PART IV: DERIVATIVE

INSTRUMENTS
GROUP4
 Derivative Instrument

A derivative is a security with a price that is dependent upon or

derived from one or more underlying assets. The derivative itself is a
contract between two or more parties based upon the asset or assets.
Its value is determined by fluctuations in the underlying asset. The
CONTENTS
`
most common underlying assets include stocks, bonds, commodities,
currencies,. Interest rates and market indexes.
 TYPES OF DERIVATIVE INSTRUMENTS

01 FORWARD CONTRACTS
02 SWAP CONTRACTS
CONTENTS

03 OPTION CONTRACTS
04 FUTURE CONTRACTS
 FORWARD RATE AGREEMENTS

What is Forward Rate Agreements?

• It is an over-the-counter (OTC) derivative
instrument that trades as part of the money
markets. An FRA is essentially a forward-
starting loan, dealt at a fixed rate, but with no
exchange of cash principal – only the interest
applicable on the notional amount betweenCONTENTS
the rate dealt at and the actual rate
prevailing at the time of settlement changes
hands. In other words, FRAs are off-balance
sheet (OBS) instruments. By trading today at
an interest rate that is effective at some point
in the future, FRAs enable banks and
corporates to hedge interest rate exposure.
They are also used to speculate on the level
of future interest rates.
 
 
Standard terms of Forward Rates Agreements
The following standard terms are used in the market:

• NOTIONAL SUM - The amount for which the FRA is traded.

• TRADE DATE - The date on which the FRA is dealt.

• SETTLEMENT DATE - The date on which the notional loan or deposit of funds becomes effective,
that is, is said to begin. This date is used, in conjunction with the notional
sum, for calculation purposes only as no actual loan or deposit takes place.

• FIXING DATE - This is the date on which the reference rate is determined, that is, the rate to which
the FRA dealing rate is compared.
CONTENTS

• MATURITY DATE - The date on which the notional loan or deposit expires.
• CONTRACT PERIOD - The time between the settlement date and maturity date.

• FRA RATE - The interest rate at which the FRA is traded.

• REFERENCE RATE - This is the rate used as part of the calculation of the settlement amount,
usually the Libor rate on the fixing date for the contract period in question.

• SETTLEMENT SUM - The amount calculated as the difference between the FRA rate and the
reference rate as a percentage of the notional sum, paid by one party to
the other on the settlement date.
FRA pricing
 
• As FRAs are money market instruments we are not required to
calculate rates for periods in excess of one year, 1 where
compounding would need to built into the equation.
 
FRA prices in practice CONTENTS

• The dealing rates for FRAs are possibly the most liquid and
transparent of any no exchange traded derivative instrument. This is
because they are calculated directly from exchange-traded interest-
rate contracts. The key consideration for FRA market makers however
is how the rates behave in relation to other market interest rates.
 Features of Forward Rate Agreement
Following are the unique features of the forward
rate agreements:
• These are OTC contracts, and this is what
makes them different from the futures
• Since these are futuristic contracts (all
transactions happen on the future date),
the contracts remain notional. And that is
why there is no exchange of principal at the CONTENTS
due date.
• The long (or borrower) position benefits
when the rates go up. Whereas the short
position is beneficial to the lender when the
interest rates are on a downward trend.
• They are Linear Derivative Instruments. Or,
we can say that they derive value from the
underlying security.
Forward Rate
Agreement – How
it Works?
• In FRA, the user lending an amount has a short
position, while the borrower has a long position. An
important thing about the FRA contract is that the
settlement is in cash. This means the users do not
actually lend or borrow the amount. Rather, the
interest rate in the FRA is compared with the ongoing
LIBOR rate. Title text
• If the FRA rate is more than the LIBOR rate, then the
borrower has to pay the lender for the difference in
the interest rate. And, if the FRA rate is less than the
LIBOR rate, then the borrower could effectively get
money at less than the market rate. A point to note is
that the payment eventually compensates only for
the changes in the interest rate after the contract
date. There is no involvement of the principal
amount.
OBJECTIVE OF FORWARD RATE AGREEMENTS

• The primary motive behind entering into an FRA is to lock in the interest rate for the future and save the adverse
impact of fluctuations in the interest rate. For example, a commercial bank is planning to come up with
CDs (certificates of deposit). The bank, however, expects the rate to go up. So, to minimize the risk, it can lock
the current rate by entering into a forward rate agreement. In case, the interest rate does rise, then the bank
would get the payment through FRA that compensates for the higher interest. Apart from locking the interest
rates, one can also use FRA to lock-in the price of short-term security. One can do it in the following ways:

• If you are making an investment, then you sell the FRA to protect against the risk of a drop in interest rates. This
CONTENTS
would eventually raise the price of your investment.

• If you are selling an investment, then you need to buy the FRA to protect yourself from the risk of a rise in
interest rates.

Also, one can use it to minimize foreign currency risks. For example, a businessman is
expecting a foreign currency payment within a month from now. So, to protect himself from the risk
of currency fluctuation, the businessman can lock the present currency rate by going for FRA.  
 Advantages and Disadvantages of Forward Rate Agreement

Following are the advantages of FRA:

• It helps the parties to reduce their risk of any

borrowing and lending in the future from unfavorable
market movements.

CONTENTS
• One can also use FRA for trading and earning
on the basis of interest rate expectations.

• They are off-Balance Sheet items. Thus,

they have no impact on financial ratios.
 Advantages and Disadvantages of Forward Rate Agreement

Following are the Disadvantages of FRA:

• As FRA’s are OTC contracts, they carry a higher

amount of risk than futures contracts.

CONTENTS

• In case a party wants to close the contract

before maturity, then it may be difficult to find
another party if the original party isn’t willing to
do that.
 What is a Forward Contract?
• A forward contract is an OTC instrument with terms set for
delivery of an underlying asset at some point in the future.
That is, a forward contract fixes the price and the conditions
now for an asset that will be delivered in the future. As each
contract is tailor-made to suit user requirements, a forward
contract is not as liquid as an exchange-traded futures
contract with standardized terms. The theoretical textbook
price of a forward contract is the spot price of the underlying
asset plus the funding cost associated with holding the asset
until forward expiry date, when the asset is delivered.
CONTENTS
• It is a contract agreement for buying or selling an underlying
asset at a particular price on a specified date in the future. In
this, a buyer takes a long position whereas the seller takes a
short position. The parties involved can use this contract for
managing the volatility through locking in pricing for the
underlying assets. These contracts are traded over the
counter and they are not regulated by exchanges In simple
words, it is mainly used for hedging against market
uncertainty.
 Example of a Forward Contract
· Suppose you are a farmer and you want to sell wheat at the current rate of Rs.18, but you know that wheat prices will fall in
the coming months ahead. In this case, you enter a contract with a grocery for selling them a particular amount of wheat at
Rs.18 in three months. Now, if the price of wheat falls to Rs.16, then you are protected. But if the price of wheat rises, then you
will get the price as mentioned in the contract.

How does it work?

• If the forward contract reaches its expiration date and the spot price have increased, then the seller has to pay the buyer the
difference between the forward price and the spot price.CONTENTS

• Whereas, if the spot price has reduced more than the forward price, then the buyer has to pay the difference to the seller.

When the contract ends, it is settled on certain terms, and every contract is settled on different terms. There are two ways for a
settlement: delivery or cash basis settlement.

• If the contract is settled on a delivery basis, then the seller has to transfer the underlying asset to the buyer.

• When a contract is settled on a cash basis, then the buyer has to make the payment on the settlement date and no underling
assets are exchanged.

This amount is the difference between the current spot price and the forward price.
 Short-term interest rate futures
The original futures contracts related to physical commodities, which
A futures contract is a transaction that fixes
is why we speak of delivery when referring to the expiry of financial futures
the price today for a commodity that will be
contract. Exchange-traded futures such as those on LIFFE are set to
delivered at some point in the future. Financial
expire every quarter during the year. The short sterling contract is a
futures fix the price for interest rates, bonds,
deposit of cash, so as its price refers to the rate of interest on this deposit,
equities and so on, but trade in the same manner
the price of the contract is set as P = 100 - r, where P is the price of the
as commodity futures. Contracts for futures are
contract and r is the rate of interest at the time of expiry implied by the
standardized and traded on exchanges.
futures contract. This means that if the price of the contract rises the rate
of interest implied goes down, and vice versa.

CONTENTS
For example the price of the June 2009 short sterling future (written as Jun09 or M09, from the futures identity letters of H,
M, U and Z for contracts expiring in March, June, September and December respectively) at the start of trading on 17 March
2009 was 98.35, which implied a three-month Libor rate of 1.65% on expiry of the contract in June. If a trader bought 20
contracts at this price and then sold them just before the close of trading that day, when the price had risen to 98.84, an implied
rate of 1.16%, she would have made 49 ticks profit or £12,250. That is, a 20 tick upward price movement in a long position of 20
contracts is equal to £12,250. This is calculated as follows:

Profit = ticks gained × tick value × number of contracts

Loss = ticks lost × tick value × number of contracts

The tick value for the short sterling contract is straightforward to calculate,
since we know that the contract size is £500,000, there is a minimum price
movement (tick movement) of 0.01% and the contract has a three month
‘maturity’.

               Tick value =  0.01% × £500,000 × (3/12) =  £12.50

CONTENTS
The profit made by the trader in our example is logical because if we buy short
sterling futures we are depositing (notional) funds; if the price of the futures
rises, it means the interest rate has fallen. We profit because we have
‘deposited’ funds at a higher rate beforehand. If we expected sterling interest
rates to rise, we would sell short sterling futures, which is equivalent to
borrowing funds and locking in the loan rate at a lower level.
 Pricing Interest Rate Futures

The price of a three-month interest rate futures contract is the implied interest rate for that currency’s three-month rate at the time of
expiry of the contract. Therefore there is always a close relationship and correlation between futures prices, FRA rates (which are
derived from futures prices) and cash market rates. On the day of expiry, the price of the future will be equal to the Libor rate as fixed
that day. This is known as the exchange delivery settlement price (EDSP), and is used in the calculation of the delivery amount.
During the life of the contract its price will be less closely related to the actual three-month Libor rate today, but closely related to the
forward rate for the time of expiry.

Hedging Interest Rate Futures

Banks use interest rate futures to hedge interest rate risk exposure in cash and OBS instruments. Bond trading desks also often use futures to
hedge positions in bonds of up to two or three years maturity, asCONTENTS
contracts are traded up to three years maturity. The liquidity of such ‘far month’
contracts is considerably lower than for near month contracts and the ‘front month’ contract (the current contract, for the next maturity month). When
hedging a bond with a maturity of say two years maturity, the trader will put on a strip of futures contracts that matches as near as possible the
expiry date of the bond. The purpose of a hedge is to protect the value of a current or anticipated cash market or OBS position from adverse
changes in interest rates. The hedger will try to offset the effect of the change in interest rate on the value of his cash position with the change in
value of her hedging instrument. If the hedge is an exact one, the loss on the main position should be compensated by a profit on the hedge
position. If the trader is expecting a fall in interest rates and wishes to protect against such a fall, she will buy futures, known as a long hedge, and
will sell futures (a short hedge) if wishing to protect against a rise in rates. Bond traders also use three-month interest rate contracts to hedge
positions in short-dated bonds; for instance, a market maker running a short-dated bond book would find it more appropriate to hedge his book using
short-dated futures rather than the longer-dated bond futures contract. When this happens it is important to accurately calculate the correct number
of contracts to use for the hedge. To construct a bond hedge it will be necessary to use a strip of contracts, thus ensuring that the maturity date of
the bond is covered by the longest-dated futures contract. The hedge is calculated by finding the sensitivity of each cash flow to changes in each of
the relevant forward rates. Each cash flow is considered individually, and the hedge values are then aggregated and rounded to the nearest whole
number of contracts.
 Refining the Hedging Ratio
A futures hedge ratio is calculated by dividing the amount to be hedged by the nominal value of the relevant futures contract and
then adjusting for the duration of the hedge. When dealing with large exposures and/or a long hedge period, inaccuracy will result
unless the hedge ratio is refined to compensate for the timing mismatch between the cash flows from the futures hedge and the
underlying exposure. Any change in interest rates has an immediate effect on the hedge in the form of daily variation margin, but
only affects the underlying cash position on maturity, that is, when the interest payment is due on the loan or deposit. In other
words, hedging gains and losses in the futures position are realized over the hedge period while cash market gains and losses are
deferred. Futures gains may be reinvested, and futures losses need to financed. The basic hedge ratio is usually refined to
counteract this timing mismatch, this process is sometimes called ‘tailing’. 

Appendix 15.1: The forward interest rate and futures-implied forward rate
CONTENTS
The markets assume that the forward rate implied by the price of a futures contract is the same as the futures price itself
for a contract with the same expiry date. This assumption is the basis on which futures contracts are used to price swaps
and other forward rate instruments such as FRA’s. namely when the risk-free interest rate is constant and identical for
all maturities (that is, in a flat term structure environment), this assumption holds true. However in practice, because the
assumptions are not realistic under actual market conditions, this relationship does not hold for longer-dated futures
contracts and forward rates. In the first place, term structures are rarely flat or constant. The main reason however is
because of the way futures contracts are settled, compared with forward contracts. Market participants who deal in
exchange-traded futures must deposit daily margin with the exchange clearing house, reflecting their profit and loss on
futures trading.
 TYPES OF DERIVATIVE INSTRUMENTS

2
1 3 4
CONTENTS
Swaps
Contracts
Future Option Credit
Contracts Contracts Derivatives
 What is a Swap?

 Swaps are one of the most important and useful instruments in the
debt capital markets. They are used by a wide range of institutions,
including banks, mortgage banks and building societies, corporates
and local authorities.

The following are the most common types of Swap:

• Interest rate swaps

• Zero-coupon swap
CONTENTS

• Currency Swap
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第一季度 第二季度 第三季度 第四季度

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INFOGRAPHICS
CONTENTS
02 Though there is much to be
concerned about, there is far,
far more for which to be
04
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part 01 part 02 part 03 part 04

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PRESENT
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YOUR READING, THE PROPOSAL
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 TYPES OF DERIVATIVE INSTRUMENTS

3
1 2 4
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Option
Contracts
Future Swaps
Contracts Credit
Contracts
Derivatives
 What is an Option?
• An option is a security, just like a stock or bond, and constitutes a binding
contract with strictly defined terms and properties. It is a contract giving the
buyer or the right, but not the obligation to buy or sell an underlying asset at
a specific price on or before a certain date.

Options can be used to generate enormous profits or they can be

used to hedge current positions.

CONTENTS

Call option

• A call is an option contract giving the owner the right but not the obligation to buy a
specified amount of an underlying security at a specified price within a specified time.

• When you buy a call option, you’re buying the right to purchase from the seller of that
option 100 shaves of a particular stock at a predetermined price which is called the strike
price.
Put Option

• A put is an options contract that gives the owner the right, but not the obligation, to
sell a certain amount of the underlying asset, at a set price within a specific time.
The buyer of a put option believes that the underlying stock will drop below the
exercise price before the expiration date.

Example: CONTENTS
• Purchase Price (Php. 500,000)

• Down Payment (Php. 25,000)

• 5% on Php. 500,000
YOU PLACE A DOWNPAYMENT ON YOUR HOME DEVELOPER ISSUES YOU RIGHT TO BUY HOME

YOU PURCHASE HOME YOU PURCHASE HOME

Developer: keeps down payment, Developer: keeps down payment,

obligated to sell home at agreed upon obligated to sell home at agreed upon
price. price.

Home buyer: Pays down payment, Home buyer: Pays down payment,
receives right to buy home. receives right to buy home.
 How “Call Options” Work
YOU RESERVE A PRICE ON YOUR STOCK BY BUYING CALL WRITER SELLS PRICE PRESERVATION

STOCK SETTLES ABOVE STOCK DOES NOT SETTLE

STRIKE AT EXPIRATION ABOVE AT EXPIRATION

Call seller: Keeps

Call seller: Keeps premium
premium, obligated to sell
stock at strike.

Call buyer: pays premium, Call buyer: pays premium

has right to buy stock at
strike.
So now let's define this and trading
terms and look at an actual example
trade.

A "call option" is a contract between two

parties to exchange a stock at a "strike"
price by a predetermined date. One party,
the buyer of the "call", has the right, but
not an obligation, to buy the stock at the
strike price by the future date, while the
other party, the seller or the call, has the
obligation to sell the stock to the buyer at CONTENTS
the strike price if the buyer exercises the
option.
CONTENTS
CONTENTS
How “Put Options” Work

CONTENTS
Let's look again at the definition and a
trading example.

A "put option" is a contract between two

parties to exchange stock at a "strike"
price, by a predetermined date. One party,
the buyer of the "put", has the right, but
not an obligation, to sell the stock at the
strike price by the future date, while the
other party, the seller of the put, has the
obligation to buy the stock from the buyer
at the strike price if the buyer exercises CONTENTS
the option.
OPTION PRICING: SETTING THE SCENE

The price of an option is a function of six different factors, which are the:

• Strike price of the option

• Current price of the underlying
• Time to expiry CONTENTS
• Risk-free rate of interest that applies to the life of the option
• Volatility of the underlying assets price returns
• Value of any dividends or cash flows paid by the underlying asset during
the life of the option.
What is an Option?

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 Advantages and Disadvantages of Forward Rate Agreement

• It helps the parties to reduce their risk of

any borrowing and lending in the future
from unfavorable market movements.

• One can also use FRA for trading and

earning on the basis of interest rate
Advant expectations. CONTENTS
ages of
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