HEDGING OF

FIXED INCOME SECURITIES USING

INTEREST RATE SWAP

Presented By

Abhijeetsingh Hazare
Edgesys Inc
[email protected]

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OBJECTIVE OF PRESENTATION
To Understand
Indian Financial Markets
Indian Fixed Income Markets
Various Types of Fixed Income Securities
Risk associated with Fixed Income Securities
What is Interest Rate Risk?
Strategies to Hedge Interest Rate Risk
Swaps and its types
Interest Rate Swap in detail
Risk associated with IRS
Indian Benchmark Index and their importance
IRS Vs. FRA
Uses of FRA

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Indian Financial Market

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 Raising Capital
Relationship between lenders and borrowers

Lenders Financial Intermediaries Financial Markets Borrowers

Interbank Individuals
Banks
Stock Exchange Companies
Individuals Insurance Companies
Money Market Central Government
Companies Pension Funds
Bond Market Municipalities
Mutual Funds
Foreign Exchange Public Corporations

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 Indian Fixed Income Market – Debt Market
Market Segment Issuer Instruments

Zero Coupon Bonds, Coupon

Central Government
Government securities Bearing Bonds, Treasury Bills

State Government Coupon Bearing Bonds

Government Guaranteed Bonds,
Government Agencies / Statutory
Public Sector Bonds Debentures, PSU Bonds,
Bodies, PSUs
Commercial Paper

Bonds, Debentures, Commercial

Paper, Floating Rate Bonds, Zero
Corporate, Banks
Coupon Bonds, Inter Corporate
Private Sector Bonds
Deposits, Certificates of Deposit

Financial Institutions Certificates of Deposits, Bonds

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 Indian Fixed Income Market – Money Market

Money Market Instruments

Call Money State Development Loans Fixed Deposit

Repo Treasury Bills Non-Convertible Debentures

Government Securities Certificates of Deposit Commercial Papers

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What is Risk ?

Risk is the possibility of something undesirable

In finance, risk is the probability that an investment's

actual return will be different than expected.

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Risks associated with Fixed Income Securities

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What is Interest Rate Risk ?

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Strategies to Hedge Interest Rate Risk

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What is a derivative?
Thus a derivative is an instrument whose value
depends on the values of other more basic underlying
variables

The underlying variables could be

– Stock prices
– Exchange rates
– Interest rates

These underlying variables are called cash market

variables

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Classes of Derivatives

Futures & Forwards

Swaps

Options

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FORWARD RATE AGREEMENT (FRA)
Forward Rate Agreement (FRA)

 A FRA is a forward contract on the interest rate

 It is a financial contract to exchange interest payments

based on a fixed interest rate with payments based on
floating interest rate like 6 m LIBOR/ 3 m MIBOR

 The exchange of payments is based on a notional

principal of the FRA

 Thus, there are 2 legs in a FRA - the fixed leg and the
floating leg

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 What is a FRA?

FRA start date/

settlement date
Trade date Fixing date Maturity date

t=0 t+3m-1 t+3m t+6m

Fixing date is 1 business day for INR and 2 business days is case of
non-INR

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Uses of FRA

A corporate has an expected requirement for funds

after 3 months, but is concerned that the interest rates
will head higher from the current levels and hence it
may have to pay higher interest rate on the loan.

The corporate can enter into a FRA, where he pays

fixed interest rate to hedge or fix his borrowing cost
today for an requirement after 3 months

The fixed rate agreed via the FRA will be compared to

the benchmark rate at the settlement date to determine
the settlement amount

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Contract Terms

If a corporate borrowed for a period of 3 months, 3

months from now, it is referred to as a 3 X 6 FRA

If the corporate buys a FRA, then it pays a particular

fixed rates and receive a floating rate, hence it hedges
against any rise in the interest rates

If a corporate sells a FRA, then it receives a particular

fixed rate and pays a floating rate, hence it hedges
against any fall in the interest rates

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SWAPS
What is a Swap?

To exchange one thing for another or ‘‘a barter’’

Custom tailored bilateral agreement

Cash flows determined by applying a prearranged

formula on a notional principal

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Origins of Swaps
 Although swaps only came into existence in recent years, their
origin can be related back to the 1800s and the Ricardo’s Law of
Comparative Advantage. In essence, this examined 2 countries
which produced both cloth and wine

 If country A can produce cloth more efficiently than B, then it has

an absolute advantage in cloth over B. According to Ricardo’s
law, however, even if A has an absolute advantage over B in both
cloth and wine, there is no reason for the two not to trade

 Country A should concentrate on producing the commodity in

which it has the greatest advantage, leaving production of the
other to B

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Types of swaps

Interest Rate Swap : where cash flows at a fixed rate

of interest are exchanged for those referenced to a
floating rate

Currency Swap : where cash flows in one currency are

exchanged for cash flows in another currency

Basic Swaps : where cash flows on both the legs of

the swap are referenced to different floating rates

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Swaps

Classified under the following heads

– Single Currency Swaps

• INR Swaps

• FCY Swaps

– Multi Currency Swaps

• FCY/INR Swaps

• FCY/FCY Swaps

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Interest Rate Swaps (IRS)

An interest rate swap is

Contractual agreement

Exchange a series of cash flows

– One leg of cash flow is based on a fixed interest rate
– Other leg is based on a floating interest rate over a
period of time

There is NO exchange of principal. The size of the

swap is referred to as the notional amount and is the
basis for calculating the cash flows

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IRS terminology

Pay fixed – a swap in which the party pays fixed and

receives floating rate payments

Receive fixed – reverse of the above, a swap in which

the party receives fixed and pays floating rate
payments

Long swap (buy) – a position where party pays fixed

Short swap (sell) – a position where party receives

fixed

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Uses of IRS

To create either synthetic fixed or floating rate liabilities

or assets

To hedge against adverse movements

It is a powerful asset liability management tool

Reduce the funding cost by exploiting the comparative

advantage that each counterparty has in the fixed /
floating rate markets

Trading

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Understanding IRS

An IRS can be best understood by relating them to

FRA’s

In a typical IRS, the floating rate gets reset more than
once, while the FRA involves one interest rate setting

Thus in a IRS, the exchange of payments happens

more than once, while an FRA involves only exchange
of payments

Thus, an IRS can be broken up as combination of

FRA’s

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Understanding IRS
 The IRS contract involves exchange of interest payments on the
fixed and floating side

 There is no principal exchange either at the inception or at

maturity of the swap

 However, to facilitate understanding we can include a notional

exchange of principal both at inception and at maturity

 Note that this does not make any difference to the transaction
since the exchange of principal is in the same currency

 Once we add the exchange of principal at the inception and

maturity, we can treat a swap as an exchange of a fixed rate bond
for a floating rate bond and vice-versa

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Understanding IRS

Thus, a receive fixed swap is equivalent to buying a

fixed rate bond and selling a floating rate bond

Similarly, a pay fixed swap is equivalent to selling a

fixed rate bond and buying a floating rate bond.

To summarize, we can decompose a swap in 2 ways

– As a combination of FRA’s
– As a exchange of a floating rate bond for a fixed rate
bond.

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 Understanding IRS – An example

Corporate “A” has exposure in G-Sec / any other fixed interest

bearing securities carrying interest rate of 6% for 5 years tenor.

The view of the corporate treasury is due to inflationary

pressure, the rate of interest would go up in coming months.

To protect it against rising interest rate as anticipated It does

IRS swap with a bank in OTC market.

The quotes for MIBOR IRS as on June04,2010 are provided in

next slides.

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INR-OIS-Fixed Rate

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Over Night Mibor- Benchmark Floating Rate

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Quotes – IRS

 A swap quotation 6.55-6.59 (for a 5-year INR swap) implies

– Pay 6.59% pa fixed, against receiving MIBOR floating.
– Receive 6.55% pa fixed, against payment of MIBOR floating

 The BUYER in a swap is the FIXED rate payer i.e. receive MIBOR

 The SELLER in a swap is the FLOATING rate payer i.e., receive

fixed

 The quoted swap rate is the price for buying or selling a stream of
MIBORs.

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Understanding IRS – An example

Thus the corporate “A” enters in IRS Swap paying

Fixed @ 6.59% and received floating @ 5.17%.

After 1 years the interest rate indeed moves up by 100

Bps as anticipated by the corporate “A” the payout out
under IRS swap would be as under-

The Corporate “A” will pay fix to Bank @ 6.59% and

receive floating interest at 6.17%.

Thus the corporate is able to convert its fixed income

securities to a floating rate securities.

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Understanding IRS – An example
 Notional Principal : INR 5 million  Start Date : June 04,2010
 Fixed rate payer : Corporate “A”  End date : June 04,2015

 Floating rate payer : Bank XYZ  Day count : Actual/365

 Fixed Rate : 6.59%pa.
 Int. dates : June 04, every year
 Floating Rate: ON MIBOR

 Trade Date: June 04, 2010

6.59% fixed

Bank XYZ Corporate “A”

ON NSE
MIBOR
swap
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Understanding IRS

Thus, a receive fixed swap is equivalent to buying a

fixed rate bond and selling a floating rate bond

Similarly, a pay fixed swap is equivalent to selling a

fixed rate bond and buying a floating rate bond.

To summarize, we can decompose a swap in 2 ways

– As a combination of FRA’s
– As a exchange of a floating rate bond for a fixed rate
bond.

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Interest Rate Swap (IRS)
The most common type of interest rate swap, where-

One party pays a fixed rate of interest

The other party pays Floating like LIBOR, MIBOR etc.
The swap becomes effective on the spot date and
matures on a single specified date, which is the end
date

The notional amount is constant

This simple structure is also known as ‘’Plain Vanilla
Swap’’

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IRS market

Market makers typically quote swap rates for fixed

periods, ranging from 1 to 10 years or longer

In the major currencies bid/offer spreads are very tight,

around 3 - 5 basis points

Such tight spreads reflect the very high liquidity of

these markets

Swap curve is a graphical representation of swap

rates for various maturities, similar to a bond yield
curve (GOI curve)

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Credit Risk in an IRS

Since an IRS is a notional principal contract, it does

not involve exchange of principal either at inception or
at maturity

Hence, there is no credit risk on the principal

The cash flows to be changed under an IRS on each

settlement date are netted and it is the difference
between the fixed and floating rate

Hence the credit exposure in an IRS is substantially

lesser than in a normal transaction

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Elements of a typical IRS
 Notional Principal
– the floating and fixed interest rate calculations are for a pre-
decided principal
– there is no actual exchange of principal

 Fixed rate
– predetermined rate, valid for the entire life of the Swap

 Floating rate
– linked to a benchmark rate, keeps changing periodically

 Payment dates and conventions

– swap start date, payment frequency, fixing date, maturity date

 Documentation
– ISDA

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Overnight Index

 Overnight Index is likely to be the most relevant and

acceptable floating rate benchmark

 Overnight markets are the most liquid

 Significant exposure and dependence on overnight markets

 Lack of a deep and vibrant term money market

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Who can use Overnight Indexed Swaps ?

 Banks and Financial Institutions

 Corporates

 Investors & Funds

 Primary Dealers

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QUESTIONS & ANSWERS
SESSION

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Thank You

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