2. Overview of Over the Counter Options
The OT module in Oracle Banking Treasury Management supports the complete life-cycle processing of the following over-the-counter derivative instruments:
•Interest Rate Options – Caps, Floors, Collars and Corridors
•Swaptions
•Currency Options – Plain Vanilla and Exotics
You can define products for buying or selling each of the above instruments, enter details of specific transactions, terminate or exercise option contracts and generate a comprehensive range of reports about your transactions in OT. You can enter into deals for hedging your existing exposures against interest rate or exchange rate fluctuations (hedge deals) or for speculation (trade deals).
Based on specifications, Oracle Banking Treasury Management can:
•Post accounting entries for various events in the life of an OT contract
•Generate messages for various events in the life of an OTcontract
•Automatically exercise such contracts which are so marked by you
•Revalue outstanding contracts periodically
•Track your exposure to counterparties
•Generate, or allow you to generate, foreign exchange or interest rate swap deals on the exercise of physically settled currency options and swaptions respectively.
Subject to relevance to a specific instrument, Oracle Banking Treasury Management supports all the standard option expiration styles:
•European – where the option is exercised only on a pre-specified future date
•American – where the option is exercised on any date before and including a pre-specified future date
•Bermudan – where an option is exercised on any one of a set of pre-specified dates
This topic contains the following sub-topics:
1)OT Instruments and Transactions
2.2 OT Instruments and Transactions
OT are traded in the over-the-counter market, where the active participants are banks and corporates. Therefore, deals are inter-bank or between a bank and a corporate. Deals are struck to cover an existing exposure (hedge deals) or to create a speculative exposure (trade deals).
The terms of an OT contract are tailored according to the mutual convenience of the counterparties. The counterparties also carry the complete exposure on each other, with no clearinghouse standing as a guarantor for the deals.
This topic contains the following sub-topics:
An IRO is an interest rate risk management product – it protects the buyer from an adverse movement in interest rates.
A borrower of floating rate funds is inconvenienced by a rise in interest rates, while a lender is adversely affected by a fall in floating rates.
An IRO gives the buyer the right, but not the obligation, to fix the rate of a notional underlying loan or deposit for a specified period, commencing on a specified date. Thus, the buyer of an IRO is protected against the interest rate rising above (if she is a borrower) or falling below (if she is a lender) at a specified level. At the same time, the buyer of an IRO can enjoy the benefits of the interest rate staying below (if she is a borrower) or stay above (if she is a lender) the specified level.
IROs is any one of the following categories:
•Cap – an option that gives the holder right to enter into strips of notional future borrowings at a pre-agreed interest rate
•Floor – an option that gives the holder the right to enter into strips of notional future lending at a pre-agreed interest rate
•Collar – an option strategy that involves a purchased cap and a written (sold) floor
•Corridor – an option strategy that involves two caps purchased at different exercise prices
note: An IRO does NOT have an implied commitment by either counterparty to exchange the notional principal at any stage – so no credit has to be given (no debt security purchased) or deposit accepted (debt security sold) by either party.
This also means an IRO is entered with a pure speculation objective, only to hedge against adverse interest rate movements.
A swaption gives the buyer an option to enter into an interest rate swap deal at a future date at a pre-agreed price.
Below are the list of swaption:
Table 2.3: Types of Swaptions
|
Swaption |
Description |
|---|---|
|
Payer’s Swaption |
A payer’s swaption gives the buyer of the option the right, but not the obligation, to pay a fixed rate and receive the floating interest rate in a swap contract. A swaption gives the holder the benefit of the agreed strike rate (fixed rate) if the prevailing market swap rate (fixed rate to be paid for receiving same benchmark floating rate) is higher while giving her the flexibility to enter into the prevailing market swap rate (fixed rate to be paid) if it is lower than the strike rate. |
|
Receiver’s Swaption |
A receiver’s swaption gives the buyer of the option the right, but not the obligation, to receive a fixed rate and pay the floating interest rate in a swap contract. This benefits the holder if the prevailing market swap rate (fixed rate to be received against the same benchmark floating rate to be paid) is lower than the strike rate – in this scenario, the holder can exercise the swaption and enter into a swap whereby she receives the strike rate as the fixed rate. If the reverse happens, she can not exercise the swaption and enter into a swap at the prevailing market swap rate. |
A swaption is settled in either of the following ways:
•Physically Settled, where the counterparties are obliged to enter into an interest rate swap deal on exercise of the swaption.
•Cash Settled, where the counterparties are only expected to exchange money on exercise of the swaption.
A currency option gives the holder the right, but not the obligation, to buy a specific currency against another specific currency at a pre-agreed rate on or before a pre-specified future date.
Apart from plain vanilla currency options, the OT module of Oracle Banking Treasury Management also supports exotics in the form of binary, digital, and no-touch options. Barrier options – options that get knocked in or knocked out under pre-specified conditions – are also supported.
Currency options can have either of the following expiration styles:
•Physically Settled, where the counterparties are obliged to enter into a spot foreign exchange deal on exercise of the swaption
•Cash Settled, where the counterparties are expected to exchange money on exercise of the option
The OT module interacts with the Foreign Exchange and Derivatives modules in Oracle Banking Treasury Management for the generation of FX contracts, interest rate swaps on the exercise of currency options, and swaptions respectively.
It also interacts with the following subsystems:
•Settlements
•Messaging
•ICCF
•Brokerage
•Tax
•MIS