“FOSTIIMA Business School, New Delhi”

Presented By:Atul JainKavita DeoraNavjot KaurPrabhjot Kaur

Presented To:Mr. Nitin Jain

“IRD”“CDS”

“CD”

INTEREST

RATE

DERIVATIVES

INTEREST RATE DERIVATIVES

An interest rate derivative is a derivative where the

underlying asset is the right to pay or receive a (usually notional)

amount of money at a given interest rate.

The interest rate derivatives market is the largest

derivatives market in the world. Market observers estimate that

US$180 trillion by notional value of interest rate derivatives

contract had been exchanged by September 2007 . According to

the International Swaps and Derivatives Association, 80% of the

world's top 500 companies as of April 2003 used interest rate

derivatives to control their cash flows.

IRD PRODUCTS

Interest rate swap 

Interest rate future

Forward rate agreement

Bond option

Interest rate cap or interest rate

floor

INTEREST RATE SWAP

Among the most popular of derivative instruments, interest

rate swaps are used by corporations, government entities, and

financial institutions to manage interest rate risk.

A swap is an agreement to exchange interest payments in

a single currency for a stated time period. In an interest rate

swap, each counterparty agrees to pay either a fixed or floating

rate denominated in a particular currency to the other

counterparty.

Interest rate swap is an agreement between two parties to

exchange one set of interest rate payments for another.

NOTE: Only Interest payments are exchanged, not

principal.

Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 8.65%, in exchange for periodic variable interest

rate payments of LIBOR + 70 bps (0.70%).

FUNDA OF INTEREST RATE SWAP

FORWARD RATE AGREEMENT

Forward Rate Agreements (FRAs) being traded in the OTC market. In case of FRAs, contracting parties agree to pay or receive a specific rate of interest for a specific period, after a specific period of time, on a specified notional amount. No exchange of the principal amount takes place among the parties at any point in time. Now, think about bringing this contract to the exchange. If we bring this FRA to the exchange, it would essentially be renamed as a futures contract. Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates

FORWARD RATE AGREEMENT

“PAYOFF FORMULA”

(Reference Rate – Fixed Rate)

-------------------------------------------

1 + Reference Rate

( )Payment = Notional Amount

Where:

• The Fixed Rate is the rate at which the contract is agreed.• The Reference Rate is typically Euribor or LIBOR.• “α” is the day count fraction, i.e. the portion of a year over which the rates are calculated, using the day count convention used in the money markets in the underlying currency. For EUR and USD this is generally the number of days divided by 360, for GBP it is the number of days divided by 365 days.

SEBI to allow trading in 3 interest rate derivativesBy Rajesh Abraham Feb 25 2009 , Mumbai

The Securities and Exchange Board of India (Sebi) is in the

final stages of allowing the introduction of exchange-traded interest rate derivative products.

In the first stage, the capital market regulator will allow trading in three products — 91-day treasury bill futures,

short-term interest rate futures based on an index of actual call rates and notional coupon bearing 10-yearlong

bond futures.

“The new products will expand the market depth in terms of availability of products. Right now, there are no

products available. For instance, if you want to hedge and your view is that interest rates will go up on 10-year

bonds, the only option is to sell the 10-year bond from the portfolio. With the availability of a derivative instrument, you can express your view and trade accordingly,” said

Joydeep Sen, vice-president (advisory desk) at BNP Paribas Wealth Management.

RECENT NEWS

INTEREST RATE FUTURE

If a forward contract is entered into through an exchange, traded on the exchange and settled through the Clearing Corporation/ House of the exchange, it becomes a futures contract. As one of the most important objectives behind bringing the contract to the exchange is to create marketability, futures contracts are standardized contracts so designed by the exchanges as to ensure participation of a wide range of market participants.

In other words, futures contracts are standardized forward contracts traded on the exchanges and settled through their clearing corporation/house.

Competitive advantages over the forward contracts in terms of better liquidity and risk management.

Now, it is simple to comprehend that futures contracts on interest rates would be called interest rate futures.

Most of the global markets trade futures on two underlings - one at the long end (maturity of 10 years or more) and another at the short end (maturity up to one year) of the yield curve. The futures on the long end of the yield curve are called the Long Bond Futures and futures at the short end of the yield curve are called the T-Bill Futures and Reference Rate Futures.

BOND OPTIONA Bond Option is an OTC-traded financial instrument that facilitates an option to buy or sell a particular bond at a certain date for a particular price. It is similar to a stock option with the difference that the underlying asset is a bond.

The present market value for the bond is referred to as the spot price while the future value as per the option is referred to as the strike price.

TYPES OF BOND OPTION

• A European bond option is an option to buy or sell a bond at a certain date in future for a predetermined price.

• An American Bond option is an option to buy or sell a bond on or before a certain date in future for a predetermined price

INTEREST RATE CAP & FLOOR

An Interest Rate Cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

An Interest Rate Floor is a series of European put options or floorlets on a specified reference rate, usually LIBOR. The buyer of the floor receives money if on the maturity of any of the floorlets, the reference rate fixed is below the agreed strike price of the floor.

INTEREST RATE CAP & FLOORINTEREST RATE CAP & FLOOR

Insurance?

CREDIT DEFAULT SWAPSCDS are the most widely used type of credit derivative and a powerful force in the world markets. The first CDS contract was introduced by JP Morgan in 1997. By 2007, their total value has increased to an estimated $45 trillion to $62 trillion. only 0.2% of investment companies default, the cash flow is much lower than this actual amount.

CDS are a financial instrument for swaping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond Buyer Pays a premium

He gets insurance against a debt default receives a lump sum payment if the debt instrument is defaulted. Seller Receives monthly payments. If the debt instrument defaults they have to pay the agreed amount

An investment trust owns £1 million corporation bond issued by a private housing firm. If there is a risk the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million. The investment trust will pay an interest on this credit default swap of say 3%.

If the private housing firm doesn’t default. The hedge fund gains the interest and pays nothing out. It is simple profit. If the private housing firm does default, then the hedge fund has to pay £1 million – the value of the credit default swap. Therefore the hedge fund takes on a larger risk and could end up paying £1million.

The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

ILLUSTRATION

ILLUSTRATION

ADVANTAGEHEDGE AGAINTS RISK

A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan.  Co is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract.

SPECULATION E.G. RISK IS UNDERPRICEDSpeculation has grown to be the most common function for a CDS contract. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company's bonds. An investor with a negative view of the company's credit can buy protection for a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event.

1.

2.

CONTD………ARBITRAGE

If a company’s financial position improves the credit rating also improve the CDS spread should fall to reflect improved rating.This makes CDS more attractive to sell CDS protection. If the company position deteriorated, CDS protection would be more attractive to buy.Arbitrage could occur when dealers exploit any slowness of the market  to respond to signals.

3.

E.g. Washington Mutual bought corporate bonds in 2005 and hedged their exposure by buying CDS protection from Lehman brothers. With Lehman brothers going bankrupt this CDS protection was nullified.

CDS IN INDIA In 2007, RBI had issued draft guidelines for introduction of CDSs and then withdrawn this during the financial crisis the notional outstanding contracts of CDS in global over-the-counter (OTC) markets fell by 26.9%

To start with, RBI proposes to introduce a basic, over-the-counter, single-name CDS for corporate bonds for resident entities, subject to safeguards. These will not be exchange-traded instruments. The underlying will initially be only corporate bonds.

The derivative was blamed for the collapse of AIG, the world’s largest insurer, which wrote out thousands of CDSes against debt securities, without setting aside capital for it. 

The Reserve Bank of India (RBI) had sent a questionnaire to some banks seeking their views on CDS.

All CDS trades will come to a centralised reporting platform and in due course will be brought on a central clearing platform.

CURRENCY DERIVATIVES

CURRENCY DERIVATIVES

Currency derivatives is a contract between the seller and the buyer, whose value is to be derived from the underlying asset, the currency amount. A derivative based on currency exchange rates is a future contract which stipulates the rate at which a given currency can be exchanged for another currency as at a future date.

CURRENCY DERIVATIVE PRODUCTS

Currency

Futures

Currency

Forward

Currency

Options

Currency

Swaps

CURRENCY DERIVATIVE PRODUCTS

The basic objective of forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed at its intended to free both the buyer and seller from any risk of loss. The exchange rate is fixed at the time the contract is entered and settlement takes place on a specific rate in the future at today’s pre agreed price. This is known as forward exchange rate or simply forward rate.

A currency future contract provides a simultaneous write an obligation to sell the particular currency at a specified future date, specified price at a standard quantity. these are special type of forward contract. Standardized exchange traded contracts

CURRENCY FORWARD

CURRENCY FUTURE

CURRENCY DERIVATIVE PRODUCTSCURRENCY FORWARD

Currency option contract confers on option-buyer privilege of not exercising the contract when exchange rate is not in his favor. Foreign currency option is contract for future delivery of specified currency in a exchange for another in which buyer has write to buy(call) or sell(put) a particular currency at an agreed price for or with in specified period.

Option market may be

• Listed on at stock exchange

• Over the counter market where banks dominate

• Future option market being a listed one with marking to market facilities

CURRENCY DERIVATIVE PRODUCTS

AMERICAN OPTION

EUROPEAN OPTION

EXOTIC OPTION

REAL OPTION

• Forward reversing option• Preference option• Avg. rate option• Look back option• Tunnel option• Down and out option• Down and in option• Basket option

• Call option• Put option

• Call option• Put option

TYPES OF OPTIONS