Derivatives & Hedging: Instruments, Risks & Nepalese Bank Applications

TAKEAWAYS:

• Derivatives are contracts whose value depends on an underlying asset (e.g., NPR/USD exchange rate, NEPSE index, gold price) and include forwards, futures, options, and swaps—each with distinct payoff structures.
• Hedging uses derivatives to offset risks: banks hedge interest rate risk (via swaps), currency risk (via FX forwards), and commodity risk (via futures) to stabilize profits.
• Nepalese banks (e.g., NMB, Standard Chartered Nepal) use interest rate swaps to convert floating-rate loans to fixed rates, and FX options to lock in exchange rates for importers/exporters.
• Speculation vs. Hedging: While derivatives can amplify gains (speculation), banks primarily use them to reduce volatility in assets/liabilities (e.g., a Kathmandu retailer hedging USD loan repayments).
• Regulatory constraints: Nepal Rastra Bank (NRB) limits bank exposure to derivatives (e.g., no short-selling in NEPSE), requiring collateral, mark-to-market accounting, and stress testing.
• Front/Mid/Back Office roles: The front office trades derivatives, the mid-office monitors risks, and the back office settles transactions—critical for compliance.

1. What Are Derivatives?

Derivatives are financial instruments whose value is derived from an underlying asset, index, or rate. They allow parties to transfer risk without exchanging the underlying asset itself.

Types of Derivatives

classDiagram
    class Derivatives {
        <<abstract>>
        +value depends on underlying asset
    }
    class Forwards {
        +custom terms
        +OTC (over-the-counter)
        +no daily settlement
    }
    class Futures {
        +standardized terms
        +traded on exchanges (e.g., NEPSE, CME)
        +daily margin calls
    }
    class Options {
        +right (not obligation) to buy/sell
        +call (buy) or put (sell)
        +premium paid upfront
    }
    class Swaps {
        +exchange cash flows (e.g., fixed vs. floating rates)
        +common: interest rate swaps, currency swaps
    }
    Derivatives <|-- Forwards
    Derivatives <|-- Futures
    Derivatives <|-- Options
    Derivatives <|-- Swaps

Key Differences

2. Why Do Banks Use Derivatives?

Banks use derivatives primarily for hedging (risk management) and secondarily for speculation (profit from price movements). In Nepal:

• Interest Rate Risk: Banks hedge floating-rate loans (e.g., corporate loans) using interest rate swaps to convert them to fixed rates.
• Currency Risk: Exporters/importers (e.g., Daraz suppliers) use FX forwards/options to lock in exchange rates.
• Commodity Risk: Gold refiners (e.g., in Lalitpur) use gold futures to stabilize prices.

IMAGE: NEPSE trading floor | Derivatives like index futures are traded here to hedge portfolio risks.

3. Hedging Strategies for Nepalese Banks

A. Interest Rate Hedging (Using Swaps)

Problem: A bank grants a 5-year floating-rate loan to a Kathmandu retail shop at SBL + 2% (where SBL = State Bank of Nepal’s policy rate). If SBL rises to 10%, the bank’s cost of funds increases, squeezing margins.

Solution: The bank enters an interest rate swap to convert the floating rate to a fixed rate of 8%.

• Pay: Floating (SBL + 2%)
• Receive: Fixed 8%
• Net effect: The bank’s effective lending rate becomes fixed at 8%, protecting margins.

Worked Example: NMB Bank’s Loan Hedging

flowchart LR
    A["Kathmandu Retailer"] -->|"Borrow"| B["NMB Bank: Grants 5-year loan at SBL + 2%"]
    B -->|"Hedges with"| C["Counterparty: Global IME\n(Enter into swap)"]
    C -->|"Pay"| D["Floating (SBL + 2%)"]
    C -->|"Receive"| E["Fixed 8%"]
    B -->|"Net Exposure"| F["Fixed 8% lending rate"]

B. Currency Hedging (Using FX Forwards/Options)

Problem: A Nepalese importer (e.g., a Pokhara electronics shop) orders USD 100,000 worth of goods. If NPR depreciates further, the cost in NPR rises.

Solution: The importer uses an FX forward contract to lock in today’s exchange rate (e.g., USD 1 = NPR 130) for future payment.

Worked Example: eSewa’s FX Hedging for Merchants

flowchart TD
    A["eSewa Merchant\n(Imports goods from China)"] -->|"Needs USD"| B["Today: NPR 130/USD"]
    B -->|"Enters"| C["FX Forward Contract\n(Lock USD 100k at NPR 130/USD)"]
    D["3 Months Later:\nNPR 135/USD"] -->|"Without Hedge"| E["Cost: NPR 13.5M"]
    D -->|"With Hedge"| F["Cost: NPR 13M\n(Saved NPR 0.5M)"]

C. Commodity Hedging (Using Futures)

Problem: A gold refinery in Lalitpur buys gold at NPR 100,000/10g. If gold prices rise, their cost increases.

Solution: They buy gold futures to lock in a purchase price.

4. Derivatives in Nepal: Real-World Applications

Example 1: NMB Bank’s Interest Rate Swap

• Scenario: NMB grants a NPR 50M, 3-year loan to a hotel at SBL + 3%.
• Risk: If SBL rises to 12%, NMB’s cost of funds increases.
• Hedge: NMB enters a swap to receive floating (SBL + 3%) and pay fixed 9%.
• Outcome: NMB’s net lending rate becomes fixed at 9%, protecting margins.

Example 2: Daraz Suppliers Using FX Forwards

• Scenario: A Daraz supplier in Kathmandu orders USD 50,000 worth of electronics.
• Risk: NPR depreciation could increase costs.
• Hedge: The supplier uses an FX forward to lock USD at NPR 130/USD.
• Outcome: Cost remains NPR 6.5M even if NPR later hits 135/USD.

Example 3: NEPSE Investors Using Index Futures

• Scenario: An investor holds a diversified NEPSE portfolio but fears a market crash.
• Hedge: They buy NEPSE index futures as a short hedge.
• Outcome: If the index falls, futures gains offset portfolio losses.

5. Risks of Derivatives

While derivatives hedge risks, they also introduce new ones:

1. Market Risk: Underlying asset prices move adversely (e.g., NPR strengthens unexpectedly).
2. Credit Risk: Counterparty defaults (e.g., if Global IME fails to honor a swap).
3. Liquidity Risk: Difficulty unwinding positions (e.g., OTC forwards may have no secondary market).
4. Operational Risk: Errors in trading or settlement (e.g., wrong contract terms).

Nepal-Specific Risk: NRB’s capital adequacy norms limit bank exposure to derivatives (e.g., max 20% of Tier 1 capital for trading book).

6. Regulatory Framework in Nepal

Nepal Rastra Bank (NRB) regulates derivatives through:

• Basel III Accord: Banks must hold capital against derivative risks.
• Mark-to-Market Accounting: Derivatives must be valued daily (gains/losses recorded).
• Stress Testing: Banks must simulate worst-case scenarios (e.g., NPR crash, SBL spike).
• Collateral Requirements: OTC derivatives must be collateralized (e.g., cash or securities).

NRB Circular 2022: Bans naked short-selling in NEPSE but allows hedging via futures/options.

7. Front, Mid, and Back Office Roles in Derivatives Trading

8. Numerical Example: Hedging a Loan with a Swap

Scenario: Standard Chartered Nepal grants a NPR 100M, 2-year loan to a Kathmandu textile factory at SBL + 2%. Current SBL = 6%. The bank wants to hedge interest rate risk.

Step 1: Identify Risk

• If SBL rises to 10%, the loan’s effective rate becomes 12%.
• The bank’s cost of funds (deposit rate) is 8%, so margins shrink.

Step 2: Enter a Swap

• The bank pays fixed 9% and receives SBL + 2%.
• Net effect: The loan’s rate becomes fixed at 9%.

Step 3: Outcomes Under Different SBL Scenarios

Conclusion: The swap caps the bank’s maximum rate at 9%, protecting margins.

## In the Real World

1. eSewa’s FX Hedging for Merchants

   • Idea Used: FX Forwards
   • How: eSewa allows merchants importing goods (e.g., electronics from China) to lock in USD/NPR exchange rates via partner banks (e.g., NMB). This prevents profit erosion if NPR depreciates.
   • Example: A Pokhara merchant ordering USD 20,000 of goods uses an FX forward at NPR 130/USD. If NPR later hits 135/USD, their cost remains NPR 2.6M instead of NPR 2.7M.

2. NMB Bank’s Interest Rate Swaps for SMEs

   • Idea Used: Interest Rate Swaps
   • How: NMB uses swaps to convert floating-rate SME loans (e.g., for tailors in Thapathali) into fixed rates, ensuring stable repayment schedules for borrowers and predictable margins for the bank.
   • Example: A tailor borrows NPR 5M at SBL + 1%. NMB swaps this to a fixed 7%, so the tailor pays NPR 38,500/month regardless of SBL changes.

3. Daraz’s Supply Chain Financing with Forwards

   • Idea Used: Commodity Forwards
   • How: Daraz partners with banks to offer suppliers forward contracts on raw materials (e.g., fabric, electronics). If global prices rise, Daraz’s suppliers are protected.
   • Example: A Kathmandu fabric supplier orders cotton futures to lock in a price of USD 1/kg. If global cotton prices spike, their cost remains stable.

4. NEPSE Investors Using Index Futures

   • Idea Used: Index Futures
   • How: Retail investors (via brokers like NMB Capital) use NEPSE index futures to hedge portfolios. For example, if an investor holds NEPSE stocks worth NPR 5M, they might buy futures to offset a potential 10% drop.
   • Example: If the NEPSE index falls from 2,000 to 1,800, futures gains can offset losses in the underlying portfolio.

## Exam Tip

1. Define Clearly: Start answers with precise definitions (e.g., "A swap is an OTC agreement to exchange cash flows between parties, commonly used to hedge interest rate or currency risk.").
2. Nepal Context: Always relate examples to Nepalese banks (NMB, Global IME, Standard Chartered), NRB regulations, or local businesses (Daraz, eSewa, NEPSE).
3. Diagrams > Text: Draw T-accounts for hedging impacts, flowcharts for swap structures, or tables comparing forwards/futures/options.
4. Numerical Workings: For questions like "How would a bank hedge a floating-rate loan?", show:
   • The initial exposure (e.g., SBL + 2%).
   • The swap terms (e.g., pay fixed 8%, receive floating).
   • The net outcome (e.g., fixed 8% lending rate).
5. Risk vs. Reward: Highlight both benefits (hedging volatility) and risks (counterparty default, liquidity risk).
6. Regulatory Focus: Mention NRB’s Basel III compliance, mark-to-market rules, and collateral requirements where relevant.
7. Front/Mid/Back Office: If asked about operations, describe the roles of each office in trading, monitoring, and settling derivatives.

## Practice Questions (Exam-Style)

1. Define "hedging" and explain how a Nepalese bank would use an interest rate swap to manage risk on a floating-rate loan to a Kathmandu hotel. Use a numerical example with current SBL rates.
2. Compare forwards and futures, giving one Nepalese example of each. Why might a Daraz supplier prefer a forward contract over a spot purchase of USD?
3. What are the key risks of derivatives trading for Nepalese banks? How does NRB mitigate these risks through regulations?
4. Draw a flowchart showing how an FX option is used to hedge currency risk for an importer in Pokhara. Label all steps.
5. Explain the roles of the front, mid, and back offices in derivatives trading, using the operations of Global IME as an example.