Use of Derivatives by Indian Bank

Coverage and perspectives One of the observed features of the equity derivatives market in India is that there has been little participation of institutional investors. In the en-suing sections, we examine issues and impediments in the use of different types of derivatives available for use by these institutional investors in India: Equity, Fixed Income, Foreign Currency, and Commodity Derivatives. The intensity of derivatives usage by any institutional investor is a function of its ability and willingness to use derivatives for one or more of the following purposes: 1. Risk Containment: Using derivatives for hedging and risk containment purposes. 2. Risk Trading/Market Making: Running derivatives trading book for profits and arbitrage. 3. Covered Intermediation: On-balance-sheet derivatives intermediation for client transactions, without retaining any net-risk on the balance sheet (except credit risk).

These perspectives are considered in examining issues and impediments in use of derivatives in the following sections. These sections are organised by type of institutional investor, and their use of each of the specific derivative types separately. The different institutional investors could be meaningfully classified into: Banks, All India Financial Institutions (FIs), Mutual Funds (MFs), Foreign Institutional Investors (FIIs) and Life and General Insurers.


Based on the differences in governance structure, business practices and organizational ethos, it is meaningful to classify the Indian banking sector into the following: 1. Public Sector Banks (PSBs); 2. Private Sector Banks (Old Generation); 3. Private Sector Banks (New Generation); and 4. Foreign Banks (with banking and authorized dealer license).

Credit and interest rate risks are two core risks all banks accept and hope to profit from. Foreign currency (price) risk accepted by banks varies widely across the four categories. Commodity (price) risk accepted by banks is limited to gold price risk in respect of gold deposits accepted by five banks under their schemes framed under RBI guidelines on the Gold Deposit Scheme 1999 announced in the union budget for the year 1999-2000. Equity (price) risk accepted by banks again is limited to their direct or indirect (through MFs) exposure to equities under the RBI prescribed 5 percent capItal market instruments limit (of total outstanding advances as at previous year-end). Some banks may have further equity exposure on account of equities collaterals held against loans in default.


Credit derivatives

The market for credit derivatives is currently non-existent in India, and hence has been dealt with in brief here. Credit derivatives seek to transfer credit risk and returns of an asset from one counter party to another without transferring its ownership. Credit default swaps and options, total return swaps, credit linked notes, credit spread forwards and options are some examples. The market for credit derivatives is currently nonexistent

Derivatives Markets in India in India, though it has the potential to develop. The sellers of credit derivatives must be able to hedge their risks, to be able to quote a price for the protection they are selling. Perhaps, the following evolution in the corporate credit markets in India could pave way to a credit derivatives market: 1. Presence of a liquid corporate bond market is essential for a term structure of corporate credit over the sovereign curve to emerge. 2. Insurance sector which is a seller of credit derivatives in other mar- kets would need evolve on the sell side of the credit derivatives mar- ket. spreads

3. RBI guidelines on guarantees and co-acceptances presently preclude banks from issuing guarantees favoring other lending agencies, banks or FIs for loans extended by them. This restriction would need to go if banks are to sell or write credit derivatives.

Mumbai Interbank Forward Offer Rate (MIFOR). However. IRS based on MIFOR/MITOR could well be written on a stand- .4. at best. Mumbai Interbank Tom Offer Rate (MITOR)]. RBI guidelines on investment by banks in capital market instruments do not authorize banks to use equity derivatives for any purpose. This is one of the best uses of credit derivatives internationally. 2. Since October 2000. NSE MIBOR.. Primary Dealers (PDs) and FIs have been allowed by RBI since July 1993 to write Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAs) as products for their own asset liability management (ALM) or for market making (risk trading) purposes. Direct and indirect equity exposure of banks is negligible and does not warrant serious management attention and resources for hedging purposes.poses). There is no RBI guideline permitting use of credit derivatives by banks and FIs to reduce regulatory capital on their respective balance sheet. and the attendant regulatory concerns of their investment in equities. This disables also banks possessing arbitrage trading skills and institutionalised risk management processes for running an arbitrage trading book to capture risk free pricing mismatch spreads between the equity cash and options and futures market – an activity banks currently any way undertake in the fixed income and FX cash and forward markets.g. banks with direct or indirect equity market exposure are yet to use exchange traded equity derivatives (viz. security-specific futures or security-specific options) currently available on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE): 1. The internal resources and processes in most bank treasuries are in. banks in India can. and manage related risks. Fixed income derivatives Scheduled Commercial Banks. and monitor use of equity derivatives (even if used only for risk containment pur. GoI Treasury Bills) or on implied foreign currency interest rates [e. for the following reasons. be termed as marginal investors in equities.adequate to manage the risk of equity market exposures. IRS can be written on benchmarks in domestic money or debt market (e. RBI guidelines also do not authorize banks to undertake securities lending and/or borrowing of equities.g. 2. index futures. Use of equity derivatives by banks ought to be inherently limited to risk containment (hedging) and arbitrage trading between the cash market and options and futures market. Reuter Mibor.2 Equity derivatives Given the highly leveraged nature of banking business. Inadequate technological and business process readiness of their treasuries to run a equity arbitrage trading book. 3. index options.

amongst others) in the rupee IRS market is marginal. a rupee interest rate futures market would need to first exist. Inadequate technological and business process readiness of their treasuries to run a derivatives trading book. and be exposed to subsequent onerous investigative reviews. 4. most PSBs are not yet actively offering IRSs or FRAs to their corporate customers on a “covered” basis with back-to-back deals in the interinstitutional market. Thereby. and manage related risks. Indeed. This enables corporates to benchmark the servicing cost on their rupee liabilities to the foreign currency forward yield curve. Most PSBs are either unable or unwilling to run a derivatives trading book enfolding IRS or FRAs. to better manage the asset-liability portfolio. and partly due to their own “discomfort of the unfamiliar. but are unable or unwilling to write IRS or FRAs with them. Inadequate readiness of human resources/talent in their treasuries to run a derivatives trading book. partly for reasons cited above. On the one side you have foreign banks and new generation private sector banks who run a derivatives trading book but do not have the ability to set significant counter party (credit) limits on a large segment of corporate customers of PSBs. and manage related risks.alone basis. Inadequate readiness of their Board of Directors to permit the bank to run a derivatives trading book. And. BoI. The consequence is a paradox. 3. according to one school of thought. for banks to be able to write interest rate options.3. 2. Inadequate willingness of bank managements to the “risk” being held accountable for bonafide trading losses in the derivatives book.” 2. . The presence of Public Sector Bank (PSB) majors (such as SBI. There is now an active Over-The-Counter (OTC) IRS and FRA market in India. Further. PNB. BoB.1 Interest rate options and futures The RBI is yet to permit banks to write rupee (INR) interest rate options. And. in a milieu where there is no penal consequence for lost opportunity profit. so that the option writer can delta hedge the risk in the interest rate options positions. the bulk of the activity is concentrated around foreign banks and some private sector banks (new generation) that run active derivatives trading books in their treasuries. Yet. at best. This inability or unwilling of PSB majors seemingly stems from the following key impediments they are yet to overcome: 1. the end user corporates are denied access through this route to appropriate hedging and yield enhancing products. on the other side are PSBs who have the ability and willingness to set significant counter party (credit) limits on corporate customers. and need not be a part of a Cross Currency Interest Rate Swap (CC-IRS).

wherein the cover transaction may be with a bank in India or overseas or on an internationally recognized options exchanges).1 Tax issues in foreign currency derivatives . and Swaps.perhaps the policy dilemma before RBI is: how to permit an interest rate futures market when the current framework does not permit short selling of sovereign securities. 2. 2. it may be of little consequence unless lending and borrowing of sovereign securities is first permitted. Cross-Currency Options (only on a fully covered back-to-back basis. RBI is yet to permit authorized dealers to write FCY:INR options. most PSBs do not run an active foreign currency derivatives trading book.4 Foreign currency derivatives Banks that are Authorized Dealers (ADs) under the exchange control law are permitted by RBI to undertake the following foreign currency (FCY) derivative transactions: For bank customers for hedging their FCY risks. FCY:INR Forward Contracts. the activity of most PSB majors in this market is limited to writing FCY derivatives contracts with their corporate customers on fully covered back-to-back basis. However. domestic corporates with rupee liabilities may also enter into FCY:INR swaps with authorized dealers to hedge their long-term interest rate exposures.FCY:INR Forward Contracts. on account of the impediments enumerated earlier that need to be overcome at their end. With bank customers for swapping from INR to FCY their long term INR liabilities. and Swaps. 5. Cross-Currency Forward Contracts. Further. With inter-bank participants in India or overseas for risk containment or risk trading purposes (within the overall open position limit allowed by RBI to the respective bank). There is now an active Over-The-Counter (OTC) foreign currency derivatives market in India. Interestingly. and Swaps (currency only and/or CC. and Swaps (currency only and/or CC. 2.4. And. 4. FCY:INR Forward Contracts.IRS).IRS). (This enables corporates to benchmark their rupee liability servicing costs to foreign currency yield curve). 3.Cross-Currency Forward Contracts.Cross-Currency Options. 1. even if short selling of sovereign securities were to be permitted. and Swaps (currency only and/or CC-IRS).

RBI permitted seven banks to import and resell gold as canalizing agencies. leaving themselves exposed to contingent tax risk or litigation. in absence of a prior “debt incurred”. at the end of which the deposit is repayable at the price of gold as on date of maturity. the applicability or otherwise of withholding tax on the cash flows exchanged in the FCY:INR derivatives contract. for short) are active in this business. cash flows under interest rate swaps as well as currency swaps are ‘revenue’ in character in the hands of the recipient bank. market participants in the foreign currency derivatives market transact based on their legal/internal counsel views on these tax issues. The quantum of gold mobilized so far by the bullion banks under these gold deposits schemes is about 7 tonnes. the business presence (‘permanent establishment’) of the recipient bank in India etc. The commodity risk accepted by banks is limited to price risk of gold (deposits) accepted by five bullion banks that launched their schemes under the RBI guidelines on the Gold Deposit Scheme 1999 announced in the union budget of 1999-2000. for this purpose. However. cash flows under CCIRS or IRS do not bear the character of “interest” as understood under the income tax law. the bullion bank’s customers are bullion traders and jewellery units in India. Typically.5 Commodity derivatives In 1997. There is no forward market for gold in India. In brief. In absence of a specific binding ruling either of the Central Board of Direct Taxes (‘CBDT’) or a competent Court. the key tax issue that arises is.However.. Technically. and do not retain any gold price risk on its books.4 Hence. Therefore.From a market development perspective. bullion banks do this business on consignment purchase and sale basis for a transaction fee. bullion banks have the following alternatives to hedge their gold price risk: . currently. withholding tax applicable to ‘interest’ payments should not apply. the income-tax law remains wide open to interpretation. It is understood that. requires determination about applicability of relevant double tax avoidance treaties between India and the country of tax residence of the recipient bank. 2. In fact. where the recipient bank is a tax non-resident. Resolution of these tax issues is crucial for the long-term development of the foreign currency and fixed income derivatives market in India. these bullion banks accept assayed gold as a deposit for 3 to 7 years tenors. whether any part thereof is (or is not) liable to tax in India. These gold deposits carry interest ranging from 3 percent to 4 percent per annum. a contract settled later than T+11 (days) is treated as a forward contract. forward contracts on gold are prohibited. It is understood that now about 13 banks (‘bullion banks’.And. The quantum of gold imported through bullion banks is in the region of 500 tonnes per annum. And. SBI is a market leader in this segment with a market share of perhaps over 90 percent.

product servicing cost including SLR cost.bedded in the gold futures contract. This. Thomas said the ministry will present the amendment to the cabinet in two weeks and.. Food and Consumer Affairs Minister K.e.India's parliament is likely to receive an amendment in its next session that would permit financial institutions such as banks and mutual funds to trade in commodity derivatives and introduce trading of commodity options.V. the New York Mercantile Exchange (NYMEX)) along with a matching FCY:INR forward contract to hedge the foreign currency risk em. but not SLR maintenance (though gold held by the bank in physical form constitutes and eligible SLR asset). the first alternative above) is particularly high given the two (gold and FCY) components that need to be hedged. 2. Bullion banks operating schemes under the Gold Deposit Scheme. Sell the gold in the Indian spot OTC market.1.This implies an additional SLR cost of servicing the gold deposit.) NEW DELHI -. and manage the attendant credit risk accepted by it. in a country that is one of the world's top producers and consumers of agricultural commodities and a major producer of minerals. coupled with the 3 percent to 4 percent annual interest payable on the deposit. makes the gold deposit product financially unviable for the bullion bank. . It would also enable more effective market regulation. such fully hedged rupee cost of the gold deposit (i. Mr. 1999 are permitted under the exchange control regulations to use exchange traded or OTC hedging products available overseas to manage the gold price risk. However. financial institutions would be limited to hedging against lending positions. bank guarantees and other collaterals. and ensure that the spread is adequate to cover the credit risk. The amendments would pave the way for the introduction of commodity options trading and trading in commodity derivatives by financial institutions such as banks and mutual funds. and buy gold futures or call option in an overseas commodities exchange (for example. However. Lend the gold (received in deposit) to jewelry manufacturing units in India in the form of ‘gold loans’. Thomas said Wednesday. the only viable alternative for the bullion bank is to create a gold loan portfolio to match its gold deposit liability. and reduced volatility. they say. if approved. Supporters of the amendment to a law governing commodity derivatives markets say it would lead to a massive increase in trading volumes. (Incidentally. to parliament in the next session. RBI has exempted balances under gold deposit scheme from CRR maintenance. through a combination of cash margins. Therefore.

Thomas said. Mr. 3 All India financial institutions (FIs) With the merger of ICICI into ICICI Bank. making it more effective and reducing market volatility. In the context of use of financial derivatives. Mr.26 trillion rupees ($3. NABARD and IDFC. Low trading volumes result in poor price discovery. . the Multi Commodity Exchange of India Ltd. Thomas said the proposed amendment would give the regulator greater enforcement powers and independence. a 52% increase. Chary said the amendment would also introduce index trading and new products such as shipping and freight. IFCI. chairman of the country's largest commodity bourse. Also. India's commodities exchanges traded goods worth 181. IIBI. Thomas said.32 trillion) in the fiscal year that ended March 31. A parliamentary panel in December 2011 backed the entry of banks and mutual funds into commodity derivatives trading. The Forward Markets Commission this year took several steps to check excess speculation. Mr. and the Forward Markets Commission had asked all exchanges to improve the ratio between volume and open interest by allowing more parties to hedge. the universe of all-India FIs comprises IDBI. "There will be a spurt in volumes at all the commodity exchanges once the amendment is approved. including raising trade margins and reducing position limits in several markets. the central bank has been reluctant to allow banks and other financial institutions to trade commodity derivatives because of concerns about the enforcement power of the market regulator." said Venkat Chary. the universe of FIs could perhaps be extended to include a few other financially significant players such as HDFC and NHB. EXIM. the Forward Markets Commission. Previous attempts to allow options trading failed due to political opposition." Mr."The participation of institutions such as banks is necessary to bring adequate liquidity to this market. India re-introduced commodity futures trading in 2003 and currently has five national exchanges. SIDBI.

The issues and impediments they need to yet overcome are largely similar to those facing PSBs. albeit on a fully covered back-to-back basis.pears that most FIs do not run an equities arbitrage trading book. Some FIs actively use IRS and FRA for their ALM.2 Fixed income derivatives Since July 1999. 3. There are also no credit products whose interest rate is benchmarked to any commodity prices. Therefore. even FIs are permitted to write IRS and FRA for their asset liability management (ALM) as well as for market making purposes.1 Equity derivatives Equity risk exposure of most FIs is rather insignificant. FIs too are not users of equity derivatives. the issue of they using commodity derivatives (whether in the overseas or Indian market) does not arise. FIs can also offer foreign currency derivatives as a product to their corporate borrowers on a fully “covered” back-to-back basis.tical to those outlined earlier vis-a`-vis banks. However. and for arbitrage trading purposes between the cash market and options and futures market. cross currency swaps.3 Foreign currency derivatives Most FIs with foreign currency borrowings have been users of FCY:INR swaps. and FRAs for their liabilities management. and often limited to equity devolved on them under underwriting commitments they made in the era upto the mid-1990s. However. For reasons iden. 3. to begin with. it ap. Yet. none are yet ready to run a rupee derivatives trading book. Yet. there is no RBI guideline disabling FIs from running an equities arbitrage trading book to capture risk free pricing mis-match spreads between the equity cash and options and futures market. like banks. a few have plans to offer IRS and FRA as products to their corporate customers (to hedge their liabilities). With the prior approval of RBI. CCIRS. Possible reasons could include inadequate readiness in terms of possessing arbitrage trading skills and institutionalised risk management processes for running an arbitrage trading book. 4 Mutual funds . most FIs have not yet readied themselves to explore this business opportunity.4 Commodities derivatives FIs have no proximate exposure to commodities.3. Use of equity derivatives by FIs could be for risk containment (hedging) purposes. 3. Also.

most mutual funds (whether man. Relatively insignificant investor interest in equity funds ever since exchange traded options and futures were launched in June 2000 (on NSE. Derivatives Markets in India: 2003 273 2. 4. there are also no tax issues relating to use of equity derivatives by them. SEBI (MF) Regulations also authorize use of exchange traded equity derivatives by mutual funds for hedging and portfolio re-balancing pur.aged by Indian or foreign owned asset management companies) are not yet active in use of equity derivatives available on the NSE or BSE. The following impediments seem to hinder use of exchange trade equity derivatives by mutual funds: 1.change traded derivatives for hedging and portfolio balancing purposes.fore wants SEBI to clarify the scope of this regulatory provision. such MIFOR linked IRS have the potential of generating noticeable basis risk. 3. The regulatory prohibition on use of equity derivatives for portfolio optimization return enhancement strategies. besides the liquidity risk in the underlying bond asset of longer maturity. later on BSE). SEBI (Mutual funds) regulations restrict use of exchange traded eq. given the openended nature of most bond schemes of mutual funds. being tax exempt. And. and arbitrage strategies constricts their ability to use equity derivatives.ket.uity derivatives to ‘hedging and portfolio rebalancing purposes’. and the trustees of mutual funds do not wish to be caught on the wrong foot! The mutual fund industry there. IRS and FRA transactions entered into by mutual funds are not construed by SEBI as derivatives transactions covered by the restrictive provisions which limit use of derivatives by mutual funds to ex.poses.1 Equity derivatives Mutual Funds ought to be natural players in the equity derivatives mar. by paying fixed rate and receiving floating rate. (Needless to add. At least a few mutual funds actively use IRS to optimize yield and reduce the duration of their bond scheme portfolios. Evidently. 4.4. It is understood that some of these IRS are benchmarked to MIFOR as well. The popular view in the mutual fund industry is that this regulation is very open to interpretation. Inadequate technological and business process readiness of several players in the mutual fund industry to use equity derivatives and manage related risks.2 Fixed income derivatives SEBI (MF) regulations are silent about use of IRS and FRA by mutual funds.) . MFs are emerging as important users of IRS and FRA in the Indian fixed income derivatives market. However.

subject to a maximum of US$ 50 million per mutual fund. interestingly. the units may trade on the exchange at a premium to NAV-closer to the retail price of gold in India]. mutual funds can invest only in transferable financial securities. Therefore. for market makers of the fund. recently.wards) in the form of a financial asset. Several mutual funds have now obtained the requisite SEBI and RBI approvals for making these investments. given that most ADRs/GDRs of Indian companies traded in the overseas market at a premium to their prices on domestic equity markets. this facility has remained largely unutilized. subject to maximum of US$ 50 million per mutual fund. Once in. However. though the scheme NAV is computed at the wholesale price of gold in India. with a sub-ceiling for individual mutual funds of four percent of net assets managed by them as on 28 February 2002. mutual funds ought to emerge as active users of FCY:INR swaps to hedge the foreign currency risk in these investments. the issue of they using commodity derivatives (whether in the overseas or Indian market) does not arise. This product aspires to offer investors the ability to hold gold as an asset class (with its attendant risks and re. the question of using FCY:INR forward cover or swap did not much arise. mutual funds cannot offer a fund product that entails a proximate exposure to the price of any commodity. 4. However. Therefore. In absence of any financial security linked to commodity prices. Several mutual funds had obtained the requisite approvals from SEBI and RBI for making such investments. from 30 March 2002. However.vestment in foreign debt securities pick-up.all limit of US$ 500 million with a sub-ceiling for individual mutual funds of 10 percent of net assets managed by them (at previous year-end). it also offers the possibility of profiting from the spread which exists between the wholesale price of gold in India11 at which the banks would issue the gold receipts/certificates.and the retail price of gold in India (which is often about five percent higher than the wholesale price) at which the units of the scheme could trade in the secondary market.9 Indian mutual funds were allowed to invest in ADRs/GDRs of Indian companies in the overseas market within the over.10 domestic mutual funds have been permitted to invest in foreign sovereign and corporate debt securities (AAA rated by S&P or Moody or Fitch IBCA) in countries with fully convertible currencies within the overall market limit of US$ 500 million. . one of the players in the mutual fund industry proposes to offer an exchange traded gold fund that would invest solely in transferable gold receipts/certificates issued by one or more of the 13 bullion banks which have been authorized by RBI to accept gold deposits under the Gold Deposit Scheme 1999.3 Foreign currency derivatives In September 1999. with the prospect of also getting some regular income in the form of interest on the gold receipts/certificates held by the fund.4 Commodity derivatives Under SEBI (MF) regulations.4. The draft offer document of the scheme is awaiting SEBI clearance. [The implicit assumption here is that. Incidentally.

2. is it speculative business income or non-speculative business income. their activity in the exchange traded equity derivatives mar. Applicability or otherwise of withholding tax on profits from equity derivatives contracts.1 Tax issues in equity derivatives for FIIs Two crucial tax issues arise in use of equity derivatives by FIIs: 1. given the short tenor of equity derivative contracts.1 Equity derivatives Till January 2002.)With the enabling regulatory framework available to FIIs from February 2002. In absence of a specific finding ruling either from the CBDT or a competent court. the income-tax law on these issues remains wide open to interpretation. the CBDT circular dating back to 12 September 196014 interprets very generously hedging transactions in commodities. stocks and shares. and if business income. the better view seems to be that the profit or loss from equity derivative contracts would be business profit or loss rather than a capital gain/loss. the two years of successful track record of the NSE in managing the systemic risk associated with its futures and options (F&O) segment would also pave way for greater FII activity in the equity derivatives market in India in the emerging future.1. And. Technically.5 Foreign institutional investors (FIIs) 5. Evidently. to include portfolio and strategic hedging. (These open position limits have been spelt out in SEBI circular dated 12 February2002. several FIIs are still in the process of completing the process of their internal approvals for use of exchange traded equity derivatives on the NSE or BSE. any profit or loss from a hedging transaction in stocks and shares is treated as a non speculative business . Interestingly. 5. Tax character of profit or gain from equity derivatives contract – is it business income or capital gains. Perhaps. applicable SEBI and RBI Guidelines permitted FIIs to trade only in index futures contracts on NSE and BSE. It is only since 4 February 200212 that RBI has permitted (as a sequel to SEBI permission in December 2001) FIIs to trade in all exchange traded derivatives contracts within the position limits for trading of FIIs and their sub-accounts.ket in India should increase noticeably in the emerging future. and does not confine hedging transactions to a position hedge.

3 Foreign currency derivatives Equity investing FIIs leave their foreign currency risk largely unhedged since they believe that the currency risk can be readily absorbed by the expected returns on equity investments. 5. FII investment in the domestic sovereign and corporate debt market has been negligible. 5. Consequently. 10 percent to 15 percent under some double tax avoidance treaties) applicable on interest earned in India by FIIs. FIIs are also permitted to enter into foreign exchange derivative contracts (including currency swaps and CCIRS) by RBI16 to hedge the currency and interest rate risk to the extent of market value of their debt investment under the 100 percent debt route. Given that all FIIs are non-residents for tax purposes. the spread could turn negative after payment of Indian taxes (20 percent under domestic law. FII activity in the foreign currency derivatives market in India has also been negligible till now. requires technical determination about applicability of the relevant double tax avoidance treaties between India and country of tax residence of the recipient FII.2 Fixed income derivatives Since May 2000. Perhaps. Therefore. However. barring in periods of unforeseen volatility (such as the far eastern crisis). with individual sub-ceilings allocated by SEBI to each FII or sub-accounts. The applicability or otherwise of withholding tax on profits from equity derivatives transactions by FIIs would also have to be based on the foregoing determination. Resolution of these tax issues at the policy level is perhaps crucial for the long term development of the equity derivatives market in India. . FIIs are permitted to invest in domestic sovereign or corporate debt market under the 100 percent debt route subject to an overall cap under the external commercial borrowing (ECB) category. This is significant because losses from speculative transactions are ‘ring fenced’ and cannot be offset against capital gains or other business profits. FII activity in the domestic fixed income derivatives market has been largely absent. the spread between fully hedge rupee cost of funds for an FII and the return on investment in India sovereign securities or top rated domestic corporate debt securities is too thin to be attractive.profit or loss. whether any part of the profit or loss from equity derivatives transactions is liable to tax in India or not. investment by FIIs in the domestic sovereign or corporate debt market has been negligible till now. the business presence (‘permanent establishment’) of the recipient FII in India etc. In fact.

the market value of banks assets (i. In doing so they recognize that there are different types of risk such as credit risk. interest rate risk. with special reference to interest rate derivatives. price risk. It helps in mobilizing the nations saving and in channelizing them into high investment priorities and better utilization of available resources. The study would also examine if there is any significant impact of ownership structure on the use of interest rate derivatives in sample banks. INTRODUCTION The Banking sector has played a commendable role in fuelling and sustaining growth in the economy. operational risk.e. Out of these risks Interest rate risk is the most prevalent risk which refers to the exposure of a bank’s financial condition to adverse movements in interest rate. To serve this particular objective the study is based on two major giants. fees and the cost of borrowed funds are affected by changes in interest rates. Tier I Capital. 1. Modern banking is something different from lending and borrowing. ROA. loans and securities) will fall with increase in interest rates. Total deposit Ratio. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder’s value. changes in the shape of the yield curve (yield curve risk) and option values embedded in the products (options risk). liquidity risk. foreign exchange risk. Total loan Ratio.INTEREST RATE DERIVATIVES IN INDIAN BANKS Аbstract The present research paper makes an attempt to provide a comprehensive profile of the global OTC derivatives market. correlation and ANOVA to find out the extent to which these banks have managed the adverse movements in interest rate with the help of interest rate derivatives. Changes in interest rate effect a bank’s earning by changing its net interest income and the level of other interest sensitive income and operating expenses. ROE. It is the risk to earnings and capital that if market rates of interest changes unfavorably. Different variables such as Total Asset. etc. Advances. Interest rate refers to volatility in net . In addition earnings from assets. It has analyzed various issues related to interest rate derivatives in Indian banks. This risk arises from differences in timing of changes in rates. They accept risk in order to earn profits. the largest public sector and private sector bank in India namely SBI and ICICI Bank. Deposit. Interest Margin. etc have been analyzed with the help of various statistical tools such as ratios. In essence. the timing of cash flows (reprising risk).

The time duration for the study was from 2006 to 2009. 2. it is possible to partially or fully transfer price risk by locking in asset prices. Commodity linked derivatives remained the sole form of such products for almost three hundred year. In other words. In the wake of deregulation of interest rates as part of financial sector reforms. Through the use of derivatives products. The Reserve Bank had introduced interest rate swaps (IRS) and forward rate agreements (FRA) in March 1999 and interest rate futures (IRF) in 2003 and reintroduced IRF on 31st Aug 2009.interest income (NII) or in variation in net interest margin (NIM) i. a need was felt to introduce hedging instruments to manage interest rate risk. Deposit. By their very nature financial markets are marked by a very high volatility. their complexity and also turnover. They add to the completeness of financial market that is by their very nature marked by a very high degree of volatility. interest rate risk arises from holding assets and liabilities with different principal and maturity dates or reprising dates. indeed prices are the balancing wheels of the market mechanism.e. This paper has also emphasized on the contribution of various segments in the global OTC derivatives market. In that context. Secondary data have been collected from the websites of Bank for International Settlement and Annual Reports of SBI and ICICI Bank. In generic terms. the largest public sector and private sector bank in India namely State Bank of India (SBI) and Industrial Credit and Investment Corporation of India (ICICI) Bank (ICICI) Bank. Banks can reduce their interest rate risk by hedging with derivatives securities and by using the asset/liability management techniques. NII divided by earning assets due to changes in interest rate. reference rate or an index. However since their emergence. . these products have been very popular and by 1990’s they accounted for about 2/3 of total transaction in derivatives products. an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of banks. In recent years the market for financial derivatives has grown tremendously in terms of. variety of instruments available. markets are meant for price determination and exchange of goods and services. An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given Interest rate. derivatives are considered facilitators of price discovery in financial market and also as risk allocators. Accordingly. Advances. RESEARCH METHODOLOGY The present research paper makes an attempt to examine the various aspects related to interest rate derivatives in Indian banks. Financial derivatives came into spotlight in the post 1970 period due to growing instability in the financial market. To serve this particular objective the study is based on two major giants. These products initially emerged as hedging devices against fluctuation in commodity prices. The emergence of the market for derivative product can be traced back to the willingness of risk–averse economic agents to guard themselves against uncertainties arising out of fluctuation in asset prices. This paper makes an effort to study different variables such as Total Asset. They are defined as financial instruments whose payoff is based on the price of an underlying asset. The present study makes an attempt to test the hypothesis that there is no relationship between ownership structure and the use of interest rate derivatives in the sample banks.

Implication of Interest Rate Derivatives in Indian Banks Bank participation in derivative markets has risen sharply in recent years. 690. in 2007 to Rs. Significant decrease was recorded in the use of interest rate derivatives in SBI as well as in ICICI Bank during March 2008 to March 2009 due to global slow down.652. Scheduled commercial banks reduced their off-balance sheet exposure by 26.563.76 cr. the country's second largest bank. in Interest Rate Derivatives in March 2009. ICICI Bank. . 652.4 percent during 2008-09. 103.50 cr. SBI. 928.00 cr. SBI has used interest rate derivatives conservatively with a slight increase from 2006 to 2007 but has shown a decreasing trend from Rs.155. ROE. Total loan Ratio. Total deposit Ratio. in 2008 and IRD in SBI and ICICI Bank Rs.16 cr. in Interest Rate Derivatives during the same period. has the exposure of 195. has an estimated exposure of Rs. partly due to strengthening of prudential norms by RBI. which has decreased to Rs. ROA.186. 610. 2.76 Cr. A major concern facing policymakers and bank regulators today is the possibility that the rising use of derivatives has increased the riskiness and profitability of individual banks and of the banking system as a whole. Interest rate derivatives used in ICICI was maximum in March 2008 amounting Rs.Figure decrease in 2009 in both the banks.42 cr. in 2009.97. etc with an objective to study the role of interest rate derivatives in the sample banks. Interest Margin. in March 2009. the country's largest bank.195. 690.50 cr.97.3.Tier I Capital.

Investment of banks in interest rate derivativeshas been considerably asymmetric with respect to trading and hedging activities. Trading aims at willingness to take risk with one’s money in hope of reaping risk profit from investment in risky assets out of their frequent price changes. The growth in the value of hedging derivatives is much lower. thereby. There are two different attitudes towards risk: Risk aversion or hedging and risk seeking or trading. interest. ICICI Bank has extensively used trading in interest rate derivatives as compared to SBI over the years. Tier I capital etc. 2. It aims at isolating profit from the damaging effects of interest rate fluctuations – concentrating on interest sensitive assets and liabilities – loans. interest margin. the value of derivatives held by banks for hedging is much smaller (see Figure 5). protecting the NIM ratio.The primary objective of any investor is to maximize returns and minimize risks (uncertainty of outcome). deposit demand deposit. return on asset.3.1. loan. The trading activities in both the banks have decreased in 2009 as compared to 2008. Asset and IRD in SBI and ICICI Bank The following paragraph intend to examine the implication of IRD towards the performance of banks in question by establishing the relationship between IRD and different variables such as size. return on equity. IRD and Asset . It can cause both unforeseen losses and unexpected gains. borrowings etc. Hedging aims at devising a plan to manage the risk and convert it into desired form by replacing the uncertainty by certainty or by paying a certain price for obtaining the potential gain opportunity while avoiding the risk of adverse outcomes.bearing deposits. Compared with the value of derivatives used for trading. investment.

94 % in 2007.2. loan and IRD in SBI . As a risk management instrument. making new loans. whereas it was 141 %. The total asset and IRD Ratio in 2009 was 51. banks decision on hedging with derivatives may be related to their loan making activities. Such operation would involve the acquisition of new assets.17 % in 2009 respectively. 2007 and 2006 respectively. Brewer.3. rise from 2006 to 2008 but fall in 2009 2.58 % in 2009. This shows that the dependence on interest rate derivatives in SBI is relatively low as compared to ICICI Bank which shows a different picture. derivatives provide additional opportunity to mange the risk exposures in banks.06 % in 2008 and 11. but has shown a decreasing trend by 21. Over all it has used this instrument extensively as compared to SBI but similar trend have been noticed in both the banks i.58 %. One way to manage this risk is to increase or decrease the holding of asset that give rise to the interest rate risk. The percentage explains that ICICI bank has aggressively used IRD in 2008 but which has declined to 51.e.In the year 2006 the ratio of interest rate derivatives to asset in SBI was 19. i. These loans typically have longer maturity and higher interest rate sensitivities than liabilities. IRD and Loan ratio Bank loans as an asset are risky investments by banks in various areas.e. Duffee and Zhou (2001) have concluded that. which may interrupt the lending policy and may damage the relationship with corporate clients as well as. Minton and Moser (2000) find a positive relation between banks use of interest rate derivatives for hedging and the making of loans . and 70 % and 80 % in 2008. ranging from commercial and industrial loans to loans to individual customers. Interest rate risk arises when there is maturity mismatches between banks asset and liabilities. or premature sale of existing assets.83 % which has increased up to 32. Asset.

2. 2007.4 in 2006 and 2007 and again 11.57 in 2006. IRD and Deposits The flow of deposit provides a natural hedging for banks to cover their liquidity needs a potential substitution for derivatives. More profitable banks appear to have stronger financial strength against adverse shocks and are remote from financial distress which reduces the likelihood for hedging.4 to 13. and 11.4.44 and 57.04 during 2006 to 2009 SBI but in case of ICICI Bank it has marginally decreased from 1. It has further decreased to 15.18. 6. 2008 and 2009 respectively showing a mixed trend.24 in 2007. in ICICI Bank it was recorded as 65.e. 76. 64. 1.07 during 2006 to 2009 whereas in ICICI Bank it has ranged between 2. The ratio of net interest income to total asset (interest margin). 77 in 2007.While calculating the ratio between advances and IRD we found that the ratio of advances to IRD was 2.89 to 1. 17. In 2006 it was .73 in 2009.59.67 in 2006. High level of withdrawal risk reduces the liquidity of the deposit from the bank’s perspective and in turn reduces the potential ability to substitute other hedging instruments such as derivatives. focuses on the interest –income generating ability of banks. Return to total asset (ROA) is useful in the study of the over all efficiency of a bank in using its asset.3.1 to 7. but reached to its highest level i.7 and 6. The return on equity was 15. Return to equity (ROE) is particularly important to shareholders and is related to the charter value of a bank.e. High interest margin is the indicator of high risk in terms of interest rates which in turn is a positive indicator for the use of interest rate derivatives.80 in 2007. The demand deposit ratio was 13.4.3. again 2. 66. Interest margin was minimum in the case of SBI which ranged in between 0. in 2007 it was .11 . This may be a reason why ICICI Bank has extensively used interest rate derivatives than SBI 2. 14 in 2007 and 2008. An increasing trend could be seen in the deposit ratio in the case of SBI i.67.3.48 in 2009 in SBI while in the case of ICICI Bank it was 6.400 and in 2009 it reached to 1.810.On the contrary.2 to 2. In case of ICICI Bank it has shown a negative trend from 16.722. .93 in 2006.037 in 2009. The return on asset has increasing from 0.7 in 2008 and 2009(Figure 10). in 2008 it was .82 in 2008.02 to 0. While in the case of ICICI Bank the ratio between the two is much lower which means that the dependency between advance and IRD is much higher as compared to SBI. This implies that demand deposit is more in ICICI as compared to SBI during the same period under study. 5.76 in 2006. 74 in 2008 and again 77 in 2009 except a decrease in 2008(74).3 to 1 during the same period (Figure 9).88.47 in 2006 which decreased to 14.67 in 2008 and 5.2. IRD and Bank profitability The literature generally shows a negative relation between profitability and the hedging behavior for financial entities (Purnanandam2006).

there ought to be a negative association between bank capital and the use of other risk management institution such as derivatives. OWNERSHIP STRUCTURE AND USE OF INTEREST RATE DERIVATIVES The present study has used correlation as well as ANOVA test in order to establish the relationship between the ownership structure and the use of interest rate derivatives. it is evident from the Table: 3 that there is a negative correlation between the two (-0. While calculating the correlation between the asset and IRD. Negative correlation was found in between the loan and IRD (-0. In this sense the capital reserve of banks and other risk management policies such as derivatives may be substitute for each other.36). negative correlation was found in SBI in deposit and demand deposit ratio -0.07) which means that as asset increases the investment in interest rate derivatives decreases in SBI.3. but decreased to 8. IRD and Tier I capital The risk adjusted capital requirement such as the tier I capital in the Basel II framework is intended to serve as safety cushion against various contingencies.5. In the case of ICICI Bank approximately zero correlation was found (0. In the case of SBI Tier I capital has been fluctuating from year to year.2. In the case of ICICI Bank positive correlation was found in deposit ratio 0.2 to 11. It has again registered an increase up to 9.14 in 2008 but again decreased to 8. Controlling for the risk profile of bank loans. Similarly.59 respectively. Tier I capital 3.01 in 2007.02 and .014 %) in SBI signifying that as the loan increases the investment in interest rate derivatives decreases while positive correlation was found in ICICI Bank (0.0006) which means that there was no relation or the two variables are independent to each other and no predictive pattern could be identified between the two. It was 9.84 in between 2006 to 2009 with an exception in 2007. In the case of ICICI Bank Tier I Capital has been increased from 9.25 and negatives correlation in demand deposit .53 in 2009.36 in 2006. Banks with stronger capital position are arguably more capable of servings interest rate.0.

-0. deposit. In ICICI Bank we can see positive correlation (0. The difference in the pattern of investment in IRD may be attributed to the change in ownership structure and policies adopted by these two banks. increases the use of IRD.e. the systematic risk can be captured by the size of the banks as in the case of SBI. ROE. although few suggestions could be useful. hence the hypothesis is accepted i. The government owns 59. ROE and interest margin which depicts that as the three increases interest rate derivatives decreases and vice-versa.90. over the years but the predictability remains uncertain due to limited data available. which means as the variables. Almost similar pattern of fluctuations could be seen among the variables. The interest rate risk is managed by the large pool of asset in the case of SBI while ICICI Bank has . which means that as Tier I capital increases IRD decreases and viceversa. In the case of SBI negative correlation exists in ROA. On the other hand ICICI Bank has used this instrument extensively. Tier I capital increases the investment in IRD decreases. it was also proved in the present study that SBI and ICICI Bank differ in their approach towards the use of interest rate derivatives. While applying the Analysis of Variance Test it was found that the calculated value of F is smaller than the table value. The hypothesis is rejected in the case of advances proving that sample means of the banks in question are different . 4.43) which means that as tier I capital increases use of IRD in ICICI Bank also increase.10. As banks grow larger and make more loans. Net NPA and Tier I Capital. Interest margin and IRD show a negative correlation. CONCLUSION Public sector banks are operated by government bodies with a share of more than 51 % and have deep commitment to social obligations. As the public and private sector banks are different in their policy making. In the case of ICICI Bank positive correlation was seen. loan. the largest bank in India which seems to be conservative in using interest rate derivatives. Interest margin. which means that as ROA and ROE increases the use of IRD also increases. NPA. demand deposit. On the other hand ICICI Bank shows almost positive correlation in all the variables except demand deposit and ROA.41 percent stake in SBI. which is a major draw back in this research paper. sample means in both banks are equal with respect to IRD. The study of different variable reveals that a negative correlation have been found in SBI which mean that as the volume of asset. also increases. While calculating the correlation between IRD and Tier I Capital it was found a negative correlation with a value of -0. ROA. they are basically committed to earn profit. Private sector banks are the banks which are controlled by the private lenders with the approval from the RBI.

The regulatory framework applicable to the respective derivative markets and participants would need to evolve further. . . and foreign currency are at their nascent stage of evolution in India. 5.sures and risks relating their activity in the derivatives market. one or more of the following issues or impediments would have to be over. needs to be ushered in. fixed income.come and resolved: 1. 280 Use of Derivatives by India’s Institutional. (b) but concomitantly holds managements of public sector banks and FIs accountable for lost opportunity profit. but have significant growth poten. The human resources/talent of several key participants in these markets needs to be vastly upgraded and readied to manage the expo. The senior and top management of several key participants needs to undergo an orientation phase to familiarize themselves with the conceptual underpinnings and microstructure of these derivatives markets to help them establish an appropriate governance framework for the derivatives market activity of the participant. For this potential to be realized. A framework which (a) relieves managements of PSBs and FIs of the risk of being held accountable for bonafide trading losses in the derivatives book and being exposed to subsequent onerous investigative reviews. 2. . The tax treatment applicable to the participants visa versa respective derivative contracts would need to be clarified to provide certainty about it to the market participants. 4.tial. 6. The technological and business process framework of several key participants in these markets needs to readied to manage the risks relating their activity in the derivatives market. 3. as discussed in the previous sections.7 Concluding remarks Derivative markets in equities.


Hedging with Interest rate and Credit Derivatives by Banks. & Zhou Chunsheng (2001).G. Brewer III Elijah. pg no. A Study of Profitability Performance of Public Sector Banks in India. Credit derivatives in banking: Useful tools for managing risk? Journal of Monetary Economics 48. Kathiravan P.. Chand & Company Delhi. Indian Journal of Finance. Vol. Duffee Gregory R. Xu Ying (2007). 2009 Bank for International Settlement.References Annual report of SBI and ICICI Bank. pg no. Minton Bernadette A. 2006. & Moser James T. Interest-rate derivatives and bank lending Journal of Banking & Finance 24. 353-379 Datt Ruddar. Indian Economy. Ltd. 6th Edition. Mahieu Ronald..P. (2000). (2009). 25–54. S.(2009). New .M. Selvakumar M. 2007. III. 2008. May 2009. Sundharam K. 3-21. pg no.

New England Economic Review. Interest rate derivatives and asset-liability management by commercial banks. .Simons Katerina Jan-Feb. (1995).

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