International Derivatives

Market






Ashwini Karkera C024
Ajit Nayak C033
Jay Parikh C037
Shramana Saha Roy C043
Romit Salecha C044
Omkar Athalekar E005
Hina Gupta E022
Rohan Sarmandal E048

Contents
1) Introduction ........................................................................................................................ 2
2) Currency Futures ............................................................................................................... 4
3) Options ................................................................................................................................ 7
a) Call Option ................................................................................................................... 8
b) Put Option................................................................................................................... 10
c) Exotic Option .............................................................................................................. 13
4) Currency Swaps ............................................................................................................... 20
5) Interest Rate Swaps ......................................................................................................... 22
6) Collateralized Debt Obligation ....................................................................................... 25
7) Credit Default Swap ........................................................................................................ 28



Introduction
As the word suggests, a derivative is an instrument that derives its value from an underlying
asset or simple an underlying. On the basis of how they are traded, derivatives are of two
types:
Over the counter
Exchange traded(on organised exchanges)
Parameter OTC Markets Exchange Traded Markets
Centralization
of market
The market is decentralized; there
are many mediators who compete to
link buyers to sellers.
Here transactions are completed
through a centralized source
(exchanges) which acts as the
clearing house.
Standardization
All contract terms such as delivery
quality, quantity, location, date and
prices are negotiable between the
two parties. Therefore, the contract
can be tailor-made to the two
parties liking.
Since all market participants
counter-parties is the exchange, the
derivative contracts are standardised
with specific delivery or settlement
terms

Counterparty
Risk
Higher counterparty risk
Very low counterparty risk since
counterparty is the exchange itself
Visibility
It is an open market wherein there is
a clear visibility for prices, start
date, expiration dates in the public
domain
All the terms & conditions
associated with any derivative
transaction is between the
counterparties only. Prices cannot
be determined since contracts are
customised.
Examples
Interest Rate Swaps
Currency Swaps
Forwards
Currency Futures


Types of Derivatives Instruments which we will be covering:
I. Futures
a. Currency Futures
II. Options
a. Call option
b. Put Option
c. Exotic Options
III. Swaps
a. Currency Swaps
b. Interest Rate Swaps
c. Credit Default Swaps

As we can see from the graph, the notional amount outstanding of the Exchange traded
market is $ 64 trillion which is dwarfed by the size of OTC market at $ 710 trillion. Also the
lions share of the OTC market belongs to the Interest Rate instruments. The reason why
these numbers are so staggering is that they denote the notional amounts outstanding and not
the actual cash flows of the transactions. The amount of net cash flows arising out of the
derivative contracts would be considerably less.
Benefits of derivatives make them indispensable to the global financial system and the
economy. Derivatives provide benefits such as:
Risk protection with minimal upfront investment and capital consumption
Allow investors to trade on future price expectations
Have very low total transaction costs compared to investing directly in the underlying
asset
Allow fast product innovation because new contracts can be introduced rapidly
Can be tailored to the specific needs of any user
Derivative instruments are subjected a number of risks such as:
Market risk arising from price behavior of the underlying instrument
Credit risk stems from loss that occurs when the counter party to derivative contract
defaults
Operational risk arises when losses occur because of inadequate systems and control
or human error
Settlement risk when there is delay in settlement of payment or delivery of
securities from the counterparty
Systemic risk failure of financial market as a whole

7,10,183
64,615
Size and Composition of
International Derivatives Market
in $ billion
OTC
Exchange
Traded
82%
10%
4%
3%
1%
Split of OTC Market
Interest Rate
Contracts
Foreign
Exchange
contracts
Unallocated
Credit Default
Swaps
Equity Linked
Contracts
Currency Futures
Suppose an individual wants to export after a month and wants to hedge the foreign exchange
risk, then he could enter a currency future contract. This contract is to exchange two
currencies at a fixed exchange rate on a specified date in the future. On NSE, the price of a
currency future, also known as FX future, is in terms of INR per unit of other currency e.g.
US Dollars. In the Unites States, the price is generally stated in USD/unit and the size is set in
units of foreign currency. Thus a Euro contract EUR125,000 would mean that a change in
price of the currency unit of USD 0.0001 would translate into a gain or loss of USD12.5 on
the contract. Currency future contracts, unlike forward contracts, are traded on organized
exchanges. They are highly standardized contract which specify the quantity, delivery time
and manner of delivery. The exchange sets the minimum price fluctuation called tick size and
the maximum price movement allowed in a single day.
Advantages of Futures over Forwards:
The main advantage of currency futures over forwards which are traded over the counter lies
in transparency in prices and elimination of counterparty credit risk. It also has a greater
reach in terms of easy accessibility to all. Arbitrageurs, speculators and traders who want to
bet on exchange rate movements also participate in currency futures apart from pure hedgers.

Currency Futures on NSE:
On NSE, the currency futures contract are available for US$, Euro, GBP and Japanese Yen.
The contract could be carry forward or intra-day with following specifications
Symbol USDINR EURINR GBPINR JPYINR
Unit of Trading 1 unit-denotes
1000 USD
1 unit-denotes
1000 EURO
1 unit-denotes
1000 POUND
STERLING
1 unit-denotes
1000
JAPANESE
YEN
Tick Size 0.25 paise or INR 0.0025
Contract Trading Cycle 12 month trading cycle.
Initial Margin SPAN Based Margin
Price Operating Range Tenure up to 6 months: +/-3 % of base price
Tenure greater than 6 months: +/-5 % of base price
Settlement Daily settlement : T + 1
Final settlement : T + 2
Mode of Settlement Cash settled in Indian Rupees

Currency Futures on CME Group:
CME Group Inc. (Chicago Mercantile Exchange) is one of the largest options and futures
exchanges. It trades a number of currency futures and some of them are also in cross currency
that helps companies to hedge risk directly. Some of the contracts are described below.
Product Contract Size Tick Size Contract Months Maintenance Margin
Euro 12,500 Euros US$1.25
Quarterly
1,750 US$
Japanese Yen 10,000 US dollars 100 2,750 US$
British Pound 6,250 British pounds US$0.625 1,250 US$
Australian
Dollar
10,000 Australian
dollar
US$1 1,300 US$
Initial margins are set at 110% of the maintenance margin.
For the currency futures, certain amount of money needs to be deposited in an account before
any trading takes place. This is called Initial Margin. Based on daily fluctuations, the margin
balance is adjusted. However there has to be a fixed amount of margin that must be
maintained in the account which is called Maintenance margin. If the margin balance falls
below it, additional funds must be deposited to bring balance up to the initial margin. These
margins are set by the clearing houses.
In case of futures, there is a buyer and seller on each side of the trade where the exchange
selects the contracts that will trade. Each time there is a trade, the delivery price for that
contract is the equilibrium price at that point in time, which depend on supply and demand.
The mechanism used to determine this equilibrium is an open outcry at a particular location
on the exchange floor called pit. Each trade is reported to the exchange so that the
equilibrium price is known to all traders.
Consider a future contract that has daily price limits of two paise and settled at $1.04 and next
day it settles at $1.07. The price is said to be limit up. If the contract would have settled at
$1.03 then the price is said to be limit down. Suppose the exchange has daily price limits of
two cents and the traders wish to trade at $1.07 then no trades would take place and
settlement price would be reported as $1.06 and the contract would be said to be limit move.
The margin balances in future account is adjusted each day for the change in value of the
exchange rate from the previous trading day and this process is called Marking-to-market.
Illustration:
Suppose a trader buys i.e. long on August future contract at the rate of $1.5612 per British
Pound with a contract size of 62,500 units per contract in July. He opens a margin account
with an initial margin of $2,000 and a maintenance margin of $1,750 is set for the future.
Time Futures Price
($/)
Change in
$/
Gain/Loss Cumulative
Gain/Loss
Margin
Account

14
th
July 1.5612 $2,000
15
th
July 1.5616 +$0.0004 +$25 +$25 $2,025
16
th
July 1.5600 $0.0016 $100 $75 $1950
17
th
July 1.5565 $0.0035 $218.75 $231.25 $1,718.75
This contract has a tick size of $6.25. Thus when the future price increases next day to $
1.5616 per British Pound, a gain of $25 (4*6.25) is realized. The gain of $25 increases
margin account to $2,025. Next day, the future price declines to $1.5600 per British Pound
that accounts to a loss of $100 (16*6.25) and reduces margin account to $1,950. The margin
account is still above maintenance margin. On 17
th
July, the change in the futures price is
$0.0035. This results in additional loss of $218.75 and margin account declines to $1,718.75.
The margin falls below the maintenance margin and the trader has to bring in additional
funds to increase cash in the margin account to $2000 i.e. initial margin. The trader can settle
the account on any day.
Most of the currency futures contracts settle in cash. In fact, most of them settle before the
expiry date. Another way to settle the contract is actual delivery of currencies as per the
contract. Deliveries account for only 1% of all the contract terminations. Also by making
reverse or offsetting trade, the contract can be terminated.
The currency future market in India is increasing due to the several advantages it possesses
and is more traded by speculators as compared to hedgers. The table below summarizes the
future market statistics on NSE
Year No. of Contracts Turnover (Rs. Crore) Average Daily
Turnover
2014-15
10,99,12,684

6,87,026.51 10,475.95
2013-14
47,83,01,579

29,40,885.92 16,444.73
2012-13
68,41,59,263

37,65,105.33 21,705.62
2011-12
70,13,71,974

33,78,488.92 19,479.12
2010-11
71,21,81,928

32,79,002.13 13,854.57

Applications:
Hedging:
There are many reasons to use a hedging strategy in the forex futures market. One main
purpose is to neutralize the effect of currency fluctuations on sales revenue. For example, if a
business operating overseas wanted to know exactly how much revenue it will obtain (in U.S.
dollars) from its Mexican stores, it could purchase a futures contract in the amount of its
projected net sales to eliminate currency fluctuations. Suppose the MNC is expecting to
receive 500,000 pesos. It will then enter a contract on 4
th
June to sell 500,000 pesos at $0.09
per pesos on 17
th
August. And now any decrease in spot rate hedges the risk for the company.
Here the sole purpose is to reduce currency risk.

Speculation:
Speculating is by nature profit-driven. Suppose a person expects the underlying currency to
depreciate. He will then enter a contract on 4
th
June to sell 500,000 pesos at $0.09 per pesos
on 17
th
August. On 17
th
August, suppose the spot rate is $0.08 per pesos. He will buy 500,000
pesos from the spot market and sell the pesos to fulfil contract gaining $5000.









Options
In finance, an option is a contract which gives the buyer (the owner) the right, but not the
obligation, to buy or sell an underlying asset or instrument at a specified strike price on or
before a specified date. The seller has the corresponding obligation to fulfill the transaction
that is to sell or buy if the buyer (owner) "exercises" the option.

Characteristics of Options
Option Price/Premium: The amount per share that an option buyer pays to the seller
Expiration date: The day on which the contract ends and option is no longer valid. The
longer the period of the contract (generally 1, 2, 3 months) the greater the premium to be
paid. It generally expires on last Friday of the month
Strike Price: The reference/specified price at which the underlying security is traded
Short position: Seller of an option assumes a short position
Long position: Buyer of the option assumes a long position

When the contract gives the buyer the right to buy, but not the obligation, the underlying
asset or instrument then it is called Call option. And if the contract gives the buyer the right
to sell, but not the obligation, the underlying asset or instrument then it is called Put Option.
Styles of Options
American Option If the strike is K, and at time t the value of the underlying is S(t), then
in an American option the buyer can exercise the call or put for the payout of any time up
until the option's maturity time T.
European option can only be exercised at time T rather than any time up until T
Bermudan option can be exercised only on specific dates listed in the terms of the
contract. If the option is not exercised by maturity, it expires worthless.
Options on NSE
Option contracts on NSE are European style and cash settled.Option contracts are available
on 210 securities stipulated by the Securities & Exchange Board of India (SEBI).Options
contracts have a maximum of 3-month trading cycle - the near month (one), the next month
(two) and the far month (three). Currency options are currently available on US Dollars.
Options are also available for indices like Nifty, Bank Nifty, CNX Infra, Nifty Midcap 50 etc.
Options on CBOE
The Chicago Board Options Exchange is the worlds largest options exchange with daily
trading volume that hover around one million contracts.The CBOE is an exchange that
focuses on options contracts for individual equities, indexes and interest rates.CBOE
currently trades cash-settled index options on approximately 40 different indexes.
Call Option
The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a
particular commodity or financial instrument (the underlying) from the seller of the option at
a certain time (the expiration date) for a certain price (the strike price). The seller (or writer)
is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides.
The buyer pays a fee (called a premium) for this right. When a call option is bought, the
buyer is buying the right to buy a stock at the strike price, regardless of the stock price in the
future, any time before the expiration date. To compensate the risk taken, the buyer pays a
premium, also known as the price of the call. The seller of the call is said to have shorted the
call option, and keeps the premium (the amount the buyer pays to buy the option) whether or
not the buyer ever exercises the option.
An investor typically 'buys a call' when he expects the price of the underlying instrument will
go above the call's 'strike price,' before the call expires. The investor pays a non-refundable
premium for the legal right to exercise the call at the strike price, i.e. to purchase the
underlying instrument at the strike price. If the call buyer decides to exercise his option to
buy, then the writer has the obligation to sell the underlying instrument at the strike price.
Often the writer of the call does not actually own the underlying instrument, and must
purchase it in the open market in order to be able to sell it to the buyer of the call. The seller
of the call will lose the difference between his purchase price of the underlying instrument
and the strike price. This risk can be huge if the price of underlying instrument skyrockets
unexpectedly.
Illustration: Consider a stock trading at $45 today. Buyer B buys a call contract for 100
shares from S, the call writer/seller. The strike price for the contract is $50 per share, and B
pays a premium of $5 per share, or $500 total.
Case 1: The stock price goes up to $60 before contract expires. B exercises call option for a
total of $5,000. Thus B has paid a $500 contract premium plus a stock cost of $5,000, i.e. a
total of $5,500 and received stock worth $6000 thus a net profit of $500.
Case 2: The stock price falls to $40 by the time call expires. B will not exercise call option as
stock is available cheaper in market. B loses the premium amount of $500 whereas S keeps
the premium without any other out of pocket expenses. In case of call options, B profit
depends to the extent to which the underlying instrument rises which means the person who
is short carries unlimited loss risk.
Option values vary with the value of the underlying instrument over time. The price of the
call contract must reflect the "likelihood" or chance of the call finishing in-the-money (i.e.
the price of the instrument surpassing strike value). The call contract price generally will be
higher when the contract has more time to expire (except in cases when a
significant dividend is present) and when the underlying financial instrument shows
more volatility.
Theoretical option price = (current price + theoretical time/volatility premium) strike price
Example: Buyer B bought 3 call options (each consisting of 100 shares) for strike price of
$45 per share in April 2014 for $11.75 & the contract is set to expire in Dec 2014 i.e. B paid
$3525 for buying 300 shares between April and Dec. Say the stock is trading at $50.65 in
April 14. For calculating premium: Theoretical Call Premium = Option price + Strike price
Current price. Hence theoretical call premium in April 14 is $6.1 (11.75+45-50.65). Say in
Aug the option is worth $19.45, and the stock is trading at $64, thus theoretical call premium
is of 45 cents. The call premium tends to go down as the option gets closer to the call date.
And it goes down as the option price rises relative to the stock price, i.e. the 19.45 option is
now worth is 30% (19.45/ $64) of the price per share. In April it was 23% (11.75/$50.65).
The lower percentage of the option's price is based on the stock's price, the more upside the
investor has, therefore the investor will pay a premium for it.
Covered and Naked call option:
A call option is said to be naked call when a speculator writes (sells) a call option on a
security without ownership of that security. It is one of the riskiest options strategies because
it carries unlimited risk. If the option buyer decides to exercise the option, the seller has to
buy stock at the open market in order to deliver it at the strike price. Since the share price has
no limits to how far it can rise, the naked call seller is exposed to unlimited risk.
An options strategy whereby an investor holds a long position in an asset and writes (sells)
call options on that same asset in an attempt to generate increased income from the asset is
said to be covered call. This is often employed when an investor has a short-term neutral
view on the asset and for this reason holds the asset long and simultaneously has a short
position via the option to generate income from the option premium.

Put Option
A put option is a stock market device which gives the owner of the put option, the right, but
not the obligation, to sell an underlying security, at a specified price, by a predetermined date
to a given party. Put options are most commonly used in the stock market to protect against
the decline of the price of a stock below a specified price.
If the price of the stock declines below the strike price of the put option, the owner/buyer of
the put has the right, but not the obligation, to sell the asset at the specified price, while the
seller of the put, has the obligation to purchase the asset at the strike price if the
owner exercises the put or put option. In this way the buyer of the put will receive at least the
strike price specified, even if the asset is currently worthless. The Put option buyers are
buying the rights and transferring the risks to the sellers of the option. The buyers transfer the
risk to the sellers and hence have to compensate the sellers by paying an option premium.
The buyer of the put option is bearish on the underlying security and can achieve his profits
by short selling as well. However, the advantage of buying a put is that the option owner's
risk of loss is limited to the premium paid for it, whereas risk of loss is unlimited in the short
seller's case. The put buyer's prospect of gain is limited to the option's strike price less the
underlying securities spot price and the premium/fee paid for it.
Illustration
If you believe that a stock price is going to fall in the near future. Maybe the stock has gone
up too much too quickly. Or suppose you know that a stock is about to release bad earnings
or report some other bad news. If this is the case, then you best way to make money in the
short term is to just buy a put option on the stock.
Suppose you think Infosys is overpriced at Rs 3380 a share. You believe the stock will drop
in the near future; you can buy put options on. The strike price and the expiration month that
you choose depends on how far you think INFY will drop and when you think it will drop.
Suppose it is February 1st, INFY is at Rs. 3380, and you know that INFY earnings are to be
released tomorrow and results are not looking good. You can buy an INFY February Rs.
3370 put option for maybe Rs 5 or Rs 500 per contract (assuming each option contract covers
100 shares).
You would
tend to buy the nearest expiration month because that would be the cheapest, and you would
buy the nearest strike price under the current market price because that is where you tend to
get the greatest percentage return. When the price of INFY drops to Rs 3300 per share, then
your INFY Rs 3370 put option will be priced at Rs 70 or more and you could sell it for Rs
7000 per contract and make a nice Rs 6500 profit.
Types of Put
Naked Put: It is a put option where the option writer does not have a position in the
underlying stock or other instrument. If the option buyer doesn't exercise on or before
expiration, the seller keeps the option premium. Due to the risks involved, put writing is
rarely used alone. Investors typically use puts in combination with other options contracts. If
the market price of the underlying stock is below the strike price of the option on the day the
option expires, the option buyer can exercise the put option and force the seller to buy the
underlying stock at the strike price. That allows the buyer to profit from the difference
between the market price of the stock and the option's strike price. But if the market price is
at or above the strike price when expiration day arrives, the option expires worthless and the
put writer (seller) profits by keeping the premium collected earlier.
During the option's lifetime, if the stock price moves lower, then the option premium
increases (depending on how much the stock falls and time has passed), and it becomes more
costly to close (repurchase the put sold earlier) the position - resulting in a loss. The
maximum loss scenario for the put seller occurs if the stock price drops to zero. In that case,
the loss is equal to the strike price minus the premium received. Loss is not unlimited, as in
the case of a naked call.
Married/Protective Put: It is a portfolio strategy where an investor buys shares of a stock
and, at the same time, enough put options to cover those shares. The strategy is used as
a hedge, or insurance, on the invested stock. The buyer of a put protects himself from a huge
drop in the stock price below the strike price of the put. In the event that the put is not
exercised (because the stock price is above the strike price), the buyer loses only the premium
he paid for the put.
A put by itself has a limited upside or potential gain, which occurs when the stock becomes
worthless. By "marrying" puts with shares of the stock, the resulting portfolio has a
potentially unlimited upside (due to the theoretically possible gains of the stock), while
limiting the downside (due to the nature of puts). One pays for this through the premium for
the put and any other transaction costs.
Illustration
Today is January 1 and you purchase 200 shares of Reliance Ind at Rs1000/share and two
February Rs 900 puts for Rs 25 (Rs2500 per contract). In the given example, you have a total
cash outlay of Rs 205000. You have paid Rs 200000 for the stock and Rs5000 for your
insurance policy. If the stock goes up above Rs 1025, you are now in a profit position on
paper and won't have to consider the put option because it will expire worthless. If, however,
Reliance Ind plummets to Rs 600 a share, then the value of the insurance quickly becomes
apparent. If you were faced with a stock value of Rs 600 at the February expiry, you would
be looking at a loss of Rs 25000 (200 X [1025-900]). However the loss without the married
put strategy: Rs 80000 (200 X [1000-600]).
As you work through the example, it becomes obvious that a married put makes a lot more
sense for an investment in which you expect some news to raise the price significantly,
which, if left undelivered, will result in a dramatic fall. Such a situation might be an
upcoming earnings release date, when the company will either deliver positive cash flow or
lose its credibility completely. In such a case, a married put can protect your downside while
allowing you to participate fully in any upside.





















Exotic Option
An exotic option is any type of option other than the standard calls and puts found on major
exchanges. In other words, exotic option has features that make it more complex than plain
vanilla options. An exotic option may also include non-standard underlying. These are
generally traded over the counter (OTC). Exotic options offer the writer the opportunity to
explore a wider bid-ask spread. This is due to the fact that exotic options are not extensively
traded and the competition on the market is not as strong as on vanilla option market. This
fact makes it possible for the writer to maintain higher profit margins. The main reason for
buying exotic options is that they offer tailor made protection for a moderate price. A trader
that had a view of declining volatility can employ a barrier option instead of strategy based
on vanilla option is less expensive.

Types of Exotic Options
Barrier Option: The payoff of a barrier option depends on whether the underlying assets
price reaches a certain level during a certain period of time. There are many types of barrier
options. Barrier options are first classified into knock-in and knock-out options. Knock-out
options exist until they reach a certain level and cease to exist once the level is reached.
Knock-in options fail to exist until they reach a certain level at which point they come into
existence. The barrier level can be reached from above or from below and so these options
can be classified further as either down or up. If the initial price is above the barrier level,
then it is labelled down. Similarly, if the initial price is below the barrier level is labelled up.
This gives us four types of barrier options: up-and-in, up-and-out, down-and-in, down-and-
out. Furthermore, each of these options can be either a call or a put. Barrier options are
usually used by investors who are looking to hedge, but at a cheaper price. For example, a
portfolio manager might want to hedge against a large drop in the price of the portfolio. The
manager could protect against a large drop with a European put, but could do it for less
money by obtaining a down-and-in put. The manager could simply set a price at which they
were not willing to let the price of the portfolio fall below. This set price would be the barrier.
The price would be approaching from above the barrier and the manager would not want the
option to come alive until the barrier was reached, so the manager would purchase a down-
and input.

Lookback Option: The payoff from a lookback call is the difference between the final price
of the stock minus the lowest observed price of the stock during a specific time period. The
payoff from the lookback put is the difference between the highest observed price of the
stock minus the final price of the stock during a specific time period. The owner of the
lookback option does not have to worry about when to exercise the option. The owner can
simply look back over the life of the option and find when it was most advantageous to
exercise the option. Consequently, lookback options are more expensive than other vanilla
and exotic options. Investors are more likely to use a lookback option in a more volatile
marketplace where it is more likely the payout will offset the high premium on the option.

Chooser Option: Also known as as you like it options, chooser options allow you to
choose whether the option is a put or a call at a specific date. The underlying options in
chooser options are usually both European and have the same strike price. More complex
chooser options do not have the same strike price or time to maturity. These options will,
consequently, be more expensive than the individual underlying put or call options, because
the owner has the right to choose. Chooser options are most useful in hedging against a future
event that might not occur. They are used often around major events such as elections and
when large market movements are expected. The date at which the option holder must choose
between the put and the call is often a few days after the major event takes place. For
example, the passage of a bill in Congress is expected to positively affect a particular
company. However, if the bill is not passed, the company might be affected negatively.
Buying a chooser option allows a stockholder in the company to hedge against a possible
loss.

Binary Option: (a) Cash-or-Nothing Option: A cash-or-nothing call pays a fixed amount at
expiration if the stock price at expiration exceeds the exercise price. Similarly, a cash-or-
nothing put pays a fixed amount at expiration if the stock price is less than the exercise price
at expiration. The exercise price for this particular option plays no role in determining the
amount of the payoff, but simply determines whether the owner of the option receives the
fixed payoff. (b) Asset-or-Nothing Option: In asset-or-nothing option, the option owner
receives the asset, instead of a fixed amount as in cash-or-nothing option. The stock price
must be greater than the exercise price at expiry for the owner of the option to receive the
asset in a call otherwise the owner receives nothing. Similarly, the stock price must be less
than the exercise price at expiry for the owner to receive the asset in a put option.
A European call option is equivalent to a long position in an asset-or-nothing call and a short
position in a cash-or-nothing call where the cash payoff is equal to the strike price. In
addition, a European put option is equivalent to a short position in an asset-or-nothing put and
a long position in a cash-or-nothing put where the cash payoff is equal to the strike price.
Because a European option can be formed from short and long positions in binary options,
binary options tend to be cheaper than European options.

Asian Option: The payoff of an Asian option depends on the average price of the underlying
asset during a specific time period. The payoff for an Asian call is the maximum of zero and
the stock price at expiry minus the average stock price. The payoff for an Asian put is the
maximum of zero and the average stock price minus the stock price at expiry. The expected
payoff from Asian options is less than the expected payoff from a European option and
therefore, is less expensive than European options. Asian options are most helpful when
hedging against events that take place over a period of time.

Advantages: Exotic options offer structured protection when Vanilla options cant be
successfully employed. Consider a company that has revenues in many foreign currencies
and thus is exposed to exchange rate risk in many currencies. The profits of this company can
be protected against large movements of exchange rates be a very costly strategy of buying
put options on each of these currencies. Instead, an exotic option on a basket of foreign
currencies might be considered. This exotic option offers protection against large movements
of the whole basket of currencies which actually is the case here because the profits of
company under investigation depend on join behaviour of all the currencies.

Drawbacks: One of the drawbacks is low liquidity on some exotic option markets. This
might make it difficult or even impossible to buy/sell sufficient amount of exotic options to
hedge investors portfolio. Another disadvantage of exotic options is that underlying market
might become manipulative if large amounts of exotic options are traded and approach
maturity. In some cases the writer might, for instance, try to kill the barrier options on less
liquid underlying market if this would protect him against large loss when option expires in-
the-money.

Option Strategies
Option Strategies are the simultaneous and often mixed buying or selling of one or more
options that differ in one or more of the options variables. This is often done to gain
exposure to a specific type of opportunity or risk while eliminating other risks as part of a
trading strategy. A very straight forward strategy might simply be the buying or selling of a
single option, however option strategies often refer to a combination of simultaneous buying
and or selling of options.

1. Bullish Strategies:
Bullish options strategies are employed when the options trader expects the underlying stock
price to move upwards. Moderately bullish option trader usually set a target price for the Bull
Run and utilizes bull spreads to reduce risk. Bull call spread and bull put spread are the
common examples of moderately bullish strategies.
(a) Bull Call Spread: Bull call spreads can be implemented by buying an at-the-money call
option while simultaneously writing a higher striking out-of-money call option of the same
underlying security and the same expiration month. By shorting the out-of-the-money call,
the options trader reduces the cost of establishing the bullish position but forgoes the chance
of making a large profit in the event that the underlying asset price skyrockets.
Limited Upside Profits: Maximum gain is reached for the bull call spread options strategy
when the stock price move above the higher strike price of the two calls and it is equal to the
difference between the strike prices of the two call options minus the initial debit taken to
enter the position. Maximum profit can be calculated as:
Max Profit = Strike Price of Short Call - Strike Price of Long Call - Net Premium Paid -
Commissions Paid
Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Limited Downside Risk: The bull call spread strategy will result in a loss if the stock price
declines at expiration. Maximum loss cannot be more than the initial debit taken to enter the
spread position. Maximum loss can be calculated as:
Max Loss = Net Premium Paid + Commissions Paid
Max Loss Occurs When Price of Underlying <= Strike Price of Long Call
Breakeven: Breakeven Point = Strike Price of Long Call + Net Premium Paid


(b) Bull Put Spread: Bull put spreads can be implemented by selling a higher striking in-the-
money put option and buying a lower striking out-of-the-money put option on the same
underlying stock with the same expiration date.
Limited Upside Profit: If the stock price closes above the higher strike price on expiration
date, both options expire worthless and the bull put spread option strategy earns the
maximum profit which is equal to the credit taken in when entering the position. The formula
for calculating maximum profit is given below:
Max Profit = Net Premium Received - Commissions Paid
Max Profit Achieved When Price of Underlying >= Strike Price of Short Put
Limited Downside Risk: If the stock price drops below the lower strike price on expiration
date, then the bull put spread strategy incurs a maximum loss equal to the difference
between the strike-prices of the two puts minus the net credit received when putting on the
trade. The formula for calculating maximum loss is given below:
Max Loss = Strike Price of Short Put - Strike Price of Long Put Net Premium Received +
Commissions Paid
Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
Breakeven: Breakeven Point = Strike Price of Short Put - Net Premium Received

2. Bearish Strategies:
Bearish strategies in options trading are employed when the options trader expects the
underlying stock price to move downwards. Moderately bearish options traders usually set a
target price for the expected decline and utilize bear spreads to reduce risk. Bear call spread
and bear put spread are the common examples of moderately bearish strategies.
(a) Bear Call Spread: Bear call spreads can be implemented by buying call options of a
certain strike price and selling the same number of call options of lower strike price on the
same underlying security expiring in the same month.
Limited Downside Risk: The maximum gain attainable using the bear call spread options
strategy is the credit received upon entering the trade. To reach the maximum profit, the stock
price needs to close below the strike price of the lower striking call sold at expiration date
where both options would expire worthless. The formula for calculating maximum profit is
given below:
Max Profit = Net Premium Received - Commissions Paid
Max Profit Achieved When Price of Underlying <= Strike Price of Short Call
Limited Upside Risk: If the stock price rise above the strike price of the higher strike call at
the expiration date, then the bear call spread strategy suffers a maximum loss equals to the
difference in strike price between the two options minus the original credit taken in when
entering the position. The formula for calculating maximum loss is given below:
Max Loss = Strike Price of Long Call - Strike Price of Short Call - Net Premium Received
+ Commissions Paid
Max Loss Occurs When Price of Underlying >= Strike Price of Long Call
Breakeven: Breakeven Point = Strike Price of Short Call + Net Premium Received


(b) Bear Put Strategies: Bear put spreads can be implemented by buying a higher striking
in-the-money put option and selling a lower striking out-of-the-money put option of the same
underlying security with the same expiration date.
Limited Downside Profit: To reach maximum profit, the stock price need to close below the
strike price of the out-of-the-money puts on the expiration date. Both options expire in the
money but the higher strike put that was purchased will have higher intrinsic value than the
lower strike put that was sold. Thus, maximum profit for the bear put spread option strategy
is equal to the difference in strike price minus the debit taken when the position was entered.
The formula for calculating maximum profit is given below:
Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid -
Commissions Paid
Max Profit Achieved When Price of Underlying <= Strike Price of Short Put
Limited Upside Risk: If the stock price rise above the in-the-money put option strike price
at the expiration date, then the bear put spread strategy suffers a maximum loss equal to the
debit taken when putting on the trade. The formula for calculating maximum loss is given
below:
Max Loss = Net Premium Paid + Commissions Paid
Max Loss Occurs When Price of Underlying >= Strike Price of Long Put
Breakeven: Breakeven Point = Strike Price of Long Put - Net Premium Paid
3. Straddle Strategies:
Straddle Strategies involve holding a position in both a call and put with the same strike price
and expiration.
(a) Long Straddle: The long straddle, also known as buy straddle or simply "straddle, is a
neutral strategy in options trading that involve the simultaneously buying of a put and a call
of the same underlying stock, striking price and expiration date. Long straddle options are
unlimited profit, limited risk options trading strategies that are used when the options trader
thinks that the underlying securities will experience significant volatility in the near term.
Unlimited Profit Potential: By having long positions in both call and put options, straddles
can achieve large profits no matter which way the underlying stock price heads, provided the
move is strong enough. The formula for calculating profit is given below:
Maximum Profit = Unlimited
Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid
OR Price of Underlying < Strike Price of Long Put - Net Premium Paid
Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price
of Long Put - Price of Underlying - Net Premium Paid
Limited Risk: Maximum loss for long straddles occurs when the underlying stock price on
expiration date is trading at the strike price of the options bought. At this price, both options
expire worthless and the options trader loses the entire initial debit taken to enter the trade.
The formula for calculating maximum loss is given below:
Max Loss = Net Premium Paid + Commissions Paid
Max Loss Occurs When Price of Underlying = Strike Price of Long Call/Put
Breakeven: There are 2 break-even points for the long straddle position.
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid


(b) Short Straddle: The short straddle, or sell straddle, is a neutral options strategy that
involves the simultaneous selling of a put and a call of the same underlying stock, striking
price and expiration date. Short straddles are limited profit, unlimited risk options trading
strategies that are used when the options trader thinks that the underlying securities will
experience little volatility in the near term.

Limited Profit: Maximum profit for the short straddle is achieved when the underlying stock
price on expiration date is trading at the strike price of the options sold. At this price, both
options expire worthless and the options trader gets to keep the entire initial credit taken as
profit. The formula for calculating maximum profit is given below:
Max Profit = Net Premium Received - Commissions Paid
Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put
Unlimited Risk: Large losses for the short straddle can be incurred when the underlying
stock price makes a strong move either upwards or downwards at expiration, causing the
short call or the short put to expire deep in the money. The formula for calculating loss is
given below:
Maximum Loss = Unlimited
Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium
Received OR Price of Underlying < Strike Price of Short Put - Net Premium Received
Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Strike
Price of Short Put - Price of Underlying - Net Premium Received + Commissions
Paid
Breakeven: There are 2 break-even points for the short straddle position.
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

























Currency Swaps
Introduction
A swap is an agreement between two parties to exchange sequences of cash flows for a
defined period of time. Usually when time the contract is initiated, at least one of these series
of cash flows is determined by a random or uncertain variable, such as an interest rate,
foreign exchange rate, equity price or commodity price. The two most common types of
swaps are the interest rate swaps and currency swaps.

The Swaps Market
Swaps are customized contracts that are traded in the over-the-counter (OTC) market
between private parties. Firms and financial institutions dominate the swaps market, with few
individuals ever participating. Because swaps occur on the OTC market, there is always the
risk of a counterparty defaulting on the swap.

Currency Swap
A currency swap involves two parties who exchange a notional principal with each other in
order to gain exposure to a desired currency. Currency swaps allow an institution to take
leverage on advantages it might enjoy in specific countries. Currency swaps are an essential
financial instrument utilized by banks, multinational corporations and institutional investors.
At the origination of a swap agreement, the counterparties exchange notional principals in the
two currencies. During the life of the swap, each party pays interest (in the currency of the
principal received) to the other. At maturity, each party makes a final exchange (at the same
spot rate) of the initial principal amounts, thereby reversing the initial exchange. Generally,
each party in the agreement has a comparative advantage over the other with respect to fixed
or floating rates for a certain currency.
Understanding a Currency Swap
Company A, an American multinational may wish to expand its operations into Brazil.
Simultaneously, a Brazilian company B is seeking entrance into the U.S. market. Financial
problems that company A might face will typically stem from Brazilian banks' unwillingness
to extend loans to international corporations. Therefore, in order to take out a loan in Brazil,
company A might be subjected to a high interest rate of 10%. Likewise, company B will not
be able to attain a loan with a favourable interest rate in the U.S. market. The Brazilian
company may only be able to obtain credit at 9%.
While the cost of borrowing in the international market is unreasonably high, both of these
companies have a competitive advantage for taking out loans from their domestic banks.
Assuming company A could take out a loan from an American bank at 4% and company B
can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates
is due to the partnerships and ongoing relations that domestic companies usually have with
their local lending authorities.
Setting up the Currency Swap
Given the competitive advantages of borrowing in their domestic markets, company A will
borrow the funds that company B needs from an American bank while company B borrows
the funds that company A will need through a Brazilian Bank. Both companies have
effectively taken out a loan for the other company. The loans are then swapped.
Assuming that the exchange rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00
USD and that both companies require the same equivalent amount of funding, the Brazilian
company receives $100 million from its American counterpart in exchange for 160 million
real - these notional amounts are swapped. Company A now holds the funds it requires in
BRL while Company B is in possession of USD. However, both companies have to pay
interest on the loans to their respective domestic banks in the original borrowed currency.
This means that although Company B swapped BRL for USD, it still must satisfy its
obligation to the Brazilian bank in BRL.
Company A faces a similar situation with its domestic bank. As a result, both companies will
incur interest payments equivalent to the other party's cost of borrowing. This last point forms
the basis of the advantages that a currency swap provides.
Advantages of a Currency Swap
One of the main advantages of a currency swap agreement is the reduction of interest for both
the parties. In the above example, rather than borrowing at 10% from the Brazilian bank,
company A will have to satisfy the 5% interest rate payments incurred by company B under
its agreement with the Brazilian banks. Company A has effectively managed to replace a
10% loan with a 5% loan. Similarly, company B no longer has to borrow funds from
American institutions at 9%, but realizes the 4% borrowing cost incurred by its
swap counterparty.
A currency swap agreement may sometimes involve a swap dealer who serves as the
intermediary for the currency swap transaction. With the presence of the dealer, the realized
interest rate might be slightly higher as a form of commission to the swap dealer. Typically,
the spreads on currency swaps are fairly low and, depending on the notional principals and
types of clients, may be in the vicinity of 10 basis points. Therefore, the effective borrowing
rates for companies A and B in the previous example are 5.1% and 4.1%, which are still
superior as compared to the international rates.
Termination of a Currency Swap contract
Currency based instruments include an immediate and terminal exchange of notional
principal. In the above example, the US$100 million and 160 million BRL are exchanged at
initiation of the contract. At termination, the notional principals are to be returned to the
appropriate party. Company A would have to return the notional principal in BRL back to
Company B, and vice versa. The terminal exchange, however, exposes both companies to
foreign exchange risk as the exchange rate will likely not remain stable at original
1.60BRL/1.00USD level when the contract is terminated.
Interest Rate Swaps
An interest rate swap is a forward-type derivatives contract between two parties (known as
counterparties) where one stream of future interest payments is exchanged for another based
on a specified principal amount. Interest rate swaps often exchange a fixed payment (Swap
rate) for a floating payment that is linked to an interest rate (most often the LIBOR). On the
payment date, it is only the difference between the fixed and variable interest amounts that is
paid; there is no exchange of the full interest amounts. These contracts are traded in the OTC
market.

Illustration: Assume that Person X owns a $1000 investment that pays him LIBOR + 1%
every month. And Person Y owns a $1000 investment that pays her 1.5% every month.
Person X decides that that he would rather receive a constant payment and Person Y decides
that she'd rather receive payments at a floating rate. So Person X and Person Y agree to enter
into an interest rate swap contract. Under the terms of their contract, Person X agrees to pay
Person Y LIBOR + 1% per month on a $1000 principal amount (called the "notional
amount"). Person Y agrees to pay Person X 1.5% per month on the $1000 notional amount.
This is a plain vanilla swap.
Scenario A: LIBOR is 0.25%









Person Y owes Person X $ 1000*(1.5%)
$ 1000
Investment
Person X
$ 1000
Investment
FIXED @ 1.5% = $15
Person X owes Person Y $
1000*(LIBOR+ 1%)
Net Person Y pays $ 2.5 to Person X
Person Y
$ 1000
Investment
Person X
$ 1000
Investment
FIXED @ 1.5% = $15
Person X owes Person Y $
1000*(LIBOR+ 1%)
Person Y owes Person X $ 1000*(1.5%)
Net Person X pays $ 5 to Person Y
Person Y
Scenario B: LIBOR= 1%
LIBOR+1% = $12.5
LIBOR+1% = $20
Normally the counterparties do not swap payments directly, but rather each sets up a separate
swap with a financial intermediary such as a bank. Investment and commercial banks with
strong credit ratings are swap market-makers, offering both fixed and floating-rate cash flows
to their clients. The counterparties in a typical swap transaction are a corporation, a bank or
an investor on one side (the bank client) and an investment or commercial bank on the other
side. After a bank executes a swap, it usually offsets the swap through an interdealer broker
and retains a fee for setting up the original swap.

Types:
Being OTC instruments, interest rate swaps can come in a huge number of varieties and can
be structured to meet the specific needs of the counterparties. However, in the interbank
market, just a few, standardized types are traded. They are listed below.
Fixed-for-floating rate swap, different currencies
Floating-for-floating rate swap, same currency
Floating-for-floating rate swap, different currencies
Fixed-for-fixed rate swap, different currencies

Indian Market:
In India interest rate swaps are commonly traded on 2 benchmarks viz MIBOR and MIFOR.
(i) Overnight Index Swaps (OIS): This swap consists of exchange of a fixed rate for the NSE
MIBOR rate. The tenor of the swap may extend from 1 month to 10 years however the most
actively traded swaps are for 1 year and 5 year maturity. The MIBOR rate is compounded
daily and interest exchanges on the notional principal (generally Rs 25 crore) are exchanged
half-yearly. The OIS swap rates track the underlying G-sec yields of relevant maturity. The
market witnesses average daily volumes of Rs 6,000-Rs 8,000 crore and includes foreign
banks, private sector, banks, primary dealers and few nationalized banks as the major
participants.
(ii) MIFOR swaps: The MIFOR is another popular benchmark that has developed into a
proxy for the AAA corporate funding cost in India. MIFOR is derived from USD Libor and is
simply the Indian equivalent of USD Libor and the USD Interest Rate Swaps market. There
are a large number of Indian Corporates who now regularly use this benchmark to actively
manage the interest rate risk on their debt portfolios, and access funding at better rates

International Market:
Out of the total $ 710 trillion (Notional amounts Outstanding) OTC Derivatives Market,
around $ 584 trillion is of Interest Rate Derivatives, further $ 461 trillion is of Interest Rate
Swaps. Hence, Interest Rate swaps are the largest component of the OTC derivatives Market.
The market for OTC interest rate derivatives has grown massively since its inception in the
1980s. Its structure remained stable between the late 1980s and the mid-2000s, but is now
changing rapidly. This is partly the result of regulatory changes that aim to make the market
more transparent and reduce counterparty risk. For instance, an increasing share of
transactions is being centrally cleared. These changes will have implications for market
liquidity. Tighter regulation will make trading in this market more costly. But at the same
time, it will reduce counterparty risk. How both factors will impact market liquidity remains
to be seen.

Applications of Interest Rate Swaps
Interest rate swaps became an essential tool for many types of investors, as well as corporate
treasurers, risk managers and banks, because they have so many potential uses:
Portfolio management. Interest rate swaps allow portfolio managers to add or subtract
duration, adjust interest rate exposure, and offset the risks posed by interest rate
volatility.
Speculation. Because swaps require little capital up front, they give fixed-income
traders a way to speculate on movements in interest rates while potentially avoiding
the cost of long and short positions in Treasuries.
Corporate finance. Firms with floating rate liabilities, such as loans linked to LIBOR,
can enter into swaps where they pay fixed and receive floating, as noted earlier.
Companies might also set up swaps to pay floating and receive fixed as a hedge
against falling interest rates, or if floating rates more closely match their assets or
income stream.
Risk management. Banks and other financial institutions are involved in a huge
number of transactions involving loans, derivatives contracts and other investments.
The bulk of fixed and floating interest rate exposures typically cancel each other out,
but any remaining interest rate risk can be offset with interest rate swaps.
Risks Associated with Interest Rate Swaps:
Interest rate risk which arises from the fluctuating interest rates
Credit risk, which is known in the swaps market as counterparty risk









Collateralized Debt Obligation
A Collateralized Debt Obligation (CDO) is a structured derivative product, which is backed
by a pool of cash flow generating assets which represent some form of a debt obligation. The
assets (debt obligations) which serve as a collateral against a CDO, could include Mortgage
loans, Car Loans, Credit Card receivables, below investment grade Corporate Bonds etc.
These assets, on converting into cash (as a result of payment by the debtors), are passed on to
the investors depending on certain criteria. To understand the concept of a CDO better, it is
essential to understand the basic structure and parties involved in structuring and managing a
CDO.






















Borrowers
Mortgage Loans
Auto Loans
Credit Card Rec
MBS/ABS
Corporate Debt
Seller/Servicer
(Banks,
Mortgage
Lenders)
Issuers(Special
Purpose
Vehicles)
Trustee
(Fiduciary
duties and
investor
protection)
Cash
Prin
& Int
Swap
Counterparty
(Interest rate
risk)

Underwriter
(Investment
Banks)
Senior Tranche
Mezzanine
Tranch
Equity Tranche
Prin &
Int
Collateralized Debt
Obligation Structure
The following explains the process involved in creation of a CDO and how it works:
The seller/servicer is a bank or a mortgage lending institution which has made a
variety of loans like mortgage loans, auto loans, low grade corporate loans etc. to its
borrowers
The issuer is generally a Special Purpose Vehicle which is created such that the seller
can sell its loan portfolio to the SPV and receive cash in exchange
The Trustee is basically a body which holds title to the assets of the CDO and would
ensure that the investors interests are protected and they receive the dues from
holding the CDO securities
The Swap Counterparty can be a dealer or an institution which writes interest rate
swaps such that the SPV can protect the floating rate receipts from the borrowers
against any fluctuations by entering into interest rate swap contracts with the Swap
Counterparty
The Underwriters are generally Investment Banks, which underwrite the entire bond
portfolio held by the SPV and re-package it in such a way that the investors are
offered three broad categories of securities, also known as tranches of securities
The three tranches of securities are:
o The Senior Tranche, which is the tranche with the lowest risk(highest certainty
and priority) of receipt of payments and hence the one with the lowest returns
primarily determined by the Credit Rating ascribed to it by the Credit Rating
Agencies
o The Mezzanine Tranche, which is the tranche with intermediate risk and
intermediate returns(both more than the senior tranche)
o The Equity Tranche, which is the tranche with the highest risk and
returns(both more than the senior and mezzanine tranche)
As explained above, the investors could choose securities from three broad categories or
tranches, depending on their risk appetite. These tranches would receive payments (Principle
and Interest) made by the borrowers in a waterfall scheme as displayed below.







This meant that the Senior Tranche would receive payments first, thus making it the least
risky tranche, followed by the Mezzanine Tranche and then by the Equity Tranche. In this
Senior Tranche
Mezzanine Tranche
Equity Tranche
order, the risk of defaults by the borrowers increased from Senior to the Equity Tranche, thus
requiring an increasing rate of return from Senior to the Equity Tranche. Consequently, the
Senior tranches were assigned higher Credit Ratings as compared to the Mezzanine and
Equity tranches, by Credit Rating Agencies like Moodys, Fitch and S&P.
As can be seen, the CDO acts like a pass-through security, passing on the payments made by
the borrowers on to the investors depending on the tranche that they invest into. Some of the
motivations behind issuing a CDO are:
Passing on the risk of holding the loans through the securitization chain, from the
banks/mortgage lenders to the investors
Generating cash by selling the loan portfolio to the SPV, such that it can be used to
make further loans and also to keep the Balance Sheet healthy
Broadly, there are two types of CDOs:
Cash Flow CDOs, which pay cash flows like principle and interest payments from the
assets to the tranche holders and are affected by the credit quality of the assets
Market Value CDOs, which derive returns through trading and sale of the underlying
collateral assets and hence depend on the asset managers ability to realize capital
gains on the assets in the portfolio
Though CDOs were originally developed for the corporate debt market, they eventually
evolved into a product that encompassed even the mortgage and the MBS (Mortgage Backed
Securities) market. The CDO market proliferated starting in 2004, as mortgage lenders across
the United States started selling the loans issued by them to investment banks, which in turn
engineered them and sliced and diced them to create CDO products. The process began with
the prime mortgages and eventually encouraged the bankers to securitize the sub-prime (poor
quality) mortgages, so that the CDOs were now secured by sub-prime mortgages and yet
issued good credit ratings by the Credit Rating Agencies owing to their inherent structure
(senior tranches were issued AAA i.e highest investment grade rating even though all the
tranches were backed by sub-prime mortgages). The series of defaults across the country
eventually resulted in many CDO products failing to pass-through any payments and hence
the sub-prime mortgage crisis.
To summarize, a CDO is a structured derivative product backed by a pool of debt, which is
aimed at distributing risk by creating tranches out of the pool and issuing securities from the
tranches to investors based on their risk appetite, such that the payments from the pool of
debt are passed through to the investors depending on the tranche that they are holding. The
tranches are rated by Credit Rating Agencies depending on certain criteria and the returns on
the tranche are proportionate to the rating that is awarded to it.



Credit Default Swap
Credit default swap is a contract that provides insurance against the risk of default by a
particular company. The company is known as reference entity and the default by the
company is called as credit event. The buyer of the insurance obtains the right to sell bonds
issued by the company for their face value when a credit event occurs and the seller of the
insurance agrees to buy the bonds for their face value when a credit event occurs. The total
face value of the bonds that can be sold is known as the credit default swaps notional
principal. The total amount paid per year, as a percent of the notional principal to buy
protection is known as CDS spread.
The buyer of the CDS makes periodic payments to the seller until the end of the life of the
CDS or until a credit event occurs. These payments are typically made in arrears every
quarter, every half year or every year. The settlement in the event of a default involves either
physical delivery of the bonds or a cash payment.
Let us take an example. Suppose that two parties enter into a 5year credit default swap on
March 1, 2010. Assume that the notional principal is 10 crores and the buyer agrees to pay 90
basis points annually for protection against default by the reference entity.
90 basis points per year
Payment if default by
reference entity
The CDS is shown in the figure above. If the reference entity does not default (i.e. if there is
no credit event), the buyer receives no payoff and pays 9,00,000 Rs on March 1 of each of the
years of 2011,2012,2013,2014 and 2015. If there is a credit event, a substantial payoff is
likely.
Settlement
Suppose the buyer notifies the seller of the credit even on June 1, 2013, then the contract
needs to be settled. Settlement of the CDS can be of two types and is usually specified in the
contract
Physical Settlement: the buyer upon the credit event sells the bonds issued by reference
entity with a face value of 10 crore for 10 crore.
Cash settlement: In the case of a cash settlement, the payout amount is the payout ratio
times the notional principal. The payout ratio depends on the recovery rate (i.e., the
proportion of par that the bond trades at after default)
Payout amount = payout ratio x notional principal where:
Payout ratio = 1 - recovery rate (%)

Default
protection seller
Default
protection buyer
Uses of Credit default swaps:
Hedging:
A CDS can be used to hedge a position in a corporate bond. Suppose an investor buys a 5-
year corporate bond yielding 10% per year for its face value and at the same time enters into
a 5-year CDS to buy protection against the issuer of the bond defaulting. Suppose that the
CDS spread is 200 basis point or 2% per annum. The effect of the CDS is to convert the
corporate bond to a risk-free bond. If the bond issuer does not default the investor earns 8%
per year when the CDS spread is netted against the corporate bond yield. If the bond does
default the investor earns 8% up to the time of the default. Under the terms of the CDS, the
investor is then able to exchange the bond for its face value. This face value can be investor
at the risk free rate for the remainder of the 5 years.
Speculation:
Credit default swaps allow investors to speculate on changes in CDS spreads of single names
or of market indices. An investor might believe that an entity's CDS spreads are too high or
too low, relative to the entity's bond yields, and attempt to profit from that view by entering
into a trade, known as basis trade.
For example, a hedge fund believes that Risky Ltd will soon default on its debt. Therefore, it
buys $10 million worth of CDS protection for two years from AAA-Bank, with Risky Ltd as
the reference entity, at a spread of 500 basis points (=5%) per annum.
If Risky Ltd does indeed default after, say, one year, then the hedge fund will have paid
$500,000 to AAA-Bank, but then receives $10 million (assuming zero recovery rate, and
that AAA-Bank has the liquidity to cover the loss), thereby making a profit. AAA-Bank,
and its investors, will incur a $9.5 million loss minus recovery unless the bank has
somehow offset the position before the default.
However, if Risky Ltd does not default, then the CDS contract runs for two years, and the
hedge fund ends up paying $1 million, without any return, thereby making a loss. AAA-
Bank, by selling protection, has made $1 million without any upfront investment.
Note that there is a third possibility in the above scenario; the hedge fund could decide to
liquidate its position after a certain period of time in an attempt to realize its gains or losses.
For example:
After 1 year, the market now considers Risky Ltd more likely to default, so its CDS
spread has widened from 500 to 1500 basis points. The hedge fund may choose to sell
$10 million worth of protection for 1 year to AAA-Bank at this higher rate. Therefore,
over the two years the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but
receives 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000.
In another scenario, after one year the market now considers Risky much less likely to
default, so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge
fund may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this
lower spread. Therefore over the two years the hedge fund pays the bank 2 * 5% *
$10 million = $1 million, but receives 1 * 2.5% * $10 million = $250,000, giving a total
loss of $750,000. This loss is smaller than the $1 million loss that would have occurred if
the second transaction had not been entered into.

The Future of CDS market
Although CDS have been linked to the fall of
Lehmann Brothers and AIG, they have
continued to survive the 2008 crisis. CDS
have today one of the important tools to
manage credit risk. A company can either
reduce its credit risk or diversify the risk by
taking CDS. For example, a financial
institution having too much credit exposure to
a particular business sector can buy protection
against defaults by companies in the sector
and at the same time sell protection against
default by companies in other unrelated
sector.