Derivatives Markets In Interest Rate
& Foreign Exchange Rate
Utility For Importer & Exporter
NEHA ABHISHEK, BANGALORE
Batch: 22, (5th July to 30th August, 2014)
Agenda
• Derivatives
• List of Derivatives under various categories
• Concept of Hedging
• Exposure of Importer and Exporter
• Derivatives on Foreign Exchange
• Forwards Contracts
• Future
• Option Contract
• Interest Rate Derivatives
• Forwards Rate Agreement (FRA)
• SWAP
• Interest Rate Option
Derivatives
As per Clause (a) of Section 45U of RBI Act 1934 "derivative" means an instrument, to be
settled at a future date, whose value is derived from change in
interest rate,
foreign exchange rate,
credit rating or credit index,
price of securities (also called "underlying"), or
a combination of more than one of them and includes
•
•
•
•
•
•
•
interest rate swaps,
forward rate agreements,
foreign currency swaps,
foreign currency-rupee swaps,
foreign currency options,
foreign currency-rupee options or
such other instruments as may be specified by the Bank from time to time;
List of Derivatives under various categories
Derivatives
Location
Basic Variable
Real Assets
Commodities
Metals
Real Estates
Plant &
Equipment
Financial Assets
Bonds
Shares
Loan
Currencies
Price Risk
Forwards
Futures
Options
Others
Weather
Power
Insurance
Interest Rate Risk
Swaps
Futures
Options
OTC
Forwards
Options
Swaps
ETC
Futures
Options
Nature
Forwards
Future
Options
Swap
Concept of Hedging
Exporter
Gain
Foreign Currency
Local Currency
Importer
Gain
Foreign Currency
Local Currency
Exposure of Importer and Exporter
Month
USD/INR
April 14
60.22
August 14
August 14
March 15
March 15
59.27
59.27
62.85
62.85
Importers
Hedged (Y)
Happy (H)
Unhedged (N)
Unhappy (U)
Exporters
Hedged (Y)
Happy (H)
Unhedged (N)
Unhappy (U)
Remarks
Reference
Rate
N
Y
N
Y
(H)
(U)
(U)
(H)
N
Y
N
Y
(U)
(H)
(H)
(U)
Forward Contract
•
•
•
•
•
•
A foreign exchange forward is an OTC contract
Purchaser agrees to buy from the seller, and
Seller agrees to sell to the buyer,
A specified amount of a specified currency
On a specified date in future.
In India there are two types of Forward Contract
• Fixed Forward Contract: Delivery of foreign exchange should take place on specified
future date.
• Option Forward Contract: The customer can sell or buy from the bank foreign
exchange at any given period of time at a predetermined rate of exchange. The
Option Period of delivery should not exceed one month.
Future
 An agreement entered into with the specified future exchange to buy or sell standard amount of foreign
currency at a specified price for delivery on specified future date.
 Maximum Limit in currency future is USD 5 million or 6% of the open interest, whichever is higher.
The Features of Currency Future in India
Currency
Size
Quotation
The contract is available on US Dollar/ Indian Rupee.
The Size of one Future is USD 1,000.
The future is quoted in rupee terms with a minimum price charge of 0.25 paise.
However the outstanding position is reckoned in dollar terms.
Maturities
Due Date
The contract is available with maturity ranging from 1 to 12 months.
The contract expire on last working day of the month, excluding Saturday.
Outstanding contract are settled on this day.
Two days before the expiry date.
The Settlement price is fixed on last trading day at the Reserve’s Bank reference
rate.
The contract is settled by payment in Indian Rupee. The difference between the
strike price and settlement price is exchanged between the buyer and seller. No
delivery of Dollar take place.
Trading can be done between 9a.m. to 5p.m.
Last Trading Day
Settlement Price
Settlement
Trading Hours
Option
Option
Call
Buy
Importer
Right to Buy
Sell
Exporter
Obligation to Sell
Put
Buy
Exporter
Right to Sell
Sell
Importer
Obligation to Buy
Concept of In the Money (ITM), At the Money (ATM) and Out of the Money (OTM)
Nature of Option Based on
Strike
In the Money (ITM)
At the Money (ATM)
Out of the Money (OTM)
Exporter
Importer
Illustration
Strike Price of Buy Put >
Strike price of Buy Call <
FRR = 45
Forward Reference Rate (FRR) Forward Reference Rate (FRR) Buy USD Put @ 46
Buy USD Call @ 44
Strike Price of Buy Put =
Strike price of Buy Call =
FRR = 45
Forward Reference Rate (FRR) Forward Reference Rate (FRR) Buy USD Put @ 45
Buy USD Call @ 45
Strike Price of Buy Put <
Strike price of Buy Call >
FRR = 45
Forward Reference Rate (FRR) Forward Reference Rate (FRR) Buy USD Put @ 44
Buy USD Call @ 46
Option - Exporter
Assume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.
Buy USD Put at INR 45 (ATM Option) – premium paid upfront INR 1.
Buy USD Put at INR 46 (ITM Option) – premium paid upfront INR 2.
Buy USD Put at INR 44 (OTM Option) – premium paid upfront INR 0.50.
Table plot the exercisability and payoff matrix for maturity by taking some random market rates.
Market Rate
FRR = 45
BP = 45
P/L matrix
BP = 46
P/L matrix
BP = 44
P/L matrix compared with
Prem. =1
compared
Prem. = 2
compared
Prem. = .5
FRR
(ATM)
with FRR
(ITM)
with FRR
(OTM)
43
45
Y
-1
Y
-1
Y
-1.5
44
45
Y
-1
Y
-1
Y
-1.5
45
45
Y
-1
Y
-1
N
-0.5
46
45
N
0
Y
-1
N
0.5
Assume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.
Sell USD Call at INR 45 (ATM Option) – premium paid upfront INR 1.
Sell USD Call at INR 46 (OTM Option) – premium paid upfront INR 0.50.
Sell USD Call at INR 44 (ITM Option) – premium paid upfront INR 2.
Table plot the exercisability and payoff matrix for maturity by taking some random market rates.
Market Rate
FRR = 45
BC = 45
P/L matrix
BC = 44
P/L matrix
BC = 46
P/L matrix compared
Prem. =1
compared
Prem. = 2
compared
Prem. = 0.5
with FRR
(ATM)
with FRR
(ITM)
with FRR
(OTM)
43
45
N
1
N
2
N
0.5
44
45
N
1
Y
2
N
0.5
45
45
Y
1
Y
1
N
0.5
46
45
Y
0
Y
0
Y
0.5
Option - Importer
Assume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.
Buy USD Call at INR 45 (ATM Option) – premium paid upfront INR 1.
Buy USD Call at INR 46 (OTM Option) – premium paid upfront INR 0.50.
Buy USD Call at INR 44 (ITM Option) – premium paid upfront INR 2.
Table plot the exercisability and payoff matrix for maturity by taking some random market rates.
Market
FRR = 45
BC = 45
P/L matrix
BC = 44
P/L matrix
BC = 46
Rate
Prem. =1
compared
Prem. = 2
compared
Prem. = 0.5
(ATM)
with FRR
(ITM)
with FRR
(OTM)
43
45
N
1
N
0
N
44
45
N
0
Y
-1
N
45
45
Y
-1
Y
-1
N
46
45
Y
-1
Y
-1
Y
Assume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.
Sell USD Put at INR 45 (ATM Option) – premium paid upfront INR 1.
Sell USD Put at INR 46 (ITM Option) – premium paid upfront INR 2.
Sell USD Put at INR 44 (OTM Option) – premium paid upfront INR 0.50.
Table plot the exercisability and payoff matrix for maturity by taking some random market rates.
Market Rate FRR = 45
BP = 45
P/L matrix
BP = 46
P/L matrix
BP = 44
Prem. =1
compared
Prem. = 2
compared
Prem. = .5
(ATM)
with FRR
(ITM)
with FRR
(OTM)
43
45
Y
-1
Y
-1
Y
44
45
Y
0
Y
0
Y
45
45
Y
1
Y
1
N
46
45
N
1
Y
2
N
P/L matrix compared
with FRR
1.5
0.5
-0.5
-1.5
P/L matrix compared
with FRR
-0.5
0.5
0.5
0.5
Exchange Rate Derivatives - Importer Perspective
On 12th Jan, an Indian Firm knows that it has $600000 payable, on 12 th March. The Spot Rate is 40.45/$, while 2month
forward rate is Rs.40.62/$. 2month INR/USD Interest Rate is 10%/4% p.a. resp. $ future for maturity ending March is
Rs.40.65/$. Call and Put option on $ at E = Rs.40.60/$ traded at premium of .40p & .50p respectively. On 12 th March Spot
Rate Rs.40.7/$. Future traded at Rs.40.74/$. The outflow in the following situation will be as follows:
Outflow on 12th March= Total $ Payable × Spot Rate on 12th March
No Hedging
$600,000×Rs.40.7/$ = Rs.24,420,000
Money Market
The firm will invest in PV of $600000 i.e. $600,000 = $ 596,027
Cover
1 + .04
(Invest- Buy6
Therefore, Present Outflow = $596,027 × Rs.40.45/$ = Rs.24,109,292
Borrow)
And, Total Outflow = Rs.24,109,292 ( 1 + 0.1 ) = Rs.24,511,114
6
th
Outflow on 12 March = Total $ Payable × Forward Rate
Forward Cover
$600,000 × Rs.40.62/$ = 24,372,000
Profit on Squaring Future on 12th March = ( Rs.40.74/$ - Rs.40.65/$ ) × $600,000
Future Cover
= Rs.54,000
th
On 12 March $ Purchase at $600,000 × Rs.40.7/$ = Rs.24,420,000
Therefore, Total Outflow under Future = Rs.24,420,000 – Rs.54,000 = Rs.24,366,000
FV of Premium Outflow on C+ = ( $600,000 × 0.4p ) × ( 1 + 0.1 ) = Rs. 244,000
Option
6
Call exercised as Spot Price > E, therefore Buy $ at $600,000 × Rs.40.6/$ = Rs.24,360,000
Total Outflow on 12th March = Rs.24,360,000 + Rs.244,000 = Rs.24,604,000.
Exchange Rate Derivatives - Exporter Perspective
On 12th Dec, an Indian Firm knows that it has $600000 receivable, on 12th March. The Spot Rate is 60.45/$, while 2month
forward rate is Rs.60.62/$. 2month INR/USD Interest Rate is 10%/4% p.a. resp. $ future for maturity ending March is
Rs.60.65/$. Call and Put option on $ at E = Rs.60.60/$ traded at premium of .40p & .50p respectively. On 12th March Spot
Rate Rs.60.7/$. Future traded at Rs.60.74/$. The Inflow in the following situation will be as follows:
No Hedging
Inflow on 12th March= Total $ Receivable × Spot Rate on 12th March
$600,000×Rs.60.7/$ = Rs.36,420,000
Money Market
The firm will Borrow in PV of $600000 i.e. $600,000 = $ 594,059
Cover
1 + .04
(Borrow-Sell4
Invest)
Therefore, Present Inflow = $594,059 × Rs.60.45/$ = Rs.35,910,867
And, Total Inflow = Rs. 35,910,867 ( 1 + 0.1 ) = Rs.36,808,639
4
Forward Cover
Future Cover
Option
Inflow on 12th March = Total $ Receivable × Forward Rate
$600,000 × Rs.60.62/$ = 36,372,000
Profit on Squaring Future on 12th March = ( Rs.60.74/$ - Rs.60.65/$ ) × $600,000 = Rs.54,000
On 12th March $ Purchase at $600,000 × Rs.60.7/$ = Rs. 36,420,000
Therefore, Total Inflow under Future = Rs. 36,420,000 + Rs.54,000 = Rs.36,474,000
FV of Premium Outflow on P+ = ( $600,000 × 0.5p ) × ( 1 + 0.1 ) = Rs. 307,500
4
Put not exercised as Spot Price > E, therefore Buy $ at $600,000 × Rs.40.7/$ = Rs. 36,420,000
Total Inflow on 12th March = Rs. 36,420,000 - Rs.307,500 = Rs.36,112,500.
Interest Rate Derivatives
Over-the-counter (OTC) interest rate derivatives include instruments such as
• Forward Rate Agreements(FRAS): A Forward Rate Agreement (FRA) is a
financial contract between two parties to exchange interest payments for a
'notional principal' amount on settlement date, for a specified period from
start date to maturity date.
• Interest Rate Swaps (IRS):provide for the exchange of payments based on
differences between two different interest rates.
• Caps, Floors, And Collars: are option-like agreements that require one party
to make payments to the other when a stipulated interest rate, most often
a specified maturity of LIBOR, moves outside of some predetermined
range.
Settlement under FRA
HDFC Bank quotes on 15 march its 6×9 FRA at (MIBOR) 5.35 – 5.45. ABC barrows Rs. 5
crores under FRA. MIBOR on 13th September is 6%.
The following formula applied in calculating the compensation payable under FRA:
Compensation = (L-R) or (R-L) × D × A
(B × 100) + D × L
Where, L = Settlement Rate (LIBOR, MIBOR, etc.) i.e. 6%
R = Contract reference rate i.e. 5.45%
D = No. of days in contract period i.e. 91 days
B = Days basis that is, 360 or 365 days in a year
A = Notional principal amount i.e. Rs.50,000,000
Compensation = (6 - 5.45) × 91 × 50,000,000 = Rs.67551.15
(365 × 100) + 91 × 6
SWAP
SWAP
Currency
Swaps
A Plain
Vanilla
Swap
A Basis
Swap rate
An
Amortizing
Swap
Interest
Rate Swap
Step up
Swap
Cross
Currencies
Interest Rate
Swap
Extendable
Swap
Delayed
Start
Swaps/
Forward
Swap
Differential
Swap
Interest Rate Swap Structure
Companies A and B faces the following Interest Rates:
A
B
U.S. Dollars (Floating Rate)
LIBOR + 0.5%
LIBOR + 1%
Canadian (Fixed Rate)
5%
6.5%
Assume that A wants to borrow U.S. Dollars at a floating rate of interest and B wants to borrow Canadian dollars at
a fixed rate of interest. A Bank is planning to arrange a swap and requires 50 basis point spread. If swap is equally
attractive to A and B, what interest rate will A and B end up paying?
SWAP STRUCTURE
L + 0.25%
Bank
L + 1%
5%
B
A
5%
L + 0.25%
6.25%
Spread = 0.5%
L + 1%
6.25%
Interest Rate Option
• Allows the buyer of the option to borrow or lend the specified amount of a
specified currency at a specified future date at a specified rate of interest
without any obligation to do so.
• A buy call option means a buyer with right to borrow
• A buy put option mean right to invest.
• Interest Rate Cap enforce an upper limit on the floating rate payment and
the risk of higher interest rates is crystallized into a single payment to be
made upfront, without sacrificing downside risk.
• Interest Rate Floor is a series of put option meant to protect the lender
against drop in interest below a specified rate in a floating rate asset.
Collar: Interest Rate Risk Hedging Strategy
Index
USD 6 months LIBOR
Notional
USD 10 Million
Tenor
5 years
Cap strike
3.75%
Floor strike
2.50%
Bank will charge 225 bps
Here the interest coupon is floored at 2.50% + 2.25% = 4.75% and cap at 3.75% + 2.25% = 6%
LIBOR
On ECB /
FCY loan
Pay
On collar
(Floor at 2.50%, Cap at 3.75%)
2.25%
4.50%
Receive from/ Pay
out
Pays
0
3.25%
5.50%
-
4.25%
6.50%
4.75%
7.00%
Receive
Net
Pays
Pays
0.25%
4.75%
0
0
5.50%
Receive
0.50%
0
6.00%
Receive
1.00%
0
6.00%
Seagull: Interest Rate Risk Hedging Strategy
Index
USD 6 months LIBOR
Notional
USD 10 Million
Tenor
5 years
Cap 1 strike
3.75%
Cap 2 strike
4.50%
Floor strike
1.75%
Bank will charge 225 bps.
In the above illustration contract holder sell two deep out of money floor at interest coupon of 4% and cap 2 at
interest coupon of 6.75%. Buy single cap 1 which is relatively less out of the money at interest coupon of 6%.
LIBOR
On ECB /
FCY loan
Pay
1.00%
2.50%
3.50%
4.50%
5.50%
3.25%
4.75%
5.75%
6.75%
7.75%
On collar
(Floor at 1.75%, Cap 1 at 3.75% and Cap 2 at 4.50%)
Receive from/ Pay
out
Pays
Receive
Receive
Net
Receive
Pays
Pays
0
0
0
0.75%
0.75%
0.75%
0
0
0
0
4.00%
4.75%
5.75%
6.00%
7.00%
Thank You