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Term Paper Derivatives
Term Paper Derivatives
ICICI Bank Limited (the Bank), incorporated on January 5, 1994, is a banking company
engaged in providing a range of banking and financial services, including commercial
banking and treasury operations. It operates under four segments: retail banking,
wholesale banking, treasury and other banking. The Bank’s subsidiaries include ICICI
Prudential Life Insurance Company Limited, ICICI Lombard General Insurance
Company Limited, ICICI Trusteeship Services Limited, ICICI Prudential Pension Funds,
Management Company Limited, ICICI Home Finance Company Limited and ICICI
Securities Limited.
The retail sales and service architecture has been organized into four geographies.
These have been further divided into zonal and regional structures. The Retail Strategy,
Product & Policy Group has been formed to develop customer-segment specific
strategies, including product design and service propositions. The Retail Banking Group
is also responsible for inclusive and rural banking. The Bank’s retail portfolio (including
builder finance and dealer funding) as of March 31, 2010 was Rupees 790.45 billion,
constituting 43.6% of its overall loan portfolio.
The Bank has segmented offerings for the small and medium enterprises sector while
adopting a cluster based financing approach to fund small enterprises that have a
homogeneous profile, such as engineering, information technology, transportation and
logistics and pharmaceuticals. It also offers supply chain financing solutions to the
channel partners of corporate clients and business loans (in the form of cash
credit/overdraft/term loans) to meet the working capital needs of small businesses. The
Bank’s corporate banking strategy is based on providing customized financial solutions
to its corporate customers. It offers a range of corporate banking products, including
rupee and foreign currency debt, working capital credit, structured financing, syndication
and commercial banking products and services.
The Banks international strategy is focused on building a retail deposit franchise,
meeting the foreign currency needs of its Indian corporate clients, taking select trade
finance exposures linked to imports to India and achieving the status of the preferred
non-resident Indian (NRI) community bank in key markets. It also seeks to build
wholesale funding sources and syndication capabilities to support the corporate and
investment banking business, and to expand private banking operations for India-centric
asset classes. ICICI Bank has subsidiaries in the United Kingdom, Russia and Canada,
branches in Singapore, Bahrain, Hong Kong, Sri Lanka, Dubai International Finance
Centre, Qatar Financial Centre and the United States and representative offices in the
United Arab Emirates, China, South Africa, Bangladesh, Thailand, Malaysia and
Indonesia. The Bank’s wholly owned subsidiary ICICI Bank UK PLC has 11 branches in
the United Kingdom and a branch each in Belgium and Germany. ICICI Bank Canada
has nine branches. ICICI Bank Eurasia Limited Liability Company has two branches.
Wholesale Banking includes all advances to trusts, partnership firms, companies and
statutory bodies. It comprises the Corporate Banking Group, Commercial Banking
Group, Investment Banking Group, Project Finance Group, Financial Institutions and
Capital Markets Group, Government Banking Group and Mid-corporate & Small
Enterprises Group.
Treasury
Treasury includes the entire investment portfolio of the Bank. It provides foreign
exchange and derivative products and services to its customers through the Global
Markets Group. These products and services include foreign exchange products for
hedging currency risk, foreign exchange and interest rate derivatives like options and
swaps and bullion transactions. The Bank also hedges its own market risks related to
these products with banking counterparties. The Bank’s overseas branches and
subsidiaries also invest in credit derivatives with investments in this portfolio
representing exposures to Indian corporate.
Other Banking includes hire purchase and leasing operations and other items not
attributable to any particular business segment.
ICICI Bank, India's second largest bank by assets under management, has worked hard
to cement its position as Asia Risk's Indian house of the year for the third successive
year. As well as offering one of the widest range of derivatives products and risk
solutions in the country - it is the leading interest rate and foreign exchange derivatives
market-maker in India with 15-25% notional derivatives volumes market share
according to its own estimations - ICICI has been pushing to expand the range of new
derivatives products in the business, both through its own innovation and its influence
on India's regulatory authorities.
Over the past year, ICICI has continued to find innovative risk management solutions for
its domestic Indian corporate clients. And the bank's capacity to run a whole range of
currency and interest rate products has helped it keep bid/ask spreads down to a
minimum.
Take foreign exchange. ICICI not only runs one of the biggest corporate forex desks in
the country, but also says it is the biggest market-maker in rupee options. Last year, the
bank provided a large Indian chemicals company running a carbon credits business with
one of the biggest currency hedges done in India to date. The company, which sells a
large proportion of its carbon credits into Europe, wanted to hedge itself against
movements in the euro/rupee exchange rate.
Own-book innovation
Given the absence of a domestic long-dated euro/rupee options market, ICICI created a
long-tenor euro/rupee option structure, which it ran off its own book. "We were of the
view that the rupee will appreciate in the long term, given strong growth in the Indian
economy and expected capital inflows, so advised exporters to hedge their long-term
exposures," says Shilpa Kumar, head of the global markets group at ICICI in Mumbai.
"In this instance, with the limited one-year tenor on dollar/rupee options, we used our
book to develop five-year options, something that doesn't exist in the market."
The dealer has also worked hard to promote a long-tenor - that is, up to five years -
currency options business in India. "Dollar/rupee has been quite volatile in the past
year," says Kumar. "But the options market is only liquid up to one year. As one of the
biggest market-makers in the field, we have been working hard to extend the volatility
curve on dollar-rupee options, and have completed some large-size transactions this
year."
ICICI also worked with an Indian drinks maker, the second largest liquor business in the
world, to find a cost-reduction solution on a pound-denominated floating-rate liability.
The company entered into a floating-to-fixed interest rate swap in which the bank
embedded a series of range accruals, enabling the corporate to save 50 basis points on
its liability.
The bank has also sought - through its position on the Derivatives Review Committee,
set up by the Securities and Exchange Board of India - to encourage the growth of
equity derivatives in India, particularly equity derivatives options. It has also been
providing a great deal of input to India's Fixed Income Money Markets and Derivatives
Association on the development of the long-awaited credit derivatives markets in India.
Meanwhile, ICICI's derivatives research shines brightest in the Indian banking sector.
The research team created its Global Risk Index for clients in 2007, combining
individual measures of risk - such as the Chicago Board Options Exchange Volatility
Index, currency volatility, interest rate swap spreads and emerging market and
corporate bond spreads - into a consolidated whole. ICICI also created a series of Data
Surprise indexes to capture the effects of economic and financial news on the forex and
rates markets.
On an international level, ICICI started its offshore client-centric treasury desk - the first
initiative of its kind by an Indian bank. Its key objective is to manage the risks arising
from the structuring solutions provided to overseas clients. This division plays a dual
role by market-making in vanilla non-rupee derivatives, such as foreign-currency
interest rate swaps and vanilla currency options, as well as structuring and executing
trades for its overseas franchise.
For example, the bank has emerged as a one-stop shop for Nepalese banks looking to
buy a range of structured derivatives products and has helped Singaporean and Kazakh
companies manage their liability and funding risks. ICICI has also has been working
with Sri Lankan banks to help create depth in their domestic derivatives and forex
market, by offering them its own online platform to cover transactions at interbank rates.
ICICI has comfortably justified its claims to this award yet again.
Currency risk:
is a form of risk that arises from the change in price of one currency against another.
Whenever investors or companies have assets or business operations across national
borders, they face currency risk if their positions are not hedged.
Transaction risk is the risk that exchange rates will change unfavorably over time.
It can be hedged against using forward currency contracts;
Translation risk is an accounting risk, proportional to the amount of assets held in
foreign currencies. Changes in the exchange rate over time will render a report
inaccurate, and so assets are usually balanced by borrowings in that currency.
The exchange risk associated with a foreign denominated instrument is a key element
in foreign investment. This risk flows from differential monetary policy and growth in real
productivity, which results in differential inflation rates.
For example if you are a U.S. investor and you have stocks in Canada, the return that
you will realize is affected by both the change in the price of the stocks and the change
of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the
stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you
would make a small loss.
When a firm conducts transactions in different currencies, it exposes itself to risk. The
risk arises because currencies may move in relation to each other. If a firm is buying
and selling in different currencies, then revenue and costs can move upwards or
downwards as exchange rates between currencies change. If a firm has borrowed funds
in a different currency, the repayments on the debt could change or, if the firm has
invested overseas, the returns on investment may alter with exchange rate movements
Currency risk exists regardless of whether you are investing domestically or abroad. If
you invest in your home country, and your home currency devalues, you have lost
money. Any and all stock market investments are subject to currency risk, regardless of
the nationality of the investor or the investment, and whether they are the same or
different. The only way to avoid currency risk is to invest in commodities, which hold
value independent of any monetary system.
Currency risk has been shown to be particularly significant and particularly damaging for
very large, one-off investment projects, so-called megaprojects. This is because such
projects are typically financed by very large debts nominated in currencies different from
the currency of the home country of the owner of the debt. Megaprojects have been
shown to be prone to end up in what has been called the "debt trap," i.e., a situation
where – due to cost overruns, schedule delays, unforeseen foreign currency and
interest rate increases, etc. – the costs of servicing debt becomes larger than the
revenues available to do so. Financial restructuring is typically the consequence and is
common for megaprojects.
Commodity risk refers
Price risk (Risk arising out of adverse movements in the world prices, exchange
rates, basis between local and world prices)
Quantity risk
Cost risk (Input price risk)
Political risk
There are broadly four categories of agents who face the commodities risk:
Asset liability management is a common name for the complete set of techniques used
to manage risk within a general enterprise risk management framework.
Calculating interest rate risk
Interest rate risk analysis is almost always based on simulating movements in one or
more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield
curve movements are both consistent with current market yield curves and such that no
riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in
the early 1990s by David Heath of Cornell University, Andrew Morton of Lehman
Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell University.
There are a number of standard calculations for measuring the impact of changing
interest rates on a portfolio consisting of various assets and liabilities. The most
common techniques include:
Marking to market, calculating the net market value of the assets and liabilities,
sometimes called the "market value of portfolio equity"
Stress testing this market value by shifting the yield curve in a specific way. Duration is
a stress test where the yield curve shift is parallel
Calculating the multiperiod cash flow or financial accrual income and expense for N
periods forward in a deterministic set of future yield curves
Doing step 4 with random yield curve movements and measuring the probability
distribution of cash flows and financial accrual income over time.
Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by
classifying each asset and liability by the timing of interest rate reset or maturity,
whichever comes first.
Banks and interest rate risk
Basis risk
The risk presented when yields on assets and costs on liabilities are based on different
bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate.
In some circumstances different bases will move at different rates or in different
directions, which can cause erratic changes in revenues and expenses.
The risk presented by differences between short-term and long-term interest rates.
Short-term rates are normally lower than long-term rates, and banks earn profits by
borrowing short-term money (at lower rates) and investing in long-term assets (at higher
rates). But the relationship between short-term and long-term rates can shift quickly and
dramatically, which can cause erratic changes in revenues and expenses.
Repricing risk
The risk presented by assets and liabilities that reprice at different times and rates. For
instance, a loan with a variable rate will generate more interest income when rates rise
and less interest income when rates fall. If the loan is funded with fixed rated deposits,
the bank's interest margin will fluctuate.
Option risk
Most banks are asset sensitive, meaning interest rate changes impact asset yields more
than they impact liability costs. This is because substantial amounts of bank funding are
not affected, or are just minimally affected, by changes in interest rates. The average
checking account pays no interest, or very little interest, so changes in interest rates do
not produce notable changes in interest expense. However, banks have large
concentrations of short-term and/or variable rate loans, so changes in interest rates
significantly impact interest income. In general, banks earn more money when interest
rates are high, and they earn less money when interest rates are low. This relationship
often breaks down in very large banks that rely significantly on funding sources other
than traditional bank deposits. Large banks are often liability sensitive because they
depend on large concentrations of funding that are highly interest rate sensitive. Large
banks also tend to maintain large concentrations of fixed rate loans, which further
increases liability sensitivity. Therefore, large banks will often earn more net interest
income when interest rates are low.
Interest rate risk has been shown to be particularly significant and particularly damaging
for very large, one-off investment projects, so-called megaprojects. This is because
such projects are typically debt-financed and are prone to end up in what has been
called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays,
unforeseen interest rate increases, etc. – the costs of servicing debt becomes larger
than the revenues available to pay interest on and bring down the debt.[1]
Interest rate risks can be hedged using fixed income instruments or interest rate swaps.
Interest rate risk can be reduced by buying bonds with shorter duration, or by entering
into a fixed-for-floating interest rate swap.
Methods:
A method for hedging an investor against a currency risk associated with a purchase of a
security having a value, said investor purchasing said security in a foreign currency and said
investor desiring to receive proceeds from a sale of at least a portion of said security in a home
currency, said foreign currency and said home currency having an exchange rate at the time of
said purchase and an exchange rate at the time of said sale, said method comprising the steps
of: receiving a request for hedging against said currency risk for a time period;
calculating a cost for hedging against said currency risk based on said foreign currency, said
home currency, said exchange rate at the time of said purchase, said value and said time
period;
providing the investor with said proceeds from said sale based on said exchange rate at the
time of said sale if said exchange rate at the time of said sale is greater than the exchange rate
at the time of said purchase; and
providing the investor with said proceeds from said sale based on said exchange rate at the
time of said purchase if said exchange rate at the time of said purchase is greater than or equal
to the exchange rate at the time of said sale,
2. The method of claim 1, wherein said value of said security appreciates after said purchase,
and the step of calculating a cost includes the step of:
calculating said cost for hedging against said currency risk based on said appreciated value of
said security.
3. The method of claim 1, wherein said investor desires to extend the time period for hedging
against said currency risk, and the step of calculating a cost includes the step of:
calculating said cost for hedging against said currency risk based on said extended time period.
4. The method of claim 1, wherein said purchase is a limit order purchase comprising a plurality
of individual purchases each having a value and wherein said calculating step includes the step
of:
calculating a cost for hedging against said currency risk for each of said plurality of individual
purchases based on said foreign currency, said home currency, said exchange rate at the time
of said each of said plurality of individual purchases, said value of said each of said plurality of
individual purchases and said time period.
hedging against the currency risk using an American-style non-tradable foreign exchange
option.
hedging against the currency risk using currency certificates of the bear type having standard
strike levels and maturity dates and being broken down into currency units.
7. A system for hedging an investor against a currency risk associated with a purchase of a
security having a value, said investor purchasing said security in a foreign currency and said
investor desiring to receive proceeds from a sale of at least a portion of said security in a home
currency, said foreign currency and said home currency having an exchange rate at the time of
said purchase and an exchange rate at the time of said sale, said investor desiring to insure
against said currency risk for a time period, the system comprising:
a pricing engine, said pricing engine receiving said exchange rate at the time of said purchase
and the exchange rate at the time of said sale from said foreign exchange rate data source, said
pricing engine calculating a cost for hedging against said currency risk based on said foreign
currency, said home currency, said exchange rate at the time of said purchase, said value and
said time period;
wherein the investor is provided with said proceeds from said sale based on said exchange rate
at the time of said sale if said exchange rate at the time of said sale is greater than the
exchange rate at the time of said purchase and the investor is provided with said proceeds from
said sale based on said exchange rate at the time of said purchase if said exchange rate at the
time of said purchase is greater than or equal to the exchange rate at the time of said sale.
8. The system of claim 7, wherein said value of said security appreciates after said purchase,
and wherein said pricing engine calculates said cost for hedging against said currency risk
based on said appreciated value of said security.
9. The system of claim 7, wherein said investor desires to extend the time period for hedging
against said currency risk, and wherein said pricing engine calculates said cost for hedging
against said currency risk based on said extended time period.
10. The system of claim 7, wherein said purchase is a limit order purchase comprising a plurality
of individual purchases each having a value and wherein said pricing engine calculates a cost
for hedging against said currency risk for each of said plurality of individual purchases based on
said foreign currency, said home currency, said exchange rate at the time of said each of said
plurality of individual purchases, said value of said each of said plurality of individual purchases
and said time period.
11. The system of claim 7, further comprising a trading engine, said trading engine causing said
security to be purchased by the investor through a securities exchange, wherein said pricing
engine receives said value of said security from said trading engine.
12. The system of claim 11, further comprising a trading station, said pricing engine receiving
from said trading station said time period for hedging against said currency risk.
13. The system of claim 12, wherein said trading engine receives from said trading station a
request to purchase said security and a request to sell said security.
Particular instruments
9.Commodity swaps where one side of the transaction is a fixed price and the other the
current market price shall be incorporated into the maturity ladder approach, as set out in
points 13 to 18, as a series of positions equal to the notional amount of the contract, with
one position corresponding with each payment on the swap and slotted into the maturity
ladder set out in Table 1 to point 13. The positions would be long positions if the
institution is paying a fixed price and receiving a floating price and short positions if the
institution is receiving a fixed price and paying a floating price.
Commodity swaps where the sides of the transaction are in different commodities are to
be reported in the relevant reporting ladder for the maturity ladder approach.
However, the competent authorities may also prescribe that institutions calculate their
deltas using a methodology specified by the competent authorities.
Other risks, apart from the delta risk, associated with commodity options shall be
safeguarded against.
The competent authorities may allow the requirement for a written exchange- traded
commodity option to be equal to the margin required by the exchange if they are fully
satisfied that it provides an accurate measure of the risk associated with the option and
that it is at least equal to the capital requirement against an option that would result from
a calculation made using the method set out in the remainder of this Annex or applying
the internal models method described in Annex V.
The competent authorities may also allow the capital requirement for an OTC commodity
option cleared by a clearing house recognised by them to be equal to the margin required
by the clearing house if they are fully satisfied that it provides an accurate measure of the
risk associated with the option and that it is at least equal to the capital requirement for
an OTC option that would result from a calculation made using the method set out in the
remainder of this Annex or applying the internal models method described in Annex V.
In addition they may allow the requirement on a bought exchange- traded or OTC
commodity option to be the same as that for the commodity underlying it, subject to the
constraint that the resulting requirement does not exceed the market value of the option.
The requirement for a written OTC option shall be set in relation to the commodity
underlying it.
13.The institution shall use a separate maturity ladder in line with Table 1 for each
commodity. All positions in that commodity and all positions which are regarded as
positions in the same commodity pursuant to point 7 shall be assigned to the appropriate
maturity bands. Physical stocks shall be assigned to the first maturity band.
Table 1
Maturity band Spread rate (in %)
(1) (2)
0 ≤ 1 month 1,50
> 1 ≤ 3 months 1,50
> 3 ≤ 6 months 1,50
> 6 ≤ 12 months 1,50
> 1 ≤ 2 years 1,50
> 2 ≤ 3 years 1,50
> 3 years 1,50
14.Competent authorities may allow positions which are, or are regarded pursuant to
point 7 as, positions in the same commodity to be offset and assigned to the appropriate
maturity bands on a net basis for the following:
o (a)positions in contracts maturing on the same date; and
o (b)positions in contracts maturing within 10 days of each other if the
contracts are traded on markets which have daily delivery dates.
15.The institution shall then calculate the sum of the long positions and the sum of
the short positions in each maturity band. The amount of the former (latter) which are
matched by the latter (former) in a given maturity band shall be the matched positions in
that band, while the residual long or short position shall be the unmatched position for
the same band.
16.That part of the unmatched long (short) position for a given maturity band that is
matched by the unmatched short (long) position for a maturity band further out shall be
the matched position between two maturity bands. That part of the unmatched long or
unmatched short position that cannot be thus matched shall be the unmatched position.
17.The institution's capital requirement for each commodity shall be calculated on
the basis of the relevant maturity ladder as the sum of the following:
o (a)the sum of the matched long and short positions, multiplied by the
appropriate spread rate as indicated in the second column of Table 1 to point 13 for
each maturity band and by the spot price for the commodity;
o (b)the matched position between two maturity bands for each maturity band
into which an unmatched position is carried forward, multiplied by 0,6 % (carry rate)
and by the spot price for the commodity; and
o (c)the residual unmatched positions, multiplied by 15 % (outright rate) and
by the spot price for the commodity.
18.The institution's overall capital requirement for commodities risk shall be
calculated as the sum of the capital requirements calculated for each commodity
according to point 17.
(b) Simplified approach
Table 2
The commodities cycle has yet again turned bullish. Although better placed than their
retail counterparts, manufacturing companies are not insulated from the impact of rising
raw material prices. There is little relief from the rising wholesale price inflation. The
inflation index has moved up to 8.4% in December from 7.5% in November. If these
numbers are any indication, prices of most basic items of consumption have shot up
(see the table). Prima facie, this indicates an inflated raw material bill for manufacturing
companies but it is not bad news for all.
Companies use variety of means to protect their bottom lines from escalating input
costs. Some enter into forward contracts by booking the price of a key commodity in
advance for the next few quarters. There are others, which hedge their commodity
exposure by taking a position in the futures market equivalent to their physical market
requirement. Some other companies ensure supply of raw materials at competitive
prices through contracts with farmers or producers. While all these measures do help in
mitigating the risk of input prices, none of these is enough to ensure a complete
insulation. Though companies from almost all sectors are impacted, some sectors bear
the brunt more so than others. Even within a sector, some companies end up getting
severely impacted than others due to their distinct product profiles.
To understand this better, ET Intelligence Group studied the impact of rising costs on a
sample of companies that feature in the BSE 500 index. We analysed the impact of
increasing input costs on companies, which spend more than 40% of their revenues to
cover raw material costs. We excluded corporate producers of commodities. Read on to
know more about the impact of higher costs on these companies and which of them
could still be able to maintain their profitability.
CAPITAL GOODS
These companies typically spend 60-70% of their revenues on sourcing raw materials
like ferrous and non-ferrous metals. Capital goods players such as ABB , Siemens ,
Thermax, Voltas , Cummins India , Crompton Greaves, Havells India, BEML and Bhel
figure in our study. Rise in input costs has a negative impact on capital goods
companies. But the companies that command a premium on products would be in a
position to pass on higher input prices to customers. Also, those who enjoy flexibility in
contracts with their clients could reduce the impact of cost escalation by revising the
contract prices upwards. Companies such as ABB, Siemens, Thermax and Suzlon that
have fixed price contracts are likely to adversely impact due to a rise in input prices. On
the other hand, Bhel, which mostly has long-term projects in its order book, is likely to
be less impacted. Cummins is also not likely to have a significant impact because of its
high pricing power due to superior product profile. Voltas, with high pricing power in
selected markets, will also be among the less affected ones.
AUTO
CONSUMER GOODS