Universal Banking:

Universal Banking can be defined as a combination of investment bank and commercial

bank. This has been most common in the European and American scenarios. The most
common examples are Barclays, Chase, CITI Group etc.
This culture is being highly encouraged by the RBI report on Banking Structure of India.
Where it said that Universal Banking Model, in the form of Financial Holding Company
(FHC), is the most preferred model because of its distant advantages.
The merger of the ICICI Bank with ICICI (probably one of the largest merger of
Corporate India) lead to the birth of Universal Banking Culture in India.
Three business areas are:
1) Retail Banking: Consumer loans, credit cards, deposits, mortgages etc.
2) Commercial/ Corporate Banking: Full range of financial products for various
enterprises and corporates.
3) Wealth Management: tailored products and advisory for individual customers.
Need and Scope:
1. A universal bank is an one stop solution for all the banking needs for all the
people. The kind of services they can provide is deposits, long and short-term
loans, insurance, investment, advisory etc.
2. One of the major advantages for the industry is that it can exploit economics of
scale and scope. The average costs are reduced as the overheads are divided over
much larger products. The products can be cross-sold. This in turn helps in better
utilization of resources.
3. Banks can expand scale of operations and diversify its activities.
4. Many financial services are interlinked activities, a bank can use one of its
instrument in one activity to exploit other.
5. One-Stop-Shop helps save a lot on transaction costs and increase the speed of
economic activities.
6. Another manifestation in this is the bank can hold stakes in the firm.
7. India being a budding economy, banks have an opportunity to diversify in a big
way.
8. IRDA has given a green light to banks for them to enter into insurancee business
by acting as agents or by collaborating with others.
The example of Universal Bank is ICICI Bank which merged in 2000, with the
permission from RBI. Now it is doing pretty well for it and has been named as Too Big
to Fail list along with SBI. Now, it is heading towards global leadership position.

Narrow Banking:
Narrow banking is a term used to define a very restricted form of banking, where
institutions are not allowed to take risks by giving out loans, rather to hold on for
liquidity. Instead, incremental funds are used to invest in zero risk government bonds.
This is to prevent the bank from fresh bad loans.
As the return on these bonds are very low, the banks compensate for them by bringing
down operating costs or by getting additional cash. It was proposed by the former
Deputy Governor of Reserve Bank of India SS Tarapore during the LPG period when
some of the public banks were weak and running losses. Narrow banking reduces the net
return because risk free assets yield low return.
Need and Scope:
9. Narrow banking has both pros and cons, it can create stable payment systems by
backing transactions deposits with risk free securities. This can help contain
interest outgo and can eliminate credit risk. As this has minimum risk depositors
in case of failure government need not intervene.

10. This should be one of the elements in the banking sector, which diversifies the
industry and minimises risks and loses.
11. The main hurdles which need to be looking into for implementing narrow
banking are the economy(as whole) and the banking regulations which make this
a difficult propaganda in the present Indian scenario.
12. Treasury management skills need to be improved to implement this, otherwise it
will heighten the risks than to reduce it.
13. In the context of Basel norms, narrow banking could be employed to circumvent
capital requirements by use of tier-3 capital to support market risks.
A known example is after the Liberalisation, Privatisation and Globalisation post 1991,
there was immense competition from private and foreign players for the bank. This
resulted in losses for them which they could not bail and government had to bear the
fiscal burden of Rs 16,384 during the period of 1993-94 to 1996-97. After this narrow
banking was suggested as an option. General thumb rule is a bank with more than 15%
NPAs should be converted to narrow banks.

Shadow Banking:
It is a financial intermediary involved in facilitating the creation of credit across the
global financial system but whose members are not subjected to regulatory
oversight.This system also refers to unregulated activities by regulated institutions.
Example of intermediaries which are not subjected to regulation are hedge funds,
unlisted activities by regulated institutions are credit default swaps.
Shadow banks are different from conventional banks. Like, shadow banks cannot raise
money through deposits and have to depend on market based instruments. Secondly, as
they are not regulated, they are not as transparent as conventional ones. The liabilities
are not secured in shadow banks in opposite to commercial banks, who enjoy a
minimum guarantee from the government.
These type of entities in India are known as Non Banking Finance Corporations(or
NBFCs in short). The regulatory institution for these in India is the Reserve Bank of
India(RBI). These in India doesn't only mean finance companies, but also encompasses
who range of investment, insurance, chit-funds, merchant banks etc

Asset & Liability Structure of Shadow Bank

Need and Scope:

14. It is a universal phenomena and helps different economies in different way: In

matured financial system of advanced economics, it works as risk transformation
by securitisation. While in developed financial institutions of backward
economics, financial intermediate activities are undertaken with less
transparency and regulation than conventional banks.
15. NBFCs in India, being financial intermediaries play a supplementary role to the
banks.
16. NBFCs(NBFC-MFIs, Asset Financial Companies etc) cater to rural and urban
poor by complimenting the financial inclusion agenda of the country.
17. Some of the bigger NBFC(like infrastructure finance companies) are engaged in
lending business exclusively to Infrastructure sector, factoring business; thereby
contributing to the growth and development of the sector.
18. They are needed to bring the much needed diversity to the financial sector.
19. Even though they subserve the economy by playing complementary and
supplementary roles for banks, they pose dangers. Mainly, in terms of consumer
protection.
20. Reserve Bank needs to have a constant endeavour to enable prudential growth of
the sector, simultaneously taking care of financial stability, consumer protection,
increase the number of players in the market and addressing the regulatory
arbitrage concerns while not losing its NBFC identity.
The example of shadow banks are most NBFCs like Tata Capital, Shriram Chit fund etc.

Islamic Banking:
Wikipedia defines Islamic Banking as, A banking activity that is consistent with the
principles of Sharia(Islamic Law) and its practical application through the development
of Islamic Economics.
Sharia prohibits acceptance of specific interest or fee on loans(known as riba), the
payments can be fixed or floating. And investing money on businesses which in anyway
contradict islamic principles(like industries related to pork and alcohol) are
prohibited(haraam). As of 2014, these types of banks held 1% of worlds total assets.
These are expected to grow at a rate of 19.7% by 2018. They have different councils and
standards governing them. Like Shariah Supervisory Board (SSB), Islamic Financial
Services Board (IFSB); and, Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) which drafts the accounting standards to be followed.
There are many products which are similar to the conventional banking products, but are
very much different. For Example, In deposits and loans, the interest paid is on will
basis(as gifts) and not promised by either parties.
Need and Scope:
1. India has a big opportunity in this sector, as it has 140million muslims
(Approximately) which is around 15% of world islamic population.
2. According to survey, it has a potential market of $4 trillions. Which can be a
major tool for enhancing economic development in India.
3. Most of the foreign banks in India, have interest free windows for this in other
countries. For example, CITIGroup, HSBC, Standard Chartered etc in West Asia,

4.
5.
6.
7.

UK, US etc. As the awareness is growing in India, there is a potential market for
this, which can be tapped by both Indian and Foreign Banks.
There has to be strict regulations in place because banks are showing interest in
these interest-free banking. Otherwise, it would be impossible to follow the
islamic laws by the banks.
This not only benefits the muslim population but the whole community as whole.
This can improve the FDI and FII from Middle-east or Arab Countries who only
operate through Islamic Banks.
This banking has other features like: inclusive growth with control over inflation,
equity financing, equitable profit sharing and micro-loans.

There are not many islamic banks in India, but Many foreign banks like Citi, HSBC
have islamic banking windows in various countries.

Virtual Banking:
A virtual bank is defined as a financial institution which handles all transactions through
web, e-mail, mobile check deposits and ATM machines. They minimise the overheads
incurred by physical branches and in turn are expected to pay a higher interest on
deposits. All transactions are handled online. This is the emergence of ebanking/
netbanking, mbanking, phone banking etc. Many of the banks have launched their
mobile apps, where all the bank transactions can be carried out in a single window, from
encashment of cheque to paying for a movie ticket. For example, in ICICI bank, from
the app you can take a picture of the cheque you received and they cheque is verified
and the funds are transferred instantly and the cheque can be deposited to the bank later.
We have moved from cash to cheque to card to mobile. Cash to Cashless to Card to
Cardless now(with introduction of new technology like Apple Pay). With the affect and
effects of demonetisation, virtual banking has eased the life of many of its users.
Another such example of virtual banks is collapsible branches by ICICI, which is great
initiative by ICICI towards capturing market and contributing towards governments
financial inclusion agenda. In this system, there is one employee, with a bike, laptop and
internet connectivity, who goes to inaccessible places and carries out all the transactions
of the bank in a small space with no significant overheads.

Need And Scope:

8. This can be great initiative for reducing the branch sizes(in area, employees) and
go for more smaller branches.
9. Customers can have instantaneous services with low transaction and account
maintenance costs.
10. The number of customers handled at once in virtual bank is way more than a
conventional brick mortar branch.
11. With virtual banks all the transactions are easy to track and there can be minimal
masking of funds in the form of black money.
12. The need of the hour for virtual banking is privacy and security issues which
need to be taken care of and having a proper infrastructure in place to carry out
all the functions.
13. People need to educated about how to use and why to use virtual banking
services.
There are many examples of virtual banking as you can see from the image above(50%
penetration in mobile banking) it is an emerging field. Many players have come in like
ICICI Bank with its app and collapsable branch concept, DBS with its mobile banking
facility, Indusind Bank with its various channels etc.

An interest-rate derivative like interest rate swaps, caps and floors, is a financial
instrument with a value that increases and decreases based on interest rates movement. It
is often used as hedge by institutional investors, banks, companies and individuals for
protection against changes in market interest rates. They also serve as to increase or
refine the holder's risk profile.
Interest rate derivatives can be simple or complex; they can be used to vary interest rate
exposure.
Table 2: Derivatives in India: A Chronology
Date
14 December 1995

Progress
NSE asked SEBI for permission to trade index futures.

18 November 1996

SEBI setup L. C. Gupta Committee to draft a policy

framework for index futures.

11 May 1998

L. C. Gupta Committee submitted report.

7 July 1999

RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps

24 May 2000

SIMEX chose Nifty for trading futures and options on an

Indian index.

25 May 2000

SEBI gave permission to NSE and BSE to do index futures

trading.

9 June 2000

Trading of BSE Sensex futures commenced at BSE.

12 June 2000

Trading of Nifty futures commenced at NSE.

1 August 2000

Trading of futures and options on Nifty to commence at

SIMEX.

June 2001

Trading of Equity Index Options at NSE

July 2001

Trading of Stock Options at NSE

9 November, 2002

Trading of Single Stock futures at BSE

June 2003

Trading of Interest Rate Futures at NSE

13 September, 2004

Weekly Options at BSE

1 January, 2008

Trading of Chhota (Mini) Sensex at BSE

1 January, 2008

Trading of Mini Index Futures & Options at NSE

29 August, 2008

Trading of Currency Futures at NSE

2 October, 2008
th

20 September 2010

Trading of Currency Futures at BSE

United Stock Exchange

3 What is a Derivative?
Derivative is a financial instrument whose value depends upon value of underlying asset. Its
primary purpose is not to borrow or lend but to transfer price risk associated with
fluctuations to asset values. It helps in managing risk, price discovery and transactional
efficiency.
Derivatives products like futures and options are used to systematically hedge business
risk and an opportunity to earn wealth for speculators and arbitrageurs.
Unlike debt instruments, no principal amount is advanced to be repaid and no investment
income accrues. For example, A speculator on the gold futures market anticipated a price
increase from the current futures price of $ 450. The market lot being 100 oz, he buys one
lot of futures gold. 100 oz of gold at $ 450 have a value of $ 45000. But the speculator is
only required to pay out a margin or deposit of $ 4500. Now assume that a 10% increase
occurs in the price of gold, to $ 495.The value of 100 oz at $ 495 is $ 49,500. Subtracting
original contract value, the profit on the transaction is $ 4,500. As far as the speculator is
concerned, he/ she has achieved a profit of $ 4,500 on a capital of $ 4,500. In short, he/ she
has achieved a 100% profit through a 10% price rise.

Derivatives include forwards, futures, options and swaps

Forward contract: This is a legal agreement between two parties to purchase

or sell a specific quantity of a commodity, government security or foreign
currency or other financial instrument at a price specified now, with delivery
and settlement at a specified future date.
Futures contract: This is an agreement to buy and sell a standard quantity
and quality of a commodity, financial instrument, or index at a specified
future date and price.
Interest rate swap: This is an agreement between two parties to exchange
interest payments on a specified principal amount for a specified period.
Option: This is a contract conveying the right, but not the obligation to buy or
sell a specified item at a fixed price within a specified period. The buyer of
the option pays a non -refundable fee, called a premium, to the writer of the
option and the maximum loss is the premium paid for the option. Options can
be divided into caps, collars and floors:

Cap: This gives the purchaser protection against rising interest rates
and sets a limit on interest rates and amount of interest that will be
paid.

Floor: This sets a minimum below which interest rates cannot drop.

Collar: By purchasing a cap and simultaneously selling a floor, a bank

gives up some potential downside gain to protect against a potential
up -side loss.

Table 7: Common examples of the derivative products

Underlying

Exchangetraded
futures

Equity

DJIA Index
future
Single-stock
future

Commodity

WTI crude
oil futures

Foreign
exchange

Currency
future

Credit

Bond future

Interest
rate

Eurodollar
future
Euribor
future

CONTRACT TYPES
ExchangeOTC
OTC
traded
swap
forward
options
Option on
DJIA Index
Back-tofuture
Equity
back
Singleswap
Repurchase
share
agreement
option
CommIron ore
Weather
odity
forward
derivatives
swap
contract
Option on
Currency Currency
currency
swap
forward
future
Credit
default
Option on
swap
Repurchase
Bond future
Total
agreement
return
swap
Option on
Eurodollar
Interest
Forward
future
rate
rate
Option on
swap
agreement
Euribor
future

OTC option

Stock option
Warrant
Turbo warrant

Gold option
Currency option

Credit default
option

Interest rate cap

and floor
Swaption
Basis swap
Bond option

Players in the Derivative Markets

Derivative instruments are traded in Commodities, Equities, Foreign Exchange and Money
Markets in India. Equity. Derivative Markets could be broadly classified into:

Exchange traded Derivatives

OTC Derivatives (Over The Counter)

Open outcry system

1.4.1 Exchanges:
1.4.1.1 Exchange traded Derivatives: In India we have, NSE (shares and index), BSE
(shares and index), NCDEX (commodities), MCX (commodities) and recently opened
United Stock Exchange for Banks (currency) dealing in derivatives instruments. Operation
st

of United Stock Exchange on 21 September 2010, an exchange to trade in currency and

interest rate derivatives has marked the beginning of a new chapter in the development of
Indian financial markets. The exchange is backed by 21 Indian public sector banks and five
private sector banks.
1.4.2

The Over the Counter Exchange: The OTCE market is an important alternative to

exchanges and report high volume trading. Not all trading is done on the exchanges. In
OTCE, trading is done on telephone and computer networks which are linked to dealers.
Trade between two financial institutions could be done with bid and offer prices being
offered simultaneously by the institutions. The OTCE trading in India is carried out in
foreign exchange and currency. Foreign Exchange and currency trading in stock exchanges
(NSE and United Stock Exchange) are allowed to be traded only in futures and not in the
spot market.

1.4.3

Open outcry system: Although not in practice in major exchanges anymore, an

open outcry system involves traders and brokers operating on an exchange floor where they
communicate their deals by shouting at each other and using hand signals. On such

exchanges, the floor is a very noisy and a colourful place, and the activities seem to be
chaotic.
Difference between exchange traded and OTC derivatives
Sr. No.

Exchange Traded
Derivatives traded on a

competitive floor, open outcry

and electronically

2
3
4

OTC
Derivatives traded on a private
basis and individually negotiated

Standardized and published

No standardized and published

contract specifications

contract specifications

Prices are transparent and easily

Prices are less transparent and not

Available

easily available

Market players not known to

Market players are known to each

each other

other
Commoditized vanilla contracts

Trading hours are published and

trade 24 hours a day while less

exchange rules must be kept

liquid and customized one- time

deals trade during local hours

6
7

Positions can easily be traded

Positions are not easily closed or

Out

transferred

Few contracts result in expiry or

Majority of contracts result in

Delivery

expiry or delivery

Source: John Wiley & Sons (Asia) Pte. Ltd. The Reuters Financial Training Series, "An introduction
to Derivatives" (1999)

Market Participants and Makers:

The following enter into derivative contracts either as hedgers, speculators or
arbitrageurs:

Banks

Producers/ Corporations/ Traders/ Farmers

Financial Institutions like Insurance companies, Investment Banks, Merchant

Banks

Exporters and Importers

Individuals

Governments: National, State, Local

Hedgers: Hedgers enter into a derivative contract to cover risk associated with the
business deal. For example farmer growing wheat is uncertain about the price he would
get during harvest season. Similarly a flour mill is unsure about the price at which it may
have to procure the wheat in future. Both the farmer and the flour meal would enter into a
forward contract where the farmer agrees to sell his wheat to the flour mill at a predetermined price. The farmer is expecting a price fall during harvest season and the flour
meal is expecting a price rise. Hence both the parties face price risk. The forward contract
in which they have entered into would eliminate the price risk for both the parties. This is
called as hedging and the participants are called as hedgers.
1.5.1

Speculators: Speculators enter into a derivative contract to profit by

assuming risk. The speculators have an independent view of future price behavior
of the underlined asset and take appropriate position in derivatives with the
intention of making profit later. For example, the forward price in US dollars for a
contract maturing in three months is Rs. 48. If the speculator believes that three
months later the price of US dollar would be Rs. 50, he/she would buy forward
today and sell later. On the contrary if he believes that US dollar would depreciate
to Rs. 46 in one month, he would sell now and buy later. The intention is not to
take delivery of underline but instead gain from the differential in price.
Speculators render liquidity to the market and make markets competitive and
expand the market size. They also helps hedgers find counter parties
conveniently.
Arbitrageurs: Arbitrageurs perform the function of making the prices in different
markets converge and the in tandem with each other. The markets could be physical
market and the commodity exchange. Since there cannot be any disparity in prices in the
physical markets and the commodity exchange, arbitrageurs constantly monitor the prices
of different assets in different markets and identify opportunities to make profit that
emanate from mis-pricing of products in the different markets. Unlike hedgers and
speculators, arbitrageurs take riskless position and yet earn profit. For example if the
share price of Infosys is Rs. 1750/- in National Stock Exchange and Rs. 1770/- in
Bombay Stock Exchange the arbitrageurs will buy at NSE and sell at BSE simultaneously
and pocket the difference of Rs. 20/- per share. An arbitrageur takes risk neutral position
and makes profits in markets which are imperfect.
Regulation involves the following factors:

 One is the issue of information and transparency of the system.

Another is referred to as investor protection. This is in terms of minimizing fraud,
and the detection and punishment of fraud.

Indian Market Segment and Regulators

Market Segment

Equity and Equity Derivatives

Currency and Currency Derivatives
(Both Indian and Cross Currency)

Interest rate & fix income derivative

Regulator
Securities and Exchange Board of India
(SEBI)
Reserve Bank of India (RBI)

Reserve Bank of India (RBI)

Forward Market Commission

Commodity trading and derivatives

Reserve Bank of India: Reserve Bank of India (RBI) was established in 1935 and is the
Central /Federal bank of India. RBI is the regulator for financial and banking system,
formulates monetary policy and prescribes foreign exchange control norms. The Banking
Regulation Act, 1949 and the Reserve Bank of India Act, 1934 authorize the RBI to
regulate the banking sector in India. The Reserve Bank of India regulates a large segment
of financial institutions in India which includes commercial banks, cooperative banks,
non-banking financial institutions and various financial markets.. The Board for Financial
Supervision (BFS) has been mandated to ensure integrated oversight over the financial
institutions that are under the purview of the Reserve Bank.
Securities and Exchange Board of India: Securities and Exchange Board of India
(SEBI) established under the Securities and Exchange board of India Act, 1992 is the
regulatory authority for capital markets in India. In addition to the SEBI Act, the
Securities Contracts (Regulation) Act, 1956 and the Companies Act, 1956 regulates the
stock markets. SEBI regulates the securities market, institutions and intermediaries such
as stock exchanges, depositories, mutual funds and other asset management companies,
brokers, merchant bankers, credit rating agencies and venture capital funds etc. The stock
exchanges have to regulate the activities of the derivative traders and clearing agents.

The powers and functions of SEBI are as per SEBI act 1992. It also exercises power
under Securities Contract (Regulation Act) 1956, the Depositories Act 1996 and certain
provisions of Companies Act 1956. (RBI).

Forwards Market Commission:

IT is a regulatory authority for commodity futures market in India. is under the
administrative control of the Ministry of Consumer Affairs, Food & Public Distribution,
Department of Consumer Affairs, Government of India and It is a statutory body set up
under Forward Contracts (Regulation) Act 1952 .
The Commission regulates the commodity futures markets to protect market integrity by
prescribing the following measures:
1. Limit

open position of an individual members and client to prevent over

trading;
2. Limit price fluctuation to prevent sudden price upswing or downswing ;
3. Special margin deposits collection on outstanding purchases or sales to curb
excessive speculative activity
As regulatory measures, the Commission during shortages, take extreme steps like
skipping trading in certain deliveries of the contract, closing the markets even closing out
the contract for a specified period to overcome emergency situations. In addition to the
above measures, the regulator calls for daily reports from the Exchanges and takes proactive steps to ensure no misuse of the market. It regulates prices reflecting on the
Exchange platform by making sure that the prices are governed by the demand and supply
in the physical markets.
Other Financial Regulators in India are as follows:
Ministry of Finance (MoF)
Department of Economic Affairs
Department of Expenditure
Department of Disinvestment
Ministry of Corporate Affairs
Insurance Regulatory Authority of India
Pension Fund Regulatory and Development Authority
ADVANTAGES OF USING DERIVATIVES IN BANKS:

Apart from using derivatives for interest rate risk management (hedging
against interest rate risk), they can also be used to:

a)
b)
c)
d)
e)
f)

Lower funding cost;

Diversify sources of funding;
Hedge debt;
Hedge changes in foreign currency exchange rates;
Manage the risk related to day-to-day operations ;
Manage the balance sheet and results; and Take open or speculative
positions to benefit from anticipated market movements.

g) Risk, which could not be easily avoided previously, can now be insured;
h) Economic means for banks to alter their interest rate risk exposure;
i) Derivatives provide a means for banks to more easily separate interest
rate risk management from their other business objectives;
j) fosters more loan making or financial intermediation;
k) preferable to balance sheet adjustments using securities and loans
lessening the need to hold expensive capital
l) Banks can remove unprofitable activities and make up the difference
with appropriate financial instruments
Disadvantages of derivatives:
a.
b.

It can affect the banks overall risk exposure, and so seen as a potential source of
increased solvency exposure;
Knowing more about the derivatives position of a bank may not allow outside stakeholders to determine the overall riskiness of the bank. Banks invest in many non derivative instruments that are illiquid and opaque. so even if the value of their derivatives
positions were known, it would be hard to know its relationship between interest rate

c. Fixed cost associated with initially learning to use derivatives

INTRODUCTION
The Banking sector has played an important part in increasing and sustaining growth
in the economy. It helps in directing the nations saving into high investment options
and efficient utilization of available resources. Modern banking accept the risk to earn
profits. There are different types of risk such as credit risk, operational risk, interest
rate risk, liquidity risk, price risk, foreign exchange risk, etc. Interest rate risk refers to
the exposure of a banks financial condition to adverse movements in interest rate. It
is the risk for earnings and capital if market rates of interest vary unfavorably. This
risk arises from timing differences of changes in rates, the timing of cash flows
(reprising risk), and changes in the shape of the yield curve (yield curve risk) and
option values in the products (options risk). In all, the market value of banks assets
(i.e. loans and securities) will fall with increase in interest rates. Earnings from assets,
fees and the cost of borrowed funds are affected by changes in interest rates.
Accepting this risk is a part of banking and an important source of profitability and
value of shareholder. Changes in interest rate change its net interest income and the
level of other interest sensitive income and operating expenses, and thus changing

banks earning. Interest rate refers to volatility in net interest income (NII) or in
variation in net interest margin (NIM) i.e. NII divided by earning assets due to
changes in interest rate. Interest rate risk arises from holding assets and liabilities with
different principal and maturity or repricing dates. So an effective risk management
process for safety of banks is must to maintain interest rate risk within certain levels.
Financial markets have a nature of a very high volatility. Derivative products can
partially or fully transfer price risk by locking in asset prices. These products initially
emerged as commodity linked derivatives, which remained the base form of such
products for three hundred year. Financial derivatives came into limelight after 1970
period due to growing unstable financial market. They financial instruments whose
payoff is based on the price of an underlying asset, reference rate and index. By
1990s they accounted for about 2/3 of total transaction in derivatives products.
Markets means price determination and exchange of goods and services. Prices are
the base of the market mechanism. Derivatives are considered supporters of price
discovery in financial market and allocators of risk. An interest rate derivative is
where the underlying asset is the to pay or receive a notional amount at a given
Interest rate. The RBI introduced interest rate swaps (IRS) and forward rate
agreements (FRA) in 1999 and interest rate futures (IRF) in 2003 and reintroduced
IRF in 2009.

RATE DERIVATIVES IN INDIAN BANKS

Interest rate derivative can be defined as a financial instrument where change in value
is based on the movements in interest rate. The most common are interest rate swaps,
caps and floors.
These are commonly used as hedges by institutional investors, banks, companies and
investors against change in market interest rates. It can also be used to refine holders
risk profile.
They can be used to increase or reduce interest rate exposure and vary from simple to
highly complex.

The emergence of the market for derivative product can be

traced back to the willingness of riskaverse economic agents to
guard themselves against uncertainties arising out of fluctuation
in asset prices. By their very nature financial markets are
marked by a very high volatility. Through the use of derivatives
products, it is possible to partially or fully transfer price risk by
locking in asset prices. These products initially emerged as
hedging devices against fluctuation in commodity prices.
Commodity linked derivatives remained the sole form of such
products for almost three hundred year. Financial derivatives
came into spotlight in the post 1970 period due to growing

instability in the financial market. They are defined as financial

instruments whose payoff is based on the price of an underlying
asset, reference rate or an index. However since their
emergence, these products have been very popular and by
1990s they accounted for about 2/3 of total transaction in
derivatives products. In recent years the market for financial
derivatives has grown tremendously in terms of, variety of
instruments available, their complexity and also turnover. In
generic terms, markets are meant for price determination and
exchange of goods and services, indeed prices are the balancing
wheels of the market mechanism. In that context, derivatives are
considered facilitators of price discovery in financial market and
also as risk allocators. They add to the completeness of financial
market that is by their very nature marked by a very high degree
of volatility. An interest rate derivative is a derivative where the
underlying asset is the right to pay or receive a (usually
notional) amount of money at a given Interest rate. In the wake
of deregulation of interest rates as part of financial sector
reforms, a need was felt to introduce hedging instruments to
manage interest rate risk. The Reserve Bank had introduced
interest rate swaps (IRS) and forward rate agreements (FRA) in
March 1999 and interest rate futures (IRF) in 2003 and
reintroduced IRF on 31st Aug 2009.
Rate derivatives in Indian Banks:
Interest rate derivative can be defined as an financial instrument where change in
value is based on the movements in interest rate. The most common are interest rate
swaps, caps and floors.
These are commonly used as hedges by institutional investors, banks, companies and
investors against change in market interest rates. It can also be used to refine holders
risk profile.
They can be used to increase or reduce interest rate exposure and vary from simple to
highly complex.
The Global OTC Derivatives Market

Derivative contracts are entered into or traded, either OTC or on exchanges.

In OTC, trades are contracted and prices agreed bilateral, i.e. between a pair
of one seller and one buyer, either directly or is intermediated by brokers
through electronic communication system.

Gross market values, which measure the cost of replacing all existing
contracts, prove to be a better measure of market risk than notional amounts.
Even though there is a drop in outstanding amounts, significant movement in
price resulted in notably higher gross market values.

Global OTC derivatives market

In billions of US dollars

Table D5
Notional amounts outstanding

Gross market value

H2 2014

H1 2015

H2 2015

H1 2016

H2 2014

H1 2015

H2 2015

H1 2016

628,003

551,489

492,707

544,052

20,837

15,485

14,492

20,701

75,043

73,607

70,446

74,036

2,936

2,539

2,579

3,063

Outright forwards and fx swaps

36,596

36,699

36,331

38,853

1,202

932

947

1,340

Currency swaps

24,042

23,566

22,750

23,485

1,348

1,283

1,345

1,462

Options

14,405

13,342

11,365

11,697

386

324

287

261

...

...

...

...

505,443

434,507

384,025

418,082

15,586

11,062

10,148

15,096

All contracts
Foreign exchange contracts
By instrument

Other products
Interest rate contracts
By instrument
FRAs

80,818

74,633

58,326

71,842

145

143

114

255

Swaps

381,141

319,821

288,634

311,474

13,925

9,796

8,993

13,480

Options

43,484

40,053

37,065

34,743

1,516

1,124

1,042

1,361

24

...

...

...

...

6,968

7,544

7,141

6,631

612

606

495

515

Forwards and swaps

2,495

2,801

3,321

2,537

177

168

147

172

Options

4,473

4,743

3,820

4,094

435

438

348

343

Other products
Equity-linked contracts
By instrument

The Global OTC Interest Rate Derivatives market

Interest rate derivatives are extensively used by different market players world
over, such as Corporations, banks, insurance companies, fund managers,
governments, individuals and the financial services industry. They use interest
rate derivative as a tool to solve their financial risk management problems.
The global Interest rate derivatives market has been divided into different
market participants namely reporting dealers, financial institutions and non
financial institutions. Bank for International Settlement has identified these
groups namely reporting dealers the institutions, whose head office is located
in G10 countries and which participate in the semiannual OTC derivatives

market statistics, financial institutions such as commercial, investment banks,

security houses and lastly non financial institutions.
OTC, interest rate derivatives
In billions of US dollars
Notional amounts outstanding
Total interest rate contracts
FRAs
Reporting dealers
Other financial institutions
Central counterparties
Non-financial customers
Gross market values
Total interest rate contracts
FRAs
Reporting dealers
Other financial institutions
Central counterparties
Non-financial customers

Table D7
Total
H1 2016

USD
H1 2016

EUR
H1 2016

JPY
H1 2016

GBP
H1 2016

CHF
H1 2016

CAD
H1 2016

SEK
H1 2016

Other
H1 2016

418,082
71,842
1,501
69,732
66,106
608

148,898
38,525
606
37,491
35,080
428

120,459
20,008
110
19,872
19,771
26

49,740
17
0
13
10
3

41,857
8,039
64
7,971
7,939
4

3,562
726
7
718
703
1

8,728
9
1
1
0
7

4,675
1,631
167
1,432
1,328
32

40,163
2,887
546
2,233
1,275
107

15,096
255
13
224
196
17

3,862
235
12
208
185
15

6,401
8
0
7
4
1

1,441
0

0
...

2,205
5
0
5
5
0

119
0
0
0
0
0

218
0

0
0
0

121
1
0
1
1
0

728
5
1
4
1
1

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.
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 Net Interest
Margin (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 derivatives has
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
IRD and Asset