Happy To Hedge

MARKET MECHANICS

Foreign currency derivatives have been allowed by the Reserve Bank of India for some time now and although hard numbers are difficult to come by, bankers say business is booming. Much of the focus so far has been on the rupee derivatives market which has been struggling. But over these past two years, hedging activity in foreign currency has taken off.

The main factor driving the growth of the foreign currency derivatives market in India has been interest rate movements in India relative to that of the United States. Since the latter part of last year, the US Federal reserve has consistently raised interest rates in a bid to cool down what it sees as an overheating US economy.

Consequently US dollar Libor rates have gone up by nearly two percentage points from levels of about 4.96 per cent in January 1999 to 6.88 per cent as of now. This has meant a sharp increase in costs for corporates who have borrowed in foreign currency since most of the borrowing is at floating rates pegged to Libor.

Added to this is the fact that over the same period, Indian interest rates have seen a decline and this has meant a high real cost and a high opportunity cost for Indian corporates borrowing in foreign currency, says Anindya Dutta, Vice president, foreign exchange and interest rate derivatives at Credit Lyonnais.

"This is definitely a trend which is happening. Its due to interest rate movements as well as a greater awareness on the part of corporates and banks as to the range of products available to hedge interest liabilities," says Amit Gupta, Head of treasury corporate sales at HSBC. "Among the main types of derivatives are interest rate swaps, forward rate agreements, interest rate options and structured caps," he adds.

However Arvind Sethi, Managing Director of Global Capital Markets at Bank of America disagrees. "We don't find any significantly increased interest in hedging activity and there doesn't seem to be any big trend one way or the other. People have got a little averse to dollar exposure now and there just are not that many projects around to finance."

Most corporate foreign currency borrowings are of maturities between five to seven years.

The simplest hedging tool involves an interest rate swap whereby the bank pays the corporate a floating rate linked to Libor and the corporate pays the bank a fixed rate derived from the US yield curve. However given that the swap is of the maturity of the loan _ five years _ the corporate at the outset has to pay a very high rate. Thus the corporate has a negative carry from the beginning.

Therefore the derivative contract usually involves a mechanism whereby the corporate gains when rates increase but is willing to give up some of its gains if rates drop beyond a certain point.

Thus a more common hedging procedure will involve the corporate paying a fixed rate of say, 6.8 per cent. However if interest rates hit 8 per cent the swap would get `knocked out'. If interest rates go below 6.80 per cent the corporate continues to pay 6.8 per cent. "These types of contracts have seen a big increase in the last two years with almost any corporate which has borrowed in sizeable amounts abroad looking to hedge its borrowings,"says Anindya Dutta.

Another type of derivative seeks to take advantage of the relative weaknesses of various currencies against the dollar by way of currency swaps. In a currency swap, the bank pays the corporate a principal amount and interest denominated in dollars while the corporate pays the bank equal amounts in dollar terms but in a different currency at a fixed exchange rate.

Bankers say that many such currency swaps are being conducted in the Euro-dollar currency pair. A corporate paying Euros will benefit hugely since the Euro has depreciated by almost 25 per cent against the dollar since it was launched in January1999.