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March 2011 Newsletter

March 14, 2011  ·  By mfx

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Using Basis Swaps to Enhance Return

MFX has been working with our clients to help them manage the fine line between effectively hedging their loans and offering their MFI clients competitive pricing in local currency. In cases where a full hedge of all loan flows may be too expensive, a cross currency basis swap is a way to limit the currency risk to acceptable levels while allowing for a higher potential return or more competitive local currency pricing.

The basis swap allows the investor to hedge the principal of the loan and a portion of the interest (generally cost of funds) while running fx risk on the remainder of the credit margin. Different from fixed rate swaps, where the full cash flow of the loan is hedged, basis swaps are quoted with either one or both legs floating and with minimal or no spread over the benchmarks.

For example, consider the case of a US-based MIV looking to offer a loan to an MFI in Tanzania for 3 years with semi-annual interest payments and bullet notional on final settlement. The fund is looking for a return of around 6.00% in USD. (All values used in this example are hypothetical and do not represent actual quotes).

A typical 3y USD/TZS ccs, semi-annual interest, bullet notional would quote:
Fix USD rate 6.00% vs. Fix TZS rate 14.73%

If the local MFI is not willing to take 14.73%, but is open to a loan at 13.00%, the resulting fix rated in USD via a swap would be 4.22%. Using a basis swap, the fund could use the following 2 alternatives.

Alternative 1

A 3y USD/TZS ccs, semi-annual interest, bullet notional quotes:
Floating USD 6m LIBOR flat vs. Floating TZS 6m t-bill +30 bps

In this case, the MFI would have to be willing to accept a loan with floating rate of TZS 6m t-bill + spread. Assuming the latest 6m t-bill in Tanzania at 6.63%, the fund could offer the loan at 6m t-bill + 6.30%. Every payment period, the fund will swap the “basis” (the t-bill) with MFX in an exchange for USD 6m LIBOR, and keep the spread of 6.00%. The principal and a return of LIBOR is fully hedged on the USD notional, and the fund could potentially make the 6.60% if exchange rate doesn’t change. If the exchange rate appreciates then the loan would actually earn more than 6.60%, or less it if it depreciates. However the risk is rather small. Even a large depreciation of around 20% would only reduce the effective return for the MIV to a bit below 5%.

If the MFI will not accept a floating rate, a modified basis swap can also help enhance return in exchange for taking on a small amount of risk.

Alternative 2

The same 3y USD/TZS ccs, semi-annual interest, bullet notional quotes:
Floating USD 6m LIBOR flat vs. Fixed TZS rate 8.59%

The fund will still offer the loan at TZS 13.00% to the MFI, in return the swap guaranties full FX protection on the principal and a return in USD of 6m LIBOR. In this case the fund will keep the difference between the loan rate and the swap rate (13.00% – 8.59% = 4.41%) though that 4.41% return is subject to FX movements. Assuming a stable 6m LIBOR of 0.60%, this swap could potentially offer a total return of 5.00%, with some potential up and down side, vs. a fully swapped rate of 4.22%. The reason that the revenue enhancement is less than in the first example is that the MFI, by taking a fixed rate, is assuming less risk. Nevertheless MFIs in many markets are increasingly willing to accept floating rate loans.

These example highlight how basis swaps can make the difference between a hedged loan that is competitive and one that is not. For MIVs, the full fixed rate swap is still the safest for those who wish to eliminate all currency risk. Basis swaps can be a useful tool to manage FX risk for funds willing to take some currency exposure and who need to compete in price-sensitve local currency markets.

For more explanation on basis swaps please contact MFX’s trading team.


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