Introduction of Futures

Derivatives Indian Scenario
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TYPES OF FINANCIAL DERIVATIVES
Financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently there are Complex varieties of derivatives already in existence and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, OTC traded, standardized or organized exchange traded, etc. are available in the market. Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present context, the basic financial derivatives which are popularly in the market have been described. In the simple form, the derivatives can be classified into different categories which are shown below :
DERIVATIVES
Financials
Commodities
Basics
Complex
1. Forwards 2. Futures 3. Options
1. Swaps 2.Exotics (Non STD)
Derivatives Indian Scenario 4. Warrants and Convertibles
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One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or assets. In commodity derivatives, the underlying instrument is commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas, gold, silver and so on. In financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters.
Another way of classifying the financial derivatives is into basic and complex. In this, forward contracts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivatives of derivatives. Derivatives are traded at organized exchanges and in the Over The Counter ( OTC ) market :
Derivatives Trading Forum
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Organized Exchanges Counter
Over The
Commodity Futures Financial Futures Options (stock and index) Stock Index Future
Forward Contracts Swaps
INTRODUCTION OF FUTURES Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contract, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contract, the exchange specifies certain standard features of the contract. It is standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (Or which can be used for reference purpose in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 90% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery
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The units of price quotation and minimum price change Location of settlement DIFINITION A Futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.
HISTORY OF FUTURES Merton Miller, the 1990 Nobel Laureate had said that financial futures represent the most significant financial innovation of the last twenty years. The first exchange that traded financial derivatives was launched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called the international monetary market (IMM) and traded currency futures. The brain behind this was a man called Leo Melamed, acknowledged as the father of financial futures who was then the Chairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollars.
These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange, the Chicago Board of Trade and the Chicago Board Options Exchange. By the
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1990s, these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps, and their success transformed Chicago almost overnight into the risk-transfer capital of the world.
DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS
Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of futures price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. Comparison between two as follows:
FUTURES
FORWARDS
Derivatives Indian Scenario 1.Trade on an 1. OTC in nature
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Organized Exchange 2.Standardized contract terms 3. hence more liquid 4. Requires margin payment 5. Follows daily Settlement 5. Settlement happens at end of period 2.Customized contract terms 3. hence less liquid 4. No margin payment
Table 2.1
FEATURES OF FUTURES Futures are highly standardized. The contracting parties need not pay any down payment. Hedging of price risks. They have secondary markets too.
TYPES OF FUTURES
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On the basis of the underlying asset they derive, the futures are divided into two types: Stock Futures Index Futures
PARTIES IN THE FUTURES CONTRACT
There are two parties in a futures contract, the buyers and the seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is who is SHORT on the futures contract. The pay-off for the buyers and the seller of the futures of the contracts are as follows:
PAY-OFF FOR A BUYER OF FUTURES
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PROFIT
E2 LOSS F E1
Figure 2.1
CASE 1:- The buyers bought the futures contract at (F); if the futures Price Goes to E1 then the buyer gets the profit of (FP). CASE 2:- The buyers gets loss when the futures price less then (F); if The Futures price goes to E2 then the buyer the loss of (FL).
PAY-OFF FOR A SELLER OF FUTURES
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P PROFIT
E2 E1 F
LOSS L
Figure 2.2 F PRICE E1, E2 = SETLEMENT PRICE CASE 1:- The seller sold the future contract at (F); if the future goes to E1 Then the seller gets the profit of (FP). CASE 2:- The seller gets loss when the future price goes greater than (F); If the future price goes to E2 then the seller get the loss of (FL). = FUTURES
MARGINS
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Margins are the deposits which reduce counter party risk, arise in a futures contract. These margins are collect in order to eliminate the counter party risk. There are three types of margins: Initial Margins:Whenever a future contract is signed, both buyer and seller are required to post initial margins. Both buyers and seller are required to make security deposits that are intended to guarantee that they will infect be able to fulfill their obligation. These deposits are initial margins and they are often
referred as purchase price of futures contract. Mark to market margins:The process of adjusting the equity in an investors account in order to reflect the change in the settlement price of futures contract is known as MTM margin. Maintenance margin:The investor must keep the futures account equity equal to or greater than certain percentage of the amount deposited as initial margin. If the equity goes less than that percentage of initial margin, then the investor receives a call for an additional deposit of cash known as maintenance margin to bring the equity up to the initial margin. ROLE OF MARGINS The role of margins in the futures contract is explained in the following example: Siva Rama Krishna sold an ONGC July futures contract to Nagesh at Rs.600; the following table shows the effect of margins on the Contract. The contract size of ONGC is 1800. The initial margin amount is say Rs. 30,000 the maintenance margin is 65% of initial margin.
Derivatives Indian Scenario PRICING FUTURES
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Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a future contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to captures the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below. F = SerT Where: F S r = = = Futures price Spot Price of the Underlying Cost of financing (using continuously compounded Interest rate) T e = = Time till expiration in years 2.71828 (OR)
F = S (1+r- q) t Where: F S r q t = = = = = Futures price Spot price of the underlying Cost of financing (or) interest Rate Expected dividend yield Holding Period
FUTURES TERMINOLOGY
Derivatives Indian Scenario Spot price: The price at which an asset trades in the spot market. Futures Price: The price at which the futures contract trades in the futures market. Contract cycle:
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The period over which a contract trades. The index futures contracts on the NSE have one-month and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered under one contract. instance, the contract size on NSEs futures markets is 200 Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. These will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. For
Cost of carry:
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The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called marking-to-market. Maintenance margin: This is some what lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
Derivatives Indian Scenario INTRODUCTION TO OPTIONS
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In this section, we look at the next derivative product to be traded on the NSE, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirement) to enter into a futures contracts, the purchase of an option requires as up-front payment. DEFINITION Options are of two types- calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyers the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. HISTORY OF OPTIONS Although options have existed for a long time, they we traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firms would then attempt to find a seller or writer of the option either from its own clients of those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered form two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the
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writer of the option would honour the contract. In 1973, Black, Merton and scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for option developed so rapidly that by early 80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back. Option made their first major mark in financial history during the tulipbulb mania in seventeenth-century Holland. It was one of the most
spectacular get rich quick brings in history. The first tulip was brought Into Holland by a botany professor from Vienna. Over a decade, the tulip
became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices spiraled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.
Derivatives Indian Scenario PROPERTIES OF OPTION
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Options have several unique properties that set them apart from other securities. The following are the properties of option: Limited Loss High leverages potential Limited Life PARTIES IN AN OPTION CONTRACT There are two participants in Option Contract. Buyer/Holder/Owner of an Option: The Buyer of an Option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Seller/writer of an Option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
TYPES OF OPTIONS The Options are classified into various types on the basis of various variables. The following are the various types of options. 1. On the basis of the underlying asset: On the basis of the underlying asset the option are divided in to two types: Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options contracts are also cash settled.
Stock options:
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Stock Options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. 2. On the basis of the market movements : On the basis of the market movements the option are divided into two types. They are: Call Option: A call Option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. It is brought by an investor when he seems that the stock price moves upwards. Put Option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. It is bought by an investor when he seems that the stock price moves downwards.
3. On the basis of exercise of option: On the basis of the exercise of the Option, the options are classified into two Categories. American Option: American options are options that can be exercised at any time up to the expiration date. Most exchange traded options are American. European Option: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.
PAY-OFF PROFILE FOR BUYER OF A CALL OPTION
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The Pay-off of a buyer options depends on a spot price of an underlying asset. The following graph shows the pay-off of buyers of a call option.
PROFIT ITM
S ATM OTM E1
E2
LOSS
Figure 2.3 S= Sp = E1 = E2 = SR = Strike price ITM = In the Money premium/loss ATM = At the Money Spot price 1 OTM = Out of the Money Spot price 2 Profit at spot price E1
CASE 1: (Spot Price > Strike price) As the Spot price (E1) of the underlying asset is more than strike price (S). The buyer gets profit of (SR), if price increases more than E1 then profit also increase more than (SR) CASE 2: (Spot Price < Strike Price) As a spot price (E2) of the underlying asset is less than strike price (S) The buyer gets loss of (SP); if price goes down less than E2 then also his loss is limited to his premium (SP) PAY-OFF PROFILE FOR SELLER OF A CALL OPTION The pay-off of seller of the call option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a call option:
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PROFIT P ITM E1 ATM E2 S OTM
R LOSS
S= SP = E1 = E2 = SR =
Figure 2.4 Strike price ITM = In the Money Premium / profit ATM = At The money Spot Price 1 OTM = Out of the Money Spot Price 2 loss at spot price E2
CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying is less than strike price (S). The seller gets the profit of (SP), if the price decreases less than E1 then also profit of the seller does not exceed (SP). CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (S) the Seller gets loss of (SR), if price goes more than E2 then the loss of the seller also increase more than (SR).
PAY-OFF PROFILE FOR BUYER OF A PUT OPTION The Pay-off of the buyer of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of the buyer of a call option.
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PROFIT
ITM S E1 ATM OTM E2
LOSS
S= SP = E1 = E2 = SR =
Figure 2.5 Strike price ITM = In the Money Premium / loss ATM = At the Money Spot price 1 OTM = Out of the Money Spot price 2 Profit at spot price E1
CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying asset is less than strike price (S). The buyer gets the profit (SR), if price decreases less than E1 then profit also increases more than (SR). CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (S), The buyer gets loss of (SP), if price goes more than E2 than the loss of the buyer is limited to his premium (SP).
PAY-OFF PROFILE FOR SELLER OF A PUT OPTION The pay-off of a seller of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a put option.
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PROFIT P ITM E1 ATM S R LOSS E2
OTM
S = SP = E1 = E2 = SR =
Strike price Premium/profit Spot price 1 Spot price 2 Loss at spot price E1
Figure 2.6 ITM = In The Money ATM = At The Money OTM = Out of the Money
CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying asset is less than strike price (S), the seller gets the loss of (SR), if price decreases less than E 1 than the loss also increases more than (SR). CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (S), the seller gets profit of (SP), of price goes more than E2 than the profit of seller is limited to his premium (SP).
FACTORS AFFECTING THE PRICE OF AN OPTION The following are the various factors that affect the price of an option they are: Stock Price:
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The pay-off from a call option is an amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa. Strike price: In case of a call, as a strike price increases, the stock price has to make a larger upward move for the option to go in-the money. Therefore, for a call, as the strike price increases option becomes less valuable and as strike price decreases, option become more valuable. Time to expiration: Both put and call American options become more valuable as a time to expiration increases. Volatility: The volatility of a stock price is measured of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. The value of both calls and puts therefore increases as volatility increase. Risk- free interest rate: The put option prices decline as the risk-free rate increases where as the price of call always increases as the risk-free interest rate increases.
Dividends: Dividends have the effect of reducing the stock price on the X- dividend rate. This has a negative effect on the value of call options and a positive effect on the value of put options.
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PRICING OPTIONS
An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is
potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option. There are various models which help us get close to the true price of an option. Most of these are variants of the celebrated Black- Scholes model for pricing European options. Today most calculators and spread-sheets come with a built-in Black- Scholes options pricing formula so to price options we dont really need to memorize the formula. All we need to know is the variables that go into the model.
The Black-Scholes formulas for the price of European calls and puts on a non-dividend paying stock are:
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Call option CA = SN (d1) Xe- rT N (d2) Put Option PA = Xe N (- d2) SN (- d1)

- rT
Where d1 = ln (S/X) + (r + v2/2) T vT And d2 = d1 - vT Where CA = VALUE OF CALL OPTION PA = VALUE OF PUT OPTION S = SPOT PRICE OF STOCK N = NORMAL DISTRIBUTION VARIANCE (V) = VOLATILITY X = STRIKE PRICE r = ANNUAL RISK FREE RETURN T = CONTRACT CYCLE e = 2.71828 r = ln (1 + r)
Table 2.2
OPTIONS TERMINOLOGY Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date:
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The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the option contract is known as the strike price or the exercise price. In-the-money option: An in-the-Money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price). Out- ofthe money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow it was exercised immediately. A call option on the index is out-of-the-the money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components- intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
Derivatives Indian Scenario Time value of an option:
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The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equal. At expiration, an option should have no time value.
DISTINCTION BETWEEN FUTURES AND OPTIONS FUTURES 1. Exchange traded, with Novation 2. Exchange defines the product 3. Price is zero, strike price moves 4. Price is Zero 5. Linear payoff 6. Both long and short at risk OPTIONS 1. Same as futures 2. Same as futures 3. Strike price is fixed, price moves 4. Price is always positive 5. Nonlinear payoff 6. Only short at risk
Table 2.3
CALL OPTION
PREMIUM STRIKE PRICE INTRINSIC VALUE TIME VALUE TOTAL VALUE CONTRACT OUT OF THE MONEY
560 540 520
0 0 0
2 5 10
2 5 10
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500 480 460 440
0 20 40 60
15 10 5 2
15 30 45 62
AT THE MONEY IN THE MONEY
Table 2.4 PUT OPTION

PREMIUM INTRINSIC VALUE TIME VALUE TOTAL VALUE
STRIKE PRICE
CONTRACT
560 540 520
60 40 20
2 5 10
62 45 30
IN THE MONEY AT THE MONEY OUT OF THE MONEY
500 480 460 440
0 0 0 0
15 10 5 2
15 10 5 2
Table 2.5 PREMIUM = INTRINSIC VALUE + TIME VALUE The difference between strike values is called interval
SWAPS
A contract between two parties, referred to as counter parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counter parties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many
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different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.
3.1 Why did swaps emerge?

In the late 1970's, the first currency swap was engineered to circumvent the currency control imposed in the UK. A tax was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty. Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-to-back loans were used to exchange debts in different currencies. For example, a British company wanting to raise capital in the France would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position. Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity. However this type of arrangement lead to development of more sophisticated swap market of today. Facilitators The problem of locating potential counter parties was solved through dealers and brokers. A swap dealer takes on one side of the transaction as counterparty. Dealers work for investment, commercial or merchant banks. "By positioning the swap", dealers earn bidask spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party. In an ideal situation, the dealer would offset his risks by matching one step with another to streamline his payments. If the dealer is a counterparty paying fixed rate payments and receiving floating rate payments, he would prefer to be a counterparty receiving fixed payments and paying floating rate payments in another swap. A perfectly netted position as just described is not necessary. Dealers have the flexibility to cover their exposure by matching multiple parties and by using other tools such as futures to cover an exposed position until the book is complete.
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Swap brokers, unlike a dealer do not take on a swap position themselves but simply locate counter parties with matching needs. Therefore, brokers are free of any risks involved with the transactions. After the counter parties are located, the brokers negotiate on behalf of the counter parties to keep the anonymity of the parties involved. By doing so, if the swap transaction falls through, counter parties are free of any risks associated with releasing their financial information. Brokers receive commissions for their services.
3.2 Swaps Pricing:

There are four major components of a swap price.
Benchmark price Liquidity (availability of counter parties to offset the swap). Transaction cost Credit risk 1
Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates. Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counter parties for long duration swaps, specially so in India Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference. Yield on 91 day T. Bill - 9.5% Cost of fund (e.g.- Repo rate) 10% The transaction cost in this case would involve 0.5%
Source: www.appliederivatives.com
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Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating. Swap Market Participations Since swaps are privately negotiated products, there is no restriction on who can use the market. However, parties with low credit quality have difficulty entering the market. This is due to fact that they cannot be matched with counter parties who are willing to take on their risks. In the U.S. many parties require their counter parties to have minimum assets of $10 million. This requirement has become a standardized representation of "eligible swap participants".
3.3 Introduction of Forward Rate Agreements and Interest Rate Swaps

The Indian scene 2 Objective To further deepen the money markets To enable banks, primary dealers and all India financial institutions to hedge interest rate risks.
These guidelines are intended to form the basis for development of Rupee derivative products such as FRAs/IRS in the country. They have been formulated in consultation with market participants. The guidelines are subject to review, on the basis of development of FRAs/IRS market. Accordingly, it has been decided to allow scheduled commercial banks (excluding Regional Rural Banks), primary dealers and all -India financial institutions to undertake FRAs/IRS as a product for their own balance sheet management and for market making purposes. Prerequisites
Source: RBI Guidelines
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Participants are to ensure that appropriate infrastructure and risk management systems are put in place. Further, participants should also set up sound internal control system whereby a clear functional separation of trading, settlement, monitoring and control and accounting activities is provided.
Description of the product

A Forward Rate Agreement (FRA) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed benchmark/reference rate prevailing on the settlement date.
An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount of multiple occasions on specified periods. Accordingly, on each payment date that occurs during the swap period-Cash payments based on fixed/floating and floating rates are made by the parties to one another.
Currency swaps can be defined as a legal agreement between two or more parties to exchange interest obligation or interest receipts between two different currencies. It involves three steps: Initial exchange of principal between the counter parties at an agreed upon rate of exchange which is usually based on spot exchange rate. This exchange is optional and its sole objective is to establish the quantum of the respective principal amounts for the purpose for calculating the ongoing payments of interest and to establish the principal amount to be re-exchanged at the maturity of the swap. Ongoing exchange of interest at the rates agreed upon at the outset of the transaction. Re-exchange of principal amount on maturity at the initial rate of exchange.
This straight forward, three step process results in the effective transformation of the debt raised in one currency into a fully hedged liability in other currency.
Participants

Schedule commercial banks. Primary dealers All India financial institutions
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3.5 Currency Swaps in India

RBI in its slack season credit policy '97 allowed the authorized dealers to arrange currency swap without its prior approval. This was to enable those requiring long-term forward cover to hedge themselves without altering the external liability of the country. Prior to this policy RBI had been approving rupee foreign currency swaps between corporates on a case basis, but no such swaps were taking place.
RBI in its process of making the Indian corporates globally competitive has simplified their access to this instrument by making changes in its credit policy. But despite an easing regulation, swaps have not hit the market in a big way.
India has a strong dollar-rupee forward market with contracts being traded for one, two, six-month expiration. Daily trading volume on this forward market is around $500 million a day. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets. Outside India, there is a small market for cash settled forward contracts on the dollar rupee exchange rate.
While studying swaps in the Indian context, the counter parties involved are Indian corporates and the swap dealers are the Authorized dealers of foreign exchange, i.e., the banks allowed by RBI to carry out the swaps. These banks form the counterparty to the corporates on both sides of the swap and keep a spread between the interest rates to be received and offered. One of the currencies involved is the Indian rupee and the other could be any foreign currency. The interest rate on the rupee is most likely to be fixed, and on foreign currency it could be either fixed or floating.
3.5.1 The Players Swaps are instruments, which allow the user to hedge - that are to offset risk or to take risk deliberately in the expectation of making profit. The user in this case would be any
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corporate having a foreign exchange exposure/ a risk. A foreign exchange exposure will arise out of the mismatch between the currency of inflow and outflow. The outflow being considered here is the interest and the principal payment on the borrowings of the corporates. Corporates having such currency mismatches would be of the following types
3.5.2Corporates with rupee loan and forex revenue Mainly the exporters would fall in this category. Corporates with foreign subsidiaries would also be having forex revenues but due to cheaper availability of funds abroad, it is unlikely that these subsidiaries would be funded by a rupee loan. Thus the main players meeting this criterion would be the exporters. The main players in the Indian market are Tata Exports, Hindustan Levers Ltd., ITC Ltd., and Nestle Indian Ltd. among the others.
3.5.3 Corporates with forex loan and rupee revenue The corporates having foreign currency loan could further be classified into two groups. One which have net imports and thus may have raised loans to meet their import requirements, for example Bharat Heavy Electricals Ltd., Apollo Tyres Ltd., Tata Power Co. Ltd. Two, which do not have net imports but have raised foreign currency loan for funding requirements, for example Arvind Mills Ltd., Ballarpur Industries etc.
3.5.4 Corporates with no foreign exposure There may be corporates with no existing exposure but willing to take up an exposure in an expectation of making profit out of this transaction. Thus they would be willing to swap their rupee loan with forex loan and book in forward cover or make the payments on spot basis on the day of disbursements. These corporates may also consider the option of raising new loans in foreign currency and swap a rupee loan if it turns out to be cheaper option. Thus many corporates would fall under this category. 3.5.5 Banks Banks act as the authorized dealers and are instrumental in arranging swaps. They have to take the swaps on their books. A bank would enter into swap with a party and then try to find another with opposite requirement to hedge itself against any fluctuation in exchange
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rates. They would normally keep a spread between the offer and bid rate thus make profit from transaction. They also take up the credit risk of counterparties.
3.6 The needs of the players and how currency swaps help meet these needs
3.6.1 To manage the exchange rate risk Since the international trade implies returns and payments in a variety of currencies whose relative values may fluctuate it involves taking foreign exchange risk. The players mentioned above are facing this risk. A key question facing the players then is whether these exchange risks are so large as to affect their business. A related question is what, if any, special strategies should be followed to reduce the impact of foreign exchange risk. One-way to minimize the long-term risk of one currency being worth more or less in the future is to offset the particular cash flow stream with an opposite flow in the same currency. The currency swap helps to achieve this without raising new funds; instead it changes existing cash flows.
3.6.2 To lower financing cost Currency swaps can be used to reduce the cost of loan. The following example deals with such a case. Consider two Indian corporates A & B. Corporate A is an exporter with a rupee loan at 14% fixed rate. B has a dollar loan at LIBOR + 0.25% floating rate. Due to difference in the credit rating of the two companies, the rates at which the loans are available to them are different. A has access to 14% rupee loan and dollar loan at LIBOR + 0.25%. A would like to convert its rupee loan into a dollar loan, to reverse its revenue in dollars and B would like to convert the dollar loan into a fixed rupee loan thus crystallizing its cost of borrowing. They can enter into a swap and reduce the cost compared to what it would have been if they had taken a direct loan in the desired currencies. Comparative advantage
Company A Exporter Options: Borrow ruppe at 13%
Company B Options: Borrow ruppe at 14.5%

Borrow dollars at LIBOR +100 bps
- 35 Borrow dollars at LIBOR +200 bps
Company A has an absolute advantage over B in both the markets/ rates. The advantage in terms of rupee funds is 150 bps while it is 100 bps in case of dollar rates. Thus B has a comparative advantage in terms of dollar rates. Now as A is an exporter he would be more interested in a dollar denominated loan to offset his future receivables. Therefore it would be advantageous if A would borrow at rupee rates and B borrows at LIBOR rates. Then they may go in for a currency swap. The net gain arising out of such a swap will be 50 bps, which may be shared between the parties. The swap will thus result in A paying B a floating rate of LIBOR + 75 bps in return for a 13% fixed rupee rate. The swap will take place on a notional principal basis. The effective cost for A is LIBOR + 75 bps and for B it is 14.25%. The effective cost for A is 12.75%. This results into a net saving of 25 bps for both the parties. Figure 3.1 LIBOR +75 bps Company A 12.75% in INR Company B
13% in INR
Libor +200 bps
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To access restricted markets
Many countries have restrictions on the type of borrowers that can raise funds in their bond markets. Foe example an Indian firm exporting goods to Japan may wish to issue bonds in yen to form a natural hedge by reversing their cash flows. To issue a yen bond, the borrower must qualify for a single A credit rating. If the company does not qualify in this regard it would fail to issue yen denominated bond. By issuing bonds in the rupee market and then entering into a currency swap, the firm can meet its expectation of raising a yen denominated loan.
3.6.3 Swaps for reducing the cost of borrowing With the introduction of rupee derivatives the Indian corporates can attempt to reduce their cost of borrowing and thereby add value. A typical Indian case would be a corporate with a high fixed rate obligation. Eg. Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of 18.5%. Today a 364-day T. bill is yielding 10.25%, as the interest rates have come down. The 3month MIBOR is quoting at 10%.
Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month MIBOR.
The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next one year.
The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75 %. Figure 3.2 Fixed 10.75 Mehta Ltd 3 Months MIBOR Counter Party
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18.75%s
MIBOR
The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75 = 7.75 + MIBOR At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75%
The gain for the firm is (18.5 - 17.75) = 0.75 %
The risks involved for the firm are - Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments. - The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond 10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firm hold a strong view that MIBOR shall remain below 10.75%. This will require continuous monitoring on the path of the firm.
How does the bank benefit out of this transaction? The bank either goes for another swap to offset this obligation and in the process earn a spread. The bank may also use this swap as an opportunity to hedge its own floating liability. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%.
Taking advantage of future views/ speculation If a bank holds a view that interest rate is likely to increase and in such a case the return on fixed rate assets will not increase, it will prefer to swap it with a floating rate interest. It may also swap floating rate liabilities with a fixed rate.
3.7 Factors to be looked at while doing a swap
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Though swaps can be used in the above conditions effectively, corporates need to look at a few factors before deciding to swap.
The estimated net exposure They need to estimate the net exposure that they are likely to have in the future. Projecting the growth in exports/ imports, taking into account the changes in management and government policies can do this. Expected range of exchange rates This can be determined by a fundamental and technical analysis. For fundamental analysis one needs to keep track of the balance of payment condition, GDP growth rate, etc. of the country. The technical factors look at past trends and expected demand-supply position. Other factors like political stability also needs to be considered. Expected interest rates Since currency swaps include exchange of interest payments, the interest rates also need to be traced. By keeping an eye on the yield curve of long term bonds and the macro economic variables of different countries, the interest rates can be estimated. Amount of cover to be taken Having estimated the amount of exposure, the expected exchange rates and the interest rates, the parties can determine the risks involved and can decide upon the amount of cover to be taken. This shall depend on the management policy whether they believe in minimizing the risk for a given level of return or maximizing the gain for a given level of risk. The risk taking capability of a corporate will depend upon the financial backup to absorb the losses, if any, the availability of time and resources to monitor the forex market.
(i)
FUTURE 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
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called the settlement price. The settlement price, normally, converges towards the futures 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. 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 are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.
BASIC FEATURES OF FUTURE CONTRACT

1. Standardization: Futures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted. The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month. The last trading date. Other details such as the tick, the minimum permissible price fluctuation.
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2. Margin: Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Initial Margin: is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid. 3. Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel
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out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract. PRICING OF FUTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the future/forward, present value at time to maturity , will be found by discounting the .
by the rate of risk-free return
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows. In the case where the forward price is higher: 1. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. 2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit. In the case where the forward price is lower: 1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds. 2. On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate.
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3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.] 4. The difference between the two amounts is the arbitrage profit.
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TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATURE Operational Mechanism FORWARD CONTRACT FUTURE CONTRACT
Traded directly between Traded on the exchanges. two parties (not traded on the exchanges).
Contract Specifications Counter-party risk
Differ from trade to trade.
Contracts contracts.
are
standardized
Exists.
Exists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally settlement. guarantees their
Liquidation Profile
Low, tailor
as
contracts
are High, as contracts are standardized
made
contracts exchange traded contracts.
catering to the needs of the needs of the parties.
Price discovery
Not efficient, as markets Efficient, as markets are centralized are scattered. and all buyers and sellers come to a common platform to discover the price.
Examples
Currency market in India.
Commodities, futures, Index Futures and Individual stock Futures in India.
Derivatives Indian Scenario OPTIONS -
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A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as option. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the strike price.
There are two types of options i.e., CALL OPTION & PUT OPTION. CALL OPTION:
A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Call option. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. PUT OPTION:
A contract that gives its owner the right but not the obligation to sell an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as a Put option. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.
Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.
Derivatives Indian Scenario SWAPS -
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Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a SWAP. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are: INTEREST RATE SWAPS: Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract. CURRENCY SWAPS: Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. FINANCIAL SWAP: Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

1 1 FUTURES
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Futures contract is a firm legal commitment between a buyer & seller in which they agree to exchange something at a specified price at the end of a designated period of time. The buyer agrees to take delivery of something and the seller agrees to make delivery. 1.1 1.2 2.2 STOCK INDEX FUTURES Stock Index futures are the most popular financial futures, which have been used to hedge or manage the systematic risk by the investors of Stock Market. They are called hedgers who own portfolio of securities and are exposed to the systematic risk. Stock Index is the apt hedging asset since the rise or fall due to systematic risk is accurately shown in the Stock Index. Stock index futures contract is an agreement to buy or sell a specified amount of an underlying stock index traded on a regulated futures exchange for a specified price for settlement at a specified time future. Stock index futures will require lower capital adequacy and margin requirements as compared to margins on carry forward of individual scrips. The brokerage costs on index futures will be much lower. Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. The impact cost will be much lower in case of stock index futures as opposed to dealing in individual scrips. The market is conditioned to think in terms of the index and therefore would prefer to trade in stock index futures. Further, the chances of manipulation are much lesser. The Stock index futures are expected to be extremely liquid given the speculative nature of our markets and the overwhelming retail participation expected to be fairly high. In the near future, stock index futures will definitely see incredible volumes in India. It will be a blockbuster product and is pitched to become the most liquid contract in the world in terms of number of contracts traded if not in terms of notional value. The advantage to the equity or cash market is in the fact that they would become less volatile as most of the speculative activity would shift to stock index futures. The stock index futures market should ideally have more depth, volumes and act as a stabilizing factor for the cash market. However, it is too early to base any conclusions on the volume or to form any firm trend.
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The difference between stock index futures and most other financial futures contracts is that settlement is made at the value of the index at maturity of the contract.
1.3 1.4
2.3 FUTURES TERMINOLOGY
Contract Size The value of the contract at a specific level of Index. It is Index level * Multiplier.
Multiplier It is a pre-determined value, used to arrive at the contract size. It
is the price per index point. Tick Size It is the minimum price difference between two quotes of similar nature. Contract Month The month in which the contract will expire. Expiry Day The last day on which the contract is available for trading. Open interest Total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted.
Volume No. Of contracts traded during a specific period of time. During a day, during a
week or during a month. Long position Outstanding/unsettled purchase position at any point of time.

Short position Outstanding/ unsettled sales position at any point of time. Open position Outstanding/unsettled long or short position at any point of time. Physical delivery
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Open position at the expiry of the contract is settled through delivery of the underlying. In futures market, delivery is low. Cash settlement Open position at the expiry of the contract is settled in cash. These contracts Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is settled by two parties - one buyer and one seller, at the terms other than defined by the exchange. World wide a significant portion of the energy and energy related contracts (crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.
2.4 Pay off for futures: A Pay off is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits, for the buyer and the seller of futures contracts, are unlimited.
Pay off for Buyer of futures: (Long futures) The pay offs for a person who buys a futures contract is similar to the pay off for a
person who holds an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves
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up, the long futures position starts making profits and when the index moves down it starts making losses . Pay off for seller of futures: (short futures) The pay offs for a person who sells a futures contract is similar to the pay off for a person who shorts an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits and when the index moves up it starts making losses.
OPTIONS
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3.1 OPTIONS
An option agreement is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer a designated instrument at a specific price within a specified period of time. Certain options are shorterm in nature and are issued by investors another group of options are long-term in nature and are issued by companies. 2.1 2.2 3.2 OPTIONS TERMINOLOGY:
Call option: A call is an option contract giving the buyer the right to purchase the stock. Put option: A put is an option contract giving the buyer the right to sell the stock. Expiration date: It is the date on which the option contract expires. Strike price: It is the price at which the buyer of a option contract can purchase or sell the stock
during the life of the option Premium: Is the price the buyer pays the writer for an option contract. Writer: The term writer is synonymous to the seller of the option contract. Holder: The term holder is synonymous to the buyer of the option contract.
Straddle:
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A straddle is combination of put and calls giving the buyer the right to either buy or sell stock at the exercise price. Strip: A strip is two puts and one call at the same period. Strap: A strap is two calls and one put at the same strike price for the same period. Spread: A spread consists of a put and a call option on the same security for the same time period at different exercise prices. The option holder will exercise his option when doing so provides him a benefit over buying or selling the underlying asset from the market at the prevailing price. These are three possibilities. 1. In the money: An option is said to be in the money when it is
advantageous to exercise it. 2. Out of the money: The option is out of money if it not advantageous to exercise it. 3. At the money: IF the option holder does not lose or gain whether he exercises his option or buys or sells the asset from the market, the option is said to be at the money. The exchanges initially created three expiration cycles for all listed options and each issue was assigned to one of these three cycles. January, April, July, October. February, March, August, November. March, June, September, and December.
In India, all the F and O contracts whether on indices or individual stocks are available for one or two or three months series and they expire on the Thursday of the concerned month.

2.3 3.3 CALL OPTION:
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An option that grants the buyer the right to purchase a designated instrument is called a call option. A call option is a contract that gives its owner the right, but not the obligation, to buy a specified price on or before a specified date. An American call option can be exercised on or before the specified date only. European options can be exercised on the specified date only. 3.4 PUT OPTION: An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares. A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price. For example, if you have one Mar 09 Taser 10 put, you have the right to sell 100 shares of Taser at $10 until March 2008 (usually the third Friday of the month). If shares of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in the market and sell the shares to the option's writer for $10 each, which means you make $500 (100 x ($10-$5)) on the put option. Note that the maximum amount of potential proft in this example ignores the premium paid to obtain the put option. 3 3.5 FACTORS DETERMINIG OPTION VALUE: 4 Stock price Strike price Time to expiration Volatility Risk free interest rate Dividend
3.6 DIFFERENCE BETWEEN FUTURES & OPTION:
FUTURES 1) Both the parties are obligated to perform. 2) With futures premium is paid by either party.
OPTIONS 1) Only the seller (writer) is obligated to perform. 2) With options, the buyer pays the seller a

3) The parties to futures contracts must perform premium.
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at the settlement date only. They are not 3) The buyer of an options contract can exercise obligated to perform before that date. any time prior to expiration date.
4) The holder of the contract is exposed to the 4) The buyer limits the downside risk to the option entire spectrum of downside risk and had the potential for all upside return. 5) In futures margins to be paid. They are approximate 15-20% on the current stock price. premium but retain the upside potential. 5) In options premiums to be paid. But they are very less as compared to the margins.
5.1.1.1.1 3.7 Advantages of option trading:

Risk management: put option allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.
Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry day to decide whether or exercised the option and buys the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.
Speculations: The ease of trading in and out of option position makes it possible to trade options with no intention of ever exercising them. If investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised.
Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly however leverage usually involves more risks than a direct
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investment in the underlying share. Trading in options can allow investors to benefit from a change in the price of the share without having to pay of the share.
3.8 Summary of options Call option buyer Pays premium Right to exercise and buy the share Profits from rising prices Limited losses, potentially unlimited gain Put option buyer Pays premium Right to exercise and sell shares Profits from falling prices Limited losses, potentially unlimited gain Call option writer (seller) Receives premium Obligation to sell shares if exercised Profits from falling prices or remaining neutral Potentially unlimited losses, limited gain
Put option writer (seller) Receives premium Obligation to buy shares if exercised Profits from rising prices or remaining neutral Potentially unlimited losses, limited gain
Options in India: Teji and Mandi
The operations in the Indian market have been confined to call options (known as teji), put options (know as mandi), their combination in the form of straddles (know as jhota or duranga) and bhav- bhav on stock only. While in options trading markets in the world, options with exercise price less than, equal to, greater than the stock price are available in the markets only out-of-the-money call options i.e. options with an exercise price higher than the current stock price, are traded. Hence the name teji. The seller or the writer of such an option is called teji khaii-wal as he agrees to sell the share in case of teji (the price arising out above the exercise price) for a value, the option premium. The buyer of the option is called teji lagaiiwal.
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Similarly, the put options traded are also those which are out-of-the-money options i.e. options with an exercise price lower than the current stock price. The writers of such options agree to buy a share in the event of its price falling below the exercise price, i.e. mandi, in consideration for a premium. The writer of an option of this type is called the mandi khaii-wal while the buyer is a mandi lagaii-wal. Both teji and mandi have an expiry time at the stroke of 15 minutes before the closing time of trading of the next business day. However, sometimes they are event-based, so that while they can originate any day the exercise date is fixed, like the day following the budget day or the day following the annual general meeting of the company whose share underlies the teji/mandi contract. The premium on teji/mandi options is fixed customarily, usually at 25 paise per share, and is not negotiable, although the strike price may be negotiated. On event-based options, the premium payable is double than that on the ordinary options. The greater part of the derivative trading in India is in the form of jhota or fatak, which involves the buyer, known variously as lagaii-wal or lagane-wale or punter, the writer, known by various names like khaii-wal, khane-wala or bookie, and a broker, the mediator. A fatak involves a call option and put option available to the punter at exercise prices higher and lower than a certain value, which is generally the closing price of a share on a given day. The size of fatak, that is to say, the gap between the exercise prices of call and put options is generally higher before and after the market trading hours and it is smaller during these hours. Another derivative traded in the market is known as bhav-bhav or nazrana. In this case, the closing price of the day is taken as the exercise price and the holder of nazrana can exercise a call or put option depending on the price of the stock. For instance, if the closing price of a stock is Rs 66 on a given day, then the holder shall hold both options with him: buy the share from the bookie at a price of Rs 66 or sell to him the share at the same price (Rs 66) at the time of exercise. It will obviously pay the option buyer to buy at Rs 66 if the share price goes beyond this level and sell it to the writer at Rs 66 if the share price decreases below Rs 66.
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In nazrana, then, the exercise price is fixed and so is the date of expiry. However, the premium is negotiable. The premium is roughly one-half of the amount of gap in fatak. Thus, with the share price of Rs 66 and a fatak with exercise prices of Rs 63 and Rs 69, the gap is equal to Rs 3. In such case, the premium payable by a buyer shall be around Rs 1.50 per share. The nazrana apparently exposes the writer to greater risk by providing call and put options to the buyer at the same exercise price, in contrast to a fatak where the same options are given but with a gap in the exercise prices. However, a closer look at the two reveals that for a given amount of premium, one has to write option on a larger number of shares in case of a fatak than in case of nazrana. Accordingly, when there are significant fluctuations in the price of the underlying share, a fatak involves a far greater degree of risk than a nazrana.
The chronology of introduction of the futures and options in India is given below:
Although exchanges like Bombay Stock Exchanges and Vadodara Stock Exchange have for long shown their willingness for trading in futures and options, but a concerted effort in this direction was made by the National Stock Exchange (NSE) only in July 1995, when it considered the modalities of introducing deritivative trading, mainly futures and options. Within a few months, NSE developed a system of future and option trading aiming at modifying the carry forward system to include future and options in its scope. By January 1996, the NSE started work on the scheme of such trading in March 1996; it made a presentation to SEBI on its plan to commence trading in futures and options. The exchange proposed to start with index based future and index base of options, which are seen as comparably safer forms of derivatives. By May 1996, the NSE finalized the net worth requirement for the membership of the purposed future and options trading segments, which was set at 5 crore. These constitute NSEs first step towards initialing futures and options trading, which, the NSE visualized, would commence in the month of November, 1996.
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The NSE decided for the future and options segment to have two type of membership (restrict to just corporate members): member trading only in futures products, and those who write options. The members were to further earmark cash deposits for the National securities Clearing Corporation Limited (NSCCOL). The deposits collected by the NSCCL were to form part of members contribution to a separate settlement fund for the future and options segment, which was to commence operations along with trading in futures and options. Around this time the Bombay Stock Exchange (BSE) also decided to form a committee to consider the introduction of trading in derivatives, government paper and debt market instruments. It proposed to be working on index- based future and submitted a proposal to SEBI. THE SEBI, in the mean time, set up a special derivatives regulatory department which would coordinate and ensure the sharing the information between stock exchanges. It also set up the L.C. Gupta Committee to go into the question of derivatives trading and to suggest various policy and regulatory measures that need to be undertaken before trading is formally allowed. Recently, the Union Law Ministry has asked SEBI to go ahead with the proposed introduction of futures and options trading without effecting changes in the Securities Contract Regulation Act (SCRA) 1956. In 1995, the Centre had passed an enabling legislation effecting changes in the SCRA which allowed the issuance and trading of options in securities. The L.C.Gupta committee appointed by SEBI is likely to suggest the various policy and regulatory measures that need to be on place before derivatives trading may be formally allowed in India. The trading of futures and options will see light of the day only after the SEBI gives its assent to it.
ayoff & Pricing of Futures and Options - October 1st, 2010 A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the Xaxis and the profits/losses on the Yaxis. In this section we shall take a look at the payoffs for buyers and sellers of futures and options.

Payoff for futures
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Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.
Options payoffs The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. Payoff profile of buyer of asset: Long asset In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price,S4 it is purchased, the investor is said to be long the asset. Payoff profile for seller of asset: Short asset In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and buys it back at a future date at an unknown price S4 Once it is sold, the investor is said to be short the asset. Payoff profile for buyer of call options: Long call
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A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option.
Swap Market in India. In India, the Reserve Bank of India has permitted banks to arrange currency swaps with one currency leg being Indian Rupee. However, the USD/INR forward foreign exchange markets are illiquid beyond one year. Since currency swaps involve the forward foreign exchange markets also, there are limitations to entering the Indian Rupee currency swaps beyond twelve months. Moreover, banks are also not allowed to take risk /run open swap books i.e., they have to locate counter parties with matching requirements; e.g. one desiring to swap a dollar liabilities into rupee liabilities and the other wishing to exchange rupee debt servicing obligation for dollar obligations. However, some aggressive banks do provide quotes for currency swaps for three to five years out for reasonable size transactions. Corporates who have huge rupee liabilities and want have foreign currency loans in their books, both as a diversification as well as a cost reduction exercise could achieve their objective by swapping their rupee loans into foreign currency loans through the dollar/rupee swap route. However, the company is assuming currency risk in the process and unless carefully managed, might end up increasing the cost of the loan instead of reducing it. In India, it is more the norm for corporates to swap their foreign currency loans into rupee liabilities rather than the other way round. Example: A corporate has a loan of USD 10 million outstanding with remaining maturity of 2 years, interest on which is payable every six months linked to 6-month Libor + 150 basis points. This dollar loan can be effectively converted into a fixed rate rupee loan through a currency swap. If the corporate wants to enter into a currency swap to convert his loan interest payments and principal into INR, he can find a banker with whom he can exchange the USD interest payments for INR interest payments and a notional amount of principal at the end of the swap period. The banker quotes a rate of say 10.75% for a USD/INR swap. The total cost for the corporate would now work out to 12.25%. If the spot rate on the date of transaction is 44.65, the rupee liability gets fixed at Rs. 446.50 mio. At the end of the swap, the bank delivers USD 10 million to the corporate for an exchange of INR 446.50 mio, which is used by the corporate to repay his USD loan. The corporate is able to switch from foreign currency. http://www.emecklai.com/Market_Resources.aspx?name=Mecklai_Knowledge_Centre/Currency Swap http://www.hdfcbank.com/wholesale/fit/financial_institutions/derivatives_desk/derivatives_desk _fcw.htm
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6 The BRIC Currency Swap Proposal Is A Global Game Changer

S.N. Kapadia, LiveMint | Jun. 1, 2012, 4:10 AM | 1,284 | 2
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6.1 S.N. Kapadia
S.N. Kapadia is a Geopolitical Strategist and Consultant
6.1.1.1.1
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Romney's Sinophobia A Coal Crisis in India... and China India's Austerity Sham At the last BRICS summit held in March in New Delhi, development banks of the participating countries agreed on a proposal to extend credit in local currency for trade, project financing and infrastructure projects. So far, no clear mechanism on how they will extend local currency credit has been announced. Some financial gurus even dismiss the BRICS agreement as purely symbolic. Yet banks in London, New York, Tokyo and Singapore would be wise to take a second look at what now could be the most significant agreement in international finance since the euro. BRICS countries make up a massive trade bloc. Current intra-BRICS trade stands at $307 billion; it is set to reach $500 billion by 2015. Within BRICS, China is the dominant country, exporting $135 billion in goods and services a year to its partners. India imports $50 billion annually from China and Chinese goods account for 11.8% of Indias total imports, increasing their share of the Indian market by 2% in just four years. As trade increases, China could move swiftly to provide renminbi for importers of Chinese goods. At this time, China facilitates payment in renminbi through a central bank liquidity swap. Since 2009, 16 countries have exchanged local currencies for a total of 1.6 trillion renminbi; more are in line to participateJapan and Great Britain are rumored to be in queue. But after the Delhi meeting, Chinas BRICS partners may leapfrog and be next on the list. From BRICS, Russia is currently the only country that swaps its currency with ChinaIndia, Brazil, and South Africa should take note.
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Four factors make a central bank liquidity swap particularly important. First, BRICS countries are losing purchasing power because of depreciation against the dollar. The dollar accounts for 40% of global foreign exchange trade. But its getting harder for BRICS to buy dollars. Brazil has seen its currency depreciate by over 16% since February 2012 and the Indian rupee fell to an all-time low of 56.51 to the dollar on Thursday, losing more than 20% of its value in the last 12 months. India is paying more for dollars than it has done in over a decade.
Second, following the 2008 financial crisis, rupee-dollar exchange rate volatility has increased by as much as 50%, making it difficult to predict the cost of dollars.
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This uncertainty places India in a tough situation, given rising prices for key commodities such as crude oil, a slowdown in capital inflows and a current account deficit now at a decadal high of 4% of gross domestic product (GDP). India isnt aloneBrazil and South Africa face the same problem as their currencies have seen deviations of 25% to the dollar. Their current account deficits too are high, at -2.1% and -3.4% of gross domestic product, respectively. Third, there is an opportunity to save on transaction costs, which can cost Indian business up to 1-2% of a deal. Vladimir Dmitriev, chair of the Russian development bank, suggested in the BRICS summit agenda that countries will save up to 4% by entering into these agreements, saving on transaction costs, financing fees and currency fluctuations. Quick math shows that at full potential, BRICS countries save $12.3 billion a year in banking services. India could save a whopping $2.3 billion. Lastly, a central bank liquidity swap will benefit small business. With the credit rating agencies such as S&P downgrading India, small- and mid-cap companies are struggling to get dollar loans at reasonable interest rates. Drawing on a swap line from China, the Reserve Bank of India (RBI) can offer attractive loans to businesses through the Export-Import Bank in renminbi to finance Chinese deals without having to worry about inadequate dollar supply. There is geopolitical risk in this, however.
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In the late 1950s, India entered into a similar currency agreement with the former Soviet Union largely for arms deals. But India ran up a trade deficit and from 1955-76, Russia accumulated upwards of $350 million in non-convertible rupees. As a result, Russia sought a strategic advantage from its poorer trading partner. Indias signature commodities such as tea were re-exported by Russia to Western markets, shrinking Indias market share with key trading partners. Moscow even petitioned for naval base rights. Prime minister Indira Gandhi refused, believing that the quid pro quo would threaten regional security. As with the Soviet Union then, so is the possibility with China now; Indias trade deficit with China is estimated to reach $60 billion by 2014-15. In negotiating its rupee relationship with Russia, H.V.R. Iyengar, governor of RBI (1957-62), wrote to prime minister Jawaharlal Nehru warning him of the dangers of such currency arrangements. Nehru ignored him, declaring that political compulsions far outweigh economic considerations. Indias motives now are economic. BRICS swaps save money on imports by freeing India from currency fluctuations and reducing the cost of funds. The key for India will be to negotiate favorable terms of agreement. Only then will Indias economic advantages outweigh the geopolitical risks of such a deal
period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps. The Swaps Market Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-thecounter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. SEE: Futures Fundamentals The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than 15 times the size of the U.S. public

equities market. Plain Vanilla Interest Rate Swap
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The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. SEE: How do companies benefit from interest rate and currency swaps? For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount. Figure 1
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shows the cash flows between the parties, which occur annually (in this example). SEE: Corporate Use Of Derivatives For Hedging
Figure 1: Cash flows for a plain vanilla interest rate swap

Plain Vanilla Foreign Currency Swap The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated. For example, Company C, a U.S. firm, and Company D, a European firm, enter into a fiveyear currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (e.g. the dollar is worth 0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million euros. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).
Figure 2: Cash flows for a plain vanilla currency swap, Step 1.

Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar
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interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be $4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to Company C.
Figure 3: Cash flows for a plain vanilla currency swap, Step 2

Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.
Figure 4: Cash flows for a plain vanilla currency swap, Step 3

Who Would Use a Swap? The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would

match up well with its floating-rate liabilities.
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Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing. For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less known. It will likely receive more favorable financing terms in the U.S. By then using a currency swap, the firm ends with the euros it needs to fund its expansion. Exiting a Swap Agreement Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this:
1.
Buy Out the Counterparty: Just like an option or futures contract, a swap has a
calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent. 2.
Enter an Offsetting Swap: For example, Company A from the interest rate swap
example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate. 3.
Sell the Swap to Someone Else: Because swaps have calculable value, one party
may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. 4.
Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would
allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2.
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The Bottom Line Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for.

Introduction of Futures

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Introduction of Futures

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Derivatives Indian Scenario

TYPES OF FINANCIAL DERIVATIVES

1. Forwards 2. Futures 3. Options

1. Swaps 2.Exotics (Non STD)

Derivatives Indian Scenario 4. Warrants and Convertibles

Derivatives Trading Forum

Derivatives Indian Scenario

Organized Exchanges Counter

Forward Contracts Swaps

Derivatives Indian Scenario

Derivatives Indian Scenario

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

Derivatives Indian Scenario 1.Trade on an 1. OTC in nature

Derivatives Indian Scenario

PARTIES IN THE FUTURES CONTRACT

PAY-OFF FOR A BUYER OF FUTURES

Derivatives Indian Scenario

PAY-OFF FOR A SELLER OF FUTURES

Derivatives Indian Scenario

Derivatives Indian Scenario

Derivatives Indian Scenario PRICING FUTURES

Derivatives Indian Scenario

Derivatives Indian Scenario INTRODUCTION TO OPTIONS

Derivatives Indian Scenario

Derivatives Indian Scenario PROPERTIES OF OPTION

Derivatives Indian Scenario

PAY-OFF PROFILE FOR BUYER OF A CALL OPTION

Derivatives Indian Scenario

Derivatives Indian Scenario

PROFIT P ITM E1 ATM E2 S OTM

Derivatives Indian Scenario

ITM S E1 ATM OTM E2

Derivatives Indian Scenario

PROFIT P ITM E1 ATM S R LOSS E2

Derivatives Indian Scenario

Derivatives Indian Scenario

Derivatives Indian Scenario

Call option CA = SN (d1) Xe- rT N (d2) Put Option PA = Xe N (- d2) SN (- d1)

Derivatives Indian Scenario

Derivatives Indian Scenario Time value of an option:

560 540 520

Derivatives Indian Scenario

500 480 460 440

AT THE MONEY IN THE MONEY

Table 2.4 PUT OPTION

560 540 520

IN THE MONEY AT THE MONEY OUT OF THE MONEY

500 480 460 440

Derivatives Indian Scenario

3.1 Why did swaps emerge?

Derivatives Indian Scenario

3.2 Swaps Pricing:

Derivatives Indian Scenario

3.3 Introduction of Forward Rate Agreements and Interest Rate Swaps

Source: RBI Guidelines

Derivatives Indian Scenario

Description of the product

Derivatives Indian Scenario

3.5 Currency Swaps in India

Derivatives Indian Scenario

Derivatives Indian Scenario

Company A Exporter Options: Borrow ruppe at 13%

Company B Options: Borrow ruppe at 14.5%

Derivatives Indian Scenario