Interest

Rate  
Swaps

     

  Introduction:

Interest rate swaps are used to hedge interest rate risks as well as to take on interest rate
risks. If a treasurer is of the view that interest rates will be falling in the future, he may
convert his fixed interest liability into floating interest liability; and also his floating rate
assets into fixed rate assets. If he expects the interest rates to go up in the future, he may do
vice versa. Since there are no movements of principal, these are off balance sheet
instruments and the capital requirements on these instruments are minimal.

A swap transaction, is a custom-tailored bilateral agreement, in which, two counter-parties

agree to exchange specified cash flows at periodic intervals over a pre-determined life of the
swap. It is a powerful tool, which allows the user to align risk characteristics of assets and
liabilities (hedging)

An interest rate swaps can be defined as a contractual agreement entered into between two
banks under which each agrees to make periodic payment to the other for an agreed period
of time based upon a notional amount of principal. The principal amount is notional because
there is no need to exchange actual amounts of principal. A notional amount is required in
order to compute the actual cash amounts that will be periodically exchanged. Swaps can
thus transform cash flows through a bank to more closely match the pattern of cash flows
desired by management.

Payments are based upon a notional principal amount. While any payment frequency is
possible, the most common frequencies are overnight and semi-annual. The floating rate
side of the swaps is pegged to a floating rate index such as the O/N MIBOR (OIS Swap) and is
normally reset at the beginning of each payment interval. The notional principal, swaps
tenor, reference floating rate index, fixed rate and payment frequency are all specified at
contract inception.

Fixed-for-Floating Interest Rate Swaps

A series of payments calculated by applying a fixed rate of interest to a notional principal

amount is exchanged for a stream of payments similarly calculated but using a floating rate
of interest. Swap participants can convert from fixed to floating or vice-versa and more
closely match the maturities of their Assets and Liabilities.

Definition: A contract which involves two counter parties to exchange over an agreed period,
two streams of interest payments, each based on a different kind of interest rate, for a
particular notional amount.

Mechanism of an Interest Rate Swap:

Take the case of an interest rate swap, in which Counter Party A and Counter Party B agree
to exchange over a period of say, five years, two streams of semi-annual payments. The
payments made by A are calculated at a fixed rate of 6% (Fixed rate) per annum while the
payments to be made by B are to be calculated using periodic fixings of 6-month Libor
(floating). The swap is for a notional principal amount of USD 10 million. The above swap is
called the "plain vanilla" or the "coupon swap". Interest rates are normally fixed at the
beginning of the contract period, but settled at the end of the period.

Typical Characteristics of the Interest Rate Swaps:

The principal amount is only notional.
Opposing payments through the swaps are normally netted.
The frequency of payment reflects the tenor of the floating rate index.

What is a Coupon Swap?

If an interest rate swap involves the swapping of a stream of payments based on the fixed
interest rate for a stream of floating interest rate, then it is called a coupon swap.

Counter parties to the Coupon Swap:

Payer of the fixed interest stream is called the Payer in the swap.
Receiver of the fixed interest stream is called the Receiver in the Swap.

What is a generic swap?

The term generic is used to describe the simplest of any type of financial instrument – plain
vanilla. So, a plain vanilla swap can be called a generic swap. Typically, generic swaps contain
the simple characteristics, such as a constant notional principal amount, exchange of fixed
against floating interest (coupon swap), an immediate start (i.e., on the spot date). A simple
coupon swap can be called a generic swap.

What is a Basis Swap?

Two streams of payments can be calculated using different floating rate indices. These are
called basis swaps or floating-against-floating swaps.
a. It is possible to enter into a swap with a 3-month Libor against a 6-month Libor.

b. It is also possible to enter into a swap with a 91-Day T-Bill Yield against a 6-Month Libor.  
Basis index swaps come under the classification of non-generic swaps.

Counterparties to a basis swap:

In a basis swap, each counter party is described in terms of both the interest stream it pays
and the interest stream it receives.

Asset Swap:
If in an interest rate swap, one of the streams of payments being exchanged is funded with
interest received on an asset, the whole mechanism is called the asset swap. In other words,
it is an interest rate swap, which is attached to an asset. It does not however involve any
change in the swap mechanism itself.

Asset swaps are used by investors. If an investor anticipates a change in interest rates, he can
maximize his interest inflow by swapping the fixed interest paid on the asset for floating
interest, in order to profit from an expected rise in interest rates.

Term Swaps
A swap with an original tenor of more than two years is referred to as a term swap.

What does an Interest Rate Swap do?

Interest rate swaps can be used to take on fresh interest rate risk as well as to manage
existing interest rate risk. Interest Rate swaps without offsetting underlying create interest
rate risk. : Each counter party in an interest rate swap is committed to pay a stream of
interest payments and receive a different stream of interest payments. A payer of fixed
interest rate payments is exposed to the risk of falling interest rates, while a payer of floating
interest rate payments is exposed to the risk of rising interest rates. Similarly, a receiver of
fixed interest rate payments is exposed to the risk of rising interest rates while the receiver
of floating interest payments is exposed to the risk of falling interest rates. To summarize,
interest rate swaps create an exposure to interest rate movements, if not offset by an
underlying exposure.

Interest rate swaps can be used to hedge interest rate risk:

Floating rate loans expose the debtor to the risk of increasing interest rates. To avoid this
risk, he may like to go for a fixed rate loan, but due to the market conditions and his credit
rating, his fixed rate loans are available only at a very high cost. In that case, he can go for a
floating rate liability and then swap the floating rate liability into a fixed rate liability. He can
do the swap with another counter party whose requirements are the exact opposite of his or
, as is more often the case, can do the swap with a bank.

Interest Rate Swaps in India:

With a view to deepening the money market and also to enable banks; primary dealers and
all-India financial institutions to hedge interest rate risks, the Reserve Bank of India has
allowed scheduled commercial banks, primary dealers and all-India financial institutions to
make markets in Interest Rate swaps from July 1999. However, the market which has taken
off seriously so far, is the one based on Overnight Index Swaps(OIS). Benchmarks of tenor
beyond overnight have not become popular due to the absence of a vibrant inter bank term
money market. The NSE publishes MIBOR(Mumbai Interbank Offered Rate) rates for three
other tenors viz., 14-day, 1month and 3 month. The other longer tenor benchmark that is
available is the yield based on forex forward premiums. This is called MIFOR(Mumbai
Interbank Forward Offered Rate). Reuters published 1m,3m,6m 1yr MIFORs are the market
standard for this benchmark.

BENCHMARK
MIBOR (Mumbai Interbank Offer Rate)
It is the benchmark rate for the call money market, interest rate swaps, forward rate
agreements, floating rate debentures and term deposits. MIBOR rate is available for
overnight, 14-day, 1-month and 3- months.

MIFOR
MIFOR means the implied Forward Rupee rate for a period greater than 1 day (which is
MITOR). Hence, 6M MIFOR is the (1+ 6 month Forward Premia) X (1 + 6M USD LIBOR) – 1.
6M MIFOR rates are polled by Reuters every day. The floating rate and the fixed rate is reset
6 months before settlement date, I.e. the 2 counterparties know their cash flows that they
would exchange after 6 months. On every settlement date, the floating rate is set for the
next settlement date at the 6M Reuters MIFOR rate prevailing on that day.

INBMK
This benchmark is gaining popularity in recent times. INBMK is an acronym for Indian
Benchmark rate published by Reuters. This effectively presents a yield for government
securities for a respective tenor

INBMK
In a INBMK Swap, the floating rate is decided as the 1 YR GOI yield on the reset date. INBMK
refers to the page on which the GOI yields are quoted daily by Reuters, hence they have
been named INBMK swaps. Also, by convention, the floating GOI tenor is taken as 1 year GOI
yield as it appears on Reuters page 0#INBMK= prevailing 1 day prior.

INBMK (GOI) Swap

The floating rate is reset annually before settlement date, I.e. the 2 counterparties know
their cash flows that they would exchange after 12 months
On every settlement date, the floating rate is set for the next settlement date at the Reuters
1year interpolated 0#INBMK= bid yield prevailing 1 day prior

Definition and Mechanism of Overnight Index Swap:

The Overnight Index Swap (OIS) is an INR interest rate swap where the floating rate is linked
to an overnight inter bank call money index. The swaps will be flexible in tenor i.e. there is no
restriction on the tenor of the swaps. The interest would be computed on a notional
principal amount and settled on a net basis at maturity. On the floating rate side, the interest
 amounts are compounded on a daily basis based on the index. At the moment, the NSE O/N
Mibor is the most widely used floating rate index, the Reuters O/N Mibor being the other
used.

The following definitions are provided for educational purposes only. They are not in any way meant to
serve as legal or official definitions, nor are they meant to serve as standard market definitions. In
practice, terminology can differ across firms and across market segments.

1. What is a derivative?
2. Major derivative categories
3. How do privately negotiated (OTC) derivatives differ from futures?
4. Product description: Forward contracts
5. Definition: Trade date
6. Definition: Notional principal
7. Product description: Forward rate agreements (FRA)
8. Short-term interest rates: Libor
9. What is a swap?
10. Product description: Interest rate swaps
11. Risks associated with interest rate swaps
12. Suppose a client enters into an interest rate swap with a derivatives dealer to protect against rates
rising by locking in a fixed rate. Doesn’t that mean the dealer expects rates to fall? Otherwise, why
would the dealer take on the risk of losing money?
13. The value of an interest rate swap
14. Credit risks associated with swaps
15. What is the actual amount at risk in a swap?
16. Product description: Options
17. How do options differ from swaps and forwards?
18. Credit exposures associated with options
19. Is an option a form of insurance?
20. Product description: Interest rate options
21. Currency derivatives
22. Product description: Cross-currency swaps
23. What is a credit derivative?
24. Product description: Credit default swaps
25. What risks does do the parties to a credit default swap give up and what risks do they take on?
26. Product description: Total return swaps
27. What risks does do the parties to a total return swap give up and what risks do they take on?
28. Why is derivatives documentation (such as the ISDA Master Agreement) important?
29. Definition: Payment netting
30. Definition: Close-out netting
31. What is the status of an individual transaction under the ISDA Master Agreement?

Product Descriptions and some Frequently Asked Questions

1. What is a derivative?
A derivative is a risk transfer agreement, the value of which is derived from the value of an underlying
asset. The underlying asset could be a physical commodity, an interest rate, a company’s stock, a stock
index, a currency, or virtually any other tradable instrument upon which two parties can agree. An over-
the-counter (OTC) derivative is a bilateral, privately-negotiated agreement that transfers risk from one
party to the other.

2. Major derivative categories

Derivatives fall into two categories. One consists of customized, privately negotiated derivatives, which
are known generically as over-the-counter (OTC) derivatives or, even more generically, as swaps. The
other category consists of standardized, exchange-traded derivatives, known generically as futures. In
addition, there are various types of product within each of the two categories as described below.

3. How do privately negotiated (OTC) derivatives differ from futures?

First, the terms of a futures contract—including delivery places and dates, volume, technical
specifications, and trading and credit procedures—are standardized for each type of contract. For
swaps, the same characteristics are subject to negotiation by the parties to the contracts. Second,
futures contracts are always traded on an exchange, while swaps are traded on a bilateral basis. Third,
those who engage in futures transactions assume exposure to default by the exchange’s clearinghouse;
for OTC derivatives, the exposure is to default by the counterparty. Fourth, credit risk mitigation
measures, such as regular mark-to-market and margining, are automatically required for futures but
optional for swaps. Finally, futures are generally subject to a single regulatory regime in one jurisdiction,
while swaps—although usually transacted by regulated firms—are transacted across jurisdictional
boundaries and are primarily governed by the contractual relations between the parties. Various
products, including futures contracts and exchange-traded options, fall within the generic category of
futures, but all have the common characteristics described above. The definitions that follow refer
exclusively to privately negotiated (OTC) derivatives.

4. Product description: Forward contracts

A forward is a customized, privately negotiated agreement between two parties to exchange an asset or
cash flows at a specified future date at a price agreed on the trade date. Entering a forward contract
typically does not require the payment of a fee.

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5. Definition: Trade date
The trade date is the date on which the parties agree to the terms of a contract. The effective date is the
date on which the parties begin calculating accrued obligations, such as fixed and floating interest
payment obligations on an interest rate swap.

6. Definition: Notional principal

Notional principal, or notional amount, of a derivative contract is a hypothetical underlying quantity
upon which interest rate or other payment obligations are computed.

7. Product description: Forward rate agreements (FRA)

A forward rate agreement is a forward contract on a short-term interest rate, usually Libor, in which
cash flow obligations at maturity are calculated on a notional amount and based on the difference
between a predetermined forward rate and the market rate prevailing on that date. The settlement
date of an FRA is the date on which cash flow obligations are determined.

8. Short-term interest rates: Libor

Libor, which stands for London Interbank Offered Rate, is the interest rate paid on interbank deposits in
the international money markets (also called the Eurocurrency markets). Because Eurocurrency deposits
priced at Libor are almost continually traded in highly liquid markets, Libor is commonly used as a
benchmark for short-term interest rates in setting loan and deposit rates and as the floating rate on an
interest rate swap.

9. What is a swap?
A swap is a privately negotiated agreement between two parties to exchange cash flows at specified
intervals (payment dates) during the agreed-upon life of the contract (maturity or tenor). Entering a
swap typically does not require the payment of a fee.

10. Product description: Interest rate swaps

An interest rate swap is an agreement to exchange interest rate cash flows, calculated on a notional
principal amount, at specified intervals (payment dates) during the life of the agreement. Each party’s
payment obligation is computed using a different interest rate. In an interest rate swap, the notional
principal is never exchanged. Although there are no standardized swaps, a plain vanilla swap typically
refers to a generic interest rate swap in which one party pays a fixed rate and one party pays a floating
rate (usually Libor).

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11. Risks associated with interest rate swaps

Typically, a party entering a swap gives up (or takes on) exposure to a given interest rate. At the same
time, each party take on the risk—known as counterparty credit risk—that the other party will default at
some time during the life of the contract.

12. Suppose a client enters into an interest rate swap with a derivatives dealer to protect against rates
rising by locking in a fixed rate. Doesn’t that mean the dealer expects rates to fall? Otherwise, why
would the dealer take on the risk of losing money?
The dealer’s view on interest rates does not matter. When the dealer assumes a client’s risk, the dealer
typically lays off—that is, hedges—that risk with an offsetting transaction. Suppose, for example, a
dealer enters into a swap in which the client pays a fixed rate to the dealer and the dealer pays a
floating rate to the client. The dealer could hedge the risk by entering into an offsetting swap with
another client or dealer. Or, it could take a Treasury security position with interest rate exposure that
offsets the swap. Or, it could take an offsetting futures position. Over the entire portfolio some risks
might be uncovered at various times—which is essential to the existence of a liquid market—but such
risks are carefully monitored and controlled by dealers.

13. The value of an interest rate swap

The value of an interest rate swap to a counterparty is the net difference between the present value of
the payments the counterparty expects to receive and the present value of the payments the
counterparty expect to make. At the inception of the swap, the value is generally zero to both parties,
and becomes positive to one and negative to the other depending on the movement of interest rates.
Present value is the value of a quantity to be received in the future, adjusted for the time value of
money (interest foregone while waiting for the quantity).

14. Credit risks associated with swaps

Loss on a swap occurs if two things happen: First, the counterparty must default; and second, the swap
must have a positive value to the party that does not default. The amount of the loss depends on the
credit exposure of the swap.

15. What is the actual amount at risk in a swap?

The credit exposure of a swap is the amount that would be lost if default were to occur immediately.
Credit exposure is generally equal to the current market value if positive, and zero if current market
value is negative. Swap participants also calculate future exposures of swaps, which are potential
positive values during the life of the swap; future exposures are used to establish credit charges
(expected exposure) and credit limit usage (peak exposure).

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16. Product description: Options

An option is an agreement that gives the buyer, who pays a fee (premium), the right—but not the
obligation—to buy or sell a specified amount of an underlying asset at an agreed upon price (strike or
exercise price) on or until the expiration of the contract (expiry). A call option is an option to buy, and a
put option is an option to sell.

17. How do options differ from swaps and forwards?

In a forward or swap, the parties lock in a price (e.g., a forward price or a fixed swap rate) and are
subject to symmetric and offsetting payment obligations. In an option, the buyer purchases protection
from changes in a price or rate in one direction while retaining the ability to benefit from movement of
the price or rate in the other direction. In other words, the option involves asymmetric cash flow
obligations.
18. Credit exposures associated with options
For a buyer of an option, the amount at risk is generally the value (premium) of the option at default.
For the seller of an option, there is no credit exposure.

19. Is an option a form of insurance?

Options differ from insurance in that options do not require one party to suffer an actual loss for
payment to occur. In addition, the owner of an option need not have an insurable interest—such as
ownership in the underlying asset—in the option.

20. Product description: Interest rate options

In an interest rate option, the underlying asset is related to the change in an interest rate. In an interest
rate cap, for example, the seller agrees to compensate the buyer for the amount by which an underlying
short-term rate exceeds a specified rate on a series of dates during the life of the contract. In an interest
rate floor, the seller agrees to compensate the buyer for a rate falling below the specified rate during
the contract period. A collar is a combination of a long (short) cap and short (long) floor, struck at
different rates. Finally, a swap option (swaption) gives the holder the right—but not the obligation—to
enter an interest rate swap at an agreed upon fixed rate until or at some future date.

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21. Currency derivatives

A currency forward is a contract in which the parties agree to exchange cash flows in two different
currencies at an agreed upon date in the future. A cross-currency swap is essentially an interest rate
swap in which each side is denominated in a different currency. And a currency option is a contract that
gives the buyer the right, but not the obligation, to exchange one currency for another at a
predetermined exchange rate on or until the maturity date.

22. Product description: Cross-currency swaps

A cross-currency swap is an interest rate swap in which the cash flows are in different currencies. Upon
initiation of a cross-currency swap, the counterparties make an initial exchange of notional principals in
the two currencies. During the life of the swap, each party pays interest (in the currency of the principal
received) to the other. And at the maturity of the swap, the parties make a final exchange of the initial
principal amounts, reversing the initial exchange at the same spot rate. A cross-currency swap is
sometimes confused with a traditional FX swap, which is simply a spot currency transaction that will be
reversed at a predetermined date with an offsetting forward transaction; the two are arranged as a
single transaction.

23. What is a credit derivative?

A credit derivative is a privately negotiated agreement that explicitly shifts credit risk from one party to
the other.

24. Product description: Credit default swaps

A credit default swap is a credit derivative contract in which one party (protection buyer) pays an
periodic fee to another party (protection seller) in return for compensation for default (or similar credit
event) by a reference entity. The reference entity is not a party to the credit default swap. It is not
necessary for the protection buyer to suffer an actual loss to be eligible for compensation if a credit
event occurs.

25. What risks does do the parties to a credit default swap give up and what risks do they take on?
The protection buyer gives up the risk of default by the reference entity, and takes on the risk of
simultaneous default by both the protection seller and the reference credit. The protection seller takes
on the default risk of the reference entity, similar to the risk of a direct loan to the reference entity.

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26. Product description: Total return swaps

A total return swap is a agreement in which one party (total return payer) transfers the total economic
performance of a reference obligation to the other party (total return receiver). Total economic
performance includes income from interest and fees, gains or losses from market movements, and
credit losses.

27. What risks does do the parties to a total return swap give up and what risks do they take on?
The total return receiver assumes the entire economic exposure—that is, both market and credit
exposure--to the reference asset. The total return payer—often the owner of the reference obligation—
gives up economic exposure to the performance of the reference asset and in return takes on
counterparty credit exposure to the total return receiver in the event of a default or fall in value of the
reference asset.

28. Why is derivatives documentation (such as the ISDA Master Agreement) important?
Swaps and related OTC derivatives combine characteristics of loans with characteristics of traded capital
market instruments. On the one hand, each swap transaction creates a credit relationship between the
counterparties, the terms of which need to be negotiated and documented just as would the terms of a
traditional loan. But unlike a loan, the credit exposure is two-way and unknown at the inception of the
swap (see above, items 13 – 15). On the other hand, swaps are traded in the market and might involve
repeated interaction between two counterparties; renegotiation of credit terms for each transaction
would be costly and would act as a drag on trading activity. Consequently, market participants
developed the ISDA Master Agreement (click here for a history), which would contain the ‘non-
economic’ terms—such as representations and warranties, events of default, and termination events—
leaving counterparties free to negotiate only the ‘economic’ terms—that is, rate or price, notional
amount, maturity, collateral, and so on. Additional benefits of the ISDA Master Agreement include
provisions that facilitate payment netting and close-out netting.

29. Definition: Payment netting

Payment netting reduces payments due on the same date and in the same currency to a single net
payment.

30. Definition: Close-out netting

If a counterparty to an ISDA Master Agreement defaults, the close-out netting provisions of the ISDA
Master Agreement provide that offsetting credit exposures between the two parties will be combined
into a single net payment from one party to the other.

31. What is the status of an individual transaction under the ISDA Master Agreement?
In jurisdictions where close-out netting is enforceable, all transactions under the ISDA Master
Agreement constitute a ‘single agreement’ between the two counterparties instead of being separate
contracts. The confirmation of a transaction serves as evidence of that transaction, and each transaction
is incorporated into the ISDA Master Agreement.

Rupee Interest Rate Derivatives

Product development and rationalisation of accounting and risk reporting

 

PREFACE

The Reserve Bank of India has over time introduced guidelines on Interest rates derivatives products -
both over-the-counter (OTC) and Exchange traded. Since the permissible underlying and purpose, capital
requirement and accounting guidelines of OTC interest rate swaps differed substantially from those for
interest rate futures, the need was felt to do a detailed study on the prevailing regulations with a view
to harmonising these regulatory prescriptions. Accordingly, a Group was constituted to study issues
related to interest rate derivatives on an on-going basis, under order of DG (RM) on August 7, 2003. The
current Group was chaired by Shri G. Padmanabhan, Chief General Manager – Internal Debt
Management Department, Reserve Bank of India (currently Regional Director for Andhra Pradesh) with
the following objectives.

1. Evaluating the present regulatory framework for Interest Rate Derivatives and recommend steps
to rationalise the prevailing regulations

2. Highlight major issues which are acting as roadblocks in the development of interest rate
derivatives market and suggest a roadmap for the future.

The other members of the Committee are as follows:

Member Institution Name of the Person

Reserve Bank of India Shri Shyam Sunder

Reserve Bank of India Shri Amitava Sardar

Reserve Bank of India Shri K Damodaran

Reserve Bank of India Shri T Rabi Sankar

Reserve Bank of India Shri Indranil Chakraborty

External members co-opted into the Group

ICICI Bank Ltd Shri Neeraj Gambhir

J P Morgan Shri V Srinivasan

J P Morgan Shri Harish Aggrawal

The Committee had a series of meetings over the period from Sep 2003 to Nov 2003. The report is
structured in the following manner. Chapter I discusses the prevailing regulations on OTC / Exchange
Traded derivatives, highlighting the need for rationalisation. Chapter II details the key issues with the
existing regulatory framework and the need to harmonise regulatory requirements for various kinds of
products. Chapter III suggests definite measures to be taken in order to rationalise regulatory reporting
and ensuring uniform accounting and disclosure norms, while Chapter IV chalks out the roadmap for
future development of the interest rate derivatives market.

Table of Contents

  Page

 Chapter I 1-6

Existing products and regulation

 Chapter II 7-9

Issues with existing regulatory framework

 Chapter III 10-13

Recommendations

 Chapter IV 14-16

Road Map for development of Interest Rate Derivatives Market

Annex  

1. A framework for risk management for enabling banks to take i

trading positions in interest rate derivatives with linear pay offs

2. Monthly Return on Trading Derivatives Interest Rate Risk Positions Iii

3. Back-up for Return on Trading Derivatives Interest Rate Risk iv-vii

Positions

Chapter I - Existing Products and Regulations

Deregulation of interest rates, which helped in making financial market operations efficient and cost
effective, has brought to the fore a wide array of risks faced by market participants. To manage and
control these risks, instruments such as Forward Rate Agreement (FRA) and Interest Rate Swap (IRS)
were introduced in July 1999 which could provide effective hedge against interest rate risks.

1. Rupee interest rate derivative products

The Reserve Bank of India, vide its circular Ref. No. MPD.BC.187/07.01.279/1 1999-2000 dated July 7,
1999 had issued guidelines for Scheduled Commercial Banks (excluding Regional Rural Banks), primary
dealers and all-India financial institutions to undertake Forward Rate Agreements and Interest Rate
Swaps (FRAs/IRS) as a product for their own balance sheet management and for market making
purposes. Corporates were also allowed to use IRS and FRA to hedge their exposures.

Further, in June 2003, the Reserve Bank of India had issued guidelines to banks/primary dealers/FIs for
transacting in exchange traded interest rate futures. In the first phase, the Securities and Exchange
Board of India (SEBI) has decided to introduce anonymous order driven system for trading in Interest
Rate Derivatives (IRDs) on The Stock Exchange, Mumbai (BSE) and National Stock Exchange (NSE).

As a result of these initiatives, a number of derivative products have evolved in the domestic interest
rate market:

a. OTC Rupee Interest Rate Swaps

These are basically plain vanilla fixed to floating swaps where a market determined benchmark rate is
used as the floating rate. Due to the absence of a liquid term money market, several alternative floating
rate benchmarks have evolved:

o Overnight Index Swaps - Floating rate is usually the overnight call rate polled by NSE
(NSE MIBOR).

o MIFOR Swaps - Floating rate is the implied rupee interest rate derived from USD/INR
forward rates

o Swaps with floating rates linked to GOI Security yields

o Rupee Swaps with LIBOR rate based benchmarks

Since the July 1999 circular explicitly prohibited use of optionality features in the swap structures, most
of the innovation has been limited to use of alternative benchmarks.

a. Forward rate agreements (FRAs)

FRAs can be used to hedge the risk of a particular interest rate setting in a floating rate asset or liability.
FRAs can again be used with refernce to any floating benchmark rate.

b. Exchange Traded Rupee Interest Rate Futures

NSE introduced Interest rate futures in June 2003 as cash settled contracts. Currently there are three
types of contracts:

o Futures on 10-year Notional GOI Security with 6% coupon rate

o Futures on 10 year Zero coupon notional GOI Security

o Futures on 91 day Treasury bills

Contracts are available for maturities upto 1 year. At present the exchanges are using a Zero Coupon
Yield curve based methodology to arrive at the final settlement price of the contracts

1. Market Volumes

There has been a sharp increase in the volume of transactions in the IRS market during the current
financial year so far. Available data show that such transactions, both in terms of no of contracts and
outstanding notional principal amounts, rose from 9633 contracts amounting to Rs 2,42,983 crores as on
April 4, 2003 to 14,748 contracts for Rs 3,83,866 crores as on October 17, 2003. Though there has been
a significant increase in the number and amount of contracts, participation in the markets continues to
remain restricted mainly to select foreign and private sector banks and a PD. In a majority of these
contracts, NSE MIBOR and MIFOR were used as benchmark rates.

2. Regulatory framework for OTC Rupee Interest Rate Derivatives

a. Purpose

From commercial banks’ perspective, interest rate swaps may be entered into for one of three reasons:

o Customer transactions -The transactions with customers to hedge their (customers’)

interest rate risk.

o Balance sheet hedging - hedging an existing asset or liability on the books of the banks.
The underlying can be explicitly identified or can be derived (e.g. for hedging of ALM
mismatch).

o Proprietary trading/market making - where the bank deals as principal on its own
account with a view to make trading gains from interest rate movements.

a. Product Restrictions
Banks / PDs / FIs are allowed to undertake different types of plain vanilla FRAs / IRS. However, swaps
having explicit / implicit optionality features such as caps / floors / collars are not permitted. There are
no restrictions on the size and tenors of the FRAs / IRS.

b. Benchmark Rate

Parties are free to use any domestic money or debt market rate as benchmark rate, provided
methodology of computing the rate is objective, transparent and mutually acceptable to counterparties.

c. Reporting requirements

A specific fortnightly return on FRAs / IRS is prescribed by the Reserve Bank of India. This report reflects
the outstanding position on the fortnight ended and the trades entered during the fortnight. It discloses
information on the notional value of the deals, the tenors and the benchmarks used. However, this does
not give any risk indicators.

d. Capital Adequacy

The institutions are required to maintain capital for FRAs / IRS by converting the notional values at the
prescribed conversion factor based on the original maturity of the contracts.

e. Counterparty credit exposure

The institutions have to arrive at the credit equivalent amount for the purposes of reckoning exposure
to counterparty. For this purpose the participants may apply the conversion factors used for capital
adequacy. In case of banks / FIs, the exposure on account of FRAs / IRS together with other credit
exposure should be within single / group borrower limits as prescribed by RBI.

f. Risk Management & Internal Controls

In terms of risk management, the guidelines require prudential limits on swap positions arising on
account of market making activity. The FRAs / IRS undertaken by the banks should be within the
prudential limits set by their respective Boards / Management Committees for different time buckets.
Participants who can employ more sophisticated methods such as Value at Risk (VaR) and Potential
Credit Exposure (PCE) can do so.

Participants should provide for a clear functional separation of front and back offices relating to hedging
and market making activities. Similarly, functional segregation of trading, settlement, monitoring and
control and accounting activities should also be provided. The deals should be subject to concurrent
audit and result should be intimated to top management of the institution regularly. A document
detailing Product Policy and Internal Control System should be approved by the top management and
submitted to RBI.

g. Accounting & Disclosure Requirements

Transactions for hedging and market making purposes should be recorded separately. Trading positions
should be marked to market with changes recorded in the income statement. Transactions for hedging
purposes should be accounted for on accrual basis.

The institutions are required to disclose in their annual balance sheet various details of their FRAs / IRS
portfolio including the notional value, nature and terms of the swaps, credit risk concentrations, fair
value and market risk

h. Valuation

For valuation purpose the respective boards should lay down an appropriate policy to reflect the fair
value of the outstanding contracts.

i. Documentation

Participants could consider using ISDA documentation, as suitably modified to comply with the
guidelines for undertaking FRAs / IRS transactions and also in line with the changes suggested by RBI in
this regard.

1. Regulatory framework for Exchange Traded Interest Rate Derivatives for banks and FIs

With a view to enabling regulated entities to manage their exposure to interest rate risks, it was decided
to allow Scheduled Commercial Banks excluding RRBs & LABs (SCBs). In the first phase, such entities
were allowed to transact only in interest rate futures on notional bonds and T-Bills for the limited
purpose of hedging the risk in their underlying government securities investment portfolio.

a. Stock exchange membership

SCBs and FIs can seek membership of the F & O segment of the stock exchanges for the limited purpose
of undertaking proprietary transactions for hedging interest rate risk. SCBs and AIFIs desirous of taking
trading membership on the F & O segment of the stock exchanges should satisfy the membership
criteria and also comply with the regulatory norms laid down by SEBI and the respective stock exchanges
(BSE/NSE). Those not seeking membership of Stock Exchanges, can transact IRDs through approved F &
O members of the exchanges.

b. Settlement of trades

As trading members of the F&O segment, SCBs and AIFIs should settle their derivative trades directly
with the clearing corporation/clearing house. Regulated entities participating through approved F & O
members shall settle proprietary trades as a participant clearing member or through approved
professional / custodial clearing members. Broker / trading members of stock exchanges cannot be used
for settlement of IRD transactions.

c. Eligible underlying securities

At present, only the interest rate risk inherent in the government securities classified under the
Available for Sale and Held for Trading categories is allowed to be hedged. For this purpose, the portion
of the Available for Sale and Held for Trading portfolio intended to be hedged must be identified and
carved out for monitoring purposes.

d. Accounting

The Accounting Standards Board of the Institute of Chartered Accountants of India (ICAI) is in the
process of developing a comprehensive Accounting Standard covering various types of financial
instruments including accounting for trading and hedging. However, as the formulation of the Standard
is likely to take some time, the Institute has brought out a Guidance Note on Accounting for Equity Index
Futures as an interim measure. Till ICAI comes out with a comprehensive Accounting Standard, SCBs and
AIFIs may follow the above guidance note mutatis mutandis for accounting of interest rate futures also.
However, since SCBs and AIFIs are being permitted to hedge their underlying portfolio, which is subject
to periodical mark to market, the following norms will apply:

If the hedge is 'highly effective', the gain or loss on the hedging instruments and hedged portfolio may
be set off and net loss, if any, should be provided for and net gains if any, ignored for the purpose of
Profit & Loss Account.

If the hedge is not found to be "highly effective" no set off will be allowed and the underlying securities
will be marked to market as per the norms applicable to their respective investment category.

Trading position in futures is not allowed. However, a hedge may be temporarily rendered as not 'highly
effective'. Under such circumstances, the relevant futures position will be deemed as a trading position.
All deemed trading positions should be marked to market as a portfolio on a daily basis and losses
should be provided for and gains, if any, should be ignored for the purpose of Profit & Loss Account.
SCBs and AIFIs should strive to restore their hedge effectiveness at the earliest.

Any gains realized from closing out / settlement of futures contracts can not be taken to Profit & Loss
account but carried forward as "Other Liability" and utilized for meeting depreciation provisions on the
investment portfolio.

e. Capital adequacy

The net notional principal amount in respect of futures position with same underlying and settlement
dates should be multiplied by the conversion factor prescribed by RBI to arrive at the credit equivalent.
The credit equivalent thus obtained shall be multiplied by the applicable risk weight of 100%.

f. ALM classification

Interest rate futures are treated as a combination of a long and short position in a notional government
security. The maturity of a future will be the period until delivery or exercise of the contract, as also the
life of the underlying instrument. For example, a short position in interest rate future for Rs. 50 crore
[delivery date after 6 months, life of the notional underlying government security 3½ years] is to be
reported as a risk sensitive asset under the 3 to 6 month bucket and a risk sensitive liability in four years
i.e. under the 3 to 5 year bucket.

g. Disclosures

The regulated entities undertaking interest rate derivatives on exchanges may disclose as a part of the
notes on accounts to balance sheets various details as per the attached RBI circular.

h. Reporting

Banks and Specified AIFIs should submit a monthly statement to DBS or DBS (FID) respectively as
specified in the circular.

Chapter II - Issues with Existing Regulatory Framework

The regulations for exchange traded interest rate derivative contracts were introduced much later
compared to those for OTC IRS/FRAs. There are significant differences in the regulatory framework for
both kinds of products even though both represent the same family of derivative contracts i.e. - linear
pay -offs with regard to the underlying.

At the same time, due to increase in market volume of IRS, there is a need to comprehensively review
the regulatory reporting for these contracts as existing reporting framework does not adequately
disclose the risk being carried by market players.

Consequently, there is a need to harmonise the regulatory and reporting framework for both OTC and
Exchange traded products. The following sections elaborate upon the issues with regard to the
regulatory and reporting framework.

1. Type of transactions

While the guidelines for IRS/FRA allow various entities to undertake both hedge as well as market
making/trading transactions, the guidelines for IRF contracts allow only hedging of AFS and HFT portfolio
of GOI Securities. Specifically, trading positions in IRF contracts are not allowed for commercial banks.
Also while IRS can be entered into to hedge both assets and liabilities by the banks, the IRF can only be
used to hedge GOI Securities portfolio under AFS and HFT category.

Both these products reflect the same kind of risks since both represent linear pay-offs on the underlying
and hence the regulatory framework for both IRS and IRF should be symmetrical.

2. Regulatory Reporting

Current guidelines require the participants to report, as per the pro forma indicated in the RBI circular,
their FRAs / IRS operations on a fortnightly basis to Adviser-in-Charge, Monetary Policy Department,
Reserve Bank of India, with a copy to respective RBI departments. The said report captures only the
volumes and the outstanding deal values with the benchmarks, but does not capture the interest rate
risk arising from such activities. In case of Exchange Traded Interest Rate Derivatives, the specific return
is required on monthly and basis.

Returns of IRS/FRAs transactions require the entities to report the number of contracts and the notional
amount of deals executed during the period as well as outstanding as at the end of the period
aggregated based on the benchmarks / underlying interest rate exposures. This report is a good
indicator on the market volumes, however, the current reporting format captures only a segment of the
total interest rate exposure of the participants and does not give an integrated view of the interest rate
risk faced by the participant across asset classes and products. So far as the returns on Interest rate
futures are concerned, since the banks can undertake only hedging transactions, the reporting format
concentrates only on the hedge effectiveness reporting.

3. Credit exposure and capital for credit risk

Recently, there has been a revision in the guidelines on credit exposure norms for all the derivative
products. The new recommendation is to follow current exposure method. However, for capital
adequacy purposes, the original exposure method is still being followed.

Further, there is no prescribed methodology for disclosing credit risk in the balance sheet in case of
IRS/FRA.

Also, currently 100% risk weight is specified for the clearing agencies like CCIL, NSCCL and BOI Clearing
house. This needs to be reviewed.

4. Capital for market risk

Banks currently do not have to provide capital for market risk except for 2.5% risk weight on all
investments. Given the volatility in the derivatives market, particularly in the MIFOR linked swap
segment, it is appropriate to consider market risk charge on the derivatives portfolio. In this regard RBI is
considering a transition from the current 2.5% risk weight based market risk charge to BIS duration/
maturity bucket mapping based capital adequacy requirements.

It is imperative that the banks which are desirous of playing a more active role in derivatives segment in
the form of running trading book should be subject to a more robust and strict capital adequacy
computation methodology .

5. Demand and Time Liabilities

The valuation of FRAs/ IRS / IRFs results in unrealised gains / losses on the balance sheet of the entity on
the date of valuation. The guidelines are silent on the treatment of the same for the purposes of
regulatory reporting involving the computation of demand and time liabilities of the banks which has a
bearing on the determination of the cash reserve requirement, statutory liquidity requirement and
assets in India. In absence of specific guidelines, there are different treatments being followed by
various market participants.
 

6. Accounting and Disclosure

Trading positions are required to be marked to market. However, the accounting of unrealised gains /
losses on these positions is not clarified i.e. whether the gains should be accounted for on a deal by deal
gross basis or on a net portfolio basis. This has resulted in different accounting practices in the market.

Further, in case of trading portfolio of securities, RBI has prescribed to account for net depreciation, and
ignore net gains. Since rupee interest rate derivatives, in terms of risk are similar to rupee securities
portfolio, to have consistency in accounting, some market participants follow similar basis of accounting
for their trading positions in FRAs / IRS and account for the mark to market on a net basis, ignoring the
unrealised gains.

To be able to qualify for hedge, strict rules have been specified for Interest rate futures transactions.
However, no such methodology is specified for IRS/FRAs. Further the accounting treatment for IRFs is
dependent upon whether the hedges are effective or ineffective. No accounting rules have been
prescribed for trading transactions for commercial banks since they are not allowed to run trading
books.

Disclosure of the notional value of the interest rate swaps outstanding under ‘Contingent Liabilities’ on
the balance sheet, leads to a portrayal of unrealistically large size of such liabilities. In most of the
interest rate swaps, there is no exchange of principals involved; hence the notional value does not
reflect the true contingent liability of the bank. The contingent liability is better captured by the
replacement cost of the contracts.

In addition to the above-mentioned regulatory issues, the committee also discussed a few other issues,
which were hindering the growth of these markets.

Close out Netting of transactions for OTC contracts

In absence of the netting arrangements, the banks compute credit exposure on transaction-to-
transaction basis. This results in large counterparty credit exposures even if the transactions are of
offsetting nature with the same counterparty.

Valuation and termination of transactions

There is a lack of standardisation in terms of computation of mark to market values of transactions.

Some participants do the same on YTM basis while in others use zero coupon methodology. A
standardised methodology for computing the close out value would go a long way in promoting
transparency and widening participation.
Product Design of Exchange Traded IRFs

The existing product design of exchange traded IRFs relies upon ZCYC for determining the settlement
and daily mark-to-market amounts. It was observed that this methodology resulted in large errors
between ZCYC and underlying bond yields resulting in large basis risk between futures and underlying
prices. The committee observed that the product design needs to be improved so that the basis risk
between the cash and derivatives can be reduced.

Chapter III - Recommendations

The committee, based on its deliberations on the issues specified in the previous chapter, arrived at
several suggestions to harmonise the regulatory framework for interest rate derivatives. The suggestions
mentioned here are with regard to the trading portfolios of the banks, and do not cover the banking
book.

1. Trading permission for Interest rate derivatives

The committee felt that banks having adequate internal risk management and control systems and
robust operational framework could be allowed to run trading positions across various interest rate
derivatives including interest rate futures. The committee evolved a check -list of the conditions
(specified in Annex 1) required to be met by the banks based on which such permissions can be granted.
Since the banks are already permitted to undertake trading positions in IRS/FRA, it is suggested that the
requirements specified in the check-list mentioned above need to be adhered to by these banks on a
time-bound basis.

2. Regulatory reporting

In order to measure the interest rate risk arising from the banks’ trading activities from rupee interest
rate products (both cash and derivatives), the committee proposes a comprehensive risk report. The
format of the report is given in Annex 2. This report focuses on BPV (basis point value - the change in the
value of the portfolio due to a 1 bps change in interest rates) of the positions as key risk indicator of
various trading positions.

This report includes all rupee trading positions including bonds, Interest rate futures and Interest rate
swaps based on various benchmarks.

MIFOR based Interest rate swaps, although are rupee derivatives, but they carry Libor interest rate risk.
So to enable the assessment of correct interest rate risk picture, it is proposed to report the entity’s
rupee currency interest rate derivative trading portfolio also.

Also attached in Annex 3 is the format in which the banks may monitor their BPV risks within each
portfolio based on maturity buckets. This is an indicative format and each Bank is free to devise their
format to be able to report to Reserve Bank of India the summary BPV report.

 
 3. Internal Limits set-up

With the introduction of this interest rate risk report, the entities are expected to use BPV values for
setting up of prudential risk limits and get them approved by their respective Boards. The committee,
however, does not recommend any particular way of setting up of risk limits. The committee felt that
banks should be allowed to adopt any approach (including VaR, BPV or stop loss based) for setting up of
risk limits on their trading portfolios as long as the limits adequately capture the risk on said portfolios.
Further, these limits could be set up at any level of aggregation i.e. portfolio based or product based
depending upon the organisation structure of various entities. However, the committee felt that these
limits should be approved by ALCOs/Risk Management committees/Boards.

4. Accounting

To ensure uniformity in accounting of various classes of interest rate products, the committee examined
various guidelines in this regards. It may be noted that there is no specific accounting standard issued by
the Institute of Chartered Accountants of India (ICAI) on accounting of interest rate derivative products.
However, the guidance Note on Accounting for equities index futures issued by the ICAI recommends
accounting for anticipated losses and ignoring the gains, on a ‘net’ basis.

The above is contradictory to FASB 133 and IAS 39, which prescribes the gain or loss on a derivative
instrument shall be recognised in earnings (profit and loss account).

The current RBI guidelines for accounting of trading portfolios of various interest rate products are
summarised as under:

Securities Trading Portfolio: The individual scrips are required to be marked to market. The unrealised
gains on HFT portfolio are ignored whereas unrealised losses are taken into account.

Trading FRAs / IRS - Trading positions are required to be marked to market with changes recorded in the
income statement. However, since these guidelines were issued prior to the guidelines for cash market
products, some market players are using the same accounting methodology as prescribed for cash
market products i.e. ignore the MTM gains whereas account for MTM losses.

Trading portfolios for exchange Traded IRFs - Banks are not allowed to run trading positions in IRFs.
However, PDs who can run a trading book, have been advised to mark to market the positions and
record the gains / losses in the Profit and loss account.

It may be noted that as per the US GAAP, securities held as trading securities are reported at fair value,
with unrealised gains and losses included in earnings.

It is recommended to follow mark to market for all interest rate products undertaken for trading
purposes including bonds. While it is understood that ICAI is not in favour of accounting for unrealised
gains, the committee recommends that the resultant unrealised gains / losses are taken to profit and
loss account for trading portfolios. The unrealised gains and losses (UGL) on derivative contracts should
be recorded on the balance sheet as an asset or liability.
In the general ledger, the unrealised gains / losses arising from mark to market of trading positions may
be recorded in a separate account ‘Unrealised Trading gains/losses - Interest Rate Derivatives’. On
settlement of the interest payments on fixing dates, the net payments may be accounted under
‘Realised Trading gains / losses – Interest Rate Derivatives’. In the ‘Profit and Loss Account’, the gains /
losses from derivatives transactions may be reflected under the Schedule of 'Other Income' as a
separate line item – 'Net profit / (loss) on derivatives transactions'.

Hedge accounting

The circular on Interest rate swaps has not specified any particular hedge accounting norms except for
the stipulation that the accounting treatment for the hedge should be similar to that of the underlying
asset/liability. No particular hedge effectiveness test has been recommended to qualify for hedge
accounting. However, the IRF guidelines stipulate such a test for fair value hedges. No suggestions have
been made for cash-flow hedges since the underlying permitted to be hedged are only HFT/AFS portfolio
of GOI securities which are subject to mark to market requirements.

In order to harmonise the accounting treatment of IRS and IRFs, there are two alternatives:

1. Introduce the hedge effectiveness test for IRS hedges for future transactions. This would
necessitate laying down guidelines for cash flow hedges for both IRS as well as IRFs. This would
enable eligible underlying for IRFs to be all interest rate risk sensitive asset / liability of the
balance sheet.

2. To relax the IRF guidelines by removing the hedge effectiveness requirements.

The committee also recognised the fact that while RBI may specify selective accounting treatments for
derivatives, it is recommended that a comprehensive derivatives accounting standard should be
adopted by ICAI. Such a standard should be made applicable to all market participants including
corporates to bring about uniformity in accounting treatment and balance sheet disclosures.

Netting in Accounting

It is a general principle of accounting that the offsetting or netting of assets and liabilities in the balance
sheet is inappropriate, except where a right of setoff exists. US GAAP FASB Interpretation (FIN) no. 39,
offsetting amounts related to certain contracts, defines the right of setoff and specifies conditions that
must be met to permit offsetting. In a nutshell, all of the following criteria must be met in order to
qualify for offsetting:

o Each of two parties owes the other determinable amounts

o The reporting party has the right to set off

o The reporting party intends to set off

o The right of set off is enforceable at law

It is recommended that the unrealised gains and losses from Derivatives contracts must be recorded
gross in the balance sheet, unless the criteria of netting are met or the contracts are executed with the
same party under a legally enforceable master netting arrangement.

1. Risk weight for exposure on clearing agencies

The committee recommends reduction in risk weight for exposures on clearing agencies like CCIL,
NSCCL, BOI Clearing house to 20% from existing 100%. The rationale for this recommendation is the fact
that they act as central counterparties using multilateral netting/novation and have robust settlement
guarantee funds/systems which greatly reduces the counterparty risk.

2. Demand and Time liabilities

Although, it is recommended to adopt gross accounting method for unrealised gains / losses on the
balance sheet, for the purposes of computing demand and time liabilities (DTL), the committee
recommends use of net unrealised gains / losses under trading portfolio arising from all rupee interest
rate derivative products. Net unrealised losses, if any, represent a credit exposure of others on the bank
and hence may be taken to 'Other Liabilities'.

Similarly in Form X (statement of assets and liabilities), net unrealised losses will be taken under
liabilities arising in India and net unrealised gains would be considered as ‘assets in India’.

3. ALM Classification

For trading portfolio, the net unrealised gain / losses outstanding on the balance sheet may be reported
as inflow / outflow in the first time bucket in ‘Structural Liquidity Statements’.

4. Balance sheet disclosures

The committee felt that the disclosure of derivative transactions on the balance sheet should be linked
to the market and credit risk on these transactions rather in addition to the gross notional value of the
transactions. Accordingly the guidelines could be modified to only report market risk (as measured by
BPV) and credit risk (as mentioned above) for each product used under trading portfolios.

Chapter IV - Road Map for Development of Interest Rate Derivatives Markets

There has been secular growth in the market volumes of OTC interest rate derivatives in the recent past.
It is expected that the harmonisation of regulatory regime and redesign of IRF products will further
provide fillip to the interest rate derivatives market in India. Simultaneously, the sophistication and
understanding of market participants about these products has grown. Consequently, market
participants have been requesting RBI for allowing greater flexibility in terms of structure and array of
products.
Accordingly, the committee makes the following recommendations with regard to further development
of Rupee interest rate derivatives:

1. Introduction of Rupee interest rate option products

Rupee Interest rate swaps were introduced in July 1999. Since then the market has gained significant
depth in terms of traded volumes and number of active participants. Increasingly a number of players
including Primary dealers and corporates have started using Rupee interest rate derivatives for
management of interest rate risk and for trading purposes. The committee felt that with a view to
further enhance the spectrum of available products for hedging of interest rate risk, interest rate option
products should be introduced in the market. These products could take the following forms:

a. Swaptions

Vanilla Payers and receiver’s options on liquid swaps like OIS and IRS with MIFOR benchmarks could be
introduced as a first step.

b. Options on interest rate benchmarks i.e. caps, floors etc

Vanilla caps and floors on liquid money market benchmarks like MIBOR, MIFOR, 91 day T-Bill rates
should be introduced in the first stage.

c. Optionalities in swaps

The July 1999 circular prohibits use of optionalities in interest rate swaps. It is recommended that once
the OTC interest rate options like caps and floors are allowed, the same may be permitted to be
embedded in the IRS contracts.

d. Exchange traded Options on Interest rate futures

At present the exchange traded interest rate futures are not very liquid. To address the situation,
FIMMDA has recommended a revised product design. In addition, the product is likely to become liquid
once banks are allowed to run trading books in interest rate futures. As a second stage of development
of exchange traded interest rate derivatives, exchange traded options on underlying benchmarks or on
futures themselves should be considered.

1. Physical settlement of interest rate futures

At present, interest rate futures are traded on the basis of cash settlement. Since the notional
underlying in the case of these futures are hypothetical securities like a notional 10 year coupon bearing
bond or a notional 91 day T-bill, to some extent the settlement prices are essentially theoretical. This
can lead to situations whereby, the futures trade at significant basis as compared to the cash markets.
To ensure that futures reflect true expectations about the evolution of cash market, physical settlement
should be introduced .

2. Short selling in cash markets

The derivative pricing models including those for options, futures and swaps assume that it is possible to
replicate the derivatives pay-offs in the underlying cash market in order to hedge the derivative
positions. At present, while it is possible to take two-way positions (i.e. both long and short) in FX
markets, the same is not true for GOI Securities and Corporate bonds. It could be argued that one
reason for non-development of GOI Sec yield based swap benchmarks is the lack of hedging ability in
case of certain structures since short-selling in these securities is prohibited. To provide for better price
discovery of derivatives, it is recommended that allowing short-selling in GOI Securities should be
considered with adequate checks and balances in place. Accordingly, short selling could be allowed in
two phases:

a. In the first phase, banks could be allowed to hedge derivatives positions by short selling
in the cash segment.

b. Based on the experience gained, the facility of short selling could be extended without
any reference to derivative positions in the second phase.

3. Close-out netting - legal framework

At present, close out netting is not possible in case of derivative contracts. It may be noted that in the
absence of close-out netting, banks calculate the counterparty exposure on trade-by trade gross basis
not withstanding the fact that there may be offsetting transactions with the same counterparty. This
leads to high utilisation of counterparty limits and restricts the liquidity in the interbank OTC derivatives
market. The group, therefore, recommends that RBI should pursue necessary legal changes to allow
close-out bilateral netting.

4. Multilateral netting using CCIL

While bilateral netting is an efficient way of ensuring optimisation of counterparty credit limits,
Multilateral netting with a central counterparty is an efficient way of ensuring that banks have
exposures on a sound counterparty. To manage the risk out of multilateral netting, the central
counterparty usually maintains a settlement guarantee fund by imposing margins on the transacting
counterparties using multilateral netting facility. It is recommended that CCIL should be encouraged to
evaluate the feasibility of multilateral netting in OTC derivative contracts like IRS.

Annex 1

A framework for risk management for enabling banks to take trading positions in interest rate
derivatives with linear pay offs

The issue of enabling banks to take trading positions in exchange traded interest rate derivatives has
been raised by individual banks as well as FIMMDA in various fora. The issue also needed to be relooked
with a view to impart liquidity to exchange traded interest rate futures segment as banks are one of the
major providers of liquidity in the cash markets of government securities. Also in view of the fact that
Primary Dealers have already been allowed to run a trading position in IRFs , the issue of the banks
participating in the IRF segment was revisited by the Group . Whilst it is desirable that the market for
IRFs be as wide as possible so that liquidity in the segment gets enhanced, it is also felt that given the
volatility in the underlying cash markets , participants desirous of running a trading book should need to
fulfill some additional criteria .

To have a fix on the criteria , dealing rooms of some of the banks active in OTC derivatives segment was
visited.

A wide disparity in terms of skills as well as infrastructure among participants active in OTC derivatives
was observed while visiting the dealing rooms. It was also felt by the group that a minimum
infrastructural needs have to be maintained in order to run a trading book in derivatives. According to
the group the following issues need particular attention:

1. Fixation of product/portfolio wise risk limits (PV01/ ALM) and counterparty wise exposure limits.

2. Robust mid office systems to monitor interest rate risk exposure on an ongoing basis.

3. Documentation of product specific risk management guidelines, documentation of limits.

4. Appropriate exception reports for MIS/ control purposes.

While the Group notes that there have been alternative models for capturing the interest rate risks, it is
of paramount importance that such risks be monitored on a real time basis. None of the banks, the
group visited has yet set up infrastructure for trading in the exchange traded derivatives. The exchange
traded derivatives require certain additional infrastructural requirements like availability of trading
screen (proprietary / broker), allocation of trading limits on the trading terminals , online monitoring of
the order book, margins account oversight by mid as well as front office etc. While most of the issues in
this regard can be satisfactorily resolved in case the entity is a member of the stock exchange. But in
case the entity trades through a broker account, satisfactory additional internal controls need to be put
in place for independent oversight by the mid office.

Based on the deliberations of the group, the entry point criteria in respect of running a trading book in
Interest Rate Futures are as follows:

1. CRAR of 10%

2. Minimum networth of Rs 200 crores

Banks satisfying the above criteria may apply for RBI’s consideration of granting them in principle
approval to run a trading book.

On receiving in principle approval the banks may revert to RBI on the following issues :
 1. Corporate interest rate risk limit ( in terms of loss in Rs crores on account of 100 basis point
parallel shift in the yield curve) for trading portfolio which may not exceed a certain proportion
of Tier I capital.

2. Board Policy on interest rate risk management

3. Clear definition of authority for setting, modifying, reviewing sub limits and periodicity of review
of limits

4. Control lines and responsibilities for interest rate risk management

5. Past experience in management of trading portfolio in IRS/FRAs, securities, fx options.

RBI can consider authorizing the entities to undertake trading positions in Interest Rate futures after
satisfying itself about the bank's capabilities to undertake the above activities and considering the
quality of internal and regulatory compliance.