The Hindu Business Line : MIFOR exit will narrow options on risk management

LAST week, suddenly, out of the blue, the RBI asked the financial market to stop using the Mumbai Inter-bank Forward Offer Rate (MIFOR) as a benchmark for swaps.

A six-month phase-out period has been given, after which MIFOR swaps will disappear. Existing contracts may run till maturity or be unwound on mutually agreed terms.

The RBI's move has predictably shocked the financial community. The central bank was flooded with pleas to allow continuance of the MIFOR benchmark.

In its circular, the RBI explained that, in the incipient stage of the domestic derivatives market, it was necessary to use foreign interest rate indices such as LIBOR as no local index was sufficiently well-developed to serve the purpose. Now that the market has grown in size and liquidity and the Mumbai Inter-bank Offer Rate (MIBOR) is widely used to price the floating leg of swaps, it is time to dispense with MIFOR, which is essentially a LIBOR-linked rate.

MIFOR is nothing but the all-in cost of rupee funds through the dollar route. It is the sum of LIBOR and the forward premium on the US currency vis-a-vis the rupee and enables comparison of the costs of raising resources abroad and from the domestic market.

In a fully arbitraged market, the cost of funds should be the same whether the source is the domestic money market or the offshore market, because the interest rate advantage in (say) dollars will be neutralised in its forward premium.

For reasons not relevant to this discussion, this is not so in the dollar-rupee forward market. Thus, till recently, before US interest rates and forward premiums went up, there was a clear advantage of 3 per cent or so in the cost of dollar funding.

The dollar-rupee forward market is liquid only up to 12 months. To meet hedging requirements beyond 12 months, the market came up with the innovation of the MIFOR swap in which the counterparties exchange a fixed rate and a floating rate reset every six months, based on prevailing LIBOR and the dollar-rupee forward premium. Through this product, a dollar borrower can, for example, lock in the forward premium for as long as five years.

The beauty of a MIFOR swap is that it is a pure rupee swap but also offers protection against currency risk. Indeed, MIFOR swaps are inherently much less risky than currency swaps. As the market for long-term dollar-rupee swaps is thin, they fulfil the market's need for an alternative to freeze the cost of dollar liabilities in rupee terms. Even an exporter with predictable dollar cash flows can `fix' his rupee conversion rate for several years into the future using MIFOR swaps.

In these times of increasing multi-currency balance sheets, it would be a blow to effective risk management - another major concern of the RBI - if this instrument exits the market.

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