MMS-Derivatives-Risk-Managememt-munotes

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1 1
INTRODUCTION TO DERIV ATIVES
Unit Structure
1.1 Introduction
1.2 Managing Risk
1.3 Types of Business Risk
1.4 Participants in Derivatives Markets
1.5 Functions of Derivatives Markets
1.1 INTRODUCTION
INTRODUCTION OF RISK MANAGEMENT:
Risk is inherent in all the activities we perform in our day today life and
all of us remain concerned about it. Risk can be defined as a deviation of
the actual research from the expected. We all would like to eliminate this
risk altogether and to live in a world of unce rtainty. However complete
elimination of risk is impossible but certain steps can be taken to mitigate
raised to consider a considerable extent. Example when we buy an
insurance policy against the theft in the house or for a vehicle version or
attempting t o minimize the potential loss that we may incur upon theft.
The magnitude of risk is normally estimated from the following two
factors : (1) the probability of an adverse event happening; (2) guess the
event occurs the magnitude of the lost it can cause.
The measures mitigate risks are determined by the combined impact of the
probability and magnitude of loss. Therefore, from the perspective of its
management risk can be viewed into two ways, (1) risk of small losses
with high probability (2) risk of high losses with low probability. The first
category of all the changes in the stock prices, commodity prices where
the changes are small but occur frequently. In the second category or
earthquake, tsunami, theft etc. which cause huge losses but probability of
their occurrence is far lower even though the expected loss in the two
categories may be same, the strategies of risk management would differ.
In business enterprises the management of risk is mainly confined to
situations of high probability of small los ses. The management of other
kind of risk of low probability of large losses or more strategic in nature
such as capital budgeting decisions. The tool of handling such risk from
different subject. With derivatives we turn our focus on the management
of the risk that emanate from conduct of normal operation of the business
that is risk of small losses with probability of it being large.
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2 1.2 MANAGING RISK:
There are various ways in which different peoplemanage different kinds of
risk. Insurance policy is a classic example of managing risk with which
we all are familiar. One possible way to avoid risk is not to undertake an
activity at all. There are people who abstain from air travel because they
see to great risk with such a mode of transport. Likewise cer tain people do
not invest in equity market due to risk associated with the stock market
and prefer to invest in safer avenues. While certain activities can be
avoided purely on the ground of high race and one can still live without it
like not investing in the equity market. It may not be possible to abstain
from mandatory activities. Not to enter into business at all to avoid
business risk is not a solution to the problem. Instead, it is a problem in
itself. One has to find out better avenues to manage ris k rather than
avoidance of activity together. Another possible way to manage risk is to
control potential damage. Once we decide to own a vehicle for personal
use we observe speed control and traffic rules to avoid damage to life and
property. As another m ajor of managing risk, we can buy an accident
insurance policy. Similarly, firms can protect against losses by buying a
suitable loss of profit insurance. Yet another way of managing this is to
defuse the risk across source of risk many call centres prefer to have multi
location operation to protect against natural disasters. We all are too
familiar risk diversification through portfolio management investor prefers
to have investment in many alternative securities to protect themselves
against fall in expec ted return from single investment the risk of failure of
many investments simultaneously is far less than the risk of failing of
single investment. Likewise firm do not have single supplier or single
customer to manage business. They prefer to have many su ppliers or
customers as all of the suppliers do not fail to deliver at the same point of
time or all customers cannot be weaned away by competitors. One can
manage this by transferring it to another party who is willing to assume
risk. Insurance companies do not do anything to content that is per say but
assume risk on your behalf. They have no means of controlling theft,
flood, earthquake, riots etc. but offer insurance against this risk. It is a
business of the insurance company to assume such a risk as i t earns an
income. Similarly, there are people who are willing to assume risk of other
kind for consideration. Are used as such does not and cannot vanish but
get transferred from one who wants to avoid it and one who is willing to
accept the risk upon exc hange of consideration.
Here we shall discuss the various kinds of risk that a business enterprise is
likely to face and the ways of managing the same. Their existence wide
array of financial instruments and financial market that enable business
enterpris e is content this inherent in their day -to-day operations. We
concentrate here on risk that have high probability of small losses and
ignore other kind of risk. Non -financial risk such as financial loss due to
certain key employee leaving an organisation, failure of research and
development department to develop a product, breakdown of production
machine, losses due to vagaries of nature, are not in the scope of
discussion. Though there could be some mechanism to control or mitigate munotes.in

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3 such risks, there does not exist a free market where the instruments
providing protection can be freely treaded amongst participants.
1.3 TYPES OF BUSINESS RISK:
(1) Price Risk: all market be it of commodity, stock or material or dynamic.
The forces of demand and supply very contin uously though striving for
equilibrium the prices are never stable. The price of commodities, share
industrial products are subject to continuous change this change in price causes
the profit of business enterprise to change which is cause of anxiety for m anagers
of the firm. The the investors also face the same situation when they invest in
financial securities, the prices of which vary causing uncertainty of returns. The
risk of change in price can be mitigated or kept within the acceptable limits with
the help of financial instruments specifically device for the purpose.

(2) Exchange Rate Risk: Exchange rate risk derived from the transaction
denominated in foreign currency where a firm or an individual faces uncertainty
regarding the exchange rate at which f oreign currency will be converted in the
domestic currency or vice versa. As an example let us consider a firm selling
goods on credit and realizing the sale proceeds in a foreign currency. Even
though the price in foreign currency is frozen, the firm face s and uncertainty
regarding the amount that will be realized in domestic currency depending upon
the rate prevailing at the time of realization of sales and its conversion to
domestic currency. Likewise an importer having to pay in foreign currency at a
later date would be uncertain about the actual amount to be paid in domestic
currency. The risk of variation in exchange rate or manage through specific
financial instruments such as futures, options and swap on foreign currency.

(3) Interest Rate Risk: like th e changes in the prices and exchange rate the
interest rate to keep changing depending upon various macro -economic factors
both national and international all forms that need capital, resort to borrowing
while those surpluses invest their funds. Both the b orrowers and lenders face the
risk of changes in the interest rate subsequent to the transaction. These risk can
be hedged through tailor made or standard financial products.
DERIVATIVES:
The three kinds of rules describe in the preceding section can be ma naged
through products that are classified as derivatives. They are best suited to
manage risk of small losses with high probability. Derivatives are
arrangements that derive their values on the basis of some assets called
underlying assets. Derivatives me ans that one that derives its value from
the value of some other assets physical or notional. For example: - an
Indian exporter is expecting to realise $1000 in six months from now, he
had price his product with a profit of Rs.2000 based on the current mark et
price of dollar at 80. The actual money that will be realized by him in an
Indian rupee will depend upon the exchange rate prevailing six months
later, this rate is not known today, exporter expect Rs. 80,000 but may end
up getting Rs. 79,000 if the exc hange rate is Rs.79 six months later or if
fortunate he may realise Rs.81 if exchange rate goes to Rs.81, if the rate
happens to be 79 his profit will stand reduced to half by Rs.1000, though
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4 and hence his profit he can definitely take some measures to reduce the
uncertainty of the exchange rate and consequential profit.
One of the ways he can reduce the uncertainty is to sale Dollar to party
who needs them six months later and negotiat e the exchange rate today, by
doing so he would and assuring himself of differential definite cash flow
and profit, such a contract will be called a forward contract, where the
actual exchange of currency will take place later but a price that is
determine d today. Of course the price at which this foreign contract will
be negotiated will be dependent upon the current price of dollar, known as
spot price. Since the price of the forward contract is the determined or in
other words, derived from the spot price in the foreign currency market
surcharge contract is classified as derivatives. The spot price of foreign
exchange on basis of which forward contract price will be is called
underlying asset, beside the price of underlying asset there will be other
factor s that will influence the price of the forward contract. In the case of
foreign -exchange forward contract the other factors influencing the price
would be interest rate of the currencies involved in the transaction.
Similarly, a forward contract can be neg otiated for any commodity subject
to legal constraint and feasibility.
DERIVATIVES PRODUCTS:
There is a wide meaning of instruments available as derivatives, each of
the instruments is different in some respects or other, conceptually,
operationally or i n its uses. The derivative products are continuously in
evolving and can be categorized in various ways: -
(1) FORWARDS are contracts where the buyer and seller agree to exchange
the asset and its price at future date, at a price fixed in advance.

(2) FUTURES are similar to forward contracts in terms of their pricing and
conception, but or operational different from forward in terms of other
features. It is also forward contract to be settled at future date. The shortest
definition of future is that it is an exchan ge traded forward contract. The
feature of future contracts are standardised in terms of quality, delivery
dates, delivery venue, quality of the product etc. Unlike forward contracts
which facilitate exchange -based trading.

(3) OPTIONS are contracts for delive ry in future like forwards and futures,
except that one of the two parties involved holds an option whether to
enforce the contract or not while the other party is of obligated to perform at
the option of the first party. Option is the right without an obl igation to buy
or sale an asset at predetermined price with a specified time interval.

(4) SWAPS are arrangements between 2 parties to exchange a set of cash flows
according to a predetermined method. For example, one party may pay a
fixed rate of interest in exchange of receiving a variable rate of interest on a
notional principal amount for specified intervals of time.


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5 Based on the underlying assets the derivative s can be classified as follows
(1) Commodities
(2) Currencies
(3) Interest rates
(4) Equity shares
(5) Indices
(6) Credit
(7) Weather
Yet another classification of derivatives can be based on the way they are
traded, derivatives can further be grouped according to the market the year
deal in :
(1) Over The Counter (OTC) Products: where the contract is directly entered
between two mutually parties with the matching needs that are known to each
other are called over the counter products. These contracts are specific to the
parties involved and or not traded in the market, these contracts are customized to
the requirement of coun terparties and are normally settled by delivery of
underlying acid, though there is a possibility of existing the obligation by
entering into subsequent contract opposite to the first one. Forward contract is an
OTC product that determine the foreign excha nge markets. App is also an OTC
product. If the product gives rise to another risk called counterparty risk
concerned with the failure of one of the parties to the contract to honour the
obligation undertaken. They also suffer with the disadvantages of fin ding
matching parties, skewed pricing as 2 parties are not equally strong and difficult
exit.

(2) Exchange Traded Products: other kind of derivatives namely the exchange
traded products are traded on the organised exchanges where the buyer and seller
did not to know each other, the exchange being the counterparty for both buyer
and seller. They are standard products whose specifications are designed by the
exchange authorities taking into consideration the characteristics of the
underlying assets. Credit deri vatives are free from counterparty risk, the
transaction cost in exchange traded products or transparent and nominal while in
case of OTC product the transaction costs are included in pricing. Investor can
enter and exit from derivatives position very conv eniently as trading take place
continuously. Futures are traded only on exchange while options can be both
exchange traded as well as OTC. Options on stock and in dices are mostly
exchange traded while options on foreign exchange rates are mostly OTC. Swap
remain and OTC product.
1.4 PARTICIPANTS IN DERIVATIVES MARKETS
The participants in the derivatives market can be broadly classified in
three depending upon their motives.
(1) Hedgers: Hedger are those who enter into derivative contract with the
objective of covering risk. Pramod growing wheat faces uncertainty about the
price of this product produced at the time of the harvest similarly a flour mill
needing a bit also faces uncertainty of price of input. Both the farmer and the
flour Mill can enter into forw ard contract where the farmer agrees to sell his
produce when harvested at predetermined price to the flour mill. The farmer
apprehends price fall while the flour mill fears price rise. Put the parties face the
price risk, forward contract would eliminate the price of price for both the munotes.in

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6 parties’ forward contract is entered into with the objective of hedging against the
price risk of being faced by the farmer as well as the flour mill. Participants in
the derivatives markets are called hedgers.

(2) Speculato rs: Speculators are those who enter into a derivatives contract to
make profit by assuming risk. We have independent view of future price
behaviour of the underlying asset and take appropriate position in the derivatives
with the intention of making profit later. For example, the forward price in US
Dollar for contracts maturing in three months is Rs.80, if one believes that three
months later the price of US dollar would be Rs.82, one would buy forward today
and sale later. On the opposite, if one believes US dollar would depreciate to Rs.
78 in 3 months, one would sell now and buy later. Note that the intention is not to
take delivery of underlaying assets, but to make profit from differences in the
currency prices.

(3) Arbitrageurs: The third category of p articipants that is arbitrators,
perform the function of making the prices in different markets coverage and be in
tandem with each other. While hedges and speculators want to eliminate and
assume risk respectively, the arbitrators take risk less position and eight on profit.
They are constantly monitoring the prices of different assets in different markets
and identify opportunities to make profit that emanate from mispricing of
products. For example, if the share price of listed company in NSE is Rs. 200 and
Rs. 202 in BSE, the arbitrageur will buy at NSE and sell at BSE simultaneously
and make the profit of Rs. 2 for the differences in prices.
1.5 FUNCTIONS OF DERIVATIVES MARKETS
(1) Enable Price Discovery: the derivatives and their market increases the
compe titiveness of the market as it encourages more number of participants with
the wearing objectives of hedging, speculation and arbitrating with broad with
broadening of the market the changes in the price of the product or watched by
many who trade on the s lightest of the reason, even a minor variation in price
prompt action on the part of speculators, participation by large number of buyers
and sellers ensures fair prices, the derivatives markets therefore facilitates price
discovery of assets due to increa sed participants, increase volume and increase
sensitivity of participants to react to smallest price change. By increase dipped in
the market, faster and smooth dissemination of information among different
participants the process of discovery of price be comes more efficient.

(2) Facilitate Transfer of Risk: hedges among them self could eliminate risk
if two parties face risk from opposite movement of price. As seen earlier the
weight farmer needing to sell his produce faced a rise from the fall in prices,
while the flour mill needing to buy the weight was worried about the rising price.
Since risk was derivingfrom opposite direction of price moment and the coverage
of the two was possible. If the farmer and the flour mill wanted to hedge against
the price ris e the two would not meet when speculators enter the market they
discharge an important function and help transfer of risk from those wanting to a
limit to those wanting to assume risk.




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7 (3) Provide Leveraging: Taking position in derivatives involves only fract ion
outlay of capital when compared with the opposition in the underlying asset in
the spot market. Assume a speculator is convinced that price of wheat will be
Rs.16 per KG in six months and farmer agrees to sell at Rs.15.50 per KG, to take
advantage the speculator will have to pay the full price of Rs.15.5 per KG now
and realised Rs.16 six months later, instead if a mechanism is available by which
he can absorb himself of making the full payment, he will be to glad to enter into
contract. Derivatives as a product and their market provides search exit route by
letting him first enter into contract and then permitting him to neutralize position
by Booking and opposite contract add later date, this magnifies the profit many
folds with the same resources base, this also helps build volume of trade, further
helping the price discovery process.

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8 2
FORWARDS AND FUTURES CONTRACTS
Unit Structure
2.1 Introduction
2.2 Forward Contracts
2.3 Features of Forward Contracts
2.4 Settlement of Forward Contracts
2.5 Future Contracts
2.6 Specification of a Future Contracts
2.7 Open Interest
2.8 Differe nces between Forward and Future Contracts
2.9 Types of Futures
2.1 INTRODUCTION:
As described earlier derivatives or a contract that derive their value from
the prices of underlying assets. The asset in question is called the
underlying can be commodity s uch as wheat, rice silver etc. or financial
products such as stocks, various currencies or hypothetical asset such as
interest -rate, in dices etc.
Forwards and futures are the most common form of derivatives, these are
contracts that specify price of the acid today but are settled at a later date.
A settlement is referred to as extinguishment of obligation undertaken
while initiating the contract. How to determine the price of an acid today
that is to be delivered at a later date? Naturally this price woul d be depend
upon the Price of the asset that is prevailing today called the spot market
for underlying, hence the forward or future contract derives its price enter
alia from the price of the underlying asset travelling today. The value of
derivative fluct uates with the value of underlying asset the underlying
assets can be commodity, metal, stop, currency, bond, index, treasury
bills, a reference interest -rate or any other real or hypothetical asset.
2.2 FORWARD CONTRACT:
Forward contracts are all pervasiv e, knowingly or unknowingly we all
enter into forward contract. In most cases we all acquire assets and pay the
consideration for the same simultaneously. All transaction of cash or made
on the spot, however in some cases we book purchased in advance and
execute the delivery and its situation at a later point of time. Booking a
movie ticket on phone is one such example. It is the sort of forward munotes.in

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9 contract because we buy the ticket now through there is a no formal
written contract and pay its price only after reaching the cinema hall.
Similarly most auto mobiles are booked in advance and the price is paid
only upon the physical delivery of the vehicle. This is to is like a forward
contract the asset and its purchases consideration is exchange at later date.
A typical forward contract that is normally written an extent for a
considerable time is a rent agreement for house or flat where fixed amount
of rent is determined for a specific period of time usually a year. Every
month the tenant pay a fixed amount of re nt to the landlord that is
determined at the given date. This essence of forward contract lies in the
fixing of the price in advance, while the asset and its consideration in
question or settled at later date.
2.3 FEATURES OF FORWARD CONTRACTS:
1. Two Parti es : Like any contract forward contract involves minimum
two parties, buyer and a seller of an asset. The buyer of the contract is also
referred to as long position while the seller is referred to as having taken a
short position.

2. Over The Counter Produc t: It is an OTC product where all
relevant aspects of contract such as the asset, its quantity and quality and
the price and delivery date are fixed on one to one basis customized to the
needs of the parties involved. The buyer and the seller are in direct touch
with each other.

3. Mutual Obligation to Perform: On due date of the contract the
seller makes the delivery of the acid and the buyer pays the price there is
mutual obligation to perform by both the buyer and the seller. The seller is
committed to ma ke delivery on due date and the buyer is obligated to pay
the consideration.

4. Counterparty Risk: The buyer and seller of the contract assume
risk, referred as counterparty risk on each other. The seller may fail to
deliver the asset and or the buyer may fa il to make the payment on agreed
date. While entering the forward contract both contracting parties or aware
of the possible default by the other party and take adequate precautions to
prevent such default on either side. To mention here that upon maturity of
forward contract only one and not both the parties would be having and
advantageous position. The party in the losing situation is more likely to
make a default.

5. Mutual Consent For Cancellation: Once a forward is booked both
parties or obligated to pe rform however the cancellation can only be done
through mutual consent of both the parties at any time prior to the maturity
of the contract. The feasibility and the terms and conditions of cancellation
to may be decided in advance.

6. No Front -End Payment: Exchange of money is done at the time of
entering the forward contract through either party can insist on initial munotes.in

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10 deposit adjustable against the price and or delivery to mitigate
counterparty risk.
2.4 SETTLEMENT OF FORWARD CONTRACTS:
Settlement refers t o extinguishment of the obligations created under the
forward contract, on the due date of the forward contract that is upon
maturity there are two possible ways of settling the application:
(1) By Delivery of Asset and the Consideration : For example, if an
exporter had sold Euro 10,000 to bank 6 months forward at say Rs. 66 per
euro, then at maturity the contract would be settled by delivery of Euro
10,000 by the exporter to the bank who would pay Rs. 6,60,000/ -

(2) By Entering into an offsetting contract opposi te to the original
contract at maturity or prior at a price prevailing then: For Example,
the exporter having sold 6 months forward euro 10,000 at price Rs. 66 per
euro, may after 3 months, decide to buy 3 -month forward euro 10,000 at
Rs. 67 per euro; of course, this is subject to the acceptance by the bank.
Settlement by delivery is where upon maturity of the contract period the
buyer and seller discharge their mutual obligation. Settlement by
cancellation is done by entering into an offsetting contract opposite to the
date of initial contract. A buyer in the initial contract can sale the assets at
new price P1 at any time prior to maturity or upon maturity to another
party or to the original seller. Similarly the seller in the initial contract can
buy th e asset from any party prior or upon maturity at new price. However
the obligation entered in the first contract state still would have to be
discharge upon maturity, by cancellation the exchange then reduces to the
differential of the prices of the origin al and offsetting contract. Settlement
by cancellation may not be feasible for several reasons, in case a set in
question is not readable, cancellation becomes a most impossible or
delivery may be essential under law. Forward contracts are very common
in foreign exchange markets. Exporters expecting to receive money in
foreign currency cancel it forward while importers can buy foreign
currency forward so as to meet their liability in future. Bank offers
forward contract on various currencies to importers an d exporters.
2.5 FUTURE CONTRACTS
Futures are relatively newer instruments as compare to forwards and
classified as derivatives. Future contract is modified version of a forward
contract but is fundamentally same as forward contract that is promising
settlement on expiry having fixed the price today. However operationally
there are substantial differences in the forward and future contracts.
Counterparty Risk: future contracts came into existence to overcome
some of the problems that exist in the forward co ntract. In a forward
contract there is a very strong inclination for at least one of the parties to
default in fulfilling its commitment towards the party, pending upon the
price in a row of the underlying asset at the time of settlement. One way of munotes.in

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11 elimin ating the counterparty risk is to involve another party to the
transaction. The forward contract is executed on a one -to-one basis and the
two parties assume the counterparty risk. It can be easily visualize that one
default will lead to chain reaction and the whole market may collapse with
one default triggering another. This raised the issue of credibility of parties
involved in the forward contract, unless both the parties are convinced
about each other creditability the forward contact will not fructify . This
will seriously limit the volume of trade in the forward market, as volume
or inadequate the price cannot be said to be driven competitively, as a
solution to the two parties in the forward contract court involved a third
party in the contract that e nsures performance of the contract, however
locating the third -party acceptable to the both the buyer and the seller will
be another task.
The Future Exchange: the issue of counterparty risk can be solved if the
transaction is done on the exchange that se rves as a counterparty to both
the buyer and the seller. Rather than conducting business on one -to-one
basis they do the business on the exchange. Both the buyer and the seller
become liable to the exchange which in turn makes commitment to both,
in case o f default by one party they exchange meet the commitment from
alternative sources. To protect itself the exchange can develop suitable
risk containment measures with the exchange serving as a guarantor to
both the buyer and the seller the contract or assur ed of the performance.
This also eliminate the need for parties to know each other and the
establish creditability before undertaking of forward deal. Call of the
guarantor to ensure a default free execution can be performed by an
organised body that is an exchange. Rather than settling the transaction to
the both the buyer and seller can make their promise good to an exchange.
Standardised Contract / Product: However, if the trades have to take
place on an exchange the product cannot be tailor made to the specific
need of the two parties and instead would have to be standard. Exchange
cannot commit itself to a quantity, quality and timing of the acid as per the
specific requirement of the individual buyer and seller.
2.6 SPECIFICATION OF A FUTURE CONTRACT S:
(1) Underlying Asset: Futures being derivatives or price according to
the asset on which it is written. Contracts are normally specified by the
name of the underlying asset and month and year of the expiry of the
contract for example future contract in rice at Multi Commodity Exchange
note denoted as RICE DEC23 implies that contract is due for delivery in
December 2023

(2) Contract Period: contract period relate to the time when contract
expires. The exchange specifies when the contract for delivery in a
partic ular month will come into force and when will it close for trading for
example the gold contract will open for trading 12 months prior to the
delivery month. The opening date and last date of trading will be specified
by the exchange unlike forward where t he delivery is as per the contract
between the two parties, in future contract the delivery date is fixed by the munotes.in

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12 exchange. This has important implications in terms of period for which
hedging can be done or speculative positions can be taken.

(3) Contract Size :Contract size or trading unit refers to the standard
contract size that will be traded on the exchange each future for gold on
NMCE is for 100 grams.

(4) Price Quotation: Quotation is the basis of the price; it is not the
value of the future contract the pric e quoted for the product is generally
the way prices are quoted in the physical market for example price
quotation for future contracts on a rice is rupees per quintal hence the
quotation of Rs.550 would mean Rs.550 per quintal and the contract value
is Rs .55,000.

(5) Tick Size: Tick size is the minimum change that will be recognized
in the price quotation. For rice contract it is Rs.1, hence a price quotation
of Rs.551.50 is not possible the dick size for the contract will be rupees
hundred (Rs.1 per quintal o ver 10 MT).

(6) Settlement: Forward contracts were either settled by delivery or by
closing out the position at the expiry with opposite contract. The
settlement of the futures allows for squaring up prior to the expiry. Being
exchange traded the consent of t he counterparty is not required. The
settlement of future can also be done by cash settlement at the expiry or by
delivery. The alternative of settlements or again specified by the exchange.
The settlement by delivery can be at option of the seller or at t he option of
the buyer or compulsory.

(7) Delivery Notice Period: Delivery notice period refers to the period
in which for each contract the intention to give or take delivery has to be
notified to provide enough time for counterparty to make arrangements.
2.7 OPEN INTEREST
An important parameter in the future market is the open interest. The
number of contract outstanding at any point of time is called open interest,
as a new contract is introduced the invert investors start taking a view on
the market of un derlying assets and take an exposure on future contracts.
For every buyer of contract there would be a seller. Under normal
conditions initially is open interest rises with the time as more and more
investors start evincing interest in the new contract and either buy or sale
contract depending upon their individual opinion. But as the maturity of
contract approaches the investors tend to reduce their exposure and
unwind the initial position. Those who were long would unwind by selling
the contract and those who went short initially square up by buying the
contract. Hence open interest starts declining as maturity approaches. It
signifies reduced investors interest in the contract that have little time to
expire. Ultimately on the expiry of contract all posit ions would be squared
up. The position that are left exposed by the investors are compulsory
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13 The position or settled by exchanging the difference of closing price and
the price of in itial contract.
2.8 DIFFERENCES BETWEEN FORWARD AND
FUTURE CONTRACTS
As seen from the discussion about the principle and purpose of the
forward contract and future contracts are same however there are key
differences that have cash flow implication that ne ed to be understand.
Besides the standardization and as exchange traded products the future
have to substantial differences from forward contract from the viewpoint
of cash flow as follows :
(1) Margin Requirements : the exchange serve as a counterparty to
both buyer and seller of future contract. The delivery of the underlying
asset and the cash flow market to essential ingredients of the future
contracts. Despite the fact the most contract or neutralize prior to the
delivery the link of delivery and resultant cash flow cannot be broken. The
exchange works to eliminate the counterparty risk and therefore it has to
assure itself of the financial standing of the participating members. It
further needs to curb the tendency of overtrading by the members. To
assure itself of financial credit ability of the participants and also to check
the speculative tendencies we exchange prescribes the margin to be
deposited with it. The margin is some percentage of the contract value and
is prescribed by the exchange depending u pon the volatility in price of the
underlying asset. An initial margin is required to be deposited to open
position in the future and is normally set equal to the maximum loss that
position can suffer in a day, it is charge from buyer and the seller both. If
the initial margin of 4% is stipulated by the exchange it implies that loss
is not expected to exceed 4% in a day suppose at Rs.550 per quintal the
trader by one contract of price of 10 MT valued at Rs.55,000; he will
required to deposit 4% that is Rs. 2200 and initial deposit. When the
position remains open the trader can incur loss or profit as the price
change. Falls to Rs.535 to the next day the trader has to incur a loss of
Rs.1500 and his margin now stand reduced to Rs.700 (Rs. 2200 –
Rs.1500). Men make the exchange uncomfortable and insecure as any
further decline in price will wipe out the entire margin. The exchange
therefore prescribes a minimum level below which the margin should not
fall. If it does exchange ask the trader to replenish immedia tely the margin
to original level of 4%.

(2) Marking to Market: Initial margin is intended to cover the potential
loss in an open position. However the loss that is already incurred during
the day has to be made good at the end of the day, it is a practice of
exchange to settle the difference of price on daily basis. This daily
settlement is referred to as marking to market. For example: investor has
bought a future contract on a stock of Maruti Udyog at national stock
exchange at a price of Rs.4 10, as each c ontract consist of 400 shares the
exposure is of Rs.1,64,000. There is no cash flow from buyer to seller at
the time of entering the contract. Initial margin payable by both buyer and munotes.in

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14 seller to exchange is ignored for the purpose of this example. Investor hold
this position till day four and closes out by selling the contract when the
price is 440 at the end he will gain Rs.12,000 from the transaction that is a
gain of Rs.30 per share for 400 shares. Ever what happens to the price
during the intervening per iod is to be accounted for in the future contract
at the end of each day the profit or loss on the position is calculated and
the loss if any is made good to the exchange by the investors. Likewise
any profit at the end of each day is credited to the accou nt of the investor.
Profit or loss is settled at the end of each day as if the investor was closing
out the position. At the end of day one the closing price had risen to Rs.4
20 the investors account will be credited with the amount of profit of
Rs.4000, similarly if at the end of debt to the price fell to Rs.400 the
investor will have to deposit the loss of Rs.8000 with the exchange. This
way the position is Mark Daily to the end of the day price. It impact on
profit or loss remains the same as a differen ce of buying and selling price
as would be the case with forward contract but with the futures contract
the net profit or loss is represented as a series of cash flow on daily basis.
2.9 TYPES OF FUTURES
Futures can be classified on the basis of an underly ing asset. As stated
earlier there can be a host of assets on which future contracts can be
created it is a matter of standardization of the contract broadly the futures
were categorized into two commodity futures and financial futures.
(1) Commodity Futures are those where the underlying asset is,
commodity. Contracts are available in India on agriculture, it is such as
wheat, rice, soya, coffee, sugar, tea, cumin, paper, edible oils, cotton,
coconut etc. Contracts on metals such as gold, silver or also availa ble in
future contracts on oil also available. Future contracts on oil also fall
under commodity futures.

(2) Financial Futures are that where underlying asset is a financial
product. They can further be categorized into four:

(a) Currency futures are those wher e underlying assets or currencies.
Future contracts on various currencies are available in major centres
such as Chicago, London, Singapore etc.

(b) Stock Futures are those where underlying our stocks. Stock futures
were introduced in 1882.

(c) Interest Rate Fu tures are those where underlying assets are interest
rates. In India, interest rate futures were launched on 24 June 2003 at
NSE. They were re -launched on 31 Aug 2009 with modification to
the underlying asset and contract features.

(d) Index futures are thos e where the underlying assets are stock indices
such as BSE Sensex or NSE Nifty.
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15 3
MECHANICS AND PROPERTIES OF
OPTIONS
Unit Structure
3.1 Introduction
3.2 Terminology of Options
3.3 Call Option
3.4 Put Option
3.5 Moneyness of Options
3.6 Types of Options
3.7 Trading a nd Settlement
3.8 Margins in Options
3.9 Adjustment for Corporate Actions on Stock Options
3.1 INTRODUCTION
An option is a unique instrument that force right without an obligation to
buy or sell another asset called the underlying acid. Like forwards and
futures, it is a derivative instrument because the value of the rig ht so
conferred would depend on the price of that underlying asset. As such
option derive their value enter alia from the price of the underlying asset.
For easier comprehension of the concept of an option an example from the
stock as underlying asset is t he most apt.
Consider an option on the share of a firm say ITC Limited it would confer
the right to the holder either buy or sell a share of ITC. Naturally this right
would be available at a price which in turn is derived from the price of the
share of IT C. Hence an option on ITC would be price according to the
price of ITC shares prevailing in the market. Of course, this right can be
made available at a specific predetermined price and remains valid for a
certain period of time rather than extending indef initely in time.
The unique feature of an option is that while it confers the right to buy or
sell the underlying asset the holder is not obligated to perform. The holder
of the option can force the counterparty to honour the commitment made.
Application o f the holder would arise only when he decides to exercise the
right. Where for an option may be defined as a contract that gives the
owner the right but no obligation to buy or sell at predetermined price
within the given time frame. It is the absence of o bligation to perform for
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16 different derivative product from forwards and futures, where there is
equal and binding obligation on both the parties to the contract. This
unique feature of an option makes several applications possible that may
not be feasible with the other derivative products.
3.2 TERMINOLOGY OF OPTIONS:
(1) Call Option : A right to buy the underlying asset at predetermined price
within the specified interval of time is ca lled call option.

(2) Put Option : Aright to sell the underlying asset at predetermined price
within the specified interval of time is called a put option.

(3) Buyer or Holder : The person who obtains the right to buy or sell but has
no obligation to perform is ca lled the owner or holder of the option. One
who buy an option has to pay a premium to obtain the right.

(4) Writer or Seller : One who confers the right and undertake the obligations
to the holder is called seller or writer of an option.

(5) Premium: While conferr ing a right to the holder who is under no obligation
to perform the writer is entitled to charge a fee upfront. This upfront amount
is called premium; this is paid by the holder to the writer and is also called
the price of the option.

(6) Strike Price : The predetermined price at the time of buying or writing of
an option at which it can be exercised is called the strike price. It is the price
at which the holder of an option buy or sell the asset.

(7) Strike Date / Maturity Date : The right to exercise the opt ion is valid for a
limited period of time, the latest time when the option can be exercise is
called the time to maturity, it is also referred to as expiry or maturity date.
3.3 CALL OPTION
Assume that share of ITC is currently trading at Rs.180. An inves tor
called Ms. Narayani, believes that the share is going to rise at least to Rs.
20 in the immediate future in the next three months. Ms. Narayani does
not have adequate funds to buy the shares now but is expecting to receive
substantial money in the ne xt three months. She cannot afford to miss an
opportunity to own this share. Waiting for three months appliance not only
a greater outlay at a later point of time, but also means foregoing of
substantial potential gain. Another investor, Ms. Apurva holds c ontrary
views and believes that optimism of Ms. Narayani is exaggerated. She is
willing to sell the share.
What can Ms. Narayani do under these circumstances where she cannot
buy the shares on an outright basis now? She possibly could borrow to
acquire th e stock of ITC. This is fraught with risk of falling prices.
Amongst the many alternatives that may be available to miss Narayani is
included an instrument called a call option. She can instead buy a call
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Mechanics and Properties of
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17 share of ITC from Miss Apurva at a price of say Rs.190 at any time during
the next three months. This would be a call option. Miss Narayani is the
holder of the option while Apurva is a writer/seller of the option. In case
Narayani dec ide to buy the share, she would pay Rs.190 the strike or
exercise price. Read up to which Narayani can exercise this option is three
months. Note that Narayani has the option, which she may not exercise but
Apurva has no such choice and she stands committe d to deliver the share
and receive Rs.190 from Narayani, irrespective of the price of ITC share at
that time. Naturally Apurva would not provide such a right for free as she
is obligated to perform at the option of another. Therefore, Apurva would
charge s ome fee called option premium, to grant this right to Narayani.
This premium is determined inter alia by the price of underlying asset the
ITC share.
We now discuss the situation when Narayani would exercise her option.
She would use this right only when t he actual price of the ITC share has
gone beyond Rs.190. Imagine it has moved to Rs.200. By exercising the
option, she stands to gain immediately Rs.10, as he gets one share from
Apurva by paying Rs.190 and send immediately in the market at Rs.200.
Logical ly Narayani would not exercise the option if the price remained
below Rs.190. In many cases she loses the premium paid. If the price
remains below Rs.190, Apurva would not be asked to deliver and the
upfront premium she received would be her profit.
We ma y generalize the outcome of a call option in the following manner.
As long as the price of the underlying asset S, remains below the strike
price X, the buyer of the Col call option will not exercise it and the laws of
the buyer would be limited to the pr emium paid on the call option C and if
the price is more than the exercise price the holder exercise the option and
generate profit equal to the difference of the two prices.
When,
S < X Buyer lets the call
expire Loss = Premium C
S = X Buyer is indiffe rent Loss = Premium C
S > X Buyer exercises the call
option Gain = S – X – C
Value of the Call Option = Max (0, S – X) – C

A graphical depiction of the payoff of the holder and writer of the call
options is easier to comprehend and is presented in be low figure :
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18

3.4 PUT OPTION
Call option expect the fact that is an option to sell. Again, we take a small
example from the Stock Market to classify have put option works. Again,
assume that share of ITC is currently trading at Rs.180, an investor
Nara yani in a position of the share believes that the share is likely to fall to
Rs.150 in the immediate future of the next three months. Narayani is not
sure of the fall but would like to exit from her investment at Rs.175. She is
seeking protection against t he heavy fall in the price. Another investor
Apurva holding contra view believes that the pessimism of Narayani is
exaggerated. She is willing to buy the shares at Rs.175 since she feels that
is the lowest it can go.
Narayani believes ITC is a good long -term buy but is unsure when the
scrip would show its potential. She does not want to exit unnecessarily.
Under these conditions Narayani can buy a put option to Apurva stating
that she has a right to sell of shares of ITC at a price of Rs.175 at any time
during the next three months. Narayani decided to sell the share she would
receive Rs.1 75 the strike/exercise price in the next three months.
Narayani has the option which she may or may not exercise but Apurva
has no such choice and she stands committed t o pay the agreed price and
claim the share. Like in the call option Narayani would not grant such for
free and charge some fee called option premium. This premium is
determined inter -alia by the price of the underlying asset ITC share.
Apurva would exerci se her option only when it is profitable to do so. This
option would become profitable when the actual price of the ITC share
falls below Rs.175. Imagine that has mood to Rs.1 60. By exercising the
option stands to gain immediately Rs.15 by placing the sha re to Apurva
and realised Rs.175 and using the proceeds to acquire a share of ITC from
the market at Rs.1 60. This keeps his earlier position intact and it gives
Rs.15 as a profit. Logically Narayani would not exercise the option if the
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Mechanics and Properties of
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19 price remains above Rs.175. However, under all conditions she loses the
premium paid.
May generalize the outcome of a put option in the following manner.
As long as the price of the security remains below the strike price the
buyer of the option will exercise it becomes a stand to gain, otherwise her
loss would be limited to the premium paid on the put option P.
S < X Buyer lets the call
expire Gain = S – X – P
S = X Buyer is indifferent Loss = Premium P
S > X Buyer exercises the call
option Loss = Premium P
Value of t he Call Option = Max (0, X – S) – P
A graphical depiction of the payoff for put option, holder and writer is
easier to comprehend and is presented in below figure :

3.5 MONEYNESS OF OPTIONS
In The Money (ITM), At The Money (ATM) and Out of The Money
(OTM) Options:
Depending upon the payoff of the option they often referred to as in the
money, add the money or out of the money. At any time ITM options are
those which if exercise would result in positive cash flow to the holder.
Similarly, OTM option w ould result in cash flow if exercise and ATM
option would have no cash flows.
Call option becomes profitable when the price of the underlying acid
exceeds the exercise price. Similarly, a put option is worth exercising
when the price of the assets is less than the exercise price. A call option is
called ITM when a set price exceeds exercise price. A put option would be
ITM when the asset price is lower than the exercise price.
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20 When a set price equals exercise price it is called an ATM option. It
applies to both call and put options.
Similarly, when asset price is lower than its price for call option it is
OTM, while put option would be OTM when a set price exceeds exercise
price.
3.6 TYPES OF OPTIONS
Options have several features, certainly more than forward s and futures
making several differentiations possible in the basic products of calls and
puts. Based on several consideration the options be categorized in a
number of ways such as :
(a) Based on nature of exercise of options
(b) Based on how are they generated, traded and settled
(c) Based on the underlying asset on which options are created.
Nature of Exercise : American v/s European
The timing of exercise the option can be either American or European.
The American options can be exercised at any point of time befo re the
expiry date of the option, while European options or exercisable only upon
maturity.
Nature of Markets : OTC v/s Exchange Traded
Options can also be categorized as OTC or exchange traded depending
upon where and how they are created, traded and set tled. Option may be
like forward contracts, which are specific and negotiated by two
contracting parties mutually with direct negotiations known as OTC, or
they can be like few futures which may be bought and sold on specific
changes where to contracting p arties or not to be known to each other but
instead enter into contract on the floor or screen of exchange. In the
extended option the contract needs to be standardize while an OTC
product is tailor made to the requirement of the parties concerned. The
standardization of option contract would be in at discretion of the
exchange and he’s done in terms of :
(a) Only specific quantity of the underlying acid could be traded on the
exchange and need to be predetermined.

(b) Only specific strike price can be handled in standardised product credit on
exchange. OTC product can I have any strike price as agreed by the two
contracting parties.

(c) Light strike price the expiration date too must be known before trading can
take place in option at the exchanges.

(d) Whether the opti on or American or European in nature too must be known
to trader in options.

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21 (e) Options can be settled either by delivery of underlying assets or by cash
settlement which is closing out by exchanging the differential of price at
initiation and closing out. Cash settlement at the expiry is done by
exchanging difference between the exercise price and the price of
underlying assets. It can also be settled by cancellation of the contract by
entering into an equal and opposite contract to the original one.
Nature of Underlying Assets
Like forwards and futures, options too can have any asset as underlying.
Options on stocks, indexes, commodities, currencies, and interest rates are
available either OTC or on exchanges. In India as of now option on
commodities are tr aded internationally on agriculture products livestock,
food products energy and metals. Options are also available on various
currencies such as US dollar, euro, yen, pound in major exchanges in the
USA and Europe and also other parts of the world. Option s on currency
are mostly OTC. Besides options are also traded on exchanges on future
contracts rate. Options on future have a future contract as underlying
assets which gives the buyer a right to buy or sell the specified future
contracts within or at spe cified time. The expiry of the future contract
must extend beyond that of option contract. Option can also be traded on
interest rate either on cash assets such as treasury bonds and notes or on
interest rate futures contracts. These options serve the same purpose this as
do the option on stocks and indices. Options on stocks and stock in dices
are most common most common, several exchanges across the world offer
option on indices and stock. NSE in India offer options on several indices
such as nifty, a bro ad-based index of 50 stocks from banking, information
technology, infrastructure etc. Presently these options are limited price
and cover periods up to 3 months. However internationally options for
longer period of up to 2 to 3 years are also available. N SE attempts to
provide minimum five strike price that is 2 ITM, 1 ATM and 2 OTM at
any point of time.
3.7 TRADING AND SETTLEMENT
The life of the option contract is specified when the contract is entered. No
right can be given forever. Number of contracts t hat are not yet settled is
known as open interest. All option contract must close by any of the three
modes by exercise, by letting it expire or by selling.
(a) By Exercising: As options are brought with a view to make profit, there
would be exit opportuniti es to make again. The holder of an option may decide to
exercise the right and force the writer to honour the obligation undertaken. The
writer has to deliver the assets under call or pay the price for the or state under a
food. Note that application appli es for the writer of the option and not to the
holder of an option. The holder has a right to exercise. If American the exercise
can be done at any time and if European exercise only be at maturity.

(b) By Letting Option Expire: is not necessary that the hold er exercise the
option whenever profitable opportunities arising during the life of an option.
Even if the option is profitable the holder may not exercise the right in the hope
of making larger gain later. If no action is taken by the option holder the
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22 (c) By Selling The Contract: apart from exercising or letting it expire, the
obligation in the option contract may be nullified by entering into an offsetting
contract that create s obligation opposite to that of the initial contract. Two point
must be noted here First obligation under the initial and subsequent contract were
independent and remain as they were but get nullified only on a net basis;
Second, it must be noted that obl igation under call and put or not opposite and
nullifying. An application created by writing a call gets nullified by buying a call
and not by put option.

(d) Assignment: in case of OTC option the buyer and seller of options enter
the contract directly and th erefore the holder know whom to approach if and
when he decides to exercise his right. The writer of the option has to fulfil the
obligation. In an exchange traded option, the buyer and the seller enter the
contract through exchange with the buyer and the seller unknown to each other.
To each of them the counterparty is the exchange. If the buyer needs to exercise
the option he has to advise the decision to the exchange only. Such a case the
exchange has the task of making good the claim made by the holder of the
option. A suitable writer needs to be identified among us several options sellers.
Among many others assume that you have bought a call option at strike price of
Rs.1 20. You do not know who exactly has written the call. If the asset price has
moved up to Rs.1 25 then by exercising the call you stand to gain Rs.5. Not all
investors decide to exercise the call. If you decide exercise someone must pay
you Rs.5. The exchange therefore assign the liability to one of the several writers
of the option who will be assigned the liability arising out of the exercise by one
of the folders. It is normally done on a random basis. The one who is assigned the
liability makes the payment, and therefore loses the opportunity of cancelling the
obligation by entering i nto an opposite contract. If the short position in the option
was taken as hedge the seller now stands exposed to the risk again that he had
presumably covered through the initial position. In case of European options the
issue of assignment does not arise as on the date of maturity there is equality of
long and short position. However in case of European option the issue of
assignment does not arise as on the date of maturity there is equality of long and
short position however American option or exercise any time before or on
maturity. The exchange has a responsibility to assign the exercise option to some
seller of option this exercise of assignment is carried out during non -trading
hours. Exchange allow only cash settlement of option and therefore only I TM
options are allowed to be exercise.
3.8 MARGINS IN OPTIONS
Options or lopsided contract where buyer has no obligation to perform
expect upon exercise. In case of Paul the holder has to deliver cash equal
to exercise price and in case of put the underlyi ng asset. On initiating
position, the buyer of the option satisfied his application by paying the
premium. On the opposite the writer of the option of James unlimited risk
in case price of acid most unfavorably. Exchange has the responsibility for
settleme nt it faces risk from the seller of the options. Position in option for
cash settled it is assumed that the writer of option would nullify the
liability by paying the option back. His obligation would limit to the
premium payable on buying less premium rec eived from selling option.
The credit risk of the exchange can be eliminated if position of the seller
or MTM and losses collected as it done in case of future. In case of futures
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Mechanics and Properties of
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23 in ca se of option where MTM loses collected from seller or losers are
passed on to option buyer or Gainer. If such a practice is adopted the
position of option buyer to would need to mark to market and they to be
subject to margin call. Practice is referred to as future style option where
both buyer and seller are marked to market. As an alternative the exchange
may decide to keep all MPM losses collected from writers with itself and
not pass on to the gainer. This is known as premium style option. Most
exchange s follow premium style option for margin in which obviate the
need for making to market for option buyers. Only writers of the options
have to make good the MTM losses.
3.9 ADJUSTMENT FOR CORPORATE ACTIONS ON
STOCK OPTIONS
Options or contracts that are set tled by delivery or cash in future, with the
implicit assumption that basic characteristics of the underlying as it do not
change during the tenure of options. However stop issued by firm or
subject to corporate action at any point of time. Corporate actio ns such as
dividend, bonus shares and stock split change the value of stock and such
options on the stock to code change in value. This action being not part of
normal process of price determination of options and the underlying acid
require change in the characteristics of an option.
(a) Adjustment of Dividend: options traded on stock exchange do not
provide for adjustment of dividend. The price of the stock falls by the amount of
dividends on the ex -dividend date. Therefore, Intrinsic value of the ATM call to
fall by the amount of dividend on the ex - dividend date. Ideally strike of the call
must be reduced by the amount of dividend to so as to keep the intrinsic value
same. Option premium depend upon the value of the underlying stock would
change on ex -divide nd date. The difference in the option premium must be equal
to the present value of the dividend. Since stock prices are supposed to be present
value of all future expected dividend, there seems to be little logic in adjusting
for the payment of cash divid end. No adjustment to the option feature is made
with respect to cash dividend on the stock. However extraordinary dividends or
not anticipated by the investor neither in the price of underlying nor by trader in
derivatives. In such cases the adjustment to the option contract can be made by
reducing the strike price appropriately. In Indian stock market a dividend in
excess of 10% (subject to change) of the value of the stock promotes adjustment
to the strike price.

(b) Adjustment For Bonus Share: good Times firm also make bonus offer
by capitalizing the reserves rather than cash dividend though it does not change
the aggregate value of the share in the hand of the investor it affect the price of
shares substantially as the large number of shares become availa ble for same
value. For example, consider as 3:5 bonus issue by a firm with share price of
Rs.200. The value of 5 shares is Rs. 1000. After the bonus issue same five shares
become eight and in order to keep the value same the shares must now trade at
Rs.12 5 (1000 / 8). Since the aggregate value of the underlying asset has got not
change but for its composition therefore the value of land contract two must not
change but for its composition. For parity of cum -bonus and ex -bonus the
following two adjustment m ust be made to the option contract.

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Derivatives and
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24 (1) The number of shares in the contract must increase by (1 + Bonus ratio)

(2) The strike price must reduce to 1/(1+ bonus ratio)

If there is ATM call at Rs.200 for 100 shares the contract must noun stands
modify as an op tion to buy 100 X 2 = 200 Shares, i.e. Original Contract Size X
(1+ bonus ratio) at strike price of 200/2 = Rs.100 i.e. the original strike price /
(1+ bonus ratio). These two adjustments would keep the commitment under
option contract same.

(c) Adjustme nt for the Stock Splits: the stock split the number of shares
increase with the price reduced proportionately for example a 2:1 split doubles
the supply of share and that must reduce the price of the share a half. This meant
as in case of bonus issue with respect to contract size and exercise price or made
so that the value of the option contract free split and post split remains the same.
Therefore the exercise price must be used to half and the number of shares in
option contract must be double.

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25 4
OPTION TRADING STRATEGIES
Unit Structure
4.1 Introduction
4.2 Straddle – Long and Short
4.3 Strangle – Long and Short
4.4 Straps and Strips
4.5 Bull Spread
4.6 Bear Spread
4.7 Butterfly Spread
4.8 Condor Spread
4.9 Calendar Spreads
4.10 Diagonal Spreads
4.11 Box Spread
4.1 INTRODUCTION
Position of single option provides an even gain or losses with the change
in the price of the underlying assets. For payment of small premium a call
option gives unlimited upside game, while a put option provides larger
gain in falling markets. Because of the non -symmetric profile of risk and
return, options can be used as a combination in many way that can
generate vast number of risk profiles. New strategies are used for trading
as well as for hedging purposes. If options are combined with the
objective of containment it would be called hedging but when combined to
take a specific view on future price and the risk it would become
speculative. The major distinction between hedge and speculation would
be whether the position taken is with the vie w of reducing risk or
assuming risk. Option prices being dependent on many factors as
compared to other derivatives the dimension of risk can be with respect to
many parameters. This parameters or time, volatility, assets, price along
which many positions can be formed. This flexibility do not exist with
futures and forwards being instrument of not as many parameters.
Combination of options can be done on various parameters some of them
or as follows:
(a) Different type of options
(b) Different exercise prices
(c) Different ratio of calls and puts.
(d) Different expiration times.
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26 The risk profile of the combination of option is an aggregation of the risk
profiles of the individual options constituting the combination. Some of
the most common an d popular combinations which are certainly not
exhaustive are discuss here.
4.2 STRADDLE – LONG AND SHORT

Straddle is a combination of simultaneous position taken in the call and
the put option on the same underlying asset with same expiry. Straddle
constitut e long call and long coat with the same strike price on the same as
it with the same expiry. As both the options are brought it cost to set up a
long straddle.

If the price remains equal to exercise price both call and put remain on
exercise and the inves tor lose the premium. However, if the price moves
away from the exercise price either the call or the put becomes in the
money depending on the direction of price moment. The investor start
recovering big boss incurred in setting up of long straddle.

If the price goes higher than the exercise price call option become in the
money and if the price is below exercise price the put option is in the
money. Long straddle a suitable strategy when one expect volatility in the
price of the underlying asset. An inve stor with long straddle game with
price movement in either direction. It is suitable in time when large
movement in price is forecast but the direction of movement is uncertain.

The short straddle his form by simultaneous selling a call and a put on the
same as It with the same strike price and same expiry. It generates income
as a premium on both the option that is call and put written, are received.
With the change in the price of the underlying acid either the Call or the
food return goes in the money. Movement of price away from exercise
price is detrimental to the interests of the investor with short straddle.
Position of short straddle is suitable for investors who foresee stability
rather than volatility of the price around exercise price.

Note th at combined position of long and short straddle result in 0P of
confirming the view that options or zero -sum game.

For example : The Long straddle where the investor has bought a call and
put both at the same strike price of Rs.780 on the same underlying acid,
the stock of reliance with the same expiry dates. In setting up this putfolio
the investor in incur a cost of Rs.25 equal to the sum of the premium on
call and put. Would be maximum loss. The investor breaks even with the
price of reliance had to pay 755, when put is exercise and at Rs.8 05 when
call is exercise, Long straddle ends up in a profit with the price of
Reliance below 755 or above Rs.805. Within the range of Rs.755 to
Rs.805 there would be some losses with a big loss at the price equal to t he
strike price of two option that is Rs.780.
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27 The payoff for Investor of short straddle called a writer of a straddle
would be exactly opposite to the investor of long straddle. His big profit
would be Rs.25 when the price of Reliance remained static at Rs.780 the
strike price of the option written. Search investor would incur losses when
the price of Reliance falls below Rs.755 or goes about Rs.805 however his
breakeven would be same as that of investor with long straddle. The writer
of straddle strongly believes in the phenomena of convergence of price –
the price of the asset converges to the strike price when options are close
to maturity.

Saddle is not an appropriate strategy if the asset stays in the tight trading
range and does not break out suffi ciently before the expiry of option. The
right way would be to set up a straddle just before the anticipated price
breakout and depending upon the direction of breakout immediately
liquidate one of the option to earn further income.

Bing combination of ind ependent call and put option long straddle may be
created without an investor with an equivalent short straddle. Call and put
option may be bought from different person to have long straddle. Same
applies to creation of short straddle which may be created without
corresponding long schedule. However few exchanges offer straddle as an
independent composite product.

4.3 STRANGLE – LONG AND SHORT

Strangle is similar to straddle except that in strangle the exercise price of
call and put option bought/written or di fferent. For a long Strangle the
excise price of the put option is lower than that of call option. If the price
remain within the two exercise prices none of the option is exercised and
the premium paid on the option is lost. If the prices goes above the strike
of the call or goes below that of the foot long strangle starts paining of the
cost initially and then result in the profit if movement is large enough.

For a short strangle the premium earned by the investor is the profit if the
price remain withi n the band of two exercise prices.

Both the call and put options or out of the money when one set up the
Long Stratton for shares of reliance trading at Rs.780. Stranger is created
by buying a call at X = 800 and put at X = 716. Within the price range
both the call and put options or worthless. When the price goes below
Rs.760 the put becomes valuable and when the price is greater than Rs.800
call terms in the money.

Like straddle stranger to becomes profitable with a large breakout of the
price in either direction. To the strategy is fruitful under number of
situations where volatility is expected with the direction unknown. Some
of them are described below:

 When stock or trading in the rain with a variety of identified
resistance and supput level and wh en does not know which of the two munotes.in

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28 would be pierced, the breakouts are usually significant whenever they
occur.

 Another situation favourable for going long on strangle or the times
of takeover attempt. Great uncertainty exists when takeover attempts are
made. Similar situation when some litigation reaches a point of decision
specific to a particular firm.

 Yet another time to have long strike triangle is when widespread
uncertainty prevailed at the time of major or significant economic or
political events s uch as presentation of budget, announcement of monitory
policies, declaration of election result which caused large movement in the
market price but with direction unknown.
A standard cost lesser than the Stadel has the call with high year exercise
price and put with a lower exercise price would cost lesser. With lesser
cost of strangle the investor with long position low losses on some of the
likely gain from the volatility as compared to the position of long saddle.
Investor with long strangle on lesser profit but over a smaller range of
price as compared to invest with long straddle once larger profit but at
single price. Similar observations regarding losses can be made for an
Investor with a short strangle and short straddle.
4.4 STRAPS AND STRIPS

In a l ong straddle or is tangible the payoff from the volatility what is
symmetrical in either direction of movement of price. This was due to
equal position taken in the call and put option in terms of number of
contracts.

The payoff from changes in price can be made unequal and non -
symmetrical by changing the ratio of call and put option. For example if
the investor not only expect the volatility in price but also believe that
likelihood of prices going up is far more than the prices coming down then
we can b uy two calls rather than one along with one put. In such a case the
gains from upside movement would be double as two calls will become in
the money. The gain from upside movement will be larger than straddle,
and remain same for downside moment. This comb ination is known as
strap.

Similarly in the opposite situation of expected volatility being higher for
downside movement as compare to the upside movement the investor can
buy two put and one call. When prices goes down to puts become in the
money and whe n prices go up only one call become in the money, making
gain unequal for same rise then fall in prices this combination is known as
strip.



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29 4.5 BULL SPREAD

Combination as discussed above are created using two different types of
options on the same acid and sa me expiration date. Spread or created with
the position on the same type of option on the same underlying asset but
with different strike prices. Spread can be created using either call or put.
Bull and beer spread or discussed here.

A bull spread is used by one who is mandatory Lee bullish about the
market in near future. Buying a call is regarded as more bullish but if cost
becomes a consideration and prospect or not as bright then one can reduce
the investment in call by writing another call at higher s trike price than the
one bought, dead by decreasing investment and increasing returns on the
investment.

The call with higher strike price trades at lower premium than the call with
lower strike price. There will be net cash flow while setting up a bull
spread. This is also known as debit spread as it resulted in an outflow of
cash at the time of set up.

If the market does not rise as expected the price remains below both the
strikes, both calls would expire worthless. Loss will be limited to the
differe nces of the premium paid and received on the call bought and return
respectively. If the spot price is higher than both the strike price, both the
call will be in the money and the payoff shall be equal to the differences of
the strike price less set up co st.

4.6 BEAR SPREAD

Opposite to that of bull spread is a beer spread. An investor who believes
that the market will be weak in the near future deploys a beer spread by
buying a call with higher strike price and simultaneously writing a call
with lower strike price. The set up of beer spread is likely to generate a
positive cash flow since call written with lower strike on more than the
coal board with higher strike price and this is called a credit spread. Beer
spread is useful when one is moderately bearish.

For example : call of .2600 is bought and the one with the strike of 2500 is
sold knitting in Rs.28 which is the maximum profit when the market
remain big and both the calls or worthless the investor makes the profit
equal to the income generated while set up setting up the beer spread
however if the market behave contra to the expectation and rise so as to
make both the call in the money the investor loses. Or loss will be equal to
the difference in the strike price of the two calls less than the income
generated in creating the beer spread position.

This strategy is bearish strategy but not as risky as a written naked calls. It
limits the losses to the differences in the strike price of the calls less initial
cash inflow. Writing a naked call would be extremely risky and such munotes.in

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30 strategy is adopted when one is extremely bearish. Under beer spread one
Paul is bought to provide protection against substantial price rise. Both
bull and bear spread can also be created using the put option alone it
would have th e same profile of pay off as that with the calls.

Both bull and beer spread limit the upside and downside potential as
compared to the Prabhu position in single option. Buying a call provides
unlimited upside gain while protecting the downside loss. By w riting
another call at higher strike price in bull spread one reclaim some of the
premium paid on the first call sacrificing upside potential. Similarly
writing a call implies unlimited downside loss while earning premium. By
buying another call at a highe r strike price while creating a beer spread the
investor limit downside loss and sacrifice some income.

4.7 BUTTERFLY SPREAD

Butterfly spread his created by option with three different strike price as
follow:
 Buy one call with strike price X 1
 By another call with Hire strike price X 3.
 Two calls at strike price X 2 that lies between X 3 and X 1

The two calls written at strike of X to around a current level of price the
underlying asset fake income. The call at lower strike price X1 is in the
money and commands a larger premium. The other call bought with
higher strike price X3 is out of the money and has a lower price. The
initial cost of creating a butterfly spread is nominal which is great
attraction to set up the butterfly spread.

If the two calls that are bou ght have the strike price as X1 and X3 the
strike price of two columns written at X2 is normally chosen as average of
X1 and X3. If the price remains below X1 all calls or workplace and
expire without exercise.

The investors suffer a nominal law is equival ent to set up cost. If the price
exceeds X3 all calls are in the money and exercise. Two calls bought
compensate exactly for the liabilities of the two calls return and investor
ends up with nominal loss equal to the cost of spread. When price is above
X1 but below X to only one called bot is in the money and the investors
start making profit. He has maximum profit when price reaches X2
beyond which both the call return become in the money and get exercise.
He starts losing the profit as he pay for two call s and receive from one
call. When price reaches X3 the second call what also become in the
money matching the aggregate liabilities on the call written.

4.8 CONDOR SPREAD

Condor is modified version of the strangle. It is a less risky than strangle.
Uses for strike price X1, X2, X3 and X4 – set of to use in triangle with X1
< X2 < X3 < X4. Condor products created as follows. munotes.in

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Option Trading Strategies
31  Buy call with two out a strike price that is X1 and X4
 Same call with strike price in between X2 and X3.
This can also be thought as a co mbination of bull and beer spread, a bull
spread with lower strike price and beer spread with higher strike prices. A
call with X1 and X to construct a bull spread while other to call make beer
spread.
All calls or out of the money for a price below X one. Between X1 and X
to the call board with lower price is in the money leading to gain. Between
X2 and X31 call written and one called baht cancel out and other set of
calls have not come in the money as yet. Between X3 and X for the second
called return is exercise and the liability arises the price beyond X for all
four calls or in the money but the call bought and written cancel out each
other. Condor can also be formed with put alone or from a combination of
calls and puts. An investor by two puts with ou t a strike price of X1 and
X4 and write two with strike price between X2 and X3 he will have the
same profile as the one created through calls. Condor can also be formed
with a set of calls long at X1 followed by short at X2 and set of put, Long
at X3 and shot at X4. Usually the combination that cost less is chosen.
Long Condor looks like a short strangle with extreme curtailed two wins
similarly a short Condor is similar to long strangle. The condor is deemed
as less risky version of strangle. Long condor can also be seen as a
butterfly spread with flattened top. A strangle when chipped at the end
from the Condor, Condor cost less and compromise is on curtailing the
game at extreme prices. Along Condor can also be treated as a
combination of bull spread and beer spread. An investor has a choice to
choose the exact risk profile desired by him.
4.9 CALENDAR SPREADS

Calendar spread or form by using the option on the same as it with the
same exercise price but with a different expiry expiration dates. An
investor o f calendar spread is aiming to make a profit based on the time
value of options. A bullish University take a position in calendar spread on
the premise that the price of acid would not increase enough in the new
near term but would exceed predetermined lev el in the longer term. For
bullish investor by a distinct call and writes a near call, expecting the
distant call bought to be in the money and expiration while reducing the
cost by writing a near call. Only very experienced investor uses such
strategy.

Similarly, a bearish investor may buy a near call but sale a distant call in
the hope that price would rise enough in the near -term to make the near
call in the money but will fall thereafter so as to make the distant call out
of the money.

As we know that the value of an option consists of two particles that is the
intrinsic value and time value. Unlike other spread calendar spread play on
the time value of option. With larger time to maturity the time value munotes.in

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32 declines but not fast enough. Time value decline s more rapidly as maturity
in nears. An investor of calendar spread capital life by writing option who
is time value declines more rapidly.

4.10 DIAGONAL SPREADS

Diagonal straight or constructed by using different strike price and
different maturities of optio n on the same base. The interpretation and
objectives of such great or hard to explain and R2 numerous for tabulation
and generalization.

However as an example consider an investment investor who believes that
the price of the stock will exceed Rs.80 by No vember but remained below
Rs.100 till December the investor can adopt following strategy
 Buy Nov Call at X = 80 paying a premium of Rs. 5
 Write Dec Call at X = 100 earning a premium of Rs. 10
Price < 80 80 < Price < 100 Price > 100
In Nov In Dec In No v In Dec In Nov In Dec
Dec Call at X = 100 - - - - -(S - 100) - (S - 100)
Nov Call at X = 80 - - S - 80 - S – 80 -
Initial Income 5 5 5 5 5 5
Net Profit 5 5 25 5 25 (S –105)

As is apparent the investor rules out the possibility of price in excess o f
hundred at the end of December and hence his payoff is larger than the
strategy of simply buying a November call at Rs.80 which would give him
maximum of Rs.15 as profit. By writing another call at rupees hundred for
distant future he earns an extra prem ium of Rs.10 and at the same time has
an option to square up the December call any time, in case his forecast
about the future price appears to be failing.

4.11 BOX SPREAD

Though options are thought to be risky in nature their combination can be
remarkably sta ble different options can be combined to obtain a risk -free
position search position called box spread.

A box produce created by (a) buying a call and writing a put at the same
strike price (b) simultaneously selling another call and buying a put again
at the same strike price but different from those in (a)

This result in certain profit equal to the difference of two strike price. This
may be used for arbitrage in the pricing of different options as follows :
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33 Cost of Box
Spread >Discounted value of the box spread;
Go short on the box spread
Cost of Box
Spread Go long on the box spread.

FACTORS AFFECTING THE SPREAD
While trading on independent and single option is rather easy, creating a
spread it require deep t hinking and understanding before assuming a
position. Though in general spread or safer, then construction needs prior
evaluation in terms of the following factors.

(1) Initial Cost of the Spread : Dealing in spread means trading in
multiple options involving long and short positions. Short position implies
cash inflow in the long position means the cash outflow, resulting in cost
or income at the time of set up. An investor has to determine the additional
parameter of the initial cost or income in setting up of the spread. Since
similar risk profile is obtainable in several way from either put or call one
has to find out a way to create a spread at minimum cost or with maximum
income. A complete understanding of risk profile with the prevailing
market price of various options required.

(2) Initial Margin Requirements : urgent requirement on the position
as independent contract or different than for specific combination of
options. Buyer of the option does not need to bring any margin as he is
under no obligation t o perform. His obligation towards the contract is met
when he pay the required premium. The writer of an option under an
obligation to perform is required to deposit margin with the exchange.
Margin for writer of option or larger for independent single con tract than
for spread which is simultaneous position on several options.

(3) Risk Profile And Selection Of Exercise Prices : an additional
parameter in construction of spread is to know exactly the risk profile
required to be generated which in turn involves selection of particular set
of exercise price out of the many that are available. The liquidity of distant
options and those deep in the money or deep out of the money is over
compared to near option and at the money options. Pricing may be not
competitive for distant and deep in the money options. This restrict the
choice for trade trading, it is suggested to create a spread with frequently
traded options to obtain competitive pricing and necessary liquidity as one
needs to unwind the original spread befor e expiration of option. It is
possible that at around expiration time the combination may become a
liquid and one has to be on constant vigil for unwinding.
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34 5
INTRODUCTION TO OPTIONS
Unit Structure
5.0 Objectives
5.1 Introduction
5.2 Introduction to Options
5.3 Valuation Binominal Model for valuation
5.4 Black and Scholes Model,
5.5 Summary
5.6 Unit End Questions
5.7 References

5.0 OBJECTIVES
After studying thi s unit, you will be able:
 To understand Options
 To discuss valuation Binominal Model for valuation
 To understand Black and Scholes Model,
5.1 INTRODUCTION
A contract known as an option gives its holder the choice to buy or sell an
underlying asset or fina ncial instrument at a predetermined strike price on
or before a specified date, depending on the option's form. This option
may be used before or after the contract's stated expiration date. The spot
price (market price) of the underlying securities or com modity may be
used to determine the option's striking price on the day it is
offered.Alternatives include setting the strike price at a premium or a
reduction compared to the going rate. If the holder "exercises" the option,
the issuer is obligated to exec ute the transaction (either to sell or to buy).
The right to buy at a specific price is granted by a call option, and the right
to sell at a specific price is granted by a put option. Financial derivatives
are a category that includes both of these choices .
5.2 INTRODUCTION TO OPTIONS
As part of another transaction (such the issuance of shares or an employee
incentive programme), an option may be granted to the buyer.
Alternatively, the buyer may pay a premium to the issuer in exchange for
the option. As an alternative, the issuer may decide to provide the buyer
the option. The strike price of a call option normally needs to be less than
the underlying asset's current market value in order to be exercised. In munotes.in

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Introduction to Options
35 contrast, a put option would normally need to hav e a strike price higher
than the asset's current market value in order to be exercised. When an
option is exercised, the holder of the option, in addition to any premium
that is due to the "issuer" of the option, must pay a sum equal to the "strike
price" of the asset being purchased. The option is said to have expired and
the holder's premium payment to the issuer is regarded as having been lost
if the expiry date of the option passes without being exercised. In any
instance, the premium represents income for the issuer but, in the majority
of circumstances, represents a capital loss for the option holder.The owner
of an option may resell that option to a third party in a secondary market
via an over -the-counter transaction or on an options exchange, depend ing
on the type of option. Any of these two options can happen in this
situation. An option drafted in the American manner frequently closely
reflects the market price of the underlying stock.The difference between
the underlying stock's current market pri ce and the option's strike price is
used to determine the market price of the option. The real price of the
option on the market may change depending on a variety of variables. A
substantial option holder who needs to sell the option because the
expiration date is approaching and they lack the funds to exercise the
option is one of these circumstances. A buyer in the market who is aiming
to accumulate a sizable option holding is another factor.Most of the time,
holding an option does not grant the holder an y rights over the underlying
asset, such as voting rights, nor does it grant them any income from the
underlying asset, such as dividends. These are some instances of rights
that are normally not granted by option ownership.
Options on modern stocks and sh ares:
Options -based contracts have been used for many years. When the
Chicago Board Options Exchange was established in 1973, it led to the
development of a system that included the use of standardised terminology
and forms, as well as the trading of asse ts through an insured clearing
house. Since then, both business activity and scholarly interest have
increased. Other OTC options are drafted as bilateral, customised
contracts between a single buyer and seller, either of whom may be a
dealer or market mak er. Today's market features a large number of
standardised options that are created and exchanged via clearing houses on
authorised options exchanges. Options are a type of derivative product,
which is sometimes just called derivatives. Derivatives are a b roader
category of financial instruments than only options.
5.3 VALUATION BINOMINAL MODEL FOR
VALUATION
A common technique in finance for valuing options and other financial
derivatives is the binomial model. It is predicated on the notion that the
price of the underlying asset exhibits discrete binomial distribution. Other
kinds of investments and securities can be valued using the binomial
model.
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36 An explanation of how to apply the binomial model for valuation is given
below:
 Recognise the underlying as set: Establish the details of the asset you
are valuing, including its current price, volatility, dividend yield (if
applicable), and expiration date.
 Decide on the time intervals by dividing the remaining time into a
predetermined number of periods. The m odel's complexity and
necessary accuracy determine how many periods are needed. Every
cycle corresponds to a distinct time step.
 Determine the elements that affect the asset price's upward and
downward movement in each period by computing the up -and-down
factors. These variables are depending on the asset's volatility and the
time frame. Typically, the following formulas can be used to
determine the up factor (u) and down factor (d):
u = exp( σ * √(Δt))
d = 1/u
Where:
σ is the volatility of the asset.
Δt is the length of each time period
 Binomial tree construction: Begin by creating a binomial tree with
the current asset price as the first node. Determine the potential asset
prices base d on the up and down factors for each succeeding period.
As a result, a tree -like structure with numerous nodes reflecting
potential future prices will be formed.
 Calculate option values : Based on the option's payoff at that price,
determine the option val ues for each node starting with the final nodes
(at expiration). A call option, for instance, would have a maximum
payment at each node of zero or the difference between the asset price
and the strike price. The greatest payoff for a put option would be ze ro
or the difference between the strike price and the asset price.
 Move backward through the tree , determining the value of each
option depending on what is anticipated to happen at the next nodes.
This entails utilising a risk -free interest rate to discou nt the anticipated
option values for the following time period.
 Calculate the option value . The calculated option value at the initial
node (beginning point) is the projected fair value of the option or
securities you are pricing.
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37 An Overview of the Funda mentals of the Binomial Option Pricing
Model :
Binomial option pricing models are predicated on the idea that there are
two possible outcomes; this is how the "binomial" part of the model gets
its name. An rise in price or a drop in price are the two outco mes that can
occur when utilising a pricing model.
One of the main advantages of binomial option pricing models is that they
are mathematically simple. However, these models may grow quite
complex when used with data covering multiple time periods.
The bin omial model allows for the computation of both the asset and the
option for many time periods as well as the range of outcomes that are
viable for each time period separately, in contrast to the Black -Scholes
model, which creates a numerical output dependi ng on the inputs.
When employing this multi -period view, one of the benefits is that the
user can see how asset prices vary over time and evaluate the option
based on decisions made at various points in time. The binomial model
might provide information ab out when it might be profitable to exercise
an option with a U.S. basis and when it should be kept on the books for
longer periods of time when it has no expiration date and can be
exercised at any time. At any time, the option may be exercised.
By examini ng the binomial tree of values, a trader can predict when a
decision regarding an exercise may be made. If the value of the option is
greater than zero, it should be held for lengthier periods of time before
being exercised; however, if the value of the op tion is less than zero, it
should be exercised right away.
The Binomial Model's Application to Price Calculation:
Prices for different financial instruments, particularly options and
derivatives, can be determined using the binomial model. Here are some
significant uses of the binomial model in determining prices:
 Option pricing: Both the European and American versions of the
binomial model are frequently used to value options. The approach
builds a binomial tree to represent potential price trajectories fo r the
underlying asset, calculates the option values at each node, and then
works backward to estimate the starting point's fair value of the option.
This strategy considers elements such the strike price, the remaining
time before expiration, volatility, and the risk -free interest rate.
 Bond pricing: Bonds having embedded options, such as callable or
putable bonds, can be valued using the binomial model. The model
determines the bond's value by discounting the anticipated cash flows
at each node of the bin omial tree and treating the optionality as a set of
alternatives. This makes it possible to estimate the bond's price more
precisely while taking the likelihood of early redemption into account.
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38  Convertible securities: The binomial model can be used to va lue
convertible bonds and other convertible securities. The option to
convert the security into common shares at a preset conversion ratio is
included in the model. The binomial model can calculate the fair value
of the convertible instrument by analysing the anticipated cash flows
from the bond's fixed income component and the possible gain from
converting into equity.
 Risk management: The binomial model can be utilised for this purpose
as well. The binomial tree can be used to simulate various price
scena rios and be used to analyse the potential outcomes and related
risks. This enables more informed decisions to be made about risk
reduction, portfolio allocation, and hedging techniques.
 Real options: Real options are investment opportunities that offer
flexibility and the capacity to adjust to shifting market conditions. The
binomial model can be used to value real options. Real alternatives
might be the choice to enlarge, postpone, or drop a project. The
flexibility of the binomial model makes it appropria te for reflecting the
value of various strategies.
Binomial Options Calculations:
Binomial options calculations involve using the binomial model to
determine the value of options at different nodes of the binomial tree. Here
are the key calculations involv ed:
1. Calculation of up and down factors:
 Calculate the up factor (u) and down factor (d) using the formulas: u =
exp(σ * √(Δt)) d = 1/u where σ is the volatility of the underlying asset
and Δt is the length of each time period.
2. Construction of the binomial tree:
 Start with the current price of the underlying asset as the initial node.
 For each subsequent period, calculate the possible asset prices at that
time based on the up and down factors. This involves multiplying the
current asset price by u and d to o btain the upward and downward
price movements.
3. Calculation of option values at expiration:
 Determine the option's payoff at each node at expiration based on the
option type (call or put) and the difference between the asset price and
the strike price.
 For a call option, the payoff at each node is Max(0, asset price - strike
price).
 For a put option, the payoff at each node is Max(0, strike price - asset
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39 4. Calculation of option values at preceding nodes:
 Starting from the final nodes (at expiration), m ove backward through
the tree and calculate the option values at each node.
 For each node, calculate the expected option value as the discounted
value of the expected payoffs at the subsequent nodes.
 The expected option value at each node is given by the f ormula:
Option value = (p * option value up + (1 - p) * option value down) / R
where p is the probability of an up movement, option value up is the
option value at the node representing an upward price movement,
option value down is the option value at the node representing a
downward price movement, and R is the risk -free interest rate.
5. Determination of the option value:
 At the initial node (starting point), the calculated option value
represents the estimated fair value of the option.
 This value takes int o account the discounted expected payoffs at each
node and the probabilities of the different price movements.
The above steps provide a general overview of the binomial options
calculations. It's important to note that the number of nodes in the
binomial tree increases exponentially with the number of time periods,
leading to more complex calculations. Therefore, advanced software or
programming tools are often utilized to implement the binomial model
efficiently.
5.4 BLACK AND SCHOLES MODEL
Option pricing theory determines the value of an options contract by
attaching a price, also known as a premium, to the contract and basing
that price on the likelihood that the contract will expire in the money
(ITM). The main goal of option pricing theory is to estima te an option's
fair value so that traders may incorporate it into their trading plan.
Pricing models, in addition to the current market price and the strike
price, also take into account a variety of other elements when evaluating
an option potentially. Vo latility, interest rates, and the remaining time
before the option expires are some other factors. A few models that are
frequently employed in the process of valuing options include Black -
Scholes, binomial option pricing, and Monte Carlo simulation.
The B lack-Scholes model, also known as the Black -Scholes -Merton
model, is a widely used mathematical model for pricing options and other
derivatives. It was developed by economists Fischer Black and Myron
Scholes in 1973, with contributions from Robert C. Merto n. The model is
based on several key assumptions, including:
1. Efficient markets: The model assumes that markets are efficient,
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40 2. Log-normal distribution of asset prices: The model assumes that the
price of the underlying asset follows a log -normal distribution over
time. This assumption allows for the incorporation of historical price
data and the estimation of future price movements.
3. Constant volatility: The model assumes that the volatility of the
underlying asset's returns is constant throughout the option's life. This
assumption is known as the constant volatility assumption and is an
important factor in option pricing.
4. No dividends: The model assumes that the underlying asset does not
pay any divi dends during the option's life. This assumption simplifies
the calculations but can be adjusted to incorporate dividend payments
if needed.
Option pricing theory describes the method of valuing an options contract
within a probabilistic framework.
 Calculat ing the likelihood that an option will be exercised, commonly
referred to as being in -the-money (ITM), at the time the option's term
expires is the fundamental goal of option pricing theory.
 An increase in an option's maturity or its implied volatility, wi th all
other factors remaining constant, will drive up the price of the option.
 Only a few of the models that are frequently used to value options
include the Black -Scholes model, the binomial tree model, and the
Monte Carlo simulation method.
Acquiring Knowledge of the Option Pricing Theory:
The main goal of option pricing theory is to determine the probability
that an option will be exercised, often known as being in the money at
expiry, and to assign a monetary value to that probability. The
underlying a sset price (such as the cost of a stock), the exercise price, the
volatility, the interest rate, and the time until expiration are often used
variables that are entered into mathematical models to determine an
option's potential fair value. The number of d ays between the
computation date and the day the option may be exercised is referred to
as the time till expiration.
The idea of pricing options also creates a set of risk factors or
sensitivities based on those inputs. These are referred to as an option's
"Greeks," and they are obtained from the inputs. With the help of the
Greeks, traders may assess how sensitive a particular contract is to
changes in price, volatility, and time. This is useful since the Greeks help
traders adjust to changing market condi tions.
The more time an investor has to exercise an option before it expires, the
more likely it is that it will be profitable and in the money. This
demonstrates that, everything else being equal, longer -dated options are
more valuable. Similar to this, m ore underlying asset volatility raises the
possibility of an option expiring in the money. An increase in interest rates
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41 Taking Into Account Particulars:
Marketable versus non -marketable options must be valued using
different methodologies. Real traded options are valued in the open
market, and like the value of any other asset, this value may differ from
what is thought of as the theoretical value of the option. Having access to
the theoretical value of the options allows traders to assess their odds of
profiting from trading such options.
Generally speaking, the pricing model that Fischer Black and Myron
Scholes published in 1973 is credited with being the impetus for the
growth of the modern options ma rket. The Black -Scholes formula is
frequently used to estimate a theoretical price for a financial instrument
whose maturity date is known. However, this is not the only model that
is offered. Also frequently employed are the Monte -Carlo simulation and
the Cox, Ross, and Rubinstein binomial option pricing model.
Applying the Black -Scholes Model of Option Pricing:
Five factors had to be entered into the original Black -Scholes model: the
option's striking price, the stock's current price, the remaining time
before it expires, the risk -free rate of return, and volatility. Future
volatility must be estimated or inferred because it is challenging to make
a firsthand observation of it. Implied volatility is so distinct from
historical volatility or volatility that actually occurred.
The Black -Scholes model, which is widely regarded as one of the most
reliable approaches to pricing, assumes that stock prices follow a log -
normal distribution since asset values can never go below zero. The
model further assumes that t here are no transaction fees or taxes, that the
risk-free interest rate is constant for all maturities, that the funds from
short sales of securities may be used for other purposes, and that there
are no chances for risk -free arbitrage. These additional pr esumptions are
made.
It is quite evident that even the great majority of the time, not all of these
assumptions are true. The model, for instance, assumes that the
underlying volatility of the option won't vary over the length of its
existence. Since volat ility varies according to the amount of supply and
demand, this is an absurd expectation that is rarely, if ever, even close to
being true.
The implied volatility for options is represented graphically throughout
the range of strike prices for options with the same expiration date as the
volatility skew. As a result, some changes will be made to the option
pricing models to account for the volatility skew. The resulting shape
frequently exhibits a skew, sometimes known as a "smile," which shows
that the imp lied volatility values for options that are more out of the
money (OTM) have higher values than those for options with a strike
price that is more closely aligned with the price of the underlying asset.
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42 are of the European type, which means they can only be exercised after
reaching maturity. American -style options may be exercised at any time
up until the day of expiration, including on the day of expiration itself,
although this is not t aken into account by the model. On the other hand,
the binomial and trinomial models can handle every type of option since
they can calculate the value of the option at any given time during the
course of its existence.
Options sensitivity to different var iable
Greeks is a term used in the options market to describe the various types
of risk associated with holding a position, whether it be in a single option
or a portfolio of options. Since the Greek script is frequently employed to
describe the notions th at these variables represent, they are known as
Greeks. Each risk factor results from a flawed premise or an inadequate
connection between the option and one or more underlying factors.
Using a range of Greek values, traders assess the risk of options and
manage option portfolios.
DELTA
The term "delta" () denotes the rate of change between the option's price
and a one -dollar increase or decrease in the value of the underlying asset.
In other words, the degree to which changes in the price of the underlying
affect the option's price. A call option's delta can have a value between 0
and 1, whereas a put option's delta can have a value between 0 and -1.
Consider the situation of a trader who holds a call option with a delta of
0.50. As a result, the price of t he option could climb by as much as fifty
cents if the price of the underlying stock rose by one dollar.
Option traders utilise delta, commonly referred to as the hedging ratio, to
attain a delta -neutral position.
If you purchase a traditional American cal l option with a delta of 0.40, you
will need to sell 40 shares of stock in order to fully hedge your position.
The net delta of an options portfolio can also be used to calculate the
hedging ratio for that portfolio.
Finding the current likelihood that the option will expire with a positive
intrinsic value is a less common use of an option's delta. As an illustration,
a call option with a delta of 0.40 today has a 40% stated chance of
expiring in the money.
THETA
Theta (Θ) represents the temporal sensitivity, or rate of change between
the option price and time. The time decay of an option is another name for
this variable. Theta is the percentage that, if all other variables remained
constant, the price of an optio n would decrease with the length of time left
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43 Consider an investor's position who possesses a long option with a theta of
-0.50. The cost of the alternative would decrease by 50 cents per day if all
other factors stayed constant. If the option was not exercised within three
trading days, its value could decrease by $1.50.
When an option's strike price is closer to its inherent value, theta
increases; when it is further from its intrinsic value, theta decreases. The
temporal decay of optio ns that are approaching their expiration date is
likewise speeding up. When dealing with long calls and long puts, theta is
frequently negative. On the other hand, due to their shortness, short calls
and short puts both have positive Theta. A stock, for in stance, is said to
have a Theta value of zero if it continues to increase in value over time.
GAMMA
The Greek letter gamma (Γ) stands for the rate of change that occurs
between an option's delta and the priceof the underlying asset. Thiskindof
price sensitivity isreferred toassecond -orderor second -derivativeprice
sensitivity. The value of gamma reveals h ow much the delta would shift in
response to a change of onedollarin theunderlyinginvestment.
Suppose an investor purchased one call option and is currently in the black
on the fictitious commodity XYZ. According to the Greek letters, the call
option has a delta of 0.50 and a gamma of 0.10. Therefore, a $1 gain or
decrease in the price of stock XYZ would cause a 0.10 increase or
decrease in the delta of the corresponding call option.
The element that is utilised to evaluate the consistency of a given option 's
delta is gamma. The delta may change dramatically in response to even
relatively small changes in the price of the underlying asset, according to
higher gamma values. Gamma grows larger as the expiration date
approaches and is highest for options that a re more likely to be "at the
money" compared to options that are either more likely to be "in the
money" or more likely to be "far from the money."
Gamma levels are normally lower the further away you are from the
expiration date. This corresponds to choic es having longer expiration dates
being less sensitive to delta changes. Gamma levels tend to rise as the
expiration date approaches because the impact of price movements on
gamma becomes more pronounced.
Option traders who want to be delta -gamma neutral m ay chose to hedge
not just the delta but also the gamma. This indicates that the delta will
remain generally steady at a value close to zero regardless of how much
the underlying price moves.
VEGA
The rate of change between an option's value and the implie d volatility of
the underlying asset is represented by the variable Vega (V). The
sensitivity of the option to volatility changes is seen by this. The Vega munotes.in

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44 value indicates how much an option's price changes in reaction to a 1%
change in its implied volatil ity.
For example, a Vega of 0.10 indicates that the option's value is expected to
change by 10 cents if the implied volatility rises by 1%.
An increase in the underlying instrument's volatility raises the option's
value directly since it means that the und erlying instrument is more likely
to experience values that are at either extreme. On the other side, if the
volatility of the underlying asset decreases, the option's value declines.
Vega has achieved its maximum level for options that are currently
profi table but have some time left before they expire.
RHO
The symbol Rho (p) denotes the rate of change that occurs between the
value of an option and a change ofone percentage point in the interest rate.
This determines how sensitive the asset is to changes i n the interestrate.
Take, for instance, a call option with a price of $1.25 and a rho of 0.05 as
an example. If there is nochange to any other factor, the value of the call
option would remain the same at $1.20 even if there was a1% increase in
interest ra tes. For put options, the situation is exactly the reverse. The best
use of Rho is foroptions that arealreadyprofitable but havealongwayto go
beforetheyexpire.
5.5 SUMMARY
 Put-call parity provides an iron law connecting the values of put and
call options w ithout instructing us on how to price either, making it a
typical illustration of arbitrage -based pricing.
 In accordance with the put -call parity, the price difference between a
call option and a put option with the identical terms should be equal
to the v alue of the underlying asset less the present discounted value
of the exercise price.
 In finance, the binomial options pricing model offers a generalizable
numerical method for valuing options.
 The binomial model was first put forth by Cox, Ross, and Rubin stein
in 1979.
 The Black -Scholes model, also referred to as Black -Scholes,
illustrates how the cost of financial instruments, especially stock
options, varies over time.
5.6 UNIT End Questions
A. Descriptive Questions:
Short Answers:
1. ExplainindetailBlack -Scholesoptionpricing. munotes.in

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45 2. Explainin detail binomialoption pricingmodel.
3. Discuss acquiringKnowledgeoftheOptionPricingTheory.
4. Write note on DELTA.
5. What is THETA?
B. Fill in the blanks:
1. The value of theta (Θ) denotes the rate of change between the option
price and time, also known as …………..
2. The Greek letter gamma is denoted by……...
3. …………….indicates the sensitive of option in respect to changes in
volatility.
4. The rate of change that occurs between the value of an option and a
change ofone percentage point in the interest rate is ………….
5. The binomial option pricing model makes useof an iterative approach,
which enables the definition ofnodes,alsoknownas……………...
Answers :
1 timesensitivity, 2 - Γ, 3- VEGA , 4-RHO , 5- pointsintime
5.7 REFERENCES
References book
 Derivatives Market NCFM Module. National Stock Exchange India
Limited Publications : Bombay : 2007.
 Gupta S. L (2007). Financial Derivatives Prentice Hall. New Delhi.
 Indian Stock Market Review. National Stock Exchange Publications.
 Jaynath Rama Varma (2008). Derivatives and Risk Management.
Tata Mc Graw Hill Publications : New Delhi

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46 6
RISK MANAGEMENT
Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Hedging Using Greeks (Delta - Gamma Hedging)
6.3 Hedging with Futures (Strategies of Hedging, Speculation And
Arbitrage)
6.4 Advantages and disadvantage of Risk Management
6.5 Risk Manag ement Process
6.6 Risk Management Structure and Policies in India
6.7 Reasons for Managing Derivatives risk
6.8 Types of risk in Derivatives Trading
6.9 Summary
6.10 Unit End Questions
6.11 References
6.0 LEARNING OBJECTIVES
After studying this unit, you will be able to:
 Describe hedging using Greeks (Delta - Gamma hedging)
 Explain hedging with futures
 Describe strategies of hedging
 State the benefits of speculation and arbitrage in futures
 Define index options and futures
 Describe VaR and historical simulation
 Discussr is k management structure and policiesin India
6.1 INTRODUCTION
What Is Risk Management?
Risk management is the process of recognising, assessing, and either
accepting or mitigating the effects of uncertainty in investment decision -
making. In its mos t basic form, risk management is the process by which a
fund manager or investor examines and attempts to quantify the possibility
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47 whether to take the appropriate action (or not) in li ght of the fund's
investment objectives and level of risk tolerance.
Risk and reward are mutually exclusive. There is always some risk
associated with investments, whether it be nearly zero in the case of a U.S.
T-bill or overly high in the case of somethi ng like emerging -market stocks
or real estate in an inflationary environment. Risk can be measured in
absolute or relative terms depending on the circumstance. Investors may
find it advantageous to have a wide grasp of risk in all of its numerous
manifesta tions in order to better appreciate the potential outcomes, trade -
offs, and costs linked to the various investing approaches.
 Recognising, assessing, and either accepting or mitigating the effects of
uncertainty in financial decision -making is the process of risk
management.
 In the realm of finance, return cannot be calculated without taking risk
into account.
 One of the most popular methods for assessing risk is the use of
standard deviation, a statistical indicator of dispersion relative to a
central tend ency.
 The volatility of a single stock, also known as its systematic risk, is
compared to the volatility of the entire market using a statistic called
beta, which is frequently referred to as market risk.
 Money managers that employ active methods in an eff ort to outperform
the market are susceptible to alpha risk because alpha is a gauge for
excess return.UnderstandingRiskManagement:
Risk management is the process of identifying, assessing, and mitigating
potential risks in order to protect assets, investme nts, or business
operations. It involves analyzing uncertainties and implementing strategies
to minimize the negative impact of risk events and maximize
opportunities.
 Risk identification: The first step in risk management is identifying and
recognizing po tential risks. This involves assessing internal and
external factors that could lead to adverse outcomes. Risks can be
categorized into various types, such as operational, financial, strategic,
compliance, legal, or reputational risks.
 Risk assessment: Onc e risks are identified, they need to be evaluated to
understand their potential impact and likelihood of occurrence. This
step involves analyzing the probability of risks happening and assessing
the potential magnitude of their impact. Risk assessment help s
prioritize risks and determine where resources should be allocated for
mitigation.
 Risk mitigation: Risk mitigation involves developing strategies to
reduce the likelihood or impact of identified risks. This can include
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48 and procedures, diversifying investments, hedging against potential
losses, or transferring risk through insurance or contracts. The goal is to
proactively manage risks and minimize their potential negative
consequences.
 Risk monitoring: Risk management is an ongoing process that requires
continuous monitoring and evaluation. Regularly assessing the
effectiveness of risk mitigation strategies and monitoring changes in the
risk landscape allows for timely adjustments and ad aptations. This
includes staying updated on industry trends, regulatory changes, and
emerging risks that may impact the organization or investment
portfolio.
 Risk communication: Effective risk management involves clear and
transparent communication of risk s to stakeholders, including
management, employees, investors, and customers. Open
communication channels facilitate a shared understanding of risks and
encourage proactive risk management efforts throughout the
organization. Risk communication also helps manage expectations and
build trust.
 Risk response planning: In addition to mitigating risks, organizations
should also develop plans for responding to risk events if they occur.
This includes establishing protocols and procedures to address and
recover fr om risk incidents, ensuring business continuity, and
minimizing disruptions.
 Risk culture and awareness: Risk management is not solely the
responsibility of a dedicated risk management team. It is important to
foster a risk -aware culture throughout the org anization, where
employees at all levels are educated about risks, encouraged to report
potential risks, and empowered to contribute to risk mitigation efforts.
Promoting risk awareness and integrating risk management into
decision -making processes strengt hens the organization's resilience.
How Risk Management Works:
Risk management works by systematically identifying, analyzing, and
addressing potential risks to minimize their impact on an organization or
investment portfolio. Here's a step -by-step overvie w of how risk
management typically works:
 Risk identification: The first step is to identify and understand the
risks that could affect the organization or investment portfolio. This
involves conducting risk assessments, reviewing historical data,
analyzin g industry trends, and engaging with stakeholders to identify
potential risks.
 Risk assessment: Once risks are identified, they need to be assessed in
terms of their potential impact and likelihood of occurrence. This step
involves evaluating the severity of each risk and estimating the
probability of it happening. Various tools and techniques, such as risk munotes.in

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49 matrices or qualitative/quantitative analysis, can be used for risk
assessment.
 Risk prioritization: After assessing the risks, they need to be
prioriti zed based on their significance and potential impact. This helps
determine which risks require immediate attention and allocation of
resources for mitigation.
 Risk mitigation: Risk mitigation involves developing strategies and
implementing measures to redu ce the likelihood or impact of identified
risks. This can include implementing controls, establishing risk
management policies and procedures, diversifying investments,
hedging, or transferring risk through insurance or contracts.
 Risk monitoring and contr ol: Once risk mitigation strategies are in
place, it is crucial to continuously monitor the risks to ensure the
effectiveness of the implemented measures. Regular monitoring helps
identify changes in risk profiles, detect emerging risks, and assess the
performance of risk controls. Adjustments to risk management
strategies can be made based on the monitoring results.
 Risk reporting and communication: Effective risk management
involves clear communication of risks and their status to relevant
stakeholders. T his includes regular reporting to management, boards of
directors, investors, and other stakeholders. Transparent
communication enables informed decision -making, fosters
accountability, and ensures a shared understanding of risks across the
organization.
 Risk review and improvement: Risk management is an ongoing
process that requires periodic review and improvement. Regular
evaluations and audits of risk management processes help identify areas
for improvement, assess the effectiveness of risk controls, and align
risk management practices with changing business or market
conditions.
 Integration with decision -making: Risk management should be
integrated into the decision -making processes of an organization or
investment strategy. This ensures that risks are c onsidered when
making strategic choices, setting objectives, and evaluating potential
opportunities.
Risk management and psychology:
Risk management and psychology are closely intertwined as human
behavior and cognitive biases play a significant role in ho w risks are
perceived, evaluated, and managed. Here are some key aspects of the
relationship between risk management and psychology:
 Perception of risk: The way individuals perceive and interpret risks
can be influenced by psychological factors. People may overestimate or
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50 emotions, biases, and heuristics. Understanding these cognitive and
emotional factors is crucial for effective risk management as it helps
identify potential gaps in risk per ception.
 Behavioral biases: Behavioral biases are systematic patterns of
deviation from rational decision -making that can affect risk
management. Common biases include loss aversion, where individuals
emphasize avoiding losses more than acquiring gains, an d
overconfidence, where individuals tend to overestimate their abilities
and underestimate risks. These biases can lead to suboptimal risk
assessment and decision -making if not recognized and addressed.
 Risk tolerance and risk appetite: Risk tolerance refe rs to an
individual's or organization's willingness and ability to take on risk,
while risk appetite refers to their desired level of risk exposure. These
concepts are influenced by psychological factors such as risk aversion,
financial goals, past experie nces, and emotional biases. Understanding
these psychological drivers is important for aligning risk management
strategies with the risk preferences of stakeholders.
 Decision -making under uncertainty: Risk management involves
making decisions in the face o f uncertainty. Psychological factors, such
as ambiguity aversion and the framing effect, can influence how
decisions are made. For example, individuals may be more risk -seeking
when decisions are framed in terms of potential gains rather than
losses. Under standing these biases can help in designing effective
decision -making processes and risk management strategies.
 Herd behavior and group dynamics: Human beings are social
creatures, and herd behavior can impact risk management. People often
look to others f or guidance and tend to follow the actions of the crowd,
even if it may not be rational. This can lead to the underestimation or
neglect of certain risks. Recognizing the influence of group dynamics
and promoting independent thinking within risk management processes
can help mitigate the impact of herd behavior.
 Emotional factors and risk aversion: Emotions can significantly
impact risk management. Fear, anxiety, and other emotions can lead to
risk aversion and a preference for certainty, potentially hinder ing the
ability to take calculated risks. Conversely, excessive optimism or
greed can lead to excessive risk -taking. Effective risk management
requires acknowledging and managing emotional factors to ensure
rational decision -making.
 Communication and risk framing: Effective communication is
crucial in risk management. The way risks are communicated can
influence how they are perceived and understood by stakeholders. The
framing of risks, the use of visual aids, and clear, concise messaging
can help overcome psychological barriers and improve risk
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51 6.2 HEDGING USING GREEKS (DELTA -GAMMA
HEDGING)
What Is Gamma Hedging?
Gamma hedging is an options trading strategy that aims to manage the risk
associated with changes in the delta of an options position. Delta measures
the sensitivity of an option's price to changes in the price of the underlying
asset. Gamma, on the other hand, measures the rate at which the delta of
an option changes as the price of the underlying asset moves.
When an options trader eng ages in gamma hedging, they take offsetting
positions in the underlying asset or other options contracts to maintain a
neutral or desired delta position. The purpose of gamma hedging is to
minimize the impact of changes in the underlying asset's price on t he
overall options position.
KEY TAKE AWAYS:
 Gamma hedging is a sophisticated options strategy that can be used to
lessen the exposure of an option position to significant changes in the
underlying securities.
 Gamma hedging is also employed at option expir y to guard against the
effects of abrupt changes in the price of the underlying asset that could
happen as the option's expiration date approaches.
 Gamma and delta hedging are frequently used in conjunction with one
another.
How the Gamma Hedging Strategy Operates:
 Initial position: The trader starts with an options position, which
includes a combination of call and/or put options on a particular
underlying asset.
 Delta monitoring: As the price of the underlying asset changes, the
delta of the options posit ion also changes. The trader closely monitors
the delta to track the sensitivity of the options to changes in the asset's
price.
 Adjusting the hedge: When the delta changes, the trader executes
offsetting trades in the underlying asset or other options to adjust the
delta back to the desired neutral position. This involves buying or
selling the underlying asset or options contracts in such a way that the
overall delta of the position remains within the desired range.
 Delta -neutral position: The goal of gamm a hedging is to maintain a
delta -neutral position. A delta -neutral position means that the overall
delta of the options portfolio is zero or close to zero, indicating that the
options position is less sensitive to changes in the underlying asset's
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52  Continuous monitoring and adjustment: The trader continues to
monitor the delta and gamma of the options position and adjusts the
hedge as needed. This ensures that the overall position remains delta -
neutral and mitigates the risk of significant losses due to changes in the
underlying asset's price.
Gamma hedging is particularly useful in situations where options traders
want to manage their exposure to price movements while maintaining a
specific risk profile. By adjusting the delta through gamma hedging,
traders can potentially reduce the impact of price changes and achieve a
more stable options portfolio.
Gammavs. Delta:
Gamma is a common variable in the Black -Scholes Model, which was the
first formula to be accepted as a benchmark for pricing options. The name
of this variable was derived from the Greek characters.
The rate at which the delta of an option changes in response to changes in
the price of an underlying stock or other asset is measured by gamma.
Gamma can also be used to define the rate at whic h an option's delta
changes. The simplest definition of gamma is the rate of change in the
price of an option. Gamma, on the other hand, is also thought of by some
investors as the projected price shift that comes after the second
successive one -dollar cha nge in the price of the underlying asset.
Consequently, to the first equation, you would need to add gamma and
delta.
Delta -GammaHedging:
In order to lessen the risk of changes in the underlying asset as well as the
risk of changes in the delta itself anyt ime the underlying asset is in motion,
one type of options technique called delta -gamma hedging combines delta
hedging with gamma hedging. When delta hedging is utilised alone, a
position is protected from even little fluctuations in the value of the
under lying asset. However, substantial changes will result in the hedge
shifting (changing the delta), leaving the position exposed to risk. Even
after a gamma hedge is added, the delta hedge is kept in place.
Every time the delta of the underlying asset change s when an investor
utilises a gamma hedge in addition to a delta hedge, the investor must
create new hedges. The number of underlying shares that are bought or
sold in the context of a delta -gamma hedge depends not only on whether
the price of the underlyi ng asset is rising or dropping, but also on how
much it is changing.
When making a transaction, a trader who is seeking to be delta -hedged or
delta -neutral would often make atrade that has very little change
depending on the short -term price volatility of a lesser magnitude. A trade
ofthis kind is often a wager on the likelihood that volatility, or, to put it
another way, demand for the optionsassociated with that asset, would
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53 evenusing delt a hedging will not provide a great deal of protection for an
options trader on the day before thecontract expires. On this day, the effect
of even a moderate price movement in the underlying asset might produce
extremely big price fluctuations in the optio n. Thisis dueto thefact that
there is such little time
remaining before the option expires. Under these conditions, delta hedging
is not an adequater is k management strategy.
Gamma hedging is a strategy that is combined with delta hedging to
safeguard the trader from more significant than anticipated changes to a
security or perhaps the entire portfolio. Gamma hedging is most frequently
employed, nevertheless, to guard against the effects of a sudden change in
the option's price after the time value has al most entirely depleted.
6.3 HEDGING WITH FUTURES (STRATEGIES
OFHEDGING, SPECULATIONANDARBITRAGE)
Comparing Hedging and Speculation : An Overview:
The phrases "speculators" and "hedgers" are used to designate a specific
type of trader or investor. Both hedging and speculating are strategic
investing practises. Although speculating and hedging are both rather
intricate strategies, they couldn't be more dissimilar from one another.
In contrast to speculating, which aims to benefit from a security's price
shift, he dging attempts to reduce the risk or volatility associated with a
security's price variation.
An investor may lessen the risk of price swings associated with the asset
in question by taking positions in an asset that are symmetrical to those
that the inves tor already has, a practise frequently referred to as "hedging."
The fundamental objective of speculation, in contrast, is to generate profits
through the placement of wagers on the future course of an asset.
KEY TAKE AWAYS:
 Hedging and speculating are two separate types of investing strategies.
 Hedging, often known as "off setting positions," is a strategy used to
reduce price volatility associated with a certain asset by holding
holdings that are the opposite of those that an investor already holds.
 Specu lation is the action of trying to profit from a security's price
fluctuation and is more vulnerable to market gyrations.
 Conversely, hedgers are viewed as risk -averse, whilst speculators are
perceived as risk -takers.
 Hedging and diversity, though they are two separate tactics, both work
to lower risk through counter balancing and other strategies.
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54 HEDGING
Investors may occasionally take what is known as a "offsetting position"
in an investment to protect themselves against future gains or losses in the
value of the underlying asset. The stance that supports the derivative is
also frequently referred to as the opposing position. By keeping a position
that is against the market's expectation in the hopes of "covering all their
bases," hedgers try to protect t hemselves from the asset's price shifting in
any direction.
The ideal situation when it comes to hedging would be to figure out a
method to have one consequence balance out another. It is a method
designed to lessen or get rid of risk.
Consider a company t hat specialises in the manufacture of jewellery and
has a substantial order that is due in six months and requires a sizable
quantity of gold. The company is worried about the volatility in the gold
market and anticipates that gold prices will probably inc rease dramatically
in the not too distant future. To protect itself against the danger brought on
by the uncertainty, the firm has the option of buying a gold futures
contract for a six -month term. In this way, if the price of gold increases by
10%, the fu tures contract will lock in a price that is high enough to cover
the increase.
As can be seen, hedgers are protected from any possible losses, but this
protection means that their prospective earnings are constrained. Despite
being diversified, the portfol io is never the less exposed to systemic risk.
A corporation may choose to hedge against specific business operations in
order to smooth out fluctuations in its profit and safeguard itself from any
potential losses, taking into account its internal regulat ions and the nature
of the business it conducts.
The investor hedges their portfolio by selling short futures contracts on the
market and buying put options as a hedge against their long holdings in
order to lessen the impact of this risk on their investme nts. However, if a
speculator is paying attention to this situation, they may want to think
about shorting an exchange -traded fund (ETF) and a market futures
contract in order to potentially profit from a decline in the market price.
SPECULATION
Speculatio n refers to the act of engaging in risky financial transactions or
investments with the aim of profiting from short -term price fluctuations or
market movements. Speculators typically take positions in assets such as
stocks, bonds, commodities, currencies, or derivatives, with the
expectation of capitalizing on price changes.
 Timeframe: Speculation focuses on short -term price movements and
takes advantage of market inefficiencies or perceived opportunities.
Speculators often aim to profit from price fluctuat ions over days,
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55  Risk and Reward: Speculation involves a higher level of risk
compared to traditional investment strategies. Speculators seek above -
average returns, but they also face the poten tial for significant losses.
The risk -reward tradeoff in speculation is generally higher due to the
short -term nature of positions and the potential volatility of markets.
 Information and Analysis: Speculators rely on various sources of
information, market analysis, and forecasting techniques to make
informed decisions. They may consider technical indicators,
fundamental analysis, market sentiment, and other factors to assess
potential price movements and identify trading opportunities.
 Leverage and Derivat ives: Speculators often use leverage, which
involves borrowing funds to amplify potential returns. Leverage can
increase profitability but also magnify losses. Additionally, speculators
may utilize derivatives such as options, futures, or contracts for
difference (CFDs) to gain exposure to underlying assets without
owning them directly.
 Market Liquidity: Speculators tend to operate in liquid markets where
buying and selling assets can be easily executed. Higher liquidity
allows for efficient entry and exit from positions, enabling speculators
to respond quickly to market developments and capitalize on price
movements.
 Market Participants: Speculators can include individual traders,
hedge funds, proprietary trading firms, and institutional investors. They
play a role in providing liquidity to markets and contribute to the price
discovery process.
 Market Efficiency: Speculation is based on the belief that markets are
not always perfectly efficient and that there are opportunities to profit
from mispriced assets . Speculators seek to exploit market inefficiencies
and generate profits by correctly predicting short -term price
movements.
ARBITRAGE
Arbitrage is something that can be seen pretty often among institutional
investors and hedge funds, and itcarries a manag eable level of risk. A big
holding in a securities that is traded in two distinct marketplaces at
different prices is required for this sort of approach to be implemented
successfully. The investor will purchase it at a low price on one market
and then sel l it for a price that is somewhat higher on another market; this
will allow them to make a profit off of the difference in price between the
two markets. As aresultof thenatureof thismethod, it is not oftenused
byindividual investors workingonasmall scale. Arbitrage refers to the
practice of simultaneously purchasing and selling an item in the hope of
making aprofit from very minor variations in price. Because of the
market's in efficiencies, arbitrage is a strategy that may be used.
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56 The term "arbitrageurs " refers to individuals who routinely purchase
stocks on one market, such as the New York Stock Exchange (NYSE), and
simultaneously sell those same stocks on another market, such as the
London Stock Exchange. The LSE provides an illustration of how
arbitra ge operates. In contrast to London, where the stock would be traded
using British pounds, the stock would be traded in the United States using
US dollars. This typically happens very quickly, and once it has been
taken advantage of, the opportunity is gone .
A number of variables, such as market inefficiencies, pricing
discrepancies, and even changes in the dollar -to-pound exchange rate,
could momentarily affect the values of the same stock. Arbitrage is not
always limited to using the same instrument. Contr arily, arbitrageurs have
the opportunity to profit on the expected correlations between similar
financial instruments, such as gold futures and the price at which actual
gold is exchanged.
When carried out properly, arbitrage, which is buying and selling a n asset
at the same time, essentially serves as a form of hedging and subjects its
participants to a low amount of risk. Keep in mind that constrained does
not always equate to inconsequential. Even though there is a chance that
losses could result from ve ry small price changes, other risks, such a drop
in the value of a currency, could be far more serious. Traders must alter
their conditions in order to increase their chances of profiting from
arbitrage because it carries some risk.
Arbitrageurs frequently take very large stakes in the markets because they
want to profit from relatively small price fluctuations. Due to their
significant market holdings, individual investors frequently choose not to
engage in arbitrage. On the other hand, the most frequent u sers of this
strategy are hedge funds and other significant institutional investors.
6.4 ADVANTAGES AND D ISADVAN TAGE OF RISK
MANAGEMENT PROCESS
Advantages of Risk Management:
The process of risk management is regarded as a crucial discipline that the
busin ess has developed recently. Businesses frequently recognise the
benefits of enterprise risk management. A few advantages of risk
management in projects are listed below:
1. Benefits of risk identification:
Risk assessment contributes to the promotion of al ertness in times of
peace and calm in times of disaster. It implies that every risk from the past
that is most likely to occur is planned to happen without any underlying
presumptions.
The majority of incidents frequently fall under these positive risks. I t
assists in reducing opportunity risks so that one is aware of impending
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57 2. Benefits of risk assessment:
It focuses on the activities that have been recognised as assisting with a
project's or business's effect. The primary focus of this phase is on the
concepts that the stakeholders have investigated. The ability to handle
resolved difficulties with a greater selection of alternative solutions is the
biggest advantage.
3. Treatment of risks:
It assists in controlling personal risks, which are nece ssary for
implementing a strategy. Internal compliance is put into place and used to
mitigate the effects of the stopped acts.
Lack of preparation results in the opportunity being wasted, which is made
even clearer by the profitable data that internal cont rols liberate.
4. Minimization of risks:
The company operations foresee the risks that are taken into account in the
offered assessment plans. It allows for quicker updating of policies and
contingencies that have been successfully applied inside the mappe d
business functions.
Here, the cost -benefit analysis needs to be revised due to the risk
ownership. It focuses on the alteration of rules within the complex
structural behaviour.
5. Awareness about the risks:
The phrases that stand out in this context wil l increase awareness among
the planned terms of risks and lead to a successful analysis and evaluation
of exercising the risk module.
It enables one to concentrate on the risk management strategies built into
the lessons gained and scheduled into a lack of preparation. There are
additional phases for each module within the identified data.
6. Successful business strategies:
The most current state determines the grade points, and the risk
management plan is a continuous process. From inadequate planning,
preparation, and successful execution of all tactics, there are numerous
stages that range in severity.
The decrease of negative risks results in operational effectiveness. It has
varying policies regarding how commerce is conducted and how therapy is
deliver ed.
7. Saving cost and time:
Projects and other firm strategies are at risk because of the task that is
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58 used things are always saved. It decreases waste and the time needed to
prepare for fighting fires.
8. New opportunities:
The opportunities are growing because of the new ways of discussing the
unresolved difficulties.
Most of the scenarios match up with their least significant component and
aggregate. It gets ready for new proj ects and the demanding inputs that go
along with them.
9. Harvesting knowledge:
The knowledge of the stakeholder's experience with the preemptive
approach, which is employed for the unprepared threats and which
provides a template to deal with the ready -made risks, must be applied in
this situation.
It has continual tactics that are used from the start to the point of
widespread comprehension.
10. Safeguarding resources
The risk management strategies and tactics outlined below help to protect
the organizati on's assets. This promotes the resources rather than utilising
them unlawfully.
Among the flexible alterations to the employee options, it also offers
safety with the other resources. It develops rerouting process production
and backup plans.
11. Improveme nt in credit ratings:
The increase in credit ratings causes many organisations that support the
finished operations to change, which reduces budget investments.
It has increased confidence issues as a result of its capital volatility,
particularly with sta keholders. It aims to provide a variety of commercial
aspects that actually provide benefits.
12. Compliance with regulations
This framework complies with regulatory criteria. It collects measures and
handles hazards. Better credit features are now simpler to acquire thanks
to this improvement.
In terms of capital turbulence and even the grading standards applied to
the paid business plans, it also generates improved efficiency. The insured
firm experiences a rise in stakeholder confidence as a result.

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59 13. Values shareholders:
It focuses on the ability of the shareholder who makes a major
contribution to management and assumes the key roles that the company
can play in extending credit.
It features the precise decision -making procedure used in the present
models as well as the anticipated hiring of regulatory personnel.
14. Risk possibilities:
It identifies the plainly visible risk potentials that are under control based
on the significance or impact of the organization's updated risk
management plans. Th e actual balance sheets that support the risk
management culture are revealed.
It alters the desired data as well as the approach to balancing insight and
determining compatibility. It supports all of the requirements for a typical
plan.
15. Faster competi tion:
If the organisation makes contributions at multiple budget levels utilising
individuals with a variety of skill sets, the organisation will be more
committed to the task.
It gains a competitive advantage on the better logic schedules. Risk
management is at its most complex level. These contests are held in the
midst of all of life's highs and lows.
16. Offers assistance:
It helps the company manage the risks connected to both the success and
failure of financial plans.
The benefits of financial risk management in this case are not completely
appreciated, both in terms of boosting the likelihood of making the
acquisition and achieving a potential breakthrough in the supply chain. It
has provided concentrated support for the chances of executing the
financial actions that were budgeted.
17. Identification of risks:
A risk management system assists in identifying the threats that have a
precise network in order to determine the best strategy to manage risks. It
has a greater potential for the risks relate d to putting the provided advise
into practise.
When the risks are identified, the entire company provides thorough
support. It will be simplified and improved within the challenging
elements.
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60 18. Provides guidance:
It offers advice in advance on analysin g the risks that are modelled within
the strategies of risk and using the framework that is enabled within the
experience.
It has developed cutting -edge risk management strategies that are
connected to other risks and the effects of newly acquired knowledg e.
19. Identification of possible threats:
This identification provides uninteresting tasks to make up for it and
motivate personnel to learn about the resulting changes.
Research and the development of strategies for maintenance
implementation take time. It helps the staff become accustomed to the
scheduled time.
20. Reduces impact and loss:
When there is a pre -planned schedule or an object loss, risk management
procedures are more clearly specified. It makes stress and concern worse
in some ways. When the y are assembled, complexity matters.
Here, it guarantees that the business will receive all potential results of the
impartial assessments that are examined while taking on problems.
21. Stability of earnings:
The business operations that are held within t he next operation level will
concentrate more on the scheduled amount of data.
It reduces the impact of business activities. Employees will be retrenched
so as to keep in the comfort zone.
Disadvantages of Risk Management Process:
Managing risks results in time loss as compensation for projects. It
convinces projects that are reciprocal to increase the money in the
business. It is used for the investigation and advancement of the specified
problems that support project management.
1. Complex calculations:
It reduces the impact of business activities. Employees will be retrenched
so as to keep in the comfort zone
Complicated calculations are necessary when it comes to risk
management. Without automated technologies, estimating risks becomes
difficult in every circumstance.
2. Unmanaged losses:
If a loss is interfered with by the firm, such compensation will be given to
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61 The organisation in this instance is responsible for the loss that happened
as a result of a flawed risk management sch edule.
3. Ambiguity:
Even if the uncertainty causes a loss, the people must make up for it from
discounts within the allocated amount and even take unnecessary
insurance discounts into account.
4. Depends on external entities:
Typically, risk management de pends on outside information and outside
parties that are controlled within the company.
It offers all necessary information regarding the risks provided by other
trustworthy sources. The transferrable resources are dependent on other
parties who frequentl y possess data.
5. Mitigation:
Typically, risk management is made better by mitigating losses from
concealed financial impairment. As a result, accepting riskier data and rare
business losses result.
6. Difficulty in implementing:
Information about strateg ic strategies is difficult to acquire for risk
management. According to monetary values, it has universal norms that
are moderated and approved.
It is compatible with a firm understanding without current experience and
the necessary amount of data.
7. Perf ormance :
Risk management keeps control over prospects inside each issue because
it can only be dealt with subjectively. It is identifiable by the difficult
controls implementation.
The incomplete cost -benefit analysis is managed. This process is mainly
concerned with establishing controls.
8. Potential threats:
These potential threats need to be carefully maintained if they're to
organise and disappear from the market. This tactic reduces risk while
enhancing control over it proportionally.
For project risk management, each method has advantages and
disadvantages of its own. Therefore, focusing on risk -mitigation tactics
that benefit risk -takers is essential for developing an efficient risk
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62 Risk management becomes a significant concern when a corporation has
defined objectives in addition to potential risks, damages, and
vulnerabilities.
6.5 RISK MANAGEMENT PROCESS
The risk management process in volves a systematic approach to
identifying, assessing, mitigating, and monitoring risks within an
organization. While specific steps may vary depending on the context and
industry, the general risk management process typically includes the
following stage s:
Risk Identification:
 Identify and document potential risks that may affect the organization's
objectives, projects, or operations.
 Utilize various techniques such as brainstorming, checklists,
interviews, and historical data analysis to identify risks.
 Categorize risks into different types such as strategic, financial,
operational, compliance, or reputational risks.
Risk Assessment:
 Evaluate the likelihood and potential impact of identified risks.
 Assess the significance of risks by considering their pot ential
consequences on objectives, financials, resources, or stakeholders.
 Prioritize risks based on their level of severity and potential impact to
focus resources on the most critical risks.
Risk Mitigation:
 Develop strategies and plans to manage and mit igate identified risks.
 Determine appropriate risk responses for each identified risk, including
avoidance, reduction, transfer, or acceptance.
 Implement control measures, safeguards, or risk mitigation actions to
minimize the probability or impact of risk s.
 Consider risk transfer mechanisms such as insurance, contracts, or
hedging strategies where applicable.
Risk Monitoring and Communication:
 Regularly monitor and review risks to ensure the effectiveness of risk
mitigation measures.
 Establish key risk ind icators (KRIs) or metrics to track and measure the
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63  Communicate risk information and updates to relevant stakeholders,
including management, employees, and external parties as necessary.
 Foster a risk -aware culture by promoting awareness, t raining, and
continuous improvement in risk management practices.
Review and Adaptation:
 Periodically review and reassess the risk management process to
identify areas for improvement.
 Incorporate lessons learned from previous risk events or incidents into
the risk management framework.
 Stay updated with changes in the internal and external environment that
may impact risk profiles.
 Adjust risk mitigation strategies and plans as needed to address
emerging or evolving risks.
Effective risk management require s ongoing commitment and
involvement from all levels of an organization. It is an iterative process
that should be integrated into the overall decision -making and operational
processes to ensure risks are proactively identified, assessed, and managed
to protect the organization's objectives and enhance its resilience.
6.6 RISK MANAGEMENT STRUCTURE AND
POLICIES IN INDIA
In India, risk management structure and policies vary across different
sectors and organizations. However, there are certain guidelines and
regulations established by regulatory authorities that provide a framework
for risk management practices. Here are some key aspects of risk
management structure and policies in India:
Regulatory Framework:
 The Reserve Bank of India (RBI) is the primary regulat ory authority for
risk management in the banking sector. It issues guidelines and
directives to banks and financial institutions regarding risk
management practices, including credit risk, market risk, liquidity risk,
operational risk, and more.
 The Insura nce Regulatory and Development Authority of India
(IRDAI) oversees risk management in the insurance sector and sets
regulations for insurers to manage risks effectively.
Risk Management Committees:
 Many organizations, particularly in the financial sector, establish
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64  These committees are responsible for setting risk management policies,
reviewing risk exposures, ensuring compliance with regulations, and
making informed decisions to mitigate ris ks.
Risk Management Policies and Frameworks:
 Organizations are required to develop and implement risk management
policies and frameworks tailored to their specific industry, size, and
risk profile.
 These policies outline the risk appetite of the organizati on, risk
assessment methodologies, risk mitigation strategies, and reporting
procedures.
 The policies should align with regulatory requirements and
international best practices.
Risk Assessment and Reporting:
 Organizations are expected to conduct regular r isk assessments to
identify, assess, and quantify risks.
 Risk assessment methodologies may include scenario analysis, stress
testing, and sensitivity analysis to evaluate potential impacts on
financials, operations, and other aspects.
 Reporting mechanisms are established to communicate risk exposures,
mitigation measures, and overall risk profile to relevant stakeholders,
including management, board of directors, and regulatory authorities.
Risk Mitigation Measures:
 Risk management policies emphasize the im portance of implementing
appropriate risk mitigation measures.
 This may involve implementing internal controls, adopting risk transfer
mechanisms such as insurance, diversifying risk exposures, and
ensuring robust business continuity and disaster recovery plans.
Training and Awareness:
 Organizations in India promote risk management training and
awareness programs to build a risk -aware culture among employees.
 Employees are educated about risk management concepts, policies, and
procedures to enhance their un derstanding of risks and their role in
mitigating them.
It's important to note that risk management practices can differ across
sectors and individual organizations. The specific risk management
structure and policies are influenced by industry -specific re gulations, best
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65 encouraged to adopt robust risk management practices to strengthen their
resilience and protect stakeholders' interests.
Risk Management Policy:
A risk management p olicy is a formal document that outlines an
organization's approach and principles for identifying, assessing,
mitigating, and monitoring risks. It serves as a guiding framework that
establishes the overall direction and objectives of risk management withi n
the organization. Here are key components typically included in a risk
management policy:
Policy Statement:
 The policy begins with a clear statement of the organization's
commitment to risk management and its importance in achieving
strategic objectives.
 It highlights the organization's risk management philosophy,
emphasizing the proactive and integrated approach to managing risks.
Objectives:
 The policy specifies the overarching objectives of the risk management
process, aligning with the organization's overall goals.
 These objectives may include protecting assets, enhancing decision -
making, ensuring business continuity, and optimizing risk -reward
trade -offs.
Scope and Applicability:
 The policy defines the scope of the risk management process,
specifying the areas, projects, or activities to which it applies.
 It identifies the stakeholders and individuals responsible for
implementing and overseeing risk management activities.
Risk Management Framework:
 The policy establishes the risk management framework, including the
methodologies, processes, and tools to be used.
 It may reference industry standards, regulations, or best practices that
guide the organization's risk management efforts.
Risk Governance:
 The policy defines the roles, responsibilities, and au thorities of
individuals and committees involved in risk management.
 It specifies reporting lines, decision -making processes, and escalation
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66 Risk Assessment and Reporting:
 The policy outlines the approach for id entifying, assessing, and
prioritizing risks within the organization.
 It may detail the criteria, methodologies, and tools to be used for risk
assessment.
 Reporting requirements, including frequency, formats, and stakeholders
to be informed, are typically addressed in this section.
Risk Mitigation and Control:
 The policy highlights the organization's approach to risk mitigation and
control.
 It may provide guidelines for selecting risk response strategies such as
risk avoidance, reduction, transfer, or accep tance.
 The policy may also address the establishment of control measures,
monitoring mechanisms, and contingency plans.
Risk Monitoring and Review:
 The policy emphasizes the importance of ongoing monitoring and
review of risks and risk management activitie s.
 It may specify key risk indicators (KRIs), thresholds, and triggers for
monitoring risk exposure.
 The policy may address the process for regular reviews, updates, and
continuous improvement of the risk management framework.
Compliance and Ethics:
 The po licy reinforces the organization's commitment to complying with
applicable laws, regulations, and ethical standards.
 It may outline specific risk management requirements related to legal
and regulatory compliance, as well as ethical conduct.
Communication and Training:
 The policy emphasizes the importance of effective communication and
training on risk management.
 It may outline the channels, frequency, and stakeholders for risk
communication within the organization.
 The policy may also address training pro grams to enhance risk
awareness and competence among employees.

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67 Policy Review and Approval:
 The policy specifies the process for reviewing, updating, and approving
the risk management policy.
 It may outline the roles and responsibilities of individuals o r
committees involved in the policy review process.
Prescriptions from regulators with reference to the policyof risk
management:
In addition to the a fore mentioned, it is required to adhere to the general
standards that have been establishedby the partic ular regulators who are in
charge of managing an organisation. These criteria may be interpretedas
follows:
The Companies Act, 2013: Section 134(3)(n) of the Companies Act,
2013 stipulates that a statement addressing the risk management policy of
the busin ess must be included in the report of the board ofdirectors of the
firm. This requirement is in effect. This policy need to address all aspects
of risk, and morespecifically, those aspects of risk that might
endangerthesurvival of thefirm.
Securities and E xchange Board of India: Regulation 17 of the SEBI
(LODR) Regulations, 2015 stipulatesthat the company's board of directors
is responsible for drafting and putting into action the company's
riskmanagement strategy. This obligation was given to the directors by the
Securities and Exchange Board ofIndia. In addition, the Regulations
provide in Schedule II that it is the responsibility of the risk management
committee toformulatea comprehensive policy for risk management,
which must always contain the following provisions:
 A frame work for the identification of risks, including but not limited to
financial, operational, sectoral, sustainability (especially ESG related
concerns), information, and cyber security threats.
 The company's strategy for the continuation of its operations.
 Systems for risk mitigation and internal control mechanisms designed
to reduce the impact of hazards that have been identified.
 In addition to this, the committee is accountable for monitoring the
execution of the risk management policy and conducting regular
reviews ofthe same.
Reserve Bank of India: In the case of non -banking financial companies
(NBFCs), the Reserve Bank ofIndia places a particular emphasis on the
liquidity risk management approach that must be applied by relevant In
order to do this, the board of directors of the NBFC is going to create a
policy for the management of liquidity risk that will include the following
provisions:
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68  Method for always sustaining liquidity ; Limits to the amount of risk
that may be to lerated at the entity level
 the funding measures that the NBFC should implement in order to keep
its liquidity levels stable;
 Prudential limitations;
 Establishment of a system for the periodic examination of the NBFC's
liquidity and of the assumptions used in the p rojection of that liquidity;
 Planfor payingif thereareunexpected costs;Framework forstress testing
 Characteristics of management reporting, including its frequency
In addition, non -bank financial companies (NBFCs) and banks are both
obliged to establish as set liability committees in order to strike a balance
between the two facets of the organisation that are being discussed.
Nevertheless, there is a distinction in their framework, as liquidity is the
most stressed point in NBFCs,whereas in the case of bank s, the RBI has
laid out a more comprehensive "risk appetite framework," which
prescribes risks to be managed at an aggregated level and not to be
restricted at a specific risk or function. In addition to the other
requirements that must be met, the framewo rk mandates that ananalys is of
risks must be conducted from both a qualitative and aquantitative vantage
point. The framework that has been recommended has as its goal the
reduction of financial risks, notably those associated with interest rate
andliquid ity.
The importance of the framework may be understood simply by focusing
on the stringent composition andquorum standards that must be met by the
risk management committee. In this connection, the Reserve Bankof India
(RBI) has also prescribed a "Internal Capital Adequacy Assessment
Process" that is in accordancewith the Basel regulations and is to be
written down at both the individual bank level and the group level inorder
to analyse important risks that are faced by the banks. Because of the
evident fac t that banks play anessential part in the circulation of money in
the economy, this may be regarded to be the most stringent prescription
ever issued by a regulatory body in respect to the framework for risk
management.
Insurance Regulatory and Development Authority of India: The
regulator, by means of its corporate governance guidelines for insurers,
reposed the responsibility of laying down a risk management
frameworkand a risk policy with the risk management committee of the
insurer. This responsibility was reposed in the regulator. Particular
emphasis has been placed on the control of the fraud risk that the insurer is
exposed to.
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69 6.7 REASONS FOR MANA GING DERIVATIVES RIS K
 Risk Mitigation:
Derivatives, such as options, futures, swaps, and forward contra cts, can
expose organizations to various risks, including market risk, credit risk,
liquidity risk, and operational risk. Managing derivatives risk helps
mitigate the potential adverse effects of these risks and protects the
organization's financial stabil ity.
 Hedging:
Derivatives are commonly used as hedging instruments to offset or reduce
risks associated with underlying assets or liabilities. Effective risk
management of derivatives allows organizations to hedge against price
fluctuations, interest rate changes, currency exchange rate volatility, and
other market uncertainties. This helps stabilize cash flows, protect profit
margins, and minimize potential losses.
 Regulatory Compliance:
Many jurisdictions have specific regulations and reporting requirem ents
for derivatives trading. Proper risk management ensures compliance with
regulatory frameworks, reducing the potential for penalties, legal issues,
and reputational damage. Compliance also enhances transparency and
accountability in financial markets.
 Financial Stability:
Derivatives can introduce complexities and interconnectedness in financial
markets. Poor risk management of derivatives can contribute to systemic
risks and financial instability. Managing derivatives risk helps safeguard
the stabilit y of financial institutions, reduces the potential for market
disruptions, and promotes overall market resilience.
 Investor Confidence:
Effective risk management practices enhance investor confidence and trust
in the organization. Investors, both individu al and institutional, look for
organizations that demonstrate robust risk management capabilities,
including the management of derivatives risk. Transparent and prudent
risk management practices can attract investors and potentially lower the
cost of capit al.
 Competitive Advantage:
Proper management of derivatives risk can provide a competitive
advantage to organizations. It enables them to navigate volatile markets,
respond to changing business conditions, and capitalize on opportunities
more effectively. Organizations with effective risk management
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70  Operational Efficiency:
Managing derivatives risk involves implementing efficient processes,
controls, and sy stems to monitor, measure, and mitigate risk exposures.
This focus on risk management can improve overall operational
efficiency, streamline internal processes, and enhance risk -adjusted
returns. It helps organizations identify and allocate resources more
effectively and efficiently.
 Long -Term Sustainability:
Effective risk management of derivatives contributes to the long -term
sustainability of organizations. It helps protect the organization's financial
health, preserves shareholder value, and supports s trategic objectives. By
actively managing derivatives risk, organizations can navigate
uncertainties, protect against downside risks, and position themselves for
sustainable growth.
6.8 TYPES OF RISK IN DERIVATIVE TRADING
In derivative trading, various ty pes of risks are associated with the use and
trading of derivative instruments. These risks can arise from market
movements, counterparty actions, operational factors, and other sources.
Here are some key types of risks in derivative trading:
The use of de rivatives is thought to be quite dangerous. When it comes to
opinions regarding the risks associated with a derivative transaction, the
market is divided on two fronts. Some people question how derivatives
might add new risk to the market as they aren't ne w securities on their
own. This argument is accepted by the other side. However, they also
claim that derivatives have the ability to concentrate risks to a point where
the economy is unable to easily absorb them.
Market Risk
The principal risk of every in vestment is market risk. Investors make
decisions and take positions based on assumptions, technical analysis, or
other factors that aid them in making detailed assessments about how an
investment is projected to perform.
There is no failsafe method to pro tect against market risk since all
investments are subject to changes in the market, but understanding how
much a derivative is affected by market movements may help investors
make wise selections. In fact, two key aspects of investment research are
estima ting the likelihood that an investment will be profitable and
assessing the risk/reward ratio of potential losses vs potential returns.
Counterparty Risk
Counterparty risk, commonly referred to as counterparty credit risk, arises
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71 marketplaces since they are much less regulated than traditional trading
platforms.
Margin deposits are necessary on regular tradi ng exchanges, and they
must be updated daily through the mark -to-market process, which helps
contracts perform. Thanks to the mark -to-market process, pricing
derivatives is more likely to accurately reflect current value. Traders can
lower counterparty ris k by only transacting with dealers they are familiar
with and perceive to be trustworthy.
Liquidity Risk
Liquidity risk applies to investors who plan to close out a derivative trade
before maturity. Liquidity risk generally refers to a company's capacity t o
repay debts without experiencing large losses to its operations. To assess
the liquidity risk, investors compare the company's liquid assets and short -
term liabilities. Businesses with low liquidity risks can quickly turn their
investments into cash to h alt a loss.
Another important consideration for derivatives -interested investors is the
danger of limited liquidity. These investors need to assess whether it will
be difficult to close the sale or whether the current bid -ask spreads will be
so large that they will be a significant expense.
Credit Risk:
Credit risk is the risk of financial loss resulting from the failure of a
counterparty to fulfill its contractual obligations. In derivative trading,
credit risk arises when one party fails to make payments or fulfill its
obligations under the derivative contract. This risk becomes significant
when trading with counterparties of lower creditworthiness or during
periods of financial stress.
Operational Risk:
Operational risk relates to the risk of loss resul ting from inadequate or
failed internal processes, people, systems, or external events. In derivative
trading, operational risk can arise from errors in trade processing,
settlement failures, technology disruptions, inadequate controls, fraud, or
regulator y compliance failures. Robust operational risk management
practices are crucial to mitigate such risks.
Legal and Regulatory Risk:
Legal and regulatory risk arises from non -compliance with applicable
laws, regulations, and contractual obligations. It incl udes the risk of legal
disputes, regulatory sanctions, changes in regulations, and the impact of
new laws or court decisions on derivative contracts. Organizations need to
stay updated with relevant regulations and maintain compliance to
mitigate legal and regulatory risks.
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72 Model Risk:
Model risk refers to the risk of losses arising from the use of imperfect or
inaccurate models to price, value, or manage derivatives. Derivative
pricing models rely on assumptions, mathematical formulas, and historical
data, and they may not fully capture complex market dynamics or
unforeseen events. Organizations need to assess and manage model risk to
ensure the reliability and accuracy of derivative pricing and risk
management.
Systemic Risk:
Systemic risk refers to the risk of widespread disruption or instability in
financial markets caused by interconnectedness and interdependencies
among market participants. It can arise from factors such as major market
shocks, economic crises, policy changes, or failures in the fina ncial
system. Systemic risk can impact derivative trading by amplifying market
volatility and counterparty risks.
6.9 SUMMARY
 Risk management is the process of recognising, assessing, and either
accepting or mitigating the effects of uncertainty in investm ent
decision -making.
 Money managers that employ active methods in an effort to outperform
the market are subject to alpha risk because alpha is a gauge for excess
return.
 The rate at which the delta of an option position shifts in response to a
one-point c hange in the price of the underlying asset is known as the
gamma of a position.
 Gamma hedging is a strategy that is used in conjunction with delta
hedging to protect the trader from changes to a security or maybe the
entire portfolio that are more signific ant than anticipated..
 Hedging and speculating are strategic behaviors that are related to
investing, and the terms "speculators" and "hedgers" are used to define
a certain kind of trader or investor.
6.10 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. Differentiate between Gamma Hedgingvs. Delta Hedging: .
2. Explainin detail Hedging.
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73 4. Discuss the advantages and disadvantages of Risk Management
Process.
5. Explain risk management process.
B. Fill in the blanks:
1. …………… is a metric f or excess return, and money managers that use
active strategies in an effort to outperform the market are exposed to
alpha risk.
2. Gamma hedging is a trading strategy that aims to keep the delta in an
options position………...
3. The…………….., the first formula to b e accepted as a standard for
pricing options .
4. ……………….. are investors who make financial decisions based on
informed assumptions about the futuredirection of a market.
5. Managing ……………… results in time loss as compensation for
projects.
Answers :
1- Alpha, 2 - constant, 3 - Black -Scholes Model , 4-Speculators, 5 - risks
6.11 REFERENCES
 Derivatives Market NCFM Module. National Stock Exchange India
Limited Publications : Bombay : 2007.
 Gupta S. L (2007). Financial Derivatives Prentice Hall. New Delhi.
 Indian Stock Market Review. National Stock Exchange Publications.
 Jaynath Rama Varma (2008). Derivatives and Risk Management.
Tata Mc Graw Hill Publications : New Delhi

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74 7
OPTIONS
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Options Volatility
7.3 Historical and implied volatility
7.4 Volatility smile
7.5 Volatility term structure
7.6 Advance models of volatility estimation
7.7 Value at risk (VaR) and Historical sim ulation
7.8 Model building approach
7.9 Stress testing and back testing
7.10 Summary
7.11 Unit End Questions
7.12 References
7.0 OBJECTIVES
After studying this unit, you will be able:
 To understand options volatility
 To discuss historical and implied volatility
 To explain Volatility smile
 To describe Volatility term structure
 To understand advance models of volatility estimation
 To anlayse Value at risk (VaR)
 To discuss Historical simulation
 To explain Model building approach
 To understand Stress testi ng and back testing
7.1 INTRODUCTION
Options are aptly named financial derivatives that give their holders the
option to purchase or sell an underlying asset at a predetermined strike
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75 written on stocks but can be linked to other types of assets as well. To
induce investors to issue an option and thereby obligate themselves to
make a disadvantageous trade, option holders must pay a premium to the
option issuer based on the option typ e, strike price, expiration date,
interest rates, and volatility of the underlying asset.
Options can be used to hedge or speculate in various ways. An investor
might buy a call option on a stock in the hopes that the stock price will rise
above the strik e price, allowing her to buy the stock at the strike price
(e.g., $90) and immediately resell it at the higher market price (e.g., $100).
Or an investor might buy a put option to minimize his losses. If the stock
fell from $100 to $50 per share, for exampl e, a put option at $75 would be
profitable or “in the money” because the investor could buy the stock in
the market at $50 and then exercise his option to sell the stock to the
option issuer at $75 for a gross profit of $25 per share.
7.2 OPTIONS VOLATILIT Y
Financial derivatives known as options give the holder (the buyer) the
right to buy (in the case of a call) or sell (in the case of a put) the
underlying asset at a certain price on or before a given date. Call option
holders look to profit from an incre ase in the value of the underlying
asset, whereas put option holders profit from a decrease in value. Options
are flexible and have a wide range of applications. While some traders
only employ options for speculation, other investors, such those in hedge
funds, frequently use options to reduce the risks associated with asset
ownership.
Options Pricing:
The term "premium" is frequently used to describe an option's cost. The
buyer pays the premium to the option seller (also known as the writer) in
exchange fo r receiving the above -described right to buy (or sell). The
buyer has two options: they can either use the option or let it expire
worthless. The seller keeps the premium regardless of whether the option
is exercised because the buyer still pays it. As a r esult, the cost of the
option is determined by the likelihood that the buyer will be able to
exercise it profitably.
The intrinsic value of the option and its temporal value make up the two
components of an option's premium (extrinsic value).
The discrepan cy between the price of the underlying asset and the strike
price is known as the intrinsic value. The latter is the portion of the option
premium that is in -the-money. A call option's intrinsic value is
determined by subtracting the strike price from the option's underlying
value. On the other hand, the intrinsic value of a put option is equal to the
strike price less the underlying price. However, the time value is the
portion of the premium that is related to how much time is left until the
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76 7.3 HISTORICAL AND IMPLIED VOLATILITY
Historical Volatility
Historical volatility, also known as statistical volatility, measures price
changes across predefined time periods to estimate the fluctuations of
underlying securities. Compared to implied volatility, it is the less used
statistic because it is backward -looking.
The price of an investment will fluctuate more than usual when historical
volatility increases. There is a current expectation that something will
change or already has. On the other hand, if historical volatility is
declining, it indicates that all uncertainty has been removed and that
things have returned to normal.
Although this estimate may be based on int raday fluctuations, it
frequently gauges moves as the difference between two closing prices.
Historical volatility can be calculated in steps of 10 to 180 trading days,
depending on the anticipated length of the options trade.
Investors can learn more abou t relative values for the targeted time
frames of their options trading by analysing the percentage changes over
larger time periods. A stock is trading with higher -than-normal volatility,
for instance, if the historical volatility average over 180 days is 25% and
the reading for the 10 days prior is 45%. Because implied volatility takes
a forward -looking reading on option premiums at the time of the deal, and
historical volatility examines prior metrics, options traders frequently
combine the data.
Implied Volatility:
A key indicator for options traders is implied volatility (IV), also known
as predicted volatility. As the name implies, it enables them to predict how
volatile the market will be in the future. Additionally, this idea offers
traders a mechani sm to compute likelihood. It's vital to keep in mind that
since it shouldn't be regarded as science, it cannot predict how the market
will behave in the future.
Implied volatility, which derives from an option's price and represents its
future volatility, differs from historical volatility. Trading performance
cannot be used as a predictor of future performance because it is implied.
Instead, they must make an assessment of the option's market potential.
Implied volatility measures the anticipated variation s of an underlying
stock or index over a given time period by identifying substantial
imbalances in supply and demand. The price of options premiums is
strongly associated with these expectations, increasing in times of
apparent excess supply or demand and decreasing in times of equilibrium.
Numerous factors, ranging from market -wide events to news specifically
pertaining to one particular company, can have an impact on the degree of
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77 For in stance, implied volatility and option premiums could significantly
rise in the few days before a quarterly earnings report if multiple Wall
Street experts predict three days beforehand that a business will soundly
outperform predicted earnings. In the abse nce of a future event to boost
demand and volatility, implied volatility is likely to decrease once the
earnings are released.
7.4 VOLATILITY SMILE
Plotting the strike price and implied volatility of a collection of options
with the same underlying asset a nd expiration date yields a similar graph
shape known as a volatility smile. The volatility smile got its name
because it resembles a mouth -smile. When an option's underlying asset is
further out -of-the-money (OTM) or in -the-money (ITM) than it is at the
money, implied volatility increases (ATM). Not all options fall under the
scope of the volatility smile.
What Does a Volatility Smile Tell You?
Volatility smiles are caused by changes in implied volatility as the
underlying asset swings more in one directio n or the other. The implied
volatility of an option increases with the percentage of ITM or OTM.
With ATM options, implied volatility is typically at its lowest.
The Black -Scholes model, one of the key formulas used to price options
and other derivatives, does not forecast the volatility grin. When plotted
against different strike prices, the implied volatility curve should be flat,
according to the Black -Scholes model. The model predicts that regardless
of the strike price, the implied volatility would be the same for all options
having the same underlying asset and expiring on the same date.
However, this is not how things actually work.
Moreover, the inconsistent The existence of grin demonstrates that ITM
and OTM choices are frequently more popular than ATM options. Prices
are driven by demand, which has an impact on implied volatility. This
may be partially caused by the aforementioned factor. Extreme
occurrences can lead to large price changes in options. Implied volatility
takes into account the potent ial for significant shifts.
Limitations of Using the Volatility Smile:
Finding out whether the option being traded genuinely corresponds with a
volatility smile is crucial first. One model that an option may align with is
the volatility smile, however impl ied volatility may align more with a
reverse or forward skew/smirk.
Additionally, the volatility smile (if applicable) may not have a clear U -
shape due to other market considerations like supply and demand (or
smirk). It might be choppy, with certain optio ns exhibiting more or less
implied volatility than would be predicted by the model, but it might have
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78 The volatility smile shows traders where to seek to get more or less
implied volatility, but there are a lot of other things to thi nk about when
choosing an options strategy.
7.5 VOLATILITY TERM STRUCTURE
The volatility term structure, which is a component of the volatility
surface, illustrates how, even for the same strike price, options on the
same stock would exhibit various implie d volatilities for various expiry
months. The volatility term structure can have an upward or downward
slope depending on market conditions and expectations, similar to the
term structure of bonds (where interest rates vary based on maturity). The
term str ucture's slope tells traders whether they anticipate the underlying
stock to become more volatile over time or less volatile over time.
Understanding Term Structure Of Interest Rates :
According to general principles, yields rise with maturity, creating an
upward -sloping, or normal, yield curve. The term structure of interest
rates for typical U.S. government -issued securities is depicted by the
yield curve. This is significant because it provides insight into how the
debt market perceives risk. One common yield curve contrasts U.S.
Treasury paper with maturities of three months, two years, five years, ten
years, and thirty years. The Treasury's interest rate website typically has
yield curve rates by 6:00 p.m. Eastern Standard Time on trade days.
The term o f the structure of interest rates has three primary shapes:
1. Long -term rates have an upward slope and are higher than short -term
yields. This yield curve's slope is thought to be "normal" and shows
that the economy is growing.
2. In a downward sloping curve, s hort-term yields surpass long -term
yields. A yield curve that has "inverted" suggests that the economy is
currently undergoing or is soon to experience a recession.
3. Flat—yields over the short - and long -terms do not differ significantly.
This suggests that the market is unsure about the direction the
economy will head in. .
7.6 ADVANCE MODELS OF VO LATILITY
ESTIMATION
Calculating the standard deviation of a security's prices over time is the
easiest method for identifying a security's volatility. The follow ing steps
can be used to accomplish this:
1. Compile the security's historical pricing.
2. Determine the average (mean) price of the security's previous prices.
3. Calculate the difference between the average price and each price in the
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79 4. Square the discrepancie s from step 3.
5. Add up the differences by squares.
6. Subtract the squared variations from the total number of prices in the
collection (find variance).
7. Square -root the result of the preceding step's calculation.
7.7 VALUE AT RISK (VAR) AND HISTORICAL
SIMULA TION
Value at risk, or VaR, is a statistic that gauges the possible magnitude of
financial losses that could happen inside a business, portfolio, or position
over the course of a specific time frame. Investment and commercial
banks most frequently utilise this figure to determine the sort, size, and
possibility of future losses in their separate institutional portfolios.
Risk managers utilise Value at Risk (VaR) as a technique to assess and
cap the degree of risk exposure. Value at risk calculations can be used to
assess the overall risk exposure of a full company as well as individual
holdings and entire portfolios.
KEY TAKEAWAYS:
Value at risk, commonly abbreviated as VaR, is a technique for estimating
the risk of potential losses that a business or inves tment might experience.
Numerous methods, including the historical, variance -covariance, and
Monte Carlo procedures, can be used to determine this metric. Investment
banks frequently use VaR modelling to assess enterprise risk. The reason
for this is that distinct trading desks may unintentionally expose the
company to assets that are closely related.
Understanding Value at Risk (VaR):
The value at risk (VaR) modelling procedure determines the entity being
evaluated's potential for loss as well as the like lihood that the indicated
loss will occur. The three factors that are considered in order to compute
VaR are the timeframe, the probability that the potential loss will occur,
and the potential loss amount.
For instance, a financial institution might deter mine that an asset has a
VaR of 3 percent for one month, meaning there is a 3 percent chance that
the asset's value will fall by 2 percent during that month. We discover that
the probability of experiencing a loss of two percent occurs once every
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80
It is possible to determine the aggregated risks posed by the positions held
by the various trading desks and divisions that make up the organisation
by using a VaR evaluation that is company -wide. With the aid of the data
provided by VaR modelling, financial institutions are able to assess
whether they have sufficient capital reserves in place to absorb losses or
whether they need to reduce the amount of concentrated assets th ey have
due to higher -than-acceptable risks.
VaR Methodologies:
The three main methods for calculating VaR are as follows. The historical
technique, or the first strategy, compiles a person's prior return history in
the order of worst losses to largest pr ofits. This strategy is predicated on
the idea that a person's past return experiences will influence future
outcomes.
The variance -covariance approach is the name given to the second
methodology. Instead of assuming that the past will offer insight into the
future, this approach assumes that profits and losses follow a normal
distribution. In this way, it is possible to conceptualise the possibility of
loss in terms of the standard deviation of events in relation to the mean.
The third and last method for determining VaR involves the use of a
Monte Carlo simulation. This strategy use computer models to simulate
expected returns over a range of potentially dozens to millions of
iterations. Then, it calculates the effect by factoring in the probability that
a loss will occur, say 5% of the time.
The Concept That Drives VAR:
Volatility is often considered to be the most accurate and reliable indicator
of risk. However, the primary issue with volatility is that it does not care
about the direction in which an investment moves. For example, a stock
may be considered volatile if it suddenly rises upward in price. Naturally,
investors aren't bothered by increases in their portfolios.
The VAR model is based on the self -evident notion that, in the context of
financ ial investments, "risk" refers to the likelihood of suffering a
financial loss. By assuming investors are worried about the likelihood of
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81 incurring a very large loss, VAR offers a solution to the questions "What
is my worst -case scenario?" and "How much mi ght I lose in a truly terrible
month?"
Let's now get to the meat of the matter. The loss amount, time period, and
confidence level (or loss percentage) are the three components that make
up a VAR statistic. As we walk through many examples of various ways
that the question to which VAR reacts could be formulated, keep in mind
these three elements:
 What should I expect to happen financially in the worst -case scenario
with a 95 or 99 percent degree of con fidence for the upcoming month?
 How much weight loss c an I anticipate in the upcoming year with a 95
or 99 percent confidence level? What is the most percentage I may
reasonably expect to lose?
You can see how the "VAR question" is made up of three elements: an
estimate of investment loss (expressed in eithe r dollars or percentage
terms), a time period, and a relatively high level of confidence (often
either 95 percent or 99 percent).
Calculating VAR Using Various Methods:
To evaluate the risk of a single index that moves like a stock, however, we
shall use V AR for the purposes of this introduction. The Nasdaq 100
Index, which is traded through the INVESCO QQQ Trust, is the index in
question. VAR is used by institutional investors to assess the overall risk
of their portfolios. The most prominent non -financial stocks that are traded
on the Nasdaq exchange are tracked by the exceedingly well -known QQQ
index.
Calculating variance and covariance (VAR) may be done in one of three
ways: the historical technique, the variance -covariance method, or by a
Monte Carlo si mulation:
1. A Method Based on History:
The historical technique entails nothing more than rearranging the actual
historical results and placing themin descending order from the poorest to
the highest. From a risk management point of view, it is thuspresumedt hat
previousevents will berepeated.
The Nasdaq 100 Exchange Traded Fund (ETF), whichbegan trading
inMarch of 1999 and goes by thetickercode QQQ and issometimes
referredtoas the"cubes"in certaincircles,is agoodhistorical example.
If we do calculations for e ach daily return, we would end up with a
comprehensive data collection that hasmore than 1,400 points. Put them in
a histogram that compares the different "buckets" of the frequency of
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82 2. The Approach Based on Variance and Covariance:
This strategy assumes that stock return distributions are normally
distributed. To put it another way, we only need to estimate two
components in order to represent a normal distribution curve: the expected
(or average) return and the standard deviation. We'll be able to plot the
curve thanks to these two variables. The same real return data displayed
above is used to illustrate the normal curve:

Fig:3.1
With the exception of using the well -known curve rather than the actual
data, the idea underlying variance -covariance is the same as the idea
underlying the historical approach. The advantage of adopting a normal
curve is that it allows us to instantly identify where the worst 5% and
worst 1% of the data are located on the curve. They depend on both the
standard deviation and the desired level of confidence in the results.

Fig:3.2
The blue curve that can be seen above is based on the actual daily standard
deviation of the QQQ, which is 2.64 percent. For the purpose of
simplicity, we will assume that the average return is zero because it just so
happened that the average daily return was rather close to zero. The
following conclusions have been reached after incorporating the real
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83

Fig:3.3
3. Monte Carlo Simulation:
The third method involves developing a model to forecast future stock
price returns and then testing that model using a variety of fictitious
scenarios. Any method that generates trials in a random order is a Monte
Carlo simulation, however the word "Monte Carlo simulation" by itself
says nothing about the methodology being employed.
A Monte Carlo simulation can be viewed as a "black box" generator of
random and probabilistic outputs by the vast majority of users. We will
not go into further details, but we did a Monte Carlo simulation on the
QQQ using the historical trading pattern. We conducted a total of 100
different experiments in our simulation. We would receive a different
result if we repeated the experiment, but it's likely that the d ifferences
would be rather minor.
Briefly stated, we ran 100 fictitious simulations of monthly returns for the
QQQ. Three of the findings fell between a range of 20 and 25 percent,
while two of the results fell between -15 and -20 percent. This suggests
that the worst five results, or the worst 5% of results, were less than a
negative 15%. As a result, the Monte Carlo simulation leads to the
following VAR -type conclusion: we do not anticipate losing more than 15
percent during any given month with a level o f certainty of 95 percent.
How do you determine the value that is at risk?
The three techniques that can be used to calculate the variance -covariance
ratio (VAR) are the historical approach, the variance -covariance
methodology, and the Monte Carlo method. The historical technique,
which operates under the assumption that the results of subsequent
observations will be comparable, is used to assess the data from earlier
observations. Based on a measured standard deviation, the variance -
covariance technique gi ves predictions about risk. It is assumed that
potential losses have a normal distribution in order for this strategy to
work. The simulation method creates a model that may be applied to
subsequent simulations of the process' results.
How Do You Calculate Value at Risk in Excel?
You may find the VAR of a stock or index using the statistics tools in
Excel or any other spread sheet programme. A calculator may also be used
to perform this computation. Getting a dataset with historical pricing is the
first thi ng that needs to be done. Use the statistical tools given by the
spreadsheet to determine the mean and standard deviation of the daily
percentage returns. By taking the inverse of the normal distribution curve
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84 and applying it to the data, one can determine the Value at Risk. The
function, which goes by the name NORM.INV(), can be found in Excel.
Confidence Level, Mean, and Standard Deviation are acceptable reasons.
What are some of Value at Risk's Downsides as an Investment
Strategy?
VAR can be misleading e ven if it is useful for estimating the risks that an
investment may encounter. The fact that different methodologies give
conflicting findings is one critique. For instance, utilising the historical
approach may result in a gloomy forecast, while the outco mes of Monte
Carlo simulations are frequently more optimistic. Due to the fact that
many of the assets in a large portfolio will be tied to one another, it may
be difficult to compute the VAR for each individual asset in a large
portfolio. In conclusion, t he data and assumptions utilised in any VAR
calculation's formulation are wholly responsible for determining how
accurate the calculation is.
The Bottom Line
The Bottom Line Value at Risk (VAR) is a calculation that determines the
greatest loss that may be p redicted (or the worst case scenario) on an
investment, given a certain degree of confidence and taking into account a
particular amount of time. We examined three methods that are frequently
used to compute VAR. However, keep in mind that two of our metho ds
computed a daily VAR, and the third technique computed a monthly
VAR.
7.8 MODEL BUILDING A PPROACH
The model -building strategy, also known as the variance -covariance
approach, is an alternative to the historical simulation approach for
computing risk me trics like VaR and expected shortfall (ES). This entails
making an assumption about a model for the joint distribution of changes
in market variables and estimating the model's parameters using historical
data.
A portfolio with long and short positions in stocks, bonds, commodities,
and other items is well suited for the model -building technique. It is
founded on Harry Markowitz's ground breaking portfolio theory
research. The mean and standard deviation of the returns on the underlying
products and the corr elations between those returns can be used to
compute the mean and standard deviation of the value of a portfolio. The
probability distribution for the change in the value of the portfolio over the
course of a day is also normal if, and this is a major if, daily returns on the
assets are assumed to be multivariate normal. Calculating the value at risk
is made very simple by this.
7.9 STRESS TESTING A ND BACK TESTING
The resilience of institutions and investment portfolios against potential
future financial s cenarios is tested using the computer simulation
approach known as "stress testing." Such testing is frequently employed
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85 as investment risk and asset sufficiency. Regulators have r ecently
mandated that financial institutions conduct stress tests to make sure their
capital reserves and other assets are sufficient.
Stress testing is a typical tool used by businesses that manage assets and
investments to assess portfolio risk and imple ment any hedging
techniques necessary to protect against potential losses. Their portfolio
managers specifically use in -house, proprietary stress -testing methods to
assess how well the assets they manage might withstand specific market
developments and out side events.
Additionally, firms that want to make sure they have the right internal
controls and processes in place frequently conduct asset and liability
matching stress tests. The alignment of cash flow, payout levels, and
other metrics is regularly che cked in retirement and insurance portfolios
as well.
Types of Stress Testing
Run simulations as part of stress testing to find unknown vulnerabilities.
The literature on corporate governance and company strategy suggests
various methods for conducting thes e exercises. Stylized scenarios,
hypotheticals, and historical scenarios are some of the most well -liked
types.
Historical Stress Testing
In a historical scenario, a simulation based on a past crisis is run for the
firm, asset class, portfolio, or individu al investment. The stock market
crash of October 1987, the Asian crisis of 1997, and the tech bubble that
burst in 1999 –2000 are a few examples of historical crises.
Hypothetical Stress Testing
A hypothetical stress test is typically more focused, frequent ly
concentrating on how a single organisation may handle a specific
catastrophe. A company in California might do a stress test against a
fictitious earthquake, or an oil company would do so against the start of a
Middle Eastern war.
Insofar as only one or a few test variables are changed at once, stylized
situations are a little more scientific. The stress test, for instance, might
see the Dow Jones index lose 10% of its value in a single week.
Simulated Stress Testing
Monte Carlo simulation is one of the most well -known stress test
methodologies. With regard to particular variables, this kind of stress
testing can be used to estimate the likelihood of various outcomes. The
Monte Carlo simulation, for instance, frequently takes a variety of
economic variabl es into account.
For different kinds of stress tests, businesses can also resort to
professionally run risk management and software providers. One example
of an external stress -testing programme that can be used to assess risk in
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86 Backtesting
The standard technique for determining how well a strategy or model
would have performed ex -post is backtesting. Backtesting examines the
performance of a trading strategy using past data to determine its
viability. If backtesting is successful, traders and analysts might feel
confident using it in the future.
Before investing any real money, a trader can backtest a trading strategy
by simulating it with past data to create outcomes and assess risk and
profitability.
Traders can be certain that a strategy is fundamentally good and is likely
to produce profits when put into practise by looking at a well -conducted
backtest that produces favourable outcomes. A well -conducted backtest
that produces unsatisfactory outcomes, on the other h and, will lead
traders to adjust or reject the strategy.
A trade notion can be backtested as long as it can be quantified. To
transform the concept into a tested form, some traders and investors
might seek the assistance of a trained coder. Typically, a pr ogrammer
would implement the concept in the trading platform's proprietary
language.
User -defined input variables can be added by the programmer, giving the
trader the ability to "tweak" the system. The simple moving average
(SMA) crossover mechanism is an illustration of this. The lengths of the
two moving averages that make up the strategy could be inputted by the
trader or altered. The trader might then do a backtest to identify the
moving average lengths that would have had the best results on the
histo rical data.
7.10 SUMMARY
● Financial derivatives known as options give the holder (the buyer) the
right to buy (in the case of a call) or sell (in the case of a put) the
underlying asset at a certain price on or before a given date.
● The intrinsic value of the opt ion and its temporal value make up the
two components of an option's premium (extrinsic value).
● Implied volatility, which derives from an option's price and represents
its future volatility, differs from historical volatility.
● The volatility smile shows tr aders where to seek to get more or less
implied volatility, but there are a lot of other things to think about
when choosing an options strategy.
● The value at risk (VaR) modelling process identifies the potential for
loss in the entity being evaluated as w ell as the chance that the stated
loss will take place.
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87 7.11 UNIT END QUESTIONS
A. Descriptive Questions:
Short Answers:
1. What are Options?
2. Explain the difference between Historical and implied volatility.
3. Write note on Volatility smile.
4. Explai n the three primary shapes of interest rates .
5. What is VaR?
6. Explain in detail Stress testing and back testing.
B. Fill in the blanks:
1. 1 The term "……………." is frequently used to describe an option's
cost.
2. Historical volatility, is also known as…………… .
3. Implied volatility (IV), is also known as…………..
4. ……………….. is a tool that is used by risk managers to quantify and
limit the amount of risk exposure.
5. ……………. is one of the most well -known stress test methodologies.
Answers :
1- premium , 2- statistica l volatility , 3- predicted volatility , 4-Value at Risk
(VaR), 5 - Monte Carlo simulation.
7.12 REFERENCES
 Derivatives Market NCFM Module. National Stock Exchange India
Limited Publications : Bombay : 2007.
 Gupta S. L (2007). Financial Derivatives Prentice Hall. New Delhi.
 Indian Stock Market Review. National Stock Exchange Publications.
 Jaynath Rama Varma (2008). Derivatives and Risk Management.
Tata Mc Graw Hill Publications : New Delhi .

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88 8
TRADING, CLEARING AND
SETTLEMENT IN DERIVATIVES
MARKETS
Unit Structure
8.0 Objectives
8.1 Introduction
8.2 Concept of Trading
8.3 Clearing and Settlement in Derivatives Markets
8.4 SEBI guidelines
8.5 Trading mechanism
8.6 Learning mechanism - role of NSCCL
8.7 Settlement mechanism
8.8 Types of settlement
8.9 Accounting and taxation aspect of derivatives trade
8.10 Summary
8.11 Unit End Questions
8.12 References
8.0 OBJECTIVES
After studying this unit, you will be able to:
 To illustrate the c oncept of Trading
 Discuss Clearing and Settlement in Derivatives Markets
 To explain SEBI guidelines
 To understand Trading mechanism
 To describe Learning mechanism - role of NSCCL
 To analyse Settlement mechanism
 To discuss types of settlement
 To analyse accounting and taxation aspect of derivatives trade. munotes.in

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89 8.1 INTRODUCTION
Futures trading is a vital industry for a nation's economy to expand. The
first kind of derivatives trading is a specific field that requires experts with
in-depth knowledge of the subje ct. As a speculator, arbitrageur, trader,
investor, or hedger, you must have the requisite understanding and
awareness of how the futures markets function in order to operate the
market effectively. These are essential for establishing how derivatives
good s should be valued and priced so that market participants can select
them depending on their objectives.
Futures are only important to market participants when their prices
accurately reflect information about how much the underlying assets are
worth. As a result, it's critical to understand how futures markets function
and how futures contract prices relate to spot pricing. In this part, we'll
examine the factors that commonly affect futures pricing. Commodities,
foreign exchange, and securities are just a few examples of the different
assets whose futures values are impacted by several factors that are not
common to all of these assets. The futures values of foreign currencies, for
instance, can be determined by a variety of factors, just like the prices o f
cereals and vegetables might be.
8.2 CONCEPT OF TRADI NG
The NEAT -F&O trading system, which is used by the NSE to trade
futures and options, provides screen -based trading for stock futures and
options as well as fully automated national trading for Nifty futures and
options. It enables an order -driven market and provides complete
transparency in trading activity. The cash market sector equities trading is
comparable.
Entities in the Trading System There are four parties/entities in the trading
system. They are trading members, clearing members, professional
clearing members and participants.
 Trading members: Trading participants are members of the NSE.
They can choose to trade for themselves or for their customers, which
includes other traders. An ID is gi ven to each trading participant by the
exchange. For each trading partner, there could be a number of users.
The number of users allowed is frequently communicated to members
who can trade. Each user of a trading member who registers with the
exchange rece ives a special user ID. All orders and traders from
different users can be identified by their unique trading member IDs.
This ID is shared by all users of a certain trade member.
 Clearing members: Clearing participants are NSCCL participants.
Through the trading system, they perform risk management tasks and
confirm or enquire about trades.
 Professional clearing members: A professional clearing member is a
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90 institutions like banks and custod ians join professional clearing bodies
to clear and settle deals for their trading members.
 Participants: Financial institutions' and other trading members' clients
are referred to as participants. These clients may transact with a number
of trading membe rs but only with one clearing member.
Types of Traders
In the futures markets, traders are essential because they provide liquidity.
Futures were initially developed to assist hedgers in controlling their
exposure to price risk, even though traders, also referred to as speculators,
are essential to the maintenance of a market of buyers and sellers.
Speculators offer the majority of market liquidity, allowing the hedger to
enter and exit the market more quickly.
In other words, the two basic categories of t raders are speculators and
hedgers. Hedgers use the futures market to manage price risk. Speculators,
on the other hand, are people who use the futures market with the goal of
profiting from it. As a result, in exchange for the possibility to make
money, t he speculator takes market risk. There are different ways to
categorise futures traders. Professional traders might have full -time or
part-time occupations, and they can trade from a desk or on the trading
floor. Each of these market participants makes a s ubstantial contribution to
the markets' efficiency as venues for conducting business.
Public Traders
The vast majority of speculators are private individuals who trade off the
floor with their own money. This broad range of companies is typically
referred to as "retail" firms. As activity on the trading floor shifts more
and more to the computer screen, the retail consumer is becoming a more
important factor in futures trading. Furthermore, computer -based trading
has made "levelling the playing field" betw een different sorts of traders a
reality.
“Local” Traders
The most prominent and colourful speculator is probably the professional
floor trader, sometimes known as a local, who transacts on the exchange
floor for his own account. Many of the locals, who come from a variety of
backgrounds, began their careers as runners, clerks, or assistants for other
traders and brokers. Locals frequently exhibit greater interest in the
trading pit's market activity than they do in the underlying markets'
fundamentals. A trader known as a "electronic local" operates similarly to
a floor local due to the widespread use of electronic trading.
Proprietary Traders
Another crucial type of trader is the proprietary trader, who works off the
trading floor for a respected tradin g organisation. These "upstairs" traders
are employed by large banks, trading corporations, and investment
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91 group engages in commerce to achieve a range of specific objectives.
Some traders engage in speculative transactions, profiting when the
market changes in their favour. These proprietary traders are paid
according on the revenue they generate. various proprietary traders
manage risk by hedging or spreading it across various ma rkets, including
both the cash and futures markets, to shield their organisation from the
threat of price volatility or the chance of profiting from differences and
transient inefficiencies in market -to-market pricing.
Market Makers
Market makers continuo usly declare a bid (an expression to buy) and an
offer (an expression to sell), so supplying the market with liquidity. In
electronic markets, market makers are becoming increasingly important
since they ensure that all types of traders can buy and sell wh enever they
want. Market makers frequently profit from the "spread," or the little
difference between the bid and offer (or ask) prices.
8.3 CLEARING AND SETTLEM ENT IN DERIVATIVES
MARKETS
A Clearing Member (CM) of NSCCL, who clears and settles such trades
through businesses, must clear and settle every transaction made by a
Trading Member (TM) on the NSE. The following organisations work
with NSCCL to conduct clearing and settlement activities in the F&O
segment:
 ClearingMembers
 ClearingBanks
Clearing Membe rs
Self-clearing participants are those F&O segment participants that only
clear and settle agreements for their own account or the account of their
clients. In addition to clearing and settling the deals of other trading
members (TMs), certain people are known as trading members -cum-
clearing members. Professional clearing members (PCM), a specific
membership category, are also responsible for clearing and settling
transactions conducted by TMs. The members clearing their own trades
and the transactions of others are required to submit additional security
deposits, as must the PCMs, for every TM whose trades they agree to clear
and settle. The CM mostly performs the following tasks:
1. Clearing: Calculating all of his TMs' responsibilities, or deciding
which po sitions to settle.
2. Settlement: The act of really settling. Index and Stock futures and
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92 3. Risk Management: Risk management, which entails establishing
position limits based on upfront deposits margins for each TM and
continuously tracking positions.
Types of Clearing Members : The types of clearing members are:
 Trading Member Clearing Member (TM -CM): a TM who also
participates in clearing. Any deal, including those of other TMs, their
clients, and their ow n trades, can be cleared and settled by these CMs.
 Professional Clearing Member (PCM): CM who cannot be TM. A
PCM may often be a bank or a custodian who would clear and settle for
TMs.
 Self Clearing Member (SCM): A TM who is also a clearing member.
These C Ms are only permitted to clear and settle their own proprietary
trades and those of their clients; they are not permitted to clear and settle
deals of other TMs.
Clearing Banks
Funds are settled by clearing banks. Each clearing member is required to
open a unique bank account with one of the organisations listed below:
The NSCCL designated clearing bank for the F&O market is one of the
following: ICICI Bank, IDBI Bank, IndusInd Bank, Kotak Mahindra
Bank, Standard Chartered Bank, State Bank of India, or Unio n Bank of
India Ltd.
Every clearing member is required to maintain and operate clearing
accounts at any of the permitted clearing bank branches with any of the
empanelled clearing banks. The only purposes for which the clearing
accounts may be put to use a re clearing and settlement.
8.4 SEBI GUIDELINES
The regulatory framework for derivative trading in India was established
by the Dr. L.C. Gupta Committee, which was established by SEBI. For
Derivative Exchanges/ Segments and their Clearing Corporations/ Houses,
SEBI has also drafted a suggested bye -law that lays out the rules for the
trading and settlement of derivative contracts. According to the suggested
byelaws, the Rules, Bye -laws & Regulations of the Derivative Segment of
the Exchanges and their Cleari ng Corporation/ House must be written.
Additionally, SEBI has established the requirements for Derivative
Exchange/ Segment and its Clearing Corporation/ House. Derivative
Exchange/ Segment & Clearing Corporation/ House has been required to
provide a trans parent trading environment, safety, and integrity, as well as
facilities for the resolution of investor complaints, which is why the
eligibility requirements have been set forth. Some of the important
eligibility conditions are -
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93 1. The use of an online scre en-based trading system for derivative
trading.
2. To prevent market manipulation, the Derivatives Exchange/Segment
must have online surveillance capacity to track positions, prices, and
volumes in real time.
3. The Derivatives Exchange/Segment should have plans in place to
provide for the real -time transmission of information regarding deals,
volumes, and quotes over at least two easily accessible information
vending networks for investors across the nation .
4. The Arbitration and Investor Dispute Resolution Mechan ism for the
Derivatives Exchange/Segment should be operational from all four
areas / regions of the nation.
5. The Derivatives Exchange/Segment should have a reliable system in
place to keep track of investor complaints and stop trade irregularities.
6. The Exch ange's Derivative Segment would have its own Investor
Protection Fund.
7. The Clearing Corporation/House shall perform full novation, i.e., the
Clearing Corporation/House shall intervene between both legs of each
trade, becoming the legal counterparty to both , or alternatively, the
Clearing Corporation/House should give an absolute guarantee for the
settlement of all trades.
8. For those Members who participate in both the derivatives market and
the market for underlying securities, the Clearing Corporation/House
shall have the ability to monitor the overall position of Members
across both markets.
9. The initial margin amount for Index Futures Contracts shall be based
on the position's risk of loss. The appropriate level of initial margins
shall be determined using the value -at-risk principle. The starting
margins have to be sufficient to cover the potential one -day loss on the
position on 99% of the days.
10. To facilitate the quick transfer of margin payments, the clearing
corporation or house shall provide up EFT capa bilities.
11. If a Member fails to pay its obligations, the Clearing
Corporation/House must cancel out any open accounts or transfer
client positions and assets to another Member in good standing.
12. The clearing corporation or house must be able to separate the initial
margin deposits made by clearing members for trades executed on
their own accounts from those executed on behalf of their clients. The
Clearing Corporation/House must keep the clients' margin funds in
trust and utilise them exclusively for those pu rposes; they must not
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94 13. For trades completed on the derivative exchange or segment, the
clearing corporation or house must establish a separate Trade
Guarantee Fund.
At this time, SEBI has allowed derivative trading o n the BSE's derivative
segment and the NSE's F&O segment.
8.5 TRADING MECHANIS M
The trading mechanism mainly consists of settling open positions and
clearing members' obligations (self -clearing, trading -cum-clearing,
professional clearing). This stake is t aken into account for exposure and
daily margin calculations. Clearing members (CMs) may calculate their
own open positions by aggregating the open positions of all trading
members (TMs) and all custodial participants clearing via him in contracts
in which they have traded. A TM's open position in the contracts in which he
has traded is determined by adding his own open position and the open
positions of his clients. When submitting orders on the trading system, TMs
must use the 'Pro/Cli' indicator, which i s provided in the order entry screen, to
differentiate between proprietary (if they are their own trades) and client (if
placed on behalf of clients) orders. Proprietary positions are calculated on a net
basis (buy - sell) for each contract. The net (buy - sell) positions of all of the
clients are added to determine each client's position.
8.6 LEARNING MECHANI SM- ROLE OF NSCCL
The NSCCL is in charge of clearing and settling transactions made on the
NSE's stock and futures markets. It employs the standard se ttlement cycle
without any modifications or delays. It aggregates transactions made
during a trading period, nets positions to ascertain the liabilities of
members, and ensures that money and assets are transferred to cover
individual obligations.
The NSCC L has designated 13 clearing banks to provide banking services
to trading members, and connectivity with both depositories has been
established for electronic settlement of securities.
8.7 SETTLEMENT MECHANISM
All contracts for future delivery and exercise of options are settled in cash,
i.e., by exchanging actual currency. For index futures or options, the Nifty
index cannot be used as the underlying. Therefore, it is necessary to pay
for these responsibilities using cash.
But at the moment, both stock opt ions and futures must be settled in cash.
A CM's settlement amount with regard to their obligations for MTM,
premium, and exercise settlement is netted over all of their TMs and
clients.

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95 Settlement of Futures Contracts
The two types of settlements that a pply to futures contracts are the MTM
settlement, which happens constantly at the end of each trading day, and
the final settlement, which happens on the last trading day of the futures
contract.
MTM Settlement: All futures contracts for each member are ma rked-to-
market (MTM) at the relevant futures contract's daily settlement price at
the conclusion of each day. The profits/losses for daytime contracts that
weren't squared up are determined as the difference between:
1. The day's settlement price and the trad e price.
2. The settlement prices from the previous day and the present day for
contracts that were brought forward.
3. The prices paid for the acquisition and sale of the daytime transactions
that were squared.
Futures Settlement Prices : The daily settlement pr ice for a trading day is
based on the closing prices of all individual futures contracts. The closing
price of a futures contract shall be the weighted average price of the
contract for the preceding half -hour on the F&O Segment of the NSE. The
final settl ement price is determined by the closing price of the relevant
underlying index or security on the last trading day of the contract.
Settlement of Options Contracts
For option contracts on securities, there are three main types of settlements:
the daily pr emium settlement, the exercise payment, and the interim
exercise settlement.
Settlement of Daily Premiums: The buyer of an option must pay the
premium for the choices they have bought. Similar to this, the seller of an
option is entitled to the premium for the option he sold. The premium
payable amount and the premium receivable amount are netted to come up
with the net premium payable or receivable amount for each customer for
each option contract.
Exercise Settlement : Even while most option buyers and sel lers close out
their options holdings through offset closure transactions, an
understanding of exercise can help an option buyer assess if exercise could
be more profitable than an offset sale of the option. It is always possible
for an exercise to be assi gned to the option seller. The option seller is
required to satisfy his obligation (pay the cash settlement amount in the
case of a cash -settled option) once an exercise of an option has been
assigned to him, even though he has not yet been informed of the
allocation.
Interim exercise settlement; The only options that are settled upon
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96 is open. At the end of trading on the day of exercise, interim exercise
settlement is finished for such options. At the client level, short positions
in the same series of options contracts —those with the same underlying,
same expiration date, and identical strike price —are assigned at random to
validly exercised option contracts.
Final exercise settlement : Any open long in -the-money strike price
options that remained open at the close of business on the day the option
contract expires are eventually settled. These long positions are all
randomly and automatically paired with short positions in option contracts
from the same series. The Investor shall pay to the Investor to whom the
Option Contract has been allocated the Exercise Settlement Value per Unit
of the Long In -the-Money Option o n the Expiration Date.
Exercise process : There are many time periods within which an option
may be exercised, depending on the type of option. Index options traded
on the NSE are of the European kind, which means that they will only
automatically expire in -the-money on the day of expiration. In contrast to
this, options on securities are American -style. In such cases, the exercise is
automatic on the expiration date of the option contract and voluntary prior
to that date if they are in -the-money. NSCCL woul d automatically
exercise all of the in -the-money options on the contract's expiration day.
The option buyer is not obligated to give an exercise notification in such
cases.
To ensure that an option is exercised on that day, the buyer must notify his
TM to exercise before the cut -off time for accepting exercise instructions
for that day. Ordinarily, the system will accept workout requests right up
until the close of business. TMs may have various cutoff timeframes for
receiving workout instructions from clie nts for various alternatives.
Options that are not exercised before they expire are worthless. Some TMs
might take standing orders to exercise an option that is in -the-money at
expiration or have special protocols.
An exercise directive that has already be en given to NSCCL by a CM
cannot often be reversed. After the trading day's trading hours have ended,
NSCCL processes exercise notices submitted by buyers at any time. The
legitimacy of each exercise notice that NSCCL receives from the NEAT
F&O system is e xamined. Basic validation checks are made to see if the
option contract is in -the-money and the exercising client's or trader's open
buy position.
Exercise settlement computation: An exercise directive that has already
been given to NSCCL by a CM cannot of ten be reversed. After the trading
day's trading hours have ended, NSCCL processes exercise notices
submitted by buyers at any time. The legitimacy of each exercise notice
that NSCCL receives from the NEAT F&O system is examined. Basic
validation checks ar e made to see if the option contract is in -the-money
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97 The exercise settlement price is the closing price of the underlying (index
or security) on the exercise day (for interim exercise) or the expir y day of
the relevant option contract (final exercise).
The exercise settlement value that a buyer is entitled to for call options is
the difference between the final settlement price and the strike price for
each unit of the underlying that the option con tract conveys, whereas for
put options, it is the difference between the strike price and the final
settlement price. Currently, the settlement of option exercises occurs in the
form of cash payments rather than the delivery of securities. For option
contr acts that are profitable, it occurs.
The exercise settlement value for each unit of the exercised contract is
computed as follows:
Call options=Closing price of the security on the day of exercise -
Strike price
Put options=Strike price - Closing price of the security on the day of
exercise
The final exercise is based on the closing price of the underlying securities
on the day of expiration. The exercise would typically be settled by
NSCCL on the third day following the workout day. The workout
settlement am ount may be paid sooner upon the members' request to
assigned clients.
Special Facility for Settlement of Institutional Deals: NSCCL provides
a special facility to Institutions/ foreign Institutional Investors (FIIs)/
Mutual Funds etc. to execute trades th roughany TM, which may be
cleared and settled by their own CM. Such entities are called custodial
participants (CPs). To avail of this facility, a CP is required to register
with NSCCL through hisCM. A unique CP code is allotted to the CP by
NSCCL. All tra des executed by a CP through anyTM are required to have
the CP code in the relevant field on the trading system at the time oforder
entry. Such trades executed on behalf of a CP are confirmed by their own
CM (and not the CM of the TM through whom the order is entered), with
in the time specified by NSE on the trade day though the on-line
confirmation facility.
The trade is regarded as a trade of the TM until it is verified by the CM of
the relevant CP, at which point the CM of the TM is in charge of settlin g
the trade. Following confirmation from the CM of the relevant CP, this
CM is in charge of clearing and settling deals for such custodial clients.
FIIs have been allowed to trade in all exchange -traded derivative contracts
as long as they adhere to the po sition limitations established for them and
their sub -accounts, as well as the established reporting and settlement
procedures. To be able to trade in the F&O portion of the exchange, a Fl/a
sub-account of the FII, as the case may be, must receive a specia l
Custodial Participant (CP) code from the NSCCL. Only FII/sub -accounts
of FIIs with a certain CP code that has been assigned by NSCCL are
allowed to trade on the F&O section. The FII/sub -account of Fl makes munotes.in

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98 sure that every order they put on the Exchange c arries the appropriate CP
code that NSCCL has assigned.
8.8 TYPES OF SETTLEM ENT
1. Cash Settlement
The seller of the financial instrument transfers the Net Cash position rather
than the underlying asset in this manner of settlement. For instance, if the
buyer of a Sugarcane Futures contract wants the deal to be settled in cash,
they will need to pay the difference between the contract's Spot price on
the settlement day and the Futures price set beforehand. The buyer does
not need to receive the sugarcane bu ndles physically.
Cash settlement is employed in derivatives because a futures contract is
governed by an exchange, assuring smooth contract execution.
2. Physical Settlement/ Delivery
This refers to a derivatives contract that, as opposed to trading out n et cash
position or contract offsetting, requires delivery of the actual underlying
asset on the specified delivery date. Most derivative transactions are
traded, not necessarily completed before delivery deadlines. However,
physical delivery of the underl ying asset can happen with other financial
instruments as well as some exchanges (most commonly with
commodities).
8.9 ACCOUNTING AND TAXAT ION ASPECT OF
DERIVATIVES TRADE
Since the underlying asset is neither transferred or delivered, futures
cannot be taxed as "capital gains". Accordingly, the head of income —
either income from business and profession (IB&P) or income from other
sources (IFOS) —will be determined based on whether the assessee is a
trader or an investor. However, in either scenario, the i ncome will be taxed
on a net basis at the assessee's appropriate tax rates. For the option writer,
the option premium is a source of revenue, while for the option buyer, it is
a tax -deductible expense. Gains from executing an option in the event of a
trade r are taxable, similar to gains from trading futures.
The gain from this will be considered a capital gain rather than an IFOS
because there has been a right extinguishment in the investor's case, and
the premium will be accepted as the cost of acquisition . On the final day
of the fiscal year, when there are still open derivatives contracts in the
hands of market players, this is known as a "open interest" position. There
may have been unrealized MTM gains or losses as of March 31. If the
assessee will bene fit from the losses in this circumstance or be subject to
tax on the gains. Derivatives contracts must be marked -to-market (MTM)
in accordance with conservative accounting rules.
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99 When Tax audit mandatory for Derivative Transactions (F&O
Trading)
 If you have a business revenue and a turnover of more than Rs 1 crore,
an audit is necessary. In accordance with Section 44AD, an audit is
also necessary where the total income exceeds the minimum
exemption threshold but the profits are less than 8% (or 6% if all
transactions are digital).
Therefore, in the instance of F&O Trading, the following will apply to the
tax audit:
In case of Profit from transactions of F&O Trading:
 In the case of profit from derivative transactions, tax audit will be
applicable if the turnover from such trading exceeds Rs. 1 crore.
 Tax audit u/s 44AB row’s. 44AD will also be applicable, if the net
profit from such transactions is less than 8% (6%, if all trades are
digital) of the turnover from such transactions.
In case of Loss from F&O Trading:
 A tax audit will be applicable under Section 44AB of the Revenue
and Customs Code in the case of a loss from derivative trading because
the profit (in this example, the loss) is less than 8% (or 6% if all trades are
digital).
Loss in respect of Speculative Business Income:
 According to Section 73 of the Income Tax Act, a loss incurred in a
speculative enterprise may only be offset against other speculative
incomes earned during the year. In the event that any such loss is not
offset, it may be carried forward and offset only against speculative
incomes for a maximum of four additional assessment years.
8.10 SUMMARY
 The National Securities Clearing Corporation Limited (NSCCL), which
also serves as the transactions' legal counterparty, oversees the financial
settlement of all transactions on the NSE's futures and options (F&O)
market.
 The institutional lot sector and the trade -for-trade segment, two
exclusive extra market divisions, have been created to support an
institutional market where lar ge volume trades occur.
 Clearing and settlement activities in the F&O segment are carried out
by NSCCL with the assistance of the Clearing Members and Clearing
Banks.
 Some participants in the F&O segment, known as self -clearing
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100 account or the account of their clients. Settlement of funds is done
through clearing banks .
 The clearing mechanism essentially involves working out open
positions and obligations of clearing (self-clearing/ trading -cum-
clearing/ professional clearing) members.
 All futures and options contracts are cash settled, i.e. through exchange
of cash. The underlying for index futures/ options of the Nifty index
cannot be delivered.
 Options contracts have three types of settlements, daily premium
settlement, exercise settlement, interim exercise settlement in the case
of option contracts on securities and final settlement.
 In case of index option contracts, all open long positions at in -the-
money strike prices areautomati cally exercised on the expiration day
and assigned to short positions in option contracts with the same series
on a randombasis.
8.11 UNIT END QUESTI ONS
A. Descriptive Questions
1. Write about clearing members .
2. Write down the functions of clearing members ?
3. Briefly explain about the clearing mechanism ?
4. What is marked -to-market settlement ?
5. Explain the various types of settlements.
B. Fill in the Blanks
1. . ............. undertakes clearing and settlemen t of all trade sexecuted on the
2. . In the case of options, final exercise settlement is………
3. . On expir y of a derivatives contract, the settlement price is
the…………….
4. . ………….. is a banking institution that is a member of a national check
clearing network that has the ability to approve or clear checks for
payment, even if those checks are not written on accounts associated
with that bank.
5. . ………………. constituted by SEBI had laid down the regulatory
framework for derivative trading in India.

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101 Answers
1-National Securities Clearing Corporation Limited (NSCCL) , 2-
Automatic , 3- Spot price of underlying asset , 4-Clearing Bank ,
5- Dr. L.C Gupta Comm ittee
8.12 REFERENCES
References book
 Derivatives Market NCFM Module. National Stock Exchange India
Limited Publications : Bombay : 2007.
 Gupta S. L (2007). Financial Derivatives Prentice Hall. New Delhi.
 Indian Stock Market Review. National Stock Exchange Publications.
 Jaynath RamaV arma (2008). Derivatives and Risk Management.
Tata Mc Graw Hill Publications : New Delhi.

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