Relaunch of Interest Rate Futures?-VRK100-18Oct2013

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Interest rate futures (IRF) may be relaunched for the third time in India, according to media reports widely circulated today—quoting sources in the Reserve Bank of India, India’s central bank.

Exchange traded interest rate futures (ETIRF) were earlier launched by National Stock Exchange (NSE), country’s premier stock exchange, once in 2003 and again in 2009. If this financial derivative product is launched again, this will be third time that the product will be making a re-entry in the Indian market.

On 31 August 2009, NSE relaunched ETIRF based on 10-year Government of India (GOI) security having a notional coupon of 7 percent, with physical settlement. And on 4 July 2011, NSE launched another IRF based on 91-day Treasury Bill, with cash settlement. Initially, these two products experienced some trades from market players. Later, market interest in these products died down. According to NSE’s IRF Tracker, trades are nil in them now.

Liquidity was confined to only a few government bonds. Traders were not interested in holding such illiquid bonds, which adversely affected trading interest in this ETIRF product.

The failure of this product could be attributed to a few things. The ownership of government securities in India is highly skewed towards banks and insurance companies, which keep these assets for long term and their risk appetite for trading is very low. So only a few players are in this market.

Another distorting factor is that banks need not value government securities as per the market value at day’s end (mark-to-market or MTM) since bulk of their investments are allowed to be kept in held-to-maturity (HTM) category. More than 90 percent of such securities are held in this HTM category, which prompts banks not to trade them and thereby avoid any interest rate risk.

Moreover, RBI is the Government’s money manager, undertaking issue of government securities, treasury bills and cash management bills. As a regulator and as a government’s fund manager, RBI exercises enormous control over banks in India—relating to reserve requirements and tweaking rules. As a Government's money manager and enforcer of reserve requirements for banks, it can be said that RBI has a conflict of interest. (However, a few studies dispute this conflict of interest argument).

If this interest rate futures product is to made successful in the Indian market, both RBI and SEBI (Securities and Exchange Board of India, capital market regulator) will have to make it more attractive by allowing flexibility for exchanges to design the product and features, allow cash settlement as against physical settlement, and permit contracts in various maturities.

Time will tell whether the new RBI governor, Raghuram G Rajan, will make this product click and tick. 


(Please see below to know about basics of interest rate futures, their features and contract specifications).

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For the benefit of readers, I reproduce my earlier article dated 28 August 2009 when NSE relauched interest rate futures.

It is two months since the operational guidelines for ETIRF were issued by an RBI-SEBI Committee. Now, National Stock Exchange is re-launching trading in ‘Exchange-Traded Interest Rate Futures’ (ETIRF) from August 31, 2009.  The operational guidelines for the interest rate futures (IRFs) in India were issued on June 17, 2009, by a committee jointly set up by RBI and SEBI. Institutions like, banks, insurance companies, primary dealers, pension funds, mutual funds, financial institutions, companies and provident funds are exposed to interest rate risk on account of their huge exposure to government securities and other fixed income securities. To mitigate the interest rate risk, RBI along with SEBI, has introduced interest rate futures in India. This is a measure that helps in deepening the debt market in India. (IRFs were first launched in 2003 by National Stock Exchange, but did not find favour with market players).

Exchange-Traded Interest Rate Futures (ETIRF): 

An IRF is a contract between two parties – a borrower and a lender – who agree to fix the rate at which they will borrow/lend on a future date. To put simply:

·        It is a hedging mechanism used by economic agents affected by interest rate movements

·        Alternatively put, it is a tool to manage interest rate risk

·        It is a derivative contract – providing standardization and transparency

·        It may be used by banks, insurers, primary dealers, provident funds, etc

·        Even FIIs and NRIs are allowed to take trading positions subject to norms

·        It will be traded on a stock exchange which bears the counterparty risk

Who are permitted:

·        Members registered by SEBI for trading in currency/equity derivatives are eligible to trade in IRF

·        Even individuals who have got interest rate exposures inherent in their fixed deposits, housing and car loans can hedge their positions with the help of an IRF

·        The minimum net worth of a trading member should be Rs one crore

·        The minimum net worth of a clearing member should be Rs 10 crore

The Exchange-Traded IRF product:

·        The IRF is based on yield-to-maturity curve

·        The notional coupon on the underlying 10-year Government Security would be seven per cent with semi-annual compounding

·        The size of the IRF contract would be Rs two lakh

·        Maximum maturity of the contract will be 12 months

·        The contract will be settled by the physical delivery of securities

·        The contract cycle will be at the end of March, June, September and December quarters

Gross Open Position:

·        The gross open position of a trading member across all contracts should not exceed 15 per cent of the total open interest or Rs 1,000 crore, whichever is higher

·        At the client level, the gross open position should not exceed six per cent of the total open interest or Rs 300 crore, whichever is higher

·        FIIs and NRIs, the gross long position in the debt market and the IRF contract should not exceed their maximum permissible debt market limit prescribed from time to time.

What is not permitted as of now:

·        IRF based on overnight rate (based on money market rates) is not permitted

·        IRF based on 91-day Treasury bill is not permitted now, but may be considered later

NSE’s ETIRF Product:

 The salient features of NSE’s new product are:

NSE Contract Specifications
Trading unit	One lot – equal to notional bonds of FV of Rs 2 lakhs
Underlying	10 Year Notional Coupon bearing Government of India (GOI) security (Notional Coupon 7% with semi annual compounding)
Tick size	Rs.0.0025 paise
Trading hours	Monday to Friday 9:00 a.m. to 5:00 p.m.
Contract trading cycle	Four fixed quarterly contracts for entire year ending March, June, September and December
Last trading day	Seventh business day preceding the last business day of the delivery month
Quantity Freeze	501 lots or greater
Settlement	Daily settlement  MTM:  T + 1 in cash Delivery settlement :  In the delivery month i.e. the contract expiry month
Mode of settlement	Daily Settlement in Cash
Deliverable Grade Securities	GOI securities

• NSE has waived transaction charges on IRF until December 31, 2009

Till now, the only interest rate derivative available for trading is Overnight Indexed Swap (OIS) which is a type of Interest Rate Swap (IRS). Interest rate swaps are agreements where one side pays the other a particular interest rate (fixed or floating) and the other side pays the other a different interest rate (fixed or floating). However, OIS is traded in the OTC market. The new IRF is the first interest rate derivative that is being traded on an Exchange.

IRF will be the first derivative product which will be settled by delivery whereas other exchange-traded derivatives (for example, stock futures, index futures, index options, etc) are settled by cash. Physical delivery will be in the demat form through the depositories NSDL, CDSL and Public Debt Office (PDO) of the Reserve Bank of India. 

Other Exchanges:

While NSE introduces ETIRF from 31.8.09, BSE it appears would introduce the product through United Stock Exchange in which BSE took a 15 per cent stake recently.

Interest Rate Scenario:

The huge borrowing programme of the Indian Government has muddied the interest rate scenario. What has been exacerbating the interest rate situation is the food inflation (based on Consumer Price Index or CPI) which has been rising to alarming levels of more than 10 per cent for several months. Any pick up in credit disbursement during the oncoming festive season and credit off-take from corporate sector during the second-half of the fiscal year will put further pressure on the interest rates. With the benchmark 10-year Government Security yield hovering around 7.30 per cent, an increase of more than 30/35 basis points in the past one month; the bond market is jittery about further hardening of bond yields. The bond market has completely lost the appetite for new government paper with Banks’ SLR (statutory liquidity ratio) holdings higher by more than 300 basis points over and above the statutory levels.

The 10-year benchmark yield is expected to touch 7.50 per cent in the next few months due to higher inflationary expectations, huge government borrowing programme, loss of agricultural output of around 20 per cent during the Kharif Season on account of monsoon failure across several states in India, rising international crude oil prices and anticipated credit demand in the second half of the fiscal. However, any revival in the manufacturing sector and consequent rise in tax collections; usage of disinvestment proceeds that are kept in National Investment Fund (NIF) for reducing fiscal deficit; and huge resources of around Rs 35,000 crore that are expected to accrue to the Government’s exchequer from 3G spectrum auction to the Telecom Sector are likely to mitigate the crunch situation in the interest rate cycle in India.

The launch by NSE is ushering in a product that seems to have been timed well in the current rising interest rate scenario so that market participants can hedge their positions.

Note: Interest rate risk: If interest rates rise, the bond prices will fall. Similarly, if interest rates fall, the bond prices will go up. As such, the movement of interest rates will have a big impact on the bondholders; be it, banks, insurance companies, mutual funds or such others, including individuals. The risk that the interest rate fluctuations will affect the prices of bonds or fixed-income investments is interest rate risk.

References: RBI Report on IRF dt. Aug.8, 2008; RBI-SEBI Report on IRF dt. Jun.17, 2009; and NSE.

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Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/

http://www.scribd.com/vrk100

Connect with him on twitter @vrk100

Why is US Inflation Low?-VRK100-04Oct2013

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One question that tickled my mind in recent months was why the US inflation is low even though the US Federal Reserve has flooded its economy with fiat money. I’m no expert on economics. Nor do I have any great understanding of the dynamics of the US economy. Anyway, let me make an attempt.

What is Inflation?

Inflation rates go up when prices go up. Too many dollars are chasing lesser quantity of goods and services pushing up their prices. As prices rise, the value of your money falls. One of the key factors influencing inflation is money supply (See notes 2 to 8 below). Other factors could be expectations, fiscal deficit, economic activity, investment by firms, wages and others.

“Inflation in a fiat money world is difficult to suppress,” opined Alan Greenspan, the former chair of the US Fed. Fiat money or fiat currency is simply paper money printed by a central bank on behalf of a government and released to the economy. One important feature of fiat money is that the governments have enormous power to create or destroy this paper money. For several decades though, the world has been experiencing a very large creation of paper money, but not its destruction.

The dynamics of the world economy have changed enormously and in several ways in the last two to three decades. Inflation has, more or less, remained low in many advanced economies, like, the US, the UK and the eurozone countries. For over two decades, Japan has suffered deflation—decrease in price levels. In the last six months or so, the Asian giant seems to be coming out of deflationary trends after Japan decided to double its monetary base.

The Standard Medicine in the US:

What does the US Fed do in order to stimulate a weak economy? In normal times, the Fed eases monetary policy by lowering its target for the short-term policy interest rate, the federal funds rate. And to tame inflationary pressures, the Fed raises short-term interest rates, which makes the money costlier to borrow. This is the standard medicine.

The US has zero-bound interest rates (federal funds rate of 0 to 0.25 percent) since December 2008. Theoretically, the record-low interest rates would have stimulated credit growth and resulted in a gradual increase in inflation. But none of this has happened in the US in the last five years since the global financial crisis.

Inflation is always and everywhere a monetary phenomenon, said noted economist Milton Friedman. His argument was that to contain inflationary pressures, you’ve to first restrain the money supply. However, using this tool to control inflation is considered blunt. Interestingly, the importance of money supply in stoking or subduing inflationary pressures has diminished in the US in the recent past (See notes 7 and 8 below).

After the 2007/2008 global financial crisis, the Fed has been trying to stimulate the US economy with its easy money policy. As part of the quantitative easing (QE) program, the Fed has been buying bonds as it cannot lower its interest rates below the present 0 to 0.25 percent. As a result of the unconventional QE program, the monetary base in the US has gone up by almost four times in the last six years or so.

Related: What are Fed Tapering and Quantitative Easing? 19Sep2013

But the US inflation rate has been at an annual average of around 1.5 percent in the past five years. When the monetary base has gone up four times and the interest rates have been kept close to zero percent in the last five years, why is that the US inflation rate has been below the US Fed’s comfort level of two percent?

The Answer is:

1. The money pumped in by the US Fed has reached banks. But the banks are holding the funds as excess reserves, instead of lending them; and these reserves are again kept with the Fed! Of late, the Fed has been paying interest on these reserves to banks and other financial institutions.

So, the banks find it more attractive to receive interest from the Fed rather than lend to households or businesses. The lending is not happening as the economy is weak. It’s no surprise that the growth in the US national income too is below two percent in recent years and unemployment rate continues to be at more than 7 percent.

2. The US households’ savings rate was close to zero percent prior to 2008, but now it’s anemic at around three to four percent of GDP. Household debt was very high prior to 2008. After the global financial crisis, wage incomes are down for many millions of US citizens.

They want to save more rather than spend their money. The US households have been focused on reducing their debt, rather than increasing personal consumption. Consumer consumption growth is a dominant factor in the US economy. Of late, consumer consumption growth too is anemic at less than two percent. So, the deleveraging continues in the US economy resulting in low inflation, while the unemployment rate continues to remain at elevated levels.

3. The balance sheets of many US companies are very healthy and they are awash with liquid money. As they aren’t sure about the prospects of US economy, they’ve been using their excess cash to repurchase (buyback) shares rather than invest in new plant and machinery or creating new jobs.

The tech-giant Microsoft has announced a $40-billion share buyback recently. The company has increased its dividend also. Companies, like, Apple, Merck, GE, Home Depot, Time Warner and 3M, too have offered/undertaken share buybacks in the past six months to one year.

Relation between money supply and inflation becomes tenuous now:

Evidence in the past indicated that there was a strong connection between money supply and inflation rates. But history need not repeat itself. This strong connection becomes tenuous now, at least in the US. (See notes 7 and 8 below).

The US Fed has been preparing the world markets for unwinding of its asset purchases, by floating “balloons” since May this year, when they first talked about tapering. When the markets reacted violently—after the talk of tapering started— resulting in the steep decline in prices of bonds, shares, commodities and large scale outflow of funds from the emerging markets; the Fed, the ECB and the IMF tried to assuage the markets by communicating that they would continue their easy money policies as long as the economic growth remains weak.

At the same time, the Fed wants the unwinding of highly risky and levered positions in the markets. (It may be recalled the easy money available in the US and other nations moved to commodities and non-US markets, especially emerging markets, for achieving higher yields).

Between May and the middle of September this year, many such highly levered positions have already been unwound. Now that the markets have already experienced this fall due to talk of tapering; the market’s future reaction may be muted once the Fed starts actual tapering of its bond buying program.

Finally:

It is inevitable that the US interest rates have to go up one day. It won’t be a surprise if the inflation rises in the next 12 to 18 months above the US Fed’s comfortable level of two percent. The world is deluged with dollars printed by the US Fed. Investors have borrowed money at lower rates in the US and invested the money in emerging markets and others in their quest for higher yields. As we have seen in the last four months, the unwinding of levered bets has created problems not only for the emerging economies, such as, India and Indonesia (See note 9 below); but also to investors themselves.  

The US banks have to start lending their excess reserves once the US economy picks up momentum and the demand for money grows. The concerns that the inflation in the US and other developed world will rear its head once again are genuine.

Related:

What is US government shutdown and debt ceiling limit? 27Sep2013

Emerging markets down but not out 10Aug2013

References: US Fed FAQs; “The Age of Turbulence” by Alan Greenspan

Photos above are courtesy of US Fed. Left is Marriner S Eccles Bldg of the Fed and right is Fed board room.

Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions.

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Notes:

1. The US Federal Reserve (US Fed) is the central bank of the US

2. Money supply: It is a group of assets that households and business can use to make payments and to hold as short-term investments. One way to calculate money supply in the US is to aggregate currency and balances held in checking accounts and savings accounts.

3. Monetary base, M1 and M2 are various ways to measure money supply.

4. Monetary base: It is the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the US Fed).

5. M1: It is the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions that obtain their funds mainly through deposits from the public, such as commercial banks, savings and loan associations, savings banks, and credit unions). 

6. M2: is defined as M1 plus savings deposits, small-denomination time deposits (those issued in amounts of less than $100,000), and retail money market mutual fund shares.

7. For several decades in the past, central banks including the US Fed used these measures of the money supply as an important guide for conducting its monetary policy because these measures used to have fairly close relationships with other factors such as, gross domestic product (GDP) and price level. Based partly on these relationships, some economists—like Milton Friedman—argued that the money supply provided important information about the near-term course for the economy and determines the level of prices and inflation in the long run.

8. However, these relationships between the money supply measures and GDP and inflation in the US have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time. The Fed regularly reviews money supply data in conducting monetary policy, but money supply figures are just part of a variety of data points it takes into account.

9. Fragile Five: Morgan Stanley described five countries—Brazil, India, Indonesia, South Africa and Turkey—as the “Fragile Five.” These countries are facing outflow of funds due to the fear of US Fed tapering. More over, these nations are experiencing severe current account deficits and political risk. All these nations are going to the polls next year and investors are focusing too much on political risk in these countries.

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The Brand New US$100 Note Begins Circulation-VRK100-03Oct2013

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Watch the video link given below with details of the new US$100 Note:

The above are front and back specimen images of the new and redesigned one hundred US dollar note that begins circulation on 8 October 2013, which is just five days from now. The new note will have two new features, 3-D security ribbon and bell in the inkwell. Let us learn a bit more above the brand new design of the note. Video link is also given above.

New features of the Redesigned $100 Note:

Number one and two below are new and technologically-advanced features, while the third is an additional feature: 

1. 3-D security ribbon:

The note has a blue ribbon on its front. If you tilt the note back and forth while focusing on the blue ribbon, you will see the bells change to 100s as they move. The ribbon is woven into the paper, not printed on it.

2. Bell in the inkwell:

On the front of the new note there is a color-shifting bell inside a copper-colored inkwell. If you tilt it, you’ll see the bell change from copper to green.

3. Portrait watermark:

If you hold the note to light, you’ll see a faint image of Benjamin Franklin in the blank space to the right of the portrait—it’s visible from both sides of the note.

The circulation begins on 8^th October:

As per the US Federal Reserve—the central bank of the US—the resigned $100 note will begin circulating on 8 October 2013.

What are the merits of the new note?

One big advantage of the new note is that it’s difficult to counterfeit or replicate due to the new design features mentioned above. It’ll be easier for the public to authenticate or verify the new note and to use them in day-to-day transactions.

Several highly effective features were also retained from the previous design, including the portrait watermark, the security thread, and the color-shifting numeral 100.

Consumers and businesses will not have to trade in older $100 notes for new ones. Older designs of Federal Reserve notes remain legal tender, and will not be recalled, demonetized, or devalued.

The US dollars are widely used and circulated across the globe and are easy to convert to other currencies. Earlier, the US currency was subject to counterfeiting threats. So, the new $100 note will help in preventing such threats.

To Know more about the redesigned $100 note, just click:

http://www.newmoney.gov/uscurrency/redesigned100.htm

The new US$100 image courtesy: The US Federal Reserve

References: www.federalreserve.org

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Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/

http://www.scribd.com/vrk100

Connect with him on twitter @vrk100