Interest Rate Swaps

THE CLEARING CORPORATION OF INDIA LTD.
INTEREST RATE SWAPS

Payal Ghose & Aparna Vachharajani* (October 2007) Today corporates and bankers use complex and innovative financing tools to decrease borrowing costs and increase control over other financial variables. Financial instruments like derivatives have made it possible to transfer or sell risk to individuals or institutions who are prepared to buy risk. (Because of this derivatives are also known as insurance products.) The various types of financial derivatives include forward and future contracts (agreements to buy or sell an asset at a certain time in the future for a certain price), option contracts (a contract between two parties in which the buyer of the option buys the right to buy or sell a standardized quantity of a financial instrument on or before a pre-determined date at a specified price) and swaps (an agreement between two parties to exchange cash flows in the future). A swap is basically a contractual agreement for exchange of cashflows between two parties. Swaps take place because corporates and institutions with differing financing and risk requirements have specific access to different financial markets. The origin of swaps can be traced back to the early 1970s as a tool to circumvent the exchange regulations imposed by many countries to restrict cross border capital flows. To overcome such hurdles corporates started a new arrangement popularly known as parallel loans . Under such an arrangement American companies used to lend dollars to British subsidiaries in the US while the British holding companies used to lend pound sterling to the American subsidiaries in the UK. This practice gained momentum with the exchange rate instability following the demise of the Bretton Woods System during 1971-73. Following the exchange rate liberalization in the 1980s, swaps rapidly replaced existing products like parallel and back-to-back loans because of their flexibility and lower financing and taxation costs. The formation of the International Swap Dealers Association (ISDA) in 1985 was a significant development that speedened up the growth of the swap market by standardizing swap documentation. The emergence and growing popularity of swaps has led to refinement of the risk management techniques enabling corporates
*Ms. Payal Ghose & Ms. Aparna Vachharajani are Senior Executive Officers, Economic Research and Surveillance Department, The Clearing Corporation of India Limited
COLLECTION OF ARTICLES
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to tap newer capital markets and making further use of new financial instruments without substantial increase in the risk element. The range of risks and types of cash flows hedged through swaps is rapidly expanding. Currency swaps were introduced in the late 1970s, interest rate swaps in 1981, equity and commodity swaps in the mid1980s and credit derivatives in 1990. Recently derivatives based on the climate have also been launched. INTEREST RATE SWAPS One of the largest components of the global derivatives markets and a natural adjunct to the fixed income markets is the interest rate swap (IRS) market. The IRS market gives a deeper insight into the capital flows that drive the bond markets, the manner in which the corporates m a n a g e t h e i r e x p o s u re t o fluctuations in interest rates and the way banks and financial institutions make a great deal of their income. IRS transactions began in 1981, with Eurobonds being the principal security employed in these transactions. The most basic form of an IRS involves two counterparties that agree to exchange over a certain period of time, two streams of interest payments, each calculated using a different interest rate index but based upon some agreed upon or notional amount. The underlying debt is referred to as the notional principal/amount because it is only used as
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the basis for interest calculation under the swap and not exchanged by the participants. Figure 1 shows the basic structure of an IRS. The first party may be a borrower that wants to pay interest at a fixed rate but has already borrowed at a floating rate. The other party has a counter-position having borrowed at a fixed rate but desiring a floating rate interest structure. The two can enter into an agreement in which the second party agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time.
Figure 1
Rationale behind an IRS All firms pay a credit-quality premium over the risk-free rate when they issue debt securities. Firms with good credit ratings pay lower risk premiums than firms with lower credit ratings and the credit-quality premium rises faster with maturity for the lower rated firms. The table given below depicts the rates
Rating Firm A Firm B AA+ AB+ Fixed Rate 10.00% 11.20% Floating Rate 6-Month LIBOR + 0.30% 6-Month LIBOR + 1.00%
at which two firms with varied ratings can borrow funds for five years to meet their requirements. Firm A has an absolute cost advantage in raising funds in either the short-term or longterm debt markets, but firm B has a comparative advantage in raising funds in short-term debt markets. If both firms raised funds in their desired markets directly, the total cost for them would be LIBOR + 11.50% (i.e. LIBOR + 0.30% for A and 11.20% for B). Both firms could lower their funding costs if firm A were to issue long-term debt, firm B were to issue short-term debt, and they swapped interest payments. The total cost in such a case would be LIBOR + 11% (i.e. 10.00% for A and LIBOR + 1.00% for B). The gain from entering into the swap is (11.50% 11.00% =) 0.50% which is shared equally between the two parties. This gain arises out of the credit spread differential. The quality spread between the interest rate paid by the lower-rated firm B and that paid by the higher-rated firm A which is only 70 TYPES OF IRS 1) Plain vanilla swap or fixed-forfloating swap: In this swap, a floating interest rate liability is exchanged with a fixed rate liability. Floating-to-floating or basis swap: In this swap, one party pays one floating rate (e.g. LIBOR) while its counterparty pays using another reference rate (e.g. T-Bill rate).
basis points in the short-term debt market, but rises to 120 basis points at longer maturities. This quality-spread differential (i.e. the difference in the quality spread at two different maturities), exists because of the nature of contracts in the fixed and the floating markets. In the above example the fixed rates are the rates at which the firms can issue five year fixed rate bonds while the floating rates based on LIBOR are 6 month rates. The floating rate lender has the option of reviewing the rates every 6 months. He can raise the spread over LIBOR if the firms creditworthiness deteriorates or even cancel the contract. However, the fixed rate lender has no such option. Hence, the spread rises faster with increase in maturities. The spread differential between A and B also reflects the extent to which B is more likely to default than A. Generally, the probability of default rises faster for firms with lower credit ratings. As a result, the spread between the 5 year rates is higher than the spread between the six month rates.
3)
Asset swap: In this type of swap the interest streams being exchanged are funded with interest received on specific assets. Alternative floating rate: In this type of swap, the floating reference rate can be switched to other alternatives like 3-month LIBOR, TBill rate etc. as per the requirement of the counter party to meet the
4)
2)
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exposure. 5) Forward swap: This swap involves an exchange of interest rate payment that does not begin until a specified future point in time. Extendable swap: This type of swap allows fixed for floating counter party to extend the swap period. Equity swap: An equity swap involves the exchange of interest payments linked to the changes in a stock index. For example, an equity swap agreement may allow a company to swap a fixed interest rate of 6% in exchange for the rate of appreciation on a particular index like the BSE or NSE indices each year over the next 4 years. Term swap: A swap transaction having an original tenor of more than 2 years is referred to as a term swap. Money market swap: It is a swap transaction with original tenor up to 2 years.
6)
holders of zero-coupon bonds get the full amount of loan and the interest accrued at the maturity of the bond. Hence in this type of swap, the fixed rate player makes a bullet payment at the end while the floating rate player makes the periodic payment throughout the swap period. Swaptions: Option interest rate swaps are referred as swaptions. The swaption agreement specifies whether the buyer of the swaption will be a fixed rate receiver or a fixed rate payer. If the buyer exercises the option then the writer of the option will become the counter party. A callable swap provides the party making the fixed payments with the right to terminate the swap to its maturity. The writer will become the fixed rate receiver and floating rate payer. On the other hand a puttable swap provides the party making the floating rate payments with the right to terminate the swap. In this case, the writer of the put swaption becomes the floating rate receiver and fixed rate payer.
7)
8)
9)
10) Zero coupon to floating: The
Illustration: (One week swap) Suppose Bank A and Bank B enter into a swap whose effective date is September 18, 2007 where Bank A is a fixed rate receiver of Rs.10 crore for a week at 6% and Bank B is a floating rate receiver and the rates are linked to the NSE overnight index. The floating rate, as an overnight rate, would be compounded every
Mumbai business day. This implies that the floating rate interest is compounded on a daily basis except when there is a holiday. In case of a holiday, the interest would be computed on simple interest basis for the holiday. In this example, the NSE MIBOR rates for the seven days are taken and settled at the end of the swap period.
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The overnight call money rates (FIMMDANSE-MIBOR rate) for 7 days are as per the table below.
NSE MIBOR Rate Floating Index (%) 18-Sep-07 19-Sep-07 20-Sep-07 21-Sep-07 22-Sep-2007 & 23-Sep-07 (Sat & Sun) 24-Sep-07
th
the swap: then,
VSWAP = BFIX - BFL

NPA + Simple Interest at Fixed Rate Rs.
(1)
Day
Notional Principal Amount (NPA) Rs. 100000000 100018137 100036003 100053242 100073171 100115832
NPA + Floating Compounded Interest at Rate MIBOR Interest Rates Rs. 18137 17866 17239 19928 21331 20133 100135965 Rs.
The value of the swap to a company receiving fixed rate and paying floating rate is: The value of fixed-rate bond underlying the swap equals its notional amount at the initiation of the swap. To value the swap some time after the initiation, following notations are used: ti : Time until ith (1<= i <= n) payments are exchanged
6.62 6.52 6.29 7.27 7.78 7.34
100115068
On the 8 day, i.e. on September 25, 2007 Bank B will pay Bank A an interest of Rs.1,15,069 (10,00,00,000 * 6% * 7/365) and Bank A has to pay Bank B interest of Rs.1,35,965 (10,01,35,965 10,00,00,000) as per the calculation. They will settle the difference of Rs.1,35,965 and Rs.1,15,069 i.e. Bank A will pay Rs.20,896 to Bank B. Valuation of IRS Assuming no default risk, an interest rate swap can be valued either as a long position in one bond combined with short position in another bond or as a portfolio of forward contracts. In both the cases, MIBOR rates have been used for discounting. Valuation of swap in terms of Bond Prices: If; BFIX : Value of fixed-rate bond underlying the swap BFL : Value of floating-rate bond underlying
L : Notional amount in swap agreement ri : MIBOR rate corresponding to maturity ti k : Fixed payment made on each payment date Considering fixed-rate bond, the cash flows are k at time ti and L at time tn, so that
n
BFIX =
i =1
ke-riti + Le-rntn
(2)
In case of the floating rate bond, its value becomes identical to a newly issued floatingrate bond immediately after a payment date. In this case, BFL = L immediately after a payment date. Before the next payment date, its value becomes BFL = L + k* (k* is the floating-rate payment that will be made on the next payment date). If t1 is the time until the next payment date and r1 is the discount rate used to calculate the value of the swap
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today which equals its value just before the next payment date, then in such a case, the value of this floating-rate bond is
BFL = (L + k*) e-r1t1
(3)
After calculating BFIX and BFL, formula given in equation (1), can be used to calculate the value of swap. Suppose a financial institution pays 1-month MIBOR and receives 6.12% per annum (with semi-annual compounding) on a swap with a notional amount of Rs.100 million and the next payment dates are after 1, 2 and 3 months, i.e. the swap has remaining life of 3 months. The MIBOR rates with continuous compounding for 1-month, 2-month and 3month maturities are 7.70%, 7.99% and 8.28% respectively. The 1-month MIBOR rate on the last payment date was 9.30%. In this case, k = Rs.3.06 million and k* = Rs.3.50 million, so that BFIX = 3.06e -0.0770 * 1/12 + 3.06e -0.0799 * 2/12 + 103.06e 0.0828 * 3/12
determined rate of interest with the market rate of interest which will apply to a certain principal for a certain period of time in the future. An IRS can be regarded as a portfolio of FRAs. Assuming that forward interest rates are realized, a plain vanilla IRS can be valued by applying the following steps: 1. To determine swap cash flows, calculate forward rates for each of the MIBOR rates using following equation:
Rf = R2T2 R1T1 / T2 T1
Where;
(4)
Rf Forward interest rate R1 and R2 are the zero rates for maturities T1 and T2.
2. Calculate swap cash flows assuming that the MIBOR rates will equal the forward rates. 3. Setting the swap value equal to the present value of these cash flows.
100 * (0.0612/2 0.0930/2) e -0.0770 * 1/12 = Rs.- 1.5798
(5)
= Rs.107.01 million BFL = 3.50e -0.0770 * 1/12 + 100e 0.0770 * 1/12 = Rs.102.84 million Hence, the value of the swap is 107.01 102.84 = Rs.-4.17 million. Valuation of swap in terms of Forward Rate Agreements (FRA): FRAs are agreements to exchange pre-
Considering the situation in the previous example, a rate of 6.12% will be exchanged for 9.30%. The value of the exchange to the financial institution is: To calculate the value of the exchange in 2 months, the forward rate corresponding to the period between 1 and 2 months needs to be calculated by using equation 4. This will be equal to 0.0828 or 8.28% with continuous compounding. To make it equivalent to the rate with compounding 2 times per annum, following equation is used where Rc = 0.0828 and m = 2.
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Rm = m ( eRc/m 1 )
(6)
through a single net value for all the outstanding transactions. 4. Reverse swap: A party may enter into a new swap at current market rates to offset or reverse the terms of the existing swap agreement. 5. Selling: A party may exit a swap agreement by selling it off to another party. Application of IRS IRS can be used to gain advantage of various market imperfections. IRS are very popular as: 1) As tools of arbitrage: The IRS market evolved because of the differing financing needs of its participants. Differential information in different markets, institutional restrictions and transactions costs create some market imperfections and the presence of comparative advantages among different borrowers in these markets. An IRS acts as a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. 2) As tools of hedging: Let us assume that a company needs to borrow funds for five years but finds that current rates are relatively high. The management believes that rates will decline, but wishes to obtain the necessary funds as soon as possible. In this situation the company could issue fixed rate debt and then swap it down by agreeing to pay a
The value 0.0828 will become 0.0845 with semi-annual compounding. The value of FRA corresponding to the exchange in 2 months is therefore 100 * (0.0612/2 0.0845/2) e -0.0799 * 2/12 = Rs. -1.1498 million Following the above given steps, the forward rate corresponding to the period between 2 and 3 months will be equal to 0.0885 and 0.0905 (with semi-annual compounding). The value of FRA, then, is Rs.-1.4356 million. The total value of the swap, to the financial institution, is - 1.5798 1.1498 - 1.4356 = Rs. -4.17 million Closure A swap agreement can be terminated using any of the following methods. 1. Cancellation: A swap may be terminated prior to maturity. The counterparties make/receive a payment reflecting current market rates and are released from their contractual obligations. 2. Novation: A new swap agreement may be created canceling one or more existing swap agreements. 3. Netting: Two counterparties may have more than one IRS agreements with each other. In such a case instead of going for individual settlement of each IRS contract, they may opt for settlement
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floating rate in exchange for receiving a fixed rate. The fixed income from the swap offsets the debt cost, and the firm is left having to make floating rate payments on the swap. If rates decline as expected, the firms financing cost falls commensurately. However, if the management is wrong and rates go up, the company will be paying more for the variable rate swap than if it had held on to the fixed rate debt. 3) As tools of speculation: The timing of any decision to issue debt always involves some judgment regarding the future movement of interest rates. Swaps are a sophisticated mechanism to take advantage of expectations of future interest rate movements. The floating rate stream under a swap tends to reflect current interest levels while the fixed interest stream reflects the historical level. Thus, the profitability of an IRS broadly reflects the market trends in interest rate movements in the future. Speculators with a contrarian view from the general market perception bet on these movements through swaps to book profits. Advantages and Disadvantages of IRS Advantages: i. An IRS helps in locking in low variable rates when interest rates are low. ii. An IRS involves no upfront premium. iii. An IRS is tailored to the specific needs of
the participants as to the principal, payment frequency and maturity profile. iv. It allows management of interest rate risk without affecting the financing arrangement. v. IRS can be executed with widely varying maturities. vi. IRS facilitates matching (variable) taxable interest earning assets with a similar amount of variable tax-exempt interest debt. Disadvantages: i. As parties effectively lock in a fixed interest rate they cannot participate in favorable interest rate movements. ii. There is significant potential for credit and counter-party risk within the IRS market. iii. Early termination may incur a pay-out cost (break-cost) subject to market movements. iv. Swaps can involve infinite leverage and risk. Global statistics In 1981 the benchmark interest rate in the U.S. was at an extremely high 17% due to the anti-inflationary tight monetary policy of the Fed under Paul Volcker. The corresponding rates in West Germany and Switzerland were 12% and 8% respectively. Both governments had imposed limits on the amount the World Bank could borrow in their markets. IBM at that time had large amounts of Swiss franc and German deutsche mark debt and thus
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had debt payments to pay in Swiss francs and deutsche marks. IBM and the World Bank worked out an arrangement in which the World Bank borrowed dollars in the U.S. market and swapped the dollar payment obligations with IBM and in exchange taking over IBMs Swiss 6,000 franc and deutsche 5,000 mark obligations 4,000 3,000 leading to the birth 2,000 of the first interest 1,000 0 rate swap contract.
O utstanding (USD T rn)
98 99 00 19 20 19
IRSs quickly gained immense popularity all over the world because of their flexibility and continue to dominate the market for OTC instruments. Greater standardization and transparency was facilitated by the ISDA Master Agreement.
TOTAL OUTSTANDING
01
02
20 04
03
05
20
20
Within a span of just Year seven years, interest IRS Volumes Total OTC Volumes Source: BIS rate swaps had Amounts outstanding of over-thedeveloped into a fully operative market with counter (OTC) derivatives an annual volume estimated at over $300 (In USD billion) billion and outstanding Notional amounts outstanding Risk Category/Instrument swaps valued over $1 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 trillion. ISDA was formed in Total Contracts 111,178.00 141,665.00 197,167.00 257,894.30 297,669.57 415,182.53 16,748.00 18,448.00 24,475.00 29,288.99 31,364.03 40,179.32 1985, after a group of 18 Foreign exchange contracts a) Forward and Forex swaps 10,336.00 10,719.00 12,387.00 14,951.19 15,873.03 19,828.41 swap dealers and their b) Currency swaps 3,942.00 4,503.00 6,371.00 8,222.77 8,503.92 10,771.88 2,470.00 3,226.00 5,717.00 6,115.05 6,987.10 9,579.04 counsel began work in 1984 c) options Interest rate contracts 77,568.00 101,658.00 141,991.00 190,501.95 211,970.50 291,987.07 to develop standard terms a) Forward Rate Agreement 7,737.00 8,792.00 10,769.00 12,788.66 14,268.68 18,689.43 b) Interest rate swaps 58,897.00 79,120.00 111,209.00 150,631.33 169,106.21 229,780.14 for IRSs. ISDAs primary c) options 10,933.00 13,746.00 20,012.00 27,081.95 28,595.60 43,517.51 purpose is encouraging the Equity - linked contracts 1,881.00 2,309.00 3,787.00 4,384.97 5,793.21 7,485.22 598.00 923.00 1,406.00 1,443.43 5,434.50 6,937.82 p r u d e n t a n d e ff i c i e n t Commodity contracts Source: BIS development of the privately negotiated (or OTC) Role of intermediaries derivatives business by the development and Nowadays in most swap transactions, the maintenance of derivatives documentation parties to a swap do not directly transact with and promoting the development of sound each other directly. Instead, there is a third risk management practices. The ISDA Master party in that acts as counterparty to each of Agreement acts as a reference point for all the two original parties. Initially banks just swap agreements. acted as intermediaries between two
20
20
20
06
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corporates to match swapping needs for a fee. Gradually large banks started offering their clients the type and size of swap transaction they desired immediately and thereafter found out a different party with opposite requirements to hedge the original swap. This type of swap warehousing or running mismatches enabled the customer to cover an exposure almost as soon as the decision to do so while the banks could quote the most competitive price to their clients and maximize their businesses. Most intermediaries often act as market makers p ro v i d i n g t w o w a y quotes as well as a settlement agent, collecting and paying the obligated cash flows when they are due. One of the reasons i n t e rm e d i a r i e s h a v e assumed such an important role in the swap market is that they diversify credit risk. Most intermediaries attempt to build a sizable
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portfolio of swaps and actively manage the interest rate risk of that portfolio in the futures and options markets. By specializing in this function and building a large portfolio, they can become more efficient at this task of risk management. Swap customers rely on the competition among these intermediaries to ensure that they are receiving efficient pricing of the risk they pass on when engaging in a swap. Benefits of having a clearinghouse for OTC products A clearing house substitutes itself as central counterparty to all transactions that its
Source: BIS
members agree to submit for clearing. The use of a clearing house has the potential to mitigate each of the types of counterparty risk associated with OTC derivatives like IRS namely credit risk, liquidity risk, legal risk, operational risk and to some extent the systemic risk. It thus enables investors, brokers and dealers to transact high volumes of business while economizing on capital and collateral utilization. The box given below depicts how the OTC market can benefit from the support of clearinghouses. IRS In India Over the years, Indias interest rate scenario has seen significant reforms where structural rigidities like administered rates, mandated floors and caps on deposit and lending rates, guaranteed high yields on government owned funds & tax-free bonds are increasingly becoming things of the past. Deregulation of interest rates, which helped in making financial market operations efficient and cost effective, has brought to the fore a wide array of risks faced by market participants. To manage and control these risks, instruments such as Forward Rate Agreement (FRA) and Interest Rate Swap (IRS) were introduced in July 1999 which could provide effective hedge against interest rate risks. The Reserve Bank of India (circular Ref. No. MPD.BC.187/07.01.279/1 1999-2000 dated July 7, 1999) issued guidelines for scheduled commercial banks (excluding regional rural banks), primary dealers and all-India
financial institutions to undertake FRAs and IRS as a product for their own balance sheet management and for market making purposes. Corporates were also allowed to use IRSs and FRAs to hedge their exposures. The parties were allowed to use any domestic money or debt market rate as benchmark rate for entering into FRAs/IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counterparties. There were no restrictions on the minimum or maximum size of notional principal amounts and tenor of FRAs/IRS. Banks, financial institutions and PDs needed to maintain capital based on the computation method provided by RBI for risk weighted assets. Along with undertaking FRAs/IRS for hedging underlying exposures, market participants were also allowed to undertake market making activity for the development of the product subjected to the required prudential limits. For the sake of uniformity and standardization, participants could consider using ISDA documentation, as suitably modified to comply with these guidelines for undertaking FRAs/IRS transactions. Participants were required to report their FRAs/IRS operations on a fortnightly basis to Adviser-in-Charge, Monetary Policy Department, Reserve Bank of India, with a copy to respective departments. Since the inception of derivative trading in India, swap products were widely used by the
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market to convert floating rate exposures to fixed rate and vice versa. Swaps linked to benchmarks like NSE-MIBOR and 6-month MIFOR became quite liquid. IRS contracts increased from about 200 contracts with outstanding notional principal amounting to Rs.4000 crore in March, 2000 to 6500 contracts worth Rs.150,000 crore in December 2002. However, the market was highly concentrated among a few foreign banks and private sector banks. The market was particularly characterized by the absence of MFs, insurance companies and public sector banks. In order to make the market broad-based in terms of participants, the Working Group on Rupee Derivatives (Chairman: Shri Jaspal Bindra) was constituted by RBI in November 2002 and submitted its report in January 2003. Following the recommendations of the Working Group on Rupee Derivatives, the SEBI decided to introduce anonymous order driven system for trading in Interest Rate Derivatives (IRDs) with effect from April 28, 2003 on the BSE and NSE. RBI allowed commercial banks, primary dealers and all India financial institutions to trade in interest rate derivatives in a phased manner. In the first phase, these entities could transact only in interest rate futures for hedging the interest rate risk in their underlying Government securities portfolio classified under the Available for Sale (AFS) and Held for Trading (HFT) categories. In spite of these measures participation in the
OTC derivative market remained restricted mainly because of lack of specific legal validity for such OTC derivative contracts. OTC derivative contracts were excluded from the purview of the Securities Contracts Regulation Act. The ambiguity regarding their legal validity was inhibiting the growth and stability of the market for such derivatives. Lack of transparency in terms of disclosures of quotes and valuation curves and lack of legality of netting of obligations were other issues impeding the growth of derivative market. On the recommendation of the Standing Committee on Finance, the Reserve Bank of India (Amendment) Bill, 2005, was proposed to provide clear legal validity of such contracts. The definition of OTC derivatives was expanded empowering the RBI to deal in derivatives as well as lay down policy and issue directions to any agency dealing in derivatives. RBI also had the powers to inspect the records of these agencies. In the Mid-term Review of Annual Policy for year 2006-07, an Internal Group was constituted by RBI to review the existing guidelines on derivatives and formulate comprehensive guidelines on derivatives by banks. RBI released the Comprehensive Guidelines on Derivatives on April 20, 2007. Commercial banks (excluding regional rural banks) and primary dealers were permitted to trade in rupee interest rate derivatives, including Interest Rate Swap (IRS), Forward Rate Agreement (FRAs) and Interest Rate Futures,
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FEATURES OF AN IRS AS PER FIMMDA GUIDELINES Minimum Notional Principal Amount: The minimum notional principal amount for which market makers will stand committed to their two-way quote is Rs. 5 crores. Tenor: The swap can be flexible in tenor i.e. there are no restrictions on the tenor of the swap. Unless stated otherwise, a rupee interest rate swap shall be assumed to have a day count basis of Actual/365. Trading Hours: The trading hours will be 9.00 a.m - 5.30 p.m. for all swaps wherein the benchmark is based on the money market or the fixed income market. In respect of swaps, wherein the benchmark is based on the foreign exchange market, the trading hours will be in accordance with the trading hours for foreign exchange transactions. Effective Date: The effective date will be the first Mumbai Business Day (excluding Saturday) after the Trade Date, except for interest rate swaps against which payments are based upon the INR-MIFOR Floating Rate Option, for which the Effective Date will be the second Mumbai Business Day (excluding Saturday) after the Trade Date. Business Day Convention: The business day convention applicable to all INR interest rate swaps shall be the Modified Following Business Day Convention, unless otherwise specified in the confirmation. Business Day: Unless otherwise specified in the Confirmation, Saturdays shall not be Business Days for any purpose, except in relation to INRMIBOR-OIS-COMPOUND for which Saturday shall be deemed to be a Business Day. It is recommended that regardless of the centre where the deal is transacted, the benchmark and the holiday calendar for the purposes of computation of interest streams be as that in Mumbai, except in case of interest rate swaps wherein the benchmark is based on the foreign exchange market, for which the holiday calendar of the relevant centre for that currency will also be applicable. Reset dates: No fixing of rates and compounding of interest will be done on a Saturday. Day count fraction: The Day Count Fraction applicable to all INR interest rate swap transitions shall be Actual / 365 Fixed. Broken or short calculation periods: The rate for any Calculation Period which is shorter than the Designated Maturity set forth in the Confirmation will be determined by the Calculation Agent based upon straight line interpolation between the Floating Rate Option with a Designated Maturity that is immediately shorter than the Calculation Period and the Floating Rate Option with a Designated Maturity that is immediately longer than the Calculation Period.
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Foreign Currency derivatives and Foreign Currency Forwards (Currency Swap and Currency Option). Types of IRS in the Indian market: The Indian OTC derivatives market has witnessed phenomenal growth over the past few years with the trades in the IRS market occasionally matching the trade in the G-sec market. The Indian IRS market has evolved from simple plain vanilla swaps to complex exotic structures. However, the Indian IRS market is dominated by the following types of swap structures. A. Overnight Indexed Swaps: The Overnight Index Swap (OIS) is a fixed/floating interest rate swap where the overnight rate is exchanged for some fixed interest rate. The floating leg of an OIS is tied to a published index of a daily overnight reference rate. Generally the interest of the overnight rate portion of the swap is compounded and paid at maturity. The two parties agree to exchange the difference between interest accrued at the agreed fixed rate and interest accrued through geometric averaging of the floating index rate at maturity, on the agreed notional amount. As the exposure of the OIS counterparties is only for the amount of any P/L, credit exposures are minimal. OISs usually trade on spreads of 1.5-5 bps and can be traded for forward and broken dates. OIS is the most popular and liquid segment in the Indian swap market. The underlying
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benchmark is the overnight call money rate (MIBOR) which is a daily fixing done by the NSE. The OIS curve is widely used by banks and primary dealers for hedging their bond portfolio as well as computing call rate funding risk. Payments are exchanged at maturity for the swaps with tenors less than 1 year, otherwise, payments are exchanged at 6month interval. Users of OIS in India: Scheduled Commercial Banks Use OIS contracts for managing interest rate risk while utilizing minimal capital. The OIS swap can be used to manage interest rate risk for flexible periods, without taking liquidity risk and with minimum credit risk (hence there is efficient usage of capital). This will lead to deeper and more efficient markets. Primary Dealers Use OIS for management of asset price risk and cash surplus. In periods of subdued activity in the GOI primary market, it is expected that a PD parks this surplus in the overnight interbank market. The OIS would, in such situations, be an excellent instrument for the PD to lock in a high yield by receiving fixed. On the other hand, in the period just after a primary issue, a PD is exposed to a call rate funding risk, since it has surplus securities, and there is an unavoidable time lag involved in distribution. This is especially true in periods of high call rate volatility. A PD can shield itself against this interest-rate risk by locking into an appropriate fixed-rate payer swap. It, therefore, protects a PD
against its exposure to overnight rates, and facilitates bidding in primary auctions. A PD would therefore be a natural two-way participant in the OIS market. Corporate Sector Use OIS for reducing interest cost/risk management. An overnight swap can effectively be used by a corporate for matching its interest rate expectations and interest-rate-risk exposure Using OIS, corporates can raise term funds (bills, CP etc) but pay overnight interest rates. OIS are an excellent positioning tool for putting on carry trades or expressing a directional view. Since the floating leg exactly follows overnight rates, rate cuts or hikes can be directly exploited, with none of the expectations element at settlement involved in trading FRAs or futures. Participant-wise share in Indian IRS-OIS Market The Indian IRS market had an outstanding volume of Rs.3,185,422.30 crores as on March 31, 2007. The major players were foreign banks and private sector banks.
Category-wise share in the total number of trades outstanding

Category Foreign Banks Private Banks Primary Dealers Public Sector Banks Total No. of Contracts Outstanding 67705 16464 4312 6910 95391 % Share 70.98 17.26 4.52 7.24 100.00
Market Share of top players in outstanding IRS volumes

Top 'n' Market Players Top 1 Top 5 Top 1 0 Top 15 Share in outstanding 11% 45% 75% 90%
As on March 31st, 2007 there were two contracts outstanding for Forward Rate Agreements worth Rs. 60 crores. B. MIFOR Swaps:
In a MIFOR (Mumbai interbank forward offer rate) swap, the counterparty pays a fixed rate and receives the six months implied rupee yield through the forwards, semi-annually and vice-versa. The Participant-wise Share in Total Outstanding Volumes as at end-March 2007 implied rupee yield through the forwards Public Sector Banks is nothing but the 8% rate at which one can Private Banks 19% raise rupees through Foreign Banks the forward route. 68% Primary Dealers 5% If a party has dollars and is required to swap the same into
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rupees, the total cost of the swap is the premium paid as a percentage of spot and the six months LIBOR as that is the opportunity cost of swapping funds in rupees and not keeping the same in dollars. So essentially, the floating leg on the MIFOR swap is a combination of the six months LIBOR and the six months forward rate. If a company raises a dollar loan for five years, say at six months LIBOR and wishes to swap the same into rupees, it will have to enter into a currency swap with a bank domestically. Under the currency swap, the corporate will give the dollars to the bank and take an equivalent amount of rupees based on the spot rate. It will then pay the bank a fixed rate of interest every six months and receive the then LIBOR rate on the principal. At the end of the swap, it will have to give back the rupees to the bank and take its dollars to repay its loan. So effectively, the corporate would have raised rupee resources at a fixed rate, as the LIBOR payment that it receives from the bank every six months will go towards the payment of interest on its dollar loan. All that the bank will have to do to hedge itself is pay the five-year MIFOR in the market for an equivalent amount and swap the dollars that it gets from the corporate into rupees for six months by paying the six months forward premium. Under the MIFOR swap, it will pay a fixed rate and receive a combination of LIBOR and the sixmonth dollar-rupee forward rate, every six
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months. From the banks perspective, every six months, it pays a fixed rate to the market, which is what it receives from the corporate under the currency swap. Similarly, every six months it receives the floating leg, of which it uses the LIBOR component to pay to the corporate under the currency swap and the dollar-rupee forward component to roll over the six-month sell buy swap. The MIFOR swap is very credit efficient, as it is a pure interest rate swap and hence does not involve the exchange of principal. In the absence of MIFORs, banks will be able to hedge themselves, but only by doing an identical currency swap in the market. Currency swaps are very credit intensive and will thereby choke credit lines for counterparties very quickly. This will in turn make currency swaps illiquid, thereby increasing the market bid offer. MIFORs are not only used to hedge and price currency swaps, they are also used for pricing and hedging long-term forwards and options. The absence of MIFORs will hurt their liquidity as well and we shall go back at least five years in terms of market development. As per the directives issued by the Reserve Bank of India (RBI) on May 20, 2005, market participants were advised to use only domestic Rupee benchmarks for interest rate derivatives. The RBI was concerned about the rapid growth in outstanding contracts in MIFOR to over Rs.1,00,000 crore which were mainly used as a speculative tool by corporates without any underlying
exposures like loans under ECBs. Market participants were, however, given a transition period of six months for using MIFOR as a benchmark, subject to review. However, on request from the Fixed Income Money Market and Derivatives Association (FIMMDA), market participants have been allowed to use MIFOR swaps in respect of transactions having underlying permissible forex exposures, for market making purpose, subject to appropriate limit prescribed by the RBI. C. INBMK Swaps: While the earlier category of benchmarks like OIS and MIFOR are linked to corporate/bank funding costs in India, there is another category of benchmarks linked to the Government of Indias borrowing cost, i.e. yields on G-Sec. Just as a company can enter into a swap where the benchmark for the floating leg is 6-month MIFOR, it can also enter into a swap where the benchmark is the yield on the 1-year G-Sec. The daily setting for G-Sec yields for different tenors is exhibited on a Reuters page known as INBMK. These swaps are important as they allow banks and corporates to take view on the relative movements of GOI yields and corporate spreads, without taking positions in the securities. D. Principal Only Swaps: Another product popular among Indian corporates entails hedging only the principal exposure under currency swap, keeping
coupon payments unhedged. A party with an exposure in INR, may have a view that dollar shall weaken against the rupee over the tenor of the INR exposure. Such a party can enter into a Principal-Only swap in which INR exposure gets swapped into dollar exposure at a predetermined forward rate. With the volatility of the rupee quite low as against LIBOR FRA, the risk on this swap is even lower than that on Coupon-Only swap. Conclusion RBI, in its Annual Policy Statement for the Year 2007-08, had highlighted the necessity of a mechanism for transparent capture and dissemination of trade information as well as an efficient post trade processing infrastructure for transactions in OTC interest rate derivatives. As a precursor towards this CCIL was advised to start a trade reporting platform for Rupee Interest Rate Swaps (IRS) which was to be made functional by August 31, 2007. To achieve this objective, a deal reporting utility has been created by CCIL, which can be used by CCIL members to report their deals in a convenient manner. Apart from processing the deals, certain post trade processing services like resetting interest rates, providing settlement values etc. to the reporting members will also be provided. Information regarding traded rates and volumes will also be made available. RBI as per its notification (Ref. No. RBI/2007-2008/122 IDMD/11.08.15/809/
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2007-08) dated August 23, 2007 notified that the reporting platform developed by CCIL for capturing the transactions in OTC interest rate derivatives (Interest Rate Swaps and Forward Rate Agreements (IRS/FRA)), would be operationalised by August 30, 2007. All banks and primary dealers will have to report all their IRS/FRA trades on the reporting platform within 30 minutes from the deal time. Banks and PDs will also have to ensure that details of all outstanding IRS and FRA contracts (excluding the client trades) are migrated to the reporting platform by September 15, 2007.
Interest rate swaps trading in India is currently carried out mostly by telephone through brokers in India and deals are settled between market participants after the end of trading hours each day. Daily volumes in these swaps are estimated at Rs.80 billion ($1.9 billion). As of now the market is dominated by mainly foreign banks and private banks. The reporting platform developed by CCIL will enable dealers to get the rates on a real-time basis and the volumes at the end of the day. This is expected to facilitate better price discovery, enhance transparency and help in increasing the participant base.
ANNEXURE Functionalities & Coverage of CCILs Platform for trade reporting and dissemination of market information on Rupee IRS & FRA 1. Instruments Covered a) Interest Rate Swaps Fixed Float and Basis Swaps (Up to maximum maturity 10 years) b) Forward Rate Agreements (Up to maximum maturity 2 years) 2. Acceptable Benchmarks a) NSE-FIMMDA MIBOR (Designated Maturities Overnight, 14 days, 1m & 3m) b) MIFOR (Designated Maturities 2m, 3m, 6m, 12m) c) INBMK (Designated Maturity 1year) 3. Functionalities: a) Acceptance of trades reported of by the market participants and matching of these trades; b) Dissemination of trade information through CCIL website and also through the website of RBI; c) Providing information to the reporting members and their counter-parties about matched and un-matched trades, alleged deals etc. for their tracking of trades & for accounting;
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d) Keeping record of outstanding trades of the market participants (individually and at an aggregate level) and providing them consolidated information of their outstanding trades; e) Effecting interest rate resets for the outstanding trades, when due and advising the reporting members and their counter-parties about such resets alongwith the reset rates; f) Providing market participants with information about their settlement obligations g) Recording of cancellation of outstanding trades by market participants. 4. Deal Reporting: a) All reporting entities will be made member of CCILs Derivatives Segment. b) Deals are to be reported in the format specified by CCIL.
References: i. Swaps/Financial Derivatives 3rd Edition (Vol. I) - Satyajit Das
ii. Options, Futures and other Derivatives (Fifth Edition) - John C. Hull iii. Financial Derivatives Theory, Concepts and Problems S. L. Gupta iv. www.rbi.org.in v. www.bis.org vi. www.fimmda.org vii. www.ccilindia.co.in
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