Futures And Options

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Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain specified time in future for certain specified price. In this, it is similar to a forward contract. However, there are a number of differences between forwards and futures. These relate to the contractual features, the way the markets are organized, profiles of gains and losses, kinds of participants in the markets and the ways in which they use the two instruments. Futures contracts in physical commodities such as wheat, cotton, corn, gold, silver, cattle, etc. have existed for a long time. Futures in financial assets, currencies, interest bearing instruments like T-bills and bonds and other innovations like futures contracts in stock indexes are a relatively new development dating back mostly to early seventies in the United States and subsequently in other markets around the world. Major Features Of Futures Contracts The principal features of the contract are as follows: Organized Exchanges Unlike forward contracts which are traded in an over-the-counter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready, liquid market in which futures can be bought and sold at any time like in a stock market. Standardization In the case of forward currency contracts, the amount of commodity to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor-made to buyer's requirements. In a futures contract both these are standardized by the exchange on which the contract is traded. Thus, for instance, one futures contract in pound sterling on the International Monetary Market (IMM), a financial futures exchange in the US, (part of the Chicago Board of Trade or CBT), calls fore delivery of 62,500 British Pounds and contracts are always traded in whole numbers i.e. you cannot buy or sell fractional contracts. A three-month sterling deposit on the London International Financial Futures Exchange (LIFFE) has March, June, September, December delivery cycle. The exchange also specifies the minimum size of price movement (called the "tick") and, in some cases, may also impose a ceiling on the maximum price change within a day. In the case of commodity futures, the commodity in question is also standardized for quality in addition to quantity in a single contract.

http://www.linny.org/forum/ Clearing House The exchange acts as a clearinghouse to all contracts struck on the trading floor. For instance, a contract is struck between A and B. Upon entering into the records of the exchange, this is immediately replaced by two contracts, one between A and the clearing house and another between B and the clearing house. In other words, the exchange interposes itself in every contract and deal, where it is a buyer toe very seller and a seller to every buyer. The advantage of this is that A and B do not have to undertake any exercise to investigate each other's creditworthiness. It also guarantees the financial integrity of the market. The exchange enforces delivery for contracts held until maturity and protects itself from default risk by imposing margin requirements on traders and enforcing this through a system called "marking to market".

Margins Like all exchanges, only members are allowed to trade in futures contracts on the exchange. Others can use the services of the members as brokers to use this instrument. Thus, an exchange member can trade on his own account as well as on behalf of a client. A subset of the members is the "clearing members" or members of the clearinghouse and non-clearing members must clear all their transactions through a clearing member. The exchange requires that a margin must be deposited with the clearinghouse by a member who enters into a futures contract. The amount of the margin is generally between 2.5% to 10% of the value of the contract but can vary. A member acting on behalf of a client, in turn, requires a margin from the client. The margin can be in the form of cash or securities like treasury bills or bank letters of credit. Marking To Market The exchange uses a system called marking to market where, at the end of each trading session, all outstanding contracts are repriced at the settlement price of that trading session. This would mean that some participants would make a loss while others would stand to gain. The exchange adjusts this by debiting the margin accounts of those members who made a loss and crediting the accounts of those members who have gained. This feature of futures trading creates an important difference between forward contracts and futures. In a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows. Whereas, in a futures contract, even though the gains and losses are the same, the time profile of the accruals is

http://www.linny.org/forum/ different. In other words, the total gains or loss over the entire period is broken up into a daily series of gains and losses, which clearly has a different present value. Actual Delivery Is Rare In most forward contracts, the commodity is actually delivered by the seller and is accepted by the buyer. Forward contracts are entered into for acquiring or disposing off a commodity in the future for a gain at a price known today. In contrast to this, in most futures markets, actual delivery takes place in less than one percent of the contracts traded. Futures are used as a device to hedge against price risk and as a way of betting against price movements rather than a means of physical acquisition of the underlying asset. To achieve this, most of the contracts entered into are nullified by a matching contract in the opposite direction before maturity of the first. Types of futures As is evident from the previous discussion, trading in futures is equivalent to betting on the price movements in futures prices. If such betting is used to protect a position - either long or short - in the underlying asset, it is termed as hedging. On the other hand, if the activity is undertaken only with the objective of generating profits from absolute or relative price movements, it is termed as speculation. It must be noted that speculators provide liquidity to the markets by their willingness to enter open positions. We shall briefly look at currency, interest rate and stock index futures. There are others like commodity futures as well which are not covered under this section.

Currency Futures We shall look at both hedging and speculation in currency futures. Corporations, banks and others use currency futures for hedging purposes. The underlying principle is as follows: Assume that a corporation has an asset e.g. a receivable in a currency A that it would like to hedge, it should take a futures position such that futures generate a positive cash whenever the asset declines in value. In this case, since the firm in long, in the underlying asset, it should go short in futures i.e. it should sell futures contracts in A. Obviously, the firm cannot gain from an appreciation of A since the gain on the receivable will be eaten away by the loss on the futures. The hedger is willing to sacrifice this potential profit to reduce or eliminate the uncertainty. Conversely, a firm with a liability in currency A e.g. a payable, should go long in futures.

http://www.linny.org/forum/ In hedging too, the corporation has the option of a direct hedge and a cross hedge. A British firm with a dollar payable can hedge by selling sterling futures (same effect as buy dollar futures) on the IMM or LIFFE. This is an example of a direct hedge. If the dollar appreciates, it will lose on the payable but gain on the futures, as the dollar price of futures will decline. An example of a cross hedge is as follows: A Belgian firm with a dollar payable cannot hedge by selling Belgian franc futures because they are not traded. However, since the Belgian franc is closely tied to the Deutschemark in the European Monetary System (EMS). It can sell DM futures. An important point to note is that, in a cross hedge, a firm must choose a futures contract on an underlying currency that is highly positively correlated with the currency exposure being hedged. Also, even when a direct hedge is available, it is extremely difficult to achieve a perfect hedge. This is due to two reasons. One is that futures contracts are for standardized amounts as this is designed by the exchange. Evidently, this will only rarely match the exposure involved. The second reason involves the concept of basis risk. The difference between the spot price at initiation of the contract and the futures price agreed upon is called the basis. Over the term of the contract, the spot price changes, as does the futures price. But the change is not always perfectly correlated - in other words, the basis is not constant. This gives rise to the basis risk. Basis risk is dealt with through the hedge ratio and a strategy called delta hedging. A speculator trades in futures to profit from price movements. They hold views about the future price movements - if these differ from those of the general market, they will trade to profit from this discrepancy. The flip side is that they are willing to take the risk of a loss if the prices move against their views of opinions. Speculation using futures can be in the either open position trading or spread trading. In the former, the speculator is betting on movements in the price of a particular futures contract. In the latter, he is betting on the price differential between two futures contracts.

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An example of open position trading is as follows: $/DM Prices Spot March Futures June Futures September Futures

0.5785 0.5895 0.5915 0.6015

These prices evidently indicate that the market expects the DM to appreciate over the next 6-7 months. If there is a speculator who holds the opposite view i.e. he believes that the DM is actually going to depreciate. There is another speculator who believes that the DM will appreciate but not to the extent that the market estimates - in other words, the appreciation of the DM will fall short of market expectations. Both these speculators sell a September futures contract (standard size - DM 125,000) at $ 0.6015. On September 10, the following rates prevail: Spot $/DM - 0.5940, September Futures - 0.5950 Both speculators reverse their deal with the purchase of a September futures contract. The profit they make is as follows: $(0.6015-0.5950) i.e. $0.0065 per DM or $(125000 x 0.0065) i.e. $ 812.5 per contract. A point to be noted in the above example is that the first speculator made a profit inspite the fact that his forecast was faulty. What mattered therefore, was the movement in September futures price relative to the price that prevailed on the day the contract was initiated. In contrast to the open position trading, spread trading is considered a more conservative form of speculation. Spread trading involves the purchase of one futures contract and the sale of another. An intra-commodity spread involves difference in prices of two futures contract with the same underlying commodity and different maturity dates. These are also termed as time spreads. An intercommodity spread involves the difference in prices of two futures contracts with different but related commodities. These are usually with the same maturity dates.

Interest Rate Futures

http://www.linny.org/forum/ Interest rate futures is one of the most successful financial innovations in recent years. The underlying asset is a debt instrument such as a treasury bill, a bond or time deposit in a bank. The International Monetary Market (IMM) - a part of the Chicago Mercantile Exchange, has futures contracts on US Government treasury bonds, three-month Euro-dollar time deposits and medium term US treasury notes among others. The LIFFE has contracts on euro-dollar deposits, sterling time deposits and UK Government bonds. The Chicago Board of Trade offers contracts on long term US treasury bonds. Interest rate futures are used by corporations, banks and financial institutions to hedge interest rate risk. A corporation planning to issue commercial paper can use T-bill futures to protect itself against an increase in interest rate. A treasurer who is expecting some surplus cash in the near future to be invested in some short term investments may use the same as insurance against a fall in interest rates. Speculators bet on interest rate movements or changes in the term structure in the hope of generating profits. A complete analysis of interest rate futures would be a complex exercise as it involves thorough understanding and familiarity with concepts such as discount yield, yield-to-maturity and elementary mathematics of bond valuation and pricing. Stock Index Futures A stock index futures contract is an obligation to deliver on the settlement date an amount of cash equivalent to the value of 500 times the difference between the stock index value at the close of the last trading day of the contract and the price at which the futures contract was originally struck. For example, if the S&P 500 Stock Index is at 500 and each point in the index equals $ 500, a contract struck at this level is worth $ 250,000 (500 * $500). If, at the expiration of the contract, the S&P 500 Stock Index is at 520, a cash settlement of $ 10,000 is to be made [ (520 - 510) * $500]. It must be noted that no physical delivery of stock is made. Therefore, in order to ensure that sufficient funds are available for settlement, both parties have to maintain the requisite deposit and meet the variation margin calls as and when required.

Options A options agreement is a contract in which the writer of the option grants the buyer of the option the right purchase from or sell to the writer a designated instrument for a specified price within a specified period of time. The writer grants this right to the buyer for a certain sum of money called the option premium. An option that grants the buyer the right to buy some instrument

http://www.linny.org/forum/ is called a call option. An options that grants the buyer the right to sell an instrument is called a put option. The price at which the buyer an exercise his option is called the exercise price, strike price or the striking price. Options are available on a large variety of underlying assets like common stock, currencies, debt instruments and commodities. Also traded are options on stock indices and futures contracts – where the underlying is a futures contract and futures style options. Options have proved to be a versatile and flexible tool for risk management by themselves as well as in combination with other instruments. Options also provide a way for individual investors with limited capital to speculate on the movements of stock prices, exchange rates, commodity prices etc. The biggest advantage in this context is the limited loss feature of options. Types Of Options As mentioned earlier, the underlying asset for options could be a spot commodity or a futures contract on a commodity. Another variety is the futures-style option. An option on spot foreign exchange gives the option buyer the right to buy or sell a currency at a stated price (in terms of another currency). If the option is exercised, the option seller must deliver or take delivery of a currency. An option on currency futures gives the option buyer the right to establish a long or short position in a currency futures contract at a specified price. If the option is exercised, the seller must take the opposite position in the relevant futures contract. For example, suppose you had an option to buy a December DM contract on the IMM at a price of $ 0.58 / DM. You exercise the option when December futures are trading at $ 0.5895. You can close out your position at this price and take a profit of $ 0.0095 per DM or, meet futures margin requirements and carry a long position with $ 0.0095 per DM being credited to your margin account. The option seller automatically gets a short position in December futures. Futures style options are a little bit more complicated. Like futures contracts, they represent a bet on a price. The price being betted on, is the price of an option on spot foreign exchange. Simply put, the buyer of the option has to pay a price to the seller of the option i.e. the premium or the price of the option. In a futures style option, you are betting on the changes in this price, which, in turn depends on several factors including the spot exchange rate of the currency involved. For instance, a trader feels that the premium on a particular option is going to increase. He buys a futures-style call option. The seller of this call option is betting that the premium will go down. Unlike the option on the spot, the buyer does not pay the premium to the seller. Instead, they both post margins related to the value of the call on spot.

http://www.linny.org/forum/ Options Terminology To reiterate, the two parties to an options contract are the option buyer and the option seller, also called the option writer. For exchange traded options, as in the case of futures, once the agreement is reached between two traders, the exchange (the clearing house) interposes itself between the two parties becoming buyer to every seller and seller to every buyer. The clearing house guarantees performance on the part of every seller. Call Option A call option gives the option buyer the right to purchase currency Y against currency X, at a stated price X/Y, on or before a stated date. For exchange traded options, one contract represents a standard amount of the currency Y. The writer of a call option must deliver the currency if the option buyer chooses to exercise his option. Put Option A put option gives the option buyer the right to sell a currency Y against currency X at a specified price on or before a specified date. The writer of a put option must take delivery if the option is exercised. Strike Price (also called exercise price) The price specified in the option contract at which the option buyer can purchase the currency (call) or sell the currency (put) Y against X. Maturity Date The date on which the option contract expires is the maturity date. Exchange traded options have standardized maturity dates. American Option An option, call or put, that can be exercised by the buyer on any business day from initiation to maturity. European Option A European option is an option that can be exercised only on maturity date.

Premium (Option price, Option value)

http://www.linny.org/forum/ The fee that the option buyer must pay the option writer at the time the contract is initiated. If the buyer does not exercise the option, he stands to lose this amount. Intrinsic value of the option The intrinsic value of an option is the gain to the holder on immediate exercise of the option. In other words, for a call option, it is defined as Max [(S-X), 0], where s is the current spot rate and X is the strike rate. If S is greater than X, the intrinsic value is positive and is S is less than X, the intrinsic value will be zero. For a put option, the intrinsic value is Max [(X-S), 0]. In the case of European options, the concept of intrinsic value is notional as these options are exercised only on maturity. Time value of the option The value of an American option, prior to expiration, must be at least equal to its intrinsic value. Typically, it will be greater than the intrinsic value. This is because there is some possibility that the spot price will move further in favor of the option holder. The difference between the value of an option at any time "t" and its intrinsic value is called the time value of the option. At-the-Money, In-the-Money and Out-of-the-Money Options A call option is said to be at-the-money if S=X i.e. the spot price is equal to the exercise price. It is in-the-money is S>X and out-of-the-money is S<X. Conversely, a put option is at-the-money is S=X, in-the-money if S<X and out-ofthe-money if S>X. Option Pricing Black & Scholes, in their celebrated analysis on option pricing, reached the conclusion that the estimated price of a call could be calculated with the following equation: Pc = [Ps][N(d1) – [Pe][antilog (-Rft)[N(d2)] Where: Pc - market value of the call option Ps - price of the stock Pe - strike price of the option Rf - annualized interest rate t - time to expiration in years antilog – to the base e

http://www.linny.org/forum/ N(d1) and N(d2) are the values of the cumulative normal distribution, defined as follows: d1 = Ln (Ps / Pe) + (Rf + 0.5 s 2)t sÖt d2 = d1 - (s Ö t) where: Ln (Ps / Pe) is the natural logarithm of (Ps / Pe) s 2 is the is the variance of continuously compounded rate of return on stock per time period. Admittedly, the definitions of d1 and d2 are difficult to grasp for the reader as they involve complex mathematical equations. However, the basic properties of the Black-Scholes model are easy to understand. What the model establishes is that the estimated price of options vary directly with an option’s term to maturity and with the difference between the stock’s market price and the option’s strike price. Further, the definitions of d1 and d2 indicate that option prices increase with the variance of the rate of return on the stock price, reflecting that the greater the volatility, higher the chance that the option will become more valuable. Relationship Between The Option Premium And Stock Price It is obvious that the option premium fluctuates as the stock price moves above or below the strike price. Generally, option premiums rarely move point for point with the price of the underlying stock. This typically happens only at parity, in other words, when the exercise price plus the premium equals the market price of the stock. Prior to reaching parity, premiums tend to increase less than point per point with the stock price. One reason for this are that point per point increase in premium would result in sharply reduced leverage for the option buyers – reduced leverage means reduced demand for the option. Also, a higher option premium entails increased capital outlay and increased risk, once again reducing demand for the option. Declining stock prices also do not result in a point per point decrease in option premium. This is because, even a steep decline in the stock price in a span of a few days has only a slight effect on the option’s total value – its time value. This term to maturity effect tends to exist as the option is a wasting asset.

http://www.linny.org/forum/ Option Strategies This section deals with some of the most basic strategies that can be devised using options. The idea is to familiarize the reader with the flexibility of options as a risk management tool. In order to keep matters simple, we make the following assumptions: • •

•

We shall ignore brokerage, commissions, margins etc. We shall assume that the option is exercised only on maturity and not prematurely exercise - in other words, we assume that we are only dealing with European options All exchange rates, strike prices and premia will be in terms of dollars per unit of a currency and the option will be assumed to be on one unit of the currency.

Call Options A call option buyer's profit can be defined as follows: At all points where S<X, the payoff will be -c At all points where S>X, the payoff will be S-X- c, where S = Spot price X = Strike price or exercise price c = call option premium Conversely, the option writer's profit will be as follows: At all points where S<X, the payoff will be c At all points where S>X, the payoff will be -(S-X- c) To illustrate this, let us look at an example and construct the payoff profile. Consider a trader who buys a call option on the Swiss Franc with a strike price of $ 0.66 and pays a premium of 1.95 cents ($0.0195). The current spot rate is 0.6592. His gain or loss at time T when the option expires depends upon the value of the spot rate at that time. For all values of S below 0.66, the option buyer lets the option lapse since the Swiss francs can be bough in the spot market at a lower price. His loss then will be limited to the premium he has paid. For spot values greater than the strike price, he will exercise the option.

Let us look at the payoff profile of the call option buyer.

http://www.linny.org/forum/ Spot Rate 0.6000 0.6500 0.6600 0.6700 0.6795 0.6800 0.6900 0.7000

Gain (S-X-c) 0.0005 0.0105 0.0205

Loss (-c) -0.0195 -0.0195 -0.0195 -0.0195 -

Similarly, we can construct the payoff profile for the call writer. This will be as follows: Spot Rate 0.6000 0.6500 0.6600 0.6700 0.6795 0.6800 0.6900 0.7000

Gain (c) 0.0195 0.0195 0.0195 0.0195 -

Loss (S-X-c) -0.0005 -0.0105 -0.0205

Put Option A put option buyer's profit can be defined as follows: At all points where S<X, the payoff will be X-S-p At all points where S>X, the payoff will be -p, where S = Spot price X = Strike price or exercise price p = put option premium Conversely, the put option writer's profit will be as follows: At all points where S<X, the payoff will be -(X-S- p) At all points where S>X, the payoff will be p

http://www.linny.org/forum/ For example, let us take the case of a trader who buys a June put option on pound sterling at a strike price of $1.7450, for a premium of $0.05 per sterling. The spot rate at that time is $ 1.7350. For all values of S greater than $1.7450, the option will not be exercised as the sterling has a higher price in the spot market. For values between $1.6950 and $ 1.7450, the option will be exercised, though there will still be a loss. Here the option buyer is trying to minimize the loss. For values of spot rate below $ 1.6950, the option will be exercised and will lead to a net profit. At expiry, the put option buyer's payoff profile can be depicted as follows: Spot Rate 1.6600 1.6800 1.6900 1.6950 1.7400 1.7500 1.7800 1.8000

Gain (X-S-p) 0.0350 0.0150 0.0050 -

Loss (-p) -0.0450 -0.0500 -0.0500 -0.0500

Similarly, we can construct a payoff profile for the put option writer. His gains and losses will look as follows: Spot Rate 1.6600 1.6800 1.6900 1.6950 1.7400 1.7500 1.7800 1.8000

Gain (p) 0.0450 0.0500 0.0500 0.0500

Loss -(X-S-p) -0.0350 -0.0150 -0.0050 -

Spread Strategies Spread strategies with options involve simultaneous sale and purchase of two different option contracts. The objective in these strategies is to realize a profit if the underlying price moves in a fashion that is expected and to limit the magnitude of loss in case it moves in an unexpected fashion. Evidently, these are

http://www.linny.org/forum/ speculative in nature. However, these strategies are such that they provide limited gains while also ensuring limited losses. Spread strategies involving options with same maturity but different strike prices are called vertical spreads or price spreads. The types of vertical spread strategies are bullish call spreads, bearish call spreads, bullish put spreads and bearish put spreads. The expectation when going in for these strategies is that the underlying rate is likely to either appreciate or depreciate significantly. Horizontal or time spread strategies involve simultaneous buying and selling of two options which are similar in all respects except in maturity. The basic idea behind this is that the time value of the short maturity option will decline faster than that of the long maturity option. The expectation when going for this strategy is that the underlying price will not change drastically but the difference in premia will over time. Vertical Spread Strategies A bullish call consists of selling the call with the higher strike price and buying the call with the lower strike price. The expectation is the underlying currency is likely to appreciate. The investor however, would like to limit his losses. Since a lower priced call is being bought i.e. higher premium is paid and a higher priced call is being sold i.e. lower premium is received, the initial net investment would be the difference in the two premia. The maximum profit potential will be the difference in the strike prices minus the initial investment. The maximum loss is the initial investment. This strategy thus yields a limited profit if the currency appreciates and a limited loss if the currency depreciates. On the other hand, if the investor expects the currency to depreciate, he can go in for the bearish call spread. This is the reverse of the bullish spread i.e. the call with the higher strike price is bought and that with the lower strike price is sold. The maximum gain will be the difference in the premia. The maximum loss will be the difference is premia minus the difference in the strike prices. A bullish put spread consists of selling a put option with higher strike price and buying a put option with a lower strike price. In this case, if there is a significant appreciation in the underlying rate, neither put will be exercised and the net gain will be the difference in premia. Maximum loss will be the difference in strike prices minus the difference in premia. A bearish put spread is the opposite of a bullish put spread. An extension of the idea of vertical spreads is the butterfly spread. A butterfly spread involves three options with different strike prices but same maturity. A butterfly spread is bought by purchasing two calls with the middle strike price and selling one call each with the strike price on either side. The investor's

http://www.linny.org/forum/ expectation is that there will be a significant movement in the underlying rate - he is, however, unsure of the direction of this movement. This strategy yields a limited profit if there is a significant movement in the underlying rate appreciation or depreciation. But if the movements are moderate or not very significant, it tends to result in a loss. Selling a butterfly spread involves selling two intermediate priced calls and buying one on either side. As opposed to the buyer of a butterfly spread, the seller here is betting on moderate or non-significant movements. He does not expect drastic movements either way. Therefore, this strategy yields a small profit if there are moderate changes in the exchange rate and a limited loss if there are large movements on either side. Horizontal Or Time Spreads As mentioned earlier, horizontal or time spread strategies involve simultaneous buying and selling of two options which are similar in all respects except in maturity. The basic idea behind this is that the time value of the short maturity option will decline faster than that of the long maturity option. Straddles And Strangles A Straddle strategy consists of buying a call and a put both with identical strikes and maturity. If there is a drastic depreciation, the investor gains on the put i.e. by exercising the option to sell. If there is a drastic appreciation, the investor exercises the call and purchases at the lower price. However, if there is a moderate movement either way, the investor will suffer a loss. A strangle is similar to a straddle. It consists of buying a call with strike above the current spot rate and a put with a strike price below the current spot. Like the straddle, it yields a profit for drastic movements and a loss for moderate movements. Currency options thus, provide the corporate treasurer a tool for hedging foreign exchange risks arising out of the firm's operations. Unlike the forward contracts, options allow the hedger to gain from favorable exchange rate movements while being protected against unfavorable movements

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Swaps 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. Floating rates are tied to an index which could be the London Interbank borrowing rate (LIBOR), US treasury bill rate etc. This helps investors exchange one type of asset for another for a preferred stream of cash flows. 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. 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. Types Of Swaps 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. The two most widely prevalent types of swaps are interest rate swaps and currency swaps. A third is a combination of the two to result in cross-currency interest rate swaps. Of course, a number of variations are possible under each of these major types of swaps. Interest Rate Swaps An interest rate swap as the name suggests involves an exchange of different payment streams which fixed and floating in nature. Such an exchange is referred to as a exchange of borrowings or a coupon swap. 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

http://www.linny.org/forum/ 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. LIBOR is the interest rate offered by banks on deposits from other banks in the Eurocurrency markets. LIBOR is determined by trading between banks and changes continuously as the economic conditions change. Just as the Prime Lending Rate (PLR) is used as the benchmark or the peg for many Indian floating rate instruments, LIBOR is the most frequently used reference rate in international markets. Usually, two non-financial companies do not get in touch with each other to directly arrange a swap. They each deal with a financial intermediary such as a bank who then structures the plain vanilla swap in such a way so as to earn them a margin or a spread. In international markets, they typically earn about 3 basis points (0.03%) on a pair of offsetting transactions. At any given point of time, the swap spreads are determined by supply and demand. If more participants in the swap markets want to receive fixed rather than floating, swap spreads tend to fall. If the reverse is true, the swap spreads tend to rise. In real life, it is difficult to envisage a situation where two companies contact a financial institution at exactly the same time with the proposal to take opposite positions in the same swap. Most large financial institutions are therefore prepared tow are house interest rate swaps. This involves entering into a swap with a counterparty, then hedging the interest rate risk until an opposite counterparty us found. Interest rate future contracts are resorted to as a hedging tool in such cases. Currency Swaps Currency swaps involves 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. The deal could be structured such that company B borrows in the market in which it has a lower disadvantage and

http://www.linny.org/forum/ company A in which it has a higher advantage. They swap to achieve the desired currency to the benefit of all concerned. A point to note is that the principal must be specified at the outset for each of the currencies. The principal amounts are usually exchanged at the beginning and 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 that carefully monitor their exposure in various currencies so that they can hedge their currency risk. Other 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 that principal in a swap agreement can be varied throughout the term of the swap to meet the needs of the two parties. In an amortizing swap, the principal reduces in a predetermined way. This could be designed to correspond to the amortization schedule on a particular loan. Another innovation could be the deferred or forward swaps where the two parties do not start exchanging interest payments until some future date. Another 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. A constant maturity swap (CMS) is an agreement to exchange a LIBOR rate for a swap rate. Foe example, an agreement to exchange 6-month LIBOR for the 10year swap rate every six months for the next five years is a CMS. Similarly, a constant maturity treasury swap (CMT) involves swapping a LIBOR rate for a treasury rate. An equity swap is an agreement to exchange the dividends and capital gains realized on an equity index for either a fixed or floating rate of interest. These are only a few of the innovations in swaps that exist in the financial markets. The above have been mentioned to underscore the fact that swaps and other derivatives that have been dealt with in this module are all born out of necessity or needs of the many participants in the international financial market.