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Derivatives

In the CFA® Level 1 study session on Derivatives you learn about Forwards, Futures, Options and Swaps. 

Here is a quick refresher of what you studied:

Forward Contracts:  A forward contract is an agreement between two parties to conduct a transaction at a later point in time.   For example, Bank A and Company C sign an agreement that Bank A will sell $10 million at Rs. 90/$ in six months.  Another type of forward contract is a Forward Rate Agreement (FRA).  This is simply an agreement on an interest rate and is discussed in more detail below.  Forwards are private contracts and hence not exchange traded. 

Futures Contracts:  Like a forward contract, a futures contract is an agreement between two parties to conduct a transaction at a later point.  The major difference between forwards and futures is that futures contracts are standardized and exchange traded. 

Options:  The most basic type of option is a call option which gives the buyer of the option the right but not the obligation to buy the underlying asset at a given price by a given date.  A put option gives the buyer of the option the right but not the obligation to sell the underlying asset at a given price by a given date.  Standardized options are traded on exchanges such as CBOT (Chicago Board of Trade).

Swaps:  A swap is an agreement between two parties to exchange cash flows.  The most basic type of swap is an interest rate swap (IRS) whereby one counterparty pays a fixed rate and the other counterparty pays a floating rate based on a notional principal and agreed benchmark (such as LIBOR).

 
Derivatives in Pakistan

Details on Pakistan’s derivatives-related regulations are contained in SBP’s BSD Circular No. 17 of 2004 (http://www.sbp.org.pk/bsd/2004/C17.htm). 

While the derivatives market in Pakistan is not large, a few banks such as SCB, UBL and RBS have been allowed by the State Bank of Pakistan to engage in derivative transactions.  These banks are referred to as Authorized Derivative Dealers (ADDs).   The derivatives allowed by SBP are:

·         Foreign Currency Options

·         Forward Rate Agreements

·         Interest Rate Swaps

Foreign Currency (FX) Options allow organizations to hedge foreign currency risk.  Example:  A large local company will be importing equipment in 6 months for which it will need $10 million at that time.  The company is uncertain about exchange rate movements.  It wants to hedge against the risk of adverse FX movements but wants to benefit if the FX movements is favorable.  In this case the company will buy a six-month FX call option from an Authorized Derivatives Dealer.  If the strike price on the call option is Rs 90/$ this means that the company will have the right but the not the obligation to purchase dollars for Rs 90/$.  This option will be exercised if the exchange rate at maturity is more than Rs. 90/$.  If the exchange rate is less than Rs. 90/$, the option is out of the money and will not be exercised. 

Forward Rate Agreements allow organizations to hedge against interest rate risk.  Example:  An organization knows it will need to borrow Rs. 100 million in six months.  To mitigate the risk of an increase in rates the organization can enter into a forward rate agreement to borrow Rs. 100 million in six months at 14%.  This way, regardless of the interest rates at time, the organization will be able to borrow at 14%.

Interest Rate Swaps (IRS) offer organizations another mechanism to manage interest rate risk.  As indicated above, an IRS allows interest payments between two counterparties to be swapped.  The most common type of IRS is where one pays a fixed interest rate while the other makes a floating rate payment.   Example:  A power generation company is making floating rate payments on a Rs. 150 million 10-year loan.  The regulatory authority wants this floating rate loan converted to a fixed rate loan.  This can be accomplished by entering into an interest rate swap where the power generation company pays a fixed rate and receives a floating rate.  The floating rate it receives from the IRS counterparty offsets the floating rate payment on the loan.  Hence the power generation company effectively only makes a fixed rate payment.

Notably absent from the SBP’s circular on financial derivatives is the mention of futures contracts.   This is because futures contracts in Pakistan are traded on the National Commodity Exchange Limited (www.ncel.com.pk).  NCEL is regulated by the Securities and Exchange Commission of Pakistan (SECP).  Commodities traded on NCEL are rice, palm oil, gold, silver and crude oil.  Interest rate futures (3-month KIBOR) can also be traded on NCEL. 

For questions or comments on this article write to arif.irfanullah@gmail.com.

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