7 - Swaps & Other Derivatives

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Swaps

History of Swaps
• The swap as a financial instrument came into existence
due to the presence of exchange controls that restricted
the movement of capital from one country to another.
• The MNC’s operating in various countries could not
freely remit funds back and forth among their
subsidiaries due to exchange controls exercised by
various governments on capital flows, they came out
with the innovation of back to back or parallel loans
among themselves.
Cont…
• Two companies located in different countries
would mutually swap loans in the currency of
their respective countries.
• This arrangement allowed each company to have
access to the foreign exchange of the other
country and avoid paying any foreign currency
taxes.
Swap
• A swap is a derivative contract through which two
parties exchange the cash flows or liabilities from two
different financial instruments.
• Swaps do not trade on exchanges, and retail investors
do not generally engage in swaps.
• Rather, swaps are over-the-counter contracts primarily
between businesses or financial institutions that are
customized to the needs of both parties..
• IBM and the World Bank entered into the first formalized swap

agreement in 1981.

• The World Bank needed to borrow German marks and Swiss francs

to finance its operations, but the governments of those countries

prohibited it from borrowing activities.

• IBM, on the other hand, had already borrowed large amounts of

those currencies, but needed U.S. dollars when interest rates were

high for corporate borrowers.

• Salomon Brothers came up with the idea for the two parties to

swap their debts.


Cont.…
• IBM swapped its borrowed francs and marks for

the World Bank’s dollars. IBM further managed its

currency exposure with the mark and franc.

• This swaps market has since grown exponentially

to trillions of dollars a year in size.


• The history of swaps wrote another chapter during the
2008 financial crisis when credit default swaps on
mortgage backed securities (MBS) were cited as one of
the contributing factors to the massive economic
downturn.

• Credit default swaps were supposed to provide protection


for the non-payment of mortgages, but when the market
started to crumble, parties to those agreements defaulted
and were unable to make payments.
Cont.…
• This has led to substantial financial reforms of
how swaps are traded and how information on
swap trading is disseminated.
• Swaps were historically traded over the counter,
but they are now moving to trading on centralized
exchanges.
Interest Rate Swap
• Interest rate swaps provide a way for businesses
to hedge their exposure to changes in interest rates.
• If a company believes long-term interest rates are
likely to rise, it can hedge its exposure to interest rate
changes by exchanging its floating rate payments for
fixed rate payments.
• An interest rate swap is an agreement between two
parties to exchange one stream of interest payments
for another, over a set period of time.
• The most common type of interest rate swap is
“vanilla” swaps in which Party A agrees to make
payments to Party B based on a fixed interest rate,
and Party B agrees to make payments to Party A
based on a floating interest rate. The floating rate
is tied to a reference rate (in almost all cases, the
London Interbank Offer Rate, or LIBOR).
Example
• Assume that Ram owns Rs.10,00,000 investment that pays him MIBOR + 1% every

month. As MIBOR goes up and down, the payment Ram receives changes.

• Now assume that Shyam owns a Rs.10,00,000 investment that pays him 1.5% every

month. The payment he receives never changes.

• Ram decides that that he would rather lock in a constant payment and Shyam

decides that he'd rather take a chance on receiving higher payments.

• So Ram and Shyam agree to enter into an interest rate swap contract.

• Under the terms of their contract, Ram agrees to pay Shyam MIBOR + 1% per

month on a Rs.10, 00,000 principal amount (called the "notional principal"). Shyam

agrees to pay Ram 1.5% per month on the Rs.10,00,000 notional amount.
Scenario A: MIBOR = 0.25%
• Ram receives a monthly payment of Rs.12,500 from
his investment (Rs. 10,00,000 * (0.25% + 1%)).
• Shyam receives a monthly payment of Rs.15,000
from his investment (Rs.10,00,000 x 1.5%).
• Now, under the terms of the swap agreement, Ram
owes Shyam Rs. 12,500 (Rs.10,00,000 x LIBOR+1%) ,
and shyam owes him Rs.15,000 (Rs.10,00,000 x 1.5%).
• The two transactions partially offset each other and
Shyam owes Ram the difference: RS.2,500.
Scenario B: MIBOR = 1.0%
• Now, with MIBOR at 1%, Ram receives a monthly payment of
Rs.20,000 from his investment (Rs.10,00,000 x (1% + 1%)).
• Shyam still receives a monthly payment of Rs.15,000 from her
investment (Rs.10,00,000 x 1.5%).
• With MIBOR at 1%, Ram is obligated under the terms of the
swap to pay Shyam Rs.20,000 and Shyam still has to pay Ram
Rs.15,000.
• The two transactions partially offset each other and now Ram
owes Shyam the difference between swap interest payments:
Rs.5,000.
Solve the Problem on Interest Rate Swaps
Q1 Aditya has obtained a loan at fixed rate of 13% from HSBC. He
expects the interest rates to decline and is willing to take the benefit
of declining interest rates. He wants to convert his loan into a floating
rate. HSBC offers him the floating rate of MIBOR + 1.9%.

Another party, Krishna has borrowed from Citi Bank at floating rate of
MIBOR + 1.5%. He expects the interest rates to rise in future and this
will increase his commitment towards interest expenses. He is
therefore willing to convert his loans into a fixed rate. Citi Bank offers
him fixed rate of 14% p.a.
• Both these parties approach “NJ Ltd.” (A swap Bank) to find
out whether any swap deal can be effected and decide to
swap their interest obligations and the overall benefit of
swap shall be shared by the 3 parties including the swap
bank into the ratio of 5:5:4
• You are required to:
– Determine whether the interest rate swap deal can be effected
– Determine the differential surplus that benefits each of the 3
parties
– Show how the interest rate swap deal will be arranged
– Show how Swap Bank is benefited from the swap deal
Aditya’s Case:

• The swap bank shall borrow from Aditya on Notional basis at the
same rate that Aditya pays to his bank,i.e.13%

• Thereby swap bank shall reimburse the interest of same amount to


Aditya that he has paid to his bank.

• In turn, Aditya shall borrow from the swap bank on Notional basis
at an interest rate which is 0.5% lower than the rate offered by his
bank, i.e. @ M +1.4%
• With this arrangement, Aditya could convert his fixed rate loan into
a floating rate loan, that too at lower rate.
Krishna’s Case:

• Swap bank shall borrow from Krishna on notional basis at


the same rate that Krishna pays to his bank, i.e. M + 1.5%
• Thereby swap bank shall reimburse the interest of same
amount to Krishna that he has paid to his bank.

• In turn, Krishna shall borrow from the swap bank on


notional basis at an interest rate which is 0.5% lower than
the rate offered by his bank, i.e. @ 13.5%
• With this arrangement, Krishna could convert his floating
rate loan into a fixed rate loan, that too at lower risk.
Benefit to Swap Bank

• Interest Income = 13.5% + (M +1.4%) = M +14.9%

• Interest Expense = 13% + (M + 1.5%) = M + 14.5%

Differential Surplus = 0.4%


Q2. Assume that both Aditya and Krishna have
borrowed from their respective Banks an amount of
Rs.1,00,00,000 each. For interest rate swap
arrangement consider a notional loan of
Rs.1,00,00,000. Determine the net Payoff under the
legs for each of the following situations:
Case 1: MIBOR = 9% p.a.
Case 2: MIBOR = 13% p.a.
Case 3: MIBOR = 10.5% p.a.
Q3. If the swap bank is not involved as the intermediary then
Aditya and Krishna could have shared the overall benefit of
1.4% just between two of them. How would you arrange a swap
deal in such a case where Aditya and Krishna decide to share
the net differential equally without involving NJ Ltd. As
intermediary? Explain how the interest rate swap deal will be
arranged. Also specify the benefit flowing to each party.
Consider the notional amount of loan as Rs.20,00,000 and
MIBOR = 11.5%. Specify how much differential will be settled
between the two parties by the end of the year.
Q4. Speculative Swap Transaction
Currency Swaps
• The purpose of engaging in a currency swap is usually
to procure loans in foreign currency at more
favourable interest rates than if borrowing directly in
a foreign market or to hedge exposure to exchange
rate risk.

• The World Bank first introduced currency swaps in


1981 in an effort to obtain German marks and Swiss
francs.
• A currency swap is similar to an interest rate swap, except
that in a currency swap, there is often an exchange of
principal, while in an interest rate swap, the principal does
not change hands.
• A foreign currency swap is an agreement to exchange
currency between two foreign parties, in which they swap
principal and interest payments on a loan made in one
currency for a loan of equal value in another currency
• There are two main types of currency swaps: fixed-for-fixed
currency swaps and fixed-for-floating swaps.
Example
• Company A wants to transform $100 million USD
floating rate debt into a fixed rate GBP loan. On
trade date, Company A exchanges $100
million USD with Company B in return for 80
million pounds. This is an exchange rate of 0.80
USD/GBP (equivalent to 1.20 GBP/USD).
• During the life of the transaction, Company A pays
a fixed rate in GBP to Company B in return for USD
six-month LIBOR.
Cont..
• The USD interest is calculated on $100 million USD,
while the GBP interest payments are computed on
the 74 million pound amount.
• At maturity, the principal amounts are exchanged
again. Company A receives their original $100 million
USD and Company B receives 74 million pounds.
• Company A and B might engage in such a deal for a number
of reasons. One possible reason is the company with US
cash needs British pounds to fund a new operation in
Britain, and the British company needs funds for an
operation in the US.
• The two firms seek each other and come to an agreement
where they both get the cash they want without having to
go to a bank to get loan, which would increase their debt
load.
• As mentioned, currency swaps don't need to appear on a
company's balance sheet, where as taking a loan would.
Credit Swaps
• A CDS is like an insurance policy, wherein the debt holder
pays periodic amount (akin to insurance premium) to the
other party.
• In case of happening of the credit event, the other party
compensates the former for the loss.
• In case, there occurs no loss to the debt holder, then the
protection seller will pay nothing and periodic premium
amount already received by him would be his income.
Cont.…
• The credit events must be specified in the CDS
agreement.
• Credit event may be delay or non-payment of interest
• Delay or non-payment of the loan amount, etc.
• The protection buyer may be required to serve a credit
event notice to the protection seller giving the details
of credit event and providing publicly available
information , if any, validating the claim.
• In case of physically settled claims, the protection
buyer would return the security of the reference
entity, to the protection seller who will in turn pay
the full face value.
• In case of cash settled claims, the defaulted
obligation of the reference entity is valued and
would be paid by the protection seller to the
protection buyer.
Example
• Suppose ‘X’ bank has 10,000 10% bonds of the face
value of Rs.1000 each. It has bought a CDS under
which it has been regularly paying the premium.
• In case a credit event occurs, the settlement of loss
may be through physical delivery of bonds to the
protection seller and receiving the face value of the
bonds.
Exotic Options
• In finance, an exotic option is an option which has features making it more complex
than commonly traded vanilla options.

• They differ from traditional options in their payment structures, expiration dates
and strike prices.

• They usually trade in the over-the-counter (OTC) market. The OTC marketplace is a
dealer-broker network as opposed to a large exchange such as the New York Stock
Exchange (NYSE).

• They have payoffs that are more complicated than payoffs in general options.

• One primary reason for the popularity of exotic options is the reduction in premium
for the buyer.
Types of Exotic Options
• Chooser Options - allow an investor to choose
whether the option is a put or call during a certain
point in the option's life. Both the strike price and the
expiration are usually the same, whether it is a put or
call. Chooser options are used by investors when there
might be an event such as earnings or a product
release that could lead to volatility or price
fluctuations in the asset price.
Binary Options

• A binary option or digital option pays a fixed amount only if an


event or price movement has occurred.

• Binary options provide an all-or-nothing pay-out structure.

• Unlike traditional call options, in which final pay-outs increase


incrementally with each rise in the underlying asset price
above the strike, binaries pay a finite lump sum if the asset is
above the strike.

• Conversely, a buyer of a binary put option is paid the finite


lump-sum if the asset closes below the stated strike price.
• For example, if a trader buys a binary call
option with a stated pay-out of Rs.10 at the strike
price of Rs.50 and the stock price is above the
strike at expiration, the holder will receive a
lump-sum pay out of Rs.10 regardless of how high
the price has risen.
• If the stock price is below the strike at expiration,
the trader is paid nothing, and the loss is limited
to the upfront premium.
• Asian Options - take the average price of the underlying
asset to determine if there is a profit as compared to the
strike price.
• For example, an Asian call option might take the average
prices for 30 days. If the average is less than the strike price
at expiration, the option expires worthlessly.
• Extendible Options - allow the investor to extend the
expiration date of the option. As the option reaches its
expiration date, extendable options have a specific period
that the option can be extended.
• LEAPS – Long-term equity anticipation securities.
• These were created for investors who wanted to
create long- term strategies.
• Normally, options have a maturity period up to 3
months but LEAPS have maturity period even
extending up to 3 years.
• LEAPS are available in both call and puts.
• Shout Options - allows the holder to lock in a certain
amount in profit while retaining future upside potential on
the position.
• If a trader buys a shout call option with a strike price of
Rs.100 on stock ABC for one month, when the stock price
goes to Rs.118, the holder of the shout option can lock in
this price and have a guaranteed profit of Rs.18.
• At expiry, if the underlying stock goes to Rs.125, the option
pays Rs.25. Meanwhile, if the stock ends at Rs.106 at expiry,
the holder still receives Rs.18 on the position.
• Compound Options are options that give the owner
the right—not obligation—to buy another option at a
specific price on or by a specific date. Typically, the
underlying asset of a traditional call or put option is an
equity security. However, the underlying asset of a
compound option is another option.
• Compound options come in four types:
– Call on call
– Call on put
– Put on put
– Put on call
• Barrier Options - are similar to plain vanilla calls and puts, but only
become activated or extinguished when the underlying asset hits a
pre-set price level.

• As an example, let's say a barrier option has a knock-out price of


Rs.100, and a strike price of Rs.90 and the stock is currently trading at
Rs.80 per share.

• The option will behave like a standard option when the underlying is
below Rs.99.99, but once the underlying stock price hits Rs.100, the
option gets knocked-out and becomes worthless.
• A knock-in would be the opposite. If the underlying is below Rs.99.99,
the option does not exist, but once the underlying hits Rs.100, the
option comes into existence and is RS. 10 in-the-money.
Energy Derivatives
• Energy derivatives are a type of financial contract in which
the underlying asset is an energy product, such as crude oil.
• They trade mainly on organized exchanges but can also be
traded on a more ad-hoc basis through OTC transactions.
• The energy derivatives market has become vast, with a wide
variety of products.
How Energy Derivatives Are Used
• Energy derivatives are a valuable tool used
by industrial companies and financial traders.

• For companies, energy derivatives can help to


smooth out production processes, allowing them
to secure prices ahead of time for the
commodities they need in their production lines.
• For example, a company that requires a set
amount of oil to run its operations can secure that
oil at a predetermined price by purchasing
oil futures contracts ahead of time.
• hat way, if the price of oil suddenly increases
during the year, the company will not suffer from
any unexpected increase in their production costs.
• Energy derivatives can also be very useful for financial
traders. In addition to letting speculators bet on the
anticipated price changes in energy commodities,
energy derivatives also permit traders to hedge their
risk exposure.
• For instance, an investment firm that owns a large
amount of stock in oil companies might hedge their
exposure to the price of oil by purchasing derivatives
that would increase in value if the price of oil declines.
Energy Products
• Crude oil and natural gas are the two most popularly traded
commodities, not only in India but across the world.
• Crude oil production is dominated by the US, Russia and Saudi
Arabia which jointly account for 35% of the world oil production.
• Russia and Qatar are the largest producers of natural gas in the
world. Relatively, natural gas is considered to be a much cleaner
source of energy from an environmental perspective.

• OPEC accounts for 35% of the world output but controls nearly
75% of the potential reserves.
• The price of oil is dependent on a variety of dynamics
which includes OPEC supply, US supply and inventory
movements, global crude inventories, refining demand,
global demand, trade wars, geopolitical risk in the
Middle East / West Asia, speculative buying by oil
traders.
• Broadly, there are two benchmarks in terms of oil viz.
Brent Crude and the West Texas Intermediate (WTI).
• Crude oil is measured in terms of Dollars per British
Barrels ($/bbl).
• The oil and gas industry can be segregated
into three sections:
– The Upstream industry
– The Downstream industry
– The Midstream industry
Crude Oil
Up Stream Industry
• The upstream companies are the ones that do the dirty work – they take
on geological surveys, dig up bore wells to get a sense of what’s in the
ground underneath, and if they find oil reserves, they then begin the
drilling and extraction of crude oil.
• It takes many years for upstream companies to identify an asset (potential
oil well) and convert it into a fully functional, profitable oil well.
• Upstream companies manufacture and store crude oil in barrels (millions
of barrels are produced everyday).
• Every upstream company has a breakeven point – defined as the cost of
producing one barrel of oil. The breakeven point is also referred to as the
‘full cycle cost’.
• Companies such as ONGC, Cairn India, Reliance Industries,
Oil India are some of the Indian upstream companies.
• Internationally companies such as Shell, BP, Chevron etc.,
fall in this category.
• The key point to note here is that low oil prices do not
really favour upstream companies in general
• Obviously, higher oil price is good for these companies as
their efforts to extract oil remain the same, but margins
improve drastically.
Downstream Companies
• The job of the upstream companies ends at producing crude oil.
‘Crude oil’ is produced is in its raw form.
• If we have to use it as petrol or diesel, then the crude oil has to be
refined. This is where the downstream industry comes into the
picture.

• These companies refine the crude oil to various forms such as –


petrol, diesel, aviation fuel, marine oil, kerosene, lubricants,
waxes, asphalts, liquefied petroleum gas etc.,.
• Companies in this sector also go the extent of distributing these
products across the value chain, right from (B2B distribution) to (B2C)
distribution.
• In fact, petrol bunks are a good example of this phenomenon.
• Downstream companies in the Indian context are – BPCL, HPCL, IOC

• So, if the oil prices cool off, then it implies that the downstream
companies can buy oil at cheaper prices from the upstream company
(which is not so good for upstream as their efforts to produce oil is
still the same). However, the benefit of lower oil price is not passed
on to the end user, but in developed countries like US and UK, this
benefit is passed on to the end users quite quickly.
• Upstream and downstream companies share a see-saw
relationship
• Low oil prices is bad for the upstream companies but good for
the downstream companies
• Higher oil price is good for upstream companies but bad for
downstream companies.
• When the price of crude oil fluctuates, take a minute to
understand whether the company is downstream or upstream
company, and analyse the impact of oil prices on the company
before deciding to buy/sell its shares in the market.
Midstream Companies
• Midstream companies are the ones act as a courier between the upstream
and downstream companies.
• They are responsible for the transport of oil from the oil well to the
refineries.
• They do this via pipelines, road transportation (oil tankers), and by ocean
shipments. Consider them as the wholesalers of crude oil.

• They are kind of caught in the middle, they neither want oil prices to
increase or decrease, but seek stability in oil prices.

• Some of the top players in this segment are TransCanada, Spectra Energy,
Willams and Company etc.
The Crude oil Contract in MCX
• Crude oil is the most actively traded commodity on MCX.
• There are two main Crude oil contracts which are traded on the MCX:
– Crude Oil (the big crude or the main contract)

– Crude Oil Mini (the baby version)

• The contract details are as follows:


– Price Quote – Per barrel

– Lot size – 100 barrels

– Tick Size – Rs.1/-


– P&L per tick – Rs.100/-

– Expiry -19/20th of every month

• The crude oil on MCX is quoted on a per barrel basis (one barrel is equal to
42 gallons or about 159 litres).
Cont..
• Lot size crude mini’s is 10 barrels.
• Price quote is on a per barrel basis
• Every month new crude oil contracts are introduced
which expire 6 months later.
• Expiry is on 19th of every month.
• The current month contract attracts maximum liquidity
Natural Gas
• Natural gas is a vital component of the world's energy supply.

• It is one of the cleanest, safest, and the most useful of all energy sources.
• Given its growing resource base and relatively low carbon emissions
compared with other fossil fuels, natural gas is likely to play a greater role
in the world energy mix.

• As early as about 500 BC, the Chinese discovered the potential of natural
gas seeping through the earth’s surface.

• They used it to boil sea water, separating the salt and making it drinkable.
• Around 1785, Britain became the first country to commercialize the use of
natural gas; natural gas produced from coal was used to light houses as well
as streetlights.
• Once the transportation of natural gas was possible, new uses were
discovered.
• These included heating homes and operating appliances, such as water
heaters, ovens, and cooktops.
• Industry began to use natural gas in manufacturing and processing plants, in
boilers used to generating electricity.
• India is the 7th largest producer of natural gas in the world, accounting for
nearly 2.5% of the natural gas production in the world. The bulk of the
natural gas produced in India is used towards power generation and
industrial fuel.
• A large chunk is also used in the fertilizer industry.
The contract specs for Natural Gas are as below:
• Price Quote – Rupee per Metric Million British
Thermal Unit (mmBtu)
• Lot size – 1250 mmBtu

• Tick size – Rs. 0.10

• P&L per tick – Rs. 125/-

• Expiry – 25th of every month


Weather Derivatives

• Weather derivatives are financial products that derive their values


from weather-related variables such as temperature, rainfall,
snowfall, frost and wind.
• Weather derivatives are typically used by organisations to hedge
or mitigate the risks associated with adverse or unexpected
weather conditions.
• Typical users of weather derivatives include farmers, to hedge
against poor harvests caused by frosts or low rainfall, and energy
companies that may use weather derivatives to smooth earnings
caused by unseasonably warm or cool temperatures.
How does it work?

• Commonly used weather derivatives include futures or options contracts linked to


heating degree day (HDD) and cooling degree day (CDD) indices with final pay outs
linked to the index.

• HDDs are calculated as the number of days in a set period, multiplied by the difference
in the average temperature (calculated as the midpoint of the day’s high and low
temperatures) from 18 degrees Celsius, which has been determined as the ideal
temperature where no heating or cooling is required.

• For example, if the average temperature measured at the Sydney Airport weather
station was 12 degrees Celsius on every day in June, then the HDD index for June would
be 30 days multiplied by six degrees (i.e. 18 less 12) or 180.

• CDDs are the reverse, measuring the number of days that cooling or air conditioning
may be required when the average temperature exceeds 18 degrees Celsius.
Settlement of weather derivatives

• Settlement of weather derivatives is always in cash, as


opposed to many other derivatives where counterparties
can physically deliver the underlying commodities or
securities at the expiry of the contract.
• The cash settlement value is calculated based on the final
value of the HDD, CDD, rainfall, snowfall or hurricane index
multiplied by a certain price, for example $20 per index
point.

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