With the introduction of rupee derivatives the Indian corporates can attempt to reduce their cost of borrowing and thereby add value.
A typical Indian case would be a corporate with a high fixed rate obligation.
Eg.
Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of 18.5%. Today a 364-day T.
bill is yielding 10.25%, as the interest rates have come down. The 3-month MIBOR is quoting at 10%.
Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month MIBOR.
The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next one year.
The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75 %.
The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75
= 7.75 + MIBOR
At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75%
The gain for the firm is (18.5 - 17.75) = 0.75 %
The risks involved for the firm are
- Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments.
- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond 10.75% will raise the cost of funds for the firm.
Therefore it is very essential that the firm hold a strong view that MIBOR shall remain below 10.75%. This will require continuous monitoring on the path of the firm.
How does the bank benefit out of this transaction?
The bank either goes for another swap to offset this obligation and in the process earn a spread. The bank may also use this swap as an opportunity to hedge its own floating liability. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%.
Taking advantage of future views/ speculation
If a bank holds a view that interest rate is likely to increase and in such a case the return on fixed rate assets will not increase, it will prefer to swap it with a floating rate interest. It may also swap floating rate liabilities with a fixed rate.
A typical Indian case would be a corporate with a high fixed rate obligation.
Eg.
Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of 18.5%. Today a 364-day T.
bill is yielding 10.25%, as the interest rates have come down. The 3-month MIBOR is quoting at 10%.
Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month MIBOR.
The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next one year.
The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75 %.
The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75
= 7.75 + MIBOR
At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75%
The gain for the firm is (18.5 - 17.75) = 0.75 %
The risks involved for the firm are
- Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments.
- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond 10.75% will raise the cost of funds for the firm.
Therefore it is very essential that the firm hold a strong view that MIBOR shall remain below 10.75%. This will require continuous monitoring on the path of the firm.
How does the bank benefit out of this transaction?
The bank either goes for another swap to offset this obligation and in the process earn a spread. The bank may also use this swap as an opportunity to hedge its own floating liability. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%.
Taking advantage of future views/ speculation
If a bank holds a view that interest rate is likely to increase and in such a case the return on fixed rate assets will not increase, it will prefer to swap it with a floating rate interest. It may also swap floating rate liabilities with a fixed rate.