MarketderativeSbPhumancanlearnaboutderative.ppt

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Derivatives
 A derivative is a financial contract which
derives its value from the performance of
another entity such as an asset, index, or
interest rate, called the "underlying".
 Derivatives are one of the three main
categories of financial instruments, the other
two being equities and debt.
 Since it is a separate contract, accounting for
all derivatives is also conducted separately.
 Used for hedging & managing market risk.

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Uses of Derivatives
 Banks/Financial Institutions trade in Financial
Derivatives:
 To hedge interest rate, foreign exchange risk
and equity prices risk
 To offer derivative structured products to their
clients to hedge their exposure.
 Corporations trade in Financial Derivatives:
 To hedge interest rate, foreign exchange risk &
equity prices risk
 To hedge commodity prices risk.
 Traders also use it for speculation (2008 Crisis)

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2 Dimensions in Exposures
 Uncertainty
 Uncertainty about the final rate or price
 Opportunity
 Opportunity Loss or Gain
 Some Derivatives cover only the first part
while other cover both of these dimensions.

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Derivative Instruments
 Forward Rate Agreement (FRA)
 Futures
 Options
 American & European
 Put & Call
 Caps, Floors & Collars
 Swaps
 Interest Rate Swap (IRS)
 Cross Currency Swap (CCS)

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Forward Rate Agreement (FRA)
 Agreement on a rate of interest for a specified period
of time period starting at a future date. Important
factors are:
 Rate
 Time Period
 Settlement Date (Contract Starting Date)
 Notional Amount – Amount on which compensatory
settlement will be calculated
 Short term instruments to hedge interest rate risk
(Usually 3, 6 & 9 months)
 Over the counter

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Hedging through FRA
 Borrowers buy FRA to hedge rising interest rates.
 Fixes the interest rate to be paid to the lender
 Buy FRA means Pay Fixed & Receive Variable.
 For e.g. A borrower has taken a loan on floating rate
(Currently 10%) and is expecting it will rise in next MPS
to 11%. He buys the FRA.
 On settlement date, if SBP decides to increase discount
rate to 11%, the borrower will have to repay @ 11% (due
to floating rate).
 On FRA, he will receive 11% (floating rate) and pay 10%
(fixed) where he will earn a gain of 1% which will be
passed on to the lender.
 In net terms, the rate is fixed at 10%

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Hedging through FRA
 Lenders sell FRA to hedge declining interest rates.
 Fixes the interest rate to be received from the borrower.
 Sell FRA means Receive Fixed & Pay Variable
 For e.g. A lender has given a loan on variable rate
(currently 10%) and is expecting a rate cut in the next
MPS. He sells the FRA.
 On settlement date, if SBP decides to change the
discount rate to 9%, the lender will receive 9% as
interest income on the variable rate loan.
 On FRA, he will pay 9% (variable) and receive fixed
(10%) earning a net gain of 1%on FRA which will be
passed on for interest income.
 In net terms, interest income will be fixed @ 10%

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Futures
 Specialized contract to buy or sell a specific quantity of
goods at a specified future date at an agreed price.
Important factors are:
 Quantity
 Price
 Period
 Specified Future Date
 Standardized exchange traded contracts for specific
quantities for e.g. 10 ounces gold future.
 Futures are non delivery based and are settled by reversing
the position on settlement date
 First Future Exchange was established in Chicago known
as Chicago Board of Mercantile Exchange.

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Hedging through Futures
 Example: An agriculturist is expecting to harvest wheat in
August and is expecting the price to decline to $3 by that
time.
 Current price is $3.5/bushel and August Future price is
$3.45/bushel.
 He enters into a future contract to sell the wheat at $3.45
in August.
 This way, he has been able to lock the price today for his
wheat production in August.
 If price goes to $3, he will be in an opportunity gain of
$0.45 while if it goes above $3.45 then he will be in an
opportunity loss.
 Vice versa for a buyer of the same commodity in future.

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Difference between Futures &
Forwards
 Exchange Trades vs. Over the counter
 Standardized vs. Customized
 Margin requirement vs. No margin requirement
 Non Delivery based vs. Delivery based
 No Credit Risk vs. Credit Risk

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Options
 Right & not an obligation to buy or sell an agreed amount of
commodity at a specified price for a specified period or on a
fixed date.
 It is like insurance where you have to pay premium and if
something goes wrong, you are protected.
 Option writers are usually brokers and are exchange traded or
over the counter.
 Put Option – Right to sell
 Market Price > Option Price – Walkover
 Market Price < Option Price – Exercise
 Call Option – Right to buy
 Market Price > Option Price – Exercise
 Market Price < Option Price - Walkover

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Options
 American Options – Specified Period
 European Options – Fixed Date
 Specified Price is strike price or exercise price.
 In the money option – in green
 Out of money option – in red
 Buyer of the option has to pay premium irrespective
of exercising the contract so limited loss and
unlimited gain
 Seller/Writer of the option earns a premium
irrespective of exercising the contract so limited gain
and unlimited loss.

Profit
Loss
0
E
Premium
SHORT CALL
B
Asset price
Profit
Loss
0
E
Premium
LONG CALL
B
Asset price
Option Contract Expiry Profiles
E = exercise price
B = breakeven
LONG CALL
Limited downside risk with
unlimited profit potential
SHORT CALL
Unlimited downside risk with
limited profit potential

Option Contract Expiry Profiles
Profit
Loss
0
E
Premium
SHORT PUT
B
Asset price
Profit
Loss
0
E
Premium
LONG PUT
B
Asset price
E = exercise price
B = breakeven
Buy a put when you expect a fall in the underlying market price
LONG PUT
Limited downside risk with
limited profit potential between
breakeven and zero
SHORT PUT
Limited downside risk between
breakeven and zero
with limited profit potential

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Interest Rate Caps
 Interest Rate Cap is a derivative instrument in which the
buyer of the cap receives differential payments if the
interest rate exceeds the agreed strike rate.
 It fixes a ceiling rate for the borrower.
 Just like option, buyer pays a premium while seller is a
broker or writer who earns premium income but pays the
extra interest to the buyer over the agreed strike rate in
case interest rates move up.
 Virtually, it ensures that borrowing rate remains in control
for the buyer – hedges the rising interest rates
 Long Cap – buying a cap
 Short Cap – selling a cap

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Interest Rate Floors
 Interest Rate Floor is a derivative instrument in which the
buyer of the floor receives differential payments if the
interest rate falls below the agreed strike rate for.
 It fixes a floor rate for the lender
 Just like an option, buyer pays a premium while seller is
a broker or writer who earns premium income but pays
extra interest to the buyers under the agreed strike rate
in case interest rate goes down.
 Virtually, it ensures that the lending rate remains in
control for the buyer – hedges the falling interest rates.
 Long Floor – buying a floor
 Short Floor – selling a floor

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Interest Rate Collars
 Interest Rate Collar is a combination of a long cap and a short
floor to create a range of interest rate which the borrower has
to pay. It sets a floor and ceiling at the same time.
 Long Cap – buyer of cap to hedge rising interest rate.
 On Long Cap – you receive differential interest to offset higher
borrowing cost.
 On Short Floor – you pay differential interest to the buyer
limiting your benefit of paying lower interest rates to the
lender.
 Short Floor – generates premium income to offset the
premium paid on long cap.
 Effectively, a zero premium interest rate hedging.
 Ideal when you are clear that interest rates will not fall to that
extent

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Interest Rate Caps, Floors &
Collars

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Interest Rate Swaps (IRS)
 An agreement to exchange interest payment
obligations for a certain period.
 A series of FRA is Interest Rate Swap and is a
long term hedging strategy.
 Principles are not exchanged and a notional
amount is set to calculate the interest payment
obligations
 Over the counter transaction and got a maximum
period of 25 years.
 Fixed to Floating IRS – e.g. 10% to KIBOR
 Floating to Fixed IRS – e.g. KIBOR to 10%

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 Borrower:
 Floating to Fixed IRS – To hedge rising interest
rates by fixing the rate of interest payments.
 Fixed to Floating IRS – To hedge declining interest
rates by converting to a floating rate to gain
benefit of lower interest rates.
 Lender/Investor/Bank:
 Floating to Fixed IRS – To hedge declining interest
rate by fixing the interest rate on investments.
 Fixed to Floating IRS – To hedge rising interest
rates by converting to a floating rate to gain
benefit of higher interest rates on investments.

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 Floating to Floating IRS (Same Currency)
 Different reference rates e.g. Japanese LIBOR vs.
TIBOR. Hedges the trend of one floating rate over
other floating rate
 Different tenors e.g. 1 M LIBOR vs. 3M LIBOR.
Used as a hedging tool for ALM
 Same Currency so principals are not exchanged -
Net is zero!!!
 Can be used by both investors and borrowers.
 Floating to Floating (Different Currencies)
 What is it called?

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Cross Currency Swaps
 Floating to Floating IRS but different currencies is a
Cross Currency Swap.
 E.g. 1M LIBOR vs. 1M KIBOR
 Important: KIBOR is calculated on PKR amount
while LIBOR on equivalent USD amount.
 Principal Amounts are exchanged as different
currencies.
 Interest payments in different currencies will also be
exchanged.
 At the end of the contract, principal amount will be
exchanged again
 Therefore, liability only remains the interest payment

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Cross Currency Swaps
 Reasons of entering into a CCS:
 Competitive rates in different economies creating
arbitrage opportunities.
 A way of borrowing and obtain financing at
competitive rates for MNCs in their own economy
for an offshore project – Example: Etisalat in
U.A.E and Nishat Mills in Pakistan.
 To avoid mismatch in assets & liabilities and FX
exposure hedging. IRS which hedges both interest
rates and FX risk (Market Risk)

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FRA: Compensatory Settlement
 You bought a 3 x 9 FRA on 4th Oct at 6.5%. Calculate
the compensatory payment/receipt on the settlement
date when LIBOR is at 6.75%, 360 Days Basis &
Notional is USD 25mn.
 CP = ((LIBOR – Rate) X (Days X Notional Amount)) /
((Days X LIBOR) + (Base X 100))
 CP= ((6.75 – 6.5) X (180 X 25)) / ((180 X 6.75) + (360
X 100))
 CP = $29,829/=
 It will be received by you since you need to pay fixed
i.e. 6.5% while receive variable i.e. 6.75% so you
receive the 0.25% compensatory amount discounted

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FRA
 Can a borrower sell FRA & a lender buy FRA?

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Futures: Gain/Loss Calculation
 An agriculturist is expected to harvest 40,000 bushels of
wheat in August. On June 15th the price of wheat is $3.5
and he is expecting that the prices will decline to $3 by
August. 3M future of wheat is trading at $3.45. Assuming
he hedged the price through buying wheat futures,
calculate the opportunity gain & loss in each of the
following cases:
 If the price goes down to $3:
 Opportunity Gain = (3.45 – 3) * 40,000 = 18,000/=
 If the price goes up to $3.6:
 Opportunity Loss = (3 .45 – 3.6) * 40,000= 6,000/=

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