Derivatives Markets In Interest Rate & Foreign

Exchange Rate Utility For Importer & Exporter

NEHA ABHISHEK, BANGALOREBatch: 22, (5th July to 30th August, 2014)

Agenda

• Derivatives• List of Derivatives under various categories• Concept of Hedging

• Exposure of Importer and Exporter

• Derivatives on Foreign Exchange• Forwards Contracts• Future• Option Contract

• Interest Rate Derivatives• Forwards Rate Agreement (FRA)• SWAP• Interest Rate Option

Derivatives

As per Clause (a) of Section 45U of RBI Act 1934 "derivative" means an instrument, to be settled at a future date, whose value is derived from change in interest rate,foreign exchange rate,credit rating or credit index, price of securities (also called "underlying"), or a combination of more than one of them and includes

• interest rate swaps, • forward rate agreements, • foreign currency swaps,• foreign currency-rupee swaps, • foreign currency options,• foreign currency-rupee options or• such other instruments as may be specified by the Bank from time to time;

List of Derivatives under various categories

Derivatives

Basic Variable

Real Assets

Commodities

Metals

Real Estates

Plant & Equipment

Financial Assets

Bonds

Shares

Loan

Currencies

Price Risk

Forwards

Futures

Options

Interest Rate Risk

Swaps

Futures

Options

Others

Weather

Power

Insurance

Location

OTC

Forwards

Options

Swaps

ETC

Futures

Options

Nature

Forwards

Future

Options

Swap

Concept of Hedging

Month USD/INR Importers Exporters Remarks  Hedged (Y)

Unhedged (N)Happy (H)

Unhappy (U)Hedged (Y)

Unhedged (N)Happy (H)

Unhappy (U)

April 14 60.22 Reference Rate

August 14 59.27 N (H) N (U) August 14 59.27 Y (U) Y (H) March 15 62.85 N (U) N (H) March 15 62.85 Y (H) Y (U)

Exposure of Importer and Exporter 

Exporter Gain Foreign Currency Local Currency

Importer Gain Foreign Currency Local Currency

Forward Contract

• A foreign exchange forward is an OTC contract• Purchaser agrees to buy from the seller, and • Seller agrees to sell to the buyer, • A specified amount of a specified currency • On a specified date in future.• In India there are two types of Forward Contract

• Fixed Forward Contract: Delivery of foreign exchange should take place on specified future date.

• Option Forward Contract: The customer can sell or buy from the bank foreign exchange at any given period of time at a predetermined rate of exchange. The Option Period of delivery should not exceed one month.

Future

Currency The contract is available on US Dollar/ Indian Rupee.Size The Size of one Future is USD 1,000.Quotation The future is quoted in rupee terms with a minimum price charge of 0.25 paise.

However the outstanding position is reckoned in dollar terms.

Maturities The contract is available with maturity ranging from 1 to 12 months.Due Date The contract expire on last working day of the month, excluding Saturday.

Outstanding contract are settled on this day.Last Trading Day Two days before the expiry date.Settlement Price The Settlement price is fixed on last trading day at the Reserve’s Bank reference

rate.Settlement The contract is settled by payment in Indian Rupee. The difference between the

strike price and settlement price is exchanged between the buyer and seller. No delivery of Dollar take place.

Trading Hours Trading can be done between 9a.m. to 5p.m.

The Features of Currency Future in India

An agreement entered into with the specified future exchange to buy or sell standard amount of foreign currency at a specified price for delivery on specified future date.

Maximum Limit in currency future is USD 5 million or 6% of the open interest, whichever is higher.

OptionOption

CallBuy

Importer Right to Buy

SellExporter

Obligation to Sell

PutBuy

ExporterRight to Sell

SellImporter

Obligation to Buy

Nature of Option Based on Strike

Exporter Importer Illustration

In the Money (ITM) Strike Price of Buy Put > Forward Reference Rate (FRR)

Strike price of Buy Call < Forward Reference Rate (FRR)

FRR = 45 Buy USD Put @ 46 Buy USD Call @ 44

At the Money (ATM) Strike Price of Buy Put = Forward Reference Rate (FRR)

Strike price of Buy Call = Forward Reference Rate (FRR)

FRR = 45 Buy USD Put @ 45 Buy USD Call @ 45

Out of the Money (OTM) Strike Price of Buy Put < Forward Reference Rate (FRR)

Strike price of Buy Call > Forward Reference Rate (FRR)

FRR = 45 Buy USD Put @ 44Buy USD Call @ 46

Concept of In the Money (ITM), At the Money (ATM) and Out of the Money (OTM)

Option - ExporterAssume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.Buy USD Put at INR 45 (ATM Option) – premium paid upfront INR 1.Buy USD Put at INR 46 (ITM Option) – premium paid upfront INR 2.Buy USD Put at INR 44 (OTM Option) – premium paid upfront INR 0.50.Table plot the exercisability and payoff matrix for maturity by taking some random market rates.

Assume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.Sell USD Call at INR 45 (ATM Option) – premium paid upfront INR 1.Sell USD Call at INR 46 (OTM Option) – premium paid upfront INR 0.50.Sell USD Call at INR 44 (ITM Option) – premium paid upfront INR 2.Table plot the exercisability and payoff matrix for maturity by taking some random market rates.

Market Rate FRR = 45 BP = 45Prem. =1 (ATM)

P/L matrix compared with FRR

BP = 46Prem. = 2

(ITM)

P/L matrix compared with FRR

BP = 44Prem. = .5

(OTM)

P/L matrix compared with FRR

43 45 Y -1 Y -1 Y -1.544 45 Y -1 Y -1 Y -1.545 45 Y -1 Y -1 N -0.546 45 N 0 Y -1 N 0.5

Market Rate FRR = 45 BC = 45Prem. =1 (ATM)

P/L matrix compared with FRR

BC = 44Prem. = 2

(ITM)

P/L matrix compared with FRR

BC = 46Prem. = 0.5

(OTM)

P/L matrix compared with FRR

43 45 N 1 N 2 N 0.544 45 N 1 Y 2 N 0.545 45 Y 1 Y 1 N 0.546 45 Y 0 Y 0 Y 0.5

Option - ImporterAssume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.Buy USD Call at INR 45 (ATM Option) – premium paid upfront INR 1.Buy USD Call at INR 46 (OTM Option) – premium paid upfront INR 0.50.Buy USD Call at INR 44 (ITM Option) – premium paid upfront INR 2.Table plot the exercisability and payoff matrix for maturity by taking some random market rates.

Assume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.Sell USD Put at INR 45 (ATM Option) – premium paid upfront INR 1.Sell USD Put at INR 46 (ITM Option) – premium paid upfront INR 2.Sell USD Put at INR 44 (OTM Option) – premium paid upfront INR 0.50.Table plot the exercisability and payoff matrix for maturity by taking some random market rates.

Market Rate

FRR = 45 BC = 45Prem. =1 (ATM)

P/L matrix compared with FRR

BC = 44Prem. = 2

(ITM)

P/L matrix compared with FRR

BC = 46Prem. = 0.5

(OTM)

P/L matrix compared with FRR

43 45 N 1 N 0 N 1.544 45 N 0 Y -1 N 0.545 45 Y -1 Y -1 N -0.546 45 Y -1 Y -1 Y -1.5

Market Rate FRR = 45 BP = 45Prem. =1 (ATM)

P/L matrix compared with FRR

BP = 46Prem. = 2

(ITM)

P/L matrix compared with FRR

BP = 44Prem. = .5

(OTM)

P/L matrix compared with FRR

43 45 Y -1 Y -1 Y -0.544 45 Y 0 Y 0 Y 0.545 45 Y 1 Y 1 N 0.546 45 N 1 Y 2 N 0.5

Exchange Rate Derivatives - Importer Perspective

On 12th Jan, an Indian Firm knows that it has $600000 payable, on 12 th March. The Spot Rate is 40.45/$, while 2month forward rate is Rs.40.62/$. 2month INR/USD Interest Rate is 10%/4% p.a. resp. $ future for maturity ending March is Rs.40.65/$. Call and Put option on $ at E = Rs.40.60/$ traded at premium of .40p & .50p respectively. On 12 th March Spot Rate Rs.40.7/$. Future traded at Rs.40.74/$. The outflow in the following situation will be as follows:

No Hedging Outflow on 12th March= Total $ Payable × Spot Rate on 12th March $600,000×Rs.40.7/$ = Rs.24,420,000

Money Market Cover(Invest- Buy- Borrow)

The firm will invest in PV of $600000 i.e. $600,000 = $ 596,027 1 + .04

6Therefore, Present Outflow = $596,027 × Rs.40.45/$ = Rs.24,109,292And, Total Outflow = Rs.24,109,292 ( 1 + 0.1 ) = Rs.24,511,114

6Forward Cover Outflow on 12th March = Total $ Payable × Forward Rate

$600,000 × Rs.40.62/$ = 24,372,000Future Cover Profit on Squaring Future on 12th March = ( Rs.40.74/$ - Rs.40.65/$ ) × $600,000

= Rs.54,000On 12th March $ Purchase at $600,000 × Rs.40.7/$ = Rs.24,420,000Therefore, Total Outflow under Future = Rs.24,420,000 – Rs.54,000 = Rs.24,366,000

Option FV of Premium Outflow on C+ = ( $600,000 × 0.4p ) × ( 1 + 0.1 ) = Rs. 244,000 6

Call exercised as Spot Price > E, therefore Buy $ at $600,000 × Rs.40.6/$ = Rs.24,360,000Total Outflow on 12th March = Rs.24,360,000 + Rs.244,000 = Rs.24,604,000.

Exchange Rate Derivatives - Exporter PerspectiveOn 12th Dec, an Indian Firm knows that it has $600000 receivable, on 12th March. The Spot Rate is 60.45/$, while 2month forward rate is Rs.60.62/$. 2month INR/USD Interest Rate is 10%/4% p.a. resp. $ future for maturity ending March is Rs.60.65/$. Call and Put option on $ at E = Rs.60.60/$ traded at premium of .40p & .50p respectively. On 12th March Spot Rate Rs.60.7/$. Future traded at Rs.60.74/$. The Inflow in the following situation will be as follows:No Hedging Inflow on 12th March= Total $ Receivable × Spot Rate on 12th March

$600,000×Rs.60.7/$ = Rs.36,420,000

Money Market Cover(Borrow-Sell- Invest)

The firm will Borrow in PV of $600000 i.e. $600,000 = $ 594,059 1 + .04

4Therefore, Present Inflow = $594,059 × Rs.60.45/$ = Rs.35,910,867And, Total Inflow = Rs. 35,910,867 ( 1 + 0.1 ) = Rs.36,808,639 4

Forward Cover Inflow on 12th March = Total $ Receivable × Forward Rate $600,000 × Rs.60.62/$ = 36,372,000

Future Cover Profit on Squaring Future on 12th March = ( Rs.60.74/$ - Rs.60.65/$ ) × $600,000 = Rs.54,000On 12th March $ Purchase at $600,000 × Rs.60.7/$ = Rs. 36,420,000Therefore, Total Inflow under Future = Rs. 36,420,000 + Rs.54,000 = Rs.36,474,000

Option FV of Premium Outflow on P+ = ( $600,000 × 0.5p ) × ( 1 + 0.1 ) = Rs. 307,500 4

Put not exercised as Spot Price > E, therefore Buy $ at $600,000 × Rs.40.7/$ = Rs. 36,420,000Total Inflow on 12th March = Rs. 36,420,000 - Rs.307,500 = Rs.36,112,500.

Interest Rate Derivatives

Over-the-counter (OTC) interest rate derivatives include instruments such as • Forward Rate Agreements(FRAS): A Forward Rate Agreement (FRA) is a

financial contract between two parties to exchange interest payments for a 'notional principal' amount on settlement date, for a specified period from start date to maturity date.• Interest Rate Swaps (IRS):provide for the exchange of payments based on

differences between two different interest rates.• Caps, Floors, And Collars: are option-like agreements that require one party

to make payments to the other when a stipulated interest rate, most often a specified maturity of LIBOR, moves outside of some predetermined range.

Settlement under FRA

HDFC Bank quotes on 15 march its 6×9 FRA at (MIBOR) 5.35 – 5.45. ABC barrows Rs. 5 crores under FRA. MIBOR on 13th September is 6%.The following formula applied in calculating the compensation payable under FRA:Compensation = (L-R) or (R-L) × D × A

(B × 100) + D × LWhere, L = Settlement Rate (LIBOR, MIBOR, etc.) i.e. 6%

R = Contract reference rate i.e. 5.45%D = No. of days in contract period i.e. 91 daysB = Days basis that is, 360 or 365 days in a yearA = Notional principal amount i.e. Rs.50,000,000

Compensation = (6 - 5.45) × 91 × 50,000,000   = Rs.67551.15 (365 × 100) + 91 × 6

SWAP

SWAP

Currency Swaps

Interest Rate Swap

A Plain Vanilla Swap

A Basis Swap rate

An Amortizing 

Swap

Step up Swap

Extendable Swap

Delayed Start 

Swaps/ Forward Swap

Differential Swap

Cross Currencies 

Interest Rate Swap

Interest Rate Swap StructureCompanies A and B faces the following Interest Rates: A BU.S. Dollars (Floating Rate) LIBOR + 0.5% LIBOR + 1%Canadian (Fixed Rate) 5% 6.5%Assume that A wants to borrow U.S. Dollars at a floating rate of interest and B wants to borrow Canadian dollars at a fixed rate of interest. A Bank is planning to arrange a swap and requires 50 basis point spread. If swap is equally attractive to A and B, what interest rate will A and B end up paying?

Bank

A B

L + 0.25%

Spread = 0.5%

6.25%

5% L + 1%

5% L + 1%

L + 0.25% 6.25%

SWAP STRUCTURE

Interest Rate Option

• Allows the buyer of the option to borrow or lend the specified amount of a specified currency at a specified future date at a specified rate of interest without any obligation to do so.• A buy call option means a buyer with right to borrow • A buy put option mean right to invest.• Interest Rate Cap enforce an upper limit on the floating rate payment

and the risk of higher interest rates is crystallized into a single payment to be made upfront, without sacrificing downside risk.• Interest Rate Floor is a series of put option meant to protect the lender

against drop in interest below a specified rate in a floating rate asset.

Collar: Interest Rate Risk Hedging Strategy

 LIBOR

On ECB /FCY loan

On collar(Floor at 2.50%, Cap at 3.75%)

Net

Pay Receive from/ Pay out

Receive Pays Pays

2.25% 4.50% Pays 0 0.25% 4.75%

3.25% 5.50% - 0 0 5.50%

4.25% 6.50% Receive 0.50% 0 6.00%

4.75% 7.00% Receive 1.00% 0 6.00%

Index USD 6 months LIBORNotional USD 10 MillionTenor 5 yearsCap strike 3.75%Floor strike 2.50%Bank will charge 225 bpsHere the interest coupon is floored at 2.50% + 2.25% = 4.75% and cap at 3.75% + 2.25% = 6%

Seagull: Interest Rate Risk Hedging StrategyIndex USD 6 months LIBORNotional USD 10 MillionTenor 5 yearsCap 1 strike 3.75%Cap 2 strike 4.50%Floor strike 1.75%Bank will charge 225 bps.In the above illustration contract holder sell two deep out of money floor at interest coupon of 4% and cap 2 at interest coupon of 6.75%. Buy single cap 1 which is relatively less out of the money at interest coupon of 6%.

 LIBOR

On ECB /FCY loan

On collar(Floor at 1.75%, Cap 1 at 3.75% and Cap 2 at 4.50%)

Net

Pay Receive from/ Pay out

Receive Pays Pays

1.00% 3.25% Pays 0 0.75% 4.00%2.50% 4.75% - 0 0 4.75%3.50% 5.75% - 0 0 5.75%4.50% 6.75% Receive 0.75% 0 6.00%5.50% 7.75% Receive 0.75% 0 7.00%

Thank You