Derivatives and risk management case study:

On November 1, 2008, Akhil, the manager of Bharat Funds, is contemplating how he can provide positive returns to the shareholders of the fund. Bharat Fund was started on January 1, 2005, with a total capital of INR 300 million. This capital was mainly invested in the equity of stocks traded on the Indian market. Since the Indian market was doing very well from 2005 to 2008, this fund also did very well during this period. For example, the CNX Nifty index started at 2,115 on January 3, 2005. The return on the fund and the benchmark Nifty Index are shown in Table 1. Akhil was happy that he was able to beat the benchmark index by a big margin during this period. The net asset value increased from INR 300 million on January 1, 2005, to INR 1,007 million by December 2007. However, he started facing problems when the Indian stock market dropped considerably, in line with all the other markets during the financial crisis. He calculated the return on the benchmark index and his fund for every quarter from January 2008 to September 2008 and for October 2008, as shown in Table 2.

From January 1, 2008, to October 31, 2008, the benchmark index dropped from 6,138 to 2,885, a drop of 53% over 10 months. The net asset value had decreased to INR 568 million, a decrease of 44% from January 1, 2008, to October 31, 2008. All the global markets had been going down considerably since January 1, 2008, and there was no consensus about how long the effect of the financial crisis will last. All the governments in the world were using stimulus plans to spur the economic growth and many analysts believed that the economy as well as the stock market will recover and start an increasing trend from January 1, 2009.

On November 10, Akhil wants to follow some strategies that will protect the shareholders of Bharat Fund from a further drop in the net asset value of the fund. Since the market has been highly volatile over the last 10 months, he decides to concentrate on his portfolio on a month-to-month basis. He wants to use options to protect the net asset value from dropping and to provide additional gains. He has collected some data about various options available on the CNX Nifty index as of November 1, 2008. There were 49 call options and 49 put options available with exercise prices ranging from INR 2,300 to INR 4,750 and with an exercise date of November 27, 2008. He has also estimated that the index is likely to be in the range of 2,600 to 3,300 on November 27, 2008. Table 3 shows the call and put prices for various exercise prices with the expiry date of November 27, 2008. Akhil has heard about covered call writing and portfolio insurance using options but is not sure which of these strategies will be better.

Discussion Questions 1. If he wants to enter into covered call writing, which of these options should he choose? If the value of the index on November 27, 2008, is 2,752, what will be the value of the portfolio on November 27, 2008? 2. If Akhil enters into a portfolio insurance strategy using puts, which of these options should he choose? If the value of the index on November 27, 2008, is 2,752, what will be the value of the portfolio on November 27, 2008? 3. Since the market is expected to be bearish, Akhil wants to enter into a bearish money spread. How can this be accomplished using call options and what would be the gain from this money spread transaction if the index is at 2,752 on November 27? 4. Since the market is expected to be bearish, Akhil wants to enter into a bearish money spread. How can this be accomplished using put options and what would be the gain from this money spread transaction if the index is at 2,752 on November 27? 5. How can Akhil use a butterfly spread using calls and what would be the gain if the index is at 2,752 on November 27? 6. How can Akhil use a straddle strategy and what would be the gain if the index is at 2,752 on November 27? 7. How can Akhil use a strip strategy and what would be the gain if the index is at 2,752 on November 27? 8. How can Akhil use a strap strategy and what would be the gain if the index is at 2,752 on November 27? 9. Akhil wants to use a calendar spread using a call with an exercise price of INR 2,700 call with expiry on November 27 and December 28. The price of the 2,700 call with expiry on November 27 is INR 338.40 and the price of the 2,700 call with expiry on December 28 is INR 402 on November 1, 2008. The 2,700 December call is priced at INR 185.50 on November 27, when the index value is 2,752.

Table 1 Period Return on Benchmark CNX Nifty Index Return on Bharat Fund 2005 34% 40% 2006 40% 48% 2007 55% 62% Table 2 Period Return on Benchmark CNX Nifty Index Return on Bharat Fund Q1, 2008 -23.0% -18% Q2, 2008 -14.7% -10% Q3, 2008 -2.9% -2% -26.4% -22% October 2008 Table 3 Exercise Price (INR) Call Price (INR) Put Price (INR) 2,600 403.85 124.70 2,650 301.05 141.55 2,700 338.40 151.00 2,750 299.60 167.00 2,800 268.35 189.30 2,850 242.55 208.35 2,900 218.30 229.80 2,950 181.90 306.40 3,000 169.05 279.35 3,050 147.75 264.00 3,100 127.35 337.10 3,150 110.75 429.95 3,200 88.95 425.85 3,250 72.50 498.80 3,300 60.55 495.80 Table 1 Period Return on Benchmark CNX Nifty Index Return on Bharat Fund 2005 34% 40% 2006 40% 48% 2007 55% 62% Table 2 Period Return on Benchmark CNX Nifty Index Return on Bharat Fund Q1, 2008 -23.0% -18% Q2, 2008 -14.7% -10% Q3, 2008 -2.9% -2% -26.4% -22% October 2008 Table 3 Exercise Price (INR) Call Price (INR) Put Price (INR) 2,600 403.85 124.70 2,650 301.05 141.55 2,700 338.40 151.00 2,750 299.60 167.00 2,800 268.35 189.30 2,850 242.55 208.35 2,900 218.30 229.80 2,950 181.90 306.40 3,000 169.05 279.35 3,050 147.75 264.00 3,100 127.35 337.10 3,150 110.75 429.95 3,200 88.95 425.85 3,250 72.50 498.80 3,300 60.55 495.80