Overnight indexed swap (OIS) rates have scaled to a seven-month high, as concerns over inflation and fiscal deficit pushed yields higher over the last few weeks. OIS are derivative instruments used to hedge interest rate risks. The one-year OIS rate has shot up to 6.46%, while the five-year OIS rate scaled to 6.73% on Friday — both rates are at seven-month highs. In an OIS transaction, while one party exchanges a fixed rate of interest for a floating rate, the counter-party agrees to pay a floating rate of interest in exchange for the fixed rate. The floating rate is based on the MIBOR rate. The decision to pay fixed or floating rate depends on the perception of future interest rates. A market participant who believes interest rates are going to come down decides to pay a floating rate of interest, while opting to receive a fixed rate of interest. In contrast to this, the counter party who decides to pay the fixed rate of interest believes interest rates are set to rise. The transaction is based on a notional principal amount. Of all the different OIS, the one-year and the five-year instruments are the most traded in India.
MS Gopikrishnan, head of FXRC trading, South Asia, Standard Chartered Bank, points out that bond yields have been rising on the back of supply overhang from open market operations (OMO) sales by the RBI, fiscal slippage worries, rate hike expectations, etc. “This is also reflected in the higher swap rates, as traders look to hedge their bond position through swaps. The swap market is now fully pricing in a rate hike in the first quarter of 2018,” he pointed out. The ten-year benchmark yield closed at a 17-month high of 7.27% on Friday. Bond traders have been cautious over the past few days, as mixed reports have kept the market volatile. On Thursday, traders interpreted the minutes of the monetary policy committee (MPC) meeting as more hawkish than what was seen in the previous meeting. This led to a sharp sell-off in the market.
The losses were reversed later during the day when a report filtered in that indicated the government was considering a spending cut worth Rs 30,000 crore to meet the fiscal deficit target, and was expecting to raise Rs 1 lakh crore from divestment, against the budgeted amount of Rs 72,500 crore. The enthusiasm soon fizzled out on Friday as traders got no confirmation on the report. Sometimes, movements in the the non-deliverable OIS (NDOIS)—offshore OIS— rates also tend to have an impact on the onshore OIS rates, said a banker. This could be attributed to the fact that foreign portfolio investors having exposure to Indian bonds tend to take positions in the NDOIS for hedging purposes. Sometimes, these positions could also be a pure speculative play based on their interest rate outlook, the banker indicated.