Since the inception of derivative trading in India, swap products are being widely used by the market to convert floating rate exposures to fixed rate and vice versa. Swaps linked to benchmarks like NSE-MIBOR and 6-month MIFOR have become quite liquid. While the OTC derivatives market has shown healthy growth under extant regulations in a relatively short period of time, the Group was of the opinion that it is important to move to the next stage of development by introducing option products. Since the RBI circular of 1999 clearly disallows option products, the Group recommends that RBI issue a sequel to the original circular that permits the use of options.

Since interest rate options as derivatives are being introduced for the first time in India, the Group recommends that the same be introduced in the local market in a phased manner so as to avoid any unwarranted shock. It is suggested that relatively less complex interest rate options may be permitted in the first phase. These products could include:

• Vanilla caps, floors and collars

• European Swaptions

• Call and put options on fixed income instruments or benchmark rates

While unleveraged structured swaps based on overnight indexed swaps (OIS) and FRAs where the risk profile of such structure is similar to that of the building blocks could simultaneously be introduced, the Group recommends that more sophisticated products may be introduced in the next phase which may include American and Bermudan swaptions, Digital options, Barrier options, Index Amortising caps, floors and other complex structures.

The Group felt that the introduction of interest rate option products in India, complementing the currently existing swap market, would lead to the following benefits.

Availability of options will provide the entire universe of hedging avenues to corporates. Options are a useful instrument to hedge both on-balance sheet and off-balance sheet exposures. A typical example of hedging an on-balance sheet exposure would be the purchase of a cap to hedge a floating rate liability or purchase of a floor to hedge a floating rate asset. Similarly, a typical example of hedging an off-balance sheet item could be the purchase of a swaption by a corporate for hedging a loan commitment, which is yet to be drawn down.

Options are very useful in managing risks on contingent exposures. For example, if a company participates in the bidding of a project where a sizeable amount of funding is required, but does not know whether it would be awarded the bid, it may make use of options to hedge the risks of an adverse move in the interest rate markets.

Active option trading has been seen to impart reasonable liquidity and direction to the underlying market.

In the case of a floating rate loan, if interest rates rise, the borrower may like to prepay the loan. But the prepayment penalty could be high. In such cases, a cap may be preferable as the initial upfront premium could work out to be cheaper. In order to reduce the premium, the company can both buy a cap and sell a floor, creating a collar structure. In a swap, by having an embedded cap on the floating rate, the fixed rate will be lower than in a normal swap. So, if the fixed rate payer has a view that interest rates will not rise to the extent of breaching the cap, entering into this kind of swap will provide cost reduction or yield enhancement.

Currently, it is not possible to accurately price a number of products such as floating rate bonds and constant maturity treasury (CMT) swaps, since their pricing requires some estimate of interest rate volatility. Once there are interest rate options, the implied option volatilities can be used to infer volatilities in the underlying market, leading to better price discovery.

In the context of a developing market, the sophistication levels of various banks, institutions, corporate clients and institutional investors are very different. The Group recommends that scheduled commercial banks (excluding RRBs), financial institutions and primary dealers should be allowed to both buy and sell options for hedging balance sheet related exposures and market making, albeit with appropriate safeguards. These entities may also offer these products to corporates to help them hedge their balance sheet exposures. The Group felt that in order to increase depth in the market, it would be desirable to allow corporates to sell options to hedge their balance sheet exposures. Keeping in view the inherent risks involved and issues of monitoring of risk management of corporates, the Group recommends that initially corporates may sell options without being net receivers of premium. Such transactions of corporates should be monitored on a per transaction basis by banks. Mutual funds and insurance companies may also buy and sell options as and when their respective regulators allow them.

The Group felt that it is time for the market to adopt certain best practices to follow while offering derivative products to their clients. Some of the safeguards that may be employed by banks and institutions while offering derivatives to their clients are listed below:

• Banks could internally institute a procedure to enter into derivative transactions, particularly option-based structures, only with those counterparties that clearly understand the benefits and potential risks. In order to determine the same, some very basic criteria like an external risk rating or a minimum net worth could be employed by the bank as the first level check.

• Further, banks should clearly delineate risks and benefits of the suggested derivatives strategies in their term-sheet/offer letter to clients. Where possible, this should be corroborated with a sensitivity analysis of the changes in the payoff of such strategies with respect to changes in the underlying to clearly demonstrate the risks and rewards of the strategy.

• While it is relatively simpler for banks in the foreign currency products to examine the underlying, the task becomes extremely difficult when the underlying is a rupee exposure. Hence, a corporate buying a derivative structure needs to certify in writing that the same is being used to hedge balance sheet exposures.

• There must be a formal credit clearance sought internally, either for the specific transaction or for a derivative facility, for every client that deals in derivatives.

With the current ban on short selling, “received” risks in the books of the dealers can only be hedged on a portfolio basis, which is inefficient and is fraught with different kind of risks, particularly “basis risks” as “like for like” hedging is not achieved. Permitting short sale would reduce such risks. Therefore, a re-look at the definition of “short selling” is warranted since this definition is unduly restrictive for development of derivatives market.

While the way forward in expanding the derivatives market despite the current restrictions in place have been delineated in the earlier part of this Section, the Group recommends that the definition of short sale, as currently used, may be reviewed and modified so that it conforms to both practical and prudential requirements. The Group also recommends that regulatory guidelines for short selling may be put in place as per international best practices.

Options involve non-linear payoffs and, hence, hedging schemes for options positions tend to be dynamic in nature and hedges are required to be rebalanced frequently. Static one-time hedging of an option position is possible only by entering into an offsetting option transaction. The hedging of an options portfolio entails calculation of various “Greeks”.

Interest rate option contracts have to be hedged by neutralising the delta of the option (changes in the level of the underlying asset’s price) by taking a position in spot underlying. The most efficient way to delta hedge interest rate option positions is to use the interest rate futures market, if available. However, where the benchmark is fixed income security, hedging for selling put options and purchased call options would not be possible till short selling is allowed in underlying securities. Hence, in the absence of interest rate futures and ability to short sell securities, delta hedging of options will require warehousing the correlation risk in the bank’s books and hedging it on a portfolio basis using swaps, securities and other financial instruments that the bank deals in.

Although the exposure of an option’s value to changes in the level of the underlying asset’s price can be hedged, exposure to changes in the volatility of the underlying (gamma and vega) is not hedgeable with a linear fixed income instrument. On the other hand, as the inter-bank players are likely to be net writers of options, their exposure to volatility risk would be significant. An option’s volatility risk (gamma and vega of options portfolio) can be hedged fully only with another option. Generally, a portfolio that is gamma-neutral, will not be vega-neutral and vice versa. To make a portfolio both gamma and vega-neutral, at least two traded derivatives on the same underlying asset must usually be used. All these risks will require constant rebalancing as the changes in underlying will constantly affect the values of these Greeks. As the "greeks" change over time, hedging positions will have to be readjusted.