What are derivatives?

Derivatives are financial contracts, which derive their value off a spot price time-series,
which is called "the underlying". The underlying asset can be equity, index, commodity
or any other asset. Some common examples of derivatives are orwards, utures, !ptions
and Swaps.
Derivatives help to improve mar"et efficiencies because ris"s can be isolated and sold to
those who are willing to accept them at the least cost. #sing derivatives brea"s ris" into
pieces that can be managed independently. rom a mar"et-oriented perspective,
derivatives offer the free trading of financial ris"s.
What is the importance of derivatives?
There are several ris"s inherent in financial transactions. Derivatives are used to separate
ris"s from traditional instruments and transfer these ris"s to parties willing to bear these
ris"s. The fundamental ris" involved in derivative business includes$
Credit Risk
This is the ris" of failure of counterparty to perform its obligation as per the contract.
%lso "nown as default or counterparty ris", it differs with different instruments.
Market Risk
&ar"et ris" is a ris" of financial loss as a result of adverse movements of prices of the
underlying asset'instrument.
Liquidity Risk
The inability of a firm to arrange a transaction at prevailing mar"et prices is termed as
liquidity ris". % firm faces two types of liquidity ris"s
(. )elated to liquidity of separate products
*. )elated to the funding of activities of the firm including derivatives.
Legal Risk
Derivatives cut across +udicial boundaries, therefore the legal aspects associated with the
deal should be loo"ed into carefully.
What are the various types of derivatives?
Derivatives can be classified into four types$
orwards
utures
!ptions
Swaps
Who are the operators in the derivatives market?
,edgers - !perators, who want to transfer a ris" component of their portfolio.
Speculators - !perators, who intentionally ta"e the ris" from hedgers in pursuit of
profit.
%rbitrageurs - !perators who operate in the different mar"ets simultaneously, in
pursuit of profit and eliminate mis-pricing.
Forwards
What is a Forward contract?
-n a forward contract, two parties agree to do a trade at some future date, at a price and
quantity agreed today. .o money changes hands at the time the deal is signed.
What are the features of Forward contract?
The main features of forward contracts are
They are bilateral contracts and hence exposed to counter-party ris".
/ach contract is custom designed, and hence is unique in terms of contract si0e,
expiration date and the asset type and quality.
The contract price is generally not available in public domain.
The contract has to be settled by delivery of the asset on expiration date.
-n case, the party wishes to reverse the contract, it has to compulsorily go to the same
counter party, which being in a monopoly situation can command the price it wants.
Inde Futures
What are Inde Futures?
-ndex utures are uture contracts where the underlying asset is the -ndex. This is of
great help when one wants to ta"e a position on mar"et movements.
What are the uses of Inde Futures?
-ndex futures can be used for hedging, speculating, arbitrage, cash flow management and
asset allocation.
!ow are Inde Futures valued?
The theoretical way of valuing any future contract is as follows$
uture value 1 Spot price 2 carry cost 3 carry returns
4here,
Spot price 1 current index
5arry cost 1 ,olding cost of the future index
5arry return 1 Dividends accrued during the period of carry.
"ricing Futures
5ost and carry model of utures pricing
air price 1 Spot price 2 5ost of carry - -nflows
6
tT
1 56
t
2 56
t
7 8)
tT
- D
tT
9 7 8T-t9':;<
4here,
6
tT
- air price of the asset at time t for time T.
56
t
- 5ash price of the asset.
)
tT
- -nterest rate at time t for the period up to T.
D
tT
- -nflows in terms of dividend or interest between t and T.
5ost of carry 1 inancing cost, Storage cost and insurance cost.
-f utures price = air price> ?uy in the cash mar"et and simultaneously sell in the
futures mar"et.
-f utures price @ air price> Sell in the cash mar"et and simultaneously buy in the
futures mar"et.
This arbitrage between 5ash and uture mar"ets will remain till prices in the 5ash
and uture mar"ets get aligned.
Set of assumptions
.o seasonal demand and supply in the underlying asset.
Storability of the underlying asset is not a problem.
The underlying asset can be sold short.
.o transaction cost> no taxes.
.o margin requirements, and so the analysis relates to a forward contract, rather than a
futures contract.

!#$%I&%
What is hedging?
,edging is a mechanism to reduce price ris" inherent in open positions. Derivatives are
widely used for hedging. % ,edge can help loc" in existing profits. -ts purpose is to
reduce the volatility of a portfolio, by reducing the ris".
,edging does not mean maximi0ation of return. -t only means reduction in variation of
return. -t is quite possible that the return is higher in the absence of the hedge, but so also
is the possibility of a much lower return.
What are the general hedging strategies?
The basic logic is "-f long in cash underlying - Short uture and -f short in cash
underlying - Aong uture". -f you have bought (BB shares of 5ompany % and want to
,edge against mar"et movements, you should short an appropriate amount of -ndex
utures. This will reduce your overall exposure to events affecting the whole mar"et
8systematic ris"9. -n case a war brea"s out, the entire mar"et will fall 8most li"ely
including 5ompany %9. So your loss in 5ompany % would be offset by the gains in your
short position in -ndex utures.
Some examples of where hedging strategies are useful include$
)educing the equity exposure of a &utual und by selling -ndex utures>
-nvesting funds raised by new schemes in -ndex utures so that mar"et exposure
is immediately ta"en> and
6artial liquidation of portfolio by selling the index future instead of the actual
shares where the cost of transaction is higher.
What is hedge ratio?
The hedge ratio is defined as the number of utures contracts required to buy or sell so as
to provide the maximum offset of ris". This depends on the
Calue of a utures contract>
Calue of the portfolio to be ,edged> and
Sensitivity of the movement of the portfolio price to that of the -ndex 85alled
?eta9.
The ,edge )atio is closely lin"ed to the correlation between the asset 8portfolio of
shares9 to be hedged and underlying 8index9 from which uture is derived.
Who are hedgers' speculators and ar(itrageurs?
,edgers wish to eliminate or reduce the price ris" to which they are already exposed.
Speculators are those class of investors who willingly ta"e price ris"s to profit from price
changes in the underlying. %rbitrageurs profit from price differential existing in two
mar"ets by simultaneously operating in two different mar"ets. %ll class of investors are
required for a healthy functioning of the mar"et.
,edgers and investors provide the economic substance to any financial mar"et. 4ithout
them the mar"ets would lose their purpose and become mere tools of gambling.
Speculators provide liquidity and depth to the mar"et. %rbitrageurs bring price uniformity
and help price discovery.
The mar"et provides a mechanism by which diverse and scattered opinions are reflected
in one single price of the underlying. &ar"ets help in efficient transfer of ris" from
,edgers to speculators. ,edging only ma"es an outcome more certain. -t does not
necessarily lead to a better outcome.
What are hedge funds?
% hedge fund is a term commonly used to describe any fund that isnDt a conventional
investment fund, i.e., it uses strategies other than investing long. or example
Short selling
#sing arbitrage
Trading derivatives
Aeveraging or borrowing
-nvesting in out-of-favour or unrecogni0ed undervalued securities
The name hedge fund is a misnomer as the funds may not actually hedge against ris".
The returns can be high, but so can be losses. These investments require expertise in
particular investment strategies. The hedge funds tend to be speciali0ed, operating within
a given niche, specialty or industry that requires the particular expertise.

)"#C*L+,I-& ),R+,#%I#)
What are the general strategies for speculating?
-n general, the speculator ta"es a view on the mar"et and plays accordingly. -f one is
bullish on the mar"et, one can buy utures, and vice versa for a bearish outloo".
There is another strategy of playing the spreads, in which case the speculator trades the
"basis". 4hen a basis ris" is ta"en, the speculator primarily bets on either the cost of
carry 8interest rate in case of index futures9 going up 8in which case he would pay the
basis9 or going down 8receive the basis9.
6ay the basis implies going short on a future with near month maturity while at the same
time going long on a future with longer term maturity.
)eceiving the basis implies going long on a future with near month maturity while at the
same time going short on a future with longer term maturity.
What are long. short positions?
-n simple terms, long and short positions indicate whether you have a net over-bought
position 8long9 or over-sold position 8short9.
What is gearing?
Eearing 8or leveraging9 measures the value of your position as a ratio of the value of the
ris" capital actually invested. -n case of index futures, if the margin requirement is <F,
the gearing possible is *Btimes as on a given fund availability, an investor can ta"e a
position *B times in si0e.

"RIC# RI)/
What is price risk?
6rice ris" is defined as the standard deviation of returns generated by any asset. This
indicates how much individual outcomes deviate from the mean. or example, an asset
with possible returns of <F, (BF and (<F is more ris"y than one with possible returns of
3(BF, (F and *<F.
What are the different types of price risk?
Diversifiable ris" 8also "nown as non mar"et ris" or unsystematic ris"9 of a security
arises from the security specific factors li"e stri"e in factory, legal claims, non
availability of raw material, etc. This component of ris" can be reduced by
diversification.
.on-diversifiable ris" 8also "nown as systematic ris" or mar"et ris"9 is an outcome of
economy related events li"e diesel price hi"e, budget announcements, etc that affect all
the companies. %s the name suggests, this ris" cannot be diversified away using
diversification or adding stoc"s in portfolio.
Can price risk (e controlled?
Ges, but to an extent. %s mentioned earlier, the different types of price ris" impacting any
stoc" or company can be classified into two categories$
(. 5ompany specific> and
*. /conomy or mar"et related.
The 5ompany specific ris"s 8also "nown as diversifiable ris" or non-mar"et ris"
or unsystematic ris"9 can be reduced by proper diversification.
0#,+ 1 ,IC/ )I2#
What is (eta and a tick si3e?
?eta measures the sensitivity of the stoc" compared to the index. Tic" si0e is the
minimum price difference between the two quotes of a similar nature. The tic" si0e is B.(
point of the ?S/ Sensex, which is equivalent to )s <. -n case of .ifty, tic" si0e is B.B<
which is equal to )s (B.
CIRC*I, 0R#+/#R)
What are circuit (reakers or circuit filters?
5ircuit brea"er means trading is halted for a specified period in stoc"s or ' and stoc"
index futures, if the mar"et price moves out of a pre-specified band. 5ircuit filters do not
result in trading halt but no order is permitted if it falls out of the specified price range.
%dvantages
%llows participants to gather new information and to assess the situation -
controls panic.
?ro"erages firms can chec" on customer funding and compliance.
/xchanges' 5learing houses can monitor their members.
Disadvantages
(. !nly postpones the inevitable.
*. Aimits the flow of mar"et information 3 no one "nows the real value of a
stoc".
:. They precipitate the matter during volatile moves as participantsD rush to
execute their orders before anticipated trading halt.

M+R%I&)
What is margin money?
The aim of margin money is to minimi0e the ris" of default by either counter-party. The
payment of margin ensures that the ris" is limited to the previous dayDs price movement
on each outstanding position. ,owever, even this exposure is offset by the initial margin
holdings.
&argin money is li"e a security deposit or insurance against a possible uture loss of
value.
+re there different types of margin?
Ges, there can be different types of margin li"e initial margin, variation margin,
maintenance margin and additional margin.
What is the o(4ective of initial margin?
The basic aim of initial margin is to cover the largest potential loss in one day. ?oth
buyer and seller have to deposit margins. The initial margin is deposited before the
opening of the day of the utures transaction. .ormally this margin is calculated on the
basis of variance observed in daily price of the underlying 8say the index9 over a
specified historical period 8say immediately preceding ( year9. The margin is "ept in a
way that it covers price movements more than HHF of the time. #sually three sigma
8standard deviation9 is used for this measurement. This technique is also called value at
ris" 8or C%)9.
?ased on the volatility of mar"et indices in -ndia, the initial margin is expected to be
around I-(BF.
What is variation or mark5to5market margin?
%ll daily losses must be met by depositing of further collateral - "nown as variation
margin, which is required by the close of business, the following day. %ny profits on the
contract are credited to the clientDs variation margin account.
What is the concept of maintenance margin?
Some exchanges wor" on the system of maintenance margin, which is set at a level
slightly less than initial margin. The margin is required to be replenished to the level of
initial margin, only if the margin level drops below the maintenance margin limit. or
e.g.. -f -nitial &argin is fixed at (BB and &aintenance margin is at IB, then the bro"er is
permitted to trade till such time that the balance in this initial margin account is IB or
more. -f it drops below IB, say it drops to JB, then a margin of :B 8and not (B9 is to be
paid to replenish the levels of initial margin. This concept is not expected to be used in
-ndia.
What is the concept of additional margin?
-n case of sudden higher than expected volatility, additional margin may be called for by
the exchange. This is generally imposed when the exchange fears that the mar"ets have
become too volatile and may result in some crisis, li"e payments crisis, etc. This is a
preemptive move by exchange to prevent brea"down.
What is the concept of cross margining?
This is a method of calculating margin after ta"ing into account combined positions in
utures, options, cash mar"et etc. ,ence, the total margin requirement reduces due to
cross-,edges. This is unli"ely to be introduced in -ndia immediately.
M+R/#, M+/#R
Who is a market maker?
% dealer is said to ma"e a mar"et when he quotes both bid and offer prices at which he
stands ready to buy and sell the security. Thus, he is a person that brings buyers and
sellers together. ,e lends liquidity in the system by ma"ing trading feasible.
What is marked5to5market?
This is an arrangement whereby the profits or losses on the position are settled each day.
This enables the exchange to "eep appropriate margin so that it is not so low that it
increases chances of defaults to an unacceptable level 8by collecting &T& losses9 and is
not so high that it increases the cost of transactions to an unreasonable level 8 by giving
&T& profits9.
F*,*R#) I& I&$I+
&IF,6 F*,*R#)
The .ational Stoc" /xchange commenced trading in -ndex utures on (* Kune, *BBB.
The .-TG futures contracts are based on the popular mar"et benchmar" SL6 5.M
.-TG -ndex.
)ecurity descriptor
The security descriptor for the SL6 5.M .ifty futures contracts will be$
&ar"et type $ .
-nstrument Type $ #T-DM
#nderlying $ .-TG
/xpiry date $ Date of contract expiry
,rading cycle
SL6 5.M .ifty futures contracts have a maximum of :-month trading cycle - the near
month 8one9, the next month 8two9 and the far month 8three9. % new contract will be
introduced on the trading day following the expiry of the near month contract.
#piry day
SL6 5.M .ifty futures contracts expire on the last Thursday of the expiry month. -f the
last Thursday is a trading holiday, the contracts shall expire on the previous trading day.
Contract si3e
The permitted lot si0e of SL6 5.M .-TG contracts is *BB and multiples
"rice steps for contracts
The price step in respect of .-TG futures contracts is )e. B.B<.
"rice (ands
There is no day minimum'maximum price ranges applicable for utures contract.
,owever in order to prevent erroneous order entry by trading members the operating
ranges are "ept at 2 (B F. -n respect of orders which have come under price free0e, the
members would be required to confirm to the /xchange that there is no inadvertent error
in the order entry and that the order is genuine. !n such confirmation the /xchange may
approve such order.

0)# )#&)#7 F*,*R#)
What is the underlying for )ense Futures?
The underlying for the Sensex utures is the ?S/ Sensitive -ndex of :B scrips, popularly
called the Sensex.
What is the contract multiplier?
The contract multiplier is <B. This means that the )upee notional value of a futures
contract would be <B times the contracted value.
What is the maturity of the futures contract?
)egulations permit introduction of futures up to (* months maturity. -nitially, however,
futures for the three near months have been introduced. !n H Kune the three futures for
Kune, Kuly and %ugust *BBB were started. These futures would expire on *H Kune, *J Kuly
and :( %ugust respectively. This is because the expiry date has been fixed as the last
Thursday of the month for each month. The day after the expiry, a new future would
come into existence for three-month maturity. or example on :B Kune, the September
future would come into existence. This future would expire on *I September, being the
last Thursday of the month.
What is the tick si3e?
The tic" si0e is "B.(". This means that the minimum price fluctuation in the value of a
future can be only B.(. -n )upee terms, this translates to minimum price fluctuation of )s.
< 8 Tic" si0e M 5ontract &ultiplier 1 B.( M )s. <B9.
!ow is the final settlement price determined?
The futures closing price will be calculated based on a set of (*B price points of the cash
sensex values ta"en between the last half an hour of trading. The highest and lowest *B
price points will be ignored and the closing price computed as an average of the
remaining IB price points. This process will ensure that manipulation of the closing price
by moving it in one direction for a short duration or for only a few contracts is
eliminated.
What happens to the profit or loss due to daily settlement?
-n case the position is not closed the same day, the daily settlement would alter the cash
flows depending on the settlement price fixed by the exchange every day. ,owever the
net total of all the flows every day would always be equal to the profit or loss calculated
above. 6rofit or loss would only depend upon the opening and closing price of the
position, irrespective of how the rates have moved in the intervening days.
!ow does the initial margin affect the a(ove profit or loss?
The initial margin is only a security provided by the client through the clearing member
to the exchange. -t can be withdrawn in full after the position is closed. Therefore it does
not affect the above calculation of profit or loss.
,owever there would may be a funding cost ' transaction cost in providing the security.
This cost must be added to your total transaction costs to arrive at the true picture. !ther
items in transaction costs would include bro"erage, stamp duty etc.
-ptions
What is an -ption?
!ptions are contracts that confer on the buyer of the contract certain rights 8rights to buy
or sell an asset9 for a predetermined price on or before a pre-specified date. The buyer of
the option has the right but not the obligation to exercise the option.
!ptions come in a variety of forms. Some !ption contracts, which have been
standardi0ed, are traded on recogni0ed exchanges. !ther !ption contracts exist that are
traded "over-the-counter", i.e., a mar"et where financial institutions and corporates trade
directly with each other over the phone. ?esides these, options also exist in an embedded
form in several instruments.
They popular basic instruments'variables underlying options are$
/quity 3 -ndex !ptions, !ptions on individual stoc"s, /mployee Stoc" !ptions
-nterest rates 3 ?ond !ptions, -nterest rate utures !ptions, !ptions embedded in
bonds, caps L floors, etc
oreign exchange 3 6lain vanilla calls and puts, barrier !ptions, various "inds of
exotic !ptions
!thers 3 including commodities, weather, electricity, etc.
Classification
!ption Seller - !ne who gives'writes the option. ,e has an obligation to perform,
in case option buyer desires to exercise his option.
!ption ?uyer - !ne who buys the option. ,e has the right to exercise the option
but no obligation.
5all !ption - !ption to buy.
6ut !ption - !ption to sell.
%merican !ption - %n option, which can be exercised anytime on or before the
expiry date.
/uropean !ption - %n option, which can be exercised only on expiry date.
Stri"e 6rice' /xercise 6rice - 6rice at which the option is to be exercised.
/xpiration Date - Date on which the option expires.
/xercise Date - Date on which the option gets exercised by the option
holder'buyer.
!ption 6remium - The price paid by the option buyer to the option seller for
granting the option.
What are Call -ptions?
% call option gives the holder 8buyer' one who is long call9, the right to buy specified
quantity of the underlying asset at the stri"e price on or before expiration date.
The seller 8one who is short call9 however, has the obligation to sell the underlying asset
if the buyer of the call option decides to exercise his option to buy.
What are "ut -ptions?
% 6ut option gives the holder 8buyer' one who is long 6ut9, the right to sell specified
quantity of the underlying asset at the stri"e price on or before a expiry date.
The seller of the put option 8one who is short 6ut9 however, has the obligation to buy the
underlying asset at the stri"e price if the buyer decides to exercise his option to sell.
What are Covered and &aked Calls?
% call option position that is covered by an opposite position in the underlying instrument
8for example shares, commodities etc9, is called a covered call.
4riting covered calls involves writing call options when the shares that might have to be
delivered 8if option holder exercises his right to buy9, are already owned.
/.g. % writer writes a call on )eliance and at the same time holds shares of )eliance so
that if the call is exercised by the buyer, he can deliver the stoc".
5overed calls are far less ris"y than na"ed calls 8where there is no opposite position in
the underlying9, since the worst that can happen is that the investor is required to sell
shares already owned at below their mar"et value.
4hen a physical delivery uncovered' na"ed call is assigned an exercise, the writer will
have to purchase the underlying asset to meet his call obligation and his loss will be the
excess of the purchase price over the exercise price of the call reduced by the premium
received for writing the call.
What is the Intrinsic 8alue of an option?
The intrinsic value of an option is defined as the amount by which an option is in-the-
money, or the immediate exercise value of the option when the underlying position is
mar"ed-to-mar"et.
or a call option$ -ntrinsic Calue 1 Spot 6rice - Stri"e 6rice
or a put option$ -ntrinsic Calue 1 Stri"e 6rice - Spot 6rice
The intrinsic value of an option must be a positive number or B. -t cannot be negative. or
a call option, the stri"e price must be less than the price of the underlying asset for the
call to have an intrinsic value greater than B. or a put option, the stri"e price must be
greater than the underlying asset price for it to have intrinsic value.
Who are the players in the -ptions Market?
Developmental institutions, &utual unds, -s, --s, ?ro"ers, )etail 6articipants are the
li"ely players in the !ptions &ar"et.
&IF,6 -",I-&)
%n option gives a person the right but not the obligation to buy or sell something. %n
option is between two parties wherein the buyer receives a privilege for which he pays a
fee 8premium9 and the seller accepts an obligation for which he receives a fee. The
premium is the price negotiated and set when the option is bought or sold. % person who
buys an option is said to be long in the option. % person who sells 8or writes9 an option is
said to be short in the option.
!ow &ifty -ptions will work
.S/ plans to commence trading in -ndex options shortly. The proposed contract
specifications for -ndex options are as below$
*nderlying Inde9
SL6 5.M .ifty
Contract )i3e
6ermitted lot si0e shall be *BB or multiples thereof
"rice steps for contracts
The price step in respect of .-TG options contracts is )e. B.B<.
"rice (ands
not applicable
)tyle
/uropean'%merican
,rading cycle
The options contract will have a maximum of three months trading cycle- the near month
8one9, the next month 8two9 and the far month 8three9. .ew contract will be introduced on
the next trading day following the expiry of the near month contract
#piry day
The last Thursday of the expiry month or the previous trading day if the last Thursday is
a trading holiday.
)ettlement (asis
5ash settlement on a T 2 ( basis
)ettlement prices
?ased on expiration price as may be decided by the /xchange
)W+")
What is a swap?
% swap is nothing but a barter or exchange but it plays a very important role in
international finance. % swap is the exchange of one set of cash flows for another. %
swap is a contract between two parties in which the first party promises to ma"e a
payment to the second and the second party promises to ma"e a payment to the first. ?oth
payments ta"e place on specified dates. Different formulas are used to determine what the
two sets of payments will be.
5lassification of swaps is done on the basis of what the payments are based on. The
different types of swaps are as follows.
-nterest rate swaps
5urrency Swaps
5ommodity swaps
/quity swaps
Interest rate swaps
The interest rate swap is the most frequently used swap. %n interest rate swap generally
involves one set of payments determined by the /urodollar 8A-?!)9 rate. %lthough, it
can be pegged to other rates. The other set is fixed at an agreed-upon rate. This other
agreed upon rate usually corresponds to the yield on a Treasury .ote with a comparable
maturity. %lthough, this can also be variable.
%dditionally, there will be a spread of a pre-determined amount of basis points. This is
+ust one type of interest rate swap. Sometimes payments tied to floating rates are used for
interest rate swaps. The notional principal is the exchange of interest payments based on
face value. The notional principal itself is not exchanged. !n the day of each payment,
the party who owes more to the other ma"es a net payment. !nly one party ma"es a
payment.
Currency swaps
% currency swap is an agreement between two parties in which one party promises to
ma"e payments in one currency and the other promises to ma"e payments in another
currency. 5urrency swaps are similar yet notably different from interest rate swaps and
are often combined with interest rate swaps.
5urrency swaps help eliminate the differences between international capital mar"ets.
-nterest rates swaps help eliminate barriers caused by regulatory structures. 4hile
currency swaps result in exchange of one currency with another, interest rate swaps help
exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap
transaction are diametrically different. Swaps are not traded or listed on exchange but
they do have an informal mar"et and are traded among dealers.
% swap is a contract, which can be effectively combined with other type of derivative
instruments. %n option on a swap gives the party the right, but not the obligation to enter
into a swap at a later date.
Commodity swaps
-n commodity swaps, the cash flows to be exchanged are lin"ed to commodity prices.
5ommodities are physical assets such as metals, energy stores and food including cattle.
/.g. in a commodity swap, a party may agree to exchange cash flows lin"ed to prices of
oil for a fixed cash flow.
5ommodity swaps are used for hedging against
luctuations in commodity prices or
luctuations in spreads between final product and raw material prices 8/.g.
5rac"ing spread which indicates the spread between crude prices and refined
product prices significantly affect the margins of oil refineries9
% 5ompany that uses commodities as input may find its profits becoming very volatile if
the commodity prices become volatile. This is particularly so when the output prices may
not change as frequently as the commodity prices change. -n such cases, the company
would enter into a swap whereby it receives payment lin"ed to commodity prices and
pays a fixed rate in exchange. % producer of a commodity may want to reduce the
variability of his revenues by being a receiver of a fixed rate in exchange for a rate lin"ed
to the commodity prices.
#quity swaps
#nder an equity swap, the shareholder effectively sells his holdings to a ban", promising
to buy it bac" at mar"et price at a future date. ,owever, he retains a voting right on the
shares.
C-M"-&#&,) -F )W+" "RIC#
What are the components of a swap price?
There are four ma+or components of a swap price.
?enchmar" price
Aiquidity 8availability of counter parties to offset the swap9.
Transaction cost
5redit ris"
0enchmark price9 Swap rates are based on a series of benchmar" instruments. They
may be quoted as a spread over the yield on these benchmar" instruments or on an
absolute interest rate basis. -n the -ndian mar"ets the common benchmar"s are &-?!),
(N, H(, (I* L :;N day T-bills, 56 rates and 6A) rates.
Liquidity9 Aiquidity, which is function of supply and demand, plays an important role in
swaps pricing. This is also affected by the swap duration. -t may be difficult to have
counterparties for long duration swaps, especially so in -ndia.
,ransaction Costs9 Transaction costs include the cost of hedging a swap. Say in case of
a ban", which has a floating obligation of H( day T. ?ill. .ow in order to hedge the ban"
would go long on a H( day T. ?ill. or doing so the ban" must obtain funds. The
transaction cost would thus involve such a difference.
Gield on H( day T. ?ill - H.<F
5ost of fund 8e.g.- )epo rate9 3 (BF
The transaction cost in this case would involve B.<F
Credit Risk9 5redit ris" must also be built into the swap pricing. ?ased upon the credit
rating of the counterparty a spread would have to be incorporated. Say for e.g. it would
be B.<F for an %%% rating.