in
MUMBAI
October 4th, 2009
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The articles discusses the world of Swaps – Interest Rate Swap (IRS), Overnight
Index Swaps (OIS), mechanism of OIS, currency swaps, equity swap, CDS and
others in the Indian context. An example of OIS is also given to help the readers.
DEFINITION OF SWAP
A simple definition of a swap is an exchange, trade or barter. In the financial world, a
swap is a financial transaction involving simultaneous exchange of assets (the swap) of
comparable value by the counterparties. The assets may be commodities or financial
instruments involving interest rates, cash flows, foreign exchange, debts or equities.
A swap has also been defined as a financial transaction in which two counterparties
agree to exchange streams of payments, or cash flows, over time on the basis agreed at
the time of inception of the arrangement. A swap is like a series of forward contracts.
Swaps are basically financial derivative instruments traded over the counter (OTC).
TYPES OF SWAPS: There are mainly two types of swaps—one is interest rate swap
and the other currency swap. However, commodity swaps and tax rate swaps too are
being introduced and finding acceptance.
INTEREST RATE SWAP (IRS):
Interest rate swaps are agreements where one side pays the other a particular interest
rate (fixed or floating) and the other side pays the other a different interest rate (fixed or
floating). Under an interest rate swap, interest payment streams of differing character
are periodically exchanged. There are two main types:
A. Coupon swaps: fixed for floating rates; and
B. Basis, or floating to floating, swaps: the exchange of one benchmark for another
under floating rates (e.g., LIBOR for T-bill rate)
CURRENCY SWAP
Under a currency swap, the two counterparties agree to exchange interest and principal
in one currency for interest and principal in another currency. These exchanges are
generally done at the spot exchange rate ruling, when the swap was entered into, and
would involve:
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 2 of 10
A. an initial exchange of principal in the two currencies; and
B. exchange of interest and repayment obligations (in instalments or in the form for
re-exchange of the principal amount, i.e., bullet repayment); or
C. debt servicing obligations alone (i.e., B)
The interest rates for the two currencies would differ, and may be fixed or floating.
MERITS OF SWAPS: Swaps are essentially used as a devise for:
Reducing the cost of borrowing
Exploit a view on the market
Hedge against a risk
Arbitrage between markets
GENESIS: Currency swaps became famous worldwide with a swap transaction entered
into between the World Bank and IBM in 1981. This year also saw the birth of interest
rate swaps in London.
ADVANTAGES OF IRS: In general, in the international capital markets, fixed rate
lenders are individuals or institutions like insurance companies or pension funds. When
they raise funds, the cost of funds would depend on their credit rating given by rating
agencies and other factors. On the other hand, in the floating rate markets (say LIBOR-
linked), the lender are international banks who study the commercial and political risks
relevant to a given loan and price it accordingly. (Their view does not always correspond
to that of rating agencies). As such, companies will try to exploit the differences in
interest rates in fixed and floating markets and enter into swaps with a view to reducing
their cost of borrowing.
BANK INTERMEDIATION: In practice, it is difficult for a corporate to locate a
counterparty for a swap because the structure of swaps is such that the counterparties
need to have not only differing but mutually complementary needs, but also identical
amounts and maturities. Counterparty’s financial strength (over the period of the swap)
to meet the obligation also needs to be known. Swaps suffer from counter party risk.
Therefore, major international banks step in and make two separate swaps with the two
counterparties.
While banks/financial institutions initially entered the swap market as brokers or
intermediaries, their role widened quickly. Soon, major banks started “warehousing”
transactions without the ready availability of a matching counterparty, and hedged the
exposure in the interim in other markets until another counterparty with opposite
requirements could be located. In other words, banks started running swap books.
BASIS SWAP: Basis swaps are swaps where the two sides pay each other rates
determined by different benchmarks. In the case of a basis swap, instead of exchanging
LIBOR for a fixed rate, the swap could be LIBOR for T-bill rate (or the CD rate).
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 3 of 10
SWAP MARKETS IN INDIA:
INTEREST RATE SWAP: Interest rate swaps started trading in India only in 1999-2000
after RBI issued the guidelines. Now, swaps and forward rate agreements have proved
very popular in India. RBI has issued guidelines on risk management in swaps to banks,
primary dealers and financial institutions.
EXAMPLE:
Consider a Simple illustration:
Com. A Com.B
Fixed Rate 8% 9%
Floating Rate Mibor +1% Mibor +3%
Company A has an advantage in both markets but has a better advantage in Floating
Rate Market.
Company A can borrow in the floating rate market at the given rate of Mibor +1
and Company B can borrow fixed at 9%
Both Companies can enter into a swap
Company A can receive Mibor+2 from Company B and pay 8.25 fixed interest to
Company B.
Consider cost to both companies
Com. A Com. B
Borrow -(Mibor+1) -9%
Swap Receive +(Mibor+2) +8.25%
Swap Pay -8.25% -(Mibor+2)
Net Cost -8.25+1 -(Mibor+2)-.75
Net Cost -7.25% -(Mibor+2.75)
Gain 0.75% 0.25
The difference to be shared is 1%. This could be shared in any combination
desired.
Usually the company with relative advantage in both markets will take away a
larger share of the gain.
Note that the swap would work only if A wants to borrow Fixed and B Floating.
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 4 of 10
BENCHMARKS FOR IRS IN INDIA:
The commonly used floating rate benchmarks for IRS in the domestic swap market are:
1. MIBOR – Mumbai Inter-Bank Offer Rate – the overnight, interbank call money
rate
(MIBOR overnight rates are decided based on overnight call money rates.
MIBOR overnight rates are closely linked to call money rates.)
2. MITOR – Mumbai Inter-Bank Tom Offer Rate – the overnight interbank rate
implied by the Federal Funds rate in New York added to the cash/tom forward
margin in the exchange market (MITOR is the foreign currency variant of the
MIBOR rate-It is determined by Reuters by polling); and
3. MIFOR – Mumbai Inter-Bank Forward Offer Rate – the relevant period inter-bank
rate implied rate by the USD LIBOR for the corresponding period added to the
annualized forward margin in the exchange market.
OVERNIGHT INDEXED SWAPS (OIS): The most popular IRS in the Indian Market is the
OIS where the floating rate is linked to an overnight inter bank call money index. There
are no restrictions on the tenor of the swap. The interest is calculated on a notional
principal amount settled on a net basis at maturity. On the floating rate side, the interest
rate amounts are compounded on a daily basis based on the index. The notional
principal is not exchanged. Only net interest payments are exchanged. The most popular
benchmarks are FIMMDA-NSE overnight MIBOR and the Reuters overnight MIBOR. An
OIS is used to hedge short-term assets and liabilities. OIS is traded in the OTC market.
MECHANISM OF OIS: The mechanism is best described with the following example.
Example:
Bank A is a fixed rate receiver for INR 5 crores for a period of one week at 10% (which is
the OIS rate) and a floating rate payer (FIMMDA-NSE MIBOR).
Bank B is a receiver of floating rate linked to the Overnight index (i.e., FIMMDA-NSE
MIBOR) and a fixed rate receiver (OIS RATE).
The FIMMDA-NSE MIBOR rates for the seven days are taken and settled at the end of
the swap period. At the end of the period of one week, i.e., the 8th day, Bank B will have
to pay to Bank A Rs. 95,890/- (being interest on Rs. 5 crores for 7 days at 10%) and has
to receive from A Rs. 97,508/-. The payments are netted and the only payment that
takes place is a payment by A of Rs. 1,608 (97508 – 95890) to B. Please note that
FIMMDA-NSE MIBOR rates are compounded daily.
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 5 of 10
Notional
NSE Mibor Principal Interest for
Index Amount One day
1st day 10.25% 500,00,000 14,041
2nd day 10.00% 500,14,041 13,702
3rd day 9.75% 500,27,743 13,363
4th day 10.125% 500,41,107 13,881
5 & 6 day 10.25% 500,54,988 28,113
7th day 10.50% 500,83,101 14,407
500,97,508 97,508
In case of a 1-year OIS, this settlement goes on for one year. Coming to the volumes,
OIS volumes outnumber spot volumes. Minimum lot in OIS is Rs 25 crores whereas in
spot it is Rs 5 crores.
CURRENCY SWAPS:
RBI has given general permission to authorized dealers to deal in currency swaps with
one currency leg being the Indian rupee. The circular of RBI guidelines was dated
January 19, 2000. In terms of the provisions, authorized dealers can offer the following
products: interest rate swaps, currency swaps, coupon swaps, interest caps/collars
(purchase) and Forward Rate Agreements. The circular contains other provisions
concerning corporate requirements for swaps, reporting of the deals to RBI, premium
payment, etc. Two important limitations placed by RBI on the use of derivatives are that
the notional principal should not exceed the amount of the loan, nor should the maturity
of the derivative extend beyond the maturity of the underlying.
EQUITY SWAP: This is an equity derivative. An equity swap is a swap transaction
whereby the underlying will be linked to an index of the stock market. These are not
available in India.
CREDIT DEFAULT SWAP (CDS): This is an example of a credit derivative. A credit
derivative is an arrangement whereby the credit risk of an asset is transferred from the
buyer to the seller of protection. A CDS is a contract where the protection seller receives
premium or interest related payments in return for contracting to make payments to the
protection buyer upon a defined credit event. Credit events normally include bankruptcy,
payment default and rating downgrades. RBI had considered introduction of CDS in
India during 2007, but had later decided not to introduce them in India in view of the
global financial crisis. (CDS has earned immense notoriety of late due to the sub-prime
crisis in the US).
REGULATORS: The regulators for swaps in India are SEBI, ICAI and RBI. ICAI has
issued guidelines for accounting of derivative instruments. ICAI has issued Accounting
Standard 30 (AS-30) norms for recognition and measurement of all financial derivative
instruments. However, AS-30 will come into effect from April 1, 2009 and will be
recommendatory in nature until 2011. RBI also has various norms for the regulation of
swaps.
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 6 of 10
ISDA AGREEMENT: All swap transactions involve signing of an agreement between the
parties. The standard document is known as ISDA (International Swaps and Derivatives
Association) Master Agreement.
SWAPTIONS: A swaption or a swap option is an option on an interest rate swap. It gives
the buyer of the swaption the right (but not the obligation) to enter into an interest rate
swap of specified parameters (maturity of the option, notional principal, strike rate, and
period of the swap). Swaptions are traded over the counter.
CAPITAL ADEQUACY: RBI’s capital adequacy norms are applicable to banks and
financial institutions for undertaking interest rate swaps.
CROSS CURRENCY MARKET IN INDIA:
Banks in India act as intermediaries between the international markets and their
corporate customers in India. Thus, they work on a fully hedged basis, charging a
spread for their services over the quotations that they get from their correspondents
abroad.
USD: INR Swaps: FIMMDA releases daily rates for such swaps. The rate for such swaps
in known as MIOCS rate, that is, Mumbai Inter-bank Offered Currency Swaps.
MIFOR Swap market: The MIFOR swap market exchanges rupee interest flows but with
the floating rate benchmark based on forex market variables. The MIFOR is a proxy for
the term inter-bank rupee market. FIMMDA releases MIFOR rates every day. In India,
MIFOR swaps are used by corporates to hedge long-term USD/INR currency swaps.
COUPON ONLY SWAPS: USD: INR coupon only swaps are very popular in India.
Usually, these are used by companies with rupee debt. Companies use them to reduce
their costs. Coupon only swaps exchange interest payments in one currency (INR) for
interest payments in another currency (USD) with the principal amount remaining
outside the scope of the exchange or swap.
PERCY MISTRY RECOMMENDTIONS: The High Powered Expert Committee (HPEC)
on Making Mumbai an International Finance Centre had in 2007 recommended the
immediate creation of a currency spot market, with a minimum transaction size of Rs. 10
million, accessible to all financial firms. In addition, it had recommended that an INR-
settled exchange-traded currency derivatives market be created, with trading in futures,
options and swaps on currencies, accessible to all.
The Central Government had recently allowed SEBI and RBI to start exchange-traded
currency futures. NSE had started exchange-traded currency futures on August 29, 2008
and afterwards BSE and MCX-SX had also introduced the product according to the
guidelines of SEBI and RBI. As of now only USD-INR currency futures are allowed.
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 7 of 10
SOME PRACTICAL ASPECTS ON SWAPS:
Any financial product or derivative is available for people or organizations to exploit their
view. First, they need to have a view on the future course of interest rate or exchange
rate or other assets. Then, intermediaries are available to provide access to exploit such
view and make money in the process. If the view is proved to be wrong at a future date,
the party may lose money also. That’s why risk management is very vital here.
Swaps are extensively used in asset liability management structures.
Typically used by bankers. If their asset is floating rate loan and their liability is in
fixed rate, they could enter into a swap to match the two.
Most software companies have entered into long term contracts with receipts
structured in dollars. Dollar depreciation is a major concern for them.
Various types of Swaps are actively used by corporate India. With increased
globalization and many Indian companies acquiring numerous overseas
companies, the operational complexities for Indian companies have gone up. As
a result, financial derivatives are getting very popular in India. However, since the
beginning of November 2007, Corporate India has incurred huge losses due to
their inexperience with the complexities of the products and the over enthusiasm
on the part of a few banks in India.
VOLUMES REPORTED ON CCIL:
CCIL has developed the MIBOR / MIBID rates based on the trades in the NDS-CALL
platform. CCIL releases MIBOR/MIBID rates at 10.10 am and again at 1.10 pm in the
afternoon. The rates are released on Mondays through Fridays.
According to CCIL, for the year 2007-08, the total number of Interest Rate Swaps
(MIBOR) transactions reported was 25,431 deals and the total notional principal involved
was around Rs 18.05 lakh crore (single leg). The tenors of the deals ranged from one to
10 days; and from one month to nine months. The most active participants were foreign
banks, whose share in the total market was around 75 per cent, while the rest was
between private banks and primary dealers. Public sector banks’ turnover was
negligible, according to CCIL’s figures for 2007-08. For the month of November 2008,
the number of MIBOR deals was 469; with the total principal amount around Rs 32,000
crore. For the month of November 2008, the market share of foreign banks, private
banks, primary dealers and public sector banks was 84.76%, 9.47%, 5.11% and 0.66%
respectively. Total number of participants was 63 during the month of November 2008.
In the past few months, volumes have come down drastically due to adverse market
conditions.
According to CCIL, for the year 2007-08, the total number of Interest Rate Swaps
(MIFOR) transactions reported was 4,395 deals and the total notional principal was
around Rs 1.96 lakh crore (single leg). The most active participants were foreign banks,
whose share in the total market was almost 90 per cent, while the rest was from private
banks. The turnover of public sector banks and primary dealers turnover was negligible,
according to CCIL’s figures for 2007-08. For the month of November 2008, the number
of MIFOR deals was 145; with the total principal amount around Rs 6,900 crore. The
market share of foreign banks and private banks was 92.71% and 7.29% respectively.
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 8 of 10
FIMMDA-NSE REFERENCE RATES IN INDIA:
FIMMDA-NSE MIBID MIBOR: These reference rates are used by many market
participants due to their wide acceptability among the players in the market. These are
the basis for other derivative products, like, IRS, etc.
FIMMDA and NSE release overnight and 3-day rates (MIBOR and MIBID) at 9.40 am
every day; while, 14-day, 1-month and 3-month rates are released at 11.30 am every
day. Polling is used for obtaining reference rates by polling a few market participants and
summarizing the prices they report. These rates are available on the NSE and FIMMDA
websites.
ABBREVIATIONS USED:
BSE Bombay Stock Exchange
CCIL The Clearing Corporation of India Limited
FEMA Foreign Exchange Management Act
FIMMDA Fixed Income Money Market and Derivatives Association of India
ICAI The Institute of Chartered Accountants of India
INR Indian Rupee
IRS Interest Rate Swaps
ISDA International Swaps and Derivatives Association
LIBOR London Inter-Bank Offer Rate
MCX-SX MCX Stock Exchange
MIBID Mumbai Inter-Bank Bid Rate
MIBOR Mumbai Inter-Bank Offer Rate
MIFOR Mumbai Inter-Bank Forward Offer Rate
MIOCS Mumbai Inter-Bank Offered Currency Swaps
NDS-CALL Call money platform on the NDS (Negotiated Dealing System)
NSE National Stock Exchange of India
OIS Overnight Indexed Swaps
OTC Over the counter
SEBI Securities and Exchange Board of India
USD US Dollar
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 9 of 10
References:
1. “Foreign Exchange International Finance & Risk Management” by A V Rajwade
2. CCIL
3. FIMMDA
4. NSE
5. Inputs from Mr. Manoj Kumar, SBI, Hong Kong
SWAPS IN
GRAPHICS
Rama Krishna Vadlamudi, MUMBAI. [email protected]. Oct. 4th, 2009 Page 10 of 10
