-CA Priyanka Satarkar

TOPICS 1. Investment

meaning, importance, investment alternatives. Criteria for evaluation of investments. Portfolio management process. Approaches to investment decision making. Errors in investment management. Qualities for successful investing. 2. Financial markets and financial derivatives 3. Futures: Key features of a futures contract, Difference between futures and forwards. Calculate the theoretical price of various contracts. Use of a futures contract for hedgers and speculators. Assess economic functions performed by futures 4. Options: Meaning, how options work, equity options in India, options and their payoffs, types of options, option strategies. Factors determining option values. Models for option valuation. Calculation of option values. 5. Investment in Futures and options evaluation.

Investment vs SpeculationINVESTMENT Longer planning horizon Atleast a year Not willing to assume high risk y Modest rate of return is expected y More importance to fundamental factors for evaluation y More owned capitaly y y y

SPECULATION Short plan horizon Few days to few months Willing to assume high risk y Investor looks for high rate of return y More importance to technical charts and market psychology y More borrowed capitaly y y y

INVESTMENT ALTERNATIVESy REAL ASSETS: these are represented by tangible assets like residential houses, commercial property, agricultural farm, gold, precious stones etc y FINANCIAL ASSETS: These are paper or electronic claims on some issuer such as government or corporate body.

TYPES OF SECURITIES

NON MARKETABLE SECURITIES

MARKETABLE SECURITIES

1. 2. 3. 4. 5. 6. 7. 8. 9.

BANK DEPOSITS POST OFFICE SAVINGS ACCOUNT POST OFFICE TIME DEPOSITS MONTHLY INCOME SCHEME OF POST OFFICE KISAN VIKAS PATRA NATIONAL SAVINGS CERTIFICATE COMPANY DEPOSITS EMPLOYEE PROVIDENT FUND SCHEME PUBLIC PROVIDENT FUND

1. MONEY MARKET INSTRUMENTS 2. BONDS OR DEBENTURES 3. EQUITY SHARES 4. MUTUAL FUND SCHEMES 5. FINANCIAL DERIVATIVES

Criteria for evaluation of Investment AvenuesyRate of Return yRisk yMarketability yTax Shelter

Portfolio Management Process1. 2. 3. 4. 5. 6.

Specification of investment objectives and constraints Choice of the asset mix Formulation of Portfolio strategy Selection of Securities Portfolio Revision Performance evaluation

Approaches to portfolio management processy Fundamental Approach y Psychological approach y Academic Approach y Eclectic Approach

1. Inadequate comparison of Risk and Return 2. Vaguely formulated Investment policy 3. Nave Extrapolation of the past 4. Cursory Decision making 5. Untimely entry and exit 6. High cost 7. Over diversification and under Diversification 8. Wrong attitude towards losses and profits

1. Contrary Thinking 2. Patience 3. Composure 4. Flexibility and Openness 5. Decisiveness

TYPES OF FINANCIAL DERIVATIVES

FUTURES

OPTIONS

CALL OPTION

PUT OPTION

FUTURESMEANINGy A futures contract is an

PARTIES TO FUTURESy THE PURCHASING PARTY it

agreement between two parties to exchange an asset for cash at a predetermined future date for a price that is specified today.

is said to be in a long positiony THE SELLING PARTY it is

said to be in a short position.

Futures - their originy A poor philosopher in Militus used it in crude form

It was used for the trade of Olive y First Futures exchange began in Japan as the Dojima rice Exchange for the Samurai in 1730 y Chicago board of trade listed the first ever traded forward contracts in 1864 which were called as future contracts y In 1875 Cotton Futures were being traded in Mumbai

Difference between Forwards and FuturesForwardsy This is a tailor made contract y No secondary market y It end with deliveries y No collateral is required y They are settled on maturity

Futuresy Standardized contract y Secondary market available y It ends with settlement y Margin is required y Future contract are marked to

date y Both parties are exposed to credit risk

market on the maturity date y It is free from credit risk as it comes with risk eliminating measures

Advantages of Futuresy y y

y y

y y

Futures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point -- the location where delivery must be made. The delivery month and The last trading date. Other details such as the the minimum permissible price fluctuation.

Types of Futuresy COMMODITY FUTURES: Where the underlying is a

commodity or physical asset.y FINANCIAL FUTURES: Where the underlying is a

financial asset such as Foreign Exchange, Interest rates, Shares, Treasury bills etc.

PARTICIPANTS IN FUTURES MARKET

HEDGERS

SPECULATORS

ARBITRAGEURS

Key aspects of Futures

y The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. y In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all that is, for financial futures, the underlying asset or item can be currencies Securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates . y The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.

MARGIN REQUIREMENT OF FUTURESy To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract's value. y To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. y Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

MARGIN REQUIREMENT OF FUTURESy Clearing margin are financial safeguards to ensure that

companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. y Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin. y Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange.

MARGIN REQUIREMENT OF FUTURESy Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. y Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls. y Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

CONTRACT SPECIFICATIONSy Trading unit - The Trading unit is the minimum quantity for a

contract that can be bought or sold. e.g. If a member is buying 1 lot of cardamom, he has to buy minimum 100kg of cardamom given trading unit of 100kg. y Quotation / Base value It is the Quantity in Lot or Weights for which the prices are quoted for online trading. e. g. If the quotation or base value for Gold contract is given as 10 grams and the price available for trading is 8000, that price is for 10 grams of the Gold. y Maximum order size Maximum order size is the maximum no. of lots that can be bought or sold in one Single order. The maximum order size of each commodity is given in its contract specifications.

CONTRACT SPECIFICATIONSy Tick Size

Tick size is the minimum price difference between the bids and asks for a particular contract. The tick size is given in the contract specifications. DPR Daily Price Limit i.e. circuit filter limit is the percentage of variation allowed in the price of a commodity in a day with respect to the previous day s close price for the day DDR - Due date rate is final settlement price for particular future contract and calculation process called computation of DDR.

y

y

y Circuit Filter: The Exchange notifies a daily circuit filter limit for

futures Contract in terms of percentage of intra day variation allowed in a day with respect to the close price of previous day. Circuit filter provides the maximum range within which a contract can be traded during day. Such circuit filter is different for different commodities. The orders, which are in violation of such circuit filter, are rejected by the system.

ORDER TYPESSTOP LOSS ORDER ORDERS ON BASIS OF PERIOD

REGULAR ORDER Regular orders can be placed in the system with market price or limit price

LIMIT ORDER: Specifying the price at which the trade should be executed

MARKET ORDER: It should be executed at whatever prevailing market price

ORDER TYPES(ON BASIS OF PERIODEnd of the session (EOS): are available for execution during the current trading session until executed or cancelled. All EOS orders will get cancelled at the end of the day during which such orders were submitted. Good till date: which are available for execution till end of the date indicated in the order or till the last trading day of that contract month, whichever is earlier? Good till cancel: which is available for execution till maturity of the contract, or till it is cancelled by the Member /user, whichever is earlier. Immediate or Cancel (IOC): orders will get cancelled if not executed on submission of such an order. Such orders will not remain in the order book. Day Order: are available for execution during the current trading until executed or cancelled. All DAY orders will get cancelled at the end of the day during which such orders were submitted

COMMODITY MARKETMeaningy These are the markets where

raw or primary goods are traded y These commodities are traded on regulated commodities exchange y Here they are bought and sold on basis of standardized contracts

OPTIONS- MeaningAn option gives the owner the right to buy or sell an underlying asset on or before a given date at a fixed price Eg: Option to buy a certain flat on or any time before 31st Jan 2011 at Rs 50 lacs. There are many different option contracts as the number of items to buy or sell. Eg: Stock options, commodity options, foreign exchange options etc

FEATURES OF AN OPTIONy The option is exercisable only by the buyer of the option y The owner has limited liability y Owner of options have no right affordable to shareholders such as voting rights and dividend right y Option have high degree of risk as to the option writers y Options are popular because they allow the buyer profits from favourable movements in exchange rate y Options involve buying counter positions by the option sellers y Flexibility in investor needs y No certificates are issued by the company

Difference between futures and optionsFUTURESy Both the parties are obligated to

OPTIONSy Only the Seller (Writer) is

perform y No premium is paid by either parties y The holder of the contract is exposed to the entire spectrum of downside risk and has the potential for all the up side return y The parties to the contract must perform at the settlement date. They are not obliged to perform before the date

obligated to perform y The buyer pays the Seller (writer) a premium y The buyer s loss is restricted to the premium amount but retains upward indefinite potentialsy The buyer can exercise the

option at any time prior to the expiry date

OPTION TERMINOLOGYCALL OPTION: the option to buy PUT OPTION: The option to sell OPTION HOLDER: Buyer of the option OPTION WRITER: Seller of the option EXERCISE PRICE OR STRIKING PRICE: The fixed price at which the option holder can buy and/or sell the underlying asset y MATURITY DATE: The date when the option expires y EUROPEAN OPTION: Can be exercised only at the time of maturity y AMERICAN OPTION: It can be exercised on or before the expiration date.y y y y y

CALL OPTION: A Call option is the right but not theobligation to buy some commodity or security at a specific price which is the exercise priceCALL OPTION

BUYER- Holder Long

SELLER- Writer short

Has the right but not the obligation to buy 100 shares of the underlying stock at the strike price

Is obligated on demand to sell 100 shares of the underlying stock at the strike price that the holder exercises

CALL OPTIONBUYER- Holder Long SELLER- Writer short

1. EXPECTATION: Wants the market price of the underlying stock to rise 2. REWARD: Potential unlimited gain when the price of the underlying stock appreciates 3. RISK: Losses only restricted to the premium paid for the call when the market price of the underlying stock declines

1. EXPECTATION: Wants the market price of the underlying stock to stay flat on rise 2. REWARD: Premium amount 3. RISK: Potentially unlimited loss when the market price of the underlying stock rises.

PUT OPTION: A Put option is the right but not theobligation to sell some commodity or security at a specific price which is the exercise pricePUT OPTION

BUYER- Holder Long

SELLER- Writer short

Has the right but not the obligation to sell 100 shares of the underlying stock at the strike price

Is obligated on demand to buy 100 shares of the underlying stock at the strike price that the holder exercises

PUT OPTIONBUYER- Holder Long SELLER- Writer short

1. EXPECTATION: Wants the market price of the underlying stock to decline 2. REWARD: Potential unlimited gain when the price of the underlying stock appreciates 3. RISK: Losses only restricted to the premium paid for the call when the market price of the underlying stock rises

1. EXPECTATION: Wants the market price of the underlying stock to stay flat or rise 2. REWARD: Premium amount 3. RISK: Potentially unlimited loss when the market price of the underlying stock falls.

OPTION TYPETYPE y ATM (At the money)y ITM (In they CALL OPTION

Exercise price=Market price

money)y OTM(Out of

Exercise price Market price

OPTION TYPETYPE y ATM (At the money)y ITM (In they PUT OPTION

Exercise price=Market price

money)y OTM(Out of

Exercise price >Market price

the money)

Exercise price < Market price

EQUITY OPTIONS IN INDIAINDEX OPTIONS : Index Options are options on stock market indices. Currently the most popular index option is the option on the S & P CNX Nifty which is traded on the NSE. The salient features of this contract are: 1. The contract size is 200 times or multiples thereof the underlying index viz the S & P CNX Nifty 2. It is a European style contract 3. The maximum period is 3 months 4. The expiry date is the last Thursday of the expiry month or the previous trading day is the last Thursday is a holiday 5. It is cash settled

OPTIONS ON INDIVIDUAL SECURITIESOptions on individual securities have been introduced in the NSE and BSE. The salient features of this contract are: 1. Maximum 3-month trading cycle 2. Minimum of 5 strike prices for every option type 3. The contracts shall expire on last Thursday of the expiry month 4. Value shall not be less than Rs 2,00,000. Permitted lot size will be 100 units or multiples 5. Price steps shall be Rs 0.05 6. Base price shall be arrived at using the Black Scholes model 7. They will be of American style 8. Cash Settled

Strategies with individual Stock optionsy PROTECTIVE PUT: Protect against downfall. Buy the

stock and invest in put option. y COVERED CALL: It involves writing a call option on an asset along with buying the asset. y SPREAD: Combining two or more call options or two or more put options

Formula for calculating Future priceFo =So(1+rf-d)^T Where: F0= futures price S0=Stock index Rf = Risk free interest rate d= Dividend yeild T=Time in months

Problems on Futures & Options1.

In May beginning you decide that shares of X Ltd will rise over the next months. The current price is Rs 100 and you hope that it will rise to Rs 150 by the end of July. If an option is traded it will be a call option at a premium of 10% of the option value. Calculate your position for 100 shares a. If the option is traded in July as the market price is Rs 150 per share b. If market price declines to Rs 90 and no option is traded c. If you do not purchase any option but decide to buy the shares in secondary market at the cost of 2% per trade and either the part a) or b) above works out

Problem 2Assume that an investor buys a stock index futures contract on 1st March at Rs 1125. The position is closed out on March 5th at that day s settlement price. The stock index prices on four days after purchase were 1128, 1127, 1126 and 1128. Calculate the cash flow to the investor on daily basis. Ignore margin requirements.

Problem 3Stock index is currently Rs 1200. The risk free interest rate is 1% per month and the dividend yield on the stock is 0.25% per month. Find net cost of carry and also the stock future price if the future matures after 3 months

PROBLEM 4A non dividend paying stock has a current price of Rs 40. What will be the futures price if the risk free rate is 8% and the maturity of the futures contract is 2 months

Problem 5A Person Mr Q is expecting that the shares of a petroleum company would be traded ahead after 2 months for Rs 2500. Currently they are selling at Rs 1000. He purchases a call option for 100 shares from Mr Z at the current market price. He pays a premium of 10% of the current market price. Estimate the profit or loss that Mr Q and Mr Z will incur in case: a. Share price after 2 months is Rs 2100 b. Share price after 2 months is Rs 850 c. Share price after 2 months is Rs 1000

Computation of Price of spreadThis is used to determine the relationship between future prices of contracts having different maturity dates. F(T2) = F(T1) (1+rf d) ^(T2-T1) Where T1 and T2 are the two time periods

Problem 1If the risk free interest rate is 6% and the dividend yield is 2% and the contract prices and maturity is given as follows: June 25th Future price is Rs 1060 July 25th Future price is Rs 1063 Calculate the correct price of July future and check whether there is any arbitrage opportunity.

Problem 2The share of Omega Company which is not expected to pay dividend in the near future is currently selling for Rs 150. The risk free interest rate is 0.8% per month. A three month futures contract is selling for Rs 152. Develop an arbitrage strategy and show how your profit will be three months hence.

Asset Pricing modelsy The first is the non-arbitrage principle which states that the market forces tend to align the prices of financial assets so as to eliminate arbitrage opportunities Arbitrage opportunity arises when assets can be combined in a portfolio by buying and selling such that the portfolio has zero cost, no chance of a loss and a positive probability of gain. Arbitrage opportunities tend to be eliminated by trading in financial markets since prices adjust in investors attempt to exploit them y The second concept is financial markets equilibrium. Investors desired holdings of financial assets derive from an optimization problem. In financial market equilibrium the first order conditions of an optimization problem must be satisfied.

Black-Scoles Modely The Black Scholes model of the market for a particular equity makes the following explicit assumptions: y It is possible to borrow and lend cash at a known constant risk-free interest rate. y The stock price follows a geometric Brownian motion with constant drift and volatility. y There are no transaction costs, taxes or bid-ask spread. y The underlying security does not pay a dividend. y All securities are infinitely divisible (i.e., it is possible to buy any fraction of a share). y There are no restrictions on short selling. y There is no arbitrage opportunity.

BLACK AND SCHOLES OPTION PRICING MODELy BLACK AND SCHOLES FORMULA FOR EUROPEAN

CALL: Rt C=S N(d1)-K/e N(d2) Where: C= Market value of an option S = Current market price of underlying stock k= Option s Striking price r = The continuously compounded risk free rate(annual) t=The time until expiration in years

N(d1) (Read as N of d1) =Normal distribution function at value d1 =ln (S/k)+(r+0.5 ^2)t t N(d2) (Read as N of d2) =Normal distribution function at d2 =d1- t = standard deviation of changes in price of the underlying ie volatility ^2 =Instantaneous variation of the price of the underlying ie measure of the return volatility of the underlying ln =Natural Log

Stepsy Values of d1 and d2 must be computed first y Values for the normal distribution, log and PV need to

be found and inserted y Then insert the final values and calculate C

Problem 1The following is a data for a stock Price of the stock currently is =Rs 60 Exercise price = Rs 56 Standard deviation of continuously compounded annual returns = 0.3 Years to maturity = 0.5 Interest rate per annum =0.14 Apply the black-Scholes formula and calculate the option price [ln of 1.0714=0.068993, N (0.7614) = 0.7768 N(0.5493) = 0.7086 and PV of .007 is 1.0726]

Understanding the put-call parityThe put-call parity is said to work when the price lines up with the calculation as per the put-call parity formula which is C = S + P E/e ^ rt

Calculating the value of Put option from the call optionValue of the put option is calculated as followsP = C S + E/e^rt

ProblemCheck from the following data if the put-call parity is working when PV of 0.025 is 1.025Particulars Call Option Put Option

Ti e t ex irati ( t s) Risk free rate Exercise rice St ck Price Price

3

3

10% Rs 50 Rs 60 Rs 16

10% Rs 50 Rs 60 Rs 2

LIMITATIONS OF THE MODELy Among the most significant limitations are: y the underestimation of extreme moves, yielding tail risk, which can be hedged with out-of-the-money options; y the assumption of instant, cost-less trading, yielding liquidity risk, which is difficult to hedge; y the assumption of a stationary process, yielding volatility risk, which can be hedged with volatility hedging; y the assumption of continuous time and continuous trading, yielding gap risk, which can be hedged with Gamma hedging. y In short, while in the Black Scholes model one can perfectly hedge options by simply Delta hedging, in practice there are many other sources of risk.

Risks associated with derivatives1. 2. 3. 4. 5. 6. 7. 8.

Market risk: Risk of adverse price, interest rate, index level and other fluctuations. Credit Risk: It is the risk of the derivative contract counterparty would default Liquidity risk: Relating to getting or giving at the time of fulfillment of the contract Legal Risk: This arises with the possibility that the entity may not be able to collect on a winning position or enforce a hedge Operational risk: By human error, management failure or fraud Valuation risk: Models of valuation may not reflect the real picture Regulatory Risk: These markets are relatively new hence there is a possibility of this risk Contagion Risk: A large amount of inter dealer position and high replacement cost to total assets ratio expose major OTC to derivative risk.

Advantages of Derivativesy RISK SHARING y Implementation of asset allocation decision y Information gathering y Price discovery and liquidity

Derivatives their other typesy Weather Derivatives: They provide hedging against

the weather changes that affect the products or services y Credit Derivatives: Types are: 1. Credit default Swap 2. Credit spread option 3. Total return Swap 4. Credit Linked notes

Risk minimization through derivativesy Reducing the risk by selling the source of it y Reducing the risk of diversification y Reducing the risk of buying the insurance against

losses