Interest Rates & Credit Derivatives

Interest Rates & Credit Derivatives Ashish Ghiya Derivium Tradition (India) 25/06/14 1

Agenda Introduction to Interest Rate & Credit Derivatives Practical Uses of Derivatives Derivatives Going Wrong Practical Examples 25/06/14 2

Interest Rate Derivatives Interest Rate Futures Interest Rate Swaps

What Are Futures? A futures contract is an agreement between a buyer (seller) and an exchange or its clearinghouse in which the buyer (seller) agrees to take (give) delivery of a standard quantity of a specific asset / financial instrument at a specified price at the end of a designated date

Characteristics of Futures Exchange Traded Standardized Counterparty risk is absent Settlement of trades is guaranteed by the clearing corporation of the exchange Margining system Daily Marked-to-Market (MTM) settlement

Role of The Clearing House Central counterparty to every contract Matched position Enables netting of contracts Guarantees contract performance to clearing members Operates centralised margining and daily MTM settlement process

Role of The Clearing House Client A Client B Clearing Member Clearing Member Bought Sold Registered Trade Sold Clearing House Bought Registered Trade

Interest Rate Futures Face value of underlying bonds in IRFs is INR 100 & each contract represents 2000 underlying bonds of a total FV of INR 200,000 Quotes in clean price format Serially monthly contracts with a maximum maturity of 3 months & quarterly contracts maximum upto 1Y

IRF : Example DAY 1 : P.M. Sell 250 Feb Futures @ 100.84 (Close of business) Initial Margin @ 2.5% = 1,260,500 DAY 2 : P.M. Feb Futures Closes at 100.95 DAY 3 : A.M. Pay 0.11 (100.84-100.95) MTM Margin (- Rs. 55,000) P.M. Feb Futures Closes at 100.80 DAY 4 : A.M. Receive 0.15 (100.95-100.80) MTM Margin (Rs. 75,000) P.M. Buy 250 Feb Futures at 100.64 DAY 5 : A.M. Receive 0.16 (100.80-100.64) MTM Margin (Rs. 80,000) and Rs. 1,260,500 Initial margin refunded Net Profit/Loss = Rs. 100,000

Bond Futures In India Notional 10Y bond, with a cheapest to deliver option on maturity Actual bond with the underlying maturity of close to 10Y, with cash settlement on maturity 5Y, 7Y & 15Y cash settled bond futures are approved but yet to be introduced

Practical Applications Hedge against interest rate risk Arbitrage between cash and futures markets

Cash & Carry Strategy Buy the bond and fund the long bond position through short term borrowing (repo) Sell the futures At expiry, cover the short futures and reverse the repo transaction & selling the bond in cash markets

Cash & Carry Strategy Buy cash bond (Dirty) : - 99.00 (100.14) Repo (1 st leg) @7.40% + 100.14 Sell a futures : 99.06 Trade Initiation 17 th Jul At Expiry 30 th Jul Sell cash bond (Dirty) : + 98.60 (99.99) Repo (2 nd leg) - 100.40 Expire futures : 98.60 Net gain from Arbitrage MTM of bond = -0.40 (98.60-99.00) Net carry = -0.01 MTM of Futures = +0.46 (99.06-98.80) Net earnings of 0.05, yielding an HPR of 8.90% on Investment of 100.14

Interest Rate Swaps A custom-tailored bilateral agreement Two counterparties agree to exchange specified cash flows at periodic intervals over a pre-determined life of the swap on a notional principal

Interest Rate Swap Counter-Party A enters into a Interest Rate swap with a Bank on the following terms Notional Principal Amt. Counter-Party A to receive Counter-Party A to pay Trade Date of the swap Start Date of the swap Tenor of the swap End Date of the swap Rs. 25 cr. 3 Month Tbill (Floating) Rs. 7.80% (Fixed) 17-Jul-15 18-Jul-15 6 months 18-Jan-16 Interest Payment Dates Quarterly (18 Oct 2015 & 18 Jan 2016)

Interest Rate Swap 3 Month Tbill on 17 Jul 2015 : 7.55% Cash Flow On the 18 Oct 2015 A to Receive (Rs. 25 cr. X 7.55% X 92 days / 365 days) Rs. 47.57 lakhs A to pay (Rs. 25 cr. X 7.80% X 92 days / 365 days) Rs. 49.15 lakhs Net Cash Flow A Pays Rs. 1.58 lakhs

Interest Rate Swap 3 Month Tbill on 17 Oct 2015 : 8.25% Cash Flow On the 18 Jan 2016 A to Receive (Rs. 25 cr. X 8.25% X 92 days / 365 days) Rs. 51.99 lakhs A to pay (Rs. 25 cr. X 7.80% X 92 days / 365 days) Rs. 49.15 lakhs Net Cash Flow A Receives Rs. 2.84 lakhs

Interest Rate Swaps in India Overnight Indexed Swaps (OIS) Floating benchmark linked to daily overnight MIBOR INBMK Swaps Floating benchmark linked to 1Y Gsec yield MIFOR Swaps Floating benchmark linked to FX forwards rates

Overnight Indexed Swap Floating leg linked to Overnight NSE MIBOR benchmark for overnight call money, which is compounded daily Receiving a fixed rate mimics the payoff from buying a GOI security and funding it through the call money markets

Overnight Indexed Swap Notional Principal Amt. Counter-Party A to Pay Counter-Party A to Receive Rs. 25 cr. O/N NSE MIBOR (Floating) Rs. 7.32% (Fixed) Trade Date of the swap 17 Jul 2015 Start Date of the swap 18 Jul 2015 Tenor of the swap 7 days End Date of the swap 23 Jul 2015 Interest Payment Dates Compounding On Maturity Applicable

NSE MIBOR Effective MIBOR Overnight Indexed Swap Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 7.20% 7.25% 7.35% 7.40% 7.50% 7.75% 7.60% ((1+7.20%/365)*(1+7.25%*/365)*(1+7.35%/365)*(1+7.40%/365)*(1+7.50%/365) *(1+7.75%/365) *(1+7.60%/365)) -1 X 365 / 7 7.44% Fixed Rate 7.32% Difference Net Settlement 12 bps 25 crs * 0.12% * 7 days / 365 5753

5Y OIS Term-sheet Notional Principal Amt. Counter-Party A to Pay Counter-Party A to Receive Rs. 25 cr. O/N NSE MIBOR (Floating) Rs. 7.21% (Fixed) Trade Date of the swap 17 Jul 2015 Start Date of the swap 18 Jul 2015 Tenor of the swap 5 Years End Date of the swap 18 Jul 2020 Interest Payment Dates Compounding Semi-Annual Applicable 25/06/14 22

Applications of Interest Rate Derivatives

Hedging Fair Value Hedge - To reduce or eliminate the exposure to a change in fair value that is associated with an existing asset or a liability Cash Flow Hedge - To reduce the variability in the expected future cash flows due to changes in variable rates or prices

Fair Value Hedge Exposure A Fund Manager has an Investment in a 5Y Govt. security currently trading at 7.95%, which is subject to interest rate risk Risk It is exposed to the risk of a fall in market value due to a rise in yields and wants to protect itself against the same Hedge It pays a fixed rate (7.15%) in 5Y OIS 1M Later The Govt. security is trading at 8.45% s.a. (versus 7.95%), while the 4 years 11 months OIS rate : 7.65% s.a. (versus 7.15%); thereby protecting the fund manager s portfolio against rising yields

Fair Value Hedge The underlying could be a fixed rate asset viz. GOI security, corporate bond, loan etc. The risk being hedged would be the interest rate risk, excluding the credit risk embedded in a corporate bond or a loan.

Hedging Portfolio PVBP Fixed income portfolios carries an interest rate risk against any upward movement in interest rates This can be hedged actively through the Interest Rate derivatives The consolidated portfolio can be measured in terms of Price Value Basis Points (PVBP) to maintain only desirable amount of risk

Hedging in a Rising Interest Rate Scenario In a rising interest rate scenario, the fixed income portfolio runs the risk of portfolio devaluation as yields rise & bond prices fall In order to immunize the portfolio in such a scenario, it can enter into pay fixed-receive floating interest rate swaps or sell futures

Hedging in a Rising Interest Rate Scenario Total Portfolio Portfolio to be hedged PVBP PVBP of 10Y OIS :Rs 3500 crs :Rs 1250 crs :Rs 75 lacs :Rs 1.80 lacs Notional amount of 10Y OIS to be paid to hedge the portfolio is Rs 1050 crs

Cash Flow Hedge A cash flow hedge is a hedge of the exposure to variability in cashflows that is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecasted transaction or an unrecognized firm commitment, and could affect P&L Cash flow hedges are structured to reduce the variability in the expected future cash flows due to changes in market rates or prices

Cash Flow Hedge Examples Investment in a floating rate bond and hedged using Receive Fixed / Pay Floating IRS. This protects the future cashflows to be received on the bond against a fall in interest rates. Forecasted policy premium inflow, interest receipts, redemption of securities to be invested in fixed rate bonds.

Cash Flow Hedge Exposure A Fund Manager has an Investment in a 3Y floating rate bond linked to MIBOR, which is subject to interest rate risk Risk Future cashflows on the bond are variable / uncertain. It is exposed to the risk of a fall in interest rates, which could result in lower interest income from the bond Hedge It receives a fixed rate in 3Y OIS to convert its floating rate asset into a synthetic fixed rate asset On Maturity This enables the fund manager to lock-into a fixed rate, and immunize its interest income due to a fall in interest rates

Leverage & Capital Efficient Given a positive view on softening interest rates, strategy can either be to buy GSecs directly in cash for 100 crs OR Buy futures contract (pay margin money) and invest the rest in high yielding security (CD @10%) or liquid fund Holding period of 23 days

Leverage & Capital Efficient Initial Investment of 102.29 crs. Cash Bond Position: Futures + Liquid Inv. Position: Buy Price: 100.60 (102.29) Amt paid: 102.29 cr Sell Price: 100.885 (103.14) Profit on Bonds : 2,850,000 Accrued Interest: 5,700,000 Total Return: 8,550,000 Annualized HPR: 13.26% Buy Price: 100.45 Margin = 4.02 cr + CD Inv. = 98.27 cr Sell Price: 100.885 Profit on Futures : 4,350,000 CD Interest : 10% *98.27 *23/365 =6,192,400 Total Return: 10,542,400 Annualized HPR: 16.4%

Credit Default Swaps

Credit Default Swaps Credit Default Swap (CDS) is a bilateral OTC agreement, which transfers a defined credit risk from buyer to the seller of the contract, for a fee The buyer of credit protection pays a periodic fee to the seller in return for protection against a Credit Event of an underlying Reference Entity In essence it is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of a default

Credit Default Swaps Protection Buyer X bps per annum Contingent Payment (Par Recovery) Protection Seller Via a Credit Default Swap, the Protection Buyer transfers risk that the Reference Entity will default Protection Seller receives a fee, similar to an insurance premium, and assumes the risk that the Reference Entity will default Upon a default or Credit Event, protection seller makes a contingent payment to the protection Buyer

Credit Default Swaps Credit Risk Transfer Protection Buyer x bps p.a. If Credit Event: Par Amount If Credit Event: Deliverable Obligation Protection Seller If no Credit Event occurs, the only cash flow is the premium paid by the buyer to the seller

Credit Default Swaps If a Credit Event occurs, the premium payments stop and the transaction is settled Physical: The buyer delivers bond and the seller delivers 100% of the notional to the buyer. Physical settlement is the market standard Cash: A valuation mechanism is used to determine a Final Price for the defaulted bond obligations and the seller delivers the notional of the transaction x (100% - Final Price) to the buyer

Transferring of Risk Reference Entity Counterparty Risk X bps per annum Contingent Payment Bank Buyer decreases exposure to Reference Credit(s), but assumes contingent exposure to Seller Seller receives a fee in return for making a Contingent Payment if there is a Credit Event of the Reference Credit

Credit Default Swap Reference Entity B Protection Buyer Buy CDS Buy Protection Pay periodic payments Receive contingent payment Hedges Credit Risk Risk (Notional) Fee/premium Contingent Payment upon a credit event A Protection Seller Sell CDS Sell Protection Receive periodic payments Pay contingent payment Assumes Credit Risk

CDS v/s Bond Credit Risk Funding Risk Credit Risk Risk Free Rate Bond Credit Default Swap

Derivatives Risk Management or Risk Enhancement

CDS - 2008.A Defining Moment

CDS - 2008.A Defining 70 $ Trn. Moment % 120.00% 60 50 40 30 20 100.00% 80.00% 60.00% 40.00% 20.00% 0.00% -20.00% CDS notional amounts outstanding declined 57% from 2008 to 2013 (from $ 57.39 trn. $ 24.5 trn.) 10-40.00% 0 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13-60.00% Source: www.bis.org Single-name CDS instruments Multi-name CDS instruments Growth Rate

2008 Post Lehman Crises In September 2008, CDS assumed center-stage as one of the causes of Lehman Brothers' bankruptcy, which accentuated the global financial crisis In the case of Lehman collapse, market participants and supervisors were confronted with the failure of a CDS counterparty that was also an important reference entity

2008 Post Lehman Crises This was followed by collapse of AIG largely due to exposures to un-hedged CDS contracts written on subprime mortgage securities & acceleration of cash collaterals The issue that shook the markets was that the CDS contracts failed largely due to the financial counterparty failing, which turned into a financial crises, thereby accelerating the probability of the underlying reference entities credit risk

Derivatives Going Bad Indian Example

INR-JPY Structures Back in 2007, banks issued Tier II bonds and undertook Rupee cost reduction structures - where the cost of the Rupee liability was hedged through coupons being swapped into Yen

INR-JPY Structures Why did such structures become attractive? The genesis, maybe started as Rupee interest rates were high, which increased the liability cost of the long term borrower Yen was the lowest interest rate currency, which made the initial carry attractive Hence, coupon only swaps were performed, where the liability counterparty received a fixed Rupee rate (which would typically equate the interest cost on its fixed Rupee borrowing), and paid a floating JPY interest rate

INR-JPY Structures This transaction runs the risk of JPY interest rate rising, and hence to protect the same low JPY interest rate caps were bought, which would protect the liability counterparty of rising JPY interest rates The liability counterparty hence converted its fixed Rupee liability into floating JPY liability with a protection on interest rates too Even so, it yet runs the risk of JPY appreciating against Rupee on the coupon exchange dates

Coupon Swap Structure Tenor 10 years Spot Reference Rate USD/INR 46.15 USD/JPY 112.00 JPY/INR 0.4121 INR Notional 100,00,00,000 JPY Notional 253,06,80,302 Fixed Rate Payer Bank Counterparty Fixed Rate Currency INR Fixed Rate 9.00% Day Count basis Act/365

Coupon Swap Structure Floating Rate Payer Corporate Floating Rate Currency JPY Floating Rate IF 6M JPY LIBOR <= 1.00%, then 6M JPY LIBOR + Spread Indicative Spread 5.70% 5.95% Day Count basis Act/360 Interest Settlement Dates semi-annual Principal Exchange None

Risks In The INR JPY Structure JPY LIBOR RISK The liability counterparty runs the risk of Yen interest rates rising faster than expected, which would imply a greater outflow by the corporate under its floating rate JPY payments. However, this risk is limited by the purchase of an interest rate cap at 1.00%.

Risks In The INR JPY Structure INR / JPY CURRENCY RISK The liability counterparty runs a JPY/INR currency risk on the coupon exchanges under the swap. The corporate receives the Fixed Rate in Rupee, while it pays the floating JPY LIBOR + spread in JPY. Hence, it runs the risk of a sharp appreciation of the Yen versus the Rupee on a continuous basis for the tenor of the swap

Risks In The INR JPY Structure USD/JPY dropped below 80 and USD/INR breached 50, leading to the structure losing significantly

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