INTEREST RATES

DERIVATIVES AND RISK MANAGEMENT

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AGENDA

Types of interest rates

Reference rates
The risk-free rate
Measuring interest rates
Zero Rates

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INTEREST RATES

Savings – Delayed Gratification – postponing consumption –compensation is interest rate

Opportunity cost and Risk
Interest rates are key component of valuation of all Derivative products
Cash flows are protected over time through use of derivative products ( interest rate value those cash flows)
Types of interest rates
Ways to measure interest rates
Continuous compounding
Bond pricing –yields
Forward rates and forward rate agreements
Theories of term structure

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TYPES OF INTEREST RATES
Borrower and Lender ( Exchange of cash flows at specified point in time “T”)
Excess cash paid over the initial amount is the interest payment
Mortgage (loan rate)
Deposit rates
REPO linked lending rates
One important factor influencing interest rates is “credit risk” – CIBIL scores, Rating scales.
CREDIT RISK : situation where the borrower does not pay the lender the dues on time
Higher the credit risk higher the interest rate charged by the lender
Credit Spread or Credit Risk Spread : The extra amount added to a risk free interest rate to allow for a credit
risk

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Rating Description
Securities with this rating are considered to have the highest degree of safety
CRISIL AAA regarding timely servicing of financial obligations. Such securities carry lowest
credit risk.
Securities with this rating are considered to have high degree of safety
CRISIL AA regarding timely servicing of financial obligations. Such securities carry very low
credit risk.

CRISIL A
Securities with this rating are considered to have adequate degree of safety
regarding timely servicing of financial obligations. Such securities carry low
credit risk.
RATING
CRISIL BBB
Securities with this rating are considered to have moderate degree of safety
SCALE
regarding timely servicing of financial obligations. Such securities carry
moderate credit risk.

Securities with this rating are considered to have moderate risk of default
CRISIL BB
regarding timely servicing of financial obligations.

Securities with this rating are considered to have high risk of default regarding
CRISIL B
timely servicing of financial obligations.
Securities with this rating are considered to have very high risk of default
CRISIL C
regarding timely servicing of financial obligations.
CRISIL D Securities with this rating are in default or are expected to be in default soon.
Source: https://www.crisilratings.com/en/home/our-business/ratings/credit-ratings-scale.html

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 Source: Axis Bank and State Bank of India Websites
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DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Friday, 19 April 2024 7

Source: State Bank of India

TYPES OF RATES
Treasury Rates Understanding fractional
Treasury rates are the rates an investor earns on treasury Reserve System
bills and treasury bonds
CRR
Issued by government to borrow in domestic currency SLR
Therefore, no risk of default
Interest rate on treasury is risk free rate Bank Rate
Repo
Overnight Rates
Reverse Repo
Excess balances exchanged between banks Standing Deposit Facility
Federal funds rate US FED
RBI Overnight rate (Liquidity Adjustment Facility LAF Instruments of Monetary
window) Policy
Operational targets
Short term interest rates

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TYPES OF RATES
https://www.fbil.org.in/#/home

Repo Rates
Repurchase Operation
Sell and buy back at a specified price and time in future
Asset ownership changes hands
But buyback is guaranteed
Underlying securities and market conditions determine rate
Overnight repo
Term repos also
Repo and
Reverse Repo
Standing deposit facility

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CALL RATES – MIBOR AND MIFOR
Fixed versus floating rate loans

Call money market

Unsecured lending – against the standing of the company/ bank
India –overnight market is the call money market
Weighted average call lending rate (WACR)
Corporates can participate as borrowers but not as lenders
MIBOR - Mumbai Interbank Offer Rate – LIBOR
Benchmark on which other products are priced
Mumbai Interbank Forward Offer Rate – MIFOR
For forex borrowings
LIBOR + corresponding forward premia derived from forex
markets
MIFOR only for bank
MIFOR discontinuation

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 CBLO _ COLLATERALIZED BORROWING AND LENDING OBLIGATION

CBLO is unique to India by CCIL

Lending based on approved securities as underlying – derivative debt instrument
CBLO offers better flexibility compared to repo in terms of prepayment, adjustment etc.
CBLO: mandatory requirement (obligation ) – CCIL
Tri Party repo – G-secs and Corporate Bonds: Repo – Haircut
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REFERENCE RATES What Is the LIBOR Scandal?
Reference interest rates are important in financial markets The LIBOR Scandal was a highly-
publicized scheme in which bankers at
The parties to transactions frequently enter into contracts where the several major financial institutions
future interest rate paid or received is uncertain but will be set equal to colluded with each other to manipulate
the value of an agreed reference interest rate the London Interbank Offered
Rate (LIBOR). The scandal sowed
distrust in the financial industry and led
LIBOR to a wave of fines, lawsuits, and
What is the unsecured interest rate that banks are willing to offer regulatory actions. Although the scandal
came to light in 2012, there is evidence
each other suggesting that the collusion in question
Whole spectrum of rates had been ongoing since as early as
2003.
New Reference Rates
Secured Overnight Financing Rate (SOFR) is a broad measure of https://www.investopedia.com/terms/l/
the cost of borrowing cash overnight collateralized by Treasury libor-scandal.asp
securities.
Longer tenures can be obtained by compounding overnight rates
Reference RATES and CREDIT RISK ( SOFR + Credit Spreads)

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THE RISK-FREE RATE

Recall Capital Asset Pricing Model and Optimal Hedge ratio

Ra = Rf + b(Rm-Rf)
Derive Risk free rates based on T-bills and other government
securities
Vs
Derive Risk free rates based on overnight lending
Capital and taxation rules
Overnight lending based computation

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MEASURING INTEREST RATES John C Hull Chapter 4

The compounding frequency defines the

units in which an interest rate is
measured
A rate expressed with one compounding
frequency can be converted into an
equivalent rate with a different
compounding frequency

A(1+R)n (yearly compounding)

A(1+R/m)mn (Compounding m times a year)
Conversion between two different compounding periods

AeRn (Continuous compounding)

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 ZERO RATES John C Hull Chapter 4

Zero Rates: The n-year zero coupon interest rate is the rate of interest earned on an investment that starts
today and lasts for n years without intermediate payments

0.05∗5
100 ∗ = 128.40

T is always in years ( need to convert – partial time frames)

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BOND PRICING John C Hull Chapter 4

Government of India security 8.22% GS 2026

•Maturity Date: January 11, 2026
•Coupon: 8.22%

• The Theoretical price of bond can be calculated

as the present value of all the cash flows that
will be received by the owner of the bond

• Single discount versus using Zero rates

Bond Yield : Is the single discount rate that when

applied to call the cash flows gives a bond price
equal to the market price

Par Yield: For a certain maturity is the coupon

rate that causes the bond price to equal its par
value.

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BOND PRICING
Bond Yield : Market price is given as 98.39 and the
semi annual coupon is ₹3, bond yield is ?
Is the single discount rate that when applied to call
the cash flows gives a bond price equal to the
market price ( 6.76%)
Par Yield: For a certain maturity is the coupon
rate that causes the bond price to equal its par
value. ( 6.87%)
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More generalized approach for Par yield
If d is the present value of the ₹ 1 received at
the maturity of the bond, A is the value of an
“Annunity” that pays one dollar on each
coupon payment date, and “m” is the number
of coupon payments per year, then the par
yield must satisfy
Friday, 19 April 2024 17
 DETERMINING ZERO RATES (BOOT STRAP METHOD)
Face Years to Annual Bond Bond Zero
Value Maturity Coupon ₹ Price ₹ Yield % Rates %
100 0.25 0 99.6 1.6064 1.603
100 0.50 0 99.0 2.0202 2.010
100 1.00 0 97.8 2.2495 2.225
100 1.50 4 102.5 2.2949 2.284
100 2.00 5 105.0 2.4238 2.416 John C Hull Chapter 4

Rates given in the last column (zero rates) are depicted as a function Interpolation
of maturity known as Zero Curve Polynominal or exponential
functions
A common assumption is that zero curve is linear between points – Cubic Spline
linear combination

1.25 year zero rate would be average of 1 year and 1.5 year values
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 CCIL Rupee Yield Curve (Zero Coupon Yield
Curve)
7.30000

7.15000

Zero Yield
7.00000

6.85000

6.70000
0.00 4.50 9.00 13.50 18.00 22.50 27.00 31.50 36.00 40.50 45.00 49.50
Years to Maturity

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FORWARD RATES
Forward rates are the rates of interest implied
by the current zero rates for the periods of time
R1 and R2 are zero rates for maturities
in the future.
T1 and T2 respectively and RF
(Forward rate) for period of time
between T2 and T1 is given by the
above formula, which can be re-written
as below

This shows that the if the zero curve is

upward sloping between T1 and T2 so
that R2> R1 then RF > R2 and if it is
downward sloping then RF < R2. As T2
approaches T1
This can be given as

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 FORWARD RATE AGREEMENTS
• Forward rate agreement (FRA) is an agreement to
exchange a “Predetermined “ FIXED rate for a
“REFERENCE” rate that will be observed in the
market at a “FUTURE” time.
• Both interest rates are computed on a “specified”
principal – only interest portions are exchanged.
• LIBOR used to be the reference rate
• Party A will pay 3% (fixed) and receive a 3-month
LIBOR (Reference rate) from Party B 2 years
(future date) on $100 million (specified principal).
• 2 years later LIBOR is 3.5%, Party B has to Pay
the differential interest to Party A.
• 100 * (3.5%-3.0)* 0.25 (quarterly compounding) =
125000
• Payment is due in next quarter i.e., from 2.25
years from contract
• FRA is a way of “locking” a rate that will be paid
or received in future
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• When fixed rate equals forward rate the
value of FRA is zero (no need to exchange)
• When a FRA if first set fixed rate is equal to
forward rate. Initial value is zero, and as
forward rate vary the value of FRA changes
• Rk = the fixed rate agreed to in the FRA
• Rf = the current forward rate for the reference
rate
• T = the period of time to which the rates apply
• L = the principal in the amount
• L*(Rk-Rf)*T
• Value for the party that receives
• Compare with FRA where RK=RF
• Present value of A is the value of FRA
• L*(Rf-Rk)*T (value for the party that pays)
• FRA can be valued by assuming that the
forward interest rate for the underlying
reference rate will be the one that determines
the exchange
Friday, 19 April 2024 21
• FRA timeline
 DURATION
• Duration of a bond is the measure of “How long” −
∑
B=
the holder of the bond has to wait before receiving •
the present value of the cash payments =1
−
∑ =1
• n-year Zero coupon bond payment is made after n • Duration D is defined as D =
years so the duration is “n”. −

∑ [ ]
• Whereas in others, say n- year semi annual bond
D=
• Periodic coupon payments ( half yearly for n •
years) =1
• This reduces the time taken to receive the present • The value in the square bracket is the ratio of
value of the bond the present value of the cash flow at time to
• In such cases duration d < n the Bond price. ( Functions as weight)

• Bond price B = Sum of discounted values of the • The bond price is the present value of the all
cash flows and the discount rate is called “Bond payments
Yield”
• The duration is therefore the weighted average
of the times when payments are made, with
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 DURATION (CONTD) Modified Duration
−
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Recall B = and D =
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=1 1+
• When small change in yield is considered ∆ it is
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−
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Dollar duration ∆ =− $ ∆ ; dollar value
=1
Bond Portfolios
• There is a “ Negative” relationship between bond prices
and yields. As yields (interest rates) increase bond Duration of bond portfolio can be defined as a
price falls vice versa weighted average of durations of individual bonds
with weights being proportional to bond prices
−
∑
∆ =− ∆
= Implicit assumption all yields change approximately
by same amount – parallel shift of curve
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 CONVEXITY Chapter 4 John C Hull

• Convexity tends to be greatest when the

portfolio provides payments evenly over a long
period of time, it is less when payments are
concentrated around one point in time
• The gradients of the two curves are same at the
origin- small changes similar results
• By choosing a portfolio with net zero duration
and convexity of zero, the bank can eliminate
• For large changes Portfolio X behaves differently
the risk of large parallel shifts in zero curve.
from that of Y owing to its higher curvature
(convexity)
• However it is still exposed to non-parallel Friday, 19 April 2024 24
shifts. AND RISK MANAGEMENT :: ACV SUBRAHMANYAM
DERIVATIVES
THEORIES OF THE TERM STRUCTURE OF INTEREST RATES
Structure of the ZERO Curve
( Downward and Upward slope)
Expectations theory
• Long term interest rates should reflect
expected future short-term rates
• Forward interest rate corresponding to a
certain future period is equal to the
expected future zero interest rate for that
period
Market segmentation theory
• Interest rate markets are segmented into
three types – short / medium and long
term
• Demand and supply in each segment
determines the interest rates
Liquidity preference theory
• Investors desire to preserve the “liquidity”
by investing in short period of time
• Borrowers on the other hand prefer to
borrow at fixed rates for long period
• Forward rates are greater than expected
future zero rates
• More upward sloping than downward Source: FBIL
sloping Friday, 19 April 2024 25
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MANAGEMENT OF NET INTEREST INCOME
• Net Interest Income of the Bank = Interest
received on assets ( loans) – interest paid on
liabilities ( deposits)

• Expectations are similar across time buckets

• 5 year deposit = reinvestment 1 year
deposit for 5 times (same with
borrowing)
• Deposits – Short term
• Advances – Long term fixed

Asset liability mismatch on bank’s balance sheet

• Impact on Net Interest Income
• Differential pricing of maturities and size
buckets
• Interest rate swaps manage risks

Liquidity Risks
• Wholesale versus retail funding
• Risk of loosing funding sources
• Concentration of deposits/ creditors
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