Apart from traditional ways of measuring and managing interest rate risk, derivatives are used by banks and financial institutions. Put in another way, risks can be managed with debt capacity, payout flexibility, as well as with derivative contracts. Banks participate in the derivative markets, especially because their traditional lending and borrowing activities expose them to financial market risks; and doing so can help them hedge or reduce risk and achieve acceptable financial performance. Corporate or individual borrowers may have specific objectives when choosing a hedging strategy. The goal may be to lock in a fixed interest rate, taking advantage of a favourable environment without considering interest rate risk; to match interest rate-sensitive assets and liabilities more effectively; to better diversify financial risks in a loan portfolio. Interest rate derivatives enable commercial banks to shield their lending policy against interest rate shocks; to better exploit lending opportunities arising from real shocks; and to make dividend distributions smoother. However, a note of caution may be sounded on the use of derivatives, as they can both increase or reduce the occurrence of bank defaults while exacerbating or mitigating the agency conflict between debt and equity claimants. This is because derivatives can be optimally used to achieve transfers between parties that are less associated with defaults to parties that are more associated with defaults, or vice versa.
Derivatives can either be traded on organised exchanges or negotiated privately between two parties like banks and corporate entities. Over-the-counter (OTC) trades allow parties to customise features of the derivatives to serve the specific needs of the users. Trading on OTC interest rate derivatives market is a common thing for the European countries as well as the United States. The interest rate contracts are today the largest segment in the global OTC derivatives market. The interest rate derivatives are less transacted in emerging markets compared to those in the larger, well-known markets. Derivatives activities pursued by dealers based in emerging countries focus mainly on the foreign exchange rate risk, and less on interest rate risk. Although it significantly expanded during the last decade (mainly in Asia), interest rate derivatives market in developing countries is still at a nascent stage. Some developing countries have undertaken a series of reforms to deepen the local bond market and create the necessary preconditions for the growth of derivatives market. In most of the developing countries, the main hindrance to the development of interest rate derivatives is still the lack of basic conditions. This includes inadequate measurement of interest rate risk exposure; underdevelopment of financial markets, especially of market instruments that cover underlying derivatives; weak and/or inadequate infrastructure and legal framework; misunderstanding and lack of experience in operations with financial derivatives; and the complexities of derivatives accounting.
Equity derivatives, interest rate derivatives, commodity derivatives, foreign exchange derivatives and credit derivatives are products available all over the world. Among all types of derivatives, interest rate derivative is regarded as the most popular product and accounts for the largest derivative market in the world. There are two ways of trading these derivative products - one is through OTC derivatives market and the other through recognised exchanges. In OTC, market, contracts are bilateral, and each party can have credit risk concerns with respect to the other party. The OTC derivatives market is significant in case of some asset classes like interest rate, foreign exchange, stocks, and commodities that allow parties to customise features to serve the specific needs of the users. The development of the interest rate derivatives has its roots in the mid-1970s, which passed through constant modification and development. Formal OTC interest rate hedging came into focus in early 1980s when IBM and the World Bank made the first formalised swap through currency transaction. The interest rate swap is basically a succession to the currency swap, and the currency swap was a successor to the back-to-back loan. Back-to-back loans were developed when exchange controls were in force in the United Kingdom in the 1970s, which in effect limited the access of residents and non-residents to each other's capital markets. The evolution of Forward Rate Agreement from the perspective of the currency in which they are denominated shows that the trend is almost the same as in the case of the evolution of global OTC interest rate derivatives market. Since its introduction in the early 1980s, interest rate swaps have become one of the most powerful and popular risk-management tools for banks and business entities. Banks, functioning as financial intermediaries, are natural users of interest rate swaps. They use swaps to hedge interest rate risks in their business operations as well as to meet the demands for swap transactions from their clients. Banks have emerged as the major players in the market for interest rate swaps.
Both investment and commercial banks have been active in arranging interest rate swaps. They earn fees by bringing different parties together and by acting as settlement agents who collect and pay the net difference in the interest payments and serve as guarantor of the agreement. Most intermediaries have gone beyond their initial role of merely bringing different parties together by actually functioning as dealers. In other words, each party has an agreement only with the intermediary, and is totally unaware of who might be on the other side of the swap. The intermediary actually sells one party a swap without having the opposite swap with someone else at that particular time. It holds the swap in inventory with the hope that another firm will later want a swap with the opposite party. This arrangement has facilitated the development of a secondary market in swaps - thereby increasing the liquidity of this instrument. The development of a secondary market, in turn, allowed the reversing, termination and general selling of existing swaps. Other variations on swaps began to develop at approximately the same time as variable/variable rate swaps based on different indexes.
Corporate entities may obtain benefits by using OTC derivatives offered by the banks. Interest rate risk can be problematic for corporate entities due to several reasons. Companies having floating or variable rate outstanding debts are exposed to increases in interest rates, whereas companies with borrowing costs that are totally or partly fixed are exposed to falls in interest rates. The reverse is true for companies having cash term deposits. Recently, publicly-funded universities have started using interest rate swaps. Universities have resorted to commercial borrowings for construction and renovation of residential and other buildings, as the share of public funding for universities has started shrinking over the past decade. Available reports indicate that most universities in Canada actually designate the swap as a hedging instrument to manage interest rate risk.
Dr. Shah Md. Ahsan Habib is Professor and Director (Training), Bangladesh Institute of Bank Management (BIBM). ahsan@bibm.org.bd.