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Derivatives
Derivatives are instruments whose value is based on, or
derived from the prices of currencies, or interest rates,
shares and share indices, commodities, etc.
Derivatives are of two types
Traded on the floor of an exchange
OTC or over the counter
Different types of Financial derivatives are marked over -
the counter, main among them are:
Forwards (ex. Forward contracts on exchange or interest
rates, currency and interest rate futures, interest and
currency swaps)
Options (ex. Caps and collars, range / participating forwards,
currency options)
Forwards create a right and an obligation to exchange
cash flows at a predetermined future date on the basis
agreed now

Options confer on the buyer the right to exchange cash
flows at a future date on the basis agreed now, but it
creates no obligation on the buyer to go ahead with the
exchange.

Derivative contracts are designed to transfer price risk
from a party unwilling to carry it to a party willing to do
so.

They can also be used to take complex highly leveraged
speculative bets on price movements.

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Futures Contracts
A Financial Futures Contract has been defined as the
simultaneous right and obligation to buy / sell a standard
quantity of a special financial instrument (or commodity)
at a specific future date and at a price agreed between the
parties at the time the contract was signed.
Thus it is an exchange traded version of a traditional
forward contract

Advantages
Standardised amounts and maturity
Tradeability
Liquidity
Transparency of prices
Ease in taking and unwinding positions
No counter party risks
Disadvantages
Does not provide a perfect hedge as amount and
maturity of contracts rarely coincides with
standardised amounts and maturities of contracts
traded on the exchange
Types
Currency Futures
Interest Futures
Forward Rate Agreements (FRAs)

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Futures Contracts (contd.)
1. 1972: Chicago Mercantile Exchange opens International Monetary
Market. (IMM)
IMM provides
an outlet for hedging currency risk with futures
contracts.
Futures contracts are
contracts written requiring
a standard quantity of an available currency
at a fixed exchange rate
at a set delivery date.
Available Futures Currencies:
1.) British pound 5.) Euro
2.) Canadian dollar 6.) Japanese yen
3.) Deutsche mark 7.) Australian dollar
4.) Swiss franc
Standard Contract Sizes:
contract sizes differ for each of
the 7 available currencies.
Examples:
Euro = 125,000
British Pound = 62,500
Maximum price movements
Contracts set to a daily price limit restricting maximum daily
price movements.
If limit is reached a margin call may be necessary to maintain
a minimum margin









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Difference between Forwards and
futures market
Forwards Futures
Market place Global network
Of players
connected through
telephone, fax etc.
Like stock exchange
has a trading floor
with players
communicating face
to face
Deal size Non standard
amounts agreed by
buyer and seller
Standard contract
sizes. Players can
deal in multiples of
standard sizes
Currencies All currencies that
are traded
Limited currencies
Cross rates Available in one
contract
Usually requires two
contracts
Price Not set by the
exchange
Daily price limit is
set
Delivery date Any valid business
date
Standard dates eg.
Third Wednesday of
every third month
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Difference between Forwards and
futures market (contd.)
Forwards Futures
Furthest maturity Open forwards has
dealt as far as as 20
years
12 months forward
Credit risk Credit risk of counter
party exists
Exchange is the
counterparty.
Hence risk is
covered
Cash Flow None until maturity
date
Initial margin plus
ongoing variation
margin as
contracts are
marked to market
on daily basis and
final payment on
maturity date
Trading 24 hours market 4- 8 hours. Trading
hours as per
timings of
exchange
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Forward Rate Agreements (FRAs)
An FRA is a contract between two parties fixing a rate of
interest on a notional amount of principal for a future loan
or deposit for a period commencing on an agreed future
date. They are essentially an over the counter product for
interest rate risk management.
The agreement specifies that the difference between the
agreed rate and the actual rate ruling on the specified
date will be made good by one party to the other.
For ex. If the agreed six month LIBOR rate under is 9% per
annum on a given future date, and the actual rate happens
to be 10% per annum, the bank will reimburse to the buyer
of the FRA 1 % p.a. If on the other hand the actual rate is
8%, the borrower will have to pay the difference to the
bank
Buying and selling of FRA
The buyer and seller of an FRA are not exchanging any
amount. Instead they are entering into an agreement whereby
The buyer is fixing the interest rate payable by him on
a notional principal amount
Seller is fixing the interest rate receivable by him on a
notional principal amount
Thus BUY an FRA FIX RATE ON BORROWING
SELL an FRA FIX RATE ON DEPOSIT /
INVESTMENT
Who Pays/ receives the settlement proceeds?
Floating benchmark rate Higher than FRA rate seller pays
Floating benchmark rate Lower than FRA rate Buyer pays
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Features and Uses of FRAs
Features
Can be of any agreed amount and hence offer
flexibility
Contract dates available for two years and
hence better than interest rate futures which
have specific periods and commence on
standardised dates.
Good volumes and finer spreads
Provide opportunity to hedge interest rate
exposures without recourse to cash markets.
Are off balance sheet items and have no margin
requirements
Relate only to interest rate movements and not
the underlying amount. Therefore counterparty
credit risk is smaller
Uses
Manage or hedge interest rate risk
Can be used to eliminate the interest rate risk of
a bank in funding relatively long term fixed rate
loans with short term or variable rate deposits
Can be used by a Corporate borrower to
convert a variable rate loan to a fixed rate loan
Can be used for speculation on interest rates in
future
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Swaps
A Swap is defined as a financial transaction in
which two counterparties agree to exchange
streams of payments, or cash flows, over time on
the basis agreed at the inception of the agreement.
Thus a Swap is like a series of forward contracts.
Swap is nothing but exchange of liabilities between
two parties.
Types of swaps
Interest rate Swaps
Involves periodic exchange of streams of
interest payments of differing character in
accordance with predetermined terms, on a
notional agreed principal.
Currency swaps
Is a financial transaction whereby two
counterparties agree to exchange specific
amounts of two different currencies at the
outset and repay these overtime in instalments,
reflecting interest and principal. In some cases,
there may be no exchange of currencies at the
outset, but only servicing payments are
swapped, exchanging cash flows in one
currency for cash flows in another

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Interest Rate Swaps
Two main types
Coupon swaps : Fixed for Floating rates
Basis swaps : the exchange of one benchmark for another uner floating
rates
(Eg. LIBOR for T bill rate)

Let us take an ex. Of an Indian company and an AAA rated
company XYZ. The AAA rated company can borrow at 1/8% over
LIBOR in floating rate and % over T Bills in fixed. Similarly, the
Indian company can borrow at 2 % over LIBOR in floating rate and
3 % over T Bills in the Fixed.
ABC Company in India requires a seven year fixed rate
funding
Being not well known in the fixed market, it has a comparative
advantage in the floating market. It therefore, raises a seven
year floating debt of LIBOR + 2%.
It locates XYZ an AAA rated company which needs seven year
floating rate funds, but has a comparative advantage in the
fixed market and therefore has raised seven year fixed rate
debt at 6.5% p. a. (US treasury Bill interest at 6%)
XYZ and ABC swap interest liabilities. XYZ agrees to pay
interest at LIBOR to ABC and ABC agrees to pay interest at
6.75% to XYZ.

Thus XYZ has now got floating rate funds at an effective
cost of LIBOR -.25%, (as it pays LIBOR to ABC but makes
a profit of .25% on the fixed side), or0.375% below what it
would have paid for floating funds
ABC has got a fixed rate loan at a total cost of 8.75%
(6.75% paid to ABC and 2% loss on floating side) or .25 %
below what it would have paid for a fixed loan

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Currency Swaps
They involve exchange of cash flows ( on principal and
repayments, or repayments alone) in two currencies. The
exchange rate generally used is the ruling spot rate.
They allow a corporate borrower to alter an existing
currency exposure to one that is more suited to its cash
flow and risk reward perception.
It is also used to raise funds in the market (currency,
interest rate, etc.) in which it has a comparative advantage
and use currency and / or interest rate swaps to achieve
the desired liability portfolio, at a lower cost than
otherwise.
It involves the following:
Exchange the equivalent amount of different currencies
Exchange periodic interest payments during the life of the
swap
Re exchange of principal sum at predetermined rate on the
maturity of the swap.
Eg. A US Company wants CHF funds for a factory in
Switzerland and a Swiss company wishes to raise a US$
loan. As both these companies have a comparative
advantage in their own country/currency, The US
company raises a $ loan at 6%and hands it over to the
Swiss Company, which in turn raises a CHF loan at 3.5 %
and hands over the CHF to the US Company.
These amounts will be re exchanged at predetermined
rates at the maturity of the currency swap. The parties will
service the loans in the respective currencies.
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Other forms of Swaps
Cross currency Swap
Is a combination of currency and interest rate
swap wherein two parties having borrowings
in different currencies with different interest
profiles agree to service the principal and
interest liability of the counter party
Asset Swap
In an Interest Rate Swap, if the interest
streams being exchanged are funded with
interest received on a specific asset . It is
named on the account of the purpose it
serves.
Term Swap
If Swap is for more than two years. The fixed
interest paid is yield on fixed income bonds
of the same tenor
Money market Swap
Swaps having a tenor upto two years. Also
known as IMM swaps
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Uses of Swaps
Swaps are used for:

1. Raising finance at cheaper cost
2. Obtaining high yield assets
3. Hedging against interest rate exposure
4. Hedging against exchange rate exposures
5. Raising resources abroad which may
otherwise not be allowed by authorities
6. Used as a tool of Asset Liability
Management especially in the short term
7. Arbitraging in different countries
8. Speculation
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Interest Rate Caps, Floors, Collars
These instruments are used to hedge interest
rate risk. They protect Corporates from
interest rate volatility. They are also used to
fund medium term projects with short term
money.
Interest Rate Cap
This is an agreement between a bank and a
corporate borrower with floating rate debt,
whereby the bank, in return for a premium,
undertakes to bear the extra cost on interest rate
going up beyond the agreed rate during an agreed
premium. This caps the interest payment of the
borrower as any rise will be borne by the bank.
Interest rate floor
This is an agreement under which the bank and a
corporate lender on floating basis agree that the
bank, for a premium ,will set a floor on the interest
income to be earned by the lender.
Interest Rate Collar
If a corporate takes a view that the interest rates
will remain in a range (band), it can combine a cap
and a floor, thus protecting its upside risk at a
very low cost.


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CURRENCY OPTIONS
Currency options
offer another method to hedge exchange rate
risk.
first offered on Philadelphia Exchange (PHLX).
fastest growing segment of the hedge markets.
Definition:
a contract from a writer ( the seller) that gives the
right not the obligation to the holder (the buyer) to
buy or sell a standard amount of an available
currency at a fixed exchange rate for a fixed time
period.
Types of Currency Options:
American
exercise date may occur any time up
to the expiration date.
European
exercise date occurs only at the
expiration date.
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CURRENCY OPTIONS (contd.)
Exercise Price
Sometimes known as the strike price.
the exchange rate at which the option
holder can buy or sell the contracted
currency.
Status of an option
In-the-money
Call: Spot > strike
Put: Spot < strike
Out-of-the-money
Call: Spot < strike
Put: Spot > strike
At-the-money
Spot = the strike
The premium
the price of an option that the writer
charges the buyer.



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CURRENCY OPTIONS (contd.)

When to Use Currency Options
For the firm hedging foreign exchange risk
With sizable unrealized gains.
With foreign currency flows forthcoming.
For speculators
profit from favorable exchange rate changes
Option Pricing and Valuation
Value of an option equals
Intrinsic value - the amount in-the-money
Time value - the amount the option is in
excess of its intrinsic value.
Other factors affecting the value of an option
value rises with longer time to expiration.
value rises when greater volatility in the exchange rate.
Value is complicated by both the home and foreign interest
rates.

Market Structure
Location
Organized Exchanges
Over-the-counter
Two levels
retail and wholesale
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Uses of options
When one is not sure of the direction of
exchange rates, options limit losses and
provide access to unlimited profits
When market is stable writing options is
profitable as premium is earned without much
risk.
When one is not sure of winning a tender, it
comes as a handy hedging tool.
Useful in hedging exposure to uncertain
amounts and timing
Best answer to hedging translation exposure
as that is not real exposure
Very useful in hedging on account of foreign
currency loans as the amounts are relatively
large
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Risks in Forex and Derivatives
market
Market Risk

Credit Risk

Operations Risk

Legal Risk

Liquidity Risk

Settlement Risk

Systemic Risk
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Market Risk
Risk arising out of open currency position
If one is overbought in a currency and it
weakens one has to square the position by
selling the currency at a loss. Similarly if one
is oversold and the currency hardens one has
to buy and incur heavy losses.
Open Positions and Stop loss limits
Non linear Risks especially in options
Maturity mismatches
Measures adopted to limit risks are:
Limits on intraday open positions
Limits on overnight open positions in each
currency
Limit on aggregate open position for all
currencies taken together
A turnover limit on total daily transaction
volume for all currencies
A monthly gap limit for each currency
A cumulative gap limit for each currency
A cumulative gap limit for all currencies taken
together

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Credit Risks
These arise when a counterparty, whether a
customer or another bank, fails to meet his
obligation resulting in an open position that
has to be covered at the prevailing rate. If the
rates move against the dealer, a loss can be
suffered.
To control credit risks banks impose limits on
customers as well as other banks. In general
separate limits are set for spot as well as
forward transactions
For forward transactions a net limit is set.
Increasingly for weaker counterparties, banks
insist on cash margins as a percentage of the
limit.
It must be noted that credit risks are an
inherent part of the over the counter market.
They are practically non existent in exchange
traded derivatives because of the system of
margins.
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Operations Risk
These can arise due to:
computer problems,
human errors,
Frauds
Lack of internal controls, etc.
Deals being carried out on the phone and there
could be genuine misunderstanding over what
has been agreed
Important measure of controlling operations
risk is to separate the back office and front
office functions.
The front office puts through the deals and
should be separated from the back office
which handles contract exchanges,
settlements, reporting.
Rigorous internal audits and controls are the
sine qua non of controlling operations risk.
Taping all dealing room conversations is a
standard precaution to avoid disputes.



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Legal Risk
This arises from legal enforceability of
contracts, especially the netting of all
outstanding contracts of failed
counterparties
Certain East Asian Companies refused
to bear losses arising from currency
and derivative transactions on the plea
that their dealers were not authorised
to do so
In the case of options, legal risks arise
if the transactions are likely to be
considered inappropriate for the
counterparty in question.
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Other Risks
Liquidity Risk
Arises when markets turn illiquid and positions cannot
be liquidated except at a huge loss.
Settlement Risk
Risk of counterparty failure during settlement, because
of time differences in the markets in which cash flows in
the two currencies have to be paid and received
Measures to eliminate Settlement Risk
Netting of inter bank Payments
SWIFT has introduced ACCORD
CCIL in India has introduced netting of
transactions
RBI is in the process of introducing RTGS
Systemic Risk
Possibility of a major bank failing and the resultant
losses to counterparties reverberating into a banking
crisis world wide eg. Collapse of Long Term Capital
Management
The Basle Committee proposals covering risk
management and capital adequacy are aimed at reducing
Systemic Risk
In General, it is very difficult to regulate, control
and oversee that dealers are adhering to limits
without proper computerisation of dealing rooms
and sophisticated monitoring software.