Fixed Income Money Market and Derivatives Association of India (FIMMDA)

London Inter-bank Offer Rate (LIBOR)

Debt instruments are contracts in which one party lends money to another on
pre-determined terms with regard to rate of interest to be paid by the
borrower to the lender, the periodicity of such interest payment, and the
repayment of the principal amount borrowed (either in installments or in
bullet).
Treasury Strips
In the United States, government dealer firms buy coupon paying treasury
bonds, and create out of each cash flow of such a bond, a separate zero
coupon bond. For example, a 7-year coupon-paying bond comprises of 14
cash flows, representing half-yearly coupons and the repayment of principal
on maturity. Dealer firms split this bond into 14 zero coupon bonds, each one
with a differing maturity and sell them separately, to buyers with varying
tenor preferences. Such bonds are known as treasury strips. (Strips is an
acronym for Separate Trading of Registered Interest and Principal Securities).
We do not have treasury strips yet in the Indian markets. RBI and
Government are making efforts to develop market for strips in government
securities.
Callable Bonds
Bonds that allow the issuer to alter the tenor of a bond, by redeeming it prior
to the original maturity date, are called callable bonds.
Puttable Bonds
Bonds that provide the investor with the right to seek redemption from the
issuer, prior to the maturity date, are called puttable bonds.
Amortising Bonds
The structure of some bonds may be such that the principal is not repaid at
the end/maturity, but over the life of the bond. A bond, in which payment
made by the borrower over the life of the bond, includes both interest and
principal, is called an amortising bond. Auto loans, consumer loans and home
loans are examples of amortising bonds.
Yield T-bills are issued at a discount and are redeemed at par. The implicit yield in
the T-bill is the rate at which the issue price (which is the cut-off price in the
auction) has to be compounded, for the number of days to maturity, to equal
the maturity value.
Yield, given price, is computed using the formula:
= ((100-Price)*365)/ (Price * No of days to maturity)
Similarly, price can be computed, given yield, using the formula:
= 100/(1+(yield% * (No of days to maturity/365))
Commercial paper (CP) is a short-term instrument, introduced in 1990, to
enable non-banking companies to borrow short-term funds through liquid
money market instruments
Certificates of Deposits (CDs) are short-term borrowings by banks. CDs differ
from term deposit because they involve the creation of paper, and hence have
the facility for transfer and multiple ownerships before maturity

What are interest rate swaps (IRS)?

An IRS can be defined as an exchange between two parties of interest rate
obligations (payments of interest) or receipts (investment income) in the
same currency on an agreed amount of notional principal for an agreed period
of time.
The most common type of interest rate swaps are the plain vanilla IRS.
Currently, these are the only kind of swaps that are allowed by the RBI in
India. Dealing in Exotics or advanced interest rate swaps have not been
permitted by the RBI.
In a plain vanilla swap, one party agrees to pay to the other party cash flows
equal to the interest at a predetermined fixed rate on a notional principal for
a number of years. In exchange, the party receiving the fixed rate agrees to
pay the other party cash flows equal to interest at a floating rate on the same
notional principal for the same period of time. Moreover, only the difference in
the interest payments is paid/received; the principal is used only to calculate
the interest amounts and is never exchanged.
An example will help understand this better:
Consider a swap agreement between two parties, A and B. The swap was
initiated on July 1, 2001. Here, A agrees to pay the 3-month FIMMDA NSEMIBOR
rate on a notional principal of Rs. 100 million, while B pays a fixed
12.15% rate on the same principal, for tenure of 1 year.

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We assume that payments are to be exchanged every three months and the
12.15% interest rate is to be compounded quarterly. This swap can be
depicted diagrammatically as shown below:
MIBOR (3m)
12.15%
An interest rate swap is entered to transform the nature of an existing liability
or an asset. A swap can be used to transform a floating rate loan into a fixed
rate loan, or vice versa. To understand this, consider that in the above
example;
A had borrowed a 3 yr, 1 crore loan at 12%. This means that following the
swap, it will:
(a) Pay 12% to the lender,
(b) Receive 12.15% from B
(c) Pay 3 month MIBOR
Thus, As 12% fixed loan is transformed into a floating rate loan of MIBOR
0.15%. Similarly, if B had borrowed at MIBOR + 1.50%, it can transform this
loan to a fixed rate loan @ 13.65% (12.15 + 1.50). Following figure
summarizes this transaction.
12% MIBOR (3m)
MIBOR (3m)
+ 1. 50% 12.15%
An IRS can also be used to transform assets.
Example
A fixed-rate earning bond can be transformed into variable rate earning asset
and vice versa. In the above example, it could be that A had a bond earning
MIBOR+0.5% and B a bond earning 12.5% interest compounded quarterly.
The swap would then result in A receiving a fixed income of 12.65% and B
receiving a variable income of MIBOR+0.35%.
This can be shown diagrammatically as follows:

MIBOR MIBOR (3m) 12.

50%
+ 0. 50%
12.15%
Party A Party B

Party A Party B

Party A Party B
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Sometimes, a bank or financial intermediary is involved in the swap. It
charges a commission for this. The two parties often do not even know who
the other party is. For them, the intermediary is the counter-party. For
example, if a financial institution charging 20 basis points were acting as
intermediary, the swap would look as follows:
12.17% 12. 37%
MIBOR (3m) MIBOR (3m)
Swap as a Combination of Bonds
A swap can be interpreted as a combination of bonds in such a way that the
receive fixed leg is short on a floating rate bond and long on a fixed rate bond
and vice versa for the receive floating leg.
This has significant implication on the pricing and valuation of plain vanilla
interest rate swaps because a swap can be valued as a combination of the
two:
An example will make this very clear. Consider the swap for a notional of Rs
100.
Party A pays 3 month MIBOR and receives 12.15% for a period of two years.
This is equivalent to A having a short position in a 3 month MIBOR linked
bond and a long position in a 2 year 12.15% bond with quarterly payments.
12.15% is also the going swap rate at the time of inception of the swap.
Assume that 1-month has passed since the inception of the bond. Hence
there are two months left for the interest payments to be exchanged. Let us
also assume that the swap has a look ahead configuration i.e. the MIBOR to
be paid after two months has already been set.
1. The 12.15% fixed rate bond can be valued according to conventional
methods i.e. by discounting each cash flow from the bond by the
discounting rate for the relevant period.
2. The MIBOR linked bond will reset to par. This is because on the next
reset date, the coupon that will be fixed (MIBOR) will also be equal to
the discounting rate for the relevant period. Hence we have the par
value + MIBOR to be discounted for a period of two months (time to
reset).
The value of the swap is simply the difference between the above two.
A swap as a string of FRAs or futures
A swap can also be interpreted as a strip of FRAs or futures contracts.
Consider that every time the floating index is reset an interest rate payment
goes from one counterparty to the other in just the same way that
compensation is payable/received under an FRA. In a similar way, as interest
rate changes so the value of a futures position changes.
Party A BANK Party B

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Consider a long futures long position and a short FRA position remember
these denote the same obligation. Each position gains if interest rates fall and
loses if interest rates rise. The risk/return profile is that of a swap-floating
rate payer.

Similarly, for a swap fixed rate payer the position is the same as that for a
short futures position and a long FRA position. Each will lose if interest rates
fall and gain if interest rates rise.
Pricing an IRS
In order to determine the fixed rate or the swap rate to be paid or received
for the desired interest rate swap, the present value of the floating rate
payments must equate the present value of fixed rates. The truth of this
statement will become clear if we reflect on the fact that the net present
value of any fixed rate or floating rate loan must be zero when that loan is
granted, provided, of course, that the loan has been priced according to
prevailing market terms. However, we have already seen that a fixed to
floating interest rate swap is nothing more than the combination of a fixed
rate loan and a floating rate loan without the initial borrowing and subsequent
repayment of a principal amount. Hence, in order to arrive at an initial fixed
rate, we find that rate for the floating leg that gives a zero present value for
the entire swap. The market maker then adds some spread so that the
present value to the market maker is slightly positive.
Why do firms enter into interest rate swaps?
Swaps for a comparative advantage
Comparative advantages between two firms arise out of differences in credit
rating, market preferences and exposure.

Basis Point
One hundredth of a percentage (i.e. 0.01). As interest rates are generally
sensitive in the second place after the decimal point, the measure has large
importance for the debt market
Dutch Auction
This is the process of auction in which after receiving all the bids a particular
yield is determined as the cut-off rate. All bids received at yields higher than
the cut-off rate (i.e. at higher prices) are rejected. All bids received at yields
below the cut-off rate are given allotment at the cut-off rate.
Modified Duration
This is a slight variation to the concept of Duration. Modified Duration can be
defined as the approximate percentage change in price for a 1% change in
yield. Mathematically it is represented as Mod. Duration = Duration / (1+y/n),
where n=number of coupon payments in the year and y=yield to maturity.