Ironically, its RBI which was pretty enthusiastic about ushering in hedging products for the bond market. And now, it has been inadvertently responsible, at least in part, for the hasty waning of interest in the IRFs. On the launch day, IRF volumes were at a remarkably healthy R3,080 crores. Then on January 22, the committee appointed by Raghuram Rajan proposed adopting a CPI target, moving away from the current practice of using WPI as the benchmark for living costs. According to data from the Ministry of Statistics and Programme Implementation, CPI inflation has been climbing faster, averaging 9.3% last year versus WPI gains of 6.3%. RBI indicated on January 22 that it would target CPI inflation of 4% by 2016. It specified its aim to reduce CPI to 8% percent this year from the 9.3% average in 2013. And that it would target 7% in 2015 and 6% in 2016, at which point the target of 4% would be formally adopted. The IRF market inferred that a steeper target of reducing inflation, because of the change of benchmark, may add pressure on RBI to tighten policy rates now.
IRF contracts, as you might guess, are contracts to buy or sell
10-year Government of India Security (G-Sec) at a set price and a set day in the future. The underlying 10-year G-Sec, in this case, was the 8.83% 2023 one issued on November 25, 2013. With IRFs on this underlying, market participants could express their view on what the 10-year G-Sec price would be 1, 2 and 3 months from now. The futures contract thus provides an expectation of future G-Sec prices and, in turn, expected future yields on the Government of India paper. Since bond prices vary inversely with interest rates, prices of bonds and IRFs decrease if interest rates rise. When the committee recommended a move from WPI to CPI as the inflation benchmark, the market inferred that if the recommendations of this report are accepted, RBI would maintain its anti-inflationary stance over a prolonged period of time because of the increased focus on CPI over WPI and CPI being at least 3% larger than WPI. So, G-Sec and IRF markets were anticipating a rate hike, even though at the previous policy meeting, repo rates had been kept unchanged. The continued focus on inflation had an adverse effect on the bond markets. The yield on the 8.83% notes due November 2023, which is the underlying for the IRFs, climbed seven basis points to 8.90% percent on January 22, according to data from the Fixed
Income Money Market and Derivatives Association (FIMMDA). It rose a further three basis points the next day. Likewise, one-year MIBOR interest-rate swaps, which are derivative contracts used to guard against swings in funding costs, increased four basis points on January 22, a day after the launch of IRFs.
The markets expectation that the new CPI-based inflation targeting framework would keep interest rates higher for longer was spot-on. They were corroborated when RBI did hike short-term repo rate, to 8% from 7.75% on January 28. It seemed unexpected to many economists, but for keen observers of the IRF markets, the writing was clearly on the wall. The total contracts had decreased from 1,51,134 on January 21 to 14,442 on January 27, a day before the rate hike. Similarly, the total value of those contracts came down from R3,081.50 crores to R290.50 crores, on the expectations of a rate hike. In fact, of the 25 basis points hike, a good seven basis points was priced-in on the day RBI announced the change in inflation benchmarka good one week before the actual policy rate hike.
IRF provides an effective means of managing interest rate risk in these uncertain macroeconomic conditions. However, it is embryonic and nascent at this stage. RBI has tried planting the seeds of interest rates hedging thrice before and each time it was a no-show. As they say, the seeds have to be appropriate to the kind of soil which was not the case the last three times. They seemed to have made amends this time but the ensuing climate has not been conducive so far. For a seed to sprout and grow, the soil has to be fertile and the gardener, caring and tending. IRFs have a good future as we have the fertile soil of a vibrant G-Sec market and the gardener (RBI) values the value of the seed. What it needs is good nurturing.
The author, formerly with JPMorganChases Global Capital
Markets, trains finance professionals on derivatives and risk management