Financial Derivatives
for
Risk Management
Derivatives- Category
Credit Derivatives
Equity Derivatives
Fixed Income Derivatives
Foreign Currency Derivatives
Commodit...
OTC vs Listed derivatives
Issuer or writerClearing Corporation of
the Exchange
Guatrantee
Private agreement
Limited liquid...
Forward contract –
foreign currency
1. A contract between a banker and the customer to
buy or sell foreign currency on a f...
Currency Futures
• Exchange rate risk can be covered through futures
contract also
• Futures contracts are exchange traded...
Currency futures - example
• Receive from exchange = Rs. 4,55,20,000
• Pay to exchange = Rs. 4,54,80,000
• Receive differe...
Call and Put Option
• Customer can buy option for purchase of foreign
currency or sale of foreign currency with a bank
for...
Option Premium
• Option premium is the price for the option
• Premium is payable upfront which is the gain
realised by the...
Hedge or not to hedge
• ABC Export House with export receivables
of US$ 1,000,000 due on 1.2.2005
• There are three possib...
Pricing Methods
• In 1972, Fisher Black and Myron Scholes
introduced “Black Sholes Model” for pricing the
European style o...
Option valuation
• The delta of an option is produced as a by product
of the pricing formula (Black Sholes Model) and
repr...
IRS/FRA guidelines…
• Documentation -ISDA documentation as suitably
modified
• Internal control – Sound internal control s...
IRS – Benchmark rate
• R-MIBOR – Reuter-Mumbai Interbank
Offered Rate (weighted average of traded
call money rates sourced...
IRS- example
• Two parties X and Y have the following potential to
borrow on fixed and floating terms
X Y
Credit Rating AA...
IRS – Current trend
• Foreign banks and Primary dealers are the dominant
players in the IRS market
• In majority contracts...
FRA structure
Trade
date
Fixing
date
Settlement
date
Term
date
TIME
Fixing date = Settlement date – 2 working days
3/6 For...
FRA Settlement
Buyer pays sellerLower than FRA
fixed rate
Floating Rate
(benchmark)
Seller pays buyerHigher than FRA
fixed...
Fixed Income Derivatives by MFs
• SEBI (MF) Regs are silent about use of IRS and FRA
by mutual funds
• IRS and FRA transac...
1
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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.

Published in: Business, Economy & Finance

Financial Derivatives - Forwards/Futures/Options

  1. 1. Financial Derivatives for Risk Management
  2. 2. Derivatives- Category Credit Derivatives Equity Derivatives Fixed Income Derivatives Foreign Currency Derivatives Commodity Derivatives This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  3. 3. OTC vs Listed derivatives Issuer or writerClearing Corporation of the Exchange Guatrantee Private agreement Limited liquidity Exchange Traded Highly liquid Trading Terms are flexible and negotiable •Strikes at any level •Any maturity date •Varying contract size •American/ European •Physical/ cash •Payouts are flexible Standardised contracts •Strikes •Maturities •Contract size •Exercise type •Delivery •Pay outs Features OTCListed (Exchange TradedType This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  4. 4. Forward contract – foreign currency 1. A contract between a banker and the customer to buy or sell foreign currency on a future date at the exchange rate determined today 2. It is a OTC contract 3. Contract agreed on Amount to be bought/sold Settlement date Exchange Rate This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  5. 5. 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 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  6. 6. Currency futures - example • Receive from exchange = Rs. 4,55,20,000 • Pay to exchange = Rs. 4,54,80,000 • Receive difference = Rs. 40,000 • Sell US$ 1,000,000 to market at 45.48 and receive Rs. 4,54,80,000 • Exchange pays Rs. 40,000 • Therefore the exchange rate of Rs. 45.52 per dollar is protected through this contract This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  7. 7. 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) This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  8. 8. Option Premium • Option premium is the price for the option • Premium is payable upfront which is the gain realised by the option writer • Option buyer has unlimited profit potential but loss is limited to the premium paid • Option writer has no right but face unlimited obligation • Option writer covers his option contracts with customers on back to back basis either in the domestic market or in overseas market This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  9. 9. 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 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  10. 10. Pricing Methods • In 1972, Fisher Black and Myron Scholes introduced “Black Sholes Model” for pricing the European style options • With the introduction of American style option, pricing became further complex due to probability of early exercise • In 1979 Cox, Ross and Rubinstein published a pricing model to price American style options which is called Binomial Method This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  11. 11. 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 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  12. 12. IRS/FRA guidelines… • Documentation -ISDA documentation as suitably modified • Internal control – Sound internal control system with clear functional separation of front and back offices • Capital adequacy norms – for reckoning the minimum capital ratio, the FRAs/IRS should be risk weighted. The notional principal of each instrument is to be multiplied by the conversion factor: – Less than one year maturity = 0.5% – One year and less than 2 years = 1.0% – For each additional year = 1.0% – The adjusted value should be multiplied by 20% This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  13. 13. 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 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  14. 14. IRS- example • Two parties X and Y have the following potential to borrow on fixed and floating terms X Y Credit Rating AAA BBB Fixed Rate cost 8% 9.5% Floating rate cost FR FR+50 bp Comparative advantage for X is fixed rate borrowing Comparative advantage for Y is floating rate borrowing Therefore, X to borrow at fixed and service floating (FR) Y to borrow at floating and service at fixed (8.5%) Therefore, X receives 8.5% from Y and pay FR to Y Y receives FR from X and pay 8.5% The cost for Y is 8.5% + 0.50% = 9.00% (fixed) cheaper by 0.50% This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  15. 15. 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) This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  16. 16. FRA structure Trade date Fixing date Settlement date Term date TIME Fixing date = Settlement date – 2 working days 3/6 Forward Rate Agreement (5.15/40) This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  17. 17. FRA Settlement Buyer pays sellerLower than FRA fixed rate Floating Rate (benchmark) Seller pays buyerHigher than FRA fixed rate Floating Rate (benchmark) ABC Limited like to borrow Rs. 1,00,000 for 6 months at floating rate(to be borrowed after 3 months) To protect interest rate after 3 months, he buys 3/9 FRA from 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 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
  18. 18. Fixed Income Derivatives by MFs • SEBI (MF) Regs are silent about use of IRS and FRA by mutual funds • IRS and FRA transactions entered into by mutual funds are not construed by SEBI as derivatives transactions • Mutual Funds emerging as important users of IRS and FRA in the Indian fixed income derivatives market • A few mutual funds actively use IRS to optimize yield and reduce the duration of their bond scheme portfolios, by paying fixed rate and receiving floating rate • It is understood that some of these IRS are benchmarked to MIFOR as well. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/financial-derivatives-forwards-futures-options-103
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