Note on FRA, Swap and Eurodollar bonds: Derivative in the Fixed Income

markets

Forward rate agreements (FRAs)

1. FRAs are forward contracts on interest rates. They are negotiated and
settled “over-the-counter” ie bilaterally and not traded on any exchange
2. Buyer of FRA expects that interest rate would increase. Buyer makes
profit on FRA transaction if interest rates move up.
3. Likewise, seller of FRA makes profit if interest rates go down. Seller of
FRA expects interest rates to decline.
4. To take an example, if the buyer and the seller agree for 6.1% p.a. as the
FRA rate and the actual interest rate is 6.2% p.a.; buyer makes 0.1%p.a.
and seller loses 0.1% p.a.
a. Usually, the underlying reference interest rate used is 91day
MIBOR. ie in the example above, 6.2% is actual 91day MIBOR with
which the FRA rate is compared to compute profit/loss.
b. Buyer and seller agree on a notional amount to transact in FRA. In
the example above, the notional amount is (say) INR 100 cr. The
profit in INR is then 0.1% p.a. * INR 100 cr or INR 10 lacs p.a.
c. The underlying is 91day MIBOR. Hence the profit is also computed
for 91 days. INR 10 lacs p.a. ( ie for 365 days) becomes 10*91/365
= INR 2,49,315
d. The reference MIBOR rate to be taken is the rate as on the
settlement date. ie 6.2% p.a. in the above example would be the
91day MIBOR rate as on the settlement day.
e. Usually the rate on the settlement day applies to a loan taken on
the settlement day for 91 day period ie if the settlement day is 1st
April 2018, loan of INR 100 cr is taken on 1st April 2018 for 91 days
then the interest payable is INR 6.2 cr*(91/365) ie INR 1.55 cr. This
amount is payable at the end of 91day period ie on 1st July 2018.
Interest usually gets paid along with the repayment of the loan
principal on the maturity day of the loan.
f. FRA is a derivative contract. There is no actual loan transaction
involved in FRA. Loan amount of 100 cr is notional. Effectively the
buyer of FRA notionally borrows 100 cr at 6.1% p.a. and lends 100
 cr for 6.2% p.a. This notional loan is for 91 day period. Accordingly
the settlement amount is calculated as above.
g. Since there is no need to wait for the entire 91 day period to settle
an FRA transaction (as there is no actual loan amount and there is
no repayment of loan amount on the maturity day. Settlement
works on notional amounts only), amount exchanged on the
settlement day is the discounted value.
i. Settlement day is (say) 1st April,2018
ii. Notional loan maturity day would be 91 days later ie 1st July,
2018
iii. The settlement amount shown in para 4c above would be
payable on 1st July, 2018
iv. A discounted value of this amount is exchanged on 1st
April,2018. The discounted value is calculated as the
amount above/ (1 + 6.2%*91/365). The denominator
discounts the value so that settlement can be completed on
1st April itself. The amount on settlement is 249315 / (1+
6.2%*91/365) = 245519.9
5. Actual FRA rate is quoted by the fixed income market participants. It is
compared with the expected forward rate to evaluate whether the
offered rate is “high” or “low”.
a. For example, 1 month spot rate is 6.1% p.a. and 4 month spot rate
is 6.15% p.a. This implies a 3 month rate 1 month from now =
6.17% p.a.
i. The calculation for this one month forward rate is based on
the formula:
3 month rate (in % p.a.) 1 month from now =
{( 1+ 4mnth spot rate) ^ (4/12) )/ (1 + 1mnth spot rate) ^(1/12))}^4 –
1
={ (1.0615^(4/12))/(1.0610^(1/12) } ^ 4 -1
= 6.17% p.a.
b. Now, if the offered rate for FRA settling 1 month from now is
6.25% p.a. then the offered rate is “high”. In this case, speculative
position would be to short FRA. If the offered rate is 6.10%p.a.,
the speculative position would be to go long on the FRA.
6. FRA contracts are commonly used for hedging purposes. In these
situations, the intent is not speculative unlike para 5 b above. Hedging
entity looks for avoiding negative outcomes and would not mind
sacrificing possible upside for the sake of stabilising revenues.
a. For example, take example of an NBFC is borrowing at MIBOR
linked ie variable rate. If MIBOR (which changes every day) goes
up, NBFC incurs higher interest cost. If NBFC is lending at fixed
rate, its gross margin (ie the difference between the lending and
the borrowing rates) changes every time MIBOR changes. NBFC
may end up showing poor results despite making growing number
of good loans if the MIBOR increases and its gross margin shrinks.
b. If that NBFC buys FRA, then the FRA transaction results in gain to
NBFC when MIBOR increases. This gain offsets the increase in
borrowing cost that the NBFC faces due to its floating rate
borrowing.
c. On the other hand, if MIBOR reduces, the borrowing of the NBFC
becomes cheaper but the FRA transaction loses money.
d. Hence, whether MIBOR goes up or down, NBFC gets the same
gross margin. In other words, NBFC locks its margins
e. To illustrate, (say) an NBFC borrows at MIBOR plus 1% and lends
at 8%.
i. If MIBOR is 6%, its borrowing cost is 7% (MIBOR plus 1%)
gross margin is 1% (8% - 7%). If MIBOR is 6.2%, its
borrowing cost is 7.2% and its gross margin is 0.8% (8% -
7.2%). If MIBOR is 5.8%, its gross margin would be 1.2%. If
MIBOR increases, the gross margin reduces. If MIBOR
reduces, gross margin increases.
ii. Now, if the NBFC buys FRA at 6.1%, NBFC gains 0.1% when
MIBOR is 6.2%. This gain increases the NBFC gross margin
from 0.8% mentioned above to 0.9%. When MIBOR is 5.8%,
FRA loses 0.3%. Hence margin plus FRA gain/loss is again
0.9% (1.2% as shown in the para above - 0.3%). Whatever
be the MIBOR, gross margin plus net gain/loss in FRA would
be 0.9%. The effective margin is locked at 0.9%. This was the
intent of hedging on interest rate and hence the FRA was
bought.
f. Likewise, an NBFC which is receiving floating rate income by
lending based on MIBOR but borrowing at a fixed rate would sell
FRA to lock its effective gross margin
 g. FRA achieves the stable margin for one quarter only as the
underlying is 91day MIBOR.
Swaps
7. If stability in gross margins is sought on ongoing basis then swap
transactions are entered into.
a. For example an NBFC which is borrowing funds and paying
interest on these funds at rates linked to MIBOR would pay
variable rates of interest. If this company lends funds at fixed rate
of interest then its income is fixed. The margin would not be
stable as interest outflow (borrowing cost) is at variable rate but
the interest inflow (ending income) is at fixed rate.
b. This company would like to pay fixed rate on its borrowing cost so
that the cost as well revenue are based on fixed rates and hence
the margin becomes stable.
c. Such a company would enter into a swap arrangement wherein it
would swap its variable rate payment for fixed rate. In other
words, it would receive variable rate and pay fixed rate.
d. To illustrate, take NBFC X which borrows INR 2000 cr at MIBOR
plus 1% p.a. and lends INR 2000 cr at 8% p.a.

M+1% 8% , 160 cr
NBFC X

Note that the arrows are showing the direction of the interest
flow. Inward arrow showing 8% indicates that X is lending at fixed
rate of 8% p.a. and receives 8% on 2000 cr ie INR 160 cr
Outward arrow shows that X is paying M+1% on INR 2000 cr. No
amount is mentioned by way of interest outflow as the actual
amount depends upon the value of MIBOR on the interest
payment day. If MIBOR is 6% then the amount of outflow would
be 7% of 2000 cr is 140 cr. On the other hand, if the MIBOR is 5%
then the amount of outflow would be INR 120 cr
 e. Now, X enters into a swap arrangement so that it swaps MIBOR
for a fixed rate. This arrangement can be with a swap dealer as
shown below.

Swap
Dealer S
6.1%
M
M+1%
NBFC X
8%

As shown in the diagram, the swap dealer

pays MIBOR to NBFC
X in exchange for fixed rate of 6.1%. Effectively, NBFC X pays
7.1% interest and receives 8% interest and locks margin of 0.9%.
NBFC receives MIBOR from swap dealer and pays MIBOR plus
1% to its borrowers. ie net outflow of 1%. In addition NBFC
pays 6.1% to the swap dealer. ie total outflow of 7.1% ( 1% plus
6.1%). The revenue (interest inflow) continues to be at 8%.
Hence the gross margin of 0.9%.
f. Like in case of FRA, there is a notional amount based on which the
exchange takes place with the swap dealer. For instance, in this
situation the notional would be INR 2000 cr. If MIBOR is 6% and
fixed rate payment to the swap dealer is at the rate of 6.1% then
the net payment to the swap dealer at 0.1% is computed using the
notional of 2000 cr. ie the payment to the swap dealer by the
NBFC X would be 2 cr. This amount is calculated on yearly basis.
However, usually the settlement happens every quarter. Hence in
case of quarterly settlement the net amount payable would be
1/4th ( ie for one quarter) of the annual amount or 1/4th of 2 cr ie
50 lacs.
g. Likewise an NBFC receiving floating rate and paying fixed rate
would become fixed rate receiver in a swap arrangement to lock
its margin, as shown in the diagram below.
Swap
Dealer S
M
6%
NBFC Y
7% M + 4%

In this diagram, Y receives 6% from S and pays M. Y receives

M+4% from its customers. Hence it has inflow of 10%. The interest
outflow is fixed at 7%. Hence the gross margin is fixed at 3%.

h. Most NBFCs have combination of fixed rate as well as floating rate

lending as well as borrowing. In such situations, net floating rate is
 found by the process of eliminating exposures of matching types
( ie fixed rate lending vs fixed rate borrowing and floating rate
lending vs floating rate borrowing), as shown below.
Initial diagram

3000cr@M+2% 6000 cr@ M+4%

NBFC N
9000cr@7.5% 8000 cr@ 9%

2000 cr funded through owned funds

Step 1 knocking off lower amounts in the matching types, ie 3000 cr in floating rate, 8000 cr in fixed rate

Amount Gross margin 3000cr, 0 @M+2% 6000 cr, 3000 cr@ M+4%
3000 cr 2.0% NBFC N
8000 cr 1.5% 9000cr, 1000 cr@7.5% 8000 cr, 0@ 9%

2000 cr funded through owned funds ie at 0% charge to the P&L

This is same as
3000 cr lending at M+4%
funded by
1000 cr borrowing at 7.5%, and
2000 cr owned funds

Step 2 Define the swap arrangement

NBFC is net lender in floating rate, hence would enter into swap arrangement to become fixed rate receiver
Notional amount INR 3000 cr
If swap rate quoted is 6%-6.1%, NBFC N would receive fixed rate of 6% in return for paying MIBOR.
Step 3 Compute margins
Amount Gross margin % Gross margin INR cr
3000 cr 2.0% 60
8000 cr 1.5% 120
1000 cr 10%-7.5%=2.5% 25
2000 cr 10% - 0% =10% 200
Total 405

8. Swaps are also entered into for gaining relative advantage, as illustrated in
the relevant Excel file
9. Eurodollar bonds
10.Globally, the most actively traded fixed income derivative instrument is
future contracts on Eurodollar bonds. Eurodollar bonds are USD
denominated bonds issued by global corporations. Historically, these
were originated by European companies seeking to do business in the
US and hence required borrowings in USD. Now these bonds are issued
by various global corporations.
11.Future contracts on such bonds are actively traded in the derivative
markets. The price of such bonds goes up when interest rate goes down
and vice-a-versa. The underlying is 3 month LIBOR. Lot size is USD 1
million. Prices are quoted as 100 – LIBOR. If LIBOR is 0.6%, the price
quoted is 99.4.
12.Key feature of this bonds is that buyer of these bonds gains USD 25 for 1
bps drop in interest rate per 1 lot of the Eurodollar future contracts.
13.If bonds are purchased when 3 month LIBOR is 0.6% p.a. and the LIBOR
goes down to 0.55% p.a., the holder of 100 lots gains 100* 25 * 5
ie USD 12,500
These bonds are traded on CBOE and hence mark-to-market settlement
happens on daily basis.
14.A company with floating rate borrowing would sell Eurodollar bonds to
hedge interest rates. If interest rate goes up, the bond price goes down.
Hence the seller gains.
15.Likewise, a company with floating rate lending would buy Eurodollar
bonds.