Financial Markets Derivatives Options Notes

Financial Markets, Derivatives Notes

1. 3/26/2024
MSL310
Financial
Institutions
and
Markets
Topic
6:
Derivatives
Market
1
ReferencesKidwell,
D.
S.,
Blackwell,
D.
W.,
Whidbee,
D.
A.,
and
Peterson,
R.
L.
(2005).
Finonciol
institutions,
markets,
and
money.
gth
edition.
John
Wiley
and
Sons
2
ReferencesReserve
Bank
of
lndia.
Droft
comprehensive
guidelines
on
derivatives.
RBl.
h
lt
p
s
: /l
r
*
i
C
gc
E.
:"
i:
i
. *
r'*.
j
r:
/
r"d
c
rs/C_;.n
i
*
n_ti
F
D.Liir
7
4
5
I
-1.
P_fi
t
Securities
and
Exchange
Board
of
lndia.
(2015).
Developments
in
Commodities
Markets
-
Post
Merger.
SEBI.
hl
l
ps
:
li'^*.i:!v.
se
h
l
g*v.
i.n
l.
r:..e
d
r
lrL*
re,ss
re
iee
r*
sf
!_e
p
-
")ft4
C
l;^.,-l^n,*^^r-
;^
^^*.*-t:&;"--
*--i,^+-
^^*a
r.Jr_
ru{
L
iu
vr:iir
#
il.ip
{.:4.}-
ij-i.::?1";-LiL:J-jsi!}::l
I
({:r,u:"13,:inL:
m*tr*{
t?-:UL
htnl
r
t
1<-
r
4(.
t
\.,
+.r
^/
d,
,1
11,1
,
11
Securities
and
Exchange
Board
of
lndia.
(2021).
Annual
report
2O2O-
2
1.
S
E
B
l.
htt.*s:
llwlyI+.
l*
b
i.
g!v,
i
r:1r*
p*
;"i:-a.n
d-
ctatictirr/nithiir.tfin,tc/rlrrt-lr'r']11:rnnr::i-rogglf-sg2C-2:.5161"*.ntml.J**"",+",*-i},":..1:!l:',\/j'.ji1l':h
a<JAl,tjl,.:.l.:i.}j1..:..):..
.......-.................................................--......'.
J
OverviewDerivatives:
Forwards,
futures,
options,
swaps
.
Characteristics,
uses,
associated
risks,
Market
participants
Options
versus
forwa
rd/futu
res
contracts
Regulation
of
the
futures
and
options
markets
Swap
contracts
4
1.

2. 3/26/2024
OverviewRisk
for
investors,
businesses,
and
financial
institutions
.
What
are
interest
rates
going
to
be?
.
What
about
exchange
rates?
.
What
about
the
share
market?
lnvestors
are
exposed
to
more
or
less
risk
than
they
desire
in
one
or
more
securities
or
markets
Common
risk
factors:
lnterest
rates,
commodity
prices,
share
market
indices,
and
foreign
exchange
rates
Market
participants
can
use
derivatives
to
alter
their
risk
exposure
and
return
possibilities
5
Overview"Derivatives"
securitles
derive
their
value
from
changes
in
value
of
.
Other
assets
(such
as
shares
or
bonds)
.
Values
(such
as
interest
rates)
.
Events
(such
as
credit
defaults,
catastrophes
or
even
temperature
changes
in
certain
localities)
Examples:
.
The
value
of
futures
contract
to
buy
oil
at
some
future
point
in
time
is
derived
from
the
value
of
oil
.
The
value
of
a
futures
contract
to
buy
Treasury
bonds
is
derived
from
the
value
ofthose
bonds
6
Cash-market
transaction:
Buyer
and
seller
conduct
their
transaction
today
at
the
spot
price
7
Forward
Contracts
lnvolves
two
parties
-
buyer
of
an
asset
and
seller
of
that
asset
The
future
date
on
which
the
buyer
pays
the
seller
(and
the
seller
delivers
the
asset
to
the
buyer)
is
referred
to
as
the
settlement
date
The
two
parties
agree
today
on
a
price
that
will
be
paid
in
future
-
this
predetermined
price
is
called
forward
price
On
the
settlement
day,
purchaser
will
buy
a
specified
amount
of
an
asset
from
the
seller
at
forward
price
r=0Agreement
Date
TSettlement
Date
8

3. 3126/2024
Forward
Contracts
Farmer:
Wants
to
sell
wheat
in
three
months
time
.
Risk:
Wheat
prices
may
fall
Baker:
Wants
to
buy
wheat
in
three
months
time
.
Risk:
Wheat
prices
may
rise
Farmer
and
baker
sign
a
contract,
agree
on
the
price
at
which
they
will
buy/sell
wheat
in
three
months
time
9
Forward
Contracts
Farmer;
Wants
to
sell
wheat
in
three
months
time
.
Risk:
Wheat
prices
may
fall
Baker:
Wants
to
buy
wheat
in
three
months
time
.
Risk:
Wheat
prices
may
rise
They
manage
their
risk
by
entering
into
a
forward
contract
t=0Agreement
Date
All
aspects
ofthe
deal
defined
in
the
contract
Underlying
asset:
Wheat
(quality)
Forward
price:
Rs
100/kg
Quantity:
10
kB
Settlement
date:
March
30
(suppose,
today
is
January
1)
f
=
3
Months
Settlement
Date
Wheat
delivered
by
farmer
Payment
made
by
baker
10
Forward
Contracts
Scenario
1:
At
f
=
3
months,
actual
wheat
price
is
Rs
150/kg
Farmer
only
gets
Rs
1,000
from
his
position
in
the
forward
contract
.
He
could
have
got
Rs
1,500
by
selling
wheat
in
the
spot
market
Baker
only
pays
Rs
1,000
from
his
position
in
the
forward
contract
.
He
would
have
to
pay
Rs
1",500
to
buy
wheat
from
the
spot
market
Baker's
gain:
Rs
500
Farmer's
loss:
Rs
500
11
Forward
Contracts
Scenario
2:
At
t
=
3
months,
actual
wheat
price
is
Rs
80/kg
Farmer
gets
Rs
l-,000
from
his
position
in
the
forward
contract
.
He
would
have
got
only
Rs
800
by
selling
wheat
in
the
spot
rnarket
Baker
pays
Rs
1,000
from
his
position
in
the
forward
contract
.
He
could
have
bought
10
kg
wheat
for
Rs
800
from
the
spot
market
Baker's
loss:
Rs
200
Farmer's
gain:
Rs
200
1.?

4. 3/26/2024
150C
o
Fai-nre:"'s
Gain
c
2t
4C
scr
33
1*N
i4a
:5c
lsc
2c9
Forward
Contracts
14
Forward
Contracts
Wheat
Market
Price
Contract
Price
Farmer's
Gain
Baker's
Gain
Overall
Gain/Loss
-1,000
0
-800
0
-600
0
-400
0
-200
0
00
200
0
400
0
600
0
800
0
1,000
0
1,000
800600400200
0
-200-400-600-800
-1,000
0
100
20
100
40
100
60
100
80
100
100
100
L20
100
L40
100
160
100
180
100
200
100
13
Forward
Contracts
15C0
5C6
-5fi0
16
1CC8
o
-:40
1Ci
1:0
140
15C
i80
2C8
Bakei"'s
Gain
Forward
Contracts
-100ri
15
4
2'
40
Ccrrbineci
Gain,llass
Baker's
gain

5. Forward
Contracts
One
of
the
parties
to
a
forward
contract
assumes
a
i*ng
pcsiiict.:
and
is
obligated
to
buythe
undrl
rlying
assel
on
the
settlement
date
at
the
forward
price
The
other
party
assumes
a
sh*rt
positi*n
and
is
obligated
to
s*1i
Ihe
assei
on
the
settlement
date
at
the
agreed
price
Farmer:
Short
position
Baker:
Long
position
3/26/2024
Forward
Contracts
The
forward
price
of
an
asset
is
that
price
that
makes
the
forward
contract
have
zero
net
present
value
LU
5
Forward
Contracts
The
i*i"rryard
prire
for
a
contract
is
the
delivery
price
that
would
be
applicable
to
the
contract
and
is
ntg*iiated
toCay
(Rs
100/kg
for
wheat
in
the
farmer-baker
example)
//A**^-"1
^,"i-^r,
The
forward
price
may
be
different
for
contracts
of
different
maturities
.
Price
will
be
different
from
Rs
100/kg
if
farmer
and
baker
enter
Into
another
agreement
in
which
wheat
will
be
delivered
in
one
year
time
Agreement
Date
t
=
3
Months
t
=
6
Months
18
Forward
Contracts
Both
parties
to
the
contract
are
bound
by
the
contract
lndividual
parties
to
forward
contracts
are
exposed
to
counterparty
risk
-
potential
loss
should
their
counterparties
default
rather
than
honour
their
obligations
on
the
settlement
dates
.L:1

6. 3/2612024
Forward
Contracts
Consider
following
two
cases:
(1)Asset
is
purchased
forward
(say
six
months
from
now)
(2)
Borrow
funds
to
purchase
that
asset
now
(1)
Pay
interest
and
principal
in
six
months
time
(2)
lncome
earned
or
costs
incurred
during
those
six
months
Therefore,
the
forward
price
must
be
equal
to
the
current
price
plus
whal
it
would
cost
to
borrow
for
six
months
+
+Fo
t=0
t=f
11
Forward
Contracts
-so
t=0NPV^=,4,-r^:n
"
(l+;)
u
22
Forward
Contracts
Derivative
markets
help
in
the
transmission
of
information
Suppose
the
price
of
the
six
month
forward
contract
on
wheat
rises
\A1t
-+
,J^^-
+9-;.
+^li
^L*,,+
+1.^
"*--1.^lr-
^..^^-+^+i-^-
^€+l-^.,.L^-+
UBila{
iiUL:}
i!li,
lill}
clUr-JUl.
ri
!ai
jll<lJnUl.:
gAll(;1.1.<Jl.lLJJl>
Lrt
l.l
lt1
VVllij+i
prires
ir:
iuit;re
{six
r**nthsi?
Farrner
and
baker
will
agree
on
the
future
"expected
price"
of
the
wheat
23
Forward
Contracts
If
the
asset
had
any
storage
costs
or
paid
any
income,
the
forward
price
would
be
adjusted
upwards
(to
incorporate
the
storage
costs)
or
downwards
(to
incorporate
the
income)
Purchases
asset
now
versus
later
.
lncome
lost
.
StoraBe
costs
24
6
+Fo
*
**-1-*
"
t=
f

7. 3/26/2024
Forward
Contracts
Foreign
exchange
contracts
let
importers
and
exporters
manage
the
currency
risk
inherent
in
future
dealings
by
guaranteeing
future
exchange
rates
For
example,
when
an
importer
wishes
to
guarantee
a
forward
exchange
rate
to
fix
the
cost
of
a
delivery
of
merchandise
and
pay
the
bill,
he
can
enter
into
a
forward
contract
with
a
bank
.
The
contract
guarantees
delivery
of
a
certain
amount
of
foreign
currency
(say,
one
million
British
pounds)
in
exchange
for
a
specific
amount
of
domestic
currency
(say,
lndian
rupees)
23
Futures
Contracts
Similar
to
forward
contracts,
futures
contracts
involve
two
parties
agreeing
today
on
a
price
at
which
the
purchaser
will
buy
a
given
amount
of
a
commodity
or
financial
instrument
from
the
seller
at
a
fixed
date
sometime
in
the
future
Futures
contracts
differ
from
forward
contracts
in
several
ways
.
Future
contracts
are
standardised
in
quantities,
delivery
periods,
and
grades
of
deliverable
items,
whereas
forward
contracts
are
not
Many
of
the
differences
can
be
attributed
to
futures
contracts
being
traded
on
an
organised
exchange
while
forward
contracts
are
traded
ove
r-the-cou
nter
ma
rket
)A
Futures
Contracts
GOLDGOLDM
(Gold
Mini)
SilverCrude
Oil
GOLD
FUTURES:
https://www.
nseindia.
com/p
rod
ucts-se
rvices/com
modity-
derivatives-contract-specificatio
ns-bu
I
lion
27
Futures
Contracts
GOLD:
Bimonthly
contracts
:
GSu6
i
i"""-'
-'
6il;ai#"i;
fi"a;*-*-l'
*"''
aiiii:#;;it
;;**'"
-'
+r
PEdt*
$sr.h
Oare
i.a.
Zd
7

8. 3/26/2024
Futures
Contracts
29
Futures
Contracts
30
Futures
Contracts
21
Futures
versus
Forward
Contracts
Both
buyer
and
seller
in
a
futures-market
transaction
hold
formal
contracts
with
the
futures
exchange
(not
with
each
other)
.
Every
major
futures
exchange
operates
a
clearinghouse
that
acts
as
the
counterparty
to
all
buyers
and
all
sellers
This
decreases
the
counterparty
risk
involved
in
futures
trading
Traders
need
not
worry
about
the
creditworthiness
of
the
party
they
trade
with
Forward
contracts
are
riskier
because
one
party
may
default
if
prices
change
dramatically
before
the
delivery
date
32
8
Sourcel
:
*[W
#]ft
*S
I
F#
ffi

9. 3/26/2024
Futures
versus
Forward
Contracts
A
futures
contract
(just
Iike
a
forward
contract)
is
a
zero-sum
game
Whenever
the
market
price
of
the
underlying
asset
changes,
the
value
of
a
long
(purchase)
or
short
(sale)
position
also
changes
One
party's
gain
is
the
other
party's
loss
The
futures
exchange
is
protected
from
default
risk
by
requiring
daily
cash
settlement
of
all
contracts,
called
marking
to
market
.
The
party
making
a
loss
has
to
make
payment
to
the
party
making
a
gain
(through
their
broker
and
clearinghouse)
33
Futures
versus
Forward
Contracts
Futures
Contracts:
Market
participants
post
margin
money
to
take
account
of
gains
or
losses
accruing
from
daily
price
fluctuations
Forward
contracts:
There
are
no
cash
flows
between
origination
and
termination
of
the
contract
34
**!1S
:,
"_C"",.1._tIa
cts
:
M
a
rg
i
n
R
e
q
u
i
re
m
e
n
ts
Consider
an
investor
who
contacts
his
broker
on
Thursday
June
5
to
buy
two
December
gold
futures
contracts
Suppose
that
the
current
futures
price
is
56OO
per
ounce
The
contract
size
is
l-00
ounces
The
investor
is
required
to
deposit
funds
in
a
margin
account
Suppose
the
initial
margin
is
52,000
per
contract,
or
54,000
in
total
(amount
that
must
be
deposited
at
the
time
the
contract
is
entered
into)
35
LV"t_*1*
Contlacts
:
M
a
rgi
n
Req
u
i
rements
Suppose
that
by
the
end
ofthe
day
(June
5)
the
futures
price
has
dropped
from
Sooo
to
$597
lnvestor
has
made
a
loss
of
S0OO
(=
200
x
53)
The
balance
in
the
margin
account
would
therefore
be
reduced
by
Sooo
to
S3,4oo
The
investor's
broker
pays
$0OO
to
the
exchange,
which
passes
the
money
to
the
broker
of
an
investor
with
a
short
position
and
then
the
investor
receives
that
amount
in
his
margin
account
9

10. 3/26/2024
Futures
Contracts:
Margin
Requirements
Margin
Cash
Flows:
When
Futures
Price
Decreases
(short
position
benefits)
Clearing
House
//
Clearing
House
Member
Broker
Long
Trader
\
>t
i*H:StoStlacts:
Ma
rgi
n
Req
u
i
rements
Suppose
that
by
the
end
of
June
5
the
futures
price
increased
from
Sooo
to
Soo+
lnvestor
has
made
a
gain
of
SSOO
(=
200
x
54)
The
balance
in
the
margin
account
would
therefore
be
increased
by
Sgoo
to
S4,8oo
The
broker
for
parties
with
a
short
position
pay
money
to
the
exchange
and
brokers
for
parties
with
long
position
receive
money
from
the
exchange
38
I_y:H{"ff
S,gltlacts
:
Ma
rgi
n
Req
ui
rements
Margin
Cash
Flows:
When
Futures
Price
lncreases
(long
position
benefits)
Clearing
House
t
cr*.rilI
I
M.-b.,
I
-Tt-
v
T--T."r---t-;-___l
U
\
Clearing
House
Memberg#
39
Futures
Contracts:
Margin
Requirements
Cumulative
Gain
(S)
-
r5U!-,
-
-){ti
-.
_)
:nn
10
Brokert
shod
Trader
Day
Trade
Price
(S)
Settle
Price
(S)
Daily
Gain
(S)
Margin
Balance
(s)
1
1
l('r1r
L
1
li!1
nn
3C0xi325S-l-241-)
=
-1,800
1200c,
1800
2
200x(1241,-1238.3)
10,200
-
54G
l1I'

11. 312612024
Futures
Contracts:
Margin
Requirements
Day
Trade
Price
(s)
Settle
Price
(S)
Daily
Gain
($)
Cumulative
Gain
($)
Margin
Balance
(S)
Margincall
($)
L
1,250.00
12,000
1
7,24L.OO
-1,800
-
1,800
10,200
2
1,238.30
-540
-2,340
9,660
6
L,236.20
-780
-2,760
9,240
7
1.,229.90
-t,260
-4,O20
7,980
4,020
8
1,230.80
180
-3,840
L2,780
L6
1,226.90
780
-4,620
r-5,180
Futures
Contracts:
Margin
Requirements
The
effect
of
the
marking
to
market
is
that
a
futures
contract
is
settled
daily
rather
than
all
at
the
end
of
its
life
At
the
end
of
each
day,
the
investor's
gain
(loss)
is
added
to
(subtracted
from)
the
margin
account,
bringing
the
value
of
the
contract
back
to
zero
Afutures
contract
is
in
effect
closed
and
rewritten
at
a
new
market
price
each
day
42
Futures
versus
Forward
Markets
In
the
futures
market,
almost
all
contracts
are
offset
before
delivery
.
Party
with
long
(short)
position
close
its
position
by
selling
(purchasing)
a
futures
contract
ln
the
forward
exchange
markets,
contracts
are
ordinarily
satisfied
by
actual
delivery
of
specified
items
on
the
specified
date
43
Futures
versus
Forward
Markets
Forwards
Futures
Market
Overthe-counter
Organised
markets
Contract
terms
Customised
Standardised
Contracted
goods
Customised
Standardised
Contract
parties
Customised
Exchange
Default
risk
Could
be
high
Nil
Delivery
Physical
delivery
Cash
settlement
or
closing
out
of
position
(more
common)
AA
L'1,

12. 3/26/2024
Futures
Contracts
Contract
unit
or
contract
size
Contract
or
delivery
months
Last
trading
day
DeliveryCash
settlement
price
lnitial,
daily,
and
intraday
margins
Minimum
price
movements
Position
limits
45
Futures
Contracts
The
contract
unit
or
contract
size
is
the
standard
quantity
of
the
product
that
is
the
subject
of
each
contract
The
contract
must
specify
closely
what
exactly
is
being
traded
.
This
is
necessary
so
that
all
parties
are
getting
or
supplying
what
they
want
o1
with
contracts
in
which
the
product
is
not
delivered,
the
settlement
price
can
be
accurately
found
The
last
trading
day:
Last
day
on
which
trading
occurs
Futures
contracts
specify
how
the
prices
of
their
contracts
will
be
quoted
and
minimum
price
changes
that
are
acceptable
Some
futures
exchanges
impose
position
limits
.
Maximum
number
of
contracts
that
speculators
may
hold
for
any
individual
type
of
commodity
or
asset
nc
Futures
Contracts
Each
contract
specifies
the
delivery
month,
in
which
deliveries
are
made
or
contracts
are
settled
Deliverable
contracts;
Settled
by
physical
delivery
.
For
example,
the
contracts
on
individual
shares,
holders
of
buy
contracts
(long
positions)
receive
shares
and
holders
of
sell
contracts
(short
positions)
transfer
their
shares
Nondeliverable
or
mandatory-settled
contracts:
Settled
by
means
of
a
cash
settlement
price
(for
example,
index
futures)
47
Futures
Contracts
The
margin
requirements
ensure
that
holders
of
futures
contracts
have
no
incentive
to
renege
or
repudiate
a
contract
.
Both
buyers
and
sellers
lodge
deposits
with
their
brokers
to
pass
on
to
the
clearinghouse
attached
to
each
market
These
initial
deposits
or
margins
are
set
by
the
clearinghouse
according
to
the
value
of
the
contract,
its
liquidity
and
the
likely
volatility
of
its
price
based
on
previous
experience
.
The
exchange
will
set
its
margins
so
that
margln
covers
speclfied
limit
of
the
dally
price-movement
risk
.
Margins
are
also
varied
by
the
clearinghouse
from
time
to
time
to
reflect
changes
in
price
volatility
and
liquidity
experienced
by
each
contract
.
lntraday
margin
calls
during
periods
of
extreme
price
volatility
48
L2

13. 3/26/2024
Futures
Contracts
Marking-to-Market:
All
future
contracts
are
settled
on
daily
basis
according
to
the
end-of-day
settlement
price
for
the
contract
Daily-settlement
margin
calls
based
on
each
day's
trading
results
are
issued
by
the
clearinghouses
lf
payments
are
not
received
on
time,
open
positions
are
closed
out
or
compulsorily
cancelled
by
the
clearinghouse
.
The
margin
account
of
the
defaulting
trader
is
decreased
by
the
loss
(difference
between
the
value
of
the
open
position
and
the
value
of
the
closing-out)
Clearinghouse
ensures
that
the
balance
in
margin
accounts,
remains
positive,
so
that
any
closing-out
losses
can
be
recovered
and
the
clearinghouse
itself
does
not
suffer
losses
/to
Futu
res
Contracts
Suppose
a
given
futures
contract
has
an
initial
margin
of
S1,500
and
a
minimum
margin
account
balance
of
S1,000
Contract
is
marked
to
market
at
the
close
of
trade
each
day
The
buy
contract
is
maintained
for
ten
days
before
being
reversed
on
the
1"1th
day
5U
Futures
Contracts
Dav
Change
in
contract
price
(S)
Margin
account
balance
($)
0
1500
T
-250
1250
2
-50
7200
3
100
1300
4
150
1450
5
-300
1150
6
-200
950
(marein
call
5550)
7
100
1500
150
L750
9
100
1650
10
150
1800
11
-200
1600
Total
Chanee
-450
51
Futu
res
Contracts
The
balance
in
the
margin
account
varied
as
the
contract
price
moved
in
the
market
When
the
contract
price
fell,
the
clearinghouse
deducted
funds
from
the
margin
account
(loss
made)
of
the
trader
with
long
position
.
This
is
the
amount
which
the
party
with
short
position
will
receive
When
the
balance
in
the
margin
account
fell
below
the
rninimum
margin
Ievel,
a
margin
call
is
made
to
top
up
the
account
The
contract
price
had
fallen
in
total
by
S450
The
balance
in
the
margin
account
was
$1,600
(initial
S1,500
plus
S550
margin
call
minus
$+SO
drop
in
contract
price)
13

14. 3/26/2024
Futures
Contracts
NSE
Gold
Futures
htt
ps
://www.
n
se
i
n
d
i
a.
co
m/
p
ro
d
u
cts-se
rvi
ces/co
m
mo
d
ity-
derivatives-contract-specificatio
ns-bullion
53
Futures
Contracts
There
are
two
major
types
of
participants
in
futures
and
forward
markets:HedgersSpeculato
rs
54
Futures
Contracts
Hedgers
attempts
to
reduce
their
risk
exposure
by
using
derivatives
'For
example,
interest
rate
risk,
exchange
rate
risk,
cost
of
financing
Speculators,
on
the
other
hand,
take
on
risk
to
make
profits
.
May
speculate
either
on
a
rise
in
prices
by
buying
futures
contracts
(going
long)
or
on
a
fall
in
prices
by
selling
futures
contracts
(going
short)
55
Futures
Contracts
Market
participants
can
use
futures
contracts
to
manage
their
risk
and
exploit
arbitrage
opportunities
Reducing
systematic
risk
in
share
portfolios
lncreasing
returns
through
index
arbitrage
Guaranteeing
costs
of
funds
Hedging
a
balance
sheet
56
L4

15. 3/26/2024
Futures
Contracts
Reducing
systematic
risk
in
share
portfolios
Systematic
risk
measures
a
share
portfolio's
tendency
to
vary
relative
to
the
market
as
a
whole
.
Systematic
risk
cannot
be
diversified
away
lndex
futures
can
be
used
to
reduce
the
systematic
risk
in
an
investor's
portfolio
.
lndex
futures
derive
their
value
from
averaging
the
prices
of
a
'basket'
of
underlying
shares
that
were
included
in
the
share
index
Futures
Contracts
Reducing
systematic
risk
in
share
portfolios
Suppose
investor's
portfolio
is
worth
S11
million,
with
a
beta
of
one
Assume
that
the
index
futures
contract
is
se
lling
ai
44**
.
One
index
futures
contract
is
worth
$25
per
point,
therefore
index
futures
contract
is
worth
S110,000
in
shares
(S25
x
4400)
Selling
100
contracts
of
the
index
futures
would
have
the
same
effect
as
selling
Stt
million
worth
of
shares
with
an
average
beta
of
one
58
Futures
Contracts
Reducing
systematic
risk
in
share
portfolios
Suppose
investor's
portfolio
is
worth
$11
million,
with
a
beta
of
1
By
selling
100
contracts
of
the
index
futures,
investor
would
be
able
to
fully
offset
the
systematic
rlsk
in
his
portfolio
and
have
a
net
portfolio
beta
of
zero
lnvestor's
portfolio
consists
of:
Long
$11
million
worth
of
shares
with
a
beta
of
one
Short
S11
million
worth
of
index
futures
(also
with
a
beta
of
one)
59
Futu
res
Contracts
Reducing
systematic
risk
in
share
portfolios
lf
the
investor's
portfolio
has
a
beta
of
1.2
Investor
would
short
120
index
futures
contracts
The
investor
would
have
to
sell
20
percent
more
contracts
because
the
systematic
risk
of
their
portfolio
is
20
percent
higher
than
the
systematic
risk
of
the
futures
contract
60
15

16. Futures
Contracts
Reducing
systematic
risk
in
share
portfolios
Difficult
to
predict
the
rises
and
falls
in
the
market
By
selling
futures
contracts,
the
investor
need
no
longer
fear
that
the
value
of
the
share
portfolio
would
change
substantially
if
share
market
prices
generally
rose
or
fell
61
Futures
Contracts
Reducing
systematic
risk
in
share
portfolios
Shorting
of
futures
contracts
provides
insurance
but
also
limits
investors'
potential
to
make
gains
Selling
of
Index
futures
would
cause
losses
that
would
offset
part
of
the
gain
on
the
investor's
share
portfolio
if
share
prices
rose
62
3/2612024
Futures
Contracts
Reducing
systematic
risk
in
share
portfolios
Dealers
profit
by
buying
shares
at
a
lower
price
and
selling
them
at
a
hlgher
price
Dealers
are
exposed
to
the
risk
that
the
price
of
the
shares
they
own
may
decline
before
they
can
resell
them
Therefore,
dealers
may
want
to
reduce
the
systematic
risk
of
their
portfolio
by
using
futures
53
Futures
Contracts
lncreasing
returns
through
index
arbitrage
Arbitrageurs
enter
markets
by
buying
and
selling
identical
(or
near
identical
assets)
Arbitrageurs
exploit
differences
in
prices
between
different
markets
and
so
serve
to
move
prices
in
separate
markets
closer
to
one
universal
price
64
L6

17. 3/26/2024
Futures
Contracts
lncreasing
returns
through
index
arbitrage
The
index
futures
are
selling
at
4,4OO
and
expire
in
three
months
Underlying
shares
in
the
share
index
are
selling
for
an
equivalent
prlce
of
4,200
Arbitrageurs
could
buy
those
shares
and
short
index
futures
65
Futures
Contracts
lncreasing
returns
through
index
arbitrage
The
value
of
the
index
futures
must
equal
the
value
of
the
underlying
shares
in
the
share
index
when
it
expires
in
three
months
Arbitrageurs
can
make
a
riskless
gain
of
4.7
percent
(aaOOl42OO)in
three
months
by
buying
underlying
shares
for
4,200
and
selling
them
for
4,400
through
index
futures
66
Futures
Contracts
lncreasing
returns
through
index
arbitrage
ln
addition,
by
owning
the
shares
for
three
months,
the
investor
might
accrue
dividends
When
index
futures
prices
rise
too
far
above
share
prices,
arbitrageurs
sell
the
futures
index
and
buy
great
amounts
of
shares
that
replicate
the
price
movement
of
the
underlying
share
index
6V
Futures
Contracts
Guaranteeing
costs
of
funds
When
a
corporation
plans
a
major
investment,
it
typically
commits
itself
to
major
cash
outlays
for
several
years
in
the
future
A
promising
project
may
become
unprofitable
if
interest
rates
unexpectedly
rise
and
the
corporation
has
to
pay
substantially
more
to
borrow
needed
funds
The
corporation
can
avoid
this
risk
by
borrowing
allfunds
at
the
time
the
investment
is
planned
and
investing
excess
funds
in
short-term
securities
until
they
are
needed
68
L7

18. 3/26/2024
Futures
Contracts
Guaranteeing
costs
of
funds
Howeve;
because
short
term
rates
are
often
lower
than
long-term
rates,
it
could
be
costly
to
borrow
long
term
and
invest
the
temporarily
excess
money
at
a
lower
rate
Alternatively,
the
corporation
may
use
the
futures
market
to
guarantee
its
future
financing
costs
AA
Futures
Contracts
Guaranteeing
costs
of
funds
lf
the
corporation
usually
pays
a
1
percent
premium
over
the
government
bonds
rate
to
borrow,
it
can
use
the
government
bond
futures
to
hedge
its
costs
of
funds
70
Futures
Contracts
Guaranteeing
costs
of
funds
Suppose
the
company
needs
to
borrow
$tO
million
now
and
S10
million
in
another
year
It
could
sell
$10
million
in
long-term
bonds
now
and
simultaneously
sell
three-year
government
bond
futures
with
a
market
value
of
S10
million
for
a
delivery
one
year
from
now
Hedging
will
allow
company
to
obtain
a
known
interest
cost
on
in
future
sale
of
corporate
bonds
71
Futu
res
Contracts
GuaranteeinB
costs
of
funds
lf
interest
rates
rise
during
the
next
year,
the
corporation
will
have
to
pay
more
to
borrow,
but
futures
prices
will
fall
Therefore,
the
corporation
will
have
a
capital
gain
on
its
futures
contractsThe
capital
gain
can
be
used
to
reduce
borrowing
requirements
72
18

19. Futu
res
Contracts
Guaranteeing
costs
of
funds
Howeve;
because
of
hedging,
the
corporation
will
also
lose
the
ability
to
obtain
funding
at
a
lower
rate
If
interest
rates
fall:
.
lt
might
be
able
to
sell
bonds
at
a
lower
rate
one
year
from
now
.
lt
would
also
lose
on
its
sale
of
the
futures
contracts
which
will
rise
in
price
72
3/26/2024
Futures
Contracts
Hedging
a
Balance
Sheet
Financial
futures
can
be
used
to
protect
a
financial
institutions
against
interest
rate
risk
1t
Futu
res
Contracts
Hedging
a
Balance
Sheet
Suppose
that
a
financial
institution
specializing
in
providing
financing
for
housing
loans
has
.
5300
million
in
liabilities,
all
with
maturities
of
one
year
or
less,
and
$15
million
in
members'
equity
.
5300
million
in
fixed-rate
mortgages
and
only
S15
million
in
assets
with
maturities
under
one
year
Liabilities:
Short-term
Assets:
Long-term
+
Highly
exposed
to
loss
should
interest
rates
increase
because
of
a
mismatch
in
the
maturities
of
its
assets
and
liabilities
Futures
Contracts
Hedging
a
Balance
Sheet
ASSETS
LIABILITIES
AND
EQUITY
Short
Term
Securities
(Reprice
<
1
year)
SlsM
Borrowings(Reprice
<
1
year)
Ssootvt
Fixed
Rate
Mortgages
s3ooM
Equity
Srsvt
Total
Assets
Ssrsvl
Liabilities
+
Equity
s31sM
/b
ftr
19

20. 3126/2024
Futures
Contracts
Hedging
a
Balance
Sheet
lf
interest
rates
rise:
.
Revenues
on
its
mortgage
portfolio
will
change
very
little
(mortgages
are
fixed-rate)
.
Because
of
higher
discount
rate,
the
value
of
mortgages
will
fall
.
Liabilities
will
mature,
it
will
either
have
to
pay
more
interest
to
its
liability
holders
or
lose
its
deposits
+
lnterest
costs
will
rise
more
than
interest
revenues
Consequently,
the
financial
institution
will
suffer
Iarge
losses
77
Futures
Contracts
Hedging
a
Balance
Sheet
Short
sell
futures
contracts
on
ten
year
government
bonds
to
offset
the
interest
rate
risk
of
the
53OO
million
in
mortgages
held
in
its
portfoliolf
interest
rates
rise,
capital
gain
on
the
futures
will
offset
the
loss
from
fixed-rate
mortgages
.
lnterest
rates
increases,
prices
will
fall,
gain
from
short
position
on
futures
Futu
res
Contracts
Risks
in
the
Futures
Markets
Basis
risk
Related-contract
risk
Margin
risk
79
Futures
Contracts
Risks
in
the
Futures
Markets
Basis
indicates
the
difference
between
the
spot
price
and
futures
price
of
an
asset
Basis
risk
results
from
uncertainties
related
to
the
change
in
basis
.
Spot
price
of
an
underlying
asset
may
not
always
keep
the
same
price
relationship
to
futures
contracts
for
the
asset
88
20

21. 3/26/2024
Futures
Contracts
Risks
in
the
Futures
Markets
A
share
portfolio
manager
may
sell
an
index
futures
contracts
to
hedge
his
portfolio
against
a
slide
in
the
share
market
lf
the
share
market
moves
downwards,
the
decrease
in
portfolio
value
would
be
offset
by
gains
in
the
futures
market
However,
if
the
fall
in
share
prices
in
the
spot
market
is
greaterthan
the
fall
in
price
of
index
futures,
the
decrease
in
portfolio
value
would
not
be
completely
matched
by
the
gains
in
the
future
market
81
Futures
Contracts
Risks
in
the
Futures
Markets
Financial
institution
with
long-term
assets
(mortgages)
and
short-
term
liabilities
Hedge
using
ten-year
government
bonds
Mortgage
rates
and
the
government
bond
yields
may
not
always
move
together
.
The
spread
between
these
rates
may
change
82
Futures
Contracts
Risks
in
the
Futures
Markets
The
corporation
might
find
that
due
to
increase
in
perceived
risk
by
lenders,
its
cost
of
borrowing
is
1.5
percent
rather
than
1
percent
above
the
risk-free
rate
after
one
year
However,
the
change
in
government
bond
futures
price
would
not
reflect
this
increased
riskiness
of
the
corporation
Therefore,
a
futures
hedge
would
only
partly
offset
its
increase
in
interest
costs
a?
Futures
Contracts
Margin
Risk
An
individual
with
illiquid
assets
can
also
encounter
difficulty
by
hedging
in
the
futures
markets
if
the
futures
price
moves
adversely
and
the
individual
must
constantly
post
more
maintenance
margin
fu
nds
This
could
cause
a
cash
shortage,
which
might
force
him
to
liquidate
his
futures
contracts
at
a
loss
before
the
illiquid
asset
matured
Forward
contracts
are
sometimes
preferred
to
futures
contracts
because
there
are
no
margin
requirements
84
2L

22. 3/26/2024
Futures
Contracts
Hedging
with
futures
reduces
the
losses
if
prices
move
adversely
It
also
eliminates
potential
gains
if
prices
move
favourably
85
OptionsAn
option
gives
the
holder
the
right
but
not
the
obligation
to
buy
or
sell
an
asset
Therefore,
options
allow
holders
to
enter
into
contracts
to
buy
or
sell
shares,
commodities,
or
other
securities
at
a
predetermined
price,
called
the
strike
or
exercise
price,
until
some
future
time
86
Optionsln
afutures
contracts
both
the
buyer
and
the
seller
have
obligations
Options:An
option
buyer
has
a
right
but
not
an
obligation
The
option
seller
or
writer
has
an
obligation,
if
the
other
party
exercises
the
option
The
price
that
an
option
buyer
pays
the
option
seller
is
called
the
option
premium
OptionsThere
are
two
types
of
options:
calls
and
puts
Call
options
give
the
buyerthe
right
to
buy
a
security
orfutures
contract
at
the
strike
price
The
writer
of
a
call
agrees
to
sellthe
security
(orfutures
contract)
at
the
strike
price
if
the
buyer
exercises
the
option
.QR
22

23. 3126/2024
Options
asset
at
maturity,
5i
Shcrt
Pcsitian
89
OptionsAn
option
provides
the
buyer
with
a
choice
lf
price
movements
are
advantageous,
the
option
buyer
exercises
the
option
and
realises
a
gain
lf
price
movements
are
adverse,
the
buyer
can
limit
potential
losses
by
letting
the
option
expire
unexercised
The
option
premium
is
the
price
of
this
insurance
1U
*Pot1on1.,
There
are
two
types
of
options:
calls
and
puts
Put
options
give
the
option
buyerthe
right
to
sella
security
or
futures
contract
at
the
strike
price
The
writer
of
a
put
agrees
to
buy
the
security
(orfutures
contract)
for
the
strike
price
if
the
buyer
exercises
the
option
v1
Long
Position
Price
of
Underlying
at
Maturit/,.Sh*t"t
Pmsiticn
Price
of
Underlying
at
Maturity,
57.
97
23

24. 3/26/2024
OptionsAmerican
option:
Option
can
be
exercised
at
any
time
before
and
including
the
expiry
date
European
option:
Option
can
be
exercised
only
on
the
expiry
date
93
OptionsOption
premiums
are
influenced
by
the
difference
between
the
strike
prices
and
the
current
and
expected
market
prices
for
the
underlying
assets
Premiums
decrease
on
call
options
as
the
strike
prices
rise
.
Payoff
from
a
call
option
=
max(Sr
-
1(,0)
Premiums
rise
or
fall
according
to
the
demand
and
supply
for
a
particular
option
94
OptionsAn
investor
buys
a
call
option
on
1,000
ABC
Ltd
shares
at
54
with
a
strike
price
of
S44
and
a
six-month
expiry
(delivery)
When
the
price
in
the
physical
market
goes
to
556,
she
decides
to
exercise
the
option
to
buy
and
then
sell
the
shares
What
is
the
financial
result?
95
OptionsThe
total
cost
of
the
premium
($
)
plus
the
shares
(S++)
is
S48rt,ooo=$48,ooo
lgnoring
transaction
costs,
the
shares
sell
for
$56x1,ooo=$56,ooo
The
profit
is
58,000
24

25. OptionsAn
investor
holds
1,000
shares
of
ANZ
Bank
He
buys
a
put
option
to
sellthe
1,000
shares
The
strike
price
is
NZS22
and
the
premium
NZS2
During
the
whole
time
the
option
is
current
(untilthe
date
of
expiry),
the
market
price
of
the
shares
does
not
fall
below
N2524
yh;t'r",iri
lhc
investsr
dc?
97
3126/2024
Options
Underlying
asset
is
USD
i1,r.:..),:r)ii);,rl
:iiii:::1..,,.1:i
:::r)l"iiilrii.-r',
i'rrr:iii11
l;::
'L:'irlii:lilri:
:'ri.
100
Optionslf
he
sells
shares
in
the
market,
he
gains
at
least
NZS24
per
share
lf
he
exercises
the
option,
he
gains
only
NZ$22
per
share
Doing
nothing
costs
her
NZS2
x
1,000
=
$2,000
The
writer,
in
contrast,
earns
the
NZS
2,000
premium
in
return
for
taking
the
risk
that
he
might
have
to
buy
the
shares
on
a
falling
market
98
Optionslf
the
market
price
had
fallen
to
NZS20,
the
buyer
would
have
exercised
the
option
and
the
sellerof
the
option
would
have
had
to
buy
the
shares
at
NZS22
This
NZ52
would
have
cut
out
the
NZ$2,000
gain
made
through
receipt
of
the
premium
3v
25
H'*
'
sftgol'
sPweAT€'
Tr:
tilff
:':.:..
.:
'
tf
t
Strlke
Price:
74.5
)tItKe
rilue:
/+.f,
You
can
buy
1
USD
for
Rs
Expiration
Datei
13-:h
Novgm!er;
2020
.
lf
the
exchange
rate
is
greater
than
74.5?
,
lf
the
exchange
rate
is
less
than
74.5?

26. Options
Strike
Price:
74.25
You
can
sell
1
USD
for
Rs
74.25
Expiration
Date:
13th
November,
2020
,,.
lf
the
exchange
rate
is
greater
than
74.25?
,
,
lf
lhe
exchange
rate
is
teg-sthan74,L5?
CU$iREN'Y
D:RIVAII1JSS
i.,'a.r?ri<rii6rB:r
,.i:i':rri:iall;::ri.rr
i.,i::i:ri!iiirrjiir-r,i
irlix,rili!:lr''::f'l
.j;Jr'j:r:itii,.:iilll:lij
10L
3/2612024
The
price
data
(exercise,
previous,
settlement,
and
change)
for
the
index
option
contracts
are
all
in
index
points
The
value
in
dollars
of
the
change
ls
computed
at
amount
per
point
L04
Options
.
..
:
tt)
j
,
t.:
Current
Stock
Price:
Rs
2,025.15
Strike
Price:
Rs
2,100
You
can
buy
Reliance
stock
for
Rs
2,100
llpl
l3,iol
-D.te
:
.26th-N.ov-e
T
!_e1
z!
zo
lf
the
stock
price
increases
to
Rs
2300?
lf
the
stock
price
falls
to
Rs
1900?
102
,
Current
Stock
Price:
Rs
2,025.15
Strike
Price:
Rs
1,900
You
can
buy
Reliance
stock
for
Rs
2,100
Expiration
Date:
26th
November,
2020
lfthe
stock
price
increases
to
Rs
2,300?
lf
the
stock
price
falls
to
Rs
1,800?
26
ffil
sw@*
awilE
flw
mE
:m"mH
sjril*ot
.:
aHftorlE*
rwE
lffiET*"a
-
sYmor
.
{xPrRY
HTt
;
rFE
:i
L
t
Options
rc

27. 3/26/2024
OptionsFutures
options
exercise
into
a
futures
position
For
example,
when
a
call
option
is
exercised
on
the
index
futures
contract,
the
holder
buys
a
futures
contract
at
the
exercise
price
L05
OptionsPotential
gains
and
losses
are
quite
different
for
buyers
and
writers
of
puts
and
calls
147
OptionsFor
instance,
if
the
futures
contract
is
trading
at
4,400
when
the
owner
of
a
4,200
call
exercises
the
option
lf
the
futures
are
based
on
525
per
index
point,
he
will
make
an
immediate
gain
of
55,000
(200
times
$25
per
point
gained)
if
the
index
futures
is
sold
at
a
price
of
4,4O0
t_06
OptionsConsider
a
call
option
on
a
security
with
a
strike
price
of
S40
and
a
premium
of
55
if
the
option
is
exercised
on
expiry
day
The
call
buyer's
potential
gain
is
unlimited
and
the
writer's
potential
loss
is
unlimited
if
the
security
price
rises
Meanwhile
if
the
security
price
falls,
the
buyer's
maximurn
loss
is
limited
to
the
premium
paid
for
the
option
108
27

28. 3/26/2024
Options
Short
position
(writer)
5b
-*--
Long
position
(holder)
109
Options
5hort
position
lwriter)
K=540
lai
OptionsPut
options
are
similar
except
that
the
put
buyer
gains
when
the
security
prlce
declines
and
the
put
buyer
loses
the
amount
of
the
premium
if
the
security
price
rises
110
28
Optionsln
contrast
with
options,
buyers
and
sellers
of
futures
gain
and
lose
symmetrically
and
without
limits
as
futures
prices
vary
However
there
are
transaction
costs
to
be
considered
Futures,
however,
have
no
premium
and
provide
symmetric
gains
and
losses
150a1C0!
-100i-150!
hart
p:osition
1.12

29. 3/2612024
Optionsln
all
of
these
examples,
the
gain
to
the
buyer
of
an
option
or
future
equals
a
loss
to
the
seller
(orwriter)
of
the
contract,
and
vice
versa
*9-"p_tsm_._
Value
of
Options
The
option
premium
varies
positively
with
(1)the
price
variance
of
the
underlying
commodity
or
security
(2)the
time
to
the
option's
expiry
(3)the
level
of
interest
rates
(4)
lncome
earned,
storage
costs
L1.4
jlplionS
The
more
price
variability
a
share
has,
the
greaterthe
chance
that
the
buyer
can
exercise
the
option
for
a
larger
profit
.
Buyer
will
not
exercise
the
option
and
take
a
loss
Options
have
greater
value,
the
longer
they
have
to
expiry
.
Given
more
time,
bigger
cumulative
price
changes
can
be
expected
115
OptionsCall
options
have
a
higher
value
when
interest
rates
are
high
Because
the
purchase
of
an
option
allows
the
buyer
to
conserve
capital
untilthe
option
is
actually
exercised
and
the
underlying
share
or
commodity
is
purchased
lf
a
buyer
purchases
a
call
option
instead
of
a
share
lnvests
the
money
saved
Still
benefits
from
the
price
appreciation
of
the
share
but
earns
more
on
the
invested
funds
when
interest
rates
are
high
116
29

30. 3/26/2024
A
call
on
a
share
will
be
more
valuable
when
its
strike
price
is
lower
relative
to
the
share's
value
Conversely,
a
put
option
will
be
more
valuable
when
its
exercise
price
is
higher
relative
to
the
share's
value
L17
OptionsCall
options
lose
value
(and
put
options
will
gain
value)
when
a
company
distributes
some
of
its
assets
as
dividends
to
shareholders
and
so
reduces
its
share's
price
_t
16
OptionsThe
value
of
an
option
changes
over
time
Consider
a
call
option
with
a
share
price
of
100
Just
before
expiry,
the
value
of
a
call
is
equalto
its
intrinsic
value
max(S7
-
K,0)
This
is
the
value
that
could
be
realised
by
exercising
the
option
immediately
119
OptionsHowever,
before
expiry,
an
option
will
have
time
value,
which
is
usually
positive
before
expiry
Even
if
the
option
has
an
intrinsic
value
of
zero
as
long
as
the
underlying
asset
is
sufficiently
volatile
and
there
is
enough
time
left
until
expiry,
the
option
will
have
a
chance
of
becoming
valuable
before
it
expires
The
time
value
of
an
option
reflects
this
chance
124
30

31. 3/7612024
O
ptions
The
chances
that
an
option
will
become
valuable
before
expiry
are
greater
the
longer
the
time
to
expiry
The
option
value
will
be
higher
if
there
is
a
longer
time
to
expiry
or
the
asset
prices
are
more
volatile
Conversely,
because
there
is
less
chance
that
the
option
can
still
become
valuable
as
expiry
approaches,
the
option
value
will
experience
'time
decay'
and
lose
value
as
expiry
approaches
When
the
option
is
due
to
expire,
it
will
retain
only
its
intrinsic
value
OptionsOptions
have
a
time
premium
that
exceeds
their
intrinsic
value
by
a
greater
amount
as
the
volatility
of
the
underlying
security
or
the
time
to
expiry
increases
As
an
option
approaches
expiry
its
value
will
experlence
time
decay
until
it
is
worth
only
its
intrinsic
value
122
Options
,.1a:.
/
-*,.G-*E
!".--F...*.-,"-.^-
"*/*
K=S4o
sr
Intrinsic
value
=
max(St
-
K,0)
123
9lli-o*'_**
""
.
Call
Option
premium
(*.e
nil'<
1.L..*,-
Udue
</
K=Sa0
Intrinsic
value
=
max(St
-K,0)
114
31
Payoff

32. Optlons
versus
Futures
The
gains
and
losses
to
buyers
and
sellers
of
futures
contracts
are
quite
different
from
those
for
buyers
and
sellers
of
option
contracts
For
futures,
both
gains
and
losses
can
vary
virtually
without
limit
Options
give
a
price
protection
as
well
as
upside
potential
that
is
not
available
from
futures
.
Howeve4
the
premiums
on
options
may
be
high,
and
options
experience
time
decay
.
The
potential
buyer
of
the
protection
must
decide
whether
the
insurance
value
promised
by
the
option
is
worth
its
price
125
Swap
Contracts
ln
a
swap
contract,
two
parties
agree
to
exchange
payment
obligations
on
two
underlying
financial
liabilities
that
are
equal
in
notional
principal
amount
but
differ
in
payment
patterns
The
principal
amount
is
notional
(or
fictional)
in
that
it
is
never
actually
transferred
between
counterparties,
it
serves
only
as
the
basis
for
calculating
the
swapped
interest
payments
126
3/26/2024
Swap
Contracts
Swaps
principally
involve
interest
rate
and
foreign
exchange
contracts
128
32
Swap
Contracts
For
instance,
one
party
may
pay
a
9
percent
fixed-interest
rate
on
the
notional
principal
while
the
other
may
pay
2
percent
more
than
the
benchmark
rate,
which
would
be
8
percent
if
the
benchmark
rate
is
6
percent
127

33. Swap
Contracts
Suppose
a
financial
institution
specialises
in
housing
loans
It
is
able
to
attract
relatively
short-term
deposits
at
relatively
low
interest
rates
lf
interest
rates
rise,
its
revenues
will
be
stable
(because
of
fixed-rate
mortgages)
but
its
liabilities
will
increase
=
lt
is
exposed
to
interest
rate
risk
(
Liabi
lities:
Short-te
rm,
Assets:
Long-te
rm
)
179
312612024
Swap
Contracts
This
institution
can
benefit
from
swap
contract
Particularly
if
it
can
find
a
counterparty
with
opposite
interest
rate
risk
concerns
130
lm,gcgltlact:
Consider
a
commercial
bank
that
raised
55
million
by
issuing
10-year
bonds
paying
7
percent
interest
Suppose
it
invests
SS
million
in
short-term
assets
lf
market
rates
fell,
it
would
earn
lower
rates
on
its
short-term
assets
.
lt
might
not
be
able
to
pay
the
fixed
rate
of
interest
it
had
agreed
to
pay
to
its
bondholders
for
the
next
ten
years
=r
lt
is
exposed
to
interest
rate
risk
(
Lia
bi
lities
:
Long-term,
Assets
:
Short-term)
131
Swap
Contracts
lnterest
rate
risk
Housing
Finance:
Liabilities:
Short-term(t),
Assets:
Long-term
Commercial
Bank:
Liabilities:
Long-term,
Assets:
Short-term
(J)
The
se
two
financial
institutions
can
e
nter
into
a
siuap
contract
Decide
on
the
n*tior'rai
arnoilnt
and
exchange
interest
paynrents
132
33

34. 3/26/2024
Swap
Contracts
Suppose
commercial
bank
(AA
Ltd)
has
better
credit
rating
than
housing
finance
company
(BB
Ltd)
AA
has
borrowed
$S
milllon
at
a
fixed
interest
rate
of
7
percent
.
AA
could
have
borrowed
atthe
variable
rate
of
(benchmark
rate
plus
0.1
percent)
BB
has
borrowed
$S
milllon
at
a
variable
rate
of
(benchmark
rate
plus
1.7
percent)
.
BB
could
have
borrowed
a
fixed
interest
rate
at
9
percent
-t5
5
Swap
Contracts
Firm
AA
Firm
BB
Fixed
7
per
cent
iBorrawed
at
fixed
ratei
9
per
cent
Floating
Benchmark
+
0.1
per
cent
Benchnrark
+
1.7
per
cent
{Borrowed
at
variable
rate}
134
Swap
Contracts
Suppose
the
two
firms
want
to
change
their
interest
rate
obligations
AA
has
subsequently
decided
it
would
rather
have
floating-rate
obligatlons
because
of
the
expected
fall
in
interest
rates
BB
has
decided
it
would
rather
have
fixed
rate
obligations
to
ensure
ce
rta
i
nty
C;n
the
sr
iws
cornpanirs
e
ach
inrprsvs
lhrir
posilians
I
Yes
l-J5
Swap
Contracts
The
interest
rates
quoted
by
the
two
markets
(fixed-rate
and
floating
rate)
are
different
AA
has
an
absolute
advantage
over
BB
as
it
hasthe
bettercredit
ratingAA
can
borrow
at
a
.
Fixed-rate
which
is
2
percent
cheaper
than
BB
.
Floating-rate
which
is
1.6
percent
cheaper
than
BB
_t-.f
o
34

35. 3/26/2024
Swap
Contracts
Swaps
are
commonly
used
when
there
is
difference
in
the
risk
perception
between
the
two
markets
.
Different
risk
premiums
for
fixed-rate
and
floating-rate
loans
(2
versus
1.6
percent)
.
This
is
the
basis
for
the
gains
that
each
firm
can
make
by
designing
a
swap
contract
Firm
AA
Firm
BB
Difference
Fixed
7
per
cent
9
per
cent
2
Floating
Benchmark
+
0.1
per
cent
Benchmark
+
3..7
per
cent
1,.60.4
13t
Swap
Contracts
Each
of
them
will
be
able
to
use
funds
0.2
per
cent
cheaply
than
otherwise
(if
the
benefit
is
shared
equally
by
AA
and
BB)
AA
will
be
able
to
transform
its
liabilities
from
fixed-rate
to
floating
rateBB
will
be
able
to
transform
its
liabilities
from
floating
rate
to
fixed-
rate
_L36
Swap
Contracts
The
difference
between
the
fixed-rate
differential
(2
percent)
and
the
floating
rate
differential
(1.6
percent)
is
0.4
percent
This
margin
may
be
shared
(suppose
equally)
by
AA
and
BB
.
Each
of
them
will
be
able
to
use
funds
0.2
per
cent
cheaply
than
otherwise
Firm
AA
Firm
BB
Difference
Fixed
9
per
cent
2
Floati
ng
Benchmark
+
0.1
per
cent
Benchmark
+.
X.7
per
cent
t.60.4
_r
5v
jyqP.9sntracts
Suppose
AA
has
borrowed
at
the
fixed
rate
and
BB
has
borrowed
at
the
variable
rate
Firm
AA
Firm
BB
Difference
Fixed
/
uei
Let
i!
9
per
cent
2
Floating
Benchmark
+
0.1
per
cent
Senchmark
+
1.7
per
cent
1.60.4
Firm
AA
Firm
BB
Flxed
7
per
cent
I
-
0.2
=
S"E
per
cent
Floating
(Berrchmark+$.n)-0.2
=
{Benchmark
-
0.X.}
per
cent
Benchmark
+
1.7
per
cent
MA
35

36. 3/2612024
Swap
Contracts
Firm
AA
Firm
BB
Fixed
7
per
cent
S
*
CI.?
=
S.8
per
ce
nt
Floating
(Senchrnark+CI.1)
-CI.2
=
{Benc}rrnark
*
0.1}
per
cent
Benchmark
+
1.7
per
cent
Firm
AA
Pays
lo
Bank
(-)
7
per
cent
Receives
from
BB
Pays
to
BB
Net
borrowing
cost
-
{*enchmerk
*
0.1}
L43-
Swap
Contracts
Firm
AA
Firm
BB
Fixed
7
per
cent
I
*
S.2
=
S.8
per
cent
Floating
{Benchmark+S.1}-S.2
=
{Benchmark
*
0.L}
per
cent
Benchmark
+
1.7
per
cent
Firm
AA
Pays
to
Bank
(-)
7
per
cent
Receives
from
BB
Pays
to
BB
,-
-:j.t
.:
:::_ri.r
r1
Net
borrowing
cost
-
{Senchmark
*
S"1}
1.42
jm"p,Sgntracts
Firm
AA
Firm
BB
Fixed
7
per
cent
I
*
S.2
*
S.$
per
ce
nt
Floating
i$enchrnark+CI.1)-0.I
.
{B*nehmark
*
$"1}
per
cent
Benchmark
+
1.7
per
cent
Firm
AA
Pays
to
Bank
(-)
7
per
cent
Receives
from
BB
{+}
?"n
Pays
to
BB
{-}
Se*chmark
Net
borrowing
cost
-
(Senchmark
*
0.1)
143
_lm,pjgntracts
Firm
AA
Firm
BB
Fixed
7
per
cent
$
*
0.2
*
8.8
per
cent
Floati
ng
{&enc}rmark+0.1}
*0.2
=
{Senclsmark
*
$"tr}
per
cent
Benchmark
+
1.7
per
cent
Firm
AA
Firm
BB
Pays
to
Bank
(-)
7
per
cent
(-)
Benchmark
+
1.7
Receives
from
BB
(AA)
(+)7.1
{+}
Benchmark
Pays
to
BB
(AA)
(-)
Benchmark
{-}
?.1
Net
borrowing
cost
-
{Senc}":mank
*
0.1}
-
{s.8}
1.44
36

37. Swap
Contracts
The
risks
involved
in
a
swap
are
low
for
both
the
parties
Only
the
net
difference
in
interest
payments
is
exchanged
lf
one
party
defaults,
the
potential
loss
is
just
a
small
rate
difference
(principal
amount
is
notional)
145
3126/2024
Swap
Contracts
Commercial
banks
and
investment
banks
play
a
major
role
as
swap
dealers
(serving
as
a
counterparty)
They
charge
fees
for
designing
this
swap
contract
146
Swap
Contracts
Swap
markets
are
subject
to
regulation
There
is
no
central
clearinghouse
for
swaps
in
lndia
but
RBI
has
a
regulatory
role
Regulators
are
concerned
with
the
risks
banks
take,
when
acting
as
counterparties
to
a
swap
141
The
2007-2009
Financial
Crisis
Derivatives
partly
contrlbuted
to
the
2OO7-2009
financlal
crisis
ln
view
of
this,
regulators
were
keen
to
make
changes
which
would
offer
better
protection
for
all
concerned
parties
by
preventing
excessive
speculation
or
market
manipulation
148
37

38. 3/26/2024
Derivatives
Market
in
lndia
Derivatives
markets
in
lndia
have
been
in
existence
fora
long
period
of
time
The
Bombay
Cotton
Trade
Association
started
futures
trading
in
1875
ln
1952,
the
Government
of
India
banned
cash
settlement
and
options
trading
Financial
derivatives
trading
was
reintroduced
in
lndia
with
the
implementation
of
Securities
Laws
(Amendment)
Ordinance,
1995
It
was
only
in
2000,
that
the
ban
was
lifted
and
trading
in
derivatives
was
permitted
1.49
Derivatives
Market
in
lndia
Derivatives
trading
commenced
in
lndia
in
June
2000
.
SEBI
permitted
derivatives
trading
on
two
major
stock
exchanges,
NSE
and
BSE
lnitially,
SEBI
approved
trading
in
index
futures
contracts
based
on
various
stock
market
indices
such
as
Nifty
and
Sensex
Subsequently,
more
types
of
derivatives
were
allowed
to
trade
on
these
exchanges
(and
new
ones)
1qn
Derivatives
Market
in
India
Different
derivative
instruments
are
permitted
and
regulated
by
various
regulators
like
the
Reserve
Bank
of
lndia
(RBl),
Securities
and
Exchange
Board
of
lndia
(SEBI),
and
Forward
Markets
Commission
(FMC)Broadly,
RBI
is
empowered
to
regulate
the
interest
rate
derivatives,
foreign
currency
derivatives
and
credit
derivatives
The
derivative
exchanges
are
monitored
and
regulated
by
the
Securities
and
Exchange
Board
of
lndia
(SEBI)
151
Derivatives
Market
in
lndia
The
Forward
Markets
Commission
(FMC)
regulated
the
exchange
traded
commodity
derivatives
market
but
now
it
has
merged
with
SEBIThe
exchange
traded
foreign
currency
and
interest
rate
futures
are
jointly
regulated
by
the
RBI
and
SEBI
The
foreign
currency,
interest
rate,
and
credit
derivatives
traded
in
over
the
counter
(OTC)
market
are
under
RBI's
jurisdiction
1.52
38

39. 3126/2024
Derivatives
Market
in
lndia
ln
2020,
NSE
was
the
world's
Iargest
derivatives
exchange
based
on
the
number
of
contracts
traded
NSE
ranked
first
in
2020
among
the
global
equity
derivatives
exchanges
in
terms
of
total
volume
traded
NSE
and
BSE
were
ranked
6th
and
17th,
respectively
amongst
the
top
exchanges
in
terms
of
volume
traded
in
single
stock
futures
and
options
153
Derivatives
Market
in
lndia
Crude
and
natural
gas
futures
contracts
traded
at
Multi
Commodity
Exchange
of
lndia
Limited
(MCX)were
ranked
12th
and
14th
respectively
in
the
global
energy
contracts
by
volume
MCX
was
ranked
Tthand
10th
globally
in
terms
of
contracts
traded
in
commodity
futures
and
commodity
options,
respectively
154
Derivatives
Market
in
lndia
il'.rlir:,l..ll|
lirnris
in
tle
Cqrrtrrv
l)rr!rati!,cs
idilsqt
155
Derivatives
Market
in
lndia
1.:;,ir
..
l.:
l::
::;i.
.::
..
I
-r.i,
ii,ri
r
ilill;.
!:,:
''
.
i
\i
i,
:::.1
i'il.
156
39
B .
i|l
l1![:
rt
)
\5t.
-i.
i
]irt,rl
ldL)
il
5rl:.:,r.rlir,,ii
J:r.liri,r,r','
2{}19-:0
:0lr!21
:01r-lr}
20:0-:t
l0lq"lu
!n:0-:1
lis!:
9.j.il
r,ir
j
ir&
5
!.1:
i
il.ll.irr.l
:1o
ii,r
sil
r,.t
Ll.r
ii..t?j
t,.r
1n:
ii..it'r
|r.i.
ntl
Nin
i!..,i.]
t:..'',::,
&i:.i,I
llj
1.,:i.lti,i:-(
::)."'it
-li
i'r.ii
Iotal
:!,911
:1.99.1
l,{'3.r2.qe!
f.i3,:b.l.1i'
rii.6l(r
s'.:ri
Far({rit$c
lhi(
'li)
:r
;i'
:
lq
i
il.a.'
il..l
r1.i3
h".
i
i!.,,
a.'r.n
100.r.r
lri0.0
lfir.d
C)l'r'n
lrrhrro:i
ll
thc
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oi
Ycar
il
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tt
1r.1.0
I.,..,-
I(r
..
i
i
tr

40. 3/2612024
Su
m
mary
Forward
and
Future
Contracts
Two
parties
agree
to
exchange
specified
amounts
of
an
asset
for
predetermined
prices
at
predetermined
prices
in
time
in
the
future
.
To
insulate
themselves
against
changes
in
interest
rates
and
asset
prices
Forward
and
futures
contracts
differ
in
several
ways
.
Futures
contracts
trade
on
an
organised
exchange
while
forward
contracts
trade
in
the
informal
OTC
market
.
Futures
contracts
are
standardised
in
quantities,
delivery
periods,
and
grades
of
deliverable
items,
whereas
forward
market
contracts
are
not
-Lf
/
SummaryFinancial
futures
can
be
used
to
Reduce
the
systematic
risk
of
share
portfolios
Make
profits
through
index
arbitrage
Guarantee
future
returns
or
costs
Hedge
balance
sheet
of
financial
institutions
158
SummaryRisks
involved
in
futures
contracts
Basis
risk:The
value
of
an
item
being
hedged
may
not
always
keep
the
same
price
relationship
to
contracts
purchased
or
sold
in
the
futures
ma
rkets
Hedges
can
also
fail
because
of
a
defect
in
the
contract
being
hedged
lf
the
futures
price
moves
adversely,
the
indlvidual
must
constantly
post
more
maintenance
margin
funds
-
liquidity
concerns
159
SummaryAn
option
contract
grants
the
option
buyer
the
right
(but
not
the
obligation)
to
buy
(call)
or
sell
(put)
underlying
assets
at
a
specified
price
for
a
specific
period
of
time
.
lf
price
movements
are
advantageous,
the
buyer
exercises
the
option
and
realises
a
gain
.
lf
price
move
is
adverse,
the
buyer
can
limit
potential
losses
by
lettingthe
option
expire
unexercised
and
lose
the
premium
paid
to
buy
the
option
.
Therefore,
options
can
provide
their
buyers
with
insurance
against
adverse
price
movements
-
Option
premium
is
the
price
of
this
insurance
Options:
Share
indices,
individual
shares,
futures
contracts
Options
can
be
American
or
European
lbu
40

41. 3/26/2024
SummarySwap
contracts
-
How
they
can
be
used
to
reduce
interest
rate
risk
lnvolve
interest
rate
and
forelgn
exchange
contracts
Two
parties
agree
to
exchange
payment
obligations
on
two
underlying
financial
liabilities
that
are
equal
in
principal
amount
but
differ
in
payment
patterns
A
swap
works
because
the
market
has
misaligned
the
risk
ratings
of
the
parties
in
two
markets
16L
4t