Derivative Products Treasury management
Derivative Products
Derivatives don’t have independent value. Their value is derived from the underlying market.
The market may be financial market dealing in forex, bonds and equities as well as commodity
market dealing with underlying commodities like Gold, Silver etc.
Derivatives refer to Future Price based on Spot Market. Two types of Products are as under:
1. OTC Products
These are Over The Counter products which include Forward Contracts and Options.
These are offered by FIs. These derivatives offer contracts with date, amount of terms
fixed as per requirement of the client. Price is quoted by banks/FIs after adding margin.
Settlement is made by physical delivery. Counterparty Risk is always present.
2. Exchange Traded products
These include Futures traded on organized exchanges. Size of the contract is
standardized. Price is transparent. The exchanges collect margin based on Mark to
Market price. Physical delivery is not must. There is no counter party risk.
Types of Derivatives
1. Forward Contracts
2. Futures
3. Options
4. Interest Rate Swaps
5. Currency Swaps
Forward Contracts
It is a deal to buy or sell Shares, Commodity or Foreign Exchange at a contracted rate with
desired maturity. Forward rate is the interest rate differentiation of two currencies. If Interest
rate is high in a country, its currency will be cheaper.
Futures
It is Exchange traded product. The seller agrees to deliver a specified security, currency or
commodity on specified date at a fixed price. Currency Futures are traded in EURO, GBP, JPY,
CHF, AUD& CAD.
Forward Contract Futures
It is OTC (Over the Counter) Product It is Exchange traded product
It can be for any odd amount It is always for Standard amount
It can be for any Odd period It is always for Standard period
Delivery is essential Delivery is not must
Margin is not essential It is based on Margin requirement and
Marked to market
Contract size of USD/INR is USD 1000. The settlement takes place in INR.
EURO/INR/GBP is traded in cross currency rates.
Future of INR is allowed with Contract size minimum Rs. 2.00 lac based on 7% synthetic
10 year G-Sec.
OPTIONS
Option is a contract to buy or sell currency, bonds or Equity on future date. The party has right
to exercise option but there is no obligation.
Option is Right to buy or sell an agreed quantity of currency or commodity without obligation to
do so. The buyer will exercise the option if market price is in favor or otherwise option may be
allowed to lapse.
There are two types of Option: 1. Call Option 2. Put Option
Call Option
Right to buy at fixed price on or before fixed date.
Put Option
Right to sell at fixed price on or before fixed date.
Final day on which it expires is called maturity. The pre-fixed rate is called Strike Rate.
CALL OPTION;
If Strike price is below the spot price, the option is In the money(ITM)
If Strike price is equal to the spot price, the option is At the money.(ATM)
If Strike price is above the spot price, the option is Out of money.(OTM)
PUT OPTION
If Strike price is more the spot price, the option is In the money.
If Strike price is equal to the spot price, the option is At the money.
If Strike price is less than spot price, the option is Out of the money.
American Option
Option can be exercised on any day before expiry.
European Option
Option can be exercised on maturity only.
Plain Vanilla Option
It is an option without any conditions. It is ideal for Hedging.
Zero Cost Option
It does not attract any premium. There is risk of holder i.e. importer to pay higher rate if market
rises beyond certain level.
Embedded Option
The bond holder is given option to convert its debt into equity.
Other features of an Option Contract
Option is based on Notional amount as only exchange difference is settled.
Price of Option is much smaller than the Notional Value.
The premium depends upon Volatility of the underlying product.
Longer the maturity, costlier will be the option.
Interest Rate Swaps (IRS)
It is OTC product. It deals with exchange of Interest flows on an underlying assets and liability.
For Example: A company is paying interest on 5 years Debentures @7%. In market, rate of
interest is declining; the company will be benefitted if Interest rate is linked to market rate of
interest. The Company enters into Interest rate swap with bank with the terms that Fixed rate of
interest on Debentures will Swap 3M T-bills @5%. The fixed rate of 7 % on Debentures will be
swapped with T+2%. After every 3 months, bank will pay the company @ T-bills+2%.
Assuming that in the next quarter, 90 days T-bill rate is 4%, the Company will pay to
bank@6%(4+2%) and will receive from bank 7% thereby saving of 1%. This will neutralize the
loss of interest @1% (notional) on account of fall in the market interest rate.
On the other hand, if T-bill rate is increased to 5%, the company will lose by 1% which will
neutralize the gain of interest @1% (notional) on account of increase in the market interest rate.
FRA (Forward Rate Agreement)
It is Forward Interest rate which is an over-the-counter contract between parties that determines
the rate of interest to be paid or received on an obligation beginning at a future start date. The
contract will determine the rates to be used along with the termination date and notional value.
On this type of agreement, it is only the differential that is paid on the notional amount of the
contract.
For a basic example, assume Company A enters into an FRA with Company B in which
Company A will receive a fixed rate of 5% for one year on a principal of $1 million in three years.
In return, Company B will receive the one-year LIBOR rate, determined in three years' time, on
the principal amount. The agreement will be settled in cash in three years.
If, after three years' time, the LIBOR is at 5.5%, the settlement to the agreement will require that
Company A pay Company B. This is because the LIBOR is higher than the fixed rate.
Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million
at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net
difference between the two amounts is $5,000, which is paid to Company B.
Currency Swaps
It is exchange of cash flow in one currency with that of another currency. Two types of currency
swaps are there: Currency Only Swap & Principal Only Swap. Currency Swaps are used to
mitigate exchange risks for meeting Principal or Interest obligations.
Example: An investor in Germany needs INR to Invest in India. On the other hand, Reliance in
India needs Euro to acquire a Co. in France. German Investor will raise Euro funds at low rates
and Reliance India will raise Rupee loans at low rates from India. Two parties will Swap Loans
with Bank as financial intermediary.
Principal Only Swap allows the borrower to pay interest in USD. But payment of
Principal is made in home currency. As such risk fluctuations in respect of Principal are
eliminated.
Coupon Only Swap allows the borrower to pay interest in INR. Whereas Principal
amount is hedged by using some other derivative.
P+I Swap is there when borrower eliminates Currency risks as well as Interest Risk. The
risk is zero. Borrower will pay Principal + Interest in Domestic currency to settle Foreign
Currency borrowings. The swap cost is included in rupee interest rates.
RBI Guidelines on Risk Exposure
1. Banks and Counter parties will sign agreement known as ISDA (International Swap
Derivative Association) – Master Agreement which is standardized by SDA (Swap
Derivative Association). The agreement is cleared by FIMMDA(Fixed Income Money
Market and Derivatives Association) and FEDAI.
2. RBI allowed MIFOR (combination of LIBOR and Forward Premium) for Inter-bank
dealings only.
3. RBI permitted banks under ISDA agreement to opt for dual jurisdiction.
4. Ceiling for Forward Contract for Designated Importers and Exporters is 100% of
previous year’s exports or average of 3 years exports (whichever is higher). The ceiling
is 50% for other Importers and Exporters.
Derivative Products
Derivatives don’t have independent value. Their value is derived from the underlying market.
The market may be financial market dealing in forex, bonds and equities as well as commodity
market dealing with underlying commodities like Gold, Silver etc.
Derivatives refer to Future Price based on Spot Market. Two types of Products are as under:
1. OTC Products
These are Over The Counter products which include Forward Contracts and Options.
These are offered by FIs. These derivatives offer contracts with date, amount of terms
fixed as per requirement of the client. Price is quoted by banks/FIs after adding margin.
Settlement is made by physical delivery. Counterparty Risk is always present.
2. Exchange Traded products
These include Futures traded on organized exchanges. Size of the contract is
standardized. Price is transparent. The exchanges collect margin based on Mark to
Market price. Physical delivery is not must. There is no counter party risk.
Types of Derivatives
1. Forward Contracts
2. Futures
3. Options
4. Interest Rate Swaps
5. Currency Swaps
Forward Contracts
It is a deal to buy or sell Shares, Commodity or Foreign Exchange at a contracted rate with
desired maturity. Forward rate is the interest rate differentiation of two currencies. If Interest
rate is high in a country, its currency will be cheaper.
Futures
It is Exchange traded product. The seller agrees to deliver a specified security, currency or
commodity on specified date at a fixed price. Currency Futures are traded in EURO, GBP, JPY,
CHF, AUD& CAD.
Forward Contract Futures
It is OTC (Over the Counter) Product It is Exchange traded product
It can be for any odd amount It is always for Standard amount
It can be for any Odd period It is always for Standard period
Delivery is essential Delivery is not must
Margin is not essential It is based on Margin requirement and
Marked to market
Contract size of USD/INR is USD 1000. The settlement takes place in INR.
EURO/INR/GBP is traded in cross currency rates.
Future of INR is allowed with Contract size minimum Rs. 2.00 lac based on 7% synthetic
10 year G-Sec.
OPTIONS
Option is a contract to buy or sell currency, bonds or Equity on future date. The party has right
to exercise option but there is no obligation.
Option is Right to buy or sell an agreed quantity of currency or commodity without obligation to
do so. The buyer will exercise the option if market price is in favor or otherwise option may be
allowed to lapse.
There are two types of Option: 1. Call Option 2. Put Option
Call Option
Right to buy at fixed price on or before fixed date.
Put Option
Right to sell at fixed price on or before fixed date.
Final day on which it expires is called maturity. The pre-fixed rate is called Strike Rate.
CALL OPTION;
If Strike price is below the spot price, the option is In the money(ITM)
If Strike price is equal to the spot price, the option is At the money.(ATM)
If Strike price is above the spot price, the option is Out of money.(OTM)
PUT OPTION
If Strike price is more the spot price, the option is In the money.
If Strike price is equal to the spot price, the option is At the money.
If Strike price is less than spot price, the option is Out of the money.
American Option
Option can be exercised on any day before expiry.
European Option
Option can be exercised on maturity only.
Plain Vanilla Option
It is an option without any conditions. It is ideal for Hedging.
Zero Cost Option
It does not attract any premium. There is risk of holder i.e. importer to pay higher rate if market
rises beyond certain level.
Embedded Option
The bond holder is given option to convert its debt into equity.
Other features of an Option Contract
Option is based on Notional amount as only exchange difference is settled.
Price of Option is much smaller than the Notional Value.
The premium depends upon Volatility of the underlying product.
Longer the maturity, costlier will be the option.
Interest Rate Swaps (IRS)
It is OTC product. It deals with exchange of Interest flows on an underlying assets and liability.
For Example: A company is paying interest on 5 years Debentures @7%. In market, rate of
interest is declining; the company will be benefitted if Interest rate is linked to market rate of
interest. The Company enters into Interest rate swap with bank with the terms that Fixed rate of
interest on Debentures will Swap 3M T-bills @5%. The fixed rate of 7 % on Debentures will be
swapped with T+2%. After every 3 months, bank will pay the company @ T-bills+2%.
Assuming that in the next quarter, 90 days T-bill rate is 4%, the Company will pay to
bank@6%(4+2%) and will receive from bank 7% thereby saving of 1%. This will neutralize the
loss of interest @1% (notional) on account of fall in the market interest rate.
On the other hand, if T-bill rate is increased to 5%, the company will lose by 1% which will
neutralize the gain of interest @1% (notional) on account of increase in the market interest rate.
FRA (Forward Rate Agreement)
It is Forward Interest rate which is an over-the-counter contract between parties that determines
the rate of interest to be paid or received on an obligation beginning at a future start date. The
contract will determine the rates to be used along with the termination date and notional value.
On this type of agreement, it is only the differential that is paid on the notional amount of the
contract.
For a basic example, assume Company A enters into an FRA with Company B in which
Company A will receive a fixed rate of 5% for one year on a principal of $1 million in three years.
In return, Company B will receive the one-year LIBOR rate, determined in three years' time, on
the principal amount. The agreement will be settled in cash in three years.
If, after three years' time, the LIBOR is at 5.5%, the settlement to the agreement will require that
Company A pay Company B. This is because the LIBOR is higher than the fixed rate.
Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million
at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net
difference between the two amounts is $5,000, which is paid to Company B.
Currency Swaps
It is exchange of cash flow in one currency with that of another currency. Two types of currency
swaps are there: Currency Only Swap & Principal Only Swap. Currency Swaps are used to
mitigate exchange risks for meeting Principal or Interest obligations.
Example: An investor in Germany needs INR to Invest in India. On the other hand, Reliance in
India needs Euro to acquire a Co. in France. German Investor will raise Euro funds at low rates
and Reliance India will raise Rupee loans at low rates from India. Two parties will Swap Loans
with Bank as financial intermediary.
Principal Only Swap allows the borrower to pay interest in USD. But payment of
Principal is made in home currency. As such risk fluctuations in respect of Principal are
eliminated.
Coupon Only Swap allows the borrower to pay interest in INR. Whereas Principal
amount is hedged by using some other derivative.
P+I Swap is there when borrower eliminates Currency risks as well as Interest Risk. The
risk is zero. Borrower will pay Principal + Interest in Domestic currency to settle Foreign
Currency borrowings. The swap cost is included in rupee interest rates.
RBI Guidelines on Risk Exposure
1. Banks and Counter parties will sign agreement known as ISDA (International Swap
Derivative Association) – Master Agreement which is standardized by SDA (Swap
Derivative Association). The agreement is cleared by FIMMDA(Fixed Income Money
Market and Derivatives Association) and FEDAI.
2. RBI allowed MIFOR (combination of LIBOR and Forward Premium) for Inter-bank
dealings only.
3. RBI permitted banks under ISDA agreement to opt for dual jurisdiction.
4. Ceiling for Forward Contract for Designated Importers and Exporters is 100% of
previous year’s exports or average of 3 years exports (whichever is higher). The ceiling
is 50% for other Importers and Exporters.
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