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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.
