Month: September 2022

Every business starts with a small venture and grows gradually along with power in the business. And with great power comes great responsibilities. As the business grows, demands from the customer increases, retailers tend to seek temporary systems and management for each hurdle that comes along the way, but down the line, they start to act more like a burden than a useful resource.

Retailing software or retail shop software as an integrated platform as a total management system, designed to handle all the aspects of your business is the best solution so far. On daily basis, you have a deal with sales, receipts, transactions, returns, supply chain management, stocks, inventories, customer management system and many other things, and imagining a system which can handle everything at one place is itself a miracle.

Three systems are crucial to the efficiency of retail businesses and restaurants:

• Point of Sale (POS)
• Payroll
• Human Resources

The developing and developed businesses have converted their retail software into retail management as a platform to improvise retailing along with other actions that are needed to be performed. Here’s why:

No more multi-headaches: You get to have more time to attend to your business rather than working yourself on management issues and responsibilities. It directly kills the IT maintenance issues and integration and deployability charges.

Everything on one thing: You can see real-time values of assets, sales, stocks and many other details from anywhere on a single platform in billing software for a retail shop. It helps you keep the track of what is getting purchased from your retail shop.

Paved and Polished streamlined transaction: Immediate access to prices, customer profiles and discounts creates a way to have faster checkouts and proper history of transaction made at by the customer to the cashier, decreasing waiting time of the customer.

Extensive and expandable: Customized retail POS software is the true nature for business platforms as a software. You can easily deploy new systems to new locations anywhere inside your shop or shops to be specific. Along with this, you can add any new application to your system as per your need.

Interconnected networks and smooth operations: No your all departments can have a direct view of what’s the status and can become more cooperative having a harmonized flow of events in your business.

Efficient and smart: Business is now crucially dependent on data. An integrated platform not only collects accurate data but also manages and filters it to provide anything you need, like reports of sales to inventory, while showing effects of each department on other.

Inventory at it’s best: The most important thing a retail shop is based and valued upon is its inventory. An IRMS platform will provide better details about your stock along with suggesting and notifying what to be ordered according to the sales being made.

Customers’ happiness: Faster, adaptability to advanced Payment and streamlined processing of billing will satisfy the one who is the fate of your business, your customer and his experience.

The ambassador of promotions: Discounts and gifts specific to the customer based on their profile history, new schemes for festivities, promotions etc can be planned and predicted by the software system itself, based on a variety of reports, analysed and displayed on a user interface screen with advanced features.

Your world on your fingertip: If you are a multi-channel retailer, you can have your website, e-commerce platform, orders etc on a single application along with providing you with an important asset, data of customers, which can be used for analysis of pros and cons of deployment of changes in your retailing business.

Retail communications are the internal communications between a retailer’s corporate management team, field and store employees on what tasks to perform.

Communication is an integral part of the retailer’s marketing strategy. Primarily, communication is used to inform the customers about the retailer, the merchandise and the services. It also serves as a tool for building the store image. Retail communication has moved on from the time when the retailer alone communicated with the consumers. Today, consumers can communicate or reach the organizations. Examples of this include toll free numbers, which retailers provide for customer complaints and queries. Another example is the section called Contact Us on the websites of many companies.

It is believed that every brand contact delivers an impression that can strengthen or weaken the customer view of the company. The retailer can use various platforms / channels for communication. The most common tools are:

1) Advertising

2) Sales Promotion

3) Public Relations

4) Personal Selling

5) Direct Marketing

Advertising can be defined as any paid form of non-personal presentation and communication through mass media. It is popularly believed that one of the main aims of advertising is to sell to a wide mix of consumers and also to induce repeat purchases. However, a retailer may use advertising to achieve any of the following objectives:

1) Creating awareness about a product or store

2) Communicate information in order to create a specific image in the customer’s mind in terms of the store merchandise price quality benefits etc.

3) Create a desire to want a product.

4) To communicate the store’s policy on various issues.

5) Help to identify the store with nationally advertised brands.

6) Help in repositioning the store in the mind of the consumer.

7) To increase sales of specific categories or to generate short term cash flow by way of a sale, bargain days, midnight madness etc.

8) Help reinforce the retailer’s corporate identity.

Initiatives come from HQ and into stores where the execution of revenue-driving ideas happens, but stores also send back essential feedback and insights necessary for decision-making.

1. Planning the Retail Communication Programme:

This is the first step in developing a retail communication programme. Each retailer knows that it is not only the matter of gaining profits but also to survive for a long time. Therefore, he decides about communication objective initially aimed for a large traffic flow so that store should get maximum branding and there on, a retailer tries to satisfy the consumers’ demand category-wise. Communication objectives are planned for both long and short term.

Long-Term Communication Objectives:

These objectives belong to long period, say, over one to three years or even more than that. These objectives, a retailer would not like to change in the short run as it takes years to achieve these goals but once the underlined objectives are achieved, these cannot be overcome by the competitors in the short run. Examples of long-term objectives are: (i) to create a strong brand image for the store, and (ii) to create a strong brand loyalty towards retailer. Hence, it has been said that these are not achieved overnight.

Short Term Communication Objectives:

As the name implies, these objectives keep on changing as per the market trend. For instance, during festival season, a retailer wants to attract footfall so he designs his communication strategy that lures the customer to visit the store during particular period of time, say, before Diwali or Christmas, Companies offer lucrative offers for customers.

2. To Device the Communication Strategy:

Once the communication objectives are set, a retailer studies the market situation and designs the communication strategy comprising of various constituents like advertising, sales, event management, sales promotion, e-mail promotion, personal selling, etc.

On the basis of situation analysis, a blue print of what-to-do, how-to-do is prepared, so as to achieve the communication objective? A retailer knows that one communication vehicle will not be suitable to interact with various target segments.

For example, in case one of the retailers’ stores is located in small but densely populated area where people would like to have a value for their money, so a retailer would like to communicate his store’s products as fair price, everyday low pricing (EDLP), cheap & affordable range, etc.

Similarly, in case of a store located in a posh area, a retailer would like to plan a strategy of maintaining an up market image and delivering merchandise at pricing that justifies that sort of image.

3. Preparing the Communication Budget:

All objectives and strategies of a retailer are achieved through funds only. Without funds, no strategy can take shape and will simply go flat. Therefore, it becomes imperative for a retailer to allocate budget considering the firm’s turnover and the affordability.

While planning a budget, a retailer should consider not only the short term and long term objectives but implications of investment also. For example, if a retailer spends more money on displays, ambience, interiors and exteriors, he would have shortage of funds to meet its day-to-day requirement (working capital).

4. Implementation of Communication Programme:

Implementing the communication programme is one of the critical stages of retail communication process. A retailer must understand that retail market is the fast changing market and the most dynamic place in today’s era. Therefore, even after having view of the current market trends and designing the strategy, if need arises, minor changes should be made at the implementation stage itself.

An ideal communication programme always should be flexible to amend as and when need arises. Making sincere assumptions in this regard can play vital role towards the success of communication programme.

5. Evaluating the Communication Programme:

After implementing the plan of action, a retailer must look into the result of the communication programme. Once implemented, programme starts giving results within a realistic period of time. Now a retailer should plan for the success of such communication program. If the customers are persuaded and excited, it will result in increased customer traffic as well as enhanced sales.

However, in case customers are not persuaded, they can completely reject the move taken by the retailer by not visiting the store. The reason may be competitor’s communication program which came because of your move. Sometimes, the competitors’ campaigns are so successful which don’t only minimize the impact of your move but may completely neglect your outcome. Therefore, considering a retailer must have a contingency program in place so that if one becomes unsuccessful, second program should replace the earlier one.

A Computerized Inventory Control System is the integration of sub-functions involved in the management of inventory into a single cohesive system. It is software installed on the computer systems that enables a firm to keep a check on the inventory levels by performing the automatic counting of inventories, recording withdrawals and revising the stock balance.

A computerized inventory system enables a company to monitor inventory levels in real time throughout the day. Also known as inventory management software, businesses can stay updated with inventory orders, counts and sales. A computerized inventory system can help you avoid costly mistakes, know what is and isn’t moving, get your whole team on the same page, and help you keep track of inventory from anywhere.

It is very difficult for any firm to maintain a large stock of inventories, and therefore, many firms have adopted the JIT system in terms of Minimum and Maximum limit for the stock. There is an inbuilt system for placing orders in computer systems that automatically generates a PO to the supplier when the minimum level of the stock or the reorder point is reached.

The benefits of a computerized inventory control system can be derived, when the business integrates its inventory control system with the other systems such as accounting and sales, that helps in better control of inventory levels.

In practice, when the inventory level reaches to its minimum point, the system automatically generates a purchase order, which is sent to the supplier electronically. Also, the other copy of the PO is sent to the accounting department. Once the material is received from the supplier, an inventory gets updated on the system and at the same time, the notification is sent to the accounting department, which is used against the supplier’s Invoice and the PO copy.

Thus, a computerized inventory control system has made a life of both the manufacturer and the big retailer easy, who can manage their inventories electronically without wasting much time on the manual tracking system. Also, all the documents, such as purchase order, Invoice, account statement gets automatically generated with a use of computerized inventory control system.

But however, too much reliance on the technology may be problematic in the situations of power failure and lost internet connectivity, as it may bring a system to a standstill. Also, the accuracy of inventory items inserted in the system depends on the data entry made by the person. Thus, a proper entry should be made to obtain the correct inventory levels.

Advantage

Automated Reordering and In-Stock Information

Computerized inventory informs employees and customers within seconds whether an item is in stock. Because the inventory is synced with sales, there is a running tally of what is in stock and what isn’t. This helps flag reordering needs and provides better service to customers. As inventory drops below a specific threshold, new orders are placed with vendors and tracked to let customers know when the new products will arrive.

Integration With Accounting

Many of the computerized inventory platforms integrate with accounting software to track cash flow. This makes the process of transferring inventory costs and assets between programs seamless and reduces the need for additional bookkeeping costs. Financial statements are more easily generated with shared data between inventory and bookkeeping.

Forecasting and Planning

Inventory management software does more than track where inventory is located and when to reorder it. A data collection system is used to create needed forecasting and strategic planning reports. Business owners review trends regarding which products do well in certain months or during specific cyclical seasons. Business owners use this data to plan for growth and order inventory intelligently to best utilize cash flow resources.

Disadvantage:

System Crash

One of the biggest problems with any computerized system is the potential for a system crash. A corrupt hard drive, power outages and other technical issues can result in the loss of needed data. At the least, businesses are interrupted when they are unable to access data they need. Business owners should back up data regularly to protect against data loss.

Malicious Hacks

Hackers look for any way to get company or consumer information. An inventory system connected to point-of-sale devices and accounting is a valuable resource to hack into in search of potential financial information or personal details of owners, vendors or clients. Updating firewalls and anti-virus software can mitigate this potential issue.

Reduced Physical Audits

When everything is automated, it is easy to forego time-consuming physical inventory audits. They may no longer seem necessary when the computers are doing their work. However, it is important to continue to do regular audits to identify loss such as spoilage or breakage. Audits also help business owners identify potential internal theft and manipulation of the computerized inventory system.

Governance frameworks are the structure of a government and reflect the interrelated relationships, factors, and other influences upon the institution. Governance structure is often used interchangeably with governance framework as they both refer to the structure of the governance of the organization. Governance frameworks structure and delineate power and the governing or management roles in an organization. They also set rules, procedures, and other informational guidelines. In addition, governance frameworks define, guide, and provide for enforcement of these processes. These frameworks are shaped by the goals, strategic mandates, financial incentives, and established power structures and processes of the organization.

Governance frameworks establish and perpetuate the efficiency or lack of efficiency in an organization or institution’s ability to meet its goals, and even their public relations and perception. The organization of the governance framework is important for the success of the organization meeting its goals. Sociologist John Child states that these are connected and, in a circular manner, belief that changes in governance frameworks will succeed positively impacts the chance that the framework will result in the desired changes. Additionally, Williamson suggests that the organization of a governance framework results in economic consequences for that organization.

Frequently, the term good governance framework references a preferred style of governance that the author believes to be better suited to that industry or organization, especially in relation to public relations, and organizational and financial transparency.

Applications

There are examples of the use of governance frameworks in a wide variety of industries, as well as in the government of nation states and the public sector.

In their application to specific industries, companies, and problems, governance frameworks appear differently and reflect the unique needs of the group or organization. In the governance structure of information technology (IT) organizations, multiple frameworks have been suggested by authors connecting IT issues to the underlying theoretical business, organizational sociology, and economic models. In marine ecology, governance framework suggestions proposed by Fanning et al. provide a guiding structure for the management and conservation of marine in the Wider Caribbean Region. Corporate governance frameworks are also well established and the theories behind how they are structured are discussed in academic papers, with different theoretical perspectives shaping how governance structures are used and influenced by the business. For example, Braganza and Lambert suggest that business leaders use an adaptable governance framework that they believe better addresses strategy as well as operation.

In the public sector’s governance frameworks, issues of public opinion and financial transparency tied to the concept of good governance frameworks are important, according to consulting firm Clayton Utz. The Charity Commission for England and Wales, a public commission responsible for ensuring trustworthiness of registered charities in the United Kingdom emphasizes its motives and mission, and accountability and transparency goals in its governance framework. It also uses the governance framework to make publicly available its internal organization and leadership structure. Loorbach suggests governance frameworks for nation state governments’ development which challenge current paradigms and that he suggests will lead to more sustainable development.

Important

Governance systems are complex and multi-faceted. By changing any part of a governance system, it has an effect on many other parts of the structure including the individuals and groups that make up the system and extend to it.

An organization’s mission, vision, and values comprise the primary parts of a governance system. The mission statement gives an organization direction and a purpose. It’s necessary for organizational leaders to share a common mission in order to ensure a strong foundation.

The risk side of model governance is especially important, since it ensures that models involved with finances stay clear of dangerous risks. Since models are programmed to continue learning as they run, they can accidentally learn biases if they are presented with data that creates a bias, which can affect the decisions the model makes from that point on.

Model governance allows models to be audited and tested for speed, accuracy, and drift while in production. This avoids any issues of model bias or inaccuracy, allowing models with risks involved to operate smoothly.

A key benefit of model governance is its ability to clearly identify who has ownership of a model while a company changes over time. For example, if someone worked on a project years ago but has left the company, model governance helps keep track of projects, how they run, and where you left off.

Credit sScoring

Credit scoring models help banks make informed decisions in the loan approval process by providing predictive analysis information concerning the potential for loan default or delinquency. This helps the bank determine the model risk pricing they should use for the loan.

Problem: This type of model involves risk for both parties: The bank and the loan applicant. If the model shows bias toward the bank, then the loan applicant cannot get the money they deserve. Or worse, if the model shows bias toward the loan applicant, they may take out a loan they cannot afford, causing a loss for the bank and financial trouble for the loan recipient.

Solution: Model governance solves this problem by auditing the model while it’s in production to make sure no biases are involved. Credit scoring models are more accurate and reliable than manual credit scoring, as long as they are governed.

Interest rate risk modelling

Interest rate risk models monitor earnings exposure to a range of potential market conditions and rate changes in order to measure risk. The purpose of this type of model is to give an overview of the potential risks of the account it is monitoring.

Problem: This model is directly related to risk, since risk is the output. If the model inaccurately judges the account as low risk, the account owner may lose money or miss out on potential gains by keeping the account where it is. If the model inaccurately judges the account as high risk, the account holder may move their money to other accounts and lose money or miss out on potential gains.

Solution: Model governance ensures that the model achieves its intended purpose. It is one thing to train a model in the development stages and get great results, and another thing to continue getting great results over time while that model is in production. With model management after deployment, you can be sure the models perform accurately over time.

Derivatives pricing

Derivatives pricing models estimate the value of assets by providing a methodology for determining the value of both new products and complex products without market observations readily available. This helps banks and investors determine if a business is worth investing in or not.

Problem: Investment banking is largely done by assessing the value of a company’s assets to determine the current value of the company. If this type of model includes inaccuracies, banks and investors may invest in companies that aren’t profitable investments.

Solution: This model needs to be governed and managed well into production and continuously throughout its lifespan in order to ensure investments are made with accurate information.

An external auditor performs an audit, in accordance with specific laws or rules, of the financial statements of a company, government entity, other legal entity, or organization, and is independent of the entity being audited. Users of these entities’ financial information, such as investors, government agencies, and the general public, rely on the external auditor to present an unbiased and independent audit report.

The manner of appointment, the qualifications, and the format of reporting by an external auditor are defined by statute, which varies according to jurisdiction. External auditors must be members of one of the recognised professional accountancy bodies. External auditors normally address their reports to the shareholders of a corporation. In the United States, certified public accountants are the only authorized non-governmental external auditors who may perform audits and attestations on an entity’s financial statements and provide reports on such audits for public review. In the UK, Canada and other Commonwealth nations Chartered Accountants and Certified General Accountants have served in that role.

For public companies listed on stock exchanges in the United States, the Sarbanes-Oxley Act (SOX) has imposed stringent requirements on external auditors in their evaluation of internal controls and financial reporting. In many countries external auditors of nationalized commercial entities are appointed by an independent government body such as the Comptroller and Auditor General. Securities and Exchange Commission’s may also impose specific requirements and roles on external auditors, including strict rules to establish independence.

Work:

External auditors are appointed by corporate shareholders with the intent of carefully examining the validity of the organization’s financial records. Like internal auditors, external auditors will pore over accounting books, payroll, purchasing records, and other financial reports to spot red flags. Getting to know the organization and its operations comes first for audit planning. Then, it’s their job to determine whether the company is fairly following the Generally Accepted Accounting Principles (GAAP), according to the Financial Accounting Foundation. Finding financial misstatements due to error, fraud, or even embezzlement is what external auditors do. After performing their tests, external auditors prepare detailed, unbiased reports on corporate ethics for management executives.

The Difference between an External Auditor and Internal Auditor

Internal auditors are employees of a company, and so are not independent from it, as is the case with an external auditor. Further, internal auditors are more concerned with investigating whether processes are functioning properly, while external auditors are more concerned with whether an entity’s financial statements are fairly stated. In addition, internal auditors are more likely to obtain the Certified Internal Auditor designation, while external auditors obtain the Certified Public Accountant designation.

Detection of fraud

If an external auditor detects fraud, it is their responsibility to bring it to the management’s attention and consider withdrawing from the engagement if management does not take appropriate actions. Normally, external auditors review the entity’s information technology control procedures when assessing its overall internal controls. They must also investigate any material issues raised by inquiries from professional or regulatory authorities, such as the local taxing authority.

External Auditors’ Liability to Third Parties

Auditors may be liable to 3rd parties who are damaged by making decisions based on information in audited reports. This risk of auditors’ liability to third parties is limited by the doctrine of privity. An investor or creditor, for instance, can not generally sue an auditor for giving a favourable opinion, even if that opinion was knowingly given in error.

The extent of liability to 3rd parties is established (in general) by 3 accepted standards: Ultramares, restatement, and foreseeability.

Under the Ultramares doctrine, auditors are only liable to 3rd parties who are specifically named. The Restatement Standard opens up their liability to named “classes” of individuals. The foreseeability standard puts accountants at the most risk of liability, by allowing anyone who might be reasonably foreseen to rely on an auditor’s reports to sue for damages sustained by relying on material information.

While the Ultramares doctrine is the majority rule, (to the relief of many new and budding accountants pursuing an auditing career!) the restatement standard is preferred in several states and is growing in popularity. The foreseeability standard will not likely be widely adopted anytime soon because the cost (time and financial) of litigation would be enormous.

CFOs, company accountants, and other employees are not provided the same luxuries of the doctrine of privity. Their material actions and statements open them (and their companies) up to liability from third parties damaged by relying on these statements.

An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.

Caps and floors can be used to hedge against interest rate fluctuations. For example, a borrower who is paying the LIBOR rate on a loan can protect himself against a rise in rates by buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period the payment received from the derivative can be used to help make the interest payment for that period, thus the interest payments are effectively “capped” at 2.5% from the borrowers’ point of view.

An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%. They are most frequently taken out for periods of between 2 and 5 years, although this can vary considerably. Since the strike price reflects the maximum interest rate payable by the purchaser of the cap, it is frequently a whole number integer, for example 5% or 7%. By comparison the underlying index for a cap is frequently a LIBOR rate, or a national interest rate. The extent of the cap is known as its notional profile and can change over the lifetime of a cap, for example, to reflect amounts borrowed under an amortizing loan. The purchase price of a cap is a one-off cost and is known as the premium.

The purchaser of a cap will continue to benefit from any rise in interest rates above the strike price, which makes the cap a popular means of hedging a floating rate loan for an issuer.

Interest rate floor

An interest rate floor is a series of European put options or floorlets on a specified reference rate, usually LIBOR. The buyer of the floor receives money if on the maturity of any of the floorlets, the reference rate is below the agreed strike price of the floor.

Interest rate collars and reverse collars

An interest rate collar is the simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount.

• The cap rate is set above the floor rate.
• The objective of the buyer of a collar is to protect against rising interest rates (while agreeing to give up some of the benefit from lower interest rates).
• The purchase of the cap protects against rising rates while the sale of the floor generates premium income.
• A collar creates a band within which the buyer’s effective interest rate fluctuates

A reverse interest rate collar is the simultaneous purchase of an interest rate floor and simultaneously selling an interest rate cap.

• The objective is to protect the bank from falling interest rates.
• The buyer selects the index rate and matches the maturity and notional principal amounts for the floor and cap.
• Buyers can construct zero cost reverse collars when it is possible to find floor and cap rates with the same premiums that provide an acceptable band.

Valuation of interest rate caps

The size of cap and floor premiums are impacted by a wide range of factors, as follows; the price calculation itself is performed by one of several approaches discussed below.

• The relationship between the strike rate and the prevailing 3-month LIBOR

1. Premiums are highest for in the money options and lower for at the money and out of the money options

• Premiums increase with maturity.

1. The option seller must be compensated more for committing to a fixed-rate for a longer period of time.

• Prevailing economic conditions, the shape of the yield curve, and the volatility of interest rates.

1. Upsloping yield curve caps will be more expensive than floors.
2. The steeper is the slope of the yield curve, ceteris paribus, the greater are the cap premiums.
3. Floor premiums reveal the opposite relationship.

Interest Rate Caps Can Be Structured

Interest rate caps can take various forms. Lenders have some flexibility in customizing how an interest rate cap might be structured. There can be an overall limit on the interest for the loan. The limit is an interest rate that your loan can never exceed meaning that no matter how much interest rates rise over the life of the loan, the loan rate will never exceed the predetermined rate limit.

Interest rate caps can also be structured to limit incremental increases in the rate of a loan. An adjustable-rate mortgage or ARM has a period in which the rate can readjust and increase if mortgage rates rise.

The ARM rate might be set to an index rate plus a few percentage points added by the lender. The interest rate cap structure limits how much a borrower’s rate can readjust or move higher during the adjustment period. In other words, the product limits the number of interest rate percentage points the ARM can move higher.

Interest rate caps can give borrowers protection against dramatic rate increases and also provide a ceiling for maximum interest rate costs.

An interest rate option is a financial derivative that allows the holder to benefit from changes in interest rates. Investors can speculate on the direction of interest rates with interest rate options. It is similar to an equity option and can be either a put or a call. Interest rate options are option contracts on the rate of bonds like RBI bond securities.

An interest rate option has a premium attached to it or a cost to enter into the contract. A call option gives the holder the right, but not the obligation, to benefit from rising interest rates. The investor holding the call option earns a profit if, at the expiry of the option, interest rates have risen and are trading at a rate that’s higher than the strike price and high enough to cover of the premium paid to enter the contract.

Conversely, an interest rate put gives the holder the right, but not the obligation, to benefit from falling interest rates. If interest rates fall lower than the strike price and low enough to cover the premium paid, the option is profitable or in-the-money.

There are two types of options that can be purchased on the exchanges, calls and puts. Interest rate options are used as a hedge for lenders and borrowers in times of economic uncertainty. When an interest rate option is purchased, like an interest rate call option, the purchaser has a right to pay a fixed rate and receive a variable rate. Interest rate options are also available for purchase over the counter and can be considered risky depending on the strike price and expiry date of the option purchased.

Institutions can hedge their risk by limiting their downside for the period when they decide to take out a loan or by creating an interest rate collar. In such situations, the lending institution that has purchased the interest rate call option can limit the total rate that they will be taking on and create more accurate financial forecasts.

These types of options differ from traditional options, which are based on an underlying security. Interest rate options are based on actual rates and are subject to actions by the Federal Reserve or other central banks worldwide. As such, a strong understanding of global markets and the macroeconomic factors that affect interest rates is required before investing in these types of options.

Important

Interest rate call or put options can be purchased as a way to hedge against interest rate fluctuations or as a trading strategy to bet on which direction interest rates will move in the short or long term. Traders who utilize this strategy may look at macroeconomic indicators that can point towards fluctuations in the interest rate or global events that may lead towards a recession or towards inflation.

Interest rate options are another way traders can broaden their portfolio of tradeable securities in order to create a more diversified trading desk. Also, they are important for banks, which often loan out sizable sums to companies. The banks may wish to cap their potential downside risk should interest rates fall and the loan is not serviced at a rate that they originally anticipated for their cash flows.

Risk in Options

An option trading does not come without risk. Options traded without understanding how to structure a trade or how options in general work can result in positions being taken that are over-leveraged or incredibly risky. Interest rate options are no exception to such warnings.

Without understanding properly how interest rate options work, traders could find themselves building a position that becomes unprofitable because they did not understand the position they were building and took on a substantial risk they did not intend to.

Interest rate options are also sensitive to market volatility and fluctuations. Interest rate options purchased that are currently in the money are considered highly sensitive to pricing fluctuations as their strike price is highly correlated to the underlying futures price.

Forward rate agreements (FRA) are over-the-counter contracts between parties that determine the rate of interest to be paid on an agreed-upon date in the future. In other words, an FRA is an agreement to exchange an interest rate commitment on a notional amount.

The FRA determines the rates to be used along with the termination date and notional value. FRAs are cash-settled. The payment is based on the net difference between the interest rate of the contract and the floating rate in the market the reference rate. The notional amount is not exchanged. It is a cash amount based on the rate differentials and the notional value of the contract.

In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs).

Steps:

• Calculate the difference between the forward rate and the floating rate or reference rate.
• Multiply the rate differential by the notional amount of the contract and by the number of days in the contract. Divide the result by 360 (days).
• In the second part of the formula, divide the number of days in the contract by 360 and multiply the result by 1 + the reference rate. Then divide the value into 1.
• Multiply the result from the right side of the formula by the left side of the formula.

Uses and Risks

Many banks and large corporations will use FRAs to hedge future interest or exchange rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates. The development of swaps in the 1980s provided organisations with an alternative to FRAs for hedging and speculating.

In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. A FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate, referred to as the Reference rate, over a predetermined time period at a future date. FRA transactions are entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the difference between the contracted interest rate and the market rate is exchanged. The buyer of the contract is paid if the published reference rate is above the fixed, contracted rate, and the buyer pays to the seller if the published reference rate is below the fixed, contracted rate. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs.

Forward Rate Agreement = R2 + (R2 – R1) x [T1 / (T2 – T1)]

Forward rate agreements typically involve two parties exchanging a fixed interest rate for a variable one. The party paying the fixed rate is referred to as the borrower, while the party paying the variable rate is referred to as the lender. The forward rate agreement could have the maturity as long as five years.

A borrower might enter into a forward rate agreement with the goal of locking in an interest rate if the borrower believes rates might rise in the future. In other words, a borrower might want to fix their borrowing costs today by entering into an FRA. The cash difference between the FRA and the reference rate or floating rate is settled on the value date or settlement date.

An interest rate future is a futures contract with an underlying instrument that pays interest. The contract is an agreement between the buyer and seller for the future delivery of any interest-bearing asset.

The interest rate futures contract allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.

These futures may also be cash-settled in which case, the one who holds the long position receives and one who holds the short position pays. These futures are thus used to hedge against or offset interest rate risks. Which means investors and financial institutions cover their risks against future interest rate fluctuations with these.

These futures can be short or long term in nature. Short term futures invest in underlying securities that mature within a year. Long term futures have a maturity period of more than one year.

Pricing for these futures is derived by a simple formula: 100 – the implied interest rate. So a futures price of 96 means that the implied interest rate for the security is 4 percent.

Since these futures trade in government securities, the default risk is nil. The prices depend only on the interest rates.

Interest rate futures in India

Interest rate futures in India are offered by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). One can open a demat account and trade in them. Government Bond or T-Bills are the underlying securities for these futures contracts. Exchange Traded Interest Rate Futures on NSE are standardized contracts based on 6-year, 10-year and 13-year Government of India Security (NBF II) and 91-day Government of India Treasury Bill (91DTB). All futures contracts which are traded on NSE are cash-settled.

Features of interest rate futures

• Expiration date: This is the final date future for the settlement of the contract which is pre-determined.
• Underlying asset: The underlying asset is the interest-bearing security on which the contract is based. In case of an interest rate futures contract, it is either a Government bond or a T-Bill.
• Size: This refers to the total amount of the contract. There is, however, a minimum requirement of Rs 2 lakh or 2,000 bonds if one wants to trade in these futures.
• Margin requirement: There is an initial amount required to enter into a futures contract. At the time of starting your trading, you will be required to pay an initial or upfront margin to your broker. This serves as a security deposit which the broker in turn has to submit to the exchange. For NSE, the minimum margin for a cash-settled interest rate futures contract is 1.5 percent of the contract’s value subject to a maximum of 2.8 percent on the first day of trading. For a 91-Days T-Bill futures contract the margin is 0.10 percent of the notional value of the futures contract on the first trading day. This becomes 0.05 of the notional value of futures contract after that.

Advantages of interest rate futures

• No security transaction tax: There is no security transaction tax on these futures, making them a cost-effective option.
• A suitable hedging mechanism: These futures act as a good hedging mechanism. They are also a useful risk management tool. As a borrower, you can hedge your risk in fluctuating interest rates by taking an opposite position in these futures.
• Transparency in trading: Since there is real-time dissemination of prices, trading is more transparent.

Interest rate options are options with an interest rate as the underlying. A call option on interest rates has a positive payoff when the current spot rate is greater than the exercise rate.

Call option payoff=Notional Amount × [Max (Current spot rate−Exercise rate, 0)]

On the other hand, a put option on interest rates has a positive payoff when the current spot rate is less than the exercise rate.

Put payoff = Notional Amount × [Max (Exercise rate−Current spot rate,0)]