Introduction

• What are Derivatives?
• Merits & Demerits of Derivatives
• Types of Derivatives
• Currency Option Contracts 
• Forward Rate Agreements
• Interest Rate Swaps
• Currency Swaps
• RBI Guidelines on Derivatives

 Derivatives

• What are Derivatives?
• Derivatives are financial contracts whose value is linked to the value of an underlying exposure. 
• They are complex financial instruments that are used for various purposes, including speculation, hedging and getting access to additional assets or markets.
• Derivatives are powerful financial contracts whose value is linked to the value or performance of an underlying exposure or instrument and take the form of simple and more complicated versions of options, futures, forwards and swaps.
• Users of derivatives include hedgers, arbitrageurs, speculators and margin traders.
• Derivatives are traded over-the-counter bilaterally between two counterparties but are also traded on exchanges.

Types of Derivatives

Derivative contracts can broken down into the following four types:

1. Forwards:

• Forwards contracts are similar to futures contracts in the sense that the holder of the contract possesses not only the right but is also under the obligation to carry out the contract as agreed. Mostly traded in currency.
• However, forwards contracts are over-the-counter-products, which means that they may be regulated or not.
• If regulated, they are bound by the regulations issued by the regulator. For example, currency forward contracts in our country are controlled by RBI and commercial banks can deal with forward contracts as per RBI norms.
• Since such contracts are unstandardized, they are customizable to suit the requirements of both parties involved. Given the nature of forward contracts, they tend to be generally held until the expiry and delivered into, rather than be unwound before the due date.

2. Futures: 

• Futures contracts are standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at an agreed price on a specific date. The parties involved in a futures contract not only possess the right but also are under the obligation to carry out the contract as agreed. 
• Futures contracts are traded on a recognized exchange and as such, they tend to be highly liquid, intermediated and regulated by the exchange. 
• Because of the highly standardized nature of futures contracts, it is easy for buyers and sellers to unwind or close out their exposure before the expiration of the contract.

3. Options:

• Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific period of time. 
• American options can be exercised at any time before the expiry of its option period. 
• On the other hand, European options can only be exercised on its expiration date.
• These are non-linear products exposing the writer of the option to undertake unlimited risk.

4. Swaps:

• Swaps are derivative contracts that involve two holders, or parties to the contract, to exchange financial obligations.  
• Interest rate swaps are the most common swaps contracts entered into by investors. 
• Swaps can be traded on the exchange market or can be over-the-counter products.
• When they are traded over the counter, they are customizable to suit the needs and requirements of both parties involved.
• As the market’s needs have developed, more types of swaps have appeared, such as credit default swaps, total return swaps etc.

What Are the Main Benefits and Risks of Derivatives?

• Derivatives can be a very convenient way to achieve financial goals. For example, a company that wants to hedge against its exposure to commodities can do so by buying or selling energy derivatives such as crude oil futures. Similarly, a company could hedge its currency risk by purchasing currency forward contracts. 
• Derivatives can also help investors leverage their positions, such as by buying equities through stock options rather than shares. 
• The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to systemic risks. For example, during the subprime crisis, all the CDS written, finally crystallized on AIG.

Advantages of Derivatives:

Derivatives can be a useful tool for businesses and investors alike. 

• They provide a way to do the following:
  • Lock in prices
  • Hedge against unfavorable movements in rates
  • Mitigate risks
  • These pluses can often come for a limited cost.
  • Derivatives also can often be purchased on margin, which means traders use borrowed funds to purchase them. This makes them even less expensive but risks more as on the due date the amount borrowed has to be returned back with interest.

Disadvantages of derivatives:

• Derivatives are difficult to value because they are based on the price of another asset. The risks for OTC derivatives include counterparty risks that are difficult to predict or value. 
• Most derivatives are also sensitive to the following:
  • Changes in the amount of time to expiration
  • The cost of holding the underlying asset
  • Interest rates
  • These variables make it difficult to perfectly match the value of a derivative with the underlying asset. This is also called as basis risk. 

 Risks in Derivative Trading

Derivatives are known for hedging risk. This is one of the reasons why it is a growing choice among traders. But they are considered to be extremely risky also.

• Before one uses these instruments, he needs to be aware of the risks involved in derivatives trading:

Market Risk

• Market risk is the general risk in any investments. It is the risk that the overall market might lose value, rather than one or more security goes out of favor. Factors that cause market risk are economic recessions, economic conditions, shifts in interest rates, political unrest, etc. Before you start with derivative trading, it is very important to conduct thorough research and determine the probability of investment being profitable.

Counterparty Risk

• The counterparty or the party on the other side of the derivative contract could go bankrupt. Counterparty risk has different names such as credit risk, legal risk, settlement risk, etc. but they all refer to the same risk. When two parties enter into a contract there could be a possibility that one of them may not follow through on the commitment.

 RBI Guidelines on Derivatives

Governance for Banks acting as Market Makers in Derivatives (Circular Dt. 21/09/2021:

• The Board of Directors (or equivalent forum) and senior management of the market-maker should have a good understanding of the nature of the derivative business undertaken by their respective entities and need to demonstrate through their actions that they have a strong commitment to an effective risk management and compliance environment throughout the organization in respect of the derivative business. 
• In particular, the Board of Directors (or equivalent forum) shall ensure implementation of:
• Adequate and effective risk management and internal control policies and procedures, commensurate with the complexity of the products;
  • Appropriate organization structure (with clear lines of responsibility and accountability), staff and other resources for prudent conduct of the derivative business, risk management function, internal control function and internal audit;
  • Adequate and effective measures towards regulatory compliance; and
  • Adequate and effective measures to address observations from internal and external audits.
• Consistent with its general responsibility for corporate governance, the Board of Directors (or equivalent forum) of the market-maker shall approve written policies which define the overall framework within which the derivative business shall be conducted, and the related risks managed. 
• Such framework shall, at a minimum, cover the following aspects:
  • Establish the entity’s overall appetite for taking risk and ensure that it is consistent with its strategic objectives, capital strength and capability to manage risk effectively;
  • Specify permitted activities, products and limits for the derivative business;
  • Establish policies for:
    • Introduction of new OTC derivative products based on the broad principles given by RBI;
    • Conduct of pre-trade due diligence based on the broad principles enumerated by RBI;
    • Risk management based on the broad principles enumerated by RBI;
    • Internal control based on the broad principles enumerated by RBI; and
    • Conduct of internal audit based on the broad principles enumerated by RBI.
  • Detail the type and frequency of reports which are to be made available to the Board of Directors (or equivalent forum) and its committees.

Products:

• The policy for the introduction of new OTC derivative products shall, at a minimum, include the process for evaluation and approval of new products.

Permitted Products:

• Market-makers shall deal only in derivative products permitted in terms of the Governing Directions of RBI.
• Market-makers may deal in derivative products which have cash instrument(s) and/or permitted derivative(s) as components.
• Market-makers shall not deal in derivative products containing a derivative instrument as underlying, unless specifically permitted in terms of the Governing Directions, that is, derivatives on derivatives or called as synthetic derivatives.  Example: option on Gold futures.
• Market-makers shall not deal in derivative products, either directly or on a back-to-back basis, which they cannot price independently.

Due diligence:

• Due diligence for the introduction of a new derivative product shall, at a minimum, include an assessment of the following aspects of the product:

1. Objective(s);
2. Type of targeted client and how the product addresses their need(s);
3. All risks that a client would potentially face;
4. Pay-off profile;
5. Pricing;
6. Costs and fees, along with analysis of their components, to be incurred by a client; and
7. Measures necessary to mitigate any conflict of interest.

• The Chief Compliance Officer (CCO) and the Chief Risk Officer (CRO) shall sign off before approval of new products.
• All new products shall be approved by the Board of Directors (or equivalent forum) which shall, inter alia, ensure that all regulations applicable to the product are documented and are complied with.

Pricing and valuation: 

• Details of pricing and valuation methodology of the products shall be documented.
• Products shall be valued on the basis of the following preferential hierarchy:

1. 1. Marking the product (or its component(s)) to market;
   2. Marking the product (or its component(s)) to a model.

• In cases where a model is used for valuation of a product:

1. 1. The purpose, design, input variables, underlying assumptions, quantitative algorithms and limitations of the model, including third-party models, shall be adequately understood and documented;
   2. Inputs underpinning the model shall be observable market variables, where available;
   3. If any of the input variables are non-observable/subjective, their use shall be justified, and their calculation methodology shall be documented; and
   4. The model shall be periodically validated through independent review and back-testing.

Product disclosure statement to the customer: 

• A product disclosure statement containing standard information about the product shall be made available to the user for providing adequate information to decide if the product will meet its needs and to facilitate comparison with other products. 
• This statement shall, at a minimum, contain the following information about the product:

1. 1. Features;
   2. All contract terms and conditions including those for termination/unwinding;
   3. Benefits;
   4. All risks;
   5. Pay-off profile;
   6. Costs and fees, including break-up and details wherever required as per the Governing Directions; and
   7. An illustration of how the product works.

Due diligence: 

Due diligence in respect of following aspects shall be carried out by the bank, before undertaking a derivative transaction with the user. 

• Such due diligence will not be mandatory in case of plain vanilla foreign exchange forward and foreign exchange call/put option (European) – deliverable and non-deliverable – with tenor up to 13 months.
• Due diligence process contains three fulfilments and they are given below:

(i) Product suitability: 

The product offered to the user shall be consistent with the objective and risk appetite of the user. In case a product is not found suitable for a user in the assessment of the market-maker, the user shall be informed of the opinion. If the user nonetheless wishes to proceed, the market-maker shall document its analysis and its discussions with the user. The approval for such transactions shall be escalated to next higher level of authority at the market-maker as also for the user.

(ii) User appropriateness:

 A product shall be offered only to those users who, in the considered assessment of the market-maker:

• Have the necessary knowledge and skill to understand the nature, pricing and risks of the product;
• Have the financial ability to bear these risks; and
• Have a risk management framework consistent with the product being offered.

(iii) Risk disclosure statement:

 A risk disclosure statement shall be provided to the user for each derivative transaction. This statement shall, at a minimum, contain the following information:

• Description and rationale of the transaction;
• Sensitivity analysis identifying the various parameters that affect the product; and
• Comprehensive scenario analysis covering key upside and downside risks on the pay-off profile.

Risk management:

• All risks to which the market-maker is exposed on account of its derivative business shall be identified and risk tolerance levels shall be set.
• Processes shall be established to manage these risks.
• A clear and comprehensive set of limits shall be established to manage these risks.
• Stress testing of risk positions shall be conducted.
• Effective policies, procedures and controls shall be implemented to manage model risk.
• Legal risk, i.e. the risk that a derivative contract is not legally enforceable, should be recognized and the market-makers should seek to manage the same by use of standard documentation (e.g. the ISDA master agreement). Specific documentation, if used, should be subject to documented legal advice.
• Counterparty credit risk from the derivative contract should be recognized and the market-makers should seek to manage the same by undertaking counterparty credit assessment and, wherever permitted, by exchanging appropriate collateral with the counterparty.

Internal audit: 

• Derivative business shall be subjected to internal audit to review the adequacy and test the effectiveness of the risk management system and internal controls. 
• The audit shall, at a minimum:

1. 1. Investigate unusual occurrences such as significant breaches of limits, unauthorized trades and unreconciled valuation or accounting differences;
   2. Evaluate the reliability and timeliness of information reported to senior management and the Board of Directors (or equivalent forum);
   3. Trace and verify information provided on risk exposure reports to the underlying data sources;
   4. Undertake an appraisal of the effectiveness and independence of the risk management process;
   5. Evaluate the product disclosure statements and risk disclosure statements provided to users.

• Internal audit shall be conducted by qualified professionals, who are independent of the business line being audited.
• Failure of management to implement the recommendations of the internal auditor within an agreed timeframe shall be reported to the Audit Committee of the Board of Directors (or equivalent forum).
• All business, control and monitoring records should be preserved up to the existing statutory retention periods. 
• Wherever statutory retention periods are not stipulated, such records shall be preserved as per the internal policy of the market-maker subject to the condition that they are preserved for at least two years after the life of the product/transaction. 
• Back up of crucial information and data shall be done and preserved according to the IT policy of the market-maker.

RBI’s General Instructions for OTC forex derivative contracts entered by Residents in India (Circular Dt. 02/08/2011):

• Before offering derivative products to clients, banks should obtain resolution of the Board of the corporation authorizing the concerned official of the company to undertake derivative transactions on behalf of the company. 
• The Board resolution being submitted by the company should:

1. 1. be signed by a person other than the persons authorized to undertake the transactions;
   2. be specific and should articulate specific products that can be transacted;
   3. also mention the person(s) authorized to sign the ISDA and similar agreements;
   4. explicitly mention the limits assigned to a particular person; and
   5. specify the names of the people to whom transactions should be reported by the bank. These personnel should be distinct from those authorized to undertake the transactions.

• Banks are required to obtain Board resolution from the corporate that states the following:
• The corporate has in place a  Risk Management Policy approved by its Board which contains the following:
  • Guidelines on risk identification,  measurement and control
  • Guidelines and procedures to be followed with respect to revaluation and monitoring of positions
  • Names and designation of officials authorized to undertake transactions and limits assigned to them
  • A requirement that the assignment of limits to an official would be specific and in case the limits assigned are not quantified, then the bank should offer derivative products to that client only after getting appropriate documents certifying assignment of specific limits
  • Accounting policy and disclosure norms to be followed in respect of derivative transactions
  • A requirement to disclose the MTM valuations appropriately
  • A requirement to ensure separation of duties between front, middle and back office
  • Mechanism regarding reporting of data to the Board including financial position of transaction etc
• Banks should require its compliance officer to submit a monthly report to the Board of Directors of the bank certifying that all the guidelines specified by RBI have been followed for all derivative transactions undertaken by the bank during the period under reference.

 Misselling

What Is Misselling?

• Misselling is a sales practice in which a product or service is deliberately or recklessly misrepresented or a customer is misled about its suitability for the purpose of making a sale. Misselling may involve the deliberate omission of key information, the communication of misleading advice, or the sale of an unsuitable product based on the customer's expressed needs and preferences.
• Misselling is both negligent and unethical and may lead to legal action, fines or professional censure for those who engage in it. 
• It has been defined by the United Kingdom's former Financial Services Authority as "a failure to deliver fair outcomes for consumers.

RBI Guidelines on Derivatives

RBI’s General Instructions for OTC forex derivative contracts entered by Residents in India (Circular Dt. 01/07/2013):

• In addition to the guidelines under the specific foreign exchange derivative product, the general instructions should be followed scrupulously by the users (residents in India other than AD Category I banks) and the market makers (AD Category I banks).

a) In case of all forex derivative transactions [except INR- foreign currency swaps i.e. moving from INR liability to foreign currency liability, AD Category I banks must take a declaration from the clients that the exposure is unhedged and has not been hedged with another AD Category I bank.

• The corporates should provide an annual certificate to the AD Category I bank certifying that the derivative transactions are authorized and that the Board (or the equivalent forum in case of partnership or proprietary firms) is aware of the same.

b) In the case of contracted exposure, AD Category I banks must obtain:

• An undertaking from the customer that the same underlying exposure has not been covered with any other AD Category I bank/s. Where hedging of the same exposure is undertaken in parts, with more than one AD Category I bank, the details of amounts already booked with other AD Category I bank/s should be clearly indicated in the declaration. This undertaking can also be obtained as a part of the deal confirmation.
• An annual certificate from the statutory auditors to the effect that the contracts outstanding with all AD category I banks at any time during the year did not exceed the value of the underlying exposures at that time. It is reiterated, however, that that the AD bank, while entering into any derivative transaction with a client, shall have to obtain an undertaking from the client to the effect that the contracted exposure against which the derivative transaction is being booked has not been used for any derivative transaction with any other AD bank.

c) In case of INR- foreign currency swaps, at the inception, the user can enter into one time plain vanilla cross currency option (not involving Rupee) to cap the currency risk.

d) In any derivative contract, the notional amount should not exceed the actual underlying exposure at any point in time. Similarly, the tenor of the derivative contracts should not exceed the tenor of the underlying exposure. The notional amount for the entire transaction over its complete tenor must be calculated and the underlying exposure being hedged must be commensurate with the notional amount of the derivative contract.

e) Only one hedge transaction can be booked against a particular exposure/ part thereof for a given time period.

f) The term sheet for the derivative transactions (except forward contracts) should also necessarily and clearly mention the following:

• the purpose for the transaction detailing how the product and each of its components help the client in hedging;
• the spot rate prevailing at the time of executing the transaction; and
• quantified maximum loss/ worst downside in various scenarios.

g) AD Category I banks can offer only those products that they can price independently. This is also applicable to the products offered even on back to back basis. The pricing of all forex derivative products should be locally demonstrable at all times.

h) The market-makers should carry out proper due diligence regarding ‘user appropriateness’ and ‘suitability’ of products before offering derivative products (except forward contracts) to users.

Forward Rate Agreements

• It is a derivative.
• How to define derivative?
  • Financial Derivatives are financial instruments, which derives its value from the underlying exposure. The underlying can be asset, liability or one more derivative.
• FRA is a short-term derivative used for hedging mainly for borrowal accounts by the borrowers for loans upto a period of one year.
• Beyond one year, we have one more derivative which is called as Interest Rate Swap (IRS).
• IRS is also a financial derivative used for hedging long term loans.

 Interest Rate Swaps (IRS)

• FRAs are issued for upto 1 year period, whereas are taken for interest rate risk exceeding one year. 
• IRS technically is a combination  of series of FRAs packaged in its. 
• Normally, ECBs are taken for long term ranging from 5 to 7 years.  All ECBs are linked mostly to 6 month LIBOR. 
• So, if the borrower is of the opinion that LIBOR would go up or he wants to finalize his costing, he can go for IRS. 
• By taking IRS, he would pay a fixed rate of interest every 6 months to the bank where he has taken the IRS and Bank would pay him ongoing 6 months LIBOR. 
• After receiving the 6 month LIBOR from the Bank which has given the IRS, he would pay the same as Interest on ECB taken by him.
• So, an interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. 
• Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.

 Currency Swaps 

• Currency swaps, in simple terms, are a legal contract between two parties who agree to exchange principal amount and interest in one currency for principal amount and interest in another currency. 
• This exchange of cash flow takes place at a fixed date and a predetermined exchange rate (either floating rate or fixed rate) throughout the contract. For accounting purpose, any currency swap is just like a foreign exchange transaction. So it does not have to be put on a company’s balance sheet by law.
• Many global banks operate as the middlemen in such currency swap deals. But the facilitators can also be companies that want to hedge against their global exposure, especially when it comes to foreign exchange risk.

Features of currency swaps

• The exchange of liabilities in currency swaps happen in three stages.

1. Initial exchange of principal amount

• At the beginning of a currency swap, the counterparties exchange a principal amount of money at an agreed rate of exchange. The rate is usually based on the spot exchange rate. Alternatively, counterparties can use a forward rate. However, such forward rates need to be set before the swap initiation date.
• The initial exchange can be either on a physical or notional basis. Its main purpose is to establish a quantum of the principal amounts to calculate both the continuing payment of interest and the re-exchangeable principal amounts at the end of the swap.

2. On-going exchange of interest payment (mechanism of IRS)

• Once the initial principal amounts establish, the counterparties then proceed to exchange interest payments. Such payments are based on the respective fixed or floating interest rates agreed upon at the beginning of the transaction.
• This initiates a series of forwarding foreign exchange contracts that take place throughout the term of the swap contract.

3. Re-exchange of principal on maturity (mechanism of Forward Contract)

• When the contract matures, both the parties re-exchange the principal amounts that were decided at the outset. This three-step process is the standard practice for currency swaps in the market.
• With this straightforward approach, it is easy to effectively turn a debt raised in one currency into a fully-hedged liability in another currency.

 Currency Option Contracts

• Option contracts are sub-set of Insurance contracts.
  • The premium has to be paid upfront, just like any life insurance contract.
  • But in case of forward contracts, no premium payable. Customers pay only incidental charges of the bank and customer’s margin is loaded in the forward price given by the bank. 

Let us take a case: 

• For the exporter, the contract amount is $ 100,000 and the premium payable is Rs. 0.50 per $.
• Exporter has taken an option contract at a strike price of Rs. 84/- by paying a premium Rs. 50,000/- ($ 1,00,000 x 0.50).

What happens to the premium paid on the above scenarios?

Situation No. 1: No loss or no gain (Market Rs. 84/- and Strike Rate Rs. 84/-). But taking into account the premium paid on the option contract, the loss/expenditure for the exporter is Rs. 50,000/-

Situation No.2: On going rate is Rs. 82/- but by booking option contract at a strike price of 84/-, you can ask the banker to deliver the $ at Rs. 84/- per $. Had not booked the option contract, you have to take delivery of the $ at the market rate of Rs. 82/-. 

• • • It means by booking the option contract, the exporter has made a  profit of Rs. 2/- per $. Actual Profit comes to Rs. 2 lakhs minus premium paid Rs. 50,000 = Net profit Rs. 1.50 lakhs.

Situation No.3: On going rate is Rs. 86/- but exporter’s strike rate is Rs. 84/-.  Now exporter need not take the $ @ Rs. 84/- and he can go for the market rate @ Rs. 86/- since he has booked the option contract. If you would not have booked the option contract, the bank would have given per $ Rs. 86/-. By booking the option contract, you have paid a premium of Rs. 50,000/- which went worthless and hence your loss is only Rs. 50,000/-.

• When the exporter is buying the option contract, he is called buyer of the option or holder of the option.
• When the bank is selling the option contract to the exporter, the bank is called seller of the option or writer of the option.
• When the exporter is taking an option contract, he is, on the due date selling the $ to the bank. So, his right is to sell the $ or his right is called as Put option. 
• When the importer is taking an option contract, he is, on the due date buying the $ from the bank. So, his right is to buy the $ or his right is called as Call option. 
• So, Bank can write a put option on the exporters  or  on $ receivables and call option on the importers or on $ payables.
• If the option is exercisable on the due date, it is called as European Option. Majority of options written in the world fall under this category.
• Option is book today with due date as 30/011/2023.  In case, this option is exercisable from tomorrow to due date, this option is called as American Option. 

For the seller of the option or writer of the option, which one of the above two options is riskier?

• For the seller, American option is riskier as it can be exercised any day from the next day of the option to due date whereas in case of European option, it can be exercised only on due date.
• Higher the risk, higher the premium. 
• Since American options are riskier than European option for the same amount and same delivery date, the premium for American option will be more than European option.
• Subsequent to Sub-Prime crisis, American Option were very much underplayed in US markets
• When the forward contract rate (which is normally represent the interest rate differential between US and our market) and the option strike price are same, this position is called as At the money option (ATM).
• Today’s rate is 1 $ = 82/-
• 30/11/2021, forward contract rate is Rs. 83/-
• Option Strike price is also Rs. 83/-, then, this option contract is called as ATM contract. 
• Forward Contract price is the price the banker is comfortable and expects the future rate to settle at this price. 

How to price the premium?

• To price the option premium, two Option pricing models are available:
  • Binomial Option pricing 
  • Black & Scholes Option pricing: This is more used in Option pricing.
• Components of Option Premium or What are the Greeks involved in Option pricing: 
• In deciding the option premium five Greeks or parameters are involved.  Let us discuss the same.