. Similarly, Noida Toll Bridge Co. Ltd issued compulsorily convertible debentures (Rs 1,000 each), which were compulsorily convertible into 100 equity shares of Rs 10 each at the end of 36 months from the date of allotment. If the instrument is compulsorily convertible at a fixed price there is an inherent risk for both investors and issuers. For example, take a hypothetical situation where a company issues convertibles that are to be converted into its shares compulsorily after two years at a fixed price. Assume also that the shares of this company are listed and traded on the exchange. If market price of the stock at the time of conversion is less than the conversion price of the convertible bond, investors will lose as they will have to buy the shares under conversion at a price higher than the market price. On the other hand, if price of the share at the time of conversion is higher than the conversion price, the issuer will lose as otherwise it could have issued fresh shares at a price higher than the conversion price (closer to the prevailing market price). Therefore, both issuers and investors carry a risk in fixed price compulsory conversion deals. Needless to say that the product will need to be restructured at either the conversion feature front or the price front to provide risk management capabilities to investors and issuers alike.

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Would investors be protected if conversion is optional in their hands? The answer to this question is in affirmative since they would convert their debt into equity only if market price of the stock at the time of conversion is higher than the conversion price; otherwise, they would continue to hold the debt. Therefore, optional conversion by investors will definitely protect them. For example, Reliance Polypropylene Ltd issued debentures with conversion optional in the hands of investors. If debentures were not converted into equity shares at the end of first year, they were to be construed as non-convertible debentures redeemable by the issuer at the end of seventh year. In case of optionally convertible bonds, investors have a choice with regard to the conversion as there is an option embedded in the product. In other words, optionally convertible bonds may be bifurcated into two pieces—vanilla bond and option. Further, this option may be viewed as either a call or a put option. If option is viewed as a call option, this is a call option on stock of the company, i.e. investors have a right to buy the stock of the company. Further, as there is no cash flow involved and bonds are being surrendered for equity, it is apparent that investors are paying in kind (surrendering bond) for exercise of their call option on the equity. Another way to look at the same option is to view it as a put option on bond, i.e. investors have a right to sell the bond back to the company. In this case, the company is not paying any cash to the investors and they will receive stock in lieu of the bond. Thus, it may be viewed as a put option on bond with a provision for payment in kind (stock).

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Structure of convertible bond may be shown as follows: Call on stock with payment in kind Convertible bond

Bond + Option Put on bond with payment in kind

Fig. 13.1: Structure of a convertible bond

The optional conversion feature of the product escalates the risk of issuers since investors will demand conversion only if the conversion price is lower than the market price of the share. In this case, issuer will lose the opportunity to issue the shares at a higher price. On the other hand, if conversion does not take place, investors may demand redemption of the bond, which will mean that the issuer has to arrange funds from alternative sources (except in cases where there are internal cash flows to take care of the redemption). If conversion option to investors increases the risk to the issuer, why would an issuer give the investor this option? The answer is that option to the investors fetches the issuer a better price for the product. Generally, price of the option is reflected on the instrument in terms of a lower coupon (may be zero coupon). But what if the issuer does not consider that the price of the option (in the form of a lower coupon) is worth the risk involved. Can the product be restructured further to protect the risk of issuers as well? It is possible to accomplish this by restructuring the instrument on the conversion price front. Concerns of both investors and issuers can be addressed if conversion price of the instrument is floating, with price of the underlying share at the time of conversion as the reference benchmark. In real life situations conversion price is fixed at a

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specific discount to the prevailing market price of stock at the time of conversion (generally X per cent discount to the monthly average closing price before conversion) and this satisfies both investors as well as issuers. Investors are content as shares are being issued to them at a discount and they are thus assured of receiving some money (to the extent of the discount). Issuers are at ease as the issue price of fresh stock is at a known discount to the prevailing market price and the issuer is aware of this discount in advance. Further, because of the benefit to the investors, they are most likely to exercise their conversion option and hence there is unlikely to be any redemption pressure on the issuer. With the floating conversion price feature, is it necessary to offer the investors a conversion option? The belief is that it will not make any difference to the investors because as long as they see an advantage in conversion presented by the discount feature, they would exercise their option anyway. However, there have been many issues in the market with and without conversion option along with floating conversion price. For example, SWIL Ltd offered compulsorily fully convertible debentures at 80 per cent of the average daily closing price of the equity shares of the company on the BSE during three months prior to the date of conversion (17th month from the date of allotment). The conversion price was capped at Rs 20 per share and floored at Rs 10 per share. Other issuers like Krishna Filaments Ltd offered the optional feature to investors with regard to conversion of debentures at 33.33 per cent discount on the average daily closing price of the equity shares of the company on the BSE during six months prior to the date of conversion. Conversion price was capped at Rs 200 per share and floored at Rs 10 per share.

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The timing of the conversion is also an important factor related to convertible bonds. Different products in the market may have different conversion features. In case of fixed price compulsorily convertible products, the product is obviously convertible at maturity. In case of floating price compulsorily convertible products, investors may have a choice of time for conversion before maturity. And, in case of optional conversion products, products may have many variants with regard to the conversion timing. For example: l

l

l

l

Conversion may be available only at maturity (European option). Conversion may be available any time after the issuance of the instrument (American option). Conversion may be available any time after a wait period (wait American option). Conversion may be available for a specific time intermittently, over a period of time (Bermuda option).

There is no set pattern to the convertible timings and all kinds of products are observed in the market. It is largely the choice of the issuer with regard to its target investors and no generalisation can be made on this subject.

Global Convertible Market: Salient Features The following are the features of most offshore convertible bonds: l

Optionally convertible in the hands of investors.

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359

Wait American option, i.e. can be exercised anytime after specific wait period.

l

Fixed conversion price.

l

Issuers reserve call option on bonds.

In global markets, most of the convertibles have a fixed conversion price and conversion is optional to investors. This essentially means that investors are protected against the price risk on conversion but issuers do carry the risk. This is often considered as a reflection of the confidence of issuers in their own stocks. From investors’ perspective, fixed price optionally convertible instruments act as quasi-equity. If equity prices go up beyond the conversion price (keeping conversion price constant), value of the convertible bond goes up. On the other hand, if equity prices go down (below conversion price) market will begin to price the convertible as a vanilla bond, which will give the convertible a floor price. Therefore, an optionally convertible instrument offers an upside to investors with an embedded downside risk protection. Further, if investors exercise their conversion option and decide to hold the stock they will be exposed to price risk of the stock. In view of all this investors are interested in delaying exercise of their conversion option to the maximum extent possible. For example, assume XYZ Company has issued $ 5 face value optionally convertible bonds with a conversion price of $ 6 anytime after one year. The stock price after a year is $ 9 and it is continuously rising. As conversion is optional in the hands of investors any time after one year, convertible starts behaving like equity—its price goes up with any upward movement in the stock price. On the other hand, if equity price goes down,

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investors may redeem their bond at the face value of $ 5. This offers investors an incentive not to exercise their option and at the same time enjoy the benefits of increase in the stock price. They may therefore want to delay the conversion. On the other hand, issuers may want investors to exercise their option at the earliest in order to improve their debt equity ratio and to create leg room for further debt and also because if stock prices keep going up and investors delay conversion, the issuer may have to issue shares at a larger discount to the prevailing market price later. This is where an issuer’s call option is effective. If price of the underlying share has been going up and investors are not converting their instruments into shares, issuers may threaten to call back the bond (exercise their call option) if conversion is not effected by the investors within a given time frame. Practically, after a specific consistent difference between the prevailing market price of stock and the conversion price (market price being higher to leave some money on table for investors) the issuer sends out a call notice informing investors to either convert the instrument into shares or surrender the instrument (sell the bond back to the issuer) at a predetermined price. In such cases, investors do exercise their conversion option as doing this is financially more advantageous than surrendering the bond. This is called “forced conversion” of bond because investors are forced to convert their instruments into equity. From the accounting point of view, funds in the issuer’s books before conversion stand as debt and after conversion turn to equity. However, no cash outflow takes place on account of conversion of convertible bonds.

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Bond with Warrants Instruments such as bonds with warrants are also traded in the Indian securities market. For example, TELCO issued bonds with warrants. These warrants issued with bonds entitle the bondholders to apply for additional shares of TELCO at a fixed price within a given timeframe. Combination of bond and warrant can be compared with convertible bonds. A warrant can be defined as an option, either call or put, that confers a right to the warrant holder. Accordingly, warrants are called call warrants or put warrants. For example, Employee Stock Options (ESOPs) granted to employees may be viewed as warrants issued to employees to buy shares of the employer company. As ESOPs enable employees to buy additional shares, they are essentially call warrants. Since a convertible bond itself is combination of a bond and an option/warrant, one can state that a bond with warrant is replica of convertible bond, served to investors differently. In this case, issuer essentially bifurcates both the components (vanilla bond and option) of convertible bonds and offers them to investors in a stripped form. In other words, in case of convertible bonds, options are embedded in the bond and in case of bonds with warrants, two parts of the package (vanilla bond and option) are stripped. Such a warrant/option is called detachable warrant. Warrants are generally issued with bonds as sweeteners to reduce the cost of borrowing. This stripped option issued in the form of a warrant may have any of the features related to options. The following salient features may be present: l

Payment on exercise of warrant may be in cash or in kind.

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l l

Warrant may be exercisable at a fixed or floating price. Option can be American, European, Bermuda or any other kind of exotic option.

Detachable warrants (stripped options) are generally exercisable in cash by investors. If these options are exercisable in kind, i.e. by surrendering of bonds, for all practical purposes combination is essentially a convertible bond. Other features of options related to the price and maturity as discussed earlier, may vary from product to product. Market participants are designing extremely creative products to fit in their specific requirements and to suite their target investors. From issuer’s perspective, this combination is better priced than the convertible bond as both the stripped instruments, i.e. plain vanilla bond and warrant can be independently traded in the market. This better price may be attributed to the greater trading flexibility to the investors as they may choose to continue with only the option, only the bond or both, after issuance of combination in the primary market. Indeed, in recent past some companies have issued warrants with equity, e.g. Mindtech issued shares with warrants. These warrants (call options) were exercisable at the end of 12, 24 or 36 months at a fixed price of Rs 50 per share. Investors could thus buy additional shares of the company at a flat price of Rs 50 at the end of 12, 24 or 36 months on payment of cash.

Convertible Equity Convertible essentially means an instrument convertible into another instrument. From this perspective, it may not be difficult

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to imagine convertible equity. Indeed, convertible preference shares already exist in the Indian Securities Market and this feature (convertibility) can be simply extended to common equity as well. Convertible equity, as its name indicates, is the equity instrument that is convertible into debt or any other financial instrument of the issuer company. For the sake of simplicity, one may say that this instrument is an equity instrument, which is convertible into debt instrument of the issuer company. New generation promoters want to issue equity but investors are not willing to buy equity considering the risk involved. On the other hand, these promoters are not able to issue debt as this would result in periodical cash flows, which the business may not be able to sustain. Therefore, as a middle path, they offer convertible equity wherein the conversion clause works to mitigate the risk for equity holders. If issuer fails to perform in an expected manner, these investors would have choice of converting their equity into debt instrument. This would offer them a fixed income flow and priority over the remaining equity holders (presumed to be the promoters as conversion clause does not exist on equity of promoters), if issuer goes into liquidation. This concept would surely enhance the risk appetite of Indian investors for equity from entrepreneurs, as they would have the option to convert their equity stakes into debt stakes in case issuers perform poorly. This in turn would encourage entrepreneurship in the economy. In developed markets, this product has been quite popular over last couple of years. The salient features of the product are as follows: l

Optional Conversion—Option on conversion to investors is a general feature of convertible equity. Investors convert

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their equity into debt instrument when equity of the company has been performing badly in the market. l

l

Fixed price conversion—Paid amount/issue price of the equity becomes par value for the bond. European Option—Option is exercisable generally after a specific period of time. Life of the option gives time to the company to perform and deliver value to investors.

Convertible equity can be considered from an investors’ perspective as: l

l

A combination of vanilla equity and call option on debt with payment in kind (equity) provision. A combination of vanilla equity and put option on equity with payment in kind (debt) provision.

Here again the product is bifurcated into two components— a stock and an option. Further, this option may be viewed as either a call or a put option. If it is viewed as a call option, it is a call option on the bond of the company, i.e. investors have a right to buy the bond. As investors are converting their existing equity into bond and there is no cash flow involved, it is apparent that they are paying in kind for exercise of their call option on the bond. The option may also be viewed as a put option on the equity, i.e. investors have a right to sell the equity back to the company. In this case, company is not paying any cash to the investors as they get the bond instead. Therefore, this option may be viewed as put option on the equity with payment in kind (bond).

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Buy Back of Shares in Kind As discussed earlier, we may view a convertible equity as an instrument wherein the company is buying its shares back and paying investors for them in kind (debt instrument). This essentially means that it is possible for companies to buy back their shares for something other than cash. This practice is widely prevalent in other global markets also. In the Indian context however, the concept needs further elaboration. Let us first consider the prevailing provisions for buy back of shares in the country. Important among them are the following: 1. Companies are required to essentially pay in cash for buy back of shares. 2. Companies may raise resources for buy back of shares through any instrument other than equity. These two provisions together mean that the company may first float, for example, a debt issuance and thus collect the money required for buy back of shares. And, then use this money to buy back its shares from the equity owners. There are potential benefits in combining these two transactions and so allowing corporates to buy back their shares for other than the cash definitely has merits. Indeed, this is being practiced globally on a large scale as a corporate restructuring exercise. It is possible that all equity holders may not be interested in debt instrument and in such cases the company may pay these investors in cash through some alternative arrangement of funds. In other words, investors may have the option of surrendering their equity either for debt instrument or for cash.

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This would open up a very wide opportunity zone for companies to be creative and do something distinctly different in the market place.

Exchangeable Exchangeable, broadly stated, is a variant to the convertible debt. In case of convertible debt, the instrument is convertible into shares of the issuer company itself. But in the case of exchangeable, the instrument is convertible into share/shares of the company/companies other than the issuer of the exchangeable. For example, Cable and Wireless PLC issued an exchangeable to be converted into shares of Pacific Century CyberWorks Ltd. This product is a result of support to the fund-raising efforts of a new company by another established company/companies. Generally, peers within a group support an unknown, new company or a parent company supports its subsidiary through this product. The idea behind the product is to leverage on the reputation of established players in the market to ensure availability of funds at an appropriate cost to the new company. Further, like any other convertible instrument this product may also have different features with regard to the conversion price, time and option. Therefore, the exchangeable may be summarised as follows: l l

Exchangeable is a variant to the convertible debt. It is convertible into shares of the company other than the issuer company.

Understanding Convertibles

l

367

Conversion generally has all the following features: ¡

Conversion is optional in the hands of investors.

¡

Fixed or floating conversion price.

¡

Option can be American, European, Bermuda or any other exotic option.

Broad Dimension of Convertibles Having discussed the concepts of convertible equity, convertible debt and exchangeable, it is apparent that the issuers have a very wide opportunity zone for convertible instruments. Indeed, any financial instrument may be converted into any other financial instrument. Therefore, there are products like: l

Convertible debt

l

Convertible preference shares

l

Convertible equity

l

Exchangeable

It would be relevant to mention here that most capital restructuring exercises across the globe take place through the exchange of instruments and there are very few cash deals at the global level. This perspective on existing products opens a plethora of opportunities and innovative thinking with regard to new financial products. It also lays down the foundation for discussions in the chapters that follow.

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Summary 1. Convertible bonds are the bonds that are to be converted into equity of the issuer company. 2. Traditionally, most of the offerings in the market have been fixed price compulsorily convertible instruments with different time horizons. There is an inherent risk in these instruments for both investors and issuers. 3. Option to the investors with regard to the conversion protects them. 4. Optionally convertible bonds may be bifurcated into two components—vanilla bond and option. This option may be viewed as either a call or a put option. 5. If we make conversion price of instrument floating with the price of underlying share, at the time of conversion, as the reference benchmark, we may address concerns of both investors and issuers. 6. Since a convertible bond itself is a combination of a bond and an option/warrant, one may state that a bond with a warrant is a replica of convertible bond served to investors differently. 7. Convertible equity, as its name indicates, is the equity instrument that is convertible into debt or any other financial instrument of the issuer company. 8. In case of convertible equity, the company buys back its shares and pays investors for them in kind (debt instrument). Similarly, buyback of shares by companies for other instrument/instruments instead of cash may be promoted. This phenomenon is a global one.

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9. Exchangeable, broadly stated, is a variant to convertible debt. In case of a convertible debt instrument, the convertible is converted into shares of the issuer company itself. But in the case of an exchangeable, the instrument is convertible into share/shares of the company/companies other than the issuer of the exchangeable. 10. Issuers have a very wide opportunity zone for convertible instruments. Indeed, any financial instrument may be converted into any other financial instrument.

Chapter 14

Covered Warrants This chapter deals with the innovative use of generic products—call and put options—to create values for institutions, who have large investment portfolios in the securities market. It will examine how they can use derivatives to enhance the returns to their investors. The chapter distinguishes between warrants issued as sweeteners, covered calls and covered warrants, in order to create a clear cut understanding of these basic concepts.

Financial institutions like mutual funds, insurance companies, pension funds etc. consistently deal in a vast number of securities, which create values in the form of dividend/interest and/or capital appreciation. Fund managers generally liquidate their positions with price and time targets in mind but until then, these securities lie passively with the custodians of these institutions. This chapter examines ways in which institutions can enhance their returns through offering long dated options on the securities held by them based on their target time/price to reap returns, which are higher than those otherwise available to them. This is done with a popularly known product—warrants. The previous chapter briefly touched on the subject of Warrants and these are dealt with in greater detail here.

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Warrants Equity shares represent an ownership stake and bonds represent a credit stake in a company. Similarly, warrants represent an ownership of right—the right to either buy or sell an underlying asset on given terms. A warrant is therefore an option and as this option can either be a call or a put option, a warrant is also called a call warrant (call option) or a put warrant (put option). The holder of a call warrant has the right to buy the underlying asset and a put warrant holder has the right to sell the underlying asset. In the Indian securities market, many companies have issued warrants along with their bonds. These warrants are call warrants and provide warrant holders with the right to secure a specific number of equity shares of the issuer company at a specific price within a specific time period and are issued as sweeteners with other products such as bonds or equity. For instance, Mindtech issued shares with warrants (call options) that could be exercised at the end of 12, 24 and 36 months at a fixed price of Rs 50 per share. This meant that investors could buy additional shares for Rs 50 each at the end of 12, 24 and 36 months at their choice. These warrants are generally detachable and can be exercised in cash by investors. Detachability essentially means that they can be stripped from the instrument they are issued with and traded separately. Further, these call warrants generate money for the investors only if market price of the stock at the time of exercise of warrants is more than the strike/exercise price plus the cost of acquiring the warrants.

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Covered Warrants This product is gaining momentum across the globe because of its value generating capabilities for institutions and their investors. The issuance of covered warrant is a variant of covered call option strategy. As defined earlier in the section on options strategies, covered call strategy implies writing call options backed by underlying shares. Thus, covered warrant is a call option written by an issuer and backed by underlying shares. This warrant may or may not be listed and traded on the exchanges. Like any other equity linked instrument, it may represent a specific number of underlying shares, i.e. the option/warrant may be linked to any number of underlying shares. It should be distinctly understood that covered warrants are significantly different from call warrants, which are issued as sweeteners by issuers while selling their equity or debt securities. Futher, these are issued by third parties holding large equity portfolios. The features of covered warrants are as follows: l

It is a variant to covered call writing strategy. (A covered call strategy is, writing call options backed by the underlying asset).

l l

l

It is a call warrant backed by the underlying asset. It is issued by third parties and not by the issuer of the underlying shares. Covered warrants may be listed and traded on the exchanges like any other security.

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373

Generally institutions that hold large investment portfolios issue covered warrants. For instance, most of the global financial giants, viz. Citibank, ABN Amro, HSBC, etc. have issued innumerable warrants across the globe. Various regulators have formulated rules/regulations/guidelines for the issuance of covered warrants and these have largely been focused on defining eligibility criteria for issuers of covered warrants and risk containment measures.

Value Drivers of Covered Warrants What are the value drivers of covered warrants and why is this product required when there are exchange-traded options and institutions can anyway do covered calls on the bourses? While institutions can make covered calls in listed options, the choice of these is very limited. For instance, there are only a limited number of shares on which options are traded and the portfolios that institutions hold are not limited only to these. Furthermore, in India, maturity of listed options is limited to three months or at the best it is exchange dependent, since they architect the products and this prevents institutions from taking a long-term view and writing long dated options. In addition, at present options on exchanges are only vanilla American options (individual stock options) and there is no provision for an institution to write for example, a European option or any other kind of exotic option. The strike prices of exchange-traded options are also fixed as determined by the exchanges and market participants do not have any say on the subject. The point is that exchange traded options are rigid in many ways and do not offer the flexibility required by institutions.

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This gap between what exists and what is actually required by institutions is filled by covered warrants. In other words, covered warrants offer tremendous flexibility to issuers in designing option instruments. Different tranches with distinctive features in relation to strike prices, maturities and different kinds of options (American, European, Bermuda, etc.) can be designed. This flexibility that is available to issuers through covered warrants has opened an entirely unique set of opportunities for the market. The growth of the covered warrants market during the past couple of years has been spectacular and unprecedented all over the world. In economic terms, the philosophy of covered calls and covered warrants remain the same. They aim at: l l

Reducing the cost of acquisition of the underlying asset. Generating money for institutions and their investors, while continuing to hold the underlying.

As discussed earlier, institutions issuing covered warrants are able to reduce the cost of acquisition of their underlying security by receiving premiums from the sale of warrants/call options. However, this premium inflow will cap their upside profit potential on the underlying security as the option will be exercised if cash market price of the security is higher than the strike price itself. This effectively means that the institution has swapped its profit potential over and above the strike price for the option premium. It is important to note here that the strike price and tenure of the warrant are essentially related to the institutions’ target price and/or time of holding the underlying security. For example, if an institution buys a security at Rs 100 with a target price of Rs 125 in a year, it can safely issue a warrant with a

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strike of around Rs 125 with maturity in one year for Rs 10. The institution would receive a premium of Rs 10 upfront, which would reduce its cost of acquiring the stock. If price of the equity does go to Rs 125 within a year and the warrant is exercised, the institution will be able to sell the stock at its target price of Rs 125.

Risk Management for Covered Warrants From the perspective of risk management, there is no risk to the system from buyers of covered warrants as they have already honoured their obligations by paying the premium upfront to the warrant seller. However, sellers of the warrants, i.e. institutions may pose some risk to the system if they are unable to honour their obligations, when holders of these warrants exercise their options. In global markets, in order to protect against this risk, underlying securities of the issuing institution are generally frozen until the maturity or exercise of the covered warrants, whichever happens earlier. Though the risk of default on exercise of these options/ warrants is contained with locked underlying securities, another risk for the institutions is created. Institutions are exposed to significant price risk in underlying securities because they would not be able to sell their securities even in a falling market as these securities are locked under the risk protection measure. To address this acute problem, over a period of time, institutions have explored alternative means of offering protection to the buyers of warrants in the form of margins. The underlying logic is simple—if their short position in options is margined they will be exempted from locking in underlying securities and on exercise of the warrant/option as defined in the offer document,

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settlement may take place either through physical delivery of stock or in cash.

Cash Settled Warrants Sometimes, institutions do not want to sell their holdings on exercise of covered warrants issued by them because they still see good potential in the stocks held. Therefore, they issue cash settled covered warrants. These are essentially warrants that are backed by stocks but are to be settled in cash through payment of the difference between the settlement price and the strike price and not through delivery of the underlying stock. Cash settled warrants have recently become very popular in global markets. The innovative spirit in the market has resulted in creation of a variety of products on the warrant front. Products such as a basket of warrants and index warrants are being designed. Basket warrants offer investors a basket of securities on the exercise of warrants. Similarly, index warrants offer a full index to investors on exercise of the options held by them. Index warrants are essentially cash settled warrants.

Difference between Covered Warrants and Covered Calls Having discussed the entire gamut of covered warrants and covered calls, let us now consider the point-to-point differences between them:

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377

Covered call n

n

n

n

Standard call option, available on an exchange, is written by the holder of the underlying stock Option is standard, so offers little flexibility to the writer Anyone in the market can write covered call. No regulations are required It is rigid in nature. It is more a strategy than a product. It does not create any separately tradable product

Covered warrants n

n

n

n

Call option/warrant is created by a third party (not the issuer of underlying stock) backed by underlying stock Option is tailor made, so offers tremendous flexibility to the option writer Only institutions are allowed to write covered warrants. Regulations for them exist in different countries It is extremely versatile in nature and results in creation of an independently tradable product

It must be understood clearly that the issuing company of the underlying share is not affected in either case.

Difference between Call Warrants as Sweeteners and Covered Warrants Let us also understand the difference between call warrants issued as sweeteners along with other financial products and covered warrants issued by third parties: Call warrants as sweeteners

Covered warrants

n

Issued by issuer of underlying shares

n

Issued by third parties

n

There is only one issuer

n

Can be issued by various third parties Contd

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378

Box Contd Call warrants as sweeteners n

n

n

n

Price of warrant is charged in terms of reduced cost of the host/primary instrument Not backed by underlying shares. Underlying shares are generally issued fresh at the time of exercise. Therefore, on exercise, warrants increase the share capital of company Generally, fresh funds come to the issuer company, on exercise May be listed and traded

Covered warrants n

n

n

n

Price of warrant is paid outrightly in form of option premium Backed by underlying shares. On exercise, have no impact on share capital of underlying share company

No fresh funds come to the issuer of underlying shares May be listed and traded

It is apparent from the preceding that call warrants issued as sweeteners result in dilution of equity on exercise but in covered warrants no equity dilution takes place. This is one of the crucial distinctions between covered warrants and warrants issued as sweeteners along with other host products.

Put Warrants Put warrants, as mentioned earlier, offer investors a right to sell underlying securities. One can consider the idea of writing covered put warrants on lines similar to a covered call. Put warrants are generally issued by institutions with an intention to buy certain stocks at a price lower than the prevailing price. Covered puts have been discussed in detail in Chapter 10.

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Summary 1. Equity shares represent an ownership stake and bonds represent a credit stake in a company. Similarly, warrants represent ownership of right—right to either buy or sell underlying asset at given terms. 2. A warrant is an option. Further, as options can be either call or put, warrants can also be either call warrants (call option) or put warrants (put option). 3. Issuance of covered warrant is a variant to covered call option strategy. Covered call strategy is writing call options on exchange traded products, backed by underlying shares. 4. Third parties, who hold large equity portfolios generally issue covered warrants. 5. Exchange traded options are rigid in many ways and do not offer the flexibility required by institutions. Covered warrants offer tremendous flexibility to issuers in designing option instruments. 6. Cash settled covered warrants essentially mean warrants backed by stocks but to be settled in cash through payment of difference between settlement price and strike price and not through delivery of underlying stocks. 7. Basket warrants offer a basket of securities to investors on exercise of warrants. Similarly, index warrants offer full index to investors at exercise of options held by them. Index warrants are essentially cash settled warrants.

Chapter 15

Fresh Perspective on Existing Financial Products In every day life, one deals with simple financial products such as bank fixed deposits, housing loans, bank guarantees etc. Can we imagine that there are options embedded in all these products? Understanding the components of these products will give readers a fresh perspective and enable them to manufacture/develop similar successful products in the future.

While some of the interesting issues in financial products structuring have already been discussed, it may now be appropriate to evaluate some familiar everyday products like bank fixed deposits, housing loans, bank guarantees etc. from derivatives perspectives. For a clear understanding of these products, one needs to bifurcate them into their components.

Fixed Deposits and Options Fixed deposits (also called term deposits) with banks are probably, one of the financial products that most people know about and

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are familiar with. It is likely that each one of us has had some experience with this product but how many of us know that this traditional product too has an option embedded. Let us understand it with an example. If one has placed a fixed deposit for a year but needs the money after two months, one would go back to the bank and request for a premature withdrawal because fixed deposits allow investors this facility. However, the bank will impose some penalty on the investor and settle the deposit at a reduced interest rate than the one assured on one-year deposit. This facility of premature payment can be seen as an option because the investor has a choice. The bank however does not have any option, as it cannot redeem the fixed deposit before maturity, at its will. One may then enquire as to what kind of option this is—a call or a put option. As investors hold the instrument (FD receipt), one may say that they have a right to sell the instrument back to the bank for early redemption. This is a put option to investors given by the bank. Further, as the deposit can be broken anytime, it is essentially an American put option. Therefore, FDs/term deposits have embedded American put options.

Pre-payment Choice and Option In contrast to the withdrawal of investment is the redemption of borrowed money. Similar to premature withdrawal, an instrument may offer a borrower the choice of making prepayment. In the context of FD/term deposit, it is akin to the bank also having a choice to make pre-payment to investors at its convenience.

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In real life situations borrowers may demand the pre-payment facility on numerous occasions and this may be due to several reasons: (a) To take advantage of favourable interest rate movements—if interest rates in the economy go down it makes economic sense for the borrower to replace high cost debt by low cost debt. This would demand fresh borrowing and utilisation of these funds for repayment to the earlier investors/lenders. (b) Unexpected availability of cash, which enables the borrower to make repayment—housing/car/personal loan repayments often take place during bonus times or at the end of the calendar or financial year. It is important to understand that an instrument with prepayment provision has an option embedded. One may state that to pre-pay, the borrower has a right to buy the instrument back from the lender for a price. It is therefore a call option on instrument and as pre-payment can be made at any time, it is an American call option. For example, ICICI and IDBI have issued various debt instruments with call options and they may exercise their call option or buy the instrument back and pay the investors at the desired time. Similarly, in case of home/car/personal loans although no instrument is issued, the terms of the contract provide for early payment. It may be noted that this option to the borrower does not come free and there is a cost attached to it.

Bank Guarantee and Option Bank guarantee is a third party assurance to the lender on behalf of the borrower. In case of bank guarantee, the bank is essentially

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383

assuring the lender that in case there is a default by the borrower, it will make payment to the lender. In other words, the bank is assuming the risk of default by the borrower. Assume for example that a borrower has issued an instrument (virtual) to the lender for the borrowed amount. The bank guarantee now means that the bank has written a put option on that instrument to the lender subject to default by the borrower, i.e. in case of default by the borrower, the lender would have a right to sell the instrument to the bank. In other words, in case of default by the borrower, the bank would honour the transaction to the lender. Corporates use guarantees as credit enhancement measures since from the lender’s perspective, the risk of the corporate is replaced by that of the guaranting institution, which is considered to be better credit. Borrower pays a fee to the guaranteeing bank for this facility.

Underwriting and Option In a public offering, the issuer is always concerned about the devolvement of the issue. Devolvement is a term used for describing a situation when actual subscription in an is she is less than the minimum subscription required. If an issue devolves and the issuer is unable to collect the required minimum subscription, the objective of issue may not be accomplished. Therefore, the issuer seeks to protect its interest through getting the issue underwritten. Underwriters are the entities that write this protection to the issuer in case of devolvement. This means that they commit to buying securities from the issuer at a predetermined price (generally the issue price itself ) in case public does not subscribe

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to the offer fully (un-subscribed portion). This ensures that the issuer receives the minimum subscription required to make the issue successful. If there are multiple underwriters to the issue the un-subscribed portion is contributed by all these underwriters on a pro-rata basis in the event of under-subscription. A close examination of the structure indicates that underwriters are writing a choice to the issuer to sell them securities at a pre-determined price subject to lack of subscription from the public. Therefore, underwriting is a put option from the underwriter to the issuer. Underwriters charge the issuer a fee for this, based on their risk perception with regard to devolvement of the issue.

Right Issue and Option If a company wants to raise fresh capital through issuance of shares, the law requires that the first offer must be made to existing shareholders. This provision exists from the perspective of offering an opportunity to existing shareholders to maintain their original stake in the company in extended share capital. Therefore, existing shareholders have first right over any proposal of augmentation of share capital by the company. Rights offered in a rights issue, confer a choice to the existing shareholders of the company to buy additional shares. In other words, there is no compulsion on the shareholders to buy shares offered under a rights issue. Therefore, rights are essentially call options written by a company on its own stock to its existing shareholders. If these shareholders want to exercise their right, they make necessary payments within the given time frame and take shares or else let the right expire worthless.

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385

Buy Back of Shares and Option Sometimes companies buy back their own shares and this is guided by two objectives—for treasury purpose as an investment or for reduction of share capital. In India however, companies are permitted to buy their shares back only for extinction purposes, i.e. reduction in share capital. In other words, regulations in India do not allow companies to buy their own stocks back and keep them as investments in the balance sheet. In countries like the US there is no such restriction on companies. Whatever the purpose of the buy back may be, in any buy back offer the company is essentially offering the investors an option to sell their shares. Therefore, a buy back offer is a put option from the company on its own stock to its existing shareholders. Indeed, in US, almost all major IT companies including IBM, Microsoft, Intel, Cisco, etc. have written several put options on their own stocks. As argued by these companies, along with the buy back programme, put options also work as a confidence building measure in the market. For instance, if Microsoft is trading at $ 100 in the market and company issues one-year European put options at $ 110, the company is essentially conveying a message to the market that its stock will be at least $ 110 after one year and if that does not happen it will buy the stock back from the investors. This works as a huge confidence building measure in the market. Interestingly, these companies charge a premium from the buyers of put and the money received from writing these options, i.e. the premium, is exempted from taxes in the US.

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Equity and Option Equity in a leveraged company may also be viewed as an option—either call or put. A leveraged company is a company that has some debt component on its balance sheet. Firstly, one can say that stockholders have sold the company to bondholders for the loan amount and they own the call option on the company. In other words, equity holders have a right to buy the company from the debt holders by paying their dues both principal and interest. If they are not able to do so, the company will remain with the debt holders. In this case, the position of debt holders is that they own the company and have sold the call option on the company to the stockholders. If stockholders pay the strike price on the company, bondholders will transfer the company to the equity holders. Alternatively, one may say that equity holders own the firm with the help of borrowed money from debt holders. In addition, they have a put option on the firm, i.e. they can turn the firm over to the debt holders, in case they are not able to honour their obligations. It is important to mention that default in any situation is a put option. From the perspective of bondholders, they have loaned money to the equity holders and sold them a put option on the firm. It may be seen that in both the cases, strike price of option is the value of debt (borrowing) plus accrued interest at a given point in time. Therefore, strike of the option is a moving phenomenon in both the cases.

Fresh Perspective on Existing Financial Products

387

Collateralised Loans and Option Collateralised loans are loans against collateral. In this case, borrower puts collateral to the lender for borrowing the money. If the borrower does not honour his obligations, under the loan the lender may seize the collateral. A collateralised borrowing position may be viewed in the following ways. l

l

Sold position in asset for loan amount and long on call on asset (strike moving – borrowing + accrued interest). It is apparent that in the event of default on the borrowing of funds, lender has the right to confiscate the assets and use the proceeds to recover the amount lent along with interest. However, if borrower meets all the obligations in a timely manner, lender returns the assets to him. Therefore, for borrower, collateralised borrowing may be viewed as a sold position in the asset for the loan amount and a long on call option on the asset. Strike of call option, which is the loan plus accrued interest, is a moving phenomenon as with every additional day accrued interest goes up. Bought position in asset with borrowing and long on put option on asset (strike moving – borrowing + accrued interest). Similarly, one may say that the owner of the asset has borrowed money from the lender to buy the asset. If borrower defaults on repayment to the lender, the lender may seize the asset to recover his money. In other words, the borrower has a choice of turning the asset over to the lender in case of non-availability of money. This is obviously a put option on the asset, by the lender to the borrower.

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Derivatives and Financial Innovations

Restructuring the Collateralised Loan Transaction Collateralised loans may be restructured as repo transactions. A repo transaction is a combination of a cash/spot and a forward transaction. Practically, two transactions take place simultaneously—one in the cash market and one in the forward market. Securities are sold to the lender at the market price (cash transaction) and simultaneously bought back at a slightly higher price (forward transaction). In this deal, forward transaction price is slightly higher than the cash market price in order to make an adjustment for interest component on the borrowed amount. In this structuring, securities are actually transferred from the borrower to the lender at the time of borrowing. It may be noted that collateralised loans and repo transactions are two alternative ways of doing the same thing—financing transactions. There are structural issues with regard to structuring the deal but the intention is the same—financing with securities as collateral. Regarding motivations or advantages of repo over collateralised loans, this restructuring of a transaction is done with the objective of better risk management from the lender’s perspective (as they own the security) and to gain some tax advantages.

Summary 1. Pre-mature withdrawal facility in FDs/term deposits is an American put option.

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389

2. Pre-payment facility in various borrowings is an American call option. 3. Bank guarantee is a third party assurance to the lender on behalf of borrower. One may assume that the borrower has issued an instrument (virtual) to the lender for borrowed amount. Now, guarantee essentially means that bank has written a put option on that instrument to lender subject to default trigger by borrower. 4. Underwriters commit to buying securities from the issuer at a pre-determined price (generally the issue price itself ), in case public does not subscribe to the offer fully (unsubscribed portion). Underwriting is a put option from the underwriter to the issuer. 5. Rights offered in a rights issue confer a choice to the existing shareholders of the company to buy additional shares. Therefore, rights are essentially call options written by a company on its own stock to its existing shareholders. 6. Companies buy back their own stocks with two objectives—for treasury purpose as an investment or for reduction of share capital. Buy back offer is a put option from the company on its own stock to its existing shareholders. 7. Equity in a leveraged company may be viewed as an option on the company, either call or put: (a) While viewing equity as a call, we may say that stockholders have sold the company to bond holders for the loan amount and they own the call option on the firm. In this case, the position of the debt holder is that they own the company and they are short the call option on the company, to the stockholders.

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Derivatives and Financial Innovations

(b) While viewing equity as put, one may say that equity holders own the company with the help of borrowed money from debt holders. From the perspective of bond-holders, they have loaned money to the equity holders and sold a put option on the company, to them. 8. Collateralised loans are loans against collateral. These borrowings may be viewed as a sold position in the asset for the loan amount and a long on call on the asset or bought position in the asset with borrowing and long on put option on the asset. 9. Repo transaction is a combination of a cash/spot and a forward transaction. In a repo transaction, unlike in a collateralised transaction, securities are actually transferred from the borrower to the lender at the time of borrowing.

Chapter 16

Interest Rate Products Markets, globally, have come a long way from the days of vanilla interest rate products. This chapter offers basic building blocks for engineering interest rate products. It describes the evolution of various structures in the market over a period of time and focuses on the motivations behind product innovation as clarity on these issues is essential when a product is being structured for the first time or an existing product is restructured to make it better suite to either investors or issuers.

We all are accustomed to fixed interest rate products, i.e. plain vanilla bonds. These bonds offer a fixed rate of interest over their life and then vanish. For example, a company may issue a bond of face value Rs 100, maturing in 5 years, at 6 per cent coupon with semi-annual interest payment and redemption at par. This means that this bond will pay Rs 3 interest on a semiannual basis to the investors for the next five years and then expire at the end of the fifth year on a bullet repayment of Rs 100 from the company to the investors. It would not be an exaggeration to state that these vanilla bonds have outlived their usefulness and many innovations are taking place, across the globe, on architecture of fixed income products.

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Analysis of a vanilla fixed interest rate bond shows the following variables: 1. Face value 2. Issue price 3. Coupon rate and frequency 4. Time to expiration 5. Redemption value Most of the innovative products on fixed income are just a variation of one or more of these variables. For example, an issuer may issue bonds at a discount to the face value and redeem them at face value. As the difference between issue price and face value will be the return to the investors, issuer may not offer any coupon on this product. This product would be a zero coupon bond and is also called zero. It is one of the most commonly used structures in the fixed income market. Similarly, a bond may have floating coupon payment, i.e. coupon on a bond may vary linked to certain variable. This bond will be termed as floating rate bond or floater.

Genesis of Floaters A floating rate instrument (also called floater) is an instrument, which does not have any fixed rate of interest. In other words, interest on a floater varies over the life of instrument. The genesis of floaters can be analysed through an understanding of issues with fixed interest rate products. Traditionally, financial products with fixed interest rates have been offered to investors. For example, some of the bonds issued

Interest Rate Products

393

by ICICI and IDBI. The key risk to the issuers and investors in this product is interest rate risk because: 1. If interest rates in the economy go down (yields go down), issuers lose the opportunity to borrow at a lower rate. 2. If interest rates in the economy go up (yields go up), investors lose the opportunity to get a better return from the competing avenues. To protect themselves against this obvious risk, issuers started thinking of early redemption of bonds at their choice. Accordingly, they began to reserve the right of a premature redemption, i.e. call option on bonds. As call option is the option to purchase the underlying, this essentially means that issuers would have an opportunity to call the bond back in falling interest rate scenario and replace the high cost debt with low cost debt. Thus call option on bond offers issuers required protection from opportunity loss in case of falling interest rate situation. Over a period of time, investors also became smarter and started demanding put option on bonds in order to protect their interest. As put option is an option to sell, the idea was to have an opportunity to come out of the existing investment by selling the bond back to the issuer (avail put option) in case interest rates in the economy go up and channelise the money to generate better returns from alternative avenues. Thus put option on a bond offers investors a tool to cease the opportunity offered by the market. This phenomenon resulted in the market witnessing introduction of bonds embedded with both put and call options (an embedded option, as defined earlier, is an option in-built in the bond, i.e. it is not detachable from the bond). A large number of bonds issued by institutions like ICICI and IDBI have call and put options embedded.

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What difference in the market yield and yield on the instrument would then trigger the exercise of an option by either the issuers or investors—30 basis point, 50 basis points, 100 basis points or 200 basis points? There is no simple answer to this as it is essentially an issue of perception. However, if objectively viewed, administrative issues and corresponding costs do drive the decision. When a company redeems its existing bonds by raising fresh funds from alternative sources, it incurs certain costs—the cost of raising fresh funds and the administrative cost of redeeming existing bonds. Similarly, investors also incur costs on premature withdrawal of their existing investment in bonds and investing in alternative sources. These cost components render the whole exercise uneconomical both for the issuers and investors unless there is a significant change in the interest rates. It is however likely that both issuers and investors may not object to continuing with each other if they are compensated for a favourable change in prevailing interest rates in the economy. In other words, if investors commit to accepting lower interest rates on their investment in case of a falling interest rate scenario and issuers accept that they will pay higher interest to investors in a rising interest rate scenario, both investors and issuers may not consider premature withdrawal or premature redemption. Therefore, a better approach for handling the situation is the floatation of interest rates. This means that increasing yield in the economy will fetch better return to the investors and falling yield in the economy will reduce the interest burden of issuers. This enables investors and issuers to accomplish their respective objectives without parting. This understanding has resulted in the emergence of floating rate instruments that are also called floaters.

395

Interest Rate Products

Floating rate instruments, by definition, mean instruments with a floating pay-off. The amount of floating return is determined based on a reference benchmark at periodical intervals called reset dates. Reference benchmark may be return on various asset classes including equity, commodities, currency and interest rates. For example, interest rate reference benchmarks may be 3 months Mumbai Inter-bank Offer Rate (MIBOR), 180 days T-bill rate, 6 months SBI fixed deposit rate etc. Reset date is the date from which the fresh interest rates will be applicable with regard to the reference rate. The concept can be better understood with the help of an example. L&T (Larsen & Toubro) issued an instrument titled FD plus, as floating rate bond with reference rate linked to SBI’s rate for “term deposit beyond 3 years.” The mark up over this rate was 4.5 per cent, i.e. L&T offered investors a rate of 4.5 per cent + the reference rate with reset annually. These bonds came with an interest rate cap of 20 per cent and a floor of 14 per cent. At every reset date, the calculating agent, which is generally the issuer looks at the reference rate and declares the interest for the next period. Following table shows the computation of interest rate on instrument at various result dates for some sample reference rates: Reset

Reference rate

Interest on instrument

I

13%

17.5%

II

14%

18.5%

III

16%

20%*

IV

15.25%

19.75%

15%

19.5%

V

* Interest rate cap of 20% limits the interest rate obligation to 20%.

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Derivatives and Financial Innovations

A close look at the instrument reveals that it is a series of fixed rate instruments because the instrument has a fixed rate of interest till the next reset date. Further, all these fixed rate pieces may also independently be viewed as zeros, i.e. pieces with zero coupon. The life (tenure) of each fixed rate piece is governed by the periodicity of reset date. If reset takes place bi-annually, the zeros would be six month zeros and if the reset periodicity is one year, the zeros would be one year zeros. Although floaters address the issue of non-departure of issuers and investors, they leave extreme ends of interest rate movements open, which results in risk to both issuers and investors since: l

l

Continuously increasing yield in the economy adds to the cost of the issuer. Continuously decreasing yield in the economy causes investors to lose on their investment.

Therefore, in case of extreme movements of interest rates there is still a potential risk to both issuers and investors.

Risk Management of Floating Rate Instruments Issuers and investors can manage the risk in floating rate instruments through the following structures/products: 1. Caps, floors and collar structures as a part of floating rate instruments. 2. Combine a floating rate instrument with inverse floater.

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397

3. Swap the floating rate obligation/receipt with fixed rate obligation/receipt (interest rate swap). 4. Use interest rate futures. 5. Use interest rate options.

Cap, Floor and Collar To deal with the risk on floaters, issuers began offering floating rate instruments with a maximum limit on interest rates. This means that the issuer will pay a floating rate as long as it is less than the limit rate and if floating rate based on the reference benchmark is more than the limit rate, the limit rate would be payable to investors. This limit is called cap on the interest rate and the instrument is called floater with cap. On the other hand, investors demanded floating rate instruments with a minimum limit on interest rates. This means that investors will receive a floating rate as long as it is more than the limit rate and if floating rate based on the reference benchmark is lower than the limit rate, the limit rate would be payable by the issuer. This limit is called floor on the interest rate and the instrument is called floater with floor. Subsequently, instruments with combination of cap and floor have been introduced in the market. This structure of cap and floor is called collar. Assume for example, a floating rate instrument with benchmark reference rate of 6 months T-bill rates, a mark up of 100 basis points with a reset period of 6 months. The instrument also has a cap of 7 per cent and a floor of 4 per cent on the interest rate. This means that at any point in time interest rate payable to the investors will not be below 4 per cent and above

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Derivatives and Financial Innovations

7 per cent. Following table shows the interest rate computation with regard to a sample of reference rates on each reset date: Reset

I

6 months T-bill rates benchmark

Reference interest rates

Rates paid to the investors

5.5%

6.5%

6.5%

II

6%

7%

7%

III

7%

8%

7%

IV

7.5%

8.5%

7%

V

5%

6%

6%

VI

4%

5%

5%

4.5%

5.5%

5.5%

2%

3%

4%

VII VIII

In practice, at each reset date, issuer compares the reference based interest rates with the cap and floor. As long as this rate is less than the cap and more than the floor, the issuer pays the computed interest rate. However, if it is more than the cap, cap rate is paid and if it is less than the floor, floor rate is paid. The instrument is structured in such a manner that at no point in time investors receive less than 4 per cent or the issuer is required to pay more than 7 per cent.

Caps and Floors as Options As mentioned before, the issuer compares the computed interest rate at each reset date with the cap and floor in order to determine the interest rate payable to investors. To examine the exact nature of cap and floor, let us start by addressing the issue of what happens in this product structure

Interest Rate Products

399

when reference interest rate is higher than the cap rate. If for example, interest rate is 8 per cent, one can say that issuer pays this floating rate, viz. 8 per cent to the investors but as investors have agreed to limit the issuer’s obligation to 7 per cent, they return 1 per cent to the issuer. Similarly, if this rate happens to be 9 per cent, issuer first pays 9 per cent to the investors and then investors return 2 per cent to the issuer. As long as this rate is lower than the cap of 7 per cent, there is no interest returned to the issuer by investors. If one looks just at the interest component returned by investors to the issuer, can one say that the issuer has bought a call option on the interest rate at strike rate of 7 per cent from investors. Accordingly, whenever the reference rate is higher than 7 per cent, the issuer exercises its option and investors pay the issuer. As long as the reference rate is less than 7 per cent, option does not come into play. Further, as this comparison between the reference rate and cap rate takes place at each reset date with regard to the decision on exercise of this option, it is obvious that cap is a series of call options. Therefore, one can summarise that cap is a series of call options on interest rate, bought by the issuer from investors. Similarly, floor may be defined as a series of put options on the interest rate with strike price of 4 per cent. In this case, if the reference rate (benchmark rate + mark up) is less than 4 per cent at any reset date, the issuer (option writer) will pay the actual floating reference rate plus the difference between the reference rate and the strike interest rate of 4 per cent. However, as long as the reference rate is more than 4 per cent, option will not come into play. Therefore, irrespective of the reference rate level, investors will get paid a minimum 4 per cent interest rate at each reset date. One may thus summarise that floor is a series of put options on interest rate, bought by investors from the issuer.

400

Derivatives and Financial Innovations

Instruments with embedded cap and floor are also called caller or range notes. They behave like floating rate notes between the cap and floor and beyond that as fixed rate instruments. From the issuers’ perspective, a bond with cap and floor embedded may be viewed as a sold floater plus long on series of call options at the cap rate and short on series of put options at the floor rate. On the other hand, from the investors’ perspective, this bond may be viewed as a long floater plus short on series of call options at the cap rate and long on series of put options at the floor rate. This instrument may also be restructured by stripping call and put options from the bond, i.e. issuers may buy cap from a financial institution independently and investors may buy floor from some third party independently. In that case, the instrument will be a pure floating rate instrument without options and both issuers and investors will manage their risks independently themselves.

Inverse Floaters An inverse floater is also a floater, where the interest rate moves inversely to the benchmark reference rate. In other words, an inverse floater like any other floater has both a reference benchmark rate and a reset date but its interest rate moves in reverse direction to the reference benchmark rate. This means that when interest rates in the economy go up (yields go up), an inverse floater pays lesser interest and when interest rates in the economy go down, return on this instrument goes up. The structure of inverse floaters may be defined as follows.

Interest Rate Products

l

l l

l

401

Unlike vanilla floaters, interest rates on inverse floaters move in a direction opposite to the benchmark reference rate. They also have a reset date. They are structured as fixed rate minus reference benchmark rate. If under extreme circumstances the reference benchmark rate goes beyond the fixed rate, the issuer will not have any liability.

Grasim has raised funds through inverse floaters twice. In its first issue, the coupon on the instrument was 14 per cent— one-year yield on government securities. The details of its second issue are as follows: Issue size: Rs 50 crore Tenor: 5 years Benchmark rate: Mibor (Mumbai inter bank offer rate) Coupon: 13.75 per cent—Mibor Frequency of interest: semi-annual Lead arrangers: DSP Merrill Lynch and HSBC Rating—AAA by Crisil.

This structure may be analysed under different interest rate scenarios from the perspective of Grasim’s interest rate obligation, as follows.

402

Derivatives and Financial Innovations

Reset

Mibor rate reference benchmark rate

Coupon on inverse floater

I

4.50%

9.25%

II

4.75%

9.00%

III

5.25%

8.50%

IV

5.00%

8.75%

V

4.50%

9.25%

VI

3.75%

10.00%

VII

4.00%

9.75%

It is evident from the table that the issuer ends up paying a lower interest rate in a rising interest rate scenario and his interest liability goes up in a falling interest rate regime. If should also be clear to the readers that if Mibor goes above 13.75 per cent in an extreme situation, the issuer will not have any coupon liability on the product. An important point to appreciate is that the combination of a floater and inverse floater results in a fixed rate instrument. For instance, if one floater with coupon 180 days T-bill rate for Rs 100 cr. par value is combined with an inverse floater with coupon 10 per cent–180 days T-bill rate for Rs 100 cr. par value, it would result in a 5 per cent fixed rate instrument on the combined par value of Rs 200 cr. (floating rates would cancel each other). Accordingly, if an issuer adds an inverse floater of equal notional with a floater on its liability/asset, the combination would result in a fixed price liability/asset. Therefore, inverse floaters can be used as risk management product for floating rate instruments.

Interest Rate Products

403

Indeed, a combination of floater and inverse floater can be issued backed by a fixed interest rate stream. This is undertaken by various institutions to earn a spread over instruments. To understand this mechanism, assume that a financial institution has bought an instrument of Rs 100 cr. par value with fixed coupon of 6 per cent. Backed by this instrument, it can issue two bonds—one floater and one inverse floater of par value Rs 50 cr. each with interest features say Libor and 11 per cent-Libor respectively. This would result in a net outflow of only 5.5 per cent at any given point in time provided that the floating rate, i.e. Libor does not go above 11 per cent. This leaves a spread of 0.5 per cent with the institution. This spread of 0.5 per cent is not absolutely risk free for the issuer because if in an extreme situation Libor goes beyond 12 per cent, issuer would pay the prevailing Libor on the floater and 0 per cent on inverse floater. The issuer’s obligation on the floater, in this situation, will eat away its spread and result in a loss. At Libor level of 12 per cent, the issuer will break-even.

Interest Rate Swap Another way to manage risk on a floating rate instrument is to swap the floating rate obligation/receipt with the fixed rate obligation/receipt through a financial institution. Swap, is a term used for exchange of something and accordingly if one swaps floating interest rates with fixed rates, ones obligation/receipt becomes fixed as shown in Figures 16.1 and 16.2.

404

Derivatives and Financial Innovations

Pay fixed rate

Floating rate obligation

Institution offering swap

Receive floating rate Pay floating rate on borrowing

Fig. 16.1: Swap of floating obligation to fixed

Floating rate receipt

Pay floating rate

Institution offering swap

Receive fixed rate Receive floating rate on investment

Fig. 16.2: Swap of floating receipt to fixed

The figures show that a floating rate obligation/receipt can be easily converted into a fixed one through the swap mechanism. In interest rate swap, only interest rate obligations/receipts are swapped on a notional principal without any principal exchanging hands. Settlement of the swap contracts take place on a periodical basis (each interest payment/receipt date) by payment and receipt of the differential between the floating and fixed interest rates. As only the difference between interest rates on specified notional is settled on periodical basis, credit risk in the structure is very little. The first interest rate swap took place between IBM and the World Bank in 1981–82 and since then this market has witnessed unprecedented growth. Today, swaps account for business running into trillions of dollars, worldwide.

Interest Rate Products

405

Interest Rate Futures Another way to manage risk of floaters for both issuers and investors is the use of interest rate futures. Interest rate futures are futures contracts with interest rates being the underlying. For instance, eurodollar futures are widely used for interest rate risk management by market participants. Eurodollar futures, is a reference rate futures contract defined as (100 – 3 months Libor). The simplicity of the contract is that every basis point change/move in interest rate, (3 months libor) results in $ 25 gain or loss to the position takers. As the product is defined as 100 – 3 months Libor rate, rising interest rates result in a decrease in the value of contract and falling interest rates result in an increase in the value of contract. Now, let us examine the use of interest rate futures in risk management of floaters. If an issuer has issued a floating rate instrument, it has risk on upside movement of interest rates. To protect itself against this risk, the issuer can go short on eurodollar futures. The number of contracts required for hedging the portfolio will depend on the change in value of the portfolio with a basis point change in interest rate (DV01 of the portfolio). If interest rates in the economy go up, issuer will pay the investors more but will be compensated by his short position in the futures contract, as with increasing interest rate, the value of futures will go down. Similarly, investors can manage their risk against fall in interest rates by going long on eurodollar futures contract. Interest rate futures is a multi-million dollar market, worldwide. In India, the National Stock Exchange (NSE) introduced interest rate futures in 2002–03 but the product did not take off. Major reasons for this are the complicated structure of the

406

Derivatives and Financial Innovations

product, lack of clarity on settlement price and regulatory restrictions on participation of institutions in the market.

Interest Rate Options If issuers or investors use interest rate futures, they are locked at a specific interest rate, i.e. they have an obligation to perform the contract. In the preceding example of the issuer, if interest rates in the economy actually go down contrary to issuer’s expectation, he will pay less to investors but will lose at his futures contract short position. So hedging using futures will result in the issuer converting his floating rate obligation into a fixed rate obligation and will deprive him of the opportunity to take advantage of any favourable movement in the interest rate at a later date. Here, usage of interest rate options can offer issuers and investors a competitive advantage as they offer a choice and not an obligation. In order to hedge, issuers and investors may buy interest rate options, which will offer them hedge as well as an opportunity to take advantage of favourable price movements, if any. Both interest rate call and put options are very popular across the globe and can be bought to protect against the risks involved in the deals. The use of interest rate options has been discussed earlier in relation to the concept of cap and floor, where cap is defined as a series of call options and floor as a series of put options. In the Indian market, interest rate options are not allowed on stand-alone manner at present. A stand-alone option means an interest rate option on an independent basis. For example, an institution exposed to the interest rate risk cannot buy a cap or floor from another institution. However, market has witnessed

407

Interest Rate Products

many structures with embedded interest rate caps and floors that are nothing but embedded call and put options in interest rate products.

Some Innovative Structures in the Debt Market Having discussed generic nuances of interest rate products, let us examine some innovations in the debt market and the logic behind those products.

Step up Bonds These bonds are bonds that offer increasing interest rates with the passage of time. Step up bonds pay the highest interest rates in the last part of their life. They may sometimes be like zeros in the initial few years and then start paying interest. Payment of interest on these instruments may be illustrated as follows: 12%

Interest rate in %

10% 8% 6% 4% 2% 0% 1

2

3 Year

Fig. 16.3: Set up interest rate structure

4

5

408

Derivatives and Financial Innovations

These bonds are generally issued by issuers, who seem to have concerns with their cash flows in the initial part of the instrument’s life. Therefore, they try to postpone their obligation on these bonds for some time. With increasing business and cash flows over a period of time, issuers serve investors on their obligations. From investors’ perspective, investors, who are looking at no/low immediate return and higher return in the later part of the instrument’s life would be attracted towards the product. Further, this product may be structured either as a fixed interest rate product or a floating interest rate product. For example, the product may either define fixed interest rates as 5 per cent, 6 per cent, 7 per cent and 8 per cent over four years of its life or it may define floating interest rates as 1-year SBI fixed deposit rates plus 100 bps (basis points) in the first year, 200 bps in the second year, 300 bps in third year and 400 bps in the fourth year. The Indian market has seen the use of both fixed and floating step up bonds. ICICI has issued bonds called encash bonds on several occasions with provision of interest rates going up over a period of time. ICICI issued these bonds at varying interest rates from time to time. One offering was half-yearly interest at increasing rates varying from 13 per cent to 18 per cent for a tenure of five years and annualised yield to maturity (YTM) of 15.89 per cent. Another issuance was of interest rate increasing from 9 per cent in the first year to 10.5 per cent in the fifth year. ABN Amro Bank has issued retail home loans on floating rate basis, where interest rates were stepped up over the life of loan.

Interest Rate Products

409

Step Down Bonds These bonds are exactly opposite to the step up bonds. They offer lower interest rates every year as the bond matures. This means that they pay higher interest rates in the beginning and the same diminishes with the passage of time. Again, as is the case with step up bonds, these bonds also may either have a fixed step down interest rate structure or a floating step down interest rate structure. L&T issued bonds with decreasing interest rates over the instrument’s life of six years. Interest payable in the first and second year was 19 per cent, in the third and fourth year was 17 per cent and in the fifth and sixth year, it was 15 per cent. Redemption was bullet at the end of sixth year.

Amortisation Bonds Amortisation bonds are bonds where principal repayment is spread over the life of instrument. In this bond, the issuer pays periodical installments, which include both interest and principal. In the initial years of the instrument, installments have higher interest component and lower principal repayment piece. However, with every subsequent installment, principal repayment component keeps increasing and interest component keeps coming down. The simplest example of amortisation bonds is a housing loan. In a hypothetical manner, we can assume that the borrower while taking home loan issues a virtual bond to the lender. Amortisation of this bond takes place in the form of equal monthly installments (EMI), which have both principal and interest components.

410

Derivatives and Financial Innovations

Indeed, any loan scheme may be designed in the form of amortised instruments.

Perpetual Bonds (Consol Bonds) Perpetual bonds are bonds, which are expected to remain live for perpetuity like equity. In other words, these bonds are irredeemable bonds. The Bank of England was the first institution, which issued perpetual bonds. These bonds were issued by the bank on behalf of British Government in 1890 to finance the Boer war in South Africa and are still outstanding. Reliance has also issued bonds with 100 years maturity in the international market, which theoretically may be considered as perpetual maturity. These bonds have call and put options embedded at the end of every 10 years. This essentially means that the issuer may redeem the bonds at the end of 10 years or investors may request for premature withdrawal after every 10 years.

Principal Protection Bonds (PPBs) Principal Protection Bonds also called Capital Protection Bonds are designed to provide protection to capital invested by the investors, i.e. at maturity of the bonds, investors are sure to get back the amount invested. Over and above principal repayment, return on the instrument is linked to some benchmark asset like equity, commodity, currency etc. Practically, this instrument is structured as a combination of fixed deposit and an instrument offering participation in the movement of the underlying benchmark asset. Let us understand the product with the help of an example.

Interest Rate Products

411

Assume that an institution offers a scheme, which guarantees 100 per cent capital protection at the end of one year. Further, the scheme offers a return of 50 per cent participation in an equity index, e.g. Nifty over this period. From the investors’ perspective, this product can be bifurcated into two sections—a debt instrument, which matures at the value of the investment and a call on Nifty to the extent of 50 per cent of notional invested. If Nifty appreciates by 20 per cent in one year, investors will get 10 per cent return on their investment. However, if Nifty shows a negative return over the year, investors will get their money back without any return. Therefore, investors carry a risk of interest opportunity loss if Nifty were to register a negative return. However, principal protection along with upside profit potential linked to an equity index is a big incentive for investors. From the issuers’ perspective, they are short a bond and short a call on Nifty to the extent of 50 per cent of the sum invested by the investors. To manage their risk, issuers will park a fixed amount in zero coupon bond, which yields the capital protection and utilise the balance amount to buy a call on the Nifty or do delta hedging. This product is extremely popular in international markets and almost all investment banks offer principal protected bonds on a variety of underlying benchmark assets.

Payment in Kind Bond (PIK bonds) Payment in kind bonds are bonds that provide a return, i.e. interest not in cash but in kind. In these bonds, interest is generally paid in the form of another bond with the same or different characteristics.

412

Derivatives and Financial Innovations

The rationale behind this instrument is quite simple. From issuers’ perspective, the instrument is issued when it perceives cash constraints over the life of instrument. From the investors’ viewpoint, once the bond is given as interest, they can encash it by selling in the market.

Treasury Inflation Protection Securities (TIPS) Treasury Inflation Protection Securities are structured to provide protection to the investors against inflation. As the concept suggests the principal invested in these bonds is escalated to make an adjustment for the inflation rate at the end of every year and the promised real rate of return is paid to investors on this escalated value. Redemption of the instrument takes place at maturity with the principal adjusted against inflation. An example of TIPS is given as follows. Treasury inflation protection securitie Par value

$ 1000

Real rate of return/Coupon

4%

Maturity

3 years

Year

Inflation in year just ended

0

Par value

Coupon payment

Principal payment

Total payment

1000.00

1

2%

1020.00

40.80

0

40.80

2

3%

1050.60

42.02

0

42.02

3

1%

1061.11

42.44

1061.11

1103.55

Generally, this instrument is issued by only government agencies. TIPS were issued for the first time in US in January

Interest Rate Products

413

1997. The Indian Government also issued TIPS in December 1997. From the perspective of issuer, it is assumed that this instrument puts pressure on the government to keep inflation under control as increasing inflation costs the government more on its obligation on the instrument. From the point of view of investors, this instrument provides protection against erosion of value of money because of inflationary pressure.

Separate Trading of Interest and Principal Securities (STRIPS) Separate trading of interest and principal securities is very popular in US. In this case, a coupon bond is bifurcated into a number of pieces depending on the number of coupons outstanding and is generally done for dated government securities. The philosophy that a coupon bond can be viewed as a combination of zeros lays the foundation for STRIPS. A look at a five-year, par, 10 per cent coupon bond, as follows, explains the concept in detail. Issue price: Rs 100 Face value: Rs 100 Coupon: 10% Frequency of interest payment: Annual Redemption: At face value Maturity: 5 years

414

Derivatives and Financial Innovations

Years

0

Cash flow +100

1

2

3

4

5

–10

–10

–10

–10

–110

Fig. 16.4: Example of a coupon bond

It is evident from Fig. 16.4 that this coupon bond of Rs 100 with interest rate of 10 per cent may be viewed as a package consisting of 5 pieces of bonds with maturity/redemption value Rs 10, Rs 10, Rs 10, Rs 10 and Rs 110 with maturities 1, 2, 3, 4 and 5 years respectively. Indeed, a 5-year piece of bond may be further bifurcated into two pieces of value Rs 100 (principal) and Rs 10 (interest). All these bonds are zeros, i.e. zero interest rate bonds. Based on simple pricing, the collective price of all these bonds should be equal to Rs 100, i.e. the price of coupon bond. If this is not the case, there is an opportunity to arbitrage. Practically, an investor holding a dated government security can go to the central bank and ask for stripping the interest and principal parts of the bond. Let us assume that maturity of the bond is five years and interest is payable bi-annually. Stripping the principal and interest will result in 11 instruments and these instruments will be independently tradable in the market. The facility of re-combining the stripped bonds may also be offered to the investors. It is all about full “fungibility” of the strips. In other words, an investor may buy independent pieces of strips and approach the central bank for issuance of a coupon bond. This fungibility is the heart of arbitrage and efficient price discovery in the market. At any point in time, if price of the

Interest Rate Products

415

original bond and combined price of the package of strips are different, profit hungry arbitragers will jump in and eliminate the mis-pricing by trading in different markets simultaneously. In India, RBI has been contemplating the launch of STRIPS for past couple of years but globally, this is a very popular product.

Summary 1. Vanilla bonds have outlived the usefulness and have been relegated to the footnote of financial literature. Today, many innovations are taking place across the globe on the architecture of fixed income products. 2. A floating rate instrument (also called floater) is an instrument, which does not have any fixed rate of interest. In other words, interest on a floater varies over the life of instrument. 3. Fixed interest rate products pose a risk to both issuers and investors in the following manner: (a) If interest rates in the economy go down (yields go down), issuers lose the opportunity to borrow at a lower rate. (b) If interest rates in the economy go up (yields go up), investors lose the opportunity to have better returns from other competing avenues. 4. Issuers reserve the right of premature redemption, i.e. call option on bonds to deal with the interest rate risk. 5. Investors demand a put option on bonds (right to sell bond back to the issuer) in order to protect their interest.

416

Derivatives and Financial Innovations

6. Floating rate instruments with maximum limit on interest rates are called floater with cap. 7. Floating rate instruments with minimum limit on interest rates are called floater with floor. 8. A combination of cap and floor is called collar. 9. Cap is a series of call options on interest rate bought by the issuer from investors. 10. Floor is a series of put options on interest rate bought by investors from the issuer. 11. Instruments with embedded cap and floor (collar) are called range notes. They behave like floating rate notes between cap and floor and beyond that as fixed rate instruments. 12. Inverse floater is also a floater wherein the interest rate moves in a direction opposite to the benchmark reference rate. 13. The combination of a floater and inverse floater results in a fixed rate instrument. 14. Interest rate futures are futures contracts with interest rates being the underlying. 15. Step up bonds are bonds offering increasing interest rates with the passage of time. Further, this product may be structured either as a fixed interest rate product or a floating interest rate product. 16. Step down bonds pay higher interest rates in the beginning and the rate diminishes with the passage of time. These bonds also may be structured either as fixed interest rate product or floating interest rate product.

Interest Rate Products

417

17. Amortisation bonds are bonds, where the principal repayment is spread over the life of instrument. Typically, an amortisation loan is settled over the life of instrument in the form of equal monthly/quarterly/annual installments. 18. Perpetual bonds are bonds, which are expected to remain alive for perpetuity like equity. In other words they are irredeemable bonds. 19. Principal Protection Bonds also called Capital Protection Bonds are designed to provide protection of the capital invested by the investors, i.e. at maturity of the bonds, investors surely get back the amount invested. Over and above that return on the instrument is linked to some benchmark asset like equity, commodity, currency etc. 20 Payment in kind bonds are bonds, which provide interest not in cash but in kind. In these bonds, interest is generally paid in the form of another bond with the same or different characteristics. 21. Treasury Inflation protection securities are structured to provide protection to the investors against erosion of value of money on account of inflation. 22. The concept that a coupon bond can be viewed as a combination of zeros lays down the foundation for separate trading of interest and principal securities (STRIPS). They are quite popular in developed countries like US and UK.

Chapter 17

Securitisation Securitisation, the process of creating securities is fast becoming popular in India. On an average, around 40 per cent of the total debt papers issued today are securitised papers. There are many benefits to securitisation as it provides an opportunity to the originator to unlock its locked capital, off balance sheet financing and better management of regulatory capital. Investors too are benefited because of the availability of an alternative investment avenue with lesser credit migration and better default recovery. Investors are attracted towards these papers as a wide range of securitised products in terms of maturity, risk and return profiles are available.

Let us commence by assuming that Bank B has extended a loan of Rs 100 crore to party P and this loan is standing in its balance sheet as an asset. The bank has another customer C, who is seeking to raise debt from the bank and although bank intends to finance this customer, it is limited by the size of its own balance sheet. The bank believes that if somehow it can get the earlier loan of Rs 100 crore re-financed, it can serve customer C. The bank, therefore, approaches other banks and financial institutions (FIs) for refinancing of its loan standing in its balance sheet and does get financing from other banks/FIs against its original loan of Rs 100 cr. From the accounting perspective,

Securitisation

419

original loan of Rs 100 cr. will continue to show on the asset side of the bank’s balance sheet and the re-financing transaction will appear as an obligation (liability). An alternate way the bank can structure the financing is to sell the loan of Rs 100 cr. to other interested party/parties. In this case, only the right hand side of its balance sheet (asset side) will be affected because the loan will get converted into cash. In order to keep the concept simple, accounting for the difference between the book value of the loan and the money realised from sale of the loan is not considered here. A third way for the bank to structure the financing is to sell this asset (loan of Rs 100 cr.) to several investors in the form of a tradable paper (security). In this case, like the second alternative, bank is selling its loan but to many investors in the form of tradable instrument with smaller denomination. This process of creating securities out of an existing asset is called securitisation. In reality, there have been only few issuances of whole loan securitisation (sale of loan through the securitisation route) and generally institutions pool similar assets like auto loans, mortgages etc. on their balance sheet and sell out through the securitisation route. It is evident that securitisation is all about packaging a designated pool of assets and marketing that to a large set of investors in the form of a tradable financial instrument. In other words, securitisation is the process of transforming an asset into marketable securities. It should be noted that securitised instruments are instruments backed by assets and they are not the securities of an issuer.

Derivatives and Financial Innovations

420

Process of Securitisation A typical securitisation process begins with an entity called originator which is interested in unlocking its assets, transferring a pool of its desired assets to an independent third party called Special Purpose Vehicle (SPV), an artificial entity created for the specific purpose of securitisation. This SPV, backed by assets, creates securities and sells them to the investors at large. In a typical securitisation deal, various assets of an originator are pooled and packaged in the form of tradable instruments and sold to investors. These assets must be of a similar nature so that the behaviour of the portfolio is clearly depicted and well understood by the investors. As securitised instruments offer investors a direct stake in the assets being securitised, investors would require information on quality of the assets, they are investing in. Financial engineering in the form of matching inflows and outflows takes place at the end of SPV. It is important to match cash flows because investors will be serviced by the cash flows from the original portfolios. The process of securitisation is given in Fig. 17.1. Investors in securitised instruments are more concerned with the quality of the underlying assets than with the originator. In fact, asset is dissociated from the originator through the securitisation process. While rating the instruments, credit rating agencies also focus on and analyse the asset being securitised and the quality of issuer is immaterial in the entire process. Originators adopt various credit enhancement measures to improve the quality and marketability of these papers and important among them are over collateralisation and first loss provision.

Securitisation

421

Reference portfolio

Originator

Financial engineering Credit enhancement Receive money

Sell assets

Issue securities Investors

SPV Receive money

Fig. 17.1: The process of securitisation

Over collateralisation essentially means that an asset portfolio that is significantly higher in value, backs the securitised papers. For example, an originator may put forward an asset portfolio of Rs 100 cr. while collecting only Rs 75 cr. from securitised securities. The difference of Rs 25 cr. provides investors with a buffer/cushion against default on part of the asset portfolio. Obviously, investors are better protected in this deal and would be more comfortable in subscribing to the securitised issue. However, it should be noted that the residual value, after serving investors’ obligations, flows back to the originator. In case of first loss provision, certain percentage of the first loss on portfolio is borne by the originator. After the first loss piece is exhausted, default begins to affect the investors. By including first loss provision in the portfolio, originators exhibit confidence in the quality of asset and at the same time, protect the investors against loss to a certain extent. For example, on an asset portfolio of Rs 100 cr., the originator may provide first loss protection of perhaps 10 per cent. In this case, any default on the portfolio to the extent of 10 per cent of its value, i.e. Rs 10 cr. will be made good by the originator and investors will be affected if default is beyond this value.

422

Derivatives and Financial Innovations

These two provisions really help originators in improving the quality of paper and thus also their marketability. Some offerings in the market have both these provisions simultaneously.

Types of Securitisation There are two components to securitisation of an asset— financing and credit risk. Broadly speaking, an originator may decide to securitise only the financing part of its portfolio (securitisation with recourse), only the credit risk of the portfolio (securitisation of credit risk) or both the credit risk as well as financing parts of the portfolio (securitisation without recourse).

Securitisation with Recourse “With recourse” is a legal term and relates to the credit risk retention by the originator. It essentially means that though assets are sold to the investors through SPV, default risk on the portfolio is retained by the originator. In other words, if there is a default on the portfolio, it will be made good by the originator. It may be noted that this is merely a financing transaction from the originator’s perspective and may be compared with other means of financing such as loan against collateral. From the accounting perspective for the originator, although assets get converted into cash, there is a contingent liability on the originator in case of any default on the portfolio. Accordingly, retention of credit risk in the form of a contingent liability appears as a note to the accounts in its balance sheet.

Securitisation

423

Securitisation without Recourse In case of securitisation without recourse, entire risk in the asset portfolio is transferred to the investors through SPV, i.e. the originator is in no way concerned with the assets once sold to the SPV. This is a true form of securitisation. In this case, asset will get converted into cash for the originator with no future obligation. Hence, this transaction performs two functions—financing and credit risk transfer from the originator to the investors. As, in this case, credit risk of the asset portfolio is passed on to the investors, they are compensated through higher returns in comparison to with recourse securitisation. It may be noted that even in case of without recourse transactions, a certain percentage of the first loss may be retained by the originator as a credit enhancement measure. Contingent liability disclosures to that extent are made in the balance sheet in the form of notes to the accounts.

Securitisation of only Credit Risk Sometimes the originator may not need any financing but it may be interested in buying credit risk protection on the portfolio. One of the simplest ways to manage credit risk on a portfolio is to buy credit risk insurance. The other alternative for originator is to securitise the credit risk of the portfolio. This means that credit risk protection is bought from a large set of insurance providers through the issuance of securities. In this case, SPV collects money from the investors equal to the sum assured and also collects the risk premium from the

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originator. This amount is invested in various securities, primarily government securities in order to generate interest income. The process of securitisation of credit risk is given in Fig. 17.2. Originator

Credit risk transferred for certain premium

Reference portfolio

Receive money in case of default

Manage the premium received and the money received from the investors

Issue credit link notes Investors

SPV Receive money

Fig. 17.2: The process of credit risk securitisation

This process of securitisation of credit risk is termed synthetic securitisation as there is no financing element in this transaction. The originator is compensated by the SPV, in case there is a credit event on the portfolio, to the extent of the sum assured. If there is no default on the portfolio, SPV returns the entire amount to the investors. Needless to say, because of the risk premium contribution by the originator, return to investors is better than that on competing avenues. Therefore, from investors’ perspective, this is high risk and high return transaction. Indeed, to cater to the different risk appetites of the investors, SPV may create tranches with senior and subordinate structures. We can thus conclude that securitisation of credit risk is an innovative way to buy insurance. In fact, credit risk linked papers are redefining credit risk management through trading of credit risk. This market is expanding on a continuous basis and taking a gigantic shape at the global level.

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What can be Securitised? In practical terms, securitisation is a process of transforming a stream of cash flows from an asset into marketable securities. Therefore, any asset that generates future cash flows can be securitised. Accordingly, financial assets like loans/loan portfolios, operational cash flows, rolling cash flows like credit card cash flows etc. can be securitised. Interestingly, market seems to have an enormous risk appetite and at present, securitisation is not limited to tangible assets only. In the recent past, market has witnessed several intangible assets being securitised. For example, in 1997, David Bowie, a British rock singer, securitised future royalties from 25 of his albums recorded prior to 1993 and collected USD 55 million from Wall Street. These bonds are called Bowie bonds. Subsequently, James Brown, another singer, also sold royalty on his songs on Wall Street and amassed USD 100 million. Today, around the world, almost anything and everything is being financed through securitisation route. For instance, schools, hospitals, corporates, government organisations etc. are all part of this league, financing their future revenues.

Instruments in Securitisation Broadly, two kinds of instruments are issued under securitisation—pass through securities and pay through securities. The salient features of these securities are given in the following paragraphs.

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Pass through Securities Pass through security, as its name indicates, passes on all cash flows from the portfolio, whenever they arise, to the investors without any intervention. It results in prepayment risk to the investors.

Pay through Securities Pay through securities differ from pass through as investors are given cash flows at a predetermined time irrespective of cash flows from the original portfolio in the deal. In other words, prepayment risk in the instrument is absorbed by the SPV, which manages pre-paid cash flows at its end and pays the investors at the predetermined time only. Pass through or pay through securities may be issued in tranches with different maturities, risk and return profiles to appeal to a wider range of investors.

Benefits of Securitisation Having discussed securitisation in detail, it is appropriate to consider the benefits of such deals. Value drivers for both originators and investors are outlined as follows.

Benefits to the Originators Originators have a number of reasons to seek securitisation of their assets. Some of these reasons are:

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1. Securitisation helps originators unlock their locked capital and multiply their asset creation ability. 2. True securitisation helps the originator remove the asset from balance sheet completely and thus provides off balance sheet funding. 3. In an environment where regulatory capital is linked to the risk on the asset, institutions sometimes go for securitisation of their asset and then subscribe to their own securitised papers. Because of various risk enhancement measures at the time of securitisation, securitised papers carry less risk. Accordingly, requirement of risk capital on the assets of institutions goes down. 4. Securitisation is emerging as an alternative way of buying credit risk protection.

Benefits to the Investors Investors are always exploring alternative and better avenues for investment. Securitised instruments have emerged as an independent asset class. Indeed, these papers offer better security as investors have a direct claim over specific assets. It is observed that securitised papers encounter lesser rating migrations. From the investors’ perspective, better default recovery in securitisation cases is another important point for consideration. Interestingly, there is enough room for financial engineering and accordingly wide range of products in terms of maturity, risk and return profiles attract a variety of investors.

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Difference Between Collateralised Loans and Securitisation As the name suggests, collateralised loans are loans that are taken against some collateral. On the other hand, securitisation is also a means of financing as discussed earlier. The clear points of differentiation between these are as follows: Collateralised Loans n

n

n

n

n

n

n

Asset is put as security/collateral for availing loan. So, it is a loan backed by asset Investors have general claim against the company Investors are exposed to the issuer’s risk No tradable security is issued in the structure Transaction affects both sides of the balance sheet As a result of transaction, the gearing (debt/equity ratio) increases Credit risk on the asset remains with the borrower

Securitisation n

n

n

n

n

n

n

Assets are sold to the investors

Investors have claim against a specific asset/portfolio of asset Investors are exposed to the asset risk Tradable security gets created in the process. Tremendous scope for financial engineering exists Transaction affects only right hand side (asset side) of the balance sheet This does not affect the gearing Credit risk on asset remains with the borrower only in case of with recourse securitisation

Securitisation appears to be gaining ground in India and almost 40 per cent of debt papers issued, at present, are securitised papers. Escalated activities on this front are also a result of securitised papers now being defined as security under the Securities Contract Regulations Act (SCRA) and many innovations in securitisations are expected in the future.

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Summary 1. Securitisation involves packaging a designated pool of assets and marketing that to a large set of investors in the form of a tradable financial instrument. 2. Securitisation is the process of transforming an asset into marketable securities. Securitised instruments are instruments backed by assets and they are not the securities of an issuer. Therefore, investors in securitised instruments are concerned with the quality of underlying assets and not that of originator. 3. In securitisation, the originator, who is interested in unlocking assets, transfers a pool of its desired assets to an independent third party called Special Purpose Vehicle (SPV). This SPV, backed by assets, creates securities and sells them to investors. 4. Originators adopt various credit enhancement measures to improve quality and marketability of these papers. Major among these are over collateralisation and first loss provision. 5. Over collateralisation essentially means that an asset portfolio that is worth significantly more backs the securitised papers. 6. In case of first loss provision, a certain percentage of the first loss on portfolio is borne by the originator. The investor is affected only after the first loss piece is exhausted. 7. In securitisation with recourse, although assets are sold to the investors, originator retains the default risk on the portfolio.

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8. In case of securitisation without recourse, entire risk in the asset portfolio is transferred to the investors. This is the true form of securitisation. 9. Securitisation of credit risk means that credit risk protection is bought from a large set of insurance providers through the issuance of securities. This is an innovative way to buy insurance. 10. Any asset that generates future cash flows can be securitised, including intangible assets. 11. Two kinds of instruments are issued under securitisation— pass through securities and pay through securities. 12. Pass through security, as its name indicates, passes on all cash flows from the portfolio, whenever they arise, to the investors without any intervention. It results in prepayment risk to the investors. 13. Pay through securities differ from pass through as investors are given cash flows at the predetermined time irrespective of cash flows from the original portfolio in the deal. 14. Securitisation helps originators to unlock their locked capital, enjoy off balance sheet financing and manage regulatory capital better. Securitisation is also emerging as an alternative way of buying credit risk protection. 15. Securitised papers offer better security as investors have direct claim over specific assets. Further, it is seen that these papers encounter lesser rating migrations and offer better default recovery.

Chapter 18

Other Innovative Ideas Innovation is an unabated phenomenon. It does not need a specific framework. It is about creativity and grasping available opportunities, discovering alternative ways of achieving goals and developing new products to satisfy a need. Needless to say, economic forces drive the entire game of Innovative Financial Products. This chapter gives a brief perspective on various innovative financial structures across the globe.

Real Estate Funds Real estate is emerging as an investment class all around the world. However, issues such as illiquidity of real estate, big denominations of deals, fear of lack of clear title of transferor and administrative hassles in transfer etc. keep lots of investors away from this market. That is where Real Estate Investment Funds (REIFs) come into play with a value proposition. Real Estate Funds mobilise funds from small investors and channelise these savings towards real estates. In a broad sense, real estate funds are specialised mutual funds. These funds offer small investors an opportunity to trade in real estate by

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converting them into financial instruments. Units issued by REIFs may get listed and traded on the exchanges. Real estate investment funds can take equity stake, debt stake or any other kind of structured stake in real estates. In the event that an equity stake is taken by REIFs in real estate project, profit will come to the scheme in terms of escalation in real estate prices and lease rentals. In case straight debt stakes are taken by REIFs, they will earn in terms of interest amount. In case of structured products, inflows will essentially depend on the structure of the deal. Generally real estate investment funds issue close-ended schemes to investors as the underlying asset is not a liquid asset and its value does not change on a day-to-day basis. The major issue faced by the market in case of real estate funds is the illiquidity and valuation of underlying assets. Globally, this issue is addressed by appointing real estate specialized valuers as valuation agents for the schemes. These agencies value the underlying held under a scheme at a predetermined frequency (say weekly/fortnightly) and the NAV of units is calculated accordingly.

Exchange Traded Funds (ETFs) Exchange traded funds (ETFs) are innovative products that provide exposure to an index or a basket of securities/ commodities and trade on the exchange like a single stock. Practically, ETFs provide the facility to trade the index itself in the cash market as an alternative to the index funds. ETF units are listed and traded like any other stock on the exchange. Thus, intra-day transactions in ETFs are possible by market participants

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in the same way as any other security is traded. Further, ETFs have competitive advantages over basket trading in terms of smaller denominations and low transaction costs. In a nutshell, ETFs are simple to understand, listed and traded products. The first ETF introduced in the world was SPIDR (S&P Index Depository Receipt) in 1993 based on the S&P 500. It took several years for the product to really catch the attention of the market but since then, several ETFs have been launched in the international market. In fact, the American Stock Exchange in the US trades more in ETFs than it does in underlying stocks and approximately 60 per cent of its volume comes from ETFs. The first ETF in the Indian securities market was the NiftyBeES introduced by Benchmark Mutual Fund in December 2001. India is the third country in Asia after Japan and Hong Kong to trade in ETFs. The salient features of the product are as follows: Product name: Nifty Benchmark Exchange Traded Scheme (NiftyBeES) Type of scheme: Open ended exchange traded scheme Minimum subscription amount: Rs 1 crore Trading on: NSE Reference index: Nifty 50 Amount collected: Around 21 crore Value of ETF: 1/100 th of Nifty Index

Subsequently, Benchmark has launched ETFs linked to various security indices and it has also filed Gold ETF offer document called “Gold BeES”, with the Securities and Exchange Board of India (SEBI) for approval.

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Prudential ICICI Mutual Fund has also launched an ETF and this unit is listed on the BSE.

Foreign Currency Denominated Bonds Foreign currency denominated bonds are essentially bonds that are denominated in a foreign currency but settled in local currency. This instrument does not result in exchange of foreign currency at any point in time. For example, an issuer in India may issue bonds denominated in US dollars. This essentially means that the money collected from the investors will represent a specific number of dollars at the time of issuance of the bond. Although bond is denominated in dollars, payment to the investors for both interest and principal will be made in Indian currency equivalent to the calculated dollars. If interest on the instrument is 6 per cent, investors would get INR equivalent to $ 6 per annum for every bond of $ 100 face value. It is apparent that if USD appreciates against the local currency, investors will benefit. However, if USD depreciates against the local currency, investors will lose. A close look at the structure indicates that the investors are long on dollar as bond is standing in their balance sheet on the asset side. Therefore, if US$/INR rate at the time of investment is Rs 46/US$ and at the time of redemption is Rs 48/US$ ($ appreciates against the rupee), investors will get Rs 48 for each Rs 46 invested. This will amount to redemption of the bond at a premium of Rs 2.

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It may be noted that in this structure, at no point in time are dollars either paid or received. All settlements take place in local currency equivalent to the required dollars. Corporates can use this instrument to dollarise their balance sheets. Dollarisation of balance sheet means creation of a dollar exposure in the balance sheet. If dollar exposure rests on a corporate's liability side of the balance sheet, it is net short position on dollars. If dollar appreciates against the INR, its liability in INR will go up and will result in additional cost. However, if dollar depreciates against the local currency, its cost in INR will reduce. An examination of the structure shows that this is an alternative to a currency swap. In case of a currency swap, entire obligation of the loan is exchanged for another currency. For instance, to replicate a dollar denominated bond, a corporation could borrow in INR and then opt for an INR to dollar currency swap. This would amount to the corporation taking dollar obligation and the counter party taking INR obligation. Thus, the corporation would effectively take a short position in USD and would benefit if dollar depreciates against INR. Therefore, it is apparent that the dollar denominated bond is an alternative to the INR borrowing combined with the currency swap.

Foreign Bonds and Euro Bonds If an Indian corporate wants to raise for example, USD, it has many options to choose from. It can raise dollars from the US directly or from other countries or synthetically, from the local market.

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Hence, if an Indian company is raising dollars from the international market, i.e. either direct from US or from other international markets through bonds, they will be called foreign bonds. If, however, dollars are raised through these bonds from non US market, they would be called euro bonds. Foreign bond is the term used for any bond when an outside entity raises funds in the local currency. Thus, when the Indian company (a non US entity) raises local currency (dollar) from US, the bonds are titled as foreign bonds. On the other hand, euro is a term used for the currency being exchanged/traded in a country other than that of the currency’s origin, e.g. dollar trading outside US or Yen trading outside Japan. Similarly, bonds that raise dollars from markets other than the US are called euro bonds. It must be clarified that euro is a generic term and has nothing to do with the currency Euro. The euro market is a huge market globally and is growing at an amazing speed. The third option, i.e. raising dollars synthetically is nothing but a combination of non-USD borrowing and a currency swap to dollars. For instance, an Indian corporate interested in raising dollars may not be able to do so through foreign bonds or euro bonds on account of having no standing in the international market. It can opt for an INR offering and convert the INR obligation into USD obligation through an INR/dollar swap. The economics of this transaction will be as good as that of the first two structures. This structure is also an instance where the corporate has dollarised its balance sheet. As dollar exposure is on the liability side of the balance sheet, corporate is net short on dollars. If dollar appreciates against INR, its liability in INR will go up and result in additional cost. However, if dollar depreciates against the local currency, its cost in INR will come down.

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Therefore, a corporate will always prefer to take the liability in a weaker currency and asset in a stronger currency. In general, these bond offerings are used by corporates, who want access to a vast resource pool. Value drivers for raising funds in USD may also be to acquire a natural exchange rate hedge in case the corporate has USD receivables.

Dual Currency Bonds Dual currency bonds are bonds, which are being paid for in one currency and redeemed in another currency. The first US company that issued dual currency bonds was American Medical International. This instrument was listed on the Zurich stock exchange. Suppose that an Indian company raises funds through either foreign bonds or euro bonds. As borrowed USD is on the liability side of the balance sheet, the corporate will be adversely affected by appreciation of USD against INR at the time of redemption. The corporate can transfer this risk to the investors if the offering can be structured in such a fashion that the redemption of the bond will take place in INR. For example, if par value of bond is USD 100 and the exchange rate at the time of offering the bond is Rs 46, the bond may be redeemed at the fixed value INR 4,600 only. Bonds with this kind of structure are called dual currency bonds. Indeed, in some offerings, interest payments are also structured in the currency other than the investment currency. Structuring this kind of instruments may be considered an ingenious way to trade the currency risk in the market. In fact,

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products may be designed to specifically aportion the risk among desired party/parties. If this structure is analysed closely, it will be seen that this is a vanilla foreign currency borrowing with embedded swap. The borrower at the time of issuance of the instrument also swaps the currency with the lender. Therefore, the instrument is essentially a USD borrowing instrument with USD/INR swap embedded in the structure. These structures are quite popular in international markets.

American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) If a local corporate wants to raise foreign capital through equity route, it issues American Depository Receipts (ADRs) and/or Global Depository Receipts (GDRs). American Depository Receipts (ADRs) are the depository receipts issued by depositories only in the US. However, if depository receipts are issued simultaneously in different markets they are called Global Depository Receipts (GDRs). Several Indian corporates have raised foreign equity through ADRs and GDRs. In practice, ADRs/GDRs do not appear anywhere in the balance sheet of local corporates. Actually, these companies issue vanilla equity shares to a depository offshore and backed by these shares, depository in the foreign market issues depository receipts. These depository receipts are subscribed by foreigners in foreign currencies and listed and traded in foreign markets. Local custodians hold the shares of these depositories.

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Therefore, conceptually ADRs and GDRs are derivative instruments without any leverage. They derive their value from value of the underlying securities. It may be noted that depository receipts may represent a specific number of shares. For example, each Infosys ADR represents 2 equity shares of Infosys and Wipro ADR represents 1 equity share of Wipro. At present in India, ADRs/GDRs are fully fungible into underlying equity shares. However, reverse fungibility is available only to the extent of the initial issue, i.e. shares can be converted into ADRs/GDRs only to the extent of the initial issuance of ADRs/GDRs. This ensures continuous price alignment across two markets. If there is any mis-pricing between offshore and local markets, arbitragers pitch in to eliminate the arbitrage. Another important point in this structure is that the corporate does not bear any currency risk in the transaction. In other words, dividend payment is in INR, which is converted into foreign currency by ADRs/GDRs holders at prevailing market rates. Therefore, entire currency risk in this structure lies with the investors.

Indian Depository Receipts (IDRs) Indian Depository Receipts (IDRs) are a variant to the ADR or GDR providing global companies an access to the Indian capital market. In other words, any global company interested in raising money from India can do so through this route, i.e. they can issue IDRs. There have been no IDR issues until now in the Indian market. The Department of Company Affairs (DCA) and SEBI

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are working on a detailed framework and regulations for issuance of IDRs.

Options on Futures Contracts Liquidity in the underlying asset is of prime importance for any option trader. For various underlying assets, futures are more liquid than the cash market. Accordingly, in these underlying assets, the market prefers to trade options on futures rather than directly on underlying assets. Another reason to trade this product is to avoid delivery risk in case of physically settled options. In other words, because of higher liquidity and no delivery risk, futures (which itself is a derivative contract) are sometimes used as underlying for option contracts. Therefore, option on futures is an option contract with futures as underlying. This contract is a second layer derivative product, also called futures option contract and is illustrated in Fig. 18.1. Option on futures Futures contract Underlying

Fig. 18.1: Futures option contract

On exercise of call/put option, buyer of option assumes a long/short position in underlying futures contract and the seller of option assumes the counter position in this futures contract. Now, both buyers and sellers manage their futures positions independent of each other like any other position in the futures market.

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It must be understood that the strike price of these option contracts is based on futures prices. While assuming positions in futures market on exercise of option, the difference between the strike price and actual futures price is immediately settled between the buyer and seller. Let us take example of an at-the-money, one month futures option, on stock X where the trader takes a long position in a Rs 240 strike call option. Suppose that the futures price move to Rs 260 and the trader exercises his call. On exercise, both option positions would be shifted to the underlying futures market at Rs 260 and the difference of Rs 20 (market price – strike price) would be settled immediately between the buyer and seller. Options on futures contracts are generally American in nature.

Options on Option Contracts In this structure, the underlying for option contracts is another option contract. These contracts are commonly called compound options. Like option on futures contracts, it is a second layer derivative product, which is shown in Fig. 18.2. Option on option Option contract Underlying

Fig. 18.2: A compound option

On exercise of a compound call/put option, buyer gets long/ short position in the underlying option contract and the seller

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assumes the counter position in that option contract. Now, both the buyers and sellers manage their option positions independent of each other like any other position in the options market. In this product, strike of the compound option contract is based on the underlying options’ premium. On exercise of the options, while assuming positions in the underlying option contract, the difference between the strike price and actual underlying option price is immediately settled between the buyer and seller. Options on option contracts are generally American in nature.

Commodity Linked Securities As discussed at the beginning of this section, financial instruments are designed to provide pay-offs linked to different asset classes—equity, commodity, currency, bullion, catastrophe, etc. Many corporates have also issued instruments with returns linked to the performance of their business itself. As generally the underlying commodity risk is passed on to the investors through this instrument, it is called commodity linked security. For example, an aviation company may issue bonds with pay-off linked to jet fuel prices. As risk to the company is on rising fuel prices, it may pay lower interest on its obligation if price of jet fuel goes up and vice versa. In this case, the company will essentially issue bonds with the interest negatively linked to the fuel prices. In US, oil company—Standard Oil—issued bonds with return linked to the price of oil. It is apparent that this instrument is just a floater with reference benchmark rate being the price of the underlying

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commodity. It is one of the most pragmatic ways to pass a part of the business risk to bond holders and make them business partners. Although, there is no activity on this front, at present, in Indian market it is believed that this will eventually happen.

Weather Derivatives Weather derivatives are fascinating innovations in the financial markets making pre-specified payouts if pre-specified weather events occur. The market, which was virtually non-existent in 1997, has grown rapidly over the last couple of years. In 1998 the market was estimated at $ 500 million with large spreads and limited secondary market activity. More recently, the market has grown to more than $ 12 billion with much better liquidity. Weather derivative instruments include weather swaps, vanilla options, option collars, and exotic (e.g. path-dependent) options. The underlying include heating degree days, cooling degree days, growing degree days, average temperature, maximum temperature, minimum temperature, precipitation (rainfall, snowfall), humidity and sunshine among others and even the National Weather Service temperature forecast for the coming week. Most trading in weather derivatives is over-the-counter but exchange based trading is gaining momentum. Temperature related weather derivatives for example, are actively traded on the Chicago Mercantile Exchange (CME) and London International Financial Futures and Options (LIFFE). Some other Internet weather derivatives portals like I-WeX are

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operating as one-stop shop, for news, information and on-line trading for the global weather derivatives market. A number of interesting considerations make weather derivatives different from standard derivatives. First, the underlying object (weather) is not traded in a spot market. Second, unlike financial derivatives, which are useful for price hedging but not quantity hedging weather derivatives are useful for quantity hedging but not necessarily for price hedging (although the two are obviously related). That is, weather derivative products provide protection against weather related changes in quantities, complementing extensive commodity price risk management tools already available through futures and options. Third, although liquidity in weather derivative markets has improved it is unlikely that it will ever be as good as in traditional commodity markets because weather is by its very nature a location-specific and non-standardised commodity unlike for example a specific grade of crude oil.

Weather Insurance Weather insurance is a variant to weather derivatives and provides cover against the deviations from the normal expected rainfall, wind speed or weather phenomenon and not just against extreme conditions like drought or flood. This expected level is arrived at after analysing statistical data on the subject over the past 30 to 50 years. Weather insurance has applications in multiple industries. For example, a farmer can be insured for lost yield due to deficient or excess rainfall; a hydrology power station can be covered for possible loss of revenue due to inadequate rainfall; a wind energy

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farm can be covered for possible loss of revenue due to inadequate flow of wind. In weather insurance, a claim is settled on the basis of a transparent index. Critical time periods assigned weightages in order to create such an index. Past weather data is then mapped on to this index in order to arrive at a normal threshold index. The actual weather data is then mapped on to the index to arrive at the actual index level. In case, there is a material deviation between the normal index and the actual index compensation is paid out to the insured on the basis of a pre-agreed formula. Therefore, claim settlement is a hassle-free process in case of weather insurance, as the insured person is not required to file the claims. Instead, the insurance company compensates the insured in the context of the contract for any deviations from normal weather conditions on the basis of the data collected from an independent source accessible to all such as a local weather station. In India, ICICI Lombard provides this facility of weather insurance. It conducted a pilot programme on rainfall insurance in July 2003 through KBS Bank (Krishna Bhima Samruddhi Local Area Bank Ltd a subsidiary of BASIX) in Mahabubnagar at the eastern end of Andhra Pradesh, bordering Karnataka. KBS Bank bought a bulk insurance policy from ICICI Lombard and sold around 200 individual farmer policies for small, medium and large groundnut and castor farmers. The claims for this policy were settled within 15 days of the end of the cover period. Additionally, the weather insurance has also been extended to 50 soya farmers in Madhya Pradesh through Pradan, an NGO and 600 acres of paddy crop in Aligarh in Uttar Pradesh through Rallis, an agri-business company.

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To obtain reliable data, ICICI Lombard has tied up with the Indian Meteorological Department for latest weather reports and historical charts. As the weather data is collected from an independent authority the whole process is very transparent, credible and hassle-free for farmers. It is apparent that weather derivatives are different from weather insurance. First, there is no need to file a claim or prove damages. Second, unlike insurance weather derivatives allow one to hedge against comparatively good weather in other locations, which may be bad for local business (e.g. a bumper crop of California oranges may lower the prices received by Florida growers).

Summary 1. Real estate funds mobilise funds from small investors and channelise that towards real estate. In a broad sense, real estate funds are specialised mutual funds. 2. REIFs can take equity stake, debt stake or any other kind of structured stake in real estates. 3. As the underlying is not a liquid asset and its value does not change on a day-to-day basis, schemes offered by REIFs are closed-ended schemes. 4. Valuation of underlying asset for calculation of NAV for units is one of the major issues in case of real estate funds. 5. Exchange traded funds (ETFs) provide exposure to an index or a basket of securities/commodities and trade on the exchange like a single stock.

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6. The first ETF introduced in the world was SPIDR (S&P Index Depository Receipt) in 1993 based on S&P 500. 7. The first ETF in the Indian capital market was NiftyBeES, introduced by Benchmark Mutual Fund in December 2001. 8. Foreign currency denominated bonds are bonds, which are denominated in foreign currency but settled in local currency. 9. Foreign bond is the term used for any bond, when an entity residing outside the country raises fund in the local currency. Bonds, helping to raise funds in a currency from markets other than the country of origin of that currency, are called euro bonds. 10. Dual currency bonds are bonds, which are paid for in one currency and redeemed in another currency. 11. If a local corporate wants to raise foreign capital through the equity route, it issues American Depository Receipts (ADRs) and/or Global Depository Receipts (GDRs). 12. American Depository Receipts (ADRs) are the depository receipts, issued by depositories, only in US. However, if depository receipts are issued simultaneously in different markets, it is called Global Depository Receipts (GDRs). 13. Indian Depository Receipts (IDRs) are a variant to the ADRs or GDRs, providing global companies with an access to the Indian Capital Market. 14. An option on futures is an option contract with futures as the underlying. It is second layer derivative product and is called futures option contract.

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15. An option on option is an option contract with another option as the underlying. These contracts are commonly called compound options. Like option on futures contracts, it is a second layer derivative product. 16. Commodity linked security is a security with pay-off linked to commodity prices. Catastrophic risk linked security is a security with pay-off linked to catastrophic risk. 17. Weather derivatives make pre-specified payouts if prespecified weather events occur. 18. Weather derivative instruments include weather swaps, vanilla options, option collars, and exotic (e.g. pathdependent) options. 19. Most trading in weather derivatives is over-the-counter but exchange based trading is gaining momentum. 20. Weather Insurance is a variant to weather derivatives and provides cover against the deviations from normal expected rainfall, wind speed or weather phenomenon and not just against extreme conditions like drought or flood.

Chapter 19

Case Studies Case 1—Unleashing Values from Rights Issue If a company wants to raise fresh capital through issuance of shares, the law requires that the first offer needs to be made to the existing shareholders. This provision exists from the perspective of offering an opportunity to existing shareholders to maintain their original stake in the company. In other words, existing shareholders have the first right over any proposal of augmentation of share capital by the company. That is the reason why offer of additional shares to the existing shareholders by a company is called Rights Issue. At present, in case of a rights issue, rights are offered to the existing shareholders in physical form (rights forms). As these shareholders have no obligation to subscribe to the issue, some shareholders do not exercise their rights and let them expire worthless. On the other hand, others who do not intend to subscribe to the issue, sell their rights in the market. But as the market for rights is an over-the-counter market (OTC market), finding a buyer is not easy. This results in sellers selling their rights if at all they do, at huge discounts to their fair values. For instance, if market price of a stock is Rs 130 and a shareholder

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is eligible to subscribe to fresh shares at Rs 80 under the rights issue, theoretical/fair value of a right is Rs 50 (Rs 130 – Rs 80). However, if this shareholder wants to sell the right, he would never be able to realise Rs 50. The actual discount on this theoretical/fair value will depend upon the demand–supply forces in the OTC market. The task here is to contemplate over the issues in the existing procedure for rights issues and devise some mechanism to unleash the values.

Analysis and Possible Solution As mentioned earlier, rights offered in a rights issue confer a choice on the existing shareholders of the company to buy additional shares. In other words, there is no compulsion on shareholders to buy the shares offered to them under a rights issue. Therefore, rights are essentially call options written by a company on its own stock to its existing shareholders. Secondly, these rights are at present traded in over-thecounter (OTC) market, which results in poor liquidity of these papers, lack of price discovery and movement of physical papers in the system. One may consider two-fold approach to address the issues raised in this case—first, one may migrate to trading rights on exchanges, i.e. list and trade rights on the exchanges; and second, eliminate physical papers by issuing rights in electronic form rather than in physical form. Hence, trading of rights in electronic form on stock exchanges may solve the existing issues of illiquidity, poor price discovery etc. to a certain extent. In addition, this migration may result in enormous administrative convenience and cost saving to both issuers and investors through

Case Studies

451

elimination of renunciation and split forms and a host of other administrative formalities. The operational dimension of the product may be as follows. l

l

l

l

l

Rights may be issued to shareholders on a proportionate basis, in electronic form by crediting their demat accounts. Rights may be listed and traded on stock exchanges for a limited period of their life. Settlement of transactions on rights may take place on a normal rolling settlement cycle basis. A separate International Security Identification Number (ISIN) may be assigned to rights for purpose of identification. In keeping with the existing practice, rights may also be issued in physical form if desired by the shareholders but trading of rights on the exchanges may essentially be in electronic form, i.e. in demat form. Provision for shareholders having a right to apply for additional shares beyond their entitlement on a proportionate basis may exist even in the proposed structure but they may be allotted additional shares only if some rights do not get exercised.

Investors may subscribe to the issue by placing a rights transfer request (delivery instruction) along with a cheque for the required money to their DPs. The DP may then transfer the relevant number of rights to the company’s designated Rights issue DP account (that may be specially opened for the purpose) and deposit the cheque for collection in the rights issue account with the company’s bankers. Trading of rights on exchanges will also make it possible for market participants to trade them like any other stock on

452

Derivatives and Financial Innovations

an intra-day basis. This would mean higher liquidity in the system. Furthermore, if some shareholders want to renounce their rights or split them and distribute them among, for example, three or four people, they have to go through a very cumbersome process at present. They need to write back to the company or its registrar for a renunciation form/split form and can do the needful only after they receive this. But, these rights may be easily renounced/split by the shareholders in the electronic form, as they would be freely transferable from one demat account to another. For instance, having received 35 rights, a shareholder may exercise these rights in part, sell in part and gift in part without any paper work. He has to simply give instructions to his DP for transfer of the relevant number of rights to various demat accounts. Thus the electronic form of rights creates huge flexibility for the shareholders and since this reduces the paper flow drastically, this approach may create convenience and save various administrative costs for both investors and corporates.

Case 2—Put Warrants Approach to Fixed Price Buy Back/Takeover Offers Issue If a company wants to buy back its shares, it invites offers from its existing shareholders. However, shareholders have no obligation to offer their shares in a buy back offer. Accordingly, some shareholders offer shares and some do not. Some financial experts believe that shareholders who do not offer their shares

Case Studies

453

under a buy back scheme probably miss out on some value creation opportunity. Similarly, in case of fixed price takeovers, when an acquirer is buying shares from shareholders of a target company, shareholders have a choice of whether to tender their shares or not. In this case also, it is believed that shareholders, who do not offer their shares to the acquirer miss out on some values. Analyse the existing procedure of fixed price buy back and takeover and architect some financial product to cease the lost values, if any, in the existing procedure.

Analysis and Possible Solution The concept of buy back of shares by listed companies was pioneered in the Indian capital market at the end of 1998. Fortune Financials was the first company that came out with buy back offer and since then many companies have undertaken buy back offers. As stipulated in the buy back regulations, companies may buy back their shares through any of the following three methods: l l

l

Through fixed price tender offer on a proportionate basis Through book building route (called reverse book building) Through open market purchase

While in case of fixed price tender offers, purchase price per share is fixed by the company and is disclosed to the investors upfront, in book building case, it is determined through free interaction of demand and supply forces. In the third method i.e. open market purchase, purchase price is market price of the share and varies from transaction to transaction.

454

Derivatives and Financial Innovations

Takeover regulations also provide for fixed price tender offers, i.e. an acquirer can invite investors of the target company to offer their shares to him at a predetermined fixed price. There have been several fixed price takeover cases in the Indian capital market. In case of fixed price buy back/takeover cases, the company invites the existing shareholders to tender/offer their shares at a specific price to the buyer. Some or all of the existing shareholders may tender their shares under the offer if tender price is better than the market price. Sometimes, the buyer receives an offer for more than the target number of shares for purchase. In that case, he generally buys the shares on a proportionate basis.

The Concept As described, in case of buy back or takeover offers, shareholders have no obligation to offer their shares. Accordingly, some shareholders offer shares and some do not. In this respect, buy back and takeover offers are similar to rights issue, i.e. they offer the shareholders a choice but in an opposite way. This means that in case of rights issues, shareholders have the choice of buying additional shares and in buyback and takeover cases, shareholders have a choice of selling their shares. Though the concept of right to buy (rights issue) and right to sell stocks (buy back/takeover offers) are similar, in case of buy back and takeover cases no rights are issued to the shareholders. In other words, investors either tender their shares or they don’t but they do not have a choice of selling their right to a third party as there is no instrument offering this right. Therefore, in buy back/takeover cases, if buy back/tender price is higher than market price of the stock and investors do not want to tender, they will clearly lose the difference.

Case Studies

455

An obvious answer to this issue is that the choice of selling shares in buy back and takeover cases be conferred on shareholders in the form of an instrument such as rights in case of rights issue. If this is done, shareholders will probably be better off because they will be able to sell their rights if they do not intend to exercise them. Therefore, the subject can be dealt with if companies coming out with fixed price buy back/tender offers do so through issuance of put warrants (right to sell) to the shareholders on a proportionate basis. Along with offering an opportunity to investors to encash their right if they do not want to participate in the offer, this mechanism will also offer a host of administrative conveniences to investors and issuers. Although issuance of fixed price put warrants will replicate the fixed price buy back/takeover offers, the operational mechanism of the product will be sizeably different. As discussed in case of rights issues (case study 1), these rights may also be issued in electronic form and be traded on the exchanges for a limited period of their life.

Offer Procedure 1. Company may issue put warrants equal to the number of shares proposed for buy back. These may be credited proportionately into the demat accounts of shareholders holding shares in demat form. 2. In respect of shareholders holding shares in physical form, rights to surrender the shares (put warrants) may be given along with the letter of offer.

456

Derivatives and Financial Innovations

3. These put warrants may trade on stock exchanges for a limited period of their life. Put warrants in electronic form only may be traded on stock exchanges. 4. For acceptance of shares in demat form, the company may open a demat account. Shareholders/security holders, holding shares/specified securities in demat form can tender their shares/securities along with the put warrants anytime during the period in which the offer is open. This can be done by a simple delivery instruction to the Depository Participant (DP) for transfer of securities (shares and put warrants). The settlement for such shares/specified securities may be done on T + 1 basis by the company, by crediting the bank account of shareholders as per the DP details. 5. Shareholders/security holders holding the shares/ specified securities in physical form may tender their shares during offer period as per the existing procedure. 6. Unexercised put warrants shall cease to exist/expire worthless after closure of the offer. 7. In case of buy back of shares, if promoters do not intend to participate in buy back process, the issuance of put warrants to investors may be increased accordingly. Similarly in the case of takeovers, the issuance of put warrants to investors will increase to the extent of the equity stake with the acquirers. 8. Further, original investors on the announcement date may always be allowed to offer additional shares without put warrants but those shares may be accepted by the company only when some investors do not exercise their rights. This acceptance of additional shares may take place on a proportionate basis.

Case Studies

457

Value Drivers of the Proposed Structure As discussed earlier, the major contribution of this product would be to bring investors out of either tender or don’t tender zone. If a right to sell is offered to the investors through this instrument, they can exercise their right, can sell their right and realise values or gift their right to someone else as discussed in the case of rights issue. In addition, there are some other important dimensions of the product, which are as follows.

Risk Arbitrage and Consistent Pricing of Stocks It may be observed from past instances of buy backs/takeovers that whenever a buy back/tender offer price has been higher than the actual stock price in the cash market, price of the stock goes up and after the offer is complete, it comes down. This phenomenon creates enormous inconsistency in the price of stocks. Let us look at some of the cases. Takeover case: Reliance Industries Ltd (RIL) made a tender offer for shares of Indian Petrochemicals Ltd (IPCL) for Rs 231 per share, which took place in August 2002. The price of IPCL was around Rs 50–60 in the month of January 2002, went up to touch Rs 150–160 in the month of June–August 2002 and then came down sharply to Rs 70 or so after the offer. This may be seen from the price pattern in Fig. 19.1. Buy back of shares case: Bajaj Auto came out with a buy back offer at Rs 400 per share, which opened on September 18, 2000. The price of stock was consistent till the end of August and then, after closure of the offer stock went down drastically. The price movement of stock may be observed from Fig. 19.2.

458

Derivatives and Financial Innovations

IPCL 180 160 140

Price

120 100 80 60 40 Close 20

21/10/2002 9/10/2002 27/9/2002 18/9/2002 6/9/2002 28/8/2002 19/8/2002 7/8/2002 29/7/2002 18/7/2002 8/7/2002 27/6/2002 18/6/2002 7/6/2002 29/5/2002 20/5/2002 9/5/2002 29/4/2002 18/4/2002 9/4/2002 28/3/2002 18/3/2002 7/3/2002 26/2/2002 15/2/2002 6/2/2002 28/1/2002 17/1/2002 8/1/2002

0

Date

Fig. 19.1: Price pattern of IPCL share during takeover

In preceding figures, pricing pattern before the completion of offer is the product of arbitrage transactions. Arbitrage opportunities arise when buy back/tender offer price is higher than the current market price of the stock. Arbitragers buy stock from the market, register it in their names before the record date for the purpose and then tender that in the buy back/tender offer. This results in a profit to them to the extent of the difference between tender price and purchase price of the stock. We may argue that because of arbitragers in the system, market price of the stock should go up and touch the tender offer price. But, in reality this does not happen because of the risk involved in this arbitrage transaction. Practically speaking, it is not a pure arbitrage deal where profits are locked out-rightly; It is a risk arbitrage deal because arbitragers do carry the risk of

459

Case Studies

non-acceptance or part acceptance of their shares by the company/acquirer in case of over-subscription. Arbitragers will be able to sell left over shares at a price, presumably, lower than their purchase price. This phenomenon prevents cash market price from actually touching the buy back/tender offer price. Therefore, market price of the stock definitely goes up just before the offer but to discount for the risk involved in arbitrage, it always remains less than the buy back/tender offer price. Bajaj Auto 450 400 350

Price

300 250 Close 200 150 100 50

1/12/2000 23/11/2000 15/11/2000 7/11/2000 30/10/2000 20/10/2000 12/10/2000 4/10/2000 25/9/2000 15/9/2000 7/9/2000 29/8/2000 21/8/2000 10/8/2000 2/8/2000 25/7/2000 17/7/2000 7/7/2000 29/6/2000 21/6/2000 13/6/2000 5/6/2000 26/5/2000 18/5/2000 10/5/2000 2/5/2000 20/4/2000 11/4/2000 3/4/2000 24/3/2000 14/3/2000 6/3/2000

0

Date

Fig. 19.2: Price pattern of Bajaj Auto share during buy back

Now, let us evaluate the proposed structure of put option/ warrants for the purpose of buy back/take over. Theoretically, as this option/warrant confers a right to the investors to sell their stock at the tender price, which may presumably be higher than the market price, price of this warrant at any point in time would

460

Derivatives and Financial Innovations

be equal to the difference between the cash price and buy back/ tender offer price of the stock. Arbitragers in the market will compare market price of the stock plus price of the warrant with the tender price. Therefore, if this instrument is traded in the market independently, market price of the stock may not rise and then fall subsequently because of the force of arbitrage. In other words, market price of the stock may afford to be consistent with the difference between market price and tender price being captured by the put warrant. Let us understand the concept with the help of an example. Assume a stock is trading at Rs 100 and buy back/takeover offer price of the stock is Rs 150. In the present scenario, price of the stock is likely to go up and may touch Rs 150. Alternatively, a put option/warrant issued for the purpose will capture the difference of Rs 50 between the cash price and tender price and will theoretically trade somewhere near Rs 50 in the market. Practically, this warrant will always trade at a price slightly lower than Rs 50 due to liquidity considerations and providing for transaction cost in arbitrage and profit to arbitragers. As price difference between the cash and tender offer prices is captured by the warrant this will result in consistency of cash market prices. Since in this scenario, arbitragers will buy the stocks and corresponding number of put warrants and then tender the combination (stock with warrant) to the company in exact numbers, risk of non-acceptance or part acceptance of their shares by the company does not exist. Further, they will also be willing to pay for elimination of this uncertainty, which will result in better price alignment of spot plus put warrant price with the tender price. Needless to say, this will ensure that investors extract the best from the offer without leaving any values on the street.

Case Studies

461

Immediate Availability of Funds to the Investors At present, company waits to release payment against tendered shares as decision to accept depends on over subscription. In the proposed scenario, i.e. buy back/tender through put option route, funds may be made available to investors immediately since there will not be any situation of over-subscription because shares would always accompany put warrants. Thus, investors may benefit by early payment on their tenders in comparison to the fixed price tender offer.

Savings of Cost to Company In a typical buy back offer, number of shares to be accepted by the company are fixed and disclosed in the offer document. If shares tendered by the public are more than the number outlined in the offer document, as stipulated in the regulations, the company needs to accept shares on a pro-rata basis. These prorata calculations often suggest the acceptance of odd numbers of shares. For electronic holdings, there is no issue if odd number of shares are returned to the investors as any number of shares may be traded in the market. But, for the holders of shares in physical form, companies have to issue fresh share certificates with smaller denominations. This entails cost and at the same time causes problems for these physical shareholders because of their odd lot holdings. In the proposed structure of warrants, this problem would be solved to a large extent as investors may either sell their warrants without selling shares or buy warrants to cover up for deficiencies without losing the values. For instance, an investor holding 100 shares and 20 warrants may simply sell

462

Derivatives and Financial Innovations

the 20 warrants at market rate or buy further 80 warrants from the market and tender his entire holding of 100 shares in the buyback/tender offer. However, in this case the company would be going for listing of warrants on the stock exchange and this will be an additional cost to the company.

Conclusion It can be easily derived from the preceding that the put warrants approach to fixed price buy back/takeover offers imparts advantages of better values distribution among the investors, convenience and better consistency in stock prices over the prevailing practice. Therefore, it would be interesting to explore this put option route for fixed price buy back/takeover offers.

Case 3—Creative Use of Options in Designing Contracts Situation Suppose that the government passes a law, which prohibits lending of money at the interest rate more than 5 per cent per annum. However the equilibrium interest rate in the market is 12 per cent per annum for a specific risk obligor. An international bank has a customer who wants to borrow $ 60,000 at the equilibrium interest rate, i.e. @ 12 per cent per annum and can offer a store worth $ 100,000 as collateral. This deal needs to be structured with the help of derivatives in such a fashion that the

Case Studies

463

transaction generates equilibrium interest rate, i.e. 12 per cent per annum on lending without violating the law.

Possible Solutions Solution 1: Structure a repo transaction—Repo or ready forward deal is a deal where two contracting parties enter into two reverse transactions simultaneously. One of these transactions takes place in the cash/spot market and the other transaction takes place in the forward market (for settlement on a future date). Legally, repo results in two separate sale and purchase transactions and from that perspective difference between the purchase and sale prices is treated as capital gain/loss to the parties involved. In other words, difference between the purchase and sale prices is not treated as interest in the case of repo. Therefore, legally, this may not be called a lending transaction. In view of the preceding, bank may structure the deal in form of a repo transaction, i.e. it may buy the store from the client for $ 60,000 now and enter into a forward contract to sell that back to the client for loan amount plus the interest amount @ 12 per cent for the required period of time. Solution 2: Use options to structure the deal—In the previous case, bank has used a forward contract to structure the deal. An alternative to this may be a synthetic forward contract created through options. As discussed in the book, a combination of call and put options may be used to create a synthetic forward/ futures position. Accordingly, instead of a forward contract on the far leg of repo transaction the bank may use a combination of options to arrive at the same result.

464

Derivatives and Financial Innovations

To structure the deal, bank may take the following positions: 1. Buy the store for $ 60,000 in spot 2. Buy a put option on the store (take right to sell) 3. Sell a call option on the store (take obligation to sell) Both call and put options on the store will be European and have a strike price equal to the loan amount plus interest over the tenure of the loan. Indeed, combination of short call (sold call) and long put (bought put) options will create a synthetic short position for the bank in the forward market, on the store. The positions of client may now be described as: 1. Sell the store for $ 60,000 in spot 2. Sell a put option on store (take obligation to purchase) 3. Buy a call option on store (take right to purchase) Combination of long call (bought call) and short put (sold put) options will create a synthetic long position on the store for the client in forward market. Now, let us analyse the positions of both bank and client. As bank buys the store on spot terms, $ 60,000 flow to client on the spot date and this completes one leg of the transaction. At the other end of the transaction, if market price of the store is more than the strike price at maturity of the contract, the customer will exercise his call option on the store and bank will be obliged to sell. On the other hand, if price of the store is less than the strike price, bank will exercise its put option on the store and client will be obliged to buy. Therefore, in all circumstances, irrespective of the price of store at maturity of the contract, transaction will go through at the strike price only (which is $ 60,000 plus interest).

465

Case Studies

If these two structures are analysed from the credit risk perspective, as in any other over-the-counter transaction (OTC transaction), in this case also both the parties are exposed to each others’ default risk, i.e. in both the structures, counterparty risk/credit risk or default risk exits.

Case 4—Collateralised Mortgage Obligations Mr X is considering a Collateralised Mortgage Obligation (CMO) that has 3 tranches. The deal is a simple sequential pay bond that was issued several years ago. The tranches are A, B, and C, with a coupon paid to each tranche each month and principal payments are made first to tranche A, then to B, and finally to C. Here is the status of deal at the time of analysis: Tranche

Coupon rate

Par amount outstanding

A

6%

$ 3 million

B

7%

$ 8 million

C

8%

$ 30 million

Based on an assumed pre-payment rate, projected principal payments (pre-payments plus regularly scheduled principal repayment) for the next 4 years, for the collateral underlying this deal, are as follows:

466

Derivatives and Financial Innovations

Month

Scheduled Principal + Pre-payments

1

520,000

2

510,000

3

490,000

4

450,000

5

448,000

6

442,000

7

410,000

8

405,000

9

400,000

10

396,000

11

395,000

12

390,000

13

388,000

14

385,000

15

380,000

16

377,000

17

375,000

18

370,000

19

369,000

20

366,000

21

300,000

22

298,000

23

292,000

24

290,000

25

287,000

26

285,000

27

283,000

28

280,000 Contd

467

Case Studies

Table Contd Month

Scheduled Principal + Pre-payments

29

278,000

30

275,000

31

271,000

32

270,000

33

265,000

34

260,000

35

255,000

36

252,000

37

250,000

38

245,000

39

240,000

40

210,000

41

200,000

42

195,000

43

190,000

44

185,000

45

175,000

46

170,000

47

166,000

48

164,000

Based upon the preceding data, Mr X wants to work out the following: (a) Compute the principal, interest and cash flow for Tranche A for 48 months. (b) Compute the principal, interest and cash flow for Tranche B for 48 months.

468

Derivatives and Financial Innovations

(c) Compute the principal, interest and cash flow for Tranche C for 48 months. (d) Compute the average life for Tranche A. Answer to case study 4 is provided on pages 469–72.

Case 5—Protection of Bondholders through Put Option Issue With increasing mergers and acquisition and corporate restructuring activities, event risks in fixed income securities are becoming prominent. Event risks essentially mean the risk of loss to the bondholders because of certain specific events like buy back of shares, capital restructuring, etc. Is it possible to devise some mechanism to protect the interest of bondholders against these risks.

Analysis and Possible Solution Conflict of interest between debt and equity holders in a company has always been debatable. Companies concentrate on enhancing the value of equity holders and attention is rarely paid to the interest of debt holders, who are probably equally important to them. The interest of debt holders is ignored even more when they are small individuals and scattered across the country.

8%

C

520,000 510,000 490,000 450,000 448,000 442,000 410,000 405,000

1 2 3 4 5 6 7 8

Total receipts

7%

B

Months

6%

A

Parts a, b and c

Coupon

Tranches

Answer to Case Study 4

0

700

2,910

5,150

7,400

9,850

12,400

15,000

Interest

0

140,000

442,000

448,000

450,000

490,000

510,000

520,000

Principal

Tranche A

30,000,000

8,000,000

3,000,000

Par Value

0

140,700

444,910

453,150

457,400

499,850

522,400

535,000

Cash flows

45,092

46,667

46,667

46,667

46,667

46,667

46,667

46,667

Interest

405,000

270,000

0

0

0

0

0

0

Principal

Tranche B

450,092

316,667

46,667

46,667

46,667

46,667

46,667

46,667

Cash flows

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

Interest

0

0

0

0

0

0

0

0

Principal

Tranche C

Contd

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

Cash flows

Case Studies 469

Parts a, b and c

Table Contd

400,000 396,000 395,000 390,000 388,000 385,000 380,000 377,000 375,000 370,000 369,000 366,000 300,000 298,000

10 11 12 13 14 15 16 17 18 19 20 21 22

Total receipts

9

Months

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Interest

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Principal

Tranche A Cash flows

0

0

0

0

0

0

0

0

0

0

0

0

0

0

14,198

15,948

18,083

42,321

22,394

24,582

26,781

28,998

31,243

33,507

35,782

38,086

40,396

42,729

Interest

298,000

300,000

366,000

369,000

370,000

375,000

377,000

380,000

385,000

388,000

390,000

395,000

396,000

400,000

Principal

Tranche B

312,198

315,948

384,083

411,321

392,394

399,582

403,781

408,998

416,243

421,507

425,782

433,086

436,396

442,729

Cash flows

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

Interest

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Principal

Tranche C

200,000 Contd

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

Cash flows

470

Derivatives and Financial Innovations

Parts a, b and c

Table Contd

Total receipts 292,000 290,000 287,000 285,000 283,000 280,000 278,000 275,000 271,000 270,000 265,000 260,000 255,000

Months

23 24 25 26 27 28 29 30 31 32 33 34 35

0

0

0

0

0

0

0

0

0

0

0

0

0

Interest

0

0

0

0

0

0

0

0

0

0

0

0

0

Principal

Tranche A Cash flows

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

823

2,444

4,078

5,728

7,391

9,065

10,757

12,460

Interest

0

0

0

0

0

141,000

278,000

280,000

283,000

285,000

287,000

290,000

292,000

Principal

Tranche B

0

0

0

0

0

141,823

280,444

284,078

288,728

292,391

296,065

300,757

304,460

Cash flows

192,000

193,733

195,500

197,300

199,107

200,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

Interest

255,000

260,000

265,000

270,000

271,000

134,000

0

0

0

0

0

0

0

Principal

Tranche C

Contd

447,000

453,733

460,500

467,300

470,107

334,000

200,000

200,000

200,000

200,000

200,000

200,000

200,000

Cash flows

Case Studies 471

Part d

Total receipts 252,000 250,000 245,000 240,000 210,000 200,000 195,000 190,000 185,000 175,000 170,000 166,000 164,000

Months

36 37 38 39 40 41 42 43 44 45 46 47 48

0

0

0

0

0

0

0

0

0

0

0

0

0

Interest

Average life of tranche A = 3.61 years.

Parts a, b and c

Table Contd

0

0

0

0

0

0

0

0

0

0

0

0

0

Principal

Tranche A Cash flows

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Interest

0

0

0

0

0

0

0

0

0

0

0

0

0

Principal

Tranche B

0

0

0

0

0

0

0

0

0

0

0

0

0

Cash flows

173,780

174,887

176,020

177,187

178,420

179,687

180,987

182,320

183,720

185,320

186,953

188,620

190,300

Interest

164,000

166,000

170,000

175,000

185,000

190,000

195,000

200,000

210,000

240,000

245,000

250,000

252,000

Principal

Tranche C

337,780

340,887

346,020

352,187

363,420

369,687

375,987

382,320

393,720

425,320

431,953

438,620

442,300

Cash flows

472

Derivatives and Financial Innovations

Case Studies

473

Often, when a company rewards equity holders, the bondholders suffer a value loss. For instance, when a company is paying a hefty dividend to its equity holders or buying shares back at a very high premium to the market price, value of the company goes down as cash holding goes down. These actions also sometimes drastically change the company’s debt/equity ratio. Generally, bondholders are neither a party to these decisions nor are they compensated in any way for the extra credit risk they bear in the new higher leveraged company (company with higher debt/equity ratio). In other words, though the interest of debt holders is at stake in these decisions taken by companies, they are rarely consulted. This phenomenon is termed bondholders’ expropriation as equity holders enjoy disproportionate values at the cost of debt holders. Risks generated by these events are termed as event risks to the debt holders. Another instance of event risk is deterioration in credit rating of a company. This enhances the credit risk (risk of default) to bondholders without any compensating provision. These events reduce the market prices of bonds. Sometimes, bond covenants (indentures) do mention certain instances when permission from bondholders is required before a company finalises decisions that affect their interest. But all possible scenarios may not be provided for in bond covenants and so the risk for investors always exists. It is believed that this issue may be addressed by offering bondholders a right to sell their bonds back to the company (put option) in case of specific events. This will also help bondholders to take independent decisions with regard to events’ impact on the company and their interests. These options may be embedded in bonds. A put option is an option to sell the underlying asset at some future date at a specific price called the strike price. The buyer of put option has a right but no obligation with regard to selling

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the underlying asset. On the other hand, seller of put option has an obligation (to buy the underlying asset from the buyer of option) and no right in the contract. In other words, if buyer of a put option wants to exercise his right, the seller of option has no choice but to honour his obligation. Further, these options are considered as being embedded in the bonds when they cannot be detached and traded separately in the market. Availability of a put option to bondholders would enable them to put the bond back to the company and obtain cash in case of some specific event, if the investors think that their interest is being jeopardized. These options become more valuable to bondholders when liquidity in the system is poor and the buyer, in case of deterioration of quality of the paper, is either not available or available at a very deep discount. Therefore in markets like India, where trading in corporate debt is very thin and risk of instruments turning into junk is high amidst event risks, event linked put options may make good sense. Put options in bonds emerged as an instrument to protect investors against interest rate risk, i.e. to allow them to sell the bond back to the issuer at a predetermined price in case of price fall because of rise in general interest rates in the economy. But, over a period of time their use has been expanded to manage event risks. Today, when interest rate risk is better managed through floating rate instruments, put options are primarily used in bonds for event risk management. In developed markets like US, embedded put options in bonds are extensively used as a protection mechanism against event risks. Indeed, often there are special provisions in bond covenants with regard to these events and these options are exercisable by investors even during the lock-in period. Exercising options is sometimes allowed only after a specific period of time

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from the date of issuance. This period when the option cannot be exercised is called lock-in period. In India, some bonds issued by ICICI bank and Industrial Development Bank of India (IDBI) also have put option provisions. Therefore, bondholders should be more demanding and ask for event linked protection provision, i.e. a put option. Debenture trustees may play a crucial role here. These options will also encourage discipline on the part of companies while taking decisions on issues, which may result in bondholder’s expropriation. Indeed, offering event linked put options to bondholders would help companies improve the perception of bondholders towards them. Further as an option is offered to investors, the issuer will receive payment of the premium in terms of lower coupon rate and the effective cost of borrowing will go down. In view of the preceding, one may conclude that embedded event linked put options in bonds create a winning situation for both companies and bondholders. These options offer a very broad spectrum of values to bondholders, who may use them to protect their interest in a variety of situations. Companies also gain by raising capital at a lower cost with better perception of bondholders towards them.

Case 6—Buy Back of Shares for Other than the Cash Issue In India, companies are allowed to buy their shares back for extinction purpose and the law stipulates that the payment for

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buy back of shares has to be in cash. Interestingly, the law also allows companies to raise funds required for the purpose of buy back of shares, from any instrument other than equity. This means that a company may raise funds through debt issue with the objective “for buy back of shares.” The assignment here is to contemplate over the issues in the case and propose possible mechanism/mechanisms to create better values in the system.

Analysis Imagine that company C is going to buy its shares back and in order to pay for this, it proposes a debt issue. It is always possible that some existing shareholders of the company will subscribe to the debt offer, which is made to raise funds to meet the outflow on buy back of shares. The company will receive cash and offer debt securities to these investors and then use the same funds to buy the equity back from the same investors. This results in two cycles of cash movement—first, money moves from investors to the company and then, it moves back. One way to create efficiency in the system may be by combining both these transactions into one i.e. by allowing buy back of shares for other than cash. Accordingly in the earlier case, the company could offer a debt instrument to investors instead of first receiving cash and then paying it back. This instrument-to-instrument transaction could have saved lots of administrative hassles for both investors and issuers. It may be prudent to argue here that all equity holders may not be interested in the debt instrument of the company. In that case, the company may pay investors in cash. In other words, the company may make it optional for investors to take either

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the debt instrument or cash in return for their equity holding. This may open up a very wide opportunity zone for the companies. Further, as a capital restructuring exercise it makes enormous sense for companies to opt for an exchange of instruments, i.e. the company may prefer to replace its equity by debt or any other instrument. Therefore, allowing companies to buy back their shares for other than cash may pave the way for enormous creativity in the system. While making a buy back offer even for other than cash, companies may comply with all other existing requirements of the regulations/laws. It may also be relevant to mention here that acquisition of shares in takeover cases is allowed for other than the cash. On similar lines, buy back of shares for other than cash may be considered to create better values in the system. This is being practiced globally on a large scale as a corporate restructuring exercise.

Case 7—Buy Back of Shares for Treasury Purpose Issue In India, companies are allowed to buy their own shares back but only for extinction purpose, i.e. they cannot buy their shares and hold them in their balance sheet as an investment. On the other hand, companies may invest in equity of other companies and hold this investment in their balance sheet.

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Some financial experts argue that companies know themselves better than others and if they are allowed to hold their own shares as an investment they would probably create better values. Analyse this statement of financial experts.

Analysis The existing buy back scenario in the country may be divided into two distinctive sequential activities—firstly, the company buys its shares back through cash payment and secondly, it extinguishes them. The first act of the company affects only the right hand side of its balance sheet as cash goes out and securities come in. However, the second action affects both the sides as investment goes off from the right hand side and equity capital goes down from the left hand side. A clear understanding shows that in this case, the statement actually argues in favour of allowing companies to stop at the first act itself if they so desire. If a company holds its own shares in its balance sheet after its first action, then surely it should also be allowed to sell these shares back in the market whenever it thinks appropriate. The moment one arrives at this proposition, one is essentially allowing companies to buy shares back for treasury purpose. Deriving from the global experiences on the subject, it may be mentioned that there is no compulsion on companies to extinct their bought back shares. In markets like US and UK, companies are allowed to buy back their shares either for treasury purpose or for extinction purpose. Therefore, there are merits in the statement and it is believed that companies may be left with the option to either extinguish bought back shares or hold them for treasury purpose.

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On the down side, one may argue that this may not be a good idea as it may result in manipulation and insider trading because the company itself would be trading in its shares. However, manipulation and insider trading are essentially the issues related to disclosures and transparency and the issue must be dealt with bearing this in mind. Therefore, as long as companies purchase shares in a transparent manner there is no issue at all. In fact, one may also argue that if a company profits as result of some wrong practice, that money will also belong to the shareholders. Another argument in favour of the statement is that these treasury operations may prove to be extremely helpful in some panic situations like militant attacks, earthquakes, etc. In these situations, market starts going down without support and allowing companies to buy back their own shares for treasury purpose may help them to support their stock prices. This phenomenon would ultimately protect the interest of investors. This philosophy was experienced practically, in the US after September 11, 2001 attack on the World Trade Centre.

Case 8—The Barings Episode: Learning for the Market Assignment It is stated that, the “Barings’ failure was not a failure of derivatives, it was a failure of management.” Please study and analyse the Barings episode and suggest possible solutions to handle the issues highlighted by this case.

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Analysis Derivatives are leveraged products, used by market participants to manage the risk in the underlying market. Many people have the perception that derivatives are very risky. This perception is created by well-publicised debacles such as the Barings episode.

The Barings Episode The man behind the debacle, Nicholas Leeson had a wellestablished track record of being a savvy trader in the derivatives market and was the darling of the top management at the Barings’ headquarters in London. He was the head of derivatives trading, responsible for both trading and clearing functions of Barings Futures, Singapore (BFS) a subsidiary of Barings Plc, London. Leeson engaged in proprietary trading in futures and options on Tokyo Stock Exchange Index-Nikkei 225 on the Singapore Exchange–Derivatives Trading Ltd, (SGX–DT) (erstwhile Singapore International Monetary Exchange, SIMEX) Singapore and Osaka Securities Exchange (OSE) Japan simultaneously. Major part of Leeson’s trading strategy involved sale of options on Nikkei 225 index futures contracts. He sold large number of options straddles (a strategy that involves simultaneous sale of both call and put options) on Nikkei 225 index futures. As we discussed in the text, a straddle position results in loss if market moves in either direction (up or down) drastically. His strategy amounted to a bet that the Japanese stock market would neither fall nor go up substantially, i.e. he had a stable price perspective on the Japanese market. The Japanese stock market started falling on the news of a violent earthquake in Kobe, Japan. With futures on Nikkei 225

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going down, his straddle position started incurring loss. In pursuit of profit from his straddles, he started supporting the index by building up extraordinarily huge long positions in Nikkei 225 futures on both the said exchanges SGX–DT and OSE. However, the management of Barings was made to understand that Leeson was performing Nikkei 225 index futures arbitrage between SGX–DT and OSE. When the OSE authorities warned him about his huge long positions on the exchange in Nikkei 225 futures, he claimed that he had built up exactly opposite positions in Nikkei 225 on SGX–DT, i.e. if his positions in Nikkei 225 at OSE suffered losses, they would be compensated for by the profits of his positions at SGX–DT. The SGX–DT authorities were given a similar explanation when they enquired about Leeson’s positions. Leeson continued to provide misleading information to both the exchanges and neither of the exchanges bothered to crosscheck Leeson’s positions on the other exchange because they were competing for business in Nikkei 225. Both the exchanges were more concerned about the protection of their financial integrity and so, allowed Leeson these exceptionally large positions after securing adequate margins. The result is well known to everyone. A single trader could not direct the market as desired and consequently the market fell drastically. As a result, Barings registered colossal losses on Leeson’s futures as well as straddle positions. The bank was unable to sustain these losses and one rogue trader collapsed one of the oldest and prestigious banks in England. However, fall-out from this debacle did not touch the financial integrity of either of the markets, SGX–DT or OSE because they were absolutely safe through proper margining.

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Issues behind the Debacle and Learning from the Experience 1. A Single trader can not move the market: Leeson was trying to drive the prices in an upward direction by buying index futures on Nikkei 225 but could not succeed as the market was gripped in the negative sentiments generating from the earthquake in Kobe. The point here is that a single trader cannot change the direction of the market and it is always prudent to go with the flow of the market movement, strategically. In the Barings case, a better strategy for Leeson would have been the dynamic management of his portfolio. For instance, with decreasing value of index, his put leg of the straddle started incurring losses (call was to expire worthless) and he had the choice of squaring his put options off at the predetermined level (cut off loss strategy). Instead of squaring off his short put option position, Leeson chose to support the index price by buying futures on the Nikkei 225 and failed. 2. Traders should have clearly defined and well communicated position limits: Position limits mean the limits set by the top management for each trader in the trading organisation. These limits are defined in various forms, e.g. in relation to a product, a market or trader’s total exposure in the market etc. Any laxity on this front may result in unbearable consequences to the trading organisation. These limits should be clearly defined and well communicated to all traders in the organisation. 3. Meticulous monitoring of the position limits is a must: We may note that Leeson too had position limits set by the

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top management, but he crossed all of them. This attempt of outpacing limits did not come to the attention of the top brass at Barings as Leeson himself was supervising the back office operations at BFS and sent fictitious reports concerning his trading activities to the Barings’ headquarters in London. Had the top management known the real position, the disaster could perhaps have been avoided. Therefore, scrupulous monitoring of the position limits is as important as setting them up. From monitoring and control perspective bifurcation of front and back office operations and independence of back office is critical. Different people should be in charge of front and back office operations so that any exposure of dealers over and above the limits set for them can be detected immediately. This issue is related to having a system of proper checks and balances in place at each level to ensure that everyone in the organisation has a disciplined approach and works within set limits. In fact, trading systems should be capable of automatically disallowing traders any enhancement in their exposures as soon as they touch their predetermined limits. 4. Exchanges should compete professionally: Both the competing exchanges SGX–DT and OSE were not concerned about checking Barings’ position at the other exchange. Though both the exchanges were safe through margins, but it must be appreciated that the effect of a big failure like Barings goes much beyond the financial integrity of a system. The point is that while the exchanges should compete they should also co-operate and share information, which is likely to have a drastic impact on the entire financial system. This is also

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important from the point of view of deterring any price manipulation effort, which a member of two exchanges can make by using two independent systems. 5. Big institutions are as prone to risk as individuals: One broad issue from the overall market’s perspective is that big institutions are as prone to incurring losses in the derivatives market as any other individual. Therefore, irrespective of the entity, margins should be collected by the clearing corporation/house and/or exchange within the allotted time. Only, timely collection of margins can protect the financial integrity of the market, as can be seen in the Barings case. Points 1–3 are relevant to all the trading organisations in the derivatives market. They have to intelligently work in-house to avoid any mishaps such as Barings at any point in time. Point 4 is relevant to the exchanges and they should work in collaboration with each other to improve inter-exchange communication and coordination. With regard to Point 5, SEBI has performed a good job in the Indian derivatives market by making margins universally applicable to all categories of participants including institutions. This provision will go a long way to create a financially safe derivatives market in India.

Conclusion In view of the preceding, we may summarise the Barings episode by stating that “Barings’ failure was not the derivatives failure, it was management failure.” After the inquiries in the Barings

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case, the Board of Banking Supervision’s report also placed responsibility for the Barings debacle on poor operational controls at Barings rather than the use of derivatives. An important lesson from this entire episode is that a disciplined and self-regulatory approach by all participants is an absolute essential. The moment this fundamental rule is flaunted this leveraged market may threaten and destroy the existence of market participants.

Glossary Additional margin: Money, which a market participant would have to deposit in addition to the initial margin in order to cover possible loss on his position in an extremely volatile market. Adjusted exercise price: Strike price of an option after adjustments have been made for corporate actions like stock splits or bonus/rights issues in its underlying security. American depository receipt (ADR): A security issued by a United States Bank, backed by foreign shares held by the bank in a trust. American option: An option exercisable anytime on or before a specified date. Arbitrage: Simultaneous purchase of one asset against the sale of the same or equivalent asset, from zero initial wealth, to create a riskless profit arising from price discrepancies. Asian option: Option, whose final payoff depends on the average price of underlying asset over a certain period of time. Also known as average price option. Assignment: Process of assigning options, exercised by option buyers, to the writers/sellers. It is a call on option seller to perform his obligation of buying (in case of put) or selling (in case of call) the underlying asset at the strike price. At-the-money option: An option with exercise price equal to the current market price. At-the-money option with strike price

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equal to the spot price is called “at-the-money spot”. And, atthe-money option with strike price equal to the forward price is called “at-the-money forward” option. At a premium: An asset is called at a premium when its forward price is more than its spot price i.e. the asset is more expensive to purchase at forward rate than at spot rate. Average price option: See Asian option. Backwardation: Market is called in Backwardation on an underlying, when its spot price exceeds its futures price. In other words, expectedly falling market is called backwardation market. This is opposite to contango. Barrier option: Option, whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. Basis: Basis is defined as difference between cash and futures prices i.e. Basis = Cash price – Futures price. If futures price of an asset is higher than its cash price, basis for the asset is negative. In contrary, if cash price of an asset is higher than its futures price, basis for the asset is positive. Basis point: 1/100th of one percentage point. Basket option: Option, whose underlying asset is a basket of commodities, securities and/or currencies. Bear calendar spread: In most commodities and financial instruments, the term refers to selling the nearby contract month, and buying the deferred contract, to profit from a possible change in the price relationship.

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Bear market: A market in which prices are falling. Bermuda option: Option, that can be exercised intermittently only on predetermined dates during its life/currency. Beta: A measure of sensitivity of movement of a security or portfolio vis a vis that of market as a whole. Generally, an index is taken as a representative of the market for this purpose. Beta is also a measure of systematic risk. Black-Scholes model: A model used to calculate the value of a European call option. Developed in 1973 by Fisher Black and Myron Scholes, it utilizes the spot price, strike price, expiration date, risk-free return/interest rate, and the standard deviation (volatility) of the underlying’s return to find the price of option. Bond: A certificate of debt, usually long-term, whereby the issuing company normally promises to pay the bondholder/ investor a specified amount of interest for a specified length of time, and to repay the principal on the expiration date. Box spread: A dual option position involving a bull and a bear spread with identical expiry dates. This investment strategy provides for minimal risk. Additionally, it can lead to an arbitrage position as an investor attempts to lock in a small return at expiry. Broker: A person who acts as an agent for others in buying and selling securities/derivative contracts in return for a commission. Bull calendar spread: In most commodities and financial instruments, the term refers to buying the nearby month, and selling the deferred month, to profit from a possible change in the price relationship. Bull market: A market in which prices are rising.

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Butterfly spread: An option strategy combining a bull and a bear spread. It uses three strike prices of the same maturity. The bull spread is created using the lowest and middle strikes and the bear spread is created using middle and highest strikes. Both puts and calls can be used to create these spreads. Calendar spread: Simultaneous purchase and sale of derivative contracts for different delivery months on the same asset. It is also called intra-commodity spread/horizontal spread or time spread. Call option: An option that gives option buyer a right to buy underlying asset at a predetermined price, called the strike price. Cash commodity: An actual physical commodity someone is buying or selling, e.g., stocks, soybeans, corn, gold, silver, Treasury bonds, etc. Also referred to as actuals. Cash market: Cash market is synonymous with the spot market. It is a market, where the assets, underlying the derivative contracts, are traded. Cash settled derivative contract: A derivative contract that is essentially settled in cash i.e. only the difference between buy/ sell and the settlement price is given to or taken from the position taker. Carrying charge: Charge for carrying an asset from one point in time to another point in time. This cost is essentially the financing cost, cost of storage, insurance etc. Also referred to as cost of carry or carry. Cash and carry arbitrage: The arbitrage made when futures price is higher than the theoretical futures price. It involves buying underlying asset in the cash market and selling futures on the same underlying.

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Class of options: Option contracts of the same type (call or put) and style (American, European etc.) that cover the same underlying security. Clearing corporation/house: An organization, connected with the exchange, responsible for clearing and settlement of all contracts on the exchange. In addition to clearing and settlement functions, it also provides counterparty guarantee to all participants on the exchange. It manages the credit risk of counter parties by charging margins from them. Clearing member: A member of the clearing corporation. Clearing corporation clears and settles all the trades through its members only. Closing buy transaction: A buy transaction, which will have the effect of partly or fully offsetting a short position. Closing sell transaction: A sell transaction, which will have the effect of partly or fully offsetting a long position. Compound option: An option on an option. Examples include a call on a call, a put on a put, a call on a put and a put on a call. Contango: Market is called in contango on an underlying, when its spot price is less than its futures price. In other words, expectedly rising market is called contango market. This is opposite to backwardation. Contract month: The month in which a derivative contract will be finally settled. It is also called expiration month. Derivative contracts are recognized by their contract months. Contract multiplier: Monetary value, which is multiplied by the index number to determine the contract value of an index futures/option contract in rupee terms. In case of individual

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stock futures and option contracts, contract multiplier is the number of underlying stocks. It is also called lot size for derivative contracts. Contract specifications: Salient features of a derivative contract to be traded on the exchanges, e.g. contract multiplier, trading time, delivery procedures etc. Contract value: Notional value of a traded contract. Convergence: Movement to equality of spot and futures prices as the expiry of futures contract approaches. Convertible debenture: A debenture that can be converted into shares of issuer company as per its terms. Cost of carry: Please see carrying charge. Counterparty: Other party (buyer or seller) to a transaction. For Buyer, counterparty is seller and for seller counterparty is buyer. Counterparty risk: Risk of default by the counterparty in a transaction. This risk arises from the possibility that the counterparty will not fulfill terms of the contract. This is also called credit risk or default risk. Covered call option writing: A strategy in which one sells call options while simultaneously owning an equivalent position in the underlying asset/futures. Covered put option writing: A strategy in which one sells puts and simultaneously is short an equivalent position in the underlying asset/futures. Cross hedge: Hedging price risk of one asset by initiating a position in a different but related asset.

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Cum rights/bonus/dividend: Means “with rights of benefits.” If a person buys the stock, which is cum rights/bonus/ dividend, he is eligible to receive rights/bonus/dividend along with stock. Day order: An order, which automatically expires at the end of that day, if remains unexecuted. Day trades: Trades that are opened and closed on the same day. Day traders: Speculators who take positions in the market and liquidate them on the same trading day. Default risk: See counterparty risk. Delta: A measure of how much an option’s premium changes, given a unit change in the underlying asset’s price. Delta is often interpreted as the probability of option ending in-the-money at expiration. Delta hedging: A hedging strategy using a portfolio of options that are insensitive to changes in price of the underlying asset. Derivative contracts: The term derivative indicates that the product/contract has no independent value i.e. it derives its value from some underlying asset. This underlying asset can be a security, commodity, bullion, currency, live stock or anything else. In other words, Derivative means a forward, futures, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of specified real or financial asset or index. Early exercise: When an option is exercised prior to its maturity date. Only an American option can be exercised before its maturity. European options can not be exercised early.

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Embedded option: An option that is an inseparable part of another instrument. In other words, instrument and option can not be detached in case of embedded option. European option: An option exercisable only on a specified date (at its maturity). Exercise: Action taken by the holder of a call option if he wishes to purchase the underlying asset or by the holder of a put option if he wishes to sell the underlying asset. Exotic option: Any non Vanilla option. These are non standard/ customized option. Expiration day: The day on which a derivative contract ceases to exist. It is last trading day of the contract. Ex-rights/bouns/dividend: Means “without rights of benefits”. If a person buys the stock, which is ex rights/bonus/dividend, he is not eligible to receive rights/bonus/dividend along with stock. Extrinsic value/Time value: Difference between an option’s price and its intrinsic value. This can be defined as quantification of the probability that an option will gain intrinsic value during its life. Face value: Amount of money printed on face of certificate of a security. Fair futures value: Theoretical value of a futures contract calculated such that there is no cash and carry arbitrage. Forward contract: Forward contract is one to one customized contract, which is to be performed in future, mutually by the contracting parties, at the terms decided today. It is an Overthe-Counter (OTC) product.

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Front running: Dealing by intermediaries/dealers on their own behalf, ahead of their customers’ orders, to take advantage of the price movements through execution of said customers’ orders. Futures contract: A legally enforceable, exchange traded, standardized contract that represents an agreement to buy or sell a quantity of asset at a predetermined delivery date/day. Futures option: An option contract written on a futures contract as underlying. Gamma: Measure of how fast delta of an option changes, given a unit change in the underlying’s price. Hedge: A portfolio of spot asset/assets and derivative positions, wherein total risk of portfolio is less than the sum of risks of all individual positions in the portfolio. Hedge ratio: Number of contracts required to hedge the value of asset in hands. Hedging: Purchase or sale of derivative contracts to offset possible changes in the value of assets or liabilities, currently held or expected to be held at some future date. Horizontal spread: See calendar spread. Impact cost: Difference between the best mid price (mid of bid and offer) and the average price of executing an order of a fixed size. Impact cost is measured separately on buy and sell sides. Implied volatility: The estimated volatility of an asset’s price based upon prevailing prices of its option in the market. Index fund: Investment portfolio that aims at replicating/ cloning the performance of a chosen market index.

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Index option: An option, wherein the underlying asset is a stock index. Initial margin: A ‘good faith’ deposit of cash or securities, which a user of exchange traded derivatives market must make with his or her broker, when purchasing or selling derivative contracts, as a guarantee of contract fulfillment. Insider trading: Dealing on the basis of inside information or information, which is not publicly available. Inter-commodity spread: Simultaneous purchase and sale of derivative contracts in different commodities/assets. In-the-money Option: An option having intrinsic value. A call option is in-the-money if its strike price is below current price of the underlying asset. A put option is in-the-money if its strike price is above current price of the underlying asset. Intrinsic value: Amount by which an option is in-the-money. Kerb trading: Unofficial trading, when the market is closed. Limit order: An order to buy or sell at a specified price (or better), to be executed only when and if the market price reaches the specified price. It is also called market-if-touched order. Limit order book: List of all outstanding limit orders in system of the exchange. Liquidation: Any transaction that offsets or closes out a previously established long or short position. It is also known as covering or offsetting or squaring off. Liquidity: The degree to which a market can accommodate large volume of business without moving the prices significantly. Liquidity is measured in the form of impact cost.

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Long hedge: A hedge involving a long derivatives position. Long position: Outstanding/unsettled purchase position in a contract. It is opposite to short position. Maintenance margin: A set minimum margin (per outstanding derivative contract) that a customer must maintain in his margin account. Margin: Deposit of funds and/or securities to provide collateral for an investment position. See initial/additional/variation/ MTM margins. Margin call: A call from a clearinghouse to a clearing member, or from a brokerage firm to a customer, to bring margin deposits up to a required minimum level. Market capitalization: Market capitalization of a company is calculated by multiplying the outstanding number of shares by its share price. Market capitalization of an exchange is the sum of market capitalization of various companies listed on it. Market order: An order to buy or sell asset/contract immediately, at the best obtainable price in the market. Market risk: Possibility of loss on investment due to movements in the general level of market. It is also referred as Systematic risk. Marking to market (MTM): Revaluation of all open positions to reflect profits and losses based on their closing/settlement market prices, at a specific point in time. In today’s volatile environment, MTM is done on daily basis by the exchanges. In a sense, through daily marking to market process all open positions are deemed to be closed by the exchange at the end of each trading day.

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Marking to market margin (MTM Margin): Gains or losses on open contracts, which are calculated with reference to the settlement price at a point in time. Practically speaking, MTM/ variation margin is the result of marking to market (MTM) exercise. It is also called as variation margin. Maturity: Length of time to expiry of contract. Minimum price movement: Minimum possible difference between two quotes of similar nature i.e. buy-buy or sell-sell, allowed by exchange. It is also called tick size. Naked position: A position in a derivative contract where buyer or seller has no underlying asset position. Negative carry: See backwardation. Net position: Difference between long and short open positions in a specific contract, held by a market participant. Novation: Legal word for conversion of a contract between a buyer and a seller into two separate contracts, each with the clearing corporation as counterparty. Offset: See liquidation. Open interest: Open interest is a crucial and dynamic measure of the derivatives market. It is calculated as total number of outstanding/unsettled positions in the market as a whole, at a specific point in time. As total long positions for the market would always be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted. Worldwide, open interest in various contracts is disclosed on-line, by the exchanges. Open interest put call ratio: A ratio of open interest of put options to call options.

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Open outcry: Method of public auction for making verbal bids and offers in the trading pits or rings of exchanges. Open position: Any long or short position in the market. Opening buy transaction: A buy transaction, which will have the effect of creating or increasing long position. Opening sell transaction: A sell transaction, which will have the effect of creating or increasing short position. Option buyer/holder: One, who buys an option. He has right to exercise the option but no obligation with regard to the contract. Option contract: Option is a right given by the option writer/ seller to the option buyer/holder to buy or sell an underlying asset at a predetermined price within or at the end of a specified period. Option premium: Price for option/right paid by the option buyer to the option seller. Irrespective of exercise of option, this money is retained by the seller. From buyer’s perspective, it is a sunk cost. Option writer/seller: One, who writes/sells option to option buyer. He has the obligation to perform the contract, if option buyer desires so. Out-of-the-money option: An option with no intrinsic value i.e. a call/put, whose strike price is above/below the current market price of underlying asset. Over-the-counter market: Virtually, any market place other than the exchange is called the OTC market. Par: Face value of a security.

Glossary

499

Perfect hedge: A hedge where, change in value of derivative contract/contracts is identical and opposite to the change in value of hedged asset or liability. Physical settlement: Settlement of derivative contracts by delivery or receipt of the asset, underlying the contract. Position: A market commitment to buy or sell an asset/contract. Position limit: A restriction on the maximum number/amount of contracts that can be held by single market participant or market as whole, at any point in time. Price discovery: Generation of information about “”future’’ cash market prices through the futures market. Price limit: Maximum and/or minimum price limit specified by the exchange, for movement of an asset’s price during a single trading session. Price range: Difference between the highest and the lowest prices during a given period. Purchasing hedge: See Long Hedge. Put call parity: Relationship between the prices of a European put and call options on the same underlying with the same expiration date. Put option: An option that gives option buyer a right to sell the underlying asset at a predetermined price. Quote: A bid to buy and an offer to sell a security in the market at a given time. Record date: Last date by which a security holder must be registered with the company in order to receive the benefits declared dividend/bonus/rights/interest etc.

500

Glossary

Rho: Rate at which the price of a derivative changes with unit change in interest rates. Risk disclosure document: A document, which explains the risks inherent in trading. Broker member is required to give a copy of risk disclosure document to its each client at the time of signing the contract for trading. Roll forward: When an investor replaces a derivatives position with a new one having a later expiration date. Scalper: A trader who trades for small, short-term profits during the course of a trading session, rarely carrying a position overnight. Secondary market: Market where previously issued securities are bought and sold. Security: A generic term used for the instrument issued by an entity raising funds from the investors. Security represents the stake of investors (ownership or otherwise) in the entity. Common or preferred stocks, bonds of a corporation, government, or quasi-government body are examples of Security. Settlement: Process by which clearing corporation/house settles all positions in the market. Short covering: When a trader buys asset/contracts to negate the initial short position created by him. Short hedge: Hedge involving a short derivative position. Short position: An outstanding/unsettled sold position in a contract. It is opposite to long position. Speculation: Trading on anticipated price changes, where the trader does not hold another position that will offset any such price movements.

Glossary

501

Split: This happens when a share of a higher face value is divided into a number of shares of smaller denominations that cumulate to the original face value. Spot market: See cash market. Spot price: Cash/spot market price of asset. Spread: Simultaneous purchase and sale of two equal or equivalent positions (spot/forward/futures/options) in expectation that the price relationship between two contracts will change so that the subsequent offsetting sale and purchase transaction will yield a net profit. Spread margin: Reduced margin payment for the holder of a spread position. Stop order: A market order to buy asset when its market price has touched a specified level above the current price, or a market order to sell asset when its market price touches a specified level below the current price. It is also know as stop-loss order. This is opposite to market-if-touched order or limit order. Straddle: Simultaneous sale or purchase of both a call and a put option with the same expiration month and same strike price. On basis of an extremely volatile view, one can buy the straddle (Long straddle) i.e. buy both call and put options. Similarly, on basis of a range bound view, one can sell the straddle (short straddle) i.e. sell both call and put options. Strangle: Simultaneous sale or purchase of both a call and a put option with the same expiration month and different strike prices. On basis of an extremely volatile view, one can buy the strangle (Long strangle) i.e. buy both call and put options. Similarly, on basis of a range bound view, one can sell the strangle (short strangle) i.e. sell both call and put options.

502

Glossary

Strap: An option strategy created by being long in one put and two call options, all with the same strike price. On basis of an extremely volatile view with positive bias, one can buy the strap (Long strap) i.e. buy both call and put options. Similarly, on basis of a range bound view with negative bias, one can sell the strap (short strap) i.e. sell both call and put options. Strike price: Price in an option contract, at which the underlying asset is contracted to be bought or sold, if option gets exercised. It is also called exercise price. Strip: 1. For bonds, process of removing coupons from a bond and then selling the separate parts as zeros. 2. In options, a strategy created by being long in one call and two put options, all with the same strike price. On the basis of an extremely volatile view with negative bias, one can buy the strip (Long strip) i.e. buy both call and put options. Similarly, on basis of range bound view with positive bias, one can sell the strip (short strip) sell both call and put options. Synthetic put: A Put option created synthetically through portfolio of futures/underlying asset and a call option. Synthetic long put entails shorting of futures/underlying asset and a long position on its call. And, Synthetic short put is created by long position on futures/underlying asset and a short position on its call option. Systematic risk: A component of price risk in securities, generated by general movement of the market. This risk cannot be reduced through diversification. It is measured by beta value of a security. It is also known as market risk. Technical analysis: Anticipating future price movement using historical prices, trading volume, open interest, and other trading data.

Glossary

503

Theta: Ratio of change in an option’s price to decrease in time to expiration. It is generally calculated over decrease of one day in time to expiration. Tick size: See minimum price movement. Time limit order: A customer order that designates the time during which it can be executed. If remains unexecuted within the given time frame, it expires automatically. Time spread: See calendar spread. Time value: Amount of money, which option buyers are willing to pay for an option in anticipation that, over time, change in the underlying asset’s price will cause option to increase in value. In general, an option premium is the sum of its time value and intrinsic value. Accordingly, any amount by which an option premium exceeds its intrinsic value can be considered as time value. It is also referred to as extrinsic value. Trading cum clearing member (TCM): An entity, which is member of both—exchange and clearing agency. TCM trades and clears his own trades and can also clear the trades of other trading members. Trading cycle: A period, as notified by the Exchange/Derivative Segment of the exchange from time to time, during which a contract will be available for trading. Trading member: A member of the Derivative Exchange/ segment. Trading member depends upon clearing member for clearing and settlement of his trades. Treasury bill: A short-term government debt instrument with an original maturity of one year or less. Bills are sold at a discount

504

Glossary

from par with the interest earned being the difference between the face value received at maturity and price paid by the investors. Uncovered call option writing: A short call option position in which the writer does not own an equivalent position in the underlying asset. Underlying asset: An asset like security, stock, commodity, live stock, index etc on which a derivative contract is based. Unsystematic risk: A component of price risk in securities, generated by company and industry related factors. This risk can be reduced to a large extent by holding a well-diversified portfolio. Vanilla option: A normal option with no special or unusual feature. Variation margin: Gains or losses on open contracts, which are calculated with reference to the settlement price at a point in time. Practically speaking, variation margin is the result of marking to market (MTM) exercise and so is also called the marking to market margin (MTM margin). Vega: Amount by which the price of an option changes with one unit change in volatility of underlying’s price. Vertical spread: Simultaneous purchase and sale of puts or calls of the same expiration month but different strike prices. Volatility: Volatility is a statistical measure of the tendency of a market/prices of assets. It is typically calculated by using variance or annualized standard deviation of the price or return of asset/ market under study. A highly volatile market means that the prices have big swings in very short period of time.

Glossary

505

Volume: Volume provides static picture of the market with regard to a specific contract, over a period of time e.g. during the day, during the week or during the life of the contract. Different markets worldwide define the volume in different ways e.g. in contacts, in value, in number of shares etc. Volume put call ratio: Ratio of the trading volume of put options to call options. It is used to gauge sentiments of market participants. Yield: A measure of annual return on an investment. Yield curve: A chart in which yield levels are plotted on the vertical axis and term to maturity of debt instruments of similar credit worthiness is plotted on the horizontal axis. Yield curve is positive when long-term rates are higher than short-term rates. However, when short-term rates are higher than yields on longterm investments, yield curve is negative or inverted. Warrant: A derivative security, which gives its holder a right to purchase (call warrants)/sell (put warrants) underlying asset. Weather derivative: Derivative contracts based on weather outcomes as underlying. Zero sum game: A situation in which one participant’s gains result only from another participant’s equivalent losses. Resultantly, the net change in total wealth among participants is zero; the wealth is just shifted from one participant to another.

Index A Additional margins 69 American call option 389 American Depository Receipts (ADRs) 438, 447 American option 25, 30, 141, 176 American put option 388 Amortisation bond 409, 417 Arbitrage 104, 124, 189, 199 Arbitrager 50, 89, 90, 91, 105, 113, 458 Assignment of options 156 At-the-money option (ATM) 146, 177

B Backwardation market 131, 135 Bank guarantee 382, 389 Barings episode 479 Basis 131, 135 Basket trading 76 Basket warrants 379 Bearish vertical option 287 Bearish vertical spread 265 Beta 92, 93, 113 Binomial model 207, 226 Black–Scholes model 212, 227 Bondholders’ expropriation 473 Bonds with warrants 361 Book building 453 Bullish vertical spread 255, 286 Butterfly spread 314, 328 Buy back 65, 385, 389, 476, 478

Buyer/holder of the option 176

C Calendar spread 53, 68, 103 Calendar spread position 77 Calendar spread/time spread or horizontal spread 103, 115 Call 29 Call and Put options 25, 249 Call option 25, 141, 144, 176, 177, 243, 249, 382, 384, 386, 387, 393, 399, 450 Call warrant 371 Caller or range notes 400 Cap 397, 399, 416 Capital Protection Bonds 410, 417 Carbon credit derivatives 11 Cash and carry 134 Cash and carry arbitrage 106 Cash and carry model 122, 133 Cash market 62, 96 Cash settled contracts 58, 156, 179 Cash settled covered warrants 376, 379 Cash settled warrants 376 Catastrophic bonds 346, 351 Chicago Mercantile Exchange (CME) 443 Clearing members 62, 63 Closing a position 54, 78 Collar 397, 416 Collar strategy 307 Collateralisation 429

Index

508

Collateralised loans 387, 388, 390, 428 Collateralised Mortgage Obligation (CMO) 465 Commodity derivatives 8, 27, 28, 85 Commodity futures 33, 34 Commodity indices 11 Commodity linked security 442, 448 Commodity markets 87 Compound options 441, 448 Compulsorily convertible instruments 354 Compulsory delivery contracts 59 Condor 317, 328 Contango market 131, 135 Contract month 35, 76 Contract multiplier 36, 42 Contract size 36, 51, 76 Contract specifications 44, 76 Contracts 59 Convenience return or convenience yield 129, 134 Convenience yield 129 Convertible bonds 368 Convertible equity 363, 368 Convertibles 353 Covered call 302, 327, 372, 377, 379 Covered option 301 Covered put 309, 327 Covered warrant 372, 373, 375, 377, 379 Credit derivatives 85 Credit enhancement 420, 429 Credit risk 17, 85, 423 Credit risk protection 427 Credit risk securitisation 424 Cross hedge 101, 114 Currency derivatives 12 Currency risk 439

D Daily margining 65 Daily settlement price 79 Default or credit risk 87, 113 Default risk 113 Deliverable grade/quality 61 Deliverable quantity 61 Delivery period 59 Delivery unit 60 Delta 172, 173, 220, 228 Depositories 438 Depository receipts 438 Derivative 3, 27, 85, 111 Derivatives market 85, 112 Detachable warrants 362 Diagonal spread 255, 275, 286 Direct cost 99 Discount 130, 135 Diversification 86 Dollarisation of balance sheet 435 Dual currency bonds 437, 447 Due date 49, 77

E Employee Stock Options (ESOPs) 361 Equity derivatives 5 Equity Linked Note (ELN) 344, 351 Euro bonds 436 European call option 189 European option 25, 30, 141, 176 Event risks 468 Exchange traded funds (ETFs) 11, 13, 75, 432, 446 Exchange-traded 5 Exchange-traded derivatives 27 Exchange-traded market 27 Exchangeable 366, 369 Exercise date/day 25, 30, 141

Index

Exercise date/day of option 176 Expectancy model 121, 130, 133, 135 Expiration date/day 25, 30, 141 Expiration date/day of the option 176 Expiration day 76 Extrinsic value 147

F Fair price 122, 124, 133 Far contract 35 Final settlement 70 Financial assets 27 First in first out (FIFO) 157 First loss 421 Fixed deposits 380 Floater 392, 394, 402, 415, 442 Floating rate instrument 392, 415 Floor 397, 399, 416 Foreign bonds 436, 447 Foreign currency denominated bonds 434, 447 Forward 23 Forward contract 15, 20, 21, 28, 29 Forward Contract Regulation Act (FCRA) 8 Forward market 20 Fungibility 414 Future fair price 124 Futures contract 19, 20, 23, 33, 76, 121, 132, 133 Futures market 20, 22, 88 Futures option 447 Futures price 124

G Gamma 222, 228 Global Depository Receipts (GDRs) 438, 447 Gold BeES 433

509

Gold ETF 433 Gross pay-off profile

189, 199

H Hedge 94 Hedge contract month 102, 114 Hedgers 50, 85, 89, 90, 99, 112, 113, 235 Hedging 90, 406 Horizontal spread 255, 286 Horizontal/calendar or time spread 274, 287

I Implementation risk 105 In-the-money 177 In-the-money option (ITM) 145, 177 Index bond 348 Index construction 72 Index derivatives 75 Index funds 74 Index futures 6, 33, 34, 85 Index options 6, 85 Index-based derivatives 87 India Index Services and Products Ltd (IISL) 72 Indian Corporate CollateralisedDebt Obligation Fun 349 Indian Depository Receipts (IDRs) 439, 447 Individual stock options 28 Initial margin 64, 67, 68, 78 Insider trading 479 Intention matching 59 Inter-commodity or inter-product spread 103, 115 Inter-exchange arbitrage 106 Interest rate derivatives 13 Interest rate futures 13, 33, 34, 405, 416 Interest rate options 406

Index

510

Interest rate swap 404 Intrinsic value 146, 147, 149, 151, 177, 178, 204 Intrinsic value of option 177 Inverse floater 400, 402, 416

L Leverage 111 Liquid Yield Option Note 343 Liquidity 16, 50, 77, 88, 113 Liquidity Risk 88, 113 London International Financial Futures and Options 443 Long call 184, 238 Long futures position 191 Long hedge 99, 114 Long on option 25 Long position 52, 77 Long position 15, 103, 140, 175, 236 Long put 184

M Manipulation 479 Margining 62 Mark to market (MTM) 154 Market or systematic risk 86 Market risk 85, 92 Marking to market 65, 79 Multi Commodity Exchange 9, 28

N Naked position 53, 77, 102, 114, 301 National Commodities and Derivatives Exchange 9, 28 “Near month” contract 35 Near-the-money option (NTM) 146, 177 Negative basis 131 Net pay-off profile 189, 199 Nifty futures 6, 95

NiftyBeES 433, 447 Non-arbitrage model 122, 133

O Obligation to perform 23 Offsetting position 53, 77 Open interest 55, 78 Open market purchase 453 Open position 53, 55, 77 Opening a position 54, 78 Operational risks 22, 88, 113 Opportunity cost 99 Option 29, 140, 175, 236 Option buyer 140, 175, 176 Option buyer/holder 29 Option Greeks 220, 228 Option on futures 440 Option premium 26, 27, 141, 176, 203 Option price/premium 177 Option seller 140, 175 Option seller/writer 29, 140, 176 Option spreads 254, 285 Optionally convertible bonds 355, 368 Options 24, 139, 463 Originator 420, 426, 429 OTC market 27, 139, 153 OTC product 6, 28 Out-of-the-money option (OTM) 146, 177 Over collateralisation 421 Over-the-counter (OTC) 15 Over-the-counter (OTC) market 140, 449, 450 Over-the-counter derivatives 5 Over-the-counter products/contracts 27

P Pass through security 426, 430 Pay through securities 426, 430

Index

Pay-off profile 185 Payment in kind bonds 411, 417 Perfect hedge 96, 114 Perpetual bonds 410, 417 Position limits 50, 77, 482 Premature redemption 415 Premium 130, 135 Price band 49, 77 Price discovery 56 Price risk 75, 85, 86, 90, 112, 113 Principal Protection Bonds 410, 417 Protective call 327 Protective Call Buying 300 Protective put 299 Protective put buying 327 Put option 25, 29, 141, 144, 176, 244, 248, 249, 381, 383, 384, 386, 387, 389, 393, 399, 459, 473 Put warrant 371, 378, 455

R Ratio call spread 276 Ratio put spread 281 Ratio spreads 275, 287 Real estate funds 446 Real Estate Investment Funds (REIFs) 431 Repo 388, 390, 463 Reverse arbitrage 124 Reverse cash and carry arbitrage 106 Reverse collar 311 Right 24, 29, 140, 175 Rights issue 384, 389, 449 Risk array 167, 171 Risk scenarios 168

S Securities Contract Regulations Act (SCRA) 428 Securities transaction tax (STT) 88 Securitisation 419, 428, 429

511

Securitisation of credit risk 430 Securitisation with recourse 429 Securitisation without recourse 430 Securitised papers 430 Seller/writer of the option 176 Seller’s option contracts 59 Separate trading of interest and principal security 413, 417 Settlement 57 Settlement guarantee fund 62 Short call 184 Short hedge 100, 114 Short on option 25 Short option 173 Short position 15, 52, 77, 103, 140, 176 Short put 185 Single stock futures 6, 33, 34, 36, 97 Single stock options 6 SPAN (Standard Portfolio Analysis of Risk) 164 Special Purpose Vehicle (SPV) 420 Specific or unsystematic risk 86 Speculator 50, 85, 89, 90, 102, 103, 104, 112, 113, 114 SPIDR (S&P Index Depository Receipt) 433, 447 Spreads 114, 170 Standard Portfolio Analysis of Risk (SPAN) 67 Step Down Bonds 409, 416 Step up bonds 407, 416 Stock index 71 Straddle 291, 326 Strangle 295, 327 Strap 324, 328 Strike price or Exercise price 25, 30, 141, 176, 441 Strip 321, 328 Synthetic derivative positions 186 Synthetic futures 122

Index

512

Synthetic long call option position 199 Synthetic long futures position 191, 199 Synthetic long put option position 199 Synthetic position 198 Synthetic short call option position 199 Synthetic short futures position 199 Synthetic short put option position 199 Systematic 92 Systematic risk 92, 112, 113

T Tender offer 453 Term deposits 380, 388 Theta 223, 229 Third party guarantee 18 Tick size 43, 76 Time spread or calendar spread 255 Time value 146, 147, 150, 151, 178, 204 Time value of option 177 Trading members 62 Trading-cum-clearing Members 63

Treasury Inflation Protection Securities 412, 417

U Underlying asset 125, 140, 175 Underwriters 383 Underwriting 384, 389 Unit of trading 49 Unsystematic risk 112

V Value at Risk (VAR) 66 Vanilla bonds 391 VAR 69 Vega 222, 229 Vertical spread 254, 286 Volume 56, 78

W Warrant 361, 371, 379, 459 Weather derivatives 11, 13, 443, 448 Weather Insurance 444, 448 With recourse 422 Without recourse 423

Authors’ Profiles MANISH BANSAL is currently Vice President with Citigroup India. Prior to this, he worked with Securities and Exchange Board of India (SEBI), Mumbai, and Institute of Chartered Financial Analysts of India, Hyderabad. Mr Bansal has a diversified portfolio of experiences as a business manager, regulator and market developer, trainer, consultant and business analyst. Manish Bansal obtained his MBA from University of Saugor, India, his CFA from Institute of Chartered Financial Analysts of India (ICFAI), Hyderabad and an MS in Business from University of Maryland, USA. He is credited with several published articles on financial markets and has been a speaker at various seminars on equity and commodities. He also serves as a guest faculty to several management institutes in India. Mr Bansal’s interests lie in the areas of derivatives, financial engineering, financial products structuring and financial modeling. NAVNEET BANSAL is currently a Director at the Equity Department in UBS AG, Hong Kong. Prior to this, he was with Kotak Securities Ltd. as Associate Vice President at the Institutional Derivatives Desk. He has also worked with the Bombay Stock Exchange, Mumbai (BSE), where he contributed to the introduction of equity derivatives in India. He has done his B.Tech from Institute of Technology, Banaras Hindu University (BHU), and a PGDBA and CFA from the Institute of Chartered Financial Analysts of India (ICFAI), Hyderabad, India. He has co-authored numerous articles on

514

Authors’ Profiles

issues related to the capital market in leading financial dailies, magazines and annual reviews. He is a regular faculty at BSE Training Institute, Mumbai, prominent business schools and engineering colleges of Mumbai and Pune, Banker’s Training College, Institute of Company Secretaries of India (ICSI), etc. He is featured regularly on CNBC for his views on derivatives market. His interest lies in the area of derivatives and their strategic applications in the different dimensions of the economy.