foreign exchange derivatives market (2)

8/8/2019 Foreign Exchange Derivatives Market (2)

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FOREIGN EXCHANGE

DERIVATIVES MARKET

VASVI AREN

AYUSH SINGHAL3246, 3258


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Whatare derivatives ?

A derivative is a financial instrument More simply, an agreement between two people or

two parties conveying ownership of the underlyingasset [rather than the asset itself]

It is a financial contract with a value linked to theexpected future price movements of the asset it islinked to - such as a share or a currency.

There are many kinds of derivatives, with the mostnotable being

futures/forwards options swaps


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Derivative markets

The derivatives market is the financialmarket for derivatives, financialinstruments like futures contracts oroptions.

The market can be divided into two, thatfor exchange-traded derivatives and thatforover-the-counter derivatives. The legal

nature of these products is very different aswell as the way they are traded, though manymarket participants are active in both


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Types of derivative markets

Over-the-counter derivatives (OTC)a] are contracts that are traded (and privately negotiated) directlybetween two parties, without going through an exchange orotherintermediary.b] The OTC derivative market is the largest market for derivatives,and is largely unregulated with respect to disclosure of informationbetween the parties, since the OTC market is made up of banks andother highly sophisticated parties, such as hedge funds.c] Reporting ofOTC amounts are difficult because trades can occur

in private, without activity being visible on any

Exchange-traded derivative contracts (ETD)

a] are tho

se derivatives instruments that are traded viaspecialized derivative exchanges orother exchanges.b] is a market where individuals trade standardized contracts thathave been defined by the exchangec] acts as an intermediary to all related transactions, and takes Initialmargin from both sides of the trade to act as a guarantee.


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1. Futures/Forwards

are contracts to buy or sell an asset on or before a future date ata price specified today.

2. Options

are contracts that give the owner the right, but not the obligation,to buy (in the case of a call option) or sell (in the case of a putoption) an asset.

3. Swaps

are contracts to exchange cash (flows) on or before a specifiedfuture date based on the underlying value of currencies/exchangerates, bonds/interest rates, commodities, stocks orother assets.

Three major classes of derivatives:


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Trading takes place on a formal exchange wherein theexchange provides a place to engage in thesetransactions and sets a mechanism for the parties totrade these contracts.

There is no default risk because the exchange acts asa counterparty, guaranteeing delivery and payment byuse of a clearing house.

The clearing house protects itself from default byrequiring its counterparties to deposit some intitalcollateral.

commision is paid to the broker.


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1. Currency Futures A currency future, also FX future or foreign exchange future, is

a futures contract to exchange one currency for another at aspecified date in the future at a price (exchange rate) that is fixedon the purchase date

Most contracts have physical delivery, so for those held at theend of the last trading day, actual payments are made in eachcurrency.

Uses Hedging

Investors use these futures contracts to hedge against foreignexchange risk. If an investor will receive a cash flow denominatedin a foreign currency on some future date, that investor can lockin the current exchange rate by entering into an offsetting

currency futures position that expires on the date of the cashflow.

SpeculationCurrency futures can also be used to speculate and, by incurring

a risk, attempt to profit from rising or falling exchange rates.


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2. Interest Rate Futures

An interest rate future is a financial derivative with an interest-bearing instrument as the underlying asset.

Examples include Treasury-bill futures, Treasury-bond futuresand Eurodollar futures.

Uses Interest rate futures are used to hedge against the risk of thatinterest rates will move in an adverse direction, causing a cost tothe company.

Borrowers face the risk of interest rates rising. Futures use the

inverse relatio

nship between interest rates and bo

nd prices to

hedge against the risk of rising interest rates.


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Example: Future Contracts

Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25 perbushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for hisnext crop, while McDonald's is trying to secure a buying price in order to determine how much tocharge for a Big Mac next year. The farmer and the corporation can enter into a futures contract

requiring the delivery of 5 million bushels of tomatoes toMcDonald's in December at a price of$3.50 per bushel. The contract locks in a price for both parties.It is this contract - and not the grain per se - that can then be bought and sold in the futuresmarket. In this scenario, the farmer is the holderof the short position (he has agreed to sell theunderlying asset - tomatoes) and McDonald's is the holderof the long position (it has agreed tobuy the asset). The price of the contract is 5 million bushels at $3.50 per bushel.

The profits and losses of a futures contract are calculated on a daily basis. In our example,suppose the price on futures contracts for tomatoes increases to $4 per bushel the day after thefarmer and McDonald's enter into their futures contract of $3.50 per bushel. The farmer, as theholderof the short position, has lost $0.50 per bushel because the selling price just increasedfrom the future price at which he is obliged to sell his tomatoes. McDonald's has profited by$0.50 per bushel.

On the day the price change occurs, the farmer's account is debited $2.5 million ($0.50 perbushel x 5 million bushels) and McDonald's is credited the same amount. Because the marketmoves daily, futures positions are settled daily as well. Gains and losses from each day's tradingare deducted or credited to each party's account. At the expiration of a futures contract, the spot

and futures prices normally converge.

Most transactions in the futures market are settled in cash, and the actual physical commodity isbought or sold in the cash market. For example, let's suppose that at the expiration date inDecember there is a blight that decimates the tomato crop and the spot price rises to $5.50 abushel.McDonald's has a gain of $2 per bushel on its futures contract but it still has to buytomatoes. The company's $10 million gain ($2 per bushel x 5 million bushels) will be offsetagainst the higher cost of tomatoes on the spot market. Likewise, the farmer's loss of $10 millionis offset against the higher price for which he can now sell his tomatoes. vasvi


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Forwards

The forward market is the over-the-counter financial market in contracts for futuredelivery.

Forward contracts are personalized betweenparties (i.e., delivery time and amount aredetermined between seller and customer).

The buyer agrees to buy an underlying asset

from the other party (the seller). The delivery ofthe asset occurs at a later time, but the price isdetermined at the time of purchase.


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Features

1. Highly customized

2. All parties are exposed to counterparty default risk

3. Transactions take place in large, private and largely

unregulated markets consisting of banks, investmentbanks, government and corporations

4. Underlying assets can be a stocks, bonds, foreigncurrencies, commodities or some combination thereof. The

underlying asset could even be interest rates


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Example: Forward Contracts

Let's assume that you have just taken up sailing and like it s

owell that you expect you might buy yourown sailboat in 12

months. Your sailing buddy, John, owns a sailboat but expects toupgrade to a newer, larger model in 12 months. You and Johncould enter into a forward contract in which you agree to buyJohn's boat for $150,000 and he agrees to sell it to you in 12months for that price. In this scenario, as the buyer, you have

entered a long forward contract. Conversely, John, the seller willhave the short forward contract. At the end ofone year, you findthat the current market valuation of John's sailboat is $165,000.Because John is obliged to sell his boat to you foronly $150,000,you will have effectively made a profit of $15,000. (You can buythe boat from John for $150,000 and immediately sell it for$165,000.) John, unfortunately, has lost $15,000 in potentialproceeds from the transaction.

Like all forward contracts, in this example, no money exchangedhands when the contract was negotiated and the initial value ofthe contract was zero.


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LinkbtwFuturesand forwards market

1. Both are derivative securities for future delivery/receipt. Agreeon future settlement or delivery in 1 week to10 years.

2. Both are used to hedge currency risk, interest rate risk orcommodity price risk.

3. Both futures and forwards are firm and binding agreements toact at a later date. In most cases this means exchanging anasset at a specific price sometime in the future.

4. Physical settlementoccurs when the actual underlying asset isdelivered in exchange for the agreed-upon price. In cases

where the contracts are entered into for purely financial reasonsthe derivative may be cash settled with a single payment equalto the market value of the derivative at its maturity or expiration.


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5. In principal they are very similar, used toaccomplish the same goal of risk management.

6. They offer a convenient means of hedging or

speculating.

8. Both physical settlement and cash settlementoptions can be keyed to a wide variety of underlying

assets including commodities, short-term debt,Eurodollar deposits, gold, foreign exchange,etc.


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OPTIONS1. It'sa contract, ora provision ofa contract,that gives one party(the optionholder)theright, butnotthe obligationto perform a

specified transactionwithanother party (the optionissuer or option

writer)accordingto specified terms.

2. Options can beembedded into manykinds of contracts.

3. Standalone optionstrade on ETD [exchanges] or OTC.


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Call options

provides the holder the right (but not the obligation) to purchase anunderlying asset at a specified price (the strike price), for a certain periodof time.

If the stock fails to meet the strike price before the expiration date, theoption expires and becomes worthless.

Investors buy calls when they think the share price of the underlyingsecurity will rise

or sell a call if they think it will fall. Selling an option is also referred to as''writing'' an option.


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Put options

gives the holder the right to sell an underlying asset at a specifiedprice (the strike price).

The seller (or writer) of the put option is obligated to buy the stock at thestrike price.

Put options can be exercised at any time before the option expires. Put buyers - those who hold a "long" - put are either speculative buyers

looking for leverage or "insurance" buyers who want to protect their longpositions in a stock for the period of time covered by the option.

Put sellers hold a "short" expecting the market to move upward (or at leaststay stable)


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1. Foreign currency option

A contract that grants the holder the right, butnot the obligation, to buy or sell currency at aspecified exchange rate during a specified

period of time. For this right, a premium ispaid to the broker, which will vary dependingon the numberof contracts

purchased. Currencyo

ptio

ns areo

neo

f thebest ways for corporations or individuals tohedge against adverse movements inexchange rates.


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2. Interestrate options

An investment tool whose payoff depends on thefuture level of interest rates. Interest rate options areboth exchange traded and over-the-counterinstruments.

Interest rate options from exchanges in the UnitedStates are offered on Treasury bond futures,Treasury note futures and eurodollar futures. Aninvestor taking a long position in interest rate call

options believes that interest rates will rise, while aninvestor taking a position in interest rate put optionsbelieves that interest rates will fall.


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Difference btwforwardsand futures

FORWARDS

1. Forward contracts are private,customized contracts between a

bank and its clients (M

NCs,exporters, importers, etc.)depending on the client's needs.

2. collateral/security deposit is notrequired,

3. Generally settled by actual

delivery4. the market place is over thetelephone , worldwide.

5. It is self regulatory

FUTURES

1 Future contracts arestandardized, specific sizedcontracts.

2. Small security deposit withthe exchange is necessary.

3. Most are offset and very feware delivered.

4. The market place is the

central exchange floo

r withworldwide communication.

5.There is a regulation calledcommodity future tradingcommision and national futureassociation.


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Diff btwforwardsand options

FORWARDS

A forward contract is anagreement between two

parties to buy or sell anasset at a certain futuretime for a certain priceagreed today.

a forward contract has tohappen

OPTIONS

An option is an agreementbetween two parties for the

option to buy or sell anasset at a certain futuretime for a certain priceagreed today.

an option may or may not

happen depending on thevalue of the assetcompared to the agreedprice


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Diff btwfuturesand options1. A futures c

ontract gives the buyer the obligation t

opurchase aspecific asset, and the seller to sell and deliver that asset at a

specific future date, unless the holder's position is closed prior toexpiration. Aside from commissions, an investor can enter into afutures contract with no upfront cost

2.Another key difference between options and futures is the size of

the underlying position. Generally, the underlying position is muchlarger for futures contracts, and the obligation to buy or sell thiscertain amount at a given price makes futures more risky for theinexperienced investor.

3.Another major difference between these two financial instrumentsis the way the gains are received by the parties. In contrast, gains

on futures positions are automatically 'marked to market' daily,meaning the change in the value of the positions is attributed to thefutures accounts of the parties at the end of every trading day -but a futures contract holder can realize gains also by going to themarket and taking the opposite position.


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4.buying an options position does require thepayment of a premium. Compared to the absence

of upfront costs of futures, the option premium canbe seen as the fee paid for the privilege of notbeing obligated to buy the underlying in the eventof an adverse shift in prices. The premium is themaximum that a purchaserof an option can lose

5.The gain on a option can be realized in thefollowing three ways: exercising the option when itis deep in the money, going to the market and

taking theopposite p

osition,or waiting until expiryand collecting the difference between the asset

price and the strike price.


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Swaps

A swap is one of the most simple and successful forms ofOTC-traded derivatives.

It is a cash-settled contract between two parties to exchange (or"swap") cash flow streams

As long as the present value of the streams is equal, swaps canentail almost any type of future cash flow.

They are most often used to change the characterof an asset orliability without actually having to liquidate that asset or liability.For example, an investor holding common stock can exchangethe returns from that investment for lower risk fixed income cash

flows - without having to liquidate his equity position.

foreign exchange derivatives market (2)

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