Interest Rate Risk Management

Interest Rate Risk Management

Forward Rate Interest Rate Interest Rate Interest Rate

Basic Concepts
Aggrement Futures Options Swap

Basic Concepts
Interest Rate Risk
Interest rate risk is the potential for financial loss to the borrowers and investors due to
changes in interest rates.
Types of Interest Rates
Fixed Interest rate
It remains constant for the entire term of the loan or financial product.
Example: 12%
Floating Interest rate
It changes on each reset date based on fluctuations in a reference interest rate.
Example: LIBOR + 2%
If LIBOR = 8% then Floating interest rate = 8% + 2% = 10%
Reference or Benchmark Rate: Interest rate decided by independent body such as
central bank that forms the basis for determination of other interest rates.
Example: LIBOR (London Interbank Offered Rate), Central Bank Rates etc.
Reset Date: Specific date on which the interest rate on a loan or financial product is
adjusted to reflect changes in the underlying reference rate.
Example: If reference rate is 6-month LIBOR then reset date will be every 6 months
when LIBOR changes.

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Forward Rate Agreement
A Forward Rate Agreement (FRA) is a financial contract between two parties that
allows them to lock in an interest rate on a notional amount of money for a future
period. It is a forward contract for interest rates.

Buy FRA (Long position) Sell FRA (Short position)

Agree to pay a pre-decided interest rate Agree to receive a pre-decided interest rate
on amount to be borrowed on amount to be lend
Benefit = If interest rate increases Benefit = If interest rate decreases

FRA quotations
FRA quotation reflects the start and end dates, which define the future period over
which the interest rate will apply
e.g., 6 × 9 FRA = FRA starts in 6 month and ends in 9 month (Loan period = 3 month)
Today entered 6×9 FRA 6th Month 9th Month

(Loan period of 3 month)

Bid and Ask rate in FRA quotation

The bid and ask rates represent the two prices at which a dealer is willing to enter into
the FRA contract with a buyer or seller.
Example: 6 × 9 FRA rate = 10.5%/10.6% p.a.

Bid (10.5% p.a.) Ask (10.6% p.a.)

Rate at which dealer buy and customer sell Rate at which dealer sell and customer buy
The lower rate is always bid rate at which The higher rate is always ask rate at which
FRA can be sold by customer FRA can be bought by customer
Bid and ask rate are decide by dealers so, they are always favourable to dealer and
unfavourable to customer (buy at high price and sell at lower price).
FRA Settlement or Gain/ (Loss) on FRA
FRAs are cash settled so, difference in FRA contract rate and actual rate is settled
between buyer and seller
Notional principal ×(Actual rate−Contact Rate) × Period
Final Settlement =
1 + (Actual rate × Period)

FRA Buyer FRA Seller

Gain if Actual rate > Contact rate Gain if Actual rate < Contact rate
Loss if Actual rate < Contact rate Loss if Actual rate > Contact rate

Question based on above concept: TYK 1, 2

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Fair Value or Theoretical value of FRA
The Rate at which neither the buyer nor the seller of the FRA would gain or lose money
if the contract were settled immediately. It can be understood from below example
9
1 +(Interest rate p.a. for 9 month × 12 )
Fair value of 6 × 9 FRA = 6
1 +(Interest rate p.a. for 6 month × 12 )

Convert the value to p.a.

Today entered 6×9 FRA 6th Month 9th Month
6-month rate = 12% p.a. 6 × 9 FRA rate
9-month rate = 11.5% p.a.

Interest Rate Futures (IRF)

An interest rate future is a contract between the buyer and seller agreeing to the future
delivery of any interest-bearing asset. The interest rate future allows the buyer and
seller to lock in the price of the interest-bearing asset for a future date.
In IRF, bonds form the underlying instruments, not the interest rate. Further, IRF,
settlement is done at two levels:
• Mark-to-Market settlement done on a daily basis and
• physical delivery which happens on any day in the expiry month
Price of Interest rate future
Price of Interest rate future = PV of Govt. bond or interest-bearing asset
*Face value of bond is considered 100 so, interest rate futures can also be calculated
Price of Interest rate future = 100 – Interest rate p.a. for future period
IRF have the inverse relationship between interest rates and bond prices.
Borrower Lender or Investor
Risk of interest rate going up when he Risk of interest rate going down when he
has to borrow in future has to invest in future
To hedge – Buy interest rate To hedge – Sell interest rate
Since there is inverse relationship Since there is inverse relationship between
between IRF and interest rate so, IRF and interest rate so,
Sell IRF Buy IRF
Number of IRF Contract to bought or sold for perfect hedge
Loan amount ×Duration of loan
No. of future contract to buy or sell =
Future contract size × Duration of future
* Duration of loan and duration of future can be different so, above formula is use to
calculate the contracts for perfect hedge.

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Gain/ (Loss) on Interest rate future
If IRF is bought = Future value × [Link] contract × (Actual rate – Contract rate) × period
If IRF is Sold = Future value × No. of contract × (Contract rate – Actual rate) × period
Effective Interest or locked interest rate if IRFs are used for hedging
Effective or locked interest rate = 100 – IRF price
But in question we have to prove the same so, we will calculate as below
Effective interest = Actual interest – Gain on future + Loss on future
Convert the effective interest as above to % p.a.
Effective interest 12
Effective interest (% p.a.) = × Duration of loan
Loan amount
Question based on above concept: AQ 1
Physical Settlement of Interest Rate Future
Physical settlement can happen only on the expiry date. Following factors are
considered in physical settelment
(a) Conversion factor: All the deliverable bonds have different maturities and coupon
rates. To make them comparable to each other, and also with the notional bond, RBI
introduced Conversion Factor. Conversion factor for each deliverable bond and for each
expiry at the time of introduction of the contract is being published by NSE.
(Conversion Factor) x (futures price) = Actual delivery price for a bond.
* Future price of the treasury bond = face value of the bond
(b) Cheapest to Deliver (CTD): The CTD is the bond that minimizes difference between
the quoted Spot Price of bond and the Futures Settlement Price (adjusted by the
conversion factor). It is called CTD bond because it is the least expensive bond in the
basket of deliverable bonds.
Profit/ (loss) on settlement
(Futures Settlement Price x Conversion factor) – Quoted Spot Price of Deliverable Bond
Question based on above concept: AQ 2

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Interest Rate Options
Interest Rate Guarantee (Call option)
It is a right, not an obligation, obtained through the payment of a premium. It acts as
insurance by allowing businesses to protect themselves against adverse interest rate
movements while still benefiting from favourable movements.
Calculation of interest payable when interest guarantee is bought ₹
Interest amount (lower of actual rate or contract rate) XX
Add: Interest Rate Guarantee Premium XX
Interest payable XX

Question based on above concept: AQ 3

Cap Option (Call)
An interest rate call option gives the holder the right, but not the obligation, to benefit
from rising interest rates.
Value of cap option on maturity = Amount × (Actual rate – Contract rate) × Period
Floor Option (Put)
An interest rate floor option gives the holder the right to receive payments if interest
rates fall below a specified level (the floor rate).
Value of floor option on maturity = Amount × (Contract rate - Actual rate) × Period
*If value of cap and floor option is negative then option will not be exercised hence its
value becomes zero.
Option premium
Option premium is decided at the beginning of the contract which can be paid at the
beginning or on each reset date by option buyer to the seller.
Total Option Premium at beginning = Loan amount × Premium %
If nothing is mentioned in question then assume that option premium is paid on each
reset date so, we have to allocate the option premium on each reset date as follow.
Total option premium at begining
Allocated option premium =
PVAF (Interest rate in begining, number of reset period)

• Fixed interest rate given in question is considered as the beginning interest rate.
• If question ask “how far interest rate risk is hedged through Cap Option” then show
the benefit using call option. (TYK 3)
• Ignore the projections of interest rate give in question only actual interest rates on
reset date are relevant for calculating pay-out (TYK 7).
Ambiguity in ICAI answer (TYK 3)
ICAI has considered 4 reset period while calculating allocated option premium and
while calculating gain/ (loss) it has considered only 3 reset period.
Question based on above concept: TYK 3, 7
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Interest Rate Swap
An interest rate swap is a financial derivative contract between two parties where they
agree to exchange (or "swap") a fixed interest rate for a floating interest rate, or vice
versa on a specified notional principal amount over a set period of time.
Plain Vanilla Swap
Also called Generic Swap or Coupon Swap and it involves the exchange of a fixed rate
loan to a floating rate loan over a period of time and that too on notional principal.

Net settlement in Interest rate swap ₹

Days
Interest payment on fixed interest rate (Principal × Fixed rate × )
360
Days
Interest payment on floating interest rate (Principal × Floating rate × )
360
Net settlement XX
* In Plain vanilla swap through on OIS (Overnight Index Swap), the floating rate changes
daily so, principal is compounded daily
* If Sunday is holiday, then interest rate of Saturday will be charged for 2 days with no
compounding (TYK 5).
*If nothing is mentioned in question then assume 365 days in a year. (TYK 5)
Question based on above concept: TYK 4, 5
Interest Rate Swap to Reduce the cost of borrowing
Interest rate swap can be used by two parties to reduce their cost of borrowing by
borrowing in different currencies and then swapping the interest rate.

India US

13%
A needs B needs
$ loan ₹ loan
10%

15% 12%
10% 13%

Indian US
Bank Bank

₹ Loan $ Loan
A – 10% A – 15%
B – 12% B – 13%

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If question specify the interest payments in swap
Action Receipt Payment Net
Interest paid to Bank in opposite currency XX
Interest paid to Swap party in opposite currency XX
Interest received from Swap party in opposite currency XX
Net payment in opposite currency
Net payment in required loan currency (XX)
Interest payable without swap in required loan currency XX
Gain on swap XX
Question based on above concept: TYK 7
If question does not specify the interest payments in swap and provide some basis for
sharing the swap gain
Calculate the benefit from the swap
Benefit from swap ₹
Interest cost of both parties without swap XX
Less: Interest cost of both parties with swap (in opposite currencies) (XX)
Gain / (loss) on swap XX
Less; Swap commission of bank (XX)
Net Gain/ (loss) in swap XX
If nothing is mentioned in question, then net gain/ (loss) on swap will be shared by
parties in equal proportion.
Net Interest Cost ₹
Interest cost in required currency XX
Less: share in net swap gain (XX)
Net interest cost XX
Question based on above concept: AQ 4, 5

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