Overview of Derivatives

2. Overview of Derivatives

2.1 Introduction

Derivatives are contracts that 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 topic contains following sub-topics:

1) Introduction

2)Types of Derivative

3)Features of Derivatives

4)Reports in derivative Module

2.2 Types of Derivative

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 counter parties 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

The Derivatives module in Oracle OBTR supports the processing of all types of Forward Rate Agreements, Interest Rate Swaps and Cross Currency Swaps.

The Oracle OBTR 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 topic contains the following sub-topics:

1) Derivatives Workflow

2) Maintain Mandatory Details

3) Define Fair price Revaluation Methods

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 Maintain 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 Charges 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 Define Fair price Revaluation Methods

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.