8.00% - 8.10%
9.10% - 9.40%
8.25% - 8.35%
8.50% - 8.60%
8.65% - 8.75%
8.90% - 9.00%
This would mean that the bank is willing to pay a fixed rate of 8.00% and receive daily daily compounded call rate for a 1 month period. If the average daily compounded call rates are below 8.00% for the next 1 month, then the bank will
pay the differential and if they are above then the counterparty would pay the differential to the bank. Similarly, the bank is willing to receive 8.10% and pay daily compounded call rate for a 1 month period. If the average daily compounded call rates are below 8.10% for the next 1 month, then the bank will receive the differential and if they are above then the counterparty would receive the differential to the bank. Similar interpretation goes for the other tenor swaps. Hence, if “Liquidity” makes a recommendation to receive 3 months OIS at 8.00%-8.15%, it actually means that
the corporate counterparty should enter into a swap agreement with the bank to receive a fixed rate of 8.15% and pay
the daily compounded call rate, as the expectations are that the call rates would, on an average, be below 8.15% over
the next 3 months. A corporate can also reverse the swap by either canceling the swap on mutually agreeable terms or entering into a reverse swap for the tenor matching the earlier swap. For, e.g. if the recommendation of receiving 3
month OIS at 8.15% wants to be reversed by the corporate after 1 month of the swap, then the corporate can pay the
market rate for a 2 month OIS at the market rate. This would also tantamount to trading in swaps, which banks do regularly, but corporate counterparties are advised to avoid unless they understand the underlying benchmark markets very well. But, the basic understanding is as follows:
Fixed rate payers :
Lose when interest rates fall; Gain when interest rates rise
Floating rate payers :
Gain when interest rates fall; Lose when interest rates rise
The advantages of an IRS:
Asset-Liability mismatch correction
IRS will help the corporate to optimally manage its Structural Balance sheet. A corporate having predominantly fixed
rate long term assets and short term liabilities can enter into a swap where it pays fixed for a long term and receive
floating linked to a shorter tenor benchmark from the counter-party. The corporate could thus keep borrowing short
term and match its longer tenor assets.
Opens up diverse avenues of funding
Swapping the underlying liability into the desired interest rate basis (fixed/floating) allows the corporate to access
various markets for funding, despite a mismatch between the characteristics of the underlying borrowing and its actual
requirements. For example, the corporate may make a long tenor issuance on the fixed rate basis but may require
that the actual liability on floating rate Rupees. In order to achieve this objective, the corporate could swap the fixed
rate funds raised to floating rate funds. As a result, the IRS offers the corporate flexibility to move to the interest rate
basis of its choice.
Hedging Floating Rate Risks
If any corporate has a floating rate liability, it would have no control if the floating rate benchmark were to shoot up. It
can, however, enter into a swap to receive the same floating benchmark and pay a fixed rate, to hedge this risk.
Taking advantage of low floating rate borrowings:
A corporate cannot borrow in the inter-bank call markets, but can create a synthetic call linked liability by borrowing its
routine fixed rate ICDs/CPs and then entering into a swap where it agrees to receive fixed rate and pay a call linked
Low Credit Risk
Only the net interest payments are exchanged, thereby, circumventing the need to exchange the gross amounts, on the settlement date. This leads to a lower credit exposure on the counter-party. The credit exposure of an IRS is less than a cash market.
Decouple funding & duration decisions
IRS allows the corporates to control the duration for which the interest rate on its short term positions is locked in without having to fund the same for matching maturity. In simplistic terms, this would mean that the corporate can borrow its funding requirements in the tenor available, but can then structure it as per its needs using IRS
Can be customized - flexibility in the management of interest rates
The IRS market is flexible in it’s maturity range. It is possible to manage the duration of its liablities in order to exploit
the opportunities or react to sudden changes in the market condition without having to prepay borrowings.
Smoothening out Interest Rate fluctuations
If varying amounts of money are borrowed or invested, it is difficult to estimate the future interest Rates. As interest
rate markets can be volatile, cash flow projections can be used to invest or fund an average balance over a longer
Risks in an IRS:
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 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 IRS
Income Tax Act
IRS solely for the purpose of hedging may be treated as a part of the original liability for which the IRS has been
undertaken, and therefore be liable to tax accordingly.
An IRS transaction falling outside the scope of loan or advance or discount, as referred to in the IT Act, may not
attract interest tax. According to IT Act, a payment can be regarded as interest only if it is payable in respect of any
money borrowed or debt incurred. In an IRS, there is no real lending of money or otherwise. The intention of the
parties entering an IRS is not to create a debtor-creditor relationship. The party paying interest does not do so in
respect of any money borrowed or debt incurred. Hence, the payments cannot be characterised as being interest
payments under the IT Act.
TDS will not be deducted on a Swap transaction, as the amounts paid by each party to the other cannot be regarded
as interest. Interest provisions of Section 194A of the Income Tax Act will thus not be applicable.
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
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.
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