Question Paper

Financial Risk Management – II (232) : October 2004

Section D : Case Study (50 Marks)
• This section consists of questions with serial number 1 - 5.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.
Case Study*
Read the case carefully and answer the following questions:
1. The case states that interest rate derivatives are more difficult to be valued than equity and foreign
exchange derivatives. State your opinion and discuss the reasons for the same.
(6 marks) < Answer >
2. Show the pay-off profile and all relevant cash flows indicating the annualized cost of the loan under
various interest rates when it is hedged through
a. a. FRA
b. b. Interest rate call option
c. c. Interest rate put option
d. d. Call option on Eurodollar futures
e. e. Put option on Eurodollar futures
To prepare pay-off profile, take the LIBOR in the range of 1.5% - 3.25% with an interval of 0.25% and
assume that there are 360 days in a year.
(5 + 5 + 5 + 5 + 5 = 25 marks) < Answer >
3. The volatility market gauges expectations for shifts in the Treasury yields and the yield curve. This is
the backbone of valuation of interest rate derivatives. In the above backdrop discuss the various
measures of sensitivities of interest rate derivatives.
(9 marks) < Answer >
4. One of the interest rate derivatives available to the CFO is swaptions. Explain how this product could
have been used by the Samintex for hedging the exposure.
(10 marks) < Answer >

Samintex Inc. is a manufacturer of electric switchgears, based in Boston. It has captured 3% market share in the
western states of USA. On a rainy evening of March 1991 when the company took off from a car garage of the
professor, retired from MIT, it would have been hard to fantasize today’s state of the company. The humble
beginning with the manufacturing of molded case circuit breaker has taken the company to a portfolio of 15
products spanning three factories in USA.
The miniature circuit breaker (MCBs) of Samintex is very popular in Mexico, Guatemala and Caribbean
countries. Currently, the company is struggling to get a foothold in European market. The air circuit breaker of
Samintex is cheap and gradually getting acceptance in Portugal and Luxemburg. However, the big guns of the
continent are yet to pay any attention towards Samintex. The business review of the company in last general
meeting pointed out two reasons for the same. First, it says that because of the high cost of fund, Samintex is
not in a position to conform to the quality standards of developed countries. Secondly, it points to the
geographical distance, which is forcing the margin to become narrower. The idea of setting up a manufacturing
unit somewhere in the continent was proposed in the meeting but the ‘Wise Man’ of the company disposed the

*
The above case is prepared only for the purpose of examination and not to illustrate either effective or
ineffective performance of the firm. The case contains real information adapted and combined with other
information to generate discussion or analysis on the desired topics.
idea in no time. His fundamental worry was whether to lock the fund and the fate in a foreign land. He
emphasized on strengthening the marketing network in the continent. However, the meeting ended in a note of
resolutions. The members pledged to start a stringent cost-cutting drive but at the same time they assured him
about meeting the quality standard of big names in European market. The CFO was reminded time and again
about the ballooning cost of funds.
As a matter of policy the company makes the foreign sales on a revolving and installment credit basis. Past
experience of the company has shown that the availability of credit is the fundamental factor in maintaining a
strong market position. This is truer now to enhance the product quality and penetrate into new markets.
Budgetary estimate of fresh requirement of marketing offices in the European continent is $100 million.
The volatility market, which gauges expectations for shifts in the Treasury yields and the yield curve, has seen
prices sliding to the lowest levels in three years and in some cases the lowest since 1998, the nightmare year of
Russian debt default and Long Term Capital Management hedge fund. The big question here is whether Federal
Reserve is raising official rates. Given the amount of doubt not only on the economy and pace of Fed
tightening, but also a pending U.S. presidential election and the threat of terrorism, strategists believe that the
relentless decline in actual and expected interest-rate volatility has perhaps gone too far. Much of the decline
reflects the widely-held view of the market that the Fed will, as promised, raise the rates at a steady pace, and
so far nothing has shaken that view.
With the current scenario the CFO is concerned for the ensuing rise in interest rate. He is aware that derivatives
would be the right instrument to battle with the vagaries of market. But the other day in one of the conferences,
where he was present as a delegate, he heard that interest rate derivatives are more difficult to be valued than
equity and foreign exchange derivatives. On October 01, 2004 the management of Samintex was looking for
the most desirable alternative to hedge the interest rate risk involved in short-term borrowing to finance the
working capital requirement. The total fund requirement is $100 million for three months in January 2005. A
London based bank has agreed to finance the requirement at 100 basis points over 3-month’s LIBOR. The
current 3-month LIBOR has been recently fixed at 2.25%. The management is considering the following
instruments to hedge the interest rate risk.
i. Forward Rate Agreement (FRA): A FRA is an agreement between two parties in which one of them
contracts to lend to the other, a specified amount of funds, in a specific currency, for a specified period
starting at a specified future date, at an interest rate fixed at the time of agreement. Entering into FRA can
act as a hedge against interest rate changes. A London based bank is quoting the following FRA:
US$ 3/6 months 2.00% – 2.50% p.a.
ii. 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 the pay off 3 months thereafter:
Face amount Exercise price Premium
$100 million 2.25% p.a $40,500 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 ends up below the agreed up on exercise price.
Management has identified following put option on 3-months LIBOR expiring in 3-months and the pay
off 3 months thereafter:
Face amount Exercise price Premium
$100 million 2.50% p.a $32,500 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 has identified a 3 months call on Eurodollar futures with a
strike price of 97.50 (futures price) carrying a premium of 25 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 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 98.10 (futures price) carrying a premium of 30 basis points.
In addition to these choices to the CFO, few other alternatives like caps/floors and swaptions are also available
but he did not consider them for technicalities. The management is interested in finding out the annualized cost
of the loan hedge through the above instruments for various interest rates and comparing these alternatives of
hedging to make decision in which scenario each alternative dominates the others.
END OF SECTION D

Section E : Caselets (50 Marks)

• • This section consists of questions with serial number 5 -
10.
• • Answer all questions.
• • Marks are indicated against each question.
• • Do not spend more than 80 - 90 minutes on Section E.
Caselet 1
Read the caselet carefully and answer the following questions:
5. The caselet states that the three most traded credit derivative instruments are total return swaps; credit
default swaps and credit spread options. What is a credit derivative? Explain the credit default swaps.
(9 marks)< Answer >
6. ‘Conversely an exotic option is some instrument that is more complex than the current frame of
reference.’ Three very popular exotic options are Asian options, Binary options and Barrier options.
Explain the pay-off with regard to these three variants.
(9 marks) < Answer >
In finance, a vanilla option is a type of derivative security. Though the term is very widely used throughout the
financial literature and the financial markets, it lacks a precise definition. Generally speaking a vanilla option is
a 'simple' option in some sense. e.g. a particular type of option may be described as vanilla if it is well-
established in the financial markets and is easy to trade - vanilla options typically have good liquidity at a wide
range of strike prices and maturities. Pricing models may also deliver closed-form solutions for the present
value of vanilla options. However the term the vanilla is almost always used in the context of where a more
complex or exotic option is being considered. Thus in one context a particular instrument may be considered to
be vanilla but exotic in another. A striking example is the following sequence of instruments each of which is
exotic compared to the preceding one in the list but rather vanilla compared to the succeeding:
Financial futures--> Interest Rate Swap--> European Swaption--> Bermudan Swaption --> Rollercoaster
Bermudan swaption.
(Note the first two of this are instruments without optionality, the term vanilla is applied to these too).
Calibration and hedging are key factors in determining which instruments are called vanilla. For example a
Bermudan swaption may be hedged by a collection of European swaptions. Thus a trader in the Bermudan
market is likely to think of European swaptions as the vanilla. Further a model developed to price Bermudan
options may be calibrated (i.e. have its parameters chosen) such that the model gives the same prices as those
found in the market for European swaptions. That is, the model takes the European prices as given and uses
them to determine a price for the more complex Bermudan product. Again the term vanilla describes the
European swaptions and exotic describes the Bermudan.
Even with the above caveats there are instruments almost universally termed vanilla in various markets. In the
foreign exchange and stock markets the most vanilla options are European call and put options. In the interest
rate market swaps and caps are the vanilla instruments, although the former does not actually involve any
optionality. European swaptions are sufficiently liquid to be called vanilla. The credit derivatives market is less
mature. Here the three most traded instruments are total return swaps; credit default swaps and credit spread
options. These are widely expected to become the mainstream vanilla products of the market in the coming
years.
Conversely an exotic option is an instrument that is more complex than the current frame of reference. The
term "third generation option" is also used somewhat frequently - it is not clear exactly as to which other
options would be placed in the first and second generations.
Caselet 2
Read the caselet carefully and answer the following questions:
7. ‘We are dealing with resurrection of commodity trading in Indian markets.’ What is the economic
significance of such an event?
(8 marks) < Answer >
8. ‘To protect the steel manufactures and consumers in volatile environments, it is essential to introduce
steel futures as a hedging mechanism.’ Describe the implications of introducing steel futures in India.
(8 marks) < Answer >
We are dealing with resurrection of commodity trading in Indian markets. If you are asked to pose the
similarity between gold and wheat, silver and soybeans, will you be able to guess whether we are grounding
them on luster, buying psyche, or trading opportunities? Well it is not narrow-minded thinking of trading in
everything. But believe it or not, there is a good market in the making, which is poised to take over,
interestingly, the all-time favorite stocks market.
In the global commodities market, steel is the largest commodity after oil. It has also been one of the most
volatile commodities during the 1990s. It is also a significant metal market lacking in price transparency and a
mechanism to hedge against price volatility. Besides, steel products are perceived as being inherently complex
and sold into equally complex regional markets. To protect the steel manufactures and consumers in these
volatile environments, it is essential to introduce steel futures as a hedging mechanism. Against this
background, the players in the recent past thought that consideration should be given to a traded forward
contract for steel. They are of the view that forward contracts have the potential to radically improve the
industry and the way its products are traded, marketed and sold.
In the recent past, the volatility of steel prices was more conspicuous. For instance, in the last 30 years,
fluctuations in prices are as much as 100 to 150% in the world markets. India produces only 3.3% of world
steel production of around 30 million tons and imports specialized steel. Hence, the steel market in India is
more vulnerable to volatility. Given the recent volatility in steel prices globally, the introduction of steel
futures, as a hedging mechanism, could not have happened at a better time. At this juncture, India’s Multi
Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDX) have taken
initiative in the global commodities market. The two exchanges are among the first in the world to introduce
trading in steel futures. In fact, for the global steel industry, a major revolution is on the card as it contemplates
the launching of futures contract on the London Metal Exchange (LME) and a number of similar non-
exchange-based entities. MCX assumes that the steel futures contracts will facilitate best price discovery,
hedging opportunity and benefits through standardized contracts. Moreover, uniformity and high quality norms
stipulated in the contracts will also ensure immense benefits to the industry. The Indian steel industry is
growing as witnessed by the recent volatility in the prices. The beneficiaries of this upswing are integrated steel
players like Tisco, Steel Authority of India Ltd. (SAIL) and Jindal Steel and Power Ltd. (JSPL).
Caselet 3
Read the caselet carefully and answer the following questions:
9. ‘Strangely, when applied to the quest for the Holy Scale, standard deviation loses its appeal found in
portfolio theory.’ Elucidate.
(7 marks) < Answer >
10. ‘VaR does not measure "event risk" like – market crash risk. That is why portfolio stress tests are
recommended to supplement VaR.’ Elaborate why stress testing is a critical component of effective risk
management.
(9 marks) < Answer >
Value at Risk ("VaR") is much on the minds of risk managers and regulators these days, because of the promise
it holds for improving risk management. It is common to hear the question being asked, could VaR have
prevented Barings, or Orange County, or Sumitomo. VaR is an estimate of the level of loss on a portfolio
which is expected to be equaled or exceeded with a given, small probability. But, some prefer to define it like –
A number invented by purveyors of panaceas for pecuniary peril intended to mislead senior management and
regulators into false confidence that market risk is adequately understood and controlled.
Folklore (if it is fair to attribute as folklore that which only dates back to five years) tells us that VaR was
developed to provide a single number which could encapsulate information about the risk in a portfolio, could
be calculated rapidly and communicated to nontechncial senior managers. Tall order and not one that could be
delivered upon without compromises.
Portfolio Theory, as taught in business schools, tells us that the risk in a portfolio can be proxied by the
portfolio standard deviation, a measure of spread in a distribution. Strangely, when applied to the quest for the
Holy Scale, standard deviation loses its appeal found in portfolio theory. An alternative measure of risk was
therefore required. Why not measure the spread of returns, then, by estimating the loss associated with a given,
small probability of occurrence. Higher spread, or risk, should mean a higher loss at the given probability. Then
senior management can be told that there is, say, 1 in 100 chance of losing X rupees over the holding period.
Not only is this intuitively appealing, but it's easy to show that when returns are normally distributed
(symmetric), the information conveyed is exactly the same as when standard deviation is employed; it's just
that the scale is different. This approach can be consistent with portfolio theory. Then it seems, that perhaps the
Holy Scale has been found in VaR.
It seems that VaR is being used for just about every need; risk reporting, risk limits, regulatory capital, internal
capital allocation and performance measurement. Yet, VaR is not the answer for all risk management
challenges.
No theory exists to show that VaR is the appropriate measure upon which to build optimal decision rules. VaR
does not measure "event risk" like – market crash risk. That is why portfolio stress tests are recommended to
supplement VaR. VaR does not readily capture liquidity differences among instruments. That is why limits on
both tenors and option greeks are still useful. VaR doesn't readily capture model risks, which is why model
reserves are also necessary.
Because VaR does not capture all relevant information about market risk, its best use is as a tool in the hands of
a good risk manager. Nevertheless, VaR is a very promising tool; one that will continue to evolve rapidly
because of the intense interest in it by practitioners, regulators and academicians.
END OF SECTION E

END OF QUESTION PAPER

 Suggested Answers
Financial Risk Management – II (232)
Section D : Case Study

1. Interest rate derivatives are instruments whose payoffs are dependent in some way on the level of interest
rate. Interest rate derivatives are more difficult to value than equity and foreign exchange derivatives. There
are a number of reasons for this:
• • The behavior of an individual interest rate is more complicated than that of stock price or an
exchange rate.
• • For the valuation of many products, it is necessary to develop a model describing the
behavior of the entire zero-coupon yield curve.
• • The volatilities of different points on the yield curve are different.
• • Interest rates are used for discounting as well as for defining the payoff from the derivative.

< TOP >

2. a. The company should buy US$ 3/6 months FRA at 2.50%.
LIBOR Cost of borrowing Cash out flow due to FRA* Total cash out flow Annualized cost
($ mln.) ($ mln.) ($ mln.)
LIBOR

LIBOR
1.50% 0.6250 0.2500 0.8750 3.5%
1.75% 0.6875 0.1875 0.8750 3.5%
2.00% 0.7500 0.1250 0.8750 3.5%
2.25% 0.8125 0.0625 0.8750 3.5%
2.50% 0.8750 – 0.8750 3.5%
2.75% 0.9375 –0.0625 0.8750 3.5%
3.00% 1.0000 – 0.1250 0.8750 3.5%
3.25% 1.0625 –0.1875 0.8750 3.5%
* 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 3.5% 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 2.25%
 LIBOR Cost of borrowing Call Pay off from call Premium Total cost Annualized
($ min.) Exercised ($ min.)
Cost
1.50% 0.6250 No – 0.0405 0.6655 2.662%
1.75% 0.6875 No – 0.0405 0.7280 2.912%
2.00% 0.7500 No – 0.0405 0.7905 3.162%
2.25% 0.8125 No – 0.0405 0.8530 3.412%
2.50% 0.8750 Yes –0.0625 0.0405 0.8530 3.412%
2.75% 0.9375 Yes –0.1250 0.0405 0.8530 3.412%
3.00% 1.0000 Yes –0.1875 0.0405 0.8530 3.412%
3.25% 1.0625 Yes –0.2500 0.0405 0.8530 3.412%
So we see that if LIBOR rises above 2.25%, it can look into a maximum interest cost of 3.412%. However,
there is a potential of lower cost of funds if LIBOR falls below 2.25%
c. To hedge the interest rate risk the company has to sell the put option at strike price 2.50%
LIBOR Cost of borrowing Put Pay off from call Premium Total cost Annualized
($mln.) Exercised ($ mln.)
Cost
1.50% 0.6250 Yes 0.2500 – 0.0325 0.8425 3.370%
1.75% 0.6875 Yes 0.1875 – 0.0325 0.8425 3.370%
2.00% 0.7500 Yes 0.1250 – 0.0325 0.8425 3.370%
2.25% 0.8125 Yes 0.0625 – 0.0325 0.8425 3.370%
2.50% 0.8750 No – – 0.0325 0.8425 3.370%
2.75% 0.9375 No – – 0.0325 0.9050 3.620%
3.00% 1.0000 No – – 0.0325 0.9675 3.870%
3.25% 1.0625 No – – 0.0325 1.0300 4.120%
So here company can lock in the minimum borrowing cost of 3.370%. However, there is possibility of
increasing borrowing cost if LIBOR goes above 2.50%.

d. d. To hedge the interest rate risk the company has to sell call on eurodollor futures contract. The
company has to sell to 100 call options.
Strike price = 97.50
Premium = 25bp × $25 × 100
= $62500 or $0.0625 million
LIBOR Futures Call Payoff Premium Cost of Total Annualized
price Exercised from call ($ min.)borrowing ($ cost
min.) Cost
1.50% 98.50 Yes 0.25 – 0.0625 0.6250 0.8125 3.25%
1.75% 98.25 Yes 0.1875 – 0.0625 0.6875 0.8125 3.25%
2.00% 98.00 Yes 0.125 – 0.0625 0.7500 0.8125 3.25%
2.25% 97.75 Yes 0.0625 – 0.0625 0.8125 0.8125 3.25%
2.50% 97.50 No – – 0.0625 0.8750 0.8125 3.25%
2.75% 97.25 No – – 0.0625 0.9375 0.8750 3.50%
3.00% 97.00 No – – 0.0625 1.0000 0.9375 3.75%
3.25% 96.75 No – – 0.0625 1.0625 1.000 4.00%
So here company can lock in the minimum borrowing cost of 3.25% if it expects interest rate will not rise
 beyond 2.50%. In case it increases beyond 2.50%, cost of borrowing will also go up.
e. To hedge the interest rate risk the company has to buy put on eurodollar futures contract. The
company has to buy 100 put options
Strike price = 98.10
Premium = 30bp × $25 × 100 = $75000 or $ 0.075 million.
LIBOR Futures Put Exercised Payoff Premium Cost of Total Annualized
price from put ($ min) borrowing ($ cost
min) Cost
1.50% 98.50 No – 0.0750 0.6250 0.7000 2.80%
1.75% 98.25 No – 0.0750 0.6875 0.7625 3.05%
2.00% 98.00 Yes –0.0250 0.0750 0.7500 0.8000 3.20%
2.25% 97.75 Yes – 0.0875 0.0750 0.8125 0.8000 3.20%
2.50% 97.50 Yes – 0.1500 0.0750 0.8750 0.8000 3.20%
2.75% 97.25 Yes – 0.2125 0.0750 0.9375 0.8000 3.20%
3.00% 97.00 Yes – 0.2750 0.0750 1.0000 0.8000 3.20%
3.25% 96.75 Yes – 0.3375 0.0750 1.0625 0.8000 3.20%
So here we see that maximum cost of borrowing is locked at 3.20% for LIBOR risen to any level above
1.90%. For LIBOR below 1.90%, there is a possibility of lower cost of borrowing.
< TOP >

3. One of the important measures of sensitivity is delta risk. It is associated with shift in the zero coupon yield
curve (ZCYC). As there are many ways in which the zero curve can shift, many alternative deltas can be
calculated. Some of the alternatives are:
• • Computation of impact of a one-basis point parallel shift in the ZCYC. This is called DV01.
• • Computation of the impact of small changes in the quotes for each of the instruments used to
construct the ZCYC.
• • In this method the ZCYC is divided into a number of sections. Now, the sensitivity is
computed as impact of shifting the rates in one section by one basis point, keeping the rest of the
initial term structure unchanged.
In practice, the traders tend to prefer the second approach. They argue that the only way the zero curve can
change is if the quote for one of the instruments used to compute the ZCYC changes. They therefore feel
that it makes sense to focus on the exposures arising from changes in the prices of these instruments.
Another very important measure sensitivity for interest rate derivatives is gamma. When several delta
measures are calculated, there are many possible gamma measures. Suppose that ten instruments are used
to compute ZCYC and that we measure deltas with respect to changes in the quotes for each of these.
Gamma is a second partial derivative. So, we would get total 55 measures of gamma. This may be more
than the trader can handle. So, most of the cases cross-gammas are ignored and focus on the 10 (for ten
instruments) partial derivatives.)
< TOP >
4. Swaptions or Swap Options are options on interest rate swaps and are increasingly popular type of interest
rate option. They give the holder the right to enter into a certain interest rate swap at a certain time in
future. Many large financial institutions that offer interest rate swap contracts to their corporate clients are
also prepared to sell them swaptions from them.
In the given case the company would borrow three months hence for three months. Normally, this working
capital advances are rolled over. Once it runs for a longer period, it would appear like a long-term floating
rate bond. The company is exposed to increase in LIBOR or benchmark rate. To protect itself from the
vagaries of unfavorable market movement it should take a fixed rate contract. However, there too it is
exposed to lowered benchmark rate. It can go for a interest rate swap but that would not protect it from
 interest rate risk. Here comes the role of swaptions.
To give an example of how a swaptions might be used, consider the company knows that in three months it
will enter in to five-year floating rate loan agreement and knows that it will wish to swap the floating
interest payments for fixed interest payments to convert the loan into fixed rate loan. At a cost, the company
could into a swaptions giving it the right to receive 3-month LIBOR and pay a certain fixed rate of interest,
say 2.5% per annum, for a five-year period starting in three months. If the fixed rate exchanged for floating
on a regular five-year swap in three months turns out to be less than 2.5% per annum, the company will
choose not to exercise the swaption and will enter into swap agreement in the usual way. However, if it
turns out to be greater than 2.5% per annum, the company will choose to exercise the swaptions and will
obtain a swap at more favorable terms than those available in the market. With a swaptions, the company is
able to benefit from favorable interest rate movements while acquiring protection from unfavorable interest
rate movements.
< TOP >
Section E: Caselets
Caselet 1

5. A Credit Derivative is a contract to transfer the risk of the total return on a credit asset falling below an
agreed level, without transfer of the underlying asset. This is usually achieved by transferring risk on a
credit reference asset. Early forms of credit derivative were financial guarantees. Some common forms of
credit derivatives are total return swap; credit default swap and credit spread options. The idea of credit
derivatives is to avoid direct ownership of the securities referenced in the transaction.
The Credit default swap or CDS has become the main engine of the credit derivatives market, offering
liquid price discovery and trading on which the rest of the market is based. It is an agreement between two
counterparties that allows one counterparty to be “long” a third party credit risk, and the other counterparty
to be “short” the credit risk. Explained another way, one counterparty is selling insurance and the other
counterparty is buying insurance against the default of the third party.
For example, suppose that two counterparties, a market maker and an investor, enter into a two-year credit
default swap. They specify what is called the reference asset, which is a particular credit risky bond issued
by a third-party corporation or sovereign. For simplicity, let us suppose that the bond has exactly two years’
remaining maturity and is currently trading at par value.
The market maker agrees to make regular fixed payments (with the same frequency as the reference bond)
for two years to the investor. In exchange the market maker has the following right. For simplicity we
assume that default can occur only at discrete times, namely, at the times the coupon payment is due. If the
third party defaults at any time within that two years, the market maker makes his regular fixed payment to
the investor and puts the bond to the investor in exchange for the bond’s par value plus interest. The credit
default swap is thus a contingent put – the third party must default before the put is activated.
< TOP >

6. Asian Options
These are options whose pay-off depends on the average price of the underlying asset during a prespecified
period of the life of the option. Assume that you have bought an Asian call option on a stock at strike price
X. The average of the stock prices of the option during a particular period of option life is S a then the pay-
off from this option is max (0, Sa – X). Similarly, if you buy an Asian put option then the pay off is max (X
– Sa, 0). The pay-off of an Asian option depends on the averaging period.
Asian options are used to avoid manipulation of the prices of the options on the underlying asset by the
traders of the options, which might turn harmful to the issuer of the underlying asset. If you own options on
the underlying asset by the traders of the options, which might turn harmful to the issuer of the underlying
asset. If you own options on a firm’s shares and if the pay-off depends on the price of the shares on a
particular day then you can manipulate the price of the firm’s shares on that particular day and can ensure a
better pay-off. If the pay-off is determined on the average price of the shares over a particular period of
time, say 60 days, the price manipulation may not be possible and hence you have a limited profit potential
 in this case and this will not affect the issuer.
Barrier Options
These are the options whose pay-off depends on whether the underlying asset price reaches a certain level
during a certain period of time.
These are numerous variations on barrier options. A barrier option may be a knock in or a knock out option.
A knock in option is one that comes into existence only when the underlying asset price reaches a certain
barrier. A knock out option is one that ceases to exist when the underlying asset price reaches a certain
barrier. Barrier options are cheaper than the plain vanilla options.
Assume that you purchase a knock out put option with both strikes price and exercise price equal to 40 and
knock out boundary (H) = 4.5. If during the life of the option the stock price never rises about 45 then pay-
off will be equal to max (0, X – St). If S rises above 45 the put is cancelled and the put buyer receives the
rebate R irrespective of the stock price on the expiration date.
Binary Options
These are options, which have discontinuous pay offs. For instance, a cash or nothing call pays off nothing
if stock price is below the strike price and pays a fixed amount say, Q if the stock price rises above the
strike price.
Assume that you buy a binary call option at strike price $50, and if on the expiration date the stock price
turns out to be $45, then the pay-off is zero. If the stock price turns out to be $55 then the pay-off will be a
fixed amount Q irrespective of the value of the stock price.
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Caselet 2
7. From the economic necessity point of view also, in India, the significance of such trading can be
understood from the fact that the Indian economy, direct and derived through industries, is mostly
dependent on agricultural produce. The commodity market already occupy a lion’s share, and with the
availability and increased interest in futures trading in commodities the market share will improve further.
It will not only provide liquidity to the market but development of such futures contract will also lead to
better risk management strategies and practices.
These contracts carry out two vital tasks, discovery of prices for exchange traded commodities and
management of price-related risks. Through active presence exchanges, price consistency and improved
demand and supply situation in an economy is maintained. Particularly, in India with the governmental
control slowly coming to an end, commodity prices are more market dependent. It necessitates the presence
of such exchanges and prevalent interest in exchange traded commodities futures.
The bouncy bourses are quite notorious for shading the returns into nightmares. In the present scenario,
when stock markets are not showing much movement it is prudent to park money with commodity futures.
If convergence could be established it would provide better risk coverage and opportunity to earn better risk
adjusted returns. The commodity futures will also invite a new stream of investors in the investment sea.
These new investors will unfurl new trading and business opportunities.
Though commodities market in India is in the nascent stage it has to cross several milestones before
establishing its identity and getting a space in the dailies. Being an agricultural-driven economy, the
beneficiaries of the commodity futures trading are more the general population than a handful of traders.

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8. Experience shows that the introduction of futures contract on certain industries creates an opportunity to
consolidate. Open exchange price and related transfer pricing make vertically integrated businessless risky.
Besides, the open exchange price allows the whole industry to share the risk. Analysts say that if steel
futures are a success, some companies could become specialist slab or billet producers, as others strengthen
their downstream operations. They further say that it will therefore be easier for companies to specialize in
what they are good at. However, if companies do not use futures contracts, there will be lack of liquidity or
traction in the market and the concept will simply fail. Majority of players are of the view that significant
difficulties are associated with achieving this link via replicating the provision a terminal market (with
 multiple-location warehousing) model for the steel industry.

The goal steel industry is witnessing a growing demand from steel market participants for more versatile
and effective price risk management tools from those currently available to the industry. The driving forces
behind this requirement are, on one hand, increasing steel price volatility and high cost of capital. However,
on other hand, limited and decreasing adequacy effectiveness of existing price hedging practices. As the
Indian steel industry is growing at a rapid pace and the recent volatility in the prices in the spot market, the
introduction of MCX steel futures could insulate the players from this volatility. Besides, these initiatives
will provide the industry participants with an immense hedging and investment opportunity.
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Caselet 3
9. The Modern Portfolio Theory (MPT) states, standard deviation is all one needs to know in order to
encapsulate all the information about risk that is relevant, and construct risk-based rules for optimal risk
"management" decisions. But, in practice the use of standard deviation of returns is not really meeting
utilities of the portfolio managers.. Few of the several reasons for the same are as follows:
(1) (1) Managers think of risk in terms of rupees of loss, whereas standard deviation defines risk in terms
of deviations, either above or below, expected return and is therefore not intuitive. It can be debated
whether deviation above should form part of risk measurement.
(2) (2) In trading portfolios deviations of a given amount below the expected return do not occur with the
same likelihood as deviations above, as a result of positions in options and option-like instruments,
whereas the use of standard deviation for risk management assumes symmetry. In short, non-linearity
comes into play due to contingent claims and it can be strongly argued about the roles of higher level
moments (like skewness, kurtosis etc.) in the complete coverage of one’s portfolio risk.
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10. Although the lessons from actual market shocks all point to the need for stress testing one’s portfolio. The
inherent nature of risk management makes stress testing imperative:
• • Risk measures are based on historical assumptions that include distributions of volatilities and
correlations, continuous prices, and adequate liquidity. Such measures are practical and useful under
normal market conditions and serve as the base case for daily management dialogue and decisions about
risks. However, they fail in extreme market moves or distress conditions. For example, VaR calculations
for market risks are typically based on up to three deviations. They are also based on limited historical
data. As we know, market shocks far exceeding three standard deviations are not uncommon. Hence the
fact that such risk measures are used to make it imperative that testing to a routine supplementary
process.
• • Business lines are necessarily biased toward likely events. They identify opportunities, serve client
needs, and make prices and decisions based on expected market moves. Stress testing focuses on what
can go wrong, the highly unlikely but severe events. Together, the institution can maximize business
opportunities while reducing the likelihood of financial distress. It also helps the institution to be
resilient in different in different market conditions.
• • Regulators, rating agencies and investors worry about catastrophic losses and restrictions in the
ability of institutions to do business in distressed market conditions. Their understanding of what
effective management requires is increasingly sophisticated. They expect to see a disciplined process of
stress testing. Liquidity risks, systematic risks, and ultimately solvency are to of mind. Merely
complying with capital requirements does not provide adequate comfort. When these constituencies are
uncertain, they generally overpenalize institutions through ratings or stock valuation multiples.
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