Copying and distributing are prohibited without permission of the publisher.



07 Dec 1998

Though Indian entities are acquiring a greater awareness of hedging instruments for exchange rate and interest rate exposures, an active derivatives market has yet to develop.

Though Indian entities are acquiring a greater awareness of hedging instruments for exchange rate and interest rate exposures, an active derivatives market has yet to develop. The majority of derivative transactions in India are in currencies other than the rupee. However, this is not to say that Indian rupee-denominated derivatives do not exist and this article will highlight currency swaps.

It was the Reserve Bank of India's mid-year Credit Policy of 1997 which paved the way for U.S. dollar/Indian rupee currency swaps. The Reserve Bank of India allowed entities in India--only some offshore entities can access the markets--to hedge long-term foreign currency exposures by entering swaps with banks in India. At the same time, the Reserve Bank allowed Indian companies with rupee-denominated liabilities to swap into foreign currency liabilities. This paved the way for currency swaps.

Controls on credit delivery, imposition of minimum reserves and capital controls mean that the Indian rupee money market is highly illiquid, especially at the long end of the yield curve. There is no reliable benchmark interest rates such as LIBOR. There has been an effort among banks to develop a benchmark overnight MIBOR--the Mumbai interbank offer rate--but the lack of a liquid money market has meant that MIBOR for longer tenors does not exist. Hence, Indian rupee currency swaps have developed as an extension of short-dated forward contracts and the absence of a reliable floating-rate benchmark has resulted in the development of swaps with a fixed interest rate on the rupee side.

Though the forward markets are liquid for tenors up to one year, interest parity does not necessarily hold true due to the reasons mentioned above. The rupee interest rate--implied from the forwards--is usually higher than local interbank money rates, making it expensive for firms to raise fully-hedged rupee resources from overseas borrowings. The difference between the implied interest rate and the risk-free Indian rupee interest rates--the swap spread--has oscillated wildly in the last few months (see graph).


A significant inhibiting factor in the development of an Indian rupee swap market is the lack of a representative market curve for marking-to-market currency swaps. Since no liquid market exists, this has to be done in a ad-hoc manner based on one of the following two methods:


Banks often obtain indicative quotes from the market and these rates (suitably interpolated) are used for marking-to-market USD/INR swaps. Through it is easy to obtain quotes from several banks, these quotes are unrepresentative of the actual cost of closing existing positions, due to the illiquidity of the market.  


Another method for deriving the relevant Indian rupee swap rate assumes that the swap rate is higher than the risk-free curve by the swap spread, which remains approximately constant across the maturity curve. The swap spread for long tenors, can be calculated as the average of the swap spread--the difference between the government bond yield curve and the forward curve--for tenors up to 12 months. Thus, the risk-free curve adjusted by the swap spread would give the Indian rupee swap curve.

As we have noticed, swap spreads are highly volatile and this reduces the efficacy of this method of valuing currency swaps. As liquidity in the swap market improves, banks would move towards using the swap offer rate, quoted by the market, for valuing swaps.


Though the Reserve Bank has opened up the swap market for Indian entities, this market is still illiquid. The main reasons are as follows:

* Lack of a liquid money market curve. A liquid money market curve would provide a benchmark cost of funds and the swap curve would be near this. Players would be better able to price and hedge positions by using the money market;

* Inability to short Government of India securities and the lack of a liquid repo market. A liquid repo market would give the ability to borrow collateralized funds for long tenors and this would help create another benchmark curve, which can be used for pricing currency swaps;

* Extreme swings in the value of the rupee and the forward premium results in a one-sided market. Until August 1997, swap rates were very low with most companies interested in taking on a dollar-denominated liability. However, with the weakness of the Indian rupee at present, most companies are interested in swapping existing dollar-denominated liabilities into rupee. Such a one-sided market view results in sharp oscillations, and hence, an illiquid market;

* Restrictions on offshore players reduces the liquidity of the market and results in arbitrage opportunities for a limited set of participants;

* Non-availability of long-dated credit limits. Foreign banks have been at the forefront of the development of the Indian rupee cross-currency swap market. The South East Asian crisis coupled with the downgrading of India's sovereign ratings have resulted in limitations on credit limits available.

* Aggregate gap limits/individual gap limits. Regulatory restrictions on forward mismatches in the form of AGL/IGL inhibits active market-making in long-tenor forwards and currency swaps;

* Documentation. This was a significant hindrance to the development of the currency swap market. However, the International Swaps and Derivatives Association's Master Agreement, suitably modified as per Foreign Exchange Dealers Association of India guidelines has become gradually accepted as the market standard. Yet, the lack of familiarity coupled with the paucity of legal counsel versed in the workings of the financial markets is a roadblock to the universal acceptance of this agreement; and

* Tax Issues. Doubts regarding the application of Indian tax laws on currency swaps are another reason for the slow development of the currency swap market.

This week's Learning Curve was written byMukund Santhanam, senior manager derivative sales atStandard Chartered Bankin India.

07 Dec 1998