Workshop on Indian Rupee Interest Rate Swaps and Forward Rate Agreements

1
Workshop on Indian Rupee Interest Rate Swaps and
Forward Rate Agreements
2
Agenda

• Introduction to Interest Rate Swaps (IRS)
• Overnight Index Swaps
• Uses of Overnight Index Swaps
• Forward Rate Agreements - Concepts Pricing

3
Introduction to Interest Rate Swaps
4
What is an Interest Rate Swap (IRS)?

• IRS is an agreement between two counterparties to
  exchange interest payments based upon a notional
  principal on specified dates over a specified
  period
• Interest payments are calculated on a notional
  principal which is not exchanged
• Typically one party pays interest based on an
  agreed fixed rate (fixed rate payer) and the
  other party pays interest linked to a floating
  benchmark rate (floating rate payer)

5
Interest Rate Swap (IRS)

• Typical Interest Rate Swap

6
Elements of a typical IRS

• Notional Principal
• there is no exchange of principal
• the floating and fixed interest rate calculations
  are for a pre-decided principal
• Exchange of coupon streams
• Normally fixed rate coupon for a floating rate
  coupon can also be floating rate for another
  floating rate
• Fixed rate
• predetermined rate, valid for the entire life of
  the swap
• Floating rate
• linked to a benchmark rate which is reset
  periodically
• Interest payments are net settled

7
Elements of a typical IRS (Continued)

• An IRS is like a fixed rate asset and a floating
  rate liability or vice versa, but without any
  exchange of principal and with net interest
  settlement. Therefore, the credit requirements
  for an IRS are minimal compared to those for cash
  instruments

8
Floating rate benchmark

• Should be a market determined rate which is
  transparent and mutually acceptable to
  counterparties
• Possible floating rate benchmarks in India are
• Overnight or Call Money Rates
• Inter-bank term money rates
• Treasury Bill yields
• Commercial Paper yields
• Bank Rate ???

9
Overnight rates are likely to be the most
relevant and acceptable floating rate benchmark

• Overnight money markets are deep and liquid and
  the Overnight Index is well accepted and
  extensively used as a market standard
• The methodology for calculating the Overnight
  Index is transparent and accepted by counterparts
• Overnight rates have been the most widely
  accepted benchmark for floating rate bond issues
  in the cash market.
• Therefore, Overnight Index Swaps (OIS) with the
  floating rate indexed to an Overnight reference
  rate are expected to be the main product in the
  swap market initially

10
Overnight Index (contd.)

• Interest rate swaps indexed to other floating
  rate benchmarks such as 14 day,1 month, 3 month
  MIBOR should hopefully develop as well

11
Pricing an OIS

• Pricing an OIS means deriving the fixed rate of
  the swap for a given floating rate benchmark
  (say MIBOR)
• Theoretically, OIS pricing should be derived from
  the inter bank term money rates
• In the absence of a liquid term money market, OIS
  pricing is expected to depend on
• the underlying of the counterparty
• the existing GOI corporate yield curve

12
Pricing an OIS

• Theoretically OIS Fixed rates are expected to lie
  between the GOI yield curve and the corporate
  yield curve
• Currently, indicative swap rates upto 1 year are
  below the GOI yield curve on account of
  substantial interest among corporates to receive
  fixed rates and pay Overnight floating rates.

13
Overnight Index Swaps (OIS) - An Example

• Bank A wants to pay fixed rates and receive
  Overnight floating rates
• Bank B wants to pay Overnight floating rates and
  receive fixed rates
• The two banks enter into an OIS
• Terms to consider
• Day Count Conventions
• Actual/365
• Start Date of the transaction - Tomorrow
• Overnight Benchmark
• NSE Overnight MIBOR, Reuters MIBOR, Reuters MIOR
• Settlement date convention
• Modified following business day
• Interest computation methodology
• Compounding of Overnight rates for every business
  day

14
OIS Details

• Bank A enters into a 7 day OIS with Bank B, where
  Bank A pays a 7 day fixed rate _at_ 8.50 and
  receives Overnight MIBOR
• Terms
• Trade Date 23rd August,1999
• Day Count Basis Actual number of days/365
• Amount INR 100 crores
• Start Date 24th August,1999
• End Date 31st August,1999

15
OIS Details (Continued)

• Terms
• O/N benchmark NSE O/N MIBOR a/365 (Bank B pays)
• Fixed Rate 8.50 simple a/365 (Bank A pays)
• Interest Computation The fixed rate is computed
  on a simple basis, but the floating rate
  would be compounded every Mumbai business
  day.
• Interest Settlement The settlement on the swap
  would be on a net basis. For e.g.., if the
  interest as per the fixed rate is higher than
  floating rate, Bank A pays the
  difference

16
Computing OIS Cashflows

• Overnight index for 7 days
• O/N MIBOR Notional Principal
  Accrued Interest
• Day 1 7.83 1,000,000,000 214,521
• Day 2 7.76 1,000,214,521 212,648
• Day 3 7.32 1,000,427,169 200,634
• Day 4 8.02 1,000,627,803 219,864
• Day 5 6 8.11 1,000,847,666 444,760
• Day 7 8.22 1,001,292,427 225,497
• Total interest accrued on the floating leg
  (Bank B pays) 1,517,923
• Interest accrued on fixed leg (Bank A pays)
  1,630,137
• 1,000,000,0008.507/365
• Net interest payment by Bank A on the settlement
  date 112,214

17
Canceling an outstanding OIS position

• Canceling /unwinding an existing OIS position is
  simple as it just entails deriving the
  mark-to-market position of the swap which is
  settled between counterparties.
• Important to understand the arithmetic, as
  corporate counterparts canceling contracts is a
  reality.
• As per the Example Bank A enters into a 7 day
  OIS with Bank B, whereby it pays fixed and
  receives floating. After 3 days Bank A wants to
  get out of the position. What can Bank A do ?
• Option 1 book a reverse swap - receive fixed and
  pay floating for 4 days
• Option 2 cancel the outstanding OIS with Bank B

18
Option 1 Booking a Reverse Swap

• Bank A has the option of booking a reverse swap
  with another counterparty for the residual tenor
  of 4 days where it receives a fixed rate and pays
  Overnight MIBOR
• The reverse swap would have to be booked on a
  revised principal which is the original principal
  plus the interest accrued on the floating leg
• This method replicates cancellation of the
  outstanding swap and the net settlement amount
  determined as per this option is equal to the
  amount determined by canceling the swap
• However, this method is credit and capital
  inefficient as it would involve booking extra
  credit limit for a reverse swap whereas
  cancellation of the outstanding swap would
  release credit limits

19
Option 2 Canceling the outstanding OIS

• Canceling an OIS will have two components
• Component 1 The first component will be the
  difference between the interest accrued on the
  OIS fixed leg and on the floating leg from the
  start date to the current date
• Component 2 The second component will be the
  difference between the rate on the fixed leg of
  the original OIS and the rate on the fixed leg of
  a cancellation OIS for the residual tenor

20
Canceling the outstanding OIS Calculations

• Original OIS
• Principal INR 100 crores
• Tenor of the swap 7 days
• Start Date 24th August, 1999
• End date 31st August, 1999
• Swap rate Bank A pays fixed rate to Bank B at
  8.50 Actual/365
• Bank A receives Overnight MIBOR from Bank
  B Actual/365
• Cancellation
• Bank A approaches Bank B to cancel the
  outstanding OIS value 27th August,1999
• Bank B quotes a rate of 8.25 to cancel the
  outstanding swap

21
Canceling the outstanding OIS Calculations

• Component 1
• Overnight index for 7 days Notional
  Principal Interest
• Day 1 7.83 1,000,000,000 214,521
• Day 2 7.76 1,000,214,521 212,648
• Day 3 7.32 1,000,427,169 200,634
• Interest accrued on floating leg
  627,803
• payable by Bank B on unwind date (27th August,
  1999)
• Future Value of INR 627,803 on maturity date
  (31st August, 1999)
• 627,803(1627,8038.254/365)
  628,371
• Interest accrued on fixed leg
  1,000,000,0008.503/365
• payable by Bank A on maturity date
  698,630
• Net interest accrued for first 3 days
  698,630- 628,371 70,259
• payable by Bank A on maturity date (31st August,
  1999)

22
Canceling the outstanding OIS Calculations

• Component 2
• Cancellation OIS rate 8.25 vs MIBOR
• Difference in fixed rates payable
  1,000,000,000(8.50-8.25)4/365
• by Bank A on maturity date (31/8/99) 27,397
• Cancellation value on maturity date Component 1
  Component 2
• (31/8/99) payable by Bank A to Bank B 97,656
• Value if settled on cancellation date 97,656 /
  (18.254/365)
• (27th August, 1999) INR 97,568

23
Uses of Overnight Index Swaps
24
OIS - Uses

• As per RBI guidelines
• Banks
• Financial Institutions
• Primary Dealers and
• Corporates
• have been permitted to transact in OIS
• OIS can be used for
• Asset-Liability Management
• Hedging Interest Rate Risks
• Cash Management
• Reducing Interest cost
• without sacrificing liquidity and by utilising
  minimal capital, thereby
• ensuring a higher return on capital

25
Example 1 Asset liability management

• A typical nationalised Bank A cash surplus,
  long term liabilities, lack of assets, lends
  overnight and therefore
• runs asset liability mismatches, and gets lower
  returns on funds
• This bank receives 1 year deposit at 9.5 ,
  options available are
• 
  Returns Liquidity ALM
• 1. Lend it in overnight market Low
  High Mismatch
• 2. Buy 1 year asset High Funds locked No
  mismatch
• 3. Enter into OIS (pay O/N,rec fixed)High
  High No mismatch
• and continue to lend in overnight
• markets

26
Example 1 Asset Liability Management
Before
Pays fixed 9.5 on deposit
Bank A
Receives o/n rates
After
Pays o/n rate in OIS
Bank A
Receives fixed in OIS
Pays fixed 9.5 on deposit
Receives o/n rates
27
Example 2 Hedging interest rate risks

• Primary dealer typically fund securities
  positions in overnight markets
• run asset liability mismatches
• are exposed to volatility in overnight rates
• Absence of term money market limits funding
  options of a PD, term funding would also restrict
  flexibility for the PD
• OIS offers the opportunity to hedge interest rate
  risk and reduce asset liability mismatches
• PD pays fixed and receives floating on the OIS
• still borrows in call and retains flexibility in
  position management

28
Example 2 Hedging interest rate risks
Entire position exposed to call rates
PD
Pays o/n for funding positions
Receives fixed on bonds
PD hedges interest rate risk through OIS
Pays fixed in OIS
PD
Pays o/n for funding positions
Receives o/n in OIS
Receives fixed on bonds
29
Example 3 Cash management tool

• Financial institutions and some corporates
  allocate surplus cash in liquid assets like
  overnight deposits for maintaining liquidity
• Through an OIS, these entities can still lend
  overnight and keep their liquidity but lock into
  a term rate thus enhancing the returns on funds
  deployed

30
Example 4 Reduction in Interest Cost

• A corporate has an outstanding fixed rate loan
  with a residual tenor of 1 year.
• Corporate has a view that interest rates will
  remain stable or decline and hence, is concerned
  about his high fixed rate loan
• Alternative 1
• Repay the fixed rate loan and raise a fresh loan
  via a MIBOR linked bond
• Inefficient
• Alternative 2
• Enter into an OIS where it receives a fixed rate
  and pays MIBOR
• Replicates Alternative 1 but more efficiently

31
Example 5 Trading/Position Taking

• Carry Trades
• overnight rates expected to remain stable
• position replicated in OIS by receiving fixed and
  paying floating
• Stable steep yield curve
• ideal position is to borrow overnight and invest
  in longer term
• position replicated in OIS by receiving fix and
  paying overnight
• Stable inverted yield curve
• ideal position is to borrow long term and lend
  overnight
• position replicated in OIS by paying fixed and
  receiving overnight
• Therefore, swaps alter the risk nature but do not
  change the normal transactions of the business.

32
Capital calculations Cash market Vs OIS

• Cash market transaction
• Borrow INR 10 crores Overnight and lend the INR
  10 crores for 1 year to a corporate
• Assuming a pre tax spread of 2.00 p.a., post tax
  spread on the trade is 1.23 p.a. (assuming tax _at_
  38.5)
• Post tax return on the deal INR 12.30 lakhs
• Capital required Risk Weightage Asset
• 100 9
  100,000,000
• INR 9,000,000
  
• Return on Capital 14 p.a.

33
Capital calculations Cash market Vs OIS

• OIS transaction
• Pay Overnight rate and receive fixed rate on a 1
  year OIS
• Assuming a pre tax spread of 1.00 p.a., post tax
  spread is 0.615 p.a. (assuming tax _at_ 38.5 p.a.)
• Post tax return INR 6.15 lakhs
• Capital required 1 100 9 100,000,000
• INR 90,000
• Return on Capital 683 p.a.
• This return can be 5 times higher if the swap
  counterpart is a bank (3415 p.a.!!!)
• Therefore, swaps help replicate cash market
  transactions with lower capital requirements and
  thereby, much higher return on capital

34
Forward Rate Agreements - Concepts Pricing
35
Forward Rate Agreements (FRAs) are similar to IRS

• A FRA is a financial contract between two parties
  to exchange interest payments based on a
  notional principal for a specified future
  period
• on the settlement date, the contract rate is
  compared to an agreed benchmark/reference rate
  as reset on the fixing date
• It is similar to an interest rate swap except
  that
• in a typical IRS the benchmark rate can be reset
  more than once, a FRA involves only one interest
  rate setting
• in a typical IRS the settlement happens at
  maturity whereas in a FRA the net settlement
  amount is discounted to the FRA start date.

36
Example of a FRA deal

• A Corporate has an expected requirement for funds
  after 3 months but is concerned that interest
  rates will head higher from current levels.
• The corporate can enter into a FRA to hedge or
  fix his borrowing cost today for the loan to be
  raised after 3 months.
• The rate agreed via the FRA has to be compared to
  a benchmark rate to determine the settlement
• Therefore, today the Corporate buys a 3X6 FRA
  from a Bank at say 10.75 p.a. with the
  benchmark rate being the 3 month CP Issuance rate
  of the Corporate 3 months later.

37
Terms for the FRA deal

• The Corporate buys from the Bank a 3 X 6 FRA at
  10.75 against the 3 month CP issuance rate for
  the Corporate. Notional principal Rs102,495,342
  (we will see why)
• the notation 3X6 refers to the start date and the
  maturity date respectively for the FRA
• Corporate pays 3X6 FRA rate (10.75) for a 3
  month period starting 3 months from trade date
• Corporate receives benchmark rate from the Bank
  for the same period. The benchmark rate may be
  the 3 month CP rate as decided upon, to be
  determined on the fixing date
• net amount is due on maturity (6 months from
  trade date) but settlement is done on the start
  date (3 months from trade date)

FRA start date/ settlement date
Trade date
Fixing date
Maturity date
t0
t3m-1
t3m
t6m
38
Terms of the FRA deal

• Bank Corporate enter into a 3 X 6 FRA.
  Corporate pays FRA rate at 10.75. Bank pays
  benchmark rate based on 3 month CP issuance rate
  of the above corporate 3 months later.
  Additional details
• Notional principal INR 102,495,342
• FRA trade date 23rd August,1999
• FRA start/settlement date 23rd November, 1999
• FRA maturity date 23rd February,2000
• FRA fixing date 22nd November, 1999

39
Cash flows for the FRA deal

• Assume, 3 month CP rate for the Corporate
  (benchmark rate) on fixing date (22/11/99)
  11.00 p.a.
• Cash flow Calculations
• (a) Interest payable by Corporate NPA
  10.75 92/365 INR
  2,777,203
• (b) Interest payable by Bank NPA 11.00
  92/365
• 
  INR 2,841,789
• (c) Net payable by Bank on maturity date INR
  64,586
• (d) Discounting (c) to settlement date (c)/(1
  discount rate
  
• 
  discount period)
• Rs 64,586/(111.092/365) Rs 62,844
• Amount payable by the Bank on settlement date Rs
  62,844

40
Pricing for the FRA deal (the Banks viewpoint)

• Pricing a FRA would imply determining the forward
  interest rate
• In the example,pricing involves determining the
  implied 3 month forward 3-month interest rate.
  The implied forward rate can be derived from the
  cash market yield curve
• Pricing Calculations
• Current 3 month CP rate for Corporate 9.90 ,
  ann
  
• Current 6 month CP rate 10.40 annual
• Notional Principal INR 10 crores
• Bank has the option of buying the 6 month CP
  (Option 1) or buying the 3 month CP and selling
  an 3x6 FRA(Option2)

41
Pricing for the FRA deal

• Pricing Calculations (contd.)
• FRA rate would be the 3 over 6 month roll-over
  rate which would make the bank indifferent
  between the 2 options today,I.e
• Principal Int. accrued on Option 1 Principal
  Int. accrued on Option2
• 100(1CP6184/365) 100(1CP392/365)(13X6R92/3
  65)
• R 10.63 p.a.
• Therefore, 3X6 FRA rate is 10.63 p.a (money
  market,Actual/365)
• Formula for determining the implied forward
  interest rate
• (1 rate1 period1) (1 forward rate future
  period) 1 rate3 period3
• where period 1 future period period 3

42
Overall Return for the Bank (in our example)

• If the Bank had done a 6 mth a CP for 6 months
  (184 days), then it would have got a return of
  10.40 p.a.
• However, by going through the FRA route, the Bank
  enhanced its returns by doing
• a) A 3 month CP (92 days _at_ 9.90 p.a.) and
  simultaneously
• b) selling a 3x6 (92 days) FRA _at_ 10.75 p.a.
  thereby
• getting an overall return of 10.46 p.a.

43
Terminology of IRS and FRA markets

• To buy a swap buying a FRA
• pay a fixed rate under a swap
• pay a fixed rate under a FRA
• To sell a swap selling a FRA
• receive a fixed
  under a swap
• receive a fixed rate under a FRA

44
Summary IRS and FRA important tools for money
markets

• Credit risk minimal compared to other
  Money-Market Instruments
• Replicate cash market transactions, but with
  lower capital requirements
• Will reinforce the development of the cash market
  benchmarks
• Easy to unwind, if required
• Efficient trading hedging tool