Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Two curves and non deliverable interest rate swaps

I have blogged about the importance of two curve discounting in valuation of swaps (here and here), and I have separately blogged (here, here, here and here) about the growing offshore market in rupees and other emerging Asian currencies. But it was an alert reader of the blog who pointed out to me a very interesting connection between the two. The instrument that lies at this intersection is the non deliverable interest rate swap (NDIRS). This is like the non deliverable forward (NDF) market in that it is cash settled in US dollars and operates out of reach of the local regulators. But the underlying product is an interest rate swap rather than a forward contract. The two parties agree to exchange a floating interest rate for a fixed interest rate in rupees or renminbi or other emerging market currency. However, the contract is non deliverable and is therefore cash settled in US dollars without any cash flows in the underlying currency.

The issue is about valuation of the swap and the complexity arises because in India and in many other emerging markets, the OTC derivative market runs without collateralisation. As I explained in my earlier blog post, this means that the valuation depends on the funding cost of the counter parties involved. The problem affects the valuation of the swap even at inception (particularly when the yield curves are quite steep), but the problem is most acute and clearly understood for a swap which has moved into or out of the money some time after inception.

For example, consider a hedge fund that entered into a five year swap agreeing to pay a fixed rate of 5.25% and received floating. After some time, suppose that the swap rate has moved to 5.75%. The hedge fund can now lock in a risk free profit of 0.50% per year for the next five years by entering into another swap in which it receives fixed at today’s rate (5.75%) and pays floating. The net effect of the old swap and the new swap is that the floating legs cancel and the hedge fund simply receives 0.5% fixed for the next five years. The question that arises is what should the hedge fund receive if it wants to unwind the two offsetting swaps and simply pocket the entire profit upfront instead of letting the profit trickle in over five years.

The simple and obvious answer of course is that the hedge fund should receive the present value of the annuity of 0.50% a year. The tricky part is to agree on the discount rate for determining this present value. If the hedge fund goes to a local bank that funds itself largely in the onshore market, the answer would clearly be a discount rate based on the onshore interest rates. On the other hand, if the hedge fund goes to a foreign bank that funds itself largely in the offshore market (borrowing US dollars and swapping into rupees or renminbi), then the discount rate would be based on the all-in (swapped) cost of the offshore borrowing. This latter cost of funds is given by the cross currency swap rates (where a US dollar floating rate is swapped for fixed rate in rupees or renminbi).

In countries with capital account convertibility, there is not too much of a difference between the onshore swap yield curve and the cross currency swap curve because of covered interest parity (CIP). But CIP is clearly not applicable to rupees and renminbi! The cross currency swap rate for currencies like renminbi can actually be negative because of the wall of money wanting to speculate on the appreciation of the currency. Even if things do not get that bad, the gap between the two curves can be several percentage points. Swap valuation using the cross currency swap rate is a form of two curve discounting – the forward rates come from the onshore swap market and the discount rates come from the cross currency swap market.

Smart hedge funds know all about this and choose the banks carefully when unwinding trades. It would clearly like a low discount rate when unwinding a winning trade and a high discount rate when unwinding a losing trade. A bank that watches the hedge fund do this probably feels frustrated, but in fact, the bank is not being cheated at all as the unwind is done at the rate offered by the bank. What the hedge fund is doing is to arbitrage between the onshore and offshore markets with their different interest rates.

All this assumes that the banks are smart and know what their funding costs are. While this may be true of the most sophisticated banks, it is certainly not true for all banks. Some banks may also not be fully clear about the difference between average cost of funds and marginal cost of funds. A foreign bank that funds 90% of its rupee balance sheet in local currency deposits and borrowing may think that its cost of funds is the onshore rate. But if it depends on offshore borrowing for the incremental growth of the balance sheet, it may still be true that its marginal cost of funds (which is all that is relevant for valuation and pricing) is actually the offshore rate. Some banks surely get this wrong.

The lesson in all of this is that the non deliverable market is quite a big mess and there is plenty of scope for supplanting this to a great extent with an onshore cash settled exchange traded currency derivative and interest rate derivative market. Without compromising on capital controls, these exchange traded markets would improve transparency and would move the market (and associated high paying jobs) onshore.

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One response to “Two curves and non deliverable interest rate swaps

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