Let me solve each ques on in detail:

1. Defini ons (2 marks):

- Arbitrage: Risk-free profit by exploi ng price differences between markets

- Specula on: Taking posi ons based on expected future price movements

- Hedging: Protec ng against adverse price movements by taking offse ng posi ons

2. Investment Strategy Analysis (4 marks):

Given:

- Current stock price = Rs 100

- Call op on strike price = Rs 101

- Premium = Rs 5

- Investment amount = Rs 10,000

Strategy 1: Buying Shares

- Number of shares = 10,000/100 = 100 shares

Strategy 2: Buying Call Op ons

- Number of op ons = 10,000/5 = 2000 op ons

Break-even analysis for op ons:A

- Break-even price = Strike price + Premium = 101 + 5 = Rs 106

- For op ons to be more profitable, stock price should rise above Rs 106

Recommenda on:

If investor strongly believes in significant upside, op ons provide be er leverage. However, shares
are safer as they don't expire and have no me decay. Given the small difference in break-even
points, shares would be the more conserva ve choice.

3. Forward Market Strategy (4 marks):

Given:

- Current price = Rs 150

- 3-month forward price = Rs 152

- Risk-free rate = 10% (con nuous compounding)

Theore cal forward price calcula on:

F = S × e^(r×t)

= 150 × e^(0.10 × 0.25)

= 153.80

Since actual forward price (152) is less than theore cal price (153.80), arbitrage opportunity exists:

- Buy stock at 150

- Short forward at 152

- Borrow 150 at 10%

Strategy:
Buy stock now and sell forward, as forward is underpriced. This will yield risk-free profit of
approximately Rs 1.80 per share.

4. Zero Rate Analysis:

1) To find con nuous compounding zero rates:

For each maturity:

r = -ln(1 + periodic_rate × t)/t

6 months: -ln(1 + 0.04 × 0.5)/0.5 = 3.94%

12 months: -ln(1 + 0.045 × 1)/1 = 4.40%

18 months: -ln(1 + 0.0475 × 1.5)/1.5 = 4.63%

24 months: -ln(1 + 0.05 × 2)/2 = 4.84%

2) For 6-month forward rate 18 months hence:

Using the formula:

[(1 + R2)^T2 / (1 + R1)^T1]^(1/(T2-T1)) - 1

Where:

R1 = 18-month rate = 4.75%

R2 = 24-month rate = 5%

T1 = 1.5 years

T2 = 2 years

Forward rate = [(1 + 0.05)^2 / (1 + 0.0475)^1.5]^(2) - 1

= 5.75% approximately

This represents the implied 6-month rate star ng 18 months from now based on current zero rates.
Let me help you with these ques ons about financial deriva ves and futures markets. I'll address
them one by one:

3a) Normal backwarda on and contango: (2.5 marks)

Normal backwarda on occurs when the futures price is below the expected future spot price, while
contango is when the futures price is above the expected future spot price. These traits are
commonly visible in commodity markets - for example, in the oil markets during supply gluts
(contango) or supply shortages (backwarda on).

b) Convenience yield and cost of carry: (2.5 marks)

- Convenience yield is the benefit or premium associated with holding the physical underlying asset
rather than the futures contract. It represents the advantages of having immediate access to the
asset when needed.

- Cost of carry refers to the total costs incurred for holding an asset over me, including storage
costs, insurance, financing costs, and any other related expenses.

c) Silver future price calcula on: (5 marks)

Let's solve this step by step:

- Spot price = Rs. 100/gm

- Storage cost = 5% per year (payable in advance)

- Convenience yield = 7%

- Borrowing cost = 10% per year

- Time period = 9 months = 0.75 years

Future price = Spot price × (1 + borrowing cost × me) + (Storage cost × Spot price) - (Convenience
yield × Spot price × me)

= 100 × (1 + 0.10 × 0.75) + (0.05 × 100) - (0.07 × 100 × 0.75)

= 100 × 1.075 + 5 - 5.25

= 107.5 + 5 - 5.25

= 107.25

4a) Different types of spreads:

- Bull spread: A bullish strategy created by buying a call op on with a lower strike price and selling
another call with a higher strike price (same expira on)

- Bear spread: A bearish strategy created by buying a put with a higher strike price and selling
another put with a lower strike price

- Bu erfly spread: Combines bull and bear spreads using three strike prices to create a range-bound
trading strategy

- Calendar spread: Involves trading op ons of the same type and strike price but with different
expira on dates

4b) Bu erfly spread crea on (6 marks):

With the given op ons:

Strike prices: Rs. 55, Rs. 60, Rs. 65

Market prices: Rs. 3, Rs. 5, Rs. 8

To create a bu erfly spread:

1. Buy one call at strike Rs. 55 (cost: Rs. 3)

2. Sell two calls at strike Rs. 60 (receive: 2 × Rs. 5 = Rs. 10)

3. Buy one call at strike Rs. 65 (cost: Rs. 8)

Net cost = Rs. 3 - Rs. 10 + Rs. 8 = Rs. 1

This creates a bu erfly spread that profits most when the price stays near the middle strike price (Rs.
60).
Let me help you solve these ques ons about bonds, swaps, and op ons:

5a) Impact of dura on on security price (2 marks):

Dura on measures the price sensi vity of a bond to interest rate changes. There is an inverse
rela onship - when interest rates increase, bond prices decrease, and vice versa. The longer the
dura on, the greater the price sensi vity to interest rate changes.

5b) 2-year bond analysis (8 marks):

i) Price of the bond:

Let's calculate using present value:

- Annual coupon = 8%

- Face value = 100

- Yield = 11%

- Time = 2 years

Price = 8/(1.11) + 8/(1.11)² + 100/(1.11)²

= 7.21 + 6.49 + 81.16

= 94.86

ii) Bond's dura on:

Dura on = [1 × 7.21/(1.11) + 2 × (6.49 + 81.16)/(1.11)²] / 94.86

= (7.21 + 175.3) / 94.86

≈ 1.92 years

iii) Effect of 20bps decrease in yield:

Price change = -Dura on × Change in yield × Current price

= -1.92 × (-0.002) × 94.86

= +0.364 or approximately +0.36

The bond price would increase by Rs. 0.36.

6) Swaps example (10 marks):

Here's an example of using swaps to convert fixed to floa ng liability and vice versa:

Suppose Company A has a Rs. 10 million loan at a fixed 8% rate but wants a floa ng rate. Company B
has a floa ng rate loan (LIBOR + 2%) but wants a fixed rate. They can enter into a swap where:

- Company A pays LIBOR to Company B

- Company B pays 8% to Company A

This effec vely converts A's fixed rate to floa ng and B's floa ng rate to fixed.

7) European call op on valua on (10 marks):

Given:

- Current stock price (S₀) = Rs. 40

- Strike price (K) = Rs. 39

- Possible prices a er 1 month: Rs. 42 or Rs. 38

- Risk-free rate = 8% (con nuous compounding)

Using the binomial op on pricing model:

1) Calculate up and down factors:

u = 42/40 = 1.05

d = 38/40 = 0.95
2) Calculate risk-neutral probability (p):

p = (e^(0.08×1/12) - 0.95)/(1.05 - 0.95)

≈ 0.4837

3) Calculate op on payoffs:

Up state payoff = max(42 - 39, 0) = 3

Down state payoff = max(38 - 39, 0) = 0

4) Op on value = e^(-0.08×1/12) × [p × 3 + (1-p) × 0]

= 0.9933 × [0.4837 × 3 + 0.5163 × 0]

≈ Rs. 1.44

Therefore, the value of the European call op on is approximately Rs. 1.44.

Let me help you solve these arbitrage and forward pricing ques ons:

a) Difference between cash-and-carry arbitrage and reverse cash-and-carry arbitrage (5 marks):

Cash-and-carry arbitrage:

- Buy the asset in spot market

- Simultaneously sell futures contract

- Hold the asset un l futures expira on

- Deliver the asset against futures contract

- Used when futures price is too high rela ve to spot price plus carrying costs

Reverse cash-and-carry arbitrage:

- Short sell the asset in spot market

- Buy futures contract

- Invest proceeds from short sale

- Take delivery on futures contract

- Return asset to lender

- Used when futures price is too low rela ve to spot price plus carrying costs

b) Gold arbitrage opportunity analysis (5 marks):

Given:

- Spot price = $2000/oz

- 1-year forward price = $1200/oz

- Interest rate = 5% p.a.

Theore cal forward price should be:

F = S × (1 + r)

F = $2000 × (1 + 0.05)

F = $2100

Since actual forward price ($1200) < theore cal forward price ($2100), there's a reverse cash-and-
carry arbitrage opportunity:

1. Short sell gold at $2000

2. Invest proceeds at 5%

3. Buy forward contract at $1200

4. Profit = $2100 - $1200 = $900 per oz (minus transac on costs)

c) Forward price of no-dividend stock (10 marks):

For a stock with no dividends, the forward price should equal:

F = S × (1 + r)

where:

- S = spot price (INR 600)

- r = risk-free rate (5%)

Given the constraints:

1. Don't own the stock

2. No surplus cash

This means you would need to:

1. Borrow to buy the stock (if going long)

2. Short sell and invest proceeds (if going short)

The theore cal forward price should be:

F = 600 × (1 + 0.05)

F = INR 630

This price represents the no-arbitrage price because:

- If F > 630: Traders could profit by short selling stock, inves ng at 5%, and buying forward

- If F < 630: Traders could profit by borrowing at 5%, buying stock, and selling forward

Therefore, the 1-year forward price should be INR 630, regardless of whether you own the stock or
have surplus cash, as arbitrageurs would push the price to this level.
Let me solve these futures trading problems:

a) Two-month futures price calcula on (5 marks):

Given:

- Spot price (S₀) = Rs. 228

- Interest rate (r) = 10% per annum

- Time (t) = 2/12 years (2 months)

- No dividends

Using the cost of carry model:

F = S₀ × (1 + r × t)

F = 228 × (1 + 0.10 × 2/12)

F = 228 × (1 + 0.0167)

F = 228 × 1.0167

F = Rs. 231.81

Therefore, the two-month futures price should be Rs. 231.81.

b) Net cost calcula on for rice futures hedge (5 marks):

Given:
- Ini al spot price (Jan 1) = INR 30/kg

- March futures price = INR 33/kg

- Final spot selling price (March 31) = INR 35/kg

Transac on sequence:

1. Jan 1: Long futures posi on at INR 33/kg

2. March 31:

- Sell spot at INR 35/kg

- Close futures posi on (effec vely selling) at INR 33/kg

Net cost calcula on:

- Revenue from spot sale = +35

- Cost of futures contract = -33 (ini al agreement to buy)

- Final cost = 35 - 33 = INR 2/kg profit

Therefore, the net cost of purchase for the rice is INR 33/kg (the futures price), as this was locked in
through the hedge, resul ng in an effec ve profit of INR 2/kg due to the favorable movement in spot
prices.
Let me help you solve these op ons and por olio management ques ons:

Q3(a) ROI calcula on for Ni y Call op on (10 marks):

Ini al posi on:

- Purchase date: Sept 21, 2021

- Strike price: 17500

- Premium paid: Rs 95

- Expiry date: Sept 30, 2021

- Final Ni y value: 17618

At expiry:

- Op on payoff = Max(Spot price - Strike price, 0)

- Payoff = Max(17618 - 17500, 0) = 118

ROI calcula on:

- Investment (Premium) = Rs 95

- Return (Payoff - Premium) = 118 - 95 = Rs 23

- ROI = (Return/Investment) × 100

- ROI = (23/95) × 100 = 24.21%

Q3(b) Op ons analysis (10 marks):

i) Moneyness analysis:

Current stock price = INR 105

- Op on A (Strike 100): In-the-money by 5 points

- Op on B (Strike 105): At-the-money

- Op on C (Strike 110): Out-of-the-money by 5 points

ii) Intrinsic and me value:

Op on A (Strike 100):
- Intrinsic value = 105 - 100 = 5

- Total premium = 2

- Time value = 2 - 5 = -3 (indicates mispricing)

Op on B (Strike 105):

- Intrinsic value = 0

- Total premium = 8

- Time value = 8 - 0 = 8

Op on C (Strike 110):

- Intrinsic value = 0

- Total premium = 14

- Time value = 14 - 0 = 14

Q4) Por olio protec on strategy (10 marks):

For a Rs 100 crore por olio with beta = 1 and maximum acceptable loss of 10%:

Recommended protec ve put strategy:

1. Calculate protec on needed:

- Maximum acceptable loss = 10% of Rs 100 crores = Rs 10 crores

- With beta = 1, por olio moves in line with market

2. Put op on strategy:

- Buy protec ve puts at strike price of 16,200 (10% below current 18,000)

- Number of puts needed = (Por olio value/Ni y value) × lot size

- This creates a floor price for the por olio

3. Implementa on steps:

- Purchase sufficient put op ons to cover the por olio value

- Select puts with adequate me to expiry

- Consider rolling over puts before expiry to maintain protec on

- Monitor cost of protec on versus poten al market decline

4. Benefits:

- Limited downside risk to 10%

- Maintains upside poten al

- Provides flexibility to adjust protec on level

- Allows por olio manager to stay invested while managing risk

The fund manager should also consider:

- Cost of put op ons

- Regular monitoring of protec on level

- Rolling strategy for put op ons

- Adjus ng protec on based on changing market condi ons

I'll provide a detailed explana on of each concept:

Q1(a) Four Basic Building Blocks of Deriva ves Contracts (5 marks)

1. Long Call:

- Gives holder the right (but not obliga on) to buy the underlying asset at strike price

- Maximum loss limited to premium paid

- Unlimited poten al profit as underlying price rises

- Used when bullish on the underlying asset

- Time decay works against the posi on

2. Long Put:

- Gives holder the right (but not obliga on) to sell the underlying at strike price

- Maximum loss limited to premium paid

- Maximum profit poten al is strike price (minus premium) if asset goes to zero

- Used for downside protec on or bearish views

- Also affected nega vely by me decay

3. Short Call:

- Obliga on to sell underlying at strike price if buyer exercises

- Limited profit poten al (premium received)

- Unlimited poten al loss as underlying price rises

- Used for income genera on or bearish views

- Benefits from me decay

4. Short Put:

- Obliga on to buy underlying at strike price if buyer exercises

- Limited profit poten al (premium received)

- Maximum loss is strike price (minus premium) if asset goes to zero

- Used for income genera on or moderately bullish views

- Benefits from me decay

Q1(b) Payoff Profiles (10 marks)

Let me create detailed visual representa ons with explana ons:

Q2(a) Cash & Carry Arbitrage Types (5 marks)

1. Cash & Carry Arbitrage:

- Also known as "Long Arbitrage" or "Basis Trading"

- Strategy:

* Buy asset in spot market

* Simultaneously sell futures contract

* Hold asset un l futures expira on

* Deliver against futures contract

- Profit opportunity arises when:

* Futures price > Spot price + Carrying costs

- Carrying costs include:

 * Interest on borrowed funds

* Storage costs

* Insurance

* Transporta on

2. Reverse Cash & Carry Arbitrage:

- Also known as "Short Arbitrage"

- Strategy:

* Short sell asset in spot market

* Buy futures contract

* Invest proceeds from short sale

* Take delivery on futures contract

* Return borrowed asset

- Profit opportunity arises when:

* Futures price < Spot price + Carrying costs

- Considera ons:

* Availability of asset for short selling

* Borrowing costs

* Storage facili es

Q2(b) Forward Price Calcula on (10 marks)

Given:

- Spot price (S₀) = Rs 600

- Risk-free rate (r) = 5% per annum

- Time period (T) = 1 year

- No dividends

- No surplus cash or stock ownership

Theore cal Forward Price Calcula on:

1. Using cost of carry model:

 F = S₀ × (1 + r)^T

F = 600 × (1 + 0.05)

F = 600 × 1.05

F = Rs 630

2. No-arbitrage principle explains why this price holds:

a) If Forward Price > Rs 630:

- Arbitrageurs would:

* Borrow Rs 600 at 5%

* Buy stock at Rs 600

* Sell forward at market price

* Profit = Forward price - Rs 630

b) If Forward Price < Rs 630:

- Arbitrageurs would:

* Short sell stock at Rs 600

* Invest proceeds at 5%

* Buy forward at market price

* Profit = Rs 630 - Forward price

3. Market forces ensure:

- These arbitrage ac vi es con nue un l forward price = Rs 630

- Price remains at Rs 630 regardless of:

* Stock ownership status

* Cash posi on

* Because arbitrageurs can execute these strategies

The lack of stock ownership or surplus cash doesn't affect the theore cal price because market
par cipants with access to these resources will exploit any price discrepancies un l the no-arbitrage
price prevails.
Let me analyze each investment op on and calculate their respec ve ROIs:

Q3(a) Investment Analysis (10 marks)

Given:

- Investment amount: Rs 4000

- Current price: Rs 20/share

- Expected price: Rs 25/share

- Time period: 6 months

Let's analyze each op on:

1. Op on (i) - Cash Market Investment

- Number of shares = 4000/20 = 200 shares

- Ini al investment = 200 × 20 = Rs 4000

- Final value = 200 × 25 = Rs 5000

- Profit = 5000 - 4000 = Rs 1000

- ROI = (1000/4000) × 100 = 25%

2. Op on (ii) - Futures Contract

- Contract value = 200 × 20 = Rs 4000

- Ini al margin required = 20% × 4000 = Rs 800

- Final value = 200 × 25 = Rs 5000

- Profit = 5000 - 4000 = Rs 1000

- ROI = (1000/800) × 100 = 125%

3. Op on (iii) - Call Op ons

- Number of op ons possible = 4000/2 = 2000 op ons

- Ini al investment = 2000 × 2 = Rs 4000

- Value at expiry = Max(0, 25 - 20) × 2000 = Rs 10,000

- Profit = 10,000 - 4000 = Rs 6000

- ROI = (6000/4000) × 100 = 150%

Q3(b) ROI Comparison and Conclusions (10 marks)

ROI Summary:

1. Cash Market: 25%

2. Futures: 125%

3. Op ons: 150%

Key conclusions about the three instruments:

1. Cash Market:

- Lowest ROI but least risky

- Full ownership of shares

- No leverage effect

- Suitable for conserva ve investors

- No me decay risk

2. Futures:

- Higher ROI due to leverage effect

- Ini al margin requirement provides leverage

- Higher risk due to leverage

- No me decay risk

- Suitable for moderate risk-takers

- Full profit/loss exposure to price movements

3. Op ons:

- Highest ROI poten al

- Limited downside risk (maximum loss = premium paid)

- Highest leverage effect

- Affected by me decay

- Suitable for aggressive investors

- Non-linear payoff profile

Investment Strategy Conclusions:

1. Risk-Return Tradeoff:

- Higher returns come with higher risks

- Leverage amplifies both gains and losses

- Op ons provide the highest leverage but most complexity

2. Suitability:

- Cash market: Long-term investors, risk-averse

- Futures: Ac ve traders, moderate risk appe te

- Op ons: Sophis cated investors, high risk tolerance

3. Considera on Factors:

- Investment horizon

- Risk tolerance

- Market outlook certainty

- Transac on costs

- Margin requirements

- Understanding of products

The choice depends on:

1. Investor's risk tolerance

2. Investment exper se

3. Capital availability

4. Market view convic on

5. Investment horizon

In this specific case, given the strong convic on about price rise, op ons provide the best return
poten al while limi ng downside risk to premium paid, making them the most a rac ve choice
despite their complexity.
I'll help you solve these ques ons step by step.

Q4. (a) (i) The determinants of op ons premium according to Black-Scholes model are:

1. Current stock price (S)

2. Strike price (K)

3. Time to expira on (t)

4. Risk-free interest rate (r)

5. Stock price vola lity (σ)

(ii) Impact of changes in variables on op on premiums:

For Call Op ons:

- Stock price (S) ↑: Premium ↑

- Strike price (K) ↑: Premium ↓

- Time to expira on (t) ↑: Premium ↑

- Risk-free rate (r) ↑: Premium ↑

- Vola lity (σ) ↑: Premium ↑

For Put Op ons:

- Stock price (S) ↑: Premium ↓

- Strike price (K) ↑: Premium ↑

- Time to expira on (t) ↑: Premium ↑

- Risk-free rate (r) ↑: Premium ↓

- Vola lity (σ) ↑: Premium ↑

Q4. (b) Let's analyze each op on:

(i) Moneyness:

- Op on A (K=100): With stock at 105, this is In-The-Money (ITM) by 5 points

- Op on B (K=105): At-The-Money (ATM) as strike equals stock price

- Op on C (K=110): Out-of-The-Money (OTM) by 5 points

(ii) Intrinsic and Time Value:

Op on A (Premium = 2):

- Intrinsic Value = 105 - 100 = 5

- Time Value = 2 - 5 = -3 (Note: This appears mispriced as op ons can't have nega ve me value)

Op on B (Premium = 8):

- Intrinsic Value = 105 - 105 = 0

- Time Value = 8 - 0 = 8

Op on C (Premium = 14):

- Intrinsic Value = 0 (OTM)

- Time Value = 14 - 0 = 14

Q5. Let's calculate the profit and ROI:

Ini al situa on:

- Bought Call op on with strike 17500

- Premium paid = Rs 95

- Ni y closed at 17618 on expiry

(i) Profit calcula on:

- Op on value at expiry = Max(0, 17618 - 17500) = 118

- Ini al cost = 95

- Profit = 118 - 95 = Rs 23

(ii) ROI calcula on:

- ROI = (Profit/Investment) × 100

- ROI = (23/95) × 100 = 24.21%

Note: This was a bullish posi on (though the ques on men ons bearish, the trade actually profited
from an upward movement), and the trader made a posi ve return as Ni y moved above the strike
price.

Let me explain each of these topics in detail:

1. Types of Swaps:

a) Full Currency Swap:

- A complex financial deriva ve where two par es exchange principal and interest payments in
different currencies

- Involves three main components:

1. Ini al exchange of principals based on spot rate

 2. Periodic interest payments during the swap term

3. Re-exchange of principal amounts at maturity

- Used for hedging currency risk and accessing be er rates in foreign markets

- Example: A US company needing Euros might swap USD principal and interest payments with a
European company needing USD

b) Interest Rate Swap:

- Agreement between par es to exchange one stream of interest payments for another over a set
period

- Most common type is "plain vanilla" swap: fixed rate for floa ng rate

- No exchange of principal - only interest payments are swapped

- Used to manage interest rate risk and op mize borrowing costs

- Example: Company A pays LIBOR + 1% but wants fixed rate, swaps with Company B who pays 5%
fixed but wants floa ng rate

c) Principal Only Swap:

- Par es exchange only principal amounts in different currencies

- No exchange of interest payments

- Used primarily for hedging currency risk on principal amounts

- Simpler than full currency swap as it eliminates interest rate component

- Useful when en es want to hedge only principal currency risk without interest rate exposure

2. Black-Scholes-Merton Model:

Key Assump ons:

1. Stock prices follow geometric Brownian mo on with constant vola lity

2. Risk-free interest rate is constant and known

3. No dividends during op on life

4. European-style op ons (exercise only at maturity)

5. No transac on costs or taxes

6. Con nuous trading is possible

7. Markets are efficient (no arbitrage opportuni es)

The Model's Op on Pricing Equa ons:

For Call Op ons:

C = S₀N(d₁) - Ke^(-rT)N(d₂)

For Put Op ons:

P = Ke^(-rT)N(-d₂) - S₀N(-d₁)

Where:

- S₀ = Current stock price

- K = Strike price

- r = Risk-free rate

- T = Time to maturity

- N() = Cumula ve standard normal distribu on func on

- d₁ = [ln(S₀/K) + (r + σ²/2)T] / (σ√T)

- d₂ = d₁ - σ√T

- σ = Stock price vola lity

The equa ons account for:

- Time value of money (through discoun ng)

- Probability of op on being exercised

- Rela onship between current price and strike price

- Impact of vola lity

- Effect of interest rates

This model revolu onized op ons trading by providing a mathema cal framework for pricing
op ons, though it has limita ons due to its assump ons not always matching real-world condi ons.

The model shows that op on prices increase with:

- Higher underlying asset price (for calls)

- Lower strike price (for calls)

- Longer me to expira on

- Higher vola lity

- Higher interest rates (for calls)

These equa ons allow traders and investors to calculate theore cal op on prices and understand
how different factors affect op on values, making it a fundamental tool in modern deriva ves
trading.

Let me explain each concept in detail:

1. Difference between Forward and Futures Contract:

Forward Contract:

- Custom, private agreement between two par es

- Over-the-counter (OTC) traded

- Not standardized, terms are customizable

- Se lement usually occurs at maturity

- Less liquid, cannot be easily transferred

- Higher counterparty risk

- No margin requirements typically

Futures Contract:

- Standardized contract traded on exchanges

- Exchange-traded, publicly available

- Standardized terms (size, quality, delivery)

- Daily se lement (mark-to-market)

- Highly liquid with ac ve secondary market

- Lower counterparty risk due to clearing house

- Requires ini al and maintenance margin

2. Types of Orders:

Market Order:

- Executes immediately at best available price

- Guarantees execu on but not price

- Used when speed is more important than price

Limit Order:

- Sets maximum price for buying or minimum for selling

- May not execute if price doesn't reach specified level

- Provides price control but doesn't guarantee execu on

Stop Loss Order:

- Triggers market order when price reaches specified level

- Used to limit poten al losses

- Converts to market order when triggered

- Doesn't guarantee execu on price

Market if Touched (MIT) Order:

- Becomes market order when specified price is reached

- Similar to stop order but used for buying below market or selling above

- Used to catch favorable price movements

3. Basis Risk and Cross Hedging:

Basis Risk:
- Risk that arises from poten al changes in the basis (difference between spot and futures price)

- Occurs when hedge is not perfect

- Factors affec ng basis risk:

* Time to delivery

* Quality differences

* Loca on differences

* Changes in local supply/demand

Cross Hedging:

- Hedging with a different but correlated instrument

- Used when exact hedging instrument isn't available

- Example: Hedging jet fuel with crude oil futures

- Effec veness depends on correla on between instruments

- Usually involves higher basis risk than direct hedging

4. Difference between Zero Rate, Bond Yield, Par Yield:

Zero Rate:

- Interest rate on zero-coupon bond

- Shows rela onship between present value and future payment

- Used in discoun ng future cash flows

- Also called spot rate

- No reinvestment risk

Bond Yield (YTM):

- Internal rate of return on bond held to maturity

- Considers all cash flows (coupons and principal)

- Assumes reinvestment at same rate

- Most commonly quoted yield measure

- Takes into account:

* Purchase price
 * Face value

* Time to maturity

* Coupon payments

Par Yield:

- Coupon rate that makes bond price equal to par value

- Used in yield curve construc on

- All cash flows discounted at zero rates

- Important for:

* Bond pricing

* Fixed income por olio management

* Interest rate deriva ves

Key differences:

- Zero rates don't assume reinvestment

- Bond yields assume reinvestment at YTM

- Par yields are hypothe cal rates for new issues

- Each serves different purpose in financial analysis

These concepts are fundamental to understanding financial markets and risk management, with each
playing a crucial role in different aspects of trading and investment decisions.

Let me explain each of these concepts in detail:

1. Forward Rates:
- These are interest rates for future periods implied by current interest rates

- Calculated from the yield curve using spot rates

- Formula: (1 + R2)² = (1 + R1)(1 + F1,2)

where R2 = 2-year spot rate

R1 = 1-year spot rate

F1,2 = Forward rate between year 1 and 2

- Used for:

* Interest rate expecta ons

* Pricing fixed income deriva ves

* Investment decision making

* Risk management

2. Forward Rate Agreement (FRA):

- Contract that allows borrowers/lenders to lock in future interest rates

- Key components:

* No onal principal amount

* Contract period (start and end dates)

* Fixed rate agreed upon

* Reference floa ng rate (usually LIBOR)

- Se lement involves difference between agreed rate and actual rate

- Used primarily for hedging interest rate risk

- Cash se lement occurs at the start of the contract period

- No exchange of principal, only interest rate differen al is se led

3. Theories on Term Structure of Interest Rates:

a) Expecta ons Theory:

- Forward rates reflect expected future spot rates

- Long-term rates are geometric averages of expected future short-term rates

- Assumes investors are risk-neutral

- Pure version vs. Biased version

b) Liquidity Preference Theory:

- Incorporates liquidity premium into expecta ons theory

- Investors prefer shorter terms and need premium for longer terms

- Explains typically upward-sloping yield curves

- Premium increases with maturity

c) Market Segmenta on Theory:

- Different maturity segments a ract different investors

- Limited subs tu on between maturi es

- Rates determined by supply/demand in each segment

- Explains why different maturi es can move independently

d) Preferred Habitat Theory:

- Combines elements of market segmenta on and liquidity preference

- Investors have preferred investment horizons but will switch for sufficient premium

- More realis c but more complex than other theories

4. Commodity Futures Concepts:

a) Convenience Yield:

- Benefit/premium of holding physical commodity vs. futures contract

- Reflects:

* Storage costs

* Supply availability

* Market condi ons

- Higher during supply shortages

- Can affect futures pricing significantly

b) Cost of Carry:

- Total cost of holding physical commodity

- Includes:

* Storage costs

* Insurance

* Financing costs

* Transporta on

* Deteriora on/spoilage

- Fundamental in futures pricing

- Formula: Futures Price = Spot Price × (1 + r + s - c)

where r = interest rate

s = storage cost

c = convenience yield

c) Contango vs. Backwarda on:

Contango:

- Futures price > Spot price

- Normal for non-perishable commodi es

- Reflects full cost of carry

- Common in well-supplied markets

Backwarda on:

- Futures price < Spot price

- Indicates:

* High convenience yield

* Current supply shortage

* Strong immediate demand

- Common in commodity markets with supply constraints

The rela onship between these elements affects commodity futures pricing and trading strategies:

- In contango markets, rolling futures posi ons typically loses money

- In backwarda on, rolling futures posi ons can be profitable

- Understanding these rela onships is crucial for:

* Hedging decisions

* Trading strategies

* Risk management

* Investment ming

These concepts are interconnected and fundamental to understanding interest rate markets and
commodity futures trading. They provide the theore cal framework for pricing, trading, and risk
management in these markets.

Let me explain each of these op on concepts in detail:

1. Call Op on:

- Right (not obliga on) to buy underlying asset at strike price un l expiry

- Profit poten al: Unlimited upside

- Maximum loss: Limited to premium paid

- Used for:

* Bullish posi ons

* Leverage with limited risk

* Por olio protec on (protec ve calls)

- Value increases with:

* Rising underlying price

* Increased vola lity

* More me to expiry
2. Put Op on:

- Right (not obliga on) to sell underlying at strike price un l expiry

- Profit poten al: Limited to strike price minus premium

- Maximum loss: Limited to premium paid

- Used for:

* Bearish posi ons

* Por olio insurance

* Hedging long posi ons

- Value increases with:

* Falling underlying price

* Increased vola lity

* More me to expiry

3. Bull Spread Structure:

- Simultaneous buy low-strike call and sell high-strike call

OR

- Buy low-strike put and sell high-strike put

- Characteris cs:

* Limited upside poten al

* Limited downside risk

* Lower cost than outright call purchase

* Maximum profit: Difference between strikes minus net premium

* Maximum loss: Net premium paid

- Used when moderately bullish on underlying

4. Bear Spread Structure:

- Buy high-strike put and sell low-strike put

OR

- Buy high-strike call and sell low-strike call

- Characteris cs:
 * Limited downside poten al

* Limited upside risk

* Lower cost than outright put purchase

* Maximum profit: Difference between strikes minus net premium

* Maximum loss: Net premium paid

- Used when moderately bearish on underlying

5. Bu erfly Spread Structure:

- Combina on of bull and bear spreads

- Construc on:

* Buy one lower strike call

* Sell two middle strike calls

* Buy one higher strike call

- Characteris cs:

* Limited risk

* Limited reward

* Profit maximum at middle strike

* Benefits from low vola lity

* Low cost strategy

- Used when expec ng:

* Low vola lity

* Price to stay near middle strike

* Time decay to work in your favor

6. Calendar Spread Structure:

- Trading same strike op ons with different expira on dates

- Construc on:

* Sell near-term op on

* Buy longer-term op on

* Same strike price

- Characteris cs:
 * Benefits from me decay

* Limited risk

* Can be constructed with calls or puts

* Maximum profit at strike price at near-term expiry

* Affected by changes in vola lity

- Used for:

* Exploi ng me decay

* Posi on around expected events

* Vola lity trading

Key Considera ons for All Spreads:

- Transac on costs affect profitability

- Liquidity in all legs important

- Greeks (Delta, Gamma, Theta, Vega) management crucial

- Posi on sizing and risk management essen al

- Market condi ons affect strategy selec on

- Margin requirements vary by spread type

These op on strategies provide different risk-reward profiles and can be used in various market
condi ons to:

- Generate income

- Protect posi ons

- Speculate on price movements

- Manage vola lity exposure

- Op mize capital usage

The choice of strategy depends on:

- Market outlook

- Risk tolerance

- Available capital

- Time horizon
- Vola lity expecta ons

- Transac on costs

- Market liquidity

Let me explain each of these important financial concepts in detail:

1. Credit Risk:

- Risk of loss from borrower/counterparty failing to meet obliga ons

- Components:

* Default risk (failure to pay)

* Downgrade risk (credit ra ng deteriora on)

* Recovery risk (amount recoverable a er default)

- Managed through:

* Credit analysis

* Diversifica on

* Collateral requirements

* Credit deriva ves

* Credit monitoring systems

2. Market Risk:

- Risk of losses due to market price movements

- Types:

* Equity price risk

* Interest rate risk

 * Currency risk

* Commodity price risk

- Measured by:

* Value at Risk (VaR)

* Beta

* Standard devia on

* Stress tes ng

* Scenario analysis

3. Opera onal Risk:

- Risk from failed internal processes, people, or systems

- Categories:

* Process risk

* Technology risk

* People risk

* External events

- Management through:

* Internal controls

* Process documenta on

* Staff training

* Backup systems

* Insurance

4. Factors Affec ng Op on Pricing:

- Primary factors (Black-Scholes inputs):

* Underlying price

* Strike price

* Time to expira on

* Vola lity

* Interest rates

* Dividends
- Impact varies by op on type:

* Calls increase in value with higher underlying price

* Puts decrease in value with higher underlying price

* Both increase with higher vola lity

* Time decay hurts buyers, helps sellers

5. Call-Put Parity:

- Fundamental rela onship between call and put prices

- Formula: C - P = S - Ke^(-rT)

Where:

* C = Call price

* P = Put price

* S = Spot price

* K = Strike price

* r = Risk-free rate

* T = Time to expira on

- Used for:

* Arbitrage opportuni es iden fica on

* Op on pricing verifica on

* Crea ng synthe c posi ons

6. Upper and Lower Bounds for Op on Prices:

For Call Op ons:

Lower bound:

- American Call: Max(0, S - K)

- European Call: Max(0, S - Ke^(-rT))

Upper bound:

- American & European Call: S (underlying price)

For Put Op ons:

Lower bound:

- American & European Put: Max(0, Ke^(-rT) - S)

Upper bound:

- American Put: K

- European Put: Ke^(-rT)

General Proper es:

- Op ons cannot be nega ve

- Call value cannot exceed underlying price

- Put value cannot exceed strike price

- American op ons ≥ European op ons

- In-the-money op ons ≥ intrinsic value

These boundaries are important for:

- Iden fying mispriced op ons

- Arbitrage opportunity detec on

- Risk management

- Op on pricing model valida on

Key Applica ons:

1. Risk Management:

- Understanding and measuring different risk types

- Developing mi ga on strategies

- Se ng risk limits

- Capital alloca on

2. Trading:

- Op on pricing accuracy

- Arbitrage iden fica on

- Strategy development

- Posi on sizing

3. Por olio Management:

- Risk assessment

- Hedging decisions

- Por olio op miza on

- Performance a ribu on

4. Regulatory Compliance:

- Capital adequacy requirements

- Risk repor ng

- Internal controls

- Opera onal procedures

Understanding these concepts is crucial for:

- Financial ins tu ons

- Risk managers

- Traders

- Investment professionals

- Regulators

- Por olio managers

They form the founda on for:

- Risk management frameworks

- Trading strategies

- Investment decisions

- Regulatory compliance

- Financial innova on
Let me answer each of these ques ons in detail:

a. Basis of a Futures Contract:

- The basis is the difference between spot price and futures price

- Basis = Spot Price - Futures Price

- It represents the cost of carry minus convenience yield

Example:

Let's say crude oil is trading at:

- Spot price: $80 per barrel

- 3-month futures price: $82 per barrel

- Basis = $80 - $82 = -$2 (market is in contango)

This nega ve basis suggests storage costs and interest rates exceed any convenience yield from
holding physical oil.

b. Convergence of the Basis:

- As the futures contract approaches expira on, the basis converges to zero

- This means futures price and spot price become almost iden cal at expiry

- Convergence occurs because:

* Arbitrage opportuni es would arise if prices didn't converge

* At expiry, futures contract becomes equivalent to spot transac on

* Cost of carry elements become negligible near expiry

- This convergence is fundamental to futures market efficiency

c. Hedging for Open-ended Fund Manager:

For an open-ended fund manager with long-term stock investments, futures hedging might not be
cri cal because:
1. Investment Horizon Considera ons:

- Long-term perspec ve means short-term vola lity is less concerning

- Time diversifica on tends to reduce risk

2. Fund Structure Implica ons:

- Open-ended funds can:

* Issue new units when investors buy in

* Redeem units when investors exit

* Maintain cash buffers for redemp ons

3. Cost Considera ons:

- Con nuous hedging would:

* Increase transac on costs

* Reduce long-term returns

* Create tracking error

4. Performance Impact:

- Full hedging might limit upside poten al

- Could underperform during bull markets

- May not align with long-term investment objec ves

d. Close-ended Fund Perspec ve:

Yes, the answer would change significantly for a close-ended fund manager because:

1. Fixed Capital Structure:

- No new units issued

- No redemp on pressure

- NAV can deviate from underlying asset value

2. Risk Management Importance:

- More cri cal to protect NAV

- Market price sensi vity is higher

- Investors can't easily exit

3. Trading Considera ons:

- Hedging becomes more relevant to:

* Manage market risk

* Protect shareholder value

* Reduce NAV vola lity

4. Strategic Benefits:

- Can use futures for:

* Tac cal asset alloca on

* Risk management

* Market ming

* Por olio rebalancing

In closing, the fund structure significantly impacts the hedging decision:

- Open-ended funds: Less cri cal due to flexibility in unit crea on/redemp on

- Close-ended funds: More important due to fixed capital and price sensi vity

The hedging strategy should align with:

- Fund objec ves

- Investment horizon

- Risk management goals

- Cost considera ons

- Market condi ons

I'll answer all these ques ons in detail:

2. Forward Price Arbitrage Analysis:

Method 1 - Cash and Carry Arbitrage:

1. Ac ons on January 1:

- Borrow INR100 at 8% p.a.

- Buy spot at INR100

- Sell April forward at INR101.5

For April 1 contract (3 months):

- Interest cost = 100 × (8% × 3/12) = INR2

- Arbitrage profit = 101.5 - 100 - 2 = -INR0.5 (No arbitrage opportunity)

Method 2 - Reverse Cash and Carry:

1. Ac ons on January 1:

- Short sell spot at INR100

- Buy October forward at INR109

- Invest proceeds at 8% p.a.

For October 1 contract (9 months):

- Interest earned = 100 × (8% × 9/12) = INR6

- Arbitrage profit = 100 + 6 - 109 = -INR3 (No arbitrage opportunity)

3. Forward Contract Value Calcula on:

Given:

- Forward price (F₀) = INR214

- Interest rate (r) = 7% p.a.

- Time passed = 6 months

- Current spot (S₆) = INR150

- Remaining me = 6 months

Value calcula on:

- Future value of forward = F₀ = INR214

- Present value of forward delivery = 214 ÷ (1 + 0.07 × 6/12) = INR206.80

- Current forward value = 150 - 206.80 = -INR56.80

The forward contract has a nega ve value of INR56.80, represen ng a loss.

4. Contango and Backwarda on:

Contango:

- Futures price > Spot price

- Arises when:

* Storage costs are high

 * Interest rates are significant

* Low convenience yield

* Adequate supply condi ons

Backwarda on:

- Futures price < Spot price

- Arises when:

* High convenience yield

* Supply shortages

* Strong immediate demand

* Storage constraints

Reasons for occurrence:

1. Storage costs and financing

2. Supply-demand imbalances

3. Seasonal factors

4. Market expecta ons

5. Convenience yield varia ons

5. Hedging as Op onal Strategy:

Disagree - hedging necessity depends on:

1. Business Nature:

- Companies directly exposed to price risk (e.g., airlines - fuel costs)

- Exporters/importers - currency risk

- Banks - interest rate risk

Examples where hedging is crucial:

a) Airlines must hedge fuel costs

b) Food processors must hedge commodity prices

c) Interna onal businesses must hedge currency exposure

2. Risk Tolerance:

- Some risks are existen al

- Can threaten business con nuity

- May affect credit ra ngs

3. Stakeholder Requirements:

- Shareholders expect risk management

- Lenders may require hedging

- Regulators might mandate it

6. OTC Deriva ves and Counterparty Risk:

Yes, OTC deriva ves expose par cipants to counterparty credit risk.

Forward Contract Example:

- Company A agrees to buy currency from Bank B

- If Bank B defaults, Company A loses protec on

- Market movement could mean significant replacement costs

Mi ga on Strategies:

1. Collateral Requirements:

- Ini al margin

- Varia on margin

- Regular mark-to-market

2. Ne ng Agreements:

- Bilateral ne ng

- Mul lateral ne ng

- Close-out ne ng
3. Central Counterpar es:

- Clearing houses

- Standardized contracts

- Regular se lement

4. Credit Support Annexes:

- Defines collateral terms

- Triggers for addi onal margin

- Acceptable collateral types

5. Due Diligence:

- Credit ra ng monitoring

- Financial statement analysis

- Regular counterparty review

6. Legal Documenta on:

- ISDA agreements

- Credit support documents

- Master ne ng agreements

These measures help manage but cannot eliminate counterparty risk in OTC markets.