Derivatives

A Derivative is a product whose value is derived from the value of one or more basic variable(s), called the underlying asset. The underlying asset can be equity, foreign exchange, commodity or any other asset.

There are basically three types of participants.

• Hedgers: They are the producers (like farmer, mining company) or users (business entities, consumers) who face the risk associated with the price of an asset and hence use derivative markets to reduce or eliminate this risk.
• Speculators: They are traders who wish to bet on the future movement in the price of an asset.
• Arbitrageurs: They are in business to take advantage of discrepancy in prices between two different markets.

• Price discovery: It helps in discovery of price of the underlying asset in future;
  Transferability of risk: It transfers risks from those who have them but may not like them to those who have an appetite for them.

Basically, there are only two types of derivative instruments

• Forward Contracts
  Option Contracts

The derivative products traded on exchanges are known as exchange traded derivatives, whereas privately negotiated derivative contracts are called Over-the-Counter (OTC) contracts. The differences between both the platforms are as follows:

The different types of derivative products available, as per RBI’s comprehensive guidelines are:

• Forward rate agreements (FRA)
• Interest rate swaps (IRS)
• Interest rate futures (IRF)
• Foreign exchange forwards
• Currency swaps
• Currency options
• Interest rate caps and floors

A forward rate agreement (or FRA) is simply speaking, a forward contract on interest rates traded over the counter. It is typically an agreement between a bank on one hand and a borrower or depositor on the other. The party which gains from an FRA when interest rates fall is referred to as the “seller” or “lender” of the FRA. Similarly, the party which benefits when interest rates rise is called the “buyer” or the “borrower” of the FRA. The amount on which the interest (difference) is calculated is the notional principal of the FRA.

For example, if the agreed 6 month LIBOR rate under an FRA is 0.75% p.a. on a given future date and the actual rate happens to be 1% p.a., the bank (seller of FRA) will reimburse to the counterparty (buyer of FRA), the difference of 0.25% p.a. Interest is paid in arrears and therefore the difference is payable not on maturity of the FRA but at the end of the interest period beginning on that day. However, in practice, parties do not wait for the end of the interest period to exchange the difference; its present value changes hands on maturity of the FRA. An example of USD FRA quotes

The first quote represents a bank selling an FRA on the 6 month LIBOR to rule after 3 months from the date of contract. If after 3 months, the 6 month LIBOR is above 0.38%, the bank will compensate the buyer of the FRA to the extent of the difference. Similarly, the second quote stands for a bank selling an FRA on the 3 month LIBOR to rule after 9 months.

An interest rate futures (IRF) contract is the exchange traded version of an FRA. One of the most popular futures contract is the 3 month Eurodollar contract. This is a contract on the 3 month LIBOR expected to rule on maturity of the contract. IRF contracts having maturities up to 10 years are quoted on the Chicago Mercantile exchange. The price of the contract is quoted as {100-rate of interest agreed}. Thus a price of 98.50 would mean an interest rate of 1.5%.

An interest rate futures (IRF) contract is the exchange traded version of an FRA. One of the most popular futures contract is the 3 month Eurodollar contract. This is a contract on the 3 month LIBOR expected to rule on maturity of the contract. IRF contracts having maturities up to 10 years are quoted on the Chicago Mercantile exchange. The price of the contract is quoted as {100-rate of interest agreed}. Thus a price of 98.50 would mean an interest rate of 1.5%.

A “derivative” is a financial instrument whose value changes (is derived from) in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, price index, or such similar variable. These variables are called the “underlying”. While there are a number of structured derivative products in the financial markets, they are essentially a variation or combination of the two basic building blocks- namely, the Forwards and the Options. The generic derivatives, which can be used in structured products in India, as per RBI’s comprehensive guidelines are:

• Forward rate agreements (FRA)
• Interest rate swaps (IRS)
• Interest rate futures (IRF)
• Foreign exchange forwards
• Currency swaps
• Currency options
• Interest rate caps and floors

A swap is defined as a “financial transaction in which two counterparties agree to exchange streams of payments, or cash flows, over time” on the basis agreed at the inception of the agreement. A swap is like a series of forward contracts. While the two main types of swaps are “interest rate” and “currency” swaps, equity swaps, credit swaps and commodity swaps have gained acceptance in recent years.

Under an interest rate swap, interest payment streams of differing character are periodically exchanged. There are two major types:

• Coupon swaps – exchange of fixed rates for floating rates
• Basis (or floating) swaps – exchange of one floating benchmark for another (eg. LIBOR for T-bill).

Under a currency and interest rate swap, the two counterparties agree to exchange interest and principal in one currency for interest and principal in another currency. These exchanges are generally done at the spot exchange rate ruling when the swap was entered into.

One basic difference between the swap market in major currencies and the USD/INR swap market in India is that, while the cash flows are similar, the pricing is different. In the major currencies, swap prices closely follow the yields on the AAA bonds. While in India, swap prices are more a function of demand and supply rather than bond prices. Due to exchange regulations and the absence of a liquid term interbank market, the forward margins in the USD/INR do not follow the interest rate differentials. Since a swap is essentially a series of forward contracts, it also suffers from the same constraints.

The banking system in India has tried to overcome this difficulty through the introduction of an INR swap called the Mumbai Interbank Forward Offered Rate (MIFOR) swap.

The swaps popularly used in the Indian market are

• MIFOR swaps
  MIFOR is the sum, in percentage per annum terms, of the USD LIBOR and the forward margin on the US Dollar in the Indian forex market, both for a given maturity. This serves a proxy for raising term Rupee funds.
• Principal Only Swaps (POS)
  Principal only swaps have become popular in recent years and in effect hedge (or create) exchange rate risk on the principal amount alone, leaving the interest payment in the original currency.
• Coupon Only Swaps (COS)
  Coupon only swaps merely exchange interest payment in one currency (eg. INR) for interest payment in another currency (eg. USD). The principal amount remains outside the scope of the coupon only swap.

An option contract is an agreement between two parties in which one party grants to the other, the right to buy (“Call option) or sell (“Put option) an asset under specified conditions and assumes the obligation to sell or buy it. A currency option is a contract where the underlying assets are currencies.

More often than not, option contracts are settled not by the sale or purchase of the asset but by the seller paying to the buyer, the difference between the market price and the agreed (Strike) price.

Some of the terms commonly used in the option market are:

• Seller (or writer) of the option: The party who has the obligation to buy/sell the underlying asset, at the agreed price and time, if the option is exercised by the buyer.
• Buyer of the option: The party who has the right but not the obligation, to sell/buy the asset underlying the contract, at the agreed price and time.
• Call option: It confers the right but not the obligation, to buy an asset.
• Put option: It confers the right but not the obligation, to sell an asset.
• Strike price: Also called ‘exercise price’, is the specified price at which the buyer of the contract can exercise his right to buy or sell the asset.
• Option premium: Fee or price paid by the buyer of the option contract to the seller.
• Value of an option: The market price of the option contract.
• Money-ness of an option:This is a measure of comparison of the strike price of an option with its market price. An option with a strike price equal to the current price of the asset is an At-the-money (ATM) option. If the strike price is more favourable to the buyer of the option than the current market price, it is an In-the-money (ITM) option. Conversely, if the strike price is less favourable to the buyer than the current market price, it is an Out-of-the-money (OTM) option.