Interest Rate Complete Ful

8/8/2019 Interest Rate Complete Ful

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GROUP MEMBERS ROLL NO.

MR. PRADEEP GORE F1310

MS. MEENAKSHI JADHAV F1410

MR. SANDEEP JAIGUDE F1510

MR. VINAY KUMAR F1710

MS. RAJASHRI MAHADIK F1810


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DERIVATIVES

A future is a derivative that is used to transfer the

price risk of the underlying instrument from one

party to another.

A future is thus a contract between two parties

whereby the one party (the buyer) agrees to buy an

underlying asset from the other party to the contracton a specific future date, and at a price determined at

the close of the contract.


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A futures contract is thus

An agreement between two parties

To buy and sell

A standardised type and quantityOf a specified underlying asset

With a certain quality

At a price determined at the closing of the contract

On a specified date

Through a central exchange.


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DERIVATIVE PRODUCTS

FORWARDS

CONTRACT

FUTURESCONTRACT

OPTIONS

CONTRACT

WARRANTS

SWAPS


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Market RiskManagementMarket RiskManagementIt helps you manage risk with integrated debt, currency, interest rate and

commodity solutions and also provide efficient funding and liquiditymanagement to the corporate, institutional and government clients.

Commodity Products

Structures to fit your broader risk management policy

Credit Derivatives

Sophisticated credit management strategies to reduce credit risk

Equity Derivatives

Customized solutions and a range of products structured using our analytical

and risk management expertise

Foreign ExchangePotentially add significant value to your dollar bond issues and equity offerings,

as well as cross-border M&A deals

Interest Rate Derivatives

Solutions to help neutralize market risk and seize market opportunities


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Interest rate DerivativesInterest rate DerivativesAn interestrate derivative is a derivative where the

underlying asset is the right to pay or receive a notional

amount of money at a given interest rate.


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The interest rate derivatives market is the largestderivatives market in the world.

The Bank for International Settlements estimates thatthe notional amount outstanding in June2009 were US$437 trillion for OTC interest rate

contracts, and US$342 trillion for OTC interestrate swaps.

According to the International Swaps and DerivativesAssociation, 80% of the world's top 500companies as of April 2003 used interest ratederivatives to control their cash flows. Thiscompares with 75% for foreign exchange options,25% for commodity options and 10% for stockoption


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Interest Rate DerivativesInterest Rate DerivativesInterest rate derivatives can be an effective way to cut exposure to economic risk. Ithelps to draws on real-time financial data and a global market perspective to develop

strategies that can neutralize market risk and bring new opportunities within reach.

Products:

Interest Rate SwapsInterest Rate Caps / Floors / Collars

Treasury Locks,Caps and Collars

Cross Currency Swaps

Swaptions

Budget Cap

Forward Rate Agreements


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Interest Rate SwapsInterest Rate Swaps

Manage interestrateriskwith a solutiontailored to match a specific risk

profile

Among the most popular of derivative instruments, interest rate swaps are used bycorporations, government entities, and financial institutions to manage interest rate

risk.

Swaps can be applied to a wide range of hedging needs and can be easily tailored tomatch a specific risk profile. Their simplicity and flexibility have made them the

workhorse of the risk manager's toolbox.

A swap is an agreement to exchange interest payments in a single currency for a

stated time period. Note that only interest payments are exchanged, not principal.

Swap terms are customized to meet the user's specific risk management objectives.Terms include starting and ending dates, settlement frequency, the notional amount

on which swap payments are based, and reference rates on which swap payments are

determined.

Reference rates are published rates such as LIBOR or benchmark Treasuries, or

customized indexes crafted to meet the client's needs.


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Why Use Swaps?

Treasurers use swaps to hedge against rising interest rates and toreduce borrowing costs. Among other applications, swaps givefinancial managers the ability to:

convert floating rate debt to fixed or fixed rate to floating ratelock in an attractive interest rate in advance of a future debtissue

position fixed rate liabilities in anticipation of a decline ininterest rates

arbitrage debt price differentials in the capital marketsFinancial institutions, pension managers and insurers use swaps tobalance asset and liability positions without leveraging up thebalance sheet and to lock-in higher investment returns for a givenrisk level.


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OtherTypical SwapApplications

Fixed-for-floating swaps

Forward-starting swapsBasic swaps

Swaps with imbedded options


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Interest Rate Caps / Floors / Collars

Rate LimitingTools: Interest Rate Caps, Floors and Collars

Caps and floors are essential tools in managing floating rate liabilitieswhile minimizing hedging and opportunity costs. They protect against adverserates risk, while allowing gains from favourable rate movements.Caps andfloors are forms of option contracts, conferring potential benefits to thepurchaser and potential obligations on the seller. When purchasing a cap orfloor, the buyer pays a premium- typically up-front. The premium amountdepends on the specified cap or floor rate and time period covered, whichmay range from a few months to several years.

Benefits of Caps, Floors and CollarsCaps and floors greatly enhance a treasurer's flexibility in managing

financial assets and liabilities. Used together or in combination with otherhedging instruments, caps and floors are efficient tools for reconfiguring acompany's financial risk profile.


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Continued.Caps and floors are used to:

Hedge floating-rate liabilitiesReduce borrowing costs

Increase investment returns

Create synthetic investments

Neutralize options embedded in assets or liabilities

Interest Rate CapsA cap creates a ceiling on floating rate interest costs. When marketrates move above the cap rate, the seller pays the purchaser the difference. A companyborrowing on a floating rate basis when 3 month LIBOR is 6% might purchase a 7% cap,for example, to protect against a rate rise above that level. If rates subsequently rise to9%, the company receives a 2% cap payment to compensate for the rise in market rates.The cap ensures that the borrower's interest rate costs will never exceed the cap rate.

Interest Rate Floors

A floor is the mirror image of a cap. When market rates fall below thefloor rate, the seller pays the difference. A 6% floor triggers a payment to the purchaserwhenever market rates drop below 6%. Asset managers buy floors to guarantee aminimum return on floating rate assets. They sell floors to generate incrementally higherreturns. Debt managers buy floors to protect against opportunity losses on fixed ratedebt when rates fall. They may sell floors as a component of a hedge strategy involvingother derivative instruments.


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Interest Rate CollarCompanypurchases a capand sells a floorto forma collar.Thenetpremium can be

reduced to zero by choosingthe strikerates thatallow forthe capand floorpremiumsto beequal.

Corporation(owns option)

BANK

Corporation

(sells option) BANK

Maximum ($0, LIBOR- strike)

Up-front, one time, premium payment

Maximum ($0, LIBOR- strike)

Up-front, one time, premium payment


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Swaption CorridorCompany buys aright-to-pay swaption, and sells aright-to-pay swaption with a higher

strike.Company is limiting its protectionto future increases inthe swaprate.However,the companypays a lowernetpremium forthis structure.

Corporation(owns option)

BANK

Corporation

(sells option) BANK

Right-to-pay fixed at 5.00%

Three-Month

Right-to-pay fixed at 7.00%

Three-Month


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Hedging PreHedging Pre--Issue Pricing Risk forIssue Pricing Risk for

FixedFixed--Rate DebtRate Debt

Many companies today are considering the issuance of fixed-

rate debt to lock in cost- effective funding and strengthen

their capital base.

There are a number of hedging tools available which can

reduce the impact of interest rate fluctuations on prospective

debt issues.


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Hedging Solutions

Treasury locks

Treasury capsTreasury collars


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Cross Currency SwapsAneffective solutionto long-term currency hedgingneeds

Cross-currency swaps offer companies opportunities to reduceborrowing costs in both domestic and foreign markets.

They are also a simple and effective solution to long-term currencyhedging needs.

Investors use cross-currency swaps to manage the currency risk inforeign investment portfolios and to create synthetic assets with a

specific currency risk profile.


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How Does itWork?

A currency swap involves the exchange of payments denominated inone currency for payments denominated in another.Payments arebased on a notional principal amount the value of which is fixed inexchange rate terms at the swap's inception.

Periodic swap payments are made in the appropriate currencies basedon specified reference interest rates. When the swap matures, a finalpayment representing the change in the value of the swap notionalprincipal is made between parties to the swap. Alternatively, theprincipal values can be re-exchanged at maturity at the originalexchange rate.

Because currency swaps involve exchange risk on principal, the creditrisk associated with these transactions is substantially greater thanwith interest rate swaps.


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Applying Currency SwapsCorporations and financial institutions use currency swaps tomanage the exchange and interest rate risks associated withforeign currency financing and investing.Currency swaps are alsovaluable as long term hedges of translation risk and in manyinstances represent an attractive alternative to long-dated forwardforeign exchange cover.

Currency swaps can be used in a variety of situations. By using

them companies can:Tap Foreign Capital Markets forLow Cost Financing.

LowerFinancing Costs forForeign Subsidiaries.

Enhance BuyerFinancing Programs.


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Swaptions

Interest rate swaptions give the holder the right, but not theobligation, to enter into or cancel a swap agreement at a

future date. The buyer may purchase either the right to

receive a fixed rate in the underlying swap or to pay the fixed

rate.Hedgeagainstadversemovements in interestrates

Swaptions are options on swaps. Like swaps, they offer

protection against adverse movements in interest rates, andare frequently used to minimize financing or hedging costs.

Combined with other instruments, swaptions are often used

to solve more complex risk management challenges.


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Managing Liabilities with Swaptions

Financial managers buy or sell swaptions to hedge

future interest rate exposures or manage borrowing

costs:

Hedge Contingent Financing

LowerBorrowing Costs.

Capture Excess Call Value.


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Forward RateAgreements

An FRA is a tailor-made futures contract. As the name implies, it is an agreement to fix afuture interest rate today, for example the 6 month LIBOR rate for value 3 months from now (a 3 X9 FRA in market terms). When the future date arrives the FRA contract rate is compared to actualmarket LIBOR. If market rates are higher than the contract rate, the borrower/FRA buyer receivesthe difference; if lower, he pays the difference. For the investor/FRA seller, the FRA flows would bereversed. Underlying borrowing or investment programs proceed normally at market rates, while thecompensating payment provided by the FRA brings the hedgers' all-in cost or yield back to the base

rate contracted for in the FRA.

Using FRAsCompanies use FRAs to protect short term borrowing or investment programs from

market surprises. For example, a borrower with debt rollovers coinciding with a scheduled meeting ofthe Federal Open Market Committee, uses FRAs to lock rollover rates in advance.

FRAs also allow companies to take advantage when the yield curve inverts (long term ratesfall below short term rates). When this happens a company which plans to borrow in the futurewould use FRAs to lock-in a future borrowing base rate at a level lower than today's rates.

FRAs are also valuable in making temporary adjustments to long term financial positions.For example, a company which has swapped floating rate debt to fixed can use FRAs to improve theswap's performance in the short run when short term rates are expected to decline. In this instanceFRAs protect the value of future swap floating rate receipts from the impact of falling rates.


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ContinuedManaging Short-term Interest Rate Risk

Most treasurers manage short term interest rate exposure by adjustingmaturities on commercial paper issuance or changing from one LIBOR reset option toanother on bank debt. Borrowers lengthen maturities when rates are expected to rise,shorten when they expect rates to drop. Sometimes, however, market movements canoutstrip the treasurer's abilities to manage rate exposure using cash market alternativesalone.

Forward Rate Agreements (FRAs) were invented to fill this gap. FRAs offer asimple way to manage short term rate exposures without tying up the balance sheet.

OtherTools forShort-Term RisksVery short-term caps and floors (caplets and floorlets) complement FRAs in

managing short term rate risk. Single period caps and floors limit exposure to very shortterm adverse rate movements while preserving the benefits of favorable market shifts.

Caplets and floorlets used in combination create cost effective hedges to fit

almost any interest rate scenario.Each of these tools enhances a hedge program by providing added flexibility and uniqueopportunities to improve control over shortterm reinvestment and rollover rate risk.


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Budget Cap

A Budget Cap is designed to hedge a companys exposure onlyto sustained interest rate movements. It establishes a maximum totaldollar interestamount the hedger will pay out over the life of the cap.

Benefits ofthe Structure: Budget cap is its cost effectiveness.

Premiums for budget caps are below the premiums for conventionalcaps.

Hedge the total interest expense over a specified time period

Disadvantage:

No payments are made under the cap until the caps maturity date, thehedger interim cash flow benefits provided by conventional cap hedges.


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How a Budget CapWorks?

To establish the terms of the terms of the cap, the hedger

determines how much principal to hedge, the maximum (capped)

dollar amount of interest over the caps life, and the final maturity

of the cap.

For each interest period, the hedged dollar interestamount is

determined by the formula:

Hedge Amount * Actual Number of Days in thePeriod/360*min[Market Libor, Cap Rate]


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MARGINS

A margin is collateral that the holder Of a financial

instrument has to deposit to cover some or all of the credit

risk of his counterparty .

MARKET LIQUIDITY

Market liquidity is an assets ability to be soldwithout causing a significant movement in the price

and with minimum loss of value.


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OPEN INTEREST

Open interest (also known as open contracts or open

commitments) refers to the total number of derivative

contracts, like futures and options, that have not been

settled in the immediately previous time period for

a underlying security.


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CONTRACT SIZE

The deliverable quantity of goods or commodities underlying

futures, forward and option contracts. Each contract will have a

well defined contract size.

TICKSIZE

At the Bombay Stock Exchange, after a reduction of the tick

size , The sizes now range from 5 paisa to 50 paisa as against 25

paisa to Rs. 2 .


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INTEREST RATE FUTURE

An interest rate future is a financial derivative with an

interest-bearing instrument as the underlying asset.

Examples:-

Treasury-bill futures, Treasury-bond futures

and Eurodollar futures.

The global market for exchange-traded interest rate futures

by the Bank forI

nternational Settlements at $5,794,200million in 2005


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Interest Rate Complete Ful

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