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Derivatives and Risk Management

Name: Derivatives and Risk Management
ISBN: 9789353067076

by Madhumathi Madhumathi, Ranganatham Ranganatham

October 2011

Intermediate to advanced

672 pages

26h 2m

English

Pearson Education India

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Cover
Title Page
About the Authors
Brief Contents
Contents
Preface
PART 1 – BASIC PRINCIPLES OF DERIVATIVES
1. Risk Management with Derivatives
1.1 Introduction1.2 Market Risk and Economic Stability1.3 Types of Risks and Risk Management Practices of Firms1.3.1 Types of risks1.3.2 Operating risk1.3.3 Financial risk1.3.4 Systems risk1.3.5 Event risk1.3.6 Active and passive hedging strategies1.4 Benefits of Hedging1.5 Hedging Tools1.6 Trading in Derivatives1.7 Derivative Instruments as Investments1.8 Scope and LimitationsChapter SummaryKey TermsDiscussion QuestionsCase for AnalysisSuggested Readings
2. Derivative Markets
2.1 Introduction2.2 Development of Derivative Markets2.3 Derivative Markets in India2.3.1 Economic impact of derivative markets2.3.2 Commodity derivatives2.3.3 Equity derivatives2.3.4 Interest-rate derivatives2.3.5 Currency derivatives2.4 Derivative Market Structure2.4.1 Exchange-traded derivative market2.4.2 OTC derivative market2.5 Derivative Segments in Markets2.5.1 National Stock Exchange (NSE)2.5.2 Multi-commodity exchange2.5.3 Chicago mercantile exchange2.6 Trading Functions and Mechanism2.6.1 Derivative trading mechanism in an exchange2.6.2 OTC derivatives trading mechanism 2.7 Clearing Mechanism in Derivative Markets2.7.1 Exchange-traded clearing facility2.7.2 Clearing of derivative trades in OTC markets2.8 Risk Mitigation in the Derivative Market2.8.1 Counterparty risk2.8.2 Operational risk2.8.3 Legal risk2.8.4 Liquidity risk2.8.5 Systemic risk2.9 Desired Derivative Market Characteristics2.10 Effectiveness of Derivative Exchange2.10.1 Product innovation2.10.2 Technological innovationChapter SummaryKey TermsDiscussion QuestionsCase for AnalysisNet-Wise ExercisesSuggested Readings
3. Derivative Market Regulation in India
3.1 Introduction3.2 Commodity Derivative Market Regulation3.2.1 Participants in indian commodity derivative markets3.2.2 Derivative market regulation3.2.3 Eligibility criteria for commodity derivative contracts3.2.4 Trading system3.2.5 Margin requirements3.3 Securities Derivative Market Regulation3.3.1 Participants in the indian equity derivative market3.3.2 Derivative market regulation3.3.3 Eligibility criteria for introducing derivative contracts on stocks3.3.4 Trading system3.3.5 Margin system3.4 Interest-Rate Derivative Market Regulation3.4.1 Derivative market participants in india3.4.2 Derivative market regulation3.4.3 Eligibility criteria3.4.4 Risk management3.5 Currency Derivative Market Regulation3.5.1 Participants in the indian derivative market3.5.2 Derivative market regulation3.6 Structured Credit Derivatives Market Regulation3.6.1 Participants in the indian derivative market3.6.2 Derivative market regulationChapter SummaryKey TermsDiscussion QuestionsSuggested Readings

4. Forward and Futures Instruments
4.1 Introduction4.2 Forward Instruments4.3 Forward Rate Agreements (FRAs)4.4 Futures Instruments4.4.1 Commodity futures4.4.2 Security futures4.4.3 Currency futures4.4.4 Interest rate futures4.5 Differences Between Forward and Futures Contracts4.6 Futures Instruments for Asset Allocation—Security Futures4.7 Futures as Portfolio Insurance—Index Futures4.8 Price Discovery in the Futures MarketChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise ExercisesSuggested Readings
5. Swap Instruments
5.1 Introduction5.2 Swaps5.3 Vanilla Swaps5.4 Amortizing Swap5.5 Forward Swap5.6 Basis Swap5.7 Constant Maturity Swap5.8 Yield Curve Swap5.9 Rate Differential Swap5.10 Corridor Swap5.11 Uses of Swap InstrumentsChapter SummaryKey TermsDiscussion QuestionsProblemsCase for Analysis
6. Option Instruments
6.1 Introduction6.2 Features of Option Instruments6.3 Index Options6.4 Currency Options6.5 Interest Rate Options6.5.1 Intrinsic and time value of interest rate option contracts6.5.2 Interest rate caps6.5.3 Interest rate floors6.6 SwaptionsChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise Exercises
7. Derivative Option Strategies
7.1 Introduction7.2 Synthetic Position7.2.1 Synthetic treasury bill7.2.2 Synthetic portfolio using futures7.2.3 Synthetic long position in a security using options7.2.4 Synthetic put option7.2.5 Synthetic call option7.3 Covered Position7.3.1 Covered call option7.3.2 Covered put option7.4 Spread7.4.1 Bull spread using call options7.4.2 Bull spread using put options7.4.3 Bear spread using call options7.4.4 Bear spread using put options7.5 Combo7.5.1 Long combo7.5.2 Short combo7.6 Straddle7.6.1 Long straddle7.6.2 Short straddle7.7 Strangle7.7.1 Long strangle7.7.2 Short strangle7.8 Butterfly7.8.1 Long butterfly7.8.2 Short butterfly7.9 Condor7.9.1 Long condor7.9.2 Short condor7.10 Strips7.10.1 Long call strip7.10.2 Long put strip7.11 Strap7.12 Collar7.13 Calendar SpreadChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise ExercisesSuggested Readings
PART 2 – APPLICATION OF DERIVATIVE PRODUCTS
8. Commodity Market Derivative Instruments
8.1 Introduction8.2 Product Category8.2.1 Bullion products8.2.2 Metal products8.2.3 Agro products8.2.4 Energy products8.2.5 Polymer products8.2.6 Weather carbon credits8.3 Contract Specifications8.3.1 Tick size8.3.2 Daily price limit8.3.3 Margin system8.3.4 Sales tax8.3.5 Contract expiry8.3.6 Tender and delivery period8.3.7 Delivery logic8.3.8 Determination of closing price8.3.9 Commission and other charges8.4 Risk-Reducing Strategies Using Commodity Futures8.4.1 Spread positions8.4.2 Spread contracts8.4.3 Cross hedging8.5 Commodity Options8.5.1 Call option hedge8.5.2 Put option hedge8.5.3 Long combo hedge8.6 Commodity Swaps8.6.1 Energy swap hedges8.6.2 Agro swap hedgesChapter SummaryKey TermsDiscussion QuestionsProblems Case for AnalysisNet-Wise ExercisesAppendixSuggested Readings
9. Equity Market Derivative Instruments
9.1 Introduction9.2 Derivative Contracts9.3 Margin System in Equity Derivative Segment9.3.1 Initial margins9.3.2 Mark-to-market margins9.3.3 Margin calls9.4 Hedging versus Speculation Using Equity Derivatives9.5 Security Hedge versus Portfolio Hedge9.6 Performance of a Hedged Portfolio9.7 Security Hedge Using Futures9.7.1 Tailing the hedge9.8 Portfolio Hedging Using Futures9.9 Security Hedge Using Options9.10 Portfolio Hedge Using Options9.11 Options on Futures9.12 Employee Stock Option Schemes (ESOS)9.13 Warrants9.14 Convertibles9.15 Derivatives in Mutual Fund PortfoliosChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise ExercisesSuggested Readings
10. Interest Rate Derivative Instruments
10.1 Introduction10.2 Interest Rate Derivative Products10.3 Interest Rate Categories10.4 Zero-Coupon Yield Curve10.5 Term Structure of Interest Rates10.5.1 Theories explaining term structure of interest rates10.5.2 Interpreting the yield curve10.5.3 Normal yield curve10.5.4 Upward yield curve10.5.5 Humped yield curve10.5.6 Flat yield curve10.5.7 Downward-sloping yield curve10.6 Trading in Forward Rate Agreements10.7 Speculation in Interest Rate Derivatives10.8 Hedging Using Interest Rate Derivatives10.9 Cheapest-to-Deliver Bonds10.10 Trading Strategies Using Interest Rate Futures10.10.1 Riding the yield curve10.10.2 Spread strategy10.10.3 TED spreads10.11 Trading Strategies Using Interest Rate Options10.12 Trading in Interest Rate Swaps10.12.1 Comparative advantage swap10.12.2 Synthetic swap spread10.13 Interest Rate StripsChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise Exercises Suggested Readings
11. Currency Derivative Instruments
11.1 Introduction11.2 Exchange Rate Quotations11.2.1 Cross-currency rates11.2.2 Effective exchange rates11.3 Currency Derivative Products11.3.1 Foreign exchange forwards11.3.2 Foreign-currency rupee swap11.3.3 Foreign-currency rupee options11.3.4 Cross-currency options11.3.5 Cross-currency swaps11.3.6 Indian currency trading platforms11.4 Determinants of Foreign-Exchange Rate11.5 Economic Theorems of Exchange Rate Determination11.6 Speculation in Currency Derivatives11.6.1 Speculating with spreads11.7 Hedging with Currency Derivatives11.8 Hedging Transaction Exposure11.8.1 Measuring exposure11.9 Currency Forwards11.9.1 Synthetic Agreements for Forward Exchange (SAFE)11.9.2 Break forward contract11.9.3 Participating forward contracts11.9.4 Range forward contracts11.10 Currency Futures11.11 Currency Options11.12 Currency SwapsChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise ExercisesSuggested Readings
PART 3 – ADDITIONAL DERIVATIVE PRODUCTS
12. Credit Derivative Instruments
12.1 Introduction12.2 Credit Risk12.3 Measurement of Credit Risk12.4 Capital Requirement for Credit Risk12.5 Credit Ratings12.6 Credit Derivatives12.7 Structured Credit Instruments12.7.1 Credit linked notes12.7.2 Collateralized debt obligations12.7.3 Cash versus synthetic CDOs12.7.4 Credit Default Swap (CDS)12.7.5 Total return swap12.7.6 Constant-maturity swap12.7.7 Credit options12.7.8 Credit spread (price) put options12.7.9 Credit spread (price) call options12.8 Trading Strategies of Credit Derivatives12.9 Risk Associated with Credit DerivativesChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise ExercisesSuggested Readings
13. Real Options
13.1 Introduction13.2 Characteristics of Real Options13.2.1 Underlying asset13.2.2 Uncertainty in the asset price value13.2.3 Exercise price13.2.4 Option expiry duration13.2.5 Risk-free rate13.2.6 Cost of delay13.3 Corporate Capital Budgeting Applications13.3.1 Expansion option13.3.2 Project abandonment13.4 Research and Development Application13.5 Property Development Application13.6 Portfolio of Real Options13.7 Practical ConsiderationsChapter SummaryKey TermsDiscussion QuestionsProblemsNet-Wise ExerciseSuggested Readings
14. Exotic Options
14.1 Introduction14.2 Asian Options14.3 Binary Options14.4 Look Back Options14.5 Barrier Options14.5.1 Knock-out barrier options14.5.2 Knock-in barrier options14.6 Chooser Options14.7 Compound Options14.7.1 Compound option: call on call14.7.2 Compound option: put on put14.7.3 Compound option: call on put14.7.4 Compound option: put on call14.8 Contingent Premium Options14.8.1 Contingent cap14.9 Deferred Strike Options14.10 Rainbow Option14.10.1 Best-of-assets rainbow option14.10.2 Worst-of-assets rainbow options14.10.3 Basket rainbow option14.10.4 Quanto14.10.5 Spread rainbow option14.11 LEAPS (Long-Term Equity Anticipation Securities)Chapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise ExercisesSuggested Readings
PART 4 – PRICING DERIVATIVE PRODUCTS
15. Pricing Futures
15.1 Introduction15.2 Principles of Pricing Futures15.2.1 Expectation hypothesis15.2.2 Backwardation principle15.2.3 Cost of carrying the underlying asset15.3 Cost of Carry Model15.4 Pricing Commodity Futures15.5 Pricing Equity Futures15.6 Pricing Interest-Rate Futures15.7 Pricing Forward-Rate Agreement (FRA)15.8 Pricing Foreign Exchange Rate Futures15.9 Forward and Futures PricesChapter SummaryKey TermsDiscussion QuestionsProblemsSuggested Readings
16. Pricing Options
16.1 Introduction16.2 Rational Boundaries of Option Contracts16.2.1 European call option lower bound value16.2.2 European call option upper bound value16.2.3 European put option lower bound value16.2.4 European put option upper bound value16.2.5 American call option lower bound value16.2.6 American call option upper bound value16.2.7 American put option lower bound value16.2.8 American put option upper bound value16.3 Variations in the Basic Structure of Options16.3.1 Value of options with different expiry dates16.3.2 Values of options with different strike prices16.3.3 Value of options with different underlying asset spot prices16.3.4 Option values when the underlying asset pays dividend16.4 Binomial Option Pricing Model16.4.1 Continuous dividend payments from underlying assets16.4.2 European put option16.4.3 American options16.5 Black-Scholes Model16.5.1 Adjustment for expected dividend inflow16.6 Pricing Option on Futures16.7 Put-call Parity Relationship16.7.1 Put-call parity in european options16.7.2 Put-call parity with dividend inflow16.7.3 Put-call parity relationship of american options16.8 Comparison of Black-Scholes with Binomial Valuations16.9 Implied Volatilities16.10 Criticism on Option-Pricing ModelsChapter SummaryKey TermsDiscussion QuestionsProblemsSuggested Readings
17. Pricing Swaps
17.1 Introduction17.2 Pricing and Valuing Interest-Rate Swaps17.2.1 Plain vanilla interest-rate swap as a zero-cost collar17.2.2 Fixed-for-floating interest-rate swap17.3 Pricing and Valuing Equity Swap17.3.1 Determining the fixed-percentage swap rate17.3.2 Computation of spread on floating interest rate17.4 Pricing and Valuing Currency Swap17.4.1 Fixed-for-fixed currency swap17.5 Pricing and Valuing Commodity Swap17.6 Swaptions17.7 Pricing and Valuing Credit Default SwapsChapter SummaryKey TermsDiscussion QuestionsProblemsSuggested Readings
PART 5 – DERIVATIVE RISK MANAGEMENT
18. Market Risk
18.1 Introduction18.2 Risk Management18.3 VaR Measure18.3.1 Nifty total return index18.3.2 Commodity index18.4 Approaches to Quantification of VaR18.4.1 Historical method18.4.2 The variance–covariance approach18.4.3 Delta normal valuation18.4.4 Delta gamma valuation18.4.5 Historical simulation approach18.4.6 Monte carlo VaR18.4.7 Extreme value theory and VaR18.5 Sub-Elements of VaR18.5.1 Marginal VaR18.5.2 Incremental VaR18.5.3 Component VaR18.5.4 Conditional VaR18.5.5 Accounting for skewness and kurtosis with the cornish–fisher expansion18.6 Evaluation of VaR18.6.1 Ability to capture the risks of options and option-like instruments18.6.2 Ease of implementation18.6.3 Reliability of the results18.6.4 Flexibility in incorporating alternative assumptionsChapter SummaryKey TermsDiscussion QuestionsProblemsNet-Wise ExerciseSuggested Readings
19. Measuring Risk Characteristics of Derivative Instruments
19.1 Introduction19.2 Derivative Greeks19.3 Delta Hedging19.3.1 Call option delta sensitivity19.3.2 Put option delta sensitivity19.3.3 Delta neutrality19.4 Gamma Hedging19.4.1 Call and put option gamma sensitivity19.5 Delta–Gamma Hedging19.6 Vega Hedging19.6.1 Vega sensitivity19.7 Delta–Gamma–Vega Hedging19.8 Theta Hedging19.8.1 Call option theta sensitivity19.8.2 Put option theta sensitivity19.9 Delta, Gamma, Vega, Theta Hedging19.10 Rho Hedging19.10.1 Call option sensitivity of rho values19.10.2 Put option sensitivity to rho values19.11 Delta, Vega, Rho Hedging19.12 Derivative Instruments Risk ManagementChapter SummaryKey TermsDiscussion QuestionsProblemsCase for AnalysisNet-Wise ExercisesSuggested Readings
20. Derivative Hedge Accounting
20.1 Introduction20.2 Accounting for Derivative Margin Payments20.2.1 Margin accounting when trades are offset20.2.2 Margin accounting when trades are physically delivered20.3 Accounting Standards for Derivative Transactions20.3.1 International accounting standards board20.3.2 Financial accounting standards board20.4 Effectiveness of Hedge Accounting20.5 Hedge Accounting20.6 Hedge Accounting Models20.6.1 Fair-value hedge accounting20.6.2 Cash-flow hedge20.6.3 Net-investment hedge20.7 Accounting for Derivative Instruments (ICAI Directive)20.8 Hedge Trade Life Cycle Accounting20.9 Taxation of Derivative Gains (Losses)20.10 IFRS and Derivative AccountingChapter SummaryKey TermsDiscussion QuestionsNet-Wise ExercisesSuggested Readings
Glossary
Index
Copyright

Content preview from Derivatives and Risk Management

chapter 6 Option Instruments

LEARNING OBJECTIVES

After reading this chapter, you will be able to understand the

features of option contracts
types of option contracts
application of option contracts to reduce financial risk

CHAPTER OUTLINE

6.1 Introduction

6.2 Features of Option Instruments

6.3 Index Options

6.4 Currency Options

6.5 Interest Rate Options

6.6 Swap Otions

THE SITUATION

Sudhir Kamath owns 1000 equity shares of Infosys. There is an increasing trend in the market price of these shares. The company is also paying dividends regularly. Can he profit from the increasing prices without selling the shares in the market?

Ranjani Saxena is a risk manager of a firm. The firm has borrowed ₹ 5 million from a bank on a floating rate of ...

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Derivatives and Risk Management

by Madhumathi Madhumathi, Ranganatham Ranganatham

chapter 6