Derivatives Introduction

(Forwards, Futures, Options and SWAPS)

Adil A khan
 Derivatives Instruments

• Derivative instruments are management

tools derived from underlying exposure such
as currency, commodities, shares, bonds or
any of the indices.
• It is used to reduce or neutralize the
exposures on the underlying contracts.
• Derivatives help to hedge against the
uncertain movements in the prices of the
underlying contracts.
• Of late, derivative products have been
developed relating to events such as rain
fall or weather, as they in turn affect
demand for say, agro-products and utilities
such as air-conditioners respectively.
• A derivative product is a financial contract
whose value is derived from spot prices in
an underlying market which may be a
financial market or a commodity market.
• By definition, derivatives always refer to a
future price.
 OTC and Exchange Traded Products
• Banks may structure a derivative product to suit the
individual client-based on his risk appetite, size of
transaction and maturity requirements
(customized).
• The derivative products that can be directly
negotiated and obtained from banks and
investment institutions are known as Over-The-
Counter (OTC) products.
• Some of the derivative products traded in
exchanges
– Stock, future, commodity exchanges (BSE,NSE,MCX)
– International monetary exchange Chicago (IME)
– London financial futures exchange (LIFFE)
– Singapore stock exchange (SGX)
 Comparison
• OTC products
– (forwards, currency and
interest rate options, SWAPS
etc)
1. Contracts of any size and
maturity can be structured and
accordingly priced to suit
requirement of individual
clients
2. Counter party risk (bank risk) is
present.
• Exchange Traded Products
– (Currency, interest rate and
commodity futures and options
stock / index options and
futures etc)
1. Only standardized contracts
with fixed delivery dates are
traded; prices fluctuate
according to market
1. There is no counter party risk,
all trades are exchange
protected.
3. Banks are the main 3. Only members of the
players in the OTC exchange can trade in the
products.
market.
3. Prices are market
determined, and members
3. Option premium – cost need to comply with margin
requirements, on the basis
of the option – is to be of their positions marked to
paid upfront; costs are market daily
loaded into agreed
rates in other products 3. Market is highly liquid; all
prices are market
determined
3. Market is not liquid;
cancellation/reversal of
positions may become
expensive.
 Forwards Exchange Contracts

• In international trade transactions, exporters

and importers run the risk of exchange rate
fluctuations.
• Floating rate, volatile, adverse/favorable.
• Exact time of shipment.
• Space, port congestion – delay.
• Goods are invoiced in foreign currency.
• Cost of goods.
• Time lag – commercial contract date, shipment
payment.
• Exporter in India exports shirts
– 1 shirt = Rs 2345 ($35)
• 1$ = Rs 67
• Buyer and seller want to protect themselves
against exchange rate movements – entering into
forward exchange contract.
• Forward exchange contract is a contract wherein
two parties (in India one party compulsorily being a
bank) agree to deliver certain amount of foreign
exchange at an agreed price / rate at a fixed future
date or in certain cases during a future period.
• A forward rate is the price the market sets for the
currency today for the delivery on a future date
• Under forward contract, since the price
of the foreign currency is fixed today for
delivery on a future date, the risk of any
adverse price movement is removed or
covered.
• Commodity – gold, silver, metal.
• Chicago Board of Trade – 1851 – Rice,
Maize
• Typically OTC derivative (made to the
order) not exchange traded facilities
fixed lots period tenors (traded on
exchange)
• Forward rate is a function of spot price plus
cost of carry.
• Forward premium / discount
• Carry – storage, insurance, int. rate
• In forex markets the forward rate is a
function of spot rate and premium/discount
of the currency
• The currency with the lower interest rate
would be at a premium at future while the
currency with the higher interest rate would
be at a discount at the future.
• The forward exchange rate would be thus be
a function of spot rate plus or minus
premium/discount as the case may be.
• The premium/discount would depend upon
mainly on the interest rate differential of the 2
currencies, but also on the demand/supply of
the currency for the future deliveries, the
perception, the political, fiscal and other
trade related conditions in the country and
for the currency.
• The forward differential should be almost
equal to the interest rate differential of the
two currencies being dealt with.
• Forward contracts could be fixed date
forward contract or option period contracts
– Fixed date delivery, 1 month, 3 month, 6 month.
• Lack of liquidity and counter party default
risks are the main drawbacks of forward
contracts
 Futures

• Futures are most popular and widely used derivative

products.

• Another version of exchange traded forward contracts.

• A currency futures contract is an agreement between

2 parties made through an organized exchange – in
this case a futures exchange. The contract is for a
specific amount of a specific currency to be delivered
at a specific time determined by the exchange.
• Investors use these futures contracts to
hedge against foreign exchange risk, they
can also be used to speculate on rising or
falling exchange rates.
• The parties that trade on exchange can trade
for themselves or for their customers.
• There are specific rules and regulations that
set the terms of the contract and procedure
for trading.
 Types of futures contract

• Commodity futures: the underlying assets of these

contracts are commodities, which may be agricultural
commodities (rice, wheat etc.) or industrial goods (gold,
silver, etc.)

• Financial futures: where the underlying assets are

financial instruments such as treasury bills, bonds, notes,
etc., they are called financial futures.

• Currency futures: where convertible currencies (US$ etc.)

are the underlying assets, they are called currency futures.

• Index futures: where an acknowledged index, e.g. the New

York Stock Exchange, etc. are underlying assets, they are
called index futures.
• Leading financial futures –
• CBOT – Chicago Board of Trade, USA
• CME – Chicago Mercantile Exchange,
USA
• IMM – International Monetary Market,
USA
• LIFFE – London International Financial
Futures Exchange
• NYMEX – New York Mercantile
Exchange
• SIMEX – Singapore Mercantile
Exchange
 Key features of the Future Contract

• An organized exchange

• Standardized Contract –

• Underlying asset size e.g. ₤ 25,000

• Time of maturity (expiry date 3rd Wednesday)

• Associated clearing house – smooth

functioning
• A distinct feature of a future is that the contracts
are marked to market daily, and the members are
required to pay a margin equivalent to daily loss if
any. This way the possibility of default on the
settlement date is avoided

• Delivery under future is not a must, and the

buyer/seller can set off the contract by packing the
difference amount at the current rate/price of the
underlined.
 Margin Process

• Initial margin – small margin to play /

enter into large value contract (US $
1.00 Mil)
• Variable margin – calculated daily by
marking to market. Adverse / favorable,
margin call.
• Maintenance margin – similar to
minimum balance
 Futures vs. Forward contract

Futures Forward
1. This is always 1. This is not exchange
exchange traded – traded as it is only on
the exchange clearing ‘over the counter’ i.e.
house acts as a private contracts.
counter – party 2. This is tailor – made
2. Terms of the contract to suit the clients, it is
in terms of quantity, flexible and non-
quality, maturity, etc. standardized
are all standardized.
 Futures vs. Forward contract

3. Maturity of the 3. Maturity of the

contract does not contract may be
generally exceed a beyond a one-year
one-year period. period.
4. Works on margin
requirements, and are 3. Margins not
marked to market compulsory. Not
everyday. marked to market
everyday.
 Futures vs. Forward contract

5. Settlement is usually 5. Delivery is essential.

done by cash
payments/closing out –
normally there is no
physical delivery.
6. Credit risk is eliminated, 5. Credit risk on counter
through margin deposit / parties i.e. buyer/sellers
due settlement with the
backing of the exchange 5. This is purely for hedging
7. This contract serves the requirements.
need for hedging and
speculating of the parties
Options
 Currency options

• The currency option is the popular foreign

exchange instrument
• It is a contract that gives the buyer / holder
the right, but not the obligation, to buy or sell
a currency at a
– Specified / prefixed exchange rate on or before
– A specified future date.
 Parties to option contracts

1. Holder of right (buy/sell) : Option buyer

2. Provider of right (buy/sell) : Option writer

 Basic types of option contracts

• Options are either call options or put options

• The buyer of a ‘call option’ or ‘call’ has the
right, but not the obligation to purchase the
currency
– In other words, he has the right to ‘call’ the
currency at the agreed rate, the ‘strike rate’
– The buyer pays fee called a premium for this call
right
• In ‘put option’ or ‘put’ the seller (‘writer’)
gives the buyers the right but not the
obligation to sell a currency to the writer
(seller) of the option at a agreed rate (the
strike price)
• The writer (seller) has the obligation to
purchase the currency at that strike price, if
the buyer decides to exercise the option
• The buyer pays the writer a fee called the
premium for that right.
• The price at which the option may be
exercised and the underlying asset bought or
sold is called strike price/exercise price

• The cost of the option usually levied upfront

on the buyer of the option is called premium.

• The final day on which the option may be

exercised is called the maturity date/expiry
date.
 Features of Option contracts

• Option Holder or buyer

– Would exercise the option (buy/sell) in case the

market price moves adversely

– Would allow the option contract to lapse in case

the market price is favorable than the option
price.
• Option Writer (Seller) usually a bank or a
financial institutions or an exchange is under
obligation to deliver the contract if exercised
at the agreed price, but has no right to refuse
the same.
• Option are traded in exchange where the
counter-party is the option exchange and
also the OTC products.
• Standard Features- Plain Vanilla Contracts
• Exotic Contracts- Generally not traded in the
exchanges and are structured between
parties. Genuine Hedging
• In the money: When the strike price is below
the spot price in case of call option or when
the strike price is above the spot price in
case of the put option, the option is in the
money giving gain to the buyer.
• At money: When the strike price is equal to
the spot price
• Out of the money:
– Strike price above the spot - call
– Strike price below the spot -put
– Option is said to be out of money - allowed to
expire
• Options are of two types when seen from
delivery/ expiry angle
– American Option- can be exercised on any date
before and including the expiry date.
– European Option- can be exercised on the
maturity date.
• The option contract insures the buyer
against the worst case scenario allows him
to take advantage of any favorable
movement in the spot rates.
 Example

• USD/Re on 01/10/2009 an exporter has a

receivable of USD 1 million value 6 months,
i.e. 01/04/2010.
• The spot 01/10/2009 USD/Re is 47.00
• Put option for USD/RE 47.50 value
01/04/2010 at a premium of 0.05paisa/USD
• On the expiry date i.e. 01/04/2010 the spot
USD/Re is 48.05.
 Solution

• The exporter allows the option to expire

and sell his USD in the market at 48.05
getting 0.50 paisa after adjustment of
premium cost.
• He has thus taken a chance to avail upside
by bearing a small cost in the form of the
premium, and thus insured the value of his
USD earning at 47.45 (47.50-0.05) on one
hand and on the other hand, retained the
right to avail the advantage of any market
move in his favour beyond the strike rate.
SWAPS
 Development of Swaps market

• Globalization of the financial markets.

• Access of financial institutions in generating
resources from different countries.
• Different currencies.
• Deploy funds in countries and currencies
which may not be same as these resources
raised countries.
• Played a role in the development of swap
market.
• Swap market started developing in 1980.
• Large multinationals felt the need for
investments in the currency of foreign
country.
• Multinationals were able to generate home
currency more easily.
• Swap market developed as an OTC market
product.
• Later on the volumes and the demand
picked up several exchange offer swap
products.
• The word swap literally means an exchange.
There are two basic kinds of swaps:
• Interest rate swap.
• Currency swap.
• Interest rate swap may regarded as truly
global derivative instrument.
• It is an agreement between two parties to
exchange interest rate obligations / receipt or
an agreed notional principle amount for a
agreed period.
• There would be no exchange of principle
amount, only interest streams would be
exchanged.
• Fixed / Floating Interest Swap.
• Typically ‘plain vanilla’ was the key stone in
the growth of the swap markets.
• Credit market users recognized the relative
advantage enjoyed in fixed and floating rate
markets due to variations in credit rating and
perceptions.
• Typically two borrowers would each
simultaneously raise funding in the market in
which they enjoyed absolute and
comparative advantage and then exchange
interest rate obligation on identical notional
principle amounts and corresponding rates,
to generate cost of funding to both parties.
 Example

• A company with a US $50million loan facility on

which it pays interest at the rate of 6 months
LIBOR plus a margin of 2.50 pa. wishes to fix its
interest cost for a 5 year period. Co requested its
bank an interest rate swap quotation. Its bank
advises that its offer rate to receive fixed rate for 5
years against the payment of 6 month LIBOR is 5%
semi annual. The CO wishes to match the payment
flows under the loan with the swap and agrees to
pay the increased fixed rate of 5.50% to receive 6
months LIBOR plus 2.50%. (all payment on over
actual / 360days basis).
 Cash flow of the above example may be illustrated as follows:

Existing LIBOR
floating rate plus 2.5 % Company
lending

Fixed LIBOR
5.5% Plus 2.5%

Bank
• In the above case the CO will be protected at
the fixed rate irrespective of the level to
which 6 months LIBOR rises.
• In executing the transaction the co treasurer
taken view.
• To fix the cost - conversion of floating to fixed.
• Interest rate view.
• The flexibility of swaps is such that as OTC
instruments they may be exactly tailored to
the user required.
• Currency swaps: involves exchange of
currencies at a specified exchange rate and
to make a series of interest payments for the
currency that is received at a specified
intervals.