The risks in the banking sector can be broadly classified into a few basic categories. Credit risk consists of bad risk arising from borrowers' inability or unwillingness to pay back the loans. Market risk includes interest rate risk, currency risk, price risk and underwriting risk which are not hedged by the banks. Operational risk are those that arise in the normal course of business and include settlement risk, performance risk, legal risks, defects in computer programmes, transmission errors, risk associated with theft, fraud or operational staff overstepping authority. Strategic risk which include misreading of market needs, creating overcapacity, cost going out of control and those arising out of underestimating customer preferences. In short, for a bank any line of business entails some risk. Market risk is in the foreground for banks operating in India consequent to deregulation of interest rate and financial derivatives are expected to meet the need. The derivative market provides several instruments to hedge the risks. They include, currency and interest rate swaps (IRS) and options, forward rate agreements (FRA) along with their variants. It must be understood that the primary economic function of a derivative is to redistribute risks besides improving allocation of resources. It can be used by investors and borrowers to get protection namely to turn a risk into a certainty (hedge) as also for speculative purposes.

"In order to facilitate hedging of interest rate risks and ensuring orderly development of the derivatives market, policy guidelines for forward rate agreement (FRAs)/interest rate swaps (IRS) were issued to SCBs (excluding RRBs), PDs and all-India FIs, allowing them to undertake FRAs/IRS as a product for their own balance sheet management and for market making purposes. To provide more flexibility for pricing of rupee interest rate derivatives and facilitate some integration between money and foreign exchange markets, use of "interest rates implied in the foreign exchange forward market" were permitted as benchmarks, in addition to existing domestic money and debt market rates.

"There was sharp increase in the volume of FRAs /IRS market during 2001-02. Available data show that FRAs /IRS transactions, both in terms of number of contracts and outstanding notional principal amount, rose from 1,615 contracts amounting to Rs.22,865 crore as on April 6, 2001 to 4,379 contracts for Rs. 86,749 crore as at end-March 2002. During 2002-03, till September 20, 2002, transaction in this segment recorded 5,675 contracts for Rs. 1,31,898 crore. Although there has been a significant increase in the number and amount of contracts, participation continues to be restricted mainly to select foreign and new private sector banks and PDs. In a majority of these contracts, NSE-MIBOR was used as the benchmark rate. The other benchmark rates used include 3-month benchmark rate on Reuters, MIFOR, government securities yield for 1 year, primary cutoff yield on 364-day treasury bills, etc."
[Source: RBI Report Trends & Progress of Banking in India 2002]

Interest rate swaps (IRS) and Forward rate agreements (FRA) in the rupee made their entry in July 1999, following guidelines issued by the RBI (RBI circular MPD.BC. 187/07.01.279/1999-2000 dated July 7, 1999). The RBI does not as yet allow any volatility (option) products on the rupee IRD side: thus caps/ floors/ barriers etc. Cannot be structured on to any IRD. As readers would be aware, IRS and FRA are derivatives that permit players to move between fixed interest rates and floating rates linked to standard benchmarks.

In a typical example, a company issuing fixed rate long tenor bonds, but expecting medium term softness of interest rates would receive a fixed rate against a floating benchmark set at an appropriate frequency (say six months). The swap along with the underlying bonds would effectively convert their fixed rate borrowing into floating rate borrowings where the rates are reset every six months.

The RBI permits corporate customers to hedge interest rate risks on both the asset and liability side, using rupee IRD. Customers need to identify and earmark genuine exposures against each IRD, ensuring that the tenor and the notional of the hedge does exceed that of the underlying. Banks dealing with customers must also satisfy themselves that the customer has genuine underlying exposures. Rupee IRD undertaken by customers can be freely cancelled and rebooked.

In the Indian case, over the years, three basic benchmarks have dominated the inter-bank market for swaps:

• those based on the overnight call rate benchmark (Mumbai Inter-bank Offer Rate or MIBOR published by the NSE),

• those based on the rupee rates implied in the US$/ INR foreign exchange (FX) market (Mumbai Inter-bank Forward Offer Rate or MIFOR & Mumbai Inter-bank Tom Offer Rate or MITOR) and

• those based on the Government of India (GOI) bond market. Other benchmarks such as the 3-month commercial paper (CP) rate have also been used in a few swaps, but no inter-bank market exists for such instruments.

"Available data show that FRAs/IRS transactions have recorded substantial increase during the recent period. In terms of number of contracts and outstanding notional principal amount, such transactions have jumped from about 200 contracts amounting to Rs.4,000 crore in March 2000 to 6,500 contracts for Rs.1,50,000 crore in December 2002. However, the market is highly concentrated as the share of 13 major participants in the aggregate outstanding notional principal amount accounted for over 90 per cent in December 2002 (Annex I.1). Though in majority of these contracts, the market players have used NSE-MIBOR as the benchmark rate, they have also been using such other benchmarks as Mumbai Inter-Bank Forward Offered Rate (MIFOR), Mumbai Inter-Bank Offered Currency Swaps (MIOCS), Mumbai Inter-Bank Overnight Index Swaps (MIOIS), Treasury Bill rates, etc."
[Source Report of Jaspal Bindra, Working Group on OTC Rupee Derivatives ]

The forward rate agreement is an off balance sheet contract between two parties under which one party agrees on the start date (or trade date) that on a specified future date (the settlement date) that party will lodge a notional deposit with the other for a specified sum of money for a specified period of time (the FRA period) at a specified rate of interest (the contract rate). The party that has agreed to make the notional deposit has thus sold the FRA to the other party who has bought it. On the settlement date, a cash settlement is made by one party with the other calculated by reference to the difference between the contract rate and the 'settlement rate'. The settlement rate is the market rate of interest prevailing on the settlement date for the FRA. The instrument has been developed out of the forward cash market. The advantage of FRAs over the forward cash market is that no principal sums are transferred on the settlement date and thus banks can easily adjust their interest rate profiles without the credit risk associated with a cash deposit or having to affect their liquidity positions.

Since the payment is made at the beginning of the FRA period rather than the end (which is the normal basis on which interest rates are quoted), the actual cash settlement is computed as the present value of the amount that would normally be received at the end of the period. This present value is calculated according to a formula agreed at the outset of the contract and is normally the end of period amount discounted for the FRA period at the settlement rate.

FRAs can be used for risk management or for trading. FRAs allow a borrower or lender to 'lock in' an interest rate for a period that begins in the future thus effectively extending the maturity of its liabilities or assets. Banks can use FRAs as an integral part of their management of interest rate risk with a typical FRA book consisting of a portfolio of FRAs of varying periods and currencies. FRAs are an important product that banks can market to their corporate customers as part of a cash management service. When a customer takes out a FRA, the bank will be left with an open interest rate position that it can close with an FRA in the inter-bank market or carry against its existing interest rate profile.

There are risks associated with FRAs. Banks are exposed to credit risk if the counterparty fails before settlement date for the replacement cost of the FRA. There is also the risk of the counterparty failing to deliver on settlement date. The potential loss in this case is the ultimate profit of the FRA. The principal sum being a notional sum is not at risk. The direction and amount of the FRA settlement are determined by interest rate movements. The bank is, therefore, exposed to market risk if the instrument is not fully matched. The market risk can generally be managed by including the interest rate positions within a financial institution's overall system for measuring and controlling interest rate exposure. As for credit risk, banks can mitigate the credit risks by taking margins.

The pricing of FRAs reflects the costs of alternative ways of constructing a similar hedge. For example, the price of a six against nine-month FRA will depend in particular on interest rates on six and nine month deposits. They are usually priced from the inter-bank yield curve.

As per Forward Rate Agreement, British Banks Association Rules, the cash settlement of the profit & loss is computed as follows :

Profit/Loss = Notional Amount x (Rfx - R)/100 x Gap/Basic
1+Rfx/100 x Gap/ Basic

Where,

- R is the dealt rate
- R fx is the fixing rate
- Gap is the number of days applying tto tthe FRA period.
- 'Basis' is the relevant money markett raate basis (360/365 days).
- The fixing rate is usually the officciall fixing of a money market period and internationally the most   commonly used benchmark is the LIBOR.

FRAs can be most easily priced from a zero coupon yield curve. From the zero curve one can derive the zero coupon rate at settlement of the FRA. The seller of FRA notionally places deposit or gives loan at a certain rate of interest. The seller seeks protection against downward slide in the interest rates. The buyer of FRA notionally accepts deposits or borrows at a certain rate of interest in order to obtain protection against upward movement in interest rates.

Indian banks may use FRA under different circumstances. For example, if Gap analysis shows that in a particular bucket (say within one year during which interest rate risk is actively managed) risk sensitive assets (RSA) are greater than risk sensitive liabilities (RSL) and a bank expects downward movement in interest rate (which will squeeze its net interest income (NII), it can sell FRA for RSA-RSL corresponding to the time bucket. If interest rates fall, the squeeze in NII will be approximately compensated due to FRA. On the other hand, if RSL>RSA and the bank expects interest rates to rise, it can buy FRA for RSL-RSA for the corresponding time bucket. Depending upon the RSA and RSL patterns in different time buckets and a view on interest rate movements a set of FRAs can be put in place to hedge against interest rate risk. A bank may also use FRA to lock in return or its borrowing cost. There may be occasions when a bank expects substantial inflow in 3 months from its recovery drive but does not expect loan demand to pick for another 6 months. In such a scenario, in order to lock in a targeted return, the bank may sell FRAs. Similarly, a bank which is funding longer-term loans by rolling over shorter-term liabilities may buy FRAs to lock in borrowing cost.

A bank, which has liabilities of longer duration, but due to capital adequacy or other considerations lends a certain amount of its liabilities in the inter-bank market for three months, can use FRAs to cover its exposure, to movements in short-term rates. To hedge its exposure this bank can sell a series of FRAs so as to match its liabilities and lock in to a spread. Similarly, another bank which has limited access to funds with maturities greater than six months and has relatively longer term assets can prefer a contract for a six against twelve month FRA and thus, increase the extent to which it can match asset and liability maturities from an interest rate perspective. In both these situations, the banks can choose to buy some FRAs depending on their market views and their perception of periods of uncertainty.

Corporates too can make use of FRAs. A company which is a big issuer of commercial paper with a tendency to roll over the CPs on maturity can at a particular point, when interest rates are low, buy a series of FRAs to hedge its funding cost.

This product enables the banks to adjust their interest rate exposure without altering their liquidity profile and also with less impact on the size of the balance sheet and the credit exposures than taking a route of interbank market. FRA is particularly attractive in a currency for which there are no futures markets. The risk of loss depends on the adverse movement in interest rates and the default by the counterparty. There is no risk on the notional principal. These are usually used to hedge existing open position but can also be used for position taking.