Download - Fixed Income & Interest Rate Derivatives
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Fixed Income /Interest Rate Derivatives (IRDs)
by
Dr B Brahmaiah,
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Derivatives are financial instruments whose
value depends on the value of other
underlying instruments or indices.
Interest rate derivatives (IRDs) are financial
instruments whose value depends on the
price of underlying fixed-income securities
or on the level of underlying interest rateindices
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Participants of IRDs
Banks
Financial Institutions
Industrial corporations utilities
Investment Managers
Governments and households.
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Objectives :
Managing exposures to interest rates
Creating synthetic investments or liabilities
Minimizing transaction costs Exploiting market discrepancies
Reducing cost of capital
Realigning Assets and LiabilityManagement
Speculation
Reduce taxes
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A bank may have fewer floating-rate assets
(investments) than floating-rate liabilities
(deposits).
To better match the two sides of its balance
sheet and
control the effect of interest rates on its
earnings and market values.
It could use IRDs to transform some of itsfixed-rate investments into floating rate
assets
to transform floating-rate liabilities into
fixed rate liabilities.
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Early interest rate swaps appeared to have been
created to exploit discrepancies among markets.
One firm had relatively cheap access to floating-
rate funds but wanted a fixed-rate liability.
Another firm could easily raise fixed-rate funds,
but preferred to have floating-rate obligations.
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IRDs permit firms to completely customize
their interest rate risk profile. They may have lower credit risk and greater
liquidity.
IRDs may allow firms to enjoy lowertransaction costs.
The instruments can be used for speculation.
Can distort tax and accounting reporting
could lead to a catastrophic failure of the
financial system
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Major Interest Rate Derivatives
swaps
forward rate agreements (FRAs)
Eurodollar futures bond options
caps / floors / collars and
swap options or swaptions
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Swaps
A contract between two parties to
exchange two streams of payments for
an agreed period of time.
The interest payments are calculated
based on the underlying notionals usingapplicable rates.
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Swaps
Market
Participants
1. Banks
2. Multinational Companies
3. Governments and public sector institutions
4. Money Managers
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Interest Rate Swaps (IRS)
Coupon swaps are basically swaps
contracts dealing with an exchange o a
fixed rate payment stream for a floating
rate one.
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Since the notional principal is an identical
amount in the same currency, the actual
principal is not exchanged.
If the payment schedules are identical, only the
difference between the two payments is
delivered.
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Interest Rate Swaps
An Interest Rate Swap is invariably an over the
counter contract.
It is a contact between two parties who agree to
exchange interest payments on a notional
principal at pre-agreed intervals of time for agiven maturity.
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When exchange control regulations prevented
free capital movements, corporates resorted toparallel loans.
Let us say a US based company has a
subsidiary in London and a UK based companyhas a subsidiary in New York.
Company wants to borrow Pound sterling and
the UK company wants to borrow US
D, exchange control regulations did not permit the
direct access to the capital markets of these
respective countries.
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Hence, a private arrangement used to be worked
out between the two companies under which the
UK company lent money in Pound Sterling to
the US subsidiary in London and the US
company lend money in USD to the UK
subsidiary in New York.
This arrangement worked well so long as
companies could find counterparties with
matching requirements in currency, tenor andsize of borrowing.
This is the origin of swaps .
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the first known currency swap was arranged bySalomon Brothers between World Bank and
IBM in the early 1970s.
Concept andMechanism:
Let us say a Corporate has issued a debt
instrument in the form of a bond and has agreed
to pay a fixed rate of10% on the bond to its
investors.
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The interest rate risk the corporate runs isobvious in the sense that if the interest rate falls
in future. The corporate will continue to pay 10% to
which it has locked itself.
If the interest rates are likely to fall
They can readily convert their fixed rateliability into a floating rate liability by means ofan interest rate swap.
It can choose to receive the (10% fixed rate)and in return offer to pay a floating rate basedon a bench mark.
The interest rates fall as was anticipated, thecorporate benefits.
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CorporatePays fixed 10% to investors
Receives fixed10%
Pays floating
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The corporate has annulled its fixed
payments by receiving fixed and haseffectively converted its fixed rate liability
into a floating liability in tune with its interest
rate view.
Corporate which has a floating rate liability
and is worried that interest rates are likely to
rise in future, will be able to convert its
floating rate liability into a fixed rate liability
by choosing to pay fixed and receive floating.
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a) The notional principalcalculate the interest differentials.
b) A bench mark rate for the floating
c) The maturity period of the swap
d) The periodic intervals of time in this maturity
when interest payments are to be exchanged.
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The start date and the end date
The price is quoted two ways in terms of the fixed
leg, say 6.5 / 6.75
which means the party needing a swap may either
choose to pay 6.75% fixed and receive the agreedfloating on the notional principal (in which event
he is said to have bought the swap from the market
maker or choose to receive 6.5% on the notional
principal and pay the agreed floating rate (in whichcase he is said to have sold the swap to the market
maker).
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The swap dealer quotes a price of 6.5/6.75 for the
above specifications with the floating rate based on
6m Mibor plus 50 basis points.
The corporate has now to receive fixed and pay
floating as it feels that the interest rate will fall in
future. So it chooses to receive 6.5% (the lower of the two
rates quoted) on the above quote and agrees to pay
6m Mibor plus 50 basis points every six months
for the next three years on the notional principal of
Rs.10 crores.
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Interest payments will be exchanged between
the corporate and the swap dealer depending onthe level at which the floating rate settles.
This mechanism resembles a Forward Rate
Agreement
There is a series of such interest payments over
a period at multiple settlement periods.
An IRS in nothing but a series ofFRAs
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Pricing Interest Rate Swap:
The net present value of the cash flows of these
two bonds should be equal to start with.
The present values of fixed and floating legs thus
obtained are equated and the rate which makes
them equal is computed.
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Interest Rate Swaps are fundamentally long
term hedging instruments. A Coupon Swap or a Plain Vanilla Swap.
A short term interest rate swap is also prevalent
in the markets. An overnight index swap is an example of such
a swap.
The interest payments are based on anovernight index (say call money rate) and a
fixed rate for a period of say 10 days.
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Currency Swaps
Currency swaps are also used to lower the risk ofcurrency exposure or to change returns oninvestment into more favourable currency.
Currency swaps are used to exchange assets orcapital in one currency for another for the
purpose of financial management.
A currency swap transaction involves anexchange of a major currency against the U.S.dollar.
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The actual exchange of principals takes place at the commencement and the
termination of the swaps.
Principals and interest payments are
exchanged based on the spot rate agreed at
the inception of the swaps.
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The uses of currency swaps are:
1. Lowering funding cost
2. Entering restricted capital markets
3. Reducing currency risk4. Supply-demand imbalances in the markets
5. Management of ALM
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Different kinds ofSwaps
1. Amortizing and Accreting Swaps
The notional principals of an amortizing swap
decrease one or more times during the tenor ofthe swap.
Accreting swaps are swaps with increasingnotional principals.
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2. Forward Swaps
Coupons are set on the transaction date.
The interest accrual commences on the givendate based on interest rates set on thetransaction date.
3. Reversible Swaps
Counterparties of reversible swaps change theirroles one or more times during the duration ofthe swap.
The payer becomes the receiver and thereceiver becomes the payer
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4. Basis Swaps
Basis swaps are swaps on which bothcounterparties pay floating rate.
Each counterpartys interest payments aretied to different floating rate indices.
Some of the indices are 3 months, 6 monthsLIBOR, T-bill rate, and the US commercial
paper rate.
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Non-par swaps : The market value of theswap at initiation is not zero, and therefore
one party pays the other at the beginning of
the contract. Forward or deferred swaps : The exchange
of net interest payments does not begin until
some point in the future.
Arrears-reset swaps : The floating rate is
set and paid at the end of the period.
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Company BCompany A
1/2 x 5% x $100 mm = $2.5 million
1/2 x 6 month LIBOR x $100 mm
Swap Cash Flow
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Forward Rate Agreements (FRA)
A forward Rate Agreement (FRA) is a contract
between two parties by which they agree to
settle between them the interest differential on anotional principal on a future settlement date
for a specified future period.
Let us assume that a corporate wants to borrow
a sum of Rs.1 crore for a period of six months
starting three months from today.
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Its main concern is that the six months
interest rate may rise higher in three monthstime and hence wants to lock in a rate right
today for a future borrowing commitment.
Borrowers at a future point of time buy theFRA to lock themselves to a fixed rate
whereas lenders sell FRA to lock in a fixed
return on their future lending. It enters into a 3 Vs 9 FRA with a
counterparty for a notional amount of Rs.1
crore.
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If the counterparty quotes, say, 6.25/6.50 for a 3 vs 9FRA,
the corporate buys the FRA at 6.50 which effectivelymeans that it is locking itself to 6.5% for the above
borrowing commitment.
If on the date of settlement, which is the date three
months from today when the borrowing commitmenthas to be met,
the bench mark rate agreed to by the counterpartssettles, say, at 7.00%,
the corporates view on the interest rate has cometrue and it is paid by the seller ofFRA the differenceof0.50%(7-6.5) on the notional principal for a periodof six months discounted at 7%
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The amount receivable by the corporate is calculated
as under:
10000000 x 0.50 x 181 1
----------------------------- x ------------
365 X 100 (1+0.07 x181/365)
On the other hand, if the benchmark interest rate
settles at, say 6.25% on the settlement date,
the corporate pays the seller ofFRA the difference of
0.25% (6.5-6.25) on the notional principal of Rs.1crore discounted at 6.25%.
In both the cases (whether interest rate rises or falls)
the corporates effective borrowing rate remains
unchanged at 6.5%
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Market conventions of FRAs:
The principal amount is only notional.
There is no commitment on either of thecounterparties to either lend or borrow thisamount.
The convention in FRA markets is to denote theFRA as 3 Vs 6, 6Vs9 etc.
A 6Vs9 FRA means seeking protection for a 3months borrowing or lending commitmentstarting 6 months from today.
A 9Vs12 FRA means seeking protection for a 3months borrowing or lending commitment
starting 9 months from today
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Prices are quoted two ways in the market forFRAs
The customer buys at the higher of the two ratesand sells at the lower rate.
The bench mark interest rate is a reference rate,basically a floating rate like T Bill rate, Liboretc,
The discounting of the amount to be settled isdue to the fact that the difference of interest issettled at the beginning of a borrowing orlending commitment whereas normally interest
is payable on maturity of a loan.
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We can borrow money for12m from the market
at8
.75%
and the repayment amount after twelvemonths will be (1+0.0875)
FRA are OTC contracts.
It is easy to customise the size and periods tosuit the needs of the customer.
As the commitment is only to settle the interest
differential,
The credit risk with the counter party is minimal.
FRAs do not enjoy very liquid markets.
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Cancellation of a FRA too would be difficult inthe absence of a ready market.
The pricing of an FRA has to be done in tunewith the market determined Yield Curve as
otherwise imperfections in pricing would lead
to financial loss.
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Therefore for each tick movement or one basis
point movement in price, the Dollar amountmovement in the 3m - contract value will be
1,000,000 x 0.0001 x 90
----------------------------- = 25$
360 x 100
The Corporate hedges itself against adverseinterest rate movements at a future point of
time. There are certain disadvantages too in using
futures.
The contract sizes and maturities are
standardized.
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Interest RateOptions
Interest Rate options are two types, the Capand the Floor.
A Cap is an interest rate option in which the buyer of the option, with the intention of
locking himself to a ceiling in interest costs forhis borrowing,
reserves the right to receive the difference in
interest rate on a notional principal in case theinterest rate on the underlying borrowing goeshigher than the ceiling
Floating rate of 6 Mibor+ 50 basis points.
Invested the money at fixed rate of8%
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Maturity of the bond is say 5 years
Means that we have an interest rate risk for the
next five years in case the 6m Mibor goeshigher and higher.
The 6m Mibor is currently 5% our return is8-5.5=2.5%
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Our break even level would be 7.5% asbeyond 7.5% level in Mibor we will make anegative spread.
Further, every higher movement in Miborwill have the effect of narrowing our initialspread of 2.5%
In order to eliminate this risk we may buy aCAP at say 7.0%.
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We are sure of getting a spread of at least 0.5%
in the above structure and any movement in 6mMibor beyond 7% will result in we being
compensated by the seller of the CAP.
The 6m Mibor rate prevailing on each of the 6monthly coupon payment dates and if it is
higher than 7%,
The difference on the notional principal will bepaid by the seller of the CAP.
A CAP is nothing but a series ofCall options
on Interest Rate.
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Floors:
A downside movement in interest rate could
expose us to interest rate risk if we are to lend
money or say create an asset.
We bought a floating rate note issued by a triple
AAA rated corporate, the interest being paidsemi annually at the rate of 6m Mibor+ 50
basis points.
Let us say we have founded this assets byborrowing at a fixed rate of 6%
The current 6m Mibor is 7% we enjoy a spread
of7.5 - 6=1.5%
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However, on the dates of coupon payments, if 6m
Mibor were to settle at a rate below 5.5% (break
even rate) we will have a negative spread.
So we may choose to lock in a minimum positive
spread of0.5% by buying a floor at 6%
If 6m Libor settles above this floor rate we are togoing to exercise our option.
A FLOOR is a series of Put Options on Interest
Rate.
The pay off profile will be similar to that of a CAP
with the difference that payment will be made by
the seller only if the 6m Libor settles below the
floor rate on the pre-agreed coupon payment dates.
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Collars:
A collar is a combination of a long position inCAP and a short position in FLOOR.
A Collar enables an interest rate option buyer to
minimize his cost. When buying a CAP there is an outflow of
premium and thus minimize his cost.
Interest Rate
Options thus, can be put toefficient use in managing interest rate risk.
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The following are the key features of instrument:
1. Cash settlement
2. No obligation to borrow or lend
3. Lock-in rate
4. Low credit risk5. Cancellation and assignment
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IndianMarkets
Fixed Income Derivatives
Deregulation of interest rates
Financial market operations efficient
Cost effective
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In India, FRA/IRS were introduced in July
1989SCB, PDs, FIIs can undertake FRAs / IRS for
Balance Sheet Management
Market Marking
Corporates are also allowed to use IRS & FRAs to
hedge their exposures.
June 200
3RBI issued guidelines to banks/PDs/FI for
transacting in exchange traded interest rate
futures.
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Derivative Products in
Domestic Interest Rate Market OTC Rupee Interest Rate Swaps
Plain vanilla fixed to floating swaps
Where a market determined benchmark rate
is used as floating rate.
Due to absence of a liquid term money
market, several alternative floating ratebench marks have evolved.
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a) Overnight Swaps: Floating rate is usually
the overnight call rate polled by NSE (NSE
MIBOR)
b) MIFOR Swaps : Floating rate is the
implied rupee interest rate derived fromUSD/INRForward
c) Swpas with floating rates linked to GOI
Security yield.d) Rupee Swaps with LIBOR rate
benchmarkets
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Forward Rate Agreements (FRAs)
Hedging Instruments : Particular interest
ratio setting in a floating rate asset or
liability.
FRAs can be used with reference to anyfloating rate.
Futures on 10 year Notional GoI security
with 6% coupon rate Futures on 10 year zero coupon notional
GoI security
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Futures on 91 day TB
Contracts are available for maturities upto
1 year.
Presently, Exchanges are using a ZCYC
based methodology to arrive at the final
settlement price of the contracts
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Regulatory Framework for OTC Rupee
Interest Rate Derivatives (RIRD)
Purpose --- for SCBs --- IRS may be
entered into for one of the three reasons.(a) customer transactions
(b) balance sheet hedging
(c) proprietary trading / market making
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Product Restrictions
Plain vanilla FRA/IRS are allowed
Caps / floors / collars are not permitted
There are no restrictions on the size and
tenor of the FRA / FRS
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BenchMark Rate
Participants are free to use any domestic
money / debt market rate as benchmark rate
(provided methodology of computing isobjective, transparent and mutually
acceptable)
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Reporting Requirements
Fortnightly return on FRA/IRS is prescribed
by the RBI - trades executed / outstanding
positions
Capital Adequacy : FRAs/IRS by
converting the notional values at the prescribed concession factor based on
original maturity of the contracts.
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RiskManagement & Internal Controls
Prudential Limits
Products
Counter parties
Value at Risk (VaR)
Potential Credit Exposure (PCE)
Functional Specialisation
Front Office
BackOffice
For hedging and market making
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Regulatory Framework Exchange
Traded Interest Rate DerivativesInterest Rate Futures on Notional Bonds on
T-Bills for the limited purpose of hedging
the risk in their underlying governmentsecurities investment portfolio.
(a) StockExchange Membership
(b) Settlement of trader
(c) Eligible underlying securities
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Road Map for development of Interest Rate
Derivatives Markets :
1. Rupee interest rate option products
2. Swaptions
3. Options on interest rate benchmarks / caps
/ floors
4. Exchange traded options on Interest RateFutures
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Thank You