Unit II
Determination of Forward Prices
Swaps
• A swap is an over-the-counter agreement between two
parties to exchange cash flows in the future.
• Swaps are customized contracts traded in the OTC
market. Firms and financial institutions are the major
players in the swaps market.
• The agreement defines the dates when the cash flows are
to be paid and the way in which they are to be calculated.
• Main variables involved in the calculation are the future
value of an interest rate and an exchange rate.
• Main types of swaps are Interest Rate Swaps, Currency
swaps, equity swaps, commodity swaps and volatility
swaps, among others.
Swaps
• Swaps are customized contracts traded in the OTC
market.
• A Plain Vanilla interest rate swap involves exchange of
cash flow for conversion of floating interest rate to fixed
interest rate for a notional principal.
• Simplest example of plain vanilla interest rate swap will
be between two parties with different opinion about
future course of interest rates.
• A party with fixed rate payment obligation may believe
that interest rate will go down, while another party with
floating rate payment obligation believes that the
interest rates will go up, increasing their liability. Both
these parties may enter into interest rate swap contract.
Swaps
Company A and Company B enters into a
five-year swap with the following terms:
• Company A pays Company B an amount
equal to 8%(fixed interest rate) per
annum on a notional principal of
$250,000 .
• Company B pays Company A an amount
equal to one-year LIBOR + 2% per annum
on a notional principal of $250,000
Decide the pay off for both the parties.
Currency Derivatives
• Currency derivatives is a futures contract to
exchange one currency for another at a
specified date in the future at a specified rate
of exchange.
• These contracts are useful for entities which
involved in import and export of goods and
services.
• Currently in India, NSE and BSE have currency
derivatives segments. The Metropolitan Stock
Exchange of India also has this segment, albeit
with very low volume.
Weather Derivatives
• These are the financial instruments which derive
their value from weather related variables.
• Such variables include rainfall, temperature,
snowfall etc.
• These instruments are used by organizations to
manage the risks associated with unexpected
weather conditions.
• Such derivative is especially important in India
where economy is heavily dependent upon
agriculture.
• In developed countries, such derivatives are
mainly used by energy companies.
Energy Derivatives
• The financial instruments which derive their
value from an energy related assets are called
energy derivatives.
• Some of the underlying in this regard are crude
oil and natural gas.
• Insurance derivatives derive their value from an
underlying insurance index.