post is contributed by Niharika Choudhary,
who is a 4th year student at the National Law University, Jodhpur]
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.
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.
most common options provided by over the counter derivatives 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.
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
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
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.
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. 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.
on Interest Rate Options, the RBI Directions permit both OTC markets and stock
exchanges for trading in IROs.
(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.
makers include banks and primary dealers and other regulated institutions and
entities subject to the approval of their respective regulators.
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 in interest rate options.
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
All market makers are required to report client trades on the same day by close
of business hours to the Trade Repository of CCIL.
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.
the requirement of board-approved ‘Suitability and Appropriateness Policy’ read along with the
Guidelines on Derivatives, 2007.
interest rate option products in India, being complementary to the currently
existing interest swap market, can lead to the following benefits:
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.
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
cash flow certainty for borrowers of floating rate loan and thus imparts reasonable liquidity.
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.
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.
negotiated directly between the buyer and the option writer that is usually a
For more information, see https://indiacorplaw.in/wp-content/uploads/2017/02/04rente20swap_swaptioner.pdf
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.
is the LIBOR Rate.
selling of securities.
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.
Circular DBOD No.BP.BC.86/21.04.157/2006-07 (April 20, 2007).