Friday, July 04, 2014

MIFOR-OIS Trade of June 2014

Avenues for Indian Financial Institutions to raise USD:
(1)    Direct Fund Raising in Global Markets
(2)    Fund Raising through Synthetic structure

Synthetic Structure Details
In this synthetic structure, they borrow INR in the Indian market at CD rates. They raise INR in any liquid tenors such as 3 Month or 1 Year Certificate of Deposits, reduce the risk of roll-overs by receiving MIBOR and hence immune to local rate swings, Swap the INR to USD at a spread over LIBOR.  The exact structure is that they enter in the market is an INR to USD Float-Float Swap wherein the local Financial institution pays 6M LIBOR+X and receives MIBOR. The synthetic structure would be a better alternative only if the cost is lower than the direct route after adjusting for basis risks.

Risk to the Synthetic Structure
Currency Risk: There is no incremental currency risk owing to the synthetic structure vis-à-vis the direct route as the FI is exposed to INR depreciation against USD equally in both the cases.
Basis Risk: The main basis risk run by the FI is with respect to the spread of CD rates over MIBOR at the times of roll-over. They can overcome this risk if direct 5Y INR money is raised. However, in the current month or in general, there was no major local bond issuance from the FIs/ PSU banks.

Rationale for the Trade
The Spread X would be a function of the difference between MIFOR and OIS levels of corresponding tenures. To arrive at the effective spread over 6M LIBOR, the spread of the bank’s CD over MIBOR needs to be added to X. The following chart highlights the direct USD fund raising rates (red line) versus the derived USD fund raising rates (blue lines). The direct USD fund raising rate is estimated using SBI 5Y CDS spread, US 5Y treasury yield and US 5Y IRS. The derived USD fund raising rate is estimated using spread of OIS over MIFOR and 1Y PSU CD spread over MIBOR.

It can be observed that the funding cost of the synthetic structure is, in general, moderately lower than the direct funding cost – likely attributable to the basis risk. The synthetic USD funding rate was about 6mL + 100 in the beginning of June 2014 and it dipped close to 6mL + 25 in the first week of June – exact time when this trade started to kick in the market. It is to be noted that SBI raised USD 1.25 Bio in April 2014 with close to USD 750 Mio in 5Y tenure at US5YT+205 or equivalently 6mL+185. They went for direct fund raising at 6mL+185 when the synthetic cost was in the similar range (6mL+150 to 6mL+200 in the Jan-Mar qtr); however in June the derived cost was significantly lower (by about 100 bps) and close to the lowest seen in the last 2 years.

A natural question arises as to whether this trade happened in October 2013 – as the difference between synthetic funding and direct funding was larger and that structured funding was happening at sub 6mL+100 levels.An educated guess would  be that October 2013 was a period of RBI firefighting to get in more USD and the said synthetic structure was tantamount to PSU banks buying USD from the local market in a period of local USD scarcity – hence in that window RBI might not have allowed this trade to go through and PSU banks themselves would have found it difficult to garner USD in quantum from the local market. Also, considering the backdrop of 300 bps rate hike and widely fluctuating CD spread over MIBOR, the perceived basis risk would have further prevented PSU banks from the synthetic structure.  Coming back to June 2014, as RBI itself was in the buy-mode in USD, they would have more than encouraged the local/PSU banks to raise USD in the synthetic route absorbing USD from the local market.

The current scenario wherein MIFOR-OIS spread almost touched zero also helped this trade to get highlighted.  Even in Oct 2013, MIFOR-OIS spread was not close to zero with OIS being higher than MIFOR by about 50 bps. Psychological viewpoint of not paying any incremental local fixed rate helped this trade gain traction in the current month. 

As this post is written, the MIFOR-OIS spread is close to zero again. It is likely the MIFOR point acts as a floor for OIS and we are likely to see a reversal in OIS from the current 7.80 level towards 8.00.

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