Professional Documents
Culture Documents
2.0 Introduction 4
14.0 Bibliography 38
1.0 Executive Summary
understanding the ISDA documentation. The parties who want to enter into a
swap transaction have to enter into an ISDA agreement which has to be signed.
This document has to be signed in association with the International Swap and
swap transaction and how does it work in the international as well as the Indian
markets and also its participants. The next step was pricing of a swap
pricing model through bootstrapping which will help in the pricing process. By
putting in the required values an investor would know the price of a swap. This
would be very theoretical but by comparing this price with the market price an
investor could know the difference and also judge the sentiments of the market.
After making a pricing model I have made a valuation model for which would
help the investors calculate the NAV on a daily basis. This would prove to be
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very beneficial as the investor knows the value of his transaction on a daily basis
Though Interest rate swaps and forward rate agreement in the rupee made their
entry in July 1999, following guidelines issued by the RBI . It has a lot of
decision of investing in a swap transaction and also once it has entered into one
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2.0 Introduction
Financial derivatives have crept into the nation’s popular economic vocabulary on
that few of us appreciate and fewer still fully appreciate. In a way, derivatives
are like electricity. Properly used, they can provide great benefit. If they are
The term "derivatives" has been used to identify a range and variety of financial
and the term often appears to be used to describe every financial instrument that
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addition, participations in pools of mortgages or other assets often are described
as "derivatives."
exposure/usage.
only alter the nature or profile of the corporation’s exposure to financial risk!
flows
transaction
prices
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• They increase the volume traded in markets because of
Set forth below are descriptions of some common types of derivative instruments.
2.3.1 Options. An option represents the right to buy or sell an underlying asset
right to purchase the underlying asset; a put option is the right to sell it. A fund
that buys options has the right to buy or sell the underlying asset. A fund that
writes (i.e., sells) options is obligated to sell the underlying asset to, or buy is
from, the party that purchased the option (if that party “exercises” the option). A
fund that writes an option is paid a premium for doing so. Options can be either
2.3.2 Forward Contracts. Funds may enter into forward contracts, which
obligate the fund and its counterparty to trade an underlying asset (commonly,
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2.3.3 Futures. Futures are similar to forward contracts, but differ in that they
are standardized and traded on a futures exchange. Unlike forward contracts, the
exchange. Futures are typically settled in cash, rather than requiring actual
are those involving the S&P 500. Parties may also buy or write options on
futures.
2.3.4 Swaps. Swaps are over-the-counter transactions that involve two parties
rate swap, the parties exchange interest payments based on an agreed upon
principal amount (referred to as the “notional principal amount”). Under the most
basic scenario, Party A would pay a fixed rate (e.g., 6%) on the notional
principal amount (e.g., $10 million) to Party B, which would pay a floating rate
payments between the parties would be netted out and settled periodically.) In
recent years, the swaps market has grown dramatically, both in terms of size and
variety. For example, interest rate swaps can involve cross-market payments (e.g.,
short-term rates in the U.S. vs. short-term rates in the U.K.) and cross-currency
payments (e.g., payments in dollars vs. payments in yen). Floating rate payments
may be subject to caps (i.e., ceilings), floors or collars (i.e., caps and floors
together).
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2.3.5 Structured Notes. Structured notes are over-the-counter debt instruments
where the interest rate and/or the principal are indexed to an unrelated indicator
(e.g., short-term rates in Japan, the price of oil). Sometimes the two are inversely
related (i.e., as the index goes up, the coupon rate goes down; inverse floaters
are an example of this) and sometimes they may fluctuate to a greater degree
than the underlying index (e.g., the coupon may change twice as much as the
change in the index rate). Structured notes are often issued by high-grade
corporate issuers. There is often an underlying swap involved; the issuer will
receive payments that match its obligations under the structured note (usually
from an investment bank that puts the deal together) and, in turn, makes more
“traditional” payments to the investment bank (e.g., fixed rate or ordinary floating
rate payments). It is important to note, however, that in such cases the mutual
fund would not be involved in the swap; the issuer of the note would remain
mortgages, the cash flow of which has been separated into its interest and
principal components. Interest only securities (“IOs”) receive the interest portion
of the cash flow and principal only securities (“POs”) receive the principal
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portion. These securities may be issued by U.S. government agencies or by
certain private issuers. Their values are highly sensitive to the rate of mortgage
principal prepayments, which tends to increase as interest rates fall and decrease
as interest rates rise. When interest rates decline and principal payments
accelerate, the interest payment stream is reduced and the value of IOs decreases.
When interest rates are rising and prepayments are slower, the average life of
Interest rate swaps and forward rate agreement in the rupee made their entry in
The RBI permits corporate customers to hedge interest rate risks on both the
assets and liability side using rupee IRD. Customers need to identify and earmark
genuine exposure against each IRD, ensuring that the tenor and the notional of
the hedge do exceed that of the underlying. Banks dealing with customers must
also satisfy themselves that the customer has genuine underlying exposure. Rupee
Banks hold fixed income securities for investment or SLR purposes and provide
commercial loans. These assets generally generate a fixed return for the bank.
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The duration of the investment and other assets of the bank ought to match the
duration of the liabilities of the bank in order to mitigate interest rate risk. In
addition, the bank may want to position their assets-liability mismatch to derive
benefit from the anticipated movements in interest rates. Interest Rates Derivates
are ideal instruments to change the asset-liability profile without changing the
Banks, Mutual funds etc maintain liquidity to meet demand for deposit withdrawal
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4.0 Understanding Interest Rate Swaps
An IRS is a transaction in which two parties agree to swap the coupon payments
receipts in the same currency on specified dates over a specified period calculated
on a notional principal.
In a plain vanilla swap, one party agrees to pay to the other party cash flows
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number of years. In exchange, the party receiving the fixed rate agrees to pay the
other party cash flows equal to interest at a floating rate on the same notional
principal for the same period of time. Moreover only the difference in the interest
payments is paid/ received; the principal is used only to calculate the interest
Interest rate swaps are used to hedge interest rate risks as well as to take on
interest rate risks. If a treasurer is of the view that interest rates will be falling
in the future, he may convert his fixed interest liability into floating interest
liability; and also his floating rate assets into fixed rate assets. If he expects the
movements of principal, these are off balance sheet instruments and the capital
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5.0 Types of IRS
the fixed interest rate for a stream of floating interest rate, then it is called a
coupon swap.
Payer of the fixed interest stream is called the payer in the swap.
Receiver of the fixed interest stream is called the receiver in the swap.
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Fixed
Payer interest
Receiver
Floating Interest
The term generic is used to describe the simplest of any types of financial
instrument- plain vanilla. So, a plain vanilla swap can be called a generic swap.
swap), an immediate start (i.e., on the spot date). A simple coupon swap can be
Basis Swap
Two steams of payments can be calculated using different floating rate indices.
month Libor.
2. it is also possible to enter into a swap with a 91 day T-Bill Yield against
a 6 Month Libor.
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In a basis swap, each counterparty is described in terms of both the interest
6 mth
Payer of 6 month Libor Payer of 91 day T-
Libor/ Receiver of
Bill Yield/ Receiver
91 day T-Bill
of 6 month Libor
yield
92 day T-Bill yield
funded with interest received on an asset, the whole mechanism is called the
asset. It does not however involve any change in the swap mechanism itself.
can maximize his interest inflow by swapping the fixed interest paid on the asset
for floating interest in order to profit from an expected rise in interest rates.
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Swaps with an original maturity of up to two years are referred to as Money
Market swaps. IMM swaps come under this category. The tenor of the swaps
A swap with an original tenor of more than two years is referred to as a term
swap.
2. Primary Dealers
4. Corporate
5. Mutual Funds
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Corporate and mutual funds can use these products only to hedge existing
asset/liabilities while the first three types of participants may do market making.
Most foreign banks and private sector banks are price makers in the market.
Large domestic corporate, MNCs, PSUs, and bank balance sheets are the users.
HSBC, Deutsche, Chartered, ISEC, JP Morgan, & BOA are the leading market
players.
Consider a swap agreement between 2 parties, A and B. the swap was initiated
notional principal of Rs 100 million, while B pays a fixed 12.1% rate on the
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It is assumed that payments are to be exchanged every three months and the
diagrammatically.
MIBOR (3m)
Party A Party B
12.15%
• Notional Principal
The floating and fixed interest rate calculations are for a pre-
decided.
Normally fixed rate coupon for a floating rate coupon, can also be
Fixed Rate
Floating Rate
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Linked to a benchmark rate which is reset periodically
An IRS is like a fixed rate asset and a floating rate liability or vice versa, but
without any exchange of principal and with net interest settlement. Therefore the
credit requirement for an IRS is minimal compared to those for cash instruments.
In the Indian market there are three main categories of products, which in turn
b. MITOR Swaps
c. MIFOR
2. Currency Swaps
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3. G-Sec Linked Swaps
These are the most basic and actively traded instruments in the market. The
underlying benchmark in these swaps is linked to funding cost for banks and
corporate.
When RBI opened IRD markets, it gave the participants freedom to choose any
floating rate benchmark from the rupee money and debt markets. Out of sheer
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lack of any other credible money market benchmarks, the overnight inter-bank call
Thus the first rupee IRD was in the MIBOR Overnight Indexed Swap (OIS). In
this swap, the floating rate is the daily compounded call rate. For short tenor
swaps (upto 1 year) settlements occur on the maturity of the swap. In case of
OIS Highlights
Overnight Index Swaps with the floating rate indexed to an Overnight reference
1. Overnight rates are likely to be most relevant and acceptable floating rate
benchmark.
2. Overnight money markets are deep and liquid and the Overnight Index is
accepted by counterparties.
4. Overnight rates have been the most widely accepted benchmark for floating
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6. Unlike cash transactions, credit exposure in OIS is minimal and requires
Understanding OIS
OIS increases for a country like India, which lacks a vibrant term money
market.
This is the most popular and liquid benchmark. we can use this because being
an investor we would like to see the daily floating rate and need to check the
the National Stock Exchange against which the swap is settled. Although the
floating rate is reset daily, for the sake of convenience, it is compounded and
settled only at a frequency which can be chosen by the swap counter parties.
Although OIS swaps are quoted out to five years, the maximum liquidity is
Description
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1. An OIS is a fixed/floating interest rate swap with the floating leg tied to
2. The term generally ranges from one week to one year. The two parties to
difference between interest accrued at the agreed fixed rate and interest
rolled ‘P plus I’ at the index rate every business day over the term of the
swap.
An OIS can be considered a swap of the total return on the call money
To pay an OIS means paying the fixed rate against receiving floating rate i.e.
receive an OIS means receiving the fixed rate against the floating rate.
However at times it may so happen that once of the parties to the swap may
followed.
Investor needs to find the valuation of the swaps they will enter into everyday
as they can discontinue at any point of time. to do this the first step is to
find the pricing of a swap transaction. This is theoretical. The market price of
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the swap may differ than the theoretical price and this will be due to the
market variables such as interest rate in the future etc which many effect the
9.1 Valuation
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It follows : V = Bfix – Bfl
9.2 The Value of the swap is zero when it is first negotiated. During its life it may
9.3 : Example :
Suppose that under the terms of a swap, a financial institution has agreed to pay
principal of Rs100 mn. The swap has a remaining life of 1.25 years. The relevant
discount rates with continuous compounding for 3month, 9month, & 15month maturities
are 10%, 10.5% & 11% respectively. The six-month MIBOR rate at the last payment date
In this case,
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= Rs98.24mn
= Rs102.51mn
9.44: If the Bank has been in the opposite of paying fixed & receiving floating, the
IRS will help the corporate to optimally manage its Structural Balance sheet. A
corporate having predominantly fixed rate long term assets and short term
liabilities can enter into a swap where it pays fixed for a long term and receives
floating linked to a shorter tenor benchmark from the counter-party. The corporate
could thus keep borrowing short term and match its longer tenor assets.
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10.2 Opens up diverse avenues of funding
Swapping the underlying liability into the desired interest rate basis (fixed/floating)
allows the corporate to access various markets for funding, despite a mismatch
requirements. For example, the corporate may make a long tenor issuance on the
fixed rate basis but may require that the actual liability on floating rate Rupees.
In order to achieve this objective, the corporate could swap the fixed rate funds
raised to floating rate funds. As a result, the IRS offers the corporate flexibility
If any corporate has a floating rate liability, it would have no control if the
floating rate benchmark were to shoot up. It can, however, enter into a swap to
receive the same floating benchmark and pay a fixed rate, to hedge this risk.
A corporate cannot borrow in the inter-bank call markets, but can create a
synthetic call linked liability by borrowing its routine fixed rate ICDs/CPs and
then entering into a swap where it agrees to receive fixed rate and pay a call
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Only the net interest payments are exchanged, thereby, circumventing the need to
exchange the gross amounts, on the settlement date. This leads to a lower credit
exposure on the counter-party. The credit exposure of an IRS is less than a cash
market
IRS allows the corporate to control the duration for which the interest rate on its
short term positions is locked in without having to fund the same for matching
maturity. In simplistic terms, this would mean that the corporate can borrow its
funding requirements in the tenor available, but can then structure it as per its
The IRS market is flexible in its maturity range. It is possible to manage the
the future interest Rates. As interest rate markets can be volatile, cash flow
period.
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10.9 Off –Balance sheet treasury product :
Banks can often trade in these derivatives & it will not be reflected in Books.
Identification of the
Need
Complete other
Documentations
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Commencing of the
swap
11.1 Identifying the Need to do a swap -
Example- the interest rates are volatile and the company wants to have a fixed rate of
interest.
What is exact nature of its liability/asset for which it wants to do the swap ?
Example – the company has taken a foreign currency loan for a Libor plus some basis
points.
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Are there any alternatives to swap?
Check whether the primary documents of the company i.e. MOA and AOA allow it. If
no, then check what alteration needs to be done and is shareholders approval or Board of
Documentation needed –
For Interbank
Corporate
transacting IRS. Also since IRS are low risk products due to netting conventions Banks
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11.4 Search for Counter party –
Identify parties specially banks who are willing to enter into such swaps with
you. This will involve an analysis of the market. Also determine the criteria for
Creditworthiness of the party – the parameter can be Credit rating of the party.
Whether it too has the sufficient approvals necessary to enter the agreement.
Do all the negotiations with the party and reach an agreement with them.
events like default. Over here the company should be very careful as to which terms of
the agreement should apply to the transaction and which should not.
submitted to the bank. When doing a swap with a bank, one will have to sign the General
Risk Disclosure Statement, which states that the company fully understands the risk
when entering into the swap and the bank is not an advisor to it. The importance of this
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statement is that while entering into a swap the bank is making it’s position clear that it is
not entering into a swap with us in the fiduciary relation of a financial advisor but just as
a counter party and it makes sure that the party fully understands the risks it is
undertaking so that later on there can be no legal dispute over the bank’s interest or
position.
When all the formalities are done with the swap commences from
the agreed date. So on the payment dates the payment should be made and sufficient
There is an inherent Interest Rate Risk on the swap just like the risk interest
Rate Risk on any other financial instrument. Any movement in interest rates
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12.1.2 Liquidity Risk
Liquidity Risk is the risk that a position will be difficult to reverse by either
IRS solely for the purpose of hedging may be treated as a part of the original
liability for which the IRS has been undertaken, and therefore be liable to tax
accordingly.
referred to in the IT Act, may not attract interest tax. According to IT Act, a
otherwise. The intention of the parties entering an IRS is not to create a debtor-
creditor relationship. The party paying interest does not do so in respect of any
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12.2.3 TDS
TDS will not be deducted on a Swap transaction, as the amounts paid by each
120/-. The confirmation would not be liable to any stamp duty as they fall
that has to be signed between the two parties who want to enter into a swap
transaction. While signing the ISDA agreement there are three documents which
the two parties need to sign between each other. The first one is the “Master
Document”, the second is the “Schedule” and the third is the “Confirmation”. If
the two parties want to enter into a swap agreement then they have to sign the
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Master Document with each other. This Master Document is a standard one and
can be downloaded from the ISDA website. From the Annexure 1 provided we
can see that the parties will have to make a few changes in the documents like
their name, address etc. this document covers all the relevant definitions and
1. Interpretations
2. Obligations
3. Representations
4. Agreements
6. Early Termination
7. Transfer
8. Contractual Currency
9. Miscellaneous
11. Expenses.
12. Notices
14. Definitions
These are the basic things that the two parties need to keep in mind while
entering into a contract. There needs to be only one Master Document that the
two parties need to sign with each other, eg. if XYZ Mutual Fund and I Sec
want to enter into a swap agreement with each other then they will have to sign
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only one Master Document with each other. The second document that the parties
need to sign with each other is the “Schedule”. The schedule is derived from the
Master Document. The Master has a lot of options that the two parties need to
decide about and in the schedule the two parties decide on the exact nature of
the transactions and the way they are going to transact with each other. The
contents of the Schedule as seen in Annexure 2 is that apart from the name,
address and the date that the parties have to enter into are:
1. Termination Provisions
2. Tax Representations
4. Miscellaneous
5. Other Provisions.
The last document that the parties need to sign between each other which is
infact on a transaction basis is the “Confirmation”. This document gives all the
details of a particular contract that the parties have entered into and it will defer
from one contract to the other. The “Schedule” supercedes the “Master” and it is
superceded by the “Confirmation”. Anything that the parties have not agreed to
initially but has been included in the confirmation has to be abided by for that
particular contract. Hence we can see from the above the importance of an ISDA
Swap markets worldwide account a substantial market share and the opportunities
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invest in and hence have made an attempt in this direction. Until today only the
big banks were the important players but slowly there will be new players in this
segment due to the convenience and hedging opportunity it offers. The investment
community has taken notice of this segment and awakens to the demand. The
emerging market. Being an emerging market it needs to hedge its risks due to
high volatility present in the current system. IRS would serve as a perfect
instrument of today if it can help the investing community in hedging their risks
Though currently the market is small but it will definitely grow and the investor
end would like to be at the forefront cause “Opportunity Dances With Those
14.0 Bibliography
www.debtonnet.com
www.yahoo.com
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www.investopedia.com
www.nse-india.com
www.rbi.org.in
www.google.com
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