Assignment Code: MFP-002/TMA/JAN/2023

Course Code: MFP-002

Assignment Name: Equity Derivatives

Year: 2023

Verification Status: Verified by Professor

1. What are ‘Derivatives’? Explain the various types of derivatives and discuss their uses and applications.

Ans) Derivatives are financial instruments that derive their value from an underlying asset, such as stocks, bonds, commodities, currencies, or indices. They are contracts between two parties, where the value of the contract is determined by the price of the underlying asset.

There are several types of derivatives, including:

1. Futures: Futures contracts are agreements to buy or sell an underlying asset at a predetermined price and time in the future. They are standardized contracts that trade on exchanges and are commonly used by investors and traders to hedge against price fluctuations or to speculate on market movements.

2. Options: Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and time. They are used for hedging and speculation and can be either call options (the right to buy) or put options (the right to sell).

3. Swaps: Swaps are agreements between two parties to exchange cash flows based on different variables, such as interest rates, currencies, or commodities. They are used for hedging, as well as for accessing new markets or financing sources.

4. Forwards: Forwards are agreements to buy or sell an underlying asset at a predetermined price and time in the future. Unlike futures, they are not standardized contracts and are traded over the counter (OTC). They are commonly used for hedging and customized investment strategies.

Derivatives are widely used by investors and traders for various purposes, such as:

1. Hedging: Derivatives can be used to hedge against price fluctuations of the underlying asset, which helps to reduce risk.

2. Speculation: Derivatives can also be used for speculation, where investors try to profit from price movements of the underlying asset.

3. Arbitrage: Derivatives can be used for arbitrage, where investors take advantage of price discrepancies between different markets or instruments.

4. Accessing New Markets or Financing Sources: Derivatives can provide access to new markets or financing sources, such as foreign currencies or commodities.

5. Customized Investment Strategies: Derivatives can be used to create customized investment strategies that meet specific investment objectives.

However, derivatives can also be complex and risky, and their use requires careful consideration of the risks and benefits. Derivatives can amplify losses as well as gains and can lead to financial instability if not used appropriately. Therefore, it is important for investors to have a thorough understanding of derivatives and their applications before using them in their investment portfolios.

2. What is Hedging? What are the various inefficiencies persisting in the process of hedging?

Ans) Hedging reduces or eliminates price risk for investors and companies. Hedging is insurance. Hedging is buying a derivative or other similar asset or security to lessen the chance of a loss. A commodity producer could hedge against falling prices by shorting futures. A portfolio manager could hedge against a market decline by buying put options on a stock index. Despite its potential for risk management, hedging can be inefficient. These inefficiencies can include the following:

1. Cost: Hedging can be costly, as it involves transaction fees, margin requirements, and other expenses associated with buying or selling derivatives.

2. Basis Risk: Basis risk refers to the risk that the hedge may not perfectly offset the risk of the underlying asset, leading to potential losses.

3. Liquidity Risk: Hedging can also involve liquidity risk, as some derivative markets may be illiquid or subject to sudden price movements.

4. Counterparty Risk: Hedging often involves entering into contracts with counterparties, which exposes the investor to counterparty risk, or the risk that the counterparty may default on their obligations.

5. Complexity: Derivatives can be complex instruments, and the process of hedging may require specialized knowledge and expertise.

6. Over-hedging or Under-hedging: Hedging can lead to over-hedging or under-hedging if the investor does not accurately assess the risk exposure of their portfolio.

Overall, hedging can be an effective risk management tool, but investors should carefully consider the potential inefficiencies and risks before engaging in hedging activities. It is important to strike a balance between the costs and benefits of hedging, and to regularly monitor and adjust the hedge as market conditions change.

3. What are Futures? Explain the process of price adjustments of futures when dividend or bonus shares are paid out.

Ans) Futures are standardized contracts that obligate the buyer to purchase an underlying asset at a specific price and time in the future and obligate the seller to sell the asset at that price and time. Futures contracts are traded on organized exchanges, and the price of the futures contract reflects the expected future price of the underlying asset. When a company pays a dividend or issues bonus shares, the price of the underlying stock is affected, which can in turn affect the price of the futures contract. The process of price adjustments in futures contracts due to dividends or bonus shares is known as "adjustment for corporate actions." There are two main types of adjustments that can be made to futures prices for dividends or bonus shares:

1. Price Adjustments for Dividends: When a company pays a dividend, the price of the underlying stock usually decreases by the amount of the dividend. To reflect this decrease in price, the futures price is adjusted downwards by the amount of the dividend. For example, if a stock is trading at $100 and pays a $2 dividend, the futures price will be adjusted downward by $2 to reflect the decrease in the stock price.

2. Price Adjustments for Bonus Shares: When a company issues bonus shares, the price of the underlying stock usually decreases because the total value of the company is divided among a larger number of shares. To reflect this decrease in price, the futures price is adjusted downward by a factor that reflects the increase in the number of shares outstanding. For example, if a company issues a 1-for-10 bonus share, the number of shares outstanding will increase by 10%, and the futures price will be adjusted downward by 10% to reflect the decrease in the stock price.

It is important to note that the adjustment for corporate actions in futures contracts is standardized and follows a predetermined formula set by the exchange. This ensures that all market participants are treated fairly and that the futures price accurately reflects the value of the underlying asset after the corporate action.

4. What is an ‘Option’? What are the factors taken into consideration for determining call option prices?

Ans) An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) on or before a specified date (expiration date). Options are commonly used for speculation or hedging purposes. Call options are a type of option that give the holder the right to buy the underlying asset at the strike price. The price of a call option is determined by several factors, including:

1. The Current Market Price of the Underlying Asset: The higher the market price of the underlying asset, the more valuable the call option becomes, as the holder has the right to buy the asset at a lower price.

2. The Strike Price: The lower the strike price, the more valuable the call option becomes, as the holder has the right to buy the asset at a lower price.

3. The Time to Expiration: The longer the time to expiration, the more valuable the call option becomes, as there is more time for the market price of the underlying asset to increase above the strike price.

4. The Volatility of the Underlying Asset: The higher the volatility, the more valuable the call option becomes, as there is a greater chance that the market price of the underlying asset will increase above the strike price.

5. Interest Rates: Higher interest rates reduce the value of the call option, as the holder could earn more by investing in a risk-free asset.

6. Dividends: Higher dividends reduce the value of the call option, as the holder does not receive any dividends on the underlying asset.

5. Explain the following:

(i) Delta

Ans) Delta is a term used in finance to measure the sensitivity of the price of an option to changes in the price of the underlying asset. It is one of the main Greeks, or risk parameters, used in options trading. Delta is defined as the rate of change of the option price with respect to changes in the price of the underlying asset. It is expressed as a number between -1 and 1, where a delta of 1 means that the option price will increase by $1 for every $1 increase in the price of the underlying asset, and a delta of -1 means that the option price will decrease by $1 for every $1 increase in the price of the underlying asset.

For call options, the delta is positive, and ranges from 0 to 1. A delta of 0 means that the option price will not increase at all in response to an increase in the price of the underlying asset. A delta of 1 means that the option price will increase by the same amount as the increase in the price of the underlying asset. For put options, the delta is negative, and ranges from -1 to 0. A delta of -1 means that the option price will increase by the same amount as the decrease in the price of the underlying asset. A delta of 0 means that the option price will not increase at all in response to a decrease in the price of the underlying asset. Delta can be used by options traders to manage their risk exposure to the underlying asset. For example, a trader who is bullish on the underlying asset might buy call options with a high delta, while a trader who is bearish on the underlying asset might buy put options with a high delta. Delta can also be used in hedging strategies to offset the risk of changes in the price of the underlying asset.

(ii) Gamma

Ans) Gamma is another Greek parameter used in options trading to measure the rate of change of an option's delta with respect to changes in the price of the underlying asset. It is an important risk parameter that helps traders manage the dynamic risk exposure of their options positions. Gamma is positive for both call and put options, and it increases as the option approaches the expiration date. It is typically highest for at-the-money options and decreases as the option moves further in or out of the money. Gamma can be used by traders to adjust their positions as the market conditions change. For example, if a trader holds a long call option position with a high gamma value, they can use this information to estimate that the value of their position will increase rapidly if the price of the underlying asset rises sharply. In this case, the trader may choose to adjust their position by buying more call options or by selling put options to limit their risk exposure.

Gamma is an important tool for managing the risk exposure of options positions, but it is not without limitations. One of the main inefficiencies of using gamma as a risk parameter is that it assumes a continuous change in the price of the underlying asset, which may not be the case in real-world trading scenarios. Additionally, gamma values can change rapidly as the option approaches expiration, which can make it difficult for traders to manage their risk exposure effectively. Overall, however, gamma is an important risk parameter that is widely used by options traders to manage their risk exposure and optimize their trading strategies.