Financial Derivatives PDF

PONDICHERRY UNIVERSITY (A Central University) DIRECTORATE OF DISTANCE EDUCATION Financial Derivatives Paper Code : MBFM 4005 MBA - FINANCE IV - Semester Author Dr. R. Kasilingam Reader, Department of Management Studies, Pondicherry Univers...

PONDICHERRY UNIVERSITY (A Central University) DIRECTORATE OF DISTANCE EDUCATION Financial Derivatives Paper Code : MBFM 4005 MBA - FINANCE IV - Semester Author Dr. R. Kasilingam Reader, Department of Management Studies, Pondicherry University Puducherry. All Rights Reserved For Private Circulation Only ISBN 978-93-81932-16-2  TABLE OF CONTENTS UNIT LESSON TITLE PAGE NO. 1.1 Basics of Financial Derivatives 4 1.2 Forward Contracts 33 I 1.3 Participants in Derivative Markets 46 1.4 Recent Developments in Global Financial Derivative Markets 52 2.1 Basics of Options 68 2.2 Fundamental Determinants of Option’s Price 79 II 2.3 Options Trading Strategies 98 2.4 Interest rate swaps 155 2.5 Currency Swaps 171 3.1 Futures Market 206 III 3.2 Pricing of Futures 223 3.3 Theories of Futures Prices 234 4.1 Hedging Strategy Using Futures 266 IV 4.2 Basis Risk and Hedging 280 4.3 Stock Index 289 5.1 Financial Derivatives Markets in India 319 V 5.2 Benefits of Derivatives in India 329 MBA Finance – IV Semester Paper code: MBFM 4005 Paper – XX Financial Derivatives Objectives   To Understand the students about the concept of Derivatives and its types   To acquaint the knowledge of Options and Futures and   To know about Hedging and the development position of Derivatives in India. Unit – I Derivatives – Features of a Financial Derivative – Types of Financial Derivatives – Basic Financial derivatives – History of Derivatives Markets – Uses of Derivatives – Critiques of Derivatives – Forward Market: Pricing and Trading Mechanism – Forward Contract concept – Features of Forward Contract – Classification of Forward Contracts – Forward Trading Mechanism – Forward Prices Vs Future Prices. Unit – II Options and Swaps – Concept of Options – Types of options – Option Valuation – Option Positions Naked and Covered Option – Underlying Assets in Exchange-traded Options – Determinants of Option Prices – Binomial Option Pricing Model – Black-Scholes Option Pricing – Basic Principles of Option Trading – SWAP: Concept, Evaluation and Features of Swap – Types of Financial Swaps – Interest Rate Swaps – Currency Swap – Debt- Equity Swap. Unit – III Futures – Financial Futures Contracts – Types of Financial Futures Contract – Evolution of Futures Market in India – Traders in Futures Market in India – Functions and Growth of Futures Markets – Futures Market Trading Mechanism - Specification of 1 the Future Contract – Clearing House – Operation of Margins – Settlement – Theories of Future prices – Future prices and Risk Aversion – Forward Contract Vs. Futures Contracts. Unit – IV Hedging and Stock Index Futures – Concepts – Perfect Hedging Model – Basic Long and Short Hedges – Cross Hedging – Basis Risk and Hedging – Basis Risk Vs Price Risk – Hedging Effectiveness – Devising a Hedging Strategy – Hedging Objectives – Management of Hedge – Concept of Stock Index – Stock Index Futures – Stock Index Futures as a Portfolio management Tool – Speculation and Stock Index Futures – Stock Index Futures Trading in Indian Stock Market. Unit – V Financial Derivatives Market in India – Need for Derivatives – Evolution of Derivatives in India – Major Recommendations of Dr. L.C. Gupta Committee – Equity Derivatives – Strengthening of Cash Market – Benefits of Derivatives in India – Categories of Derivatives Traded in India – Derivatives Trading at NSE/BSE – Eligibility of Stocks – Emerging Structure of Derivatives Markets in India -Regulation of Financial Derivatives in India – Structure of the Market – Trading systems – Badla system in Indian Stock Market – Regulatory Instruments. References 1. Gupta S.L., FINANCIAL DERIVATIVES THEORY, CONCEPTS AND PROBLEMS PHI, Delhi, Kumar S.S.S. FINANCIAL DERIVATIVES, PHI, New Delhi, 2007 2. Chance, Don M: DERIVATIVES and Risk Management Basics, Cengage Learning, Delhi. 3. Stulz M. Rene, RISK MANAGEMENT & DERIVATIVES, Cengage Learning, New Delhi. 2  UNIT - I Unit Structure Lesson 1.1 - Basics of Financial Derivatives Lesson 1.2 - Forward Contracts Lesson 1.3 - Participants in Derivative Markets Lesson 1.4 - Recent Developments in Global Financial Derivative Markets Learning Objectives After reading this chapter, students should   Understand the meaning of financial derivatives.   Know that what various features of financial derivatives are.   Understand the various types of financial derivatives like forward, futures, options, Swaps, convertible, warrants, etc.   Know about the historical background of financial derivatives.   Know that what various uses of financial derivatives are.   Understand about the myths of financial derivatives.   Understand the concept of forward contract.   Be aware about the various features of a forward contract.   Know that forward markets as fore-runner of futures markets, and also know about the historically growth of forward market.   Understand the various differences between futures and forward contracts.   Know about the classification of forward contracts like hedge contracts, transferable specific delivery, and non-transferable specific delivery (NTSD) and other forward contracts. 3  Lesson 1.1 - Basics of Financial Derivatives Introduction The past decade has witnessed the multiple growths in the volume of international trade and business due to the wave of globalization and liberalization all over the world. As a result, the demand for the international money and financial instruments increased significantly at the global level. In this respect, changes in the interest rates, exchange rates and stock market prices at the different financial markets have increased the financial risks to the corporate world. Adverse changes have even threatened the very survival of the business world. It is, therefore, to manage such risks; the new financial instruments have been developed in the financial markets, which are also popularly known as financial derivatives. The basic purpose of these instruments is to provide commitments to prices for future dates for giving protection against adverse movements in future prices, in order to reduce the extent of financial risks. Not only this, they also provide opportunities to earn profit for those persons who are ready to go for higher risks. In other words, these instruments, indeed, facilitate to transfer the risk from those who wish to avoid it to those who are willing to accept the same. Today, the financial derivatives have become increasingly popular and most commonly used in the world of finance. This has grown with so phenomenal speed all over the world that now it is called as the derivatives revolution. In an estimate, the present annual trading volume of derivative markets has crossed US $ 30,000 billion, representing more than 100 times gross domestic product of India. Financial derivatives like futures, forwards options and swaps are important tools to manage assets, portfolios and financial risks. Thus, it is essential to know the terminology and conceptual framework of all these financial derivatives in order to analyze and manage the financial risks. The prices of these financial derivatives contracts depend upon the spot prices of the underlying assets, costs of carrying assets into the future and relationship with spot prices. For example, forward and futures contracts are similar in nature, but their prices in future may differ. Therefore, before using any financial derivative instruments for hedging, speculating, or arbitraging purpose, the trader or investor must carefully examine all the important aspects relating to them. 4 Definition of Financial Derivatives Before explaining the term financial derivative, let us see the dictionary meaning of ‘derivative’. Webster’s Ninth New Collegiate Dictionary (1987) states Derivatives as: 1. A word formed by derivation. It means, this word has been arisen by derivation. 2. Something derived; it means that some things have to be derived or arisen out of the underlying variables. For example, financial derivative is an instrument indeed derived from the financial market. 3. The limit of the ratio of the change is a function to the corresponding change in its independent variable. This explains that the value of financial derivative will change as per the change in the value of the underlying financial instrument. 4. A chemical substance related structurally to another substance, and theoretically derivable from it. In other words, derivatives are structurally related to other substances. 5. A substance that can be made from another substance in one or more steps. In case of financial derivatives, they are derived from a combination of cash market instruments or other derivative instruments. For example, you have purchased gold futures on May 2003 for delivery in August 2003. The price of gold on May 2003 in the spot market is ` 4500 per 10 grams and for futures delivery in August 2003 is ` 4800 per 10 grams. Suppose in July 2003 the spot price of the gold changes and increased to ` 4800 per 10 grams. In the same line value of financial derivatives or gold futures will also change. From the above, the term derivatives may be termed as follows: The term “Derivative” indicates that it has no independent value, i.e., its value is entirely derived from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else. In other words, derivative means forward, futures, option or any other hybrid contract of predetermined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. The Securities Contracts (Regulation) Act 1956 defines “derivative” as under: 5 “Derivative” includes 1. Security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices of underlying securities. The above definition conveys that 1. The derivatives are financial products. 2. Derivative is derived from another financial instrument/contract called the underlying. In the case of Nifty futures, Nifty index is the underlying. A derivative derives its value from the underlying assets. Accounting Standard SFAS133 defines a derivative as, ‘a derivative instrument is a financial derivative or other contract with all three of the following characteristics: (i) It has (1) one or more underlings, and (2) one or more notional amount or payments provisions or both. Those terms determine the amount of the settlement or settlements. (ii) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contract that would be expected to have a similar response to changes in market factors. (iii) Its terms require or permit net settlement. It can be readily settled net by a means outside the contract or it provides for delivery of an asset that puts the recipients in a position not substantially different from net settlement In general, from the aforementioned, derivatives refer to securities or to contracts that derive from another—whose value depends on another contract or assets. As such the financial derivatives are financial instruments whose prices or values are derived from the prices of other underlying financial instruments or financial assets. The underlying instruments may be a equity share, stock, bond, debenture, treasury bill, foreign currency or even another derivative asset. For example, a stock option’s value depends upon the value of a stock on which the option is written. Similarly, the value of a treasury bill of futures contracts or foreign currency forward contract will depend upon the price or value of the underlying assets, such as Treasury bill or foreign currency. In other words, the price of the derivative is not arbitrary rather it is linked or affected to the price of the underlying asset that will automatically affect the price of the financial derivative. Due to this reason, transactions in derivative markets are used to offset the risk of price changes 6 in the underlying assets. In fact, the derivatives can be formed on almost any variable, for example, from the price of hogs to the amount of snow falling at a certain ski resort. The term financial derivative relates with a variety of financial instruments which include stocks, bonds, treasury bills, interest rate, foreign currencies and other hybrid securities. Financial derivatives include futures, forwards, options, swaps, etc. Futures contracts are the most important form of derivatives, which are in existence long before the term ‘derivative’ was coined. Financial derivatives can also be derived from a combination of cash market instruments or other financial derivative instruments. In fact, most of the financial derivatives are not revolutionary new instruments rather they are merely combinations of older generation derivatives and/or standard cash market instruments. In the 1980s, the financial derivatives were also known as off-balance sheet instruments because no asset or liability underlying the contract was put on the balance sheet as such. Since the value of such derivatives depend upon the movement of market prices of the underlying assets, hence, they were treated as contingent asset or liabilities and such transactions and positions in derivatives were not recorded on the balance sheet. However, it is a matter of considerable debate whether off-balance sheet instruments should be included in the definition of derivatives. Which item or product given in the balance sheet should be considered for derivative is a debatable issue. In brief, the term financial market derivative can be defined as a treasury or capital market instrument which is derived from, or bears a close re1ation to a cash instrument or another derivative instrument. Hence, financial derivatives are financial instruments whose prices are derived from the prices of other financial instruments. Features of a Financial Derivatives As observed earlier, a financial derivative is a financial instrument whose value is derived from the value of an underlying asset; hence, the name ‘derivative’ came into existence. There are a variety of such instruments which are extensively traded in the financial markets all over the world, such as forward contracts, futures contracts, call and put options, swaps, etc. A more detailed discussion of the properties of these contracts will be given later part of this lesson. Since each financial derivative has its own unique features, in this section, we will discuss some of the general features of simple financial derivative instrument. The basic features of the derivative instrument can be drawn from the general definition of a derivative irrespective of its type. Derivatives or derivative securities are 7 future contracts which are written between two parties (counter parties) and whose value are derived from the value of underlying widely held and easily marketable assets such as agricultural and other physical (tangible) commodities, or short term and long term financial instruments, or intangible things like weather, commodities price index (inflation rate), equity price index, bond price index, stock market index, etc. Usually, the counter parties to such contracts are those other than the original issuer (holder) of the underlying asset. From this definition, the basic features of a derivative may be stated as follows: 1. A derivative instrument relates to the future contract between two parties. It means there must be a contract-binding on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the nature of contract, for example, short term interest rate futures and long term interest rate futures contract. 2. Normally, the derivative instruments have the value which derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of derivatives depends upon the value of underlying instrument and which changes as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related. 3. In general, the counter parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative. For example, the obligation of the counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different. 4. The derivatives contracts can be undertaken directly between the two parties or through the particular exchange like financial futures contracts. The exchange- traded derivatives are quite liquid and have low transaction costs in comparison to tailor-made contracts. Example of exchange traded derivatives are Dow Jones, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on. 5. In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the pay off. For instance, in the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares, because the payoff of derivative products differs from the payoff that their notional amount might suggest. 8  6. Usually, in derivatives trading, the taking or making of delivery of underlying assets is not involved; rather underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in respect of underlying assets. 7. Derivatives are also known as deferred delivery or deferred payment instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to financial engineering. 8. Derivatives are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the corporate world; however, warrants and convertibles are exception in this respect. 9. Although in the market, the standardized, general and exchange-traded derivatives are being increasingly evolved, however, still there are so many privately negotiated customized, over-the-counter (OTC) traded derivatives are in existence. They expose the trading parties to operational risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory status of such derivatives. 10. Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be used to clear up the balance sheet. For example, a fund manager who is restricted from taking particular currency can buy a structured note whose coupon is tied to the performance of a particular currency pair. Types of Financial Derivatives In the past section, it is observed that financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently, there are complex varieties of derivatives already in existence, and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC traded, standardized or organized exchange traded, etc. are available in the market. Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present context, the basic financial derivatives which are popular in the market have been described in brief. The details of their operations, mechanism and trading, will be discussed in the forthcoming respective chapters. In simple form, the derivatives can be classified into different categories which are shown in the Fig. 9  Derivatives Financials Commodities Basic Complex Forwards Futures Options Warrants Swaps Exotics    & (Nonstandard) Convertibles Classification of Derivatives One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or asset. In a commodity derivatives, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soya beans, crude oil, natural gas, gold, silver, copper and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters. However, the distinction between these two from structure and functioning point of view, both are almost similar in nature. Another way of classifying the financial derivatives is into basic and complex derivatives. In this, forward contracts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivatives of derivatives. Basic Financial Derivatives Forward Contracts A forward contract is a simple customized contract between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike future contracts, they are not traded on an exchange, rather traded in the over-the-counter market, usually between two financial institutions or between a financial institution and its client. 10 Example An Indian company buys Automobile parts from USA with payment of one million dollar due in 90 days. The importer, thus, is short of dollar that is, it owes dollars for future delivery. Suppose present price of dollar is ` 48. Over the next 90 days, however, dollar might rise against ` 48. The importer can hedge this exchange risk by negotiating a 90 days forward contract with a bank at a price ` 50. According to forward contract in 90 days the bank will give importer one million dollar and importer will give the bank 50 million rupees hedging a future payment with forward contract. On the due date importer will make a payment of ` 50 million to bank and the bank will pay one million dollar to importer, whatever rate of the dollar is after 90 days. So this is a typical example of forward contract on currency. The basic features of a forward contract are given in brief here as under: 1. Forward contracts are bilateral contracts, and hence, they are exposed to counter- party risk. There is risk of non-performance of obligation either of the parties, so these are riskier than to futures contracts. 2. Each contract is custom designed, and hence, is unique in terms of contract size, expiration date, the asset type, quality, etc. 3. In forward contract, one of the parties takes a long position by agreeing to buy the asset at a certain specified future date. The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price. A party with no obligation offsetting the forward contract is said to have an open position. A party with a closed position is, sometimes, called a hedger. 4. The specified price in a forward contract is referred to as the delivery price. The forward price for a particular forward contract at a particular time is the delivery price that would apply if the contract were entered into at that time. It is important to differentiate between the forward price and the delivery price. Both are equal at the time the contract is entered into. However, as time passes, the forward price is likely to change whereas the delivery price remains the same. 5. In the forward contract, derivative assets can often be contracted from the combination of underlying assets, such assets are oftenly known as synthetic assets in the forward market. 6. In the forward market, the contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsory go to the same counter party, which may dominate and command the price it wants as being in a monopoly situation. 11  7. In the forward contract, covered parity or cost-of-carry relations are relation between the prices of forward and underlying assets. Such relations further assist in determining the arbitrage-based forward asset prices. 8. Forward contracts are very popular in foreign exchange market as well as interest rate bearing instruments. Most of the large and international banks quote the forward rate through their ‘forward desk’ lying within their foreign exchange trading room. Forward foreign exchange quotes by these banks are displayed with the spot rates. 9. As per the Indian Forward Contract Act- 1952, different kinds of forward contracts can be done like hedge contracts, transferable specific delivery (TSD) contracts and non-transferable specify delivery (NTSD) contracts. Hedge contracts are freely transferable and do not specific, any particular lot, consignment or variety for delivery. Transferable specific delivery contracts are though freely transferable from one party to another, but are concerned with a specific and predetermined consignment. Delivery is mandatory. Non-transferable specific delivery contracts, as the name indicates, are not transferable at all, and as such, they are highly specific. In brief, a forward contract is an agreement between the counter parties to buy or sell a specified quantity of an asset at a specified price, with delivery at a specified time (future) and place. These contracts are not standardized; each one is usually being customized to its owner’s specifications. Futures Contracts Like a forward contract, a futures contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified price and at a specified time and place. Futures contracts are normally traded on an exchange which sets the certain standardized norms for trading in the futures contracts. Example A silver manufacturer is concerned about the price of silver, since he will not be able to plan for profitability. Given the current level of production, he expects to have about 20.000 ounces of silver ready in next two months. The current price of silver on May 10 is ` 1052.5 per ounce, and July futures price at FMC is ` 1068 per ounce, which he believes to be satisfied price. But he fears that prices in future may go down. So he will enter into a futures contract. He will sell four contracts at MCX where each contract is of 5000 ounces at ` 1068 for delivery in July. 12  Perfect Hedging Using Futures Date Spot Market Futures market Anticipate the sale of 20,000 ounce in Sell four contracts, 5000 ounce each May 10 two months and expect to receive ` 1068 July futures contracts at ` 1068 per per ounce or a total ` 21.36,00.00 ounce. The spot price of silver is ` 1071 per Buy four contracts at ` 1071. To- July 5 ounce; Miner sells 20,000 ounces and re- tal cost of 20,000 ounce will be ` ceives ` 21.42,0000. 21,42,0000. Profit / Loss Profit = ` 60,000 Futures loss = ` 60,000 Net wealth change = 0 In the above example trader has hedged his risk of prices fall and the trading is done through standardized exchange which has standardized contract of 5000 ounce silver. The futures contracts have following features in brief: Standardization One of the most important features of futures contract is that the contract has certain standardized specification, i.e., quantity of the asset, quality of the asset, the date and month of delivery, the units of price quotation, location of settlement, etc. For example, the largest exchanges on which futures contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). They specify about each term of the futures contract. Clearing House In the futures contract, the exchange clearing house is an adjunct of the exchange and acts as an intermediary or middleman in futures. It gives the guarantee for the performance of the parties to each transaction. The clearing house has a number of members all of which have offices near to the clearing house. Thus, the clearing house is the counter party to every contract. Settlement Price Since the futures contracts are performed through a particular exchange, so at the close of the day of trading, each contract is marked-to-market. For this the exchange establishes a settlement price. This settlement price is used to compute the profit or loss on each contract for that day. Accordingly, the member’s accounts are credited or debited. 13 Daily Settlement and Margin Another feature of a futures contract is that when a person enters into a contract, he is required to deposit funds with the broker, which is called as margin. The exchange usually sets the minimum margin required for different assets, but the broker can set higher margin limits for his clients which depend upon the credit-worthiness of the clients. The basic objective of the margin account is to act as collateral security in order to minimize the risk of failure by either party in the futures contract. Tick Size The futures prices are expressed in currency units, with a minimum price movement called a tick size. This means that the futures prices must be rounded to the nearest tick. The difference between a futures price and the cash price of that asset is known as the basis. The details of this mechanism will be discussed in the forthcoming chapters. Cash Settlement Most of the futures contracts are settled in cash by having the short or long to make cash payment on the difference between the futures price at which the contract was entered and the cash price at expiration date. This is done because it is inconvenient or impossible to deliver sometimes, the underlying asset. This type of settlement is very much popular in stock indices futures contracts. Delivery The futures contracts are executed on the expiry date. The counter parties with a short position are obligated to make delivery to the exchange, whereas the exchange is obligated to make delivery to the longs. The period during which the delivery will be made is set by the exchange which varies from contract to contract. Regulation The important difference between futures and forward markets is that the futures contracts are regulated through a exchange, but the forward contracts are self regulated by the counter-parties themselves. The various countries have established Commissions in their country to regulate futures markets both in stocks and commodities. Any such new futures contracts and changes to existing contracts must by approved by their respective Commission. Further, more details on different issues of futures market trading will be discussed in forthcoming chapters. 14 Options Contracts Options are the most important group of derivative securities. Option may be defined as a contract, between two parties whereby one party obtains the right, but not the obligation, to buy or sell a particular asset, at a specified price, on or before a specified date. The person who acquires the right is known as the option buyer or option holder, while the other person (who confers the right) is known as option seller or option writer. The seller of the option for giving such option to the buyer charges an amount which is known as the option premium. Options can be divided into two types: calls and puts. A call option gives the holder the right to buy an asset at a specified date for a specified price whereas in put option, the holder gets the right to sell an asset at the specified price and time. The specified price in such contract is known as the exercise price or the strike price and the date in the contract is known as the expiration date or the exercise date or the maturity date. The asset or security instrument or commodity covered under the contract is called as the underlying asset. They include shares, stocks, stock indices, foreign currencies, bonds, commodities, futures contracts, etc. Further options can be American or European. A European option can be exercised on the expiration date only whereas an American option can be exercised at any time before the maturity date. Example Suppose the current price of CIPLA share is ` 750 per share. X owns 1000 shares of CIPLA Ltd. and apprehends in the decline in price of share. The option (put) contract available at BSE is of ` 800, in next two-month delivery. Premium cost is ` 10 per share. X will buy a put option at 10 per share at a strike price of ` 800. In this way X has hedged his risk of price fall of stock. X will exercise the put option if the price of stock goes down below ` 790 and will not exercise the option if price is more than ` 800, on the exercise date. In case of options, buyer has a limited loss and unlimited profit potential unlike in case of forward and futures. In April 1973, the options on stocks were first traded on an organized exchange, i.e., Chicago Board Options Exchange. Since then, there has been a dramatic growth in options markets. Options are now traded on various exchanges in various countries all over the world. Options are now traded both on organized exchanges and over- the-counter (OTC). The option trading mechanism on both are quite different and which leads to important differences in market conventions. Recently, options contracts on OTC are getting popular 15 because they are more liquid. Further, most of the banks and other financial institutions now prefer the OTC options market because of the ease and customized nature of contract. It should be emphasized that the option contract gives the holder the right to do something. The holder may exercise his option or may not. The holder can make a reassessment of the situation and seek either the execution of the contracts or its non- execution as be profitable to him. He is not under obligation to exercise the option. So, this fact distinguishes options from forward contracts and futures contracts, where the holder is under obligation to buy or sell the underlying asset. Recently in India, the banks are allowed to write cross-currency options after obtaining the permission from the Reserve Bank of India. Warrants and Convertibles Warrants and convertibles are other important categories of financial derivatives, which are frequently traded in the market. Warrant is just like an option contract where the holder has the right to buy shares of a specified company at a certain price during the given time period. In other words, the holder of a warrant instrument has the right to purchase a specific number of shares at a fixed price in a fixed period from an issuing company. If the holder exercised the right, it increases the number of shares of the issuing company, and thus, dilutes the equities of its shareholders. Warrants are usually issued as sweeteners attached to senior securities like bonds and debentures so that they are successful in their equity issues in terms of volume and price. Warrants can be detached and traded separately. Warrants are highly speculative and leverage instruments, so trading in them must be done cautiously. Convertibles are hybrid securities which combine the basic attributes of fixed interest and variable return securities. Most popular among these are convertible bonds, convertible debentures and convertible preference shares. These are also called equity derivative securities. They can be fully or partially converted into the equity shares of the issuing company at the predetermined specified terms with regards to the conversion period, conversion ratio and conversion price. These terms may be different from company to company, as per nature of the instrument and particular equity issue of the company. The further details of these instruments will be discussed in the respective chapters. SWAP Contracts Swaps have become popular derivative instruments in recent years all over the world. A swap is an agreement between two counter parties to exchange cash flows in the future. 16 Under the swap agreement, various terms like the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are determined and finalized by the parties. Usually the calculation of cash flows involves the future values of one or more market variables. There are two most popular forms of swap contracts, i.e., interest rate swaps and currency swaps. In the interest rate swap one party agrees to pay the other party interest at a fixed rate on a notional principal amount, and in return, it receives interest at a floating rate on the same principal notional amount for a specified period. The currencies of the two sets of cash flows are the same. In case of currency swap, it involves in exchanging of interest flows, in one currency for interest flows in other currency. In other words, it requires the exchange of cash flows in two currencies. There are various forms of swaps based upon these two, but having different features in general. Other Derivatives As discussed earlier, forwards, futures, options, swaps, etc. are described usually as standard or ‘plain vanilla’ derivatives. In the early 1980s, some banks and other financial institutions have been very imaginative and designed some new derivatives to meet the specific needs of their clients. These derivatives have been described as ‘non-standard’ derivatives. The basis of the structure of these derivatives was not unique, for example, some non-standard derivatives were formed by combining two or more ‘plain vanilla’ call and put options whereas some others were far more complex. In fact, there is no boundary for designing the non-standard financial derivatives, and hence, they are sometimes termed as ‘exotic options’ or just ‘exotics’. There are various examples of such non-standard derivatives such as packages, forward start option, compound options, choose options, barrier options, binary options, look back options, shout options, Asian options, basket options, Standard Oil’s Bond Issue, Index Currency Option Notes (ICON), range forward contracts or flexible forwards and so on. Traditionally, it is evident that important variables underlying the financial derivatives have been interest rates, exchange rates, commodity prices, stock prices, stock indices, etc. However, recently, some other underlying variables are also getting popular in the financial derivative markets such as creditworthiness, weather, insurance, electricity and so on. In fact, there is no limit to the innovations in the field of derivatives, Suppose that two companies A and B both wish to borrow 1 million rupees for five- years and rate of interest is: 17  Company Fixed Floating Company A 10.00% per annum 6 month LIBOR + 0.30% Company B 11.20% per annum 6 month LIBOR + 1.00% A wants to borrow at floating funds and B wants to borrow at fixed interest rate. B has low credit rating than company A since it pays higher rate of interest than company A in both fixed and floating markets. They will contract to Financial Institution for swapping their assets and liabilities and make a swap contract with bank. Both company will initially raise loans A in fixed and B in floating interest rate and then contract to bank, which in return pays fixed interest rate to A and receive floating interest rate to A and from B. Bank will pay floating interest rate and receive. Fixed interest rates and also changes commission from both A and B have the liability in which both were interested. History of Derivatives Markets It is difficult to trace the main origin of futures trading since it is not clearly established as to where and when the first forward market came into existence. Historically, it is evident that the development of futures markets followed the development of forward markets. It is believed that the forward trading has been in existence since 12th century in England and France. Forward trading in rice was started in 17th century in Japan, known as Cho-at-Mai a kind (rice trade-on-book) concentrated around Dojima in Osaka, later on the trade in rice grew with a high degree of standardization. In 1730, this market got official recognition from the Tokugawa Shogurate. As such, the Dojima rice market became the first futures market in the sense that it was registered on organized exchange with the standardized trading norms. The butter and eggs dealers of Chicago Produce Exchange joined hands in 1898 to form the Chicago Mercantile Exchange for futures trading. The exchange provided a futures market for many commodities including pork bellies (1961), live cattle (1964), live hogs (1966), and feeder cattle (1971). The International Monetary Market was formed as a division of the Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies. In 1982, it introduced a futures contract on the S&P 500 Stock Index. Many other exchanges throughout the world now trade futures contracts. Among them are the Chicago Rice and Cotton Exchange, the New York Futures Exchange, the London International Financial Futures Exchange, the Toronto Futures Exchange and the Singapore international Monetary Exchange. They grew so rapidly that the number of shares underlying the option contracts sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. 18  In the 1980’s, markets developed for options in foreign exchange, options on stock indices, and options on futures contracts. The Philadelphia Stock Exchange is the premier exchange for trading foreign exchange options. The Chicago Board Options Exchange trades options on the S&P 100 and the S&P 500 stock indices while the American Stock Exchange trades options on the Major Market Stock Index, and the New York Stock Exchange trades options on the NYSE Index. Most exchanges offering futures contracts now also offer options on these futures contracts. Thus, the Chicago Board of Trades offers options on corn futures, the Chicago Mercantile Exchange offers options on live cattle futures, the International Monetary Market offers options on foreign currency futures, and so on. The basic cause of forward trading was to cover the price risk. In earlier years, transporting goods from one market to other markets took many months. For example, in the 1800s, food grains produced in England sent through ships to the United States which normally took few months. Sometimes, during this tune, the price crashed clue to unfavourable events before the goods reached to the destination. In such cases, the producers had to sell their goods at the loss. Therefore, the producers sought to avoid such price risk by selling their goods forward, or on a “to arrive” basis. The basic idea behind this move at that time was simply to cover future price risk. On the opposite side, the speculator or other commercial firms seeking to offset their price risk came forward to go for such trading. In this way, the forward trading in commodities came into existence. In the beginning, these forward trading agreements were formed to buy and sell food grains in the future for actual delivery at the pre-determined price. Later on these agreements became transferable, and during the American Civil War period, i.e., 1860 to 1865, it became common place to sell and resell such agreements where actual delivery of produce was not necessary. Gradually, the traders realized that the agreements were easier to buy and sell if the same were standardized in terms of quantity, quality and place of delivery relating to food grains. In the nineteenth century this activity was centred in Chicago which was the main food grains marketing centre in the United States. In this way, the modern futures contracts first came into existence with the establishment of the Chicago Board of Trade (CBOT) in the year 1848, and today, it is the largest futures market of the world. In 1865, the CBOT framed the general rules for such trading which later on became a trendsetter for so many other markets. In 1874, the Chicago Produce Exchange was established which provided the market for butter, eggs, poultry, and other perishable agricultural products. In the year 1877, the London Metal Exchange came into existence, and today, it is leading market in metal trading both in spot as well as forward. In the year 1898, the butter and egg dealers withdrew from the Chicago Produce Exchange to form separately the Chicago Butter and Egg Board, 19 and thus, in 1919 this exchange was renamed as the Chicago Mercantile Exchange (CME) and was reorganized for futures trading. Since then, so many other exchanges came into existence throughout the world which trade in futures contracts. Although financial derivatives have been in operation since long, they have become a major force in financial markets only in the early 1970s. The basic reason behind this development was the failure of Brettonwood System and the fixed exchange rate regime was broken down. As a result, new exchange rate regime, i.e., floating rate (flexible) system based upon market forces came into existence. But due to pressure of demand and supply on different currencies, the exchange rates were constantly changing, and often, substantially. As a result, the business firms faced a new risk, known as currency or foreign exchange risk. Accordingly, a new financial instrument was developed to overcome this risk in the new financial environment. Another important reason for the instability in the financial market was fluctuation in the short-term interests. This was mainly due to that most of the government at that time tried to manage foreign exchange fluctuations through short-term interest rates and by maintaining money supply targets, but which were contrary to each other. Further, the increased instability of short-term interest rates created adverse impact on long-term interest rates, and hence, instability in bond prices because they are largely determined by long-term interest rates. The result is that it created another risk, named interest rate risk, for both the issuers and the investors of debt instruments. Interest rate fluctuations had not only created instability in bond prices, but also in other long-term assets such as, company stocks and shares. Share prices are determined on the basis of expected present values of future dividends payments discounted at the appropriate discount rate. Discount rates are usually based on long-term interest rates in the market. So, increased instability in the long-term interest rates caused enhanced fluctuations in the share prices in the stock markets. Further volatility in stock prices is reflected in the volatility in stock market indices which causes to systematic risk or market risk. In the early 1970s, it is witnessed that the financial markets were highly instable; as a result, so many financial derivatives have been emerged as the means to manage the different types of risks stated above, and also of taking advantage of it. Hence, the first financial futures market was the International Monetary Market, established in 1972 by the Chicago Mercantile Exchange which was followed by the London International Financial Futures Exchange in 1982. For further details see the ‘growth of futures market’ in the forthcoming chapter. 20 Uses of Derivatives Derivatives are supposed to provide the following services: 1. One of the most important services provided by the derivatives is to control, avoid, shift and manage efficiently different types of risks through various strategies like hedging, arbitraging, spreading, etc. Derivatives assist the holders to shift or modify suitably the risk characteristics of their portfolios. These are specifically useful in highly volatile financial market conditions like erratic trading, highly flexible interest rates, volatile exchange rates and monetary chaos. 2. Derivatives serve as barometers of the future trends in prices which result in the discovery of new prices both on the spot and futures markets. Further, they help in disseminating different information regarding the futures markets trading of various commodities and securities to the society which enable to discover or form suitable or correct or true equilibrium prices in the markets. As a result, they assist in appropriate and superior allocation of resources in the society. 3. As we see that in derivatives trading no immediate full amount of the transaction is required since most of them are based on margin trading. As a result, large numbers of traders, speculators arbitrageurs operate in such markets. So, derivatives trading enhance liquidity and reduce transaction costs in the markets for underlying assets. 4. The derivatives assist the investors, traders and managers of large pools of funds to devise such strategies so that they may make proper asset allocation increase their yields and achieve other investment goals. 5. It has been observed from the derivatives trading in the market that the derivatives have smoothen out price fluctuations, squeeze the price spread, integrate price structure at different points of time and remove gluts and shortages in the markets. 6. The derivatives trading encourage the competitive trading in the markets, different risk taking preference of the market operators like speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in trading volume in the country. They also attract young investors, professionals and other experts who will act as catalysts to the growth of financial markets. 7. Lastly, it is observed that derivatives trading develop the market towards ‘complete markets’. Complete market concept refers to that situation where no particular investors be better of than others, or patterns of returns of all additional securities are spanned by the already existing securities in it, or there is no further scope of additional security. 21 Critiques of Derivatives Besides from the important services provided by the derivatives, some experts have raised doubts and have become critique on the growth of derivatives. They have warned against them and believe that the derivatives will cause to destabilization, volatility, financial excesses and oscillations in financial markets. It is alleged that they assist the speculators in the market to earn lots of money, and hence, these are exotic instruments. In this section, a few important arguments of the critiques against derivatives have been discussed. Speculative and Gambling Motives One of most important arguments against the derivatives is that they promote speculative activities in the market. It is witnessed from the financial markets throughout the world that the trading volume in derivatives have increased in multiples of the value of the underlying assets and hardly one to two percent derivatives are settled by the actual delivery of the underlying assets. As such speculation has become the primary purpose of the birth, existence and growth of derivatives. Sometimes, these speculative buying and selling by professionals and amateurs adversely affect the genuine producers and distributors. Some financial experts and economists believe that speculation brings about a better allocation of supplies overtime, reduces the fluctuations in prices, make adjustment between demand and supply, removes periodic gluts and shortages, and thus, brings efficiency to the market. However, in actual practice, above such agreements are not visible. Most of the speculative activities are ‘professional speculation’ or ‘movement trading’ which lead to destabilization in the market. Sudden and sharp variations in prices have been caused due to common, frequent and widespread consequence of speculation. Increase in Risk The derivatives are supposed to be efficient tool of risk management in the market. In fact this is also one-sided argument. It has been observed that the derivatives market— especially OTC markets, as particularly customized, privately managed and negotiated, and thus, they are highly risky. Empirical studies in this respect have shown that derivatives used by the banks have not resulted in the reduction in risk, and rather these have raised new types of risk. They are powerful leveraged mechanism used to create risk. It is further argued that if derivatives are risk management tool, then why ‘government securities’, a riskless security, are used for trading interest rate futures which is one of the most popular financial derivatives in the world. 22 Instability of the Financial System It is argued that derivatives have increased risk not only for their users but also for the whole financial system. The fears of micro and macro financial crisis have caused to the unchecked growth of derivatives which have turned many market players into big losers. The malpractices, desperate behaviour and fraud by the users of derivatives have threatened the stability of the financial markets and the financial system. Price Instability Some experts argue in favour of the derivatives that their major contribution is toward price stability and price discovery in the market whereas some others have doubt about this. Rather they argue that derivatives have caused wild fluctuations in asset prices, and moreover, they have widened the range of such fluctuations in the prices. The derivatives may be helpful in price stabilization only if there exist a properly organized, competitive and well-regulated market. Further, the traders behave and function in professional manner and follow standard code of conduct. Unfortunately, all these are not so frequently practiced in the market, and hence, the derivatives sometimes cause to price instability rather than stability. Displacement Effect There is another doubt about the growth of the derivatives that they will reduce the volume of the business in the primary or new issue market specifically for the new and small corporate units. It is apprehension that most of investors will divert to the derivatives markets, raising fresh capital by such units will be difficult, and hence, this will create displacement effect in the financial market. However, it is not so strong argument because there is no such rigid segmentation of invertors, and investors behave rationally in the market. Increased Regulatory Burden As pointed earlier that the derivatives create instability in the financial system as a result, there will be more burden on the government or regulatory authorities to control the activities of the traders in financial derivatives. As we see various financial crises and scams in the market from time to time, most of time and energy of the regulatory authorities just spent on to find out new regulatory, supervisory and monitoring tools so that the derivatives do not lead to the fall of the financial system. 23  In our fast-changing financial services industry, coercive regulations intended to restrict banks’ activities will be unable to keep up with financial innovation. As the lines of demarcation between various types of financial service providers continues to blur, the bureaucratic leviathan responsible for reforming banking regulation must face the fact that fears about derivatives have proved unfounded. New regulations are unnecessary. Indeed, access to risk-management instruments should not be feared, but with caution, embraced to help the firms to manage the vicissitudes of the market. In this chapter various misconceptions about financial derivatives are explored. Believing just one or two of the myths could lead one to advocate tighter legislation and regulatory measures designed to restrict derivatives activities and market participants. A careful review of the risks and rewards derivatives offer, however, suggests that regulatory and legislative restrictions are not the answer. To blame organizational failures solely on derivatives is to miss the point. A better answer lies in greater reliance on market forces to control derivative-related risk taking. Financial derivatives have changed the face of finance by creating new ways to understand, measure and manage risks. Ultimately, financial derivatives should he considered part of any firm’s risk-management strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be taken away. Myths About Derivatives Myth Number 1 “Derivatives are new, complex, high –tech financial products created by Wall Street’s rocket scientists” Financial derivatives are not new; they have been around for years. A description of the first know option contract can be found in Aristotle’s writing tells philosopher from Mitetus who developed a financial device, which involves a principal of universal application people reproved Thales, syncing that his lack of wealth was proof that philosophy was useless occupation and of no intellect. Thales had great skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with area olive –press owners to deposit what little money he had with them to guarantee him 24 exclusive use of their olive press when the harvest was ready. Hales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield. Aristotle’s story about Tales ends as one might guess:” when the harvest –time came, and many [presses] were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like their ambition is of another sort,” So Thanes exercised the first known option contracts some 2,500 years ago. He was not obliged to exercise the option if the olive harvest had not been good, hales could have let the option contracts expire unused and limited his loss to the original price and paid for the option. Most financial derivatives traded today are the: plain vanilla” variety –the simplest form of a financial derivatives that are much difficult to measure, manage, and understand. For those instruments, the measurement and control of risk can be far more complicated, creating the increased possibility of unforeseen losses. Wall Street’s “rocket scientists” are continually creating new complex, sophisticated financial derivative products. However, those products are built on foundation of the four basis types of derivatives Most of the newest innovations are designed to hedge complex risks in an effort to reduce future uncertainties and manage risks more effectively. But the newest innovations require a firm understanding of the tradeoff of risk and rewards. To that end, derivative users should establish a guiding set of principles to provide a framework for effectively managing and controlling financial derivative activities those principles should focus on the role of senior management, valuation and market risk-argument credit measurement and management, enforceability operating systems and controls and accounting and disclosure of risk-management position. Myth Number 2 “Derivatives are purely speculative, leveraged instrument” Put another way. This myth is that “derivatives” is a fancy name for gambling. Has speculative trading of derivative products fuelled the rapid growth in their use? Are derivatives used only to speculate on the direction of interest rates or currency exchange rates? Of course not. Indeed, the explosive use of financial derivative products in recent years was brought about by three primary forces: more volatile markets, deregulation and technologies. 25  The turning point seems to have occurred in the early 1970s with the breakdown of the fixed-rate international currency exchange regime. This was established at the 1944 conference at Bretons Woods and maintained by the International monetary fund. Since then currencies have floated freely. Accompanying that development was the gradual removal of government-established interest-rate ceilings when regulation Q interest- Rate restrictions were phased out. Not long afterward came inflationary oil price shocks and wild interest-rate fluctuations. In sum, financial markets were more volatile then at any time since the Great Depression. Banks and other financial intermediaries responded to the new environment by developing financial risk-management products designed to better control risk. The first were simple foreign exchange forwards that obligated one counterpart to buy, and the other to sell, a fixed amount of currency at an agreed dated in the future. By entering into a foreign exchange forward contract, customers could offset the risk that large movements in foreign exchange rates would destroy the economic viability of their overseas projects Thus, derivatives were originally intended to be used to effectively hedge certain risks; and in fact, that was the key that unlocked their explosive development. Beginning in the early 1980s,a host of new competitors accompanied the deregulation of financial markets, and the arrival of powerful but inexpensive personal computers ushered in new ways to analyze information and break down risk into component parts. To serve customers better, financial intermediary’s offered an ever-increasing number of novel products designed to more effectively manage and control financial risks. New technologies quickened the pace of innovation and provided banks with superior methods for tracking and simulating their own derivatives portfolios. Myth Number 3 “The enormous size of the financial derivatives market dwarfs bank capital, there by making derivatives trading an unsafe and unsound banking practice” The financial derivatives market’s worth is regularly reported as more then $20trillion.That estimate dwarfs not only bank capital but also the nation‘s$7trillion annual gross domestic product. Those often quoted figures are notional amounts. For derivatives, notional principal is the amount on which interest and other payments are based. Notional principal typically does not change hands; it is simply quantity used to calculate payments. While notional principal is the most commonly used volume measure in derivatives markets, it is not on accurate measures of credit exposure. A useful proxy for the actual exposure of derivative instruments is replacement-cost credit exposure. That exposure is 26 the cost of replacing the contract at current market values should the counterpart default before the settlement date. For the 10 largest derivatives players among US bank holding companies, derivative credit exposure averages 15 percent of the total assets. The average exposure is 49 percent of assets for those banks ‘loan portfolios. In other words, if those 10 banks lost 100 percent on their loans, the loss would be more then three times greater then it would be if they had to replace all of their derivative contracts. Derivatives also help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. Corporations can keep the risks they are most willing to accept them. From a market oriented perspective, derivatives offer the free trading of financial risks. The viability of financial derivatives rests on the principle of comparative advantage –that is, the relative cost of holding specific risks. Whenever comparative advantages exist, trade can benefit all parties evolved. And financial derivatives allow for the free trading of individual risk components. Myth Number 4 “Only large multinational corporations and large banks hone a purpose for using derivatives” Very large organizations are the biggest users of derivative instruments. However, firms of all sizes can benefit from using them. For example, consider a small regional bank (SRB)with total assets of $5million.the SRB has a loan portfolio composed primarily of fixed- rate mortgages, a portfolio of government securities, and interest –bearing deposits that are often reprised, Two illustrations of how SRB can use derivatives to hedge risks are: First, rising interest rates will negatively affect prices in the SRBs$1 million securities portfolio. But by selling short a $1 million treasury –bond futures contract, the SRB can effectively hedge against that interest-rate risk and smooth earnings stream in a volatile market. if interest rates went higher, the SRB would be hurt by a drop in value of its securities portfolio, but that loss would be offset by a again from the increase in the value of its securities portfolio but would record a loss from is derivative contract. By entering into derivatives contracts, the SRB can lock in a guaranteed rate of return on its securities portfolio and not be as concerned about interest-rate volatility. 27  The second illustration involves a swap contract. As in the first illustration, rising interest rates will harm the SRB because it received fixed cash on its loan portfolio and variable cash flows with a dealer to pay fixed and received floating payments. Myth Number 5 “Financial derivatives are simply the latest risk-management fad” Financial derivatives are important tools that can help organization to meet their specific risk management objectives. As is the case with all tools, it is important that the user understand the tool’s intended function and that necessary to undertake various purpose. What kinds of derivative instruments and trading strategies are most appropriate? How will those instruments perform if there is a large increase or decrease in interest rates? Without a clearly defined risk-management strategy, use of financial derivatives can be dangerous. It can threaten the accomplishment of a firm’s long-range objectives and result in unsafe and unsound practices that could lead to the organization’s insolvency. But when used wisely financial derivatives can increase shareholder value by providing a means to better control a firm ‘sriskexposures and cash flow. Clearly, derivatives are here to stay. We are well on our way to truly globule financial markets that will continue to develop new financial innovation to improve risk-management practices. Financial derivatives are the latest risk-management fad. They are important tools for helping organizations to better manage their risk exposures. Myth Number 6 “Derivatives take money out of productive processes and never put anything back” Financial derivatives, by reducing uncertainties, make it possible for corporations initiate productive activities that not otherwise be pursued. For example, a company may like to build manufacturing facility in the United states but is concerned about the project’s overall cost because of exchange rate volatility between the dollar’s ensure that the company will have the cash available when it is needed for investment, the manufacturer should devise a prudent risk –management strategy that is in harmony with its broader corporate objective of building a manufacturing facility un the United states. As part of that strategy, the firm should use financial derivatives to hedge against foreign exchange risk. Derivatives used as a hedge can improve the management of cash flows at the individual firm level. To ensure that predictive activities are pursued, corporate finance and treasury groups should transform their operations from mundane bean counting to activist financial 28 risk management. They should integrate a clear set of risk management goals and objectives into the organization’s overall corporate strategy. The ultimate goal is to ensure that the organization has necessary resources at its disposal to pursue investments that maximize shareholder value. Used properly financial derivatives can help corporation to reduce uncertainties and promote more productive actives. Myth Number 7 “Only risk-seeking organization should use derivatives” Financial derivatives can be used in two ways: to hedge against unwanted risks or to speculative by taking a position in anticipation of a market movement. The olive-press owners, by locking in a guaranteed return no matter how good or bad the harvest, hedge against the risk that the season’s olive harvest might not be plentiful. Hales speculated that the next season’s olive harvest would be exceptionally good and therefore, paid an up-front premium in anticipation of that event. Similarly, organization actions today can use financial derivatives to actively seek out specifies risk and speculate on the direction of interest rate or exchange –rate movements, or they can use derivatives it hedge against unwanted risks. Hence, it is not true that only risk-seeking institutions use derivatives. Indeed, organizations should use derivatives as part of their overall risk management strategy for keeping those risks that they are comfortable managing and selling those that they do not want to others who are more willing to accept them. Even conservatively managed institutions can use derivatives to improve their cash flow management to ensure that the necessary funds are available to meet broader corporate objectives. One could argue that organizations that refuse to use financial derivatives are at greater risk then are those that use them. When using financial derivatives however, organization should be careful to use only those instruments that they understand and that fit best their corporate risk-management philosophy. It may be prudent to stay away from the more exotic instruments, unless the risk/reward tradeoffs are clearly understood by the form’s senior management and its independent risk-management review team. Exotic contracts should not be used unless there is some obvious reason for doing so. Myth Number 8 “The risks associated with financial derivatives are new and unknown” The kinds of risks associated with derivatives are no different from those associated with traditional financial instruments, although they can be far more complex. There are 29 credit risks, market and so on. Risks from derivatives originate with the customer. With few exceptions, the risks are man-made, that is it does not readily appear in nature. for example, when a new homeowner negotiates with a lender to borrow a sum money, the customer creates risks by the types of mortgage he chooses-risks to himself and the lending company. Financial derivatives allow the lending institution to break up those risks and distribute them around the financial system via secondary markets. Thus many risks associated with derivatives are actually created by the dealers’ customers or by their customers’ customers. Those risks have been inherent in our nation’s financial system since its inception. Banks and other financial intermediaries should view themselves as risk managers blending their knowledge of global financial markets with their clients’ needs to help their clients anticipate change and have the flexibility to pursue opportunities that maximize their success. Banking is inherently a risky business. Risk permeates much of what banks do, And for banks to survive, they must be able to understand measure and manage financial risks effectively. The types of risks faced by corporations today have not changed. Rather they are more complex and interrelated. The increase complexity anew volatility of the financial markets hone paved the way for the growth of numerous financial innovation that can enhance returns relative to risk. But a thorough understanding of a new financial –engineering tools and proper integration into a firm’s overall risk-management strategy and corporate philosophy can help to turn volatility into profitability. Risk management is not about the elimination of risk; it is about the management of the risk. selectively choosing those risks an organization is comfortable with the minimizing those that it does not want. Financial derivatives serve a useful purpose in fulfilling risk- management objectives. Through derivatives risks from traditional instruments can be efficiently unbundled and managed independently. Used correctly, derivatives can save costs and increase returns. Today dealers manage portfolios of derivatives and oversee the net, or residual, risk of their overall position. That development has changed the focus of risk management from individual transactions to portfolio exposures and has substantially improved dealers’ ability to accommodate a broad spectrum of customer transitions. Because most active derivatives players’ today trade on portfolio exposures, it appears that financial derivatives do not wind markets together any more tightly than do loans. Derivatives players do not match every trade with an offsetting trade; instead, they continually manage the residual risk of the 30 portfolio. If a counterpart defaults on a swap, the defaulted party does not turn around and default on some other counterpart that offset the original transaction. Instead, a derivatives default is very similar to a loan default. That is why it is important that derivatives players perform with due diligence in determining the financial strength and default risks of potential counter parties. Myth Number 9 “Because of the risks associated with derivatives banking regulators should ban their use by any institution covered by federal deposit insurance” The problem is not derivatives but the perverse incentive banks have under the current system of federal deposit guarantees. Deposit insurance and other deposit reforms were first introduced to address some of the instabilities associated with systemic risk. Through federally guaranteed deposit insurance, the US government attempted to avoid, by increasing depositors’confidence, the experience of deposit runs that characterized banking crises before the 1930s. The current deposit guarantee structure has, indeed, reduced the probability of large- scale bank panics, but it has also created some new problems. Deposit insurance effectively eliminates the discipline provided by the market mechanism that encourages banks to maintain appropriate capital levels and restrict unnecessary risk taking. Therefore, banks may wish to pursue higher risk strategies because depositors have a diminished incentive to monitor banks. Further, federal deposit insurance actually encourage banks to use derivatives as speculative instruments to pursue higher risk strategies, instead of to hedge, or as dealers. Since federal deposit insurance discourages market discipline, regulators have been put in the position of monitoring banks to ensure that they are managed in a safe and sound manner. Ivan the present system of federal deposit guarantees, regulatory proposals involving financial derivatives should focus on market-oriented reforms as opposed to laws that might eliminate the economic risk-management benefits of derivatives. To that end banking regulation should emphasize more disclosure of derivatives positions in financial statements and be certain that institution trading huge derivatives portfolios have adequate capital. In addition, because derivatives could have implication for the stability of the financial system, it is important that users maintain sound risk- management practices. 31  Regulation have issued guidelines that banks with substantial trading or derivatives activity should follow those guidelines include   Active board and senior management oversight of trading activities;   Establishment of an internal risk-management audit function that has independent of the trading function;   Thorough and timely audits to identify internal control weaknesses; and   Risk-management and risk-management information system that include stress tests, simulations, and contingency plans for adverse market movements It is the responsibility of a bank’s senior management to ensure that risks are effectively controlled and limited to levels that do not pose a serious threat to its capital position. Regulation is an ineffective substitute for sound risk management at the individual firm level. **** 32  Lesson 1.2 - Forward Contracts Features of Forward Contract 1. It is an agreement between the two counter parties in which one is buyer and other is seller. All the terms are mutually agreed upon by the counterparties at the time of the formation of the forward contract. 2. It specifies a quantity and type of the asset (commodity or security) to be sold and purchased. 3. It specifies the future date at which the delivery and payment are to be made. 4. It specifies a price at which the payment is to be made by the seller to the buyer. The price is determined presently to be paid in future. 5. It obligates the seller to deliver the asset and also obligates the buyer to buy the asset. 6. No money changes hands until the delivery date reaches, except for a small service fee, if there is. Classification of Forward Contracts The forward contracts can be classified into different categories. Under the Forward Contracts (Regulation) Act. 1952, forward contracts can be classified in the following categories: Hedge Contracts The basic features of such forward contracts are that they are freely transferable and do not specify any particular lot, consignment or variety of delivery of the underlying goods or assets. Delivery in such contracts is necessary except in a residual or optional sense. These contracts are governed under the provisions of the Forward Contracts (Regulation) Act, 1952. Transferable Specific Delivery (TSD) Contracts These forward contracts are freely transferable from one party to other party. These are concerned with a specific and predetermined consignment or variety of the commodity. 33 There must be delivery of the underlying asset at the expiration time. It is mandatory. Such contracts are subject to the regulatory provisions of the Forward Contracts (Regulation) Act, 1952, but the Central Government has the power to exempt (in specified cases) such forward contracts. Non-Transferable Specific Delivery (NTSD) Contracts These contracts are of such nature which cannot be transferred at all. These may concern with specific variety or consignment of goods or their terms may be highly specific. The delivery in these contracts is mandatory at the time of expiration. Normally, these contracts have been exempted from the regulatory provisions of Forward Act, but the Central Government, whenever feels necessary, may bring them under the regulation of the Act. It is evident from the above that the definition of hedge contracts corresponds to the definition of futures contracts while the latter two are not futures contracts, and hence, termed as forward contracts. Since in both hedge contracts and futures contracts, no specification about the underlying asset/commodity is mentioned because such limits are set by the rules of the exchange on which types can or cannot he delivered. If the variety is superior or inferior to the basis variety for delivery, in that case the prices are adjusted by means of premium or discount as the case may be. Such adjustments are popularly known as tendering differences. Thus, on this basis, it may be generalized that every futures contract is a forward contract but every forward contract may not be futures contract. Other Forward Contracts Forward Rate Agreements (FRA) Forward contracts are commonly arranged on domestic interest-rate bearing instruments as well as on foreign currencies. A forward rate agreement is a contract between the two parties, (usually one being the banker and other a banker’s customer or independent party), in which one party (the banker) has given the other party (customer) a guaranteed future rate of interest to cover a specified sum of money over a specified period of time in the future. For example, two parties agree that a 6 percent per annum rate of interest will apply to one year deposit in six months time. If the actual rate of interest proves to be different from 6 percent then one company will pay and other receives the difference between the two sets of interest cash flows. 34  In forward rate agreement, no actual lending or borrowing is affected. Only it fixes the rate of interest for a futures transaction. At the time of maturity, when the customer actually needs funds, then he has to borrow the funds at the prevailing rate of interest from the market. If the market rate of interest is higher than the FRA interest then the banker will have to pay to the other party (customer) the difference in the interest rate. However, if market interest is lesser than the FRA rate then the customer will have to pay the difference to the banker. This transaction is known as purchase of FRA from the bank. Sometimes, a customer (depositor) may also make a FRA contract with the bank for his deposits for seeking a guaranteed rate of interest on his deposits. If the market rate on his deposit turns out to be lower than that guaranteed interest rate in the FRA, the bank will compensate him for the difference, i.e., FRA rate minus market interest. Similarly, if the FRA is lower than the deposit rate then the customer will pay difference to the banker. This transaction is known as sale of a FRA to the bank. In this way, purchase of FRA protects the customer against a rise in interest in case of borrowing from the bank. Similarly, sale of FRA will protect the customer from deposits point of view. The bank charges different rates of interest for borrowing and lending, and the spread between these two constitutes bank’s profit margin. As a result, no other fee is chargeable for FRA contracts. Example 1 Suppose three month forward rupee is at ` 45 per US dollar. A quotation is given in terms of range. The forward rupee would be quoted at “` 48 to ` 50”. If the spot rate rises above the maximum, i.e., ` 50 then the maximum level is used. If the spot rate falls below the minimum rate, i.e., ` 48 then the minimum level will be used. Example 2 Assume two companies might agree that 8 percent per annum rate of interest will apply to a one-year deposit in fix month’s time. If the actual rate proves to be different from 8 percent per annum, one company pays and the other receives the present value of the difference between two sets of interest (cash flows). This is known as a forward-rate agreement (FRA). Range Forwards These instruments are very much popular in foreign exchange markets. Under this instrument, instead of quoting a single forward rate, a quotation is given in terms of a range, i.e., a range may be quoted for Indian rupee against US dollar at ` 47 to ` 49. It means there 35 is no single forward rate rather a series of rate ranging from ` 47 1049 has been quoted. This is also known as flexible forward contracts. At the maturity, if the spot exchange rate is between these two levels, then the actual spot rate is used. On the other hand, if the spot rate rises above the maximum of the range, i.e., ` 49 in the present case then the maximum level is used. Further, if the spot rate falls below the minimum level, i.e., ` 47, then the minimum rate will be used. As such we see that these forward range contracts differ from normal forward contracts in two respects, namely, (a) they give the customer a range within which he can earn or use from the exchange rate fluctuations, and (b) further they provide protection to the party from the extreme variation in exchange rates. Forward Trading Mechanism Forward contracts are very much popular in foreign exchange markets to hedge the foreign currency risks. Most of the large and international banks have a separate ‘Forward Desk’ within their foreign exchange trading room which is devoted to the trading of forward contracts. Let us take an example to explain the forward contract. Suppose on April 10, 2002, the treasurer of an UK Multinational firm (MNC) knows that the corporation will receive one million US dollar after three months, i.e., July 10, 2002 and wants to hedge against the exchange rate movements. In this situation, the treasurer of the MNC will contact a bank and find out that the exchange rate for a three-month forward contract on dollar against pound sterling, i.e., £I$ = 0.6250 and agrees to sell one million dollar. It means that the corporation has short forward contracts on US dollar. The MNC has agreed to sell one million dollar on July 10, 2002 to the bank at the future dollar rate at 0.6250. On the other hand, the bank has a long forward contract on dollar. Both sides have made a binding contract/commitment. Before discussing the forward trading mechanism, let us see some important terminology frequently used in the forward trading. Long Position The party who agrees to buy in the future is said to hold long position. For example, in the earlier case, the bank has taken a long position agreeing to buy 3-month dollar in futures. 36 Short Position The party who agrees to sell in the future holds a short position in the contract. In the previous example, UK MNC has taken a short position by selling the dollar to the bank for a 3-month future. The Underlying Asset It means any asset in the form of commodity, security or currency that will be bought and sold when the contract expires, e.g., in the earlier example US dollar is-the underlying asset which is sold and purchased in future. Spot-Price This refers to the purchase of the underlying asset for immediate delivery. In other words, it is the quoted price for buying and selling of an asset at the spot or immediate delivery. Future Spot Price The spot price of the underlying asset when the contract expires is called the future spot price, since it is market price that will prevail at some futures date. Delivery Price The specified price in a forward contract will be referred to as the delivery price. This is decided or chosen at the time of entering into forward contract so that the value of the contract to both parties is zero. It means that it costs nothing to take a long or a short position. In other words, at the day on writing of a forward contract, the price which is determined to be paid or received at the maturity or delivery period of the forward contract is called delivery price. On the first day of the forward contract, the forward price may be same as to delivery price. This is determined by considering each aspect of forward trading including demand and supply position of the underlying asset. However, a further detail regarding this will be presented in forthcoming chapter. The Forward Price It refers to the agreed upon price at which both the counter parties will transact when the contract expires. In other words, the forward price for a particular forward contract at a particular time is the delivery price that would apply if the contract were entered into at 37 that time. In the example discussed earlier, on April 10, 2002, 0.6250 is the forward price for a forward contract that involves the delivery of US dollar on July 10, 2002. The Determination of Forward Prices Forward contracts are generally easier to analyze than futures contracts because in forward contracts there is no daily settlement and only a single payment is made at maturity. Though both futures prices and forward prices are closely related, this will be described in the latter part of this chapter. It is essential to know about certain terms before going to determine the forward prices such as distinction between investment assets and consumption assets, compounding, short selling, repo rate and so on because these will be frequently used in such computation. We are not discussing these here in detail but the traders must be aware about them thoroughly. A brief view of these terms is explained here as under: An investment asset is an asset that is held for investment purposes, such as stocks, shares, bonds, treasury, securities, etc. Consumption assets are those assets which are held primarily for consumption, and not usually for investment purposes. There are commodities like copper, oil, food grains and live hogs. Compounding is a quantitative tool which is used to know the lump-sum value of the proceeds received in a particular period. Consider an amount A invested for n years at an interest rate of R per annum. If the rate is compounded once per annum, the terminal value of that investment will be Terminal value =A (1 +R)n and if it is compounded m times per annum then the terminal value will be Terminal value =A (1 +R/m)mn where A is amount for investment, R is rate of return, n is period for return and m is period of compounding. Suppose A = ` 100, R = 10% per annum, n = 1 (one year), and if we compound once per annum (m = 1) then as per this formula, terminal value will be 100(1 + 10)1 = 100(1.10) = ` 110, if m=2 then 100(1 + 0.05)2x1 = 100 x 1.05 x 1.05= ` 110.25 and so on. 38  Short selling refers to selling securities which are not owned by the investor at the time of sale. It is also called ‘shorting’, with the intention of buying later. Short selling may not be possible for all investment assets. It yields a profit to the investor when the price of the asset goes down and loss when it goes up. For example, an investor might contract his broker to short 500 State Bank of India shares then the broker will borrow the shares from another client and sell them in the open market. So the investor can maintain the short position provided there are shares available for the broker to borrow. However, if the contract is open, the broker has no shares to borrow, then the investor has to close his position immediate, this is known as short- squeezed. The repo rate refers to the risk free rate of interest for many arbitrageurs operating in future markets. Further, the ‘repo’ or repurchase agreement refers to that agreement where the owner of the securities agrees to sell them to a financial institution, and buy the same back later (after a particular period). The repurchase price is slightly higher than the price at which they are sold. This difference is usually called interest earned on the loan. Repo rate is usually slightly higher than the Treasury bill rate. Assumptions and Notations Certain assumptions considered here for determination of forward or futures prices are:   There are no transaction costs.   Same tax rate for all the trading profits.   Borrowing and lending of money at the risk free interest rate.   Traders are ready to take advantage of arbitrage opportunities as and when arise. These assumptions are equally available for all the market participants; large or small. Further, some Notations which have been used here are: T = Time remained upto delivery date in the contract S = Price of the underlying asset at present, also called as spot or cash or current K = Delivery price in the contract at time T F = Forward or future price today f = Value of a long forward contract today r = Risk free rate of interest per annum today t = Current or today or present period of entering the contract 39  Now, we will discuss the mechanism of determination of forward prices of different types of assets. The Forward Price for Investment Asset (Securities) Here we will consider three situations in case of investment assets: 1. Investment assets providing no income 2. Investment assets providing a known income 3. Investment assets providing a known dividend income Forward Price for An Asset that Provides no Income This is the easiest forward contract to value because such assets do not give any income to the holder. These are usually nondividend paying equity shares and discount bonds. Let us consider the relationship between the forward price and spot price with an example. Example Consider a long forward contract to purchase a share (Non-dividend paying) in three- months. Assume that the current stock price is ` 100 and the three-month risk free rate of interest is 6% per annum. Further assume that the three months forward price is ` 105. Arbitrageur can adopt the following strategy Borrow ` 100 @ 6% for three months, buy one share at ` 100 and short a forward contract for ` 105. At the end of three months, the arbitra