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B. Venkatesh

ACCORDING to Reserve Bank of India's (RBI) recent directive, banks can continue to offer MIFOR-based swaps including quanto swaps. What is a quanto swap?

Suppose as the treasurer of a big company, you are a keen follower of yield curves. These are graphs that plot bond yields against different maturities, ranging from 6 months to at least 20 years.

You believe that the difference between rupee and dollar interest rates are likely to widen. That is, dollar interest rate is likely to increase more than the rupee interest rate in the next five years. What do you do?

You approach a bank with the following proposition: Your company will pay a five-year rupee bond yield to the bank. In return, you want the bank to pay a five-year dollar bond yield.

Of course, as with every swap transaction, you need a notional principal. This is the amount on which the interest payments will be made. You agree for a notional amount of Rs 1 crore.

Note that this agreement involves two currencies. Technically, such an exchange of cash flows is called a currency swap. But what if dollar depreciates against the rupee? That means you would receive lesser rupees when the banks pays you the interest. You do not want to take the currency risk. So, you suggest that the bank pay you the five-year US dollar bond yield in rupees! The currency risk is, hence, on the bank.

You have actually structured a quanto swap. It is nothing but a combination of currency and interest rate swap. The actual contracts typically involve floating rates such as London Inter Bank Offered Rate. These swaps are also called differential or diff swaps because the parties to the contract bet on widening or narrowing of difference in interest rates.

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