PGDM II - Semester – IV

Finance
Derivatives-Deri-FIN
{Elective}

Learning Hours: 30
Credits: 02

Context:
As global financial markets continue to evolve, understanding derivatives has become
essential for finance professionals. Derivatives play a crucial role in risk management,
investment strategies, and speculative ventures. This course on Derivatives provides a
comprehensive understanding of the various types of derivative instruments, including
forwards, futures, options, and swaps, along with their applications in the financial markets.
Students will gain insights into the regulatory frameworks, trading mechanics, and strategies
involved in using derivatives to hedge risks and enhance returns. This course equips students
with the knowledge and skills necessary to navigate the complex world of derivatives in both
domestic and international markets.

Course Objectives:
● To introduce students to the fundamental concepts, types, and origins of derivatives,
along with the structure and growth of derivative markets, especially in India.
● To understand the mechanics, regulatory frameworks, and strategic uses of stock,
commodity, and currency futures for hedging and speculation.
● To analyze the components, pricing, and strategic positioning of index futures within
financial markets.
● To explore the pricing models, terminologies, and advanced strategies related to stock,
commodity, and currency options, and their application in risk management.
● To evaluate the use of index options, including their strategic applications, regulatory
considerations, and risk management techniques.
● To understand the mechanics, valuation, and strategic applications of swaps and
interest rate derivatives, including their role in hedging and speculative activities.
Course Outline
Unit 1 Introduction to Derivative Markets:
Definition and Origin of Derivatives, Types of Derivatives - Forwards, Futures, and Options,
Market Participants, Derivative Markets and Instruments, Growth of Derivatives in India,
Structure of Forwards and Futures Markets, Forward Contracts, Difference between forwards
and futures, mechanics of Future Trading, Types of orders, Major Characteristics, Trading
Process, Clearing & Settlement process, difference between Hedging & Speculation, Recent
trends in derivatives.
Unit 2 Stock, Commodity & Currency Futures:
Meaning & Types of Stock, Commodity & Currency Futures, Difference between them,
Regulatory framework- Margin requirement for futures, Taxes & Charges, Points to
breakeven, Risks involved and precautions to be taken, Using Futures as a hedge, Futures
trading strategies – long & Short.
Unit 3 Index Futures:
Types of Indices, Difference between Stock & Index Futures, Pricing of Index Futures,
Composition of the Index, Long & short positioning strategies in Index Futures, Stock Index
Arbitrage, Regulatory Framework - Margin requirement for Index Futures, Taxes & Charges,
Points to breakeven, Risks involved and precautions to be taken, Using Index Futures as a
Hedge.
Unit 4 Stock, Commodity & Currency Options:
Option pricing models - Binomial and Black Scholes, Terminologies & Types of options,
Basic and Advanced Option Strategies – Long & Short, Options Buying & Options Writing –
Process & Differences, Regulatory Framework - Margin requirement for options, Taxes &
Charges, Points to breakeven, Risks involved and precautions to be taken, Using Options as a
Hedge – against equity portfolio, against futures & against options, Option Greeks, Implied
Volatility, Option Chain.
Unit 5 Index Options:
Types of Index Options & Expiries, weightage of the index, evaluation of option alternatives,
Strategies used to trade Index Options – Fixed income & variable income strategies, risk
management in index options, Regulatory Framework - Margin requirement, Option price
prediction through statistical indicators on underlying & option chain.
Unit 6 Swaps & Interest Rate Derivatives:
Meaning & Evolution of Swap Market, Types of Swaps - Interest Rate Swaps, Currency
Swaps, Equity Swaps, Swap Terminology, Mechanics of Swap Transactions, Valuation and
Application of Swaps, Forward Rate Agreements, Interest Rate Options, Interest rate Swaps
and Forwards, Interest Rate Derivatives Strategies, Hedging & Speculation.

Reference Books:
1. Options, Futures, and Other Derivatives - Hull, John C. - Pearson Prentice Hall.
2. Derivatives and Risk Management - Srivastava, R. - Oxford University Press.
3. Derivatives and Risk Management - Mishra, S.K. - Everest Publishing House.
4. Financial Derivatives: Risk Management - Bhalla, V.K. - S Chand & Company Ltd.
5. Derivatives - Somanathan, T.V., and Mehta, D.R. - Tata McGraw-Hill Publishing
Company Limited.
6. Derivatives: An Introduction - Strong, R.A. - Thomson Learning.
7. Financial Derivatives - Kolb, Robert W., and Overdahl, James A. - John Wiley &
Sons, Inc.
8. Commodity Derivatives and Risk Management - Rajib, Prabina - PHI Learning
Private Limited.
 9. Financial Derivatives: Theory, Concepts, and Problems - Gupta, S.L. - Prentice-Hall
of India Private Limited.

Course Outcomes:
CO1 Students will be able to define and explain the fundamental concepts and types of
derivatives, including their origin, market structure, and recent trends in derivative
markets.
CO2 Students will be able to describe and differentiate between stock, commodity, and
currency futures, including their regulatory frameworks, risks, and strategic uses for
hedging.
CO3 Students will be able to apply pricing methods and develop trading strategies for index
futures, understanding their composition and regulatory requirements.
CO4 Students will be able to analyze option pricing models such as Binomial and Black
Scholes, and utilize basic and advanced option strategies for risk management.
CO5 Students will be able to evaluate index options and implement various trading
strategies, while considering the regulatory frameworks and risk management
techniques.
CO6 Students will be able to create and formulate strategies using equity, index , commodity,
swaps and interest rate derivatives, understanding their mechanics, valuation, and
applications for hedging and speculation.
Speculation with Futures Contracts
Scenario: A trader speculates that the price of Nifty50 will rise in the coming month. The
current Nifty50 spot price is 19,800, and the futures price for a one-month contract is 19,850.
The margin required to enter the contract is ₹150,000. Each Nifty futures contract represents
50 units.
Task:
 Calculate the profit/loss for the trader if the Nifty50 price at expiry is:
o (a) 20,000
o (b) 19,600
 Highlight the risks involved in speculating with futures contracts.

Arbitrage Opportunity
Scenario: XYZ Capital observes that the spot price of a stock is ₹1,000, while its three-
month futures price is ₹1,060. The annual risk-free interest rate is 8%, and the stock pays no
dividends.
Task:
 Identify if there is an arbitrage opportunity.
 Calculate the theoretical futures price based on the cost of carry model.
 Suggest the arbitrage strategy if the theoretical and observed futures prices differ.

Case : Price Discovery with Futures

Scenario: DEF Ltd., a commodity trading firm, tracks the price movement of gold. The
current spot price of gold is ₹58,000 per 10 grams, and the six-month futures price is
₹60,000. DEF Ltd. suspects that futures prices provide insights into market expectations for
gold prices.
Task:
 Analyze the futures price to determine if the market expects gold prices to rise or fall.
 Discuss factors influencing the futures price beyond the spot price and cost of carry.

Case : Long and Short Futures Position

Scenario: A farmer and a miller enter into futures contracts for wheat. The farmer wants to
secure a price of ₹2,000 per quintal for their harvest in six months, while the miller wants to
ensure the same purchase price. They both use wheat futures contracts where one contract
equals 10 quintals.
Task:
 Calculate the payoff for both parties if the price of wheat at expiry is:
o (a) ₹2,100
o (b) ₹1,950
 Explain how futures help in mitigating price risk for both parties.

Case : Futures Pricing and Convergence

Scenario: The spot price of a stock is ₹2,500, and its futures price for one month is ₹2,550.
On the day of expiry, the stock's spot price is ₹2,540.
Task:
 Explain the concept of price convergence in futures.
 Verify if the futures and spot prices converge at expiry, and discuss the implications
for traders.

Difference between Hedging and Speculation:

Aspect Hedging Speculation
Purpose Reduce or eliminate risk from Profit from price movements in
adverse price movements. the market.
Risk Appetite Low-risk appetite, focused on High-risk appetite, focused on
minimizing losses. maximizing gains.
Market Opposite position in the derivatives No underlying position required;
Position market to offset risk in the trades based on market view.
underlying.
Motive Protection against losses. Making profits from anticipated
price changes.
Strategy Uses derivatives (e.g., futures, Takes directional bets on market
options) to mitigate risks. trends (e.g., buying calls, selling
futures).
Market Impact Adds stability by managing risks. Can add volatility through
amplified trading activity.
Outcome Minimization or elimination of Significant profit or loss,
losses; profit maximization is depending on market movement
secondary. accuracy.
Nature of Practiced by entities directly Practiced by traders or investors
Participants involved with the underlying asset with no direct link to the
 (e.g., farmers, exporters). underlying asset.
Examples - An importer buying USD futures to - A trader buying crude oil
hedge against currency risk. futures expecting prices to rise.
Regulatory Encouraged for providing market Monitored closely to prevent
Focus stability and reducing systemic risk. market manipulation and
excessive volatility.
Case 1: Intraday Trading with Risk Management
Scenario: Karan is an intraday trader who identifies a potential breakout in HDFC Bank
stock. He wants to:
1. Buy the stock during the day with leverage.
2. Place a stop-loss to minimize potential losses.
3. Set a target price to lock in profits.

Case 2: Overnight and Intraday Strategy

Scenario: Radhika believes the price of Infosys stock will rise in the long term. She also sees
an opportunity for intraday profit due to volatility. She plans to:
1. Buy one lot of Infosys futures and hold it overnight.
2. Simultaneously trade intraday on Infosys stock using leverage.
Question:
 Which orders should Radhika use for these trades?

Case 3: Long-Term Strategy with Triggered Entry

Scenario: Amit believes Reliance Industries' stock will drop to ₹2,200 in the next few weeks
and plans to:
1. Buy a lot of Reliance Industries futures only when the price hits ₹2,200.
2. Hold the position for a month, expecting the price to rise after ₹2,200 is reached.
Question:
 Which orders should Amit use to execute his plan?

Case 4: Portfolio Rebalancing with Risk Control

Scenario: Sneha manages a derivatives portfolio and plans to:
1. Simultaneously rebalance by buying one lot of Nifty50 futures and selling one lot of
Bank Nifty futures.
2. Place a stop-loss for both positions to mitigate risk.
Question:
 Which types of orders should Sneha place to achieve this?
Case 5: Automated Intraday Trading
Scenario: Ravi is an active intraday trader in TCS futures and wants to:
1. Place an initial order to enter the trade with leverage.
2. Automatically set a target price and stop-loss for the trade.
3. Ensure the trade is squared off by the end of the day if neither the target nor the stop-
loss is hit.
Question:
 Which orders should Ravi use?

Case 6: Strategy Execution with Price Target

Scenario: Meera plans to:
1. Buy a lot of Nifty50 futures only if the index falls to 19,500.
2. Place both a target price and a stop-loss once the order is executed.
3. Rebalance by buying Bank Nifty futures immediately after.
Question:
 Which types of orders should Meera use to execute this?
 Unit 2: Stock, Commodity & Currency Futures
1. Defining Stocks, Commodities, and Currencies
1.1 Stocks
A stock represents ownership in a company. It grants the holder a claim to the
company’s assets and earnings. Stocks are traded on exchanges like NSE and BSE in
India. Examples include Reliance Industries and Infosys.
1.2 Commodities
A commodity is a basic good that is interchangeable with others of the same type.
Commodities are broadly classified as:
 Soft Commodities: Agricultural products like wheat, cotton, and soybean.
 Hard Commodities: Natural resources like gold, silver, and crude oil.

Aspect Soft Commodities Hard Commodities

Definition Perishable agricultural products. Natural resources that are mined or
extracted.
Examples Wheat, coffee, cotton, sugar, Gold, silver, crude oil, natural gas,
soybean. aluminum.
Lifespan Short shelf life due to Long lifespan; non-perishable.
perishability.
Supply Influenced by weather, farming Affected by mining output,
Factors cycles, and seasonality. geopolitical issues, and reserves.
Market High due to dependence on High due to geopolitical risks and
Volatility climatic conditions. global demand.

1.3 Currencies
A currency represents a system of money in use within a country or economic region.
Currency trading involves exchanging one currency for another, such as USD/INR
and EUR/INR pairs.

2. Futures Contracts: Meaning and Types

A futures contract is a legally binding agreement to buy or sell an underlying asset
(stocks, commodities, or currencies) at a predetermined price on a specific future date.
Futures are standardized and traded on organized exchanges.

2.1 Stock Futures

 Meaning:
Stock futures are contracts that obligate the buyer to purchase or the seller to sell a
specific number of shares of a company at a pre-agreed price and future date.
 Types:
o Single Stock Futures: Futures on individual stocks like Infosys and Reliance.
o Index Futures: Futures on stock indices such as Nifty50 and Bank Nifty.

2.2 Commodity Futures

 Meaning:
Commodity futures involve an agreement to buy or sell a specific quantity of a
commodity at a future date at a predetermined price.
 Types:
o Agricultural Futures: E.g., wheat, soybean, and chana.
o Metal Futures: E.g., gold, silver, and aluminum.
o Energy Futures: E.g., crude oil and natural gas.
 Use Cases in India: Traded on exchanges like MCX and NCDEX.

2.3 Currency Futures

 Meaning:
Currency futures are contracts to exchange one currency for another at a future date,
with the exchange rate fixed on the contract date.
 Types:
o Major currency pairs: USD/INR, EUR/INR, GBP/INR.
o Exotic pairs (less common in India).

3. Differences Between Stock, Commodity & Currency Futures

Aspect Stock Commodity Currency
Futures Futures Futures
Underlying Shares of Physical Currency
Asset companies commodities pairs like
or indices like gold or oil USD/INR
Market Investors, Farmers, Exporters,
Participants mutual producers, importers,
funds, FIIs speculators corporates
 Purpose Hedging Hedging Hedging
stock prices commodity forex risk or
price volatility speculation
Volatility Moderate High Moderate,
affected by
geopolitical
factors
Indian NSE, BSE MCX, NSE, BSE
Exchanges NCDEX

1. Initial Margin
 Definition: The initial margin is the upfront payment required to enter into a futures
contract. It acts as a security deposit to cover potential losses due to adverse price
movements.
 Components: The initial margin comprises two parts:
o SPAN Margin: Calculated using the Standard Portfolio Analysis of Risk
(SPAN) methodology, which assesses the maximum potential loss a portfolio
might incur over a set time frame, typically one day.
o Exposure Margin: An additional margin to cover any unforeseen risks
beyond those accounted for by SPAN.
 Calculation: The total initial margin is the sum of the SPAN and Exposure margins. It
is expressed as a percentage of the contract value, which is determined by multiplying
the futures price by the lot size. Notably, while the lot size remains constant, the
futures price fluctuates daily, leading to variations in the initial margin requirement.
In the Indian stock futures market, understanding the Initial Margin, which comprises the
SPAN Margin and Exposure Margin, is crucial for traders. Let's delve into these concepts
through a practical example.
Case Study: Trading Reliance Industries Futures
Scenario:
 Stock: Reliance Industries Ltd.
 Current Spot Price: ₹2,000 per share
 Lot Size: 250 shares
 Contract Value: ₹2,000 * 250 = ₹5,00,000
Initial Margin Components:
1. SPAN Margin:
 o Definition: The Standard Portfolio Analysis of Risk (SPAN) margin is the
minimum margin requirement set by the exchange to cover potential losses
due to price movements.
o Calculation: SPAN margin is determined using a sophisticated algorithm that
considers various risk factors, including price volatility. For stock futures, the
SPAN margin typically ranges between 7.5% to 12% of the contract value,
depending on the stock's volatility.
2. Exposure Margin:
o Definition: This is an additional margin charged by the exchange to cover any
unforeseen risks beyond those accounted for by the SPAN margin.
o Calculation: For stock futures, the exposure margin is usually 3.5% of the
contract value.
Calculating the Initial Margin:
 SPAN Margin: Assuming a SPAN margin rate of 10%,
o ₹5,00,000 * 10% = ₹50,000
 Exposure Margin: 3.5% of ₹5,00,000 = ₹17,500
 Total Initial Margin: ₹50,000 (SPAN) + ₹17,500 (Exposure) = ₹67,500
Key Points:
 Margin Requirements: Both SPAN and Exposure margins are mandatory and must
be maintained in the trader's account for the duration of the futures position. These
requirements are subject to change based on market volatility and the exchange's
assessments.
 Daily Adjustments: The initial margin is recalculated daily to account for changes in
the futures price. While the lot size remains constant, fluctuations in the futures price
lead to variations in the contract value and, consequently, the margin requirements.
 Margin Calls: If the account balance falls below the required margin due to adverse
price movements, the trader will receive a margin call, prompting them to deposit
additional funds to maintain the position.
By comprehending and adhering to these margin requirements, traders can effectively
manage risk and maintain their positions in the stock futures market.

2. Mark-to-Market (M2M) Settlement

 Purpose: To mitigate counterparty risk, futures positions are subject to daily mark-to-
market settlements. This process ensures that gains and losses are realized daily,
preventing the accumulation of significant losses over time.
 Process: At the end of each trading day:
o Profit Scenario: If the futures price increases, the buyer's account is credited
with the gain, while the seller's account is debited with the equivalent loss.
o Loss Scenario: Conversely, if the futures price decreases, the buyer's account
is debited, and the seller's account is credited.
 Adjustment: The settlement price at the day's close becomes the reference price for
the next day's M2M calculations.

3. Maintenance Margin and Margin Calls

 Maintenance Margin: A minimum account balance that must be maintained to keep
a futures position open. If the account balance falls below this level due to adverse
price movements, a margin call is triggered.
 Margin Call: A demand from the broker to deposit additional funds to restore the
account balance to the initial margin level. Failure to meet a margin call can result in
the broker liquidating the position to cover potential losses.

4. Peak Margin Requirement

 Introduction: Implemented by SEBI in 2020, the peak margin framework ensures
that adequate margins are maintained throughout the trading day, not just at the end.
 Mechanism: Clearing corporations capture multiple snapshots of traders' margin
requirements during the day. Brokers are then required to collect the highest (peak)
margin observed during these snapshots.
 Objective: This approach aims to curb excessive intraday leverage and enhance
overall market stability.

5. Penalties for Margin Shortfalls

 Regulatory Mandate: SEBI mandates that brokers collect the complete SPAN and
Exposure margins upfront.
 Penalty Structure: If a trader's account exhibits a margin shortfall, penalties are
levied based on the extent and duration of the shortfall.
 Open Interest – Varsity by Zerodha

1. Parties to the Contract:

o Farmer (Option Buyer - Holder): The farmer wants the right but not the
obligation to sell potatoes at ₹12 per kg after 3 months.
o Option Seller (Option Writer): The trader or buyer of potatoes agrees to
offer this right in exchange for a premium.
2. Key Terms in the Options Contract:
o Strike Price: ₹12 per kg (Pre-agreed selling price)
 o Expiry: 3 months (The contract expires after this period)
o Premium: ₹1 per kg (The farmer pays this fee to secure the right to sell at
₹12)
3. How the Option Works:
o If the market price falls to ₹10 per kg, the farmer will exercise the option and
sell at ₹12 per kg, avoiding a loss.
o If the market price rises to ₹14 per kg, the farmer will not exercise the option
and will sell at the higher market price. The only loss is the premium paid.
4. Types of Options in the Example:
o Put Option: The farmer buys a put option to protect against a price fall.
o Call Option: If the trader (option seller) wanted to secure potatoes at ₹12 per
kg, they could buy a call option.
The price (premium) of an option is composed of two key components:
Options Premium=Intrinsic Value+Time Value\text{Options Premium} = \text{Intrinsic
Value} + \text{Time Value}Options Premium=Intrinsic Value+Time Value
This breakdown helps traders understand why option prices fluctuate based on market
conditions.

1. Intrinsic Value (IV)

 Definition: Intrinsic value is the in-the-money (ITM) portion of the option. It
represents the immediate profit a trader would make if the option were exercised
today.
 Formula:
o For Call Options: IV=max⁡(0,Spot Price−Strike Price)\text{IV} = \max(0, \
text{Spot Price} - \text{Strike Price})IV=max(0,Spot Price−Strike Price)
o For Put Options: IV=max⁡(0,Strike Price−Spot Price)\text{IV} = \max(0, \
text{Strike Price} - \text{Spot Price})IV=max(0,Strike Price−Spot Price)
 Key Feature: Intrinsic value cannot be negative; if an option is out-of-the-money
(OTM), its intrinsic value is zero.

2. Time Value (TV)

 Definition: Time value is the portion of the option’s premium that accounts for the
time left until expiration. It reflects the potential for the option to gain intrinsic
value.
  Formula: TV=Option Premium−Intrinsic Value\text{TV} = \text{Option Premium} -
\text{Intrinsic Value}TV=Option Premium−Intrinsic Value
 Factors Affecting Time Value:
1. Time to Expiry: The longer the time remaining, the higher the time value.
2. Volatility: Higher market volatility increases time value as there is a greater
chance of the option becoming profitable.
3. Interest Rates & Dividends: These impact the theoretical pricing models but
are secondary factors.

Example: Farmer's Put Option on Potatoes

Let's continue with the farmer's put option example.
Scenario 1: Market Price Falls Below Strike Price (In-the-Money)
 Strike Price = ₹12/kg
 Market Price = ₹10/kg
 Intrinsic Value = ₹12 - ₹10 = ₹2/kg
 Total Premium Paid = ₹3/kg
 Time Value = ₹3 - ₹2 = ₹1/kg
📌 Since the market price is lower than the strike price, the option has intrinsic value.

Scenario 2: Market Price is Equal to Strike Price (At-the-Money)

 Strike Price = ₹12/kg
 Market Price = ₹12/kg
 Intrinsic Value = ₹12 - ₹12 = ₹0 (No immediate profit)
 Total Premium Paid = ₹3/kg
 Time Value = ₹3 - ₹0 = ₹3/kg
📌 All the premium is time value because the option doesn’t provide immediate profit.

Scenario 3: Market Price is Above Strike Price (Out-of-the-Money)

 Strike Price = ₹12/kg
 Market Price = ₹14/kg
 Intrinsic Value = ₹12 - ₹14 = 0 (Negative value is ignored)
  Total Premium Paid = ₹3/kg
 Time Value = ₹3 - ₹0 = ₹3/kg
📌 The option has no intrinsic value and consists entirely of time value.

Key Observations
1. As Expiry Nears, Time Value Decreases (Time Decay)
o If the farmer’s option still has time before expiry, the premium remains high
due to time value.
o As expiry approaches, time value decays to zero, leaving only the intrinsic
value.
2. OTM Options Have Only Time Value
o If the market price is above ₹12, the put option has zero intrinsic value and
is based entirely on time value and volatility expectations.
3. ITM Options Have Both IV & TV
o If the market price is below ₹12, the put option has intrinsic value and some
time value (until expiry approaches).
 Option Greeks
✅ 1. Delta (Δ) – Direction Sensitivity
 Meaning: Measures how much the option premium will change for a ₹1 change in
the price of the underlying asset.
 Range:
o Call Options: 0 to +1
o Put Options: -1 to 0
 Example:
o If NIFTY is at ₹20,000 and a call option has delta of 0.5, then if NIFTY rises
to ₹20,001, the option premium will increase by ₹0.5.
 Interpretation:
o Higher delta = More responsive to price changes.
o ATM (At-the-money) options have delta ≈ 0.5 for calls, -0.5 for puts.
 Use: Helps determine hedge ratios and directional exposure.

✅ 2. Gamma (Γ) – Delta Sensitivity

 Meaning: Measures the rate of change of Delta with respect to changes in the price
of the underlying.
 Higher Gamma = Delta changes quickly.
 Important when: Holding ATM options or large directional positions.
 Example:
o If a call option has delta 0.5 and gamma 0.05, and the stock rises by ₹2, then
new delta ≈ 0.5 + (0.05×2) = 0.6
 Gamma is highest for ATM options, and lowest for deep ITM or OTM options.
 Use: Helps assess risk of sudden moves and determine how much delta exposure can
change.

✅ 3. Theta (Θ) – Time Decay

 Meaning: Measures how much an option’s value will decline each day, assuming all
other factors remain constant.
 Always negative for buyers, positive for sellers.
 Options lose value over time, especially as expiry nears.
  Example:
o If Theta = -5, then the option’s premium will fall by ₹5 per day.
 ATM options lose time value faster, especially in the last week before expiry.
 Use:
o Option buyers lose with time (decay).
o Option sellers benefit from time decay.

✅ 4. Vega (ν) – Volatility Sensitivity

 Meaning: Measures how much the option’s price will change with a 1% change in
implied volatility (IV).
 Applies to both calls and puts.
 Example:
o If Vega = 10, and implied volatility rises by 1%, option premium increases by
₹10.
 High Vega = More sensitive to IV.
 Vega is highest for ATM options with longer time to expiry.
 Use:
o Buying options when volatility is low, expecting it to rise.
o Selling options when volatility is high, expecting it to fall.
What is Implied Volatility?
 Implied Volatility (IV) is the market's forecast of how volatile the underlying asset
will be in the future.
 It is not directly observable — it is derived from the current market price of the
option using models like the Black-Scholes Model.
How does IV impact Option Premiums?
 When IV increases, option premiums increase, for both calls and puts.
 When IV drops, premiums fall — even if the stock hasn’t moved.
 This is where Vega plays a role. Vega tells us how sensitive the premium is to
changes in IV.
📈 Example:
 NIFTY is at ₹20,000
 A NIFTY 20,000 Call Option has:
 o IV = 15%
o Premium = ₹120
o Vega = 5
If IV jumps from 15% to 16% (1% ↑), premium will rise by ₹5 → New premium = ₹125
(Vega = 5 × 1% change)

Implied vs Historical Volatility

Factor Implied Volatility (IV) Historical Volatility (HV)
What it shows Expected future volatility Past price fluctuations
Derived from Option premiums Price data of the underlying
Forward- ✅ Yes ❌ No
looking?
Use Pricing options and volatility Risk analysis
trading

✅ 5. Rho (ρ) – Interest Rate Sensitivity

 Meaning: Measures how much the price of an option will change with a 1% change
in interest rates.
 Least significant Greek in short-term options.
 Example:
o If Rho = 0.5 for a call option, and interest rates increase by 1%, the option
value will rise by ₹0.5.
 Call Options: Positive Rho
 Put Options: Negative Rho
 Use: Relevant for long-dated options and currency options in India.

✅ Bonus: Lambda (Leverage or Elasticity)

 Meaning: Measures percentage change in option value for a 1% change in the
underlying asset.
 Indicates leverage effect of options.
 Useful for comparing option responsiveness across different instruments.
Quick Summary Table
Greek Sensitivity To Effect on Option Key Insight
Delta Underlying price Price change Directional movement
Gamma Underlying price Delta change Speed of delta changes
Theta Time Price decay Time value erosion
Vega Implied Volatility Price change Volatility impact
Rho Interest Rates Price change Rate sensitivity
Lambd % change in underlying % change in option Measures leverage
a

📌 Practical Uses in Indian Market

 Option Sellers closely track Theta and Vega for time decay and volatility exposure.
 Hedgers and Delta-neutral traders use Delta & Gamma for managing positions.
 Long-dated option traders and currency traders look at Rho.