Derivatives – A journey well begun
June 2000 – Equity Index futures
June 2001 – Equity Index options
July 2001 – Stock Options
November 2001 – Stock futures
June 2003 – Interest rate futures
1980s – Currency Forwards
1997 – Long term FC –Rupee swaps
July 1999 – Interest rate swaps and FRAs
July 2003 – FC-Rupee options
Exchange tradedOTC
November 2002 - RBI Working group on Rupee derivativesMarch 2003 - RBI Working group on credit derivatives
Interest Rate SwapsCurrency Swaps
Credit Default Swaps-CDS
Rupee Interest rate swaps
Swap market is now 6 years old
FY ‘04 has seen tremendous growth in volumes and outstanding contracts
Increasing volumes have led to lower bid-offer spreads for some of the price points
No of market players have increased
More banks and PDs have joined the market
Corporate activity has also increased
Emerging consensus about benchmark rates
OIS and MIFOR have emerged as two key swap curves
Agenda
Introduction to Interest Rate Swaps (IRS)
Overnight Index Swaps Uses of Overnight Index Swaps
What is an Interest Rate Swap (IRS)? IRS is an agreement between two counterparties
to exchange interest payments based upon a ‘notional principal’ on specified dates over a specified period
Interest payments are calculated on a notional principal which is not exchanged
Typically one party pays interest based on an agreed fixed rate (fixed rate payer) and the other party pays interest linked to a floating benchmark rate (floating rate payer)
Interest Rate Swap (IRS)
Typical Interest Rate Swap
Receives floating
Bank A Bank B
Pays fixed Receives fixed
Pays floating
Comparative Cost Advantage
Example: Based on the classical comparative cost advantage.
Fixed Rate Floating Rate
IOC AAA- Rated
10.00% Mibor +0.3%
ACC LtdAA Rated
11.20% Mibor +1.00%
Difference 120 bps 70 bps
QSD 50 bps
The Swap Mechanism
IOC LtdAAA-Rated
ACC CementAA Rated
9.95%
MIBOR
10.00% MIBOR+1.00%
IOC borrows from the fixed market due the absolute advantage and ACC Borrows from the Floating Rate Market due to the comparative advantage. And both the companies enter a Swap Deal.
10
The swap of coupon flows results in benefit to both the companies
-floating rate swap payment
Mibor
+Fixed rate debt Receipt 9.95%
-fixed rate debt Payment 10.00%
= net floating debt payment
Mibor +0.05%
Cost before swap Mibor + .30%
Benefit 25 bps
Cost to IOC after swap
+ Floating rate swap receipt
Mibor
- Fixed rate debt payment 9.95%
- Floating rate debt payment
Mibor + 1.00%
= Net Fixed debt Payment 10.95%
Cost before swap 11.20%
Benefit 25 bps
Cost to ACC Cement after Swap
Therefore the total gain of 50 bps is equal to the Quality difference spread.
The total gain is 0.25%+0.25% = 50bps = 1.20% -0.7%
Elements of a typical IRS
Notional Principal there is no exchange of principal the floating and fixed interest rate
calculations are for a pre-decided principal Exchange of coupon streams
Normally fixed rate coupon for a floating rate coupon; can also be floating rate for another floating rate
Fixed ratepredetermined rate, valid for the entire
life of the swap Floating rate
linked to a benchmark rate which is reset periodically
Interest payments are net settled
6 Month MIFOR and overnight MIBOR as popular floating rate benchmarks MIFOR swaps more liquid Lack of liquid term money market
based benchmark Interest in long tenure swaps has also
grownMIFOR curve has lengthened upto 10
yrs OIS curve is active upto 5 yrsHowever, bid –offer spreads are still
relatively high (15-20 bps) for more than 5 year swaps Bid-offer on 15 year GOI Sec is less
than 1 bps
Rupee Swaps
Floating rate benchmark
Should be a market determined rate which is transparent and mutually acceptable to counterparties
Possible floating rate benchmarks in India are:Overnight or ‘Call Money” RatesInter-bank term money ratesCommercial Paper yieldsINBMK
Overnight rates are likely to be the most relevant and acceptable floating rate benchmark
Overnight money markets are deep and liquid and the Overnight Index is well accepted and extensively used as a market standard
The methodology for calculating the Overnight Index is transparent and accepted by counterparties
Overnight rates have been the most widely accepted benchmark for floating rate bond issues in the cash market.
Therefore, Overnight Index Swaps (OIS) with the floating rate indexed to an Overnight reference rate are expected to be the main product in the swap market initially
Overnight Index (contd.)
Interest rate swaps indexed to other floating rate benchmarks such as 14 day,1 month, 3 month MIBOR should ‘hopefully’ develop as well
Overnight Index Swaps (OIS) - An Example
Bank A wants to pay fixed rates and receive Overnight floating rates
Bank B wants to pay Overnight floating rates and receive fixed rates
The two banks enter into an OIS Terms to consider
Day Count Conventions Actual/365
Start Date of the transaction - Tomorrow Overnight Benchmark
NSE Overnight MIBOR, Reuters MIBOR, Reuters MIOR
Settlement date convention Modified following business day
Interest computation methodology Compounding of Overnight rates for every
business day
OIS Details
Bank A enters into a 7 day OIS with Bank B, where Bank A pays a 7 day fixed rate @ 8.50% and receives Overnight MIBOR
Terms Trade Date 23rd August,2004 Day Count Basis Actual number of
days/365 Amount INR 100 crores Start Date 24th August,2004 End Date 31st August,2004
OIS Details (Continued)
Terms O/N benchmark NSE O/N MIBOR
Act/365 (Bank B pays)
Fixed Rate 8.50 % simple Act/365 (Bank A pays)
Interest ComputationThe fixed rate is computed on a simple basis, but the floating rate would be compounded every
Mumbai business day. Interest Settlement The settlement on the
swap would be on a net basis. For e.g.., if the
interest as per the fixed rate is higher than floating
rate, Bank A pays the difference
Computing OIS CashflowsOvernight index for 7 days
O/N MIBOR Notional Principal Accrued Interest
Day 1 7.83%1,000,000,000214,521
Day 2 7.76%1,000,214,521212,648
Day 3 7.32%1,000,427,169200,634
Day 4 8.02% 1,000,627,803219,864
Day 5 & 6 8.11%1,000,847,666444,760
Day 7 8.22%1,001,292,427225,497
Total interest accrued on the floating leg (Bank B pays) = 1,517,923
Interest accrued on fixed leg (Bank A pays) = 1,630,137
1,000,000,000*8.50%*7/365Net interest payment by Bank A on the settlement date = 112,214
Swap Pricing
No-arbitrage pricing condition PV (Fixed Cash Flows)
= PV (Floating Cash Flows) Zero value contract on start date :
The PV of floating rate cash flows less PV offixed rate cash flows should be zero
A swap is a zero value contract on the Start Date of the transaction : SV = 0
V1 -- V2 = 0 OR V1 = V2
Swap Pricing
Fair Pricing on initiation based on market’s expectation of future
short-term rates . On the start date, the value of the floating leg is equal to par
For the fixed leg to be equal to par, the coupon rate should be equal to the yield on a par coupon bond (assuming no default risk)
Uses of Overnight Index Swaps
OIS - Uses
As per RBI guidelines Banks Financial Institutions Primary Dealers and Corporateshave been permitted to transact in OIS
OIS can be used for Asset-Liability Management Hedging Interest Rate Risks Reducing Interest costwithout sacrificing liquidity and by utilising minimal
capital, therebyensuring a higher return on capital
Terminology of IRS and FRA markets
To buy a swap = buying a FRA pay a fixed rate under a swap pay a fixed rate under a FRA
To sell a swap = selling a FRA receive a fixed
under a swap receive a fixed rate under a
FRA
Summary : IRS and FRA important tools for money markets
Credit risk minimal compared to other Money-Market Instruments
Replicate cash market transactions, but with lower capital requirements
Will reinforce the development of the cash market benchmarks
Easy to unwind, if required Efficient trading & hedging tool
Example2: A company accepts a 1 year FD for a Face
Value of Rs 5 crores. Deposits was issued at a rate of 8.00% Fixed Deposits has a residual maturity
maturity of 12 days The company is the view that the Call rates
will remain in the band of 5.60%-5.90%. Thus the Company is of the view that by
entering a IRS it can reduce its effective cost.
29
Notional Principal Amount : Rs 5 CrOriginal Liability Cost: 8% PACompany Receives Fixed @ 5.90%Company Pays Floating @ NSE MIBORPay Receive Pay
NSE MIBOR Floating Leg Fixed Leg Original Liability1 0.0589 50000000 8068.49 8082.191781 10958.904112 0.0588 50008068.49 8056.09 8082.191781 10958.904113 0.0568 50016124.59 7783.33 8082.191781 10958.904114 0.0593 50023907.92 8127.17 8082.191781 10958.904115 0.0591 50032035.09 8101.08 8082.191781 10958.904116 0.051 50040136.17 6991.91 8082.191781 10958.904117 0.0561 50047128.08 7692.18 8082.191781 10958.904118 0.0581 50054820.25 7967.63 8082.191781 10958.904119 0.0562 50062787.88 7708.30 8082.191781 10958.90411
10 0.0577 50070496.18 7915.25 8082.191781 10958.9041111 0.0568 50078411.43 7793.02 8082.191781 10958.9041112 0.057 50086204.46 7821.68 8082.191781 10958.9041113 50094026.14 94026.14 96,986.30 131,506.85
50000000 50000000 5000000050094026.14 50096986.3 50131506.852960.161819
7.82 Effective Cost
Total CashflowsNet Difference Receivable From Swap
Example 3: IRS to Improve the Effective Yield on Asset. A company has invested Rs 5 crores in
Treasury bills whose residual maturity is 12 days at a Money market yield of 5.70%
The company is of the view that the Overnight rates will be high in a particular range over the next fortnight.
Hence the company strikes a deal, wherein it will receive floating rate and pay fix rate.
Valuation of Swap Part I : Accrual part Part II :Mark to market
MTM for Swap
Equity Swap
Swaptions
Identify and calculate Possible Payoffs and cashflow from IRS
Swaption
Value of IRS swaption at expiry
Credit Risk and swap
Currency Swaps Another popular type of swap is known
as a currency swap. In its simplest form, that involves
exchanging principal and fixed rate payments on a loan in one currency and for a principal and fixed rate interest rate payments on an approximately equivalent loan in another currency
Reasons for Currency swap A currency swap can be used to
transform a loan in one currency into a loan in another currency
Cross Currency Swaps- without intermediary
Assume NABARD has an External Commercial Borrowing denominated in USD , coupon USD 6mth LIBOR + 100 bps
Exposed to currency risk (USD/INR depreciation) and interest rate risk (US rates going up)
Can hedge using the following• Full Cross Currency Swap (principal +
interest)• Principal Only Swap (principal hedged,
interest rate risk open)• Coupon Only Swap (only coupon hedged)
24R U
P E
E
D E
R I
V A
T I
V E
S
Full Cross Currency Swap (5 years)START MATURITYOVER LIFE
USD Princ 100 mio
Actual Exchanges
INR Princ 435 crores
NABARD
JPM
Actual Exchanges
US 6m Libor + 100bps
INR Fixed 6.35%
NABARD
JPM
USD Princ 100 mio
INR Princ 435 crores
NABARD
JPM
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
25R U
P E
E
D E
R I
V A
T I
V E
S
Full Cross Currency Swap
A tool that would eliminate the entire currency and interest rate risk for the institution
Converts the foreign currency liability to a rupee liability
Swapped cost is lower than raising funds locally (AAA corporate 7.05%)
Canceling / rebooking not allowed (unless residual maturity is less than 1 year)
Cannot take advantage of INR appreciation or falling rates
ECB Restrictions
26R U
P E
E
D E
R I
V A
T I
V E
S
FI
Company BCompany A $ 8% Sterling 12%
12% Sterling 9.4% $8% $ 11% Sterling
Cross Currency Swaps- with intermediary
Dollars SterlingCompany A 8% 11.60% AAACompany B 10.00% 12.00% AASpread 2.00% 0.40% 1.60%
Wants to borrow ActaulA sterling $B $ sterling
SwapEffective Cost Savings
Company A 11% sterling 0.6Company B 9.4% $ 0.6
Intermedairy Infllow Outflow1.4% $ 1% sterling
Net Gain 0.60%
Currency Swap A currency swap agreement requires the principal
to be specified in each of the 2 currencies. The principal amounts are usually exchanged at the beginning and end of the life of the swap.
They are chosen so that they are approximately equal at the exchange rate at the beginning of the swap.
Assume the principal amounts might be $ 15 million and sterling 10 million.
Initially, the principal amounts flow in the opposite direction to the arrows in the earlier figure
Currency Swap The interest rate payment during the life of the
swap and the final principal flow in the same directions of the arrows.
Thus, at the outset of the swap company A pays $ 15 million and receives sterling 10 million.
Each year during the life of the swap contract, company A receives $ 1.20 million (8% of $ 15 million) and pays sterling 1.10 million (11% of sterling 10 million).
At the end of the swap, it pays a principal of sterling 10 million and receives $ 15 million.
Company A Company B
$15 Million
Sterling 10 Million
Leg 2 Principal payments
Company A Company B
Sterling 10 Million
$ 15 Million
Leg 3 Principal payments
Valuation of Currency Swap
In absence of default risk, a currency swap can be decomposed into positions in 2 bonds in a similar way to an interest rate swap. Consider the position of company B in the figure. It is long on a sterling bond that pays interest @ 12% and short a dollar bond that pays interest of 9.4%
Company A Company B
Sterling 10 Million
$ 15 Million
Valuation of Swap
B pays $9.4% and receives sterling 12%
Value OF Swap V = SBf- Bd Bf = value measured in foreign currency, of the
foreign denominated bond underlying swap, Bd= value of US dollar bond underlying the swap, S= spot exchange rate The value of the swap can be thus determined
from the term structure of interest rates in domestic currency, term structure of interest in foreign currency and spot exchange rate
Example.. Suppose that the term structure of interest
rate is flat in Japan and USA. The Japanese rate is 4% and USA rate is 9%
(continuous compounding) FI enters into a currency swap where it
receives 5% in yen and pays 8% in dollar once a year.
Notional principal is $ 10 million and 1200 million yen.
Term of swap is 3 years and exchange rate is 110 yen = $1
Term Structure Japan 4%USA 9%
Pays Receive $ Yen
0.08 0.0510,000,000.00 1,200,000,000.00
Swap Structure
Example..
Example.. Bd= 0.8e^-0.09*1+0.08e^0.09*2+10.8e^0.09*3= $9.64 Milli
Bf=60e^0.04*1+60e^0.04*2+1260e^0.04*3= 1230.55 million Value of Swap is +(1230/110)/9.64=1.55 million
Credit Derivatives
Credit derivatives Credit derivatives are over the counter financial
contracts. They are usually defined as “off-balance sheet financial instruments that
permit one party to transfer credit risk of a reference asset, which it owns, to another party without actually selling the asset”.
Credit Linked Notes (CLNs), another form of credit derivative product, also achieves the same purpose, though CLNs are on-balance sheet products
Protection Seller
Protection Seller refers to the party that contracts to receive premiums or interest related payments in return for assuming the credit risk on an asset or group of assets from the Protection Buyer. The Protection Seller is also known in the market as the Credit Risk Buyer or
Protection Buyer
Protection Buyer refers to the party that contracts to transfer the credit risk on an asset
or group of assets to the Protection Seller. The Protection Buyer is also known in the market as the Credit Risk Seller or Beneficiary
Types of Credit Derivatives and basic structures:
CDS Total Return Swap
b)Total Return Swaps
Total Return Swaps (TRS), also called Total Rate of Return Swaps (TROR) are bilateral financial contracts designed to synthetically replicate the economic returns of an underlying asset or a portfolio of assets for a pre-specified time.
One counterparty (the TR payer) pays the other counterparty (the TR receiver) the total return of a specified asset, the reference obligation.
b)Total Return Swaps
In return, the TR receiver typically makes regular floating payments. These floating payments represent a funding cost.
In effect, a TRS contract allows the TRS receiver to obtain the economic returns of an asset without having to fund the assets on its balance sheet. Should the underlying asset decline in value by more than the coupon payment, the TRS receiver must pay the negative total return, in addition to the funding cost, to the TRS payer.
Total Return Swaps
At the extreme, a TRS receiver can be liable for the extreme loss that a reference asset may suffer following, for instance, the issuing company’s default
As such, a TRS is a primarily off-balance sheet financing vehicle. In contrast to credit default swaps, which only transfer credit risk, a TRS transfers not only to credit risk (i.e. the improvement or deterioration in credit profile of an issuer), but also market risk (i.e. any increase or decrease in general market prices). In TRS payments are exchanged among counterparties upon changes in market valuation of the underlying, in addition to the occurrence of a credit event as is the case with CDS contracts.