Professional Documents
Culture Documents
Submitted by
Guide
Raju.s
Reg.No: 04XQCM6069
Prof,Santhanam
Acknowledgement
Words are indeed and inadequate to convey my deep sense of
gratitude to all those who had made to this report successfully.
I wish to acknowledge with profound sense of appreciation to the
help and support I received from Prof,Santhanam and Guide, M.P.Birla
Institute of Management for providing the valuable guidance and
suggestions for completing this project report.
I owe a great debt of gratitude to my parents and other members of
my family for having helped me achieve my objective.
I would be failing in my duty if I do not acknowledge my friends
who have helped me in completing this report.
Declaration
I Mr. Raju.s student of M.P.Birla Institute of Management,
Associate Bharatiya Vidya Bhavan, studying 4th semester MBA
hereby declare that this project report entitled Study on forex and
debt market
Derivatives
Date:
Place:
(Raju.s)
PRINCIPALS CERTIFICATE
This to certify that this report titled Study on forex and Debt market
Derivatives has been prepared by Mr. Raju.s
bearing the
Place:
Date:
Principal
(Dr.N.S.Malavalli)
GUIDES CERTIFICATE
Place:
Date:
( Raju.s)
Executive Summary
Derivatives are one of the instruments in the hands of the investors which are useful
in fulfilling the needs of investors. This can be either to hedge the risk of the
underlying or to take a speculative view and make profits or losses and arbitrage
opportunities. This entirely speaks about the derivatives, its uses and the ways how
the individuals, banks and corporate use this instrument to make huge profit. To make
huge profit they want to take same amount of risk.
The topic of dissertation is Study on Forex and Debt market derivatives. This study
entirely speaks about the ways in which the interest rate risk is hedged like interest
rate futures, interest rate options, forward rate agreements and swaps, the reasons for
fluctuation in interest rates, the hedge ratio that is to be used and different ways of
calculating the hedge ratio like Market Value Nave Model, Face Value Nave Model,
Hedge Ratio, Regression Model, price sensitivity model and others.
Further the study carries towards the introduction of options, the ways how the
options are helpful in hedging the risk so that the profit is also reaped with less loss
which occurs by paying premium. The strategies used in the options like straddle,
strangle, bull spread, bear spread, and butterfly spread. It further carries towards the
Black Scholes Model and the assumption made by him for calculating the prices of
the options and it also speaks regarding the Delta, Gamma, Vega, RHO and Theta.
Then the study explains about the currency risk which is faced by most of the
exporters, importers and to those who deal in forex market and it gives a solution how
the currency risk can be hedged by using the currency futures and currency options.
The factors which play the major role in determining exchange rate and the three
important theories on exchange rate i.e., Interest rate parity, Purchase power parity
and Fishers theory.
Swaps, which are more efficient than interest rate futures, currency futures, interest
rate options and currency options. The various swaps used by the individual, banks
and corporate to hedge the interest rate risk and currency risks and the use of interest
rate swaps and currency swaps to corporate.
For most of the explanation there is a real life example how the interest rate futures
and currency futures are traded in Chicago Mercantile Exchange. Based on the study
there are two questioners for two different risks that is interest rate risk and currency
risk. This questioners speaks about the Indias position in interest rate futures and
options and currency futures and options.
At last with findings with the reasons as to why interest rate futures thinly traded in
India and reasons as to why the currency risk is the most unhedged risk in India. And
at the same time the conclusion which talks about the steps to be taken by the RBI and
SEBI in respect how to increase the trading in Interest rate futures and options and
currency futures and options
TABLE OF CONTENTS
Declaration
Certificate by Guide
Acknowledgement
Executive Summary
Chapter
No
1
Title
Page
no
Introduction to derivatives
3
3
3
3
Futures Prices
Cost-of-carry model in perfect markets
The reverse cash-and-carry
4
4
5
9
9
9
3
3.1
Hedging Strategies
Face Value Naive Model
10
10
3.2
3.3
3.4
3.5
3.6
10
10
10
11
11
13
4.1
Treasury-Bill Futures
13
4.2
4.3
5.
5.1
Eurodollar Futures
Long term Treasury Futures
Currency Futures
Currency Exchange Risk
14
16
18
18
5.2
5.3
5.3.1
18
21
21
5.3.2
21
2
2.1
2.2
2.3
2.4
2.4.1
2.4.2
2.4.6
2.4.6.1
2.4.6.2
5.3.3
22
Determination
5.3.4
23
5.3.5
24
5.3.6
24
5.3.7
25
Options
26
6.1
Introduction
26
6.2
Option Terminology
27
6.3
28
6.3.1
Long Call
28
6.3.2
Long Put
29
6.3.3
31
6.3.4
Short Put
32
6.4
33
6.5
34
7.
37
7.2
37
7.2.1
38
7.2.2
Expected Inflation
38
7.2.3
Economic conditions
39
7.2.4
39
7.2.5
Fiscal Policy
39
7.3
40
7.4
40
8.
42
8.1
42
8.2
Hedging Solutions
43
8.2.1
43
8.2.2
44
8.2.3
Treasury collars
44
45
8.3
8.4
45
8.5
47
8.6
47
Rate Futures
9.
Currency Options
49
9.1
Introduction
49
9.2
49
10.
Swaps
53
10.1
Introduction
53
10.2
53
10.3
53
54
10.5
54
10.6
56
10.7
56
10.8
58
10.9
Currency Swaps
60
10.10
61
10.11
Swaption
61
11.
Research Design
63
11.1
Questionnaire
64
12.
74
13.
Findings
90
14.
Conclusion
93
15.
Bibliography
96
10
Graphs
Figure
no.
1.
Particulars
Depicts the ways in which Banks/Firms have hedged
Page
no.
74
7
8
9
10
11
12
13
14
15
16
17
18
19
74
75
76
76
77
77
78
78
79
79
80
80
81
81
82
82
83
83
11
20
21
22
23
24
25
26
27
28
29 a
29b
84
84
85
85
86
86
87
87
88
89
89
12
1. Introduction to derivatives
A derivative is a financial instrument which derives its value from some other
financial price. This other financial price is called the underlying. A wheat farmer
may wish to contract to sell his harvest at a future date to eliminate the risk of a
change in prices by that date. The price for such a contract would obviously depend
upon the current spot price of wheat. Such a transaction could take place on a wheat
forward market. Here, the wheat forward is the derivative and wheat on the spot
market is the underlying. The terms derivative contract, derivative product, or
derivative are used interchangeably.
The emergence of the market for derivative products, most notably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties arising out of fluctuations in asset prices. By
their very nature, the financial markets are marked by a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully transfer price
risks by lockingin asset prices. As instruments of risk management, these generally
do not influence the fluctuations in the underlying asset prices. However, by lockingin asset prices, derivative products minimize the impact of fluctuations in asset prices
on the profitability and cash flow situation of risk-averse investors.
13
high correlation of the popular indexes with various portfolios and ease of use. The
lower costs associated with index derivatives visavis derivative products based on
individual securities is another reason for their growing use.
1.3 Functions
14
Futures
Forwards
OTC in nature
No margin payment
15
2.4.2 Consider the information of 4.1 given above. Now let us assume that futures
trading costs are $25 per 100-ounce gold contract, and buying or selling an ounce of
gold incurs transaction costs of $1.25. Gold can be stored for $.15 per month per
ounce. (Ignore interest on the storage fee and the transaction costs.)
What futures prices are consistent with the cost-of-carry model?
Answering this question requires finding the bounds imposed by the cash-and-carry
and reverse cash-and-carry strategies. For convenience, we assume a transaction size
of one 100-ounce contract.
2.4.2.1 For the cash-and-carry, the trader buys gold and sells the futures. This
strategy requires the following cash outflows:
Transactions
Cash flow
Buy gold
-$370(100)
-$1.25(100)
-$.15(100) (6)
0
16
-$37,215
-$25
-$39,114.95
?
Net outlays at the outset were zero, and they were $39,139.95 at the horizon.
Therefore, the futures price must exceed $391.40 an ounce for the cash-and-carry
strategy to yield a profit.
2.4.2.2 The reverse cash-and-carry incurs the following cash flows. At the outset,
the trader must:
Particulars
Cash flows
Sell gold
+$370(100)
-$1.25(100)
Invest funds
-$36,875
Buy futures
These transactions provide a net zero initial cash flow. In six months, the trader has
the following cash flows:
Collect on investment
+$36,875(1+.10/12)6= $38,757.59
-$25
?
The breakeven futures price is therefore $387.33 per ounce. Any lower price will
generate a profit. From the cash-and-carry strategy, the futures price must be less than
$391.40 to prevent arbitrage. From the reverse cash-and-carry strategy, the price must
be at least $387.33. (Note that we assume there are no expenses associated with
making or taking delivery.)
2.4.3 Consider the information given in 2.4.1 and 2.4.2 above. Restrictions on short
selling effectively mean that the reverse cash-and-carry trader in the gold market
receives the use of only 90 percent of the value of the gold that is sold short. Based on
this new information, what is the permissible range of futures prices?
17
This new assumption does not affect the cash-and-carry strategy, but it does limit the
profitability of the reverse cash-and-carry trade. Specifically, the trader sells 100
ounces short but realizes only .9($370)(100) =$33,300 of usable funds. After paying
the $125 spot transaction cost, the trader has $33,175 to invest.
Therefore, the investment proceeds at the horizon are:
$33,175(1+.10/12)6= $34,868.69.
+$370(100)
-$1.25(100)
-$3,700
Invest funds
-$33,175
Buy futures
These transactions provide a net zero initial cash flow. In six months, the trader has
the following cash flows:
Collect on investment
Receive return of deposit from broker
Pay futures transaction costs
$34,868.69
$3,700
$25
The breakeven futures price is therefore $385.44 per ounce. Any lower price will
generate a profit. Thus, the no-arbitrage condition will be fulfilled if the futures price
equals or exceeds $385.44 and equals or is less than $391.40.
2.4.4 Consider all of the information about gold from 2.4.1 to 2.4.3. The interest
rate in question 2.4.1 is 10 percent per annum, with monthly compounding. This is the
borrowing rate. Lending brings only 8 percent, compounded monthly. What is the
permissible range of futures prices when we consider this imperfection as well?
The lower lending rate reduces the proceeds from the reverse cash-and-carry strategy.
Now the trader has the following cash flows:
18
Transactions
Cash flow
Sell gold
+$370(100)
-$1.25(100)
-$3,700
Invest funds
-$33,175
Buy futures
These transactions provide a net zero initial cash flow. Now the investment will yield
only $33,175(1+.08/12)6= $34,524.31.
In six months, the trader has the following cash flows:
Transactions
Cash flow
Collect on investment
$34,524.31
$25
$ 3,700
Total proceeds on the 100 ounces are $38,199.31. Therefore, the futures price per
ounce must be less than $381.99 for the reverse cash-and-carry strategy to profit.
Because the borrowing rate has not changed, the bound from the cash-and-carry
strategy remains at $391.40. Therefore, the futures price must remain within the
inclusive bounds of $381.99 to $391.40 to exclude arbitrage.
2.4.5 Consider all of the information about gold from 2.4.1 to 2.4.4. The gold
future expiring in six months trades for $375 per ounce. Given all of the market
imperfections we have considered assuming that gold trades for $395.
If the futures price is $395, it exceeds the bound imposed by the cash-and-carry
strategy, and it should be possible to trade as follows:
19
Cash-and-Carry Arbitrage
t=0
t=6
+$37,215.00
-37,000.00
-90.00
-125.00
$395. 0.00
$0
$0
+39,500.00
-25.00
-39,114.95
-$360.05
If the futures price is $375, the reverse cash-and-carry strategy should generate a
profit as follows:
t= 0
t= 6
Collect on investment.
Receive delivery on futures.
Return gold to close short sale.
Receive return of deposit from broker.
Pay futures transaction cost.
+$37,000.00
-125.00
-3,700.00
0
-33,175.00
$0
-$34,524.31
-37,500.00
0
+3,700.00
-25.00
20
+$699.31
The figure shows the profits/losses for a long futures position. The investor bought
futures when the index was at 1220. If the index goes up, his futures position starts
making profit. If the index falls, his futures position starts showing losses.
21
3. Hedging Strategies
Alex Brown has to hedge $500 million of long-term debt that his firm plans to issue in
May. The possible strategies Alex Brown could use to hedge his impending debt
issue.
3.1 Face Value Naive Model: In this method Alex would trade one dollar of nominal
futures contract per one dollar of debt face value. The major benefit of this method is
the ease of implementation. Unfortunately, it ignores market values and the
differential responses of the bond and futures contract prices to interest rates.
3.2 Market Value Naive Model: In this method Alex would hedge one dollar of debt
market value using one dollar of futures price value. That is, the hedge ratio is
determined by the market prices instead of nominal and face values. Unfortunately, it
does not consider the price sensitivities of the two instruments.
3.3 Conversion Factor Model: This model can be used when the hedging instrument
is a T-note or T-bond futures contract. The conversion factor adjusts the prices of
deliverable bonds and notes that do not have a 6% coupon to make them equivalent
to the 6% coupon bond or note that is called for in the contract. The hedge ratio is
determined by multiplying the Face Value Naive hedge ratio by the conversion factor.
The appropriate conversion factor to use is the conversion factor of the cheapest to
22
deliver T-bond or T-note. This model still ignores price sensitivity differences
between the hedging and hedged instruments. The hedge ratio is calculated as below.
HR= - (Cash market principal/Futures market principal)*(Conversion
Factor)
3.4 Basis Point Model: This model uses the price changes of the futures and cash
positions resulting from a one basis point change in yields to determine the hedge
ratio. It is calculated as:
This model works well if the cash and futures instruments face the same rate
volatility. If they face different volatilities and that relationship can be quantified, then
the basis point model can be adjusted to account for the differing volatilities.
3.5 Regression Model: In the regression model the historic relationship between cash
market price changes and futures market price changes is estimated. This estimation is
accomplished by regressing price changes in the cash market on futures price
changes. The slope coefficient from this regression is then used as the hedge ratio.
Alex may not find this model useful, as he is trying to hedge a new debt issue. Even if
Alex had an historic price stream on 30-year corporate debt issues, the historic
relationship with the futures price might prove to be an unreliable indicator of the
present or future relationship. This stems from the fact that the price response of the
futures contract is determined by the cheapest-to-deliver bond. The cheapest-todeliver bond can vary in maturity from 15 years to 30 years. This means that the
futures contract can have very different price responses to interest rates at different
points in time.
For the RGR model the hedge ratio is:
HR= - (COVs,f/Variance of futures)
COVs,f = covariance between cash and futures.
3.6 Price Sensitivity Model: This may be a good model for Alex to use. It is designed
for interest rate hedging, and it accounts for the differential price responses of the
hedging and the hedged instruments. The model is duration-based so that it accounts
23
for maturity and coupon rate differences of the cash and the futures positions. It is
computed as:
Where:
FPF and Pi are the respective futures contract and cash instrument prices; MDi and
MDF are the modified durations for the cash and futures instruments, respectively,
and RYC is the change in the cash market yield relative to the change in the futures
yield.
Let us look at an example. Alex Brown has just returned from a seminar on using
futures for hedging purposes. As a result of what he has learned, he re-examines his
decision to hedge $500 million of long-term debt that his firm plans to issue in May.
Face Value Naive hedge: In this model Alex current hedge is a short position of
5,000 T-bond futures contracts ($100,000 each). Currently Alex has employed a Face
Value Naive hedge. For each dollar of debt principal he plans to issue, he is short $1
of nominal T-bond futures. The benefit of the strategy is its ease of implementation.
The drawback is that cash instrument and the T-bond futures may have differential
price responses to interest rate changes.
Price sensitivity hedge: Alex feels that a price sensitivity hedge would be most
appropriate for his situation. The additional information is if the debt could be issued
today, it would be priced at 119-22 to yield 6.5%. With its 8% coupon and 30 years to
maturity, the duration of the debt would be 13.09 years. On the futures side, the
futures prices are based on the cheapest-to-deliver bonds, which are trading at 124-14
to yield 5.6%. These bonds have duration of 9.64 years.
The price sensitivity hedge ratio is:
MDF= 9.128788
Pi = 119.6875%_500 million
MDi = 12.29108
24
25
The price of a $1,000,000 face value 90-day T-bill has a discount yield of 8.75
percent.
Applying the equation for the value of a T-bill, the price of a $1,000,000 face value Tbill is $1,000,000 -DY($1,000,000)(DTM)/360, where DY is the discount yield and
DTM= days until maturity. Therefore, if DY=0.0875 the bill price is:
Let us look at one more example. The IMM Index stands as 88.70. If you buy a T-bill
future at that index value and the index becomes 88.90, what is your gain or loss?
The discount yield = 100.00- IMM Index = 100.00- 88.70 = 11.30 percent.
If the IMM Index moves to 88.90, it has gained 20 basis points, and each point is
worth $25. Because the price has risen and the yield has fallen, the long position has a
profit of $25(20) = $500.
4.2 Eurodollar Futures
Eurodollars are any dollar denominated deposit in a bank outside of the U.S. Thus
dollar deposits in Singapore are still called Eurodollars. Eurodollar accounts are not
transferable but banks can lend on the basis of the Eurodollar accounts it holds. The
interest rate charged for Eurodollar loans is often based upon the London Inter bank
Offer Rate (LIBOR).
The Eurodollar contract on the IMM is also for $1 million. Since Eurodollar accounts
are not transferable it is not possible to actually make delivery on Eurodollar
contracts. Instead there is a cash settlement at the end of the contract period. In the
case of Eurodollar contracts the discount yield is replaced by an add-on yield which is
the interest earned in proportion to the original price. Thus,
Add-on Yield = DY/(1 - DY/100)
26
The value of a CME Eurodollar interest rate futures contract rises when interest rates
fall and vice versa, hence the manager would need a short position to hedge. Hence if
interest rates rise, the value of the contract falls and a short position is in the money
(sold high, can buy back low).
The notional principal of a CME Eurodollar interest rate futures contract is
US$1million. The price of the CME Eurodollar interest rate futures contract at the
maturity date is 100-R where R is the 90-day Libor interest rate that starts when the
contract matures on the 3rd Wednesday or each delivery month. This interest rate is
then the underlying variable for this contract.
The value of the CME Eurodollar interest rate futures contract on any given day
before it matures is given by the formula: 10000*[100-0.25(100-Z)] where Z is the
price of the futures contract at that time given by supply and demand! This implies
that for each basis point move in the price, the contract value changes by US$25.
E.g.: If Z = 94.32, V = 985,800
If Z = 94.33, V = 985,825
The contract is settled daily like any futures contract with variation margin payments.
Suppose the company does not hedge and interest rates and interest payments (using
90/360 convention) turn out to be:
Sep 15
1.89%
47250
Dec 15
2.44%
61000
Mar 15
2.75%
68750
Jun 15
2.90%
72500
1.89%
Futs Sep
2.08% (97.92)
Dec
2.54% (97.46)
Mar
3.18% (96.82)
Sep
Dec
Mar
97.60 (2.4%)
97.31 (2.69%)
97.15 (2.85%)
This implies
27
VToday/Sep=10*10000*[100-0.25(100-97.92)]=9948000
VSep/Sep= 10*10000*[100-0.25(100-97.60)]=9940000
Profit = 8000 = 10*25*(9792-9760)
VToday/Dec=10*10000*[100-0.25(100-97.46)]=9936500
VDec/Dec= 10*10000*[100-0.25(100-97.31)]=9932750
Profit = 3750 = 10*25*(9746-9731)
VToday/Mar=10*10000*[100-0.25(100-96.82)]=9920500
VMar/Mar= 10*10000*[100-0.25(100-97.15)]=9932750
Profit = -8250 = 10*25*(9682-9715)
Total costs
Interest costs as before
Futures profit/loss
Sep 15
1.89%
47250
Dec 15
2.44%
61000
8000
Mar 15
2.75%
68750
3750
Jun 15
2.90%
72500
-8250
249500
3500 (profit)
28
Cross-Hedge: U.S. Treasury bond and note futures can be used to control risk and
enhance the returns of non-U.S. government securities. Treasury futures can be
effective risk-management tools for corporate bonds, Eurobonds, and other fixedincome instruments.
Trade Changes in the Yield Curve
Because Treasury futures cover a wide spectrum of maturities from short-term notes
to long-term bonds, you can construct trades based on the differences in interest rate
movements all along the yield curve.
Contract Specifications:
Trading Unit
T-bond Futures - One U.S. Treasury bond with $100,000 face value at maturity.
10-year T-note Futures - One U.S. Treasury note with $100,000 face value at
maturity.
5-year T-note Futures - One U.S. Treasury note with $100,000 face value at
maturity.
2-year T-note Futures - One U.S. Treasury note with $200,000 face value at
maturity.
Deliverable Grades
T-bond Futures- Bonds with at least 15 years remaining to maturity.
10-year T-note Futures- Notes with 61/2 to 10 years remaining to maturity.
5-year T-note Futures- Notes with 4 years 3 months to 5 years 3 months remaining
to maturity.
2-year T-note Futures- Notes with 1 year 9 months to 2 years remaining to maturity.
29
Tick Size
T-bond Futures - 1/32
10-year T-note Futures - 1/32
5-year T-note Futures - 1/2 of 1/32
2-year T-note Futures - 1/4 of 1/32
5. Currency Futures
5.1 Currency Exchange Risk
How do currency fluctuations affect import/exporters?
Exchange rate volatility can work against an international company if a payment in a
foreign currency has to be made at a future date. There is no way to guarantee that the
price in the currency market will be the same in the future-it is possible that the price
will move against the company, making the payment cost more. On the other hand,
the market can also move in a business' favour, making the payment cost less in terms
of their home currency.
Generally, firms that export goods to other countries benefit when their home
currency depreciates, since their products become cheaper in other countries. Firms
that import from other countries benefit when their currency becomes stronger, since
it enables them to purchase more.
Hedging Against Currency Risk to Avoid the Volatility Trap
so how can a business protect against a risky currency? One way is to avoid the risk
by minimizing their commercial involvement with countries that have volatile
currencies like the Japanese Yen. This is however not a practical solution. Another
way is to hedge in the spot currency market by taking a position that effectively
neutralizes the volatility in the pair.
30
5.2 Currency Future: It is a futures contract to exchange one currency for another at
a specified date in the future at a price (exchange rate) that is fixed on the last trading
date. Typically, one of the currencies is the US dollar. The price of a future is then in
terms of US dollars per unit of other currency. This can be different from the standard
way of quoting in the spot foreign exchange markets. The trade unit of each contract
is then a certain amount of other currency, for instance EUR 125,000. Most contracts
have physical delivery, so for those held at the end of the last trading day, actual
payments are made in each currency. However, most contracts are closed out before
that.
Example
Peter buys 10 September CME Euro FX Futures, at 1.2713 USD/EUR. At the end of
the day, the futures close at 1.2784 USD/EUR. The change in price is 0.0071
USD/EUR. As each contract is over EUR 125,000, and he has 10 contracts, his profit
is USD 8,875. As with any future, this is paid to him immediately.
More generally, each change of 0.0001 USD/EUR (the minimum tick size), is a profit
or loss of USD 12.5 per contract.
Investors use these futures contracts to hedge against foreign exchange risk. They can
also be used to speculate and, by incurring a risk, attempt to profit from rising or
falling exchange rates. Investors can close out the contract at any time prior to the
contract's delivery date.
Currency futures were first created at the Chicago Mercantile Exchange (CME) in
1972, less than one year after the system of fixed exchange rates was abandoned
along with the gold standard. Some commodity traders at the CME did not have
access to the inter-bank exchange markets in the early seventies, when they believed
that significant changes were about to take place in the currency market. They
established the International Monetary Market (IMM) and launched trading in seven
currency futures on May 16, 1972. Today, the IMM is a division of CME. In the
31
second quarter of 2005, an average of 332,000 contracts with a notional value of USD
43 billion were traded every day. Most of these are traded electronically nowadays
A futures contract is like a forward contract it specifies that a certain currency will be
exchanged for another at a specified time in the future at prices specified today. A
futures contract is different from a forward contract. Futures are standardized
contracts trading on organized exchanges with daily resettlement through a
clearinghouse
The Standardizing Features
Contract Size
Delivery Month
Daily resettlement
Initial Margin (about 4% of contract value, cash or T-bills held in a street name at
your brokers).
Suppose you want to speculate on a rise in the $/ exchange rate (specifically you
think that the dollar will appreciate).
Japan (yen)
1-month forward
3-months forward
6-months forward
U.S. $ equivalent
Wed
Tue
0.007142857 0.007194245
0.006993007 0.007042254
0.006666667 0.006711409
0.00625 0.006289308
Currency per
U.S. $
Wed
Tue
140
139
143
142
150
149
160
159
$1
150
If tomorrow, the futures rate closes at $1 = 149, then your positions value drops.
32
$1
149
The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05
This is short of the $3,355.70 required for a new position.
$1
149
Your broker will let you slide until you run through your maintenance margin. Then
$3,355.70 .04 12,500,000
you must post additional funds or your position will be closed out. This is usually
done with a reversing trade.
For example if nation A is US and nation B is the UK the exchange rate b/w dollar and
pound is equal to the ratio of US to UK prices. If the general price level in US is twice
to the general level in UK, then the absolute PPP theory postulates equilibrium rate to
be
Rab = S 2/Stg 1
5.3.2 International Fisher Effect (IFE)
IFE Uses Interest Rates rather than inflation rate difference to explain the changes in
interest rates over time. IFE is closely related to PPP because interest rates are
significantly correlated with inflation rates. The relationship b/w the percentage
change in the spot exchange rates in different national capital markets is known as
33
IFE. IFE suggests that given two countries, the currency with the higher interest rates
will depreciate by the amount of interest rate differential. This is with a country the
nominal interest rate tends to approximately equal the real interest rate plus the
expected inflation The proportion that the nominal interest rate varies directly with
the expected inflation rate, known as Fisher effect has subsequently been incorporated
into the theory of exchange rate determination.
IRP is an arbitrage condition that must hold when international financial markets are
in equilibrium. Suppose that you have $ 1 to invest over, say a one-year period.
Consider two alternative ways of investing your fund.
1.
2.
Invest in a foreign country, say the U.K. at the foreign interest rate and hedge
the exchange risk by selling the maturity value of the foreign investment
forward.
If the Fisher effect holds in the U.S. i$ = $ + E($) and the Fisher effect holds in
Japan, i = + E() and if the real rates are the same in each country $ = then
we get the International Fisher Effect E(e) = i$ - i .
If the International Fisher Effect holds, E(e) = i$ - i and if IRP also holds
E(e)
i$ -i
(F- S)
S
(F - S)
S
34
The exchange rate between two currencies should equal the ratio of the countries
price levels.
S ($/) = P$ P
Relative PPP states that the rate of change in an exchange rate is equal to the
differences in the rates of inflation.
e = $ -
If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by
3%.
The real exchange rate is
1 $
(1 e)(1 )
(i$ -i )
(F- S)
S
If IRP failed to hold, an arbitrage would exist. Its easiest to see this in the form of an
example.
35
Consider the following set of foreign and domestic interest rates and spot and forward
exchange rates.
Spot exchange rate
S($/)
$1.25/
F360($/) =
$1.20/
i$
7.10%
11.56%
Arbitrage Strategy I
If F360 ($/) > $1.20/
i. Borrow $1,000 at t = 0 at i$ = 7.1%.
ii. Exchange $1,000 for 800 at the prevailing spot rate,
(Note that 800 =$1,000$1.25/) invest 800 at 11.56% (i) for one year to
achieve 892.48
iii. Translate 892.48 back into dollars, if F360 ($/) > $1.20/ , 892.48 will
be more than enough to repay your dollar obligation of $1,071.
Arbitrage Strategy II
If F360 ($/) < $1.20/
i. Borrow 800 at t = 0 at i= 11.56%.
ii. Exchange 800 for $1,000 at the prevailing spot rate, invest $1,000 at
7.1% for one year to achieve $1,071.
36
iii. Translate $1,071 back into pounds, if F360($/) < $1.20/ , $1,071 will be
more than enough to repay your obligation of 892.48.
5.3.6 IRP and Hedging Currency Risk
You are a U.S. importer of British woolens and have just ordered next years
inventory. Payment of 100M is due in one year.
Spot exchange rate
S($/)
= $1.25/
F360($/) = $1.20/
i$
= 7.10%
= 11.56%
IRP implies that there are two ways that you fix the cash outflow
a)
Put your self in a position that delivers 100M in one yeara long forward
100
1.1156
How many dollars will it take to acquire 89.64 million at the start of the year if
S ($/) = $1.25/?
$1.00
$112.05 89.64
1.25
37
6. Options
6.1 Introduction: An option is a contract which gives its holder the right, but not the
obligation, to buy (or sell) an asset at some predetermined price within a specified
period of time. An option is a contract which gives its holder the right, but not the
obligation, to buy (or sell) an asset at some predetermined price within a specified
period of time.
A real life example
Suppose you are on your way to home one day and you notice that house at the end of
the street is for sale. Its bigger then your current house and has a double bed room.
All this costs only $100,000. Youve just got to buy it! One problem is money: you
dont have any but within a couple of months, you think you could get it. So what
do you do? Wait and risk losing the house to another buyer?
Here is something you could do: lets say you go down and see the owner of the
house and explain your situation. He feels for your predicament and suggests that you
pay a fee of $1,000. For that $1,000 he will hold the house for exactly two months and
no longer. Should you wish to buy it, you will have to pay $100,000. This means your
total cost is $100,000 + $1,000 = $101,000.
Youve just bought yourself a call option!
Within the two months you can raise the money and buy the house. You could forget
the deal all together and lose the $1000, but not be liable for anything else. Note
paying the $1000 gives you the right but not the obligation to buy the house. The
38
owner of the house would be obliged to sell it to you should you so desire, but only
before the two months are up.
Lets fast forward. Two months are almost up and you have managed to secure some
finance. Paying the full price for the house is not a problem. However, you have just
read in the newspaper that housing prices in your area have fallen in the last two
months. Your dream house now has a $90,000 price tag.
What do you do? Take up the option to buy it for $10,000 for more than its worth?
Certainly not! You would be happy to let your option expire, losing the $1,000
deposit. You could however go and buy the house at the current market price of
$90,000 and save the difference.
However lets say housing prices have increased and the house is really worth
$110,000. What do you do? You would take up your option to buy at $100,000 and
the seller would be obliged to sell it to you. In the markets, this is the same as
exercising a call option.
Hey, if you were so inclined, you could then sell the house at market price and make a
handsome $9,000 profit ($110,000 - $101,000 = $9,000). Then again you might just
want to live in it, but thats beside the point.
6.2 Option Terminology
Call option: An option to buy a specified number of shares of a security within
some future period.
Put option: An option to sell a specified number of shares of a security with in
some future period.
Exercise (or strike) price: The price stated in the option contract at which the
security can be bought or sold.
Option price: The market price of the option contract.
Expiration date: The date the option matures.
Exercise value (intrinsic value): The value of a call option if it were exercised
today = Current stock price - Strike price.
Note: The exercise (intrinsic) value is zero if the stock price is less than the strike
price.
Seller of option is called Option Writer
Covered option: A call option written against stock held in an investors portfolio.
Naked (uncovered) option: An option sold without the stock to back it up.
39
In-the-money call: A call whose exercise (strike) price is less than the current
price of the underlying stock.
Out-of-the-money call: A call option whose exercise (strike) price exceeds the
current stock price.
LEAPs: Long-term Equity Anticipation securities that are similar to conventional
options except that they are long-term options with maturities of up to 2 1/2 years.
$25
$ 3.00
30
7.50
35
12.00
40
16.50
45
21.00
50
25.50
Price of
Strike
Exercise Value
Stock(a)
Price(b) of Option(a)-(b)
25.00
$25.00
30.00
Time Value
of Option (c)
of Option(d)
(d) - (c)
$0.00
$ 0.00
$ 3.00
$ 3.00
25.00
5.00
5.00
7.50
2.50
35.00
25.00
10.00
10.00
12.00
2.00
40.00
25.00
15.00
15.00
16.50
1.50
45.00
25.00
20.00
20.00
21.00
1.00
50.00
25.00
25.00
25.00
25.50
0.50
40
41
The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call
option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon
expiration, Nifty closes above the strike of 1250, the buyer would exercise his option
and profit to the extent of the difference between the Nifty-close and the strike price.
The profits possible on this option are potentially unlimited. However if Nifty falls
below the strike of 1250, he lets the option expire. His losses are limited to the extent
of the premium he paid for buying the option.
6.3.2 Long Put:A trader who believes that a stock's price will decrease can buy the
right to sell the stock at a fixed price. He will be under no obligation to sell the
stock, but has the right to do so until the expiry date. If the stock price
decreases, he will profit by the amount of the decrease less the premium paid.
If the stock price increases, he will just let the put contract expire worthless.
42
The figure shows the profits/losses for the buyer of a three-month Nifty 1250 put
option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon
expiration, Nifty closes below the strike of 1250, the buyer would exercise his option
and profit to the extent of the difference between the strike price and Nifty-close. The
profits possible on this option can be as high as the strike price. However if Nifty rises
above the strike of 1250, he lets the option expire. His losses are limited to the extent
of the premium he paid for buying the option.
6.3.3 Short Call (Naked short call): A trader who believes that a stock's price will
decrease can short sell the stock or instead sell a call. Both tactics are
generally considered inappropriate for small investors. The trader selling a call
has an obligation to sell the stock to the call buyer at the buyer's option. If the
stock price decreases, the short call position will make a profit in the amount
43
of the premium. If the stock price increases, the short position will lose by the
amount of the increase less the amount of the premium.
The figure shows the profits/losses for the seller of a three-month Nifty 1250 call
option. As the spot Nifty rises, the call option is in-the-money and the writer starts
making losses. If upon expiration, Nifty closes above the strike of 1250, the buyer
would exercise his option on the writer who would suffer a loss to the extent of the
difference between the Nifty-close and the strike price. The loss that can be incurred
by the writer of the option is potentially unlimited, whereas the maximum profit is
limited to the extent of the up-front option premium of Rs.86.60 charged by him.
6.3.4 Short Put: A trader who believes that a stock's price will increase can sell the
right to purchase the stock at a fixed price. This trade is generally considered
inappropriate for a small investor. If the stock price increases, the short put
position will make a profit in the amount of the premium. If the stock price
44
decreases, the short position will lose by the amount of the decrease less the
amount of the premium.
The figure shows the profits/losses for the seller of a three-month Nifty 1250 put
option. As the spot Nifty falls, the put option is in-the-money and the writer starts
making losses. If upon expiration, Nifty closes below the strike of 1250, the buyer
would exercise his option on the writer who would suffer a loss to the extent of the
difference between the strike price and Nifty-close. The loss that can be incurred by
the writer of the option is a maximum extent of the strike price( Since the worst that
can happen is that the asset price can fall to zero) whereas the maximum profit is
limited to the extent of the up-front option premium of Rs.61.70 charged by him.
45
variety of options strategies. Simple strategies usually combine only a few trades,
while more complicated strategies can combine several.
1. Covered Call: Long the stock, short a call. This has essentially the same payoff as
a short put.
2. Straddle: Long a call and long a put with the same exercise prices (a long
straddle), or short a call and short a put with the same exercise prices (a short
straddle).
3. Strangle: Long a call and long a put with different exercise prices (a long
strangle), or short a call and short a put with different exercise prices (a short
strangle).
4. Bull Spread: Long a call with a low exercise price and short a call with a higher
exercise price, or long a put with a low exercise price and short a put with a higher
exercise price.
5. Bear Spread : Short a call with a low exercise price and long a call with a higher
exercise price, or short a put with a low exercise price and long a put with a higher
exercise price.
6. Butterfly: Butterflies require trading options with 3 different exercise prices.
Assume exercise prices X1 < X2 < X3 and that (X1 + X3)/2 = X2
Long butterfly - long 1 call with exercise price X1, short 2 calls with exercise price
X2, and long 1 call with exercise price X3. Alternatively, long 1 put with exercise
price X1, short 2 puts with exercise price X2, and long 1 put with exercise price X3.
Short butterfly - short 1 call with exercise price X1, long 2 calls with exercise price
X2, and short 1 call with exercise price X3. Alternatively, short 1 put with exercise
price X1, long 2 puts with exercise price X2, and short 1 put with exercise price X3.
46
option will exercise it; that exercise will cost investor money. If stock price falls,
investor will lose on his investment in stock but gain from option (which will expire
worthless if stock price falls). Black Scholes model helps to set up so that investor
ends up with risk less position - no matter what stock does, investors portfolio
remains constant. Risk less investment yields risk less rate; if return > risk free rate,
arbitrageurs will buy this risk less position & in process push rate of return down.
Black Scholes Model: Given price of stock, its potential volatility, options exercise
price, life of option & risk-free rate, there is but one price for the option if it is to meet
the equilibrium condition -- that a portfolio consisting of stock & call option will earn
risk free rate.
The assumptions of the Black-Scholes Option Pricing Model
1. The stock underlying the call option provides no dividends during the call
options life.
2. There are no transactions costs for the sale/purchase of either the stock or
the option.
3. kRF is known and constant during the options life.
4. Security buyers may borrow any fraction of the purchase price at the shortterm risk-free rate.
5. No penalty for short selling and sellers receive immediately full cash
proceeds at todays price.
6. Call option can be exercised only on its expiration date (European).
7. Security trading takes place in continuous time, and stock prices move
randomly in continuous time.
The three equations that make up the OPM are:
V = P[N(d1)] - Xe -kRFt[N(d2)].
d1 = ln (P/X) + [kRF + (2/2)]t
t
d2 = d1 - t.
Terms in Black-Scholes equation
V = current value of call option
P = current price of underlying stock
47
What is the value of the following call option according to the OPM?
Assume: P = $27; X = $25; kRF = 6%; t = 0.5 years: 2 = 0.11
V = $27[N(d1)] - $25e-(0.06)(0.5)[N(d2)].
ln($27/$25) + [(0.06 + 0.11/2)](0.5)
d1 =
(0.3317)(0.7071)
V = $27(0.7168) - $25e-0.03(0.6327)
= $19.3536 - $25(0.97045)(0.6327)
= $4.0036.
48
Current stock price: Call option value increases as the current stock
price increases.
Exercise price (Strike price): As the exercise (strike) price increases,
a call options value decreases.
Option period: As the expiration date is lengthened, a call options value
increases (more chance of becoming in the money.)
Risk-free rate: Call options value tends to increase as kRF increases
(reduces the PV of the exercise price).
Stock return variance (volatility): Option value increases with
variance of the underlying stock (more chance of becoming in the money).
Premium (price pay) depends on:
strike (exercise) price market price (market - strike) = intrinsic value (intrinsic value =
economic value of exercising immediately)
time until expiration = time value
short term interest rates
volatility
anticipated cash payments on the underlying (div.)
Option Pricing
Factors
Put Price
Strike price
(dividends)
49
7.1 Introduction
An interest rate derivate is a derivative security where the underlying asset is the
right to pay or receive a (usually notional) amount of money at a given interest rate.
Interest rate derivatives are the largest derivatives market in the world. Market
observers estimate that $60 trillion dollars by notional value of interest rate
derivatives contract had been exchanged by May 2004.
According to the International Swaps and Derivatives Association, 80% of the world's
top 500 companies at April 2003 used interest rate derivatives to control their cash
flow. This compares with 75% for foreign exchange options, 25% for commodity
options and 10% for equity options.
The various interest rate futures contracts traded on exchanges worldwide provide an
array of portfolio hedging and cross-hedging mechanisms for financial instruments
such as mortgages or high-grade corporate bonds. A long hedge correlates to falling
interest rates, while a short hedge would be used for risk management when rising
interest rates are anticipated. For example, the manager of a bond portfolio who
foresees rising interest rates could hedge by selling T-Bond futures. As interest rates
raise, the price of the T-Bond contract falls, thus, short selling the appropriate number
of T-Bond contracts vis--vis the value of the bond portfolio would provide a hedge
against the de-valued portfolio. Similarly, a long-hedge can be used to by a fund
manager to lock in the price he/she will pay to add Treasury Bonds to the portfolio:
7.2 Points of Interest: What Determines Interest Rates?
Interest rates can significantly influence people's behaviour. When rates decline,
homeowners rush to buy new homes and refinance old mortgages; automobile buyers
scramble to buy new cars; the stock market soars, and people tend to feel more
optimistic about the future.
But even though individuals respond to changes in rates, they may not fully
understand what interest rates represent, or how different rates relate to each other.
Why, for example, do interest rates increase or decrease? And in a period of changing
rates, why are certain rates higher, while others are lower?
50
An interest rate is a price, and like any other price, it relates to a transaction or the
transfer of a good or service between a buyer and a seller. This special type of
transaction is a loan or credit transaction, involving a supplier of surplus funds, i.e., a
lender or saver, and a demander of surplus funds, i.e., a borrower.
51
general economic conditions. When economic activity is expanding and the outlook
appears favourable, consumers demand substantial amounts of credit to finance
homes, automobiles, and other major items, as well as to increase current
consumption. With this positive outlook, they expect higher incomes and as a result
are generally more willing to take on future obligations. Businesses are also optimistic
and seek funds to finance the additional production, plants, and equipment needed to
supply this increased consumer demand. All of this makes for a relative scarcity of
funds, due to increased demand. On the other hand, when sales are sluggish and the
future looks grim, consumers and businesses tend to reduce their major purchases, and
lenders, concerned about the repayment ability of prospective borrowers, become
reluctant to lend. As a result, both the supply and demand for credit may fall. Unless
they both fall by the same amount, interest rates are affected.
7.2.4 Federal Reserve Actions: As we have seen, the Fed acts to influence the
availability of money and credit by adjusting the level and/or price of bank reserves.
The Fed affects reserves in three ways: by setting reserve requirements that banks
must hold, as we discussed earlier; by buying and selling government securities
(usually U.S. Treasury bonds) in open market operations; and by setting the "discount
rate," which affects the price of reserves banks borrow from the Fed through the
"discount window."
7.2.5 Fiscal Policy: Federal, state and local governments, through their fiscal policy
actions of taxation and spending, can affect either the supply of or the demand for
credit. If a governmental unit spends less than it takes in from taxes and other sources
of revenue, as many have in recent years, it runs a budget surplus, meaning the
government has savings. As we have seen, savings are the source of the supply of
credit. On the other hand, if a governmental unit spends more than it takes in, it runs a
budget deficit, and must borrow to make up the difference. The borrowing increases
the demand for credit, contributing to higher interest rates in general.
52
General economic conditions, for example, cause all interest rates to move in the
same direction over time. Other factors vary for different kinds of credit transactions,
causing their interest rates to differ at any one time. Some of the most important of
these factors are:
1. Different levels and kinds of risk
default risk
liquidity risk
maturity risk
2.
Put provision
3.
53
buy a FRA, with a six-month hedging period, starting in six months' time (a so-called
6x12 FRA) at a rate of 5.5%.
If, for example, over the next six months the six-month EURIBOR were to rise to
6.5%, without this contract you would be subject to 1.0% higher interest for this
interest period. Thanks to the FRA, which compensate you for these additional costs,
leaving your interest expense at 5.5% plus your loan margin. Contrary to your
expectations: in this case, your interest income will fall short of the anticipated level.
You can offset this risk by purchasing a floor. If, on the fixing day for your floor
contract, the prevailing EURIBOR rate is lower than the agreed floor rate, you will be
compensated to the extent of this differential.
When you buy a floor you pay only the option premium, with no subsequent costs
incurred.
54
55
$0
10
$720,000
20
$1,440,000
30
$2,160,000
40
$2,880,000
50
$3,600,000
56
payment to compensate for the rise in market rates. The cap ensures that the
borrower's interest rate costs will never exceed the cap rate.
8.2.2 Floors-Hedging against falling interest rate
When investing liquid funds, an attractive return is a key criterion for your decision.
However, if money market rates decline this would, in practice, represent an actual
shortfall in revenue for your company. As a result, you could be missing out on
returns which you may have relied upon in your planning.
You can avoid the resulting uncertainty by buying what is known as a floor. A floor is
an agreement on a minimum interest rate basically an option on a minimum interest
rate. This protects you against the risk of falling interest rates for a period of up to ten
years.
If interest rates go up, you will benefit from this rise without restriction.
Investments with a variable rate of interest such as Floating-Rate Notes are a
common instrument to benefit from rising money market rates. However, interest
rates might fall
A floor is the mirror image of a cap. When market rates fall below the floor rate, the
seller pays the difference. A 6% floor triggers a payment to the purchaser whenever
market rates drop below 6%. Asset managers buy floors to guarantee a minimum
return on floating rate assets. They sell floors to generate incrementally higher returns.
Debt managers buy floors to protect against opportunity losses on fixed rate debt
when rates fall. They may sell floors as a component of a hedge strategy involving
other derivative instruments.
8.2.3 Treasury collars (the combination of buying a Treasury cap and selling a
Treasury floor) can be used to hedge current rates within a targeted range. The cap
protects against increases in interest rates. The sale of the floor, which eliminates the
benefit from a decline in rates below the floor rate, reduces the cost of the hedge. A
Treasury collar can be structured at no upfront cost by setting the cap and floor rates
such that the premium received for the floor entirely offsets the premium due for the
cap.
57
58
the rate of return on a covered position. If prices decline, selling the call against a long
futures position enables the writer to use the premium as a cushion to provide
downside protection to the extent of the premium received. For instance, if T-bond
futures were purchased at 80-00 and a call option with an 80 strike price was sold for
2-00, T-bond futures could decline to the 78-00 level before there would be a net loss
in the position (excluding, of course, margin and commission requirements).
However, should T-bond futures rise to 82-00, the call option seller forfeits the
opportunity for profit because the buyer would likely exercise the call against him and
acquire a futures position at 80-00 (the strike price).
The perspectives of the put buyer and put seller are completely different. The buyer of
the put option believes prices for the underlying futures contract will decline. For
example, if a T-bond put option with a strike price of 82 is purchased for 2-00, while
T-bond futures also are at 82-00, the put option will be profitable for the purchaser to
exercise if T-bond futures decline below 80-00.
In many instances, puts will be purchased in conjunction with a long cash or long Tbond futures position for "insurance" purposes. For instance, if an institution is long
T-bond futures at 82-00 and a T-bond put option with an 82 strike is purchased for 200, the futures contract could, theoretically, fall to zero and the put option holder
could exercise the option for the 82 strike price, assuming the option had not yet
expired.
The seller of put options on fixed-income securities believes interest rates will stay at
present levels or decline. In selling the put option, the writer, of course, receives
income. However, if interest rates rise, the buyer of the put option can require the
writer to take delivery of the underlying instrument at a price greater than that in the
new market environment.
Since an option is a wasting asset, an open position must be closed or exercised,
otherwise the option expires worthless. The chart below illustrates what happens to
the buyer and the seller after an option is exercised.
59
Seller assumes
Put option
Long T-bond/note
Short T-bond/note
futures position
futures position
Short T-bond/note
Long T-bond/note
futures position
futures position
8.6 Trading Example: Hedging with Options on CME Interest Rate Futures
Whenever CME Eurodollar futures can be used to lock in a rate, options on futures
can be substituted to guarantee a rate floor or ceiling. As an alternative to a long
futures position, which determines a forward investment return for an asset, the
purchase of a call option can be substituted.
The call gives the right to buy the futures contract at a stated price, providing a floor
for a return on the asset while preserving the opportunity for a potential profit. On the
other hand, instead of taking a short futures position to predetermine a liability rate,
buying a put option can provide protection. The put gives the right to sell the futures
at a stated price, providing a ceiling for the liability rate, while preserving the
opportunity for a lower cost of funds. The effective floor or ceiling rate provided by
the option is determined by its strike price and the premium paid. The strike yield
(simply 100 minus the option strike price) is adjusted to reflect the cost of the option.
For example, suppose the following prices were observed:
Contract
Jun CME Eurodollar futures
Price/Premium
Delta
96.02
1.00
0.30
0.51
0.11
0.25
0.28
0.49
0.11
0.24
Under these conditions, the user of the futures contract could expect to lock in a target
LIBOR of 3.98 percent (100.00 -96.02) - an asset return if long or a liability cost if
short. Subject to basis risk, this yield would be locked in regardless of whether market
rates rise or fall over the hedge period.
Using the 96.00-strike call to hedge a floating rate investment, a hedger could
guarantee a minimum return of 4.00 percent for a cost of 30 basis points. In other
60
words, the realized minimum return would be 3.70 percent as a worst case (4.00 .30). If the rate falls below 4.00 percent, futures prices would rise and the call option
would increase in value. The lower investment rate on the asset would be
supplemented by the profit on the call to ensure a minimum net return of 3.70 percent.
On the other hand, if the rate rises above 4.00 percent, the option would be worthless
at expiration, and the investor would simply lose the cost of the option and receive the
higher market rate on the asset.
Using the 96.50-strike call, the investment hedger would establish a minimum return
of 3.39 percent (100.00 - 96.50 -.11). Why would someone use the 96.50-strike call
rather than the 96.00-strike call, when the latter offers a higher minimum return?
The question involves an important trade off consideration. While it is true that the
96.00-strike call provides a more attractive worst-case scenario, it does so for a larger
upfront cost. The purchaser of the 96.00-strike call pays $750 for this protection ($25
x 30 basis points), while the cost of the 96.50-strike call is only $275 ($25 x 11 basis
points).
To hedge floating rate liabilities, put options present a similar set of choices. A short
futures contract can establish a forward rate of 3.98 percent. The 96.00-strike put can
provide a ceiling rate of 4.28 percent (100.00 - 96.00 + .28) for the premium of $700
($25 x 28 basis points); and the 95.50-strike put can provide a 4.61 percent (100.00 95.50 + .11) ceiling rate for the price of $275 ($25 x 11 basis points).
61
9. Currency Options
9.1 Introduction
Suppose a United Kingdom manufacturing firm is expecting to be paid $100,000 for a
piece of engineering equipment to be delivered in 90 days. If the exchange rate goes
down over the next 90 days the UK firm will lose money, but if the rate goes up then
the UK firm will make a profit. The UK firm can purchase an option (the right to sell
part or all of their expected income for pounds sterling at a given rate near today's
rate) to mitigate their risk of exchange rate fluctuation over the 90 days. Conversely
another party may wish to have the reverse option for a similar reason. A market
maker will buy and sell these options with the aim of making a profit while not
incurring too much risk.
In finance, a foreign exchange option (commonly shortened to just FX option) is a
derivative where the owner has the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed exchange rate on a
specified date.
For example a USD/GBP FX option might be specified by a contract allowing the
purchaser to exchange 1,000,000 into $2,000,000 on December 31st. In this case the
pre-agreed exchange rate, or strike price, is 2USD/GBP or 0.5GBP/USD and the
notional is 1,000,000. This type of contract may be called either a dollar call or a
sterling put depending on the market convention. If the dollar is stronger than
0.5GBP/USD come December 31st (say at 0.55GBP/USD) then the option will be
exercised, making a profit of (2 - 1/0.55)*1,000,000 = $181,818 or 100,000.
9.2 Hedging with Options
While forwards and futures are the most effective instruments used to minimize the
volatility of an exposed foreign currency transaction, they may not be appropriate for
all types of foreign exchange risk management. Their biggest limitation is the fact that
they do not provide the opportunity to benefit from favourable foreign exchange
movements. One can argue that unless a company is engaged in the currency
speculation business, foreign exchange gains should be a secondary concern, although
a counter argument is that managers should care only about downside risk since
62
nobody will penalize them for making too much money. Another limitation of
forwards and futures is that they may not match the contingent nature of some foreign
currency transactions. If, for example, a firm enters into a short futures position to
hedge an anticipated inflow that fails to materialize, there will be no gains to offset
futures losses if the exchange rate appreciates.
Currency options give the holder the right, but not the obligation, to buy or sell a fixed
amount of foreign currency at a specified price. 'American' options are exercisable at
any time prior to the expiration date, while 'European' options are exercisable only on
the expiration date. Most currency options have 'American' exercise features. Call
options give the holder the right to buy foreign currency, while put options give the
holder the right to sell foreign currency. Call options make money when the exchange
rate rises above the exercise price (allowing the holder to buy foreign currency at a
lower rate), while put options make money when the exchange rate falls below the
exercise price (allowing the holder to sell foreign currency at a higher rate). If the
exchange rate doesn't reach a level at which the option makes money prior to
expiration, it expires worthless unlike forwards and futures, the holder of an option
does not have an obligation to buy or sell if it is not advantageous to do so.
Numerical Example
63
prior to the expiration date. While the firm can specify what price it wants to lock in,
the most common strategy is to buy calls with a strike price at or very close to the
prevailing exchange rate ('at-the-money' options). Because Canadian dollar options
cover a face value of $100,000, the firm would need to buy 15 call options to cover its
US$1 million exposure (US$1 million = $1,470,588). The premium paid for these
options would be around US$0.80 per $1,000, or $17,647.06.
In 90 days, the call option will have some value if the Canadian dollar has appreciated
(since it allows the holder to buy Canadian dollars at a more favourable rate). Even if
the prevailing exchange rate is less than the strike price, the option may still have
some residual value based on the remaining time to expiration and the volatility in the
underlying currency. For strike prices that are well above the prevailing exchange
rate, the probability of making money on the option becomes so low that the option
value is effectively zero.
Table given below outlines the payoff structure of the option hedge. As before, the un
hedged position can lose up to $62,000 if the exchange rate appreciates to 0.7100
USD/CAD. The third column represents the hypothetical prices of a Canadian dollar
call option with a strike price of 0.6800 USD/CAD for each spot rate. These option
prices are based on an assumed annual interest rate of 5% and exchange rate volatility
of 7%, and the option is assumed to have one week to expiration. If the exchange rate
remains at 0.6800 USD/CAD, each option is worth about US$0.30, reflecting the time
value remaining in the option. For spot rates above 0.6800 USD/CAD, the option
value increases to reflect both the time value remaining in the option and the intrinsic
value of the option if exercised immediately. If the exchange rate falls, then the option
loses its value, but since the holder simply doesn't exercise when this happens, the
maximum loss is the premium paid when the option was purchased.
64
Spot Rate
Un hedged
Gain/Loss
Option
Gain/Loss
Hedged
USD/CAD
Receivable
Cash
Price
Option
Receivable
0.6500
1538462
+67873
0.00
-17647
1520815
0.6525
1532567
+61979
0.00
-17647
1514920
0.6550
1526718
+56129
0.00
-17647
1509071
0.6575
1520913
+50324
0.00
-17646
1497511
0.6600
1515152
+44563
0.00
-17641
1491809
0.6625
1509434
+38846
0.00
-17625
1486184
0.6650
1503759
+33171
0.00
-17576
1480682
0.6675
1498127
+27539
0.01
-17445
1475393
0.6700
1492537
+21949
0.02
-17144
1470458
0.6725
1486989
+16401
0.05
-16531
1466055
0.6750
1481482
+10893
0.10
-15427
1462358
0.6775
1476015
+5427
0.18
-13656
1459487
0.6800
1470588
0.30
-11102
1457453
0.6825
1465202
-5387
0.45
-7749
1456162
0.6850
1459854
-10734
0.64
-3692
1455446
0.6875
1454546
-16048
0.85
+900
1455116
0.6900
1449275
-21313
1.08
+5840
1455014
0.6925
1444043
-26545
1.32
+10970
1455014
0.6950
1438849
-31739
1.57
+16179
1455028
0.6975
1433692
-36896
1.82
+21403
1455095
0.7000
1428571
-42012
2.07
+26611
1455182
0.7025
1423488
-47101
2.32
+31788
1455276
0.7050
1418440
-52149
2.57
+36931
1455371
0.7075
1413428
-57161
2.82
+42039
1455466
0.7100
1408451
-62138
3.07
+47110
1455561
65
10. Swaps
10.1 Introduction: In finance a swap is a derivative, where two counterparties
exchange one stream of cash flows against another stream. These streams are called
the legs of the swap. The cash flows are calculated over a notional principal amount.
Swaps are often used to hedge certain risks, for instance interest rate risk. Another use
is speculation.
Swaps are Over-the-counter (OTC) derivatives. This means that they are negotiated
outside exchanges. They cannot be bought and sold like securities or futures contracts,
but are all unique. As each swap is a unique contract, the only way to get out of it is
by either mutually agreeing to tear it up, or by reassigning the swap to a third party.
This latter option is only possible with the consent of the counterparty.
The Bank for International Settlements (BIS) publishes statistics on the notional
amounts outstanding in the OTC Derivatives market. At the end of 2004, this was
USD 248.288 trillion (that is, USD 248,288 billion, or six times World GDP). The
majority of this (USD 147.4 trillion) were interest rate swaps. These split by currency
Usually, at least one of the legs has a rate that is variable. It can depend on a reference
rate, the total return of a swap, an economic statistic, etc. The most important criterion
is that it comes from an independent third party, to avoid any conflict of interest. For
instance, LIBOR is set by the British Bankers Association, an independent trade body.
10.2 Interest Rate Swap
Interest Rate swaps are the most common type of swap. They typically exchange
fixed rate payments against floating rate payments. Exceptions exist, such as floatingto-floating swaps (known as basis swaps).
10.3 Manage interest rate risk with a solution tailored to match a specific risk
profile
Among the most popular of derivative instruments, interest rate swaps are used by
corporations, government entities, and financial institutions to manage interest rate
risk.
66
Swaps can be applied to a wide range of hedging needs and can be easily tailored to
match a specific risk profile. Their simplicity and flexibility have made them the
workhorse of the risk manager's toolbox.
A swap is an agreement to exchange interest payments in a single currency for a
stated time period. Note that only interest payments are exchanged, not principal.
Swap terms are customized to meet the user's specific risk management objectives.
Terms include starting and ending dates, settlement frequency, the notional amount on
which swap payments are based, and reference rates on which swap payments are
determined.
Reference rates are published rates such as LIBOR or benchmark Treasuries, or
customized indexes crafted to meet the client's needs.
10.4 Why Use Swaps?
Treasurers use swaps to hedge against rising interest rates and to reduce borrowing
costs. Among other applications, swaps give financial managers the ability to:
Financial institutions, pension managers and insurers use swaps to balance asset and
liability positions without leveraging up the balance sheet and to lock-in higher
investment returns for a given risk level.
10.5 Interest Rate Swaps
An IRS is an exchange between two parties of interest rate obligations (payments of
interest) or receipts (investment income) in the same currency on an agreed amount of
notional principal for an agreed period of time. The most common type of interest rate
swaps are the plain vanilla IRS. Currently, these are the only kind of swaps that are
allowed by the RBI in India. Dealings in Exotics or advanced interest rate swaps
have not been permitted by the RBI. In a plain vanilla swap, one party agrees to pay
67
to the other party cash flows equal to the interest at a predetermined fixed rate on a
notional principal for a number of years In exchange, the party receiving the fixed rate
agrees to pay the other party cash flows equal to interest at a floating rate on the same
notional principal for the same period of time. Moreover, only the difference in the
interest payments is paid/received; the principal is used only to calculate the interest
amounts and is never exchanged. An example will help understand this better:
Consider a swap agreement between two parties, A and B. The swap was initiated on
July 1, 2001. Here, A agrees to pay the 3-month NSE-MIBOR rate on a notional
principal of Rs. 100 million, while B pays a fixed 12.15% rate on the same principal,
for tenure of 1 year.
We assume that payments are to be exchanged every three months and the 12.15%
Interest rate is to be compounded quarterly. This swap can be depicted
diagrammatically as shown below:
68
Firm A has an absolute advantage over firm B in both fixed and floating rates.
Firm B pays 200 bps more than firm A in the fixed rate borrowing and only 120 bps
69
more than A in the floating rate borrowing. So, firm B has a comparative
advantage in borrowing floating rate funds.
Now, Firm A wishes to borrow at floating rates and becomes the floating rate payer
in the swap arrangement. However, A actually borrows fixed rate funds in the cash
market. It is the interest rate obligations on this fixed rate funds, which are swapped.
At the same time, B wishes to borrow at a fixed rate, and thus will actually borrow
from the market at the floating rate.
Then, both the parties will exchange their underlying interest rate exposures with each
other to gain from the swap. The calculation of the gain from the swap is shown
below:
The gain to firm A, because it borrows in the fixed rate segment is:
14% - 12% = 200 bps.
And, the loss because firm B borrows in the floating rate segment is:
(MIBOR + 20 bps) (MIBOR + 120 bps) = 130 bps.
Thus, the net gain in the swap = 200 120 = 70 bps. The firms can divide this gain
equally. Firm B can pay fixed at 12.15% to firm A and receive a floating rate of
MIBOR as illustrated below:
70
As we have seen, firms can use IRS to transform assets and liabilities. But then,
why dont firms take the desired form of loan or asset (fixed or floating) in the
first place?
Ricardos comparative advantage theory explains this behaviour to some extent.
Continuing with the same example, let us assume that As credit rating is better than
Bs, and A and B can raise loans for fixed and floating rates as given below:
Here, we see that though firm A can borrow cheaply compared to firm B in both the
markets, the difference in rates available is not the same. Firm B has a comparative
advantage in the floating rate market because it pays only 1.30% higher here,
compared to the 2% difference in the fixed rate market. So, firm B will borrow at a
floating rate, and firm A at fixed rate.
After the swap deal, the cost of the floating rate loan to firm A will be MIBOR0.15%, a clean gain of 35 basis points. Similarly, firm B also gains 35 basis points,
because the cost of its loan will be 13.35% only, after the swap. Thus, both parties
gain from the swap, as shown below:
In a perfect market, however, the spread between fixed and floating rates offered
should vanish due to IRS. This is not seen in reality, and spreads continue to persist.
So, the credit ratings of the firms are not the only criteria by which lenders judge
firms, and the comparative advantage theory continues to hold.
71
MIPL, an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of
18.5%. Today a 364-day T-bill is yielding 10.25%, as the interest rates have come
down. The 3-month MIBOR is quoting at 10%.
Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T- bill vs. 6month MIBOR.
The treasurer is of the view that the average MIBOR shall remain below 18.5% for
the next one year. The firm can thus benefit by entering into an interest rate fixed for
floating swap, whereby it makes floating payments at MIBOR and receives fixed
payments at 50 bps over a 364-day treasury yield i.e. 10.25 + 0.50 = 10.75 %.
The effective cost for MIPL = 18.50 + MIBOR - 10.75 = 7.75 + MIBOR
At the present 3m MIBOR is 10%, the effective cost is = 10 + 7.75 = 17.75%
The gain for the firm is (18.5 - 17.75) = 0.75 %
The risks involved for the firm are:
Default/credit risk of party B: Since the counterparty is a bank, this risk is much
lower than would arise in the normal case of lending to corporate. This risk
involves losses to the extent of the interest rate differential between fixed and
floating rate payments.
The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise
beyond 10.75% will raise the cost of funds for the firm. Therefore it is very
essential that the firm hold a well-suggested view that MIBOR shall remain below
10.75%. This will require continuous monitoring.
How does the bank benefit out of this transaction?
The bank either goes for another swap to offset this obligation and in the process earn
a spread. The bank may also use this swap as an opportunity to hedge its own floating
liability. The bank may also leave this position uncovered if it is of the view that
MIBOR shall rise beyond 10.75%.
72
Swap
c/p
Floating Rate
Payments
100
(6-mth LIBOR)
(6-mth LIBOR)
(6-mth LIBOR)
(6-mth LIBOR
+ 100)
6-mth LIBOR
[act/365]
Fixed Rate
Receipts
(USD 170)
USD 11.90
USD 11.90
+ USD 170
Swap
c/p
Floating Rate
Payments
100
(6-mth USD LIBOR)
(6-mth USD LIBOR)
(6-mth USD LIBOR)
(6-mth USD LIBOR
+ USD 100)
Floating Rate
Receipts
(DEM 170)
6-mth DEM LIBOR
6-mth DEM LIBOR
6-mth DEM LIBOR
6-mth DEM LIBOR
+ DEM 170
Swap
6-mth DEM
LIBOR
73
10.10 A plain vanilla foreign currency swap has just been arranged between parties
ABC and XYZ. ABC has agreed to pay dollars based on LIBOR, while XYZ will pay
British pounds at a fixed rate of 7 percent. The current exchange rate is 1= $1.65.
The notional principal is 100 million = $165 million. The tenor of the swap is seven
years, and the swap has annual payments paid in arrears. The following table shows
the periodic cash outflows only for each party at each relevant period of the swap.
(Ignore the exchange of principal.)
Year
LIBOR (%) XYZ Sterling Pay Outflows ABC Dollar Pay Outflows
6.5800
5.870
7,000,000
0.0658*$165,000,000=10,857,000
6.745
7,000,000
0.0587*$165,000,000=$9,685,500
6.550
7,000,000
0.06745*$165,000,000=$11,129,250
6.100
7,000,000
0.0655*$165,000,000=$10,807,500
6.800
7,000,000
0.0610*$165,000,000=$10,065,000
6.350
7,000,000
0.0680*$165,000,000=$11,220,000
6.450
7,000,000
0.0635*$165,000,000=$10,477,500
10.11 Swaption
Hedge against adverse movements in interest rates and exchange rates
Swaptions are options on swaps. Like swaps, they offer protection against adverse
movements in interest rates and exchange rates, and are frequently used to minimize
financing or hedging costs. Combined with other instruments, swaptions are often
used to solve more complex risk management challenges.
Interest rate and Currency swaptions give the holder the right, but not the obligation,
to enter into or cancel a swap agreement at a future date. The buyer may purchase
either the right to receive a fixed rate in the underlying swap or to pay the fixed rate.
There are three styles of Swaptions. Each style reflects a different timeframe in which
the option can be exercised.
American Swaption, in which the owner is allowed to enter the swap on any day that
falls within a range of two dates.
74
Bermudan Swaption, in which the owner is allowed to enter the swap on a sequence
of dates.
European Swaption, in which the owner is allowed to enter the swap on one specified
date.
75
Methodology:
76
11.1 Questionnaire
Dear Sir/Madam,
Thanking you,
Ramakrishna N,
CCIM,
Bangalore
RESPONDENT PROFILE
1. Gender:
OMale
OFemale
O5-10
O10-15
O>20
77
Strongly
Agree
Agree
Neither Agree
Nor Disagree
Disagree
Strongly
Disagree
Lack Of Participants
allowed
Lack of liquidity
High margins
Standardised contract
Lack of proper
pricing
Mark to market is
cash settled
Lack of underlying
papers
4. CCIL proposal to settlement of Rupee Derivative Products [Interest Rate Swaps
(IRS) & Forward Rate Agreements (FRA)] on a guaranteed basis has increased
the number of contracts.
Strongly agree.Strongly disagree.
5. Which hedging strategy do your Bank/Firm uses to overcome the interest rate risk
OMarket Value Nave Model
78
6. How do your Bank/Firm reduce the Duration of the Portfolio/ Balance Sheet
OShortening/Lengthening of the investments
OReceive fixed/Pay fixed Swaps
OHedging Assets and Liabilities individually
OImmunize through Planning Period Case
OThrough Options
7. What do you think the favourable reasons for the more volumes in Forward
market than in Futures market?
Extremely Favourable
Extremely Unfavourable
8.
Pricing of Options create Arbitrage opportunity but due to transaction cost this
arbitrage disappears
Strongly
Agree
Agree
Neither Agree
nor
Disagree
Disagree
Strongly
Disagree
Some What
Greater Extent
To Certain
Extent
Neutral
Delta
Theta
Vega
RHO
Gamma
79
10. How many basis points do you expect above the term structure of interest rate
when you lend. (Because term structure dont consider the given below)
<25 bps
25-50 bps
50-75 bps
75-100 bps
>100 bps
Tax Status
Default Risk
Put Option
Liquidity Risk
11. Do you think Option Adjusted Spread will accommodate all the above risks
Strongly
Agree
Agree
Neither Agree
nor
Disagree
Disagree
Strongly
Disagree
Inferior
_____
5
80
15. To what extent the given below factors are important in pricing the swaps
High
Moderate
Low
Interest rate
Futures/Options
Default Risk
Basis Risk
Mismatch Risk
Interest Rate Risk
17. Rank the top 5 in given below swaps as per your preference to use
Type of Swaps
Amortizing Swap
Accreting Swap
Roller Coaster Swap
Off Market Swap
Forward Swap
Extension Swap
Rank
Type of Swaps
Basis Swap
Yield Curve Swap
Constant maturity Swap
Rate Differential Swap
Seasonal Swap
Corridor Swap
Rank
_____
2
_____
4
Inferior
_____
5
19. To over come the mismatch risk Swap Dealers enter into Interest rate
Futures/Options which has created more liquidity in the bond markets.
Strongly
Agree
Agree
Neither Agree
nor
Disagree
Disagree
Strongly
Disagree
81
Extremely Unfavourable
4
2
5
Extremely Unfavourable
4
Flexibility
Credit
Exposure
Pricing Arbitrage
Interest Swaps
Currency Swaps
23. Interest rate futures are traded very thinly in India. Interest rate options are not
started. What steps should RBI take to improve the liquidity in bond market.
Please give your suggestion.
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
82
3. What do you think the favourable reasons for the more volumes in Forward market
than in Futures market?
Extremely Favourable
Extremely Unfavourable
5. Which Derivative product you prefer to hedge for the given risk
OTransaction Exposure _________________________________________
OTranslation Exposure
_________________________________________
6. Pricing of Options create Arbitrage opportunity but due to transaction cost this
arbitrage disappears
Strongly
Agree
Agree
Neither Agree
nor
Disagree
Disagree
Strongly
Disagree
83
7. To what extent do you think given below is important in determining the exchange
rate?
Most Important 7
6
5
4
3
2
1 Unimportant
7
_____
4
Inferior
_____
5
9. Rank the factors given below which motivates for entering into Swaps
_____Customized features of swaps which is not available in Futures/Options
_____Raising the finance at lower cost through swaps
_____Reduced transaction cost
_____Lower hedging cost
_____Avoiding costly regulations
_____Maintaining privacy
_____Efficient managers who can use swaps effectively
_____
2
_____
4
Inferior
_____
5
84
11. To what extent given below factors are important in pricing the currency swaps
High
Moderate
Low
Flexibility
Credit Exposure
Pricing Arbitrage
Interest Swaps
Currency Swaps
13. Do you think FDIs and FIIs should be allowed to hedge
Yes
No
If yes, do you think inflows from FDI and FII will increase
Strongly
Agree
Agree
Neither Agree
nor
Disagree
Disagree
Strongly
Disagree
14. Currency risk is the most unhedged risk in India. To what extent given below
reasons will contribute for this
Most
Highest
Highest
Moderate
Lowest
85
15. What steps should be taken to improve the currency trading in India using
Derivatives
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
86
70
60
50
Pe rce ntage
40
32
30
20
10
0
0
Interest
rate futures
0
Interest
rate
options
Interest
Forward
rate swaps Agreement
M ode s of He dging
Series1
Figure 1 depicts the ways in which Banks/Firms have hedged there interest rates.
When the respondents were asked about how they hedge 60% respondents replied
they use IRS where as 32% use FRA where as not even a single respondent used
Interest rate futures and options.
2. Have you come across any counterparty default when you entered forward
agreements to hedge the interest rate?
13%
87%
Yes
No
87
4
2
6
6
32
16
76
12
Standardised contract
High margins
26
16
26
18
14
Lack Of Participants
allowed
Strongly Disagree
Disagree
14
28
14
20
24
0
0
Lack of liquidity 4
46
12
6
10
84
20
20
64
40
60
80 100
Perentage
Figure 3 depicts the reasons for the thin trade in the Indian Interest rate futures
market.
88
Strongly Disagree 0
4
Disagree
12
28
Agree
56
Strongly Agree
0
10
20
30
40
50
60
Percentage
Figure 4 depicts that number of contracts has been increased due to the CCILs
proposal to settle FRA and IRS.
5. Which hedging strategy do your Bank/Firm uses to overcome the interest rate risk
Strategies
Others
28
Regression Model
8
16
28
10
15
20
25
30
Percentage
Figure 5 depicts the different strategy used by the Banks and Corporate to
Hedge the interest rate risk.
89
6. How do your Bank/Firm reduce the Duration of the Portfolio/ Balance Sheet
56
32
12
Through Options
Immunize through
Planning Period
Case
0
Hedging Assets
and Liabilities
individually
0
Receive fixed/Pay
fixed Swaps
60
50
40
30
20
10
0
Shortening/Lengthe
ning of the
investments
Percentage
Figure 6 depicts the various methods used by the Banks and Corporate to reduce
the duration of Portfolio/Balance Sheet
7. What do you think the favourable reasons for the more volumes in Forward
market than in Futures market?
Favourable Reasons for More Volumes In
Forwards Than Futures
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1
2
3
4
5
Tailored to individual needs No mark to market
Convenient market place
Self regulating
No security deposit
90
8. Pricing of Options create Arbitrage opportunity but due to transaction cost this
arbitrage disappears
16
4
Strongly Agree
Agree
Figure 8 depicts that most of the respondents strongly agrees with arbitrage
opportunity exist with option pricing but due to the transaction cost this
disappears.
9. If you trade in options to what extent do you analyse these variables
Variables
Figure 9 Depicts the various variables the respondents look at while trading in
Option.
91
10. How many basis points do you expect above the term structure of interest rate
when you lend. (Because term structure dont consider the given below)
Number Of Respondents
14
13
14
12
11
10
8
6
4
2
7 7
5
3
6
4
1 1
0 0 0 0
0
<25 bps
25-50 bps
50-75 bps
75-100 bps
>100 bps
Default Risk
Call Option
Liquidity Risk
Figure 10 depicts the basis points which the respondent expects above the term
structure of interest rate because it does not accommodate tax status, default
risk, call option and liquidity risk.
11. Do you think Option Adjusted Spread will accommodate all the above risks?
Disagree
4%
Neither Agree
Nor Disagree
16%
Agree
24%
Strongly
Disagree
0%
Strongly Agree
56%
Figure 11 depicts that 56% of the respondents strongly agreed that option
adjusted spread will accommodate the risks which term structure does not
consider.
92
Wait for 6
months
20%
Collar
20%
Floorlet
24%
Caplet
36%
Figure 12 depicts the responses given by respondents when they asked about if
they would like to lend and borrow 6 months down the line.
13. Rank the factors given below which motivates for entering into Swaps
3
5
2
7
20
3 3
5 1
6
2
15
3 3 3 3
2
4
10
12
6
4 3
4
5
2
0
7
6
5
4
3
2
1
Ranks
25
30
Number Of Respondents
Customized features
Raising finance at lower cost
Reduced transaction cost
Lower hedging cost
Avoiding costly regulations
Maintaining privacy
Efficient managers who can use swaps effectively
Figure 13 depicts the various features which forces the respondents to enter into
swaps.
93
60
Percentage
50
40
30
20
16
12
12
4
10
0
Superior
About the
same
Inferior
Number Of Respondents
25
25
20
17
14
15
10
3
0
0
High
Moderate
Low
Extent Of Importance
Slope of Term Interest Rate Structure
Risk Exposure to Swap portfolio
Creditworthiness of Counterparty
94
16. For the given below risks which derivative products do you use
Number Of Respondents
17
16
15
15
10
7
4
5
1
0 0
0
Shift the Bid-Ask
Interest rate
Credit Default
spread
Futures/Options
Swap
Derivative Products
Default Risk
Basis Risk
Mismatch Risk
Immunize the
Duration
Figure 16 depicts the various derivative products used by the banks and
corporate to hedge the risks like default risk, basis risk, mismatch risk and
interest rate risk.
17. Compare to Interest Rate Future/Options Swaps is
48
40
30
24
Percentage
20
20
8
10
0
Superior
About the
same
Inferior
Figure 17 depicts most of the respondents agree that swaps are superior to
interest rate futures and options.
95
18. To over come the mismatch risk Swap Dealers enter into Interest rate
Futures/Options which has created more liquidity in the bond markets.
Increased Liquidity In Bond Market Due To Swap
Dealers Hedge Mismatch Risk
Strongly Disagree
Disagree
52
Agree
20
24
Strongly Agree
0
10
20
30
40
50
60
Percentage
Figure 18 depicts most of the respondents neither agrees nor disagree for the
statement that due to the mismatch risk, swap dealers enter into Interest rate
futures and options which has created more liquidity in bond markets.
Extremely Unfavourable
3
1
5
2
0
10
54 4
More marketable
and liquidity
00
Yield curve is
Upward/Downward
sloping
8 7
6
Less credit
evaluation and
credit risk
20
18
16
14
12
10
8
6
4
2
0
SN available in
small quantities
Nu mber Of Respondents
Extremely Favourable
96
20. What do you think the favourableness of issuers preference to issue Structured
Notes(SN)
10
15
15
20
25
30
Number Of Respondents
Reduce in Financing cost
Market imperfection
Figure 20 depicts the favourable reasons for the issuers to issue structured notes.
21. Rank the given below according to your preference for Interest Rate Swaps
Number Of Respondents
17
10
8
Flexibility
10
Credit Exposure
7
7 7
Pricing
5 5
3 3
Arbitrage
0
1
Ranks
Figure 21 depicts the features available in the interest rate swaps which the
respondents ranked according to there preference.
97
22. Rank the given below according to your preference for Currency Swaps
Number Of Respondents
15
10
7
8
6
Flexibility
Credit Exposure
7
4
6
4
2
Pricing
Arbitrage
Ranks
Figure 22 depicts the features available in the currency swaps which the
respondents ranked according to there preference.
23. Do you or your firm/bank trade in foreign currency?
Percentage
100
80
60
40
20
0
Yes
No
Response
Figure 23 depicts that 100% respondent banks and firms trade in foreign
exchange.
98
Geographical
Arbitrage
36%
Cross Rate
Arbitrage
64%
Figure 24 depicts the various type of arbitrage opportunity the bank/firms come
across when they trade in foreign currency.
Joint Float
12%
Pegged
Exchange Rate
System
4%
Freely Floating
48%
Managed Float
or Dirty Float
36%
Figure 25 depicts the exchange rate systems which the respondents liked. Most of
the respondents that is 48%liked to be the floating rate where as others had
different opinion.
99
26. To what extent do you think given below is important in determining the
exchange rate?
Factors Important In Determining Exchange Rate
90
80
78
64
56
48
Percentage
70
60
50
38
40
24
30
20
10
00
26
26
24 26
24
24
22
18
16
16
1414
1414 12
14
12
12 12
8
8
6
6 8
44
2
2
2
0
0
0
0 0
0000
00 2
0
7
Importance
Interest Rate Parity
Balance of Payment
Fiscal Deficit
Figure 26 depicts the factors which are important in determining the exchange
rate.
27. Do you think FDIs and FIIs should be allowed to hedge
Does FDI's And FII's Should Be Aloowed To
Hedge In India
No
24%
Yes
76%
Yes
No
Figure 27 depicts 76% of respondents voted for allowing the FDIs and FIIs
should be allowed to hedge there foreign exchange in India.
100
28. If yes, do you think inflows from FDI and FII will increase
Percentage
85
12
Strongly
Agree
Agree
Neither
Agree Nor
Disagree
Disagree
Strongly
Disagree
Figure 28 depicts that 85% of the respondents strongly agreed that if FIIs and
FDIs are allowed to hedge there foreign exchange the inflows will increase.
29. Currency risk is the most unhedged risk in India. To what extent given below
reasons will contribute for this
Percentage
76
58
48
32
20 24
16
4
Most Highest
Highest
12
4
Moderate
Lowest
Oil companies and Public sector undertakings are not allowed to hedge
Lack of proper risk management among importers/exporters
Restrictions on booking and cancellation of exports/imports
101
Percentage
82
58
52
32 34
20
16
Most Highest
34
14
10
Highest
12
18
Moderate
0
Lowest
Figure 29a and 29b depicts the various reasons for the currency risk which is
most un hedged risk in India.
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13. FINDINGS
In India most of the banks and firms hedge there interest rate risk either
through Interest rate swaps or forward agreements.
Nearly 87% of the respondents said that they never come across counterparty
risk. Once if they come across the party who has not full filled the contract
name will be revealed in market. This means then onwards no one will enter
contract with him. For this reason no one likes to default.
Most of the respondents strongly agreed that the main reasons for very thin
trade in interest rate futures in India is lack of underlying paper, lack of
liquidity, lack of participants allowed, Standardised contract, high margins..
Where as most of them disagreed that the following reasons contributing
towards thin trade, that is mark to market is cash settled, and lack of proper
pricing.
Nearly 80% of the respondents felt that due to CCILs proposal to settle the
Interest rate swaps and Forward rate agreements has increased the volumes in
the market.
28% of the respondents use Market Value Nave Model, 28% use Price
Sensitivity Model 16% of respondents use Regression Model and 16%
Conversion Model where as only 8% used Business point model as hedging
strategy to overcome interest rate risk.
56% 0f Bank/Firm reduce the Duration of the Portfolio/ Balance Sheet by
Receive fixed/Pay fixed, 32% through Immunizing Planning period case, 12%
through hedging assets and liabilities individually where as no one used the
options and shortening and lengthening of investments.
More volumes in forwards than futures because forwards are tailored to
individual need, no mark to market, convenient market place.
72% and 16% strongly agreed and agreed respectively that pricing of options
create arbitrage opportunity but due to the transaction charges it disappears.
21, 17, 17, 12 and 5 respondents responded that they analyse the Vega, Delta,
Gamma, Theta and RHO respectively to much greater extent when they trade
in options.
Most of the respondents expect 25-50 basis points for call option, 50-75 basis
points for liquidity risk, 75-100 basis points for default risk and 50-75 basis
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points for tax status above the term structure of interest rate when they lend.
(Because term structure dont consider the given below)
56% and 24% respondents strongly agreed and agreed respectively that option
adjusted spread will accommodate all the above risks.
If the respondents expect some cash flow in 6 months down the line to invest
the strategy used to invest is 36% responded that they will go for caplet, 24%
floorlet, 20% collar where as 20% responded that they will wait for 6 months
and then invest.
56% respondents claimed that compare to the interest rate swaps currency
swaps are about the same where as 28% claimed that they are superior.
High importance given while pricing swaps is the slope of term structure
interest rates and risk exposure of swap portfolio where as moderate
importance is taken in terms of counterparty risk.
72% of respondents claimed that compare to Interest rate futures and options
swaps are superior where as 20% claimed that it is about the same.
52% of respondents neither agreed nor disagreed the statement that to over
come the mismatch risk Swap Dealers enter into Interest rate Futures/Options
which has created more liquidity in the bond markets. Where as 24% and 20%
strongly agreed and agreed for this.
Most of the respondents felt the following factors are extremely
favourableness to invest in structured note. Those factors are
1. Structured notes available in small quantities.
2. Less credit evaluation and credit risk.
3. More marketable and liquidity.
4. Payoff pattern is good.
5. Yield curve is upward and down ward sloping.
Most of the respondents felt that the following factors are extremely
favourableness for the issuer to issue structured notes.
1. Reduce in finance cost
2. Market imperfection
3. Operationally efficient firm.
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Most of the respondents ranked high for flexibility in interest rate swaps and
currency swaps where as arbitrage, credit exposure and pricing were ranked
respectively after flexibility.
64% of respondents said that cross rate arbitrage is high where as 36% of
respondents said geographical arbitrage is high.
48% responded in favour of free floating exchange rate, 36% towards
managed float, 12% joint float where as only 4% favoured pegged exchange
rate system.
Most of the respondents felt that demand and supply will play a major role in
determining exchange rate.
76% agreed to allow FDI and FII to hedge their currency risk in India.
Most of the respondents strongly agreed that if FII and FDI are allowed to
hedge the inflows will increase.
Currency risk is the most unhedged risk in India and the reasons for this is
1. Oil companies and Public sector undertakings are not allowed to hedge
2. Lack of proper risk management among importers/exporters
3. Restrictions on booking and cancellation of exports/imports
4. Exorbitant transaction charges, charged by Banks
5. Lack of expertise among the corporation about risk management
6. Banks need to educate their clients about Forex risk and Derivatives
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14. CONCLUSION
Derivatives help in discovery of future as well as current prices.
The derivatives market helps to transfer risks from those who have them but
may not like them to those who have an appetite for them.
Derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
Interest rate futures and options are playing a major role in mitigating the
unexpected risk where as in India it is not happening.
Liquidity in the Indian Bond market is very less.
There is a little liquidity in the bond market this is due to the statutory
requirement that primary dealers want to trade in the bond market to certain
amount of transactions in a year.
Liquidity in the bond market can be increased by Interest rate futures and
options. The SEBI or RBI need to set up a committee and make a thorough
study on this and should come out with new rules and guidelines.
Even now the interest rate futures are available in the market it is restricted to
only primary dealers. Only once in the life time after introduction of interest
rate futures it is traded and that is in 2003. Then onwards not even a single
contract is traded.
The recent decision taken by RBI to allow intra day short selling in bond
market is a good move but it will not create much liquidity in the market.
Interest rate futures are not traded even after introduction and I think there is
no use of introducing interest rate options in the market.
At the same time it is not only the rules and guidelines which are affecting the
liquidity in the bond market but the risk appetite of the investors.
In India most of the investors dont like to take risk where has in many
countries the investors prefer for junk bonds due to the high returns.
Issuance of structured notes in India is very less. With the help of swaps the
issuer can reduce the finance cost and the return to the investor is high because
of the payoff pattern is very good.
When it comes to corporate bonds it is even worse.
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Most of the corporate are raising the debt from foreign countries at less rate
compare to the India interest rates. In the year 2005 India Inc has raise around
75,000 crores from overseas through FCCB, ADR and GDR.
Interest rate swaps are better than futures and options. Due to the CCIL
proposal to settle the IRS through it the number of contracts is increased.
In 1992 when Indian government accepted for Liberalisation, Privatisation and
Globalisation the then finance minister Man Mohan Singh and Present Prime
Minister took a right decision saved the country from huge depreciation of
currency. He allowed only current account convertibility and put a break on
capital account convertibility. Many of the countries like Indonesia who
allowed full convertibility is suffering. Now 1 dollar is equal to some thousand
of the Indonesian currency.
Most of the people accepted the decision and asked a question that when the
India is going to have full currency convertibility then Man Mohan Singh gave
three conditions and if three are satisfied then India can allow currency into
fully convertibility. Those conditions are:
o Inflation of the country should be less than 5%.
o Fiscal deficit should be less than 5%.
o India should have a Forex reserve of $200 bn.
Now the companies who are earning foreign exchange are allowed to invest
200% net worth of the company and every individual is allowed to invest
$25,000 in other countries.
All the above are good measures but in India the most unhedged risk is
currency risk. The reasons for this are mentioned in findings. To overcome
this problem the following steps need to be taken.
1. Oil companies and Public sector undertakings should be allowed to hedge
2. There should be proper risk management among importers/exporters
3. Restrictions on booking and cancellation of exports/imports should be
removed.
4. Exorbitant transaction charges, charged by Banks should be removed. The
loss incurred by the bank in purchasing and selling of dollars on behalf of
exporters and importers are bear upon small exporters and importers.
5. Lack of expertise among the corporation about risk management
6. Banks need to educate their clients about Forex risk and Derivatives.
107
At the same time RBI has put unreasonable restriction on FIIs and FDIs to
hedge the currency risk in India. This should be removed.
Because of this the FIIs and FDIs will hedge the currency risk in other
countries like Hong Kong, Dubai and Singapore. This type of hedging is
called Non Deliverable Forwards.
Hong Kong dealers have got more confidence in Indian rupee and now Indian
rupee is fully convertible in Hong Kong. As other countries are doing this why
not India should allow foreign currency risk to hedge.
108
15. Bibliography
http://www.derivativesindia.com
http://www.derivatives-r-us.com
http://www.igidr.ac.in/~ajayshah
http://www.mof.nic
http://www.nseindia.com
http://www.sebi.gov.in
http://www.rediff/money/derivatives
http://www.rbi.org
http://www..com
http://www.eurexchange.com
http://www.hkfe.com
http://www.liffe.com
http://www.simex.com
http://www.cbot.com
http://www.cboe.com
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