Commonly available derivative instruments

The fixed currency exchange regime which was established by the International Monetory Fund (IMF) in 1944 had eventually changed due to its incapability to accommodate the flourishing inter State trading.

The resultant effect was the introduction of floating rate exchange system, which had the capability to overcome the earlier obstacles, but resulted in huge fluctuations in exchange rates.

This has provided the ground for emergence of hedging instruments to face the uncertainties of the future exchange rates, interest rates and/or prices.

In early 1980’s many countries had to deregulate their financial markets enabling derivatives to provide much required hedging facility.

The arrival of powerful, yet less expensive personal computers had also enabled the investors to analyse information and to classify the risks they have taken into different components.

Financial intermediaries offered many novel products designed to manage and control financial risks effectively, to serve customers better.

They further provided the banks with superior methods for tracking and simulating their own derivative products.

The derivative product, which emerged in this background, is a contract that is based on or derived from an underlying asset. Some times it uses reference rates or indices in pricing the product.

There are many derivative products that had been introduced since.

For example there are many structured derivative products, which grab parts of many other derivative products, using different financial assets on the background. However when we classify the derivative products, we can clearly see following four types as the mainly used products. i.e.

(a) Forwards, (b) Futures, (c) Swaps, (d) Options

Some of these products can be related to interest rates or currencies, while others just cover one of them and/or may have commodities or other classes of assets in the background.

Derivatives serve the following main purposes in the global financial market.

1. Hedging, 2. Arbitrage and Speculation

Derivatives help people to cover their risk exposure. This is the most commonly used reason for usage of derivatives. (i.e. is hedging the risk exposure).

For instance if an individual has obtained a loan at a floating rate (Libor+10 bps) and if he anticipates the rates would go up in the future, he has few options under the present central bank approved rules and regulations.

One option is that he can make a parallel investment that will adequately compensate the rising interest rates or else he may guard his position against an interest rate cap. On the other hand, he may choose to go for an interest rate SWAP where the floating rate is changed to a fixed rate.

The latter option is a derivative. The derivatives are widely used in hedging the exposure and this is the very reason, which has increased its usage in the financial market overwhelmingly.

The other prominent usage is for speculative purposes. Here, the investor does not have any exposure to hedge, but would take positions to make profits out of market imperfections or on speculation.

In spite of the high risk involved in speculation when compared to the first usage, this is increasingly taking place a dominant role in the financial markets around the world.

Under both these options the holder or writer may trade derivatives. However, trading generally refers to those actions done on speculative purposes which generally try to benefit from the arbitrage opportunities available in the market.

a) Forward contracts

This is one of the most simplest and most liquid derivative instruments. A forward is a contract between two parties for the delivery of something at a specified future date, in specified amount at an agreed price.

This is a flexible and a customised instrument, which means that the size of the contract, expiration date and other conditions written in the contract can be adjusted in ways the two parties agree.

Sine they are customised they are traded in the Over the Counter (OTC) market unlike standardised futures which are traded on organised exchanges. There are no central clearing houses to minimise counter party credit risks for forwards. These contracts are illiquid since there is no secondary market for them. Forward contracts are either long or short.

A long position is a commitment to accept delivery of the contracted amount at a future date ad short position is a commitment to deliver the contract amount in future dates at the agreed price. One of the most commonly used forward instruments is a currency forward, where the underlying asset is currency.

Forwards are traded at formal exchanges or at in over the counter market. This does not involve clearing house facilities and there is hardly any secondary market available on forward contracts. Forward contracts are subject to the credit risk as either party may default delivery or accept the underlying asset at future specified date.

b) Futures contract

If the forward contracts discussed above is done through an homogenised contract, where the size, expiration date, and other contract specifications are preset and if the trading is done in a formal exchange then the instrument is called futures contract. Further the futures contracts are marked-to-market daily, thus reducing the risk encountered when the other party to transaction is unable to meet its obligation on the maturity, i.e. the counter party risk.

There are many types of futures contracts available. Three of the most commonly used contracts are shown below.

Stock index futures

This is effectively a bet on an upward or downward movement in a particular stock market index. Stock index futures allow the trader or hedger to participate in the upward movement of stock markets at a reduced cost. They also allow the hedger or trader to protect him/herself or benefit from downward movement in the market.

Currency Futures

Currency futures would protect a hedger against volatility in exchange rates that could affect the profitability of a particular project.

Interest Rate Futures

It’s an agreement in interest rate to trade a specified amount to deliver in March, June, September or December in a specified year.

Operational aspects of Futures

Contracts

In many developed financial markets there are exchange firms established to carry out futures trading activities. Numerous futures are available in these exchanges and the prices are determined generally by open outcry of bids and offers in the auction. Trading on the exchange is restricted to members of the exchange.

However, a non-member can trade by leasing a seat at auction premises, where the price is determined again by demand and supply. Sri Lanka is yet to venture into futures trading exchanges and it may not be practical until a proper derivatives market is established in the country.

The forward and futures contracts have zero initial value; therefore the position taker does not have anything to put on the balance sheet. The trader does not buy or sell anything tangible, but the trader has simply taken a position. Therefore, these instruments are off-balance sheet items.

c) Swaps

Swap is basically an agreement by which two cash flows generated by any process-a financial instrument, a productive activity, a natural phenomenon - is exchanged at a specified settlement date. Here also additional net cash payment at initiation is not required.

Operational aspects of Swaps

This is a very broad instrument category. Practically every cash flow sequence can be used to generate a Swap. The following had found to be the most dominant among the Swaps.

Non-interest Rate Swaps Equity Swaps

The category involves the exchange of returns from an equity or equity index against the return from another asset. In equity Swaps, the parties will exchange two sequences of cash flows. One of the cash flow sequences will be generated by dividends and capital gains (losses), while other will depend on a money market instrument, in general Libor.

Commodity Swaps

The structure is similar to Equity Swaps. There are two major types, either (1) exchange fixed to floating payments based on commodity index or, (2) exchange payments when one payment is based on an index and the other on a money market rate.

This sort of commodity Swaps can be arranged for all sorts of commodities, metals, precious metals and energy prices.

Interest Rate Swaps Plain vanilla

Interest rate Swap

This involves exchanging cash flows generated by different interest rates. The most common case is when a fixed swap rate is paid (received) against a floating Libor rate in the same currency.

These have developed into a fundamental instrument in world financial markets. These are some times called plain vanilla interest rate swaps compared with more complex types of interest rate swaps available around the world.

Currency Swaps

This is similar to interest rate swaps but there are some marked differences. Firstly, the exchanged cash flows are in different currencies, meaning two different yield curves are involved in swap pricing instead of just one.

Secondly, some times a floating rate is exchanged against another floating rate. Third difference lies in the exchange of principals at initiation and re-exchange at maturity.

Basis Swaps

This is again similar to currency swaps except that often there is only one currency involved.

This involves exchanging cash flows in one floating rate, against cash flows in another floating rate, in the same currency.

(To be continued)

Central Bank of Sri Lanka