Interest Rate Derivatives

An interest rate derivative (IRD) is an agreement to exchange payments based on

different rates over a
specified period of time. In its most common form, the single currency interest rate
swap, parties agree to exchange payments periodically based on a fixed interest
rate agreed upon at the outset of the transaction and a floating interest rate based
on a specified reference index. The floating rate reset dates and the payment
intervals for the contract are also determined at the outset. The notional amount of
the contract is used only to calculate the periodic payments due between parties
and is not exchanged.

Fixed payment
Receiver
Payer

Floating Payment

Following are the product categories:

Basis Swap(Floating v/s Floating):

A swap in which periodic payments are exchanged based on two floating rate
indices, both denominated in the same currency.

Overnight Indexed Swap:

A swap where the floating rate reference index is the overnight interbank rate
and the fixed rate is agreed between the parties. Typically, one net cash flow
is exchanged between the parties at maturity.

Single Currency Interest Rate swap(IRS):

Forward rate agreement (FRA):

A swap in which periodic payments are exchanged based on a fixed rate that
is agreed upon at execution and a specified floating rate index.
A swap that starts at a future specified date, generally with one exchange of
payments on the start date based on the present value of the difference
between the agreed fixed rate and the observed floating rate on that day.

Within product types, OTC interest rate derivatives can be customized to suit the
needs of customers.

Following are common contract features that can be customized:

Tenor:
The time between the start date and maturity date of the swap contract. Swap
tenors can
range from a few days to many years in length. We refer to the tenor as the accrual
tenor
in our analysis to distinguish it from forward or option tenors.
Forward start:
A transaction has a forward start if it has an effective date that is weeks, months or
years after trade execution. Throughout the paper, we will refer to the forward tenor
as the length of time between trade execution and effective date.
Floating rate reset dates:
The dates at which the floating rate reference indices are observed in order to
determine the floating rate payment amount. These are generally every three or six
months for swaps.
Payment frequency:
The frequency of payments for the fixed and floating rates is specified at the
execution of the contract. For swaps where payment dates occur less frequently
than floating rate reset dates, the floating interest rate may be compounded until
the next payment date.
Break dates:
Set dates at which parties can terminate IRD contracts at current market value. This
is typically used as a mechanism for parties to mitigate counterparty risk associated
with accumulated mark-to-market bal
ances on long-dated swaps.

For more information on Interest rate Swap (same currency) FIxed floating and
Floating Floating please refer to the link below:
http://en.wikipedia.org/wiki/Interest_rate_swap

Overnight Indexed Swap

Overnight Index Swaps are instruments that allow financial institutions to swap the
interest rates they are paying without having to refinance or change the terms of
their existing loan. Typically, when two financial institutions create an overnight
index swap, one of the institutions is swapping an overnight (floating) interest rate
and the other institution is swapping a fixed short-term interest rate.
For instance; assume there are two companies Company A, which has a $10
million loan where interest is linked to overnight rates and company B has a $10

million loan, on which it pays a fixed rate of interest. Now suppose Company A
expects overnight rates to remain soft and Company B wants the assurance of a
fixed rate. In this case, these two institutions could create an overnight index swap
with each other.
To get the swap rolling, both the firms would agree to continue servicing their loans,
but at the end of a specified time period whoever ends up paying less interest
will make up the difference to the other firm. For example, if company A ends up
paying an average interest rate of 1.5% on its loan and company B ends up paying
an interest rate of 2%, then company A will pay company B the equivalent of 0.3%
(2.0-1.5 = 0.5) because, according to their agreement, they swapped interest rates.
Of course, if company A ends up paying an average interest rate of 2.4% on its loan
and company B ends up paying an interest rate of 2%, company B will pay company
A the equivalent of 0.2% (2.4- 2.0 = 0.4) because of the swap contract.

Forward Rate Agreement

Basics

A Forward Rate Agreement (FRA) is an agreement between two parties that

determines the forward interest rate that will apply to an agreed notional principal
(loan or deposit amount) for a specified period. FRAs are basically OTC equivalents
of exchange traded short date interest rate futures, customized to meet specific
requirements. FRAs are used more frequently by banks, for applications such as
hedging their interest rate exposures, which arise from mis-matches in their money
market books. FRAs are also used widely for speculative activities.
Characteristics of FRAs

Achieves the same purpose as a forward-to-forward agreement

An off-balance sheet product as there is no exchange of principal

No transaction costs

Basically allows forward fixing of interest rates on money market transactions

Largest market in US dollars, pound sterling, euro, swiss francs, yen

BBA (British Bankers Association) terms and conditions have become the
industry standard

FRA is a credit instrument (same conditions that would apply in the case of a
non-performing loan) although the credit risk is limited to the compensation
amount only

Transactions done on phone (taped) or telex

No initial or variation margins, no central clearing facility

Transaction can be closed at any stage by entering into a new and opposing
FRA at a new price

Can be tailor made to meet precise requirements

Available in currencies where there are no financial futures

An Example
A corporate with a $10 million floating rate exposure with rollovers to be fixed by
reference to the 6-month USD LIBOR rate expects the short-term interest rates to
increase. The next rollover date is due in 2 months. The corporate calls his banker
and asks for a 2-8 USD FRA quote (6 month LIBOR 2 months hence). The bank
quotes a rate 6.68 and 6.71 (see FRA table below). The customer locks the offered
ra
te 6.71 (borrows at a higher rate).
Calculations
If the 6-month LIBOR 2 months from now rises by 100 basis points to 7.71 the bank pays the corporate
according to the BBA formula
(L-R) or (R-L) x D x A
[(B x 100) + (D x L)]
where: L = Settlement rate (LIBOR)

R = Contract reference rate

D = Days in the contract period
A = Notional principal amount
B = Day basis (360 or 365)
Note: Choose (L-R) or (R-L) so that the difference is positive
Therefore the bank would pay the corporate
(7.71 6.71) x 181 x $10 million = $48,401.53
[(360 x 100) + (181 x 7.71)]
If interest rates had fallen by 100 basis points the corporate would have to compensate the bank by an
equivalent amount

The result from this formula can also be obtained intuitively as follows:
The interest gain from entering the FRA is calculated as
1% x $10million x 181/360 = $50,277.78
The present value of $50,277.78 for a 6-month period discounted by the
Settlement Rate (LIBOR) is:
$50,277.78 / {1+[7.71% x 181/360]} = $48,401.53
The (D x L) factor in the denominator of the BBA formula is the present value of the compensation at the settl

ement rate. The compensation amount in the above example is therefore discounted at 7.71 for the six-month
period. This reflects the fact that the FRA payment is received at the beginning of the period (settlement date)
and the party is therefore in a position to earn interest on it. The 6-month loan payment however is
payable at the end of the period.

British Bankers Associations recommended terms

The BBA set up standards for FRA agreements, known as BBAFRA terms, to provide recommended terms and
conditions for FRA contracts to provide guidance on market practice. Banks not dealing on BBA terms have to
make it clear to the counterparty that the FRA is not governed by these terms.
FRA TERMINOLOGY
FRA

FRA Forward Rate Agreement

Forward/Contract rate

The forward rate of interest for the

Contract Period as agreed between the
parties

BBA Designated Banks

means the panel of not less than 12 banks

designated from time to time by the BBA
for the purpose of establishing the BBA

Interest Settlement Rate.

BBA Interest Settlement
Rate

The rate quoted by specified reference

banks for the relevant period and
currency.Most currencies LIBOR can be
taken as shown on LIBO or LIBOR01 on
Reuters or page 3750 on Telerate. For
AUD the corresponding Reuter page is
BBSW

Buyer (Borrower)

Party seeking to protect itself against a

future rise in interest rate.

Seller (Lender)

Party seeking to protect itself against a

future fall in interest rate.

Settlement Date

the date the contract period commences,

being the date on which the Settlement
Sum is paid.

Maturity Date

the date on which the contract period

ends.

Settlement Sum

as calculated by the BBA formula.

Fixing Date

the day that is two business days prior to

the Settlement Date except for pound
sterling for which the Fixing Date and
Settlement Date are the same.

Contract Amount

the notional principal on which the FRA is

based

Contract Currency

the currency on which the FRA is based.

Contract Period

the period from the Settlement Date to the

Maturity Date.

Broken Date

Contract Period of a different duration

from that used in the fixing of the BBA

Interest Settlement
Rate and any period
exceeding 1 year
Quotes
Prices of FRAs are quoted the same way as money market rates, i.e. as an annualized percentage. FRAs are
written as 3-6, 2.8, 4x10, 6vs9 etc. The first figure denotes the Settlement Date, the last figure the Maturity
Date, and the difference between the two figures is the Contract Period.
FRAs are sometimes quoted as "offer-bid" rates, the same method of quoting followed by money market rates.
The buyer of the FRA therefore gets the higher rate or the market makers offered rate since the buyer is a
potential borrower. Likewise, the seller or depositor gets the lower rate or the bid rate.
The main Contract Periods traded are 3 months and 6 months although 12-month periods are gaining
popularity. Broken date prices are also available though the spreads maybe wider and may take longer to
obtain. Contract periods less than 3 months are difficult to obtain due to the nature of FRA trading (slim profit
margins make it uneconomical).
Value dates for FRAs follow the dates applicable to money markets (called "straight dates"). Trading lots are
usually good for 5 million units of the currency (yen excepted).
Settlement
The compensating amount reflects the difference between the actual/Settlement Rate for the period
and the Contract Rate. The Settlement Rate, according to the BBA definition, is the rate calculated by taking
the rates quoted by eight BBA Designated Banks as being in their view the offered rate at which deposits in th
e Contract Currency for such Contract Period are being quoted to prime banks in the London interbank market
at 11.00 a.m. on the relevant Fixing Date for Settlement Date value. The two highest and the two lowest rates
are eliminated and the remaining of the four rates are averaged and then rounded upwards to five decimal
places.
In the event that the Settlement Rate is higher than the Contract Rate the borrower would receive payment
from the seller. Conversely, the depositor would receive the compensating amount if the interest rates fall.
Settlement of the compensating amount takes place at the beginning of the FRA. The first date of the Contract
Period is defined as the Settlement Date. Euro FRAs rates are fixed two days ahead of the Settlement Date.
As the payment is an upfront payment the Compensating Amount is a discounted amount. The actual/disco
unt rate used to calculate the Compensating Amount is taken as LIBOR or the offer rate of the money
market quote. For market makers (usually banks) who expect to deposit at the offer rate and buyers of FRAs
this method of discounting is not a problem. Sellers of the FRA will be disadvantaged if they place their
deposits on the bid side of the quote and therefore will not be hedged at the Contract Rate. Their effective
hedge will be lower by the spread between the quotes (usually 1/8%).
Application.
Hedging future interest rate exposure is the predominant use of a FRA. Banks hedge their money market mismatches and corporates for future borrowings/deposits. Arbitrage between FRAs and short-term interest rate
futures provide a good opportunity to banks. These short-term futures contracts provide a good source of
hedging for FRA market makers.
Arbitrage between FRAs and forward-forward rates in the cash markets may
be theoretically possible but rarely seen in practice. Speculation in FRAs is attractive, as there are no
transaction fees involved. This type of activity is usually confined to banks
FRA Conclusion
There are many variations to the traditional FRAs and are gaining popularity. These include

"Strip" FRAs or a combination of FRAs to lock a series of interest rates reset periods.

A synthetic FRA in a foreign currency by combining FRAs in one currency and FX Forwards in the
other

Forward Spread Agreements (FSAs) are essentially used to lock the interest rate differentials between
two currencies. This type of transaction is entered between two parties who wish to hedge themselves against
future changes in the LIBOR for two currencies one of which being the USD.
FRAs can be priced off forward to forward interest rates. These forward to forward rates can be obtained from
the cash market yield curve or by the implied forward rates available from the interest rate futures market in the
relevant currency.
Banks have recently started to quote FRA prices in the Indian currency. Forward rates can be constructed from
securities of different maturities. FRAs in rupee can be synthetically created using the USD FRA in conjunction
with rupee forwards in the foreign exchange markets or rupee interest rate swaps against MIBOR. However,
forward rates in the foreign exchange markets are liquid upto 12 months only.
For example, suppose an Indian corporate is to issue a 6-month commercial paper. The current 3-month CP
rates are 10.80 and the 6-month rates are 11.50. The corporate is of the view that the 6-month rates are high
and is of the view that the rates should fall in the near term. The corporate could then sell a 3x6 FRA. If the
rates do fall the corporate would receive the compensating amount from his bank therefore reducing his
borrowing cost. Alternatively the corporate could issue a 3-month CP at 10.80%, lock in the 3x6 FRA rate, and
issue another 3-month CP after 3 months (this strategy assumes the CP issuance costs involved are
negligible). The Indian bank in turn could hedge his exposure in the forward markets by paying (borrowing)
6-month forward and receiving (lending) 3-month forward. Typical trading lot size would be 10 crores although
5 crores may be acceptable.
USD

EUR

JPY

1x4

6.73

6.76

5.1650

5.1950

0.53

0.57

2x5

6.69

6.72

5.13

5.15

0.47

0.51

3x6

6.63

6.66

5.12

5.15

0.46

0.50

4x7

6.65

6.68

5.14

5.18

0.47

0.51

5x8

6.58

6.61

5.15

5.19

0.47

0.51

6x9

6.52

6.55

5.16

5.19

0.48

0.52

6x12

6.55

6.57

5.21

5.23

0.54

0.58

References
http://www.moneycontrol.com/news_html_files/news_attachment/2010/Forward_Rat
e_Agreement.pdf
http://articles.economictimes.indiatimes.com/2010-0928/news/27621091_1_interest-rate-overnight-indexed-swap-loan

en.wikipedia.org/wiki/Interest_rate_swap