Derivatives | PAPER III – ACCOUNTING & FINANCIAL MANAGEMENT FOR BANKERS | MODULE C: FINANCIAL MANAGEMENT

Derivatives: Characteristics, Functions, and Types

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What is a Derivative?

A derivative is a financial contract whose value is derived from the performance of an underlying asset, index, or rate. Common underlying instruments include stocks, bonds, interest rates, commodities, and currencies.

Characteristics of Derivatives

• They derive value from underlying assets.
• Highly leveraged instruments.
• Used for hedging, speculation, and arbitrage.
• Contracts are executed on organized exchanges or OTC.
• Price depends on time to maturity, volatility, interest rate, and underlying asset price.

Functions of Derivatives

1. Hedging against price volatility and risk.
2. Price discovery in financial markets.
3. Market efficiency through arbitrage.
4. Facilitates access to unavailable assets or markets.
5. Lower transaction costs compared to physical trading.

Users of Derivatives

• Hedgers: Manage price risk (e.g., farmers, exporters).
• Speculators: Aim to profit from price movements.
• Arbitrageurs: Exploit price differences in markets.

Types of Derivatives

1. Futures

Standardized contracts to buy/sell an asset at a predetermined price at a future date. Traded on exchanges.

2. Forward Rate Agreements (FRA)

OTC contracts between two parties to exchange interest payments for a notional principal amount on future dates, based on a fixed vs. floating rate difference.

3. Swaps

Agreements between two parties to exchange cash flows in the future. Common types: interest rate swaps and currency swaps.

4. Options

Contracts that give the buyer the right, but not the obligation, to buy (call) or sell (put) an asset at a specific price within a specific time.

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Mathematical Examples

1. Futures Profit/Loss:
   A trader buys 10 futures contracts of gold at ₹55,000 per 10g. On expiry, the price becomes ₹56,200.
   Profit = (₹56,200 - ₹55,000) × 10 = ₹12,000
2. Forward Rate Agreement (FRA):
   A 3x6 FRA is agreed at 5.5%. After 3 months, actual 3-month rate is 6.2% on ₹10 lakh.
   FRA Settlement = (6.2% - 5.5%) × (90/360) × ₹10,00,000 = ₹1,750
3. Swap Example:
   Fixed rate = 6%, Floating rate = 5.2%, Notional = ₹20 lakh
   Swap cash flow = (6% - 5.2%) × ₹20,00,000 = ₹16,000 per annum
4. Call Option Profit:
   Strike Price = ₹100, Premium = ₹5, Market Price = ₹115
   Profit = ₹115 - ₹100 - ₹5 = ₹10
5. Put Option Loss:
   Strike Price = ₹100, Premium = ₹7, Market Price = ₹110
   Loss = ₹7 (as option will not be exercised)
6. Break-even for Call Option:
   Strike Price = ₹200, Premium = ₹15
   Break-even = ₹215
7. FRA Implied Forward Rate:
   If 6-month = 5.5%, 12-month = 6.5% (simple rates), calculate 6x12 forward rate:
   F = [(1 + 0.065×1) / (1 + 0.055×0.5)] - 1 = ~7.01% (annualized)
8. Currency Swap:
   Notional: $1 million = ₹8 crore (₹80/USD). Swap INR interest = 7%, USD interest = 3%
   INR payment = ₹8 crore × 7% = ₹56 lakh
   USD receipt = $1 million × 3% = $30,000
9. Option Premium Calculation (Time value):
   Market Price = ₹120, Strike = ₹100, Intrinsic = ₹20, Premium = ₹25
   Time Value = ₹25 - ₹20 = ₹5
10. Speculation on Interest Rate:
    If you expect rates to rise, buy FRA at 5.2%. Actual rate becomes 6.1%. Notional ₹50 lakh.
    Gain = 0.009 × ₹50,00,000 × (90/360) = ₹11,250

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MCQs on Derivatives

1. Which of the following is not a type of derivative?
   A. Options
   B. Futures
   C. Debentures
   D. Swaps
   Answer: C
2. Derivatives derive their value from:
   A. Interest rates only
   B. Underlying assets
   C. Equity alone
   D. Bank reserves
   Answer: B
3. A forward rate agreement is primarily used to hedge:
   A. Equity price risk
   B. Commodity risk
   C. Interest rate risk
   D. Currency risk
   Answer: C
4. Which party is obligated to buy in a futures contract?
   A. Buyer only
   B. Seller only
   C. Both buyer and seller
   D. None
   Answer: C
5. Which of these is traded OTC and not on exchanges?
   A. Futures
   B. Options
   C. Forwards
   D. ETFs
   Answer: C
6. In an interest rate swap, fixed rate is exchanged for:
   A. Discount rate
   B. Inflation rate
   C. Floating rate
   D. Spot rate
   Answer: C
7. Call options give the buyer the right to:
   A. Sell the asset
   B. Buy the asset
   C. Exchange the asset
   D. Hedge currency
   Answer: B
8. Who benefits when interest rates rise after buying an FRA?
   A. FRA buyer
   B. FRA seller
   C. Bank
   D. Investor in equities
   Answer: A
9. Intrinsic value of an option depends on:
   A. Time value only
   B. Premium paid
   C. Difference between strike and market price
   D. Duration to maturity
   Answer: C
10. Which is a key function of derivatives?
    A. Increase risk
    B. Create volatility
    C. Hedging
    D. Eliminate trading
    Answer: C

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Author: Bank Theory