Page 198 - DCOM510_FINANCIAL_DERIVATIVES

Unit 12: Risk Management of Financial Derivatives

The difference between 1 and 4 above, if any, shall be decided in the manner laid down by the Notes
group by adjusting strike price or market lot, so that no forced closure of open position is
mandated.
 Dividends which are below 10% of the market value of the underlying stock would be
deemed to be ordinary dividends and no adjustment in the strike price would be made for
ordinary dividends. For extraordinary dividends, above 10% of the market value of the
underlying stock, the strike price would be adjusted.

 The exchange will on a case to case basis carry out adjustments for other corporate actions
as decided by the group in conformity with the above guidelines.

Self Assessment
Fill in the blanks:

13. Adjustment for corporate actions shall be carried out on the ………………………. on which
a security is traded on cum-basis.
14. Dividends which are below …………………….. of the market value of the underlying
stock would be deemed to be ordinary dividends and no adjustment in the strike price
would be made for ordinary dividends.
15. The exchange will on a …………………….. basis carry out adjustments for other corporate
actions.



Case Study Vanilla and Other Flavours

asic derivative instruments such as futures and options are often referred to as
“plain vanilla,” although this term is most often applied to an instrument called a
Bswap. More exotic “flavours” include instruments such as “repos” and some that
have more bizarre names like “frogs” or “swaptions.” While more complex, these
instruments are similar to other derivatives in that they are a contract based on another
asset. Let’s examine a swap. As the name implies, this instrument swaps one thing for
another. Usually, it’s an interest rate swap. For example, an organisation with debt, payable
at a fixed rate of interest, will swap its interest payments for a floating rate payment.
Here’s an example of how the system works.
CDB Corporation has borrowed $1 million at a floating rate, currently 7 percent. CDB is
concerned that rates will rise. CDB would like to make fixed interest payments of 8
percent. NQ, Inc. has borrowed $1 million at a fixed rate of 8 percent and has invested the
funds at a variable rate. It is concerned that, if rates fall, the investment might not be
profitable. It is willing to make CDB’s interest payments at a floating rate over five years,
if CDB will pay the 8 percent fixed rate on NQ’s loan for the same period of time. The two
parties agree to swap interest rates. CDB will still make floating-rate interest payments to
its bank, but will receive from NQ floating-rate interest payments exactly the same as
what it is paying. Similarly, NQ will still make the 8 percent fixed-rate interest payments
to its bank, but will receive from CDB interest payments precisely equivalent to the
payments it is making. The net effect of this interest rate exchange is that CDB ends up
making fixed-rate interest payments, in accordance with its wishes, and NQ ends up
making floating-rate interest payments, in accordance with its preferences. Both companies
will continue to make the appropriate principal repayments to their respective banks in
accordance with their loan agreements.
Contd....

LOVELY PROFESSIONAL UNIVERSITY 193