Equity derivatives and interest rate derivatives

Equity derivatives

Haequity 1

The important difference between futures contract and options contract is that in the case of a futures contract, the risk-reward is symmetric, whereas in an options contract, the risk reward is asymmetric. In other words, if a person enters into a futures contract, he or she stands to gain or lose exactly the same amount if the price of the underlying moves up or down. For example, let us assume that a person enters into a futures contract to buy 100 shares of ABC Limited at Rs 100 with the settlement date after 30 days. If the price of the shares of ABC Limited moves up by 10%, the investor will gain 10% and if the price goes down by 10%, the investor will lose 10% on the date of expiry. This means that the risk and the reward of owning a futures contract are symmetric.

Let us assume that the investor buys 100 call options of ABC Limited at Rs 2 for the strike price of Rs 100 with the expiry after 30 days. If the price moves up by 10%, the investor will gain Rs 10 as reduced by the call option premium of Rs 2 which is equal to Rs 8. On the other hand, if the price of the underlying shares of ABC Limited goes down by 10%, the investor will lose only the call option premium of Rs 2. This shows that risk-reward relationship for options contract is asymmetric.

So long as an investor buys an options contract – be it call option or put option – the investor is exposed only to the premium paid on such options and nothing more than that. The investor is likely to gain theoretically limited profit if it is a bought call option. If it is a bought put option, the maximum profit that an investor could get is the strike price of the put option contract as reduced by the premium paid on such contract.

Since the objective of hedging is to minimise the loss or to protect an unrealised profit, only bought options can qualify as hedging instrument. Written option has the potential of incurring unlimited losses, as a result of which, written options can never become hedging instruments. Futures contract has the effect of realising the profit and not locking the profit as a result of which, stock futures contracts cannot qualify as hedging instruments. However, index futures may qualify as hedging instruments.

To generalise the conditions for a derivative instrument to become a qualifying hedging instrument, one can say that if the fair value of the hedging instrument can always remain positive, then ipso facto it qualifies as a hedging instrument. Where there is a potential for the fair value of the hedging instrument to get into the negative zone, it does not qualify for becoming a hedging instrument. This is a general statement and there are exceptions for this as given below.

  1. Interest rate swap can have a positive or negative value and still can be designated as a hedging instrument.
  2. All FX Forward contracts and other forward contracts that deal with non-financial item can be designated as hedging instrument, even though such contracts can have positive or negative value.

Interest rate swap as qualifying hedging instrument

Interest rate swap has a pay leg and receive leg. Usually one of these legs will be fixed and other one variable. Both the legs can also have variable rate of interest provided it is referenced to different bench mark rate. For example, one leg can be based on 6M LIBOR and the other leg can be based on 6M MIBOR. Both the legs can also have a fixed rate of interest provided the notional is denominated in different currencies in which case, it becomes a cross currency swap.

Depending up on the movement of interest rates, the net fair value of an interest rate swap can oscillate between a positive value and a negative value. When the interest rate swap has a positive value, then it will be shown as an asset in the balance sheet and if it has a negative value, then it will be shown as liability in the balance sheet. One can think of interest rate swap contract to be very similar to that of a futures contract.

While futures contracts cannot be designated as a hedging instrument (in the case of equity markets), interest rate swap contract can be designated as hedging instrument in spite of the fact that the fair value of such instruments oscillates between positive and negative values. When the interest rate swap contract is entered into for the purpose of hedging the long-term fixed rate debt instrument, it may so happen that the interest rate may go up resulting in the fair value of the interest rate swap becoming negative thereby being shown as a liability in the balance sheet. The probability that the interest rate will move in a direction that will be beneficial to the entity is exactly 0.5. It may then appear that the entity would be better off not entering into the interest rate swap contract as it may eventually prove that the estimate is worse than the desired. The reason why the interest rate swap is still be regarded as a hedging instrument despite the fact that it may result in increasing the interest expense is due to the following reasons:

  1. The objective of entering into the interest rate swap contract is not to mitigate the interest expenses in respect of this particular hedging relationship, but to ensure that the risk management objective of the enterprise at the macro level is complied with.
  2. The hedging relationship involving the hedged item of a fixed rate long-term debt security with the interest rate swap may be executed to implement the risk management objective of the enterprise, the particular hedging relationship being accepted as a risk management strategy at the macro level.

The interest rate swap in effect is taken to convert the fixed rate debt into a variable rate debt so as to conform to the risk management objective of the enterprise.

Interest rate cap

Interest rate cap is an interest rate derivative contract which has a ceiling namely, a cap strike rate on a floating rate of interest on specified notional principal amount. If the cap buyer’s floating rate rises above the cap’s strike rate, the seller of the cap compensates the difference between the floating rate and the cap strike rate. Effectively, the cap buyer uses the cap contract to limit the maximum interest rate payable. If the floating rate remains below the cap strike rate, the buyer of the cap contract is not obliged to make any payment. One can draw an analogy of an interest rate cap instrument to that of a call option. Similar to the buyer of a call option, the buyer of a cap instrument has theoretically unlimited potential gains to be made from the contract but, at the same time, has a very limited risk that is restricted to the premium paid for the cap contract/call option contract. The seller of the cap instrument is exposed to unlimited risk very similar to that of the seller of a call option contract.

Interest rate floor

An interest rate floor is a form of interest rate derivative that has a minimum value known as the floor strike rate on a floating rate of interest on a specified notional principal. The buyer of the interest rate floor receives from the floor seller, the difference between the floor strike rate and the floating rate whenever it drops below the floor strike price. The floor buyer uses the interest rate floor contract to limit the minimum interest rate receivable. Sometimes, the interest rate floor is also entered into as a seller of the floor mainly to minimise the cost of a purchased interest rate cap. Interest rate floor can be that of a series of put options or floor legs based on a specified benchmark reference rate.

Interest rate collar

An interest rate collar is a form of interest rate derivative which includes two distinct components, namely:

  1. purchase of interest rate cap, and
  2. sale of interest rate floor, both the interest rates being pegged to the same bench mark reference rate and for the same maturity and notional principal amount.

The counter party for both these components is the same. The cap strike price is settled above the floor strike rate. Interest rate collar can be used as a hedging instrument only so long as the net present value of the interest rate collar is positive. The moment the fair value of the interest rate collar becomes negative, it ceases to be a hedging instrument and the hedge accounting should be discontinued immediately. The Standard prohibits a derivative instrument that contains a written option and a purchase option to be designated as a hedging instrument if it is in effect a net written option on the date of designation. When the net present value becomes negative, then the factors would indicate that the combined instrument is in effect a net written option, as it would receive net premium over the life of the combined instrument.

The objective of the buyer of interest rate collar is to protect against the rising interest rates. The purchase of the cap instrument protects against rising interest rates. The sale of the floor generates premium income which reduces the cost of the interest rate collar. In other words, interest rate collar creates a band within which the buyer’s effective interest rate fluctuates. The interest rate collar can be structured in such a way that the cost of the collar can be zero at inception which is called as zero cost collars.

Interest rate reverse collar

Interest rate reverse collar is another form of interest rate derivatives which has two distinctive components as follows:

  1. Sale of interest rate cap, and
  2. Purchase of interest rate floor.

Both the strike rates are pegged to the same bench mark reference rate for the same maturity and notional principal amount. The counterparty for both these components is the same. In the case of interest rate reverse collar, cost of buying the floor is compensated partially or fully by the premium received on selling the cap.

The objective of the buyer of interest rate reverse collar is to protect against the falling interest rates. The purchase of the floor instrument protects against falling interest rates. The sale of the cap generates premium income which reduces the cost of the interest rate reverse collar. In other words, interest rate reverse collar creates a band within which the buyer’s effective interest rate fluctuates. The interest rate reverse collar can be structured in such a way that the cost of the collar can be zero at inception which is called as zero cost collars.

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