CENTRAL BANKING- ALL DERIVATIVES OVERVIEW-BASICS

8/7/2019 CENTRAL BANKING- ALL DERIVATIVES OVERVIEW-BASICS

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BABUJI K

DEPUTY GENERAL MANAGER

FINANCIAL DERIVATIVES -

CONCEPTS `


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Friday, January 07, 20112

DERIVATIVE MARKETS


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DERIVATIVE MARKETS


DERIVATIVES FOREIGN EXCHANGE DERIVATIVES/CURRENCY DERIVATIVES

FORWARDS

NON-DELIVERABLE FORWARDS

FUTURES

OPTIONS

SWAPS INTEREST RATE SWAPS

CURRENCY SWAPS

INTEREST RATE DERIVATIVES

INTEREST RATE SWAPS

INTEREST RATE FUTURES

INTEREST RATE OPTIONS

CREDIT DERIVATIVES

COMMODITY DERIVATIVES

EQUITY DERIVATIVES

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INDIAN DERIVATIVE MARKETS


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FX outright is an agreement to exchange twocurrencies at a rate agreed today, for delivery onan agreed future date

Exchange rate fixed today while currencies getexchanged at future date

Maturity can be any fixed date or any date withinfixed period

Today Future date

Transaction Delivery or value

FX FORWARDS



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FX outright consists of a spot deal and a forwards deal

Today Future dateSpot date

Buy 3 month USD outright against INR

buy USD/INR

sell USD/INR buy USD/INR

3 month USD/INR forwards

FX FORWARDS



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Premium and Discount A currency is said to be at a premium against another currency if it is

more expensive in the forward market than the spot market.

A currency is said to be at a discount against another currency if it isless expensive in the forward market than the spot market.

If forwards are quoted as premium outright = spot + forwards pips

If forwards are quoted as discount

outright = spot - forwards pips

If the forward margins are given in ASCENDING

order,(10/15,20/25),they are premium margins If the forward margins are given in DESCENDING

order,(15/10,25/20),they are discount margins

FX FORWARDS



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Quoted among dealers as differentials Premium or discount represent the interest rate differentials

between the two currencies for the period of the forwardconverted in foreign exchange

Swap points/forward points represent amount of foreignexchange that will neutralise the interest rate differentialsbetween two currencies

If a base currency A earns higher interest rate than term currencyB the base currency will trade at forward discount or below thespot rate

If a base currency A earns lower interest rate than the termcurrency B, the base currency will trade at a forward premium orabove the spot rate

The trader who losses on the interest rate will earn the forwardpremium and vice versa

In convertible currencies, the forward points would clearly reflectinterest rate differential , else arbitrage will set in and would bringit back to the correct levels equivalent to interest rate differential

FORWARD RATES - THEORY



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A company is long USD/CHF value date 6 months andwants to hedge the FX-risk. There are

two alternatives:

1. Sell USD outright against CHF or

2. Sell USD spot against CHF and refinance USD for 6 months by means of an interbank

deposit and

invest CHF for 6 months by means of an interbank deposit

The results of both alternatives must be the same.

Otherwise the market participants would do arbitrage thatmeans they would buy the cheaper alternative and closethe position by selling the other one. Hence the differencewould disappear very quickly.

FORWARD RATES INTEREST

RATE PARITY THEORY



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FORWARD RATES Interest

Rate parity - Example



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FWD RATE =

D = No. of days I b = Base currency interest rate

O = Outright rate I v = Variable currency interest rate

Spot = Spot exchange rate B B = Basis of term in base currency

B V = Basis of term in variable currency

FORWARD RATES - FORMULA



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FORWARD RATES - EXAMPLE



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Rate(USD/INR)

BuyingRate

SellingRate

Spot 47.5500 47.5600

1 MonthFR

47.5500

+0.1000

47.6500

47.5600

+0.150047.7100

2Month FR 47.5500

+0.2000

47.7500

47.5600

+0.2500

47.8100

FX FORWARDOUTRIGHT RATES



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Hedging forward currency risks, by locking into a fixed exchange rate for apredefined future date. Eg. Corporates hedge their forward exportreceivables or import payables by entering into forward USD sales orpurchases.

Assuming an exporter is due to receive USD 1 mio after 3 months, he canenter into a forward contract with a Bank to sell USD 1 mio at the end of 3months at a predetermined exchange rate of INR 46.37 / USD.

Hedging any foreign currency borrowings / investments. Eg. Bank A raises a1yr USD liability at USD LIBOR + 50 bps. The bank runs the risk of Rupee

depreciation; to hedge this risk, the bank would hedge the currency risk bybooking a forward purchase of USDs to meet his USD liability repayment.Hence the bank enters into a forward agreement with another bank to buyUSDs at the end of 1 year

FORWARDS APPLICATIONS



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CONVERSION TO PER CENTTERMS

Forward Premia (in %)[Forward rate Spot rate] * 365 *100

= ---------------------------------------------Spot rate * no. of days

=(46.37-46.10)*365*100

------------------------------------ = 2.37%46.10*90



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FX MARKETS TYPICAL SPOT

AND FORWARD RATES



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FX MARKETS Typical Forward

points in the market

BID OFFERSpot 45.65 45.66

Dec -10 27 28Jan -11 51 52

Feb-11 71 72Mar-11 89 90Apr-11 109 110

May-11 124 125

Jun-11 139 140Jul-11 154 155Aug-11 169 170Sep-11 183 184Oct-11 197 198



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January 7, 201121

Convertibility and Transferability

Currencies like INR/CNY/ TWD/KRW

BIS Survey in September 2006 estimates around USD 500 million every day

NDF on South Asian currencies traded in Singapore

Use of NDF

NDFs allow corporations, banks and other organisation to hedge theircurrency risk simply and efficiently

Whether the exposure takes the shape of overseas assets or equity

holdings, international subsidiaries or receivables in foreign currencies NDF to protect their investment

The demand for NDFs arises principally out of regulatory and liquidityissues of the underlying currencies.

Principles

As with normal forward transaction you either buy or sell the NDFdepending on your position to be hedged or your view on the currency or

its interest rates

There is no physical delivery of currency at maturity

Instead, the difference between the agreed outright price and theprevailing spot rate is multiplied by the notional amount of the contract toreturn an amount in dollars

Settlement: Payment of Netting

NON-DELIVERABLE FORWARDSNon-deliverable forwards


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NDFs are generally short term instruments, using the samestandard foreign exchange as forward market convention

Two way prices are quoted two ways bid / offer

NDFs require a fixing mechanism to establish a spot rate onwhich to settle these transactions

The purchaser of the contract pays out the foreign exchangedifferential in dollars

Advantage of NDFs

Not subject to local regulations or restrictions

Principal not subject to settlement risk only profit and loss

Simple and easy settlement

Only settlement currency in USD so no local currencyaccounts are needed

Eliminates paying spot bid/ask spreads again at maturity ofthe contract

Non-deliverable forwards


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The formula: Settlement amount in US dollar = Notional

amount in US dollar * ((NDF rate Reference

rate on Settlement date) / Reference rate). If settlement amount < zero, contract seller

pays the difference to the contract buyer.

If settlement amount > zero, contract seller

receives the difference from the contractbuyer.

Non-deliverable forwards -

Settlement


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CURRENCY FUTURES


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CURRENCY FUTURES DIFFERENCE BETWEEN

FUTURES AND FORWARDS

Forwards/OTC Exchange Traded FuturesAccessibility Restricted entry Entry not restricted

PriceTransparency

Limited access Online

High visibility

Liquidity Depth not known Depth visible

Agreements Customized Standard

Credit Exposure Yes Mitigated throughexchange

Settlement Physical Delivery Net Settled in cash

Underlyingexposure

Required Not required

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An Option gives the buyer the right, but not the Obligation,

to buy or to sell an agreed amount of FinancialInstrument (Call/Put)

on or before an Agreed Future Date (expiry)

at an Agreed Price (strike)

in exchange for a Fee (Premium)

Right to buy Call option

Right to sell Put option

CURRENCY OPTIONS

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Option is similar to forward contract with more flexibility to thecustomers

Option contracts gives the buyer the right but not the obligation

Option can be OTC contract or exchange traded contract

Recently in India exchange traded currency option has been

introduced In Indian market, banks sell options to customer banks are

option writers

Customers are options buyers

Right to exercise the Option is available for the buyers and not

the writers

CURRENCY OPTIONS

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OPTIONS TERMINOLOGY

Underlying The currency pair on the basis of which option

is tradedNotional The amount of the underlying

Strike Price The price at which the underlying is bought orsold

Expiration Date The date on which the option expires

Delivery Date The date on which the underlying is delivered ifthe option is exercised

Settlement Date The date on which the premium is settled

Maturity / Tenor Length of time till expiration date

Cut Time at which the Option expires

Option Price orPremium

The upfront cost of the option

Style American or European



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O ti i i d t i t


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Time ValueIntrinsic Value

+

Time till maturity

Interest RateDifferential

Volatility

Difference between

strike and spot rate

Strike rate

Options pricing determinants

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Three states At The Money

In The Money

Out of The Money With reference to

holder of option

State Call Put

ATM S=X S=X

ITM S>X S


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Option premium is the price for the option Premium is payable upfront which is the gain

realized by the option writer

Option buyer has unlimited profit potential butloss is limited to the premium paid

Option writer has no right but face unlimitedobligation

Option writer covers his option contracts withcustomers on back to back basis either in thedomestic market or in overseas market

CURRENCY OPTIONS -

PREMIUM

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To hedge the option positions, market makers do spottransactions

The amount of spot that the market maker buys or sells

depends on the hedge ratio of the option, also referred to as

the delta of the option

For e.g. if the market maker buys $ 100 mio of 45.75 strike

USD Put INR call for a 1 month tenor, the following table

shows the delta of the option 1m, 2w and 1w from expiry

of the option at various spot levels

GREEKS - DELTA


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Example : Market Maker Long USD 100 mio of 1 month45.50 USD Put INR Call

1 month 2 weeks 1 weekDays toExpiry/Spot

Delta Spot Hedge Delta Spot Hedge Delta Spot Hedge

43.75 -86 +$86 mio -93 +$93 mio -97 +$97mio

44.25 -76 +$76 mio -82 +$82 mio -90 +$90 mio

44.75 -63 +$63 mio -67 +$67 mio -72 +$72 mio

45.25 -50 +$50 mio -50 +$50 mio -50 +$50 mio

45.75 -37 +$37 mio -33 -$33 mio -29 +$29 mio

46.25 -26 +$26 mio -20 +$20 mio -13 +$13 mio

GREEKS DELTA(HEDGE RATIO)


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Lets say the spot at the time of trade was at 45.75, the hedgeratio is 37%, so market maker would buy $37 mio in the spot

market to hedge the option

If spot falls to 45.25, the hedge ratio would increase to 50%,

so the market maker needs to buy $ 13 mio ( 50-37) to re-hedge the option position

If spot then rises to 46.25, the hedge ratio would be 26%, so

the market maker needs to sell $24 mio ( 50-26) to rebalance

the portfolio

GREEKS DELTA(HEDGE RATIO)

DELTA HEDGING


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Trader who is short of a call option or long of a put option

Negative delta

Buys the underlying

Trader who is long of a call option or short of a put option

Positive delta

Sells the underlying

Delta denotes the sensitivity of option price to the movement of the underlying assetprice

Delta is also known as hedge ratio or the number of units of the underlying that shouldbe bought or sold

The price of the underlying and delta keeps moving and hence needs dynamic hedgingor rebalancing every day/week

Delta Call options

close to zero for deep out of the money call options

0.5 at the money

close to one for deep in the money call options

Delta Put options

close to zero for deep out of the money call options

0.5 at the money

close to minus one for deep in the money call options

DELTA HEDGING

TECHNIQUES



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Contract between two parties to exchange periodic couponpayments in two different currencies over a period of time.

Notional principals are also exchanged on the maturity ofthe swap. The initial exchange of principal is optional asnotional principals are determined at inception using the

spot exchange rate. Effectively, this implies re-denominating a liability into the

alternate currency.

Coupon payments are calculated based on notionalprincipal amounts in two different currencies. Couponpayments can be fixed vs fixed, fixed vs floating, or floatingvs floating.

As for an interest rate swap, the price is determined byequating the NPVs of both legs of the transaction.

Cross currency swaps


Cross currency swaps


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Cross currency swaps -

ExampleSwiss bank X with A rating needs USD 100 millionfor 5 years at a fixed rate and could refinance itselfat 6.50% in USD. The current yield in capital marketis 6.25% (5 years)

X can issue a 5-year bond in Swiss franc with aninterest rate of 5.625%. The current rate in capitalmarkets is CHF 5.50%

Currency swap can be used with an exchange offixed interest rates of 6.25% in USD and 5.50% inCHF

For both initial and final exchange a USD/CHF rateof 1.4500 is fixed

With issue and simultaneous currency swap, Xcould secure the needed USD 100 million.

On the CHF side a loss of 0.125% will be incurred(5.625% expenditure for issue 5.50% interest

return in swap)Theoretically the total expenditure of the deal isUSD 6.25% in USD +0.125% in CHF = 6.375%

As refinancing cost independently for X for USD is6.50%, it saves 0.125% .




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ExampleA corporate raised Rs. 47 crore at 12% for 5 years

interest payable semi-annually. It can convert thisloan from rupees to USD by entering into currencyswaps

Under the above structure, corporate pays USD 6month LIBOR to the bank and receives 11% every 6months.

On every 1st January and 1st July the corporatereceives from the swap bank 11% on Rs.47 crore i.e.Rs.2.59 crore

Corporate pays USD LIBOR on USD 10 million and

suppose that on first reset date USD LIBOR is 5%then it pays 5% on USD 10 million in rupee termsconverted at the then prevailing exchange rate whichin this example is say Rs.48.00 per USD.

The interest payable is (10000000 x 5% x 0.5) x 48= 1.20 crore

In effect corporate receives Rs.1.39 crore.


INTEREST RATE


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INTEREST RATEDERIVATIVES


TYPES OF INTEREST RATE


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Forward rate greements

Interest rate Futures

Interest Rate SwapsInterest Rate Options Not allowed inRupees Yet

TYPES OF INTEREST RATE

DERIVATIVES


FORWARD RATE


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While futures and forward contracts are similar,forward contracts differ because

they are negotiated between counter-parties,

there is no daily settlement or marking-to-market,

no exchange guarantees performance FRAs are cash-settled at the settlement date with

no interim cash flows.

FORWARD RATE

AGREEMENTS



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The two counterparties to an FRA agree to a notionalprincipal amount that serves as a reference figure indetermining cash flows.

notional refers to the condition that the principaldoes not change hands, but is only used to

calculate the value of interest payments. The buyer of the FRA agrees to pay a fixed-rate

coupon payment and receive a floating-ratepayment against the notional principal at somespecified future date.

The seller of the FRA agrees to pay a floating-ratepayment and receive the fixed-rate paymentagainst the same notional principal.

NOTIONAL AMOUNT



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FIX FUTURE INTEREST RATE WHO USES

HEDGERS AGAINST FUTURE INTEREST RATERISK BY SETTING FUTURE INTEREST RATETODAY

SPECULATE ON FUTURE INTEREST RATE ARBITRAGE BETWEEN FUTURES AND FRA

OTC PRODUCT AT AGREED FUTURE RATE SETTLEMENT

PAYMENT DIFFERENCE . NO OBLIGATION TO EXCHANGE PRINCIPAL CASH SETTLED

FEATURES


I t t t F t


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Short term interest rate futures

Standardised exchange traded forward contracts on money marketinstruments such as treasury bill

Cash settlement and not physical settlement

Future price quoted as discount

Future price = 100 Interest rate

Forward interest rate of 5.50% equals a future price of 94.50 = 100-5.50

Purchase the futures contract on day 1 at a market price of 95.00, andat maturity the final settlement price is 96.00, then the settlementamount =

o Notional * (SP-PP/100)*days/basis

o 10000000 *(96.00-95.00)/100*90/360) = Rs. 25000

If the underlying interest rate decreases, the price will increase and viceversa


I t t t F t


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Bond futures

Exchange traded interest rate derivative contract to buyor sell a notional security or any other interest bearinginstrument or an index of such instruments or interest

rate at a specified future date at a price determined atthe time of contract

Each future will have a standard contract specifications

Normally they are contracts on Government securities

Expecting interest rate to rise, sell the future and viceversa


I t t t F t (IRF) i


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Introduction of IRS/FRA in 1999 IRF introduced in June 2003

Cash settled Futures on 10 year notional GOI security with coupon of 6%

Cash settled Futures on 10 year notional zero coupon GOI security

Cash settled Futures on 91 day treasury bill

Valuation based on ZCYC Banks allowed to use IRF only for hedging

PDs for hedging and trading

Interest rate futures directions dated August 28, 2009

Notional coupon bearing GOI security with physical settlement was relaunchedon August 31, 2009

April RBI Annual policy announced the proposal to introduce interestrate future on 2-year and 5-year notional coupon bearing securitiesand 91-day treasury bills

Interest rate Futures (IRF) in

India Genesis

I t t t F t


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Participants

Banks and primary dealers

Mutual fund and insurance companies

Corporate houses and financial institutions FIIs

Member broker and retail investors

Members in exchange

Net worth of Rs. 1 crore for trading members

Net worth of Rs.10 crore for clearing members


I t t t F t


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August 28, 2009 directions Residents may purchase or sell IRF for hedging interest rate risk or otherwise

FII may purchase or sell IRF up to their individual limit of investment in Gsec

Banks to get permission from respective regulatory departments

Banks not allowed to undertake transactions in IRF on behalf of clients

September 1, 2009 Stand alone PDs allowed to deal in IRF both for hedging and trading on own account and

not on behalf of clients

September 18, 2009

NBFCs can participate as clients only for hedging their underlying exposures

October 28, 2009

UCBs can participate only for hedging their underlying exposures and not on behalf ofclients


Contract specifications


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Contract size Rs 2,00,000

Contract base 10-year, 7 per cent notional GoI security with semi-annual compounding

Delivery grades GoI securities maturing at least 8 years but not more than 10.5 years from the first day of thedelivery months with minimum total outstanding stock of at least Rs 10,000 crores. Invoice priceequals the future settlement price times a conversion factor plus accrued interest. The conversionfactor is the price of delivered security (Rs 1 par value) to yield 7 per cent

Tick size Minimum price fluctuations shall be in multiples of Rs 0.0025

Settlement Daily settlement mark to market daily - volume weighted average price of the last half an hourperiod specified by the exchange

Final settlement Physical on delivery day on delivery month ., last working day of the month

Contract month Maximum maturity : 12 months March, June, September and December, to start with NSEintroduced two quarterly contracts

Margins As stipulated by the exchange

Last trading day Two business day preceding the last business day of delivery month

Last delivery day Last business day of the delivery month

Delivery method Physical delivery of deliverable grade securities from the first business day of delivery month tolast business day of the delivery month with owner of short deciding the date of delivery. CSGLaccounts of CDSL and NSDL

Trading hours 9:00 hrs to 17:00 hrs on weekdays

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Trends in interest rate futures at


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Friday, January 07, 2011Babuji K

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Trends in interest rate futures at NSE

Month/year No. of contracts traded Trading value (Rs. In crore)

Aug-09 14559 267

Sep-09 79648 1473

Oct-09 21198 394

Nov-09 18134 337

Dec-09 11687 215Jan-10 6443 119

Feb-10 3124 57

Mar-10 6101 111

Apr-10 407 7

May-10 1177 22

Jun-10 917 17

Jul-10 205 4

Aug-10 26 0.49

NSE

Interest rate Futures (IRF) in India


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Key points



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Conversion factorIn order to allow a wide range of bonds to be delivered, the exchange applies adelivery mechanism which approximately equalizes the cost of a wider set ofbonds which can be delivered which is called conversion factor

Cost of delivering the bond decided on the basis of conversion factor

To put all the deliverable bonds (which have a wide variety of couponsand maturity) on roughly equal footing making the cost of delivery similar

Choice as to which contract to deliver will be made by the short and theprice received by him will depend on the bond that he chooses to deliver

The conversion is the value of the bond per Rs.100 face value ascalculated on the first day of the delivery month using an annual YTM of7% with semi-annual compounding.

Conversion factor makes the seller indifferent between what bonds tochoose in the environment where the yield curve is flat at a specified yield

The bond where difference between Quoted price of the bond (Futuresprice * Conversion factor) is most beneficial to the seller


Key points



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( )Key points Conversion factor NSE


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IRF did not take off - Probable Reasons ?Markets discomfort with ZCYC pricing

Derived pricing of ZCYC

Banks not allowed to trade which was asymmetrical with whatthey were permitted to do in IRS

Jan 2004: A new product based on YTMCash settled IRF on a 10-year coupon bearing notional bond,

priced on a basket of liquid securities

Not introduced on stock exchanges

TAC appoints a committee to recommend measures to activate

IRF chairmanShri V K Sharma report submitted onFebruary 22, 2008

Joint RBI-SEBI technical Committee formed currency futures andinterest rate futures


India Recap



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Money market futures cash settledBond futures physically settled

Why Cash futures arbitrage would takeplace if physically settled which wouldguarantee that futures prices would be alignedwith underlying prices

Product specifications to be decided byexchanges

Short-selling to be permitted and co-terminuswith futures contract introduction to ensurecash-futures arbitrage


Recommendations of committee



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Cash settlement Avoids of short squeeze

Cornering of bonds in cash market by those with long futures position creatingartificial shortage

Avoids problems relating to settlement and clearing

Possibility of actual price not exactly in alignment with the traded price of thebond because of manipulation of prices

Physical settlement

Deliverable basket of bonds rather than single security

Motivation liquidity concerns if there was only one deliverable bond and itlost liquidity the future contracts would also lose its liquidity

Repo squeeze if there was only one bond, buying the futures and thedeliverable bond in large size will be profitable and cause a squeeze in therepo market for the issue


Key points

RUPEE INTEREST RATE


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Exchange of stream of cash flows Converting Fixed payments to Floating rate

payments or vice versa

Introduced in 1999

Overnight Indexed swap MIBOR

INBMK

MIFOR

RUPEE INTEREST RATE

SWAPS



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Tailored bilateral agreement Exchange of Interest Flows on a notional

Principal

A receives (pays) Floating

B pays (receives) Fixed

At periodic intervals over a pre-determined lifeof the swap

Swap is a combination of FRAs

INTEREST RATE SWAPS



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MOTIVATION

DIFFERENCES IN CREDIT QUALITY

LESS CREDIT WORTHY ENTIRY A WAY OFBORROWING FIXED RATE FUNDS FOR ALONGER TERM AT A CHEAPER RATE THANTHEY COULD RAISE SUCH FUNDS IN CAPITAL

MARKETS

INTEREST RATE SWAPS



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INTEREST RATE SWAPS



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Currently swaps are the only hedgingtools available since futures have nottaken off.. ( more about that later)

Benchmarks usedOvernight MIBOR ( Mumbai Inter

Bank Offer Rate)MIFOR ( Mumbai Inter Bank Forward

Offer Rate) INBMK ( Indian Benchmark Reuters)

INTEREST RATE SWAPS

BENCHMARKS


OIS (OVERNIGHT INDEXED


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Floating rate is NSE overnight MIBOR ( reset everymorning) remains fixed for the day

Compounded on a daily basis

Fixed rate is on simple interest basis

Available upto 10 year tenors

Cash flows are exchanged..

Quarterly basis up to 1 year tenor

Half-yearly basis for beyond 1 year

O S (O G

SWAPS)



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Over the Counter instruments Designed to transfer or assume credit risk

Bilateral contracts

Examples of Credit Derivatives

Single name Credit default swaps

Credit Linked Notes

Collateralized Debit Obligations

CDS indices

Total Return Swaps

CREDIT DERIVATIVES


ROLE OF CREDIT


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Hedge or mitigate credit exposure Transfer credit risk

Generate leverage or yield enhancement

Decompose and separate credit risk embedded in

securities Proactively manage portfolio credit risk

Manage regulatory capital ratios

DERIVATIVES


Credit derivatives - Market


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Pension funds Insurers

Mutual Funds

CorporatesHedge funds

Banks

participants



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OTC contract between buyer and seller of protection against risk of default ona set of debt obligations issued by reference entity

Insurance that protects the buyer against loss of principal on a bond or loan

Protection pays a periodic premium expressed as a basis points over notionalamount which is called CDS Spreads and payable quarterly

If pre-specified credit events occur, premium payment stops and seller paysbuyer par value of bond

If no event occurs, buyer continues to pay premium until maturity

Credit event can be anything ranging from bankruptcy or default of a bond ordebt issued by reference entity.

On occurrence of credit event, contract is settled and terminated withprotection buyer having a right to deliver any deliverable debt obligation of thereference entity to the protection seller in exchange for par

Can also be cash settled in which case protection seller pays an amount parless the market value of deliverable debt obligation

Credit default swaps


Credit Default Swaps Chart of cashflows


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flows


Credit default swaps -


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Risk profile similar to bonds but with following differences No initial funding which allows leverage

CDS can be transacted even if a cash bond of reference entityof particular maturity does not exist

By selling protection, the seller can synthetically create a short

position in the reference credit Notional usually of USD 10 to 20 million

Maturity ranges from 1 to 10 years with 5 years being the mostcommon

Risks

Default risk of reference entity

Credit spread risk (market risk)

Counterparty risk

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characteristics



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Investor

LoanBorrower

Bank

Premium payments

Loss recovery

Credit

($10 mln)

High-risk entity for default

No default: Zero

Credit Default Swaps Mechanism



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Financial contract to exchange returns on a bond,index or reference entity including cash flows andcapital appreciation or depreciation from one party toanother for LIBOR Plus spread

Reference asset and reference rate are defined whenthe contract initiates

Used to hedge the risk of an asset but it still keeps itin books

Party that agrees to pay floating rate payments andreceive total return is total return receiver

Party that agrees to receive floating rate paymentsand pay total return is total return payer

Total Return Swaps


Status of Credit Derivatives


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RBI by Working group on credit derivatives inMarch 2003

Draft guidelines on CDS May 2007

Was put on hold in view of adverse marketconditions following global financial crisis

Working group report on Introduction ofCredit Default Swaps for Corporate bonds

placed in website for comments in August2010

in India



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India has 21 commodity exchanges and/or associations including 3national exchanges viz., Multi-commodity exchange (MCX), Nationalcommodity and Derivative Exchange (NCDEX) and National Multi-Commodity exchange (NMCE)

Forward Markets Commission headquartered in Mumbai is theregulatory authority and overseen by Ministry of Consumer Affairs, Food

and Public Distribution Organized Commodities trading began in India in 1875

Futures trading in commodities gained momentum between 1900 and1920

Option trading in cotton barred in 1939

Ban on forward trading in oil seeds and some essential commodities in1943

Forward Contracts Regulation Act was passed in 1952 to regulatecommodity futures trading

Commodity Derivatives




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Products - Futures

Bullion ( Gold, Platinum, Silver)

Metals (Aluminium, Copper, Lead, Nickel, Tin, Zinc, Mid Steel)

Energy (Crude oil, Heating Oil, Gasoline, Natural Gas)

Oil and oil seeds (Crude palm oil, Kapasia, Refined Soya oil, Soya bean)

Cereals (Barely, Wheat, Maize)

Fibre ( Kapas)

Plantation (Rubber)

Pulses (Chana)

Spices ( Cardamon, Coriander, Turmeric)

Others ( Almond, Gaur, Mentha Oil, Potato, Red Chilli, Pepper, Jeera)

Most actively traded

Crude oil, Silver, Mentha Oil, Copper, Natural Gas, Gold, Nickel

Electricity exchanges

Indian Energy Exchange

Power Exchange India Ltd

National Power Exchange

Exchange Traded Carbon Instruments launched in 2008

Ban on Electricity futures with effect from August 23, 2010

Products




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MCX has the following indices both based on spot and futuresprices

No index trading as of now approved

Composite commodity index based on commodity futures price

MCXCOMDEX Weighted average of the three group indices from

2005 MCXAGRI (20%)

MCXMETAL (40%)

MCXENERGY(40%)

Indices



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Derivative Products Index Futures

Index Options

Stock Futures

Stock Options

Maximum three month cycle

Expiry last Thursday of every month

Permitted lot size informed by exchange

Equity Derivatives



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Equity Derivatives - NSE NSE CASH Traded 1360 securities

Listed 1388 (June 2010) S & P Nifty

CNX Nifty Junior

CNX 100

S & P CNX Defty

S & P CNX 500

CNX MIDCAP NIFTY MIDCAP 50

Major Sectoral indices

Bank, IT, FMCG, PSE, MNC,Energy, Pharma, Infrastructure,PSU Bank, Realty

NSE derivatives

S & P CNX Nifty Futures & Options

Market lot 50

No. of scrips - 50

Mini Nifty Futures & Options

Market lot 20

No. of scrips 50

CNX IT Futures & options

Market lot 50

No. of scrips 20

Nifty Mid Cap 50 Futures & Options

Market lot 75

No. of scrips 50

Bank NIFTY Futures & Options

Market lot 25

No. of scrips 12

Stock Futures & Options in 202 securities



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Equity Derivatives - BSE BSE-CASH

Traded 3133 securities Listed8214 (June 2010)

SENSEX 30 SCRIPS

MIDCAP 273 SCRIPS

SMALLCAP 531 SCRIPS

BSE 100, 200, 500

BSE DOLLEX

BSE-IPO 44 scrips

Major SECTORAL INDICES

CG, IT, METAL,TECk, OIL & GAS,PSU, POWER, FMCG,BANKEX,REALTY, AUTO,HC , CD

Stock futures and options on 106securities

Derivative Products same as BSE

BSE 30 SENSEX Futures & Options

Market lot 15

No. of scrips - 30

BSE 30 SENSEX Mini futures &Options

Market lot 5

No. of scrips - 30 BSE TECH Futures & Options

Market lot 70

No. of scrips - 30

BSE BANKEX Futures & Options

Market lot 20

No. of scrips - 14 BSE OIL and GAS Futures & Options

Market lot 20

No. of scrips - 10



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BABUJI KDEPUTY GENERAL MANAGER

[email protected]

THANK YOU

Documents

CENTRAL BANKING- ALL DERIVATIVES OVERVIEW-BASICS