Interest rate Derivatives & Its applications & usefulness in India.

SMBA Batch 25
Amit P. Kasar Dipika Yadav Pooja Jadhav Smita Dumbre

Meaning Of Derivatives A derivative is any instrument or contract that derives its value from another underlying asset, instrument, or contract

Interest Rate Derivatives

An interest rate derivative is a financial derivative where the underlying asset (interest-bearing instrument) is the right to pay or receive a notional amount of money at a given interest rate. An interest rate derivative is a derivative whose payoffs are dependent on future interest rates The interest rate derivatives market is the largest derivatives market in the world

Interest Rate Derivatives

OTC

Exchange Traded

Forward Rate Agreements

Interest Rate Swaps Caps

Interest Rate Options

Interest Rate Futures

Collars

Floors

Using Forward Rate Agreements to Manage Interest Rate Risk Forward Rate Agreements A forward contract based on interest rates based on a notional principal amount at a specified future date Buyer Agrees to pay a fixed-rate coupon payment (at the exercise rate) and receive a floating-rate payment Seller Agrees to make a floating-rate payment and receive a fixed-rate payment The buyer and seller will receive or pay cash when the actual interest rate at settlement is different than the exercise rate

Forward Rate Agreements (FRA) Similar to futures but differ in that they: Are negotiated between parties Do not necessarily involve standardized assets Require no cash exchange until expiration There is no marking-to-market No exchange guarantees performance

Notional Principal The two counterparties to a forward rate agreement agree to a notional principal amount that serves as a reference figure in determining cash flows. Notional Refers to the condition that the principal does not change hands, but is only used to calculate the value of interest payments.

Notional Principal Buyer Agrees to pay a fixed-rate coupon payment and receive a floating-rate payment against the notional principal at some specified future date. Seller Agrees to pay a floating-rate payment and receive the fixed-rate payment against the same notional principal.

Example: Forward Rate Agreements Suppose that Metro Bank (as the seller) enters into a receive fixed-rate/pay floating-rating forward rate agreement with County Bank (as the buyer) with a six-month maturity based on a 1 million notional principal amount The floating rate is the 3-month MIBOR and the fixed (exercise) rate is 7%

Example: Forward Rate Agreements Metro Bank would refer to this as a 3 vs. 6 FRA at 7 percent on a 1 million notional amount from County Bank The phrase 3 vs. 6 refers to a 3-month interest rate observed three months from the present, for a security with a maturity date six months from the present The only cash flow will be determined in six months at contract maturity by comparing the prevailing 3-month MIBOR with 7%

Example: Forward Rate Agreements Assume that in three months 3-month MIBOR equals 8% In this case, Metro Bank would receive from County Bank 2,451. The interest settlement amount is 2,500: Interest = (.08 - .07)(90/360) 1,000,000 = 2,500. Because this represents interest that would be paid three months later at maturity of the instrument, the actual payment is discounted at the prevailing 3month MIBOR: Actual interest = 2,500/[1+(90/360).08]=2,451

Example: Forward Rate Agreements The FRA position is similar to a futures position County Bank would pay fixed-rate/receive floating-rate as a hedge if it was exposed to loss in a rising rate environment. This is similar to a short futures position

Interest Rate Futures in India

While the name interest rate futures suggests that the underlying is interest rate, it is actually bonds that form the underlying instruments. An important point to note is that the underlying bond in India is a notional government bond which may not exist in reality. In India, the RBI and the SEBI have defined the characteristics of this bond: maturity period of 10 years and coupon rate of 7% p.a. It is also worthwhile noting that several other countries have adopted the concept of notional bond, although the characteristics of the

Rationale of IRFs
It is not just the financial sector, but also the corporate and household sectors that are exposed to interest rate risk. Banks, insurance companies, primary dealers and provident funds bear significant interest rate risk on account of the mismatch in the tenure of their assets (such as loans and Govt. securities) and liabilities. These entities therefore need a credible institutional hedging mechanism. Interest rate risk is becoming increasingly important for the household sector as well, since the interest rate exposure of several households are rising on account of increase in their savings and investments as well as loans (such as housing loans, vehicle loans ,etc.). Moreover, interest rate products are the primary instruments available to hedge inflation risk, which is typically the single most important macroeconomic risk faced by the household sector.

Benefits of Exchange traded IRF Interest rate futures provide benefits typical to any Exchangetraded product, such as Standardization Only contracts with standardized features are allowed to trade on the exchange. Standardization improves liquidity in the market. The following features are standardized: Only certain expiry dates are allowed in India viz. last working day of the months of March, June, September and December. The size of contract can only be in multiples of a certain number called the lot size. The lot size currently in India is Rs. 2 lakhs. Only some specific bonds can be used for delivery. Transparency Transparency is ensured by dissemination of orders and trades for all market participants. Also, competitive matching of orders of buyers and sellers boosts transparency.

Application of Interest Rate Derivatives

IRF: Contract Specifications

IRF contracts can be traded on the Exchange. Standardization is done both in terms of the features of the product and the mechanism of its trading and settlement. Various features of standardization are discussed in this section. Product Features The features of the product are as follows: Underlying bond: Underlying bond is a notional 10 year, 7% coupon-bearing Government of India bond. Lot size: The minimum amount that can be traded on the exchange is called the lot size. All trades have to be a multiple of the lot size. The interest rate futures contract can be entered for a minimum lot size of 2000 bonds at the rate of Rs. 100 per bond (Face Value) leading to a contract value of Rs. 200,000

Contract cycle:
New contracts can be introduced by the Exchange on any day of a calendar month. At the time of introduction, the duration of any contract can vary from 1 month to 12 months. The expiry has to be on Last Thursday of the Expiry month. Expiry day Interest rate future contracts shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day. Further, where the last Thursday falls on the annual or halfyearly closing dates of the bank, the expiry and last trading day in respect of these derivatives contracts would be preponed to the previous trading day.

Trading Parameters
Contract size The permitted lot size for the interest rate futures contracts shall be 2000. The minimum value of a interest rate futures contract would be Rs. 2 lakhs at the time of introduction. Price steps The price steps in respect of all interest rate future contracts admitted to dealings on the Exchange is Re.0.01.

The Futures contracts having face value of Rs 100 on notional ten year coupon bearing bond and notional ten year zero coupon bond would be based on price quotation and Futures contracts having face value of Rs. 100 on notional 91 days treasury bill would be based on Rs. 100 minus (-) yield.

Cont Base Price & operating ranges Base price of the Interest rate future contracts on introduction of new contracts shall be theoretical futures price computed based on previous days closing price of the notional underlying security. The base price of the contracts on subsequent trading days will be the closing price of the futures contracts. However, on such of those days when the contracts were not traded, the base price will be the daily settlement price of futures contracts. Quantity freeze Orders which may come to the Exchange as a quantity freeze shall be 2500 contracts amounting to 50,00,000 which works out on the day of introduction to approximately Rs 50 crores.

Settlement Procedure & Settlement Price

Daily Mark to Market Settlement and Final settlement for Interest Rate Futures Contract Daily Mark to Market settlement and Final Mark to Market settlement in respect of admitted deals in Interest Rate Futures Contracts shall be cash settled by debiting/ crediting of the clearing accounts of Clearing Members with the respective Clearing Bank. All positions (brought forward, created during the day, closed out during the day) of a F&O Clearing Member in Futures Contracts, at the close of trading hours on a day, shall be marked to market at the Daily Settlement Price (for Daily Mark to Market Settlement) and settled. All positions (brought forward, created during the day, closed out during the day) of a F&O Clearing Member in Futures Contracts, at the close of trading hours on the last trading day, shall be marked to market at Final Settlement Price (for Final Settlement) and settled. Daily Settlement Price shall be the closing price of the relevant Futures contract for the Trading day. Final settlement price for an Interest rate Futures Contract shall be based on the value of the notional bond determined using the zero coupon yield curve computed by National Stock Exchange or by any other agency as may be nominated in this regard. Open positions in a Futures contract shall cease to exist after its expiration day.

A Summary of Contract Specification

Contract Notional 10 underlyi year bond ng (6 % coupon ) Contract N FUTINT descript NSE10Y06 or 26JUN2003 Contract Value Lot size Tick size Expiry date Notional 10 year zero coupon bond N FUTINT NSE10YZC 26JUN2003 Notional 91 day T-Bill N FUTINT NSETB91D 26JUN2003

Rs.2,00,000
2000 Re.0.01

Last Thursday of the month

The contracts shall be for a period of a maturity of Contract one year with three months continuous contracts months for the first three months and fixed quarterly contracts for the entire year. Price limits Settleme nt Price Not applicable As may be stipulated by NSCCL in this regard from time to time.

Daily settlement price for an Interest Rate Futures Contract shall be the closing price of such Interest Rate Futures Contract on the trading day. The closing price for an interest rate futures contract shall be calculated on the basis of the last half an hour weighted average price of such interest rate futures contract. In absence of trading in the last half an hour, the theoretical price would be taken or such other price as may be decided by the relevant authority from time to time.

Daily Settlement Price

Settlement Schedule
Settlement Schedule Product 1. IRF Contracts Settlement Daily Mark-to-Market Settlement Schedule Pay-in : T+1 working day on or after 11.30 a.m. Payout : T+1 working day on or after 12.00 p.m.

2. IRF Contracts

Final Settlement

(T is expiration day)

Pay-in : T+1 working day on or after 11.30 a.m. Payout : T+1 working day on or after 12.00 p.m.

Participants in the Interest Rate Futures market

The participants in the IRF market are broadly classified into three groups, depending on what is the purpose of their participation. Hedgers: Companies and institutions having exposure to interest rates-because of their holdings of government bonds or their borrowing (liabilities) and lendings (assets)--hedge the risk arising from adverse interest rate movement by using IRF. These entities are called hedgers.

Speculators: Speculators participate in the future market to take up the price risk, which is avoided by the hedgers. They take calculated risk and gain when the prices move as per their expectation.
Arbitrageurs: Arbitrageurs closely watch the bond and futures markets and whenever they spot a mismatch in the alignment in the prices of the two markets, they enter to make some profit in a risk-free transaction.

Hedging Applications of IR Derivatives

One way to hedge a position in the spot bond market is to take an opposite position in the IRF market. This ensures that a change in interest rates will not affect the value of a portfolio and this strategy is also called Interest rate immunization. IR derivatives in general and IR futures in particular have huge hedging applications unlike equity derivatives. This is because, almost every economic entity has an exposure to interest rate fluctuation in some form or the other. Also, given its very nature, interest rates get affected by a number of macro-economic factors. Hence, hedging through IR derivative becomes crucial. This is particularly so in turbulent times, when economic uncertainty is high. As we have discussed, individuals, corporate, banks and insurance companies all are exposed to interest rate risk. So they need interest rate futures to hedge their risks.

Hedging Applications of IR Derivatives contd

Broadly the various uses of the IR derivatives are as mentioned below: Asset-liability management: Banks typically have lot of government bonds and other long term assets (loans given to corporates) in their portfolio, while their liabilities are predominantly short-term (deposits made by individuals range from 1 to 5 years). To address the risk resulting from the asset-liability mismatch, they generally sell IRF and thereby, hedge the interest rate risk. On the other hand, for the insurance companies and several big corporates, the tenure of their liabilities is longer than that of their assets. So, they buy IRF to hedge the interest rate risk. Investment portfolio management: Mutual funds and similar asset classes having a portfolio of bonds can use IR futures to manage their interest rate exposure in turbulent times.

Speculation strategies
Long Only Strategy: In the view of some investors, by consistently having a long position in assets, particularly in bonds, one can achieve fair returns. They hold this view for IRF also, as IRF has the bond as its underlying. These investors buy IRF and repeatedly roll them over before each expiry. This strategy is called Long Only Strategy. View Based Trading: In contrast to Long Only investors, some investors take both long and short positions in the IRF market, depending on their views on interest rate movements in future. If they expect interest rates to go up, they sell IRF and if they have the opposite expectation, they buy IRF. If the interest rate movement turns out to be the way the investor expected, he would make profit; otherwise, he would make losses.

Arbitrage strategy
Frequently, the price of a bond in spot market and price of futures may not be aligned with each other because of some distortions in the supply/demand factors. The arbitrage strategy employed to gain riskfree profits by exploiting the non-alignment (or mis-pricing of futures relative to spot bond prices) is called cash/futures arbitrage. Cash/Futures arbitrage is also called basis arbitrage or cash and carry arbitrage. Smart market participants take advantage of such situations to make risk free profits. It involves buying a bond in cash (spot) market and selling futures simultaneously or vice versa. It should be noted that the cost of carry has to be considered while calculating the profits. Net basis is an important parameter to track arbitrage in IRF market. Net basis is typically positive. If net basis turns negative, however, an arbitrage opportunity arises, which can be exploited to make risk-free profits.

Basic Interest Rate Swaps Basic or Plain Vanilla Interest Rate Swap An agreement between two parties to exchange a series of cash flows based on a specified notional principal amount Two parties facing different types of interest rate risk can exchange interest payments

Basic Interest Rate Swaps Basic or Plain Vanilla Interest Rate Swap One party makes payments based on a fixed interest rate and receives floating rate payments The other party exchanges floating rate payments for fixed-rate payments When interest rates change, the party that benefits from a swap receives a net cash payment while the party that loses makes a net cash payment

Basic Interest Rate Swaps Conceptually, a basic interest rate swap is a package of FRAs As with FRAs, swap payments are netted and the notional principal never changes hands

Basic Interest Rate Swaps Using data for a 2-year swap based on 3-month MIBOR as the floating rate This swap involves eight quarterly payments. Party FIX agrees to pay a fixed rate Party FLT agrees to receive a fixed rate with cash flows calculated against a 10 million notional principal amount

Basic Interest Rate Swaps

Basic Interest Rate Swaps Firms with a negative GAP can reduce risk by making a fixed-rate interest payment in exchange for a floating-rate interest receipt Firms with a positive GAP take the opposite position, by making floating-interest payments in exchange for a fixedrate receipt

Basic Interest Rate Swaps Basic interest rate swaps are used to: Adjust the rate sensitivity of an asset or liability For example, effectively converting a fixed-rate loan into a floating-rate loan Create a synthetic security For example, enter into a swap instead of investing in a security Macrohedge Use swaps to hedge the banks aggregate interest rate risk

Basic Interest Rate Swaps Swap Dealers Handle most swap transactions Make a market in swap contracts Offer terms for both fixed-rate and floating rate payers and earn a spread for their services

Basic Interest Rate Swaps

Comparing Financial Futures, FRAs, and Basic Swaps
Objective Profit If Rates Rise Profit If Rates Fall Financial Futures Sell Futures Buy Futures Position FRAs & Basic Swaps Pay Fixed, Receive Floating Pay Floating, Receive Fixed

There is some credit risk with swaps in that the counterparty may default on the exchange of the interest payments Only the interest payment exchange is at risk, not the principal

Interest Rate Options

Definition: An option in which the underlying is an interest rate; it provides the right to make a fixed interest payment and receive a floating interest payment or the right to make a floating interest payment and receive a fixed interest payment.

Interest Rate Options

Interest Rate Caps

(Hedge against higher interest rates by fixing maximum interest rate)

Interest Rate Floors

(Hedge against falling interest rates by fixing a minimum interest rate)

Interest Rate Collars

(Combination of a cap and a floor in order to fix a certain interest rate range)

Zero Cost Collar

Reverse Collar

Interest Rate Caps

An agreement between two counterparties that limits the buyers interest rate exposure to a maximum limit Buying a interest rate cap is the same as purchasing a call option on an interest rate

Interest Rate Floors

An agreement between two counterparties that limits the buyers interest rate exposure to a minimum rate. Buying an interest rate floor is the same as purchasing a put option on an interest rate

Interest Rate Collars

Interest Rate Collar: The simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount Zero Cost Collar A collar where the buyer pays no net premium The premium paid for the cap equals the premium received for the floor Reverse Collar Buying an interest rate floor and simultaneously selling an interest rate cap It protects a bank from falling interest rates

Pricing Interest Rate Caps and Floors

The size of the premiums for caps and floors is determined by: The relationship between the strike rate and the current index This indicates how much the index must move before the cap or floor is in-the-money The shape of yield curve and the volatility of interest rates With an upward sloping yield curve, caps will be more expensive than floors

Floating Rate Loans

Prime + 1% Three-Month MIBOR Bank 4.18% Fixed Fixed 3.75% Swap Counterparty

Basic Swap to Hedge Aggregate Balance Sheet Risk of Loss from Falling Rates Bank Swap Term-Pay MIBOR, Receive 4.18%

Deposits

Current Rates

Rates Fall

Constant
PRIME 5.50% MIBOR 3.00%

100 Basis Points

PRIME 4.50% MIBOR 2.00%

Rates Rise 100 Basis Points

Balance Sheet Flows: Loan Deposit Spread Interest Rate Swap Flows: Fixed Floating Spread Margin

PRIME 6.50% MIBOR 4.00%

6.50% (3.75%) 2.75%

5.50% (3.75%)

7.50% (3.75%) 3.75%

1.75%

4.18% (3.00%) 1.18% 3.93%

4.18% (2.00%) 2.18% 3.93%

4.18% (4.00%) 0.18% 3.93%

Floating Rate Loans Prime + 1%

Floor Terms: Buy a 2.50 Percent Floor on 3Month MIBOR

Receive when
Counterparty Three-Month MIBOR < 2.50% Fee: (0.30%) per year

Bank

Buying a Floor on 3Month MIBOR to Hedge Aggregate Balance Sheet Risk of Loss From Falling Rates

Fixed 3.75%

Deposits

Current Rates Constant

Rates Fall 100 Basis Points

Rates Rise 100 Basis Points

PRIME 5.50% MIBOR 3.00%

Balance Sheet Flows: Loan Deposit Spread Floor Flows: Payout Fee Amort. Spread 0.00% (0.30%) (0.30%) 6.50% (3.75%) 2.75%

PRIME 4.50% MIBOR 2.00%

PRIME 6.50% MIBOR 4.00%

5.50% (3.75%) 1.75%

7.50% (3.75%) 3.75%

0.50% (0.30%) 0.20%

0.00% (0.30%) (0.30%)

Margin

2.45%

1.95%

3.45%

Loans

Prime + 1%

Strategy: Buy a Floor on 3-Month MIBOR at 2.00 Percent, and Sell a Cap on 3-Month MIBOR at 3.50 Percent
Pay when Three-Month MIBOR > 3.50% Counterparty Receive when Three-Month MIBOR < 2.00% Premium: 0.38% per year

Bank

Buying a Reverse Collar to Hedge Aggregat e Balance Sheet Risk of Loss from Falling Rates

Fixed 3.75%

Deposits

Rates Fall

Rates Rise

100 Basis Points

100 Basis Points

PRIME 5.50%
MIBOR 3.00%

PRIME 4.50%
MIBOR 2.00%

PRIME 6.50%
MIBOR 4.00%

Balance Sheet
Flows:

Loan Deposit
Spread Reverse Collar

6.50%
(3.75%)

5.50%
(3.75%)

7.50%
(3.75%)

2.75%

1.75%

3.75%

Flows: Payout
Fee Amort. Spread

0.00%
0.38% 0.38%

0.50%
0.38% 0.88%

(0.50%)
0.38% (0.12%)

Margin

3.13%

2.63%

3.63%

Fixed Rate
Loans

Fixed 7.00%

Strategy: Pay 4.19 Percent, Receive 3-Month MIBOR

4.19% Fixed

Bank

Using a Basic Swap to Hedge Aggregat e Balance Sheet Risk of Loss From Rising Rates

Swap Counterparty
Three-Month MIBOR

3-Month MIBOR

- 0.25%

Deposits
Current Rates Rates Fall Rates Rise

Constant

100 Basis Points

100 Basis Points

MIBOR

3.00%

MIBOR

2.00%

MIBOR

4.00%

Balance Sheet
Flows:

Loan
Deposit
Spread Interest Rate

7.00%
(2.75%)

7.00%
(1.75%)

7.00%
(3.75%)

4.25%

5.25%

3.25%

Swap Flows:

Fixed
Floating Spread

(4.19%)
3.00% (1.19%)

(4.19%)
2.00% (2.19%)

(4.19%)
4.00% (0.19%)

Margin

3.06%

3.06%

3.06%

Fixed Rate
Loans

Fixed 7.00%

Strategy: Buy a Cap on 3-Month MIBOR at 4.00 Percent

Receive when Counterparty Three-Month MIBOR > 4.00%

Bank

Buy a Cap on 3Month MIBOR to Hedge Balance Sheet Rate Risk of Loss from Rising Rates

Three-Month MIBOR -0.25%

Fee: (0.50%) per year

Deposits Current Rates Constant Rates Fall 100 Basis Points Rates Rise 100 Basis Points

MIBOR 3.00% Balance Sheet Flows: Loan Deposit Spread Cap Flows: Payout Fee Amort. Spread 0.00% (0.50%) (0.50%)

MIBOR 2.00%

MIBOR 4.00%

7.00%
(2.75%)

7.00%
(1.75%)

7.00%
(3.75%)

4.25%

5.25%

3.25%

0.00% (0.50%) (0.50%)

0.50% (0.50%) 0.00%

Margin

3.75%

4.75%

3.25%

Loans Fixed 7.00%

Strategy: Buy a Cap at 3.00 Percent, and Sell a Floor at 2.00 Percent
Receive when Three-Month MIBOR > 3.00%

Using a Collar on 3-Month MIBOR to Hedge Balance Sheet Risk of Loss from Rising Rates

Bank Pay when Three-Month MIBOR < 2.00% 3-Month MIBOR - 0.25%

Counterparty

Fee: (0.75%) per year

Deposits

Current Rates Constant

Rates Fall 100 Basis Points

Rates Rise 100 Basis Points

MIBOR 3.00% Balance Sheet Flows: Loan Deposit Spread Collar Flows: Payout Fee Amort. Spread 0.00% (0.75%) (0.75%)

MIBOR 2.00%

MIBOR 4.00%

7.00%
(2.75%) 4.25%

7.00%
(1.75%) 5.25%

7.00%
(3.75%) 3.25%

(0.00%) (0.75%) (0.75%)

1.00% (0.75%) 0.25%

Conclusion
Interest rate volatility is a major source of uncertainty particularly for financial institutions A single-period interest rate exposure can be hedged using FRAs, interest rate futures, simple interest rate options and options on interest rate futures Multi-period risk can be managed with interest rate caps and floors Valuation of interest rate derivatives must take account of the stochastic evolution of the entire term structure and in certain cases, simpler approaches using binomial lattice or modifications of Black-Scholes model may be adequate