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2 Interest Rate Risk Management

IB, an Indian firm, and Zaki, a Japanese firm, each have subsidiaries in the other's country. They face different interest rates in their local currencies. Zaki wishes to borrow rupees at a floating rate while IB wishes to borrow yen at a fixed rate. A swap arrangement can benefit both firms by allowing them to effectively borrow at each other's more favorable rates. With a 25 basis point commission for the financial institution arranging the swap, the firms can share equally in the interest rate differential between their local rates.

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sandesh Sandesh
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49 views

2 Interest Rate Risk Management

IB, an Indian firm, and Zaki, a Japanese firm, each have subsidiaries in the other's country. They face different interest rates in their local currencies. Zaki wishes to borrow rupees at a floating rate while IB wishes to borrow yen at a fixed rate. A swap arrangement can benefit both firms by allowing them to effectively borrow at each other's more favorable rates. With a 25 basis point commission for the financial institution arranging the swap, the firms can share equally in the interest rate differential between their local rates.

Uploaded by

sandesh Sandesh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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QUESTIONS –1(EXAM NOV.

2020 OLD SYLLABUS, 8 MARKS)


IB an Indian firm has its subsidiary in Japan and Zaki a Japanese firm has its
subsidiary in India and face the following interest rates:

Company IB Zaki
INR floating rate BPLR + 0.50% BPLR + 2.50%
JPY (Fixed rate) 2% 2.25%

Zaki wishes to borrow Rupee Loan at a floating rate and IB wishes to borrow
JPY at a fixed rate. The amount of loan required by both the firms is same at
the current exchange rate. A financial institution may arrange a swap and
requires 25 basis points as its commission. Gain, if any, is to be shared by the
firms equally.

You are required to find out:


(i) Whether a swap can be arranged which may be beneficial to both the
firms?

(ii) What rate of interest will the firms end up paying?

Answer
Though Company IB has an advantage in both the markets but it has
comparative more advantage in the INR floating-rate market. Company Zaki
has a comparative advantage in the JPY fixed interest rate market.

However, company IB wants to borrow in the JPY fixed interest rate market
and company Zaki wants to borrow in the INR floating-rate market. This gives
rise to the swap opportunity.

IB raises INR floating rate at BPLR + 0.50% and Zaki raises JPY at 2.25%
Total Potential Gain = (INR interest differential) - (Yen rate differential)

= (BPLR + 2.50% - BPLR + 0.50%) + (2% - 2.25%) = 1.75%

Less Banker's commission (To be shared equally) = 0.25%

Net gain (To be shared equally: 0.75% each) = 1.50%

(i) Yes, a beneficial swap can be arranged


(ii) Effective cost of borrowing = pays to lenders + pays to other party -
receives from other party + banker's commission

IB = BPLR + 0.50% +1.125%* - (BPLR + 0.50%) + 0.125% = 1.25

(* has been arrived as 2% - 0.75% - 0.125%)

Zaki = 2.25% + BPLR + 0.50% - 1.125% + 0.125% = BPLR + 1.75%

Note: Candidates can also present the above Swap arrangement in a


different manner. In such case they should be awarded due marks provided
solution be ended up in correct answer.

QUESTION – 2 (EXAM MAY 2019 OLD SYLLABUS, 8 MARKS)


IM is an American firm having its subsidiary in Japan and JI is a Japanese
firm having its subsidiary in USA: They face the following interest rates

IM JI
USD Floating rate LIBOR + 0.5% LIBOR +2.5%
JPY Fixed rate 4% 4.25%

IM wishes to borrow USD at floating rate and JI JY at fixed rate. The amount
required by both the companies is same at the current Exchange Rate. A
financial institution requires 75 basis points as commission for arranging
Swap. The companies agree to share the benefit/ loss equally.

You are required to find out


(i) Whether a beneficial swap can be arranged ?

(ii) What rate of interest for both IM and JI ?

Answer
(i) IM has overall strong position and hence is in a comparative
advantageous position in both rates. However, it has a comparative
advantage in floating-rate market.
The differential between the U.S. dollar floating rates is 2.00% per
annum, and the differential between the JPY fixed rates is 0.25% per
annum. The difference between the differentials is 1.75% per annum.
The total potential gain to all parties from the swap is therefore 1.75%
per annum, or 175 basis points. If the financial intermediary requires
75 basis points, each of IM and JI can be made 50 basis points better
off.
(ii) Since the Net Benefit of 100 Basis Points to be shared equally among
IM and JI interest rate for them shall be as follows:
IM
Borrowing from Market LIBOR + 0.5%
Less : Benefit from Swap 0.5%
Net Interest LIBOR

JI
Borrowing from Market 4.25%
Less : Benefit from Swap 0.5%
Net Interest 3.75%

QUESTION – 3 (RTP NOVEMBER 2021 OLD SYLLABUS, 8 MARKS)


Derivative Bank entered into a swap arrangement on a principal of ₹ 10 crores
and agreed to receive MIBOR overnight floating rate for a fixed payment on the
principal. The swap was entered into on Monday, 19th August, 2019 and was to
commence on 20th August, 2019 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were: 8.15%, 7.98%, 7.95%,
8.12%, 8.15%, 7.75%.

If Fixed Rate of Interest is 8%, then evaluate


(i) The nature of this Swap arrangement.

(ii) The Net Settlement amount.

Notes:
(1) Sunday is Holiday.

(2) Work in rounded rupees and avoid decimal working.

(3) Consider 365 days in a year.

Answer
(i) The given swap arrangement is Plain Vanilla Overnight Index Swap
(OIS).

(ii) To compute the Net Settlement amount we shall compute Interest as


per floating rate as follows:
Day Principal (₹) MIBOR (%) Interest (₹)
Tuesday 10,00,00,000 8.15 22,329
Wednesday 10,00,22,329 7.98 21,868
Thursday 10,00,44,197 7.95 21,790
Friday 10,00,65,987 8.12 22,261
Saturday & Sunday (*) 10,00,88,248 8.15 44,697
Monday 10,01,32,945 7.75 21,261
Total Interest @ Floating Rate (A) 1,54,206
Total Interest @ Fixed Rate (B) 1,53,425
7
10,00,00,000× 8.00% × 365
Net Settlement Amount Paid 781

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