Derivatives Instruments

(Forwards, Futures, Options and SWAPS)

 Derivatives Instruments

• Derivative instruments are management tools

derived from underlying exposure such as
currency, commodities, shares, bonds or any of
the indices.
• It is used to reduce or neutralize the exposures on
the underlying contracts.
• Derivatives help to hedge against the uncertain
movements in the prices of the underlying
contracts.
• Of late, derivative products have been
developed relating to events such as rain fall
or weather, as they in turn affect demand for
say, agro-products and utilities such as air-
conditioners respectively.
• A derivative product is a financial contract
whose value is derived from spot prices in
an underlying market which may be a
financial market or a commodity market.
• By definition, derivatives always refer to a
future price.
OTC and Exchange Traded Products
• Banks may structure a derivative product to suit the
individual client-based on his risk appetite, size of
transaction and maturity requirements (customized).
• The derivative products that can be directly negotiated
and obtained from banks and investment institutions are
known as Over-The-Counter (OTC) products.
• Some of the derivative products traded in exchanges
– Stock, future, commodity exchanges (BSE,NSE,MCX)
– International monetary exchange Chicago (IME)
– London financial futures exchange (LIFFE)
– Singapore stock exchange (SGX)
 Comparison
• OTC products
– (forwards, currency and interest
rate options, SWAPS etc)
1. Contracts of any size and maturity
can be structured and accordingly
priced to suit requirement of
individual clients
2. Counter party risk (bank risk) is
present.
• Exchange Traded Products
– (Currency, interest rate and
commodity futures and options
stock / index options and futures
etc)
1. Only standardized contracts with
fixed delivery dates are traded;
prices fluctuate according to
market
1. There is no counter party risk, all
trades are exchange protected.
3. Banks are the main 3. Only members of the
players in the OTC exchange can trade in the
market. products.

3. Prices are market

3. Option premium – cost
of the option – is to be
paid upfront; costs are
loaded into agreed rates
in other products
3. Market is not liquid;
cancellation/reversal of 3. Market is highly liquid;
positions may become
expensive.
determined, and
members need to comply
with margin
requirements, on the
basis of their positions
marked to market daily
all prices are market
determined
 Forwards Exchange Contracts

• In international trade transactions, exporters and

importers run the risk of exchange rate
fluctuations.
• Floating rate, volatile, adverse/favorable.
• Exact time of shipment.
• Space, port congestion – delay.
• Goods are invoiced in foreign currency.
• Cost of goods.
• Time lag – commercial contract date, shipment payment.
• Exporter in India exports shirts
– 1 shirt = Rs 2350 ($50)
• 1$ = Rs 47
• Buyer and seller want to protect themselves against
exchange rate movements – entering into forward
exchange contract.
• Forward exchange contract is a contract wherein two
parties (in India one party compulsorily being a bank)
agree to deliver certain amount of foreign exchange at
an agreed price / rate at a fixed future date or in certain
cases during a future period.
• A forward rate is the price the market sets for the
currency today for the delivery on a future date
• Under forward contract, since the price of the
foreign currency is fixed today for delivery
on a future date, the risk of any adverse price
movement is removed or covered.
• Commodity – gold, silver, metal.
• Chicago Board of Trade – 1851 – Rice,
Maize
• Typically OTC derivative (made to the order)
not exchange traded facilities fixed lots
period tenors (traded on exchange)
• Forward rate is a function of spot price plus cost
of carry.
• Forward premium / discount
• Carry – storage, insurance, int. rate
• In forex markets the forward rate is a function of
spot rate and premium/discount of the currency
• The currency with the lower interest rate would
be at a premium at future while the currency with
the higher interest rate would be at a discount at
the future.
• The forward exchange rate would be thus be a
function of spot rate plus or minus
premium/discount as the case may be.
• The premium/discount would depend upon
mainly on the interest rate differential of the 2
currencies, but also on the demand/supply of the
currency for the future deliveries, the perception,
the political, fiscal and other trade related
conditions in the country and for the currency.
• The forward differential should be almost equal
to the interest rate differential of the two
currencies being dealt with.
• Forward contracts could be fixed date forward
contract or option period contracts
– Fixed date delivery, 1 month, 3 month, 6 month.
• Lack of liquidity and counter party default risks
are the main drawbacks of forward contracts
 Futures
• Futures are most popular and widely used derivative
products.

• Another version of exchange traded forward contracts.

• A currency futures contract is an agreement between 2

parties made through an organized exchange – in this case a
futures exchange. The contract is for a specific amount of a
specific currency to be delivered at a specific time
determined by the exchange.
• Investors use these futures contracts to hedge
against foreign exchange risk, they can also be
used to speculate on rising or falling exchange
rates.
• The parties that trade on exchange can trade for
themselves or for their customers.
• There are specific rules and regulations that set
the terms of the contract and procedure for
trading.
 Types of futures contract
• Commodity futures: the underlying assets of these contracts are
commodities, which may be agricultural commodities (rice, wheat
etc.) or industrial goods (gold, silver, etc.)

• Financial futures: where the underlying assets are financial

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

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

underlying assets, they are called currency futures.

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

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

• Standardized Contract –

• Underlying asset size e.g. ₤ 25,000

• Time of maturity (expiry date 3rd Wednesday)

• Associated clearing house – smooth functioning

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

• Delivery under future is not a must, and the buyer/seller

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

• Initial margin – small margin to play / enter

into large value contract (US $ 1.00 Mil)
• Variable margin – calculated daily by
marking to market. Adverse / favorable,
margin call.
• Maintenance margin – similar to minimum
balance
 Futures vs. Forward contract
Futures Forward
1. This is always exchange 1. This is not exchange
traded – the exchange traded as it is only on
clearing house acts as a ‘over the counter’ i.e.
counter – party private contracts.
2. Terms of the contract in 2. This is tailor – made to
terms of quantity, suit the clients, it is
quality, maturity, etc. are flexible and non-
all standardized. standardized
 Futures vs. Forward contract
3. Maturity of the contract 3. Maturity of the contract
does not generally may be beyond a one-
exceed a one-year year period.
period.
4. Works on margin 3. Margins not
requirements, and are compulsory. Not marked
marked to market to market everyday.
everyday.
 Futures vs. Forward contract
5. Settlement is usually done 5. Delivery is essential.
by cash payments/closing
out – normally there is no
physical delivery.
6. Credit risk is eliminated,
through margin deposit / due 5. Credit risk on counter
settlement with the backing parties i.e. buyer/sellers
of the exchange
7. This contract serves the 5. This is purely for hedging
need for hedging and requirements.
speculating of the parties
Options
 Currency options

• The currency option is the popular foreign

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

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

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

 Basic types of option contracts

• Options are either call options or put options

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

• The cost of the option usually levied upfront on

the buyer of the option is called premium.

• The final day on which the option may be

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

• Option Holder or buyer

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

market price moves adversely

– Would allow the option contract to lapse in case the

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

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

receivable of USD 1 million value 6 months, i.e.
01/04/2010.
• The spot 01/10/2009 USD/Re is 47.00
• Put option for USD/RE 47.50 value 01/04/2010
at a premium of 0.05paisa/USD
• On the expiry date i.e. 01/04/2010 the spot
USD/Re is 48.05.
 Solution
• The exporter allows the option to expire and sell
his USD in the market at 48.05 getting 0.50 paisa
after adjustment of premium cost.
• He has thus taken a chance to avail upside by
bearing a small cost in the form of the premium,
and thus insured the value of his USD earning at
47.45 (47.50-0.05) on one hand and on the other
hand, retained the right to avail the advantage of
any market move in his favour beyond the strike
rate.
SWAPS
 Development of Swaps market

• Globalization of the financial markets.

• Access of financial institutions in generating
resources from different countries.
• Different currencies.
• Deploy funds in countries and currencies which
may not be same as these resources raised
countries.
• Played a role in the development of swap market.
• Swap market started developing in 1980.
• Large multinationals felt the need for investments
in the currency of foreign country.
• Multinationals were able to generate home
currency more easily.
• Swap market developed as an OTC market
product.
• Later on the volumes and the demand picked up
several exchange offer swap products.
• The word swap literally means an exchange.
There are two basic kinds of swaps:
• Interest rate swap.
• Currency swap.
• Interest rate swap may regarded as truly global
derivative instrument.
• It is an agreement between two parties to
exchange interest rate obligations / receipt or an
agreed notional principle amount for a agreed
period.
• There would be no exchange of principle amount,
only interest streams would be exchanged.
• Fixed / Floating Interest Swap.
• Typically ‘plain vanilla’ was the key stone in the
growth of the swap markets.
• Credit market users recognized the relative
advantage enjoyed in fixed and floating rate
markets due to variations in credit rating and
perceptions.
• Typically two borrowers would each
simultaneously raise funding in the market in
which they enjoyed absolute and comparative
advantage and then exchange interest rate
obligation on identical notional principle
amounts and corresponding rates, to generate
cost of funding to both parties.
 Example
• A company with a US $50million loan facility on which
it pays interest at the rate of 6 months LIBOR plus a
margin of 2.50 pa. wishes to fix its interest cost for a 5
year period. Co requested its bank an interest rate swap
quotation. Its bank advises that its offer rate to receive
fixed rate for 5 years against the payment of 6 month
LIBOR is 5% semi annual. The CO wishes to match the
payment flows under the loan with the swap and agrees
to pay the increased fixed rate of 5.50% to receive 6
months LIBOR plus 2.50%. (all payment on over actual
/ 360days basis).
 Cash flow of the above example may be
illustrated as follows:

Existing LIBOR
floating rate plus 2.5 % Company
lending

Fixed LIBOR
5.5% Plus 2.5%

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