l2 Derivatives , Forwards, Swaps

8/6/2019 l2 Derivatives , Forwards, Swaps

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derivativesderivativesderivativesderivativesAn introductionAn introduction


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Financial instruments are cash,evidence of an ownership interest inan entity, or a contractual right toreceive, or deliver, cash or anotherfinancial instrument.


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Categorization F inancial instruments can becategorized by form depending onwhether they are cash instrumentsor derivative instruments :


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Derivatives are financial instrumentswhose value changes in response tothe changes in underlying variables.The main types of derivatives arefutures , forwards , options, and

swaps.


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D erivative is an instrument thatderives its value from anotherunderlying asset or value.

N o independent existence. C reated by introduction of new

security having a relationship withunderlying cash or spot rate.


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Cash instruments are financialinstruments whose value is determined

directly by markets. They can be dividedinto securities , which are readilytransferable, and other cash instrumentssuch as loans and deposits , where both

borrower and lender have to agree on atransfer.


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Derivative instruments are financialinstruments which derive their valuefrom the value and characteristics ofone or more underlying assets. Theycan be divided into exchange-traded

derivatives and over-the-counter(OT C) derivatives .


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Over the counter marketdecentralized market of securitiesnot listed on an exchange wheremarket participants trade over thetelephone, facsimile or electronicnetwork instead of a physical

trading floor. There is no centralexchange or meeting place for thismarket.


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Also referred to as the "OT C market".In the OT C market, trading occurs viaa network of middlemen, called dealers,who carry inventories of securities tofacilitate the buy and sell orders ofinvestors, rather than providing theorder matchmaking service seen inspecialist exchanges.


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nasdaqcomputerized system that facilitates trading andprovides price quotations on more than 5,000 ofthe more actively traded over the counter stocks.Created in 1971, the Nasdaq was the world's firstelectronic stock market.Stocks on the Nasdaq are traditionally listedunder four or five letter symbols. If the companyis a transfer from the New York Stock Exchange,

the symbol may be comprised of three letters.


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The term "Nasdaq" used to be capitalized

"NASDAQ " as an acronym for NationalAssociation of S ecurities Dealers AutomatedQ uotation. The acronym is no longer used andNasdaq is now a proper noun.

The Nasdaq is traditionally home to many high-tech stocks, such as Microsoft, Intel, Dell andCisco.


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M aterial for next seven slides aredrawn from financial institutions aremarkets by Meir and Kohn Ch 21 p667


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Exchange traded and otc

markets L iquidity- exc much more liquid. Easyand inexpensive to change position

F lexibility- exc less flexible.Standardized and rarely fit the needs of investor. OT C can tailor made or

offer a completely new instrument C ost- cost of hedging in OT C ishigher. OT C is relationship markets,less competitive


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M aturity-swaps have an advantage overexc. As a hedging instruments, as they a

re available for longer maturitiesnormally exchange Traded derivativesgo no longer than 2 years. swaps writtenfor as many as 15 years.

R egulation- futures and options marketsare highly regulated. specially in newinstruments. Each new future and optioncontract needs approval the process slowand uncertain. OT C markets offer newproducts as it pleases


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risk N o trading risk for exchange traded

derivatives. Open for all. G uaranteed by brokers and

exchangesOT C market is relatively a wholesalemarket where only good credits canparticipate.http://www.business-standard.com/india/news/interest-rate-futures-to-be-introduced-shortly/50707/Or currency futures in 2008, interest rate futures in 2009mulled in 2004 changes in FEMA were required.


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Serve different clientleExchange traded derivatives are more

liquid , less expensive and involvelesser trading risk.

Fit the needs of hedgers lessprecisely, so some basis risk remains

http://www.business-standard.com/india/news/mcx-sx-ties-upftse-for-domestic-index-series/365296 / MCX-SX signsagreement with FTSE.docx

Why both the markets- serve samefunction


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OT C markets better suited tohedgers with known and unchangingrisks L iquidity and position plays are moreimportant for market makers who

take unhedged positions in the goodsthey trade. M arket makers include securities

dealers and financial intermediaries. M ore attractive to speculators


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financial instruments can be categorized by"asset class" depending on whether they

are equity based (reflecting ownership ofthe issuing entity ) or debt based(reflecting a loan the investor has made tothe issuing entity ). If it is debt, it can be

further categorized into short term (lessthan one year ) or long term .


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Foreign exchangeinstruments and

transactions

are neither debt nor equity basedand belong in their own category.


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Forwards and swapsForwards and swapsForwards and swapsForwards and swapsAn initial rendezvousAn initial rendezvous


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financial transactions F orward transactionsSwaps ( 1.combination of spot &

forward2. normally used in currencytransactions )

optionsfutures


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Simple logic of financial

derivativesThis is a time-sensitive process usedin financial operations to hedge risk,as a means of speculation, or so as toallow a party to take advantage of aquality of the underlying instrument.


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So, R iskmanagementtoolsSpeculativepurposes

(Risky)


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PartiesTraders (speculators )

B rokers (for commission ) B rokers and traders B usiness clients work through broker

s and called hedgers.


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A forwardA forward contract is an agreement between twopartiesto buy or sell an asset at a specified point of

time in the future.The price of the underlying instrument, inwhatever form, is fixed before control of theinstrument changes.This is one of the many forms of buy/sell orderswhere the time of trade is not the time when thesecurities themselves are exchanged.


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The forward price of such a contract iscommonly contrasted with the spotprice, which is the price at which theasset changes hands on the spot date .

The difference between the spot andthe forward price is the forwardpremium or forward discount, generallyconsidered in the form of a profit or[loss] by the purchasing party.


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Pricing of forwardssuppose now that the initial price of Andy'shouse is $100,000 and that Bob enters into aforward contract to buy the house one yearfrom today. But since Andy knows that he canimmediately sell for $100,000 and place theproceeds in the bank, he wants to becompensated for the delayed sale. Suppose thatthe risk free rate of return R (the bank rate ) for one year is 4%. Then the money in the bankwould grow to $104,000, risk free. So Andywould want at least $104,000 one year from nowfor the contract to be worthwhile for him - theopportunity cost will be covered.


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B ob, as any other buyer would, willseek the lowest price he can for the

contract - although as we've seen,there is an invisible lower limit of$104,000 that Andy will not go below.As a result, the contract price would

be at least $104,000 or it will nothappen at all.


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F orwards are not standardized andcan be tailor made to fit specific

needs.The forward markets in currenciesare highly developed of all forward

markets.


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These markets are made by largebanks-specially those with a global

view. M ost of the transactions are interbank, but the banks can also effect

transaction son behalf of non bankclients.


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An illustrationAn Indian importer enters acontract to buy merchandise from

American manufacturer.The spot rate 39.75rs/$.Payment to be made 107 days hence.Price of goods is $110,000


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Two alternativesIShould buy the dollars today.

1,10,000 X 39.75 IIEnter into forward transaction for

$1,10,000 @ RS.41/$ for 107 days.

He is now hedged against exchange raterisks


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Forward premium and

forward discountspot 3 month forward

R e/$ 44.5000/7050 44.7000/9990(Forward premium) bid=44.7000-44.5000 X 12 X 100

44.5000 3=1.80 % per annum.


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Forward premium (ask)=2.63 % per annum F orward premium= F orward rate- spot rate X12 X 100

spot rate N


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=41-39.75/39.75 X 360/107 X 100


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U ntil recently the forwards wererarely available for as long as a year.

now these long dated forwards areavailable by an ability to synthesizeforwards from swaps or vice versa.


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Also possible in

commodities M ajor food processors have multi year contracts with farmers.

http://www.business-standard.com/india/news/exchanges-to-re-launch-wheat-

futures-today/358730 /or wheat futures.docx


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swaps

A swap transaction in foreignexchange market is acombination of spot and forwardin the opposite direction.


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It is a temporary exchange of onecurrency for another with an obligationto reverse it at a specified future date. F orward contracts without anaccompanying spot deal are calledoutright forward contracts.


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In volatile interest rate, exchangerates, and commodity price

environments.


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Basic structure of swapTwo parties agree to one moreexchanges of specified quantities of

underlying asset.


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These are nothing but an exchange oftwo payment streams.

C an be aggranged aeither directly orthrough a third party like a bank or afinantial instrument.


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Parties in a swap M ay be between two counter partiesor through a financial intermediary

that serves both the end users calledSwap dealer, a market maker, a swapbank.


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ENT ERPR I S E A ENT ERPR I S E

B

EU RO

DOLLAR

FI as a Broker


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NT ERPR I S E A ENT ERPR I S E B

DOLLAR

FI as an intermediary

FIEUR O

U S

DOLLAR

EUR O

EUR O


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Types of swaps C urrency swapsInterest rate swaps

C ommodities swaps


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Fixed to fixed rate

currency swapTwo parties want to borrow at fixed rateof interest.

EEE AAA DI FFERENCEDOLLAR RATE

7% 6% 1%

EU RORATE

8.5% 9% (0.5%)

NET DI FFERENCE 1.5%


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EEE AAA

Payment to $market at6%

Payment to. Marketat 8.5%

6.25%

8.5%


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C urrency of relative advantageAnd share the net benefit amongthemselvesEqually in this example but in anyratio practicaly


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The result is B oth companies have receivedinterest in their desired loan

currencies. B oth have paid lower rate ofinterest.


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N et interest paid by EEE= 8.5% paidto market + 6.25% paid to AAA- 8.5%

received from AAA C alculate net interest paid by AAA


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Fixed to floating

currency swapEEE AAA DI FFEREN

CEDOLLAR RATE(floating)

Libor+0.8%

Libor +0.1% 0.7%

EU

RORATE(Fixed) 8.5% 9% (0.5%)

Net difference 1.2%


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Swap contract reads like

thisEEE shall payLI BOR+.1% to bank

AAA shall receive Libor from bank

EEE FI AAALibor + .1% Libor

8.5%


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Swap contract reads like

thisAAA shall pay 8.4 % to bankEEE shallReceive 8.3% from bank

EEE FI AAA8.4%8.3%

Libor+.1%


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You need to calculate N et interest paid by EEE N et interest paid by AAA


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swaptionThe option to enter into an interestrate swap. In exchange for an option

premium, the buyer gains the rightbut not the obligation to enter into aspecified swap agreement with theissuer on a specified future date.


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Please check N et interest paid by EEE=LI BOR+.3

Net interest paid by AAA=8.5%

Net gain of the bank =0.2%

l2 Derivatives , Forwards, Swaps

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