Interest Rate Swaps

Today corporates and bankers use complex

and innovative financing tools to decrease

borrowing costs and increase control over

other financial variables. Financial

instruments like derivatives have made it

possible to transfer or sell risk to individuals

or institutions who are prepared to buy risk.

(Because of this derivatives are also known as

insurance products.) The various types of

financial derivatives include forward and

future contracts (agreements to buy or sell an

asset at a certain time in the future for a

certain price), option contracts (a contract

between two parties in which the buyer of the

option buys the right to buy or sell a

standardized quantity of a financial

instrument on or before a pre-determined

date at a specified price) and swaps (an

agreement between two parties to exchange

cash flows in the future).

A is basically a contractual agreement

for exchange of cashflows between two

parties. Swaps take place because corporates

and institutions with differing financing and

risk requirements have specific access to

different financial markets.

The origin of swaps can be traced back to the

early 1970s as a tool to circumvent the

exchange regulations imposed by many

countries to restrict cross border capital

flows. To overcome such hurdles corporates

started a new arrangement popularly known

as ‘ ’. Under such an

arrangement American companies used to

lend dollars to British subsidiaries in the US

while the British holding companies used to

lend pound sterling to the American

subsidiaries in the UK. This practice gained

momentum with the exchange rate

instability following the demise of the

Bretton Woods System during 1971-73.

Following the exchange rate liberalization in

the 1980s, swaps rapidly replaced existing

products like parallel and back-to-back loans

because of their flexibility and lower

financing and taxation costs. The formation

of the International Swap Dealers

Association (ISDA) in 1985 was a significant

development that speedened up the growth of

the swap market by standardizing swap

documentation.

The emergence and growing popularity of

swaps has led to refinement of the risk

management techniques enabling corporates

swap

parallel loans

*Ms. Ms. are Senior Executive Officers, Economic

Research and Surveillance Department, The Clearing Corporation of India Limited

Payal Ghose & Aparna Vachharajani

INTEREST RATE SWAPS

Payal Ghose & Aparna Vachharajani*

(October 2007)

THE CLEARING CORPORATION OF INDIA LTD.

217C O L L E C T I O N O F A R T I C L E S

to tap newer capital markets and making

further use of new financial instruments

without substantial increase in the risk

element. The range of risks and types of cash

flows hedged through swaps is rapidly

expanding. Currency swaps were introduced

in the late 1970s, interest rate swaps in 1981,

equity and commodity swaps in the mid-

1980s and credit derivatives in 1990. Recently

derivatives based on the climate have also

been launched.

One of the largest components of the global

derivatives markets and a natural adjunct to

the fixed income markets is the interest rate

swap (IRS) market. The IRS market gives a

deeper insight into the capital

flows that drive the bond markets,

the manner in which the corporates

manage the i r exposure to

fluctuations in interest rates and

the way banks and financial

institutions make a great deal of

their income. IRS transactions

began in 1981, with Eurobonds

being the principal security employed in

these transactions.

The most basic form of an IRS involves two

counterparties that agree to exchange over a

certain period of time, two streams of interest

payments, each calculated using a different

interest rate index but based upon some

agreed upon or “notional” amount. The

underlying debt is referred to as the notional

principal/amount because it is only used as

the basis for interest calculation under the

swap and not exchanged by the participants.

Figure 1 shows the basic structure of an IRS.

The first party may be a borrower that wants

to pay interest at a fixed rate but has already

borrowed at a floating rate. The other party

has a counter-position having borrowed at a

fixed rate but desiring a floating rate interest

structure. The two can enter into an

agreement in which the second party agrees to

pay cash flows equal to interest at a

predetermined fixed rate on a notional

principal for a number of years. In return, it

receives interest at a floating rate on the same

notional principal for the same period of

time.

All firms pay a credit-quality premium over

the risk-free rate when they issue debt

securities. Firms with good credit ratings pay

lower risk premiums than firms with lower

credit ratings and the credit-quality premium

rises faster with maturity for the lower rated

firms. The table given below depicts the rates

INTEREST RATE SWAPS

Rationale behind an IRS

Figure 1

Rating Fixed Rate Floating Rate

Firm A AA+ 10.00% 6-Month LIBOR + 0.30%

Firm B AB+ 11.20% 6-Month LIBOR + 1.00%

C O L L E C T I O N O F A R T I C L E S218


at which two firms with varied ratings can

borrow funds for five years to meet their

requirements.

Firm A has an absolute cost advantage in

raising funds in either the short-term or long-

term debt markets, but firm B has a

comparative advantage in raising funds in

short-term debt markets. If both firms raised

funds in their desired markets directly, the

total cost for them would be LIBOR + 11.50%

(i.e. LIBOR + 0.30% for A and 11.20% for B).

Both firms could lower their funding costs if

firm A were to issue long-term debt, firm B

were to issue short-term debt, and they

swapped interest payments. The total cost in

such a case would be LIBOR + 11% (i.e.

10.00% for A and LIBOR + 1.00% for B). The

gain from entering into the swap is (11.50% -

11.00% =) 0.50% which is shared equally

between the two parties. This gain arises out

of the credit spread differential.

The quality spread between the interest rate

paid by the lower-rated firm B and that paid

by the higher-rated firm A which is only 70

basis points in the short-term debt market,

but rises to 120 basis points at longer

maturities. This quality-spread differential

(i.e. the difference in the quality spread at two

different maturities), exists because of the

nature of contracts in the fixed and the

floating markets. In the above example the

fixed rates are the rates at which the firms can

issue five year fixed rate bonds while the

floating rates based on LIBOR are 6 month

rates. The floating rate lender has the option

of reviewing the rates every 6 months. He can

raise the spread over LIBOR if the firm’s

creditworthiness deteriorates or even cancel

the contract. However, the fixed rate lender

has no such option. Hence, the spread rises

faster with increase in maturities.

The spread differential between A and B also

reflects the extent to which B is more likely to

default than A. Generally, the probability of

default rises faster for firms with lower credit

ratings. As a result, the spread between the 5

year rates is higher than the spread between

the six month rates.

TYPES OF IRS

1) Plain vanilla swap or fixed-for-

floating swap:

2) Floating-to-floating or basis swap:

3) Asset swap:

4) Alternative floating rate:

In this swap, a floating

interest rate liability is exchanged with

a fixed rate liability.

In this swap, one party pays one

floating rate (e.g. LIBOR) while its

counterparty pays using another

reference rate (e.g. T-Bill rate).

In this type of swap the

interest streams being exchanged are

funded with interest received on

specific assets.

In this

type of swap, the floating reference

rate can be switched to other

alternatives like 3-month LIBOR, T-

Bill rate etc. as per the requirement of

the counter party to meet the



Illustration: (One week swap)

Suppose Bank A and Bank B enter into a swap

whose effective date is September 18, 2007

where Bank A is a fixed rate receiver of Rs.10

crore for a week at 6% and Bank B is a floating

rate receiver and the rates are linked to the

NSE overnight index. The floating rate, as an

overnight rate, would be compounded every

Mumbai business day. This implies that the

floating rate interest is compounded on a

daily basis except when there is a holiday. In

case of a holiday, the interest would be

computed on simple interest basis for the

holiday. In this example, the NSE MIBOR

rates for the seven days are taken and settled

at the end of the swap period.

exposure.

This swap involves an

exchange of interest rate payment that

does not begin until a specified future

point in time.

This type of swap

allows fixed for floating counter party

to extend the swap period.

An equity swap

involves the exchange of interest

payments linked to the changes in a

stock index. For example, an equity

swap agreement may allow a company

to swap a fixed interest rate of 6% in

exchange for the rate of appreciation

on a particular index like the BSE or

NSE indices each year over the next 4

years.

A swap transaction

having an original tenor of more than

2 years is referred to as a term swap.

It is a swap

transaction with original tenor up to 2

years.

The

holders of zero-coupon bonds get the

full amount of loan and the interest

accrued at the maturity of the bond.

Hence in this type of swap, the fixed

rate player makes a bullet payment at

the end while the floating rate player

makes the per iodic payment

throughout the swap period.

Option interest rate swaps are

referred as swaptions. The swaption

agreement specifies whether the buyer of

the swaption will be a fixed rate receiver or a

fixed rate payer. If the buyer exercises the

option then the writer of the option will

become the counter party. A

provides the party making the fixed

payments with the right to terminate the

swap to its maturity. The writer will become

the fixed rate receiver and floating rate

payer. On the other hand a

provides the party making the floating rate

payments with the right to terminate the

swap. In this case, the writer of the put

swaption becomes the floating rate receiver

and fixed rate payer.

5) Forward swap:

6) Extendable swap:

7) Equity swap:

8) Term swap:

9) Money market swap:

10) Zero coupon to floating:

Swaptions:

callable swap

puttable swap



The overnight call money rates (FIMMDA-

NSE-MIBOR rate) for 7 days are as per the

table below.

On the 8 day, i.e. on September 25, 2007

Bank B will pay Bank A an interest of

Rs.1,15,069

and Bank A has to pay Bank B interest of

Rs.1,35,965 (10,01,35,965 – 10,00,00,000) as

per the calculation. They will settle the

difference of Rs.1,35,965 and Rs.1,15,069 i.e.

Bank A will pay Rs.20,896 to Bank B.

Assuming no default risk, an interest rate

swap can be valued either as a long position

in one bond combined with short position in

another bond or as a portfolio of forward

contracts. In both the cases, MIBOR rates

have been used for discounting.

B : Value of fixed-rate bond underlying the

swap

B : Value of floating-rate bond underlying

the swap: then,

The value of the swap to a company

receiving fixed rate and paying

floating rate is:

The value of fixed-rate bond

underlying the swap equals its

notional amount at the initiation

of the swap. To value the swap some

time after the initiation, following

notations are used:

t : Time until ith (1<= i <= n)

payments are exchanged

L : Notional amount in swap agreement

r : MIBOR rate corresponding to maturity t

k : Fixed payment made on each payment

date

Considering fixed-rate bond, the cash flows

are at time and at time so that

In case of the floating rate bond, its value

becomes identical to a newly issued floating-

rate bond immediately after a payment date.

In this case, B = L immediately after a

payment date. Before the next payment date,

its value becomes B = L + k* (k* is the

floating-rate payment that will be made on

the next payment date). If ‘t1’ is the time until

the next payment date and ‘r1’ is the discount

rate used to calculate the value of the swap

th

(10,00,00,000 * 6% * 7/365)

Valuation of IRS

Valuation of swap in terms of Bond

Prices: If;

k t L t ,

FIX

FL

i

i i

FL

FL

i n

Day

NSEMIBOR

RateFloatingIndex

NotionalPrincipalAmount(NPA)

FloatingRate

Interest

NPA +Compounded

Interest atMIBORRates

NPA +Simple

Interest atFixed Rate

(%) Rs. Rs. Rs. Rs.

18-Sep-07 6.62 100000000 18137

19-Sep-07 6.52 100018137 17866

20-Sep-07 6.29 100036003 17239

21-Sep-07 7.27 100053242 19928

22-Sep-2007 & 23-Sep-07(Sat & Sun)

7.78 100073171 21331

24-Sep-07 7.34 100115832 20133 100135965 100115068

VSWAP = BFIX - BFL (1)

BFIX = �

n

i 1 ke-riti + Le-rntn(2)



today which equals its value just before the

next payment date, then in such a case, the

value of this floating-rate bond is

After calculating B and B formula given in

equation (1), can be used to calculate the

value of swap.

Suppose a financial institution pays 1-month

MIBOR and receives 6.12% per annum (with

semi-annual compounding) on a swap with a

notional amount of Rs.100 million and the

next payment dates are after 1, 2 and 3

months, i.e. the swap has remaining life of 3

months. The MIBOR rates with continuous

compounding for 1-month, 2-month and 3-

month maturities are 7.70%, 7.99% and

8.28% respectively. The 1-month MIBOR

rate on the last payment date was 9.30%. In

this case, k = Rs.3.06 million and k* = Rs.3.50

million, so that

B = 3.06e + 3.06e + 103.06e

= Rs.107.01 million

B = 3.50e + 100e

= Rs.102.84 million

Hence, the value of the swap is

107.01 – 102.84 =

FRAs are agreements to exchange pre-

determined rate of interest with the market

rate of interest which will apply to a certain

principal for a certain period of time in the

future. An IRS can be regarded as a portfolio

of FRAs. Assuming that forward interest rates

are realized, a plain vanilla IRS can be valued

by applying the following steps:

1. To determine swap cash flows, calculate

forward rates for each of the MIBOR rates

using following equation:

Rf – Forward interest rate

R and R are the zero rates for

maturities T and T .

2. Calculate swap cash flows assuming that

the MIBOR rates will equal the forward rates.

3. Setting the swap value equal to the present

value of these cash flows.

Considering the situation in the previous

example, a rate of 6.12% will be exchanged

for 9.30%. The value of the exchange to the

financial institution is:

To calculate the value of the exchange in 2

months, the forward rate corresponding to

the period between 1 and 2 months needs to

be calculated by using equation 4. This will be

equal to 0.0828 or 8.28% with continuous

compounding. To make it equivalent to the

rate with compounding 2 times per annum,

following equation is used where Rc = 0.0828

and m = 2.

FIX FL,

FIX

FL

1 2

1 2

-0.0770 * 1/12 -0.0799 * 2/12 -

0.0828 * 3/12

-0.0770 * 1/12 – 0.0770 * 1/12

Rs.-4.17 million.

Where;

Valuation of swap in terms of Forward

Rate Agreements (FRA):

(3)BFL = (L + k*) e-r1t1

(4)Rf = R2T2 – R1T1 / T2 – T1

100 * (0.0612/2 – 0.0930/2) e -0.0770 * 1/12 = Rs.- 1.5798 (5)



The value 0.0828 will become 0.0845 with

semi-annual compounding. The value of

FRA corresponding to the exchange in 2

months is therefore

Following the above given steps, the forward

rate corresponding to the period between 2

and 3 months will be equal to 0.0885 and

0.0905 (with semi-annual compounding).

The value of FRA, then, is

. The total value of the swap, to the

financial institution, is

A swap agreement can be terminated using

any of the following methods.

A swap may be terminated

prior to maturity. The counterparties

make/receive a payment reflecting current

market rates and are released from their

contractual obligations.

A new swap agreement may be

created canceling one or more existing

swap agreements.

Two counterparties may have

more than one IRS agreements with each

other. In such a case instead of going for

individual settlement of each IRS

contract, they may opt for settlement

through a single net value for all the

outstanding transactions.

A party may enter into a

new swap at current market rates to offset

or reverse the terms of the existing swap

agreement.

A party may exit a swap agreement

by selling it off to another party.

IRS can be used to gain advantage of various

market imperfections. IRS are very popular

as:

1) The IRS market

evolved because of the differing

financing needs of its participants.

Differential information in different

markets, institutional restrictions and

transactions costs create some market

imperfections and the presence of

comparative advantages among different

borrowers in these markets. An IRS acts

as a device to obtain the desired form of

financing indirectly which otherwise

might be inaccessible or too expensive.

2) Let us assume that

a company needs to borrow funds for five

years but finds that current rates are

relatively high. The management believes

that rates will decline, but wishes to

obtain the necessary funds as soon as

possible. In this situation the company

could issue fixed rate debt and then

“swap it down” by agreeing to pay a

100 * (0.0612/2 – 0.0845/2) e = Rs.

-1.1498 million

Rs.-1.4356

million

- 1.5798 – 1.1498 - 1.4356 = Rs. -4.17

million

Closure

:

:

:

:

:

Application of IRS

-0.0799 * 2/12

1. Cancellation

2. Novation

3. Netting

4. Reverse swap

5. Selling

As tools of arbitrage:

As tools of hedging:

Rm = m ( eRc/m – 1 ) (6)



floating rate in exchange for receiving a

fixed rate. The fixed income from the

swap offsets the debt cost, and the firm is

left having to make floating rate

payments on the swap. If rates decline as

expected, the firm’s financing cost falls

commensurately. However, if the

management is wrong and rates go up,

the company will be paying more for the

variable rate swap than if it had held on

to the fixed rate debt.

3) The timing of

any decision to issue debt always involves

some judgment regarding the future

movement of interest rates. Swaps are a

sophisticated mechanism to take

advantage of expectations of future

interest rate movements. The floating

rate stream under a swap tends to reflect

current interest levels while the fixed

interest stream reflects the historical

level. Thus, the profitability of an IRS

broadly reflects the market trends in

interest rate movements in the future.

Speculators with a contrarian view from

the general market perception bet on

these movements through swaps to book

profits.

i. An IRS helps in locking in low variable

rates when interest rates are low.

ii. An IRS involves no upfront premium.

iii. An IRS is tailored to the specific needs of

the participants as to the principal,

payment frequency and maturity profile.

iv. It allows management of interest rate risk

without affecting the financing

arrangement.

v. IRS can be executed with widely varying

maturities.

vi. IRS facilitates matching (variable)

taxable interest earning assets with a

similar amount of variable tax-exempt

interest debt.

i. As parties effectively “lock in” a fixed

interest rate they cannot participate in

favorable interest rate movements.

ii. There is significant potential for credit

and counter-party risk within the IRS

market.

iii. Early termination may incur a pay-out

cost (break-cost) subject to market

movements.

iv. Swaps can involve infinite leverage and

risk.

In 1981 the benchmark interest rate in the

U.S. was at an extremely high 17% due to the

anti-inflationary tight monetary policy of the

Fed under Paul Volcker. The corresponding

rates in West Germany and Switzerland were

12% and 8% respectively. Both governments

had imposed limits on the amount the World

Bank could borrow in their markets. IBM at

that time had large amounts of Swiss franc

and German deutsche mark debt and thus

As tools of speculation:

Advantages:

Disadvantages:

Advantages and Disadvantages of IRS

Global statistics



had debt payments to pay in Swiss francs and

deutsche marks. IBM and the World Bank

worked out an arrangement in which the

World Bank borrowed dollars in the U.S.

market and swapped the dollar payment

obligations with IBM and in exchange taking

over IBM’s Swiss

franc and deutsche

mark obligations

leading to the birth

of the first interest

rate swap contract.

Within a span of just

seven years, interest

r a t e s w a p s h a d

developed into a fully operative market with

an annual volume estimated at over $300

billion and outstanding

swaps valued over $1

trillion. ISDA was formed in

1985, after a group of 18

swap dealers and their

counsel began work in 1984

to develop standard terms

for IRSs. ISDA’s primary

purpose is encouraging the

prudent and eff ic ient

development of the privately

n e go t i a t e d ( o r OTC)

derivatives business by the development and

maintenance of derivatives documentation

and promoting the development of sound

risk management practices. The ISDA Master

Agreement acts as a reference point for all

swap agreements.

IRSs quickly gained immense popularity all

over the world because of their flexibility and

continue to dominate the market for OTC

instruments. Greater standardization and

transparency was facilitated by the ISDA

Master Agreement.

Nowadays in most swap transactions, the

parties to a swap do not directly transact with

each other directly. Instead, there is a third

party in that acts as counterparty to each of

the two original parties. Initially banks just

acted as intermediaries between two

Amounts outstanding of over-the-

counter (OTC) derivatives

Role of intermediaries

TOTAL OUTSTANDING

0

1,000

2,000

3,000

4,000

5,000

6,000

1998

1999

2000

2001

2002

2003

2004

2005

2006

Year

Outs

tandin

g(U

SD

Trn

)

IRS Volumes Total OTC Volumes Source: BIS

Notional amounts outstandingRisk Category/Instrument

Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06

Total Contracts 111,178.00 141,665.00 197,167.00 257,894.30 297,669.57 415,182.53

Foreign exchange contracts 16,748.00 18,448.00 24,475.00 29,288.99 31,364.03 40,179.32

a) Forward and Forex swaps 10,336.00 10,719.00 12,387.00 14,951.19 15,873.03 19,828.41

b) Currency swaps 3,942.00 4,503.00 6,371.00 8,222.77 8,503.92 10,771.88

c) options 2,470.00 3,226.00 5,717.00 6,115.05 6,987.10 9,579.04

Interest rate contracts 77,568.00 101,658.00 141,991.00 190,501.95 211,970.50 291,987.07

a) Forward Rate Agreement 7,737.00 8,792.00 10,769.00 12,788.66 14,268.68 18,689.43

b) Interest rate swaps 58,897.00 79,120.00 111,209.00 150,631.33 169,106.21 229,780.14

c) options 10,933.00 13,746.00 20,012.00 27,081.95 28,595.60 43,517.51

Equity - linked contracts 1,881.00 2,309.00 3,787.00 4,384.97 5,793.21 7,485.22

Commodity contracts 598.00 923.00 1,406.00 1,443.43 5,434.50 6,937.82

Source: BIS

(In USD billion)



corporates to match swapping needs for a fee.

Gradually large banks started offering their

clients the type and size of swap transaction

they desired immediately and thereafter

found out a different party with opposite

requirements to hedge the original swap. This

type of swap warehousing or running

mismatches enabled the customer to cover an

exposure almost as soon as the decision to do

so while the banks could quote the most

competitive price to

t h e i r c l i e n t s a n d

m a x i m i z e t h e i r

b u s i n e s s e s . M o s t

intermediaries often act

a s m a r k e t m a k e r s

prov id ing two way

quotes as well as a

s e t t l e m e n t a g e n t ,

collecting and paying the

obligated cash flows

when they are due.

One of the reasons

intermediar ie s have

a s s u m e d s u c h a n

important role in the

swap market is that they

diversify credit risk.

Most intermediaries

attempt to build a sizable

portfolio of swaps and actively manage

the interest rate risk of that portfolio in

the futures and options markets. By

specializing in this function and

building a large portfolio, they can

become more efficient at this task of

risk management. Swap customers rely

on the compet i t ion among these

intermediaries to ensure that they are

receiving efficient pricing of the risk they

pass on when engaging in a swap.

A clearing house substitutes itself as central

counterparty to all transactions that its

Benefits of having a clearinghouse for

OTC products

Source: BIS



members agree to submit for clearing. The

use of a clearing house has the potential to

mitigate each of the types of counterparty

risk associated with OTC derivatives like IRS

namely credit risk, liquidity risk, legal risk,

operational risk and to some extent the

systemic risk. It thus enables investors,

brokers and dealers to transact high volumes

of business while economizing on capital and

collateral utilization. The box given below

depicts how the OTC market can benefit

from the support of clearinghouses.

Over the years, India’s interest rate scenario

has seen significant reforms where structural

rigidities like administered rates, mandated

floors and caps on deposit and lending rates,

guaranteed high yields on government

owned funds & tax-free bonds are

increasingly becoming things of the past.

Deregulation of interest rates, which helped

in making financial market operations

efficient and cost effective, has brought to the

fore a wide array of risks faced by market

participants. To manage and control these

risks, instruments such as Forward Rate

Agreement (FRA) and Interest Rate Swap

(IRS) were introduced in July 1999 which

could provide effective hedge against interest

rate risks.

The Reserve Bank of India (circular Ref. No.

MPD.BC.187/07.01.279/1 1999-2000 dated

July 7, 1999) issued guidelines for scheduled

commercial banks (excluding regional rural

banks), primary dealers and all-India

financial institutions to undertake FRAs

and IRS as a product for their own balance

sheet management and for market making

purposes. Corporates were also allowed to

use IRSs and FRAs to hedge their exposures.

The parties were allowed 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. There were no

restrictions on the minimum or maximum

size of notional principal amounts and

tenor of FRAs/IRS. Banks, financial

institutions and PDs needed to maintain

capital based on the computation method

provided by RBI for risk weighted assets.

Along with undertaking FRAs/IRS for

hedging underlying exposures, market

participants were also allowed to undertake

market making activity for the development

of the product subjected to the required

prudential limits. For the sake of uniformity

and standardization, participants could

consider using ISDA documentation, as

suitably modified to comply with these

guidelines for undertaking FRAs/IRS

transactions. Participants were required to

report their FRAs/IRS operations on a

fortnightly basis to Adviser-in-Charge,

Monetary Policy Department, Reserve Bank

of India, with a copy to respective

departments.

Since the inception of derivative trading in

India, swap products were widely used by the

IRS In India



market to convert floating rate exposures to

fixed rate and vice versa. Swaps linked to

benchmarks like NSE-MIBOR and 6-month

MIFOR became quite liquid. IRS contracts

increased from about 200 contracts with

outstanding notional principal amounting

to Rs.4000 crore in March, 2000 to 6500

contracts worth Rs.150,000 crore in

December 2002. However, the market was

highly concentrated among a few foreign

banks and private sector banks. The market

was particularly characterized by the absence

of MFs, insurance companies and public

sector banks. In order to make the market

broad-based in terms of participants, the

Working Group on Rupee Derivatives

(Chairman: Shri Jaspal Bindra) was

constituted by RBI in November 2002 and

submitted its report in January 2003.

Following the recommendations of the

Working Group on Rupee Derivatives, the

SEBI decided to introduce anonymous order

driven system for trading in Interest Rate

Derivatives (IRDs) with effect from April 28,

2003 on the BSE and NSE. RBI allowed

commercial banks, primary dealers and all

India financial institutions to trade in

interest rate derivatives in a phased manner.

In the first phase, these entities could transact

only in interest rate futures for hedging the

interest rate risk in their underlying

Government securities portfolio classified

under the Available for Sale (AFS) and Held

for Trading (HFT) categories.

In spite of these measures participation in the

OTC derivative market remained restricted

mainly because of lack of specific legal

validity for such OTC derivative contracts.

OTC derivative contracts were excluded

from the purview of the Securities Contracts

Regulation Act. The ambiguity regarding

their legal validity was inhibiting the growth

and stability of the market for such

derivatives. Lack of transparency in terms of

disclosures of quotes and valuation curves

and lack of legality of netting of obligations

were other issues impeding the growth of

derivative market. On the recommendation

of the Standing Committee on Finance, the

Reserve Bank of India (Amendment) Bill,

2005, was proposed to provide clear legal

validity of such contracts. The definition of

OTC derivatives was expanded empowering

the RBI to deal in derivatives as well as lay

down policy and issue directions to any

agency dealing in derivatives. RBI also had

the powers to inspect the records of these

agencies.

In the Mid-term Review of Annual Policy for

year 2006-07, an Internal Group was

constituted by RBI to review the existing

guidelines on derivatives and formulate

comprehensive guidelines on derivatives by

banks. RBI released the Comprehensive

Guidelines on Derivatives on April 20,

2007. C o m m e r c i a l b a n k s

(excluding regional rural banks) and

primary dealers were permitted to trade in

rupee interest rate derivatives, including

Interest Rate Swap (IRS), Forward Rate

Agreement (FRAs) and Interest Rate Futures,



•

The minimum notional

principal amount for which market

makers will stand committed to their

two-way quote is Rs. 5 crores.

The Day Count

Fraction applicable to all INR interest

rate swap transitions shall be Actual /

365 Fixed.

The rate for any Calculation Period

which is shorter than the Designated

Maturity set forth in the Confirmation

will be determined by the Calculation

Agent based upon straight line

interpolation between the Floating Rate

Option with a Designated Maturity that

is immediately shorter than the

Calculation Period and the Floating Rate

Option with a Designated Maturity that

is immediately longer than the

Calculation Period.

Minimum Notional Principal

Amount:

Day count fraction:

Broken or short calculation periods:

• The swap can be flexible in tenor

i.e. there are no restrictions on the tenor

of the swap. Unless stated otherwise, a

rupee interest rate swap shall be assumed

to have a day count basis of Actual/365.

• The trading hours will

be 9.00 a.m - 5.30 p.m. for all swaps

wherein the benchmark is based on the

money market or the fixed income

market. In respect of swaps, wherein the

benchmark is based on the foreign

exchange market, the trading hours will

be in accordance with the trading hours

for foreign exchange transactions.

• The effective date will be

the first Mumbai Business Day

(excluding Saturday) after the Trade

Date, except for interest rate swaps

against which payments are based upon

the “INR-MIFOR” Floating Rate

Option, for which the Effective Date will

be the second Mumbai Business Day

(excluding Saturday) after the Trade

Date.

• The

business day convention applicable to all

INR interest rate swaps shall be the

Modified Following Business Day

Convention, unless otherwise specified

in the confirmation.

• Unless otherwise

specified in the Confirmation, Saturdays

shall not be Business Days for any

purpose, except in relation to INR-

MIBOR-OIS-COMPOUND for which

Saturday shall be deemed to be a Business

Day. It is recommended that regardless

of the centre where the deal is transacted,

the benchmark and the holiday calendar

for the purposes of computation of

interest streams be as that in Mumbai,

except in case of interest rate swaps

wherein the benchmark is based on the

foreign exchange market, for which the

holiday calendar of the relevant centre

for that currency will also be applicable.

• No fixing of rates and

compounding of interest will be done on

a Saturday.

Tenor:

Trading Hours:

Effective Date:

Business Day Convention:

Business Day:

Reset dates:

FEATURES OF AN IRS AS PER FIMMDA GUIDELINES



Foreign Currency derivatives and Foreign

Currency Forwards (Currency Swap and

Currency Option).

The Indian OTC derivatives market has

witnessed phenomenal growth over the past

few years with the trades in the IRS market

occasionally matching the trade in the G-sec

market. The Indian IRS market has evolved

from simple plain vanilla swaps to complex

exotic structures. However, the Indian IRS

market is dominated by the following types

of swap structures.

The Overnight Index Swap (OIS) is a

fixed/floating interest rate swap where the

overnight rate is exchanged for some fixed

interest rate. The floating leg of an OIS is tied

to a published index of a daily overnight

reference rate. Generally the interest of the

overnight rate portion of the swap is

compounded and paid at maturity. The two

parties agree to exchange the difference

between interest accrued at the agreed fixed

rate and interest accrued through geometric

averaging of the floating index rate at

maturity, on the agreed notional amount. As

the exposure of the OIS counterparties is

only for the amount of any P/L, credit

exposures are minimal. OISs usually trade on

spreads of 1.5-5 bps and can be traded for

forward and broken dates.

OIS is the most popular and liquid segment

in the Indian swap market. The underlying

benchmark is the overnight call money rate

(MIBOR) which is a daily fixing done by the

NSE. The OIS curve is widely used by banks

and primary dealers for hedging their bond

portfolio as well as computing call rate

funding risk. Payments are exchanged at

maturity for the swaps with tenors less than 1

year, otherwise, payments are exchanged at 6-

month interval.

– Use OIS

contracts for managing interest rate risk

while utilizing minimal capital. The OIS

swap can be used to manage interest rate risk

for flexible periods, without taking liquidity

risk and with minimum credit risk (hence

there is efficient usage of capital). This will

lead to deeper and more efficient markets.

– Use OIS for

management of asset price risk and cash

surplus. In periods of subdued activity in the

GOI primary market, it is expected that a PD

parks this surplus in the overnight inter-

bank market. The OIS would, in such

situations, be an excellent instrument for the

PD to lock in a high yield by receiving fixed.

On the other hand, in the period just after a

primary issue, a PD is exposed to a call rate

funding risk, since it has surplus securities,

and there is an unavoidable time lag

involved in distribution. This is especially

true in periods of high call rate volatility. A

PD can shield itself against this interest-rate

risk by locking into an appropriate fixed-rate

payer swap. It, therefore, protects a PD

Types of IRS in the Indian market:

A. Overnight Indexed Swaps:

Users of OIS in India:

Scheduled Commercial Banks

Primary Dealers



against its exposure to overnight rates, and

facilitates bidding in primary auctions. A PD

would therefore be a natural two-way

participant in the OIS market.

– Use OIS for reducing

interest cost/risk management. An overnight

swap can effectively be used by a corporate for

matching its interest rate expectations and

interest-rate-risk exposure Using OIS,

corporates can raise term funds (bills, CP etc)

but pay overnight interest rates. OIS are an

excellent positioning tool for putting on

carry trades or expressing a directional view.

Since the floating leg exactly follows

overnight rates, rate cuts or hikes can be

directly exploited, with none of the

expectations element at settlement involved

in trading FRAs or futures.

The Indian IRS market had an outstanding

volume of Rs.3,185,422.30 crores as on

March 31, 2007. The major players were

foreign banks and private sector banks.

As on March 31 , 2007 there were two

contracts outstanding for Forward Rate

Agreements worth Rs. 60 crores.

In a MIFOR (Mumbai interbank forward

offer rate) swap, the counterparty pays a

fixed rate and receives the six months

implied rupee yield through the forwards,

semi-annually and

v i c e - v e r s a . T h e

implied rupee yield

through the forwards

is nothing but the

rate at which one can

raise rupees through

the forward route.

If a party has dollars

and is required to

swap the same into

Corporate Sector

Participant-wise share in Indian IRS-OIS

Market

Category-wise share in the total number

of trades outstanding

Market Share of top players in

outstanding IRS volumes

B. MIFOR Swaps:

st

Participant-wise Share in Total Outstanding Volumesas at end-March 2007

Primary Dealers

5%

Private Banks

19%

Public Sector

Banks

8%

Foreign Banks

68%

Top 'n' Market Players Share in outstanding

Top 1 11%

Top 5 45%

Top 1 0 75%

Top 15 90%

Category No. of ContractsOutstanding % Share

Foreign Banks 67705 70.98

Private Banks 16464 17.26

Primary Dealers 4312 4.52

Public Sector Banks 6910 7.24

Total 95391 100.00



rupees, the total cost of the swap is the

premium paid as a percentage of spot and the

six months LIBOR as that is the opportunity

cost of swapping funds in rupees and not

keeping the same in dollars. So essentially,

the floating leg on the MIFOR swap is a

combination of the six months LIBOR and

the six months forward rate. If a company

raises a dollar loan for five years, say at six

months LIBOR and wishes to swap the same

into rupees, it will have to enter into a

currency swap with a bank domestically.

Under the currency swap, the corporate will

give the dollars to the bank and take an

equivalent amount of rupees based on the

spot rate. It will then pay the bank a fixed rate

of interest every six months and receive the

then LIBOR rate on the principal. At the end

of the swap, it will have to give back the

rupees to the bank and take its dollars to

repay its loan.

So effectively, the corporate would have

raised rupee resources at a fixed rate, as the

LIBOR payment that it receives from the

bank every six months will go towards the

payment of interest on its dollar loan.

All that the bank will have to do to hedge

itself is pay the five-year MIFOR in the

market for an equivalent amount and swap

the dollars that it gets from the corporate

into rupees for six months by paying the six

months forward premium. Under the

MIFOR swap, it will pay a fixed rate and

receive a combination of LIBOR and the six-

month dollar-rupee forward rate, every six

months. From the bank’s perspective, every

six months, it pays a fixed rate to the market,

which is what it receives from the corporate

under the currency swap. Similarly, every six

months it receives the floating leg, of which it

uses the LIBOR component to pay to the

corporate under the currency swap and the

dollar-rupee forward component to roll over

the six-month sell buy swap.

The MIFOR swap is very credit efficient, as it

is a pure interest rate swap and hence does

not involve the exchange of principal. In the

absence of MIFORs, banks will be able to

hedge themselves, but only by doing an

identical currency swap in the market.

Currency swaps are very credit intensive and

will thereby choke credit lines for

counterparties very quickly. This will in turn

make currency swaps illiquid, thereby

increasing the market bid offer. MIFORs are

not only used to hedge and price currency

swaps, they are also used for pricing and

hedging long-term forwards and options.

The absence of MIFORs will hurt their

liquidity as well and we shall go back at least

five years in terms of market development.

As per the directives issued by the Reserve

Bank of India (RBI) on May 20, 2005, market

participants were advised to use only

domestic Rupee benchmarks for interest rate

derivatives. The RBI was concerned about the

rapid growth in outstanding contracts in

MIFOR to over Rs.1,00,000 crore which were

mainly used as a speculative tool by

corporates without any underlying



exposures like loans under ECBs. Market

participants were, however, given a transition

period of six months for using MIFOR as a

benchmark, subject to review. However, on

request from the Fixed Income Money

Market and Derivatives Association

(FIMMDA), market participants have been

allowed to use MIFOR swaps in respect of

transactions having underlying permissible

forex exposures, for market making purpose,

subject to appropriate limit prescribed by the

RBI.

While the earlier category of benchmarks like

O I S a n d M I F O R a re l i n k e d t o

corporate/bank funding costs in India, there

is another category of benchmarks linked to

the Government of India’s borrowing cost,

i.e. yields on G-Sec. Just as a company can

enter into a swap where the benchmark for

the floating leg is 6-month MIFOR, it can

also enter into a swap where the benchmark is

the yield on the 1-year G-Sec. The daily

setting for G-Sec yields for different tenors is

exhibited on a Reuters page known as

INBMK. These swaps are important as they

allow banks and corporates to take view on

the relative movements of GOI yields and

corporate spreads, without taking positions

in the securities.

Another product popular among Indian

corporates entails hedging only the principal

exposure under currency swap, keeping

coupon payments unhedged. A party with an

exposure in INR, may have a view that dollar

shall weaken against the rupee over the tenor

of the INR exposure. Such a party can enter

into a Principal-Only swap in which INR

exposure gets swapped into dollar exposure

at a predetermined forward rate. With the

volatility of the rupee quite low as against

LIBOR FRA, the risk on this swap is even

lower than that on Coupon-Only swap.

RBI, in its Annual Policy Statement for the

Year 2007-08, had highlighted the necessity

of a mechanism for transparent capture and

dissemination of trade information as well as

an efficient post trade processing

infrastructure for transactions in OTC

interest rate derivatives. As a precursor

towards this CCIL was advised to start a trade

reporting platform for Rupee Interest Rate

Swaps (IRS) which was to be made functional

by August 31, 2007.

To achieve this objective, a deal reporting

utility has been created by CCIL, which can

be used by CCIL members to report their

deals in a convenient manner. Apart from

processing the deals, certain post trade

processing services like resetting interest

rates, providing settlement values etc. to the

reporting members will also be provided.

Information regarding traded rates and

volumes will also be made available.

RBI as per its notification (Ref. No.

RBI/2007-2008/122 IDMD/11.08.15/809/

C. INBMK Swaps:

D. Principal Only Swaps:

Conclusion



2007-08) dated August 23, 2007 notified that

the reporting platform developed by CCIL

for capturing the transactions in OTC

interest rate derivatives (Interest Rate Swaps

and Forward Rate Agreements (IRS/FRA)),

would be operationalised by August 30,

2007. All banks and primary dealers will have

to report all their IRS/FRA trades on the

reporting platform within 30 minutes from

the deal time. Banks and PDs will also have to

ensure that details of all outstanding IRS and

FRA contracts (excluding the client trades)

are migrated to the reporting platform by

September 15, 2007.

Interest rate swaps trading in India is

currently carried out mostly by telephone

through brokers in India and deals are settled

between market participants after the end of

trading hours each day. Daily volumes in

these swaps are estimated at Rs.80 billion

($1.9 billion). As of now the market is

dominated by mainly foreign banks and

private banks. The reporting platform

developed by CCIL will enable dealers to get

the rates on a real-time basis and the volumes

at the end of the day. This is expected to

facilitate better price discovery, enhance

transparency and help in increasing the

participant base.

ANNEXURE

Functionalities & Coverage of CCIL’s Platform for trade reporting and

dissemination of market information on Rupee IRS & FRA

1. Instruments Covered

2. Acceptable Benchmarks

3. Functionalities:

a) Interest Rate Swaps – Fixed Float and Basis Swaps (Up to maximum maturity – 10 years)

b) Forward Rate Agreements (Up to maximum maturity – 2 years)

a) NSE-FIMMDA MIBOR (Designated Maturities – Overnight, 14 days, 1m & 3m)

b) MIFOR (Designated Maturities – 2m, 3m, 6m, 12m)

c) INBMK (Designated Maturity – 1year)

a) Acceptance of trades reported of by the market participants and matching of these trades;

b) Dissemination of trade information through CCIL website and also through the website of

RBI;

c) Providing information to the reporting members and their counter-parties about matched

and un-matched trades, alleged deals etc. for their tracking of trades & for accounting;



d) Keeping record of outstanding trades of the market participants (individually and at an

aggregate level) and providing them consolidated information of their outstanding trades;

e) Effecting interest rate resets for the outstanding trades, when due and advising the reporting

members and their counter-parties about such resets alongwith the reset rates;

f) Providing market participants with information about their settlement obligations

g) Recording of cancellation of outstanding trades by market participants.

a) All reporting entities will be made member of CCIL’s Derivatives Segment.

b) Deals are to be reported in the format specified by CCIL.

4. Deal Reporting:

References:

i. Swaps/Financial Derivatives 3rd Edition (Vol. I) - Satyajit Das

ii. Options, Futures and other Derivatives (Fifth Edition) - John C. Hull

iii. Financial Derivatives Theory, Concepts and Problems – S. L. Gupta

iv. www.rbi.org.in

v. www.bis.org

vi. www.fimmda.org

vii. www.ccilindia.co.in



Documents

Interest Rate Swaps