Derivatives Summary

Contents:

1. Introduction
2. Option contract
(i) Call option
(ii) Put option
(iii) European option and American option
(iv) Option premium/option value/option price
(v) In/out/At the money option (i.e. status of option)
(vi) Pay-off of a call option and put option
(vii) Valuation of option
- Binomial model
- Black scholes model
(viii) Arbitrage opportunity under option contract
(ix) Put-call parity theory
(x) Strangle strategy
(xi) Straddle strategy
(xii) Bullish Call spread
(xiii) Bearish Call spread
(xiv) Bullish Put spread
(xv) Bearish Put spread
(xvi) Butterfly spread

3. Future contract
(i) Introduction to future contract
(ii) Margin requirement
(iii) Differences in forward contract and future contract
(iv) Fair future value/theoretical future value
(v) Arbitrage in future
(vi) Index
(vii) Obtaining complete/Partial hedge with the help of index future and beta
(viii) Number of future contract to be sold or purchased for increasing or reducing beta to
a desired level using index future.

4. OTC (Over-the-counter) derivatives

(i) Introduction to OTC market
(ii) Implied forward rates
(iii) Forward rate agreements (FRAs)
(iv) Arbitrage in Forward rate agreements
(v) Interest rate Caps, floors and Collars.

5. Moving average
- Simple moving average
- Exponential moving average

6. Forex with derivatives

CA. Nagendra Sah Page 1

Derivatives Summary
Introduction:
Derivative is a financial instrument whose payoff structure is derived from the value the underlying
asset.

Following example will help us to understand the meaning of three Key term namely Derivative,
underlying assets and value of derivatives.

Example: suppose you and your 1 friend wants to watch cricket match scheduled to be held at one
month time.
Each ticket cost 1,000. You call up and find that the tickets are fully sold-out.
Sachin Tendulkar, brother of your friends, gives you a “reference letter” under which if you show
the letter you can buy 2 ticket at 1,000 each.

Possibility-I
Suppose at one month time tickets are selling in black market at 1200 each.
In this case letter is now worth 2 (1,200-1,000) = 400

Possibility-II
Suppose at one month time tickets are selling in black market at 700 each
In this case letter is now worthless.

Now we can understand these three words:

(i) The “reference letter” is a derivative instrument
(ii) The “Ticket” is underlying assets.
(iii) The “value of reference letter” would be derived from the value of ticket (Underlying
assets). If value of ticket change the value of reference letter will also change.

Derivative contract

Exchange Traded derivative OTC derivative

Option Future Forward Forward Rate Caps, floor Interest

contract contract Contract agreement and Collar rate swap

 OTC derivative Contract: OTC (Over-the-counter) contract is a contract which is privately negotiated
between two parities.
Example of OTC market in India:– OTCEI (Over the counter exchange of India)
 Exchange Traded derivative: Exchange traded derivative contract is a contract which is
negotiated in an exchange between various parties. Exchange means Stock exchange.
Example of exchange in India:– BSE (Bombay stock exchange), NSE (National Stock exchange) etc.

Option Contract:
 An option is a type of derivative instrument.
 There are two parties to option contract. One is buyer of option (or Holder of option) and
another is seller of option (or writer of option)
 The person who gets rights to buy or sale an underlying asset at an agreed amount is called
Buyer of option (i.e. holder of option).
 The person who have the obligation to sale or buy an underlying asset at an agreed amount
(according to buyer’s action) is called seller of option (i.e. writer of option)

 The option may be a call option or a put option.

Email: ca_npsah@icai.org Page 2

 Derivatives Summary
Call option:
When option gives the buyer right to buy an underlying asset, then it is called Call option.

Mr. S gets Premium from

Mr. B Mr. B for selling option Mr. S
Buyer of Call option (i.e. writing option) Seller of Call option

Mr. B has right Letter (call option)

to buy share of Mr. S has obligation
Reliance at If you desire, you to sale share of
500 at 3 can buy share of Reliance at 500 at 3
month time Reliance at 500 month time, if buyer
at 3 month time approach to do so.
Underlying from now.
assets Strike Price (X)

Current price of underlying assets – PV of exercise price Exercise date

 If at 3 month time (i.e. on exercise date) price of a share is more than 500 then buyer exercise his right
and seller is bound to sell share at 500 (i.e. at strike price) even actual market price is higher.
 If at 3 month time (i.e. on exercise date) price of a share is less than 500 then buyer does not exercise
his right and he loss premium amount and seller gain premium amount.
Action of buyer (i.e. buyer of call option):

Actual price of underlying assets

Buyer of call option will exercise call option

and in this case Maximum cost of buying
underlying assets is exercise price.
Exercise price (x)
Buyer of Call option does not exercise call
option and in this case buyer loss premium
amount.

Actual price of underlying assets

 Under call option Buyer of Call option and buyer of underlying assets will be same person. If any
where written only buyer word it means he is the buyer of option (either buyer of call or buyer
of put) and not the buyer of underlying assets.
Price range for buying underlying assets:

(Exercise)

Maximum buying cost (exercise price)

(Not exercise) Price range for buying underlying assets

Zero prices

CA. Nagendra Sah Page 3

Derivatives Summary
Put option:
When option gives the buyer right to sell an underlying asset, then it is called Put option.

Mr. S gets Premium from

Mr. B Mr. B for selling option Mr. S
Buyer of Put option (i.e. writing option). Seller of Put option

Mr. B has right Letter (Put option)

to Sell share of Mr. S has obligation
Reliance at If you desire, you to buy share of
500 at 3 can sell share of Reliance at 500 at 3
month time Reliance at 500 month time, if buyer
at 3 month time approach to do so.
from now.
Underlying
Strike Price (X)
assets
PV of exercise price – current price of underlying assets Exercise date

 If at 3 month time (i.e. on exercise date) price of a share is Less than 500 then buyer exercise his right
and seller is bound to buy share at 500 (i.e. at strike price) even actual market price is less.
 If at 3 month time (i.e. on exercise date) price of a share is higher than 500 then buyer does not
exercise his right and he loss premium amount and seller gain premium amount.
 Under put option the Buyer of Put option and buyer of underlying assets will different person. In
other word buyer of put is seller of underlying assets and Seller of put is buyer of
underlying assets.
 If any where written only buyer word it means he is the buyer of option (i.e. either buyer of call
option or buyer of put option) and not the buyer of underlying assets.
Action of buyer (i.e. buyer of put option):
Actual price of underlying assets

Buyer of Put option does not exercise put option

and in this case buyer loss premium amount.

Exercise price (x)

Buyer of put option will exercise put option
and in this case Minimum sale value of
underlying assets is exercise price.

Actual price of underlying assets

Price range for selling underlying assets:

No limit

Price range for selling underlying assets

(Not exercise)
Minimum selling price (exercise price)

(Exercise)

Email: ca_npsah@icai.org Page 4

 Derivatives Summary
European option and American option:

O year Exercise date

American Option European Option

If buyer can exercise his
right to buy or right to sale
at any time before exercise
date then this option is
called American option (i.e
American call option or
American put option as the
case may be)
If buyer can exercise his
right to buy or right to sale
only at exercise date then
this option is called
European option (i.e
European call option or
European put option as the
case may be)

Note:
(i) Premium charged by seller of an American option may be greater than that of European
option because seller of option feel more risk than that of European option.
(ii) Unless otherwise stated all option are assumed to be European option.

Option Premium/option price/option Value

 When buyer buys a right (either the right to buy or right to sale) then he has to pay the seller (i.e. writer) some
price. This Price (i.e. payment) is called option premium.
 The premium payable by the buyer (i.e. holder) to the seller (i.e. writer) is a onetime premium and it is
non refundable.

Value of Call option/Call Premium

Expected market
(i) Value of option at expiration date = price of underlying - Exercise Price (It always
assets at exercise for exercise date)

date

(ii) Value of option as on today =

(iii) Value of option as on today = Spot price of underlying assets – PV of exercise price

Value of Put option/Put Premium

Expected market
(i) Value of option at expiration date = Exercise Price (It always - price of underlying
for exercise date) assets at exercise
date
(ii) Value of option as on today =

(iii) Value of option as on today = PV of exercise price - Spot price of underlying assets

Note:
(i) Value of option can never be negative. If it comes negative then take it as ‘Nil’
(ii) The option value (option premium) calculated using above formula is a fair value. However in
actual market option premium charged by the seller may be different from fair value.

CA. Nagendra Sah Page 5

Derivatives Summary

Status of the option (In/At/Out-of-the-money option)

In-the-money Option: An option is said to be “in-the-money’ if exercising the option will bring
about a gain.
At-the-money Option: An option is said to be “at-the-money” if exercising the option will result in
neither a gain nor a loss.
Out-of-the-money Option: An option is said to be “out-of-the-money” if exercising the option will
result in a loss.
Summary:
Condition Call buyer status Put buyer status
Exercise Price > Market price Out-of-the money In-the-money
Exercise price = Market price At-the-money At-the-money
Exercise price < Market price In-the-money Out-of-the-money

Note:
 The exercise price (or strike price) is fixed by the exchange. The exchange announces three exercise
prices one in-the-money another at-the-money and last out-of-the-money.
 In-the-money option is more expensive than that of at-the-money and out-of-the-money option
 At-the-money option is less expensive than that of In-the-money option but more expensive than
that of Out of the money option.
 Out-of-the-money option is less expensive than that of “In” and “At”.
[i.e. In-the-money option prem.>At-the-money option prem.> Out-of-the-money option prem.]

Pay off of a call option and put option:

 Pay off means profit and loss. In determining the profit and loss we take into consideration the
amount of premium paid.
Profit/loss to the buyer of call option/put option
= benefit from exercising call/Put – premium paid
Action of buyer:
Buyer will exercise call option when actual share price is higher than exercise price and
exercise put option when actual share price is lower than exercise price.
Benefit from exercising call option = actual share price at expiration date – exercise price.
Benefit from exercising put option = exercise price – actual share price at expiration date.

Profit/loss to the seller of call option/Put option

= Premium received – loss due to exercising call option by buyer.

 Profit to the buyer of call/put option is equal to loss to the seller of call/Put option or vice versa.
 The maximum profit to seller of Call option or put option will be premium amount only but loss
may be unlimited.
 The maximum loss to buyer of call option or put option may be premium amount and gain may
be unlimited.

Email: ca_npsah@icai.org Page 6

 Derivatives Summary

Valuation of Option (primary pricing models used for valuing options.)

Black Scholes Model Greeks: (i) Delta (ii) Gamma

(For European option Binomial model
only) (iii) Theta (iv) Rho (v) Vega

Greeks are a collection

of statistical values (in
Using Risk Using Hedge ratio and %) that give the
Neutralization buying share at this investor a better overall
Method ratio by call writer view of how a stock has
been performing.

Black-Scholes Model (also referred as Black-Scholes –Merton Model)

[N-08-12Mark] [N-06-8Marks] [RTP-N-09]
Black and Scholes have given a model for valuation of European Call option. Black scholes model
considers the risk factor (i.e. σ) in its formula. Hence, if question gives σ information then use black
scholes model for valuation of option whether question specify or not.

Value of call option = Adjusted spot price of share N(d1) – Present value of strike price N(d2)

Value of Put option = Present Value of strike price Adjusted spot price of share
-
[1-N(d2)] [1-N(d1)]

Where,
σ
(i) d1 =
σ

(ii) d2 = d1 σ
(iii) N(d1) and N(d2)= cumulative normal distribution function for a given (z or d) value (see
discussion on normal distribution table value for more clarity)

(iv) Present value of strike price = Strike price

(v) Adjusted spot price = spot price – PV of dividend received in middle period

Under blackscholes model always use interest rate as ‘compounded continuously’ whether
question specify or not.

Author Note: Always do interpolation for “ln” (i.e. loge), and for “ ”. However interpolation
for N(d1) & N(d2) can be ignored if question carry less marks or you have shortage of time in exam.

Binomial Model
This model assumes that the underlying asset can have only two values at the time of maturity of an
option. One will be higher than the strike price and the other will be lower than the strike price.

CA. Nagendra Sah Page 7

Derivatives Summary
Method –I (Risk Neutralization method)
 Risk Neutralization method assumed that the investment in risky investment or investment in
risk free assets will have same expiration date value.
 Risky investment has 2 possibilities that expiration date value is high price or low price.
 Expiration date value of risky investment and risk free investment will be equal if
probability of high price and probability of low price is being calculated using risk Neutralisation
method.

 Probability for happening of high price and low price should be calculated using following
formula (when investment is in the same country and only one risk free interest rate is given).
[When interest rate is compounded periodically]
Probability of high price =

[When interest rate is compounded continuously]

Probability of high price =

Probability of low price = (1- probability of high price)

Concept of above formula:

Suppose Mr. ABC have  100 today. He may invest in 100 in risk free assets @ 10% for 1 year
or invest in risky assets (share of current share price 100) for 1 year. Risky assets have only two
possibilities that year end value may be 120 or 90.
Mr. ABC’s risk will Neutral if expiration date investments value of risk free assets and risky
assets will be same.

Investment value at year ends if invests in risk free assets:

= Investment value (1+PIR) = 100 (1+0.10 )

Investment value at year ends if invests in risky assets:

= High price High Probability + Low price Low probability
= [High price P] + [low price (1-P)]
= 120 P + 90 (1- P) = 120 P + 90 – 90 P
= 30 P + 90
For risk Neutralisation:
Value of risk free assets = value of risky assets.
Or, 100 (1+0.10) = 30 P +90

Or, P =

 Probability for happening of high price and low price may be calculated using following
formula (when investment is in the foreign currency and risk free interest rate of two
countries is given). (Refer Q-37)
[When interest rate is compounded periodically]
Probability of high price =
[When interest rate is compounded continuously replace (1+PIR) by e rt.

Email: ca_npsah@icai.org Page 8

 Derivatives Summary

Probability of low price = (1- probability of high price)

Concept of above formula:

Suppose Mr. XYZ has 50 today for investment. He may invest it in India @10% for 1 year or he
converts 50 into dollar and invests in USA @15% for 1 year.
Spot rate is 50 for 1 dollar
Expected exchange rate at expiration date is 70 or 40 for each dollar.

Mr. XYZ’s risk will Neutral if expiration date investments value of risk free assets and risky
assets (foreign currency) will be same
Investment value at year ends if invests in risk free assets:
= Investment value (1+PIR) = 50 (1+0.10 )
Investment value at year ends if invests in risky assets:
Equivalent dollar for 50 = 50/50 = $1
Investment value at year ends in ‘$’ = $1 (1+0.15) = $1.15
High value at year ends (when rate is 70) in ‘’ = 1.15 70 = 80.5
Low value at year ends (when rate is 40) in ‘’ = 1.15 40 =  46

Risky investment value = High value High Probability + Low value Low probability
= [High value P] + [low value (1-P)]
= [80.5 P] + [46 (1-P)] = 80.5 P + 46 – 46 P = 34.5 P + 46
For risk Neutralisation:
Value of risk free assets = value of risky assets.
Or, 50 (1+0.10) = 34.5 P +46

Or, P =

Method-II (Using Hedge ratio and buying share at this ratio by call writer)
Steps for calculation of Option value:
1. Calculate Option value at both high price and low price
2. Calculate Hedge ratio (risk less hedge portfolio)
Hedge ratio =
Assume hedge ratio is 0.6. It means seller of call option have to buy 0.6 share today for
hedging the risk.

3. Calculate hedge position:

Hedge position is the future value of borrowing taken to buy share obtained under hedge
ratio.
At high share At Low share
price price
Value of 0.6 share at expiration date 0.6 High Price 0.6 Low Price

Less: Expiration date option value calculate ********** **********

under point 1
Hedge position ********** **********

CA. Nagendra Sah Page 9

Derivatives Summary
4. Calculate present value of borrowing (i.e. hedge position)
PV of borrowing =

5. Calculate fund required to buy hedge share

Fund required to buy share obtained under hedge ratio = hedge share Spot share price

6. Calculate value of call option:

Fund required to buy hedge share = borrowing + call premium

Hence, Call premium = Fund required – borrowing amount

Two periods Binomial Model

Use Risk neutralization method for valuation of two period binomial model.

Valuation of Two periods European Option: [RTP-N-09]

B=

0 Period 1 period 2 period

Mkt. price – Strike price

D or Strike price– M. Price

B
Mkt. price – Strike price
E or Strike price– M. Price
A
F Mkt. price – Strike price
or Strike price– M. Price
C

G Mkt. price – Strike price

or Strike price– M. Price

A=
C=

 Here A, B, C, D, E, F, & G used above mean Option value (either Call option or Put option) at node A, B, C, D, E,
F, & G respectively.
 Expected (i.e. average) of Option value is being calculated using probability.
 High price Probability for each node of D, F, and B will be calculated using following formula:

 Low price probability for each node of E, G and C will be calculated using following formula:

 High price probability for node D, F & B will be same and Low price Probability for node E, G and
C will be same if increase and decrease in share price will be same for each period.

Email: ca_npsah@icai.org Page 10

 Derivatives Summary

Valuation of Two periods American Option: [JUNE-09-8 Marks]

All steps are same as European Option. Only differ in calculation of option value at node B and C.

0 Period 1 period 2 period

B = See below
Same as European
D

B
Same as European
E
A
F
Same as European
C

G Same as European

A= C = see below

 B = Higher of :
(i) Value of option at node B, if buyer will exercise option at due date (i.e. at 2 period) or

(ii) Value of Option at node B, if buyer will exercise option at middle of the period (i.e. at 1 period).

Mkt. price at node B – Strike price if call option

or
Strike price– Market Price at node B if Put option

 C = Higher of :
(i) Value of Option at node C, if buyer will exercise option at due date (i.e. at 2 period) or
(ii) Value of option at node C, if buyer will exercise option at middle of the period (i.e. at period 1).

Arbitrage opportunity under option contract

Normal rule for Arbitrage:
Actual price (i.e. Premium) is Higher Sale
Actual price (i.e. Premium) is lower Buy
As we know arbitrage is a risk free profit, a seller of option can never be an arbitrageur because
profit of seller depends upon the action of the buyer. If Someone’s profit and gain depends upon other
person’s action, it means there should be uncertainty and this profit and gain is not risk free.

CA. Nagendra Sah Page 11

Derivatives Summary
Hence Arbitrage is possible only when Actual price < Fair price of Option
Condition Action Reason

For call option:

If Actual call price (call premium) is Buy “Call option” for Because “Call option” is
lesser than fair call price. arbitrage gain underpriced.
If Actual Call price (Call Premium) is No Arbitrage Because Seller cannot earn
higher than fair Call price. risk free profits.

For Put option:

If Actual Put price (Put Premium) is Buy “Put option” for Because “Put option” is
lesser than fair Put price. arbitrage gain underpriced.
If Actual Put price (Put Premium) is No Arbitrage Because Seller cannot earn
higher than fair Put price. risk free profits.

Procedure for earning arbitrage profit Under Call option

Arbitrage gain Possible when Actual Call Premium < Fair call premium
0 period Maturity date

1. Assume Arbitrageur have

1 share today. (Remember as per
the technique used in class)

2. Sale this share in cash

market at spot rate.

3B. Deposit
Balance of the 4. Receive deposit amount
sale proceeds at with interest at maturity.
risk free rate for
specific period.
5A. Share price will higher
than Exercise price
3A. Buy a Call Possibility-1: Buy share at Exercise price
option at actual from receipt of deposit. (By
market price Arbitrage gain = (4) – Ex. Price exercising call option).
out of the sale
proceeds of
share.
5B. Share price will lower
Possibility-2: than Exercise price
Buy share at market price
Arbitrage gain = (4) – Mkt. Price from receipt of deposit.
(Does not exercise call option
and buy share from market).

Email: ca_npsah@icai.org Page 12

 Derivatives Summary
Procedure for earning arbitrage profit Under Put option
Arbitrage gain is Possible when Actual Put premium < Fair Put Premium
0 period Maturity date

1. Assume Arbitrageur have

Nothing today. (Remember as per
the technique used in class)

2. Borrow Money equal to 5. Repay borrowing with

current share price plus put interest at maturity from
premium. sales proceeds of share.

4A. Share price will lower

Possibility-1: than Exercise price
3. Buy a Put
option and one Sale share at Exercise price
Arbitrage gain = Ex. Price – (5)
share at current (Exercise put option and sell
market price share to seller of option).
from borrowing
amount
Possibility-2:
4B. Share price will higher
than Exercise price
Arbitrage gain = Mkt. Price – (5)
Sale share at Market price
(Does not exercise put option
and sale share in outside
market).

Put Call Parity: [RTP-N-09]

This is a general relationship between Value of Call and Value of Put provided it has the same
exercise price and same maturity for same underlying assets.

At put call parity:

Value of Call + Present Value of Strike Price = Value of Put + Current Market Price

Total outflow under call option in Total outflow under Put option in
today’s money term for buyer of today’s money term for buyer of
option option

Logic: Buyer of put has to sell Underlying assets

at maturity. Hence buy underlying assets today,
so that he can sell it at maturity

Strategy in option:

Long Call – Buying Call Option

Short Call – Selling Call Option

Long put – Buying Put Option

Short Put – Selling Put Option

CA. Nagendra Sah Page 13

Derivatives Summary
Strangle strategy: [M-06-7 Mark] [RTP-Nov-09]
An options strategy, where the investor holds a position in both a call and a put with different
strike prices but with the same maturity and underlying asset is called strangles strategy.
Selling a Call option and a put option is called seller of strangle (i.e. Short strangle). Buying a call
and a put is called buyer of strangle (long strangle).
This is a good strategy if you think there will be a large price movement in the near future but is
unsure of which way that price movement will be.
The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A
strangle is generally less expensive than a straddle as the contracts are purchased out of the money

Price range: for Profit

Break even Price
High Strike price (Long Call)
Price range: Where get Loss
(Loss Amt = Total prem. Paid)

Low Strike price (Long Put)

Break even Price

Price range: for Profit

Maximum profit = Benefit from exercising Call/Put - Total Premium

Maximum loss = Total Premium

Straddle: [June-09-8 Marks]

An options strategy, where the investor holds a position in both a call and a put with same
strike prices, same maturity and same underlying asset is called straddle strategy.
Selling a Call option and a put option is called seller of straddle (i.e. Short straddle). Buying a call
and a put is called buyer of straddle (long straddle).
This is a good strategy if you think there will be a price movement in the near future but is unsure
of which way that price movement will be.
The strategy involves buying an At-the-money call and an At-the-money put option. A straddlele is
generally more expensive than a strangle as the contracts are purchased At the money

Price range: for Profit

Break even Price

Same Strike price (Long Call & Long Put)

Break even Price

Price range: for Profit

Maximum profit = Benefit from exercising Call/Put - Total Premium

Maximum loss = Total Premium

Email: ca_npsah@icai.org Page 14

 Derivatives Summary
Bull call spread: [RTP-Nov-09]
An options strategy that involves:
-Selling Call option at high strike price and
-Buying same no of call option at low strike price
for same underlying assets with same maturity date.
 This options strategy is being used when an option trader expects a rise in the price of the
underlying asset.

Receive Low Prem.

Price range: for Profit
High Strike price (Short Call)

Break even Price

Net premium (i.e. Prem. Paid – received)

Low Strike price (Long Call)

Pay High Prem.

Maximum profit = difference between the strike prices - Net Premium
Maximum loss = Net Premium Paid

Bear call spread

An options strategy that involves:
-Selling Call option at Low strike price and
-Buying same no of call option at High strike price
for same underlying assets with same maturity date.
This options strategy is being used when an option trader expects a decline in the price of the
underlying asset

Pay Low Prem.

High Strike price (Long Call)

Net premium (i.e. Prem. Received – paid)
Break even Price

Low Strike price (Short Call)

Price range: for Profit
Receive High Prem.
Maximum profit = Net Premium Received
Maximum loss = difference between the strike prices - Net Premium

Bull Put spread

An options strategy that involves:
-Selling Put option at high strike price and
-Buying same no of Put option at low strike price
for same underlying assets with same maturity date.
 This options strategy is being used when an option trader expects a rise in the price of the
underlying asset.

CA. Nagendra Sah Page 15

Derivatives Summary
Maximum profit = Net Premium Received
Maximum loss = difference between the strike prices - Net Premium

Bear Put spread

An options strategy that involves:
-Selling Put option at Low strike price and
-Buying same no of Put option at High strike price
for same underlying assets with same maturity date.
This options strategy is being used when an option trader expects a decline in the price of the
underlying asset

Maximum profit = difference between the strike prices - Net Premium

Maximum loss = Net Premium Paid

Butterfly spread
A long butterfly position will make profit if the future volatility is lower than the implied volatility.
A long butterfly options strategy consists of the following options:
Long 1 call with a strike price of (X a)
Short 2 calls with a strike price of X
Long 1 call with a strike price of (X + a)

A short butterfly position will make profit if the future volatility is higher than the implied
volatility.
A short butterfly options strategy consists of the same options as a long butterfly. However all the
long option positions are short and all the short option positions are long. b

Summary for calculation of Option Value:

It is summarized from above discussion.

Option value to be calculated using

either of the following method:

Normal Method Binomial Model Black-scholes Put call Parity

model

When strike price When expected When When

and expected price price of underlying Standard information of
of underlying assets will either deviation call option
assets given high price or low with other given and put
(Normal method- price (i.e. only two information value to be
when other 3 method possibility) given. calculated or
is not applicable) vice versa

Email: ca_npsah@icai.org Page 16

 Derivatives Summary

Future Contract:
Like forward contract, Future contract is also a contract entered today for future
delivery/settlement. However, forward contract may differ from future contract in various terms which
will be discussed later.

Introduction to Future contract:

 A future contract is a standardized contract (i.e. traded in lot size) that is traded in a future exchange. A
person can buy or sell underlying assets (commodity, share, index, Forex, bond etc.) at certain future date at certain
future price through future exchange. Future date and future price is being fixed today by entering
into future contract.
 Future contracts are settled daily. Hence we can say Delivery date (i.e. settlement date) is a range of delivery
date.
Future contract date Settlement date/delivery date

Future contract can be settled any

time on or before delivery date.

Margin Requirement:
 Buyer and seller of future contracts are required to deposit the initial margin in a margin account
which is fixed by exchange on the basis of contract value.
 If buyer/seller gains then margin account will be credited (i.e. increased) and when they suffer loss
then margin account will be debited (i.e. decreased).
 If margin account goes below minimum maintenance balance then buyer/seller have to add money in
margin account

Example:
Current sugar price = 25 per kg
Future price of sugar = 30 per kg
Contract size = 1000 kg
Maturity period = 5 days (for concept purpose only)

0 day 1 day 2 days 3 days 4 days 5 days

2 3 4 5
Actual25 28 34 27 29 36
Net
1
Future price  30

A. Net Gain to buyer of future contract = (36-30) 1,000 = 6,000 Gain

Net loss to seller of future contract = same amount

B. This gain of 6,000 will be distributed over maturity period because transaction is settled on
the basis of daily closing price:
Days Actual Price Future price/Previous day price Loss/gain to buyer
1 28 30 (28-30) 1,000 = - 2,000
2 34 28 (34-28) 1,000 = 6,000
3 27 34 (27-34) 1,000 = -7,000
4 29 27 (29-27) 1,000 = 2,000
5 36 29 (36-29) 1,000 = 7,000
Total 6,000/-

CA. Nagendra Sah Page 17

Derivatives Summary
Difference between future and forward contract
Future and forward contract both are agreements entered today to buy or sell underlying assets at a
certain price at certain future date. However they differ in various ways which is listed below:
Future contract Forward Contract
1 It is standardized contract that is traded in It is non-standardized contract that is
future exchange traded over-the-counter(OTC)
2. The delivery date is range of delivery date The delivery date is one specific date and
because contract can be settled prior to contract can be settled only on maturity
maturity
3 Future contract have no liquidity problem Forward contract have liquidity problem
because it is traded through exchange. because it is private contract (i.e. OTC)
4 Future contract have fixed contract size Forward contract have no fixed contract
size.
5 Price of future contracts are publically Price of forward contracts is not publically
disclosed disclosed.

Fair future value/theoretical future value [Most Imp.]

=
Fair Spot price of Future value of
= + Cost to carry -
future underlying assets Intermediate return
value

It is equal to “Spot price (1+ PIR)” It is equal to Interest cost

Concept of above formula with diagram:

0 year 2 month 3 month

Spot Share Dividend Fair Future

Price Received Price

Spot price (1+ PIR)

Less: Dividend (1+ PIR)

Arbitrage in future contract: [Nov-08] [Nov-09] [May-04] [Nov-02] [June-09]

Arbitrage is an act to earn risk free profit. Arbitrage in Future is possible when Fair future value is
not equal to Actual future value.

Condition Action Reason

If Actual future price is lesser Buy “Future” for Because “Future” is underpriced
than fair future price. arbitrage gain in future market.
If Actual future price is higher Sell “Future” for Because “Future” is Overpriced in
than fair future price. arbitrage gain future market.

Email: ca_npsah@icai.org Page 18

 Derivatives Summary
Procedure for earning arbitrage profit in Future Contract
When Actual future is lower than fair future:
For arbitrage gain Buy Share under Future contract and sale share in Cash market.
0 period Maturity date

1. Enter Future contract

today to buy U. Assets

2. Assume Arbitrageur have

1 share today. (Remember as per
the technique used in class)

3. Sale the share he has in

cash market at spot rate.

5. Receive deposit
4. Deposit the sale
amount with interest at
proceeds at risk free rate for
maturity.
specific period (i.e. future
contract period)
6. Buy share at contracted
rate (under future contract) from
the receipt of deposit
money.

Arbitrage gain = (5) – (6)

Procedure for earning arbitrage profit in future contract

When Actual future is higher than fair future:
For arbitrage gain Sale Share under Future contract and Buy share in Cash market.
0 period Maturity date

1. Enter Future contract

today to Sell U. Assets

2. Assume Arbitrageur have

Nothing today. (Remember as per
the technique used in class)

4. Sale Share at maturity

3. Buy 1 share date at contracted rate.
@ Spot rate taking borrowing
at risk free rate.
(Borrowing amount is equal to the spot share
5. Repay Borrowing with
price).
interest at maturity from
sale proceeds.

Arbitrage gain =(4) – (5)

CA. Nagendra Sah Page 19

Derivatives Summary
Index:
What is a stock market index? [May-10-Theory]
 It is an answer to the question “How is the market doing” It is the representative of the entire
stock market.
Movements of the index represent the average returns obtained by investors in the stock market.
 SENSEX (Sensitivity index) and NIFTY (S&P CNX NIFTY- Standard and Poor’s CRICIL NSE Index) are the example of index in
India.
 BSE (Bombay stock exchange) Index “SENSEX” represents the stock of 30 companies (largest and most actively traded
stocks) on BSE selected from various sector.

 NSE (National Stock exchange) Index “NIFTY” represents the stock of 50 companies (largest and most actively traded
stocks) on NSE selected from various sector.

 The shares included in index are those shares which are traded regularly in high volume. In case
the trading in any shares stops or comes down then gets excluded and another company’s shares
replace it.
 The transaction of index will settle by price difference because delivery is not possible as it is
maginary item.

Profit and loss in Index:

If the actual price of Index Buyer of Index  Gain

on due date is more than Seller of Index  Loss
future price (i.e. Contracted
Price)

If the actual price of index Buyer of Index  Loss

on due date is less than Seller of Index  Gain
future price (i.e. Contracted
Price)

How to calculate Index Point? [ May-10-4 Marks]

(i) Calculate the market capitalization of each individual company comprising the index.
(ii) Calculate the total market capitalization by adding the individual market capitalization
calculated in point (i).

Index point on = Index point on

current day previous day

Hedging with the help of Index future: [ May-05, N0v-04]

To hedge the position in security with the help of index future enter opposite contract in index.

If there is long position (i.e. Go for short position (i.e. selling

buying position) in any security position) in index future.

If there is short position (i.e. Go for long position (i.e. buying

selling position) in any security position) in index future.

Email: ca_npsah@icai.org Page 20

 Derivatives Summary

The Value of index to be bought or sold may be calculated as below.

The Value of Index = % of hedge

Value of Security Beta Security
to be bought or sold required

 Some time, we may not be interested in full hedge. For instances, we may be interested to the
extent of 15% or 50% or any other % of hedging.
In this case, value of index is being calculated by multiplying required % of hedge.

Number of future contract to be sold or purchased for increasing or reducing beta to a

desired level using index future [ RTP-june-09]
When the risk of portfolio (overall risk) is to be reduced then one has to sell the risky investment and
invest in risk free investment.
When risk is to be increased (for more return) then one has to borrow money at risk free rate and invest
in risky portfolio.

The number of futures contract to be taken for increasing and reducing beta to a desired level is
given by the following formula :

Existing value (Desired beta existing beta)

No of index contract (buy or sell) =
current alue of index contract

Concept of formula:
Exist. Portfolio Exist. Beta Value of Index future Beta index = Existing portfolio Desired Beta (New Beta)

No of contract Value of 1 Equal to

contract “1”

If calculated value (by using above formula) is –ve then sell index future.
In other word, if beta to be decreased then sell index future

If calculated value (by using above formula) is + ve then buy index future
In other word, if beta to be increased then buy index future.

Moving Average:
 Moving average is one of the popular methods of data analysis for decision making. It
identifies the direction of trend of underlying assets (i.e. stock or index).
 Moving average is being calculated by taking data of some fixed period. Like: 5 days moving
average, 10 days moving average, 30 days moving average etc.
 Higher the period in moving average  more exact will be the trend.
 Lower the period in moving average  less exact will be the trend.

Moving Average

Simple Moving Exponential

Average moving average

CA. Nagendra Sah Page 21

Derivatives Summary

Simple moving average (SMA):

A Simple moving average is formed by computing the average price of security/index over a specific
on of period.
Days 1 2 3 4 5 6 7 8
Closing price 15 16 14 17 20 18 20 22

1st 5 days SMA =

2nd 5 days SMA =

3rd 5 days SMA = 4th 5 days SMA =

Trend  16.4, 17, 17.8, 19.4 Market is bullish

Exponential moving average (EMA): [Nov-09-New]

Exponential moving average uses the weight to recent prices. Simply we can say it is weighted average moving average.

Weight is depends on the number of periods in the Exp. Moving Average.

Weight is otherwise known as exponent (How to calculate exponent? see below).
Step for calculation of EMA:
(1) Calculate simple moving average
(Calculation of EMA uses previous day EMA. Hence, SMA is used as a first day exponential
moving average.)
(2) Calculate weight (i.e. exponent) using following formula
Exponent =
2
Eg. for 30 days EMA, exponent =
(3) Calculate exponential moving average using following formula
EMA=Prev. day EMA + [ Current day closing price of Underlying A. – prev. day EMA] Exponent
Decision on the basis of moving average:
 If the moving average sows the increasing trendmarket is bullish.
In Bullish market we can make profit by buying securities.

Bullish market

To earn profit buy security

 If the moving average shows the decreasing trend  market is bearish.

In Bearish market we can make profit by selling securities.

Bearish market
To earn profit sell security

Email: ca_npsah@icai.org Page 22