Forex Swaps and IRS
An Introduction
Rama Krishna Vadlamudi
Mumbai
October 4th, 2009
The articles discusses the world of Swaps
– Interest Rate Swap (IRS), Overnight Index Swaps (OIS), mechanism of OIS,
currency swaps, equity swap, CDS and others in the Indian context. An example
of OIS is also given to help the readers.
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DEFINITION OF SWAP
|
A
simple definition of a swap is an exchange, trade or barter. In the financial
world, a swap is a financial transaction involving simultaneous exchange of
assets (the swap) of comparable value by the counterparties. The assets may be
commodities or financial instruments involving interest rates, cash flows,
foreign exchange, debts or equities.
A
swap has also been defined as a financial transaction in which two
counterparties agree to exchange streams of payments, or cash flows, over time
on the basis agreed at the time of inception of the arrangement. A swap is like
a series of forward contracts. Swaps are basically financial derivative
instruments traded over the counter (OTC).
TYPES OF SWAPS: There are mainly two types of swaps—one is
interest rate swap and the other currency swap. However, commodity swaps and
tax rate swaps too are being introduced and finding acceptance.
INTEREST RATE SWAP (IRS):
Interest
rate swaps are agreements where one side pays the other a particular interest
rate (fixed or floating) and the other side pays the other a different interest
rate (fixed or floating). Under an interest rate swap, interest payment streams
of differing character are periodically exchanged. There are two main types:
A. Coupon swaps: fixed for floating rates;
and
B. Basis, or floating to floating, swaps:
the exchange of one benchmark for another under floating rates (e.g., LIBOR for
T-bill rate)
 |
CURRENCY SWAP
|
Under
a currency swap, the two counterparties agree to exchange interest and
principal in one currency for interest and principal in another currency. These
exchanges are generally done at the spot exchange rate ruling, when the swap
was entered into, and would involve:
A. an initial exchange of principal in the
two currencies; and
B. exchange of interest and repayment
obligations (in instalments or in the form for re-exchange of the principal
amount, i.e., bullet repayment); or
C. debt servicing obligations alone (i.e.,
B)
The
interest rates for the two currencies would differ, and may be fixed or
floating.
MERITS
OF SWAPS:
Swaps are essentially used as a devise for:
l
Reducing the cost of borrowing
l
Exploit a view on the market
l
Hedge against a risk
l
Arbitrage between markets
GENESIS: Currency swaps became
famous worldwide with a swap transaction entered into between the World Bank
and IBM in 1981. This year also saw the birth of interest rate swaps in London
ADVANTAGES OF IRS: In general, in the international capital
markets, fixed rate lenders are individuals or institutions like insurance
companies or pension funds. When they raise funds, the cost of funds would
depend on their credit rating given by rating agencies and other factors. On
the other hand, in the floating rate markets (say LIBOR-linked), the lender are
international banks who study the commercial and political risks relevant to a
given loan and price it accordingly. (Their view does not always correspond to
that of rating agencies). As such, companies will try to exploit the
differences in interest rates in fixed and floating markets and enter into
swaps with a view to reducing their cost of borrowing.
BANK INTERMEDIATION: In practice, it is
difficult for a corporate to locate a counterparty for a swap because the
structure of swaps is such that the counterparties need to have not only
differing but mutually complementary needs, but also identical amounts and
maturities. Counterparty’s financial strength (over the period of the swap) to
meet the obligation also needs to be known. Swaps suffer from counter party
risk. Therefore, major international banks step in and make two separate swaps
with the two counterparties.
While
banks/financial institutions initially entered the swap market as brokers or
intermediaries, their role widened quickly. Soon, major banks started
“warehousing” transactions without the ready availability of a matching
counterparty, and hedged the exposure in the interim in other markets until
another counterparty with opposite requirements could be located. In other
words, banks started running swap books.
BASIS SWAP: Basis swaps are swaps where the two sides
pay each other rates determined by different benchmarks. In the case of a basis
swap, instead of exchanging LIBOR for a fixed rate, the swap could be LIBOR for
T-bill rate (or the CD rate).
SWAP MARKETS IN INDIA
INTEREST RATE SWAP: Interest rate swaps started trading in India India
EXAMPLE:
Consider
a Simple illustration:
Com. A Com.B
Fixed
Rate 8% 9%
Floating
Rate Mibor +1% Mibor +3%
Company
A has an advantage in both markets but has a better advantage in Floating Rate
Market.
l Company A can borrow in
the floating rate market at the given rate of Mibor +1 and Company B can borrow
fixed at 9%
l Both Companies can enter
into a swap
l Company A can receive
Mibor+2 from Company B and pay 8.25 fixed interest to Company B.
l
Consider cost to both companies
Com. A Com. B
Borrow -(Mibor+1) -9%
Swap
Receive +(Mibor+2) +8.25%
Swap
Pay -8.25%
-(Mibor+2)
Net
Cost -8.25+1 -(Mibor+2)-.75
Net
Cost -7.25% -(Mibor+2.75)
Gain 0.75% 0.25
l The difference to be
shared is 1%. This could be shared in any combination desired.
l Usually the company with
relative advantage in both markets will take away a larger share of the gain.
l Note that the swap would
work only if A wants to borrow Fixed and B Floating.
BENCHMARKS FOR IRS IN INDIA
The commonly used floating rate benchmarks for
IRS in the domestic swap market are:
- MIBOR –
Mumbai Inter-Bank Offer Rate – the overnight, interbank call money rate
(MIBOR overnight rates
are decided based on overnight call money rates.
MIBOR overnight rates are closely linked to
call money rates.)
- MITOR –
Mumbai Inter-Bank Tom Offer Rate – the overnight interbank rate implied by
the Federal Funds rate in New York added to the cash/tom forward margin in
the exchange market (MITOR is the foreign currency variant of the MIBOR
rate-It is determined by Reuters by polling); and
- MIFOR –
Mumbai Inter-Bank Forward Offer Rate – the relevant period inter-bank rate
implied rate by the USD LIBOR for the corresponding period added to the
annualized forward margin in the exchange market.
OVERNIGHT INDEXED SWAPS (OIS): The most popular IRS in
the Indian Market is the OIS where the floating rate is linked to an overnight
inter bank call money index. There are no restrictions on the tenor of the
swap. The interest is calculated on a notional principal amount settled on a
net basis at maturity. On the floating rate side, the interest rate amounts are
compounded on a daily basis based on the index. The notional principal is not
exchanged. Only net interest payments are exchanged. The most popular
benchmarks are FIMMDA-NSE overnight MIBOR and the Reuters overnight MIBOR. An
OIS is used to hedge short-term assets and liabilities. OIS is traded in the
OTC market.
MECHANISM OF OIS: The mechanism is best described with the following
example.
Example:
Bank A is a fixed rate receiver for INR 5 crores
for a period of one week at 10% (which is the OIS rate) and a floating rate
payer (FIMMDA-NSE MIBOR).
Bank B is a receiver of floating rate linked to
the Overnight index (i.e., FIMMDA-NSE MIBOR) and a fixed rate receiver (OIS
RATE).
The FIMMDA-NSE MIBOR rates for the seven days are
taken and settled at the end of the swap period. At the end of the period of
one week, i.e., the 8th day, Bank B will have to pay to Bank A Rs. 95,890/-
(being interest on Rs. 5 crores for 7 days at 10%) and has to receive from A
Rs. 97,508/-. The payments are netted and the only payment that takes place is
a payment by A of Rs. 1,608 (97508 – 95890) to B. Please note that FIMMDA-NSE MIBOR rates are
compounded daily.
NSE Mibor Index
|
Notional Principal Amount
|
Interest for One day
|
|
1st day
|
10.25%
|
500,00,000
|
14,041
|
2nd day
|
10.00%
|
500,14,041
|
13,702
|
3rd day
|
9.75%
|
500,27,743
|
13,363
|
4th day
|
10.125%
|
500,41,107
|
13,881
|
5 & 6 day
|
10.25%
|
500,54,988
|
28,113
|
7th day
|
10.50%
|
500,83,101
|
14,407
|
500,97,508
|
97,508
|
In case of a 1-year OIS, this settlement goes on
for one year. Coming to the volumes, OIS volumes outnumber spot volumes. Minimum lot in OIS is Rs 25 crores whereas in
spot it is Rs 5 crores.
CURRENCY SWAPS:
RBI has given general permission to authorized
dealers to deal in currency swaps with one currency leg being the Indian rupee.
The circular of RBI guidelines was dated January 19, 2000. In terms of the
provisions, authorized dealers can offer the following products: interest rate
swaps, currency swaps, coupon swaps, interest caps/collars (purchase) and
Forward Rate Agreements. The circular contains other provisions concerning
corporate requirements for swaps, reporting of the deals to RBI, premium
payment, etc. Two important limitations placed by RBI on the use of derivatives
are that the notional principal should not exceed the amount of the loan, nor
should the maturity of the derivative extend beyond the maturity of the
underlying.
EQUITY SWAP: This is an equity derivative. An equity swap is
a swap transaction whereby the underlying will be linked to an index of the
stock market. These are not available in India
CREDIT DEFAULT SWAP (CDS): This is an example of a
credit derivative. A credit derivative is an arrangement whereby the credit
risk of an asset is transferred from the buyer to the seller of protection. A
CDS is a contract where the protection seller receives premium or interest
related payments in return for contracting to make payments to the protection
buyer upon a defined credit event. Credit events normally include bankruptcy,
payment default and rating downgrades. RBI had considered introduction of CDS
in India during 2007, but
had later decided not to introduce them in India US
REGULATORS: The regulators for swaps in India
ISDA AGREEMENT: All swap transactions involve signing of an
agreement between the parties. The standard document is known as ISDA
(International Swaps and Derivatives Association) Master Agreement.
SWAPTIONS: A swaption or a swap option is an option on an
interest rate swap. It gives the buyer of the swaption the right (but not the
obligation) to enter into an interest rate swap of specified parameters
(maturity of the option, notional principal, strike rate, and period of the
swap). Swaptions are traded over the counter.
CAPITAL ADEQUACY: RBI’s capital adequacy norms are
applicable to banks and financial institutions for undertaking interest rate
swaps.
CROSS CURRENCY MARKET IN INDIA
Banks in India
act as intermediaries between the international markets and their corporate
customers in India
USD: INR Swaps: FIMMDA releases daily rates for such swaps. The
rate for such swaps in known as MIOCS rate, that is, Mumbai Inter-bank Offered
Currency Swaps.
MIFOR Swap market: The MIFOR swap market exchanges rupee
interest flows but with the floating rate benchmark based on forex market
variables. The MIFOR is a proxy for the term inter-bank rupee market. FIMMDA
releases MIFOR rates every day. In India
COUPON ONLY SWAPS: USD: INR coupon only swaps are very
popular in India
PERCY MISTRY RECOMMENDTIONS: The High Powered Expert
Committee (HPEC) on Making Mumbai an International Finance Centre had in 2007 recommended the immediate creation of a
currency spot market, with a minimum transaction size of Rs. 10 million,
accessible to all financial firms. In addition, it had recommended that an
INR-settled exchange-traded currency derivatives market be created, with
trading in futures, options and swaps on currencies, accessible to all.
The Central Government
had recently
allowed SEBI and RBI to start exchange-traded currency futures. NSE had started
exchange-traded currency futures on August 29, 2008 and afterwards BSE and
MCX-SX had also introduced the product according to the guidelines of SEBI and
RBI. As of now only USD-INR currency futures are allowed.
SOME PRACTICAL ASPECTS ON
SWAPS:
Any financial product or derivative is available
for people or organizations to exploit their view. First, they need to have a
view on the future course of interest rate or exchange rate or other assets.
Then, intermediaries are available to provide access to exploit such view and
make money in the process. If the view is proved to be wrong at a future date,
the party may lose money also. That’s why risk management is very vital here.
l Swaps are extensively
used in asset liability management structures.
l Typically used by
bankers. If their asset is floating rate loan and their liability is in fixed
rate, they could enter into a swap to match the two.
l Most software companies
have entered into long term contracts with receipts structured in dollars.
Dollar depreciation is a major concern for them.
l Various types of Swaps
are actively used by corporate India India India
VOLUMES REPORTED ON CCIL:
CCIL has developed the MIBOR / MIBID rates based
on the trades in the NDS-CALL platform. CCIL releases MIBOR/MIBID rates at
10.10 am and again at 1.10 pm in the afternoon. The rates are released on
Mondays through Fridays.
According to CCIL, for the year 2007-08, the
total number of Interest Rate Swaps (MIBOR) transactions reported
was 25,431 deals and the total notional principal involved was around Rs 18.05
lakh crore (single leg). The tenors of the deals ranged from one to 10 days;
and from one month to nine months. The most active participants were foreign
banks, whose share in the total market was around 75 per cent, while the rest
was between private banks and primary dealers. Public sector banks’ turnover
was negligible, according to CCIL’s figures for 2007-08. For the month of
November 2008, the number of MIBOR deals was 469; with the total principal
amount around Rs 32,000 crore. For the month of November 2008, the market share
of foreign banks, private banks, primary dealers and public sector banks was
84.76%, 9.47%, 5.11% and 0.66% respectively. Total number of participants was
63 during the month of November 2008. In the past few months, volumes have come
down drastically due to adverse market conditions.
According to CCIL, for the year 2007-08, the
total number of Interest Rate Swaps (MIFOR) transactions reported
was 4,395 deals and the total notional principal was around Rs 1.96 lakh crore
(single leg). The most active participants were foreign banks, whose share in
the total market was almost 90 per cent, while the rest was from private banks.
The turnover of public sector banks and primary dealers turnover was
negligible, according to CCIL’s figures for 2007-08. For the month of November
2008, the number of MIFOR deals was 145; with the total principal amount around
Rs 6,900 crore. The market share of foreign banks and private banks was 92.71%
and 7.29% respectively.
FIMMDA-NSE REFERENCE RATES
IN INDIA
FIMMDA-NSE MIBID MIBOR: These reference rates
are used by many market participants due to their wide acceptability among the
players in the market. These are the basis for other derivative products, like,
IRS, etc.
FIMMDA and NSE release overnight and 3-day rates
(MIBOR and MIBID) at 9.40 am every day; while, 14-day, 1-month and 3-month
rates are released at 11.30 am every day. Polling is used for obtaining reference rates by polling a few
market participants and summarizing the prices they report. These rates are
available on the NSE and FIMMDA websites.
ABBREVIATIONS USED:
BSE Bombay
CCIL The Clearing Corporation of India
FEMA Foreign Exchange Management Act
FIMMDA Fixed Income Money Market and
Derivatives Association of India
ICAI The Institute
of Chartered Accountants of India
INR Indian Rupee
IRS Interest Rate Swaps
ISDA International
Swaps and Derivatives Association
LIBOR London
MCX-SX MCX Stock Exchange
MIBID Mumbai
Inter-Bank Bid Rate
MIBOR Mumbai
Inter-Bank Offer Rate
MIFOR Mumbai Inter-Bank Forward Offer
Rate
MIOCS Mumbai
Inter-Bank Offered Currency Swaps
NDS-CALL Call money platform on the NDS
(Negotiated Dealing System)
NSE National Stock Exchange of India
OIS Overnight Indexed Swaps
OTC Over the counter
SEBI Securities and Exchange Board
of India
USD US
References:
1. “Foreign Exchange International Finance &
Risk Management” by A V Rajwade
2. CCIL
3. FIMMDA
4. NSE
5. Inputs from Mr. Manoj Kumar, SBI, Hong Kong
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