PRESENTATION ONFORWARD AND SWAPBY-SHEENASHEETAL
DERIVATIVES• A security whose price is dependent upon one ormore underlying assets. The derivative itself ismerely a contract between two or more parties.Its value is determined by fluctuations in theunderlying asset. The most common underlyingassetsinclude stocks, bonds, commodities, currencies, interest rates and market indexes. Mostderivatives are characterized by high leverage
Continue….• Derivatives are contracts and can be used as anunderlying asset.• Derivatives are generally used as an instrumentto hedge risk, but can also be usedfor speculative purposes
EXAMPLE• Bombay stock exchange share index callssensex, is a derivative whose value depends uponthe price of underlying 30 shares.
TYPES OF DERIVATIVES1. FORWARD2. SWAP3. OPTIONS4. FUTURE
FORWARD CONTRACT• Forwards are the oldest of all the derivatives.Forwards are contracts to buy or sell an asset onor before a future date at a price specified today• or an agreement between two parties toexchange an agreed quantity of an asset for cashat a certain date in future at a predeterminedprice specified in that agreement.
Example of forward• The promised asset may becurrency, commodity, instrument etc• Eg.- On January 1, Mr. X enters into anagreement to buy 5 pkts. of basmati riceon June 1 at Rs. 3000/- per pkt from Mr.Y, a wholesaler. It is a case of a forwardcontract where Mr. X has to pay Rs.15,000/- on June 1 to Mr. Y and Mr. Y hasto supply 5 pktss of basmati rice.
The primary reason for theclassification of a forward contractas a derivative is that in many casesits price can be derived through ano-arbitrage argument that relatesthe forward price of an asset to itsspot price
In a forward contract, a user (holder)who promises to buy the specifiedasset at an agreed price at a fixedfuture date said to be in the ‘Longposition’. On the other hand, the user(holder) who promises to sell at anagreed price at a future date is said tobe in ‘Short position’. Thus, ‘longposition, and ‘short position, take theform of ‘buy’ and ‘sell’ in a forwardcontract.
FEATURES OF FORWARD1.Over the Counter Trading (OTC): Thesecontracts are purely privately arrangedagreements and hence, they are not at allstandardized ones. They are traded ‘over thecounter’ and not in exchanges. There is muchflexibility since the contract can be modifiedaccording to the requirements of the parties tothe contract. Parties enter into this kind ofcontract on the basis of the custom, and hence, itis also called ‘customised contract’.
2. No Down Payment: There must be apromise to supply or receive a specifiedasset at an agreed price at a future date.The contracting parties need not payany down payment at the time ofagreement3. Settlement at Maturity: Theimportant feature of a forward contractis that no money or commoditychanges hand when the contract issigned. Invariably, it takes place on thedate of maturity only as given in thecontract ement.
4. Linearity: Another special feature of aforward rate contract is linearity. It meanssymmetrical gains or losses due to pricefluctuation of the underlying asset. When thespot price in future exceeds the contractprice, the forward buyer stands to gain. The gainwill be equal to spot price minus contract price.If the spot price in future falls below the contractprice, he incurs a loss.5.No Secondary Market: A forward ratecontract is a purely private contract, andhence, it cannot be traded on an organizedstock exchange. So, there is no secondarymarket for it.
6. Necessity of a Third Party: There is aneed for an intermediary to enable the partiesto enter into a forward rate contract. Thisintermediary may be any financial institutionlike bank or any other third party.7.Delivery: The delivery of the asset whichis the subject matter of the contract isessential on the date of the maturity of thecontract.
SWAP• A swap is a contract in which two parties agreeto exchange their respective cash flows. This isa private agreement between the parties toexchange cash flow according to someprearranged formula.• The parties to the swap contract are known ascounter parties.
• The cash flow can be swapped with the help of aswap dealer.• Swap arrangement are tailor made to theneeds of counter parties.• Swap are not subject to regulation as the futureand option are.
TYPES OF SWAP• 1. Currency swap- it is a transactionbetween two parties in which one promises tomake a series of payments to other party at aspecific dates in exchange for a payment fromthe another party in different currency. So incurrency swap the cash flows of differentcurrency are swapped.
• This can be used by the firms that operate in onecurrency but need to borrow in anothercurrency.Example-• A ltd. and B ltd. want to borrow in $ and Eurorespectively. But A ltd. Can borrow Euro at acheaper rate than B ltd. And vice versa.Then they entry into a currency swap to shareadvantage of the cheaper borrowing capacity ofthe other company.
2. INTEREST RATE SWAP• Interest rate swap is an agreement between twoparties in which each party make a series ofinterest payment to the another party atpredetermined dates at different rates.• At least one of the interest is variable i.e floatingrate .• The most common type of interest rate swap isknown as plain vanilla swap in which onerate is fixed and another is floating.
Important points• In this swap, there is no exchange of principleamount either on maturity or initially.• On each payment date, only the interestpayments or the net payment will be exchanged.Why parties enter into interest rate swap??-The reason in comparative advantage.