Derivatives by Bank

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1. Use of Derivatives by Indian Bank

Coverage and perspectives

One of the observed features of the equity derivatives market in India is that there has been little participation

of institutional investors. In the en-suing sections, we examine issues and impediments in the use of different

types of derivatives available for use by these institutional investors in India: Equity, Fixed Income, Foreign

Currency, and Commodity Derivatives. The intensity of derivatives usage by any institutional investor is a

function of its ability and willingness to use derivatives for one or more of the following purposes:

1. Risk Containment: Using derivatives for hedging and risk containment purposes.

2. Risk Trading/Market Making: Running derivatives trading book for profits and arbitrage.

3. Covered Intermediation: On-balance-sheet derivatives intermediation for client transactions, without

retaining any net-risk on the balance sheet (except credit risk).

These perspectives are considered in examining issues and impediments in use of derivatives in thefollowing sections. These sections are organised by type of institutional investor, and their use of each of the

specific derivative types separately. The different institutional investors could be meaningfully classified into:

Banks, All India Financial Institutions (FIs), Mutual Funds (MFs), Foreign Institutional Investors (FIIs) and Life

and General Insurers.

Banks

Based on the differences in governance structure, business practices and organizational ethos, it is

meaningful to classify the Indian banking sector into the following:

1. Public Sector Banks (PSBs); 2. Private Sector Banks (Old Generation); 3. Private Sector Banks (New

Generation); and 4. Foreign Banks (with banking and authorized dealer license).


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Credit and interest rate risks are two core risks all banks accept and hope to profit from. Foreign currency

(price) risk accepted by banks varies widely across the four categories. Commodity (price) risk accepted by

banks is limited to gold price risk in respect of gold deposits accepted by five banks under their schemes

framed under RBI guidelines on the Gold Deposit Scheme 1999 announced in the union budget for the year

1999-2000. Equity (price) risk accepted by banks again is limited to their direct or indirect (through MFs)exposure to equities under the RBI prescribed 5 percent capItal market instruments limit (of total outstanding

advances as at previous year-end). Some banks may have further equity exposure on account of equities

collaterals held against loans in default.

2.1 Credit derivatives

The market for credit derivatives is currently non-existent in India, and hence has been dealt with in brief

here. Credit derivatives seek to transfer credit risk and returns of an asset from one counter party to another

without transferring its ownership. Credit default swaps and options, total return swaps, credit linked notes,

credit spread forwards and options are some examples. The market for credit derivatives is currently non-

existent

Derivatives Markets in India

in India, though it has the potential to develop. The sellers of credit derivatives must be able to hedge their

risks, to be able to quote a price for the protection they are selling.

Perhaps, the following evolution in the corporate credit markets in India could pave way to a credit

derivatives market:

1. Presence of a liquid corporate bond market is essential for a term structure of corporate credit spreads

over the sovereign curve to emerge.

2. Insurance sector which is a seller of credit derivatives in other markets would need evolve on the sell

side of the credit derivatives market.

3. RBI guidelines on guarantees and co-acceptances presently preclude banks from issuing guarantees

favoring other lending agencies, banks or FIs for loans extended by them. This restriction would need to

go if banks are to sell or write credit derivatives.


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4. There is no RBI guideline permitting use of credit derivatives by banks and FIs to reduce regulatory capital

on their respective balance sheet. This is one of the best uses of credit derivatives internationally.

2.2 Equity derivatives

Given the highly leveraged nature of banking business, and the attendant regulatory concerns of their

investment in equities, banks in India can, at best, be termed as marginal investors in equities. Use of equity

derivatives by banks ought to be inherently limited to risk containment (hedging) and arbitrage trading

between the cash market and options and futures market. However, for the following reasons, banks with

direct or indirect equity market exposure are yet to use exchange traded equity derivatives (viz., index

futures, index options, security-specific futures or security-specific options) currently available on the

National Stock Exchange (NSE) or Bombay Stock Exchange (BSE):

1. RBI guidelines on investment by banks in capital market instruments do not authorize banks to use equity

derivatives for any purpose. RBI guidelines also do not authorize banks to undertake securities lending

and/or borrowing of equities. This disables also banks possessing arbitrage trading skills and

institutionalised risk management processes for running an arbitrage trading book to capture risk free

pricing mismatch spreads between the equity cash and options and futures market an activity banks

currently any way undertake in the fixed income and FX cash and forward markets.

2. Direct and indirect equity exposure of banks is negligible and does not warrant serious management

attention and resources for hedging purposes. The internal resources and processes in most bank

treasuries are inadequate to manage the risk of equity market exposures, and monitor use of equity

derivatives (even if used only for risk containment purposes).

3. Inadequate technological and business process readiness of their treasuries to run a equity arbitrage

trading book, and manage related risks.

Fixed income derivatives

Scheduled Commercial Banks, Primary Dealers (PDs) and FIs have been allowed by RBI since July 1993 to

write Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAs) as products for their own asset

liability management (ALM) or for market making (risk trading) purposes. Since October 2000, IRS can be

written on benchmarks in domestic money or debt market (e.g. NSE MIBOR, Reuter Mibor, GoI Treasury

Bills) or on implied foreign currency interest rates [e.g. Mumbai Interbank Forward Offer Rate (MIFOR),

Mumbai Interbank Tom Offer Rate (MITOR)]. IRS based on MIFOR/MITOR could well be written on a stand-


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alone basis, and need not be a part of a Cross Currency Interest Rate Swap (CC-IRS). This enables

corporates to benchmark the servicing cost on their rupee liabilities to the foreign currency forward yield

curve.

There is now an active Over-The-Counter (OTC) IRS and FRA market in India. Yet, the bulk of the activity is

concentrated around foreign banks and some private sector banks (new generation) that run active

derivatives trading books in their treasuries. The presence of Public Sector Bank (PSB) majors (such as SBI,

BoB, BoI, PNB, amongst others) in the rupee IRS market is marginal, at best. Most PSBs are either unable

or unwilling to run a derivatives trading book enfolding IRS or FRAs. Further, most PSBs are not yet actively

offering IRSs or FRAs to their corporate customers on a covered basis with back-to-back deals in the inter-

institutional market. The consequence is a paradox. On the one side you have foreign banks and new

generation private sector banks who run a derivatives trading book but do not have the ability to set

significant counter party (credit) limits on a large segment of corporate customers of PSBs. And, on the other

side are PSBs who have the ability and willingness to set significant counter party (credit) limits on corporatecustomers, but are unable or unwilling to write IRS or FRAs with them. Thereby, the end user corporates are

denied access through this route to appropriate hedging and yield enhancing products, to better manage the

asset-liability portfolio.

This inability or unwilling of PSB majors seemingly stems from the following key impediments they are yet to

overcome:

1. Inadequate technological and business process readiness of their treasuries to run a derivatives trading

book, and manage related risks.

2. Inadequate readiness of human resources/talent in their treasuries to run a derivatives trading book, and

manage related risks.

3. Inadequate willingness of bank managements to the risk being held accountable for bonafide trading

losses in the derivatives book, and be exposed to subsequent onerous investigative reviews, in a milieu

where there is no penal consequence for lost opportunity profit.

4. Inadequate readiness of their Board of Directors to permit the bank to run a derivatives trading book, partly

for reasons cited above, and partly due to their own discomfort of the unfamiliar.

2.3.1 Interest rate options and futures

The RBI is yet to permit banks to write rupee (INR) interest rate options. Indeed, for banks to be able to write

interest rate options, a rupee interest rate futures market would need to first exist, so that the option writer

can delta hedge the risk in the interest rate options positions. And, according to one school of thought,


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perhaps the policy dilemma before RBI is: how to permit an interest rate futures market when the current

framework does not permit short selling of sovereign securities. Further, even if short selling of sovereign

securities were to be permitted, it may be of little consequence unless lending and borrowing of sovereign

securities is first permitted.

2.4 Foreign currency derivatives

Banks that are Authorized Dealers (ADs) under the exchange control law are permitted by RBI to undertake

the following foreign currency (FCY) derivative transactions:

For bank customers for hedging their FCY risks.FCY:INR Forward Contracts, and Swaps (currency onlyand/or CC-IRS).Cross-Currency Forward Contracts, and Swaps.Cross-Currency Options.

With inter-bank participants in India or overseas for risk containment or risk trading purposes (within the

overall open position limit allowed by RBI to the respective bank).

1. FCY:INR Forward Contracts, and Swaps (currency only and/or CC- IRS).

2. Cross-Currency Forward Contracts, and Swaps.

3. Cross-Currency Options (only on a fully covered back-to-back basis, wherein the cover transactionmay be with a bank in India or overseas or on an internationally recognized options exchanges).

4. With bank customers for swapping from INR to FCY their long term INR liabilities.

5. FCY:INR Forward Contracts, and Swaps (currency only and/or CC- IRS).

RBI is yet to permit authorized dealers to write FCY:INR options. Interestingly, domestic corporates with

rupee liabilities may also enter into FCY:INR swaps with authorized dealers to hedge their long-term interest

rate exposures. (This enables corporates to benchmark their rupee liability servicing costs to foreign

currency yield curve).

There is now an active Over-The-Counter (OTC) foreign currency derivatives market in India. However, the

activity of most PSB majors in this market is limited to writing FCY derivatives contracts with their corporate

customers on fully covered back-to-back basis. And, most PSBs do not run an active foreign currency

derivatives trading book, on account of the impediments enumerated earlier that need to be overcome at

their end.

2.4.1 Tax issues in foreign currency derivatives


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From a market development perspective, the key tax issue that arises is, the applicability or otherwise of

withholding tax on the cash flows exchanged in the FCY:INR derivatives contract. In absence of a specific

binding ruling either of the Central Board of Direct Taxes (CBDT) or a competent Court, the income-tax law

remains wide open to interpretation. Technically, in absence of a prior debt incurred, cash flows under CC-

IRS or IRS do not bear the character of interest as understood under the income tax law.4 Hence,

withholding tax applicable to interest payments should not apply. However, cash flows under interest rate

swaps as well as currency swaps are revenue in character in the hands of the recipient bank. And, where

the recipient bank is a tax non-resident, whether any part thereof is (or is not) liable to tax in India, requires

determination about applicability of relevant double tax avoidance treaties between India and the country of

tax residence of the recipient bank, the business presence (permanent establishment) of the recipient bank

in India etc.. It is understood that, currently, market participants in the foreign currency derivatives market

transact based on their legal/internal counsel views on these tax issues, leaving themselves exposed tocontingent tax risk or litigation. Resolution of these tax issues is crucial for the long-term development of the

foreign currency and fixed income derivatives market in India.

2.5 Commodity derivatives

In 1997, RBI permitted seven banks to import and resell gold as canalizing agencies. It is understood that

now about 13 banks (bullion banks, for short) are active in this business. The quantum of gold imported

through bullion banks is in the region of 500 tonnes per annum.However, bullion banks do this business on

consignment purchase and sale basis for a transaction fee, and do not retain any gold price risk on its books.

Typically, the bullion banks customers are bullion traders and jewellery units in India. The commodity risk

accepted by banks is limited to price risk of gold (deposits) accepted by five bullion banks that launched their

schemes under the RBI guidelines on the Gold Deposit Scheme 1999 announced in the union budget of

1999-2000.

In brief, these bullion banks accept assayed gold as a deposit for 3 to 7 years tenors, at the end of which the

deposit is repayable at the price of gold as on date of maturity. These gold deposits carry interest ranging

from 3 percent to 4 percent per annum. The quantum of gold mobilized so far by the bullion banks under

these gold deposits schemes is about 7 tonnes. SBI is a market leader in this segment with a market share

of perhaps over 90 percent.

There is no forward market for gold in India. In fact, forward contracts on gold are prohibited.And, for this

purpose, a contract settled later than T+11 (days) is treated as a forward contract. Therefore, bullion bankshave the following alternatives to hedge their gold price risk:


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1. Sell the gold in the Indian spot OTC market, and buy gold futures or call option in an overseas

commodities exchange (for example, the New York Mercantile Exchange (NYMEX)) along with a matching

FCY:INR forward contract to hedge the foreign currency risk embedded in the gold futures contract.

2. Lend the gold (received in deposit) to jewelry manufacturing units in India in the form of gold loans, and

manage the attendant credit risk accepted by it, through a combination of cash margins, bank guarantees

and other collaterals.

Bullion banks operating schemes under the Gold Deposit Scheme, 1999 are permitted under the exchange

control regulations to use exchange traded or OTC hedging products available overseas to manage the gold

price risk. However, such fully hedged rupee cost of the gold deposit (i.e., the first alternative above) is

particularly high given the two (gold and FCY) components that need to be hedged. This, coupled with the 3

percent to 4 percent annual interest payable on the deposit, makes the gold deposit product financially

unviable for the bullion bank. Therefore, the only viable alternative for the bullion bank is to create a gold

loan portfolio to match its gold deposit liability, and ensure that the spread is adequate to cover the credit

risk, product servicing cost including SLR cost. (Incidentally, RBI has exempted balances under gold deposit

scheme from CRR

maintenance, but not SLR maintenance (though gold held by the bank in physical form constitutes and

eligible SLR asset).This implies an additional SLR cost of servicing the gold deposit.)

NEW DELHI -- India's parliament is likely to receive an amendment in its next session that would permit

financial institutions such as banks and mutual funds to trade in commodity derivatives and introduce trading

of commodity options, Food and Consumer Affairs Minister K.V. Thomas said Wednesday.

Supporters of the amendment to a law governing commodity derivatives markets say it would lead to a

massive increase in trading volumes, and reduced volatility, in a country that is one of the world's top

producers and consumers of agricultural commodities and a major producer of minerals. It would also enable

more effective market regulation, they say.

Mr. Thomas said the ministry will present the amendment to the cabinet in two weeks and, if approved, to

parliament in the next session.

The amendments would pave the way for the introduction of commodity options trading and trading in

commodity derivatives by financial institutions such as banks and mutual funds. However, financial

institutions would be limited to hedging against lending positions.


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"The participation of institutions such as banks is necessary to bring adequate liquidity to this market," Mr.

Thomas said.

India's commodities exchanges traded goods worth 181.26 trillion rupees ($3.32 trillion) in the fiscal year that

ended March 31, a 52% increase.

"There will be a spurt in volumes at all the commodity exchanges once the amendment is approved," said

Venkat Chary, chairman of the country's largest commodity bourse, the Multi Commodity Exchange of India

Ltd.

India re-introduced commodity futures trading in 2003 and currently has five national exchanges. Previous

attempts to allow options trading failed due to political opposition. Also, the central bank has been reluctant

to allow banks and other financial institutions to trade commodity derivatives because of concerns about the

enforcement power of the market regulator, the Forward Markets Commission.

Mr. Thomas said the proposed amendment would give the regulator greater enforcement powers and

independence, making it more effective and reducing market volatility.

The Forward Markets Commission this year took several steps to check excess speculation, including raising

trade margins and reducing position limits in several markets.

A parliamentary panel in December 2011 backed the entry of banks and mutual funds into commodity

derivatives trading.

Low trading volumes result in poor price discovery, and the Forward Markets Commission had asked all

exchanges to improve the ratio between volume and open interest by allowing more parties to hedge, Mr.

Thomas said.

Mr. Chary said the amendment would also introduce index trading and new products such as shipping and

freight.

3 All India financial institutions (FIs)

With the merger of ICICI into ICICI Bank, the universe of all-India FIs comprises IDBI, IFCI, IIBI, SIDBI,

EXIM, NABARD and IDFC. In the context of use of financial derivatives, the universe of FIs could perhaps be

extended to include a few other financially significant players such as HDFC and NHB.


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Equity risk exposure of most FIs is rather insignificant, and often limited to equity devolved on them under

underwriting commitments they made in the era upto the mid-1990s. Use of equity derivatives by FIs could

be for risk containment (hedging) purposes, and for arbitrage trading purposes between the cash market and

options and futures market. For reasons iden- tical to those outlined earlier vis-a`-vis banks, FIs too are not

users of equity derivatives. However, there is no RBI guideline disabling FIs from running an equities

arbitrage trading book to capture risk free pricing mis-match spreads between the equity cash and options

and futures market. Yet, it ap- pears that most FIs do not run an equities arbitrage trading book. Possible

reasons could include inadequate readiness in terms of possessing arbitrage trading skills and

institutionalised risk management processes for running an arbitrage trading book.

3.2 Fixed income derivatives

Since July 1999, like banks, even FIs are permitted to write IRS and FRA for their asset liability management

(ALM) as well as for market making purposes. Some FIs actively use IRS and FRA for their ALM. Also, a few

have plans to offer IRS and FRA as products to their corporate customers (to hedge their liabilities), albeit on

a fully covered back-to-back basis, to begin with. However, none are yet ready to run a rupee derivatives

trading book. The issues and impediments they need to yet overcome are largely similar to those facing

PSBs.


Most FIs with foreign currency borrowings have been users of FCY:INR swaps, cross currency swaps, CC-

IRS, and FRAs for their liabilities management. With the prior approval of RBI, FIs can also offer foreign

currency derivatives as a product to their corporate borrowers on a fully covered back-to-back basis. Yet,

most FIs have not yet readied themselves to explore this business opportunity.

3.4 Commodities derivatives

FIs have no proximate exposure to commodities. There are also no credit products whose interest rate is

benchmarked to any commodity prices. Therefore, the issue of they using commodity derivatives (whether in

the overseas or Indian market) does not arise.

4 Mutual funds


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Mutual Funds ought to be natural players in the equity derivatives market. SEBI (MF) Regulations also

authorize use of exchange traded equity derivatives by mutual funds for hedging and portfolio re-balancing

purposes. And, being tax exempt, there are also no tax issues relating to use of equity derivatives by them.

However, most mutual funds (whether managed by Indian or foreign owned asset management companies)

are not yet active in use of equity derivatives available on the NSE or BSE.

The following impediments seem to hinder use of exchange trade equity derivatives by mutual funds:

1. SEBI (Mutual funds) regulations restrict use of exchange traded equity derivatives to hedging and

portfolio rebalancing purposes. The popular view in the mutual fund industry is that this regulation is very

open to interpretation; and the trustees of mutual funds do not wish to be caught on the wrong foot! The

mutual fund industry therefore wants SEBI to clarify the scope of this regulatory provision.

Derivatives Markets in India: 2003 273

2. Inadequate technological and business process readiness of several players in the mutual fund industry to

use equity derivatives and manage related risks.

3. The regulatory prohibition on use of equity derivatives for portfolio optimization return enhancement

strategies, and arbitrage strategies constricts their ability to use equity derivatives.

4. Relatively insignificant investor interest in equity funds ever since exchange traded options and futures

were launched in June 2000 (on NSE, later on BSE).


SEBI (MF) regulations are silent about use of IRS and FRA by mutual funds. Evidently, IRS and FRA

transactions entered into by mutual funds are not construed by SEBI as derivatives transactions covered by

the restrictive provisions which limit use of derivatives by mutual funds to exchange traded derivatives for

hedging and portfolio balancing purposes. MFs are emerging as important users of IRS and FRA in the

Indian fixed income derivatives market. At least a few mutual funds actively use IRS to optimize yield and

reduce the duration of their bond scheme portfolios, by paying fixed rate and receiving floating rate. It is

understood that some of these IRS are benchmarked to MIFOR as well. (Needless to add, given the open-

ended nature of most bond schemes of mutual funds, such MIFOR linked IRS have the potential of

generating noticeable basis risk, besides the liquidity risk in the underlying bond asset of longer maturity.)


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In September 1999,9 Indian mutual funds were allowed to invest in ADRs/GDRs of Indian companies in the

overseas market within the overall limit of US$ 500 million with a sub-ceiling for individual mutual funds of

10 percent of net assets managed by them (at previous year-end), subject to maximum of US$ 50 million per

mutual fund. Several mutual funds had obtained the requisite approvals from SEBI and RBI for making such

investments. However, given that most ADRs/GDRs of Indian companies traded in the overseas market at a

premium to their prices on domestic equity markets, this facility has remained largely unutilized. Therefore,

the question of using FCY:INR forward cover or swap did not much arise.

However, recently, from 30 March 2002,10 domestic mutual funds have been permitted to invest in foreign

sovereign and corporate debt securities (AAA rated by S&P or Moody or Fitch IBCA) in countries with fully

convertible currencies within the overall market limit of US$ 500 million, with a sub-ceiling for individual

mutual funds of four percent of net assets managed by them as on 28 February 2002, subject to a maximum

of US$ 50 million per mutual fund. Several mutual funds have now obtained the requisite SEBI and RBI

approvals for making these investments. Once investment in foreign debt securities pick-up, mutual funds

ought to emerge as active users of FCY:INR swaps to hedge the foreign currency risk in these investments.

4.4 Commodity derivatives

Under SEBI (MF) regulations, mutual funds can invest only in transferable financial securities. In absence of

any financial security linked to commodity prices, mutual funds cannot offer a fund product that entails a

proximate exposure to the price of any commodity. Therefore, the issue of they using commodity derivatives

(whether in the overseas or Indian market) does not arise.

However, interestingly, one of the players in the mutual fund industry proposes to offer an exchange traded

gold fund that would invest solely in transferable gold receipts/certificates issued by one or more of the 13

bullion banks which have been authorized by RBI to accept gold deposits under the Gold Deposit Scheme

1999. The draft offer document of the scheme is awaiting SEBI clearance. This product aspires to offer

investors the ability to hold gold as an asset class (with its attendant risks and re- wards) in the form of a

financial asset, with the prospect of also getting some regular income in the form of interest on the gold

receipts/certificates held by the fund.

Incidentally, for market makers of the fund, it also offers the possibility of profiting from the spread which

exists between the wholesale price of gold in India11 at which the banks would issue the gold

receipts/certificates,and the retail price of gold in India (which is often about five percent higher than the

wholesale price) at which the units of the scheme could trade in the secondary market. [The implicit

assumption here is that, though the scheme NAV is computed at the wholesale price of gold in India, the

units may trade on the exchange at a premium to NAV-closer to the retail price of gold in India].


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5 Foreign institutional investors (FIIs)


Till January 2002, applicable SEBI and RBI Guidelines permitted FIIs to trade only in index futures contracts

on NSE and BSE. It is only since 4 February 200212 that RBI has permitted (as a sequel to SEBI permission

in December 2001) FIIs to trade in all exchange traded derivatives contracts within the position limits for

trading of FIIs and their sub-accounts. (These open position limits have been spelt out in SEBI circular dated

12 February2002.)With the enabling regulatory framework available to FIIs from February 2002, their activityin the exchange traded equity derivatives market in India should increase noticeably in the emerging future.

Evidently, several FIIs are still in the process of completing the process of their internal approvals for use of

exchange traded equity derivatives on the NSE or BSE. Perhaps, the two years of successful track record of

the NSE in managing the systemic risk associated with its futures and options (F&O) segment would also

pave way for greater FII activity in the equity derivatives market in India in the emerging future.

5.1.1 Tax issues in equity derivatives for FIIs

Two crucial tax issues arise in use of equity derivatives by FIIs:

1. Tax character of profit or gain from equity derivatives contract is it business income or capital gains, and

if business income, is it speculative business income or non-speculative business income.

2. Applicability or otherwise of withholding tax on profits from equity derivatives contracts.

In absence of a specific finding ruling either from the CBDT or a competent court, the income-tax law on

these issues remains wide open to interpretation. Technically, given the short tenor of equity derivative

contracts, the better view seems to be that the profit or loss from equity derivative contracts would be

business profit or loss rather than a capital gain/loss. Interestingly, the CBDT circular dating back to 12

September 196014 interprets very generously hedging transactions in commodities, stocks and shares, to

include portfolio and strategic hedging, and does not confine hedging transactions to a position hedge. And,

any profit or loss from a hedging transaction in stocks and shares is treated as a non speculative business


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profit or loss. This is significant because losses from speculative transactions are ring fenced and cannot be

offset against capital gains or other business profits.

Given that all FIIs are non-residents for tax purposes, whether any part of the profit or loss from equity

derivatives transactions is liable to tax in India or not, requires technical determination about applicability of

the relevant double tax avoidance treaties between India and country of tax residence of the recipient FII, the

business presence (permanent establishment) of the recipient FII in India etc. The applicability or otherwise

of withholding tax on profits from equity derivatives transactions by FIIs would also have to be based on the

foregoing determination. Resolution of these tax issues at the policy level is perhaps crucial for the long term

development of the equity derivatives market in India.


Since May 2000, FIIs are permitted to invest in domestic sovereign or corporate debt market under the 100

percent debt route subject to an overall cap under the external commercial borrowing (ECB) category, with

individual sub-ceilings allocated by SEBI to each FII or sub-accounts. FIIs are also permitted to enter into

foreign exchange derivative contracts (including currency swaps and CCIRS) by RBI16 to hedge the

currency and interest rate risk to the extent of market value of their debt investment under the 100 percent

debt route.

However, investment by FIIs in the domestic sovereign or corporate debt market has been negligible till now.

Perhaps, the spread between fully hedge rupee cost of funds for an FII and the return on investment in India

sovereign securities or top rated domestic corporate debt securities is too thin to be attractive. In fact, the

spread could turn negative after payment of Indian taxes (20 percent under domestic law, 10 percent to 15

percent under some double tax avoidance treaties) applicable on interest earned in India by FIIs. Therefore,

FII activity in the domestic fixed income derivatives market has been largely absent.


Equity investing FIIs leave their foreign currency risk largely unhedged since they believe that the currency

risk can be readily absorbed by the expected returns on equity investments, barring in periods of unforeseen

volatility (such as the far eastern crisis). FII investment in the domestic sovereign and corporate debt market

has been negligible. Consequently, FII activity in the foreign currency derivatives market in India has also

been negligible till now.


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INTEREST RATE DERIVATIVES IN INDIAN BANKS

bstract

The present research paper makes an attempt to provide a comprehensive profile of the global OTC

derivatives market, with special reference to interest rate derivatives. It has analyzed various issues related

to interest rate derivatives in Indian banks. The study would also examine if there is any significant impact of

ownership structure on the use of interest rate derivatives in sample banks. To serve this particular objective

the study is based on two major giants, the largest public sector and private sector bank in India namely SBI

and ICICI Bank. Different variables such as Total Asset, Deposit, Advances, Tier I Capital, ROA, ROE,

Interest Margin, Total loan Ratio, Total deposit Ratio, etc have been analyzed with the help of various

statistical tools such as ratios, correlation and ANOVA to find out the extent to which these banks have

managed the adverse movements in interest rate with the help of interest rate derivatives.

1. INTRODUCTION

The Banking sector has played a commendable role in fuelling and sustaining growth in the economy. It

helps in mobilizing the nations saving and in channelizing them into high investment priorities and better

utilization of available resources. Modern banking is something different from lending and borrowing. They

accept risk in order to earn profits. In doing so they recognize that there are different

types of risk such as credit risk, operational risk, interest rate risk, liquidity risk, price risk, foreign exchange

risk, etc. Out of these risks Interest rate risk is the most prevalent risk which refers to the exposure of a

banks financial condition to adverse movements in interest rate. It is the risk to earnings and capital that if

market rates of interest changes unfavorably. This risk arises from differences in timing of changes in rates,

the timing of cash flows (reprising risk), changes in the shape of the yield curve (yield

curve risk) and option values embedded in the products (options risk). In essence, the market value of banks

assets (i.e. loans and securities) will fall with increase in interest rates. In addition earnings from assets, fees

and the cost of borrowed funds are affected by changes in interest rates.

Accepting this risk is a normal part of banking and can be an important source of profitability and

shareholders value. Changes in interest rate effect a banks earning by changing its net interest income andthe level of other interest sensitive income and operating expenses. Interest rate refers to volatility in net


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Tier I Capital, ROA, ROE, Interest Margin, Total loan Ratio, Total deposit Ratio, etc with an objective to study

the role of interest rate derivatives in the sample banks.

2.3. Implication of Interest Rate Derivatives in Indian Banks

Bank participation in derivative markets has risen sharply in recent years. A major concern facing

policymakers and bank regulators today is the possibility that the rising use of derivatives has increased the

riskiness and profitability of individual

banks and of the banking system as a whole. Scheduled commercial banks reduced their off-balance sheet

exposure by 26.4 percent during 2008-09, partly due to strengthening of prudential norms by RBI.Figure

decrease in 2009 in both the banks. Interest rate derivatives used in ICICI was maximum in March 2008

amounting Rs.563, 103.00 cr. which has decreased to Rs.195, 652.76 cr. in March 2009. SBI has used

interest rate derivatives conservatively with a slight increase from 2006 to 2007 but has shown a decreasing

trend from Rs.186, 610.16 cr. in 2007 to Rs.155, 928.42 cr. in 2008 and

IRD in SBI and ICICI Bank

Rs.97, 690.50 cr. in 2009. Significant decrease was recorded in the use of interest rate derivatives in SBI as

well as in ICICI Bank during March 2008 to March 2009 due to global slow down. ICICI Bank, the country's

second largest bank, has the exposure of 195,652.76 Cr. in Interest Rate Derivatives in March 2009. SBI, the

country's largest bank, has an estimated exposure of Rs.97, 690.50 cr. in Interest Rate Derivatives during

the same period.


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The primary objective of any investor is to maximize returns and minimize risks (uncertainty of outcome). It

can cause both

unforeseen losses and unexpected gains. There are two different attitudes towards risk: Risk aversion or

hedging and risk seeking or trading. Hedging aims at devising a plan to manage the risk and convert it into

desired form by replacing the uncertainty by certainty or by paying a certain price for obtaining the potential

gain opportunity while avoiding the risk of adverse outcomes. It aims at isolating profit from the damaging

effects of interest rate fluctuations concentrating on interest sensitive assets and liabilities loans,

investment, interest- bearing deposits, borrowings etc, thereby, protecting the NIM ratio. Trading aims at

willingness to take risk with ones money in hope of reaping risk profit from investment in risky assets out of

their frequent price changes. Investment of banks in interest rate derivativeshas been considerably

asymmetric with respect to trading and hedging activities. Compared with the value of derivatives used for

trading, the value of derivatives held by banks for hedging is much smaller (see Figure 5). The growth in the

value of hedging derivatives is much lower. The trading activities in both the banks have decreased in 2009as compared to 2008. ICICI Bank has extensively used trading in interest rate derivatives as compared to

SBI over the years.

Asset and IRD in SBI and ICICI Bank

The following paragraph intend to examine the implication of IRD towards the performance of banks in

question by establishing the relationship between IRD and different variables such as size, loan, deposit

demand deposit, return on asset, return on equity, interest margin, Tier I capital etc.

2.3.1. IRD and Asset


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In the year 2006 the ratio of interest rate derivatives to asset in SBI was 19.83 % which has increased up to

32.94 % in 2007, but has shown a decreasing trend by 21.06 % in 2008 and 11.17 % in 2009 respectively.

This shows that the dependence on interest rate derivatives in SBI is relatively low as compared to ICICI

Bank which shows a different picture. The total asset and IRD Ratio in 2009 was 51.58 %, whereas it was

141 %, and 70 % and 80 % in 2008, 2007 and 2006 respectively. The percentage explains that ICICI bankhas aggressively used IRD in 2008 but which has declined to 51.58 % in 2009. Over all it has used this

instrument extensively as compared to SBI but similar trend have been noticed in both the banks i.e. rise

from 2006 to 2008 but fall in 2009

2.3.2. IRD and Loan ratio

Bank loans as an asset are risky investments by banks in various areas, ranging from commercial and

industrial loans to loans to individual customers. These loans typically have longer maturity and higher

interest rate sensitivities than liabilities. Interest rate risk arises when there is maturity mismatches between

banks asset and liabilities. One way to manage this risk is to increase or decrease the holding of asset that

give rise to the interest rate risk. Such operation would involve the acquisition of new assets, i.e. making new

loans, or premature sale of existing assets, which may interrupt the lending policy and may damage the

relationship with corporate clients as well as. As a risk management instrument, derivatives provide

additional opportunity to mange the risk exposures in banks. Duffee and Zhou (2001) have concluded that,

banks decision on hedging with derivatives may be related to their loan making activities. Brewer, Minton and

Moser (2000) find a positive relation between banks use of interest rate derivatives for hedging and the

making of loans .

Asset, loan and IRD in SBI


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While calculating the ratio between advances and IRD we found that the ratio of advances to IRD was 2.67

in 2006, 1.80 in

2007, again 2.67 in 2008 and 5.037 in 2009. While in the case of ICICI Bank the ratio between the two is

much lower which means that the dependency between advance and IRD is much higher as compared to

SBI. In 2006 it was .722, in 2007 it was .810, in 2008 it was .400 and in 2009 it reached to 1.11

.

2.3.3. IRD and Bank profitability

The literature generally shows a negative relation between profitability and the hedging behavior for financial

entities (Purnanandam2006). More profitable banks appear to have stronger financial strength against

adverse shocks and are remote from

financial distress which reduces the likelihood for hedging. Return to total asset (ROA) is useful in the study

of the over all efficiency of a bank in using its asset. Return to equity (ROE) is particularly important to

shareholders and is related to the charter value of a bank. The ratio of net interest income to total asset

(interest margin), focuses on the interest income generating ability of banks. The return on asset has

increasing from 0.89 to 1.04 during 2006 to 2009 SBI but in case of ICICI Bank it has marginally decreased

from 1.3 to 1 during the same period (Figure 9). The return on equity was 15.47 in 2006 which decreased to

14.24 in 2007, but reached to its highest level i.e. 17.82 in 2008. It has further decreased to

15.73 in 2009. In case of ICICI Bank it has shown a negative trend from 16.4 to 13.4 in 2006 and 2007 andagain 11.1 to 7.7 in 2008 and 2009(Figure 10). Interest margin was minimum in the case of SBI which

ranged in between 0.02 to 0.07 during 2006 to 2009 whereas in ICICI Bank it has ranged between 2.2 to 2.4.

High interest margin is the indicator of high risk in terms of interest rates which in turn is a positive indicator

for the use of interest rate derivatives. This may

be a reason why ICICI Bank has extensively used interest rate derivatives than SBI

2.3.4. IRD and Deposits

The flow of deposit provides a natural hedging for banks to cover their liquidity needs a potential substitution

for derivatives. High level of withdrawal risk reduces the liquidity of the deposit from the banks

perspective and in turn reduces the potential ability to substitute other hedging instruments such as

derivatives. An increasing trend could be seen in the deposit ratio in the case of SBI i.e. 76.93 in 2006, 77 in

2007, 74 in 2008 and again 77 in 2009 except a decrease in 2008(74).On the contrary, in ICICI Bank it was

recorded as 65.67, 66.88, 64.44 and 57.57 in 2006, 2007, 2008 and 2009 respectively showing a mixed

trend. The demand deposit ratio was 13.76 in 2006, 14 in 2007 and 2008, and 11.48 in 2009 in SBI while in

the case of ICICI Bank it was 6.59, 6.2, 5.7 and 6.18. This implies that demand deposit is more in ICICI as

compared to SBI during the same period under study.


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2.3.5. IRD and Tier I capital

The risk adjusted capital requirement such as the tier I capital in the Basel II framework is intended to serve

as safety cushion against various contingencies. Banks with stronger capital position are arguably more

capable of servings interest rate. In this sense the capital reserve of banks and other risk management

policies such as derivatives may be substitute for each other. Controlling for the risk profile

of bank loans, there ought to be a negative association between bank capital and the use of other risk

management institution such as derivatives. In the case of SBI Tier I capital has been fluctuating from year to

year. It was 9.36 in 2006, but decreased to 8.01 in 2007. It has again registered an increase up to 9.14 in

2008 but again decreased to 8.53 in 2009. In the case of ICICI Bank Tier I Capital has been increased from

9.2 to 11.84 in between 2006 to 2009 with an exception in 2007.

Tier I capital

3. OWNERSHIP STRUCTURE AND USE OF INTEREST RATE DERIVATIVES

The present study has used correlation as well as ANOVA test in order to establish the relationship between

the ownership structure and the use of interest rate derivatives. While calculating the correlation between theasset and IRD, it is evident from the Table: 3 that there is a negative correlation between the two (-0.07)

which means that as asset increases the investment in interest rate derivatives decreases in SBI. In the case

of ICICI Bank approximately zero correlation

was found (0.0006) which means that there was no relation or the two variables are independent to each

other and no predictive pattern could be identified between the two. Negative correlation was found in

between the loan and IRD (-0.014 %) in SBI signifying that as the loan increases the investment in interest

rate derivatives decreases while positive correlation was found in ICICI Bank (0.36). Similarly, negative

correlation was found in SBI in deposit and demand deposit ratio -0.02 and - 0.59 respectively. In the case of

ICICI Bank positive correlation was found in deposit ratio 0.25 and negatives correlation in demand deposit


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-0.90. In the case of SBI negative correlation exists in ROA, ROE and interest margin which depicts that as

the three increases interest rate derivatives decreases and vice-versa. In the case of ICICI Bank positive

correlation was seen, which means that as ROA and ROE increases the use of IRD also increases. Interest

margin and IRD show a negative

correlation. While calculating the correlation between IRD and Tier I Capital it was found a negative

correlation with a value of -0.10, which means that as Tier I capital increases IRD decreases and vice-

versa. In ICICI Bank we can see positive correlation (0.43) which means that as tier I capital increases use of

IRD in ICICI Bank also increase.

While applying the Analysis of Variance Test it was found that the calculated value of F is smaller than the

table value, hence the hypothesis is accepted i.e. sample means in both banks are equal with respect to

IRD, Net NPA and Tier I Capital. The hypothesis is rejected in the case of advances proving that sample

means of the banks in question are different .

4. CONCLUSION

Public sector banks are operated by government bodies with a share of more than 51 % and have deep

commitment to social

obligations. The government owns 59.41 percent stake in SBI. Private sector banks are the banks which are

controlled by the private lenders with the approval from the RBI; they are basically committed to earn profit.

As the public and private sector banks are different in their policy making, it was also proved in the present

study that SBI and ICICI Bank differ in their approach towards the use of interest rate derivatives. The study

of different variable reveals that a negative correlation have been found in SBI which mean that as the

volume of asset, loan, deposit, demand deposit, ROA, ROE, Interest margin, NPA, Tier I capital increases

the investment in IRD decreases. On the other hand ICICI Bank shows almost

positive correlation in all the variables except demand deposit and ROA, which means as the variables,

increases the use of IRD, also increases. The difference in the pattern of investment in IRD may be

attributed to the change in ownership structure and policies adopted by these two banks. As banks grow

larger and make more loans, the systematic risk can be captured by the size of the banks as in the case of

SBI, the largest bank in India which seems to be conservative in using interest rate derivatives.

On the other hand ICICI Bank has used this instrument extensively. Almost similar pattern of fluctuations

could be seen among the variables, over the years but the predictability remains uncertain due to limited

data available, which is a major draw back in this research paper, although few suggestions could be useful.

The interest rate risk is managed by the large pool of asset in the case of SBI while ICICI Bank has


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7 Concluding remarks

Derivative markets in equities, fixed income, and foreign currency are at their nascent stage of evolution in

India, but have significant growth potential. For this potential to be realized, as discussed in the previous

sections, one or more of the following issues or impediments would have to be overcome and resolved:

1. The regulatory framework applicable to the respective derivative markets and participants would need to

evolve further.

2. The technological and business process framework of several key participants in these markets needs to

readied to manage the risks relating their activity in the derivatives market.

3. The human resources/talent of several key participants in these markets needs to be vastly upgraded andreadied to manage the exposures and risks relating their activity in the derivatives market.

4. A framework which (a) relieves managements of PSBs and FIs of the risk of being held accountable for

bonafide trading losses in the derivatives book and being exposed to subsequent onerous investigative

reviews; (b) but concomitantly holds managements of public sector banks and FIs accountable for lost

opportunity profit, needs to be ushered in.

5. The senior and top management of several key participants needs to undergo an orientation phase to

familiarize themselves with the conceptual underpinnings and microstructure of these derivatives markets to

help them establish an appropriate governance framework for the derivatives market activity of the

participant.

280 Use of Derivatives by Indias Institutional. . .

6. The tax treatment applicable to the participants visa versa respective derivative contracts would need to

be clarified to provide certainty about it to the market participants.


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References

Annual report of SBI and ICICI Bank, 2006, 2007, 2008, 2009

Bank for International Settlement, May 2009.

Brewer III Elijah, Minton Bernadette A. & Moser James T. (2000). Interest-rate derivatives and bank lending

Journal of Banking & Finance 24, pg no. 353-379

Datt Ruddar, Sundharam K.P.M. (2009). Indian Economy, 6th Edition, S. Chand & Company Ltd., NewDelhi.

Duffee Gregory R. & Zhou Chunsheng (2001). Credit derivatives in banking: Useful tools for managing risk?

Journal of Monetary Economics 48, pg no. 2554.

Mahieu Ronald, Xu Ying (2007). Hedging with Interest rate and Credit Derivatives by Banks.

Selvakumar M, Kathiravan P.G.,(2009). A Study of Profitability Performance of Public Sector Banks in India,

Indian Journal of Finance, Vol. III, pg no. 3-21.


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Documents

Derivatives by Bank