International Derivatives

7/29/2019 International Derivatives

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By,Animesh Verma - 04Meet Buch 18

Mrinal Banerji - 21Pradyumna Swain 27

Rittvik Agarwal 32Satwik Kabisatpathy - 41


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Derivatives

A security whose price is dependent upon or derived from one or moreunderlying assets

The derivative itself is merely a contract between two or more parties.

It derives its value from the prices, or index of prices, of underlyingsecurities

The most common underlying assets include stocks,bonds, commodities, currencies, interest rates and market indexes

Derivatives are generally used as an instrument to hedge risk

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FuturesContract

Futures Contract means a legally binding agreementto buy or sell the underlying security on a future dateat a price agreed today

Contracts in terms of quantity, quality (in case ofcommodities), delivery time and place for settlementon any date in future

Expires on a pre-specified date which is called theexpiry date of the contract

The price of the underlying instrument, in whatever

form, is paid before control of the instrument changes 3


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ForwardContract

Forward is a non-standardized contract between twoparties to buy or sell an asset at a specified future timeat a price agreed upon today

Forward contracts are very similar to futurescontracts, except they are not exchange-traded, or

defined on standardized assets and they are tradedover the counter

Futures are margined, while forwards are not .Thusfutures have significantly less credit risk, and havedifferent funding.

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SWAP

Traditionally, the exchange of one security for anotherto change the maturity (bonds), quality of issues(stocks or bonds), or because investment objectiveshave changed

The benefits in question depend on the type offinancial instruments involved

If firms in separate countries have comparative

advantages on interest rates, then a swap could benefitboth firms

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Options

Options Contract is a type of Derivatives Contract whichgives the buyer/holder of the contract the right (but not theobligation) to buy/sell the underlying asset at apredetermined price within or at end of a specified period

The buyer / holder of the option purchases the right fromthe seller/writer for a consideration which is called thepremium

The seller/writer of an option is obligated to settle the

option as per the terms of the contract when thebuyer/holder exercises his right

An Option to buy is called Call option and option to sell iscalled Put option

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Types Of Options

On the basis of payoff structures

Call option

A call gives the holder the right to buy an asset at a certainprice within a specific period of time.

Put option

A put gives the holder the right to sell an asset at a certain pricewithin a specific period of time.

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Types Of Options

On the basis of exercise options

American options

Can be exercised at any time between the date of purchase and

the expiration date.Mostly American options are exercised at the time of maturity.But when the underlying makes cash payments during the lifeof option, early exercise can be worthwhile.

European options

Can only be exercised at the end of their lives

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Types Of Options

On the basis of versatility

Vanilla Option

A normal option with no special or unusual features

Exotic Option

A type of option that differs from common American or

European options in terms of the underlying asset or thecalculation of how or when the investor receives a certain

payoff.

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Foreign exchange derivatives A foreign exchange derivative is a financial derivative whose

payoff depends on the foreign exchange rate(s) of two (or

more) currencies. These instruments are commonly used for

currency speculation and arbitrage or for hedging foreignexchange risk.

Instruments:

Currency Options

Currency Futures

Currency Swap

Forward


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Currency Swap Currency Swap is an agreement between two parties of two

countries for exchanging of principle and interest of loan at itspresent value. This swap is very useful for controlling foreignexchange risk. Interest rate swap is different from currencyswap, because in interest rate swap, we just exchange the interestfrom fixed to floating rates but in currency swap, we both

principle and interest of loan is exchanged from one party toanother party for mutual benefits.

Structure:

Exchange only the principal with the counterparty at a specifiedpoint in the future at a rate agreed now.

Equivalent to forward or future contract

Commonly used for longer term

Also called FX- Swap


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Currency Swap

Combine the exchange of loan principal with an interest rate

swap

As each party effectively borrows on the other's behalf, this

type of swap is also known as a back-to-back loan

Swap only interest payment cash flows on loans of the same

size and term

Ex: Exchange of fixed-rate US dollar interest payments for

floating-rate interest payments in Euro

Also called as cross currency swap


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Example 1 Suppose one USA company wants to start his factory in

India. For this it gets $10 billion dollar in the form ofloan from USA market and Exchanges this amountfrom India company B. Now company A has Indiancurrency for doing business in India and company B

which is Indian company has USA currency and itcan get Forex earning. It means that both arebenefited with single deal of currency swap.


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Example 2 Suppose a U.S. MNC wants to finance a 10,000,000

expansion of a British plant.l) They could borrow dollars in the U.S. where they

are well known and exchange for dollars for pounds.

2) They could borrow pounds in the international

bond market, but pay a premium since they are notas well known abroad.


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Example Contd If they can find a British MNC with a mirror image

financing need they may both benefit from a swap.

If the spot exchange rate is S0($/) = $1.60/, the U.S.firm needs to find a British firm wanting to financedollar borrowing in the amount of $16,000,000.


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Example 2 Contd

Interest rate forBorrowing Dollar

Interest rate forBorrowing Euro

Firm A (Subsidiary of

US based in UK)

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Firm B (Subsidiary ofUK Based in US)

8 7


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Currency Futures

Currency Futures is a standardised foreign exchange derivative

contract traded on a recognized stock exchange to buy or sell

one currency against another on a specified future date, at a

price specified on the date of contract, but does not include a

forward contract.

Currency Futures are permitted in US Dollar Indian Rupee

(USD INR), EuroRupee (EUR INR), Great Britain Pound

Indian Rupee (GBP INR) and Japanese Yen

Indian Rupee(JPY INR).


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Settlement in future contractTime Action Cash Flow

MondayMorning

Investor buys SFr futurecontract that matures in 2 days.Price is $0.75.

None

Close of the day Future price rises to $0.755.Position is marked to market.

Investor receives125,000*(0.755-0.75)= $625

Tuesday close Future price drops to $0.752Position is marked to market

Investor pays125,000*(0.755-0.752)

=$375

Wednesday close Future price drops to $0.74.1) Contract is marked to

market.2) Investor takes delivery of SFr

125,000.

1)Investor pays125,000*(0.752-0.74)=$15002) Investor pays $92,[email protected]


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Advantages of Currency Futures

Low Commission

Cut Out the Middleman

Standardised Lot Size

Low Transaction Cost Almost Instantaneous Transactions

Low Margins, High Leverage

Online Access

No Insider Trading


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Currency Option

A currency option is a contract that allows the buyer the rightbut not the obligation to buy or sell the underlying at a stated

date and at a stated price. A call option gives the right to buy

and put option gives the right to sell. In every currency

transaction, one currency is bought and another sold.

Options are either call or put options


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Strike Price Terminology

The type of option and the relationship between the spotprice of the underlying asset and the strike price of the optiondetermine whether an option is in-the-money, at-the-moneyor out-of-the-money.

Exercising an in-the-money call or in-the-money put willresult in a payoff. Neither a call nor put that is at-the-moneywill produce a payoff.

Call Option Put Option

In-the-Money Spot > Strike Spot < Strike

At-the-Money Spot = Strike Spot = Strike

Out-of-the-Money Spot < Strike Spot > Strike


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Buying a call Option US Importer has Euro 62,500 payment to make to a

German exporter in 60 days. The importer purchased a calloption to have it delivered at a specific strike rate on duedate.

Option premium= $0.02/Euro

Strike price= $1.25

Total option premium paid by Importer= $12501) On Due date Euro rises; Spot rate = $1.30

Option is In the Money; Importersprofit=62,500*0.05=$3125

Net profit= 3125-1250= $18752) On Due date Euro declines; Spot rate= $1.20

Option is Out of Money; So the importer would let theoption expire & purchase in the spot market.


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Buying a Put option Strike Price= $1.25

Option Premium= $0.021) On Due date Euro rises; Spot rate = $1.30

Option is Out of Money; So the Investor would let theoption expire & sell in the spot market.

2) On Due date Euro declines; Spot rate= $1.20

Option is In the Money; Investorsprofit=62,500*0.05=$3125

Net profit= 3125-1250= $1875


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What is Equity Derivative ?

a financial instrument referencing an underlyingequity asset or other variable, from which the financialinstruments price or value is derived, entered into by

the parties for a purpose

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The Financial instrument

OTC derivatives : Swap, Forward, Option

Structured products : Note, Certificate,Warrant, Fund unit

Exchange traded products : Future, option, one of

the structured products

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The underlying equity asset

share or a basket of shares

ONGC, RIL, TCS, Infosys etc.

an index or basket of indices

NIFTY, Mini NIFTY, Bank NIFTY etc.

a variable linked to theseDVRs

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Price of the financial instrument

the change in the price level of the underlying asset over aperiod of time

the relative price level of different underlying assets over aperiod of time

the total return on single or multiple underlying assets over aperiod of time

Different Formulae

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Purpose of parties to enter

monetizing an existing shareholding

a corporate finance strategy

building up a stake prior to a M&A

hedging

tax advantage

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Types of Traders

Hedgers Traders who want to avoid an exposure to adverse movements

in the price of an asset

Eg; Consider an investor, in September, owns 500 ITC shares.Current share price = Rs.260. The investor is concerned thatthe share price may decline sharply in the current month and

wants protection. The investor could buy September putoption to sell 500 shares for a strike price of Rs.255. Assumingthe lot size to be 100 shares per lot and quoted option price beRs.4, the total cost of hedging strategy would be 5x4x100 =Rs.2000.

Ensured value of holding : Rs.255x500 2000 = Rs.125500


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Speculators

Traders who wish to take a position in the marketby betting that the price of the equity will go up or

go down.Eg; Investor has Rs.130000.

Strategy Rs.250 Rs.275

Buy shares -5000 7500

Buy call options 130000 487500


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Terminology Expiration date Strike prices Option series Intrinsic value

Call option : max (S-X,0) Put option :max (X-S,0)

Flex option : Traders on the floor agree to nonstandard terms Position limits : maximum number of option contracts that a

trader can hold on one side of the market Exercise limits : maximum number of the contracts that can be

exercised by any individual Basis risk : (Spot price of the underlying asset) (Future price of

the underlying asset)


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Option and future clearing corporations

It guarantees that option/future writers will fulfill theirobligations under the terms of the contract


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Commodity Derivatives Defined

Derivative contracts where underlying assets arecommodities.

If the underlying asset of the derivative contract is

Precious metals (e.g Gold, Silver etc)

Other metals (e.g tin, copper, lead etc)

Agro products (e.g coffee, wheat , pepper & cotton)

Energy products (e.g crude oil)

then the derivative is known as commodity derivative.

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Why one trades in commodities ??

A potato producer could purchase potato futures on acommodity exchange to lock in a price for a sale of aspecified amount of potato at a future date, while at

the same time a speculator could buy and sell potatofutures with the hope of profiting from future changesin potato prices.

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Commodity Derivatives- History

Trading in such derivatives started so as to protect the farmers from therisk of the value of their crop going below the cost price of their produce.

The first 'futures' contracts can be traced to the Yodoya rice market inOsaka, Japan around 1650.

The first organized exchange, the Chicago Board of Trade(CBOT) withstandardized contracts on various commodities was established in 1848.

In 1874, the Chicago produce exchange which is now the ChicagoMercantile Exchange(CME) was established.

CBOT & CME are the two largest exchanges in the world.

People speculate in the direction of prices hoping to gain if the price

movement is in their favour. Derivatives trading started in oilseeds in Bombay (1900), raw jute and jute

goods in Calcutta (1912), wheat in Hajipur (1913) and in Bullion in Bombay(1920)

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The Indian Context

A revolution in Commodity derivatives and riskmanagement

Commodity options banned in India between 1952 and

2002 Commodity market began from 2003 onwards

Almost all stock exchanges have commodity marketsegments apart from 3 national level electronic

exchanges.Almost Eighty commodities are in the list now

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After Independence The Parliament passed Forward Contracts (Regulation) Act, 1952 The Act envisages three-tier regulation:

The Exchange which organizes forward trading in commodities canregulate trading on a day-to-day basis;

the Forward Markets Commission provides regulatory oversightunder the powers delegated to it by the central Government, and

the Central Government - Department of Consumer Affairs,Ministry of Consumer Affairs, Food and Public Distribution is theultimate regulatory authority.

In 1960s, following several years of severe draughts that forced

many farmers to default on forward contracts (and even causedsome suicides), forward trading was banned in manycommodities considered primary or essential.

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Policy Shift Kabra Committee

Government set up a Committeein 1993 to examine the role offutures trading. The KabraCommittee recommendedallowing futures trading in 17commodity groups.

It recommended certainamendments to ForwardContracts (Regulation) Act 1952,particularly allowing optionstrading in goods and registrationof brokers with Forward MarketsCommission.

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After Effect

The Government acceptedmost of theserecommendations andfutures trading was permittedin all recommended

commodities. Derivatives do perform a role

in risk management led thegovernment to change itsstance.

Liberalization facilitatesmarket forces to act freely The next decade is being

touted as the decade ofcommodities.

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Comm. Exchange Hierarchy (India)

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Example On June 8 a company knows that it will need to

purchase 20,000 barrels of crude oil at some time inOctober or November. Oil future contracts are traded

for delivery on NYMEX every month, and the contractsize is 1000 barrels. The company therefore takes along position in 20 contracts and decides to use theDecember position. The futures price on June 8 us$18.00 per barrel. The company finds that it is ready topurchase the crude oil on November 10. It thereforecloses out its futures contract on that date. The spotprice & future price on November 10 are $20.00 perbarrel & $19.10 per barrel.


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Example continued Thus the gain on the futures contract is 19.10 -18.00 =

$1.10 per barrel.

The effective price paid is the final spot price less thegain on the futures or 20.00 1.10 = $18.90

Thus the total price received = 18.90 * 20,000 =$378,000


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Bond Derivatives

Bond futures

Bond options

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Bond Futures

An agreement whereby the short position agrees to deliver pre-specified bonds to the long at a set price and within a certain time

window.

Its typicallytraded on an exchange and the underlying bond is"standardized".

Futures price is set in such a way that no cash changes hands when acontract is entered into.

Bond futures are often very liquid instruments, which gives the user the

certainty that he can establish and unwind positions easily and cheaply.

The contract is used for hedging, speculation, and arbitrage byprotection against movements in the cash market for governmentbonds by taking an opposite position in the futures market.

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Bond Options An option to buy or sell a bond at a certain price on or before the

option expiry date.

These instruments are typically traded OTC.

European bond option: at a certain date in future for apredetermined price.

American bond option: on or before a certain date in future for apredetermined price.

Generally, one buys a call option on the bond if one believes thatinterest rates will fall, causing an increase in bond prices.Likewise, one buys the put option if one believes that theopposite will be the case.

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Bond Option (contd..)

A call bond option hedges that the value of a bond will increase at afuture date. If the price > strike price => bond option is valued at a premium

If the price < strike price => bond option is valued at a discount

The exact opposite would be true for a put bond option.

Why It Matters:Bond options provide investors with a tool for hedging interest rate

fluctuations.

For instance, an investor who believes that interest rates are going todrop in the future may purchase a call bond option on an underlyingbond for which the yield is higher than the current interest rate level.

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Number of ETD traded worldwide

Source: World Federation of Exchanges 49


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Growth rate by product type

Equity derivatives:14% growth

Interest rate derivatives:

Continued to grow in 2011 (+9%)

Did not recoup from their highest level reached in 2007

Currency derivatives:

Highest growth rate across all products in 2011 (+24%).

Overcame the commodity derivatives market in terms of number oftraded contracts as of 2011

Commodity derivatives:34% decrease in volumes on mainland Chinese exchanges caused a global6% decrease in commodity derivatives in 2011

+24% when excluding mainland Chinese exchanges

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Growth rate by region

25 billion Exchange Traded Derivatives (ETD) contracts

13 billion options and 12 billion futures

+12% in 2011 (+26% in 2010)

Higher growth rate than on cash markets

Asia-Pacific growth rate was lower (+10%)

than in Americas and EAME (+13%)

Growth rate of Indian market is 32%

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Facts about Indian derivative market

Korea accounted for 42% of derivatives traded across the Asia-Pacificregion in the first half of 2011, while those changing hands in Indianexchanges accounted for 32 %, the association said. Chinas exchangesmade up 16 %

Growing demand for commodity futures contracts in China and Indiawill help the worlds biggest consumers of raw materials to eventuallyovertake Korea as the regions top derivatives exchange

Contracts traded on the four Indian derivatives exchanges more than

doubled to 1.36 billion in the first half of 2010, compared with 542.4million a year earlier, according to the associations data

The growth in the currency derivative market was primarily driven bycurrency options being traded on NSE. 24% growth rate of which 18%

came from NSE 52


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Source: World Federation of Exchanges53


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Source: World Federation of Exchanges 54


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Source: World Federation of Exchanges55


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Thank You.

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