Derivatives: It is a financial instrument or a security with value whose price is derived from oneor

more underlying asset. The derivative itself is just an agreement (contract) between two or more
parties, its value is derived by the future fluctuation in price of the asset it’s linked to (underlying
asset). There is no actual transfer of ownership of the underlying asset at the time of contract
initiation. Instead the contract simply represents an agreement to transfer ownership of the
underlying asset at given place, time and price as specified by the contract.

The counter party which buys have said taken a long position, whereas counter party which sells is
said to have taken short position. Derivatives are characterized by the fact that for every long
position taken there is corresponding short position taken as well in the contract. Before the
agreement of long and short, there was no contract defining the terms of the future exchange for
the asset did not exist. This mean the contribution of aggregate net value of derivatives to the
economy is zero.

Derivative instrument:

1. Forward contract: It’s a contract in which one party agrees to buy and the other agrees to
sell a given quantity of an asset for fixed price on a specific future date.
In forward contract the buyer assumes a long position agrees to buy the underlying asset on
certain future date and price as specified in the contract.
The price specified is called delivery price. the terms of the contract like delivery, price and
quantity are mutually agreed upon. There no payable margin.
2. Futures contract: It’s a contract in which one party agrees to buy from or sell to the other
party an underlying asset at a price agreed at the time of contract and payable on a future
date. The asset can be commodity, currency, debt or equity. The futures payment is
performed by payment of the difference between the strike price (agreed price on the
contract) and the market price on fixed future date.
3. Options: it’s a contract which gives the buyer the right, not obligation to buy (call) or sell
(put) underlying asset at an agreed – upon price (strike price) during a certain period of time
or on a specific date.
Call option give the choice to buy at any price, so the buyer wouldn’t want the price to go
up. Put option gives a choice to sell at certain price, so the buyer wouldn’t want the stock to
go down.

Hedging: it’s a technique which limits investment risk with the use of derivatives (options and
futures contracts). It involves taking two positions which will offset each other if the prices change.
Hedging can be used to reduce commodity risk, credit risk, currency risk, interest risk or equity risk.

Swaps: A swap is an agreement between two parties to exchange stream of cash flows for a specific
period of time. Usually at least one of the series of cash flows is determined uncertain variables such
as interest rate, exchange rate, equity price or commodity price. Various types of swaps are:

Interest rate swap: it’s an agreement to exchange sequence of cash flows from interest bearing
instruments for specific period of time. Each party’s payment obligation is calculated using different
interest rates, usually in a plain vanilla swap one party pays a fixed rate and the other part pay a
floating rate (usually LIBOR, EURIBOR)

Currency rate swap: It’s an agreement which involves the exchange of principle and interest in one
currency for the same in another currency. It takes into the account the present value.

Major risked faced by the bank due to movement of Euro interest rate:

British banks current situation:

British bank

Banks profit at EURIBOR’s

current value of 6% is 1% of
principal. Now if the
EURIBOR 7%
EURIBOR goes up bank is
losing its margin.

When the bank decides to get into and interest rate swap for minimising its risk, let us assume that
term of swap is that the bank will pay a fixed rate to its counterpart which is 6%. The cash flow of the
bank with its counterpart would

Paying fixed rate of 6%

British bank
Counterpart

EURIBOR

After the swap bank’s entire cash flow would look like this

7%
Paying fixed rate of 6% %%
After interest rate swap the bank is
neutralising its risk as the EURIBOR rates
EURIBOR will cancel each other and bank will
maintain profit margin of 1%

EURIBOR
So in short the bank hedges its risk by interest rate swap as it now pays a fixed interest rate of 6% to
the counterpart who in turn pays the bank EURIBOR floating rate. The bank is now making money on
EURIBOR rate from counterpart and making a payment to Eurocurrency market on EURIBOR rate.
This means any fluctuation in EURIBOR rate would not affect the bank as its effect is counter balance
with the help of Interest rate swap.

In above diagram we have assumed that the principle amount of every transaction is same 50 million
Euros.