FOREIGN EXCHANGE AND RISK

MANAGEMENT-4, Financial Derivatives

BBA 4 YEARS
8TH SEMESTER

HAILEY COLLEGE OF BANKING AND

FINANCE,
UNIVERSITY OF THE PUNJAB LAHORE

SLIDES PREPARED BY: DR JAMIL AHMAD KHAN AIBP,

ASSOCIATE OF CHARTER BANKER UK

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 Dictionary Meaning of Financial
Derivatives:
 Something derived;
 Theword derivatives is derived in
mathematics
 Refersto a variable which has been
derived from another variable.

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For example;
A measure of temperature in Celsius can
be derived from a measure in Fahrenheit
 Financial derivatives is an instrument

indeed derived from the financial market.

 It is a financial instrument, which derives

its value from

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 the basic variables called bases, therefore,
bases may be underlying asset, index or
reference rate.
 e.g a forward contract on gold is a derivative

instrument, while gold is actual underlying

asset
 Derivatives includes;
 1- security derived from a debt
instrument, share, loan wheter secured
or unsecured,risk instrument,or contract,
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Contract for differences, or any other form
of security
2-A contract which derives its value from
the prices or index of prices of underlying
securities.
For example ;
Consider a farmer whose fres crop of corn
will be harvested after three months from
now. He unsure about the price he will
receive at that time, will he have a buyer at

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 at that time when he is in the market to
sell his corn after three months. There is
uncertainity about both, that is price and
buyer
 So a derivative will enable him to enter

into firm constract today, to sell a fixed

quantity of corn, upon an agreed quality of
corn, upon mutually agreed price, on a
agreed future time, in this case three
months. So the uncertainiy is removed by
the derivative and risk is controlled

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 Example 2:
 An IT company will receive its payment in

US$, a month later; The company is not

sure about rupee value of the receipt, at
that time because exchange rate fluctation
in the Fex market.
 Derivatives can enable the company to

sell the receivables in US dollar today, to

lock into prevailing US$ rate for one
month.

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 once again the company has miltigated
the uncertainty and risk, throgh
derivatives.

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TYPES OF FINANCIAL DERIVATES
 There are four generally considered
types of financial derivatives;
 1-Options Contracts
 2-Forward Contracts
 3-Futures Contracts
 4-Swaps

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1-OPTIONS CONTRACTS-one sided contract, only one
party get benefits

 CALL OPTION
 A derivative contract that gives the call

option buyer the right, not the

obligation to buy, a stock, financial
instrument at a specific price- called
striking price of the option, within a
specified time frame
 Option premium is nonrefundable
amount paid upfront by the option

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 buyer to the option seller (also known
as option writer)
 The seller of the call option is obligated to

sell the security to the buyer if the latter

decides to exercise his option to make a
purchase.
 The buyer of the call option can exercise

his option at any time prior to the specified

expiry date.
 The expiry date can be extended to three

month, six months, and upto one year in

the future.
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 For example, assume that you bought an
option of 100 shares of a stock, with an
option strike price of US$ 30
 Before your option expires, the price the

stock rises from $28 to $40

 Then you can exercise your right to buy

100 share of the stock at a price of $30,

immediately giving you a $10 profit per
share.
 Your profit will be equal to 100 share,

times $10 a share, minus whatever price

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or premium you paid for purchase of
the call option.
In this example, if you paid $200 for
the call option, then your net profit
would be $800 (100 shares x $10 per
share-$200=$800)

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Example 2 Call option-Reliance
Industries
 Suppose that;
 Spot Price = Rs 1953.15
 Strike Price = Rs 2000
 Option Premium = Rs 57.15
 Expiry Date = 31.12.2023
 Lot Size = 505 shares
 When to buy call option: If you expect

the price of shares of Reliance Industries

to increase above Rs 2000
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 When to exercise the call option:
Once the share price of Reliance
Industries increase to above Rs 2000
you have the option to exercise the
call option and seller is obligated to
sell you 1 lot of the shares of Reliance
Industries at Rs 2000 per share as you
have paid him a premium of Rs 57.15
which binds him to the contract.
 When to cancell the call option: On
the other hand, if the price of shares
of Reliance Industries does not cross
15
 Rs 2000 before 31.12.2023 then you
can cancell the contract, your loss in
this case is Rs 57.15 paid as premium
to the option writer.

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Put Option

A Put Option is an Option Contract which

gives the buyer the right, but not obligation
to sell, underlying security at a specified
price ( known as strike price) before or on
predetermined expiry date.
 For Example assume that shares of ABC

company are current trading at $ 50

 Put contracts at strike price of $ 50 are

being sold at $ 3 and have an expiry

period of six months
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Put Option

 In total, one put option costs $300 (since

one put option represents 100 shares of
ABC company)
 Assume that Mr John buys one put option

at $300 for 100 shares of the company,

with the expection that stock price of ABC
company’s share will decline.
 The stock price is expected to fall to $ 40

by the time put option expires,

 If the price does drop to $ 40,John can

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Put Option
exercise his put option, to sell the stock at
$50 and earn 100 shares times (100 x $10=
$ 1000)
So his net profit is $700=($1000- $300
option price)
However, if stock price remains above the
strike price, the put option expires
worthless.
John’s loss from the investment is capped
at price paid for the put option

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American and European Options
 European option give the option holder the
right to exercise the option only at
preagreed future date and price
 On the other hand, the American option

gives the option holder the right to

exercise the option, at any date before
the expiry date at the preagreed price
 This applies both to calls and to puts

options

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ITM/ATM/OTM OPTIONS
 ITM OPTIONS (In the Money Options)
 A call option is said to be in ITM if the

strike price is less than the current spot

price i.e;
 Spot price > strike price(spot-strike>0)
 A put option is said to be in ITM if strike

price is more than current spot price of the

security. i.e;
 Spot price < strike price (spot-strike<0)

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ATM OPTIONS
 ATM Options( at the money options):
 A call option is said to be in ATM, if the

strike price is equal to the current spot

price. i.e;
 Spot price=Spot price(spot-srike=0)
 A put option is said to be in ATM, if strike

price is equal to current spot price of the

security. i.e;
 Spot price=Srike price(spot-strike=0)

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OTM OPTIONS
 OTM OPTIONS(out of the money
options): A call option is said to be in
OTM if the strike price is more than
current spot price of the security. i.e;
 Spot price < Strike price(Spot-Strike<0)
 A put option is said to be in OTM if the

srike price is less than the current spot

price of the security. i.e;
 Spot price > Strike price(spot-strike>0)

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2-Forward Contracts
A forward contract is contract between two
parties
 Completed with one buyer and one seller
 Specific in term of;
 -the price of underlying asset/security
 -the quality type of underlying security
 -the date of delivery
 -the quantity and,
 -where applicable, the place and mode of

delivey
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Example of Forward Contract
 If A agrees to purchase 100 kg of
wheat from B at Rs 40 per kg, after 6
months, it is a forward contract
 Please note that quality, specifications

and delivery terms, all are clearly

specified in the contract.
 A is assured of a buyer of 100 kg

wheat, at the rate of Rs 40 per kg after

six months from now.

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Forward Contract

B is assured of supply of 100 kg wheat at

the rate of Rs 40 per kg after six month
from now.
 In this type of contract, the counter party

risk is high
 It a customised contract
 The parties are obligated to execute the

contract after expiry date

 The settlement is on maturity date

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Futures Contract
 Future Contract is an agreement
betwee two parties, one is the seller
and other is buyer, to buy or sell
something at future date.
 The contract trades on a futures

exchange and subject to daily

settlement procedure.
 The futures contracts are regulated

by the market

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-The stock exchange becomes the buyer for
the seller and the seller for the buyer
-Future contracts are traded on organized
exchanges are called future markets.
-These are standardized contract contrary
to forward contracts which are customized
contracts

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4-Swaps Contracts
 1-Currency Swaps
 Ir is an agreement in which two parties

exchange the principal amount of loan and

the interest in one currency and the interest
in another currency
 It is also known as a cross-currency swap

contract
 Example;
 Let us consider the following example;
 Company A is a US-based company who

want to expand its business in Europe

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 So company A requires Euro 85000 to
finance its European expansion
 On the other hand Company B is a

European company that operates in the

United States.
 Company B wants to acquire a
company in the United States to
diversify its business, the acquisition
deal requires US$ 1 million in financing

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Currency Swaps
 Neither company A nor company B holds
enough cash to finance their respective
projects
 So both the companies seek to obtain

the necessary funds through debt

financing,
 Company A and B will prefer to borrow in

their domestic currencies(that can be

borrowed at lower interest rate) then
enter into Currency Swap agreement with
each other.
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Currency Swaps
 The currency swaps between company
A and Company B can be designed in
the following manner;
 -The company A obtain a credit line of

$1 millions from Bank A with a fixed

interest rate of 3.5%
 At the same time Company B obtain a

loan of Euro 85000 at floating rate of

six month LIBOR
 The companies decide to execute a

currency swap agreement with each

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Currency Swaps
 According to the agreement, Company
A and Company B must exchange
principal amounts($ 1 millions and
Euro 850000) at the beginning of the
transaction. In addition the companies
must exchange the interest payments
amounts semi annually.
 The company A must pay company B

floating interest rate payments

denominated in Euros,while company
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Currency Swaps

 B will pay company A the fixed

interest payments in US$, On maturity
date, the companies will exchange
back the principal amount at the same
rate(1$=Euro 60.85).

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Currency Swaps-Types
 Floating VS Fixed (Circus Swaps):
One leg of currency swaps represents
stream of fixed interest rate payments
and other leg represents stream of
floating interes rate payments
Float VS Float(Basis Swaps):
The Float VS Float swaps is commonly
called Basis Swaps. In a basis swaps,
both legs of swaps represent stream of
floating interest rate payments
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Currency Swaps-Types
 FixedVS Fixed Swaps:
Both streams of Currency Swaps
contracts involve the fixed interest
rates payments.

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