1. Derivatives Markets In Interest Rate & Foreign Exchange Rate Utility For Importer & Exporter NEHA ABHISHEK, BANGALORE Batch: 22, (5 th July to 30 th August, 2014)

2. Agenda Derivatives List of Derivatives under various categories Concept of Hedging Exposure of Importer and Exporter Derivatives on Foreign Exchange Forwards Contracts Future Option Contract Interest Rate Derivatives Forwards Rate Agreement (FRA) SWAP Interest Rate Option

3. Derivatives As per Clause (a) of Section 45U of RBI Act 1934 "derivative" means an instrument, to be settled at a future date, whose value is derived from change in  interest rate,  foreign exchange rate,  credit rating or credit index,  price of securities (also called "underlying"), or  a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time;

4. List of Derivatives under various categories Derivatives Basic Variable Real Assets Commodities Metals Real Estates Plant & Equipment Financial Assets Bonds Shares Loan Currencies Price Risk Forwards Futures Options Interest Rate Risk Swaps Futures Options Others Weather Power Insurance Location OTC Forwards Options Swaps ETC Futures Options Nature Forwards Future Options Swap

5. Concept of Hedging MonthUSD/INRImportersExportersRemarks Hedged (Y) Unhedged (N) Happy (H) Unhappy (U) Hedged (Y) Unhedged (N) Happy (H) Unhappy (U) April 1460.22 Reference Rate August 1459.27N(H)N(U) August 1459.27Y(U)Y(H) March 1562.85N(U)N(H) March 1562.85Y(H)Y(U) Exposure of Importer and Exporter Exporter Gain Foreign Currency Local Currency ImporterGain Foreign Currency Local Currency

6. Forward Contract A foreign exchange forward is an OTC contract Purchaser agrees to buy from the seller, and Seller agrees to sell to the buyer, A specified amount of a specified currency On a specified date in future. In India there are two types of Forward Contract Fixed Forward Contract: Delivery of foreign exchange should take place on specified future date. Option Forward Contract: The customer can sell or buy from the bank foreign exchange at any given period of time at a predetermined rate of exchange. The Option Period of delivery should not exceed one month.

7. Future CurrencyThe contract is available on US Dollar/ Indian Rupee. SizeThe Size of one Future is USD 1,000. QuotationThe future is quoted in rupee terms with a minimum price charge of 0.25 paise. However the outstanding position is reckoned in dollar terms. MaturitiesThe contract is available with maturity ranging from 1 to 12 months. Due DateThe contract expire on last working day of the month, excluding Saturday. Outstanding contract are settled on this day. Last Trading DayTwo days before the expiry date. Settlement PriceThe Settlement price is fixed on last trading day at the Reserve’s Bank reference rate. SettlementThe contract is settled by payment in Indian Rupee. The difference between the strike price and settlement price is exchanged between the buyer and seller. No delivery of Dollar take place. Trading HoursTrading can be done between 9a.m. to 5p.m. The Features of Currency Future in India  An agreement entered into with the specified future exchange to buy or sell standard amount of foreign currency at a specified price for delivery on specified future date.  Maximum Limit in currency future is USD 5 million or 6% of the open interest, whichever is higher.

8. Option CallBuyImporterRight to BuySellExporterObligation to SellPutBuyExporterRight to SellSellImporterObligation to Buy Nature of Option Based on Strike ExporterImporterIllustration In the Money (ITM)Strike Price of Buy Put > Forward Reference Rate (FRR) Strike price of Buy Call < Forward Reference Rate (FRR) FRR = 45 Buy USD Put @ 46 Buy USD Call @ 44 At the Money (ATM)Strike Price of Buy Put = Forward Reference Rate (FRR) Strike price of Buy Call = Forward Reference Rate (FRR) FRR = 45 Buy USD Put @ 45 Buy USD Call @ 45 Out of the Money (OTM)Strike Price of Buy Put < Forward Reference Rate (FRR) Strike price of Buy Call > Forward Reference Rate (FRR) FRR = 45 Buy USD Put @ 44 Buy USD Call @ 46 Concept of In the Money (ITM), At the Money (ATM) and Out of the Money (OTM)

9. Option - Exporter Assume that FRR for maturity on 31 st December 2011 is INR 45 for USD/ INR currency pair. Buy USD Put at INR 45 (ATM Option) – premium paid upfront INR 1. Buy USD Put at INR 46 (ITM Option) – premium paid upfront INR 2. Buy USD Put at INR 44 (OTM Option) – premium paid upfront INR 0.50. Table plot the exercisability and payoff matrix for maturity by taking some random market rates. Assume that FRR for maturity on 31 st December 2011 is INR 45 for USD/ INR currency pair. Sell USD Call at INR 45 (ATM Option) – premium paid upfront INR 1. Sell USD Call at INR 46 (OTM Option) – premium paid upfront INR 0.50. Sell USD Call at INR 44 (ITM Option) – premium paid upfront INR 2. Table plot the exercisability and payoff matrix for maturity by taking some random market rates. Market RateFRR = 45BP = 45 Prem. =1 (ATM) P/L matrix compared with FRR BP = 46 Prem. = 2 (ITM) P/L matrix compared with FRR BP = 44 Prem. =.5 (OTM) P/L matrix compared with FRR 4345YY Y-1.5 4445YY Y-1.5 45 YY N-0.5 4645N0YN0.5 Market RateFRR = 45BC = 45 Prem. =1 (ATM) P/L matrix compared with FRR BC = 44 Prem. = 2 (ITM) P/L matrix compared with FRR BC = 46 Prem. = 0.5 (OTM) P/L matrix compared with FRR 4345N1N2N0.5 4445N1Y2N0.5 45 Y1Y1N0.5 4645Y0Y0Y0.5

10. Option - Importer Assume that FRR for maturity on 31 st December 2011 is INR 45 for USD/ INR currency pair. Buy USD Call at INR 45 (ATM Option) – premium paid upfront INR 1. Buy USD Call at INR 46 (OTM Option) – premium paid upfront INR 0.50. Buy USD Call at INR 44 (ITM Option) – premium paid upfront INR 2. Table plot the exercisability and payoff matrix for maturity by taking some random market rates. Assume that FRR for maturity on 31 st December 2011 is INR 45 for USD/ INR currency pair. Sell USD Put at INR 45 (ATM Option) – premium paid upfront INR 1. Sell USD Put at INR 46 (ITM Option) – premium paid upfront INR 2. Sell USD Put at INR 44 (OTM Option) – premium paid upfront INR 0.50. Table plot the exercisability and payoff matrix for maturity by taking some random market rates. Market Rate FRR = 45BC = 45 Prem. =1 (ATM) P/L matrix compared with FRR BC = 44 Prem. = 2 (ITM) P/L matrix compared with FRR BC = 46 Prem. = 0.5 (OTM) P/L matrix compared with FRR 4345N1N0N1.5 4445N0YN0.5 45 YY N-0.5 4645YY Y-1.5 Market RateFRR = 45BP = 45 Prem. =1 (ATM) P/L matrix compared with FRR BP = 46 Prem. = 2 (ITM) P/L matrix compared with FRR BP = 44 Prem. =.5 (OTM) P/L matrix compared with FRR 4345YY Y-0.5 4445Y0Y0Y0.5 45 Y1Y1N0.5 4645N1Y2N0.5

11. Exchange Rate Derivatives - Importer Perspective On 12 th Jan, an Indian Firm knows that it has $600000 payable, on 12 th March. The Spot Rate is 40.45/$, while 2month forward rate is Rs.40.62/$. 2month INR/USD Interest Rate is 10%/4% p.a. resp. $ future for maturity ending March is Rs.40.65/$. Call and Put option on $ at E = Rs.40.60/$ traded at premium of.40p &.50p respectively. On 12 th March Spot Rate Rs.40.7/$. Future traded at Rs.40.74/$. The outflow in the following situation will be as follows: No HedgingOutflow on 12 th March= Total $ Payable × Spot Rate on 12 th March $600,000×Rs.40.7/$ = Rs.24,420,000 Money Market Cover (Invest- Buy- Borrow) The firm will invest in PV of $600000 i.e. $600,000 = $ 596,027 1 +.04 6 Therefore, Present Outflow = $596,027 × Rs.40.45/$ = Rs.24,109,292 And, Total Outflow = Rs.24,109,292 ( 1 + 0.1 ) = Rs.24,511,114 6 Forward CoverOutflow on 12 th March = Total $ Payable × Forward Rate $600,000 × Rs.40.62/$ = 24,372,000 Future CoverProfit on Squaring Future on 12 th March = ( Rs.40.74/$ - Rs.40.65/$ ) × $600,000 = Rs.54,000 On 12 th March $ Purchase at $600,000 × Rs.40.7/$ = Rs.24,420,000 Therefore, Total Outflow under Future = Rs.24,420,000 – Rs.54,000 = Rs.24,366,000 OptionFV of Premium Outflow on C+ = ( $600,000 × 0.4p ) × ( 1 + 0.1 ) = Rs. 244,000 6 Call exercised as Spot Price > E, therefore Buy $ at $600,000 × Rs.40.6/$ = Rs.24,360,000 Total Outflow on 12 th March = Rs.24,360,000 + Rs.244,000 = Rs.24,604,000.

12. Exchange Rate Derivatives - Exporter Perspective On 12 th Dec, an Indian Firm knows that it has $600000 receivable, on 12 th March. The Spot Rate is 60.45/$, while 2month forward rate is Rs.60.62/$. 2month INR/USD Interest Rate is 10%/4% p.a. resp. $ future for maturity ending March is Rs.60.65/$. Call and Put option on $ at E = Rs.60.60/$ traded at premium of.40p &.50p respectively. On 12 th March Spot Rate Rs.60.7/$. Future traded at Rs.60.74/$. The Inflow in the following situation will be as follows: No HedgingInflow on 12 th March= Total $ Receivable × Spot Rate on 12 th March $600,000×Rs.60.7/$ = Rs.36,420,000 Money Market Cover (Borrow-Sell- Invest) The firm will Borrow in PV of $600000 i.e. $600,000 = $ 594,059 1 +.04 4 Therefore, Present Inflow = $594,059 × Rs.60.45/$ = Rs.35,910,867 And, Total Inflow = Rs. 35,910,867 ( 1 + 0.1 ) = Rs.36,808,639 4 Forward CoverInflow on 12 th March = Total $ Receivable × Forward Rate $600,000 × Rs.60.62/$ = 36,372,000 Future CoverProfit on Squaring Future on 12 th March = ( Rs.60.74/$ - Rs.60.65/$ ) × $600,000 = Rs.54,000 On 12 th March $ Purchase at $600,000 × Rs.60.7/$ = Rs. 36,420,000 Therefore, Total Inflow under Future = Rs. 36,420,000 + Rs.54,000 = Rs.36,474,000 OptionFV of Premium Outflow on P+ = ( $600,000 × 0.5p ) × ( 1 + 0.1 ) = Rs. 307,500 4 Put not exercised as Spot Price > E, therefore Buy $ at $600,000 × Rs.40.7/$ = Rs. 36,420,000 Total Inflow on 12 th March = Rs. 36,420,000 - Rs.307,500 = Rs.36,112,500.

13. Interest Rate Derivatives Over-the-counter (OTC) interest rate derivatives include instruments such as Forward Rate Agreements(FRAS): A Forward Rate Agreement (FRA) is a financial contract between two parties to exchange interest payments for a 'notional principal' amount on settlement date, for a specified period from start date to maturity date. Interest Rate Swaps (IRS):provide for the exchange of payments based on differences between two different interest rates. Caps, Floors, And Collars: are option-like agreements that require one party to make payments to the other when a stipulated interest rate, most often a specified maturity of LIBOR, moves outside of some predetermined range.

14. Settlement under FRA HDFC Bank quotes on 15 march its 6×9 FRA at (MIBOR) 5.35 – 5.45. ABC barrows Rs. 5 crores under FRA. MIBOR on 13 th September is 6%. The following formula applied in calculating the compensation payable under FRA: Compensation = (L-R) or (R-L) × D × A (B × 100) + D × L Where, L = Settlement Rate (LIBOR, MIBOR, etc.) i.e. 6% R = Contract reference rate i.e. 5.45% D = No. of days in contract period i.e. 91 days B = Days basis that is, 360 or 365 days in a year A = Notional principal amount i.e. Rs.50,000,000 Compensation = (6 - 5.45) × 91 × 50,000,000 = Rs.67551.15 (365 × 100) + 91 × 6

15. SWAP Currency Swaps Interest Rate Swap A Plain Vanilla Swap A Basis Swap rate An Amortizing Swap Step up Swap Extendable Swap Delayed Start Swaps/ Forward Swap Differential Swap Cross Currencies Interest Rate Swap

16. Interest Rate Swap Structure Companies A and B faces the following Interest Rates:AB U.S. Dollars (Floating Rate) LIBOR + 0.5% LIBOR + 1% Canadian (Fixed Rate) 5% 6.5% Assume that A wants to borrow U.S. Dollars at a floating rate of interest and B wants to borrow Canadian dollars at a fixed rate of interest. A Bank is planning to arrange a swap and requires 50 basis point spread. If swap is equally attractive to A and B, what interest rate will A and B end up paying? 5%L + 0.25% L + 1% 6.5% 5%Spread = 0.5%L + 1% L + 0.25%6.25% Bank A B L + 0.25% Spread = 0.5% 6.25% 5% L + 1% 5% L + 1% L + 0.25% 6.25% SWAP STRUCTURE

17. Interest Rate Option Allows the buyer of the option to borrow or lend the specified amount of a specified currency at a specified future date at a specified rate of interest without any obligation to do so. A buy call option means a buyer with right to borrow A buy put option mean right to invest. Interest Rate Cap enforce an upper limit on the floating rate payment and the risk of higher interest rates is crystallized into a single payment to be made upfront, without sacrificing downside risk. Interest Rate Floor is a series of put option meant to protect the lender against drop in interest below a specified rate in a floating rate asset.

18. Collar: Interest Rate Risk Hedging Strategy LIBOR On ECB / FCY loan On collar (Floor at 2.50%, Cap at 3.75%) Net Pay Receive from/ Pay out ReceivePays 2.25%4.50%Pays00.25%4.75% 3.25%5.50%-00 4.25%6.50%Receive0.50%06.00% 4.75%7.00%Receive1.00%06.00% IndexUSD 6 months LIBOR NotionalUSD 10 Million Tenor5 years Cap strike3.75% Floor strike2.50% Bank will charge 225 bps Here the interest coupon is floored at 2.50% + 2.25% = 4.75% and cap at 3.75% + 2.25% = 6%

19. Seagull: Interest Rate Risk Hedging Strategy IndexUSD 6 months LIBOR NotionalUSD 10 Million Tenor5 years Cap 1 strike3.75% Cap 2 strike4.50% Floor strike1.75% Bank will charge 225 bps. In the above illustration contract holder sell two deep out of money floor at interest coupon of 4% and cap 2 at interest coupon of 6.75%. Buy single cap 1 which is relatively less out of the money at interest coupon of 6%. LIBOR On ECB / FCY loan On collar (Floor at 1.75%, Cap 1 at 3.75% and Cap 2 at 4.50%) Net Pay Receive from/ Pay out ReceivePays 1.00%3.25%Pays00.75%4.00% 2.50%4.75%-00 3.50%5.75%-00 4.50%6.75%Receive0.75%06.00% 5.50%7.75%Receive0.75%07.00%

20. Thank You