Derivatives – A journey well begun

June 2000 – Equity Index futures

June 2001 – Equity Index options

July 2001 – Stock Options

November 2001 – Stock futures

June 2003 – Interest rate futures

1980s – Currency Forwards

1997 – Long term FC –Rupee swaps

July 1999 – Interest rate swaps and FRAs

July 2003 – FC-Rupee options

Exchange tradedOTC

November 2002 - RBI Working group on Rupee derivativesMarch 2003 - RBI Working group on credit derivatives

Interest Rate SwapsCurrency Swaps

Credit Default Swaps-CDS

Rupee Interest rate swaps

Swap market is now 6 years old

FY ‘04 has seen tremendous growth in volumes and outstanding contracts

Increasing volumes have led to lower bid-offer spreads for some of the price points

No of market players have increased

More banks and PDs have joined the market

Corporate activity has also increased

Emerging consensus about benchmark rates

OIS and MIFOR have emerged as two key swap curves

Agenda

Introduction to Interest Rate Swaps (IRS)

Overnight Index Swaps Uses of Overnight Index Swaps

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)

Interest Rate Swap (IRS)

Typical Interest Rate Swap

Receives floating

Bank A Bank B

Pays fixed Receives fixed

Pays floating

Comparative Cost Advantage

Example: Based on the classical comparative cost advantage.

Fixed Rate Floating Rate

IOC AAA- Rated

10.00% Mibor +0.3%

ACC LtdAA Rated

11.20% Mibor +1.00%

Difference 120 bps 70 bps

QSD 50 bps

The Swap Mechanism

IOC LtdAAA-Rated

ACC CementAA Rated

9.95%

MIBOR

10.00% MIBOR+1.00%

IOC borrows from the fixed market due the absolute advantage and ACC Borrows from the Floating Rate Market due to the comparative advantage. And both the companies enter a Swap Deal.

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The swap of coupon flows results in benefit to both the companies

-floating rate swap payment

Mibor

+Fixed rate debt Receipt 9.95%

-fixed rate debt Payment 10.00%

= net floating debt payment

Mibor +0.05%

Cost before swap Mibor + .30%

Benefit 25 bps

Cost to IOC after swap

+ Floating rate swap receipt

Mibor

- Fixed rate debt payment 9.95%

- Floating rate debt payment

Mibor + 1.00%

= Net Fixed debt Payment 10.95%

Cost before swap 11.20%

Benefit 25 bps

Cost to ACC Cement after Swap

Therefore the total gain of 50 bps is equal to the Quality difference spread.

The total gain is 0.25%+0.25% = 50bps = 1.20% -0.7%

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 ratepredetermined 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

6 Month MIFOR and overnight MIBOR as popular floating rate benchmarks MIFOR swaps more liquid Lack of liquid term money market

based benchmark Interest in long tenure swaps has also

grownMIFOR curve has lengthened upto 10

yrs OIS curve is active upto 5 yrsHowever, bid –offer spreads are still

relatively high (15-20 bps) for more than 5 year swaps Bid-offer on 15 year GOI Sec is less

than 1 bps

Rupee Swaps

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” RatesInter-bank term money ratesCommercial Paper yieldsINBMK

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 counterparties

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

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

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

OIS Details

Bank A enters into a 7 day OIS with Bank B, where Bank A pays a 7 day fixed rate @ 8.50% and receives Overnight MIBOR

Terms Trade Date 23rd August,2004 Day Count Basis Actual number of

days/365 Amount INR 100 crores Start Date 24th August,2004 End Date 31st August,2004

OIS Details (Continued)

Terms O/N benchmark NSE O/N MIBOR

Act/365 (Bank B pays)

Fixed Rate 8.50 % simple Act/365 (Bank A pays)

Interest ComputationThe 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

Computing OIS CashflowsOvernight index for 7 days

O/N MIBOR Notional Principal Accrued Interest

Day 1 7.83%1,000,000,000214,521

Day 2 7.76%1,000,214,521212,648

Day 3 7.32%1,000,427,169200,634

Day 4 8.02% 1,000,627,803219,864

Day 5 & 6 8.11%1,000,847,666444,760

Day 7 8.22%1,001,292,427225,497

Total interest accrued on the floating leg (Bank B pays) = 1,517,923

Interest accrued on fixed leg (Bank A pays) = 1,630,137

1,000,000,000*8.50%*7/365Net interest payment by Bank A on the settlement date = 112,214

Swap Pricing

No-arbitrage pricing condition PV (Fixed Cash Flows)

= PV (Floating Cash Flows) Zero value contract on start date :

The PV of floating rate cash flows less PV offixed rate cash flows should be zero

A swap is a zero value contract on the Start Date of the transaction : SV = 0

V1 -- V2 = 0 OR V1 = V2

Swap Pricing

Fair Pricing on initiation based on market’s expectation of future

short-term rates . On the start date, the value of the floating leg is equal to par

For the fixed leg to be equal to par, the coupon rate should be equal to the yield on a par coupon bond (assuming no default risk)

Uses of Overnight Index Swaps

OIS - Uses

As per RBI guidelines Banks Financial Institutions Primary Dealers and Corporateshave been permitted to transact in OIS

OIS can be used for Asset-Liability Management Hedging Interest Rate Risks Reducing Interest costwithout sacrificing liquidity and by utilising minimal

capital, therebyensuring a higher return on capital

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

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

Example2: A company accepts a 1 year FD for a Face

Value of Rs 5 crores. Deposits was issued at a rate of 8.00% Fixed Deposits has a residual maturity

maturity of 12 days The company is the view that the Call rates

will remain in the band of 5.60%-5.90%. Thus the Company is of the view that by

entering a IRS it can reduce its effective cost.

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Notional Principal Amount : Rs 5 CrOriginal Liability Cost: 8% PACompany Receives Fixed @ 5.90%Company Pays Floating @ NSE MIBORPay Receive Pay

NSE MIBOR Floating Leg Fixed Leg Original Liability1 0.0589 50000000 8068.49 8082.191781 10958.904112 0.0588 50008068.49 8056.09 8082.191781 10958.904113 0.0568 50016124.59 7783.33 8082.191781 10958.904114 0.0593 50023907.92 8127.17 8082.191781 10958.904115 0.0591 50032035.09 8101.08 8082.191781 10958.904116 0.051 50040136.17 6991.91 8082.191781 10958.904117 0.0561 50047128.08 7692.18 8082.191781 10958.904118 0.0581 50054820.25 7967.63 8082.191781 10958.904119 0.0562 50062787.88 7708.30 8082.191781 10958.90411

10 0.0577 50070496.18 7915.25 8082.191781 10958.9041111 0.0568 50078411.43 7793.02 8082.191781 10958.9041112 0.057 50086204.46 7821.68 8082.191781 10958.9041113 50094026.14 94026.14 96,986.30 131,506.85

50000000 50000000 5000000050094026.14 50096986.3 50131506.852960.161819

7.82 Effective Cost

Total CashflowsNet Difference Receivable From Swap

Example 3: IRS to Improve the Effective Yield on Asset. A company has invested Rs 5 crores in

Treasury bills whose residual maturity is 12 days at a Money market yield of 5.70%

The company is of the view that the Overnight rates will be high in a particular range over the next fortnight.

Hence the company strikes a deal, wherein it will receive floating rate and pay fix rate.

Valuation of Swap Part I : Accrual part Part II :Mark to market

MTM for Swap

Equity Swap

Swaptions

Identify and calculate Possible Payoffs and cashflow from IRS

Swaption

Value of IRS swaption at expiry

Credit Risk and swap

Currency Swaps Another popular type of swap is known

as a currency swap. In its simplest form, that involves

exchanging principal and fixed rate payments on a loan in one currency and for a principal and fixed rate interest rate payments on an approximately equivalent loan in another currency

Reasons for Currency swap A currency swap can be used to

transform a loan in one currency into a loan in another currency

Cross Currency Swaps- without intermediary

Assume NABARD has an External Commercial Borrowing denominated in USD , coupon USD 6mth LIBOR + 100 bps

Exposed to currency risk (USD/INR depreciation) and interest rate risk (US rates going up)

Can hedge using the following• Full Cross Currency Swap (principal +

interest)• Principal Only Swap (principal hedged,

interest rate risk open)• Coupon Only Swap (only coupon hedged)

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Full Cross Currency Swap (5 years)START MATURITYOVER LIFE

USD Princ 100 mio

Actual Exchanges

INR Princ 435 crores

NABARD

JPM

Actual Exchanges

US 6m Libor + 100bps

INR Fixed 6.35%

NABARD

JPM

USD Princ 100 mio

INR Princ 435 crores

NABARD

JPM

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Full Cross Currency Swap

A tool that would eliminate the entire currency and interest rate risk for the institution

Converts the foreign currency liability to a rupee liability

Swapped cost is lower than raising funds locally (AAA corporate 7.05%)

Canceling / rebooking not allowed (unless residual maturity is less than 1 year)

Cannot take advantage of INR appreciation or falling rates

ECB Restrictions

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FI

Company BCompany A $ 8% Sterling 12%

12% Sterling 9.4% $8% $ 11% Sterling

Cross Currency Swaps- with intermediary

Dollars SterlingCompany A 8% 11.60% AAACompany B 10.00% 12.00% AASpread 2.00% 0.40% 1.60%

Wants to borrow ActaulA sterling $B $ sterling

SwapEffective Cost Savings

Company A 11% sterling 0.6Company B 9.4% $ 0.6

Intermedairy Infllow Outflow1.4% $ 1% sterling

Net Gain 0.60%

Currency Swap A currency swap agreement requires the principal

to be specified in each of the 2 currencies. The principal amounts are usually exchanged at the beginning and end of the life of the swap.

They are chosen so that they are approximately equal at the exchange rate at the beginning of the swap.

Assume the principal amounts might be $ 15 million and sterling 10 million.

Initially, the principal amounts flow in the opposite direction to the arrows in the earlier figure

Currency Swap The interest rate payment during the life of the

swap and the final principal flow in the same directions of the arrows.

Thus, at the outset of the swap company A pays $ 15 million and receives sterling 10 million.

Each year during the life of the swap contract, company A receives $ 1.20 million (8% of $ 15 million) and pays sterling 1.10 million (11% of sterling 10 million).

At the end of the swap, it pays a principal of sterling 10 million and receives $ 15 million.

Company A Company B

$15 Million

Sterling 10 Million

Leg 2 Principal payments

Company A Company B

Sterling 10 Million

$ 15 Million

Leg 3 Principal payments

Valuation of Currency Swap

In absence of default risk, a currency swap can be decomposed into positions in 2 bonds in a similar way to an interest rate swap. Consider the position of company B in the figure. It is long on a sterling bond that pays interest @ 12% and short a dollar bond that pays interest of 9.4%

Company A Company B

Sterling 10 Million

$ 15 Million

Valuation of Swap

B pays $9.4% and receives sterling 12%

Value OF Swap V = SBf- Bd Bf = value measured in foreign currency, of the

foreign denominated bond underlying swap, Bd= value of US dollar bond underlying the swap, S= spot exchange rate The value of the swap can be thus determined

from the term structure of interest rates in domestic currency, term structure of interest in foreign currency and spot exchange rate

Example.. Suppose that the term structure of interest

rate is flat in Japan and USA. The Japanese rate is 4% and USA rate is 9%

(continuous compounding) FI enters into a currency swap where it

receives 5% in yen and pays 8% in dollar once a year.

Notional principal is $ 10 million and 1200 million yen.

Term of swap is 3 years and exchange rate is 110 yen = $1

Term Structure Japan 4%USA 9%

Pays Receive $ Yen

0.08 0.0510,000,000.00 1,200,000,000.00

Swap Structure

Example..

Example.. Bd= 0.8e^-0.09*1+0.08e^0.09*2+10.8e^0.09*3= $9.64 Milli

Bf=60e^0.04*1+60e^0.04*2+1260e^0.04*3= 1230.55 million Value of Swap is +(1230/110)/9.64=1.55 million

Credit Derivatives

Credit derivatives Credit derivatives are over the counter financial

contracts. They are usually defined as “off-balance sheet financial instruments that

permit one party to transfer credit risk of a reference asset, which it owns, to another party without actually selling the asset”.

Credit Linked Notes (CLNs), another form of credit derivative product, also achieves the same purpose, though CLNs are on-balance sheet products

Protection Seller

Protection Seller refers to the party that contracts to receive premiums or interest related payments in return for assuming the credit risk on an asset or group of assets from the Protection Buyer. The Protection Seller is also known in the market as the Credit Risk Buyer or

Protection Buyer

Protection Buyer refers to the party that contracts to transfer the credit risk on an asset

or group of assets to the Protection Seller. The Protection Buyer is also known in the market as the Credit Risk Seller or Beneficiary

Types of Credit Derivatives and basic structures:

CDS Total Return Swap

b)Total Return Swaps

Total Return Swaps (TRS), also called Total Rate of Return Swaps (TROR) are bilateral financial contracts designed to synthetically replicate the economic returns of an underlying asset or a portfolio of assets for a pre-specified time.

One counterparty (the TR payer) pays the other counterparty (the TR receiver) the total return of a specified asset, the reference obligation.

b)Total Return Swaps

In return, the TR receiver typically makes regular floating payments. These floating payments represent a funding cost.

In effect, a TRS contract allows the TRS receiver to obtain the economic returns of an asset without having to fund the assets on its balance sheet. Should the underlying asset decline in value by more than the coupon payment, the TRS receiver must pay the negative total return, in addition to the funding cost, to the TRS payer.

Total Return Swaps

At the extreme, a TRS receiver can be liable for the extreme loss that a reference asset may suffer following, for instance, the issuing company’s default

As such, a TRS is a primarily off-balance sheet financing vehicle. In contrast to credit default swaps, which only transfer credit risk, a TRS transfers not only to credit risk (i.e. the improvement or deterioration in credit profile of an issuer), but also market risk (i.e. any increase or decrease in general market prices). In TRS payments are exchanged among counterparties upon changes in market valuation of the underlying, in addition to the occurrence of a credit event as is the case with CDS contracts.