Description
It describes Presentation on Interest Rate (IRS) and Forward Rate Agreements (FRA). It also talks about the Indian perspective in these topics
IRS AND FRA
Agenda
? Introduction to Swaps ? Interest Rate Swaps (IRS)
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Types ? Valuation ? Uses IRS in India Forward Rate Agreements (FRAs): ? Working and Settlement ? Valuation FRAs in India Issues related to IRS and FRA in India References
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Introduction to Swaps
? Today, in almost every country, business environments are exposed to a
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? ? ?
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high degree of risks in the form of currency risk, credit risk, interest rate risk, etc Derivatives have emerged as the most actively used interest-rate risk management tool over the last two decades, both for corporates, banks and financial institutions. Mainly, the derivative market includes - futures, options and financial swaps. Usually, swapping refers to the simultaneous purchase and sale of assets, mainly foreign currencies, for different maturities. More definitively, swaps are regarded as the exchange of a stream of future cash flows among two or more parties at mutually agreed upon terms and conditions. The swap market is standardized by the International Swaps and Derivatives Association (ISDA). However, in India following ISDA standards is not compulsory as long as the RBI guidelines wrt IRS are met with.
Common terms associated with Swaps
? The tenor is the term of the swap. ? The notional value determines the size of the interest rate payments. ? The swap facilitator will find a counterparty to a desired swap for a fee
or take the other side: ? A facilitator acting as an agent is a swap broker. ? A swap facilitator taking the other side is a swap dealer (swap bank).
? Swaps can be of the following types:
? ? ? ? ?
Interest rate swaps Foreign currency swaps Commodity Swaps Equity Swaps Credit default swaps
Interest Rate Swaps
? An interest rate swap is an agreement between two parties to exchange
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interest payments for a specific maturity on a specified “notional” principal amount. i.e. there is no exchange of principal. The interest payments may be fixed or floating, depending on the terms of the agreement. Parties to the agreement may be a fixed rate payer/receiver and floating rate receiver/payer. The primary motives behind the interest rate swaps are comparative advantage of lowering the costs of borrowing and overcoming asset liability mismatch. These swaps are sold by dealers in large banks to FIs and other corporations that seek to hedge interest rate risk.
Interest Rate Swaps
? The 1st IRS occurred between IBM and the World Bank in 1981. ? In 1987, ISDA reported that the swaps market had a total notional value of
$865.6 billion. ? By 30th June 2009, this figure exceeded $ 414 trillion, according to the Bank for International Settlements (BIS).
An Example of IRS
? Consider a bank that makes a $1 million, five-year loan at a fixed 8 %
interest rate, where the borrower is required to make semi-annual payments of ½*(.08)*($1 m) = $40,000 and repay the $1 m principal at maturity. The bank finances this loan by issuing $1 million of sixmonth maturity CDs. ? These transactions expose the bank to interest rate risk. If the sixmonth market interest rates rise above 8 %, the bank?s interest payments on its CDs will exceed its 8 % loan interest payments. ? The unhedged Bank Balance Sheet will look like:
Bank Balance Sheet Assets Liabilities Fixed-Rate 5 year Loan Six-Month CDs (Long Duration) (Short Duration)
An Example of IRS
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The bank can hedge this interest rate exposure by becoming a fixed-rate payer in a five-year interest rate swap contract. The swap agreement will require the bank to pay semi-annual interest at a 7 % annual rate on a notional principal of $1 m. ? In return, the bank receives semi-annual six-month LIBOR payments. With this swap, the bank?s on and off-balance sheet assets and liabilities now look like:
Bank Balance Sheet Assets Fixed-Rate 5 year Loan (Long Duration) Liabilities Six-Month CDs (Short Duration)
Off-Balance Sheet (Swap) Assets Liabilities LIBOR Swap Payments Fixed-Rate Swap Payments (Short Duration) (Long Duration)
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Because six-month LIBOR will move with the interest rate that the bank pays on its CDs, the LIBOR swap payments will cover the bank?s required CD interest payments. The net result is that the duration of on- and off- balance sheet assets are equal to the duration of on-and off-balance sheet liabilities.
Plain Vanilla Interest Rate Swap
? It is the most basic type of IRS. ? With plain vanilla interest rate swaps, two parties facing different types of ? ?
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interest rate risk can exchange interest payments. One exchanges a fixed-rate payment for a floating rate payment and the other party exchanges a floating rate payment for a fixed-rate payment. The fixed or floating rate is multiplied by a notional principal amount. This notional amount is generally not exchanged between the parties, but is used only for calculating the size of cash flows to be exchanged. When interest rates change, the party that benefits from a swap receives a net cash payment while the party that loses makes a net cash payment. ? Only the net payment is made (difference check) ? The firm paying the floating rate is the swap seller ? The firm paying the fixed rate is the swap buyer Typically, the floating interest rate is linked to a market rate such as LIBOR or T-bill rates.
Example: Plain Vanilla IRS
Example: Plain Vanilla IRS
? A pays fixed rate to B (A receives variable rate). ? B pays variable rate to A (B receives fixed rate). ? Consider the following swap in which Party A agrees to pay Party B periodic
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fixed interest rate payments of 8.65%, in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%). There is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. The interest payments are settled in net (e.g. Party A pays (8.65%(LIBOR+0.70%)). The fixed rate (8.65% in this example) is referred to as the swap rate. At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.
Floating-for-Floating IRS
? Both the counter-parties exchange interest amounts based on two
different floating reference rates, through the life of the swap. ? Party A pays/receives floating interest indexed to X to receive/pay floating rate indexed to Y on a notional N for a tenure of T years. For example, A pays JPY 1M LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years. Example: ? If a company has a floating rate loan at JPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and wants to insulate from this risk, they can enter into a float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps.
Floating-for-floating Rate Swap
? With this, they have effectively locked in a 35 bps profit
instead of running with a current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current rate difference) comes from the swap cost which includes the market expectations of the future rate difference between these two indices and the bid/offer spread which is the swap commission for the swap dealer. ? Used to hedge against or speculate on the spread between the two indexes widening or narrowing.
Fixed-for-fixed Interest Rate Swap
? Fixed-for-fixed swaps happens only between two different currencies. ? A single-currency fixed-for-fixed rate swap is generally not possible;
as the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams. ? Toyota pays fixed interest in Yen to receive fixed rate in dollars for a term of 10 years. ? It pays JPY 2% on a JPY notional of 1.2 billion and receives USD 6% on the USD equivalent notional of 10 million at an initial exchange rate of USD:JPY 120.
Valuation of IRS
1. BOND PRICING METHOD:
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Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond. A floating (fixed) rate payer in an n-year interest rate swap has a long (short) position in an n-year fixed-coupon bond and a short (long) position in an n-year floating-coupon bond.
Example: ? Consider a company which is a floating rate payer (fixed rate receiver) in a $5 m. 10-year swap tied to 6-month LIBOR and having a fixedrate of 6 %. ? Thus, the value of this swap is the difference between a $5 m., 10-year coupon bond with an annual coupon rate of 6% less a $5m., 10-year floating rate bond tied to six-month LIBOR.
Valuation of IRS
? The value of the fixed-rate component of the swap, PVfx, is simply the
present value of an n-year fixed-coupon bond.
? The value of the floating rate component of the swap, PVfl , is equal to
the par value of a floating-rate bond at the coupon reset date.
? Hence, the value of the swap to the floating rate payer (fixed rate
receiver) is equal to the difference between the fixed rate component and the floating rate component.(PVfx – PVfl)
2. FRA PRICING:
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They can be valued as a portfolio of forward rate agreements (FRAs). Each exchange of payments in an interest rate swap is an FRA The FRAs can be valued on the assumption that today?s forward rates are realized
Uses of IRS
? Swaps were originally created to allow multi-national companies to
evade exchange controls. HEDGING ? IRS are often used by firms to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line with management's appetite for interest rate risk. ARBITRAGE: ? Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential (QSD) which allows both parties to benefit from an interest rate swap. ? QSD arises during an IRS due to the difference in the levels of interest rate obligations for the debt of the parties.
Uses of IRS
SPECULATION: ? Used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. ? Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap (as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.)
LIBOR/SWAP ZERO RATE: ? Since LIBOR only has maturities out to 12 months, and since interest rate swaps often use LIBOR as the reference rate, interest rate swaps can be used as a proxy to extend the LIBOR yield curve out past 12 months.
IRS in India
? In the wake of deregulation of interest rates as part of financial sector reforms, ? ?
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a need was felt to introduce hedging instruments to manage interest rate risk. The Reserve Bank had introduced interest rate swaps (IRS) and forward rate agreements (FRA) in March 1999. The Reserve Bank issued comprehensive guidelines in respect of interest rate derivatives (IRDs) in April 2007, incorporating the broad regulatory framework for undertaking derivative transactions. In respect of OTC derivative transactions, it became necessary to have a mechanism for transparent capturing and dissemination of trade information as well as an efficient post-trade processing infrastructure to address some of the attendant risks. In this context, CCIL was advised to start a trade reporting platform for rupee interest rate swaps (IRS) and Forward rate Agreements(FRAs). The reporting platform became operational on August 30, 2007. Banks and primary dealers (PDs) have started reporting the IRS and FRAs on the platform on a daily basis.
IRS in India
? CCIL covers various instruments of IRS and FRA like – IRS Fixed Float and
Basis Swaps with maximum maturity of 10 years and FRAs with maximum maturity of 10 years. ? CCIL extends post-trade processing services like Interest Rate Reset, Tracking payment obligation of members on their outstanding contracts etc. and settlement on Non Guaranteed basis. ? Settlement of Cash Flows: A logical extension of the trade reporting facility is the settlement services offered by CCIL on non-guaranteed basis. CCIL has commenced multilateral settlement of cash flows arising from IRS/FRA trades on non-guaranteed basis effective from 27th November 2008. ? All Banks and Primary Dealers which are members of the Rupee Derivatives Segment are eligible to participate in the non-guaranteed settlement subject to completion of documentation formalities.
Recent IRS Events
? Dec. 4 -- India?s interest-rate swaps had the biggest weekly increase in more
than a year on speculation the central bank may raise borrowing costs in the coming months to curb inflationary pressures. ? The one-year swap rate rose 35.5 basis points since Nov. 27 to 4.87 percent, its biggest jump since August 2008. (As on 4th Dec)
FORWARD RATE AGREEMENTS (FRAs)
Forward Rate Agreements (FRAs)
? A Forward Rate Agreement (FRA) is an agreement between two
parties who agree on a fixed rate of interest to be paid/received on a fixed date in the future.
The interest exchange is based on the notional principal amount (the principal is not exchanged), and these contracts are settled in cash. ? There is no daily settlement or marking-to-market ? The parties to the contract may still be exposed to default risk on the amount owed at settlement. ? Cash settled on the basis of the difference between the contract rate and prevailing reference rate on the settlement date & resultant value is discounted to adjust for an upfront settlement ? FRAs are over the counter (OTC) products and are available for a variety of periods.
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FRA Terminology
Contract Amount: The notional size of the “theoretical” loan
Settlement Date: The starting date of the theoretical loan Fixing Date: The date at which the theoretical loan?s rate is set Maturity Date: The ending date of the theoretical loan Contract Period: Difference between maturity and settlement dates
Contract Rate: Fixed interest rate agreed by the parties
Reference Rate: Market interest rate for calculating settlement amount Settlement Amount: Proceeds of FRA paid to equalise interest for both
Working of FRA
? The two counterparties to an FRA agree to a notional principal
amount that serves as a reference figure in determining cash flows.
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Notional principal: The principal does not change hands, but is only used to calculate the value of interest payments.
? The interest rate on which the parties agree (known as FRA rate)
is the price of the FRA as it is quoted by the market.
? The parties agree to compare the fixed FRA rate to a reference
interest rate (e.g. LIBOR) two days before the defined interest period (fixing date). The reference rate/settlement rate is defined on fixing date.
Settlement of FRA
? The buyer of an FRA agrees to pay a fixed-rate coupon payment
(at the exercise/contract rate) and receive a floating-rate payment against a notional principal amount at a specified future date.
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The buyer of an FRA will receive (pay) cash when the actual interest rate at settlement is greater (less) than the exercise/contract rate (specified fixed-rate).
? The seller of an FRA agrees to make a floating-rate payment and
receive a fixed-rate payment against a notional principal amount at a specified future date.
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The seller of an FRA will receive (pay) cash when the actual interest rate at settlement is less (greater) than the exercise rate.
FRA: Characteristics
? An FRA is a product that provides the purchaser with interest
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rate protection against adverse rate movements by committing to a fixed rate for a future period. The FRA does not need to be based on a particular loan. FRAs can be used for any existing and expected future loans. FRA can be cancelled at any time. This may result in a profit or loss depending on the interest rates at the time of reversal. This product can be customised to suit specific amounts and dates . FRAs are suited to all customers who are exposed to interest rates moving in the short term and who wish to cover their exposure.
FRA: Characteristics
? FRAs can be used to lock in a future borrowing or lending
requirement (e.g. The need to borrow for 3 months in 2 months time or have an existing loan rolling over) ? The customer can use advantageous moves in interest rates to lock in borrowing costs (or return on deposits) prior to the loan or deposit becoming due. ? FRAs are quoted like interest rates, but the terminology used is buy or sell. ? If a borrower wants to protect against rates moving up he can buy an FRA. A depositor would want to protect against lower rates, so he would sell a FRA.
Timing Diagram for FRAs
Value day convention
Deferment period
Contract period
Dealing date
Contract rate agreed
Spot date
Fixing date
Reference rate determined
Settlement date
Settlement sum paid
Maturity date
Forward Rate Agreements (FRAs)
? The important thing to note is that there is no exchange of
principal amount ? One of the following two formulas is used for calculating settlement payment from the seller to the buyer (L>R) or buyer to seller (R>L)
P= (L - R) x DF x A [(B x 100) + (DF x L)] (R - L) x DF x A [(B x 100) + (DF x L)]
P=
? L: Settlement Rate R: Contract Rate A: Notional Principal ? DF: No.of Days in FRA period B: Day Count Basis
Example : A Typical FRA Deal
Bank A sells to Bank B a 3 X 6 FRA at 10% against floating 91 day Tbill rate. Notional principal Rs10 crore. – Bank A receives fixed rate (10%) for a 3 month period starting 3 months from trade date – Bank B receives floating rate for the same period. The floating rate would be the 91 day T-bill rate 3 months from trade date – Though the net amount is due on maturity (6 months from trade date), settlement is done on the start date (3 months from trade date)
Trade date Fixing date FRA start date/ settlement date Maturity date
t=0
t+3m-1
t+3m
t+6m
Example: Cash Settlement For FRAs
• Bank A & Bank B enter into a 6 X 9 FRA. Bank A pays fixed rate at 9.50%. Bank B pays floating rate based on 91 day T-bill yield. Additional details – Notional principal = Rs 10 Crore – FRA start & settlement date 10/12/09, Maturity date 10/03/10 – T-bill yield on fixing date (say 09/12/09) = 8.50% – Determine cash flow at settlement (assume discount rate as 10.0%) • Working – (a) Interest payable by bank A = 10 Cr * 9.50% * 91/365 = Rs 236,849 – (b) Interest payable by bank B = 10 Cr * 8.50% * 91/365 = Rs 211,918 – (c) Net payable by bank A on maturity date ((a)-(b)) = Rs 24,932 – (d) Discounting (c) to settlement date = (c)/(1+ discount rate*discount period) = Rs 24,932/(1+10.0%*91/365) = Rs 24,325 Amount payable on settlement date = Rs 24,325 payable by Bank A
Borrowing Forward• Suppose party „X” wants to borrow Rs. 100 Crore through a 4×10 FRA against MIBOR • The bank quotes 4×10 rate at 4.6 % p.a. • If after 4 months, 6-month MIBOR is 4.8%, the bank pays 0.2% . • But if the 6-month MIBOR is 4.4%, „X? pays the bank 0.2%.
Forward Rate Agreements in India
? FRAs were introduced in the Indian money market in ?
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1999 The benchmark rate may be any domestic money market rate such as T-bill yield or relevant MIBOR (However, the interbank term money market has not yet developed sufficient liquidity) RBI guidelines permit corporates to enter into FRAs only to hedge their underlying exposures. The market-maker banks can take on uncovered positions within limits specified by their boards and vetted by RBI. Settlements of FRA takes place through CCIL (Clearing Corporation of India Ltd.)
Forward Rate Agreements in India
Participants: ? Scheduled commercial banks (Excluding RRBs), primary dealers and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own balance sheet management or for market making. ? Now mutual funds are permitted to undertake FRAs/IRS. ? Banks/Fls/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures. ? No specific permission from Reserve Bank is required to undertake FRAs/IRS. ? However, participants will be required to inform Monetary Policy Department (MPD) when they start undertaking such transactions. ? No specific benchmark, rate, size, tenor etc have been specified in the guidelines.
Forward Rate Agreements in India
Capital Adequacy: For calculating the minimum capital ratio, the computation of riskweighted assets on account of FRAs/IRS should be done as per the two steps procedure set out below: 1. The notional principal amount of each instrument is to be multiplied by the conversion factor given below: Original maturity Conversion factor Less than one year 0.5 per cent One year and less than two years 1.0 per cent For each additional year 1.0 per cent 2. The adjusted value thus obtained shall be multiplied by the risk weightage: Banks/All India Financial Institutions 20 per cent All others (except Governments) 100 per cent
Issues related to IRS and FRA in India
? Awareness among the players is very low and derivative ? ?
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instruments are perceived to be risky. There is a lack of appropriate technological backbone for trading of such instruments in India. Only a few private sector and foreign banks are active in this market. Most banks prefer statutory compliance in asset-liability management rather than being proactive Lack of development of proper benchmark rates has hindered the growth of this market. Most participants rely on overnight MIBOR rates as benchmark rates; this has led to a large umber of deals of maturity of less than one year A vibrant term money market is a precondition of the success of this market. A developed term money market can give a series of rational benchmark but it is yet to grow
References
Websites:
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www.wikipedia.com www.rbi.org.in www.investopedia.com www.gtnews.com
A Primer on IRS – by Association Of Financial
Professionals
Reports:
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Determinants on FRA usage by Indian banksWCE 2009, July 1 - 3, 2009, London, U.K.
Thank You
doc_607045306.ppt
It describes Presentation on Interest Rate (IRS) and Forward Rate Agreements (FRA). It also talks about the Indian perspective in these topics
IRS AND FRA
Agenda
? Introduction to Swaps ? Interest Rate Swaps (IRS)
? ?
? ?
?
Types ? Valuation ? Uses IRS in India Forward Rate Agreements (FRAs): ? Working and Settlement ? Valuation FRAs in India Issues related to IRS and FRA in India References
?
Introduction to Swaps
? Today, in almost every country, business environments are exposed to a
?
? ? ?
? ?
high degree of risks in the form of currency risk, credit risk, interest rate risk, etc Derivatives have emerged as the most actively used interest-rate risk management tool over the last two decades, both for corporates, banks and financial institutions. Mainly, the derivative market includes - futures, options and financial swaps. Usually, swapping refers to the simultaneous purchase and sale of assets, mainly foreign currencies, for different maturities. More definitively, swaps are regarded as the exchange of a stream of future cash flows among two or more parties at mutually agreed upon terms and conditions. The swap market is standardized by the International Swaps and Derivatives Association (ISDA). However, in India following ISDA standards is not compulsory as long as the RBI guidelines wrt IRS are met with.
Common terms associated with Swaps
? The tenor is the term of the swap. ? The notional value determines the size of the interest rate payments. ? The swap facilitator will find a counterparty to a desired swap for a fee
or take the other side: ? A facilitator acting as an agent is a swap broker. ? A swap facilitator taking the other side is a swap dealer (swap bank).
? Swaps can be of the following types:
? ? ? ? ?
Interest rate swaps Foreign currency swaps Commodity Swaps Equity Swaps Credit default swaps
Interest Rate Swaps
? An interest rate swap is an agreement between two parties to exchange
? ? ?
?
interest payments for a specific maturity on a specified “notional” principal amount. i.e. there is no exchange of principal. The interest payments may be fixed or floating, depending on the terms of the agreement. Parties to the agreement may be a fixed rate payer/receiver and floating rate receiver/payer. The primary motives behind the interest rate swaps are comparative advantage of lowering the costs of borrowing and overcoming asset liability mismatch. These swaps are sold by dealers in large banks to FIs and other corporations that seek to hedge interest rate risk.
Interest Rate Swaps
? The 1st IRS occurred between IBM and the World Bank in 1981. ? In 1987, ISDA reported that the swaps market had a total notional value of
$865.6 billion. ? By 30th June 2009, this figure exceeded $ 414 trillion, according to the Bank for International Settlements (BIS).
An Example of IRS
? Consider a bank that makes a $1 million, five-year loan at a fixed 8 %
interest rate, where the borrower is required to make semi-annual payments of ½*(.08)*($1 m) = $40,000 and repay the $1 m principal at maturity. The bank finances this loan by issuing $1 million of sixmonth maturity CDs. ? These transactions expose the bank to interest rate risk. If the sixmonth market interest rates rise above 8 %, the bank?s interest payments on its CDs will exceed its 8 % loan interest payments. ? The unhedged Bank Balance Sheet will look like:
Bank Balance Sheet Assets Liabilities Fixed-Rate 5 year Loan Six-Month CDs (Long Duration) (Short Duration)
An Example of IRS
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The bank can hedge this interest rate exposure by becoming a fixed-rate payer in a five-year interest rate swap contract. The swap agreement will require the bank to pay semi-annual interest at a 7 % annual rate on a notional principal of $1 m. ? In return, the bank receives semi-annual six-month LIBOR payments. With this swap, the bank?s on and off-balance sheet assets and liabilities now look like:
Bank Balance Sheet Assets Fixed-Rate 5 year Loan (Long Duration) Liabilities Six-Month CDs (Short Duration)
Off-Balance Sheet (Swap) Assets Liabilities LIBOR Swap Payments Fixed-Rate Swap Payments (Short Duration) (Long Duration)
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Because six-month LIBOR will move with the interest rate that the bank pays on its CDs, the LIBOR swap payments will cover the bank?s required CD interest payments. The net result is that the duration of on- and off- balance sheet assets are equal to the duration of on-and off-balance sheet liabilities.
Plain Vanilla Interest Rate Swap
? It is the most basic type of IRS. ? With plain vanilla interest rate swaps, two parties facing different types of ? ?
?
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interest rate risk can exchange interest payments. One exchanges a fixed-rate payment for a floating rate payment and the other party exchanges a floating rate payment for a fixed-rate payment. The fixed or floating rate is multiplied by a notional principal amount. This notional amount is generally not exchanged between the parties, but is used only for calculating the size of cash flows to be exchanged. When interest rates change, the party that benefits from a swap receives a net cash payment while the party that loses makes a net cash payment. ? Only the net payment is made (difference check) ? The firm paying the floating rate is the swap seller ? The firm paying the fixed rate is the swap buyer Typically, the floating interest rate is linked to a market rate such as LIBOR or T-bill rates.
Example: Plain Vanilla IRS
Example: Plain Vanilla IRS
? A pays fixed rate to B (A receives variable rate). ? B pays variable rate to A (B receives fixed rate). ? Consider the following swap in which Party A agrees to pay Party B periodic
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fixed interest rate payments of 8.65%, in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%). There is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. The interest payments are settled in net (e.g. Party A pays (8.65%(LIBOR+0.70%)). The fixed rate (8.65% in this example) is referred to as the swap rate. At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.
Floating-for-Floating IRS
? Both the counter-parties exchange interest amounts based on two
different floating reference rates, through the life of the swap. ? Party A pays/receives floating interest indexed to X to receive/pay floating rate indexed to Y on a notional N for a tenure of T years. For example, A pays JPY 1M LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years. Example: ? If a company has a floating rate loan at JPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and wants to insulate from this risk, they can enter into a float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps.
Floating-for-floating Rate Swap
? With this, they have effectively locked in a 35 bps profit
instead of running with a current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current rate difference) comes from the swap cost which includes the market expectations of the future rate difference between these two indices and the bid/offer spread which is the swap commission for the swap dealer. ? Used to hedge against or speculate on the spread between the two indexes widening or narrowing.
Fixed-for-fixed Interest Rate Swap
? Fixed-for-fixed swaps happens only between two different currencies. ? A single-currency fixed-for-fixed rate swap is generally not possible;
as the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams. ? Toyota pays fixed interest in Yen to receive fixed rate in dollars for a term of 10 years. ? It pays JPY 2% on a JPY notional of 1.2 billion and receives USD 6% on the USD equivalent notional of 10 million at an initial exchange rate of USD:JPY 120.
Valuation of IRS
1. BOND PRICING METHOD:
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Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond. A floating (fixed) rate payer in an n-year interest rate swap has a long (short) position in an n-year fixed-coupon bond and a short (long) position in an n-year floating-coupon bond.
Example: ? Consider a company which is a floating rate payer (fixed rate receiver) in a $5 m. 10-year swap tied to 6-month LIBOR and having a fixedrate of 6 %. ? Thus, the value of this swap is the difference between a $5 m., 10-year coupon bond with an annual coupon rate of 6% less a $5m., 10-year floating rate bond tied to six-month LIBOR.
Valuation of IRS
? The value of the fixed-rate component of the swap, PVfx, is simply the
present value of an n-year fixed-coupon bond.
? The value of the floating rate component of the swap, PVfl , is equal to
the par value of a floating-rate bond at the coupon reset date.
? Hence, the value of the swap to the floating rate payer (fixed rate
receiver) is equal to the difference between the fixed rate component and the floating rate component.(PVfx – PVfl)
2. FRA PRICING:
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They can be valued as a portfolio of forward rate agreements (FRAs). Each exchange of payments in an interest rate swap is an FRA The FRAs can be valued on the assumption that today?s forward rates are realized
Uses of IRS
? Swaps were originally created to allow multi-national companies to
evade exchange controls. HEDGING ? IRS are often used by firms to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line with management's appetite for interest rate risk. ARBITRAGE: ? Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential (QSD) which allows both parties to benefit from an interest rate swap. ? QSD arises during an IRS due to the difference in the levels of interest rate obligations for the debt of the parties.
Uses of IRS
SPECULATION: ? Used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. ? Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap (as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.)
LIBOR/SWAP ZERO RATE: ? Since LIBOR only has maturities out to 12 months, and since interest rate swaps often use LIBOR as the reference rate, interest rate swaps can be used as a proxy to extend the LIBOR yield curve out past 12 months.
IRS in India
? In the wake of deregulation of interest rates as part of financial sector reforms, ? ?
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a need was felt to introduce hedging instruments to manage interest rate risk. The Reserve Bank had introduced interest rate swaps (IRS) and forward rate agreements (FRA) in March 1999. The Reserve Bank issued comprehensive guidelines in respect of interest rate derivatives (IRDs) in April 2007, incorporating the broad regulatory framework for undertaking derivative transactions. In respect of OTC derivative transactions, it became necessary to have a mechanism for transparent capturing and dissemination of trade information as well as an efficient post-trade processing infrastructure to address some of the attendant risks. In this context, CCIL was advised to start a trade reporting platform for rupee interest rate swaps (IRS) and Forward rate Agreements(FRAs). The reporting platform became operational on August 30, 2007. Banks and primary dealers (PDs) have started reporting the IRS and FRAs on the platform on a daily basis.
IRS in India
? CCIL covers various instruments of IRS and FRA like – IRS Fixed Float and
Basis Swaps with maximum maturity of 10 years and FRAs with maximum maturity of 10 years. ? CCIL extends post-trade processing services like Interest Rate Reset, Tracking payment obligation of members on their outstanding contracts etc. and settlement on Non Guaranteed basis. ? Settlement of Cash Flows: A logical extension of the trade reporting facility is the settlement services offered by CCIL on non-guaranteed basis. CCIL has commenced multilateral settlement of cash flows arising from IRS/FRA trades on non-guaranteed basis effective from 27th November 2008. ? All Banks and Primary Dealers which are members of the Rupee Derivatives Segment are eligible to participate in the non-guaranteed settlement subject to completion of documentation formalities.
Recent IRS Events
? Dec. 4 -- India?s interest-rate swaps had the biggest weekly increase in more
than a year on speculation the central bank may raise borrowing costs in the coming months to curb inflationary pressures. ? The one-year swap rate rose 35.5 basis points since Nov. 27 to 4.87 percent, its biggest jump since August 2008. (As on 4th Dec)
FORWARD RATE AGREEMENTS (FRAs)
Forward Rate Agreements (FRAs)
? A Forward Rate Agreement (FRA) is an agreement between two
parties who agree on a fixed rate of interest to be paid/received on a fixed date in the future.
The interest exchange is based on the notional principal amount (the principal is not exchanged), and these contracts are settled in cash. ? There is no daily settlement or marking-to-market ? The parties to the contract may still be exposed to default risk on the amount owed at settlement. ? Cash settled on the basis of the difference between the contract rate and prevailing reference rate on the settlement date & resultant value is discounted to adjust for an upfront settlement ? FRAs are over the counter (OTC) products and are available for a variety of periods.
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FRA Terminology
Contract Amount: The notional size of the “theoretical” loan
Settlement Date: The starting date of the theoretical loan Fixing Date: The date at which the theoretical loan?s rate is set Maturity Date: The ending date of the theoretical loan Contract Period: Difference between maturity and settlement dates
Contract Rate: Fixed interest rate agreed by the parties
Reference Rate: Market interest rate for calculating settlement amount Settlement Amount: Proceeds of FRA paid to equalise interest for both
Working of FRA
? The two counterparties to an FRA agree to a notional principal
amount that serves as a reference figure in determining cash flows.
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Notional principal: The principal does not change hands, but is only used to calculate the value of interest payments.
? The interest rate on which the parties agree (known as FRA rate)
is the price of the FRA as it is quoted by the market.
? The parties agree to compare the fixed FRA rate to a reference
interest rate (e.g. LIBOR) two days before the defined interest period (fixing date). The reference rate/settlement rate is defined on fixing date.
Settlement of FRA
? The buyer of an FRA agrees to pay a fixed-rate coupon payment
(at the exercise/contract rate) and receive a floating-rate payment against a notional principal amount at a specified future date.
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The buyer of an FRA will receive (pay) cash when the actual interest rate at settlement is greater (less) than the exercise/contract rate (specified fixed-rate).
? The seller of an FRA agrees to make a floating-rate payment and
receive a fixed-rate payment against a notional principal amount at a specified future date.
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The seller of an FRA will receive (pay) cash when the actual interest rate at settlement is less (greater) than the exercise rate.
FRA: Characteristics
? An FRA is a product that provides the purchaser with interest
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rate protection against adverse rate movements by committing to a fixed rate for a future period. The FRA does not need to be based on a particular loan. FRAs can be used for any existing and expected future loans. FRA can be cancelled at any time. This may result in a profit or loss depending on the interest rates at the time of reversal. This product can be customised to suit specific amounts and dates . FRAs are suited to all customers who are exposed to interest rates moving in the short term and who wish to cover their exposure.
FRA: Characteristics
? FRAs can be used to lock in a future borrowing or lending
requirement (e.g. The need to borrow for 3 months in 2 months time or have an existing loan rolling over) ? The customer can use advantageous moves in interest rates to lock in borrowing costs (or return on deposits) prior to the loan or deposit becoming due. ? FRAs are quoted like interest rates, but the terminology used is buy or sell. ? If a borrower wants to protect against rates moving up he can buy an FRA. A depositor would want to protect against lower rates, so he would sell a FRA.
Timing Diagram for FRAs
Value day convention
Deferment period
Contract period
Dealing date
Contract rate agreed
Spot date
Fixing date
Reference rate determined
Settlement date
Settlement sum paid
Maturity date
Forward Rate Agreements (FRAs)
? The important thing to note is that there is no exchange of
principal amount ? One of the following two formulas is used for calculating settlement payment from the seller to the buyer (L>R) or buyer to seller (R>L)
P= (L - R) x DF x A [(B x 100) + (DF x L)] (R - L) x DF x A [(B x 100) + (DF x L)]
P=
? L: Settlement Rate R: Contract Rate A: Notional Principal ? DF: No.of Days in FRA period B: Day Count Basis
Example : A Typical FRA Deal
Bank A sells to Bank B a 3 X 6 FRA at 10% against floating 91 day Tbill rate. Notional principal Rs10 crore. – Bank A receives fixed rate (10%) for a 3 month period starting 3 months from trade date – Bank B receives floating rate for the same period. The floating rate would be the 91 day T-bill rate 3 months from trade date – Though the net amount is due on maturity (6 months from trade date), settlement is done on the start date (3 months from trade date)
Trade date Fixing date FRA start date/ settlement date Maturity date
t=0
t+3m-1
t+3m
t+6m
Example: Cash Settlement For FRAs
• Bank A & Bank B enter into a 6 X 9 FRA. Bank A pays fixed rate at 9.50%. Bank B pays floating rate based on 91 day T-bill yield. Additional details – Notional principal = Rs 10 Crore – FRA start & settlement date 10/12/09, Maturity date 10/03/10 – T-bill yield on fixing date (say 09/12/09) = 8.50% – Determine cash flow at settlement (assume discount rate as 10.0%) • Working – (a) Interest payable by bank A = 10 Cr * 9.50% * 91/365 = Rs 236,849 – (b) Interest payable by bank B = 10 Cr * 8.50% * 91/365 = Rs 211,918 – (c) Net payable by bank A on maturity date ((a)-(b)) = Rs 24,932 – (d) Discounting (c) to settlement date = (c)/(1+ discount rate*discount period) = Rs 24,932/(1+10.0%*91/365) = Rs 24,325 Amount payable on settlement date = Rs 24,325 payable by Bank A
Borrowing Forward• Suppose party „X” wants to borrow Rs. 100 Crore through a 4×10 FRA against MIBOR • The bank quotes 4×10 rate at 4.6 % p.a. • If after 4 months, 6-month MIBOR is 4.8%, the bank pays 0.2% . • But if the 6-month MIBOR is 4.4%, „X? pays the bank 0.2%.
Forward Rate Agreements in India
? FRAs were introduced in the Indian money market in ?
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1999 The benchmark rate may be any domestic money market rate such as T-bill yield or relevant MIBOR (However, the interbank term money market has not yet developed sufficient liquidity) RBI guidelines permit corporates to enter into FRAs only to hedge their underlying exposures. The market-maker banks can take on uncovered positions within limits specified by their boards and vetted by RBI. Settlements of FRA takes place through CCIL (Clearing Corporation of India Ltd.)
Forward Rate Agreements in India
Participants: ? Scheduled commercial banks (Excluding RRBs), primary dealers and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own balance sheet management or for market making. ? Now mutual funds are permitted to undertake FRAs/IRS. ? Banks/Fls/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures. ? No specific permission from Reserve Bank is required to undertake FRAs/IRS. ? However, participants will be required to inform Monetary Policy Department (MPD) when they start undertaking such transactions. ? No specific benchmark, rate, size, tenor etc have been specified in the guidelines.
Forward Rate Agreements in India
Capital Adequacy: For calculating the minimum capital ratio, the computation of riskweighted assets on account of FRAs/IRS should be done as per the two steps procedure set out below: 1. The notional principal amount of each instrument is to be multiplied by the conversion factor given below: Original maturity Conversion factor Less than one year 0.5 per cent One year and less than two years 1.0 per cent For each additional year 1.0 per cent 2. The adjusted value thus obtained shall be multiplied by the risk weightage: Banks/All India Financial Institutions 20 per cent All others (except Governments) 100 per cent
Issues related to IRS and FRA in India
? Awareness among the players is very low and derivative ? ?
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instruments are perceived to be risky. There is a lack of appropriate technological backbone for trading of such instruments in India. Only a few private sector and foreign banks are active in this market. Most banks prefer statutory compliance in asset-liability management rather than being proactive Lack of development of proper benchmark rates has hindered the growth of this market. Most participants rely on overnight MIBOR rates as benchmark rates; this has led to a large umber of deals of maturity of less than one year A vibrant term money market is a precondition of the success of this market. A developed term money market can give a series of rational benchmark but it is yet to grow
References
Websites:
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www.wikipedia.com www.rbi.org.in www.investopedia.com www.gtnews.com
A Primer on IRS – by Association Of Financial
Professionals
Reports:
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Determinants on FRA usage by Indian banksWCE 2009, July 1 - 3, 2009, London, U.K.
Thank You
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