Financial Derivatives         for Risk Management
Financial Risks• Credit Risk/Counterparty risk/Herstatt Risk• Market Risk  – Commodity price risk  – Exchange rate risk  –...
Derivative Products• Forward Contracts (Currency, interest rates)• Futures (Stock index, stocks, commodity)• Options (curr...
OTC vs Listed derivativesType         Listed (Exchange Traded   OTCFeatures     Standardised contracts    Terms are flexib...
Derivative Instruments in India   Year               Type of instruments1875      Commodity futures1994      Cross currenc...
Forward contract-example• ABC Export House has booked a forward contract  on 1.11.2004 with State Bank of India covering  ...
Currency Futures• Exchange rate risk can be covered through futures  contract also• Futures contracts are exchange traded ...
Currency futures - example• Amount of exports US$ 1,000,000• Contract size – US$ 100,000• Futures contract required is 10 ...
Currency Futures in India• Currency futures in India is yet to be introduced• Full fledged currency futures exchange is re...
Call and Put Option• Customer can buy option for purchase of foreign  currency or sale of foreign currency with a bank  fo...
Exercise Style• European Option = Option exercised on maturity  of the contract• American Option = Option exercise any tim...
Hedging through option• ABC Export House with export receivables of  US$ 1,000,000 due on 1.2.2005 want to hedge  through ...
Hedge or not to hedge• ABC Export House with export receivables  of US$ 1,000,000 due on 1.2.2005• There are three possibl...
Option Pricing• Pricing (fixing premium for option) is based on  following host of variables   –   Call or put option   – ...
Guidelines to banks for writing             options• Banks need to obtain one time approval from  Reserve Bank• Continuous...
Option valuation• The delta of an option is produced as a by product  of the pricing formula (Black Sholes Model) and  rep...
IRS/FRA guidelines• Interest Rate Swap/Forward Rate Agreement  introduced in July, 1999(MPD.BC.187.01.279/ 1999-  2000 dat...
Current exposure methodResidual maturity Conversion factor to be applied on                  Notional maturity principal a...
IRS – Benchmark rate• R-MIBOR – Reuter-Mumbai Interbank  Offered Rate (weighted average of traded  call money rates source...
Interest Rate Swaps- Benchmark                rates• MITOR -      Mumbai Interbank Tom Rate  – FIMMDA-Reuters implied Rupe...
IRS – cost advantage                   X          YPayment of         8.0% +FR   FR+50 bp +8.5%interestReceipt of funds   ...
IRS – Current trend• Foreign banks and Primary dealers are the dominant  players in the IRS market• In majority contracts,...
How FRAs are expressed ?• FRAs are expressed in terms of giving or receiving the fixed  rate vs short term interest rate i...
• The buyer of the FRA is the one wishing to hedge  against rise in interest rates and the seller protects  himself agains...
FRA SettlementFloating Rate      Higher than FRA Seller pays buyer(benchmark)        fixed rateFloating Rate      Lower th...
Fixed Income Derivatives by Banks & FIs• Bulk of the IRS and FRA activity concentrated around foreign banks  and some priv...
Fixed Income Derivatives by FIIs• RBI and SEBI Regs permit FIIs to hedge the currency and  interest rate risk to the exten...
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Flevy.com - Financial Derivatives - Forwards/Futures/Options

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Along with the basics of various financial derivatives required for risk management, it also covers various hedging strategies, comparisons, option valuation and brief on forward rate agreements.

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Flevy.com - Financial Derivatives - Forwards/Futures/Options

  1. 1. Financial Derivatives for Risk Management
  2. 2. Financial Risks• Credit Risk/Counterparty risk/Herstatt Risk• Market Risk – Commodity price risk – Exchange rate risk – Interest rate risk• Operational Risk
  3. 3. Derivative Products• Forward Contracts (Currency, interest rates)• Futures (Stock index, stocks, commodity)• Options (currency, stock index, stocks, interest rates)• Swaps (currency, interest rates)
  4. 4. OTC vs Listed derivativesType Listed (Exchange Traded OTCFeatures Standardised contracts Terms are flexible and negotiable •Strikes •Strikes at any level •Maturities •Any maturity date •Contract size •Varying contract size •Exercise type •American/ European •Delivery •Physical/ cash •Pay outs •Payouts are flexibleTrading Exchange Traded Private agreement Highly liquid Limited liquidityGuatrantee Clearing Corporation of Issuer or writer the Exchange
  5. 5. Derivative Instruments in India Year Type of instruments1875 Commodity futures1994 Cross currency options in foreign exchange market1996 IRS, FRA, Caps, Collars, currency swap in foreign exchange market1999 IRS,FRA in Money market2000 Stock Index Futures and Stock Options in Capital Market2001 Stock Index Options and Stock futures in Capital Market2003 Foreign currency – INR option in forex market Interest Rate Futures on Fixed Income Market Gold Futures
  6. 6. Forward contract-example• ABC Export House has booked a forward contract on 1.11.2004 with State Bank of India covering their export receipts of US$ 1,000,000 due on 1.2.2005• Contract terms – Date of contract – 1.11.2004 – Maturity - 1.2.2005 (3 months) – Amount - US$ 1,000,000 – Exchange rate - Rs.45.50/US$
  7. 7. 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
  8. 8. Currency futures - example• Amount of exports US$ 1,000,000• Contract size – US$ 100,000• Futures contract required is 10 contracts to cover the exposure• 3 months futures exchange rate is Rs. 45.52• View on exchange rate – rupee may further appreciate• 1.11.2004 – Sell 10 futures contract US$ 100,000 x 10 x 45.52 = Rs. 4,55,20,000 (Receive from exchange)• Margin 0.0025 paise per dollar 1,000,000 x 0.0025 = Rs. 2500• Last Thursday of January, 2005 (27.1.2005)– Buy 10 futures at spot futures rate of Rs. 45.48• US$ 100,000 x 10 x 45.48 = Rs. 4,54,80,000 (Pay to exchange)
  9. 9. Currency Futures in India• Currency futures in India is yet to be introduced• Full fledged currency futures exchange is required to be set up• Thin volume of forex transactions on forward basis unlike international markets• Forward contract is very popular in Indian market• Popular international currency futures exchange are, CBOT, LIFFEE, PLDX, SIMEX etc.
  10. 10. 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)
  11. 11. Exercise Style• European Option = Option exercised on maturity of the contract• American Option = Option exercise any time before the maturity of the contract• In India all currency options are OTC and European style option• Cross currency option was introduced in January, 1994• Foreign currency-Rupee option was introduced in July, 2003
  12. 12. Hedging through option• ABC Export House with export receivables of US$ 1,000,000 due on 1.2.2005 want to hedge through option• Option contract terms(Short put for customer) – Amount US$ 1,000,000 – Spot rate US$ 1=Rs.45.48 – Option rate =Rs.45.50 – Option premium 1 paise per US dollar – Exercise = European – 1.2.2005
  13. 13. 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
  14. 14. Option Pricing• Pricing (fixing premium for option) is based on following host of variables – Call or put option – Currency pair – Strike price – Amount Chosen items – Style (American or European) – Expiration date – Spot FX rate Market determined – Interest rate for each currency – Volatility of the currency pair Unknown factor
  15. 15. Guidelines to banks for writing options• Banks need to obtain one time approval from Reserve Bank• Continuous profitability for at least 3 years• Minimum CRAR of 9%• Net NPA at reasonable level (not more than 5% of net advances)• Minimum Net worth not less than Rs. 200 crore• Banks can offer plain vanilla European option• Option premium to be quoted in Rupees or as a percentage of the Rupee/FC notional
  16. 16. 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
  17. 17. IRS/FRA guidelines• Interest Rate Swap/Forward Rate Agreement introduced in July, 1999(MPD.BC.187.01.279/ 1999- 2000 dated July 7, 1999)• Banks/PDs/FIs can undertake plain vanilla FRAs/IRS – swaps having implicit option futures such as caps/floors/collars are not permitted• Benchmark rate should evolve on its own in the market- any domestic money market or debt market rate may be used as benchmark which has acceptance among users• No restriction on minimum and maximum notional amount/tenor of the contract. However, IRS are booked for a maximum period of 1 year only
  18. 18. Current exposure methodResidual maturity Conversion factor to be applied on Notional maturity principal amount (percent) Interest Rate Exchange Rate contract contractLess than one Nil 1.0yearOne year and 0.5 5.0above
  19. 19. 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
  20. 20. Interest Rate Swaps- Benchmark rates• MITOR - Mumbai Interbank Tom Rate – FIMMDA-Reuters implied Rupee rates based cash/Tom – It is based on cash/TOM dollar-rupee premium• OIS – FIMMDA-Reuters Overnight Indexed Swaps – It is an average (after taking out 2 highest and 2 lowest) quoted by 17 market participants.• MIFOR – Mumbai Interbank Forward Offered Rate
  21. 21. IRS – cost advantage X YPayment of 8.0% +FR FR+50 bp +8.5%interestReceipt of funds 8.5% FRCost with swap FR-0.50% 9.00%Cost without FR+.375% 9.50%swap
  22. 22. 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)
  23. 23. How FRAs are expressed ?• FRAs are expressed in terms of giving or receiving the fixed rate vs short term interest rate index (reference rate) and are quoted numerically.• The 3 months rate starting in 3 months time is 3/6• The 3 months rate starting in 6 months time 6/9• The 6 months rate starting in 3 months time is 3/9• The market maker gives two way quote (5.15/40)• The lower rate is the bid rate at which the bank is ready to pay fixed and the higher rate will be the offer rate at which the bank is ready to receive fixed
  24. 24. • The buyer of the FRA is the one wishing to hedge against rise in interest rates and the seller protects himself against an interest rate decline• The buyer would receive the differential, if the fixing rate (Reference rate) is higher than the dealing rate• The seller would receive when the fixing rate is lower than the dealing rate
  25. 25. FRA SettlementFloating Rate Higher than FRA Seller pays buyer(benchmark) fixed rateFloating Rate Lower than FRA Buyer pays seller(benchmark) fixed rateABC Limited like to borrow Rs. 1,00,000 for 6 monthsat floating rate(to be borrowed after 3 months)To protect interest rate after 3 months, he buys 3/9 FRAfrom 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
  26. 26. Fixed Income Derivatives by Banks & FIs• Bulk of the IRS and FRA activity concentrated around foreign banks and some private sector banks (new generation)• Most PSBs are yet either unable or unwilling to run a derivatives trading book enfolding IRS or FRAs• Further, most PSBs are not yet actively offering IRSs or FRAs to their corporate customers on a `covered‟ basis with back-to-back deals in the inter-institutional market• The consequence is a paradox: On the one side are foreign banks and private sector banks (new generation) who run a derivatives trading book are unable to set significant counter party (credit) limits on a large segment of corporate customers of PSBs; and on the other side are PSBs who have the ability and willingness to set significant counter party (credit) limits on corporate customers, but are unable or unwilling to write IRS or FRAs with them
  27. 27. Fixed Income Derivatives by FIIs• RBI and SEBI Regs permit FIIs to hedge the currency and interest rate risk to the extent of market value of their debt investment under the 100% debt route• However, investment by FIIs in the domestic sovereign or corporate debt market has been negligible till now• In fact, the spread could turn negative after payment of Indian taxes (20% under domestic law, 10% to 15% under some double tax avoidance treaties) applicable on interest earned in India by FIIs• Therefore, FII activity in the domestic fixed income derivatives market has been largely absent

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