Payal Ghose & Aparna Vachharajani* (October 2007) Today corporates and bankers use complex and innovative financing tools to decrease borrowing costs and increase control over other financial variables. Financial instruments like derivatives have made it possible to transfer or sell risk to individuals or institutions who are prepared to buy risk. (Because of this derivatives are also known as insurance products.) The various types of financial derivatives include forward and future contracts (agreements to buy or sell an asset at a certain time in the future for a certain price), option contracts (a contract between two parties in which the buyer of the option buys the right to buy or sell a standardized quantity of a financial instrument on or before a pre-determined date at a specified price) and swaps (an agreement between two parties to exchange cash flows in the future). A swap is basically a contractual agreement for exchange of cashflows between two parties. Swaps take place because corporates and institutions with differing financing and risk requirements have specific access to different financial markets. The origin of swaps can be traced back to the early 1970s as a tool to circumvent the exchange regulations imposed by many countries to restrict cross border capital flows. To overcome such hurdles corporates started a new arrangement popularly known as ‘ parallel loans ’. Under such an arrangement American companies used to lend dollars to British subsidiaries in the US while the British holding companies used to lend pound sterling to the American subsidiaries in the UK. This practice gained momentum with the exchange rate instability following the demise of the Bretton Woods System during 1971-73. Following the exchange rate liberalization in the 1980s, swaps rapidly replaced existing products like parallel and back-to-back loans because of their flexibility and lower financing and taxation costs. The formation of the International Swap Dealers Association (ISDA) in 1985 was a significant development that speedened up the growth of the swap market by standardizing swap documentation. The emergence and growing popularity of swaps has led to refinement of the risk management techniques enabling corporates

*Ms. Payal Ghose & Ms. Aparna Vachharajani are Senior Executive Officers, Economic Research and Surveillance Department, The Clearing Corporation of India Limited



interest rate swaps in 1981.20% Floating Rate 6-Month LIBOR + 0. The two can enter into an agreement in which the second party agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. The most basic form of an IRS involves two counterparties that agree to exchange over a certain period of time. equity and commodity swaps in the mid1980s and credit derivatives in 1990. The table given below depicts the rates Rating Firm A Firm B AA+ AB+ Fixed Rate 10.00% COLLECTION OF ARTICLES . Figure 1 shows the basic structure of an IRS. The other party has a counter-position having borrowed at a fixed rate but desiring a floating rate interest structure. Recently derivatives based on the climate have also been launched. The underlying debt is referred to as the notional principal/amount because it is only used as 218 the basis for interest calculation under the swap and not exchanged by the participants. with Eurobonds being the principal security employed in these transactions. The IRS market gives a deeper insight into the capital flows that drive the bond markets. each calculated using a different interest rate index but based upon some agreed upon or “notional” amount.30% 6-Month LIBOR + 1. IRS transactions began in 1981. two streams of interest payments. Currency swaps were introduced in the late 1970s. it receives interest at a floating rate on the same notional principal for the same period of time. the manner in which the corporates m a n a g e t h e i r e x p o s u re t o fluctuations in interest rates and the way banks and financial institutions make a great deal of their income. Firms with good credit ratings pay lower risk premiums than firms with lower credit ratings and the credit-quality premium rises faster with maturity for the lower rated firms. Figure 1 Rationale behind an IRS All firms pay a credit-quality premium over the risk-free rate when they issue debt securities. The range of risks and types of cash flows hedged through swaps is rapidly expanding.THE CLEARING CORPORATION OF INDIA LTD. to tap newer capital markets and making further use of new financial instruments without substantial increase in the risk element. INTEREST RATE SWAPS One of the largest components of the global derivatives markets and a natural adjunct to the fixed income markets is the interest rate swap (IRS) market. The first party may be a borrower that wants to pay interest at a fixed rate but has already borrowed at a floating rate.00% 11. In return.

the spread between the 5 year rates is higher than the spread between the six month rates. In the above example the fixed rates are the rates at which the firms can issue five year fixed rate bonds while the floating rates based on LIBOR are 6 month rates. the spread rises faster with increase in maturities. Generally. Floating-to-floating or basis swap: In this swap.50% (i. and they swapped interest payments. the total cost for them would be LIBOR + 11. the floating reference rate can be switched to other alternatives like 3-month LIBOR. LIBOR + 0.20% for B). However. If both firms raised funds in their desired markets directly.e. This gain arises out of the credit spread differential. The floating rate lender has the option of reviewing the rates every 6 months. LIBOR) while its counterparty pays using another reference rate (e. 10. This quality-spread differential (i. basis points in the short-term debt market.g.THE CLEARING CORPORATION OF INDIA LTD.g. a floating interest rate liability is exchanged with a fixed rate liability. The spread differential between A and B also reflects the extent to which B is more likely to default than A. the fixed rate lender has no such option. 3) Asset swap: In this type of swap the interest streams being exchanged are funded with interest received on specific assets. T-Bill rate).50% 11. Hence. He can raise the spread over LIBOR if the firm’s creditworthiness deteriorates or even cancel the contract. Firm A has an absolute cost advantage in raising funds in either the short-term or longterm debt markets. one party pays one floating rate (e. firm B were to issue short-term debt.00% for B). The gain from entering into the swap is (11.e. Alternative floating rate: In this type of swap. but rises to 120 basis points at longer maturities. As a result. The total cost in such a case would be LIBOR + 11% (i. at which two firms with varied ratings can borrow funds for five years to meet their requirements. exists because of the nature of contracts in the fixed and the floating markets. but firm B has a comparative advantage in raising funds in short-term debt markets. as per the requirement of the counter party to meet the 4) 2) COLLECTION OF ARTICLES 219 .30% for A and 11. The quality spread between the interest rate paid by the lower-rated firm B and that paid by the higher-rated firm A which is only 70 TYPES OF IRS 1) Plain vanilla swap or fixed-forfloating swap: In this swap. the difference in the quality spread at two different maturities).00% for A and LIBOR + 1. the probability of default rises faster for firms with lower credit ratings.00% =) 0. TBill rate etc.50% which is shared equally between the two parties.e. Both firms could lower their funding costs if firm A were to issue long-term debt.

In case of a holiday. would be compounded every Mumbai business day. the writer of the put swaption becomes the floating rate receiver and fixed rate payer. Extendable swap: This type of swap allows fixed for floating counter party to extend the swap period. Money market swap: It is a swap transaction with original tenor up to 2 years. Term swap: A swap transaction having an original tenor of more than 2 years is referred to as a term swap. the NSE MIBOR rates for the seven days are taken and settled at the end of the swap period. 7) 8) 9) 10) Zero coupon to floating: The Illustration: (One week swap) Suppose Bank A and Bank B enter into a swap whose effective date is September 18. the interest would be computed on simple interest basis for the holiday. 220 COLLECTION OF ARTICLES . In this example. 5) Forward swap: This swap involves an exchange of interest rate payment that does not begin until a specified future point in time.10 crore for a week at 6% and Bank B is a floating rate receiver and the rates are linked to the NSE overnight index. Equity swap: An equity swap involves the exchange of interest payments linked to the changes in a stock index. In this case. an equity swap agreement may allow a company to swap a fixed interest rate of 6% in exchange for the rate of appreciation on a particular index like the BSE or NSE indices each year over the next 4 years. Swaptions: Option interest rate swaps are referred as swaptions. as an overnight rate. The swaption agreement specifies whether the buyer of the swaption will be a fixed rate receiver or a fixed rate payer. On the other hand a puttable swap provides the party making the floating rate payments with the right to terminate the swap. This implies that the floating rate interest is compounded on a daily basis except when there is a holiday. the fixed rate player makes a bullet payment at the end while the floating rate player makes the periodic payment throughout the swap period. The writer will become the fixed rate receiver and floating rate payer. exposure. Hence in this type of swap. 2007 where Bank A is a fixed rate receiver of Rs. The floating rate.THE CLEARING CORPORATION OF INDIA LTD. A callable swap provides the party making the fixed payments with the right to terminate the swap to its maturity. For example. If the buyer exercises the option then the writer of the option will become the counter party. 6) holders of zero-coupon bonds get the full amount of loan and the interest accrued at the maturity of the bond.

000 * 6% * 7/365) and Bank A has to pay Bank B interest of Rs.00.52 6. an interest rate swap can be valued either as a long position in one bond combined with short position in another bond or as a portfolio of forward contracts. Bank A will pay Rs. In this case. The value of the swap to a company receiving fixed rate and paying floating rate is: The value of fixed-rate bond underlying the swap equals its notional amount at the initiation of the swap.00.35.29 7. 18137 17866 17239 19928 21331 20133 100135965 Rs.965 (10.e. Before the next payment date. To value the swap some time after the initiation.965 and Rs. its value becomes BFL = L + k* (k* is the floating-rate payment that will be made on the next payment date). NSE MIBOR Rate Floating Index (%) 18-Sep-07 19-Sep-07 20-Sep-07 21-Sep-07 22-Sep-2007 & 23-Sep-07 (Sat & Sun) 24-Sep-07 th the swap: then. MIBOR rates have been used for discounting. i. on September 25. (1) Day Notional Principal Amount (NPA) Rs.965 – 10. 100000000 100018137 100036003 100053242 100073171 100115832 NPA + Floating Compounded Interest at Rate MIBOR Interest Rates Rs. 7. following notations are used: ti : Time until ith (1<= i <= n) payments are exchanged 6.35.1.BFL NPA + Simple Interest at Fixed Rate Rs.01.THE CLEARING CORPORATION OF INDIA LTD. the cash flows are k at time ti and L at time tn.15.896 to Bank B.1.34 100115068 On the 8 day.000) as per the calculation. 2007 Bank B will pay Bank A an interest of Rs. so that n BFIX = i =1 ke-riti + Le-rntn (2) In case of the floating rate bond. They will settle the difference of Rs.20.069 (10. BFL = L immediately after a payment date.62 6. VSWAP = BFIX .069 i.78 7. BFIX : Value of fixed-rate bond underlying the swap BFL : Value of floating-rate bond underlying L : Notional amount in swap agreement ri : MIBOR rate corresponding to maturity ti k : Fixed payment made on each payment date Considering fixed-rate bond. In both the cases. If ‘t1’ is the time until the next payment date and ‘r1’ is the discount rate used to calculate the value of the swap COLLECTION OF ARTICLES 221 .00. its value becomes identical to a newly issued floatingrate bond immediately after a payment date. The overnight call money rates (FIMMDANSE-MIBOR rate) for 7 days are as per the table below. Valuation of IRS Assuming no default risk. Valuation of swap in terms of Bond Prices: If.

222 COLLECTION OF ARTICLES . To determine swap cash flows. (4) Rf – Forward interest rate R1 and R2 are the zero rates for maturities T1 and T2. Calculate swap cash flows assuming that the MIBOR rates will equal the forward rates.107.0828 and m = 2. then in such a case. the forward rate corresponding to the period between 1 and 2 months needs to be calculated by using equation 4. Assuming that forward interest rates are realized. so that BFIX = 3. 3.0770 * 1/12 = Rs. Valuation of swap in terms of Forward Rate Agreements (FRA): FRAs are agreements to exchange pre- Considering the situation in the previous example.70%. k = Rs.0828 or 8. An IRS can be regarded as a portfolio of FRAs. a rate of 6.30%. 2.0930/2) e -0.THE CLEARING CORPORATION OF INDIA LTD.e.0770 * 1/12 + 3.50 million.06 million and k* = Rs.84 = Rs.50e -0.0770 * 1/12 = Rs.06e - will be exchanged for 9.12% per annum (with semi-annual compounding) on a swap with a notional amount of Rs. Suppose a financial institution pays 1-month MIBOR and receives 6.06e -0.. 100 * (0. This will be equal to 0. can be used to calculate the value of swap. 2 and 3 months.0612/2 – 0. To make it equivalent to the rate with compounding 2 times per annum.06e 0.30%.01 million BFL = 3. 2-month and 3month maturities are 7. The MIBOR rates with continuous compounding for 1-month.102. The 1-month MIBOR rate on the last payment date was 9.3. the value of the swap is 107.84 million Hence.17 million.0828 * 3/12 determined rate of interest with the market rate of interest which will apply to a certain principal for a certain period of time in the future.5798 (5) = Rs.28% with continuous compounding. calculate forward rates for each of the MIBOR rates using following equation: Rf = R2T2 – R1T1 / T2 – T1 Where. Setting the swap value equal to the present value of these cash flows. i. a plain vanilla IRS can be valued by applying the following steps: 1. today which equals its value just before the next payment date. 7. formula given in equation (1).-4.01 – 102.99% and 8. In this case.0799 * 2/12 + 103.100 million and the next payment dates are after 1. The value of the exchange to the financial institution is: To calculate the value of the exchange in 2 months. following equation is used where Rc = 0. the swap has remaining life of 3 months.0770 * 1/12 + 100e – 0. the value of this floating-rate bond is BFL = (L + k*) e-r1t1 (3) After calculating BFIX and BFL.28% respectively.

-4. 1. 2. the forward rate corresponding to the period between 2 and 3 months will be equal to 0. An IRS acts as a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. The counterparties make/receive a payment reflecting current market rates and are released from their contractual obligations. then. The value of FRA. Cancellation: A swap may be terminated prior to maturity. Selling: A party may exit a swap agreement by selling it off to another party.4356 = Rs.0612/2 – 0.5798 – 1. 3. Differential information in different markets.0845/2) e -0. In such a case instead of going for individual settlement of each IRS contract. they may opt for settlement COLLECTION OF ARTICLES 223 . Novation: A new swap agreement may be created canceling one or more existing swap agreements.1498 million Following the above given steps. 5.17 million Closure A swap agreement can be terminated using any of the following methods.0799 * 2/12 = Rs. Reverse swap: A party may enter into a new swap at current market rates to offset or reverse the terms of the existing swap agreement. 4.THE CLEARING CORPORATION OF INDIA LTD.4356 million. institutional restrictions and transactions costs create some market imperfections and the presence of comparative advantages among different borrowers in these markets.-1. 2) As tools of hedging: Let us assume that a company needs to borrow funds for five years but finds that current rates are relatively high. -1. but wishes to obtain the necessary funds as soon as possible. Netting: Two counterparties may have more than one IRS agreements with each other. to the financial institution.1498 .0828 will become 0.0885 and 0. The value of FRA corresponding to the exchange in 2 months is therefore 100 * (0. IRS are very popular as: 1) As tools of arbitrage: The IRS market evolved because of the differing financing needs of its participants. The management believes that rates will decline. In this situation the company could issue fixed rate debt and then “swap it down” by agreeing to pay a The value 0.0845 with semi-annual compounding. is . Application of IRS IRS can be used to gain advantage of various market imperfections. is Rs. Rm = m ( eRc/m – 1 ) (6) through a single net value for all the outstanding transactions. The total value of the swap.1.0905 (with semi-annual compounding).1.

was at an extremely high 17% due to the anti-inflationary tight monetary policy of the Fed under Paul Volcker. The corresponding rates in West Germany and Switzerland were 12% and 8% respectively. the company will be paying more for the variable rate swap than if it had held on to the fixed rate debt. the profitability of an IRS broadly reflects the market trends in interest rate movements in the future. iii. v. ii. 3) As tools of speculation: The timing of any decision to issue debt always involves some judgment regarding the future movement of interest rates. payment frequency and maturity profile. There is significant potential for credit and counter-party risk within the IRS market. Early termination may incur a pay-out cost (break-cost) subject to market movements. IRS facilitates matching (variable) taxable interest earning assets with a similar amount of variable tax-exempt interest debt. Swaps can involve infinite leverage and risk. Global statistics In 1981 the benchmark interest rate in the U. if the management is wrong and rates go up. Speculators with a contrarian view from the general market perception bet on these movements through swaps to book profits. An IRS involves no upfront premium. If rates decline as expected. Swaps are a sophisticated mechanism to take advantage of expectations of future interest rate movements. IBM at that time had large amounts of Swiss franc and German deutsche mark debt and thus 224 COLLECTION OF ARTICLES . Advantages and Disadvantages of IRS Advantages: i. and the firm is left having to make floating rate payments on the swap. It allows management of interest rate risk without affecting the financing arrangement. An IRS helps in locking in low variable rates when interest rates are low.THE CLEARING CORPORATION OF INDIA LTD. iv. As parties effectively “lock in” a fixed interest rate they cannot participate in favorable interest rate movements. ii. IRS can be executed with widely varying maturities. iv. Both governments had imposed limits on the amount the World Bank could borrow in their markets.S. An IRS is tailored to the specific needs of the participants as to the principal. vi. However. Thus. floating rate in exchange for receiving a fixed rate. Disadvantages: i. The fixed income from the swap offsets the debt cost. The floating rate stream under a swap tends to reflect current interest levels while the fixed interest stream reflects the historical level. iii. the firm’s financing cost falls commensurately.

485.448.07 to develop standard terms a) Forward Rate Agreement 7.57 415.00 8.894.387. Instead.33 169.897.000 franc and deutsche 5.209. The ISDA Master party in that acts as counterparty to each of Agreement acts as a reference point for all the two original parties.51 purpose is encouraging the Equity .746.182.66 14.336.30 297.689.32 1985.05 6.00 13.987.00 101.21 7.00 8.19 15.43 b) Interest rate swaps 58.00 79.371.03 19.115. ISDA’s primary c) options 10.937. TOTAL OUTSTANDING 01 02 20 04 03 05 20 20 Within a span of just Year seven years.222.68 18.21 229.579.00 6.178.792.787.00 27.77 8.00 10.00 141.14 for IRSs.106.503.THE CLEARING CORPORATION OF INDIA LTD.00 1. O utstanding (USD T rn) 98 99 00 19 20 19 IRSs quickly gained immense popularity all over the world because of their flexibility and continue to dominate the market for OTC instruments. market and swapped the dollar payment obligations with IBM and in exchange taking over IBM’s Swiss 6.991.364.00 6.933.43 5.00 1.S.434.00 4.595.50 6.669.000 3.00 3.92 10. Initially banks just swap agreements.82 p r u d e n t a n d e ff i c i e n t Commodity contracts Source: BIS development of the privately negotiated (or OTC) Role of intermediaries derivatives business by the development and Nowadays in most swap transactions.00 2.00 923.443.000 of the first interest 1.00 24.00 5.503.00 257.00 3.288. the maintenance of derivatives documentation parties to a swap do not directly transact with and promoting the development of sound each other directly.00 18.012.717. ISDA was formed in Total Contracts 111. after a group of 18 Foreign exchange contracts a) Forward and Forex swaps 10. IBM and the World Bank worked out an arrangement in which the World Bank borrowed dollars in the U.081. had debt payments to pay in Swiss francs and deutsche marks.951.737.00 10.99 31. interest IRS Volumes Total OTC Volumes Source: BIS rate swaps had Amounts outstanding of over-thedeveloped into a fully operative market with counter (OTC) derivatives an annual volume estimated at over $300 (In USD billion) billion and outstanding Notional amounts outstanding Risk Category/Instrument swaps valued over $1 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 trillion.658.828. Greater standardization and transparency was facilitated by the ISDA Master Agreement.769.771.60 43.568.631.00 14.linked contracts 1.179.000 0 rate swap contract.470.00 141.517. there is a third risk management practices.95 28.03 40.00 111.309.788.00 12.95 211.88 2.748.970.000 leading to the birth 2.41 swap dealers and their b) Currency swaps 3. acted as intermediaries between two COLLECTION OF ARTICLES 20 20 20 06 225 .000 mark obligations 4.942.501.04 counsel began work in 1984 c) options Interest rate contracts 77.00 20.268.873.881.10 9.00 197.987.167.406.50 291.226.780.97 5.120.475.00 29.384.22 598.00 150.53 16.00 4.665.00 12.719.793.00 190.

By specializing in this function and building a large portfolio. Benefits of having a clearinghouse for OTC products A clearing house substitutes itself as central counterparty to all transactions that its Source: BIS COLLECTION OF ARTICLES . Most intermediaries often act as market makers p ro v i d i n g t w o w a y quotes as well as a settlement agent. Most intermediaries attempt to build a sizable 226 portfolio of swaps and actively manage the interest rate risk of that portfolio in the futures and options markets. Swap customers rely on the competition among these intermediaries to ensure that they are receiving efficient pricing of the risk they pass on when engaging in a swap. Gradually large banks started offering their clients the type and size of swap transaction they desired immediately and thereafter found out a different party with opposite requirements to hedge the original swap.THE CLEARING CORPORATION OF INDIA LTD. One of the reasons i n t e rm e d i a r i e s h a v e assumed such an important role in the swap market is that they diversify credit risk. This type of swap warehousing or running mismatches enabled the customer to cover an exposure almost as soon as the decision to do so while the banks could quote the most competitive price to their clients and maximize their businesses. corporates to match swapping needs for a fee. they can become more efficient at this task of risk management. collecting and paying the obligated cash flows when they are due.

MPD. Participants were required to report their FRAs/IRS operations on a fortnightly basis to Adviser-in-Charge. swap products were widely used by the COLLECTION OF ARTICLES 227 . with a copy to respective departments. The Reserve Bank of India (circular Ref. transparent and mutually acceptable to counterparties. IRS In India Over the years. Since the inception of derivative trading in India.THE CLEARING CORPORATION OF INDIA LTD. It thus enables investors. Banks. India’s interest rate scenario has seen significant reforms where structural rigidities like administered rates. has brought to the fore a wide array of risks faced by market participants. mandated floors and caps on deposit and lending rates.279/1 1999-2000 dated July 7. guaranteed high yields on government owned funds & tax-free bonds are increasingly becoming things of the past. The parties were allowed to use any domestic money or debt market rate as benchmark rate for entering into FRAs/IRS. To manage and control these risks. Reserve Bank of India. brokers and dealers to transact high volumes of business while economizing on capital and collateral utilization. 1999) issued guidelines for scheduled commercial banks (excluding regional rural banks). For the sake of uniformity and standardization. The box given below depicts how the OTC market can benefit from the support of clearinghouses. as suitably modified to comply with these guidelines for undertaking FRAs/IRS transactions. provided methodology of computing the rate is objective.187/07. Corporates were also allowed to use IRSs and FRAs to hedge their exposures. Monetary Policy Department. primary dealers and all-India financial institutions to undertake FRAs and IRS as a product for their own balance sheet management and for market making purposes. instruments such as Forward Rate Agreement (FRA) and Interest Rate Swap (IRS) were introduced in July 1999 which could provide effective hedge against interest rate risks.BC. participants could consider using ISDA documentation. operational risk and to some extent the systemic risk.01. financial institutions and PDs needed to maintain capital based on the computation method provided by RBI for risk weighted assets. The use of a clearing house has the potential to mitigate each of the types of counterparty risk associated with OTC derivatives like IRS namely credit risk. No. members agree to submit for clearing. Along with undertaking FRAs/IRS for hedging underlying exposures. Deregulation of interest rates. which helped in making financial market operations efficient and cost effective. There were no restrictions on the minimum or maximum size of notional principal amounts and tenor of FRAs/IRS. legal risk. liquidity risk. market participants were also allowed to undertake market making activity for the development of the product subjected to the required prudential limits.

228 COLLECTION OF ARTICLES . In order to make the market broad-based in terms of participants. market to convert floating rate exposures to fixed rate and vice versa. The ambiguity regarding their legal validity was inhibiting the growth and stability of the market for such derivatives. an Internal Group was constituted by RBI to review the existing guidelines on derivatives and formulate comprehensive guidelines on derivatives by banks. RBI released the Comprehensive Guidelines on Derivatives on April 20. the Reserve Bank of India (Amendment) Bill. these entities could transact only in interest rate futures for hedging the interest rate risk in their underlying Government securities portfolio classified under the Available for Sale (AFS) and Held for Trading (HFT) categories. 2003 on the BSE and NSE. 2007. The market was particularly characterized by the absence of MFs. The definition of OTC derivatives was expanded empowering the RBI to deal in derivatives as well as lay down policy and issue directions to any agency dealing in derivatives. insurance companies and public sector banks.4000 crore in March. OTC derivative contracts were excluded from the purview of the Securities Contracts Regulation Act. Forward Rate Agreement (FRAs) and Interest Rate Futures. However. On the recommendation of the Standing Committee on Finance. the SEBI decided to introduce anonymous order driven system for trading in Interest Rate Derivatives (IRDs) with effect from April 28. Commercial banks (excluding regional rural banks) and primary dealers were permitted to trade in rupee interest rate derivatives. 2005.THE CLEARING CORPORATION OF INDIA LTD. RBI allowed commercial banks. the market was highly concentrated among a few foreign banks and private sector banks. Swaps linked to benchmarks like NSE-MIBOR and 6-month MIFOR became quite liquid. the Working Group on Rupee Derivatives (Chairman: Shri Jaspal Bindra) was constituted by RBI in November 2002 and submitted its report in January 2003. primary dealers and all India financial institutions to trade in interest rate derivatives in a phased manner. RBI also had the powers to inspect the records of these agencies. including Interest Rate Swap (IRS). Lack of transparency in terms of disclosures of quotes and valuation curves and lack of legality of netting of obligations were other issues impeding the growth of derivative market. In spite of these measures participation in the OTC derivative market remained restricted mainly because of lack of specific legal validity for such OTC derivative contracts. In the Mid-term Review of Annual Policy for year 2006-07. 2000 to 6500 contracts worth Rs. In the first phase.000 crore in December 2002. Following the recommendations of the Working Group on Rupee Derivatives. was proposed to provide clear legal validity of such contracts. IRS contracts increased from about 200 contracts with outstanding notional principal amounting to Rs.150.

Saturdays shall not be Business Days for any purpose. FEATURES OF AN IRS AS PER FIMMDA GUIDELINES • Minimum Notional Principal Amount: The minimum notional principal amount for which market makers will stand committed to their two-way quote is Rs.m. the trading hours will be in accordance with the trading hours for foreign exchange transactions. Day count fraction: The Day Count Fraction applicable to all INR interest rate swap transitions shall be Actual / 365 Fixed. the benchmark and the holiday calendar for the purposes of computation of interest streams be as that in Mumbai. 5 crores. • Tenor: The swap can be flexible in tenor i. • Business Day: Unless otherwise specified in the Confirmation. unless otherwise specified in the confirmation. except in case of interest rate swaps wherein the benchmark is based on the foreign exchange market. except for interest rate swaps against which payments are based upon the “INR-MIFOR” Floating Rate Option. • Reset dates: No fixing of rates and compounding of interest will be done on a Saturday.THE CLEARING CORPORATION OF INDIA LTD. • Business Day Convention: The business day convention applicable to all INR interest rate swaps shall be the Modified Following Business Day Convention. COLLECTION OF ARTICLES 229 . 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. In respect of swaps. for which the Effective Date will be the second Mumbai Business Day (excluding Saturday) after the Trade Date. for all swaps wherein the benchmark is based on the money market or the fixed income market. wherein the benchmark is based on the foreign exchange market. there are no restrictions on the tenor of the swap.e. • Trading Hours: The trading hours will be 9. Unless stated otherwise. except in relation to INRMIBOR-OIS-COMPOUND for which Saturday shall be deemed to be a Business Day. • Effective Date: The effective date will be the first Mumbai Business Day (excluding Saturday) after the Trade Date.30 p.00 a. a rupee interest rate swap shall be assumed to have a day count basis of Actual/365.m . for which the holiday calendar of the relevant centre for that currency will also be applicable.5. It is recommended that regardless of the centre where the deal is transacted.

On the other hand. The OIS curve is widely used by banks and primary dealers for hedging their bond portfolio as well as computing call rate funding risk. otherwise. therefore. without taking liquidity risk and with minimum credit risk (hence there is efficient usage of capital). in the period just after a primary issue. A. the Indian IRS market is dominated by the following types of swap structures. It. As the exposure of the OIS counterparties is only for the amount of any P/L. Primary Dealers – Use OIS for management of asset price risk and cash surplus. OISs usually trade on spreads of 1. since it has surplus securities. it is expected that a PD parks this surplus in the overnight interbank market. This will lead to deeper and more efficient markets. Users of OIS in India: Scheduled Commercial Banks – Use OIS contracts for managing interest rate risk while utilizing minimal capital. A PD can shield itself against this interest-rate risk by locking into an appropriate fixed-rate payer swap. on the agreed notional amount. Overnight Indexed Swaps: The Overnight Index Swap (OIS) is a fixed/floating interest rate swap where the overnight rate is exchanged for some fixed interest rate. OIS is the most popular and liquid segment in the Indian swap market. a PD is exposed to a call rate funding risk. In periods of subdued activity in the GOI primary market. Payments are exchanged at maturity for the swaps with tenors less than 1 year. be an excellent instrument for the PD to lock in a high yield by receiving fixed. and there is an unavoidable time lag involved in distribution. This is especially true in periods of high call rate volatility. The OIS swap can be used to manage interest rate risk for flexible periods. credit exposures are minimal. The OIS would. The underlying 230 benchmark is the overnight call money rate (MIBOR) which is a daily fixing done by the NSE. Types of IRS in the Indian market: The Indian OTC derivatives market has witnessed phenomenal growth over the past few years with the trades in the IRS market occasionally matching the trade in the G-sec market. Foreign Currency derivatives and Foreign Currency Forwards (Currency Swap and Currency Option). The floating leg of an OIS is tied to a published index of a daily overnight reference rate.5-5 bps and can be traded for forward and broken dates. payments are exchanged at 6month interval. The Indian IRS market has evolved from simple plain vanilla swaps to complex exotic structures. protects a PD COLLECTION OF ARTICLES . in such situations.THE CLEARING CORPORATION OF INDIA LTD. However. Generally the interest of the overnight rate portion of the swap is compounded and paid at maturity. The two parties agree to exchange the difference between interest accrued at the agreed fixed rate and interest accrued through geometric averaging of the floating index rate at maturity.

of Contracts Outstanding 67705 16464 4312 6910 95391 % Share 70. 60 crores. rate cuts or hikes can be directly exploited. The major players were foreign banks and private sector banks. 2007. corporates can raise term funds (bills. An overnight swap can effectively be used by a corporate for matching its interest rate expectations and interest-rate-risk exposure Using OIS.26 4. OIS are an excellent positioning tool for putting on carry trades or expressing a directional view. A PD would therefore be a natural two-way participant in the OIS market.422.52 7. with none of the expectations element at settlement involved in trading FRAs or futures. MIFOR Swaps: In a MIFOR (Mumbai interbank forward offer rate) swap. the counterparty pays a fixed rate and receives the six months implied rupee yield through the forwards. Participant-wise share in Indian IRS-OIS Market The Indian IRS market had an outstanding volume of Rs.THE CLEARING CORPORATION OF INDIA LTD. The Participant-wise Share in Total Outstanding Volumes as at end-March 2007 implied rupee yield through the forwards Public Sector Banks is nothing but the 8% rate at which one can Private Banks 19% raise rupees through Foreign Banks the forward route. Since the floating leg exactly follows overnight rates.24 100. and facilitates bidding in primary auctions.3. 2007 there were two contracts outstanding for Forward Rate Agreements worth Rs. semi-annually and vice-versa. Category-wise share in the total number of trades outstanding Category Foreign Banks Private Banks Primary Dealers Public Sector Banks Total No.185. B. CP etc) but pay overnight interest rates.30 crores as on March 31. 68% Primary Dealers 5% If a party has dollars and is required to swap the same into COLLECTION OF ARTICLES 231 .00 Market Share of top players in outstanding IRS volumes Top 'n' Market Players Top 1 Top 5 Top 1 0 Top 15 Share in outstanding 11% 45% 75% 90% As on March 31st. Corporate Sector – Use OIS for reducing interest cost/risk management.98 17. against its exposure to overnight rates.

It will then pay the bank a fixed rate of interest every six months and receive the then LIBOR rate on the principal. rupees. it will have to give back the rupees to the bank and take its dollars to repay its loan. say at six months LIBOR and wishes to swap the same into rupees. From the bank’s perspective. market participants were advised to use only domestic Rupee benchmarks for interest rate derivatives. So effectively. MIFORs are not only used to hedge and price currency swaps. they are also used for pricing and hedging long-term forwards and options. Under the MIFOR swap. every six months it receives the floating leg. which is what it receives from the corporate under the currency swap. So essentially. as the LIBOR payment that it receives from the bank every six months will go towards the payment of interest on its dollar loan.00. the corporate would have raised rupee resources at a fixed rate. If a company raises a dollar loan for five years. the floating leg on the MIFOR swap is a combination of the six months LIBOR and the six months forward rate. The MIFOR swap is very credit efficient. every six months.000 crore which were mainly used as a speculative tool by corporates without any underlying COLLECTION OF ARTICLES . Currency swaps are very credit intensive and will thereby choke credit lines for counterparties very quickly. banks will be able to hedge themselves. every six 232 months. At the end of the swap. the corporate will give the dollars to the bank and take an equivalent amount of rupees based on the spot rate. thereby increasing the market bid offer. 2005. it will pay a fixed rate and receive a combination of LIBOR and the sixmonth dollar-rupee forward rate. it pays a fixed rate to the market. Similarly. This will in turn make currency swaps illiquid. The RBI was concerned about the rapid growth in outstanding contracts in MIFOR to over Rs. Under the currency swap. In the absence of MIFORs. as it is a pure interest rate swap and hence does not involve the exchange of principal. All that the bank will have to do to hedge itself is pay the five-year MIFOR in the market for an equivalent amount and swap the dollars that it gets from the corporate into rupees for six months by paying the six months forward premium. but only by doing an identical currency swap in the market. As per the directives issued by the Reserve Bank of India (RBI) on May 20.THE CLEARING CORPORATION OF INDIA LTD. of which it uses the LIBOR component to pay to the corporate under the currency swap and the dollar-rupee forward component to roll over the six-month sell buy swap. it will have to enter into a currency swap with a bank domestically. The absence of MIFORs will hurt their liquidity as well and we shall go back at least five years in terms of market development. the total cost of the swap is the premium paid as a percentage of spot and the six months LIBOR as that is the opportunity cost of swapping funds in rupees and not keeping the same in dollars.1.

on request from the Fixed Income Money Market and Derivatives Association (FIMMDA). may have a view that dollar shall weaken against the rupee over the tenor of the INR exposure. i. Principal Only Swaps: Another product popular among Indian corporates entails hedging only the principal exposure under currency swap. it can also enter into a swap where the benchmark is the yield on the 1-year G-Sec. Conclusion RBI. which can be used by CCIL members to report their deals in a convenient manner. RBI/2007-2008/122 IDMD/11. Apart from processing the deals. A party with an exposure in INR. Just as a company can enter into a swap where the benchmark for the floating leg is 6-month MIFOR. RBI as per its notification (Ref.e. exposures like loans under ECBs. the risk on this swap is even lower than that on Coupon-Only swap. certain post trade processing services like resetting interest rates. To achieve this objective. providing settlement values etc. keeping coupon payments unhedged. market participants have been allowed to use MIFOR swaps in respect of transactions having underlying permissible forex exposures. in its Annual Policy Statement for the Year 2007-08. had highlighted the necessity of a mechanism for transparent capture and dissemination of trade information as well as an efficient post trade processing infrastructure for transactions in OTC interest rate derivatives. Such a party can enter into a Principal-Only swap in which INR exposure gets swapped into dollar exposure at a predetermined forward rate. D. given a transition period of six months for using MIFOR as a benchmark. With the volatility of the rupee quite low as against LIBOR FRA.15/809/ COLLECTION OF ARTICLES 233 . Market participants were. Information regarding traded rates and volumes will also be made available. These swaps are important as they allow banks and corporates to take view on the relative movements of GOI yields and corporate spreads. As a precursor towards this CCIL was advised to start a trade reporting platform for Rupee Interest Rate Swaps (IRS) which was to be made functional by August 31. INBMK Swaps: While the earlier category of benchmarks like OIS and MIFOR are linked to corporate/bank funding costs in India. for market making purpose. yields on G-Sec. subject to review. however. No. a deal reporting utility has been created by CCIL. The daily setting for G-Sec yields for different tenors is exhibited on a Reuters page known as INBMK. However. subject to appropriate limit prescribed by the RBI. without taking positions in the securities. 2007. C. to the reporting members will also be provided.THE CLEARING CORPORATION OF INDIA LTD. there is another category of benchmarks linked to the Government of India’s borrowing cost.08.

The reporting platform developed by CCIL will enable dealers to get the rates on a real-time basis and the volumes at the end of the day. ANNEXURE Functionalities & Coverage of CCIL’s Platform for trade reporting and dissemination of market information on Rupee IRS & FRA 1. 6m. As of now the market is dominated by mainly foreign banks and private banks. 2007.THE CLEARING CORPORATION OF INDIA LTD.80 billion ($1. c) Providing information to the reporting members and their counter-parties about matched and un-matched trades. Functionalities: a) Acceptance of trades reported of by the market participants and matching of these trades. Instruments Covered a) Interest Rate Swaps – Fixed Float and Basis Swaps (Up to maximum maturity – 10 years) b) Forward Rate Agreements (Up to maximum maturity – 2 years) 2. for their tracking of trades & for accounting. All banks and primary dealers will have to report all their IRS/FRA trades on the reporting platform within 30 minutes from the deal time. 2007. 14 days. 12m) c) INBMK (Designated Maturity – 1year) 3. Banks and PDs will also have to ensure that details of all outstanding IRS and FRA contracts (excluding the client trades) are migrated to the reporting platform by September 15. Daily volumes in these swaps are estimated at Rs.9 billion). b) Dissemination of trade information through CCIL website and also through the website of RBI. This is expected to facilitate better price discovery. Acceptable Benchmarks a) NSE-FIMMDA MIBOR (Designated Maturities – Overnight. 3m. enhance transparency and help in increasing the participant base. Interest rate swaps trading in India is currently carried out mostly by telephone through brokers in India and deals are settled between market participants after the end of trading hours each day. would be operationalised by August 30. 234 COLLECTION OF ARTICLES . 2007 notified that the reporting platform developed by CCIL for capturing the transactions in OTC interest rate derivatives (Interest Rate Swaps and Forward Rate Agreements (IRS/FRA)). 2007-08) dated August 23. alleged deals etc. 1m & 3m) b) MIFOR (Designated Maturities – 2m.

ccilindia. www. Futures and other Derivatives (Fifth Edition) . d) Keeping record of outstanding trades of the market participants (individually and at an aggregate level) and providing them consolidated information of their outstanding trades. when due and advising the reporting members and their counter-parties about such resets alongwith the reset rates.rbi. Options. e) Effecting interest rate resets for the outstanding trades. Swaps/Financial Derivatives 3rd Edition (Vol. f) Providing market participants with information about their settlement obligations g) Recording of cancellation of outstanding trades by market participants.fimmda. I) .THE CLEARING CORPORATION OF INDIA LTD. Hull vii.bis. 4. vi. Financial Derivatives Theory. Gupta iv. L. www. Deal Reporting: a) All reporting entities will be made member of CCIL’s Derivatives Segment.John C. Concepts and Problems – S. References: i. b) Deals are to be reported in the format specified by v.Satyajit Das COLLECTION OF ARTICLES 235 . www.

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