Derivatives – Product Training

Facilitator – Krishnan-V Iyer

Objective

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 Derivatives
 What are Derivatives ?


The term “ Derivative ” indicates that it has no independent



value , i . e . its value is entirely “ derived ” from the value of the

underlying asset .


The underlying asset can be securities , commodities , currency ,



live stock or anything else .



In other words

The word “ Derivative ” originates from the mathematics and refers

to variable , which has been derived from another variable .

Derivatives are so called because they have no value for their
own .
They derive their value from the value of some other asset ,

which known as the underlying .



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 Derivatives
 Example


What will be the value of derivative if the underlying is 100



shares of Infosys which is traded at Rs . 1 , 500



 100 * 1500 = Rs . 150 , 000

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 Classification of Derivatives
 OTC Derivatives :


Products such as swaps , forward rate agreements , and exotic



options are almost always traded in this way .



The OTC derivatives market is huge . According to the Bank of



International Settlements , the total outstanding notional amount

is over USD 600 trillion ( as of April 2008 )


 Exchange Traded :


All potential sellers and buyers assemble at a place called the

‘ Exchange ’ where everyone can publicly negotiate with any other
trader .


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Exchange Trade vs Over the Counter

Features
Examples
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 A swap is a contract between two parties agreeing to exchange
payments on regular future dates for a agreed period of time, wherein
the two payment legs are calculated on a different basis.
Interest Rate Products:
Vanilla Swap (fixed for float)
Basis Swap (float for float)
Cross Currency Swaps
Forward Rate Agreement
Over-night Index Swap (OIS)
Options:
Swaptions – Straddle & Strangle
Interest Rate Options (Caps, Floors and Collars)
Misc – Call & Put, Long & Short

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Vanilla ( Fixed for float ):
One party in a contract pays fixed rate of interest calculated on
the notional amount and another floating rate as per floating rate
option
Features
The notional is fixed at the outset and remains unchanged till maturity
The notional amount is never exchanged
One party pays fixed on an agreed future dates
Another party pays interest on a variable rate of interest on agreed
future dates.

Application of Interest Rate Swap :

A company has borrowed funds by issuing a bond that pays a fixed
coupon, but believes that market interest rates will fall sharply and
will lose out the resulting cheaper borrowing costs.
Then the company enters into an IRS receiving fixed and pays float
to enjoy the floating rate decline.

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Basis ( Float for float ) Swaps :
The only difference in the case of Basis swap, as compared to Vanilla
swap, is that either parties of the contract pays interest on
floating rate basis taken from different floating rate option.
(Ex: Party “A” pays interest based on rate from EUBOR + bps and Party
“B” pays interest based on LIBOR rate sources)

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Cross currency Swaps ( XCY swap ) & Mark to Markets
Cross currency swap is a contract where one party pays interest on
notional borrowed in one currency and receives interest on notional
lent in different currencies on agreed dates.
The principal amounts are exchanged at the start of the swap and re-
exchanged at the maturity.
The XCY swaps are extension to vanilla and basis swaps. Hence, The XCY
Swap can be studied in the following ways.

Classification of
Interest rate swaps
Swap Kind of Swap Party A Party B
Vanilla / Xcy Fixed-for-float Pays fixed/float Pays Float/fixed
Swaps
Basis / Xcy Swaps Float-for-float Pays float Pays float
Only Xcy Swaps Fixed-for-fixed Pays fixed Pays fixed

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Mark to Market ( MTM )
It is a method of adjusting the value of variable currency, as
compared to base currency, in line with the spot rate in the market.
Principal amount of one currency in the transaction remains static
whilst the other foreign currency amount is periodically revalued
against it.
Application of Xcy – MTM Swap :
Americo, is a US company with a top credit rating. The other party,
Britco, is a less highly-rated UK company. Both sides wish to borrow
money on a fixed-rate basis. Americo wishes to borrow £100 million
and to pay interest in sterling to finance its UK operations. Britco
wishes to borrow $150 million and to pay interest in dollars, to fund
activities in the USA. The spot foreign exchange rate is £/$1.5, that
is, 1 pound sterling buys 1.5 US dollars. Interest in all cases is
payable once a year, in arrears.

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Interest Rate Swap (IRS)

Borrower US $ fixed rate UK £ fixed rate

Americo 5.00 % 6.00 %

Britco 6.50 % 5.75 %

It can be observed from above, that if Americo wants to raise

finances in the UK Market, it will have to pay more interest than
Britco
And similarly, If Britco wants to raise funds in US Market, it will
end up paying more interest than Americo.

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Interest Rate Swap (IRS)

The dealer does a transaction for them in the following fashion

with slight margin for himself in the transaction.

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Forward Rate Agreement (FRA)

It is an agreement between two parties to exchange the

difference between the fixed rate (agreed at the time of executing the
contract) and reference or benchmark rate as per floating rate option .
The cashflow is settled upfront on the effective date of the deal.
(Present Value of the interest payable at Maturity)

? Buyer and Seller of a FRA?

It is normally the corporate borrowers who prefer buying the
FRA to hedge against rising interest rates
and
Money market investors (short-term investors) prefer selling FRA
to protect against decline in interest rates on deposits.

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Forward Rate Agreement (FRA)
0 x 3 FRA Trade
Let’s Understand:
4
1.Seller of Swap
2.Buyer of Swap
3.Notional Amount
4.Trade Date
1 5.Effective Date
2 6.Maturity / Termination Date
3
5 7 7.Reset Date / Fixing Date
6
8.Floating rate option
9.Fixed rate
8 10.FRA Discounting

1
0
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 Forward Rate Agreement (FRA)
Example FRA contract – Broker confirmation

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Forward Rate Agreement (FRA)

2 x 3 FRA contract means trade that is starting 2 months forward from

the trade date of the transaction and ending 3 months from the trade
date
Trade date + 2 months = Start Date ; Trade date + 3 months = Maturity
date
Note: coupon is calculated for only one month i.e. from 2nd month till
3rd month
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Forward Rate Agreement (FRA)

Let ’ s consider few examples about notation and

interpretation of FRA trades
Notation Effective Date Termination Date Underlying Rate (LIBOR)
from Trade date from trade date
1x3 1 month 3 months 3-1 = 2 months
1x7 1 month 7 months 7-1 = 6 months
3x6 3 months 6 months 6-3 = 3 months
3x9 3 months 9 months 9-3 = 6 months
6 x 12 6 months 12 months 12-6 = 6 months
12 x 18 12 months 18 months 18-12 = 6 months

taking the below details as the example , FRA coupon amount

is calculated as shown in the next page :

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Forward Rate Agreement (FRA)

Taking the above example, Below will be the

calculations.
FORWARD RATE AGREEMENT
   
Deutsche Bank [/] Purchase (P)

Notional 130,000,000.00
Currency USD

Trade Date 24/02/2009

Start Date 29/06/2009
End Date 29/09/2009
Fixed Rate 1.2122
Floating rate 0.60125
Act/360 360
Days 92
If settled at maturity 202,971.17
DB Pays - If upfront 202,659.77

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Overnight Index Swap (OIS)

Over-night index swap is the contract wherein one party agrees

to pay the fixed rate of interest for a defined period of time and
another party agrees to pay Interest compounded daily.
How is OIS different from a Vanilla Swap?
OIS is all the same as a plain vanilla swap except in the following
terms
1.Accrual of coupon - Compounding
2.Fixing dates
Let’s take a look at each concept to draw a satisfactory
understanding on OIS, though they co-relate.
Coupon is compounded on a daily basis taking the rates from
markets on all good
business days till the coupon settlement or maturity.
Now it is apparent that fixing date in the case of OIS will be
everyday which is falling within a calculation period.

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 Overnight Index Swap (OIS)

Hypothetical Example of how OIS works:

Let’s take a sample how a coupon is calculated:
Say, Overnight rates are as follows:

And the notional amount is assumed to be INR 1,000,000.00 with start date:
02-Aug and maturing on 11-Aug 2008. INR is a non-deliverable currency
and is subject to conversion while settling.
Note : Rates published on Saturday are not considered for compounding
.i.e. rates published between Monday and Friday are only considered.

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 Overnight Index Swap (OIS)

Coupon Calculation on the float leg:

Date Notional Rate Days DCF - Act/365 Coupon

02-Aug-08 10,000,000.00 9.46 2 0.005479452 5,183.56

04-Aug-08 10,005,183.56 9.34 1 0.002739726 2,560.23

05-Aug-08 10,007,743.79 9.3 1 0.002739726 2,549.92

06-Aug-08 10,010,293.71 9.21 1 0.002739726 2,525.89

07-Aug-08 10,012,819.60 9.21 1 0.002739726 2,526.52

08-Aug-08 10,015,346.12 9.2 1 0.002739726 2,524.42

09-Aug-08 10,017,870.53 9.18 2 0.005479452 5,039.13

11-Aug-08         22,909.66
Settlement Date

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Overnight Index Swap (OIS)

Similarly, Every market has a rates published ,say, BBA –LIBOR; SAFEX–
JIBOR etc,

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Overnight Index Swap (OIS)

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 American Bermudan European

Option

Call Put

Long Call Short Call Long Put Short Put

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An option is a contract, or a provision of a contract, that gives one party
(the option holder) the right, but not the obligation, to perform a specified
transaction with another party (the option issuer or option writer) according
to specified terms.

Exchange Traded ( ET ) or Over The Counter ( OTC ):

Options can be ET or OTC. Below is the list, though not exhaustive, of
underlying for ET and OTC contracts:

Exchange Traded Over the counter

Equities – Individual Bonds
Stocks
Index Equities – Individual stocks
Futures Swaps
Interests Exotic products – CDS, ABS,
Currencies Bespoke
Currencies

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A trader who believes that a stock's price will increase might buy the right
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to purchase the stock ( a call option) rather than just buy the stock. He
would have no obligation to buy the stock, only the right to do so until the
expiration date. If the stock price at expiration is above the exercise price
by more than the premium paid, he will profit. If the stock price at
expiration is lower than the exercise price, he will let the call contract
expire worthless, and only lose the amount of the premium. A trader might buy
the option instead of shares, because for the same amount of money, he can
obtain a much larger number of options than shares. If the stock rises, he
will thus realize a larger gain than if he had purchased shares.

Example: If ABC is priced at Rs.60 and the

trader anticipates it to rise, Suppose if
the price of the underlying increases to
Rs.75, He shall exercise the option and
make a profit. If the price decreases to
50 he shall not exercise the right. Trader
shall just lose the amount of premium for
the option.

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A trader who believes that a stock price will increase can buy the stock


or instead sell a put. The trader selling a put has an obligation to buy
the stock from the put buyer at the put buyer's option. If the stock price
at expiration is above the exercise price, the short put position will
make a profit in the amount of the premium. If the stock price at
expiration is below the exercise price by more than the amount of the
premium, the trader will lose money, with the potential loss being up to
the full value of the stock.

Example: If ABC is priced at Rs.520

and the trader expects it to
increase. Suppose if the price
increases to Rs.590, He shall
exercise the option and make a
profit. If the price increases to 50
he shall not exercise the right.
Trader shall just lose the amount of
premium for the option.

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A trader who believes that a stock's price will decrease can buy the right


to sell the stock at a fixed price (a put option). He will be under no

obligation to sell the stock, but has the right to do so until the
expiration date. If the stock price at expiration is below the exercise
price by more than the premium paid, he will profit. If the stock price at
expiration is above the exercise price, he will let the put contract expire
worthless and only lose the premium paid.


Example: If ABC is priced at Rs.520 and

the trader expects it to decrease.
Suppose if the price decreases to
Rs.490, He shall exercise the option and
make a profit. If the price increases
to 550 he shall not exercise the right.
Trader shall just lose the amount of
premium for the option.

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A trader who believes that a stock price will decrease, can sell the stock


short or instead sell, or "write," a call. The trader selling a call has an
obligation to sell the stock to the call buyer at the buyer's option. If the
stock price decreases, the short call position will make a profit in the
amount of the premium. If the stock price increases over the exercise price by
more than the amount of the premium, the short will lose money, with the
potential loss unlimited

Example: If ABC is priced at Rs.120 and the trader

expects it to decrease. Suppose if the price
decreases to Rs.90, He shall exercise the option
and make a profit. If the price increases to 150 he
shall not exercise the right. Trader shall just lose the
amount of premium for the option.

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A Swaption is an OTC option on a swap. Usually, the underlying swap is a


interest rate swap or even a credit default swap. Unless stated otherwise,
that is how we will use the term in this article. However, the term
"Swaption" might be used to refer to an option on any type of swap.


In case you are wondering why anyone would want to buy a Swaption, the


answer is often that they don't want to. Frequently, they want to sell a
Swaption. Consider a corporation that has issued debt in the form of
callable bonds paying a fixed semiannual interest rate. The corporation
would like to swap the debt into floating rate debt. The corporation
enters into a fixed-for-floating swap with a derivatives dealer. To
liquidate the call feature of the debt, it also sells the dealer a
Swaption. For derivatives dealers, clients often want to sell them
Swaptions while other clients want to buy caps from them. The dealers then
face the challenge of hedging the short caps with the long Swaptions.


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To specify a Swaption, we must indicate three things:
Expiration date of the option
Fixed rate on the underlying swap
Tenor (time to maturity at exercise of the option) of the swap.
The purchaser of the Swaption pays an up front premium. If he exercises,

there is no strike price to pay. The two parties simply put on the
prescribe swap. Note, however, the fixed rate specified for the Swaption
plays a role very similar to that of a strike price. The holder of the
Swaption will decide whether or not to exercise based on whether swap
rates rise above or fall below that fixed rate. For this reason, the fixed
rate is often called the strike rate.
A payer Swaption is a call on a pay-fixed swap—the Swaption holder has

the option to pay fixed on a swap.

A receiver Swaption is a call on a receive fixed swap—the Swaption holder

has the option to receive fixed on a swap.

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 Call Option Put

Straddle Strangle

Long Straddle Short Straddle Long Strangle Short Strangle

Collar

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

It’s a combination of call and a put option at the same exercise price,


often called as double option



A straddle is an investment strategy involving the purchase or sale of



particular option derivatives that allows the holder to profit based on

how much the price of the underlying security moves, regardless of the
direction of price movement. The purchase of particular option derivatives
is known as a long straddle, while the sale of the option derivatives is
known as a short straddle.

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

A collar is an investment strategy that uses options to limit the



possible range of positive or negative returns on an investment in an

underlying asset to a specific range. To do this, an investor
simultaneously buys a put option and sells (writes) a call option on that
asset. The strike price on the call needs to be above the strike price for
the put, and the expiration dates should be the same.


After establishing the portfolio in this manner, the return on the



portfolio will be between the strike price on the call (potential profit),
and the strike price on the put (potential loss), meaning the possible
gains and losses will always be within a preset limit.
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An interest-rate cap is an OTC derivative that protects the holder from rise
in short-term interest rates by making a payment to the holder when an
underlying interest rate (the "index" or "reference" interest rate) exceeds a
specified strike rate (the "cap rate"). Caps are purchased for a premium and
typically have expirations between 1 and 7 years. They may make payments to
the holder on a monthly, quarterly or semiannual basis, with the period
generally set equal to the maturity of the index interest rate
Each period, the payment is determined by comparing the current level of the

index interest rate with the cap rate. If the index rate exceeds the cap
rate, the payment is based upon the difference between the two rates, the
length of the period, and the contract's notional amount. Otherwise, no
payment is made for that period. If a payment is due on a USD Libor cap, it
is calculated as

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Let’s say a client has a two year floating rate €100m loan, which resets every
6 months (3 month resets are also common).
The client faces an interest rate risk. If rates go up, the client loses. If
rates go down, the client gains (see figure below).
The client therefore wants to hedge against interest rate risk.

Interest Unhedged
Expense

Cap

Future Libor

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A cap allows the client to protect against rising interest costs, whilst at
the same time taking advantage of a reduction in rates (having paid a premium)
The diagram below shows that a two year cap is actually made up a several

‘caplets’

Caplet 3
Caplet 2
Caplet 1

0 6 12 18 24

Two Year Interest Rate Cap

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The first period (0 to 6 months) does not contain a caplet as the rate for
this period is already known
 If the two year cap has a strike of 5.5%, and at the start of the 6
to 12 month period six month Euribor turns out to be 6%, under the terms of
the cap the client will receive from the bank the difference of 0.5% on
€100m multiplied by 180/360 = €250,000
 The payment would be received by the client at the end of twelve
months - this fits in with the payment on the loan also typically being at
the end of the period
 Let’s say that at the beginning of the 12 to 18 month period, six
month Euriborsets at 5%. This is below the strike of the cap so no payments
are made - but of course the client benefits from lower borrowing costs


[NB. Note that the borrowing can be with a completely separate bank from the
bank that sold the cap
 If, in the 18 to 24 month period six month Euribor sets at 5.9% then
the client will again receive a payment under the terms of the cap (the
difference between 5.9% and 5.5% on €100m for 6 months), paid at the end of
24 months

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If you are happy that you understand caps, then floors are pretty easy
The simplest use for a floor that you might come across is a depositor trying
to protect returns (the depositor would buy a floor)
If rates go below the strike on the floor then the depositor receives a payment
If rates go up then the depositor takes the benefit.

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 A CAP Floor Straddle is buying a cap and buying a floor at the same
exercise price, thus the cap and the floor rate are at the same rate of
the interest

A Cap Floor Strangle is buying a cap and buying a floor at different

exercise prices, thus cap rate and the floor rate are at different rate of
interest

A Cap Floor Collar combines buying a cap and selling a floor, or vice
versa. Depending on the trade, usually premium paid is the same as premium
received, or there is only a small difference in cash amount between
premium paid and premium received

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 Credit default swaps are trades used by companies to protect against
specific entities defaulting.
These can be used to hedge against existing exposure with the underlying
entities .
These could be traded on a single name, Index, Loans, Bonds, Basket of
Companies. And further in different tranches as well.
The buyer of the protection is covered for the duration of the trade
against the underlying company (single name) or market quoted group of
companies (index) defaulting.
For this protection, the buyer must pay a periodic fee (coupon) until
the maturity of the CDS or until default (whichever occurs first) to
the seller.

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 Single Name credit default swaps are the buying/selling of protection of
an individual underlying entity (reference entity) for example GM, General
Motors

Should the company default the seller of protection must reimburse the
buyer on the total notional of the protection, this reimbursement or
compensation is determined by the notional x (1 – recovery rate).

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 An Index CDS is protection sold on multiple underlying entities, commonly
100 or 125 entities making up a percentage of the total notional, eg
CDX.B.4 was made up of 100 companies from a variety of industries including
aviation, power and car manufacturing companies.

Should any of the companies default, the seller of the index must
reimburse the buyer for the percentage of the notional represented by the
defaulting company adjusted by the recovery rate.

Example reference entity CKC represented 1% of the CDX.B.4 index and

defaulted. The seller must compensate the buyer of the protection for 1%
of the notional adjusted by the recovery rate. The CDX index trade will
then continue but with only 99 reference entities and the notional of the
CDS is reduced going forward by 1%.

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

Upfront fee – Cashflow exchanged between the buyer and seller of the


protection, this is affected by the current market value of the CDS as well
as any accrued interest.


Effective Date – This date determines the date the period of protection


begins


Termination Date – The date that the period of protection ends



Notional – The cash value of the protection



Coupon Date – The value date that the periodic fee for the protection is


due to the seller



Fixed Rate – The interest rate upon which the periodic fee is calculated.


Underlying Entity – The entity to which the protection relates.



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 CDS Trade Tickets – Bloomberg

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 CDS Trade – BBG Verification


This is an unwind (cancellation) of an existing trade with Forest.

Forest Sells protection in the index CDX.B.4 traded 06Sep05, effective

07Sep05 (date shown is effective date of original trade), termination date

is 20Jun10, notional $5m, price 100.7500%. Fee quoted is $74,805.56.
Fee is made up of accrued interest plus the price fee calculation.

Fee calculation

Notional * (Price – 100)%

5,000,000.00 * (100.75 – 100)% = USD 37,500.00

Accrued Interest (reasons, full coupon)

Notional * days between effective date and last coupon date / 360 * coupon

5,000,000.00 * 79 (07Sep05 – 20Jun05) / 360 * 3.40% = 37,305.56

Fee calculation $37,500.00 + $37,305.56 = 74,805.56

This is an unwind fee, but upfront fees work in exactly the same way

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 Effective dates on new trades are generally T+1, ie 1 business day after the trade date. Be
careful, effective dates on assignments can fall on a non-working day.

Fees, upfront, unwind and assignment fees are due to be paid T+3, ie 3 business days after
the trade date.

CDS trades generally will accrue 1 extra days interest on the final coupon period up to and
including the termination date.

Short/Long Stubs – a single name CDS traded less than 30 days before the next scheduled roll
date will generally have an extended first coupon period called a long stub. This is a
general market rule but is overruled by any agreement between traders.

Example a CDS with coupon dates 20Mar, 20Jun, 20Sep, 20Dec traded 23Feb06 will generally have
a long first coupon period between the effective date, 24Feb06 and the second roll date
20Jun06.

Index CDS trades generally settle full coupon on each and every coupon date irrespective of
effective date. Any accrued interest up to the effective date is offset by the upfront fee of
which the accrued interest up to effective date is factored in. For example on the CDX.B.4
trade shown earlier, if this was a new trade rather than an unwind, value 20Sep05, DB, as the
buyer if the protection would pay coupon from 20Jun05 to 20Sep05 to Forest as Forest have
already paid us accrued interest up to the effective date in the example. This appears to be
a duplication of cashflow but it if accrued interest is settled upfront, it makes assignments
and unwinds much cleaner. A company stepping into a trade does not want to pay Forest for the
period 20Jun05 – 06Sep05 and Deutsche 07Sep05 to 20Sep05.

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 What is an ABS?

An ABS stands for ‘Asset Backed Security’. The description of this is:

A financial security backed by a loan, lease or receivables against assets

other than real estate and

Mortgage backed securities. As an investor, asset-backed securities are an

alternative to investing in corporate debt.

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There are two types of CDS of ABS

Single name.
The inception of these trades was in 2004.

ABX
These are ABS index trades which began trading in the first quarter of
2006.

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As the name suggests these trades all have a single ABS as the
underlying, similar to a normal
CDS trade with a single name.

Settlement:
No up-front fees.
Short First Stubs
Assignments
Generally roll monthly 25th (New York business day) with modified
following business day
Convention.
Five Day London any New York Business Day Payment Lag

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Below are the characteristics of ABX trades.

As with CDS index trades the ABX is a pool of ABS put together. This is a set
pool for each ABX.

A underling reference will be created in summit for all new ABX names

ABX trades do have up-front fees on them.

ABS trades have factors set on them. A factor is “a change in the outstanding
principle issuance i.e. % of principle unpaid on the reference obligation”
the factors are published with in 24hrs of the roll date and are to be used
for the following period.

All trades should have the same booking methodology as the underlying bonds
i.e same business day convention and business calendar dates

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Trade Date – the day the trader says “done” and trade is executed

Effective date of trade – Three business days after the trade date - when
protection begins

Effective date of index (i.e. annex date) – date the annex was initially
published or revised

Settlement date – Five business days after the trade date - when the premium
is exchanged

Premium – fee exchanged when trade is initially done comprising the market
value of the trade and Accrued interest since last payment date

Accrued interest (in terms of premium) – interest accumulated from and

including last payment date but excluding effective date of trade

Factor - A change in the outstanding principal issuance i.e. % of principal

unpaid on the reference obligation

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Price based quoting – The percentage at which the bond is traded i.e.
Discount or premium
Initial Fixed rate Payer Calculation period – From and including last
payment date but excluding the next payment date of the bond
Valuable Dates
Trade date – T
Effective date of trade – T+3
Settlement date – T + 5 (This is currently being reviewed by the main
broker dealers with a view to reducing the fee settlement period to T +
3)
Markit Publish date - 24 hours or less after trustee report is published
(25th).

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Factors will be published 24 hours after trustee report is issued on
MarkIt website

Reasons for valid factor changes :

Credit event
Interest shortfall
Interest reimbursement
Amortization

Two reasons for corrections in Factors :

Administrative error - factor will be adjusted and payment will be
corrected on next payment date
Unknown factor at the time of trade date – factor will be updated,
possible option: cancel and correct

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INTEREST SHORTFALLS


Interest Shortfalls are adjustments made on the underlying obligation.

These are published at the end of the accrual period, and are to settle net
with the coupon (after the 5 day lag).
These are payable from the protection seller to the protection buyer.
These should be considered as margin calls against temporarily defaulting
debtors.

INTEREST REIMBURSEMENTS


Interest Reimbursements are the repayment of the interest shortfall from

the protection buyer to the protection seller, once the balance of the
underlying obligation is corrected.

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Objective – Review

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Questions