FINANCIAL MARKETS AND INSTITUTIONS

FINANCIAL DERIVATIVES AND RISK MANAGEMENT

SESSION TODAY
Financial Derivatives Futures Options & their types Swaps Futures - Basics Futures V/S Forward Types of equity futures in Indian Stock Market Futures Terminology Typical specifications of futures in India Applications of futures Futures Pricing

What are Derivatives?

A derivative can be defined as a financial instrument / contract, which derives its value from the underlying asset (i.e. the asset mentioned in the contract). Depending on what the underlying asset is, the derivative could be named differently: Stock Derivative, Commodity Derivative, Currency Derivative, Index based Derivative, etc. Thus a Stock Derivative is a contract to either sell or buy a stock i.e. equity at a certain time in future at a price agreed upon at the time of entering into such a contract.

FINANCIAL DERIVATIVES

DERIVATIVES
Real Estate
Commodity Derivatives Foreign Exchange

Equity Derivatives

Debt Derivatives

Index Products

Stock Derivatives

Interest Rate

Bonds, T-Bills, Govt. Secs.

NEED FOR DERIVATIVES

True and transparent price discovery is important for stock markets. Stock markets like any other market for financial instruments, involve risks associated with frequent price volatility. Hedging is therefore required with the objective of transferring the risk related to the possession of stocks through any adverse movement of price.

FUNCTIONS OF DERIVATIVES
Reflecting Market Perception Discovering Future as well as Current Price Transferring Risk from those who are averse to those who have an appetite Speculation in more controlled environment Involving more participants and increasing volumes

FORWARD CONTRACT

A Forward Contract is one of the simplest forms of derivatives. It is an agreement to buy or sell an asset at a certain time in future for a certain price mentioned in the contract. It is different from the spot contract Is usually traded in over the counter (OTC) mode. Buyers and Sellers would usually know each other. No institutional set up like an exchange is necessary. Example of a forward contract: ESOP (Employees Stock Option Plan)

FORWARD CONTRACT

Forward contract is specified by a legal document, the terms of which are binding on two parties involved in a specific transaction in the future.

on a priced asset, it is a financial instrument, since it has an intrinsic value determined by the market for underlying asset on a stock, it is a contract to purchase or sell a specific number of shares at specific time in future at a specific price agreed upon today buyer (long ): is obliged to take delivery of asset & pay agreed-upon price at maturity seller (short): is obliged to deliver asset & accept agreed-upon price at maturity

Contract is between two parties, buyer and seller.

Forward price applies at delivery and is negotiated so that there is little or no initial payment.

POSITIVE & NEGATIVE SIDES OF FORWARD CONTRACTS

Advantages: Each party fixes the purchase or sale price in advance. Little or No money changes hands on date 0 Drawbacks: Liquidity Counterparty or Credit Risk. Lack of centralized trading

In Nutshell:

A forward contract is an agreement today to buy or sell an asset on a fixed future date for a fixed price. It is different from a spot contract which is an agreement to buy or sell immediately, The fixed future date is called the maturity date, The price fixed on date zero is called delivery / strike price (DP / SP) , The delivery price is to be paid at maturity.

TERMINOLOGY

Please note that in a forward contract:

Agreement date is different from the delivery date. The spot price (SP) is different from the delivery price (DP) at least till maturity. The date of initiation is always taken as date 0 The date of maturity will always be represented by time to maturity (T).

Stock Futures
Stock

Futures contract is an agreement between two parties to buy or sell a specified number of stocks at a certain time in future at a price agreed upon at the time of entering into the contract on a Stock Exchange.

Special Features of a Futures Contract:

To ensure Liquidity: Futures contracts are Exchange traded and Have standardized contract terms To cover the counterparty or Credit Risk: Futures contracts are guaranteed by the concerned clearing house and Are settled on daily basis by Marking to Market

Futures contracts & Delivery

A very small percentage of Futures contracts would normally result into delivery of stocks. In most cases traders would offset their futures positions before the contracts mature. The difference between the initial purchase or sale price and the price of offsetting the transaction would represent the realized profit / loss.

Forward V/S Futures Contract

Forward Contract: It is unique / customized contract and hence non-standardized Not traded on exchanges. OTC is the preferred route. Liquidity is less No margins / advance required under normal circumstances Counter party risk exists for both parties Usually buying & Selling parties would know each other Settlement happens at the end of the period Futures Contract: Have standardized contract terms (Quantity, Time) Are Exchange traded and Liquidity is more Margin payment required Counter party risk borne by the Exchange. Buyers & Sellers need not know each other Follows daily settlement (Mark to Market)

TYPES OF FUTURES IN INDIAN STOCK MARKET

-

STOCK FUTURES Underlying will be an individual security Permissible lot size (no. of shares) will be specified by the stock exchange (minimum value may also be specified) INDEX FUTURE Underlying will be an index Permissible lot size (no.) will be specified by the stock exchange (minimum value may also be specified)

FUTURES TERMINOLOGY

Spot price Futures price Contract cycle: Futures on NSE have one (near month), two (mid month) and three (far month) months expiry. Expiry cycles expire on the last Thursday of the concerned month. On last Friday of the third / far month, a new contract having an expiry of three months is introduced. Expiry date: Specified in the contract. This is the last day on which the contract will be traded. At the end of this date, it will cease to exist. Contract size: Quantity of the underlying that has to be delivered e.g. contract size of NSEs S&P CNX Nifty Index future is 100 units.

TYPICAL FUTURES SPECIFICATIONS

STOCK FUTURES:

Underlying: Individual security say Infosys equity Trading Exchange: National Stock Exchange of India ltd. i.e. NSE Contract size: As specified by the exchange (minimum value Rs. 2.00 lakhs) Price steps: Re. 0.05 Contracts available: Near month, mid month and far month Expiry Day: Last Thursday of the expiry month or the previous day of trading if the last day is a trading holiday. Settlement basis: Mark-to-market and final settlement will be cash settled on T + 1 basis. Settlement price: Daily settlement price will be the closing price of the futures contract for the trading day and the final settlement price shall be the closing price of the underlying security on the last trading day.

TYPICAL FUTURES SPECIFICATIONS

INDEX FUTURES:

Underlying: Index say S & P CNX Nifty Trading Exchange: National Stock Exchange of India ltd. i.e. NSE Contract size: Permitted size will be 100 and multiples thereof (minimum value Rs. 2.00 lakhs) Price steps: Re. 0.05 Contracts available: Near month, mid month and far month Expiry Day: Last Thursday of the expiry month or the previous day of trading if the last day is a trading holiday. Settlement basis: Mark-to-market and final settlement will be cash settled on T + 1 basis. Settlement price: Daily settlement price will be the closing price of the futures contract for the trading day and the final settlement price shall be the closing price of the underlying index on the last trading day.

APPLICATIONS AND ADVANTAGES OF FUTURES

APPLICATIONS: To protect the value of investments against fall in value. To profit by correctly anticipating future market price changes ADVANTAGES: Easy to open or close positions since market is highly liquid High leverage is possible since you have to pay margin money only.

LONG FUTURES

Implies buying a futures contract and hence agreeing to take delivery of the underlying (or its cash value) at maturity. Implies that you are bullish on the price for the underlying. If price rises as expected, you make profit. If not, you would incur a loss. Potential profit as also the potential loss could be unlimited.

BUYING A LONG HEDGE

PAYOFF FOR BUYER OF FUTURES (LONG FUTURES)
PROFIT

STRIKE PRICE 0

LOSS

Price of underlying
60

SHORT FUTURES

Implies selling a futures contract and hence agreeing to give delivery of the underlying (or accepting its cash value) at maturity. Implies that you are bearish on the price for the underlying. If price declines as expected, you make profit. If not, you would incur a loss. Potential profit as also the potential loss could be unlimited.

SELLING HEDGE
PAYOFF FOR SELLER OF FUTURES (SHORT FUTURES)

PROFIT Strike Price

LOSS

Price of underlying
61

LEVERAGING FUTURES

Assume that Indian Hotels Share is currently (January) priced at Rs. 125/- and the February future on that share is priced at Rs. 130/-. To buy the future, you have to pay a margin of 10% i.e. Rs. 13/- per share. If the future rises to Rs. 135/-, the relative returns on the share and its future would be as follows: Returns on stock: Profit of Rs. 10/- (135-125) on an investment of Rs. 125/- i.e. 8 %. Returns on future: Profit of Rs. 5/- (135-130) on an investment of Rs. 13/- i.e. 38.46%

HEDGING STRATEGY

Futures can be used to protect the value of your holdings. Example 1: X has a portfolio of shares that trades approximately in line with the S & P CNX Nifty Index. On January 1, the portfolio is worth Rs. 50,00,000/-. X anticipates that the market will decline in the next one month and wants to lock in the value of his portfolio. S&P CNX Nifty is at 2050 points and its future is trading at 2080 points for February. X decides to hedge his risk and sells 12 S&P CNX Nifty Index future contracts (each lot is of 200units) at 2080 points. If S & P CNX Nifty Index falls to 1870 points in February, let us see if X has succeeded in protecting the value of his portfolio.

HEDGING EXAMPLE
CASH MARKET
JANUARY 1 S&P CNX Nifty INDEX = 2050 points Value of Share portfolio= Rs. 50,00,000/-

FUTURES
JANUARY 1 Sell 12 S&P CNX Nifty INDEX futures at 2080 points. Total income= 12X2080X200 = Rs. 49,92,000/-

February 7 S&P CNX Nifty INDEX =1870 points Value of portfolio = 45,60,975/- (assuming proportionate decline) Unrealized loss = Rs. 4,39,025/-

February 7 Buy 12 S&P CNX Nifty INDEX futures at 1870 points to square off the position. Total cost = 12X1870X200 = Rs. 44,88,000/Profit on futures= Rs. 5,04,000/-

HEDGING EXAMPLE
CASH MARKET
JANUARY 1 S&P CNX Nifty INDEX = 2050 points Value of Share portfolio= Rs. 50,00,000/-

FUTURES
JANUARY 1 Sell 12 S&P CNX Nifty INDEX futures at 2080 points. Total income= 11X2080X200 = Rs. 49,92,000/-

February 7 S&P CNX Nifty INDEX =2150 points Value of portfolio = 52,43,900/- (assuming proportionate decline) Unrealized profit = Rs. 2,43,900/-

February 7 Buy 12 S&P CNX Nifty INDEX futures at 2150 points to square off the position. Total cost = 12X2150X200 = Rs. 51,60,000/Loss on futures= Rs. 1,68,000/-

TRADE WITHOUT OWNING STOCKS

With equity futures, you can also profit from a fall in prices of shares and not only when the prices are rising. This practice is known as going short. You could go short and square off your position alter when the price falls. Thus you can profit without owning stocks. You could also profit by simultaneously trading in futures of two different shares if you can gauge the relative performance of these shares. This is called spread trading. You could also trade in futures of different months for the same share.

SPREADS

Spread is the difference in prices of two futures contracts. If the price of the far month futures contract is higher than the price of the near month futures contract, the market is said to be normal. Otherwise, it is called an inverted market. In normal markets, if the spreads do exceed the cost of carry, you can buy near months contract and sell far months contract. Inverted market offers an opportunity to sell a futures contract in near month and buy the same futures contract in far month.

PORTFOLIO ADJUSTMENT

Futures can be used to adjust portfolio. An investor who holds a particular share can switch his exposure to another by selling futures of shares held and buying futures of shares which he thinks are likely to perform better without having an expensive market transaction. Example 2. Assume that investor X holds 10000 shares of company A; but thinks that company B will perform better in the next few months. Future contracts of both companies are of 1000 shares each. To take the advantage of better performance (as conceived by X), X decides to sell futures of Share A and buy futures of share B.

PORTFOLIO ADJUSTMENT

Example 2. The current share and future prices (in Rs.) for the said shares are as follows:
Share A Share price Futures price 320 325 Share B 250 254

X sells 10 futures on share A and buys 13 futures on share B each position reflecting approximately the same value. Exposure of X to share A: 10 X 1000 X 325 = Rs. 32,50,000/Exposure of X to share B: 13 X 1000 X 254 = Rs. 33,02,000/-

PORTFOLIO ADJUSTMENT

Example 2 contd.. Assume that the share and future prices (in Rs.) for the said shares rise within a month as follows:
Share A Share price Futures price 336 338 Share B 275 277

X buys 10 futures on share A and sells 13 futures on share B to square off his position. Loss on share A: 10 X 1000 X (338 325) = Rs. 130,000/Profit on share B: 13 X 1000 X (277 254) = Rs.299,000 /Net profit would be = Rs. 169,000/- without losing ownership in shares of company A.

SPREAD TRADING

Example 3. X feels that share A is likely to outperform share B over the next few months. Both futures are for 1000 shares. The current share and future prices (in Rs.) for the said shares are as follows: January 4 Share price Share A 600 Share B 400

Futures price

675

450

X decides to buy 2 futures of share A and sell three futures of share B each position reflecting approximately the same value.

SPREAD TRADING

Example 2. Cost of purchase of futures of share A will be

Rs. 1000 X 2 X 675 = Rs. 13,50,000/- whereas the realization through sale of share B will also be Rs. 450 X 3 X 1000 = Rs. 13,50,000/-. Assume that the prices (in Rs.) after a few weeks (on February 14) are as follows

February 14 Share price Futures price

Share A 540 546

Share B 340 344

Prices of both shares have fallen though the price of share B has fallen by greater proportion than that of share A. While X would lose money on Share A, he will profit from share B.

Example 2 of spread contd.

Loss incurred by X on share A = - (675 546) X 2 X 1000 = - Rs. 2,58,000/ Profit made by X on share B = (450 344) X 3 X 1000 = Rs. 3,18,000/Net profit earned by X = Rs. 60,000/

Meaning and types of options:

An option is a formal futures contract which gives the holder the right, without the obligation, to buy or sell a certain quantity of an underlying asset at a stipulated price within a specific period of time.

Futures and options on both Index and Stock are traded on NSE

Forward Contracts V/S Options

The holder of forward contract is obliged to trade at the maturity of the contract.

Unless the position is closed before maturity, the holder must take possession of the stock, commodity, currency or whatever is the subject of the contract, regardless of whether the asset price has risen or fallen. An option gives the holder the right to trade in the future at a previously agreed price but takes away the obligations.
If stock / commodity price falls, you do not have to buy it after all. An option is a privilege sold by one party to another that offers the buyer the right to buy or sell a security at an agreed-upon price during a certain period of time or on a specific date.

Types of options
There are two types of options viz. a Call Option and a Put Option.

A Call Option is a contract that gives the owner of the call option the right, but not obligation to buy the underlying asset by a specified date and at a specified price. Upon exercise of that right, the option seller is obliged to sell the underlying product under the specified conditions to the option buyer. A Put Option is a contract that gives the owner of the put option the right, but not obligation to sell the underlying asset by a specified date and at a specified price. Upon exercise of that right, the option seller has the obligation to sell the underlying product to the option buyer under the specified conditions. THESE OPTIONS ARE ALSO CALLED VANILLA OPTIONS AND ARE THE SIMPLEST FORM OF OPTIONS TRADED ON EXCHANGES.

Call Option
The

right to buy a particular asset (stock) for an agreed amount at a specified time in the future. holder of a call option expects / wants the commodity price to rise so that he or she can sell the asset for more than it is worth (The holder is bullish on the market). option is exercised at expiry if the underlying price rises above the strike price and not if it is below.

The

Call

OPTION PAYOFF LONG CALL

FOR BUYER OF CALL OPTION

Break-even = 205

LOSS RESTRICTED TO PREMIUM, PROFIT UNLIMITED, IF PRICES RISE

Strike Price=185

Premium=20

OPTION PAYOFF SHORT CALL

FOR WRITER OF CALL OPTION

INCOME RESTRICTED TO PREMIUM, LOSS UNLIMITED IF PRICES RISE

Break-even = 205,

Premium=20

Strike Price=185

Put Option
The

right to sell a particular asset for an agreed amount at a specified time in the future. holder of a put option wants the commodity / stock price to fall so that he or she can buy the asset for less than it is worth. option is exercised if the commodity / stock price falls below the strike price and not if it rises above the strike price.

The

Put

LONG PUT

PAYOFF FOR A BUYER OF PUT OPTION (LONG PUT)

PROFIT Strike Price

Premium Paid LOSS

Price of the underlying asset

WRITING A PUT OPTION

PAYOFF FOR A SELLER OF PUT OPTION (SHORT PUT)

PROFIT

Premium Received

LOSS

Strike Price

Break even

Price of the underlying asset

More about options:

The purchase of an option limits the maximum loss and at the same time allows the buyer to take advantage of favorable price movements. Options are called options since they are not obligatory! The process by which the option holder uses the right conveyed by the option is known as exercise and the time by which exercise has to have taken place is expiry.

SUMMARY OF RISK & REWARD

POSITION
Long Future Short Future Long Call Option Short Call Option Long Put Option Short Put Option

RISK
Almost unlimited Unlimited Limited to Premium Unlimited (if not covered) Limited to Premium Almost unlimited

REWARD
Unlimited Almost unlimited Unlimited Limited to Premium Almost unlimited Limited to Premium

OPTIONS PREMIUM

An option premium is made up of two components its intrinsic value and time value. Intrinsic value is the difference between the exercise price and the current price. The intrinsic value is that part of the premium which could be realized if the option were exercised. Such an option is referred to as "in-the-money". A call option has intrinsic value only if the underlying product price is above the option price. Conversely, a put option has intrinsic value only if the underlying product price is below the option price. Time value is the amount, if any, by which an options premium exceeds its current intrinsic value. Time value reflects the willingness of buyers to pay for the right offered by the option and the willingness of sellers to incur the obligations of the options.

Types of Options (Exercise Mode)

American style options: The buyer of the option can choose to exercise his option at any given period of time between the purchase date and the expiry date European style options: The buyer of the option can choose to exercise his option only on the expiry date WHY? The premium paid to buy an American style option is normally equal to or greater than the European style option for the same underlying commodity futures contract.

Some more options!!

Bermudan options Exercise on specific days or periods only Asian Options Payoff depends on average price of underlying asset over a certain period of time Exotic Options More complex cash flow Structures. EXAMPLES :Barrier, look-back, Shout, Exchange, & so on

PRICING OF FUTURES

Spot prices and Futures prices are different mainly because of the Cost of Carry Cost of carry in case of commodities would include following elements of cost : Cost of storage (Food Grains / perishable commodities),

Cost of insurance, Cost of financing, Cost of feeding (Live stock), and Other undefined on unquantifiable costs such as security risks (Gold).

Simple pricing model for futures:

The cost of carry model can be defined as: F=S+C Where F=Futures price S=Spot price C=Cost of carry The fair value of a futures contract is therefore a theoretical value of where a futures contract should be positioned, given the current spot price, cost of financing, etc. & the time to expiration.

Pricing Futures Contract

F = S (1+r)n

Where, F=Futures price S=Spot price r= percentage cost of financing (annually compounded) n= Time till expiration of the contract If the value of 'r' is compounded m times in a year, the formula to calculate the fair value will be mn F = S (l+r/m) Where m = no. of times compounded in a year

Example

The cost of 100 grams of gold in the spot market is Rs. 60,000 & the cost of financing is 12% p.a., compounded monthly, the fair value of a 100 grams 4 months futures gold contract will be F = S * (l+r/m)mn F= 60,000 (1+0.12/ 12)12*4/12 F= 60,000(1.01)4 F = 60,000 * 1.0406 F=Rs. 62,436

Daily / continuous compounding

The fair value of a futures price with continuous / daily compounding can be expressed as: rn Where: F=Se r=percentage cost of financing n = Time till expiration of the contract e = 2.71828 The above formula is used to calculate the futures price of a commodity when no storage costs are involved. The futures price is equal to the sum of money 'S' invested at a rate of interest 'r' for a period of n years.

Example

For example: If the cost of 100 grams of gold in the spot market is Rs. 60,000 & the cost of financing is 12% p.a., the fair value of a 100 grams 4 month futures gold contract will be: F = 60,000 *e (0.12* 0.333) , F = 60,000 * 2.71828 (00399) F = 60,000 * 1.0407 F = Rs. 62,442

SWAPS

SWAPS

After studying Forward Contracts and Futures and Options, we would also study another class of contract / financial instrument called Swap. A swap is an agreement / contract between two parties to exchange different streams of cash flows in the future according to a predetermined formula.

SWAPS (CONTD.)

Usually swaps are used more often in case of cash flows related to interest rates and exchange rates. The first ever swap contract was negotiated and entered into between IBM and the World Bank in 1981. Ever since then the market for swaps (particularly in interest rates and exchange rates) has increased very rapidly. The swaps are however, still very rarely used in case of commodities or equities.

EXAMPLE OF SWAP

The company X :

Pays 5.5% to its lender It pays at the LIBOR under the SWAP with Y It receives 5% under the SWAP with Y

The company Y : It pays interest at (LIBOR + 0.30) to Lenders. It pays at 5% under the SWAP with X. It receives at LIBOR under the SWAP with X.

AFTER THE SWAP IS IN PLACE!

Effective or net outflow for X will be LIBOR + 0.5

LIBOR

5.5%

Company X 5%

Company Y

LIBOR + 0.3%

Effective or net outflow for Y will be 5.3%

Comparative advantage

Normally the parties do not swap payments directly. Each of them sets up a separate swap with a financial intermediary such as a bank. In return for matching the two (or more if necessary) parties together, the bank takes a spread from the swap payments. Swaps originated mainly from the need to exploit the comparative advantage that different players have in different markets such as difference in perception of lenders in different markets or differences in fixed and floating interest rates in different markets.

SWAP FOR COMPARATIVE ADVANTAGE:

-----------------------------------------------------------------------------------FIXED RATE FLOATING RATE

----------------------------------------------------------------------------------- TCS 8.5 % (LIBOR +0.35) % XYZ LTD. 9.4 % (LIBOR +0.85) % ------------------------------------------------------------------------------------TCS enjoys an advantage over XYZ Company in overseas markets and can raise the required amount at a comparatively cheaper rate than XYZ Co. And yet both these companies could get benefited if they were to enter into a swap.

HOW?

Assume that TCS decides to borrow at fixed rate of 8.5 % per annum from Citi Bank while XYZ Co. decides to borrow at LIBOR plus 0.85 percent per annum also from Citi Bank.

SOLUTION

Both these companies (since they know and trust each other) then enter into an interest rate swap in which TCS agrees to pay interest at LIBOR to XYZ and the later agrees to pay a fixed rate of 8.35 percent per annum to TCS. The net impact of this swap will be as follows: Effective or net outflow for TCS will be (LIBOR + 0.15)%
ORIGINAL: 8.5%

LIBOR

TCS
8.35%

XYZ Co.
ORIGINAL: LIBOR+0.85%

Effective or net outflow for company XYZ will be 9.2% Usually a Banker or a Swap Dealer would organize a swap deal for a small commission. Include a Banker in above deal for a total commission of 0.1%

vanilla swaps

Simple or plain interest rate swaps explained earlier are also called plain vanilla swaps and fixed rates on vanilla swaps are called swap rates. Usually, plain vanilla swaps are those swaps in which fixed interest rate obligations are exchanged with floating interest rate obligations over a period of time. They are also known as coupon swaps or generic swaps. Vanilla swaps are of two types viz. Liability Swap and Asset Swap.

Liability and Asset Swaps

When interest obligations are exchanged, these are called Liability Swaps (as explained in earlier case). When interest incomes are exchanged, the swaps are called Asset Swaps e.g. A corporate may be holding treasury bonds with fixed rate of interest. Not comfortable with this situation, it may want to convert that into floating rate of interest by a swap with a bank. Please note that in these swaps there is no exchange / swap of the principal amount; only interest cash flows are swapped. The interests are calculated on the basis of notional value of the principal only.

Asset Swap an example

Corporate X possesses Treasury Bonds worth Rs. 20 crore that fetch it 7 % p.a. X will like to have floating rate of return and hence approaches Bank B for a swap. The bank agrees to pay it 3M NSE MIBOR while X agrees to pay the Bank at 6.5% p.a. Bank and X enter into an interest rate swap with following terms: Nominal Principal Amt. : Rs. 20 cr. X to pay : INR 6.5 % Fixed X to receive from Bank B : 3 Month NSE MIBOR Start Date of the swap : 19th Sep 06 Tenor of the swap : 6 months Termination of the swap : 19th Mar 07 Interest Payment Dates : 19th Dec & 19th Mar First Fixing : 6. 20% (NSE MIBOR as on 19/09/06) Assume that 3M NSE MIBOR moves to 6.3 on 19/03/07

ASSET SWAP ARRANGED

After the swap, Corporate X gets effectively (MIBOR + 0.5) in place of fixed rate of 7% p.a.

MIBOR
BANK BANK B B CORPORATE X.

7%

6.5%

SOLUTION
Cash Flow On the 19th Dec 06 : 3 Month NSE MIBOR : 6.20 % (This was the 3M NSE MIBOR on 19th Sep 06) X to pay : Rs. 0.3205 cr.

( Rs. 20 cr. X 6.50% X 90 days / 365 days)

Bank to pay

: Rs. 0.3058 cr.

Rs. 20 cr. X 6.20% X 90 days / 365 days)

Cash Flow On the 19th Mar 07 : 3 Month NSE MIBOR : 6.30 % (This was the 3M NSE MIBOR on 19th Dec 06) X to pay : Rs. 0.3277 cr.

( Rs. 20 cr. X 6.50% X 92 days / 365 days)

Bank to pay

: Rs. 0.3179 cr.

X pays Bank pays: : Rs. 0.6482 cr. : Rs. 0.6237 cr.

(Rs. 20 cr. X 6.30% X 92 days / 365 days)

RESULT:

BASIS SWAP

Also known as Floating - Floating interest rate swap It is a swap which involves floating rates either on the same or on two different currencies. Unlike the vanilla swaps which involve swapping fixed rate interest with floating interest rate (in the same currency and where the principal amount is notional and not swapped), basis swap would involve swapping floating rate interest on one financial instrument with floating rate interest of another financial instrument. For example,

Swapping a treasury bill yield (variable / floating) with MIBOR (same currency). Swapping Dollar LIBOR with Yen LIBOR (different currencies)

CURRENCY SWAP

This is a financial instrument / contract between two counter parties for exchange of principal & fixed rate of interest payments on a loan in one currency with a loan in another currency. In a currency swap two parties effectively trade assets and liabilities denominated in different currencies. The simplest currency swap is an agreement to sell a currency now at a given price and then repurchase it at a stated price on a specified future date. The difference between the two prices is called the swap rate. Example: A German bank might swap for $ with a Canadian bank by agreeing to sell 1 million at a price of /$ = 0.60 and to repurchase 1 million a year later at a price of /$ = 0.70. This currency swap allows the German bank to borrow $ and the Canadian bank to borrow .

CURRENCY SWAP

A Company in Japan is interested in borrowing US Dollars 100 million while a company in USA is interested in borrowing equivalent amount in Japanese yen. They have comparative advantages and hence decide to raise money through issue of bonds in their own countries and later arrange a swap. US company raises US $ 100 Mn. from investors in US by issuing 5.6% USD bonds and Japanese Company raises JY 8.6 billion from investors in Japan by issuing 1.65% JY Bonds. Both have a maturity period of 5 years period for which they wish to avail of the finance. At the beginning of the swap they exchange the money (principal) collected by them in their respective countries and agree to pay interest on them. Conversion rate agreed at the time of swap is one US Dollar for 86 Japanese Yen Thus US company gets JY 8.6 billion and starts paying interest at the rate of 1.65% per annum i.e. JY 1.419 Bn per annum (Annual Simple Interest assumed) whereas Japanese company gets US $ 100 Mn and starts paying annual interest of US $ 5.60 Mn.

CURRENCY SWAP EXPLAINED IN THREE SIMPLE STEPS

STEP I

US COMPANY
STEP II

US Dollars 100.0 Mn.

Japanese Yen 8.6 Bn

JAPANESE COMPANY

JY 141.9 Mn @1.65% per annum

US COMPANY
STEP III

US $ 5.60 Mn @5.6 % per annum

JAPANESE COMPANY

Japanese Yen 8.6 Bn

US COMPANY

US Dollars 100.0 Mn.

JAPANESE COMPANY

CURRENCY SWAP
JPY 8.6 BN

AT THE START OF SWAP

USD 100 MN

JPY 1.65%

U.S. COMPANY
USD 5.6%

JAPANESE CORPORATE Y

COMPANY

AT THE MATURITY OF SWAP

USD 100 MN JPY 8.6 BN

CURRENCY SWAP

Often currency swaps are tied to debt issues. Two parties issue debt instruments denominated in two different currencies and then agree to swap the proceeds of the debt issues and to repay each other's debts effectively transforming each debt into the other currency. Though we have taken the example where the interest rates are fixed for both currencies, a different combination could also be arranged:

Fixed rate of interest on USD and floating rate on JPY Floating rate on USD and fixed rate on JPY Floating rate on USD and floating rate on JPY Fixed rate of interest on both currencies as explained in the example.

Meaning of Basis and Spreads

Basis is the difference between the cash / spot price of a commodity and its futures price Basis = Spot or Cash Price Futures price If cash price is less than the futures price, basis is negative and the market is said to be in contango. A strong basis is indicative of short supply. As soon as supply needs are met, basis levels (offerings) will weaken. Short supply in a given period for a commodity, will result in strong basis offerings until supply needs are met.

Basis (Contd.)
If the spot price of an asset is more than the futures price of the underlying asset, the basis is positive and the market is said to be in backwardation. When the futures contract approaches expiry, the spot price and futures price converge with each other. (WHY?)

REVIEW QUESTIONS

Define the following, draw pay-off diagrams and explain in brief: i. Short Put ii. Long Put iii. Long Hedge Describe how you would use futures to protect the value of your portfolio if it trades approximately in line with a given stock index. Explain how you would hedge your risks in falling markets. Define forward contract and futures contract and describe how futures contract is different from forward contract. Write short notes on i. Basis iv. Option premium ii. Spread v. Deep in-the-money put option iii.Hedge ratio vi. Vanilla options

REVIEW QUESTIONS

How options could be used to hedge planned purchase of shares in the future. Describe the circumstances in which a put option on shares will not be exercised by its owner. Also discuss the consequences of a put option remaining unexercised.

Reference text books / Study Material

NSEs Study Material Options, Futures and other derivatives by John C. Hull Futures, Options and Swaps by Robert W. Kolb & James A. Overdahl