Risk management and financial Derivatives

Assignment - II,

Q1. Define option. Explain different terminology used in option contract.

Ans. An option is a particular type of a contract between two parties where one person gives the
other person are right to buy or sell a specific asset at a specified price within a specific time
period. In other words, the option is a specific derivative instrument under which one party gets
the right, but no obligation, to buy or sell a specific quantity of an asset at an agreed price, on or
before a particular date. Terminology Following are the important terms which are frequently
used in option trading:

1. Parties of the option contract

There are two parties to an option contract: the buyer (the holder) and the writer (the seller). The
writer grants the buyer a right to buy or sell a particular asset in exchange for a certain sum of
money for the obligation taken by him in the option contract.

2. Exercise price
The price at which the underlying asset may be sold or purchased by the option buyer from the
option writer is called as exercise or strike price. At this price the buyer can exercise his option

3. Expiration date and exercise date

The date on which an option contract expires is called as expiration date or maturity date. The
option holder has the right to exercise his option on any date before the expiration date. In other
words, the date after which an option is void is called the expiration date. Exercise date is the
date upon which the option is actually exercised whereas the expira- tion date is the last day
upon which the option may be exercised.

4. Option premium
The price at which option holder buys the right from the option writer is called option premium
or option price. This is the consideration paid by the buyer to the seller and it remained with the
seller whether the option is exercised or not. In other words, the price or premium is paid by the
holder to the writer of the option against the obligation under- taken. This is fixed and paid at the
time of the formation or writing an option deal.

Q 2 List out the principles of put option pricing.

Ans: A call option is an instrument having limited liability. The call holder will exercise the call
when it is beneficial and will not exercise the call when the wealth of the call holder decreases.
Thus, the option will not have unofficial value as the holder is not compelled to exercise it.
Hence, the price of the call option can be expresses
 C [S0,X, P] > = 0
Where,
C = Price of the call option
S0 = Present stock price
X = The time to expiration
P = Exercise price.

In case of an American call, a call option has a minimum value of zero which is
controlled by a stronger statement, i.e.,

C [S0, X, P] > = max [0,S,0- P]

The expression Max [0,S,P] signifies that the maximum value of two arguments i.e., zero
(or) S0 - P is considered. Intrinsic value is the minimum value of an option. It is sometimes also
called as parity value, parity (or) exercise value. This intrinsic value remains positive in case of
in the-money calls and zero for out-the-money calls.

For an American call, the intrinsic value is greater than zero (or) difference between the
stock price and the exercise price. The intrinsic value is not applicable to European call as it is
exercised only on the expiration day. The major difference between the price and the intrinsic-
value is termed as time value (or) speculative value of the call. This can be expressed as,

C [S0, X, P] > = max [0,S,0- P]

The willingness of the traders to pay towards the uncertainty of the underlying stock is
called as 'time value'. The difference between the call price and the intrinsic value is called as the
time value of an American call.

Q 3.What is Black Scholes and Merton model? Write Assumption of Black Schols model.
Ans. Black Scholes Model has been developed to calculate the price of options either be call
option or put option. It is a Mathematical equation of pricing the option. The model is used to
determine the fair prices (theoretical value) of stock options.
It is based on six variables such as
a. Type of option, (Call or Put)
b. Underlying stock price (Spot price),
c. Time,
d. Strike price,
e. Volatility, and
f. Risk-free rate
The Black-Scholes Model was developed by economists Fischer Black and Myron Scholes in
1973. The idea was first put forward by Robert C.Merton, so he is also credited for this model. It
is also known as Black-Scholes-Merton model i.e BSM Model. The model is used to determine
the price of a European option, which simply means that the option can only be exercised on the
expiration date.

The Black Scholes Model makes certain assumptions

 European style option: The option is European and can only be exercised at expiration.
 Constant & Known Volatility: The volatility of the underlying asset are known and
constant.
 Known & Constant risk free rate of return: The risk free rate of the underlying asset are
known and constant.
 Log-Normally distributed return: The returns of the underlying asset are normally
distributed.
 No Dividend: No dividends are paid out during the life of the option.
 Efficient Market: Markets are random (i.e. market movements cannot be predicted).

C = S * N (d1) – Xe – rt N (d2)
Where,
C – Call option price
S – Current Stock price
X – Strike price / Exercise price
t – Risk free rate of interest
t – Time remaining to the expiration (Measured as a fraction of 1 year)
e – Base of Natural logarithms
d1 – Normal distribution function of d1

d1 = ln (S/X) + (r + 0.5σ2)t d2 = d1 σ (√t)

σ (√t)

σ = Standard deviation of continuously compounded return of the asset

ln = Natural log of the share prices.

4. Explain briefly about the various types of swaps

Ans. The following are the different types of swaps are :
Interest rate swaps
An interest rate swap is a financial agreement between the two parties who wish to change, the
interest payments or receipts in the same currency on assets or liabilities to a different basis.
There is no exchange of principal amount in this swap. In other words, it is an exchange of
interest payment for a specific maturity on a agreed upon term 'notional' the theoretical principal
underlying the swap. The principal amount applies only for the purpose of calculating the
interest to be exchanged under an interest rate swap. Maturities range from a year to over 15
years; however, most transactions fall within two years to ten years period

Currency swaps
A swap deal can also be arranged across currencies. It is an oldest technique in swap market. In
this swap, the two payment streams being ex. changed are denominated in two different cur-
rencies. For example, a firm which has borrowed Japanese yen at a fixed interest rate can 'swap
away' the exchange rate risk by setting up a con- tract whereby it receives yen at a fixed rate in
return for dollars at either a fixed or a floating interest rate. The currency swap is, like interest
rate swap, also two party transactions, involving two counter par- ties with different but
complimentary needs being bought by a bank. In this swap, normally three basic steps are
involved which are as under:

1. Initial exchange of principal amount

The first step in this swap is the initial ex- change of the principal amounts at an agreed rate of
exchange. This rate is usually based on the spot exchange rate. This initial exchange can be on a
notional basis, i.e., no physical exchange of principal amounts. The counter parties simply con-
vert principal amounts into the required currency-via-the spot market.

2. Ongoing exchange of interest

The second step is related with ongoing ex- change of interest. After establishing the principal
amounts, the counter parties’ ex- change interest payment on agreed date based on the
outstanding principal amounts at the fixed interest rates agreed at the outset of the transaction.

3. Re-exchange of principal amounts on maturity

The third step is the re-exchange of principal to principal amounts. Agreement on this enables
the counter parties to re-exchange the principal sums at the maturity date. These three steps have
been shown through an example.

(i) Commodity swaps

The parties in a swaps contract exchange cash flows depending on the prices or the value of
commodities like crude oil and energy-related products like metals such as gold, silver and
copper and agricultural products like wheat, grains and sugar. These swaps are fixed-for-floating
which depends only on one commodity.

(ii) Liquidity swaps

In debt-equity swap, a firm buy's a country's debt on the secondary loan market at a discount and
swaps it into local equity. In other words, the debts are exchanged for equity by one firm with the
other. Recently, a market for less-developed countries (LDC) debt-equity swap has developed
that enable the investors to purchase the external debts of such underdeveloped countries to
acquire equity or domestic currency in those same countries.

5. What is currency swap discuss the three steps of currency swap?

Ans. A swap deal can also be arranged across currencies. It is an oldest technique in swap
market. In this swap, the two payment streams being exchanged are denominated in two different
currencies. For example, a firm which has borrowed Japanese yen at a fixed interest rate can
'swap away' the exchange rate risk by setting up a contract whereby it receives yen at a fixed rate
in return for dollars at either a fixed or a floating interest rate.
Nature
1. It is different from interest rate swap as it comprises of two different currencies.
2. It is more efficient and flexible as differential of rates is periodically computed instead of
settling at the end of the contract.
3. It is developed from back to back loans and parallel loans.
4. Its market even through older than interest rate market, still it is small and not much
standardized.

1. Fixed-to-fixed currency swap

In this category, the currencies are exchanged at fixed rate. This swap works like this. One firm
raises a fixed rate liability in currency X, say US dollar ($) while the other firm raises fixed rate
funding in currency Y, say, Pound (£). The principal amounts are equivalent at the current mar
ket rate of exchange. In swap deal, first party will get pound whereas the second party gets dol-
lars. Subsequently, the first party will make periodic get (pound) payments to the second, in tum
gets dollars computed at interest at a fixed rate on the respective principal amount of both
currencies. At maturity, the dollar and pound principal are re-exchanged

2. Floating-to-floating swap
In this category, the counter parties will have payments at floating rate in different currencies.

3. Fixed-to-floating currency swap

This swap is a combination of a fixed-to-fixed currency swap and floating swap. In this, one
party makes the payment at a fixed rate in currency, say, X while the other party makes the
payment at a floating rate in currency, say, Y. Contracts without the exchange and re-exchange
of principals do exist. In most cases, a financial intermediary (a swap bank) structures the swaps
deal and routes the payments from one party to another party.