Financial Derivatives - Forwards/Futures/Options

Financial Derivatives
for
Risk Management

Derivatives- Category
Credit Derivatives
Equity Derivatives
Fixed Income Derivatives
Foreign Currency Derivatives
Commodity Derivatives
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OTC vs Listed derivatives
Issuer or writerClearing Corporation of
the Exchange
Guatrantee
Private agreement
Limited liquidity
Exchange Traded
Highly liquid
Trading
Terms are flexible and negotiable
•Strikes at any level
•Any maturity date
•Varying contract size
•American/ European
•Physical/ cash
•Payouts are flexible
Standardised contracts
•Strikes
•Maturities
•Contract size
•Exercise type
•Delivery
•Pay outs
Features
OTCListed (Exchange TradedType

Forward contract –
foreign currency
1. A contract between a banker and the customer to
buy or sell foreign currency on a future date at the
exchange rate determined today
2. It is a OTC contract
3. Contract agreed on
Amount to be bought/sold
Settlement date
Exchange Rate

Currency Futures
• Exchange rate risk can be covered through futures
contract also
• Futures contracts are exchange traded standardised
contracts unlike OTC forwards
• Forward contract settlement is by delivery but
futures contracts are cash settled
• Exchange acts as counterparty – credit risk of the
transaction is eliminated
• Future contract is based on the view on the
exchange rate movement

Currency futures - example
• Receive from exchange = Rs. 4,55,20,000
• Pay to exchange = Rs. 4,54,80,000
• Receive difference = Rs. 40,000
• Sell US$ 1,000,000 to market at 45.48 and
receive Rs. 4,54,80,000
• Exchange pays Rs. 40,000
• Therefore the exchange rate of Rs. 45.52
per dollar is protected through this contract

Call and Put Option
• Customer can buy option for purchase of foreign
currency or sale of foreign currency with a bank
for a forward period
• Call option – to buy foreign currency
• Put option - to sell foreign currency
• Customer (Option buyer)– Buy call option or buy
put option (Long call or long put)
• Bank (Option writer) – Sell call option or sell put
option (shot call or short put)

Option Premium
• Option premium is the price for the option
• Premium is payable upfront which is the gain
realised by the option writer
• Option buyer has unlimited profit potential but
loss is limited to the premium paid
• Option writer has no right but face unlimited
obligation
• Option writer covers his option contracts with
customers on back to back basis either in the
domestic market or in overseas market

Hedge or not to hedge
• ABC Export House with export receivables
of US$ 1,000,000 due on 1.2.2005
• There are three possible choices
– Do nothing (keep the position open)
– Book forward contract to mature on 1.2.2005
– Buy USD put option at Rs.45.50 with premium
of Re.0.01

Pricing Methods
• In 1972, Fisher Black and Myron Scholes
introduced “Black Sholes Model” for pricing the
European style options
• With the introduction of American style option,
pricing became further complex due to probability
of early exercise
• In 1979 Cox, Ross and Rubinstein published a
pricing model to price American style options
which is called Binomial Method

Option valuation
• The delta of an option is produced as a by product
of the pricing formula (Black Sholes Model) and
represents the mathematical calculation of the
options likelihood of exercise on maturity. The
delta of an option can have a value between 0 and
1 but is usually expressed in percentage terms
• Market makers are allowed to hedge the delta of
their option portfolio b accessing the spot markets

IRS/FRA guidelines…
• Documentation -ISDA documentation as suitably
modified
• Internal control – Sound internal control system with
clear functional separation of front and back offices
• Capital adequacy norms – for reckoning the
minimum capital ratio, the FRAs/IRS should be risk
weighted. The notional principal of each instrument
is to be multiplied by the conversion factor:
– Less than one year maturity = 0.5%
– One year and less than 2 years = 1.0%
– For each additional year = 1.0%
– The adjusted value should be multiplied by 20%

IRS – Benchmark rate
• R-MIBOR – Reuter-Mumbai Interbank
Offered Rate (weighted average of traded
call money rates sourced from 25 banks,
PDs and FIs)
• N-MIBOR- NSE Mumbai Interbank
Offered Rate which is the rate issued by the
NSE
• Interest rate is reset periodically

IRS- example
• Two parties X and Y have the following potential to
borrow on fixed and floating terms
X Y
Credit Rating AAA BBB
Fixed Rate cost 8% 9.5%
Floating rate cost FR FR+50 bp
Comparative advantage for X is fixed rate borrowing
Comparative advantage for Y is floating rate borrowing
Therefore, X to borrow at fixed and service floating (FR)
Y to borrow at floating and service at fixed (8.5%)
Therefore, X receives 8.5% from Y and pay FR to Y
Y receives FR from X and pay 8.5%
The cost for Y is 8.5% + 0.50% = 9.00% (fixed)
cheaper by 0.50%

IRS – Current trend
• Foreign banks and Primary dealers are the dominant
players in the IRS market
• In majority contracts, the NSE-MIBOR and MIFOR
are used as the benchmark rates
• Volume
Year No.of contracts Notional Principal
FY 2003-04 19867 Rs. 5,18,260 crore
FY 2004-05 23331 Rs. 6,11,595 crore
(upto May
2004)

FRA structure
Trade
date
Fixing
date
Settlement
date
Term
date
TIME
Fixing date = Settlement date – 2 working days
3/6 Forward Rate Agreement (5.15/40)

FRA Settlement
Buyer pays sellerLower than FRA
fixed rate
Floating Rate
(benchmark)
Seller pays buyerHigher than FRA
fixed rate
Floating Rate
(benchmark)
ABC Limited like to borrow Rs. 1,00,000 for 6 months
at floating rate(to be borrowed after 3 months)
To protect interest rate after 3 months, he buys 3/9 FRA
from Hong Kong Bank (3/9 quote 6.25-50)
ABC Ltd buys FRA at 6.50% today (Trade date)
After 3 months, the benchmark rate is 7.00%(settlement date)
Now Hong Kong Bank pays ABC Ltd (7.00-6.50 = 0.50%)
for 6 months on Rs. 1,00,000

Fixed Income Derivatives by MFs
• SEBI (MF) Regs are silent about use of IRS and FRA
by mutual funds
• IRS and FRA transactions entered into by mutual funds
are not construed by SEBI as derivatives transactions
• Mutual Funds emerging as important users of IRS and
FRA in the Indian fixed income derivatives market
• A few mutual funds actively use IRS to optimize yield
and reduce the duration of their bond scheme portfolios,
by paying fixed rate and receiving floating rate
• It is understood that some of these IRS are benchmarked
to MIFOR as well.

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