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Derivatives Final Assignment: Mr. Avijit Mallik Course Instructor: Financial Derivatives Course Code: F604
Derivatives Final Assignment: Mr. Avijit Mallik Course Instructor: Financial Derivatives Course Code: F604
Prepared for:
Mr. Avijit Mallik
Course Instructor: Financial Derivatives
Course Code: F604
Prepared by:
Anika Ema
Batch: MBA 59D; Roll: 32
d1 = (ln (So / K) + (r + σ2 / 2) T) / σ√T = (ln (41.12 / 28) + (0.0046 + 0.302 / 2) 0.5) / (0.30√0.5) = 1.93
d2 = d1 - σ√T = 1.72
N(d1) = 0.9732, N(d2) = 0.9564, N(-d1) = 0.0268, N(-d2) = 0.0436
C = SoN(d1) – Ke-rTN(d2) = 41.12 x 0.9732 – 28e-0.0046 x 0.5 x 0.9564 = 13.299
P = Ke-rTN(-d2) – SoN(-d1) = 28e-0.0046 x 0.5 x 0.0436 – 41.12 x 0.0268 = 0.116
A minimal fractional difference is seen between hand calculative price and software calculated price due
to use of decimal places.
A minimal fractional difference is seen between hand calculative price and software calculated price due
to use of decimal places.
Question 4: Pick any European call and put option with same maturity and same strike price from yahoo
finance. Use put call parity model to evaluate the parity. If the parity does not hold then show how an
arbitrager can make profit. Show the arbitrage strategy and calculate the amount of the profit.
Solution:
.
Part-B
Choose a specific derivative instrument such as commodity swap, option, interest rate swap etc. and
show how any particular sector of Bangladesh can benefit from such derivative. Explain the mechanism
in detail using numerical calculation and hypothetical example or case study. Try to make the analysis
comprehensive as your mark depends mostly on the completeness and comprehensiveness of the analysis.
Solution:
To show the benefit of having derivative instrument in Bangladesh, I have chosen the
pharmaceutical industry of our country where the top one company in this industry ‘SQUARE
Pharmaceuticals Ltd’ has been chosen for building up hypothetical examples and deriving the
profitability of usage of different derivative instruments in those different scenarios.
Pharmaceuticals Industry in Bangladesh:
The pharmaceutical industry of Bangladesh enjoys a well-earned reputation in both domestic and
foreign markets. This lucrative sector makes around Tk1,100 annually by exporting
pharmaceutical products to over 147 countries across the globe.
Once largely dependent on imports and multinational companies to meet the local demand,
Bangladeshi pharmaceutical industry is growing very fast meeting 98% of domestic demand and
posting a 27% growth in export earnings. This industry is maintaining a compound annual
growth rate (CAGR) of 15.6% for the last five years.
Growing per capita income, population growth, rise in life expectancy, changing disease profile,
lifestyle change and rapid urbanization are the key drivers for boom in the domestic market
consumption. People are now more conscious about health and want to live longer, leading them
to consult physicians regularly and take different medicine as per the prescription, the business
leader says. According to Bangladesh Association of Pharmaceutical Industries Secretary
General SM Shafiuzzaman, “Bangladesh’s economy is growing at over 8% per annum with
increased per capita income of $1909, while life expectancy increased to 73 years”.
Besides, new investment in the sector and adoption of modern technology have increased the
production capacity.
Export-Import Scenario:
After the RMG industry, this industry is the highest export earning sector of our country.
According to Export Promotion Bureau (EPB) data, Bangladesh’s medicine exports registered a
25.60% rise to $130 million in FY19, which was $103.46 million the previous year. Global
certification and adoption of new technologies along with efforts to make local medicine familiar
abroad and cash incentives against exports of medicine are the key reasons for the sharp rise in
exports earnings, the sector people say.
One of the major challenges for the country’s medicine sector is high dependency on imports for
raw materials, which eats up competitiveness in the global markets. Every year Bangladesh is
spending a fortune on importing 97 percent of the raw materials required by this industry. China
and India are the largest importing hub for this industry; almost 70% of total imports are covered
from those two countries only. According to the Dhaka Chamber of Commerce & Industry
sources, the pharmaceutical industry spent $600 million or Tk5,000 crores for importing Active
Pharmaceutical Ingredients (API) in the 2018-19 fiscal year. To bring down the expenses related
to medicine raw material imports, the organisation placed a strong demand for the speedy
completion of the API Industrial Park being constructed in Munshiganj. According to
Bangladesh Investment Development Authority Executive Chairman Sirazul Islam, "We will
lose many of the export facilities we are currently enjoying. If an API Industry is not built by
2027, Bangladesh will lose its competitive edge."
Scope of Growth of this industry:
In reaping the benefits, Bangladesh needs to develop the knowledge and capacity to grab a
bigger share of the global pharmaceutical market
SQUARE Pharmaceuticals Limited has extended its range of services towards the highway of
global market. It pioneered exports of medicines from Bangladesh in 1987 and has been
exporting antibiotics and other pharmaceutical products. Present export market covers 42
countries. Some of major exporting markets in Asia are: Afghanistan, Azerbaijan, Bhutan,
Cambodia, Georgia, Hong Kong, Iraq, Laos, Macau, Malaysia, Maldives, Myanmar, Nepal,
Philippines, Singapore, Sri Lanka, Tajikistan, Vietnam, Yemen.
Financial performance over the years of this company at a glance:
Shareholding status of this company is:
Investment negatives:
The Company is exposed to foreign exchange risk as around 86% of raw materials and
35% of packing materials are imported. As majority of the Company’s foreign currency
transactions are denominated in USD, unfavorable exchange movement may affect the
profitability of the Company. However, cost of raw materials is expected to reduce
considerably upon operational of the country’s API Park.
Derivatives Instruments:
A derivative is an instrument whose value is derived from the value of one or more underlying,
which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four
most common examples of derivative instruments are Forwards, Futures, Options and Swaps.
These instruments are used to increase returns and reduce risk. They provide a diversification
channel for investors to protect themselves from the vagaries of the financial markets.
ADVANTAGES DISADVANTAGES
Though prudential and judgmental use of these instruments can avoid the high risks caused by it.
Besides, it provides opportunity for incredible gains to anyone in a very short period.
But unfortunately there is no derivative market in Bangladesh. If this instrument could be
introduced, a lot of industries could make a huge profit out of it. Not only companies, single
personnel would be benefited through the derivative trading as well.
To understand the profitability of implementation of these instruments in our country, three cases
are built below on SQUARE Pharmaceutical Ltd. using three different derivatives:
1. Currency swap
2. Interest rate swap
3. Call option
Currency Swap: A currency swap is an agreement in which two parties exchange the principal
amount of a loan and the interest in one currency for the principal and interest in another
currency. At the inception of the swap, the equivalent principal amounts are exchanged at the
spot rate.
Interest Rate Swap: An interest rate swap is a forward contract in which one stream of future
interest payments is exchanged for another based on a specified principal amount. Interest rate
swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to
reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower
interest rate than would have been possible without the swap.
Call option: Call options are financial contracts that give the option buyer the right, but not the
obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price
within a specific time period. The stock, bond, or commodity is called the underlying asset. A
call buyer profits when the underlying asset increases in price.
SQUARE Pharmaceuticals Ltd. Is currently planning to open a subsidiary in Malaysia, for that it
requires to borrow Malaysian Ringgit near about 10,000 unit. They suddenly came to know a
Malaysian company X who has already their business setup in Bangladesh, is planning to expand
their operation there. So they require some Bangladeshi currency in that purpose.
The interest rate scenario for both the companies in two countries are as follow:
Finding this out, SQUARE Pharmaceuticals reached to the Malaysian company X to make a deal
of currency swap on the borrowed amount of each where both are willing to get benefit out of it.
They decided to take help of a financial intermediary to design the swap.
Numerical Calculation:
BDT Ringgit
SQUARE Pharmaceuticals 5.0% 7.6%
Company X 7.0% 8.0%
Interest rate difference 2.0% 0.4%
Difference between differences = (2.0% - 0.4%) = 1.6%, which is 160 basis points
Financial Intermediary is demanding to gain 40 basis points. So, each company will receive
benefit of (160 – 40)/2 = 60 basis points.
Hence, the effective interest rates for the two organizations would be –
This is the module of interest rate swap between two different currencies loan amount where
each company, besides the intermediary derives the benefit.
For expanding its business activities SQUARE Pharmaceuticals is considering to take a loan of
about 200 million BDT with a repayment period of 3 years where the interest rate on the loan
amount is 6 months LIBOR rate which will be changing with the market risk. To avoid the
interest rate risk SQUARE Pharmaceuticals entered into a contract with a Financial Institution
where the Financial Institution will pay the 6 months LIBOR rate semiannually on 200 million
BDT to SQUARE Pharmaceuticals in exchange for 10% interest rate constantly in 3 years. The
swap contract is for 3 years. The payment will be exchanged in 6 months frequency. The first
payment will start on January 10, 2021.
10%
SQUARE Financial
Pharmaceuticals Institution
6 months
LIBOR rate
Now it needs to be found out if the swap contract will be beneficial for SQUARE
Pharmaceuticals or not.
Numerical Calculation:
The total net cash flow after 3 years is 2.8 Mn BDT. However, according to the predictive
LIBOR rate, the NPV of the net cash flow for the SQUARE Pharmaceuticals is,
Such ambiguity cannot answer whether one organization has greater comparative advantage over
the other or not. Such ambiguity can be erased with the help of the proper valuation of the swap
contract. Now,
As the value of the swap contract for SQUARE Pharmaceuticals is positive, this contract will be
beneficial for this company.
Case 3: Call Option
SQUARE Pharmaceuticals imports raw materials from China. For that purpose, they are
expecting to need 1mn Yuan in 1 year to pay for the raw materials that will be imported. The
existing spot rate of Yuan is 11.99 BDT. Probability distribution for the spot rate in 1 year are as
follow:
SQUARE Pharmaceuticals is planning to avail this call option but requires to know if it will be
profitable or not.
Numerical Calculation:
Considering the future spot rates, payable amount in 1 year for SQUARE Pharmaceuticals will
be,
{(12.00 * 0.2) + (12.02 * 0.5) + (12.05 * 0.3)} * 1mn Yuan = 12,025,000 BDT
Now if the SQUARE Pharmaceuticals avail the 1 year call option which has a strike price of
BDT 11.99 and premium of BDT 0.01, to calculate if it will be profitable or not, first we will
have to find out the probability of exercising the call option.
So, the payable amount in one year is = {(12.00 * 0.2) + (12.00 * 0.5) + (12.00 * 0.3)} * 1mn
Yuan = 12,000,000 BDT
Profit after exercising the call option is (12,025,000 – 12,000,000) BDT = 25,000 BDT
○
References:
Noyon, A. U. (2019, November 2). Pharma industry spending a fortune on importing raw
materials. The Business Standard. Retrieved from https://tbsnews.net
Noyon, A. U. and Tajmim, T. (2020, March 11). Pharma industry braces for raw materilas
crisis. The Business Standard. Retrieved from https://tbsnews.net
The know-what’s of derivative market and how you can benefit. Retrieved from
https://www.motilaloswal.com/