This is a partial preview of the document found here: https://flevy.com/browse/business-document/financial-derivatives-103 Description: 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.

1. Financial Derivatives
for
Risk Management

2. Financial Risks
• Credit Risk/Counterparty risk/Herstatt Risk
• Market Risk
– Commodity price risk
– Exchange rate risk
– Interest rate risk
• Operational Risk

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. OTC vs Listed derivatives
Type Listed (Exchange Traded OTC
Features 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 flexible
Trading Exchange Traded Private agreement
Highly liquid Limited liquidity
Guatrantee Clearing Corporation of Issuer or writer
the Exchange

5. Derivative Instruments in India
Year Type of instruments
1875 Commodity futures
1994 Cross currency options in foreign exchange market
1996 IRS, FRA, Caps, Collars, currency swap in foreign exchange
market
1999 IRS,FRA in Money market
2000 Stock Index Futures and Stock Options in Capital Market
2001 Stock Index Options and Stock futures in Capital Market
2003 Foreign currency – INR option in forex market
Interest Rate Futures on Fixed Income Market
Gold Futures

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Current exposure method
Residual maturity Conversion factor to be applied on
Notional maturity principal amount
(percent)
Interest Rate Exchange Rate
contract contract
Less than one Nil 1.0
year
One year and 0.5 5.0
above

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. 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. IRS – cost advantage
X Y
Payment of 8.0% +FR FR+50 bp +8.5%
interest
Receipt of funds 8.5% FR
Cost with swap FR-0.50% 9.00%
Cost without FR+.375% 9.50%
swap

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. 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. • 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. FRA Settlement
Floating Rate Higher than FRA Seller pays buyer
(benchmark) fixed rate
Floating Rate Lower than FRA Buyer pays seller
(benchmark) fixed rate
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

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. 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