Latest Ck-Derivatives Final2

Derivative Instruments
Overview of derivatives markets Introduction
The emergence of the market for derivative products, most notably forwards, futures and options can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However by locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash How situation of risk-averse investors. The growth in trading of financial options and futures began subse uent to !hicago Board of Trade"s #$%& organization of !hicago Board of 'ptions ()change *!B'(+ to trade standardized option contracts on individual stocks. The success of this market contributed to the growth of other options and futures to the point that many of the most popular contracts are now traded on several different e)changes and in volumes e)ceeding those of the underlying securities themselves. The term ,derivative, indicates that it has no independent value, i.e. its value is entirely derived from the value of one or more basic variables called bases *underlying asset, inde), or reference rate+. The underlying asset can be e uity, -'.(/, commodity, or any other asset. -or e)ample a wheat fanner may wish to sell his harvest at a future date to eliminate the risk of a change in prices by that date. 0uch a transaction is an e)ample of derivative, the price of this derivative is driven by the spot price of wheat which is the ,underlying,.
1erivatives are meant essentially to facilitate temporary hedging of price risk of inventory holding or a financial 2 commercial transaction over a certain period. 3n practice every derivative ,contract ,has a fi)ed e)piration date, mostly in the range of & to #4 months form the date of commencement of the contract. 3n the market"s idiom, they are ,risk management tools,. 3n order to illustrate the use of this risk hedging techni ue we may take the e)ample of a processor of manufacturer, for whom ma5or source of risk is the fluctuation in the market price of his main raw material. -or instance, a maker of gold 5ewellery may have accepted an e)port order to he delivered over three months. 3f, in the meanwhile the cash price of gold *the raw material+ rises, the 5ewellery manufacturer"s e)port order may become unviable. The availability of gold futures alleviates the manufacturer-e)porter"s problem. He can buy gold futures. Any loss caused by rise in cash price of gold purchased for the e)port order will he offset by profit on futures contract. Any e)tra profit on account of fall in cash price of gold will be offset by losses in the futures contract. Thus, hedging is like insurance against risk form market price variation. The manufacturer-e)porter in the e)ample above could, of course, have bought all the gold re uired in advance but that would have entailed heavy interest, insurance and storage costs. This, the futures contract offers a cost efficient and convenient way for hedging against price risk. Apart from the risk of variation of gold prices the above manufacturer-e)porter, also faces the risk form variation of e)change rate. 3f rupee appreciates before he is able to bring e)port proceeds into 3ndia, his rupee receipts would be reduced. He may hedge against such currency risk also.
Derivatives defined
1erivative is a product whose value is derived from the value of one or more basic variables, called bases *underlying asset, inde), or reference rate+, in a contractual manner. The underlying asset can be ( uity, -ore), !ommodity or any other asset. -or e)ample, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. 0uch a transaction is an e)ample of a derivative. The price of this derivative is driven by the spot price of wheat which is the 6underlying7. 3n the 3ndian conte)t the 0ecurities !ontracts *.egulation+ Act, #$89 *0!*.+ A+ defines derivative to includei+ A security derived form a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. ii+ A contract, which derives its value from the prices, or inde) of prices, of underlying securities. 1erivatives are securities under the 0!*.+ A and hence trading of derivatives is governed by the regulatory framework under the 0!*.+ A.
&
Classification
1erivative products can be classified into basically these ma5or types: Forwards A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today"s pro-agreed price.
Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price- -utures contracts are special types of forward contracts in the sense that the former are standardized e)change traded contracts,
Forward Rate Agreements A forward rate agreement is a simple derivative which is used when an institution is e)posed to a single period interest rate risk. 3t allows the forward fi)ing of interest rates. 0imply put it is a forward contract on interest rates.
Swaps 0waps are private agreements between two parties to e)change cash flows in the future according to a pre-arranged formula. They can be regarded as series of forward contracts. Two commonly used types of swaps are: Interest Rate Swaps: these entail swapping only the interest related cash flows between me parties in the same currency. Currency Swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
Derivative Instruments Options An option gives the buyer or holder of the option the right to do something- usually to buy or sell an underlying at a previously agreed price at a given point in future, without the concomitant obligation to do so. 3n other words, a holder of an option has the right to buy or sell an underlying without the obligation. These derivatives can also be classified on the basis of their characteristics into the following categories:
Over the Counter and E change ! "raded Derivatives

1erivatives on the basis of their characteristics can also be classified as 'T! and ()change Traded products. 'T! products are customized products, which are written across the counter or struck on telephone, fa), or e-mail or nay other mode of communication by financial institutions to suit the need of their customers. These products are fle)ible, since almost any situation can be hedged for the right price. However, the cost may be slightly e)pensive and li uidity limited compared to an e)change traded product. Typical 'T! products are forward and -.As. ()change traded products are those, which are traded '< the floor of a physical e)change. The most distinguishing feature of such products is standardization in terms of various characteristics, like . uantity, and uality of the underlying, the start and e)piry dates of the contract, payment and settlement mechanisms etc. 0uch standardization facilitates the participation of a large number of market players, which ensures the high li uidity of such instruments. !onse uently, they are less e)pensive in comparison to e)change traded products. -utures are the principal form of e)change-traded derivatives. 0waps and options are available both as 'T! and e)change traded derivatives.
'T! 1erivatives
()change Traded 1erivatives
Traded on a private basis and bilaterally Traded on the floor of an e)change through negotiated open cry or electronically. <o standard specifications. !ustomized to 0tandardized and widely published
needs of individual customers specifications. =rices ate less transparent. >ay be higher =rices are transparent and easily available. than for comparative e)change traded Highly li uid other. >arket players not known to each other. =layers need not have a high credit standing and anyone who can post margin money can participate in the market. =ositions transferred. >a5ority of contracts lead to physical delivery @ery few contracts lead to physical delivery. cannot be easily closed or =ositions can easily be closed out. contracts ?ess li uid >arket players
known
to
each
players need to be highly creditworthy.
Indian Derivatives #ar$et
0tarting from a controlled economy, 3ndia has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in 3ndia gained momentum in the last few years due to liberalization process and .eserve Bank of 3ndiaAs *.B3+ efforts in creating currency forward market. 1erivatives are an integral part of liberalization process to manage risk. <0( gauging the market re uirements initiated the process of setting up derivative markets in 3ndia. 3n Buly #$$$, derivatives trading commenced in 3ndia Chronology of instruments #$$# #; 1ecember #$$8 #C <ovember #$$9 ?iberalisation process initiated <0( asked 0(B3 for permission to trade inde) futures. 0(B3 setup ?.!.Dupta !ommittee to draft a policy framework for inde) futures. ## >ay #$$C % Buly #$$$ ?.!.Dupta !ommittee submitted report. .B3 gave permission for 'T! forward rate agreements *-.As+ and interest rate swaps. 4; >ay 4EEE 48 >ay 4EEE $ Bune 4EEE #4 Bune 4EEE 4 Bune 4EE# 03>(/ chose <ifty for trading futures and options on an 3ndian inde). 0(B3 gave permission to <0( and B0( to do inde) futures trading. Trading of B0( 0ense) futures commenced at B0(. Trading of <ifty futures commenced at <0(. 3ndividual 0tock 'ptions F 1erivatives
%eed for derivatives in India today
3n less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in ma5or part of the world. Gntil the advent of <0(, the 3ndian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investorsA aspirations of the markets and the available means of trading. The opening of 3ndian economy has precipitated the process of integration of 3ndiaAs financial markets with the international financial markets. 3ntroduction of risk management instruments in 3ndia has gained momentum in last few years thanks to .eserve Bank of 3ndiaAs efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.
#yths and realities a&out derivatives
3n less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. -inancial derivatives came into the spotlight along with the rise in uncertainty of post-#$%E, when G0 announced an end to the Bretton Hoods 0ystem of fi)ed e)change rates leading to introduction of currency derivatives followed by other innovations including stock inde) futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in ma5or parts of the world. There are many myths about derivatives but the realities that are different especially for ()change traded derivatives, which are well regulated with all the safety mechanisms in place.
'hat are these myths &ehind derivatives( 1erivatives increase speculation and do not serve any economic purpose
C
Derivative Instruments 3ndian >arket is not ready for derivative trading 1isasters prove that derivatives are very risky and highly leveraged instruments 1erivatives are comple) and e)otic instruments that 3ndian investors will find difficulty in understanding 3s the e)isting capital market safer than 1erivativesI
Derivatives increase speculation and do not serve any economic purpose Hhile the fact is... <umerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. 1erivatives are a low-cost, effective method for users to hedge and manage their e)posures to interest rates, commodity prices, or e)change rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the comple)ity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. ?ooking at the e uity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock inde) futures and options. An e uity fund, for e)ample, can reduce its e)posure to the stock market uickly and at a relatively low cost without selling off part of its e uity assets by using stock inde) futures or inde) options.
By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in
$
Derivative Instruments the global economy, lowering the cost of capital formation and stimulating economic growth. <ow that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market li uidity and efficiency and facilitating the flow of trade and finance. Indian #ar$et is not ready for derivative trading Hhile the fact is... 'ften the argument put forth against derivatives trading is that the 3ndian capital market is not ready for derivatives trading. Here, we look into the pre-re uisites, which are needed for the introduction of derivatives and how 3ndian market fares:
=.(-.(JG303T(0 ?arge market !apitalisation
3<13A< 0!(<A.3' 3ndia is one of the largest market-capitalized countries in
#E
Derivative Instruments Asia with a market capitalisation of more than .s.%98EEE High ?i uidity in the underlying crores. The daily average traded volume in 3ndian capital market today is around %8EE crores. Hhich means on an average every month #;K of the countryAs >arket capitalisation gets traded. These are clear indicators of high li uidity in Trade guarantee the underlying. The first clearing corporation guaranteeing trades has become fully functional from Buly #$$9 in the form of <ational 0ecurities !learing !orporation *<0!!?+. <0!!? is responsible for guaranteeing all open positions on the <ational 0tock ()change *<0(+ for which it does A 0trong 1epository the clearing. <ational 0ecurities 1epositories ?imited *<01?+ which started functioning in the year #$$% has revolutionalised A Dood legal guardian the security settlement in our country. 3n the 3nstitution of 0(B3 *0ecurities and ()change Board of 3ndia+ today the 3ndian capital market en5oys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
Disasters prove that derivatives are very ris$y and highly leveraged instruments Hhile the fact is... 1isasters can take place in any system. The #$$4 0ecurity scam is a case in point. 1isasters are not necessarily due to dealing in derivatives, but derivatives make
##
Derivative Instruments headlines... Here 3 have tried to e)plain some of the important issues involved in disasters related to derivatives. !areful observation will tell us that these disasters have occurred due to lack of internal controls and2or outright fraud either by the employees or promoters. )arings Collapse #. 4&& year old British bank goes bankrupt on 49th -ebruary #$$8 4. 1ownfall attributed to a single trader, 4C year old <icholas ?eeson &. ?oss arose due to large e)posure to the Bapanese futures market ;. ?eeson, chief trader for Barings futures in 0ingapore, takes huge position in inde) futures of <ikkei 448 8. >arket falls by more than #8K in the first two months of A$8 and Barings suffers huge losses 9. Bank looses L#.& billion from derivative trading %. ?oss wipes out the entire e uity capital of Barings The reasons for the collapse: ?eeson was supposed to be arbitraging between 'saka 0ecurities ()change and 03>(/ -- a risk less strategy, while in truth it was an unhedged position. ?eeson was heading both settlement and trading desk -- at most other banks the functions are segregated, this helped ?eeson to cover his losses -- ?eeson was unsupervised. ?ack of independent risk management unit, again a deviation from prudential norms. There were no proper internal control mechanisms leading to the discrepancies going unnoticed M 3nternal audit report which warned of ,e)cessive concentration of power in ?eesonAs hands, was ignored by the top management. The conclusion as summarised by Hall 0treet Bournal article 6Bank of (ngland officials said they did not regard the problem in this case as one peculiar to derivatives. 3n
#4
Derivative Instruments a case where a trader is taking unauthorised positions, they said, the real uestion is the strength of an investment housesA internal controls and the e)ternal monitoring done by ()changes and .egulators. , #etallgesellschaft #. >etallgesellshaft *>D+ -- a hedge that went bad to the tune of L#.& billion DermanyAs #;th largest industrial group nearly goes bankrupt from losses suffered through its American subsidiary - >D.> 4. >D.> offered long term contracts to supply #CE million barrels of oil products to its clients -- commitments were uite large, e uivalent to C8 days of NuwaitAs oil output &. >D.> created a hedge position for these long term contracts with short term futures market through rolling hedge --, As there was no viable long term contracts available ;. !ompany was e)posed to basis risk -- risk of short term oil prices temporarily deviating from long term prices. 8. 3n #$$&, oil prices crashed, leading to billion dollars of margin call to be met in cash. The !ompany was faced with temporary funds crunch. 9. <ew management team decides to li uidate the remaining contracts, leading to a loss of #.& billion. %. ?i uidation has been criticised, as the losses could have decreased over time. AuditorsA report claims that the losses were caused by the size of the trading e)posure. .easons for the losses: The transactions carried out by the company were mainly 'T! in nature and hence lacked transparency and risk management system employed by a derivative e)change ?arge e)posure Temporary funds crunch
#&
Derivative Instruments ?ack of matching long-term contracts, which necessitated the company to use rolling short term hedge -- problem arising from the hedging strategy Basis risk leading to short term loss
Derivatives are comple and e otic instruments that Indian investors will have difficulty in understanding Hhile the fact is... Trading in standard derivatives such as forwards, futures and options is already prevalent in 3ndia and has a long history. .eserve Bank of 3ndia allows forward trading in .upee-1ollar forward contracts, which has become a li uid market. .eserve Bank of 3ndia also allows !ross !urrency options trading. -orward >arkets !ommission has allowed trading in !ommodity -orwards on !ommodities ()changes, which are, called -utures in international markets. !ommodities futures in 3ndia are available in turmeric, black pepper, coffee, Dur *5aggery+, hessian, castor seed oil etc. There are plans to set up commodities futures e)changes in 0oya bean oil as also in !otton. 3nternational markets have also been allowed *dollar denominated contracts+ in certain commodities. .eserve Bank of 3ndia also allows, the users to hedge their portfolios through derivatives e)changes abroad. 1etailed guidelines have been prescribed by the .B3 for the purpose of getting approvals to hedge the userAs e)posure in international markets.
1erivatives in commodities markets have a long history. The first commodity futures e)change was set up in #C%8 in >umbai under the aegis of Bombay !otton Traders Association *1r.A.0.<aik, #$9C, !hairman, -orwards >arkets !ommission, 3ndia, #$9&-9C+. A clearinghouse for clearing and settlement of these trades was set up in #$#C. 3n oilseeds, a futures market was established in #$EE. Hheat futures market began in Hapur in #$#&. -utures market in raw 5ute was set up in !alcutta in #$#4. Bullion
#;
Derivative Instruments futures market was set up in >umbai in #$4E. History and e)istence of markets along with setting up of new markets prove that the concept of derivatives is not alien to 3ndia. 3n commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign e)change markets. Dovernment of 3ndia has also been facilitating the setting up and operations of these markets in 3ndia by providing approvals and defining appropriate regulatory frameworks for their operations. Approval for new e)changes in last si) months by the Dovernment of 3ndia also indicates that Dovernment of 3ndia does not consider this type of trading to be harmful albeit within proper regulatory framework. This amply proves that the concept of options and futures has been well ingrained in the 3ndian e uities market for a long time and is not alien as it is made out to be. (ven today, comple) strategies of options are being traded in many e)changes which are called te5i-mandi, 5ota-phatak, bhav-bhav at different places in 3ndia *@ohra and Bagari,#$$C+ 3n that sense, the derivatives are not new to 3ndia and are also currently prevalent in various markets including e uities markets. Is the e isting capital mar$et safer than Derivatives( Hhile the fact is... Horld over, the spot markets in e uities are operated on a principle of rolling settlement. 3n this kind of trading, if you trade on a particular day *T+, you have to settle these trades on the third working day from the date of trading *TO&+. -utures market allow you to trade for a period of say # month or & months and allow you to net the transaction taken place during the period for the settlement at the end of the period. 3n 3ndia, most of the stock e)changes allow the participants to trade during one-week period for settlement in the following week. The trades are netted for the settlement for the entire one-week period. 3n that sense, the 3ndian markets are already operating the futures style settlement rather than cash markets prevalent internationally.
#8
3n this system, additionally, many e)changes also allow the forward trading called badla in Du5arati and !ontango in (nglish, which was prevalent in GN. This system is prevalent currently in -rance in their monthly settlement markets. 3t allowed one to even further increase the time to settle for almost & months under the earlier regulations. This way, a curious mi) of futures style settlement with facility to carry the settlement obligations forward creates discrepancies. The more efficient way from the regulatory perspective will be to separate out the derivatives from the cash market i.e. introduce rolling settlement in all e)changes and at the same time allow futures and options to trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more fle)ibility to the market participants. 3n addition, the e)isting system although futures style, does not ask for any margins from the clients. Diven the volatility of the e uities market in 3ndia, this system has become uite prone to systemic collapse. This was evident in the >0 0hoes scandal. At the time of default taking place on the B0(, the defaulting member of the B0( >r.Paveri had a position close to .s.#C crores. However, due to the default, B0( had to stop trading for a period of three days. At the same time, the Barings Bank failed on 0ingapore >onetary ()change *03>(/+ for the e)posure of more than G0 L 4E billion *more than .s.C;,EEE crore+ with a loss of appro)imately G0 L $EE million * around .s.&,CEE crore+. Although, the e)posure was so high and even the loss was also very big compared to the total e)posure on >0 0hoes for B0( of .s.#C crores, the 03>(/ had taken so much margins that they did not stop trading for a single minute.
Comparison of %ew System with E isting System

>any people and brokers in 3ndia think that the new system of -utures F 'ptions and banning of Badla is disadvantageous and introduced early, but 3 feel that this new system is very useful especially to retail investors. 3t increases the no of options investors for investment. 3n fact it should have been introduced much before and <0( had approved it
#9
Derivative Instruments but was not active because of politicization in 0(B3. "he figure * ! + shows how advantages of new system *implemented from Bune 4EE#+ v2s the old system i.e. before Bune 4EE# %ew System ,s E isting System for #ar$et -layers Figure * Speculators
E isting
S.S"E#
%ew
Approach /-ri0e #+ 1eliver based Trading, margin tradingF carry forward transactions. 4+ Buy 3nde) -utures hold till e)piry. Advantages
-eril /-ri0e
Approach
-eril
#+ Both profit F loss to e)tent of price change.
#+ Buy F0ell stocks on delivery basis 4+ Buy !all F=ut by paying premium
#+ >a)imum loss possible to premium paid
Dreater ?everage as to pay only the premium. Dreater variety of strike price options at a given time. Figure 1 Ar&itrageurs
#%
E isting
S.S"E#
%ew
Approach /-ri0e #+ Buying 0tocks in one and selling in another e)change. forward transactions. 4+ 3f -uture !ontract more or less than -air price
-eril /-ri0e
Approach
-eril
#+ >ake money whichever way the >arket moves.
#+ B Droup more promising as still
#+ .isk free game.
in weekly settlement 4+ !ash F!arry arbitrage continues
-air =rice Q !ash =rice O !ost of !arry.
Figure 2 3edgers
#C
E isting
S.S"E#
%ew
Approach /-ri0e #+ 1ifficult to offload holding during adverse market conditions as circuit filters limit to curtail losses.
-eril /-ri0e
Approach
-eril
#+ <o ?everage available risk reward dependant on market prices
#+ -i) price today to latter by paying premium. 4+ -or ?ong, buy AT> =ut 'ption. 3f market goes up, long position benefit else e)ercise the option. &+ 0ell deep 'T> call option with underlying shares, earn
#+ Additional cost is only premium.
premium O profit with increase price Advantages Availability of ?everage
Figure +
#$
Derivative Instruments Small Investors
E isting
S.S"E#
%ew
Approach /-ri0e #+ 3f Bullish buy stocks else sell it.
-eril /-ri0e
Approach
-eril
#+ =lain Buy20ell implies unlimited profit2loss.
#+ Buy !all2=ut options based on market outlook 4+ Hedge position if holding underlying stock
#+ 1ownside remains protected F upside unlimited.
Advantages
?osses =rotected.
Symmetric and Asymmetric Derivatives
4E
1erivatives such as forwards, futures and swaps have linear2 symmetric pay off profiles, highlighting the fact that both the buyer and seller of these products have e ual rights and obligations. The pay offs are a linear function of the price of the underlying. -A. OFF OF 4I%EAR CO%"RAC"S
Buyer"s pay off
Profit
0pot price of Gnderlying
?oss
Seller's Pay-off
-A.!OFF OF A CA44 O-"IO%
Buyer"s call option

Profi t
?oss
Seller's call option
0ince the rights and obligations are skewed in the favour of buyer to the detriment of the seller, the latter is compensated upfront, by way of a fee known as option premium. The pay-offs to the buyer and seller is not linear vis-R-vis the price of the underlying.
4#
5rowth in Derivatives: Contri&uting factors

The ma5or factors that have contributed to the e)plosive growth of derivatives are:
Increased ,olatility in the 'orld Economy: 3n the #$%Es and #$CEs, the financial and commodity asset prices became uite
volatile. This was due to a variety of factors such as the breakdown of the Brettonwoods 0ystem of fi)ed e)change rates, the oil price shocks in #$%# and #$%&, e)cess government spending and inflation policies. These apart, the e)ponential rise in the magnitude of world trade and capital flows aided by progressive dismantling of tariff harrier, coupled with lifting of e)change controls in several countries have also contributed to the increased volatility in the world economy. !onse uently, the need to insulate income streams in different currencies from the ma5or risks, namely the interest rate risk and e)change rate risk became a prime concern for all economic agents in the international field
"echnological Changes Technological changes have arisen from advances on two fronts: physical
e uipment and finance theory. 3n the former, advancements in communication and computer technologies have ushered in the ,information age, transforming the world into a ,global village,. Hith the advent of cheaper communications, real time access to information has become a reality leading to increased volatility in interest and e)change rates, as market players factor such news into their e)pectations. !oncurrently, financial innovations like 4; hour global trading and online risk management systems have been put in place. 'n the latter, breakthroughs in modem finance theory have allowed institutions to create new instruments and better understand the dynamic management of financial risks. 'ne such breakthrough for instance is the celebrated Black-0choles model which is used to price and hedge options.
44
Increasing -rofessionalism among #ar$et!players -rom the #$%Es onward, risk management as a separate science came to the fore
bringing about increasing professionalism amongst market players. The use of science and maths in con5unction with increased computing power triggered the birth of financial engineering as a profession. A financial engineer by definition is one who structures tailor made solutions to mitigate the uni ue and specific financial risks faced by the clients.
4&
-articipants
1erivative !ontracts have several variants- The most common variants arc forwards, futures, options and swaps. There are three broad categories of participants in the derivative market: *6 3edgers: Hedgers face risk associated with the price of an asset. They use derivatives to reduce or eliminate this risk. 16 Speculators: 0peculators wish to bet on future movements in the price of an asset. -utures and options contracts can give them an e)tra leverageS that is they can increase both the potential losses and gains in a speculative venture. 26 Ar&itrageurs: Arbitrageurs are in business to take advantage of a discrepancy in prices in two markets. 3f, for e)ample they see the futures prices of an asset getting out of line with the cash price, they will take offsetting positions in two markets to lock in a profit.
4;
Forwards
6A forward contract is a bilateral contract in which the Buyer and seller agree upon the delivery of an asset or a financial instrument at a future date at a predetermined price. -orward contracts are typical 'ver the !ounter *'T!+ derivatives. As the name itself suggests, forwards are transactions involving delivery of an asset or financial instrument at a future date. 'ne of the first modem forward contracts was agreed at !hicago Board of Trade in >arch #C8# for maize corn to be delivered in Bune. Characteristics The main characteristics of forward contracts are: They are 'T! contracts Both the buyer and seller are committed to the contract. 3n other words, they have to take delivery and deliver respectively, the underlying asset on which the forward contract was entered into. As such, they do not have any discretion as regards completion of the contract. -orwards are price fi)ing in nature- Both the buyer and seller of a forward contract are locked at the price decided upon. -or e)ample if an e)porter has proposed to sell one G0 dollar to a bank , one month forward at Rs ;&.%8, he has to sell at the same rate to the bank on delivery date irrespective of the fact what the market rate is. 3f the market rate is .s ;&.8E the e)porter stands to gain .s E.48. on the other hand if the market price is .s ;; the e)porter stands to lose .s E.48. in both the circumstances the bank as well as the e)porter arc bound to take delivery and deliver irrespective of whether they stand to lose or gain. Because of the bilateral nature of the contract, a forward carries high counterparty or credit risk. !onse uently forward contracts are agreed to between parties who have good credit standing. Hence, forward contracts are not available to the
48
Derivative Instruments common man.
However forward contracts in certain markets have become very standardized, as in the case of foreign e)change, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. -orward contracts are very useful in hedging and speculation. The classic hedging application would be that of an e)porter who e)pects to receive payment in dollars three months later. He is e)posed to the risk of e)change rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. 0imilarly an importer who is re uired to make a payment in dollars two months hence can reduce his e)posure to e)change rate fluctuations by buying dollars forward. 3f a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. 0peculators may well be re uired to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator. 4imitations of forward mar$ets -orward markets world-wide are afflicted by several problems: ?ack of centralization of trading 3lli uidity, and !ounter party risk 3n the first two of these, the basic problem is that of too much fle)ibility and generality. The forward market is like a real estate market in that any two consenting
49
Derivative Instruments adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts nontradable. !ounterparty risk arises from the possibility of default by any one party to the transaction. Hhen one of the two sides to the transaction declares bankruptcy, the other suffers. (ven when for-ward markets trade standardized contracts, and hence avoid the problem of illi uidity, still the counterparty risk remains a very serious issue.
4%
Futures
6A futures contract can simplistically be defined as an agreement to Buy or sell an asset at a certain time in future at a certain price. A more comprehensive definition of a futures contract would be that futures are firm financial agreements to buy or sell a standardized quantity of an underlying commodity / instrument, at a pre established price agreed on a regulated e change at a specified future date.
-utures have evolved out of forwards and are e)change traded versions of forward contracts. They are one of the most popular and widely used derivatives instruments.
-utures Trade on an organized e)change 0tandardized contract terms Hence more li uid .e uires margin payments "ypes of Futures Contracts
-orwards 'T! in nature !ustomised contract terms Hence less li uid <o margin payment
1epending on the underlying upon which futures are constructed and traded, there arc four ma5or typesS Commodity futures are those in which the underlying asset is a commodity. 3t can be agricultural commodity like wheat corn, soybeans or a perishable commodity like fruits or even a precious metal like gold, silver etc. Financial futures are those where the underlying assets arc financial instruments like money market paper, T-bill, notes, bonds etc.
4C
Derivative Instruments Currency futures are those in which the underlying assets are ma5or convertible currencies like G.0 1ollar, the =ound 0terling, the (uro and the Ten. Index futures are those in which the underlying asset is an inde). >ost, but not all of these contracts are on stock indices. Characteristics of Futures Contracts The essential features of a Futures contract are: !ontract between two parties through a e)change ()change is the legal counterparty to both parties =rice decided today Juantity decided today * uantities have to he in standard denominations specified by e)change+ Juality decided today * uality should be as per the specifications decided by the e)change+ Tick size *i.e. the minimum amount by which the price uoted can change+ 1elivery takes place sometime in future *e)piry dale is specified by the e)change+ >argin payable by both parties to the e)change.
Functions of a future mar$et -rice discovery =rice discovery is the revealing of information about future cash market prices through the futures market. There is a high degree of correlation between the futures prices and the price that people e)pect to prevail for the underlying at the delivery date specified in the futures contract. By using the information contained in the futures prices today, market observers can form estimates about the price of underlying at a certain time in future.
4$
Derivative Instruments 3edging -utures contract arc used either as hedging or trading instruments. !orporate treasurers can use interest rate contract rates to mange interest rate risk. Banks, -inancial 3nstitutions and individuals may use futures contracts as trading instruments.
-ricing
3t is fundamentally the same to buy a futures contract as it is to buy the underlying and borrow the money to do so, 4ong futures 7 long underlying 8 &orrowing cash ?ikewise it is fundamentally the same to sell futures as it is to sell the underlying and invest the proceeds of the sale in the money market Short futures 7 short underlying 8 lending cash -ricing: E pectation "heory There are many school of thoughts used to price a -utures contract, the e)pectation theory is one of them. The theory says that only e)pectations drive the -utures price. 3n the e)pectation hypothesis view, futures prices are forecast of subse uent *e)pected+ cash prices. 'n an average, the predictions are not biased toward either a consistent positive or negative return.
Thus, the e)pected profit to cither position of a futures contract e uals zero. But supply-and-demand factors could cause the futures to be consistently under or overpriced relative to its true value. This means that the hypothesis that -utures should always be more than the cash price may not hold true if one looks at the e)pectation theory. ()pectation theory can be best merged and e)plained through hedging theory using the e)ample of commodity futures. 3n the normal - backwardation situation, hedgers are typically producers that will take short positions to deliver the commodity in the future at a guaranteed price, and speculators are at the long side of the contract. Therefore, futures .prices must be under-priced relative to their true value to encourage speculators
&E
Derivative Instruments to buy futures *if net short-hedging e)ceeds net long-speculation+. This theory suggests that the futures price will bid down to a level below the e)pected spot price, and will rise over the life of the contract until the maturity date. Therefore futures prices must be overpriced relative to their true value to encourage speculators to buy futures *if net long-hedging e)ceeds net short-speculation+. Advantages of futures There are certain obvious advantages in using futures as hedging instruments: Absence of !redit .isk Being an e)change-traded product, the clearing house of the e)change takes the credit risk in respect of all transactions. High ?i uidity High ?everage
Disadvantages of Futures 4ess versatile Being a standardized product it cannot customized. Single -eriod 3edging -roduct 1ue to very nature of futures products, they can be used for hedging only single period risk
&#
Forward Rate Agreement 9FRA:

-orward .ate Agreement *-.A+ is a forward contract on interest rates between two parties, typically a bank on one hand and borrower on the other. -.A as name itself suggests, involves one party2 bank uoting to the other a rate of interest form a future date to a further future date. 3t is written on a notional principal and cash settled on the basis of difference between contract rate and prevailing reference date on the settlement date. The resultant settlement is discounted to ad5ust for an upfront settlement. -.As can be used to lock in a future borrowing or lending re uirement *e.g. need to borrow money for & months, in two months time or have an e)isting loan rolling over. 3t is to be noted that -.A is not a commitment to enter into a loan or deposit 5ust a contract for differences. The customer can use advantageous moves in interest rates to lock in borrowing cost *or return on deposits+ prior to the loan or deposit becoming due. As only interest differential is settled the underlying loan or deposit does not have to be entered into if cash flow forecasts change.
Strategy The -.As are uoted as interest rates, but the terminology used is buy 2 sell. 3f a borrower wants to protect himself against upward movement of rates he can buy -.A, A depositor would want to protect himself against lower rates, so he would sell an -.A. Features The broad features of an -.A can be summed up as under:
&4
Derivative Instruments Traded in the 'T! market. Available in all convertible currencies. =rincipal not e)changed. 'nly interest differential is paid or received on the notional principal on the settlement day. 3nterest rates applied is usually ?3B'.. -rom end discounted payment.
Advantages The principal advantages of -.As over other methods of hedging interest rate risk are: -.As are much simpler to administer when compared to futures since there is no re uirement for margins. !an be customized as they are 'ver the !ounter products !redit .isk is limited to interest variation level based on principal and not the full principal amount. As there is no fee involved in -.A, the instrument represents a highly leveraged method of taking a view on future interest rates. Disadvantages -.As have the following disadvantages also: As -.As are 'T! products, their secondary market li uidity is limited. (ven the limited credit risk is not there for futures as the clearing house assumes it.
&&
Swaps
A contract between two parties, referred to as counter parties, to e)change two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. 0waps contracts also include other provisional specified by the counter parties. 0waps are not debt instrument to raise capital, but a tool used for financial management. 0waps are arranged in many different currencies and different periods of time. G0L swaps are most common followed by Bapanese yen, sterling and 1eutsche marks. The length of past swaps transacted has ranged from 4 to 48 years. 'hy did swaps emerge( 3n the late #$%E"s, the first currency swap was engineered to circumvent the currency control imposed in the GN. A ta) was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to e)pand its foreign operations without paying sizeable penalty. >oreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-to-back loans were used to e)change debts in different currencies. -or e)ample, a British company wanting to raise capital in the -rance would raise the capital in the GN and e)change its obligations with a -rench company, which was in a reciprocal position. Though this type of arrangement was providing relief from e)isting protections, one could imagine, the task of locating companies with matching needs was uite
&;
Derivative Instruments difficult in as much as the cost of such transactions was high. 3n addition, back-to-back loans re uired drafting multiple loan agreements to state respective loan obligations with clarity. However this type of arrangement lead to development of more sophisticated swap market of today.
Swaps -ricing: There are four ma5or components of a swap price. Benchmark price ?i uidity *availability of counter parties to offset the swap+. Transaction cost !redit risk 0wap rates are based on a series of benchmark instruments. They may be uoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. 3n the 3ndian markets the common benchmarks are >3B'., #;, $#, #C4 F &9; day T-bills, != rates and =?. rates. ?i uidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. 3t may be difficult to have counter parties for long duration swaps, specially so in 3ndia Transaction costs include the cost of hedging a swap. 0ay in case of a bank, which has a floating obligation of $# days T. Bill. <ow in order to hedge the bank would go long on a $# day T. Bill. -or doing so the bank must obtain funds. The transaction cost would thus involve such a difference. Tield on $# day T. Bill - $.8K !ost of fund *e.g: - .epo rate+ M #EK
&8
Derivative Instruments The transaction cost in this case would involve E.8K !redit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. 0ay for e.g. it would be E.8K for an AAA rating.
"he needs of the players and how currency swaps help meet these needs "o manage the e change rate ris$ 0ince the international trade implies returns and payments in a variety of currencies whose relative values may fluctuate it involves taking foreign e)change risk. The players mentioned above are facing this risk. A key uestion facing the players then is whether these e)change risks are so large as to affect their business. A related uestion is what, if any, special strategies should be followed to reduce the impact of foreign e)change risk. 'ne-way to minimize the long-term risk of one currency being worth more or less in the future is to offset the particular cash flow stream with an opposite flow in the same currency. The currency swap helps to achieve this without raising new fundsS instead it changes e)isting cash flows. "o lower financing cost !urrency swaps can be used to reduce the cost of loan. The following e)ample deals with such a case. !onsider two 3ndian corporates A F B. !orporate A is an e)porter with a rupee loan at #;K fi)ed rate. B has a dollar loan at ?3B'. O E.48K floating rate. 1ue to difference in the credit rating of the two companies, the rates at which the loans are
&9
Derivative Instruments available to them are different. A has access to #;K rupee loan and dollar loan at ?3B'. O E.48K. A would like to convert its rupee loan into a dollar loan, to reverse its revenue in dollars and B would like to convert the dollar loan into a fi)ed rupee loan thus crystallizing its cost of borrowing. They can enter into a swap and reduce the cost compared to what it would have been if they had taken a direct loan in the desired currencies.
Comparative advantage !ompany A ()porter 'ptions: Borrow rupee at #&K Borrow dollars at ?3B'. O#EE bps !ompany B 'ptions: Borrow rupee at #;.8K Borrow dollars at ?3B'. O4EE bps
!ompany A has an absolute advantage over B in both the markets2 rates. The advantage in terms of rupee funds is #8E bps while it is #EE bps in case of dollar rates. Thus B has a comparative advantage in terms of dollar rates. <ow as A is an e)porter he would be more interested in a dollar denominated loan to offset his future receivables. Therefore it would be advantageous if A would borrow at rupee rates and B borrows at ?3B'. rates. Then they may go in for a currency swap. The net gain arising out of such a swap will be 8E bps, which may be shared between the parties. The swap will thus result in A paying B a floating rate of ?3B'. O %8 bps in return for a #&K fi)ed rupee rate. The swap will take place on a notional principal basis. The effective cost for A is ?3B'. O %8 bps and for B it is #;.48K. The effective cost for
&%
Derivative Instruments A is #4.%8K. This results into a net saving of 48 bps for both the parties. ?3B'. O%8 bps !ompany A #4.%8K in 3<. !ompany B
#&K in 3<.
?ibor O4EE bps
&C
"o access restricted mar$ets >any countries have restrictions on the type of borrowers that can raise funds in their bond markets. -oe e)ample an 3ndian firm e)porting goods to Bapan may wish to issue bonds in yen to form a natural hedge by reversing their cash flows. To issue a yen bond, the borrower must ualify for a single A credit rating. 3f the company does not ualify in this regard it would fail to issue yen denominated bond. By issuing bonds in the rupee market and then entering into a currency swap, the firm can meet its e)pectation of raising a yen denominated loan. Swaps for reducing the cost of &orrowing Hith the introduction of rupee derivatives the 3ndian corporates can attempt to reduce their cost of borrowing and thereby add value. A typical 3ndian case would be a corporate with a high fi)ed rate obligation. (g. >ehta ?td. an AAA rated corporate, & years back had raised ;-year funds at a fi)ed rate of #C.8K. Today a &9;-day T. bill is yielding #E.48K, as the interest rates have come down. The &-month >3B'. is uoting at #EK.-i)ed to floating # year swaps are trading at 8E bps over the &9;-day T. bill vs 9-month >3B'..The treasurer is of the view that the average >3B'. shall remain below #C.8K for the ne)t one year. The firm can thus benefit by entering into an interest rate fi)ed for floating swap, whereby it makes floating payments at >3B'. and receives fi)ed payments at 8E bps over a &9; day treasury yield i.e. #E.48 O E.8E Q #E.%8 K.
&$
Derivative Instruments -i)ed #E.%8 >ehta ?td & >onths >3B'. !ounter =arty
#C.%8Ks The effective cost for >ehta ?td. Q #C.8 O >3B'. - #E.%8 Q %.%8 O >3B'.
>3B'.
At the present &m >3B'. at #EK, the effective cost is Q #E O %.%8 Q #%.%8K The gain for the firm is *#C.8 - #%.%8+ Q E.%8 K The risks involved for the firm are 1efault2 credit risk of counterparty. This may be ignored, as the counterparty is a bank. This risk involves losses to the e)tent of the interest rate differential between fi)ed and floating rate payments. The firm is faced with the risk that the >3B'. goes beyond #E.%8K. Any rise beyond #E.%8K will raise the cost of funds for the firm. Therefore it is very essential that the firm hold a strong view that >3B'. shall remain below #E.%8K. This will re uire continuous monitoring on the path of the firm.
;E
Options
Introduction to options 3n this section, we look at the ne)t derivative product to be traded on the <0(, namely options. 'ptions are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to e)ercise this right. 3n contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Hhereas it costs nothing *e)cept margin re uirements+ to enter into a futures contract, the purchase of an option re uires an upMfront payment. 3istory of options Although options have e)isted for a long time, they were traded 'T!, without much knowledge of valuation. Today e)change-traded options are actively traded on stocks, stock inde)es, foreign currencies and futures contracts. The first trading in options began in (urope and the G0 as early as the eighteenth century. 3t was only in the early #$EEs that a group of firms set up what was known as the put and call Brokers and 1ealers Association with the aim of providing a mechanism for bringing buyers and sellers together. 3f someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. 3f no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. -irst, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. 3t was in #$%&, that Black, >erton and 0choles invented the famed Black 0choles formula. 3n April #$%&, !B'( was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early ACEs, the number of shares underlying the option contract sold each day e)ceeded the daily volume of shares traded on the <T0(. 0ince then, there has been no looking back.
;#
Derivative Instruments Option "erminology Inde options: These options have the inde) as the underlying. 0ome options are (uropean while others are American. ?ike inde) futures contracts, inde) options contracts are also cash settled. Stoc$ options: 0tock options are options on individual stocks. 'ptions currently trade on over 8EE stocks in the Gnited 0tates. A contract gives the holder the right to buy or sell shares at the specified price. )uyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to e)ercise his option on the seller2writer. 'riter of an option: The writer of a call2put option is the one who receives the option premium and is thereby obliged to sell2buy the asset if the buyer e)ercises on him. There are two basic types of options, call options and put options. !all option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. "ut option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: 'ption price is the price which the option buyer pays to the option seller. E piration date: The date specified in the options contract is known as the e)piration date, the e)ercise date, the strike date or the maturity. Stri$e price: The price specified in the options contract is known as the strike price or the e)ercise price. American options: American options are options that can be e)ercised at any time upto the e)piration date. >ost e)change-traded options are American. European options: (uropean options are options that can be e)ercised only on the e)piration date itself. (uropean options are easier to analyze than American options, and properties of an American option are fre uently deduced from those of its (uropean counterpart. In!the!money option: An in-the-money *3T>+ option is an option that would lead to a positive cash flow to the holder if it were e)ercised immediately. A call option on
;4
Derivative Instruments the inde) is said to be in-the-money when the current inde) stands at a level higher than the strike price *i.e. spot price U strike price+. 3f the inde) is much higher than the strike price, the call is said to be deep 3T>. 3n the case of a put, the put is 3T> if the inde) is below the strike price. At!the!money option: An at-the-money *AT>+ option is an option that would lead to zero cash flow if it were e)ercised immediately. An option on the inde) is at-themoney when the current inde) e uals the strike price *i.e. spot price Q strike price+.V Out!of!the!money option: An out-of-the-money *'T>+ option is an option that would lead to a negative cash flow it it were e)ercised immediately. A call option on the inde) is out-of- the-money when the current inde) stands at a level which is less than the strike price *i.e. spot price W strike price+. 3f the inde) is much lower than the strike price, the call is said to be deep 'T>. 3n the case of a put, the put is 'T> if the inde) is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is 3T>, if it is 3T>. 3f the call is 'T>, its intrinsic value is zero. =utting it another way, the intrinsic value of a call is<X= which means the intrinsic value of a call is >a) YE, *0t M N+Z which means the intrinsic value of a call is the *0t M N+. 0imilarly, the intrinsic value of a put is >a) YE, *N -0t +Z ,i.e. the greater of E or *N - 0t +. N is the strike price and 0t is the spot price. "ime value of an option: The time value of an option is the difference between its premium and its intrinsic value. A call that is 'T> or AT> has only time value. Gsually, the ma)imum time value e)ists when the option is AT>. The longer the time to e)piration, the greater is a callAs time value, all else e ual. At e)piration, a call should have no time value.
;&
Distinction &etween futures and options

-utures ()change traded, with novation ()change defines the product =rice is zero, strike price moves =rice is zero ?inear payoff Both long and short at risk 'ptions 0ame as futures. 0ame as futures. 0trike price is fi)ed, price moves. =rice is always positive. <onlinear payoff. 'nly short at risk.
Advantages An option contract protects the buyer against movement of asset prices in one direction at a price* premium, fee paid+ but at the same leaves him free to secure the profit arising from movement of prices in the other direction. 'ption products are particularly useful to customers with contingent liabilities. Banks, -inancial 3nstitutions, and investors can also use currency options as a tool to manage their foreign currency assets and liabilities. ,alue of an Option @alue of an option is made up of two components 3ntrinsic @alue: 3ntrinsic @alue represents the amount by which the option is in the money i.e. the value that can be realised if the option is e)ercised immediately. Time or ()trinsic @alue: Time @alue of an 'ption is the amount the buyers are willing to pay over and above the intrinsic value in anticipation that over the time 'ption @alue will increase. -actors which effect time value are: !urrent price of underlying asset 0trike price Time to e)piration @olatility of the underlying .isk free interest rate
;;
Derivative Instruments !ash flows e)pected during the life of the option
Option -ricing
)lac$!Scholes Option -ricing "heory -actors taken into account Time to e)piration 0trike price @alue of underlying 3mplied volatility !urrent price Historic volatility data
.isk-free interest rate
Assumptions =rice of underlying log normally distributed <atural log of variables is normally distributed <o transaction costs or ta)es >arkets trade continuously *no sudden 5umps in market price+ .isk-free rate is constant and the same for all securities The Black 0choles formula for prices at time zero of a (uropean option on a nondividend paying stock are: ! Q 0<*d#+ M /e-rT <*d4+ = Q /e-rT <*-d4+- 0<*-d#+ Hhere Hhere, d# Q Y ln s2) O*rO[424+T Z2 [ \T 0 Q 0pot price t # time to e)piration Q volatility
;8
And d4 Q d# M[\T
/Q 0trike price r # risk free 2re uired rate of return
Derivative Instruments % 9dl: Q !umulative standard normal distribution function
Option Strategies
Strategies Involving a Single Option and Stoc$ Covered Call This is a combination of long position in -ore) and short position in call option. The long position in fore) protects or "covers" the investor from the payoff on the short call than would arise if the fore) rate rises sharply.
;9
0T Q ()change .ate N - 0trike =rice Derivative Instruments
;%
-rotective -ut
This involves buying a put option and also the underlying.
0T -()change .ate N - 0trike =rice
Spreads
A spread trading strategy involves taking a position in two more options of the same type *two or more calls or two or more puts+
;C
)ull Spreads
'ne of the most popular types of spread is a bull spread. 3t can be created by buying a call option with a strike price and sell another call on the same underlying with a higher strike price. Both options have the same e)piration date. The strategy is illustrated in the figure below. The profits from two option positions taken separately arc shown with
dotted lines. The profit from the whole strategy is the sum of profits given by dashed lines, indicated by the continuous line. Because the call price always decreases as strike price increases, the value of option sold is less than the value of option bought. A bull spread, when created from calls therefore re uires an initial investment.
N#
- 0trike =rice for the !all 'ption Bought
N4 - 0trike =rice for the !all 'ption 0old
)ear Spread An investor who enters into a bull spread is hoping that the prices would rise. By contrast, an investor who enters into a bear spread is hoping that the prices would decline. A bear spread can be
;$
Derivative Instruments created by buying a call at one strike price and simultaneously selling another call with another strike price. The strike price of option
purchased is greater than the stock option sold. A bear spread created from call options involves an initial cash flow, because the price of call sold is higher than the call purchased. Assume that strike prices are N# and N4. 3f cash price is higher than Ns the payoff is negative at - *N4 M N#+. 3f cash price is less than N# the pay off is zero. 3f the cash price is between the two strike prices then the pay off is - * 0T M N#+. The profit is calculated by adding the initial cash flow to the payoff.
Com&inations
8E
Derivative Instruments A combination is an option trading strategy that involves taking a position in both calls and puts on the same underlying.
Straddles
'ne popular combination is a straddle, which involves buying a call and put with the same strike price an e)piration date- The profit pattern is represented in the diagram below.
The strike price is denoted as N. 3f cash price is close to this strike price at the time of e)piration, the straddle leads to a loss. However if there is a sufficiently large movement in either direction, a -significant profit would be made. A straddle is appropriate when an investor is e)pecting a large move in price but does not know the direction of the move. 0traddle seems to be a natural trading strategy when a big 5ump in the price is e)pected.
8#
Derivatives instruments
Strangles 3n strangle, sometimes called bottom vertical combination, an investor buys a put and call with same e)piration date but different strike prices. The profit obtained is depicted below:
The call strike price, N4 is higher than the put strike price N#. A strangle is a similar strategy to straddle. The investor is betting that there will be a large price move but is uncertain whether it will be an increase or decrease. The strike price has to move farther in a strangle than in a straddle to make a profit. However the downside risk is less in a strangle if the cash price ends up at a central value. The profit pattern of a strangle depends on how further apart are the two strike prices. The farther they are the less the down side risk and the farther the prices have to move to make a profit.
84
Ris$ #anagement
1erivatives, which have come into e)istence as risk management tools, are in turn, ironically sources of various risks.
Credit Ris$
!redit .isk is the conventional counterparty risk i.e a counter party may not fulfill its obligation on the appointed day. !redit risk in case of derivatives may he divided into presettlement and settlement risk -re!settlement .isk is the risk associated before the settlement dayS which can be two types !urrent !redit ()posure and =otential credit e)posure Current Credit E posure crystallizes in the event a counterparty defaults before the settlement day. The amount of credit loss is determined by cost of replacing the contract. -otential Credit e posure ! A derivative product may be an asset or liability depending on the market prices. This e)posure is nebulous, and a function of residual term to maturity, e)pected volatility of the price, rate or inde) underlying the contract. Settlement Ris$ is the credit e)posure on the settlement date, which e uals the full value of any cash flow or securities the institution is due to receive. #easurement Hhile current credit e)posure is e ual to the replacement value of the contract, measure of potential credit e)posure is very difficult considering the fact that it involves predicting *the future movements of market prices of underlying and other related variables- ?ess sophisticated users measure this risk by applying a fi)ed percentage to the outstanding derivative notional principal amounts. 'n the hand large and sophisticated derivative participants measure through simulation and other techni ues. #anagement !redit risk generically can be managed through use of credit limits or lines for counterparties, use of various credit enhancements like collateral or third party guarantees.
8&
#ar$et Ris$
The market risk is basically price risk of all types which mainly includes interest rate risk, fore) risk, commodity prices and e uity prices depending on the type of derivative used. >arket risk arises out of changes in the level or volatility of market prices. #easurement The measurement of market risk is increasing done through @alue at .isk approach. 3t essentially involves revaluing of derivative e)posures on a daily basis. #anagement >anagement of market risk has become e)tremely crucial in the management of derivative portfolio because, of the increased volatility in financial markets. The management of market risk in an institution essentially involves establishing limits for market risk, in respect of all counterparties besides having various limits like intra day, overnight, and stop loss.
4i;uidity Ris$
?i uidity risk is of two types in the conte)t of derivatives, Specific 4i;uidity Ris$ - This relates to the lack of li uidity in specific products or markets. An institution cannot unwind easily or offset a particular at or near the previous market prices due to shallow markets or disruptions in the market place. 5eneral 4i;uidity Ris$ -This risk relates to general funding of derivative activities. 3n other words, an institution would he unable to meet its payment obligations on settlement day or in *the event of margin calls, due to drying up of li uidity in the overall markets. #easurement and #anagement ?i uidity risk can he uantified by preparing the li uidity ladder for the institution is a whole, while mitigation is essentially through its funding 2 li uidity plans.
8;
Operational Ris$s
'perational risk refers to the risk arising due to inade uate systems and procedures. internal control, computer failures or frauds by employees. #easurement 3t can be evaluated by e)amining a series of worst case scenarios or what-if analysis in various circumstances like failure of power loss, -ailure of computers, etc. 3n case of options, one important operational risk is the model risk. This refers to the risk in using a particular model which may lead to inappropriate pricing of options.
4egal Ris$
This refers to the risk that a derivative contract may be unenforceable due to defective documentation or due to various losses or any other lacunae. ?egal risk came into sharp focus in #$$E in the case of Hammersmith and -ulham. ?egal risk is sought to be mitigated through use of standard international documentation, besides taking the advice of legal counsel in case of slightest doubt.
88
Derivatives instruments <sing inde futures There are eight basic modes of trading on the inde) futures market 3edging 3* ?ong stock, short <ifty futures 31 0hort stock, long <ifty futures 32 Have portfolio, short <ifty futures 3+ Have funds, long <ifty futures Speculation S* Bullish inde), long <ifty futures S1 Bearish inde), short <ifty futures Ar&itrage A* Have funds, lend them to the market A1 Have securities, lend them to the market
89
Derivatives instruments <sing inde options There are potentially innumerable ways of trading on the inde) options market. However we shall look at eight basic modes of trading on the inde) futures market: 3edging 3= Have portfolio, buy puts Speculation S2 Bullish inde), buy <ifty calls or sell <ifty puts S+ Bearish inde), sell <ifty calls or buy <ifty puts S= Anticipate volatility, buy a call and a put at same strike S> Bull spreads, Buy a call and sell another S? Bear spreads, 0ell a call and buy another Ar&itrage A2 =ut-call parity with spot-options arbitrage A+ Arbitrage beyond option price bounds
8%
E;uity Derivatives and #utual Funds

E;uity Derivatives ( uity derivatives were introduced in 3ndia in Bune 4EEE. 3t initially started with inde) futures, followed by inde) options in Bune 4EE# and stock options in Buly 4EE#. The last to come to the scene were stock options in <ovember 4EE#. The volumes in the derivatives market took a big leap when stock futures were introduced. 3ncidentally, stock futures were introduced in 3ndia before they were introduced on some e)changes in the G0. The growth in the volumes at <0( was from an average daily turnover of .s. #8 bn in 4EE4 to .s. 9E bn in 4EE&, .s. #EE bn in 4EE; and .s. #48 bn in 4EE8. There have been days when the derivatives market volumes had three times cash market volumes. !hart # shows the growth of the e uity derivatives market volume at <0( in the last five years and compares it with the cash market volume. The e uity derivative instruments generally used are, 3nde) -utures 0tock -utures 3nde) 'ptions 0tock 'ptions
#utual Funds >utual fund as an industry has really come a long way since its inception in 3ndia in #$9&. The assets under management have increased from a modest .s. 9%,EEE mn in #$CC to .s. ;%E,E;E mn in #$$&. Hhen private players were allowed in this segment, a great deal of fund deployment, innovations and increased participation happened in this segment. On Buly &#, 4EE8 the total assets under management touched $s. %,;E4,%9E mn with a total of #,99% schemes managed by &# asset management companies.
All these facts indicate one thing, i.e., 3ndia is uickly becoming an economy where money would be more and more institutionalized. !urrently, the ma5or avenues of investment for
8C
Derivatives instruments these institutions are debt and e uities markets. The debt markets are less volatile, when compared with e uities. 0o, a lot of focus and energies are being invested in managing these volatilities and benefiting from them. 'ne of the effective methods of managing risk and e)ploiting the benefits in the e uity markets is by using e uity derivative instruments.
#utual Funds and E;uity Derivatives >utual funds can use derivatives for the following purposes, within the restraints of the regulations. a. Hedging b. =ortfolio .ebalancing c. Arbitrage d. Gsing 'ptions
Changing 5ears The regulatory environment for mutual funds saw a paradigm shift on 0eptember #;, 4EE8. The erstwhile highly regulated environment gave way to a much more liberal system for the use of derivatives. The main idea behind this change is to bring mutual funds at parity with -oreign 3nstitutional 3nvestors *-33s+ as far as the limits for using derivatives are concerned, thus, creating a level playing field. Table # provides a more comprehensive picture,
Table *: !hanges in 0ebi Duidelines 03 no #. Area of !hange Hedging =reviously <ow
The 0ebi guidelines relating to 0hort positions *short futures, long this were that mutual funds puts short calls+ should not e)ceed could not take position more the notional value of the mutual than that of the beta-ad5usted fundAs holding of stock value of tile portfolio. 0o, if one ?ong position *long futures , short has a portfolio of .s.#E mn and
8$
Derivatives instruments the beta of the portfolio is #.4, puts and long calls + should not the ma)imum e)tent of position e)ceed the notional value of one can take would be worth mutual funds holdings in cash, g.s#4 mn. in case of futures, this sec, T-bills etc. was the ma)imum e)tent of futures worth they could go short and in case of puts this was the 4. =ortfolio .ebalancing ma)imum e)posure amount The stock should be available in The previous guideline now stands the derivatives market at lower suppressed. 3n case of stocks value than cash market and in where the market wide limit is less case of options the amount than .s 48E cr, mutual fund invested in a stock would be position can be 4EK of the market calculated based on the notional wide position. However, in case of value. Thus , while calculating stocks where the market wide limit the limit of having a stock in a is more than .s 48E cr, mutual portfolio the amount considered fund positionsall be more than .s &. Gse of 3nde) -utures and 'ptions would be the notional value. 8E cr They were not allowed to use it A mutual fund can have position in e)cept for hedging inde) options and inde) futures each to the tune of .s 48E cr or #8K of the total open interest whichever is higher per stock ;. =osition limit for each scheme e)change. There were no rules related to Higher of # K of the free float this previously. market capitalization * in terms of shares+ or 8K of open interest in terms of derivatives contract on a particular contracts+ 3f one looks at points 4 and &, it is clear that the changed rules would infuse a great deal of funds into the e uity derivative markets. -or e)ample, on 0eptember #;, 4EE8, the inde)
9E
stock
*in
terms
of
Derivatives instruments futures" open interest was around Rs6 9,;EE cr, so as per the changed guidelines each mutual fund can take position worth .s. 48E cr or .s. $9E cr *#8K of .s. 9,;EE cr+, whichever is higher. This gives an idea regarding the e)tent of volume increase that the markets shall be e)periencing. This would lead to lower impact cost and better price discoveries. Also, mutual funds shall come up with specific schemes on derivatives only. 3ow Can "hey )enefit( A million-dollar uestion that needs to be answered is how the funds can benefit themselves using derivatives. Here is the answer: 3edging Hedging means to take offsetting position so as to manage the losses that may be incurred on the e)isting position2portfolio. 3t is basically creating a defense against financial loss. Hedging against the e)isting portfolio using derivatives can be done mainly in two ways by mutual funds]selling inde) futures or buying puts. The idea behind this is to keep the <A@ of the mutual funds intact or least affected in the wake of some unfavorable events. However, hedging in case of mutual funds against their portfolio is very important, looking at the highly volatile nature of the market. Also, with the integration of global economies, the unfavorable events of other economies can hurt the e)isting portfolio. The previous ma5or stock market falls like that of >ay #%, 4EE; proved that the traditional methods of portfolio risk management like portfolio diversification had been ineffective. The institutions sheepishly saw their portfolio values melt on such occasions. The following e)ample e)plains how going short on <ifty would be a better way to hedge risk.
0uppose a mutual fund has a diversified portfolio worth .s. 48E mn on April 9, 4EE8 The portfolio consists of various sectors and frontline stocks within those sectors. However, at times of corporate declared results, election, etc., the market sentiments can turn negative, affecting the whole portfolio. This is e)actly what happened on >ay #%, 4EE;. >utual funds could have shorted <ifty futures in order to hedge their portfolio, against the downside risk -or this one should know the portfolio beta, which is E.C$ in this case *see Table 4+. 0o, one needs to take the position of hedge to the e)tent of .s. 44,48,EE,EEE. The <ifty levels on
9#
Derivatives instruments >ay 9, 4EE8 were around 4E8E, so one can short around #,#EE contracts of <ifty Y44,48,EE,EEE2 *4E8E^#EE+Z. The cost of hedging *margin payable O transaction costs+ would have been around ##-#4K of the portfolio amount. -ortfolio Re&alancing =ortfolio rebalancing means to shift positions to some other stock or to some other instrument of the same stock. The reasons behind it can be varied and many. 3f some other stock is giving better returns, then the fund may switch position to that counter. Also, if some e)isting counter is available cheaper in, the" derivatives market, it can also resort to the same. The idea behind it is to keep the cost of managing portfolio lower and thus enhance # the <A@s.
=ortfolio rebalancing can be 3 done in three ways: )uying at lower price using futures6 3n case of futures, if some stock is trading at a discount *i.e., the price in the futures market is lower than the price in the cash market+, then a fund can buy it from the futures market rather than the cash market. The limitation in this case would be that mutual funds would not get the benefit of dividends or any other corporate action.
-or e)ample, on 0eptember $, 4EE8 the price of Bharti in cash market was Rs6 &&# while in the futures market it was uoting at .s. &4C. 3f a mutual fund wants to take position in Bharti, they can buy it in futures market, thus getting a discount of around E,$K. The cost of taking this position would be lower as compared to that in cash market as one is re uired to pay the margin money only, which in this case would work out to #9-#%K of the e)posure. Converting cash position to long call 3n case of options, if a stock is trading at an all-time high or any up move from e)isting levels seems dicey, the fund can sell its holding in that stock and replace it and buy calls. Thus, if there is any up move it can benefit out of it and if it doesn"t move as e)pected the risk is only to the tune of the premium paid, which is around &-8K of the value, which would be lesser than the cost of selling the stocks and buying them back later.
94
Derivatives instruments -or e)ample, on Buly 49, 4EE8 0B3< reached .s. %88, which was a new high price at that time. 3f a fund is skeptical about further price movements, it can sell its stake in cash market and replace it by calls. The CEE-strike call of 0B3< e)piring on August 48, 4EE8 was uoting at .s, C. 'n 0eptember ##, 4EE8 the stock reached .s. C4; thus recording gains of .s. 9$, i.e., $K. Along with it, the call price increased to .s. &$, thus gaining .s. &#, i.e., &C%.8K or around four times. 0o, though the returns in absolute terms would be less, returns in percentage terms are much higher. But, the most important thing is that, the mutual fund could see the upward movement with lower risk e)posure.
)eta management 1erivatives can be used for portfolio beta management. The fund can increase its
e)posure to stock or reduce the e)posure to a stock using derivatives and thus manage the beta. Ar&itrage Arbitrage is basically taking opposite positions in two different markets on the same underlying with the same uantity and thus locking in the price difference. This is a market neutral strategy. The gains locked in are risk free. Any movement in the prices from there doesn"t affect the net returns as the losses in position are offset by the gains in another position. 3ow does ar&itrage wor$( 0uppose the futures price of a stock is more than its cash price, the markets are said to be in contango, i.e., the futures are uoting at a premium to cash. Thus, mutual funds can sell the security in futures market and buy it in cash market, by locking certain returns. Denerally, these returns are in the band of C-#4K annualized. As the e)piry approaches, the futures price and cash price tend to converge. This is when one can unwind the position. 3n case one wants to carry forward his position, he can keep the cash position status quo, buy back the near month futures contract and sell the mid-month contract. Thus, he has a similar position like he had in the previous e)piry, ()hibit # provides a better understanding on the same.
0uppose the futures price of stock is less than its cash price, markets are said to be in backwardation *i.e., the futures are uoting at a discount to cash+. Thus, if a fund is having stocks
9&
Derivatives instruments of such counters which are in backwardation, it can sell the stocks in the cash market and buy them in futures. This position shall be similarly unwounded or rolled over as per the market conditions. Arbitrage can be done in various methods: 0ingle 0tock Arbitrage ! Buy !ash - 0ell -utures - Buy -uture - 0ell !ash 3nde) Arbitrage - Buy 3nde) - 0ell 3nde) 0tocks in cash or futures - 0ell 3nde) - Buy 3nde) 0tocks in cash or futures Arbitrage can be done using indices alsoS the only difference is instead of single stock, one would be dealing with a basket of stocks. 0o, a basket of stocks on an inde) would be bought 2 sold in cash2futures and the inde) would be sold2bought. There are certain problems like slippages, basis risk, e)ecution problem, transaction costs, impact costs and stock limits. <sing Options 'ptions are one such tool, which give fle)ibility to take position as per the risk profile and view on the markets. >utual funds can utilize option strategies widely to benefit from the market. -or e)ample, during election results or any such events in corporate or political sphere, the volatilities tend to shoot up. 3n order to benefit from such choppiness in the market, mutual funds can buy straddles or strangles.
'ption writing is one tool, which can be widely used by mutual funds as a source to strengthen its <A@s. 3n case of trending markets they can either write calls2puts depending on whether the markets are bearish 2 bullish. 3n case of non-trending markets, covered call writing can be undertaken. The only limitation being that the option writing is an unlimited risk strategy.
Also, while calculating the net e)posure of a mutual fund on a stock, buying call and selling puts is considered as longS and selling calls and buying puts is considered as short. Thus,
9;
Derivatives instruments it can take position accordingly so that it can take position in more number of shares. Conclusion Thus, net-net one can say that as far as e uity derivatives are concerned mutual funds have really a long way to go. As for the derivatives market, which has .5ust stepped into 3ndia, there are many more things to come. The thing to set eyes on is how these two giants get together to benefit and pass it on to the investors
Case study: ! Allied Irish )an$ @ Currency Derivative Fiasco

Introduction
98
Derivatives instruments 'n -ebruary E9, 4EE4, Allied 3rish Banks *A3B+ revealed that its G0 subsidiary]A3lfirst -inancial 3nc. *Allfirst+ had incurred a loss of G0 L%8E mn in foreign e)change trading operations *.efer ()hibit 3 for information on the A3B Droup+. The losses incurred were Yhe result of fraudulent trading activities of Bohn .usnak *.usnak+, a trader in foreign currency operations at Allfirst.
.usnak"s 5ob was to make arbitrage profits by taking advantage of discrepancies in the price of currencies in the cash, futures and options markets. 1uring the period #$$% to 4EE#, .usnak incurred heavy losses in foreign e)change transactions. However, he was able to successfully conceal these losses by constructing fictitious option trades that offseced those that were genuine. He manipulated bank records and documents and reported false profits. 1ue to the senior management"s carelessness, and lack of knowledge and e)perience in foreign e)change trading, Allfirst finally landed up in a financial mess.
Analysts said that though A3B would be able to bear this loss as it amounted to less than #EK of its e uity capital, it could also make the bank more vulnerable to future takeover attempts. They commented chat this scam had once again sent across a strong message that inade uate risk management control systems and improper supervision of traders" activities could lead to massive financial losses with a negative impact on even the most successful companies. )ac$ground %ote Allied 3rish Banks *A3B+ was formed in #$99 by merging three leading 3rish banks]the =rovincial Bank, the .oyal Bank and the >unster F ?einster Bank. -ounded in #C48. the =rovincial Bank had pioneered the branch banking concept in 3reland, whereas the .oyal Bank, established in #C&9, was famous for its mercantile links. The >unster F ?einster Bank, formed in #CC8, was the largest of the three banks with the most e)tensive branch network. 3n the mid#$9Es, in their efforts to e)pand their operations and seize the emerging opportunities in global markets, the three banks agreed to merge and form A3B. 'ver the decades, A3B became an increasingly global organization. 3t established a branch network in the GN in #$%Es, followed by ma5or investments in the G0 in #$CEs. 3n #$C&, A3B made an initial investment in the e uity of the G0-based -irst >aryland Bancorp *->B+. 3n
99
Derivatives instruments #$C$. A3B purchased #EEK e uity stake in ->B. 3n Buly #$$%, A3B ac uired another G0-based company 1auphin 1eposit !orporation which was later merged with ->B in #$$$ to form Allfirst. Allfirst"s treasury operations were divided into three departments ]Treasury -unds >anagement *T->+S Asset and ?iability >anagement *A?>+S and .isk !ontrol and Treasury 'perations *.!FT'+. (ach of these offices was headed by a 0enior @ice-=resident who reported to the Allfirst treasurer. 3n #$$&, Yhe T-> was headed by Bob .ay *.ay+ and it acted as the front office for Allfirst"s treasury operations. 3t had four ma5or functions]treasury fundingS interest rate risk management investment portfolio managementS and global trading. The global trading division had two managing directors]one responsible for interest rate derivatives and the second .usnak;, promoted as managing director in Bune 4EE#, responsible for foreign e)change trading. The A?> acted as a middle office of Allfirst"s treasury operations. 3t had two vicepresidents and an assistant vice-president responsible for asset and liability management, a vicepresident in charge of financial analysis for the treasury, and a risk control officer. The responsibility for reporting trader"s compliance with Allfirst"s limits on value-at-risk, trading losses and counterparty credit was entrusted to die risk control officer. The .!FT' acted as a back office for processing, confirming, settling and booking the trades e)ecuted by the bank"s foreign e)change and interest rate derivatives trade s. This division also included portfolio operations function and a vice-president in charge of systems and technology, Events 4eading to the 4oss 3n #$C$, Allfirst"s currency trading activities were limited. 3t used to meet the foreign e)change needs of its commercial customers engaged in import2e)port activities, which was essentially a fee-based business and did not entail much risk. 3n #$$E, proprietary trading 8 was started and a new person was recruited for the 5ob. 3n early #$$&, the trader left the Bob and .ay appointed .usnak to the pose. .usnak
9%
Derivatives instruments introduced arbitrage trading in Allnrst. =reviously, Allnrst was engaged in directional spot and forward trading] simple bets that a particular currency would rise or fall, .usnak convinced his seniors that his trading style would enable Allfirst to take advantage of price discrepancies between currency options and currency forwards thereby diversifying the revenue screams arising from simple directional trading. .usnak claimed that he had vast e)perience in foreign e)change option trading and could easily and consistently make money by taking a large option position, and hedging the position in the cash markets. The trading strategy would involve buying options when they were cheaper relative to cash *when the implied volatility of the option is lower than its normal range+, and selling them when they were e)pensive *when the implied volatility is higher than normal+. .usnak was allowed to go ahead with his plans and was kept under the supervision of a trading manager who also supervised proprietary interest rate traders.
.usnak, however, started trading contrary to his arbitrage trading style. He engaged in directional trading involving bets that the market would move in a particular direction. He took positions in currency forwards and foreign e)change options with high deltas *options that were deep in the money and had large premiums+. 1uring #$$%, .usnak, while betting on the movement of Bapanese yen, entered into currency forwards and bought large amount of yen for future delivery. 0ubse uently, the value of yen declined and he incurred huge losses on his forward positions. 3n order to hide his losses and the size of his positions, .usnak engaged into fraudulent activities and created fictitious options.
The modus operandi used by .usnak to e)ploit weaknesses in Allfirst"s control system was a cleverly thought-out one. He simultaneously entered two bogus trades into Allfirst"s trading system. The fictitious options were so designed as to give it the appearance of-fully hedged positions. He claimed #E have sold a "deep-in-the-money" option on yen to a counterparty in Tokyo or 0ingapore, and then purchased an offsetting option from the same purported counterparty. The two options involved the same currency and the same strike price, and would offset
9C
Derivatives instruments each other from a cash standpoint. The first option involved the receipt of a large premiumS and the second Si payment of an identical premium. The only difference in the options was the e)piry date. The option involving the receipt of a premium would e)pire on the same day it was purportedly written, but the other option would e)pire after a month or so. Allfirst did not prepare any reports listing the e)piring one-day options and hence these moves of .usnak did not attract the attention of his supervisors. The surveillance system installed by Allfirst for options did not have the feature of an automatic alert to supervisors if such options were not e)ercised, The inade uate supervision on .usnak meant that no one raised the uestion of how two options with two different e)piration dates could have the same premium and why the "deep-in-the-money" option would e)pire une)ercised by the counterparty. The uitting of the immediate supervisor *the trading manager+ of .usnak in #$$$ and the scrapping of that post due to financial constraints led .usnak to report directly to .ay. Hhile .ay had significant e)perience with interest rate products, he had limited knowledge about foreign e)change. Hence, he devoted less attention to .usnak"s trading activities. 3n order to prevent the back office from detecting bogus trades, .usnak created bogus broker confirmations to validate the trades undertaken by him- =ost-#$$C, he was successful in persuading the back office staff not to seek confirmation for the purported pairs of options. .usnak argued that since there was no need transfer of cash there was no need for confirmation. Hith less back office interference, .usnak ensured that the liability represented by oneday bogus options would not appear on Allfirst"s books, while the other purported une)pired deep-in-the-money option for which Allfirst had supposedly paid a large premium appeared in the books. Thus, Allfirst"s balance sheet reflected that the bank was holding a valuable asset and concealed the losses .usank had accumulated through his directional spot and forward trades. .usnak continued to keep the non e)istent asset in the books by repeatedly rolling it over into new bogus options when the original ones purportedly became due-Hhile .usnak made bogus options to cover up his losses, he also continued to lose money in real spot and forward transactions that he entered into. He entered into prime brokerage agreements with Bank of America and !itibank. According to the agreements, spot foreign e)change transactions between Allfirst and its counterparties were settled with the broker and "rolled" into a forward transaction.
9$
Derivatives instruments Ac the end of each day, all spot foreign e)change trades were swapped into a forward foreign e)change trade between the prime broker and Allfirst. These forward trades were cash settled in dollars at a fi)ed date each month. Hhile prime brokers typically charged full bid-offer pricing on the forward transaction rollovers, they were paid a fee for settlement of foreign e)change spot transactions. These accounts not only enabled .usnak to significantly increase the size and scope of his real trading but also effectively permitted Allfirst to make trades in the prime brokers" names. This in effect made the prime brokers the back office for those trades and .usnak was able to convince his supervisors to allow this setup by arguing that it would eliminate the need for e)tensive back office operations.
The use of prime brokerage accounts helped .usnak increase his trading activity significantly. .usnak"s use of Allfirst"s balance sheet through bogus option positions also increased simultaneously. 3n 4EEE. Allfirst"s treasurer found that while die overall trading income had increased from L9.9 mn to L #&.9 mn, when ad5usted for the cost of funds, it showed an increase of only L#.# mn. 0o he ordered that henceforth the charge for the cost of funds should be reflected in the trading income. By 4EE#, the finance department and the auditors started taking note of the fact chat .usnak"s earnings were inade uate to 5ustify his use of the balance sheet- An in uiry was launched by audit and internal finance department. 0ubse uently, the treasury funds manager directed .usnak to reduce his balance sheet usage. The increasing supervision and control led .usnak to change-his strategy.
0tarting from -ebruary 4EE#, .usnak started to sell real one -year, deep-in-the -money options. The funds raised through these options were used for the monthly settlement of foreign e)change forward transactions. The options *selling yen puts against the dollar+ also reinforced .usnak"s long spot and forward positions in yen- These options were liabilities of Allfirst and were recorded as such in the books. .usnak was able to get these liabilities out of the books by recording bogus option deals which gave the impression that the original options had been repurchased. This activity of .usnak ensured that a large amount of liabilities remained unrecorded in Allfirst"s books.
%E
Derivatives instruments .usnak"s annual bonus was directly related to his net trading profits. He received a bonus e ual to &EK of the net trading profits he generated in e)cess of five times his salary. By constantly manipulating his trading profit figures, .usnak was able to generate a hefty bonus for himself during the "a&le I : Rusna$As Compensation five-year period from #$$% to 4EE# *.efer Table 3 for details about .usnak"s compensation+. 3n Bune 4EE#. .usnak also got promoted to the post of managing director in charge of foreign e)change trading.
Table 3 : .usnak"s !ompensation #$$%-4EE#
Tear #$$% #$$C #$$$ 4EEE 4EE#
0alary L#E4,EEE L#E;,EEE L#E;,EEE L#EC,EEE L##4,EEE
Bonus ------L#4C,#E4 L#44,;;# L%C,EEE L44E,;89
Total L#E4,EEE L4&4,#E4 L449.;;# L#C9,EEE _#C9_E,_ L##4,EEE
0ource: www.aib.ie
3n 1ecember 4EE#, during a checking, the back-office supervisor made an en uiry with
%#
Derivatives instruments an employee responsible for confirming foreign e)change options about two trade rickets that did not have confirmations attached to them. The back office employee said that offsetting trades with the same counterparty did not re uired confirmation. However, the supervisor insisted chat all trades re uired confirmations, regardless of any offset and irrespective of the counterparty. -or the month of 1ecember 4EE#, the foreign e)change trading turnover was reported to be L48 bn. The high turnover drew the attention of Allfirst"s treasurer and he became concerned about .usnak"s trading operations. 3n order to verify .usnak"s trading, he planned to s uare off all .usnak"s trading positions. 'n Banuary 4C, 4EE4, the treasurer ordered the settlement of all .usnak"s trading positions. The back office staff supervisor started verifying the confirmations of .usnak"s trading deals. 3t was found that there were #4 unconfirmed trades. 0ubse uent confirmations provided by .usnak for these trades seemed bogus and the back office manager insisted on confirmations on the phone. .usnak agreed co provide the phone numbers of brokers who arranged the trades by -ebruary E&, 4EE4. However, .usnak neither called up nor reported to the office from -ebruary ;. The treasurer reported the matter to Allfirst"s senior management who informed the A3B head uarters.
The discovery of bogus options immediately led to an intensive review of .usnak"s trading transactions by A3B and Allfirst. Transactions for each of the %# counterparties were e)amined. <ineteen of them were Asian counterparties to whom all the transactions were found to be bogus. -or ;% counterparties, no bogus transactions were found, and none of the transactions fitted the bogus-option pattern *that is, same-day transactions that netted out+. -inally, A3B and Allfirst discovered that there were five counterparties with whom there were unrecorded real options that had been removed with bogus li uidating options. 'ut of L9$#.4 mn loss, a ma5or portion of the toss occurred in 4EE# and 4EE4 *.efer Table 33+.
Table 33: !umulative ?osses on .usnak"s Trading 'perations *in L mn+ Tear !umulative ?osses
%4
Derivatives instruments 1ecember 1ecember 1ecember -ebruary EC,4EE4 &#,#$$$ C$.C &#,4EEE &EE.C &#,4EE# 9%;.E *4$&.4 - bogus assets, &CE.C - unrecorded liabilities+ 9$#.4 *4$#.9 - bogus assets, &$%.& - unrecorded liabilities, 4.& - legitimate trading loss+
0ource: www.aib.ie
'hy did it happen( 3ndustry analysts felt that a combination of factors led to the loss at Allfirst. The bank had completely failed to implement a proper operational control system. 1ue to the lack of effective control and supervision, .usnak got an opportunity to conduct fraud and also successfully hide them from being detected. The ma5or reasons that led to the disaster were:
Control System Deficiency There were numerous deficiencies in the control system of Allfirst. The absence of any net cash payment from .usnak"s trading activity and the difficulty in confirming trades at midnight had resulted in the back office decision to not confirm offsetting pairs of options trades with Asian counterparties from early 4EEE. !onfirmation of all trades was the basic standard practice, and failure to do so proved to be a disaster for Allfirst.
Another ma5or deficiency was the failure of the middle and back offices to obtain foreign e)change rates from an independent source. 'n the re uest of .usnak, the treasury risk control analyse had developed a system wherein the rates would be downloaded from .usnak"s .euters terminal to his personal computer"s hard disk drive, and then fed into a database on the shared network, making it accessible to the front, back, and middle offices. Through this system, .usnak could manipulate the prices]a key input into the bank"s back office and risk control
%&
Derivatives instruments functions. The lack of e)perience and inade uate staff resulted in the 3nternal audit department paying less attention to foreign e)change trading as a possible risk area. The confusion between the middle office and the credit risk department regarding their scope of control ensured that neither of them investigated the instances where .usnak had e)ceeded the counterparty credit limits. Inade;uate Supervision 3nade uate supervision ensured that .usnak was able to carry on with his fraudulent activities without being detected. 3n spite of the huge size of .usnak"s positions, none of his supervisors]trading manager, treasury funds manager or treasurer]undertook a careful e)amination of .usnak"s trading positions. A little vigilance would have raised uestions as to why the offsetting options for the two different e)pired on dates had the same premium and why the deep-in-the-money options e)pired une)ercised by the counter party. The basic re uirement of e)amining .usnak"s daily profit-and-loss figures and their reconciliation with the general ledger was also not done properly.
The prime brokerage account used by .usnak had a feature Yhat allowed .usnak to net trades at the end of each day. This prevented the treasury risk control from determining if there had been off-market trades with a particular counterparty in the course of that day. The back office also did not always confirm the end of the day settlement positions and considered the confirmation process as a mere formality. Failure to Review -olicies and -rocedures The risk control department at Allfirst never made an attempt to benchmark the policies and procedures against the best practices in the industry. They relied on the @alue at .isk *@A.+ model *.efer ()hibit 33+ and ignored other risk-related information that was available to them. The @A. model developed by the A3B Droup used the >onte !arlo simulation techni ue to generate #,EEE hypothetical foreign e)change spot and volatility rates and calculated the resulting profit or loss. The @A. is e uated to the tenth-worst outcome produced by the simulation, which yields a $$K level of statistical certainty.
%;
Derivatives instruments .usnak manipulated the @A. in many ways. -irstly the bogus options noted by .usnak appeared to hedge his real positions thus reducing @A.. 0econdly, he manipulated the figures of holdover transactions *transactions entered into after a certain hour towards the end of each day+, which were critical inputs in the calculation of the @A.. As a result, the transactions created an illusion of reduction in .usnak"s open currency position, which in turn, resulted in a lower @A. *the larger the open position, the higher the calculated @A.+. The employee responsible for checking the @A. relied on a spreadsheet that obtained information regarding the holdover transactions from .usnak"s personal computer.
"he End Result After the fraud was discovered, A3B undertook a thorough investigation into the foreign e)change trading operations at the Baltimore head uarters of Allfirst. The investigation was led by (ugene A ?udwig, an eminent G0 banking figure. ?udwig disclosed his findings in a report which blamed the weak control environment at Allfirst for rhp fraud- Alfred B T Byme, the !hairman of the financial institutions practice at ?e!lair .yan, a .ichmond-based law firm said, ,The ?udwig report makes clear that some of those responsible for compliance with internal controls at Allfirst were asleep at the switch. 'ne has to wonder whether the lights were out at !iti or Bank of America on these transactions as well.,
-ollowing the report, A3B discontinued all foreign e)change trading operations in Allfirst with the e)ception of customer service obligations. The company decided to centralize the management and control of all its treasury activities throughout the A3B Droup, bringing them under its subsidiary A3B capital markets, based in 1ublin, 3reland, The fraud was reported to the G0 -ederal Bureau of 3nvestigation on seeking its assistance in the investigation. A3B fired .usnak and si) other employees ] the e)ecutive vice -president and treasurer, the senior vice -president of treasury funds management, the senior vice-president of investment operations, the head of the internal audit, an operation unit clerk and an internal audit staff. To reflect the fraud losses, A3B restated Allfirst"s earnings from #$$% to 4EEE and the first three uarters of 4EE#. The restatement reduced #$$%-4EE# earnings by L;&C.# mn. The reduction for 4EE# was L4;4.9
%8
Derivatives instruments mn. -rank Bramble, the !hairman of Allfirst, opted for retirement. Apart from creating strong risk management policies and procedures, banks should provide effective management supervision, e)amine all new trading strategies very carefully and avoid dual reporting relationships.
%9

Latest Ck-Derivatives Final2

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Latest Ck-Derivatives Final2

Hochgeladen von

Copyright:

Verfügbare Formate

Derivative Instruments

Overview of derivatives markets Introduction

Over the Counter and E change ! "raded Derivatives

()change Traded 1erivatives

players need to be highly creditworthy.

Indian Derivatives #ar$et

%eed for derivatives in India today

#yths and realities a&out derivatives

=.(-.(JG303T(0 ?arge market !apitalisation

3<13A< 0!(<A.3' 3ndia is one of the largest market-capitalized countries in

Comparison of %ew System with E isting System

#+ Both profit F loss to e)tent of price change.

#+ >a)imum loss possible to premium paid

#+ >ake money whichever way the >arket moves.

#+ B Droup more promising as still

#+ .isk free game.

in weekly settlement 4+ !ash F!arry arbitrage continues

-air =rice Q !ash =rice O !ost of !arry.

#+ <o ?everage available risk reward dependant on market prices

#+ Additional cost is only premium.

premium O profit with increase price Advantages Availability of ?everage

Derivative Instruments Small Investors

Approach /-ri0e #+ 3f Bullish buy stocks else sell it.

#+ =lain Buy20ell implies unlimited profit2loss.

#+ 1ownside remains protected F upside unlimited.

Symmetric and Asymmetric Derivatives

0pot price of Gnderlying

-A.!OFF OF A CA44 O-"IO%

Buyer"s call option

Seller's call option

5rowth in Derivatives: Contri&uting factors

Derivative Instruments common man.

Forward Rate Agreement 9FRA:

?ibor O4EE bps

Distinction &etween futures and options

.isk-free interest rate

/Q 0trike price r # risk free 2re uired rate of return

Derivative Instruments % 9dl: Q !umulative standard normal distribution function

0T Q ()change .ate N - 0trike =rice Derivative Instruments

0T -()change .ate N - 0trike =rice

- 0trike =rice for the !all 'ption Bought

N4 - 0trike =rice for the !all 'ption 0old

E;uity Derivatives and #utual Funds

Table *: !hanges in 0ebi Duidelines 03 no #. Area of !hange Hedging =reviously <ow

Case study: ! Allied Irish )an$ @ Currency Derivative Fiasco

Table 3 : .usnak"s !ompensation #$$%-4EE#

Tear #$$% #$$C #$$$ 4EEE 4EE#

0alary L#E4,EEE L#E;,EEE L#E;,EEE L#EC,EEE L##4,EEE

Bonus ------L#4C,#E4 L#44,;;# L%C,EEE L44E,;89

Total L#E4,EEE L4&4,#E4 L449.;;# L#C9,EEE _#C9_E,_ L##4,EEE

Das könnte Ihnen auch gefallen