Financial Derivatives

Financial Derivatives Dr K Ramesha Professor

Financial Derivatives • “ in our view, derivatives are financial weapons of mass destruction, carrying dangers that while now latent, are potentially lethal” – Mr Warren Buffett • “derivatives made it possible for banks and financial institutions avert the adverse effects of the collapse of Enron, Worldcom, Adelphi etc” – Alan Greenspan

Financial Derivatives • Derivatives can be defined as “contracts which do not have any intrinsic value, but derive their value from an underlying product or asset, whether tangible or intangible” • These contracts broadly fall into five categories – – – – –

Forwards Futures Options Swaps and Credit derivatives

Forward Contracts • These contracts are known to bankers for a long time and are extensively used in dealings in foreign exchange. Essentially, these are meant to hedge one’s exposure in a currency, viz., to protect oneself from an adverse movement in the price of a currencey – An example of importer or exporter

• All forward contracts are “over the counter” products meaning contracting parties do the deal themselves without disclosing information to outsiders • There is no supervisory mechanism in any country other than normal contract laws to ensure both the parties fulfill their respective obligations • Currently, it is estimated that over 95 percent of forward contracts in currencies are entered into by speculators who have no underlying trade (export/import) transactions

Futures • A variant of Forward Contract is “Futures” – All forward contracts are put through a recognized exchange which acts as an intermediary between the dealer and client (buyer and seller) – Details of contract are in public domain – Contracts are of fixed amounts and mature on fixed dates – Margins are required to be posted daily – may increase or decrease – market to market mechanism and no credit risk unlike forward contracts – Orderly trading through accredited brokers to exchanges who collect/pay margins

Options • Option is a contract to buy or sell an underlying asset, tangible or intangible • There are two parties – option writer and option holder • Option holder has every right to exercise the option, but no obligation to do so • Option writer has no rights but only the obligation to fulfill his side of the contract should the holder exercise his right • But the option holder is required to pay a premium upfront

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Option contract is specific and indicates the price at which the underlying asset will be bought or sold (strike price) and the date/period in which it can be exercised Option holder can agree to either buy/sell a particular share at the strike price after say, 2 months. Option to buy is termed as “call option” and option to sell is “put option” If a person has some shares in company C which cost him Rs 250 per share and if he anticipates that the price may move downwards in the next 2 months, he can take a put option at Rs 300 exercisable after 2 months, on paying a premium of say Rs 10 per share If on the strike date, the price rules at Rs 280 he can exercise the option and get a profit of Rs 10 (300-280=20 –premium of 10) If price rules at 300 and more, he will not exercise the option but write off the premium as loss If exercising an option results in a profit it is called “in-the-money” and when it is not profitable, “out-of-the-money”

SWAPS • Swaps are contracts for exchanging one product by another. Typically these are in use in currencies and interest rates along with their myriad combinations • A currency swap is one where two parties exchange one currency for another • A simple example is where two reputed companies, based in India (IC) and US (UC have subsidiaries in the other country. • IC has highest credit rating in India and UC highest credit rating in US – IC’s subsidiary is not well known in US and UC’s subsidiary not well known in India

SWAPS • Both subsidiaries need long term credit from banks in local currencies • If they were to approach local banks, cost will be high • Instead, IC arranges to raise rupee loan in India and UC arranges to raise $ loan in US at relatively cheaper rates • IC lends on-lends to UC’s subsidiary in India in rupees in return for UC’s on lending to IC’s subsidiary in US • Maturity dates and the repayment schedules of both the loans must be idential

SWAPS • A leading financial house was able to raise long term loans in US and did not have any use in US$ • Financial house offered US$ funds to three Indian banks and three Indian financial institutions in return for their lending equivalent Indian Rupees • Rupee loans were priced lower than the ruling rates of interest, because the $ loan was also at a rate below the ruling rates there – a win-win situation

Interest Rate Swaps • Interest rate swaps, typically started as exchange of one interest rate instrument by another. • This arose after floating rates of interest became more common. • Thus a party paying a fixed interest rate can exchange it for another paying floating rate instrument

Interest Rate Swaps – An Example • Suppose two companies – World Bank (WB) and an Indian Company (INC) are in the market to borrow $100 mn for 5 years • INC wants fixed interest rate and WB floating rate • If INC borrowed in floating rate interest rate will be LIBOR plus 0.5% and if borrowed in fixed rate, cost would be 6% • For WB – floating rate cost is LIBOR and fixed rate cost is 5% • An clever investment bank would grab this opportunity to do a swap deal

Interest Rate Swaps – An Example • WB borrows at fixed rate & lends to investment bank at 5% • Inv Bank lends to INC at 5% • INC borrows at floating rate & lends to Inv Bank at LIBOR minus 0.30% • Inv Bank lends to WB at LIBOR minus 0.20% • All the three parties – WB, INC and Inv Banks have made gains

Interest Rate Swaps – An Example • WB – its cost of funds now is LIBOR minus 0.2% (if it had gone to market it would have paid LIBOR) – in borrowing at 5% and lending to Inv Bank, it had made no gain no loss • INC – it lost 0.8% in total (borrowing at LIBOR plus 0.5% on floating rate and on-lending at LIBOR minus 0.3%). But gained 1% (borrowed at 5% rather than 6% on fixed rate). Thus the net gain for INC is 0.2% • Inv Bank – No gain in borrowing from WB and lending to INC. But in borrowing from INC and on-lending to WB, it gained 0.10% • The above gains (WB - 0.20, INC – 0.20 and Inv Bank – 0.10) arose because of the peculiarity in the market for loans • Market for floating rate loan is dominated by banks, whereas the fixed rate market is generally dominated by investors. Thus INC gets a better deal in floating rate market

Interest Rate Swaps – An Example • Broad conclusions – Interest rate swap arises because two parties have opposite views on the likely movement of interest rates in future (WB wanted floating rate and INC fixed rate) – Generally such swaps which are backed by borrowing deals arise due to market imperfections as in the above example. However, these days interest rate swaps are entered into mostly as speculative deals, where both parties bet on the future movement of rates.

Credit Derivatives • Fundamentally these are guarantee or insurance products. Any lender assumes two risks; ability to raise funds for the period of loan and default risk • In credit derivatives a third party takes over the default risk from the lender • Lender who sells the risk is called protection buyer and the guarantor/issuer is called as protection seller • Usually banks (commercial and investment banks) are protection buyers and other banks, insurance companies, mutual funds, hedge funds are protection seller

Credit Derivatives • Basic concept of guarantee is packaged into mind-boggling forms, such as credit default swaps, total return swaps, credit linked notes, credit options etc • Risk can again can be sliced into myriad ways; senior subordinate, mezzanine, and so on • Part or whole debt can be collateralized and that portion of risk can be sold through collateralized debt obligations (CDO) • Payment of the sum in default can be in straight cash for full amount or for part of the amount after deducting the value of security or a part of the amount on the event of default occurring • Tricky part is to clearly define as to what is an event of default. It could be plain non-payment or bankruptcy or deterioration in borrowers financial position or credit rating down grade or repudiation of loan or reduction in value of collateral etc