II Sem Derivatives (1)
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Transcript of II Sem Derivatives (1)
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Derivatives
Derivatives are financial products whosevalue is derived from the value of
underlying.
Underlying can be shares, commodities,bonds, currency, index, cost of living,weather, freight, electricity, LTC or any
other thing.1
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DERIVATIVES
Derivatives
Forwards Futures Options Swaps
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FORWARD CONTRACT
An agreement to buy or sell something on a specifieddate for a specific price decided at the time of
entering in to contract.
Features of a forward contract Bilateral Contract
Custom designed
Counter party risk
Settlement by delivery on expiry date
Low liquidity
Reversing trade is difficult
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PROBLEMS OF FORWARD CONTRACT
Lack of centralization of trading
Illiquidity
Counterparty risk risk of default
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PAY OFF FOR BUYER AND SELLER
Long position Shortposition
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FUTURES CONTRACT
A futures contract is a promise to buy or sell an asset/goodat a
certain time in the future for a certain price.
Features of futures contract Traded on the Exchange
Standardized contract
No counter party risk
High liquidity (any time it can be closed)
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FUTURES TERMINOLOGIES
Spot price Futures price
Contract cycle
Expiry date
Margin money
Marking to market
Open interest
Basis
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FORWARD VS FUTURES
1. Customized contract
2. Traded off the Exchange
3. No margin money
4. Counter party risk
5. Settlement on expiry
1. Standardized contract
2. On the Exchange
3. Margin money exists
4. No counter party risk
5. Daily settlement & Finalsettlement
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CASH MARKET VS FUTURES
MARKET
1.Actual assets are traded
2. One should have it tosell it
3. Settlement isimmediate
4. No Margin money
5. Full payment6. Actual delivery ofassets
1. Standardized contractsare traded
2. Not necessary
3. On expiry date or before
4. There is margin money
5. No Payment
6. Actual delivery is not
necessary
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Positions in the Futures Market
NowFirst Leg(1)
Before ExpirySecond Leg(2)
BUY (OPEN) SELL (CLOSE)
SELL (OPEN) BUY (CLOSE)
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EXAMPLEDays Settlement
price (RS.)
Transaction Profit/Loss
(Rs.)1 9500 Buy (Open)
2 9600
3 9550
4 9650 Sell (Close) + 150
5 9700
6 9600
7 9800 Sell (Open)
8 9700
9 9850
10 9700 Buy (Close) + 100
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PROCESS OF MARKING TO MARKET
Trade price Rs.6450
Day Daily
settlement
price
P/L to the
long
P/L to the
short
1 6500 +50 -50
2 6600 + 100 -100
3 6800 + 200 -200
4 6600 - 200 +200
5 6700 + 100 -100
Total + 250 - 250
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FUTURES PRICE
FP is determined in the same way as cash marketprices on the basis of demand and supply (after allthey are the same assets)
Futures price are generally more than the cash pricedue to cost of carry
Futures price converges with the spot price on expiry
There is interrelationship between cash price and
futures price Open-High-Low-Closing price-Volume-OI
Settlement price-Daily-Final
Change in price
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CONVERGENCE OF FUTURES PRICE
TO SPOT PRICE ON EXPIRY
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ARBITRAGE
Actual futures price must be equal totheoretical futures price
MIS-PRICING
Futures price > Theoretical Futures price
Futures price < Theoretical Futures price
Arbitrage results in:
Zero risk
Zero investment Positive profit
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EXAMPLE: COST OF CARRY
Cash Price Rs.100
Futures Price Rs.105 (6months to expiry)
Interest cost Rs. 100 X 0.10 X 6/12 = 5
Futures Price = Cash Price + Cost of Carry
105 = 100 + 5
STRATEGY WHEN FUTURE PRICE IS RICH
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Transactions
March 1,
Sell August Futures contract @ Rs. 110
Borrow Rs. 100 at 10% p.a. for 6 months
Buy the asset in the cash market
August 30,
Deliver the goods in the futures market and
Receive payment from the futures market
Repay loan with interest (100 + 5)
Arbitrageprofit
Cash Flow
(Rs.)-------
+ 100
- 100
---------00
---------
+ 110- 105
----------
5.00
----------
STRATEGY WHEN FUTURE PRICE IS RICH
Buy in the spot market and sell in the futures market
Cash Price=Rs.100 and FP =Rs.110
STRATEGY WHEN FUTURE PRICE IS RICH
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Transactions
March 1,Sell August Futures contract @ Rs. 110
Borrow Rs. 100 at 10% p.a. for 6 months
Buy the asset in the cash market
August 30,
Buy August Futures @Rs. 200
Payoff from futures
Sell the asset in the cash market @Rs.200
Repay the loan with interest
Arbitrage
profit
Cash Flow
(Rs.)-------
+ 100
- 100
---------00
---------
-90
+200-105
----------
+5
-------------
STRATEGY WHEN FUTURE PRICE IS RICH
Buy in the spot market and sell in the futures market
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REVERSE ARBITRAGEWhen Futures price is poor compared to cash price
Market information
Cash price of the asset on march 1, Rs. 100 Per k.g.
August Futures price Rs. 102 Per k.g.
Interest rate 10 % p.a.
Theoretical futures price Rs. 100 + 5 = 105
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STRATEGY WHEN FUTURE PRICE IS POORBuy in the futures and sell in the cash market
TransactionsMarch 1,
Buy August Futures contract @ Rs. 102
per k.g.
Borrow pepper & sell it in the cash marketInvest the proceeds at 10 % p.a.
August 30,
Receive from the investment (100+5 )
Take delivery in futures market and pay
Repay pepper to the lender
Arbitrage profit
Cash Flow(Rs.)
-------
+ 100
- 100---------00
---------
+ 105
- 102
----------
3.00
----------
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STRATEGY WHEN FUTURE PRICE IS POORBuy in the futures and sell in the cash market
TransactionsMarch 1,
Buy August Futures contract @ Rs. 102 per
k.g.
Borrow pepper & sell it in the cash marketInvest the proceeds at 10 % p.a.
August 30,
Receive from the investment (100+5 )
Sell August Futures @150
Payoff from August Futures(150-102)
Purchase the asset in the cash market and
return
Cash Flow(Rs.)
-------
+ 100
- 100---------00
---------
+ 105
+48
-150
----------
3.00----------
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Types of traders/Uses of forward
contract
Hedgers- Hedging
Speculators- Speculation
Arbitrageurs -Arbitrage
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Hedging
Trading the forward/futures contract for the purpose ofreducing or controlling the price risk is called hedging.
Hedger must have position in both cash and derivativemarkets.
Hedging also reduces the potential gains
Hedging involves taking a position in the derivativescontract that is opposite in the cash market
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Speculation
Bull Buy the futures when you are expecting
an increase in price
Bear
Sell futures when you are expecting adecrease in price
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BULLISH VIEWLONG STOCK FUTURESMay 3, 2012Infosys cash market price Rs.2295
Infosys May Rs.2298
Infosys June Rs.2300
1 contract of 100 sharesBuy price Rs. 2300
Contract value Rs.230,000
Initial margin 20% - Rs. 46,000
Final settlement price Rs. 2400
Contract value Rs. 240,000
Profit or gain Rs. 10000
ROI 10000/46000 = 22% for 2 months or 130 % per annum !!!
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BEARISH VIEWSHORT STOCK FUTURESMay 3, 2012
Infosys cash market price Rs.2300
Infosys May Rs.2296
Infosys June Rs.2300
Market lot 100 shares
Sale price Rs. 2300
Contract value Rs.230,000
Initial margin 20% - Rs. 46,000
Final settlement price Rs. 2000Contract value Rs. 200,000
Profit or gain Rs. 30,000
ROI 30000/46000 = 65% for 2 months or 391 % per annum
!!!
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Settlement of Futures Contract
1. Physical delivery on expiry
2. Offsetting at any time beforeexpiry
3. Cash delivery at expiry
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Mechanics of Trading Futures
1. Signing an agreement and opening a derivativetrading account
2. Depositing the margin money
3. Placing the order & taking long or short position
4. Reversing the trade or giving or taking delivery
5. Settlement of the transaction
Trading shares and Trading futures
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Trading shares and Trading futures
1.Security Trading a/c the with CMbroker
2.Demat a/c is a must
3.Becomes SH of the Company
4.Receives div, notices to AGM etc
5.Must buy before selling
6.Minimum lot is one share
7.Maturity period is not there
1.Futures Trading a/c withderivative broker
2. Not Necessary
3. Does not become
4. Does not receive
5. Not necessary
6. Market lot is specified
7. There is maturity or expiry date.
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Futures Vs Options
1.Linear pay off
2.Both long and short are at risk
3.Price of the asset is determinedby the market forces
4.Buyer and seller need not paypremium
5.Both the parties must depositmargin money
6.Maximum loss to both buyer and
seller ins unlimited7.Futures do not have differentstrike prices
1.Non linear payoff
2. Only short is at risk
3.Price of the option is determinedby market forces
4. Buyer must pay the premium tothe seller
5.Only the seller must pay themargin money
6.Maximum loss to the buyer is
limited to the premium paid.7.Options are available at differentstrike prices.
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OPTIONS: MEANING
An option is a legal contractwhich gives the holder theright to buy or sell aspecific amount of underlying
asset at a fixed price within aspecified period of time.
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POINTS TO REMEMBER
1. Legal Contract2. Buyer and Seller of the option contract
3. Option Exchange OTC
4. Buyer has a right to buy / sell the asset
5. Seller has the obligation to buy / sell
6. Buyer must pay the premium to the seller
7. Contract should be completed within or onexpiry of the contract
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OPTIONS : TYPES
Options
Call Option Put Option
Buyer Seller Buyer Seller
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OPTIONS TERMINOLOGY
1. Call Option
2. Put Option
3. American Option
4. European Option5. Option Premium
6. Strike/Exercise Price
7. Expiry date8. Exercise date
9. Option holder
10. Option seller/writer
11. Option series
12. In the money option13. At the money option
14. Out of the money option
15. Deep ITM and OTM
16. Open interest
17. Assignment
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OPTION POSITIONS
Buy call Buy put
Write callWrite put
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PROFITABILITY OF OPTIONS
S=Stock price & x= exercise price
Price Call Option Put Option
S > X In the Money Out of the Money
S = XAt the Money At the Money
S < XOut of theMoney
In the Money
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Stock
Price (S)
Strike
Price (X)
Condition
s
Status for
call
Status for
put
270 360
300 360
360 360
400 360
450 360
500 360
EXERCISE FOR OTM, ITM & ATM
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Stock
Price (S)
Strike
Price (X)
Condition Status for
call
Status for
put
270 360 S < X OTM ITM
300 360 S < X OTM ITM
360 360 S = X ATM ATM
400 360 S > X ITM OTM
450 360 S > X ITM OTM
500 360 S > X ITM OTM
EXERCISE FOR OTM, ITM & ATM
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ATTITUDES OF BUYERS & SELLERS
1. Call Option Buyer
Bullish
2. Call Option Seller Bearish
3. Put Option Buyer Bearish
4. Put Option Seller Bullish
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OPTIONS TO OPTION HOLDERS
(BUYERS)
1. Do nothing till expiry day
2. Close out the position by reversing the trade
3. Exercise the option if it is American type
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Asset: Nifty-CE-4880-JulyAsset: Nifty-CE-4800-July
Option type: European
Strike price : 4800
Market lot : 50 times index
Option premium : Rs. 50 X 96= 4800
Nifty at expiry : 5200
Gross profit : 50 X400 = 20000
Less Premium : Rs. 4800
Brokerage (App.) Rs. 200
Net gain Rs. 15000
ROI : 15000 / 4800 =312.50% for 2 months or 1875% P.A
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Nifty-PE-4880-JulyAsset: Nifty-PE-4880-July
Option type: European
Strike price : 4880
Market lot : 50 times index
Option premium : Rs. 50 X 96 = 4800Nifty at expiry : 4480
Gross profit : 50 X 400 = 20,000
Less Premium : Rs. 4800
Brokerage (App.) Rs. 200Net gain Rs. 15,000
ROI : 15,000 /4800 = 312.50% for 2 months or 1875%
P.A
OPTIONS PAYOFF
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OPTIONS PAYOFFCall option buyer (Long Call)
Stock Price Strike Price Premium P/L to the
buyer
500 600 25
525 600 25
550 600 25575 600 25
600 600 25
625 600 25
650 600 25
675 600 25
700 600 25
OPTIONS PAYOFF
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OPTIONS PAYOFFCall option buyer (Long Call) (in Rs.)
Stock Price Strike Price Premium P/L to the
buyer
500 600 25 -25
525 600 25 -25
550 600 25 -25575 600 25 -25
600 600 25 -25
625 600 25 00
650 600 25 25
675 600 25 50
700 600 25 75
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OPTIONS PAYOFFCall option Buyer (Long Call)
OPTIONS PAYOFF
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OPTIONS PAYOFFCall option Seller (Short Call)
Stock Price Strike Price Premium P/L to the
seller
500 600 25
525 600 25
550 600 25575 600 25
600 600 25
625 600 25
650 600 25
675 600 25
700 600 25
OPTIONS PAYOFF
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OPTIONS PAYOFFCall option Seller (Short Call) (Rs.)
Stock Price Strike Price Premium P/L to the
seller
500 600 25 25
525 600 25 25
550 600 25 25575 600 25 25
600 600 25 25
625 600 25 00
650 600 25 -25
675 600 25 -50
700 600 25 -75
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OPTIONS PAYOFFCall option Seller (Short Call)
Options Payoff
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Options PayoffPut option buyer (Long Put) (in Rs.)
Stock Price Strike Price Premium P/L to the
buyer
500 600 25
525 600 25
550 600 25575 600 25
600 600 25
625 600 25
650 600 25
675 600 25
700 600 25
OPTIONS PAYOFF
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OPTIONS PAYOFFPut option buyer (Long Put)
Stock Price Strike Price Premium P/L to the
buyer
500 600 25 75
525 600 25 50
550 600 25 25575 600 25 00
600 600 25 -25
625 600 25 -25
650 600 25 -25
675 600 25 -25
700 600 25 -25
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OPTIONS PAYOFFPut option buyer (Long Put)
OPTIONS PAYOFF
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OPTIONS PAYOFFPut option writer (Short Put)
Stock Price Strike Price Premium P/L to the
buyer
500 600 25
525 600 25
550 600 25575 600 25
600 600 25
625 600 25
650 600 25
675 600 25
700 600 25
OPTIONS PAYOFF
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OPTIONS PAYOFFPut option writer (Short Put)
Stock Price Strike Price Premium P/L to the
buyer
500 600 25 -75
525 600 25 -50
550 600 25 -25575 600 25 00
600 600 25 25
625 600 25 25
650 600 25 25
675 600 25 25
700 600 25 25
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OPTIONS PAYOFFPut option writer (Short Put)
INDEX OPTIONS
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INDEX OPTIONSNifty
Contract specificationsContract size : 50 Nifty
Style : European
Price band : Not Applicable
Trading cycle : 3 months, 3 contracts
Near, Next and Far month
New contract: Next day of the expiry date
Expiry date: Last Thursday of the 3rd monthSettlement : Cash Settlement on T+1 basis
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Stock options
Asset: Suzlon-CE-June-30Option type: European
Strike price : 20
Market lot : 8000 shares
Option premium : Rs. 2 X 8000 = 16000Suzlon at expiry : 30
Gross profit : 10 X8000 = 80,000
Less Premium : Rs. 16,000
Brokerage (App.) Rs. 200
Net gain Rs. 64,000
ROI : 64000 / 16000 =400%p.m
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Stock option
Asset: P E- Suzlon- JuneOption type: European
Strike price : 20
Market lot : 8000 shares
Option premium : Rs. 2 X 8000 = 16000
Suzlon at expiry : 15
Gross profit : 5 X8000 = 40,000
Less Premium : Rs. 16,000Brokerage (App.) Rs. 200
Net gain Rs. 24,000
ROI : 24000 / 16000 =150%p.m
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Introduction to swaps Swaps are private agreements between 2 parties to exchange cash
flows in the future according to prearranged formula.
Started from early 1980s
In 1984 ONGC entered in to swap with consortium of foreign banks tohedge interest rate risk (foreign jurisdiction).
RBI permitted swaps in 1995on a case by case basis.
RBI permitted banks to enter in to swap and report such deals from1999
In 2005 finance minister allowed the swap contract by amending SCRAin parliament.
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Types of Swaps
Commodity swap
Equity swap
Interest rate swap
Currency swap
Credit default swap
COMMODITY SWAP
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COMMODITY SWAP
FARMER USER
Market Price
Rs. 120
FARMER USER FARMER USER
-150
+120
+ 150
-120
-60
+120
+60
-120- 30 + 30 + 60 - 60
If the price is Rs.150 If the price is Rs. 60
EQUITY SWAP
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A (Equity) B( Debt)
Variable return
Fixed return (10%)
When the variable return is
40% and -10%
A B A B
Receives in cash market
Pays under swap
Receives under swap
+40%
-40%
+10%
+10%
-10%
+40%
-10%
+10%
+10%
+10%
-10%
-10%
Net cash flow +10% +40% +10% -10%
Position of variable return payer and fixed return payer
EquityInvt.
DebtInvt.
I t d ti t I t t R t S
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Introduction to Interest Rate Swap Definition: A contract which involves two counter parties to exchange
over an agreed period, two streams of interest payments, each based ona different kind of interest rate, for a particular notional amount.
Contract between two parties
Notional principal amount
One party pays fixed rate and receives floating rate
The other party pays floating rate and receives fixed rate
Fixed rate remains the same and floating rate changes
Interest amount is exchanged for several future dates
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Fixed or Floating Rate?
Borrow atFixed Rate
Borrow atFloating Rate
Risk of fall ininterest rate
Benefit ifinterest raterises
Risk of riseininterest rate
Benefit fromfall inInterest rate
Low risk if theinterest rates are near thebottom of a cycle
Low risk if theInterest rates are
At the top of a cycle
I t t R t S
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Interest Rate Swap
A borrowed at fixed rate and B at floating rate
A BMIBOR
7 %
A B
- 7% Fixed
+ 7% Fixed
- MIBOR
- MIBOR
+ MIBOR
- 7 % Fixed
- MIBOR - 7 %
-7 % -MIBOR
Transformation of assets and
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Transformation of assets andliabilities
IRS can be used to transform
1. Fixed rate loan in to floating rate loan
2. Floating rate loan in to fixed rate loan
3. Fixed rate investments in to floating rate investments
4. Floating rate investments in to fixed rate investments
T f i Fl ti R t L i t Fi d R t L
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Transforming Floating Rate Loan in to Fixed Rate Loan
The company must enter in to swap as a floating rate payer
After the swap cash flows are as below
1. Pays floating rate under loan contract
2. Receives floating rate under swap contract
3. Pays fixed rate under swap contract
The above 3 cash flows net out as a floating rate loan
Company X Company Y
Floating rate loan Pays fixed rate under swap
Receives floating rate under swap
T f i fi d t l i t fl ti t l
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Transforming fixed rate loan in to floating rate loan
The company must enter in to swap as a floating rate payer
After the swap cash flows are as below
1. Pays fixed rate under loan contract
2. Receives fixed rate under swap contract
3. Pays floating rate under swap contract
The above 3 cash flows net out as a floating rate loan
Company X Company Y
10% under loan
Pays floating under swap
Receives fixed 10% under swap
T f i fl i i i fi d
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Transforming floating rate investment in to fixedrate investment
The company must enter in to swap as a floating ratepayer
After the swap cash flows are as below
1. Receives floating rate for its investments
2. Receives fixed rate under swap contract
3. Pays floating rate under swap contract
The above 3 cash flows net out as fixed rateinvestments
Comparative advantage argument
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Comparative advantage argument
AAA wants to borrow floating & BBB wants to borrow fixed rate funds
AAA has comparative advantage in fixed rate market because it need to pay2.5% less than BBB
BBB has comparative advantage in floating rate market because it need to pay0.5% more than AAA
AAA wants floating but borrows fixed and transforms fixed loan in to floatingthrough swap
BBB wants fixed but borrows floating and converts floating in to fixedthrough swap
Rates quoted to them by their banks are:
Fixed Floating
AAA 10% MIBOR+0.50%
BBB 12.50% MIBOR+1.00%
E l C ti Ad t
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Example Comparative Advantage
AAA BBB
Fixed 10%
Libor
10.50%
Libor+1.00%
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Cash Flows to Parties
Cash flows AAA BBB
Payment under loan -10% -LIBOR+1.00%
Receipt under swap
Payment under swap
+10.50%
-LIBOR
+LIBOR
-10.50%
Net payment after swap
Net cost before swap
-LIBOR-0.50%
-LIBOR+0.50%
-11.50%
-12.50%
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Currency Swap
A currency swap is an agreement betweentwo parties to exchange payments or receiptsin one currency for payments or receipts inanother currency.
In an IRS the principal is not exchanged
In a currency swap the principal is exchangedat the beginning and the end of the life of theswap
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Mechanics of currency swap
A (Borrows USD) B (Borrows GBP)
Pays $ principal Receives $ principal
Receives GBP principal Pays GBP principal
Pays GBP interest Receives GBP interest
Receives $ interest Pays $ interest
Receives $ principal Pays $ principal
Pays GBP principal Receives GBP principal
Transforms $ loan in toGBP loan
Transforms GBP loan into $ loan
What happens in a currency swaps
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TIME
$ principalSterlingprincipal
GBP Interest $ Interest
GBP Interest $ Interest
GBP Interest $ Interest
GBP Interest $ Interest
GBP Principal $ Principal
Near valuedate
Periodic intervals
Far valuedate
Exchange of principal at on agreed rate of exchange
Exchange of interest payment at previously agreed rateof interest
Re-exchange of principal at same rate of exchange as for
the original exchange at the near value date
Currency swap( with no exchange of principal at the near value date)
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Exchange of principal at an agreed rate of exchange
TIME
Euro Interest $ Interest
Euro Interest $ Interest
Euro Interest $ Interest
Euro Interest $ Interest
Euro Interest $ Interest
Euro Principal $ Principal
SWAP termbegins
Maturity Exchange of interest payment on specifiedamount of principal
Party A Party B
Euro principal $ principal
Credit default swaps
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Credit default swaps1. Bilateral contract CPB and CPS
2. CPB pays fixed periodic payment to CPS
3. Protection against adverse credit event.
4. Buyer has aright to sell the bond for face value when the credit
event occurs.
5. Payment is expressed as annualized basis point on notional
principal.6. Third party and specific obligation Ref entity and ref
obligation.
7. Credit event triggers the obligation (Bankruptcy, Rating downgrade,
Obligation default etc.)
8. CDS can be settled in cash or physical based on formulaagreed.
9. CDS spread is the % p.a. of notional principal paid for the
protection
10. In credit market, banks quote two way price on CDS (250-260
bps)
C dit d f lt
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Credit default swaps
CPB CPS
Ref entity/obligation
Premium (periodic) X bps per annum.
No credit event
Credit event
Zero
Cr Event payment(CEP)
CEP = Par value recovery value
CASH SETTLEMENT BASIS