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Financial Derivatives

Dr K Ramesha
Professor
Financial Derivatives
• “ in our view, derivatives are financial
weapons of mass destruction, carrying
dangers that while now latent, are
potentially lethal” – Mr Warren Buffett
• “derivatives made it possible for banks
and financial institutions avert the adverse
effects of the collapse of Enron,
Worldcom, Adelphi etc” – Alan Greenspan
Financial Derivatives
• Derivatives can be defined as “contracts which
do not have any intrinsic value, but derive their
value from an underlying product or asset,
whether tangible or intangible”
• These contracts broadly fall into five categories
– Forwards
– Futures
– Options
– Swaps and
– Credit derivatives
Forward Contracts
• These contracts are known to bankers for a long time and are
extensively used in dealings in foreign exchange. Essentially,
these are meant to hedge one’s exposure in a currency, viz.,
to protect oneself from an adverse movement in the price of a
currencey
– An example of importer or exporter
• All forward contracts are “over the counter” products meaning
contracting parties do the deal themselves without disclosing
information to outsiders
• There is no supervisory mechanism in any country other than
normal contract laws to ensure both the parties fulfill their
respective obligations
• Currently, it is estimated that over 95 percent of forward
contracts in currencies are entered into by speculators who
have no underlying trade (export/import) transactions
Futures
• A variant of Forward Contract is “Futures”
– All forward contracts are put through a recognized
exchange which acts as an intermediary between the
dealer and client (buyer and seller)
– Details of contract are in public domain
– Contracts are of fixed amounts and mature on fixed
dates
– Margins are required to be posted daily – may
increase or decrease – market to market mechanism
and no credit risk unlike forward contracts
– Orderly trading through accredited brokers to
exchanges who collect/pay margins
Options
• Option is a contract to buy or sell an underlying
asset, tangible or intangible
• There are two parties – option writer and option
holder
• Option holder has every right to exercise the
option, but no obligation to do so
• Option writer has no rights but only the
obligation to fulfill his side of the contract should
the holder exercise his right
• But the option holder is required to pay a
premium upfront
Options
• Option contract is specific and indicates the price at which the
underlying asset will be bought or sold (strike price) and the date/period
in which it can be exercised
• Option holder can agree to either buy/sell a particular share at the strike
price after say, 2 months.
• Option to buy is termed as “call option” and option to sell is “put option”
• If a person has some shares in company C which cost him Rs 250 per
share and if he anticipates that the price may move downwards in the
next 2 months, he can take a put option at Rs 300 exercisable after 2
months, on paying a premium of say Rs 10 per share
• If on the strike date, the price rules at Rs 280 he can exercise the option
and get a profit of Rs 10 (300-280=20 –premium of 10)
• If price rules at 300 and more, he will not exercise the option but write
off the premium as loss
• If exercising an option results in a profit it is called “in-the-money” and
when it is not profitable, “out-of-the-money”
SWAPS
• Swaps are contracts for exchanging one product by
another. Typically these are in use in currencies and
interest rates along with their myriad combinations
• A currency swap is one where two parties exchange
one currency for another
• A simple example is where two reputed companies,
based in India (IC) and US (UC have subsidiaries in
the other country.
• IC has highest credit rating in India and UC highest
credit rating in US – IC’s subsidiary is not well
known in US and UC’s subsidiary not well known in
India
SWAPS
• Both subsidiaries need long term credit from banks in
local currencies
• If they were to approach local banks, cost will be high
• Instead, IC arranges to raise rupee loan in India and UC
arranges to raise $ loan in US at relatively cheaper rates
• IC lends on-lends to UC’s subsidiary in India in rupees in
return for UC’s on lending to IC’s subsidiary in US
• Maturity dates and the repayment schedules of both the
loans must be idential
SWAPS
• A leading financial house was able to raise long
term loans in US and did not have any use in
US$
• Financial house offered US$ funds to three
Indian banks and three Indian financial
institutions in return for their lending equivalent
Indian Rupees
• Rupee loans were priced lower than the ruling
rates of interest, because the $ loan was also at
a rate below the ruling rates there – a win-win
situation
Interest Rate Swaps
• Interest rate swaps, typically started as
exchange of one interest rate instrument
by another.
• This arose after floating rates of interest
became more common.
• Thus a party paying a fixed interest rate
can exchange it for another paying floating
rate instrument
Interest Rate Swaps – An Example
• Suppose two companies – World Bank (WB) and an
Indian Company (INC) are in the market to borrow $100
mn for 5 years
• INC wants fixed interest rate and WB floating rate
• If INC borrowed in floating rate interest rate will be
LIBOR plus 0.5% and if borrowed in fixed rate, cost
would be 6%
• For WB – floating rate cost is LIBOR and fixed rate cost
is 5%
• An clever investment bank would grab this opportunity to
do a swap deal
Interest Rate Swaps – An Example
• WB borrows at fixed rate & lends to
investment bank at 5%
• Inv Bank lends to INC at 5%
• INC borrows at floating rate & lends to Inv
Bank at LIBOR minus 0.30%
• Inv Bank lends to WB at LIBOR minus
0.20%
• All the three parties – WB, INC and Inv
Banks have made gains
Interest Rate Swaps – An Example
• WB – its cost of funds now is LIBOR minus 0.2% (if it had
gone to market it would have paid LIBOR) – in borrowing at
5% and lending to Inv Bank, it had made no gain no loss
• INC – it lost 0.8% in total (borrowing at LIBOR plus 0.5% on
floating rate and on-lending at LIBOR minus 0.3%). But
gained 1% (borrowed at 5% rather than 6% on fixed rate).
Thus the net gain for INC is 0.2%
• Inv Bank – No gain in borrowing from WB and lending to INC.
But in borrowing from INC and on-lending to WB, it gained
0.10%
• The above gains (WB - 0.20, INC – 0.20 and Inv Bank –
0.10) arose because of the peculiarity in the market for loans
• Market for floating rate loan is dominated by banks, whereas
the fixed rate market is generally dominated by investors.
Thus INC gets a better deal in floating rate market
Interest Rate Swaps – An Example
• Broad conclusions
– Interest rate swap arises because two parties have
opposite views on the likely movement of interest
rates in future (WB wanted floating rate and INC fixed
rate)
– Generally such swaps which are backed by borrowing
deals arise due to market imperfections as in the
above example. However, these days interest rate
swaps are entered into mostly as speculative deals,
where both parties bet on the future movement of
rates.
Credit Derivatives
• Fundamentally these are guarantee or insurance
products. Any lender assumes two risks; ability
to raise funds for the period of loan and default
risk
• In credit derivatives a third party takes over the
default risk from the lender
• Lender who sells the risk is called protection
buyer and the guarantor/issuer is called as
protection seller
• Usually banks (commercial and investment
banks) are protection buyers and other banks,
insurance companies, mutual funds, hedge
funds are protection seller
Credit Derivatives
• Basic concept of guarantee is packaged into mind-boggling
forms, such as credit default swaps, total return swaps,
credit linked notes, credit options etc
• Risk can again can be sliced into myriad ways; senior
subordinate, mezzanine, and so on
• Part or whole debt can be collateralized and that portion of
risk can be sold through collateralized debt obligations
(CDO)
• Payment of the sum in default can be in straight cash for full
amount or for part of the amount after deducting the value of
security or a part of the amount on the event of default
occurring
• Tricky part is to clearly define as to what is an event of
default. It could be plain non-payment or bankruptcy or
deterioration in borrowers financial position or credit rating
down grade or repudiation of loan or reduction in value of
collateral etc