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Morning Briefing
Liquidity Concept

From this week, Liquidity introduces Concepts, an educative segment to the ever changing world of finance, and its best uses. This week Liquidity introduces the basic concepts of Interest Rate Swaps, the most powerful financial tool to take care of interest rate movements, balance sheet management and enhance corporate profitability.

An Interest Rate Swap (IRS) is an agreement between two parties to exchange stated interest rate obligations for a certain period in respect of a notional principal amount.

Basic Characteristics of an IRS

  • contractual agreement
  • exchange a series of cash flows
  • only net cash flows exchanged
  • over a period of time
  • not in itself either a borrowing or lending
  • the size of the swap is referred to as the notional amount and is the basis for calculation
  • actual principal of the swap NOT exchanged
  • it is an off-balance sheet transaction


  • An Example

    Days A corporate enters into a swap agreement with a bank, whereby both agree to exchange cash flows as follows:
    The Bank pays a fixed rate of 8.50% to the corporate and the corporate, in turn, pays a floating rate computed at the inter-bank call rate benchmark of NSE Mumbai Interbank Offer Rate (MIBOR). The tenor of the deal is 7 days and the settlement of the deal would take place at the end of the 7 day period. The corporate would pay the call rate benchmark on a daily compounded basis. The face value of the transaction is Rs. 10 cr. Now, suppose the NSE MIBOR for the tenor of 7 days is as given in the adjoining table:

    At the end of the tenor of the swap, i.e. 7 days, the bank has to pay 8.50% on a notional amount of Rs. 10 cr. for 7 days. The corporate, in turn, has to pay the floating rate (i.e. NSE MIBOR) compounded daily, which is calculated as follows:

    Floating Rates

    Hence, the Floating Rate that the corporate has to pay would be 8.33% As mentioned in the characteristics, the payment is on net basis, i.e. the corporate has to receive 8.50% and has to pay 8.33% on a notional principal of Rs. 10 cr, i.e. a differential of 0.17%. Hence, in this transaction, the corporate receives a net payment of Rs. 3261, which is computed as follows:

    Rs. 10,00,00,000 X 0.17% differential X 7 days tenor / 365 days = Rs. 3261

    By entering into a swap agreement, at the beginning of the period, the corporate took advantage of the falling short term interest rates. On the converse had the short term rates gone up, the corporate would have to pay to the bank. However, all the receipts or payments are on net basis on a principal amount which is notional. In the above example we have used the call rate benchmark as the floating rate leg against a fixed rate of 8.50%. This kind of a swap is called as an Overnight Indexed Swap (OIS), since the floating rate is benchmarked against an overnight, i.e. call rate index. This is what “Liquidity” has been mentioning in its weekly reports in the inter-bank section. Hence, generically this is a fixed versus floating swap. To put a very simple diagramatic representation of the swap:

    Chart

    Other floating rate benchmarks that can be used are:
  • Commercial Paper Rates
  • Treasury Bill Rates
  • Government of India security rates/yields
  • Inter-bank term money rates
  • Inter-bank Rupee/USD Forward rates
  • Certificate of Deposit Rates
  • Prime Lending rates
  • Bank Rate
  • OR any other rates which are in agreement by the two counterparties


  • There are also floating versus floating swaps, in which both the benchmarks are of floating nature, i.e. agreeing to receive call rates + 130bps and receiving 3 month Rupee/USD Forwards. Here both the legs of the swap are of a floating nature. Swaps can be structured as per the needs of both the counterparties.

    Some important terminologies used in the swaps are: When a swap is made, there are several dates to consider:
    The transaction date or trade date is the date when the parties agree to enter into a swap.
    The effective date for a swap is the date from which the fixed and floating rate payments begin to accrue.
    A reset date or a fixing date is the date when the floating rate is reset.
    The maturity date is the end of the term of the swap.


    For example, Bank enters into a swap with a corporate counterparty on 1st January 2001, to pay a fixed rate of 10% & receive 3 month MIBOR, after every 3 months, having a tenor of 1 year. The swap starts on 1st April 2001, and ends on 1st April 2002. The transaction date is 1st January 2001, the effective date of the swap is 1st April 2001. Reset dates are every 3 months, i.e. 1st July 2001, 1st October 2001, 1st January 2002. The maturity date of the swap is 1st April 2002.

    Sale And Purchase of IRS
    The sale of an IRS by the bank, means that the bank is receiving fixed and paying floating interest rates, at each reset date. This protects against a fall in the interest rates, where any party is to lend in the cash markets.

    The purchase of an IRS, means that the bank is paying fixed and receiving floating interest rates, at each reset dates. This protects against a rise in the interest rates, where any party is to borrow in the cash markets.

    In the Indian markets, the most widely quoted and liquid swaps are the OIS, explained in the example above. A typical quote sheet would look as follows:


    1 Month

    9.23%
    8.00% - 8.10%

    9.10% - 9.40%
    2Months

    8.25% - 8.35%
    3Months

    8.50% - 8.60%
    6Months

    8.65% - 8.75%
    1Year

    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 floating rate.

    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 period.

    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
    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.

    Interest Tax
    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
    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.

    Stamp Duty
    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

    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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