The Hindu Business Line : RBI decision to drop MIFOR needs relook

In the absence of MIFORs, banks will be able to hedge themselves, but only by doing an identical currency swap in the market. Currency swaps are very credit intensive and will choke credit lines for counterparties very quickly.

IN a surprise move, the central bank stopped the use of all non-rupee benchmarks for interest rate derivatives with immediate effect.

However, it has granted a transition period of six months, subject to review, for using MIFOR (Mumbai interbank forward offer rate) as a benchmark.

Discontinuing the other non-rupee benchmarks will not have so much of an impact, but MIFOR if discontinued, is sure to have far reaching implications. Moreover, MIFOR isn't really a non-rupee benchmark.

MIFORs are essentially an efficient hedge for currency swaps.

In a MIFOR swap, a counterparty pays a fixed rate and receives the six months implied rupee yield through the forwards, semi-annually and vice-versa.

What one means by the implied rupee yield through the forwards is nothing but the rate at which one can raise rupees through the forward route.

If one has dollars and is required to swap the same into rupees, the total cost of the swap is the premium paid as a percentage of spot and the six months LIBOR (London inter-bank offered rate) as that is the opportunity cost of swapping funds in rupees and not keeping the same in dollars.

So essentially, the floating leg on the MIFOR swap is a combination of the six months LIBOR and the six months forward rate.

If a company raises a dollar loan for five years, say at six months LIBOR and wishes to swap the same into rupees, it will have to enter into a currency swap with a bank domestically.

Under the currency swap, the corporate will give the dollars to the bank and take an equivalent amount of rupees based on the spot rate.

It will then pay the bank a fixed rate of interest every six months and receive the then LIBOR rate on the principal.

At the end of the swap, it will have to give back the rupees to the bank and take its dollars to repay its loan.

So effectively, the corporate would have raised rupee resources at a fixed rate, as the LIBOR payment that it receives from the bank every six months will go towards the payment of interest on its dollar loan.

In the current circumstance, all that the bank will have to do to hedge itself is pay the five-year MIFOR in the market for an equivalent amount and swap the dollars that it gets from the corporate into rupees for six months by paying the six months forward premium.

Under the MIFOR swap, it will pay a fixed rate and receive a combination of LIBOR and the six-month dollar-rupee forward rate, every six months. From the bank's perspective, every six months, it pays a fixed rate to the market, which is what it receives from the corporate under the currency swap.

Similarly, every six months it receives the floating leg, of which it uses the LIBOR component to pay to the corporate under the currency swap and the dollar-rupee forward component to roll over the six-month sell buy swap.

The MIFOR swap is very credit efficient, as it is a pure interest rate swap and hence does not involve the exchange of principal.

In the absence of MIFORs, banks will be able to hedge themselves, but only by doing an identical currency swap in the market.

Currency swaps are very credit intensive and will thereby choke credit lines for counterparties very quickly. This will in turn make currency swaps illiquid, thereby increasing the market bid offer spread to 30-40 basis points from 5 basis points currently.

MIFORs are not only used to hedge and price currency swaps, they are also used for pricing and hedging long-term forwards and options.

The absence of MIFORs will hurt their liquidity as well and we shall go back at least five years in terms of market development.

In a theoretical framework, the six-month implied rupee yield through the forwards should be exactly the same as the six-month inter-bank term money rate.

We have read in our textbooks that the forward rate is nothing but the interest rate differential between two currencies, but in the Indian context that is not true.

If you look at the data for the last couple of years, the six months composite swap yield has rarely been close to the cash rate.

In periods of dollar shortage, the swap yield has been significantly lower than the cash rate for considerable periods of time, which makes it extremely difficult for a bank to hedge its currency swap risk using any other rupee benchmark swap.

In this context, I would request the central bank to review its decision of discontinuing MIFOR swaps after six months.

Thanks to the MIFORs, India has a very liquid currency swap curve out to 10 years.

Its discontinuation will not only hurt the long-term balance sheet hedging but also impact the development of the rupee options market.

(The author is senior trader, Interest Rates at HSBC Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Left to oppose pension Bill

Foreign inward remittance — Getting rid of the stumbling blocks

RBI decision to drop MIFOR needs relook

Life insurers, MFs help bonds rally

Visakhapatnam girijans suffer exploitation by money-lenders