PRESENTATION

ON

RISK MANAGEMENT &

INTRODUCTION TO
DERIVATIVES
BY
B.Y.OLKAR
Former Chief Executive, FEDAI
RISK MANAGEMENT FRAMEWORK

• IDENTIFYING RISK. DEFINING RISK.

• MEASURING OF RISK. MODELS SUCH
AS “VAR”.
• MONITORING RISK.
• CONTROLLING RISK.
• PERFORMING EVALUATION.
 Value at Risk
• Value at Risk is a measure of the maximum
potential change in value of a portfolio of financial
instruments with a given probability over a pre-set
horizon.
• It answers the question : How much is the
maximum loss one can suffer with __ %
probability if the portfolio is held for __ period.
• Confidence level is used to define the probability
that the loss will not exceed the specified amount.
• An unwind period is assumed which represents the
minimum period required to liquidate the
portfolio.
 FEDAI Value at Risk (VaR) - Revised
Comparative Evaluation
Major Parameters Present Models Proposed (Revised)
Model
1. Confidence Level 97.5% 99.0%

2. Holding Period 3 days 3 days

3. Distribution Assumption Unconditional normality Empirical unconditional

distribution of residuals.
4. Back Testing Not done by FEDAI Back Testing provided for

5. Coverage of instruments/ USD/INR limited to three Wider coverage - $/Rupee

maturities maturities upto 6 months Spot, Forwards upto 1 year
& 10 major cross currency
pairs.
6. Computation of volatility Unconditional – uses EWMA – (Exponential
Standard Deviation Weighted Moving Average)
which implies more weight
as to recent data.
7. Based on volatility data for Latest 251 days data. Latest 500 days data.
 VaR Models
“VaR Model tells you how much you will lose on good days –
not on the one bad day”
[Ethan Berman, CEO,
Risk Metrics Group set up, J P Morgan]
1. Many models do not account for liquidity risk – (option
pricing models created by brilliant minds at LTCM
assumed continuous markets).
2. Assume that future will not be vastly different from
today. Assumptions are as good as the historical data fed
into them.
3. Take into account relatively short period, say 24 hours to
3 days to determine their potential trading losses.
4. Focussed on two or three standard derivatives world –
system breaks down when many more events fall outside
the two/three standard deviation.
5. More money lost than what models predicted.
 RISK MANAGEMENT
CONTROL MEASURES
• Internal inspection and audits.
• Review of systems and procedures.
• Monitoring compliance.
• Risk education.
• Comprehensive IT infrastructure for
reduction of human errors.
 Role of Risk Management :
Disaster Strikes !
1. Long Term Capital Mgmt [Leverage: spread
trading] $3.0 b.
2. Sumitomo [Copper mkt manipulation] $2.6 b.
3. Orange County (Citron) [Leverage: interest rate
speculation] $1.5b.
4. Barings (Leeson) [Unauthorised trading] $1.3 b.
5. Metallgesellschaft A.G. [Oil futures] $1.3b.
6. Daiwa Bank (Iguchi [Unauthorised trading] $1.1b.
7. Prudential securities [Misleading sale of
partnerships] $1.1 b.
 Role of Risk Management :
Disaster Strikes ! [cont.]
8. Hammersmith & Fulham counties [Disallowed
swap activities] c/p loss $1.0 b.
9. Askin Capital Group (Askin) [Mortgage-backed
securities] $600 m.
10. Deutsche Morgan Grenfell [Violation of
valuation guidelines] $600 m.
11. Kidder Peabody (Jett) [Unauthorised trading]
$350 m.
12. Salomon Brothers (Mozer) [Unauthorised
trading] $290 m.
13. West Virginia (Lester) [Interest Rate
speculation] $280 m.
14. Allied Irish Banks/All First (J.Rusnak) $690 mn.
 SMALLER DISASTERS
1. Merrill Lynch (Rubin) [Unauthorised trading]
$275 m.
2. Salomon Brothers [book-keeping errors] $200m.
3. Paine Webber [Misleading sale of partnerships]
$200 m.
4. Mellon Bank [Securities lending: interest rate
speculation] $200 m.
5. Nolderhoffer Investments [Thailand, S&P puts]
$100+m.
6. Salomon Brothers [Clerical error in program
trading] $100+m.
 SMALLER DISASTERS [cont.]
7. Procter & Gamble [Interest rate swap] $157 m.
8. First Cap. Strategists [Unauthorsied trading]
$128 m.
9. Natwest Markets [Interest rate swaps] $145 m.
10. Porugal’s central bank [Gold losses in Drexel
collapse] $100 m.
11. State of Wisconsin [Foreign interest rate
speculation] $95 m.
12. Gibson Greetings [Interest rate swap] $23 m.
 BARING BANK FAILURE
1. Baring Bank Established in 1762.
2. Barings set up derivative business in
Singapore to deal on SIMEX on account
of customers.
3. In 1992, Nick Leeson persuaded
management that he could generate “Risk
Free” profit by arbitraging stock index
future ‘NIKKEI 225’.
4. Nick Leeson controlled dealing as well as
backup.
BARING BANK FAILURE (Cont.)

5. Shown profits by manipulating accounts.

6. Management did not understand and did

not control risk.

7. Head office kept remitting margin money.

8. Bank failed due to huge losses.

 Allied Irish Banks (AIB)
Currency Fraud at its Baltimore Subsidiary
The Man : John Rusnak. (not a ‘star trader’).
Attempted to recoup money he had lost on
proprietary trading strategy.
Total losses stand around $690 mn. Wiping out 60%
of AIB’s 2001 earnings and significantly depleting
capital.
Sold number of deep in-the-money options for high
premium.
Arbitrage between FX options and spot & forward
markets: Buying options cheap and selling when
expensive.
1997 – incurred serious losses on forward deals
taking position on movement of JPY.
 Allied Irish Banks (AIB)
Currency Fraud at its Baltimore Subsidiary [cont.]
Created fictitious options positions to hide losses.
First option involved receipt of large premium and second one
involved identical amount payment. But first would expire the
same day; the second after several weeks. How can the premium
be same ? How no payouts on first option?
Exploited weaknesses in the controls.
Failure in back-office to obtain transaction confirmations.
Failure in back-office to check rates.
Manipulated VaR : (i) Bogus options appeared as ‘hedge’, (ii)
interferred directly with inputs into VaR calculation.
Senior Management in Dublin & Baltimore failed to pay enough
attention to All First’s propritary trading.
 LTCM – (Over-Leveraged Hedge Fund)
1. Founded in 1994. Managed by a dream team of
best brains in finance, including Nobel Laurets
and top investment bankers and former Vice
Chairman of Federal Reserve Board.
2. Being hedge fund, not regulated by SEC.
3. In 4 years built up assets close to $ 125 bn. –
Capital base $ 4 bn.
4. Off-Balance Sheet business = Notional principal
amount over $ 1 trillion.
5. Complex swaps, equity derivatives, total-return
swaps, index options, bets on take over targets.
Single default by LTCM would trigger cross
default on all trades.
 LTCM – (Over-Leveraged Hedge Fund)
[cont.]
5. Return on Equity :
1995     .. 47%
1996     .. 45%
1997     .. 17%
Even planning to handing back $ 3 bn. of capital to investors.
6. Exposures (mainly by way of loan)
Chase .. $ 3.2 bn. (13%)*
Morgan .. $ 0.9 bn. (8%)
Bankers Trust .. $ 0.875 bn. (17%)
Lehman Bms .. $ 0.447 bn. (8%)
BOA .. $ 0.400 bn. (1%)
Merrill Lynch .. $ 1.40 bn.
JPM/Goldman Sachs .. Not Disclosed
(figures exclude potential losses on derivatives)
* Approximate % to tangible equity.
Total Bank Exposure (both on and off Balance Sheet) $ 200 bn.
 LTCM – (Over-Leveraged Hedge Fund)
[cont.]
7. Investors lost 90% of their money in just two
months.
 
8. Original prospectus = It would employ “tons of
leverage and have a lot of volatility in earnings”
(Leverage was 40-60 to one)
 
9. Rescued by Banks in their own interest & by FED
to avoid systemic risk.
 
10. VAR Model failed to reveal the full inpact.
 RISK MANAGEMENT
1. Life is full of Risks.
2. If one buys a Lottery Ticket one hour before
draw, risk of dying before draw may be greater
than chance of winning first prize.
3. Risk management is not risk avoidance.
4. Risk management does not necessarily prevent
losses, but it ensures bank’s awareness of level
of risks.
5. One must bear in mind that no on can absolutely
guarantee that losses will not cross certain
threshold.
 SETTLEMENT RISK

1. Settlement Risk : Risk of incorrectly funding or

not receiving consideration.
2. Lesser understood and appreciated risk. Also
called as Herstatt Risk.
3. Herstatt Bank in Germany failed on 26 June 74.
Banking license was withdrawn after close of
banking hours. By then DEM payments were
received locally irrevocably. Correspondent
bank in N.Y. suspended payments in New York.
 BANK BORROWERS AT FLOATING AND
LENDS AT FIXED – Possible Impact on Spread
[Amount = Say, US$ 100 Mn.]

HALF Assured Interest Interest Spread

YEAR 6 Month Payments Receipts on (+) OR
LIBOR USD Mn. Loan at Fixed (-)
Rate 8% p.a.
USD Mn. USD Mn.

1. 6.00 % 3.00 4.00 1 (+)

2. 5.50 % 2.75 4.00 1.25 (+)
3. 7.50 % 3.75 4.00 0.25 (+)
4. 8.00 % 4.00 4.00 NIL
5. 9.00 % 4.50 4.00 0.50 (-)
6. 10.00 % 5.00 4.00 1.00 (-)
 INTEREST RATE SWAP – (PLAIN
VANILLA SWAP)
SITUATION Amount say, US$ 100 Mn.

I. ‘A’ is a Corporate
‘A’ has issued 3 year bond at Fixed Rate of 9%
‘A’ has lent funds at .. (LIBOR + 1%)

II. ‘B’ is a Corporate with an exactly opposite situation i.e. his income
is at Fixed Rate (9.25%) and payments are at a Floating Rate
(LIBOR).

PROBLEM
Mismatch in inflows and outflows in interest payments (Floating
v/s. Fixed)
 INTEREST RATE SWAP – (PLAIN
VANILLA SWAP) [cont.]

SOLUTION

INTEREST RATE SWAP WHERE

1. A pays Floating to B
2. A receives Fixed from B

III. An intermedium perceives the needs of both the

parties and brings them together.
 INTEREST RATE SWAPS –
(Plain Vanilla) - Example
RECEIVES (LIBOR + 1) RECEIVES FIXED 9.25%

Pays LIBOR to ‘B’

A B
Receives from ‘B’
Fixed At 8.5% P.A.

PAYS 9% FIXED PAYS LIBOR

 INTEREST RATE SWAPS –
(Plain Vanilla) – Example [cont.]
RESULT OF THE ARRANGEMENT

A’s Income (LIBOR + 1) + Fixed 8.5 B’s Income 9.25% + LIBOR

A’s Payment = Fixed 9% + LIBOR B’s Payment = LIBOR + 8.5%

I.E. LIBOR + 1 + 8.5% - 9% - LIBOR I.E. 9.25% + LIBOR – LIBOR

– 8.5%

NET SPREAD = (0.5%) NET SPREAD = (0.75%)

 INTEREST RATE SWAP (IRS)
1. Only interest payments on Notional amount are exchanged. The
principal amount itself is NOT exchanged.

2. One party pays floating Rate, the other party pays a fixed rate
(Typical Coupon Swap). Floating Rate Indexes used are :
LIBOR (in most US$ Swaps – about 75%), PRIME, CP Rate,
FED Funds Rate, T-Bill Rate.

3. Notional Principal amount and maturity are specific.

4. SWAP RATE i.e. fixed rate is quoted as spread over appropriate

maturity current coupon. Treasury payments on floating Rate
side are usually (but not always) made flat, i.e. at selected Index
Rate without spread.
Interest Rate Swap (IRS) [cont.]
Definition (IRS)

An Interest Rate Swap is a financial contract between

two parties exchanging or swapping a stream of interest
payments for a ‘notional principal amount on multiple
occasions during s specified period. Such contracts
generally involve exchange of a ‘fixed to floating’ or
‘floating to floating’ rates of interest. Accordingly, on
each payment date – that occurs during the swap period
– cash payments based on fixed/floating and floating
rates, are made by the parties to one another.
(RBI Guidelines)
 SWAP STRUCTURES
A 1. BULLET SWAP (PLAIN VANILLA SWAP)
|________________ (Notional amount does not vary)
| |
| |
| |
|________________|_______ T
A 2. AMORTIZING SWAP
|___ Notional principal amount decreases (in
| |_____ regular or irregular increments) over the
| |____ life of the swap.
| |
| |___
| |
|________________|_______ T
A = Notional Principal T = Time (No. of Year)
 SWAP STRUCTURES [cont.]
A 3. ACCRETING (APPRECIATING) SWAP
| ____ (Opposite of [2])
| ___| |
| ____| |
| __| |
|__| |
|________________|________ T
A 4. ROLLER COASTER SWAP
| ___ (Combination of 2 & 3)
|___ | | ___|
| | | | | |
| | | |___| |
| |___| |
|________________|______ T
A = Notional Principal T = Time (No. of Year)
 INTEREST RATE SWAP
(Comparative Advantage)
  FIXED RATE FLOATING RATE
 
‘X’ can Borrow @ 8.60% LIBOR
(Rating : ‘AAA’)
 
‘Y’ can Borrow @ 9.60% LIBOR + 0.50%
(Rating : ‘A’)
  
FIXED RATE FLOATING RATE
BORROWING BORROWING
 
8.85%

X SWAP Y
LIBOR
 INTEREST RATE SWAP
(Comparative Advantage) [cont.]
 
‘X’ Receives : 8.85% and PAYS : 8.60% + LIBOR
(Net Cost : LIBOR – 0.25%)
 
‘Y’ Receives : LIBOR and PAYS : 8.85% +
LIBOR + 0.50%
(Net Cost : 9.35%)
 
Both Save : 0.25%
 THE PRICING OF
INTEREST RATE SWAPS
Dealers quote LIBOR flat for a spread over US
treasury yield.
Example: 5-year swap quoted at 30-33, implying that
a pay-fixed side will pay 33-basis point over 5-
year treasury yield.

Floating Rates LIBOR (per cent)

6 month 3.5
6 month 3.5625
12 month 3.6875
 THE PRICING OF INTEREST
RATE SWAPS [cont.]
--------------------------------------------------------
Fixed Rates Spread (B.P.) Treasury Yield Swap Rate (%)

--------------------------------------------------------
2-year .18 - .21 4.09 4.27 – 4.30
3-year .31 - .35 4.57 4.88 – 4.92
5-year .30 - .33 5.50 5.80 – 5.83
7-year .34 - .37 6.03 6.37 – 6.40
10-year .35 - .38 6.53 6.88 – 6.91
 OPTION - Definition
AN OPTION
• GIVES THE HOLDER THE RIGHT
• BUT NOT THE OBLIGATION
• TO BUY OR SELL A SPECIFIC ASSET
• AT A PREDETERMINED (SPECIFIC) PRICE
• AT A CERTAIN FUTURE DATE OR TIME.
THE BUYER (OR HOLDER) OF THE OPTION
PAYS PREMIUM TO THE SELLER
THE SELLER (OR WRITER) HAS THE
OBLIGATION TO BUY OR SELL THE ASSET IF
THE BUYER (HOLDER) OF THE OPTION
EXERCISES HIS RIGHT.
 OPTION - Terminology
• Call/Put

• Volatility

• Strike Price

• American/European
OPTION – Terminology [cont.]
• Exercise
• Intrinsic Value
• Time Value
• Seller/Writer
• Buyer/Holder
• In the Money/At the Money/Out of
the Money
 DEFINITION
A “CALL” IS THE RIGHT TO “BUY” THE UNDERLYING ASSET.
 

BUY A CALL – LONG CALL 

 
CALL BUYER OR HOLDER BENEFITS FROM INCREASED PROFITS AS
MARKET PRICES RISE WITH THE POTENTIAL FOR UNLIMITED
PROFITS. IF PRICES FALL THE LOSS IS LIMITED TO THE PREMIUM
PAID FOR THE OPTION.

SELL A CALL – SHORT CALL 

 
CALL SELLER OR WRITER KEEPS THE PREMIUM AS PROFIT WHILE
MARKET PRICES IN THE UNDERLYING REMAIN STATIC OR DECLINE.
IF PRICES RISE THEN THE POTENTIAL LOSSES ARE UNLIMITED.
 
 DEFINITION [Cont.]
A “PUT” IS THE RIGHT TO “SELL” THE UNDERLYING ASSET.
 

SELL A PUT – SHORT PUT 

 
PUT SELLER OR WRITER KEEPS THE PREMIUM AS PROFIT WHILE
MARKET PRICES IN THE UNDERLYING REMAIN STATIC OR RISE. IF
PRICES FALL THEN THE POTENTIAL LOSSES ARE UNLIMITED.

BUY A PUT – LONG PUT 

 
PUT BUYER OR HOLDER BENEFITS FROM INCREASED PROFITS AS
MARKET PRICES DECLINE WITH THE POTENTIAL FOR UNLIMITED
PROFITS. IF PRICES RISE THE LOSS IS LIMITED TO THE PREMIUM
PAID FOR THE OPTION.
 
 BOUGHT CALL
1.View : Price of underlying asset will rise.

2.Maximum possible loss is the premium

paid.
 
3.No limit to potential profit, as there is no
limit to how high the price of underlying
can rise.
 SOLD CALL
1.View : Price of underlying asset will decline (or
remain unchanged). [If unchanged seller gains the
rime value].
 
2. Maximum possible gain is the premium received.
 
3. Maximum possible loss is unlimited, as there is no
limit to how the asset will rise (and hence the
option will be exercised against the call seller).
 BOUGHT PUT
1.View : Price of underlying asset will fall.

2.Maximum possible loss is the premium

paid.
 
3.Limit to potential profit is limited to how
low the price of asset falls, possible zero.
 SOLD PUT
1.View : Price of underlying asset will
increase (or remain unchanged).
 
2. Maximum possible gain is the premium.
 
3. Limit of potential loss is limited to how low
the price of the asset can fall.
 WHY OPTIONS ?
1. THEY GIVE PROTECTION FROM ADVERSE MOVEMENTS, BUT RETAIN
THE GAINS FROM FAVOURABLE MOVEMENTS.
 
* AN IMPORTER OF MACHINERY WHO HAS TO PAY JPY AFTER 2
MONTHS.
 
* AN EXPORTER, SELLING TEXTILES TO GERMANY, WHO HAS TO
RECEIVE EURO/DEM SOMETIME WITHIN THE NEXT 3 MONTHS.
 
2. FOR INSURANCE
 
* A CONTRACTOR WHO IS BIDDING FOR A CONTRACT IN EURO,
WHERE THE RESULTS WILL BE KNOWN SOMETIME IN THE NEXT
MONTH.
 
3. OTC OPTIONS ARE VERY FLEXIBLE, AND CAN BE LOW-COST
 
 
4. CUSTOMERS WANT THEM
 Value of an Option

VALUE OF AN
OPTION = Intrinsic Value + Time Value

• Intrinsic Value – Difference between

Option Rate and Market Rate.

• Time Value – Time Left to Maturity

 PRICING AN OPTION
FACTORS INCLUDED IN PRICING
MODEL (BLACK & SCHOLES)

• STRIKE PRICE
• UNDERLYING PRICE
• TIME TO EXPIRY
• INTEREST RATE
• VOLATILITY
 PRICING AN OPTION:
An Intuitive Approach (Probability/Pay Out)

• OPTION PRICES DEPEND ON THE

PROBABILITY OF GIVEN CURRENCY
MOVEMENTS AND THE PAYOFFS
THAT WILL OCCUR IF AND WHEN
THOSE MOVEMENTS TAKE PLACE.

• AN OPTION PRICE IS JUST THE

PRESENT VALUE OF THE EXPECTED
PAYOUT.
 PRICING AN OPTION:
An Intuitive Approach (Probability/Pay Out)
[cont.]
EXAMPLE
* YOU ARE LOOKING TO DRILL OIL FROM A CERTAIN PIECE OF LAND YOU WOULD
LIKE TO BUY. THERE IS:
 
* 50% CHANCE OF FINDING SOMETHING WHEN YOU DRILL
 
* IF YOU DO FIND SOMETHING THERE IS:
 
* 30% CHANCE OF FINDING CRUDE YIELDING $500,000 PROFIT.
 
* 40% CHANCE OF FINDING CRUDE AND GAS YIELDING $750,000 PROFIT.
 
* 30% CHANCE OF FINDING HIGH GRADE CRUDE YIELDING $1.5 MILLION PROFIT.

* WHAT IS THE MAXIMUM YOU WOULD BUY IT FOR?

KNOCK-OUT (DROPOUT) OPTION
KNOCK-IN (DROPIN) OPTION
• European style currency Option.
• Dropout level built into the Option.
• If dropout level is breached at any time
during the life of the option, the contract is
immediately terminated.
• If dropout level is not breached during the
lifetime of the option, then the option will
behave precisely the same manner on
expiry as a normal European style option.
 EXAMPLE
The spot Pound Sterling/Dollar is 1.6000
 
Customer buys European style currency option which gives him the
right to buy Pound Sterling and sell USD at 1.6000 with 3 months
maturity.
 
Premium is say 1.72% of Sterling amount payable with two business
days value from the contract date.
 

On Expiry
 
Spot Rate is above 1.6000. Will he exercise ?
 
Spot Rate is below 1.6000. Will he exercise ?
 EXAMPLE [Cont.]
With Drop Out Feature
Dropout level is say 1.5600.
 
Premium is say 1.05% of Sterling amount
 
If at any time before expiry the rate falls below 1.5600, then the
contract lapses.
 
With Drop in Feature
Drop in level is say 1.5600
If the spot rate falls through 1.5600 during the lifetime of the option
and if, on expiry the option is “in-the-money” the option will be
exercised in precisely the same manner.
 
If on expiry, the spot rate is below 1.6000, then the option will be “out-
of-the-money” and will not be exercised.
 LOOK BACK OPTION
European Style currency Option
 
Fixed Maturity and Call and Put currencies as agreed on the contract date.
 
Strike Rate (price) is set on the expiry of the option
 
Premium payable with (usually two business days from the date of contract)
 
Source of Reference fixing is agreed on the contract date.
 
During the lifetime of the option reference fixings are recorded.
 
On expiry, the strike rate is set at the highest (in case of Put) or the lowest (in case of
call).
 
Exercised and settled two business days from the expiry.
 EXAMPLE
Customer purchases 3-month Sterling Call Dollar Put Look
Back Option (Say for Sterling Pound 10 mn.)
 
Premium is say, 4.37% of the Sterling amount payable.
 
On expiry Pound Sterling/USD is 1.6350. Highest rate during
the 3 month period is 1.6500 and the lowest 1.6100.
 
Q. 1. What it the strike rate of the Sterling Call Look
Back
Option?

Q.2. Will the customer exercise the Option?

 
Example of Interest Rate “CAP”
(CAP is an Interest Rate Option)
PERIOD 1 YEAR 2 YEAR 3 YEAR AVERAGE
RATE
% % %
LIBOR
RATES 6.5% 9.5% 11.0 9.00 p.a.
(AVERAGE)

CAP
RATE 8.0 8.0 8.0 8.0
COST OF
PREMIUM FOR CAP 1.1875 1.1875 1.1875 1.1875
(ANNUALISED)
ALL IN
BORROWING COST 7.6875 9.1875 9.1875 8.6875
 INTEREST RATE – COLLAR
(Combination of CAP & FLOOR)
BUY A CAP (Say) ---10%------------- 10%--------------------10%-----------
| - BAND TO WHICH OPPORTUNITY |
| TO BENEFIT IS RESTRICTED |
| | 
| - NEITHER BUYER OF CAP NOR |
| BUYER OF FLOOR WOULD |
| EXERCISE WHEN MARKET |
| RATES ARED IN THIS BAND |
SELL A FLOOR (Say) --- 7%------------ 7%------------------------- 7%----------
 
1. ENSURES PROTECTION BEYOND 10% BY EXERCISING CAP.
2. RESTRICTS THE OPPORTUNITY TO BENEFIT IN CASE RATES FALL
BELOW 7% DUE TO BUYER EXERCISING FLOOR BELOW THIS LEVEL.
3. EFFECTIVE INTEREST RATE COST WOULD RANGE BETWEEN 10% AND
7%.
4. PREMIUM EARNED ON FLOOR REDUCES TO THE COST OF CAP. (CAP
PREMIUM PAID – FLOOR PREMIUM EARNED).
 Caps & Floor

• Cap – the right to fix the borrowing

rate.

• Floor – the right to fix the lending

rate.
Forward Rate Agreement (FRA)
Definition
A Forward Rate Agreement (FRA) is a
financial contract between two parties to
exchange interest payments for a ‘notional
principal’ amount on settlement date, for a
specified period from start date to maturity
date.
[RBI Guidelines]
 Forward Rate Agreement (FRA) [cont.]
FEATURES
• traded in the OTC market

• no standardisation of amount

• in all convertible currencies

 
• never any transaction of principal (notional principal only)
 
• only interest differential is paid or received on the notional principal on the settlement day
 
• interests applied are LIBOR
 
• front-end discounted payment
 
• no up-front fees, except the transaction costs
 
• contract currency, amount, contract rate, settlement date are specified in advance
 
• (3 x 6) “Three Sixes” : An interest rate for 3 months to start in 3 months from the date of
contract.
 FRABBA MARKET QUOTES
(ILLUSTRATIVE)
  USD FRAS JPY FRAS
 
1/4 6.19/15 1/7 6.53/49 1/4 2.45/42 1/7 2.62/58
 
2/5 6.30/26 2/8 6.68/64 2/5 2.57/54 2/8 2.71/67
 
3/6 6.56/52 3/9 6.91/87 3/6 2.68/65 3/9 2.81/77
 
4/7 6.74/70 4/10 7.10/06 4/7 2.76/73 4/10 2.91/87
 
5/8 6.94/90 5/11 7.26/22 5/8 2.82/79 5/11 3.00/97
 
6/9 7.14/10 6/12 7.43/39 6/9 2.92/89 6/12 3.10/07
 Forward Rate Agreement (FRA)
Examples of Confirmations
PART 1
To be Used on the Agreement Date
F.R.A. CONTRACT
AGREEMENT DATE
CONFIRMATION NOTICE
TO :-
FROM :-
We are pleased to confirm the following Forward Rate Agreement (F.R.A.) made
between ourselves as per FRABBA Recommended Terms and Conditions dated
………. 1985. (Direct/Broker …………………………….).
CONTRACT CURRENCY & AMOUNT …………………….……….…………...
FIXING DATE ……………………….
SETTLEMENT DATE ……………….. MATURITY DATE ………….………...
CONTRACT PERIOD (DAYS) …………………………………………………….
CONTRACT RATE ………….. % per annum on an actual over 360/365
days basis (as applicable)
 Forward Rate Agreement (FRA)
EXAMPLE [Cont.]
SELLER’S NAME ………………………………………………………………….
BUYER’S NAME …………………………………………………………………..
NON-STANDARD TERMS & CONDITIONS (IF ANY)
…………………………

Any payment to be made to us under the F.R.A. hereby confirmed should be

credited to our Account Number
…………………………………………………… at
…………………………………………………………………………………….
PLEASE ADVISE BY TELEX, OR CABLE US IMMEDIATELY, SHOULD
THE PARTICULARS OF THIS CONFIRMATION NOT BE IN
ACCORDANCE WITH YOUR UNDERSTANDING.

Either :- Or :-

SIGNED : …………………………. TESTED TELEX CONFO

FOR AND ON BEHALF OF
……………………………………...
 ADVANTAGES OF FRA
A. HEDGE : BANK CAN HEDGE ITS FUTURE LENDING/ DEPOSIT
OPERATIONS AND FIX FUTURE RATES IN A SIMPLE AND
EFFICIENT MANNER.
B. CREDIT RISK : CREDIT RISK IN FRA IS NEGLIGIBLE AS THE
EXPOSURE IS ONLY TO THE EXTENT OF INTEREST
VARIATIONS.
C. FLEXIBILITY : AN OPPORTUNITY TO REVERSE OR SQUARE THE
POSITION BY MAKING OFFSETTING CONTRACTS.
D. CREDIT LIMITS : FRA DOES NOT TIE UP THE BORROWING
LIMITS TO THE SAME EXTENT AS ACTUAL BORROWING IN
VIEW OF LIMITED RISK AS MENTIONED IN (B) ABOVE.
E. BALANCE SHEET : SINCE THERE IS NO EXCHANGE OF
PRINCIPAL AMOUNT, FRAs ARE TREATED AS OFF BALANCE
SHEET ITEMS AND HENCE DO NOT ATTRACT RESERVE
REQUIREMENTS.
F. SAVING ON FUNDING COST : A JUDICIOUS COMBINATION OF
FRA AND MARKET BORROWING CAN ENABLE A BORROWER
BANK REDUCE ITS FUNDING COST AS COMPARED TO THE
COST IN THE CASH MARKET.
 FRA Example
A firm plans to borrow $ 10 million for 3 months 3 months from now. The
current 3 month Euro/Dollar rate is 8 1/16%. The firm has to pay LIBOR +
0.25%.
 
Apprehensive of future rate increase the firm buys a 3/6 FRA at 8 ½%.
 
Now suppose, three month LIBOR has risen to 10 ½ percent. The firm receives
the difference between the actual LIBOR and the agreed forward rate (10
½% - 8 ½% = 2%) on $ 10,000,000 for three months, discounted to take
account of the fact that it is paid at the start rather than the end of the
three month loan period. This comes to:
 
$ 10,000,000 x 2% x 0.25
------------------------------- = $ 48,721.07
1 + (10.5% x 0.25)
 
The firm can invest $48,721.07 for the three months, which along with interest
becomes the total compensation. The cost of the loan will not exceed 8.75%
p.a.
THANK YOU