The most common type of swap is a "plain vanilla" interest rate swap. In a typical plain vanilla swap, which is a single currency swap, one party agrees to pay to the counterparty cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years and at the same time the other party agrees to pay a floating rate on the same notional value for the same period of time. Principals are not exchanged either while contracting or at maturity. Usually these instruments are routed through an intermediary. The usefulness of derivatives is generally thecomparative advantages and the need for hedging the risks in accordance with risk management objectives and find solutions to risk management.

Derivatives are useful tools for asset-liability management with lower cost than other means. Hence there has been a shift from cash market to derivatives market for short-term exposures. The three main types of IRS are "coupon swap" which is fixed rate to floating rate swap, "basis swap" which is floating rate against one reference rate to floating rate with another reference rate and "cross currency" which is a swap of fixed rate flows in one currency to floating rate flows of another.

Forward rate agreement is a financial contract between two parties agreeing on the interest rate to be paid on a "notional principal" of specified maturity at predetermined future (settlement) date. Principal amounts are agreed but never exchanged and contracts are settled in cash on the settlement date by way of difference between the agreed rate and the reference rate asspecified in the agreement. The difference is multiplied by the notional principal amount and the period thereof to determine the amount due. If the reference rate on the settlement date is higher than the agreed rate, the buyer of FRA receives the payment of the difference from the seller and vice versa. In market terminology, the "buyer" is the party wishing to protect against a rise in interest rates by seeking to set the rate today and the "seller" is a party wishing to protect against a fall in the interest rate by fixing a rate today. This product enables the banks to adjust their interest rate exposure without altering their liquidity profile and also with less impact on the size of the balance sheet and the credit exposures than taking a route of interbank market. FRA is particularly attractive in a currency for which there are no futures markets. The risk of loss depends on the adverse movement in interest rates and the default by the counterparty. There is no risk on the notional principal. Theseare usually used to hedge existing open position but can also be used for position taking.

As noted earlier the prime function of IRS and FRA is not the extension of credit, the credit risks are significantly less than for conventional credit instruments. In the case of IRS, there is no principal risk, risk is limited to replacement cost and default cancels future obligations. In FRA also it is mostly cash settled credit risk is limited to the amount of market risk. Market risk is small on basis interest rate swap. When it comes to settlement risk it is restricted to interest payments on payment days. The central issue in accounting for swaps is whether to view all contracts as trading positions or to treat them as hedges of underlying assets and liabilities. Trading positions and portfolio are generally marked to market daily as they are off-balance sheet items. On the other hand the on-balance sheet items are usually valued at lower of the cost or market values. In the case of IRS the payments related toswaps which hedge commitments valued at cost are usually accrued over each period and reported as a net adjustment to the interest payment/expense of the underlying asset/liability or income. This has the effect of changing the terms on the underlying asset or liability to reflect swap payments. Costs incurred in executing the swap, such as commission, brokerage etc, are deferred and amortised. In other words they are treated as expenses only at the end. If swaps are in the nature of position-taking they are generally either marked to market or valued at the lower of the cost/market.

With a view to further deepening the money market as also to enable banks, primary dealers and all-India financial institutions to hedge interest risks, the Reserve Bank of India has authorised them to undertake forward rate agreements and interest rate swaps on July 7, 1999 as a product for their own balance sheet management, to offer these products to corporates and also for market making. However, these are restricted todifferent types of "plain vanilla" FRAs and IRS. Swaps having explicit/ implicit option features are not permitted. The benchmark rates are those of domestic money or debt market rates which should necessarily evolve on their own and require market acceptance. There are no restrictions on the size and the exposures subject to capital requirements for banks and FIs. Computed on the basis of risk weighted assets arrived at by specified conversion factor and risk weightage. Counterparty exposure limit is arrived at the credit equivalent amount by using the specified conversion factors. Ideally the swaps should be derivatives of underlying "genuine" exposures but relaxations are made for market making. While offering these swap facilities to corporates, the intermediary should exercise "due diligence" to ensure the corporates are undertaking only for hedging their own rupee balance sheet exposures as evidenced by a certificate from the authorised signatory. For banks the exposures are a part of their assetliability management (ALM) system. Transactions for hedging and market making must be separately recorded in the books. Market making transactions are to be marked to market fortnightly and those of hedging be accounted on accrual basis. Boards of banks have to lay down appropriate policy for reflecting the "fair value" of outstanding transactions in the books of accounts. Accounting must be done in accordance to the "general accounting principles". The suggested documentation is that designed by International Swap Dealers' Association as customised. There is an off-site supervision by RBI through a fortnightly information system.

The pioneers have already plunged into this new-born and long-awaited opportunity on the same day as they have been waiting on their wings to launch these products in the Indian market. They quickly added value for their customers. For some more time to come they are bound to enjoy the power of incumbency and their customer list will include other banks and in particular the oldgeneration private sector banks, who are already struggling with their ALM exercise, for hedging their risks associated with their traditional banking activities. What is in store for the market is difficult to say but there are bound to be players as long as there are hedging needs and differing perceptions of future rate of interest. This is a market wider than inter-bank and ultimately which benchmark rate would emerge as of practical utility one has to wait and see. These are bound to be multiple transactions derived from the original ones giving scope for divergent opinions between the participants and the regulators over the "genuineness" of the hedging operations in the background of present scope of the scheme. The market is also bound to develop the variants of plain vanilla. Hopefully introduction of the rupee derivatives is a prelude to full convertibility at which time these products will have a shot in the arm.

The author is a senior general manager with The Karnataka Bank Ltd,Mangalore