2. Derivatives - An Overview
2.1 Introduction
Derivatives are contracts which derive their value from one or more
underlying assets. The underlying assets can be stocks, bonds,
commodities, currencies, interest rates, market indexes or even
the weather. The value of the derivative is determined by fluctuations
in these underlying assets.
Derivatives are generally used as an instrument to hedge risk.
Additionally, it can also be used for the following purposes:
- To speculate - to reflect a view on the future direction of the market
- To enhance liquidity
- To change the nature of an investment without incurring the costs
of selling one portfolio and buying another
This chapter contains the following sections:
2.2 Types of Derivatives
There are two distinct groups of derivative contracts which are distinguished
by the way they are traded in the market.
Based on the market in which they can be traded, derivatives are broadly
classified as:
- Over-the-counter (OTC) derivatives – These are contracts that
are traded (and privately negotiated) directly between two parties, without
going through an exchange or other intermediary. Products such as swaps,
forward rate agreements, and exotic options are almost always traded
in this way.
- Exchange-traded derivatives (ETD) – These are derivatives products
that are traded via specialized derivatives exchanges or other exchanges.
The most common types of derivative instruments are as follows:
- Futures and Forwards – Futures/Forwards are contracts to buy
or sell an asset on or before a future date at a price specified today.
A futures contract differs from a forward contract in that the futures
contract is a standardized contract written by a clearing house that
operates an exchange where the contract can be bought and sold, while
a forward contract is a non-standardized contract written by the parties
themselves.
- A Forward rate agreement (FRA) is a specific type of a Forward. FRA
is a contract between two parties in which one party agrees to lend and
the other agrees to borrow a specific amount at a specified interest
rate for a specified tenor. FRAs are settled through cash payments that
represent the difference between the contracted rate and the spot value
of the pre-determined market benchmark rate
- Options - An option is a contract between a buyer and a seller that
gives the buyer the right but not the obligation to buy or to sell a
specified amount of a particular asset (the underlying asset) at an agreed
price on or before a particular day. In return for granting the option,
the seller collects a payment called the ‘premium’ from the
buyer. A ‘call’ option gives the buyer the right to buy an
underlying asset; a ‘put’ option gives the buyer of the option
the right to sell an underlying asset.
- Swaps - A swap is a transaction in which two counterparties agree
to exchange one stream of cash flows against another stream over time.
These streams are called the legs of the swap. Most swaps are traded
over-the-counter. The most common type of swaps are:
- Interest Rate Swaps – also known as Vanilla Swaps. It represents
contracts between two parties to exchange calculated interest obligations
related to a certain amount of principal without exchanging the principal
amount itself. For instance, One series of fixed rate interest rate flows
is exchanged for another series of floating rate interest flows
- Cross Currency Swaps – A cross-currency swap is a contract
between two counter-parties for the exchange of loans in different currencies.
Principal amounts are exchanged at the inception, with a re-exchange
upon closure. Between the inception and the closing dates, a series of
cash flows are made between the two parties reflecting the interest payments
on the two swapped principal amounts
2.3 Features of Derivatives Module
The Derivatives module in Oracle FLEXCUBE supports the processing
of all types of Forward Rate Agreements, Interest Rate Swaps and Cross
Currency Swaps.
The Oracle FLEXCUBE Derivatives module caters to the following requirements:
- Processing the following types of instruments:
- Forward Rate Agreements (FRAs)
- Interest Rate Swaps (IRS)
- Cross Currency swaps (CCS)
- Creating products/instruments to suit the bank’s requirements
- Segregating hedge and trade deals increasing the flexibility to define
the required accounting treatment
- Integrating with standard Treasury front office systems to provide
seamless processing
This section contains the following topics:
2.3.1 Derivatives Workflow
The various operations and events in the life cycle of a derivatives
contract are summarized below:
- Booking, amendment, termination and settlements
- Accounting treatment for life cycle events
- Initial and final exchange of principal (if applicable) and interest
schedules
- Assumptions/purchase and assignments/sale of running contracts (trade
deals)
- Brokerage Processing
- Revision of floating interest indices and interest accruals
- Revaluation of contracts
- Amortizations – Inception and Termination gains/losses
- Counterparty limit tracking under credit lines
- Exposure tracking under ISDA and other Master agreements
- SWIFT Messaging including multi-party messaging
- Queries and reports
2.3.2 Maintaining Mandatory Details
For Derivatives module to become completely operational you need to
set up certain mandatory information. Before doing the module specific
maintenance you need to complete the core static maintenance of Customer,
GL, Accounts, Currency etc.
The information that you need to maintain in the Derivatives module
includes:
- Defining Derivative Types
- Bank and Branch Parameter details
- Revaluation details
- Specifying Limits
- Messaging party details
- Counterparty details
- Interest, Tax and Charge classes.
For more details on module specific and generic maintenance
that you need to do, refer the chapters titled ‘General Maintenance for the Derivatives Module’
and ‘Defining Attributes Specific to Derivative
Products’ in this User Manual
2.3.3 Defining Fair Price Revaluation Methods
In Oracle FLEXCUBE, you can revalue the worth of contracts by using
either one of the following methods. They are as follows:
- Maintaining Contract Fair Prices - whereby you have to indicate the
fair price of individual contracts, which will be used for revaluation.
- Maintaining Branch Interest Rates - whereby you can maintain branch
level forward interest rates, which will determine the fair price to
be used for revaluation.
- Maintaining Contract Interest Rates - whereby you maintain contract
specific forward interest rates which will determine the fair price to
be used for revaluation.
2.4 Reports in Derivatives Module
This section contains the following topic:
2.4.1 Generating reports in Derivatives Module
In Oracle FLEXCUBE, you can generate following reports for the Derivatives
module:
- Interest Accrual report
- Back Dated Deals report
- Contract Activity report
- Customer-wise Details report
- Customer-wise Summary report
- Process Exception report
- Revaluation Log report
- Settled Deals report
For more details on generating reports in Derivatives module,
refer the chapter titled ‘Reports’ in this User Manual.