DERIVATIVES

DEFINITION
 Any security whose value is determined by,
or derived from the value of another asset
known as underlying

 Contract between at least two parties.

 Whose value is based on underlying asset
 Bonds, Commodities, currencies
TYPES OF DERIVATIVES

●
Forward
LOC contract
K ●
Interest Rate
Swap

TYPES OF OPT
ION
●

●
Call
Option
Put Option

DERIVATIVES
WHY DERIVATIVES ???

HEDGING

PROFITABILITY
FORWARD CONTRACT

 A customized contract between two parties

to buy or sell an asset at a specific price at a
specific date.
 EXAMPLE

Sell
Potato Chips
Farmer
Company
Buy

RISKS INVOLVED RISKS INVOLVED

Availability of Potatoes
Sale of Potatoes
Price fluctuations
Storage of Potatoes

Price fluctuations
CURRENCY OPTIONS

 Currency options are contracts that give the buyer the

right, but not the obligation, to buy or sell a foreign
currency against another foreign currency or Indian Rupee,
at a predetermined price called Strike Price and for a
delivery on or before a predetermined date.

 Call Option
 Put Option
EXAMPLE
14

12 12
11
10 10 10
9.5
9
8.5
8
Floating Interest
Rate
6 Fixed Interest rate

0
2015 2017 2019 2021 2023
CALL OPTION EXAMPLE

●
Booked
●
USDINR moved
●
Expecting as per
depreciation of
future call expectation of
Rupee in future option at importer will
Future
Impo date Call USDINR 71.50
Scenar
execute call
rter
●
Present Value Option ●
Option option
io
USDINR 70 and Position goes
charges 0.50
●

expecting 73 in reverse will not

future making total execute call
rate of 72 option
PUTExporte
OPTION EXAMPLE
r

●
Expecting appreciation
of Rupee in future date
●
Present Value USDINR 70
and expecting 67 in
future

Call
Option
●
Booked future call
option at USDINR 68.50
●
Option charges 0.50 Future
making total rate of 69
Scenario
• USDINR moved as per expectation of importer
will execute call option
• Position goes reverse will not execute call
option
PROFILE OF DERIVATIVE
PRODUCTS
A. Currency Derivatives
 Forward Contracts
 Currency Options

B. Interest Rate Derivatives:

 Interest Rate Swaps

Forward Rate Agreement

C. Credit Default Swap

OBJECTIVES

 To manage balance sheet exposure to various

risks such as interest rate risk, currency risk,
arising from the banking operations.
 To offer derivative products to existing and new
corporate clients so as to help them in managing
interest and currency risk and in the process
earn non-interest income.
 To have trading book and thus to undertake
derivative transactions to earn profits.
INTEREST RATE SWAPS
 Interest rate swaps are transactions in which two
counter parties agree to exchange interest
payment obligations. Interest rate swaps do not
generally require any exchange of principals.
EXAMPLE OF AN INTEREST RATE
SWAP
 To avoid the risk of default, borrowers often approach a bank
as an intermediary. Accordingly the bank will act as a swap
banker.
 Borrower ABC Ltd. has a fixed liability of 6.5 per cent
 Borrower XYZ Ltd. has a floating liability of MIBOR + 100 bp

 They both approach Punjab & Sind Bank to act as an

intermediary to convert these cash flows from fixed to floating
and vice versa to secure their liabilities. Punjab & Sind Bank
enters into the following transactions to earn a spread of say
10 basis point.
 A swap with Borrower ABC Ltd. where Punjab & Sind Bank Ltd.
pays 6.5% fixed and receives MIBOR floating + 110 basis points.
 A swap with Borrower XYZ Ltd. where Punjab & Sind Bank
receives 6.5% fixed and pays MIBOR + 100 bps floating.
 EXAMPLE

ABC paying REC MIBOR + 110 BASIS

fixed XYZ paying
interest PSB interest at
payment at MIBOR + 1%
6.5 % PAY @ 6.5% PAY MIBOR + 100 BASIS

Has the Afraid

opinion that that
MIBOR may MIBOR
come down might go
up
MARGIN IN FUTURES
 Initial Margin This is the initial amount of cash that must be
deposited in the account to start trading contracts. Usually this is
determined looking at the volatility of the underlying asset

 Maintenance Margin This is the balance a Trader must maintain in

his or her account as the balance changes due to price
fluctuations. It is usually a % of the initial margin for a position. If
the balance in the trader's account drops below this margin, the
trader is required to deposit enough funds or securities to bring the
account back up to the initial margin requirement. Such a demand
is referred to as a margin call

 Variation Margin This is the amount of cash or collateral that brings

the account up to the initial margin amount once it drops below
the maintenance margin
INTEREST RATE OPTIONS
 Caps, Floors & Collars
 These are Interest Rate Options used for Risk
Management
 These option products can be used to
establish maximum (cap) or minimum (floor)
rates or a combination of the two which is
referred to as a collar structure
 These products are used by investors and
borrowers alike to hedge against adverse
interest rate movements
CAPS FLOORS AND COLLARS
 Interest Rate Caps: A Cap provides variable rate borrowers
with protection against rising interest rates while also
retaining the advantages of lower or falling interest rates.
Here, the buyer receives payments at the end of each period
in which the interest rate exceeds the agreed strike price
 Interest Rate Floors: Provides variable rate investors with
protection against falling interest rates while also retaining
the advantages of rising interest rates. Here, the buyer
receives payments at the end of each period in which the
interest rate is below the agreed strike price
 Interest Rate Collars: Variable rate borrowers are typical
users of Interest Rate Collars. They use Collars to obtain
certainty for their borrowings by setting the minimum and
maximum interest rate they will pay on their borrowings.
An Interest Rate Collar is simply a combination of an Interest
Rate Cap and an Interest Rate Floor.
PROFILE OF DERIVATIVE
PRODUCTS
A. Currency Derivatives
 Forward Contracts
 Currency Options

B. Interest Rate Derivatives:

 Interest Rate Swaps

Forward Rate Agreement

C. Credit Default Swap

FRA (FORWARD RATE AGREEMENT)
 FRA, is an agreement between two parties who want to protect
themselves against future movements in interest rates. By entering into
an FRA, the parties lock in an interest rate for a stated period of time
starting on a future settlement date, based on a specified notional
principal amount.

 The buyer of the FRA enters into the contract to protect itself from a
future increase in interest rates. This occurs when a company believes
that interest rates may rise and wants to fix its borrowing cost today.

 The seller of the FRA wants to protect itself from a future decline in
interest rates. This strategy is used by investors who want to hedge the
return obtained on a future deposit

 FRAs are settled using cash on the settlement date. This is the start date
of the notional loan or deposit. The exposure to each counterparty is
determined by the interest rate differential between the market rate on
settlement date and the rate specified in the FRA contract. There are no
principal flows.
FEATURES OF A FRA
 FRA is a very flexible instrument and can be
tailored to meet the needs of both the buyer and
seller
 Counterparty exposure is limited to the interest
rate differential between the market rate and
the contract rate.
 Administration costs are minimized as there is
only one cash flow on the settlement date as
opposed to daily futures settlement
 Can be easily be reversed or closed out using an
offsetting FRA at a new price
EXAMPLE OF FRA
 A corporation learns that it will need to borrow
USD 1 mio in six months' time for a 6-month
period. The interest rate at which it can borrow
today is 6-month LIBOR plus 50 basis points. Let
us further assume that the 6-month LIBOR
currently is at 2.18%, but the company’s treasurer
thinks it might rise over the forthcoming months.
 The treasurer chooses to buy a 6x12 FRA in order
to cover the period of 6 months starting 6 months
from now. He receives a quote of 2.71% from his
bank and buys the FRA for a notional of USD 1
mio.
CREDIT DEFAULT SWAP

 A credit default swap (CDS) is a financial swap agreement

that the seller of the CDS will compensate the buyer in the
event of a loan default or other credit event . The buyer
of the CDS makes a series of payments (the CDS "fee" or
"spread") to the seller and, in exchange, receives a payoff
if the loan defaults.
CDS EXAMPLE