ADVANCED FINANCIAL

MANAGEMENT

Topic: Derivatives & Risk

Management

DERIVATIVES AND RISK MANAGEMENT

The Derivatives Market is meant as the market where exchange of derivatives

takes place. Derivatives are one type of securities whose price is derived from

the underlying assets. And value of these derivatives is determined by the

fluctuations in the underlying assets. These underlying assets are most commonly

stocks, bonds, currencies, interest rates, commodities and market indices. As

Derivatives are merely contracts between two or more parties, anything like

weather data or amount of rain can be used as underlying assets The Derivatives

can be classified as

Types of derivatives

Forward

Futures

Options

Swaps

The Types of Derivative Market

The Derivative Market can be classified as Exchange Traded Derivatives

Market and over the Counter Derivative Market. Exchange Traded Derivatives

are those derivatives which are traded through specialized derivative exchanges

whereas Over the Counter Derivatives are those which are privately traded

between two parties and involves no exchange or intermediary. Swaps, Options

and Forward Contracts are traded in Over the Counter Derivatives Market or OTC

market.

The main participants of OTC market are the Investment Banks, Commercial

Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks

markets the derivatives through traders to the clients like hedge funds and the rest.

In the Exchange Traded Derivatives Market or Future Market, exchange acts as the

main party and by trading of derivatives actually risks is traded between two

parties. One party who purchases future contract is said to go “long” and the

person who sells the future contract is said to go “short”. The holder of the “long”

position owns the future contract and earns profit from it if the price of the

underlying security goes up in the future. On the contrary, holder of the “short”

position is in a profitable position if the price of the underlying security goes down,

as he has already sold the future contract. So, when a new future contract is

introduced, the total position in the contract is zero as no one is holding that for

short or long. The trading of foreign exchange traded derivatives or the future

contracts has emerged as very important financial activity all over the world just

like trading of equity-linked contracts or commodity contracts. The derivatives

whose underlying assets are credit, energy or metal, have shown a steady growth

rate over the years around the world. Interest rate is the parameter which influences

the global trading of derivatives, the most.

DERIVATIVE MARKET AND FINANCIAL MARKET

Derivatives play a vital role in risk management of both financial and non-financial

institutions. But, in the present world, it has become a rising concern that

derivative market operations may destabilize the efficiency of financial markets. In

today’s world the companies the financial and non-financial firms are using

forward contracts, future contracts, options, swaps and other various combinations

of derivatives to manage risk and to increase returns. It is true that growth of

derivatives market reveal the increasing market demand for risk managing

instruments in the economy. But, the major concern is that, the main components

of Over the Counter (OTC) derivatives are interest rates and currency swaps. So,

the economy will suffer surely if the derivative instruments are misused and if a

major fault takes place in derivatives market.

THE OVER- THE- COUNTER DERIVATIVES

The derivatives traded over the counter are known as the over the counter

derivative market. The Over the counter derivative market consists of the

investment banks and include clients like hedge funds, commercial banks,

government sponsored enterprises etc. The products that are traded over the

counter are swaps, forward rate agreements, forward contracts, credit derivatives

etc. Derivatives are basically the financial instruments whose value is a function of

the value of the underlying asset. The participants who enter into the contract do so

when they agree on the exchange rate or the value of some asset to be delivered on

a future date.

DERIVATIVE MARKET EQUITY

The derivative market equity includes the financial instruments such as

futures, options and swaps. The equity derivatives are stocks or stock indices

whose prices depend on the prices of the underlying equity instrument. The equity

derivatives are traded in the futures and options exchanges or in the over the

counter markets. The most common forms of the derivative market equity are the

futures and the options market. The options and futures market Options are

contracts that give the buyer or seller the right and not the obligation to buy or sell

the underlying asset at a fixed price at a future date. The call option gives the

right to buy while the put option gives the right to sell. The buyer of the call

option can gain by an increase in the price of the underlying asset without buying

the underlying asset. Conversely the put option holder benefits from the fall in the

price level of the underlying asset. Contrast to the option market the person who

goes long or short in the futures market is bound to buy or sell the contract at the

specified price and date. Hence the futures contracts are much more

standardized in comparison to the options and hence they are traded in

accredited exchanges.

WARRANTS

Unlike the options and the futures which are exchange traded financial

instruments, the warrants are equity derivatives that are traded over the counter.

Warrants are used sometimes to increase the yield of bonds. Warrants are similar

to the equity options but are an exception since they are traded by private parties.

CONVERTIBLE BONDS

Convertible bonds are a combination of bonds and equity. The convertible bonds

provide asset protection, high equity returns and they are of less volatile nature.

The investors in the equity derivative can hedge their risk. The equity derivatives

are also used as a speculative instrument. The derivative market equity traders use

the data on stock and their derivatives. They also need, in addition, the factors that

may affect the equity prices. To analyze the data the equity market traders need

appropriate statistical tools. For further information on derivative market equity,

the following websites need to be looked at equityderivatives.com, reuters.com,

asx.com, amazon.com etc.

FORWARD AND FUTURES CONTRACTS

Fundamentally, Forward and futures contracts have the same function: both

types of contracts allow people to buy or sell a specific type of asset at a

specific time at a given price futures contracts are traded on the exchange,

forwards contracts are traded over- the-counter market. In case of futures contracts

the exchange specifies the standardized features of the Contract, while no pre

determined standards are there in the forward contracts. Exchange provides the

mechanism that gives the two parties a guarantee that the Contract will be honored

whereas there is no surety/guarantee of the trade settlement in case of forward

Contract.

A forward Contract is an agreement between two parties to buy or sell an

asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the

trade date and delivery date are separated. It is used to control and hedge risk, for

example currency exposure risk (e.g. forward contracts on USD or EUR) or

commodity prices (e.g. forward contracts on oil). One party agrees to buy, the

other to sell, for a forward price agreed in advance. In a forward transaction, no

actual cash changes hands. If the transaction is collaterised, exchange of margin

will take place according to a pre-agreed rule or schedule. Otherwise no asset of

any kind actually changes hands, until the maturity of the Contract.

The forward price of such a Contract is commonly contrasted with the spot

price, which is the price at which the asset changes hands (on the spot date, usually

next business day). The difference between the spot and the forward price is the

forward premium or forward discount. A standardized forward Contract that is

traded on an exchange is called a futures Contract. In finance, a futures Contract is

a standardized Contract, traded on a futures exchange, to buy or sell a certain

underlying instrument at a certain date in the future, at a pre-set price. The future

date is called the delivery date or final settlement date. The pre-set price is called

the futures price. The price of the underlying asset on the delivery date is called the

settlement price. The futures price, naturally, converges towards the settlement

price on the delivery date. A futures Contract gives the holder the right and the

obligation to buy or sell, which differs from an options Contract, which gives the

buyer the right, but not the obligation, and the option writer (seller) the obligation,

but not the right. In other words, the owner of an options Contract can exercise (to

buy or sell) on or prior to the pre-determined settlement/expiration date. Both

parties of a "futures Contract” must exercise the Contract (buy or sell) on the

settlement date. To exit the commitment, the holder of a futures position has to sell

his long position or buy back his short position, effectively closing out the futures

position and its Contract obligations. Futures contracts, or simply futures, are

exchange traded derivatives. The exchange acts as counterparty on all contracts,

sets margin requirements, etc. While futures and forward contracts are both a

Contract to trade on a future date, key differences include:

Futures are always traded on an exchange, whereas forwards always trade

over-the-counter Futures are highly standardized, whereas each forward is unique

The price at which the Contract is finally settled is different:

Futures are settled at the settlement price fixed on the last trading date of the

Contract (i.e. at the end) Forwards are settled at the forward price agreed on the

trade date (i.e. at the start) The credit risk of futures is much lower than that of

forwards: Traders are not subject to credit risk due to the role played by the

clearing house. The profit or loss on a futures position is exchanged in cash every

day. After this the credit exposure is again zero. The profit or loss on a forward

Contract is only realised at the time of settlement, so the credit exposure can keep

increasing In case of physical delivery, the forward Contract specifies to whom to

make the delivery. The counterparty on a futures Contract is chosen randomly by

the exchange. In a forward there are no cash flows until delivery, whereas in

futures there are margin requirements and periodic margin calls.

OPTION/ OPTIONS CONTRACT

Futures Option are an excellent way to trade the futures markets. Many new traders

start by trading futures Option instead of straight futures contracts. There is

generally less risk and volatility when using Option instead of futures. Actually,

many professional traders only trade Option.

FUTURES OPTION

An Option is the right, not the obligation, to buy or sell a futures contract at a

designated strike price. For trading purposes, you buy Option to bet on the price of

a futures contract to go higher or lower. There are two main types of Option - calls

and puts.

Calls – You would buy a call Option if you believe the underlying futures price

will move higher. For example, if you expect corn futures to move higher, you will

want to buy a corn call Option.

Puts – You would buy a put Option if you believe the underlying futures price will

move lower. For example, if you expect soybean futures to move lower, you will

want to buy a soybean put Option.

Premium – You are obviously going to have to pay some kind of price when you

buy an Option. The term used for the price of an Option is premium. You can think

of the pricing of Option as a bet. The bigger the long shot, the less expensive they

will be. Oppositely, the more sure the bet is, the more expensive it will be.

Contract Months (Time) – Option have an expiration date, which means they only

last for a certain period of time. When you buy an Option, you cannot hold it

forever. For example, a December corn call expires in late November. You will

need to close the position before expiration. Generally, the more time you have on

an Option, the more expensive it will be.

Strike Price – This is the price at which you could buy or sell the underlying

futures contract. For example, a December $3.50 corn call allows you to buy a

December futures contract at $3.50 anytime before the Option expires. Most

traders do not convert Option; they just close the Option position and take the

profits

Example of Buying an Option:

Let’s say you expect the price of gold futures to move higher over the next 3-6

months. It is currently January, so you would probably buy an August gold call to

give yourself enough time. Gold is currently trading at $590 per ounce. You expect

the price to climb to $640 within 6 months.

You purchase: 1 August $600 gold call at $15

1 = number of Option you are buying

August = Month of Option contract

$600 = strike price

Gold = underlying futures contract

Call = type of Option (bet on price moving higher)

$15 = premium ($1,500 is the price to buy - 100 ounces of gold x $15 = $1,500)

Call Option Example

Suppose the market price of equity share of reliance on the expiration date is

Rs 140 and the exercise price is Rs 125 .The value of call option is Rs 15 [Rs 140 –

Rs 125] In case the value of share on expiration date turn out to be Rs 120 the

value of c would not be negative Rs 5 [Rs 120 –rs125 ], it would be zero as the

investor would not purchase share Rs 125 which is available in the market and

thereby incur a loss Rs 5per share.

Put Option Example

Consider an investor who wants the right to sell reliance equity shares at Rs

135 after 2 months. He is to buy a 2 month put option with a Rs 135 exercise

price. In case the market price of the reliance share increases to Rs 150 (S1< E) the

put option will expire worthless as it will be more profitable for an investor to sell

in the open market at Rs 150 than to the put option writer at Rs 135.

If the market price falls below the sp say to Rs 125 it will be profitable for

the put option holder to excise his put option right as he get Rs 135 compared to Rs

125.

An important difference between futures and options is that trading in futures

contracts is based on prices, while trading in options is based on premiums. The

premium depends on market conditions such as volatility, time until expiration,

and other economic variables affecting the value of the underlying futures contract.

The buyers and sellers of futures can be classified as hedgers or speculators.

Hedgers use futures to minimize risk, like the farmers who use futures to

guarantee a price for their product, or a miller who wants a set price for grain when

it is harvested. Futures can also be used to hedge investment portfolios. Thus,

futures is a significant means of price risk transfer—transferring price risk to

someone with an opposite risk, or to a speculator who is willing to accept risk to

make a profit.

Speculators use futures to make a profit, by buying low and selling high (not

necessarily in that order). The speculator has no intention of making or taking

delivery. A speculator is making a bet on the future price of a commodity. If he

thinks the price of the commodity will drop, he takes a short position by selling a

futures contract. If he thinks that the price of the commodity will increase, then he

takes a long position by buying a futures contract. Later, he will close out his

position by offsetting the contract. If he sold short, he will buy back the contract,

and if he bought long, then he will sell the contract.

The buying and selling of futures contracts is a zero sum gain, because it is

basically a contract between 2 traders. It is not an investment in a company that

creates wealth, where every shareholder can win—or lose. If the short side profits,

the long side loses an equal amount, and vice versa.

SWAPS

A swap is an agreement between two parties to exchange the cash flows in

the future. The agreement defines the dates when the cash flow are to be paid and

the way it has to be calculated.

There are two basic types of swaps : (1) Interest Rate Swap

(2) Currency Swap

A currency swap is an agreement between two parties to exchange the

principal loan amount and interest applicable on it in one currency with the

principal and interest payments on an equal loan in another currency. These

contracts are valid for a specific period, which could range up to ten years, and are

typically used to exchange fixed-rate interest payments for floating-rate payments

on dates specified by the two parties. Since the exchange of payment takes place in

two different currencies, the prevailing spot rate is used to calculate the payment

amount. This financial instrument is used to hedge interest rate risks

A currency swap agreement specifies the principal amount to be swapped, a

common maturity period and the interest and exchange rates determined at the

commencement of the contract. The two parties would continue to exchange the

interest payment at the predetermined rate until the maturity period is reached. On

the date of maturity, the two parties swap the principal amount specified in the

contract. The equivalent amount of the loan value in another currency is calculated

by using the net present value (NPV). This implies that the exchange of the

principal amount is carried out at market rates during the inception and maturity

periods of the agreement.

Benefits of Currency Swaps

Help portfolio managers regulate their exposure to interest rates.

Speculators can benefit from a favorable change in interest rates.

Reduce uncertainty associated with future cash flows as it enables companies to

modify their debt conditions.

Reduce costs and risks associated with currency exchange.

Companies having fixed rate liabilities can capitalize on floating-rate swaps and

vice versa, based on the prevailing economic scenario

Limitations of Currency Swaps

Exposed to credit risk as either one or both the parties could default on interest

and principal payments.

Vulnerable to the central government’s intervention in the exchange markets.

This happens when the government of a country acquires huge foreign debts to

temporarily support a declining currency. This leads to a huge downturn in the

value of the domestic currency.

COMPANIES BENEFIT FROM INTEREST RATE AND CURRENCY SWAPS

An interest rate swap involves the exchange of cash flows between two

parties based on interest payments for a particular principal amount. However, in

an interest rate swap, the principal amount is not actually exchanged. In an interest

rate swap, the principal amount is the same for both sides of the currency and a

fixed payment is frequently exchanged for a floating payment that is linked to an

interest rate, which is usually LIBOR.A currency swap involves the exchange of

both the principal and the interest rate in one currency for the same in another

currency. The exchange of principal is done at market rates and is usually the same

for both the inception and maturity of the contract, generally, both interest rate and

currency swaps have the same benefits for a company. Essentially,

these derivatives help to limit or manage exposure to fluctuations in interest rates

or to acquire a lower interest rate than a company would otherwise be able to

obtain. Swaps are often used because a domestic firm can usually receive better

rates than a foreign firm. 

For example, suppose company A is located in the U.S. and company B is

located in England. Company A needs to take out a loan denominated in

British pounds and company B needs to take out a loan denominated in U.S.

dollars. These two companies can engage in a swap in order to take advantage of

the fact that each company has better rates in its respective country. These two

companies could receive interest rate savings by combining the privileged access

they have in their own markets. Swaps also help companies hedge against interest

rate exposure by reducing the uncertainty of future cash flows. Swapping allows

companies to revise their debt conditions to take advantage of current or expected

future market conditions. As a result of these advantages, currency and interest rate

swaps are used as financial tools to lower the amount needed to service a debt.

Currency and interest rate swaps allow companies to take advantage of the

global markets more efficiently by bringing together two parties that have an

advantage in different markets. Although there is some risk associated with the

possibility that the other party will fail to meet its obligations, the benefits that a

company receives from participating in a swap far outweigh the costs.

Examples of Interest rate swaps and Currency swaps

Interest rate swaps Example

It can be used to overcome the asset-liability mismatch, with the help of the

following example. Bank A has floating rate assets earning (MIBOR+3%) 

(Mumbai Inter Bank Offer Rate) funded with fixed rate liability of 12%. Bank B

has fixed rate assets earning 17%, funded with floating rate liability (MIBOR+1%).

Now, if the interest rate falls, Bank A will suffer as it will receive less on its assets

whereas it will have to pay fixed interest. And if the interest rate rises, Bank B will

suffer as it will have to pay more, liabilities being floating in nature. Hence both

the banks suffer from asset-liability mismatch.

To overcome this, they may enter into a swap transaction wherein:

Bank A will pay Bank B, floating rate of interest, say MIBOR annually, on

the notional principal.

Bank B will pay Bank A, a fixed rate of interest, say 14% annually, on the

same notional principal.

This would ensure that both the banks will stand to gain a definite spread

irrespective of the level of MIBOR.

Currency Swaps Example

Suppose company C wants to borrow US$ funds and the Company D wants

to borrow £ funds. Their financing details are given in the following example:

Company $ Borrowing £ Borrowing Preference

C 10% 7% $ Loan

D 11% 11% £ Loan

Spread 1% 4%  

From the given information, C enjoys absolute advantage over D in both the

$ and £ loan market. But the comparative advantage for C exists in the £ loan

market. So it is advisable for C to borrow £ funds and for D to borrow $ funds

from the market and then enter into a foreign currency swap deal to achieve their

preferred form of funding with a lower cost. Let us check how to construct a deal

between them. It is assumed that C needs $100 crores. The current spot $/£ rate at

the time of entering into the swap is 1.80 $/£.

The calculation of the benefit earned from the swap is :

Total cost of borrowing without the swap = 10 + 11 = 21%

Total cost of borrowing with the swap = 7+11 = 18%

Therefore, net savings = 3%

This savings may be shared between C and D in a mutually agreed upon

ratio. In our discussion, we assume it to be shared equally for easy calculation.

Hence, the net cost of borrowing for both the parties will be:

C = 10-1.50 = 8.50%

D = 11-1.50 = 9.50%

Their swap structure is : 

Therefore, to enter into the swap deal the following transactions are

required:

Exchange of Principal: C will borrow £55.55 (100/1.80) crore and

give it to D and D will borrow $100 crore and give it to C.

Interest Payments: C will pay 11% to D on the $100 crore borrowed

by D and D will pay 9.5% to C on the £55.55 crore borrowed by C.

Re-exchange of Principal: After the swap matures, the principal

amount exchanged between C and D will be re-exchanged between

them. That is, C will return $100 crore to D and D will return £55.55

crore to C.