Use of Derivatives for Interest Rate Risk Management
[This is authored by Priya Misra and Raghavendra Prasad. They are Second Year PGDM students at Indian Institute of Management, Bangalore.]
The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities imply the need for the banking system to hedge the Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The immediate impact of a change in interest rates is on the bank's earnings by affecting its Net Interest Income (NII). A longer-term impact is on the bank's Market Value of Equity (MVE) or Net Worth. The economic value of bank's assets changes with the variation in interest rates.
Banks use a number of derivative instruments (Interest Rate Futures, Interest Rate Options, Interest Rate Caps, Collars and Interest Rate Swaps) to hedge against Interest Rate Risk. The risk is considerably enhanced during a period when a decline in interest rates bottoms out and begins to move in the opposite direction. In India, this risk is further exacerbated since it is the RBI -- and not the market forces -- which still dictate the prevailing level of interest rates.
(i) Interest Rate Swaps
An interest rate swap can be defined as a contractual agreement entered into between two banks under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal. A notional amount is required in order to compute the actual cash amounts that will be periodically exchanged. Swaps can thus transform cash flows through a bank to more closely match the pattern of cash flows desired by management.
Fixed-for-Floating Interest Rate Swap
A series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. Swap participants can convert from fixed to floating or vice-versa and more closely match the maturities of their Assets and Liabilities.
click here to read Rationale behind an Interest Rate Swap & ways to do it
(ii) Interest Rate Futures
A financial futures contract is an agreement between a buyer and a seller reached at this point of time that calls for the delivery of a particular security in exchange for cash at some future date helps in managing this loss.
Short Hedge in Futures
A bank whose asset portfolio has an average duration longer than the average duration of its liabilities has a positive Duration Gap. A rise in the market interest rate will cause the value of the bank's assets to decline faster than the liabilities, reducing the bank's net worth. In this instance a short hedge in financial futures can be used. The bank's asset-liability manager should sell contracts calling for future delivery of securities on a futures exchange around the time new deposit borrowings will occur, when a fixed-rate loan is made. Later, as borrowings and loans approach maturity or securities are sold and before the first futures contract matures, alike amount of futures contract is purchased on the futures exchange. If market interest rates have risen significantly, the interest cost of the bank's borrowings will increase and the value of any fixed rate loans and securities held by the bank will decline. However, those losses will be approximately offset by a price gain on the futures contract.
On the other hand, the bank can use a long hedge in futures when it has a negative duration gap and expects the interest rates to decline in the economy.
Also read about :
(iii) Interest Rate Caps
(iv) Interest Rate Floors
(v) Interest Rate Collars