int. rate derivatives & it's application in india(1) (1)

7/28/2019 Int. Rate Derivatives & It's Application in India(1) (1)

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Interest rate Derivatives

&

Its applications & usefulness in India.

SMBA Batch 25Amit P. Kasar Pooja Jadhav

Dipika Yadav Smita Dumbre


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Meaning Of Derivatives

A derivative is any instrument or contractthat derives its value from anotherunderlying asset, instrument, or contract


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Interest Rate Derivatives

An interest rate derivative is a financial derivative wherethe underlying asset (interest-bearing instrument) is theright to pay or receive a notional amount of money at agiven interest rate.

An interest rate derivative is a derivative whose payoffs aredependent on future interest rates

The interest rate derivatives market is the largest derivativesmarket in the world


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Interest RateDerivatives

OTC

ForwardRate

Agreements

InterestRate

Swaps

Interest RateOptions

Caps Floors Collars

Exchange Traded

InterestRate

Futures


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Using Forward Rate Agreements to Manage Interest RateRisk

Forward Rate Agreements

A forward contract based on interest rates based on anotional 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 paymentSeller

Agrees to make a floating-rate payment and receive afixed-rate payment

The buyer and seller will receive or pay cash when theactual interest rate at settlement is different than theexercise rate


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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


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Notional Principal

The two counterparties to a forward rate agreement agree toa notional principal amount that serves as a reference figurein determining cash flows.

Notional

Refers to the condition that the principal does notchange hands, but is only used to calculate the value

of interest payments.


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Notional Principal

Buyer

Agrees to pay a fixed-rate coupon payment and receive afloating-rate payment against the notional principal atsome specified future date.

Seller

Agrees to pay a floating-rate payment and receive thefixed-rate payment against the same notional principal.


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Example: Forward Rate Agreements

Suppose that Metro Bank (as the seller) enters into a receivefixed-rate/pay floating-rating forward rate agreement withCounty Bank (as the buyer) with a six-month maturitybased on a 1 million notional principal amount

The floating rate is the 3-month MIBOR and the fixed(exercise) rate is 7%


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Metro Bank would refer to this as a 3 vs. 6 FRA at 7percent on a 1 million notional amount from County Bank

The phrase 3 vs. 6 refers to a 3-month interest rateobserved three months from the present, for a security witha maturity date six months from the present

The only cash flow will be determined in six months atcontract maturity by comparing the prevailing 3-monthMIBOR with 7%


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Assume that in three months 3-month MIBOR equals 8%

In this case, Metro Bank would receive from CountyBank 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 paidthree months later at maturity of the instrument, theactual payment is discounted at the prevailing 3-month MIBOR:

Actual interest = 2,500/[1+(90/360).08]=2,451


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The FRA position is similar to a futures position

County Bank would pay fixed-rate/receive floating-rateas a hedge if it was exposed to loss in a rising rateenvironment.

This is similar to a short futures position


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Interest Rate Futures in India

While the name interest rate futures suggests that theunderlying 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 notionalgovernment

bond which may not exist in reality. In India, the RBI and theSEBI have

defined the characteristics of this bond: maturity period of 10years and

coupon

rate of 7% p.a. It is also worthwhile noting that several othercountries have

adopted the concept of notional bond, although thecharacteristics of the


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Rationale of IRFs

It is not just the financial sector, but also the corporate andhousehold sectors that are exposed to interest rate risk.

Banks, insurance companies, primary dealers and providentfunds bear significant interest rate risk on account of themismatch in the tenure of their assets (such as loans andGovt. securities) and liabilities. These entities therefore needa credible institutional hedging mechanism. Interest rate

risk is becoming increasingly important for the householdsector as well, since the interest rate exposure of severalhouseholds are rising on account of increase in their savingsand investments as well as loans (such as housing loans,vehicle loans ,etc.). Moreover, interest rate products are theprimary instruments available to hedge inflation risk, which

is typically the single most important macroeconomic riskfaced by the household sector.


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Benefits of Exchange traded IRF

Interest rate futures provide benefits typical to any Exchange-traded product, such as

StandardizationOnly contracts with standardized featuresare allowed to trade on the exchange. Standardizationimproves liquidity in the market.

The following features are standardized:

Only certain expiry dates are allowed in India viz. last workingday of the months of March, June, September and December.

The size of contract can only be in multiples of a certainnumber called the lot size. The lot size currently in India is Rs. 2

lakhs.Only some specific bonds can be used for delivery.

TransparencyTransparency is ensured by dissemination oforders and trades for all market participants. Also, competitive

matching of orders of buyers and sellers boosts transparency.


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Application of Interest Rate Derivatives


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IRF: Contract Specifications

IRF contracts can be traded on the Exchange.

Standardization is done both in terms of the features of theproduct and the mechanism of its trading and settlement.Various features of standardization are discussed in thissection.

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 theexchange is called the lot size. All trades have to be a multipleof the lot size. The interest rate futures contract can be enteredfor a minimum lot size of 2000 bonds at the rate of Rs. 100 perbond (Face Value) leading to a contract value of Rs. 200,000


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Contract cycle:

New contracts can be introduced by the Exchange on anyday of a calendar month. At the time of introduction, theduration of any contract can vary from 1 month to 12months. The expiry has to be on Last Thursday of theExpiry month.

Expiry dayInterest rate future contracts shall expire on the lastThursday of the expiry month. If the last Thursday is atrading holiday, the contracts shall expire on the previous

trading day.

Further, where the last Thursday falls on the annual or half-yearly closing dates of the bank, the expiry and last trading

day in respect of these derivatives contracts would be pre-oned to the revious tradin da .


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Trading Parameters

Contract sizeThe 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 thetime of introduction.

Price stepsThe price steps in respect of all interest rate future contracts admitted to dealingson the Exchange is Re.0.01.

The Futures contracts having face value of Rs 100 on notional ten year couponbearing bond and notional ten year zero coupon bond would be based on pricequotation and Futures contracts having face value of Rs. 100 on notional 91 daystreasury bill would be based on Rs. 100 minus (-) yield.


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Cont

Base Price & operating rangesBase price of the Interest rate future contracts onintroduction of new contracts shall be theoretical futuresprice computed based on previous days closing price of thenotional underlying security. The base price of the contractson subsequent trading days will be the closing price of the

futures contracts. However, on such of those days when thecontracts were not traded, the base price will be the dailysettlement price of futures contracts.

Quantity freezeOrders which may come to the Exchange as a quantityfreeze shall be 2500 contracts amounting to 50,00,000 whichworks out on the day of introduction to approximately Rs

50 crores.


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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 theclearing 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&OClearing Member in Futures Contracts, at the close of trading hours on a day, shall bemarked to market at the Daily Settlement Price (for Daily Mark to Market Settlement) andsettled.

All positions (brought forward, created during the day, closed out during the day) of a F&OClearing 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 theTrading day.

Final settlement price for an Interest rate Futures Contract shall be based on the value of thenotional 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.


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A Summary of Contract Specification

Contractunderlying

Notional 10year bond(6 % coupon )

Notional 10year zerocoupon bond

Notional 91 dayT-Bill

Contractdescriptor

N FUTINTNSE10Y0626JUN2003

N FUTINTNSE10YZC26JUN2003

N FUTINTNSETB91D26JUN2003

ContractValue

Rs.2,00,000

Lot size 2000

Tick size Re.0.01

Expirydate

Last Thursday of the month

Contract

months

The contracts shall be for a period of a maturity ofone year with three months continuous contracts

for the first three months and fixed quarterlycontracts for the entire year.

Pricelimits

Not applicable

Settlement Price

As may be stipulated by NSCCL in this regardfrom time to time.


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Daily Settlement PriceDaily settlement price for an Interest Rate Futures Contractshall be the closing price of such Interest Rate Futures Contract

on the trading day. The closing price for an interest rate futurescontract shall be calculated on the basis of the last half an hourweighted average price of such interest rate futures contract. Inabsence of trading in the last half an hour, the theoretical pricewould be taken or such other price as may be decided by therelevant authority from time to time.


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Participants in the Interest Rate Futures market

The participants in the IRF market are broadly classified into threegroups, 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 adverseinterest rate movement by using IRF. These entities are called hedgers.

Speculators: Speculators participate in the future market to take up theprice risk, which is avoided by the hedgers. They take calculated riskand gain when the prices move as per their expectation.

Arbitrageurs: Arbitrageurs closely watch the bond and futures marketsand whenever they spot a mismatch in the alignment in the prices of thetwo markets, they enter to make some profit in a risk-free transaction.


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Hedging Applications of IR Derivatives

One way to hedge a position in the spot bond market is to take anopposite position in the IRF market. This ensures that a change in

interest rates will not affect the value of a portfolio and this strategy isalso called Interest rate immunization.

IR derivatives in general and IR futures in particular have huge hedgingapplications unlike equity derivatives. This is because, almost everyeconomic entity has an exposure to interest rate fluctuation in some

form or the other. Also, given its very nature, interest rates get affectedby a number of macro-economic factors. Hence, hedging through IRderivative 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 ratefutures to hedge their risks.


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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 theirportfolio, while their liabilities are predominantly short-term (depositsmade by individuals range from 1 to 5 years). To address the riskresulting from the asset-liability mismatch, they generally sell IRF andthereby, hedge the interest rate risk. On the other hand, for the

insurance companies and several big corporates, the tenure of theirliabilities is longer than that of their assets. So, they buy IRF to hedge theinterest rate risk.

Investment portfolio management: Mutual funds and similar assetclasses having a portfolio of bonds can use IR futures to manage their

interest rate exposure in turbulent times.


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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 IRFalso, as IRF has the bond as its underlying. These investors buy IRF andrepeatedly roll them over before each expiry. This strategy is called Long OnlyStrategy.

View Based Trading:

In contrast to Long Only investors, some investors take both long and shortpositions in the IRF market, depending on their views on interest ratemovements in future. If they expect interest rates to go up, they sell IRF and ifthey have the opposite expectation, they buy IRF. If the interest rate movementturns out to be the way the investor expected, he would make profit; otherwise,

he would make losses.


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Arbitrage strategy

Frequently, the price of a bond in spot market and price of futures maynot be aligned with each other because of some distortions in the

supply/demand factors. The arbitrage strategy employed to gain risk-free profits by exploiting the non-alignment (or mis-pricing of futuresrelative to spot bond prices) is called cash/futures arbitrage.Cash/Futures arbitrage is also called basis arbitrage or cash and carryarbitrage. Smart market participants take advantage of such situations

to make risk free profits. It involves buying a bond in cash (spot) marketand selling futures simultaneously or vice versa.

It should be noted that the cost of carry has to be considered whilecalculating the profits. Net basis is an important parameter to trackarbitrage in IRF market. Net basis is typically positive. If net basis turns

negative, however, an arbitrage opportunity arises, which can beexploited to make risk-free profits.


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Basic Interest Rate Swaps

Basic or Plain Vanilla Interest Rate Swap

An agreement between two parties to exchange a seriesof cash flows based on a specified notional principalamount

Two parties facing different types of interest rate risk canexchange interest payments


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Basic or Plain Vanilla Interest Rate Swap

One party makes payments based on a fixed interest rateand receives floating rate payments

The other party exchanges floating rate payments forfixed-rate payments

When interest rates change, the party that benefits from aswap receives a net cash payment while the party thatloses makes a net cash payment


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Conceptually, a basic interest rate swap is a package ofFRAs

As with FRAs, swap payments are netted and thenotional principal never changes hands


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Using data for a 2-year swap based on 3-month MIBOR asthe 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 notionalprincipal amount


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Firms with a negative GAP can reduce risk by making afixed-rate interest payment in exchange for a floating-rateinterest receipt

Firms with a positive GAP take the opposite position, bymaking floating-interest payments in exchange for a fixed-rate receipt


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Basic interest rate swaps are used to:

Adjust the rate sensitivity of an asset or liabilityFor example, effectively converting a fixed-rate loaninto a floating-rate loan

Create a synthetic security

For example, enter into a swap instead of investing ina security

Macrohedge

Use swaps to hedge the banks aggregate interest rate

risk


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Swap Dealers

Handle most swap transactions Make a market in swap contracts

Offer terms for both fixed-rate and floating rate payersand earn a spread for their services


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Comparing Financial Futures,FRAs, and Basic Swaps

There is some credit risk withswaps in that the counterpartymay default on the exchange ofthe interest payments

Only the interest payment

exchange is at risk, not theprincipal

Objective Financial Futures FRAs & Basic Swaps

Profit If Rates Rise Sell Futures Pay Fixed, Receive Floating

Profit If Rates Fall Buy Futures Pay Floating, Receive Fixed

Position


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Interest Rate


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Interest RateOptions

Interest RateCaps

Interest RateFloors

Interest RateCollars

Zero Cost Collar

Reverse Collar

(Hedge againsthigher interest ratesby fixing maximuminterest rate)

(Hedge againstfalling interestrates by fixing aminimum interest

rate)

(Combination of a capand a floor in order tofix a certain interestrate range)

C


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Interest Rate Caps

An agreement between two counterparties that limits thebuyers interest rate exposure to a maximum limit

Buying a interest rate cap is the same as purchasing a calloption on an interest rate

I R Fl


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Interest Rate Floors

An agreement between two counterparties that limits thebuyers interest rate exposure to a minimum rate.

Buying an interest rate floor is the same as purchasing aput option on an interest rate

Interest Rate Collars


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Interest Rate CollarsInterest Rate Collar:

The simultaneous purchase of an interest rate cap andsale of an interest rate floor on the same index for thesame 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 premiumreceived 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

P i i I t t R t C d Fl


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Pricing Interest Rate Caps and Floors

The size of the premiums for caps and floors is determinedby:

The relationship between the strike rate and the currentindex

This indicates how much the index must move beforethe cap or floor is in-the-money

The shape of yield curve and the volatility of interestrates

With an upward sloping yield curve, caps will bemore expensive than floors

Floating Rate


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Basic Swapto Hedge

AggregateBalance

Sheet Riskof Loss

from

FallingRates

Bank SwapTerm-Pay

MIBOR,Receive4.18%

Current Rates

Constant

Rates Fall

100 Basis Points

Balance Sheet

Flows:

Loan

Deposit

Spread

6.50%

(3.75%)

2.75%

5.50%

(3.75%)

1.75%

7.50%

(3.75%)

3.75%

4.18%

(3.00%)

1.18%

4.18%

(2.00%)

2.18%

4.18%

(4.00%)

0.18%

3.93% 3.93% 3.93%

Interest Rate

Swap Flows:

Fixed

Floating

Spread

Margin

Rates Rise

100 Basis Points

PRIME 5.50%

MIBOR 3.00%

PRIME 4.50%

MIBOR 2.00%

PRIME 6.50%

MIBOR 4.00%

Loans

Prime + 1%

Bank

Fixed 3.75%

4.18% Fixed

Three-Month MIBOR

Deposits

Swap

Counterparty

Floor Terms: Buy a 2 50 Percent Floor on 3Floating Rate


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Buying aFloor on 3-

MonthMIBOR to

Hedge

AggregateBalanceSheet Risk

of LossFrom

Falling

Rates

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

Rates Fall

100 Basis Points

Balance Sheet

Flows:

Loan

Deposit

Spread

6.50%

(3.75%)

2.75%

5.50%

(3.75%)

1.75%

7.50%

(3.75%)

3.75%

0.00%

(0.30%)

(0.30%)

0.50%

(0.30%)

0.20%

0.00%

(0.30%)

(0.30%)

2.45% 1.95% 3.45%

Floor

Flows:

Payout

Fee Amort.

Spread

Margin

Rates Rise

100 Basis Points

PRIME 5.50%

MIBOR 3.00%

PRIME 4.50%

MIBOR 2.00%

PRIME 6.50%

MIBOR 4.00%

Loans

Prime + 1%

Bank

Fixed 3.75%

Three-Month MIBOR < 2.50%

Fee: (0.30%) per year

Receive when

Deposits

Counterparty

Current Rates

Constant

Loans Strategy: Buy a Floor on 3-Month MIBOR at


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Buying aReverseCollar toHedge

Aggregat

e BalanceSheet

Risk ofLoss from

Falling

Rates

Rates Fall

100 Basis Points

Balance Sheet

Flows:

Loan

Deposit

Spread

6.50%

(3.75%)

2.75%

5.50%

(3.75%)

1.75%

7.50%

(3.75%)

3.75%

0.00%

0.38%

0.38%

0.50%

0.38%

0.88%

(0.50%)

0.38%

(0.12%)

3.13% 2.63% 3.63%

Reverse Collar

Flows:

Payout

Fee Amort.

Spread

Margin

Rates Rise

100 Basis Points

PRIME 5.50%

MIBOR 3.00%

PRIME 4.50%

MIBOR 2.00%

PRIME 6.50%

MIBOR 4.00%

Loans

Prime + 1%

Bank

Fixed 3.75%

Three-Month MIBOR < 2.00%Premium: 0.38% per year

Receive when

Three-Month MIBOR > 3.50%

Pay when

Deposits

Counterparty

Strategy: Buy a Floor on 3 Month MIBOR at2.00 Percent, and Sell a Cap on 3-MonthMIBOR at 3.50 Percent

Fixed Rate

Loans


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Using aBasicSwap toHedge

Aggregate

BalanceSheet

Risk ofLossFrom

RisingRates

Rates Fall

100 Basis Points

Balance Sheet

Flows:

Loan

Deposit

Spread

7.00%

(2.75%)

4.25%

7.00%

(1.75%)

5.25%

7.00%

(3.75%)

3.25%

(4.19%)

3.00%

(1.19%)

(4.19%)

2.00%

(2.19%)

(4.19%)

4.00%

(0.19%)

3.06% 3.06% 3.06%

Interest Rate

Swap Flows:

Fixed

Floating

Spread

Margin

Rates Rise

100 Basis Points

MIBOR 3.00% MIBOR 2.00% MIBOR 4.00%

Loans

Fixed 7.00%

Bank

3-Month MIBOR -0.25%

Three-Month MIBOR

4.19% Fixed

Deposits

Swap

Counterparty

Current Rates

Constant

Strategy: Pay 4.19 Percent, Receive 3-Month MIBOR

Fixed Rate


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Buy a Capon 3-

MonthMIBOR to

Hedge

BalanceSheet Rate

Risk ofLoss from

Rising

Rates

Rates Fall

100 Basis Points

Balance Sheet

Flows:

Loan

Deposit

Spread

7.00%

(2.75%)

4.25%

7.00%

(1.75%)

5.25%

7.00%

(3.75%)

3.25%

0.00%

(0.50%)

(0.50%)

0.00%

(0.50%)

(0.50%)

0.50%

(0.50%)

0.00%

3.75% 4.75% 3.25%

Cap

Flows:

Payout

Fee Amort.

Spread

Margin

Rates Rise

100 Basis Points


Fixed Rate

Loans

Bank

Three-Month MIBOR -0.25%


Fee: (0.50%) per year

Receive when

Deposits

Counterparty

Fixed 7.00%

Current Rates

Constant

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

S B C 3 00 P d S ll Fl


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Using aCollar on3-Month

MIBOR toHedge

BalanceSheet Risk

of Lossfrom

Rising

Rates

Rates Fall

100 Basis Points

Balance Sheet

Flows:

Loan

Deposit

Spread

7.00%

(2.75%)

4.25%

7.00%

(1.75%)

5.25%

7.00%

(3.75%)

3.25%

0.00%

(0.75%)

(0.75%)

(0.00%)

(0.75%)

(0.75%)

1.00%

(0.75%)

0.25%

Collar

Flows:

Payout

Fee Amort.

Spread

Rates Rise

100 Basis Points


Loans

Fixed 7.00%

Bank

3-Month MIBOR -0.25%

Three-Month MIBOR < 2.00%Fee: (0.75%) per year

Pay when


Receive when

Deposits

Counterparty

Current Rates

Constant

Strategy: Buy a Cap at 3.00 Percent, and Sell a Floor at2.00 Percent

Conclusion


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Conclusion

Interest rate volatility is a major source of uncertaintyparticularly for financial institutions

A single-period interest rate exposure can be hedged usingFRAs, interest rate futures, simple interest rate options andoptions on interest rate futures

Multi-period risk can be managed with interest rate capsand floors

Valuation of interest rate derivatives must take account ofthe stochastic evolution of the entire term structure and incertain cases, simpler approaches using binomial lattice or

modifications of Black-Scholes model may be adequate


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int. rate derivatives & it's application in india(1) (1)

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