Download - 011-Vishal Dawda-Intrest Rate Swaps in India
TABLE OF CONTENTS
S.No. PARTICULARS Page No.
1.0 Executive Summary 2
2.0 Introduction 4
3.0 Interest Rate Derivatives Products in India 9
4.0 Understanding Interest Rate Swaps 11
5.0 Types of IRS 13
6.0 The Indian Players 16
7.0 A Typical IRS 17
8.0 Plain Vanilla Interest Rate Swaps – OIS 20
9.0 Valuations & Pricing of a Swap 24
10.0 Advantages of IRS 26
11.0 Checklist When Entering A Swap 29
12.0 Risk & Taxation Issues 33
13.0 ISDA Agreement 35
14.0 Bibliography 38
1.0 Executive Summary
In my project I have tried to understand the way swaps function. Moreover to get
a better understanding on the swap transactions my first step was in understanding
the ISDA documentation. The parties who want to enter into a swap transaction
have to enter into an ISDA agreement which has to be signed. This document
has to be signed in association with the International Swap and Derivate
Association. The documentation involves three documents which have to be agreed
and signed between the two parties respectively.
After the documentation was done, I went on to understand the process of a
swap transaction and how does it work in the international as well as the Indian
markets and also its participants. The next step was pricing of a swap
transaction. We will be using the MIBOR OIS because it is convenient and
reliable benchmark. To help in the process of pricing I have made a small
pricing model through bootstrapping which will help in the pricing process. By
putting in the required values an investor would know the price of a swap. This
would be very theoretical but by comparing this price with the market price an
investor could know the difference and also judge the sentiments of the market.
After making a pricing model I have made a valuation model for which would
help the investors calculate the NAV on a daily basis. This would prove to be
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very beneficial as the investor knows the value of his transaction on a daily basis
and can make decisions accordingly.
Though Interest rate swaps and forward rate agreement in the rupee made their
entry in July 1999, following guidelines issued by the RBI . It has a lot of
growth potential. This is because of the very nature of the instrument.
In my research project I have tried to look as to how an investor can make a
decision of investing in a swap transaction and also once it has entered into one
it can keep a check by valuing the swap on a daily basis.
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2.0 Introduction
Financial derivatives have crept into the nation’s popular economic vocabulary on
a wave of recent publicity. They however remain a type of financial instruments
that few of us appreciate and fewer still fully appreciate. In a way, derivatives
are like electricity. Properly used, they can provide great benefit. If they are
mishandled or misunderstood, the results can be catastrophic. Derivatives are not
inherently “bad.” When there is full understanding of these instruments and
responsible management of the risks, financial derivatives can be useful tools in
pursuing an investment strategy.
2.1 Definition of Derivatives
The term "derivatives" has been used to identify a range and variety of financial
instruments. There is no discrete class of instruments that is covered by the term,
and the term often appears to be used to describe every financial instrument that
is not a traditional stock or bond. A "derivative" commonly is defined as a
financial instrument whose performance is derived, at least in part, from the
performance of an underlying asset (such as a security or an index of securities).
These financial instruments include, for example, futures, options on securities,
options on futures, forward contracts, swap agreements, and structured notes. In
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addition, participations in pools of mortgages or other assets often are described
as "derivatives."
2.2 Why do we need a Derivatives Market?
Derivatives allow greater control of these risks with smaller cash requirements
and usually have lower transaction costs and credit exposure/usage.
Derivatives do not change the normal transaction of the business, while
altering the risk nature.
Derivatives do not change the normal transactions of the business – they only
alter the nature or profile of the corporation’s exposure to financial risk!
Derivatives can be used to change duration of a portfolio of cash
flows
Derivatives can be used to change currency exposure of a
transaction
They help in transferring risks from risk averse people to risk oriented people
They help in the discovery of future as well as current prices
They catalyze entrepreneurial activity
They increase the volume traded in markets because of participation of risks
averse people in greater numbers
They increase savings and investment in the long run
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2.3 Types of Derivative Instruments
Set forth below are descriptions of some common types of derivative instruments.
2.3.1 Options. An option represents the right to buy or sell an underlying asset
(often, a security) at a specified time for a specified price. A call option is a
right to purchase the underlying asset; a put option is the right to sell it. A fund
that buys options has the right to buy or sell the underlying asset. A fund that
writes (i.e., sells) options is obligated to sell the underlying asset to, or buy is
from, the party that purchased the option (if that party “exercises” the option). A
fund that writes an option is paid a premium for doing so. Options can be either
standardized or customized and privately negotiated. Some are exchange-listed and
others are traded over-the-counter.
2.3.2 Forward Contracts. Funds may enter into forward contracts, which
obligate the fund and its counterparty to trade an underlying asset (commonly,
foreign currency) at a specified price at a specified date in the future. Forward
contracts are traded in the over-the-counter markets.
2.3.3 Futures. Futures are similar to forward contracts, but differ in that they
are standardized and traded on a futures exchange. Unlike forward contracts, the
counterparty to a futures contract is the clearing corporation for the appropriate
exchange. Futures are typically settled in cash, rather than requiring actual
delivery of the instrument in question. Perhaps the best-known futures contracts
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are those involving the S&P 500. Parties may also buy or write options on
futures.
2.3.4 Swaps. Swaps are over-the-counter transactions that involve two parties
exchanging a series of cash flows at specified intervals. In the case of an interest
rate swap, the parties exchange interest payments based on an agreed upon
principal amount (referred to as the “notional principal amount”). Under the most
basic scenario, Party A would pay a fixed rate (e.g., 6%) on the notional
principal amount (e.g., $10 million) to Party B, which would pay a floating rate
(e.g., LIBOR) on the same notional principal amount to Party A. (Typically,
payments between the parties would be netted out and settled periodically.) In
recent years, the swaps market has grown dramatically, both in terms of size and
variety. For example, interest rate swaps can involve cross-market payments (e.g.,
short-term rates in the U.S. vs. short-term rates in the U.K.) and cross-currency
payments (e.g., payments in dollars vs. payments in yen). Floating rate payments
may be subject to caps (i.e., ceilings), floors or collars (i.e., caps and floors
together).
2.3.5 Structured Notes. Structured notes are over-the-counter debt instruments
where the interest rate and/or the principal are indexed to an unrelated indicator
(e.g., short-term rates in Japan, the price of oil). Sometimes the two are inversely
related (i.e., as the index goes up, the coupon rate goes down; inverse floaters are
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an example of this) and sometimes they may fluctuate to a greater degree than
the underlying index (e.g., the coupon may change twice as much as the change
in the index rate). Structured notes are often issued by high-grade corporate
issuers. There is often an underlying swap involved; the issuer will receive
payments that match its obligations under the structured note (usually from an
investment bank that puts the deal together) and, in turn, makes more “traditional”
payments to the investment bank (e.g., fixed rate or ordinary floating rate
payments). It is important to note, however, that in such cases the mutual fund
would not be involved in the swap; the issuer of the note would remain obligated
even if its counter party defaulted.
2.3.6 Mortgage-Backed Securities. The term “mortgaged-backed securities”
encompasses a broad array of instruments with differing characteristics. Some of
these instruments often are referred to as “derivatives.” One such example is
stripped mortgage-backed securities, which represent interests in a pool of
mortgages, the cash flow of which has been separated into its interest and
principal components. Interest only securities (“IOs”) receive the interest portion of
the cash flow and principal only securities (“POs”) receive the principal portion.
These securities may be issued by U.S. government agencies or by certain private
issuers. Their values are highly sensitive to the rate of mortgage principal
prepayments, which tends to increase as interest rates fall and decrease as interest
rates rise. When interest rates decline and principal payments accelerate, the
interest payment stream is reduced and the value of IOs decreases. When interest
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rates are rising and prepayments are slower, the average life of POs increases and
their value decreases.
3.0 Interest Rate Derivates Products in India
Interest rate swaps and forward rate agreement in the rupee made their entry in
July 1999, following guidelines issued by the RBI.
The RBI permits corporate customers to hedge interest rate risks on both the
assets and liability side using rupee IRD. Customers need to identify and earmark
genuine exposure against each IRD, ensuring that the tenor and the notional of
the hedge do exceed that of the underlying. Banks dealing with customers must
also satisfy themselves that the customer has genuine underlying exposure. Rupee
IRD undertaken by customers can be freely cancelled and rebooked.
Banks hold fixed income securities for investment or SLR purposes and provide
commercial loans. These assets generally generate a fixed return for the bank. The
duration of the investment and other assets of the bank ought to match the
duration of the liabilities of the bank in order to mitigate interest rate risk. In
addition, the bank may want to position their assets-liability mismatch to derive
benefit from the anticipated movements in interest rates. Interest Rates Derivates
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are ideal instruments to change the asset-liability profile without changing the
underlying assets or liabilities.
Banks, Mutual funds etc maintain liquidity to meet demand for deposit withdrawal
asset deployment opportunities. Liquidity is maintained at the cost of low returns.
Rupee derivates provide the investment management company an opportunity to
maximize their returns without compromising on their liquidity position. Thus, an
Indian investment management companies can use the following products:
Interest Rate Swap (Over The Counter)
Forward Rate Agreement (Over The Counter)
Interest Rate Futures(Exchange Traded)
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4.0 Understanding Interest Rate Swaps
An IRS is a transaction in which two parties agree to swap the coupon payments
arising on account on issuing of investing in fixed income bearing securities the
essence of the transaction is the exchange coupon/interest payments that originally
could have had any characteristics.
A legal agreement between two counterparties to exchange interest obligations or
receipts in the same currency on specified dates over a specified period calculated
on a notional principal.
In a plain vanilla swap, one party agrees to pay to the other party cash flows
equal to the interest at a predetermined fixed rate on a notional principal for a
number of years. In exchange, the party receiving the fixed rate agrees to pay the
other party cash flows equal to interest at a floating rate on the same notional
principal for the same period of time. Moreover only the difference in the interest
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payments is paid/ received; the principal is used only to calculate the interest
amounts and is never exchanged.
Interest rate swaps are used to hedge interest rate risks as well as to take on
interest rate risks. If a treasurer is of the view that interest rates will be falling
in the future, he may convert his fixed interest liability into floating interest
liability; and also his floating rate assets into fixed rate assets. If he expects the
interest rate to go up in the future, he may do vice-versa. Since there are no
movements of principal, these are off balance sheet instruments and the capital
requirements on these instruments are minimal.
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5.0 Types of IRS
5.1 Coupon Swaps
If an interest rate swap involves the swapping of a stream of payments based on
the fixed interest rate for a stream of floating interest rate, then it is called a
coupon swap.
Counter parties to the coupon swap
Payer of the fixed interest stream is called the payer in the swap.
Receiver of the fixed interest stream is called the receiver in the swap.
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Floating Interest
Payer ReceiverFixed interest
5.2 Generic Swaps
The term generic is used to describe the simplest of any types of financial
instrument- plain vanilla. So, a plain vanilla swap can be called a generic swap.
Typically, generic swaps contain the simplest characteristics, such as a constant
notional principal amount, exchange of fixed against floating interest (coupon
swap), an immediate start (i.e., on the spot date). A simple coupon swap can be
called a generic swap.
Basis Swap
Two steams of payments can be calculated using different floating rate indices.
These are called basis swaps or floating-against-floating swaps.
1. it is possible to enter into a swap with a 3 month Libor against a 6
month Libor.
2. it is also possible to enter into a swap with a 91 day T-Bill Yield against
a 6 Month Libor.
Basis index swaps come under the classification of non-generic swaps.
Counterparties to a swap transaction
In a basis swap, each counterparty is described in terms of both the interest
stream it pays and the interest stream it receives
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5.3 Asset Swap
If in an interest rate swap, one of the streams of payments being exchanged is
funded with interest received on an asset, the whole mechanism is called the asset
swap. In other words, it is an interest rate swap, which is attached to an asset. It
does not however involve any change in the swap mechanism itself.
Investors use asset swaps. If an investor anticipates a change in interest rates, he
can maximize his interest inflow by swapping the fixed interest paid on the asset
for floating interest in order to profit from an expected rise in interest rates.
5.4 Money Market Swaps
Swaps with an original maturity of up to two years are referred to as Money
Market swaps. IMM swaps come under this category. The tenor of the swaps
matches exactly with the short-term interest futures in the IMM.
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92 day T-Bill yield
6 mth Libor
Payer of 6 month Libor/ Receiver of 91 day T-Bill yield
Payer of 91 day T-Bill Yield/ Receiver of 6 month Libor
5.5 Term Swaps
A swap with an original tenor of more than two years is referred to as a term
swap.
6.0 The Indian Players
The following participants are allowed to undertake IRS/FRAs
1. Scheduled Commercial Banks
2. Primary Dealers
3. All India Financial Institutions
4. Corporate
5. Mutual Funds
Corporate and mutual funds can use these products only to hedge existing
asset/liabilities while the first three types of participants may do market making.
RBI has currently allowed transactions only in plain vanilla IRS/FRA.
Most foreign banks and private sector banks are price makers in the market.
Large domestic corporate, MNCs, PSUs, and bank balance sheets are the users.
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HSBC, Deutsche, Chartered, ISEC, JP Morgan, & BOA are the leading market
players.
7.0 A Typical IRS
Consider a swap agreement between 2 parties, A and B. the swap was initiated
on July1, 2001. Here, A agrees to pay the 3 month NSE-MIBOR rate on a
notional principal of Rs 100 million, while B pays a fixed 12.1% rate on the
same principal, for tenure of 1 year.
It is assumed that payments are to be exchanged every three months and the
12.15% interest rate is to be compounded quarterly. This swap can be depicted
diagrammatically.
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Elements of a typical IRS
Notional Principal
There is no exchange of principal
The floating and fixed interest rate calculations are for a pre-
decided.
Exchange of coupon streams
Normally fixed rate coupon for a floating rate coupon, can also be
floating rate for another floating rate.
Fixed Rate
Predetermined rate, valid for the entire of the swap
Floating Rate
Linked to a benchmark rate which is reset periodically
Interest payments are net settled
Floating rate benchmark
12.15%
Party A Party BMIBOR (3m)
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Should be market determined rate, which is transparent and mutually
acceptable to counter parties.
An IRS is like a fixed rate asset and a floating rate liability or vice versa, but
without any exchange of principal and with net interest settlement. Therefore the
credit requirement for an IRS is minimal compared to those for cash instruments.
In the Indian market there are three main categories of products, which in turn
have different benchmarks on which these are transacted:
1. Plain Vanilla Interest Rate Swaps
a. Overnight Index Swaps
b. MITOR Swaps
c. MIFOR
2. Currency Swaps
3. G-Sec Linked Swaps
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8.0 Plain Vanilla Interest Rate Swaps – OIS
These are the most basic and actively traded instruments in the market. The
underlying benchmark in these swaps is linked to funding cost for banks and
corporate.
The Mibor OIS Market
When RBI opened IRD markets, it gave the participants freedom to choose any
floating rate benchmark from the rupee money and debt markets. Out of sheer
lack of any other credible money market benchmarks, the overnight inter-bank call
rate was a natural first choice.
Thus the first rupee IRD was in the MIBOR Overnight Indexed Swap (OIS). In
this swap, the floating rate is the daily compounded call rate. For short tenor
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swaps (upto 1 year) settlements occur on the maturity of the swap. In case of
longer tenor swaps, settlements generally occur every six months.
OIS Highlights
Overnight Index Swaps with the floating rate indexed to an Overnight reference
rate was the main product in the swap market initially.
Short Term Interest Rate Trading
1. Overnight rates are likely to be most relevant and acceptable floating rate
benchmark.
2. Overnight money markets are deep and liquid and the Overnight Index is
well accepted and extensively used as a market standard.
3. The methodology for calculating the Overnight Index is transparent and
accepted by counterparties.
4. Overnight rates have been the most widely accepted benchmark for floating
rate bond issues in the cash market.
5. OIS are particularly useful from risk management perspective to hedge
short term interest rate risk.
6. Unlike cash transactions, credit exposure in OIS is minimal and requires
very little capital allocation.
7. Could act as a catalyst for the development of term money markets.
Understanding OIS
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An Overnight Indexed Swap is a very useful and convenient asset liability
management tool and a hedging instrument. The relevance of a product like
OIS increases for a country like India, which lacks a vibrant term money
market.
This is the most popular and liquid benchmark. we can use this because being
an investor we would like to see the daily floating rate and need to check the
valuations on a daily basis.
The floating benchmark is known as MIBOR, which is a daily fixing done by
the National Stock Exchange 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.
Although OIS swaps are quoted out to five years, the maximum liquidity is
for tenor up to two years.
Description
1. An OIS is a fixed/floating interest rate swap with the floating leg tied to a
daily overnight rate difference.
2. The term generally ranges from one week to one year. The two parties to
an OIS agree to exchange at maturity, on the agreed notional amount, the
difference between interest accrued at the agreed fixed rate and interest
accrued through compounding the floating index rate.
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3. The floating rate calculation is made to replicate the accrual on an amount
rolled ‘P plus I’ at the index rate every business day over the term of the
swap.
4. Settlement at maturity is made net & there is no exchange of principal.
An OIS can be considered a swap of the total return on the call money
against a fixed rate.
To pay an OIS means paying the fixed rate against receiving floating rate i.e.
it means borrowing at a fixed rate against lending at the floating rate. To
receive an OIS means receiving the fixed rate against the floating rate.
However at times it may so happen that once of the parties to the swap may
want to discontinue and in these circumstances a different method needs to be
followed.
Investor needs to find the valuation of the swaps they will enter into everyday
as they can discontinue at any point of time. to do this the first step is to
find the pricing of a swap transaction. This is theoretical. The market price of
the swap may differ than the theoretical price and this will be due to the
market variables such as interest rate in the future etc which many effect the
pricing of the swap.
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9.0 Pricing & Valuation of a Swap
9.1 Valuation
V : Value of swap to financial institution
Bfix : Value of fixed-rate bond underlying the swap.
Bfl : Value of floating-rate bond underlying the swap.
Q : Notional principal in swap agreement.
It follows : V = Bfix – Bfl
Bfix = ∑ke-riti + Qe-rntn
Bfl = ∑Qe-r1t1 + Ke-r1t1
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9.2 The Value of the swap is zero when it is first negotiated. During its life it may
have a positive or negative value.
9.3 : Example :
Suppose that under the terms of a swap, a financial institution has agreed to pay
six-month MIBOR & receive 8% pa(with semiannual compounding) on a notional
principal of Rs100 mn. The swap has a remaining life of 1.25 years. The relevant
discount rates with continuous compounding for 3month, 9month, & 15month maturities
are 10%, 10.5% & 11% respectively. The six-month MIBOR rate at the last payment date
was 10.2% (with semiannual compounding).
In this case,
kfix = Rs 4mn. & kfl=Rs5.1mn.
Bfix = 4e-.025*0.1+ 4e-.075*0.105 + 104e-1.25*0.11
= Rs98.24mn
Bfl = 5.1e-.025*0.1+ 100e-0.25*0.1
= Rs102.51mn
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Value of Swap is 98.24-102.51 = Rs-4.27mn.
9.44: If the Bank has been in the opposite of paying fixed & receiving floating, the
value of the swap would be Rs+4.27mn
10.0 THE ADVANTAGES OF AN IRS
10.1 Asset-Liability mis-match correction
IRS will help the corporate to optimally manage its Structural Balance sheet. A
corporate having predominantly fixed rate long term assets and short term
liabilities can enter into a swap where it pays fixed for a long term and receives
floating linked to a shorter tenor benchmark from the counter-party. The corporate
could thus keep borrowing short term and match its longer tenor assets.
10.2 Opens up diverse avenues of funding
Swapping the underlying liability into the desired interest rate basis (fixed/floating)
allows the corporate to access various markets for funding, despite a mismatch
between the characteristics of the underlying borrowing and its actual
requirements. For example, the corporate may make a long tenor issuance on the
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fixed rate basis but may require that the actual liability on floating rate Rupees.
In order to achieve this objective, the corporate could swap the fixed rate funds
raised to floating rate funds. As a result, the IRS offers the corporate flexibility
to move to the interest rate basis of its choice.
10.3 Hedging Floating Rate Risks
If any corporate has a floating rate liability, it would have no control if the
floating rate benchmark were to shoot up. It can, however, enter into a swap to
receive the same floating benchmark and pay a fixed rate, to hedge this risk.
10.4 Taking advantage of low floating rate borrowings:
A corporate cannot borrow in the inter-bank call markets, but can create a
synthetic call linked liability by borrowing its routine fixed rate ICDs/CPs and
then entering into a swap where it agrees to receive fixed rate and pay a call
linked floating rate.
10.5 Low Credit Risk
Only the net interest payments are exchanged, thereby, circumventing the need to
exchange the gross amounts, on the settlement date. This leads to a lower credit
exposure on the counter-party. The credit exposure of an IRS is less than a cash
market
10.6 Decouple funding & duration decisions
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IRS allows the corporate to control the duration for which the interest rate on its
short term positions is locked in without having to fund the same for matching
maturity. In simplistic terms, this would mean that the corporate can borrow its
funding requirements in the tenor available, but can then structure it as per its
needs using IRS
10.7 Can be customized - flexibility in the management of interest rates
The IRS market is flexible in its maturity range. It is possible to manage the
duration of its liabilities in order to exploit the opportunities or react to sudden
changes in the market condition without having to prepay borrowings.
10.8 Smoothening out Interest Rate fluctuations
If varying amounts of money are borrowed or invested, it is difficult to estimate
the future interest Rates. As interest rate markets can be volatile, cash flow
projections can be used to invest or fund an average balance over a longer
period.
10.9 Off –Balance sheet treasury product :
Banks can often trade in these derivatives & it will not be reflected in Books.
Hence bank can take more open position for trading
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11.0 Checklist When Entering A Swap
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Identification of the Need
Define the Objective
Prerequisites of doing a swap like checking whether the company can do the swap
Search for Counter party and select the best party from all the alternatives
Negotiate and Reach an Agreement with the Counter party.
Complete other Documentations
Sign ISDA Master Agreement
Commencing of the swap
11.1 Identifying the Need to do a swap -
Example- the interest rates are volatile and the company wants to have a fixed rate of
interest.
11.2 Define the Objective -
Here the company should first confirm the following –
What is exact nature of its liability/asset for which it wants to do the swap ?
Example – the company has taken a foreign currency loan for a Libor plus some basis
points.
What is the need for doing such a swap?
Are there any alternatives to swap?
Finally define the objective.
11.3 Prerequisites to enter into such a transaction -
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Check whether the primary documents of the company i.e. MOA and AOA allow it. If
no, then check what alteration needs to be done and is shareholders approval or Board of
Directors approval needed.
Documentation needed –
For Interbank
ISDA Master Agreement
Individual confirmations for each transaction
Corporate
ISDA Master Agreement
Individual confirmations for each transaction
Company Board Resolution
Delegation of authority along with specimen signatures
Document of Underlying exposure
Confirmation that Board has knowledge of the transaction
Foremost a company needs to have sanctioned lines from institutions/Banks for
transacting IRS. Also since IRS are low risk products due to netting conventions Banks
readily sanction such lines.
11.4 Search for Counter party –
Identify parties specially banks who are willing to enter into such swaps with
you. This will involve an analysis of the market. Also determine the criteria for
evaluating the other party. The criteria can be
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Creditworthiness of the party – the parameter can be Credit rating of the party.
The terms offered by that party.
Whether it too has the sufficient approvals necessary to enter the agreement.
11.5 Reach an Agreement with the Counter party–
Do all the negotiations with the party and reach an agreement with them.
11.6 Sign ISDA Master Agreement –
This is a very important step as it is compulsory to sign it before entering
the swap. ISDA (International Swap Dealers Association) Master Agreement is a
comprehensive document containing a lot of clauses that stipulate even contingency
events like default. Over here the company should be very careful as to which terms of
the agreement should apply to the transaction and which should not.
11.7 Complete other Documentations –
Other documentation which is mentioned before should be prepared and
submitted to the bank. When doing a swap with a bank, one will have to sign the General
Risk Disclosure Statement, which states that the company fully understands the risk
when entering into the swap and the bank is not an advisor to it. The importance of this
statement is that while entering into a swap the bank is making it’s position clear that it is
not entering into a swap with us in the fiduciary relation of a financial advisor but just as
a counter party and it makes sure that the party fully understands the risks it is
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undertaking so that later on there can be no legal dispute over the bank’s interest or
position.
11.8 Commencing Of the swap –
When all the formalities are done with the swap commences from
the agreed date. So on the payment dates the payment should be made and sufficient
liquidity should be ensured so there is no paucity of funds on those due dates.
12.0 Risks and Taxation Issues
12.1 RISKS IN AN IRS
12.1.1 Interest Rate Risk
There is an inherent Interest Rate Risk on the swap just like the risk interest
Rate Risk on any other financial instrument. Any movement in interest rates
would affect the cash-flow.
12.1.2 Liquidity Risk
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Liquidity Risk is the risk that a position will be difficult to reverse by either
liquidating the instrument or by contracting an offsetting position as these
contracts are customised to the requirement of the counterparties.
12.2 TAXATION ISSUES OF IRS
12.2.1 Income Tax Act
IRS solely for the purpose of hedging may be treated as a part of the original
liability for which the IRS has been undertaken, and therefore be liable to tax
accordingly.
12.2.2 Interest Tax
An IRS transaction falling outside the scope of loan or advance or discount, as
referred to in the IT Act, may not attract interest tax. According to IT Act, a
payment can be regarded as interest only if it is payable in respect of any money
borrowed or debt incurred. In an IRS, there is no real lending of money or
otherwise. The intention of the parties entering an IRS is not to create a debtor-
creditor relationship. The party paying interest does not do so in respect of any
money borrowed or debt incurred. Hence, the payments cannot be characterised as
being interest payments under the IT Act.
12.2.3 TDS
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TDS will not be deducted on a Swap transaction, as the amounts paid by each
party to the other cannot be regarded as interest. Interest provisions of Section
194A of the Income Tax Act will thus not be applicable.
12.2.4 Stamp Duty
The master ISDA agreement would be liable to a one-time stamp duty of Rs
120/-. The confirmation would not be liable to any stamp duty as they fall
outside the definition of an ‘instrument’ under the Bombay Stamp Act
13.0 ISDA Agreement
ISDA stands for International Swaps and derivates Association. It is a document
that has to be signed between the two parties who want to enter into a swap
transaction. While signing the ISDA agreement there are three documents which
the two parties need to sign between each other. The first one is the “Master
Document”, the second is the “Schedule” and the third is the “Confirmation”. If
the two parties want to enter into a swap agreement then they have to sign the
Master Document with each other. This Master Document is a standard one and
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can be downloaded from the ISDA website. From the Annexure 1 provided we
can see that the parties will have to make a few changes in the documents like
their name, address etc. this document covers all the relevant definitions and
information such as:
1. Interpretations
2. Obligations
3. Representations
4. Agreements
5. Events of Default and Termination Events
6. Early Termination
7. Transfer
8. Contractual Currency
9. Miscellaneous
10. Offices : Multibranch Parties
11. Expenses.
12. Notices
13. Governing Law and Jurisdiction
14. Definitions
These are the basic things that the two parties need to keep in mind while
entering into a contract. There needs to be only one Master Document that the
two parties need to sign with each other, eg. if XYZ Mutual Fund and I Sec
want to enter into a swap agreement with each other then they will have to sign
only one Master Document with each other. The second document that the parties
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need to sign with each other is the “Schedule”. The schedule is derived from the
Master Document. The Master has a lot of options that the two parties need to
decide about and in the schedule the two parties decide on the exact nature of
the transactions and the way they are going to transact with each other. The
contents of the Schedule as seen in Annexure 2 is that apart from the name,
address and the date that the parties have to enter into are:
1. Termination Provisions
2. Tax Representations
3. Agreement to Deliver Documents
4. Miscellaneous
5. Other Provisions.
The last document that the parties need to sign between each other which is
infact on a transaction basis is the “Confirmation”. This document gives all the
details of a particular contract that the parties have entered into and it will defer
from one contract to the other. The “Schedule” supercedes the “Master” and it is
superceded by the “Confirmation”. Anything that the parties have not agreed to
initially but has been included in the confirmation has to be abided by for that
particular contract. Hence we can see from the above the importance of an ISDA
agreement in any swap and derivate transaction.
Swap markets worldwide account a substantial market share and the opportunities
are ever expanding. We believe that this is going to be a good opportunity to
invest in and hence have made an attempt in this direction. Until today only the
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big banks were the important players but slowly there will be new players in this
segment due to the convenience and hedging opportunity it offers. The investment
community has taken notice of this segment and awakens to the demand. The
growth in IRS is bound to increase in the future mainly because India is an
emerging market. Being an emerging market it needs to hedge its risks due to
high volatility present in the current system. IRS would serve as a perfect
instrument of today if it can help the investing community in hedging their risks
and become an instrument which is sought after.
Though currently the market is small but it will definitely grow and the investor
end would like to be at the forefront cause “Opportunity Dances With Those
Already on the Dance Floor”.
14.0 Bibliography
Options Futures, & Other Derivatives by John Hull
www.debtonnet.com
www.yahoo.com
www.investopedia.com
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www.nse-india.com
www.rbi.org.in
www.google.com
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