Fixed Income & Interest Rate Derivatives

8/8/2019 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

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