A study on the evolution and growth of Indian

derivatives market

Submitted in Partial Fulfillment of the requirements for the Three

Year Full Time of
Bachelor of Commerce (Honors)
Batch (2020-23)

Submitted to: Submitted by:

Dr. Priyank Sharma Madhur Manglik
Department of Commerce B.com (hons) VI Sem
Roll No. 2067005019
 DECLARATION
I Madhur Manglik do hereby declare that the research report entitled A study on the
evolution and growth of Indian derivatives market has been undertaken by me for the
award of the degree of Bachelor of commerce. I have completed this research study under
the guidance of Dr. Priyank Sharma , Professor, Department of Commerce, School of
Commerce and Management, IIMT University, Meerut.
I further declare that this research report has not been submitted to any discussion of any
degree, certificate, higher education or scholarship or other title by the University or othe
r higher education institutions.

Place: Meerut (Name & Signature of the candidate):

Madhur Manglik

Date:

Roll Number: 2067005019

2
 CERTIFICATE
This is to certify that the Research report submitted by Madhur Manglik on the title A
study on the evolution and growth of Indian derivatives market is a record of
research work done by her during the academic year 2023-2024 under my guidance and
supervision in partial fulfillment of Bachelor of Commerce.
I further declare that this research report has not been submitted to any discussion of any
degree, certificate, higher education or scholarship or other title by the University or
other higher education institutions.

Place: Meerut

Date: (Name & Signature of the Guide)

3
 ACKNOWLEDGEMENT

I am indebted to many people who helped me to accomplish this Graduation Research

successfully. First, I thank the Vice Chancellor of IIMT University for giving me the
opportunity to do my research. I owe my deepest gratitude to Dr Satish Kumar Singh,
Dean, School of Commerce and Management and Mr. Puneet Kumar, HOD, Department
of Commerce for their kind support. It gives me great pleasure in acknowledging the
support and help of My Mentor Dr. Priyank Sharma, during the course of my research.
It is immense gratitude that I acknowledge the constant support and blessings of my
parents, without which this research would not have seen the light of day.

NAME: Madhur Manglik

ROLL NO: 2067005019

4
 TABLE OF CONTENTS

S. No. Subject

1 Acknowledgement

2 Objectives

3 Methodology used

4 Introduction of PNB Gilts Ltd.

4.1 Background

4.2 Products & Services

4.3 Financials

5 Introduction to Derivatives

6 Types of Derivatives

6.1 Forwards

6.2 Futures

6.3 Options

6.4 Swaps

7 Derivatives market in India

5
8 Some Preliminaries

8.1 Spot & Forward Interest rates

8.2 Hedging

9 Introduction to Interest Rate Derivatives

10 Interest rate Futures

10.1 Introduction

10.2 Treasury Bill Futures

10.3 Treasury Bond Futures

10.4 Portfolio Hedging Using Interest Rate Futures

11 Interest rate Swaps

11.1 Introduction

11.2 Types of interest rate swap

11.3 Pricing the Interest rate swap

11.4 Portfolio Hedging using interest rate swaps

12 Conclusion

13 Bibliography

6
 OBJECTIVES

The project “Derivative market in India” aims at fulfilling the

following objectives: -

1. To understand what are Derivatives? What are different types

of derivative available in the market and how they are

traded?

2. Understanding Derivatives market in India.

3. To understand different kind of interest rates and the hedging

concept.

4. To know what are Interest rate futures and swaps? How they

are priced? And how hedging is done using them?

7
 METHODOLOGY USED

1. The project involves a great understanding of Derivatives

concept from the book “Financial management & policy by

James C. Van Horne”

2. The study of Indian market is taken from internet.

3. However the Hedging concept is described by the project

guide as well as examples are taken from the various

educational websites.

8
 OBJECTIVES

The objectives of the Company are in line with objectives laid

down by RBI for the Primary Dealers: -

1. Strengthen the infrastructure in the government securities

market in order to make it vibrant, liquid and broad based.

2. Ensure the development of underwriting and market making

capabilities for Government Securities.

3. Improve secondary market trading system, which would

contribute to price discovery, enhance liquidity and turnover

and encourage voluntary holding of Government securities

amongst a wider investor base.

4. Become an effective conduit for conducting open market

operations

9
 INTRODUCTION

Everyone talks about derivatives these days. Derivative products have been

around for a long time. Do you know derivatives first came about in

Japanese rice markets?

Yes, as early as the 1650s, dealings resembling present day derivative

market transactions were seen in rice markets in Osaka, Japan.

The first leap towards an organized derivatives market came in 1848,

The Chicago Mercantile Exchange, the world's largest derivatives exchange,

was established.

Today, equity and commodity derivative markets are rapidly gaining in size

in India. In terms of popularity too, these markets are catching on like a

forest fire. So, what are these markets all about? What are the products that

they trade in? Why do people feel the need to trade in such products and

what sort of traders benefit from such trades?

Do these markets hold scope for retail investors too? And if so, how exactly

can you go about trading in them?

10
Derivatives markets broadly can be classified into two categories, those that

are traded on the exchange and the those traded one to one or 'over the

counter'. They are hence known as:

 Exchange Traded Derivatives

 OTC Derivatives (Over The Counter)

 OTC Equity Derivatives

Traditionally equity derivatives have a long history in India in the OTC

market.

Options of various kinds (called Teji and Mandi and Fatak) in un-organized

markets were traded as early as 1900 in Mumbai

The SCRA however banned all kind of options in 1956.

SCRA's ban on options was lifted in 1995. Foreign currency options on curr

ency pairs other than the rupee were the first options allowed by the Reserve

Bank of India (RBI).

RBI allows risk-

reducing options, interest rate swaps, currency swaps and other OTC derivati

ves.

11
Besides the Forward market in currencies has been a vibrant market in India

for several decades.

The word "derivative" indicates that it has no independent value, meaning th

at its value is "derived" entirely from the asset's value.

The underlying asset can be securities, commodities, bullion, currency, live

stock or anything else. In other words, Derivative means a forward, future,

option or any other hybrid contract of pre determined fixed duration, linked

for the purpose of contract fulfillment to the value of a specified real or

financial asset or to an index of securities.

Derivative trading in India takes can place either on a separate and

independent Derivative Exchange or on a separate segment of an existing

Stock Exchange. Derivative Exchange/Segment function as a Self-

Regulatory Organisation and Sebi acts as the oversight regulator. The

clearing & settlement of all trades on the Derivative Exchange/Segment

would have to be through a Clearing Corporation/House, which is

independent in governance and membership from the Derivative

Exchange/Segment.

12
With the amendment in the definition of 'securities' under SC(R)A (to

include derivative contracts in the definition of securities), derivatives

trading takes place under the provisions of the Securities Contracts

(Regulation) Act, 1956 and the Securities and Exchange Board of India Act,

1992.

Dr. L.C Gupta Committee constituted by Sebi had laid down the regulatory

framework for derivative trading in India. SEBI has also framed suggestive

bye-law for Derivative Exchanges/Segments and their Clearing

Corporation/House which lay's down the provisions for trading and

settlement of derivative contracts.

The Rules, Bye-laws & Regulations of the Derivative Segment of the

Exchanges and their Clearing Corporation/House have to be framed in line

with the suggestive Bye-laws. Sebi has also laid the eligibility conditions for

Derivative Exchange/Segment and its Clearing Corporation/House.

The eligibility conditions have been framed to ensure that Derivative

Exchange/Segment & Clearing Corporation/House provide a transparent

13
trading environment, safety & integrity and provide facilities for redressal of

investor grievances.

14
 COMPANY PROFILE

2.1 Introduction

Sharekhan is India's leading retail financial services company with We have

over 250 share shops across 115 cities in India. While our size and strong

balance sheet allow us to provide you with varied products and services at

very attractive prices, our over 750 Client Relationship Managers are

dedicated to serving your unique needs.

Sharekhan is lead by a highly regarded management team that has invested

crores of rupees into a world class Infrastructure that provides our clients

with real-time service & 24/7 access to all information and products. Our

flagship Sharekhan Professional Network offers real-time prices, detailed

data and news, intelligent analytics, and electronic trading capabilities, right

at your finger-tips. This powerful technology complemented by our

knowledgeable and customer focused Relationship Managers. We are

Creating a world of Smart Investor.

15
Sharekhan offers a full range of financial services and products ranging

from Equities to Derivatives enhance your wealth and hence, achieve your

financial goals.

Sharekhan' Client Relationship Managers are available to you to help with

your financial planning and investment needs. To provide the highest

possible quality of service, Indiabulls provides full access to all our products

and services through multi-channels .

Services provided by the SHAREKHAN :--

1. Equities & Derivatives :--Comprehensive services for

independent investors,

active traders & Non-Resident

Indians.

2. Sharekhan equity analysis :-- Premium research on 401+

companies updated daily.

3. Depository Services :-- Value added services for

seamless delivery.

16
1. Equities and Derivatives

Our Retail Equity Business caters to the needs of individual Indian and Non-

Resident Indian (NRI) investors. Sharekhan offers broker assisted trade

execution, automated online investing and access to all IPO's.

Through various types of brokerage accounts, Indiabulls offers the purchase

and sale of securities which includes Equity, Derivatives and Commodities

Instruments listed on National Stock Exchange of India Ltd (NSEIL), The

Stock Exchange, Mumbai (BSE) and NCDEX.

Choose the service options that fit you best.

 Sharekhan Classic account - Comprehensive services including

research and investing guidance for independent investors.

 Sharekhan Fast trade - Sharekhan is dedicated to empower Active

Traders through personal service and advanced trading technology.

 Sharekhan Speed trade plus - With an extensive range of investment

products, you will discover an unwavering commitment to helping

you invest in India.

17
2. Sharekhan equity analysis

Building and maintaining your ideal portfolio demands objective,

dependable information. Sharekhan Equity Analysis helps satisfy that need

by rating stocks based on carefully selected, fact-based measures. And

because we're not focused on investment banking, we don't have the same

conflicts of interest as traditional brokerage firms. This objectivity is only

one important difference in our ratings.

18
 Types of categories

1. Evergreen :--These stocks are steady compounders, churning out

steady growth rates year on year. They are typically significant players

in their markets, with sound strategies that will help them achieve and

sustain market dominance in the long run. They have strong brands,

management credentials and a consistent track record of achieving super

normal shareholder returns. We expect stocks in this category to

compound at between 18-20% per annum for the next five to ten years.

2. Apple Green :-- These are stocks that have the potential to be steady

compounders and are attempting to move upwards, to turn Evergreen.

They rank a shade below the Evergreen companies, only because their

potential in the five to ten years' time is still not very clear, although they

might grow at rates faster than that of the Evergreen stocks in the next

year or two. They could grow at 25-30% per annum over the next two to

three years.

19
3. Emerging Star :-- These are typically young companies, often in niche

businesses, that have the potential to grow and dominate their niches.

Even better, they might turn out to be real giants, if their niches explode

into full-blown markets in their own rights. These stocks are potential

ten-baggers but you need to be patient.

4. Ugly Duckling :-- These are companies that are trading below their fair

value or at values which are at a significant discount to that of their peer

group, due to a combination of circumstances. But things are now

starting to happen in these companies or in their markets that are likely

to cause a reevaluation of their prospects. These stocks could double in

two to three years' time.

5. Vulture's Pick :-- These are companies with valuable assets or brands

that have been trashed to ridiculously low prices. Buy a Vulture's Pick

and wait for a predator who finds its assets undervalued to come along.

This could be a long wait but the returns could be startlingly high.

6. Cannonball :-- These are companies with valuable assets or brands that

have been trashed to ridiculously low prices. Buy a cannonball and wait

for a predator who finds its assets undervalued to come along. This could

be a long wait but the returns could be startlingly high.

20
 3. Depository Services

Sharekhan is a depository participant with the National Securities

Depository Limited and Central Depository Services (India) Limited for

trading and settlement of dematerialised shares. Sharekhan performs

clearing services for all securities transactions through its accounts. We offer

depository services to create a seamless transaction platform – execute

trades through Sharekhan Securities and settle these transactions through the

Indiabulls Depository Services. I Sharekhan Depository Services is part of

our value added services for our clients that create multiple interfaces with

the client and provide for a solution that takes care of all your needs.

21
 Online trading account

Sharekhan provide two types of trading account:

1. Classic account (For beginners and medium investor)

2. Speed Trade (For heavy investor)

22
Financial

The company achieved a turnover of Rs.53, 390 Crores during

2005-2006.

2001-02 2002-03 2003-04 2004-05 2005-06

Turnover 106800 102875 116468 61740 53390

Income 234.39 230.09 237.94 11.31 127.06

Expenditure 58.13 80.08 69.29 79.44 98.54

PBT 176.26 150.01 168.64 (68.13) 28.52

PAT 112.59 92.51 106.95 (68.25) 29.64

Net Worth 414.67 472.45 541.33 471.51 485.58

Dividend (in %) 24 25 25 - 8

23
 5. Introduction to Derivatives

The outcome of trading derivatives, particularly futures, futures an

d options, can be traced back to the interest of the risk-

averse market operator to hedge against uncertainty in the value of

the asset. By their very nature, financial markets are characterized

by a high level of volatility. By using derivatives, the price risk can

be partially or completely changed by locking in the value of the a

sset. As risk management tools, they often do not reflect changes i

n the asset's value. However, derivatives fix the value of the asset,

reducing the impact of changes in asset price on investors' profits a

nd cash flows.

24
 Derivatives defined

A derivative is an asset whose value is contracted from the value of

one or more underlying variables (asset, index, or reference value)

called the underlying. The underlying asset can be stocks, currenci

es, stocks or other assets.

For example, a farmer may want to sell his produce the next day to

avoid the risk of changes before that day. Such a business is an ex

ample of a commodity. The price of this derivative is determined b

y the "base" price of the grain.

In India, the Securities Contracts (Regulation) Act 1956 (SC(R)A)

defines "derivatives" as:-

1. Derivatives Derivatives from debt instruments, stocks, loans (col

lateralized or unsecured), derivatives from risk Instruments or CFD

s or other securities.

2. A security that derives its value from the price or valuation of th

e underlying security.

25
Derivatives are securities under SC(R)A and therefore trading in d

erivatives is regulated by the regulatory authority under SC(R)A.

26
Participants and Functions

The participants in derivative market are as follow: -

1. Hedgers use futures or options markets to reduce or eliminate

the risk associated with price of an asset

2. Speculators use futures and options contracts to get extra

leverage in betting on future movements in the price of an asset.

They can increase both the potential gains and potential losses by

usage of derivatives in a speculative venture.

3.Arbitrageurs take advantage of price differences in two different markets to

trade. For example, if they find that the future price of an asset is not the same a

s the spot price, they will take a offset position in both markets to generate inco

me.

Derivatives trading performs the following trading activities:

1. Prices in an organized derivatives market reflect the

perception of market participants about the future and lead

the prices of underlying to the perceived future level.

The value of derivatives converges to the value of the base w

27
 hen the derivative contract expires. Thus, derivatives help to

see future and current prices.

2. Trading derivatives help transfer the risk of those who own th

em but may not like them to those who love them.

3. Derivatives from their origin, are linked to the underlying

cash markets. With the introduction of derivatives, the

underlying market witnesses higher trading volumes because

of participation by more players who would not otherwise

participate for lack of an arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of

derivatives market. In the absence of an organized derivatives

market, speculators trade in the underlying cash markets.

Margining, monitoring and surveillance of the activities of

various participants become extremely difficult in these kinds

of mixed markets.

5. One of the main benefits of trading derivatives is that it can a

ct as a vehicle for new trading. The derivatives have a history

28
 of attracting many bright, creative, well-educated people with

an entrepreneurial attitude. They often energize others to

create new businesses, new products and new employment

opportunities, the benefit of which are immense.

6. In the long run, commercial derivatives can help save money an

d capital. Changing risk forces business participants to expand thei

r activities.

29
 The Growth of the Derivatives Market in India

The first step in the introduction of the derivatives market in India

was the enactment of the Securities Act (Amendment) Regulations,

1995, which removed the restriction on the choice of securities. H

owever, the derivatives market did not rise as there is no regulation

regulating the derivatives market. SEBI, Dr. L.C.

On 18 November 1996, Gupta published Section

to regulate the derivatives market in India. On 17 March 1998, the

Committee presented its report laying out the prerequisites for laun

ching derivatives trading in India. The Commission recommends t

hat derivatives be declared as "securities" so that the regulatory fra

mework for transactions in "securities" also regulates securities tra

nsactions. SEBI was also introduced in June 1998 by Prof. JJ

R. Varma, Disclosure on Securities Regulations in the Indian Deriv

atives Market. The report, published in October 1998, detailed inte

rest rate transactions, initial interest rate collection procedures, inc

30
ome tax rates and deposit interest rates, and time management poli

cies. The Securities Contracts Regulatory Act (SCRA) No.

was amended in December 1999 to include securities within the sc

ope of "securities" and to establish a regulatory framework for deri

vative transactions. The bill also clarifies that derivative contracts a

re only valid if they are traded on a recognized exchange, thus excl

uding over-the-counter products.

The government also withdrew the three-

year plan banning future investments in securities in March 2022.

Derivatives trading started in India in June 2022 after SEBI receive

d final approval in May 2001. SEBI allowed derivatives distributio

n on two exchanges, NSE and BSE, and their clearing house/busin

esses began approving contracts for commodity trading and settlem

ent. Previously, SEBI approved the trading of futures contracts bas

ed on the S&P CNX Nifty and BSE-

30 (Sensex) indices. Both indicators-

based trading options and trading options on individual securities a

31
re then recommended.

BSE Sensex options trading started on June 4, 2001 and stock opti

ons trading started on July 2001. A futures contract was launched i

n November 2001. NSE derivatives trading started in June with S&

P CNX Nifty index futures. On December 12, 2022, index options

trading began on June 4, 2001, and individual stock options on Jul

y 2, 2001. Individual stock futures were launched on November 9,

2001.

Trading and clearing of index futures and options contracts based o

n NSE's S&P CNX

derivative contract is subject to the rules, regulations and rules of t

he exchange and its institutions. The bank/company is approved by

SEBI and published in the Official Gazette. Foreign Institutional I

nvestors (FIIs) may trade any derivatives traded on the exchange.

32
 Some Preliminaries

8.1 Spot & Forward Interest Rates

The n-year spot interest rate or n-year zero coupon rate is interest

rate on an investment that is made for a period of time starting

today and lasting for n-years. Thus, the three year spot rate is the

rate of interest on an investment lasting three years; the five year

spot rate is the rate of interest on an investment lasting five years,

and so on. The investment considered should be a “pure” n-year

investment with no intermediate payments. This means that all the

interest and the principle are repaid to the investor at the end of

year n.

Forward interest rates are the rates of interest implied by

current spot rates for periods of time in the future. If r is the spot

rate of interest applying for T years and r* is the spot rate of

interest applying to T* years where T*>T, the forward interest rate

for the period of time between T and T*, R, is given by

33
 R = r*T* - rT/T* - T

To illustrate the use of this formula, consider the calculation of the

year 2 forward rate, where, T = 1, T* = 2, r = 0.10 and r* = 0.105

R = (0.105*2) – (0.10*1/2) – 1 = 0.11 or 11%

8.2 Hedging

In finance, a hedge is an investment that is taken out specifically to

reduce or cancel out the risk in another investment. Hedging is a

strategy designed to minimize exposure to an unwanted business

risk, while still allowing the business to profit from an investment

activity. Typically, a hedger might invest in a security that he

believes is under-priced relative to its "fair value" (for example a

mortgage loan that he is then making), and combine this with a

short sale of a related security or securities. Thus the hedger is

indifferent to the movements of the market as a whole, and is

interested only in the performance of the 'under-priced' security

relative to the hedge

34
Type of Hedges: -

. A long hedge is appropriate when you know you will

purchase an asset in the future and want to lock in the price.

1. A short hedge is appropriate when you know you will sell an

asset in the future & want to lock in the price.

Example

A stock trader believes that the stock price of Company A will rise

over the next month, due to the company's new and efficient

method of producing widgets. He wants to buy Company A shares

to profit from their expected price increase. But Company A is part

of the highly volatile widget industry. If the trader simply bought

the shares based on his belief that the Company A shares were

under priced, the trade would be a speculation.

35
Since the trader is interested in the company, rather than the

industry, he wants to hedge out the industry risk by short selling an

equal value (number of shares × price) of the shares of Company

A's direct competitor, Company B. If the trader were able to short

sell an asset whose price had a mathematically defined relation

with Company A's stock price (for example a call option on

Company A shares) the trade might be essentially risk less and be

called an arbitrage. But since some risk remains in the trade, it is

said to be "hedged."

The first day the trader's portfolio is:

 Long 1000 shares of Company A at $1 each

 Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares.)

On the second day, a favorable news story about the widgets

industry is published and the value of all widgets stock goes up.

36
Company A, however, because it is a stronger company, goes up

by 10%, while Company B goes up by just 5%:

 Long 1000 shares of Company A at $1.10 each — $100 gain

 Short 500 shares of Company B at $2.10 each — $50 loss

(In a short position, the investor loses money when the price goes

up.)

The trader might regret the hedge on day two, since it reduced the

profits on the Company A position. But on the third day, an

unfavorable news story is published about the health effects of

widgets, and all widgets stocks crash -- 50% is wiped off the value

of the widgets industry in the course of a few hours. Nevertheless,

since Company A is the better company, it suffers less than

Company B:

Value of long position (Company A):

 Day 1 — $1000

37
  Day 2 — $1100

 Day 3 — $550 => $450 loss

Value of short position (Company B):

 Day 1 — -$1000

 Day 2 — -$1050

 Day 3 — -$525

Without the hedge, the trader would have lost $450. But the hedge

- the short sale of Company B - gives a profit of $475, for a net

profit of $25 during a dramatic market collapse.

38
 Interest rate derivative

An interest rate derivative is a derivative that has a right to pay or

receive an (usually negative) interest on the underlying asset.

Some examples of interest rate derivatives

Interest rates

Interest rates are designed to hedge the company's largest exposure

to interest rate hikes. Sets the maximum amount of interest Hedger

will pay for the limited period. A price ceiling is actually a set of i

ndividual price ceilings, each a separate option from the underlying

price index. Interest is paid in advance and the buyer then realizes

the benefits of interest over the life of the instrument.

Bermuda Swap

Suppose a company buys and sells fixed callable coupons. Howeve

r, the issuer enters into an interest rate swap to convert the fixed co

39
upon payment (possibly based on LIBOR) into a variable rate pay

ment. However, because it can be called, the issuer can redeem mo

ney it receives from investors at certain dates during the bond's life

. However, the issuer can still enter into an interest rate transaction

if requested. Therefore, the issuer also enters into a Bermuda swap

when the contract is specified and the execution date is equal to the

contract call date.

If the contract is called, the swap option will be applied, the swap

will be canceled and the person will be deducted from the risk inter

est.

40
 Interest rate futures

10.1 Introduction

Interest rate futures are futures contracts that use interest rates as th

e underlying asset. or in other words a financial contract where

settlement of a transaction happens at a future date while all other

financial aspects of the transaction is fixed today. Interest rate

futures contracts are contracts based on the list of underlying as

may be specified by SEBI from time to time. To begin with,

interest rate futures contracts on the following underlying shall be

available for trading on the F&O segment of the exchange: -

 Notional T-Bills

 Notional 10 year bonds (coupon bearing or non-coupon

bearing)

The list of securities on which futures contracts would be available

on their symbols for trading are as under: -

41
S.No. Symbol Description

1 NSETB91D Futures contract on Notional 91 day T bill

2 NSE10Y23 Futures contract on Notional 10 year

coupon bearing bond

3 NSE10YZC Futures contract on Notional 10 years zero

coupon bond

Contract specification

Security descriptor

The security descriptor for the interest rate future contact is: -

Market type: N

Instrument type: FUTINT

Underlying: Notional T-bills and Notional 10 year bond (coupon

bearing or non-coupon bearing)

Expiry date: Last Thursday of the expiry month.

42
Instrument type represents the instrument i.e. Interest rate futures

contract

Underlying symbol denotes the underlying.

Expiry date identifies the date of expiry of the contract.

Underlying instrument

Interest rate futures contract are available on Notional T-bill,

Notional 10 year zero coupon bond and Notional 10 year coupon

bearing bond stipulated by the Securities & Exchange Board of

India (SEBI).

Trading Parameters

 Contract size

The permitted lot size for the interest rate futures contracts shall

be 2022. The minimum value of an interest rate contract would

be Rs. 2 lakhs at the time of introduction.

 Price steps

43
The price steps in respect to all interest rate futures contracts

admitted to dealings on the exchange is Re.0.01

The futures contracts having face value of Rs.100 on Notional

10 year coupon bearing bond and Notional 10 year zero coupon

bond would be based on price quotation and Futures contracts

having face value of Rs.100 on Notional 91 days treasury bill

would be based on Rs.100 minus(-) yield.

 Base price & Operating ranges

Base price of the interest rate futures contracts on introduction

of new contracts shall be theoretical futures price computed

based on pervious days closing price of the notional underlying

security. The base price of the contracts on subsequent trading

days will be the closing price of future contracts. However, on

such of those days when the contracts would not traded, the

base price will be the daily settlement price of future contracts.

44
 There will be no day minimum/maximum price ranges

applicable for the futures contracts. However, in order to

prevent/take care of erroneous order entry, the operating ranges

for the interest rate futures contracts shall be kept at +/- 2% of

the would be required to confirm to exchange that the order is

genuine. On such confirmation, the exchange at its discretion

may approve this order. If such a confirmation is not given by

any member, such order shall not be processed and as shall

lapse.

Quantity Freeze

Orders which may come to the exchange as a quantity freeze

shall be 2500 contracts amounting to 50, 00,000 which works

out on the day of introduction to approximately Rs.50 crores. In

respect to such orders which have come under quantity freeze,

the members shall be required to the exchange that the order is

genuine. On such confirmation, the exchange at its discretion

45
may approve such order subject to availability of

turnover/exposure limits, etc. if such a confirmation is not given

by any member, such order shall not be processed and as such

shall lapse.

10.2 Treasury Bill Futures

Treasury Bills are money market instruments, issued by the

Reserve Bank of India on behalf of the government of India to

finance its short-term requirements of funds. These are

discounted securities and thus are issued at a discount to face

value, the return to the investor being the difference between the

maturity value and issued price.

There are different types of Treasury bills based on the

maturity period and utility of the issuance, but futures contract

can only be on 91 day Treasury Bill.

46
In U.S. the T-bill futures contract are traded by the international

monetary market of the Chicago Mercantile Exchange, which

calls for the delivery of T-bills having a face value of

$1,000,000 and a time to maturity of 90 days at the expiration of

the futures contract. Price quotations for T-bill futures use the

IMM index, which is a function of the discount yield:

IMM index = face value – DY

Where

DY = discount yield e.g. 5.6 is 5.6 percent

With a discount yield of 8.32 percent on the futures contract, the

price to be paid for the T-bill at delivery would be:

Bill price = $1,000,000 – 0.832($1,000,000) (90)/360 =

$979,200

If the future yield rose to 8.35 percent, the delivery price would

be $979,125, changing $25 for each basis point.

47
Quoted Prices

Treasury bill price quotes are for a treasury bill with a face

value of $100. There is a difference between the cash price and

the quoted price for a treasury bill. If Y is the cash price of a

Treasury bill that has a face value of $100 and n days to

maturity, the quoted price is:

360/n (100-Y)

This is referred to as discount rate. It is the annualized dollar to

provide by the Treasury bill expressed as a percentage of the

face value. If for a 91-day treasury bill the cash price Y, were

98, the quoted price would be 8.00

The discount rate is not the same as the rate of return

earned on the Treasury bill. The latter is calculated as the dollar

return divide by the cost, in the preceding example, where the

quoted price is 8.00, the rate of return would be 2/98 or 2.04

percent per 90 days. This amounts to:

2/98 * 365/90 = .0828

48
Or 8.28 percent per annum with compounding every 90 days.

The rate of return is sometimes referred to as the bond

equivalent yield.

A 90-days treasury bill futures contract is for delivery

of $1 million of treasury bills. Treasury bill futures prices are

not quoted in the same way as the prices of treasury bills

themselves. The following relationship is used: -

Treasury bill future price quote = 100 – corresponding

treasury bill price quote

If Z is the quoted future price and Y is the corresponding price

that would be paid for delivery of $100 of 90-day treasury bills,

this means that:

Z = 100 – 4 (100-Y)

Or equivalently,

Y = 100 – 0.25 (100-Z)

49
Thus the closing quote of 96.93 for September 1993 treasury

bill corresponds to price of 100 – 0.25 (100-96.93) = $99.2325

per $100 of 90-day treasury bill or a contract price of $992,325.

If the treasury bills that are delivered have 89 days to

maturity, the price received is calculated by replacing the 0.25

in the preceding formula for Y by 89/360 or 0.2472. if they have

91 days to maturity, the 0.25 in the formula becomes 91/360 or

0.2528.

Example

Suppose that the 140-day interest rate is 8% per annum and the

230-day rate is 8.25% per annum with continuous compounding

being used for both rates. The forward rate for the time period

between day 140 and day 230 is:

0.0825*230 - 0.08*140/90 = .0864 or 8.64%

50
To calculate future price for $100 0f 90-day treasury we will use

cost of carry model formula which is as follow: -

F = Sert

Where:

F = future value

S = selling price

r = financial value (using continued value)

t = time to maturity

e = 2.61828

in the above example

S = $100

r = 8.64% or .0864

t = 90 days or 0.2466 year

So future price will be

F = 100e (0.0864*0.2466) = 97.89

This would be quoted as 100 – 4 (100 – 97.89) = 91.56

10.3 Treasury Bond Futures

51
In U.S. market the most popular long term interest rate futures

are the Treasury bond futures contracts traded on the CBOT. In

the Treasury bond contract, any government bond with more

than 15 years to maturity and not callable within 15 years can be

delivered.

Quotes

Treasury bond prices are quoted in dollars and thirty-

seconds of a dollar. The quoted price is for a bond with a face

value of $100. Thus, a quote of 90-05 means that the indicated

price for a bond with a face value of $100,000 is $90,156.25

The product quoted is not the same as the cash price

that is paid by the purchaser, in general

Cash price = quoted price + Accrued interest rate since

last coupon date

52
To illustrate this formula, suppose that is March 5, 2007 and the

bond under consideration is an 11 percent coupon bond

maturing on July 10, 2023 with a quoted price $95.50. Since

coupons are paid semiannually on government bonds, the most

recent coupon date is January 10, 2007 and the next coupon date

is July 10, 2007. The number of days between January 10, 2007

and July 10, 2007 is 181. On $100 face value of bonds, the

coupon payment is $5.50 on January 10 and July 10. The

accrued interest on March 5, 2007 is calculated as

54/181 * $5.5 = $1.64

The cash price per $100 face value for the July 10, 2023 bond

is, therefore,

$95.5 + $1.64 = $97.14

The cash price of a $1000,000 bonds is, therefore, $97,140.

53
Conversion Factors

There is a provision in the Treasury bond futures contract for

the party with the short position to choose to deliver any bond

with a maturity over 15 years and not callable within 15 years.

When a particular bond is delivered, a parameter known as its

conversion factor defines the price received by the party with

the short position. The quoted price applicable to the delivery is

the product of the conversion factor and the quoted futures

price. Taking accrued interest into account, we have the

following relationship for each $100 face value of the bond

delivered: -

Cash received by party with the short position = (Quoted future

price) * (Conversion factor for bond delivered) + (Accrued

interest bond delivered)

54
Each contract is for the delivery of $1000,000 face value of

bonds. Suppose the quoted futures price is $90.00, the

conversion factor for the bond delivered is 1.38, and the accrued

interest on this bond at the time of delivery is $3.00 per $100

face value. The cash received by the party with the short

position (and paid by the party with the long position) is then:

(1.38 * 90.00) + 3.00 = $127.20

Per $100 face value. A party with the short position in one

contract would deliver bonds with face value of $100,000 and

receive $127,200.

55
 Portfolio Hedging using Interest rate futures

As we have already discussed some interest rate futures like

treasury bill futures and treasury bond futures so now we will

how we can use these futures in portfolio hedging: -

Hedging the future purchase of six-month Treasury bill

Suppose that on May 20, a corporate treasurer learns that $3.3

million will be received on August 5. The funds will be needed for

a major capital investment the following February. The treasurer,

therefore, plans to invest the funds in six-month treasury bills as

soon as they are received. The current yield on six-month treasury

bills, expressed with semi-annual compounding, is 11.20%. The

treasurer is concerned that this may be decline between May 20

and August 5 and decides to hedge using treasury bill futures. The

quoted price for September treasury bill futures contract is 89.44.

In this case the company will lose money if interest

rates go down. A long hedge is therefore required. If interest rates

56
do go down, the treasury bill price will go up and a gain will be

made on the futures position.

To calculate the number of treasury bill futures

contracts that should be purchased, we note that the asset

underlying the futures contract lasts three months. Since it is a

discount instrument, its duration is also three months or 0.25 years.

Similarly, the six-month treasury bill investment planned by the

treasurer has a duration of six months or 0.50 years. Each treasury

bill futures contract is for the delivery of $1 million of treasury

bills. The contract price is: -

10,000 {100 – 0.25 (100 – 89.44)} = $973,600

The number of contracts that should be purchased is,

3,300,000/973,600 * 0.5/0.25 = 6.78

Rounding to the nearest whole number, the treasurer should

purchase seven contracts.

57
 Between May 20 and August 5, the treasurer’s worst fears

were realized and the yield on six-month treasury bills declined by

1.40% per annum to 9.80% per annum. This cost the treasurer

$3,300,000 * 0.014 * 0.5 = $23,100 in lost interest.

The price quote for the September treasury bill futures contract

was 90.56 on August 5. This corresponds to a contract price of

$976,400. The gain on the futures contract was, therefore, 7 *

($976,400 - $973,600) = $19,600. When invested for six months at

9.80% per annum, this grew to $20,540. The company, therefore,

lost only $23,100-$20,560 = $2,540 relative to the position it

would have been in if the interest rat had remained unchanged

between May 20 and August 5.

2. Hedging a Bond Portfolio

On august 3, a fund manager has $10 million invested in

government bonds and is concerned that interest rates are expected

to be highly volatile over the next three months. The fund manager

decides to use the December treasury bond futures contract to

58
hedge the value for the portfolio. The current futures price is

93.0625. Since each contract is for the delivery of $100,000 face

value of bonds, the futures contract price is $93,062.50.

The average duration of the bond portfolio in three

months Will be 6.80 years. The cheapest to delivery bond in the

treasury bond contract is expected to be a 20 year, 12% per annum

coupon bond. The yield on this bond is currently 8.80% per

annum, and the duration will be 9.20 years at maturity of the

futures contract.

The fund manager requires a short position in treasury bond

futures to hedge the bond portfolio. If the interest rates go up, a

gain will be made on the short futures position and a loss will be

made on the bond portfolio. If interest rate decreases, a loss will be

made on the short position, but there will be a gain on the bond

portfolio. The number of bond futures contracts that should be

shorted can be calculated like this:

10,000,000/93,062.50 * 6.80/9.20 = 79.42

59
Rounding to the nearest whole number, the portfolio manager

should short 79 contracts.

During the period August 2 to November 2, interest rates

declined rapidly. The value of the bond portfolio increased from

$10 million to $10,45,000. On November 2, the T-bond futures

price was 98.50. This corresponds to a contract price of $98,500.

This means that the total loss on the treasury bond futures contracts

was

79 * ($98,500 - $93,062.50) = $429,562.50

The net charge in the value of the portfolio manager’s position

was, therefore, only

$450,000 - $429,562.50 = $20,437.50

60
 Interest Rate Swap

11.1 Introduction

An interest rate swap is an advantage where one party exchanges i

nterest payments for cash flows from another party.

Structure

In an interest rate swap, each counter party agrees to pay either a

fixed or floating rate denominated in a particular currency to the

other counterparty.

Fixed or floating interest is distributed by the principal (for exampl

e, $1 million). This assumption is not usually exchanged between p

artners, it is simply used to calculate the size of the cash flow to be

exchanged.

The most common type of interest rate swap is where counterparty

A pays counterparty B a fixed rate (the swap rate) and receives a v

61
ariable rate (usually fixed at a reference rate such as LIBOR).

A pays B a fixed amount (A gets a variable amount).

B pays A a variable rate (B gets a fixed rate).

take the case of an interest rate swap, in which Counter Party A

and Counter Party B agree to exchange over a period of say, five

years, two streams of semi-annual payments. The payments made

by A are calculated at a fixed rate of 6% (Fixed rate) per annum

while the payments to be made by B are to be calculated using

periodic fixings of 6-month Libor (floating). The swap is for a

notional principal amount of USD 10 million. The above swap is

called the "plain vanilla" or the "coupon swap". Interest rates are

normally fixed at the beginning of the contract period, but settled

at the end of the period.

62
The contract can be simplified as follows.

Counter parties:: A and B

Maturity:: 5 years

A pays to B : 6% fixed p.a.

B pays to A : 6-month LIBOR

Payment terms : semi-annual

Notional Principal amount: USD 10 million.

Diagram:

63
Cash flows in the above swap are represented as follows:

Payments
Floating rate
at the end Fixed rate Net Cash
Payments
Half year payments From
6m Libor
period A to B

1 300000 337500 -37500

2 300000 337500 -37500

3 300000 337500 -37500

4 300000 325000 -25000

5 300000 325000 -25000

6 300000 325000 -25000

7 300000 312500 -12500

8 300000 312500 -12500

9 300000 312500 -12500

10 300000 325000 -25000

-250000

64
.11.2 Types of Interest Rate Swap

As a commodity on the market, interest rate swaps can take many f

orms and be designed to meet the specific needs of bidders. Howev

er, most are fixed to fixed, fixed to floating, or floating. The two pa

rties to the exchange can be the same currency or different currenci

es.

(A single-currency fixed-for-fixed rate swap is generally not

possible; since the entire cash-flow stream can be predicted at the

outset there would be no reason to maintain a swap contract as the

two parties could just settle for the difference between the present

values of the two fixed streams; the only exceptions would be

where the notional amount on one leg is uncertain or other esoteric

uncertainty is introduced).

65
Fixed rate swap Variable rate swap, same currency

Party P pays/receives interest in currency A to receive/pay a floatin

g rate fixed to X at nominal N for a period of T years in currency A

. For example, you pay a flat rate of 5.32% per month and receive

a Libor of $1 million per month with negative $1 million for 3 year

s. The party paying a fixed coupon rate and receiving a floating co

upon is said to be in a long interest rate swap.

Fixed to floating swaps in the same currency are used to convert fi

xed assets/liabilities to depreciable assets/liabilities and vice versa.

For example, if a company has a $10 million loan that pays 5.3% p

er month and a $10 million investment that pays $1 million per mo

nth LIBOR + 25 points, the company can swap interest. In this tran

saction, the company will pay $1 million Libor + 25 basis points fl

oating rate and will receive a 5.5% flat rate, locking in 20 basis poi

nts revenue.

66
Fixed interest and interest rate swaps, different currencies

Party P pays/receives interest in currency A, gets/pays variable inte

rest in currency B based on X, is called N as initial currency and pe

riod is T years. For example, to receive 3 million JIBOR on an outs

tanding amount of JPY 1.2 billion per month (initial exchange rate

of USD 120) for 3 years, you would pay a fixed interest rate of 5.3

2% on an outstanding amount of US$ 10 million per month. For no

n-

delivered transactions, the US Dollar equivalent of JPY interest is

accrued/paid (based on the exchange rate on the Currency date adj

usted for the interest date).

The initial conversion of the assumption will not occur unless the

Currency Fixation Date and Swap Start Date are in the future.

Fixed-

variable swaps between different currencies are used to convert fix

ed assets/liabilities in one currency to floating assets/liabilities in a

nother currency and vice versa. For example, if a company has $10

67
million loan amount and JPY 1.2 billion variable rate investment t

hat pays 5.3% per month, it has a return of JPY 1 million +50 bps

per month and JPY 1 million Libor falls or USDJPY rises to lock i

n USD as required. (JPY depreciates against USD), then they will

do a fixed floating swap in a different currency, where the compan

y will pay floating JPY 1M Libor + 50bps and receive 5.

The 6% flat rate was locked in 30 basis points of income from inter

est rate and currency risk.

Floating Rate Swap, Single Currency

Party P pays/receives interest in X-

indexed currency A, receives/pays interest in Y-

indexed A over representative N for year T for the period T. For ex

ample, on Libor you pay JPY 1 million per month and on Tibor yo

u get JPY 1 million per month, defaulting to JPY 1 billion for 3 ye

ars.

Floating interest rate swaps are used to hedge or speculate on the w

idening or narrowing spread of two indices. For example, if a com

68
pany has a loan of JPY 1 million and one of the company's return o

n investment is JPY 1 million Tibor + 30 basis points, Current Tib

or is JPY 1 million = JPY 1 million Libor + starting point of 10 bas

is points.

Currently, the company's earnings are 40 basis points. If a compan

y believes that 1 million JPY tibor will fall or 1 million yen Libor

will rise in the future and wants to hedge this risk, it can make a flo

ating exchange in the same currency that pays on the basis of JPY

TIBOR + 10. points and receives Yuan LIBOR + 35 basis points p

er day. In doing so, they locked onto 15 profit principles instead of

the existing 40 profit and risk principles. 5 different principles fro

m the exchange rate, including the market's expectations for future

prices, both for indicators and for buying/selling that owns the stoc

k market.

69
Variable rate swaps are also swaps where two parties refer to the sa

me index but have different payment dates or use different busines

s day rules. These have almost no use for speculation, but can be

vital for asset-liability management. An example would be

swapping 3M Libor being paid with prior non-business day

convention, quarterly on JAJO (i.e. Jan, Apr, Jul, Oct) 30, into

FMAN (i.e. Feb, May, Aug, Nov) 28 modified following.

Variable interest rate exchange, different currencies

Side P pays/receives the interest rate of currency A with X as the i

ndex using nominal N as nominal N and receives/pays the variable

rate of currency B with Y as the token of the first currency. T is the

value of time for years. For example, to buy Tibor of JPY 3 millio

n per month over the expected JPY 1.2 billion (from the starting pr

ice of JPY 120) over 4 years, you would pay a floating interest rate

of $1 million Libor over the expected $10 million per month.

To illustrate the use of this type of exchange, consider an America

70
n company operating in Japan. They need 10 billion yen to finance

their growth in Japan.

The easiest option for the company is to lend in Japan. This can be

an expensive option because the company will be new to the Japan

ese market without the reputation of Japanese traders. In addition, t

he company may not have a suitable payment plan in Japan and ma

y not have the resources to operate in Japan. In order to overcome t

he above-

mentioned problems, it can create dollar debt in the foreign market

and convert it to yen. Although this option solves the first problem,

it introduces two new risks for the company:

• Currency risk.

If the dollar-

yen exchange rate rises when debt grows, the company receives les

s money and suffers when it converts yen to dollars to pay off its d

ebt.

• USD and JPY rates are dangerous. If the Yen's interest rate falls, i

71
nvestment returns in Japan will fall, indicating interest rate risk.

The first result above can be hedged by using a long currency contr

act, but this introduces a new risk that the price will affect spot curr

ency and forward currency contracts. The first is a fixed rate, but th

e yen capital reverts to a floating rate. While there are many ways t

o hedge against both risks without taking new risks, the easiest and

most effective option is to use the exchange rate between different

currencies.

In this case, the company raised money by issuing debt securities a

nd exchanging them for yen. It takes a floating rate in dollars (henc

e the interest rate on the dollar debt) and pays a variable yen rate th

at matches the return on its yen investment.

Fixed Rate Swap, Different Currencies

Party P pays/receives interest in currency A and receives/receives i

nterest in currency B for T years. For example, you would pay 1.6

% JPY for one JPY 1.

72
2 billion at the initial exchange rate of 120 yen to receive 5.36% of

the 10 million equivalent nominal interest rate.

11.3 Valuation and pricing

The current value of vanilla (that is, a fixed price with a variable pr

ice) can be easily calculated using the method of determining the c

urrent value (PV) of the fixed branch and the variable.

The present value of an asset (that is, a fixed asset with varia

ble cost) can be easily calculated using the method of determi

73
 ning the present value (PV) and variances of a fixed asset.

The present value of an asset (that is, a fixed asset with variable co

st) can be easily calculated using the method of determining the cu

rrent value (PV) and variable of fixed assets, ti is the number of

days in period i, Ti is the basis according to the day count

convention and dfi is the discount factor.

Similarly,

The float amount is derived from the current value of the coupon p

ayments determined at the agreed date for each payment. However,

at the beginning of the transaction, the future only knows the actua

l price paid on the fixed leg when the price is posted.

(derived from the yield curve) are used to approximate the floating

rates. Each variable rate payment is calculated based on the

forward rate for each respective payment date. Using these interest

74
rates leads to a series of cash flows. Each cash flow is discounted

by the zero-coupon rate for the date of the payment; this is also

sourced from the yield curve data available from the market. Zero-

coupon rates are used because these rates are for bonds which pay

only one cash flow. The interest rate swap is therefore treated like

a series of zero-coupon bonds. Thus, The

The value of the floating branch is given as:

Where N is the number of floating payments, fj is the forward rate,

P is the notional amount, tj is the number of days in period j, Tj is

the basis according to the day count convention and dfj is the

discount factor. The discount factor always starts with 1. The

discount factor is found as follows:

75
[Discount factor in the previous period]/[1 + (Forward rate of the

floating underlying asset in the previous period × Number of days

in period/360)].

(Depending on the currency, the denominator is 365 instead of

360; e.g. for GBP.)

The fixed price included in the exchange is the price at which

the fixed price is valued at the same PV as the payment diffe

rence using today's reference price, for example:

Therefore, neither party has an advantage when entering into

a contract, for example:

The barter therefore does not require an upfront payment by either

party.

76
The same valuation method is used throughout the life of the transa

ction, but because the transfer price changes over time, the PV of t

he variable of the transaction will be different from the unchanged

exchange rate. Thus, the transaction is an asset for one party and a

liability for the other. Characteristics of changes in reported results

are the content of IAS 39 for determination after IFRS and FAS 1

33 for determination after US GAAP.

Swps are marked by the market by traders to show their stocks at a

specific time.

77
Hedging using Interest rate Swaps

Floating rate loans expose the debtor to the risk of increasing

interest rates. To avoid this risk, he may like to go for a fixed rate

loan, but due to the market conditions and his credit rating, his

fixed rate loans are available only at a very high cost. In that case,

he can go for a floating rate liability and then swap the floating rate

liability into a fixed rate liability. He can do the swap with another

counter party whose requirements are the exact opposite of his or ,

as is more often the case, can do the swap with a bank.

The following diagram illustrates the case in which an

intermediary, e.g. a bank, is involved in a swap deal between two

counter parties. Borrower A has a floating rate loan, but would

prefer a fixed rate loan. There is another borrower B who has a

fixed rate loan, but would prefer a floating rate loan. The

intermediary can now match these two borrowers as described in

the following diagram.

78
Diagram:

Example:

A manufacturing company embarks on a project for which it

borrows USD 4 million working capital on a floating interest rate

basis, payable quarterly for two years. Since the treasurer of the

company felt that the floating rate payments will involve serious

risks, he decides to enter into a swap with a bank and convert the

same into a fixed rate loan. The bank now swaps the floating rate

payments into a fixed rate at 12%. The resultant cash flow arising

out of the transaction is illustrated on the next page.

79
 Floating Net cash

Floating rate Fixed rate paid by

Quarter rate payments payments Co.

1 12.25 122500 120220 -2500

2 12.25 122500 120220 -2500

3 12.25 122500 120220 -2500

4 12 120220 120220 0

5 12 120220 120220 0

6 12 120220 120220 0

7 11.75 117500 120220 2500

8 11.75 117500 120220 2500

962500 960000 -2500

80
Getting comparative advantage in different markets:

Various segments of the capital markets differ in terms of how

sensitive they are to differences in the creditworthiness of the

issuers. Particularly, in bond markets, where retail investors play

an important role and tend to be averse to default risk,

disproportionately higher yields are offered to them to invest in

less creditworthy bonds. Issuers with a lower rating find

themselves paying more than the issuers enjoying a stronger rating.

Often, we find that cost of funds is higher in the bond markets than

in the credit markets. Whenever, these differences occur in

different markets, it would be possible to arbitrage between the

markets.

81
Let us take the following example

Consider two companies, rated AAA and BBB. AAA has a higher

credit rating than BBB. Both companies can raise funds either by

issuing fixed-interest bonds or by taking bank loans (at a floating

interest rate). Their borrowing costs are:

Cost of Funds to AAA and BBB

Fixed rate bonds Floating rate

loans

AAA 10.00% p.a. Libor+100bp

BBB 12.00% pa Libor+160bp

Differential 200 bps 60bps

Assume now that AAA wants to raise floating rate money and

BBB wants to raise fixed rate money. It will be realized that the

advantage (200 basis points) of AAA raising fixed rate money in

the bond market as against BBB, which is, is greater than the

82
disadvantage (60 basis points) of letting BBB raise floating rate

money in the credit market. There is a comparative advantage of

140(200-60) basis points. Both the parties can share the difference

and reduce their borrowing costs. A Banker normally acts as an

intermediary and arranges most of these deals. A share of the

advantage is passed on to the banker. In this case, if the three

parties agree to share the difference as 80:40:20 basis points, then

AAA will receive 9.80% fixed from the bank in exchange for

Libor, while paying 10.00% on his bonds. The net outcome for

AAA is a floating rate liability at Libor+20 bps. This represents a

gain of 80 basis points, than if he had borrowed at Libor+100 bp.

Similarly Borrower BBB receives Libor in lieu of 10.00% fixed

while paying Libor+160 bp to his creditor. The net effect is

equivalent to paying 11.60% fixed, which represents a 40 basis

points gain over fixed rate borrowing at 12.00%. The intermediary

bank receives 10.00% fixed from BBB and pays 9.80% fixed to

83
AAA in effect gaining 20 basis points on this transaction. The

following diagram illustrates the transaction.

84
 CONCLUSION

The conclusion of this report is that “The market is full of risk, and

derivatives are the tools which can reduce the risk. Finally it all

depends on the investor that which derivative he/she should use for

hedging purpose”

85
 BIBLIOGRAPHY

The secondary data is collected from the following sources: -

Books

1. Financial management & policy by James C. Van Horne

2. Management Accounting and financial analysis by Jeroen

F.J. Munnik

Websites

1. www.pnbgilts.com

2. www.wikipedia.org

3. www.igidr.ac.in

4. www.ssrn.com

5. www.moneycontrol.com

86