kCILC1 SNCSIS

CN
Deve|opment of Interest kate C1C
Der|vat|ves market |n Ind|a


SubmlLLed 8y
Aparna Mv
Summer 1ralnee
8eserve 8ank Cf lndla
CuM 200911
llM kCZPlkCuL

CkGkCUND CI S1UD
1he C1C derlvaLlves markeLs all over Lhe world have shown Lremendous growLh ln recenL years
AfLer flnanclal crlsls of 2008 whlch ls belleved Lo have been exacerbaLed by C1C derlvaLlves
lncreaslng aLLenLlon ls belng pald Lo analyzlng Lhe regulaLory envlronmenL of Lhese markeLs
1he lndlan C1C derlvaLlves markeLs unllke many oLher [urlsdlcLlons are well regulaLed Cnly
conLracLs where one parLy Lo Lhe conLracL ls an 88l regulaLed enLlLy are consldered legally valld
ln lndla A good reporLlng sysLem and a posLLrade clearlng and seLLlemenL sysLem Lhrough a
cenLrallzed counLer parLy has ensured good survelllance of Lhe sysLemlc rlsks ln Lhe lndlan C1C
markeL
lrom amongsL Lhe varlous C1C derlvaLlves markeLs permlLLed ln lndla lnLeresL raLe swaps and
forelgn currency forwards are Lhe Lwo promlnenL markeLs
lnterest kote uerivotives
88l permlLLed banks/lls/us Lo underLake lnLeresL raLe swaps/forward raLe agreemenLs ln !uly
1999 l8us have been slow Lo emerge ln lndla An C1C markeL has sprung up prlmarlly lnvolvlng
lnLeresL raLe swaps (l8S) and forward raLe agreemenLs (l8A)
lotetest kote 5wops
A swap ls a cashseLLled over Lhe counLer derlvaLlve under whlch Lwo counLerparLles exchange
Lwo sLreams of cash flows lL ls called an lnLeresL raLe swap lf boLh cash flow sLreams are ln Lhe
same currency and are deflned as cash flow sLreams LhaL mlghL be assoclaLed wlLh some flxed
lncome obllgaLlons 1he mosL popular lnLeresL raLe swaps are flxedforfloaLlng swaps under
whlch cash flows of a flxed raLe loan are exchanged for Lhose of a floaLlng raLe loan 1hese are
called vanllla lnLeresL raLe swaps 1here ls also a llquld markeL for floaLlngfloaLlng lnLeresL raLe
swapswhaL are known as basls swaps 1o keep Lhlngs slmple (and mlnlmlze seLLlemenL rlsk)
concurrenL cash flows are neLLed 1he prlnclpal amounL ls called Lhe noLlonal amounL of Lhe
swap lnLeresL raLe swaps are used by a wlde range of commerclal banks lnvesLmenL banks
nonflnanclal operaLlng companles lnsurance companles morLgage companles lnvesLmenL
vehlcles and LrusLs governmenL agencles and soverelgn sLaLes for one or more of Lhe followlng
reasons l) 1o obLaln lower cosL fundlng ll) 1o hedge lnLeresL raLe exposure lll) 1o obLaln hlgher
yleldlng lnvesLmenL asseLs lv) 1o creaLe Lypes of lnvesLmenL asseL noL oLherwlse obLalnable v)
1o lmplemenL overall asseL or llablllLy managemenL sLraLegles vl) 1o Lake speculaLlve poslLlons
ln relaLlon Lo fuLure movemenLs ln lnLeresL raLes



An example of usage uslng Swap Lo Lransform llablllLy
Conslder a hypoLheLlcal swap beLween llrm A and llrm 8 Suppose llrm A agrees Lo pay llrm 8
an lnLeresL of 3 per annum on a noLlonal prlnclple of $100 mllllon and ln reLurn llrm 8 agrees
Lo pay llrm a slx monLh Ml8C8 raLe on Lhe same noLlonal prlnclple We assume Lhe agreemenL
speclfles LhaL paymenLs are Lo be exchanged every slx monLhs and Lhe 3 lnLeresL raLe ls
quoLed wlLh semlannual compoundlng
Suppose llrm A has arranged Lo borrow $100 mllllon aL Ml8C8 plus 10 basls polnLs AfLer llrm
A has enLered lnLo Lhe swap lL has Lhree seLs of cash flows
1 lL pays Ml8C8 plus 01 Lo lLs ouLslde lenders
2 lL recelves Ml8C8 under Lhe Lerms of Lhe swap
3 lLs pays 3 under Lhe Lerms of Lhe swap

1hree seLs of cash flows neL ouL Lo an lnLeresL paymenL of 311hus for llrm A Lhe swap could
have Lhe effecL of Lransformlng borrowlngs aL a floaLlng raLe of Ml8C8 plus 10 basls polnLs lnLo
borrowlngs aL a flxed raLe of 31
8everse ls Lhe case for llrm 8 Suppose lf llrm 8 has a loan of $100 mllllon on whlch lL pays
32 lnLeresL and Lhen Lhe neL effecL wlll be Lransformlng a flxed raLe loan of 32 lnLeresL lnLo
borrowlngs aL a floaLlng raLe of Ml8C8 plus 20 basls polnLs
An explanaLlon commonly puL forward Lo explaln popularlLy of swaps concerns Lhe comparaLlve
advanLages Conslder Lhe above examples of uslng an lnLeresL raLe swap Lo Lransform a llablllLy
Some companles lL ls argued have a comparaLlve advanLage when borrowlng ln flxed raLe
markeLs whereas oLher companles have a comparaLlve advanLage when borrowlng ln floaLlng
raLe markeLs 1o obLaln a new loan lL makes sense for Lhe company Lo go Lo Lhe markeL where
lL has a comparaLlve advanLage As a resulL Lhe company may borrow flxed when lL wanLs
floaLlng or borrow floaLlng when lL wanLs flxed 1he swap ls Lhen used Lo Lransform a flxed raLe
loan lnLo floaLlng raLe loan and vlce versa



twotJ kote Aqteemeot (kA)
A forward raLe agreemenL (l8A) ls an agreemenL Lo lend/borrow money for a speclfled perlod
on a noLlonal prlnclpal on a parLlcular daLe ln Lhe fuLure aL a raLe LhaL ls deLermlned Loday lL ls
llke a forward conLracL where Lhe underlylng ls a loan or deposlLs boLh noLlonal l8As are C1C
conLracLs Many banks and large corporaLlons wlll use l8As Lo hedge fuLure lnLeresL raLe
exposure 1he buyer hedges agalnsL Lhe rlsk of rlslng lnLeresL raLes whlle Lhe seller hedges
agalnsL Lhe rlsk of falllng lnLeresL raLes CLher parLles LhaL use lorward 8aLe AgreemenLs are
speculaLors purely looklng Lo make beLs on fuLure dlrecLlonal changes ln lnLeresL raLes 1he
dlfference beLween Lhe l8A raLe and Lhe acLual markeL raLe on Lhe maLurlLy daLe ls pald by one
parLy Lo Lhe oLher lf Lhe markeL raLe ls hlgher Lhan Lhe l8A raLe Lhe seller pays Lhe buyer
whereas ln case of markeL raLe belng lower Lhan Lhe l8A raLe Lhe buyer pays Lhe seller All
l8As are execuLed as C1C deals beLween Lwo counLerparLles who are comforLable Lradlng wlLh
each oLher 1hese can also be lnLermedlaLed by a broker ln elLher case each counLerparLy
Lakes on Lhe credlL rlsk of Lhe oLher Lyplcally for duraLlons of Lwo weeks Lo slx monLhs 1he
reference raLe LhaL ls Lyplcally used Lo seLLle Lhese producLs are shorLLerm raLes LhaL are
polled from Lhe markeL uslng a meLhodology slmllar Lo LhaL of Ll8C8 Cf Lhese Lhe nSL
Mumbal lnLerbank Cffer 8aLe (Ml8C8) polled by Lhe nSL ls a wellknown benchmark
entro/ited /eorinq Porties
CClL Clearlng CorporaLlon of lndla L1u whlch sLarLed funcLlonlng ln 2002 ls Lhe only cenLrallzed
clearlng parLy for Lrade processlng and seLLlemenL servlces ln lndla lL currenLly provldes a
guaranLeed seLLlemenL faclllLy for governmenL securlLles Lradlng clearlng of collaLerallzed
borrowlng and lendlng obllgaLlons (C8LC) guaranLeed seLLlemenL of forelgn exchange Lradlng
and seLLlemenL of all l8S
lssues
1he surface level undersLandlng of Lhe rlsks as well as mlsuse of Lhese producLs has broughL
sysLemlc lmpllcaLlons around Lhe globe durlng Lhe subprlme crlsls lndla was noL much affecLed
as lL has mlnlscule markeL share ln derlvaLlves segmenL 8uL lL ls clear LhaL C1C markeL ls
essenLlal for Lhe developmenL of real economy So before deepenlng Lhls markeL few aspecLs
regardlng Lransparency regulaLlon and llquldlLy needs Lo be addressed ln order Lo prevenL Lhe
flnanclal sysLem from shocks
kL kLSLkCn ULS1ICN CILC1IVL
1he ob[ecLlve of Lhe pro[ecL ls Lo analyze Lhe developmenL of l8us markeL ln lndla Lhe
regulaLory framework adopLed as well as Lhe lssues and lmpedlmenLs ln Lhe Lhelr usage by
lndla's lnsLlLuLlonal lnvesLors

,L1nCDCLCG
1hls meLhodology adopLed ls a sLepwlse approach whlch can be llsLed as follows
1 A ueLalled analysls of Lhe presenL markeL sLrucLure of C1C uerlvaLlves ln lndla lL wlll
malnly encompass Lhe sLudy of MarkeL parLlclpaLlon of varlous lnsLlLuLlons ln Lhe
lnLeresL 8aLe derlvaLlves segmenL over Lhe years 1he reporL also alms aL analyzlng Lhe
varlous deLermlnanLs of usage lssues and lmpedlmenLs ln Lhe usage of l8us by lndla's
lnsLlLuLlonal lnvesLors
2 1hls would be followed by an analysls of Lhe regulaLory framework adopLed for lndlan
C1C uerlvaLlves Approach Lo CenLrallzed Clearlng Pow cenLral counLerparLles CCs
reduce Lhe counLerparLy and credlL rlsks and how good supervlslon Lhrough a well
deflned regulaLory framework underplns Lhe sysLemlc rlsk
llnally as a parL of recommendaLlons Lhe reporL wlll dellberaLe on Lhe measures LhaL
would help ensure more sLablllLy and also conLrlbuLe Lo Lhe developmenL of Lhe C1C
uerlvaLlves markeL ln lndla

1I,LLINL
1ask
Weeks
(SLarLlng 3
Lh
Aprll)
LlLeraLure 8evlew on lnLeresL 8aLe uerlvaLlves 2
uaLa Analysls on MarkeL arLlclpaLlon of varlous lnsLlLuLlons ln Lhe lndlan
markeL 2
Analysls of Lhe varlous deLermlnanLs of usage lssues and lmpedlmenLs ln
Lhe usage of l8us by lndla's lnsLlLuLlonal lnvesLors
2
Analysls of Lhe regulaLory framework adopLed for lndlan C1C uerlvaLlves
8ecommendaLlons 1
reparaLlon of Lhe flrsL drafL revlew modlflcaLlons flnal submlsslon of Lhe
pro[ecL reporL 1




kLILkLNCLS
'CpLlons luLures and uerlvaLlves' by !ohn C Pull
Worklng aper on 'C1C uerlvaLlves MarkeL ln lndla 8ecenL 8egulaLory lnlLlaLlves and Cpen
lssues for MarkeL SLablllLy and uevelopmenL' lnulAn CCunClL lC8 8LSLA8CP Cn
ln1L8nA1lCnAL LCCnCMlC 8LLA1lCnS
'lndlan uerlvaLlves MarkeL' by Asanl Sarkar
'CverLhecounLer derlvaLlve markeLs ln lndla lssues and perspecLlves' by Shyamala CoplnaLh




SIGN CI 1nL GUIDL