Workshop on Indian Rupee Interest Rate

Swaps and Forward Rate Agreements

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Agenda

• Introduction to Interest Rate Swaps (IRS)

• Overnight Index Swaps
• Uses of Overnight Index Swaps
• Forward Rate Agreements - Concepts & Pricing

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Introduction to Interest Rate Swaps

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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)

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Interest Rate Swap (IRS)

• Typical Interest Rate Swap

Pays fixed Receives fixed

Bank A Bank B

Receives floating Pays floating

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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

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Elements of a typical IRS (Continued)

• An IRS is like a fixed rate asset and a floating rate liability

or vice versa, but without any exchange of principal and
with net interest settlement. Therefore, the credit
requirements for an IRS are minimal compared to those
for cash instruments

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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
– Treasury Bill yields
– Commercial Paper yields
– Bank Rate ???

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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 counterparts

• 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

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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

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Pricing an OIS

• Pricing an OIS means deriving the fixed rate of the swap

for a given floating rate benchmark (say MIBOR)

• Theoretically, OIS pricing should be derived from the inter

bank term money rates

• In the absence of a liquid term money market, OIS pricing

is expected to depend on
– the underlying of the counterparty
– the existing GOI & corporate yield curve

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Pricing an OIS

• Theoretically OIS Fixed rates are expected to lie between

the GOI yield curve and the corporate yield curve

• Currently, indicative swap rates upto 1 year are below the

GOI yield curve on account of substantial interest among
corporates to receive fixed rates and pay Overnight
floating rates.

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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

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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,1999
– Day Count BasisActual number of days/365
– Amount INR 100 crores
– Start Date 24th August,1999
– End Date 31st August,1999

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OIS Details (Continued)

• Terms
– O/N benchmark NSE O/N MIBOR a/365 (Bank B pays)
– Fixed Rate 8.50 % simple a/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

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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

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Canceling an outstanding OIS position

• Canceling /unwinding an existing OIS position is simple as it just

entails deriving the mark-to-market position of the swap which is
settled between counterparties.

• Important to understand the arithmetic, as corporate

counterparts canceling contracts is a reality.

• As per the Example : Bank A enters into a 7 day OIS with Bank
B, whereby it pays fixed and receives floating. After 3 days Bank
A wants to get out of the position. What can Bank A do ?
– Option 1: book a reverse swap - receive fixed and pay
floating for 4 days
– Option 2: cancel the outstanding OIS with Bank B

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Option 1: Booking a Reverse Swap
• Bank A has the option of booking a reverse swap with another
counterparty for the residual tenor of 4 days where it receives a
fixed rate and pays Overnight MIBOR

• The reverse swap would have to be booked on a revised

principal which is the original principal plus the interest accrued
on the floating leg

• This method replicates cancellation of the outstanding swap and

the net settlement amount determined as per this option is equal
to the amount determined by canceling the swap

• However, this method is credit and capital inefficient as it would

involve booking extra credit limit for a reverse swap whereas
cancellation of the outstanding swap would release credit limits
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Option 2 : Canceling the outstanding OIS

• Canceling an OIS will have two components

– Component 1 : The first component will be the difference
between the interest accrued on the OIS fixed leg and on the
floating leg from the start date to the current date

– Component 2 : The second component will be the difference

between the rate on the fixed leg of the original OIS and the
rate on the fixed leg of a cancellation OIS for the residual
tenor

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Canceling the outstanding OIS: Calculations

Original OIS
Principal INR 100 crores
Tenor of the swap 7 days
Start Date 24th August, 1999
End date 31st August, 1999
Swap rate Bank A pays fixed rate to Bank B at 8.50 %
Actual/365
Bank A receives Overnight MIBOR from Bank B
Actual/365

Cancellation
Bank A approaches Bank B to cancel the outstanding OIS value 27th
August,1999
Bank B quotes a rate of 8.25% to cancel the outstanding swap

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Canceling the outstanding OIS: Calculations
Component 1
Overnight index for 7 days Notional Principal 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
Interest accrued on floating leg = 627,803
payable by Bank B on unwind date (27th August, 1999)

Future Value of INR 627,803 on maturity date (31st August, 1999)

= 627,803*(1+627,803*8.25%*4/365) = 628,371

Interest accrued on fixed leg = 1,000,000,000*8.50%*3/365

payable by Bank A on maturity date = 698,630
Net interest accrued for first 3 days = 698,630- 628,371 = 70,259
payable by Bank A on maturity date (31st August, 1999)

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Canceling the outstanding OIS: Calculations

Component 2

Cancellation OIS rate = 8.25% vs MIBOR

Difference in fixed rates payable = 1,000,000,000*(8.50%-8.25%)*4/365
by Bank A on maturity date (31/8/99) = 27,397

Cancellation value on maturity date = Component 1 + Component 2

(31/8/99) payable by Bank A to Bank B = 97,656

Value if settled on cancellation date = 97,656 / (1+8.25%*4/365)

(27th August, 1999) = INR 97,568

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Uses of Overnight Index Swaps

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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
– Cash Management
– Reducing Interest cost
without sacrificing liquidity and by utilising minimal capital, thereby
ensuring a higher return on capital

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Example 1 : Asset liability management

• A typical nationalised Bank A : cash surplus, long term liabilities, lack of

assets, lends overnight and therefore
– runs asset liability mismatches, and gets lower returns on funds
• This bank receives 1 year deposit at 9.5% , options available are

Returns Liquidity ALM

1. Lend it in overnight market Low High Mismatch

2. Buy 1 year asset High Funds locked No mismatch

3. Enter into OIS (pay O/N,rec fixed)High High No mismatch
and continue to lend in overnight
markets

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Example 1: Asset Liability Management

Before
Pays fixed 9.5% on deposit

Bank A

Receives o/n rates

After

Pays o/n rate in OIS

Pays fixed 9.5% Bank A Receives fixed

on deposit in OIS

Receives o/n rates

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Example 2 : Hedging interest rate risks

• Primary dealer typically fund securities positions in overnight

markets
– run asset liability mismatches
– are exposed to volatility in overnight rates

• Absence of term money market limits funding options of a PD,

term funding would also restrict flexibility for the PD

• OIS offers the opportunity to hedge interest rate risk and reduce
asset liability mismatches
– PD pays fixed and receives floating on the OIS
– still borrows in call and retains flexibility in position management

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Example 2: Hedging interest rate risks

Entire position exposed to call rates

Pays o/n for PD Receives fixed

funding positions on bonds

PD hedges interest rate risk through OIS

Pays fixed in OIS

Pays o/n for PD Receives o/n in

funding positions OIS

Receives fixed on bonds

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Example 3 : Cash management tool

• Financial institutions and some corporates allocate surplus cash

in liquid assets like overnight deposits for maintaining liquidity

• Through an OIS, these entities can still lend overnight and keep
their liquidity but lock into a term rate thus enhancing the returns
on funds deployed

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Example 4: Reduction in Interest Cost

• A corporate has an outstanding fixed rate loan with a residual

tenor of 1 year.
• Corporate has a view that interest rates will remain stable or
decline and hence, is concerned about his high fixed rate loan
• Alternative 1
– Repay the fixed rate loan and raise a fresh loan via a
MIBOR linked bond
• Inefficient
• Alternative 2
– Enter into an OIS where it receives a fixed rate and pays
MIBOR
• Replicates Alternative 1 but more efficiently

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Example 5: Trading/Position Taking

• Carry Trades
– overnight rates expected to remain stable
– position replicated in OIS by receiving fixed and paying floating
• Stable steep yield curve
– ideal position is to borrow overnight and invest in longer term
– position replicated in OIS by receiving fix and paying overnight
• Stable inverted yield curve
– ideal position is to borrow long term and lend overnight
– position replicated in OIS by paying fixed and receiving overnight

• Therefore, swaps alter the risk nature but do not change

the normal transactions of the business.

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Capital calculations : Cash market Vs OIS

• Cash market transaction

– Borrow INR 10 crores Overnight and lend the INR 10 crores
for 1 year to a corporate
– Assuming a pre tax spread of 2.00% p.a., post tax spread on
the trade is 1.23% p.a. (assuming tax @ 38.5%)
– Post tax return on the deal = INR 12.30 lakhs
– Capital required = Risk Weightage * Asset
– = 100% * 9% * 100,000,000
– = INR 9,000,000
– Return on Capital = 14% p.a.

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Capital calculations : Cash market Vs OIS

• OIS transaction
– Pay Overnight rate and receive fixed rate on a 1 year OIS
– Assuming a pre tax spread of 1.00% p.a., post tax spread is
0.615% p.a. (assuming tax @ 38.5% p.a.)
– Post tax return = INR 6.15 lakhs
– Capital required = 1% * 100% * 9% * 100,000,000
= INR 90,000
– Return on Capital = 683% p.a.
This return can be 5 times higher if the swap counterpart is a bank
(3415 % p.a.!!!)

• Therefore, swaps help replicate cash market transactions with

lower capital requirements and thereby, much higher return on
capital

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Forward Rate Agreements - Concepts & Pricing

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Forward Rate Agreements (FRAs) are similar to
IRS
• A FRA is a financial contract between two parties to
exchange interest payments based on a ‘notional
principal’ for a specified future period
– on the settlement date, the contract rate is
compared to an agreed benchmark/reference rate
as reset on the fixing date

• It is similar to an interest rate swap except that

– in a typical IRS the benchmark rate can be reset
more than once, a FRA involves only one interest
rate setting
– in a typical IRS the settlement happens at maturity
whereas in a FRA the net settlement amount is
discounted to the FRA start date.
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Example of a FRA deal

• A Corporate has an expected requirement for funds

after 3 months but is concerned that interest rates will
head higher from current levels.
• The corporate can enter into a FRA to hedge or fix his
borrowing cost today for the loan to be raised after 3
months.
• The rate agreed via the FRA has to be compared to a
benchmark rate to determine the settlement
• Therefore, today the Corporate buys a 3X6 FRA from
a Bank at say 10.75% p.a. with the benchmark rate
being the 3 month CP Issuance rate of the Corporate
3 months later.

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Terms for the FRA deal
• The Corporate buys from the Bank a 3 X 6 FRA at 10.75%
against the 3 month CP issuance rate for the Corporate.
Notional principal Rs102,495,342 (we will see why)
– the notation 3X6 refers to the start date and the maturity date
respectively for the FRA
– Corporate pays 3X6 FRA rate (10.75%) for a 3 month period
starting 3 months from trade date
– Corporate receives benchmark rate from the Bank for the same
period. The benchmark rate may be the 3 month CP rate as
decided upon, to be determined on the fixing date
– net amount is due on maturity (6 months from trade date) but
settlement is done on the start date (3 months from trade date)
FRA start date/
Trade date Fixing date settlement date Maturity date

t=0 t+3m-1 t+3m t+6

m
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Terms of the FRA deal

• Bank & Corporate enter into a 3 X 6 FRA. Corporate pays FRA

rate at 10.75%. Bank pays benchmark rate based on 3 month
CP issuance rate of the above corporate 3 months later.
Additional details

– Notional principal INR 102,495,342

– FRA trade date 23rd August,1999
– FRA start/settlement date 23rd November, 1999
– FRA maturity date 23rd February,2000
– FRA fixing date 22nd November, 1999

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Cash flows for the FRA deal

• Assume, 3 month CP rate for the Corporate (benchmark rate) on

fixing date (22/11/99) = 11.00% p.a.
• Cash flow Calculations
– (a) Interest payable by Corporate = NPA * 10.75% *92/365
= INR 2,777,203
– (b) Interest payable by Bank = NPA * 11.00% * 92/365
= INR 2,841,789

– (c) Net payable by Bank on maturity date = INR 64,586

– (d) Discounting (c) to settlement date = (c)/(1+ discount rate

*discount period)
= Rs 64,586/(1+11.0%*92/365) = Rs 62,844
Amount payable by the Bank on settlement date =Rs 62,844

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Pricing for the FRA deal (the Bank’s viewpoint)

• Pricing a FRA would imply determining the forward

interest rate
• In the example,pricing involves determining the
implied 3 month forward 3-month interest rate. The
implied forward rate can be derived from the cash
market yield curve
• Pricing Calculations
– Current 3 month CP rate for Corporate 9.90% , ann

– Current 6 month CP rate 10.40% annual

– Notional Principal INR 10 crores
– Bank has the option of buying the 6 month CP (Option 1)
or buying the 3 month CP and selling an 3x6
FRA(Option2)

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Pricing for the FRA deal

• Pricing Calculations (contd.)

– FRA rate would be the 3 over 6 month roll-over rate which
would make the bank indifferent between the 2 options
today,I.e
Principal + Int. accrued on Option 1 = Principal + Int. accrued
on Option2
– 100(1+CP6*184/365) = 100(1+CP3*92/365)(1+3X6R*92/365)
– R= 10.63% p.a.
– Therefore, 3X6 FRA rate is 10.63% p.a (money
market,Actual/365)

• Formula for determining the implied forward interest rate

– (1+ rate1 * period1) * (1+ forward rate * future period) = 1 +
rate3 * period3
– where period 1+ future period = period 3

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Overall Return for the Bank (in our example)

• If the Bank had done a 6 mth a CP for 6 months (184 days),

then it would have got a return of 10.40% p.a.

• However, by going through the FRA route, the Bank enhanced

its returns by doing
a) A 3 month CP (92 days @ 9.90% p.a.); and simultaneously
b) selling a 3x6 (92 days) FRA @ 10.75% p.a.; thereby

• getting an overall return of 10.46% p.a.

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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

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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

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