Parvesh Aghi

INTEREST RATE RISK

MANAGEMENT

CA Parvesh Aghi
Introduction
Companies with low
profit margins and high
Interest rate derivatives
capital expenses may are valuable tools in
be extremely sensitive
to interest rate managing risks.
increases.

Derivatives are
They help companies to
powerful tools that
develop a risk
mitigate risk and build
value. mitigation strategy

2
What Is an Interest Rate Derivative?

An interest rate derivative

is a financial These may include
instrument with a value forwards , futures,
that is linked to the options, or swaps
movements of an interest contracts
rate or rates.
What Is an Interest Rate Derivative?

Interest rate derivatives are often

used as hedges by institutional
investors, banks, companies, and
individuals to protect themselves
against changes in market interest
rates, but they can also be used to
increase or refine the holder's risk
profile or to speculate on rate moves.
What Is an Interest Rate Derivative?

Entities with interest rate Interest rate derivatives

risk can use these are most often used to
derivatives to hedge or hedge against interest rate
minimize potential losses risk, or else to speculate
that may accompany a on the direction of future
change in interest rates. interest rate moves.
Interest Rates
INTEREST RATE IS :
• The cost of borrowing
money.
• Compensation for the
service and risk of lending
money.
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Interest rates are
The lender of money
always changing, and
takes a risk that the
different types of
borrower may not pay
loans offer various
interest rates. back the loan
Thus, interest
provides a certain
compensation for
bearing risk
Interest Rates

When you lend money now,

Thus, interest protects
the prices of goods and
Coupled with the risk of against future rises in
services may go up by the
inflation. A lender such as a
default is the risk time you are paid back, so
bank uses the interest to
of inflation. your money's original
process account costs as
purchasing power would
well.
decrease.

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How Interest Rates are Determined

SUPPLY AND DEMAND-

Demand/supply of money- INFLATION- The higher the
The factors affecting When economic growth is inflation rate, the more
interest rates are largely high, demand for money interest rates are likely to
macro-economic in nature: increases, pushing the rise.
interest rates up and vice
versa.

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How Interest Rates are
Determined
Central bank actions :
Biggest borrower : The
by either printing more
level of borrowing also
GOVERNMENT notes or through its
determines the
Open Market
interest rates.
Operations (OMO).

Change the key rates

(CRR, SLR and Repo
rates) depending on
the state of the
economy or to combat
inflation

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Open Market Operations (OMO):

Open Market Central banks use OMO The purpose of OMO is

Operations : OMO refers to control the money often to achieve
to the buying and selling supply and influence monetary policy
of securities in the open interest rates, which, in objectives, such as price
market by a central turn, can affect inflation stability and economic
bank. and economic activity. growth.
Rs 15.4 lakh crore plan to borrow
Union Budget 2023: The government plans to borrow a record Rs 15.4 lakh
crore from dated securities in FY24 to meet its expenditure requirement to prop up
the economy.

This is higher than the total borrowing of Rs 14.21 lakh crore for the current
financial year ending March 31, 2023.

Fiscal deficit at 5.9 percent of GDP for FY24. Target to reach a fiscal deficit below
4.5 per cent by 2025-26 ,
HEDGING INTEREST RATE RISK
Traditional Methods: These
methods can further be
classified in following
categories:
• Asset and Liability Management
(ALM)
• Forward Rate Agreement (FRA)
Modern Methods: These
methods can further be
classified in following
categories:
• Interest Rate Futures (IRF)
• Interest Rate Options (IRO)
• Interest Rate Swaps
 INTEREST RATE SWAPS ( IRS)

OTC DERIVATIVE

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 SONIA : Sterling Overnight

Interest rate swaps ( IRS) Index Average

SOFR : Secured Overnight
Financing Rate.

IRS are contracts entered into between two counterparties

under which each agrees to make periodic payment to the
other for an agreed period of time based upon a notional
amount of principal.

One party makes payments at a fixed interest rate. In

exchange, this party receives payments at a floating rate
from the counterparty.

Floating interest rates are variable and pegged to a specific

index, such as SONIA , SOFR etc.

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Interest rate swaps ( IRS)
When both legs are in the same currency, this
notional amount is typically not exchanged
between counterparties, but is used only for
calculating the size of cashflows to be
exchanged.

When the legs are in different currencies, the

respective notional amount are typically
exchanged at the start and the end of the swap.

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Example

Party A: Currently has a

Parties
loan linked to SONIA and Party B: Currently has a
Involved fixed-rate loan and wants
wants to switch to a fixed
:
rate. to switch to SONIA.
Terms of Existing Loans:

Party A has a loan Party B has a fixed-

with an interest rate rate loan with an
linked to SONIA, annual interest rate
reset periodically. of 3.5%.
Structuring the Interest Rate Swap:

Notional Principal: Decide

on the notional principal Swap Period: Determine the
amount, which is the amount length of the swap. For
on which the interest simplicity, let's say it's a 5-
payments are based. Let's year swap.
say it's £15 million.
Structuring the Interest Rate Swap

Floating Rate (SONIA) (for

Fixed Rate (for Party A):
Party A agrees to pay Party B
a fixed rate of 3.5% annually
on the notional principal.
Party B): Party B agrees to
pay Party A the compounded
daily SONIA rate plus a
spread of 0.2%, calculated
and reset periodically.
 Example
A FIXED 3.5%
B
SONIA+ .02%

SONIA + 0.2%% Fixed : 3.5%

LENDERS A LENDERS B

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Benefits:

Party B: Manages
Party A: Achieves
the risk of interest
fixed interest rate
rate fluctuations by
payments, providing
moving from a fixed
predictability.
rate to SONIA
Sterling Overnight Index
Average :SONIA
SONIA

SONIA stands for Sterling

Overnight Index Average. It is
the key interest rate
benchmark for the British
sterling, or GBP (Great British
Pound), money markets.
SONIA
SONIA represents the
weighted average of
unsecured overnight
transactions in the sterling
market. It is calculated and
published by the Bank of
England.
SONIA
SONIA (Sterling Overnight Index
Average) is a widely used
benchmark interest rate in the
United Kingdom, and it
represents the average interest
rate at which banks lend to one
another overnight in the sterling
unsecured market.
Key features of SONIA include:
Reform Efforts: SONIA gained
prominence as a preferred benchmark in
the wake of global efforts to reform
interest rate benchmarks after the LIBOR
scandal. Policymakers and financial
regulators encouraged the use of more
robust and transaction-based
benchmarks, leading to increased
adoption of SONIA in various financial
contracts.
Key features of SONIA include:
Benchmark Transition: SONIA is
being increasingly used as an
alternative to LIBOR in financial
contracts and derivative instruments.
This transition is part of the broader
global movement toward risk-free
rates (RFRs) to replace traditional
interbank offered rates like LIBOR.
Summary
In summary, SONIA is a key interest
rate benchmark for the sterling
market, providing a reliable and
transaction-based reference rate for
overnight lending in the United
Kingdom. Its adoption has been
encouraged as part of global efforts to
enhance the integrity and robustness
of benchmark interest rates.
Key features of SONIA include:
Overnight Rate: SONIA reflects the
average interest rate paid by banks for
unsecured overnight transactions in
the sterling market. Unlike some other
benchmark rates, SONIA is based on
actual transactions rather than bank
estimates.
Secured vs. Unsecured: While many
other interbank rates, such as LIBOR
(London Interbank Offered Rate), are
based on banks lending to each other
in the interbank market, SONIA is
based on unsecured transactions.
However, there are also "compounded
SONIA" versions that take into account
secured transactions.
 Secured
Overnight
Financing Rate
SOFR
SOFR
SOFR stands for the Secured Overnight
Financing Rate. It is a benchmark
interest rate that serves as an alternative
to the London Interbank Offered Rate
(LIBOR) for pricing short-term variable-
rate debt. SOFR is based on the cost of
borrowing cash overnight, secured by
U.S. Treasury securities.
The need for an alternative to LIBOR
arose due to concerns about the
reliability and robustness of LIBOR,
which was subject to manipulation and
lacked a strong underlying market. As a
result, financial authorities, including the
Federal Reserve in the United States,
sought to develop more transparent and
reliable benchmark rates.
SOFR

SOFR is published daily by the Federal

Reserve Bank of New York and is based on
The transition from LIBOR to alternative
transactions in the repurchase agreement rates like SOFR has been a significant
(repo) market, where financial institutions
focus in the financial industry, with efforts
borrow and lend money overnight, using to mitigate the risks associated with the
U.S. Treasury securities as collateral. SOFR
discontinuation of LIBOR in various
is considered a more objective and financial contracts and instruments.
representative benchmark, as it is based
on observable market transactions.
MIBOR Replacement
There are discussions and
initiatives underway in India to
replace MIBOR (Mumbai
Interbank Offered Rate) with an
alternative reference rate.
This move was part of a global
trend in response to concerns
about the integrity and
reliability of interbank offered
rates, especially following the
LIBOR (London Interbank
Offered Rate) scandal.
MIBOR Replacement
The replacement of MIBOR in
India was primarily driven by the
need for a more robust
benchmark rate that reflects the
actual borrowing costs in the
money markets and aligns with
international best practices.
The Reserve Bank of India (RBI)
and other relevant authorities
have been working on
developing a suitable alternative
reference rate.
MIBOR Replacement
One of the leading contenders to
replace MIBOR in India is the
Secured Overnight Financing Rate
(SOFR).
SOFR is a benchmark rate that
reflects the cost of borrowing cash
overnight collateralized by Treasury
securities in the United States.
However, adopting SOFR or any other
alternative rate in India would require
careful consideration and
adjustments to ensure its suitability
for the Indian financial markets
Example 1
A borrows from B borrows from A & B will enter
Market @ SONIA Market @ 8.5% in a Interest rate
+1.5%. Fixed. swap agreement

B pays floating
A pays fixed rate
rate to A (B
to B (A receives receives fixed
floating rate)
rate)
 Example
A B

SONIA+ 1.50% Fixed : 8.5%

FLOATING FIXED

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 Example
Consider the following swap in which Party A
agrees to pay Party B periodic fixed interest rate
payments of 8.65%, in exchange for periodic
variable interest rate payments of SONIA +
70 bps (0.70%) in the same currency.

Note that there is no exchange of the principal

amounts and that the interest rates are on a
"notional" (i.e. imaginary) principal amount.

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 Example
8.65%

SONIA +.70%

SONIA+ 1.50% 8.5%

FLOATING FIXED

NET : 9.45% NET :

SONIA+
.55%
By entering an interest
Party B is currently rate swap, the net result
Party A is currently is that each party can
paying fixed rate, but
paying floating rate, but swap their existing
wants to pay floating
wants to pay fixed rate.
rate. obligation for their
desired obligation.
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 Example
Also note that the interest payments are
settled in net (e.g. Party A pays (SONIA +
1.50%)+8.65% - (SONIA +0.70%) = 9.45% net).

Party B pays (8.5% + SONIA+ .70% - 8.65%=

SONIA + .55%

The fixed rate (8.65% in this example) is

referred to as the swap rate.

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 Benefits
The advantage of an interest rate swap is that it
limits a company’s exposure to interest
rate fluctuations, and thus reduces risk.

By swapping interest rates, a firm is able to alter

its interest rate exposures and bring them in line
with management’s appetite for interest rate risk.
Principal amounts do not trade hands in interest
rate swaps. The difference between fixed and
floating interest expense is paid to one party at
settlement.

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Risks
Interest rate swaps do
not trade upon
exchanges.
Counterparty default
and lack of liquidity are
concerns.
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Example 2

Company A and Company B

want to borrow $ 10,00,000
each at the lowest possible
cost for a 5 year period with
annual compounding
Example 2
Company A expects the
interest rates to decline and
wants floating rate
borrowings , while company
B expects the interest rates
to rise and wants to lock in
fixed rate available to it
Following are rate quoted by bank
COMPANY A COMPANY B
Credit Rating A B
Fixed rate 6% 8%
Floating rate SONIA + 1% SONIA +1.5%
A expects the interest rates to B expects the interest rates to
decline and wants floating rise and wants to lock in fixed rate
rate available to it
Company A has Absolute Advantage
Credit Rating A B

Fixed rate 6% 8%

Floating rate SONIA + 1% SONIA +1.5%

COMPANY A COMPANY B

Absolute Advantage Comparative Advantage

Fixed Rate Company A : 2%

Floating Rate Company A : .5% Thus Company B has

advantage if borrows at
floating rate. If both the rates
were same Company B will not
have comparative advantage
Strategy to lower the interest rate
cost

Although Company A wants

Both companies intend to
to borrow at floating rate
but plans to borrow at fixed lower the borrowing cost
and wind up at the type of
rate and then swap its cash
borrowing they wanted at
flows with Company B that
wants to do the opposite the first place
Arbitrage Possibility
The comparative advantage creates a 1.5% an Arbitrage
profit opportunity

We will assume both the parties will split the arbitrage

profit evenly

Thus each party can lower its cost of borrowing by .75 % or

75 basis points

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Arbitrage Condition

Note that the arbitrage

opportunity would not exist if
the both parties had the same
credit rating
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SWAP DEAL

Normally there would be

Financial Intermediary that
would help to structure a
swap deal but here we are
assuming that they are
structuring the deal directly
COMPANY A & B Borrow

6% Fixed SONIA + 1.5%

A LENDERS B LENDERS

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COMPANY A & B Borrow
SONIA + .5%
6.25% Fixed

6% Fixed SONIA + 1.5%

A LENDERS B LENDERS

Company A= 6.25% - 6% = .25% + SONIA + .5% = SONIA +.25%

Company B = SONIA + .5%- SONIA +1.5%= 1% +6.25% = 7.25%

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 Net Gain From Swap Deal
COMPANY A COMPANY B

Fixed Rate +.25% + 1.75% (1)A pays 6% to the bank but

gets 6.25% from B (2)
Company B is paying 6.25%
fixed to A against 8% fixed
(offer from Bank)
Floating Rate +.50% -1.00% (1) A pays SONIA +.5% to B
against SONIA +1% offer
from his bank
(2) B receives SONIA +.5%
but has to pay SONIA +
1.5%
Total Gain +.75% +.75%
Points to remember
Company A is betting that interest will decline but if
the interest starts rising he will stand to loose (
SONIA Beyond 5.75%)

Company B is betting on that interest rate will rise

but if the interest rates falls he going to loose
Say SONIA is 8%

Company A= SONIA Company A =

+.25% 8.25%

Company B = SONIA+ .5%- Company B = 8.5% -

SONIA +1.5%= 1% +6.25% = 9.5%=1% + 6.25=
7.25% 7.25%
Say SONIA is 3%

Company A= SONIA
+.25% Company A = 3.25%

Company B = SONIA+ .5%- Company B = 3.5% -

SONIA +1.5%= 1% +6.25% = 4.5%=1% + 6.25=
7.25% 7.25%
 CURRENCY SWAPS

OTC DERIVATIVE

59
Features of currency swaps
Interest payments and
principal in one currency
Over-the-counter are exchanged for Interest payments are
derivative principal and interest exchanged periodically
payments in a different
currency.

Principal exchanged at Based on comparative

the origin and maturity. advantages of borrowing
What Is a Cross-Currency Swap?

Cross-currency swaps
are an over-the-counter (OTC)
derivative in a form of an
agreement between two parties
to exchange interest payments
and principal denominated in
two different currencies.
What Is a Cross-Currency Swap?

Interest payments are

In a cross-currency
swap, interest payments and
principal in one currency are
exchanged for principal
and interest payments in a
different currency.
exchanged at fixed intervals
during the life of the
agreement. Cross-currency
swaps are highly customizable
and can include variable, fixed
interest rates, or both.
 Currency Swaps

Although these type of

Currency swaps are an swaps function in a similar
fashion to interest rate
essential financial
instrument utilized by swaps , there are some
major fundamental
banks, multinational
corporations and qualities that make
currency swaps unique and
institutional investors.
thus slightly more
complicated

63
Currency Swaps
A currency swap involves
two parties that exchange a Following the initial notional
notional principal with one exchange, periodic cash
another in order to gain flows are exchanged in the
exposure to a desired appropriate currency.
currency.

Let's back up for a minute to

fully illustrate the function
of a currency swap.

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Purpose of Currency Swaps
An American multinational
company (Company A) may
wish to expand its
operations into Brazil.
Simultaneously, a Brazilian
company (Company B) is
seeking entrance into the
U.S. market.

Financial problems that

Therefore, in order to take
Company A will typically
face stem from Brazilian out a loan in Brazil,
Company A might be
banks' unwillingness to
extend loans to subject to a high interest
rate of 10%.
international corporations.

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 Currency Swaps

While the cost of borrowing in

Likewise, Company B will not
be able to attain a loan with a
favorable interest rate in the
U.S. market. The Brazilian
Company may only be able to
obtain credit at 9%.
the international market is
unreasonably high, both of
these companies have a
competitive advantage for
taking out loans from their
domestic banks.

66
 Currency Swaps

The reason for this discrepancy

Company A could hypothetically
take out a loan from an American
bank at 4% and Company B can
borrow from its local institutions
at 5%.
in lending rates is due to the
partnerships and ongoing
relations that domestic
companies usually have with
their local lending authorities

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 Currency Swaps

Based on the
companies' competitive
advantages of borrowing in their
domestic markets, Company A will Both companies have effectively
borrow the funds that Company B taken out a loan for the other
needs from an American bank while company.
Company B borrows the funds that
Company A will need through a
Brazilian Bank.

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 Currency Swaps 1 US Dollar = 5.00 Brazilian Real

Assuming that the exchange rate between Brazil

(BRL) and the U.S (USD) is 5.0 BRL/1.00 USD and
that both Company's require the same equivalent
amount of funding, the Brazilian company receives
The loans are then $100 million from its American counterpart in
swapped. exchange for 500 million real; these notional
amounts are swapped.

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Currency Swaps
However, both companies
Company A now holds the have to pay interest on
funds it required in real the loans to their
while Company B is in respective domestic
possession of USD. banks in the original
borrowed currency.

Basically, although
Company B swapped BRL
for USD, it still must
satisfy its obligation to
the Brazilian bank in real.

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 Currency Swaps
As a result, both
Company A faces a companies will incur
similar situation with its interest payments
domestic bank. equivalent to the other
party's cost of borrowing.

This last point forms the

basis of the advantages
that a currency swap
provides.

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 Currency Swaps

Advantages of the Currency Swap

Rather than borrowing real at 10%
Similarly, Company B no longer has
Company A will have to satisfy the to borrow funds from American
5% interest rate payments incurred
institutions at 9%, but realizes the
by Company B under its agreement 4% borrowing cost incurred by its
with the Brazilian banks. Company
swap counterparty.
A has effectively managed to
replace a 10% loan with a 5% loan.

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 Currency Swaps
Instead of borrowing from
Under this scenario,
international banks, both
Company B actually companies borrow
managed to reduce its
domestically and lend to
cost of debt by more than one another at the lower
half.
rate.

The diagram below depicts

the general characteristics
of the currency swap.

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Currency Swaps
4 % Interest on 100 Million USD

500 Million Real

COMPANY A COMPANY B
100 million USD

4%
5% on 500 million Real 5% to
to
Bank Bank
 Currency Swaps
For simplicity, the aforementioned
With the presence of the dealer, the
example excludes the role of a
swap dealer, which serves as the realized interest rate might be
intermediary for the currency swap increased slightly as a form of
commission to the intermediary.
transaction.

Typically, the spreads on currency

swaps are fairly low and, depending
on the notional principals and type
of clients, may be in the vicinity of
10 basis points.

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Currency Swaps
Therefore, the actual
borrowing rate for
Companyies A and B is
5.1% and 4.1%, which is
still superior to the offered
international rates
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 Currency Swaps
Currency Swap Basics
There are a few basic considerations that
differentiate plain vanilla currency swaps from other
types of swaps.

In contrast to plain vanilla interest rate swaps and return

based swaps, currency based instruments include an
immediate and terminal exchange of notional principal.
In the above example, the US$100 million and 500
million reals are exchanged at initiation of the contract.

77

At termination, the notional
principals are returned to the
appropriate party. Company A
would have to return the notional
principal in reals back to Company
B, and vice versa.
1 US Dollar = 5.20 Brazilian Real
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The terminal exchange, however,
exposes both companies to foreign
exchange risk as the exchange rate
will likely not remain stable at
original 5.00BRL/1.00USD level.
(Currency moves are unpredictable
and can have an adverse effect on
portfolio returns.

Additionally, most swaps involve a
net payment Every settlement date,
the return of one party is netted
against the return of the other and
only one payment is made.
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Contrastingly, because the periodic
payments associated with currency
swaps are not denominated in the
same currency, payments are not
netted. Every settlement period,
both parties are obligated to make
payments to the counterparty.
Bottom Line

Corporations with international exposure

will often utilize these instruments for
Currency swaps are over-the-
counter derivatives that serve two main the former purpose while institutional
investors will typically implement
purposes. First, they can be used to
minimize foreign borrowing costs. currency swaps as part of a
comprehensive hedging strategy.
Second, they could be used as tools to
hedge exposure to exchange rate risk.

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Summary

Cross-currency These instruments

swaps are used to Interest rates can be trade OTC, and can
lock in exchange fixed, variable, or a thus be customized
rates for set periods mix of both. by the parties
of time. involved.
Summary

While the exchange rate is locked

in, there is still opportunity
costs/gains as the exchange rate
will likely change. This could result
in the locked-in rate looking quite
poor (or fantastic) after the
transaction occurs.
Cross-currency swaps are not
typically used to speculate, but
rather to lock in an exchange rate
on a set amount of currency with
a benchmarked (or fixed) interest
rate.