DERIVATIVES IE & IFS IMPORTANT NOTES | JAIIB IEIFS EXAM 2024 PREPARATION

DERIVATIVES IE & IFS IMPORTANT NOTES | JAIIB IEIFS EXAM 2024

‘Derivatives’ is an important topic of the 1st paper of the JAIIB May 2024 exam (Indian economy and Indian financial system), which is going to conduct on 7 May 2024. 

You must have attended our Live IE & IFS class on Derivatives, here are revisionary short notes for it so you revise and retain what you learned so far. 

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Derivatives: Introduction

A derivative has an independent value derived from an underlying market, such as a financial, commodity, or index of market prices. 

The main objective of derivatives is speculation and hedging.

Derivatives feature significant leverage, complicated pricing and trading procedures, little or little initial net investment requirements, are paid at a later period, and change in value in reaction to changes in an underlying asset.

By the use of derivatives, risk can be effectively transferred from the buyer to the seller. They increase the underlying instrument’s liquidity, carry out price discovery, offer better ways to raise capital, and greatly increase market depth.

Hedgers, speculators, and traders make up the majority of participants in a financial market. Hedgers employ derivatives to shield their assets or positions from depreciation brought on by unfavourable changes in market price. Derivatives traders aim to increase their profits by setting two-way pricing for other market participants. Speculators aim to profit from the erratic price swings to make rapid cash. A speculator is not concerned with stabilising his future cash flows because he has no assets to protect. He merely wants to profit from market price fluctuations to make quick money.

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Derivative markets

• Over-the-counter (OTC) derivatives

Without the use of a middleman or exchange, contracts are transacted directly between two parties. The parties mutually agree upon the contract’s terms, which are not standardised.

Banks and other financial institutions provide OTC goods with the contract dates, sums, and terms that the client requests. The bank quotes a price and increases the market quote by a margin. The bank will decide on security based on the situation of each client. There is a risk of a counterparty. Settlement for hedging underlying risk is primarily accomplished through physical delivery.

• Exchange-traded derivatives 

The maturity and size of derivative products are standardised by the Exchange and traded on an exchange. Only through a member of the exchange and by funding a variable margin account can a trade be executed.

Only regulated futures exchanges allow for the trading of futures contracts. They are standardized, with pre-set settlement dates and transparent pricing. The Exchange collects daily cash margin based on the MTM value of the contract. There is no counter-party risk, as the Exchange is the counterparty and manages the risk by the margining system. Mostly net settlement by cash is used for trading and speculation.

REGULATORS OF DERIVATIVES

Types of derivatives

Forwards, futures, swaps, and options are the four primary categories of derivatives.

• Forward contract

An over-the-counter (OTC) arrangement to provide foreign currency at a predetermined exchange rate at a later time is known as a forward contract. Since the contracted rate determines the forward currency value regardless of market movement, it is the ideal hedging option to attain zero risk. The holder of a forward contract cannot profit from a situation in which the market rate on the day of usage is greater than the contracted rate. An opportunity cost is what it is called.

• Futures

The seller of a futures contract promises to deliver a specific security, currency, or commodity to the buyer on a specific date at a fixed price. Futures are forward contracts exchanged on a futures market. Although commodity futures are tied to oil, metals, and agricultural products, financial futures are related to equity prices, interest rates, and exchange rates. Futures contracts have predetermined settlement dates and are of regular sizes.

Interest rate futures 

Interest rate futures are contracts created on fixed-income securities of a specific magnitude, such as Treasury bills and bonds. Based on the inverse relationship between interest rates and bond prices, they are the most often used securities to hedge interest rate risk. 

If a business expects to borrow US dollars in three months but wants to lock in the current interest rate, it will short-sell the 90-day treasury futures contract for an equivalent amount. The benefit from trading T-bill futures will offset the increased interest rate on the loan amount if interest rates rise on the day the loan is requested because the bond price will have reduced proportionately.

Key difference b/w forward and future contract

A futures contract’s buyer and seller deal with the Futures Exchange rather than with one another. The contract is marked-to-market daily and losses are recovered from the holder by way of margin. Unlike forwards, futures contracts are actively traded on the exchange, with contracts bought and sold several times during the day.

Pricing futures

Based on the following essential components pricing of any future contract is based:

1. Underlying asset’s spot price
2. Storing, insuring and transportation cost 
3. Income generated from the asset (If any)

After accounting for these three elements, the futures price (FP) will be the same as the spot price (SP) plus financing fees, additional costs, and any revenue.

F.P. = S.P. + costs – income.

3. Swaps 

In the financial markets, a swap is a transaction used to “barter” or trade one thing for another. It’s a bespoke bilateral agreement where cash flows are calculated by using a predetermined formula on a fictitious principal.

Swaps can be used to manage asset obligations, produce synthetic fixed or variable rate liabilities or assets, hedge against negative movements, and lower funding costs. Banks are permitted to run a book of swaps with an Indian Rupee leg on the Indian market, but they are required to cover these with an overseas bank back-to-back.

Swaps are generally of the following types:

The key distinction between a generic interest rate swap (IRS) and a generic currency swap is: The currency swap comprises both the initial and termination exchange of principal amounts in addition to the exchange of interest rate payments.

Options

Options are agreements that give the buyer or seller of a financial instrument the right but not the obligation to do so. The upfront cost of an option is paid by the buyer to the option writer in the form of a Premium.

The agreed-upon price is known as the “strike price,” and depending on current market prices, the buyer may exercise their right to buy or sell at that price. The final day that an option may be exercised is known as the Maturity Date.

Types of option

Call Option
The right to purchase a predetermined amount of the underlying asset at the strike price on or before the expiration date is provided to the buyer of a call option.

The seller must sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Put Option
A Put option gives the buyer the right to sell a specified quantity of the underlying asset at the strike price on or before the expiry date.
The seller of the put option must buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

IMPORTANT DERIVATIVE PRODUCTS IN THE INDIAN FINANCIAL MARKET

• Forward rate agreements (FRAs)

Over-the-counter (OTC) contracts known as forward rate agreements (FRAs) are made between parties to specify the interest rate to be paid at a future date.

The notional amount is a cash sum based on the rate differentials and the notional value of the contract; it is not traded.

A borrower might desire to enter into an FRA to fix their borrowing expenses as of right now.

Features

In an OTC contract known as a “forward rate agreement,” two parties agree to settle the interest differential on a hypothetical principal at a future settlement date for a predetermined future time. FRAs are used to protect against short-term interest rate risk, although their markets are not particularly liquid. FRAs are helpful in asset liability management because they are used to manage the gaps between rate-sensitive assets and liabilities on the balance sheet and to lock in interest rates.

An individual who has made a commitment to borrow money at a later date purchases an FRA to protect himself against interest rate risk, while an individual who has made a commitment to lend money at a later date sells an FRA to reduce his exposure to interest rates.

• Plain vanilla swap

A plain vanilla swap is the most basic type of interest rate swap in which, during the course of the contract, a fixed rate is swapped for a variable rate or vice versa on a specified notional principal at pre-agreed intervals.

A plain vanilla swap is the most basic type of interest rate swap in which, during the course of the contract, a fixed rate is swapped for a variable rate or vice versa on a specified notional principal at pre-agreed intervals.

RBI guidelines regarding interest rate swaps

RBI guidelines regarding interest rate swaps require banks to ensure adequate infrastructure and risk management systems before venturing into market-making activities. 

The Benchmark rate should evolve on its own in the market and require market acceptance. Parties are free to use any domestic money or debt market rate as a benchmark rate provided the methodology is objective, transparent and mutually acceptable. 

Banks are required to maintain capital for FRAs and IRS. require banks to ensure adequate infrastructure and risk management systems before venturing into market-making activities. 

The Benchmark rate should evolve on its own in the market and require market acceptance. Parties are free to use any domestic money or debt market rate as a benchmark rate provided the methodology is objective, transparent and mutually acceptable. Banks are required to maintain capital for FRAs and IRS.

Credit derivatives

Credit derivatives are contracts that allow creditors to transfer credit risk related to an underlying entity from one party to another without transferring the actual underlying entity. Examples include credit default swaps, total retIE urn swaps, credit default swap options, and credit spread forwards.

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