Deutsche Bank Derivaties

1.Derivatives

Firms are exposed to several risks in the ordinary course of operations and when borrowing funds

For some risks, management can obtain protection from an insurance company

Similarly, there are capital market products available to protect against certain risks.Such risks include risks associated with a rise in the price of commodity purchased as an input, a decline in a commodity price of a product the firm sells, a rise in the cost of borrowing funds and an adverse exchange rate movement.The instruments that can be used to provide such protection are calledderivative instruments

Derivative instruments are called so because they derive their value from whatever the contract is based on

A derivative contract is a financial instrument whose payoff structure is derived from the value of the underlying asset

These instruments include futures contracts, forward contracts, options contracts, swap agreements, and cap and floor agreements

Example: You [along with two friends] want to go for the Aero India 2007 air show, for which tickets are sold out.Through one of your close friends, you obtain a recommendation letter, which will enable you to buy three tickets.The price of a ticket is Rs 1,000.Is this letter a derivative instrument?

The letter is a derivative instrument.It gives you a right to buy the ticket

The underlying asset is the ticket

The letter does not constitute ownership of the ticket

It is instead a promise to convey ownership

The value of the letter changes with changes in the price of the ticket.It derives its value from the value of the ticket

Case 1

You have imported machinery for $ 100,000 on 180 days credit at zero interest.The dollar quotes at Rs 40.Is this deal risk free?

This deal is not free of risk because after six months when you pay the loan, if the dollar quotes anything more than Rs 40, say Rs 45, you will end up paying more [Rs 5 extra for every $ 1, which is equivalent to Rs 500,000 additional cost].On the other hand, if the dollar quotes anything less than Rs 40, you will stand to gain

The question here is not whether you stand to gain or loose it is theriskyou are taking

Forward Contract

You can protect your risk in this case if you can freeze the price at which you will buy dollars six months from today [specified future date]

If you enter into a contract today [on Day 1] to buy dollars at Rs 43 on the specified future date, you are certain of the cash outflow for you and the amount that should be paid by you

In case on the specified date, the dollar quotes at Rs 45 instead of Rs 43, you will be saving Rs 2 on every $ 1 [ie Rs 200,000]

Such a deal, where you freeze today, the price that you will pay tomorrow is called aforward contract

Futures Contract

There is no guarantee that on the specified future date, you will keep your part of the bargain, ie buy dollars from the bank at the agreed rate

There is also no guarantee that on the specified future date, the bank will keep its part of the bargain, ie it would sell dollars to you at the agreed rate

If you can develop a mechanism by which performance of the contract can be assured, you would have an instrument far superior to that of a forward contract

Such a standardised instrument, which is traded on an exchange and under which both parties are obliged to perform and there is no risk of default, is called afutures contract

Options Contract

In a forward contract, you have to buy $ 1 at Rs 43 on the specified future date

If on the specified future date, the dollar quotes at Rs 42, you will be losing Re 1 on every $ 1 you buy [ie Rs 100,000]

Hence, if there is a legal mechanism by which you can elect not to buy at Rs 43, you will be at an advantage

Such a contract where you have anoptionto buy $ 1 at Rs 43 is calledan options contract

Case 2

You have surplus cash for investment.You think of investing in Wipro, currently quoting at Rs 3,500, which you believe will rise to Rs 3,950 in six months. Is this deal risk free?

This deal is not free of risk because there is no guarantee that Wipros shares would touch Rs 3,950 in six months time.

The share prices could rise beyond Rs 3,950 or could also fall below Rs 3,500 giving you no return on investment and you could stand to loose some portion of your investment

Case 3

You are the purchasing manager of a company.You decide to buy a raw material in bulk because it is available at a good discount.You decide to purchase the raw material in anticipation of a sales order. Is this purchase risk free?

Though you are quite sure that you will get the sales order, there is uncertainty about the selling price at which it would be executed.

How do you cover your risk in each of the above three cases?

Different players, different strokes there are different players in the derivative markets, who are there because they have different objectives

Hedgers: The hedgers are there because they want to protect themselves against adverse price movements

Speculators: Speculators take risks in order to make profits from price fluctuations

Arbitrageur: An arbitrageur looks for opportunities where the same product is available in two different markets at two different prices

The derivative market helps people meet diverse objectives such as:

Hedging

Profit making through price changes

Profit making through arbitrage

Price discovery

The more informed players play in the derivative market because of low transaction cost and consequential high returns.

Most price changes are first reflected in the derivative market.That way derivative market feeds the spot market

For instance, if the call premiums are going up, it means that the professional investors are expecting prices to rise in the future this is a good sign for you to buy in the spot market

Risk transfer

A derivative market is like an insurance company

Derivative instruments redistribute the risk amongst market players

However, if you want protection against adverse price movements, you must pay a price, ie the premium

Burning of fossil fuels is a major source of industrial greenhouse gas emissions, especially for power, cement, steel, textile, and fertilizer industries. The major greenhouse gases emitted by these industries are carbon dioxide, methane, nitrous oxide, hydrofluorocarbons (HFCs), etc, which all increase the atmosphere's ability to trap infrared energy and thus affect the climate.

The concept of carbon credits came into existence as a result of increasing awareness of the need for controlling emissions. The IPCC has observed[2] that:

Policies that provide a real or implicit price of carbon could create incentives for producers and consumers to significantly invest in low-GHG products, technologies and processes. Such policies could include economic instruments, government funding and regulation,

while noting that a tradable permit system is one of the policy instruments that has been shown to be environmentally effective in the industrial sector, as long as there are reasonable levels of predictability over the initial allocation mechanism and long-term price.

The mechanism was formalized in the Kyoto Protocol, an international agreement between more than 170 countries, and the market mechanisms were agreed through the subsequent Marrakesh Accords[3]. The mechanism adopted was similar to the successful US Acid Rain Program to reduce some industrial pollutants.

The Protocol agreed 'caps' or quotas on the maximum amount of Greenhouse gases for developed and developing countries, listed in its Annex I [4]. In turn these countries set quotas on the emissions of installations run by local business and other organisations, generically termed 'operators'. Countries manage this through their own national 'registries', which are required to be validated and monitored for compliance by the UNFCCC[5]. Each operator has an allowance of credits, where each unit gives the owner the right to emit one metric tonne of carbon dioxide or other equivalent greenhouse gas. Operators that have not used up their quotas can sell their unused allowances as carbon credits, while businesses that are about to exceed their quotas can buy the extra allowances as credits, privately or on the open market. As demand for energy grows over time, the total emissions must still stay within the cap, but it allows industry some flexibility and predictability in its planning to accommodate this.

By permitting allowances to be bought and sold, an operator can seek out the most cost-effective way of reducing its emissions, either by investing in 'cleaner' machinery and practices or by purchasing emissions from another operator who already has excess 'capacity'.

Since 2005, the Kyoto mechanism has been adopted for CO2 trading by all the countries within the European Union under its European Trading Scheme (EU ETS) with the European Commission as its validating authority[6]. From 2008, EU participants must link with the other developed countries who ratified Annex I of the protocol, and trade the six most significant anthropogenic greenhouse gases. In the United States, which has not ratified Kyoto, and Australia, whose recent ratification comes into force in March 2008, similar schemes are being considered.

A credit can be an emissions allowance which was originally allocated or auctioned by the national administrators of a cap-and-trade program, or it can be an offset of emissions. Such offsetting and mitigating activities can occur in any developing country which has ratified the Kyoto Protocol, and has a national agreement in place to validate its carbon project through one of the UNFCCC's approved mechanisms. Once approved, these units are termed Certified Emission Reductions, or CERs. The Protocol allows these projects to be constructed and credited in advance of the Kyoto trading period.

The Kyoto Protocol provides for three mechanisms that enable countries or operators in developed countries to acquire greenhouse gas reduction credits[7]

* Under Joint Implementation (JI) a developed country with relatively high costs of domestic greenhouse reduction would set up a project in another developed country.

* Under the Clean Development Mechanism (CDM) a developed country can 'sponsor' a greenhouse gas reduction project in a developing country where the cost of greenhouse gas reduction project activities is usually much lower, but the atmospheric effect is globally equivalent. The developed country would be given credits for meeting its emission reduction targets, while the developing country would receive the capital investment and clean technology or beneficial change in land use.

* Under International Emissions Trading (IET) countries can trade in the international carbon credit market to cover their shortfall in allowances. Countries with surplus credits can sell them to countries with capped emission commitments under the Kyoto Protocol.

These carbon projects can be created by a national government or by an operator within the country. In reality, most of the transactions are not performed by national governments directly, but by operators who have been set quotas by their country.

[Emission markets

For trading purposes, one allowance or CER is considered equivalent to one metric tonne of CO2 emissions. These allowances can be sold privately or in the international market at the prevailing market price. These trade and settle internationally and hence allow allowances to be transferred between countries. Each international transfer is validated by the UNFCCC. Each transfer of ownership within the European Union is additionally validated by the European Commission.

Climate exchanges have been established to provide a spot market in allowances, as well as futures and options market to help discover a market price and maintain liquidity. Carbon prices are normally quoted in Euros per tonne of carbon dioxide or its equivalent (CO2e). Other greenhouse gasses can also be traded, but are quoted as standard multiples of carbon dioxide with respect to their global warming potential. These features reduce the quota's financial impact on business, while ensuring that the quotas are met at a national and international level.

Currently there are at least four exchanges trading in carbon allowances: the Chicago Climate Exchange, European Climate Exchange, Nord Pool, and PowerNext. Recently, NordPool listed a contract to trade offsets generated by a CDM carbon project called Certified Emission Reductions (CERs). Many companies now engage in emissions abatement, offsetting, and sequestration programs to generate credits that can be sold on.

Managing emissions is one of the fastest-growing segments in financial services in the City of London with a market now worth about 30 billion, but which could grow to 1 trillion within a decade. Louis Redshaw, head of environmental markets at Barclays Capital predicts that "Carbon will be the world's biggest commodity market, and it could become the world's biggest market overall." [8]

Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. Emissions become an internal cost of doing business and are visible on the balance sheet alongside raw materials and other liabilities or assets.

By way of example, consider a business that owns a factory putting out 100,000 tonnes of greenhouse gas emissions in a year. Its government is an Annex I country that enacts a law to limit the emissions that the business can produce. So the factory is given a quota of say 80,000 tonnes per year. The factory either reduces its emissions to 80,000 tonnes or is required to purchase carbon credits to offset the excess.

After costing up alternatives the business may decide that it is uneconomical or infeasible to invest in new machinery for that year. Instead it may choose to buy carbon credits on the open market from organizations that have been approved as being able to sell legitimate carbon credits.

* One seller might be a company that will offer to offset emissions through a project in the developing world, such as recovering methane from a swine farm to feed a power station that previously would use fossil fuel. So although the factory continues to emit gases, it would pay another group to reduce the equivalent of 20,000 tonnes of carbon dioxide emissions from the atmosphere for that year.

* Another seller may have already invested in new low-emission machinery and have a surplus of allowances as a result. The factory could make up for its emissions by buying 20,000 tonnes of allowances from them. The cost of the seller's new machinery would be subsidized by the sale of allowances. Both the buyer and the seller would submit accounts for their emissions to prove that their allowances were met correctly.

Features of a Forward Contract

Unique

Performance Obligation

Price risk is eliminated

No margins

Default risk

Illiquid

How is forward price determined

The forward price is the delivery price which would render a zero value to the contract on the date of settlement of the forward contract

In other words, the forward price is equal to the estimated spot price on the date of settlement of the forward contract

If on the date of the settlement of the forward contract, the spot price is different from the delivery price, there would be a gain or loss to the two parties this is referred to aspay off

A futures contract is a standardized contract between two parties where one of the parties commits to sell and the other commits to buy, a specified quantity of a specified asset at an agreed price on a given date in the future

Features of a Futures Contract

Standardisation

Quantity

Quality

Date and month of delivery

Units of price quote

Deal with the clearing house guarantees performance

Mark to market margin [profits and losses are settled on a day-to-day basis

What is a stock index futures contract? Stock index futures are traded in terms of number of contracts. Each contract is to buy or sell a fixed value of the index. The value of the index is defined as the value of the index multiplied by the specified monetary amount

Trading in stock index futures contracts was introduced by the Kansas City Board of Trade on February 24, 1982

In April 1982, the Chicago Mercantile Exchange (CME) began trading in futures contract based on the Standard and Poor's Index of 500 common stocks. The introduction of both contracts was successful, especially the S&P 500 futures contract, adopted by most institutional investors

Like most other financial instruments, futures contracts are traded on recognised exchanges

In India, both the NSE and the BSE have introduced index futures in the S&P CNX Nifty and the BSE Sensex. The operations are similar to that of the stock market, the exception being that, in index futures, the marking-to-market principle is followed, that is, the portfolios are adjusted to the market values on a daily basis

Depending on the position of the portfolio, margins are forced upon investors

The other important aspect of index futures is that the contracts are settled on a cash basis. This means it is impossible to make actual delivery of the index. The difference between the cash and the futures index on the date of settlement is the profit/loss for the players

In some cases, the introduction of the index futures has actually reduced the volatility in the underlying index

Technical analysts thrive on their ability to predict the movement of the broad market indices. However, as they cannot trade the index, the normal practice is to try to capture a relation between the index and individual stocks.The introduction of the futures contract on stock indices gives them the opportunity to actually buy into the components of the index

The other important use of stock index futures is for hedging. Mutual funds and other institutional investors are the main beneficiaries. Hedging is a technique by which such institutions can protect their portfolios from market risks.

There are three different views on the nature and purpose of hedging:

Risk minimisation

Profit maximisation

Reaching a satisfactory risk-return trade-off using a portfolio

Historically, stock index futures have supplemented, and often replaced, the secondary stock market as a stock price discovery mechanism. The futures market has heralded institutional participation in the market with increased velocity and concentration on stock-trading

Programme-trading and index arbitrage are necessary for an efficient and thriving futures market. However, on the flip side, these strategies have increased the risks associated with stock specialists. The increased concentration, the velocity of futures trading, and the resultant increase in volatility in the stock market, may have a long-term impact on the participation of individual investors in the market

However, index futures provide investors an efficient and cost-effective means of hedging and significant improvements in market timing. The introduction of index futures need not necessarily be bad for the capital market, so long as proper checks are in place to prevent unwarranted speculation

AnInterest Rate Futureis a futures contract with aninterest-bearinginstrument as the underlying asset

Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures

It is simple to comprehend that futures contracts on interest rates would be called interest rate futures

Introduction of Interest Rate Futures in India is an excellent example of collaborative efforts on the part of market participants, exchanges and regulators. It is a great addition to the existing portfolio of financial products in the Indian Financial Markets

Basis Risk

Hedging eliminates price risk but opens up a second risk called Basis risk

Basis refers to the difference between the spot price and futures price

Basis risk is the possibility that the basis will change over time

Counterparty Risk

The parties in a forward contract are exposed to credit risk because either party may default on the obligation

The risk that the counterparty may default is referred to ascounterparty risk

In a futures contract, the clearing corporation/ house bears the counterparty risk

Liquidity Risk

There can be no assurance that, at all times, a liquid market will exist for offsetting a futures contract that you have previously bought or sold. This could be the case, if a futures price has increased or decreased by the maximum allowable daily limit and there is no one presently willing to buy the futures contract you want to sell or sell the futures contract you want to buy

Even on a day-to-day basis, some contracts and some delivery months tend to be more actively traded and liquid than others. Two useful indicators of liquidity are the volume of trading and the open interest (the number of open futures positions still remaining to be liquidated by an offsetting trade or satisfied by delivery). These figures are usually reported in newspapers that carry futures quotations. The information is also available from your broker or advisor and from online market reporting services and exchange web sites

The rules for valuation of futures is based on:

Principle of continuous compounding

Short selling

It refers to a technique of selling a stock you dont own and buying it back later

Typically used in a falling market

Since, you dont have shares now, your brokers borrows shares on your behalf and delivers them.This is called stock lending.

When a position is taken in a futures contract, the investor must deposit a minimum amount per contract as specified by the exchange this is called theinitial margin

The initial margin may be in the form of interest-bearing security

As the price of the futures contract fluctuates, the value of the investors equity in the position changes.At the end of each trading day, the exchange determines the settlement price for the futures contract and any gain/ loss is reflected in the investors account.This is known asmarking to market

Maintenance marginis the minimum level [specified by the exchange] by which an investors equity position may fall as a result of an unfavourable price movement before the investor is required to deposit additional margin

The additional margin deposited is calledvariation margin usually in the form of cash [not interest-bearing security]

Mr Brave gave a loan to Mr Y amounting to Rs 100,000 with continuous compounding interest rate of 12% p.a. for 3 months.What is the maturity value

X Ltd, a company that historically has not paid any dividend and has no plans to do so in the future, is currently quoted at BSE at Rs 60.You wish to enter into a futures contract on this stock maturing in 3 months time.

If the risk free rate of return of 8% p.a. continuously compounded what do you expect the futures price to be?

If the futures contract were priced at Rs 64, what action would you take?

In case it is priced at Rs 61 will your decision change?

ABC Ltd is quoted in the market at Rs 40.A 6-month futures contract on 100 shares of ABC Ltd can be bought.The risk free rate of return of 12% p.a. continuously compounded.ABC Ltd is certain to pay a dividend of Rs 2.5 per share 3 months from now.

What should be the value of the futures contract?

If the futures contract were priced at Rs 4,100, what action would you take?

In case it is priced at Rs 3,800 will your decision change?

Consider the following data relating to KM stock.KM has a beta of 0.7 with Nifty.Each Nifty contract is equal to 200 units.KM now quotes at Rs 150 and the Nifty futures is 1400 Index points.You are long on 1200 shares of KM in the spot market.

How many futures contracts will you have to take?

Suppose the price in the spot market drops by 10%, how are you protected?

Suppose the price in the spot market jumps by 5%, what happens?

Consider the following example.A company has three stocks A, B and C, which it hold in the proportion of 0.5, 0.25 and 0.25.Their respective betas are 1.6, 2 and 0.8.The risk of the portfolio is therefore weighted average beta which in this case is 1.5.This portfolio is riskier than the stock market by 50%.If Nifty futures is 1700 and are in multiples of 50, we can decrease the portfolio risk to 1.2 or increase it to 1.68.See how.

As prescribed by SEBI vide its Circulars regarding the eligibility criteria for introducing Futures and Options Contracts on stocks and indices, the following eligibility criteria would be applied with effect from September 22, 2006, to determine the eligibility of stocks and indices on which Futures and Options contract could be introduced for trading in Derivatives:

The stocks would be chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six-month on a rolling basis

For a stock to be eligible, the median quarter-sigma order size over the last six months should not be less than Rs 1 lakh (Rs 0.01 Million).For this purpose, a stock's quarter sigma order size shall mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation

The Market Wide Position Limit in the Stock shall not be less than Rs 50 crores (Rs 500 Million).The Market Wide Position Limit is valued taking into consideration 20% of number of shares held by the Non Promoters (i.e free-float holding) in the relevant underlying Security (ie free-float holding) and the closing prices of the stock in the underlying cash market on the date of expiry of contract in the month.Market Wide Position Limit is calculated at the end of every month

The methodology used for calculating quarter sigma order size is as follows:

Quarter sigma order size would be calculated taking four snapshots in a day from the order book of the stock in the past six months

The sigma (standard deviation) or volatility estimate would be calculated in the manner specified by Prof. J. R. Varma Committee on risk containment measures for Index Futures. This daily closing volatility estimate value would be applied to the day's order book snapshots to compute the order size

The quarter sigma percentage would be applied to the average of the best bid and offer price in the order book snapshot to compute the order size to move price of the stock by quarter sigma

The median order size to cause quarter sigma price movement shall be determined separately for the buy side and the sell side. The average of the median order size for the buy and the sell side is taken as the median quarter sigma order size

The quarter sigma order size in stock shall be calculated on the 15th of each month, on a rolling basis, considering the order book snapshots in the previous six months. Similarly, the average daily market capitalization and the average daily traded value shall also be computed on the 15th of each month, on a rolling basis, to arrive at the list of top 500 stocks

Eligibility criteria for unlisted companies coming out with IPO

For unlisted companies coming out with initial public offering, if the net public offer is Rs. 500 crores (Rs 5 Billion) or more, then the exchange may consider introducing stock options and stock futures on such stocks at the time of its listing in the cash market

Eligibility criteria for stocks on account of corporate restructuring:

All the following conditions should be met in the case of shares of a company undergoing restructuring through any means for eligibility to re-introduce derivative contracts on that company from the first day of listing of the post restructured company in the underlying market:

The Futures and Options contracts on the stock of the original (pre-restructure) company were traded on any exchange prior to its restructuring

The pre restructured company had a market capitalization of at least Rs. 1000 crores (Rs 10 Billion) prior to restructuring

The post restructure company would be treated like a new stock and if it is, in the opinion of the exchange, likely to be at least one third of the size of the pre structuring company in terms of revenues or assets or analyst valuations

In the opinion of the exchange, the scheme of restructuring does not suggest that the post restructured company would have any characteristic that would render the company ineligible for derivatives trading

If the post restructured company comes out with an Initial Public Offering (IPO), then the same prescribed criteria as currently applicable for introduction of derivatives on a company coming out with an IPO is applied for introduction of derivatives on stocks of the post restructured company from its first day of listing

Discontinuance / Exit of Futures & Options Contracts on stocks

No fresh month contracts shall be issued on stocks under the following instances

If a stock does not conform to the above eligibility criteria for a consecutive period of three months, no fresh month contracts shall be issued on the same

If the stock remains in the banned position [as per SEBIs Circular], for a significant part of the month, consistently for three months, then no fresh month contracts shall be issued on those scrips

The exit criteria shall be more flexible as compared to entry criteria in order to prevent frequent entry and exit of stocks in the derivatives segment. Therefore, for a stock to become ineligible, the criteria for market wide position limit shall be relaxed upto 10% of the criteria applicable for the stock to become eligible for derivatives trading. The other eligibility conditions would be applicablemutasmutandis for the stock to become ineligible

If a stock fails to meet the aforesaid eligibility criteria forthree months consecutively , then no fresh month contract shall be issued on that stock

However, the existing unexpired contracts may be permitted to trade till expiry and new strikes may also be introduced in the existing contract months

The Exchange may compulsorily close out all derivative contract positions in a particular underlying when that underlying has ceased to satisfy the eligibility criteria or the exchange is of the view that the continuance of derivative contracts on such underlying is detrimental to the interest of the market keeping in view the market integrity and safety. The decision of such forced closure of derivative contracts shall be taken in consultation with other exchanges where such derivative contracts and are also traded shall be applied uniformly across all exchanges

A stock, which is dropped from derivatives trading, may become eligible once again. In such instances, the stock is required to fulfill the eligibility criteria forthree consecutive months(instead of one month as specified earlier) to be re-introduced for derivatives trading. Derivative contracts on such stocks may be re-introduced by the exchange itself. However, introduction of futures and option contracts on a stock for the first time would continue to be subject to SEBI approval

The Futures Options Contracts on an index can be issued only if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index

The index on which Futures and Options contracts are introduced shall be required to comply with the eligibility criteria on a monthly basis

If the index fails to meet the above eligibility criteria for three months consecutively, then no fresh month contract shall be issued on that Index. However, the existing unexpired contracts shall be permitted to trade till expiry and new strike prices will continue to be introduced in the existing contracts

The above requirements as prescribed by SEBI need to be necessarily met for introduction of Futures and options contracts on underlying stocks of the cash market. However, once the criteria are met, it is at the discretion of the Exchange to apply to SEBI for permission to launch Futures and options contract on the eligible stocks. Once the SEBI approval in respect of those stocks is obtained, the exchange issues a suitable notice to the market, in advance and then introduces Futures and options contracts on the respective stocks

An option is a contract in which thewriter of the optiongrants thebuyer of the optionthe right, but not the obligation, to purchase from or sell to the writer an asset at a specified price within a specified period of time (or at a specified date)

The writer, also referred to as the seller, grants this right to the buyer in exchange for a certain sum of money, which is called the option price or option premium

The price at which the asset may be bought or sold is called the exercise price or strike price

The date after which an option is void is called the expiration date

As with a futures contract, the asset that the buyer has the right to buy and the seller is obligated to sell is referred to as the underlying

When an option grants the buyer the right to purchase the underlying from the writer (seller), it is referred to as acall option , orcall

When the option buyer has the right to sell the underlying to the writer, the option is called aput option , orput

An option is also categorized according to when the option buyer may exercise the option. There are options that may be exercised at any time up to and including the expiration date. Such an option is referred to as anAmerican option

There are options that may be exercised only at the expiration date. An option with this feature is called aEuropean option

An option that can be exercised before the expiration date but only on specified dates is called aBermuda option

The option price is a reflection of the optionsintrinsic valueand any additional amount over its intrinsic value

The premium over intrinsic value is often referred to as thetime premium

Theintrinsic valueof an option is the economic value of the option if it is exercised immediately, except that if there is no positive economic value that will result from exercising it immediately, then the intrinsic value is zero

The intrinsic value of a call option is the difference between the current price of the underlying and the exercise price if positive; it is otherwise zero

When an option has intrinsic value, it is said to be in the money

When the exercise price of a call option exceeds the current price of the underlying, the call option is said to be out of the moneyit has no intrinsic value

An option for which the exercise price is equal to the current price of the underlying is said to be at the money

Both at-the-money and out-of-the-money options have an intrinsic value of zero because it is not profitable to exercise the option

A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments

The rupee amount of the payments exchanged is based on some predetermined rupee principal, which is called the notional principal amount or simply notional amount

The dollar amount each counterparty pays to the other is the agreed-upon periodic rate times the notional amount. The only dollars that are exchanged between the parties are the agreed-upon payments, not the notional amount

A swap is an over-the-counter contract. Hence, the counterparties to a swap are exposed to counterparty risk. The three types of swaps typically used by non-finance corporations are interest rate swaps, currency swaps, and commodity swaps. We illustrate these types of swaps in the ensuing slides

In an interest rate swap, the counterparties swap payments in the same currency based on an interest rate

For example, one of the counterparties can pay a fixed interest rate and the other party a floating interest rate

The floating interest rate is commonly referred to as the reference rate

For example, suppose the counterparties to a swap agreement are Farm Equip Corporation (a manufacturing firm) and PNC Bank. The notional amount of this swap is $100 million and the term of the swap is five years. Every year for the next five years, Farm Equip Corporation agrees to pay PNC Bank 9% per year, while PNC Bank agrees to pay Farm Equip Corporation the one-year London interbank offered rate (LIBOR)

LIBOR is the reference rate. This means that every year, Farm Equip Corporation will pay $9 million (9% of $100 million) to PNC Bank. The amount PNC Bank will pay Farm Equip Corporation depends on LIBOR. For example, one-year LIBOR is 6%, PNC Bank will pay Farm Equip Corporation $6 million (6% times $100 million)

In a currency swap, two parties agree to swap payments based on different currencies

To illustrate a currency swap, suppose two counterparties are the High Quality Electronics Corporation (a U.S. manufacturing firm) and Citibank. The notional amount is $100 million and its Swiss franc (SF) equivalent at the time the contract was entered into is SF 127 million. The swap term is eight years. Every year for the next eight years the U.S. manufacturing firm agrees to pay Citibank Swiss francs equal to 5% of the Swiss franc notional amount, or SF 6.35 million. In turn, Citibank agrees to pay High Quality Electronics 7% of the U.S. notional principal amount of $100 million, or $7 million

Currency swaps are used by corporations to raise funds outside of their home currency and then swap the payments into their home currency

This allows a corporation to eliminate currency risk (ie, unfavorable exchange rate or currency movements) when borrowing outside of its domestic currency

In a commodity swap, the exchange of payments by the counterparties is based on the value of a particular physical commodity

Physical commodities include precious metals, base metals, energy stores (such as natural gas or crude oil), and food (including pork bellies, wheat, and cattle). Most commodity swaps involve oil

For example, suppose that the two counterparties to this swap agreement are Comfort Airlines Company, a commercial airline, and Prebon Energy (an energy broker). The notional amount of the contract is 1 million barrels of crude oil each year and the contract is for three years

Each year for the next three years, Comfort Airlines Company agrees to buy 1 million barrels of crude oil for 99 per barrel. So, each year Comfort Airlines Company pays $99 million to Prebon Energy ($99 per barrel times 1 million barrels) and receives 1 million barrels of crude oil.

The motivation for Comfort Airlines of using the commodity swap is that it allows the company to lock-in a price for 1 million barrels of crude oil at $99per barrel regardless of how high crude oils price increases over the next three years.

If we look carefully at a swap, we can see that it is not a new derivative instrument. Rather, it can be decomposed into a package of derivative instruments that we have already discussed

To see this, consider our first illustrative swap.

Every year for the next five years Farm Equip Corporation agrees to pay PNC Bank 9%, PNC Bank agrees to pay Farm Equip Corporation the reference rate, one-year LIBOR. Since the notional amount is $100 million, Farm Equip Corporation Manufacturing agrees to pay $9 million

Alternatively, we can re-phrase this agreement as follows: Every year for the next five years, PNC Bank agrees to deliver something (one year LIBOR) and to accept payment of $9 million. Looked at in this way, the counterparties are entering into multiple forward contracts: One party is agreeing to deliver something at some time in the future, and the other party is agreeing to accept delivery. The reason we say that there are multiple forward contracts is that the agreement calls for making the exchange each year for the next five years.

While a swap may be nothing more than a package of forward contracts, it is not a redundant contract for several reasons:

First, in many markets where there are forward and futures contracts, the longest maturity does not extend out as far as that of a typical swap

Second, a swap is a more transactionally efficient instrument. By this we mean that in one transaction an entity can effectively establish a payoff equivalent to a package of forward contracts. The forward contracts would each have to be negotiated separately

Third, the liquidity of certain types of swaps has grown since the inception of swaps in 1981; some swaps now are more liquid than many forward contracts, particularly long-dated (ie, long-term) forward contracts

There are agreements available in the financial market whereby one party, for a fee (premium), agrees to compensate the other if a designated reference is different from a predetermined level

The party that will receive payment if the designated reference differs from a pre-determined level and pays a premium to enter into the agreement is called the buyer

The party that agrees to make the payment if the designated reference differs from a predetermined level is called the seller

When the seller agrees to pay the buyer if the designated reference exceeds a predetermined level, the agreement is referred to as acap

The agreement is referred to as afloorwhen the seller agrees to pay the buyer if a designated reference falls below a predetermined level

In a typical cap or floor, the designated reference is either an interest rate or commodity price

The predetermined level is called theexercise value

As with a swap, a cap and a floor have a notional amount

Only the buyer of a cap or a floor is exposed to counterparty risk

In general, the payment made by the seller of the cap to the buyer on a specific date is determined by the relationship between the designated reference and the exercise value

If the former is greater than the latter, then the seller pays the buyer an amount delivered as follows:

Notional amount [Actual value of designated reference Exercise value]

If the designated reference is less than or equal to the exercise value, then the seller pays the buyer nothing

For a floor, the payment made by the seller to the buyer on a specific date is determined as follows. If the designated reference is less than the exercise value, then the seller pays the buyer an amount delivered as follows:

Notional amount [Exercise value Actual value of designated reference]

If the designated reference is greater than or equal to the exercise value, then the seller pays the buyer nothing.

The following example illustrates how a cap works. Suppose that the FPK Bookbinders Company enters into a five-year cap agreement with Fleet Bank with a notional amount of $50 million

The terms of the cap specify that if one-year LIBOR exceeds 8% on December 31 each year for the next five years, Fleet Bank (the seller of the cap) will pay FPK Bookbinders Company the difference between 8% (the exercise value) and LIBOR (the designated reference)

The fee or premium FPK Bookbinders Company agrees to pay Fleet Bank each year is $200,000

The payment made by Fleet Bank to FPK Bookbinders Company on December 31 for the next five years based on LIBOR on that date will be as follows

If one-year LIBOR is greater than 8%, then Fleet Bank pays $50 million [Actual value of LIBOR 8%]. If LIBOR is less than or equal to 8%, then Fleet Bank pays nothing.

So, for example, if LIBOR on December 31 of the first year of the cap is 10%, Fleet Bank pays FPK Bookbinders Company $1 million as shown below:

$50 million [10% 8%] = $1 million

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