BASICS OF FINANCIAL DERIVATIVES

This 'starter chapter' introduces you to the module, and offers tips on how to make optimal use of it. About this module:

CONTENTS: 1. Introduction to the Course 1.1. Course Contents 1.2. Course Pre-requisites 1.3. Course Overview 2. Interest Rates Refresher 2.1. Compounding 2.2. Day Count Conventions and Conversion 2.3. Continuously Compounded Interest Rates 2.4. Floating Interest Rates and Benchmarks 3. Foreign Exchange Refresher 4. Commodities and Financial Markets 5. The Three Building Blocks 5.1. Credit Extension 5.2. Price Fixing 5.3. Price Insurance 5.4. Combining the Building Blocks 6. Conclusion. COURSE PRE-REQUISITES: What do you need to know before you come into this course? Surprisingly little, as it turns out. The course participant should have a basic introduction to interest rates and the concept of time value of money. A basic introduction to foreign exchange markets helps (check out the CorporateAcademy course on Basics of Foreign Exchange). If you have neither, I strongly recommend that you blow the dust off some of those books you studied in college or school . If you have had exposure to these concepts but are a little rusty, we begin this course with a short refresher. PARTICIPANT PROFILE: I would like to think that this module is intended for any person who is interested in derivatives. Realistically, the contents would interest and add value to: Treasury professionals in financial institutions and corporates. Students of finance in MBA programs. Tax and Legal professionals who deal with derivatives. Operations and Risk Management professionals in financial institutions and corporates PROGRAM DESCRIPTION & OBJECTIVES: This course is designed to give participants an introduction to the exciting world of financial derivatives. The contents of the course will take you , the participant, from the basic to the advanced - from learning how the basic products and building blocks work to how standard derivatives are priced to an introduction how these are used in the real world. It is difficult to be a participant in financial markets today - and all of us are inexorably drawn to the financial markets due to personal or professional reasons - without understanding how basic financial derivatives work. Weve split the course into three modules. The first module provides a basic introduction to derivatives. You learn about the basic types of financial derivatives, how they work and what is the typical jargon that practitioners may throw at you. The next modules take you through more advanced material. They talk about the nitty gritty of actual derivative

pricing, based on market instruments. Of course, pricing is of little use if you cannot hedge the derivative using the same market instruments. So, we also talk about how traders who run derivative portfolios (or "derivative books" as it is sometime referred to) use these instruments to hedge standard derivatives such as interest rate swaps and options. At the end of the course, you should be able to understand and price forwards, futures, swaps on a wide variety of underlying assets - equity, interest rates, foreign exchange and even traded commodities. SUGGESTED READING: Of course, you can direct questions on any of the material, or related topics to the course faculty. We will try and answer your questions in as much detail, and as quickly as possible. There are many books about derivatives out there as well as many web sites. I found the books below very useful in my education for derivatives. Some of them are available in paperback edition as well. 1. Options, Futures, and Other Derivative Securities, 2nd Ed., John Hull, Prentice Hall of India. 2. The Handbook of Financial Engineering, Clifford W. Smith, Jr., Charles W. Smithson, Harper Business. 3. Swaps and Financial Derivatives, Satyajit Das, The Law Book Company Limited. 4. Yield Curve Analysis, Livingston G. Douglas, New York Institute of Finance. 5. Options Markets, John C. Cox and Mark Rubinstein, Prentice Hall Inc.

BASICS OF FINANCIAL DERIVATIVES 1. Introduction

WHAT IS A FINANCIAL DERIVATIVE?

A derivative is a financial instrument that derives its value from the value of some more basic underlying instrument or variable. The underlying instrument or variable is commonly referred to as simply the "underlying". The underlying may be an equity share, the price of barrel of crude oil, a foreign exchange rate, a bond, all of these or another derivative. A derivative that has another derivative as an underlying is often called a compound derivative (remember compound sentences from English grammar - the same idea). Derivatives are around us as well. A contract to purchase a flat a year from today is a derivative. The value of the flat purchase contract depends on the price of the flat today in relation to the price fixed by the purchase contract.

Of course, the flat purchase contract itself can be bought and sold i.e. transferred between different owners. Thats trading in the derivative contract! Derivatives can quickly become very complex. Its easy to think of one, but difficult to price and hedge complex derivatives i.e. to manufacture derivatives.

A derivative is also sometime referred to as a contingent security. That is another way of saying that the value of the derivative security is contingent on the value of some other underlying security or variable. Sometimes you might hear people talk about contingent claim analysis. Thats derivative pricing for the layman. Once derivatives are defined in this general manner its difficult not to think of all financial instruments as derivatives. Every financial instrument you encounter can be thought of as a derivative. Lets start from the most basic one a equity share. What does the value of a share depend upon ?

The price of a bond or a certificate of deposit depends on the interest rate level. The underlying is the interest rate. The price of a BSE index futures contract depends on the value of BSE Sensex today. In order to price and understand derivatives you obviously need to understand how the underlying behaves. This usually involves defining the mathematical process that the underlying variable follows. Most financial variables such as equity

share prices or foreign exchange prices follow stochastic or probabilistic processes. In other words we can only define approximately what the future value of the variable will be. Of course, if you could define the future value exactly, there would not be any fun in it, right? The range of future values or the distribution is defined in terms of statistical parameters that are peculiar to the stochastic processes that the financial variable follows. For those mathematically inclined, most derivatives are priced assuming that the underlying variable follows a Normal or a Lognormal process.

WHY DO PEOPLE USE DERIVATIVES?:

While it's conceptually pretty to think about everything as a derivative, it will be helpful to step back for a moment to think about why people use derivatives. Several reasons why: Derivatives help alter Risk Derivatives offer a simple way for firms or individuals to alter their risk profile - either increase the amount of risk they are running, or reduce (also called hedging) their risk. Derivatives thus transfer risk between market participants - from firms to individuals, between firms from banks to industrial companies and vice versa. A common example of how an individual could use derivatives is stock grants. Many companies provide their employees with grants on their company's stock. These grants are preferential allotments of shares in the company to its employees awarded at the time of an IPO (Initial Public Offering). These preferential allotments usually come with a lock-in period within which it is not possible to sell the shares. Lets say a person owns 100 shares in his/her company that the person cannot sell for the next six months. However, the person believes that there is considerable chance that the share price has peaked and will fall before the shares come out of the lock-in period and can be sold. In order to reduce the risk of losing the current gain implied by today's share price, the person could enter into a forward contract to sell 100 shares six months from today with another counterparty. The forward contract priced off today's share price locks in the price at which the person sells 100 shares six months from today. The risk of share price falling is transferred from the owner of the shares to the forward contract counterparty. Of course, the forward contract counterparty may not have any restrictions on selling shares today and could use this fact to in turn hedge its risk. Derivatives, such as the forward contract described above, transfer risk from one party to another. But, what is the advantage of doing so? Isn't the system as a whole carrying the same risk? Does hedging risk in this manner using derivatives have any overall economic value? It turns out there are five economic reasons why firms or individuals should use derivatives - taxes, transaction costs, debt capacity, cost of financial distress, and reduction of borrowing costs. Derivatives reduce Expected Taxes

Most tax laws (as anyone who as read a tax guide or filled out a tax form will tell you) are complex and one-sided. That means they are usually designed to favor the authority raising the tax. These breakages or irrationalities in tax laws allow a firm or an individual to reduce taxes by altering the timing or size of its cash-flows using derivatives. One common example is that of carried forward losses. Many firms that set up new projects are allowed some tax incentives in their first few years of operation. During these setup years the firm is allowed to pay tax at a lower rate sometimes the firm is given a tax holiday. However, paradoxically these are also the years where the firm makes the least amount of money, as it is paying off startup costs and may not have full production and marketing capacities in place. A common derivative used in such cases is a swap that allows the firm to reduce its tax liability. The swap increases the firm's profits in the initial years and reduces the profits in the subsequent years by bringing forward its cashflows. Another tax rule that allows firms to profitably use derivatives is one that taxes capital gains at a rate different from revenue gains. Derivatives can be used to change the nature of gains from revenue gains to capital gains or vice versa depending on which is taxed at a lower rate. The other manner in which derivatives reduce expected taxes is, they allow a firm to hedge its earnings streams. By hedging its revenue or expense streams, a firm is reducing the uncertainty in the cash-flow streams. By reducing this uncertainty, the firm also reduces its expected tax outflow. (See example below on carry forward losses) Example : Carry Forward Losses and Derivatives: Let there be equal probability of the firm having a pre-tax income of +500 and -300. The firms expected earnings are then: E(Earnings) = * (500) + * (-300) = 250 -150 = 100 If the tax rate on earnings is 30%, then the tax on expected earnings is: Tax(E(Earnings)) = T(100) = 30 If the firm is allowed to carry-forward all its losses, then in a multi-period case, the firm can always reduce its profits by deducting prior period losses. Thus, a loss creates an equivalent amount of tax credit that can be used in later periods (like a tax refund). The expected tax of the firm then is: E(Tax) = * Tax(500) + * Tax(-300) = * 150 + * (-90) = 75 - 45 = 30 The expected tax of the firm and tax on expected earnings is the same. The situation changes if the firm is allowed to carry forward only half its losses. Under this regime the tax on expected earnings remains the same. Tax(E(Earnings)) = 30 However, the expected tax changes as losses now provide only half the tax credit as before. The expected tax is: E(Tax) = * Tax(500) + * Tax(-300) = 75 + * (30% * -150) = 75 - * 45 = 75 - 22.5 = 52.5 You may have intuitively reached the same conclusion. The expected tax is higher than the tax on expected earnings. In such a case, if a firm is able to hedge its earnings so that its earnings are always equal to the expected earnings level, its expected tax will be: E(Tax) = 1 * Tax(100) = 30 Derivatives reduce Transaction Costs Derivatives are such convenient ways to transfer risks, that firms and institutions can now choose exactly which risks they wish to run and which they would rather discard. This leads to a natural specialization in risk taking ability. Firms that refine crude can choose to assume crude oil price risk, whereas banks and financial institutions can choose to assume interest rate and foreign exchange risk. They can each transfer non-core risk elements to other firms by using derivatives. This leads to a natural accumulation of risk in the hands of financial intermediaries such as banks and insurance companies. Firms can then use economies of scale to manage risk more efficiently. Many risks cancel each other at the portfolio level, and the firm need manage only the net residual risk. This naturally reduces the number of hedging transactions that need

to be executed to hedge the same portfolio. Large banks and financial institutions acting as market makers make the financial system more efficient. None of this would have been possible without the use of derivatives to smoothly transfer risk amongst market participants. Derivatives reduce cost of financial distress and increase the debt capacity of the firm When firms use derivatives to hedge their income or expense streams, they reduce the volatility of the stream of future cash-flows. A firm's expected cost of financial distress depends on: a. the probability of financial distress or default and b. the cost when in a defaulted situation. Hedging derivatives reduce expected cost of financial distress by reducing factor (a). As the firm is less likely to default if its earnings are less volatile, derivatives directly reduce the expected cost of financial distress. Naturally, a firm less likely to default will also be charged a smaller credit spread by its lenders and given larger amounts of debt by its lenders. Thus, derivatives increase the debt capacity and reduce borrowing costs as well. Derivatives "arbitrage" Regulations Finally, while few practitioners like to admit this, derivatives are commonly used to get around regulations relating to flow of capital (sovereign regulations), accounting and securities ownership. A foreign equity investor may wish to hedge its exposure to foreign exchange rate fluctuations. However, country regulations may prohibit the investor from hedging directly. Enter from left stage - Mr. Derivative in the form of a nondeliverable forward contract1 ! These derivatives are described in greater detail in the sections that follow.
1

A non-deliverable forward contract is like a standard forward contract, except that only the net value of the contract is settled on maturity. The net value is determined by looking at a standard fixing page. Principal cash-flows are not delivered, hence the name.

2. Interest Rates Refresher

COMPOUNDING:

Before we plunge into the course, this section and the one that follows takes you through the basics of interest rates and foreign exchange. If you know all this stuff already, you can skip Chapters 2 & 3. You still have to get past the section questions though! It's not that we don't believe you, we just want to be sure that everyone is on the same page as far as the basics are concerned. The arithmetic of interest rates is rooted in the time value of money. Very simply, a sum of money given today is worth more than the same sum of money promised at a future date. This is because the sum of money can be invested to produce a positive return on the initial investment over time. To an investor interest is then simply the compensation for deferring consumption to some future date. To a borrower, interest is cost of money. Simple Interest and Compound Interest: Simple interest is the interest earned on the principal amount invested or borrowed. Compound interest has two parts. The first is the interest on the principal amount. The second is the interest earned on the interest amount. Interest earned on interest is also known as re-investment return. If an amount A is invested at a simple interest rate of r for a period of T years then the maturity value of the investment will be: Equation 1

If the same amount is invested for 'T' years at a compound interest rate of 'r' then the maturity value will be: Equation 2

This is, of course, the maturity value if the interest rate is compounded annually. Compounding frequency is the frequency with which interest is paid out. If interest is paid out n times in a year, then each interest amount is r / n. The principal and this interest amount is re-invested nT times. The maturity value is then : Equation 3

Example 1: T = 5; A = 100; r = 10%; n = 1 Maturity value = 100 (1 + 0.10)5 = 161.051 Example 2: T = 5; A = 100; r = 10%; n = 2 Maturity value = 100 (1 + 0.10/2)5x2 = 162.88946

Example 3: T = 5; A = 100; r = 10%; n = 4 Maturity value = 100 (1 + 0.10/4)5x4 = 163.86164 Example 4: T = 5; A = 100; r = 10%; n = 1 Maturity value = 100 (1 + 0.10/365)5x365 = 164.86084

CONTINUOUS COMPOUNDING:

In general, the more frequent the compounding the higher the effective interest rate and lower the nominal interest rate. In the limiting case if we make 'n' a very large number close to infinity then the interest rate is said to be continuously compounded. The maturity value is : Equation 4

where e is the mathematical constant 2.71828. For mathematical simplicity, continuously compounded interest rates are used frequently in derivatives pricing formulae as they are easier to manipulate (mathematically, that is) than the compound interest formula in Equation 2. However, interest rates in real life are rarely quoted on a continuously compounded basis. Conversions from one form of compounding to another are made by simply solving the following equation:

Equation 5 Here, loge is the natural logarithm of a number and R is the interest rate that is compounded with a frequency N. Let's work out an example on the basis of the above. What is the continuously compounded interest rate that is equal to an interest rate of 10% per annum, compounded semi-annually?

We have introduced the concepts of compounding and also seen the ultimate in compounding frequency - continuously compounded interest rates. We have also seen how to convert between interest rates that are quoted on the basis of a different compounding frequency.

DAY COUNT CONVENTIONS:

The next convention about interest rates that makes life difficult for a newcomer (and many old-timers as well) is the day

count convention. Simply put, day count conventions tell us how to count the number of days between two interest dates and convert the number of days into a year fraction. A year fraction has two parts: 1. The numerator that is the number of days between two dates 2. The denominator that is the number of days in a year The day count conventions that are commonly used are: Act/360 The number of days between two dates is the Actual number of days. The denominator that contains the number of days in a year is 360. This is the day count convention used for US Dollar deposits, and most G7 currency deposits. Let's work an example: Example 5 The interest payable on a deposit is 12.00% per annum, Act/360, payable on maturity (i.e. simple interest). What is the interest amount on a deposit of 100,000 between 1-Jan-2000 and 1-Jun-2000? The actual number of days between 1-Jan-2000 and 1-Jun-2000 = 152 (we include the first date and exclude the last date)

Act/365 This convention is similar to the previous one, except that the denominator used is 365 instead of 360. This is the day count convention used for INR deposits and most emerging market currency deposits. 30/360 The denominator year count used is 360. The denominator is the number of 30 day months between two dates. The rules for calculating this are a little confusing. Let's assume that the beginning date is (Da, Ma, Ya) and the end date is (Db, Mb, Yb). Then, If Da is 31 always change it to 30 If Db is 31 leave it alone unless Da is 30 or 31, when Db becomes 30. Then the number of days between the two dates as per the convention is: Equation 6:

30E/360 This is a slight variant of the 30/360 convention. The denominator remains the same, the numerator is computed as follows: If Da is 31 change it to 30 If Db is 31 change it to 30 Apply Equation 6. Let us work an example to see the difference between the two conventions and with the Act/360 convention: Example 6 What is the number of days between 1-Jul-2000 and 31-July-2000 using (a) 30/360 convention and, (b) 30E/360 convention? (a) 30/360: Ya = Yb = 2000 Ma = Mb = 7 Da = 1; Db = 31 (check this with our rule for 30/360) Then, the number of days = 31 - 1 = 30

(b) 30E/360: Ya = Yb = 2000 Ma = Mb = 7 Da=1 Db=30 (changed from 31, as if Db = 31 then change it to 30) Then, the number of days = 30 - 1 = 29 Act/Act This convention is used in the US Treasury bond market. The numerator is the actual number of days between two interest dates. For the denominator, we take the actual number of days in the current coupon period and multiply it by the number of coupons paid in a year. So, if the number of days in the current coupon period is 184 and coupons are paid twice a year, the denominator will be 2x184 = 368.

Converting interest rates quoted in one convention to an equivalent rate in another convention is easy. Example 7: If RAct/365 is the interest on a Act/365 day count convention, and RAct/360 is the equivalent rate on a Act/360 convention, then:

Do I need to remember all this? In practice, one does not have to laboriously calculate the interest amount or remember the convention for different day count bases. Most spreadsheet programs have built-in date functions that do this for you. I find the Excel function Yearfrac particularly useful for all my pricing spreadsheets. Check it out now, if you have Excel installed on your computer. The function provides built-in calculations for Act/360, Act/365, 30/360 and 30E/360 day count conventions.

FLOATING INTEREST RATES & BENCHMARKS:

Interest rates like all other financial market rates vary with time. A financial institution makes loans to its customers or purchases investments by accepting deposits or re-financing itself from other banks. The interest rate on a loan (or in general an asset on a firm's balance sheet) or a deposit (or in general a liability on a firm's balance sheet) can be fixed over its entire life or varied at periodic intervals. If the interest rate is varied or re-priced at periodic intervals it is said to be floating. As re-fixing the interest rate may cause disagreement on the actual interest rate to be used, the re-fixing is usually done by referring to a market benchmark rate set by a neutral body such as an association of banks (e.g. British Bankers Association, Foreign Exchange Dealer's Association of India etc.) or an information services provider such as Reuters or Telerate. The most widely known benchmark rate is LIBOR. What does LIBOR stand for ?

LIBOR is calculated every working day in London by a poll conducted by the British Banker's Association. Around 11 a.m. London time, 20 or more banks are asked what, in their view, are the offered rates at which deposits are quoted to prime banks in the London inter-bank market at 11 am London time. The two highest and two lowest rates are discarded and an average of the remaining quotes is fixed as the LIBOR for each tenor. LIBOR fixings are published daily on Reuters

and Telerate. It is interesting to note how carefully the question is worded. The banks are not expected to disclose the actual rates at which they have dealt with other prime banks. They are expected to give only the rate that they believe is being quoted. Floating Interest Rate Resets: When a floating interest rate loan is made, the interest rate for an interest period is fixed two business days prior to the start of the interest period. Sometimes, the interest rate for the period may be fixed two business days prior to the end of the period. This is unusual; this form of fixing is known as fixing in arrears. Normal Floating Interest Rate Reset:

Interest Set in Arrears:

What are the issues in using a Benchmark Rate? Inter-bank deposits are a good way to set interest rate benchmarks that are used in floating rate loans and deposits. However, in most emerging markets there are high levels of mandatory reserve requirements on deposits. Reserves may have to be maintained in the form of liquid securities or cash. Reserve requirements distort deposit pricing, and hence interbank deposit rates no longer make good benchmark rates. In many emerging markets (including India), the Swap Offer Rate ("SOR") as implied by the foreign exchange swap market is used as the benchmark short term interest rate. Loans, deposits and derivative contracts that use floating interest rates are priced off the SOR. In the next section, we will see how this SOR is derived from the foreign exchange market. SOR benchmarks are usually published on Reuters and determined by an association of banks.

Broadly, in order to satisfy the requirements of a good benchmark rate a fixing must satisfy the following criteria: Fairness: The rate must be fair to both the borrower and lender. One party to deposit transaction should not have an undue influence in setting the rate. Accessibility: The rate set must be accessible for both borrowing and lending transactions. Liquidity: The benchmark rate must be a liquid rate. In other words, it must be good for dealing in reasonable amounts. There must not be any significant change in the market rate if reasonable amounts are dealt (sometimes the change in rates caused because of the amount dealt is called the impact cost of dealing). The benchmark rate must also be easily available from a number of market makers. Transparency: The rate must be determined in a transparent manner by an independent agency. Basis Risk: The benchmark rate must closely track the actual cost incurred in borrowing or lending. For example, if a bank borrows at a floating rate linked to LIBOR and lends at a rate linked to the Swap Offer Rate, it is running a basis risk.

3. Foreign Exchange Refresher

If you are a cat in the foreign exchange markets, skip this section. For those who are a little rusty, or beginning out, read on. For an excellent introduction to the Basics of Foreign Exchange ,see our online course. Foreign exchange markets trade in the value of one currency against another. Foreign exchange (or "FX") rates express the value of one currency against another currency. So, in a FX rate there are two currencies involved: Commodity or Fixed currency: This is the currency whose unit value is measured in terms of variable amounts of the other currency. Terms or Variable currency: The currency used to express the value of the Commodity or Fixed currency. Example 8: 1 Euro = 0.9550 US Dollars Here Euro is the Commodity currency and US Dollar is the Terms currency. 1 US Dollar = 44.70 Indian Rupees Which is the Commodity currency and which one is the Terms Currency ?

The foreign exchange market is possibly the most perfect market in the world. The market is open 24 hours a day, five days a week. At any time during the day it possible to buy or sell very large amounts of one currency against another currency. In a dealing room of a large bank it is not uncommon to buy or sell amounts as large as 1 billion US Dollars against other currencies in a matter of minutes. The total volume traded daily in the foreign exchange market is more than 1 trillion US dollars! Foreign exchange rates are usually quoted in the form of a two-way price. A two-way price comprises of a bid price, a price at which the market maker will buy the commodity currency and an offer price, a price at which the market maker will sell you the commodity currency. The difference between the bid price and the offer price is called the bid-offer spread. Example 9: Typical quote for US Dollar ("USD")/Japanese Yen ("JPY"): 1 US Dollar = Japanese Yen 105.25 / 105.28 Here 105.25 is the rate at which the market maker, will buy US Dollars from you (the bid rate). 105.28 is the rate at which the market maker will sell US Dollars to you (the offer rate). You can see that the bid-offer spread always favors the market maker. In this case, when the market maker buys 1 USD, you receive in exchange 105.25 JPY. If you buy USD instead, you will need to pay 105.28 JPY which is 0.03 JPY more than what you received on the other transaction. As you can see, in an FX transaction two cashflows are exchanged - one in the commodity currency and the other in the terms currency. The market convention refers to the party that receives the commodity currency as the buyer in the FX transaction. The other party that pays the commodity currency is therefore the seller. In the earlier example (Example 9), if you are the buyer of USD 1 then the cashflows will look like this:

SPOT TRANSACTIONS:

The default settlement period when these cashflows are exchanged in the foreign exchange markets is in two business days. This is also known as a Spot transaction. The cashflows are settled in the respective clearing centers. For US Dollars the clearing center will be New York; for Sterling Pound, London; for Japanese Yen Tokyo; of course, for the Indian Rupee it is Mumbai. Due to time zone differences, usually two clear business days are required to send settlement instructions (funds transfer instructions to transfer funds from your account to the counterparty's account) to the clearing center. The two business days must not be holidays in either clearing center. Example 10: If the transaction date is Monday, 19-Jun-2000 for a USD-JPY Spot FX deal, then the Spot Settlement Date will be Wednesday, 21-Jun-2000. 20-Jun-2000 and 21-Jun-2000 both must be working days in New York and Tokyo. If they are holidays in either place, the settlement date is postponed to the next working day. If the transaction date is Thursday, 22-Jun-2000 for a USD-JPY transaction, then the Spot Settlement Date will be 26-Jun2000. Saturday and Sunday are not working days in Tokyo and New York. Cashflows may be exchanged before the Spot Date. If cashflows are exchanged for the same day value, it is called a Cash FX deal. If it is settled the next business day, then it is called a Tom FX deal.

FORWARD TRANSACTIONS

If the settlement date for a FX transaction is more than two business days away, it is called a forward transaction. Because cashflows in the future are worth less than the same cashflows today, the Forward FX rate is different from the Spot FX rate. Example 11: A FX deal to buy 1 USD against JPY settled two months from today is a forward transaction. Transaction Date: 19-Jun-2000 Settlement Date: 21-Aug-2000 (19 & 20th Aug. are weekend holidays) It turns out that it is possible to calculate the Forward FX rate from the Spot FX rate and the interest rate for the two currencies involved. Forward FX Rate (USD/JPY) = Function of (Spot FX Rate, USD interest rate, JPY interest rate) The interest rate for the currency is the interest rate applicable for the period from the Spot Date to the Settlement Date of the forward FX deal.

For a detailed discussion of how to determine the Forward FX rate, see : "Financial Derivatives :Forwards, Futures

&Swaps", Chapter 1.2. For the purpose of this refresher it will suffice to say we can calculate the Forward FX rate from the Spot FX rate and two interest rates using the formula: Equation 7:

where, S= Spot Rate RC = Commodity Currency Interest Rate for the tenor T RT = Terms Currency Interest Rate for the tenor T TC = Year fraction for the period from the Spot Date to the Forward FX settlement date using the day count basis for RC TT = Year fraction for the period from the Spot Date to the Forward FX settlement date using the day count basis for RT What is the USD-INR forward FX rate for the following deal? Deal Date: 19-Jun-2000 Spot Date: 21-Jun-2000 Forward FX Settlement Date: 21-Sep-2000 Spot Rate: 1 USD = INR 44.70 USD Interest Rate = 6.70%, Act/360 basis INR Interest Rate = 10.00%, Act/365 basis

The Forward FX Rate is higher than the Spot Rate of 44.70. The difference between the Forward FX Rate and the Spot Rate is called Swap Points. If the Swap Points are positive, the commodity currency is said to be at a Premium in the forward market. From equation 7, you can see that this will be the case when the terms currency interest rate is greater than the commodity currency interest rate. If it's the other way around where the Forward FX rate is lower than the Spot Rate, the commodity currency is said to be at a Discount in the forward market. This will be the case when the terms currency interest rate is lesser than the commodity currency interest rate (e.g. JPY interest rates are lower than USD interest rates, hence USD is at a discount in the forward market).

IMPLIED SWAP OFFER RATES:

In Chapter 2, we had promised to explain how a floating benchmark interest rate, Swap Offer Rate, is derived from the Forward FX market. Again, it all comes back to equation 7. From equation 7, we can see that the Forward FX rate is directly derived from the Spot Rate and two interest rates. Like any mathematical equation, this would work the other way around as well. Suppose we knew the Forward FX rate, the Spot Rate and one interest rate. We could then use equation 7 to derive the second interest rate. Or, if we knew the Forward FX rate and the two interest rates, we could derive the Spot Rate. The relationship can be described by the diagram below:

So, if we flip equation 7 around we can use the FX forward market, the Spot Rate and one interest rate to derive the second interest rate. If we want to find out the terms currency interest rate implied by the Forward Rate then the formula is:

Equation 8:

(try and derive this formula from equation 7 yourself)

4. Commodities and Financial Markets

You might wonder how a section on commodities is important to our understanding of the derivatives markets. It turns out that commodity derivatives are an important tool used by hedgers worldwide to hedge their commodity trades. Commodity derivatives have been written on most things that you can think of: Precious metals: Gold, silver, platinum, palladium Base metals: Aluminum, Zinc, Copper, Nickel Energy: Crude oil, Gas, Electricity Food: Soybean, Corn, Wheat, Orange juice, Coffee, Pork Bellies! Others: DRAM chip prices, Weather! Most of these commodity prices are defined in standard ways so as to avoid the confusion that may be associated with dealing with real commodities rather than abstract financial market variables such as foreign exchange rates or interest rates.

COMMODITY TYPES

Commodities traded in financial markets fall into two broad categories: Investment commodities: These include Gold, Silver, Platinum Consumption commodities: Oil, Orange Juice, Soybean, Coffee etc. Commodities purchased for consumption need to be treated slightly differently from those that are held purely for investment. Do you take Delivery of a commodity derivative contract ?

STORAGE COSTS AND CONVENIENCE YIELDS

It turns out that pricing a commodity derivative is very similar to pricing a derivative on any other financial instrument. The difference lies in storage costs and convenience yields. Storage Costs It is common sense that it costs money to physically store a commodity. For a precious metal such as Gold or Silver this storage cost would be expense of hiring a safe deposit box at a bank or institution specializing in safekeeping precious metals. For oil or corn it would be cost of hiring warehouse space, as well as any wastage incurred during storage due to leakage or deterioration in the commodity. Insurance premiums paid to insure the inventory from loss due to fire, theft etc. also adds to storage costs. Thus, unlike cash in the bank, or shares which earn interest or dividend as long as they are with us, commodities actually cost money to keep. Storage costs can be thought of being similar to a negative interest rate. When you deposit gold in a bank, instead of earning money, you have to pay the bank to store it for you. So any derivatives pricing formula for a financial instrument such as equities, foreign exchange or bonds can be used to price commodity derivatives by replacing the interest rate with a "negative interest rate" equivalent to the storage cost rate. Convenience Yields Convenience yield is subtly more interesting. Unlike a financial instrument such as a bond or a equity share there might be an additional value to physically owning a commodity today than a forward contract on the commodity that settles at a future date. This additional value arises from the fact that the commodity is used in a production process and inadequate availability of the commodity in the future due to supply shortages may hamper the production process. So, users may prefer to store the commodity as inventory rather than enter into a derivative contract that net settles at a future date. Unlike financial instruments, commodities are tougher to manufacture! This additional value is simply known as a

convenience yield, the additional "yield" obtained due to physical ownership of the commodity. Convenience yield is directly related to the level of inventories that exist for a commodity. The higher the inventory levels, lower convenience yields are likely to be.

Again, just as storage costs can be thought as negative interest rates, convenience yields are similar to a dividend or interest yield earned by owning the underlying security. Hence, any derivative formula used for pricing a derivative on a equity or bond can be used for pricing a commodity derivative by replacing the interest rate term with net of storage costs and convenience yield. Commodity "Interest Rate"= Convenience Yield - Storage Cost

5. The Three Building Blocks

The financial markets trade in a bewildering array of cash (as in non-derivative) and derivative products. Almost every financial institution has its own custom designed derivative product that offers unique payoffs different from products offered by other firms. But, are these financial products all so different from each other or can they be decomposed into more basic financial products? The title gives it away here - it turns out that all financial products can be broken down into a combination of three basic financial products: Credit extension Price fixing Price insurance This section provides a brief overview of each type of basic financial product, as well as some examples of combining them to create complex financial products.

CREDIT EXTENSION PRODUCTS

Credit extension products are forms of extending credit or loans. These are the products all of us are most familiar with. At some time, all of us have dealt in a credit extension product. When we place a deposit with a bank, we have extended credit to the bank. If the bank goes bust, we will lose all the money placed as deposit. If you purchase a bond issued by a firm, you have extended credit to the firm. Gentlemen prefer bonds.. Bonds, deposits, promissory notes, commercial papers, loans are all forms of credit extension products. Credit extension products differ from each other in how they pay interest and how the principal is repaid. The four basic types of credit extension products are: Fixed Rate: A bond, loan or deposit that provides a return at a fixed interest rate. Floating Rate: A bond, loan or deposit that provides a return at a floating interest rate (see our section on how floating interest rates are determined and reset). Bullet: The term bullet refers to how the credit extension product pays back the principal. If the principal pays back in one installment, at maturity, the repayment is said to be "bullet". Amortizing: If the principal is repaid in installments over time, the principal is said to be amortized. A annuity deposit, or a loan that is repaid in equal installments over time are examples of amortizing credit extension products. Of course, the principal may not be drawn down in one shot but gradually over time. If it is drawn down over time and then repaid in installments, the principal repayment type is called Roller Coaster (can you guess why?!). On-balance sheet Credit extension products usually appear on the balance sheet of the firm as a real asset or liability. This is in contrast to most derivative products that are off-balance sheet. Most derivative contracts appear as contingent assets or liabilities on the firm's balance sheet. Thus, while the accounting world finds it easy to account for the value of on-balance sheet products such as loans and deposits (credit-extension products), other derivative products are considerably more difficult to account for in a consistent way.

Cashflows on a 2 year Fixed Rate loan with Bullet Repayment

Cashflows on a 2 year Floating Rate loan with Bullet Repayment of principal

Cashflows on a loan with Equal Amortizations of Principal

Principal cashflows on a "Roller Coaster" loan

Principal outstanding on a "Roller Coaster" loan

PRICE FIXING PRODUCTS

Price fixing products are financial products that fix the price at which exchange of value takes place at a future date. Price fixing products are all around us. We have already seen an example of a price fixing product in foreign exchange. A FX forward contract fixes the rate at which we will exchange two cashflows in different currencies at a future date. If you agree to purchase a flat from someone in 3 months time at a rate of Rs. 1500 / square feet, you have entered into a price fixing contract. There are three main types of price fixing products that we encounter: Forward Contracts Futures Contracts Swaps In the next module 'Financial Derivatives : Forwards, Futures & Swaps' , we will look at each of these products in some detail. Value of a Price Fixing Product The value of a price fixing product is simply a function of the current price for the same cashflow exchange in relation to the price fixed in the contract. If the value of the price fixing product is positive for the holder, it is said to be in the money. If the value is negative it is out of the money. If the value is zero it is called..

If we graph the value of the price fixing product as a function of the market price, we will get something like this:

If the market price on maturity is less than the forward contract price, and we have agreed to purchase the underlying (also referred to as being Long the underlying) we have incurred a loss. If the market price is more than the forward contract price and we have purchased the underlying, we have made a profit on the forward contract. The P/L equation for a forward contract: P/L = (Market Price - Fwd Contract Price) x Amount Purchased

The value of the forward contract depends on the price of the underlying being purchased. The forward contract is thus a derivative. If we have agreed to sell the underlying in the forward contract, we are said to be Short the underlying. The P/L equation will simply be the negative of the formula written above: P/L = (Fwd Contract Price - Market Price) x Amount Sold The graph drawn above is also called a Payoff Diagram. It is very commonly used to graph the P/L profile for derivatives and we will use it frequently during the rest of the module. Binding obligation on both parties Price fixing products such as the forward contracts described above create a two-way obligation. Price fixing products create an obligation on both parties to perform the exchange of value at the future date. Not doing so will amount to a default on the contract. For example, if you reneged on buying the flat at the agreed price, it would be a default on the flat purchase forward contract. Obviously, you would not default if the price moved in your favor. If the current price of the same flat in the market is Rs. 2000 / square feet, there would be no incentive for you to default as the flat forward contract is in the money. If the current price of the flat is Rs. 1000 / square feet, on the other hand, there would be some incentive for you to default as the flat forward contract is out of the money. Thus, price fixing products also create credit risk exposure on the counterparty. The only difference from the credit extension products is that the credit exposure varies depending on whether the price fixing product is in the money or out of the money. The ideal situation would be if we could enter into a contract that would allow us to purchase the underlying if the contract was in the money, and walk away from the contract if it was out of the money. Sounds too good to be true? Not really, and the third basic type of financial products do exactly this - insure the price for the buyer or the seller of an underlying.

PRICE INSURANCE PRODUCTS:

Price insurance products give the owner the right, but not the obligation, to exchange value at a future date, at a predetermined price today. As the owner of a price insurance contract you can either exercise your right or walk away if it is advantageous for you to do so. Let's see an example. Example 12: A RIL equity warrant provides the owner the right to convert 1 warrant into 1 share of RIL any time within the next 3 years at a price of Rs. 300 per share. This is a price insurance product. If you own this warrant, you will choose to exercise your right to convert (i.e. purchase 1 share of RIL) if the market price is more than Rs. 300. By exercising your right, you can then make a profit by selling the same share at the higher market price. If RIL shares were trading below Rs. 300, it would make no sense to exercise the right. You could buy the shares cheaper in the market, rather than convert the warrant. You can never lose more money in this product than the initial outlay to purchase the warrant. The P/L formula for one RIL equity warrant will be: If RIL share price > Rs. 300, then P/L = (RIL share price - 300) - Warrant Cost If RIL share price <= Rs. 300, then P/L = (-Warrant Cost) This can also be written in one line as: P/L = Maximum of (RIL share price - 300, 0) - Warrant Cost The P/L (or payoff) from this warrant will look like this:

Price insurance products are also known as Options. Options are of two types: Call Options: Price insurance products that give the owner the right to buy the underlying at a pre-determined price in the future. The warrant described above is a call option on RIL shares. Put Options: Price insurance products that give the owner the right to sell the underlying at a pre-determined price in the future. Can you think of an example of a put option? (Hint: Car insurance policy)
One-sided obligation Price insurance products give the owner a right but not the obligation to exercise. What about the other party to the price insurance product - the seller of the option? It turns out that the seller of the price insurance product / option has an obligation to perform if the buyer exercises. The seller cannot renege or walk away from the contract.

Options thus create one way obligations. The seller of the option is obligated to perform.

The seller of an option is also known as the writer of the option. Off-balance sheet Price fixing products are obligations of the parties to the contract at a future date. As they have no cashflow exchanged today, the transaction date, these represent contingent liabilities of the parties to the contract. Price fixing products do not appear on the balance sheet as real assets or liabilities, but appear below the line as contingent items. Because they are not balance sheet intensive, many firms prefer these products as they do not bloat the balance sheet. Increasingly, accounting bodies require capital to be set aside and mandatory revaluation for price fixing and price insurance products that appear as contingent liabilities on a firm's balance sheet.

COMBINING THE BUILDING BLOCKS

Now that we have seen the three basic building blocks of all financial products, it's Lego time! Let us try our hand at analyzing a complex product: Analyzing a Convertible Bond: Analysis is the process of breaking down a complex idea or product into more basic components and then evaluating the basic components. We are going to a complex financial product and break it down into its basic building blocks. A convertible bond is a bond that gives its holders a fixed coupon. At or before the maturity of the convertible bond, the holder has the right to convert the bond into equity shares of the issuer at a fixed conversion price. Of course, if the holder decides not to convert the bond into shares, it receives the principal amount back on the maturity date. A typical convertible bond may have the following terms:

Financial professionals when analyzing products typically look for keywords that give clues on the embedded components. The two clues here are in the words "right" and "interest rate". The first tells us that there is an embedded price insurance product (or option). The second together with the word "bond" tells us that there is a credit extension product bundled in as well. It turns out that a convertible bond is package of an equity warrant and a coupon-bearing bond - a package consisting of a price insurance product and a credit extension product.

Pricing a convertible bond is then simply a matter of pricing the individual components and snapping the blocks together. The issuer, XYZ, thus sells an equity warrant together with a coupon bearing bond to the buyer of the convertible. The price of the equity warrant subsidizes the coupon payout. Hence, convertible bonds typically provide a interest return lower than a plain bond issued by the same firm. Hence, Price of convertible bond = Price of Equity Warrant + Price of Coupon Bond This concludes our basic module on derivatives.The objective here was to lay the foundation on the concept of derivatives. Only if you are crystal clear at this stage , should you move on to our next module. Feel free to revise what you have learnt.