PRESENTATION ONFORWARD AND SWAP

BY-SHEENA SHEETAL

DERIVATIVES

•A security whose price is dependent upon one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage

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•Derivatives are contracts and can be used as an underlying asset.

•Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes

EXAMPLE

•Bombay stock exchange share index calls sensex, is a derivative whose value depends upon the price of underlying 30 shares.

TYPES OF DERIVATIVES

1. FORWARD

2. SWAP

3. OPTIONS

4. FUTURE

FORWARD CONTRACT

•Forwards are the oldest of all the derivatives. Forwards are contracts to buy or sell an asset on or before a future date at a price specified today

• or an agreement between two parties to exchange an agreed quantity of an asset for cash at a certain date in future at a predetermined price specified in that agreement.

Example of forward

•The promised asset may be currency, commodity, instrument etc

•Eg.- On January 1, Mr. X enters into an agreement to buy 5 pkts. of basmati rice on June 1 at Rs. 3000/- per pkt from Mr. Y, a wholesaler. It is a case of a forward contract where Mr. X has to pay Rs. 15,000/- on June 1 to Mr. Y and Mr. Y has to supply 5 pktss of basmati rice.

The primary reason for the classification of a forward contract as a derivative is that in many cases its price can be derived through a no-arbitrage argument that relates the forward price of an asset to its spot price

In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date said to be in the ‘Long position’. On the other hand, the user (holder) who promises to sell at an agreed price at a future date is said to be in ‘Short position’. Thus, ‘long position, and ‘short position, take the form of ‘buy’ and ‘sell’ in a forward contract.

FEATURES OF FORWARD1.Over the Counter Trading (OTC): These

contracts are purely privately arranged agreements and hence, they are not at all standardized ones. They are traded ‘over the counter’ and not in exchanges. There is much flexibility since the contract can be modified according to the requirements of the parties to the contract. Parties enter into this kind of contract on the basis of the custom, and hence, it is also called ‘customised contract’.

2. No Down Payment: There must be a promise to supply or receive a specified asset at an agreed price at a future date. The contracting parties need not pay any down payment at the time of agreement

3. Settlement at Maturity: The important feature of a forward contract is that no money or commodity changes hand when the contract is signed. Invariably, it takes place on the date of maturity only as given in the contract ement.

4. Linearity: Another special feature of a forward rate contract is linearity. It means symmetrical gains or losses due to price fluctuation of the underlying asset. When the spot price in future exceeds the contract price, the forward buyer stands to gain. The gain will be equal to spot price minus contract price. If the spot price in future falls below the contract price, he incurs a loss

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5.No Secondary Market: A forward rate contract is a purely private contract, and hence, it cannot be traded on an organized stock exchange. So, there is no secondary market for it.

6. Necessity of a Third Party: There is a need for an intermediary to enable the parties to enter into a forward rate contract. This intermediary may be any financial institution like bank or any other third party.

7.Delivery: The delivery of the asset which is the subject matter of the contract is essential on the date of the maturity of the contract.

SWAP

•A swap is a contract in which two parties agree to exchange their respective cash flows. This is a private agreement between the parties to exchange cash flow according to some prearranged formula.

•The parties to the swap contract are known as counter parties.

•The cash flow can be swapped with the help of a swap dealer.

•Swap arrangement are tailor made to the needs of counter parties.

•Swap are not subject to regulation as the future and option are.

TYPES OF SWAP

•1. Currency swap- it is a transaction between two parties in which one promises to make a series of payments to other party at a specific dates in exchange for a payment from the another party in different currency. So in currency swap the cash flows of different currency are swapped.

•This can be used by the firms that operate in one currency but need to borrow in another currency.

Example-•A ltd. and B ltd. want to borrow in $ and

Euro respectively. But A ltd. Can borrow Euro at a cheaper rate than B ltd. And vice versa.

Then they entry into a currency swap to share advantage of the cheaper borrowing capacity of the other company.

2. INTEREST RATE SWAP

•Interest rate swap is an agreement between two parties in which each party make a series of interest payment to the another party at predetermined dates at different rates.

•At least one of the interest is variable i.e floating rate .

•The most common type of interest rate swap is known as plain vanilla swap in which one rate is fixed and another is floating.

Important points

•In this swap, there is no exchange of principle amount either on maturity or initially.

•On each payment date, only the interest payments or the net payment will be exchanged.

Why parties enter into interest rate swap??

-The reason in comparative advantage.