Chapter 5 – Derivative Products

Chapter 6 – Derivative Products

Treasury makes use of derivative products for the purpose of

• Management of risk including the risk relating to ALM
• Catering to requirement of corporate customers
• Taking trade positions in derivative products;

Derivative

A derivative is a financial contract that derives its value frorn another financial product/commodity (say spot rate) which is called underlying (that may be a stock, stock index, a foreign currency, a commodity). Forward contract in foreign exchange transaction, is a simple form of a derivative.

Objectives and instruments of derivatives

The major purpose that is served by derivatives is to hedge the risk. Futures, forwards, options, swaps’ etc. are the common derivative instruments. The derivatives do not have any independent existent and are based on the underlying assets that could be a stock index, a foreign currency, a commodity or an individual stocks. This means that derivatives relate to future value.

Over the counter & exchange traded derivatives

The derivative products that can be obtained from banks and investment institutions are called Over-the-counter (OTC) products.

Option

It is contract that provides a right but does not impose any obligation to buy or sell a financial instrument, say a share or security. It can be exercised by the owner. Options offer the buyers, profits from favourable movement of prices say of shares or foreign exchange.

Components of options

1. Call option : Owner or the buyer has the right to purchase and the seller has to obligation to sell, a specified no. Of instruments say shares at a specified price during the time prior to expiry date

A call option protects the buyer from rise in the stock price.

2. Put option : Owner or the buyer has the right to sell and the seller has the obligation to buy during a particular period.

A put option protects the buyer from the fall in the stock price.

Maturity date or expiration date in an option: It is the last day on which the option can be exercised.

In the money : Where exercising the option provides gain to the buyer, it is called ‘in the money’. It happens when the strike price is below the spot price, in case of a call option OR the strike price is above the spot price, in case of a put option.

At the money : Where exercising the option provides no gain or loss to the buyer, it is called ‘at the money’.

Out of the money : Where exercising the option results into loss to the buyer, it is called ‘out of the money’. It is better to let the option expire

Embedded option : Where the buyer is given an option to repay before maturity period, in case of a structured credit product. A 10 year bond has been issued by a company in which an option is given to the investor to get back the money at the end of 7th year (which is a also put option)

Swap

Interest Rate Swaps

An interest rate swap is an exchange of interest flows on an underlying asset or liability, the value of which is the national amount of the swap. In a swap, basic for calculation of interest is charged according to the requirement of the borrower.

An interest rate swap is shifting of basic of interest rate calculation, from fixed rate to floating rate, floating rate to fixed rate or floating rate to floating rate. The cash flows representing the interest payments during the swap period are exchanged accordingly.

Currency Swaps

A currency swap is an exchange of cash flow in one currency, with that of another currency. The cash flow may relate to repayment of principal and/or interest under a loan obligation where the lender or the borrower intends to eliminate currency risk.

Operationally, the three variants of currency swap function as under

Principal Only Swap (POS)

The borrower continue to pay interest in USD terms, but has the benefit of using the principal amount in home currency, without exchange risk. The repayment takes place in domestic currency, at a fired rate of exchange, hence there is no exchange.

Coupon Only Swap (COS)

The USD loan is utilized in the same currency, but interest on USD loan is swapped into Rupees interest – the borrower has to pay interest in Rupees at swap rate, principal repayment is as per original loan terms.

P+I Swaps

Without initial exchange – where the borrower has eliminated the currency risk and interest rate risk completely – zero risk and will pay principal and interest in domestic currency to settle the foreign currency borrowing. The swap cost is included in the rupees interest rate.

Futures

• The futures are the contracts between sellers and buyers under which the sellers have to deliver, a prefixed quantity (of currency or security or commodity), at a pre-fixed time in future, at a pre-fixed price, to the buyers. It is a legally binding obligation between two parties to give/take delivery at a certain point of time in-future. The main features of a futures contract are that:
• These are traded in organised exchanges which means that these are bought and sold only through the members of the exchange, the buyers need to pay only the margin.
• These are marked to market on a daily basis and the members are required to pay margin equivalent to daily loss, if any This way the possibility of default on settlement date is avoided.
• These are regulated by institutions such as SERI. The exchange guarantees all trades. Routed through its members and in case of default by the member, the payment obligation shall be met by the exchange from Trade Protection Fund.
• The future positions can be closed easily.
• These contract are made primarily for hedging, speculation, price determination and allocation of resources.
• Future contracts are of standard size with pre-fixed settlement dates.