Derivatives – Indian Scenario

-1-

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

-2-

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

Derivatives – Indian Scenario

-3-

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

Before IMM opened in 1972. the 1990 Nobel Laureate had said that “financial futures represent the most significant financial innovation of the last twenty years. By 1990. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. HISTORY OF FUTURES Merton Miller. These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange. By the . 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. A division of the Chicago Mercantile Exchange.Derivatives – Indian Scenario -4-  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. the underlying value of all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollars. the Chicago Board of Trade and the Chicago Board Options Exchange. it was called the international monetary market (IMM) and traded currency futures.” The first exchange that traded financial derivatives was launched in Chicago in the year 1972. the Chicago Mercantile Exchange sold contracts whose value was counted in millions.

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 . DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS Forward contracts are often confused with futures contracts. and their success transformed Chicago almost overnight into the risk-transfer capital of the world.Derivatives – Indian Scenario -5- 1990s. these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of futures price uncertainty.

Derivatives – Indian Scenario 1.Trade on an 1.  The contracting parties need not pay any down payment.1 FEATURES OF FUTURES  Futures are highly standardized.Customized contract terms 3. OTC in nature -6- Organized Exchange 2. Follows daily Settlement 5. Requires margin payment 5. TYPES OF FUTURES . No margin payment Table 2. hence less liquid 4. Settlement happens at end of period 2.  Hedging of price risks.Standardized contract terms 3. hence more liquid 4.  They have secondary markets too.

Derivatives – Indian Scenario -7- On the basis of the underlying asset they derive. the buyers and the seller. 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 . 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 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.

if the futures Price Goes to E1 then the buyer gets the profit of (FP).1 CASE 1:. CASE 2:.The buyers bought the futures contract at (F).Derivatives – Indian Scenario -8- P PROFIT E2 LOSS F E1 L Figure 2. PAY-OFF FOR A SELLER OF FUTURES . if The Futures price goes to E2 then the buyer the loss of (FL).The buyers gets loss when the futures price less then (F).

2 F PRICE E1. if the future goes to E1 Then the seller gets the profit of (FP). E2 = SETLEMENT PRICE CASE 1:. CASE 2:. If the future price goes to E2 then the seller get the loss of (FL).Derivatives – Indian Scenario -9- P PROFIT E2 E1 F LOSS L Figure 2. = FUTURES MARGINS .The seller sold the future contract at (F).The seller gets loss when the future price goes greater than (F).

600. Maintenance margin:The investor must keep the futures account equity equal to or greater than certain percentage of the amount deposited as initial margin. The contract size of ONGC is 1800. The initial margin amount is say Rs. 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. . arise in a futures contract.000 the maintenance margin is 65% of initial margin. There are three types of margins: Initial Margins:Whenever a future contract is signed. Mark to market margins:The process of adjusting the equity in an investor’s account in order to reflect the change in the settlement price of futures contract is known as MTM margin. 30. the following table shows the effect of margins on the Contract. These deposits are initial margins and they are often referred as purchase price of futures contract.Derivatives – Indian Scenario . both buyer and seller are required to post initial margins. If the equity goes less than that percentage of initial margin.10 - Margins are the deposits which reduce counter party risk. 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 margins are collect in order to eliminate the counter party risk. 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.

11 - Pricing of futures contract is very simple.71828 (OR) F = S (1+r. The cost of carry model used for pricing futures is given below. Every time the observed price deviates from the fair value. Using the cost-of-carry logic. This in turn would push the futures price back to its fair value. we calculate the fair value of a future contract. arbitragers would enter into trades to captures the arbitrage profit.Derivatives – Indian Scenario PRICING FUTURES . 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.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 .

Contract size: The amount of asset that has to be delivered under one contract. This is the last day on which the contract will be traded. Basis: In the context of financial futures. In a normal market.12 - The period over which a contract trades. Expiry date: It is the date specified in the futures contract.Derivatives – Indian Scenario Spot price: The price at which an asset trades in the spot market. For Cost of carry: . The index futures contracts on the NSE have one-month and three-month expiry cycles which expire on the last Thursday of the month. instance. 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. Contract cycle: . the contract size on NSE’s futures markets is 200 Nifties. Futures Price: The price at which the futures contract trades in the futures market. basis will be positive. basis can be defined as the futures price minus the spot price. This reflects that futures prices normally exceed spot prices. a new contract having a three-month expiry is introduced for trading. at the end of which it will cease to exist. These will be a different basis for each delivery month for each contract.

This is called marking-to-market. Maintenance margin: This is some what lower than the initial margin. . at the end of each trading day. 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.13 - The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. Marking-to-market: In the futures market.Derivatives – Indian Scenario . This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. This is set to ensure that the balance in the margin account never becomes negative. 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. If the balance in the margin account falls below the maintenance margin.

If someone wanted to buy an option. without much knowledge of valuation. they we traded OTC. DEFINITION Options are of two types. In contrast. Options are fundamentally different from forward and futures contracts. at a given price on or before a given future date. An option gives the holder of the option the right to do something. namely options. 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. but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. The holder does not have to exercise this right. the purchase of an option requires as up-front payment. HISTORY OF OPTIONS Although options have existed for a long time. Puts give the buyers the right. First. 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. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset. This market however suffered form two deficiencies. Whereas it costs nothing (except margin requirement) to enter into a futures contracts. there was no secondary market and second. the firm would undertake to write the option itself in return for a price.14 - In this section.Derivatives – Indian Scenario INTRODUCTION TO OPTIONS .calls and puts. we look at the next derivative product to be traded on the NSE. he or she would contact one of the member firms. in a forward or futures contract. there was no mechanism to guarantee that the . the two parties have committed themselves to doing something. If no seller could be found. The first trading in options began in Europe and the US as early as the seventeenth century.

The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. the more Tulip bulb prices began rising. CBOE was set up specifically for the purpose of trading options. The more popular they became. options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. They were initially used for hedging. The market for option developed so rapidly that by early’ 80s. In 1973. Over a decade. . 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. tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. there has been no looking back. The first tulip was brought Into Holland by a botany professor from Vienna.15 - writer of the option would honour the contract. however. By purchasing a call option on tulip bulbs. the tulip became the most popular and expensive item in Dutch gardens. Similarly. As long as tulip prices continued to skyrocket. 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. Black. Later. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs. the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. That was when options came into the picture.Derivatives – Indian Scenario . Since then. Merton and scholes invented the famed Black-Scholes formula. In April 1973.

index options contracts are also cash settled. 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. The following are the various types of options. Like index futures contracts. 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.Derivatives – Indian Scenario PROPERTIES OF OPTION . 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. 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. Stock options: . TYPES OF OPTIONS The Options are classified into various types on the basis of various variables. 1.16 - Options have several unique properties that set them apart from other securities. Some options are European while others are American.

It is brought by an investor when he seems that the stock price moves upwards. On the basis of the market movements : On the basis of the market movements the option are divided into two types.17 - Stock Options are options on individual stocks.Derivatives – Indian Scenario . It is bought by an investor when he seems that the stock price moves downwards. 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. Most exchange –traded options are American. PAY-OFF PROFILE FOR BUYER OF A CALL OPTION . European options are easier to analyze than American options. 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. Options currently trade on over 500 stocks in the United States. European Option: European options are options that can be exercised only on the expiration date itself. 2. On the basis of exercise of option: On the basis of the exercise of the Option. and properties of an American option are frequently deduced from those of its European counterpart. 3. American Option: American options are options that can be exercised at any time up to the expiration date. A contract gives the holder the right to buy or sell shares at the specified price. the options are classified into two Categories.

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). 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. R PROFIT ITM S ATM OTM E1 E2 LOSS P Figure 2.18 - The Pay-off of a buyer options depends on a spot price of an underlying asset. 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). The buyer gets profit of (SR). The following graph shows the pay-off of buyers of a call option. The following graph shows the pay-off of seller of a call option: .Derivatives – Indian Scenario .

The seller gets the profit of (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). .Derivatives – Indian Scenario .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). if price goes more than E2 then the loss of the seller also increase more than (SR). if the price decreases less than E1 then also profit of the seller does not exceed (SP). The following graph shows the pay-off of the buyer of a call option.19 - PROFIT P ITM E1 ATM E2 S OTM R LOSS S= SP = E1 = E2 = SR = Figure 2. 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 buyer gets the profit (SR).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). CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (S). if price decreases less than E1 then profit also increases more than (SR).Derivatives – Indian Scenario .20 - PROFIT R ITM S E1 ATM OTM E2 P LOSS S= SP = E1 = E2 = SR = Figure 2. The buyer gets loss of (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. . if price goes more than E2 than the loss of the buyer is limited to his premium (SP). The following graph shows the pay-off of seller of a put option.

of price goes more than E2 than the profit of seller is limited to his premium (SP). the seller gets profit of (SP). the seller gets the loss of (SR). FACTORS AFFECTING THE PRICE OF AN OPTION The following are the various factors that affect the price of an option they are: Stock Price: . CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (S).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). if price decreases less than E 1 than the loss also increases more than (SR).21 - 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.Derivatives – Indian Scenario .

The value of both calls and puts therefore increases as volatility increase. the chance that the stock will do very well or very poor increases. Volatility: The volatility of a stock price is measured of uncertain about future stock price movements. Time to expiration: Both put and call American options become more valuable as a time to expiration increases.dividend rate.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. the stock price has to make a larger upward move for the option to go in-the –money. Strike price: In case of a call. Dividends: Dividends have the effect of reducing the stock price on the X.Derivatives – Indian Scenario . as the strike price increases option becomes less valuable and as strike price decreases. As volatility increases. Risk. Therefore. as a strike price increases. This has a negative effect on the value of call options and a positive effect on the value of put options. by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa. . Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount.22 - The pay-off from a call option is an amount by which the stock price exceeds the strike price. for a call. option become more valuable.

23 - PRICING OPTIONS An option buyer has the right but not the obligation to exercise on the seller. There are various models which help us get close to the true price of an option.Scholes model for pricing European options. Just like in other free markets. which is expressed in terms of the option price.Scholes options pricing formula so to price options we don’t really need to memorize the formula. Most of these are variants of the celebrated Black. The worst that can happen to a buyer is the loss of the premium paid by him.Derivatives – Indian Scenario . The Black-Scholes formulas for the price of European calls and puts on a non-dividend paying stock are: . but his upside is potentially unlimited. This optionality is precious and has a value. it is the supply and demand in the secondary market that drives the price of an option. His downside is limited to this premium. All we need to know is the variables that go into the model. Today most calculators and spread-sheets come with a built-in Black.

v√T 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.rT Where d1 = ln (S/X) + (r + v2/2) T v√T And d2 = d1 .d1) . Expiration date: .24 - Call option CA = SN (d1) – Xe.Derivatives – Indian Scenario .rT N (d2) Put Option PA = Xe N (.d2) – SN (. It is also referred to as the option premium.2 OPTIONS TERMINOLOGY Option price/premium: Option price is the price which the option buyer pays to the option seller.

the strike date or the maturity. If the index is much lower than the strike price.intrinsic value and time value. If the index is much higher than the strike price. Intrinsic value of an option: The option premium can be broken down into two components.e. spot price > strike price). if it is ITM. 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. Out.Derivatives – Indian Scenario .of–the money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow it was exercised immediately.e. the call is said to be deep ITM. If the call is OTM. 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. In the case of a put. its intrinsic value is zero. An option on the index is at-themoney when the current index equals the strike price (i. .e. 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. the put is ITM if the index is below the strike price. the put is OTM if the index is above the strike price. the exercise date. spot price < strike price). spot price = 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. the call is said to be deep OTM. In the case of a put. The intrinsic value of a call is the amount the option is ITM.25 - The date specified in the options contract is known as the expiration date. Strike price: The price specified in the option contract is known as the strike price or the exercise price.

Nonlinear payoff 6. Price is Zero 5. Both long and short at risk OPTIONS 1. At expiration. An option that is OTM or ATM has only time value. Both calls and puts have time value. the maximum time value exists when the option is ATM. all else equal. an option should have no time value. Price is zero. Price is always positive 5. strike price moves 4. Linear payoff 6.26 - The time value of an option is the difference between its premium and its intrinsic value. Exchange defines the product 3. with Novation 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 . Same as futures 3. DISTINCTION BETWEEN FUTURES AND OPTIONS FUTURES 1. Only short at risk Table 2. Usually.Derivatives – Indian Scenario Time value of an option: . price moves 4. Strike price is fixed. the greater is an option’s time value. The longer the time to expiration. Exchange traded. Same as futures 2.

to exchange two streams of payments for agreed period of time. are calculated based on the underlying notional using applicable rates.Derivatives – Indian Scenario .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. but a tool used for financial management.5 PREMIUM = INTRINSIC VALUE + TIME VALUE The difference between strike values is called interval SWAPS A contract between two parties. Swaps are not debt instrument to raise capital. commonly called legs or sides. Swaps contracts also include other provisional specified by the counter parties.27 - 500 480 460 440 0 20 40 60 15 10 5 2 15 30 45 62 AT THE MONEY IN THE MONEY Table 2. The payments. Swaps are arranged in many . referred to as counter parties.

the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. he would prefer to be a counterparty receiving fixed payments and paying floating rate payments in another swap. which was in a reciprocal position. 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.28 - different currencies and different periods of time. 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. A tax was levied on overseas investments to discourage capital outflows. Therefore. one could imagine. If the dealer is a counterparty paying fixed rate payments and receiving floating rate payments. In addition. Though this type of arrangement was providing relief from existing protections. In other words. this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. 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. Dealers work for investment.1 Why did swaps emerge? In the late 1970's. commercial or merchant banks. sterling and Deutsche marks. A swap dealer takes on one side of the transaction as counterparty. The length of past swaps transacted has ranged from 2 to 25 years. US$ swaps are most common followed by Japanese yen. . the swap dealer earns the difference between the amount received from a party and the amount paid to the other party. the first currency swap was engineered to circumvent the currency control imposed in the UK. back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity. 3. "By positioning the swap". a British company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty.Derivatives – Indian Scenario . To overcome such a predicament. In an ideal situation. the dealer would offset his risks by matching one step with another to streamline his payments. back-to-back loans were used to exchange debts in different currencies. A perfectly netted position as just described is not necessary. Moreover. dealers earn bidask spread for the service. For example.

29 - Swap brokers. Liquidity. specially so in India Transaction costs include the cost of hedging a swap.. unlike a dealer do not take on a swap position themselves but simply locate counter parties with matching needs. brokers are free of any risks involved with the transactions. which is function of supply and demand.g. 91. CP rates and PLR rates. The transaction cost would thus involve such a difference. For doing so the bank must obtain funds. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. Therefore. 14.     Benchmark price Liquidity (availability of counter parties to offset the swap). In the Indian markets the common benchmarks are MIBOR. plays an important role in swaps pricing.2 Swaps Pricing: There are four major components of a swap price. Yield on 91 day T. Brokers receive commissions for their services. 182 & 364 day T-bills. Say in case of a bank.com . Bill. if the swap transaction falls through.Derivatives – Indian Scenario . Now in order to hedge the bank would go long on a 91 day T. Bill. counter parties are free of any risks associated with releasing their financial information. By doing so. After the counter parties are located.5% Cost of fund (e. the brokers negotiate on behalf of the counter parties to keep the anonymity of the parties involved.appliederivatives. which has a floating obligation of 91 day T. It may be difficult to have counter parties for long duration swaps. This is also affected by the swap duration.9. 3.5% 1 Source: www.Repo rate) – 10% The transaction cost in this case would involve 0. Transaction cost Credit risk 1 Swap rates are based on a series of benchmark instruments. Bill .

primary dealers and all India financial institutions to hedge interest rate risks. 3.Derivatives – Indian Scenario . In the U. They have been formulated in consultation with market participants. there is no restriction on who can use the market. This is due to fact that they cannot be matched with counter parties who are willing to take on their risks. Based upon the credit rating of the counterparty a spread would have to be incorporated. Prerequisites 2 Source: RBI Guidelines .S.3 Introduction of Forward Rate Agreements and Interest Rate Swaps The Indian scene 2 Objective   To further deepen the money markets To enable banks. This requirement has become a standardized representation of "eligible swap participants". Accordingly. on the basis of development of FRAs/IRS market. These guidelines are intended to form the basis for development of Rupee derivative products such as FRAs/IRS in the country. Swap Market Participation’s Since swaps are privately negotiated products.5% for an AAA rating. However.30 - Credit risk must also be built into the swap pricing. The guidelines are subject to review. parties with low credit quality have difficulty entering the market. Say for e. it would be 0.g. many parties require their counter parties to have minimum assets of $10 million. 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. it has been decided to allow scheduled commercial banks (excluding Regional Rural Banks).

Accordingly. Accordingly. on the settlement date. 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. 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. 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. participants should also set up sound internal control system whereby a clear functional separation of trading. for a specified period from start date to maturity date. cash payments based on contract (fixed) and the settlement rate. The settlement rate is the agreed benchmark/reference rate prevailing on the settlement date.   Ongoing exchange of interest at the rates agreed upon at the outset of the transaction. 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. 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. monitoring and control and accounting activities is provided.Derivatives – Indian Scenario . 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. Participants . 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.31 - Participants are to ensure that appropriate infrastructure and risk management systems are put in place. Further. settlement. are made by the parties to one another.

.that are to offset risk or to take risk deliberately in the expectation of making profit. six-month expiration.32 - 3. But despite an easing regulation. Daily trading volume on this forward market is around $500 million a day. One of the currencies involved is the Indian rupee and the other could be any foreign currency. India has a strong dollar-rupee forward market with contracts being traded for one.e. two.5. swaps have not hit the market in a big way. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets. 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.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. the banks allowed by RBI to carry out the swaps. Outside India. Prior to this policy RBI had been approving rupee foreign currency swaps between corporates on a case basis. 3. which allow the user to hedge . and on foreign currency it could be either fixed or floating. i. but no such swaps were taking place. the counter parties involved are Indian corporates and the swap dealers are the Authorized dealers of foreign exchange. This was to enable those requiring long-term forward cover to hedge themselves without altering the external liability of the country.1 The Players Swaps are instruments. While studying swaps in the Indian context. The user in this case would be any . Primary dealers All India financial institutions . 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. The interest rate on the rupee is most likely to be fixed.Derivatives – Indian Scenario Schedule commercial banks. there is a small market for cash –settled forward contracts on the dollar –rupee exchange rate.

3.. Corporates with foreign subsidiaries would also be having forex revenues but due to cheaper availability of funds abroad. The main players in the Indian market are Tata Exports. They have to take the swaps on their books. it is unlikely that these subsidiaries would be funded by a rupee loan. among the others.. Two. The outflow being considered here is the interest and the principal payment on the borrowings of the corporates.. for example Bharat Heavy Electricals Ltd.5.. 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. Ballarpur Industries etc. 3.33 - corporate having a foreign exchange exposure/ a risk.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. Corporates having such currency mismatches would be of the following types 3.5. Thus many corporates would fall under this category. 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. Apollo Tyres Ltd.Derivatives – Indian Scenario . 3. 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 . and Nestle Indian Ltd.3 Corporates with forex loan and rupee revenue The corporates having foreign currency loan could further be classified into two groups.5. which do not have net imports but have raised foreign currency loan for funding requirements. Ltd. One which have net imports and thus may have raised loans to meet their import requirements.. Thus the main players meeting this criterion would be the exporters. for example Arvind Mills Ltd. Hindustan Levers Ltd. Tata Power Co.2Corporates with rupee loan and forex revenue Mainly the exporters would fall in this category. ITC Ltd. A foreign exchange exposure will arise out of the mismatch between the currency of inflow and outflow.5.5 Banks Banks act as the authorized dealers and are instrumental in arranging swaps.

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. 3.25% floating rate. 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. A would like to convert its rupee loan into a dollar loan.Derivatives – Indian Scenario .2 To lower financing cost Currency swaps can be used to reduce the cost of loan. A key question facing the players then is whether these exchange risks are so large as to affect their business. They also take up the credit risk of counterparties. Due to difference in the credit rating of the two companies. They would normally keep a spread between the offer and bid rate thus make profit from transaction. A has access to 14% rupee loan and dollar loan at LIBOR + 0.34 - rates. A related question is what.6 The needs of the players and how currency swaps help meet these needs 3.25%. if any. special strategies should be followed to reduce the impact of foreign exchange risk. 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. 3.6. the rates at which the loans are available to them are different. The players mentioned above are facing this risk. The following example deals with such a case. instead it changes existing cash flows. Corporate A is an exporter with a rupee loan at 14% fixed rate. Comparative advantage Company A Exporter Options: Borrow ruppe at 13% Company B Options: Borrow ruppe at 14.5% . The currency swap helps to achieve this without raising new funds. 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. Consider two Indian corporates A & B. B has a dollar loan at LIBOR + 0.6.

The net gain arising out of such a swap will be 50 bps. The effective cost for A is LIBOR + 75 bps and for B it is 14.1 LIBOR +75 bps Company A 12. The advantage in terms of rupee funds is 150 bps while it is 100 bps in case of dollar rates. Then they may go in for a currency swap. This results into a net saving of 25 bps for both the parties.35 Borrow dollars at LIBOR +200 bps Company A has an absolute advantage over B in both the markets/ rates. Figure 3. Therefore it would be advantageous if A would borrow at rupee rates and B borrows at LIBOR rates. which may be shared between the parties. Thus B has a comparative advantage in terms of dollar rates.25%.75%. Now as A is an exporter he would be more interested in a dollar denominated loan to offset his future receivables.75% in INR Company B 13% in INR Libor +200 bps . The effective cost for A is 12. 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.Derivatives – Indian Scenario Borrow dollars at LIBOR +100 bps .

If the company does not qualify in this regard it would fail to issue yen denominated bond. Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. the firm can meet its expectation of raising a yen denominated loan. bill vs 6-month MIBOR. whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day treasury yield i. 3. The firm can thus benefit by entering into an interest rate fixed for floating swap.Derivatives – Indian Scenario .50 = 10.25 + 0. Mehta Ltd. 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. bill is yielding 10. To issue a yen bond. Figure 3. the borrower must qualify for a single A credit rating.6.75 Mehta Ltd 3 Months MIBOR Counter Party . A typical Indian case would be a corporate with a high fixed rate obligation. 10.3 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. The treasurer is of the view that the average MIBOR shall remain below 18.75 %.25%.e.36 - - To access restricted markets Many countries have restrictions on the type of borrowers that can raise funds in their bond markets. Today a 364-day T. By issuing bonds in the rupee market and then entering into a currency swap. Eg.5% for the next one year. an AAA rated corporate. as the interest rates have come down. The 3month MIBOR is quoting at 10%.2 Fixed 10.5%. 3 years back had raised 4-year funds at a fixed rate of 18.

75) = 0.17. It may also swap floating rate liabilities with a fixed rate. This may be ignored.75%.75%. = 18.Default/ credit risk of counterparty. 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.75 = 7.7 Factors to be looked at while doing a swap . 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.75%.5 + MIBOR .10.75% The gain for the firm is (18.The firm is faced with the risk that the MIBOR goes beyond 10. .75 = 17. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.37 - 18. This will require continuous monitoring on the path of the firm. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments.Derivatives – Indian Scenario . Therefore it is very essential that the firm hold a strong view that MIBOR shall remain below 10.75%s MIBOR The effective cost for Mehta Ltd. it will prefer to swap it with a floating rate interest.5 .75 % The risks involved for the firm are . The bank may also use this swap as an opportunity to hedge its own floating liability. 3.75% will raise the cost of funds for the firm.75 + MIBOR At the present 3m MIBOR at 10%. Any rise beyond 10. as the counterparty is a bank. the effective cost is = 10 + 7.

The risk taking capability of a corporate will depend upon the financial backup to absorb the losses. 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. For fundamental analysis one needs to keep track of the balance of payment condition. The price of the underlying asset on the delivery date is . of the country. corporates need to look at a few factors before deciding to swap. The future date is called the delivery date or final settlement date. the availability of time and resources to monitor the forex market. etc. to buy or sell a certain underlying instrument at a certain date in the future. if any. Other factors like political stability also needs to be considered. the parties can determine the risks involved and can decide upon the amount of cover to be taken. the interest rates can be estimated. By keeping an eye on the yield curve of long term bonds and the macro economic variables of different countries.38 - Though swaps can be used in the above conditions effectively. Expected range of exchange rates This can be determined by a fundamental and technical analysis. Projecting the growth in exports/ imports. (i) FUTURE CONTRACT In finance. the interest rates also need to be traced.Derivatives – Indian Scenario . Expected interest rates Since currency swaps include exchange of interest payments. a futures contract is a standardized contract. The technical factors look at past trends and expected demand-supply position. traded on a futures exchange. at a pre-set price. GDP growth rate. The pre-set price is called the futures price. taking into account the changes in management and government policies can do this. the expected exchange rates and the interest rates. Amount of cover to be taken Having estimated the amount of exposure. The estimated net exposure They need to estimate the net exposure that they are likely to have in the future.

  The last trading date. either cash settlement or physical settlement. Standardization: Futures contracts ensure their liquidity by being highly standardized. The grade of the deliverable. Futures contracts are exchange traded derivatives. which gives the buyer the right.39 - called the settlement price. usually by specifying:    The underlying. sets margin requirements.   The currency in which the futures contract is quoted. the minimum permissible price fluctuation. In case of physical commodities. the holder of a futures position has to sell his long position or buy back his short position. normally. The amount and units of the underlying asset per contract. The settlement price. This can be the notional amount of bonds.Derivatives – Indian Scenario . this specifies which bonds can be delivered. which differs from an options contract. converges towards the futures price on the delivery date. In case of bonds. etc. The type of settlement. a fixed number of barrels of oil. The delivery month. etc. BASIC FEATURES OF FUTURE CONTRACT 1. The exchange acts as counterparty on all contracts. Other details such as the tick. the notional amount of the deposit over which the short term interest rate is traded. and the option writer (seller) the obligation. A futures contract gives the holder the right and the obligation to buy or sell. but not the right. . effectively closing out the futures position and its contract obligations. but not the obligation. To exit the commitment. this specifies not only the quality of the underlying goods but also the manner and location of delivery. units of foreign currency. This can be anything from a barrel of sweet crude oil to a short term interest rate.

as specified per type of futures contract:  Physical delivery . Initial Margin: is paid by both buyer and seller. In practice. 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. This renders the owner liable to adverse changes in value. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin.the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange. as determined by historical price changes. buying a contract to cancel . a further margin. It may be 5% or 10% of total contract price. is required by the exchange. To understand the original practice. Margin: Although the value of a contract at time of trading should be zero. if he is on the losing side.that is.e. To minimize this risk. and creates a credit risk to the exchange. It represents the loss on that contract. which is not likely to be exceeded on a usual day's trading. If the trader is on the winning side of a deal. consider that a futures trader. Settlement Settlement is the act of consummating the contract. i.Derivatives – Indian Scenario . and by the exchange to the buyers of the contract. the exchange demands that contract owners post a form of collateral. the contract is marked to its present market value. who always acts as counterparty. Most are cancelled out by purchasing a covering position . when taking a position. called a "margin". agreeing on a price at the end of each day. the exchange will debit his account. called the "settlement" or mark-to-market price of the contract. This is intended to protect the exchange against loss.40 - 2. If he cannot pay. and the exchange pays this profit into his account. usually called variation or maintenance margin. 3. On the other hand. its price constantly fluctuates. and can be done in one of two ways. it occurs only on a minority of contracts. At the end of every trading day. This is calculated by the futures contract. deposits money with the exchange. his contract has increased in value that day. then the margin is used as the collateral from which the loss is paid.

and convenience yields. In other words. and receives the agreed forward price. He then repays the lender the borrowed amount plus interest. Any deviation from this equality allows for arbitrage as follows. 2. this happens on the Last Thursday of certain trading month. Expiry is the time when the final prices of the future are determined. present value at time to maturity . the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset.  Cash settlement . for no arbitrage to be possible. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. In the case where the forward price is lower: 1. 4. The arbitrageur buys the futures contract and sells the underlying today (on the spot market). 3. or selling a contract to liquidate an earlier purchase (covering a long). The difference between the two amounts is the arbitrage profit. such as a short term interest rate index such as Euribor. the value of the future/forward. dividends. Thus. PRICING OF FUTURE CONTRACT In a futures contract. . In the case where the forward price is higher: 1. he invests the proceeds. he cashes in the matured investment. which has appreciated at the risk free rate. A futures contract might also opt to settle against an index based on trade in a related spot market. by the rate of risk-free return This relationship may be modified for storage costs.Derivatives – Indian Scenario .a cash payment is made based on the underlying reference rate. the arbitrageur hands over the underlying. dividend yields. non-dividend paying asset. for a simple. On the delivery date. On the delivery date. For many equity index and interest rate futures contracts.41 - out an earlier sale (covering a short). or the closing value of a stock market index. the rational forward price represents the expected future value of the underlying discounted at the risk free rate. On this day the t+2 futures contract becomes the t forward contract. will be found by discounting the . 2.

The difference between the two amounts is the arbitrage profit. He then receives the underlying and pays the agreed forward price using the matured investment.Derivatives – Indian Scenario .] 4.42 - 3. . he returns it now. [If he was short the underlying.

Derivatives – Indian Scenario . . futures. and all buyers and sellers come to a common platform to discover the price. assumed by the clearing corp. are standardized Exists. tailor as contracts are High. However. Index Futures and Individual stock Futures in India. Contracts contracts. two parties (not traded on the exchanges). Price discovery Not efficient. as markets are centralized are scattered. Exists. catering to the needs of the needs of the parties. as markets Efficient.43 - TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATURE Operational Mechanism FORWARD CONTRACT FUTURE CONTRACT Traded directly between Traded on the exchanges. guarantees their Liquidation Profile Low. as contracts are standardized made contracts exchange traded contracts. Contract Specifications Counter-party risk Differ from trade to trade. Examples Currency market in India. which becomes the counter party to all the trades or unconditionally settlement. Commodities..

bonds and warrants become the subject of options. no option will be exercised if the future price does not increase. at a specified price on or before a specified date is known as a ‘Put option’. Hence.e. called the strike price.Derivatives – Indian Scenario OPTIONS - . although occasionally preference shares. Underlying asset refers to any asset that is traded. CALL OPTION & PUT OPTION. The price at which the underlying is traded is called the ‘strike price’. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. 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. Put and calls are almost always written on equities. . There are two types of options i. CALL OPTION: A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset. during a period or on a specific date in exchange for payment of a premium is known as ‘option’.44 - A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price. at a specified price on or before a specified date is known as a ‘Call option’..

Under a currency swap. only the payment flows are exchanged and not the principle amount. They can be regarded as portfolios of forward's contracts.45 - 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. 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. The parties to the swap contract of currency generally hail from two different countries. 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. based on some notional principle amount is called as a ‘SWAP’. . cash flows to be exchanged are determined at the spot rate at a time when swap is done. In case of swap. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream. A contract whereby two parties agree to exchange (swap) payments.Derivatives – Indian Scenario SWAPS - . This arrangement allows the counter parties to borrow easily and cheaply in their home currencies.

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 buyer agrees to take delivery of something and the seller agrees to make delivery. The stock index futures market should ideally have more depth. it is too early to base any conclusions on the volume or to form any firm trend. 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. The brokerage costs on index futures will be much lower. 1. The impact cost will be much lower in case of stock index futures as opposed to dealing in individual scrips. Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. which have been used to hedge or manage the systematic risk by the investors of Stock Market. In the near future. The market is conditioned to think in terms of the index and therefore would prefer to trade in stock index futures. stock index futures will definitely see incredible volumes in India. . They are called hedgers who own portfolio of securities and are exposed to the systematic risk.2 STOCK INDEX FUTURES Stock Index futures are the most popular financial futures. 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 will require lower capital adequacy and margin requirements as compared to margins on carry forward of individual scrips. Further.2 2. volumes and act as a stabilizing factor for the cash market. 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.Derivatives – Indian Scenario 1 1 FUTURES .46 - 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.1 1. 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. However.

During a day.4  2. .  Volume No.    Contract Month The month in which the contract will expire.  Tick Size It is the minimum price difference between two quotes of similar nature. It is Index level * Multiplier. Expiry Day The last day on which the contract is available for trading. 1.  Long position Outstanding/unsettled purchase position at any point of time.47 - 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. used to arrive at the contract size.3 FUTURES TERMINOLOGY Contract Size The value of the contract at a specific level of Index.  Multiplier It is a pre-determined value. for calculation of open Interest. Open interest Total outstanding long or short positions in the market at any specific point in time.3 1. Of contracts traded during a specific period of time. It is the price per index point. As total long positions for market would be equal to total short positions. during a week or during a month. only one side of the contracts is counted.Derivatives – Indian Scenario .

at the terms other than defined by the exchange. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. for the buyer and the seller of futures contracts. When the index moves .  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.Open position at the expiry of the contract is settled by two parties . delivery is low. Physical delivery .one buyer and one seller. The underlying asset in this case is the Nifty portfolio.  Cash settlement Open position at the expiry of the contract is settled in cash. Open position Outstanding/unsettled long or short position at any point of time. In simple words. Futures contracts have linear payoffs.48 - Open position at the expiry of the contract is settled through delivery of the underlying. These contracts Alternative Delivery Procedure (ADP) . are unlimited. heating and gasoline oil) are settled through Alternative Delivery Procedure. 2. it means that the losses as well as profits. In futures market. He has potentially unlimited upside as well as downside.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.Derivatives – Indian Scenario    Short position Outstanding/ unsettled sales position at any point of time. World wide a significant portion of the energy and energy related contracts (crude oil.

the short futures position starts making profits and when the index moves up it starts making losses. the long futures position starts making profits and when the index moves down it starts making losses . The underlying asset in this case is the Nifty portfolio. When the index moves down.49 - up. OPTIONS . He has potentially unlimited upside as well as downside.Derivatives – Indian Scenario . Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220.  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.

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. Put option: A put is an option contract giving the buyer the right to sell the stock. 2.50 - 2 3.Derivatives – Indian Scenario .1 2.  Straddle: .2 OPTIONS TERMINOLOGY:     Call option: A call is an option contract giving the buyer the right to purchase the stock. 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. Writer: The term writer is synonymous to the seller of the option contract. 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. Holder: The term holder is synonymous to the buyer of the option contract.2 3. Expiration date: It is the date on which the option contract expires.

2. June.    Strip: A strip is two puts and one call at the same period. 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. In India. October. March. April. 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.  February. 1. 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. . 3. Strap: A strap is two calls and one put at the same strike price for the same period. and December. November.  January.  March. the option is said to be at the money. August. In the money: An option is said to be in the money when it is advantageous to exercise it. The exchanges initially created three expiration cycles for all listed options and each issue was assigned to one of these three cycles. Spread: A spread consists of a put and a call option on the same security for the same time period at different exercise prices. September.Derivatives – Indian Scenario .51 - A straddle is combination of put and calls giving the buyer the right to either buy or sell stock at the exercise price. These are three possibilities. Out of the money: The option is out of money if it not advantageous to exercise it. July.

which means you make $500 (100 x ($10-$5)) on the put 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. 3. European options can be exercised on the specified date only. A call option is a contract that gives its owner the right. 2) With options. Note that the maximum amount of potential proft in this example ignores the premium paid to obtain the put option.Derivatives – Indian Scenario 2. 3 3. An American call option can be exercised on or before the specified date only.4 PUT OPTION: An option contract giving the owner the right. but not the obligation.6 DIFFERENCE BETWEEN FUTURES & OPTION: FUTURES 1) Both the parties are obligated to perform. For example. 2) With futures premium is paid by either party. to sell a specified amount of an underlying security at a specified price within a specified time. which gives the holder the right to buy shares. to buy a specified price on or before a specified date. you have the right to sell 100 shares of Taser at $10 until March 2008 (usually the third Friday of the month). if you have one Mar 09 Taser 10 put. but not the obligation.3 CALL OPTION: .5 FACTORS DETERMINIG OPTION VALUE:       4 Stock price Strike price Time to expiration Volatility Risk free interest rate Dividend 5 3.52 - An option that grants the buyer the right to purchase a designated instrument is called a call option. If shares of Taser fall to $5 and you exercise the option. A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price. This is the opposite of a call option.3 3. the buyer pays the seller a . OPTIONS 1) Only the seller (writer) is obligated to perform.

they may decide to buy call options. If expecting a fall.  Speculations: The ease of trading in and out of option position makes it possible to trade options with no intention of ever exercising them. 5. they may decide to buy put options. This can be considered similar to taking out insurance against a fall in the share price. If investor expects the market to rise. . as there is no stamp duty payable unless and until options are exercised.Derivatives – Indian Scenario 3) The parties to futures contracts must perform premium. Trading options has a lower cost than shares. They are not 3) The buyer of an options contract can exercise obligated to perform before that date. This gives the call option holder until the Expiry day to decide whether or exercised the option and buys the shares.  Time to decide: By taking a call option the purchase price for the shares is locked in.1 3.  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 .7 Advantages of option trading:  Risk management: put option allow investors holding shares to hedge against a possible fall in their value.1.1.53 - at the settlement date only. 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. premium but retain the upside potential.1. Likewise the taker of a put option has time to decide whether or not to sell the shares. 5) In options premiums to be paid. 5) In futures margins to be paid. But they are very less as compared to the margins. They are approximate 15-20% on the current stock price. any time prior to expiration date. Either way the holder can sell the option prior to expiry to take a profit or limit a loss.

Derivatives – Indian Scenario

- 54 -

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.

Derivatives – Indian Scenario

- 55 -

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.

Derivatives – Indian Scenario

- 56 -

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 NSE’s first step towards initialing futures and options trading, which, the NSE visualized, would commence in the month of November, 1996.

The L. It proposed to be working on index. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X–axis and the profits/losses on the Y–axis. . the Centre had passed an enabling legislation effecting changes in the SCRA which allowed the issuance and trading of options in securities. In 1995. ayoff & Pricing of Futures and Options . 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. The deposits collected by the NSCCL were to form part of members’ contribution to a separate settlement fund for the future and options segment.based future and submitted a proposal to SEBI. and those who write options. In this section we shall take a look at the payoffs for buyers and sellers of futures and options. It also set up the L. in the mean time. THE SEBI.Derivatives – Indian Scenario .57 - 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. 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. The members were to further earmark cash deposits for the National securities Clearing Corporation Limited (NSCCOL).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. 2010 A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. set up a special derivatives regulatory department which would coordinate and ensure the sharing the information between stock exchanges. The trading of futures and options will see light of the day only after the SEBI gives its assent to it. Recently.C.October 1st.C. which was to commence operations along with trading in futures and options. 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.

Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. Payoff profile for seller of asset: Short asset In this basic position. Nifty for instance. the investor is said to be “short” the asset. for 1220. His profits are limited to the option premium. the long futures position starts making profits.58 - Futures contracts have linear payoffs. Payoff profile of buyer of asset: Long asset In this basic position. In simple words. an investor shorts the underlying asset. however the profits are potentially unlimited. He has a potentially unlimited upside as well as a potentially unlimited downside. The underlying asset in this case is the Nifty portfolio. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. 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. Payoff profile for buyer of call options: Long call . He has a potentially unlimited upside as well as a potentially unlimited downside. the short futures position starts making profits. it means that the losses for the buyer of an option are limited.S4 it is purchased. an investor buys the underlying asset. The underlying asset in this case is the Nifty portfolio.Derivatives – Indian Scenario Payoff for futures . When the index moves down. and buys it back at a future date at an unknown price S4 Once it is sold. and sells it at a future date at an unknown price. Options payoffs The optionality characteristic of options results in a non-linear payoff for options. for 1220. it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. When the index moves up. We look here at the six basic payoffs. the investor is said to be “long” the asset. however his losses are potentially unlimited. the payoff is exactly the opposite. and when the index moves down it starts making losses. Nifty for instance. 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. and when the index moves up. it starts making losses. 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. In simple words. For a writer.

Example: A corporate has a loan of USD 10 million outstanding with remaining maturity of 2 years. the company is assuming currency risk in the process and unless carefully managed.59 - A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. If the spot price of the underlying is less than the strike price. might end up increasing the cost of the loan instead of reducing it. more is the profit he makes. His loss in this case is the premium he paid for buying the option. he lets his option expire un-exercised.com/wholesale/fit/financial_institutions/derivatives_desk/derivatives_desk _fcw. The total cost for the corporate would now work out to 12. 446. the USD/INR forward foreign exchange markets are illiquid beyond one year. they have to locate counter parties with matching requirements. The banker quotes a rate of say 10. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. he makes a profit. the Reserve Bank of India has permitted banks to arrange currency swaps with one currency leg being Indian Rupee. If the corporate wants to enter into a currency swap to convert his loan interest payments and principal into INR.e.hdfcbank. Moreover.aspx?name=Mecklai_Knowledge_Centre/Currency Swap http://www. If upon expiration.Derivatives – Indian Scenario . However. e. http://www.emecklai.50 mio. some aggressive banks do provide quotes for currency swaps for three to five years out for reasonable size transactions. banks are also not allowed to take risk /run open swap books i. it is more the norm for corporates to swap their foreign currency loans into rupee liabilities rather than the other way round. 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. 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. However. one desiring to swap a dollar liabilities into rupee liabilities and the other wishing to exchange rupee debt servicing obligation for dollar obligations. Higher the spot price. there are limitations to entering the Indian Rupee currency swaps beyond twelve months.75% for a USD/INR swap. In India. which is used by the corporate to repay his USD loan.g.com/Market_Resources. the bank delivers USD 10 million to the corporate for an exchange of INR 446. In India. Since currency swaps involve the forward foreign exchange markets also. Swap Market in India. At the end of the swap. interest on which is payable every six months linked to 6-month Libor + 150 basis points. The corporate is able to switch from foreign currency.25%. the spot price exceeds the strike price. This dollar loan can be effectively converted into a fixed rate rupee loan through a currency swap.50 mio. If the spot rate on the date of transaction is 44.65. However.htm . the rupee liability gets fixed at Rs..

. China’s BRICS partners may leapfrog and be next on the list. 2012. Kapadia S. Kapadia is a Geopolitical Strategist and Consultant 6. Brazil.. As trade increases. 16 countries have exchanged local currencies for a total of 1. BRICS countries make up a massive trade bloc. LiveMint | Jun.1    Recent Posts Romney's Sinophobia A Coal Crisis in India. project financing and infrastructure projects.N. exporting $135 billion in goods and services a year to its partners.60 - 6 The BRIC Currency Swap Proposal Is A Global Game Changer S. At this time. Current intra-BRICS trade stands at $307 billion.N..1 S. So far. China is the dominant country. From BRICS. development banks of the participating countries agreed on a proposal to extend credit in local currency for trade. and South Africa should take note. China could move swiftly to provide renminbi for importers of Chinese goods.Derivatives – Indian Scenario . Within BRICS. Russia is currently the only country that swaps its currency with China—India. 4:10 AM | 1.1. Yet banks in London. 1.6 trillion renminbi. more are in line to participate—Japan and Great Britain are rumored to be in queue. increasing their share of the Indian market by 2% in just four years.1.1. no clear mechanism on how they will extend local currency credit has been announced. Kapadia. Some financial gurus even dismiss the BRICS agreement as purely symbolic. But after the Delhi meeting. New York. Since 2009. it is set to reach $500 billion by 2015. India imports $50 billion annually from China and Chinese goods account for 11. 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.N.284 | 2        inShare Email More 6. and China India's Austerity Sham At the last BRICS summit held in March in New Delhi. China facilitates payment in renminbi through a central bank liquidity swap.8% of India’s total imports.

First. making it difficult to predict the cost of dollars. 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.51 to the dollar on Thursday. BRICS countries are losing purchasing power because of depreciation against the dollar. rupee-dollar exchange rate volatility has increased by as much as 50%. The dollar accounts for 40% of global foreign exchange trade. But it’s getting harder for BRICS to buy dollars. following the 2008 financial crisis.61 - Four factors make a central bank liquidity swap particularly important.Derivatives – Indian Scenario . . Brazil has seen its currency depreciate by over 16% since February 2012 and the Indian rupee fell to an all-time low of 56. Second.

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. a central bank liquidity swap will benefit small business.and mid-cap companies are struggling to get dollar loans at reasonable interest rates.Derivatives – Indian Scenario . at -2. India could save a whopping $2. Vladimir Dmitriev.3 billion. There is geopolitical risk in this. Third. Quick math shows that at full potential. respectively. chair of the Russian development bank. suggested in the BRICS summit agenda that countries will save up to 4% by entering into these agreements. . Their current account deficits too are high. small.4% of gross domestic product. saving on transaction costs. given rising prices for key commodities such as crude oil. Drawing on a swap line from China. Lastly. financing fees and currency fluctuations. however. a slowdown in capital inflows and a current account deficit now at a decadal high of 4% of gross domestic product (GDP). which can cost Indian business up to 1-2% of a deal.3 billion a year in banking services. BRICS countries save $12.1% and -3. India isn’t alone—Brazil and South Africa face the same problem as their currencies have seen deviations of 25% to the dollar. With the credit rating agencies such as S&P downgrading India.62 - This uncertainty places India in a tough situation. there is an opportunity to save on transaction costs.

India’s signature commodities such as tea were re-exported by Russia to Western markets. swaps are customized contracts that are traded in the over-thecounter (OTC) market between private parties. shrinking India’s market share with key trading partners. so is the possibility with China now. Prime minister Indira Gandhi refused. according to the Bank for International Settlements. But India ran up a trade deficit and from 1955-76. such as an interest rate. India entered into a similar currency agreement with the former Soviet Union largely for arms deals.V. Russia accumulated upwards of $350 million in non-convertible rupees. The Swaps Market Unlike most standardized options and futures contracts. wrote to prime minister Jawaharlal Nehru warning him of the dangers of such currency arrangements. That's more than 15 times the size of the U. with few (if any) individuals ever participating. declaring that “political compulsions far outweigh economic considerations”. However. SEE: Futures Fundamentals The first interest rate swap occurred between IBM and the World Bank in 1981.63 - In the late 1950s. BRICS swaps save money on imports by freeing India from currency fluctuations and reducing the cost of funds. Moscow even petitioned for naval base rights. Usually. Conceptually. swaps are not exchange-traded instruments. India’s motives now are economic. Russia sought a strategic advantage from its poorer trading partner. the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865. there is always the risk of a counterparty defaulting on the swap. As with the Soviet Union then. at least one of these series of cash flows is determined by a random or uncertain variable.6 billion. By mid-2006. or as a long position in one bond coupled with a short position in another bond. equity price or commodity price. despite their relative youth. public . this figure exceeded $250 trillion. The key for India will be to negotiate favorable terms of agreement. India’s trade deficit with China is estimated to reach $60 billion by 2014-15.Derivatives – Indian Scenario .R. believing that the quid pro quo would threaten regional security. at the time the contract is initiated. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps. foreign exchange rate. Iyengar. H.S. In negotiating its rupee relationship with Russia. As a result. Firms and financial institutions dominate the swaps market. swaps have exploded in popularity. Because swaps occur on the OTC market. Only then will India’s economic advantages outweigh the geopolitical risks of such a deal period of time. one may view a swap as either a portfolio of forward contracts. In 1987. Instead. governor of RBI (1957-62). Nehru ignored him.

At the end of 2007. beginning in 2007 and concluding in 2011. Concurrently. Company A will pay Company B $20. let's assume the two parties exchange payments annually on December 31. 2006. and the time between are called settlement periods.000 * (5. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. On Dec. In a plain vanilla swap. 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.Derivatives – Indian Scenario equities market.33%. or at any other interval determined by the parties. fixed rate of interest on a notional principal on specific dates for a specified period of time. quarterly. 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. 2006. For simplicity. Company B will pay Company A $20. or London Interbank Offer Rate. The specified payment dates are called settlement dates.000 * 6% = $1. Party A agrees to pay Party B a predetermined.000. therefore.000. At no point does the principal change hands. one-year LIBOR was 5.266.000. is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. LIBOR.64 - The most common and simplest swap is a "plain vanilla" interest rate swap. which is why it is referred to as a "notional" amount. Normally. SEE: How do companies benefit from interest rate and currency swaps? For example. Here. and Company A pays nothing. In this swap. 31. on Dec.000. interest payments may be made annually. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. 31. Figure 1 . Because swaps are customized contracts. swap contracts allow for payments to be netted against each other to avoid unnecessary payments. the floating rate is usually determined at the beginning of the settlement period. the two cash flows are paid in the same currency. Company B pays $66. Plain Vanilla Interest Rate Swap .33% + 1%) = $1. monthly.200. In a plain vanilla interest rate swap.000.

Then. Step 1. Figure 2: Cash flows for a plain vanilla currency swap. the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. This satisfies each company's need for funds denominated in another currency (which is the reason for 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. beginning one year from the exchange of principal. will pay interest in dollars. which occur annually (in this example). a European firm. Unlike an interest rate swap. Company C pays $50 million. based on a dollar . which borrowed dollars. For example. the dollar is worth 0. Let's assume the exchange rate at the time is $1.Derivatives – Indian Scenario .80 euro).S. the parties will exchange interest payments on their respective principal amounts. firm. let's say they make these payments annually. 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. To keep things simple. enter into a fiveyear currency swap for $50 million. Likewise. at intervals specified in the swap agreement. Company C. Because Company C has borrowed euros. First. a U.65 - shows the cash flows between the parties.g. Company D. So. the firms will exchange principals.25 per euro (e. and Company D pays 40 million euros. it must pay interest in euros based on a euro interest rate. and Company D.

000.25%.$1.125.000 euros * 3.40 per euro.960.125. For this example. If.165.000) to Company C. then Company C's payment equals $1. which pays a floating rate of interest on deposits (e. This mismatch between assets and liabilities can cause tremendous difficulties. and Company D's payment would be $4. at the end of the swap (usually also the date of the final interest payment).25% = $4. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate.000.960. the parties will actually net the payments against each other at the then-prevailing exchange rate. Thus.000 euros to Company D. 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. In practice.000. For example. Company C pays 40.400.000. and the euro-denominated interest rate is 3. liabilities) and earns a fixed rate of interest on loans (e. These principal payments are unaffected by exchange rates at the time. the parties re-exchange the original principal amounts. the exchange rate is $1. each year.Derivatives – Indian Scenario . Figure 3: Cash flows for a plain vanilla currency swap. consider a bank. Figure 4: Cash flows for a plain vanilla currency swap.125. As with interest rate swaps. Step 2 Finally.g. assets). let's say the agreed-upon dollar-denominated interest rate is 8.000 .66 - interest rate. Company D will pay Company C $50. at the one-year mark.000 ($4. Step 3 Who Would Use a Swap? The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage.000.50% = 1.5%.000 * 8. Company D would pay the net difference of $2.g. which would .

Buy Out the Counterparty: Just like an option or futures contract. Exiting a Swap Agreement Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. By then using a currency swap. It will likely receive more favorable financing terms in the U. This would reduce some of the market risks associated with Strategy 2. so either it must be specified in the swaps contract in advance. However. one party may sell the contract to a third party. the firm ends with the euros it needs to fund its expansion. . .S. 4. 2. Company A from the interest rate swap example above could enter into a second swap. this comparative advantage may not be for the type of financing desired. but not enter into. a potentially offsetting swap at the time they execute the original swap. In this case. For example. so one party may terminate the contract by paying the other this market value. a swap has a calculable market value.Derivatives – Indian Scenario match up well with its floating-rate liabilities. Use a Swaption: A swaption is an option on a swap. or the party who wants out must secure the counterparty's consent. Purchasing a swaption would allow a party to set up. then use a swap to convert it to the desired type of financing. There are four basic ways to do this: 1. This is similar to an investor selling an exchange-traded futures or option contract before expiration. this is not an automatic feature. As with Strategy 1. However. the company may acquire the financing for which it has a comparative advantage.S. this time receiving a fixed rate and paying a floating rate. firm that wants to expand its operations into Europe. this requires the permission of the counterparty. Enter an Offsetting Swap: For example. 3. where it is less known. Sell the Swap to Someone Else: Because swaps have calculable value. consider a well-known U.67 - Some companies have a comparative advantage in acquiring certain types of financing.

68 - The Bottom Line Swaps can be a very confusing topic at first. can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. but this financial tool. if used properly. . This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study.Derivatives – Indian Scenario . 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.