Tuesday, June 9, 2015

CAIIB-BFM-CHAP 18-DERIVATIVE PRODUCTS

·         Derivatives always refer to a future price and the value of derivative depends on spot market.
 
·         The derivative products that can be directly negotiated and obtained from banks and investment institutions are known as Over-the-Counter (OTC) products.
 
·         Forward contract is a contract to deliver foreign currency on a future date at a fixed exchange rate. This is a OTC product where the counterparty is always a bank.
 
·         Forward rate, as we stated earlier, represents interest rate differential of the two currencies. The forward rate is either at premium or discount to the spot rate
 
·         Options refer to contracts where the buyer of an option has a right but no obligation to exercise the contract.
 
·         Options are either put options or call options. Call option gives a right to the holder to buy an underlying product (currency/bonds/commodities) at a prefixed rate on a specified future date. Put option gives a similar right to the holder to sell the underlying at a prefixed rate on a specified future date or during a specified period.
 
·         The prefixed rate is known as the strike price. The specified time is known as expiry date.
 
·         In India we use only European type of options wherein option can be exercised only on the expiry date
·         The option is known to be at-the-money (ATM) if the strike price is same as the spot price of the currency.
·         The option is in-the-money (ITM), if the strike price is less than the forward rate in case of a call option, or, if the strike price is more than forward rate in case of a put option.
·         The option is out-of-money (OTM), if the strike price is more than the forward rate in case of a call option, or, if the strike price is less than forward rate in case of a put option.
·         ITM is when the strike price is better than the market price, and OTM is when the strike price is worse than the market price.
·         Intrinsic value of an ITM option is the difference between the strike price and current forward rate of the currency, or zero whichever is less. Intrinsic value cannot be negative.
·         The option price less the intrinsic value is time value of the option.
·         The time value is maximum for an ATM option, and decreases with the option becoming more and more ITM or OTM, as the expiry date approaches.
·         An option without any conditionalities is called plain vanilla option, which is ideal for hedging.
·          A convertible option may give the bond-holder option of converting the debt into equity on specified terms. Such options are called embedded options and have a direct effect on pricing of the bond.
·         An interest rate swap is an exchange of interest flows on an underlying asset or liability, the value of which is the notional amount of the swap.
·         Interest Rate Swap (IRS) is a OTC instrument normally issued by a bank.
·         Quanto swaps refer to paying interest in home currency at rates applicable to a foreign currency (now prohibited in India).
·         Coupon swaps refer to floating rate in one currency exchanged to fixed rate in another currency.
·         In Indian Rupee market only plain vanilla type swaps are permitted.
·         Banks and counterparties (other banks/clients) need to execute ISDA Master Agreement before entering into any derivative contracts.