derivatives

AN OVERVIEW

By

J. Jairam B.COM(HONS)

We view them as time bombs both for the parties that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
- WARREN BUFFETT, the Chairman of Berkshire Hathaway and his critique of the derivatives market. (March 2003)

Derivatives An Introduction
The
financial instruments such as- stocks, bonds, commodities and currencies - are generally referred to as cash instruments (or sometimes, primary instruments). The value of cash instruments is determined directly by markets. By contrast, a derivative derives its value from the value of some other financial asset or variable. For example, a stock option is a derivative that derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from an interest rate index. The asset from which a derivative derives its value is referred to as the underlying asset. The price of a derivative rises and falls in accordance with the value of the underlying asset. Derivatives are designed to offer a return that mirrors the payoff offered by the instruments on which they are based. Derivatives are further distinguished from cash instruments in that they are contracts between two or more parties. (Note that the major exceptions to this are warrants and convertible bonds which are, in fact, assets).These contracts are promises to convey ownership of an asset rather than the asset itself. Like other contracts, derivatives represent an agreement between two parties; the terms of the agreement are highly flexible and the contract has a fixed beginning and ending date. Investors use derivatives to capture profits resulting from price variations in the underlying investment. Because of this, derivatives are often referred to as leveraged investments. Of course, whenever leverage is employed the results, both positive and negative, can be greatly magnified Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, an Indian investor who uses U.S. dollars to buy shares in a U.S. company (traded on a U.S. exchange) would be exposed to exchange-rate risk when she sells the shares and converts dollars back to her home currency. To hedge this risk, the investor could purchase derivatives - currency futures - to lock in a favourable exchange rate. Despite the risks, derivatives are also attractive to investors because they trade for a fraction of the price of the underlying asset, enabling investors to control more of an asset for less money. Because derivatives are contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Options are the most commonly traded type of derivative. An options contract gives the owner the right to buy or sell an asset at a set price on or before a given date. Other products include futures contracts, forward contracts, warrants and swap contracts. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Exchange-traded vs. Over-The-Counter derivatives Like their underlying cash instruments, some derivatives are traded on established exchanges (BSE, NSE, MCX). These are referred to as exchange-traded derivatives and, generally, they have highly standardized terms and features. The advantage of exchange-traded derivatives is that regulated exchanges provide clearing and regulatory safeguards to investors.
Many other derivative instruments, including forwards, swaps and exotic derivatives, are traded outside of the formal, established exchanges. These are over-the-counter or OTC-traded derivatives. They can be created by any two counterparties with highly flexible terms and a nearly infinite number of underlying assets or asset combinations. In the OTC derivatives market, large financial institutions serve as derivatives dealers, customizing derivatives for the specific needs of clients. 1

1.

Forward Contract

A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an
asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. However, this also means it is more difficult to reverse a position, as the counterparty must agree to cancelling the contract, or you must find a third party to take an offsetting position in. This also increases credit risk for both parties. USES OF FORWARDS Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of scarce resources. Speculators also use forward contracts to make bets on price movements of the underlying asset. Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty about prices. For instance, coffee growers may enter into a forward contract with Fresh & Honest Caf Ltd. (FHCL) to lock in their sale price of coffee, reducing uncertainty about how much they will be able to make. Fresh & Honest Caf Ltd. benefits from contract because it is able to lock in their cost of purchasing coffee. Knowing what price it will have to pay for its supply of coffee ahead of time helps Fresh & Honest Caf Ltd. avoid price fluctuations and assists in planning. WORKING OF FORWARDS Forward contracts have a buyer and a seller, who agree upon a price, quantity, and date in the future in which to exchange an asset. On the delivery date, the buyer pays the seller the agreed upon price and receives the agreed upon quantity of the asset. If the contract is cash settled, the buyer would have a cash gain (and the seller a cash loss) if the spot price, or price of the asset at expiry, is higher than the agreed upon Forward price. If the spot price is lower than the Forward price at expiry, the seller has a cash gain and the buyer a cash loss. In cash settled forward contracts, both parties agree to simply pay the profit or loss of the contract, rather than physically exchanging the asset. A quick example would help illustrate the mechanics of a cash settled forward contract. On January 1, 2009 Company X agrees to buy from Company Y 100 pounds of coffee on April 1, 2009 at a price of `250.00 per pound. If on April 1, 2009 the spot price (also known as the market price) of coffee is greater than `250.00, at say `300.00 a pound, the buyer has gained. Rather than having to pay `300.00 a pound for coffee, it only needs to pay `250.00. However, the buyer's gain is the seller's loss. The seller must now sell 100 pounds of coffee at only `250.00 per pound when it could sell it in the open market for `300.00 per pound. Rather than the buyer giving the seller `25000 for 100 pounds of coffee as he would for physical delivery, the seller simply pays the buyer `5000. The `5000 is the cash difference between the agreed upon price and the current spot price, or (`300.00`250.00)*100. 2

RISKS OF FORWARD CONTRACT Because no money exchanges hands initially, there is counterparty credit risk involved with forward contracts. Since you depend on the counterparty to deliver the asset (or cash if it is a cash settled forward contract), if the counterparty defaults between the initial agreement date and delivery date, you may have a loss. However, two conditions must apply before a party faces a loss:
1. The spot price moves in favour of the party, entitling it to compensation by the counterparty, and 2. The counterparty defaults and is unable to pay the cash difference or deliver the asset. 2.

Futures Contract

The

futures contract is an agreement between two parties that commits one party to buy an underlying financial instrument (bond, stock or currency) or commodity (gold, soybean or natural gas) and one party to sell a financial instrument or commodity at a specific price at a future date. The agreement is completed at a specified expiration date by physical delivery or cash settlement or offset prior to the expiration date. In order to initiate a trade in futures contracts, the buyer and seller must put up "good faith money" in a margin account. Regulators, commodity exchanges and brokers doing business on commodity exchanges determine margin levels. Suppose A buyer B and a Seller S enter into a 5,000 kgs corn futures contract at `5 per kg. Assuming that on the second day of trading the settle price (settle price is generally the representative price at which the contracts trade during the closing minutes of the trading period and this price is designated by a stock exchange as the settle price. In case the price movement during the day is such that the price during the closing minutes is not the representative price, the stock exchange may select a price which it feels is close to being a representative price, e.g., average of the high and low prices which have occurred during a trading day) of March corn is `5.20 per kg. This price movement has led to a loss of `1,000 to S while B has gained the corresponding amount. Thus, the initial margin account of S gets reduced by `1,000 and that of B is increased by the same amount. While the margin accounts, also called the equity of the buyer and the seller, get adjusted at the end of the day in keeping with the price movement, the futures contract gets replaced with a new one at a price which has been used to make adjustments to the buyer and sellers equity accounts. In the instant case, the settle price is ` 5.20, which is the new price at which next days trading would start for this particular futures contract. Thus, each future contract is rolled over to the next day at a new price. This is called marking-to-market. Stock Futures Contract: A stock futures contract is an agreement to buy or sell shares or stock such as Microsoft, Intel, ITC, or Tata Steel at a point in the future. The buyer has an obligation to purchase shares or stock and the seller has an obligation to sell shares or stock at a specific price at a specific date in the future. That is a stock futures contract is a standardised contract to buy or sell a specific stock at a future date at an agreed price. A stock future is, as the name suggests, a future on a stock i.e. The underlying is a stock. Single-stock futures contracts are completed via offset or the delivery of actual shares at expiration. Margin on a single-stock futures contract is expected normally to be 20% of notional value. Each Stock Future contract is standardized and includes basic specifications. The terms of the contract call for delivery of the stock by the seller at some time specified in the future. However, most contracts are not held to expiration. The contracts are standardized, making them highly liquid. To get out of an open long (buying) position, the investor simply takes an offsetting short position (sells). Conversely, if an investor has sold (short) a contract and wishes to close it out, he or she buys (goes long) the offsetting contract.

TRADING BASICS
When an investor has a long margin account in stock, he or she is borrowing part of the money to buy stock, using the stock as collateral. In a Stock Future contract, the margin deposit is more of a good faith deposit, which is held by the brokerage firm toward the settlement of the contract. The margin requirement in a stock future applies to both buyers and sellers. The 20% requirement represents both the initial and maintenance requirement. In a stock future contract, the buyer (long) has not borrowed money and pays no interest. At the same time, the seller (short) has not borrowed stock. The margin requirement for both is the same. The 20% is a regulatory authoritys mandated percentage, but the individual brokerage house can require additional funds. Another major difference in the margin requirements for stock futures is that the margin requirement is continuous. Every business day, the broker will calculate the margin requirement for each position. The investor will be required to post additional margin funds if the account does not meet the minimum margin requirement. To illustrate in a stock future contract on ITC stock at `120, both the buyer and seller have a margin requirement of 20% or `2400. If ITC stock goes up to `122, the account of the long contract is credited with `200 (`122- `120 = `2 X 100 = `200) and the account of the seller (seller) is debited by the same `200. This indicates that investors in stock futures must be very vigilant - they must keep close track of market movements. Furthermore, the exact margin and maintenance requirements of an investor's brokerage firm are key issues that must be considered in determining the suitability of stock futures investments. SPECULATION GOING LONG: Suppose an investor is bullish on McDonald's (MCD) and goes long one September stock future contract on MCD at `80. At some point in the near future, MCD is trading at `96. At that point, the investor sells the contract at `96 to offset the open long position and makes a ` 1600 gross profit on the position. This example seems simple, but lets examines the trades closely. The investor's initial margin requirement was only `1600 (`80 x 100 = `8,000 x 20% = `1600). This investor had a 100% return on the margin deposit. This dramatically illustrates the leverage power of trading futures. Of course, had the market moved in the opposite direction, the investor easily could have experienced losses in excess of the margin deposit. GOING SHORT: An investor is bearish in Kochi Refinery (KR) stock for the near future and goes short an August stock future contract on KR at ` 160. KR stock performs as the investor had guessed and drops to `140 in July. The investor offsets the short position by buying an August stock future at `140. This represents a gross profit of `20 per share, or a total of `2,000. Again, let's examine the return the investor had on the initial deposit. The initial margin requirement was `3,200 (`160 x 100 = Rs,16,000 x 20% = `3,200) and the gross profit was `2,000. The return on the investor's deposit was more than 60% - a terrific return on a short-term investment. DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACT Features Forward Contract Futures Contract
Operational Mechanism Contract specifications Counterparty risk Liquidation Profile Price Discovery Not traded on exchange Differs from trade to trade Exists Poor Liquidity as contracts are tailor-made Poor ; as markets are fragmented Traded on exchange Contracts are standardised Exists, but assumed by Clearing House Very High as contracts are standardised Better as they are in common platform

PRICING
Cost and carry model of Futures pricing Fair price = Spot price + Cost of carry - Inflows FPtT = CPt + CPt * (RtT - DtT) * (T-t)/365 FPtT - Fair price of the asset at time t for time T. CPt - Cash price of the asset. RtT - Interest rate at time t for the period up to T. DtT - Inflows in terms of dividend or interest between t and T. Cost of carry = Financing cost, Storage cost and insurance cost. If Futures price > Fair price; Buy in the cash market and simultaneously sell in the futures market. If Futures price < Fair price; Sell in the cash market and simultaneously buy in the futures market This arbitrage between Cash and Future markets will remain till prices in the Cash and Future markets get aligned. HEDGING -PROTECTING STOCK POSITIONS To hedge, the investor takes a stock future position exactly opposite to the stock position. That way, any losses on the stock position will be offset by gains on the future position. However, this is only a temporary solution because the future will expire. Using Stock Future as a Hedge Consider an investor who has bought 100 shares of Tata Steel (TS) at `300. In July, the stock is trading at `350 The investor is happy with the unrealized gain of `50 per share but is concerned that in a stock as volatile as TS, the gain could be wiped out in one bad day. The investor wishes to keep the stock at least until September, because of an upcoming dividend payment. To hedge, the investor sells a `350 September stock future contract - whether the stock rises or declines, the investor has locked in the `50-per-share gain. In August, the investor sells the stock at the market price and buys back the future contract. September Price Value of 100 shares Gain or Loss on SF Net Value `300 `30,000 +`5,000 `35,000 `350 `35,000 0 `35,000 `400 `40,000 -`5,000 `35,000 Until the expiration of the stock future in September, the investor will have a net value of the hedged position of `35000. The negative side of this is that if the stock price dramatically increases, the investor is still locked in at `350 per share. INDEX FUTURES CONTRACT: A contract for stock index futures is based on the level of a particular stock index such as the S&P 500 or the Dow Jones Industrial Average or NIFTY or BSE sensex. The agreement calls for the contract to be bought or sold at a designated time in the future. Just as hedgers and speculators buy and sell futures contracts and options based on a future price of corn, foreign currency, etc, they mayfor mostly the same reasonsbuy and sell such contracts based on the level of a number of stock indexes. Stock index futures may be used to either speculate on the equity market's general performance or to hedge a stock portfolio against a decline in value. It is not unheard of for the expiration dates of these contracts to be as much as two or more years in the future, but like commodity futures contracts most expire within one year. Unlike commodity futures, however, stock index futures are not based on tangible goods, thus all settlements are in cash. Because settlements are in cash, investors usually have to meet liquidity or income requirements to show that they have money to cover their potential losses. 5

Stock index futures are traded in terms of number of contracts. Each contract is to buy or sell a fixed value of the index. The value of the index is defined as the value of the index multiplied by the specified monetary amount. In the S&P 500 futures contract traded at the Chicago Mercantile Exchange (CME), the contract specification states: 1 Contract = $250 * Value of the S&P 500 If we assume that the S&P 500 is quoting at 1,000, the value of one contract will be equal to $250,000 (250*1,000). The monetary value - $250 in this case - is fixed by the exchange where the contract is traded.
Using Stock Index as Hedge Selling stock index futures to protect the portfolio Sometimes, you may have a view that the market will fall in the future. At other times, you may feel that the market is going to have a few days of massive volatility, and you do not want to bear that amount of volatility. The union budget, and period of onset of monsoon etc. are such events. Many investors do not want to speculate on such events. When investors have such anxieties, stock index futures provides a convenient alternative to remove exposure to the stock market for a short time. Investors having a portfolio can sell the stock index futures and have an hedged position. How to do this actually? 1. The beta of the portfolio needs to be calculated. Beta is a measure of likely change in the value of the portfolio in relation to the change in the stock price index. Beta of the portfolio is the weighted average (weights in proportion to the value of holding) of betas of the shares in the portfolio. The values of betas of individual shares are calculated by regression of daily return on the share and daily return on the index. NSE web site gives beta values of for the actively traded shares. 2. The value of the portfolio is multiplied by the value of beta to get the value of the futures position to be sold. 3. Let us assume a) Portfolio value is `30 lakhs. b) Beta of the portfolio is 1.2 c) Current value of NSE NIfty is 3410. d) July NIfty future is selling at 3445. 4. The position to be taken in futures is portfolio value multiplied by beta i.e. `36 lakhs (`30 lakhs*1.2) 5. The number of future contracts to be sold is the position to be taken in futures divided by the value of one futures contract. Each futures contract will be for `1,72,250 (3445*50). Hence number of contracts is `36 lakhs/172250 = 20.90 contracts. Let us round it to 21 contracts. 6. What will happen if after 15 days Nifty goes down to 3000. The July future may go down to 3030. Investor buys back the futures contract now and thus squares off the futures position. The profit made on the futures position would be `4,35,750 ((3445-3030)*50*21). 7. The loss suffered on cash position is `4,32,845 [{(3410-3000)/3410}*1.2*`30 lakhs] 8. Thus the hedge in futures market compensates for the fall in spot market prices.
Warning: Hedging does not always make money. If the index has gone up instead of going down futures position will show a loss and the investor has to fund it if required by reducing his portfolio. The best that can be achieved using hedging is the removal of unwanted exposure. The hedged position will make less profits than the un-hedged position, half the time.

The investor should adopt this strategy for the short periods of time where the market volatility that he anticipates makes him uncomfortable, or when he plans to sell his holdings in the near future

Buy stock index futures to hedge planned purchase of equity shares in the future A mutual fund has received large amount of funds which are to be invested in the stock market. The fund managers need time to research stocks and carefully pick stocks that are expected to do well. After selecting the stocks, they cannot rush to the market and place orders to buy as it would generate large impact costs. The execution would be improved substantially if they could instead place limit orders and accumulate the shares at favorable places. But all this effort takes time, and during this time the market may go up. Index futures offer a convenient way of acquiring exposure to the stock market. The mutual fund can buy futures contracts for the value of the funds to be invested immediately. As and when its buys the shares it wants it can sell contracts equal to that amount. This hedging ensures that the fund will buy the shares it wants close to their current prices. Any increase in the market would be compensated by the profits it makes on the futures position. Once again it is to be noted that if market goes down in price, the mutual fund does not benefit. The hedge locks in the prices. Hedger does not lose if prices go up. He does not gain if prices come down. Options provide an opportunity to the hedger to enjoy profits if the market moves in a favorable position and protect him if the market moves in an unfavorable position. Hedged long position in a share (Long Stock/Short Futures) A stock picker picks a share to outperform the market due to reasons specific to the stock. A position in that stock may not provide profit to him if the general market goes down. Every buy position on a stock is simultaneously a buy position on the general market. The exposure to the general market can be removed by selling an index future. Then the position becomes a focused play on the performance of the stock. The earliest hedge funds were involved in similar hedging strategies only. Example: 1. An investor wants to acquire a long position of ` 1 Million in GMR Infra. The current market price of `60. The beta of GMR Infra is 1.23 according the NSE site. 2. Hence he requires a short position of `1.23 million on the Nifty futures market to totally remove his Nifty exposure. 3. Nifty futures with August maturity is available at 4099. Each contract will have a value of `2,04,950. 6 contracts of Nifty futures need to be sold. 4. With this hedge if Nifty goes down, investor will not suffer as his short position in futures will earn him the profit. He will have the benefit of relative performance of GMR INfra to the market. Hedged short position (Short stock/Long futures) Stock pickers may be good in identifying shares likely to have a bad performance in the market. Their short positions in such shares may not yield them profits because of a rise in the general market. Stock pickers can create hedged short positions by combining the short position in the stock with a long position in the index future. The mechanics of this strategy are exactly similar to the creating of a hedged long position in the stock.

3. Forward

Rate Agreement (FRA)

Forward Rate Agreements, or FRAs, are a way for a company to lock in an interest rate today, for money the company intends to lend or borrow in the future. FRAs trade over the counter (OTC), and because they are not exchange traded, both the notional amount of the loan and the FRA rate can be negotiated and customized. Also, since the contract is cash settled, no loan is actually given or received, but rather the contracts are settled on the first day of the underlying loan. The fixed rate, also called the FRA rate, is negotiated and agreed upon by both parties before the contract is entered into. The floating rate, also known as the reference rate, is an interest rate that will fluctuate between when the contract is agreed upon, and when the loan is set to begin. The two most common floating rates used in FRAs are LIBOR (London Inter-Bank Offer Rate) and Euribor. The Indian equivalent is MIBOR (Mumbai Inter-Bank Offer Rate)
LIBOR-The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. Countries that rely on the LIBOR for a reference rate include the United States, Canada, Switzerland and the U.K.

FRAs are quoted in the format AxB, with (A) representing the number of months until the loan is set to begin, and (B) representing the number of months until the loan ends. To find the length of the loan, subtract A from B. For example, 1x4 quote would mean a 3 month loan, set to begin 1 month in the future. Common formats for these quotes include 1x4, 1x7, 3x6, 3x9, 6x9 and 6x12. An example would help illustrate the point. Suppose the current month is February. Widget Co. needs ` 50,00,000 in April which it can repay back in May. In order to hedge against the risk that interest rates may be higher in April than it is in February, the company enters into an FRA with Bank Z at 6% FRA rate. In this case it would be a 2X3 FRA, meaning a 1 month loan to begin in 2 months, with a notional principal of ` 50,00,000. In April, if the interest rate rises to 8%, Bank Z would pay Widget Co the increased interest arising from the higher rate. If on the other hand interest rate falls to 4%, Widget Co would pay Bank Z. FRAs trade over the counter (OTC), and because they are not exchange traded, both the notional amount of the loan and the FRA rate can be negotiated and customized. Also, since the contract is cash settled, no loan is actually given or received, but rather the contracts are settled on the first day of the underlying loan. MECHANICS OF FRA Consider Company Z on March 1, 2009, which due to unforeseen circumstances must now find `1 crore for an expenditure to occur on June 1, 2009. Company Z expects to generate revenue, and the company expects to be able to repay this amount on September 1, 2009. Company Z has a number of ways to meet this expenditure; in this example we only compare a traditional loan to an FRA. Let's assume Company Z can normally borrow funds for 3 months from its local bank at a rate of 3 month Libor plus 100 basis points (bps). If the company takes the first alternative, the effective interest rate it would be able to borrow at would remain unknown until June 1, when it borrows the actual `1 crore at 3 month LIBOR plus 100 bps. Note that this represents a variable interest rate, as the interest rate in 3 months remains unknown until the actual day arrives. What if the company wishes to know on March 1, 2009 the interest they must pay on the loan, which will not occur for another 3 months? 8

Company Z can also get a quote from a FRA dealer (normally a bank). In this example, the company needs a 3x6 FRA quote (with 3x6 meaning a 3 month loan, to begin in 3 months). Let's assume the FRA dealer offers a quote of 7.0%. This means if the 3 month Libor on June 1 is lower than 7.0%, the FRA dealer will earn the difference between 7.0% and the actual interest rate. Intuitively this makes sense, as the FRA dealer is earning 7.0% on this loan, but it can borrow at the lower 3 month LIBOR rate. However, if on June 1 the rate is higher than 7.0%, it will lose the difference. If Company Z accepts the FRA rate of 7.0% on March 1, then 3 months later (June 1), it will settle in cash this difference between the previously agreed upon 7.0% and 3 month LIBOR on June 1 2009. If the 3 month LIBOR on June 1 is lower than 7.0%, the company must pay the FRA dealer. However, if it is higher, the company receives payment from the FRA dealer. Since the company is effectively borrowing at a lower interest rate than otherwise possible if the 3 month LIBOR is higher than 7.0%, and as such receives payment. To calculate the amount of the payment, refer to the formula below. FRA rate Reference rate days basis days 1 + Reference rate basis

Compensation Payment = Notional Amount

Note: This payment is from the borrower's perspective. For positive quantities, the borrower pays the FRA dealer; for negative amounts, the borrower receives payment from the FRA dealer. The basis refers to the day count applicable for money market transactions. For U.S. Dollar (USD) and Euro (EUR), it is 360' for British Pound (GBP) it is 365.

LOCK-IN OF INTEREST RATES It may seem confusing how giving or receiving cash payment helps the company lock in an interest rate. To understand the compensation payment in context, this example will be extended. On June 1, only 3 possibilities can occur: the 3 month LIBOR is exactly 7.0%, no settlement is needed, the 3 month LIBOR is higher than 7.0%, Company Z receives payment, the 3 month LIBOR is lower than 7.0%, Company Z makes payment. If the 3 month LIBOR on June 1 increased to 7.5% for example, then the FRA dealer must make payment to Company Z. Continuing with this example, the FRA dealer will pay Company Z: 90 7% 7.5% 360 . 1 crores = Rs. 12,269.94 90 1 + 7.5% 360 If the 3 month LIBOR fell to 6.5%, the company would make an equal the payment to the FRA dealer. But how does this help Company Z achieve the previously agreed upon 7.0% rate? If the 3 month LIBOR increased to 7.5%, then Company Z receives payment of `12,269.94. It then goes to its local bank (from the start of the example), and borrows `1 crore less `12,269.94, or `99,87,730.06. Assuming its local bank's markup rate has not changed, it would need to repay 90 Rs. .99,87,730.06 1 + 7.5% + 100 basis points = Rs. 1,01,99,969.32 360 This implies a quarterly rate of interest of 2.0% 1,01,99,969.32 1,00,00,000 1 which annualized comes out to exactly 8.0%. This 8.0% rate is precisely the 7.0% locked in rate, plus the 100 bps mark-up rate. If the 3 month LIBOR decreased to 6.5%, Company Z makes payment of `12,269.94 to the FRA dealer. It would again go to its local bank, but borrow `1 crore plus ` 12,269.94, or `1,00,12,269.94. In 3 months time, it would need to repay 90 Rs. 1,00,12,269.94 1 + 6.5% + 100 basis points = Rs. 1,02,00,000 360 9

This implies a quarterly rate of interest of 2.0%, which annualized comes out to 8.0%. Once again, the variable 3 month LIBOR has been replaced by the previously agreed upon FRA rate of 7.0%. As evidenced by this example, Company Z, as of March 1, knows its cost of borrowing `1 crore, and this amount is independent of fluctuations in the 3 month LIBOR. When the 3 month LIBOR increases, it must borrow at a higher rate, but receives cash compensation from the FRA dealer. If the 3 month LIBOR decreases, it benefits from borrowing at a lower rate, but must pay the FRA dealer compensation.
FRA VALUATION A 6 X 12 FRA is priced at todays implied six-month forward, six-month interest rate (6R12). This rate can be calculated using the six-month (0R6) and one-year (0R12) interest rates by solving the following equation. 1 + 0R6 0.5 1 + 6R12 0.5 = 1 + 0R12 1 The price of FRAs with different maturities can be calculated by setting up similar equations. For example, the price of a 3x6 FRA can be derived if 0R3 and 0R6 are known; a 3x12 can be priced if 0R3 and 0R12 are known etc. To value an existing FRA one needs: Notional principal P Contract rate C Forward period t1 to t2 Spot or zero coupon interest rates with maturities t1 and t2 (denoted 0R1 and 0R2, respectively). RISKS OF FRA Because FRAs are settled in cash and no loan is actually extended, only the compensation amount is ever at risk. In other words, the most either party in a Forward Rate Agreement will lose is the amount that must be cash settled, and not the entire notional amount of the loan. Furthermore, two conditions must apply before a party faces losses; 1. Interest rates move in favour of the party, entitling it to compensation by the counterparty, and 2. The counterparty defaults and is unable to pay the compensation amount.

4. Interest

Rate Futures

An interest rate future is a binding contract between a buyer and a seller for delivery of an agreed
interest rate commitment on an agreed date and at an agreed price. It can be used to protect against unwanted interest rate movements. For example, if a borrower is worried about interest rates rising, it may sell interest rate futures, knowing that if interest rates do rise, the price of the futures will fall, allowing the borrower to buy them back at a lower price. The gain on the futures market can be offset against the additional interest suffered. The reverse happens if interest rates fall. This will have the effect of more or less fixing the effective interest rate paid by the borrower. Equally, if an investor is concerned about interest rates falling, it may buy interest rate futures, knowing that if interest rates do fall, the price of the futures will rise, allowing the investor to sell them at a higher price. The gain on the futures market can be added to the smaller amount of interest actually earned. The reverse happens if interest rates rise. This again has the effect of more or less fixing the effective interest rate received by the investor. Each futures exchange has a Clearing House. When a futures deal has been made the Clearing House assumes the role of counterparty to both the buyer and the seller. Thus the buyer has effectively bought from the 10

Clearing House, whilst the seller is treated as having sold to the Clearing House, thus removing the risk of default on the futures contract. When a deal has been made, both buyer and seller are required to pay margin to the Clearing House. This sum of money must be deposited (and maintained) in order to provide protection to both parties. Initial margin (of between 5% and 10% of contract value) is the sum deposited when the contract is first made. Variation margin is payable or receivable to reflect the day-to-day profits or losses made on the futures contract. If the futures price moves adversely a cash payment must be made to the Clearing House, whilst if the futures price moves favourably the party concerned can elect to receive a cash refund from the Clearing House. This process of realising profits or losses on a daily basis is known as marking to market. Contract sizes are for fixed sums, e.g. 500,000 for short sterling contracts, which means that a perfect hedge is difficult to achieve. A further reason why a perfect hedge is unlikely is basis risk i.e. the possibility of variability in the prices of the two related securities in the hedging arrangement. For example, if changes in the price of the interest rate future do not perfectly match the changes in the rate of interest, a profit or loss may occur on the hedge position.
ILLUSTRATION It is now 31 December 2012. The corporate treasurer of Tripod Ltd. is concerned about the level of cash flows of the company during the next six months, and how the company might be protected from the adverse effects of changing interest rates. Interest rates are widely expected to change in late April when a General Election is due, but the size and direction of the change is dependent upon the result of the election which is forecast by opinion polls to be very close. Current interest rates for Tripod are 11% per year for short-term borrowing, and 8% per year for short-term investment. Apart from an overdraft facility to finance short-term cash shortages, the company has no other form of floating rate debt. Cash forecasts reveal that the company expects to have a fairly consistent overdraft level of approximately 2,420,000 between the end of April and the end of June 2012. June sterling three months deposit futures are currently priced at 90.25. The standard contract size is 500,000 and the minimum price movement is one tick (the value of one tick is 0.01% per year of the contract size). Forward rate agreements are available for period of up to four months from May at 11.88-11.83%. Required: If at the end of April, interest rates have moved as follows: Scenario (1) Scenario (2) Borrowing rate for Tripod 13% per year Borrowing rate for Tripod 9.5% per year Investment rate for Tripod 10% per year Investment rate for Tripod 6.8% per year June sterling three month time deposit futures June sterling three month time deposit futures 88.05 91.75, Evaluate with hindsight, separately for each of scenarios (1) and (2) above, the results of four alternative strategies that the company might have adopted towards its interest rate risk. Taxation, margin requirements and the time value of money may be ignored. Solution Three strategies company can adopt
Adopt no protective strategy on the basis that the companys exposure to adverse rate movements may be negligible;

Enter into forward rate agreements (FRAs) with bank;

Use sterling three month interest rate futures.

11

1. No Hedge
May and June Interest Scenario (1) 2.42m x 13% x 2/12 52,433 Scenario (2) 2.42m x 9.5% x 2/12 38,317

2. Use an FRA -(A 4 x 6 FRA is needed i.e. one starting 4 months hence and ending in 6 months time) Scenario (1) Scenario (2)
Cost in cash market Less compensation paid by the bank to Tripod May and June interest 2.42m x 13% x 2/12 2.42m x (11.88% 13%) x 2/12 52,433 (4,517) 47,916 2.42m x 9.5% x 2/12 2.42m x (11.88% 9.5%)x 2/12 38,317 9,599 47,916

Note: Once the FRA has been entered into, the interest paid by the company for the two months will be 47,916, whatever the prevailing level of interest rates).

3. Use futures In December, the company wants to hedge for two months an amount of 2.42m using three month futures contracts each of 500,000. 2.42m Therefore it needs to sell 2 3 500,000 = 3.22 contracts
We may choose to round down to 3 contracts see result in the Summary shown below. However, rounding up, the company must sell 4 contracts to be fully hedged. Scenario (1) Scenario (2)
Cash Market: May and June Interest as above Profit/(loss) on future contracts 52,433 4 x (90.25 88.05) 4 x 220 ticks 4 x 220 x 12.50 52,433-11,000 4 x (91.75 90.25) 4 x 150 ticks 4 x 150 x 12.50 38,317-7,500 38,317

Net Interest payable

(11,000) 41,433

7,500 45,817

Note: one tick is valued at 0.0001 x 500,000 x 3/12 = 12.50

Summary
No Hedge FRA Futures Using 3 contracts Using 4 contracts Scenario (1) 52,433 47,916 44,183 41,433

Scenario (2) 38,317 47,916 43,942 45,817

5.

Interest Rate Swaps

An interest rate swap is a contract between two parties to exchange a series of cash flows similar
to those that would result if the parties instead were to exchange equal rupee values of different types of bonds. Swaps arose originally as a means of managing interest rate risk. The volume of swaps has increased from virtually zero in 1980 to about $60 trillion today WORKING OF INTEREST RATE SWAPS To illustrate how swaps work, consider the manager of a large portfolio that currently includes `10 crore par value of long-term bonds paying an average coupon rate of 7%. The manager believes that interest rates are about to rise. As a result, he would like to sell the bonds and replace them with either short-term or floating-rate issues. However, it would be exceedingly expensive in terms of transaction costs to replace the portfolio every time the forecast for interest rates is updated. A cheaper and more flexible way to modify the portfolio is for the manager to swap the `70 lakh a year in interest income the portfolio currently generates for an amount of money that is tied to the short-term interest rate. That way, if rates do rise, so will the portfolios interest income. 12

A swap dealer might advertise its willingness to exchange or swap a cash flow based on the sixmonth LIBOR rate for one based on a fixed rate of 7%. (The LIBOR, or London Interbank Offer Rate, is the interest rate at which banks borrow from each other in the Eurodollar market. It is the most commonly used short-term interest rate in the swap market.) The portfolio manager would then enter into a swap agreement with the dealer to pay 7% on notional principal of `10 crores and receive payment of the LIBOR rate on that amount of notional principal. In other words, the manager swaps a payment of 0.07 x `10 crores for a payment of LIBOR x `10 crores. The managers net cash flow from the swap agreement is therefore (LIBOR - 0.07) x `10 million.
Note: The participants to the swap do not loan each other money. They agree only to exchange a fixed cash flow for a variable cash flow that depends on the short-term interest rate. This is why the principal is described as notional. The notional principal is simply a way to describe the size of the swap agreement. In this example, the parties to the swap exchange a 7% fixed rate for the LIBOR rate; the difference between LIBOR and 7% is multiplied by notional principal to determine the cash flow exchanged by the parties.

Now consider the net cash flow to the managers portfolio in three interest rate scenarios: LIBOR Rate 6.5 7 7.5 Interest income from bond portfolio(=7% of `10 crore bond portfolio) `70,00,000 `70,00,000 `70,00,000 Cash flow from swap(=(LIBOR-7%) x Notional principal of `10 crores (`5,00,000) 0 `5,00,000 Total (= LIBOR x `10 crores) `65.00.000 `70,00,000 `75.00.000 Notice that the total income on the overall positionbonds plus swap agreementis now equal to the LIBOR rate in each scenario times`10 crores. The manager has in effect converted a fixed-rate bond portfolio into a synthetic floating-rate portfolio. You can see now that swaps can be immensely useful for firms in a variety of applications. For example, a corporation that has issued fixed-rate debt can convert it into synthetic floating-rate debt by entering a swap to receive a fixed interest rate (offsetting its fixed-rate coupon obligation) and pay a floating rate. Or, a bank that pays current market interest rates to its depositors might enter a swap to receive a floating rate and pay a fixed rate on some amount of notional principal. This swap position, added to its floating-rate deposit liability, would result in a net liability of a fixed stream of cash. The bank might then be able to invest in long-term fixed-rate loans without encountering interest rate risk. What about the swap dealer? Why is the dealer, which is typically a financial intermediary such as a bank, willing to take on the opposite side of the swaps desired by these participants? Consider a dealer who takes on one side of a swap, lets say paying LIBOR and receiving a fixed rate. The dealer will search for another trader in the swap market who wishes to receive a fixed rate and pay LIBOR. For example, company A may have issued a 7% coupon fixed-rate bond that it wishes to convert into synthetic floating-rate debt, while company B may have issued a floating-rate bond tied to LIBOR that it wishes to convert into synthetic fixed-rate debt. The dealer will enter a swap with company A in which it pays a fixed rate and receives LIBOR, and it will enter another swap with company B in which it pays LIBOR and receives a fixed rate. When the two swaps are combined, the dealers position is effectively neutral on interest rates, paying LIBOR on one swap, and receiving it on another. Similarly, the dealer pays a fixed rate on one swap and receives it on another. The dealer is an intermediary, funnelling payments from one party to the other. The dealer finds this activity profitable because it will charge a bidask spread on the transaction.
Bid-Ask Spread or Swap Spread: A swap spread represents the difference in interest rates between a fixed-rate investment and an interest-rate swap.

13

6.95%
7% Company A Swap Dealer

7.05%
Company B LIBOR

LIBOR

LIBOR

Company B pays a fixed rate of 7.05% to the swap dealer in return for LIBOR. Company A receives 6.95% from the dealer in return for LIBOR. The swap dealer realizes a cash flow each period equal to .1% of notional principal. And also note that interest rates spreads or differences are expressed in basis points (bps) and 100 bps=1%. So the swap dealer gained 10 bps.

This arrangement is illustrated above. Company A has issued 7% fixed-rate debt (the leftmost arrow in the figure) but enters a swap to pay the dealer LIBOR and receive a 6.95% fixed rate. Therefore, the companys net payment is 7% + (LIBOR - 6.95%) =LIBOR + 0.05%. It has thus transformed its fixed-rate debt into synthetic floating-rate debt. Conversely, company B has issued floating-rate debt paying LIBOR (the rightmost arrow), but enters a swap to pay a 7.05% fixed rate in return for LIBOR. Therefore, its net payment is LIBOR + (7.05% - LIBOR) = 7.05%. It has thus transformed its floating-rate debt into synthetic fixedrate debt. The bidask spread in the example illustrated above is 0.1% of notional principal each year.
Note: Actually, things are a bit more complicated. The dealer is more than just an intermediary because it bears the credit risk that one or the other of the parties to the swap might default on the obligation. Referring to the illustration, if company A defaults on its obligation, for example, the swap dealer still must maintain its commitment to company B. In this sense, the dealer does more than simply pass through cash flows to the other swap participants.

How do Swap Dealers lock-in their profits by taking advantage of these spreads? Consider Company A which has outstanding debt on which it pays fixed rate of 9.5%. The company intends to refinance the debt with a floating rate interest. The best floating rate it can obtain is LIBOR+2% (LIBOR+200 bps). However it does not want to pay more than LIBOR. Another company B is looking for a loan at a fixed rate of interest to finance its exports. The best rate it can obtain is 13.5% but it cannot afford to pay more than 12%. However one bank has agreed to offer finance at a floating rate of LIBOR +2%. A swap dealer is in the process of arranging an interest rate swap between these two companies. This is how swap will be structured.

9.5% Company A Swap Dealer Company B

LIBOR+2%

Wants floating rate at LIBOR but only LIBOR+200 bps available

SPREAD ALLOCATION

SPREAD DESIGN
Co. FIXED FLOATING A 9.50% LIBOR+2% B 13.50% LIBOR+2% Diff 400 bps 0 bps Spread available = 400 bps

Wants fixed rate at 12% but only available at 13.5%

Company A ( LIBOR+2%-200bps)

Company B (13.5%-150bps)

Balance spread to Dealer=50bps

14

LIBOR
9.5% Company A Swap Dealer

LIBOR
Company B LIBOR+2%

9.5%

10%

The differential between the fixed and floating rate is 400-0 = 400bps. A total of 400bps need to be shared between A, B and Swap Dealer. Since A cannot afford more than LIBOR, it needs 200bps benefits out of the total 400bps (LIBOR+2% less LIBOR). Similarly B cannot pay more than 12% as against the existing available fixed rate funding of 13.5%. It needs 150 bps(13.5% less 12%) out of the balance 200bps. The residual 50bps will be taken by the Swap Dealer. The table illustrates this construction.
Company Paid to Lender OBJECTIVE Received from dealer Paid to Dealer Spreads used up

A B

200bps 150bps 50bps Note that the Swap Dealer pays Company A at LIBOR and receives the same from Company B. Now it can use up its entire 50bps spread by receiving from Company A at 10% and paying only 9.5% to Company B. Thereby benefitting a cash flow of 0.5% converting its spread into profits. All the three parties have gained in this transaction as their individual objectives have been met.
EXITING A SWAP AGREEMENT Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. There are four basic ways to do this: 1. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent. 2. Enter an Offsetting Swap: For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a floating rate and paying a fixed rate. 3. Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. 4. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2. RISKS OF SWAPS Interest rate swaps expose users to interest rate risk and credit risk. Market Risk: A typical swap consists of two legs, one fixed, the other floating. The risks of these two components will naturally differ. Newcomers to market finance may think that the risky component is the floating leg, since the underlying interest rate floats, and hence, is unknown. This first impression is wrong. The risky component is in fact the fixed leg and it is very easy to see why this is so. Credit Risk: Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party.

9.5% LIBOR+2%

LIBOR 12%

9.5% LIBOR

LIBOR 10%

15

DETAILED ILLUSTRATION
Swappy Ltd. has `1.4 crores of fixed rate loans at an interest rate of 12% per year which are due to mature in one year. The companys CFO believes that interest rates are going to fall, but does not wish to redeem the loans because large penalties exist for early redemption. Swappy Ltd.s bank has offered to arrange an interest rate swap for one year with a company that has obtained floating rate finance at London Interbank Offered Rate (LIBOR) plus 1.125%. The bank will charge each of the companies an arrangement fee of `20,000 and the proposed terms of the swap are that Swappy Ltd. will pay LIBOR plus 1.5% to the other company and receive from the company 11.625%. Corporation tax is at 35% per year and the arrangement fee is a tax allowable expense. Swappy Ltd. could issue floating rate debt at LIBOR plus 2% and the other company could issue fixed rate debt at 11.75%. Assume that any tax relief is immediately available. Required: (a) Evaluate whether Swappy Ltd. would benefit from the interest rate swap 1. If LIBOR remains at 10% for the whole year 2. If LIBOR falls to 9% after 6 months (b) If LIBOR remains at 10% evaluate whether both companies could benefit from the interest rate swap if the terms of the swap were altered. Any benefit would be equally shared. SOLUTION a) EVALUATION OF INTEREST RATE SWAP 1. If LIBOR remains at 10% throughout the year Particulars Swappy(%) Other company(%) Existing commitment (12) (Fixed) (11.125)(LIBOR+1.125) Swappy pays LIBOR +1.5% (11.5) 11.5 Other company fixed 11.625% 11.625 (11.625) Revised commitment (11.875) (11.25) The current cost of fixed rate debt (After tax) `1.4 crores x 12% x (1-35%) = `10,92,000 The cost under the Swap is (After tax) `1.4 crores x 11.875% x(1-35%) = 10,80,625 Plus arrangement fee (After tax) ` 20,000 x (1-35%) = 13,000 Total cost = `10,93,625 Conclusion : The swap would not be beneficial, as the final cost, after tax, is increased by (`10,93,625 less `10,92,000) = `1,625 2. If LIBOR falls to 9% after six months Particulars Swappy(%) Other company(%) Existing commitment (12) (Fixed) (10.125)(LIBOR+1.125) Swappy pays LIBOR +1.5% (10.5) 10.5 Other company fixed 11.625% 11.625 (11.625) Revised commitment (10.875) (11.25) If LIBOR falls to 9% after six months the cost is First six months-`1.4 crores x 11.875% x 6/12 x (1-35%) = 5,40,312 Last six months-`1.4 crores x 10.875% x 6/12 x (1-35%) = 4,94,813 Plus arrangement fee(After tax) ` 20,000 x (1-35%) = 13,000 Total cost = `10,48,125 Conclusion : The swap would then be beneficial since Swappy benefits by (`10,92,000 less `10,48,125) = `43,875

16

b) Whether both parties would benefit from the swap if LIBOR remains at 10% Ignoring the arrangement fee, both companies are benefiting from the swap i.e. Particulars For a floating rate arrangement: Swappy would normally pay LIBOR + 2% But is actually paying LIBOR +1.875% Thus saving For a fixed interest rate arrangement: The other company would normally pay 11.75% But is actually paying 11.25% Thus saving TOTAL SAVINGS If this saving were divided equally, each company would save 0.3125% i.e

0.125

0.50 0.625

Particulars Swappy(%) Other company(%) Normal rates for both companies 12(LIBOR +2) 11.75(Fixed) Savings for both companies (0.3125) 0.3125 Revised commitment 11.6875 11.4375 Accordingly if the terms of the swap were varied so that Swappy paid the other company LIBOR plus 1.3125%, which is calculated as follows: Particulars % Present arrangement of LIBOR plus 1.5 Add back original saving 0.125 Less revised savings (0.3125) Revised arrangement of LIBOR plus 1.3125 and the remaining terms of the swap were unchanged, the effect would be: Particulars Swappy(%) Other company(%) Existing commitment (12) (11.125) (LIBOR+1.125) Swappy pays (11.3125)(LIBOR+1.3125) 11.3125 Swappy receives 11.625 (11.625) Revised commitment (11.6875) (11.4375) Thus Swappy is paying interest at 0.3125% below its normal floating rate of LIBOR + 2% and the other company is paying at 0.3125% below its normal fixed rate of 11.75%.

The total cost to Swappy of using these new terms is: `1.4 crores x 11.6875% x 0.65 Plus arrangement fee (net of tax) Total cost = = = 10,63,562 13,000 ` 10,76,562

This is a saving of (`10,92,000 less `10,76,562) = `15,438 relative to not undertaking the swap.

17