Final Report

Study and Measurement of Counterparty Exposure in Derivative Transactions Page 1

Study and Measurement of Counterparty Exposure for Derivative Transactions

Amritananda Chattopadhyay

Enrollment No. 07BS0478

STUDY AND MEASUREMENT OF COUNTERPARTY EXPOSURE IN DERIVATIVE TRANSACTIONS

BY:AMRITANANDA

CHATTOPADHYAY07BS0478

A report submitted in fulfillment of the requirements of

MBA program of ICFAI Business School


ACKNOWLEDGEMENT

The present project is submitted to ICFAI Business School, Mumbai for

partial fulfillment of degree, Master of Business Administration (MBA).

I being the student of ICFAI Business School, Mumbai convey my

sincere thanks to Dr.Y.K.Bhushan for giving me such a learning

opportunity and providing facilities required for making this project

successful.

I take a deep pleasure in thanking Prof. Poonam Nam Joshi for all

morale support and guidance which she gave me throughout the project.

I am having a deep sense of gratitude to whole of the Forex Treasury

Team – Mr. Conrad D’Souza (Sr. General Manager – Treasury), Ms.

Manaswini Goel (Manager – Treasury), Mr. Tejas Mehta (Assistant

Manager – Treasury) and Ms. Geeta Venkatesh (Manager - Treasury),

for providing me the guidance for this project work. Under their supervision

and inspiring guidance this project was embarked upon, planned and

executed. Their sincere suggestions and training helped me gain a complete

knowhow about the subjects – Treasury Operations and Risk Management.

(Amritananda Chattopadhyay)


TABLE OF CONTENTS

Acknowledgement iiiTable of illustrations vAbstract viIntroduction vii

Page No.1. Scope, Methodology and Limitations

8

2. Financial Derivatives9

(I) Derivatives Market and Global Derivative Markets 10(II) Derivative Users in India 14(III) Financial Derivative Instruments 15

(IV) Features of Foreign Currency & Options 20(V) Derivative Strategies 21(VI) Risk Measurement 30

3. Counterparty Risk 31(I) Methods to Calculate Credit Risk Exposure 32(II) Measurement and Calculation of Exposure Values 37(III) Calculations 38(IV) The Counterparty Exposure Values for HDFC Ltd. 39

Glossary xliReferences xliv


TABLE OF ILLUSTRATIONS

FIGURE 1 GLOBAL OTC DERIVATIVES TURNOVER………………………………….. 11

FIGURE 2:INTEREST RATE SWAPS................................................17

FIGURE 3 CURRENCY SWAPS......................................................17

FIGURE 4CALL OPTION..............................................................21

FIGURE 5 PUT OPTION..............................................................22

FIGURE 6 LONG STRADDLE........................................................22

FIGURE 7 LONG STRANGLE........................................................23

FIGURE 8 RISK REVERSAL (BUY CALL - SELL PUT)..........................23

FIGURE 9 RISK REVERSAL (BUY PUT - SELL CALL)..........................24

Figure 10 Comparative Analysis of the 2 methods..............41

TABLE 1: THE PERCENTAGE SHARE OF VARIOUS CURRENCIES IN TOTAL DERIVATIVE TURNOVER.............................................11

TABLE 2 : GLOBAL FOREIGN EXCHANGE TURNOVER.........................12

TABLE 3: CONVERSION FACTOR TO BE MULTIPLIED TO NOTIONAL AMOUNTS AS PER ORIGINAL EXPOSURE METHOD........................32

TABLE 4: CONVERSION FACTOR TO BE MULTIPLIED TO NOTIONAL AMOUNTS AS PER CURRENT EXPOSURE METHOD........................33

TABLE 5: PERCENTAGES TO BE MULTIPLIED TO NOTIONAL AMOUNTS AS PER MTM METHOD...............................................................34


Table 6: CCR multipliers for different hedging set categories.......................................................................................35

ABSTRACT

'By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it - a process that has undoubtedly

improved national productivity growth and standards of living.' –

Alan Greenspan

Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates.

Market surveys conducted by the International Swaps and Derivatives Association (ISDA) show notional amounts of outstanding interest rate and currency swaps reaching US$866 billion in 1987, US$17.7 trillion in 1995, and US$ 285.73 trillion in 2006 an astonishing compounded growth rate of 37.2% per year.

Derivatives have expanded the opportunities to transfer risks, allowing for substantially improved risk sharing. They have also created connections among markets and market participants.

Counterparty risk, an example of one such connection, is the risk that a party to an OTC derivatives contract may fail to perform on its contractual obligations, causing losses to the other party. Losses are usually quantified in terms of the replacement cost of the defaulted derivatives and include, beyond mid-market values, the potential market impact of large and/or illiquid positions. Counterparty risks are bilateral – i.e., both parties may face exposures depending on the value of the positions they hold against each other. Counterparty risks have mushroomed in the financial markets due to

(a) the usual practice of ‘offsetting’ rather than ‘unwinding’ derivative positions and

(b) the array of inter-dealer trades required to connect final risk-takers.


INTRODUCTION

Market deregulation, growth in global trade, and continuing technological developments have revolutionized the financial marketplace during the past two decades. A by-product of this revolution is increased market volatility, which has led to a corresponding increase in demand for risk management products. This demand is reflected in the growth of financial derivatives from the standardized futures and options products of the 1970s to the wide spectrum of over-the-counter (OTC) products offered and sold in the 1990s.

Although derivatives are legitimate and valuable tools for financial institutions, like all financial instruments they contain risks that must be managed. Fundamentally, the risk of derivatives (as of all financial instruments) is a function of the timing and variability of cash flows. Risk is the potential that events, expected or unanticipated, may have an adverse impact on the corporation’s capital and earnings. The risk of a loss can be most directly quantified in relation to market risk and credit risk. These 2 types of risk are clearly related since the extent to which a derivatives contract is “in the money”(ITM) as a result of marked price movements will determine the degree of credit risk.

Counterparty risk is a typical case of credit risk, which arises because counterparty to a transaction defaults before the final settlement of the transaction's cash flows.

For this risk an exposure – “counterparty exposure” or EAD (Exposure at Default) is calculated for derivative transactions. EAD can be seen as an estimation of the extent to which a financial institution may be exposed to a counterparty in the event of, and at the time of, that counterparty’s default.As per the RBI Guidelines there are 2 methods of calculation of these exposures – the original exposure method and the current exposure method.

This is a rapidly evolving area of risk management. The phenomenal expansion of the credit derivatives markets has caused a fundamental change in the perception and management of those risks.


Scope and Methodologies

The project aimed at understanding the various derivative transactions and risk exposures attached to these transactions, studying the current method, i.e., the original exposure method followed by the corporation and implementation of the alternative method of calculation of counterparty exposure as per RBI norms. Thus it gives an option to the corporation of using the current exposure method, which is a more accurate method of measuring credit exposure in a derivative product, for determining individual / group borrower exposures. It also had a global view of derivatives and methods used by global firms for the calculation of counterparty exposure.

Methodology that was used can be divided broadly into 2 phases;

PHASE I consisted of going through the literature and analyst reports of derivatives which gave a very clear understanding of derivatives, various instruments under it like swaps, options etc… It proved to be an eye opener about the global derivative markets as well as the Indian scenario.

PHASE II involved the crux of the project i.e. the risks attached with these derivatives and mainly concentrating on the counterparty credit risk. It consisted of understanding these risks, exposures attached with these risks, and finally methods to calculating these risk exposures.

Limitations The core issue pertaining with the Indian companies, is that they do not get the fact that putting the right hedging strategy in place is only half the battle won; companies need to continuously monitor and assess the effectiveness of the hedging strategies and ensure that they are in sync with the underlying risk profile.Some of the key challenges that Indian companies face are:

- Lack of technical expertise to evaluate the complexity of the hedge transactions and ability to identify, understand and quantify the risks by performing periodic Mark-to-Market calculations.


- Limited or no access to risk measurement tools as well as market data systems to independently validate the Mark-to-Market numbers reported by counterparties.

- Inability to quantify counterparty risk exposures in the event of defaults.

Financial Derivatives

A derivative is a financial instrument:

(a) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the 'underlying');(b) that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and(c) that is settled at a future date.

Derivatives trading commenced in India in June 2000. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.

Broadly, RBI is empowered to regulate the interest rate derivatives, foreign currency derivatives and credit derivatives. For regulatory purposes, derivatives have been defined in the Reserve Bank of India Act, as follows:

“Derivative - means an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time.”



Derivatives Markets

There are two distinct groups of derivative contracts: Over-the-counter (OTC) derivatives: Contracts that are traded directly

between two eligible parties, with or without the use of an intermediary and without going through an exchange. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “havala” or forwards markets.

Exchange-traded derivatives: Derivative products that are traded on an exchange. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE. Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchange-traded contracts, relative to OTC contracts.

Global Derivative Markets

Derivative markets worldwide have witnessed explosive growth in recent past. According to the BIS (Bank for International Settlements) Triennial Central Bank Survey of Foreign Exchange and Derivatives in April 2007 the average daily turnover for forex market had grown by an unprecedented 69% since April 2004, to $3.2 trillion. Average daily turnover in OTC foreign exchange and interest rate contracts went up by 73% relative to the previous survey in 2004, to reach $4,198 billion in April 2007.


Figure 1Source: Triennial Central Bank Survey,

Growth in turnover was broad-based across instruments. More than half of the increase in turnover can be accounted for by the growth in foreign exchange swaps, which rose 80% compared with 45% over the previous three-year period. Changes in hedging activity may have been one factor underlying the increasing importance of foreign exchange swap instruments. Growth in the turnover of outright forward contracts also picked up significantly to 73%.

The currency composition of turnover has become more diversified over the past three years. The share of the four largest currencies fell, although the US dollar/euro continued to be the most traded currency pair. The most notable increases in share were for the Hong Kong dollar, which has benefited from being associated with the economic expansion of China, and the New Zealand dollar, which has attracted attention from investors as a high yielding currency. More broadly, the share of emerging market currencies in total turnover has increased, to almost 20% in April 2007.

USD Euro Yen GBP HKD INRApr-04 88.7 36.9 20.2 16.9 1.9 0.3Apr-07 86.3 37 16.5 15 2.8 0.7

Table 1 Source: Triennial Central Bank Survey

Indian forex and derivative markets have also developed significantly over the years. As per the BIS global survey the percentage share of the rupee in total turnover covering all currencies increased from 0.3 percent in 2004 to 0.7 percent in 2007. As per geographical distribution of foreign exchange market turnover, the share of India at $34 billion per day increased from 0.4 in 2004 to 0.9


percent in 2007. But still the size of the Indian derivatives market as clearly evident from the above data, compared to global standards is still in its nascent stage.

Foreign exchange derivatives

Accelerating growth in FX contracts

Growth in the FX segment of the OTC derivatives market accelerated since 2004 and, for the first time since the BIS began to survey the market, outstripped growth in the interest rate segment. In April 2007, currency contracts accounted for 58% of aggregate turnover, which was slightly higher than the 56% recorded in 2004.

Activity in the foreign exchange segment of the OTC derivatives market continued to be dominated by traditional instruments such as outright forwards and FX swaps.

Source: BIS Data, Bank of International Settlements

1998 2001 2004 2007Forex Turnover 959 853 1303 2319Outright Forwards & Forex Swaps

862 786 1163 2076

Currency Swaps 10 7 21 32Options 87 60 117 212Table 2 Source: BIS Data, Bank of International Settlements


With an average daily turnover of $2.1 trillion, outright forwards and FX swaps accounted for 90% of turnover in FX derivatives, virtually unchanged from 2004. Among the non-traditional, more complex, products, turnover in currency options increased by 81% to $0.2 trillion, or 9% of the total FX segment. Volumes of currency swaps, which involve the exchange of recurring interest payments denominated in different currencies, increased by 49% to $0.03 trillion.

The US dollar maintained its role as the leading currency in the FX derivatives market, with the euro a distant second. Across all contracts, 89% had one leg denominated in US dollars, and 35% in Euros. Only 3% of all transactions in FX derivatives did not involve either the euro or the dollar, underlining their importance as vehicle currencies.

The Need for a Derivative Market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to risk oriented people

2. They help in the discovery of future as well as current prices3. They catalyze entrepreneurial activity4. They increase the volume traded in markets because of participation

of risk averse people in greater numbers5. They increase savings and investment in the long run

Participants

Participants of this market can broadly be classified into two functional categories, namely, market makers and users.

1. User: A user participates in the derivatives market to manage an underlying risk.

2. Market maker: A market maker provides continuous bid and offer prices to users and other market makers. A market maker need not have an underlying risk.

At least one party to a derivative transaction is required to be a market maker.


Derivative Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives.

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.


1.1 Financial Derivative Instruments

Many forms of financial derivatives instruments exist in the financial markets. Among them, the three most fundamental financial derivatives instruments are: forward contracts, swaps, futures, and options.

Forward Contract – A forward contract is an agreement between 2 parties to buy or sell an asset (which can be of any kind) at a pre agreed future point in time. Therefore, the trade date and delivery date are separated. It’s used to control and hedge risk for e.g. currency exposure risk (forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil).The buyer in the contract is said to hold a long position, and the seller is said to hold a short position. The specified price in the contract is called the delivery price and the specified time is called maturity.

Let K-delivery price, and T-maturity, then a forward contract's payoff VT at maturity is:

VT = ST - K, (long position)VT = K – ST, (short position)

where ST denotes the price of the underlying asset at maturity t = T

Forward Contracts are generally traded OTC (over-the-counter).

Swaps – The term “swap” implies that it’s a temporary exchange mainly of one currency for another obligation to reverse it at a specific future date. Swaps are double deals one deal involving a buy and the other involving a sell, separated in time but one has to cancel the other.

A Swap transaction in the forex market is a combination of a spot and a forward in opposite direction. The swaps are of following categories:

Spot – forward swap: In this swap, one deal is done in spot market and another in the forward market, i.e., one buys in the spot and sells in the forward or the converse. If the buy is in spot and sell the forward then is called the swap-in and if sell is in the spot and buy is in the forward the swap is called a swap-out.

Forward – forward swap: In this case both the deals are in the forward, e.g., one buys one month forward and sells three months forward, each deal canceling the other or vice-versa.


Pure swaps: Pure swaps are those swaps where both the deals are contracted with one party, i.e., a swap dealer and a bank agrees to contract both buy and sell agreements.

Reasons for Swaps:1. Comparative Advantage – Due to imperfections there may be a

comparative advantage in raising one type of financing but really the corporation prefers others. It can take the advantage of price difference by raising money in the cheaper market and then swapping it to the terms of its choice.

2. Skirting Taxes and Regulations – In certain cases, the swap allows a party to get around tax laws and regulations.

3. Asset and Liability Management – In any large FI the continuous creation of assets and liabilities of varying maturities and different currencies makes it necessary to manage the interest rate risks continuously. The swaps are an important in the hand of treasurer to change the interest and currency profile of his portfolio. In some ways the swap completes the gaps in the market availability of security of various maturities. By using swaps one may be able to shift risks in ways that otherwise are not available.

Swaps are of 2 principle types:

Interest Rate Swaps In case of interest rate swaps, interest payment obligations are exchanged between 2 parties where both the obligations are denominated in the same currency. The most common is the fixed-floating rate swap. No transfer of principal just notional only. Net interest obligation is only exchanged normally, every 6 months. The party that owes more interest than it receives makes the net payment to the other party. Normally the arrangements are done through an intermediary – a bank or financial institution. The floating rate payments are generally linked through LIBOR (London Interbank offered rate).


Figure 2: Interest Rate Swaps

Another form of interest rate swap is the “Basis Swap” or floating to floating swaps. Here, 2 floating rate obligations are exchanged where the 2 obligations are based on different basis, e.g. LIBOR and Central Bank rate.

Currency Swaps – In case of currency swaps two parties exchange interest obligations on debt denominated in different currencies. At maturity the principal amounts are exchanged agreed upon in advance. As in case of interest rate swaps all exchanges are done on “net” basis.

USD Interest

GBP Interest

USD Principal

At Maturity

GBP Principal


PARTY A BANK PARTY B

Floating rate loan

Fixed rate loan

Fixed InterestFloating Interest

UK BANK US BANK

Figure 3 Currency SwapsCurrency swaps involve an exchange of cash flows in two different currencies. Therefore an exchange rate, generally the prevailing spot rate is used to calculate the amount of cash flows, apart from interest rates relevant to these 2 currencies.

Characteristics of SWAP markets:

The main characteristics of swaps are:

Swaps are custom tailored to the needs of the counter parties. Swaps meet the specific needs of the customers/ counter parties.

Exchange trading necessarily involves some amount of transparency, by contrast in swap market only the counter parties know about the transaction.

Counter parties can select amounts, currencies, maturities etc.

Limitations of Swap markets – Each party must find a counter party which wishes to take opposite position. Also, since swap is an agreement between 2 parties, therefore it cannot be terminated at one’s instance. The termination can to be accepted by counter parties.

Futures - An agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price. Futures have evolved from standardization of forward contracts. In forward contract, gains or losses arise only on maturity. There are no intermediate cash flows. In futures contract, even though the overall gain/loss is same, the time profile of its accrual is different – total gain or loss over the entire period is broken up into a daily series of gains and losses, which clearly has a different PV’s.

Futures differ from forward contracts in the following respects:a) Futures are generally traded on an exchange.b) A future contract contains standardized articles.c) The delivery price on a future contract is generally determined on an

exchange, and depends on the market demands.

Currency Future ContractsAt a first glance, a currency futures contract, like a forward contract, is a contract for future delivery of a specified currency against another. In other words, it is an agreement between two parties to exchange one currency for another, with the actual exchange taking place at a specified date in future but with the exchange rate being fixed at the time the agreement is entered into.


Options- An agreement that the holder can buy from, or sell to, the seller of the option at a specified future time a certain amount of an underlying asset at a specified price. But the holder is under no obligation to exercise the contract. The holder of an option has the right, but not the obligation, to carry out the agreement according to the terms specified in the agreement. In an options contract, the specified price is called the exercise price or strike price, the specified date is called the expiration date, and the action to perform the buying or selling of the asset according to the option contract is called exercise.

Options have proved to be a very versatile and flexible tool for risk management in a variety of situations arising in corporate finance, stock portfolio risk management, interest rate risk management and hedging of commodity price risk. By themselves and in combination with other financial instruments, options permit creation of tailor made risk management strategies. Options also provide a way by which individual investors with moderate amounts of capital can speculate on the movements of stock prices and so forth.

According to buying or selling an asset, options have the following types:1. Call Option – It gives its holder the right to buy a given quantity of an

asset at a predetermined strike price.2. Put Option – It gives its holder the right to sell a given quantity of an asset at a

predetermined strike price.3. European Option – It can be exercised only at expiration date.4. American Option – It can be exercised on or prior to the expiration date.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.


Features of Foreign Currency Futures and Options

1. Organized Exchanges – Unlike forward contracts which are traded in OTC market, futures are traded on organized exchanges either with a designated physical location where trading takes place, the trading pit or via computer screens. This provides a ready, liquid market in which futures can be bought and sold at any time during trading hours like in a stock market.

2. Standardization – In Forward contract amount of the currency to be delivered and the expiry date are negotiated between the buyer and the seller can be tailor made to suit the requirements of either party. But in futures contract, both these are standardized by an exchange on which the contract is traded,

Exchange specifies a set of delivery months and specific delivery days within those months. The exchange also specifies the minimum size of the price movement (known as “tick”) and in some cases, may also impose a ceiling on the maximum price change within a day.

3. Clearing House – On the trading floor, a future contract is agreed between 2 parties A and B. When it is recorded by the exchange, the contract between A and B is immediately replaced by 2 contracts, one between A and the clearing house and the other between B and the clearing house. This is called “Novation”. Thus the clearinghouse interposes itself in every deal, being buyer to every seller and being seller to every buyer. Furthermore the clearing house guarantees performance.


Derivative Strategies

Strategies are specific game plans created by one based on one’s idea of how the market will move. Strategies are generally combinations of various products – forwards, futures, calls and puts and enable one to realize unlimited profits, limited profits, unlimited losses or limited losses depending on the profit appetite and the risk appetite.

Vanilla products - Vanilla options are used to create popular strategies that offer genuine alternatives to simple hedging with forward contracts. They provide various degree of participation in favorable exchange rate movements.

1. Call and Put Options: They provide the client with instruments that protect against adverse rate movements. In return of this protection, client pays a premium for the option. If the option is exercised there is physical delivery of the underlying currency.A “Call” option gives its holder the right to buy a given quantity of a currency in return for another currency at a pre-determined “strike price” at a future date {European style call} or until a future date {American style call}

At expiry, holder of the call has unlimited upside potential if the spot rate is higher than the strike price.

If it ends up lower than the strike price, call is not exercised and the loss is limited to the amount of the option premium.

A “Put” option gives its holder the right to sell a given quantity of a currency in return for another currency at a pre-determined strike price.At expiry, it works completely opposite to that as a “call” option.

CALL OPTIONPayoff

Figure 4Spot rate at maturity

Strike


PUT OPTIONPayoff

Figure 5

Spot rate at maturity

Strike

2. Straddle: It’s a combination of a call and a put on the same underlying asset with the same strike price and expiry date.A long straddle is obtained by buying a call and a put while a short straddle is obtained by selling a call and a put.

Value of a straddle increases with maturity and the volatility of the underlying asset

Payoff LONG STRADDLE

Figure 6

Spot rate at expiry Strike

3. Strangle: It’s a combination of a call and put on the same underlying asset with same expiry date but different strike rate.


A long strangle is created by buying a call and a put, while short strangle is created by selling a call and a put.

Payoff LONG STRANGLE

Figure 7

Spot rate at expiry

Put strike Call strike

At expiry, the owner of the option has unlimited upside potential if the spot rate should move either direction by a large extent.

4. Risk reversal strategy: A “Risk Reversal” Strategy (“R/R”) is obtained wither by buying a call and selling a put or selling a call and buying a put. It’s a cheaper hedging strategy.

Premium – The net cost of a risk reversal is very low since the sold option covers the cost of the purchased option, sometimes even making it a zero cost strategy.

Payoff Buy Call – Sell Put

Figure 8Spot rate at maturity

Put CallStrike Strike


Payoff Buy Put – Sell Call

Spot rate at maturityFigure 9

Put Strike Call Strike

5. Butterfly: A long butterfly is created by buying a straddle and selling a strangle.A short butterfly is created by selling a straddle and selling a strangle.

Premium: This strategy requires a small initial investment since the cost of the bought options is partly offset by the premium received on the sold options.

Derivative transactions are mainly done for 3 purposes – hedging, speculation and arbitraging.

Hedging - A derivative enables a trader to hedge some pre -existing risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivative users describe themselves as hedgers, and Indian law generally require that derivatives be used for hedging purposes only.

The existence of uncertainty in the value of receivables/ payables denominated in foreign currencies, due to the exchange rate movement, generates exchange risk. Hedging in the forex market is the avoidance or elimination of risk. The purpose of hedging is loss minimization, and not profit maximization i.e. hedging is not profit centered activity.

It’s achieved by avoiding open positions in foreign exchange. The open positions are the imbalances in assets and liabilities denominated in foreign currencies.

A long position arises when foreign currency assets exceed foreign currency liabilities. A short position arises when foreign currency liability exceeds foreign currency assets. Both positions involve exchange risk, because these


open positions expose the holder of assets and liabilities to potential losses resulting from adverse movements in forex rates.

A spot depreciation in foreign currency against domestic currency will reduce the value of assets denominated in foreign currency and similarly an appreciation of foreign currency will increase their value. The case of liabilities is the converse one, i.e. when foreign currency depreciates the value of foreign currency denominated liabilities in terms of domestic currency reduces.

Losses due to the depreciation and appreciation can be avoided by hedging in the foreign exchange market, which involves a forward sale/ purchase of these assets or liabilities in terms of domestic currency reduces.

2 Hedging Instruments

Hedging can be short term or long term and therefore the ways and instruments of hedging are different for each of these 2 types of hedging.

3 Short term hedging: Short term hedging can be done with the help of following instruments:

a. Forward contractb. Future contractc. Currency option contract

Long term hedging: Long term hedging can be done through a. Long term forward contractsb. Currency swapsc. Parallel loansd. Leading and lagging payments

Speculation – Acceptance of foreign exchange risk is speculation. It is opposite of hedging. Speculation is a difficult trading technique, because one has to identify, with high degree of reliability, the movement in exchange rate so that a position may be taken from benefiting from this movement.

Speculation refers to deliberate creation of a position for the purpose of generating a profit from the exchange rate fluctuations, accepting the added risk. This is a deliberate attempt to benefit from the exchange rate movement. Consequently, speculation is considered to be present whenever open foreign exchange position is taken. These positions may be long or short. In this case, the speculator is convinced with his analysis about the movement of exchange rates. All the open position involves risk and hence the possibility of speculative gains.


Speculators are those class of investors who willingly take price risks to profit from price changes in the underlying asset. Speculators do not have any position on which they enter into futures and options market. They just have a view or belief about a commodity, currency, stock index, interest rates etc that is based on policy announcements by the government, international events or any other news.

Speculation may be conducted through either the spot or forward exchange markets and involves the establishment of short positions in weak currencies, which are expected to depreciate or be devalued and long positions in strong currencies, which are expected to appreciate or be revalued.

The rule of speculation on weak currency is: Sell dear and buy cheap. One can speculate either in the spot or forward market.

The rule of speculation on strong currency is: Buy cheap and sell dear. This means purchasing a currency in the forward in the expectation of selling the currency in the spot market after it has appreciated or has been revalued to a level above that of the original forward contract.

Arbitrage – The act of purchasing a security or commodity in one market and selling it immediately in another at a higher price is termed “Arbitrage”, or specifically, Deterministic Arbitrage. It means taking advantage of discrepancy in the prices of commodities existing in various markets at the same or different times.

However, the meaning of Arbitrage has been expanded to include any activity wherein the difference of pricing is exploited. Arbitrage is popularly applied in trading options, convertible securities and futures, wherein purchase and sale of packages of related instruments is involved.

Risk-free profits continue until market correction occurs, when the security is traded at the same price in both the exchanges.

There are 2 types of arbitrage that we shall be considering:

1. Spatial Arbitrage – without cost of transaction2. Spatial Arbitrage – with cost of transaction

Spatial Arbitrage – without cost of transaction


When discrepancy between the price quotations of a currency at two disjoint markets exists, the arbitrage possibilities exist. The rule to earn profit is, buy cheap and sell dear i.e. buy from the market where the currency is selling cheap and sell the currency where it has a higher price. The two transactions are simultaneously conducted.

Spatial Arbitrage – with cost of transaction

Commercial banks providing foreign exchange services will normally quote about the same rate on currencies, therefore shopping around for better quotes may not result in an advantage. If demand and supply conditions for different banks for a particular currency differs, in that case the bank may quote different prices for the same currency and market will force realignment of the prices so that the price offered by the bans for the currency become equal.

Permissible derivative instruments as per the RBI guidelines are:

Interest Rate Derivatives – Interest Rate Swaps (IRS), Forward Rate Agreements (FRA’s) & Interest Rate Futures (IRF).

Foreign Currency Derivatives – Foreign Currency Forwards, Currency Swaps and Currency Options.

The rapid growth of derivatives market, especially structured derivatives has increased the focus on ‘suitability’ and ‘appropriateness’ of derivative products being offered by market makers to customers (users) as also customer appropriateness.

It’s imperative that market – makers offer derivative products in general, and structured products, in particular to only those users who understand the nature of the risks inherent in these transactions and further that products being offered are consistent with user’s business, financial operations, skill and sophistication, internal policies as well as risk appetite. Market – makers may also be exposed to credit risk if the counterparty fails to meet his financial obligations under the contract.

More Indian firms are using derivatives to hedge currency exposure as the rupee, long locked in a rough 43-49 rupee per dollar range, and rose rapidly last year due to big capital inflows. Analysts say typical trades were currency swaps to cut costs, but volatile markets caught some the wrong way and bankers estimate firms' losses may total $5-7 billion.

According to a Credit Suisse report, the size of the potential market-to-market (MTM) losses of corporates is between Rs 12,000 crore and Rs 20,000 crore. The report also states that Indian banks have taken a hit of $328 million or


1.8% of book value (BV). Analysts may agree that the erratic movements in currency may have triggered this bloodbath, but there is no consensus on whether it is corporate houses that went wrong or the zealous approach by banks, which made them, enter into complicated derivative contracts.

These happenings in the Indian derivative markets drive home the point of “risk” in derivative transactions. Warren Buffet, CEO Berkshire Hathaway in an interview in 2002 said “We view them (derivatives) as time bombs, both, for the parties that deal in them and the economic system. In our view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Risk can bring unexpected gains. It can also cause unforeseen losses, even catastrophes. These risks associated with derivatives are credit risk, market risk, liquidity risk, operational risk, legal risk, regulatory risk, reputation risk.

1. Credit Risk – The risk of loss due to a counterparty’s failure to perform on an obligation to the institution. Credit risk in derivative products comes in two forms:

Pre-settlement risk is the risk of loss due to a counterparty defaulting on a contract during the life of a transaction. The level of exposure varies throughout the life of the contract and the extent of losses will only be known at the time of default.Settlement risk is the risk of loss due to the counterparty's failure to perform on its obligation after an institution has performed on its obligation under a contract on the settlement date. Settlement risk frequently arises in international transactions because of time zone differences. This risk is only present in transactions that do not involve delivery versus payment and generally exists for a very short time (less than 24 hours).

2. Market Risk - The risk of loss due to adverse changes in the market value (the price) of an instrument or portfolio of instruments. Such exposure occurs with respect to derivative instruments when changes occur in market factors such as underlying interest rates, exchange rates, equity prices, and commodity prices or in the volatility of these factors.

3. Liquidity Risk - The risk of loss due to failure of an institution to meet its funding requirements or to execute a transaction at a reasonable price. Institutions involved in derivatives activity face two types of liquidity risk: market liquidity risk and funding liquidity risk.

Market liquidity risk is the risk that an institution may not be able to exit or offset positions quickly, and in sufficient quantities, at a reasonable


price. This inability may be due to inadequate market depth in certain products (e.g. exotic derivatives, long-dated options), market disruption, or inability of the bank to access the market (e.g. credit down-grading of the institution or of a major counterparty).

Funding liquidity risk is the potential inability of the institution to meet funding requirements, because of cash flow mismatches, at a reasonable cost. Such funding requirements may arise from cash flow mismatches in swap books, exercise of options, and the implementation of dynamic hedging strategies.

4. Operational Risk - The risk of loss occurring as a result of inadequate systems and control, deficiencies in information systems, human error, or management failure. Derivatives activities can pose challenging operational risk issues because of the complexity of certain products and their continual evolution.

5. Legal risk - The risk of loss arising from contracts, which are not legally, enforceable (e.g. the counterparty does not have the power or authority to enter into a particular type of derivatives transaction) or documented correctly.

6. Regulatory risk - The risk of loss arising from failure to comply with regulatory or legal requirements.

7. Reputation risk - The risk of loss arising from adverse public opinion and damage to reputation.


Risk measurement

Accurate measurement of derivative-related risks is necessary for proper monitoring and control. All significant risks should be measured and integrated into an entity-wide risk management system.

The risk of loss can be most directly quantified in relation to market risk and credit risk (though other risks may have an equally or even greater adverse impact on earnings or capital if not properly controlled). These two types of risks are clearly related since the extent to which a derivatives contract is "in the money" as a result of market price movements will determine the degree of credit risk. This illustrates the need for an integrated approach to the risk management of derivatives. The methods used to measure market and credit risk should be related to:

a) the nature, scale and complexity of the derivatives operation;b) the capability of the data collection systems; andc) the ability of management to understand the nature, limitations

The major problem faced by Indian companies is they think by putting the right kind of strategy the task is complete. But in reality, putting the right hedging strategy in place is only half the battle won; companies need to continuously monitor and assess the effectiveness of the hedging strategies and ensure that they are in sync with the underlying risk profile. Lack of technical expertise to evaluate the complexity of the derivative transactions and ability to identify, understand and quantify the risks by performing periodic Mark-to-Market (MTM) calculations, inability to closely match the derivative transactions with the underlying exposures, thereby causing ineffectiveness and inability to quantify counterparty risk exposures in the event of defaults are few of the issues bothering India Inc. in derivative transactions, which make them look at these instruments with a lot of suspicion.

Mark – to – Market: This essentially means that at the end of a trading session, all outstanding contracts are re-priced at the settlement price of that session.


Counterparty Risk

‘Counterparty Credit Risk (CCR)’ means the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. The issue of counterparty credit risk has also great importance for the Indian financial system; the negative mark-to-market value of the outstanding transactions seems to have amounted to a significant percentage of the corporate’s net worth. (In some cases, incredibly, it seems to be as high as 150 per cent of the net worth!). In the US, one has serious doubts whether the Federal Reserve would have participated in, let alone committed as much as $30 billion of public money for the rescue of an investment bank: it did so only because Bear Stearns was counterparty to a very large number of outstanding derivatives with an aggregate notional in trillions of dollars, and its insolvency would have posed a systemic risk for the banking system.

A first step in the measurement of credit risk is to determine the exposure to counterparties in each portfolio and across portfolios (firm wide exposure).

Counterparty credit exposure is the larger of zero or the market value of a transaction or portfolio of transactions within netting set with a counterparty that would be lost upon the default of the counterparty.

Exposures may exist in securities or derivative positions, or may arise from pending settlements of contracts or positions executed with a financial institution or letters of credit issued by an institution for another counterparty. Purpose of exposure calculations is to support the assessment of portfolio and confirm compliance with policies and guidelines, and to assess credit concentrations.

For security positions, exposure is straightforward (i.e. equal to the value of the security).For derivative positions exposure measurement must consider not only the current value of the position, but also the potential change in value of the position over its life that could lead to larger exposure on the position.

As per the RBI Master Circular on Exposure Norms for Financial Institutions1

with effect from April 1, 2003, the FIs are required to include in the non-funded credit limit, the forward contracts in foreign exchange and other derivative products like currency swaps, options, etc at their replacement cost in determining the individual / group borrower exposures. This replacement cost is the exposure value in a derivative transaction.

1 RBI/2006-2007/6; DBOD. No. FID. FIC.4 /01.02.00/2006-07


Methods to calculate credit risk exposure

There are two methods for measuring the credit risk exposure inherent in derivatives, as described below.

1. The original exposure method

Under this method, which is a simpler alternative, the credit risk exposure of a derivative product is calculated at the beginning of the derivative transaction by multiplying the notional principal amount with the prescribed credit conversion factors. The method, however, does not take account of the ongoing market value of a derivative contract, which may vary over time. In order to arrive at the credit equivalent amount under this method, an FI should apply the following credit conversion factors to the notional principal amounts of each instrument according to the nature of the instrument and its original maturity:

Original Maturity

Credit Conversion Factor to be applied to Notional Principal Amount

Interest Rate Contract

Exchange rate Contract

Less than one year 0.5 % 2.0%

One year and less than two years

1.0% 5.0 % (2 % + 3

%)

For each additional year 1.0% 3.0 %

Table 3: Conversion factor to be multiplied to notional amounts as per original exposure method

2. The current exposure method

Under this method, the credit risk exposure / credit equivalent amount of the derivative products is computed periodically on the basis of the market value of the product to arrive at its current replacement cost. Thus, the credit equivalent of the off-balance sheet interest rate and exchange rate instruments would be the sum of the following two components:


(a) The total 'replacement cost' - obtained by "marking-to-market" of all the contracts with positive value (i.e. when the FI has to receive money from the counterparty); and

(b) An amount for 'potential future exposure' - calculated by multiplying the total notional principal amount of the contract by the following credit conversion factors according to the residual maturity of the contract:

Table 4: Conversion factor to be multiplied to notional amounts as per current exposure method

Residual MaturityConversion Factor to be applied onNotional Principal AmountInterest Rate Contract Exchange Rate

ContractLess than one year Nil 1.0 %One year and over 0.5% 5.0 %

Under the current exposure method, the FIs should mark to market the derivative products at least on a monthly basis and they may follow their internal methods for determining the marked-to-market value of the derivative products. However, the FIs would not be required to calculate potential credit exposure for single currency floating / floating interest rate swaps. The credit exposure on these contracts would be evaluated solely on the basis of their mark-to-market value.

Global Practices for calculation of Exposure Values

Firms have 3 alternative methods of calculating the exposure of their OTC derivatives.

1) Mark to Market Method – This is the simplest method; the exposure value is calculated as follows:

a. By attaching current market values to contracts (mark-to-market), the current replacement cost of all contracts with positive values is obtained.

b. To obtain a figure for potential future credit exposure, except in the case of single-currency ‘floating/floating’ interest rate swaps in


which only the current replacement cost will be calculated, the notional principal amounts or underlying values are multiplied by the percentages as per the following table:

Table 5: Percentages to be multiplied to notional amounts as per MTM method

Residual Maturity

Interest Rate Contracts

Contracts concerning foreign currency rates and gold

Contracts concerning equities

Contracts concerning precious metals except gold

Contracts concerning commodities other than precious metals

One years or less

0% 1% 6% 7% 10%

Over one year and not exceeding 5 years

0.5% 5% 8% 7% 12%

Over 5 years

1.5% 7.5% 10% 8.5% 15%

2) Standardized method – The standardized method is a more risk sensitive than the MTM method, while providing a simple and workable alternative. The exposure value is determined as the product of the larger of the net current market value or a “supervisory EPE”, times a scaling factor, termed beta (). It is proposed to set the beta multiplier at 2.0. Exposure value =

β*max (CMV – CMC;∑│∑RPTij - ∑RPCij│*CCRMj) j i l

where: CMV = current market value of the portfolio of transactions within the

netting set with a counterparty gross of collateral, that is where:

CMV = ∑ CMVi

iwhere:

CMVi = the current market value of transaction i;


CMC = the current market value of the collateral assigned to the netting set, that is, where:

CMC = ∑ CMCl

lwhere:

CMCl = the current market value of collateral l; i = index designating transaction; l = index designating collateral; j = index designating hedging set category. These hedging sets corresponds

to risk factors for which the risk positions of opposite sign can be offset to yield a net risk position on which the exposure measure is then based;

RPTij = risk position from transaction i with respect to hedging set j; RPClj = risk position from collateral l with respect to hedging set j; CCRMj = CCR multiplier set out in Table 4 with respect to hedging set j; = 1.4

Table 6: CCR multipliers for different hedging set categoriesHedging Set Categories CCRM

1. Interest Rates 0.2%

2. Interest Rates for risk positions from a reference debt instrument that underlies a credit default swap and to which a capital charge of 1.6% or less

0.3%

3. Interest Rates for risk positions from a debt instrument or a reference debt instrument to which a capital charge of more than 1.6 %

0.6%

4. Exchange rates 2.5%

5. Electric Power 4.0%

6. Gold 5.0%

7. Equity 7.0%

8. Precious Metals (except gold) 8.5%

9. Other Commodities (excluding precious metals and electricity power)

10%

10. Underlying instruments of OTC derivatives that are not in any of the above categories

10%


3) Internal Model Method – Internal model, is typically based on an effective expected positive exposure (effective EPE) method. This provides the most risk – sensitive approach for calculating exposure values & is aligned to the firm’s internal risk management practices.

The exposure value shall be calculated as the product of ‘α’ times Effective EPE, as follows:

Exposure value = α × Effective EPE

min (1 yr maturity)

Effective EPE = ∑ EffectiveEEtk _ Δtk k=1

where the weights Δtk = tk - tk-1 allow for the case when future exposure is calculated at dates that are not equally spaced over time.EE is expected exposure

Feedback from industry based on its own analysis, and competent authorities simulations, suggest that alphas may range from 1.1 for large global dealer portfolios to more than 2.5 for new users of derivatives with concentrated exposures and little or no current exposure in their book.

Suggested = 1.4With the approval of the competent authorities institutions can estimate their own of 1.2.

Standardized method and internal model methods allows risk to be bucketed at a more granular level and allows the risk position to be derived more accurately rather than simply using the notional value of the contract. They provide a more risk sensitive approach to calculating exposure values.

But since these 2 methods are complex in nature; the global best practice for calculation of counterparty exposure is normally done by the “Marked to Market” method. This is according to the Directive 2000/12/EC of the European Commission.


MEASUREMENT AND CALCULATION OF EXPOSURE VALUES

HDFC Ltd. enters into cross currency swaps and interest rate swaps with various global as well as nationalized banks. The MTM’s for these derivative transactions are updated on a monthly basis and so are the calculated exposure values.

As per various analyst reports, during the previous financial year HDFC had MTM profits of INR 2.9 billion.

Exposure calculations are done in the Corporation as per the “Original Exposure Method” where the notional amounts are multiplied with the credit conversion factor depending on the kind of swap.

But as mentioned by RBI in its “Master Circular - Exposure Norms for Financial Institutions” the FIs are encouraged to follow, with effect from April 1, 2003, the Current Exposure Method, which is an accurate method of measuring credit exposure in a derivative product, for determining individual / group borrower exposures.

The current exposure method is a better method since it takes into account the positive MTM values which is the amount HDFC receives from the various banks, which needs to be taken into account while calculation of counterparty exposure.

One marked difference other than consideration of MTM value is the use of residual maturity for the calculations, i.e., maturity till the date when the exposure value is being calculated.

The current exposure method falls in line with the Mark – to – Market method which is considered to be one of the global best practice methods for calculation of counterparty exposure. Both these methods include a ‘potential future exposure’ which is an estimate of the future replacement cost of derivatives transactions.


CALCULATIONS

Consider all the deals done with Bank of America, Mumbai Branch.

They are in total of 20 deals done – with 4 being interest swaps and 16 cross currency swaps.

None of the interest rate swaps done with Bank of America has a positive MTM as on Dec 31, 2007. So it accounts for a simple calculation as per the current exposure method:

Deal No: 2006/87Loan Type: NCDDeal Particulars: INR Coupon Only Swap Counterparty Branch: MumbaiType of swap: InterestNotional Principal: Rs. 2,500,000,000MTM (in INR): Rs. (107,238,350)Start Date: 8 – Dec – 2005 Maturity Date: 8 – Dec – 2017 Current Date: 31 – Dec – 2007 Residual Maturity: (Maturity Date – Current Date)/365 = 9.95

Rounding it off to 10 and then multiplying with the conversion factor given as per the RBI guidelines the exposure value came out to be:5% * 2500000000 = Rs. 125,000,000

Similarly calculating the exposure values for the other 3 deals the total exposure value comes out to be: Rs. 242,500,000

Using the original exposure method the value came out to be Rs. 510,000,000.

For currency swaps there are 10 deals with a positive MTM value and therefore there is a sizeable difference in the exposure values calculated as per the 2 methods.

Exposure value as per:(a) Original Exposure method: Rs. 534.32 crores(b) Current Exposure method: Rs. 1072.72 crores


THE COUNTERPARTY EXPOSURE VALUES FOR HDFC LTD. (ANALYSIS AND RECOMMENDATION)

Credit Exposure to Counterparty Banks 31-Dec-07

S No Bank Counterparty Branch

Interest /Currency

No. of deals

Credit Exposure calculated as per Current Exposure Method(Rs. In Crores)

Exposure calculated as per Original Exposure Method(Rs. In Crores)

1 JP Morgan Chase Bank

London Currency 3.00

444,037,500

44.40 35.72

Mumbai Interest 4.00

96,574,597

9.66 22.75

Currency 6.00

1,660,002,940

166.00 98.00

New York Interest 2.00

40,290,621

4.03 5.92

15.00 224.09 162.39

2 Calyon Bank Paris Currency - - Mumbai Interest 1.0

0 19,735,000 1.97 3.95

Currency 3.00

680,512,138 68.05 70.42

4.00

70.02 74.37

3 Barclays Bank London Interest 1.00

41,443,500 4.14 11.84

Mumbai Currency 6.00 3,992,253,141 399.23 295.69

7.00 403.37 307.53

4 Standard Chartered Mumbai Interest 3.00

22,301,250 2.23 11.00

5 Deutsche Bank Mumbai Interest 6.00

203,212,218 20.32 34.99

Currency 6.00

3,242,171,216 324.22 178.17

12.00

344.54 213.16

6 HSBC Mumbai Interest 10.00

377,264,198 37.73 61.45

Currency 13.00

5,993,629,899 599.36 328.46

23.00

637.09 389.91


7 Citibank Mumbai Interest 1.00

13,858,154 1.39 1.00

Currency 8.00

2,256,519,805 225.65 148.98

9.00

227.04 149.98

8 Bank of America Mumbai Interest 4.00

242,500,000 24.25 51.00

Currency 16.00

10,656,149,169

1065.61 534.32

Charolette Interest 1.00

9,867,500

0.99 0.99

21.00

1090.85 586.30

9 BNP Paribas Paris Interest 1.00

18,948,626

1.89 2.96

Currency 1.00

29,602,500

2.96 1.58

Mumbai Currency 2.00

663,530,636

66.35 33.96

4.00

71.21 38.49

10 Bank of India Mumbai Currency 1.00

500,000,000

50.00 70.04

11 HDFC Bank Mumbai Interest 1.00

20,000,000

2.00 4.50

Currency 3.00

434,256,802

43.43 18.85

4.00

45.43 23.35

12 ICICI Mumbai Interest 1.00

9,183,000

0.92 3.75

Currency 1.00

12,500,000

1.25 10.56

2.00

2.17 14.31

13 ICICI Securities Mumbai Interest 4.00

215,000,000

21.50 44.75

14 Axis Bank Mumbai Interest 1.00

100,000,000

10.00 22.50

15 Yes Bank Mumbai Currency 2.00

195,529,184

19.55 12.41

16 Punjab National Bank

New Delhi Currency 1.00

500,000,000

50.00 70.04

113.00

3269.09 2190.54


Figure 10 Comparative Analysis of the 2 methods

The substantial difference in few of the exposure values among the 2 methods is due to the MTM values i.e. the positive MTM values. These are the amount HDFC receives from the banks they enter derivative transactions with.

CONCLUSION:

Thus counterparty exposure should be calculated as per the current exposure method even though it gives a relatively larger value of exposure but it gives a more accurate one as:

(a) It takes into account the current market value of the derivative transaction by taking the MTM values.

(b) Under the original exposure method the exposure value will remain same throughout the life of the derivative but with current exposure method since residual maturity is taken, it will give the exposure value of the derivative transaction at that particular date in which the exposure calculation is done; hence there are many cases where potential future exposure comes out be zero for those whose residual maturities are less than 1 year for interest rate swaps.

GLOSSARY


1. SPOT Market – Market where the transactions are conducted for the spot deliveries of currencies. Here spot delivery means, the delivery takes place 2 business days after the day on which the spot contract is closed.

If the exchange of currencies takes place on the same day of transaction its known as Cash Deal. If the exchange of currencies takes place on the next working day, i.e., tomorrow it’s known as Tom Deal. Wherever forex rate will be delivered after the Spot date it’s known as Forward transaction.

2. Strike Price – Price at which option can be exercised.

3. OTM [Out of money] – An option whose intrinsic value is equal to zero.

4. ITM [In – the – money] – An option with non – zero intrinsic value.

A call strike whose strike is below the current spot is ITM. OTM is the exact opposite. A Put strike whose strike is above the current spot is ITM. OTM is the exact opposite.

5. ATM [At – the – money] – An option whose strike price is equal to the current spot rate (ATM spot) or to the current forward rate (ATM Forward). But by market convention, it’s generally understood to means a zero - delta straddle strike.

6. Delta – The sensitivity of an option premium with respect to a change in the value of an underlying instrument. The partial derivative of an option premium with respect to underlying price.


7. Bullish Spread – A bullish spread is created by buying a Call option and selling a further OTM Call option and selling a further OTM Call with the same expiry.

8. Bearish Spread – A bearish spread is created by buying a Put and selling a further OTM Put option with the same expiry.

9. Netting Set – A group of transactions with a single counterparty that are subject to legally enforceable bilateral netting arrangement.

10. Expected Exposure – ‘Expected Exposure (EE)’ means the average of the distribution of exposures at any particular future date before the longest maturity transaction in the netting set matures.


REFERENCES

Web Sites

1. www.rbi.org.in

2. www.fsa.gov.uk

3. www.economictimes.com

4. www.dnb.nl

5. www.iimcal.ac.in

6. www.isda.org

7. www.riskinstitute.ch

8. www.federalreserve.gov

Literature

1. HDFC Annual report 2006-07

2. Dun & Bradstreet - Tata McGraw-Hill Publication -

Foreign Exchange Risk Management

3. Bank of International Settlements – Triennial

Central Bank Survey

4. BNP Paribas – FX Derivatives

5. Indian Derivative Market – Asani Sarkar


Final Report

Documents

counterparty risk

derivative transactions

counterparty exposure

derivative users

original exposure method

current exposure method

risk factor

table of illustrationsfigure