International Finance Group 10 Derivatives

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INTERNATIONAL FINANCE

Group 10

Karan Menghani - F27

Nikhil Rao - F77

Nishant Jhangiani - F19

Pankti Pandya - F74

Pathik Shah - F38

Prashant Surana - F46

Rohan Doshi - F11

Sharved Mahajan - F67

Sushil Gurav - F60

DERIVATIVES

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DERIVATIVES

Derivative is a contract that derives its value from the performance of an underlying

entity. This underlying entity can be an asset, index, or interest rate, and is often called

the "underlying"

They are used for hedging, increasing exposure to price movements for speculation or

getting access to otherwise hard-to-trade assets or markets

The most common derivatives are forwards, futures, options, swaps

The trading happens either OTC or via an exchange

Both OTC and Exchanges transact in commodities, financial

instruments (including stocks), and derivatives

In the foreign exchange market, Currency Derivatives come into action which derive

their value from the underlying Foreign Exchange Rates for various currency pairs

Some common variants of derivative contracts are:

o Forwards - A tailored contract between two parties, where payment takes

place at a specific time in the future at today's pre-determined price

o Futures - are contracts to buy or sell an asset on a future date at a price

specified today. A futures contract differs from a forward contract in that the

futures contract is a standardized contract written by a clearing house that

operates an exchange where the contract can be bought and sold; the forward

contract is a non-standardized contract written by the parties themselves

o Options – are contracts that give the owner the right, but not the obligation,

to buy (in the case of a call option) or sell (in the case of a put option) an asset.

The price at which the sale takes place is known as the strike price, and is

specified at the time the parties enter into the option. The option contract also

specifies a maturity date

o Binary options - are contracts that provide the owner with an all-or-nothing

profit profile

o Warrants - Apart from the commonly used short-dated options which have a

maximum maturity period of 1 year, there exists certain long-dated options as

well, known as Warrant. These are generally traded over-the-counter

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o Swaps are contracts to exchange cash (flows) on or before a specified future

date based on the underlying value of currencies exchange rates,

bonds/interest rates, commodities exchange, stocks or other assets

The various types of contract types existing in currency derivatives are:

o Currency Future (Exchange-Traded)

o Option on Currency Future (Exchange-Traded)

o Currency Swap (OTC)

o Currency Forward (OTC)

o Currency Option (OTC)

CALLS AND PUTS

CALLS- A call is an option to buy an underlying stock at a specified exercise price, or

strike price, within a certain period.

PUTS- It is a way to make money should the price of the underlying stock decline,

because it gives the holder the right to sell a stock at a specified strike price within a

certain period of time.

For example, let's say you think XYZ's stock, now trading at $20, is going down by half

in 60 days. You do not currently hold any XYZ stock. You buy a put giving you the right

to sell 10,000 shares of it at $18. Turns out, you were right about XYZ and its stock

does indeed drop to $10. You buy 10,000 shares on the open market at $10 each and

sell them for $18 to the party who sold you the put.

FUTURES MARKET

Market in which participants can buy and sell commodities and their future delivery

contracts.

A futures market provides a medium for the complementary activities of hedging and

speculation, necessary for dampening wild fluctuations in the prices caused by gluts

and shortages.

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MARK TO MARKET

Mark-to-market (MTM) is an accounting method that records the value of an asset

according to its current market price.

For example, the stocks you hold in your brokerage account are marked-to-market

every day. At the closing bell, the price assigned to each of your stocks is the price that

the larger market of buyers and sellers decided it would be at the end of the day. No

other pricing information is included.

MTM is similarly used to price futures contracts, which is very important for investors

who trade commodities with margin accounts.

Most agree that MTM pricing accurately reflects the true value of an asset. However,

MTM can be problematic in times of uncertainty because the value of assets can vary

wildly from second to second, not because of changes in the underlying value of

assets, but because buyers and sellers are surging in and out in unpredictable ways.

VOLATILITY

Volatility is a measure for variation of price of a financial instrument over time. Historic

volatility is derived from time series of past market prices. An implied volatility is

derived from the market price of a market traded derivative (in particular an option).

The symbol σ is used for volatility, and corresponds to standard deviation.

Volatility measures the risk of a security. It is used in option pricing formula to gauge

the fluctuations in the returns of the underlying assets. Volatility indicates the pricing

behaviour of the security and helps estimate the fluctuations that may happen in a

short period of time.

If the prices of a security fluctuate rapidly in a short time span, it is termed to have

high volatility. If the prices of a security fluctuate slowly in a longer time span, it is

termed to have low volatility.

Seasoned traders who monitor the markets closely usually buy stocks and index

options when the Volatility Index is high. When the Volatility Index is low, it usually

indicates that investors believe the market will head higher. This, in turn, can trigger

a market selloff, as speculators try to unload their holdings at premium prices.

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Relative volatility of a particular stock to the market is measured using its beta. A beta

approximates the overall volatility of a security’s returns against the returns of a

relevant benchmark. For example, a stock with a beta value of 1.1 has historically

moved 110% for every 100% move in the benchmark, based on price level.

SPOT PRICE MODELS

The current price at which a particular security can be bought or sold at a specified

time and place is called Spot Price.

A security's spot price is regarded as the explicit value of the security at any given time

in the marketplace. In contrast, a securities futures price is the expected value of the

security, in relation to its current spot price and time frame in question.

Spot prices are most often used in relation to pricing of futures contracts of securities,

typically commodities. In pricing commodity futures, the futures price is determined

using the commodity's spot price, the risk free rate and time to maturity of the

contract.

This class of models aims at capturing the hourly price behaviour by fitting their model

to historical spot price data.

Most models for the spot market employ at least two risk factors: one factor capturing

the short-term hourly price dynamics characterized by mean reversion and very high

volatility, and the other factor representing long-term price behaviour observed in the

futures market.

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DIFFERENTIAL INTEREST RATE AND ITS USES

An interest rate differential is a differential measuring the gap in interest rates

between two similar interest-bearing assets. Traders in the foreign exchange market

use interest rate differentials (IRD) when pricing forward exchange rates.

Based on the interest rate parity, a trader can create an expectation of the future

exchange rate between two currencies and set the premium (or discount) on the

current market exchange rate futures contracts.

Interest rate parity is a no-arbitrage condition representing an equilibrium state under

which investors will be indifferent to interest rates available on bank deposits in two

countries. The fact that this condition does not always hold allows for potential

opportunities to earn riskless profits from covered interest arbitrage.

Two assumptions central to interest rate parity are capital mobility and perfect

substitutability of domestic and foreign assets. Given foreign exchange

market equilibrium, the interest rate parity condition implies that the

expected return on domestic assets will equal the exchange rate-adjusted expected

return on foreign currency assets.

Investors then cannot earn arbitrage profits by borrowing in a country with a lower

interest rate, exchanging for foreign currency, and investing in a foreign country with

a higher interest rate, due to gains or losses from exchanging back to their domestic

currency at maturity.

Interest rate parity takes on two distinctive forms:

o Uncovered interest rate - parity condition in which exposure to foreign

exchange risk (unanticipated changes in exchange rates) is uninhibited.

o Covered interest rate parity - condition in which a forward contract has been

used to cover (eliminate exposure to) exchange rate risk.

Each form of the parity condition demonstrates a unique relationship with

implications for the forecasting of future exchange rates: the forward exchange

rate and the future spot exchange rate.

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IMPACT OF INFLATION ON INTERNATIONAL FINANCE

The purchasing power parity relationship can explain some events can have major

effects on MNCs through their impact of oil prices on inflation and therefore on

exchange rates in countries that import oil.

In 2000, the European countries that participate in the Euro import oil and were

subjected to higher prices of oil. Since the United Kingdom produces its own oil it was

not directly affected by the higher market price of oil. Inflation increased in Europe,

which placed pressure on euro relative to the British pound. MNCs based in Eurozone

countries were also affected.

Its MNCs however, were adversely affected as a result of their businesses with other

European countries. MNCs in the United Kingdom that export to those Eurozone

countries were adversely affected because the pound became more expensive

relative to the Euro, reducing the demand for British products. Those that export to

the United Kingdom benefitted because their products became cheaper to British

consumers.

However, the inflation in the Eurozone countries caused the European central bank to

raise interest rates in an attempt to reduce the inflationary pressure. Consequently

the economy of these counties weakened and the local demand for the products

produced by the MNCs was reduced

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MULTI-CURRENCY HEDGE STRATEGY

Hedging is defined as holding two or more positions at the same time, where the

purpose is to offset the losses in the first position by the gains received from the other

position. When the currencies of more than two countries are involved, for mitigating

the risks such as exchange rate fluctuations, hedging is done, which is currency

hedging.

TRANSFER PRICING

Transfer pricing is the setting of the price for goods and services sold between

controlled (or related) legal entities within an enterprise. For example, if a subsidiary

company sells goods to a parent company, the cost of those goods is the transfer price.

Transfer pricing happens whenever two companies that are part of the same

multinational group trade with each other: when a US-based subsidiary of Coca-Cola,

for example, buys something from a French-based subsidiary of Coca-Cola. When the

parties establish a price for the transaction, this is transfer pricing.

Transfer price policy is generally aimed at (1) evaluating financial performance of

different business units (profit centres) of a conglomerate, and/or to (2)

shift earnings from a high tax jurisdiction to a low-tax one.

Tax authorities usually frown upon transfer pricing aimed at tax avoidance and insist

that each internal part of the firm deals with the other on 'arm's length' (market price)

basis. Also called transfer cost.

Transfer mispricing is a form of a more general phenomenon known as trade

mispricing, which includes trade between unrelated or apparently unrelated parties,

and hence is illegal.

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HAWALA

An alternative remittance channel that exists outside of traditional banking systems.

Hawala is a method of transferring money without any actual movement. One

definition from Interpol is that Hawala is "money transfer without money movement."

Transactions between Hawala brokers are done without promissory notes because

the system is heavily based on trust.

Hawala remittance systems are not per se illegal. As a remittance system, Hawala is

submitted to the national regulations governing remittance services. In some

countries, Hawala is illegal from a regulatory perspective, although enforcement is

difficult

A customer – usually a migrant worker- approaches a Hawala broker and gives him a

sum of money to be transferred to a beneficiary – usually a relative - in another city

or country. The Hawala broker often runs a legitimate business in addition to the

financial services he offers and has a business contact, a friend or a relative in this

city/country. The Hawala operator contacts their Hawala partner – usually a contact

from their personal or business network - in the recipient city/country by phone, fax

or e-mail. The operator instructs the partner to deliver the funds to the beneficiary,

providing amount, name, address and telephone number of the recipient and

promises to settle the debt at a later stage. The customer does not necessarily receive

a receipt but is given an identification code for the transaction. The Hawala broker in

the recipient city/country contacts the beneficiary and delivers the funds. The

recipient can receive the funds without producing identity documents other than the

previously agreed code

Hawala partners may be business partners, typically involved in import/export

activities. In such case, transferring money is one of the activities they are regularly

engaged in as part of their normal dealings with one another. The debt settlement can

be done by “manipulating” invoices to conceal money transfers, for example by under-

invoicing or over-invoicing shipment of goods

Hence issue with Hawala is irregular economic activity and no paper trail, hence funds

cannot be traced and their usage can be for illegal or terrorist activity.

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Lack of paper work and documentation also helps to bend around economic and forex

regulations in many cases

BLACK-SCHOLES MODEL

The Black-Scholes Model was first discovered in 1973 by Fischer Black and Myron

Scholes, and then further developed by Robert Merton

The Black Scholes Model is one of the most important concepts in modern financial

theory. The Black Scholes Model is considered the standard model for valuing options

The model assumes that the price of heavily traded assets follow a geometric

Brownian motion with constant drift and volatility

When applied to a stock option, the model incorporates the constant price variation

of the stock, the time value of money, the option's strike price and the time to the

option's expiry

The exact 6 assumptions of the Black-Scholes Model are :

1. Stock pays no dividends.

2. Option can only be exercised upon expiration.

3. Market direction cannot be predicted, hence "Random Walk."

4. No commissions are charged in the transaction.

5. Interest rates remain constant.

6. Stock returns are normally distributed, thus volatility is constant over time.

These assumptions are combined with the principle that options pricing should

provide no immediate gain to either seller or buyer.

Many assumptions of the Black-Scholes Model are invalid, resulting in theoretical

values which are not always accurate. Therefore, theoretical values derived from the

Black-Scholes Model are only good as a guide for relative comparison and is not an

exact indication to the over- or under-priced nature of a stock option

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Among the most significant limitations are:

1. The Black-Scholes Model assumes that the risk-free rate and the stock’s

volatility are constant.

2. The Black-Scholes Model assumes that stock prices are continuous and that

large changes (such as those seen after a merger announcement) don’t occur.

3. The Black-Scholes Model assumes a stock pays no dividends until after

expiration.

4. Analysts can only estimate a stock’s volatility instead of directly observing it, as

they can for the other inputs.

5. The Black-Scholes Model tends to overvalue deep out-of-the-money calls and

undervalue deep in-the-money calls.

6. The Black-Scholes Model tends to misprice options that involve high-dividend

stocks

The Black-Scholes Model

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ROLE OF AUTHORITIES IN THE FOREX MARKETS

ROLE OF RBI

Foreign Exchange Market in India works under the Central Government in India and

executes wide powers to control transactions in foreign markets.

Foreign Exchange Management Act 199, FEMA regulates the whole FOREX market in

India. Before this act was introduced FOREX market in India was regulated by the

Reserve Bank of India through the Exchange Control Dept. by the FERA, Foreign

Exchange Regulation Act, 1947

.

RBI is responsible for administration of the FEMA 1999, and regulates the market by

issuing licenses to banks and other select institutions to act as authorised dealers in

foreign exchange. The Foreign Exchange Dept., FED, is responsible for the regulation

and development of the market.

RBI’s Financial Market Dept., FMD, participates in the foreign exchange market by

undertaking sales/ purchase of foreign currency to ease volatility in periods of excess

demand for /supply of foreign currency.

FOREX INTERVENTION

Foreign exchange intervention is defined generally as foreign exchange transactions

conducted by the monetary authorities with the aim of influencing exchange rates. It

is the process by which the monetary authorities attempt to influence market

conditions and/or the value of the home currency on the foreign exchange market.

Intervention usually aims to promote stability by countering disorderly markets, or in

response to special circumstances.

In Japan, the Minister of Finance is legally authorized to conduct intervention as a

means to achieve foreign exchange rate stability. In the United States, the

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Government and Federal Reserve Board (FRB); in Euro Area, the European Central

Bank (ECB); in the United Kingdom, the Bank of England (BOE) operates it.

ROLE OF FEDERAL RESERVE

The U.S. monetary authorities occasionally intervene in the foreign exchange (FX)

market to counter disorderly market conditions.

The Treasury, in consultation with the Federal Reserve System, has responsibility for

setting U.S. exchange rate policy, while the Federal Reserve Bank New York is

responsible for executing FX intervention.

U.S. FX intervention has become less frequent in recent years.

ROLE OF WTO & IMF

The WTO and IMF both have major institutional responsibilities in the area of international

trade.

IMF is an international organization created for the purpose of:

1. Promoting global monetary and exchange stability

2. Facilitating the expansion and balanced growth of international trade

3. Assisting in the establishment of a multilateral system of payments for current

transactions.

The IMF plays three major roles in the global monetary system. The Fund surveys and

monitors economic and financial developments, lends funds to countries with

balance-of-payment difficulties, and provides technical assistance and training for

countries requesting it.

World Trade Organisation WTO deals with the rules of trade between nations at global

or near-global level.

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WTO acts as a negotiating forum, where countries have faced trade barriers and

wanted them lowered, the negotiations have helped liberalize trade.

At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s

trading nations. They are essentially contracts, binding governments to keep their

trade policies within agreed limits.

Trade relations often involve conflicting interests and interpretation of agreements.

The most harmonious way to settle these is through some neutral procedure based

on an agreed foundation. This is the purpose behind the dispute settlement process

written into the WTO agreements.

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COLLATERALIZED DEBT OBLIGATION (CDO)

Collateralized Security: A security with value collaterized by a pool of underlying fixed-

income assets. Owing to the process of deriving payments from the performance of

the pool, it is an investment that yields a regular return. A structured, asset-backed

security, it is split into different rick classes, referred to as tranches.

Tranching: Splitting of an income stream into multiple tradable instruments is referred

to as Tranching. The lowest risk or rather the safest security is in the ‘senior’ tranche

& have first priority claim on the collateral in case of a default. The junior tranche,

referred to as ‘equity tranche’ or colloquially as ‘toxic waste’ is at the greatest risk of

not receiving a payment. This leads to it having higher coupon payments or rates, to

offset the increased risk of a default.

The junior tranches played a major role in the 2008-09 ‘Sub-Prime Mortgage’ crisis in

US.

Around 5 different parties involved in a CDO construction:

Securities firms for approving the collateral selection, structuring the notes

into tranches & selling to investors.

CDO managers are involved in collateral selection & managing the CDO

portfolio

Rating agencies for assessing the CDO & assigning them a credit rating

Financial guarantors, who guarantee reimbursement to investors for any

losses on the CDO tranches in exchange for premium payments

Investors, who can be pension funds or hedge funds

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Once a money making machine on Wall Street, it was responsible for nearly $542

billion loss in 2007-08.

In perfect capital markets, CDOs would serve no purpose; the costs of constructing and

marketing a CDO would inhibit its creation. In practice, CDO s address some important market

imperfections. First, banks and certain other financial institutions have regulatory capital

requirements that make it valuable for them to securitize and sell some portion of their

assets, reducing the amount of (expensive) regulatory capital that they must hold. Second,

individual bonds or loans may be illiquid, leading to a reduction in their market values.

Securitization may improve liquidity, and thereby raise the total valuation to the issuer of the

CDO structure.

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2 popular CDO classes :

Balance Sheet CDO: The balance-sheet CDO, typically in the form of a collateralized

loan obligation (CLO), is designed to remove loans from the balance sheets of banks,

achieving capital relief, and perhaps also increasing the valuation of the assets through

an increase in liquidity. Balance-sheet CDOs are normally of the cash-flow type.

Arbitrage CDO: An arbitrage CDO, often underwritten by an investment bank, is

designed to capture some fraction of the likely difference between the total cost of

acquiring collateral assets in the secondary market and the value received from

management fees and the sale of the associated CDO structure. Arbitrage CDOs may

be collateralized bond obligations (CBOs), and have either cash-flow or market-value

structures.

Generic Types of SF CDOs

Cash SF CDOs

Bespoke SF CDOs

Hybrid SF CDOs

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Cash SF CDOs :

> Cash SF CDO Asset Portfolio Highlights

o Portfolios contain between 60 and 140 bonds

o Assets may be diversified by market sector, however recent vintage SF CDOs

have been concentrated in subprime RMBS

o Assets may be diversified by risk profile (initial ratings)

o Assets may be diversified by vintage

o Asset acquisition and selection

o Asset manager warehouses bonds prior to issuing CDO notes

CDO notes typically issued when asset manager has accumulated

approximately 60-80% of the target portfolio

Initial portfolio is typically fully ramped within 6 months of CDO note

issuance

Bespoke CDO

> Bespoke SF CDO Asset Portfolio Highlights

o Portfolios reference between 60 and 100 securities

o Assets may be diversified by market sector but typically have a concentration

in subprime RMBS

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o Assets may be diversified by risk profile (initial ratings)

o Assets may be diversified by vintage

o Asset selection

Portfolio is negotiated between the Bespoke CDO note holder and the

CDS Swap counterparty

Hybrid SF CDO:

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> Hybrid SF CDO Asset Portfolio Highlights

o Portfolio assets may be in a cash or synthetic form

o Portfolios contain between 60 and 140 bonds or CDS

o Asset attributes similar to the cash SF CDO portfolios

o Portfolios are typically managed

Asset managers can find relative value on the same asset between cash

and synthetic markets

Asset managers can use the synthetic market to access collateral from

vintages that are not available in the secondary market

Asset managers can use the synthetic market to get full exposure to

cash bonds where they received a partial allocation

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CREDIT DEFAULT SWAP – CDS

A swap designed to transfer the credit exposure of fixed income products between

parties.

A credit default swap is also referred to as a credit derivative contract, where the

purchaser of the swap makes payments up until the maturity date of a contract.

Payments are made to the seller of the swap. In return, the seller agrees to pay off a

third party debt if this party defaults on the loan.

A CDS is considered insurance against non-payment. A buyer of a CDS might be

speculating on the possibility that the third party will indeed default.

Source: RBI

HEDGING AND SPECULATION

CDS have the following two uses.

A CDS contract can be used as a hedge or insurance policy against the default of a

bond or loan. An individual or company that is exposed to a lot of credit risk can shift

some of that risk by buying protection in a CDS contract. This may be preferable to

selling the security outright if the investor wants to reduce exposure and not eliminate

it, avoid taking a tax hit, or just eliminate exposure for a certain period of time.

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The second use is for speculators to "place their bets" about the credit quality of a

particular reference entity. With the value of the CDS market, larger than the bonds

and loans that the contracts reference, it is obvious that speculation has grown to be

the most common function for a CDS contract. CDS provide a very efficient way to take

a view on the credit of a reference entity. An investor with a positive view on the credit

quality of a company can sell protection and collect the payments that go along with

it rather than spend a lot of money to load up on the company's bonds. An investor

with a negative view of the company's credit can buy protection for a relatively small

periodic fee and receive a big payoff if the company defaults on its bonds or has some

other credit event. A CDS can also serve as a way to access maturity exposures that

would otherwise be unavailable, access credit risk when the supply of bonds is limited,

or invest in foreign credits without currency risk.

TRADING

While most of the discussion has been focused on holding a CDS contract to expiration,

these contracts are regularly traded

The value of a contract fluctuates based on the increasing or decreasing probability

that a reference entity will have a credit event. Increased probability of such an event

would make the contract worth more for the buyer of protection, and worth less for

the seller.

The opposite occurs if the probability of a credit event decreases. A trader in the

market might speculate that the credit quality of a reference entity will deteriorate

sometime in the future and will buy protection for the very short term in the hope of

profiting from the transaction. An investor can exit a contract by selling his or her

interest to another party, offsetting the contract by entering another contract on the

other side with another party, or offsetting the terms with the original counterparty.

Because CDSs are traded over the counter (OTC), involve intricate knowledge of the

market and the underlying assets and are valued using industry computer

programs, they are better suited for institutional rather than retail investors.

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Source: Bloomberg

MARKET RISKS

The market for CDSs is OTC and unregulated, and the contracts often get traded so much

that it is hard to know who stands at each end of a transaction.

There is the possibility that the risk buyer may not have the financial strength to abide by

the contract's provisions, making it difficult to value the contracts.

The leverage involved in many CDS transactions, and the possibility that a widespread

downturn in the market could cause massive defaults and challenge the ability of risk

buyers to pay their obligations, adds to the uncertainty.

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THE BOTTOM LINE

Despite these concerns, credit default swaps have proved to be a useful portfolio

management and speculation tool, and are likely to remain an important and critical part of

the financial markets.

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