INTEREST RATE SWAPS

AGENDA
Swaps and its evolutionEvolution of IRS IRS Why IRSTypes Mechanism Examples Pros and cons IRS in India. Why failed Future of IRS in India

DEFINITION
A contract which involves two counter parties to exchange over an agreed

period, two streams of interest payments, each based on a different kind of

interest rate, for a particular notional amount. Interest rate swaps are used to hedge interest rate risks . If a treasurer s view is that the interest rates will be falling in the future, he may convert his fixed interest liability into floating interest liability; and also his floating rate assets into fixed rate assets. If he expects the interest rates to go up in the future, he may do vice versa.

Since there are no movements of principal, these are off balance sheet
instruments and the capital requirements on these instruments are minimal.

Characteristics
Contractual agreement Over a period of time Exchange a series of interest cash flows Only net cash flows exchanged on the maturity date The size of the swap is referred to as the notional amount and is the basis for calculation Actual principal of the swap NOT exchanged

Types of Interest Rate Swaps

Coupon Swap
If an interest rate swap involves the swapping of a stream of payments based on the fixed interest rate for a stream of floating interest rate, then it is called a coupon swap.
Counter parties to the Coupon Swap: Payer of the fixed interest stream is called the Payer in the swap. Receiver of the fixed interest stream is called the Receiver in the Swap

Generic swap
A plain vanilla swap is a generic swap. It contain the simple characteristics, such as a constant notional principal amount, exchange of fixed against floating interest (coupon swap), an immediate start (i.e., on the spot date).

 Asset Swap
If in an interest rate swap, one of the streams of payments being exchanged is funded with interest received on an asset, the whole mechanism is called the asset swap. i.e. it is an interest rate swap, which is attached to an asset. Asset swaps are used by investors. If an investor anticipates a change in interest rates, he can maximize his interest inflow by swapping the fixed interest paid on the asset for floating interest, in order to profit from an expected rise in interest rates.

Term Swaps
A swap with an original tenor of more than two years is referred to as a term swap.

 Basis Swap
Two streams of payments can be calculated using different floating rate indices. These are also called as floating-against-floating swaps. It is possible to enter into a swap with a 3-month Libor against a 6 months LIBOR It is also possible to enter into a swap with a 91-Day T-Bill Yield against a 6-Month Libor.
Counterparties to a basis swap: In a basis swap, each counter party is described in terms of both the interest stream it pays and the interest stream it receives.

 Money Market Swaps

Swaps with an original maturity of up to two years are referred to as Money Market swaps. IMM swaps come under this category. The tenor of the swaps matches exactly with the short-term interest futures in the IMM (International Monetary Market- Traded in the Chicago Mercantile Exchange).

Participants 5. Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own balance sheet management or for market making. Banks/Fls/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures. No specific permission from Reserve Bank would be required to undertake FRAs/IRS. However, participants when they start undertaking such transactions, will be required to inform Monetary Policy Department (MPD), Reserve Bank of India and abide by such reporting requirements as prescribed by the Reserve Bank from time to time. 6. Participants undertaking FRAs/IRS are, however, advised that before undertaking market making activity in FRAs/IRS, they should ensure that appropriate infrastructure and risk management systems such as ability to price the product and mark to market their positions, monitor and limit exposures on an ongoing basis, etc., are put in place. Types of FRAs/IRS 7. Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having

explicit/implicit option features such as caps/floors/collars are not permitted. Bench Mark Rate 8. The benchmark rate should necessarily evolve on its own in the market and require market acceptance. The parties are therefore, free to use any domestic money or debt market rate as benchmark rate for entering into FRAs/IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counterparties. Size 9. There will be no restriction on the minimum or maximum size of 'notional principal' amounts of FRAs/IRS. Norms with regard to size are expected to emerge in the market with the development of the product. Tenor 10. There will be no restriction on the minimum or maximum tenor of the FRAs/ IRS. Capital Adequacy 11. Banks and financial institutions are required to maintain capital for FRAs/IRS, as per the stipulations contained in An-nexure 1. Primary dealers should follow the norms as indicated in Annexure 2.

Mechanism of an Interest Rate Swap:

Example: "plain vanilla" or the "coupon swap
Counter parties:: A and B Maturity:: 5 years A pays to B : 6% fixed p.a. B pays to A : 6-month LIBOR Payment terms : semi-annual Notional Principal amount: USD 10 million Diagram: 6% Fixed PARTY A 6 m LIBOR PARTY B

USES
Originally created to allow multi-national companies to evade exchange controls.

Hedging To alter exposure to interest-rate fluctuations. Swapping fixed-rate obligations for floating rate obligations, or vice versa.
Speculation Used by hedge funds to change in interest rates or the relationship between them. Arbitrage opportunities. Insurers with long term assets and shorter term liabilities can enter a swap in which they pay a fixed rate and receive a floating rate This swap provides cash inflows if interest rates rise

Risk Involved
Interest Rate Risk - Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis Risk - If the floating rates of the two counterparties are not pegged to the same index. Tax Risk -The risk created by potential tax events that could affect the relationship of the swap index with the interest rate on our variable rate bonds. Counterparty Risk -The failure of the counterparty to make required payments or otherwise comply with the terms of the swap agreement.

 Termination Risk
- The risk that there will be a mandatory termination of the swap. A termination will almost always result in our either owing or being due to receive a termination payment.

Rollover Risk
- The mismatch of the maturity of the swap and the maturity of the underlying bonds

Liquidity Risk
- The risk that liquidity is unavailable when needed for future renewals or that the price for the liquidity is unattractive at that time.

Credit Risk - The occurrence of an event modifying the credit quality or credit rating of the swap provider or its credit support provider.

Dealing and Quotations

Trade date : The date on which the swap is entered

Effective date/ : The date on which the swap Value date becomes effective i.e. when the interest obligations start to accrue

Maturity date : The date on which the swap stops accruing interest and terminates

A quote of 9.75% - 10.25% against 3 month MIBOR means

One Party agrees to pay (bid) 9.75% fixed and receives INR 3 month MIBOR.
Another Party agrees to receive (ask/offer) 10.25% fixed and pay the 3 month MIBOR determined 3 months from today.

Who can enter into IRS

For Rupee IRS
Banks, primary dealers and financial institutions for hedging & market making Other corporate can enter only for hedging the interest rate risk on an underlying asset/liability

For Non-Rupee IRS

All participants are allowed to enter into these transactions only for the purposes of hedging an underlying exposure.

A Closer Look at Interest Rate Swaps

One party pays a fixed interest rate while receiving a floating rate payment Typical contract:
Floating rate is LIBOR (note, this has credit risk) Settlement is quarterly

However, interest rate swaps are privately negotiated so anything goes

A Closer Look at Interest Rate Swaps (p.

2)

Assume a quarterly settlement At the first settlement date (in three months), the floating rate is (current) spot 3-month LIBOR For future periods, the floating side is determined by the future level of LIBOR At settlement, the payment is based on the difference of LIBOR and the fixed rate times the notional principal

Interest Rate Swap

Cash flows for fixed rate receiver

NP*Rfix

NP*Rfix

NP*Rfix

NP*Rfix

Time 0 1 2 T-1 T

NP*Rfloat

NP*Rfloat

NP*Rfloat

NP*Rfloat

Why Use Interest Rate Swaps?

Essentially translates a fixed cash flow into a floating cash flow (or vice versa) Companies with interest rate exposure can adjust their interest rate risk Insurers with long term assets and shorter term liabilities can enter a swap in which they pay a fixed rate and receive a floating rate
This swap provides cash inflows if interest rates rise

PRICING INTEREST RATE SWAPS

INTEREST RATE SWAPS
s #days t1 #days t2 #days t3 #days

Trade Date

Start (1R) Date

2nd Reset Date

3rd Reset Date

4th Reset Date

Maturity Date

Notional principal = amount on which interest is computed Cash settlement = payment of loss by one counterparty to the other Start Date = date on which the first floating rate is set (usually the Trade Date or Contract Date except for forward start IRS) Value (Effective) Date = date on which the interest rate payments start to accrue; could be start date Reset Date = date on which the floating rate is reset (includes the first set date at start date) Reset Frequency = number of times per year floating rate is reset e.g. quarterly or semi-annually Reset period = 1/(reset frequency) year Maturity Date = date when swap matures, the last day on which interest accrues for usual swap in-fine where settlement takes place at the end of the accruing period Tenor* = total period in years from value date to maturity date Front stub period = time from value date to first payment
Note:* For interest rate caps, tenor sometimes refer to the reset period, i.e. time length between two adjacent payments.

Copyright Prof Kian-Guan Lim SMU

24

Mechanism of Interest Rate SWAPS

In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty The fixed or floating rate is multiplied by a notional principle amount

Mechanism of Interest Rate SWAPS

For example : one counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate. So here A pays fixed rate to B (A receives variable rate) B pays variable rate to A (B receives fixed rate)

Interest Rate SWAP between Alfa Corp. and Strong Financial Corp.
Terms: Fixed rate payer: Alfa Corp Fixed rate: 5 percent, semiannual Floating rate payer: Strong Financial Corp Floating rate: 3-month USD Libor Notional amount: US$ 100 million Maturity: 5 years

 Alfa Corp agrees to pay 5.0% of $100 million on a semiannual basis to Strong Financial for the next five years That is, Alfa will pay 2.5% of $100 million, or $2.5 million, twice a year Strong Financial agrees to pay 3-month Libor (as a percent of the notional amount) on a quarterly basis to Alfa Corp for the next five years That is, Strong will pay the 3-month Libor rate, divided by four and multiplied by the notional amount, four times per year

Advantages
Asset-Liability Mismatch Correction Opens up Diverse Avenues of Funding Hedging Floating Rate Risks Taking advantage of low floating rate borrowings Low Credit Risk Decouple Funding and Duration Decisions Can be CustomizedFlexibility in the Management of Interest Rates Improve Funding Cost

Interest Rate Swaps In The Indian Market

According to RBIs, Mid-Term Review of Monetary and Credit Policy for 1998-99, it would facilitate introduction of Interest Rate Swaps as a step towards liberalizing and deepening the Indian Money Markets. Banks and Financial Institutions are permitted to make a market in IRS without any restrictions on the size of the notional principal and the tenor of the agreement. Corporates are allowed to enter into IRS agreements only to hedge underlying exposures. Banks and financial institutions must observe capital adequacy for IRS, as per the stipulations contained in Annexure 1. Primary dealers should follow the norms as indicated in Annexure 2. Benchmark rate for the floating side of the swap can be any domestic money or debt market rate which is market determined, provided the methodology of computing the rate was objective, transparent and mutually acceptable to counterparties. Majorly used Benchmarks used in the Indian Market MIFOR, MIBOR

Rupee Interest Rate Swaps

Swap market is now four years old FY 03 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

Reasons for failure of IRS in India

Interest rate swaps

Lack of credible term money benchmark Lack of participation large players with interest rate risk - PSU Banks, MFs and Insurance companies Absence of cash market for floating rate products Legality of OTC derivatives Transparency availability of price and volume data MTM and valuation framework

Remedies
Measurement and management of credit risk in OTC derivative transactions Robust mark-to-market and valuation framework Accounting and disclosure guidelines (IAS 39)

Minimisation of taxation and regulatory arbitrage across products and institutions

Reasons of entering into IRS

To obtain lower cost funding To hedge interest rate exposure To obtain higher yielding investment assets To create types of investment asset not otherwise obtainable To implement overall asset or liability management strategies To take speculative positions in relation to future movements in interest rates.