Question Paper

Financial Risk Management – II (232) : April 2005

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. What is a Forward Rate Agreement (FRA)? Explain the benefits of hedging through FRA. How do you
compare the hedge with Eurodollar futures and a FRA?
(10 marks) < Answer >
2. Assume that the month-end closing of different Eurodollar futures contracts are as follows:
September December
Month-end June Futures
Futures Futures
June 97.48 97.15 96.94
September – 97.06 96.88
December – – 96.81
a. Explain how the company
can hedge interest rate risk through the Eurodollar futures. Also calculate the effective return from
the deposit if 6-month LIBOR in July turns out to be 2.85%.
b. If the company wishes to capitalize on the rising interest rate scenario during the period July 2005 to
December 2005, what are the different strategies using Eurodollar futures the company may adopt?
Explain.
(8 + 7 = 15 marks) < Answer >
3. Calculate the effective return from the deposit when covered through the FRA if 6-month LIBOR turns
out to be 2.85% or 3.60% in July, 2005 showing all the relevant cash flows.
(8 marks) < Answer >
4. If Mr. Synster decides to convert $50 million into euro, at spot rate in July, 2005 then calculate the daily
value-at-risk (VaR) at 95% confidence level for the euro spot position in July, 2005 if expected spot price
in July, 2005 is $/Euro 1.3045 and annual standard deviation of $/Euro exchange rate is 7.20%. (Assume
250 trading days in a year)
(7 marks) < Answer >
5. Discuss in brief the various approaches to risk management that a firm can adopt.
(10 marks) < Answer >
Madison Oil Corporation (MOC), headquartered in Pennsylvania, is engaged in petroleum exploration,
manufacturing of petroleum exploration related equipments, provide various services related to oil and
petroleum industry including consultation, to integrated power and petroleum companies in the United States
and abroad. In 2004, MOC’s sales reached about $5 billion, of which oil and petroleum production, accounted
for 75 percent of worldwide sales, equipment and supplies accounted for 20 percent, and energy related
services such as consulting and transportation accounted for 5 percent of sales. MOC’s performance ratios
show that rate of return on shareholder’s investment averaged 12 percent in 1990’s, which has been almost
doubled at 23% in 2000’s.
In recent years, the company is engaged in several large onshore and offshore petroleum exploration projects in
Southern Europe, Southeast Asia and Southern Asia. These projects were promoted and financed primarily by
multilateral and regional economic and financial institutions, including the World Bank, in conjunction with the
respective country.
The CEO of MOC, Mr. Harold Brown, was approached at a recent international petroleum conference in
London by the oil and petroleum minister of Greece, offering MOC the opportunity to participate in an
international consortium to construct an offshore petroleum production facility in Greece. MOC was expected
to put up around $100 million for the project costs over 3 years, but would be given the option of converting its
credit into equity after the second year of operation by acquiring the production facility’s common shares at a
discount of 25 percent from the prevailing market price.
During the preliminary discussions between the CFO of MOC Mr. Synster and Greece government officials,
and according to the investment prospectus that was issued by a European investment bank, it was estimated
that the construction of the project could cost $700-$750 million, of which $400-$450 million was expected to
be in local currency euro.
MOC’s Board of Directors was briefed on several preliminary details of the offshore petroleum production
facility and the request to participate in the project. A board member – oil and petroleum industry expert and a
former chief economist for a Fortune 500 global oil company - recently visited Greece and was impressed by
their progress in the project. Subsequently, the board recommended a thorough review of the proposed project,
with the objectives of (i) determining under which terms and conditions MOC should join the international
consortium and (ii) whether an investment in the proposed project is viable considering different alternative
opportunities available at the present scenario.
The CFO Mr. Synster and his team were instructed to travel to Greece and obtain all relevant details
concerning the proposed investment. After returning from Athens, Mr. Synster presented the details of
commitment required for the project, and the Board of Directors accepted the project and decision was taken to
sign the MOU with the Greece government.
According to the commitment made by Mr. Synster, MOC has to infuse euros equivalent to $ 50 million in
December 2005. As on April 06, 2005 Mr. Synster is expecting to generate surplus fund of $ 50 million at the
beginning of July 2005. He wants to keep this fund aside for the project, and decided to invest in LIBOR based
deposit with a Monaco based bank in July, for five months maturing in December, so that this fund can be
utilized for the project. The Monaco based bank has quoted 6-month LIBOR plus 75 basis points for the five
months deposit at the 6-month LIBOR rate prevailing in July 2005. However, Mr. Synster thinks that the
Eurodollar interest rates will decline within July, thus reducing the earnings from the deposit. So he is
considering to hedge the fall in interest rate by using either Eurodollar futures contract or a FRA quoted by a
London based bank.
The following rates are observed by Mr. Synster on April 06:
Exchange rates
$/Euro Spot 1.3032/35
September Forward 30/35
Interest rates
Current 3-month US$ LIBOR 2.78%
Current 6-month US$ LIBOR 3.02%
Eurodollar Futures
June 97.20
September 96.97
December 96.78
FRA quoted by a London based bank
US$ 3/8-months 3.50% / 3.75%
END OF SECTION D

Section E : Caselets (50 Marks)

 • This section consists of questions with serial number 6 - 12.
• 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:
6. Compare LEAPS with standard options.
(6 marks) < Answer >
7. Discuss the benefits of investing in LEAPS.
(7 marks) < Answer >
8. Discuss the various risks faced by the LEAPS investors.
(7 marks) < Answer >
Options are one of the seven wonders in the investment world and remaining six are option products. These are
capable of immense mathematical and investment manipulations and almost any investment scenario can be
replicated by combinations of these options. Interestingly, they not only complete the market but have also
created a market of their own. That is why we have more innovations in the options market than in any other
market today.
Long-term Equity Anticipation Securities (LEAPS) are option products with a maturity longer than
conventional options. Having a maturity period of two or more years is common. It provides investors an
opportunity to enlarge their selection base. Similar to a conventional option, an Equity LEAPS (call or put) is
traded at a premium and the holder has the right to buy (call) or sell (put) and the writer has an obligation to
honor it.
Two distinct advantages are available because of longer maturity periods. Firstly, compared to conventional
options which are more of a wasted asset in a short span of time, it is more soothing to invest in LEAPS.
Secondly, price of the underlying can be locked for a longer duration and it is easier to take a long-term view
on the underlying. Therefore, it facilitates for a long-term strategy.
Since other features of LEAPS are common to conventional options, trading strategies are similar. But one
important thing is the impact of time on premium. The premium reduces at a lesser rate in case of LEAPS than
conventional options that shift to some extent the choice of going long than going short, the reason being the
extended maturity. Therefore, speculation of shorting that is favored due to the time factor is eliminated. So,
option strategies involving shorting of the options takes a back seat here. Again, because of the time factor
LEAPS are more sensitive to dividends and interest rates. LEAPS, like options, are available on stocks as well
as on indices.
LEAPS was first introduced by the Chicago Board of Option Exchange (CBOE) in 1990. Since then it has
become inevitable to any of the investment strategies. It was started for countable stocks. Their popularity
incited other derivative exchanges to list LEAPS and the stock and indices list got soon enlarged. LEAPS are
listed on exchanges like Chicago Board of Option Exchange Inc. (CBOE), Philadelphia Stock Exchange Inc.
(PHLX), The American Stock Exchange Inc. (AMEX), Pacific Exchange Inc. (PCX), etc. LEAPS are,
however, not available in India.
Similar to conventional options, LEAPS constitute puts and calls. That gives the holder the right to buy an
underlying (LEAPS call) and the right to sell (LEAPS put) at a strike price by paying a premium. For starting a
trade with LEAPS, four of the given specifications are required the type (i.e. "put or call"), underlying security,
exercise price and the expiration. The features are common to a conventional option, the only difference being
standardization of the exercise price and expiration which is longer.
Equity LEAPS are American i.e., they may be exercised any time before expiration. Index LEAPS are
European as well as American. Terms like in-the-money, out-of-the-money, at-the-money, put-call parity etc.
are also shared by LEAPS. Premium, therefore, depends on the same factors affecting the premium of an
option. These are price of the underlying, exercise price, expiration, volatility, risk free rate and dividend on the
underlying. However, impact and influence of these parameters on LEAPS are considerably different. Investors
need to analyze these parts very carefully.
 Caselet 2
Read the caselet carefully and answer the following questions:
9. The caselet states that journey of derivatives in India started with introduction of index futures. Discuss
the benefits of index derivatives to India’s financial markets.
(7 marks) < Answer >
10. What are the measures that could be taken by both the regulators and investors to improve the current
state of affairs of the Indian derivatives market?
(9 marks) < Answer >
Given the phenomenal growth of the stock market in India, in recent times and its emergence as one of the
favorite investment destinations on the radar of the Foreign Institutional Investors (FIIs), there is no denying
that Sebi's achievements so far are very impressive. However, the market regulator and the stock exchanges
seem to have lost their initiatives in derivatives trading after the end of 2001. One indication of the lack of
initiative is the drastic fall in the volume of trading in the derivative segments. From a maximum of Rs. 22,000
cr it has tumbled down to Rs. 7,000 cr at present on an average. Why?
The National Stock Exchange (NSE) started trading in derivatives on June 12, 2000. As a beginning, futures
contracts based on S&P CNX NIFTY were introduced. Approximate notional value of one contract was fixed at
Rs. 2,00,000. As NIFTY was trading at around 1000 at that time, `one lot' of a futures contract was fixed at Rs.
200. This instrument became very popular within a short period of time because Indian operators were very
familiar with the Badla system, which has a lot of similarities with futures trading.
Moreover, it eliminated the defects of the Badla system, reduced cost and at the same time gave traders an
opportunity to take a view on the market for one, two or even three months.
After almost a year, NSE introduced options based on NIFTY. Call and put options were simultaneously
allowed. In this case also, the notional value of a contract remained at Rs. 2,00,000. Once the traders became
familiar with these new instruments, NSE launched trading in options on individual securities from July 2,
2000. Traders and investors accepted these instruments so enthusiastically that the volumes in the derivative
segment improved considerably. Stock exchanges also adopted modern risk containing measures and used
SPAN software developed by Chicago Mercantile Exchange (CME) to determine the initial margin
requirements. The introduction of single stock futures on November 9, 2001 was a revolutionary step. Even
now single stock futures are traded only in one stock exchange in the US. Thus, Indian investors had the most
modern stock exchanges with all the sophisticated financial instruments within a short period of 18 months.
NSE also introduced futures and option contracts on CNX-IT from August 29, 2003. As futures and options are
cash settled, market-wide position limits were introduced on all individual scrips to curtail too much
speculation and avoid market manipulation.
Now futures and options on individual securities are available on 51 securities. Volumes soared in the
derivative segments and overtook the spot markets within a short period of time. In fact, the turnover in the
derivative segments grew to such an extent that it reached the staggering figure of Rs. 21, 921 cr on January 28,
2004. The cumulative FII positions as a percentage of the total gross market position in the Indian derivative
segment vary between 25% and 30% now.
Derivative instruments came into existence to mitigate risks in financial markets. However, in India only high
net worth individuals and financial institutions could hedge the risks because of the enormous contract sizes
and subsequent high margins demanded by the exchanges. Most of the ordinary investors still buy calls and
puts and thereby lose their capital. Even though the lot size of contracts has been reduced to some extent
recently, they are still very high. As a result, the number of trades in the derivative markets is going down daily.
This is going to continue in the future and it will be very difficult to control the slide if Sebi and the exchanges
take hands off attitude.
Caselet 3
Read the caselet carefully and answer the following questions:
11. Discuss the significance of commodity futures market in India.
(6 marks) < Answer >
12. What are the current issues hindering the growth of the commodity futures market in India? Explain.
(8 marks) < Answer >
The past several decades have seen explosive growth in exchange-traded commodity futures across the globe.
A wealth of research has conclusively established the potential benefits of including exposure to commodities
in traditional financial portfolios. Commodities have negative correlation with stocks and bonds and, therefore,
improve the risk-adjusted return of the portfolio. These properties (negative correlation with stocks and bonds
and lower volatility) of commodities make them an ideal asset for diversification and increase the attractiveness
of a portfolio.
Commodity exchanges worldwide offer lot of economic benefits in the form of greater price discovery enabling
more efficient pricing in underlying spot market, risk transfer between various heterogeneous market
participants, greater transparency and better price dissemination on a nationwide scale, rationalization of
transaction costs and better margins for producers. Commodity futures exchange is a facilitator of numerous
functions, viz., hedging and arbitrage, bulk trades, investment opportunities, balancing back price differences
by areas and times and fair price indication.
To overcome a long period of hibernation (almost three decades starting from the 1960s) for commodity futures
in India, the Forward Market Commission, the governing body for commodity trading in India, has taken
several initiatives to set up the National Multi-Commodity Exchanges. As a result, NMCEIL, NBOT, MCX and
NCDEX have been set up to address key problems that have plagued commodity exchanges in the country so
far. With the establishment of these exchanges, the issue of single commodity exchanges with low liquidity has
been addressed. The modern exchanges enable multiple commodity trading on online world standard trading
platforms, with a nationwide reach. The exchanges now provide real-time price and trade data dissemination.
From the risk perspective, the new exchanges maintain capital settlement guarantee funds and have stringent
capital adequacy norms for brokers, which ensure trade guarantee to the participants. They have enabled
deliveries in electronic form. Warehouse receipts exchanged through the depository participants facilitate
efficient settlement procedures and attract participants from all key sections of the commodity business cycle.
Commodities account for a substantial share of India’s Gross Domestic Product (GDP). The need for
commodity price risk management is immense and, hence, commodity risk management products, should find
a larger customer base. The physical market for commodities still encounter a lot of obstacles in the shape of
various government controls and regulations, minimum support price, monopoly procurement, varying tax
structures, etc. Efforts are being made to tackle these problems by various administrative departments. The
objective is to provide an efficient risk management mechanism and increase the value of commodity futures
trading to 10% of GDP by 2007 from 1.26% at the end of 2002.

END OF SECTION E

END OF QUESTION PAPER

 Suggested Answers
Financial Risk Management – II (232) : April 2005
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.
FRAs offer banks and non-bank corporations the ability to hedge their interest rate exposure without
inflating their balance sheets, and they can be used to reduce interbank outstanding. While companies
initially used the market for hedging purposes, many corporate participants are presently engaged in trading
per se.
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 would be made. But interest rate futures to be sold to hedge against
possible increase in interest rate and to be bought when there is possible decrease in interest rate.
FRAs are more flexible than interest rate futures like eurodollar futures or US T-Bill futures in terms of
maturity and amounts, they do not involve margins, they are usually not subject to marked-to-market and
the consequent cash flows, and they eliminate the basis risk associated with futures. The FRAs credit risk is
relatively small – unless interest rate volatility is significant. FRAs are also available in foreign currencies
for which the organized exchanges do not trade. FRAs allow market participants to hedge their interest rate
exposure without an impact on their liquidity position and / or balance sheet. FRAs cannot be traded unless
both parties to the contract agree.
FRAs offer banks and non-bank corporations the ability to hedge their interest rate exposure without
inflating their balance sheets, and they can be used to reduce interbank outstanding. While companies
initially used the market for hedging purposes, many corporate participants are presently engaged in trading
per se. Accounting treatment of FRA transactions varies among the major industrial countries, with some
requiring that they be marked-to-market with the resulting gains/losses flowing through the Profit and Loss
account.
< TOP >
2. a. The company needs to hedge the fall in interest rate, which will reduce its investment yield. Though
the company is exposed to 6-month LIBOR, and Eurodollar futures are based on 3-month LIBOR,
still it can hedge it through Eurodollar futures though it will not be a perfect hedge. As the company
needs to invest funds, so it should go long on Eurodollar futures contract. As the contract size for
Eurodollar futures is $1 million and the duration of investment is 5/3 times that of Eurodollar deposit
underlying the futures contract
50, 000, 000 5
×
1, 000, 000 3
So the company should buy = = 83.33 » 83 eurodollar futures contract. If interest
rate falls, the price of Eurodollar futures will increase, thus buying futures at lower rate and selling at
higher rate the company can book profit, which will reduce the loss in interest income in the actual
deposit.
Now the question arises which Eurodollar futures contract will give the company the best hedge. As
the company is expecting the interest rate will fall within July, so hedging with June Eurodollar
futures will give the company better hedge, because the fall in interest in next three months will be
best reflected in the June futures than longer dated futures. So the company should buy 83 June
 Eurodollar futures.
Now in June, futures closes at 97.48.
∴ Gain from the futures = (97.48 – 97.20) × 100 × 25 × 83 = $58,100.
Interest earned on deposit
3.60 5
×
100 12
= 50,058,100 ×
= $ 750,871.50.
Effective return on investment
750, 871.50 12
× ×100
50, 000, 000 5
=
= 3.604%.
b. In between the period of July to December 2005, if interest rate rises, the company will lose the
potential higher interest income on the deposit. To profit from the rising interest rate scenario, the
company can sell Eurodollar futures contract. So that if interest rate rises, futures price will be lower,
thus selling at a higher rate and buying at a lower rate the company can make profit.
Suppose, the company sold the December futures contract in June, which was quoting at 96.94. If it
holds the contract till December closing of 96.81.
Profit from each contract = (96.94 – 96.81) × 100 × 25
= $ 325
Thus by selling December euro dollar futures contract the company can gain $325 per contract
entered. However, this strategy is a speculative strategy, the firm can loose if the interest rates do not
rise. Instead the firm can enter into spread strategy where it can buy a near end contract like
September futures and sell the far end contract like December futures so that gains and losses are
offset to some extent and if interest rate changes its direction, he can close the position before
December itself.
< TOP >
3. Since the company will be depositing $ 50 million, so FRA rate applicable to him is 3.50%.
If 6-month LIBOR in July is 2.85%:
Interest amount receivable on deposit
5
12
= $50,000,000 × 0.0360 ×
= $750,000
Difference receivable on FRA
 5
(0.0350 − 0.0285) ×   × 50, 000, 000
 12 
 5
1 + 0.0285 × 
 12 
=
135, 416.67
1.011875
= = $ 133,827.47.
Value of difference received after 5-month
 5 
1 + 0.0285 × 
 12 
= $ 133,827.47
= $ 135,416.67
Total interest earned = $ 750,000 + $ 135,416.67
= $ 885,416.67
 885, 416.67 12
× ×100
50, 000, 000 5
Effective return =
= 4.25%
If 6-month LIBOR in July is 3.60%
Interest amount receivable on deposit
5
12
= $ 50,000,000 × 0.0435 ×
= $ 906,250
Difference payable on FRA
5 
(0.036 − 0.035) ×   × 50, 000, 000
 12 
 5 
1 + 0.036 × 
 12 
=
20, 833.33
1.015
=
= $ 20,525.45
Value of difference after 5-month
 5 
1 + 0.036 × 
 12 
= $ 20,525.45
= $ 20,833.33
Net interest earned on deposit
= $ 906,250 – $ 20,833.33
= $ 885,416.67
885, 416.67 12
× ×100
50, 000, 000 5
Effective return =
= 4.25%
So, by FRA the company is able to locked in a investment yield of 4.25%.
< TOP >
1
1.3045
4. Position value in euro = $ 50 million × = € 38.3289 million
7.20%
250
Daily volatility = = 0.4554%
Now the potential fluctuation of the $/Euro at 95% confidence level is:
€ 38.3289 (1 + 1.645 × 0.004554) = € 38.616 million
Or,
€ 38.3289 (1 – 1.645 x 0.004554) = € 38.0418 million
i.e., Daily value-at-risk at 95% confidence level is:
38.3289 × 1.645 × 0.004554 = € 0.2871 million = $ 0.3745 million.
< TOP >
5. The following are some of the different approaches to managing risks:
• Risk avoidance
• Loss control
• Combination
• Separation
• 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.
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 way 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 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. 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.
Another example is a range forward, an instrument used for sharing currency risk. Under this contract, who
 parties agree to buy/sell a currency at a future date. While the buyer is assured a maximum price, the seller
is assured a minimum price. The actual rate for executing the transaction is based on the spot rate on the
date of maturity and these two prices. The buyer takes the loss if the spot rate falls below the minimum
price. The seller takes the loss if the spot rate rises above the maximum price. If the spot rate lies between
these two rates, the transaction is executed at the spot rate.
< TOP >
Section E: Caselets
Caselet 1

6. LEAPS are either long-term stock options or index options, with expiration dates up to three years away.
LEAPs are very similar to standard options except for the fact that they expire much further in the future.
They can be safer than traditional options because it is somewhat easier to predict stock movement over
longer periods. Like options, they allow an investor to lock in a fixed price for the underlying security.
Therefore, like options, they can be effective for both leverage and insurance purposes. Expiration
generally occurs 36 months after purchase, and LEAPs are mainly American style, so they can be exercised
at any time before expiration. Having a longer maturity period, LEAPS are more susceptible to changes in
factors like volatility, interest rate and dividends. These can be attributed to two main things: First,
perception in the long run; i.e., if changes continue in future, premium may be affected largely. Second,
over a longer period the impact is cumulative; for instance if there is a trend in interest rates it may not
affect an option which has three months to expire but it will affect LEAPS which has one year or more to
expire.
< TOP >
7. LEAPS offer investors an alternative to stock ownership. LEAPS calls may allow investors to benefit from
the appreciation of equities while placing substantially less capital at risk than is required to purchase stock.
Should a stock appreciate to a level above the exercise price of the LEAPS, the LEAPS call holder may
exercise the option and purchase shares at a price below the current market price or the same investor may
sell the LEAPS calls in the open market for a profit (provided the sale price including transaction costs and
commissions exceeds the total price paid).
Investors can utilize LEAPS calls to diversify their portfolios. Historically, the stock market has provided
investors significant and positive returns over the long term. Few investors purchase shares in each
company they follow. A buyer of a LEAPS call has the right to purchase shares of stock at a specified date
and price up to three years in the future. Thus, an investor who makes decisions for the long term can
benefit from buying LEAPS calls.
LEAPS puts provide investors with a means to hedge current stock holdings. Investors should consider
purchasing LEAPS puts if they are concerned with the downside risk of a particular stock that they own. A
purchase of a LEAPS put gives the purchaser or holder the right to sell the underlying stock at the strike
price up until the cutoff time for the submission of exercises notices prior to option expiration.
< TOP >
8. Like any option position, if you are a buyer of LEAPS calls (bullish) or LEAPS puts (bearish) the risk is
limited to the premium paid for the position. If you are an uncovered seller of LEAPS calls (bearish), there
is unlimited risk, or a seller of LEAPS puts (bullish), significant risk. Risk varies depending upon the
strategy followed, and it is important for an investor to understand fully the risk of each strategy he or she
might utilize. In addition, there are a number of differences between an investment in common stock and an
investment in options that are important to understand. Unlike common stock, an option has a imited life.
Common stock can be held indefinitely in the hope that its value may increase, while every option has an
expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a
financial instrument. For this reason, an option is considered a “wasting asset.” As a result, even if an
investor correctly picks the direction that the value of an underlying interest will move, unless the investor
also correctly selects the time frame within which that movement will take place, the investor will not profit
as desired. Finally, investors run the risk of losing their entire investment in a relatively short period of time
and with relatively small movements of the underlying interests. Unlike a purchase of common stock for
cash, the purchase of an option involves “leverage,” whereby the value of the option contract generally will
fluctuate by a greater percentage than the value of the underlying asset.
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Caselet 2
9. India’s financial market will strongly benefit from the smooth functioning of index derivatives markets.
• Internationally, the launch of derivatives has been associated with substantial improvement in market
quality on the underlying equity market. Liquidity and market efficiency on India’s equity market will
improve once the derivatives commence trading.
• Many risks in the financial markets can be eliminated by diversification. Index derivatives are special
as they can be used by the investor to protect themselves from the one risk in the equity market that
cannot be diversified away, i.e. a fall in the market index. Once the investors use index derivatives,
they will suffer less when fluctuations in the market index takes place.
• Foreign investors coming in India will be more comfortable if the hedging vehicles routinely used by
them worldwide are available to them.
• The launch of index derivatives is a logical step in the development of human capital in India. Once
India have skill in the core derivatives markets, capabilities in derivatives can be easily applied to
unexpected areas.
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10. The the following measures can be taken to change this state of affairs of the derivatives market:
• Reduce the lot size of contracts. the contract size is reduced to 100 and mini contracts are introduced
on indexes, volumes in the exchanges will move up considerably.
• Indian investors can use hedging strategies to reduce the risks in trading. This will increase the
number of contracts and improve the volumes. This will make it possible for a large of number of
ordinary traders to enter the market.
• Millions of Indians own shares in blue chip companies' shares. For instance, a large number of people
own shares in companies like Reliance, Satyam Computers, Hindustan Lever, etc. Most of these
shareholders belong to the middle class. The size of their holdings is only 100 shares or less. If the lot
size is reduced, they will be able to take covered calls on these otherwise dormant shares and earn
income from such shares every month. This involves no risk because they write calls at strike prices
far above the prices at which they have bought the shares. Think of the enormous volumes this would
bring to the exchanges if millions of small time investors indulged in this activity every month.
• People who want to buy 100 shares of a blue chip company can write `out of the money puts' every
month and reduce the cost of their purchases. They can also receive some moderate income as interest
on the funds deployed as margins, if they fail to get the shares on which they wrote puts. Here also
volumes in the exchanges will go up considerably as it is a strategy with very little risk to the buyer of
the share. In fact, he gets his shares at a lower price.
• Using spread strategies traders can get better control of their positions. For example, a person
executing a bull spread can make profits from both positions if he can make correct judgments about
market behavior.
• Reduce margins on spread strategies that run to expiration where risks are limited and protect the
spread strategies from assignment. In the US markets, spread strategies need only margins limited to
the maximum risk.
• Abolish monthly options and introduce quarterly contracts. This will reduce the volatility in the
markets. There is considerable manipulation going on in the markets on the expiration date. By
increasing the contract period, manipulation can be reduced.
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Caselet 3
12. If a trader has a long or short position in a commodity, it may happen that on the date of delivery of the
contract, spot prices vary adversely from the traded price, thus creating loss to the trader. This variation of
spot prices is called the price risk. India’s farmers and downstream industrial users of agricultural output,
are exposed to extremely high price risk. The creation of commodity derivatives markets will provide them
with the choice of obtaining insurance against price fluctuations. It will improve liquidity and price
 discovery of the underlying spot markets. Once futures markets exist, the private sector will maintain buffer
stocks, which will reduce the spot price volatility, and the private sector can do this far more efficiently
than government-sponsored efforts at maintaining buffer stocks. In addition, the creation of these markets is
consistent with the growth of skills in India’s financial industry in the area of derivatives.
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13. Like most traditional financial markets in India, the commodity futures market is weak. Our country still
lacks technologically improved pre-processing units (like ginning and processing factories for cotton) and
modern warehouses with facilities for grading and testing quality standards. The country needs huge
investments to build adequate quality pre-processing units, modern warehouses including cold storages and
tank farms for perishables.
In spite of the fact that the government has promoted commodity exchanges at a national level, there are
still many deals, which are executed unofficially at various centers. The participants are unwilling to move
to a central trading platform because of the varying tax rates imposed. Probably, a preferential tax
treatment, if extended to the commodities market, might prompt participants to come and trade on a central
trading platform. Interestingly, another reason why many participants still keep themselves away from the
central trading platform is because of the availability of options on commodities futures in the unorganized
market, which offers a more lucrative proposition to the market participants at the local centers.
The other issue, which has come to light, is that as of now the settlement is not consistent across
commodities contracts. Moreover, the settlement calendars and procedures for settlement vary across
exchanges. However, this phenomenon is basically due to the characteristic of each commodity namely, the
seasonality. The investor should understand the underlying commodity to fully comprehend the reason for
the existence of a varied settlement cycle.
Finally, even though the Indian commodity futures market is growing rapidly and is generating interest
amongst various market participants, there is no benchmarking or an index that can provide investors with a
snapshot of the commodity futures market.

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