DERIVATIVES
Derivatives existed in its crudest form even in the rural agro based economies when farmers and merchants would sell the harvest in advance at a fixed price to hedge against any adverse change in crop price. In today's world when financial operations have become complex in the liberalized environment, many new variants have evolved. CONCEPT Derivatives are financial instruments whose value is derived from price of the underlying asset. The underlying asset can be commodity or financial instrument such as currency, stocks, and interest rates and even share indices. Derivatives are basically risk management tools against uncertainties of business environment. Its main economic function is to transfer the market price risk whether it is the commodity market or the financial market. They provide a hedge against risk of fluctuation in currency and interest rates. Thus they facilitate efficient planning / management of cash flows. Derivatives can be classified in two categories : (i) Over the Counter derivatives (OTC). These are customised contracts to suit the individual customers' needs. (ii) Exchange Traded derivatives. They are traded on organised exchanges and are for standard amounts and maturity period. In India, Commercial Banks, Primary Dealers and All India Financial Institutions have been allowed by the RBI to use derivative products such as Interest Rate Swaps/ Forward Rate agreements, both for their own balance sheet management as well as market making purposes. DERIVATIVE PRODUCTS FOR RESIDENT / CORPORATE CLIENTS Presently the authorised Dealers are permitted by RBI to offer the following derivative products to their clients: o Forward Exchange Contract o Currency Swaps such as Foreign Currency Rupee swaps, Cross Currency Swaps, Coupon Swaps o Interest Derivatives such as Interest Rate Swaps (IRS), Forward Rate Agreements (FRA), Interest Rate Caps/Collars (purchase) o Options such as Cross Currency options DERIVATIVE PRODUCTS FOR BANKS To hedge their Asset – Liability portfolio, banks can use (i) Interest Rate Swaps (ii) Currency Swaps (iii) Forward Rate Agreements FORWARD EXCHANGE CONTRACT Forward rates are quoted for different maturities. The rates are with reference to Spot Rates and forward contract is traded at a premium or discount vis-a-vis Spot rate. The rate is based on differential of interest rates of two currencies. Forward market provides mechanism for covering of exchange risk by fixing the rate for a date later than the one on which the contract is entered into. For example, an importer can hedge against the appreciation of the currency of invoice by fixing an exact value of the contract in equivalent sum of domestic currency. Likewise an exporter can avoid an exposure against depreciation of currency of invoice by fixing a definite value of his currency receivables in terms of domestic currency. INTEREST RATE DERIVATIVES Interest Rate Derivatives provide mechanism for two parties to exchange interest obligations for a certain period in respect of a notional principal amount. The basic tools for managing the interest risks are IRS / FRA and interest rate caps / floor / collar. IRS / FRA help to change the interest profile of interest rate payments from fixed to floating or vice versa. IRS can be used to transform one type of interest obligation into another thereby enable a swap participant to meet its needs in a given rate environment. Interest rate caps / floors / collars are used to place a limit or a band within which the interest rate on one's asset or liability can move. CURRENCY OPTIONS
Currency Option gives the holder a right but no obligations to buy (or sell) a currency sometime in future. It can be used when the volatility of rates is significant and when one anticipates an unfavourable rate trend of the currency or when the cash flows are uncertain. Options are traded on OTC market as well in the organized market. There are two types of Options: Call and Put Options A buyer of a Call Option acquires a right (but no obligation) to buy currency ‘X’ at a certain price against the currency ‘Y’. A buyer of a Put Option acquires a right (but no obligation) to sell currency ‘X’ against currency ‘Y’ at a pre fixed price. The exporter can cover his receivables denominated in foreign currency by taking a ‘Put’ Option. Buying of ‘Put’ Option is based on the anticipation of decline in the underlying currency. Covering with ‘Put’ Option is more beneficial than Forward Cover if the appreciation of Foreign Currency (depreciation of domestic currency) is greater than the amount of premium. It provides a cover against a decrease in the value of currency while at the same time enabling the holder of the option to benefit from the increase in the value of the currency. The use of Currency Call Option can be made to cover the payables denominated in a foreign currency. Code Of Conduct For Trading In Derivatives Although banks are following their own 'KYC' norms, Fixed Income Money Markets & Derivatives Association (Fimmda) is framing the code of conduct for trading in derivatives transactions, enlisting 'know your counter-party' guidelines, in line with Financial Services Authority's London Code of Conduct for principals and broking firms, for derivative players. Further IBA is seeking amendment in Banking Regulation Act and Securities Contract and Regulation Act to provide legality to trading over the counter (OTC) derivatives. Put-Call Ratio Put-call ratio is the number of put options divided by number of call option, which tells us about the level of bullishness or bearishness in the market. It can be used in either the direct way or the contrarian way. Under direct way, one follow the ratio and flow with the tide, whereas under contrarian way, when bullishness is high then the downside risk is also high so one takes a contrarian view and sell or viceversa.
doc_909570779.doc
Derivatives existed in its crudest form even in the rural agro based economies when farmers and merchants would sell the harvest in advance at a fixed price to hedge against any adverse change in crop price. In today's world when financial operations have become complex in the liberalized environment, many new variants have evolved. CONCEPT Derivatives are financial instruments whose value is derived from price of the underlying asset. The underlying asset can be commodity or financial instrument such as currency, stocks, and interest rates and even share indices. Derivatives are basically risk management tools against uncertainties of business environment. Its main economic function is to transfer the market price risk whether it is the commodity market or the financial market. They provide a hedge against risk of fluctuation in currency and interest rates. Thus they facilitate efficient planning / management of cash flows. Derivatives can be classified in two categories : (i) Over the Counter derivatives (OTC). These are customised contracts to suit the individual customers' needs. (ii) Exchange Traded derivatives. They are traded on organised exchanges and are for standard amounts and maturity period. In India, Commercial Banks, Primary Dealers and All India Financial Institutions have been allowed by the RBI to use derivative products such as Interest Rate Swaps/ Forward Rate agreements, both for their own balance sheet management as well as market making purposes. DERIVATIVE PRODUCTS FOR RESIDENT / CORPORATE CLIENTS Presently the authorised Dealers are permitted by RBI to offer the following derivative products to their clients: o Forward Exchange Contract o Currency Swaps such as Foreign Currency Rupee swaps, Cross Currency Swaps, Coupon Swaps o Interest Derivatives such as Interest Rate Swaps (IRS), Forward Rate Agreements (FRA), Interest Rate Caps/Collars (purchase) o Options such as Cross Currency options DERIVATIVE PRODUCTS FOR BANKS To hedge their Asset – Liability portfolio, banks can use (i) Interest Rate Swaps (ii) Currency Swaps (iii) Forward Rate Agreements FORWARD EXCHANGE CONTRACT Forward rates are quoted for different maturities. The rates are with reference to Spot Rates and forward contract is traded at a premium or discount vis-a-vis Spot rate. The rate is based on differential of interest rates of two currencies. Forward market provides mechanism for covering of exchange risk by fixing the rate for a date later than the one on which the contract is entered into. For example, an importer can hedge against the appreciation of the currency of invoice by fixing an exact value of the contract in equivalent sum of domestic currency. Likewise an exporter can avoid an exposure against depreciation of currency of invoice by fixing a definite value of his currency receivables in terms of domestic currency. INTEREST RATE DERIVATIVES Interest Rate Derivatives provide mechanism for two parties to exchange interest obligations for a certain period in respect of a notional principal amount. The basic tools for managing the interest risks are IRS / FRA and interest rate caps / floor / collar. IRS / FRA help to change the interest profile of interest rate payments from fixed to floating or vice versa. IRS can be used to transform one type of interest obligation into another thereby enable a swap participant to meet its needs in a given rate environment. Interest rate caps / floors / collars are used to place a limit or a band within which the interest rate on one's asset or liability can move. CURRENCY OPTIONS
Currency Option gives the holder a right but no obligations to buy (or sell) a currency sometime in future. It can be used when the volatility of rates is significant and when one anticipates an unfavourable rate trend of the currency or when the cash flows are uncertain. Options are traded on OTC market as well in the organized market. There are two types of Options: Call and Put Options A buyer of a Call Option acquires a right (but no obligation) to buy currency ‘X’ at a certain price against the currency ‘Y’. A buyer of a Put Option acquires a right (but no obligation) to sell currency ‘X’ against currency ‘Y’ at a pre fixed price. The exporter can cover his receivables denominated in foreign currency by taking a ‘Put’ Option. Buying of ‘Put’ Option is based on the anticipation of decline in the underlying currency. Covering with ‘Put’ Option is more beneficial than Forward Cover if the appreciation of Foreign Currency (depreciation of domestic currency) is greater than the amount of premium. It provides a cover against a decrease in the value of currency while at the same time enabling the holder of the option to benefit from the increase in the value of the currency. The use of Currency Call Option can be made to cover the payables denominated in a foreign currency. Code Of Conduct For Trading In Derivatives Although banks are following their own 'KYC' norms, Fixed Income Money Markets & Derivatives Association (Fimmda) is framing the code of conduct for trading in derivatives transactions, enlisting 'know your counter-party' guidelines, in line with Financial Services Authority's London Code of Conduct for principals and broking firms, for derivative players. Further IBA is seeking amendment in Banking Regulation Act and Securities Contract and Regulation Act to provide legality to trading over the counter (OTC) derivatives. Put-Call Ratio Put-call ratio is the number of put options divided by number of call option, which tells us about the level of bullishness or bearishness in the market. It can be used in either the direct way or the contrarian way. Under direct way, one follow the ratio and flow with the tide, whereas under contrarian way, when bullishness is high then the downside risk is also high so one takes a contrarian view and sell or viceversa.
doc_909570779.doc