Concepts introduces Foreign Currency swaps, in this issue. A foreign currency swap (FCS) is an "exchange of borrowings", where the principal and interest payments in one currency are exchanged for principal and interest payments in another currency. A formal definition of the same is a contractual arrangement between two counter-parties in which one counter-party agrees to make payments in one currency to the second counter-party, in return for receiving payments in another currency from the second counter-party.
The following are the basic combinations of FCS that are generally structured:
Corporate pays fixed Rupee interest and receives fixed FC interest.
Corporate pays fixed Rupee interest and receives floating FC interest.
Corporate pays floating FC interest and receives fixed Rupee interest.
Corporate pays fixed FC interest and receives fixed Rupee interest.
In effect, FCS is nothing but an IRS (described in earlier Concept issues), where one interest rate is in Rupees and the other stream of cash flows is in a foreign currency, the net settlement flows of which are multiplied at the predetermined exchange rate
Exchange of interest flows
The flow of interest between the two counterparties, i.e. the corporate and it’s swap bank, would happen on the reset dates at pre-determined interest rates to the corporate on the FC funds obtained under the initial principal exchange. The corporate would pay its swap bank interest on the Rupee amount obtained from them at a pre-determined interest rate. Net Rupee flows would be exchanged based on the spot exchange rate prevailing on the interest payment dates. The frequency of the interest rate exchange could be as per the corporate’s underlying borrowing interest payment dates.
Exchange of principal flows
The exchange of principal amounts in different currencies is optional at swap inception, but mandatory on swap maturity, as explained below: Exchange of Principal amounts at start and maturity of the swap :
This occurs when the corporate has not utilised the funds drawn down under the underlying borrowing. The corporate exchanges the principal with its swap bank at the start and termination of the swap. The corporate’s swap bank exchanges the equivalent Rupee funds in return for the FC principal amount proposed to be swapped, on the start and maturity dates at the then prevailing spot exchange rate. The structure of the swap depends upon the corporate’s underlying borrowing. This is generally done when the corporate is undertaking a fresh borrowing and wants to use the FCS to structure the actual nature of its borrowings. Exchange of principal only on maturity of swap :
This occurs when the amount drawn down under the underlying borrowing has already been utilised by the corporate, the FCS could involve exchange of principal amounts only on termination, based on the structure of the underlying borrowing. The corporate’s swap bank exchanges the equivalent Rupee funds in return for the FC principal amount proposed to be swapped, on the maturity date at the spot exchange rate on the start of the FCS. This is generally done when the corporate is hedging a borrowing that it has already contracted and is taking advantage of the low market rates to hedge the remaining maturity of its borrowing.
Lets study the following illustration. An export oriented corporate enters a FCS with the following terms:
Under the above mentioned terms, the corporate pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5 years. Hence, the corporate, which would earlier have to pay fixed Rupee interest on his Rupee borrowings, has now converted the same into a USD floating rate borrowing. Hence, if the Corporate’s original Rupee borrowing is done at 12.00% p.a., it has converted the same into 6 months LIBOR + 1.00% (under the FCS, it would receive only 11.00%), effective borrowing. Such kind of structures are useful for corporates having USD income, hence it would stand to reduce its cost as it pays USD interest rates.
Interest Flows:
On every 1st January and 1st July, the corporate receives from the swap bank 11.00% of Rs. 47 cr. X (6 / 12) = Rs. 2.59 cr. The corporate, in turn pays the 6 month USD LIBOR on USD 10 million. Suppose on the first reset date, such rate is USD 5.00%. Then the corporate pays 5.00% of USD 10 million in Rupee terms, converted at the then prevailing exchange rate, which if in the e.g. is Rs. 48.00 / USD, the interest amount payable by the corporate would be (10,000,000 X 5.00% x 0.5) X 48.00 = 1.20 cr.
In effect, the corporate receives 1.39 cr. This continues on every interest payment dates till the maturity of the swap.
In the above example, the corporate is taking 2 risks - one is the rising USD LIBOR rates and second is the depreciation in Rupee-Dollar exchange rate. The first risk can be hedged by converting the USD floating rate into USD fixed rate by doing a further USD fixed to floating swap. As regards the risk of currency depreciation, since the corporate is an Exporter any depreciation in Rupee would also earn it extra on its export earnings. In a similar manner, corporates having long term FC borrowings can also hedge their exchange rate risk by entering into a FCS, with the reverse implications. The above example is converting fixed Rupee into floating USD rate. Corporates can also convert their fixed Rupee into fixed USD, by doing a floating USD to fixed USD swap, which are very liquid markets traded in the international markets. Hence, all the four combinations can be hedged into.
Advantages of FCS
Conversion of the currency profile of the underlying liability based on appetite for exchange risk
Corporates with limited appetite for exchange rate risk may move to a partially or completely hedged position through the mechanism of the FCS, while leaving the underlying borrowing intact. On each due date, the FC amounts necessary for meeting the debt service obligation on the underlying borrowing would be provided by the swap bank. Apart from covering the exchange rate risk, the FCS also allows the corporates to hedge the floating interest rate risk. Conversely, if the client has a natural hedge in FC, it could swap an existing Rupee liability into FC and avail of the benefit of lower FC interest rates.
Lower charge for credit risk compared to a loan, due to the cash- collateralised nature of the transaction
FCS involves exchange of interest and principal payments in two currencies, between the corporate and the swap bank on each due date. As the transaction is cash-collateralised, the credit charge is considerably lower than that on a comparable loan. In the event the corporate is able to borrow in FC at a low interest cost, it could swap the FC into Rupee with a minimal credit charge for the swap and obtain a lower overall cost for the Rupee financing.
Opens up diverse avenues of funding
Swapping the underlying liability into the desired currency and interest rate basis (fixed/floating) allows the corporate to access various markets for funding, despite a mis-match between the characteristics of the underlying borrowing and its actual requirements. For example, the corporate may make a long tenor issuance in the USD bond market on fixed rate basis but may require that the actual liability be denominated in fixed rate Rupees. In order to achieve this objective, the corporate could swap the fixed rate FC funds raised by way of the USD issuance into fixed rate Rupee funds from the swap bank. As a result, the FCS offers the client flexibility to borrow in any market, domestic or international, and ultimately move to the currency and interest rate basis of its choice
The corporate could benefit from differential credit risk perception between markets
In case the corporate enjoys a more favorable credit risk perception in a certain segment of the international capital markets, it can borrow FC funds, with a lower credit risk premium as compared to the domestic market. However, if the corporate does not require the resultant exposure to exchange rate risk, it could opt for a FCS with the swap bank, which would convert the corporate’s liability into Rupees, while protecting the benefit of the lower credit risk premium.
Risks of FCS
Interest Rate Risk
There is an inherent Interest Rate Risk on the swap just like the risk interest Rate Risk on any other financial
instrument. Any movement in interest rates would affect the cashflow.
Liquidity Risk
Liquidity Risk is the risk that a position will be difficult to reverse by either liquidating the instrument or by
contracting an offsetting position as these contracts are customised to the requirement of the counterparties.
Taxation Issues of FCS
Income Tax Act
FCS solely for the purpose of hedging may be treated as a part of the original liability for which the FCS has been
undertaken, and therefore be liable to tax accordingly.
Withholding Tax
Withholding tax will not be deducted on a Swap transaction, as the amounts paid by each party to the other cannot
be regarded as interest. This is one of the biggest advantages as the current budget has hiked the withholding tax to 20% of the gross interest amount payable of FC loans. By borrowing Rupees and swapping it into USD an FCS can help circumvent this provision.
Stamp Duty
One school of thought opines that the master ISDA agreement would be liable to a one-time stamp duty of Rs 120/-. The confirmation would not be liable to any stamp duty as they fall outside the definition of an ‘instrument’ under the Bombay Stamp Act. A second school of thought, on the other hand, says that a confirmation overrides the ISDA and must be stamped for it to be accepted in a court of law. It is advisable for transacting parties to seek professional legal counsel in this aspect if there is any doubt.
DISCLAIMER
The above views are based on the latest available information. Though the information sources are believed to be reliable, the information is not guaranteed for accuracy. While the views are proffered with the best of intentions, neither the author, nor the firm are liable for any losses that may occur as a result of any action based on the above. The financial markets, and especially the Indian money markets, are illiquid and inherently risky and it is assumed that those who trade these markets are fully aware of the risk of real loss involved.
Unauthorized copying, distribution or sale of this publication is strictly prohibited.
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