ADVANCED FINANCIAL

MANAGEMENT

Topic: Derivatives & Risk

Management
DERIVATIVES AND RISK MANAGEMENT
The Derivatives Market is meant as the market where exchange of derivatives
takes place. Derivatives are one type of securities whose price is derived from
the underlying assets. And value of these derivatives is determined by the
fluctuations in the underlying assets. These underlying assets are most commonly
stocks, bonds, currencies, interest rates, commodities and market indices. As
Derivatives are merely contracts between two or more parties, anything like
weather data or amount of rain can be used as underlying assets The Derivatives
can be classified as
Types of derivatives
Forward
Futures
Options
Swaps

The Types of Derivative Market

The Derivative Market can be classified as Exchange Traded Derivatives
Market and over the Counter Derivative Market. Exchange Traded Derivatives
are those derivatives which are traded through specialized derivative exchanges
whereas Over the Counter Derivatives are those which are privately traded
between two parties and involves no exchange or intermediary. Swaps, Options
and Forward Contracts are traded in Over the Counter Derivatives Market or OTC
market.
The main participants of OTC market are the Investment Banks, Commercial
Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks
markets the derivatives through traders to the clients like hedge funds and the rest.
In the Exchange Traded Derivatives Market or Future Market, exchange acts as the
main party and by trading of derivatives actually risks is traded between two
parties. One party who purchases future contract is said to go long and the
person who sells the future contract is said to go short. The holder of the long
position owns the future contract and earns profit from it if the price of the
underlying security goes up in the future. On the contrary, holder of the short
position is in a profitable position if the price of the underlying security goes down,
as he has already sold the future contract. So, when a new future contract is
introduced, the total position in the contract is zero as no one is holding that for
short or long. The trading of foreign exchange traded derivatives or the future
contracts has emerged as very important financial activity all over the world just
like trading of equity-linked contracts or commodity contracts. The derivatives
whose underlying assets are credit, energy or metal, have shown a steady growth
rate over the years around the world. Interest rate is the parameter which influences
the global trading of derivatives, the most.
DERIVATIVE MARKET AND FINANCIAL MARKET
Derivatives play a vital role in risk management of both financial and non-financial
institutions. But, in the present world, it has become a rising concern that
derivative market operations may destabilize the efficiency of financial markets. In
todays world the companies the financial and non-financial firms are using
forward contracts, future contracts, options, swaps and other various combinations
of derivatives to manage risk and to increase returns. It is true that growth of
derivatives market reveal the increasing market demand for risk managing
instruments in the economy. But, the major concern is that, the main components
of Over the Counter (OTC) derivatives are interest rates and currency swaps. So,
the economy will suffer surely if the derivative instruments are misused and if a
major fault takes place in derivatives market.
THE OVER- THE- COUNTER DERIVATIVES
The derivatives traded over the counter are known as the over the counter
derivative market. The Over the counter derivative market consists of the
investment banks and include clients like hedge funds, commercial banks,
government sponsored enterprises etc. The products that are traded over the
counter are swaps, forward rate agreements, forward contracts, credit derivatives
etc. Derivatives are basically the financial instruments whose value is a function of
the value of the underlying asset. The participants who enter into the contract do so
when they agree on the exchange rate or the value of some asset to be delivered on
a future date.
DERIVATIVE MARKET EQUITY
The derivative market equity includes the financial instruments such as
futures, options and swaps. The equity derivatives are stocks or stock indices
whose prices depend on the prices of the underlying equity instrument. The equity
derivatives are traded in the futures and options exchanges or in the over the
counter markets. The most common forms of the derivative market equity are the
futures and the options market. The options and futures market Options are
contracts that give the buyer or seller the right and not the obligation to buy or sell
the underlying asset at a fixed price at a future date. The call option gives the
right to buy while the put option gives the right to sell. The buyer of the call
option can gain by an increase in the price of the underlying asset without buying
the underlying asset. Conversely the put option holder benefits from the fall in the
price level of the underlying asset. Contrast to the option market the person who
goes long or short in the futures market is bound to buy or sell the contract at the
specified price and date. Hence the futures contracts are much more
standardized in comparison to the options and hence they are traded in
accredited exchanges.
WARRANTS
Unlike the options and the futures which are exchange traded financial
instruments, the warrants are equity derivatives that are traded over the counter.
Warrants are used sometimes to increase the yield of bonds. Warrants are similar to
the equity options but are an exception since they are traded by private parties.
CONVERTIBLE BONDS
Convertible bonds are a combination of bonds and equity. The convertible bonds
provide asset protection, high equity returns and they are of less volatile nature.
The investors in the equity derivative can hedge their risk. The equity derivatives
are also used as a speculative instrument. The derivative market equity traders use
the data on stock and their derivatives. They also need, in addition, the factors that
may affect the equity prices. To analyze the data the equity market traders need
appropriate statistical tools. For further information on derivative market equity,
the following websites need to be looked at equityderivatives.com, reuters.com,
asx.com, amazon.com etc.

FORWARD AND FUTURES CONTRACTS

Fundamentally, Forward and futures contracts have the same function: both
types of contracts allow people to buy or sell a specific type of asset at a
specific time at a given price futures contracts are traded on the exchange,
forwards contracts are traded over- the-counter market. In case of futures contracts
the exchange specifies the standardized features of the Contract, while no pre
determined standards are there in the forward contracts. Exchange provides the
mechanism that gives the two parties a guarantee that the Contract will be honored
whereas there is no surety/guarantee of the trade settlement in case of forward
Contract.
 A forward Contract is an agreement between two parties to buy or sell an
asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the
trade date and delivery date are separated. It is used to control and hedge risk, for
example currency exposure risk (e.g. forward contracts on USD or EUR) or
commodity prices (e.g. forward contracts on oil). One party agrees to buy, the other
to sell, for a forward price agreed in advance. In a forward transaction, no actual
cash changes hands. If the transaction is collaterised, exchange of margin will take
place according to a pre-agreed rule or schedule. Otherwise no asset of any kind
actually changes hands, until the maturity of the Contract.
The forward price of such a Contract is commonly contrasted with the spot
price, which is the price at which the asset changes hands (on the spot date, usually
next business day). The difference between the spot and the forward price is the
forward premium or forward discount. A standardized forward Contract that is
traded on an exchange is called a futures Contract. In finance, a futures Contract is
a standardized Contract, traded on a futures exchange, to buy or sell a certain
underlying instrument at a certain date in the future, at a pre-set price. The future
date is called the delivery date or final settlement date. The pre-set price is called
the futures price. The price of the underlying asset on the delivery date is called the
settlement price. The futures price, naturally, converges towards the settlement
price on the delivery date. A futures Contract gives the holder the right and the
obligation to buy or sell, which differs from an options Contract, which gives the
buyer the right, but not the obligation, and the option writer (seller) the obligation,
but not the right. In other words, the owner of an options Contract can exercise (to
buy or sell) on or prior to the pre-determined settlement/expiration date. Both
parties of a "futures Contract must exercise the Contract (buy or sell) on the
settlement date. To exit the commitment, the holder of a futures position has to sell
his long position or buy back his short position, effectively closing out the futures
position and its Contract obligations. Futures contracts, or simply futures, are
exchange traded derivatives. The exchange acts as counterparty on all contracts,
sets margin requirements, etc. While futures and forward contracts are both a
Contract to trade on a future date, key differences include:
Futures are always traded on an exchange, whereas forwards always trade
over-the-counter Futures are highly standardized, whereas each forward is unique
The price at which the Contract is finally settled is different:
Futures are settled at the settlement price fixed on the last trading date of the
Contract (i.e. at the end) Forwards are settled at the forward price agreed on the
trade date (i.e. at the start) The credit risk of futures is much lower than that of
forwards: Traders are not subject to credit risk due to the role played by the
clearing house. The profit or loss on a futures position is exchanged in cash every
day. After this the credit exposure is again zero. The profit or loss on a forward
Contract is only realised at the time of settlement, so the credit exposure can keep
increasing In case of physical delivery, the forward Contract specifies to whom to
make the delivery. The counterparty on a futures Contract is chosen randomly by
the exchange. In a forward there are no cash flows until delivery, whereas in
futures there are margin requirements and periodic margin calls.
OPTION/ OPTIONS CONTRACT
Futures Option are an excellent way to trade the futures markets. Many new traders
start by trading futures Option instead of straight futures contracts. There is
generally less risk and volatility when using Option instead of futures. Actually,
many professional traders only trade Option.
FUTURES OPTION
An Option is the right, not the obligation, to buy or sell a futures contract at a
designated strike price. For trading purposes, you buy Option to bet on the price of
a futures contract to go higher or lower. There are two main types of Option - calls
and puts.
Calls You would buy a call Option if you believe the underlying futures price
will move higher. For example, if you expect corn futures to move higher, you will
want to buy a corn call Option.
Puts You would buy a put Option if you believe the underlying futures price will
move lower. For example, if you expect soybean futures to move lower, you will
want to buy a soybean put Option.
Premium You are obviously going to have to pay some kind of price when you
buy an Option. The term used for the price of an Option is premium. You can think
of the pricing of Option as a bet. The bigger the long shot, the less expensive they
will be. Oppositely, the more sure the bet is, the more expensive it will be.
Contract Months (Time) Option have an expiration date, which means they only
last for a certain period of time. When you buy an Option, you cannot hold it
forever. For example, a December corn call expires in late November. You will
need to close the position before expiration. Generally, the more time you have on
an Option, the more expensive it will be.
Strike Price This is the price at which you could buy or sell the underlying
futures contract. For example, a December $3.50 corn call allows you to buy a
December futures contract at $3.50 anytime before the Option expires. Most
traders do not convert Option; they just close the Option position and take the
profits
Example of Buying an Option:
Lets say you expect the price of gold futures to move higher over the next 3-6
months. It is currently January, so you would probably buy an August gold call to
give yourself enough time. Gold is currently trading at $590 per ounce. You expect
the price to climb to $640 within 6 months.
You purchase: 1 August $600 gold call at $15
1 = number of Option you are buying
August = Month of Option contract
$600 = strike price
Gold = underlying futures contract
Call = type of Option (bet on price moving higher)
$15 = premium ($1,500 is the price to buy - 100 ounces of gold x $15 = $1,500)

Call Option Example

 Suppose the market price of equity share of reliance on the expiration date is
Rs 140 and the exercise price is Rs 125 .The value of call option is Rs 15 [Rs 140
Rs 125] In case the value of share on expiration date turn out to be Rs 120 the
value of c would not be negative Rs 5 [Rs 120 rs125 ], it would be zero as the
investor would not purchase share Rs 125 which is available in the market and
thereby incur a loss Rs 5per share.

Put Option Example

Consider an investor who wants the right to sell reliance equity shares at Rs
135 after 2 months. He is to buy a 2 month put option with a Rs 135 exercise
price. In case the market price of the reliance share increases to Rs 150 (S1< E) the
put option will expire worthless as it will be more profitable for an investor to sell
in the open market at Rs 150 than to the put option writer at Rs 135.
If the market price falls below the sp say to Rs 125 it will be profitable for
the put option holder to excise his put option right as he get Rs 135 compared to Rs
125.

An important difference between futures and options is that trading in futures

contracts is based on prices, while trading in options is based on premiums. The
premium depends on market conditions such as volatility, time until expiration, and
other economic variables affecting the value of the underlying futures contract.
The buyers and sellers of futures can be classified as hedgers or speculators.
Hedgers use futures to minimize risk, like the farmers who use futures to
guarantee a price for their product, or a miller who wants a set price for grain when
it is harvested. Futures can also be used to hedge investment portfolios. Thus,
futures is a significant means of price risk transfertransferring price risk to
someone with an opposite risk, or to a speculator who is willing to accept risk to
make a profit.
Speculators use futures to make a profit, by buying low and selling high (not
necessarily in that order). The speculator has no intention of making or taking
delivery. A speculator is making a bet on the future price of a commodity. If he
thinks the price of the commodity will drop, he takes a short position by selling a
futures contract. If he thinks that the price of the commodity will increase, then he
takes a long position by buying a futures contract. Later, he will close out his
position by offsetting the contract. If he sold short, he will buy back the contract,
and if he bought long, then he will sell the contract.
The buying and selling of futures contracts is a zero sum gain, because it is
basically a contract between 2 traders. It is not an investment in a company that
creates wealth, where every shareholder can winor lose. If the short side profits,
the long side loses an equal amount, and vice versa.

SWAPS
 A swap is an agreement between two parties to exchange the cash flows in
the future. The agreement defines the dates when the cash flow are to be paid and
the way it has to be calculated.
There are two basic types of swaps : (1) Interest Rate Swap
(2) Currency Swap

A currency swap is an agreement between two parties to exchange the

principal loan amount and interest applicable on it in one currency with the
principal and interest payments on an equal loan in another currency. These
contracts are valid for a specific period, which could range up to ten years, and are
typically used to exchange fixed-rate interest payments for floating-rate payments
on dates specified by the two parties. Since the exchange of payment takes place in
two different currencies, the prevailing spot rate is used to calculate the payment
amount. This financial instrument is used to hedge interest rate risks
A currency swap agreement specifies the principal amount to be swapped, a
common maturity period and the interest and exchange rates determined at the
commencement of the contract. The two parties would continue to exchange the
interest payment at the predetermined rate until the maturity period is reached. On
the date of maturity, the two parties swap the principal amount specified in the
contract. The equivalent amount of the loan value in another currency is calculated
by using the net present value (NPV). This implies that the exchange of the
principal amount is carried out at market rates during the inception and maturity
periods of the agreement.

Benefits of Currency Swaps

 Help portfolio managers regulate their exposure to interest rates.
Speculators can benefit from a favorable change in interest rates.
Reduce uncertainty associated with future cash flows as it enables companies to
modify their debt conditions.
Reduce costs and risks associated with currency exchange.
Companies having fixed rate liabilities can capitalize on floating-rate swaps and
vice versa, based on the prevailing economic scenario

Limitations of Currency Swaps

Exposed to credit risk as either one or both the parties could default on interest
and principal payments.
Vulnerable to the central governments intervention in the exchange markets.
This happens when the government of a country acquires huge foreign debts to
temporarily support a declining currency. This leads to a huge downturn in the
value of the domestic currency.

COMPANIES BENEFIT FROM INTEREST RATE AND CURRENCY SWAPS

An interest rate swap involves the exchange of cash flows between two
parties based on interest payments for a particular principal amount. However, in
an interest rate swap, the principal amount is not actually exchanged. In an interest
rate swap, the principal amount is the same for both sides of the currency and a
fixed payment is frequently exchanged for a floating payment that is linked to an
interest rate, which is usually LIBOR.A currency swap involves the exchange of
both the principal and the interest rate in one currency for the same in another
currency. The exchange of principal is done at market rates and is usually the same
for both the inception and maturity of the contract, generally, both interest rate and
currency swaps have the same benefits for a company. Essentially,
these derivatives help to limit or manage exposure to fluctuations in interest rates
or to acquire a lower interest rate than a company would otherwise be able to
obtain. Swaps are often used because a domestic firm can usually receive better
rates than a foreign firm.
For example, suppose company A is located in the U.S. and company B is
located in England. Company A needs to take out a loan denominated in
British pounds and company B needs to take out a loan denominated in U.S.
dollars. These two companies can engage in a swap in order to take advantage of
the fact that each company has better rates in its respective country. These two
companies could receive interest rate savings by combining the privileged access
they have in their own markets. Swaps also help companies hedge against interest
rate exposure by reducing the uncertainty of future cash flows. Swapping allows
companies to revise their debt conditions to take advantage of current or expected
future market conditions. As a result of these advantages, currency and interest rate
swaps are used as financial tools to lower the amount needed to service a debt.
Currency and interest rate swaps allow companies to take advantage of the
global markets more efficiently by bringing together two parties that have an
advantage in different markets. Although there is some risk associated with the
possibility that the other party will fail to meet its obligations, the benefits that a
company receives from participating in a swap far outweigh the costs.
Examples of Interest rate swaps and Currency swaps
Interest rate swaps Example
It can be used to overcome the asset-liability mismatch, with the help of the
following example. Bank A has floating rate assets earning (MIBOR+3%)
(Mumbai Inter Bank Offer Rate) funded with fixed rate liability of 12%. Bank B
has fixed rate assets earning 17%, funded with floating rate liability (MIBOR+1%).
Now, if the interest rate falls, Bank A will suffer as it will receive less on its assets
whereas it will have to pay fixed interest. And if the interest rate rises, Bank B will
suffer as it will have to pay more, liabilities being floating in nature. Hence both
the banks suffer from asset-liability mismatch.

To overcome this, they may enter into a swap transaction wherein:

Bank A will pay Bank B, floating rate of interest, say MIBOR annually, on
the notional principal.
Bank B will pay Bank A, a fixed rate of interest, say 14% annually, on the
same notional principal.
This would ensure that both the banks will stand to gain a definite spread
irrespective of the level of MIBOR.
Currency Swaps Example
Suppose company C wants to borrow US$ funds and the Company D wants
to borrow funds. Their financing details are given in the following example:

Company $ Borrowing Borrowing Preference

C 10% 7% $ Loan
D 11% 11% Loan
Spread 1% 4%

From the given information, C enjoys absolute advantage over D in both the
$ and loan market. But the comparative advantage for C exists in the loan
market. So it is advisable for C to borrow funds and for D to borrow $ funds
from the market and then enter into a foreign currency swap deal to achieve their
preferred form of funding with a lower cost. Let us check how to construct a deal
between them. It is assumed that C needs $100 crores. The current spot $/ rate at
the time of entering into the swap is 1.80 $/.
The calculation of the benefit earned from the swap is :
Total cost of borrowing without the swap = 10 + 11 = 21%
Total cost of borrowing with the swap = 7+11 = 18%
Therefore, net savings = 3%

This savings may be shared between C and D in a mutually agreed upon

ratio. In our discussion, we assume it to be shared equally for easy calculation.
Hence, the net cost of borrowing for both the parties will be:
C = 10-1.50 = 8.50%
 D = 11-1.50 = 9.50%

Their swap structure is :

Therefore, to enter into the swap deal the following transactions are
required:
Exchange of Principal: C will borrow 55.55 (100/1.80) crore and
give it to D and D will borrow $100 crore and give it to C.
Interest Payments: C will pay 11% to D on the $100 crore borrowed
by D and D will pay 9.5% to C on the 55.55 crore borrowed by C.
Re-exchange of Principal: After the swap matures, the principal
amount exchanged between C and D will be re-exchanged between
them. That is, C will return $100 crore to D and D will return 55.55
crore to C.