Derivatives Markets In

Interest Rate & Foreign

Exchange Rate
Utility For Importer & Exporter
NEHA ABHISHEK, BANGALORE
Batch: 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

Location

Basic Variable

Real Assets
Commodities
Metals
Real Estates
Plant &
Equipment

Financial Assets
Bonds
Shares
Loan
Currencies

Price Risk
Forwards
Futures
Options

Others
Weather
Power
Insurance

Interest Rate Risk

Swaps
Futures
Options

OTC

Forwards
Options
Swaps

ETC
Futures
Options

Nature
Forwards
Future
Options
Swap

Concept of Hedging
Exporter

Gain

Foreign Currency

Local Currency

Importer

Gain

Foreign Currency

Local Currency

Exposure of Importer and Exporter

Month

USD/INR

April 14

60.22

August
14
August
14
March 15
March 15

59.27

Importers
Exporters
Remarks
Hedged (Y)
Happy (H)
Hedged (Y)
Happy (H)

Unhedged
Unhappy (U) Unhedged (N) Unhappy (U)
(N)

Reference
Rate
N
(H)
N
(U)

59.27

(U)

(H)

62.85
62.85

N
Y

(U)
(H)

N
Y

(H)
(U)

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
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.

The Features of Currency Future in India

Currency
Size
Quotation
Maturities
Due Date
Last Trading Day
Settlement Price
Settlement

The contract is available on US Dollar/ Indian Rupee.

The Size of one Future is USD 1,000.
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.
The contract is available with maturity ranging from 1 to 12
months.
The contract expire on last working day of the month, excluding
Saturday. Outstanding contract are settled on this day.
Two days before the expiry date.
The Settlement price is fixed on last trading day at the Reserves
Bank reference rate.
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.

Option
Option
Call
Buy
Importer
Right to Buy

Sell
Exporter
Obligation to
Sell

Put
Buy
Exporter
Right to Sell

Sell
Importer
Obligation to
Buy

Concept of In the Money (ITM), At the Money (ATM) and Out of the
Moneyof(OTM)
Nature
Option
Exporter
Importer
Illustration
Based on Strike
In the Money (ITM)
At the Money (ATM)
Out of the Money
(OTM)

Strike Price of Buy Put >

Forward Reference Rate
(FRR)
Strike Price of Buy Put =
Forward Reference Rate
(FRR)
Strike Price of Buy Put <
Forward Reference Rate
(FRR)

Strike price of Buy Call

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

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

Option - Exporter
Assume 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.
Market
FRR =
BP = 45 P/L matrix BP = 46 P/L matrix BP = 44
P/L matrix
Rate
45
Prem. =1 compared Prem. = compared Prem. = . compared with FRR
(ATM)
with FRR
2
with FRR
5
(ITM)
(OTM)
43
45
Y
-1
Y
-1
Y
-1.5
44
45
Y
-1
Y
-1
Y
-1.5
45
45
Y
-1
Y
-1
N
-0.5
46
45
N
0
Y
-1
N
0.5
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
FRR =
BC = 45 P/L matrix BC = 44 P/L matrix
BC = 46
P/L matrix
Rate
45
Prem. =1 compared Prem. = compared
Prem. =
compared with
(ATM)
with FRR
2
with FRR
0.5
FRR
(ITM)
(OTM)
43
45
N
1
N
2
N
0.5
44
45
N
1
Y
2
N
0.5
45
45
Y
1
Y
1
N
0.5
46
45
Y
0
Y
0
Y
0.5

Option - Importer

Assume 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
Market
FRR =
BC = 45
P/L
BC = 44
P/L
BC = 46
P/L matrix
rates.
Rate
45
Prem.
matrix
Prem. =
matrix
Prem. =
compared with
=1
compare
2
compare
0.5
FRR
(ATM)
d with
(ITM)
d with
(OTM)
FRR
FRR
43
45
N
1
N
0
N
1.5
44
45
N
0
Y
-1
N
0.5
45
45
Y
-1
Y
-1
N
-0.5
Assume that FRR for maturity on 31st December 2011 is INR 45 for USD/ INR currency pair.
46
45
Y
-1
Y
-1
Y
-1.5
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
FRR =
BP = 45
P/L
BP = 46
P/L
BP = 44
P/L matrix
Rate
45
Prem.
matrix
Prem. =
matrix
Prem.
compared with
=1
compared
2
compared
= .5
FRR
(ATM)
with FRR
(ITM)
with FRR
(OTM)
43
45
Y
-1
Y
-1
Y
-0.5
44
45
Y
0
Y
0
Y
0.5
45
45
Y
1
Y
1
N
0.5
46
45
N
1
Y
2
N
0.5

Exchange Rate Derivatives - Importer Perspective

On 12th Jan, an Indian Firm knows that it has $600000 payable, on 12th March. The Spot Rate is 40.45/$, 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
Money Market
Cover
(Invest- BuyBorrow)

Forward Cover
Future Cover

Option

Outflow on 12th March= Total $ Payable Spot Rate on 12th March

$600,000Rs.40.7/$ = Rs.24,420,000
The firm will invest in PV of $600000 i.e. $600,000 = $ 596,027
1 + .04
6
Therefore, Present Outflow = $596,027 Rs.40.45/$ = Rs.24,109,292
And, Total Outflow = Rs.24,109,292 ( 1 + 0.1 ) = Rs.24,511,114
6
Outflow on 12th March = Total $ Payable Forward Rate
$600,000 Rs.40.62/$ = 24,372,000
Profit on Squaring Future on 12th March = ( Rs.40.74/$ - Rs.40.65/$ ) $600,000
= Rs.54,000
th
On 12 March $ Purchase at $600,000 Rs.40.7/$ = Rs.24,420,000
Therefore, Total Outflow under Future = Rs.24,420,000 Rs.54,000 = Rs.24,366,000
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.24,360,000
Total Outflow on 12th March = Rs.24,360,000 + Rs.244,000 = Rs.24,604,000.

Exchange Rate Derivatives - Exporter Perspective

On 12th Dec, an Indian Firm knows that it has $600000 receivable, on 12 th March. The Spot
Rate is 60.45/$, 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 12 th 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
$600,000Rs.60.7/$ = Rs.36,420,000
Money
The firm will Borrow in PV of $600000 i.e. $600,000 = $ 594,059
Market Cover
1 + .04
(Borrow-Sell4
Invest)
Therefore, Present Inflow = $594,059 Rs.60.45/$ = Rs.35,910,867
And, Total Inflow = Rs. 35,910,867 ( 1 + 0.1 ) = Rs.36,808,639
4
th
Forward
Inflow on 12 March = Total $ Receivable Forward Rate
Cover
$600,000 Rs.60.62/$ = 36,372,000
Future Cover Profit on Squaring Future on 12th March = ( Rs.60.74/$ - Rs.60.65/$ ) $600,000 =
Rs.54,000
On 12th March $ Purchase at $600,000 Rs.60.7/$ = Rs. 36,420,000
Therefore, 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.
36,420,000

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 69 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 L
Where,

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 days
B = Days basis that is, 360 or 365 days in a year
A = Notional principal amount i.e. Rs.50,000,000
Compensation = (6 - 5.45) 91 50,000,000
(365 100) + 91 6

= Rs.67551.15

SWAP
SWAP

Currenc
y Swaps

A Plain
Vanilla
Swap

A Basis
Swap
rate

An
Amortizi
ng Swap

Interest
Rate
Swap

Step up
Swap

Cross
Currencies
Interest
Rate Swap

Extenda
ble
Swap

Delayed
Start
Swaps/
Forward
Swap

Different
ial Swap

Interest Rate Swap Structure

Companies A and B faces the following Interest Rates:
A
B
U.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
ASWAP
and B end up paying?
Bank
6.25
L+
STRUCTURE
%
0.25%
L+
5
B
A
1%
%

5
%
L+
0.25%

Spread =
0.5%

L+
1%
6.25%

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
Index
USD 6 months LIBOR
Notional
USD 10 Million
Tenor
5 years
Cap strike
3.75%
Floor strike
2.50%
Bank will charge 225 bps
Here the interest coupon is floored at 2.50% + 2.25% = 4.75% and cap at 3.75% +
2.25% = 6%

LIBOR

On ECB /
FCY loan
Pay

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

Pays

Net

2.25%

4.50%

Receive from/
Pay out
Pays

Pays

3.25%

5.50%

5.50%

4.25%

6.50%

Receive

0.50%

6.00%

4.75%

7.00%

Receive

1.00%

6.00%

0.25%

4.75%

Seagull: Interest Rate Risk Hedging Strategy

Index
USD 6 months LIBOR
Notional
USD 10 Million
Tenor
5 years
Cap 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
at interest
coupon of 6%. On collar
of the money
On ECB
/
Net
LIBOR

FCY loan
Pay

1.00%
2.50%
3.50%
4.50%
5.50%

3.25%
4.75%
5.75%
6.75%
7.75%

(Floor at 1.75%, Cap 1 at 3.75% and Cap 2

at 4.50%)
Receive from/
Receive
Pays
Pay out
Pays
0
0.75%
0
0
0
0
Receive
0.75%
0
Receive
0.75%
0

Pays
4.00%
4.75%
5.75%
6.00%
7.00%

Thank
You