Use of Interest Rate Swaps in hedging bond portfolio
1. A summer internship project on
Use of Interest Rate Swaps in
hedging bond portfolio
IFFCO Tokio General Insurance Co Ltd
Submitted in partial fulfillment of the requirements of
Post Graduate Diploma in Management ( Finance )
By
Name- Radhakrishnan V
Roll No. - 232/2014
LAL BAHADUR SHASTRI INSTITUTE OF MANAGEMENT,
DELHI
JUNE, 2015
2. PAGE 1
Acknowledgement
I would like to express my gratitude to all those who have been instrumental in the preparation
of my project report.
I am thankful to the organization IFFCO Tokio General Insurance Co Ltd for providing me the
opportunity to undertake this internship study and allowing me to carry out my project.
I am deeply grateful to my company guide and mentor, Mr. Samir Malik a, who guided me
to take this project and helped me bring it to conclusion. I am thankful to him for his continuous
support, advice and words of encouragement.
I extend my heartfelt gratitude to Mrs. Pragati Kakkar, Chief Manager – Training at IFFCO
Tokio General Insurance Co Ltd for her guidance and support throughout the internship which
helped to stay motivated.
I am also grateful to Prof. Anil Kanungo , my mentor from Lal Bahadur Shastri Institute of
Management for his guidance and for giving me an opportunity to word.
How can I forget my immediate family. ?My wife Nanditha willingly took over many house
hold responsibilities as I began to start my project work, I am thankful to her for
accommodating me. Lastly I wish to thank my family and my friends for their valuable support
and understanding
3. PAGE 2
Table of Contents
1. Executive Summary...............................................................................................................5
2. Introduction............................................................................................................................6
2.1 Profile of IFFCO Tokio GIC Ltd......................................................................................6
2.2 Introduction to the Project ................................................................................................6
2.3 Objectives of the project...................................................................................................7
3. Methodology..........................................................................................................................8
4. General Insurance Sector in India..........................................................................................9
5. Risk ......................................................................................................................................10
5.1 Types of Risk..................................................................................................................11
5.2 Risk in Insurance Sector.................................................................................................11
6. Fixed Income Securities in India .........................................................................................13
6.1 Types of Bonds...............................................................................................................13
6.2 Investing in Bonds..........................................................................................................16
6.3 Yield Curve.....................................................................................................................17
6.4 Price Sensitivity of a Bond to interest rates or YTM .....................................................17
6.5 Forecasting change in Bond prices using Duration & Convexity ..................................20
7. Investment Portfolio of IFFCO Tokio GIC .........................................................................21
8. Interest Rate Risk.................................................................................................................23
8.1 Factors affecting Interest Rate Fluctuations ...................................................................23
8.2 Recent Trends in Indian economy which affected Interest Rate & Yield of Bonds ......25
8.3 How to hedge Interest Rate Risk....................................................................................28
9. Interest Rate Swaps – Its use for IFFCO Tokio GIC...........................................................30
9.1 Interest Rate swaps & its application .............................................................................30
9.2 Application of 1 year Interest Rate Swaps for swapping interest rates.....................30
9.3 Application of 5 year Interest Rate Swaps for swapping interest rates.....................31
9.4 Hedge portfolio creation against 5 year 8.27% G-Sec 2020 for rising opportunity cost
of holding the bond...............................................................................................................32
4. PAGE 3
9.4.1 Hedging bond portfolio......................................................................................32
10. Findings and Interpretations ..............................................................................................34
11. Key Learnings from the project .........................................................................................34
12. Recommendations to IFFCO Tokio...................................................................................35
13. Limitations & future scope of study ..................................................................................36
14 Conclusion ..........................................................................................................................36
References................................................................................................................................37
Appendix..................................................................................................................................39
Appendix I: IFFCO Tokio GIC ............................................................................................39
Appendix II: Data used for analysis .....................................................................................42
Appendix III: IRDA Investment regulations, 2013..............................................................45
5. PAGE 4
Table of Figures
Figure 1 - Insurance Players in India .........................................................................................9
Figure 2 Insurance Penetration in India against GDP..............................................................10
Figure 3 Types of Risks...........................................................................................................11
Figure 4 Types of Financial Risks ...........................................................................................12
Figure 5 Yield Curve of Central Govt Benchmark Securities .................................................18
Figure 6 Yield Curve & Price - 10 Year Benchmark Bond.....................................................18
Figure 7 Convexity - Price - Yield Relation ............................................................................20
Figure 8 Investment Portfolio of IFFCO Tokio GIC...............................................................22
Figure 9 Bond Portfolio of IFFCO Tokio GIC ........................................................................22
Figure 10 Investment - Based on Residual Maturity ...............................................................23
Figure 11 Interest Rate Swaps .................................................................................................29
Figure 12 Market Share - General Insurance companies.........................................................40
Figure 13 Gross direct premium - product wise ......................................................................41
Figure 14 Profit Before Tax performance................................................................................41
List of Table
Table 1: Forecasting future price of a bond………………………………………………….21
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1. Executive Summary
When compared to life insurance and general insurance, the most importance difference is the
amount of liability a life insurance company has and for general insurer. In life insurance
business, premiums are collected for long term and for that reason, liability for a life insurance
would be for long term and in general insurer would be for short term. The main reason is their
policy expires in 1 year. GICs need more liquidity than a life insurance companies because of
claims that need to be settled with priority basis. The IRDA investment regulations for both
life insurance and general insurance are different. Their investment includes mutual funds,
fixed deposits, equity shares, corporate bonds, government bonds , housing bonds etc. As their
investment portfolio is very large, a small change in yield will have a large impact on their
profits.
General Insurance Companies (GICs) should invest minimum 20% in central government
securities or 30% in approved securities including both central government and state
government securities. Even though central government and state government securities do not
bear any default or credit risk, it is exposed to interest rate risk and reinvestment risk. This
study aims to analyse the interest rate risk in bonds and to know the situation when it will affect
the bonds adversely.
Interest rate risk in an investment portfolio can be mitigated by using the Interest Rate Swaps
(IRS). It can be used as a hedging instrument. In June 2014, the Insurance Regulatory and
Development Authority (IRDA) allowed insurers to invest in interest rate derivatives for
hedging against interest rate risks in their transactions.
This project tries to enlighten the uses of interest rate swaps in hedging bond portfolio and to
foresee the macro factors that leads to a change in Interest rates. This project also gives an idea
how change in interest rates will impact the value of the bond. If there is a change in 50 basis
points in interest rates, what will be the change in bond price and based on the analysis, it has
been found that price of a bond in near future can be projected using financial tools.
Using IRS general insurance companies can decrease their impact on bond portfolio and the
opportunity cost of holding the bond. In a market when interest rates are volatile, IRS helps to
hedge against the portfolio loss and opportunity cost. From this analysis it has been proven that
interest rate swaps will help IFFCO Tokio to mitigate the rising opportunity cost and loss in
market value of bond investments. Till FY 2014-15 IFFCO Tokio GIC have not used interest
rate derivatives to hedge against the interest rates. This project aims to suggest the company
whether IFFCO Tokio GIC will benefit from the use interest rate swaps in future.
7. PAGE 6
2. Introduction
2.1 Profile of IFFCO Tokio GIC Ltd
IFFCO-Tokio General Insurance was incorporated on 4th December 2000. It is a joint venture
between the Indian Farmers Fertilizer Co-operative (IFFCO) and its associates and
Tokio Marine and Nichido Fire Group, Japan. IFFCO Tokio is also the only insurance
company in the country to have a 100%-owned distribution channel to service its retail
customers called IFFCO-TOKIO Insurance Services Ltd (ITIS).
2.2 Introduction to the Project
Insurance companies are the largest investors in equity market, government bonds and other
fixed income securities etc. Their business is buying risks and to compensate the policy holder
to make good the loss. So when they are buying risks from the public, it is important for an
insurance company to manage the risk or the risk they are buying from the public would be
enough to engulf them which would lead to bankruptcy. So managing risk efficiently and
effectively is the primary function of a general insurance company in order to deliver maximum
profit to the shareholders.
Insurance Regulatory Development Authority controls the whole insurance sector in India.
General insurance and life insurance are two types of insurance and their asset liability
management is different from the one another. IRDA have separate investment regulations for
general insurers, life Insurers and reinsurers. Life insurers should invest minimum 50% in
Government and other approved securities but in case of general insurers they need to invest
only 30% in government and other approved securities because for general insurers liquidity
might be a problem. In case of life insurers their liability is long term in nature and in case of
non-life insurers, their liability would be short term. IRDA recently approved for 3 year motor
insurance policies, but it won’t have much impact because customer will always aim for short
term policies.
Where there is an investment there is risk. Even though central government and state
government securities do not bear any default or credit risk, they are exposed to interest rate
risk and reinvestment risk. This project aims to study the interest rate risk in bonds and to
know how it affects the bonds portfolio adversely. For example, there is an inverse relationship
between the interest rates and bond prices. When interest rates increases, bond prices will
decrease and it will give better reinvestment return. But in case of decrease in interest rates,
bond price will increase leading to a capital gain and also increased reinvestment risk.
8. PAGE 7
Insurance companies have large amount of corpus fund which increases daily which should be
invested with top priority. As their portfolio is thousands of crores, a small change in the
interest rates can impact their profit positively and negatively. The investment assets of IFFCO
Tokio GIC is worth Rs. 4368 crores and the present yield is 9.16% for the FY 2014-15.
There are different types of risk for insurance companies. Among them Interest rate risk, which
is a financial risk can be mitigated by using the Interest Rate Swaps (IRS) by using as a hedging
instrument. In June 2014, the Insurance Regulatory and Development Authority (IRDA)
allowed insurers to invest in interest rate derivatives for hedging against interest rate risks in
their transactions. IRS helps life insurance companies a lot to hedge the interest rate risk,
because their liabilities are long term in nature. Any change in interest rate will impact their
future value of investments. In case of non-life insurance companies, the importance of interest
rate risk is not very important compared to life insurance companies. But still IRDA have given
the permission to both life insurers and non-life insurers to use interest rate derivatives like
Interest rate swaps (IRS) and Forward rate agreements for hedging against changes in interest
rates in a highly volatile market like India where inflation changes a lot.
Insurance companies can protect their future earnings using IRS. The investment portfolio of
IFFCO Tokio is Rs. 4368 crores and Rs 2732 crores in Bond market and the return from the
bonds are constant for fixed rate bonds. So if interest rates increases, the value of bond portfolio
will decrease and at the same time interest or yield of the bonds in the portfolio will not change
based on the market fluctuations. So to increase the return based on market rates, interest rate
swaps can be used by swapping the fixed rate of interest with the floating rate of interests there
by it can decrease the effect of increase in an interest rate in the future. This project shows how
IRS helps to mitigate the Interest Rate Risk
2.3 Objectives of the project
The primary objective of the project is to create a hedge portfolio for the fixed rate bonds and
to recommend, whether IFFCO Tokio GIC should use interest rate swaps in future.
Secondary Objectives are:
To judge interest rates by daily observing the rates:
Observing macro factors that impacts on interest rates
Interest rate & Bond price relation
9. PAGE 8
3. Methodology
Research methodology is a way to systematically solve the research problem. It may be
understood as a science of studying how the research has to be done scientifically. The study
undertaken makes the evaluation of the bond investments by the company and to study how
interest rates impact bonds and to study the cause and effect relationship between them using
financial tools from fixed income securities and interest derivatives
Research
Research is a common parlance refers to search for knowledge. Research can be defined as as
a scientific and systematic search for pertinent information on a specified topic. Research
design is a frame work or plan for a study that guides the collection and analysis of the data. A
research design is the arrangement of conditions for collection and analysis of data in a manner
that aims to combine relevance to the research purpose with economy in procedure. The
research design can be broadly classified into 3 categories namely exploratory, descriptive and
experimental. The design used in the study was descriptive and exploratory research design.
Data collection
For this study the data was collected by means of primary & secondary sources. Primary data
was collected from Clearing Corporation of India website for live market quotes of bonds and
derivatives. Secondary data was collected through books, journals, websites, articles and
company brochure.
Data Analysis
Data analysis has been done using MS Excel. The transactions are studied on a daily basis with
the exceptions of days when market is closed. Every day data is recorded and plotted on MS
Excel. Data for research has been taken from live market quotes on a day with last quote on the
day.
Assumptions & Key points
This project is based on the assumption that all investments made by IFFCO Tokio
GIC in Government Bonds are in fixed rate bonds or conventional baonds. Details
of investments made by IFFCO Tokio GIC in bonds are not disclosed as per the
company norms.
Real time data has been taken for the data analysis. The price of bonds, Yield of the
bonds, interest rates swaps were available from Clearing Corporation of India
(CCIL) website which was instructed by the project mentor.
10. PAGE 9
Price of the bond, Yield Till Maturity, 1 Year fixed interest rate swaps quote, 5 Year
interest rate swaps quote are on the basis of last traded price of the day.
Interest rates & yield are terms which has been used in the project interchangeably.
Assuming there is no default or credit risk in Central government and state
government securities
Interest rate swaps do not bear any credit risk from the counter party
NSE Overnight MIBOR rate has been taken for calculating floating rate of interest.
4. General Insurance Sector in India
The insurance industry in India consists of 52 insurance companies of which 24 are in life
insurance business and 28 are non-life insurers. Among the life insurers, Life Insurance
Corporation (LIC) is the sole public sector company. In addition to these, there is sole national
re-insurer, namely, General Insurance Corporation of India. Apart from that, among the non-
life insurers there are six public sector insurers. In addition to these, there is sole national re-
insurer, namely, General Insurance Corporation of India. Other stakeholders in Indian
Insurance market include agents (individual and corporate), brokers, surveyors and third party
administrators servicing health insurance claims.
Figure 1 - Insurance Players in India
11. PAGE 10
The general insurance business in India is currently at Rs 84715 crore (2014-15) premium per
annum industry. The general insurance industry had plunged to single digit growth of 9.3 per
cent at Rs 84,715 crore in 2014-15 from Rs 77,540 crore in 2013-14. FY15 growth was the
lowest in past three years. The general insurance industry has set a target of crossing Rs 1
trillion mark (General Insurance Council) in annual premium income this fiscal, up from Rs
84,715 crore in 2014-15.
Non-life insurance penetration from year 2004 has been increased from .61% of the GDP in
year 2005 to .80% in 2014, reflecting the steady growth of the non-life insurance sector fuelled
by the growth in motor insurance sector and health insurance sector.
Figure 2 Insurance Penetration in India against GDP
Recently, The Insurance Laws (Amendment) Bill, which provides for raising the foreign
investment cap from 26 per cent to 49 per cent, was passed by the Lok Sabha and in Rajya
Sabha in March 2015. It will will give insurance players enhanced risk taking ability and to
decrease their reinsurance premium.
5. Risk
Risk in other word is uncertainty. Well in financial aspect, risk implies future uncertainty about
deviation from expected earnings or expected outcome. Risk measures the uncertainty that an
investor is willing to take to realize a gain from an investment. The greater the risk the greater
the return for the investor. An Indian central government bond is considered be one of the safest
12. PAGE 11
investments and, when compared to a corporate bond, it provides a lower rate of return. The
reason for this is that a corporation is much more likely to go bankrupt than the India
government. The risk of investing in a corporate bond is higher, so investors are offered a
higher rate of return and as a result, the higher the risk, the investor gets higher return. Risks
are of different types and originate from different situations. They are
Systematic Risks
Unsystematic Risks
5.1 Types of Risk
Systematic Risk
Systematic risks cannot be controlled by an organization and are macro in nature. These type
of risk occurs because of the external factors in an organization. It affects a large number of
organization operating under the similar stream or same domain. Some of the Systematic Risks
are Interest Rate risks, Market risks and inflationary risks. Interest rates, recession and wars all
represent sources of systematic risk because they affect the entire market and cannot be avoided
through diversification. Systematic risk can be mitigated only by being hedged.
Unsystematic Risk
Unsystematic risks are those which can be controlled by the organization are micro in nature.
These type of risk occur due to the internal factors of an organization. These factors are
controllable by the organization. To mitigate the impact of these risks, companies can take
necessary actions. Examples are business risks, credit risks etc.
5.2 Risk in Insurance Sector
Insurance companies are in the business of taking risks. The key risks in an insurance company
are
Figure 3 Types of Risks
13. PAGE 12
1. Financial Risk
Financial risk is the risk that as a result of market movements and economic changes in the
economy. A company may be exposed to fluctuations in the value of its assets, the amount of
its liabilities, or the income from its assets. Sources of this type of risk include movements in
interest rates, equities, exchange rates and real estate prices etc. This Summer Internship Project
is mainly based on Interest rate risks. Different types of financial risks are
Figure 4 Types of Financial Risks
− Interest Rate Risk
The risk that an investment's value will change due to a change in the absolute level of interest
rates is called interest Rate risk. So the fluctuation in interest rates will lead to increase or
decrease in the portfolio value. Reinvestment risk is a part of Interest rate risk. Reinvestment
risk is the chance that an investor will not be able to reinvest cash flows from an investment at
a rate equal to the investment's current rate of return.
− Liquidity Risk
Liquidity risk is the risk that a company may be unable to meet short term financial demands.
This usually occurs due to the inability to convert a security or asset to cash without a loss
of capital and/or income in the process. Liquidity risk generally arises when a company with
immediate cash needs, holds a valuable asset that it cannot trade or sell at market value due to
a lack of buyers, or due to an inefficient market where it is difficult to bring buyers and sellers
together.
− Real Estate Risk
The risk which results in change in real estate value is called real estate risk. Prices of land,
building etc. will change a lot based on the economic situation in a country.
14. PAGE 13
− Credit Risk
Credit risk is incurred whenever an insurance company is exposed to loss if counterparty fails
to perform its contractual obligations including failure to perform them in a timely manner.
Credit risk may therefore have an impact upon a company's ability to meet its valid claims as
they fall due.
− Equity Risk
The rise or fall in stock price is called equity risk. Equity risk, at its most basic and fundamental
level, is the financial risk involved in holding equity in a particular investment.
2. Operational Risk
The uncertainty arising from events caused by failures in people, process and technology as
well as external dependencies is called operational risk. The risk of loss resulting from
inadequate or failed internal procedures, people, and systems or from external events.
Examples of operational risk exposures are internal and external frauds, failure to comply with
employment law or meet workplace safety standards; damage to physical assets; business
disruptions etc.
3. Insurance Risk
The uncertainty due to differences between the actual and expected amounts of claims and
benefits payments and the cost of embedded options and guarantees related to insurance risks.
6. Fixed Income Securities in India
Securities are financial instruments that represent some value. A Fixed Income Security
represents a creditor relationship with a corporation, government, bank, etc. Generally debt
instruments represent agreements to receive certain cash flows depending on the terms
contained within the agreement which is known as the bond indenture. Fixed-income securities
are investments where the cash flows are according to a predetermined amount of interest,
normally paid on a fixed schedule or floating basis. The different types of fixed income
securities include government securities, corporate bonds, Treasury Bills etc. Their maturity
period ranges from 91 days to 30 years.
6.1 Types of Bonds
Based on Issuer there are mainly 3 types of bonds. They are
15. PAGE 14
Government Securities-
G-Secs are issued by the Reserve Bank of India on behalf of the Government of India. Normally
the dated Government Securities have a period of 1 year to 30 years. These are sovereign
instruments generally bearing a fixed interest rate with interest payable annually and principal
as per schedule. G-Secs provide risk free return to investors.
Treasury Bills:
Treasury Bills are short term borrowing instruments of the Government of India. RBI issues T-
Bills for three different maturities: 91 days, 182 days and 364 days.
Corporate Bonds-
Corporate Bonds are issued by public sector undertakings and private corporations, or in other
words entities other than government. Compared to government bonds, corporate bonds
generally have a higher risk of default. This risk depends, of course, upon the particular
corporation issuing the bond, the current market conditions, the industry in which it is operating
and the rating of the company. Corporate bond holders are compensated for this risk by
receiving a higher yield than government bonds.
− Based on Coupon
Fixed Rate Bonds: - They have a coupon that remains constant throughout the life of the bond.
Floating Rate Bonds: - Coupon rates are reset periodically based on benchmark rate like
MIBOR (Mumbai Interbank Offered Rate).
Zero-coupon Bonds: No coupons are paid. The bond is issued at a discount to its face value, at
which it will be redeemed. There are no intermittent payments of interest. Interest and principal
amount will be paid on the maturity date.
− Based on Option
Bond with call option: - This feature gives a bond issuer the right, but not the obligation, to
redeem his issue of bonds before the bond's maturity at predetermined price and date. It helps
the issuer against interest rate risk
Bond with put option: - This feature gives bondholders the right but not the obligation to sell
their bonds back to the issuer at a predetermined price and date. These bonds generally protect
investors from interest rate risk.
16. PAGE 15
− Based on redemption
Bonds with single redemption: - In this case principal amount of bond is paid at the time of
maturity only.
Amortizing Bonds: - A bond, in which payment made by the borrower over the life of the bond,
includes both interest and principal, and is called an amortizing bond.
Important Terms:
Yield on a security is the interest offered by a security over its life, given its current market
price. It generally indicates return on the investment.
Issue Price is the price at which the Bonds are issued to the investors. Issue price is mostly
same as Face Value in case of coupon bearing bond. In case of non-coupon bearing bond (zero
coupon bond), security is generally issued at discount.
Face Value (FV) is also known as the par value or principal value. Coupon (interest) is
calculated on the face value of bond. FV is the price of the bond, which is agreed by the issuer
to pay to the investor, excluding the interest amount, on the maturity date. Sometime issuer can
pay premium above the face value at the time of maturity.
Coupon / Interest is the cash flow that are offered by a particular security at fixed intervals /
predefined dates. The coupon expressed as a percentage of the face value of the security gives
the coupon rate.
Coupon Frequency means how regularly an issuer pays the coupon to holder. Bonds pay
interest monthly, quarterly, semi-annually or annually. For a Central Govt bond coupon
payment is annually.
Maturity date is a date in the future on which the investor's principal will be repaid. From that
date, the security ceases to exist.
Maturity / Redemption Value is the amount paid by issuer other than coupon payment is called
redemption value. If the redemption proceeds are more than the face value of the
bond/debentures, the debentures are redeemed at a premium. If one gets less than the face value,
then they are redeemed at a discount and if one gets the same as their face value, then they are
redeemed at par.
17. PAGE 16
MIBOR is an interest rate at which banks can borrow funds, in marketable size, from other
banks in the Indian interbank market. The Mumbai Interbank Offered Rate (MIBOR) is
calculated everyday by the National Stock Exchange of India (NSEIL) as a weighted average
of lending rates of a group of banks, on funds lent to first-class borrowers. The MIBOR was
launched on June 15, 1998 by the Committee for the Development of the Debt Market, as an
overnight rate. The NSEIL launched the 14-day MIBOR on November 10, 1998, and the one
month and three month MIBORs on December 1, 1998. MIBOR rates have been used as
benchmark rates for the majority of money market deals.
6.2 Investing in Bonds
The rate of return anticipated on a bond if held until the end of its lifetime is called Yield Till
maturity. YTM is considered a long-term bond yield expressed at an annual rate. The YTM
calculation takes into account the bond’s current market price, par value or face value, coupon
rate and time to maturity or residual maturity. It is also assumed that all coupon payments are
reinvested at the same rate. The longer the residual maturity of a bond, the higher would be the
YTM (depends upon the economy)
A fundamental principle of bond investing is that market interest rates and bond prices
generally move in opposite directions. When market interest rates rise, prices of fixed-rate
bonds fall. A bond’s yield to maturity shows how much an investor’s money will earn if the
bond is held until it matures. So when the interest rates increases, price of a bond decreases. So
if an investor do not want to hold the bond till maturity then he or she faces the risk of interest
rate because price of a bond will decrease when the interest rate increases. Then it would be
difficult for an investor to sell the bond at a profit. Investor cannot even recover the amount he
have invested in the bonds.
Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to
all bondholders. As interest rates rise, bond prices fall and vice versa. Usually Interest rate risks
affects mainly long term bonds than the short term bonds. If an investor holds a bond until
maturity, should be less concerned about these price fluctuations because the investor will
receive the par, or face value of the bond at maturity.
Interest rate risk is common to all fixed bonds which is known as plain vanilla bonds. A bond’s
maturity and coupon rate generally affect how much its price will change as a result of changes
in market interest rates. If two bonds offer different coupon rates while all of their other
characteristics like maturity and credibility are the same, the bond with the lower coupon rate
generally will experience a greater decrease in value or it will show more price volatility.
18. PAGE 17
Central, State Government & other Approved securities investment by
IFFCO Tokio GIC
As per IRDA regulations ( See Appendix III ), every general insurance companies shall invest
and at all times keep invested his investment assets in central government securities, (not less
than 20%) state government and other approved securities for not less than 30% of investment
assets which means that 30% of government bonds have fixed return. The investment portfolio
of IFFCO Tokio is Rs. 4368 crores and Rs 2732 crores invested in Bond market and Rs 1381
crore in fixed bonds
6.3 Yield Curve
Yield is a figure that shows the return on a bond. The yield curve is an important tool in fixed-
income investing. The yield curve is a line graph that plots the relationship between yields to
maturity and residual maturity for bonds of the same asset class and credit quality.
Although a bond’s coupon interest rate is usually fixed, the price of the bond fluctuates
continuously in response to changes in interest rates, as well as the supply and demand, time
to maturity, and credit quality of that particular bond. After bonds are issued, they generally
trade at premiums or discounts to their face values until they mature and return to full face
value. There are three different movements of yield curves.
Flattening of Yield Curve- When the yield curve flattens, it means that the gap between the
yields on short-term bonds and long-term bonds decreases, making the curve appear less steep
Inverted Yield Curves- On the rare occasions when a yield curve flattens to the point that short-
term rates are higher than long-term rates, the curve is said to be inverted
Steepening of Yield Curves-When the yield curve steepens, the gap between the yields on
short-term bonds and long-term bonds increases, making the curve appear steeper.
6.4 Price Sensitivity of a bond to interest rates or YTM
As discussed, yield and price of a bond are inversely related. When the price of a bond
increases, its yield to maturity (YTM) decreases. Interest rate sensitivity is a measure how
much the price of a fixed-income asset will fluctuate as a result of changes in the interest rate
environment. Bonds that are more sensitive will have greater price fluctuations than those with less
sensitivity. This type of sensitivity must be taken into account when selecting a bond. But it affects
both positively and negatively. For example, when interest rate decreases, price of bond will
increase which is positive and vice versa. The longer the maturity of a bond, the greater would be
the sensitivity. So bonds which have longer maturity will be more sensitive to interest rates.
19. PAGE 18
Figure 5 Yield Curve of Central Govt Benchmark Securities
Figure 6 Yield Curve & Price - 10 Year Benchmark Bond
7.0000
7.2000
7.4000
7.6000
7.8000
8.0000
8.2000
8.4000
2 Months 3 5 9 15 29
Yield
Residual Maturity in Years
Yield Curve of Benchmark Central Government Securities
as on 5th June 2015
13-Apr-15
5-Jun-15
101.5000
102.0000
102.5000
103.0000
103.5000
104.0000
104.5000
7.6000
7.6500
7.7000
7.7500
7.8000
7.8500
7.9000
7.9500
8.0000
8.0500
13-Apr-15
15-Apr-15
17-Apr-15
19-Apr-15
21-Apr-15
23-Apr-15
25-Apr-15
27-Apr-15
29-Apr-15
1-May-15
3-May-15
5-May-15
7-May-15
9-May-15
11-May-15
13-May-15
15-May-15
17-May-15
19-May-15
21-May-15
23-May-15
25-May-15
27-May-15
29-May-15
31-May-15
2-Jun-15
4-Jun-15
Yield
Date
Benchmark 10 Year Bond: 8.40% Govt Securiity
2024 - Yield Curve 13th April to 5th June 2015
Yield Bond Price
20. PAGE 19
Yield Curve Analysis ( See figure 5 & 6 )
From 13th
April to 5th
June 2015 yield of bonds has been increased to 25 basis points on an
average. But yield for short term bonds with 2 months residual maturity has been decreased to
30 basis points. Short term bond’s price decreases, when they move to the maturity date
because on the maturity of the bond, investor will receive only the face value of the bond.
Yield of Benchmark 10 year G-sec has also increased which means that price of the bond have
decreased. The yield change was mainly because of macro-economic factors and FIIs
involvement in Indian capital market. From the figure it can be clearly understood that yield
and price are inversely related.
Duration of a Bond
Duration is not simply a measure of time. Duration of a bond signals how much the price of a
bond investment is likely to fluctuate when there is an up or down movement in interest rates.
The higher the duration number, the more sensitive bond investment will be to changes in
interest rates. In developed countries like US & Europe, interest rates are hovering near historic
lows. Globally, interest rates are not likely to get much lower, as US has kept its interest rates
almost zero after the financial crisis in 2008. So in subsequent years if interest rates rises, as
mentioned by US fed reserve Chairman Janet Yellen, then bonds, particularly those with a low
coupon rate and high duration may experience significant price drops as interest rates rise along
the way.
− How Duration affects price of a Bond
Duration risk is the risk associated with the sensitivity of a bond’s price to a one percent change
in interest rates. Variables such as how much interest or coupon rate, a bond pays during its
lifespan as well as the bond’s call features and yield, play a role in the duration computation.
Maturity—the length of time before the bond’s principal is repaid—also plays a role. So if
duration of a Bond is 4, it means that a hundred basis point or 1% change in YTM will lead
into 4% change in the bond price. If interest increased to 1%, bond price will fall 4% and vice
versa. Duration only gives an approximate value of the change.
Modified Duration
Modified duration is calculated as duration divided by one plus the bond’s yield to maturity.
Modified duration provides an approximate percentage change in bond’s price for a 1% change
in YTM. This project is mainly based on central government securities which are option free
bonds and for option free bonds Modified duration will give the true picture of bond price
21. PAGE 20
relationship. However, because of the convexity of the price-yield relationship, the price
increase for a given decrease in yield, is larger than the price decrease when the yield increases
to the same basis points. So if something good happens like decrease in interest rates, a lot of
good happens and when something bad happens like increase in interest rates, the quantum of
decrease in price is lower than the increase in the bond price.
Convexity
Modified duration is a linear approximation of the relationship between yield and price and
that, because of the convexity of the true price-yield relation, duration based estimates of
bond’s full price for a given change in YTM will be increasingly different from actual prices.
Figure 7 Convexity - Price - Yield Relation
Convexity, which is a measure of the curvature of the changes in the price of a bond in relation
to changes in interest rates, is used to address this error. Basically, it measures the change in
duration as interest rates change. In general, the higher the coupon, the lower the convexity - a
5% bond is more sensitive to interest rate changes than a 10% bond.
6.5 Forecasting change in Bond prices using Duration & Convexity
Forecasting Price of 10year Bench mark Bond 8.40% G-Sec 2024 and 5 year
Benchmark Bond 8.27% G-Sec 2020
Based on Modified duration & convexity, a price of a bond can be projected depending
upon what will be the change in YTM of a bond.
Forecasting has been done using Modified Durations and Convexity
Starting date 13th
April 2015 and ending date 5th
June 2015
22. PAGE 21
Forecasting has been done for change in the yield which is 100 basis points and
forecasting for actual change in yield has also been done to know the true picture
of the forecast and future value of bond price.
Table 1: Forecasting future price of a bond
Analysis
Forecast shows true change in the bond price based on modified duration &
convexity.
So change in interest rates can be used to measure the change in price of a bond and
there by estimate future change in portfolio value.
Advanced methods has not been used like embedded options, modified convexity
etc. because of lack of experience in the subject
7. Investment Portfolio of IFFCO Tokio GIC
Total amount of investment by IFFCO Tokio is worth Rs 4368 crores as on 31st
March 2015.
Total investment in Bond market including Central government securities & state government
securities is is Rs 1381 crores, i.e. 32%. Minimum amount required by IRDA is 30% of total
investment to be invested in central government securities & state government securities.
IFFCO Tokio have invested more in corporate bonds which gives more return as compared to
the government bonds.
IRDA investment regulations do not requires a general insurer to hold the bonds till its maturity.
If the bond is held till its maturity, then there would not be any interest rate risks for the
company, because irrespective of the change in the interest rates, i.e. yield, the investor would
get the face value of the bond at its maturity. But in case of a liquidity problem or in case of
reconstruction of portfolio for better returns or when the problem arises of a reinvestment risk,
there are chances for disposing the bonds. So for protecting the future earnings, to avoid the
risk of increase in interest rates and opportunity cost of the investment in bonds, investors can
Description LTP LTYTM LTP LTYTM
Change
in Yield
M Duration Convexity
Convexity
Adjustment
for actual
change in
Yield
New
Price -
Actual
YTM
Change
Convexity
Adj for 1%
NewPrice if
yield
increased to
100 BPS
8.27% GS 2020 102.14 7.75 101.06 8.01 0.25 3.82 46.23 1.00 101.12 4.29 97.76
8.40% GS 2024 103.92 7.80 102.65 7.98 0.19 6.01 71.60 1.15 102.72 6.73 96.93
13th April 2015 5th June 2015
23. PAGE 22
use interest rate swaps as a hedging instrument against all the mentioned future uncertainties
in the market.
Figure 8 Investment Portfolio of IFFCO Tokio GIC
Exposure to Bond market for IFFCO Tokio is 62.54% of the total portfolio, i.e. Rs. 2732 crores.
50% of bonds are in corporate securities.
Figure 9 Bond Portfolio of IFFCO Tokio GIC
Main investment principle for IFFCO Tokio GIC is, they won’t sell bonds until there is a
liquidity issue and all bonds are held till maturity. As per the information available, under the
total investments, 36% of the investment have less than 1 year residual maturity, which means
21%
11%
28%
40%
Total Portfolio
Government Securities
State Government & other
approved securities
Housing Bonds, Infrastructure
Investments
Approved Investments
33%
17%
50%
Bond Portfolio of IFFCO Tokio GIC
Central Govt Securities State Govt Securities Corporate Securities
24. PAGE 23
Rs.1554 crores would be available in next year for reinvestment. Investment in bonds would
be disposed only on rarest of rare cases. Only 12% of the bonds have residual maturity with
more than 10 years, as a result, long term bond holdings are very low.
Figure 10 Investment - Based on Residual Maturity
8. Interest Rate Risk
8.1 Factors affecting Interest Rate Fluctuations
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, RBI exert influence over both inflation and exchange rates, and change in interest rates
impacts inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries.
In India, RBI takes the decision to increase or decrease the interest rates during the bi-monthly
monetary policy. The governor of RBI takes decision by evaluating numerous factors because
a higher interest rate should not cost the country, higher growth. So RBI have to take decision
without impacting the growth of the economy. The main factors that affects Interest rate
decision of RBI are
36%
16%
22%
14%
12%
Residual Maturity
Upto 1 year 1 Year - 3 Years More than 3 Years - 7 years
More than 7 Years - 10 years More than 10 Years
25. PAGE 24
1. Government borrowing and fiscal deficit
Since the government is the biggest borrower in the debt market, the level of borrowing also
determines the interest rates. On the other hand, supply of money is controlled by the central
bank by either printing more notes or through its Open Market Operations. A higher fiscal
deficit will lead to higher spending by the government which leads to higher interest rates
2. Inflation
All the macro factors lead to a change in an inflation and the change in inflation leads to change
in interest rate by the RBI. When there is a higher inflation, lenders and investors will expect
higher returns from their money. So RBI do not have a choice other than to increase the interest
rates in order to compensate the reduced purchasing power of the people. In the previous
financial year, Crude oil prices were very low and because of that inflation reduced, and it is
the main reason RBI had reduced the interest rates in the past 6 months. But crude oil prices
are not the only factor which leads to change in inflation. Global commodity prices, food prices,
wholesale products all leads to change in the inflation. RBI mainly uses Consumer Price Index
to measure the inflation
3. Stock Market Conditions
Companies meet their needs of funds through equity expansions in the stock markets or
borrowings from banks or from debt markets. Bullish trends in the stock markets prompt
companies to go in for the equity expansion route. For example the present condition in equity
market is good for equity expansion because market is bullish, so companies can raise funds
through equity market. This reduces the demand for funds through borrowing. On the other
hand, a sluggish stock market condition like the 2008 financial crisis, prompts companies to go
in for the borrowing route, and thus increases the demand for funds.
4. International borrowings & global liquidity
With the increasing globalization over last few years, the economic conditions of international
markets have also started playing an important role in deciding the interest rate direction. The
global economic conditions influence the lending pattern of foreign investors to domestic
companies, and thus compete with domestic sources of funds in the market. If the liquidity in
global market is high then there probability of decreasing the interest rates by RBI is very high.
5. Foreign Exchange
When rupee is depreciating, interest rates will fall. When interest rates are low, aggregate
demand in the economy will pick up and as a result exports will decrease. So when there is a
26. PAGE 25
fall in interest rates, it will affect foreign exchange of a country. RBI is trying to increase the
forex reserves for keeping the rupee from further appreciating.
8.2 Recent Trends in Indian economy which affected Interest Rate & Yield of
Bonds
Even though the interest rates are affected by the above given factors, the recent macro-
economic factors that affected the Indian economy are discussed below. These factors resulted
in an increase in bond yield of Indian Govt bonds and decrease in interest rates by RBI
a. REER
The RBI’s REER that measures the currency’s competitive value against a basket of 36
currencies was 113.23 in March, which means the rupee has to depreciate by at least 13% for
Indian exports to be competitive. REER was 111.7 at the end of April. With the Real Effective
Exchange Rate (REER) showing that the Indian rupee is overvalued by 13% as of March, and
11% as of April, the Reserve Bank of India could potentially buy a record amount of dollars
for the second year in a row to keep the country’s products competitive compared with other
emerging market economies. This metric could also be giving the central bank the room to buy
dollars. So RBI will not allow Rupee to appreciate further because it will make the Rupee
overvaluation in the international market which will impact export competitiveness of the
country. So for further depreciating of rupee, RBI will adjust the interest rate and also will
create more forex reserves. RBI cannot allow Rupee to depreciate a lot, because it will affect
inflation, fiscal deficit and current account deficit which is detrimental for the economic growth
of the country.
b. Rising US bonds yield and fall in bond prices
The bond yields in developed markets are too low—a consequence of years of easy liquidity
provided by global central banks. The result was a wide spread consensus that bonds are
overvalued. The upward movement in US yields began a couple of months ago but accelerated
in mid-April. Since 20 April, the US 10year treasury yield has gone from 1.88% to 2.24% the
highest in nearly two months. The main reason behind is expectation that the US Fed will start
raising rates this year, the substantial rebound in oil prices etc.
For India, the rising global yields have come at a time when the equity markets were already
under pressure from foreign investor selling. Indian equity markets have shown an inverse
correlation with US treasury yields. In the Indian bond markets, yields have risen by about 25
basis points since end April.
27. PAGE 26
c. Slow implementation of reforms.
Indian benchmark Index BSE Sensex had been the best performer in the year 2014 but the same
has not been happened for the year 2015. In this year the Narendra Modi led BJP government
is struggling to implement the reforms and promises offered by them. Investors are of the
opinion that nothing has been changed at the ground level. While almost all are overweight on
Indian equities, there are room for concerns that nothing has been really changing on the
ground. The FIIs will continue to buy stocks where they feel the fundamentals remain solid
and where they see value.
After the success of NDA government, they are now facing to implement the reforms like FDI
in Insurance, GST, Land Acquisition bill etc. because of minority in Upper house of parliament.
Since Indian markets have corrected a fair bit from their peak levels, whether to withdraw from
India or look to redeploy cash here is a difficult decision for FIIs.
d. Greek Crisis
Leaving the euro would make Greece a pariah in international markets, enforce a devaluation
of their currency that probably would require capital controls and make banks fresh targets.
The economy would probably contract again and the government would be pushed off the
deleveraging and deregulatory policies that euro membership demands and which, while
painful, have begun to bear some fruit.
India with its exports geared to the EU markets is already affected by slack demand from the
Eurozone countries and it will further worsen when Greek will exit from Euro zone. Moreover,
crisis in Greek would trigger another crisis in Europe which will affect Indian market adversely
resulting into outflow from Indian equity and bond market.
e. Increase in crude oil prices
Crude price was trading below the $50 in April and now it is around $65, which means 40 per
cent jump in crude oil prices. Crude oil prices play a very significant role on the economy of
any country. India’s growth story hovers around the import of oil, as India imports 70% of its
crude requirements. Any negative change in the crude oil price has an immediate positive
impact on the increment in the GDP, CAD, Fiscal deficit and IIP. A one-dollar fall in the price
of oil saves the country about 40 billion rupees. That has a three-fold effect spread across the
economy. The fall in international oil prices will reduce subsidies that help sustain the domestic
prices of oil products. The increase in crude oil prices will lead to inflation which will lead to
increase in interest rates. So increase in crude oil price will have a negative impact over India.
28. PAGE 27
f. The possibility of a rate increase by the US Federal Reserve
When the next Federal Reserve meeting is expected to bring interest rate cuts or increases, it is
wise to be aware of the potential effects behind such decisions. Although the relationship
between interest rates and the stock market is fairly indirect, the two tend to move in opposite
directions. A hike in the US rates reduces the interest rate differential between the US and
India, thereby, making it less appealing to foreign investors, in turn triggering dollar outflows.
It could also potentially make difficult for the Reserve Bank of India to cut the repo rate. With
the Fed now expected to hold on to ultra-low rates for some more time, RBI has got more room
to consider cutting interest rates as the threat of dollar outflows has reduced.
The Federal Reserve has kept its key short-term rate near zero since late 2008 to bolster the
economy after a devastating financial crisis and recession. A rate hike would ripple through the
economy and could slow borrowing and possibly squeeze stocks and bonds. A complicating
factor is a surging U.S. dollar, which is helping keep inflation excessively low and posing a
threat to U.S. corporate profits and possibly to the economy. A rate increase could send the
dollar even higher.
US Fed Reserve Chairman Janet Yellen has said that unless there is significant improvement
in the job market there won’t be any increase in interest rates. Still inflation and personal
consumption expenditure has not met the target. US fed Reserve targets an inflation of 2% and
it is still below 1.50 % which means that a sudden cut in interest rates is impossible. But she
also mentioned that Fed will raise interest rates by the end of this year. A rise in interest rates
cannot be ruled out which will impact emerging market adversely.
g. MAT on foreign portfolio investors
Overseas investors have poured in over $2.3 billion in the Indian capital markets in April,
taking total inflows to $15 billion since January. But, the pace of investment by overseas
investors has slowed down in April compared to the previous three months on apprehensions
that government will impose a 20 per cent minimum alternate tax (MAT) on profits earned by
them.
The Income Tax department has sent notices to 68 foreign investors for payment of dues
totaling Rs 602.83 towards MAT. Investors are now planning to move court against the
department contending that the tax does not apply to them. During budget presentation, Jaitley
clarified that capital gains "which are liable to tax at a lower rate, shall not be subject to MAT.
Jaitley, however, did not clarify that whether this would apply retrospectively and the I-T
29. PAGE 28
department has taken a view that the finance minister's clarification doesn't apply to earlier
years.
If MAT is levied on FPIs/FIIs for the past years on the basis that the amendment, which is not
clarified, it will be a huge disappointment for FIIs. Another risk is that once the authorities
decide to levy MAT, they would also want to charge MAT for the past years by issuing a notice
for reassessment. Finance Minister Arun Jaitley has recently announced that a high-level
committee will look into the controversial issue of payment of Minimum Alternate Tax (MAT)
by FIIs and until this issue is resolved, FIIs will think twice before investing.
h. Government achieving fiscal deficit target
A lower fiscal deficit means reduced government borrowings and it would help the central bank
to reduce the interest rates. For the FY 2014-15 fiscal deficit have been achieved by Central
government above the target. Finance Minister has targeted Fiscal deficit for 2015-16 at 3.9%
of GDP and proposed to lower it to 3% by 2017-18 by using Fiscal Responsibility and Budget
Management Act, 2003. So it gives more room decrease in interest rates
i. Current Account Deficit
Changes in the interest rates have an impact on CAD through real demand for money. The
demand for real money reduces due to the fact that the rise in the interest rates would increase
the cost of keeping the money. Also, increased interest rate encourages foreign capital inflows
as well but not beyond a certain limit. So in India if CAD increases, government will try to
increase the interest rates. India's current account deficit narrowed to 0.2 per cent of gross
domestic product in the January-March quarter. For the FY 2014-15 Current account deficit
has been narrowed 1.3% of GDP which has come down significantly. So if CAD decreases
continuously it will give more room for decrease in interest rates.
8.3 How to hedge Interest Rate Risk
All these macro factors which have been discussed are not under control of a company or even
the government. Every business is subject to the risk of change in interest rates, and these
changes are unpredictable. However, it is possible to mitigate the effects of interest rate risks
by using hedging instruments. The only choice left for the investors is to hedge the interest
rate risk by using Interest Rate Swaps (IRS).
Swaps are generally liability based exchange of interest payments on debt obligations or asset
based exchange of interest income stream on assets. Swaps are among the most versatile of all
financial instruments. All swaps are based on one central principle, one participant exchanging
30. PAGE 29
an advantage available to another participant in a different credit market. The advantage is
reduced costs or greater availability of funds. Swaps enable borrowers to tap markets where
they can obtain the best relative terms and then swap obligations to obtain the desired interest
rate structure.
The interest rate swap is a derivative interest instrument in which both parties agree to make
interest payments at fixed dates in the future. Here one party pays the other a fixed interest rate,
while the other party makes interest payments in line with the future interest rates, i.e. at a
floating rate of interest. The floating rate quoted is generally MIBOR in case of Indian market
and LIBOR (London Interbank offered rate) for other markets. The interest rate swap can be
used for mainly used for the management of large asset portfolios like loans, bonds etc. The
only risk in hedging is limited to the interest rate difference, as capital is not exchanged. In
IRS, what one party gains, the other party loses.
Cash flow in IRS
Because the notional principal swapped is the same for both counterparties and is in
same currency units, there is no need to actually exchange the cash. Notional principal
is generally not swapped in single currency swaps.
The difference between the fixed rate payment and variable rate of payment is
calculated and paid to the appropriate counterparty. Net interest is paid by the one who
owes it.
Figure 11 Interest Rate Swaps
31. PAGE 30
9. Interest Rate Swaps – Its use for IFFCO Tokio GIC
9.1 Interest Rate swaps & its application
Total investment in fixed rate bonds is Rs 1381 crores and the average yield from these bonds
is 8.18% in an year which is lower than the average yield of 9.16% from total investment of
Rs.4368 crores. The return from bonds are fixed and what happens when interest rate increases.
It will affect both opportunity cost of holding the investment with less interest rates because
market interest are more than the interest IFFCO Tokio gets from the fixed rate bonds. It will
lead into higher opportunity cost because when interest rates increases, bonds cannot be
disposed. It will lead into capital loss as both interest rates and bond prices are inversely related.
So the risk when interest rates or yield increases are
Increase in the opportunity cost of holding the bond
Decrease in the portfolio value of bonds
To hedge the market for the above risk, interest rate swaps are used. Application of interest rate
swaps will show how it mitigates the risk of interest rates.
9.2 Application of 1 year Interest Rate Swaps for swapping interest rates
MIBOR is the benchmark floating rate used in this IRS. Overnight MIBOR rates are taken from
the NSE and IRS from CCIL. 1 Year IRS has been used when interest rates are showing
decreasing trend.
Assumptions:
1 Year fixed interest rate swaps, by paying floating rate of interest and receiving fixed
rate of Interest
Last quote on 10th
April 2015 has been taken to calculate IRS for receiving the interest
payments which would be constant throughout the year.
Notional Principal is Rs 10 crores
Paying Floating rate of interest from 10th
April onwards with MIBOR 7.47% and
receiving 1 Year IRS @ 7.575% for 1 year swap trade on a notional principal of Rs. 10
Crores
Brokerage or trading charge is nil.
Analysis: based on trade between 10th
April 2015 and 5th
June 2015
Initially MIBOR between 7.55% and 7.80% and resulted into loss till may end, and
profit from 2nd
June because RBI decreased Repo rate from 7.50% to 7.25%, which
32. PAGE 31
means a decrease in 25 basis points has been impacted on MIBOR rates which resulted
into decreased floating interest payments.
Loss of Rs 9270 in receiving fixed 1 year swap till 5th
June 2015 because MIBOR was
higher than IRS. The impact of a rate cut on MIBOR was more than 25 basis points.
In a deflationary economy go for Fixed 1 year swap – pay floating rate of interest and
receive fixed IRS. When MIBOR goes down interest payment will decrease but investor
will get fixed payment.
9.3 Application of 5 year Interest Rate Swaps for swapping interest rates
MIBOR is the benchmark floating rate used in this IRS. Overnight MIBOR rates are taken from
the NSE and IRS from CCIL.
Assumptions:
5 Year fixed interest rate swaps, by receiving floating rate of interest and paying fixed rate
of Interest
Last quote on 10th
April 2015 has been taken to calculate IRS for paying the interest
payments which would be constant for next 5 years.
Notional Principal: Rs 10 crores
Paying fixed rate of interest from 10th
April onwards 5 Years IRS @ 7.575% for 5 year
swap trade and receiving with MIBOR 7.47% on a notional principal of Rs. 10 Crores
Brokerage or trading charge is nil.
Analysis: based on trade between 10th
April 2015 and 5th
June 2015
Profit of Rs 78763 in paying Fixed 5 year swap till 5th
June 2015
If MIBOR decreases more than 40 basis points, will lead to a loss and if MIBOR increases
(floating) will lead to a huge profit.
In the initial stage, MIBOR was high resulted into profit and then it decreased resulting
into decreased profit.
The decrease in MIBOR was mainly because of RBI monetary policy on June 2nd
2015.
The decrease in Repo rate was 25 basis points but the impact on MIBOR was more than
25 basis points. Overnight MIBOR decreased from 7.60% on 2nd
June 2015 to 7.23% on
3rd
June 2015.
Fixed 5 year IRS for paying fixed rate of interest can be used to hedge against 5 year Bonds
held in the portfolio, which gives constant rate return.
33. PAGE 32
9.4 Hedge portfolio creation against 5 year 8.27% G-Sec 2020 for rising
opportunity cost of holding the bond
Whenever a fund has been lying idle, it incurs an opportunity cost. So if funds are not utilized,
companies will lose interest payments, thereby decreasing their profitability drastically
particularly for insurance companies. Insurance companies have current accounts with their
banks which do not yield any return because it is a current account. So a single penny in the
account won’t give any return.
Hedge portfolio is based on the assumption that every investment has an opportunity cost for
holding the fund in a particular security or instrument. For example if Rs 1 crore has been
invested in fixed deposit today for 1 year which gives 8.5% interest. There is a corporate bond
available with AAA rating which yields 9% interest per annum. Here for holding the fixed
deposit, opportunity cost is higher because of bond available with greater return. This hedge
portfolio is for protecting the return from the bond investment. If an opportunity cost of a bond
increases, simultaneously this hedge portfolio will make sure that returns from the bond market
are not affected.
9.4.1 Hedging bond portfolio.
Notional Principal: Rs 10 crores for IRS trade
Assuming Rs 10 crores has been invested in 5 Years residual maturity, Benchmark security
8.27% GS 2020 with yield of 7.7541 %
IRS swapping with paying Fixed 5 year Swap. Pay 5 years IRS @ 7.12% as on 13th
April
2015
Receive floating (MIBOR) interest for 5 year starting from 13th
April with MIBOR as
7.53% with compounding interest on daily closing balance.
Opportunity cost for IFFCO Tokio is ranging between 7% & 8% which is calculated on
daily closing balance. The opportunity cost is based on call money market rates for holding
5 year Bond which changes daily.
Analysis
By paying 5 year Interest Rate Swaps which is 7.12% and receiving bond yield of
7.75%, 0.63% return of the investment is protected for next 5 year.
The correlation between the MIBOR and funding cost is 0.78, which means that both
MIBOR & funding cost are related.
34. PAGE 33
If funding cost or opportunity cost increases, investor will receive MIBOR which will
increase or decrease based on opportunity cost. So the net effect is that it will get
cancelled each other resulting into a minor profit or loss.
Profit of Rs 14,536 by receiving MIBOR and funding cost
If IRS is not used:
o If the funding cost increases, it will lead into negative return from the portfolio
because Bond yield is constant
IRS Used: Benefit
o If the funding cost increases, MIBOR will also increase, resulting into offsetting
of the transaction because both are on floating basis which is correlated to
market rates in the economy and as result 0.63% of yield from bond will be
protected.
Use of IRS: Impact
Yield 0.63% - Rs 92074/-protected from rising interest rates.
Total profit from swap trade is Rs 84029/-
If interest rate rises or decreases, IFFCO Tokio GIC will receive constant return from
hedge portfolio which eliminates market fluctuation.
35. PAGE 34
10. Findings and Interpretations
Interest Rate Swaps will help to mitigate interest rate risk in bonds in an inflationary or
deflationary economy. Based on the market situation offsetting transactions can be done
between paying and receiving floating interest rates.
IRS can be used when inflation is volatile. IRS helps to protect the return from market
fluctuations
IRS protects return from Fixed income
Interest Rate Swaps can be used in Life Insurance segment, where there is future
liabilities like Pension & Annuity.
IRS can be used if company have floating liabilities or fixed liabilities to decrease the
risk
Higher coupon payments leads to low interest rate risk.
Based on duration and convexity of a bond, future price of a bond can be estimated. So
change in portfolio value can be forecasted for the change in YTM, say 50 basis points
or 25 basis points
Liquidity is very important for a general insurer compared to life insurer.
11. Key Learnings from the project
Importance of Bond market in insurance sector and for the government in raising funds
Difference between types of bonds and risks associated with bonds
Sensitivity of bonds to global factors and interest rates
Investment regulations laid by IRDA for general insurance companies
Monetary policy of RBI and its impact on interest rates and Indian economy
Global factors that impact interest rates and growth of Indian economy
Impact of interest rates in YTM is not significant. Interest rate swaps and yield till
maturity is affected by a lot of economic factors. Among them only major one is RBI
monetary policy but other macro-economic factors make the yield and interest rates
move
Positive correlation between international bonds and Indian Government bonds.
Inverse relationship between Indian Equity market and yield of the bond.
How insurance companies manage their funds efficiently and effectively from the
premium they receive.
How to behave and work like a professional
36. PAGE 35
12. Recommendations to IFFCO Tokio
To use interest rate swaps for Central Government Securities that have RM for more
than 3 year.
On a short term basis, use fixed 1 year IRS to receive the payment and for paying on
floating basis because in short term, interest rates & MIBOR are not going to change a
lot.
For short term, Inflation is expected to rise and settle down after 3 years. Use IRS to
exchange fixed payments from bonds for receiving floating MIBOR for 5 year basis.
To invest in high duration and high convexity, long term bonds to make use of market
fluctuations to make profit. For long term, inflation is expected to come down, which
results into increase in capital gain. As bonds are held till maturity, even if there is an
interest rate hike, it won’t affect the portfolio.
On a long term basis, inflation will settle down around 4 – 6%, so recommends to buy
long term fixed rate bonds with high yield.
37. PAGE 36
13. Limitations & future scope of study
Limitation to the project include and not limited to :
Limited time scope
Lack of experience in understanding the market and its macroeconomic factors
Availability of data for such a short period of time
The lack of existing literature.
Best efforts were made to consider all important variables of the study. Chances of
some of the variable not appearing in the study are also there.
Keeping the confidentiality of some of the data provided by IFFCO Tokio has been another
limitation for the project. Different type of investments held by the company is not
disclosed as per the company norms. So the real risk for the company cannot be detected
without knowing type of instrument and its yield.
Annual report for the FY 2014-15 is not available.
Future scope of study
The future scope of the project includes and not limited to:
The project can be further improved by using forward rate agreements which has not
been used in general insurance sector. IRDA allowed general insurers to use FRA also
but not used in this project because of lack of understanding the concepts
The project can be used to minimize interest rate risk on investments like bonds,
liabilities, future income like premium due to receive etc.
If combined with other interest derivatives, this project can help to hedge other risks
associated to Indian economy.
14 Conclusion
Insurance companies can improve their risk management by implementing framework based
approach and governance structure in the company so that risks associated with interest rates
fluctuations are assessed, understood and controlled. IFFCO Tokio GIC have not used interest rate
derivatives till date. By applying interest derivatives, they can mitigate the interest rate risk and
reinvestment risk in their investments they hold. The major concern for them is increase in
opportunity cost of holding an investment because bonds are held till maturity. So for long term
management of assets and liabilities, insurance companies can use interest rate derivatives.
38. PAGE 37
References
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“Fixed Income, Derivatives & Alternative Investments”, 2013, Kaplan Inc,
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Websites
www.iffcotokio.co.in
www.ccilindia.com
www.nseindia.com
www.actuariesindia.org
www.ibef.org
www.livemint.com
www.financialexpress.com
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40. PAGE 39
Appendix
Appendix I: IFFCO Tokio GIC
IFFCO-Tokio General Insurance was incorporated on 4th December 2000 with a vision of
being industry leader by building customer satisfaction through fairness, transparency, and
quick response. It is a joint venture between the Indian Farmers Fertilizer Co-operative
(IFFCO) and its associates and Tokio Marine and Nichido Fire Group, Japan. IFFCO Tokio is
also the only insurance company in the country to have a 100%-owned distribution channel to
service its retail customers called IFFCO-TOKIO Insurance Services Ltd (ITIS).
IFFCO-Tokio Insurance Services Limited (ITIS) is a wholly owned subsidiary and a retail
marketing arm of IFFCO Tokio General Insurance. It was incorporated on 1st August 2003.
Developing of retail and personal lines has been the major focus of the company along with
spreading into Tier II & III towns and developing co-operative initiatives for IFFCO Tokio.
Indian Farmers Fertiliser Cooperative Limited (IFFCO) is the world's largest fertilizer
manufacturer & marketer in cooperative sector. It was incorporated on 3rd November, 1967.
Its prime role is to provide quality fertilizer and agricultural services to India's farming
community. IFFCO holds 72.64% shareholding and its Associate M/s Indian Potash Ltd. holds
1.36% shareholding in IFFCO-Tokio General Insurance.
TOKIO Marine Asia Pte. Ltd holds 26% shareholding in IFFCO Tokio General Insurance.
TOKIO Marine Asia is a subsidiary company of Millea Holding Inc Japan; a holding company
for Tokio Marine & Nichido Fire Insurance Company
Management Team:
Managing Director & CEO: Mr. Yogesh Lohiya
Directors: Mr. H.O. Suri (Marketing), Mr. Hiroshi Yasui (Operation)
Chief Operating Officer: Mr. Ichiro Maeda,
Financial Advisors: Mr. M. K. Tandon, Mr. Harbhajan Singh
Executive Vice President: Mr. K. K. Aggarwal, Mr. R. Kannan, Mr. Parag Gupta, Mr. Sanjay
Seth, Mr. Sanjeev Chopra, Mr. Sumesh Mahendra, Mr. B. Ravindra, Mr. Ramesh Kumar, Mr.
Abhay Kumar, Mr. V. Rajaraman, Mr. Gunasekhar Boga, Mr. Abhijit Chatterjee
Corporate Office: IFFCO Tower, Plot No. 3, Sector 29, Gurgaon -122001, Haryana(India)
41. PAGE 40
Products:
IFFCO Tokio introduced Crime insurance in FY 2014-15. However it is pending for approval
from IRDA. Other products offered are Fire Insurance, Motor Insurance, Health Insurance,
Cargo Insurance, Marine Insurance, Aviation Insurance, Engineering Insurance, Workmen’s
Compensation Insurance and Personal Accident Insurance.
Market Share:
Market share of IFFCO Tokio is 4% among the total general insurance industry and 9.5%
among the private insurers.
Figure 12 Market Share - General Insurance companies
Source: www.ibef.org
Investments
The Total Investments of the Company as at 31March, 2015 increased to Rs 4368 crores from
Rs. 3576.06 crores in 2013-14 FY and Rs`3117.44 Crores in FY 2012-13
Financial Performance:
Despite tough economic and market conditions, the Company recorded a Gross Direct
premium income of Rs 3330 crores in FY 2014-15 compared to Rs. 2,930 Crores in FY 2013-
14. But profit for this financial year has been decreased even though there was an increase in
premium income because.
