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## Derivatives – A journey well begun

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**Derivatives – A journey well begun**Exchange traded OTC • 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 November 2002 - RBI Working group on Rupee derivatives March 2003 - RBI Working group on credit derivatives**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)**Receives fixed**Pays fixed Bank B Bank A Pays floating Receives floating Interest Rate Swap (IRS) • Typical Interest Rate Swap**The Swap Mechanism**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. 9.95% IOC Ltd AAA-Rated ACC Cement AA Rated MIBOR 10.00% MIBOR+1.00%**The swap of coupon flows results in benefit to both the**companies Cost to IOC 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 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**Rupee Swaps**• 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 grown • MIFOR curve has lengthened upto 10 yrs OIS curve is active upto 5 yrs • However, 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**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 • Commercial Paper yields • INBMK**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 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**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 1,000,000,000*8.50%*7/365 Net 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 of fixed 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)**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 • Reducing Interest cost without sacrificing liquidity and by utilising minimal capital, thereby ensuring 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.**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**Identify and calculate Possible Payoffs and cashflow from**IRS Swaption