The Example. Company X has obtained a loan of $20 million, with interest rates pegged to the six-month LIBOR. The CFO is of the view that interest rates in the US are on the rise. To prevent a loss by way of a higher interest outflow in the coming years, he decides to enter into an interest rate swap with his banker. Essentially, the banker agrees to pay the corporate a six-month LIBOR rate in return for a fixed interest payment by the corporate.

The Regulation. The banks are permitted to offer both fixed-to-floating as well as coupon swaps. Of course, the banks have to ensure that the final approval for the underlying loan has been received from the RBI. The notional principal amount of the hedge cannot exceed the amount of the underlying loan, and the maturity of the hedge should not exceed the remaining life of the underlying loan.

INTEREST RATE CAPS

The Definition. An interest rate cap is an agreement between the seller and the borrower of a cap, to limit the borrower's floating interest rate to a specific level for a specified time. The cap provides protection against rising interest rates while retaining the opportunity to benefit from lower interest rates if the rates stay below the specified level.

The Instrument. Essentially, the seller of the cap agrees to reimburse the borrower the cost of the LIBOR in excess of a specified rate on each payment date during the duration of the loan. The borrower benefits from the downward movements in interest rates, and limits the upside risks. Interest rate swaps from floating rates to fixed rates lock on to a particular interest rate and, therefore, do not allow a corporate to benefit from favourable interest rate movements. Since the cap is a series of options, the pricing will depend on the strike (CAP) price, the difference between the cap rate and the LIBOR, the tenure of the cap, and the inherent volatility of the exchange rate of the currency in question.

The Example. Company X has obtained a $20-million seven-year loan. The interest on the loan is payable on a six-monthly basis, and is pegged to the six-month LIBOR. To limit the maximum interest rate payable in a period without forfeiting the possibility of lower interest rates, the CFO decides to buy an interest rate cap option. The cap strike rate of 6.50 per cent is based on the US dollar six-month LIBOR, and the maturity period is the same as that of the loan. The company pays an upfront premium of 5.40 per cent of the principal. If, on any date, the LIBOR is more than 6.50 per cent, the company will exercise the option, and the banker will have to pay the corporate the difference.

INTEREST RATE COLLARS

The Definition. An interest rate collar is an agreement between the seller of a collar and the borrower to limit the fluctuations in the borrower's effective interest rate to a band between a specified ceiling rate and a floor rate. It is a combination of an interest rate floor (the reverse of a cap) and an interest rate cap, which provides protection against rising interest rates but limits the gains when interest rates are falling.

The Instrument. The upfront premia on cap options tend to be large. To reduce the cost of the hedge transaction, a limit is placed on the upside gains. As the corporate is assured of both maximum and minimum cash outflows for its future payment obligations by way of interest, the cost of funding is crystallised within an acceptable band.

The Example. Company X has to pay off a floating rate dollar loan. It wishes to insure against the upward movements of the interest rate, but the upfront premium on a cap option will result in a large cash outflow. Therefore, the CFO decides to give away some of his possible gains by limiting the downward movement of interest rates, and creating a collar (band) for his loan. If the LIBOR moves above the collar, the bank will pay the corporate the difference. If the LIBOR dips below the collar, the corporate compensates the bank for the difference.

The Regulation. Banks can now offer both interest rate caps and collars. But the net premium inflow to the corporate still has to be non-negative, stipulates the RBI.

Project Coordinated By Manis Thanawala and Subramanian Sharma, Directors, Greenback Forex Services, Mumbai