PAPER - PERSPECTIVES IN MODELLING OF PRICING OF

INTEREST RATE SWAPS W.R.T INDIAN MARKETS

________________________________________________________________________
By Prof. Deepak Tandon Professor . (Finance) IILM Institute for Higher Education Plot No 69 Sector 53 IILM GURGAON Email-deepak.tandon@iilm.edu

Abstract
Swaps are an integral part of the world of international finance. Their use has permeated almost every aspect of domestic and international capital and money markets. Banks use them to reduce their exposure to the risk of changes in interest rates and currency movements, thereby reducing the potential tax burden on the public which results from the failure of the banks. The existence of swaps creates greater choice for consumers and in the provision of fixed rate finance for mortgages, or even of loans with caps or other embedded options. The arbitrage opportunities which are capitalized in the swap markets have resulted in a narrowing of the capital markets bid/offer spread. This means that the institutional investors get a better return on their investments and international borrowers pays lower financing costs. This in turn, results in more competitively priced goods for consumers and in enhanced returns for pensioners. Swaps therefore have an effect on almost all of us yet they remain in arcane derivatives risk management tool, sometimes suspected of providing the international banking system with the tools required to bring about its destruction. This Paper covers the basic understanding of Swap Markets in India and also emphasizes the pricing aspects of Interest Rate Swaps Interest rate swaps are over-the-counter contracts, in which one party agrees to pay a fixed interest rate in exchange to receiving a floating interest rate from the other counterparty, on a given notional principal during a certain time period. The amount of the principal, however, never changes hands. Both rates are specified when the contract is initialized. These instruments are widely used in the management of interest rate risks in a wide range of fields of business, e.g the acquisition of funds and asset management. KEY WORDS - IRS ( Interest Rate SWAPS ), OIS(Overnight Indexed Swaps ) MIBOR ( Mumbai Inter Bank Offered Rate ) ,IN BMK rate- derived from rate on the benchmark Indian Government Securities _____________________________________________________________________

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INTRODUCTION
SWAPS are arrangements between two firms to exchange a series of future payments . A SWAP is necessarily is a long dated forward contract between two parties through the intermediation of a third party , such as a Bank . Through the Interest rate Swaps two parties agree to exchange interest with each other over an agreed period . In the early days the interest rate market was driven by bonds. However, during the last decades the interest rate market has expanded immensely and the contracts traded tends to get more complicated every day. This has implied a need for sophisticated models in order to price and hedge these contracts, normally called interest rate swaps. Banks undertake both Cross-Currency-Swaps and Interest-Rate-Swaps with an average of 2receive and 1-pay deals per day. Seeing the liquidity and the standardization of the product Swaps are quite popular at the Bank.But, in the journey of Swap at the time of initiation of swap the present value of all future cash flows (both fixed and floating) are equal. But due to dynamic nature of interest rates there is change in the benchmark rate to which the floating leg payment rests. As the benchmark rate changes the floating rate payments also undergoes a change. Now with the change in benchmark interest rates the Present value of all future cash flows also undergoes a change. The spot rate also undergoes a change. With change in benchmark interest rates the value of swap also changes after initiation. Due to this dynamic nature of the Swap products it becomes quite imperative to study the short term interest rate forecasting. This helps in developing the view (as to increase or decrease in the interest rates) and subsequently makes the decision to go for the type of structure i.e. trading, hedging or back-to-back deals.

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Also as per the RBI guidelines for valuations the bank has to Mark-To-Market their portfolios on daily basis, calculate the hedge effectiveness and estimate the asset-liability mismatches. For this purpose the bank valuates its swap portfolio on the Reuters and records them on their swap book. Thus a need was identified at the bank for having there own model for daily MTM of the swap deal which would return the same values as returned by Reuters and also incorporates the investment objectives of the bank.

A>INTEREST RATE SWAPS : A. Characteristics - An Interest Rate Swap is an off-balance sheet contract between two counterparties to exchange a stream of payments on specified dates based on a notional principal. In a plain vanilla interest rate swap, a series of payments calculated by applying a fixed rate of interest to the notional principal amount is exchanged for a stream of payments calculated by using a floating rate of interest on the same principal. This is a standard fixed-for-floating interest rate swap. Alternatively, both series of cash flows could be calculated using floating rates of interest that are based upon different benchmarks. Floating rate benchmarks include MIBOR, the 91 day T-Bill rate, the Reuters CP reference rate, the Bank Rate etc. Further, the interest payments are not grossed-up like in call money transactions but are net settled on periodic payment dates.

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B. Participants The following participants are allowed to undertake IRS/FRAs -Scheduled Commercial Banks, Primary Dealers, All India Financial Institutions, Corporates, Mutual Funds and Corporates Corporates and mutual funds can use these products only to hedge existing assets/liabilities while the first three types of participants may do market making. RBI has currently allowed transactions only in plain vanilla IRS/FRA. Swaps having explicit or implicit options such as cap, floors or collars are not permitted. C Overnight Indexed Swaps (OIS) Currently, the most common form of Interest Rate Swaps in the Indian market is the Overnight Indexed Swap (OIS). An OIS or call money swap is a fixed to floating interest rate swap with the floating leg linked to the overnight borrowing rate (call money rate). The tenor of the swap ranges typically from 2 days to one year. D.Pricing an IRS Pricing an IRS refers to ascertaining the fixed rate of the swap, also called swap rate. First, the credit of the borrower is priced into the swap rate (whether inter-bank or corporate). Further refinements to the term money rate are added to account for notional principal, payment frequency and basis risk. The above would require the swap curve to lie between the T-Bill curve and inter-bank Term Money curve or Commercial Paper curve. However, expectation of overnight rates (floating leg) weighs heavily in the final pricing. OIS are quoted on a bid/offer basis with the bid referring to the quoting partys willingness to pay the fixed rate and offer referring to the partys willingness to receive

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the fixed rate. In developed markets however, swaps are quoted as a spread over the sovereign curve signifying the credit risk. B >Advantages of interest rate swaps The primary advantage offered by Interest Rate Swaps is the facility to hedge interest rate exposure in a flexible and easy manner. Further, due to netting off of interest payments, credit exposure is minimal. However, swaps may also be used to execute interest rate views. Specifically, banks, primary dealers and institutions may use Interest Rate Swaps for the following: Asset Management: Swaps may be used to lock-in to a fixed rate, which may be higher than the average floating rate while still maintaining liquidity by receiving the fixed rate in an IRS Hedging: A short period of volatility in the interest rates may be hedged by paying the fixed rate in an IRS and removing the risk of floating rates shooting up

Liability Management: Raising term deposits can be replicated by overnight borrowing and paying fixed in an IRS. This is cheaper and more flexible route than term deposits.

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Execution of Interest Rate View: Portfolio size can be expanded without putting a strain on funding by receiving the fixed rate in an IRS. Also IRS allows a rising interest rate view to be executed by paying fixed in an IRS. Reducing Asset Liability Mismatch: Banks can use swaps of specific tenors to reduce the mismatch between assets and liabilities Corporates may use swaps to hedge interest rate exposure on their liabilities or assets whether fixed or floating. Most corporates in India have PLR linked (and hence floating rate) loans from financial institutions or banks. These may be hedged by receiving the floating rate (PLR, Bank Rate, MIBOR etc) and paying a fixed rate. This way the corporate can fix its cost of funds in an uncertain or tightening scenario. Additionally, there are corporates which have issues fixed rates bonds or debentures. Such corporates may wish to receive fixed and thereby convert their liabilities to floating rates (MIBOR, Bank rates etc). In a liquid scenario this swap allows corporate to benefit from lower rates by converting high cost fixed rates debt into a floating rate.Corporate desiring to borrow through floating rate instruments may find it difficult to do so owing to the low investor appetite for such products. They may now borrow funds through fixed rate instruments and swap it into floating by received fixed and pay floating. This way they effectively simulate the desired floating rate instrument. Corporates can also convert high cost fixed deposits to floating rate if it reduces their cost of funds by receiving the fixed rate in an OIS. Open ended mutual funds maintain a certain portion of their corpus in call money for liquidity management. On this they earn a variable return. They may wish to remove this uncertainty by receiving a fixed rate in an OIS (paying the overnight rate). The key

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advantage of this strategy is that the amount so hedged continues to be maintained in call money and can be used to meet an unexpected redemption. Floating rate debentures currently held by a mutual fund may similarly be effectively converted to fixed rate instruments. In a bearish or Uncertain market, a fund may use swaps to hedge its portfolio by paying the fixed rate (receiving the floating rate) thus offsetting the losses on its portfolio with gains on the swaps. C>Documentation and regulatory requirements RBI has suggested that participants may consider using the standard ISDA documentation suitably modified for IRS/FRA transactions. Participants also need to ensure that they have adequate internal approvals and control systems prior to concluding transactions. RBI has stipulated that Swap positions be added to risk weighted assets after applying certain conversion factors in order to account for the i) potential credit exposure and ii) adjusting for the appropriate risk weight. Adjusting for Potential Credit Exposure (PCE) Original Maturity Conversion Factor Less than 1 year 0.50% 1-2 years 1.00% each additional year 1.00% Adjusting for risk weighting Banks and FIs 20% All others 100% 4 Interest Rate Swaps and Forward Rate Agreements ICICI Securities Ltd. D>Valuation of an IRS A swap can be decomposed into two parts - Accrual and Mark-to Market (MTM). Accrual refers to the difference between the interests payments on both legs from the start date till the valuation date. MTM value of a swap would be the replacement value of an existing swap on the valuation date

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II. HOW DOES A SWAPS WORK A swap is a tool for changing riskThe major risks, which can be changed with swap transactions, are: Interest rate Currency Commodity Equity Credit Climatic (weather, temperature)

Any variable in which there are natural buyers or sellers of risk is potentially a candidate for a swap structure. This change in risk is achieved in two stages the two legs: the payments and the receipts. The first leg of a swap matches the existing risk, while the second leg creates an exposure to the required risk. In order to determine which way round a swap transaction needs to be structured it is necessary to look at the existing position.

The First Leg of Swap Transaction: The figure below shows a borrower, or an investor, and an existing position which offset by the first leg of a swap deal. Match existing position Borrower/Investor

Existing position

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So in all interest rate swaps where the existing position is debt, the first leg of the swap is interest income which matches the interest payments of the debt. The Second Leg of Swap Transaction: Having matched the existing exposure with the first leg of the Swap, the borrower creates the required exposure with the second leg of the swap. Match existing position: fixed rate YEN

Borrower/Investor

Scenario - An Interest Rate Swap is a method for managing Debt:

Interest rate swaps allow users to switch from one basis to another, for example, from a fixed-rate export credit to a floating-rate bank borrowing (say 3-month Libor), or to switch within a specific interest rate type, e.g.: from 6-month Libor to 3-month Libor. Scenario 1: Interest rates are expected to rise significantly. A floating-rate borrower could consider fixing the cost of debt for whatever time horizon is deemed prudent. Scenario 2: Interest rates are expected to fall significantly. A fixed-rate

borrower could consider receiving a fixed rate and paying a floating rate in a swap transaction.

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RATIONALE OF INTEREST RATE SWAPS A Single Currency Interest Rate Swap (IRS) is an exchange of cash flows between two counter parties at predetermined specifications. It is an obligation between them for exchange of interest payments or receipts on investments, in the same currency on an agreed amount of notional principal at regular intervals, over an agreed period of time. Swaps can broadly be classified into two types: (a) Fixed to Floating-In this type of a swap the customer receives cash flows at a fixed rate of interest and simultaneously pays cash flows at a floating rate of interest or vice versa. The cash flows are calculated on a Notional Principal amount. The floating rate of interest is usually determined by reference to a transparent benchmark (b) Floating to Floating In this kind of a swap, both the counter-parties exchange

interest amounts based on two different floating reference rates, through the life of the swap. Dealing and Quotations: Trade date is the date the counterparties agree on the swap conditions. Effective date is the date that the swap becomes effective, i.e. when the interest obligations start to accrue. Maturity date is the date the swap stops accruing interest and terminates. Market quotations for swaps are usually quoted against standard benchmark / index rates and non-amortising national principal, free from the margin actually payable in the cash market by the relevant counterparties. The rate is thus quoted flat and any amortising structure that envisages a customised rate is adjusted accordingly. A quote of 9.75% - 10.25% against 3 month MIBOR means that the market maker: (i)Pays (bid) 9.75% fixed and receives INR 3 month MIBOR

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(ii) Receives (ask/offer) 10.5% fixed and pays INR 3 month MIBOR Overnight Trade rate or MIBOR ,Treasury Bills and Term Money rate are examples of floating rate benchmarks REGULATIONS FOR IRS : RBI regulations for Swaps are as under: a. Banks can offer these derivatives to corporates for hedging underlying genuine exposures b. c. d. No specific permission is required from the RBI to undertake FRAs/IRS Benchmark can be any rate from the domestic money or debt market, or any rate implied in the forward foreign exchange markets, provided that the methodology of calculating the rate is objective, transparent and mutually acceptable e. There are no restrictions on size or tenor for interest rate swaps, though there are some limits on currency swaps f. Banks are allowed to deal without underlying exposure for market making activity (within prudential internal limits)

II> OBJECTIVES

AND RATIONALE OF STUDY

(a) The main objective of this paper to make the treasurer to understand the companys Interest rate risk exposure . , how it is likely to change over time , and where any of the exposures are compensating , how they can be netted against each other

(b) As heavy dependence upon short term borrowing not only increases risk of insolvency from funding long term assets with short term borrowings but also exposes a Corporate to short term interest rate increases .IRS are hedging tools to reduce Interest rate risk . It

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has therefore become pertinent and inevitable to study the approaches to manage interest rates . METHODOLOGY FOR PRICING IRS :

The methodology adopted is to develop the model for pricing vanilla interest rate swap is as follows: The project has parts:

and valuation of plain

PART I : undertakes the study of the Pricing and Valuation of Plain Vanilla Interest Rates Swaps in India and formulates the model for the same on Microsoft Excel.Literature survey was made to understand the different theoretical concepts of Pricing and Valuation of Plain Vanilla Interest Rate swaps. This process was extended to understand and conceptualize the structure used by Reuters for pricing and valuation of the Swaps. This was finally modeled in the excel sheet which generates the same value as returned by Reuters for Generic Swaps

THE APPLICATIONS OF INTEREST RATE SWAPS: Changing A Borrowers Mix Of Fixed-And-Floating Rate Debt: The three most commonly used techniques, which change floating-rate debt to fixed-rate basis, are: Pay a fixed rate and receive a floating rate in an interest rate swap.

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Buy FRAs (Forward Rate Agreements). Sell three-month Eurodollar futures.

It would be possible to change floating-rate debt to fixed-rate debt by borrowing fixedrate money and using the proceeds of the fixed-rate loan to repay the floating-rate debt. This technique is administratively burdensome and often very costly as there are likely fees charged on both loans. There are other difficulties. It may not be possible to prepay the existing floating-rate debt and it may be difficult to source fixed-rate money. Liquidity in the fixed-ate markets varies with currency, maturity, the borrowers credit quality and the economic cycle. Many borrowers therefore use Swaps or FRAs or futures as a cost effective alternative.

Example NO 1 : The lender of the floating-rate funds spreads the price of the long off a floating rate index, Overnight Mibor. If the borrower pays a 50 basis point spread over this floating rate index to the lender of the floating-

6 Month MIBOR rate index to the lender of the floating-rate funds then it is necessary for the borrower to receive the floating-rate index in the swap transaction in order to hedge its floatingrate risk as shown below: Floating rate Borrower 5.75% Interest rate swap market maker

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The floating rate borrowers net floating-rate position is now fixed at a cost of 50 basis points. O matter what the level of Mibor, the borrower is hedged from changes in the floating rate because its both payer and a receiver of Mibor. So if the daily Mibor is 6% the borrower will pay 6.50% for the loan and receive 6.0% in the swap: net cost 50 basis points.

6-month Mibor + 0.50%

Credit Arbitrage, Reducing The Cost Of Floating-Rate Money Credit arbitrage exists because there is no universal price for credit. This helps to contribute to inefficiencies in the credit markets.

Example No 2 : Let there be two corporates with different credit ratings (AAA and BBB). Investor preferences and the relative demand for the fixed-rate credits will determine the fluctuations in the spread between the cost of borrowing on a fixed-rate basis for the AAA and the BBB rated companies. In a market, where credit suddenly becomes major concern, it would be evidenced in a widening of the spread between these two particular credit.

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Corporate AAA rating Corpoarte BBB rating Relative advantage of AAA over BBB Absoulte advantage of AAA over BBB

Cost of Borrowing Fixed Floating g + 50 Mibor + 20 g + 100 Mibor + 50 50 30 20 Basis Point

For the AAA isuer this means borrowing on a fixed-rate basis because it 50 less on a fixed-rate basis than the BBB borrower. On the floating-rate basis the AA borroer pays only 30 basis points less than floating relative to the BBB borrower. In the absolute terms it is a better borrower of both fixed and floating rate debt. By the same token the BBB borrower is a better relative borrower of floating rate debt than fixed rate debt. The BBB pays 30 over the AAA for floating rate money and 50 over the AAA for fixed rate money. In absolute terms it is more expensive borrower than the AAA in both the fixed rate and the floating rate markets. Structuring SWAP between Corporates AAA rated and BBB rated g + 40 AAA Daily MIBOR g + 50 Daily MIBOR + 50 BBB

The cost of floating rate debt to the AAA issuer is MIBOR + 10 basis points calculated as follows: -(g + 50) + (g + 40) - (MIBOR) = MIBOR + 10 The cost of fixed rate debt to the BBB issuer is g + 90, calculated as follows: -(MIBOR + 50 + (MIBOR) - (g + 40) = g + 90

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So the AAA issuer saves 10 basis points by swapping from the fixed to floating by paying MIBOR + 10 rather than MIBOR + 20, and the BBB issuer also saves 10 basis points by paying g + 90 rather than g + 100. The combined savings are equal to the difference between the differences in their respective cost of credit on a fixed and a floating rate basis. So, the credit arbitrage is created by the different prices of credit in different markets. This happens as a result of the different motivations of institutional and retail investors in the bond markets and the competitive forces of syndicated loan pricing amongst banks in the loan market. Example 3

Consider two companies, rated AAA and BBB. AAA has a higher credit rating than BBB. Both companies can raise funds either by issuing fixed-interest bonds or by taking bank loans (at a floating interest rate). Their borrowing costs are: Cost of Funds to AAA and BBB Fixed rate bonds Floating rate loans 10.00% p.a. Libor+100bp 12.00% pa Libor+160bp 200 bps 60bps

AAA BBB Differential

Assume now that AAA wants to raise floating rate money and BBB wants to raise fixed rate money. It will be realized that the advantage (200 basis points) of AAA raising fixed rate money in the bond market as against BBB, which is, is greater than the disadvantage (60 basis points) of letting BBB raise floating rate money in the credit market. There is a comparative advantage of 140(200-60) basis points. Both the parties can share the difference and reduce their borrowing costs. A Banker normally acts as an intermediary and arranges most of these deals. A share of the advantage is passed on to the banker. In this case, if the three parties agree to share the difference as 80:40:20 basis points, then AAA will receive 9.80% fixed from the bank in exchange for Libor, while paying 10.00% on his bonds. The net outcome for AAA is a floating rate liability at Libor+20 bps. This represents a gain of 80 basis points, than if he had borrowed at Libor+100 bp. Similarly Borrower BBB receives Libor in lieu of 10.00% fixed while paying - 16 - -

Libor+160 bp to his creditor. The net effect is equivalent to paying 11.60% fixed, which represents a 40 basis points gain over fixed rate borrowing at 12.00%. The intermediary bank receives 10.00% fixed from BBB and pays 9.80% fixed to AAA in effect gaining 20 basis points on this transaction. The following diagram illustrates the transaction.

Asset Swaps In its simplest form and Asset Swap consists of a fixed-rate bond swapped to a floating rate basis. It is a package consisting of a bond and a swap, hence the term asset swap. An investor buys a fixed rate bond and receives the coupon payments which are then paid to an interest rate swap market maker (fixed interest rate). In return the interest rate swap market pays a floating interest rate to the investor.

Fixed interest rate Investor Floating interest rate

Interest rate swap market maker

Fixed rate bond

The effect of this package, a fixed rate bond and an interest rate swap is o provide the investor with returns which are linked to changes in

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the floating rate index, often LIBOR, while still owning a fixed rate bonds. Assets swaps mirror liability swaps and the motive behind them mirrors the motive for liability swaps.

OTHER MOST WIDLEY USED APPLICATIONS OF SWAPS ARE: Asset and Liability management Locking in interest rate gains and losses Changing an investors portfolio mix of fixed-and floating-rate investments.

1.

Plain Vanilla Interest Rate Swaps: These are the most basic and actively traded instruments in the market. The underlying benchmark in these swaps is linked to funding costs for banks or corporates.

The principal benchmarks are:

A.

Overnight Index Swaps (OIS): This is the most popular and liquid benchmark, especially in the Interbank market This was the first benchmark that was actively used by banks, since it fulfilled a long felt need for them to be able to extend the duration and manage the volatility of their overnight borrowings. As the name implies, the underlying benchmark is the overnight

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call

money

rate.

The

floating

benchmark is known as MIBOR, which is a daily fixing done by the National Stock Exchange (NSE) against which the swap is settled. Although the floating rate is reset daily, for the sake of convenience, it is compounded and settled only at a frequency which can be chosen by the swap counter parties (e.g., every month, quarter or half year). Although OIS swaps are quoted out to five years, the maximum liquidity is for tenors upto two years. FIXED vs NSE Overnight MIBOR Index B. MITOR Swaps: These are similar to OIS swaps, with the difference being that the underlying overnight floating rupee rate is derived from the USD Fed Funds Rate and the USD/INR C/T Premia, rather than being directly derived from the actual call rate in the Indian market. This benchmark is not as popular as the preceding OIS benchmark.

C.

MIFOR Swaps : This is another popular benchmark that has developed into a proxy for the AAA corporate funding cost in India. Since India does not have a fully developed term money market, it is derived from USD Libor and the USD/INR Forward Premia, both of which are extremely deep and liquid markets. Although the popular perception is that MIFOR might be subject to sudden swings on account of the fact that it is derived from the forex forwards market, this is a misplaced fear it is simply the Indian equivalent of USD Libor and the USD Interest Rate Swaps market, and behaves like an interest rate benchmark, not a forex benchmark. There are a large number of Indian

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Corporates who now regularly use this benchmark to actively manage the interest rate risk on their debt portfolios, and access funding at better rates.

Fixed vs Implied INR yield derived from USD /INR

2.

Currency Swaps: These are interest rate derivatives whereby Rupee debt held by banks or corporate can be swapped into debt in another currency or vice versa. As expected, the most popular currency for swapping debt is the US Dollar, with the Japanese Yen coming in second. It is especially useful for companies having raised forex debt who wish to hedge all or part of the foreign exchange risk and interest rate risk by swapping into Rupees. Similarly, companies holding rupee debt who wish to either lower funding costs or diversify the currency mix of their debt portfolios often choose to swap from rupee debt into forex debt. An interesting point to note is that while no optionality is permitted on the Rupee leg of the currency swap, there is substantial scope for employing more sophisticated hedging strategies by embedding options on the forex leg of the swap. There are also many variants of currency swaps, like coupon swaps and Principal Only swaps (POS) which are popular amongst Indian corporates.

3.

GSec Linked Swaps: While the first category of benchmarks like OIS and MIFOR are linked to corporate/bank funding costs in India, this category of benchmarks is linked to the Government of Indias borrowing cost, viz. yields on Government Securities (GSec). 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

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swap where the benchmark is the yield on the 1Year GSec. The daily setting for GSec yields for different tenors is exhibited on a Reuters page known as INBMK. IN BMK SWAP =Fixed vs 1 year IN BMK rate These swaps are important as they allow banks and corporates to take views on the relative movements of GOI yields and corporate spreads, without necessarily actually taking positions in the securities themselves. Apart from these basic products, there are a variety of complex products that can be built from these underlying benchmarks. e.g. a popular variant in India has been the Constant Maturity Treasury (CMT) swap, where the underlying floating rate, instead of being a 3month or 6month rate, is the 5 Year GSec Yield. There are also forward rate agreements, rate locks, spread locks, quanto swaps etc which all use these basic building blocks to allow the swap counter parties to take more sophisticated views on not only the future movement of interest rates, but also the shape and slope of the yield curve and the widening or narrowing of spreads between different benchmarks, to name just a few.

PRICING OF INTEREST RATE SWAP GENERIC INTEREST RATE SWAP A generic or Plain Vanilla interest rate swap is the simplest form of medium-term IRS. A contract which involves two counterparties to exchange over an agreed price streams of interest payments during the period of swap contract, each based on a different kind on interest rate, on a notional amount which is not exchanged during the period of contract.

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Interest rate swaps are used to hedge interest rate risks as well as to take interest rate risks. If a bank is of the view that interest rates will fall, it may convert its fixed interest liability into a floating interest liability and also his floating rate into fixed rate assets. If it expects the interest rate to go up then it may convert its floating rate liability into fixed liability and fixed rate assets into floating rate assets. The characteristics of Interest Rate Swaps:1. 2. 3. The principal amount is only notional. Opposing payments through the swap are normally netted. The frequency of payment reflects the tenor of the floating rate index.

These constitute the vast bulk of inter-bank trading. Definition An interest rate swap is a financial contract between two parties exchanging or swapping a stream of interest payments for a 'notional principal' amount on multiple occasions during a specified period. Such contracts generally involve exchange of a fixed to floating or floating to floating rate of interest. Accordingly, on each payment date - that occurs during the swap period - cash payments based on fixed/floating and floating rates, are made by the parties to one another.

Features 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.

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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 am -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. Currently the trading hours for foreign exchange is from 9.00/10.00 a.m. to 4.00p.m.

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.

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Business Day: Unless otherwise specified in the Confirmation, Saturdays shall not be Business Days for any purpose, except in relation to INR-MIBOR-OISCOMPOUND 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.

Floating Rates: The definitions of the various floating rates that are currently dealt with in respect of interest swaps and their definitions are given below:

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INR-MIBOR-OIS-COMPOUND

INR-MIBOR-OIS-COMPOUND means that the rate for a Reset Date, calculated in accordance with the formula set forth below, will be the rate of return of a daily compound interest investment (it being understood that the reference rate for the calculation of interest is the arithmetic mean of the daily rates of the day to day interbank INR offered rate).

Formula for calculation of the floating rate

INR-MIBOR-OIS-COMPOUND will be calculated as follows, and the resulting percentage will be rounded in accordance with method set forth in Section 8.1(a) of the 2000 ISDA Definitions, but to the nearest one ten-thousandth of a percentage point (0.0001%)

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 do Ri ni 365 1 + 365 1 d i =l

where: "do", for any Calculation Period, is the number of Business Days in the relevant Calculation Period; "i" is a series of whole numbers from one to do, each representing the relevant Business Days in chronological order from, and including, the first Business Day in the relevant Calculation Period; "ni" is the number of calendar days in the relevant Calculation Period on which the rate is RI; "d" is the number of calendar days in the relevant Calculation Period; and "Ri", for any Business Day "i" in the relevant Calculation Period means:

1.

The Mumbai Inter-Bank Offered Rate (as published jointly by Fixed Income Money Market and Derivatives Association of India (FIMMDA) and the National Stock Exchange of India (NSE)) for a period of the Designated Maturity which appears under the heading MIBOR on Reuters Screen "MIBR=NS" as of 9:40 a.m. India Standard Time on that Business Day.

2.

The same rate can also be picked up from the NSE website or from the Benchmarks Menu on the Home Page of FIMMDA (www.fimmda.org). - 26 - -

3.

If such rate does not appear on the Reuters Screen MIBR=NS or on the website of FIMMDA / NSE, as of 9:40 a.m. India Standard Time, the rate for that Business Day will be the Fixing Rate which appears on Reuters Screen "MIBR=" as of 9:40 a.m. India Standard Time on that Business Day.

4.

If such rate does not appear on Reuters Screen "MIBR=" prior to 10:40 a.m. India Standard Time on that Business Day then the rate for that Business Day shall be determined as if the parties had specified INR-Reference Banks as the applicable Floating Rate Option for purposes of determining Ri.

Confirmations to include

Floating Rate Option: Designated Maturity: Spread: Floating Rate Day Count Fraction:

INR-MIBOR-OIS-COMPOUND Overnight +/- [ ]% per annum Actual / 365 Fixed

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Reset Dates: Compounding: Compounding Date: Business Days

The last day of each Calculation Period. Inapplicable Inapplicable Mumbai

GENERIC INRIRS SWAP Maturity Trade date Effective date Settlement Fixed Side Fixed Coupon Frequency Day count Pricing date Floating Side Current market rate (as quoted on OIS Index) Either Annual or Semiannual Act/365 Trade date 1 year to 10 years (5 Years OIS most liquid) Date of agreeing to enter into the swap Depends upon convention in floating rate market Effective date

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Floating index Spread Payment frequency Day count Reset frequency First Coupon Premium/Discount

Defined money market indices ( MIBOR/MIFOR/MITOR) None Tenor of the floating index Act/365 Tenor of the floating index (daily compounding) Current market rate for index None

Documentation and regulatory requirements RBI has suggested that participants may consider using the standard ISDA documentation suitably modified for IRS/FRA transactions. Participants also need to ensure that they have adequate internal approvals and control systems prior to concluding transactions. Corporates need to provide supporting documentation to show the underlying asset or liability which is sought to be hedged. Further, some participants require that a Risk Disclosure Statement be signed in order that the corporate is aware of the risks being undertaken. RBI has stipulated that Swap positions be added to risk weighted assets after applying certain conversion factors in order to account for the i) potential credit exposure and ii) adjusting for the appropriate risk weight. Adjusting for Potential Credit Exposure (PCE) Original Maturity Conversion Factor Less than 1 year 0.50% 1-2 years 1.00% each additional year 1.00% Adjusting for risk weighting Banks and FIs 20% All others 100% 4 Interest Rate Swaps and Forward Rate Agreements ICICI Securities Ltd.

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THE JOURNEY OF SWAP CONTRACT 1. At the time of initiation of swap the Present value of all future cash flows (both fixed and floating) are equal. 2. Due to dynamic nature of interest rates there is change in the benchmark rate to which the floating leg payment rests. As the benchmark rate changes the floating rate payments also undergoes a change. 3. Now with the change in benchmark interest rates the Present value of all future cash flows also undergoes a change. 4. 5. The spot rate also undergoes a change. With change in benchmark interest rates the value of swap also changes after initiation, which can be found out by arriving at by discounted future cash flows by changed spot rates to arrive at the present value (PV). 6. The difference of the PV will give the value of swap or the market value of swap.

There are three different aspects to be understood in an IRS deal. i. Pricing of interest rate swap. ii. Valuation of interest rate swap and iii. Impact of interest rate changes in the portfolio.

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Pricing:In a fixed` floating interest rate swap, one party agrees to make a series of fixed payments and receive a series of floating or variable payments. Thus the goal of swap pricing is to determine the fixed interest rate that makes the present value of fixed payments equal to the present value of the floating receipts. At its origination the theoretically correct swap price will create a swap with zero value. The pricing of interest rate swaps will depend on the price of a package of forward contracts with the same settlement dates in which the underlying for the forward contract is the same reference rate. The pricing of swap will depend upon the fixed rate and the forward interest rate as on date on the basis of which we will arrive at the floating rate payments. The pricing will be done on the basis in which the PV of both the legs (fixed and floating) is equal at the time of initiation. At the time of initiation of swap: Expected fixed payment PV = Expected floating payment PV

Valuation:Interest rate being dynamic in nature will change after swap initiation. Valuing swaps after they have been originated is important for many related reasons. First the organizations wish to know their current financial position by estimating the true value of their assets and liabilities. Secondly, firms wishes to know the default risk they face. If a swap has become a net asset for them they will become more concerned about the ability

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of the counter party to make the payments. Thirdly swaps are marked to market. This requires valuing of swap after they have been originated. After the initiation of swap deal there is always a change in interest rates and as such the spot and the corresponding forward rate also undergo a change.

Thus there is a difference in future forward rates estimated at the initiation of swap and the current forward rates. In a Fixed Floating swap the fixed coupons for the tenure of swap is known at the time of origination and the first floating cash flow is known, but the remaining cash flows are unknown. With a change in interest rates the future floating cash flows also undergoes a change. The detailed calculation is placed in Annexure- B

Value of swap (Short position) = PV of remaining Fixed cash flows remaining floating cash flows.

PV of

Value of swap (Long position) = PV of remaining floating cash flows - PV of remaining fixed cash flows.

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Approaches to Interest Rate Risk:-

Two approaches to IRR are:1. 2. Earning approach. Economic value approach.

Earnings approach: - The earnings approach otherwise known as accounting approach. The main focus of the approach is on the impact of interest rate changes on Net Interest Income. NII is an important top line performance indicator of a bank and is computed as under:-

NII = Interest Income - Interest Expenses.

NII in monetary terms can be expressed as a percentage in the form of Net Interest Margin (NIM) and impact of interest rate change can be analysed on NIM. The earnings approach concentrates on accrual income proxies of NII and has a short term focus as the analysis of interest rate impact is restricted to maximum of a year as the accounting cycle has a period of one year.

As the derivative portfolio of bank mainly includes Interest Rate Swaps (IRS). NII approach to assess the impact of interest rate changes on IRS include bucketing of notional principal amounts according to time to repricing. IRS could be considered as a combination of a short position and long position. The notional of the fixed and floating

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leg of an interest rate swap could be shown in the respective maturity bucket based on the maturity date for the fixed leg and the reset date for the floating leg. e.g. Suppose bank receives 5 year fixed rate of 5% and pays MIBOR on a notional principal of 10 lacs, then the fixed leg of swap could be shown on asset side as positive in the 5-7 year bucket and the floating leg would be shown as a negative in <1month bucket. The gap in the respective bucket can be measured and the interest rate sensitivity can be measured.

Economic value approach (EVE): - Earnings approach of IRR has a short term focus and covers only a shorter period with a max of one year whereas the Economic value approach considers the long term impact of interest rate changes by covering the entire life.

EVE = Economic value of assets - Economic value of liability.

This approach calls for the valuation of each rate sensitive asset and liability to arrive at EVE. The approach to the valuation includes estimating the present value of future cash flows. This approach recognizes the fact that changes in interest rates not only affect the NII but also the economic value also which in turn is reflected in the value of equity.

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III. METHODOLOGY : PERSPECTIVES IN IRS PRICING AND MODELLING - CASE STUDIES : CASE 1 Bank A is a fixed rate receiver for INR 5 crores for a period of one week at 10% and Bank B is a receiver of floating rate linked to the Overnight index. The NSE Mibor rates for the seven days are taken and settled at the end of the swap period. At the end of the period of one week, i.e., the 8th day, Bank B will have to pay to Bank A Rs. 95890/(being interest on Rs. 5 crores for 7 days at 10%) and has to receive from A Rs. 97508/-. The payments are netted and the only payment that takes place is a payment by A of Rs. 1,608 (97508 95890) to B.

NSE Mibor Index 1st day 2nd day 3rd day 4th day 5 & 6 day 7th day 10.25% 10.00% 9.75% 10.125% 10.25% 10.50%

Notional Principal Amount 50000000 50014041 50027743 50041107 50054988 50083101 50097508

Interest for One day 14041 13702 13363 13881 28113 14407

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CASE 2: VALUATION OF AN OIS (OVERNIGHT INDEX SWAP) A swap can be decomposed into two parts - Accrual and Mark-to Market (MTM). Accrual refers to the difference between the interests payments on both legs from the start date till the valuation date. MTM value of a swap would be the replacement value of an existing swap on the valuation date. A swap can be decomposed into two parts Accrual and Mark-to Market (MTM). Accrual refers to the difference between the interests payments on both legs from the start date till the valuation date. MTM value of a swap would be the replacement value of an existing swap on the valuation date. Assume the actual call money rates as below.

Day Monday Tuesday Wednesday Thursday Friday Saturday & Sunday

MIBOR 10.25% 11.00% 10.70% 10.00% 9.50% 9.75%

Fixed Rate 10.50% 10.50% 10.50% 10.50% 10.50% 10.50%

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If a Bank has entered into an OIS wherein it receive a fixed rate of 10.50% (and pays the floating rate, i.e., MIBOR) for 6 months, then the valuation at the end of the week would be done as follows. The bank would have received interest (notionally) at the fixed rate of 10.50% p.a. for the past week. Thus, it would have an accrued interest receivable of Rs 25, 00, 00,000*0.1050*7/365= 5, 03,424.66 As far as the payment of the floating interest is concerned, the notional interest payable will be equal to ((1+r1/365)*(1+r2/365)1+r6*2/365)-1)*365= Rs 4, 86,345.90. The rates r1, r2, etc. are the daily MIBOR rates. A key point to be noted is that the interest payable on the floating side here is compounded daily, as the floating benchmark is overnight MIBOR. Similarly, for other floating benchmarks, the compounding frequency will vary. As a market convention, the interest payable for Sunday or a holiday is taken to be the same as the previous working day (in this case, Saturday). In other words, the interest is obtained through simple interest calculation across holidays and not on daily compounded basis. Thus, the principal for calculation of interest payment applicable to a non-working day (Sunday) is the same as the previous working day.

Netting the notional payments from the notional receipts, i.e. the fixed interest accrued less floating interest payable, the accrued profit works out to Rs 17,078.76 (Rs 5, 03,424.66 less Rs 4, 86,345.90).

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Now for MTM purpose, the bank has to check quotes for a 173-day tenure contract, which is the residual maturity of the swap. If the quotes available are 10.00%/10.25%p.a., the bank has the option to pay 10.25%p.a. fixed rate (and receive MIBOR) and unwind the existing swap. This way the bank may lock-in to a profit, irrespective of movements in the overnight rate from then till maturity of the swap. The MTM value then is derived as follows: On a notional principal of Rs 25 crore, the bank pays interest under the new contract of Rs 25,00,00,000*0.1025*173/365= Rs 1,21,45,547.95. On the earlier contract, the bank continues to receive at the rate of 10.50% p.a., which for the next 173 days equals Rs 1, 24, 41,780.83. Thus, the bank will have a net gain of Rs 2, 96,232.88, which is termed as the Mark to Market (MTM) gain. Actually, the MTM gain will be a tad lower than this. This is because of the different notional principals on which the bank receives (new contract) and pays MIBOR (old contract). Under the new contract, while it receives MIBOR for the next 173 days on a principal of Rs 25 crore, under the old contract, it pays MIBOR for the residual 173 days effectively on a higher principal, because of continuous compounding done over the first seven days.

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FORMULAES USED FOR CALULATION OF SWAP PRICE, VALUATION (MTM) AND HEDGE EFFECTIVENESS:

Calculation of ZERO COUPON Curve: Description The bond curve is made using the standard bootstrapping technique. As the market does not quote bonds with all standard maturities needed to build the par yield curve directly, the iterative bootstrapping technique is used to derive the zero coupon rates progressively. At each step, the zero coupon rates to the maturity date of the bonds are calculated. Then the zero coupon rates are interpolated to the other cash flow dates. Bond theoretical price The theoretical price (that is, the net present value) of a bond i am calculated using the curve as follows:

is the cash flow paid by bond i at time where:

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is the discount function. is the number of cash flows paid by bond i. is the settlement date of bond i. is the value date of bond i.

Then the Adjusted bootstrapping is calculated as follows

Compound interest form

Once the discount curve is calculated, then the zero coupons curve can be derived by first determining the discount factor and then using the result as follows:

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In above expression, the zero coupon rate is expressed on an annual bond equivalent basis. Solving the previous equation, the zero coupon rate is:

Exponential form Another way to link the zero coupon curve to the discount curve is to use the exponential form as follows:

From this equation, the zero coupon rate is a function of the discount rate, as follows:

For determining the values between two dates Linear method of Interpolation is used Linear Interpolation Point on zero coupon curve Linear interpolation of point C on the zero coupon curve is done as follows:

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Exponential form Using the exponential form of the discount curve, the preceding equation can be expressed using the discount factor on points A and B. Solving the previous equation for the time interval, y, and results in:

Discount factors Then substituting y in the first equation, the discount factor at point C is:

or:

This equation can be rewritten using the discount factors for A and B:

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or:

NET PRESENT VALUE:

Where NPV is Net Present Value Values are Income or Payment Rate is Rate of Discount over the length of one period and n is No. of Cash Flows

DURATION: N D=n=1 P Where C is the bond cash flow at time n n Cn (1 + r) n

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r is Yield to Maturity P is the Present Value.

MDURATION:

PRICE:

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- 45 - -

YIELD:

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IV. CONCLUSIONS:
This paper examines recently developed class of models to price interest rate swaps, the so-called model plain vanilla interest rates swaps. This class of models has several advantages over the traditional approach. (a)These models are based directly on observable market rates, such as Mibor rates and swap rates, instead of instantaneous (forward) interest rates. (b) The models yield pricing formulas for caplets or swaptions that correspond to the Black pricing formulas that are used in practice. (c ) As a consequence, these models can easily be calibrated to market prices of caps or swaptions.

V. OBSERVATIONS & RECOMMENDATIONS:

(a) There is heterogeneity seen across banks. In India, banks holding similar portfolios of government securities seem to have rather different interest rate risk exposures. This suggests that the RBIs investment fluctuation reserve, which is computed as a fraction of the investment portfolio without regard for the extent to which risk is hedged,is an unsatisfactory approach to addressing interest rate risk. (b) As a result of the above many banks have twisted RBI regulations to sell leveraged products to corporate clients This has resulted in a situation where corporates have taken currency bets where the amount at stake is a few multiples of the actual underlying. Say, an exporter eager to protect its income has cut a deal where an adverse movement in the euro or dollar could expose it to an amount which may be twice or thrice its export

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income. Companies have entered into such deals since the exchange rate the bank offers is more attractive than in a plain vanilla forward contract.

( c ) India already has interest rate swaps and over-the-counter forwards and options for currency trading but needs more hedging tools as the country integrates more with the global economy and because it has moved to more market-driven interest rates. The Reserve Bank of India (RBI) expects the broad framework for currency futures trading to be finalised by the end of May and senior dealers say trading could start within the year. (d) More liberalized norms for IRS ( borrowing in fixed Rate basis ) and Exchanges the periodical interest payments be on floating rate terms be made available to the Banks .

VI. REFERENCES:

1.

Flavell Richard -Swaps and Other Derivates-, John Wiley & Sons Ltd, 2002, Wiley Finance Series.

2.

Choudhury Moorad- Bond Market Securities-, Pearson Education Ltd, 2001, Financial Times Prentice Hall Professional Finance Series.

3.

Choudhury Moorad - Analyzing & Interpreting the YIELD CURVE-, John Wiley & Sons (Asia) Pte Ltd, 2004, Wiley Finance Series.

4.

McDougall Alan - Mastering Swaps Markets A step-by-step guide to products, applications and risks-, Pearson Education Ltd, 2000, Financial Times Prentice Hall Market Editions.

5.

Eales Brian - Financial Engineering-, MACMILLAN PRESS LTD 2000, MACMILLAN Business Series

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6.

Hull John C. - Options, Futures and Other Derivatives-, Fifth Edition Pearson Education Inc, 2003, Prentice Hall Finance Series

7.

Marshall J.F. and Kapner K.R- Understanding Swaps-, John Wiley & Sons Ltd, 1999, Wiley Finance Series.

8.

De Lurgio Stephen A.- Forecasting Principles and Applications- Tata Mc Graw Hill, 1998

9.

Levine, Krehbiel, Berenson- Business Statistics A First Course, 3rd Edition Pearson Education Ltd, 2003

10.

Hank John E, Wichern Dean W., Reitsch Arthur G.- Business Forecasting 7th Edition Pearson Education Ltd, 2002

Journals and Publications 1. 2. 3. Overnight Indexed Swap Rates- Reserve Bank of Australia Bulletin- June 2002. Financial Markets- Banque DeFrance Bulletin Digest No. 136 April 2005 The determinants of the Overnight interest rate in the Euro area by J. Moschitz, September 2004- European Central Working Paper Series 393 4. Inferring market interest rate expectations from money market rates by Martin Brooke of the Banks Gilt-edge and Money Markets Division, and Neil Cooper and Cedric Scholtes of the Banks Monetary Instruments and Markets Division- Bank of England, 2002 5. Estimating a bank liability forward curve using the Banks VRP curve-fitting technique by Anderson and Sleath- Bank of England, 1999.

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6. 7.

Fixed Income Derivatives in India- Citibank 2005 Fixed income derivatives for India by Vijayan Subramani and Ananth Narayan G.

8.

Fiscal policy Events and Interest rate Swap spreads:Evidence From the EU- By Antnio Afonso and Rolf Strauch working paper series No. 303 / february 2004 European central bank

9.

Product Training Module VII Swaps Morgan Stanley Master circulars and notifications:

1.

FIMCIR/2005-06/69, March 28, 2006- Valuation of Investments as on 31st March 2006- FIXED INCOME MONEY MARKET AND DERIVATIVES ASSOCIATION OF INDIA

2.

Circular MPD BC. 187/07.01.279- Usage of Fixed Income Derivatives by banksFIs/PDs Reserve Bank of India.

3.

Handbook of Market Practices- January 2003 FIXED INCOME MONEY MARKET AND DERIVATIVES ASSOCIATION OF INDIA

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ANNEXURE I: Vanilla Interest Rate Swaps Swap Details value (settlement) date maturity date effective date first payment date - fixed leg next to last payment date - fixed leg first payment date - floating leg next to last payment date - floating leg notional principal 5-Oct-2005 9-Sep-2009 9-Nov-2005

1,000,000

swap structure exchange of principal interpolation method Fixed Leg Details coupon cash flow frequency accrual method business day convention cash flow type Floating Leg Details margin above or below a floating rate scale factor for forward rates cash flow frequency accrual method business day convention accrual method for reset rates # bus days prior to reset date that rate is fixed first reset rate second reset rate

2 2 1

2.500% 2 4 4 1

0.000% 100.000% 2 2 4 2 4 1.350%

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Results market price accrued interest clean price (excludes accrued) par swap rate par spread basis point value modified duration (bond equivalent) convexity (bond equivalent) par spread (dirty price) DV01 swap 150,932.20 0.00 150,932.20 7.090% -4.593% 296.6995 3.5356 15.2667 -0.0459 296.3415 fixed leg 150,932.20 0.00 150,932.20 7.090% -4.593% 296.6995 3.6285 15.3208 -0.0459 296.3415 floating leg 0.00 0.00 0.00 7.090% -4.593% 0.0000 0.0929 0.0541 -0.0459 0.0000

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