CURRENCY SWAPS
THE DEFINITON . A currency swap is a legal agreement between two parties to exchange the principal and interest rate obligations, or receipts, in different currencies. The transaction involves two counter-parties who exchange specific amounts of two currencies at the outset, and repay them over time according to a pre-determined rule that reflects both the interest payment and the amortisation of the principal amount.

THE  INSTRUMENT. Currency swaps enable CFOs to exploit their comparative advantage in raising funds in one currency to obtain savings in other currencies. Usually, banks with a global presence act as intermediaries in swap transactions, helping to bring together the two parties. Sometimes, banks themselves may become counter-parties to the swap deal, and try to offset the risk they take by entering into an offsetting swap deal. Alternatively, banks can hedge themselves by taking positions in the futures markets.

Currency swaps also permit corporates to switch their loans from a particular currency to another depending on their expectations of the future movement of the currency and interest rates. Thus, it offers tremendous flexibility to CFOs seeking to hedge the risks associated with a particular currency. A CFO no longer has to live with a bad decision; if he has selected a wrong currency for his overseas funding operations, a currency swap can undo the damage.

THE EXAMPLE. A CFO has taken a large loan in Japanese yen, and wants to fix the dollar cost and the interest cost of the liability over the tenure of the loan. He would, in this case, enter into a currency swap with his banker to swap the yen loan for a dollar loan to protect himself against a yen appreciation against the dollar, or a rise in yen-denominated interest rates in the future.

THE REGULATION. From August, 1997, the banks have been permitted to offer currency swaps to corporates by booking the transaction overseas, or on a back-to-back basis, without any prior approval from the RBI. Unwinding from such hedge transactions and the payment of upfront premia, as well as the charges incidental to the transaction, can also be effected without the prior approval of the RBI. However, the onus is on the banker to ensure that such hedge transactions are done purely for liability management--and not as stand-alone deals.

INTEREST RATE RISKS

FORWARD RATE AGREEMENTS

THE DEFINITION. A Forward Rate Agreement (FRA) is an agreement between two parties who wish to protect themselves against fluctuations in interest rates. The parties agree on an interest rate for a specific period of time on a specified principal amount.

THE INSTRUMENT. FRAs are an effective instrument for companies which have borrowed at floating rates of interest, and wish to hedge their interest rate risks. The buyer of a FRA is a party wishing to protect itself against a rise in the interest rates, and the seller is a party insuring itself against a decline.

The price of a FRA will depend on the slope of the yield curve--which, essentially, reflects interest rate expectations. Earlier, the FRA was confined to dollar-linked borrowings since the dollar was perceived to be more volatile than the European currencies. However, FRAs now cover a wide selection of currencies and maturities. In an environment of increasing interest rate volatility, a fra helps a corporate crystallise its interest costs.

The Example. Company X is raising a dollar loan, with the effective annual rate at the London Inter-Bank Offered Rate (LIBOR) plus 100 basis points. Instalments are payable every six months. The CFO believes that interest rates in the US will rise in the near future by at least 0.25 per cent. The payments are due in end-September, 1997, and end-March, 1998. Since this is a floating interest loan, the LIBOR for interest payments is crystallised six months in advance. While the LIBOR on August 1, 1997, was 5.70 per cent, the corporate enters into a FRA for two against eight months to protect its interest liability in March, 1998, the LIBOR for which will be fixed in end-September, 1997. The "2s Vs 8s" FRA costs 5.77 per cent. If no interest rate hike takes place, the LIBOR will be applied (5.70 per cent), and the corporate will pay the difference of 0.07 per cent to the FRA-seller as the FRA is independent of the loan agreement. In case the hike happens as expected, and interest rates rise to 5.95 per cent, the corporate will receive 0.18 per cent (5.95Ä5.77) from the seller, and interest on the instalment will be calculated at 5.95 per cent.

The Regulation. The banks can offer FRAs linked to the LIBOR. Again, they have to ensure that such agreements are used purely as a liability management tool.

Interest rate swaps

The Definition. An interest rate swap is a legal agreement between two parties to exchange their interest rate obligations or receipts. Thus, in such a transaction, interest payment streams of differing characters are exchanged according to pre-determined rules, and are based on an underlying notional principal amount.

The Instrument. Interest rate swaps can take different forms as they can be structured to meet each corporate's specific requirements. A fixed-to-floating swap changes the profile of your foreign currency borrowings from fixed to floating rates, or vice-versa. Ideally, to minimise the interest rate risk over the life-span of the loan, a corporate should move from a floating to a fixed rate term at the bottom of an interest rate cycle, and do the opposite at its crest.

A coupon swap, which is also known as an interest-only swap, is an agreement between two parties to exchange their interest rate obligations denominated in different currencies. For instance, if the interest rates on the US dollar are expected to rise, a company with dollar borrowings may wish to switch its interest payments to another currency whose interest rates are expected to fall, or remain steady. The pricing of the swap will depend on the market, and the yield-curves of the currencies in question.

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