Understanding the derivative:
A derivative is a financial instrument whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable called the underlying. It requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions, and is settled at a future date.
In India, different derivatives instruments are permitted and regulated by various regulators, like Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and Forward Markets Commission (FMC). Broadly, RBI is empowered to regulate the interest rate derivatives, foreign currency derivatives and credit derivatives. For regulatory purposes, derivatives have been defined in the Reserve Bank of India Act, as follows:
‘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 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.
To simplify, derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates market indexes etc.
Development of Derivatives
Fixed exchange rate was in existence under the Bretton Woods system. Financial derivatives came into the spotlight, when during the post- 1970 period, the US announced its decision to give up gold- dollar parity, the basic king pin of the Bretton Wood System of fixed exchange rates. With the dismantling of this system in 1971, exchange rates couldn’t be kept fixed. Interest rates became more volatile due to high employment and inflation rates. Less developed countries opened up their economies and allowed prices to vary with market conditions. Price fluctuations made it almost impossible for the corporate sector to estimate future production costs and revenues.
The derivatives provided an effective tool to the problem of risk and uncertainty due to fluctuations in interest rates, exchange rates, stock market prices and the other underlying assets. The derivative markets have become an integral part of modern financial system in less than three decades of their emergence.
Derivatives in India
Indian Derivatives markets have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875. In 1952, with the ban on cash settlement and option trading by the Government of India, derivatives trading shifted to informal forwards markets.
The first step towards the introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. This provided for withdrawal of prohibition on options in securities.
Classification of derivatives contracts in India
The Indian financial market also participated in the new generation of financial instrument and the Indian derivatives markets with modern instruments commenced with forex derivatives in 1997. Many derivatives on different underlying’s have been introduced in the Indian market during the past few years. Currently, the following broad categories of contracts are allowed for trading in Indian markets:
- INDEX FUTURES AND OPTIONS
- SINGLE STOCK OPTIONS AND FUTURES
- INTEREST RATE FUTURES AND FORWARDS
- INTEREST RATE SWAPS
- FORWARD CONTRACTS
- CROSS CURRENCY SWAPS
- FUTURES AND OPTIONS
Regulatory guidelines are given in Reserve Bank of India’s Master Circular on Risk Management and Inter Bank dealings. Please refer to the updated circular for the current regulatory provisions.
MAJOR PLAYERS IN DERIVATIVE MARKET
There are three major players in the financial derivatives trading:
- Hedgers: Hedgers are traders who use derivatives to reduce the risk that they face from potential movements in a market variable and they want to avoid exposure to adverse movements in the price of an asset. Majority of the participants in derivatives market belongs to this category.
- Speculators: Speculators are traders who buy/sell the assets only to sell/buy them back profitably at a later point in time. They want to assume risk. They use derivatives to bet on the future direction of the price of an asset and take a position in order to make a quick profit. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
- Arbitrageurs: Arbitrageurs are traders who simultaneously buy and sell the same (or different, but related) assets in an effort to profit from unrealistic price differentials. They attempts to make profits by locking in a riskless trading by simultaneously entering into transaction in two or more markets. They try to earn riskless profit from discrepancies between futures and spot prices and among different futures prices.
What is a Forward Contract?
A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. In case of a forward contract the price which is paid/ received by the parties is decided at the time of entering into contract. It is the simplest form of derivative contract. Forward contracts are very popular amongst the trading community in India for hedging of their foreign exchange related risks.
Understanding a forward contract:
Suppose a farmer wishes to fix the sale price of his crops in advance, an importer arranges to buy foreign currency at a fixed rate in the future, a fund manager who wants to sell stocks for a price known in advance. What can the farmer, the importer or the fund manager do to address their problems?
Each one of them should enter into a forward contract to become independent of the unknown future price of his risky asset (the crops, the foreign currency and the stocks).
So, how exactly the forward contract work?
The holder of a long (short) forward contract has an agreement to buy (sell) an asset at a certain time in the future for a certain price, which is agreed upon today. The buyer (or seller) in a forward contract:
- acquires a legal obligation to buy (or sell) an asset (known as the underlying asset)
- at some specific future date (the expiration date)
- at a price (the forward price) which is fixed today.
Let us take one example to understand the mechanism of forward contract.
Our importer wants to lock in a price of his import consignment worth USD 50000, for which he is likely to make payment after three months. He is afraid that the exchange price of USD vis a vis INR , which is USD 1=INR 67.00 today, will go up during these three months and he will end up paying higher price in terms of INR after three months. So he enters into a forward contract (on the underlying asset “USD Currency”) with the three month forward price of INR 68.00.
You may observe that the importer is taking a view on the future exchange rates on USD vs INR and execute the contract. However, the view may not be correct. Let us assume different scenario after three months.
Depending upon the rates prevailing on the day, the importer might have paid more or less in INR terms as per the column 3, if the forward contract was not booked.
USD/INR Rate payable Difference
Rates after by the importer in INR for
Three months USD 50000
67.00 68.00 +50000
67.50 68.00 +25000
68.00 68.00 0
68.50 68.00 -25000
69.00 68.00 – 50000
69.50 68.00 – 75000
Options are derivative contract that give the right, but not the obligation to either buy or sell a specific underlying security for a specified price on or before a specific date. In theory, option can be written on almost any type of underlying security. Equity (stock) is the most common, but there are also several types of non-equity options, based on securities such as bonds, foreign currency, indices or commodities such as gold or oil.
The person who buys an option is normally called the buyer or holder. Conversely, the seller is known as the seller or writer. We can say that “An option is a particular type of a contract between two parties where one person gives the other person the right to buy or sell a specific asset at a specified price within a specified time period.” The buyer, who has right but not an obligation is to pay a fee or premium to the writer or seller of the option for this arrangement. Today, options are traded on a variety of instruments like commodities, financial assets as diverse as foreign exchange, bank TDR, treasury securities, stock, stock indexes, petroleum products, food grains, metals etc.
The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you liked very much and want to purchase. Unfortunately, you have no liquidity to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $100,000. The owner agrees, but for this option, you pay a price of $1,000.
Now, consider the hypothetical situations as under:
- During the three months, you discovered that a big mall is being constructed near the house and lots of development is taking place in the nearby area. Due to this, the property prices have gone up in the locality. The house prices have also gone up due to this development and similar houses in the vicinity are being sold at $200000. Because the owner sold you the option, he is obligated to sell you the house at $100,000. In the end, you stand to make a profit of $99,000 ($200,000-$100000- $1,000).
- Now, consider the situation that due to riots in the area where house is situated, property prices declined sharply, there were no takers of property at through away price. You also changed your mind to purchase the house in such an area. Since, as a buyer of the option you have right but not an obligation, you can choose not enforcing the option. Here your loss is limited to the premium $1000, paid by you.
IMPORTANT TERMINOLOGY USED IN OPTIONS:
|AT THE MONEY||Option with an exercise price equal to or nearly equal to the current price of the asset. In case of currency option, this means the current spot rate or the forward rate ruling for the expiry date of the option.|
|AMERICAN OPTION||An option that can be exercised anytime during its life.|
|CALL OPTION||An agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period.|
|CASH MARKET||The market in the actual financial instrument on which an option contract is based. In a cash market, the exchange of goods and money between the seller and the buyer takes place in the present, as opposed to the futures market where such an exchange takes place on a specified future date.|
|EUROPEAN OPTION||An option which can be exercised only on the expiry date.|
|EXERCISE OR STRIKE PRICE||The strike price or exercise price of an option is the fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity.|
|EXPIRY||The last date on which the option may be exercised. If it was not exercised before that date the option has no value.|
|EXPIRATION TIME||A specified time, after which the options contract is no longer valid. The expiration time gives a more specific deadline to an options contract in addition to the expiration date, by giving a time of day. E.g. 10.00 a.m. New York time or 3.00 p.m. Tokyo time.|
|IN THE MONEY||For a call option, in-the-money is when the option’s strike price is below the market price of the underlying stock. For a put option, in the money is when the strike price is above the market price of the underlying stock. In other words, this is when the stock option is worth money and can be turned around and exercised for a profit.|
|INTRINSIC VALUE||The intrinsic value of an option is the amount by which an option is in-the-money or the immediate exercise value of the option when the underlying position is marked-to-market.|
|OUT OF THE MONEY||A call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset.|
|PREMIUM||The price of an option. i.e. The income received by an investor who sells or “writes” an option contract to another party.|
|PUT OPTIONS||An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.|
|TIME VALUE||The difference between the option premium and the intrinsic value. An option’s premium is comprised of two components, its intrinsic value and its time value. The intrinsic value is the difference between the price of the underlying and the strike price of the option. Any premium that is in excess of the option’s intrinsic value is referred to as its time value.|
MECHANISM OF OPTIONS:
Consider that on January 1, company “A”‘s stock price is USD 73 and premium cost is USD 2.25 for a March 77 call. This means that expiration is the third Friday of March and the strike price is USD 77. The total price of the contract is USD 2.25 x 100 = USD 225 for a market lot of 100 shares, excluding some petty charges like commission etc.
Since, the strike price is USD 77, the stock must rise above USD 77 for having some worth. Also, the breakeven price will be USD 79.25, considering the premium cost. When the stock price is less than USD 77 i.e. the strike price, the option is worthless. However, considering the premium USD 225 paid, you may be down by this amount.
Suppose three weeks later the stock price has gone up to USD 85. The option contract price will also move up along with the change in rate. Assume, that it is now worth USD 8.25 x 100 = USD 825. After considering your initial cost of USD 225, your position is with profit of USD 825 – USD 225 = USD 600. If you close your position at this point of time, you make profit of USD 600. However, you were optimistic on the stock and preferred to continue with the option till its maturity date.
Unfortunately, on expiry date, the prevailing price of the stock was USD 72. Since, the price is less than the strike price and no time left, the option is worthless. You do not gain anything from the contract, in fact down by the original investment of USD 225.
To sum up,
|ON 1ST JANUARY||ON 21ST JANUARY||EXPIRY DATE|
|STOCK PRICE||USD 73||USD 85||USD 72|
|OPTION PRICE||USD 2.25||USD 8.25||USD 0|
|CONTRACT VALUE||USD 225||USD 825||USD 0|
|GAIN/LOSS||USD 0||USD 600||USD 225|
VARIATIONS IN OPTIONS:
The example we discussed is the basic option contract and usually referred to as plain vanilla option. If it is made more complex involving more varieties of the financial instruments, it may be referred as exotic option. There are various options available with different names. Let us have some of them explained as under:
- Tunnel Option or Range Forward option:
An option-based strategy that is mostly used in currency (and interest rate) markets and involves the purchase of a foreign exchange call (put) option and the sale of a foreign exchange put (call) option, at the same time (i.e., simultaneously) and for different strike prices. In other words, this strategy consists of a series of range forwards or collars based on corresponding forward prices or rates in interest rate or currency markets. Sometime it is so chosen that the upfront cost of option comes to zero.
- Ratio Range Forward:
This is more flexible version of Range Forward Option. Here the amount that is bought and sold is different. The ratio between both the amounts is so chosen that the resultant cost will be brought to zero or to the desired level.
- Knock out options:
It is an option that is knocked out or nullified, if the underlying instrument reaches a certain price. They are cheaper than standard options as they offer limited opportunities for profit. For example, an option writer might sell an option on a share trading at USD 95 giving the option buyer the right to buy it at USD 100 with a knockout limit of USD 109. If the share price rises above USD 100 the buyer will the option. If the price rises above USD 109 then the option is nullified thereby the option writer has limited his losses.
- Knock in Option:
An option contract that becomes active only when a certain price is reached. For example, one may purchase a knock-in option with a “knock-in price” of USD 35 and a strike price of USD 45. If the price of the underlying never reaches USD 35 at any point over the course of the option’s life, the option is treated as if it never existed in the first place. If it does, however, it becomes a regular option with a strike price of USD 45.
- Binary Option:
A type of option in which the payoff is structured to be either a fixed amount of compensation if the option expires in the money, or nothing at all if the option expires out of the money. It is, sometime referred to as “all-or-nothing options” or “digital options”.
- Average Rate Option:
An option used to hedge against fluctuations in exchange rates by averaging the spot rates over the life of the option and comparing that to the strike price of the option. Average rate options are typically purchased for daily, weekly or monthly time periods. Upon maturity, the average of the spot prices is compared to the strike price. If the average rate is less favorable than the strike price, the option issuer will pay the difference. If the average rate is more favorable than the option will expire worthless with no payment being made.
- Shout Options:
In this option the holder is allowed to lock in a defined profit while maintaining the right to continue participating in gains without a loss of locked-in monies. Shout options can be structured so that holders of this contract have more than one opportunity to “shout” or lock in profits. This allows holders to continue to benefit from positive market movements without the possibility of losing already locked-in profits.
- Ratchet or Cliquet option:
This option periodically settles and resets its strike price at the level of the underlying during the time of settlement. Each forward start option comprising the cliquet enters into force when the previous option expires. Investors can opt to receive their payout when each option expires or wait until the entire series has played out. For example, a three-year cliquet option with a strike of USD 1,000 would expire worthless on the first year if the underlying was to be USD 900. This value (USD 900) would then be the new strike price for the following year and should the underlying on the settlement be USD 1,200, the contract holder would receive a payout and the strike would reset to this new level. Higher volatility provides better conditions for investors to earn profit.
Futures contract is an agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset. They are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. It is an exchange traded version of the regular forward contracts.
In olden days farmers would grow their crops and then bring them to market in the hope of selling their inventory. But demand and supply will never match and some time the crop will remain unpurchased. Conversely, when a given commodity – wheat, for instance – was out of season, the goods made from it became very expensive because the crop was no longer available.
In the mid-nineteenth century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (spot trading) or for forward delivery. The latter contracts – forward contracts – were the forerunners of today’s futures contracts. In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season.
Today’s futures market is a global marketplace for not only agricultural goods, but also for currencies and financial instruments such as Bonds and Securities. It’s a diverse meeting place of farmers, exporters, importers, manufacturers and speculators. Thanks to modern technology, commodities prices are seen throughout the world, so a farmer has world market instead of a limited nearby market.
MECHANISM OF FUTURES CONTRACT:
Assuming that a producer of wheat is trying to secure a selling price for next season’s crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of wheat to the buyer in June at a price of USD 4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. This contract is tradable and can be bought and sold in the futures market.
In short, futures contract is an agreement between two parties. It creates two positions, a short position – the party who agrees to deliver a commodity and a long position – the party who agrees to receive a commodity. In the above example, the farmer would be the holder of the short position who has agreed to sell wheat, whereas the bread maker would be the holder of long position agreeing to buy. Remember that every contract involves both the positions.
In a typical futures contract, everything is specified:
- The quantity and quality of the commodity.
- The specific price per unit.
- The date and method of delivery.
The exchanges have standard lot for the quantity of the commodity and specify the settlement dates.
PROFIT AND LOSS – CASH SETTLEMENT:
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, the futures contracts for wheat increases to USD 5 per bushel the day after the above farmer and bread maker entered into their futures contract of USD 4 per bushel. The farmer, as the holder of the short position, has lost USD 1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by USD 1 per bushel because the price he is obliged to pay is less than the market price in the futures for wheat.
On the day the change occurs, the farmer’s account is debited with USD 5000 (i.e. USD1 per bushel X 5,000 bushels) and the bread maker’s account is credited with USD 5000. As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day’s trading are deducted or credited to a person’s account each day.
As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at USD 5 per bushel, the farmer would lose USD 5,000 on the futures contract and the bread maker would have made USD 5,000 on the contract.
But after the settlement of the futures contract, the bread maker still needs wheat to make bread, so he will in actuality buy his wheat in the cash market for USD 5 per bushel. However, considering the bread maker’s futures profits of USD 5,000 already credited in his account, he pays his locked-in price of USD 4 per bushel only. The farmer, after closing out the contract, can sell his wheat on the cash market at USD 5 per bushel but because his account is already debited with USD 5000 in effect the farmer receives only USD 4 per bushel.
Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost USD 5000 while the long speculator would have gained that amount. They need not go to the cash market to buy or sell the commodity after the contract expires.
TYPE OF FUTURES CONTRACTS:
There are different kinds of futures contracts, reflecting the many different kinds of “tradable” assets about which the contract may be based on such as commodities, securities, currencies or intangibles such as interest rates and indexes. These are traded on various exchanges throughout the world. Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME). These instruments became highly successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982, Deutsche Terminbörse and the Tokyo Commodity Exchange (TOCOM). There are more than 90 futures and futures options exchanges worldwide providing trading opportunities to the operators.
It is an over-the-counter (OTC) contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract.
These are usually agreements dealing with interest rates, the parties to the contract will exchange a fixed rate for a variable one. The party paying the fixed rate is usually referred to as the borrower, while the party receiving the fixed rate is referred to as the lender.
Assume that Company A enters into an FRA with Company B in which Company A will receive a fixed rate of 5% for one year on a principal of USD 1 million in three years. In return, Company B will receive the one-year LIBOR rate, determined in three years’ time, on the principal amount. The agreement will be settled in cash in three years.
If, after three years’ time, the LIBOR is at 5.5%, the settlement to the agreement will require that Company A to pay Company B. This is because the LIBOR is higher than the fixed rate. Mathematically, USD 1 million at 5% generates USD 50,000 of interest for Company A while USD 1 million at 5.5% generates USD 55,000 in interest for Company B. Ignoring present values, the net difference between the two amounts is USD 5,000, which is paid to Company B.
EXPLAINING THE CONCEPT:
Meaning of various Terms:
Notional Amount: Notional Amount of Loan on which interest is calculated.
Buyer of FRA: Borrows notional sum of money – The one who longs the FRA – i.e. the one who pays fixed interest
Seller of FRA: Lends the notional sum of money – The one who shorts the FRA –i.e. the one who pays floating interest.
Reference Rate: The floating rate used in the FRA contract (LIBOR, EURIBOR etc)
FRA Rate: This is the fixed interest rate the buyer of FRA pays or price of the FRA.
Deal Date: Date on which the FRA deal is agreed upon.
Value Date / Settlement Date: The date on which the forward loan becomes effective – this in fact is the settlement date on which FRA is cash settled with exchange of interest differential.
Participants in FRA market: Banks / Corporates.
Market: Quotes are available with banks / dealers across all major currencies
Three Sixes (3X6) FRA – means 3 months loan beginning in 3 months’ time
One Fours (1X4) FRA – means 3 months loan beginning in 1 month
Three Nines (3X9) FRA – means 6 months loan beginning in 3 months
What happens after FRA is contracted:
- If on settlement date, the prevailing market rate of Reference Rate is greater than the contract rate, the seller pays the buyer of the FRA the difference;
- If on settlement date, the prevailing market rate of Reference Rate is less than the contract rate, the buyer pays the seller of the FRA the difference;
- If Reference Rate is same as the FRA rate on settlement date, there is no exchange of cash flows
Calculation of Pay Off:
For the following example of a 3×6 FRA
|NOTIONAL AMOUNT||USD 5000000||The notional amount for which the FRA is contracted.|
|TARDE DATE||13-01-2014||Date on which FRA is contracted.|
|SPOT DATE||15-01-2014||Effective Date of contract.|
|VALUE/SETTLEMENT DATE||15-04-2014||The date on which notional loan becomes effective. FRA gets cash settled on this date.|
|FIXING DATE||13-04-2014||The date on which the reference rate is determined, two working days before the settlement Date.|
|MATURITY DATE||15-07-2014||The date on which notional loan matures.|
|CONTRACT/ FRA RATE %||4.50||The fixed interest rate at which the FRA is contracted.|
|REFERENCE RATE||3M LIBOR||The Reference rate used for calculation of settlement amount.|
Settlement of FRA:
As the FRA settlement happens on loan start date (settlement date) i.e., upfront rather than at the end of the contract period (maturity date), the amount of interest differential (between contracted FRA rate and prevailing reference rate on settlement date) is discounted to the settlement date for computing the actual settlement amount; The settlement amount therefore is calculated using the following formula:
[(REFERENCE RATE-FRA RATE) x DAYS / BASIS]
PAYMENT= NOTIONAL AMOUNT x ————————————————————-
1+ (REFERENCE RATE x DAYS/BASIS)
Interest Rate Swap is an agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to a benchmark interest rate, usually LIBOR. A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the interest rate swap.
Interest rate swaps are simply the exchange of one set of cash flows, based on interest rate specifications, for another. Because they trade OTC, they are really just contracts set up between two or more parties, and thus can be customized in any number of ways.
The first interest rate swap took place between IBM and the World Bank in 1981. However, the swaps soon became very popular. In 1987, the ISDA reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements.
UNDERSTANDING INTEREST RATE SWAP:
The most common and simplest swap is a “plain vanilla” interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, FIXED RATE OF INTERSET on a NOTIONAL PRINCIPLE on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a FLOATING INTEREST RATE to Party A on the same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called SETTLEMENT DATES, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.
Let us take an Example to understand this concept:
Assuming that, on Dec. 31, 2013, Company A and Company B enter into a five-year swap with the following terms:
– Company A pays Company B an amount equal to 6% per annum on a notional principal of USD 20 million.
- Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of USD 20 million.
LIBOR, is the bench mark interest rate offered by London banks on deposits made by other banks in the money market. The market for interest rate swaps usually uses LIBOR as the base for the floating rate. For simplicity, let’s assume the two parties exchange payments annually on December 31, beginning in 2014 and concluding in 2018.
At the end of 2014, Company A will pay Company B USD 20,000,000 * 6% = USD 1,200,000. On Dec. 31, 2014, one-year LIBOR was 5.33%; therefore, Company B will pay Company A USD 20,000,000 * (5.33% + 1%) = USD 1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays USD 66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a “notional” amount. The stream of payments will be made till the continuation of the contract.
Currency swaps involve an exchange of cash flows in two different currencies. It is generally used to raise funds in a market where the corporate has a comparative advantage and to achieve a portfolio in a different currency of his choice, at a cost lower than if he accessed the market of the second currency directly. However, since these types of swaps involve an exchange of two currencies, an exchange rate, generally the prevailing spot rate is used to calculate the amount of cash flows, apart from interest rates relevant to these two currencies. By its special nature, these instruments are used for hedging risk arising out of interest rates and exchange rates.
UNDERSTANDING CURRENCY SWAPS:
Consider the following situation:
A US corporation with operations in UK can obtain comparatively better terms by borrowing dollars, but prefers a loan in GBP. British corporation with operations in the US can obtain comparatively better terms by borrowing GBP, but prefers a loan in dollars. The two companies could go to a bank who could arrange for a loan swap.
As an example, suppose the British Petroleum Company plans to issue a five-year bonds worth GBP 100 million at 5.00 % interest, but actually needs an equivalent amount in dollars, USD 150 million (considering 1GBP = USD1.50), to finance its new refining facility in the U.S.
Also, suppose that the PepsiCo, a U. S. company, plans to issue USD 150 million in bonds at 4 %, with a maturity of five years, but it really needs GBP 100 million to set up its distribution center in London.
To meet each other’s needs, suppose that both companies go to a bank that sets up the following three agreements:
- The British Petroleum Company will issue 5 year GBP 100 million bonds paying 5 % interest. It will then deliver the GBP 100 million to the bank who will pass it on to the U.S. PepsiCo Company to finance the construction of its British distribution center.
- The PepsiCo Company will issue 5 year USD 150 million bonds. The Company will then pass the USD 150 million to the bank that will pass it on to the British Petroleum Company who will use the funds to finance the construction of its US refinery.
- The British company, with its U.S. asset (refinery), will pay the 4 % interest on USD 150 million (USD 6 million) to the bank who will pass it on to the American company so it can pay its US bondholders.
- The American company, with its British asset (distribution center), will pay 5% interest on GBP100 million (GBP 5 million), to the bank who will pass it on to the British company so it can pay to its British bondholders.
- At maturity, the British company will pay USD 150 million to the bank who will pass it on to the American company so it can pay its U.S. bondholders.
- At maturity, the American company will pay GBP 100 million to the bank who will pass it on to the British company so it can pay its British bondholder
In the above swap agreement, the American company will receive USD 6 million each year for five years and a principal of USD 150 million at maturity and will pay GBP 5 million each year for five years and GBP100 million at maturity. To the American company, this swap agreement is equivalent to a position in two bonds:
A long position in a dollar-denominated, five-year, 4 % annual coupon bond with a principal of USD 150 million and trading at par.
A short position in a sterling-denominated, five-year, 5 % annual coupon bond with a principal of GBP 100 million and trading at par.
The British company’s swap position in which it will receive GBP and pay US dollars is just the opposite of the American company’s position. It is equivalent to a long position in a sterling-denominated bond and short position in a dollar denominated bond.
If a dealer provided a swap to just the American company, then it could have hedged its swap position of paying USD 6 million and receiving GBP 5 million by shorting the GBP 5% sterling-denominated bond and buying the 4% U.S. dollar-denominated bond.
Given this hedge, a currency swap, like an interest rate swap, generally has an economic value of zero when it is created. The zero economic value of the swap positions will change over time with changes in US rates, British rates, and the spot exchange rate.
Now consider the scenario that the American company is more creditworthy and can obtain a loan at lower rates than the British company in both the US and British markets.
Suppose the American company can obtain 4 % U.S. dollar-denominated loans in the U.S. market and 4.75 % GBP denominated loans in the British market, whereas the best British company can obtain is 5 % in the U.S. market and 5 % in the British market
The American company has a comparative advantage in the US market:
It pays 1% less than the British company in the US market, compared to only 0.25% less in the British market.
The British company has a comparative advantage in the British market:
It pays 0.25% more than the American company in the British market, compared to 1% more in the US market.
When such comparative advantage exists, a bank is in a position to benefit one or both parties. The bank will arrange for swaps, loans and also cover the open positions in Currencies to arrive at a profitable position for all the concerned parties to this arrangement.