1. Derivatives
Session 5

2. Foreign Currency Derivatives
Financial management of the MNE in the 21st century involves financial derivatives.
These derivatives, so named because their values are derived from underlying assets, are a powerful tool used in business today.
These instruments can be used for two very distinct management objectives:
Speculation – use of derivative instruments to take a position in the expectation of a profit
Hedging – use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow

3. The Nature of Derivatives
A derivative is an instrument whose value depends on the values of other more basic underlying variables called bases (underlying asset, index, or reference rate), in a contractual manner

4. The Nature of Derivatives
The underlying asset can be equity, forex, commodity or any other asset.
For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such
a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.

5. Examples of Derivatives
Forward Contracts
Futures Contracts
Swaps
Options

6. The Players in a Derivative Market
The following three broad categories of participants
Hedgers
Speculators
Arbitrageurs
Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

7. Why are they used? To discover price To hedge risks
To speculate (take a view on the future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one portfolio and buying another

8. Derivatives in India
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines
“derivative” to include –
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying securities.

9. Derivatives in India
Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

10. Currency Forwards
A forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future.
Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms.

11. Currency Forwards
When MNCs anticipate a future need for or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate.
The % by which the forward rate (F ) exceeds the spot rate (S ) at a given point in time is called the forward premium (p ).
F = S (1 + p )
F exhibits a discount when p < 0.

12. Currency Forwards Example S = $1.681/£, 90-day F = $1.677/£
annualized p = F – S  360
S n
= –  360 = –.95%
The forward premium (discount) usually reflects the difference between the home and foreign interest rates, thus preventing arbitrage.

13. Foreign Currency Futures
A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price.
It is similar to futures contracts that exist for commodities such as cattle, lumber, interest-bearing deposits, gold, etc.
In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange.

14. Currency Forwards
A swap transaction involves a spot transaction along with a corresponding forward contract that will reverse the spot transaction.
A non-deliverable forward contract (NDF) does not result in an actual exchange of currencies. Instead, one party makes a net payment to the other based on a market exchange rate on the day of settlement.

15. Forward Market
An NDF can effectively hedge future foreign currency payments or receipts:
Expect need for 100M Chilean pesos.
Negotiate an NDF to buy 100M Chilean pesos on Jul 1. Reference index (closing rate quoted by Chile’s central bank) = $.0020/peso.
April 1
Buy 100M Chilean pesos from market.
July 1
Index = $.0023/peso  receive $30,000 from bank due to NDF.
Index = $.0018/peso  pay $20,000 to bank.

16. Currency Futures
Currency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date.
They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements.

17. Currency Futures
The contracts can be traded by firms or individuals through brokers on the trading floor of an exchange (e.g. Chicago Mercantile Exchange), automated trading systems (e.g. GLOBEX), or the over-the-counter market.
Brokers who fulfill orders to buy or sell futures contracts typically charge a commission.

18. Foreign Currency Futures
Contract specifications are established by the exchange on which futures are traded.
Major features that are standardized are:
Contract size
Method of stating exchange rates
Maturity date
Last trading day
Collateral and maintenance margins
Settlement
Commissions
Use of a clearinghouse as a counterparty

19. Foreign Currency Futures
Foreign currency futures contracts differ from forward contracts in a number of important ways:
Futures are standardized in terms of size while forwards can be customized
Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less)
Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks
Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward
Futures are rarely delivered upon (settled) while forwards are normally delivered upon (settled)

20. Comparison of the Forward & Futures Markets
Forward Markets Futures Markets
Contract size Customized Standardized
Delivery date Customized Standardized
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.

21. An Option is….
A contract where the buyer has the right, but not the obligation to
Buy/Sell
Specified quantity of a currency
At a specified price (strike price)
By a particular date (expiry date)
For this right, the buyer pays the seller(writer) of the option an upfront fee (called option premium)

22. Forwards  Options
Forwards – most common & and popular derivative instrument for hedging forex exposures.
Offers best protection against adverse exchange rate movements BUT carries risk of opportunity loss in the event of favorable movements.
An Option offers the protection of a forward contract but without its commitment.

23. Options v/s Forwards Options give the buyer a right but no obligation.
Good instrument to hedge adverse price moves & avoiding opportunity loss.
Upfront premium
Can choose the strike price
Forwards are fixed price contracts wherein the buyer/seller is obligated to the price
Opportunity loss
No upfront premium
Cannot choose the price

24. Option Terminologies Call Option:
Gives the holder the right but not the obligation to BUY an underlying at a fixed price from the writer of the option.
Put Option:
Gives the holder the right but not the obligation to SELL an underlying at a fixed price to the writer of the option

25. Two types of option American Option
May be exercised at any time during the life of a contract.
European Option.
May be exercised only at maturity or expiry date.

26. Options - specifications
Strike Price or Exercise price
The fixed price at which the option holder has the right to buy or sell the underlying currency.
Expiry Date
The last day on which the option may be exercised.
Life or Exercise Period
The period of time during which the option holder enjoys the purchased option contracts.

27. Advantage of Option over Forwards
Forward Contract
On April 01, importer A buys USD forward at with an expiry date May 31.
Currency Option
Same day, importer B buys a USD call option, with a strike price of at same expiry on 31st May and pays a premium of 15 paisa. His worst effective rate is now
On May 31
USD/INR trades at Importer A buys Dollars at Importer B can ignore the option and buy USD at the current market rate of
His net cost now works out to =

28. Options example… USD imports - due 31st May
Company buys an USD call option with a strike price of when spot rate is
2 business days before the expiry date, the company has to decide whether or not to exercise the option.
So on 29th May at the specified cut-off time, if spot USD is over 43.70, the company will exercise the option and buy USD at 43.70
However, if spot rate is less than 43.70, then the company can let the option lapse and instead fix the spot rate for the transaction on 29th May.

29. Options example… USD exports - due 31st May
Company buys an USD put option with a strike price of when spot rate is
2 business days before the expiry date, the company has to decide whether or not exercise the option.
So on 29th May at the specified cut-off time, if spot USD is below 43.70, the company will exercise the option and Sell USD at 43.70
However, if spot rate is more than 43.70, then the company can let the option lapse and instead fix the spot rate for the transaction on 29th May.

30. Risk / Profit Profile Buyer Seller Profit Unlimited Premium
Risk Premium Unlimited

31. Option strike price In the money (ITM)
The option is In the Money when the Strike Price is favourable to the option holder(buyer) than the current forward rate.
Eg: USD put option with strike – current fwd rate – option in the money
Out of the money (OTM)
The option is Out of the Money when the Strike Price is unfavourable to the option holder(/buyer) than the current forward rate.
Eg: USD call option with strike – current fwd rate – option out of the money
At the money (ATM)
The option is At the Money when the Strike Price is equal to the current forward rate.

32. Option, Forwards & Open Position
A call option will outperform a forward contract when spot rate at maturity plus option premium is less than the forward rate.
A put option will outperform a forward contract when spot rate at maturity less the option premium is greater than the forward rate.
As to unhedged positions, a call option will be better than an unhedged position only if the strike price plus premium is less than the spot at maturity.
Likewise, a put option will be better than an unhedged position only if the strike price less the option premium is greater than the spot at maturity.

33. Price of an Option Can the Option buyer have the cake & eat it too?
Not really - since the option seller charges the buyer an upfront premium payable in cash.
And the upfront premium can be as high as 1% or even more depending on the strike price and the maturity period.

34. Why Option Premium?
An option buyer never loses money with reference to the strike price but may make or save money.
The option seller is in an opposite position – he can have windfall losses.
Based on the probability distribution of spot prices at maturity, there is an ‘expected’ gain or profit to the buyer.
This is charged as upfront premium.
Option seller – always incurs a loss, while he hedges his short option position using mathematical hedging techniques
The loss is recovered by way of the upfront premium.

35. Option premium - Quotations
Points of the second currency/terms currency or
Premiums are quoted as a flat percentage of the base currency Principal amount
Example:
USD/INR put 1m $
USD/INR strike price = 43.90
Premium quoted as 0.33 INR
Or 0.33*1,000,000 = 3,30,000 INR
330,000 INR = 7,569 $ (330,000/43.60 spot)
7,569 $ is 0.75% of 1m $ principal

36. Factors determining Premium value
Volatility
Strike Price
Life or Exercise Period
Interest Rates - domestic & foreign
Current Market Rate

37. Volatility – historic v/s implied
Volatility is defined as the standard deviation over the mean on the returns on prices.
Historic volatility is the volatility calculated using a set of historical data (usually the set of data corresponds to the period of the option).
Implied volatility is the market expectation of future volatility.
Traders in the option market quote the option premium, which is then used as an input in the Black & Scholes option pricing formula to calculate the implied volatility.
Research has proved that option trading affects the volatility of the underlying market, causing a reduction in most cases.

38. Change in premium with change in volatility

39. Strike Price Dynamics
The option premium can be quite high for ATM options.
Is there a way to reduce the premium ?
There is one golden rule. You can’t get anything in the market for free.
So to reduce the premium, you have to give up some protection.
To reduce the premium, you have to raise the strike price and consider buying an OTM option thereby giving up some protection. The more OTM the option is, the lower will be the premium. Conversely, the more ITM an option is, the higher will be the premium.

40. Strike Price
The more otm the option is, the lower will be the premium. Conversely, the more itm an option is, the higher will be the premium. For eg: USD/INR Spot = 43.50
It is seen that the reduction in premium is less than the protection sacrificed.

41. Choosing the right strike price
USD/INR spot = 43.50; 6 months ATM = 43.86
Worst case rate = 43.35
You have USD exports
Fix the worst case rate (WCR)
Bearish on Rupee
You buy an OTM Put with lowest strike so that the strike minus premium is above WCR
Strike = Premium = WCR = Strike - Premium = 43.35
Bullish on Rupee
You buy ATM USD Put
Strike = Premium = 0.41, WCR= Strike - Premium = 43.45, which is more than (WCR)

42. Comparison between Strike Price & WCR Pay off Profile
X axis - Spot at maturity
Y axis - Effective rate
Strike > premium > WCR > If bearish on Rupee.
Strike > premium > WCR > If bullish on Rupee.

43. Option Strategies

44. Long USD Call Option Profit 43.90 Loss Profit Unlimited Loss Area
Strike Price
Price of underlying (USD/INR)
43.90
Loss Area
Break-even price
Cost of Premium
= 44.35
Loss

45. Short USD Call Option Profit 43.90 Loss Loss Unlimited
Break-even price
= 44.35
Premium Income or Profit
Price of underlying USD/INR
43.90
Loss Unlimited
Strike Price
Loss

46. Long USD Put Option Profit unlimited 43.90 Loss 43.90 - 0.45 = 43.45
Break-even price
Price of underlying USD/INR
Cost of Premium
Strike Price
43.90
Loss

47. Short USD Put Option Profit 43.90 Loss Loss Unlimited
= 43.45
Break-even price
Premium Income or Profit
Price of underlying
Loss Unlimited
Strike Price
43.90
Loss

48. Indian Scenario
In the pre-liberalization era, the insular economic environment felt no scope for the derivative market to develop.
Indian corporate depended on term lending institutions for their project financing & commercial banks for working Capital.
Forward contract was the only derivative product to hedge financial risk.
Post-liberalization India saw developments in the instrument – forward contract.
Corporate was allowed to cancel & rebook forward contracts.

49. Why Rupee options?
Rupee options would enable an Indian corporate to hedge against downside risk on FC/INR while retaining the upside, by paying a premium upfront – better competitiveness.
Hedge against uncertainty of cash flows – due to NON LINEAR payoff of option – for eg. – Indian company bidding for an international contract – bid quote in Dollars but cost in Rupees – Risk of USD/INR falling till the contract is awarded – forwards will bind the company even if the overseas contract not allotted – Option contract will freeze the liability only to the option premium paid upfront.
Attract more forex investment due to availability of another mechanism for hedging forex risk.

50. Rupee options – why now? RBI’s earlier concerns
Poor risk management skills at banks, who would be selling options to customers
Options market may impact the spot rupee
Current considerations
Increasing volatility in the rupee makes it difficult for corporates to manage risk
Exchange rate policy appears looser; strong reserves provides comfort
Option use is getting more commonplace

51. Issues in pricing
Different banks will use different pricing models, although FEDAI is already polling banks for implied volatility, which will be available on their web-site
Spread between theoretical price and quoted price can be quite high
Need to shop around

52. Your Portfolio USD/INR Spot – 43.50 6 month fwd rate – 43.86
You are an importer
Worst Case Rate (WCR) – 44.40
6 month USD/INR volatility – 3% / 3.5%
Diff based on Risk free rate – 1.65%

53. Low Cost Option Strategies
An option buyer can reduce his premium cost by selling another option. The combination can reduce the cost as the premium received on the option sold could either partially or fully offset the cost of option bought.
Different Strategies:
Range Forward
Participating Forward
Seagull
Leveraged forward

54. Zero Cost Range Forward (RF)
Range Forward - involves buying an out of the money call/put option with the worst case rate as the strike price and selling an out of the money put/call option with such a strike price (best case rate) that the net premium is zero
If price at maturity is beyond the ‘wcr’ the bought option will be exercised
If the price at maturity is beyond ‘bcr’ the sold option will be exercised
If price at maturity is between the ‘wcr’ & ‘bcr’ you buy or sell at spot
Although entry is painless, exit could be painful

55. Buy USD Call at 44.40, Sell USD Put at 43.50

56. Participating Forward (PF)
Participating forward - involves buying an out of the money call/ put option with the worst case rate as the strike price and selling an in the money put/call option for a reduced amount and with the same strike price so that the net premium is zero
In effect there is a synthetic OTM forward contract for the amount of the ITM option sold and a free OTM option for the balance amount

58. Seagull (S)
Involves buying an out of the money call/put option (A) and selling an out of the money put/call option (B) & also selling a far-of-the-money call/put option (C ) so that the net premium of the whole portfolio is zero
If price at maturity is between the strikes of (A) and (C), only (A) will be exercised
If the price at maturity is beyond the strike of (B), only (B) will be exercised
If the price at maturity is beyond the strike of (C), both (A) and (C) will be exercised.
If price at maturity is between the strikes of (A) & (B) you buy or sell at spot
This a a variant of the range forward as a far-out-of-the-money call/put is sold with the range forward to improve the best case rate or the strike of (B).

60. Leveraged Forward (PF)
Leveraged forward - involves buying an in the money call/ put option and selling an out of the money put/call option for an increased amount and with the same strike price so that the net premium is zero
In effect there is a synthetic in the money forward contract for the full amt with a leveraged loss beyond the synthetic ITM forward rate (strike price).

62. Rupee Options – Product specifications
Vanilla European options & combinations thereof at introduction. This will continue till banks have sophisticated systems & risk management frameworks to hedge this new non-linear product.
Over the counter contracts.
Can be tailored to suit the corporate’s need.
FC-INR – where foreign currency may be the ccy desired by the corporate.
No minimum amt recommended by RBI.
Premium payable on spot basis.

63. Rupee Options – Product specifications..
Settlement would be either by delivery on spot basis or net cash settlement in Rupees on Spot basis, depending on the FC-INR spot rate on maturity date. (specs will be specified in the contract) – RBI reference rate could be the reference rate for settlement.
Strike Price & Maturity could be tailored to suit counterparties’ needs – typical maturities are 1 week, 2weeks, 1, 2, 3, 6, 9 & 12 months.
Exercise style: European.

64. Uses of Rupee options
To hedge genuine FX exposures arising out of trade/business (Banks may book transactions based on estimated exposure for uncertain amounts)
To hedge FC loans.
To hedge GDR after the issue price is finalised.
Balance in EEFC accounts.
Special cases & contingent exposures.
Derived FX exposure viz FX exposure generated due to a asset/liability coupon &/or P+I swap.

65. One hedge for one exposure
Only one hedge may be booked against a particular exposure for a given time period.
For eg – Exporter with USD receivables after 6 months, can sell a forward for 3 month & after 3 month square the forward & book an option for another 3 months.
But the exporter cannot book a forward & an option for the same exposure at the same time.

66. Hedging Rupee Options
Authorized dealers to be allowed to hedge options by accessing the spot market.
Extent & frequency to be decided by dealers.
ADs to be allowed to hedge “Greeks” using options.

67. Clients as net receivers of premium
Earlier clients could not receive net premium.
Now large corporates with aggressive treasury operations have been allowed to receive net premium as the market matures.
They can buy as well sell option contracts.

68. Barrier options These are two types of barriers in options:
- Knock in barrier
- Knock out barrier
These can be single barrier or double barrier options
Barriers are American in nature
Main advantage is smaller upfront premium compared to Plain Vanilla option with same strike price

69. Barrier Options
A barrier option, also known as knock out option, is a type of financial option where the option to exercise depends on the underlying crossing or reaching a given barrier level.
Barrier options were created to provide the insurance value of an option without charging as much premium.
For example, if you believe that US Dollar will go up this year, but are willing to bet that it won't go above Rs45, then you can buy the barrier and pay less premium than the vanilla option.

70. Barrier Options
Barrier options are path-dependent exotics that are similar in some ways to ordinary options.
There are put and call, as well as European and American varieties.
But they become activated or, on the contrary, null and void only if the underlying reaches a predetermined level (barrier).

71. In and Out
"In" options start their lives worthless and only become active in the event a predetermined knock-in barrier price is breached.
"Out" options start their lives active and become null and void in the event a certain knock-out barrier price is breached.
In either case, if the option expires inactive, then there may be a cash rebate paid out.
This could be nothing, in which case the option ends up worthless, or it could be some fraction of the premium.

72. Four main types of barrier options
Up-and-out: spot price starts below the barrier level and has to move up for the option to be knocked out.
Down-and-out: spot price starts above the barrier level and has to move down for the option to become null and void.
Up-and-in: spot price starts below the barrier level and has to move up for the option to become activated.
Down-and-in: spot price starts above the barrier level and has to move down for the option to become activated.

73. Barrier Options (Example)
A European call option may be written on an underlying with spot price of $100, and a knockout barrier of $120.
This option behaves in every way like a vanilla European call, except if the spot price ever moves above $120, the option "knocks out" and the contract is null and void.
Note that the option does not reactivate if the spot price falls below $120 again. Once it is out, it's out for good.

74. Knock out barrier options
Knock out options get knocked out (dead or cease to exist) only when the spot rate hits the specified barrier or either of the two barriers.
There are two kinds of knock out barriers in India:
- Up and out knock out
- Down and out knock out

75. Knock in barrier options
Knock in options get knocked in (come alive) only when the spot rate hits the specified barrier or either of the two barriers.
There are two kinds of knock in barriers:
- Up and in knock in
- Down and in knock in
Knock out + Knock in options with same strike & barriers equals plain vanilla option.

76. Euro import portfolio You have Euro imports EUR/USD Spot – 1.2870
Worst case rate – 1.31
Time – 6 months
6M Forward rate –
Volatility – 9.5% / 10%
6M USD Libor – 2.99%
6M Euro Libor – 2.19%

77. Smart Forward (SF) Zero cost exotic hedge
Plain ‘out of the money’ option as long as a specified ‘in the money’ trigger is not hit
Option gets transformed into a ‘out of the money’ synthetic forward contract if the trigger is hit
If the market view turns out to be wrong, there can be an opportunity loss, and
The SMART FORWARD becomes a DUMB BACKWARD

78. Buy Euro Call at 1.31, Sell Euro Put at 1.31
with KI at

79. Choice Forward (CF) Zero cost exotic hedge
Involves buying an in-the-money option with two knock out barriers.
Also simultaneously buying an out-of-money option with the same two knock in barriers – (A)
Also selling in-the-money option with same two knock in barriers – (B)
(A) & (B) put together constitute an out-of-money, double knock-in, synthetic, forward contract

80. Buy Euro Call at 1.27 with KO at 1.38 & 1.20, Sell Euro Put at 1.31
with KI at 1.38 & 1.20, Buy Euro Call at 1.31 with KI at 1.38 and 1.20