DERIVATIVES AND RISK MANAGEMENTThe Derivatives Market is meant as the market where exchange of derivativestakes place. Derivatives are one type of securities whose price is derived fromthe underlying assets. And value of these derivatives is determined by thefluctuations in the underlying assets. These underlying assets are most commonlystocks, bonds, currencies, interest rates, commodities and market indices. AsDerivatives are merely contracts between two or more parties, anything likeweather data or amount of rain can be used as underlying assets The Derivativescan be classified asTypes of derivativesForwardFuturesOptionsSwapsThe Types of Derivative MarketThe Derivative Market can be classified as Exchange Traded DerivativesMarket and over the Counter Derivative Market. Exchange Traded Derivativesare those derivatives which are traded through specialized derivative exchangeswhereas Over the Counter Derivatives are those which are privately tradedbetween two parties and involves no exchange or intermediary. Swaps, Optionsand Forward Contracts are traded in Over the Counter Derivatives Market or OTCmarket.The main participants of OTC market are the Investment Banks, CommercialBanks, Govt. Sponsored Enterprises and Hedge Funds. The investment banksmarkets the derivatives through traders to the clients like hedge funds and the rest.In the Exchange Traded Derivatives Market or Future Market, exchange acts as the
main party and by trading of derivatives actually risks is traded between twoparties. One party who purchases future contract is said to go “long” and the personwho sells the future contract is said to go “short”. The holder of the “long” positionowns the future contract and earns profit from it if the price of the underlyingsecurity goes up in the future. On the contrary, holder of the “short” position is in aprofitable position if the price of the underlying security goes down, as he hasalready sold the future contract. So, when a new future contract is introduced, thetotal position in the contract is zero as no one is holding that for short or long. Thetrading of foreign exchange traded derivatives or the future contracts has emergedas very important financial activity all over the world just like trading of equity-linked contracts or commodity contracts. The derivatives whose underlying assetsare credit, energy or metal, have shown a steady growth rate over the years aroundthe world. Interest rate is the parameter which influences the global trading ofderivatives, the most.DERIVATIVE MARKET AND FINANCIAL MARKETDerivatives play a vital role in risk management of both financial and non-financialinstitutions. But, in the present world, it has become a rising concern thatderivative market operations may destabilize the efficiency of financial markets. Intoday’s world the companies the financial and non-financial firms are usingforward contracts, future contracts, options, swaps and other various combinationsof derivatives to manage risk and to increase returns. It is true that growth ofderivatives market reveal the increasing market demand for risk managinginstruments in the economy. But, the major concern is that, the main componentsof Over the Counter (OTC) derivatives are interest rates and currency swaps. So,the economy will suffer surely if the derivative instruments are misused and if amajor fault takes place in derivatives market.
THE OVER- THE- COUNTER DERIVATIVESThe derivatives traded over the counter are known as the over the counterderivative market. The Over the counter derivative market consists of theinvestment banks and include clients like hedge funds, commercial banks,government sponsored enterprises etc. The products that are traded over thecounter are swaps, forward rate agreements, forward contracts, credit derivativesetc. Derivatives are basically the financial instruments whose value is a function ofthe value of the underlying asset. The participants who enter into the contract do sowhen they agree on the exchange rate or the value of some asset to be delivered ona future date.DERIVATIVE MARKET EQUITYThe derivative market equity includes the financial instruments such asfutures, options and swaps. The equity derivatives are stocks or stock indiceswhose prices depend on the prices of the underlying equity instrument. The equityderivatives are traded in the futures and options exchanges or in the over thecounter markets. The most common forms of the derivative market equity are thefutures and the options market. The options and futures market Options arecontracts that give the buyer or seller the right and not the obligation to buy or sellthe underlying asset at a fixed price at a future date. The call option gives theright to buy while the put option gives the right to sell. The buyer of the calloption can gain by an increase in the price of the underlying asset without buyingthe underlying asset. Conversely the put option holder benefits from the fall in theprice level of the underlying asset. Contrast to the option market the person whogoes long or short in the futures market is bound to buy or sell the contract at thespecified price and date. Hence the futures contracts are much morestandardized in comparison to the options and hence they are traded inaccredited exchanges.
WARRANTSUnlike the options and the futures which are exchange traded financial instruments,the warrants are equity derivatives that are traded over the counter. Warrants areused sometimes to increase the yield of bonds. Warrants are similar to the equityoptions but are an exception since they are traded by private parties.CONVERTIBLE BONDSConvertible bonds are a combination of bonds and equity. The convertible bondsprovide asset protection, high equity returns and they are of less volatile nature.The investors in the equity derivative can hedge their risk. The equity derivativesare also used as a speculative instrument. The derivative market equity traders usethe data on stock and their derivatives. They also need, in addition, the factors thatmay affect the equity prices. To analyze the data the equity market traders needappropriate statistical tools. For further information on derivative market equity,the following websites need to be looked at equityderivatives.com, reuters.com,asx.com, amazon.com etc.FORWARD AND FUTURES CONTRACTS Fundamentally, Forward and futures contracts have the same function: bothtypes of contracts allow people to buy or sell a specific type of asset at aspecific time at a given price futures contracts are traded on the exchange,forwards contracts are traded over- the-counter market. In case of futures contractsthe exchange specifies the standardized features of the Contract, while no predetermined standards are there in the forward contracts. Exchange provides themechanism that gives the two parties a guarantee that the Contract will be honoredwhereas there is no surety/guarantee of the trade settlement in case of forwardContract.
A forward Contract is an agreement between two parties to buy or sell anasset (which can be of any kind) at a pre-agreed future point in time. Therefore, thetrade date and delivery date are separated. It is used to control and hedge risk, forexample currency exposure risk (e.g. forward contracts on USD or EUR) orcommodity prices (e.g. forward contracts on oil). One party agrees to buy, the otherto sell, for a forward price agreed in advance. In a forward transaction, no actualcash changes hands. If the transaction is collaterised, exchange of margin will takeplace according to a pre-agreed rule or schedule. Otherwise no asset of any kindactually changes hands, until the maturity of the Contract. The forward price of such a Contract is commonly contrasted with the spotprice, which is the price at which the asset changes hands (on the spot date, usuallynext business day). The difference between the spot and the forward price is theforward premium or forward discount. A standardized forward Contract that istraded on an exchange is called a futures Contract. In finance, a futures Contract isa standardized Contract, traded on a futures exchange, to buy or sell a certainunderlying instrument at a certain date in the future, at a pre-set price. The futuredate is called the delivery date or final settlement date. The pre-set price is calledthe futures price. The price of the underlying asset on the delivery date is called thesettlement price. The futures price, naturally, converges towards the settlementprice on the delivery date. A futures Contract gives the holder the right and theobligation to buy or sell, which differs from an options Contract, which gives thebuyer the right, but not the obligation, and the option writer (seller) the obligation,but not the right. In other words, the owner of an options Contract can exercise (tobuy or sell) on or prior to the pre-determined settlement/expiration date. Bothparties of a "futures Contract” must exercise the Contract (buy or sell) on thesettlement date. To exit the commitment, the holder of a futures position has to sellhis long position or buy back his short position, effectively closing out the futures
position and its Contract obligations. Futures contracts, or simply futures, areexchange traded derivatives. The exchange acts as counterparty on all contracts,sets margin requirements, etc. While futures and forward contracts are both aContract to trade on a future date, key differences include: Futures are always traded on an exchange, whereas forwards always tradeover-the-counter Futures are highly standardized, whereas each forward is uniqueThe price at which the Contract is finally settled is different:Futures are settled at the settlement price fixed on the last trading date of theContract (i.e. at the end) Forwards are settled at the forward price agreed on thetrade date (i.e. at the start) The credit risk of futures is much lower than that offorwards: Traders are not subject to credit risk due to the role played by theclearing house. The profit or loss on a futures position is exchanged in cash everyday. After this the credit exposure is again zero. The profit or loss on a forwardContract is only realised at the time of settlement, so the credit exposure can keepincreasing In case of physical delivery, the forward Contract specifies to whom tomake the delivery. The counterparty on a futures Contract is chosen randomly bythe exchange. In a forward there are no cash flows until delivery, whereas infutures there are margin requirements and periodic margin calls.
OPTION/ OPTIONS CONTRACTFutures Option are an excellent way to trade the futures markets. Many new tradersstart by trading futures Option instead of straight futures contracts. There isgenerally less risk and volatility when using Option instead of futures. Actually,many professional traders only trade Option.FUTURES OPTIONAn Option is the right, not the obligation, to buy or sell a futures contract at adesignated strike price. For trading purposes, you buy Option to bet on the price ofa futures contract to go higher or lower. There are two main types of Option - callsand puts.Calls – You would buy a call Option if you believe the underlying futures pricewill move higher. For example, if you expect corn futures to move higher, you willwant to buy a corn call Option.Puts – You would buy a put Option if you believe the underlying futures price willmove lower. For example, if you expect soybean futures to move lower, you willwant to buy a soybean put Option.Premium – You are obviously going to have to pay some kind of price when youbuy an Option. The term used for the price of an Option is premium. You can thinkof the pricing of Option as a bet. The bigger the long shot, the less expensive theywill be. Oppositely, the more sure the bet is, the more expensive it will be.Contract Months (Time) – Option have an expiration date, which means they onlylast for a certain period of time. When you buy an Option, you cannot hold itforever. For example, a December corn call expires in late November. You willneed to close the position before expiration. Generally, the more time you have onan Option, the more expensive it will be.
Strike Price – This is the price at which you could buy or sell the underlyingfutures contract. For example, a December $3.50 corn call allows you to buy aDecember futures contract at $3.50 anytime before the Option expires. Mosttraders do not convert Option; they just close the Option position and take theprofitsExample of Buying an Option:Let’s say you expect the price of gold futures to move higher over the next 3-6months. It is currently January, so you would probably buy an August gold call togive yourself enough time. Gold is currently trading at $590 per ounce. You expectthe price to climb to $640 within 6 months.You purchase: 1 August $600 gold call at $151 = number of Option you are buyingAugust = Month of Option contract$600 = strike priceGold = underlying futures contractCall = type of Option (bet on price moving higher)$15 = premium ($1,500 is the price to buy - 100 ounces of gold x $15 = $1,500)Call Option Example
Suppose the market price of equity share of reliance on the expiration date isRs 140 and the exercise price is Rs 125 .The value of call option is Rs 15 [Rs 140 –Rs 125] In case the value of share on expiration date turn out to be Rs 120 thevalue of c would not be negative Rs 5 [Rs 120 –rs125 ], it would be zero as theinvestor would not purchase share Rs 125 which is available in the market andthereby incur a loss Rs 5per share.Put Option Example Consider an investor who wants the right to sell reliance equity shares at Rs135 after 2 months. He is to buy a 2 month put option with a Rs 135 exerciseprice. In case the market price of the reliance share increases to Rs 150 (S1< E) theput option will expire worthless as it will be more profitable for an investor to sellin the open market at Rs 150 than to the put option writer at Rs 135. If the market price falls below the sp say to Rs 125 it will be profitable forthe put option holder to excise his put option right as he get Rs 135 compared to Rs125.An important difference between futures and options is that trading in futurescontracts is based on prices, while trading in options is based on premiums. The
premium depends on market conditions such as volatility, time until expiration, andother economic variables affecting the value of the underlying futures contract.The buyers and sellers of futures can be classified as hedgers or speculators.Hedgers use futures to minimize risk, like the farmers who use futures toguarantee a price for their product, or a miller who wants a set price for grain whenit is harvested. Futures can also be used to hedge investment portfolios. Thus,futures is a significant means of price risk transfer—transferring price risk tosomeone with an opposite risk, or to a speculator who is willing to accept risk tomake a profit.Speculators use futures to make a profit, by buying low and selling high (notnecessarily in that order). The speculator has no intention of making or takingdelivery. A speculator is making a bet on the future price of a commodity. If hethinks the price of the commodity will drop, he takes a short position by selling afutures contract. If he thinks that the price of the commodity will increase, then hetakes a long position by buying a futures contract. Later, he will close out hisposition by offsetting the contract. If he sold short, he will buy back the contract,and if he bought long, then he will sell the contract.The buying and selling of futures contracts is a zero sum gain, because it isbasically a contract between 2 traders. It is not an investment in a company thatcreates wealth, where every shareholder can win—or lose. If the short side profits,the long side loses an equal amount, and vice versa.SWAPS
A swap is an agreement between two parties to exchange the cash flows inthe future. The agreement defines the dates when the cash flow are to be paid andthe way it has to be calculated. There are two basic types of swaps : (1) Interest Rate Swap (2) Currency Swap A currency swap is an agreement between two parties to exchange theprincipal loan amount and interest applicable on it in one currency with theprincipal and interest payments on an equal loan in another currency. Thesecontracts are valid for a specific period, which could range up to ten years, and aretypically used to exchange fixed-rate interest payments for floating-rate paymentson dates specified by the two parties. Since the exchange of payment takes place intwo different currencies, the prevailing spot rate is used to calculate the paymentamount. This financial instrument is used to hedge interest rate risks A currency swap agreement specifies the principal amount to be swapped, acommon maturity period and the interest and exchange rates determined at thecommencement of the contract. The two parties would continue to exchange theinterest payment at the predetermined rate until the maturity period is reached. Onthe date of maturity, the two parties swap the principal amount specified in thecontract. The equivalent amount of the loan value in another currency is calculatedby using the net present value (NPV). This implies that the exchange of theprincipal amount is carried out at market rates during the inception and maturityperiods of the agreement.Benefits of Currency Swaps
• Help portfolio managers regulate their exposure to interest rates.• Speculators can benefit from a favorable change in interest rates.• Reduce uncertainty associated with future cash flows as it enables companies to modify their debt conditions.• Reduce costs and risks associated with currency exchange.• Companies having fixed rate liabilities can capitalize on floating-rate swaps and vice versa, based on the prevailing economic scenarioLimitations of Currency Swaps• Exposed to credit risk as either one or both the parties could default on interest and principal payments.• Vulnerable to the central government’s intervention in the exchange markets. This happens when the government of a country acquires huge foreign debts to temporarily support a declining currency. This leads to a huge downturn in the value of the domestic currency.COMPANIES BENEFIT FROM INTEREST RATE AND CURRENCY SWAPS An interest rate swap involves the exchange of cash flows between twoparties based on interest payments for a particular principal amount. However, inan interest rate swap, the principal amount is not actually exchanged. In an interestrate swap, the principal amount is the same for both sides of the currency and afixed payment is frequently exchanged for a floating payment that is linked to aninterest rate, which is usually LIBOR.A currency swap involves the exchange of
both the principal and the interest rate in one currency for the same in anothercurrency. The exchange of principal is done at market rates and is usually the samefor both the inception and maturity of the contract, generally, both interest rate andcurrency swaps have the same benefits for a company. Essentially,these derivatives help to limit or manage exposure to fluctuations in interest ratesor to acquire a lower interest rate than a company would otherwise be able toobtain. Swaps are often used because a domestic firm can usually receive betterrates than a foreign firm. For example, suppose company A is located in the U.S. and company B islocated in England. Company A needs to take out a loan denominated inBritish pounds and company B needs to take out a loan denominated in U.S.dollars. These two companies can engage in a swap in order to take advantage ofthe fact that each company has better rates in its respective country. These twocompanies could receive interest rate savings by combining the privileged accessthey have in their own markets. Swaps also help companies hedge against interestrate exposure by reducing the uncertainty of future cash flows. Swapping allowscompanies to revise their debt conditions to take advantage of current or expectedfuture market conditions. As a result of these advantages, currency and interest rateswaps are used as financial tools to lower the amount needed to service a debt. Currency and interest rate swaps allow companies to take advantage of theglobal markets more efficiently by bringing together two parties that have anadvantage in different markets. Although there is some risk associated with thepossibility that the other party will fail to meet its obligations, the benefits that acompany receives from participating in a swap far outweigh the costs.Examples of Interest rate swaps and Currency swaps
Interest rate swaps Example It can be used to overcome the asset-liability mismatch, with the help of thefollowing example. Bank A has floating rate assets earning (MIBOR+3%)(Mumbai Inter Bank Offer Rate) funded with fixed rate liability of 12%. Bank Bhas fixed rate assets earning 17%, funded with floating rate liability (MIBOR+1%).Now, if the interest rate falls, Bank A will suffer as it will receive less on its assetswhereas it will have to pay fixed interest. And if the interest rate rises, Bank B willsuffer as it will have to pay more, liabilities being floating in nature. Hence boththe banks suffer from asset-liability mismatch.To overcome this, they may enter into a swap transaction wherein: Bank A will pay Bank B, floating rate of interest, say MIBOR annually, on the notional principal. Bank B will pay Bank A, a fixed rate of interest, say 14% annually, on the same notional principal. This would ensure that both the banks will stand to gain a definite spread irrespective of the level of MIBOR.Currency Swaps Example
Suppose company C wants to borrow US$ funds and the Company D wantsto borrow £ funds. Their financing details are given in the following example:Company $ Borrowing £ Borrowing PreferenceC 10% 7% $ LoanD 11% 11% £ LoanSpread 1% 4% From the given information, C enjoys absolute advantage over D in both the$ and £ loan market. But the comparative advantage for C exists in the £ loanmarket. So it is advisable for C to borrow £ funds and for D to borrow $ funds fromthe market and then enter into a foreign currency swap deal to achieve theirpreferred form of funding with a lower cost. Let us check how to construct a dealbetween them. It is assumed that C needs $100 crores. The current spot $/£ rate atthe time of entering into the swap is 1.80 $/£. The calculation of the benefit earned from the swap is : Total cost of borrowing without the swap = 10 + 11 = 21% Total cost of borrowing with the swap = 7+11 = 18% Therefore, net savings = 3% This savings may be shared between C and D in a mutually agreed uponratio. In our discussion, we assume it to be shared equally for easy calculation.Hence, the net cost of borrowing for both the parties will be: C = 10-1.50 = 8.50% D = 11-1.50 = 9.50% Their swap structure is :
Therefore, to enter into the swap deal the following transactions arerequired: Exchange of Principal: C will borrow £55.55 (100/1.80) crore and give it to D and D will borrow $100 crore and give it to C. Interest Payments: C will pay 11% to D on the $100 crore borrowed by D and D will pay 9.5% to C on the £55.55 crore borrowed by C. Re-exchange of Principal: After the swap matures, the principal amount exchanged between C and D will be re-exchanged between them. That is, C will return $100 crore to D and D will return £55.55 crore to C.