Hedging USD 500 Million of Reg S Notes: Forward Strip, Cross-Currency Swap or Option
IRFC has on its books USD 500 million of 4.50% five-year Reg S notes issued at par, with principal repayable as a bullet in March 2030 and coupons semi-annual. The borrowing is unhedged. Spot USD/INR is 83.20; the five-year forward is 88.90; a five-year fixed-for-fixed cross-currency swap is quoted at 7.30% INR against 4.55% USD. A bank has offered a five-year USD/INR European call at a strike of 88.00 for an upfront premium of 2.80% of notional. Treasury's house view is rupee depreciation of 2.5–3.5% a year. Board policy requires at least 75% of foreign-currency principal to be hedged. The CFO calls the forward premium a 'cost' and prefers to stay unhedged to save it. The company reports under Ind AS and wants hedge accounting.
1. Quantify the all-in INR cost of the borrowing under (a) a full forward hedge, (b) no hedge, and (c) the cross-currency swap. Which instrument is cheapest and why?
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Base data. Annual USD coupon = 500m × 4.50% = USD 22.5 million.
(a) Forward hedge (principal plus coupon strip at 88.90).
- INR principal = 500m × 88.90 = ₹4,445 crore.
- INR coupon = 22.5m × 88.90 = ₹200.0 crore = 4.50% of the INR principal.
- Annualised FX cost = (88.90 ÷ 83.20)^(1/5) − 1 = (1.0685)^0.2 − 1 = 1.33%.
- All-in cost = 4.50% + 1.33% = ≈5.83%.
(b) Unhedged. Cost = 4.50% + realised depreciation. At the house view of 2.5–3.5%, that is 7.0%–8.0%. This is a forecast, not a certainty.
(c) Cross-currency swap. IRFC pays 7.30% INR and receives 4.55% USD, which more than offsets the 4.50% bond coupon (net +0.05% USD received). Net INR cost ≈ 7.30% − 0.05% = ≈7.25%.
Conclusion. The forward strip at ≈5.83% is the cheapest executed hedge. The swap is expensive because the INR curve is steep and the cross-currency basis is against the rupee payer. The option costs 2.80% of notional upfront (USD 14 million ≈ ₹116 crore, roughly 0.56% a year if amortised over five years) but protects only above 88.00 and leaves the 83.20–88.00 band to the market - it is a volatility purchase, not a cost-reduction tool.
Correcting the CFO. The forward premium is not a fee; it is the market's priced expectation of depreciation. Not hedging is an active directional bet that contradicts board policy.
2. Recommend a hedge ratio and execution strategy that satisfies policy without creating ineffectiveness, and explain the Ind AS 109 designation.
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Hedge ratio. Policy requires at least 75% of principal. Hedging principal alone while leaving coupons open creates a deliberately mismatched, partially hedged exposure: the cash-flow profile of the hedged item and the hedging instrument then diverge. Hedge 100% of principal and 100% of the coupon stream with a layered forward programme: 80% of each future cash flow transacted now and 20% rolled over at predefined intervals. This keeps the ratio at or above the 75% floor at all times and avoids discretionary, view-driven changes.
Match the fixing dates. Align each forward maturity with the actual coupon and principal dates, allowing the standard two-business-day settlement convention. A near-miss on dates is a common source of ineffectiveness.
Counterparty limits. Split the notional across at least three banks within approved ISDA and credit limits, with daily mark-to-market and collateral terms documented.
Ind AS 109 designation. Designate the forwards as a cash flow hedge of the FX risk component of the USD-denominated coupons and principal. Document at inception: the risk being hedged (USD/INR spot), the hedged item and its designated component, the economic relationship (the forward's notional and timing match the cash flows), and the hedge ratio. Under Ind AS 109 the 80–125% bright line no longer exists; instead, demonstrate prospectively that the economic relationship exists and that credit risk does not dominate. Forward points (time value) may be separated as a cost of hedging where the hedged item is transaction-related, deferred in OCI and released to P&L when the cash flows affect profit or loss. Measure effectiveness at each reporting date and reclassify the OCI balance on settlement.
Disclosure. Show the notional, maturity profile, the OCI balance and the amount reclassified during the period.