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Interest Rate Risk Management

Determinants Types Methods to Measure Hedging

1. Supply and Demand: 1. The traditional Maturity Gap

When economic growth is
Gap Exposure Basis Risk Embedded Option Risk Yield Curve Risk Price & Reinvestment Risk Analysis (to measure the
high, demand for money interest rate sensitivity of
increases, pushing the 1. The risk that the interest 1. Significant changes in market 1. In a floating interest rate 1. Price risk is simply the risk that the price of a security will fall. earnings),
Gap Interest Rate Interest Rate
interest rates up and vice rate of different assets, interest rates create another source scenario, banks may price their
Exposure = Sensitive Assets - Sensitive Liabilities assets and liabilities based on 2. Duration (to measure interest
liabilities and off-balance of risk to banks’ profitability by 2. In the financial market, bond prices and yields are inversely
versa. (RSAs) rate sensitivity of capital),
(RSLs) different benchmarks, i.e. TBs related.
1. A positive or asset sensitive Gap means that an increase in sheet items may change encouraging prepayment of cash yields, fixed deposit rates, call
2. Inflation - The higher the in different magnitude is credit/demand loans/term loans and 3. Simulation and
market interest rates could cause an increase in Net Interest money rates, MIBOR, etc. 3. Increase in Interest Rates will lead to fall in prices
inflation rate, the more Income (NII). termed as basis risk. exercise of call/put options on
interest rates are likely to 2. In case the banks use two 4. Decrease in Interest Rates will lead to increase in prices 4. Value at Risk.
bonds/debentures and/or premature
2. Conversely, a negative or liability sensitive Gap implies 2. For example while assets different instruments maturing
rise. withdrawal of term deposits before at different time horizon for
that the banks’ NII could decline as a result of increase in may be benchmarked to 1. Uncertainty with regard to interest rate at which the future
their stated maturities. pricing their assets and
3. Government- market interest rates. Fixed Rate of Interest, cash flows could be reinvested is called reinvestment risk.
liabilities, any non-parallel
Government is the biggest liabilities may be 2. The faster and higher the magnitude movements in yield curves
3. Positive or Negative Gap is multiplied by the assumed interest 2. Any mismatches in cash flows would expose the banks to
borrower. The level of benchmarked to Floating of changes in interest rate, the would affect the NII.
rate changes to derive the Earnings at Risk (EaR). The EaR variations in NII as the market interest rates move in
Rate of Interest. greater will be the embedded option
borrowing also determines different directions.
method facilitates to estimate how much the earnings might risk to the banks’ NII.
the interest rates. be impacted by an adverse movement in interest rates.

Traditional Methods Modern Methods

Asset & Liability Management Forward Rate Agreement Interest Rate Futures Interest Rate Options Interest Rate Swaps Meaning 1. An interest rate swaption is simply an option on an interest
rate swap. It gives the holder the right but not the obligation
to enter into an interest rate swap at a specific date in the
1. ALM is the management of structure of 1. A forward rate agreement (FRA) is an over-the- 1. An interest rate future is a contract Caps: An interest rate swap is an agreement between two future, at a particular fixed rate and for a specified term.
balance sheet (liabilities and assets) in such counter contract between parties that between the buyer and seller agreeing to counterparties in which one stream of future interest
A cap provides a guarantee that the coupon rate 1. A swaption is effectively an option on a forward-start IRS,
a way that the net earnings from interest are determines the rate of interest to be paid or the future delivery of any interest- bearing Features
each period will not be higher than agreed limit. It payments is exchanged for another based on a specified where exact terms such as the fixed rate of interest, the
maximized within the overall risk received on an obligation beginning at a future asset. will be capped at certain ceiling. floating reference interest rate and the tenor of the IRS are
principal amount.
preference (present and future) start date. established upon conclusion of the swaption contract.
2. Interest rate futures are used to hedge It’s a derivative instrument where the buyer of the 2. A 3-month into 5-year Swaption would therefore be seen as
against the risk that interest rates will cap receives payment at the end of each period
2. Banks and other financial institutions 2. An FRA involves two counterparties: the fixed an option to enter into a 5-year IRS, 3 months from now.
move in an adverse direction, causing a where the rate of interest exceeds the agreed strike
provide services which expose them to rate receiver (short) and the floating rate 3. The 'option period' refers to the time which elapses between
cost to the company. price. the transaction date and the expiry date.
various kinds of risks like credit risk, receiver (long). Thus, being long the FRA
3. Currently, Interest Rate Futures segment Floors: 4. The swaption premium is expressed as basis points.
interest risk, and liquidity risk. (Fixed Payer) means that you gain when Libor Types Swaptions 5. Swaptions can be cash-settled; therefore at expiry they are
rises (because you have to pay fix rate even if of NSE offers two instruments i.e. Futures
3. It is therefore appropriate for institutions on 6 year, 10 year and 13 year Government A floor provides a guarantee that the coupon rate marked to market off the applicable forward curve at that
the libor has increased). each period will not be lower than agreed limit. It Plain Vanilla Rate Swap time and the difference is settled in cash.
(banks, finance companies, leasing of India Security and 91- day Government
will be floored at certain ceiling. 1. In t h i s s w a p , Pa r t y A a g r e e s to p a y Pa r t y B a
companies, insurance companies, and 3. If we are the fixed receiver, then it is of India Treasury Bill (91DTB). predetermined, fixed rate of interest on a notional
o t h e r s ) t o f o c u s o n a s s e t- l i a b i l i t y understood without saying that we also are the It’s a derivative instrument where the buyer of the principal on specific dates for a specified period of time. 1. Swap traders can use them for speculation purposes or to
4. Bonds form the underlying instruments, floor receives payment at the end of each period 1 Uses
management when they face financial risks floating payer, and vice versa. 2. Concurrently, Party B agrees to make payments based on a hedge a portion of their swap books.
not the interest rate. Further, IRF, where the rate of interest goes below the agreed floating interest rate to Party A on that same notional
of different types. 2. Swaptions have become useful tools for hedging embedded
settlement is done at two levels: strike price. principal on the same specified dates for the same optionality which is common to the natural course of many
4. Because there is no initial exchange of cash
specified time period. businesses.
flows, to eliminate arbitrage opportunities, the 1. Mark-to-Market settlement done on a Collars:
Where, 3. Swaptions are useful to borrowers targeting an acceptable
FRA price is the fixed interest rate such that daily basis and borrowing rate.
Collar provides a guarantee that the coupon rate Basis Rate Swap
N = the notional principal amount of the agreement; the FRA value is zero on the initiation date. 4. Swaptions are also useful to those businesses tendering for
1. A basis swap is a floating-floating interest rate swap. A
2. Physical delivery which happens on each period will not fall below lower limit and will 2 simple example is a swap of 1-month Libor for 6-month contracts.
RR = Reference Rate for the maturity specified by 5. FRAs are identified in the form of “X × Y,” any day in the expiry month. not go beyond upper limit. It will be capped at
upper limit and floored at lower limit. Libor. 5. Swaptions also provide protection on callable/puttable bond
the contract prevailing on the contract settlement where X and Y are months and the 5. In IRF following are two important terms: issues.
date; typically LIBOR or MIBOR
multiplication symbol, ×, is read as “by.” To It’s a combination of caps and floors. Asset Rate Swap
FR = Agreed-upon Forward Rate; and grasp this concept and the notion of exactly 1. Similar in structure to a plain vanilla swap, the key
difference is the underlying of the swap contract. Rather
what is the underlying in an FRA, consider a 3 × In which the owner is allowed to
dtm = maturity of the forward rate, specified in days Conversion factor: All the deliverable bonds have different maturities and coupon rates. To make than regular fixed and floating loan interest rates being Categories Bermudian Swaption
enter the swap on multiple specified
(FRA Days) 9 FRA, which is pronounced “3 by 9.” swapped, fixed and floating investments are being
them comparable to each other, and also with the notional bond, RBI introduced Conversion Factor. 3 exchanged.
dates.

DY = Day count basis applicable to money market 1 Conversion factor is published by NSE.
6. The 3 indicates that the FRA expires in three 2. In a plain vanilla swap, a fixed libor is swapped for a In which the owner is allowed to
transactions which could be 360or 365 days. floating libor. In an asset swap, a fixed investment such as European Swaption enter the swap only on the
months. The underlying is implied by the (Conversion Factor) x (futures price) = actual delivery price for a given deliverable bond. a bond with guaranteed coupon payments is being expiration date.
If LIBOR > FR the seller owes the payment to the difference in the 3 and the 9. swapped for a floating investment such as an index.
buyer, and if LIBOR<FR the buyer owes the seller In which the owner is allowed to
Cheapest to Deliver (CTD): The CTD is the bond that minimizes difference between the quoted Spot Price
the absolute value of the payment amount 7. FRAs are cash settled with the payment based American Swaption enter the swap on any day that falls
determined by the above formula. of bond and the Futures Settlement Price (adjusted by the conversion factor). It is called CTD bond because it Amortising Rate Swap within a range of two dates.
on the net difference between the interest rate is the least expensive bond in the basket of deliverable bonds.
1. An exchange of cash flows, one of which pays a fixed rate
The differential amount is discounted at post change and the reference rate in the contract.
(actual) interest rate as it is settled in the beginning 2 Profit of seller of futures of interest and one of which pays a floating rate of interest,
= (Futures Settlement Price x Conversion factor) – Quoted Spot Price of Deliverable Bond and both of which are based on a notional principal
of the period not at the end.
4 amount that decreases.
Loss of Seller of futures
2. In an amortizing swap, the notional principal decreases
= Quoted Spot Price of deliverable bond – (Futures Settlement Price x Conversion factor) periodically because it is tied to an underlying financial
That bond is chosen as CTD bond which either maximizes the profit or minimizes the loss instrument with a declining (amortizing) principal balance,
such as a mortgage.

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