Derivatives

A derivative is broadly defined as a financial instrument that primarily obtains its value from the performance of an underlying variable, such as interest rates, bond price, FX rate, credit spread, among others. These instruments allow trading in the return or price fluctuations of financial assets without the necessity of trading in the assets themselves.

Financial derivatives consist of three primary types of instruments – forward contracts, swap contracts and option contracts. These are the building blocks of all derivative products.

Foreign Exchange Forward

A transaction to exchange currencies – to buy or sell a particular currency at an agreed date in the future

Foreign Exchange Swap

A simultaneous purchase and sale of identical amounts of one currency for another with two different value dates

Non Deliverable Forward (NDF)

A forward foreign exchange contract where only the net difference between the contract forward rate and the market rate shall be settled on maturity date.

Interest Rate Swap

An interest rate swap (IRS) is an agreement between two counterparties to exchange interest payments over a specified period of time by reference to a notional principal amount.

Cross Currency Swaps

A Cross Currency Swap (CCS) is a special type of interest rate swap in which the interest streams being swapped are denominated in different currencies.

 

A transaction to exchange currencies – to buy or sell a particular currency at an agreed date in the future (more than two business days or later) at a rate agreed on deal date.

There is no exchange of currency until that future date arrives.  This agreement is covered by a forward contract to be signed by both parties.

A simultaneous purchase and sale of identical amounts of one currency for another with two different value dates . On the near date, you swap one currency for another at an agreed foreign exchange rate and agree to swap the currencies back again on a future (far) date at a price agreed upon inception of the swap.

FX swaps allows one to utilize the temporary surplus funds he has in one currency to fund obligations denominated in a different currency, without incurring foreign exchange risk.  It is an effective cash management tool for companies that have assets and liabilities denominated in different currencies.

A forward foreign exchange contract where only the net difference between the contract forward rate and the market rate shall be settled on maturity date.

It is similar to an outright forward foreign exchange contract where a notional principal amount, forward exchange rate and forward date are all agreed at the deal’s inception, except that at maturity, there will be no physical transfer of the principal amount.

The deal is agreed on the basis that only the net difference between the agreed forward rate and the prevailing spot rate (fixing rate) is settled between the contracting parties on forward maturity date. 

An interest rate swap (IRS) is an agreement between two counterparties to exchange interest payments over a specified period of time by reference to a notional principal amount.

This instrument is essentially an exchange of different streams of cash flows over a specified length of time, normally long term in nature. 

Before entering into such swap, the two parties have to agree on the following:
  1. The notional principal amount of the swap;
  2. The tenor of the swap; and
  3. The basis for calculating payments based on the notional principal (e.g. LIBOR + a spread or fixed interest rate), in order to determine the exact cash amounts that each party owes the other.
As an example, the following interest rate swaps can be created:
  • Fixed-(for)-Floating-Swaps in which a fixed rate payment stream is exchange for a payment stream referenced to a floating rate index.
  • Floating-(for)-Floating-Swaps in which both parties pay a floating rate.

A Cross Currency Swap (CCS) is a special type of interest rate swap in which the interest streams being swapped are denominated in different currencies.

Cross currency swaps also involve an exchange of principal.  Therefore, a standard currency swap would operate in three distinct phases

  •  Initial principal exchange between an agreed pair of currency;
  • Periodic interest payments in the respective currencies computed using the relevant interest rates and the respective principal in the initial exchange; and  
  • Re-exchange of principal at maturity

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