Professional Documents
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“IRD”
“CDS”
“CD”
Pre se n te d To :
M r. N itin Ja in
Pre se n te d B y:
A tu l Ja in
K a vita D e o ra
N a vjo t K a u r
Pra b h jo t
INTEREST
RATE
DERIVATIVES
INTEREST RATE DERIVATIVES
An interest rate derivative is a derivative where the underlying asset is the
right to pay or receive a (usually notional) amount of money at a given interest
rate.
The interest rate derivatives market is the largest derivatives market in the
world. Market observers estimate that US$180 trillion by notional value of interest
rate derivatives contract had been exchanged by September 2007 . According to the
International Swaps and Derivatives Association, 80% of the world's top 500
companies as of April 2003 used interest rate derivatives to control their cash
flows.
IRD PRODUCTS
Consider the following swap in which Party A agrees to pay Party B periodic
fixed interest rate payments of 8.65%, in exchange for periodic variable interest
rate payments of LIBOR + 70 bps (0.70%).
FORWARD RATE AGREEMENT
Forward Rate Agreements (FRAs) being traded in the OTC
market. In case of FRAs, contracting parties agree to pay or receive a specific
rate of interest for a specific period, after a specific period of time, on a
specified notional amount. No exchange of the principal amount takes place
among the parties at any point in time. Now, think about bringing this contract
to the exchange. If we bring this FRA to the exchange, it would essentially be
renamed as a futures contract.
( )
(Reference Rate – Fixed Rate)
Payment = Notional Amount -------------------------------------------
1 + Reference Rate
Where:
In the first stage, the capital market regulator will allow trading in three
products — 91-day treasury bill futures, short-term interest rate futures based
on an index of actual call rates and notional coupon bearing 10-yearlong bond
futures.
“The new products will expand the market depth in terms of availability of
products. Right now, there are no products available. For instance, if you
want to hedge and your view is that interest rates will go up on 10-year
bonds, the only option is to sell the 10-year bond from the portfolio. With the
availability of a derivative instrument, you can express your view and trade
accordingly,” said Joydeep Sen, vice-president (advisory desk) at BNP Paribas
Wealth Management.
INTEREST RATE FUTURE
If a forward contract is entered into through an exchange, traded on the
exchange and settled through the Clearing Corporation/ House of the exchange, it
becomes a futures contract. As one of the most important objectives behind bringing the
contract to the exchange is to create marketability, futures contracts are standardized
contracts so designed by the exchanges as to ensure participation of a wide range of
market participants.
The present market value for the bond is referred to as the spot price
while the future value as per the option is referred to as the strike price.
CDS are a financial instrument for swaping the risk of debt default. Credit
default swaps may be used for emerging market bonds, mortgage backed
securities, corporate bonds and local government bond
Buyer Pays a premium
He gets insurance against a debt default receives a lump sum
payment if the debt instrument is defaulted.
Seller Receives monthly payments.
If the debt instrument defaults they have to pay the agreed amount
ILLUSTRATION
An investment trust owns £1 million corporation bond issued by a private
housing firm. If there is a risk the investment trust may buy a CDS from a
hedge fund. The CDS is worth £1 million. The investment trust will pay an
interest on this credit default swap of say 3%.
If the private housing firm doesn’t default. The hedge fund gains the interest
and pays nothing out. It is simple profit. If the private housing firm does
default, then the hedge fund has to pay £1 million – the value of the credit
default swap. Therefore the hedge fund takes on a larger risk and could end
up paying £1million.
The higher the perceived risk of the bond, the higher the interest rate the
hedge fund will require.
ILLUSTRATION
ADVANTAGE
1.
HEDGE AGAINTS RISK
A CDS contract can be used as a hedge or insurance policy against the
default of a bond or loan.
Co is exposed to a lot of credit risk can shift some of that risk by buying
protection in a CDS contract.
2.
SPECULATION E.G. RISK IS UNDERPRICED
Speculation has grown to be the most common function for a CDS
contract.
An investor with a positive view on the credit quality of a company
can sell protection and collect the payments that go along with it
rather than spend a lot of money to load up on the company's bonds.
An investor with a negative view of the company's credit can buy
protection for a relatively small periodic fee and receive a big payoff
if the company defaults on its bonds or has some other credit event.
CONTD………
3.
ARBITRAGE
If a company’s financial position improves the credit rating also
improve the CDS spread should fall to reflect improved rating.
This makes CDS more attractive to sell CDS protection.
If the company position deteriorated, CDS protection would be more
attractive to buy.
Arbitrage could occur when dealers exploit any slowness of the
market to respond to signals.
E.g. Washington Mutual bought corporate bonds in 2005 and hedged their
exposure by buying CDS protection from Lehman brothers. With Lehman
brothers going bankrupt this CDS protection was nullified.
CDS IN INDIA
ü In 2007, RBI had issued draft guidelines for introduction of CDSs and then
withdrawn this during the financial crisis the notional outstanding contracts of
CDS in global over-the-counter (OTC) markets fell by 26.9%
üThe derivative was blamed for the collapse of AIG, the world’s largest insurer,
which wrote out thousands of CDSes against debt securities, without setting
aside capital for it.
üThe Reserve Bank of India (RBI) had sent a questionnaire to some banks
seeking their views on CDS.
üAll CDS trades will come to a centralised reporting platform and in due
course will be brought on a central clearing platform.
CURRENCY DERIVATIVES
CURRENCY DERIVATIVES
CURRENCY FUTURE
A currency future contract provides a simultaneous write an obligation to
sell the particular currency at a specified future date, specified price at a
standard quantity. these are special type of forward contract. Standardized
exchange traded contracts
CURRENCY DERIVATIVE PRODUCTS
CURRENCY FORWARD
Currency option contract confers on option-buyer privilege of not
exercising the contract when exchange rate is not in his favor. Foreign
currency option is contract for future delivery of specified currency in a
exchange for another in which buyer has write to buy(call) or sell(put) a
particular currency at an agreed price for or with in specified period.
Future option market being a listed one with marking to market facilities
CURRENCY DERIVATIVE PRODUCTS
TYPES OF OPTIONS