How to Structure Financial Swaps in India
Today, in almost every country, business environments are exposed to a high degree of risk. This risk may be in the form of currency risk, credit risk, interest rate risk, etc. In this article, we will only consider interest rate risk. Whenever we think of hedging this interest rate risk, we cannot ignore the term ‘derivatives’. Derivatives have emerged as the most actively used risk management tool over the last two decades, both for corporates, banks and financial institutions. Mainly, the derivative market includes – futures, options and financial swaps. The Indian market has interest rate futures but has failed to attract market participants, whereas interest rate options have yet to be introduced. So to hedge interest rate risk, forward rate agreements and interest rate caps and collars are mostly used.
As far as interest rates are concerned, financial swaps are fundamentally a sound device to hedge against the interest rate risks. However, in India, it seems that swap transactions have lost their identity, as there is little evidence of widespread use. The reasons may be lack of awareness in risk management areas, lack of initiative from the regulatory bodies and threat of high default risk. This article fundamentally aims to make treasury managers aware of the dynamics of financial swaps in real life situations.
Usually, swapping refers to the simultaneous purchase and sale of assets, mainly foreign currencies, for different maturities. To be more specific, it is also regarded as the exchange of a stream of future cash flows among two or more parties at mutually agreed upon terms and conditions. In our discussion, we will consider the latter definition.
Swaps can be of two types:
An interest rate swap is defined as a mutual agreement among different parties, to exchange interest payments over a predetermined period. Here the interest payments may be fixed or floating, depending on the terms of the agreement. Parties to the agreement may be a fixed rate payer/receiver and floating rate receiver/payer. With interest rate swaps, there is no exchange of principal at the beginning, i.e. principal is notional. The primary motives behind the interest rate swaps are to lower the costs of borrowing and to overcome the asset liability mismatch.
|
UCO Bank to diversify into risk hedging Kolkata , June 15 UCO Bank proposes to diversify into risk hedging through interest rate swaps, options and futures, both in foreign currencies and rupees, according to the Chairman/Managing Director, Mr. V.P. Shetty. Addressing shareholders at the company’s first annual general meeting held after last year’s first public issue, Mr. Shetty stated that the new business initiatives would also see maximization of fee-based income through the sale of insurance and mutual fund products, the extension and expansion of depository services through the bank’s wide branch network and the garnering of fresh corporate agency business. “The whole purpose of the drive is to attain such a level of fee-based income as it would either fully cover or overtake the entire non-interest expenses on a sustainable basis”, he observed. Risk management would receive top priority, particularly for monitoring and review of advance portfolios, so that the net NPA level could be brought down to less than two per cent at the end of the current year from last year’s 3.65 per cent. |
Source: The Hindu Business Line
Let us discuss how interest rate swaps can be used to overcome the asset-liability mismatch, with the help of the following example. Bank A has floating rate assets earning (MIBOR+3%) (Mumbai Inter Bank Offer Rate) funded with fixed rate liability of 12%. Bank B has fixed rate assets earning 17%, funded with floating rate liability (MIBOR+1%). Now, if the interest rate falls, Bank A will suffer as it will receive less on its assets whereas it will have to pay fixed interest. And if the interest rate rises, Bank B will suffer as it will have to pay more, liabilities being floating in nature. Hence both the banks suffer from asset-liability mismatch. To overcome this, they may enter into a swap transaction wherein:
This would ensure that both the banks will stand to gain a definite spread irrespective of the level of MIBOR. The swap transaction between these two banks can be shown as follows.
From the swap structure shown above, it is clear that both Bank A and Bank B benefit from the swap deal with a definite spread of 5% and 2% respectively, irrespective of the change in MIBOR.
Now, we will consider another example to understand the dynamics of interest rate swaps in lowering the cost of borrowings. Let us assume that there are two companies X and Y whose financing details are as follows:
| Company | Fixed Rate Loan Market | Floating Rate Loan Market | Preference |
|---|---|---|---|
| X | 10% | MIBOR% | Floating Loan |
| Y | 13% | MIBOR+1% | Fixed Loan |
| Spread | 3% | 1% |
In the above example, we find that X has absolute advantage over Y, in both the fixed and floating rate market. X has a preference to borrow at floating rate and Y has the preference to borrow at fixed rate. It is clear that X has more advantage or comparative advantage if it borrows at a fixed rate because the spread is 3%, which is more than 1% in the floating rate market. Therefore, it would be sensible for X to borrow at fixed rate and for Y to borrow at floating rate and then enter into a swap deal to achieve their preferred mode of funding and to lower their cost of borrowing. In the swap deal the following transactions will be done:
If X and Y had not entered into the swap transaction, then the total cost they would have incurred would have been: MIBOR+13%
After, entering into the swap, their total cost becomes:
= 10 + (MIBOR+1%)
= MIBOR+11%
So, by entering into the swap, they save 2% which they may share equally.
Therefore, X’s net cost of borrowing = MIBOR-1%
Y’s net cost of borrowing = 13-1% = 12%
Their swap structure is shown as under:
By entering into the swap deal they have achieved their preferred mode of funding with a lowered cost that might not have been possible without the swap.
|
Limitations of Swap Deals
|
It is to be noted that sometimes banks may be appointed as an intermediary in the swap deal to overcome the counterparty risk. In that case, all the cash flows will be exchanged through the bank. Banks generally charge a nominal amount for this service. So, a portion of the spread earned from a swap is passed onto the bank and the balance is shared between the parties at a mutually agreed upon ratio.
Unlike interest rate swaps, foreign currency swaps involve the exchange of the principal at the beginning of the contract and the re-exchange of the principal at the end of the contract. Let us understand its application, through an illustration.
Suppose company C wants to borrow US$ funds and the Company B wants to borrow £ funds. Their financing details are given in the following example:
| Company | $ Borrowing | £ Borrowing | Preference |
|---|---|---|---|
| C | 10% | 7% | $ Loan |
| D | 11% | 11% | £ Loan |
| Spread | 1% | 4% |
From the given information, C enjoys absolute advantage over D in both the $ and £ loan market. But the comparative advantage for C exists in the £ loan market. So it is advisable for C to borrow £ funds and for D to borrow $ funds from the market and then enter into a foreign currency swap deal to achieve their preferred form of funding with a lower cost. Let us check how to construct a deal between them. It is assumed that C needs $100 crores. The current spot $/£ rate at the time of entering into the swap is 1.80 $/£.
The calculation of the benefit earned from the swap is shown below:
Total cost of borrowing without the swap = 10 + 11 = 21%
Total cost of borrowing with the swap = 7+11 = 18%
Therefore, net savings = 3%
This savings may be shared between C and D in a mutually agreed upon ratio. In our discussion, we assume it to be shared equally for easy calculation. Hence, the net cost of borrowing for both the parties will be:
C = 10-1.50 = 8.50%
D = 11-1.50 = 9.50%
Their swap structure is shown hereunder:
Therefore, to enter into the swap deal the following transactions are required:
Exchange of Principal: C will borrow £55.55 (100/1.80) crore and give it to D and D will borrow $100 crore and give it to C.
Interest Payments: C will pay 11% to D on the $100 crore borrowed by D and D will pay 9.5% to C on the £55.55 crore borrowed by C.
Re-exchange of Principal: After the swap matures, the principal amount exchanged between C and D will be re-exchanged between them. That is, C will return $100 crore to D and D will return £55.55 crore to C.
Swaps first evolved in 1981, in the form of currency swaps, with the contract between IBM and the World Bank. Later on, interest rate swaps emerged, which offered an alternative method to overcome asset-liability mismatches and to lower the cost of borrowing. Swaps provide a level playing field for risk management but still struggle to find a future, especially in developing countries like India. In the case of stock markets, we have NSCCL, a wholly owned subsidiary of National Stock Exchange of India Ltd, to provide settlement guarantees to all the trades done at NSE. Similarly, if such a ‘clearing and settlement organization’ could be set up for the swap market, there is a huge opportunity for this segment to develop. The clearing organization would monitor the activities in the swap market and reduce the high credit risk, thereby protecting the interests of the market players.
This discussion is mainly intended to explain the application of financial swaps in real life situations for the practicing treasury manages and students of risk management. Moreover, it is a proposal to the business world to adapt to this risk hedging technique in order to hedge their capital expenditure funds requirements, payables and receivables, both in domestic currency and foreign currencies. Hence, with the initiative taken by UCO bank in India, to diversify into the swaps market, we may expect more banks, financial institutions and corporates to join the race.