A number of traditional methods (such as operational limits on credit lines, loan provisioning, portfolio diversification and collateralisation) and innovative methods (such as loan securitisation and separately capitalised derivatives) are already available internationally to manage credit risk. These are considered to be significantly less flexible on their own than the techniques available in the area of market risk. Capital adequacy guidelines have also encouraged financial institutions to put greater emphasis on the risk and return characteristics of their assets and liabilities. Credit derivatives, make it possible to evaluate and trade credit risk without liquidating the original product. They enhance flexibility and reduce costs. They allow banks to hedge the credit risk of a loan without having to assign the loan and with no risk to deteriorate the relationship. Credit derivatives, therefore, offer banks the advantage of improving the flexibility of their credit structures without imposing constraints on their client relations. This enhances efficient balance sheet management and adds to traditional hedging instruments.

Credit derivatives are a new market segment in the area of financial derivatives. They are financial products which transfer either specific or all the inherent risks of a credit position from one partner in the transaction viz., the risk seller, to another viz., the risk buyer, against payment of a premium. They are a new management tool, which facilitates evaluation and transfer of credit risk. Credit derivatives thus serve to evaluate and separate risks and to make them fungible. The areas of application are the traditional credit and bond business as well as risk and portfolio management. Credit derivatives deal with credit risk or risk of debtor default as pure debtor risk and not general market risk. The hedge refers directly to a particular debtor. The credit risk is typically debtor specific. The focus is placed on individual solutions designed to fulfil customer-specific wishes with an eye on their balance sheets. The products are hardly standardised, and there is practically no secondary market trade, even in the USA. Internationally, capital treatment has yet to be clarified and standardised documentation is not available for most of the products

Credit derivatives fall into two basic categories - swap-based (i.e. created on the basis of swap structures) and option-based. The swap-based versions include credit-swaps, basket credit swaps or notes and total return swaps. The option-based versions include spread options and sovereign risk options.

In sum, a bank can reduce credit risk without straining its relationship with a client or losing him altogether. However, in the Indian context, it may be feasible to experiment with credit default swap to begin with. By doing credit swaps, it is possible to take on additional credit lines. Credit swaps make it possible to take over risk without having to grant a loan. Under Indian conditions, credit swaps provide a mechanism for an institution like IDFC to take on the credit risks of banks. The market for credit derivatives is attractive for banks as well as institutional investors. Creditors can eliminate credit risk in part or entirely without documentating this to the market. At the same time, other institutional investors can gain access to credit markets, which would otherwise not be open to them.

Before this, the credit market will get a fillip if existing instructions on banks giving guarantees are reviewed. Scheduled commercial banks cannot currently give guarantees on debt instruments or give a loan/credit facility based on the guarantee of another bank or financial institution. The rationale is that the institution taking the credit risk should also fund the loan. There is an apprehension that the bank giving the loan will rely on the guarantee rather than on the viability of the project. There is need for a rethinking on the issue as a financial guarantee separates the credit risk from funding risk. It enables sound banks particularly international banks operating in India with skills to appraise projects, particularly infrastructure projects, but not in a position to fund these projects due to lack of rupee resources. Banks with resources that do not have the risk appetite for such project can invest in these guaranteed instruments. Financial institutions are giving such guarantees but banks are unable to do so. Banks can be permitted with certain prudential regulations such as treating these guarantees on par with loans for purposes of capital adequacy and exposure norm. Similarly, each bank could lay down a limit on the total amount of such guarantees issued to ensure that it does not over-extend itself.

In the absence of MIS and slow pace of computerisation, the RBI has suggested traditional gap analysis as a suitable method to measure interest rate risk. The analysis begins with constructing a maturity gap report. This report categorises assets and liabilities according to the time remaining to their repricing or maturity in specific time periods known as 'repricing' buckets. The time buckets range from one month and beyond one year. Categorising assets and liabilities lacking definite time frames into specific time periods (buckets) varies according to institution. RBI guidelines permit banks to make reasonable assumptions while categorising these items.

The maturity gap approach enables a bank to measure for each time period or bucket the positive gap or the negative gap. A positive gap (asset sensitive) indicates that more assets than liabilities will reprice in a given time period. In this case earnings tend to increase as interest rates increase because more assets than liabilities reprice at higher rates. A negative gap indicates (liability sensitive) that more liabilities than assets will reprice in a given time period. If rates increase, earnings will be adversely affected. However, the gap approach does not adequately address the rate sensitivity of longer term fixed rate instruments, the value of which can change dramatically without affecting short term interest income. Duration analysis can complement gap analysis and can be used to analyse the financial condition of a bank with a complicated series of repricing mismatches. Duration analysis can add significant insights into the interest rate risk exposure of an institution. However, a caveat will be in order. Duration analysis presupposes the existence of a parallel yield curve.

Interest rate risk is an aspect of normal banking operations that has become increasingly important since the deregulation of interest rates. Interest rate exposure associated with a mismatching of asset and liability maturity or duration gap can be controlled using a variety of techniques, which fall into the general classification of direct and synthetic methods. Direct restructuring of the balance sheet relies on changing the contractual characteristics of assets and liabilities to achieve a particular duration or maturity gap. On the other hand, the synthetic method relies on instruments such as futures, options, interest rate swap and customised agreements to alter balance sheet exposure. Since direct restructuring may not always be possible, the availability of synthetic methods adds a certain degree of flexibility to the asset/liability gap management process. This flexibility can be further enhanced if new financial instruments used to hedge or profit from interest rate changes are allowed to be introduced in the Indian market.

In the absence of exchanges, derivative products which are widely used overseas in managing interest rate risk are forward rate agreements and interest rate swaps.

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 :

Where,

R is the dealt rate
R fx is the fixing rate

Gap is the number of days applying to the FRA period. 'Basis' is the relevant money market rate basis (360/365 days). The fixing rate is usually the official 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.

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.

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.