Part : 2

CH:5

The Foreign Exchange Markets

Derivative

Chapter

5
Copyright 2010, Madhu Vij

5-1

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5 Introduction

The Foreign Exchange Markets

Derivative

A derivative is a two-party contract whose value is derived from the

value of an underlying asset, reference rate or index.

A derivative is a financial product which has been derived from a market for another product. In the international scenario, a new accounting standard, FAS 133 exclusively designed for accounting for derivatives, was introduced by the Financial Accounting Standard Board (FASB) in June 1988.

Copyright 2010, Madhu Vij

5-2

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Definition of a Derivative Under FAS 133

A financial instrument or other contract is a derivative instrument if it has the following characteristics: It has (a) one or more underlying assets; (b) one or more notional amounts or payment provisions or both. It requires no initial net investment or an initial net investment that is smaller than what would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

Definition The common derivative products are forwards, futures, options and swaps. Stock Index futures is also another important derivative which has been launched in BSE and NSE. Copyright 2010, Madhu Vij
International Financial Management (3rd Edition) Madhu Vij Excel Books

5-3

Part : 2
CH:5 Swap

The Foreign Exchange Markets

Derivative

A swap is a contract between two counter-parties to exchange two streams of payments for an agreed period of time.

Swaps are not debt instruments to raise capital, but a tool used for financial management.

Some other derivatives commonly used are: An over-the-counter Leverage

Exotics

Copyright 2010, Madhu Vij

5-4

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Traders in the Derivative Market

A very successful innovation in the capital market over the last 20 years
has been the growth of the derivatives markets. Three types of traders can be identified in the derivative markets

1.
2. 3.

Hedgers,
Speculators, Arbitrageurs.

Copyright 2010, Madhu Vij

5-5

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Hedging Currency Risk through the Purchase of Currency Options

Companies purchasing inventory or machinery abroad can hedge
currency risk through the purchase of currency options. Here, currency risk is defined as the possibility that the exchange rate

will change prior to the actual purchase of the machinery which, in turn,
affects the price of the machinery in terms of Indian rupees. For example, a company agrees to buy machinery from a US manufacturer for a specified price.

Copyright 2010, Madhu Vij

5-6

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Hedging Risk through Forward Contracts

Traders dealing in exports and imports of goods are subject to fluctuations in the foreign exchange rates. The availability of derivative instruments allow the market participants the opportunities of making profits either by taking risk i.e. speculation,

or simultaneously taking opposite positions in the spot and futures

markets. For example, today, with the dollar-rupee forward contracts and with the cross-currency options in India, it is possible to engage in foreign trade with a lesser degree of risk. Use of currency forward to lock in an effective interest rate in foreign borrowing.
Copyright 2010, Madhu Vij

5-7

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Refinancing with Interest Rate Swaps

A business which had previously entered into a variable rate financing arrangement may prefer to switch to fixed rate financing. Because refinancing can be burdensome, interest rate swaps may provide an attractive alternative. For example, a company that entered into a variable rate mortgage one year ago, might believe that interest rates will rise.

Copyright 2010, Madhu Vij

5-8

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Hedging Interest Rate Exposure

A bank providing fixed rate mortgages is exposed in a period of falling interest rates if the borrowers choose to pre-pay their mortgages and get refinance at a lower rate. Important Currency Derivative Exchanges 1. Singapore International Monetary Exchange (SIMEX)

2.
3. 4. 5.

London International Financial and Futures Exchange (LIFFE)

Chicago Mercantile Exchange (CME) New York Mercantile Exchange (NYMEX) Chicago Board Option Exchange (CBOE) etc.
Copyright 2010, Madhu Vij

5-9

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

FAS-133
Accounting for Derivative Instruments and Hedging Activities, known as FAS 133, is an accounting standard issued in January 2001 by the Financial Accounting Standards Board (FASB) that provides companies with the ability to measure all assets and liabilities on their balance sheet at "fair value". FAS-133 eliminates the following loopholes and inconsistencies in the earlier derivative accounting norms. 1. The existing guidelines lacked an integral approach and were not very clear as far as the various types of hedging techniques were concerned. The absence of proper accounting standards led to the lack of appropriate measurement and disclosure on the part of the companies.
Cont. Copyright 2010, Madhu Vij

2.

5-10

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

The standards set by FAS-133 emphasise the following key areas:

1. 2. Classify all derivative instrument either as an asset or as a liability. Report the fair value of the instrument when they are mentioned in the

financial statement.
3. Detailed documentation and processes of the various procedures involved in derivative trading. 4. Include the gain/loss arising out of derivative trading under current periods income.

Copyright 2010, Madhu Vij

5-11

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Indian Derivatives Market

India is one of the few countries which has a long trading experience in one form or the other in derivatives markets. The following are some important suggestions that will help in the growth of derivatives market in India-

5-12

Increase the limits on trading of derivatives by foreign institutional investors Increase the number of stocks on which options and futures are traded Reduce the minimum contract size from Rs 2,00,000 to say Rs 1,00,000 Participation of mutual funds in derivatives Infrastructural issues in derivatives to be addressed immediately by the regulatory bodies and the government.
Copyright 2010, Madhu Vij

International Financial Management (3rd Edition)

Madhu Vij

Excel Books

Part : 2
CH:5

The Foreign Exchange Markets

Derivative

Forward Rate Agreements

A Forward Rate Agreement (FRA) is a widely used financial derivative by various participants in the money and securities market to manage interest rate risk. The various elements of a FRA are: 1. 2. 3. 4. 5. 6.
5-13

National principal Fixed rate Floating rate Tenor Payment dates and Connections Documentation
Copyright 2010, Madhu Vij

International Financial Management (3rd Edition)

Madhu Vij

Excel Books