MODULE 5

DERIVATIVES

Rise of Derivatives
The global economic order that emerged after World War II was a system where many
less developed countries administered prices and centrally allocated resources. Even the
developed economies operated under the Bretton Woods system of fixed exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation and
unemployment rates made interest rates more volatile. The Bretton Woods system was
dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like
India began opening up their economies and allowing prices to vary with market
conditions.
Price fluctuations make it hard for businesses to estimate their future production costs
and revenues.2 Derivative securities provide them a valuable set of tools for managing
this risk. This article describes the evolution of Indian derivatives markets, the popular
derivatives instruments, and the main users of derivatives in India. I conclude by
assessing the outlook for Indian derivatives markets in the near and medium term.

Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long
time. In the area of commodities, the Bombay Cotton Trade Association started futures
trading in 1875 and, by the early 1900s India had one of the world’s largest futures
industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years, government
policy has changed, allowing for an increased role for market-based pricing and less
suspicion of derivatives trading. The ban on futures trading of many commodities was
lifted starting in the early 2000s, and national electronic commodity exchanges were
created.
In the equity markets, a system of trading called “badla” involving some elements of
forwards trading had been in existence for decades.6 However, the system led to a
number of undesirable practices and it was prohibited off and on till the Securities and
Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the
stock market between 1993 and 1996 paved the way for the development of
exchangetraded equity derivatives markets in India. In 1993, the government created the
NSE in collaboration with state-owned financial institutions. NSE improved the
efficiency and transparency of the stock markets by offering a fully automated screen-
based trading system and real-time price dissemination. In 1995, a prohibition on trading
options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded
derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended
a phased introduction of derivative products, and bi-level regulation (i.e., self-
regulation by exchanges with SEBI providing a supervisory and advisory role).
Another report, by the J. R. Varma Committee in 1998, worked out various operational
details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act
of 1956, or SC(R)A, was amended so that derivatives could be declared “securities.” This
allowed the regulatory framework for trading securities to be extended to derivatives. The
Act considers derivatives to be legal and valid, but only if they are traded on exchanges.
Finally, a 30-year ban on forward trading was also lifted in 1999.
The economic liberalization of the early nineties facilitated the introduction of derivatives
based on interest rates and foreign exchange. A system of market-determined exchange
rates was adopted by India in March 1993. In August 1994, the rupee was made fully
convertible on current account. These reforms allowed increased integration between
domestic and international markets, and created a need to manage currency risk. Figure 1
shows how the volatility of the exchange rate between the Indian Rupee and the U.S.
dollar has increased since 1991.7 The easing of various restrictions on the free movement
of interest rates resulted in the need to manage interest rate risk.

Meaning and definition

In finance, a derivative is a financial instrument derived from some other asset; rather
than trade or exchange the asset itself, market participants enter into an agreement to
exchange cash, assets or some other value at some future date based on the underlying
asset.
The term derivatives indicates that it has no independent value ie., its value is entirely
derived from value of underlying asset. The underlying asset can be securities,
commodities, bullion, currency, indices, live stock etc. Derivative means a forward,
future, option or any other hybrid contract of pre determined fixed duration, linked for the
purpose of contract fulfilment to the value of a specified real or financial asset or to an
index of securities.
There are many types of financial instruments that are grouped under the term
derivatives, but options/futures and swaps are among the most common.

BASIC FEATURES OF DERIVATIVES

1. As derivatives are not physical assets , transactions are setteled by
offsetting/squaring transactions. The difference in value of derivative is cash
setteled.
2. There is no limit on number of units transacted in derivative market because there
is no physical asset to be transacted.
3. Derivative markets are usually the screen based /computarised.
4. Derivatives are secondary market securities and and cannot help raising funds to a
firm.
5. Derivative market is quiet liquid and transactions can be effected easily.
6. Derivative provides a hedging against different risks.

The participants in a derivatives market

• Hedgers use futures or options markets to reduce or eliminate the risk associated
with price of an asset.
• Speculators use futures and options contracts to get extra leverage in betting on
future movements in the price of an asset. They can increase both the potential
gains and potential losses by usage of derivatives in a speculative venture.
• Arbitrageurs are in business to take advantage of a discrepancy between prices in
two different markets. If, for example, they see the futures price of an asset getting
out of line with the cash price, they will take offsetting positions in the two markets
to lock in a profit.
Types of derivatives

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which
are distinguished by the way that they are traded in market:

• Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or
other intermediary. Products such as swaps, forward rate agreements, and
exotic options are almost always traded in this way. The OTC derivatives
market is huge. According to the Bank for International Settlements, the
total outstanding notional amount is USD 298 trillion (as of 2005)[1].

• Exchange-traded derivatives are those derivatives products that are traded via
Derivatives exchanges. A derivatives exchange acts as an intermediary to all
transactions, and takes Initial margin from both sides of the trade to act as a
guarantee. The world's largest[2] derivatives exchanges (by number of
transactions) are the Korea Exchange (which lists KOSPI Index Futures &
Options), Eurex (which lists a wide range of European products such as interest
rate & index products), Chicago Mercantile Exchange and the Chicago
Board of Trade. According to BIS, the combined turnover in the world's
derivatives exchanges totalled USD 344 trillion during Q4 2005.

Types of Derivatives

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded contracts

Options: Options are of two types - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are :
• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the
parties, with the cashflows in one direction being in a different currency than those
in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.

Examples

Some common examples of these derivatives are:

CONTRACT TYPE
Exchange Exchange
UNDERLYING
traded traded OTC swap OTC forward OTC option
futures options
Option on
DJIA Index DJIA Index
future future
Equity Index n/a Back-to-back n/a
NASDAQ Option on
Index future NASDAQ
Index future
Option on
Interest
Eurodollar Eurodollar
rate cap
Money future future Interest Forward rate
and floor
market Euribor Option on rate swap agreement
Swaption
future Euribor
Basis swap
future
Option on Repurchase Bond
Bonds Bond future n/a
Bond future agreement option

Stock
Single- option
Single-share Equity Repurchase
Single Stocks stock Warrant
option swap agreement
future Turbo
warrant
 Foreign Option on Currency
FX future FX forward FX option
exchange FX future swap

Credit Credit
Credit n/a n/a default n/a default
swap option
Other examples of underlyings are:

• Economic derivatives that pay off according to economic reports ([1]) as

measured and reported by national statistical agencies
• Energy derivatives that pay off according to a wide variety of indexed energy
prices. Usually classified as either physical or financial, where physical means the
contract includes actual delivery of the underlying energy commodity (oil, gas,
power, etc)
• Commodities
• Freight derivatives
• Inflation derivatives
• Insurance derivatives
• Weather derivatives
• Credit derivatives

FORWARDS

Forward contract is an agreement entered today between two parties namely buyer and
seller wherein buyer agrees to buy a particular asset at a particular price on a particular
date. In a forward contract, two parties irrevocably agree to settle a trade at a future date,
for a stated price and quantity. No money changes hands at the time the trade is agreed
upon.

Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2001
at Rs.5,000/tola. Here, Rs.5,000/tola is the “forward price of 31 Dec 2001 Gold”.
The buyer L is said to be long and the seller S is said to be short.
Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31
Dec 2001, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to
accept Rs.500,000 on 31 Dec 2001, and give 100 tolas of gold in exchange.

Features

• It’s a unique contract between two parties buyer and

seller
• Forward is unique in terms of size, time and types of asset.
• Price fixation may not be transparent and is publicly not
disclosed.
• Forwards are traded off the exchanges and exposed to default
risk.

Forward markets tend to be afflicted by poor liquidity and from unreliability deriving
from “counterparty risk” (also called “credit risk”).

FUTURES

A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts

Features
• Futures are organized or standardized contract in terms
of quantity, quality, delivery time and place of settlement
• Three parties are involved buyer, seller and clearing
house.
 • Contract expires on a pre-specified date which is called
the expiry date of the contract.
• On expiry futures can be settled by delivery of the underlying
asset or cash.
• Cash settlement enables the settlement of obligations arising out
of the futures/option contract in cash.
• Futures are traded in organized exchanges only.
• Exchange provides counter party guarantee through its clearing
house.
• Participating parties have to deposit an initial cash margin as
well as the difference in traded price and actual price on daily
basis.

Determinants of future prices

Supply and demand on the secondary market determines the futures price. Price of future
refers to the rate at which the futures contract will be entered into. The basic determinants
of future prices are spot rate and other carrying costs which in turn based on rate of
interest and time involved.

On dates prior to 31 Dec 2000, the “Nifty futures expiring on 31 Dec 2000” trade at
a price that purely reflect supply and demand. There is a separate order book for each
futures product which generates its own price.

Economic arguments give us a clear idea about what the price of a futures should be.
If the secondary market prices deviate from these values, it would imply the presence of
arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is
nothing innate in the market which forces the theoretical prices to come about.
 OPTIONS

The right but not the obligation to buy (sell) some underlying cash instrument at a pre-
determined rate on a pre-determined expiration date in a pre-set notional amount.
An option is the right, but not the obligation, to buy or sell something at a stated date
at a stated price. A “call option” gives one the right to buy, a “put option” gives one the
right to sell.

The buyer /holder of the option purchases the right from seller / writer for a
consideration which is called a premium. The seller / writer of an option is obligated to
settle the option as per the terms of contract when the buyer /holder exercises his right.
The underlying asset could be an index, security etc.

Features
• Options are organized or standardized contract
• Three parties are involved buyer, seller and clearing
house.
• Contract expires on a pre-specified date which is called
the expiry date of the contract.
• Futures are traded in organized exchanges only.
• Exchange provides counter party guarantee through its clearing
house.

Call option ( an option to buy )

A call option is a financial contract giving the owner the right but not the obligation to
buy a pre-set amount of the underlying financial instrument at a pre-set price with a pre-
set maturity date.

Put Option ( an option to sell)

A put option is a financial contract giving the owner the right but not the obligation to sell
a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set
maturity date.

European Style Option

It is an option that has to be exercisable only on expiry date An option that can be
exercised only at expiry as opposed to an American Style option that can be exercised at
any time from inception of the contract. European Style option contracts can be closed
out early, mimicking the early exercise property of American style options in most cases.

American Style Option

It is an option that can be exercisable on or before expiry date. An option that can be
exercised at any time from inception as opposed to a European Style option which can
only be exercised at expiry. Early exercise of American options may be warranted by
arbitrage. European Style option contracts can be closed out early, mimicking the early
exercise property of American style options in most cases.

Premium charged in case of American option is more compared to that of European

option. This is because, in case of American option can be exercised at any time before
expiry date.
Naked option or covered option

A call option is covered if it is covered or written against asset owned by the option
writer. In case of excise of the call option by the option holder , the option writer can
deliver the asset or price differential. On the other hand, if the option is not covered by
physical asset, it is known as Naked option.

Differences between forward, future and option

Features Forward Future Option

Standardization No Yes Yes
Liquidity NO Yes Yes
Margin No Yes Yes
Guarantor No CH CH
Obligation to perform B&S B&S Seller
Default risk Yes No No
Parties 2 3 3
Contract closure By delivery By paying price By paying price
differentials differentials

Strike Price

The price at which the holder of a derivative contract exercises his right if it is economic
to do so at the appropriate point in time as delineated in the financial product's contract.
Valuation of options

Valuation depends upon number of factors viz,

1. Current price of the underlying asset
2. Expected volatility in the value of the underlying asset.
3. Strike price of the option.
4. Expiration time of options.(longer the time of expiry higher would be the value of
options)
5. Rate of interest
6. Income from the underlying asset ( int/div – income is generated value of asset
reduces and value of options changes)

In money, out of money and at money options

In money – Brings about gain

Out of money - Results in a loss
At money – no loss no gain

Value or intrinsic value of an option.

It’s the interplay of strike price and market price.

In call option - Mp > Sp In money

Mp < Sp Out of money
Mp = Sp At money.

In put option - Mp < Sp In money

Mp > Sp Out of money
Mp = Sp At money.
STRADDLE
An options strategy with which the investor holds a position in both a call and put
with the same strike price and expiration date . Straddles are a good strategy to pursue
if an investor believes that a stock's price will move significantly, but are unsure as to
which direction. The stock price must move significantly if the investor is to make a
profit. As shown in the diagram above, should only a small movement in price occur
 in either direction, the investor will experience a loss. As a result, a straddle is
extremely risky to perform. Additionally, on stocks that are expected to jump, the
market tends to price options at a higher premium, which ultimately reduces the
expected payoff should the stock move significantly
.

The Black & Scholes Model

European Option Pricing

A model of price variation over time of financial instruments such as stocks that can,
among other things, be used to determine the price of a European call option. The
model assumes that the price of heavily traded assets follow a geometric Brownian
motion with constant drift and volatility. When applied to a stock option, the model
incorporates the constant price variation of the stock, the time value of money, the
option's strike price and the time to the option's expiry.

The Black Scholes Model is one of the most important concepts in modern financial
theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and
is still widely used today, and regarded as one of the best ways of determining fair prices
of options.

There are a number of variants of the original Black-Scholes model.

The Assumptions Underlying the Model

1. No dividends are paid out on the underlying stock during the option life.
2. The option can only be exercised at expiry (European characteristics)
3. Efficient markets (Market movements cannot be predicted)
4. Commissions are non-existent
5. Interest rates do not change over the life of the option (and are known)
6. Stock returns follow a lognormal distribution
The Model (Non-Dividend)
The basic inputs to price a European option on a non-dividend paying stock is as follows:
S = Underlying stock price
X = Strike price
r = Risk free rate of interest
V = Volatility
T-t = Time to maturity
We can then apply these input variables into the following set of equations to derive the
price for a European call option on a non-dividend stock:

And for a European put option on a non-dividend stock:

Where N(d1) and N(d2) are the cumulative normal distribution functions for d1 and d2,
which are defined as:

d2 can be further simplified as:

By means of substitution.
In order to compute the cumulative normal distribution function, we can consider the
partial derivative of N(x).

We then apply the terms and to the equation and we obtain the solutions to the
terms (as defined above). We will shortly discuss the Partial differential equations
resulting in the Black-Scholes equation and its greeks.
The Model (Dividend Paying) - Merton (1973)
For a dividend paying stock, we can alter the standard Black-Scholes model to
incorporate an annual dividend yield (extended by Merton in 1973) and include the term
"d" (no-subscript) as being the dividend yield per year.
The value of a call option can be calculated as:

Where d1 and d2 equals:

And similarly, the non-dividend version of the model, we can simplify d2 as being:

The value of a put can be calculated using the put-call parity (for non dividend paying
options):

or for dividend paying options:

Or with the full formula:

The work done by Black & Scholes in the 70's made way for further pricing of
derivatives and in particular, exotic options. The Black-Scholes partial differential
equation also enabled derivation of the 'greeks' of option pricing.
The Black-Scholes model today is used in everyday pricing of options and futures and
almost all formulas for pricing of exotic options such as barriers, compounds and asian
options take their foundation from the Black-Scholes model.

Advantages & Limitations

Advantage: The main advantage of the Black-Scholes model is speed -- it lets you
calculate a very large number of option prices in a very short time.
Limitation: The Black-Scholes model has one major limitation: it cannot be used to
accurately price options with an American-style exercise as it only calculates the option
price at one point in time -- at expiration. It does not consider the steps along the way
where there could be the possibility of early exercise of an American option.
As all exchange traded equity options have American-style exercise (ie they can be
exercised at any time as opposed to European options which can only be exercised at
expiration) this is a significant limitation.
The exception to this is an American call on a non-dividend paying asset. In this case the
call is always worth the same as its European equivalent as there is never any advantage
in exercising early.
Various adjustments are sometimes made to the Black-Scholes price to enable it to
approximate American option prices (eg the Fischer Black Pseudo-American
 method) but these only work well within certain limits and they don't really work
well for puts.

The Binomial Model

The binomial model breaks down the time to expiration into potentially a very large
number of time intervals, or steps. A tree of stock prices is initially produced working
forward from the present to expiration. At each step it is assumed that the stock price will
move up or down by an amount calculated using volatility and time to expiration. This
produces a binomial distribution, or recombining tree, of underlying stock prices. The
tree represents all the possible paths that the stock price could take during the life of the
option.
At the end of the tree -- ie at expiration of the option -- all the terminal option prices for
each of the final possible stock prices are known as they simply equal their intrinsic
values.
Next the option prices at each step of the tree are calculated working back from
expiration to the present. The option prices at each step are used to derive the option
prices at the next step of the tree using risk neutral valuation based on the probabilities of
the stock prices moving up or down, the risk free rate and the time interval of each step.
Any adjustments to stock prices (at an ex-dividend date) or option prices (as a result of
early exercise of American options) are worked into the calculations at the required point
in time. At the top of the tree you are left with one option price.
To get a feel for how the binomial model works you can use the on-line binomial tree
calculators: either using the original Cox, Ross, & Rubinstein tree or the equal
probabilities tree, which produces equally accurate results while overcoming some of
the limitations of the C-R-R model. The calculators let you calculate European or
American option prices and display graphically the tree structure used in the
calculation. Dividends can be specified as being discrete or as an annual yield, and
points at which early exercise is assumed for American options are highlighted.
Advantages & Limitations
Advantage: The big advantage the binomial model has over the Black-Scholes model is
that it can be used to accurately price American options. This is because with the
binomial model it's possible to check at every point in an option's life (ie at every step of
the binomial tree) for the possibility of early exercise (eg where, due to eg a dividend, or
a put being deeply in the money the option price at that point is less than its intrinsic
value).
Where an early exercise point is found it is assumed that the option holder would elect to
exercise, and the option price can be adjusted to equal the intrinsic value at that point.
This then flows into the calculations higher up the tree and so on.
The on-line binomial tree graphical option calculator highlights those points in the tree
structure where early exercise would have have caused an American price to differ from a
European price.
The binomial model basically solves the same equation, using a computational procedure
that the Black-Scholes model solves using an analytic approach and in doing so provides
opportunities along the way to check for early exercise for American options.
Limitation: The main limitation of the binomial model is its relatively slow speed. It's
great for half a dozen calculations at a time but even with today's fastest PCs it's not a
practical solution for the calculation of thousands of prices in a few seconds.

Relationship to the Black-Scholes model

The same underlying assumptions regarding stock prices underpin both the binomial and
Black-Scholes models: that stock prices follow a stochastic process described by
geometric brownian motion. As a result, for European options, the binomial model
converges on the Black-Scholes formula as the number of binomial calculation steps
increases. In fact the Black-Scholes model for European options is really a special case of
the binomial model where the number of binomial steps is infinite. In other words, the
binomial model provides discrete approximations to the continuous process underlying
the Black-Scholes model.
Whilst the Cox, Ross & Rubinstein binomial model and the Black-Scholes model
ultimately converge as the number of time steps gets infinitely large and the length of
each step gets infinitesimally small this convergence, except for at-the-money
options, is anything but smooth or uniform. To examine the way in which the two
models converge see the on-line Black-Scholes/Binomial convergence analysis
calculator. This lets you examine graphically how convergence changes as the
number of steps in the binomial calculation increases as well as the impact on
convergence of changes to the strike price, stock price, time to expiration, volatility
and risk free interest rate.
 SWAPS

Swap is a transaction in which two or more parties swap ( exchanges) one set of
predetermined payments for another. Swaps are of recent origin and basically there are
two types of swaps
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are :

• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the
parties, with the cashflows in one direction being in a different currency than those in the
opposite direction.

A swap is a cash-settled OTC derivative. Except for forwards, swaps are the most
simple form of OTC derivative.

A swap is an agreement between two counter parties to exchange two streams of cash
flows—the parties "swap" the cash flow streams. Those cash flow streams can be defined
in almost any manner. All that matters is that their present values be equal (except for a
bid-ask spread, if one party to the swap is a dealer). While swaps are used for various
purposes—from hedging to speculation—their fundamental purpose is to change the
character of an asset or liability without liquidating that asset or liability.
For example, an investor realizing returns from an equity investment can swap those
returns into less risky fixed income cash flows—without having to liquidate the equities.
A corporation with floating rate debt can swap that debt into a fixed rate obligation—
without having to retire and reissue debt.

This is illustrated in Exhibit 1. Suppose you are receiving Cash Flow Stream A from a
counterpart. You would like to change the nature of that cash flow stream—perhaps
making it less risky. Rather than attempt to renegotiate the obligation with the
counterpart, you enter into a swap agreement with another party. Under that agreement,
you swap Cash Flow Stream A for a Cash Flow Stream B, which better suits your needs.

With a Swap, You Can Change the

Character of an Asset Without Having to
Liquidate the Asset.

By entering into a swap with a third party, you can convert

a Cash Flow Stream A into a different Cash Flow Stream B.
This does now require the liquidation or renegotiation of
Cash Flow Stream A. Indeed, the counterpart paying you
Cash Flow Stream A doesn't even need to know about the
offsetting swap.
 A vanilla swap is any swap with fairly standardized provisions. The term is usually
applied to vanilla interest rate swaps or vanilla currency swaps. Vanilla swaps are
appealing because pricing tends to be transparent and transaction costs are small.
Vanilla swaps can be used to speculate or to quickly hedge the market risk of a position
without necessarily offsetting the specific cash flows of that position.

Swaps can also be customized to offset the specific cash flows of a position. Dealers
often structure such non-vanilla swaps for clients. They may charge a fee for doing so,
and pricing may reflect a large bid-ask spread (caveat emptor). An asset swap is a non-
vanilla swap customized to change the character of a specific asset. A liability swap is
such a swap customized to change the character of a specific liability.

Swaps are also categorized according to the nature of the cash flow streams being
exchanged.

interest rate swaps

currency swaps

Swaps have traded since the 1980s. The first known transaction was a currency swap
between the World Bank and IBM in August 1981

Interest rate swaps

It is the exchange of one set of cash flows for another. A pre-set index,
notional amount and set of dates of exchange determine each set of cash
flows. The most common type of interest rate swap is the exchange of fixed
rate flows for floating rate flows under which cash flows of a fixed rate loan
are exchanged for those of a floating rate loan. Among these, the most
common use a 3-month or 6-month Libor rate (or Euribor, if the currency is
the Euro) as their floating rate. These are called vanilla interest rate
swaps. There is also a liquid market for floating-floating interest rate swaps
—what are known as basis swaps.

Consider an example. Two banks enter into a vanilla interest rate swap. The term is four
years. They agree to swap fixed rate USD payments at 4.6% in exchange for 6-month
USD Libor payments. At the outset, the fixed rate payments are known. The first floating
rate payment is also known, but the rate will depend on future values of Libor.

Interest rate swaps are used for many purposes. If a corporation has borrowed money at
a floating rate of interest but would prefer to lock in a fixed rate, it can swap its floating
rate payments into fixed rate payments. This is illustrated here

Swapping Floating Debt into Fixed

By entering into a swap with a third party, a corporation can

convert floating rate payments into fixed rate payments.
Interest rate swaps can also be used to speculate on interest rates. A trader who believes
that interest rates will rise could incur the expenses of borrowing and then shorting
bonds.

Currency swaps

A currency swap is a form of swap. It is most easily understood by comparison with an

interest rate swap. An interest rate swap is a contract to exchange cash flow streams
that might be associated with some fixed income obligations—say swapping the cash
flows of a fixed rate loan for those of a floating rate loan. A currency swap is exactly the
same thing except, with an interest rate swap, the cash flow streams are in the same
currency. With a currency swap, they are in different currencies.

That difference has a practical consequence. With an interest rate swap, cash flows
occurring on concurrent dates are netted. With a currency swap, the cash flows are in
different currencies, so they can't net. Full principal and interest payments are exchanged
without any form of netting.

Suppose the spot JPY/USD exchange rate is 109 JPY per USD. Two firms might enter
into a currency swap to exchange the cash flows associated with

a five-year USD 100MM loan at 6-month USD Libor, and

a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.

Vanilla currency swaps are quoted both for fixed-floating and floating-floating (basis
swap) structures. Fixed-floating swaps are quoted with the interest rate payable on the
fixed side—just like a vanilla interest rate swap. The rate can either be expressed as an
absolute rate or a spread over some government bond rate. The floating rate is always
"flat"—no spread is applied. Floating-floating structures are quoted with a spread applied
to one of the floating indexes.

Currency swaps can be used to exploit inefficiencies in international debt markets.

Suppose a corporation needs an AUD 100MM loan, but US-based lenders are willing to
offer more favorable terms on a USD loan. The corporation could take the USD loan and
then find a third party willing to swap it into an equivalent AUD loan. In this manner, the
firm would obtain its AUD loan but at more favorable terms than it would have obtained
with a direct AUD loan. That advantage must, of course, be balanced against the
transaction costs, pre-settlement risk and settlement risk associated with the
swap. This is illustrated in Exhibit

Swapping a USD Loan Into an AUD Loan

By entering into a swap with a third party, a corporation can

convert an USD loan into an AUD loan.

WARRANTS
A warrant, like an option, gives the holder the right but not the obligation to buy an
underlying security at a certain price, quantity and future time. However, unlike an
option, an instrument of the stock exchange, a warrant is issued by a company. The
security represented in the warrant (usually share equity) is delivered by the issuing
company instead of an investor holding the shares.

Companies will often include warrants as part of a new-issue offering to entice investors
into buying the new security. A warrant can also increase a shareholder's confidence in a
stock, if the underlying value of the security actually does increase overtime.

There are two different types of warrants: a call warrant and a put warrant. A call warrant
represents a specific number of shares that can be purchased from the issuer at a specific
price, on or before a certain date. A put warrant represents a certain amount of equity that
can be sold back to the issuer at a specified price, on or before a stated date.

Characteristics of a Warrant
Warrant certificates have stated particulars regarding the investment tool they represent.
All warrants have a specified expiry date, the last day the rights of a warrant can be
executed. Warrants are classified by their exercise style: an American warrant, for
instance, can be exercised anytime before or on the stated expiry date, and a European
warrant, on the other hand, can be carried out only on the day of expiration.

The underlying instrument the warrant represents is also stated on warrant certificates. A
warrant typically corresponds to a specific number of shares, but it can also represent a
commodity, index or a currency.

The exercise or strike price is the amount that must be paid in order to either buy the call
warrant or sell the put warrant. The payment of the strike price results in a transfer of the
specified amount of the underlying instrument.
The conversion ratio is the number of warrants needed in order to buy (or sell) one
investment tool. Therefore, if the conversion ratio to buy stock XYZ is 3:1, this means
that the holder needs three warrants in order to purchase one share. Usually, if the
conversion ratio is high, the price of the share will be low, and vice versa. (In the case of
an index warrant, an index multiplier would be stated instead. This figure would be used
to determine the amount payable to the holder upon the exercise date.)

Investing In Warrants
Warrants are transferable, quoted certificates, and they tend to be more attractive for
medium-term to long-term investment schemes. Tending to be high risk, high return
investment tools that remain largely unexploited in investment strategies, warrants are
also an attractive option for speculators and hedgers. Transparency is high and warrants
offer a viable option for private investors as well. This is because the cost of a warrant is
commonly low, and the initial investment needed to command a large amount of equity is
actually quite small.

Advantages
Let us look at an example that illustrates one of the potential benefits of warrants. Say
that XYZ shares are currently priced on the market for $1.50 per share. In order to
purchase 1,000 shares, an investor would need $1,500. However, if the investor opted to
buy a warrant (representing one share) that was going for $0.50 per warrant, with the
same $1,500, he or she would be in possession of 3,000 shares instead!

Because the prices of warrants are low, the leverage and gearing they offer is high. This
means that there is a potential for larger capital gains and losses. While it is common for
both a share price and a warrant price to move in parallel (in absolute terms) the
percentage gain (or loss), will be significantly varied because of the initial difference in
price. Warrants generally exaggerate share price movements in terms of percentage
change.
Let us look at another example to illustrate these points. Say that share XYZ gains $0.30
per share from $1.50, to close at $1.80. The percentage gain would be 20%. However,
with a $0.30 gain in the warrant, from $0.50 to $0.80, the percentage gain would be 60%.

In this example, the gearing factor is calculated by dividing the original share price by the
original warrant price: $1.50 / $0.50 = 3. The '3' is the gearing factor, and the higher the
number, the larger the potential for capital gains (or losses).

Warrants can offer significant gains to an investor during a bull market. They can also
offer some protection to an investor during a bear market. This is because as the price of
an underlying share begins to drop, the warrant may not realize as much loss because the
price, in relation to the actual share, is already low.

Disadvantages
Like any other type of investment, warrants also have their drawbacks and risks. As
mentioned above, the leverage and gearing warrants offer can be high. But these can also
work to the disadvantage of the investor. If we reverse the outcome of the example from
above and realize a drop in absolute price by $0.30, the percentage loss for the share price
would be 20%, while the loss on the warrant would be 60%!

Another disadvantage and risk to the warrant investor is that the value of the certificate
can drop to zero. If that were to happen before it is exercised, the warrant would lose any
redemption value.

Finally, a holder of a warrant does not have any voting, shareholding or dividend rights.
The investor can therefore have no say in the functioning of the company, even though he
or she is affected by any decisions made.
 CONVERTIBLE SECURITIES

A convertible security is a bond or debenture or preferred stock that can be converted into
equity of a company. Usually a original security is a debt instrument, which can be
converted into ownership instrument, after a time. The period of time necessary for
conversion, the ratio of conversion and other terms including the price are laid down in
the beginning only.

Convertible bonds are a combination of bonds and equity. Convertible bonds are bonds
with a maturity date and coupon, with a call option where the holder has the right to
convert into equity.

A convertible bond has several desirable qualities for the investor or trader. Some of them
include the following:

• They provide ‘asset protection’. The value of the convertible bond will only fall to
the value of the ‘bond floor’.
• Convertible bonds can provide the possibility of ‘high equity returns’.
• Convertible bonds are usually of a less volatile nature than ‘regular’ shares.

In other words: Convertible bonds offers the following main advantages for the trader or
investor:

• Asset protection of the bond, combined with the possibility of equity returns.

Convertible bonds offer the following main advantage for the issuer of the CB:

• Debt at a relatively low cost.

Derivatives Instruments Traded in India

In the exchange-traded market, the biggest success story has been

derivatives on equity
products. Index futures were introduced in June 2000, followed by
index options in June
2001, and options and futures on individual securities in July 2001 and
November 2001,
respectively. As of 2005, the NSE trades futures and options on 118
individual stocks and
3 stock indices. All these derivative contracts are settled by cash
payment and do not
involve physical delivery of the underlying product (which may be
costly).8

Derivatives on stock indexes and individual stocks have grown rapidly

since inception. In
particular, single stock futures have become hugely popular,
accounting for about half of
NSE’s traded value in October 2005. In fact, NSE has the highest
volume (i.e. number of
contracts traded) in the single stock futures globally, enabling it to
rank 16 among world
exchanges in the first half of 2005. Single stock options are less
popular than futures.
Index futures are increasingly popular, and accounted for close to 40%
of traded value in
October 2005.

NSE launched interest rate futures in June 2003 but, in contrast to

equity derivatives,
there has been little trading in them. One problem with these
instruments was faulty
contract specifications, resulting in the underlying interest rate
deviating erratically from
the reference rate used by market participants. Institutional investors
have preferred to
trade in the OTC markets, where instruments such as interest rate
swaps and forward rate
agreements are thriving. As interest rates in India have fallen,
companies have swapped
their fixed rate borrowings into floating rates to reduce funding costs.
Activity in OTC
markets dwarfs that of the entire exchange-traded markets, with daily
value of trading
estimated to be Rs. 30 billion in 2004 (FitchRatings, 2004).

Foreign exchange derivatives are less active than interest rate

derivatives in India, even
though they have been around for longer. OTC instruments in currency
forwards and
swaps are the most popular. Importers, exporters and banks use the
rupee forward market
to hedge their foreign currency exposure. Turnover and liquidity in this
market has been
increasing, although trading is mainly in shorter maturity contracts of
one year or less
(Gambhir and Goel, 2003). In a currency swap, banks and corporations
may swap its
rupee denominated debt into another currency (typically the US dollar
or Japanese yen),
or vice versa. Trading in OTC currency options is still muted. There are
no exchangetraded currency derivatives in India.
Exchange-traded commodity derivatives have been trading only since
2000, and the
growth in this market has been uneven. The number of commodities
eligible for futures
trading has increased from 8 in 2000 to 80 in 2004, while the value of
trading has
increased almost four times in the same period . However, many
contracts
barely trade and, of those that are active, trading is fragmented over
multiple market
venues, including central and regional exchanges, brokerages, and
unregulated forwards
markets. Total volume of commodity derivatives is still small, less than
half the size of
equity derivatives.