Derivatives

DERIVATIVES An Introduction

Derivatives • What is a derivative?: a financial product which has been derived from another financial product or commodity. Without the underlying product or market, the derivative would have no independent existence. Common types of derivatives are Forwards, Swaps and Options. • Derivatives have risen from the need to manage the risk arising from movements in markets beyond our control, which may severely impact the revenues and costs of the firm.

Swaps • A swap, a popular financing tool, is a contract between two parties (counter parties) to exchange two streams of payment for an agreed period of time. Variants of swaps - interest rate, currency, commodities, equity • Financial swaps are a funding technique, which permit a borrower to access one market and then exchange the liability for another type of liability. The global financial markets present borrowers and investors with a wide variety of financing and investment vehicles in terms of currency and type of coupon - fixed or floating. • It must be noted that swaps by themselves are not a funding instrument; they are a device to obtain the desired form of financing indirectly. The borrower might otherwise have found this too expensive or even inaccessible.

Swaps • A common explanation for the popularity of swaps concerns the concept of comparative advantage. The basic principle is that some companies have a comparative advantage when borrowing in fixed rate markets while other companies have a comparative advantage in floating rate markets. This may lead to some companies borrowing in fixed markets when the need is of a floating rate loan and vice versa. Swaps are used to transform the fixed rate loan into a floating rate loan. All swaps involve exchange of a series of periodic payments between two parties. • A swap transaction usually involves an intermediary who is a large international financial institution. The two payment streams are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant markets.

Interest Rate Swaps • The two most widely prevalent types of swaps are interest rate swaps and currency swaps. • An interest rate or coupon swap involves an exchange of different payment streams which are fixed and floating in nature. In this, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. At the same time, party A agrees to pay party B cash flows equal to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. The life of the swap can range from two years to over 15 years. This type of a standard fixed to floating rate swap is also called a plain vanilla swap in the market jargon. • London Inter-bank Offer Rate (LIBOR) is often the floating interest rate in many of the interest rate swaps.

E.g. of Interest Rate Swap Interest rate swaps are calculated based on the under-lying notionals using applicable rates. Example of Coupon Swap: Cost of Funds Fixed Rate Floating Rate Good Credit 6% Libor Poor Credit 8% Libor + 1% Spread 2% 1% Net Position Good Credit Poor Credit Cost of Funds 6 L+1 Less Receipts on Swap (6.5) (L) Plus Payments on Swap L 6.5 Overall Cost L-0.5 7.5 Note: The difference in spread of 1% is up for negotiation.

Why enter into interest rate swaps? • Lowering financing cost: use comparative advantage • Hedge exposure to interest rate risks: mismatched income and outflow • Restructuring the debt in the balance sheet • Swaps are privately negotiated products. However, parties with low credit rating have difficulty in entering the swap market. • Participants: MNCs, Banks, Sovereign and Public Sector Institutions, etc. • Facilitators: Dealers and Brokers

Currency Swaps • Currency swaps involve exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an approximately equivalent loan in another currency. • Suppose that a company A and company B are offered the fixed five-year rates of interest in U.S. dollars and sterling. Also suppose that sterling rates are generally higher than the dollar rates. Also, company A enjoys a better creditworthiness than company B as it is offered better rates on both dollar and sterling. What is important to the trader who structures the swap deal is that difference in the rates offered to the companies on both currencies is not the same. Therefore, though company A has a better deal in both the currency markets, company B does enjoy a comparatively lower disadvantage in one of the markets. This creates an ideal situation for a currency swap.

Currency Swaps • The deal could be structured such that company B borrows in the market in which it has a lower disadvantage and company A in which it has a higher advantage. They swap to achieve the desired currency to the benefit of all concerned. • It should be noted that the principal must be specified at the outset for each of the currencies. The principal amounts are usually exchanged at the beginning and at the end of the life of the swap. They are chosen such that they are equal at the exchange rate at the beginning of the life of the swap. • Like interest rate swaps, currency swaps are frequently warehoused by financial institutions

Currency Swaps

•

• • •

Currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management. Examples: Lowering funding cost: raise capital in the most favourable market and then exchange the currency of the raised capital for another by swapping Entering restricted capital markets Reducing currency risk: exchanging foreign currency payments into home currency payments Diversifying currency liabilities

E.g. of Currency Swap • HDFC raises floating rate dollar debt in the US market, backed by the guarantee of USAID – leading to borrowings being at very fine rates. However, HDFC’s requirement is for long term fixed rate rupees. Hence, HDFC swaps floating rate dollar loans with Indian banks for fixed rate rupees. • Result: The counter parties (the Indian banks) have access to floating rate dollars at a rate they would not have been able to raise on their own, while HDFC has access to fixed rate rupees at less than market rates.

Other Types of Swaps • A swap in its most general form is a contract that involves the exchange of cash flows according to a predetermined formula. There is no limit to the number of innovations that can be made given this basic structure of the product. • One innovation is the combination of the interest and currency swaps where the two parties exchange a fixed rate currency A payment for a floating rate currency B payment. • Swaps are also extendable, where one party has the option to extend the life of the swap or puttable, where one party has the option to terminate the swap before its maturity. • Options on swaps or Swaptions, are also gaining in popularity.

Swaps • A Swap Dealer takes one side of the transaction and acts as a counter party. A Broker only gets the two counter parties together for the deal. The parties to early swaps were end-user organisations with merchant banks acting as arrangers. Today a few banks run swap books or warehouse. Running a swap book is a highly complex activity. Today a range of commercial software has become available. • A swap is a contingent liability and does not have to appear in balance sheet.

Swaps • Swap Documentation: Swap agreements are usually initiated over telephone, and then confirmed over telex, fax, letter within 24 hours. This is followed by documentation. • Documentation standardised by New York based International Swap and Derivatives Association (ISDA). • Standardisation of documentation has facilitated the transaction process.

Futures and Options • Futures are a form of Forward Contract in which one agrees to take delivery at an agreed price, quantity and time in the future in a specific market. Future contracts differ from Forward Contracts by the fact that they are traded on a recognised public exchange. • Options convey the right, but not the obligation to take future delivery of an agreed quantity, at a certain price. • The three major players in the derivatives markets are hedgers, speculators and arbitrageurs. • Arbitrage ensures that similar assets and similar risks are priced uniformly throughout the world, thus promoting stability. Futures and options markets have created a mechanism for pricing and transferring risks around the world.

History & Development • Japanese rice traders: hundreds of years • Venetian spice traders: During the Renaissance period • American ranchers: 19th century • Recent explosion of growth: the collapse of the Bretton Woods fixed exchange rate regime during the early 1970s

Major Markets • Chicago Mercantile Exchange: exchange-traded currency futures in 1973 • Chicago Mercantile Exchange: interest rate futures in 1975 • Philadelphia Stock Exchange: currency options in 1983 • New York Futures Exchange: 1980 • London International Financial Futures Exchange (Liffe): 1982 • Singapore Monetary Exchange (SIMEX): 1983 • An important feature in the evolution of derivatives has been the evolution of Over-the-Counter (OTC) market. “Financial engineers” using off-the-shelf futures and options products to satisfy special needs can develop custom-made solutions. Such products with unique risk/reward profiles are called hybrids.

Forward Contracts • A forward contract is a transaction in which buyer/ seller agree upon delivery of a specified quality and quantity of asset at a future specified date. A price may be agreed upon in advance or at the time of delivery • Forward contracts exist for a variety of underlying assets: • Metals (contracts for base metals on LME) • Energy Products (crude oil and oil products) • Interest Rates (Forward Rate Agreements - FRAs) • Currency (forward forex transactions)

Currency Forwards • • • • • •

Banks and other traders - no single location Dealing by telephone/ telex Tailor made contract No secondary market Bank is the counter party Usually end with deliveries, while futures are usually settled with differences • No collateral or margin is usually required

Futures Market • Hedging in interest rates, currency rates and share prices by taking a position that is equal and opposite to an existing exposure • A futures contract obligates the buyer to purchase the underlying contract and the seller to sell it, unless the contract is sold to another before settlement date, which may happen in order to take a profit or limit a loss. In practice, only a very small percentage of futures contracts result in delivery of the underlying commodity or security.

Futures Market • Open outcry by authorised brokers (commission) on behalf of clients on trading floor (or pit) • Period of contract: normally trade in a cycle of four times annually – say four delivery dates in a year. (e.g. 2nd Wednesday of March, June, September and December on the LIFFE) • Standard quantities in a few currencies • Minimum price movement of the contract: tick • Exchange traded instruments: hence credit worthiness of the exchange is important, not counter parties: settlement through clearing house

Futures Market • Credit worthiness of the exchange is maintained by imposition of margins - `marked to market’ on daily basis • Margins are deposits which hedgers and speculators offer as collateral for their futures position. As the value of a position may change daily, the margin is adjusted to ensure adequate collateral. The initial margin is based upon the value of the position and its inherent risk as measured by its volatility.

Comparison of forward and futures markets in foreign exchange Financial Futures

Forward markets

Location

Futures Exchange

No single location

Trading medium

Open Outcry

Telephone/ telex

Contract size

Standardised

As reqd. by customer

Maturity/ Deliver Date

Standardised

As reqd. by customer

Counterparty

Clearing House

Known bank/ trader

Credit Risk

Clearing House

Individual counterparty

Commissions

Always Payable

Negotiable

Security

Margin required

Counterparty risk

Liquidity

Provided by credit risk

Leverage

Provided by margins Very high

Settlement

Via Clearing House

Via bank arrangements

No formal gearing

Example of Currency Future • A UK importer has to pay USD 160,000 to his seller on 15th April for imports made in January. In February he is worried that the dollar may appreciate against the pound and decides to cover the exchange risk in the LIFFE futures market. The amount of the LIFFE sterling dollar contract is STG 25,000 and the maturity 2nd Wednesday in June. The current spot rate is $ 1.50 and June contract is being traded at $ 1.45. • Decision: He decides to sell four June contracts at $ 1.45. On 15th of April, the spot rate in the cash market is $1.40 and the June futures is now trading at $ 1.36. This means that the $ 160,000 purchase in the cash market will cost him 160,000/ 1.40 = STG114285.71. At the original spot rate of $ 1.50, the UK importer would have paid 160,000/ 1.50 = STG 106,666.66; thus there is a loss of STG 7619.05. However, in the futures market, he can now buy back the four contracts sold at $ 1.45 at $ 1.36, thus making a profit of 9 cents per pound, or $ 9,000 or 9,000/ 1.40 = STG 6428.57 at current spot rate. • Result: The hedge is not perfect, but the loss on account of adverse movement in the spot market has been partially made up by resorting to the futures market.

Forward Rate Agreements (FRAs) • FRAs allow borrowers to lock-in today an interest rate (say LIBOR) accruing from a forward start date for a given period, for eg. for month 6 in the future to month 9.Very popular in 2-3 years range. • The FRA is a contract between two parties to agree on an interest rate on a notional loan or deposit of a specified amount and maturity at a specified future date and to make payments between counter parties computed by reference to changes in the interest rate. • FRAs involve no exchange of principal amount.

Example of an FRA • The agreed 6 month LIBOR under an FRA is 3.5% per annum on a given future date. If the actual LIBOR rate happens to be 4%, the bank will reimburse to the buyer of the FRA the difference of 0.5% p.a. • On the other hand, if the actual LIBOR rate happens to be 3% p.a., the borrower will have to pay the difference to the bank. • It is not necessary that the bank be a lender in the transaction.

Options • The buyer of the option has the right but not the obligation to buy or sell a specific quantity of a particular asset, at a specified price at or before a specific date in the future. On account of price movements, the option may increase, decrease or remain unchanged in value. • Maximum risk of the buyer of the option is the actual upfront premium cost of the option. • Users are able to obtain insurance against an adverse movement in the exchange rate while still retaining the opportunity to benefit from favourable exchange movements • Currency option contracts available on an exchange are standardised

Options • Prices, or premia, for foreign exchange options are arrived at through competition between sellers and buyers on the floor of the exchange • Currency options are of particular interest to the treasurer where a future currency cash flow is uncertain, say when putting in a contract tender. If the contract is not awarded the company allows the currency option to lapse, or sells at a profit. • Popular in times of large volatility in markets • OTC market takes care of tailor-made options between banks and customers. Often banks use exchange traded options to hedge OTC positions

Option Terminology • Call Option : The right to buy at a fixed price, on or before a fixed date, a fixed quantity • Put Option: The right to sell at a fixed price, on or before a fixed date, a fixed quantity • Strike or Exercise Price: Fixed price at which the option may be exercised and the underlying asset bought or sold • Premium: The price or cost of an option • In-the-Money: The option has an exercisable value, i.e. in the case of a Call Option the exercise price is below the spot price; and in the case of a Put Option, the exercise price is above the prevailing spot price. • At-the-Money: The Option exercise price equals the prevailing price of the underlying asset • Out-of-the-Money: The Option price lies above the prevailing price of the underlying asset in the case of a Call or below in the case of a Put

Option Terminology • Maturity or Expiration Date: Final day on which an option may be exercised • American Option: The option may be exercised by the buyer at any time before maturity • European Option: The option can only be exercised by the buyer on the maturity date, and not before that date. • Intrinsic Value: The positive difference between exercise price and market price. An option has intrinsic value if it is in-the-money. For a call option the strike price has to be under the price of the underlying; for a put option the strike price has to be over the price of the underlying.

Call Option Perspectives Option Buyer’s Perspective

Option Seller’s Perspective

Pay-offs per $

46.50 0

Profit Area

0.50

47.00

0.50

Exercise Price = Rs. 46.50 per $ 0.50 per $

0

47.00 46.50

Loss Area

Option Premium = Rs.

Put Option Perspectives Option Buyer’s Perspective Pay-offs per $

0

Profit Area

Option Seller’s Perspective Pay-offs per $

46.50 46.00

Exercise Price = Rs. 46.50 per $ per $

0

46.00 Loss Area

46.50

Option Premium = Rs. 0.50

Example of Currency Option • A US manufacturer imports his raw materials from UK. In six months time (i.e. say June 2005) he will need to import goods worth STG 1 million and has to pay for the imports. He wants to protect himself from exchange fluctuations, yet wants to take advantage of favourable ER movement. • Jan.2005: Market conditions: STG/ USD = 1.50 • June Calls @ Strike Price of STG/ USD = $ 1.51, premium 4 US cents • Result: In June 2005, the USD does weaken and the new spot rate is STG/ USD = 1.60. Hence the Call Option now has an intrinsic value of 9 US cents: the exercise of the Call Option Contract will net $ 90,000 ($ 1.6 million minus $ 1.51 million.) • The premium price was $ 40,000 (1million x 4/100). Net gain by US importer = $ 90,000 - $ 40,000 = $ 50,000.

Option Pricing • Mathematical model developed by Fischer Black and Myron Scholes (1973). Adapted by Garman and Kohlhagen (1983) for currency options • The Black-Scholes model determines a fair value price based on current price (spot) , exercise price, time remaining before expiration of the option, the compounded risk less rate of interest and the value of the cumulative normal density function • The fair value price as well as supply and demand then determines market price of the option. • Nowadays various menu driven packages are available for arriving at the values of call and put options after feeding the primary data.

Option Pricing by Black and Scholes Pc = [Ps][N(d1)] – [Pe][antiln(-Rft)][N(d2)], where Pc = market price of the call option Ps = price of the stock Pe = striking price of the option antiln = antilog (base e) Rf = annualised interest rate t = time to expiration (in years) N(d1) and N(d2) are the values of the cumulative normal distribution defined by • d1 = [In(Ps/Pe) + (Rf + 0.5 σ2)t] / σ√ t, d2 = d1 – (σ√ t) • Where In(Ps/Pe) = the natural logarithm of (Ps/Pe) • σ2 is the variance of continuously compounded rate of return on the stock per time period • • • • • • • •

Option Pricing • In 1983 Garman and Kohlhagen extended the BlackScholes model to cope with the presence of two interest rates (one for each currency). Suppose that rd is the riskfree interest rate to expiry of the domestic currency and rf is the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of foreign currency per unit of domestic currency"). Then the value of a call option into the foreign currency has value • exp( − rfT)SN(d1) − Kexp( − rdT)N(d2), where • S is the current spot rate, K is the strike rate • N is the cumulative normal distribution function • and σ is the volatility of the FX rate.

Values of d1 and d2

Interest Rate Options • They enable a co. to take advantage of favourable movements of interest rates by providing the right but not the obligation to fix a rate of interest, on a notional loan or deposit, for an agreed amount, for a fixed term, on a specified forward date. The seller of the option guarantees an interest rate if the option is exercised. The seller receives a fee, the premium, for providing this guarantee. • The most common type of interest rate option is available to borrowers as a hedge against rising interest rates. This is known as the interest rate cap.

Caps • Major international banks offer, for a fee, a kind of insurance cover for fluctuations in interest rates like the LIBOR. In such cases, the bank agrees to reimburse to the borrower the cost of LIBOR exceeding a particular level during the currency of the loan. This is known as a `cap’. • The fee to be paid by the borrower would depend upon the difference between the cap and the current rate, the period for which the contract is to run, the anticipated interest rate volatility, etc. The higher the cap, the lower the fee; the longer the period, the higher the fee, etc.

Collars • Interest rate floors protect investors against falling interest rates. When a contract specifies both the cap and floor, it is known as a `collar’ or `band’. • Dealing with an interest rate collar is cheaper than buying the straight interest rate cap or floor since the buyer is giving up some of his upside benefit if rates move in his favour. Effectively, the simultaneous purchase and sale of a cap and a floor is known as a `collar’. For example, if the actual LIBOR is lower than the band, the buyer of the collar will pay the difference to the insurer. • It is possible to structure zero cost options for both currencies and interest rates.

Derivatives in India • Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 • Residents in India and residents outside India are allowed to enter into a Foreign Exchange Derivative Contract as well as a Commodity Hedge to hedge an exposure to risk in respect of FEMA permissible transaction • In respect of permissible transactions, an AD in India may remit outside India foreign exchange towards option premium payable as well as amounts incidental to the derivative contracts (including necessary margins).

Foreign Exchange Derivative Contracts: Forward Contract A person resident in India may enter into a forward contract with an AD in India subject to: • The AD through documentary evidence is satisfied about the genuineness of the underlying exposure • The maturity of the hedge does not exceed the maturity of the underlying exposure • The currency of hedge and tenor are left to the choice of the customer • Where the exact amount of the underlying transaction is not ascertainable, the contract is booked on the basis of a reasonable estimate

Foreign Exchange Derivative Contracts: Forward Contract contd. • Substitution of contracts for hedging trade transactions may be permitted by an AD on being satisfied with the circumstances under which such substitution has become necessary. • ADs are permitted to offer forward contracts to their importer/exporter constituents on the basis of last 3 years average import/export performance, or the previous year’s actual import/export turnover, whichever is higher, without production of the underlying contracts. • Cancellation and rebooking of all eligible forward contracts booked by residents, irrespective of tenor, allowed subject to certain conditions.

Foreign Exchange Derivative Contracts: Contracts other than Forward Contracts • A person resident in India who has borrowed foreign exchange may enter into an Interest Rate Swap/ Currency Swap/ Coupon Swap/ Foreign Currency Option/ Interest Rate Cap or Collar (Purchases) or Forward Rate Agreement (FRA) contract with an AD in India or with a branch outside India of an AD for hedging his loan exposure and unwinding from such hedges. • A person resident in India, who owes a foreign exchange or rupee liability, may enter into a contract for foreign currency- rupee swap with an AD in India to hedge long-term exposure.

Foreign Exchange Derivative Contracts: Contracts other than Forward Contracts • All Indian clients are allowed to purchase cross currency options to hedge exposures arising out of trade. They are allowed to use cost reduction strategies and structures as long as they are not net receivers of premium. Authorised Dealers (ADs) in India who offer these products are required to cover these products back to back in international markets and not carry the risk in their own books. • Indian banks are allowed to use the above products to hedge interest rate and currency mismatches on their balance sheets.

Foreign Exchange Derivative Contracts: Permissible for Residents outside India A Registered FII may enter into a forward contract with rupee as one of the currencies, to hedge an exposure in India, provided: • The value of the hedge does not exceed the current market value of its investments; • Forward contracts once cancelled shall not be rebooked but may be rolled over on or before maturity; • The cost of hedge is met out of repatriable funds and/ or inward remittance through normal banking channels.

Foreign Exchange Derivative Contracts: Permissible for Residents outside India • A non-resident Indian (NRI) or Overseas Corporate Body (OCB) may enter into a forward contract with the rupee as one of the currencies, with an AD in India, to hedge: • The amount of dividend due to him on shares held in an Indian company; • The balances held in FCNR/ NRE accounts; • The amount of investment made under portfolio scheme

Foreign Currency Rupee Options • Introduction of Foreign Currency- Rupee Options in India wef July 7, 2003. Initially only OTC contracts introduced – plain vanilla products, i.e. European exercise call and put options. • Only customers with genuine foreign currency exposures are eligible to enter into contracts. At present options cannot be used to hedge contingent or derived exposures except exposures arising out of tender bids in foreign exchange. • Customers can also enter into packaged products involving cost reduction structures and does not involve customers receiving premium.

Foreign Currency Rupee Options contd. • Writing of options by customers is not permitted. • ADs may quote the option premium in Rupees or as a % of the rupee/ foreign currency notional. • Option contracts may be settled on maturity either by delivery on spot basis or by net cash settlement in Rupees on spot basis. • The limit available for booking of forward contracts on past performance would be inclusive of option transactions. • Only one hedge transaction can be booked against a particular exposure/ part thereof for a given time period.

Foreign Currency Rupee Options contd.

• • • •

ADs having adequate internal control, risk monitoring / management systems, mark to market mechanism and fulfilling the following criteria will be allowed to run an option book after obtaining approval from RBI: Continuous profitability for three years; Minimum CRAR of 9% Net NPAs at reasonable levels (not more than 5% of net advances) Minimum net worth not less than Rs. 200 crores

Foreign Currency Rupee Options contd. • The product may be offered by other ADs having a minimum CRAR of 9% on a back-to-back basis. • Banks can use the product for hedging trading and balance sheet exposures. They have to put in place necessary systems for marking to market the portfolio on a daily basis. • Market participants may follow only ISDA documentation.

Commodity Hedge • Banks have been allowed to approve proposals for commodity hedging in international exchanges from their corporate customers. • Basically, Indian entities who have genuine exposures to commodity price risk can undertake hedging activities. All standard exchange traded futures will be permitted. • As regards options, only purchases will be allowed. However, it is open to the corporates to use combinations of option strategies involving a simultaneous purchase and sale of options as long as there is no net inflow of premium, direct or implied. Corporates are also allowed to cancel an option position with an opposite transaction with the same broker.

Commodity Hedge contd. • The corporates should not undertake any arbitraging/speculative transactions. The responsibility of monitoring transactions in this regard will be that of the AD. • RBI, through this process, has allowed Indian corporates need based access to a wide range of derivative products available in established international exchanges like LME, Simex, LIFFE, CBOT and the OTC market. Large Indian players in commodities are fairly active in these markets.