RISK MANAGEMENT

UNIT 1 - RISK – MEANING, TYPES, RISK ANALYSIS IN CAPITAL BUDGETING.

Concept of Risk

Risk is expressed differently by different people. To some, it is a chance or possibility of loss, to

others, it may be uncertain situations. The word risk has been derived from the Latin word
‘resecare’ where, ‘re’ means ‘against’ and ‘secare’ means ‘to cut’. It means to cut against or the
part that is cut off or lost. Thus risk is losing something or suffering loss due to future
uncertainties.

Risk is also derived from the early Italian word ‘risco’ which means ‘danger’ or ‘risicare’ which
means ‘to dare’ or a French word ‘risque’. Risk is known or unknown but always inherent in
individual or business actions therefore it is more of a ‘choice’ other than fate accompli. In other
words, it means that Risk is the potential that a chosen action will lead to a loss or undesirable
outcome. The idea implies that, a choice of having an influence on the outcome exists.

Meaning of Risk

Risk is a probability or threat of damage, injury, liability, loss or any other negative occurrence
that is caused by external or internal vulnerabilities and that may be avoided through pre-emptive
action. Risk means potential danger, insecurity, threat or harm of future event.

In Finance it refers to the probability that an actual return on investment will be lower than the
expected return. Risk is the potential variability of returns. An investment whose returns are
fairly stable is considered to be a low risk investment, whereas an investment, whose returns
fluctuate widely are considered to be risky investment.

Definition of Risk

According to Hansson and Suen Oue, “Risk is the potential of losing something of value,
weighted against the potential of gaining something of value. Values such as physical health,
social status, emotional well being or financial wealth can be gained or lost when taking risk
resulting from a given action, activity and/or inaction, foreseen or unforeseen”

According to Emmett J. Vaughan, “Risk is a condition in which there is a possibility of an

adverse deviation from a desired outcome that is expected or hoped so far”.

According to Harriaton and Michans, “At its most generous level, risk is used to describe any
situation where there is uncertainty about what outcome will occur”.

According to Douglas, “Risk is the probability of an event combined with the magnitude of the
losses or gains that it will entail”.
According to Irving Fisher, “risk may be defined as combination of hazards measured by
probability”.

Types of Risks of a Business Enterprise

Risk can be classified into two broad categories; Systematic Risk and Unsystematic

Risk. Systematic Risk

It arises out of external and uncontrollable factors like changes in economic, political and
societal aspects. It is macro in nature as it affects a large number of organisations operating
under same domain. Changes in security’s total return are directly related to overall movements
in general market or economic condition. It cannot be controlled by an investor, it is critical to all
investors.

Types of Systematic Risk:

a) Market Risk - It is associated with consistent fluctuations seen in the trading price of any
particular shares or securities. That is, it arises due to rise or fall in the trading price of
listed shares or securities in the stock market.
Market price of shares move up or down consistently for time periods. A general rise in
the share prices are referred to bullish trend whereas a general fall in share prices is
referred to as bearish trend. In other words the shares market alternates between the
bullish phase and the bearish phase. The alternative movement can be easily seen in the
movement of share price indices such as the BSE Sensitive Index, BSE National Index,
NSE Index etc.

b) Interest Rate Risk – It arises due to variability in the interest rates from time to time. It
particularly affects debt securities as they carry the fixed rate of interest. The fluctuations
in the interest rates are caused by the changes in the government monetary policy and the
changes that occur in the interest rates of treasury bills and the government bonds.

The types of Interest Rate Risk are depicted and listed below:
i) Price Risk arises due to the possibility that the price of the shares, commodity,
investment, etc may decline or fall in the future.
ii) Reinvestment Rate Risk results from fact that the interest or dividend earned from
an investment cannot be reinvested with the same rate of return as it was
acquiring earlier.

c) Purchasing power or Inflationary Risk – It is also called inflation risk since it emanates
(originates) from the fact that it affects purchasing power adversely. It is not desirable to
invest in securities during an inflationary period.

The two types of Inflationary Risk are as below:

 i) Demand Inflation Risk arises due to increase in price, which result from an excess
of demand over supply. It occurs when supply falls to cope up with the demand
and hence cannot expand anymore. In other words, demand inflation occurs when
production factors are under maximum utilisation.
ii) Cost Inflation Risk arises due to sustained increase in the prices of goods and
services. It is actually caused by higher production cost. A high cost of production
inflates the total price of finished goods consumed by people.

Unsystematic Risk

It occurs due to the influence of internal factors prevailing within an organisation. It is caused by
factors like labour unrest, management policies, shortage of power, recession in a particular
industry, consumer preference etc. Such factors are normally controllable from an organization’s
point of view. It is micro in nature as it affects only a particular organization. It can be planned
so that necessary actions can be taken by the organization to mitigate (reduce the effect of) the
risk.

Types of Unsystematic Risk:

a) Business Risk – It refers to the possibility of inadequate profits or even losses due to
uncertainties. It can be internal as well as external. Internal business risk is caused due to
absence of strategic management improper product mix etc .Internal risk is associated
with the efficiency with which a firm conducts its operation with the broader
environment. External business risk arises due to changes in operating conditions which
are beyond the firm’s control such as changes in preferences of consumers, strikes,
increased competition, changes in government policies, obsolesce, international market
conditions etc.

Every business organisation contains various risk elements while doing the business.
Business risk implies uncertainty in profits or danger of loss due to some unforeseen
events in future, which causes business to fail. A company with a high business risk
should choose a capital structure that has a lower debt ratio to ensure that it can meet its
financial obligation at all times. The variation that occurs in the expected operating
income indicates the business risk.

b) Financial Risk – It is associated with the capital structure of the company. A company
with no debt financing has no financial risk. The extent of financial risk depends on the
leverage of the firm’s capital structure. Proper financial planning and other financial
adjustments can be used to correct the risk as it is controllable.

It is the risk borne by the equity shareholders due to a firm’s use of debt. If the company
raises capital by borrowing money, it must pay back the money at some future date plus
financing charges. This increases the degree of uncertainty about the company because it
must have enough income to pay back this amount at some time in the future.
 c) Credit or Default Risk – It arises due to default on fulfilling the duties of transaction by
the parties or the probability of loss from a debtor’s default. it is the risk of loss due to a
debtor’s non-payment of a loan or other line of credit either the principal or interest
coupon or both.

The chances that the borrower will not pay can stem from a variety of factors. The
borrower’s credit rating might have fallen suddenly and he became default prone and in
the extreme form may lead to insolvency. In such cases, the investor may get no return or
negative returns. Proper management of credit risk reduces the chances of non-payment
of loan by the borrowers and involves exploration by the company of ways and means of
encouraging prompt payment.

Other types of Risks:

a) Currency Risk – Exchange rate is volatile and risk arising from the change in price of one
currency against another is called currency risk or exchange rate risk. The constant
fluctuations in the foreign currency affect the investment made across the borders.

b) Country Risk – It arises from an adverse change in the financial conditions of a country
in which a business operates. The three aspects of country risk are:
i) Political Risk – This is the risk of determining financial conditions from the
consequences of a change of government or political regime or from continuing
uncertainty about what the government might do?
The risk is greater in countries with political instability, because change in
government could be sudden and the actions of the incoming government are
unpredictable and drastic eg the imposition of exchange controls, nationalization
of banks etc.

ii) Liquidity Risk – It refers to the possibility that the market for a security, such as a
bond or stock, might be illiquid, so that holders of the security could have
difficulty in selling their holding easily, should they wish to do so, at a fair price.

iii) Economic Risk – This is the risk that economic conditions within a country will
have harmful financial consequences, particularly for inflation, interest rates and
foreign exchange rates.

c) Taxability Risk – It refers to the risk associated with the changes made in tax rate. If
refers to the risk that the company faces that was issued with tax-exempt status could
potentially lose that status.
d) International Risks – These types of risks are faced by firms whose business consists
mainly of exports or those who procure their main raw material from international
markets.

e) Management Risk – Errors or constant changes made in the managerial decisions affects
the investors who have invested in the particular company. In other words it is the risk
arising out of managerial inefficiencies.

f) Technological Risk – The changes in technology affect all the firms and the companies
have to adopt themselves in emerging into a new technology in order to survive.

g) Individual and Group Risks: If a risk affects the economy or its participants at the macro
basis, it is a group risk. These risks affect most of segments of the society. These risks
may be unemployment, war, floods, earthquakes etc.

Individual Risks are confined to individual identities or small groups, Risks such as fire,
theft, robbery etc are individual risks. Some of the individual risks are insurable.

h) Pure and Speculative Risks: Pure risks are those situations where the possibility of loss
may or may not be there. If such a risk is insured and loss arises then insurance company
will compensate that loss. For example, an insurance policy for a car is purchased, there
is no accident during the period of insurance policy, there will be no compensation, if
damage occurs to car due to accident then the insurer will indemnify the loss There is no
situation of profit under such case.

Speculative Risks are those risks where there is a possibility of profit or loss. These risks
are undertaken with the intention of earning profit but profitability of loss also remains.
An investment in stock and shares may bring profit or loss. Pure risks have a possibility
of avoiding loss only whereas speculative risks have the possibility of gain also.

i) Static and Dynamic Risks: Dynamic risks are those which are the outcome of changes in
economy or the environment. These risks mainly refer to macro- economic variables like
inflation, income and output levels, technological changes etc. Dynamic risks emanate
from the economic environment as these may not ne anticipated or quantified.

Static risks are more or less predictable and are not affected by economic environment.
These risks are similar to pure risks and are suitable for insurance.
 j) Quantifiable and Non-quantifiable Risk - The risks which can be measured like financial
risks are quantifiable risks. Those risks which may result in situation like tension, loss of
peace etc are non-quantifiable.

k) Project-Specific Risk: It could be treated to something quite specific to the project.

Managerial efficiencies or error in estimated to a situation of actual cash flows realised
being less than the projected cash flows or discount rate may lead to a situation of actual
cash flows realised being less than the projected cash flows.

l) Industry-Specific Risk: It refers to that type of risk which affect all the firms in the
particular industry.

Risk Analysis in Capital Budgeting

Risk analysis should be incorporated in capital budgeting exercise. The capital budgeting
decisions are based on the benefits derived from the project. These benefits measured in terms of
cash flows based on estimates. The estimation of future returns is done on the basis of various
assumptions. The actual return in terms of cash inflows depends on a variety of factors such as
price, sales volume, effectiveness of advertising, competition, cost of raw materials,
manufacturing cost and so on. Each of these in turn, depends on other variables like state of the
economy, rate of inflation, etc. The accuracy of the estimates of future returns and the reliability
of the investment decision would largely depend upon the accuracy with which these factors are
forecasted. The actual return will vary from the estimated return, which is technically referred to
as risk. Thus risk with reference to investment decision is defined as "the variability in actual
returns arises from a project in future over its working life in relation to the estimated return as
forecast at the time of the initial capital budgeting decisions".

Why Risk Analysis is an Essential Aspect in Capital Budgeting

For determining the validity of long-term investments, risk analysis is without equal in terms of
providing measured assessments of targeted risk factors. With today’s market uncertainty as well
as the glaring unknown of the future, safeguarding and securing a company with expert insights
regarding investment outcomes is simply the smart way to do business.

For example, if an organization is part of the IT industry, then a risk analysis can be useful to
position technology-related goals with a company’s business strategies. In capital budgeting,
allocating resources towards necessary capital expenditures can result in increased value for
shareholders, but this is only applicable if a company has exercised wise investment practices.

Risk analysis is, therefore, imperative in the context of long-term investment decision-making
measures. By constructing a process for appraising new opportunities, organizations can develop
long-term objectives, estimated future cash flows, and command capital expenditures.

Measuring and Managing Capital Budgeting Risks

Risk is a difficult concept to understand, and a great deal of controversy has surrounded attempts
to define and measure it. The lighter the probability distribution of expected future returns, the
smaller the risk of a given investment. For a better capital budgeting decision it is better to
measure risk.

It is assumed that the proposed investment projects do not involve any kind of risk and cash
flows of the projects are known with certainty. This assumption was taken to simplify the
understanding of the capital budgeting techniques. However, in practice, this assumption is not
correct. In real world situation, the firm in general and its investment projects in particular are
exposed to different degrees of risks. There can be three types of decision-making:

1) Decision making under certainty: When cash flows are certain.

2) Decision making involving risk: When cash flows involve risk and probability can be
assigned.
3) Decision making under uncertainty: When the cash flows are uncertain and probability
cannot be assigned.

The risk arises in investment evaluation because we cannot anticipate the occurrence of the
possible future events with certainty and consequently, cannot make any correct prediction about
the cash flow sequence. In formal terms, the risk associated with the project may be defined as
the variability that is likely to occur in the future returns from the project.

The greater the variability of the expected returns the riskier the project. Risk can however be
measured more precisely. To handle risk, there are different techniques. The evaluation of risk
therefore depends, on decision maker ability to identify and understand the nature of uncertainty
surrounding the key variables and on the other, having the methodology to process its risk
implications.

Risk management involves identifying, measuring, monitoring and controlling risks. The process
is to ensure that the individual clearly understand risk management and business strategy and
objectives. In other words, Risk management is a crucial process used to make investment
decisions. It involves identifying and analyzing risk in an investment and deciding whether or
not to accept that risk given the expected returns for the investment. The different techniques
used to measure risks are Sensitivity Analysis, Scenario Analysis, Simulation Analysis, Standard
Deviation and Co-efficient of Variation, Risk-Adjusted Discount Rate Method, Certainty
Equivalent Co-efficient Method, Decision Tree Analysis and Probability Distribution Method.

Techniques of Measuring Risks

1) Sensitivity Analysis.

This is an approach for assessing risk that uses several possible-return estimates to obtain a sense
of the variability among outcomes. It provides information as to how sensitive the estimated
project parameters (input variables), namely economic life, discount rate, expected cash flows
are to estimation errors. Since the future is uncertain, the decision maker may like to know what
will happen to the viability of the project when project parameters deviate from their expected
value, Sensitivity analysis is also known as “what if analysis”.

Where cash inflows are very sensitive under different circumstances, more than one forecast of
the future cash inflows may be made. These inflows may be regarded as “Optimistic”, “Most
Likely” and “Pessimistic”. Further cash inflows may be discounted to find out the net present
values under these three different situations. If the net present values under the three situations
differ widely it implies that there is a great risk in the project and the investor’s decision to
accept or reject a project will depend upon his risk bearing abilities.

Where different returns from an asset are possible under different circumstances more than one
forecast of the future returns may be made. These returns may be regarded as “Optimistic”,
“Most Likely” and “Pessimistic”. The range of the returns is the difference between the highest
possible rate of return and the lowest possible rate of return. According to this measure, an asset
having greater range is said to be more risky than the one having lesser range.

Assumptions:

1 Only one variable changes at a time, while other variables of the project remain constant.

2 There is absence of correlation between any two variables or among the group of variables
under consideration in the project.

Advantages:

1 Identifies the variables and their relationships: It forces the management to identify the
underlying variables and their relationships in assessing impact on NPV of project.

2 It assesses the strength or weakness of a given project: The sensitivity analysis exposes clearly
how strong or how weak is or vulnerable a project is to the changes in the underlying variables.

3 It hints the need for further task: In case of Met Present Value or IRR is highly sensitive to the
changes in some variable, it warrants further investigation and collect further information to have
correct results.

Limitations:

1 It studies impact of one variable at a time: Sensitivity analysis studies the impact of variation in
one of the factors at a time, holding other factors constant. This is not true and meaningful when
the underlying factors are to have interrelationship. For instance, with a change in the selling
price there may be change in the quantity sold which are closely interrelated. Such situation is
not considered in Sensitivity analysis.
2 Sensitivity Analysis is merely indicative and does not provide remedy: It presents merely a
complicated set of switching values without throwing light on them. That is, it indicates merely
the likely variation in results in case of change in a variable. It does not provide any remedy. A
decision in the matter depends on the judgement of the management for which not only
sensitivity analysis but also other information may be taken into consideration.\

Illustrations

1 Dream Well Company, a custom gulf equipment manufacturer wants to choose the better of the
two investments X and Y. Each requires an initial outlay of Rs 1,00,000 and each has a most
likely annual rate of return of 14 per cent. Management has made pessimistic and optimistic
estimates of the returns associated with each and are as follows:

X Y

Pessimistic (%) 15 8

Optimistic (%) 20 25

You are required to determine range and suggest to Dream Well the better project.

2 Mr Venkat is considering two mutually exclusive projects ‘Q’ and ‘R’. From the following
information, you are required to calculate NPV for each possible outcome assuming 16 per cent
cost of capital and suggest which project is risky.

Possible Situation Project Q Project R

Initial cash outlay 65,000 65,000
Cash Inflow estimates (for 5
years) Pessimistic 20,000 10,000
Most Likely 25,000 25,000
Optimistic 35,000 45,000
3 From the following information calculate Range:

Particulars Asset A Asset B

Initial Cash Outlay Rs 100 lakhs Rs 100 lakhs
Rate of return
(percent) Pessimistic 10 6
Most likely 12 12
Optimistic 14 18

4 Mr Risky is considering two mutually exclusive projects A and B. You are required to advise
him about the acceptability of the projects from the following information:

Project A Project B
Cost of the Investment 50,000 50,000
Forecast Cash Inflows per annum for 5 years
 Optimistic 30,000 40,000
Most Likely 20,000 20,000
Pessimistic 15,000 5,000
(The cut-off rate may be assumed to be 15%)

2) Scenario Analysis

It commonly focuses on estimating what a portfolio’s value would decrease to if an unfavorable

event, or the “worst-case scenario”, were realized. It involves computing different reinvestment
rates for expected returns that are reinvested during the investment horizon.

For example, analysis of the possibility of the earth being struck by a large celestial object it
suggests that probability is low, the damage inflicted is so high that the even is much more
threatening than the low probability. However, this possibility is usually disregarded using
scenario analysis to develop a strategic plan since it has over reaching repercussions.

Scenario Analysis is the process of estimating the expected value of a portfolio after a given
period of time, assuming specific changes in the values of the portfolio’s securities or key factors
that would affect security values such as changes in the interest rate.
 Chapter 2
Investment Risk and Derivatives

Derivatives are financial contracts whose value/price is dependent on the behaviour of the price of
one or more basic underlying assets (often simply known as the underlying). These contracts are
legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in
future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude
oil, soyabean, cotton, coffee and what you have.
Thus, a 'derivative' is a financial instrument, or contract, between two parties that derived its value
from some other underlying asset or underlying reference price, interest rate, or index. A derivative
by itself does not constitute ownership, instead it is a promise to convey ownership. The Underlying
Securities for Derivatives are: (a) Commodities (Castor seed, Grain, Coffee beans, Gur, Pepper,
Potatoes) (b) Precious Metals (Gold, Silver) (c) Short-term Debt Securities (Treasury Bills) (d)
Interest Rate (e) Common Shares/Stock (f) Stock Index Value (NSE Nifty)
Eg:- A very simple example of derivatives is curd, which is derivative of milk. The price of curd
depends upon the price of milk which in turn depends upon the demand and supply of milk.
Types of Derivatives

ee
Forwards: A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today's pre-agreed price. The rupee-dollar exchange
rates is a big forward contract market in India with banks, financial institutions, corporate and
exporters being the market participants. Forward contracts are generally traded on OTC.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Futures contracts are special types of forward contracts in the
sense that the former are standardized exchange-traded contracts. Unlike forward contracts, the
counterparty to a futures contract is the clearing corporation on the appropriate exchange. Futures
often are settled in cash or cash equivalents, rather than requiring physical delivery of the
underlying asset. Parties to a Futures contract may buy or write options on futures.

Options: An option represents the right (but not the obligation) to buy or sell a security or other
asset during a given time for a specified price (the "strike price"). Options are of two types - calls
and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the
underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but
not the obligation to sell a given quantity of the underlying asset at a given price on or before a
given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts. Swaps
generally are traded OTC through swap dealers, which generally consist Notes of large financial
institution, or other large brokerage houses. There is a recent trend for swap dealers to mark to
market the swap to reduce the risk of counterparty default
Participants of Derivative markets: -
Hedgers - Hedgers are risk-averse traders in the stock markets. They aim at derivative markets to
secure their investment portfolio against market risk and price fluctuations. They do this by
assuming the exact opposite position in the derivatives market. In this manner, they transfer the risk
to those ready to take it. However, they have to pay a premium to the risk-taker for the hedging
available.
Arbitrageurs - These use low-risk market imperfections to gain profits. They usually buy low-
priced securities simultaneously in one market and sell them at a higher price in another market.
However, this can only happen when the same security is quoted at different prices in different
markets.
Speculators - Speculators bear the risk in the market. They embrace risk to earn a profit. They have
an opposite point of view as compared to the hedgers. This opinion difference helps them make
huge profits if the bets turn correct. Let's say that you bought a put option to secure yourself from a
fall in stock prices. Your counterparty, i.e. the speculator, will have to bet that the stock price won't
fall. If it is so, then you won't exercise your put option. Therefore, the speculator keeps the premium
and makes a profit.
Margin Traders - Margin means the minimum amount you need to deposit with the broker to
participate in the derivative market. It is used to reflect losses and gains daily based on the market
movements. It gives leverage in the derivative market and maintains a large outstanding position.

Functions of derivatives: -
Risk management:
The prices of derivatives are related to their underlying assets, as mentioned before. They can thus
be used to increase or decrease the risk of owning the asset. For example, you can reduce your risk
by buying a spot item and selling a futures contract or call option. This is how it works. If there is a
fall in the spot price, the corresponding futures and options contract will also fall. You can
repurchase the contract at a lower price, which will result in a gain. This can partially offset the loss
on the spot item. The ease of speculation in the derivatives market makes it easier for an investor
seeking to protect a position or an anticipated position in the spot market.
Price discovery:
Derivative market serves as an important source of information about prices. Prices of derivative
instruments such as futures and forwards can be used to determine what the market expects future
spot prices to be. In most cases, the information is accurate and reliable. Thus, the futures and
forwards markets are especially helpful in price discovery mechanism.
Operational advantages:Derivative markets have greater liquidity than the spot markets. The
transactions costs therefore, are lower. This means commissions and other cost for traders is lower
in derivatives markets. Further, unlike securities markets that discourage shorting, selling short is
much easier in derivatives. Therefore, by virtue of risk management, short selling, price discovery,
and improved liquidity, derivatives make the markets more efficient.

Advantages of Derivatives

 Reducing exposure to risk

 Improve market effectiveness
 Non-binding agreements
 Returns on borrowing
 Computing the underlying asset price
 Access to unavailable markets or assets
  Minimal transaction costs

Disadvantages of Derivatives

 High risk involved

 Speculative Features
 Counter party Risk

Factors affecting the growth of Derivatives

 Price Volatility - A price is what one pays to acquire or use something of value. The
objects having value maybe commodities, local currency or foreign currencies. The
concept Of price is clear to almost everybody when we discuss commodities. There is a
price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for
use Of a unit of another persons money is called interest rate. And the price one pays in
one’s Own currency for a unit of another currency is called as an exchange rate.
 Globalization of the Markets - Earlier, managers had to deal with domestic economic
concerns; what happened in other part of the world was mostly irrelevant. Now
globalization has increased the size of markets and as greatly enhanced competition .it has
benefited consumers who cannot obtain better quality goods at a lower cost. It has also
exposed the modern business to significant risks and, in many cases, led to cut profit
margins
 Technological Advances - A significant growth of derivative instruments has been driven
by technological breakthrough. Advances in this area include the development of high
speed processors, network systems and enhanced method of data entry. Closely related to
advances in computer technology are advances in telecommunications. Improvement in
communications allow for instantaneous worldwide conferencing, Data transmission by
satellite. At the same time there were significant advances in software programmed without
which computer and telecommunication advances would be meaningless. These facilitated
the more rapid movement of information and consequently its instantaneous impact on
market price.
 Advances in Financial Theories - Advances in financial theories gave birth to derivatives.
Initially forward contracts in its traditional form, was the only hedging tool available.
Option pricing models developed by Black and Scholes in 1973 were used to determine
prices of call and put options. In late 1970’s work of Lewis Edeington extended the early
work of Johnson and started the hedging of financial price risks with financial futures. The
work of economic theorists gave rise to new products for risk management which led to the
growth of derivatives in financial markets

Terminologies used in Derivative markets

 Underlying Security - An underlying security is a stock or bond on which derivative

instruments, such as futures, ETFs, and options, are based. In most cases, the underlying
security is the item which must be delivered by one party in the derivative contract and
accepted by the other party.
 Underlying Asset - Underlying asset are the financial assets upon which a derivative's price is
based. Options are an example of a derivative. A derivative is a financial instrument with a
price that is based on a different asset.
 Long position - refers to the purchase of an asset with the expectation it will increase in value
—a bullish attitude. A long position in options contracts indicates the holder owns the
 underlying asset. A long position is the opposite of a short position.
 Short Position - A "short" position is generally the sale of a stock you do not own. Investors
who sell short believe the price of the stock will decrease in value. If the price drops, you can
buy the stock at the lower price and make a profit.
 Hedging - Hedging is a strategy that tries to limit risks in financial assets. It uses financial
instruments or market strategies to offset the risk of any adverse price movements. Put another
way, investors hedge one investment by making a trade in another.
 Expiry Date - It is the date at which the final settlement of the contract takes place
 Margin/Initial Margin - Margin money is a deposit to secure a futures position while it is
open. Margins must be maintained at the level required by the brokerage firm. When the futures
position is closed, the remaining margin money after trade settlement can be returned to the
account holder.
 Mark to Market - Marking to market refers to the daily settling of gains and losses due to
changes in the market value of the security. For financial derivative instruments, such as futures
contracts, use marking to market.
 Clearing House - A clearing house is a financial institution formed to facilitate the exchange
(i.e., clearance) of payments, securities, or derivatives transactions. The clearing house stands
between two clearing firms (also known as member firms or participants).
 LIBOR - The London Inter-Bank Offered Rate is an interest rate average calculated from
estimates submitted by the leading banks in London. Each bank estimates what it would be
charged were it to borrow from other banks.
 MIBOR - The Mumbai Interbank Offer Rate (MIBOR) is modeled closely on London
InterBank Overnight Rate (LIBOR). The rate is used currently for forward contracts and
floating-rate debentures. Over time and with more use, MIBOR may become more significant.

Forwards

A forward contract is an agreement between two parties to buy or sell underlying assets at a pre
determined future date at a price agreed when the contract is entered into. Forward contracts are
not standardized products. They are over-the-counter (not traded in recognized stock exchanges)
derivatives that are tailored to meet specific user needs.

Features of Forwards

 Forward contracts do not fall under the Securities and Exchange Board of India (SEBI)
regulations. Thus, they do not have any margin requirements.
 They are not listed or standardised by the stock exchanges and thus are customizable. The
buyer and seller can easily make changes to the contract’s terms and conditions as per their
requirement.
 To settle these contracts, the parties involved have two options. One is that the seller pays the
appropriate differential by cash and does not physically deliver the goods. Alternatively, the
individual can just deliver the goods and get the predetermined price from the buyer.

Advantages of Forwards

Hedging: The preset specifications in the agreement made by the parties allow them to manage
risks and protect themselves from market fluctuations that can affect the asset price.

Customization: The parties involved in the agreement make specific requirements, including
expiry date, lot size and pricing.
Simplicity: These are simpler to understand the price protection and enable proximity among
traders with less regulation.

Disadvantages

Regulatory Risk: These are executed with the mutual consent of both parties involved. Also,
they are not governed by any specific regulatory authority. Because there is no regulatory
authority, it increases the risk ability of either of the parties to default.

Liquidity Risk: The trading decision is impacted in these contracts due to low liquidity. Even
though the trader has a strong trading view, they may not be able to execute the strategy because
of low liquidity.

Default Risk: The institution that drafted the agreement is exposed to a high level of risk in the
event of default or non-settlement by the client. Thus, these are risky for both parties as it is
over the counter investments.

Futurers

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
future at a certain price. These are basically exchange traded, standardized contracts. The
exchange stands guarantee to all transactions and counterparty risk is largely eliminated. The
buyers of futures contracts are considered having a long position whereas the sellers are
considered to be having a short position. It should be noted that this is similar to any asset
market where anybody who buys is long and the one who sells in short.

Types of future Contracts

Equity stock futures: If you expect Reliance to go up and want to buy 1000 shares but don’t
have the money, then what do you do? You can buy Reliance Futures. Similarly, if you expect
the Reliance price to go down, you can also sell the Reliance futures. Either way, you make
profits if the price movement is in your favor, otherwise, you make a loss. Equity futures in the
organized format is less than 20 years old in India. Equity futures give you leverage. You
deposit an initial margin like say 20% with the broker and you can trade 5 times the money you
have. Futures are only available on a selected list of stocks.

Equity Index Futures: If you don’t want to take the risk of stocks, you can buy or sell index
futures. In India, the Nifty futures and the Bank Nifty futures are not only popular but also
extremely liquid. Index futures can be used to speculate on the movements of broad-based
indices with lower risk than stock futures. Index futures can be used for hedging and arbitrage
but we will not get into all that now.

Currency Futures: This organized currency futures market came into India in 2008 and has
become extremely popular. You can bet on currencies and protect your currency payment or
receipt risk. For example, if you expect the dollar to strengthen, you buy USDINR futures and if
you expect the rupee to strengthen then you sell USDINR futures. You can trade futures on
dollars, pounds, euros, and yen.

Commodity Futures: have been very popular but CTT has taken some sheen off commodity
futures. Like the other futures, commodity futures also allow hedging against price changes in
the various commodities including agricultural products, precious metals like gold and silver,
 hydrocarbons like oil and natural gas as well as industrial metals like aluminum, zinc, nickel,
and copper. Initial margins are low in commodities so it attracts a lot of speculators. Commodity
futures happen principally in MCX and NCDEX in India.

Interest rate futures: Interest rate futures represent a contract to buy or sell government
security or T-Bill at a specified price on a predetermined date. The interest yield is implied in
the bond prices and you can bet on rates rising or rates falling and also hedge your interest rate
risk.

Difference Between Forwards and Futures

Parameter Future Contract Forward Contract

Trading on Stock Traded Not traded
Exchange
Type of Contract Standard contract Customizable depending on buyer and seller
needs
Initial Margin Required Not required
Purpose Speculation Hedging
Maturity Date Standardized Depending on the transaction
Contract Size Standardized Depends on the terms of the contract
Pricing Standardized and transparent Opaque pricing as two parties dictate
Trading On Stock exchange Over the counter
Settlement Settled anytime during trading Settled at a specific maturity date
hours.
Type of Settlement Cash settlement Delivery of asset or cash settlement
Regulation Regulated by stock exchanges Self-regulated
Clearing House Involved in settlement of futures Not involved
Risk Low counterparty risk High counterparty risk
Liquidity High Low

Maregin and Margin trading

Margin is the money borrowed from a broker to purchase an investment and is the difference
between the total value of an investment and the loan amount. Margin trading refers to the
practice of using borrowed funds from a broker to trade a financial asset, which forms the
collateral for the loan from the broker.

Types of margin

Initial Margin - Initial Margin is computed on collection of futures & options positions. The
initial margin is calculated to cover the highest possible loss for each scenario and collected at
the time of placing the order. SPAN is computed six times a day. High volatility means high
SPAN margin.

Premium Margin - Options Buyers pay a premium margin equal to value of premium
multiplied by the number of options purchased. The premium covers maximum possible loss on
the options buy position. It is collected at the time of the trade.
 Assignment margin - It is collected from Options contract seller on assignment, charged on
the net exercise settlement value due from the option writer.

Exposure Margin - Exposure margin is collected in addition to SPAN Margin. The exposure
margin is charged as a percentage of a share’s face value. For index futures and index option
sell positions is 3% of the notional value.

Future’s Market in India.

Trading in Futures market in India is done by incorporating the below elements.

Understand thoroughly how futures and options work: Futures are complex financial instruments
and are different from other tools such as stocks and mutual funds. Trading in futures can prove to
be a challenge for an individual investing in stocks for the first time. If you want to start trading in
futures, you need to know how futures work, as well as the risks and costs associated with it.

Get a fix on your risk appetite: While all of us want to make profits in the markets, one can also lose
money in futures trading. Before you get into how to invest in futures, it is essential to know your
risk appetite. You should know how much money you can afford to lose and if losing the amount
will affect your lifestyle.

Determine your approach to trading: It is important to decide one’s strategy to future trading. You
may want to buy futures based on your understanding and research. You may also hire an expert to
help you with the same.

Practice with a simulated trading account: Once you have understood how to trade in futures, you
can try and practice the same on a simulated trading account, which is available online. This will
enable you to have first-hand practical experience on how future markets work. This makes you
better at trading in futures without making any actual investments.

Open a trading account: To start trading in futures, you need to open a trading account. Do a
thorough background check before opening a trading account. You also need to inquire about the
fees. While investing in futures, it is important for you to select a trading account that suits you
best.

Arrange for the margin money requirement: Future contracts require one to deposit some amount of
margin money as a security, which can be between 5-10 percent of the contract size. Once you
know how to buy futures, it is essential to arrange for the margin money required. When you
purchase futures in the cash segment, you have to pay the entire value of the shares purchased,
unless you are a day trader.

Deposit the margin money: The next step is to pay the margin money to the broker who in turn will
deposit it with the exchange. The exchange holds the money for the entire period you hold your
contract. If the margin money goes up during that period, you will have to pay extra margin money.

Place buy/sell orders with the broker: You can then place your order with your broker. Placing an
order with a broker is similar to buying a stock. You will have to let the broker know the size of the
contract, the number of contracts you want, the strike price, and the expiration date. Brokers will
provide you with the option to select from various contracts available, and you can choose from
them.

Settle future contracts: Finally, you need to settle the future contracts. This can be done on expiry or
before the date of expiry. A settlement is nothing but the delivery obligations associated with
a futures contract. While in some cases such as agricultural products, physical delivery is done,
when it comes to an equity index, and interest rate futures, delivery takes place in terms of cash
paid. Future contracts can be settled on the expiration date or before the expiration date.
 Chapter -3

Future Contracts, Hedging and Trading

Speculation is an important function of the stock exchange. Speculation means purchase or sale of a
commodity with a view to earning profit from future price changes.

BASIS FOR
INVESTMENT SPECULATION
COMPARISON
Meaning The purchase of an asset with the Speculation is an act of conducting a risky
hope of getting returns is called financial transaction, in the hope of
investment. substantial profit.
Basis for decision Fundamental factors, i.e. Hearsay, technical charts and market
performance of the company. psychology.
Time horizon Longer term Short term
Risk involved Moderate risk High risk
Intent to profit Changes in value Changes in prices
Expected rate of Modest rate of return High rate of return
return
Funds An investor uses his own funds. A speculator uses borrowed funds.
Income Stable Uncertain and Erratic

Types of Speculator in Stock Exchange

 Bull - He is a speculator who buys different types of shares in the expectations of rising in their
price in the future. He may sell these securities at the expected higher price without their
coming into his possession. He is regarded as a potential seller in reaping of his profit. He
sustains losses if the prices fall instead of rising.
 Bear - He is also speculator who sells various securities for the objective of taking advantages
of an expected fall in the prices. He is always in a position to impose of security which he does
not possess. In this way, he makes the profit on each transaction. He may suffer losses if the
price of security rises by the date of delivery. As he feels the prices will certainly fall in future
so he is considered the potential buyer.
 Stag - A stag is a speculator who applies for shares of the newly floated company as if he were
a genuine investor. He has no intention to become an actual holder of the shares but he buys the
shares with the object of selling them above the par value to gain the premium. His activities
are not free from risk.
 Lameduck - When a bear finds it difficult of meeting his obligations, he is called to be
marketing like a lame duck. This may happen where he has been cornered. A bear generally
agrees to dispose of certain shares on a specific date. But are some cases on the specific date he
cannot deliver the shares because no shares are obtainable in the market.The second party may
refuse to postpone the delivery. Thus lame duck may suffer heavy financial losses and his
activities may come to end,
 Broker - The broker is a bonafide member of the stock exchange who deals outside the house
for the purpose of bringing together his clients and jobber. In other words, he is an intermediary
for his clients who cannot deal directly on the stock exchange. Broker thus transacts business in
securities on behalf of his clients.
Basis Of
Arbitrageurs Hedgers Speculators
Comparison

Hedgers take an
offsetting position in a
These traders aim to profit from financial asset to Speculators buy and
the price difference in securities by reduce risk exposure. sell securities based
Meaning
simultaneously buying and selling Contrary to on assumptions and
them in different markets. speculators, they do expectations.
not execute trades
based on a hunch.

Hedgers primarily aim

to reduce their risk
Speculators have a
Risk Appetite They are risk-averse. exposure. They are not
high-risk appetite.
risk-loving by nature,
unlike speculators.

Usually, investment banks, mutual

funds, and other institutional Similar to hedgers,
Retail investors can be
investors opt for the arbitrage speculators do not
hedgers as they do not
strategy owing to the requirement require technical
Suitability require technical
of technical resources. But, on the resources. Hence,
resources like in the
other hand, retail investors lack any retail investor
case of arbitrage.
such resources. Hence, it might can be a speculator.
not be suitable for them.
Hedging with Futurers

Hedging means to protect. It is done by traders to protect themselves from adverse price
fluctuations in the future. Futures and options trading offers them price stability in such instances.

Hedging Instruments
 Stocks - A stock, also known as equity, is a security that represents the ownership of a fraction
of the issuing corporation. Units of stock are called "shares" which entitles the owner to a
proportion of the corporation's assets and profits equal to how much stock they own.
 Exhange Traded funds - An exchange-traded fund (ETF) is a type of pooled investment
security that operates much like a mutual fund. Typically, ETFs will track a particular index,
sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on
a stock exchange the same way that a regular stock can.
 Insurance - Hedging may either take the form of insuring against adverse market prices or other
events, or fixing the price of a market variable or other uncertain event, often via a derivative.
For example, someone who buys house insurance hedges themselves against fires or break-ins.
 Forward contracts - A forward contract is an agreement between two parties to buy or sell
underlying assets at a pre determined future date at a price agreed when the contract is entered
into. Forward contracts are not standardized products.
 Swaps - A swap Derivative is a contract wherein two parties decide to exchange liabilities or
cash flows from separate financial instruments. Often, swap trading is based on loans or bonds,
otherwise known as a notional principal amount.
 Options - Options are financial derivatives that give buyers the right, but not the obligation, to
buy or sell an underlying asset at an agreed-upon price and date. Call options and put options
form the basis for a wide range of option strategies designed for hedging, income, or
speculation.

Long Hedging - A long hedge involves purchasing a futures contract (or other long position) to
protect against rising prices It is often used by manufacturers who require certain inputs and do not
want to risk prices rising on those commodities.
Eg - Say that a farmer produces corn and wants to lock in today's price, when the seeds are planted.
The farmer does not want to risk the price going down between now and the harvest time several
months into the future. They can sell futures contracts that expire at or after the harvest month. At
harvest, the physical corn is sold and the futures contract either expires or is bought back to close
the hedge. Regardless of what the price of corn does in the interim, every dollar change in the price
of corn will be offset by the opposite position in the futures contract.
Short Hedge - A short hedge is an investment strategy used to protect (hedge) against the risk of a
declining asset price in the future. Companies typically use the strategy to mitigate risk on assets
they produce and/or sell. A short hedge involves shorting an asset or using a derivative contract that
hedges against potential losses in an owned investment by selling at a specified price
Cross Hedging - Cross hedging refers to the practice of hedging risk using two distinct assets with
positively correlated price movements. The investor takes opposing positions in each investment in
an attempt to reduce the risk of holding just one of the securities.
 Chapter 4
Optrions, Basics and Strategies

The term option refers to a financial instrument that is based on the value of underlying securities
such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on
the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to
buy or sell the asset if they decide against it.
options are versatile financial products. These contracts involve a buyer and seller, where the buyer
pays a premium for the rights granted by the contract. Call options allow the holder to buy the asset
at a stated price within a specific timeframe. Put options, on the other hand, allow the holder to sell
the asset at a stated price within a specific timeframe. Each call option has a bullish buyer and a
bearish seller while put options have a bearish buyer and a bullish seller.

Featurers of Options

 Premium or down payment: The holder of this type of contract must pay a certain amount
called the ‘premium’ for having the right to exercise an options trade. In case the holder does
not exercise it, s/he loses the premium amount. Usually, the premium is deducted from the total
payoff, and the investor receives the balance.

 Strike price: This refers to the rate at which the owner of the option can buy or sell the
underlying security if s/he decides to exercise the contract. The strike price is fixed and does
not change during the entire period of the validity of the contract.

 Contract size: The contract size is the deliverable quantity of an underlying asset in an options
contract. These quantities are fixed for an asset. If the contract is for 100 shares, then when a
holder exercises one option contract, there will be a buying or selling of 100 shares.

 Expiration date: Every contract comes with a defined expiry date. This remains unchanged until
the validity of the contract. If the option is not exercised within this date, it expires.

 Intrinsic value: An intrinsic value is the strike price minus the current price of the underlying
security. Money call options have an intrinsic value.

 Settlement of an option: There is no buying, selling or exchange of securities when an options

contract is written. The contract is settled when the holder exercises his/her right to trade. In
case the holder does not exercise his/her right till maturity, the contract will lapse on its own,
and no settlement will be required.

 No obligation to buy or sell: In case of option contracts, the investor has the option to buy or
sell the underlying asset by the expiration date. But he is under no obligation to purchase or
sell. If an option holder does not buy or sell, the option lapses.
Advantages -
 An option buyer can only lose the value of the bought premium
 Options allow you to benefit from stock price movements without having to buy actual shares.
Consequently, your potential returns could be much higher compared to what you initially put
in. If things don't go your way, you're only out the contract premium.
 Many more investment strategy can be achieved trading options than with stocks. Depending
on the type of option and whether you are the buyer or seller, options can be used to protect
existing investments, provide supplemental income from existing stocks, or meet other
investment objectives.

Disadvntages

 Not many people trade in the options market hence they are not easily available when needed.
This could often mean buying at a higher rate and selling at a lower rate as compared to other
more liquid investment options

 Depending on the type of option, an options trader can stand to lose either just the premium or
perhaps even an unlimited sum.

 One needs to take a call on the price movement of a particular security and the time by which
this price movement will occur. Getting both right can be tough.

Types of Options

 Call option - A call option is a type of options contract which gives the call owner the right, but
not the obligation to buy a security or any financial instrument at a specified price (or the strike
price of the option) within a specified time frame.

 Put option - Put options give the option holder the right to sell an underlying security at a
specific strike price within the expiration date. This lets investors lock a minimum price for
selling a certain security. Here too the option holder is under no obligation to exercise the right.
In case the market price is higher than the strike price, he can sell the security at the market
price and not exercise the option.

 American Options - These are options that can be exercised at any time up to the expiration
date.

 European Option - These options can be exercised only on the expiration date.

 Real options- A real option gives a firm's management the right, but not the obligation to
undertake certain business opportunities or investments. Real option refer to projects involving
tangible assets versus financial instruments. Real options can include the decision to expand,
defer or wait, or abandon a project entirely.

 Double options - An option to buy (call) or sell (put) but not both. Exercise of the call causes
 the put to expire and exercise of the put causes the call to expire. Double options have been
used primarily in unlisted commodity option trading, but they are also found in OTC financial
structures.

 Exchange traded options - An exchange-traded option is a standardized contract to either buy

(using a call option), or sell (using a put option) a set quantity of a specific financial product,
on, or before, a predetermined date for a predetermined price (the strike price).

 Vanilla Options - vanilla option is a financial instrument that gives the holder the right, but not
the obligation, to buy or sell an underlying asset at a predetermined price within a given
timeframe. A vanilla option is a call option or put option that has no special or unusual features.

 Exotic Options - Exotic options are options contracts that differ from traditional options in their
payment structures, expiration dates, and strike prices. Exotic options can be customized to
meet the risk tolerance and desired profit of the investor. Although exotic options provide
flexibility, they do not guarantee profits.

 Index options - An index option is a financial derivative that gives the holder the right (but not
the obligation) to buy or sell the value of an underlying index, such as the S&P 500 index, at
the stated exercise price. No actual stocks are bought or sold.

 STock options - A stock option (also known as an equity option), gives an investor the right,
but not the obligation, to buy or sell a stock at an agreed-upon price and date. There are two
types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock
will rise.

Distingwish between Futurers and Options

Particulars Futures Options

Meaning Futures contracts are contracts Options contracts are standardized contracts that
to trade an underlying asset at a allow investors to trade an underlying asset at a
predetermined price at a future predetermined price before a specific date (the
date. expiry date for the options).

Risk They are subject to higher risks. They are subject to limited risk.

Profit or It could reap unlimited profit It could again bring you unlimited profit and loss,
Loss and loss. although it reduces the chances of incurring a
potential loss.
 Obligation The buyer is obliged to buy the In this, the buyer will have no obligation to buy or
asset on the certain stated execute the contract.
future date.

Contract A futures contract is executed Options contracts can be executed by the buyer
Execution on the date agreed upon. anytime before the expiry date.

Advance In a futures contract, there is no The buyer in an options contract is supposed to pay
Payment upfront cost when entering. a premium. The premium payment allows the
options buyer the chance to not purchase the asset
Although, the buyer is on a future date if it tends to become unattractive.
supposed to pay the agreed
price for the asset ultimately. Note that if the options contract holder opts not to
buy the asset, the premium paid is the amount he is
supposed to lose.

Terminologies of Options Trading

Pay off Diagrams

A Payoff diagram is a graphical representation of the potential outcomes of a strategy. Results may
be depicted at any point in time, although the graph usually depicts the results at expiration of the
options involved in the strategy.

Long call options

According to the Payoff diagram of Long Call Options strategy, it can be seen that if the underlying
asset price is lower then the strike price, the call options holders lose money which is the equivalent
of the premium value, but if the underlying asset price is more than the strike price and continually
increasing, the holders’ loss is decreasing until the underlying asset price reach the breakeven point,
and since then the call options holders profit from their long call positions
More payoff examples of 4 main strategies of options investment
Long Call options

Short call options

Long put options

Short put options

Trading strategies With Options
Long Straddle - A long straddle options strategy occurs when an investor simultaneously
purchases a call and put option on the same underlying asset with the same strike price and
expiration date. An investor will often use this strategy when they believe the price of the
underlying asset will move significantly out of a specific range, but they are unsure of which
direction the move will take. Theoretically, this strategy allows the investor to have the opportunity
for unlimited gains. At the same time, the maximum loss this investor can experience is limited to
the cost of both options contracts combined.

In the P&L graph above, notice how there are two breakeven points. This strategy becomes
profitable when the stock makes a large move in one direction or the other. The investor doesn’t
care which direction the stock moves, only that it is a greater move than the total premium the
investor paid for the structure.

Strangle - In a long strangle options strategy, the investor purchases a call and a put option with a
different strike price: an out-of-the-money call option and an out-of-the-money put option
simultaneously on the same underlying asset with the same expiration date.An investor who uses
this strategy believes the underlying asset's price will experience a very large movement but is
unsure of which direction the move will take.
In the P&L graph above, notice how the orange line illustrates the two break-even points. This
strategy becomes profitable when the price of the stock, either up or down, has significant
movement. The investor doesn't care which direction the stock moves, only it moves enough to
place one option or the other in-the-money. It needs to be more than the total premium the investor
paid for the structure.

Strip and Straps - A strap, also referred to as a "triple option", is similar to a straddle, but because
there are two calls for every put, the strategy is bullish. This is in contrast to a strip, which involves
two puts and one call, making it a bearish straddle modification.
Spreds - A calendar spread involves buying (selling) options with one expiration and
simultaneously selling (buying) options on the same underlying in a different expiration. Calendar
spreads are often used to bet on changes in the volatility term structure of the underlying.
 Chapter 5
Options Pricing

Put Call Parity Theory

The term "put-call" parity refers to a principle that defines the relationship between the price of
European put and call options of the same class. Put simply, this concept highlights the
consistencies of these same classes. Put and call options must have the same underlying asset, strike
price, and expiration date in order to be in the same class. The put-call parity, which only applies to
European options, can be determined by a set equation.
This concept says the price of a call option implies a certain fair price for the corresponding put
option with the same strike price and expiration and vice versa. Put-call parity doesn't apply to
American options because you can exercise them before the expiry date.If the put-call parity is
violated, then arbitrage opportunities arise.
You can determine the put-call party by using the formula C + PV(x) = P + S.
Put-call parity states that simultaneously holding a short European put and long European call of the
same class will deliver the same return as holding one forward contract on the same underlying
asset, with the same expiration, and a forward price equal to the option's st
rike price. If the prices of the put and call options diverge so that this relationship does not hold,
an arbitrage opportunity exists. This means that sophisticated traders can theoretically earn a risk-
free profit. Such opportunities are uncommon and short-lived in liquid markets.

Portfolio replication Method

Two assets that provide the same cash flow must logically have the same value/price. This concept
is derived from the underlying valuation principle in finance that states that the value of any asset is
the sum of the present values of all future cash flows. So if the cash flows of two assets are the
same, the price or value must be equal. The replicating portfolio approach to valuing options finds a
portfolio of assets that has the same payoff as the option on expiry. We then value the portfolio
today to account for the discounting effect of time. The replicating portfolio can be formed from
any asset but it is usually comprised of bonds (lending or borrowing) and stocks (short or long
positions).
The replicating portfolio to value a call option is a long position in the stock with borrowed money.
This portfolio is called a replicating portfolio because if you borrowed money and purchased a
specific number of shares in the stock (discussed below), your payoff will exactly match the payoff
from the call option.
The replicating portfolio to value a put option is a short position in the stock and purchase of a
bond. This portfolio is called a replicating portfolio because if you sold the stock now (quantity
discussed below) and lent the present value of the stock, your payoff will exactly match the payoff
from the put option
.
Risk Neutralization Method
Risk-neutral probabilities are probabilities of potential future outcomes adjusted for risk, which are
then used to compute expected asset values. In other words, assets and securities are bought and
sold as if the hypothetical fair, single probability for an outcome were a reality, even though that is
not, in fact, the actual scenario.
Risk neutral is a concept used in both game theory studies and in finance. It refers to a mindset
where an individual is indifferent to risk when making an investment decision. This mindset is not
derived from calculation or rational deduction, but rather from an emotional preference. A person
with a risk-neutral approach simply doesn't focus on the risk, regardless of whether or not that is an
ill-advised thing to do. This mindset is often situational and can be dependent on price or other
external factors.
Risk Neutralization means the process of reducing the market risk associated with a Defaulting
Clearing Member's obligations to the Clearing House under Contracts by hedging the exposure
prior to the auction process as described in Regulation 204(b)(ii).

Binomial Model
The binomial option pricing model is an options valuation method developed in 1979.The binomial
option pricing model uses an iterative procedure, allowing for the specification of nodes, or points
in time, during the time span between the valuation date and the option's expiration date. The
binomial option pricing model values options using an iterative approach utilizing multiple periods
to value American options. With the model, there are two possible outcomes with each iteration—a
move up or a move down that follow a binomial tree. The model is intuitive and is used more
frequently in practice than the well-known Black-Scholes model.

With binomial option price models, the assumptions are that there are two possible outcomes—
hence, the binomial part of the model. With a pricing model, the two outcomes are a move up, or a
move down. The major advantage of a binomial option pricing model is that they’re mathematically
simple. Yet these models can become complex in a multi-period model.
The basic method of calculating the binomial option model is to use the same probability each
period for success and failure until the option expires. However, a trader can incorporate different
probabilities for each period based on new information obtained as time passes.
A binomial tree is a useful tool when pricing American options and embedded options. Its
simplicity is its advantage and disadvantage at the same time. The tree is easy to model out
mechanically, but the problem lies in the possible values the underlying asset can take in one period
of time. In a binomial tree model, the underlying asset can only be worth exactly one of two
possible values, which is not realistic, as assets can be worth any number of values within any given
range.
The binomial option pricing model presents two advantages for option sellers over the Black-
Scholes model. The first is its simplicity, which allows for fewer errors in the commercial
application. The second is its iterative operation, which adjusts prices in a timely manner so as to
reduce the opportunity for buyers to execute arbitrage strategies.

Black Scholes Model

The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is one of the
most important concepts in modern financial theory. This mathematical equation estimates the
theoretical value of derivatives based on other investment instruments, taking into account the
impact of time and other risk factors. Developed in 1973, it is still regarded as one of the best ways
for pricing an options contract.
The Black-Scholes model, aka the Black-Scholes-Merton (BSM) model, is a differential equation
widely used to price options contracts. The Black-Scholes model requires five input variables: the
strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the
volatility. Though usually accurate, the Black-Scholes model makes certain assumptions that can
lead to predictions that deviate from the real-world results. The standard BSM model is only used to
price European options, as it does not take into account that American options could be exercised
before the expiration date.

Black-Scholes Assumptions
 The Black-Scholes model makes certain assumptions:
 No dividends are paid out during the life of the option.
 Markets are random (i.e., market movements cannot be predicted).
 There are no transaction costs in buying the option.
 The risk-free rate and volatility of the underlying asset are known and constant.
 The returns of the underlying asset are normally distributed.
 The option is European and can only be exercised at expiration.
Benefits of the Black-Scholes Model
The Black-Scholes model has been successfully implemented and used by many financial
professionals due to the variety of benefits it has to offer. Some of these benefits are listed below.
 Provides a Framework: The Black-Scholes model provides a theoretical framework for pricing
options. This allows investors and traders to determine the fair price of an option using a
structured, defined methodology that has been tried and tested.
 Allows for Risk Management: By knowing the theoretical value of an option, investors can use
the Black-Scholes model to manage their risk exposure to different assets. The Black-Scholes
model is therefore useful to investors not only in evaluating potential returns but understanding
portfolio weakness and deficient investment areas.
 Allows for Portfolio Optimization: The Black-Scholes model can be used to optimize portfolios
by providing a measure of the expected returns and risks associated with different options. This
allows investors to make smarter choices better aligned with their risk tolerance and pursuit of
profit.
 Enhances Market Efficiency: The Black-Scholes model has led to greater market efficiency and
transparency as traders and investors are better able to price and trade options. This simplifies
the pricing process as there is greater implicit understanding of how prices are derived.
 Streamlines Pricing: On a similar note, the Black-Scholes model is widely accepted and used
by practitioners in the financial industry. This allows for greater consistency and comparability
across different markets and jurisdictions.
Limitations of the Black-Scholes Model
 Though the Black-Scholes model is widely use, there are still some drawbacks to the model;
some of the drawbacks are listed below.
 Limits Usefulness: As stated previously, the Black-Scholes model is only used to price
European options and does not take into account that U.S. options could be exercised before the
expiration date.
 Lacks Cashflow Flexibility: The model assumes dividends and risk-free rates are constant, but
this may not be true in reality. Therefore, the Black-Scholes model may lack the ability to truly
reflect the accurate future cashflow of an investment due to model rigidity.
 Assumes Constant Volatility: The model also assumes volatility remains constant over the
option's life. In reality, this is often not the case because volatility fluctuates with the level of
supply and demand.
 Misleads Other Assumptions: The Black-Scholes model also leverages other assumptions.
These assumptions include that there are no transaction costs or taxes, the risk-free interest rate
is constant for all maturities, short selling of securities with use of proceeds is permitted, and
there are no risk-less arbitrage opportunities. Each of these assumptions can lead to prices that
deviate from actual results.