7 - Swaps & Other Derivatives
7 - Swaps & Other Derivatives
7 - Swaps & Other Derivatives
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
those currencies, but needed U.S. dollars when interest rates were
• Salomon Brothers came up with the idea for the two parties to
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
• Ram decides that that he would rather lock in a constant payment and Shyam
• 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%
• 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:
• 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
• 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.
• 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.
• 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)
• 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
• 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