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ADV-CM301

OTC Derivatives

Contents

1.

INTRODUCTION AND OVERVIEW TO OVER THE COUNTER (OTC) MARKETS ............. 6


1.1 What are OTC derivatives?.............................................................................................. 6
1.2 History of OTC Derivatives .............................................................................................. 7
1.4 Price Discovery and liquidity .......................................................................................... 9
1.5 Types of OTC Derivatives: ............................................................................................. 11
1.6 Role of Broker/Dealer in OTC Markets: ........................................................................ 12
1.7 Models in OTC Derivatives Markets.............................................................................. 13

2.

INTRODUCTION TO FORWARD CONTRACTS ............................................................... 15


2.1 Features of forward contracts ....................................................................................... 15
2.2 How are forward contracts entered into?..................................................................... 16
2.3 Different Types of Forward Contracts .......................................................................... 18
2.4 Participants in Forward Contracts ................................................................................ 24
2.5

3.

Pricing of Forward Contracts ................................................................................... 25

INTRODUCTION TO FORWARD RATE AGREEMENTS (FRAS) ..................................... 30


3.1

What are FRAs? ........................................................................................................ 30

3.2 Why are they entered into? ........................................................................................... 32

4.

3.2

How are they quoted and traded? ............................................................................ 34

3.3

How are they priced? ................................................................................................ 35

INTRODUCTION TO SWAPS ............................................................................................ 37


4.1 What are swaps?............................................................................................................ 37
4.2 Types of Swaps .............................................................................................................. 40
4.3 Risks involved in Swap Transactions: ......................................................................... 40

4.4 How is the risk managed? ................................................................................................ 44

4.5 Other Types of Swaps ....................................................................................................... 47


4.5.1 Credit Default Swaps (CDS): ...................................................................................... 47
4.5.2 Commodity swaps ...................................................................................................... 49
4.5.3 Equity Swaps............................................................................................................... 50
5. INTEREST RATE SWAPS .................................................................................................... 52
5.1 Types of Interest rate Swap........................................................................................... 52
5.2 What are the Fixed to Floating, floating to floating IRS? ............................................ 53
5.3 Specifications of Interest rate Swaps: .......................................................................... 58
5.4 What is Plain Vanilla Swap? .......................................................................................... 59
5.5 Difference between IRS and FRA .................................................................................. 60
6. CURRENCY SWAPS ............................................................................................................ 62
6.1 Purpose of Currency Swap: .......................................................................................... 63
6.2 Structure of Currency Swap: ......................................................................................... 63
6.3 Specifications of Currency Swaps................................................................................ 65
6.4 Major Differences between the Interest rate and Currency Swaps: ........................... 68
7. MECHANICS OF SWAPS ..................................................................................................... 70
7.1 How are Swaps traded? ................................................................................................. 70
7.2 How are the swaps priced? .............................................................................................. 72
8. LIFE CYCLE OF TRADE FOR OTC DERIVATIVES ............................................................ 80
8.1 Process of OTC trades from Trade Capture to Trade Maturity ....................................... 80
8.2 What details are required for Trade Capture? ................................................................. 82
8.3 What kind of Trade Support is required?......................................................................... 83
8.4 What are trade fails and why do they occur? .................................................................. 86
8.5 What are Nostro and Vostro Accounts? .......................................................................... 88
8.6 Payment and Reconciliation of Nostro and Vostro Accounts ........................................ 88
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8.7 What is ISDA documentation and what is its importance? ............................................ 89


8.8 Static data and importance of maintaining accurate static Data ................................... 92
9. OTC OPTIONS..................................................................................................................... 95
9.1 Basics of options, various terms related to options ....................................................... 95
9.2 What are different types of OTC or Exotic options? ....................................................... 96
9.3 Basic option strategies ................................................................................................... 101
9.4 How is the settlement of options done? ........................................................................ 104
9.5 Valuation and pricing of OTC options............................................................................ 105
9.6 Applications of Options (Currency, Commodity and interest rates) ............................ 106
10 OTHER DERIVATIVE PRODUCTS .................................................................................... 109
10.1 Understanding interest rate Caps, Floors and Collars ............................................... 109
10.2 What are Amortizing / Accreting swaps, Overnight Index Swaps .............................. 110
10.3 What are Swaptions? .................................................................................................... 112

Note:
Important concepts are underlined
Important calculations / formulas are marked by

Illustrative concepts are marked by !

1. INTRODUCTION AND OVERVIEW TO OVER THE COUNTER (OTC) MARKETS

After studying this unit, you should be able to understand:

Broad overview of the OTC markets

Difference between OTC and exchange-traded markets

Concept of price discovery and liquidity

Types and models of OTC markets

Role of intermediaries such as brokers and dealers

1.1 What are OTC derivatives?

A derivative is an instrument or a contract whose value is derived from the value of underlying
assets. Derivatives can be traded over the counter (OTC) or through exchanges. OTC
derivatives are bilateral customized contracts that are traded between two entities while
exchange-traded derivatives are contracts traded via exchanges with clearing corporations,
mitigating counterparty risk. OTC derivatives include complex and innovative instruments that
can be used to manage risks associated with the underlying markets. But all transactions in
OTC markets are negotiated between two parties, which may result in liquidity and counterparty
risk. The counterparty risk is also termed as credit or default risk. According to the Bank for
International Settlements data, the notional amount outstanding (of OTC Derivatives) is
$614,674 billion at end-2009. The number was $595,738 billion and $547,983 billion at the end
of 2007 and 2008, respectively. In the global derivative markets, there is dominance in the OTC
markets, where 91% of the overall notional amount outstanding belongs to OTC markets
and 9% belongs to organized (exchange-traded) markets as of end-2008.

OTC derivatives can be traded on financial instruments or commodities. Financial instruments


include stocks, bonds and currencies. Commodities include tangible commodities and intangible
commodities. Types of OTC derivatives (session 1.5) will cover information on financial and
commodity derivatives.

1.2 History of OTC Derivatives

Year

Instruments

Location

1848

Commodity Forwards

Chicago

1900

Equity Forwards

USA

1972

Currency options

CME

1981

Currency SWAP

World Bank and IBM

1.3 OTC vs. exchange-traded derivatives


Sr.

Parameters

Over the counter

Exchange traded

Instruments

Forward, Vanilla and Exotic Options

Futures and Options

No
1

and Swaps
2

Platform for Trading Telephone, Customized Trading

Exchange Floor/Exchange

Platforms

Electronic Trading Systems

Clearing and

Mostly directly between parties or via

Via Clearing Corporations

Settlement

institutions such as

associated with Exchanges

Banks/Independent Clearing
Corporation
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Contract

Customized in terms of Maturity, size,

Standardized Terms decided

Specifications

underlying, Settlement, location,

by the Exchange in

counter parties etc

consultation with the


respective regulator

Settlement

Either Cash or Physical Settlement

Mostly Cash settlement

Risks Involved

Counterparty, Liquidity and

Operational Risk only

Operational Risk
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Transparency

Trading information may not be

Trading Information is easily

readily available. However

available on Exchange/broking

Bloomberg/Reuters provide

firms/regulators websites

information about OTC instruments


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Regulators

Intermediaries

International Swaps and Derivatives

Securities Exchange

Associations

Commission (US), SEBI, FSA

Mainly Banks

Via Stock Exchange and


Brokers (Members of the
Exchange), Clearing
Corporations

10

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Price

Major Market

Price Discovery is poor as the

Better; as traded on a

markets are fragmented

transparent exchange

Institutions and Banks

Institutions, Banks, HNI,

Participants
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Type of Trading

Individuals
Via Market Makers, Mostly Quote

Order Driven

Driven
8

13

Redressal

Via regulators

Via Stock Exchanges

Bigger (5 times) than Exchange

Smaller marker compared

Traded

with OTC Markets

Mainly among few institutions

Mass participation

Mechanism
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Size of the Markets

Nature of the
market

1.4 Price Discovery and liquidity

Derivatives Instruments play an important role in price discovery through futures and options
markets. Price discovery is defined as a process of determining a price of a specific stock,
currency or a commodity through market demand and supply forces. Since derivatives
instruments are settled at a future date, market prices of derivatives contracts reflect prices of
underlying instruments on the settlement date. Hence, the price may be higher or lower than the
current spot rate, reflecting the markets bullish or bearish perception about the future price of
the underlying. But, since OTC instruments are traded in a scattered manner, efficiency in price
discovery may be affected to a great extent. For example, currency swaps are traded between
two banks. Hence the traded price is known to the counterparties at the time of trade and may
not be informed to other market participants. However, some OTC instruments such as currency
forwards are traded via Reuters/Bloomberg platform, which create efficient price discovery as
traded rate and quotes are flashed on the trading terminal. Normally, efficient price discovery is
extremely challenging for instruments that are highly customized such as exotic options or
exotic swaps.

Efficiency in price discovery depends on following factors:


1. Open and centralized trading in the underlying market:
If trading in the underlying market is centralized, then all buyers and sellers will be trading
through one platform. This may be possible if the underlying is trading through exchanges
through one centralized electronic order book. This feature will assist in creating liquidity, which
is one of the parameters in price discovery.
2. Large number of buyers and sellers creating high liquidity:
An instrument is traded actively when market participants have opposite expectations about the
future price of the commodity and eventually underlying market will establish price equilibrium.
3. Free market:
For efficient price discovery, there should not be any trading restrictions on market participants.
In 2008, the US Regulators implemented trading restrictions such as ban on short selling (for a
short span) as there was a free fall in the financial markets. Short selling strategies are used by
market participants to trade if they expect bearishness in the market (strategies will be covered
later).
4. Participants comprising hedger, arbitrageurs and speculators:
Market participants trade in different instruments based on their risk-return expectations and
requirements. They can be classified as hedgers (who trade to manage risk in the underlying
markets), arbitrageurs (who trade to take advantage of mispricing) or speculators (who trade by
taking view on the markets). Each player is extremely important for well-functioning of the
financial markets. Historically, when regulators banned speculators from trading in the markets,
it was noticed that the markets became highly illiquid, thus impacting price discovery.
Linkages between price discovery and liquidity:
Liquidity is measured in terms of volume, open interest, number of buy and sell orders, and
market depth in the order book. If there are few buyers or sellers, it will widen the bid-ask

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spread quoted in the markets. Illiquid markets are one of the reasons of inefficiency in price
discovery.

1.5 Types of OTC Derivatives:

OTC Derivatives can be classified on the basis of underlying (e.g. equity, interest rates,
currency, and commodity) or the risk-return profile (symmetric or asymmetric). Forwards have
symmetric risk-return payoff profile, while options have an asymmetric one. The table below
highlights various types of OTC Derivatives:
Instruments
Equity
based on Risk
Ret/Underlying
Forwards
Equity
Forwards
Options
Swaps

Equity
Options/Warrants
Equity Swaps

Interest rates

Currency

Forward
Rate Currency
Agreements
Forwards
(FRA)
Caps/ Floors
Currency
Options
Swaptions
Currency
Swaps

Commodity

Commodity
Forwards
Commodity
Options
Commodity
Swaps

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1.6 Role of Broker/Dealer in OTC Markets:

Brokers/dealers perform an important function of bringing buyers and sellers together,


especially in the OTC derivatives markets, as OTC derivatives are customized and traded off
the exchanges. The matching of requirements of buyers/sellers in terms value of contracts,
maturity, underlying, quality in case of commodity, and price are managed by brokers. Brokers
are individuals/institutions that trade on behalf of buyers and sellers for commission fees that
depend on the complexity of transactions. These trades are known as agency trades in the US
and Europe markets. The activity of brokers is free of price risk as they do not take any
positions in the market. However, they are exposed to the possibility of default by buyers or
sellers. Their revenue is based on volumes of transactions and their value. As volumes
increase, brokers may reduce their commission fees. Normally, brokers have brokerage
structure with various commission rates (%) offered to market participants, which may differ
from individuals to institutions.
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Dealers are mainly institutions who trade on their own accounts. These trades are known as
principal or proprietary trades. The risks associated with dealers positions are market, credit,
operational and liquidity risk. Dealers are essential for OTC derivatives markets as liquidity is
poor.

1.7 Models in OTC Derivatives Markets

The Models in OTC derivative markets can be categorized as follows:


1. The traditional dealer market: In the traditional dealer markets, one or more dealers
make a market by maintaining bid and offer quotes to market participants. These quotes
are posted by dealers on the electronic bulletin boards. The execution prices are
decided usually on telephone through bilateral negotiation.
2. Electronically brokered markets: OTC markets have now adopted electronic and
networking technologies for creating a multilateral trading environment. These electronic
brokering platforms are same as electronic trading platforms used by exchanges. The
firm that operates the platform only acts as a broker. They do not take position or act as
a counterparty for any trade routed through that system.
3. Proprietary electronic dealer (or trading platform): It is a composite of the traditional
dealer and the electronic brokering platform. The OTC dealer establishes their own
proprietary electronic trading platform. The quotes are posted by dealers and other
market participants observe these quotes. The dealer is the counterparty to every trade
and they hold the credit risk in the market. Commodity Exchange Act definition of
trading facility section V discloses that The Proprietary Electronic Dealer Platform is
not considered a trading facility because the bids and offers cannot be posted by all

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participants and thus not all participants can trade by accepting bids and offers made by
other participants that are open to multiple participants in the facility or system.

Summary:
The objective of this unit was to provide you with some exposure to introduction to the OTC
Derivatives Markets. The unit covers how the OTC Derivatives market is unique compared with
exchange traded derivatives markets. It is followed by an explanation on price discovery and
liquidity parameters governing the OTC markets. Finally, it covers types of participants such as
brokers and dealers, types of OTC markets, and OTC models.

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2. INTRODUCTION TO FORWARD CONTRACTS

After studying this unit, you should be able to understand:

Broad specifications (features ) and concept of forward contracts


Trading alternatives in futures transactions
Types of forward contracts
Participants involved in forward contracts trading
Pricing of forward contracts

A forward contract is a customized contract between two parties, where settlement takes place
on a specific date (maturity date/expiry date/expiration date) in future, with terms and conditions
(specifications) agreed upon today.

2.1 Features of forward contracts

They are OTC bilateral contracts (between two parties) and hence are exposed to
counter party risk.

Each forward contract is custom designed in terms of price, underlying, quality, quantity,
maturity date and settlement type (delivery/cash), location and currency. The underling
can be equity, currency, interest rates or commodity. Quality is relevant only in case of
commodity forwards. Delivery settlement results in actual delivery of the underlying; in
cash settlement, the intermediary calculates the profit or loss on settlement date.

The traded price or bid-offer price is not easily available in the public domain.

Risk associated with forward contracts are:

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Default risk/counter party risk/credit risk: Either party will deviate from the obligation.

Transparency risk: The price and other specifications are normally not available to
the market at large (unlike equity markets where details are available to trading
participants).

Non-transferrable contracts: These contracts are not transferrable hence either


party need to go back to their respectively counterparties to cancel/reverse the
contracts.

Liquidity Risk: Liquidity is a function of how easily trader can buy/sell a product. It
depends upon:
No. of buyers for a product
No. of sellers for a product
Quantity available for buying
Quantity available for selling
As forwards are not traded on exchanges, liquidity is low and hence traders normally
find it difficult to buy/sell in forward markets.

2.2 How are forward contracts entered into?

Forward contracts are entered via two options:


Dealing Desk: In case of dealing desk, the banks are the market makers who offer bid (buy)
ask (sell) quotes (via terminal/ telephone) to other market participants. Market makers mainly
create markets by buying the underlying if the counterparty intends to sell and vice a versa. The
difference in the bid ask quote (spread) is the profit for the market maker. When the volatility in
the market increases, the spread increases and vice a versa. The market participants like
importers or exporters accept the quote or verify with other bankers for better rates.

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No Dealing Desk: In case of no dealing desk, market participants trade via STP (Straight
through processing) route or via ECN (Electronic communication networks). No Dealing desk
brokers provide access to interbank market via STP automated screen based trading terminal
where order from market participants get matched with the best available quotes in the
interbank market. In case of ECNs, all the existing participants can allowed to trade with other
participants. Brokers charge a commission in case of STP/ ECNs.

(Source: forexbrokers.com)

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2.3 Different Types of Forward Contracts


Broadly Forwards are classified as Follows:

Currency

Commodity

Equity

Standard Forwards

Standard Forwards

Forwards

Par Forwards

Flat Forwards

Non-Deliverable

Spot deferred Forwards

Forwards

Standard Currency Forwards:


Currency Forwards (popularly known as FX forwards) are outright standard transactions where
the seller agrees to deliver fixed amount of one currency (base currency) for the known amount
of the second currency (variable) at a future date.

! Illustration of Specification of a Standard Currency Forwards transaction:


Specification

Value

Description

Trade date

9th Sept 2010

Transaction date

Tenure

1 month

Tenure ranges from 1 month to n years ( market practice : max


18months )

Value date

8th Oct 2010

Based on Day Convention (following/ preceding business day if


the day is non business day)

Base Currency

USD

Fixed currency

Second

Yen

Variable Currency

Currency

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Spot rate

$/yen 85/85.15

Settlement is t+2

Forward points

$/yen 0.55/0.60

Forward points are also called as swap points

Forward rate

$/yen

Forward rate is normally quoted in forward points/swap points

85.55/85.75
Quantity

$ 10000

Expressed in base currency

Documentation

ISDA

International Swaps and Derivatives Association, Inc. ISDA was


chartered in 1985, and today has over 830 member institutions
from 57 countries on six continents.

Buyer

Bank HSBC

Agrees to buy USD (Base currency) and sell Yen

Seller

Exporter in USD

Agrees to sell USD and buy Yen

Settlement

Delivery

Settlement is defined as the transfer of currencies between the


two entities

Par Forwards:
A Par Forward is series of forward contracts at single rate rather than at different rates based on
the tenure of the forward time periods.

! Below illustration explains how a Par forward contract is designed:

Specification

Value

Description

Trade date

9th Sept 2010

Transaction date

Tenure

1, 2,3 month

Tenure ranges from 1 month to n years ( market practice


: max 18months )

Value date

8th Oct / 8th Nov/ 8th Dec Based


2010

on

Day

Convention

(following/

preceding

business day if the day is non business day)

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Base Currency

USD

Fixed currency

Second Currency

Yen

Variable Currency

Spot rate

$/yen 85/85.15

Settlement is t+2

Forward points

$/yen 0.55/0.60 ( 1m )
$/yen 0.57/0.625 ( 2m )
$/yen 0.59/0.65 ( 3m )

Forward

rate

( $/yen 85.57/85.775

Applicable rate for all the three months will be average

applicable )

rate of 1m, 2m and 3m forward rates

Quantity

$ 10000

Expressed in base currency

Documentation

ISDA

International Swaps and Derivatives Association, Inc.


ISDA was chartered in 1985, and today has over 830
member institutions from 57 countries on six continents.

Buyer

Bank HSBC

Agrees to buy USD and sell Yen

Seller

Exporter in USD

Agrees to sell USD and buy Yen

Settlement

Delivery

Settlement is defined as the transfer of currencies


between the two entities

E.g. 2.3.1: USD/INR Spot and forward rates


FORWARDS
Maturity ( in month )

Spot rate

Amount ( in USD millions)


Standard forwards

45

1.3

1.4

1.5

1.4

1.5

45.5

45.8

46.5

47

48

59.15

64.12

69.75

65.8

72

( USD/INR )
Amt received in INR(millions)
( Standard forwards )

20

Amt received in INR(millions)

66.164

66.164

66.164

66.164

66.164

( Flat forwards )

Explanation: The flat forwards is equal to the average of standard forwards. Therefore, the
calculation is as follows: (59.15+64.12+69.75+65.8+72)/5 = 66.164 (INR in millions)

Non-Deliverable Forward Contracts


A NDF contract is a cash settled outright currency forward contract wherein the net settlement
is not by physical delivery of currency, but by calculating the diff between the contracted rate
and prevailing spot rate on the settlement date. NDFs are traded on non-convertible or
restricted currencies traded over the counter outside the direct jurisdiction of the respective
national authorities. They allow multinational corporations, portfolio investors, hedge funds and
proprietary foreign exchange accounts of commercial and investment banks to hedge their
positions in local currencies. The settlement of the transaction is not by delivering the underlying
pair of currencies, but by making a net payment in a convertible currency equal to the difference
between the agreed forward exchange rate and the subsequent spot rate. These are generally
settled in USD.
For example, FII and NRI are not allowed to trade in forward market in India. Hence they hedge
their INR (Rupee) risk by taking positions in the NDF market which is very active in Dubai and
Singapore. FII invest in the Indian equity markets by buying USD NDF contracts and exit from
the Indian Equity markets by selling USD NDF. The major Asian NDF markets are Chinese
Yuan, Korean won, Taiwanese dollar, Philippine peso, Indonesian rupiah, Malaysian ringgit,
Thai baht, Pakistani rupee and Indian rupee.
Major drivers of the NDF markets are:
1. No physical transfer of two currencies as NDF is settled in one of the currencies
(normally USD).

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2. Two offshore entities can hedge their risk and thus avoid any regulatory controlled
restrictions on currency trading in domestic markets.

# Example 2.3.2:
Suppose an FII wishes to sell Indian Rupees (INR) forward. The transaction is to hedge an
underlying investment exposure that is not eligible for currency forward coverage in the formal
or official INR market. The counterparty enters into a NDF with a dealer for US $ 1 m for a 6
month maturity at rate US $ 1 = Rs 45.
If the rate goes to $/INR = 43 then the FII pays (20 lacs/ Rs 43) = $ 45311 (loss)
If the rate goes to 47, then FII will receive (20 lacs/ Rs 47) = $ 42533 (profit)
Explanation: The difference between the exchange rates of Rs45 Rs43 is 2rupees per dollar.
Therefore, computation is as follows:
1. $1000000 @ Rs43 is Rs43000000
2. $1000000 @ Rs45 is Rs45000000
3. $1000000 @ Rs47 is Rs47000000
If the rate goes to $/INR = 43 then the FII will pay the difference between Rs45million and Rs43
million which is equal to Rs2million or Rs20lakhs.
Alternatively, if the rates goes to $/INR = 47 then the FII will receive the difference between
Rs47million and Rs45million which is equal to Rs2million or Rs20lakhs.

# Example 2.3.3:
Assuming a counterparty wishes to sell Indian Rupees (Rs.) forward. The transaction is to
hedge an underlying investment exposure that is not eligible for currency forward coverage in
the formal or official Rs (Rupee) currency market. The counterparty enters into a NDF with a
dealer for US $ 1 m for a 6 month maturity at rate US $ 1 = Rs 40.
Solution:

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Rs Appreciates

Rs Depreciates

Spot rate at Settlement date

35

45

Rs Amount at NDF ( Rs40 )

40,000,000

40,000,000

NDF 35,000,000

45,000,000

Rs

Amount

at

Settlement rate
Net Settlement

Counterparty
142,857

or

pays

US

$ Counterparty receives US $

Rs5000000 111,111

{40000000-35000000}

or

Rs5000000

{45000000-40000000}

Commodity forwards:
Standard Forward Contracts: They are simple outright purchase / sell of commodity at the future
date. They are similar in nature when compared to currency forwards except for the underlying
which is a commodity like gold, silver etc
Flat Contracts: A series of forward contracts structured at a constant price (weighted average
price). In a contango market (forward price is greater than the spot price, and increases with the
time), the weighted average price of the Flat contracts will be higher for near maturity contracts
as compared to standard forward contracts. Hence the cash flow from these contracts will be
higher in the near term which will match the higher project cost during the initial phase of any
project.
Spot Deferred Contracts: These contracts covers an option (to one of the parties) to defer the
settlement by a fixed tenure.

Equity Forwards:
These are forward contracts on equity stocks. In this case, two parties agree to exchange the
underlying stock (or index) at a future date at a price decided today.
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2.4 Participants in Forward Contracts

OTC Forwards serves various applications for hedgers and arbitrageur. In case of currency
markets, hedgers can be classified as importers or exporters. Most of the importers and
exporters are exposed to unfavorable price movements and need to hedge their underlying
exposure to the currency markets. Exporters such as software companies hedge their
remittances in USD by selling forwards (forward covers) to banks. Importers such as
manufacturing companies (e.g. purchase of machinery from the US) hedge their positions by
buying forward contracts (forward covers) from banks. Banks use spot and swap market to
hedge their exposure to importers and exporters. But the trading volumes of Currency Forwards
still form a smaller portion of the overall foreign exchange markets (refer to the table below). It
highlights that fact that the forward trading in 2007 was 362 billion out of the total trading of $
3.4 Trillion.
Arbitrageurs are risk averse participants who trade on the mispriced currencies. When the
market is imperfect, they buy in one market and simultaneously sell in the other market to earn
risk less profits. The possible arbitrage opportunities are mentioned below:
1. Spot and forwards
2. Forward and swaps
3. Forward and Futures
4. NDF and domestic forwards
5. NDF and Futures
6. NDF and Swaps

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Most of the arbitrageurs are Banks who trade in these markets to avail any arbitrage
opportunities.

2.5 Pricing of Forward Contracts

Forward contracts are priced using Static replication strategy (the carry cost of model). The cost
of carry model considers the cost of financing, storing the asset, income of the asset. Pricing
forwards is by replicating forward position by financing a position in the underlying spot market.

! Assumptions in Pricing Model:


No transaction costs or restrictions on short sale
Lending and borrowing at the risk free rate
Arbitrage opportunities are exploited as they arise
The general equations for the cost of carry model are as follows:

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A. #F = S

where S

is the cost of borrowing funds to buy the underlying asset and

carrying it forward to time t. F is the todays forward price and S is todays spot rate. r
is the annual interest rate, t is the time.
B. #F = (S- I )

where S

is the cost of borrowing funds to buy the underlying asset

and carrying it forward to time t. where I stands for the cash received by the owner of the
asset. If cash is received, the present value of the amount is reduced from the price of
the asset as the cost to buy the underlying asset reduces.
C. #F = S

where q stands for the dividend amount received. We assume here that

the q is paid continuously and hence continuous compounding formula is applied.


D. In case of commodity forward, storage cost and convenience yield has to be considered.

#The formula for commodity forwards is as follows: F = S

where u = storage cost and

y is convenience yield.

In all the above cases, if the forward price is greater that the right hand side of the equation,
arbitrage opportunity exist. But before you try applying these equations for trading and pricing in
the market, read the assumptions mentioned above!!!

# Example 2.5.1:

Share Price: $100


Spot date: 1st April 2010
Forward date 1st Oct 2010
Time to Maturity: 183 days
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Interest rates: 6% pa
Dividend: $ 2 per share (payable in one Installment)
Dividend payable on 27th August 2010

Forward Price:
Calculate Adjusted Spot rate
No of days: 148
Adjustable spot price: $100 - $1.95 = $98.05

Forward price = (98.05*0.06*183/365) + 98.05 = 100.99

# Example 2.5.2:
A. The Price of the underlying asset is $ 100. If the prevailing interest rate in the US market
is 1%. The price of the 6 m Forward contract will be F = S

, F = 100*

100.5013.
B. The face value of the underlying government bond is $ 1000 with a semiannual coupon
of 2%. The coupon is paid in three months. If the prevailing interest rates in the US
market are 3%. Income (I) is calculated as follows: (general forumale to calculate income
is 10*e-rt)10 *e(-0.03)*0.25 = 9.9252. (since the US market prevailing interest rate is 3% it is
converted to 0.03 and incorporated into the formulae, while 0.25 is the time period, since
coupon is paid every three months therefore 3/12 = 0.25)
C. The price of the 6 m Forward contract will be F = (S- I )

, F = (1000 9.9252)*

= 1005.038

27

D. A dividend paying underlying (1% continuous compounding) is priced at the value of $


1000. Interest rate is assumed as 4 %. A price of 6 month forward contract is 1015.11 (
F = S

, 1000*

The following website provided reading material on Pricing of Forwards:


http://www.bondtutor.com/btchp3/topic9/topic9.htm

28

The payoff profile of forwards:


Payoff profiles indicate the profit or loss that is generated for a buy or sell position in forward
market as underlying asset price changes. These are depicted below.
Profit / loss

Forwards have symmetrical profile. i.e. profit


potential and loss potential is same

Adjoining figure highlights the long position in the


Market Price

forward contract
On X Axis, we plot Market price of the underlying

Profit / loss

and on the Y axis we plot the profit (above the X


axis) and loss (below the X axis)

Market Price

Adjoining figure highlights the short position in


the forward contract

If an instrument has unequal profit and loss


potential, it is called as asymmetrical profile
(option)
On X Axis, we plot Market price of the underlying
and on the Y axis we plot the profit (above the X
axis) and loss (below the X axis)

Summary:
The objective of this unit was to provide you with some exposure to Forward markets. The unit
covers the designing of forward market specifications, trading alternatives, and Forward market
types. It is followed by types of forward derivatives markets such covers equity, commodity, fx
and interest rates as underlying. Finally, it covers major market participants such as hedgers,
speculators, arbitrageurs and the pricing techniques and payoff of forward contracts.

29

3. INTRODUCTION TO FORWARD RATE AGREEMENTS (FRAS)

After studying this unit, you should be able to understand:


Concept and definition of FRA
Techniques of entering into a FRA
How FRAs are quoted in the markets
How FRAs are traded in the markets
How FRAs are priced in the markets

3.1 What are FRAs?

FRA is a forward contract on interest rates between two parties to protect themselves against
future movement in interest rates. The buyer in a FRA wants to be shielded against increase in
interest rates while the seller wants to be protected from any decreases. But there is no
commitment to lend or borrow funds. The maximum exposure for either parties is the interest
rate differential between the contracted rate and settlement rate. All FRAs are settled in cash. If
the settlement rate > the agreed rate, the borrower will receive the difference from the lender or
vice versa.
Settlement amount = [(Settlement Rate - Agreed Rate) x contract run x principal amount]/
[(36000 or 36500) + (Settlement Rate x contract period)]

Where
Settlement Date is the start date of the loan or deposit upon which the FRA is based
Maturity Date is the date on which the FRA contract period ends
Fixing Date for most currencies two business days before the settlement date

30

Settlement rate is the mean rate quoted by specified reference banks for the relevant
period and currency. For most currencies LIBOR shown on BBA site (British Bankers
Association)
Run is the Period or term of underlying investment or borrowing-----normally 90 or 180
days.

Practical Illustration of a FRA !


Type

US$ FRA

Notional Amount

US$ 100 million

Trade Date

15-May-10

Effective Date

17-May-10

Settlement Date

17 August 2010

maturity Date

17-Nov-10

Parties
seller (Lender )

Party A

buyer (borrower)

Party B

Rates
5.75% pa payable semi-annually in accordance with the Fixed
Fixed rate

Rate Day count Fraction


US$ LIBOR of the designated Maturity reset semi-annually plus
the spread payable semi-annually in accordance with the floating

Floating Rate

rate day count fraction


Semi-annual money market basis calculated on an actual/360 day

Fixed rate day Count Fraction

year

Designated Maturity

Three months

spread

Nil

31

rate set date

15-Aug-10
Semi-annual money market basis calculated on an actual/360 day

floating Rate day

year

count fraction

y year

3.2 Why are they entered into?

FRAs are used to hedge short term exposure to interest rates on borrowings and deposits. Let
us look at the applications of FRA as hedging tool for future borrowings or future investment.

Hedging Future Borrowing

Requirement

Need to borrow $ 1 M in one month for a period of 6 months

Expectation

Interest rates may rise by the time the company borrows the money

Why FRA

To fix the borrowing cost today

Buyer

Company who wishes to borrow ( hedger )

Seller

FRA Provider

FRA

1 x 7 FRA rate of 6.50% pa

Daycount

Actual / 360 ( day count convention is the no of days considered in a month

basis

and in a year

#The settlement under FRA will be as follows:


If in one months time the settlement rate is 8.00%then the FRA provider will settle the
difference in favor of the company as follows:
[((8.00-6.50) x 182 x1000000)/ (36,000 + (8.00 x182))] =$ 7218.40

32

# If in one month the settlement rate is 5.00%pa then the company will settle the difference in
favour of the FRA provider as follows:
[((6.50-5.00) x182 x1, 000,000)/ (36,000+ (5.00 x182))] =$ 7396.36

Hedging Future Investment

Requirement

Will have $1million to deposit in three months for a six month period

Expectation

Interest rates may fall by the time the company invest the money

Why FRA

To fix the return on investment today

seller

Company who wishes to deposit ( hedger )

buyer

FRA Provider

FRA

3x9 FRA rate of 10% pa

Day
basis

count Actual / 365 ( day count convention is the no of days considered in a month
and in a year

# To determine the FRA settlement it is necessary to calculate the discount sum:


[(Face Value x 36,500)/ ((Agreed Rate days) +36,500)]
= [(1,000,000x36,500)/ ((10 x182)+36,500)] =$952505.20

The settlement under FRA will be as follows:


# If in one month time the settlement rate is 8.00%then the FRA provider will settle the
difference in favour of the company as follows:
[((10.00-8.00) x 182 x952505.20)/ (36,500 + (8.00 x182))] =$ 9134.57

33

# If in one month the settlement rate is 12.00%pa then the company will settle the difference in
favour of the FRA provider as follows:
[((12-10) x182 X 952505.20)/ (36,500+ (12.00 x182))] =$ 8962.66

3.2 How are they quoted and traded?

FRAs are quoted in rate terms as mentioned below. The lower rate (1.78 %) is the bid rate, rate
at which the dealer is prepared to buy a FRA and the rate at which the counterparty would sell a
FRA effectively locking the deposit rate. The higher rate (1.80%) is the offer (ask) rate, rate at
which the dealer is prepared to sell a FRA and the rate at which the counterparty would buy a
FRA effectively locking the borrowing rate.
FRA Quotations
Maturity (months )

Bid /Ask

1x4

1.78/80

3x5

1.91/93

4x6

2.01/02

5x7

2.15/17

6x8

2.29/31

1x4 in the first example refers to a contract on the 3 months rate in 1 months time. The first
number refers to the settlement date of the FRA in months from the effective date. The second
number refers to the maturity date from the effective date.

34

3.3 How are they priced?

The FRA rates are calculated from the currently prevailing yield curve. The yield curve is the
relation between the yields and maturity of bonds. Generally, yield curve is upward sloping
meaning, higher yields for longer maturities.

The yields represent yields on the zero coupon bonds.

Yield

Maturity

Formula:
(1+ R1) (1+ F1) = (1+ R2)
Where R1 is the interest rate for the one year
Where R2 is the interest rate for the two years
F1 is the forward rate for between year 1 and 2

# Example 3.4.1:
Year

Interest rate

6%

8%

The forward rate between year 1 and 2 is calculated as follows:


(1+ 6%) (1+ f1) = (1+ 8 %)
F1 = 10.03 %, so the FRA 1x2 will be quoted at 10.03%

35

Summary:
The objective of this unit was to provide you with some exposure to introduction and concept of
FRA. The unit covers how the FRAs are traded and how the settlement amount is calculated. It
is followed by the hedging examples for borrower as well as for lender. Finally it covers how it is
traded and priced in the market.

36

4. INTRODUCTION TO SWAPS

After studying this unit, you should be able to understand the:


Concept and definition of Swaps
Evolution of swaps
Risks involved in swap transactions
Management of these risks

4.1 What are swaps?


Swaps are over the counter contracts between two parties who agree to exchange cash flows
based on some underlying principal amounts. Stream of cash flows can be based on domestic
interest rates (fixed vs. floating), different currencies and their respective interest rates, equity
returns or two commodities. The principal amounts may be notional or actually exchanged. The
contracts can be customized in terms of the principal amounts, tenure, exchange of payment
etc. Normally Banks are the arrangers of the swap contracts acting as intermediaries between
buyers and sellers.

BANK acts as Intermediary

In this example, Company A and B are the swap counterparties while bank arranges the swap
deal between these companies. Here the Company A agrees to pay fixed rate (say 6 %) to
company B. In return, company B agrees to pay floating rate (variable based on the benchmark,

37

say Libor (London Interbank offer rate)) to Company A. They get into this agreement due to
various reasons which is explained in the following sections.

4.1.1 History of SWAP Markets

The First Swap transaction was traded in the year 1981between IBM and World Bank.

Prior to this, swaps were traded in form of parallel loans. Due to stringent foreign exchange
control, companies conducting business in a foreign country were unable to convert foreign
currency into domestic currency. To overcome this difficulty, the two companies based in
different countries, used to borrow domestic currency and lend the domestic currency to each
other. This arrangement was known as parallel loans. In case of parallel loans, the practical
difficulties faced by the market participants were default risk, accounting issues and arranging
the deal. As Swaps are arranged by banks, the default risk and arrangement issues are
managed by banks (popularly known as swap brokers/dealers). As Swaps are off balance sheet
transactions most of the accounting issues are also addressed.
A swap transaction is closed when the two parties agree to the specification of a swap deal. The
specification covers coupon rate, floating rate basis, day basis, the start date, the maturity date,
rollover dates, governing law and documentation details.

4.1.2 The First SWAP Deal

The transaction was between World Bank and IBM. The deal valued at $210 million for 10years
was brokered by Soloman Brothers. World Bank was planning to borrow Swiss Franc through a
mega size issue. Prior to this issue they had raised Swiss Franc from Swiss investors and
feared that they may have to pay a higher coupon to attract Swiss investors. At the same time

38

IBM was looking for dollar issue and had not accessed Swiss Market. In this scenario, they got
into a swap arrangement wherein it was agreed that IBM will raise Swiss franc as the effective
cost for IBM will be lower than that incurred by World Bank and in return, World Bank will raise
dollar. They swapped liabilities between them as both share a comparative advantage.

Since then the volumes in swap market has grown significantly.


Year

Instrument

Notional Value

2009

Interest rate swap

$ 342 trillions

2007

Interest rate swap

$ 310 Trillions

2007

Currency Swap

$ 240 Trillion

The Fees and other expenses charged by the arranger may be charged over the period of the
swap. The fees charged depend upon the credit risk (default risk) of the two parties involved,
the deal size and the tenure of the deal.

When a swap is made, there are several dates to consider:


1. The transaction date or trade date is the date when the parties agree to enter into a
swap.
2. The effective date for a swap is the date from which the fixed and floating rate
payments begin to accrue.
3. The settlement date is the date on which there is net settlement of interest accruals at
the end of each period.
4. A reset date or a fixing is the date when the floating rate is reset.
5. The maturity date is the end of the term of the swap.

39

4.2 Types of Swaps

Deferred start swap

Adjustment Swaps

Delayed Start swaps

Amortising Swaps

Discount Swaps

Arrear reset Swaps

Equity Swaps
Flexible Swaps

Asset credit swaps

Forward Currency Swaps

Asset swaps

Forward Swaps
Interest Rate Swaps

Securitised Asset swaps


Basis Swaps

Non Generic Swaps


Structured coupon swaps
Off market swaps

CAT Swaps

Overnight index swaps

Choice of LIBOR SWAPS

Premium Swaps

CMT SWAPS

Index Differential Swaps

Commodity basis swaps


Commodity crack swaps

Yield curve swaps


Total Return Swap
Variable Swap

Commodity swaps

4.3 Risks involved in Swap Transactions:

Major Risk Management Failures in SWAP Transactions:


1. UK Local Authorities incurred a loss in SWAP transactions in 1988 to the tune of GBP
600 millions

40

The risks associated with swap transactions are substantial due the following reasons:
a. Volatile nature of interest rates,
b. Fluctuation in currency exchange rates,
c. The counterparties involved
d. Settlement procedures involved

The principal type of risk involved is as follows:

1. Market Risk: The risk is mainly due to fluctuation in the floating interest rates. If the
floating rate ( e.g. LIBOR ) increases , the floating rate payer may default resulting in the
loss to the fixed payer ( unless necessary provisions are implemented by the swap
arranger )

2. Credit Risk: Risk of Loss arising due to default of the counterparty. The default may be
due to market risk

3. Liquidity Risk: If either partys inability to make payment on the settlement date, it will
create liquidity risk to the counterparty which may fail to meet its obligation. Many a
times, it results in systemic risk. Failure of one major institution to meet its commitment
may result in failure of other institutions thus creating systemic failures

4. Operational Risk : Refers to the risk of


a. Technology Failure like trading system failure
b. Human Risk like Fraud
c. Legal Risk ( Non enforceability of contracts )
d. Regulatory Risk ( breach of regulatory requirements )

41

To manage these risks, the intermediaries need to create a risk infrastructure comprising of
A. Organization/ Resourcing
B. Risk Administration
C. Risk Management Systems
D. Risk Disclosures

As recommended by G 30 (Established by Study Group on Derivatives) and GARP (Generally


accepted Risk Principles), following are the Key Risk Management Principles

Risk Management Framework

Responsibility of board of directors, Capital allocation, Risk


process organization

Market Risk

Mark to Market calculations ( either of daily . weekly or


quarterly basis ), Value at Risk , stress testing

Credit Risk

Credit Aggregation, net settlement, enhancement

Liquidity Risk

Analyzing Market liquidity ( based on money flow index ),


funding and investment strategies

Operational Risk

Authorization, system audit, reporting, personnel audit

The bank will run the following risks while handling any derivative transaction.

A. Credit Risk
Pre-Settlement and Settlement Risk:
The Pre-settlement Risk (PSR) and settlement risk are associated with the counter party of the
SWAP transaction. The pre-settlement risk will be monitored during the life of the Derivative
contract however the settlement risk will be for the settlement date and to the extent of the
payment obligation of the Derivative transaction and may not be for the notional principal
amount (in case of interest rate swaps). The calculation of the PSR is based on the notional
principal amount and the tenor of the contract.
42

The Departments involved in Risk Measurement and management are


Risk Management department
Dealing Room
Treasury Back Office

The responsibility of the Risk Management department (RMD) is to confirm the calculation of
the PSR to the Dealing Room and to Treasury Back Office. Risk Management and Dealing
departments use Risk Metrics to calculate the amount to be blocked against the PSR limit for
the counter party. However if the limits are not available for a counter party, the dealer should
approach the RMD to get the necessary approval.

B. Regulatory Risks /Documentation Risk :There are certain requirements in the form of documentary evidence which bank needs to
ensure before and after conclusion of any derivative transactions. Any delay/ error in the
documentation may lead to regulatory actions and penalty imposed the transacting parties.
Some of the swaps transaction may have trading restrictions or may be under ban period.
Dealing in such instruments may be void and considered as illegal.

C. Appropriateness Risk :This risk is mainly related complex nature of the transactions. The counterparty may not be able
to understand the derivative Swaps and the risk behind these contracts due to the complex
nature of the transactions. In order to ensure the appropriateness risk effectively, the bank has
a policy to obtain the Risk Disclosure Statement covering this risk arising out of any Swap
transactions.

43

D. Operational Risk: This risk is mainly associated with the processing of such deals. Operational risk can be
classified as system risk or human risk. The system risk can be system failure, internal reporting
failure. Human risk is defined as human fraud or error. The concerned back office personnel
should be properly trained to understand the nature and extent of the risks associated with
Swaps transactions as Swap may involve the unpredictable amount of future payment
obligations. Adherence to stringent reporting and auditing procedures can avoid human risk.

E. Legal Risk: Misinterpretation of terms used in Agreement Document.


This risk is associated with the legal document i.e. ISDA Master Agreement and Schedule to the
ISDA Master Agreement. As a market practice, the counter parties can customize the
Agreement based on their requirements by putting it in the schedule to the ISDA Master
Agreement.

The bank has a policy to confirm certain new clauses or deletion in the schedule to ISDA master
Agreement with their Solicitors.

4.4 How is the risk managed?


Management of risk starts with identifying the risk involved in a swap transaction. There are four
types of risk involved namely

1. Credit risk
2. Basis risk
3. Mismatch risk
44

4. Interest rate risk

Credit Risk
It arises because of failure of one of the counterparties to perform as per the contractual
agreement. Generally, in swaps, default will be restricted to the net amount receivable. Hence
default risk is less severe than bonds. Hence a bank which arranges swap does a check on
creditworthiness of counterparty before arranging a swap. Similarly, to compensate for credit
risk, a bank adjusts fixed rate by creating a swap spread. Swap spread is a spread over the
benchmark rate and reflects credit risk of counterparty.
Basis Risk
This risk arises only in case of Basis swaps. For example, consider a floating-to-floating interest
rate swap based on US LIBOR and EUR LIBOR. Assume that the swap dealer has to pay EUR
LIBOR and receive EUR LIBOR. Due to some market developments, if the existing relationship
between USD Libor and EUR Libor changes, the swap dealer may suffer a loss. This is the
basis risk for him.

Mismatch Risk
Usually, swap dealers offset their risk exposure in swap transactions by entering into counter
swap deals. Mismatch risk means that a swap dealer may find it difficult to offset his position
easily and may not get counter swap deals.

Interest rate risk


This is the most serious risk that a swap dealer faces. Interest rate risk refers to the change in
the value of the swap portfolio value due to a change in interest rates. For example, in a plain
vanilla swap, if the swap dealer has to pay floating rate and receive fixed and the interest rates
increase, the swap dealer has to pay higher interest rate and he will continue to receive the
45

fixed interest rate. Usually, the swap dealer finds another party and enters into a counter swap
agreement to contain the interest rate risk.

1.

Dealer / Broker / parties involved should undertake more stringent credit analyses and
use greater care in selecting counter parties. Financially strong counterparty minimizes
the chances of default and facilitates the transfer of a swap, if need arises.

2. Master agreement stipulates that all swaps between two parties are cross defaulted to
each other i.e. Default on any one swap triggers suspension of payments on all other
swaps covered in the agreements. Such agreements normally assume frequent
transactions between the parties. They also are the most effective in reducing exposure
when a balance exists in swap positions between the two parties.

3. Collateralization: Collateralization with marketable securities has become an essential


feature of swaps with dubious credits. The right to call for collateral can be mutual, more
often; it applies only in one direction, depending on relative strength of two parties.

4. Better documentation: More proactive documentation in swap agreements can provide


trigger points for remedial action in advance of actual default. Users would require, for
example, that the various tests of financial condition found in credit agreement are
incorporated into swap contracts.

5. Net Settlement: Swaps are settled on the same day and on net basis. Net settlement is
defined as the difference in the payment obligation of the two parties involved.

46

4.5 Other Types of Swaps

4.5.1 Credit Default Swaps (CDS):

Credit default swaps can be defined as exchange of payment based on the underlying credit
event. The buyer (bond holder or lender) of this swap buys a protection from the seller (who is
normally a dealer) for a premium amount. The protection is linked to a credit event such as
failure to pay or payment default of interest/ principal amount of the bond or restructuring event.
If the event happens, the protection seller (dealer) will pay the total loss to the protection buyer.
The premium paid by the protection buyer will be a fixed percentage of the notional principal
amount (Example: 1.25 % per annum). The Bond / company on which the credit default swap is
based are known as Reference entity. Credit default swaps are designed to isolate the risk of
default on credit obligations. These instruments are referred to as credit default swaps or credit
default options.

Example:
An institution invests $ 100 m in a Bond Issue. The bond Issuer agrees to pay fixed coupon
every year to the institution. But the institution has a view that the issuer may default on

47

payment terms. Hence the institution purchases a protection from an insurance company and
agrees to pay premium every year to the insurance company. In return the insurance company
agrees to pay the institutions, the face value of the bond if the issuer defaults.
The essential elements of a credit default swap are:
i)

A series of payments (premium) by the protection buyer to protection seller. In return


protection seller pay any loss incurred by the protection buyer due to non performance
of the reference entity ( bond issuing entity )

ii) The concept of credit event that triggers the payment to cover loss arising from default.
The settlement can take in one of the following forms.
Cash settlement In cash settlement, the protection seller pays the protection buyer an
amount based on the change in price of a reference asset. The change in price is the
difference in the price of the reference asset at the time of entry into the credit default swap
and the price of the asset immediately following the credit event (default). If the underlying is
a loan amount, the total loan amount will be paid by the protection seller to protection buyer.
Physical settlement or delivery - In this case, the protection buyer delivers to the
protection seller an agreed asset (generally a bond or loan given by the reference entity)
following a credit event .The seller of protection purchases the (defaulted ) security at preagreed value (the face value of the credit default swap).
Fixed Payment This entails the protection seller paying the protection buyer a pre
agreed fixed amount in the event of default. The amount paid reflects an agreed estimate of
loss given default. This structure is also referred to as a binary or digital credit default swap.
Actual workout /recovery value This entails the protection seller paying the protection
buyer the full face value amount of the credit default swap if a credit event occurs. The

48

buyer of protection is required to collect and pay through to the seller of protection all actual
amounts recovered from the reference entity following the credit event.
Buyer of protection

Investor

Seller of Protection

Dealer

Buyer of Protection

Bond holder

Maturity

3 years

Reference Entity

ABC Company
Reference Entity's 10 year 8.50%coupon bond(Bankruptcy or

Reference Bond

insolvency event),
(Failure to pay or payment default above a nominated minimum

Credit Event

amount ) or (restructuring event as defined)


Notional amount x [100% - Fair Market value of Reference Bond

Default Payment

after Credit Event ]

Default Swap Premium

1.25% pa payable by Buyer of protection to seller of protection


On default, the protection seller pays default payment to the

Payment on Default

protection buyer

4.5.2 Commodity swaps


A commodity price swap is an agreement between the two parties where one Party is the
producer and the other is the consumer. Even other parties who are neither producers nor
consumers can enter into the swap. The consumer (producer) fixes the purchase (sale) price of
its commodity based on the market pricing benchmark for the commodity for a period of time
(normally 1- 3 yrs). The commodities include metals, oil & gas, energy and agricultural
commodities.

49

# Example:
For example, producer gets into a swap arrangement with a consumer on a notional principal of
1000 barrels of crude oil. The producer agrees to sell crude oil on semi-annual basis at a predetermined price of Rs 1800/bbl. On the first settlement date, if the spot price of crude oil is Rs
2,000/bbl, consumer must pay (Rs 1800/bbl)*(1000 bbl) = Rs 1,800,000. But the consumer
receives (Rs 2,000/bbl)*(1000 bbl) =Rs 2,000,000. The net payment made by the producer is
Rs 200,000. If the spot rate goes down to Rs 1600/ bbl, then the consumer will pay Rs 200,000.

FIXED OIL PRICE x FIXED QUANTITY OF OIL

FLOATING OIL PRICE (WTI) X FIXED QUANTITY OF OIL


Where Company A is the Oil producer and Company B is the Oil consumer

4.5.3 Equity Swaps


An equity swap is agreement to exchange payments linked to the performance of an equity
market index against payments based on an interest rate index or another equity market index.
(One index can be Sensex while other can be Dow Jones Industrial average. These payments
are swapped on periodic basis (typically, quarterly or semi-annually).

Similar to interest rate swaps, the principal is actually not exchanged, but the payments are
based on some notional principal amounts. The payment linked to equity index is calculated as
50

a percentage change in the equity index or stock price. The party to the transaction receives a
return if it is positive and has to pay if the return is negative. The return is calculated as the
percentage change in the index value. The party is required to make a payment (for example
linked to the interest rate index) to the counterparty. So when the equity index return is negative,
the party has to make two payments, one linked to interest rate index and other linked to
negative returns of the index. The dividend paid by the underlying stocks of the index may also
be paid to the party by the counterparty.

PARTY A

PARTY A pays Equity

Party B pays LIBOR

Returns

linked

to

Equity Index

PARTY B

Summary:
The objective of this unit was to provide you with some exposure to introduction to the Swaps
Markets. The unit covers how the different types of SWAPS like interest rate, currency swaps
and others such as Credit default swaps, Commodity swaps and Equity swaps. It also covers
the risks involved in swap transactions and management of those risks.

51

5. INTEREST RATE SWAPS

After studying this unit, you should be able to understand the:


Different type of Interest rate Swaps
Concept and definition of Fixed for Floating, Floating for Floating IRS?
Understanding of vanilla IRS and what are its uses?
Major differences between an IRS and a FRA

Interest rate Swap: A swap arrangement where interest payments based on the notional
principal amount is exchanged between two parties.
Interest
From

Rate Interest Rate


To
Currency

Floating

Fixed

Same

Floating

Floating

Same

Floating

Fixed

Different

Fixed

Fixed

Different

Floating

Floating

Different

Example
Swapping from floating rate loan into fixed
rate
Swapping the interest rate basis of a loan
from US$ 6month LIBOR to US$ 3 month
CP rates.
Swapping a US$ floating rate loan to a
fixed rate GBP loan
Swapping a fixed rate US$ loan to a fixed
rate Yen loan
Swapping floating rate US$LIBOR
to
Floating rate Yen LIBOR

5.1 Types of Interest rate Swap

1. Fixed to Floating Swap: In this swap, one party receives fixed & pays floating interest
rates to the other party, through the life of the swap at each reset date.
2. Floating to Floating Swap: In this kind of a swap, both the counter parties exchange
two different floating reference rates, on the reset date through the life of the swap.

52

5.2 What are the Fixed to Floating, floating to floating IRS?

Interest Rate Swap (IRS) is an exchange of cash flows between two counter parties at preset
specifications as mentioned in the section 4.4.1 The two parties are obliged to exchange
interest payment or receipts on an agreed notional principal at regular intervals (normally
3months or 6months), over an agreed period of time (normally 5 years) in order to reduce the
cost of financing.
In this case, one party desires fixed rate funding but has access to comparatively cheaper
floating rate funding but while other party desires floating rate funding but has access to
comparatively cheaper fixed rate funding. By entering into swaps with the swap dealer, both the
parties can obtain the form of financing they desire and simultaneously exploit their comparative
borrowing advantages.

In the above figure Party A and B have following two options:


1. Enter into a swap agreement via a SWAP dealer or

53

2. Independently approach an institution in the debt market to receive fixed or floating rate
amount.
# Suppose Company A and Company B wants to borrow $ 100mn for 1 year and have been
offered the following rates
Fixed

Floating

12.1%

6m Libor +0.3

13.3%

6m Libor + 1%

Spread

1.2%

0.7%

Difference in Spread = 1.2% - 0.7% = 0.5%

Desired borrowing
obligation

Comparative advantage
in borrowing

Company A

Floating

Fixed

Company B

Fixed

Floating

So the two parties decide to enter into a swap agreement. The cost for A is LIBOR and that of B
is 13.1 %.

Explanation:
The upper part of the table provides the base data

Spread for fixed rate is 13.3% - 12.1% = 1.2%

Spread for floating rate is 1% - 0.3% = 0.7%

Difference between the spread is 1.2% - 0.7% = 0.5%

This benefit of 0.5% will be shared by Company A 30bps. And by Company B 20 bps.

So for Company B the cost will be 13.3% - 20 bps. Which comes to 13.1%

For Company A it will be LIBOR + 0.3% - 30bps. And therefore it will be LIBOR only

54

Alternatively this can also be explained as below:

In case of Company A it desires to borrow floating but has comparative advantage is in


fixed as the spread is more 1.2% compared to 0.7%

In the case of Company B reverse is true that is it desires to borrow fixed but has
comparative advantage in floating as spread is low 0.7% compared to 1.2%

Now Company B will borrow floating LIBOR + 1% and lend to Company A at LIBOR and
incurs additional cost of 1%

Company A will borrow fixed rate and lend to B at 12.1%

Therefore for Company B cost will be 12.1% + 1% = 13.1%

A. Fixed to Floating Swap :


The Swap dealer is counterparty to each party (A and B) of the Swap Transaction. Party A has
entered into a swap with a counter party B , whereby it would receive a fixed rate of 12% from
Party B and pay 3 month LIBOR to Party B (London interbank Offer rate) every 3 months, for a
period of 1 year. The Libor rate is available on daily basis on the British Banker Association
website. Assume the notional principal of the swap is USD 100,000,000/-. 3 month LIBOR for
each interval is set in advance at the beginning of that interval. The periodic net settlement
payment is done at end of every period. The reset of the LIBOR rate is in advance and paid in
arrears.

55

#
Month

Party B receives $

Net Settlement

10,00,00,000*(0.

10,00,00,000*(0.11)

In practice ,on net

( beginning of

12)*(3/12)=

*(3/12)=

terms, the Party B

the 3m period )

$ 30,00,000

$ 27,50,000

will pay the Bank

0M

Libor

11%

Settled

Party A

after

receives $

3M

A $ 250,000
3M

10%

6M

10,00,00,000*(0.

10,00,00,000*(0.10)

In practice ,on net

12)*(3/12)=

*(3/12)

terms, the Party B

$ 30,00,000

$ 25,00,000

will pay the Bank


A $ 5,00,000

6M

14%

9M

10,00,00,000*(0.

10,00,00,000*(0.14)

In practice ,on net

12)*(3/12)=

*(3/12)

terms, the Party B

$ 30,00,000

$ 35,00,000

will receive from


the

Bank

5,00,000
9M

15%

12M

10,00,00,000*(0.

10,00,00,000*(0.15)

In practice ,on net

12)*(3/12)=

*(3/12)

terms, the Party B

$ 30,00,000

$ 37,50,000

will receive from


the

party

750,000
#
B. Floating to Floating Swap :
In this kind of a swap, both the parties (A and B) exchange cash flows linked to two floating rate
benchmark rates on the reset date through the life of the swap.

For example Bank A enters into a swap with a Party B, whereby, the Party B pays to the Party A
latest 91 Day T Bill cut-off, in exchange for the prevailing 3 month Commercial Paper Rate
minus 200 basis points (i.e. 2%), of a AAA rated corporate, for a notional principal of $ 10, 00,
00,000.The reset is done every 3 months though the life of the swap periods of 1 year.

56

Month 3: 91 day T bill cut-off is 9% & the latest CP rate of AAA rated corporate is 11.00% set in
month 0 and settled in month 3. The Party B has to pay the Party A 9%, and the Party A has to
pay the Party B 9% (11.00%-2.00%). Hence, no net payments exchanged.

Month 6: 91 Day T Bill cut-off is 10% & the latest CP rate of an AAA rated corporate is 12.50%,
--- set in month 3 and settled in month 6. The Party B has to pay the Party A 10% and the Party
A has to pay the party B 10.50 % (12.50%-2.00%). Hence, net payment will be made from the
Party

to

the

Party

of

0.50%

on

Rs

10,00,00,000/-

for

months

,i.e.

$10,00,00,000*0.0050*(3/12)= $ 1,25,000
Month 9: 91 Day T Bill cut-off is 9% & the latest CP rate of an AAA rated corporate is 10.50%
,set in month 6 and settled in month 9. The Party B has to pay the Party A 9%, and the Party A
has to pay the Party B 8.50% (10.50%-2.00%). Hence , net payment will be made from the
Party

to

Party

of

0.50%

on

Rs.10,00,00,000/-

for

months

i.e.

10,00,00,000*0.0050*(3/12) = $ 1,25,000.

Month 12: 91 Day T Bill cut-off is 8% & the latest CP rate of an AAA rated corporate is 10 .50%,
set in month 9 and settled in month 12. The Party B has to pay the Party A 8% and the Party A
has to pay the party B 8.50 %( 10.50%-2.00%). Hence, net payment will be made from the Party
A to Party B of 0.50% on Rs.10,00,00,000/- for 3 months , i.e. $ 10,00,00,000*0.005 *(3/12) = $
1,25,000.

Some examples of the floating rate benchmarks are as follows:


a) Overnight money rate or MIBOR
b) Treasury Bills yield to Maturity
c) Term money rate

57

d) Government Securities yield to maturity (example: US Treasury bond/ Notes).

5.3 Specifications of Interest rate Swaps:


Terms

Definition

Value

One to 30 years (up to 10-12 years October 5 2013


Maturity

in most currencies )
Depending on market convention, October 5, 2010 ( As Oct 2 and 3 are
up to five business days from trade holidays)

Effective Date

date (typically 2 days )

Trade date : October 1, 2010

Settlement Date

Effective Date

October 5, 2010

Current market swap rate

6.25% pa payable semi -annually

Fixed Payment
Fixed Coupon

Either quarterly, semi-annually or Every April 5 and October 5 commencing


annually

depending

on

market October 5, 2010 and terminating on

Payment Frequency

convention.

October 5, 2013

Day count

Based on Market convention

Semi -annual bond equivalent basis

Pricing date

Trade Date

October 1, 2010

Floating Payment
US $ LIBOR of the designated Maturity
reset semi -annually plus the spread
payable semi-annually200 basis points
(Example: LIBOR + 2%) ( 1 basis point
Floating Index

Certain Money market indices

= 0.01%, 200 basis points will be 2 % )

Determination

Some publicly quoted source

BRITISH BANKERs ASSOCIATION

58

source
Every April 5 and October 5 commencing

Payment frequency

Mostly The term of the floating

October 5 2010 and terminating on

index itself -

October 5, 2013
Semi

Day count *

-annual

money

market

basis

Based on market convention

calculated on an actual/ 360 day year

Mostly The term of the floating

6 Months

Reset frequency

index itself

First coupon

Current market rate for the index.

* Day count: there are four types of day count convention: Actual / Actual, Actual / 360,
Actual / 365, 30/ 360

US$ Interest Rate Swap Quotations (hypothetical example)


Maturity

Absolute Swap Rates Swap

(years)

(%pa)

Spreads

(Basis

points) over treasury

3.44/3.46

42/44

4.24/4.26

64/67

5.08/5.11

58/60

5.42/5.45

60/63

5.4 What is Plain Vanilla Swap?

A plain vanilla swap is defined as fixed-for-floating interest rate swap and this type of swap is
commonly encountered structure hence named as plain vanilla.
59

This swap is widely used by corporates to hedge their underlying exposure of interest rate
sensitive assets/ liability. Assets result into receipt of fixed / floating interest or liabilities require
payment of fixed / floating interest.

5.5 Difference between IRS and FRA


Parameter

Interest Rate Swaps

Forward rate Agreements

Instrument

Swap

Forward contract

Rationale behind the Conversion of floating to fixed interest - Mainly for fixing up the future
transaction

payment / receipt or vice a versa

investment or borrowing rate.

(rationale can also be similar to FRA)


Two options available to convert fixed to
floating or floating to fixed or reduced the
cost of borrowing due to comparative
advantage
Exposure

Difference between the floating rate and Interest rate differential between
fixed rate due to net settlement

the contracted rate and settlement


rate

Obligation

Conversion of Current Obligations from Management of future obligation


fixed to floating or floating to fixed

(Investment or Borrow in the future


at the agreed rate )

Rate

Fixed and floating rates are considered

Either

floating

or

fixed

rates

considered
Intermediaries

Broker or Dealer

Settlement

( Fixed Floating rate ) * notional Settlement amount =[(Settlement


amount

Mainly dealer

date - Agreed Rate )x contract run


x principal amount ]/[(36000 or
36500)+(Settlement

Rate

contract period )]

60

Summary:
The objective of this unit was to provide you with exposure to Interest rate Swaps. The unit
covers how the different types of interest rate swaps like Fixed for Floating, Floating for
Floating IRS. It is followed by the Understanding of vanilla IRS and what are its uses. Finally
it covers major differences between an IRS and a FRA.

61

6. CURRENCY SWAPS

After studying this unit, you should be able to understand the:

Concept and Rationale in entering into currency swaps

Defining Structure of Currency swaps - Fixed for fixed, Fixed for Floating, Floating
for Floating

Difference between interest rate swaps and currency swaps

A currency swap is a swap transaction in which two parties agree to exchange their respective
currency and interest rate positions between a currency pair at the commencement and
completion of the transaction (which is in the future).
The amount to be swapped is established in one currency based on the prevailing spot
exchange rate. Periodic payments similar to interest rate swaps are made which are based on
fixed or floating rates.

Types of Currency Swaps:

a) Cross Currency Interest rate Swap is defined as swap involving two currencies & two types
of interest rates (i.e. one fixed & the other floating).
b) Fixed /Fixed currency swap include two currencies and both currencies are having fixed
interest rates.
c) Cross currency Basis swaps: This swap involving two currencies with floating rate exposure
for both currencies.

62

6.1 Purpose of Currency Swap:

1. Arbitrage: Borrowing US dollars at 1% and swap the dollars with INR. Investing INR at 9
%. Converting it back to USD after few years.

2. Asset / Liability management: Asset Liability mismatch happens when a company has
more assets in one currency and more liabilities in other currency. Swaps can be used to
convert such mismatch.

3. Hedging currency exposure: An Indian Company may have an outstanding Yankee Bond
issue where it is paying US$ Libor. In case, it expects US interest rates to go up and Indian
interest rates to fall. It has to convert dollar liability into INR. The company may enter into a
swap with a financial Institution or a bank wishing to swap fixed German rate with floating
US rates. Naturally Indian company will be paying fixed German rate while swap party will
be paying US$ Libor. This hedge is complete for the Indian company.

6.2 Structure of Currency Swap:

Company A has an INR liability of over 600,000,000 on account of debt issue in the Indian
market. It would like to convert the liability into USD. This can be achieved by the company by
converting their INR liability into a USD liability through a Currency Swap transaction. At the
same time, company B has USD liability of 16,850,000 on account of floating rate loan. Since
the company is an India based company having its commitments as well as its assets in INR, it
desires to have and monitor its USD liability converted into INR.

63

Both the companies contact Bank H for fulfilling their requirements. This leads to conclusion of 2
separate deals between H Bank and both the companies.

a) Deal with A:
Bank H undertakes the INR liability of Rs. 600,000,000/- @ 35.6083 of Company A on swapping
its own USD liability of 16,850,000 through a currency swap deal for the period of 5 years. This
swap will also ensure the swapping of the interest liability of both the counter parties on the
respective loans along with repayment responsibility. In this case, Company A will take the
responsibility to pay USD Libor (i.e. floating rate) to Bank H while receiving the INR fixed rate of
15% from Bank H on the repayment dates as per schedule. Due to this deal, company A has
two benefits:

a) Company A has got its INR interest inflow fixed against outflow on account of
debenture issue.
b) Company A has also locked into INR rate of 15.00% for the whole period of loan of 5
years thus hedging against any future adverse movements in interest rates (it goes
without saying that any beneficial movement cannot be exploited by the corporate).

b) Deal With Company B: Company B enters into a Currency Swap transaction with bank H to
swap into INR

liability of Rs 600,000,000/- against US$ 16,850,000 for 5 years .This will

ensure Bank H taking over the responsibility of USD repayment of Corporate Bs USD loan.
Under this contract, Bank H has agreed to pay 6mth USD Libor to company B while
company B will pay INR interest @15.25%. this agreement will ensure the following for
company B:

Company B has fixed Borrowing cost exposure at 15.25% so as to hedge itself from any future
adverse movement in INR interest rate
64

This deal also ensures a stable & assured income to the bank. This income is accrued &
received by the bank due to difference between the INR interest Inflows & Outflows from the
corporate. In this case, income from Bank H is 0.25% (i.e. 15.25 -15.00) % on the outstanding
INR borrowing amount as on every interest repayment date for next 5 years.

6.3 Specifications of Currency Swaps


Currency swap process flow
14%p.a. (in A$)
Company A

Company B

US $ 6month (in US)


US $ 6month (in US)
14%p.a. (in A$)
A$ Lenders

Final

Exchange

US$ Lenders

(Re-

exchange at maturity

US $94million
Company B

Company A

A$100million
US $94million
A$100million

A$ Lenders

US$ Lenders

65

Terms

Definition

Value

One to 30 years (up to 10-12


Maturity

years in most currencies )


The

date

on

which

October 5 2013
the October 5, 2010 ( As Oct 2 and 3

principal will be transferred are holidays)


and the date from which the October 1, 2010
interest rate calculation will
commence. It can be up to five
business days from trade date
Effective Date

(typically 2 days )
Market

Exchange

Rate

as US$94 million (Calculated as the

between US$ and the relevant

US$ equivalent of AUD Notional)

currency (or the two currencies A$1.00=US$0.9400


Contractual

exchange if US$ is not involved )for

Rate

value the effective date


Depends

on

market AUD 94 Mn or USD 100 MN

convention, but usually the


quarterly,
annual

semi-annual
equivalent

of

or
the

internal rate of return of the


Fixed flows in the relevant
currency versus US$ three or
All -in -cost

six month LIBOR flat

Premium or Discount

None

66

Fixed rates

Non-US currency
US$

Notional Principal

notional

principal

x AUD 100 million

contractual exchange rate


14 %pa payable semi-annually in
accordance with the Fixed Rate
Current Market rate (swap DAY Count Fraction on the A$

Fixed Coupon

rate) in the relevant currency

Notional Amount
Every April 5 and October 5

Either quarterly, semi-annual commencing October 5, 2010


or
Payment Frequency

annual

depending

on and terminating on October 5,

market convention

2013
Semi-annual

bond

equivalent

basis calculated on an actual


Day count

Based on market convention

/365 day year

Pricing date

Trade Date

October 1, 2010

Floating Payment

US currency
US$ LIBOR of the Designated
Maturity reset semi-annually plus

Floating Index

US$ three or six month LIBOR

the Spread

Some publicly quoted source


Determination source

(e.g. Reuters page LIBO)


Every April 5 and October 5
commencing October 5, 2010
The term of the floating rate and terminating on October 5,

Payment frequency

index

2013

67

Based on market convention Semi-annual money market basis


Day count

(generally actual/360).

calculated on actual/360 day year

The term of the floating index 6 M


Reset frequency

itself.
Current Market rate for the Based on the LIBOR Rate

First coupon

index

Principal Exchanges
Company A shall pay to Company B the AUD Notional Amount
Initial Exchange

and Company B shall pay to Company A the US$ Notional Amount


Company B shall pay to Company A the AUD Notional Amount

Exchange at Maturity

and Company A shall pay to Company B the US$ Notional Amount

6.4 Major Differences between the Interest rate and Currency Swaps:
Sr. No

Parameter

INTEREST RATE SWAPS

CURRENCY SWAPS

Underlying

Interest rate

Mainly Currency

Currency

Only one currency is involved

Two currencies involved

Parties Involved

Normally parties to the swap Parties


are from the same country

Interest rates

across

different

countries may be involved

Either floating to floating or Normally fixed to floating or


floating to fixed interest rates is fixed to fixed interest rate are
traded in this swap.

Principal Amt.

Principal

amount

traded in this swap.


is

not Principal amount is transferred

transferred between the parties between the parties involved.

68

involved. Hence it is called as In some cases, principal may


Notional Principal amount on not be transferred example:
which the interest amount is coupon only swap.
calculated

Exchange

rate No impact as one currency is The exchange rate risk will

Risk

involved

have an impact as the principal


amount is calculated based on
the prevailing exchange rates

Regulations

ISDA/ Domestic regulations

Credit Risk

Lesser as only interest rate Much higher as the principal


payments are exchanged

Market Risk

ISDA / Domestic regulations

amount is exchanged

Mark to market calculation will Mark to market calculation will


not have a major impact unless have a major impact
the interest rate changes are
substantial

10

Interest payment

Mainly quarterly payment

Mainly semi-annual payment

Summary:
The objective of this unit was to provide you with some exposure to currency swaps. This
unit covers the Concept and board understanding of the currency swaps. This is followed by
defining the various structures of Currency swaps. The structures can be classified as Fixed
for fixed, Fixed for Floating, Floating for Floating. It also covers the differences between
interest rate swaps and currency swaps.

69

7. MECHANICS OF SWAPS
After studying this unit, you should be able to understand the:

Trading in Swaps along with the specifications

Pricing of Swaps

Risk Management in Swap transactions

7.1 How are Swaps traded?


Swaps are traded based on the specifications mentioned by the swap broker or dealer.
Following are the specifications mentioned in the Swap transaction:

The specifications start with defining the dates:


a. The transaction date or trade date is the date when the parties agree to enter into a
swap.
b. The effective date for a swap is the date from which the fixed and floating rate
payments begin to accrue.
c. The settlement date is the date on which there is net settlement of interest accruals at
the end of each period.
d.

A reset date or a fixing date is the date when the floating rate is reset.

e. The maturity date is the date on which term of swap ends.


For example, Bank A enters into a swap with a corporate counter party on 1st January 2010, to
pay a fixed rate of 12% and receive 3 month MUMBAI INTERBANK OFFER RATE (MIBOR),
after every 3 months, having a tenor of 1 year .The swap starts on 1 st April 2010, and ends on
1st April 2011.

70

Fixing Date is the date on which the reference rate of the swap is decided. This date is generally
two working dates prior the start dates, however this date can be decided mutually by both the
counter parties. This would give adequate time to both the counter parties to complete the
documentation & other formalities. In our above mentioned example, the fixing or reset dates
would be 2 working days before each start dates, i.e. on 30th March 2010, 29th June 2010, 29th
September 2010 & 30th December 2010. The maturity date of the swap is 1st April 2011.

Size & tenor of the transaction: The dealer in consultation with the two parties involved
decides the size and tenor of the transaction. However, generally no regulator keeps any
restriction on the minimum or maximum size of notional principal amounts of the swaps as well
as the tenor of the transaction. Norms with regard to size are expected to emerge in the market
with the development of the product.

7.1.1 Example:
An investor has a portfolio of longterm bonds. The investor is worried that the interest rates will
rise and cause a loss in capital value. Thus, the investor can become a fixed rate payer (i.e. a
floating rate receiver) -. Effectively, the fixed rate bonds have been converted into floating rate
bonds, the portfolios value being immunized from interest rate fluctuations. If the interest rates
rise, the value of the portfolio will fall, this will be offset by the gain in the value of the swap
position. Similarly, if the interest rates fall, the value of the portfolio will rise, this will be offset by
the loss in the value of the swap position. This is an asset swap.

7.1.2 Example:
A fall in interest rates will increase the value of the liabilities. Thus, the company can hedge
itself from interest rate risk by becoming a floating rate payer (i.e. a fixed rate receiver). As
interest rates fall, the floating ratepayer gains. The gain from the swap will offset the losses to

71

the insurer as its liabilities increase in value. A rise in interest rates will increase the value of the
liabilities is the borrowing on floating rate. Thus, the company can hedge itself from interest rate
risk by becoming a fixed rate payer (i.e. a floating rate receiver). As interest rates rise, the fixed
rate payer gains. The gain from the swap will offset the losses to the insurer as its liabilities
increase in value. This is a liability swap.
7.1.3 Dealings and Quotations
Swap dealer/ market maker usually sets the floating rate equal to a benchmark/ index rate, free
from the margin actually payable in the cash market by the relevant counter parties. The floating
rate is thus, said to be quoted flat .after doing this, the fixed rate is set.

A quote of 15.65% - 15.85% against 3 month MIBOR means that the market maker:
a. Pays (bid) 15.65% fixed and receives INR 3 month MIBOR.
b. Receives (ask /offer ) 15.85% fixed and pays INR 3 month MIBOR
The floating rate benchmark used may be any transparent rate available in the market.

Some examples of the floating rate benchmarks are as follows:


a. Overnight money rate or LIBOR
b. T Bills yield to Maturity
c. FED rate
d. G sec/ Munis yield to maturity.

7.2 How are the swaps priced?


The pricing of swaps is driven by the fundamental principle, that the value of any interest rate
products is the present value of all future cash flows. At the time of the initiation, the Value of
the Fixed & Floating Rate legs of the swap should be equal. This would mean that fixed rate

72

should be equal to the forward forward rates of the same reset dates through the tenor of the
swap. These forward rates can be arrived at by using interest rate futures contract as shown in
the example below.

Example:

Consider a company Melico Inc has borrowed $ 25M by issuing 5.5 % Bonds in April 2010. The
company expects that the interest rate will decrease in the future and hence approaches the
banks to swap fixed to floating rate, so that the company will pay amount based on floating rate
and bank will make fixed payment which in turn will be paid by the company to lenders.

For pricing, Following steps are followed:

Step 1:
Calculate Forward rates from spot interest rates. In practice, they are derived from Futures
contracts on Eurodollar CDs traded on exchanges such as CME. The prices of Eurodollar CD
futures enable us to arrive at implied forward rates.
Expiry

Price

Expiry

Price

Sep-10

97.83

Jun-12

96.555

Dec-10

97.735

Sep-12

96.37

Mar-11

97.695

Dec-12

96.195

Jun-11

97.475

Mar-13

96.055

Sep-11

97.235

Jun-13

95.935

Dec-11

97.005

Sep-13

95.815

Mar-12

96.765

Dec-13

95.7

Mar-14

95.615

73

Step 2:
Assume that current USD Libor rates are as follows. 3 m 2.5420, 6 m - 2.3825
Step 3:
Calculate the cash flows
The value of interest rate swap at inception to both the parties is Zero. Subsequently the swap
value changes due to change in interest rates. Valuation of interest rate swap involves arriving
at Present

Values of Fixed and Floating cash flows.


Euro dollar CD
Futures quotes.
Forward.
Expiry

Price

rate

future
Swap Period

rate

Begins

Ends

YrFrac

NP

CF

2.54%

01-Apr-10

30-Jun-10

0.2500

25000000 158750.00

Sep-10

97.8300

2.17%

1-Jul-10

30-Sep-10

0.2528

25000000 137131.94

Dec-10

97.7350

2.27%

01-Oct-10

31-Dec-10

0.2528

25000000 143135.42

Mar-11

97.6950

2.31%

1-Jan-11

31-Mar-11

0.2472

25000000 142461.81

Jun-11

97.4750

2.53%

01-Apr-11

30-Jun-11

0.2500

25000000 157812.50

Sep-11

97.2350

2.77%

1-Jul-11

30-Sep-11

0.2528

25000000 174732.64

Dec-11

97.0050

3.00%

01-Oct-11

31-Dec-11

0.2528

25000000 189267.36

Mar-12

96.7650

3.24%

1-Jan-12

31-Mar-12

0.2472

25000000 199940.97

Jun-12

96.5550

3.44%

01-Apr-12

30-Jun-12

0.2500

25000000 215312.50

Sep-12

96.3700

3.63%

1-Jul-12

30-Sep-12

0.2528

25000000 229395.83

Dec-12

96.1950

3.81%

01-Oct-12

31-Dec-12

0.2528

25000000 240454.86

Mar-13

96.0550

3.94%

1-Jan-13

31-Mar-13

0.2472

25000000 243822.92

Jun-13

95.9350

4.07%

01-Apr-13

30-Jun-13

0.2500

25000000 254062.50

Sep-13

95.8150

4.19%

1-Jul-13

30-Sep-13

0.2528

25000000 264468.75

Dec-13

95.7000

4.30%

01-Oct-13

31-Dec-13

0.2528

25000000 271736.11

Mar-14

95.6150

4.39%

1-Jan-14

31-Mar-14

0.2500

25000000 274062.50

74

In the above table, we are calculated the future cash flows for each quarter based on the
forward rate which is calculated from Futures price.

For Example : 2.17 % is calculated for the period ending September 2010 based on the
September Futures contract trading at 97.83 as ( 100- 97.83 ). Year Fraction is calculated
based on the difference between the respective quarters. In excel we can use the yearfrac ()
function.

NP stands for the notional principal amount considered as $ 25M.


CF stands for Cash flow calculated as
NP * Year frac * the forward rate
= 25M * 0.25 * 2.17 % = 137131.94
Similar one can calculate the remaining cash flows

Step 5:
Calculate the Present value of the cash flows. The discounting has to be done for each quarter
cash flow based on the respective discount rate

Rs 157748.3 (Present value of September 2010 cash flow) is calculated as

CF of September 2010/ (1+r1) where r1 is forward rate year frac


r1 (Period Forward rate (FR) = 0.0254* 0.25 = 0.6350%
Forward Discount rate = 1/ (1+ r1) = 0.99369
PV = 158750* 1/ (1+r1) = 158750* 0.99369 = 157748.3

Rs 135523.27 (Present value of Dec 2010 cash flow) is calculated as

75

CF of December 2010/ (1+r1) (1+r2) where r1 is Forward rate year fraction of the first quarter
and r 2 is Forward rate * year fraction of the second quarter

r1 (Period Forward rate (FR) = 2.54%* 0.25 = 0.6350%


r2 (Period Forward rate (FR) = 2.17%* 0.25 = 0.5485%
Forward Discount rate = 1/ (1+r1)* (1+ r2) = 0.998827
PRESENT VALUE (PV) = 158750* 1/ (1+r1) * (1+r2) = 137131.94* 0.98827 = 135523.27
Forward.
Date

CF

Forward. Rate

Period F R

Disc. F

PV of CF

30-Jun-10

158750.00

2.54%

0.6350%

0.99369

157748.3

30-Sep-10

137131.94

2.17%

0.5485%

0.98827

135523.27

31-Dec-10

143135.42

2.27%

0.5725%

0.98264

140651.03

31-Mar-11

142461.81

2.31%

0.5698%

0.97708

139195.91

30-Jun-11

157812.50

2.53%

0.6313%

0.97095

153227.44

30-Sep-11

174732.64

2.77%

0.6989%

0.96421

168478.44

31-Dec-11

189267.36

3.00%

0.7571%

0.95696

181121.7

31-Mar-12

199940.97

3.24%

0.7998%

0.94937

189817.85

30-Jun-12

215312.50

3.44%

0.8612%

0.94126

202665.65

30-Sep-12

229395.83

3.63%

0.9176%

0.93270

213958.52

31-Dec-12

240454.86

3.81%

0.9618%

0.92382

222136.77

31-Mar-13

243822.92

3.94%

0.9753%

0.91490

223072.64

30-Jun-13

254062.50

4.07%

1.0163%

0.90569

230102.37

30-Sep-13

264468.75

4.19%

1.0579%

0.89621

237019.86

31-Dec-13

271736.11

4.30%

1.0869%

0.88657

240914.34

76

31-Mar-14

274062.50

4.39%

1.0963%

0.87696

240342.11
3075976.2

Thus PV of floating leg payments =

3075976.2

which should also be PV of fixed leg payment =

3075976.2

Step 6: (Candidate should note that this example may be important from test point of view)
Calculate the SWAP rate (fixed rate)

To calculate the SWAP rate the PV of Fixed Cash flow = PV of Floating Cash Flow
Assume the SWAP rate is X%
PV of Fixed Cash flow = PV of Floating Cash Flow
PV of Fixed Cash flow = (X * NP * Year frac1)
(1+ r1)
(X * NP * Year frac1) +
(1+ r1)

(X * NP * Year frac2)
(1+ r2)

(X * NP * Year frac2) = 3075976.2


(1+ r2)

X {(NP * Year frac1) +


(1+ r1)

(NP * Year frac2) } = 3075976.2


(1+ r2)

This equation is solved in the table below


(NP * Year frac1)
(1+ r1)

(NP * Year frac2) = 94458720.09


(1+ r2)

77

Swap rate can be worked out as follows :


For. Disc. F

NP

Yr. Frac.

B*C*D

0.99369

25000000

0.2500

6210562.93

0.98827

25000000

0.2528

6245311.91

0.98264

25000000

0.2528

6209758.45

0.97708

25000000

0.2472

6038867.93

0.97095

25000000

0.2500

6068413.51

0.96421

25000000

0.2528

6093252.73

0.95696

25000000

0.2528

6047469.18

0.94937

25000000

0.2472

5867630.58

0.94126

25000000

0.2500

5882892.60

0.93270

25000000

0.2528

5894174.12

0.92382

25000000

0.2528

5838022.88

0.91490

25000000

0.2472

5654566.17

0.90569

25000000

0.2500

5660575.03

0.89621

25000000

0.2528

5663556.95

0.88657

25000000

0.2528

5602659.16

0.87696

25000000

0.2500

5481005.95
94458720.09

Hence swap rate =

3.2564%

78

Hence X = 3075976.2/ 94458720.09 = 3.2564%


If PV of fixed leg is higher than PV of floating leg, then the swap value is positive (gain) for
floating rate payer and negative (loss) for fixed rate payer. If PV of floating leg is higher than PV
of fixed leg, then swap has turned beneficial for fixed rate payer and adverse for floating leg
payer. This is part of valuation of swap after pricing.

Summary:
The objective of this unit was to provide you with some exposure to trading, pricing and risk
management of swaps transactions. It starts with the trading along with the specifications of
swap transactions. It was followed by the pricing example of Swap transaction. Finally it covers
the concept of risk management along with the process followed in risk management.

79

8. LIFE CYCLE OF TRADE FOR OTC DERIVATIVES

After studying this unit, you should be able to understand the:


Definition of Trade life cycle for a OTC trade
Various department involved in Trade Capture to settlement
Reasons for trade failure
Concept of Nostro and Vostro Accounts
Understanding ISDA documentation and its importance
Role of Trade Support in Trade life cycle
Importance and sources of Static data

8.1 Process of OTC trades from Trade Capture to Trade Maturity

80

8.1.1 The trade life cycle involved three offices namely


1. Front Office
2. Middle Office
3. Back Office

Front office provide the trade information to the middle and back office. However all the
operations mentioned above are undertaken by the back office team.
Front office comprises

Traders,

Clients,

Sales Officials who are mainly involved in pre and post trade client servicing,

Research and Analytic departments.

Middle Office comprises of

Compliance: This department looks in the regulatory and legal compliance with respect
to all the transaction undertaken by the trading organisation. It has to liaison with the
counterparties, regulators, legal experts to safeguard the trading organisation from any
potential legal and regulatory non- compliances.

Risk Management: This department management all the types of risk namely market
risk, credit risk, operational and liquidity risk.

Finance/Capital Management : This department deals with funding requirements in


terms of cash/ collateral or securities management

Trade Support: This department provide support to the front and back office by providing
the trade enrichment data like static data and other related information.

81

Customer Support: This department deals with the clients and provide with information
and necessary support for trading related activities.

Back Office comprises of

Static/ reference data capturing : This function comprising of capturing data which
doesnt change frequently.

Cash Settlement : This function comprises of transfer cash from loss making parties to
profit making. This is known as mark to market settlement. Cash Settlement can also be
interms of delivery based derivatives where cash is transferred from buyer to seller.

Cash Management : Cash Management function comprises of managing excess cash or


deficit cash by lending or borrowing cash respectively

Securities Settlement and Management : This function refers to lending or borrowing


securities as well as management the securities held in the depot account. Securities
are lend to earn interest while securities are borrowed if the trader is short and needs to
deliver the securities.

Reconciliation : The process of checking the account held by the trading member and its
custodians.

Investigation : The process of checking the trading book and is followed after inspection.

Assets Services: The process of providing investment advisory, financial planning


services and offering investment products like equity, fixed income, commodities and
derivatives

8.2 What details are required for Trade Capture?


The trade gets captured in the front and back office. If the front office and back office
applications are integrated then the data needs to be captured only once. Normally the details
captured in a trade are

82

Trading Book (Trader/ Arbitrageur/ Market Maker/ Repo)


Trade Date
Deal Time
Value Date
Operation (e.g. Buy/Sell, Lend/Borrow, in/out)
Quantity
Instrument/Security
Price
Counterparty

All trades must be recorded formally by the market participant. A Trade is captured
to update a trading position for a specific security within a trading book,
to update average price of the current trading position to enable the trader to calculate
trading profit or loss,
To allow trade detail to be sent through to the Back Office for trade processing and
settlement
To meet market & regulatory reporting requirements
To facilitate risk management

Traders use complex trading systems to facilitate trading & position management, trade
processing is usually done via Back Office processing systems.

8.3 What kind of Trade Support is required?


The middle office (also known as trade support department) within a trading firm is responsible
for a number of servicing and support related tasks of the traders, market makers and sales
peoples.
83

These tasks may include:


1. The keying of trade details to trading systems (on behalf of the traders ),
The middle office is responsible to key in the trade details in the settlement systems for
processing if the trading and settlement systems are not linked, thereby allowing the traders
to focus on trading.
2. The agreement of trade details with counterparties:
Trade Agreement is an important step in trade life cycle. Trade agreement process details are
mentioned below:
A Trading organization may trade with an institution or with another trading orgranisation. If the
trading organization trades with an institution then the trade agreement is done via trade
affirmation facility. In case of trade affirmation, the institution has the option to accept the trade
or reject the trade. OASYS Global is widely used trade affirmation facility. If the trading
organization trades with another trading organisation then the trade agreement is done via trade
matching facility. In case of trade matching facility, both the trading organizations send the trade
details to a centralized location where the trade details are matched. TRAX is widely used
trade matching as well as trade reporting facility.

TRADING
ORGANISATION

TRADE AFFIRMATION
FACILITY

TRADING

TRADING
ORGANISATION A

INSTITUTIONS

TRADE MATCHING

ORGANISATION B

FACILITY

84

3. The investigation of trade detail

discrepancies between the STO

and its

counterparties:
If the trades are not matched, the middle office will investigate the trade discrepancies with the
counterparties. This is a time bound activity as the trade needs to be reported to the regulator
within the stipulated time. In UK, the stipulated time is 30 minutes.
4. New counterparty and security set-up within internal systems :
This is related to the updation of static information. The counterparty related data is provided by
third parties such as Alert of Omega. The securities related data is provided by Data vendors
like Reuters, Standard and Poors, Bloomberg etc
5. Production of the daily trading Profit and loss Account:
The daily P&L Account is essential to evaluate each trader or trading book performance on daily
basis. As most of the positions are marked to market on daily basis, the default risk is analysed
based on this account. As the financial markets are dynamic in nature, organizational
performance can be evaluated on daily basis after analyzing this report,
6. The reconciliation of trading positions
The reconciliation of trading positions (i.e. the quantity of specific securities within each
trading book) between the trading organizations books and records with the information in
the trading and settlement system.

85

8.4 What are trade fails and why do they occur?


Settlement is a process of exchanging securities and cash between the two parties of a
derivatives transaction in order to discharge their respective obligations. Delivery of securities
commonly takes place in a depository while transfer of funds commonly takes place through a
banking or payments system. A trade is deemed to be failed if either the securities or cash
transfer are not transferred. In order to minimise the principal risk incurred in the case of default
by either counterparty most of the trades are settled by DVP (delivery Vs Payment) procedure.
DvP can be achieved via real-time gross settlement (RTGS) system which is the continuous
settlement of funds and securities transfers individually on a trade to trade basis. In case of FoP
(Free of Payment) settlement, one or both parties to the trade will be forced to deliver securities
or pay cash before they have taken delivery of the corresponding asset from the other
counterparty. In case of FOP, the probability of one of the parties defaulting is very high.

However trade fails due to settlement failures. The settlement fails due to many reasons
namely:
1. Non-matching settlement instruction: The settlement instruments are generated by
the counterparties which may not match. The contents of settlement instructions are as
follows
!
From

The name of the issuing Broker

To

The name of the Brokers custodian

Depot account The Broker 's account number over which the securities
no.

movement is to be effected

Nostro account The Broker 's account number over which the cash
no.

movement is to be effected

Trade reference

The Broker's settlement system trade reference number

Deliver/receive

Whether securities are to be delivered or received

Settlement

Whether to be settled on a Free of Payment or DVP basis

86

basis
Value date

The value date of the trade (the earliest date that


settlement is to be effected)

Quantity

The quantity of shares, or quantity of bonds

Security

The security identifier code, e.g. ISIN, Cusip, Quick

reference
Settlement

The ISO code of the net settlement value currency

currency
Net

settlement The cash value to be paid or received

value
Counterparty

The counterparty's (securities) custodian details, including

depot

account number

Counterparty

The counterparty's (cash) custodian details, including

nostro

account number

Transmission

A clear statement of the date and time of transmission

time

The above instructions are generated by buyers broker as well as by sellers broker and
transferred to their respective custodians. The transaction may lead to settlement failure if the
instructions send to both the custodians do not match.

2. Insufficient Securities: The seller has insufficient securities to deliver (in case of short
forward or short call) and unable or unwilling to borrow securities to meet its shortfall.
The shortfall may result, for example, because the seller is awaiting delivery of a
purchase of securities, or because securities are out on loan and the seller has been
unable to recall them to meet its settlement obligations.

3. Insufficient Cash, collateral or credit line: The buyer having insufficient cash to settle
the cash leg of the trade because, for example, it is awaiting the funds from a previous
sale of securities or is experiencing a cash funding/ liquidity problem.
87

4. Corporate actions. Securities are not available for delivery because the clearing
organisation has blocked delivery in respect of some corporate action or event.

8.5 What are Nostro and Vostro Accounts?

8.5.1 NOSTRO ACCOUNT


Nostro account
It is defined as one bank's foreign currency account with another (foreign) bank in a country
other than the domestic country
Vostro Account:
In continuation with the above statement, the other bank (foreign bank) will define the same
account as Vostro account.

For example1:
HDFC BANK does some transactions in USD, but banks in India will only handle payments in
INR. So HDFC BANK opens a USD account at foreign bank NEW YORK BANK, and instructs
all counter-parties to settle transactions in USD in its account at New York Bank". HDFC BANK
refers to this account as its nostro account. NEW YORK BANK calls this account as the vostro
account.

8.6 Payment and Reconciliation of Nostro and Vostro Accounts


Now, HDFC BANK sells INR100, 000,000 to C (a counterparty company who has an INR
account with HDFC BANK, and a USD account with New York Bank) for a net consideration of
USD2, 000,000.

88

Example 2: Nostro Transfer Transaction

Here an institution may transfer funds from one custodian in country to another custodian in
another country. This transaction is termed as Nostro Transaction.

From Nostro

Custodian S Brussels

To Nostro

Custodian H Hongkong

Currency

HKD

Amount

37,800,000

Value date

25th Oct

Nostro and Vostro payment and reconciliation are a part of the back office functions in any
securities trading organisation, bank, financial institution, investment management companies
etc. when securities are cleared and settled these accounts are used.

8.7 What is ISDA documentation and what is its importance?

ISDA documentation is the ISDA Master Agreement ('Master Agreement'). Once the buyer and
seller sign this agreement, it governs all individual transactions entered into between these
parties. The two counterparties must negotiate with care and prudence while formulating the
agreement. The types of derivatives that may be documented under the Master Agreements are
rate swaps, basis swaps, forward rates, commodity swaps, commodity options, equity/equity
index swaps, equity/equity index options, bond options, interest rate options, foreign exchange,
caps, floors, collars, swaptions, currency swaps, cross currency swaps, currency options, credit
derivatives and combinations of the above.

89

The Agreement can be classified as below:

Each Agreement covers Standard terms (which may be customised by the two players) and the
schedule.
# ( below table is very important from exam point of view )

90

91

IMPORTANCE OF THE AGREEMENT

Developing standardized documentation;

Generating legal and netting opinions;

To deal with regulatory and capital issues in a formal manner;

Strengthening risk management by enabling adherence to the agreement;

Improving the industrys operational infrastructure;

Increasing transparency by building central trade repositories; and Facilitating sound


collateral management practices;

8.8 Static data and importance of maintaining accurate static Data


Static data is necessary to set up at five levels, namely:

Counterparties of the trading company

Trading books within a trading company

Currencies

Securities

Security groups

The term static data implies that the information does not change .The majority of static
data items are static and not subject to change; however, certain aspects of static data are
subject to periodic change or updating. This activity is outsourced to third party data vendors
as mentioned in the previous section. The challenge for a trading company is to gather the
relevant data, Store it securely, update it when necessary and utilise it appropriately.

92

Counterparties / Security
STOs need to hold static data relating to all their counterparties/ securities, to enable
automated enrichment of trades and subsequent actions, such as the production of trade
confirmations and settlement instructions containing the counterpartys custodian details.

# Few examples of static data for a security are mentioned below:

Static data item

Example of a bond

Example of an equity

Full name of the security

Corporate Bund ( German )8.25% XYZ

plc

GBP

1st June 2020

Ordinary Shares

Short name of the security

XOX 8.25% 1.6.20

XYZ Ord

Security internal reference

BD007894839

SH00434930843

Security external reference

ISIN: XS 098765430

ISIN: GB82739289

Issued currency

EURO

GBP

Issued quantity

EURO 1,000,000,000.00

100,000,000

Security type

Bond

Equity

Security group

Corporate Bond (EURO)

UK Equity

Coupon rate type

fixed rate

NA ( Not Applicable )

Coupon rate

8.25%

NA ( Not Applicable )

Coupon frequency

Annual

NA ( Not Applicable )

st

Coupon payment dates

1 JAN

NA ( Not Applicable )

Primary value date

1st JAN 2010

16th January 2000

First coupon payment date

1st JAN 2010

NA ( Not Applicable )

Maturity date

1st JAN 2020

NA ( Not Applicable )

Maturity price

100%

NA ( Not Applicable )

Denominational values and EURO

5000.00

and

1.00

EURO 500 shares

board lots

20,000.00

Default trading book

Trading book 'Y'

Trading book 'D'

Credit rating

BBB

NA ( Not Applicable )

93

Summary:
The objective of this unit was to provide you with some exposure to Trade Life Cycle of
structured products. It covers the process of settlement of OTC trade (trade life cycle) and
the role played by the front , middle and back office in a trading organization. It is followed
by the reasons for trade failure and role of Trade Support in Trade life cycle. It explains the
concept of Nostro and Vostro Accounts. Finally it covers the importance and regulatory
clauses of ISDA documentation along with the Importance and sources of Static data

94

9. OTC OPTIONS
After studying this unit, you should be able to understand the:
Definition and concept of options, various terms related to options
Different types of OTC or Exotic options
Basic option strategies
Types of settlement mechanism in options
Valuation and pricing of OTC options
Applications of Options

9.1 Basics of options, various terms related to options

9.1.1 Major Difference between OTC and Exchange Traded Options:


Parameters

OTC Options

Exchange Traded Options

Type

Exotic

Plain Vanilla

Regulations

Higher due to credit risk

Lower than OTC options

Liquidity

Limited

Higher Liquidity

Execution

Slower as the liquidity is lower

Easily execution due to high


liquidity

Confidentiality ( for Preferable as banks may like to deal Less


intermediaries )

with one to one with a counterparty

confidentially

trade

data

is

as

the

accessible

through the exchange


Credit Risk

Becoming lesser due to use of the Noncollateral

Operation risk

Settlement

Existence

due

to

clearing house

As exotic options are complex, the Operational risk is less as


operational risk is very high

compared by

Exercising or hold till maturity

Exercising, Sq off or hold till


maturity

95

9.2 What are different types of OTC or Exotic options?


The term "exotic option" was known after Mark Rubinstein's published his paper in 1992 with
Eric Reiner. OTC Options are also known as exotic options as the specifications are highly
customised to create synthetic and structured risk return pay off structures. The Specifications
include

Maturity of the contracts

Strike Prices of Call and Put Options

Market Prices of the underlying instruments ( equity shares, index, fixed income
securities, Fx, Commodity )

Strike Price Intervals ( intervals between two consecutive strike price )

Type of Exercising ( American , European, Asian, Bermudan )

Premium Calculation ( Type of Models )

Underlying ( equity shares, index, fixed income securities, Fx, Commodity, or


combination of the underlying )

Some of the exotic options are mentioned below:


1. Cross-Currency Options :
These Options that are priced in a different currency to that of the underlying asset. For
Example if we have payoff Microsoft options in Rs. This may be useful if the investor wants the
asset priced locally to him. There are two possible options:

Exchange Rate Floating (Flexos) - Payment to be made in the currency of the option
using the exchange rate at exercise.

Exchange Rate Fixed (Quantos) - Payment is made in currency of option translated at a


fixed exchange rate. (I.e. the specified exchange rate is fixed.)
96

2. Barrier Options
These options are designed to allow the investor to benefit from their expectation of share price
path movement, (e.g. the share will first go down and then Rocket up; or the shares going up
but never past 20).
There are several types of barriers:
A. Knockout - if the share price exceeds the barrier the option is blown out. In this
example the barrier is 20 and if the share price exceeds this barrier the option ceases.
Note the option price is dramatically reduced - therefore if the clients view (that the
share will go up but not as high as 20) is correct the investor will make a larger gain.
B. Knockin options only kick-in if their barriers are past. E.g. If the user believes the stock
will go down first and then go up he can reduce his option cost by purchasing a Down
and In Barrier Option - the option only kicks in if the stock first falls below 14.00 (it
must then go up to be In-the-money). Note if the stock just went up without first crossing
the barrier the option holder gets nothing.

3. Asian Options
These are popularly known as averaging option. In case of Asian options, the payout is
calculated based on the closing price. The closing price is based average price of the day/week
/ month instead of the last half an hour weighted average price as in case of a plain vanilla
option. The payout is determined by deducting the average from the strike. (Please refer to the
exchange traded derivatives section for plain vanilla options)
This option is far cheaper because the volatility of an average is lower than that of the price
itself.
The averaging feature protects the writer and holder from last minute sharp spikes or share
price movement, and reduces the possibility and impact of manipulation.

97

Another alternative is to average the strike price instead of the share price. This gives the holder
the right to purchase the share at the average price (over the averaging time period.). At expiry
the holder can purchase the share at the average price over the averaging period.

4. Look Back Options


These Options allow the holder to look back over the Look Back period and pick the most
advantageous value. The holder can look back over the life of the option and chose the lowest
share price as the strike. Effectively he can purchase the shares at the low. This is a very
attractive but the option price is consequently higher.
# Example: If the option is purchased in Oct 2010 with a maturity of Dec 2010. On maturity, the
buyer will get (Max Price of the stock (during Oct and Dec) Strike Price) in case of the call
option.
If the strike price is $ 100 and the highest price during OCT DEC is $ 120 then the buyer get
the $ 20

The option may give the buyer the right to select the lowest of the stock as the strike price. Then
the profit for the buyer will be (Closing price of the Dec 2010 Lowest price of the stock (during
Oct dec).
If the current closing price is $ 85 and the lowest price during the period Oct Dec is $ 76, then
the buyer get $ 9.

5. Ladder Options

An option where the gains are locked in once the underlying reaches a predetermined price
levels or rungs, guaranteeing some profit even if the underlying security falls back below these
levels before the expiry of the option. For example, a ladder call option with an underlying price
98

of $30 has a strike price of $35 and rungs at $40, $45 and $50. If the underlying price reaches
$43 then the gain locked in would be $5 (40-35), the underlying price reaches $48 then the gain
locked in would be $10 (45-35), even if the underlying price decreases below these levels
before the expiration date.

6. Chooser options
These options give the holder the right to wait and choose whether the option is a Call or Put.
Clearly this allows the user to win if share goes up or down and therefore is more attractive than
a straight Option and consequently priced accordingly.

7. Compound Option
This is an option on an option. In this case, the holder has a Call option that expires 30th June
to purchase a Call option for 3.00 which will then give the holder the right to purchase the
shares at 16.00 on 31st December. The holder pays less up-front initially making this a highly
geared instrument. However, the over-all cost (including the first strike) will be higher.

8. Digital Options / Binary Options


In this exotic option, we have two types of alternatives namely Cash or Nothing or Asset or
Nothing, In case of Cash or Nothing the holder gets the stated payoff, if the strike price is
exceeded or nothing. Asset or Nothing means that the asset is handed over if strike is broken.
In case of binary option the payoff is either some fixed amount of some asset or nothing at all.
Thus, the options are binary in nature because there are only two possible outcomes. They are
also called all-or-nothing options, digital options (more common in forex/interest rate markets),
and Fixed Return Options (FROs) (on the American Stock Exchange).

99

For example, a purchase is made of a binary cash-or-nothing call option on ABC INC at $100
with a binary payoff of $1000. Then, if at the future maturity date, the stock is trading at or above
$100, $1000 is received. If its stock is trading below $100, nothing is received.

9. Cliquet
A cliquet option or ratchet option is a series of consecutive forward start options. The first is
active immediately. The second becomes active when the first expires, etc. Each option is
struck at-the-money (market price = strike price) when it becomes active.

A cliquet is, therefore, a series of at-the-money options but where the total premium is
determined in advance. A cliquet can be thought of as a series of "pre-purchased" at-the-money
options. The payout on each option can either be paid at the final maturity, or at the end of each
reset period.

10. Rainbow option


Rainbow option is a derivative exposed to two or more underlying assets. Rainbow options are
usually calls or puts on the best or worst of n underlying assets with the number of assets
popularly called as colours of the rainbow. The options are often considered a correlation trade
since the value of the option is sensitive to the correlation between the various basket
components.

11. VIX Options


A Vix Options is an over-the-counter financial derivative that allows one to speculate on or
hedge risks associated with the magnitude of movement, i.e. implied volatility, of some
underlying product, like an exchange rate, interest rate, or stock index.

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12. Bermudan options


An option where the buyer has the right to exercise at a set number of times is Bermudan
option. This is intermediate between a European option which allows exercise at a single time
i.e. on expiry date and an American option which allows exercise at any time upto expiry date.
For example, a bond option that can be exercised only on coupon payment dates. A corporation
issues a five-year callable bond with a refunding provision. This issue can be called on any
coupon date and replaced with a new issue at a lower rate.

9.3 Basic option strategies


View on the underlying

Loss Potential

Long Call

Bullish

Limited

Short Call

Bearish

Unlimited

Long Put

Bearish

Limited
Unlimited

Short Put

Bullish

(until the underlying hits zero),


a highly theoretical assumption!!!!!

Long Call: Here the trader expects a bullish view on the underlying. As the market moves up,
the buyer makes profit
Short Call: Here the trader expects a bearish view on the underlying. As the market moves up,
the seller makes loss
Long Put: Here the trader expects a bearish view on the underlying. As the market moves
down, the buyer makes profit
Short Put: Here the trader expects a bullish view on the underlying. As the market moves
down, the seller makes loss

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CALL OPTIONS

Long
Call
Spot
290
300
310
320
330
340
350
360
370
380
390

Net P/L
-15
-15
-15
-15
-15
-15
-5
5
15
25
35

Strike: 340
1 Call Buy: Prem: 15

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Spot
290
300
310
320
330
340
350
360
370
380
390

Short
Call
Net P/L
15
15
15
15
15
15
5
-5
-15
-25
-35

Spot
290
300
310
320
330
340
350
360
370
380
390

Long
Put
Net P/L
38
28
18
8
-2
-12
-12
-12
-12
-12
-12

Strike: 340
1 Call Sell: Prem: 15

Strike: 340
1 Put Buy: Prem: 12

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Spot
290
300
310
320
330
340
350
360
370
380
390

Short
Put
Net P/L
-38
-28
-18
-8
2
12
12
12
12
12
12

Strike: 340
1 Put Sell: Prem: 12

9.4 How is the settlement of options done?


In case of the OTC Contracts, most of the options are delivery based. The settlement will end in
either accepting or delivery of the underlying asset.
In case of OTC options, the settlement can be done by
1. Exercising/ assignment
2. Hold till maturity

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9.5 Valuation and pricing of OTC options


Pricing and valuing an option depends on expected probability of the market price moving
above or below the strike price. In principle, the premium paid by the buyer to the seller
represents the buyers expected immediate profit on exercising the option. Option pricing theory
therefore depends on assessing these probabilities and deriving from them an expected
outcome, and hence a fair value for the premium.
The factors on which these probabilities depend are as follows:

The strike price compared to the market price:


Call Options:
Higher the strike price as compared to the market price, call premium will be lower as the buyer
has to pay a higher price ( strike price ) to buy the underlying. Similarly lower the strike price as
compared to the market price, call premium will be higher as the buyer has to pay a lower price
(strike price) to buy the underlying.

Put Options:
Higher the strike price as compared to the market price, put premium will be higher as the buyer
will receive a higher price ( strike price ) to sell the underlying. Similarly lower the strike price as
compared to the market price, Put premium will be lower as the buyer will receive a lower price
(strike price) to sell the underlying.

Volatility: Volatility is a measure of how much the price fluctuates. The more volatile the price,
The greater the probability that the option will become of value to the buyer at some time,
Therefore the higher its value charged by the seller. Hence the price of call and put options will
increase as the volatility increases

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The time to expiry: the longer the time to expiry, the greater the probability that it will become of
value to the buyer at some time, because the price has a longer time in which to fluctuate.
Therefore, as an option move closer to its expiration, if all other factors remain the same, it
loses value each day. This is known as time decay.

Interest rates: The premium represents the buyers expected profit when the option is
exercised, but is payable up-front and is therefore discounted to a present value. The rate of
interest therefore affects the premium to some extent. If the interest rises, the call premium will
increase and put premium will decrease.

9.6 Applications of Options (Currency, Commodity and interest rates)


The Application of Option can be classified as
1. Hedging
2. Arbitrage
3. Speculation

OTC Options applications are similar to that of exchange trade options. Please refer the
application of exchange traded options.
Organisations

Derivatives Instruments

banks

interest rates, bonds, equities, for speculation, for arbitrage,


commodities, FX

Applications

and to both structure and


hedge products provided to
clients;

mortgage lenders

interest rate derivatives

to hedge borrowing costs and


lending income

fund managers

interest rates, bonds, equities,

to hedge assets

commodities, FX

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insurance companies

interest rate, bond and equity to hedge assets


derivatives

industrial companies

interest rate derivatives

to hedge borrowing costs

industrial companies

commodity and FX

to hedge costs of supplies

derivatives
industrial companies

FX derivatives

hedge income from sales

energy providers and raw

interest rate derivatives

to hedge borrowing

material producers
energy providers and raw

costs,
commodity and FX derivatives

to hedge income from sales

material producers
farmers

and

agricultural interest rate derivatives

to hedge borrowing costs

businesses
farmers

and

agricultural agricultural

(commodity) to hedge income from sales

businesses

derivatives

transportation companies

interest rate derivatives

to hedge borrowing costs

transportation companies

commodity

to hedge fuel costs

derivatives
transportation companies

FX derivatives

hedge costs and income from


sales;

governments

interest rate derivatives

to hedge borrowing costs

# Example of Hedging using options:


Suppose that the EURO/INR three-month forward rate in the situation described above is 56
INR per euro, and that the company buys an INR call (i.e., a EURO put) at a strike of 50 INR per
euro and pays a premium equivalent to 3INR per euro.
If the spot exchange rate after three months is anything less than 50, the company will exercise
the option and buy the INR at 50. As it has already paid a premium of 3, the all-in rate achieved
by the company is 47 INR per euro.
If the spot exchange rate after three months is anything greater than 50, the company will not
exercise the option. For example, if the rate is 59, the company will simply buy INR in the

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market at 59. Again, as it has already paid a premium of 3, the all-in rate achieved by the
company is 56 INR per euro.

# Example of Speculation:
A speculator believes that the price of gold will fall below $1200 per ounce, so he buys a gold
put option at a strike of $1200, for a premium cost of $55, with expiry in one month. After one
month, the spot price is $1000. He exercises the option to sell gold at $1200 and immediately
buys the gold in the market at $1000 for a $200 profit. This gives him an all-in gain of $145 after
taking into account the initial $55 premium cost of the option. If the price of gold had not fallen
below $1200 at expiry, his loss would have been limited to the $55 premium paid up-front.

Summary:
The objective of this unit was to provide you with some exposure to introduction to the OT
options. It covered the broad definition and concept of options followed by the various terms
related to options like strike price, maturity etc. The reader should read the exchange traded
writeup along with this writeup. It mainly covers the various different types of OTC or Exotic
options. It is followed by the basic option strategies like buying a call, buying a put, selling a call
and selling a put. Finally it covers the different types of settlement mechanism in options like
exercising or square up followed by valuation pricing and applications of OTC options

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10 OTHER DERIVATIVE PRODUCTS


After studying this unit, you should be able to understand the:
Concept and Understanding interest rate Caps, Floors and Collars
Board definition of amortizing , accreting swaps, Overnight Index Swaps
Concept and application of Swaptions
Concept and application of Foreign Exchange OTC derivatives such as Non deliverable
forwards

10.1 Understanding interest rate Caps, Floors and Collars


A cap is an option product which protects floating-rate borrowing against the rise in the
borrowing rate.
Example: If a borrower has a 3-year loan which he rolls over every three months at the threemonth floating rate (LIBOR / MIBOR). He can buy a 3-year cap which puts a cap on the
maximum borrowing cost. Whenever the LIBOR rate exceeds the cap strike rate he receives the
difference. Suppose the strike rate on the cap is 3% and LIBOR is set at 3.5%. Then, at the end
of the three-month interest rate period, the purchaser of the cap will receive 0.5% accrued over
the three-month period. Whenever the rollover rate is lower than the cap strike rate, nothing is
paid or received.

Floors are options that protect the lender from the fall in the interest rates by offering him a
minimum rate of interest. Here if the (floating) deposit rate is lower than the floor strike rate, the
buyer receives the difference. Whenever the (floating) deposit rate is higher than the floor strike
rate, nothing is paid or received. The settlement mechanics for a floor are analogous to those
for a cap.

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Collars are contracts that incorporate both a cap and a floor. When a cap is purchased and a
floor is sold the structure is called a collar. Collars can be constructed so that the two premiums
- the premium paid to buy the cap and the premium received when a floor is sold net zero. This
is referred to as a zero-cost collar. A collar is also known as a cylinder or tunnel.

10.2 What are Amortizing / Accreting swaps, Overnight Index Swaps

10.2.1 Amortizing / Accreting Swaps


A company can use an interest rate swap to convert the interest rate risk on a borrowing, e.g.,
from floating-rate to fixed-rate. But if the borrowing arrangement with a bank involves paying
back the loan amount in instalments during its life (example: an amortising loan), then, the
swap needs to be amortising one, to match the loan pattern; the notional principal on which the
swap payments are based will decrease over the life of the swap.
For example, the notional principal in the swap is designed to increase (an accreting swap)
rather than decrease.

If the loan requirement rise and fall repeatedly, in line with seasonal borrowing requirements, a
rollercoaster swap can be considered whose notional principal amount will rise or fall
accordingly.
.
10.2.2 Overnight Index Swaps
An overnight index swap (OIS) is a specific kind of interest rate swap. Their main features
include:
1. These contracts involve the exchange of obligations for relatively short periods such as
from one week to around a year, while normal interest rate swap contracts are for long
periods such as one to thirty years

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2. The floating reference rate in the OIS contract is overnight rate, while floating rate in the
interest rate swap contract is set less frequently with reference to a quarterly or semiannual interest rate.

In an OIS transaction, the counterparties agree to exchange the difference between the interest
accrued on the fixed OIS rate and the compounded floating amount on expiry of the contract.
Pay floating rate (daily compounded reference rate)

OIS receiver

OIS payer
Pay fixed OIS rate

For example, a bank raises money by issuing three month bank bills and lends the money on an
overnight basis to its customers. The banks customers would pay a floating overnight interest
rate while the bank would be paying its lenders a three month fixed interest rate. When market
interest rates fall significantly, the bank would have to continue paying its lender at the fixed
interest rate while the bank would receive the lower floating interest rate. The OIS transaction
facilitates protection against unfavourable shift in the overnight rate.
Example:
Bank X raises $1million by issuing three month banks bills. Bank X pays the bank bill holder a
fixed interest rate. Bank X lends its customers on an overnight basis. i.e. Bank Xs customers
pay floating overnight interest rate. Therefore, Bank X is exposed to unfavourable shift in the
overnight interest rate. Bank X enters into a three month OIS contract for $1million with PQR
Ltd. (OIS counterparty).

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The transaction will look as follows:

Pay floating rate (daily compounded reference rate)


OIS receiver Bank X

OIS payer PQR Ltd.

Pay fixed OIS rate

The floating leg of the OIS transaction offsets the floating interest rate payments received from
the customers.

10.3 What are Swaptions?


A swaption is an option which has a swap as its underlying asset and gives the buyer the right,
but not the obligation, to enter into an interest rate swap with a fixed-rate as the strike rate of the
option. Exercising the option either delivers the agreed swap from the time of exercise onwards,
or is cash-settled against the swap rate at that time.

Swaption can be of two types:


Receivers Swaption: In this case, the buyer has the right to enter into a swap as receiver of the
fixed rate.
Payers Swaption: In this type of swaption, the buyer has the right to enter into the swap
contract as the payer of the fixed-rate.

The counterparties to a swaption must agree start date and maturity date as well as the specific
details of the swap. Swaptions may be European or American style.

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As with many other OTC derivatives, ISDA (International Swaps and Derivatives Association)
has developed market trading standards and responsibilities for participants in the swaption
market.

# Example:
A company is planning to take a three-year floating rate loan which will start after two months. It
is also planning to swap this loan into a fixed rate loan.
The company is of the opinion that the swap rates will decline in two months time and so would
like to wait until then before arranging a swap. However, the swap rates may move the other
way also. In order to avoid any potential loss, it may buy a two months option to be a payer of
fixed rate three year swap at 6% against LIBOR. If after two months, the market rate of fixedfloating swap is less than 6% it will let the option expire. On the other hand, if the market rate is
more than 6%, it will exercise its option on swap at 6%.

Summary:
The objective of this unit was to provide you with some exposure to introduction to the other
type of OT derivatives products. It covers the interest rate Caps, Floors and Collars in terms of
concept, applications and examples. It is followed by the different instruments such as
amortizing, accreting swaps, Overnight Index Swaps, Swaptions.

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End of Document

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