Blackbook Project On Money Market 163426471
Blackbook Project On Money Market 163426471
Blackbook Project On Money Market 163426471
INTRODUCTION
The financial system of any country is the backbone of the economy of that
country. The financial systems of all economies are broadly sub-divided into
money market, capital market, gilt-edged securities market and foreign
exchange market. The money market, capital market and the gilt securities
market provides avenues to the surplus sector such as household
institutions in the economy to deploy their funds to the deficit sector such as
corporate and government sectors to mobilize funds for their requirements.
The operations in the money market are generally short-term (upto 1 year) in
nature, in capital market short-term to long term and in gilt securities market
generally long-term. However, in an integrated financial system, the
occurrence of an event in one market of the financial system will have an
impact on the other market system.
The Indian money market is a market for short-term money and financial
asset that are close substitutes for money, which are close substitute for
money, with the short-term in the Indian context being for 1 year. The
important feature of the money market instruments is that it is liquid and can
be turned quickly at low cost.
The money market is not a well-defined place where the business is
transacted as in the case of capital markets where all business is transacted at
a formal place, i.e. stock exchange. The money market is basically a
telephone market and all the transactions are done through oral
communication and are subsequently confirmed by written communication
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1.1 Lenders:
These are the entities with surplus lendable funds like-
Banks (Commercial, Co-operative & Private)
Mutual Funds
Corporate Entities with bulk lendable resources of minimum of Rs. 3 crores
per transaction
Financial Institutions
1.2 Borrowers:
These are entities with deficit funds and includes the ones as above.
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1. Call Money
Features
The call market enables the banks and institutions to even out their
day-to-day deficits and surpluses of money.
Commercial banks, Co-operative Banks and primary dealers are
allowed to borrow and lend in this market for adjusting their cash
reserve requirements.
Specified All-India Financial Institutions, Mutual Funds and certain
specified entities are allowed to access Call/Notice money only as
lenders.
It is a completely inter-bank market hence non-bank entities are not
allowed access to this market.
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Interest rates in the call and notice money market are market
determined.
In view of the short tenure of such transactions, both the borrowers
and the lenders are required to have current accounts with the Reserve
Bank of India.
It serves as an outlet for deploying funds on short term basis to the
lenders having steady inflow of funds
In the short term, the lowest risk category instruments are the
treasury bills.
RBI issues these at a prefixed day and a fixed amount.
These are four types of treasury bills.
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Inter bank market for deposits of maturity beyond 14 days and upto three
months is referred to as the term money market. The specified entities are
not allowed to lend beyond 14 days. The development of the term money
market is inevitable due to the following reasons
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After treasury bills, the next lowest risk category investment option is the
certificate of deposit (CD) issued by banks and FIs.
Allowed in 1989, CDs were one of RBI's measures to deregulate the cost of
funds for banks and FIs. A CD is a negotiable promissory note, secure and
short term (upto a year) in nature. A CD is issued at a discount to the face
value, the discount rate being negotiated between the issuer and the investor.
Though RBI allows CDs upto one-year maturity, the maturity most quoted
in the market is for 90 days.
CDs are issued by banks and FIs mainly to augment funds by attracting
deposits from corporates, high net worth individuals, trusts, etc. the issue of
CDs reached a high in the last two years as banks faced with reducing
deposit base secured funds by these means. The foreign and private banks,
especially, which do not have large branch networks and hence lower
deposit base use this instrument to raise funds.
The rates on these deposits are determined by various factors. Low call rates
would mean higher liquidity in the market. Also the interest rate on one-year
bank deposits acts as a lower barrier for the rates in the market.
Apart from CPs, corporates also have access to another market called the
inter- corporate deposits (ICD) market. An ICD is an unsecured loan
extended by one corporate to another. Existing mainly as a refuge for low
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rated corporates, this market allows funds surplus corporates to lend to other
corporates. Also the better-rated corporates can borrow from the banking
system and lend in this market. As the cost of funds for a corporate in much
higher than a bank, the rates in this market are higher than those in the other
markets. ICDs are unsecured, and hence the risk inherent in high. The ICD
market is not well organised with very little information available publicly
about transaction details
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to issue CPs at lower rates than the lending rates on it's banks lines of credit.
This is partly for the reason that banks could also firm up the lending rates
during such periods. The maturity management of CPs should also affect the
CP rates. It has been observed that in a period of prolong low and steady
money market rates there is no significant different between the discount
rates if CPs for 90 and 180 days.
ADVANYAGES OF CP’s
The advantage of CP lies in its simplicity involving less paper work as large
amounts can be raised without having any underlying transaction. It gives
flexibility to the company by providing an additional option of raising funds
particularly when the conditions prevailing in the money market are
favorable. In a regime where there is a prescription of a minimum lending
rate for banks advances, the raising of funds by a company upto 75% of its
working capital limit through issue of CPs at somewhat lower interest rates,
enables it to reduce the overall cost of short-term funds. It is, however, to be
recognised that under the cash credit system of lending, the borrowers'
effective interest cost is lower than the prescribed lending rate as this system
affords flexibility to borrowers to reduce the outstanding as and when
surplus funds accrue to them. Hence, a company proposing to issue CPs
should have a clear perception as to its cash flow during the period for which
CPs are proposed to be issued and accordingly fix the discount rates at
which the instrument is to be issued.
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From the investor's point of view, the investment in CPs gives comparatively
higher yields than those obtained on bank deposits of similar maturities.
Although CP is an unsecured promissory note, the availability of stand-by
facility by banks to the issuing companies makes it's holders confident of
getting the payment on due dates. This agreement also facilitated quicker
payment as a company's banker and make the payment to the holders on
their behalf and as the companies permissible working capital limit gets
reinstated to the extent of maturing CPs provided, however, at the time of
maturity of CPs, the companies maximum permissible bank finance has not
been revised downwards.
It is a transaction in which two parties agree to sell and repurchase the same
security. Under such an agreement the seller sells specified securities with
an agreement to repurchase the same at a mutually decided future date and a
price. Similarly, the buyer purchases the securities with an agreement to
resell the same to the seller on an agreed date in future at a predetermined
price. Such a transaction is called a Repo when viewed from the prospective
of the seller of securities (the party acquiring fund) and Reverse Repo when
described from the point of view of the supplier of funds. Thus, whether a
given agreement is termed as Repo or a Reverse Repo depends on which
party initiated the transaction.
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Uses of REPO’s
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8. Commercial Paper
The RBI introduced the Bills Market scheme (BMS) in 1952 and the scheme
was later modified into New Bills Market scheme (NBMS) in 1970. Under
the scheme, commercial banks can rediscount the bills, which were
originally discounted by them, with approved institutions (viz., Commercial
Banks, Development Financial Institutions, Mutual Funds, Primary Dealer,
etc.).
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(from 15 days upto 90 days) on the basis of genuine trade bills, discounted
by the discounting bank.
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Owing to the absence of a central bank until 1935, the Imperial Bank of
India performed some of the functions of the banker’s bank. The other Bank
are not bound to keep balances with it, but in practice the exchange Banks
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and larger India joint-stock banks kept a substantial part of their cash
balances with it. The Imperial bank’s grant of loans to joint-stock banks
against government securities at the bank rate proved very useful to them,
but the high bank rate frequently reduced to a considerable extent the
benefits of such loan. On account of the special banks concessions that the
Imperial bank received from the government and later from the Reserve
Bank also, the joint-stock banks have regarded it more as an unfair
competitor than as a friendly supporter. Their feeling towards the State Bank
was not much better. The exchange banks were also considered as powerful
competitors owing to their large resources and encroachment upto the field
of the finance of internal trade at ports as well as in the interior. The state co-
operative banks used to maintain current accounts with the state bank and
also used to get credit and overdraft facilities from it. The co-operative
banks have no connection with the indigenous bankers and the
moneylenders beyond the fact that a few of them were depositors or
directors of central cooperative banks. There is also not much contact
between the indigenous bankers and the moneylenders and both of them
usually did not maintain account with the State Bank of India and not at all
with the Reserve bank of India (RBI). Till the mid- 1970s, during the busy
season (October-April), when the supply of hundis was greater than the
resource of the indigenous bankers, a temporary connection was established
between a number of them who were selected And placed on the approval
list and the State Bank and the joint stock banks rediscounted the hundis
drawn and endorsed by the by the approved indigenous bankers up to a
certain maximum limits determined according to the financial standing off
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the financial standing of the banker or gave them advances against demand
promissory notes signed by to of them.
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Call money market is the core of the central part of the money market, in
which banks lend money to each other. To begin with call money operated
from Mumbai and later Calcutta, Delhi and Madras joined. The call money
is most sensitive part of the money market and indicates the current
condition of the market. The major participants are the public sector banks.
Over the period pf time, the RBI has permitted other institutions, flush with
funds, such as LIC, GIC, UTI, IDBI, NABARD to participate in money
market as lenders. The call money transaction are unsecured, enabling the
borrowing banks to replenish their funds without touching their other assets.
In this market, banks operate with their own surplus funds and usually
without any help from outside. Thus, banks with surplus funds lend to those
that are in need. This helps in spreading the liquid funds evenly among the
various banks and thus enables a more economic use of resources in the
banking system. The role of banks, as a borrowers or lenders, change
according to liquidity position.
Upto 1956, the exchange banks were the chief borrower on account of nature
of their business. Their advances were generally very liquid and they held
large proportion of bills. As a consequence, they functioned with a fine cash
ratio and turned to the call market to make up any deficiency of funds for
day or two. Prior to 1956, some of the Indian banks also resorted to the call
money market occasionally as a borrowers in order to maintain their cash
ratio at the level required by law. However since 1956, the India Bank have
been resorting to the call money market mare frequently whenever the
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demand upon them for credit owing to increasing investment activity press
upon their resources. Hence, the funds now flow more easily and to a large
extent, not among Indian banks center like Mumbai or Calcutta, but also
among various centers.
The bill market can be divided into two viz., the commercial bills market
and the treasury bills market.
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has always been subject to one percentage point lower rate of interest than
prime lending rate fixed for corporate borrowers. Further, interest rate on
rediscounting of bills was deregulated in May 1989.
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sometimes had to intervene and purchase Bills on its own account. The
Reserve Bank has tried to organize and widen the Treasury bill market, in
order to secure better control of the money market, with the rediscounting of
the bills with itself and to enable the market to carry a large floating debt and
thereby reduce the cost of Government borrowing. The efforts of the
Reserve Bank in widening the Treasury bill market have not succeeded fully
until the late 1980s, owing to the absence of a discount market in these bills.
Banks were reluctant to discount Treasury bill with the Reserve Bank
because the money market regarded such discount as a sign of weakness.
This lead to funds being locked in and market elasticity was not there in case
of Treasury bill. Sales of treasury bills were suspended from 20 th April 1954
to 2nd November 1954 and form 6th April 1956 to 1st August 1958. However,
since 1970s, the treasury bills were issued at a fixed rate of 4.6% and were
for tenure of 91 days. However, with the setting up of the Discount and
Finance House of India (DFHI) in 1988, the secondary market for the
treasury bills began to develop.
The other important sub-markets that have come into existence in the
money market are the Certificate of deposits (CDs) market and the
Commercial Papers (CPs) market.
These sub-markets are of recent origin. While the CDs market becomes
operational during 1989-1990, the CPs market emerged in 1990-91.
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autorised share capital of Rs. 100 crores subscribed by the RBI (Rs. 33
crores) and all-India financial institutions (Rs 16 crores).
DHFI quotes regular bid and offer rates for treasury bills and commercial
bills rediscounting. However only bid prices for CDs and CPs are normally
quoted. DHFI is also autorised to undertake “REPO” transaction against
treasury bills and it provides daily buy back and sell back rates for treasury
bills to suit their requirements of commercial banks.
The STCI is of recent orign. Basically, set-up for dealing in government
securities market to broaden and deepen this market, the STCI also has been
allowed to deal in call money market and the treasury bills market.
The Indian money market has undergone metamorphosis during the last
few years owing to a series of measure which increased the number of
participants, introduced newer instrument and deregulated interest rate. The
Reserve Bank of India (RBI) set up a committee to review the functioning of
monetary system, viz., SUKHMOY CHAKRAVARTY COMMITTEE in
1982, a working group to review the functioning of money market, viz.,
VAGHUL WORKING GROUP in 1986 and the NARASIHMHAM
COMMITTEE to review the functioning of the financial system in India.
While the Chakravarthy Committee recommended measures for
improvement in the monetary system, the Vaghul Working Group
recommended measures to activate and vitalize the money market and the
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Today the Bank Rate has emerged as a reference rate and the call money
rates generally operate in a corridor with the Repo rate acting as a floor and
the Bank Rate as a ceiling.
At present the overnight money market rate is the only floating rate
benchmark. The methodology used for calculating the overnight index is
transparent.
Reuters MIBOR is the weighted average of call money transactions of 22
banks and other players.
NSE-MIBOR (Mumbai Inter-bank Offer Rate) is the rates polled from a
representative panel of 32-banks/ institutions/ PDs.
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The other benchmark instruments are 14, 91, 182 & 364 day T.bills. Also we
have the SBI-PLR rate.
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1. The lending and deposit rates that have, over time, been considerably
freed. Lending rates are now linked to the PLR, and the banks depending on
their risk perceptions freely determine the spreads. Deposit rates beyond one
year have been freed, and deposit rates less than one year linked or pegged
to the Bank Rate. All re-finance; the OMO operations and liquidity to the
Primary Dealers (PDs) have been linked to the Bank Rate. To that extent the
Bank Rate has been emerging as a kind of reference rate in the interest rate
scenario.
2. The second interesting aspect has been that the borrowings by the
government (since 1992) have been at market rates.
3. The PSUs and FIs, who had been largely depending on budgetary
support for their resources, have been forced to go to the market to raise
their resource requirements.
Integration of Markets
The other important aspect of the fixed income market is the close inter-
linkage between the money and debt segments. The Call, Notice & Term
money markets are to be made purely inter-bank markets. The non-bank
participants are being shifted to the Repo market. However the existing
players have been allowed to park their short-term investments till they find
other avenues. The corporates have the facility of routing their call
transactions through the PDs.
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Primary Dealers
In order to make the government securities market more vibrant, liquid and
to ensure market making capabilities outside RBI a system of PD’s was
established. The PDs have been allowed to operate a current account and
along with a SGL account. They also have been allowed to open constituent
SGL accounts. RBI has provided them liquidity support facility. In order to
facilitate their continued presence in auctions the RBI invites bids for
underwriting in respect of all auctions. Routing of operations in the call
money market is allowed through PD’s. They are allowed the facility of
funds from one centre to another under RBI’s Remittance facility scheme.
The number of PDs has been increased from 7 to 13. Infact the introduction
of PDs has added to the liquidity in the market.
Valuation of securities
Banks have been required to mark 70% of their portfolio to market from the
year 1998-99 and 75% from 1999-2000.
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As per the suggestions of the Narasimham Committee II, the RBI in the
Mid-Term Review of October 1998 that it would move towards a pure inter-
bank call/notice/term money market, including the PDs. Towards this end
the non-bank participants can invest their short-term resources in the Repo
market and other money market instruments. Taking into consideration the
transitional problems, it has also been decided to continue with the present
system of permitting FIs and MFs to lend in the call/notice money market.
The corporates can route their call/notice money transactions through the
PDs.
Term Rate
Inter-bank CRR, other then minimum 3% has been done away with. In this
direction the Interest Rate Swaps (IRS) have been introduced for the
participants to hedge their interest risks. For benchmarking we have the 14,
91& 364 T.Bills. Also we have the CPs. Now it is to the participants to use
this opportunity.
Many Mutual Funds have started funds which spcifically focus on money
market. They have also been permitted to invest in rated corporate bonds and
debentures with a residual maturity of up to only one year, within the ceiling
existing for CP.
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Non-bank entities, which are currently permitted to take Repos, have been
permitted to borrow money through reverse Repos at par with banks and
PDs. There is no restriction for the duration of a Repo. All government
securities have been made available for Repo. The Repos have also been
permitted in PSU bonds and private corporate debt securities provided they
are held in demat form in a depository and the transactions are done in
recognized stock exchanges.
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Transparency
Anyway this system may not really be effective enough to substitute the
telephonic mode of operation. The system as has been planned does not
provide for a participant to withhold his identity. Now this factor alone could
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Short selling
The participants feel that this would add to the depth of the market and also
help in providing two-way quotes. However it is not evident whether the
RBI will be allowing this.
Primary dealers
The banks maintain that with all the benefits provided to them they should
be providing fine two-way quotes at market rates. For this the PDs feel that
it is essential to allow the short selling of securities and that every
participant provides a two-way quote.
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Awareness
The government along with the RBI has decided to do some publicity work.
Since the beginning of the reforms it has been recognized that a strong retail
segment for government segment needs to be developed. The basic objective
of setting up of primary and Satellite Dealers was to enhance distribution
channels and encourage voluntary holding of government securities among a
wider investor base. To give a fillip to this scheme for availing of liquidity
support from RBI has been made available to them. Now banks are allowed
to buy or sell freely government securities on an outright basis and retail
government securities to non-bank clients without any restriction on the
period between sale and purchase. The big question is whether the banks
would actually take interest in the task, as this will effect their deposits.
Towards this end there is the need for introducing STRIPS.
Market Microstructure
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To develop the primary and the secondary markets the following points need
careful evaluation
1. At present the PDs underwrite a sizeable portion of the market loans
and quote an underwriting commission. It has been suggested that it be made
compulsory for them to bid for a minimum percent for a minimum percent
of the notified amount. By increasing the number of PDs the total bids
should be brought upto 100% of the notified amount.
2. The RBI should try and move out of the primary auctions but in
transition could take upto 20% of the notified amount. Incase of the issue
being not fully subscribed the RBI should have the option of canceling the
entire issue.
3. Gradually the RBI should move out of the 14 and 91 day T. Bill
auction and then the 364 day auction and then finally from the dated of
securities.
The RBI should have a strong presence in the secondary market by means of
providing two-way quotes.
Standardization of Practices
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Most importantly the code of conduct will have to be compatible with the
contemplated dealing screen and the technological upgradation.
Risk Management
Investors in debt instrument face three major types of risks namely credit
risk, interest rate risk and foreign currency risk. Incase of the government
securities the credit risk is zero. For the domestic investors the foreign
exchange risk is none. Investment in all debt instruments is exposed to
interest rate risk. Introduction of rupee derivatives will go a long way in
providing investors an opportunity to hedge their exposures. IRS and FRA
have already been introduced. Also there is a need for the dealers (especially
in PSU banks) to be provided with more freedom to make decisions. Finally
it remains on the willingness of the participants to trade. This indeed would
provide the needed fillip to the market.
Derivatives
As their name implies, are contracts that are based on or derived from
some underlying asset, reference rate, or index. Most common financial
derivatives can be classified as one, or a combination, of four types:
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forwards, futures, options and swaps that are based on interest rates or
currencies.
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10.5%
LIBOR + 0.25%
Y
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Objective
These guidelines are intended to form the basis for development of Rupee
derivative products such as FRAs/IRS in the country. They have been
formulated in consultation with market participants. The guidelines are
subject to review, on the basis of development of FRAs/IRS market.
Prerequisites
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Participants
Schedule commercial banks.
Primary dealers
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Benchmark rate
The benchmark rate should necessarily evolve in the market and require
market acceptance. The parties are therefore; free to use any domestic
money or debt market rate for entering into FRAs/IRS, provided
methodology of computing the rate is the objective, transparent and
mutually acceptable to counter parties.
Size
No restrictions
Capital adequacy
Exposure limits
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Banks, FIs and PDs have to arrive at the credit equivalent amount for the
purposes of reckoning exposure to a counter party. For this purpose
participants may apply the conversion factors to notional principal amounts
as per the original exposure method prescribed in Annexure I and II. The
exposure should be within sub limit to be fixed for FRAs/IRS to corporates/
banks/ FIs/ PDs by the participants concerned. In case of banks and FIs, the
exposure on account of FRAs/IRS together with other credit exposures
should be within single/ group borrower limits as prescribed by RBI. Further
while dealing with corporates, banks, FIs and PDs should exercise due
diligence to ensure that they (corporates) are undertaking FRAs/ IRS only
for hedging their own rupee balance sheet exposures. Banks, FIs and PDs
are advised to also obtain a certificate from the authorized signatory/
signatories of corporate/s to such an effect.
Swap Position
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time buckets and fix prudential limits on individual gaps (as per the
procedure laid down in the procedure laid down in the RBI Circular on ALM
system).The prudential limits for different time buckets approved by boards
of participants will require vetting by the RBI as mentioned below:
Firm A with high credit rating can borrow fixed at 80 bps over PLR and
floating at 50 bps over MIBOR. Another firm B with a lower rating can
borrow fixed at 150 bps over PLR and floating at 80 bps over MIBOR.
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The firm A has absolute advantage over firm B in both fixed and floating
rates. Firm B pays 70 bps more than firm A in the fixed rate borrowing and
only 30 bps more than A in the floating rate borrowing. So firm B has
comparative advantage in borrowing floating rate funds. Hence B borrows
funds at MIBOR plus 80 bps.
The gain because firm A borrows in the fixed rate segment is:
The loss because firm B borrows in the floating rate segment is:
The firms can divide this gain equally. Firm B can pay fixed at (PLR + 130
bps) to firm A and receive a floating rate of (MIBOR + 80 bps).
PLR+30bps
A B
MIBOR + 130bps
PLR+80bps Mibor+80bps
Effective cost for firm A = ((PLR + 80) + (MIBOR + 80) - (PLR + 130))
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This results into a gain of ((MIBOR + 50) - (MIBOR + 30)) i.e., a gain of 20
bps.
Effective cost for firm B = ((MIBOR + 80) + (PLR + 130) - (MIBOR + 80))
This results into a gain of ((PLR + 150) - (PLR + 130)) i.e., a gain of 20
bps.
With the introduction of rupee derivatives the Indian corporates can attempt
to reduce their cost of borrowing and thereby add value. A typical Indian
case would be a corporate with a high fixed rate obligation.
Pawan-Priya Ltd. an AAA rated corporate, 3 years back had raised 4-year
funds at a fixed rate of 18.5%. Today a 364-day T. bill is yielding 10.25%,
as the interest rates have come down. The 3-month MIBOR is quoting at
10%.
Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill
vs 6-month MIBOR.
The treasurer is of the view that the average MIBOR shall remain below
18.5% for the next one year.
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The firm can thus benefit by entering into an interest rate fixed for floating
swap, whereby it makes floating payments at MIBOR and receives fixed
payments at 50 bps over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75
%.
Mibor 18.5%
The effective cost for Pawan- Priya Ltd. = 18.5 + MIBOR - 10.75
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- The firm is faced with the risk that the MIBOR goes beyond 10.75%.
Any rise beyond 10.75% will raise the cost of funds for the firm. Therefore
it is very essential that the firm hold a strong view that MIBOR shall remain
below 10.75%. This will require continuous monitoring on the path of the
firm.
After the fall of the Bretton Woods System, the government of the Great
Britain undertook various steps to prevent the downslide of the Pound and
instituted new internal controls. One of the control measures was the
creation of the Dollar premium market to discourage the direct foreign
investment. However, this created opportunities for financial ingenuity by
the British merchant bankers.
To avoid Dollar premium, Parallel Loans were introduced. Here, the parties
were required to exchange the principal on the value date. During the life of
the contract, each party was to pay the interests on the currency it had
received. The next crucial step was the introduction of the Back-to-back
Loans, in which the loan was directly arranged between two parent
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Currency Swaps
The breakdown of the Bretton Woods System had opened up a whole new
area of the foreign exchange trading. In a deregulated market, banks could
offer products to the clients, collect a fee, and improve their profit margins.
Gaining entry into the Parallel and the Back-to-back Loans was easy for the
banks. But two problems began to emerge.
One was the old issue of the paperwork, except that increased volume of the
loans gave a new urgency to its resolution. The other problem was related to
accounting. Both of the above mentioned loans were recorded as two
separate transactions. This ignored the contingent nature of the loansm,
inflated the balance sheets and distorted the accounting ratios that were used
in analysing the financial health of the banks. The answer, drawing heavily
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on the experience of the swap network, came in the form of the Currency
Swaps.
In a Currency Swap, the notional amount of the trade was designated as off-
balance-sheet, and payment of interest by each party was made contingent
upon the other party’s performance. With the principal amount of the
Currency Swap no longer subject to the counterparty default risk, it was
possible to classify swaps as off-balance-sheet instruments. Incorporating
the cash-flow structure of the Back-to-back Loans into the legal notion of
the contingency took the Currency Swap one step further from being a
concept and made it a financial instrument as well.
The early Currency Swap deals were not disclosed to the public because of
the proprietary nature. In 1981, the World Bank and IBM announced a
Currency Swap deal which was well publicised and gave an impetus to the
swap market.
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Euromarket
Beginning in the '50s, the Socialist governments began to deposit their hard
currency holdings in European banks because they were concerned that, in
the Cold War environment of the '50s, the US would freeze their assets.
However these deposits were not enough to create and sustain a large
market. It was the Dollar holdings of the US corporations that created the
Euromarket, as it was against the outflow of the US funds that the Interest
Equalisation Tax Act (IETA) was passed (IETA created a strong incentive
for the US investors to keep their Dollars in Europe). The Euromarket was
created because of the higher rates of return in Europe and it was sustained
due to the tax differentials that could not be arbitraged because of the
sovereignty. Euromarket was a concept of the laissez-faire. Transactions in
this market are mostly wholesale in the nature and the interest rates are
heavily influenced by the availability of, and demand for the funds. Loans in
this market are basically variable in nature and if necessary, on a roll over
basis with fixed maturities and non-prepayment clauses.
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Thus, we can see that IRS or more precisely the swap market was born as
insurance market directly related to the Euromarket loans. This insurance
market fuelled and sustained the swap market. Swaps became insurance
vehicle of the borrowers because their premiums were borrowed.
Taking a view on the future direction of the interest rates, swaps can be
proved to very attractive instrument, and under a variety of yield curve
conditions, they are among the cheapest to transact. Speculative trading of
the swaps added enormously to the depth and liquidity of the market.
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After the first swap in 1981, the interest rate swap market has exploded. In
1998, the annual turnover, in terms of notional principal, is around $32
trillion. The market is regulated by the local level exchanges, which together
form the International Swap and Derivatives Association (ISDA). ISDA has
set for the guidelines and the regulatory framework, and most of the local
regulations are based on these. ISDA has about 104 members, and it
publishes regular statistics about the markets. It also holds conferences and
spreads awareness of the instruments. ISDA has contributed significantly to
the standardization and documentation of swaps and consequently, their
acceptance in financial markets. The ISDA Master Document is used to
record swaps.
Most of the IRS deals are pegged to the six month LIBOR. The quotations
for the fixed rate are normally in terms of basis points over the US T-bill
rates. Most swaps are of duration of 2 to 6 years, with swaps as long as 15
years also having been recorded. IRS are mature products, and there are
widely accepted theories and research on their pricing and various varieties.
Most players have adequate systems and exposure limits to internally control
their risk management. New forms of swaps keep on emerging, and then,
theories for pricing them also follow. Gradually small banks and corporates
have also realised the usefulness of swaps as hedging instruments, and their
use is still increasing. For the last 5 years, the turnover for IRS has been
increasing by about 25-30% annually.
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It must also be noted that more than 80% of the deals are speculative in
nature, and this will continue to be the case in the future in world markets.
Swaps in currencies other than USD have gradually come of age, and now,
form substantial part of the total swap market.
Interest rates in India have been RBI determined for decades now. In the
past five years, we have seen this situation changing. Gradually, India is
moving towards a market determined interest rate regime. RBI is gradually
freeing interest rates, and this has forced banks to manage risks on their own.
Moreover, the Indian companies were used to the earlier easy go approach
and surety in interest rates that they can borrow on. But now, corporates
have a plethora of rates at which they can borrow. They have the option of
loans linked to fixed or floating rates. Thus, Indian companies have to be
self sufficient with regards to management of financial uncertainties, like
firms are elsewhere in the world. With all this deregulation and integration
with global practices, there was a felt need for instruments to hedge against
various risks. Derivatives for the money market were the next logical step in
the process. This is exactly what RBI has done.
The RBI Governor’s Statement on ‘Mid-Term Review of Monetary and
Credit Policy for 1998-99’ announced on October 30, 1998, indicated that
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to further deepening the money market and to enable banks, primary dealers
(PDs) and all-India financial institutions (FIs) to hedge interest risks, the
RBI had decided to create an environment that would favour the introduction
of Interest Rate Swaps.
Accordingly, on July 7, 1999 RBI issued final guidelines to introduce IRS
and Forward Rate Agreements (FRAs). The players are allowed to practice
IRS/FRAs as a product for their own balance sheet management and for
market making purposes.
The RBI has been criticised for being hasty in introducing such interest rate
derivatives. It was said that our debt market is not mature enough to
incorporate and deal with such products. Though the Indian debt market has
not been properly developed, blaming the RBI move does not seem to be
proper because these products will have to be introduced sooner or later and
the present time appears to be as good a time as any other. Moreover, this
move may also help in quickening the development of a mature debt and
money market.
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Benchmark rate: The players can use any domestic money or debt market
rates as reference rate for entering into FRA/IRS, provided methodology of
computing the rate is objective, transparent and mutually acceptable to
counter-parties. The reason stated for the same is that the benchmark rate is
expected to evolve on its own in the market.
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Exposure: The exposure should be within the sub limits and this should be
fixed for the FRAs/IRS to corporates/FIs, banks/PDs by the participants
concerned. In case of the banks and the FIs, the credit exposure should be
within the single/group borrower limits as prescribed by the RBI.
Before coming to the actual trends in the market, let us look at the players.
Most of the active participation is by foreign banks, followed by Indian
banks, corporates and finally, FI’s. The absence of nationalised banks from
the IRS scene is noteworthy.
IRS today can be used by corporates only for an actual hedging exercise, and
it has to have board permission. Moreover, the deal would be within the
exposure limits of that firm for the bank with which it is dealing. These
measures are to ensure that corporates do not undertake speculative
activities, and start dealing only after they have proper risk-management
systems in place.
On the first day of trading, more than 30 deals were recorded, worth over Rs,
600 crores in notional principal terms. Rs. 500 crores of this was accounted
for by corporate deals. The rush was because the European and private banks
wanted to be a part of the history, dealing on first day, rather than actual
hedging. It has also been reported that some deals were circular between
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three players, with no real effect in any players’ position. No deal was stuck
for more than a year’s tenor.
Since the first day, there have been almost no deals, and the markets are
cold. The reasons for this are many. At the short term level, almost all the
players expect the interest rates to go down in the next few months. This
means that there are no conflicting views among players about interest rates,
and so IRS deals are not very tempting. Again, there are very few floating
rate loans around. These and other fundamental reasons have been discussed
in the next section.
In spite of these, there are many underlying reasons for going for IRS.
Today, the major financial intermediaries’ viz. Indian banks, foreign banks,
financial instutions, and corporates have radically different sets of asset-
liability structures. Thus for ALM alone, IRS are a good options. For
example, the FI’s have much of their liabilities as bullet repayment bonds,
and the bulk of their assets by way of installment repayment loans. Thus,
chances are that their liabilities portfolio is longer thatn their assets portfolio.
Commercial banks, on the other hand, have bulk of thier liability portfolio in
relatively short-term maturities, and assets are at longer maturities with fixed
interest rates. Thus, banks and FI’s alone can enter in a lot of mutually
beneficial deals.
Corporates would also like to hedge their interest rate risks, and convert their
fixed rate loans to floating rates, now that the options are available.
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The market is only about 2 months old now, and is yet to evolve. The likely
problems in its evolution and the future are discussed in the following
sections.
10. OBSTACLES TO DEVELOPMENT OF IRS IN INDIA
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11. CONCLUSION
The Indian money market was controlled by tight controls and
administered interest rate structure up to late 1980s. However, following
the policy measures during the early 1990s the money market has
become broad based with the enlargement of participants and
instruments, and change in liquidated conditions is quickly transmitted.
The reform measures have greatly contributed to the development of
inter-linkages; increasing liquidity across various segments of the money
market. An enabling environment has thus been created whereby the
monetary authority can gradually switch away from the direct
instruments of control to indirect methods like open market operation,
including repos. The market determined interest rate is gradually
emerging as an important intermediate target with the ultimate objective
of achieving price stability and economic growth.
Radical measures are taken to transform the Indian money market from a
closed, inward and narrow domestic space to open, outward-looking and
international, can have competitive and efficient operation for optimal
gain. Interest rates have been freed at certain level of bank deposits and
lending, foreign financial institutions have been allowed to invest in
domestic market. Securities market has been reorganised with the setting
up of new institutions (like DFI and Primary Dealers), introduction of
new instruments (like CP, CD) and new organisation (like NSE).
Liberalisation and globalisation of money market has brought many
distortions without necessarily increasing the efficiency of institutions
and allocation of resources. Credit does not reach the productive sector,
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12. Suggestions
Few suggestions relevant to the development of money market in India
are enumerated below:
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(viii) Money Market Mutual Funds should be set up by various banks and
institutions. This would increase the retail participation in the market.
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BIBLIOGRAPHY
SOURCE AUTHOR
1. Interest Rate Swaps Nasser Saber
2. Emerging Money Market R.S. Agrawal
3. Indian Money Market Structure, operation and M.S. Gopalan
Development
4. Financial Management Prasanna Chandra
5. www.stcionline.com
6. www.rbi.org.in
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