Derivatives depend on the price of the underlying asset. Investors can hedge price risk with a wide range of derivative products in financial markets.
In the Indian fixed-income market, derivative products consist of Interest Rate Swaps, Forward Rate Agreements, Interest Rate Futures, Bond Futures, and Credit Default Swaps.
Since June 1998, the Bank for International Settlement has published semi-annual data on over-the-counter derivatives. Since then, Interest Rate Derivatives have been the most actively traded over-the-counter derivatives worldwide, with Interest Rate Swaps having the largest market share.
What is an Interest Rate Swap?
Interest Rate Swaps are derivative contracts that exchange a stream of agreed interest payments for a "notional principal" several times over a predetermined period.
The interest rate is tied to benchmark reference rates like Mumbai Interbank Outright Rate.
Banks and other lenders charge interest on company loans. These organisations must tailor their lending interest rate based on a principal amount; because interest rates fluctuate.
Interest Rate Swap allows the notional principal amount to switch between fixed and floating rates.
The notional principal calculates interest payments, but is not traded. The parties agree to exchange the accumulated interest difference at the maturity of the notional principal amount.
Companies engage in swap contracts when the overall fixed interest rate equals the expected floating interest rate flows. The floating rate is the benchmark reference rate plus basis points.
India trades interest rate swaps on the Mumbai Interbank Outright Rate and Mumbai Interbank Forward Outright Rate.
Interest Rate Swap—Fixed/Floating Swaps referred to as MIBOR have a maximum maturity of 10 years, while MIFOR-referenced Interest Rate Swap – Fixed/Floating have a residual maturity of 5 years.
Overnight index swaps, where the floating leg is linked to an overnight index compounded daily during the payment period, are the most popular interest rate derivatives in India.
The notional principal calculates interest payments but is not traded. The parties agree to exchange the accumulated interest difference at the maturity of the notional principal amount.
Scheduled commercial banks, primary dealers, and all India financial institutions are allowed to use interest rate swaps for balance sheet management or market making by the Reserve Bank of India.
Local Area and Regional Rural Banks cannot trade interest rate swaps.
Origins of Interest Rate Swaps in India
From July 1999, the Reserve Bank of India allowed interest rate derivatives as plain vanilla products for financial institutions to manage their balance sheets and market making.
Lehman Brothers' September 2008 collapse shocked global financial markets. Global Financial Crisis, the G20 promised to restructure the OTC derivatives industry to increase transparency and reduce operational and systemic risks.
On September 24-25, 2009, G20 leaders mandated that OTC derivative transactions be disclosed to trade repositories, transacted on exchanges or electronic trading platforms, and cleared by central counterparties.
Since then, the regulators in India have created neutral and independent counterparty infrastructure for over-the-counter derivatives to improve transparency and reduce counterparty risk.
The Clearing Corporation of India Ltd released an Anonymous IRS Dealing System for OTC Rupee Derivative trades in August 2015. ASTROID provides a complete solution for interest rate swaps, including trading, reporting, central counterparty, and settlements.
ASTROID accepts orders with a minimum lot size of ₹50 million and multiples thereof and a minimum disclosure quantity of 25%.
The Financial Benchmarks of India Ltd. launched the FBIL MIBOR-OIS benchmark in April 2018 and advocated allowing non-residents to participate in Indian Rupee interest rate markets.
Benefits & Risks
Interest rate swaps are used to exchange cash flow to minimise losses arising due to fluctuating interest rates in the economy. It helps adjust the interest exposure and reduce interest rate volatility.
The primary benefits or uses of Interest Rate Swaps include:
- Reduction in credit risk
- Reduction in capital requirements
- Allows financial institutions the flexibility to move to the interest rate basis of choice.
- Can be used to convert the fixed rate liability into floating rate liability and vice versa.
- Customisation provides closer duration matching of investment portfolios by reducing the impact of interest rate volatility.
- Mitigating reinvestment cost and reducing reinvestment risk by better matching of cash flows.
- Banks can hedge their floating rate liabilities and Insurance Companies their fixed interest liabilities by entering interest rate swaps.
Apart from the benefits listed above, these derivative contracts also carry some inherent risks such as:
- Counterparty risk – If a counterparty to an interest rate swaps, the contract defaults and cannot fulfill its contractual obligation.
- Operational risk – Market safety is at risk if there are operational breakdowns within the organization of relevant market participants or infrastructure providers.
- Legal risk - Market safety could be affected in the case of legal uncertainty regarding widely used derivative products.
- Liquidity risk - A derivative cannot be sold for its fair value since there is no demand for that derivative at that fair value.