Saturday, February 18, 2017

The Introduction of Interest Rate Options In India

[The following guest post is contributed by Niharika Choudhary, who is a 4th year student at the National Law University, Jodhpur]

Introduction

Trade in financial derivatives has led to an enormous growth of the Indian financial system. New instruments have proliferated and trading volume has exploded. The use of financial derivatives has transformed the way financial institutions deal with risk. In February 2016, the Reserve Bank of India (RBI) for the first time proposed to introduce interest rate options in India in order to enable all domestic entities, including banks that have underlying interest rate risk, to hedge their risk by trading in interest rate options. Interest rate options were finally introduced in the Indian financial market by way of the Interest Rate Options (Reserve Bank) Directions, 2016 (RBI Directions) in December 2016, which have become effective from 31 January 2017.

Before this, interest rate swaps (IRS) and forward rate agreements (FRA) in the OTC segment and interest rate futures (IRF) on the exchanges were the only interest rate derivatives traded in India. The need for interest rate options came to the fore when the RBI’s Technical Advisory Committee of the Financial Market Regulation Department held a meeting on 21 April 2015 and constituted a Working Group headed by PG Apte. The Working Group on Interest Rate Options perceived that the financial entities and intermediaries, including banks, lacked any instrument to manage the engrossed risks on their balance sheets, such as premature withdrawal of deposits, prepayment of loans, and the like.

What are Interest Rate Options?

The most common options provided by over the counter derivatives[1] are options on foreign exchange and various interest rate options. Interest rate options are options that derive value from changes in the underlying interest rate. The value of these options is based on Rupee interest rates or Rupee interest rate instruments.

Interest rate options largely include caps, floors, and collars. These concepts are dealt with in detail in the RBI Directions. Interest rate caps are designed to provide insurance against rising interest rates by payment of a premium to the other party, who promises to make interest payments on specified future dates based on the excess, if any, of interest rates above a certain specified rate. In a cap, the insurer on the payment of a premium ensures that its interest payment will not rise above the cap provided and, in case it rises, the writer of the option pays the difference. A floor (on the payment of premium) guarantees that the interest received will not fall below some stated minimum. In a collar there is no requirement of payment of premium and it combines the purchase of a cap with a sale of a floor on the same reference rate for the same maturity and notional principal amount. Therefore, the borrower’s net interest cost cannot rise above the cap nor fall below the floor. In a reverse interest rate collar, there is a purchase of a floor and a sale of a cap on the same reference rate for the same maturity and notional principal amount. Another kind of interest rate option, which was proposed by the Working Group on Interest Rate Options, was Swaption. A Swaption is an option for interest rate swap. Swaptions are a kind of insurance contracts issued on the interest rate swaps i.e., on the decision to change floating into fixed rate loans.

Key Highlights

1.         Types of Interest Rate Options

The Working Group on Interest Rate Options in its report had recommended that simple call and put options, caps, floors, collars and swaptions be permitted. However, the RBI Directions seem to have excluded swaptions in the list of permitted product types. Swaptions are options on forward-starting interest rate swaps. Swaption is defined under the Report of the Working Group on Rupee Derivatives, 2003 as an option to enter into an interest rate swaps. A swaption gives the buyer the right, but not the obligation, to enter into an interest rate swap at a specific date in the future, at a particular fixed rate (the strike rate), and for a specified term. The option is called a receiver swaption if the buyer has the right to receive fixed interest in the swap, and is called a payer swaption if the buyer has the right to pay fixed and receive floating interest in the swap. One of the greatest advantages of using swaptions is that it is possible to lock the rate at present for exchange in the future without incurring any opportunity cost except the expense of the premium. The other advantage is that swaptions can be used for hedging an off-balance sheet item by purchase of a swaption for hedging a loan commitment, which is yet to be drawn down. But the premiums in swaptions are very expensive, liquidity is low and the transaction is very difficult to unwind in case of frequent price fluctuations.[2]

2.         Exercise

The Working Group on Interest Rate Options had recommended that only European options be permitted in the OTC market and also suggested that American options be allowed in next phase.[3] Another recommendation of the Working Group on Interest Rate Options was to allow stock exchanges to introduce both European and American options, keeping in mind the practice in the international markets. However, the RBI Directions do not provide for any special allowance of American options on registered stock exchanges. While executing an American option at any time during the contract provides more flexibility, generally these options are costly in comparison with European options. Also, determining the value of that flexibility further complicates the pricing or valuing American options more complex. Currently, in India, only European options are permitted in terms of option products.

3.         Venue/ Market in which IROs can be traded:

As proposed by the Working Group on Interest Rate Options, the RBI Directions permit both OTC markets and stock exchanges for trading in IROs.

4.         Benchmarks/ Underlying to be used

The benchmark here refers to the reference rate[4] (strike rate) on which the interest rate option is based. It is a moving index, and is usually used in the adjustable rate mortgages. The RBI Directions direct the Fixed Income Money Market and Derivative Association of India (FIMMDA), in consultation with market participants, to publish a list of money or debt market rates or instruments as the underlying such as G-Sec, T-Bills, MIBOR, OIS MIFOR,IRF etc. Also, the Financial Benchmark India Pvt. Ltd. (FBIL) shall publish rates / prices for the reference rate / asset/derivatives for assessing the settlement value in the OTC market.

5.         Market Participants

Market Makers: Market makers include banks and primary dealers and other regulated institutions and entities subject to the approval of their respective regulators.

Users: The users include all entities carrying underlying interest rate risk. They can enter into interest rate option contracts for hedging underlying risk. As per the RBI Directions, ‘users’ shall not be permitted to run net short position[5] in interest rate options.

6.         Reporting

Following the recommendations Working Group on Interest Rate Options, the RBI Directions propose that all OTC transactions are to be reported within 30 minutes of the trade to the Trade Repository of the Clearing Corporation of India Ltd (CCIL). All market makers are required to report client trades on the same day by close of business hours to the Trade Repository of CCIL.

7.         Settlement

The RBI Directions provide that OTC transactions shall be settled bilaterally or through RBI-approved clearing arrangements. FIMMDA is to specify the settlement basis and other market conventions for interest rate option transactions in the OTC.

8.         Suitability and Appropriateness Policy

Market makers ought to comply with the requirement of board-approved ‘Suitability and Appropriateness Policy’[6] read along with the Guidelines on Derivatives, 2007.[7]

Benefits of Interest Rate Option Products

The introduction of interest rate option products in India, being complementary to the currently existing interest swap market, can lead to the following benefits:

1.         Constructive Hedging

Interest rate options can be used to hedge current and future borrowing requirements against sharp rises in interest rates. It is a useful instrument to hedge both on-balance sheet and off-balance sheet exposures. An example of hedging an on-balance sheet exposure would be the purchase of a cap that can be used to hedge a floating rate liability; similarly, a floor can be purchased to hedge a floating rate asset.

2.         Managing Contingency

Options are very useful in managing risks on contingent exposures. For example, if a company participates in the bidding of a project where a sizeable amount of funding is required, but it does not know whether it would be awarded the bid, it may make use of options to hedge the risks of an adverse move in the interest rate markets.

3.         Liquidity

Fixation of interest cost of debt increases cash flow certainty for borrowers of floating rate loan and thus imparts reasonable liquidity.

4.         Price Discovery

Without interest rate options, it was not possible to accurately price a number of products such as floating rate bonds and constant maturity treasury (CMT) swaps, since their pricing requires some estimate of interest rate volatility. After the introduction of interest rate options, the implied option volatilities can be used to infer volatilities in the underlying market, leading to better price discovery.

Conclusion

Interest rate options are versatile tools available to the investors, which would allow the investors to control their exposure to interest rate fluctuations. These will also allow speculation on interest rate volatility. Interest rate options, being hedging instruments, are particularly attractive for those who do not have any strong view on the direction of rates. Interest rate options operate as hedging instruments where the size of risk is highly uncertain. The use of interest rate options would give rise to advantageous hedging and trading opportunities in the derivatives market in India.

- Niharika Choudhary




[1] An over the counter option is negotiated directly between the buyer and the option writer that is usually a bank.

[3] European Option is an option that can be exercised only on the expiration date. American Option is an option that can be exercised at any time before and on the expiration date.

[4] The most common reference rate is the LIBOR Rate.

[5] Short Position refers to selling of securities.

[6] Market makers, while selling such structured products, should carry out due diligence, risk identification, management and control, and should ensure that the products are sold to the users following prudent accounting and disclosure norms.

[7] Circular DBOD No.BP.BC.86/21.04.157/2006-07 (April 20, 2007).

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