8A IRRM-Summary PDF

CA Final
CMA Final
Interest Rate Risk

Management (SFM)
Concept Summary
CA. Nagendra Sah

FCA, CFA L1, B. Sc. (H), Visiting faculty of ICAI, Stock
Market Expert, Highest Mark scorer in SFM, Best paper
award winner in Mathematics and Statistics in B. Sc.
// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

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CA Nagendra Sah
CA Nagendra Sah is a widely acclaimed Chartered Accountant in the field of Financial Management,
qualified Chartered Accountancy with highest Marks in Strategic Financial Management (SFM). He teaches
SFM to CA/CMA final students and Cost and Management Account and Financial Management &
Economics for finance to CA-Inter Students. He has cleared all the levels of CA examinations in his first
attempt. He completed 12th as well as graduation in Science with Statistics honors from the esteemed
Tribhuvan University. He had been a University Topper and awarded by University for securing highest
marks in Statistics as well as Mathematics.
He is the premier author who wrote Strategic Financial Management (SFM) book for CA Final, Cost and
Management Accounting (CMA) and Financial Management & Economics for finance for CA Intermediate.
His summary book and Revision Lectures Uploaded on YouTube are one of the most popular among CA
Students which is beneficial to revise whole syllabus in very less time with logical explanation.
CA Nagendra Sah is a firm believer of conventional and customary practices being adopting in training and
coaching for over many years. He is a Chartered Accountant who took up teaching as profession, who
believes in a teaching methodology that relates to human brains.
His goal is not only to enable students to pass in CA Exam but also to provide tips and knowledge to earn
money from stock Market by trading in Equity, Bond, Derivative, Currency, commodity and unit of Mutual
Fund.
His students get a practical linkage of concept with actual financial data of company and economy. They
get awareness of government policy, RBI policy, Fed policy, global market that affects Indian stock
exchange.
He also provides practical knowledge of excel sheet for financial planning (like, installment calculator etc.)
His intense urge to bring about a sea of radical change in the traditional teaching techniques and
pedagogies has culminated in the form of this institution.
When a bird is alive, it eats ants. When the bird is dead, Ants eat the bird.
Time & Circumstances can change at any time. Don’t devalue or hurt anyone in life.
You may be powerful today. But remember, Time is more powerful than you!
One tree makes a million match sticks. Only one match stick needed to burn a million
trees. So be good and do well.

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Chapter - 8
INTEREST RATE RISK MANAGEMENT
Contents
1. INTRODUCTION ........................................................................................................................................................................................................2
2. FAIR FORWARD INTEREST RATE .....................................................................................................................................................................2
(A) APPROPRIATE TERMINOLOGY TO IDENTIFY FORWARD INTEREST RATE .........................................................................2
(B) CALCULATION OF FORWARD INTEREST RATE (FAIR FORWARD INTEREST RATE) ......................................................3
(C) CALCULATION OF FORWARD INTEREST RATE USING CASH FLOWS.....................................................................................4
3. FORWARD RATE AGREEMENT (FRA) .............................................................................................................................................................4
(A) MEANING ..............................................................................................................................................................................................................4
(B) APPROPRIATE TERMINOLOGY TO IDENTIFY FRA ...........................................................................................................................5
(C) FRA QUOTATION / RATE OF FRA ..............................................................................................................................................................5
(D) DIFFERENT NAME OF INTEREST RATES ..............................................................................................................................................6
(E) VARIOUS DATES USED IN FRA....................................................................................................................................................................6
(F) SETTLEMENT AMOUNT OF FRA ................................................................................................................................................................6
4. ARBITRAGE IN FRA: ................................................................................................................................................................................................7
5. INTEREST RATE FUTURE (IRF) .........................................................................................................................................................................8
(A) MEANING ..............................................................................................................................................................................................................8
(B) VALUATION OF INTEREST RATE FUTURE (IRF) ...............................................................................................................................8
(C) ACTION IN IRF ....................................................................................................................................................................................................8
6. BOND FUTURE ...........................................................................................................................................................................................................8
7. INTEREST RATE SWAP (IRS) ..............................................................................................................................................................................9
(A) MEANING ..............................................................................................................................................................................................................9
(B) CALCULATION OF FIXED INTEREST OR INTEREST ON FIXED LEG ....................................................................................... 10
(C) CALCULATION OF FLOATING INTEREST OR INTEREST ON FLOATING LEG ..................................................................... 10
(C) TYPES OF IRS ................................................................................................................................................................................................... 10
(D) SETTLEMENT AMOUNT OF IRS .............................................................................................................................................................. 11
(E) IRS RATE QUOTATION: .............................................................................................................................................................................. 11
(I) FIXED RATE QUOTE .............................................................................................................................................................................. 11
(II) FLOATING RATE QUOTE ................................................................................................................................................................... 11
(F) BUYER/SELLER OF IRS................................................................................................................................................................................ 12
8. USES OF IRS .............................................................................................................................................................................................................. 12
(A) FOR SPECULATION: ...................................................................................................................................................................................... 12
(B) HEDGING EXISTING BORROWING COST & DEPOSIT INCOME: ................................................................................................ 12
(C) REDUCING NEW BORROWING COST USING IRS ............................................................................................................................. 13

Page 8.2 SFM (CONCEPT SUMMARY)
9. CURRENCY SWAP .................................................................................................................................................................................................. 15
10. USE OF CURRENCY SWAP .................................................................................................................................................................................. 15
TO HEDGE CURRENCY FLUCTUATION RISK ............................................................................................................................................. 15
TO REDUCE FOREIGN BORROWING COST (NEW BORROWING) .................................................................................................... 15
11. INTEREST RATE OPTION OR INTEREST RATE GUARANTEE ........................................................................................................... 16
12. INTEREST RATE CAP ........................................................................................................................................................................................... 16
(A) MEANING OF CAP OPTION ........................................................................................................................................................................ 16
(B) AMORTIZATION OF CAP PREMIUM ...................................................................................................................................................... 17
(C) LOSS/GAIN ON CAP OPTION ..................................................................................................................................................................... 17
13. INTEREST RATE FLOOR ..................................................................................................................................................................................... 17
14. INTEREST RATE COLLAR................................................................................................................................................................................... 17
15. SWAPTIONS.............................................................................................................................................................................................................. 17
INTRODUCTION
Following are some derivative instrument of interest rate which are traded in OTC (Over-the-counter) market:
Interest Rate Derivatives
Forward Interest Rate Bond Interest Rate Interest Rate Caps, floor
Future Swap and Collar Swaption
Contract Future Option
Forward contract Forward contract www.nagendrasah.com

for Currency for Interest rate CA Nagendra Sah
Refer Forex Forward Rate [FCA, CFA L1, B. Sc. (H)]
Agreement (FRA)
FAIR FORWARD INTEREST RATE

Interest rate contracted today for future borrowing/deposit is known as Forward interest rate.
(A) APPROPRIATE TERMINOLOGY TO IDENTIFY FORWARD INTEREST RATE

(i) 6 Month Forward Rate 3 Months from now OR 6 Months Forward Rate 3 Month Forward
0M 3M 9M
6 Months
Borrowing/deposit period
Rate contracted
Today for this B/D www.nagendrasah.com
CA Nagendra Sah
[FCA, CFA L1, B. Sc. (H)]
(ii) Second year Forward Rate OR 1 Year Forward Rate at 1 Year Forward
0Y 1Y 2Y
1 Year
Rate contracted
Today for this B/D

INTEREST RATE RISK MANAGEMENT Page 8.3
(iii) First year forward rate OR 1 Year forward rate as on today
In fact, it is spot rate for 1-year period.
0Y 1Y
1 Year
Rate contracted
Today for this B/D
(B) CALCULATION OF FORWARD INTEREST RATE (FAIR FORWARD INTEREST RATE)

For calculation of forward rate, we need short period interest rate and long period interest rate.
0M 3M 9M
Short Period Forward Period

Long Period
www.nagendrasah.com
(1 + PIR of short period)n × (1 + PIR of forward rate)n = (1 + PIR of Long period)n
=
Explanation: 3M 9M
0M
Route-A ₹1 8%p.a. (2% for 3M) 6-month fair forward rate (Say ‘R’) ₹1.09
₹1.02
Route-B ₹1 ₹1.09
12% p.a. (i.e. 9% for 9 month)
At fair forward rate, investor should be at indifference between route A and route B.
It means investing/borrowing at 8% p.a. for first 3 months and investing/borrowing again at R% p.a. for next 6
months is equal to investing/borrowing at 12% p.a. for 9 months period.
Route-A FV = Route-B FV www.nagendrasah.com

or, 1.09 = 1.09 CA Nagendra Sah
6 [FCA, CFA L1, B. Sc. (H)]
or, 1.02 × (1 + R × 12
)= (1+0.09)
3 6 9
or, (1 + 0.08 × 12) × (1 + R × 12) = (1 + 0.12 × 12)
∴ (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐬𝐡𝐨𝐫𝐭 𝐩. )𝐧 × (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐅𝐑)𝐧 = (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐋𝐨𝐧𝐠 𝐩. )𝐧
Hence,
(𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐬𝐡𝐨𝐫𝐭 𝐩. )𝐧 × (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐅𝐑)𝐧 = (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐋𝐨𝐧𝐠 𝐩. )𝐧
Note:
Calculation of forward interest rate is nothing but segregation of long period interest rate into different short period
interest rates. In other words, merging different short period interest rates results to long period interest rate.

(C) CALCULATION OF FORWARD INTEREST RATE USING CASH FLOWS
Current interest for 1 year period = 10%
2 Year bond with coupon 12% p.a. is issued at 1050.
Calculate 1 year forward rate 1 year from now.
1 YEAR INVESTMENT
0Y 1Y
10%
Invest FV = 1155
(1050)
2 YEARS INVESTMENT:
Percentage return of 2-year investment is not available. We can calculate it using interpolation technique but it
consumes a lot of time. Hence, segregate total into two parts where first year return is 10% and balance return in
second year.
0Y 1Y 2Y
Interest = 120
Invest (1050) Interest = 120
RV = 1000
CALCULATION:
Assume first period return is 10% (as given) and balance return is available in second year. In this way, we can
calculate 2nd year forward interest rate:
0Y 1Y 2Y
@10% FR=?
@10%
Invest (1050) FV = 1155
Less: Interest received = 120 Interest+ RV
@ FR=?
Balance investment = 1035 = 1120
[1050×(1+0.10)-120] × (1+FR) = 1120

or, (1+FR) = 1120/1035
∴ FR = 1.082-1 = 0.08212 (8.212%)
FORWARD RATE AGREEMENT (FRA)

(A) MEANING
Contract as on today for future borrowing/deposit is known as FRA.
0M 3M 9M
Z
6M Borrowing/Deposit Period
Mr. A agrees to borrow and It doesn’t matter what

Mr. B agrees to deposit at will be interest rate on
3M, contract will be www.nagendrasah.com
3M time for 6M period
executed at 10% CA Nagendra Sah
(Negotiated rate 10%) [FCA, CFA L1, B. Sc. (H)]
Difference between actual rate and contracted forward rate is loss/gain of FRA.
Note: Actual borrowing/deposit under forward contract is not possible. Hence settlement is made by differential
amount.

ON 3MONTHS TIME:
CASE-1 INTEREST RATE =12% CASE-II INTEREST RATE = 9%
(A) For He can borrow amount @ contracted rate (A) For He has to borrow fund @ 10% p.a. under
Borrower of 10% even actual interest rate is 12%. Borrower contract but actual rate is 9% p.a.
(Mr. A) Contract Gain = 2%p.a. (Mr. A) Contract Loss = (10-9) % = 1% p.a.
(B) For He has to deposit fund @10% but actual (B) For He has to deposit fund @10% p.a. under
Depositor interest rate is 12%. Depositor forward contract but actual interest rate is
(Mr. B) Contract Loss = (12-10) % = 2% p.a. (Mr. B) 9% p.a.
Contract Gain = [10-9] % = 1% p.a.
Summary:
When interest rate moves up borrower earns profit and depositor makes loss and vice-versa.
Actual rate at 3M = 12%
www.nagendrasah.com

CA Nagendra Sah
Borrower/Buyer  Gain 2%
Depositor/Seller  Loss 2%
Contacted rate = 10%
Borrower/Buyer  Loss 1%
Depositor/Seller  Gain 1%
Actual rate at 3M = 9%
NOTE:
1. Buyer of FRA:
Borrower is also known as buyer of FRA as borrower earns profit from up movement and buyer also earns profit
from up movement.
2. Seller of FRA:
Depositor is also known as seller of FRA as depositor earns profit from down movement & seller also earns profit
from down movement.
(B) APPROPRIATE TERMINOLOGY TO IDENTIFY FRA

Contract for 9M borrowing/deposit to be made at 3 months’ time is also termed as “3×9 FRA” or 3/9 FRA or 3Vs9
FRA, 3-9 FRA, 3.9 FRA.
0M 3M 9M
Contract 6 Months Borrowing/deposit period
www.nagendrasah.com
In this contract, we have to use 6M forward CA Nagendra Sah
3×9 FRA rate at 3M from now. [FCA, CFA L1, B. Sc. (H)]
(C) FRA QUOTATION / RATE OF FRA

FRA rate = 8% / 10%
Deposit rate of Borrowing rate

customer of customer
FRA selling rate FRA buying rate

for customer for customer

(D) DIFFERENT NAME OF INTEREST RATES
1. Contracted rate of FRA is also termed as:  Fixed rate  Agreed rate  Actual FRA rate
2. Actual interest rate prevailing on  Floating interest rate (MIBOR, LIBOR, etc.)
borrowing/deposit date is also termed as:  Reference rate
 Variable interest rate
Where,
MIBOR = Mumbai Inter Bank Offer Rate
[i.e. Average interest rate of short-term securities traded on Mumbai money market.)
LIBOR = London Inter-Bank Offer Rate.
(E) VARIOUS DATES USED IN FRA

Here, in FRA 3×9: Now 3-month 6 month (i.e. contract period)
www.nagendrasah.com
2 Days 2 Days
Transaction Start Fixing Contact Settlement Maturity
Date Date Date Date (CSD) Date
Spot rate Value date B/D maturity date

Transaction/Trade/Contract Date Date when forward contract has been entered.
(TD)
Start/Effective date Date from which settlement date is counted. It may be 1 day or 2 day
(SD) or zero day after transaction date.
Settlement Date/expiry date: When loss/gain (i.e. differential amount) is settled. It may be 1 day or
(CSD) 2 day or zero day after fixing date.
Fixing date Date when actual rate of market is recorded for settlement. Loss/gain
(FD) is calculated using interest rate prevailing on fixing date.
Maturity date: The date when borrowing/deposit period is be matured.
Note: It is better to remember zero-day gap between “TD & SD” and “FD & CSD” for no confusion.
(F) SETTLEMENT AMOUNT OF FRA

No of days in a contract period
Notional Principal ×(Difference in Actual rate and contract rate)×
Settlement amount = 360 0r 365
(1+periodic Actual interest rate)
IF Actual rate > Contract rate Receivable to Borrower/Buyer and payable by depositor/seller.
IF Actual rate < Contract rate Receivable to depositor/seller and payable by Borrower/Buyer.
Explanation:
Suppose, it is 3×9 FRA. Contracted rate: 10% p.a.
Actual rate on 3M time for 6M borrowing/deposit = 12% p.a.
0M 3M 9M
6 Months Borrowing/deposit period
Contracted Actual rate = 12% p.a. on B/D

rate = 10% date
B/D under FRA @ 10% p.a. Interest at 10% for 6M = 5000
Notional B/D if no FRA @ 12% p.a. Interest at 12% for 6M = 6000
Principal
= 100,000 Discount for
Settlement at 3M = 943.396 6M @ 12% Difference = 1000
Gain for borrower and www.nagendrasah.com

Loss for depositor. CA Nagendra Sah

ARBITRAGE IN FRA:
 Act to earn risk free profit is known as arbitrage.
 Arbitrage is possible by borrowing at low interest rate and depositing at high interest rate. Both borrowing and
depositing rate should be risk free.
 FRA arbitrage is possible when Fair Forward rate ≠ Actual Forward Rate quoted under FRA.
Situation-1: FRA Deposit rate > Fair FRA rate
0M 3M 9M
Route-1 8% p.a. Actual FRA (Deposit) > Fair FRA Amt.  High
Route-2 12% p.a. Amt.  Low
Action to earn arbitrage:

(a) Borrow @8% for 9M www.nagendrasah.com
(b) Deposit @8% for 3M & CA Nagendra Sah
(c) Sale 3×9FRA
Arbitrage = Withdrawal Amount – Repayment
Logic behind above action:

 At fair forward rate, both routes amount (i.e., future value) becomes same.
 However, actual forward rate is higher than forward rate. It means Route-1 amount should be higher
than Route - 2 amount. Hence, use Route-1 for deposit and use Route-2 for borrowing.
Situation-2: FRA Deposit rate < Fair FRA rate

Arbitrage is not possible.
Situation-3: FRA Borrowing rate < Fair FRA rate

0M 3M 9M
Route-1 8% p.a. Actual FRA (Borrowing) < Fair FRA Amt.  Low
Route-2 12% p.a. Amt.  High
Action to earn arbitrage:

(a) Borrow @10% p.a. for 3M
(b) Buy 3×9 FRA
(c) Deposit @12% p.a. for 9M
Arbitrage = Withdrawal Amount - Repayment
Logic behind above action:

 At fair forward rate, future value in both routes remain same.
 As actual forward rate under FRA is lesser than fair forward rate, future value of Route-1 becomes
lower than Route-2. Hence, use Route-1 for borrowing & Route-2 for deposit.
Situation-4: FRA Borrowing rate > Fair FRA rate

Arbitrage is not possible.

INTEREST RATE FUTURE (IRF)
(A) MEANING
 Contract traded on exchange for future borrowing/deposit is known as Interest rate future.
 When interest rate decreases, borrower makes loss and depositor earns profit. Similarly, when interest rate
increases, borrower earns profit & depositor makes loss.
(B) VALUATION OF INTEREST RATE FUTURE (IRF)

Interest rate future price = 100-Interest rate
Suppose, interest rate is 5%. In this case, interest rate future price is 95 (i.e. 100-5)
(C) ACTION IN IRF

Borrower Sell IRF today and close position by Purchasing IRF on expiry.
Depositor Buy IRF today and close position by Selling IRF on expiry.
Particulars Now Expiry Net Position

Interest rate (say) 5% 3% -
Future price 95 97 -
Borrower Sell @ 95 Buy @ 97 95-97=-2 (i.e.2% Loss)
Depositor Buy @ 95 Sell @ 97 97-95 = 2 (i.e. 2% Gain)
Conclusion
Do not get confused in above calculations. Simply co-relate loss/gain of borrower/depositor with change in
interest rate. You will find same result as FRA.
Here, decrease in interest rate is 2% and loss to borrower is 2% and gain to depositor is 2%
WHICH IS SAME AS FRA CONCEPT.
BOND FUTURE
Under Bond Future, two parties enter into a contract to buy/sell notional bond which does not exist in market
On expiry date, seller of contract (i.e. seller of Bond future) has to give delivery of Bond to buyer of future.
Now question arise. How can he give delivery of that bond which does not exist?
There are few bonds which exists in market. We find list of those deliverable bond on NSE website.
Seller of contract can buy any bond from that list and deliver to buyer.
We know: -
High coupon rate Bond price → High
Low coupon rate Bond price → Low
In deliverable Bond set we find different coupon bond with different price
To make them comparable, NSE declares “conversion factor”
Coupon Price Conversion factor;
Low Low Low
High High High
Currently, NSE calculates conversion factor by taking 7.5% semi-annual coupon Bond price as base price.
Coupon Rate Bond Price Conversion factor
7.5% semi annual 102 1
5% annual coupon 95 0.9314 (i.e.,
95
)
102
10% annual coupon 108 1.059 (i.e.,

108
)
102
Conversion factor calculates NSE and informs it to trader.

Cheapest to deliver Bond
Seller of contract wants to give delivery of cheaper bond to buyer of contract. [i.e. Seller wants to buy cheaper
Bond and give it to buyer under contract.
Contracts price will be adjusted by Conversion Factor so that sale price and buy price becomes comparable.
Bond (Deliverable)
Mr. A Mr. B
(Seller of Bond future) (Buyer of Bond future)
Contract price
Buy deliverable
Bond @ MP
Adjusted price
NSE Contract price ×

conversion Factor
Loss/gain to seller of Bond Future

= [Contract price × conversion factor] – Buy price of Bond
(i.e. Adjusted price – Buy price of Bond)
Cheapest to deliver bond is that Bond which provides maximum profit to seller of Future or, minimum loss to
seller of future. In other words, Seller of future select that Bond from set of deliverable bond to give it to buyer
which provides max gain or minimum loss.
INTEREST RATE SWAP (IRS)

(A) MEANING
 Exchange of sequence of one interest payment for another interest payment is known as Interest rate swap.
 Interest may be “fixed interest” or “floating/variable interest”.
Example: IRS
Fixed Int.  10%

1 Mr. A Swap Dealer
Floating Int.MIBOR
IRS
Fixed Int.  8%
2 Mr. A Swap Dealer
Floating Int. MIBOR
IRS
www.nagendrasah.com
Floating Int. MIBOR CA Nagendra Sah
3 Mr. A Swap Dealer [FCA, CFA L1, B. Sc. (H)]
Floating Int. LIBOR

(B) CALCULATION OF FIXED INTEREST OR INTEREST ON FIXED LEG
Interest that remains same during whole life of swap is known as fixed interest.
Example: 10%, 12%, 8% p.a., etc.
Fixed interest amount = Notional principal × Fixed Interest × Period
Where, period = Duration of settlement period
Use period in days
180 𝐴𝑐𝑡𝑢𝑎𝑙 𝑑𝑎𝑦𝑠
For 6 months: Either (Use it for Generic swap) or (Use it for Plain Vanilla swap)
360 360 𝑜𝑟 365
(C) CALCULATION OF FLOATING INTEREST OR INTEREST ON FLOATING LEG

Interest that vary according to referred benchmark is known as floating interest rate. Normally, floating interest rate
is interest rate derived from money market instrument.
Example:
(a) MIBOR Mumbai Inter Bank offer rate
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(b) LIBOR London Inter Bank offer rate
(c) EURIBOR Euro Inter Bank offer rate CA Nagendra Sah
(d) BR Base rate
(e) CP Commercial paper
(f) T-Bill Treasury Bill
 Floating interest rate decides at beginning of period but interest due at end of period.
0M 6M 12M 18M 24M
6M MIBOR = 10% 6M MIBOR = 9.5% 6M MIBOR = 9% 6M MIBOR = 9.8%
Int. @ 10% Int. @ 9.5% Int. @ 9% Int. @ 9.8%
 In the above example, 6M is reset period (or revision period of interest) and above MIBOR rate is based on 6M
instrument.
 Floating interest amount = Notional Principal × Floating Interest Rate × Period
(C) TYPES OF IRS
Interest Rate Swap
Fixed Vs Floating Floating Vs Floating
In this swap, one leg is based on fixed

In this swap, both legs are based on
interest and another leg is based on
floating interest.
floating interest.
It is also known as non-Generic swap or

Generic Swap Plain Vanilla Swap Basis Swap.
Both are conceptually same. Difference is in duration of period.

30 30 days in a month
Fixed leg (Only for Generic)
360 360 days in a Year www.nagendrasah.com
CA Nagendra Sah
Fixed Leg (Plain Vanilla) 𝐴𝑐𝑡𝑢𝑎𝑙 𝑑𝑎𝑦𝑠 [FCA, CFA L1, B. Sc. (H)]
 (360
Floating Leg (Generic, Non-generic, Plain Vanilla) 𝑜𝑟 365)

(D) SETTLEMENT AMOUNT OF IRS
Difference between fixed leg interest and floating leg interest is called settlement amount.
Fixed Int. = Amount X

Mr. A Swap Dealer
Floating Int. = MIBOR Y
Difference = Settlement amount www.nagendrasah.com

X >Y  Gain to Mr. A CA Nagendra Sah
Y >X  Gain to Swap dealer [FCA, CFA L1, B. Sc. (H)]
(E) IRS RATE QUOTATION:

 Normally, swap dealer is bank. Swap dealer keep margins in interest rate. It plays low interest and receives
high interest.
 Swap dealer may quote fixed interest with margin or floating interest with margin
(I) FIXED RATE QUOTE
In this quote, swap dealer keeps margin in floating rate.
(a) 10%/12% against MIBOR
It means swap dealer is willing to pay 10% against MIBOR & willing to receive 12% against MIBOR.
Here, Benefit of Bank (Swap dealer) = 2%
Interpretation
MIBOR
Customer-1 Swap Dealer
12% Receive - High
Pay - Low
MIBOR
10%
(b) 9%, 10Y Gov. security + 50/125 bps against T-Bill www.nagendrasah.com
IRS rate: CA Nagendra Sah
(9% + 0.50%) + 9% +1.25%) against T-Bill [FCA, CFA L1, B. Sc. (H)]
∴ 9.5%/10.25% against T-Bill
It means swap dealer is willing to pay 9.5% against T-Bill and receive 10.25% against T-Bill.
T-Bill
10.25% Receive -High
%
Pay - Low
T-Bill
9.5%
Note: Fixed rate quote for floating float is known as AIC (ALL IN COST)
Above quotes are AIC quote.(i.e no margin with floating)
(II) FLOATING RATE QUOTE

In this quote, swap dealer keeps margin in floating rate.
(a) (MIBOR-0.25)/(MIBOR+1%) against 10%
It means swap dealer is willing to pay (MIBOR-0.25)% against 10% and receive (MIBOR+1%) against 10%.
(MIBOR-0.25%)
10% Pay-Low
(MIBOR+1%) Receive-High
10%

(b) (LIBOR+25/75bps) against 10% OR (LIBOR+0.25%) / (LIBOR +0.75%) against 10%
It means swap dealer is willing to pay (LIBOR+0.25%) and willing to receive (LIBOR+0.75%)
LIBOR+75bps
10% Receive - High
(LIBOR+25bps) Pay - Low
10%
(F) BUYER/SELLER OF IRS

(a) Floating rate receiver is also known as buyer of IRS as buyer earns profit when floating rate moves up.
(b) Floating rate payer is also known as seller of IRS as seller earns profit when floating rate moves down.
USES OF IRS
Uses of IRS
For hedging existing borrowing For reducing new

For speculation
cost or deposit income borrowing cost
(A) FOR SPECULATION:

Case-1: Floating rate is expected to move up
Enter IRS agreement to receive floating & pay Floating
fixed. [Buy IRS] C-2 Swap Dealer
Fixed
Case-2: Floating rate is expected to move down. Floating
Enter IRS agreement to pay floating & receive C-2 Swap Dealer
fixed. [Sale IRS] Fixed
(B) HEDGING EXISTING BORROWING COST & DEPOSIT INCOME:

Risk of loss/
Existing Position Action to hedge risk
opportunity loss
(1) Floating rate Rising floating Enter IRS agreement to receive floating and pay fixed
borrowing interest rate
BR
Where BR = Base rate C Swap Dealer
C = Customer 11%
%
Interest Assume,
C
“BR+2%” Swap dealer quotes following IRS rate 10%/11% against
BR.
Assume, Net cost of customer after IRS = (BR+2%-BR)+11%=13%
Borrowing rate=BR+2% www.nagendrasah.com
C = Customer CA Nagendra Sah It doesn’t matter what will be BR rate net cost should be
[FCA, CFA L1, B. Sc. (H)] 13%.
IRS is beneficial only when BR>11%.
(2) Fixed rate Falling floating Enter IRS agreement to receive fixed and pay floating
borrowing interest rate 10%
C Swap Dealer
Interest Risk of Opportunity BR
C loss
10.5%
Suppose, swap dealer quoted following rate:
10%/11% against BR
Here, Net cost of customer after IRS = (10.5-10)%+BR=BR+0.5
Existing cost = Fixed
New Cost = Floating IRS is beneficial when BR<10% (i.e. when customer will
receive something from swap dealer)

(3) Floating deposit Falling floating Enter IRS agreement to pay floating and receive fixed.
Interest rate BR
Interest C C Swap Dealer
s BR-1 10%
Say Swap dealer quoted following rate:
10%/11% against BR
Here, Net income to customer after IRS = [(BR-1%)-BR] +10% =
Existing income=Floating 9%
New Income = Fixed In all conditions, net income of customer after IRS should
be 9%
IRS is beneficial when BR<10%.
(4) Fixed deposit Rising floating Enter IRS to pay fixed interest and receive floating
interest interest rate interest.
Interest C  Risk of Opportunity
s 9.5% loss
11%
C Swap Dealer
BR
Here,
Existing income = Fixed Suppose swap dealer quoted following rates:
New Income = Floating 10%/11% against BR
Net income of customer after IRS = (9.5-11)%+BR = BR-
1.5%
IRS is beneficial when BR>11%
Note:
From above four situations/examples, it is clear that IRS converts nature of existing interest from floating to fixed or vice-
versa.
(C) REDUCING NEW BORROWING COST USING IRS

Let us consider following example/situation to understand entire concept of reducing borrowing cost.
Borrowing Rate Borrowers
Fixed Floating Borrowers
Rate Rate
Mr. HFX Mr. HFL Mr. LFX Mr. LFL

High Rating borrowers
10% BR+1%
(Strong financial position) BR+1% BR+3.2%
10% 11%
H  High rating
Low rating borrowers L  Low rating
11% BR+3.2%
(Weak financial position) FX  Fixed interest choice
FL  Floating interest choice
Objectives: www.nagendrasah.com
Borrower-1: Cost of borrowing less than 10% CA Nagendra Sah
but fixed cost (not floating) [FCA, CFA L1, B. Sc. (H)]
[Mr. HFX]
Borrower-2: Cost of borrowing less than
[Mr. HFL] BR+1% but floating cost Borrower approaches to Swap Dealer for
Borrower-3: Cost of borrowing less than 11% Reducing Cost
[Mr. LFX] but fixed cost
Borrower-4 Cost of borrowing less than Combination-1: Combination-2:
[Mr. LFL] BR+3.2% but floating cost Mr. HFX & LFL Mr. HFL & LFX

Cost Reduction for combination-1:
Swap Deal:
Under swap deal, both parties have to take loan at “unwanted cost”. After that, enter swap agreement to convert
unwanted cost into desired cost.
In our example:
 HFX has to borrow fund at BR+1% (unwanted cost) and enter IRS to receive floating & pay fixed.
 LFL has to borrow fund at 11% (unwanted cost) and enter IRS to receive fixed & pay floating.
Net Saving:
Total own choice cost = Fixed cost for HFX + Floating cost for LFL
= 10% + (BR+3.2%) = BR+13.2%
Total Swap Deal cost = Floating cost for HFX + Fixed cost for LFL
= BR+1% + 11% = BR+12%
Total saving = (BR+13.2%) - (BR+12%) = 1.2%
Distribution of saving:
Assume, equal distribution among all.
Total Saving = 1.20%
Mr. HFX Mr. LFL Swap Dealer
0.40% 0.40% 0.40%

www.nagendrasah.com
Net cost after swap deal (HFX) = Own choice cost – Saving = 10%-0.40% = 9.60% CA Nagendra Sah
Net cost after swap deal (LFL) = (BR+3.2%-0.40) = BR + 2.80% [FCA, CFA L1, B. Sc. (H)]
Swap Deal with rates:

(BR+1) + 0.40% BR+3.2%
BR+1% 11%
HFX SD LFL
Floating Fixed
10% 11 + 0.4%
9.6% Net Cost Saving = 0.40% Net Cost: BR+2.8%
Alternatively, swap dealer may quote other rates also.
BR+1% (BR+3.2%) -0.4%

BR+1% 11%
HFX SD LFL
Floating Fixed
10% - 0.4% 11%
9.6% Net cost Saving = 0.40% Net cost BR+2.8%
Note: There are unlimited combinations of swap rates which swap dealer can quote to “HFX & LFL”.
Objective:
Net cost of HFX = 9.6%
Net cost of LFL = BR+2.8%
Saving of SD = 0.40%
Cost reduction for combinations-2 [Mr. HFL & Mr. LFX]

Total own choice cost = Floating cost of HFL + Fixed cost of LFX = (BR+1%) +11% = BR+12%
Swap deal cost = Fixed for HFL + Floating for LFX = 10%+ (BR+3.2%) = BR+13.2%
As own choice cost < swap deal cost, cost reduction is not possible.

CURRENCY SWAP
Exchange of sequence of one currency for another currency is known as currency swap.
Under currency swap, amount of each settlement remains same.
Sequence of currency may be for:
(a) Initial principal and period end repayment amount.
(b) Periodic fixed amount at each equal time interval.
(c) Initial principal period end repayment & periodic fixed amount.
Example (a):
Initial Payment Repayment at 1 Year
$100 6500
Mr. India Mr. USA
6500 $100
Example (b):
Periodic Interest Periodic Interest
www.nagendrasah.com
$10 $10 CA Nagendra Sah
Mr. India Mr. USA [FCA, CFA L1, B. Sc. (H)]
650 650
Example(c): Both (a) & (b) Combined contract
USE OF CURRENCY SWAP
USE OF CURRENCY SWAP
TO HEDGE CURRENCY FLUCTUATION RISK TO REDUCE FOREIGN BORROWING COST (NEW

BORROWING)
As same amount is exchanged every time, Use same concept as studied above to reduce home
there is no question of currency fluctuation currency borrowing cost using IRS.
and hence no risk.
It means, take loan in unwanted currency and convert
one currency into another using currency swap (i.e.
www.nagendrasah.com under swap deal Mr. India has to borrow  currency and
CA Nagendra Sah Mr. USA has to borrow $ currency but own choice of Mr.
[FCA, CFA L1, B. Sc. (H)] India is to borrow $ & Mr. USA is to borrow)

INTEREST RATE OPTION OR INTEREST RATE GUARANTEE
Contract which provides rights to borrow/deposit fund is known as interest rate option/guarantee.
All concepts and logic are same as option contract of stock, commodity & currency.
INTEREST RATE OPTION
Call option Put option

Right to borrow fund or right to receive Right to deposit fund or right to receive
upper difference to holder of call. downside difference to holder of put.
Holder has to pay premium to writer. Holder has to pay premium to writer.
Payoff =Notional Principal (NP) × Payoff =Notional Principal (NP) ×
Upper difference in interest rate Downside difference in interest
× period rate × period
When interest rate moves down= Call lapse When interest rate moves up = Put lapse
Net Profit (Holder) = Payoff – Premium Net Profit (Holder) = Payoff – Premium
Net Profit (Writer) = Premium – Payoff Net Profit (Writer) = Premium - Payoff
Diagrammatic Representation
Diagrammatic representation
0M 3M 12M
Buy 3×12 call option @ strike Due date of

rate 10% against MIBOR MOBOR = 12%
borrowing/deposit
Payoff = 2% Payoff
Confirmed (Settlement date)
2% of NP for 9M
Note:
In call & put Option, settlement is made at due date (i.e., due date of interest payment on borrowing/deposit) but rate
is fixed on beginning of period (i.e., Borrowing/deposit date).
INTEREST RATE CAP

(A) MEANING OF CAP OPTION
⦿ Interest rate cap is a series of more than one call options of interest rate providing a payoff equal to difference of
actual rate and the strike rate (also known as cap rate) when actual rate exceeds strike rate.
⦿ In other word Caps, is a combination of more than one call option whose strike price is same for each settlement.
⦿ Lump-sum Premium for all call option would be payable upfront which is being amortize equally to calculate the
benefit at each reset period.
0M 6M 12M 18M 24M
Buy Reset P-1 Reset P-2 Reset P-3

6×12 Call, Interest Interest Interest www.nagendrasah.com
12×18 Call, may may may CA Nagendra Sah
18×24 Call rise rise rise [FCA, CFA L1, B. Sc. (H)]
No payoff Payoff-1 Payoff-2 Payoff-3
Or buy cap Series of 3 call option.

option which Pay lump sum premium at beginning.
covers all 3 Single strike price.

Note:
 Interest rate decides at beginning of period and due at end of period. Hence, payoff is settled at due date of interest
payment.
 No need to hedge today’s interest rate. Today’s interest rate is applicable for first period interest which due at end
of first period. Hence, no payoff at first period end.
(B) AMORTIZATION OF CAP PREMIUM

Single lumpsum is payable for all payoff under cap option. Hence, we have to amortise premium to calculate loss/gain.
0M 1P 2P 3P 4P
Premium paid Payoff-1 Payoff-2 Payoff-3
Assumed, equal amortised premium = x X X X

Calculation of x:
PV of all x = Premium paid
𝑥 𝑥 𝑥
(1+𝑖)2 + 3 +
(1+𝑖) 4 = Premium
(1+𝑖)
Loss/Gain under cap (Holder) = Payoff – premium
Note:
Use fixed interest rate (normally question provides it) as discount rate to calculate x.
(C) LOSS/GAIN ON CAP OPTION

Loss/gain under cap for holder = Payoff received – Amortized Prem.
Loss/gain under cap for writer = Amortized Prem. – Payoff received
INTEREST RATE FLOOR

 Series of put option (i.e., combination of more than one put option) is known as floor option.
 All concepts are same as cap option read with put option.
INTEREST RATE COLLAR

 Combination of “1 long cap” & “1 short floor” or 1 short cap & 1 long cap is known as collar.
 Net cost of this strategy = Premium paid on long option – Premium received on short option.
 When premium paid = premium received then it is called zero cost collar.
SWAPTIONS
Option of interest rate swap is termed as swaption.
There are two types of swaption.
SWAPTION
Payer Swaption Receiver Swaption

`
www.nagendrasah.com

CA Nagendra Sah
It provides rights to pay fixed It provides rights to receive fixed

interest under IRS (to holder). interest under IRS (to holder).
H FX W H FX
FX W
FL FL
It is beneficial when FL>FX. It is beneficial when FL>FX.
When FL<FX then option lapses. When FL>FX then option lapses.
Holder has to pay premium to writer. Holder has to pay premium to writer.

Important Notes

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CA Final

Interest Rate Risk

CA. Nagendra Sah

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

Forward contract Forward contract www.nagendrasah.com

FAIR FORWARD INTEREST RATE

(A) APPROPRIATE TERMINOLOGY TO IDENTIFY FORWARD INTEREST RATE

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

(B) CALCULATION OF FORWARD INTEREST RATE (FAIR FORWARD INTEREST RATE)

Short Period Forward Period

(1 + PIR of short period)n × (1 + PIR of forward rate)n = (1 + PIR of Long period)n

Route-A FV = Route-B FV www.nagendrasah.com

∴ (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐬𝐡𝐨𝐫𝐭 𝐩. )𝐧 × (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐅𝐑)𝐧 = (𝟏 + 𝐏𝐈𝐑 𝐨𝐟 𝐋𝐨𝐧𝐠 𝐩. )𝐧

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

[1050×(1+0.10)-120] × (1+FR) = 1120

FORWARD RATE AGREEMENT (FRA)

Mr. A agrees to borrow and It doesn’t matter what

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

Actual rate at 3M = 12%

[FCA, CFA L1, B. Sc. (H)]

Contacted rate = 10%

(B) APPROPRIATE TERMINOLOGY TO IDENTIFY FRA

Contract 6 Months Borrowing/deposit period

(C) FRA QUOTATION / RATE OF FRA

Deposit rate of Borrowing rate

FRA selling rate FRA buying rate

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

(E) VARIOUS DATES USED IN FRA

Spot rate Value date B/D maturity date

(F) SETTLEMENT AMOUNT OF FRA

Contracted Actual rate = 12% p.a. on B/D

Gain for borrower and www.nagendrasah.com

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

Situation-1: FRA Deposit rate > Fair FRA rate

Route-2 12% p.a. Amt.  Low

Action to earn arbitrage:

Arbitrage = Withdrawal Amount – Repayment

Logic behind above action:

Situation-2: FRA Deposit rate < Fair FRA rate

Situation-3: FRA Borrowing rate < Fair FRA rate

Action to earn arbitrage:

Arbitrage = Withdrawal Amount - Repayment

Logic behind above action:

Situation-4: FRA Borrowing rate > Fair FRA rate

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

(B) VALUATION OF INTEREST RATE FUTURE (IRF)

(C) ACTION IN IRF

Particulars Now Expiry Net Position

10% annual coupon 108 1.059 (i.e.,

Conversion factor calculates NSE and informs it to trader.

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

NSE Contract price ×

Loss/gain to seller of Bond Future

INTEREST RATE SWAP (IRS)

Fixed Int.  10%

// CA NAGENDRA SAH // WWW.NAGENDRASAH.COM

(C) CALCULATION OF FLOATING INTEREST OR INTEREST ON FLOATING LEG

6M MIBOR = 10% 6M MIBOR = 9.5% 6M MIBOR = 9% 6M MIBOR = 9.8%

Int. @ 10% Int. @ 9.5% Int. @ 9% Int. @ 9.8%