Borrowers who expect interest rates to fall can swap their fixed rate loans into a floating rate loan. Borrowers who expect interest rates to rise can swap their floating rate loan into a fixed rate loan. Borrowers who have loans benchmarked to one floating rate can swap to another floating rate to reduce their risks or take advantage of the expected movement in one benchmark rate against another.
Money market dealers can pay in fixed IRS for 90 days instead of funding government securities deals through the highly volatile call money market. Dealers can also create synthetic long tenor assets at higher than current fixed yields by swapping upwards Mibor linked debentures. For example, a one year AAA rated Mibor linked debenture issued at Mibor + 50 bps can be swapped into a fixed rate for the same period.
Interest rate swap can be regarded as the exchange of a fixed rate bond for a floating rate bond. It can be used to transform a fixed rate loan extending over many years into a floating arte loan and vice versa, Thus, IRS can be viewed as series of forward contracts. IRSs help in reducing the cost of financing managing risks, and creating synthetic instruments (created by combining other instruments) to enter new markets.
Forward rate Agreements:
FRAs are a type of forward contracts, originally introduced by British banks in 1993. FRAs are important hedging instruments in global banking.
A forward rate agreement is a financial contract between two parties where the interest at a predetermined rate for a notional principal amount and for a specified period is exchanged at the market interest rate prevailing at the time of settlement. The market interest rate is an agreed benchmark / reference rate prevailing on the settlement date. In India, the NSE / Reuters Mibor is used as a reference rate.
The cash payment at maturity (settlement) is based on the difference between the predetermined rate and the Mibor rate.
Plain Vanilla Forward rate Agreements:
In a forward rate agreement a party that is seeking protection from a possible increase in interest rates would buy FRAs; hence he is called a purchaser. A party that wants protection from a possible decline in interest rates would sell FRAs; hence he is a seller. It is assumed that the forward interest rate is certain to be realized. There is no risk of default on the part of the writer of the FRA. A 360 day year convention is used in computing interest.
The specified period of the contract is the point in time when the deposit is to commence and the point in time when the deposit is to terminate. For example, 3 x 9 FRA is read as three months against nine months Mibor which means a six month Mibor deposit to commence in three months and terminate in nine months.
The actual amount received is calculated as follows:
The difference between the reference rate on the contract’s settlement date and the agreed interest rate is multiplied by the notional principal and the terms of the deposit. The sum obtained is discounted with the reference rate to arrive at the present value which is the sum paid or received.
In three months an Indian bank wants to lend Rs 75,00,000 to a client for a period of six months. The spot NSE Mibor rate is 9.25 per cent. The bank, in order to commit itself to an interest rate, approaches a FRA dealer who offers a 6 month Mibor deposit, at a rate of 9.32 per cent to commence in three months. The bank enters into the contract as a FRA buyer. The bank then offers its client a rate of 9.82 percent (cost of funds + 50 basis points) a higher rate for profit and risk coverage. If interest rates rise at the time of FRA settlement and six month Mibor is at 9.95 per cent, then the pay off is calculated as follows:
First calculate the lending profit / loss:
Lending profit / Loss = (Rate received – rate paid) x principal x term
= (9.82% — 9.95%) x 7500000 x 182 / 360 = Rs (-) 4,929
This loss on lending is hedged to enable the bank to earn profit
The hedge profit / loss and the amount received or paid is calculated as follows:
(RR – CR)P x t / [1 + (RR x t)]
RR = Reference rate, here NSE Mibor rate
CR = FRA contract rate
P= Notional Principal
t = term, here 182 / 360 as a six month deposit.
The numerator of the equation gives the hedge profit / loss and the denominator discounts the sum obtained to arrive at its present value:
= [(9.95% — 9.32%)] x 182 / 360 / [ 1+ 99.95% x 182 / 360)]
= 23888 / [1 + 0.05030]
= Rs 22, 743.5
Hence, the net profit to the bank is Rs 22,743.5 – Rs 4,929 = Rs 17,814.5.
Besides being used as a hedging vehicle, FRA can be used by banks to arbitrage against futures or swaps or cash deposits.
The FRA market tends to be limited as parties are exposed to more risk than parties to a future contract. Hence, generally institutions with strong credit undertake FRA contracts.