Hedging Rupee Interest Rates

Case 1:

Assume Company X wants to borrow rupees for six months. It intends to take the loan after three months. The interest rate for the future borrowing will normally be determined at the time of taking the loan. The Bank tells Company X that it will lend at prime lending rate (PLR)+1 per cent. Company X needs the funds for a specific order for which the margins are tight. Hence, it wants to decide upon the interest cost now. The bank does not want to crystallise the interest rate at this stage. Company X therefore carries an interest rate risk for three months.

 

Case 2 :

There is another company, Company Y, which succeeds in negotiating a fixed rate for a similar future borrowing. In this case, the bank carries the interest rate risk for three months The simplest way for the bank to hedge its risk is to arrange for a deposit for six months, starting three months later. This may not always be possible. Alternatively, the bank - lets call it Bank A -could enter into a deal with another bank, Bank B, to swap interest flows. Bank B would pay interest at a floating rate three months later and receive a fixed rate of interest.

Bank A can, after three months, borrow in the interbank money market for six months at the prevailing floating rate. The following diagram(refer to box : interest rate flows 1) illustrates the flow arising out of this transaction.

Company Y has crystallised its interest rate for a future period and Bank A has hedged its interest rate risk.This simple product that the bank uses is called a Forward Rate Agreement (FRA). For the two banks to conclude the derivatives transaction, a proper rupee term money market is required. Of course, this could be structured as a one-off transaction without a term money market. But if one wanted a deep, liquid market with a lot of deals flowing through, one would need a term money market. And a pre-requisite for a proper term money market in the rupee would be the freeing of interbank borrowings from reserve requirements. A rupee term money market would have a specific interest rate for a specific period. Each bank would have a specific interest rate for borrowing and lending for say, one month, two mon-ths, three months, six months or twelve months like there exists for various currencies overseas.

LIBOR (London Inter Bank Offer Rate) is the most popular floating rate reference and is the interest rate at which the top corporates or banks would be lent funds. An Indianised reference rate could be the Mumbai Inter Bank Offer Rate (MIBOR).

Case 3 :

Assume that Company Z needs fixed rate funds from a bank for three years. The bank is willing to lend at its PLR. This rate varies from bank to bank and is not a fixed rate. For example, in the past twelve months, this rate could have changed( depending on the bank), around six times. Company Z does not want to be exposed to such variations in the interest rate. Hence, it enters into an agreement with a bank to swap all its floating rate flows (MIBOR - based) into fixed rate flows, as shown in the following diagram(refer to box : interest rate flows 2). Every period, say six months, these interest flows will be exchanged. Company Z would still not be fully hedged - there remains a basis risk since PLR may not move totally in tandem with six month MIBOR.

This risk could also be hedged with a PLR / MIBOR interest rate swap. The beauty of derivatives is that the underlying transaction - in Case 3 it is the floating rate cash credit facility - does not get affected. Secondly, the interest rate hedge can be offered by any bank and not just the bank offering the cash credit facility (corporates will not be tied down to the bank offering the underlying funding facility). Thirdly, the interestrate swap avoids the need for exchange of principals, resulting in lower capital adequacy provisions.

Luis Miranda is vice president and head ( foreign exchange & derivatives) at HDFC Bank. The views expressed here are the author's own.