Treasury Derivative Products

Derivative Products

Treasury makes use of derivative products for the purpose of

Management of risk including the risk relating to ALM Catering to requirement of corporate customers
Taking trade positions in derivative products;

What is a derivative? A derivative is a financial contract that derives its value frorn another financial product/commodity (say spot rate) which is called underlying (that may be a stock, stock index, a foreign currency, a commodity). Forward contract in foreign exchange transaction, is a simple form of a derivative.

Objectives and instruments of derivates: The major purpose that is served by derivatives is to hedge the risk. Futures, forwards, options, swaps' etc. are the common derivative instruments. The derivatives do not have any independent existent and are based on the underlying assets that could be a stock index, a foreign currency, a commodity or an individual stocks. This means that derivatives relate to. future value.

Over the counter & exchange traded derivatives The derivative products that can be obtained from banks and investment institutions are called Over-the-counter (OTC) products. Some of the derivative products (called exchange traded derivatives) are traded in the stock exchanges including at International Monetary Exchange (IME) Chicago, London Financial Futures Exchange (LIFFE), Singapore Stock Exchange (SGX). Distinction between these two is as under:
Over the counter products — Forwards, currency & Ex c hange t r ade pr od uc t s s uc h as cur r e nc y, interest options, swaps etc. i nt er e st r a t e & c o m m odi t y f ut ur es & o pt i o ns,

st oc k / i ndex o pt i ons & f ut ur e s.

Size of the contract and its maturity can be | Only standardized contracts and with fixed maturity are traded.
according to requirement of the customer. |Price fluctuates according to market.
It is exposed to Counterparty (bank) risk. |No Counterparty risk. These are exchange protected.
Banks are the main players.                      |   Only members of the exchange can trade
- Option premium is upfront and the cost is loaded |Prices market driven. Members to contribute margin on the
agreed rates. basis of daily marking to market
Market is not liquid. Cancellation or reversal is expensive.| Market very liquid and prices are market determined.


Treasury makes use of OTC products such as forward contracts, options and swaps. Larger banks, which are market makers, cover their residual position in Futures traded in the exchanges.

Components of derivatives: The derivatives have components such as Options, Futures-forwards and Swaps. Option

It is contract that provides a right but does not impose any obligation to buy or sell a financial instrument, say a share or security. It can be exercised by the owner. Options offer the buyers, profits from favourable movement of prices say of shares or foreign exchange.

It is important to note that option can be exercised by the owner (the buyer, who has the right to buy or sell), who has limited liability (to the extent, the premium, he pays) but possibility of realization of profits from favourable movement in the rates. Option writers on the other hand have high risk and they cover their risk through counter buying. The owner's liability is restricted to the premium he is to pay.

Example : XYZ Limited, a broking company makes an offer to A to purchase from it 10000 shares of a Blue Chip company during the month of March, at Rs.2000 per share. A shall not have obligation to purchase the shares, if he does not want to do so_ For this, A has to pay Rs.I0000 to XYZ Limited, as premium.

This is an option transaction. In this transaction XYZ Limited are the option seller, who have the obligation to sell, if A wants to buy. A is the Option buyer, who has the right to buy but not the obligation to purchase. Rs.10000 is the premium payable by A as cost of the option. Similarly, A may be given an option to sell, some quantity of shares, at a pre-fixed price during a pre-fixed period.
Variants of options: There are 2 variants of options.

European option where the holder can exercise his right on the expiry date and

American option where the right can be exercised anytime between purchase date and the expiry date: Components of options: Options have two components i.e. call option and pu: option_
Cal! option : The owner Le_ the buyer, has the right to purchase and the seller has to obligation to sell, a specified no. of instruments say shares at a specified price during the time prior to expiry date (please refer to the example above).

A call option protects the buyer from rise in the stock price.

Put option : Owner or the buyer has the right to sell and the seller has the obligation to buy during a particular period. A put option protects the buyer from the fall in the stock price

Premium:The cost of the option charged upfront, from the buyer is called 'premium'. In other words, it is the fee paid for option contract (just lace insurance premium).

Maturity date or expiration date in an option: It is the last day on which the option can be exercised.

`In the money' under an option : Where exercising the option provides gain to the buyer, it is called 'in the money'. It happens when the strike price is below the spot price, in case of a call option OR the strike price is above the spot price, in case of a put option_

`At the money' : Where exercising the option provides no gain or loss to the buyer, it is called 'at the money'.

`Out of the money' : Where exercising the option results into loss to the buyer, it is called 'out of the money'. It is better to let the option expire.

Embedded option : Where the buyer is given an option to repay before maturity period, in case of a structured credit product. A 10 year bond has been issued by a company in which an option is given to the investor to get back the money at the end of 7^th year (which is a also put option).

Options and forward contract

	Option	Forward Contract
1.	Buyer has the option to buy or not to buy i.e. to make	1 Contract has to be settled on maturity_ It cannot be
	the contract or allow it to expire_		expire
2.	Buyer can chose the price (called strike price) himself.	2. Buyer has to accept the forward rate that is prevailing
3.	, Price of the option (premium) is payable up front.		market.
4.	Option contract is tradable and it can be sold if not	3.	There is no price for the contract. Interest differentials
	required.	of two
		4.	It cannot be sold but it can be rolled over or cancelled.

Futures

The futures are the contracts between sellers and buyers under which the sellers (termed 'short') have to deliver, a prefixed quantity (of currency or security or commodity), at a pre-fixed time in future, at a pre-fixed price, to the buyers (known as 'long'). It is a legally binding obligation between two parties to give/take delivery at a certain point of time in-future. The main features of a futures contract are that:

these are traded in organised exchanges which means that these are bought and sold only through the members of the exchange,

the buyers need to pay only the margin. These are marked to market on a daily basis and the members are required to pay margin equivalent to daily loss, if any This way the possibility of default on settlement date is avoided.

these are regulated by institutions such as SERI. The exchange guarantees all trades. routed through its members and in case of default by the member, the payment obligation shall be met by the exchange from Trade Protection Fund.

The future positions can be closed easily.

these contract are made primarily for hedging, speculation, price determination and allocation of resources. Future contracts are of standard size with pre-fixed settlement dates.

Financial futures : Futures relating to exchange rates (currency futures), interest rates (bond futures) and equity prices (stock / index futures), are called financial futures.

Currency futures issued by banks, serve the same purpose as the forwar• d contract. However, they being the standardized contracts, can be sold on stock exchanges. The currency forward contracts are on-the-counter product only_ Currency futures are traded for major currencies such as Euro, Pound, Yen, Australian and Canadian Dollar.

For example a contract of Pound 10000 is traded at London Financial & Futures Exchange (LIFFE) for delivery on January 22 at 2.105 US S. This means that on Jaifuary 22, the seller shall deliver to the holder of the contract Pound 10000 against payment in US S at 2.105 per Pound. If on the settlement date, the market rate is higher, the seller shall pay to the holder, the difference in the contract price and spot price. If, on the other hand, the market rate is lower than the contracted price, the buyer of contract shall bear the loss. Being a futures contract, the contract has to be performed by both the parties.

Interest rate futures are the contracts made on the basis of fixed income securities (say Bonds or Treasury bill) of specified size. Contracts based on Bonds deal in medium or long term interest rates and the contracts based on Treasury Bills trade in short term interest. Interest rate futures help in hedging the interest rate risk.

For example, a futures contract of say US $ 10000, on 1-year Treasury Bond traded at 96 if the expected interest rate at the end of the period is 4% (100-4 = 96, the futures price).