Foreign Exchange Derivatives Market 4k4f5g

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VASVI AREN AYUSH SINGHAL 3246, 3258

Whatareerivatives 4 4

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A derivative is a financial instrument 2 re simply, an agreement between tw pe ple r tw parties c nveying wnership f the underlying asset [rather than the asset itself] It is a financial c ntract with a value linked t the expected future price m vements f the asset it is linked t - such as a share r a currency. There are many kinds f derivatives, with the m st n table being futures/f rwards pti ns swaps

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The derivatives market is the financial market f r derivatives, financial instruments like futures c ntracts r pti ns. The market can be divided int tw , that f r exchange-traded derivatives and that f r ver-the-c unter derivatives. The legal nature f these pr ducts is very different as well as the way they are traded, th ugh many market participants are active in b th

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Yver-the-c unter derivatives (YTC) a] are c ntracts that are traded (and privately neg tiated) directly between tw parties, with ut g ing thr ugh an exchange r ther intermediary. b] The YTC derivative market is the largest market f r derivatives, and is largely unregulated with respect t discl sure f inf rmati n between the parties, since the YTC market is made up f banks and ther highly s phisticated parties, such as hedge funds. c] Rep rting f YTC am unts are difficult because trades can ccur in private, with ut activity being visible n any

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Exchange-traded derivative c ntracts (ETD) a] are th se derivatives instruments that are traded via specialized derivative exchanges r ther exchanges. b] is a market where individuals trade standardized c ntracts that have been defined by the exchange c] acts as an intermediary t all related transacti ns, and takes Initial margin fr m b th sides f the trade t act as a guarantee.

hreeajrasseserivatives: A. Futures/F rwards are c ntracts t buy r sell an asset n r bef re a future date at a price specified t day. 2. Ypti ns are c ntracts that give the wner the right, but n t the bligati n, t buy (in the case f a call pti n) r sell (in the case f a put pti n) an asset. 3. Swaps are c ntracts t exchange cash (fl ws) n r bef re a specified future date based n the underlying value f currencies/exchange rates, b nds/interest rates, c mm dities, st cks r ther assets.

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A futures c ntract is a type f derivative instrument, r financial c ntract, in which tw parties agree t transact a set f financial instruments r physical c mm dities f r future delivery at a particular price. But participating in the futures market d es n t necessarily mean that y u will be resp nsible f r receiving r delivering large invent ries f physical c mm dities it is an Exchange traded derivative, ETD When a new c ntract is intr duced, the t tal p siti n in the c ntract is zer . Theref re, the sum f all the l ng p siti ns must be equal t the sum f all the sh rt p siti ns. In ther w rds, risk is transferred fr m ne party t an ther.

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Trading takes place n a f rmal exchange wherein the exchange pr vides a place t engage in these transacti ns and sets a mechanism f r the parties t trade these c ntracts. There is n default risk because the exchange acts as a c unterparty, guaranteeing delivery and payment by use f a clearing h use. The clearing h use pr tects itself fr m default by requiring its c unterparties t settle gains and l sses An invest r can ffset his r her future p siti n by engaging in an pp site transacti n bef re the stated maturity f the c ntract.

A rren|tres A currency future, als FX future r f reign exchange future, is a futures c ntract t exchange ne currency f r an ther at a specified date in the future at a price (exchange rate) that is fixed n the purchase date 4 2 st c ntracts have physical delivery, s f r th se held at the end f the last trading day, actual payments are made in each currency. 4 Uses Hedging Invest rs use these futures c ntracts t hedge against f reign exchange risk. If an invest r will receive a cash fl w den minated in a f reign currency n s me future date, that invest r can l ck in the current exchange rate by entering int an ffsetting currency futures p siti n that expires n the date f the cash fl w. Speculati n Currency futures can als be used t speculate and, by incurring a risk, attempt t pr fit fr m rising r falling exchange rates. 4

nterestate|tres 4

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An interest rate future is a financial derivative with an interestbearing instrument as the underlying asset. Examples include Treasury-bill futures, Treasury-b nd futures and Eur d llar futures. Uses Interest rate futures are used t hedge against the risk f that interest rates will m ve in an adverse directi n, causing a c st t the c mpany. B rr wers face the risk f interest rates rising. Futures use the inverse relati nship between interest rates and b nd prices t hedge against the risk f rising interest rates.

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The forward market is the ver-the-c unter financial market in c ntracts f r future delivery. The f rward market is a general term used t describe the inf rmal market by which these c ntracts are entered int F rward c ntracts are pers nalized between parties (i.e., delivery time and am unt are determined between seller and cust mer). N t frequently traded n exchanges. The buyer agrees t buy an underlying asset fr m the ther party (the seller). The delivery f the asset ccurs at a later time, but the price is determined at the time f purchase.

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Features A. Highly cust mized 2. All parties are exp sed t c unterparty default risk 3. Transacti ns take place in large, private and largely unregulated markets c nsisting f banks,investment banks, g vernment and c rp rati ns 4. Underlying assets can be a st cks, b nds, f reign currencies, c mm dities r s me c mbinati n there f. The underlying asset c uld even be interest rates

iinktw|tresanrwarsarket A.

B th are derivative securities f r future delivery/receipt. Agree n future settlement r delivery in A week t A years.

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B th are used t hedge currency risk, interest rate risk r c mm dity price risk.

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B th futures and f rwards are firm and binding agreements t act at a later date. In m st cases this means exchanging an asset at a specific price s metime in the future.

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Physical settlement ccurs when the actual underlying asset is delivered in exchange f r the agreed-up n price. In cases where the c ntracts are entered int f r purely financial reas ns the derivative may be cash settled with a single payment equal t the market value f the derivative at its maturity r expirati n.

5. In principal they are very similar, used t acc mplish the same g al f risk management. 6. They ffer a c nvenient means f hedging r speculating. 8. B th physical settlement and cash settlement pti ns can be keyed t a wide variety f underlying assets including c mm dities, sh rt-term debt, Eur d llar dep sits, g ld, f reign exchange,etc.

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÷all options

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pr vides the h lder the right (but n t the bligati n) t purchase an underlying asset at a specified price (the strike price), f r a certain peri d f time. If the st ck fails t meet the strike price bef re the expirati n date, the pti n expires and bec mes w rthless. Invest rs buy calls when they think the share price f the underlying security will rise r sell a call if they think it will fall. Selling an pti n is als referred t as ''writing'' an pti n.

âut options

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gives the h lder the right t sell an underlying asset at a specified price (the strike price). The seller ( r writer) f the put pti n is bligated t buy the st ck at the strike price. Put pti ns can be exercised at any time bef re the pti n expires. Put buyers - th se wh h ld a "l ng" - put are either speculative buyers l king f r leverage r "insurance" buyers wh want t pr tect their l ng p siti ns in a st ck f r the peri d f time c vered by the pti n. Put sellers h ld a "sh rt" expecting the market t m ve upward ( r at least stay stable)

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A c ntract that grants the h lder the right, but n t the bligati n, t buy r sell currency at a specified exchange rate during a specified peri d f time. F r this right, a is paid t the br ker, which will vary depending n the number f c ntracts purchased. Currency pti ns are ne f the best ways f r c rp rati ns r individuals t hedge against adverse m vements in exchange rates.

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An investment t l wh se pay ff depends n the future level f interest rates. Interest rate pti ns are b th exchange traded and ver-the-c unter instruments. Interest rate pti ns fr m exchanges in the United States are ffered n Treasury b nd futures, Treasury n te futures and eur d llar futures. An invest r taking a l ng p siti n in interest rate call pti ns believes that interest rates will rise, while an invest r taking a p siti n in interest rate put pti ns believes that interest rates will fall.

ierenetwrwarsantres FYRWARDS A. F rward c ntracts are private, cust mized c ntracts between a bank and its clients (2NCs, exp rters, imp rters, etc.) depending n the client's needs. 2. c llateral/security dep sit is n t required, 3. Generally settled by actual delivery 4. the market place is ver the teleph ne , w rldwide. 5. It is self regulat ry

FUTURES A Future c ntracts are standardized, specific sized c ntracts. 2. Small security dep sit with the exchange is necessary. 3. 2 st are ffset and very few are delivered. 4. The market place is the central exchange fl r with w rldwide c mmunicati n. 5.There is a regulati n called c mm dity future trading c mmisi n and nati nal future ass ciati n.

itwrwarsantins FYRWARDS 4

A f rward c ntract is an agreement between tw parties t buy r sell an asset at a certain future time f r a certain price agreed t day.

YPTIYNS 4

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a f rward c ntract has t happen

An pti n is an agreement between tw parties f r the pti n t buy r sell an asset at a certain future time f r a certain price agreed t day. an pti n may r may n t happen depending n the value f the asset c mpared t the agreed price

itwtresantins A. A futures c ntract gives the buyer the Ñ Ñ t purchase a specific asset, and the seller t sell and deliver that asset at a specific future date, unless the h lder's p siti n is cl sed pri r t expirati n. Aside fr m c mmissi ns, an invest r can enter int a futures c ntract with n upfr nt c st 2.An ther key difference between pti ns and futures is the size f the underlying p siti n. Generally, the underlying p siti n is much larger f r futures c ntracts, and the bligati n t buy r sell this certain am unt at a given price makes futures m re risky f r the inexperienced invest r. 3.An ther maj r difference between these tw financial instruments is the way the gains are received by the parties. In c ntrast, gains n futures p siti ns are aut matically 'marked t market' daily, meaning the change in the value f the p siti ns is attributed t the futures acc unts f the parties at the end f every trading day but a futures c ntract h lder can realize gains als by g ing t the market and taking the pp site p siti n.

4.buying an pti ns p siti n d es require the payment f a . C mpared t the absence f upfr nt c sts f futures, the pti n can be seen as the fee paid f r the privilege f n t being bligated t buy the underlying in the event f an adverse shift in prices. The is the maximum that a purchaser f an pti n can l se 5.The gain n a pti n can be realized in the f ll wing three ways: exercising the pti n when it is deep in the m ney, g ing t the market and taking the pp site p siti n, r waiting until expiry and c llecting the difference between the asset price and the strike price.

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A swap is ne f the m st simple and successful f rms f YTCtraded derivatives. It is a cash-settled c ntract between tw parties t exchange ( r "swap") cash fl w streams As l ng as the present value f the streams is equal, swaps can entail alm st any type f future cash fl w. They are m st ften used t change the character f an asset r liability with ut actually having t liquidate that asset r liability. F r example, an invest r h lding c mm n st ck can exchange the returns fr m that investment f r l wer risk fixed inc me cash fl ws - with ut having t liquidate his equity p siti n.

A nterestrateswas 4

In general, an interest rate swap is an agreement t exchange rate cash fl ws fr m interest-bearing instruments at specified payment dates. Each party's payment bligati n is c mputed using a different interest rate. Alth ugh there are n truly standardized swaps, a plain vanilla swap typically refers t a generic interest rate swap in which ne party pays a fixed rate and ne party pays a fl ating rate (usually LIBYR). F r each party, the value f an interest rate swap lies in the net difference between the present value f the cash fl ws ne party expects t receive and the present value f the payments the ther party expects t make. At the riginati n f the c ntract, the value f r b th parties is usually zer because n cash fl ws are exchanged at that p int. Yver the life f the c ntract, it bec mes a zer -sum game. As interest rates fluctuate, the value f the swap creates a pr fit n ne c unterparty's b ks, which results in a c rresp nding l ss n the ther's b ks. ? A p rtf li manager with a $A milli n fixed-rate p rtf li yielding 3.5% believes rates may increase and wants t decrease his exp sure. He can enter int an interest rate swap and trade his fixed rate cash fl ws f r fl ating rate cash fl ws that have less exp sure when rates are rising. He swaps his 3.5% fixed-rate interest stream f r the three-m nth fl ating LIBYR rate (which is currently at 3%). When this happens, he will receive a fl ating rate payment and pay a fixed rate that is equivalent t the rate the p rtf li is receiving, making his p rtf li a fl ating-rate p rtf li instead f the fixed-rate return he was receiving. There is n exchange f the principal am unts and the interest payments are netted against ne an ther. F r example, if LIBYR is 3%, the manager receives .5%. The actual am unts calculated f r semiannual payments are sh wn bel w. The fixed rate (3.5% in this example) is referred t as the swap rate. A typical exam questi n c ncerning interest rate swaps f ll ws:

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ƒ. Tw parties enter a three-year, plain-vanilla interest rate swap agreement t exchange the LIBYR rate f r a A % fixed rate n $A milli n. LIBYR is AA% n w, A2% at the end f the first year, and 9% at the end f the sec nd year. If payments are in arrears, which f the f ll wing characterizes the net cash fl w t be received by the fixed-rate payer? A. $A B. $A C. $2 D. $2

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at the end at the end at the end at the end

f year tw . f year three. f year tw . f year three.

A. The c rrect answer is "C". What's imp rtant t is that the payments are in arrears, s the end- f-year payments depend n the interest rate at the beginning f the year ( r pri r year end). The payment at the end f year tw is based n the A2% interest rate at the end f year ne. If the fl ating rate is higher than the fixed rate, the fixed rate payer receives the interest rate differential times the principal am unt ($A , x ( .A2- .A ) = $2 , ). ÷alculate the âayments on an Interest Rate Swap C nsider the f ll wing example: N ti nal am unt = $A milli n, payments are made semiannually. The c rp rati n will pay a fl ating rate f three-m nth LIBYR, which is at 3% and will receive a fixed payment f 3.5%.  Fl ating rate payment is $A milli n(. 3)(A8 /365) = $A4,79 Fixed payment is $A milli n(. 35)(A8 /365) = $A7,225 The c rp rati n will receive a net payment f $2,435

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a currency swap is a c ntract t exchange cash fl w streams fr m s me fixed inc me bligati ns (f r example, swapping payments fr m a fixed-rate l an f r payments fr m a fl ating rate l an). In an interest rate swap, the cash fl w streams are in the same currency, while in currency swaps, the cash fl ws are in different m netary den minati ns. Swap transacti ns are n t usually discl sed n c rp rate balance sheets. As we stated earlier, the cash fl ws fr m an interest rate swap ccur n c ncurrent dates and are netted against ne an ther. With a currency swap, the cash fl ws are in different currencies, s they can't net. Instead, full principal and interest payments are exchanged. Currency swaps all w an instituti n t take leverage advantages it might enj y in specific c untries. F r example, a highly-regarded German c rp rati n with an excellent credit rating can likely issue eur den minated b nds at an attractive rate. It can then swap th se b nds int , say, Japanese yen at better than it c uld by g ing directly int the Japanese market where its name and credit rating may n t be as advantage us. At the riginati n f a swap agreement, the c unterparties exchange n ti nal principals in the tw currencies. During the life f the swap, each party pays interest (in the currency f the principal received) t the ther. At maturity, each makes a final exchange (at the same sp t rate) f the initial principal am unts, thereby reversing the initial exchange. Generally, each party in the agreement has a c mparative advantage ver the ther with respect t fixed r fl ating rates f r a certain currency

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? ample: Future ÷ontracts

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Let's assume that in September the sp t r current price f r hydr p nic t mat es is $3.25 per bushel and the futures price is $3.5 . A t mat farmer is trying t secure a selling price f r his next cr p, while 2cD nald's is trying t secure a buying price in rder t determine h w much t charge f r a Big 2ac next year. The farmer and the c rp rati n can enter int a futures c ntract requiring the delivery f 5 milli n bushels f t mat es t 2cD nald's in December at a price f $3.5 per bushel. The c ntract l cks in a price f r b th parties. It is this c ntract - and n t the grain per se - that can then be b ught and s ld in the futures market. In this scenari , the farmer is the h lder f the sh rt p siti n (he has agreed t sell the underlying asset - t mat es) and 2cD nald's is the h lder f the l ng p siti n (it has agreed t buy the asset). The price f the c ntract is 5 milli n bushels at $3.5 per bushel. The pr fits and l sses f a futures c ntract are calculated n a daily basis. In ur example, supp se the price n futures c ntracts f r t mat es increases t $4 per bushel the day after the farmer and 2cD nald's enter int their futures c ntract f $3.5 per bushel. The farmer, as the h lder f the sh rt p siti n, has l st $ .5 per bushel because the selling price just increased fr m the future price at which he is bliged t sell his t mat es. 2cD nald's has pr fited by $ .5 per bushel. Yn the day the price change ccurs, the farmer's acc unt is debited $2.5 milli n ($ .5 per bushel x 5 milli n bushels) and 2cD nald's is credited the same am unt. Because the market m ves daily, futures p siti ns are settled daily as well. Gains and l sses fr m each day's trading are deducted r credited t each party's acc unt. At the expirati n f a futures c ntract, the sp t and futures prices n rmally c nverge. 2 st transacti ns in the futures market are settled in cash, and the actual physical c mm dity is b ught r s ld in the cash market. F r example, let's supp se that at the expirati n date in December there is a blight that decimates the t mat cr p and the sp t price rises t $5.5 a bushel. 2cD nald's has a gain f $2 per bushel n its futures c ntract but it still has t buy t mat es. The c mpany's $A milli n gain ($2 per bushel x 5 milli n bushels) will be ffset against the higher c st f t mat es n the sp t market. Likewise, the farmer's l ss f $A milli n is ffset against the higher price f r which he can n w sell his t mat es. vasvi

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? ample: Forward ÷ontracts Let's assume that y u have just taken up sailing and like it s well that y u expect y u might buy y ur wn sailb at in A2 m nths. Y ur sailing buddy, J hn, wns a sailb at but expects t upgrade t a newer, larger m del in A2 m nths. Y u and J hn c uld enter int a f rward c ntract in which y u agree t buy J hn's b at f r $A5 , and he agrees t sell it t y u in A2 m nths f r that price. In this scenari , as the buyer, y u have entered a l ng f rward c ntract. C nversely, J hn, the seller will have the sh rt f rward c ntract. At the end f ne year, y u find that the current market valuati n f J hn's sailb at is $A65, . Because J hn is bliged t sell his b at t y u f r nly $A5 , , y u will have effectively made a pr fit f $A5, . (Y u can buy the b at fr m J hn f r $A5 , and immediately sell it f r $A65, .) J hn, unf rtunately, has l st $A5, in p tential pr ceeds fr m the transacti n. Like all f rward c ntracts, in this example, n m ney exchanged hands when the c ntract was neg tiated and the initial value f the c ntract was zer .vasvi