IRFs augur well for derivatives market : Economic Times: 24th June 2009

INTEREST rate futures (IRFs) are probably the last piece in the puzzle of derivatives that was missing from the menu. The need to hedge interest-rate fluctuations is immense for all participants in the financial market. And here, the purpose is to look at the extent of participation from the market. Banks and other financial institutions carry the highest-consolidated interest-rate risk on their books. This holds on the assets and liabilities side. Banks have investments in government paper of around Rs 13 lakh crore, of which 25% can be kept under the held-to-maturity bucket (HTM). The rest of the paper would be under available-for-sale (AFS) or held-for-trading (HFT) categories, which means that roughly Rs 10 lakh crore of government paper runs the risk of mark-to market (MTM) depreciation. The Reserve Bank of India’s (RBI) rules say that these losses should be booked while appreciation, when it occurs, is ignored. Hence, any increase in interest rates or excess of paper in the market will cause bond prices to fall, thus leading to losses. Even 10-bps rise in rates can lead to a theoretical Rs 1,000 crore of booking of loss. Clearly, banks would use this instrument to hedge their risk based on their individual perception of interest-rate movements. The current model proposes to allow banks to even go beyond their investment portfolio and include other components on balance sheet which are vulnerable to interest rate changes. In the past 6-7 years, it has been noticed that the interest spread of banks has come down to 4% from around 6%. Further, when lending rates come down, deposit rates are slower to adjust which affects banking margins. Therefore, they should typically be going long in the IRF market, buying bonds with the anticipation of rates moving down, which means that bond prices would increase in the future which would compensate for the potential loss on net interest income. Hence, banks should ideally do a sensitivity analysis of the potential hit on their net interest income in the event of a downturn in interest rates and accordingly invest an equivalent net income worth of securities in the market as buy position, as the notional yield has also been specified in the contract. Now, IRFs would be a very effective tool for individuals who as savers often find themselves short-charged by banks with the idiosyncratic nature of deposit rates. It often happens when individuals get into a deposit when interest rates are low and realise within three months that the rates have gone up. As flexible deposit rates do not exist, the IRF market can be tapped for this purpose. The fact that the minimum lot size is Rs 2 lakh makes it attractive. Also, since it would be only the margin that will have to be put upfront, which could be in the region of around 20%, it will not be too significant for individuals provided they are taking a call on interest rates. Hence, this will help in portfolio diversification. Maybe our policy should gear towards allowing mutual funds to float schemes that invest in IRFs which will appeal to the retail investor. Another interesting option which is open to participants in the derivatives market is that IRFs can be used effectively by players who are dealing with either commodity or forex futures. The futures prices of any product are defined as spot and cost of carry, with interest rates being the chief component. Hence, the direction and pace of movement of the futures prices in an efficient market will depend a lot on interest-rate risk which is embedded in this structure besides the underlying. Taking a view in the IRF segment will help. Let’s suppose that the investment is in, say, soybean where the futures value of contract would fall in case interest rates decline under ceteris paribus conditions leading to a notional loss. To counter this movement, the player could also go long in the IRF market and have his position covered to the extent of interest-rate risk which is embedded in any derivative product. Quite clearly, we are moving into a sophisticated system where the three markets — commodities, forex and interest rates — are getting integrated offering opportunities to cross-hedge and arbitrage to bring about all around efficiency. Therefore, this move does augur for exciting times in the derivatives market.