Treasury makes use of derivative products for the purpose of :
Management of risk including risk related to ALM
Catering to requirement of corporate customers
Taking trade positions in derivative products
What is Derivative :
It is a financial contract that derives its value from another financial product/commodity (underlying).The underlying variable could be Stock prices, exchange rate or interest rate.
Objective of Derivative :
The derivatives are being used as hedging risk. The derivative products are over the counter (OTC) as well as exchange traded contracts. They shift the risk to market players.
Definition :A Forward Contract is an agreement between Bank and Customer where Bank agrees to buy/sell foreign exchange at a future date at a rate fixed on the date of contract. It is obligatory on the part of the customer to fulfill the contract.
•The contract is negotiated directly by the buyer and seller. It is an over the counter (OTC) agreement.
•Terms of the contract can be tailored to suit the needs of the each party. No money is changes hands when a contract is first negotiated and it is settled at maturity.
•Early delivery under the contract is accepted.
•Extension of contract is only by cancellation and rebooking at current rates.
•Contracts may be booked for fixed date as well as for option period ranging between one month.
•If the contract is not used, it will be automatically cancelled on 3rd business day of the maturity date.
•Definition : An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). • •Types of Options :
i) European option : Where the holder can exercise his right on the expiry date.
ii) American option: Where the right can be exercised anytime before maturity date.
Features of Option Contracts
Option seller •Components of options :
Call option : Buyer has right to purchase
Put option : Buyer has right to sell
•Premium : Consideration for the seller to offer the right for the buyer
•Strike price : Exchange rate
•Maturity & expiration date : The last day on which option can be exercised
•In the money : Where exercising the option, results gain to buyer •At the money : Where exercising the option, results no gain or no loss to buyer •Out of money : Where exercising the option, results loss to buyer •Embedded option : Where the buyer is given option to repay before maturity
It is an agreement to buy and sell an asset for a certain price at a certain time in future. •
•Features of Futures :
Traded through an exchanges.
The size and maturities are standardized.
Participants needs to maintain margins.
The future exchange guarantee the settlement.
Marking to market of outstanding position at the end of each trading day.
A swap in a contract that binds two counterparties to exchange the different streams of payment over the specified period at specified rate.
•Foreign Exchange Swap : Simultaneous purchase or sale of foreign currency on spot against forward.
•Interest Rate Swap : It is exchange of different streams of interest structures i.e fixed to floating or vice versa.
•Currency Swap : It is contract where pre-determined streams of payments in different currencies are exchanged on a prefixed period at pre fixed rate.