Foreign Derivatives

I) Introduction

Derivative in finance is generally referred to a financial contract whose value is derived from the value of an underlying asset. A derivative derives its value from the value of some other financial asset or variable. For example, a stock option is a derivative that derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from an interest rate index. The asset from which a derivative derives its value is referred as the underlying asset. The price of a derivative rises and falls in accordance with the value of the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Like other contracts, derivative represents an agreement between two parties; the terms of the agreement are highly flexible and the contract has a fixed beginning and ending date. Derivative transactions are now common among a wide range of entities, including commercial banks, investment banks, central banks, fund managers, insurance companies and other non-financial corporations.

Futures and options are actively traded on many exchanges throughout the world. Many different types of forward contracts, swaps, options, and other derivatives are entered into by financial institutions, fund managers, and corporate treasures in the over-the-counter market. Derivatives are added to bond issues, used in executive compensation plans, embedded in capital investment opportunities, used to transfer risks in mortgages from the original lenders to investors, and so on. We have now reached and era of development in financial instruments where we working in financial and non-financial institutes are bound to know how derivatives work, how they are priced and how they are used.

II) History of Derivative

In ancient in ancient Greece and Rome, forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700’s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of ‘credit risk’ and to provide centralized location to negotiate forward contracts. From ‘forward’ trading in commodities emerged the commodity ‘futures’. The first type of futures contract was called ‘to arrive at’. Trading in futures began on the CBOT in the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984. In 2008 Bangladesh Bank publish a circular called “Hedging the price risk of commodities”. From that time authorized dealers can hedge the price risk of commodities of their customers through standard exchanged traded futures/options and OTC derivatives on commodities. Establishment of a financial derivative market improves the capital structure and profit making ability of commercial banks. Hedgers can easily use derivative as safeguard against the risks associated with their assets. Derivative market can play a pivotal role to strengthen the effect of monetary policy and absorb the foreign capital into a country as it helps bring stability in the overall financial markets. After the catastrophic fall of capital market of Bangladesh in 2010, it hasn’t yet recovered yet; causing rapid decline of FDI and scarcity of innovative and versatile financial products. As derivative securities are prevailing in Bangladesh, the establishment of financial derivative market may be a proper decision for the country.

III) Derivative Instruments in Bangladesh

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. In Bangladesh we are getting three types of derivatives products they are: Foreign Exchange Derivatives, Interest Rate Swap and Commodity Derivatives. (Standard Chartered, AB Bank, Premier Bank, NRB Ltd., The City Bank Limited,)

1. Foreign Exchange Derivatives

Foreign exchange is the conversion of one country's currency into that of another. In a free economy, a country's currency is valued according to factors of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value also may be fixed by the country's government. However, most countries float their currencies freely against those of other countries, which keeps them in constant fluctuation. (Eugene, 1984)

1. Foreign Exchange Options

In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date (Villamar, 2011)

The foreign exchange options market is the deepest, largest and most liquid market for options of any kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $158.3 trillion in 2005. (JKA)

1. Foreign Exchange SWAPS

A Foreign Exchange swap agreement is a contract in which one party borrows one currency from, and simultaneously lends another to, the second party. Each party uses the repayment obligation to its counterparty as collateral and the amount of repayment is fixed at the Foreign Exchange forward rate as of the start of the contract. Thus, Foreign Exchange swaps can be viewed as Foreign Exchange risk-free collateralized borrowing or lending.

Foreign Exchange swaps have been working to raise foreign currencies, both for financial institutions and their customers, including exporters and importers, as well as institutional investors who wish to hedge their positions. They are also frequently used for speculative trading, typically by combining two offsetting positions with different original maturities. Foreign Exchange swaps are most liquid at terms shorter than one year, but transactions with longer maturities have been increasing in recent years. (BIS, 2007)