ÞkCILC1 S¥NCÞSIS

CN
Deve|opment of Interest kate C1C
Der|vat|ves market |n Ind|a


SubmlLLed 8y
Aparna MŦvŦ
Summer 1ralnee
8eserve 8ank Cf lndla
ÞCuM 2009Ŵ11
llM kCZPlkCuL

CkGkCUND CI S1UD¥
1he C1C derlvaLlves markeLs all over Lhe world have shown Lremendous growLh ln recenL yearsŦ
AfLer flnanclal crlsls of 2008ţ whlch ls belleved Lo have been exacerbaLed by C1C derlvaLlvesţ
lncreaslng aLLenLlon ls belng pald Lo analyzlng Lhe regulaLory envlronmenL of Lhese markeLsŦ
1he lndlan C1C derlvaLlves markeLsţ unllke many oLher [urlsdlcLlonsţ are well regulaLedŦ Cnly
conLracLs where one parLy Lo Lhe conLracL ls an 88l regulaLed enLlLy are consldered legally valld
ln lndlaŦ A good reporLlng sysLem and a posLŴLrade clearlng and seLLlemenL sysLemţ Lhrough a
cenLrallzed counLer parLyţ has ensured good survelllance of Lhe sysLemlc rlsks ln Lhe lndlan C1C
markeLŦ
lrom amongsL Lhe varlous C1C derlvaLlves markeLs permlLLed ln lndlaţ lnLeresL raLe swaps and
forelgn currency forwards are Lhe Lwo promlnenL markeLsŦ
lnterest kote uerivotives
88l permlLLed banks/lls/Þus Lo underLake lnLeresL raLe swaps/forward raLe agreemenLs ln !uly
1999Ŧ l8us have been slow Lo emerge ln lndlaŦ An C1C markeL has sprung up prlmarlly lnvolvlng
lnLeresL raLe swaps (l8S) and forward raLe agreemenLs (l8A)Ŧ
lotetest kote 5wops
A swap ls a cashŴseLLled over Lhe counLer derlvaLlve under whlch Lwo counLerparLles exchange
Lwo sLreams of cash flowsŦ lL ls called an lnLeresL raLe swap lf boLh cash flow sLreams are ln Lhe
same currency and are deflned as cash flow sLreams LhaL mlghL be assoclaLed wlLh some flxed
lncome obllgaLlonsŦ 1he mosL popular lnLeresL raLe swaps are flxedŴforŴfloaLlng swaps under
whlch cash flows of a flxed raLe loan are exchanged for Lhose of a floaLlng raLe loanŦ 1hese are
called vanllla lnLeresL raLe swapsŦ 1here ls also a llquld markeL for floaLlngŴfloaLlng lnLeresL raLe
swapsŸwhaL are known as basls swapsŦ 1o keep Lhlngs slmple (and mlnlmlze seLLlemenL rlsk)ţ
concurrenL cash flows are neLLedŦ 1he prlnclpal amounL ls called Lhe noLlonal amounL of Lhe
swapŦ lnLeresL raLe swaps are used by a wlde range of commerclal banksţ lnvesLmenL banksţ
nonŴflnanclal operaLlng companlesţ lnsurance companlesţ morLgage companlesţ lnvesLmenL
vehlcles and LrusLsţ governmenL agencles and soverelgn sLaLes for one or more of Lhe followlng
reasonsť l) 1o obLaln lower cosL fundlngŤ ll) 1o hedge lnLeresL raLe exposureŤ lll) 1o obLaln hlgher
yleldlng lnvesLmenL asseLsŤ lv) 1o creaLe Lypes of lnvesLmenL asseL noL oLherwlse obLalnableŤ v)
1o lmplemenL overall asseL or llablllLy managemenL sLraLeglesŤ vl) 1o Lake speculaLlve poslLlons
ln relaLlon Lo fuLure movemenLs ln lnLeresL raLes



An example of usage Ŷ uslng Swap Lo Lransform llablllLy
Conslder a hypoLheLlcal swap beLween llrm A and llrm 8Ŧ Suppose llrm A agrees Lo pay llrm 8
an lnLeresL of 3Ʒ per annum on a noLlonal prlnclple of $100 mllllon and ln reLurn llrm 8 agrees
Lo pay llrm a slx monLh Ml8C8 raLe on Lhe same noLlonal prlnclpleŦ We assume Lhe agreemenL
speclfles LhaL paymenLs are Lo be exchanged every slx monLhs and Lhe 3Ʒ lnLeresL raLe ls
quoLed wlLh semlannual compoundlngŦ
Suppose llrm A has arranged Lo borrow $100 mllllon aL Ml8C8 plus 10 basls polnLs ŦAfLer llrm
A has enLered lnLo Lhe swap lL has Lhree seLs of cash flows Ŷ
1Ŧ lL pays Ml8C8 plus 0Ŧ1Ʒ Lo lLs ouLslde lenders
2Ŧ lL recelves Ml8C8 under Lhe Lerms of Lhe swap
3Ŧ lLs pays 3Ʒ under Lhe Lerms of Lhe swapŦ

1hree seLs of cash flows neL ouL Lo an lnLeresL paymenL of 3Ŧ1Ŧ1hus for llrm A Lhe swap could
have Lhe effecL of Lransformlng borrowlngs aL a floaLlng raLe of Ml8C8 plus 10 basls polnLs lnLo
borrowlngs aL a flxed raLe of 3Ŧ1ƷŦ
8everse ls Lhe case for llrm 8Ŧ Suppose lf llrm 8 has a loan of $100 mllllon on whlch lL pays
3Ŧ2Ʒ lnLeresLţ and Lhen Lhe neL effecL wlll be Lransformlng a flxed raLe loan of 3Ŧ2Ʒ lnLeresL lnLo
borrowlngs aL a floaLlng raLe of Ml8C8 plus 20 basls polnLsŦ
An explanaLlon commonly puL forward Lo explaln popularlLy of swaps concerns Lhe comparaLlve
advanLagesŦ Conslder Lhe above examples of uslng an lnLeresL raLe swap Lo Lransform a llablllLyŦ
Some companles ţlL ls argued have a comparaLlve advanLage when borrowlng ln flxed raLe
markeLsţ whereas oLher companles have a comparaLlve advanLage when borrowlng ln floaLlng
raLe markeLsŦ 1o obLaln a new loanţ lL makes sense for Lhe company Lo go Lo Lhe markeL where
lL has a comparaLlve advanLageŦ As a resulL Lhe company may borrow flxed when lL wanLs
floaLlng or borrow floaLlng when lL wanLs flxed Ŧ1he swap ls Lhen used Lo Lransform a flxed raLe
loan lnLo floaLlng raLe loan and vlce versaŦ



twotJ kote Aqteemeot (kA)
A forward raLe agreemenL (l8A) ls an agreemenL Lo lend/borrow money for a speclfled perlod
on a noLlonal prlnclpal on a parLlcular daLe ln Lhe fuLure aL a raLe LhaL ls deLermlned LodayŦ lL ls
llke a forward conLracL where Lhe underlylng ls a loan or deposlLsţ boLh noLlonalŦ l8As are C1C
conLracLsŦ Many banks and large corporaLlons wlll use l8As Lo hedge fuLure lnLeresL raLe
exposureŦ 1he buyer hedges agalnsL Lhe rlsk of rlslng lnLeresL raLesţ whlle Lhe seller hedges
agalnsL Lhe rlsk of falllng lnLeresL raLesŦ CLher parLles LhaL use lorward 8aLe AgreemenLs are
speculaLors purely looklng Lo make beLs on fuLure dlrecLlonal changes ln lnLeresL raLesŦ 1he
dlfference beLween Lhe l8A raLe and Lhe acLual markeL raLe on Lhe maLurlLy daLe ls pald by one
parLy Lo Lhe oLherŦ lf Lhe markeL raLe ls hlgher Lhan Lhe l8A raLeţ Lhe seller pays Lhe buyer
whereas ln case of markeL raLe belng lower Lhan Lhe l8A raLeţ Lhe buyer pays Lhe sellerŦ All
l8As are execuLed as C1C deals beLween Lwo counLerparLles who are comforLable Lradlng wlLh
each oLherŦ 1hese can also be lnLermedlaLed by a brokerŦ ln elLher caseţ each counLerparLy
Lakes on Lhe credlL rlsk of Lhe oLherţ Lyplcally for duraLlons of Lwo weeks Lo slx monLhsŦ 1he
reference raLe LhaL ls Lyplcally used Lo seLLle Lhese producLsţ are shorLŴLerm raLes LhaL are
polled from Lhe markeL uslng a meLhodology slmllar Lo LhaL of Ll8C8Ŧ Cf Lheseţ Lhe nSL
Mumbal lnLerbank Cffer 8aLe (Ml8C8) polled by Lhe nSL ls a wellŴknown benchmarkŦ
entro/ited /eorinq Porties
CClL Clearlng CorporaLlon of lndla L1uţ whlch sLarLed funcLlonlng ln 2002ţ ls Lhe only cenLrallzed
clearlng parLy for Lrade processlng and seLLlemenL servlces ln lndlaŦ lL currenLly provldes a
guaranLeed seLLlemenL faclllLy for governmenL securlLles Lradlngţ clearlng of collaLerallzed
borrowlng and lendlng obllgaLlons (C8LC)ţ guaranLeed seLLlemenL of forelgn exchange Lradlngţ
and seLLlemenL of all l8SŦ
lssues
1he surface level undersLandlng of Lhe rlsks as well as mlsuse of Lhese producLs has broughL
sysLemlc lmpllcaLlons around Lhe globe durlng Lhe subprlme crlslsŦ lndla was noL much affecLed
as lL has mlnlscule markeL share ln derlvaLlves segmenLŦ 8uL lL ls clear LhaL C1C markeL ls
essenLlal for Lhe developmenL of real economyŦ So before deepenlng Lhls markeLţ few aspecLs
regardlng Lransparencyţ regulaLlon and llquldlLy needs Lo be addressed ln order Lo prevenL Lhe
flnanclal sysLem from shocksŦ
kL¥ kLSLkCn ÇULS1ICNť CILC1IVL
1he ob[ecLlve of Lhe pro[ecL ls Lo analyze Lhe developmenL of l8us markeL ln lndla ţ Lhe
regulaLory framework adopLed as well as Lhe lssues and lmpedlmenLs ln Lhe Lhelr usage by
lndla's lnsLlLuLlonal lnvesLors Ŧ

,L1nCDCLCG¥
1hls meLhodology adopLed ls a sLepwlse approach whlch can be llsLed as follows Ŵ
1Ŧ A ueLalled analysls of Lhe presenL markeL sLrucLure of C1C uerlvaLlves ln lndlaŦ lL wlll
malnly encompass Lhe sLudy of MarkeL parLlclpaLlon of varlous lnsLlLuLlons ln Lhe
lnLeresL 8aLe derlvaLlves segmenL over Lhe yearsŦ 1he reporL also alms aL analyzlng Lhe
varlous deLermlnanLs of usageţ lssues and lmpedlmenLs ln Lhe usage of l8us by lndla's
lnsLlLuLlonal lnvesLorsŦ
2Ŧ 1hls would be followed by an analysls of Lhe regulaLory framework adopLed for lndlan
C1C uerlvaLlves Ŵ Approach Lo CenLrallzed ClearlngŦ Pow cenLral counLerparLles CCÞs
reduce Lhe counLerparLy and credlL rlsks and how good supervlslon Lhrough a wellŴ
deflned regulaLory framework underplns Lhe sysLemlc rlskŦ
Ŧllnallyţ as a parL of recommendaLlonsţ Lhe reporL wlll dellberaLe on Lhe measures LhaL
would help ensure more sLablllLy and also conLrlbuLe Lo Lhe developmenL of Lhe C1C
uerlvaLlves markeL ln lndlaŦ

1I,LLINL
1ask
Weeks
(SLarLlng Ŵ3
Lh
Aprll)
LlLeraLure 8evlew on lnLeresL 8aLe uerlvaLlves 2
uaLa Analysls on MarkeL ÞarLlclpaLlon of varlous lnsLlLuLlons ln Lhe lndlan
markeL 2
Analysls of Lhe varlous deLermlnanLs of usageţ lssues and lmpedlmenLs ln
Lhe usage of l8us by lndla's lnsLlLuLlonal lnvesLorsŦ
2
Analysls of Lhe regulaLory framework adopLed for lndlan C1C uerlvaLlves Ǝ
8ecommendaLlons 1
ÞreparaLlon of Lhe flrsL drafLţ revlewţ modlflcaLlonsţ flnal submlsslon of Lhe
pro[ecL reporLŦ 1




kLILkLNCLS
'CpLlonsţ luLures and uerlvaLlves' by !ohn C Pull
Worklng Þaper on 'C1C uerlvaLlves MarkeL ln lndlať 8ecenL 8egulaLory lnlLlaLlves and Cpen
lssues for MarkeL SLablllLy and uevelopmenL' Ŵ lnulAn CCunClL lC8 8LSLA8CP Cn
ln1L8nA1lCnAL LCCnCMlC 8LLA1lCnS
'lndlan uerlvaLlves MarkeL' by Asanl Sarkar
'CverŴLheŴcounLer derlvaLlve markeLs ln lndla Ŵ lssues and perspecLlves' by Shyamala CoplnaLh




SIGN CI 1nL GUIDL

@-9 -   ½¯ °€°  ¾f @.

  . I  ¯¯ @f°   ¾   f°€° f 9. .  f ¾¯f °° f    ¯   ½f°f.

 .

D-@D @ @.

 f ¾¯f ¾f   f ¾° ¯ ° ¾–° n ° f¾  €  €°f°nf n¾¾ €   n ¾     f  ° fn  f   @.

 f ¾  °n f¾°– f °° ¾ °– ½f   f°f°–    –f °°¯ ° €  ¾  ¯f ¾  @  ° f° @.

 f ¾ ¯f ¾  °  ¯f°   ©¾ n°¾  f     –f  ° n°fn¾  ° ½f n°fn¾f°  –f  °f n°¾   –ff  °° f –  ½°–¾¾ ¯f° f½¾ f n f°–f° ¾  ¯ °¾¾ ¯ –f n °f n° ½f f¾ °¾ – ¾ f°n € ¾¾ ¯n¾¾° ° f°@.

 ¯f   ¯f¯°–¾ f¾@.

 f ¾¯f ¾½ ¯ °° f °  ¾f ¾f½¾f°  € –°n °n€f ¾f  ½¯° °¯f ¾  °  ¾f  f ¾  ½ ¯  f°¾$¾$9¾° f °  ¾f ¾f½¾$€f f f– ¯ °¾°  ¾f  °¾ ¯ – °° f °@.

¯f f¾¾½°–½½¯f°°– °  ¾f ¾f½¾%%f° €f f f– ¯ °¾%%  °  ¾f f½¾ ¾f½¾fnf¾ ¾    n°  f ° nn° ½f ¾ nf°–  ¾ f¯¾€nf¾€¾ ¾nf f°°  ¾f ¾f½€ nf¾€¾ f¯¾f °  ¾f¯ n °nf° f  €° f¾nf¾€¾ f¯¾f¯– f¾¾nf ¾¯ €  °n¯   –f°¾  @  ¯¾ ½½f °  ¾ f  ¾f½¾ f  € € €f°– ¾f½¾ °  nnf¾€¾€f€ f f°f  nf°– €¾ €f€f°–f f° @ ¾ f  nf f°f°  ¾f ¾f½¾ @  ¾f¾f ¯f €€f°– €f°–°  ¾f  ¾f½¾ ff °°f¾ f¾¾¾f½¾ @ ½°–¾¾¯½ %f° ¯°¯ ¾  ¯ °¾%  n°n ° nf¾ €¾ f  °   @  ½°n½f f¯° ¾ nf    °°f f¯° €   ¾f½  °  ¾ f  ¾f½¾ f  ¾   f   f°–  € n¯¯ nf f°¾  ° ¾¯ ° f°¾  °° €°f°nf ½ f°– n¯½f° ¾  °¾f°n  n¯½f° ¾  ¯–f–  n¯½f° ¾  ° ¾¯ °  n ¾f° ¾¾ – °¯ °f– °n ¾f° ¾  –°¾f ¾€° ¯ € €°–  f¾°¾ %@ f° n¾€° °– %@ – °  ¾f  ½¾ %@ f°–    °–° ¾¯ °f¾¾ ¾ %@n f ½ ¾€° ¾¯ °f¾¾ ° ¾  f°f  % @¯½ ¯ ° ff¾¾ f ¯f°f– ¯ °¾f – ¾ %@f ¾½ nf ½¾°¾ ° f°€ ¯ ¯ °¾°°  ¾f ¾   .

 ° f¯½ €D¾f–  D¾°–f½f°¾€¯f  .

 f ° ¾f¯ °°f½°n½ J f¾¾¯  f– ¯ ° ¾½ n€ ¾ f ½f¯ °¾ f    nf°–    ¾ ¯°¾ f°      °  ¾ f  ¾  ¾ ¯f°°fn¯½° °–  ½½¾ ¯f¾ff°–  ¯°f. ½¾ f¾¾½°¾ € ¯ f¾ °  ° ¾f½f¾ ¾ ¾€nf¾€¾    ½f¾. ½¾ f¾¾½°¾° °–¾ff€ f €     ¾  ¾  nf¾  € ¯  ½½¾  € ¯  f¾ f f° €  ¯° ° n  ½f¾   °  ¾ f°  ° °  €€ n f°¾€¯°–f€ f f°€  °  ¾° °–¾ff€f°–f €. ½¾ f¾¾½°¾  ° ½f°f°n¯¯°½€f  ½f°½½f€¾f½¾n°n °¾ n¯½ff  f f°f– ¾ . °   ¯¾€ ¾f½   ¾½f¾ °   ¯¾€ ¾f½   @ ¾ ¾€nf¾€¾° f°°  ¾½f¯ °€  @¾€¯ ¾f½n  f   €€ n€f°¾€¯°– °–¾ff€f°–f €.°¾ f½ nf¾f½  °¯f° ¯ ½½¾ ¯f– ¾½f¯  f°°  ¾€ ½ f°°¯°f°°f½°n½ €¯°f° ° °¯ f– ¾ ½f¯f¾¯°. ½¾  ¾¾  ° ¾    n  ¾.

°¾  f   f¯½ ¾€¾°–f°°  ¾f ¾f½f°¾€¯ff   ¯  n¯½f° ¾  ¾ f–  f  f n¯½ff  f f°f–   ° °– ° €  f  ¯f ¾   f¾ n¯½f° ¾f fn¯½ff f f°f–  ° °–°€f°– f ¯f ¾ @ f°f° f° ¯f ¾¾ °¾ € n¯½f°– ¯f     f¾ f n¯½ff  f f°f–  ¾ f  ¾   n¯½f° ¯f  €   °  f°¾ €f°– €f°– °f°¾€  @ ¾f½¾ °¾ f°¾€¯f€ f  f°°€f°–f f°f° n  ¾f    .

 f f – ¯ °%% €f f f– ¯ °%%¾f°f– ¯ ° ° $ ¯° €f¾½ n€ ½   °f°°f½°n½f°f½fnf f ° € fff f¾  ¯°  f ¾  f€f n°fn   ° °–¾ff° ½¾¾  °°f ¾f @.

f° f°¾ f°  f–  n½f°¾  ¾  ¾   –  €  °  ¾ f  ½¾  @     – ¾ f–f°¾   ¾ € ¾°– °  ¾ f ¾      ¾    – ¾ f–f°¾   ¾ € €f°– °  ¾ f ¾    ½f ¾ f ¾  f  f  – ¯ °¾ f  ¾½ nf¾ ½  °–  ¯f  ¾ ° €   n°f nf°– ¾ ° °  ¾ f ¾  @  €€  °n   ° f f°  fnf¯f f ° ¯f f ¾½f  °  ½f       €   ¯f  f  ¾ –  f°    f    ¾   ½f¾       f¾ ° nf¾  € ¯f  f  °–   f°    f      ½f¾   ¾     ¾f   n f¾@. n°fn¾  .

 f¾  °n° ½f ¾f n¯€f  f °– fn    @ ¾  nf° f¾  ° ¯ f   f    °   nf¾  fn n° ½f f ¾ °   n  ¾ €      ½nf € f°¾ €   ¾  ¾ ¯°¾  @   €  °n  f  f ¾ ½nf ¾   ¾    ¾  ½ n¾  f  ¾  ¯ f ¾ f f  ½  €¯   ¯f  ¾°– f ¯  – ¾¯f  f €    €  ¾    - . %½   -¾f  °° °n¯f  .¯ f°  f°€€ f %.

°f .

 f°–9f ¾ .

.

.

 f°–.

½f°€° f@ n¾f €°n°°–° ¾ °n °f  n f°– ½f € f  ½n ¾¾°– f°  ¾  ¯ ° ¾ n ¾ ° ° f   n ° ½ ¾ f –ff°  ¾  ¯ ° €fn € – °¯ ° ¾ n ¾ f °–  n f°– € nf f  °–f°  ° °– –f°¾%.

% –ff° ¾  ¯ °€€ –° nf°– f °–  f° ¾  ¯ °€f  ¾¾ ¾ @  ¾€fn     ° ¾f° °– €   ¾¾ f¾   f¾ ¯¾¾  €  ¾  ½ n¾ f¾ – ¾¾ ¯n¯½nf°¾f°  –  °– ¾ ½¯ n¾¾ ° ff¾°¯nf€€ n  f¾  f¾ ¯°¾n  ¯f  ¾f  ° f ¾ ¾ –¯ °    ¾ n f f @.

 ¯f  ¾ ¾¾ °f€   ½¯ °€ f n°¯  €  ½ °°–¾¯f  € f¾½ n¾  –f °–f°¾½f °n  –f°f°  ° ¾ f  ¾¾ ° ½  °  €°f°nf¾¾ ¯€¯¾n¾  .

 ..D@.

@I @   © n  €   ½© n ¾  f°f     ½¯ ° € ¾ ¯f  ° ° f     –f €f¯  f ½  f¾   f¾   ¾¾ ¾ f°  ¯½ ¯ °¾ °     ¾f–   ° f#¾°¾°f° ¾¾  .

@ @¾¯  –f ½ ¾f¾ ½¾ f½½fnnnf° ¾ f¾€¾      f  f°f¾¾ €   ½ ¾ ° ¯f  ¾n  € @. .

  f ¾ ° ° f    ¯f° °n¯½f¾¾   ¾  € .f  ½fn½f° € f¾ °¾°¾ °   °  ¾f  f ¾¾ –¯ °   f¾  @  ½f¾f¯¾ff°f°–  f¾  ¯°f°¾€¾f– ¾¾ ¾f° ¯½ ¯ °¾° ¾f– €¾ ° f#¾ °¾°f° ¾¾    @¾  €  f°f°f¾¾€  –f€f¯ f ½ €° f° @.

  f ¾  ½½fn  .

°f  .

 f°–   n °f n° ½f ¾ .

.

9¾  n    n° ½f f°  n  ¾¾ f°   –  ¾½ ¾° – f   €°  –f€f¯ ° ½°¾ ¾¾ ¯n¾    °f f¾f½f€ n¯¯ ° f°¾   ½  f ° ¯ f¾ ¾f    ½ °¾  ¯  ¾f  f°  f¾ n°       ½¯ ° €   @.

- J ¾  @f¾ %f°– ½%   f   °°  ¾f  f ¾ ff °f¾¾ ° .f  9fn½f° € f¾ °¾°¾ °   ° f° ¯f  °f¾¾ €   f¾  ¯°f°¾ € ¾f–  ¾¾ ¾ f°  ¯½ ¯ °¾ °  ¾f– €¾ ° f#¾°¾°f° ¾¾  °f¾¾€  –f€f¯ f ½ €° f°@.  f ¾¯f °° f   @.

 f ¾   n¯¯ ° f°¾ 9 ½ff°€ €¾ f€    ¯ €nf°¾ €°f¾ ¯¾¾°€  ½© n ½        .

  -.

 #½°¾  ¾f°  f ¾# °.

 J°– 9f½  ° #@.

  f ¾ .f  f  f°    ½¯ °#  -- .f  ° ° f   n °  –f °f ¾ f°  ½ ° ¾¾ ¾ € .

D-.

  .

 - -@-@-.

.-.

f # ¾f°ff #   n°  f ¯f ¾°° f ¾¾ ¾f° ½ ¾½ n ¾# f¯ff½°f     -@D .@- #° f° f ¾.