Product Brief

Interest Rate Swaps and Forward Rate Agreements

INTEREST RATE SWAPS Features
An Interest Rate Swap is an off-balance sheet contract between two counter parties 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.

Participants
The following participants are allowed to undertake IRS/FRAs Scheduled Commercial Banks Primary Dealers All India Financial Institutions Corporates Mutual Funds 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.

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.

Terminology

To pay an OIS or to be long the OIS is to pay the fixed rate and receive the overnight rate. It is akin to borrowing at a fixed rate and lending at the overnight rate. A participant expecting call money rates to tighten would pay an OIS. To receive an OIS or to be short the OIS is to receive the fixed rate and pay the overnight rate. It is akin to lending at a fixed rate and borrowing at the overnight rate. A participant expecting call money rates to soften would receive an OIS.

Illustration: A seven day OIS

Let us assume Party A is a large lender in the call money market with a view that overnight rates may fall affecting his returns. Party B is borrower in the call money market with a view that call money rates may be volatile and will prefer to hedge or lock-in to a fixed rate. Party A is the fixed rate receiver and Party B is the floating rate receiver. A seven day OIS at 9.25% for a notional principal of Rs 10 crores between them would require Party B to pay an amount of Rs 177,397 (100,000,000 X 9.25% X 7 / 365) to A. Party A in turn will be required to pay B the floating leg which is calculated as follows:

Actual Overnight Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 & 7+ Total Rate (MIBOR) 8.00% 8.25% 8.75% 9.25% 10.50% 8.20%

Opening Principal Amount (Rs.) 100,000,000 100,021,918 100,044,526 100,068,509 100,093,869 100,122,663

Interest (Rs.) 21,918 22,608 23,983 25,360 28,794 44,987 167,649

Closing Principal Amount (Rs.) 100,021,918 100,044,526 100,068,509 100,093,869 100,122,663 100,167,649

+ Days 6 and 7 are clubbed together to indicate Saturday and Sunday which will have the same call money rate. The interest will be calculated by the Simple Interest Method for these 2 days.

As shown above A will be required to pay B a sum of the Rs. 167,649. Instead of exchanging the gross amounts Party B will simply pay Party A, the difference or the net amount i.e. Rs 9,748 (Rs 177,397 Rs 167,649). The net effect of the cash flows after the swap will ensure that Party A has earned a fixed rate for seven days. Similarly Party B has fixed his cost of funds for seven days irrespective of the movements in the call money rate for seven days.

Pricing an IRS
Pricing an IRS refers to ascertaining the fixed rate of the swap, also called swap rate. Firstly 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.
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OIS are quoted on a bid/offer basis with the bid referring to the quoting party s willingness to pay the fixed rate and offer referring to the party s willingness to receive the fixed rate. In developed markets however, swaps are quoted as a spread over the sovereign curve signifying the credit risk.

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 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 rate bonds or debentures. Such corporates may wish to receive fixed and thereby convert their liabilities to floating rate (MIBOR, Bank rate etc). In a liquid scenario this swap allows corporates to benefit from lower rates by converting high cost fixed rate debt into a floating rate. Corporates 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 advantage of this strategy is that the amount so hedged, continues to be maintained in call money and can be used to meet an
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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 swap.

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 Less than 1 year 1-2 years Each additional year Adjusting for risk weighting Banks and FIs All others

Conversion Factor 0.50% 1.00% 1.00%

20% 100%

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 interest payment 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.

Illustration: Valuation of an OIS Assume the actual call money rates as below.

Day Monday

MIBOR 10.25%
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Fixed Rate 10.50%

Tuesday Wednesday Thursday Friday Saturday & Sunday

11.00% 10.70% 10.00% 9.50% 9.75%

10.50% 10.50% 10.50% 10.50% 10.50%

If a Bank has entered into an OIS wherein it is required to receive a rate of 10.50% (and pay MIBOR) for 6 months, then the valuation at the end of the week would be as follows. The bank would have (notionally) received 10.50% for the 7 days illustrated above. Hence, on an accrual basis Bank A would be at a profit of Rs 17,465.75 on a notional principal of Rs 25 crores. Now for MTM purpose, the bank has to check quotes for a 173 day tenure which is the residual maturity of the swap. If the quotes available are 10.00%/10.25% i.e. the bank may now has the option to pay 10.25% (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 Rs 296,232 ((10.50% -10.25%)*250,000,000*173/365).

FORWARD RATE AGREEMENTS (FRA) Definition

A Forward Rate Agreement (FRA) is an off balance sheet contract to exchange an interest payment for a specified period starting in future. Hence, it is an agreement between two parties to contract an interest rate for a specified period of time from a specified future date on an agreed principal amount. It is like a forward start single period Interest Rate Swap. Interest payments are calculated on a notional principal. The specified period refers to the period from start date (which is in the future) to maturity date. FRAs can be quoted for specific dates and amounts. A buyer of an FRA is looking for protection against a rise in interest rates. He is hedging against the benchmark rate going above an agreed upon rate above is usually a borrower of funds for the period of the FRA. A seller of an FRA is looking for protection against a drop in interest rates. He is hedging against the benchmark rate going below an agreed upon rate above is usually a lender of funds for the period of the FRA.

Quoting Terminology
FRAs are quoted by the forward month in which they mature. A 1X4 FRA (against a floating rate) starts one month from now and matures four months from now.

Let us assume that today's date is Septmber 30 th . For the 1 X 4 FRA - Start date is October 30 th - Maturity Date is January 30 th - Specified Period is October 30 th to January 30 th - Settlement date October 30 th - Notional Principal is the contracted amount - Fixed rate is the quoted rate - Floating rate is the benchmark rate If on settlement date (start date) the floating rate is greater than the fixed rate the buyer receives the difference. If however, the fixed rate is higher, the buyer pays the difference to the seller of the FRA. A 1X4 FRA quoted at 10.00%/10.25% against the CP reference rate refers to the 3 month CP rate one month from today (hence maturing in 4 months from today). The fixed rate payer is willing to pay 10.00% and receive the actual CP reference rate. Alternatively at against receiving 10.25% the party is willing to pay the CP reference rate one month from today.

Illustration
Let s say a bank which has a regular exposure to 91 Day T-Bills takes a view that the yields are likely to fall. In order to lock-in to the rates three months hence, he can buy a 182 Day T-Bill and short the 91 Day T-Bill. Since short selling of debt securities is not allowed in the Indian markets this view is not possible to execute. Using FRAs, however the bank can lock-in to the available rates. Essentially, the bank is locking in to a 91 Day T-Bill rate 3 months from now (irrespective of the prevalent rate at that point of time). Say, today s date is September 30 th and the spot 91 Day T-Bill rate is 9.50% and the 3X6 FRA is quoted at 9.40%/9.60%. The bank now receives fixed 9.40% (pays the 91 Day T-Bill rate three months from now) on the 3X6 FRA for a notional principal of Rs 10 crores. On settlement date, the bank receives the fixed rate from the swap market maker and pays the floating rate (the actual 91 Day T-bill cut off). Say the bank's view is correct and three months from now (December 30 th ) the T-Bill cutoff is 9.25%. The exact cash settlement is at follows:

Date September 30, 1999

Action 6

Cash flow 0

The difference between the fixed and floating legs is discounted to settlement date since it is actually payable at maturity. December 30, 1999 Bank to receive fixed (9.40%) Bank to pay 91 Day TBill cut-off (9.25%) Bank invests in 91 Day T-bill In this case, the Bank is to receive 9.40%*91/365*10 crores=Rs 23,43,562 The Bank is to pay: 9.25%*91/365* 10 crores=Rs 23,06,164 The difference of Rs 37,397.26 is to be discounted to settlement date. Hence the actual cash settlement is Rs 37397.26 /(1+10%*91/365) = Rs 36,487.57 The discount rate of 10% is a mutually negotiated rate depending on the credit of the counter party. Any suitable CP or T-Bill rate may be used in the absence of a benchmark rate. The swap market maker pays the Bank a sum of Rs 36,487.57. The bank invests in the T-Bill at 9.25%, i.e. at a price of Rs 9,77,10,100. The netting of the cash flows ensures that the yield to the bank remains at 9.40%.

Advantages of FRAs
The flexibility of operation of an FRA comes from the fact that they may be quoted for a specific date and may match a exact payment of the corporate on that date. Most corporates in India have PLR linked floating rate loans from financial institutions or banks. In a scenario, which may appear to be gradually tightening, FRAs allow the corporate to fix his cost of funds by converting these floating rate liabilities to fixed by buying FRAs. The corporate receives payments linked to a floating rate benchmark and pays a fixed rate. This would enable the corporate to insulate itself from a rise in interest rates during the period of the FRA.

Applications of FRAs
Hedging for floating rate borrowers/investors Interest rate view execution

Risks in Interest Rate Swaps and Forward Rate Agreements

Though IRS/FRAs are effective in removal of interest rate risk, there are still some risks inherent in these instruments, which we describe below:
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Risks

Counterparty Risk

Market Risk

Credit Risk

Settlement Risk

Liquidity Risk

Basis Risk

Price Risk

Counterparty risks refer to risks of default or delay in payment settlement. Market risks are further divided into liquidity, basis and price. Liquidity risks refer to bid-offer spreads and ease of unwinding or reversing swaps. Basis risk is the risk of mismatch i.e. risks that arise when the underlying asset/liability is not perfectly correlated with the floating benchmark. Price risk refers to unexpected changes in the market value of the swap.

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