INTEREST RATE

DERIVATIVES

SANGEETA (MBA4507/09)
PRIYANKA (MBA4544/09)
 MEANING

 An interest rate derivative is a derivative where the

underlying asset is the right to pay or receive a
notional amount of money at a given interest rate.

 Interest rate derivatives, which are investment

products that derive their profits and losses based on
the movement of bond prices (equivalently on
movements in interest rates).
 interest rate derivatives can be classified as having
two payment legs:
a funding leg and an exotic coupon leg.

 A funding leg usually consists of series of fixed

coupons or floating coupons (LIBOR) plus fixed
spread.

 An exotic coupon leg typically consists of a

functional dependence on the past and current
underlying indices (LIBOR, CMS rate, FX rate)
 interest rate derivatives is usually done on a time-
dependent multi-dimensional tree built for the
underlying risk drivers, examples of which are
domestic or foreign short rates and Forex rates
 EXAMPLE OF INTEREST RATE
DERIVATIVES

 Interest rate cap : is designed to hedge a company’s

maximum exposure to upward interest rate
movements.

 Range accrual note

 Bermudan swaption
 TYPES OF INTEREST RATE
DERIVATIVES

 FORWARD RATE AGREEMENT

 INTEREST RATE FUTURES

 INTEREST RATE OPTIONS

 INTEREST RATE SWAPS

 FORWARD RATE AGREEMENT

 A forward contract is the simplest derivative

instrument.

 It is a private agreement between two parties in which

one party (the buyer) agrees to buy from other party
(the seller) an underlying asset, on a future date at a
price established at the start of the contract.
 SETTLEMENTS

 Physical Delivery: In this mechanism, the forward

contract is settled by the physical delivery of the
underlying asset by the seller to the buyer on the
agreed upon price while entering into the contract.

 Cash Settlement: An alternative procedure, called

cash settlement permits the long and short to pay the
net cash value of the position on the delivery date.
There are three scenarios possible. Depending on what
scenario prevails on the expiry date, the net payoffs
are determined for both the parties:

1. Spot Price (ST) > Forward Price (FT)

2. Spot Price (ST) = Forward Price (FT)
3. Spot Price (ST) < Forward Price (FT)
 INTERST RATE FUTURES

 Is a financial derivate based on an underlying security

actually a debt obligation that moves in value as
interest rates change.

 Buying an interest rate futures contract will allow the

buyer to lock in a future investment rate

 The interest rate futures market had priced the futures

so that there is sparse room for arbitrage
 NEED FOR INTEREST RATE FUTURES
 Interest rate risk affects not only the financial sector,
but also the corporate and household sectors

 Banks, insurance companies, primary dealers and

provident funds bear a major portion of the interest
rate risk on account of their exposure to government
securities

 Interest rate products are the primary instruments

available to hedge inflation risk which is typically the
single most important macroeconomic risk faced by
the household sector
 INTEREST RATE FUTURES TRADE IN
INDIA
 The underlying for interest rate futures trading is the
Government of India's securitized 10-year notional coupon
bond

 GoI securities to be used as underlying assets should have

a maturity status between seven-and-a-half years and 15
years from the first day of the delivery month

 Outstanding should be for a minimum value of Rs 10,000

crore (Rs 100 billion)
 WHO CAN TRADE AND WHERE
 A company, or a bank, or a foreign institutional
investor, or a non-resident Indian or a retail investor
can trade in interest rate futures market
 Can trade live in interest rate futures on the currency
derivatives segment of the National Stock Exchange
 THE MAXIMUM TENOR OF THE
CONTRACT

While the maximum tenor of the futures contract is 1

year or 12 months, usually it will have to be rolled
over in three months making the contract cycle span
over four fixed quarterly contracts.
 DAILY SETTLEMENT CALCULATION
AND PROCEDURE FOR FINAL
SETTLEMENT
 The weighted average price of the futures contract for
the final 30 minutes would be taken as the daily
settlement price
 At times when this trading is not carried out the
exchange would fix the theoretical price as the daily
settlement rate
 The daily settlement is done on a daily marked-to-
market procedural basis while the final settlement
would be through physical delivery of securities
 BENEFITS OF EXCHANGE -TRADED
INTEREST RATE DERIVATIVES
 Standardization: Through standardization, the Exchanges
offer market participants a mechanism for gauging the utility
and effectiveness of different positions and strategies.
 Transparency: Transparency, efficiency and accessibility
is accentuated through online real time dissemination of
prices available for all to see and daily mark-to-market
discipline.

 Counter-party Risk :The credit guarantee of the clearing

house eliminates counter party risk thereby increasing the
capital efficiency of the market participants.
 INTEREST RATE OPTION
 An investment tool whose payoff depends on the
future level of interest rates.
 Are both exchange traded and over-the-counter
instruments
 Market is one of the most important hedging
mechanisms available and is used extensively by a
wide variety of industry participants
 Generally used to hedge exposure on a bond portfolio
 In an interest rate option, the underlying asset is
related to the change in an interest rate
TYPES OF INTEREST RATE OPTIONS

Most heavily traded exchange traded options are

futures options on T-BONDS,T-NOTES,T-BILLS
and EURO DOLLAR CONTRACTS. On the OTC
market the most popular interest rate options include
options on spot treasury securities and caps and floors
 FEATURES OF INTEREST RATE
OPTIONS
 Cash setteld: Interest Rate Options are settled in cash.
There is no need to own or deliver any Treasury securities
upon exercise.

 Contract size:Interest Rate Options use the same $100

multiplier as options on equities and stock indexes.

 European-style exercise: The holder of the option can

exercise the right to buy or sell only at expiration. This
eliminates the risk of early exercise and simplifies
investment decisions.
HOW INTEREST RATE OPTIONS WORK
 A call buyer anticipates interest rates will go up,
increasing the value of the call position.
 A put buyer anticipates that rates will go down,
increasing the value of the put position.
 A yield-based call option holder will profit if, by
expiration, the underlying interest rate rises above the
strike price plus the premium paid for the call
 A yield-based put option holder will profit if, by
expiration, the interest rate has declined below the
strike price less the premium. Option writers (sellers)
receive a premium for selling options to buyers
 INTEREST RATE SWAPS
 An interest rate swap is an unregulated over-the-
counter (OTC) derivative contract between two
parties to exchange one stream of interest payments
for another

 Is based on a notional principal amount, which is

used to calculate the amount payable by both the
parties

 Are used by commercial banks, insurance companies,

investment banks, lenders, mortgage companies and
government agencies
 TYPES OF INTEREST RATE SWAPS
 Fixed-for-floating rate swap in same currency :
This type of swap allows one party to pay fixed interest
payments, while receiving payments from the other party in
floating interest rates and vise versa. This is the most popular
form of rate swaps and is called a vanilla swap.
 Floating-for-floating rate swap in same currency: This
type of interest rate swap is used when floating rates are based
on different reference rates. For example, one interest rate
could be pegged to the LIBOR, while another to the TIBOR
(Tokyo Interbank Offered Rate). Companies opt for this type
of swap to reduce the floating interest rate applicable to them
and receive higher variable interest payments. It also helps to
extend the maturity date of loans.
  Fixed-for-fixed rate swap: This swap
is used only when both parties are dealing
in different currencies and involves the
exchange of interest payments carrying
predetermined rates. This swap helps
international companies benefit from lower
interest rates available to domestic
consumers and avoid currency conversion
costs.
 USES OF INTEREST RATE SWAPS

 Risk:An important benefit of interest rate

swaps it their ability to hedge risk for financial
institutions. For example, a company may seek
to avoid interest rate risk using an interest rate
swap. This is because fractional variances in
interest rates can have significant impact on
the cost, and benefit of a well-thought-out
interest rate swap agreement. The Federal
Reserve Bank of New York reports risk
volatility can also arise due to speculative
trading of interest rate swaps.
 Cost: Interest rate swaps are cheaper than
other methods of cost management. Large
businesses also use interest rate swaps to lower
costs, interest rate swaps can be cost-effective
because there are fewer fees involved with
interest rate swaps than other forms of debt. If
the costs of a cash-outflow are offset by the
advantages made possible with a variable
inflow half of the swap, the cost effectiveness
of the swap improves further.  
 Profit: Interest rate swaps from fixed to
variable rate interest can also preserve
corporate profits when interest on debts rise.
This is because interest rate swaps lead to a net
profit when interest rates on future cash
inflows payable are variable, and cash
outflows remain fixed. When the variable rates
rise, then the interest rate swap is profitable for
that period. This practice is speculative, but
can contribute to lower project management
costs, and higher returns on investment when
interest rates are favorable.
 Debt: Trading interest rates can be an effective way
to reorganize debt.Interest rate swaps are also used to
optimize debt. For example, suppose ABC
Company's bond indenture requires a semi-annual
payment of 5 percent interest. ABC seeks to
maximize its return on debt through an interest rate
swap with BG Corporation. To do this ABC offers
BG Corporation a slightly lower fixed rate in return
for a unpredictable floating rate. This allows ABC to
reduce having to borrow additional funds for its
monthly cash conversion cycle, and increases the
potential of a profitable interest rate swap, and cost-
effective bonds.
BENEFITS OF INTEREST RATE SWAPS

 Portfolio mangers can regulate their exposure to

interest rates and alter the yield curve in a favourable
direction.

 Speculators can benefit from a favourable change in

interest rates.

 Since interest rate swaps do not involve the exchange

of the principal amount, it eases the transaction
 Companies with fixed rate liabilities can enter into
swaps to enjoy the benefits of floating rates and vise
versa, based on the prevailing economic scenario

 Financial institutions can use these swaps to

overcome interest risk exposure and remain profitable