RISK MANAGEMENT MODULE F QUIZ 2

The writer receives the premium and assumes the obligation to perform if the holder exercises under the contract terms. A call writer may have substantial or theoretically unlimited loss if unhedged, because the underlying price can rise significantly.

Option time value is the premium in excess of intrinsic value. Here, ₹28 − ₹18 = ₹10. Time value reflects factors such as time remaining, volatility, rates and other pricing inputs.

The call payoff at expiry is max(S_T − K, 0). Since ₹92 is below the ₹100 strike, exercising would not be beneficial and the payoff is zero. The buyer’s net result is a loss of the premium paid.

Buying a put on shares already owned creates a protective put. The put establishes a floor-like payoff below the strike, while the investor retains gains from rising share prices, net of the premium and other costs.

For European options on a non-dividend-paying underlying, put-call parity is C + PV(K) = P + S₀. It follows from constructing equivalent payoffs with a call plus a risk-free bond and a put plus the underlying. Dividends and market frictions modify the relationship.

Higher volatility generally increases the value of both calls and puts, all else equal, because the option holder benefits from favourable price movements while the payoff is bounded below by zero. This is a standard result for plain-vanilla options, subject to assumptions and product details.

An interest-rate cap pays when the reference rate exceeds the cap rate under the contract’s terms. It helps a floating-rate borrower limit the effective interest rate above a specified level, while allowing the borrower to benefit if rates fall, in exchange for the premium and subject to basis risk.

An interest-rate floor pays when the reference rate falls below the floor strike. It can protect a lender or investor whose income declines as rates fall. Caps protect against rising rates; collars combine a cap and floor.

A swap is a derivative agreement to exchange cash flows according to specified terms. Interest-rate swaps commonly exchange fixed and floating interest cash flows on a notional principal, which is generally not exchanged in a plain-vanilla interest-rate swap.

The company can pay fixed and receive floating in an interest-rate swap. The floating receipts can offset the floating payments on its debt, leaving an approximately fixed net interest cost, subject to basis risk, reset dates, notional and other mismatches.

Fixed payment is 5% × ₹10 crore = ₹50 lakh. Floating receipt is 4% × ₹10 crore = ₹40 lakh. Net cash flow to the bank is ₹10 lakh paid, because its fixed payment exceeds its floating receipt. In practice, swaps generally exchange the net difference for a period rather than exchanging the full notional.

The notional principal is the reference amount used to calculate interest cash flows. In a standard interest-rate swap, it is generally not exchanged between parties; this distinguishes it from some currency swaps where principal exchanges may occur.

A cross-currency swap exchanges cash flows in different currencies and may include exchanges and re-exchanges of principal, depending on the contract. A plain-vanilla interest-rate swap generally exchanges fixed and floating interest cash flows in the same currency without exchanging the notional principal.

A swaption is an option on a swap. The holder has the right, but not the obligation, to enter into the underlying swap under the agreed terms. It can be used to manage uncertainty about future borrowing or investment rates.

Futures are centrally cleared in many markets and use margining and daily mark-to-market, which limits accumulated unpaid exposure. This does not eliminate all risk: clearing members, the clearing house and market participants remain exposed to liquidity, operational and systemic risks.

Basis risk arises when the hedging instrument does not perfectly track the exposure being hedged. Differences in maturity, deliverable basket, benchmark or market liquidity can cause the hedge to be imperfect even if the broad market factor moves as expected.

Daily mark-to-market settles gains and losses regularly through variation margin. A losing trader may need to provide additional funds promptly; failure to meet a margin call can lead to position close-out under clearing and broker rules. This reduces accumulated exposure but creates liquidity demands.

Hedging aims to reduce an existing or anticipated exposure to an underlying risk. Speculation intentionally takes exposure in expectation of profit from market movements. Both can involve gains or losses, and a hedge may be imperfect or create new risks if poorly designed.

For a short futures position, the gain is entry price minus settlement price. Here, ₹800 − ₹765 = ₹35 per unit. The actual amount depends on contract size and transaction costs.

Before offering or trading a new derivative, the bank should ensure product approval, legal and documentation review, valuation capability, risk measurement, limits, operational readiness, accounting treatment, collateral/settlement arrangements and staff competence. Independent oversight is important because complex products can create risks that are not obvious from the initial cash outlay.