Forward rate agreement (FRA) and interest rate swap (IRS) are such instruments which can provide effective hedge against interest rate risks.

To enable the market to use FRAs/IRS and for smooth development of these products, the Reserve Bank of India has formulated the guidelines for FRAs/ IRS.

Description of the product: A forward rate agreement or an interest rate swap provides means for hedging the interest rate risk arising on account of lendings or borrowings at fixed/ variable interest rates.

An FRA is a financial contract between two parties to exchange interest payments for a`notional principal' amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed bench-mark/reference rate prevailing on the settlement date. An IRS is a financial contract between two parties exchanging or swapping a stream of interest payments for a `notional principal' amount on multiple occasions during a specified period. Such contracts generally involve exchange of a `fixed to floating' or `floating to floating' rates of interest.

Accordingly, on each payment date - that occurs during the swap period - cash payments based on fixed/ floating and floating rates, are made by the parties to one another.

Participants: Scheduled commercial banks (excluding regional rural banks), primary dealers (PDs) and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their ownbalance sheet management or for market making.

Banks/FIs/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures. No specific permission from Reserve Bank would be required to undertake FRAs/ IRS.

However, participants when they start undertaking such transactions, will be required to inform RBI's monetary policy department and abide by such reporting requirements as prescribed by the central bank from time to time.Participants undertaking FRAs/IRS are, however, advised that before undertaking market making activity in FRAs/IRS, they should ensure that appropriate infrastructure and risk management systems such as ability to price the product and mark to market their positions, monitor and limit exposures on an ongoing basis, etc., are put in place.

Types of FRAS/IRS: Banks/ PDs/ FIs can undertake different types of vanilla FRAs/IRS. Swaps having explicit/ implicit option features such as caps/ floors/ collars are not permitted.

Benchmarkrate: The benchmark rate should necessarily evolve on its own in the market and require market acceptance. The parties are, therefore, free to use any domestic money or debt market rate as benchmark rate for entering into FRAs/IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counterparties.

Size: There will be no restriction on the minimum or maximum size of `notional principal' amounts of FRAs/IRS. Norms with regard to size are expected to emerge in the market with the development of the product.

Tenor: There will be no restriction on the minimum or maximum tenor of the FRAs/IRS.

Capital Adequacy: Banks and FIs are required to maintain capital for FRAs/IRS (See Annexure1.)

Exposure limits: Banks, FIsand PDs have to arrive at the credit equivalent amount for he purposes of reckoning exposure to a counterparty. For this purpose participants may apply the conversion factors to notional principal amounts as per theoriginal exposure method prescribed in Annexures 1. The exposure should be within sub-limit to be fixed for FRAs/IRS to corporates/banks/FIs/PDs by the participants concerned.

In case of banks and FIs, the exposure on account of FRAs/ IRS together with other credit exposures should be within single/ group borrower limits as prescribed by RBI.

Further, while dealing with corporates, banks/FIs/PDs should exercise due diligence to ensure that they (corporates) are undertaking FRAs/IRS only for hedging their own rupee balance sheet exposures.

Banks/ FIs/ PDs are advised to also obtain a certificate from the authorised signatory/ signatories of corporate/s to the effect that the transactions undertaken by them are meant for hedging balance sheet exposures only, i.e., size and tenor of the transactions undertaken are not in excess of their underlying rupee exposures.

Swap position: Ideally, participants should undertake FRAs/IRS only for hedging underlying genuine exposures. However, recognising thecrucial role played by the market-maker in development of the product and creating of the market itself, participants have been allowed to undertake market making activity, which would involve at times dealing in the market without underlying exposure.

However, to ensure that market makers do not over extend themselves, market makers are required to place prudential limits on swap positions, which may arise on account of market making activity.

Scheduled commercial banks, should place various components of assets, liabilities and off-balance sheet positions (including FRAs,IRS) in different time buckets and fix prudential limits on individual gaps as per the procedure laid down in the Reserve Bank of India directive on ALM system. The FRAs/IRS, etc. undertaken by banks will have to be within the prudential limits for different time buckets, approved by boards/management committees of banks.

Primary Dealers/FIs should identify swap positions in each maturity bucket and place prudential limits with theapproval of their respective boards.

The prudential limits on swap positions will require vetting by the RBI after approval of respective boards. While the above procedures for setting up of limits on `swap positions' and exposure limits may form the bottomline for the risk management, participants who can employ more sophisticated methods such as value at risk (VaR) and potential credit exposure (PCE) may do so. They are, however, advised to report the methods followed for VaR/ PCE to Monetary Policy department with a copy to the respective departments of RBI.

Accounting and valuation: Transactions for hedging and market making purposes should be recorded separately. While transactions for market making purposes should be marked to market (at least at fortnightly intervals), those for hedging purposes could be accounted for on accrual basis.

For valuation purposes, the respective boards should lay down an appropriate policy to reflect the fair value of the outstandingcontracts.

Documentation: For the sake of uniformity and standardisation, participants could consider using ISDA documentation, as suitably modified to comply with these guidelines for undertaking FRAs/IRS transactions.Institutions should further evaluate whether the counterparty has the legal capacity, power and authority to enter into FRAs/IRS transactions.

Internal Control: Participants should set up sound internal control system. They should provide for a clear functional separation of front and back offices relating to hedging andmarket making activities.

Similarly, functional separation of trading, settlement, monitoring and control and accounting activities should also be provided. The deals should be subjected to concurrent audit and result should be intimated totop management of the institution regularly.

Reporting: Participants are required to report, their FRAs/IRS operations on a fortnightly basis to adviser-in-charge, monetary policy department, Reserve Bank ofIndia.

These guidelines are intended to form the basis for development of rupee derivative products such as FRAs/IRS in the country. The guidelines are subject to review, on the basis of development of FRAs/IRS market.

Annexure -1: Capital adequacy norms applicable to banks/FIs for undertaking FRAs/IRS: For reckoning the minimum capital ratio, the computation of risk weighted assets on account of FRAs/ IRS should be done as per the two steps procedure set out below: