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Jayshree Bose
When the Reserve Bank of India (RBI) released the guidelines for rupee derivatives on Thursday, banks and corporates jumped into the fray with alacrity and clinched between 15-20 deals within a single day, revealing the pent-up demand for hedging interest rate risks. Next day, when there was a lull (only a single deal materialised that day), confirmed cynics ascribed it to their perception that the deals concluded on the first day were cosmetic and done more for publicity. There could be some truth in that- but dealmakers could surely be excused for jostling with each other to go down in history as the first to kickstart the long-awaited rupee derivatives market in India.
There are more concrete reasons, behind this lull, though. It is naive to expect the market to be abuzz with activity even otherwise from day two, especially at a time when the risk management systems of neither banks nor corporates are fully in place. Then again, even benchmarks like Mibor (to which floating rates are expected to beanchored most often) of all tenures save the overnight one, are still trying to find their place under the sun (while there are quotes, very few deals are taking place at these levels on apprehensions that the polling has to perfected further and the quotes are not fully market-related). Add to this the fact that the absence of nationalised banks (and the liquidity they are expected to bring) from the scene initially have spawned large spreads-such as 60-70 basis points for a one year deal and between 30-40 basis points even for one month deals. And last but not least, the dominance of the government in money supply still continues to upset the natural equilibrium of the financial markets, throw benchmarks haywire and make long-term interest rate forecasting impossible. The more circumspect players are obviously adopting a wait and watch attitude.
What is the upside of all this is that the RBI guidelines on rupee derivatives--widely acclaimed to be among the most liberal issued by the central bank--providesnot just banks with hedging instruments but gives corporates access to benchmarks such as Mibor and many other cash instruments. The benefits are easy to gauge--since it is no longer a pure inter-bank market, a contrasting viewpoint that is so necessary for market liquidity can emerge from the corporate sector.
As the market takes off, we are likely to see variants of the plain vanilla swap emerge gradually. The most common one is where, say, one party with floating rate liabilities linked to Mibor or some other benchmark (but with fixed rate assets) exchanges it with another party which not only has a contrasting asset-liability profile but also a contrasting viewpoint on the way interest rates and benchmarks will move. A player who has fixed rate liabilities will go in for a swap with a floating rate one if he perceives that interest rates are headed southwards--and this deal will materialise only if he finds a counterparty who has an opposite view about interest rates. In other words, a swap can takeplace typically if two parties have not only contrasting interest risk management needs, but also contrasting perceptions of interest rate movement. In an inter-bank market, where most banks think alike, there would, therefore, be very little liquidity.
The swap market could also generate more activity in other markets such as commercial paper, for instance, where the issuer has borrowed fixed and wants to switch over to a floating rate instrument. Like all other swap transactions, in this case too, there is no exchange of the principal--at the end of the swap period, the difference in interest is calculated (depending on whether floating rates have gone higher than the fixed rate contracted or vice versa) and paid to the gainer. So, players get a chance to hedge their risks at low financial outgo even where there is a loss.
This swap can be taken a step further and the underlying instrument sold off by one of the parties to a third party (this is an uncovered swap) and further to various others who wishto swap their exposures. Since nothing has been specified to the contrary, players are expecting that there will be no RBI embargo on such chain transactions once they are ready for it. Players may also like to swap, say, their floating rate liabilities benchmarked to 90 day Mibor with other floating rate exposures linked to the 91 day T-Bill to eliminate basis risk, if their floating rate assets are mainly linked to the 91 day T-Bill--this is a floating-to-floating swap.
But there's a flip side to it. Although one could improve one's ALM considerably through swaps provided one took the correct view about interest rate movements, both banks and corporates would need to have well-defined exposure and stoploss limits, preferably in the form of capital allocation for this activity so that limits are indeed well-defined, before embarking on the game. In fact, corporates, who are not subject to RBI prudential guidelines, may need to beef up their risk management systems further--the temptation of switching overfrom a 12.5 per cent fixed to a floating rate at an apparently lower rate of 10.5 per cent may mean a Rs 10 lakh loss on a one year deal of Rs 10 crore, in case of adverse movements in the benchmark rate. As the market becomes more sophisticated and swap deal tenures get longer, this would become imperative since taking a view on interest rates for such long periods of time are naturally that much more difficult. For example, Libor in the eighties was 21 per cent, dipping down to 3.5 per cent in the early nineties and then moving up to 7.5 per cent--if someone had gone in for a Libor -based floating rate swap in 1985, he would have lost millions--without the backing of options, which, anyway, are not allowed in India. Mercifully, very long-tenure swaps are a rarity, even in the sophisticated international markets--most such deals are customised. And in India, we are right now only in the midst of grappling with more basic issues such as accounting norms, the possibility of legal hassles if a rate fails,whether the rate has to be compounded daily, transparency in benchmarks, etc. And that is going to take time to sort out. Itsonly then that we would need to face the challenges of sophisticated long-term interest rate forecasting.
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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