Project on Foreign Exchange Risk Management

A Project On Foreign Exchange Risk Management

1

Table of Contents
Sr. No. 1 2 3 4 5 6 7 8 9 10 11 12 Particulars What Is Exchange Risk? The Foreign Exchange Market Classification Of Foreign Risk Traditional Risk Management Tools Derivatives – A Risk Management Tool Forward Contract Futures Contract Options Swaps Forward Rate Agreement Conclusion Bibliography Page No. 5 9 14 19 22 23 25 33 70 79 82 83

2

1. What Is Exchange Risk?
Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in Hitachi, the Japanese company, he or she will lose if the value of the yen drops. Yet from this simple question several more arise. First, whose gain or loss? Clearly not just those of a subsidiary, for they may be offset by positions taken elsewhere in the firm. And not just gains or losses on current transactions, for the firm's value consists of anticipated future cash flows as well as currently contracted ones. What counts, modern finance tells us, is shareholder value; yet the impact of any given currency change on shareholder value is difficult to assess, so proxies have to be used. The academic evidence linking exchange rate changes to stock prices is weak. Moreover the shareholder who has a diversified portfolio may find that the negative effect of exchange rate changes on one firm is offset by gains in other firms; in other words, that exchange risk is diversifiable. If it is, than perhaps it's a non-risk. Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the market expects currencies to go. And these contracts offer the ability to lock in the anticipated change. So perhaps a better concept of exchange risk is unanticipated exchange rate changes. These and other issues justify a closer look at this area of international financial management.

1.1 Should Firms Manage Foreign Exchange Risk?
Many firms refrain from active management of their foreign exchange exposure, even though they understand that exchange rate fluctuations can affect their earnings and value. They make this decision for a number of reasons.

3

First, management does not understand it. They consider any use of risk management tools, such as forwards, futures and options, as speculative. Or they argue that such financial manipulations lie outside the firm's field of expertise. "We are in the business of manufacturing slot machines, and we should not be gambling on currencies." Perhaps they are right to fear abuses of hedging techniques, but refusing to use forwards and other instruments may expose the firm to substantial speculative risks. Second, they claim that exposure cannot be measured. They are right -- currency exposure is complex and can seldom be gauged with precision. But as in many business situations, imprecision should not be taken as an excuse for indecision. Third, they say that the firm is hedged. All transactions such as imports or exports are covered, and foreign subsidiaries finance in local currencies. This ignores the fact that the bulk of the firm's value comes from transactions not yet completed, so that transactions hedging is a very incomplete strategy. Fourth, they say that the firm does not have any exchange risk because it does all its business in dollars (or yen, or whatever the home currency is). But a moment's thought will make it evident that even if you invoice German customers in dollars, when the mark drops your prices will have to adjust or you'll be undercut by local competitors. So revenues are influenced by currency changes. Finally, they assert that the balance sheet is hedged on an accounting basis-especially when the "functional currency" is held to be the dollar. The misleading signals that balance sheet exposure measure can give are documented in later sections. But is there any economic justification for a "do nothing" strategy? Modern principles of the theory of finance suggest prima facie that the management of corporate foreign exchange exposure may neither be an important nor a legitimate concern. It has been argued, in the tradition of the Modigliani-Miller Theorem, that the firm cannot improve shareholder value by financial manipulations: specifically, investors themselves can hedge corporate exchange exposure by taking out forward contracts in

4

accordance with their ownership in a firm. Managers do not serve them by second-guessing what risks shareholders want to hedge. One counter-argument is that transaction costs are typically greater for individual investors than firms. Yet there are deeper reasons why foreign exchange risk should be managed at the firm level. Operating managers can make such estimates with much more precision than shareholders who typically lack the detailed knowledge of competition, markets, and the relevant technologies. Furthermore, in all but the most perfect financial markets, the firm has considerable advantages over investors in obtaining relatively inexpensive debt at home and abroad, taking maximum advantage of interest subsidies and minimizing the effect of taxes and political risk. Another line of reasoning suggests that foreign exchange risk management does not matter because of certain equilibrium conditions in international markets for both financial and real assets. These conditions include the relationship between prices of goods in different markets, better known as Purchasing Power Parity (PPP), and between interest rates and exchange rates, usually referred to as the International Fisher Effect (IFE) However, deviations from PPP and IFE can persist for considerable periods of time, especially at the level of the individual firm. The resulting variability of net cash flow is of significance as it can subject the firm to the costs of financial distress, or even default. Modern research in finance supports the reasoning that earnings fluctuations that threaten the firm's continued viability absorb management and creditors' time, entail out-of-pocket costs such as legal fees, and create a variety of operating and investment problems, including underinvestment in R&D. The same argument supports the importance of corporate exchange risk management against the claim that in equity markets it is only systematic risk that matters. To the extent that foreign exchange risk represents unsystematic risk, it can, of course, be diversified away provided again, those investors have the same quality of information about the firm as management a condition not likely to prevail in practice.

5

This reasoning is buttressed by the likely effect that exchange risk has on taxes paid by the firm. It is generally agreed that leverage shields the firm from taxes, because interest is tax deductible whereas dividends are not. But the extent to which a firm can increase leverage is limited by the risk and costs of bankruptcy. A riskier firm, perhaps one that does not hedge exchange risk, cannot borrow as much. It follows that anything that reduces the probability of bankruptcy allows the firm to take on greater leverage, and so pay less taxes for a given operating cash flow. If foreign exchange hedging reduces taxes, shareholders benefit from hedging. However, there is one task that the firm cannot perform for shareholders: to the extent that individuals face unique exchange risk as a result of their different expenditure patterns, they must themselves devise appropriate hedging strategies. Corporate management of foreign exchange risk in the traditional sense is only able to protect expected nominal returns in the reference currency. Unmanaged exchange rate risk can cause significant fluctuations in the earnings and the market value of an international firm. A very large exchange rate movement may cause special problems for a particular company, perhaps because it brings a competitive threat from a different country. At some level, the currency change may threaten the firm's viability, bringing the costs of bankruptcy to bear. To avert this, it may be worth buying some financial instruments which may be a useful and cost-effective way to hedge against currency risks that have very high probabilities which, have disproportionately high costs to the company.

6

2. The Foreign Exchange Market
The foreign exchange market (Currency, Forex, or FX) market is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. The foreign exchange market that we see today started evolving during the 1970s when world over countries gradually switched to floating exchange rate from their erstwhile exchange rate regime, which remained fixed as per the Bretton Woods system till 1971. Today, the FX market is one of the largest and most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Traditional daily turnover was reported to be over USD 3.8 trillion in April 2008 by the Bank for International Settlements. Since then, the market has continued to grow. According to Euro money’s annual FX Poll, volumes grew a further 41% between 2007 and 2008. The purpose of FX market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar, Pound Sterling, etc., and the need for trading in such currencies.

2.1 Market Participants
Unlike a stock market, where all participants have access to the same prices, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bids and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 points to 1-2 points for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of

7

transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multinational corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs. 2.1.1 Banks The inter-bank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating inter-bank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing inter-bank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago. 2.1.2 Commercial Companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in 8

the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are ...not widely known by other market participants. 2.1.3 Central Banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading. The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.

2.2 Foreign Exchange Market India
The foreign exchange market India is growing very rapidly. Currency futures are the buzzword in the Indian financial markets these days. In past years, currency market has reflected the strong growth globally. In India, government efforts to ease capital movement have led the country recording the fastest rise in its turnover growth in the segment over the last three years.

9

Here are some facts on currency markets in India: • • • • • • India's share in worldwide foreign exchange market turnover has grown to 0.9 per cent this year, marking a three-fold jump from just 0.3 per cent in 2004. The increase in market share of India is the fastest as compared to any other country in the world. India is 16th largest foreign exchange market in the world in terms of total daily turnover which was US$34 billion in 2007 Average daily turnover of global forex market rose to $3.2 trillion in April 2007, an increase of 69% at current exchange rates and 63% at constant exchange rates Daily global trading volumes would likely reach US$5 trillion by 2010. Emerging market currencies are estimated to be on at least one side of almost 20% of all transactions, compared to less than 15% in April 2004 and less than 17% in April 2001 The Indian foreign exchange market consists of the buyers, sellers, market intermediaries and the monetary authority of India. The main center of foreign exchange transactions in India is Mumbai, the commercial capital of the country. There are several other centers for foreign exchange transactions in the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin. In past, due to lack of communication facilities all these markets were not linked. But with the development of technologies, all the foreign exchange markets of India are working collectively.

The foreign exchange market India is regulated by the reserve bank of India through the Exchange Control Department. At the same time, Foreign Exchange Dealers Association (voluntary association) also provides some help in regulating the market. The Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate in the foreign Exchange market in India. When the foreign exchange trade is going on between Authorized Dealers and RBI or between the Authorized Dealers and the overseas banks, the brokers have no role to play. Apart from the Authorized Dealers and brokers, there are some others who are provided with the restricted rights to accept the 10

foreign currency or travelers cheque. Among these, there are the authorized money changers, travel agents, certain hotels and government shops. The IDBI and Exim bank are also permitted to hold foreign currency. The whole foreign exchange market in India is regulated by the Foreign Exchange Management Act, 1999 or FEMA. Before this act was introduced, the market was regulated by the FERA or Foreign Exchange Regulation Act, 1947. After independence, FERA was introduced as a temporary measure to regulate the inflow of the foreign capital. But with the economic and industrial development, the need for conservation of foreign currency was felt and on the recommendation of the Public Accounts Committee, the Indian government passed the Foreign Exchange Regulation Act, 1973 and gradually, this act became famous as FEMA.

11

3. Classification Of Foreign Risk
When an institution or organization or individual deal with foreign currencies they are exposed to various types of risk related to foreign exchange

3.1 Types Of Exposure
There are mainly three types of foreign exchange exposures: 1. Translation exposure 2. Transaction exposure 3. Economic Exposure 3.1.1 Translation Exposure: It is the degree to which a firm’s foreign currency denominated financial statements is affected by exchange rate changes. All financial statements of a foreign subsidiary have to be translated into the home currency for the purpose of finalizing the accounts for any given period. If a firm has subsidiaries in many countries, the fluctuations in exchange rate will make the assets valuation different in different periods. The changes in asset valuation due to fluctuations in exchange rate will affect the group’s asset, capital structure ratios, profitability ratios, solvency ratios, etc. FASB 52 specifies that US firms with foreign operations should provide information disclosing effects of foreign exchange rate changes on the enterprise consolidated financial statements and equity. The following procedure has been followed: ? ?Assets and liabilities are to be translated at the current rate that is the rate prevailing at the time of preparation of consolidated statements. ? ?All revenues and expenses are to be translated at the actual exchange rates prevailing on the date of transactions. For items occurring numerous times weighted averages for exchange rates can he used.

12

? ?Translation adjustments (gains or losses) are not to be charged to the net income of the reporting company. Instead these adjustments are accumulated and reported in a separate account shown in the shareholders equity section of the balance sheet, where they remain until the equity is disposed off. Measurement of Translation Exposure Translation exposure = (Exposed assets - Exposed liabilities) x (Change in the exchange rate) Example Current exchange rate: $1 = Rs. 47.10 Assets - Liabilities Initial value ($1 = Rs. 47.10) Rs. 15,300,000 $ 3,24,841 Present value ($1 = Rs. 47.10) Rs. 15,300,000 $ 3,24,841

In the next period, the exchange rate fluctuates to $1 = Rs 47.50 Assets Liabilities Initial value ($1 = Rs. 47.10) Rs. 15,300,000 $ 3,24,841 Present value ($1 = Rs. 47.50) Rs. 15,300,000 $ 3,22,105

Decrease in Book Value of the assets is $ 2736. (i.e. $324841 - $322105) The various steps involved in measuring translation exposure are: ? First, Determine functional currency. ? Second, Translate using temporal method recording gains/ losses in the income: statement as realized. ? Third, Translate using current method recording gains/losses in the balance sheet as realized.

13

? Finally, consolidate into parent company financial statements. 3.1.2. Transaction Exposure: This exposure refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations. It arises from the possibility of incurring foreign exchange gains or losses on transaction already entered into and denominated in a foreign currency. The degree of transaction exposure depends on the extent to which a firm’s transactions are in foreign currency. For example, the transaction in exposure will be more if the firm has more transactions in foreign currency. According to FASB 52 all transaction gains and losses should be accounted for and included’ in the equity’s net income for the reporting period. Unlike translation gains and loses which require only a bookkeeping adjustment, transaction gains and losses are realized as soon as exchange rate changes. The exposure could be interpreted either from the standpoint of the affiliate or the parent company. An entity cannot have an exposure in the currency in which its transactions are measured. Example of Transaction Exposure - NHS Computers An Indian company, NHS Computers is involved in manufacturing of computer machines and spare parts. It imports raw materials from USA and exports the machinery to USA and receives the income in dollars. Machinery has to be imported on regular basis. As per the definition of exposure, NHS Computers is exposed to currency risk. In this case, the company is importing raw materials for which it is paying the money in dollars and while exporting it is receiving the money in dollars. It is exposed to currency risk in the form of transaction exposure, i.e. Dollar/Rupee exchange rate risk is prevalent only between the periods when it needs to pay for its imports and when it realizes the dollars for its exports and the difference between the two amounts. Thus, a company is exposed to currency risk when exchange rate movements directly affect its cash flows. It is equally important for the company to know the types of risk it is exposed to and the origins of risk.

14

In the Indian context, let us assume that all the restrictions related to imports and exports have been removed by the Government of India. Suppose a company is involved in the manufacturing of electronic goods with indigenous technology and is selling the products in India. It has no dealing whatsoever with any other countries. It is getting threatened by an American firm, which is selling the same goods with a lesser price and superior technological features. The company in this case is again exposed to the Dollar/Rupee exchange rate in spite of not having any exposure whatsoever in foreign currencies. The Solution In the above example, if it were a British firm, the extent of Indian firm’s exposure is dependent on Dollar/Pound exchange rate and Dollar/Rupee exchange rate. The company should first establish direct linkages between direct movements and cash flow destabilization before it attempts to control currency risks. In this case, the Indian firm has exposure because of its structural nature. It will be exposed to this risk as long as it is in the manufacturing of the products which it is presently involved in. If it changes the existing product mix it can eliminate the risk arising out of the Dollar/Rupee and Dollar/ Pound exchange rates on its cash flows. Structural risk is a recurring one and is long term in nature. A long-term risk can be broken into slices and can be controlled temporarily but it will not give a permanent solution. 3.1.3. Economic Exposure Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. Economic exposure is a more managerial concept than an accounting concept. A company can have an economic exposure to say Pound/Rupee rates even if it does not have any transaction or translation exposure in the British currency. This situation would arise when the company’s competitors are using British imports. If the Pound weakens, the company loses its competitiveness (or vice versa if the Pound becomes strong). Thus, economic exposure to an exchange rate is the risk that a variation in the rate will affect the company’s

15

competitive position in the market and hence its profits. Further, economic exposure affects the profitability of the company over a longer time span than transaction or translation exposure. Under the Indian exchange control, economic exposure cannot be hedged while both transaction and translation exposure can-be hedged. Some Important Points ? ?The foreign exchange business is, by its nature risky because it deals primarily in risk-measuring it, pricing it, accepting it when appropriate and managing it. The success of a bank or other institution trading in the foreign exchange market depends critically on how well it assesses, prices, and manages risk, and on its ability to limit losses from particular transactions and to keep its overall exposure controlled. ? ?Managing foreign exchange risk is a fundamental component in the safe and sound management of companies that have exposures in foreign currencies. It involves prudently managing foreign currency positions in order to control, within set parameters, the impact of changes in exchange rates on the financial position of the company. The frequency and direction of rate changes, the extent of the foreign currency exposure and the ability of counter parties to honor their obligations to the company are significant factors in foreign exchange risk management. ? ?There are mainly three type of foreign exchange exposure - translation exposure, transaction exposure and economic exposure. Transaction exposure refers to the degree to which a firm’s foreign currencies denominated financial statements are affected by exchange rate changes. It is also known as accounting exposure. Transaction exposure refers to the extent to which the future value of a firm’s domestic cash flow is affected by exchange rate fluctuations. Economic exposure, which is more a managerial concept, refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations

16

4. Traditional Risk Management Tools
4.1 Money Market Hedge
Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money markets—that is, money market hedge. Generally speaking, the firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency. Let us say that Bombardier of Montreal exports commuter aircraft to Austrian Airlines. A payment of €10 million will be received by Bombardier in one year. Money market and foreign exchange rates relevant to the financial contracts are: Canadian interest rate 6.10 % per annum European interest rate 9.00 % per annum Spot exchange rate $1.50/€ Forward exchange rate $1.46/€ Using the example presented above, Bombardier can eliminate the exchange exposure arising from the European sale by first borrowing in euros, then converting the loan proceeds into Canadian dollars, which then can be invested at the dollar interest rate. On the maturity date of the loan, Bombardier will use the euro receivable to pay off the euro loan. If Bombardier borrows a particular euro amount so that the maturity value of this loan becomes exactly equal to the euro receivable from the European sale, Bombardier’s net euro exposure is reduced to zero, and Bombardier will receive the future maturity value of the dollar investment. The first important step in money market hedging is to determine the amount of euros to borrow. Since the maturity value of borrowing should be the same as the euro receivable, the amount to borrow can be computed as the discounted present value of the euro receivable, that is, €10 million/(1.09) = €9,174,312. When Bombardier borrows €9,174,312, it then has to repay €10 million in one year, which is equivalent to its euro receivable. The step-by-step procedure of money market hedging can be illustrated as follows:

17

Step 1: Borrow €9,174,312 in Europe Step 2: Convert €9,174,312 into $13,761,468 at the current spot exchange rate of C$1.50/€ Step 3: Invest C$13,761,468 in Canadian Treasury bills. Step 4: Collect €10 million from Austrian Airways and use it to repay the euro loan. Step 5: Receive the maturity value of the dollar investment, that is, C$14,600,918 = C$13,761,468 (1.061), which is the guaranteed Canadian dollar, proceeds from the European sale. The table shows that the net cash flow is zero at the present time, implying that, apart from possible transaction costs, the money market hedge is fully self-financing. The table also clearly shows how the 10 million euro receivable is exactly offset by the 10 million euro payable (created by borrowing), leaving a net cash flow of C$14,600,918 on the maturity date. Transaction 1.Borrow Euros 2. Buy dollar spot with euro 3. Invest in Canadian TBs 4. Collect euro receivables Net Cash Flow Current Cash Flow €9,174,312 C$13,761,468 - €9,174,312 - C$13,761,468 0 Cash Flow at Maturity - €10,000,000

C$14,600,918 €10,000,000 C$14,600,918

4.2 Currency Risk Sharing
It is an agreement by the parties to a transaction to share the currency risk associated with the transaction. The arrangement involves a customized hedge contract embedded in the underlying transaction. The ratio of risk share and other terms are agreed at the time of entering into the agreement.

4.3 Insurance

18

Insurance is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed small loss to prevent a large, possibly devastating loss. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium.

5. Derivative – The Risk Management Tool

19

Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit. The main types of derivatives are forwards, futures, options, and swaps. Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation. The use of derivatives also has its benefits:
•

Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sums in utility.

•

Former Federal Reserve Board chairman Alan Greenspan had commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Let us now try to understand how some of the main types of derivatives evolved and how they function.

6. Forward Contract

20

A forward contract is an agreement for the future delivery of a specified amount of goods at a predetermined price and date. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. This process is used in financial operations to hedge risk, as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. Forward contracts are usually not standardized as futures are; they are traded over the counter directly between buyer and seller. Forward contracts are settled at the expiration of the contract. Forward contracts are meant for delivery. This delivery is usually in the form of cash settlement as opposed to physical delivery. Credit risk is inherent in forwards. Since either party of a forward contract can default on their obligation to take delivery or to deliver an asset, forwards are more risky. Example of how the payoff of a forward contract works Suppose that Bob wants to buy a house in one year's time. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell in one year's time. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000 as Bob can buy from Andy for $104,000 and immediately sell to the

21

market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. Example of how forward prices should be agreed upon Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be covered. Example of how forward helps Corporate in managing foreign exchange risk ` Suppose an Indian firm as got an export order of USD 1million which will be

received once the goods reach the destination i.e. payment at sight. The Indian firm will take six months to execute the order. Suppose the present USD/INR: 50.00/50.20. Let’s say that the six month forward rate available is USD/INR: 51.50/51.65. If the company books the forward by paying some premium, after six months when it will get the payment it cold convert it into INR at an exchange rate of 1$ = INR51.50 irrespective of the exchange rate prevalent at that time. If after six months the exchange rate is USD/INR: 49.00/49.10 the company makes a profit of INR 2.50 per USD (i.e. 51.50 – 49.00) less the premium paid and is protected from the fluctuations of the market rate. However after six months if the exchange rate is USD/INR: 53.00/53.35 the company would make a notional loss of INR 1.50 per USD (i.e. 53.00-51.50) plus the premium paid. Thus a forward agreement helps the company to make profit and protects it from downside movement of the exchange rate in the future it also prevents the firm from getting profits in case of upward movement of the exchange rates.

7. Futures Contract
22

With the evolution of the derivatives market people wanted a product which could provide them a guaranteed amount/product in exchange for some amount /product in the future thereby eliminating the risk of loss in the future due to changes in the market conditions. This led to the origin of Futures. Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Futures contract on financial instruments was introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 75 futures exchanges worldwide. A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality (which, in many cases, may be such non-traditional "commodities" as foreign currencies, commercial or government paper [e.g., bonds], or "baskets" of corporate equity ["stock indices"] or other financial instruments) at a certain date in the future, at a price (the futures price) determined by the forces of supply and demand of the product on the exchange at the time of the purchase or sale of the contract. They are contracts to buy or sell at a specific date in the future at a price specified today. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.

23

A futures contract gives the holder the obligation to make or take delivery under the terms of the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cashsettled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations. Futures contracts or simply futures (not future contract or future) are always traded on an exchange. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement. Margining Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). Thus futures have lesser credit risk as compared to forwards. This means that there will usually be very little additional money due on the final day to settle the futures contract i.e. only the final day's gain or loss, not the lifetime gain or loss. In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, limiting credit risk in futures. Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This means that the mark-to-market would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of the other side of the future.

24

Thus, while under mark to market accounting, for both assets the gain or loss accrues over the holding period, for a futures the gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized until expiry. Note that, due to the path dependence of funding in futures the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, but also on the path of prices on the way.

7.1 Margin
To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract's value. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread among traders who have offsetting contracts balancing their position. Clearing margin: These are financial safeguards to ensure that companies or corporations perform on their customers' open futures contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures contracts are required to deposit with brokers. Customer margin: Within the futures industry, financial guarantees are required of both buyers and sellers of futures contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. It is also referred to as performance bond margin. Initial margin: It is the money required to open a derivatives position (in futures or forex). It is a security deposit to ensure that traders have sufficient funds to meet any potential loss from a trade. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred

25

to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client’s account. Some Exchanges also use the term “maintenance margin”, which in effect defines, by how much the value of the initial margin can reduce before a margin call is made. However, most brokers only use the term “initial margin” or “variation margin”. The Initial Margin requirement is established by the Futures exchange A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level. Maintenance margin: A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. Margin-equity ratio: It is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls. Performance bond margin: It is the amount of money deposited by both a buyer and seller of a futures contract to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Return on margin (ROM): It is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin).

26

7.2 Standardization
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
•

The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.

• •

• •

The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery.

• • •

The delivery month. The last trading date. Other details such as the commodity tick (a minimum amount that the price of a commodity can fluctuate upward or downward).

7.3 Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
•

Physical delivery - The amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position i.e. buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).

27

•

Cash settlement - A cash payment is made, based on the underlying reference rate, such as the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market.

Expiry is the time and the day of a particular delivery month when a futures contract stops trading and the final settlement price for that contract is obtained. For many equity index and interest rate futures contracts this happens on the third Friday of the trading month. On this day the t+1 futures contract becomes the t futures contract. For example, for most Chicago Mercantile Exchange contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. Who Trades In Futures? Futures traders can traditionally be placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use. Hedgers typically include producers and consumers of a commodity. For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap. The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator. 28

7.4 Currency Futures
A currency futures, also FX futures or foreign exchange futures, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is a certain amount of other currency, for instance €125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date. Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972, less than one year after the system of fixed exchange rates was abandoned along with the gold standard. Some commodity traders at the CME did not have access to the interbank exchange markets in the early 1970s, when they believed that significant changes were about to take place in the currency market. They established the International Monetary Market (IMM) and launched trading in seven currency futures on May 16, 1972. Today, the IMM is a division of CME. Currently most of these are traded electronically. Other futures exchanges that trade currency futures are Euronext.liffe and Tokyo Financial Exchange. 7.4.1 Uses of Currency Futures Hedging: Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cash flow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cash-flow. For example, A is a US-based investor who will receive €1,000,000 on Dec 1. The current exchange rate implied by the futures is $1.2/€. ‘A’ can lock in this exchange rate by selling €1,000,000 worth of futures contracts expiring on December 1. That way, A is 29

guaranteed an exchange rate of $1.2/€ regardless of exchange rate fluctuations in the meantime. Speculation: Currency futures can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates. For example, B buys 10 September CME Euro FX Futures, at $1.2713/€. At the end of the day, the futures close at $1.2784/€. The change in price is $0.0071/€. As each contract is over €125,000, and he has 10 contracts, his profit is $8,875. As with any future, this is paid to him immediately.

8. Option
In futures one could reduce the downside of risk and one would be happy if on the settlement date the market price is equal or less than the settlement price. However if the market price is more than the settlement price on the settlement date you feel sad because if you had not entered into the futures contract you could have more profits. This led to the evolution of options. An option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation to buy or to sell a particular asset (the underlying asset) at a later time at an agreed price. In return for granting the option, the seller collects a payment (the

30

premium) from the buyer. A call option gives the buyer the right to buy the underlying asset; a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, or shares of stock or some other security, such as, among others, a futures contract. For example, buying a call option provides the right to buy a specified quantity of a security at a set agreed amount, known as the 'strike price' at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.

8.1 Contract specifications
Every financial option is a contract between the two counter parties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications
•

Whether the option holder has the right to buy (a call option) or the right to sell (a put option) The quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)

•

31

•

The strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise The expiration date, or expiry, which is the last date the option can be exercised The settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount The premium–the total amount to be paid by the holder to the writer of the option.

• •

•

8.2 Types of options
The primary types of Options are:
•

Exchange traded options (also called "listed options"): They are a class of exchange traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include: stock options, commodity options, bond options and other interest rate options index (equity) options, and options on futures contracts

•

Over-the-counter options (OTC options, also called "dealer options"): They are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: interest rate options, currency cross rate options, and options on swaps.

8.3 Intrinsic Value and Time Value
The intrinsic value (or "monetary value") of an option is the value of exercising it now. Thus if the current (spot) price of the underlying security is above the agreed (strike) price, a call has positive intrinsic value (and is called "in the money”).

32

The time value of an option is a function of the option value less the intrinsic value. It equates to uncertainty in the form of investor hope. It is also viewed as the value of not exercising the option immediately. ATM: At-the-money: An option is at-the-money if the strike price is the same as the spot price of the underlying security on which the option is written. An at-the-money option has no intrinsic value, only time value. ITM: In-the-money: An in-the-money option has positive intrinsic value as well as time value. A call option is in-the-money when the strike price is below the spot price. A put option is in-the-money when the strike price is above the spot price. OTM: Out-of-the-money: An out-of-the-money option has no intrinsic value. A call option is out-of-the-money when the strike price is above the spot price of the underlying security. A put option is out-of-the-money when the strike price is below the spot price. Call Option Spot price = Strike price Spot price > Strike price Spot price < Strike price At-the-Money In-the-Money Out- of-the-Money Put Option Spot price = Strike price Spot price < Strike price Spot price > Strike price

8.4 Option Styles
•

A European option may be exercised only at the expiry date of the option, i.e. at a single pre-defined point in time. An American option on the other hand may be exercised at any time before the expiry date.

•

For both, the pay-off - when it occurs - is via:

33

Max [(S – K), 0], for a call option Max [(K – S), 0], for a put option: (Where K is the Strike price and S is the spot price of the underlying asset) Option contracts traded on futures exchanges are mainly American-style, whereas those traded over-the-counter are mainly European. Where an American and a European option are otherwise identical (having the same strike price, etc.), the American option will be worth at least as much as the European (which it entails). If it is worth more, then the difference is a guide to the likelihood of early exercise. To account for the American's higher value there must be some situations in which it is optimal to exercise the American option before the expiration date. This can arise in several ways, such as:
•

An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend which would lower its value by more than the option's remaining time value

•

A deep ITM currency option (FX option) where the strike currency has a lower interest rate than the currency to be received will often be exercised early because the time value sacrificed is less valuable than the expected depreciation of the received currency against the strike.

•

A put option on gold will be exercised early when deep ITM, because gold tends to hold its value whereas the currency used as the strike is often expected to lose value through inflation if the holder waits until final maturity to exercise the option (they will almost certainly exercise a contract deep ITM, minimizing its time value).

Vanilla vs. Exotic Options

34

A "Vanilla Option" is an informal term used to refer a standard Option on any financial instrument. The "vanilla" or "plain vanilla" term is attached in-front of a Option to indicate that it is a simple and standard Option with terms like Strike price and Expiry, and has no complex structure. As Options may get very complex with custom features, this term helps distinguish simple option from a complex option. On the contrary, complex option is referred to as "Exotic Option". You can use "Exotic" term to refer to OTC Options. Otherwise there are no clear rules defined to distinguish these two.

8.5 Option Strategies
An option strategy is implemented by combining one or more option positions and possibly an underlying stock position. Options strategies can favor movements in the underlying stock that are bullish, bearish or neutral. The option positions used can be long and/or short positions in calls and/or puts at various strikes. Bullish Trading Strategies: Bullish strategies in options trading are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy.

Bearish Trading Strategies: Bearish strategies in options trading are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy. . Neutral Trading Strategies: Neutral options trading strategies are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.

35

Let us now have a look at some of the option strategies in detail

8.5.1 Straddle:
In finance, a straddle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement. The purchase of particular option derivatives is known as a long straddle, while the sale of the option derivatives is known as a short straddle. Long Straddle A long straddle involves going long, i.e., purchasing, both a call option and a put option. The two options are bought at the same strike price and expire at the same time. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below. Thus, an investor may take a long straddle position if he thinks the market is highly volatile, but does not know in which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential. For example, company XYZ is set to release its quarterly financial results in two weeks. A trader believes that the release of these results will cause a large movement in the price of XYZ's stock, but does not know whether the price will go up or down. He can enter into a long straddle, where he gets a profit no matter which way the price of XYZ stock moves, if the price changes enough either way. If the price goes up enough, he uses the call option and ignores the put option. If the price goes down, he uses the put option and ignores the call option. If the price does not change enough, he loses money, up to the total amount paid for the two options. The formula for calculating profit is given below:
•

Maximum Profit = Unlimited

36

•

Profit Achieved When Price of Underlying > (Strike Price of Long Call + Net Premium Paid) OR When Price of Underlying < (Strike Price of Long Put - Net Premium Paid)

•

Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid

The formula for calculating maximum loss is given below:
• •

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying is equal to Strike Price of Long Call and Strike Price of Long Put

Breakeven Point(s) There are 2 break-even points for the long straddle position. The breakeven points can be calculated using the following formulae.
• •

Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Short Straddle A short straddle is a non-directional options trading strategy that involves simultaneously selling a put and a call of the same underlying security, strike price and expiration date. The profit is limited to the premiums of the put and call, but it is risky if the underlying security's price goes up or down much. The deal breaks even if the intrinsic value of the put or the call equals the sum of the premiums of the put and call. This strategy is called "non-directional" because the short straddle profits when the underlying security changes little in price before the expiration of the straddle. A short straddle position is highly risky, because the potential loss is unlimited, whereas profitability is limited to the premium gained by the initial sale of the options. Illustration: Long Position • • Buy March 300 Call @ Rs. 10 Buy March 300 Put @ Rs. 20 Short Position: • • Sell March 300 Call @ Rs. 10 37 Sell March 300 Put @ Rs. 20

Stock Price at Expiry 200 220 240 260 270 280 300 320 330 340 360 380 400

Exercise Call No No No No No No Yes Yes Yes Yes Yes Yes Yes

Exercise Put Yes Yes Yes Yes Yes Yes Yes No No No No No No

Profit/Loss (Long Position) 70 50 30 10 0 -10 -30 -10 0 10 30 50 70

Profit/Loss (Short Position) -70 -50 -30 -10 0 10 30 10 0 -10 -30 -50 -70

Long Straddle Payoff Diagram

80 60 40 20 0
180 200 220 240 260 280 300 320 340 360 380 400 420

-20 -40

38

It can be seen that in the person who is taking a long position will obtain break even when the price of the put option at expiry is Rs.270 or when the price of the call option at expiry is Rs.330. The maximum loss is restricted to Rs.30 which is the premium paid. The profit potential is unlimited. Short Straddle Payoff Diagram

40 20 0
180 200 220 240 260 280 300 320 340 360 380 400 420

-20 -40 -60 -80

It can be seen that in the person who is taking a short position will obtain break even when the price of the put option at expiry is Rs.270 or when the price of the call option at expiry is Rs.330. The maximum profit is restricted to Rs.30 which is the premium received. The loss potential is unlimited.

8.5.2 Strangle:
Long Strangle The long strangle, also known as buy strangle is a neutral strategy in options trading that involve the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date. The owner of a long strangle makes a profit if the underlying price moves a long way from the strike price, either above or below. Thus, an investor may take a long strangle position if he thinks the market is highly volatile, but does not know in which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential. The formula for calculating profit is given below: 39

• •

Maximum Profit = Unlimited Profit Achieved When Price of Underlying > (Strike Price of Long Call + Net Premium Paid) OR When Price of Underlying < (Strike Price of Long Put - Net Premium Paid )

•

Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid

The formula for calculating maximum loss is given below:
• •

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying is in between Strike Price of Long Call and Strike Price of Long Put

Breakeven Point(s) There are 2 break-even points for the long strangle position. The breakeven points can be calculated using the following formulae.
• •

Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Short Strangle The converse strategy to the long strangle is the short strangle. Short strangle spreads are used when little movement is expected of the underlying stock price. Illustration: Suppose that the spot price of the underlying asset of the option is Rs.320 Long Position • • Buy March 340 Call @ Rs. 20 Buy March 300 Put @ Rs. 10 Short Position • • Sell March 340 Call @ Rs. 20 Sell March 300 Put @ Rs. 10

40

Stock Price at Expiry 220 240 260 270 280 300 320 330 340 360 370 380 400 420

Exercise Call No No No No No No No No Yes Yes Yes Yes Yes Yes

Exercise Put Yes Yes Yes Yes Yes Yes No No No No No No No No

Profit/Loss (Long Position) 50 30 10 0 -10 -30 -30 -30 -30 -10 0 10 30 50

Profit/Loss (Short Position) -50 -30 -10 0 10 30 30 30 30 10 0 -10 -30 -50

Long Strangle Payoff Diagram

60 50 40 30 20 10 0 -10200 -20 -30 -40 220 240 260 280 300 320 340 360 380 400 420 440

Break even is reached when price at expiry is Rs. 270 or Rs.370

Short Strangle Payoff Diagram

41

40 30 20 10 0 -10200 -20 -30 -40 -50 -60 220 240 260 280 300 320 340 360 380 400 420 440

8.5.3 Strap Strategy:
The strap is a modified, more bullish version of the common straddle. It involves buying a number of at-the-money puts and twice the number of calls of the same underlying stock, striking price and expiration date. It involves the buying of two AtThe-Money call options and one At-The-Money put option. Straps are unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying stock price will experience significant volatility in the near term and is more likely to rally upwards instead of plunging downwards. The formula for calculating profit is given below:
• •

Maximum Profit = Unlimited Profit Achieved When Price of Underlying > Strike Price of Calls/Puts + (Net Premium Paid/2) OR Price of Underlying < Strike Price of Calls/Puts - Net Premium Paid

42

•

Profit = 2 x (Price of Underlying - Strike Price of Calls) - Net Premium Paid OR Strike Price of Puts - Price of Underlying - Net Premium Paid

The formula for calculating maximum loss is given below:
• •

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Calls/Puts

Breakeven Point(s) There are 2 break-even points for the strap position. The breakeven points can be calculated using the following formulae.
• •

Upper Breakeven Point = Strike Price of Calls/Puts + (Net Premium Paid/2) Lower Breakeven Point = Strike Price of Calls/Puts - Net Premium Paid

Illustration: • • Buy 2 March 300 Call @ Rs.20 Buy March 300 Put @ Rs. 10 Exercise Call No No No No No No Yes Yes Yes Yes Yes Exercise Put Yes Yes Yes Yes Yes Yes Yes No No No No Profit/Loss 50 30 10 0 -10 -30 -50 -10 0 30 70 Comments

Stock Price at Expiry 200 220 240 250 260 280 300 320 325 340 360

Lower Breakeven Point Maximum Loss Upper Breakeven Point

43

380

Yes

No

110

Strap Payoff Diagram

120 100 80 60 40 20 0 -20180 -40 -60 200 220 240 260 280 300 320 340 360 380 400

8.5.4 Strip Strategy
The strip is a modified, more bearish version of the common straddle. It involves buying a number of at-the-money calls and twice the number of puts of the same underlying stock, striking price and expiration date. It involves the buying of two AtThe-Money put options and one At-The-Money call option. Strips are unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying stock price will experience significant volatility in the near term and is more likely to rally downwards instead of plunging downwards. The formula for calculating profit is given below:
• •

Maximum Profit = Unlimited Profit Achieved When Price of Underlying > Strike Price of Calls/Puts + Net Premium Paid OR Price of Underlying < Strike Price of Calls/Puts – (Net Premium Paid /2)

•

Profit = Price of Underlying - Strike Price of Calls - Net Premium Paid OR 2x(Strike Price of Puts - Price of Underlying) - Net Premium Paid

44

The formula for calculating maximum loss is given below:
• •

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Calls/Puts

Breakeven Point(s) There are 2 break-even points for the strip position. The breakeven points can be calculated using the following formulae.
• •

Upper Breakeven Point = Strike Price of Calls/Puts + Net Premium Paid Lower Breakeven Point = Strike Price of Calls/Puts – (Net Premium Paid/2)

Illustration: • • Buy March 300 Call @ Rs.10 Buy 2 March 300 Put @ Rs.20 Exercise Call No No No No No No Yes Yes Yes Yes Yes Yes Yes Exercise Put Yes Yes Yes Yes Yes Yes Yes No No No No No No Profit/Loss 150 110 70 30 0 -10 -50 -30 -10 0 10 30 50 Remark

Stock Price at Expiry 200 220 240 260 275 280 300 320 340 350 360 380 400

Lower Breakeven Point Maximum Loss Upper Breakeven Point

Strip Payoff Diagram

45

200 150 100 50 0 180 -50 -100

200 220

240 260

280 300

320

340 360

380 400

420

8.5.5 Butterfly Spread:
The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are three striking prices involved in a butterfly spread and it can be constructed using calls or puts. Long Call Butterfly Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-money call. A resulting net debit is taken to enter the trade. Limited Profit Maximum profit for the long butterfly spread is attained when the underlying stock price remains unchanged at expiration. At this price, only the lower striking call expires in the money. The formula for calculating maximum profit is given below:
•

Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call Net Premium Paid - Commissions Paid Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

•

Limited Risk 46

Maximum loss for the long butterfly spread is limited to the initial debit taken to enter the trade plus commissions. The formula for calculating maximum loss is given below:
• •

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call OR Price of Underlying >= Strike Price of Higher Strike Long Call

Breakeven Point(s) There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.
•

Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid

•

Example: (Note: These are used with a contract size of around 100 or more, however for simplicity only one stock is considered in this example) Suppose a stock is trading at Rs.100 in February. An options trader executes a long call butterfly by purchasing a March 80 call for Rs.30, writing two March 100 calls for Rs.25 each and purchasing another March 120 call for Rs.10. The net debit taken to enter the position is Rs.10 (i.e.-30 + 2*15 – 10), which is also his maximum possible loss. On expiration in March, if stock is still trading at Rs.100. The March 100 calls and the March 120 call expire worthless while the March 80 call still has an intrinsic value of Rs.20. Subtracting the initial debit of Rs.10; the resulting profit is Rs.10, which is also the maximum profit attainable.

47

Maximum loss results when the stock is trading below Rs.80 or above Rs.120. At Rs.80, all the options expire worthless. Above Rs120, any "profit" from the two long calls will be neutralised by the "loss" from the two short calls. In both situations, the butterfly trader suffers maximum loss which is the initial debit taken to enter the trade.

Stock Price at Expiry 75 80 85 90 95 100 105 110 115 120 125

Exercise 80 call No Yes/No Yes Yes Yes Yes Yes Yes Yes Yes Yes

Exercise 100 call No No No No No Yes/No Yes Yes Yes Yes Yes

Exercise 120 call No No No No No No No No No Yes/No Yes

Profit/Loss

Remark

-10 -10 -5 0 5 10 5 0 -5 -10 -10 Max Loss Upper Breakeven point Max Profit Lower Breakeven point Max Loss

48

15 10 5 0 -5 -10 -15 70 75 80 85 90 95 100 105 110 115 120 125 130

Long Call Butterfly Payoff Diagram

Long Put Butterfly The long put butterfly spread is a limited profit, limited risk options trading strategy that is taken when the options trader thinks that the underlying security will not rise or fall much by expiration. There are 3 striking prices involved in a long put butterfly spread and it is constructed by buying one lower striking put, writing two at-the-money puts and buying another higher striking put for a net debit. Limited Profit Maximum gain for the long put butterfly is attained when the underlying stock price remains unchanged at expiration. At this price, only the highest striking put expires in the money. The formula for calculating maximum profit is given below:
•

Max Profit = Strike Price of Higher Strike Long Put - Strike Price of Short Put Net Premium Paid - Commissions Paid Max Profit Achieved When Price of Underlying = Strike Price of Short Put

•

Limited Risk 49

Maximum loss for the long put butterfly is limited to the initial debit taken to enter the trade plus commissions. The formula for calculating maximum loss is given below:
• •

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Put OR Price of Underlying >= Strike Price of Higher Strike Long Put

Breakeven Point(s) There are 2 break-even points for the long put butterfly position. The breakeven points can be calculated using the following formulae.
•

Upper Breakeven Point = Strike Price of Highest Strike Long Put - Net Premium Paid Lower Breakeven Point = Strike Price of Lowest Strike Long Put + Net Premium Paid

•

Example: (Note: These are used with a contract size of around 100 or more, however for simplicity only one stock is considered in this example) Suppose a stock is trading at Rs.100 in June. An option trader executes a long put butterfly by buying a March 80 put for Rs.10, writing two March 100 puts for Rs.15 each and buying another March 120 put for Rs.30. The net debit taken to enter the trade is Rs.10 (i.e. -10+2*15-30), which is also his maximum possible loss. On expiration in March, stock is still trading at Rs.100. The March 100 puts and the March 80 put expire worthless while the March 120 put still has an intrinsic value of Rs.20.

50

Subtracting the initial debit of Rs.10, the resulting profit is Rs.10, which is also the maximum profit attainable. Maximum loss results when the stock is trading below Rs.80 or above Rs.120. At Rs.120, all the options expire worthless. Below Rs.80, any "profit" from the two long puts will be neutralised by the "loss" from the two short puts. In both situations, the long put butterfly trader suffers maximum loss which is equal to the initial debit taken to enter the trade.

Stock Price at Expiry 75 80 85 90 95 100 105 110 115 120 125

Exercise 80 Put Yes Yes/No No No No No No No No No No

Exercise 100 Put Yes Yes Yes Yes Yes Yes/No No No No No No

Exercise 120 Put Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes/No No

Profit/Loss

Remark

-10 -10 -5 0 5 10 5 0 -5 -10 -10 Max Loss Upper Breakeven point Max Profit Lower Breakeven point Max Loss

51

15 10 5 0 -5 -10 -15 70 75 80 85 90 95 100 105 110 115 120 125 130

Long Put Butterfly Payoff Diagram

Short Butterfly The short butterfly is a neutral strategy like the long butterfly but bullish on volatility. It is a limited profit, limited risk options trading strategy. There are 3 striking prices involved in a short butterfly spread and it can be constructed using calls or puts. Short Call Butterfly Using calls, the short butterfly can be constructed by writing one lower striking inthe-money call, buying two at-the-money calls and writing another higher striking out-ofthe-money call, giving the trader a net credit to enter the position. Limited Profit Maximum profit for the short butterfly is obtained when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration. If the stock ends up at the lower striking price, all the options expire worthless and the short butterfly trader keeps the initial credit taken when entering the position. However, if the stock price at expiry is equal to the higher strike price, the higher striking call expires worthless while the "profits" of the two long calls owned is canceled out by the "loss" incurred from shorting the lower striking call. Hence, the maximum profit is still only the initial credit taken.

52

The formula for calculating maximum profit is given below:
• •

Max Profit = Net Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying <= Strike Price of Lower Strike Short Call OR Price of Underlying >= Strike Price of Higher Strike Short Call

Limited Risk Maximum loss for the short butterfly is incurred when the stock price of the underlying stock remains unchanged at expiration. At this price, only the lower striking call which was shorted expire in-the-money. The trader will have to buy back the call at its intrinsic value. The formula for calculating maximum loss is given below:
•

Max Loss = Strike Price of Long Call - Strike Price of Lower Strike Short Call Net Premium Received + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Long Calls

•

Breakeven Point(s) There are 2 break-even points for the short butterfly position. The breakeven points can be calculated using the following formulae.
•

Upper Breakeven Point = Strike Price of Highest Strike Short Call - Net Premium Received Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Received

•

Example: Suppose a stock is trading at Rs.100 in February. An options trader executes a short call butterfly strategy by writing a March 80 call for Rs.30, buying two March 100 calls for

53

Rs.15 each and writing another March 120 call for Rs.10. The net credit taken to enter the position is Rs.10 (i.e. 30-2*15+10), which is also his maximum possible profit. On expiration in March, if stock has dropped to Rs.80. All the options expire worthless and the short butterfly trader gets to keep the entire initial credit taken of Rs.10 as profit. This is also the maximum profit attainable and is also obtained even if the stock had instead rallied to Rs.120 or beyond. On the downside, should the stock price remains at Rs.100 at expiration, maximum loss will be incurred. At this price, all except the lower striking call expires worthless. The lower striking call sold short would have a value of Rs.20 and needs to be bought back. Subtracting the initial credit of Rs.10 taken, the net loss (maximum) is equal to Rs.10. Stock Price at Expiry 75 80 85 90 95 100 105 110 115 120 125 Exercise 80 call No Yes/No Yes Yes Yes Yes Yes Yes Yes Yes Yes Exercise 100 call No No No No No Yes/No Yes Yes Yes Yes Yes Exercise 120 call No No No No No No No No No Yes/No Yes 10 10 5 0 -5 -10 -5 0 5 10 10 Max Profit Upper Breakeven point Max Loss Lower Breakeven point Max Profit Profit/Loss Remark

54

15 10 5 0 -5 -10 -15 70 75 80 85 90 95 100 105 110 115 120 125 130

Short Call Butterfly Payoff Diagram

Short Put Butterfly The short put butterfly is a neutral strategy like the long put butterfly but bullish on volatility. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a short put butterfly and it can be constructed by writing one lower striking out-of-the-money put, buying two at-the-money puts and writing another higher striking in-the-money put, giving the options trader a net credit to put on the trade. Limited Profit Maximum profit is attained for the short put butterfly when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration. If the stock ends up at the higher striking price, all the put options expire worthless and the short put butterfly trader keeps the initial credit taken when entering the trade. If, instead, the stock price at expiry is equal to the lower strike price, the lower striking put option expires worthless while the "profits" of the remaining long put is canceled out by the "loss" incurred from shorting the higher strike put. So the maximum profit is still only the initial credit taken. The formula for calculating maximum profit is given below:
•

Max Profit = Net Premium Received - Commissions Paid 55

•

Max Profit Achieved When Price of Underlying <= Strike Price of Lower Strike Short Put OR Price of Underlying >= Strike Price of Higher Strike Short Put

Limited Risk Maximum loss for the short put butterfly is incurred when the price of the underlying asset remains unchanged at expiration. At this price, only the higher striking put which was shorted expire in-the-money. The trader will have to buy back that put option at its intrinsic value to exit the trade.

The formula for calculating maximum loss is given below:
•

Max Loss = Strike Price of Higher Strike Short Put - Strike Price of Long Put - Net Premium Received + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Long Put

•

Breakeven Point(s) There are 2 break-even points for the short put butterfly position. The breakeven points can be calculated using the following formulae.
•

Upper Breakeven Point = Strike Price of Highest Strike Short Put - Net Premium Received Lower Breakeven Point = Strike Price of Lowest Strike Short Put + Net Premium Received

•

Example: Suppose a stock is trading at Rs.100 in June. An options trader executes a short put butterfly by writing a March 80 put for Rs.10, buying two March 100 puts for Rs.15 each and writing another March 120 put for Rs.30. The net credit taken to enter the position is Rs.10 (i.e. 10-15-15+30), which is also his maximum possible profit.

56

On expiration in March, if stock has dropped to Rs.80. The lower striking put expire worthless and the loss from long March 100 put worth Rs.30 is offset by the profit from the Short March 120 put worth Rs.30 and the short put butterfly trader gets to keep the entire initial credit taken of Rs.10 as profit (i.e.-2*15+30+10). This is also the maximum profit attainable and is also obtained even if the stock had instead rallied to Rs.120 or beyond. On the downside, should the stock price remains at Rs.100 at expiration, maximum loss will be incurred. At this price, all except the higher striking put expires worthless. The higher striking put sold short would have a value of Rs.20 and needs to be bought back to close the trade. Subtracting the initial credit of Rs.10 taken, the net loss (maximum) is equal to Rs.10. Stock Price at Expiry 75 80 85 90 95 100 105 110 115 120 125 Exercise 80 Put Yes Yes/No No No No No No No No No No Exercise 100 Put Yes Yes Yes Yes Yes Yes/No No No No No No Exercise 120 Put Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes/No No 10 10 5 0 -5 -10 -5 0 5 10 10 Max Profit Upper Breakeven point Max Loss Lower Breakeven point Max Profit Profit/Loss Remark

57

15 10 5 0 -5 -10 -15 70 75 80 85 90 95 100 105 110 115 120 125 130

Short Put Butterfly Payoff Diagram

8.5.6 Condor Options:
The condor option strategy is a limited risk, non-directional option trading strategy that is structured to earn a limited profit when the underlying security is perceived to have little volatility. Using call options expiring on the same month, the trader can implement a long condor option spread by writing a lower strike in-the-money call, buying an even lower striking in-the-money call, writing a higher strike out-of-the-money call and buying another even higher striking out-of-the-money call. A total of 4 legs are involved in the condor options strategy and a net debit is required to establish the position. Limited Profit Maximum profit for the long condor option strategy is achieved when the stock price falls between the 2 middle strikes at expiration. It can be derived that the maximum profit is equal to the difference in strike prices of the 2 lower striking calls less the initial debit taken to enter the trade. The formula for calculating maximum profit is given below
•

Max Profit = Strike Price of Lower Strike Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid

58

•

Max Profit Achieved When Price of Underlying is in between the Strike Prices of the 2 Short Calls

Limited Risk The maximum possible loss for a long condor option strategy is equal to the initial debit taken when entering the trade. It happens when the underlying stock price on expiration date is at or below the lowest strike price and also occurs when the stock price is at or above the highest strike price of all the options involved. The formula for calculating maximum loss is given below:
• •

Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call OR Price of Underlying >= Strike Price of Higher Strike Long Call

Breakeven Point(s) There are 2 break-even points for the condor position. The breakeven points can be calculated using the following formulae.
•

Upper Breakeven Point = Strike Price of Highest Strike Long Call - Net Premium Received Lower Breakeven Point = Strike Price of Lowest Strike Long Call + Net Premium Received

•

Example: Suppose a stock is trading at Rs.100 in June. An options trader enters a condor trade by buying a JUL 75 call for Rs.45, writing a JUL 90 call for Rs.30, writing another JUL 110 call for Rs15 and buying another JUL 125 call for Rs.10. The net debit required to enter the trade is Rs.10 (-45 + 30 + 15 – 10), which is also his maximum possible loss. To further see why Rs.10 is the maximum possible loss, let us examine what happens when the stock price falls to Rs.75 or rise to rs.125 on expiration.

59

At Rs.75, all the options expire worthless, so the initial debit taken of Rs.10 is his maximum loss. At Rs.125, the long JUL 125 call expires worthless while the long JUL 75 call worth Rs.50 (125-75) is used to offset the loss from the short JUL 90 call worth Rs.35 (90125) and the short JUL 110 call worth Rs.15 (110-125). Thus, the long condor trader still suffers the maximum loss that is equal to the Rs.10 initial debit taken when entering the trade. If instead on expiration in July, stock is still trading at Rs.100, only the JUL 75 call and the JUL 90 call expires in-the-money. With his long JUL 75 call worth Rs.25 (i.e.10075) to offset the short JUL 90 call valued at Rs.10 (i.e. 90-100) and the initial debit of Rs10, his net profit comes to Rs.5 (i.e. 25 - 10 - 10) The maximum profit for the condor trade may be low in relation to other trading strategies but it has a comparatively wider profit zone. In this example, maximum profit is achieved if the underlying stock price at expiration is anywhere between Rs.90 and Rs.110 Stock Price at Expiry 70 75 80 85 90 95 100 105 110 115 Exercise 75 call No Yes/No Yes Yes Yes Yes Yes Yes Yes Yes Exercise 90 call No No No No Yes/No Yes Yes Yes Yes Yes Exercise 110 call No No No No No No No No Yes/No Yes Exercise 125 call No No No No No No No No No No -10 -10 -5 0 5 5 5 5 5 0 Upper Breakeven Point Lower Breakeven Point Max Loss Profit/Loss Remark

60

120 125 130

Yes Yes Yes

Yes Yes Yes

Yes Yes Yes

No Yes/No Yes

-5 -10 -10 Max Loss

10 5 0 -5 -10 -15 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135

Long Condor Payoff Diagram

Short Condor The short condor is a neutral strategy similar to the short butterfly. It is a limited risk, limited profit trading strategy that is structured to earn a profit when the underlying stock is perceived to be making a sharp move in either direction. Using calls, the options trader can setup a short condor by combining a bear call spread and a bull call spread. The trader enters a short call condor by buying a lower strike in-the-money call, selling an even lower striking in-the-money call, buying a higher strike out-of-the-money call and selling another even higher striking out-of-the-money call. A total of 4 legs are involved in this trading strategy and a net credit is received on entering the trade. Limited Profit Potential The maximum possible profit for a short condor is equal to the initial credit received upon entering the trade. It happens when the underlying stock price on expiration date is at or below the lowest strike price and also occurs when the stock price is at or above the highest strike price of all the options involved. The formula for calculating maximum profit is given below:

61

• •

Max Profit = Net Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying <= Strike Price of Lower Strike Short Call OR Price of Underlying >= Strike Price of Higher Strike Short Call

Limited Risk Maximum loss is suffered when the underlying stock price falls between the 2 middle strikes at expiration. It can be derived that the maximum loss is equal to the difference in strike prices of the 2 lower striking calls less the initial credit taken to enter the trade. The formula for calculating maximum loss is given below:
•

Max Loss = Strike Price of Lower Strike Long Call - Strike Price of Lower Strike Short Call - Net Premium Received + Commissions Paid Max Loss Occurs When Price of Underlying is in between the Strike Prices of the 2 Long Calls

•

Breakeven Point(s) There are 2 break-even points for the short condor position. The breakeven points can be calculated using the following formulae.
•

Upper Breakeven Point = Strike Price of Highest Strike Short Call - Net Premium Paid Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Paid

•

Example: Suppose a stock is trading at Rs.100 in June. An options trader executes a short condor by selling a JUL 75 call for Rs.45, buying a JUL 90 call for Rs.30, buying another JUL 110 call for Rs.15 and selling another JUL 125 call for Rs.125. A net credit of Rs.10 (i.e. 45 – 30 – 15 + 10) is received on entering the trade. To further see why Rs.10 is the maximum possible profit, let us examine what happens when the stock price falls to Rs.75 or rise to Rs.125 on expiration.

62

At Rs.75, all the options expire worthless, so the initial credit taken of Rs.10 is his maximum profit. At Rs.125, the short JUL 125 call expires worthless while the profit from the long JUL 90 call worth Rs.35 (i.e. 125-90) and the long JUL 110 call worth Rs.15 (i.e. 125-110) is used to offset the short JUL 75 call worth Rs.50 (i.e. 75-125) . Thus, the short condor trader still earns the maximum profit that is equal to the Rs.10 initial credit taken when entering the trade. On the flip side, if the stock is still trading at Rs.100 on expiration in July, only the JUL 75 call and the JUL 90 call expire in the money. With his long JUL 90 call worth Rs.10 (i.e. 100-90) and the initial credit of Rs.10 received to offset the short JUL 75 call valued at Rs.25 (i.e. 75-100), there is still a net loss of Rs.5 (i.e.10+10-25). This is the maximum possible loss and is suffered when the underlying stock price at expiration is anywhere between Rs.90 and Rs.110 Stock Price at Expiry 70 75 80 85 90 95 100 105 110 115 120 Exercise 75 call No Yes/No Yes Yes Yes Yes Yes Yes Yes Yes Yes Exercise 90 call No No No No Yes/No Yes Yes Yes Yes Yes Yes Exercise 110 call No No No No No No No No Yes/No Yes Yes Exercise 125 call No No No No No No No No No No No 10 10 5 0 -5 -5 -5 -5 -5 0 5 Upper Breakeven Point Lower Breakeven Point Max Profit Profit/Loss Remark

63

125 130

Yes Yes

Yes Yes

Yes Yes

Yes/No Yes

10 10

Max Profit

15 10 5 0 65 -5 -10 70 75 80 85 90 95 100 105 110 115 120 125 130 135

Short Condor Payoff Diagram

8.6 Foreign Exchange Option
A foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a preagreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. Example: For example a GBP/USD FX option might be specified by a contract giving the owner the right but not the obligation to sell £1,000,000 and buy $2,000,000 on March31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 USD/GBP or 0.5000

64

GBP/USD and the notionals are £1,000,000 and $2,000,000 (£1,000,000 from the eyes of a USD investor, $2,000,000 from the eyes of a GBP investor). This type of contract is both a call on dollars and a put on sterling, and is often called a USD/GBP put by market participants, as it is a put on the exchange rate; it could equally be called a GBP/USD call, but isn't, as market convention is to quote the 2.0000 number (normal quote), not the 0.5000 number (inverse quote). If the rate is lower than 2.0000 USD/GBP come March 31 (say at 1.9000 USD/GBP), meaning that the dollar is stronger and the pound is weaker, then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 USD/GBP - 1.9000 USD/GBP)*1,000,000 GBP = 100,000 USD in the process. If they immediately exchange their profit into GBP this amounts to 100,000/1.9000 = 52,631.58 GBP. Terms Generally in thinking about options, one assumes that one is buying an asset: for instance, you can have a call option on oil, which allows you to buy oil at a given price. One can consider this situation more symmetrically in FX, where one exchanges: a put on USD/INR allows one to exchange INR for USD: it is at once a put on INR and a call on USD. As a vivid example: people usually consider that in a fast food restaurant, one buys Samosas and pays in rupees, but one can instead say that the restaurant buys rupees and pays in Samosas. There are a number of subtleties that follow from this symmetry. Ratio of notionals: The ratio of the notionals in an FX option is the strike, not the current spot or forward. Notably, when constructing an option strategy from FX options, one must be careful to match the foreign currency notionals, not the local currency notionals, else the foreign currencies received and delivered don't offset and one is left with residual risk.

65

Non-linear payoff: The payoff for a vanilla option is linear in the underlying, when one denominates the payout in a given numéraire (It is a basic standard by which values are measured). In the case of an FX option on a rate, one must be careful of which currency is the underlying and which is the numéraire: in the above example, an option on USD/GBP gives a USD value that is linear in USD/GBP (a move from 2.0000 to 1.9000 yields a 0.10 * $2,000,000 / 2.0000 = $100,000 profit), but has a non-linear GBP value in USD/GBP. Conversely, the GBP value is linear in the GBP/USD rate, while the USD value is nonlinear in the GBP/USD rate. This is because inverting a rate has the effect of, which is nonlinear.

8.6.1 Hedging With FX Options Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options. Suppose an Indian manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the INR strengthens against the US$ over the next 90 days the Indian firm will lose money, as it will receive less INR when the US$100,000 is converted into INR. However, if the INR weaken against the US$, then the Indian firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for INR at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.

66

If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction. Using options, the Indian firm can purchase INR call/USD put option (the right to sell part or all of their expected income for INR at a predetermined rate), which will:
•

protect the INR value that the firm will receive in 90 day's time (presuming the cash is received) cost at most the option premium (unlike a forward, which can have unlimited losses) yield a profit if the expected cash is not received but FX rates move in its favor

•

•

9. SWAPS
An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments. Market size The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. As of Dec 2008 the number rose to 4896 trillion according to the same source. 67

9.1 Structure
In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cash flows to be exchanged. The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate (usually pegged to a reference rate such as LIBOR). Illustration 1: A pays variable rate to B (A receives fixed rate) B pays fixed rate to A (B receives variable rate). Let us suppose that A can raise funds in the fixed and floating markets at 14% and LIBOR + 0.25% respectively while B san raise funds in fixed and floating market at 15% and LIBOR + 0.50% respectively. These rates are applicable for a USD 1 million borrowing. If B is interested in borrowing fixed interest rate and A is interested in borrowing in floating rates. Party A B Objective Floating rate Fixed rate Fixed Interest Rate 14% 15% Floating Interest Rate LIBOR + 0.25% LIBOR + 0.75%

It can be seen that the cost of borrowing for A is less than B in both markets. This difference is called quality spread and can be quantified for both fixed and floating rate market as below Fixed Market: 15% - 14% = 1%

Floating Market: (LIBOR + 0.75%) - (LIBOR + 0.25%) = 0.50%

68

The advantage enjoyed by A is called absolute advantage. However it can be seen that cost of funds for B is higher in fixed rate market by 100bp whereas it is higher by 25bp in the floating rate market. Thus B has a relative advantage in the floating market which is known as comparative advantage. Give the objective A will borrow in floating rate market while B will borrow in fixed rate market. However considering the comparative advantage enjoyed by B it is possible to reduce the cost of fund for both A and B if they borrow in the market where they enjoy comparative advantage and then swap their borrowing. The reduction in the cost depends upon the quality spread. In this case the amount of benefit that can be derived by both the parties will be the difference between the quality spread which is 50 bp (i.e. 1% - 0.50%). Assume that both the parties want to share the benefit equally between them.

Under the SWAP agreement: A – Borrows funds in the fixed rate market and lends to B B – Borrows funds in the floating rate market and lends to A Let us assume that B lends to A at LIBOR and A lends to B at 14%. The net cost of funds to A and B using the swap is as shown below Party A B Paid to Received from Paid to Market 14% LIBOR + 0.75% Net cost LIBOR Savings [(LIBOR + .25%) –

counterparty counterparty LIBOR 14% 14% LIBOR

LIBOR] = 0.25% 14.75% (15% - 14.75%) = 0.25%

69

As seen above funds are available to A LIBOR as against LIBOR + 0.25% and B at 14.75% instead of 15%. Thus swap enables reduction in cost of funds.

Swap agreement
LIBOR

A
Fixed rate

B

Market

Market

Illustration 2: A pays fixed rate to B (A receives variable rate) B pays variable rate to A (B receives fixed rate). Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 3.00%, in exchange for periodic variable interest rate payments of LIBOR + 50 bps (0.50%). Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. if LIBOR is 1.30% then Party B receives 1.20% (3.00% - (LIBOR + 50 bps)) and Party A pays 1.20%). The fixed rate (3.00% in this example) is referred to as the swap rate At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.

70

9.2 Types
Being OTC instruments interest rate swaps can come in a huge number of varieties and can be structured to meet the specific needs of the counterparties. By far the most common are fixed-for-fixed, fixed-for-floating or floating-for-floating. The legs of the swap can be in the same currency or in different currencies. (A single-currency fixed-forfixed rate swap is generally not possible; since the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams; the only exceptions would be where the notional amount on one leg is uncertain or other esoteric uncertainty is introduced).

9.2.1 Fixed-for-floating rate swap, same currency Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to X on a notional N for a term of T years. For example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a notional USD 1 million for 3 years. The party that pays fixed and receives floating coupon rates is said to be long the interest swap. Interest rate swaps are simply the exchange of one set of cash flows for another. Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of USD 10 million that returns USD 1M Libor + 25 bps monthly, it may enter into a fixed-forfloating swap. In this swap, the company would pay a floating USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in 20bps profit.

71

9.2.2 Fixed-for-floating rate swap, different currencies Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B indexed to X on a notional N at an initial exchange rate of FX for tenure of T years. For example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M (TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120) for 3 years. For non-deliverable swaps, the USD equivalent of JPY interest will be paid/received (according to the FX rate on the FX fixing date for the interest payment day). No initial exchange of the notional amount occurs unless the FX fixing date and the swap start date fall in the future. Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in one currency to a floating rate asset/liability in a different currency, or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50 bps monthly, and wants to lock in the profit in USD as they expect the JPY 1M Libor to go down or USD/JPY to go up (JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate and the FX exposure. 9.2.3 Floating-for-floating rate swap, same currency Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency A indexed to Y on a notional N for tenure of T years. For example, you pay JPY 1M LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years. Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the two indexes widening or narrowing. For example, if a company has a floating rate loan at JPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is 72

going to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and wants to insulate from this risk, they can enter into a float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps. With this, they have effectively locked in a 35 bps profit instead of running with a current 40 bps gain and index risk. The 5 bps difference (with respect to the current rate difference) comes from the swap cost which includes the market expectations of the future rate difference between these two indices and the bid/offer spread which is the swap commission for the swap dealer. Floating-for-floating rate swaps are also seen where both sides reference the same index, but on different payment dates, or use different business day conventions. These have almost no use for speculation, but can be vital for asset-liability management. An example would be swapping 3M LIBOR being paid with prior non-business day convention, quarterly on JAJO (i.e. Jan, Apr, Jul, Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28 modified following? 9.2.4 Floating-for-floating rate swap, different currencies Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in currency B indexed to Y on a notional N at an initial exchange rate of FX for a tenor T years. For example, you pay floating USD 1M LIBOR on the USD notional 10 million quarterly to receive JPY 3M TIBOR monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120) for 4 years. To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese growth, they need JPY 10 billion. The easiest option for the company is to issue debt in Japan. As the company might be new in the Japanese market without a well known reputation among the Japanese investors, this can be an expensive option. Added on top of this, the company might not have appropriate debt issuance program in Japan and they might lack sophisticated treasury operation in Japan. To overcome the above problems, it can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it introduces two new risks to the company:

73

•

FX risk. If this USD/JPY spot goes up at the maturity of the debt, then when the company converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a loss.

•

USD and JPY interest rate risk. If the JPY rates come down, the return on the investment in Japan might go down and this introduces an interest rate risk component. The first exposure in the above can be hedged using long dated FX forward

contracts but this introduces a new risk where the implied rate from the FX spot and the FX forward is a fixed rate but the JPY investment returns a floating rate. Although there are several alternatives to hedge both the exposures effectively without introducing new risks, the easiest and the most cost effective alternative would be to use a floating-for-floating swap in different currencies. In this, the company raises USD by issuing USD Debt and swaps it to JPY. It receives USD floating rate (so matching the interest payments on the USD Debt) and pays JPY floating rate matching the returns on the JPY investment. 9.2.5 Fixed-for-fixed rate swap, different currencies Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a term of T years. For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive USD 5.36% on the USD equivalent notional of 10 million at an initial exchange rate of USD/JPY 120.

9.3 Uses
Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates. Hedging: Today, interest rate swaps are often used by firms to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able to alter its

74

interest rate exposures and bring them in line with management's appetite for interest rate risk. Speculation: Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected the rates to fall used to purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate. Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to benefit from an interest rate swap. The interest rate swap market is closely linked to the Eurodollar futures market which trades at the Chicago Mercantile Exchange. Risks Interest rate swaps expose users to interest rate risk and credit risk.
•

Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-for-floating swap, the party who pays the floating rate benefits when rates fall. (Note that the party that pays floating has an interest rate exposure analogous to a long bond position.)

•

Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party.

75

10. Forward Rate Agreements
A forward rate agreement is a simple derivative which is used when the institution is exposed to single period interest rate risk. An FRA is a tailor-made futures contract. As the name implies, it is an agreement to fix a future interest rate today, for example the 6 month LIBOR rate for value 3 months from now (a 3 X 9 FRA in market terms). When the future date arrives the FRA contract rate is compared to actual market LIBOR. If market rates are higher than the contract rate, the borrower/FRA buyer receives the difference; if lower, he pays the difference. For the investor/FRA seller, the FRA flows would be reversed. Underlying borrowing or investment programs proceed normally at market rates, while the compensating payment provided by the FRA brings the hedgers' all-in cost or yield back to the base rate contracted for in the FRA. Using FRAs Companies use FRAs to protect short term borrowing or investment programs from

76

market surprises. For example, a borrower with debt rollovers coinciding with a scheduled meeting of the Federal Open Market Committee uses FRAs to lock rollover rates in advance. FRAs also allow companies to take advantage when the yield curve inverts (long term rates fall below short term rates). When this happens a company which plans to borrow in the future would use FRAs to lock-in a future borrowing base rate at a level lower than today's rates. FRAs are also valuable in making temporary adjustments to long term financial positions. For example, a company which has swapped floating rate debt to fixed can use FRAs to improve the swap's performance in the short run when short term rates are expected to decline. In this instance FRAs protect the value of future swap floating rate receipts from the impact of falling rates.

10.1 Terminologies
The following some of the terms used in FRAs • • • • • • • Buyer/ Borrower: The buyer of FRA is one who seeks protection against rise in interest rates. Seller/Lender: The seller of FRA is one who seeks protection against decrease in interest rates. Settlement date: This is the start date of the loan or deposit upon which the FRA is based. Maturity date: This is the date on which the FRA contract period ends. Contract period: It refers to the intervening period between the settlement date and the maturity date. Contract amount: It means the notional sum on which the FRA is based. Contract rate: It signifies the forward rate of interest for the contract period as agreed between the periods.

77

•

Fixing date: It is the day which is two business days prior to the settlement date except for pound sterling for which the fixing date and settlement date are the same

Example of FRA being used when exposed to single period interest rate risk Say SBI has funded a one year USD 5 million floating rate loan on 6 month “LIBOR+’ basis. It is exposed to interest rate risk from 6th to the 12th month. Since the LIBOR for the first six month is already fixed at the time of sanction of the loan, the bank would have already locked itself into a spread. Its main course of concern will be that at the end of the first six months period its spread would be adversely affected, if the LIBOR were to go down. If 6-12 FRA is being quoted at 5.25-5.30 percent, the bank has to sell FRA at 5.25%, since it is seeking protection against a fall in interest rates. If the actual LIBOR settles at 5.15 percent on the settlement date (i.e. six months from now), then the notional buyer/borrower (that is the quoting bank) has to compensate the SBI (i.e. the notional lender) for the difference in interest rate on the notional principal amount of USD 5 million. This is due to the fact that when the bank has sold a 6-12 FRA, the contract was that it has notionally lend an amount of USD 5 million at rate of 5.25 percent for a period starting six month and ending 12 months for now. As the interest rate has gone down and SBI is going to sustain a loss of 0.10 percent, it needs to be financially compensated for the same. It is to be noted that no actual exchange of the principal amount takes place and that the notional principal amount is used for calculating the compensating amount. The compensating amount is calculated as per normal interest calculations viz: (Difference in the interest rates) x Notional principal amount x (number of days of contract) (5.25%-5.15%) X 5000000 X 180/360 = USD 2500 However in the FRA market this amount is settled up front i.e. before the loan period. Hence the amount has to be discounted for the six month period at the on going market rate, which is 5.15% The present value of compensation amount is calculated using the formula

78

Present value of Compensation amount = (L-R) or (R-L) x D X P/B x 100 –DxL Where, L = settlement rate R = Contract reference rate D = Days in contract Period B = Days basis P = Notional principal amount Thus the present value of compensating amount is = .10 x 180 x 5000000 / (360x100) – (180 x 5.15) = USD 2437.24 Hence SBI will receive USD 2437.24, representing 10basis point from the buyer of the FRA, i.e. the quoting bank. This would compensate SBI for for the decrease in the spread due tom decrease in LINOR from 5.25% to 5.15%, in the underlying market. As such the bank is fixed to a LIBOR of 5.25% irrespective of the movement in the LICOR, by hedging through the FRA.

11. Conclusion
The foreign exchange business is, by its nature risky because it deals primarily in risk-measuring it, pricing it, accepting it when appropriate and managing it. Managing foreign exchange risk is a fundamental component in the safe and sound management of companies that have exposures in foreign currencies. It involves prudently managing foreign currency positions in order to control, within set parameters, the impact of changes in exchange rates on the financial position of the company. There are mainly three type of foreign exchange exposure - translation exposure, transaction exposure and economic exposure. Unmanaged exchange rate risk can cause significant fluctuations in the earnings and the market value of an international firm. A very large exchange rate movement may cause special problems for a particular company, perhaps because it brings a competitive threat from a different country. There are various tools that are available for managing the foreign exchange risk. These include traditional tools like money market hedge, currency 79

risk sharing, insurance and modern derivative tools like forward, futures, options, swap and forward rate agreements which can be used by organisation as per the specific needs and requirements to manage the foreign exchange risk.

Bibliography
Text books
• • • • • • Foreign Exchange Risk management – BSE Training Institute Risk Management – By Dr. G. Kotreshwar (First edition – Print 2007) Options, Futures and Other Derivatives – By John C. Hull (Seventh edition) Futures and Options – By A.N. Shridhar Financial Risk Management – ICFAI Text book Financial Derivative – By Keith Redhead (Print 2003)

Websites:
• • • www.investopedia.com www.theoptionsguide.com www.wikipedia.org

80

• •

www.kshitij.com www.financial-dictionary.thefreedictionary.com

81



doc_502765002.doc

 

[shibani0604]

please mail me the project . my id is [email protected]. There is no download option here.

 

[sanju3584]

Hi can some one tell me how to add the download option for this project?

 

[29111989]

hii plz once again send me ur project details with executive summary , last time details i wil lost it & i want it very urgently ofr this year
so plz forward me on my [email protected]
waiting for ur rpy

 

[29111989]

HII IF U HAVE EXECUTIVE SUMMARY OF THIS PROJECT ,THEN PLZ FORWARD ME

 

[karan_kp]

I am not able to download this file ... Plz mail this to me on my mail id - [email protected]

 

[Guest]

I am not able to download this file ... Plz mail this to me on my mail id - [email protected]

 

[Rakesh2012]

I am not able to download the file, Please mail to on [email protected]. really a very good study material

 

[gaurimau]

plz mail me this projct on my ID [email protected] soon as possible

 

[manoj.bharti1]

m not been able to download this project.......plz mail me @ [email protected]

 

[Guest]

plz mail me dis [email protected]

 

[harshita.vora.1]

can sum1 plzzz mail me dis project on [email protected]..... its kinda an urgent....plz mail