Bank derivative deals under lens

The Reserve Bank of India has asked select foreign banks active in the derivatives market to provide information on derivative structures sold by them.

A string of companies have suffered losses in derivative contracts entered into with some foreign banks. The affected companies have reservations about the pricing of the derivative products sold to them.

According to banking sources, the immediate trigger for the regulator's action could be a complaint lodged by the Food Corporation of India with the RBI, after the public sector company suffered losses in an interest rate swap deal struck with Barclays Bank.

FCI informed the RBI that it was not given a "fair" quote by Barclays Bank while structuring the deal, sources said.

FCI had bought the interest rate swap for its underlying fixed rate interest liability on a Rs 700-crore bond issue in October 2005.

Barclays Bank executives declined to comment on the FCI issue, while the FCI spokesperson was not available for comment.

Interest rate swap is an agreement between two counter-parties where one stream of future interest payment is exchanged for another, based on a specified principal amount.

Interest rate swaps often exchange a fixed payment for a floating one, linked to an interest rate benchmark. A company typically uses interest rate swaps to limit, or manage, its exposure to interest rate fluctuations.

Sources pointed out that FCI was to receive a fixed rate of interest from Barclays Bank and was to pay a floating rate of interest, linked to one-year government securities.

Since October 2005, the interest rate scenario has changed following two rounds of reverse repo rate hikes. The yield on the one-year paper has gone up from 5.35-5.40 per cent in October 2005 to a high of 6.85 per cent in July 2006.

It is currently hovering around 6.65 per cent. The 10-year yield, which was between 7.10 and 7.24 per cent in October 2005, peaked to 8.50 in July 2006. Subsequently, it has come down to 7.60 per cent.

Following the rising number of such cases involving corporate clients, the RBI is in the process of making it mandatory for banks to disclose their derivative deals as balance sheet items from next year. It has also pursued the matter with the ministry of company affairs.

Interest rate derivatives, most common in the global over-the-counter derivatives market, are normally used to reduce the cost of capital.

Futures contracts, forward contracts, options and swaps are the other common types of derivatives. Nearly 80 per cent of the contracts in the global OTC derivatives market are interest rate swaps.

The principal amount in an interest rate swap is just notional and is never exchanged. Only the difference between the two payment amounts is turned over to the party that is entitled to it, as opposed to exchanging the full interest amounts.