Chapter 6

Derivatives and Risk Management

By Rajiv Srivastava

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  Interest rate derivatives have some
benchmark interest rate as underlying
asset.
 Derivatives on interest rates are used for
covering the risk of changing interest rates.
 Most businesses face risk of changing profit
due to changes in the interest rates.
 Some organizations like banks, construction
companies etc are extremely prone to
changing interest rates.

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  Interest rates are of several types.
 Interest rates are broad indicators of
economy and vary depending upon
several factors
 General state of the economy, such as
inflation rate.
 Nature of transaction
 End-use of funds
 Security offered
 Credibility of the issuer

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  For the purposes of derivatives, their
valuation and uses, we choose instrument
as underlying asset whose value is almost
exclusively determined by interest rates.
 The value of the instrument must reflect the
interest rate prevailing.
 The value and the interest rate must be
 Free from default risk,
 Market determined, and
 Reflective of the changes in the economy

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  Repo and reverse repo rates apply to transactions
between the central banks and commercial banks
in an economy.
 Though these can be deemed to be free from
default risk but they cannot be used as base for
design and valuation of derivatives because they
 Cannot be said to be market determined since
transactions between banks are governed by
considerations other than commercial,
 Are tools of monetary policy to bring the desired
changes in the economy rather than reflecting changes
in interest rates, and
 Represent only banking transactions and not public.

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  Like repo and reverse repo rates, treasury rates
too are not apt to form the basis for design
and valuation of derivatives.
 Treasury rates too can be deemed to be free
from default risk they cannot be used as base
because they
 Cannot be said to be market determined because
transactions between banks are governed by
considerations other than commercial, and
 Represent mostly banking transactions and not
public, with rather low depth of secondary markets.

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  Another set of rates available for consideration as
base for design and valuation of interest rate
derivatives are the interest rate at which banks
transact among themselves called interbank
transactions.
 These rates are considered apt for use because
 They can be said to be free from default risk,
 These rates are offered purely out of commercial
motives,
 Actual transactions can take place at these rates, and
 These rates are dynamic changing continuously
reflecting expectations of returns by investors.

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  One basic input for design and
valuation of interest rate derivatives is
the interest rate expectations for
different terms of investment.
 The expected yield for different terms of
investment is called term structure of
interest rates, or yield curve.
 Yield curve is normally arrived by using
prices of zero coupon bonds through
the process of bootstrapping.
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 FRA – The Product
Pricing FRA
Hedging With FRA
Speculation with FRA

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 Forward rate agreement, commonly referred as
FRA is a contract to deposit or borrow a notional
sum in future for a specified maturity at interest
rate fixed now.
 FRA as a product is specified as follows:
Quotation of FRA
INR 3/9 months 6.00 – 6.50%

Currency Deposit Lending

Rate Rate
Commencement Maturity of
of deposit/lending deposit/lending (Bid Rate) (Ask Rate)

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 Forward rate agreement, commonly referred as
FRA is a contract that freezes the investment or
borrowing rate for a future lending/borrowing.
 It is a product that assures lending and borrowing rates
and not the actual lending and borrowing, therefore
making it a hedging as well as a speculative product.
 The bid and ask rates offered are market based rates that
are determined transparently.
 With underlying lending/borrowing transaction delinked
the obligations under FRA are cash settled based on
differential of actual and contracted rates for the period
on the notional principal.

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  Firms need to borrow capital.
 Such firms need protection against rising
interest rate.
 By booking FRA at ask rate they can
freeze the interest rate and hence the
cost of borrowing.

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  Firms surplus with cash need to invest
/lend funds.
 Such firms need protection against
falling interest rates.
 By booking FRA at bid rate they can
freeze the interest rate and hence the
revenue from lending.

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  Settlement of FRA is done by exchanging the differential
cash flow of contracted interest rate and the actual
benchmark on the notional principal.

1 d
Cash flow (Investor' s FRA) = x(f - r) x xP
(1 + r x d/365) 365
1 d
Cash flow (Borrower' s FRA) = x(r - f) x xP
(1 + r x d/365) 365
Where r = Settlement rate, f = FRA rate,
d = Nos of days in FRA contract, and
P = Notional principal amount,

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 If a borrowers books an INR 3/9 FRA at 6.5%
and the actual interest rate after three months
turns out to be 7.0% the borrower, as
settlement of FRA would receive Rs 2,40,907:
1 182
Amount to be received = x(0.07 - 0.065) x x 1,00,00,000
(1 + 0.07 x 182/365) 365
2,49,315
= = Rs 2,40,907
1.0349

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  Term structure of interest rate implies forward interest
rates and forms the basis of pricing of FRA. Assume
following term structure up to 12 months:
Investment Horizon (months) 3 6 9 12
Yields (% annualized) 5.00 5.30 5.60 6.00
 3-m interest rate expected to prevail after 3 months
used as a guide to quote 3/6 FRA. Mathematically,
(1+ 0r3)(1+ 3r6) = (1+ 0r6) or (1+ 3r6) = (1+ 0r6)/(1+ 0r3)
180
1 + 0.053 x
(1+ 3 r6 ) = 360 = 1.0265 = 1.01383;
90 1.0125
1 + 0.050 x
360
gives 3 r6 = 0.01383, or equivalent to annualised 3 r6 = 5.53%

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  FRA is an independent contract that
delinks the actual investing or borrowing
and serves as effective tool for hedging.
 FRA provides hedging against
 Rising interest rates for borrowers, and
 Falling interest rates for investors
 Borrower’s FRA is a contract that covers
risk of rising interest rates while investor‘s
FRA protects against the falling interest
rates.
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  EXCEL Industries Ltd (EIL) would have a
shortfall of Rs 500 lacs after 6 months for
next 6 months. EIL have been availing loan
at MIBOR currently at 9%. The borrowing
cost is MIBOR + 1% = 10%.
 The interest rates are expected to go up in
next 6 months.
 To hedge against rising interest rates, EIL
buys a MIBOR based 6/12 FRA from
another bank, Forward Bank (FB) at 9.25%
for notional principal of Rs 500 lacs.

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When MIBOR is above the FRA contracted rate of 9.25% say 10%

 FB would pay EIL the differential of current MIBOR and agreed rate of 9.25% on
notional principal of Rs 500 lacs for 180 days, discounted at 10%. The amount to
be paid by FB is
Cash flow to firm
1 180
= x (0.10 - 0.0925) x x 5,00,00,000
(1 + 0.10 x 180/360) 360
1,87,500
= = Rs 1,78, 571
1.05
Interest cost for loan from CB = 5,00,00,000 x 0.10/2 = Rs 25,00,000
Maturity amount of FRA at 10% = 1,78,571 x 1.05 = Rs 1,87,500
Effective interest amount paid = Rs 23,12,500
Effective borrowing cost = 23,12,500/5,00,00,000 = 0.04625
equivalent to 9.25% p.a

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 When MIBOR falls below the FRA contracted rate to 8.60%

 In case the benchmark rate falls to 8.60% EIL would have to pay FB the
differential of actual and contracted rate as follows:

Cash flow to firm

1 180
= x (0.0860 - 0.0925) x x 5,00,00,000
(1 + 0.086 x 180/360) 360
1,62,500
=- = - Rs 1,55,800
1.043

Interest cost for loan from CB = 5,00,00,000 x 0.086/2 = Rs 21,50,000

Maturity amount of FRA at 10% = 1,55,800 x 1.043 = Rs 1,62,500
Effective interest amount paid = Rs 23,12,500
Effective borrowing cost = 23,12,500/5,00,00,000 = 0.04625
equivalent to 9.25% p.a

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  Investing companies earn revenue by
lending.
 While rising interest rates are favourable to
them, a fall in interest rates is detrimental.
 They need to protect against the expected
fall in yields.
 Investing companies can lock-in the yield
offered by FRA just in the same manner as
the borrowers lock-in the cost of borrowing.

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  If one is neither an investor nor a borrower,
then position in FRA is speculative.
 The rates offered by FRA are reflecting the
future expected rates of interest.
 If one has a different view of future interest
rate than the one reflected by FRA, then
 If future interest rate expected to be > FRA rate:
Book Investor’s FRA
 If future interest rate expected to be < FRA rate:
Book Borrower’s FRA

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