Interest Rate Swaps

Interest rate swaps are over-the-counter (OTC) contracts between two counterparties for exchanging interest payments for a specified period based on a notional principal amount. The notional principal is used to calculate interest payments but is not exchanged; only interest rate payments are exchanged.

The most common type of swap is a "plain vanilla" interest rate swap. In a typical plain vanilla swap, which is a single currency swap, one party agrees to pay to the counterparty cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years and at the same time the other party agrees to pay a floating rate on the same notional value for the same period of time. Principals are not exchanged either while contracting or at maturity. Usually these instruments are routed through an intermediary. The usefulness of derivatives is generally the comparative advantages and the need for hedging the risks in accordance with risk management objectives and find solutions to risk management.

Derivatives are useful tools for asset-liability management with lower cost than other means. Hence there has been a shift from cash market to derivatives market for short-term exposures. The three main types of IRS are "coupon swap" which is fixed rate to floating rate swap, "basis swap" which is floating rate against one reference rate to floating rate with another reference rate and "cross currency" which is a swap of fixed rate flows in one currency to floating rate flows of another.

An interest rate swap can achieve any of the following:

1. alter the cost of existing or generally available borrowing from fixed to floating rate or vice versa.

2. convert the rate of return on an asset from fixed to floating or vice versa.

3. generate a profit (or a loss) from interest rate fluctuations (if the swap is not matched with an asset or borrowing.)

The principal uses to which swaps are put flow from these three specific uses. The swap market has thus seen development of many types of swap and swap related products. Each product can be tailored to the needs of the institutions that seek to use swaps to alter the interest and currency profiles of portfolios and balance sheets. The two basic forms of IRS are the fixed-versus floating swap and the basis swap.

Banks and other financial intermediaries enter into swap transactions for trading purposes or for hedging purposes. When it acts as an intermediary for other parties, a bank arranges and administers the swap transaction. The bank acts as the principal to both sides of the swap and thus both sides rely on the bank rather than each other for performance of the deal. A bank may use swap transactions for trading purposes by taking a view on the future interest rates. A bank that expects interest rates to increase might enter into a swap deal to pay a fixed rate of interest and to receive variable amounts.

Indian banks use swaps as an integral part of their management of interest rate risk. A bank can use an interest rate swap to achieve a closer match between its interest income and interest expense, thereby reducing its interest rate risk. The decision to use swaps will depend on the needs of customers and the size of the open interest rate position that it is prepared to run. A bank may use swap transactions to hedge existing assets and liabilities. If a bank finds itself with a preponderance of fixed rate assets and variable rate liabilities, an increase in interest rates could have a significant negative impact on earnings. To hedge against this possibility, the bank might enter into a series of swap contracts so as to effectively convert its variable rate liabilities into fixed rate obligations. The swaps will be profitable if the interest rates go up and will be unprofitable if they go down; however its overall earnings will be stable regardless of the direction in which rates move. Although banks tend to manage their swap portfolios on a deal by deal basis, larger banks often engage in portfolio hedging or management.

The market convention for pricing interest swaps is to quote the fixed-rate in terms of a basis point spread over the Treasury rate for receiving the floating interest rate index flat (no basis points are added to or subtracted from the floating rate). Swaps are so priced that at origination the expected present value of the fixed-rate payments equals that of the floating rate payments. Therefore, an upfront cash payment is not necessary.

Banks are exposed to both interest rate risk and credit risk in swap transactions. The payments and receipts in a swap transaction are determined by interest rate movements. Therefore, if not fully matched, the swap creates an interest rate risk. If the counterparty fails during the life of the contract, the bank is at risk for the replacement cost of the swap. There is also a liquidity risk associated with opening a position because the market is illiquid and hence difficult to close out.

A variety of interest products may also be included in the swap portfolio such as swaps with embedded options, cancelable or extendible swaps, interest rate caps and floors and other products. In contrast to a futures hedge, which fixes a specific interest rate, an options hedge, is similar to the purchase of interest rate insurance. For the price of the option, the buyer is protected against an adverse movement in interest rates while preserving the benefits of a favorable movement in rates. Different options will provide different types of insurance. If the future cash position is certain, the best hedge will typically involve use of the futures contract/FRA. If the cash flow is less certain, the options hedge will be less risky and likely to be preferred. An options hedge is generally more expensive than a futures hedge but retains some of the benefits of a favourable movement in the cash market.

When interest rate swaps/FRAs are introduced in India, banks/ FIs/NBFCs should be required to maintain capital on the basis of current exposure method prescribed in the guidelines. Similarly, capital adequacy for market risks including interest rate risks will also have to be gradually introduced. The standardised approach can be adopted as a transitional measure. As the market develops, a supervisory framework for obtaining information will become necessary. The following are some of the other dimensions :

1. It is necessary that banks and other participants having positions in these products mark them to market on a daily basis in due course. Banks should internally fix prudential limits on unmatched positions, which should be reported to RBI.

2. Capital allocation for such products should be a function of both the credit exposure as well as volatility of the underlying asset.

3. Prudential norms are required to regulate the extent of leverage that such products provide

4. Certain taxation issues arise such as whether the swap payments and receipts are treated as other income or interest income, and the tax implications if transactions are gross settled or net settled.