INTERNATIONAL FINANCE

DERIVATIVES

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

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

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.

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 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 securitys 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.

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.

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

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.

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 underinvoicing 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.

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 stocks
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) dont occur.
3. The Black-Scholes Model assumes a stock pays no dividends until after
expiration.
4. Analysts can only estimate a stocks 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.

RBIs 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
1.

is

an

international

Promoting

global

organization

created

monetary

and

for

the

purpose

exchange

of:

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.

13

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 worlds
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 fixedincome 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.
21

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.

22

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.

23

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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