A) INTEREST RATE SWAPS : An Interest Rate Swap is a financial contract between two parties exchanging or swapping a stream of interest

payments for Notional Principal Amount on multiple occasions during a specified period. Such contracts generally involve exchange of a fixed to floating or floating to floating rates of interest. Accordingly on each payment date that occurs during the swap period - cash payments based on fixed/floating and floating rates, are made by the parties to one another. Floating rates are agreed benchmark rates/reference rates on each refixing dates during the tenor of IRS. Example : Company A borrowing at six-month LIBOR plus 1% wishes to swap its variable-rate interest liability for a fixed rate liability. Bank B is willing to arrange a swap whereby it would receive fixed payments at 7.5 % per annum from Company A against payment of six-month LIBOR , with six-monthly exchanges. The effect of the swap will be as follows : Fixed payments at 7.5 % p.a. ---------------------------------------------------- -------------------------------------------------LIBOR

COMPANY A

BANK B

| Loan | interest |

V
LIBOR + 1% CONTD3 :3: The effect of the payments of Company A is as follows : PAY Borrowing Interest Rate Swap 6 month LIBOR +1% 7.5% RECEIVE 6 month LIBOR

This produces a net payment of 8.5 % fixed for Company A. As a result of Interest Rate Swap arrangement, Company A has not changed its loan. It still has a variable rate loan for which it is liable to the lender. The Interest Rate Swap, however, allows Company A to switch from variable rate payments to fixed rate payments, taking the loan and swap payments together. B) FORWARD RATE AGREEMENTS : FRA is a financial contract between two parties to exchange interest payments for a Notional Principal Amount on a future settlement date, for a specified period from start date to maturity date. Accordingly, on settlement date, cash payments based on contract (fixed) and the settlement rate, made by the parties to one another. The settlement rate is the agreed benchmark/reference rate prevailing on the settlement date. Example : Company A wants to fix a rate for borrowing USD 20 Mio for 6 months, for a loan starting in three months time from now. Company can buy an FRA 3/9 from Bank B that deals in these products. This FRA rate will apply only to Notional amount of USD 20 Mio. The FRA rate is a fixed rate that Company A thereby secures for its 6 months borrowing ( end of month3 to end of month 9) . The fixed rate is therefore, known on the trade date, but the level of floating rate benchmark is unknown at this time. Two days prior to the settlement date and start date for the Notional amount, the level of floating rate is finally determined by reference to any benchmark ( e.g. LIBOR) . The floating index thus becomes known and fixed, at its current market level, the settlement rate.

Depending on whether the FRA contract rate is higher or lower than this settlement rate, a compensation payment will be made either by Company A to Bank B or by Bank B to Company A. No loan principal is exchanged, but only compensation payment known as the settlement proceeds is exchanged. The buyer of an FRA is fixing the rate of interest payable on a notional loan. The seller of an FRA is fixing the rate of interest receivable on a notional deposit. C) CURRENCY SWAPS : A Currency Swap is an agreement between two parties to exchange payments in one currency for payments in another currency. It is a contract which commits two counter parties to an exchange , over an agreed period, two stream of payments in two different currencies , each calculated using a different interest rate and an exchange, at the end of the period, of the corresponding principal amounts at an exchange rate agreed at the start of the contract. Example : Company A has borrowed USD 10 Mio for a period of 8 years as an External Commercial Borrowings at 6 months LIBOR plus 3 % and installments repayable in 6 months time. Here Company A is exposed to Currency risk in USD/INR as the depreciation of local currency Indian Rupees may result in high cost for buying dollars at a future repayment dates. Contd.4 :4: Also Company is exposed to interest rate risk in USD as the loan is floating rate basis and rates can move higher at future dates. To mitigate these risks, Company A can enter into a Currency Swap whereby it pays fixed rate on Rupees at say 11 % on the Notional Principal amount on amortizing structure and receives USD installments as also USD interest at LIBOR + 3 % on the respective due dates as per the loan structure. Here, initial Principal Exchange may or may not take place, but Principal Exchange at the maturity takes place usually. D) INTEREST RATE CAPS : An Interest Rate Cap is a series of borrowers options which sets a maximum interest rate on a medium term floating rate borrowing. The buyer of a cap can choose the strike price, but the cost of the premium will vary according to the strike price chosen. The cap holder has the right to exercise an option on each fixing date or rollover date of the loan, and this covers the interest period upto the next fixing date. If on any fixing date, the reference market rate of interest is above the caps strike price, exercise and cash settlement are triggered automatically. Like borrowers options, caps are cash settled. The cap writer pays a compensating amount to the cap holder when the interest rate is above the pre-agreed strike level on the expiry date for any of the options in the series. st Example : A Company avails a two-year floating rate loan of USD 5 Mio on 1 Jan 2004 with th st interest payable six monthly at LIBOR plus 1 % on 30 June and 31 December for two years. The company then buys an interest rate cap with a strike price for six-month LIBOR of 3% . The cap will consist of a series of three call options on six-month LIBOR for notional principal of USD 5 Mio at a strike price of 3 % p.a. for each option. The expiry dates for each option would coincide with the interest rollover dates, which in this example would be as follows : | To cover the period . | th st st 30 June 2004 | 1 July 2004 to 31 Dec 2004 | st st th 31 December 2004 | 1 Jan 2005 to 30 June 2005 | th st st 30 June 2005 | 1 July 2005 to 31 Dec 2005 (end of the loan period) Expiry Date

The cap is a series of three borrowers options, each for a notional six-month loan period, at a strike price of 3 %. The cap can therefore, also be seen as an option of three FRAs : a 6/12 FRA, a 12/18 FRA and a 18/24 FRA. E) INTEREST RATE FLOORS : An Interest Rate Floor is the opposite to an interest rate cap. It is a series of lenders interest rate options, which hedges the risk of falling interest rates for medium term floating rate lending or for investing at variable interest rates. Interest rate floors thus provide a minimum guaranteed interest rate for a lenders or investors income. On each reset date during the period of the agreement, the holders right to lend the Notional Principal at the strike rate can be exercised for the period of the next reset date. Exercise will be automatic if the strike price is above the reference market rate of interest. CONTD.5

:5: F) INTEREST RATE COLLARS : One disadvantage of caps or floors is the high cost of the premium. Interest rate collars attempt to overcome this disadvantage. An interest rate collar is a combination of a cap and a floor which can be used to obtain either a guaranteed maximum interest rate (cost) on floating rate borrowings or a guaranteed minimum interest rate (yield) on a floating rate investment or a variable rate loan.

Example on Buying a Collar : A company wishing to set a maximum interest rate on its floating rate borrowing can transact a collar. In effect buying a collar consists of buying a cap and selling a floor. The cap which is bought sets a maximum interest rate on the loan. The floor which is sold gives the Bank writing the collar a minimum guaranteed interest rate. The collar buyer receives a premium for the floor sold. This offsets the premium paid for the cap ; therefore, the total premium paid for the collar will be less than the cost of a cap. The interest rate on the companys borrowings will therefore be set at a collar between the floor level and cap level.

Buying a Collar : Premium for a collar setting maximum rate

PREMIUM

Cost of buying a Cap

Premium from selling a floor

G) CURRENCY OPTIONS : An Option is an agreement between two parties, giving the options buyer(option holder) the right, but not the obligation, either to buy or to sell a quantity if one currency in exchange for another, at a fixed price , on or before a specified date in the future. If the option is exercised, the option writer ( seller) is obliged to sell or buy the currency on the terms specified in the option. The purchase cost of the option is called premium. Example : present :Here below is an example of Cross-currency options which is permitted by RBI at

An exporter will receive EUR 1 Mio in export proceeds in one months time. The spot EUR/USD rate is 0.9930 and 1 month forward rate currently is 0.9910.

The exporter can do either of the two with regard to these proceeds Do nothing now and sell EUR 1 Mio against USD at spot rates when they are received. Enter into a forward sale today to lock into the rate at which EURO will be converted to USD.

With cross-currency options , the exporter can buy EUR Put/ USD Call for 1 months time European option at a fixed date at a strike price say, 1.1960 , convenient to the exporter at a pre-determined premium of say, 0.0020/ EUR 1 Mio payable by the exporter to the seller of the option ( Bank). CONTD..6 :6: Here, as in the case of forward contract, exporter has no obligation to sell EUR to the seller of the option if the spot rate on the maturity date is above10.1960. The exporter can leave the option without exercising , for a fixed cost of premium paid by him and sell his proceeds in the spot market which is above 1.1960 for better pay-off. If the spot rate on the maturity is much lower say 1.1780, then the exporter can exercise the option by selling EUR to the seller of the option at strike price of10.1960 for which he already paid the premium. H) USD/INR OPTIONS : As a part of developing Derivatives market in India and adding to the spectrum of availability of Derivative products for hedging exposure risks, RBI has pronounced introductions of USD/INR th Options w.e.f. 7 July 2003. A Call Option gives its holder the right to purchase the underlying currency at the stated strike price and obliges the option writer to sell the instrument at that price, should the option be exercised. A Put Option gives its holder the right to sell the underlying currency at the stated strike price and obliges the option writer to buy that currency at that price, should the option be exercised Zero-cost Option structures : As per RBI Circular AP(DIR Series) No: 108, customers can purchase call or put options, but writing ( or selling) options by customers is not permitted. However, customers can enter into packaged products involving cost reduction structures provided the structure does not increase the underlying risk and does not involve customers receiving premium. This is called zero-cost structures, which involve selling as well as buying options. Corporates are not allowed to sell options on a standalone basis even though the downside risk in both the instances is just the same. Example of zero-cost option structure : Suppose an exporter will need to buy USD 1 Mio after 6 months. Currently, the spot rate is 43.50 and the six month forward rate is 44.00. The exporter can book forward contract at 44.00 for selling USD in six months time as he is having a strong view of stronger Rupee in the coming days. Alternatively, he can enter into USD/INR Option whereby he has to buy an At-the Money USD Put/INR Call Option for USD 1 Mio for which he has to pay premium to the seller of the Option say 0.30 paise on USD 1 Mio or Rs.300,000/-. This looks a additional cost for the exporter which he can avoid by making the Option structure Zero cost. For this he has to sell a USD Call/INR Put Option to the Bank for the same amount or double the amount to receive the premium and offset the same with which he has to pay in buying the USD Put Option. While structuring for these kind of structures, the exporter need not pay any premium and also enjoys a higher strike rate than the forward contract rate. To elaborate the above example further, an exporter can buy a USD Put Option for 6 months for USD 1 Mio at 44.20 and sell USD Call Option for USD 2 Mio at 44.20. On the due date of the

Option, if the Spot level of USD/Rupee is say, 43.10, then exporter can exercise the Put option thereby making the net gain of Rs.1.10 on USD 1 Mio. But the Bank will not exercise USD Call Option at 44.20. If the Spot level goes higher say, 44.40, then, the exporter will not exercise the USD Put option, but the Bank will exercise its USD Call Option Contd7 :7: for USD 2 Mio at 44.20 which in turn is a USD Sale for the exporter on the due date. This is also beneficial to the exporter compared to the forward contract, who otherwise would have booked forward contract at 44.00.

III. TARGET GROUP : A) Interest Rate Swaps

a) Converting a fixed Rupee liability to floating - This swap can be undertaken by a corporate that has a fixed Rupee liability. The fixed interest rate received by him is determined for the entire tenure of the swap. The floating interest paid could be linked to any of the Rupee Benchmarks available in the market . The actual payment for both the legs takes place on maturity or on the interest payment dates as the case may be. b) Converting a floating Rupee liability to fixed - This swap can be undertaken by a corporate that has a floating Rupee liability. The fixed interest rate paid by him is determined for the entire tenure of the swap. The floating interest received by the corporate could be linked to any of the Rupee benchmarks available in the market . The actual payment for both the legs takes place on maturity or on the interest payment dates as the case may be.

B)

Currency Swaps

a) Converting Rupee liability to Foreign Currency (FC) - This swap can be undertaken by a corporate that has a Rupee liability. In this case, corporate receives a Rupee rate and pays a fixed / floating FC rate. On the start date, the FC spot conversion rate is used to arrive at the equivalent FC principal amount on which the FC interest will be computed and paid by the corporate on each interest payment date. On the principal payment date the corporate receives the Rupee principal and pays the FC equivalent that was fixed on the swap initiation date. b) Converting Foreign Currency liability to Rupee - This swap can be undertaken by a corporate that has a FC liability. In this case, corporate receives a FC rate (fixed or floating based on the interest payment on its underlying FC liability) and pays a Rupee rate. On the start date, the FC spot conversion rate is used to arrive at the equivalent Rupee principal amount on which the Rupee interest will be computed and paid by the corporate on each interest payment date. On the principal payment date the corporate receives the FC principal and pays the Rupee equivalent that was fixed on the swap initiation date.

C)

Coupon-Only-Swaps

a) Converting Rupee liability to Foreign Currency (FC) This swap can be undertaken by a corporate that has a Rupee liability. In this case, corporate receives a rupee rate and pays a fixed / floating FC rate. On the start date, the FC spot conversion rate is used to arrive at the equivalent FC principal amount on which the FC interest will be computed and paid by the corporate on each interest payment date. b) Converting Foreign Currency liability to Rupee This swap can be undertaken by a corporate that has a FC liability. In this case, corporate receives a FC rate (fixed or floating based on the interest payment on its underlying FC liability) and pays a Rupee rate. On the start date, the FC spot conversion rate is used to arrive at the equivalent Rupee principal amount on which the Rupee interest will be computed and paid by the corporate on each interest payment date.

CONTD.8 :8:

D)

USD/INR Options

This product is introduced as an alternative tool to hedge the risks on foreign exchange exposures to exporters and importers. Hitherto, corporates are restricted to the use of forwards and long-term currency swaps. Forward contracts do remove uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. Currency Options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium.