While the Reserve Bank of India has allowed banks to hedge the currency risk of FCNR deposits (deposits in Indian banks in dollars) with a cost of 3.5% versus market rates of 7% or more, this facility was being considered for a great leveraged return.
The concept is:
But if the deposit should want an early withdrawal, then what happens? The bank has to do a reverse transaction for the rest of the time of the swap. Effectively the bank buys dollars from the RBI on the early termination date and does a forward to sell back those dollars at the original maturity date, thus effectively reversing the transaction.
In the above example the inverse cost for the dollar buy is 3.5%+4% penalty for the reverse leg (for the period of the deposit already completed) and then 7.4% as the market rate for the remaining period. This is again embedded in the rupee cost on the buy transaction.
Forget the calculations – they can be complex. In the above example:
That means the early withdrawal not only ate up all the interest, it ate up about 10% of the principal as well!
That’s a fairly high cost, and the bank will pass it on to the borrower.
If a customer sees a 10% prepayment penalty (plus loss of interest), the attractiveness of the product will go away.
But you say, why can’t you just stick with the product for the maturity period, instead of exiting early? Answer: because you may have other options. If US interest rates go up, there might be a great opportunity to invest elsewhere with a similar product, and get 6% or 7%. Or, you might need the money – the lock-in cost is simply too high.
Kotak is already charging for early termination:
This should make the deposits unattractive for the 3 year or higher period. But given that the dollar has now fallen to Rs. 61.77 from the 68 levels, this product will die a quiet death.