“FOSTIIMA Business School, New Delhi”

“IRD”
“CDS”
“CD”
Pre se n te d To :
M r. N itin Ja in

Pre se n te d B y:
A tu l Ja in
K a vita D e o ra
N a vjo t K a u r
Pra b h jo t
INTEREST
RATE
DERIVATIVES
 INTEREST RATE DERIVATIVES
An interest rate derivative is a derivative where the underlying asset is the
right to pay or receive a (usually notional) amount of money at a given interest
rate.
The interest rate derivatives market is the largest derivatives market in the
world. Market observers estimate that US$180 trillion by notional value of interest
rate derivatives contract had been exchanged by September 2007 . According to the
International Swaps and Derivatives Association, 80% of the world's top 500
companies as of April 2003 used interest rate derivatives to control their cash
flows.
 IRD PRODUCTS

Interest rate swap

Interest rate future
Forward rate agreement
Bond option
Interest rate cap or interest rate floor
 INTEREST RATE SWAP
Among the most popular of derivative instruments, interest rate swaps are
used by corporations, government entities, and financial institutions to manage
interest rate risk.
A swap is an agreement to exchange interest payments in a single
currency for a stated time period. In an interest rate swap, each counterparty agrees
to pay either a fixed or floating rate denominated in a particular currency to the
other counterparty.
Interest rate swap is an agreement between two parties to exchange one
set of interest rate payments for another.
NOTE: Only Interest payments are exchanged, not principal.
FUNDA OF INTEREST RATE SWAP

Consider the following swap in which Party A agrees to pay Party B periodic
fixed interest rate payments of 8.65%, in exchange for periodic variable interest
rate payments of LIBOR + 70 bps (0.70%).
 FORWARD RATE AGREEMENT
 Forward Rate Agreements (FRAs) being traded in the OTC
market. In case of FRAs, contracting parties agree to pay or receive a specific
rate of interest for a specific period, after a specific period of time, on a
specified notional amount. No exchange of the principal amount takes place
among the parties at any point in time. Now, think about bringing this contract
to the exchange. If we bring this FRA to the exchange, it would essentially be
renamed as a futures contract.


 Many banks and large corporations will use FRAs to hedge

future interest rate exposure. The buyer hedges against the risk of rising
interest rates, while the seller hedges against the risk of falling interest rates.
Other parties that use Forward Rate Agreements are speculators purely
looking to make bets on future directional changes in interest rates
 FORWARD RATE AGREEMENT
 “PAYOFF FORMULA”


( )
 (Reference Rate – Fixed Rate)  

Payment = Notional Amount  -------------------------------------------
 1 + Reference Rate  

Where:

 The Fixed Rate is the rate at which the contract is agreed.

 The Reference Rate is typically Euribor or LIBOR.
 “α” is the day count fraction, i.e. the portion of a year over which the rates are calculated,
using the day count convention used in the money markets in the underlying currency. For EUR
and USD this is generally the number of days divided by 360, for GBP it is the number of days
divided by 365 days.
 RECENT NEWS
SEBI to allow trading in 3 interest rate derivatives
By Rajesh Abraham Feb 25 2009 , Mumbai
 
The Securities and Exchange Board of India (Sebi) is in the final stages of
allowing the introduction of exchange-traded interest rate derivative
products.

In the first stage, the capital market regulator will allow trading in three
products — 91-day treasury bill futures, short-term interest rate futures based
on an index of actual call rates and notional coupon bearing 10-yearlong bond
futures.

“The new products will expand the market depth in terms of availability of
products. Right now, there are no products available. For instance, if you
want to hedge and your view is that interest rates will go up on 10-year
bonds, the only option is to sell the 10-year bond from the portfolio. With the
availability of a derivative instrument, you can express your view and trade
accordingly,” said Joydeep Sen, vice-president (advisory desk) at BNP Paribas
Wealth Management.
 INTEREST RATE FUTURE
 If a forward contract is entered into through an exchange, traded on the
exchange and settled through the Clearing Corporation/ House of the exchange, it
becomes a futures contract. As one of the most important objectives behind bringing the
contract to the exchange is to create marketability, futures contracts are standardized
contracts so designed by the exchanges as to ensure participation of a wide range of
market participants.


 In other words, futures contracts are standardized forward contracts traded

on the exchanges and settled through their clearing corporation/house.


 Competitive advantages over the forward contracts in terms of better

liquidity and risk management.


 Now, it is simple to comprehend that futures contracts on interest rates

would be called interest rate futures.
d curve. The futures on the long end of the yield curve are called the Long Bond Futures an
 BOND OPTION
 A Bond Option is an OTC-traded financial instrument that facilitates an
option to buy or sell a particular bond at a certain date for a particular price. It
is similar to a stock option with the difference that the underlying asset is a
bond.


 The present market value for the bond is referred to as the spot price
while the future value as per the option is referred to as the strike price.


 TYPES OF BOND OPTION



• A European bond option is an option to buy or sell a bond at a certain date in

future for a predetermined price.
• An American Bond option is an option to buy or sell a bond on or before a
certain date in future for a predetermined price

 INTEREST RATE CAP & FLOOR

An Interest Rate Cap is a derivative in which the buyer receives

payments at the end of each period in which the interest rate exceeds the
agreed strike price. An example of a cap would be an agreement to receive a
payment for each month the LIBOR rate exceeds 2.5%.

An Interest Rate Floor is a series of European put

options or floorlets on a specified reference rate, usually LIBOR. The buyer of
the floor receives money if on the maturity of any of the floorlets, the reference
rate fixed is below the agreed strike price of the floor.
INTEREST
NTEREST RATE
RATE CAP
CAP & FLOOR
& FLOO
Insurance?
 CREDIT DEFAULT SWAPS
CDS are the most widely used type of credit derivative and a powerful force in
the world markets. The first CDS contract was introduced by JP Morgan in
1997. By 2007, their total value has increased to an estimated $45 trillion to
$62 trillion. only 0.2% of investment companies default, the cash flow is much
lower than this actual amount.

CDS are a financial instrument for swaping the risk of debt default. Credit
default swaps may be used for emerging market bonds, mortgage backed
securities, corporate bonds and local government bond
Buyer Pays a premium
He gets insurance against a debt default receives a lump sum
payment if the debt instrument is defaulted.
Seller Receives monthly payments.
If the debt instrument defaults they have to pay the agreed amount
 ILLUSTRATION
An investment trust owns £1 million corporation bond issued by a private
housing firm. If there is a risk the investment trust may buy a CDS from a
hedge fund. The CDS is worth £1 million. The investment trust will pay an
interest on this credit default swap of say 3%.

If the private housing firm doesn’t default. The hedge fund gains the interest
and pays nothing out. It is simple profit. If the private housing firm does
default, then the hedge fund has to pay £1 million – the value of the credit
default swap. Therefore the hedge fund takes on a larger risk and could end
up paying £1million.

The higher the perceived risk of the bond, the higher the interest rate the
hedge fund will require.
ILLUSTRATION
 ADVANTAGE

1.
HEDGE AGAINTS RISK
A CDS contract can be used as a hedge or insurance policy against the
default of a bond or loan.
Co is exposed to a lot of credit risk can shift some of that risk by buying
protection in a CDS contract.

2.
SPECULATION E.G. RISK IS UNDERPRICED
Speculation has grown to be the most common function for a CDS
contract.
An investor with a positive view on the credit quality of a company
can sell protection and collect the payments that go along with it
rather than spend a lot of money to load up on the company's bonds.
An investor with a negative view of the company's credit can buy
protection for a relatively small periodic fee and receive a big payoff
if the company defaults on its bonds or has some other credit event.
 CONTD………

3.
ARBITRAGE
If a company’s financial position improves the credit rating also
improve the CDS spread should fall to reflect improved rating.
This makes CDS more attractive to sell CDS protection.
If the company position deteriorated, CDS protection would be more
attractive to buy.
Arbitrage could occur when dealers exploit any slowness of the
market to respond to signals.

E.g. Washington Mutual bought corporate bonds in 2005 and hedged their
exposure by buying CDS protection from Lehman brothers. With Lehman
brothers going bankrupt this CDS protection was nullified.
 CDS IN INDIA
ü In 2007, RBI had issued draft guidelines for introduction of CDSs and then
withdrawn this during the financial crisis the notional outstanding contracts of
CDS in global over-the-counter (OTC) markets fell by 26.9%

üTo start with, RBI proposes to introduce a basic, over-the-counter, single-

name CDS for corporate bonds for resident entities, subject to safeguards. These
will not be exchange-traded instruments. The underlying will initially be only
corporate bonds.

üThe derivative was blamed for the collapse of AIG, the world’s largest insurer,
which wrote out thousands of CDSes against debt securities, without setting
aside capital for it.

üThe Reserve Bank of India (RBI) had sent a questionnaire to some banks
seeking their views on CDS.

üAll CDS trades will come to a centralised reporting platform and in due
course will be brought on a central clearing platform.
CURRENCY DERIVATIVES
 CURRENCY DERIVATIVES

Currency derivatives is a contract between the seller

and the buyer, whose value is to be derived from the
underlying asset, the currency amount. A derivative based on
currency exchange rates is a future contract which stipulates
the rate at which a given currency can be exchanged for
another currency as at a future date.

CURRENCY DERIVATIVE PRODUCTS
CURRENCY DERIVATIVE PRODUCTS
CURRENCY FORWARD
The basic objective of forward market in any underlying asset is to fix a
price for a contract to be carried through on the future agreed at its intended
to free both the buyer and seller from any risk of loss. The exchange rate is
fixed at the time the contract is entered and settlement takes place on a
specific rate in the future at today’s pre agreed price. This is known as
forward exchange rate or simply forward rate.

CURRENCY FUTURE
A currency future contract provides a simultaneous write an obligation to
sell the particular currency at a specified future date, specified price at a
standard quantity. these are special type of forward contract. Standardized
exchange traded contracts
CURRENCY DERIVATIVE PRODUCTS
CURRENCY FORWARD
Currency option contract confers on option-buyer privilege of not
exercising the contract when exchange rate is not in his favor. Foreign
currency option is contract for future delivery of specified currency in a
exchange for another in which buyer has write to buy(call) or sell(put) a
particular currency at an agreed price for or with in specified period.

Option market may be

 Listed on at stock exchange


 Over the counter market where banks dominate

 Future option market being a listed one with marking to market facilities
CURRENCY DERIVATIVE PRODUCTS
TYPES OF OPTIONS

AMERICAN OPTION EUROPEAN OPTION EXOTIC OPTION REAL OPTION

Call option Call option

Put option Put option Forward reversing option
Preference option
Avg. rate option
Look back option
Tunnel option
Down and out option
Down and in option
Basket option