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7967 results in Economic theory

Page 112 of 399

  • 9 - Swaps – Part II: Other Swaps

  • from Part–III - Swaps
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 143-152

  • Summary

    This chapter looks at some more kinds of swap transactions and at certain general issues relating to swap markets.

    Equity swaps

    An equity swap is an arrangement by which one party pays to the counter-party an amount based on the value of the shares in a company, and receives from the counter-party an amount of fixed or floating interest on an equivalent notional value. In effect, an equity position is converted into a deposit or debenture.

    Example 9.1

    X Ltd owns a large stake of one lakh shares in Y Ltd, a quoted sister company. The shares are currently quoted at 1,000 per share. X is apprehensive that the price of Y's shares may fall, but does not want to sell its stake as that would mean relinquishing its say over the management of Y Ltd. Instead it enters into an equity swap with Z Ltd, a financial institution, whereby

    i. X will pay Z annually the value of all dividends declared by Y plus or minus any net appreciation or depreciation in the share price (from the base value of 1,000) on its one lakh shares.

    ii. Z will pay X annually the market floating rate of interest on a sum of 10 crore, being the market value of X's holding at the time of the swap.

    Financially, the effect of an equity swap is the same as that of selling the shares outright. However, the shareholder may wish to retain the shares for reasons of control (as in the Example above) or to avoid capital gains tax, or to avoid giving a negative signal to the market. (For example, a sale of Tata Motors shares by Tata Sons might provoke general bearishness in Tata Motors shares, which can be avoided through an equity swap.) The disadvantage is that there is a transaction cost. Depending on the prevailing market sentiment, a premium may have to be paid by one or other party to attract the counterparty and there will usually be a margin for the intermediary.

  • 20 - Portfolio Management and Derivatives

  • from Part–VII - Portfolio Management and Management of Derivative Risks
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 301-306

  • Summary

    Derivatives create new investment opportunities. This chapter examines techniques which are used in portfolio management with particular reference to derivatives.

    Readers are likely to have heard of Lehman Brothers, the once-famous and now-notorious American investment bank which became bankrupt in 2008. Figure 20.1 below shows the price of the shares of Lehman Brothers from 2004 to 2008. It was difficult to predict that Lehman Brothers would go bankrupt when it was hitting all-time highs in early 2007. Even in early 2008 its share price was higher than in 2004. Within a few months, it collapsed. Clearly the market valuation did not reflect the company's inherent position and the stock market did not have the right information as would have been expected under textbook finance theory.

    Consider the hypothetical case of a person whose entire portfolio of investments consisted of only the shares of Lehman Brothers. He would have lost all his money. And if he was leveraged through futures, margin loans etc., then there would have been large margin calls as well in which extra payments over and above the initial equity had to be paid to the broker.

    The conventional answer would be that the investor should have diversified into other shares. And indeed, compared to a portfolio invested entirely in Lehman Brothers, a diversified portfolio of equities would have done better. But almost all broad-based equity indices lost half, if not more, of their net worth during the period from late 2007 to early 2009 which marked the global financial crisis. Thus, diversification into other equities would have provided only limited protection. This illustrates that true diversification does not mean just different equities; it entails diversification across asset classes as well, with equities constituting just one asset class. Government bonds, corporate bonds, convertible debentures, preferred shares, precious metals, other commodities and cash or short-term bank deposits/money market investments, real estate etc. are other asset classes. Having some exposure to them in one's portfolio in 2008 would have cushioned the fall more than a pure equity portfolio.

  • 21 - Management of Derivative Risks

  • from Part–VII - Portfolio Management and Management of Derivative Risks
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 307-317

  • Summary

    There can be no doubt that derivatives are powerful tools for risk management. If used improperly, however, derivatives can produce disastrous results. With derivatives becoming increasingly important, it has become crucial for banks, financial institutions and indeed non-financial companies to properly assess, manage and account for risks arising from derivatives transactions. While many earlier chapters have dealt with the use of derivatives in the management of risk, this chapter deals with the management of risks arising from the use of derivatives.

    Enterprise risk management – covering not only financial but many other kinds of risk – is a rapidly expanding subject by itself. This chapter is a brief and introductory overview of the main principles and practices relating to a subset of those risks – the risks arising from derivatives.

    An enterprise is subject to many kinds of risk and derivatives are just one and not necessarily the most important. Nevertheless, several characteristics of derivatives make them ‘special’ and different from management of many other types of financial risk. First and foremost, derivative instruments are highly ‘geared’. Because of this, it is possible in certain kinds of derivative transactions to lose far more than the original capital deployed in the transaction. In a normal business deal, with an investment of 10 million the maximum loss that can be suffered is 10 million or thereabouts. However, if 10 million is deployed in a derivative transaction as margin through writing of options or a speculative futures contract, it is quite possible to lose 100 million, that is, ten times the value of the capital put in. This is the single most important reason why derivative transactions require a much tighter supervision and control mechanism.

    Secondly, derivative markets move at great speed. The markets are open virtually on a twenty four-hour basis, due to the integration of various exchanges across the world. Big price movements can occur overnight. (This is a feature they share with stock and spot foreign exchange markets.)

    Thirdly, several derivative transactions fall into a grey area between hedging and speculation. Derivative securities used as hedges are a risk-reducing device, but derivatives used for speculation become a risk-enhancing device.

  • Preface to the Second Edition

  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp xvii-xviii

  • Summary

    In the 19 years since the first edition of this book appeared, much has changed. There was a time when the Western expert consensus was that financial markets should be largely left alone and that derivatives should be regulated as lightly as possible. That has changed after the global financial crisis of 2008. There is now greater caution about the effects of derivatives on the economy.

    Derivatives were relatively insignificant in Indian financial markets in 1998 and were just beginning to recover from decades of severe restrictions, imposed at a time when the government pursued a ‘socialistic pattern of society’. Today, India has active derivative markets not only in commodities but also in various financial instruments (so much so that there have been criticisms that equity derivatives trading in India has reached excessive proportions vis-à-vis the cash markets). Meanwhile, the Indian economy too has grown faster than the global average. In short, derivatives are more significant now in Indian markets and Indian markets are more significant in global terms.

    Amidst all the changes, one fact remains unchanged: derivatives are an important feature of a modern market economy and are here to stay. They matter not only to developed markets but to emerging markets as well. Therefore, a basic understanding of how these markets work is essential for those who participate in these markets, those who aspire to work in them and those who comment on them, but also for those who seek to study the economy. Students of commerce, business and finance, bankers and accountants, analysts and financial journalists, non-financial economists and managers – all need a basic understanding of the essentials of derivatives markets. Yet, most books on derivatives are geared to specialists and they often take a mathematical approach.

    This book aims to enable the general reader – whether student, practitioner, banker, commentator or investor – to gain a basic understanding of the derivatives markets and how they operate. It does not presume any prior knowledge of derivatives. The response to the first edition (which went into nine reprints till 2010) indicated that it succeeded in good measure in attaining that objective. It is the authors’ sincere hope that this edition will do the same.

  • 3 - Futures and Forwards

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 37-50

  • Summary

    As pointed out in chapter 1, futures trading, or more accurately forward trading, was the first form of derivatives trading. This chapter reviews the basic concepts of futures trading – its functions, the mechanism by which risk is transferred, the role of speculation and related issues. At the outset, it is necessary to understand clearly what futures trading means.

    Definitions

    A forward contract is an agreement between two parties to buy or sell, as the case may be, a commodity (or financial instrument or currency or any other underlying) on a pre-determined future date at a price agreed when the contract is entered into.

    The key elements are that:

    • the date on which the underlying asset will be bought/sold is determined in advance; and

    • the price to be paid/received at that future date is determined at present.

    Example 3.1

    In the month of August, a rice mill agrees to buy 2.35 tonnes of rice of IR-8 variety from X, a farmer, in the following February at a price of 38,000 per tonne. This is a forward contract. Note that the farmer will receive (and the mill will pay) 38,000 x 2.35 = 89,300 in February irrespective of whether the market price in February is 40,000 per tonne or 36,000 per tonne. According to its terms, this contract may or may not be transferable by the mill or the farmer to any other person and accordingly may be called a ‘transferable’ or a ‘non-transferable’ forward contract.

    A futures contract is a contract to buy or sell, a standard quantity of a standardised or pre-determined grade(s) of a certain commodity at a pre-determined location(s), on a pre-determined future date at a pre-agreed price. If this definition is studied carefully, the differences between a futures contract and a forward contract become apparent:

    a. There is no reference to an agreement ‘between two parties’ – this is because futures contracts are almost always entered into through an intermediary (the exchange or its clearing house) that acts as the buyer to each seller and seller to each buyer. This is illustrated below:

    The absence of a one-to-one relationship between the buyer and seller also means that these contracts are freely transferable.

  • 17 - Accounting and Taxation

  • from Part–VI - Accounting, Taxation and Regulatory Framework
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 257-281

  • Summary

    This chapter deals with the accounting and tax treatment of derivatives transactions. These are specialised topics in themselves and this chapter can only serve as an introduction to the subject.

    Accounting for derivatives

    The increase in the range and complexity of derivative instruments, increased regulatory attention to accounting for derivatives after the global financial crisis, and differing accounting standards and rules in different countries, combine to make this subject exceptionally complicated. Indeed, derivatives accounting is probably the single most complicated topic in the field of accounting. This section presents a simplified summary intended to give the reader an exposure to the main concepts and issues.

    Basic principles

    The basic principles that govern accounting for derivatives can be summarised as follows:

  • a. Derivatives must be shown in the balance sheet at ‘fair value’ (see below), and all changes in fair value must normally be recognised in the profit and loss account (also referred to in this chapter simply as ‘P & L’). Thus, not only realised profits and losses, but also unrealised profits and losses must be recognised; not only must they be recognised but normally they should be recognised as part of current profits or losses. This is known as ‘fair value accounting’. This is in contrast to the normal accounting convention of prudence or conservatism which would imply not recognising unrealised gains.

  • b. The general principle in (a) above will not apply if the derivative is a hedge. To qualify as a hedge, a derivative transaction or position must meet certain criteria. The general principle for derivatives which are used as hedges is that their accounting treatment must correspond to the treatment of the asset or liability being hedged. This treatment is known as ‘hedge accounting’.

    • Fair value

    The term ‘fair value’ is important in relation to accounting for derivatives. Fair value is the price that would be received to sell an asset/paid to transfer a liability in an orderly transaction between market participants. It must be an ‘arm's length’ transaction where the parties are independent of each other, have no relationship to each other and where each is trying to protect his /its own interests. Where there is quoted market value established in a liquid and transparent market, fair value is the same as market value.

  • Foreword

  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp xiii-xiv

  • Summary

    The four decades since the 1970s have been a period of extraordinarily rapid social and technological change, with few spheres of human endeavour left untouched. In the financial markets in particular, where I have had the privilege of being an active participant at all levels, the pace of change has been frenetic, with the growing importance of derivatives being one of the most significant.

    In the pre-1970s world of fixed exchange rates, controlled interest rates, limited international trade, administered prices (and in countries like India, price controls and rationing), we hardly needed derivatives. In today's world, where price volatility is a constant feature of markets, derivatives are an integral part of financial markets and essential for sound risk management. Derivatives are no longer confined to the developed countries. Many of the most actively traded derivatives markets are now in emerging economies.

    Derivatives are important but they are also complicated. The second edition of this book provides the reader with a sound understanding of the fundamental principles and practices of derivatives markets. It is comprehensive, covering topics ranging from pricing to accounting, while remaining concise. What makes this book stand out is the fact that it is written in plain language, de-mystifies a complex subject, and is easy to understand. At the same time, it does not over-simplify the subject. It provides a clear conceptual framework to each topic, which puts issues in context and makes them easier to comprehend. I am confident it will prove very valuable to a wide variety of readers.

  • 2 - Some Basic Concepts

  • from Part–I - Introduction
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 21-34

  • Summary

    This chapter introduces the reader to some basic concepts that will be useful when reading subsequent chapters and in gaining a deeper understanding of derivatives. It describes the main types of derivatives, the economic functions of derivative markets and some related concepts.

    Types of derivatives

    Derivatives are described and classified in many ways. The primary method of describing derivatives is based on the type of contract.

    Types of contracts

    The main contract types are:

    • Forward contracts

    – Futures contracts (which are special types of forward contracts traded through an exchange and thus a sub-set of forwards)

    • Swaps (in theory, these are similar to a string of forward contracts)

    • Options contracts

    • Complex derivatives (futures and options are the basic building blocks of complex derivatives)

    – Forward rate agreements

    – Range forwards

    – Exotic options

    – Collars

    – Swaptions

    Underlying

    Each of these types of contracts may have as its ‘underlying’ one of various kinds of assets. Thus, a futures contract can be on the share of an individual company (say, Tata Consultancy Services or TCS) or on a commodity (e.g., gold) or on a foreign currency (e.g., Japanese yen) and so on. Similarly, there can be options or swaps on various kinds of underlying assets or liabilities. Derivatives are thus often described on the basis of the type of contract and the nature of the underlying, e.g., ‘pepper futures’ means a futures contract with pepper as the underlying commodity, a ‘currency swap’ means a swap contract where the underlying is a foreign currency and so on.

    Underlying assets are also grouped into classes, like commodities or financial instruments. Based on this classification, derivatives can be classified into the following.

    • Financial derivatives in which the underlying is a financial instrument (individual share, a stock market index, bonds, a foreign currency, a cost of living index, a credit risk etc.).

    • Commodity derivatives in which the underlying is a commodity which may include:

    a. gold, silver and platinum often collectively known as ‘bullion markets’;

    b. base metals like nickel, tin, lead, copper etc.;

    c. ‘soft’ commodities like coffee, cocoa, cotton, etc.; and

  • 14 - Options – IV: Real and Other Options

  • from Part–IV - Options
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 225-232

  • Summary

    This chapter concludes the treatment of options with a brief discussion of real options and employee stock options.

    Real options

    Independently of the derivatives markets, life is full of situations involving ‘options’ in the conventional English language meaning of the term. These situations often do have financial consequences, as shown in Example 14.1.

    Example 14.1

    A Professor in a university who has a tenured (i.e., permanent) post is contemplating a new offer from a private company that offers her a much higher salary. She is not expecting to return to the University. However, there is always some uncertainty and less security of tenure in the private sector. She can retain a lien on her university post for three years by applying for leave without pay (sabbatical) but this involves paying a pension contribution which will not bring any extra pension benefit. If she is successful in the private sector, the amount she pays will be a waste. However, if she is unsuccessful, she can get back her University post. In this situation, retaining her lien would be the equivalent of buying a call option on the job—the premium is the amount of pension contribution. This is an example of a real option.

    More formally and quantitatively, the concept of real options is used in corporate finance and capital budgeting. Stewart Myers coined the term ‘real option’ in 1977.

    Example 14.2

    M Ltd. proposes to acquire a copper mine. The mine is already in production and has some reserves, which are profitable to exploit at any price above $3,000. Current prices are approximately $6,000 per ton. Traditional discounted cash flow techniques have been used to arrive at a valuation of the cash flow from the production expected each year. However, there are also some reserves that will be viable to extract only at prices higher than $9,000. The seller is insisting that the price must include a premium to reflect this potential future value. There is no certainty that the price of $9,000 would ever be reached; however if it is reached then a substantial additional cash flow will arise. Intuitively, it is obvious that this potential has some value but X Ltd. is not clear how to value this.

Page 112 of 399