Rupee Interest Rate Swaps

1. Rupee Interest Rate Swaps

2. Overview • Definitions & Benchmarks • Overnight Indexed Swaps • Uses & Opportunities • Linkages between markets • Interest Rate- market views

3. IRS- Definition • Exchange of cash flows (Risks) • Notional Principal • Prescribed dates • Prescribed computation method • FIXED and FLOATING rates of interest. • Floating based on a market benchmark.

4. IRS- Floating Benchmarks • Independent & Transparent • Dependable (Past & Future) • Examples • Overnight MIBOR (Mumbai Inter-Bank Offer Rate) • Commercial Paper Rates • Prime Lending Rates • T-Bill Yields (14 , 91, 182 and 365 days ) • Forex Swap Rates (Premia)

5. CP Rates Benchmark not available Corporate Specific PLR Bank Specific 2-way Quotes not available T-Bill Yields Daily Quotes not available Cut-off yields not independent Forex Swap Rates Possible- non MMkt. No source at present IRS- Floating Benchmarks Daily MIBOR linked IRS = OIS

6. Overnight Indexed Swap (OIS) • Floating leg based on MIBOR • Daily overnight rate reference • Compounded daily/ accrued over holidays • NSE/ Reuters (26-32 bank’s average) • Other market conventions • Pre-defined notional principal. • Normal FRA / IRS terminology • Pay/ buy an OIS = pay fixed receive floating • Receive/ sell an OIS = receive fixed pay floating

7. FIXED CASH FLOW- Cfix Corporate Citibank FLOATING CASH FLOW- Cfloat Overnight Indexed Swap (OIS)

8. Fixed Coupon is calculated as follows - Cfix = P x Rfix x d basis Cfix = Fixed Coupon P = Notional Principal Rfix = Agreed Fixed Interest Rate d = Length of Coupon Period in days basis = Applicable day basis (e.g. 365) OIS - Mechanics

9. Floating Coupon is calculated as follows - Cfloat = P x Rfloat x d basis Cfloat = Floating Coupon P = Notional principal Rfloat = Compounded Floating Interest Rate (see next slide) d = Length of Coupon Period in days basis = Applicable day basis (e.g. 365) OIS - Mechanics

10. Floating Rate is calculated as follows - • d business • Rfloat = ( [ 1 + ri x d i ] - 1 ) basis • i=1 basisd total • Rfloat = Floating Rate • r i = MIBOR Rate for the ith business day • d i = Number of days the ith MIBOR rate applies • d business = Number of business days in the coupon period • d total = Total no. of calendar days in the coupon period • basis = Applicable day basis (e.g. 365) OIS - Mechanics

11. IRS- RBI Guidelines • FRA/ IRS allowed for hedging rupee balance sheet exposures. • Banks to exercise due diligence • Certificates that transaction for hedging balance sheet exposures (w.r.t. size and tenor)

12. IRS- Benefits • ‘Essentially divorces liquidity management from interest rate risk management.’ • Simple to use • Minimal credit risk • No ballooning of balance sheet

13. IRS- Opportunities • Better interest rate risk management • Diversification of risk • Implement interest rate views • Access to cheaper funding • Comparative Advantages • Good Cash/ Liquidity Management Tool • Monthly collections vs quarterly interest payments

14. IRS- Structures • Hedge increases- go fixed • Hardening rates: Fix future CP issue/ rollover costs • Convert floating WCDL into fixed rate • Reduce costs- go floating • Softening rates: Raise term funds but pay MIBOR • Receive fixed against existing fixed rate loans

15. Example I - Comparative Advantage • Funding at lower MIBOR spreads than before • AAA issues 1yr fixed at 11.10% • OIS AAA receives Fixed 10.00% • AAA pays MIBOR • Net impact is 1 year funds @ MIBOR + 110BPs

16. Example II - Lending at Call • Placement of deposits at call-linked rates • ABC buys 180 day T-Bills 9.8% • OIS ABC pays fixed 9.5% • ABC receives MIBOR • Net impact is 180 day return @ MIBOR + 30BPs • Has effectively lent in the call market

17. Example III - Hedging future CP Rates • Locking in future funding costs • ABC has Rs.100mio CP maturing in 3 months • FRA (or IRS) for 3v6 at 10.8% • Unwind FRA at time of rollover • Net impact is CP funding rate @ 10.8% • Profit/ loss on unwind will offset rate received

18. IRS- Current scenario • Flurry of OIS deals on Day 1 • Corporates - Main receivers of fixed rates • Limited inter-bank deals • ISDA documentation • Not represented fully by all foreign banks & PDs • Absence of nationalised banks

19. IRS- Future Scenario • More volumes • Longer tenors • Other new benchmarks • MIBOR, but not overnight based • Other index based • Banks end up being “Payers of fixed rates” • Keen interest by nationalised banks

20. IRS- Issues • Illiquidity in the secondary corporate bonds • T Bill reference rate yet to evolve despite existence of a T Bill auction calendar • Expected time for development of a term money market • Accounting/tax for IRS/FRAs (Hedge vs MTM) • Basis risk

21. Linkages between markets • Call Money vs Forward Premium • Arbitrage potential • Immediate response across curve • IRS vs CCY swaps (Premia) vs T-Bills • Accessible by the main banks • Different considerations • Other markets more liquid/ less bid-offer

22. Linkages between markets Call Money rate was 10.12 (as on Aug 16’99)

23. Linkage between markets • IRS = Call - 62 bps • Reflecting 6 month expectations • T Bill = IRS + 20bps • Reflecting funding risk • Swap = Tbill + 110bps • Swap= Libor + Premium • Reflecting short term reaction • IRS cannot be more than Swap

24. Continuing discontinuities • High bid-offer spreads in IRS • Lack of efficiency • Fewer aggressive banks/ Docs/ Credit issues • Logistical/ internal limitations • Cash vs. IRS • Liquidity fears (50bps) • LAF- guarantees liquidity, start made (like FED)

25. Continuing discontinuities • TBIlls vs Fwds • FCNR USD funds with few banks • surplus INR other banks • Switching difficult from both sides • Difficult to short GOI securities- 1way • 15% rule for longer tenors • Short end is relatively integrated

26. Interest Rates - so far • Shocks in Jan/ Aug’98 • Interest rates lower across the board in 1999 • Successfully survived a major event risk- Kargil • Historically low inflation • Increasing liquidity, longer tenors in bonds • RBI approach • Openness - e.g. Feedback on Policy • IRS- hedging mechanism • Public statements on objectives • Corridor of interest rates.

27. Interest Rate- Trends

28. Interest rates - Sovereign • Surplus liquidity, low inflation • Banks • Evaporating fears of liquidity crisis • shocks still there (12/08) • Surplus SLR due to lack of alternatives • Government • FY99-00 Govt. net borrowing target (78% done) • Long tenor based rally - high duration • Oct. Credit policy, higher fiscal needs- Kashmir

29. Interest rates- Corporate • Limited Supply, growing demand • Mutual Funds • Tax anomaly driving the industry • Flush with liquidity - funds seek yields • Compression in Corporate spread over GOI • Compression to shift to longer tenor/ Tier II names • Trend to reverse (Q3’00) after a few shocks • Spike in GOI yields/ Ill-liquidity/ Credit deterioration

30. Interest rates - prognosis • Likely to trend lower • Inflation yet to hit bottom(Nov) • Higher Real yields • No signs of credit pickup • Expansionary Credit policy • Bank rate/ Repo/ CRR cut; Deposit rates/ PLR sticky • Accommodate govt. borrowing targets • No $/ INR shocks/ Political uncertainties

31. Rupee Interest Rate Derivatives and Citibank • Trading expertise. Experienced team • Ability to offer low bid-offer quotes • Risk management systems in place • Exposure to IRS products in Emerging Markets • Huge corporate reach- Can match requirements

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