Question Paper Financial Risk Management - II (232) : April 2006 Section D : Case Study (50 Marks) • •
This section consists of questions with serial number 1 - 4.
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Answer all questions.
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Marks are indicated against each question.
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Do not spend more than 80 - 90 minutes on Section D.
Case Study Read the case carefully and answer the following questions: 1.
2.
What is a Forward Rate Agreement (FRA)? Explain how it is used to hedge interest rate exposures. How the payment term of an FRA in practice is different from those of most interest rate derivatives? (8 marks) < Answer > Show the pay-off profile and all relevant cash flows indicating the annualized cost of the loan under various interest rate scenarios, if the interest rate exposure is hedged through a. FRA b. Interest rate call option c. Interest rate put option d. Call option on Eurodollar futures e. Put option on Eurodollar futures. To prepare pay-off profile, take the LIBOR in the range of 4.0% – 5.75% with an interval of 0.25%. (Assume 360 days in a year)
3.
(4 + 5 + 5 + 5 + 5 = 24 marks) < Answer > Explain how the Black Scholes model for pricing options on futures can be modified for pricing interest rate options?
4.
(8 marks) < Answer > The job of a risk manager is to identify the various types of risks an organization is facing. Once the various types of risks are identified, the next step involves selecting the alternate approaches that can be adopted to manage different types of risks. Discuss those approaches of managing risks.
(10 marks) < Answer > Valero Inc. is a manufacturer of high end computer systems for services industry based in Santa Barbara in Southern California. The company mainly focused towards exports of heavy duty servers and acquired highest level of international certification. By 2005 about two-thirds of its revenues were earned from its global operation. Valero Inc. entered the Asian Australian market in the middle of 1990s by assembling and distributing computers to countries like Australia, New Zealand, Malaysia, Indonesia etc. Early in the new century, after it became known for the high quality of its products, Valero Inc. expanded its operations further in Europe with a tie up with Excon Computer Systems engaged in manufacturing of disk drivers, printers and other peripherals. Sales in Europe focused on small to medium sized enterprises, and were made on a revolving and installment credit basis. Valero Inc. is for some times feeling the pinch of competition from the other European minicomputer manufacturers. Past experience which includes domestic and overseas as well, revealed that the availability of credit is a fundamental factor in maintaining a market position. So the short term financing to the extent of $20 million is required to sustain the present level of sales. On January 01 2006 in Santa Barbara, the Management of Valero Inc was looking for the most desirable alternative to hedge the interest rate risk involved with the short-term borrowing to finance the working capital
requirement of its European Subsidiary. The total funds requirement is $20 million for three months in April 2006. The funds are required to meet competition by providing installment credit for higher sales forecast for the quarter starting from April 2006. Management of Valero Inc has finalized a floating dollar borrowing from a London bank at 150 basis points over 3-months LIBOR in April for three months. Interest rates in the international market after falling at the all time low are now on the rising path. So the management of Valero is worried about the rise in interest rates in the coming months that will make their borrowings costly. The current 3-month LIBOR on dollar has been recently fixed at 4.65%. The management is considering the following instruments to hedge the interest rate risk: i.
Forward Rate Agreement (FRA): A FRA is an agreement between two parties in which one of them contracts to lend to the other, a specified amount of funds, in a specific currency, for a specified period starting at a specified future date, at an interest rate fixed at the time of agreement. Entering into a FRA can act as a hedge against rising interest rate. A London based bank is quoting the following FRA: US$
ii.
3/6 months
4.45% – 4.90% p.a.
Interest rate call option: A call option on interest rate gives the holder the right to borrow funds for a specified duration at a specified interest rate, without an obligation to do so. The pay off from the option depends on the difference between a floating interest rate, usually LIBOR, and an interest rate designated as exercise price. The call will be exercised if the floating interest rate is greater than exercise price; otherwise the option expires without exercising. Management has identified the following call option on 3-month LIBOR expiring in 3 months and pay off 3 months thereafter: Face amount
Exercise price
Premium
$20 million
4.70% p.a.
$9,500
Face amount
Exercise price
Premium
$20 million
4.75% p.a.
$8,000
iii. Interest rate put option: A put on interest rate gives the holder the right to invest funds for a specified duration at a specified return, without an obligation to do so. These interest rate options are typically European. An interest rate put pays off if the floating interest end up below the agreed upon exercise price. Management has identified following put option on 3-months LIBOR expiring in 3-months and pay off 3 months thereafter:
iv. Call option on Eurodollar futures: A call option on Eurodollar futures contract, if exercised, entitles the holder to receive a long position in the Eurodollar futures plus a cash amount equal to the price of the contract at that time minus the exercise price. If the futures price on maturity is less than the exercise price, then the option expires without exercising. Management had identified a 3 months call on Eurodollar futures with a strike price of 95.20 (futures price) carrying a premium of 22 basis points. v.
Put option on Eurodollar futures: A put option on Eurodollar futures contract on being exercised gives the holders a short position in a futures contract plus cash equal to the exercise price minus the futures price at that time. If the futures price on maturity is more than the exercise price, then the option expires without exercising. Management has identified a 3 month put on Eurodollar futures contract with a strike price of 95.50 (futures price) carrying a premium of 35 basis points.
The management is interested in finding out the annualized cost of the loan hedge through above instruments for various interest rate scenarios and compare these alternatives of hedging to make decision in which scenario each alternative dominates the others. END OF SECTION D
Section E : Caselets (50 Marks)
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This section consists of questions with serial number 5 - 11.
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Answer all questions. Marks are indicated against each question.
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Do not spend more than 80 - 90 minutes on Section E.
Caselet 1 Read the caselet carefully and answer the following questions: 5.
“The implied volatility as perceived by the market is assumed to be good forecaster of future volatility.” Do you agree? Discuss.
6.
(6 marks) < Answer > “Higher the volatility higher should be the option premium.” Explain how volatility can be traded profitably.
7.
(7 marks) < Answer > In volatility trading, option delta has a significant role. Discuss how option delta can be used successfully to make trading profit. (7 marks) < Answer >
The theory of relativity is well applicable in the stock market, for two reasons. First, no one stops you from applying any thing that you can apply on the stock market and second stock picking is done when a stock is relatively valued, relative to index, peer group or fair price. Stock selection, evidently, is not restricted to one or two methodologies; it is an open field whether it is a buy signal when prices are over the shoulder, guidance from the candle indicators, and geometry of the chartist, call of the fundamental analysts or sheer good feeling. All these are plausible ways for a simple reason that there are different ways to track the market and take a position in anticipation of a better yield. How an option trader should devise a strategy to trade in the derivatives market, where before taking a position a few analyses are required. Since option derives value from the underlying, first is valuation of underlying, general direction of the underlying movement, effect of change in the underlying on options pricing, commonly known as delta, maturity time left and finally, purpose of hedging or trading, to decide if any necessity to hold it for particular period or simultaneous trading is to be done on underlying. Given the above fact options premium draw its value from the volatility, higher the volatility higher should be the option premium or vice versa. If one understands the impact of volatility in discovering the options pricing, it would be the most rewarding and meaningful savoir faire. Volatility projections are though difficult but it reduces the burden of correctly predicting the underlying price and its direction. You are more in the game than when position taken with due regard to volatility. The step ahead once volatility estimations are made, is to device trading strategy. One simple simulation how volatility is going to affect the net risk capital is going to tell you the suitability of the trading strategy. That means keep strategies ready in shelf for various outlooks, before volatility is unfurled. Ask your trading clerk to apply strategy kept in ‘shelf no 3’ since you have done your work on volatility. What is volatility? For the matter under discussion, it is variation in the price of the underlying over a period generally, a year is taken. Smaller period can also be taken if it is so warranted due to the market movements. Option premium is positively related to volatility of the underlying assets. Higher the volatility higher is the chances to get the option in the money. Chances of getting the option in the money are higher occur when the time to maturity is far, that is options on volatile stock will fetch higher time value premium. It is applicable for both call and put options. To make the role of volatility clearer lets’ take an example where stock is trading at Rs. 50, what should be the price of a call option of Rs. 50 strike when time to maturity is one month and condition is that stock is not
moving at all and expected to trade at Rs. 50 only after a month. In this hypothetical example the option price should be zero. If the stock is assumed to be moving creature there is possibility that stock may end up at a higher value than at a value trading today. So option should fetch some value, it should trade at a value which is value sum of the probability of stock prices at the maturity of the options contract. How far option premium can fluctuate? For this volatility estimations are required. Though volatility estimations are relative as well as subjective but these are necessary to set a range for higher and lower volatility. This will give band of option premium movement. Even when volatility trading is not resorted to volatility, estimations are required to know whether premium paid is appropriate or not and whether the payment timing is appropriate or not. Caselet 2 Read the caselet carefully and answer the following questions: 8.
Buy-Write means covered call writing. Explain when you should opt for covered call writing. Also discuss the risks involved in the strategy. (7 marks) < Answer > Explain how you can create a buy-write index? Can it be done in the Indian equity derivatives market also?
9.
(8 marks) < Answer > It has been more than half a decade now since the first brick was laid for the introduction of equity derivatives. The volumes in the equity derivatives segments have skyrocketed since then. However, much of this credit goes to stock futures and index futures. If one looks at the segment-wise break up one would see a pretty lopsided picture where stock futures contribute 65% of the total volumes; index futures contribute 25% while index options and stock options contribute 5% each. If one digs in a bit more and looks at the monthly volume breakup of the options instruments individually one would see that the volumes are high for calls on stocks and puts on the index. The use of stock call options is done mainly when one is cautiously bullish and does not wish to take high risk even though one wants to be in the market. So by paying a small amount of premium, which is generally 2 to 3% of the exposure, one takes a position. Index put options are largely used for hedging portfolio. As per the portfolio betas one would buy index puts in order to protect the portfolio from any downside. So net - net options are used for either hedging or taking limited risk position, though options bring along with them a whole plethora of possible strategies they are not actively utilized in the Indian markets. The reasons that can be attributed to this are many, to list a few they would be:
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Lack of knowledge regarding dynamics of various strategies.
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Widely accepted fallacy of options being very risky.
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High degree of reluctance towards options writing.
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High cost as the brokerage is calculated on the notional value.
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No tool to gauge the movement of option prices.
The market players are able to gauge the movement in equity markets and equity futures market due to the presence of various indices that work as benchmarks. However, in case of options there are no such indices available that would catch the attention of market participants and increase their participation in options market. In case of equity options, the index should be related to a strategy, as unlike cash or futures markets the dynamics in equity options are not simple. If the Indian bourses get proactive to create index based on various strategies it can help attract lot of attention in
such instruments and strategies using these instruments. The problem faced by the Indian exchanges is not unique as in the past other international exchanges were plagued by such problems. However, they proactively took steps to curb this problem and have come out successfully from this problem. Chicago Board Options Exchange was the first exchange to introduce options in 1973. However, the volumes were pretty thin in the options segment. With a view to create a benchmark for market participants, Buy-Write, an important option trading strategy of selling, or writing call options were introduced. The indices are currently created on three major indices-S&P 500, NASDAQ 100 and Dow Jones Industrial Average (DJIA). The indices are known as BXM, BXN and BXD respectively.
Caselet 3 Read the caselet carefully and answer the following questions: 10.
What are credit derivatives? Explain with examples.
11.
(7 marks) < Answer > “The market for credit derivatives has developed so fast that it is questionable whether the players really understand the risks inherent in these instruments.” Discuss the risks involved in dealing with credit derivatives.
(8 marks) < Answer > Financial derivatives are "weapons of mass destruction," wrote Warren Buffett, the Oracle of Omaha in Berkshire Hathaway's annual letter to the shareholders (2002). That definition seems to have a ring of truth to it, for the way the financial community is embracing new and advanced versions of derivatives is raising concerns the world over. Credit derivatives are one such instrument. Even as more of such cases are coming to the fore, the credit derivatives market is exploding, reaching gigantic proportions. From a humble beginning in 1992, the market's volume in the year 2003 reached $3.6 tn. According to McKinsey, it is all set to touch the $10 tn mark by 2007. Nonetheless, skeptics fear that eventually something will happen to bring down the global financial system. Credit derivatives allow banks to free the risk capital. Now with more capital available at their disposal, they actively get into lending business, and then again use credit derivatives to transfer credit risk to free up more capital. Ultimately, banks may end up getting exposed to more risk than they are actually supposed to take. Although, corporates have not yet ventured into the credit derivatives market fully, it is the aggressive participation of banks, hedge funds and insurance companies that is pushing the market to new heights. Banks as they are exposed to default risk on the loans they extend, buy credit derivatives, which allow them to transfer only risk and not the underlying asset. But of late, there is a stampede among banks and insurance companies to sell credit derivatives. They see it as a means to earn good returns since their traditional routes of deploying funds are not generating satisfactory returns. This active participation of financial intermediaries in the credit derivatives markets is raising fears over the possibility of the collapse of the system if one of them fails. A major criticism of the credit derivatives market is that it is not as transparent as the other financial markets. However, one should remember that credit derivatives are traded over-the-counter, with little regulation. Professor Shankarshan Basu of IIM Bangalore argues, "Not much can be done about the opacity except for the fact that one believes that with banks and insurance companies entering the market, deliberate misuse of the system will not be done." And a certain amount of opacity is accepted. He adds, "Banks and insurance companies will not want their competitors to know about their exact dealings and status." Then there is the issue of the conflict of interests and consequently insider trading, where a bank buys and sells credit derivatives. The trading desks of banks can get useful information from the lending departments giving them unfair advantage and room for abuse. In securitized form of credit derivatives like a portfolio of debt from various corporations, most of the times investors rely on the estimates of the banks, which can easily fool them as they (the banks) have better information of the credit asset. Investors' have to strike a balance between the risk and the potential returns. The ability to understand and quantify the risk reaps rich rewards. The market for credit derivatives has developed so fast that it is questionable
whether the players really understand the risks inherent in these instruments.
END OF SECTION E END OF QUESTION PAPER
Suggested Answers Financial Risk Management - II (232) : April 2006 Section D : Case Study 1.
A forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures on short-term deposits, such as Eurodollar contracts. An FRA transaction is a contract between two parties to exchange payments on a deposit, called the notional amount, to be determined on the basis of a short-term interest rate, referred to as the reference rate, over a predetermined time period at a future date. An FRA transaction is entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the difference between the contract interest and the market rate, commonly London Interbank Offered Rate (LIBOR), is multiplied by the notional deposit and the time of period to determine the cash settlement. Since FRAs are priced off LIBOR, if LIBOR is higher than the contract rate, the buyer receives a cash payment from the seller, and vice versa if the interest rate is lower. An FRA is like a short-term interest rate swap. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs. If the reference interest rate for a specific period on a specific date in the future is different from the one agreed upon, a settlement of the difference will be made. Most interest rate derivatives, specifically swaps and options, pay off later than the expiration or settlement date. For example, at the expiration of an interest rate option, the underlying interest rate is compared to the exercise rate. If the option is in-the-money, it pays off but at a later date. If the underlying rate is, for example, the rate on a 90-day Eurodollar, the payoff will typically occur ninety days later. This arrangement is in keeping with the fact that on a given day, the 90-day Eurodollar rate as of that date implies an interest payment that will be made ninety days later. A similar procedure occurs on the settlement dates of a swap. On an FRA, however, the payoff typically occurs on the expiration date. The amount paid, however, is then discounted to reflect the deferred payment.
< TOP > 2.
a.
The company should buy US$ 3/6 months FRA at 4.90%.
LIBO R LIBO R
Cost of borrowing ($ mln.)
Cash out flow due to FRA* ($ mln.)
Total cash out flow ($ mln.)
Annualized cost
LIBO R 4.00%
0.2750
0.0450
0.320
6.40%
4.25 %
0.2875
0.0325
0.320
6.40%
4.50 %
0.3000
0.0200
0.320
6.40%
4.75 %
0.3125
0.0075
0.320
6.40%
5.00 %
0.3250
–0.0050
0.320
6.40%
5.25 %
0.3375
–0.0175
0.320
6.40%
5.50 %
0.3500
– 0.0300
0.320
6.40%
5.75 0.3625 –0.0425 0.320 6.40% % * Discounting the cash flows due to FRA and again compounding the same is ignored as both are to be done at same LIBOR. Here, we see that the cost of the loan is locked at 6.40% p.a. for the range of LIBOR. b. To hedge the interest rate risk the company has to buy the call option, at strike price 4.70%.
LIBO R 4.00%
Cost of borrowing ($ min.)
Call Exercise d
Pay off from call
Premiu m ($ min.)
Total cost
Annualize Cost
0.275 No – 0.0095 0.284 5.69% 0 5 4.25% 0.287 No – 0.0095 0.297 5.94% 5 0 4.50% 0.300 No – 0.0095 0.309 6.19% 0 5 4.75% 0.312 Yes – 0.0025 0.0095 0.319 6.39% 5 5 5.00% 0.325 Yes – 0.015 0.0095 0.319 6.39% 0 5 5.25% 0.337 Yes – 0.0275 0.0095 0.319 6.39% 5 5 5.50% 0.350 Yes – 0.0400 0.0095 0.319 6.39% 0 5 5.75% 0.362 Yes – 0.0525 0.0095 0.319 6.39% 5 5 So we see that if LIBOR rises above 4.70%, it can lock into a maximum interest cost of 6.39%. However, there is a potential of lower cost of funds if LIBOR remains below 4.70%. c. To hedge the interest rate risk the company has to sell the put option at strike price 4.75%
LIBOR
Cost of borrowing ($mln.)
4.00%
0.2750
Put Exercise d Yes
Pay off from put 0.0375
Premiu m ($ mln.) – 0.008
Total cost
Annualize d Cost
0.304 6.09% 5 4.25% 0.2875 Yes 0.0250 – 0.008 0.304 6.09% 5 4.50% 0.3000 Yes 0.0125 – 0.008 0.304 6.09% 5 4.75% 0.3125 No – – 0.008 0.304 6.09% 5 5.00% 0.3250 No – – 0.008 0.317 6.34% 0 5.25% 0.3375 No – – 0.008 0.329 6.59% 5 5.50% 0.3500 No – – 0.008 0.342 6.84% 0 5.75% 0.3625 No – – 0.008 0.354 7.09% 5 So here company can lock in the minimum borrowing cost of 6.09%. However, there is possibility of increasing borrowing cost if LIBOR goes above 4.75%. d. d. To hedge the interest rate risk the company has to sell call on Eurodollar futures contract. The company has to sell to 20 call options. Strike price = 95.20 Premium = 22bp × $25 × 20 = $11,000
LIBO R 4.00%
e.
Futur es price 96.00
Call Exercis ed Yes
Payoff from call 0.0400
Premiu m ($ min.) – 0.011
Cost of borrowing ($ mln.) 0.2750
Total cost
Annualize Cost 6.08%
0.304 0 4.25% 95.75 Yes 0.0275 – 0.011 0.2875 0.304 6.08% 0 4.50% 95.50 Yes 0.0150 – 0.011 0.3000 0.304 6.08% 0 4.75% 95.25 Yes 0.0025 – 0.011 0.3125 0.304 6.08% 0 5.00% 95.00 No – – 0.011 0.3250 0.314 6.28% 0 5.25% 94.75 No – – 0.011 0.3375 0.326 6.53% 5 5.50% 94.50 No – – 0.011 0.3500 0.339 6.78% 0 5.75% 94.25 No – – 0.011 0.362 0.351 7.03% 5 5 So here company can lock in the minimum borrowing cost of 6.08% if it expects interest rate will not rise beyond 4.80%, for interest increasing beyond 4.80% cost of borrowing will also go up. To hedge the interest rate risk the company has to buy put on Eurodollar futures contract. The company has to buy 20 put options Strike price = 95.50 Premium = 35 bp × $25 × 20 = $17,500
LIBO R
Futures Put price Exercised
Payoff from put
Premiu m ($ min)
Cost of borrowin g ($ min)
Total cost
Annualiz ed Cost
4.00%
96.00
No
–
0.0175
0.2750
0.292 5
5.85%
4.25%
95.75
No
–
0.0175
0.2875
0.305 0
6.10%
4.50%
95.50
No
–
0.0175
0.3000
0.317 5
6.35%
4.75%
95.25
Yes
– 0.0125
0.0175
0.3125
0.317 5
6.35%
5.00%
95.00
Yes
– 0.0250
0.0175
0.3250
0.317 5
6.35%
5.25%
94.75
Yes
– 0.0375
0.0175
0.3375
0.317 5
6.35%
5.50%
94.50
Yes
– 0.0500
0.0175
0.3500
0.317 5
6.35%
5.75%
94.25
Yes
– 0.0625
0.0175
0.3625
0.317 5
6.35%
So here we see that maximum cost of borrowing is locked at 6.35% for LIBOR risen to any level above 4.50%. For LIBOR below 4.50%, there is a possibility of lower cost of borrowing.
3.
4.
< TOP > While the Black Scholes model is designed to price options on futures, it can be adapted to price interest rate options. The model requires the futures price, exercise price, riskfree rate, time to expiration, and volatility. When using the model to price interest rate options, the forward rate is inserted for the futures price. This rate reflects the current value of the underlying. The exercise price is just the exercise price on the interest rate option. The risk-free rate is the continuously compounded risk-free rate over the life of the option. The time to expiration is just the time to expiration of the option, and the volatility is the standard deviation of the volatility of the continuously compounded forward rate. When the option value is obtained, however, it must be discounted at the underlying forward rate to reflect the fact that the option does not pay off at its expiration, but instead, pays off at a later date. In addition, the option price must be multiplied by a factor such as days/360 because the rate produced by the model is an annual rate. Then this result is multiplied by the notional principal. < TOP > The different approaches to managing risks: • • Risk avoidance • • Loss control • • Combination • • Separation
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Risk transfer Risk retention Risk sharing
Risk Avoidance
An extreme way of managing risk is to avoid it altogether. This can be done by not undertaking the activity that entails risk. For example, a corporate may decide not to invest in a particular industry because the risk involved exceeds its risk bearing capacity. Though this approach is relevant under certain circumstances, it is more of an exception rather than a rule. It is neither prudent, nor possible to use it for managing all kinds of risks. The use of risk avoidance for managing all risks would result in no activity taking place, as all activities involve risk, while the level may vary. Loss Control
Loss control refers to the attempt to reduce either the possibility of a loss or the quantum of loss. This is done by making adjustments in the day-to-day business activities. For example, a firm having floating rate liabilities may decide to invest in floating rate assets to limit its exposure to interest rate risk. Or a firm may decide to keep a certain percentage of its funds in readily marketable assets. Another example would be a firm invoicing its raw material purchases in the same currency in it which invoices the sales of its finished goods, in order to reduce its exchange risk. Combination
Combination refers to the technique of combining more than one business activity in order to reduce the overall risk of the firm. It is also referred to as aggregation or diversification. It entails entering into more than one business, with the different businesses having the least possible correlation with each other. The absence of a positive correlation results in at least some of the businesses generating profits at any given time. Thus, it reduces the possibility of the firm facing losses. Separation
Separation is the technique of reducing risk through separating parts of businesses or assets or liabilities. For example, a firm having two highly risky businesses with a positive correlation may spin-off one of them as a separate entity in order to reduce its exposure to risk. Or, a company may locate its inventory at a number of places instead of storing all of it at one place, in order to reduce the risk of destruction by fire. Another example may be a firm sourcing its raw materials from a number of suppliers instead of from a single supplier, so as to avoid the risk of loss arising from the single supplier going out of business. Risk Transfer Risk is transferred when the firm originally exposed to a risk, transfers it to another party which is willing to bear the risk. This may be done in three ways. The first is to transfer the asset itself. For example, a firm into a number of businesses may sell-off one of them to another party, and thereby transfer the risk involved in it. There is a subtle difference between risk avoidance and risk transfer through transfer of the title of the asset. The former is about not making the investment in the first place, while the latter is about disinvesting an existing investment. The second way is to transfer the risk without transferring the title of the asset or liability. This may be done by hedging through various
derivative instruments like forwards, futures, swaps and options. The third way is through arranging for a third party to pay for losses if they occur, without transferring the risk itself. This is referred to as risk financing. This may be achieved by buying insurance. A firm may insure itself against certain risks like risk of loss due to fire or earthquake, risk of loss due to theft, etc. Risk Retention Risk is retained when nothing is done to avoid, reduce, or transfer it. Risk may be retained consciously because the other techniques of managing risk are too costly or because it is not possible to employ other techniques. Risk may even be retained unconsciously when the presence of risk is not recognized. It is very important to distinguish between the risks that a firm is ready to retain and the ones it wants to offload using risk management techniques. This decision is essentially dependent upon the firm’s capacity to bear the loss. Risk Sharing This technique is a combination of risk retention and risk transfer. Under this technique, a particular risk is managed by retaining a part of it and transferring the rest to a party willing to bear it. For example, a firm and its supplier may enter into an agreement, whereby if the market price of the commodity exceeds a certain price in the future, the seller foregoes a part of the benefit in favor of the firm, and if the future market price is lower than a predetermined price, the firm passes on a part of the benefit to the seller. < TOP > Section E: Caselets Caselet 1 5.
Implied volatility is the volatility as perceived by the trader in time to come. Therefore it can be considered as giving signals. When traders estimate about volatility they discount all possible happening on valuation as it is normally done with equity stock. In this process implied volatility generally gets overestimated. Since, discount all events differ in perception it is not an accurate indicator of future volatility. implied volatility, since based on consensus of the participants, does not change much though events happened, since opinions do not change swiftly, participants may believe that thing will restore to its original level it makes implied volatility less fluctuating. If the average implied volatility is considered then wide fluctuations in implied volatility give rise to trading opportunity. In general implied volatility are overestimated it means it is more than actual volatility. Whenever it is far in excess, options are over valued and it is the time to sell. On the same lines, if implied volatility is less then actual volatility it is the time to buy as the option is undervalued.
< TOP > 6.
Volatility trading is a mix of art and bit of mathematical calculations. Option trader would require identifying when the implied volatility is not at level it should be. In the game of volatility trading, volatility should be bought when it is relatively cheap i.e. you hold the view of less volatile outcome or vice versa. In this context it is a contrarian strategy. The mechanism of forecasting is done in the same as normally done for stock prices. When an analyst feels that equity is undervalued he recommends buy or when it is overvalued based on his analysis sell is recommended. However in case of volatility based trading, the way estimations are implemented in trades are different. When volatility is perceived to be higher options are overvalued and sell is recommended. Similarly when volatility is perceived to be lower option buying is recommended. When market is less volatile or perceived to be less volatile, option seller would be far happier if option matures worthless, if this prevails for long there would be more seller than buyer this should bring the
option prices lower. This is the time to take contrary view, since now options are cheaply available, and if volatility is forecasted at a higher level or actual volatility is at level higher then anticipated volatility, options should be bought. Sooner when the prices adjust for higher volatility option prices should move up and at this time profit booking can be done. Similarly, when market is more volatile or perceived to be higher volatile, option buyer are happier if option matures deep in the money. If this prevails for long there would be more option buyer then seller this should push the option prices at a higher level. This is the time for action, since now options are costlier, and if volatility is forecasted at a lower level or actual volatility is at level lower than anticipated volatility, options should be sold. Sooner when the prices adjust for lower volatility option prices should move down and at this time profit can be made by squaring off the contract.
< TOP > 7.
The hedging ratio, or the delta, is the ratio of shares long or short necessary to hedge one option. The Black-Scholes option pricing model specifies this delta so that by trading the underlying shares according to the predicted delta, arbitrage profits can be captured with low risk. However, this model (as with most models) employs some necessary simplifying assumptions that are not true in practice. One key assumption is that market prices are continuous and the delta adjustments can also be made continuously. Unfortunately, markets gap, particularly during periods of market stress—making delta adjustments discontinuous. To see the impact of these gaps, let’s first look at the delta curve. If the underlying share price is well below the option strike price, then the option value is very insensitive to the share price i.e., the delta is very close to zero. If the underlying share price is well above the option strike price, then the option value will move almost dollar-for-dollar with the share price i.e., the delta is very close to one. In between, delta follows a smooth positively sloped curve. The impact of this type of curve is as follows. If the position is long one option and short delta shares, then if the share price falls, the delta will decrease. Shares will therefore have to be purchased to reduce the delta. Conversely, if the share price rises, shares will have to be sold. Buying in falling markets and selling in rising markets is the most desirable position to be in.
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An option buyer has unlimited profit potential for a fixed premium paid while an option writer has the opposite payoffs with limited premium as income for which he is willing to take unlimited losses. Writing call is one of the riskiest positions in the derivatives market as the stock price can increase sharply after it is written resulting in big losses to the writer. The covered call option helps the writer minimise such losses. A long position in the underlying stock, along with writing a call option, is known as covered call writing. This is because the long stock position `covers' or protects the investor from the possibility of a sharp increase in the stock price. Any loss due to increase in the price of the stock (because of writing the call option) will be offset by the gain from the long position taken in the stock. The risk of covered call option can be looked at from two angles. If the price of the stock rises after the option is written, there is an opportunity loss to the investor as otherwise he would be in a position to take full advantage of the rise due to his long position in the cash market. The other risk is of the share price falling. If the price falls below the current level, the losses to the investor are real as against an opportunity loss when the price goes up. Though the covered call has helped reduce the break-even point, any decline below this level will be to the investor's account. Since this is a real loss, investors should be careful while choosing covered call writing.
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A buy - write index calculates the return on a hypothetical covered-call strategy on an index. It is computed by writing a one-month slightly out of the money contract on an underlying which can be an index. So on one hand a person holds a portfolio of the stocks on an index and on the other hand he sells call options of the same index of equal amount. The position is initiated on the first day of the new expiry at a point when
all the stocks of the index get traded. It is assumed that the options position is also initiated at that time. The options are held till maturity. At the end of the expiry, the existing option is valued at zero or intrinsic value which ever is higher. On the beginning of the next expiry as per the index value a fresh position in call options is again initiated by selling call options equivalent to the portfolio value. This position is initiated at Volume Weighted Average Price (VWAP) during the first half hour of the new expiry. During this period any dividends received are reinvested in the portfolio. The index is a chain-based index where the base of calculation is the previous day. The formula for its calculation is: Rt = (St + Divt - Ct) / (St-1 - Ct-1). (here St is the spot price and Ct is call price) The Rt thus calculated is multiplied by the previous day's index value. The value thus obtained is the index value for the day. The same learning can be applied and used in the Indian equity derivatives market also. The most liquid contract in the index options segment is NIFTY. A buy - write index based on NIFTY can be constructed. The NIFTY stocks have very good liquidity on the cash counters. However, in the Indian scenario there are certain problems like the transaction costs which are very heavy. So, the actual returns and index returns would be considerably different. The Indian markets are very choppy which would surely skew the results to a great extent. Also, we should not miss the fact that this strategy underperforms in a bull market. The major gains may be due to time decay of the options value. This is because as the options' expiry approaches, the reduction in options' value is fast and substantial.
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Credit derivatives, in their basic form, are contracts that allow one party called the protection buyer to transfer credit risk of the underlying asset, to another party called the protection seller. For example, Bank A enters into a credit derivative contract with Bank B on its loan portfolio. Bank B bears the risk associated with the formers loan portfolio for a fee, while Bank A continues to hold the portfolio. Supporters of credit derivatives argue that this ability to buy protection has increased banks’ appetite for extending more credit, thus stimulating economic activity. These instruments provide a win-win situation for both the buyer and the seller. While buyers enjoy diversification of risk without the transferring of assets, sellers get attractive returns. And what’s more, they can be tradable just like any other security traded in the capital markets. The above mentioned example is a watered down version of credit derivatives. They take many forms. In credit default swap, the protection seller undertakes to compensate the protection buyer over the happening of a credit event such as default, for a fee. Total return swap is a swap of the total returns out of an underlying asset against a prefixed return. Credit linked notes involve the packaging of a credit default swap into a tradable instrument either in the form of a note or a bond. Although the basic versions are harmless, it is the securitized forms of credit derivatives which are getting the flak for all the complexities in the deals and the lack of transparency in the transactions.
< TOP > 11. The risks in these markets seem to be deceptively simple. Consider this: An important aspect of credit derivatives is the credit event such as bankruptcy, credit default, credit rating deterioration, etc. With parties deciding the contract terms privately, the definition of the credit event assumes significance. The broader the definition, the greater the risk. In a report titled `Understanding the Risks of Credit Default Swaps', published by the Investors Service Department of the rating agency Moody, Jeffery Tolk argues that if credit events are defined too broadly, a credit derivative such as credit default swap may result in loss following mere credit deterioration instead of loss following an actual default. For example, "An obligation that has been restructured to defer principal payments may not technically be a default if the lender has been properly compensated. But the International Swaps and Derivatives Association (ISDA) would nonetheless define this as a credit event," he says. The other area of concern is the documentation of the contract. This takes the form of enforcement risk of the contract, as credit derivatives may not turn out to be legally enforceable contracts. JP Morgan Chase has had a bitter experience in this regard. The firm had huge exposure in Enron. When Enron filed for
bankruptcy, the firm claimed payment on coverage offered by a group of insurers. While, the company estimated that it is entitled to $965 mn, a settlement was reached whereby the firm received only $600 mn, resulting in a good $365 mn credit loss. The ISDA have a standard documentation in this regard, which can remove legal uncertainty from the derivatives market. Experts, term Credit Derivatives as `toxic waste' emitted by the commercial banks, through transfer from their balance sheets into the holdings of unwary insurers. Whereas most of the banks are of the opinion that credit risk is bad and hence their transfer is advantageous. The quest is now whether the transferee can afford to manage the credit risk better than the bankers themselves could do. A survey conducted by the London-based Center for the Study of Financial Innovation (CSFI) and PricewaterhouseCoopers revealed that the credit derivatives market is largely opaque and is a source of possible systemic risk. Respondents opined that in these markets it is not readily apparent as to who holds the risk or what concentration of risk exists. Concerns are that there is a possibility of a small group of institutions having to take a big concentration of risk. It is also believed that the explosion of the credit derivatives market could weaken the financial stability in the banking sector. Recently, Sir Andrew Large, Deputy Governor of Bank of England said, "Credit risk transfer has introduced new holders of credit risk, such as hedge funds and insurance companies, at a time when market depth is untested,". He added that, "The growth of derivative instruments and advent of a range of new asset classes, despite added dispersion and better risk management, have added to the risk of instability arising through leverage, volatility and opacity.
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