Fixed Income Derivatives in India

The fixed income derivative market is a relatively new market in India, with the first interest rate swaps
in India being traded in July 1999. It was the culmination of substantial efforts by the RBI, FIMMDA,
NSE and the banking industry to develop the term money market as well as provide hedging instruments
for the active management of interest rate risk by banks, corporates and financial institutions. In the three
years since they were first introduced, these derivatives have seen exponential growth in volumes, an
increase in liquidity as evidenced by narrowing in bid−offer spreads, and expansion of the universe of
market participants.

Ø Regulatory Background
Circular MPD.BC.187/07.01.279 issued by the RBI governs the usage by banks/FIs/PDs and corporates
of fixed income derivatives. The salient features of this circular are as under:

a. Banks can offer these derivatives to corporates for hedging underlying genuine exposures
b. No specific permission is required from the RBI to undertake FRAs/IRS
c. Benchmark can be any rate from the domestic money or debt market, or any rate implied in the
forward foreign exchange markets, provided that the methodology of calculating the rate is
objective, transparent and mutually acceptable
d. There are no restrictions on size or tenor for interest rate swaps, though there are some limits on
currency swaps
e. Banks are allowed to deal without underlying exposure for market making activity (within
prudential internal limits).

Usage of derivatives by mutual funds is governed by SEBI circular MFD/CIR/011/061/2000 which

specifies that derivatives must be used for hedging and portfolio rebalancing purposes only, and that
positions in derivatives markets must be fully covered by holding the underlying securities. In addition,
the circular has various requirements relating to valuation and disclosure.

Ø Usage of Fixed Income Derivatives

There are a variety of ways in which banks, corporates and financial institutions are using fixed income
derivatives in the Indian context. While the primary purpose is hedging, it is possible to take views on
different market factors within the overall framework of a hedging program. Some of the primary
purposes for which interest rate derivatives are used are:

1. Segregation of interest rate risk from liquidity risk: Indian corporates are now able to separate the
management of interest rate risk and liquidity risk. They can thus raise money in whichever market it
is most easily available (liquidity risk) and then actively manage the interest rate risk by swapping all
or a portion of it.

2. Debt Portfolio Management: Indian corporates and banks are now able to manage various
features of their debt portfolio like the fixed−floating mix, currency mix and portfolio duration
by simply dealing in the swap market rather than in the underlying cash markets. For example,
an Indian company can raise all of it’s debt in fixed rate rupees, and then swap a quarter of it
into floating dollar debt.

3. Investment Portfolio Management: The flip side of debt portfolio management is investment
portfolio management. For eg, the duration of the investment portfolio of a financial institution can
be changed by entering into interest rate swaps.

4. Improve Funding Costs: There are a number of Indian companies who have managed to raise
cheaper funding by arbitraging between differentials in credit spreads in the bond markets and swap

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 markets. For example, many AAA companies wanting to raise dollar funding have instead raised
cheap rupee funding and swapped it into dollars in the derivatives market, thereby raising sub−libor
funding, something which would be very difficult for them to do directly in the dollar debt market.

A peculiarity of the Indian market is that while both banks and companies have entered the fixed income
derivatives market in a big way, the role of financial institutions like mutual funds, pension funds and
insurance companies is still extremely limited. This is partly on account of the fact that many regulatory
issues and constraints still need to be cleared up, and partly because most of these institutions are state−
owned and averse to entering the derivatives market.

Ø Products and Benchmarks

At present, swaps are the only types of rupee derivatives which can be traded in India. Banks cannot trade
in or offer options on Rupee interest rates, either stand−alone or embedded in swaps. There are three
main categories of products, which in turn have different benchmarks on which these are transacted

1. Plain Vanilla Interest Rate Swaps: These are the most basic and actively traded instruments in the
market. The underlying benchmark in these swaps is linked to funding costs for banks or corporates.
The principal benchmarks are:

• Overnight Index Swaps (OIS): This is the most popular and liquid benchmark, especially in the
interbank market, with a total volume of almost Rs 70,000 Crores being transacted in 2001−02.
This was the first benchmark that was actively used by banks, since it fulfilled a long felt need
for them to be able to extend the duration and manage the volatility of their overnight
borrowings. As the name implies, the underlying benchmark is the overnight call money rate.
The floating benchmark is known as MIBOR, which is a daily fixing done by the National
Stock Exchange (NSE) against which the swap is settled. Although the floating rate is reset
daily, for the sake of convenience, it is compounded and settled only at a frequency which can
be chosen by the swap counter parties (for eg, every month, quarter or half year). Although OIS
swaps are quoted out to five years, the maximum liquidity is for tenors upto two years.

• MITOR Swaps: These are similar to OIS swaps, with the difference being that the underlying
overnight floating rupee rate is derived from the USD Fed Funds Rate and the USD/INR C/T
Premia, rather than being directly derived from the actual call rate in the Indian market. This
benchmark is not as popular as the preceding OIS benchmark.

• MIFOR: This is another popular benchmark that has developed into a proxy for the AAA
corporate funding cost in India. Since India does not have a fully developed term money
market, it is derived from USD Libor and the USD/INR Forward Premia, both of which are
extremely deep and liquid markets. Although the popular perception is that MIFOR might be
subject to sudden swings on account of the fact that it is derived from the forex forwards
market, this is a misplaced fear − it is simply the Indian equivalent of USD Libor and the USD
Interest Rate Swaps market, and behaves like an interest rate benchmark, not a forex
benchmark. There are a large number of Indian Corporates who now regularly use this
benchmark to actively manage the interest rate risk on their debt portfolios, and access funding
at better rates.

2. Currency Swaps: These are interest rate derivatives whereby Rupee debt held by banks or
corporates can be swapped into debt in another currency or vice versa. As expected, the most popular
currency for swapping debt is the US Dollar, with the Japanese Yen coming in second. It is
especially useful for companies having raised forex debt who wish to hedge all or part of the foreign
exchange risk and interest rate risk by swapping into Rupees. Similarly, companies holding rupee
debt who wish to either lower funding costs or diversify the currency mix of their debt portfolios
often choose to swap from rupee debt into forex debt. An interesting point to note is that while no
optionality is permitted on the Rupee leg of the currency swap, there is substantial scope for

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 employing more sophisticated hedging strategies by embedding options on the forex leg of the swap.
There are also many variants of currency swaps, like coupon swaps and Principal Only swaps (POS)
which are popular amongst Indian corporates.

3. G−Sec Linked Swaps: While the first category of benchmarks like OIS and MIFOR are linked to
corporate/bank funding costs in India, this category of benchmarks is linked to the Government of
India’s borrowing cost, viz. yields on Government Securities (G−Sec). Just as a company can enter
into a swap where the benchmark for the floating leg is 6 month MIFOR, it can also enter into a
swap where the benchmark is the yield on the 1−Year G−Sec. The daily setting for G−Sec yields for
different tenors is exhibited on a Reuters page known as INBMK. These swaps are important as they
allow banks and corporates to take views on the relative movements of GOI yields and corporate
spreads, without necessarily actually taking positions in the securities themselves.

Apart from these basic products, there are a variety of complex products that can be built from these
underlying benchmarks. For eg, a popular variant in India has been the Constant Maturity Treasury
(CMT) swap, where the underlying floating rate, instead of being a 3−month or 6−month rate, is the 5−
Year G−Sec Yield. There are also forward rate agreements, rate locks, spread locks, quanto swaps etc
which all use these basic building blocks to allow the swap counter parties to take more sophisticated
views on not only the future movement of interest rates, but also the shape and slope of the yield curve
and the widening or narrowing of spreads between different benchmarks, to name just a few.

Ø Whither Now?
Although the fixed income derivatives markets in India have grown by leaps and bounds since inception,
there is much that remains to be done on various fronts. Given the right environment, it is possible for the
market in India to replicate the growth that has been seen worldwide, where the swaps market, which
didn’t exist in 1980, had grown to become worth 20 trillion dollars in 1990 and almost 50 trillion by
2000. Some of the factors that need to be taken into account are:

• Multiplicity of Products and Benchmarks: Worldwide, there are a number of alternatives available
for interbank counter parties to hedge the risks arising from their fixed income derivatives portfolio.
Usually, for tenors shorter than two years, instruments like fed funds and Eurodollar futures and
FRAs are used. For tenors between two and ten years, swaps are used, and beyond ten years, the
primary hedging tools are bonds and bond futures. The effects of the absence of a futures market are
already being felt. Similarly, the restrictions on interest rate options too need to be gradually
removed so as to provide a wider range of choices for both banks and corporates.

• Participation by the Investor Segment: The virtual absence of the investor segment from the
derivatives market has the potential to hurt the growth of the market in the long run. Worldwide, the
role of financial institutions is even larger than that of corporates. In India, there still remain various
uncertainties regarding the extent to which they can deal in derivatives, which need to be cleared up
for them to be able to transact.

• Development of the Term Money Market: As mentioned earlier, the development of MIFOR has
created a fairly reliable term money market benchmark. However, banks still continue to have larger
exposures in OIS given the size of their exposures in the call market. This should slowly change,
especially after the provisions introduced in the last credit policy which limit the size of banks’
exposure in the call market, and will therefore cause them to increasingly shift from OIS to MIFOR.

• Accounting and Tax Issues: There is a crying need for a comprehensive accounting standard and a
cogent tax policy on derivatives. The guidance notes of the Institute of Chartered Accountants of
India (ICAI) are so far not all encompassing, and many changes are needed. This continues to be a
major stumbling block to the development of the derivatives market.

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In conclusion, however, the future of the fixed income derivatives market in India looks bright, with the
future holding increasing volumes and liquidity and an expanding participant base.

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