Interest Rate Derivatives

1Why interest rate derivatives exist

An interest rate derivative (IRD) is a contract whose value depends on an interest rate or on the price of an interest-bearing instrument such as a bond or Treasury bill. Its economic purpose is to let people transfer interest rate risk to those willing to bear it, without buying or selling the underlying bonds or loans.

• A borrower with a floating-rate loan fears rising rates.
• A bond investor or a bank holding bonds fears rising rates, because bond prices fall.
• A lender or a deposit-taker with floating-rate assets fears falling rates.

IRDs let each of them lock in or limit the rate. They also improve price discovery for future rates and add liquidity to the debt market.

Remember

• IRDs move interest rate risk to those willing to take it.
• The underlying is a rate (such as MIBOR) or a rate-sensitive instrument (bond, T-bill).

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2Forward rate agreements

A forward rate agreement (FRA) is an OTC contract that fixes the interest rate for a future period on a notional amount. No principal changes hands. At the start of the period, one party pays the other the difference between the agreed (FRA) rate and the actual reference rate, discounted to that date.

• The buyer of an FRA pays the fixed rate. A borrower buys to protect against rising rates and gains if the reference rate ends up above the FRA rate.
• The seller receives the fixed rate and gains if rates fall.

Example A company will borrow ₹10 crore in three months for three months and fears rates will rise. It buys a "3×6" FRA at 7%. If the reference rate is 8% when the period starts, it receives roughly 1% × ₹10 crore × 3/12 = ₹2.5 lakh (slightly less after discounting). This offsets its higher borrowing cost.

Remember

• FRA = OTC, notional only, settled in cash on the rate difference.
• Buyer of an FRA is protected against rising rates.

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3Futures, options, caps and floors

• Interest rate futures (IRF): exchange-traded, standardised contracts to buy or sell an interest-bearing instrument (a bond or T-bill) at a fixed price on a future date. Because bond prices move opposite to rates, selling bond futures protects against rising rates.
• Interest rate options: give the buyer the right, but not the obligation, to buy (call) or sell (put) a bond, or to receive a payoff linked to a rate, at an agreed strike, in return for a premium.
• Interest rate cap: a series of options that pays the holder when a floating rate goes above an agreed cap rate. It suits a floating-rate borrower who wants a ceiling on cost.
• Interest rate floor: pays when the floating rate falls below the floor rate. It suits a floating-rate lender or investor.
• Collar: buying a cap and selling a floor. The premium received on the floor reduces the cost of the cap, but the borrower gives up gains below the floor.
• Swaption: an option to enter into an interest rate swap on agreed terms.

Remember

• Cap → ceiling for borrowers. Floor → minimum for lenders.
• Collar = buy cap + sell floor, which lowers the premium.

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4Interest rate swaps

An interest rate swap (IRS) is an OTC agreement to exchange interest payments on a notional principal for an agreed period. Usually one side pays a fixed rate and the other pays a floating rate. Only the net difference is paid on each settlement date, and the notional amount is never exchanged.

• The fixed-rate payer benefits if floating rates rise. A company with a floating-rate loan can pay fixed in a swap to turn its loan into a fixed-rate one.
• The fixed-rate receiver benefits if floating rates fall.
• In India, the most common rupee swap is the overnight indexed swap (OIS), in which the floating leg is linked to the overnight MIBOR benchmark published by FBIL (Financial Benchmarks India Ltd).

Example Bank A pays 6.5% fixed and receives overnight MIBOR compounded, on a notional of ₹100 crore for one year. If compounded MIBOR works out to 6.8%, Bank A receives the net 0.3% on ₹100 crore, which is ₹30 lakh.

Remember

• Swap: exchange of interest flows on a notional amount; principal is not exchanged.
• Pay fixed → gain when rates rise.
• Indian OIS references overnight MIBOR, published by FBIL.

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5Who uses interest rate derivatives and why the market grew

Market participants:

• Hedgers: banks managing the mismatch between their assets and liabilities, primary dealers and insurers holding bond portfolios, companies with floating-rate borrowings, and mutual funds protecting debt portfolios.
• Speculators (traders): take positions on the expected direction of rates.
• Arbitrageurs: profit from price differences between the futures and the underlying bonds, or between related contracts.

Growth drivers in India include market-determined interest rates since the 1990s reforms, a large and active government securities market, rate volatility that creates a need to hedge, banks' asset-liability management needs, and regulators' push to deepen the debt market.

The RBI regulates the interest rate derivatives market. Exchange-traded IRDs are traded on SEBI-recognised exchanges under a framework set by the RBI and SEBI together.

Remember

• Hedgers, speculators and arbitrageurs: the three types of participant.
• Banks' asset-liability mismatch is a major reason for hedging.

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6OTC versus exchange-traded interest rate derivatives

Exam trap The key advantage of OTC contracts is flexibility (exact amounts and dates). The key advantages of exchange-traded contracts are standardisation, transparency, liquidity and the central counterparty guarantee.

Remember

• OTC = flexible but bilateral.
• Exchange = standardised, transparent, guaranteed by the clearing corporation.

Practise this concept (4 questions)