A derivative security is a financial contract the value of which is derived from the value of an underlying asset. These assets may be stocks, currencies, interest rates, indexes, or commodities. Derivatives help manage various types of risks through hedging, arbitraging, and acquiring insurance against them. As they increase the capability of the markets to absorb risk, they enhance liquidity and reduce transaction costs in the markets for underlying assets.
The deregulation of interest rates lead to an interest rate risk. This risk is the adverse impact of interest rate movements on an institution’s net interest income and market value, dependent on the maturity profile of the assets and liabilities of the institutions as well as their re-pricing terms. This interest rate risk can be managed with the help of derivative instruments. Lack of money market derivative instruments will force banks to physically restructure their balance sheets by purchasing or shedding assets and liabilities, which might ultimately turn out to be in efficient. Derivative instruments are off balance sheet which helps banks to manage their interest arte risks without having to restructure their balance sheet and with more efficient use of capital. Hence, in July 1999, the Reserve bank laid down guidelines to introduce two money market derivatives: interest rate swaps (IRS) and forward rate agreements (FRA). Both are over the counter derivatives. These contracts are negotiated between counterparties and tailored to meet the needs of their contract.
IRS and FRAs are new hedging instruments introduced to give more depth to the money market as also to enable market participants to hedge interest rate risk arising on account of lending or borrowings made at fixed / variable interest rates.
Interest rate swap: An interest rate swap is a financial contract between two parties, exchanging or swapping a stream of interest payments for a notional principal amount during a specified period. Such contract involves exchange or swapping of a ‘fixed to floating’ or ‘floating to fixed’ interest rate. If participants feel that rates will fall, they could receive fixed and pay floating rates. The converse is beneficial if interest rates rise.
The first interest rate swap contract was negotiated in 1981 in London. It was introduced in the United States in 1982 when the Student Loan Marketing Association (Sallie Mae) employed fixed for floating interest rate swap to convert the interest rate character of some of its liabilities. In India, some private sector banks and institutions use interest rate swap to hedge interest rate risk. The reserve bank allows the use of only plain vanilla interest rate swaps.
Plain vanilla interest rate swaps: In an interest rate swap there are two counterparties. One counterparty, say A, will make fixed, semi-annual interest payments to the other counterparty, say B, who will make semi annual floating interest payments to A. The swap contract specifies the interest rate applicable to each party, currency in which each cash payment will be made, timetable for payments, number of days in the year, provisions to cover the contingency of a defaulting counterparty, and other issues that affect the relationship between the counterparties. Payments are usually made in the same currencies. Payments are netted and only the party with the positive difference owed makes a payment equal to the netted amount. The principal is not exchanged. Hence, the term ‘notional principal’ is used. On the fixed payment side, a 365 day year is assumed; on the floating payment side, a 360 day year is used. The floating side is quoted on a money market yield basis. In India, the NSE / Reuters MIBOR has been accepted as a reference rate for interest rate swaps.
Example: Counterparty A pays a fixed rate of 8.25 per cent per annum on a semi-annual basis and receives from counterparty B Mibor + 50 basis points. The current six month Mibor rate is 7 per cent per annum. The notional principal is Rs 70 lakh.
Counterparty A Counterparty B
Pays fixed 8.25 per cent Receives fixed
NSE / Reuters Mibor + Pays floating
50 basis points
(Notional Principal) (Days in period / 365) (Interest rate / 100)
= 70,00,000 x 182 / 365 x 8.25 / 100 =
Rs 2, 87, 959
70,00,000 x 180 / 360 x 7.50 / 100 =
Rs 2,62, 500
Net payments by counterparty A to counterparty B = Rs 2,87,959 – Rs 2,62,500 = Rs 25,459
Counterparty A will benefit if the variable interest rates rise as per expectation and counterparty B benefits if the variable interest rates decline.