A power company borrows USD 100 million for five years at a floating dollar rate plus 1.8% and swaps it into a rupee fixed rate of 8.9%, with principal exchanged at 83.00. Lay out the cash flows, and compare the rupee cost of repaying principal unhedged if the rupee falls to 95.

The swap turns the dollar floating loan into a Rs 830 crore loan at 8.9% fixed, about Rs 73.87 crore a year, and removes a Rs 120 crore principal loss if the rupee falls to 95. The bank's dollar payments match the lender's, so only the rupee leg is left. Unhedged, the company saves about Rs 17.4 crore a year while the rupee holds at 83, but a steady fall to 95 costs Rs 57 crore more over five years than the swap.

A family that borrows from a relative abroad in dollars, but earns in rupees, worries about two things: the dollar instalments, and the lump sum at the end. A cross-currency swapAn agreement to exchange principal and interest in one currency for principal and interest in another, usually swapping principal at the start and back at the same rate at the end. handles both. At the start Rangpo hands the bank the USD 100 million it borrowed and gets Rs 830 crore; every year the bank pays the dollar interest the lender wants and Rangpo pays 8.9% on Rs 830 crore; at the end Rangpo pays Rs 830 crore and gets back USD 100 million to repay the loan. The dollar legs pass straight through to the lender, so the company is left with a plain rupee fixed-rate loan.

With the dollar rate at 5.0%, the loan costs 6.8%, USD 6.8 million a year. At 83 that is about Rs 56.44 crore, against Rs 73.87 crore on the swap: the swap costs about Rs 17.4 crore a year more while the rupee holds. That gap is not a fee; it reflects the difference between rupee and dollar interest rates, which is roughly what the forward market expects the rupee to lose each year. Unhedged, a steady fall to 95 raises the yearly interest to Rs 64.60 crore by year five and turns the Rs 830 crore principal into Rs 950 crore, a Rs 120 crore hit that equals about 6.9 years of the interest saving.

Lead with the mismatch. Rangpo earns rupees and owes dollars; without the swap it is running a five-year bet that the rupee will hold. The swap costs about Rs 17.4 crore a year in a calm market and protects a Rs 830 crore principal from a move that history shows is entirely possible. For a utility with regulated rupee tariffs, which cannot pass a currency loss to customers, that is insurance most boards will buy. Then name what the swap does not do: it fixes the rupee rate, so if Indian rates fall the company keeps paying 8.9%; it creates credit exposure between the company and the bank, which the bank will charge for; and breaking it early can cost a large mark-to-market if the rupee has moved. The limit of the comparison is the assumed path: it is one illustration, not a forecast of the rupee.