Column: RBI needs to nurture IRF market

Feb 10 2014, 02:51 IST
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SummaryCPI inflation targeting by the central bank impacts the IRF market adversely with increased chances of rate hikes

RBI was awfully keen to introduce interest rate hedging products. Yet, it may have unintentionally planted a kiss of death on the Interest Rate Futures (IRFs) market prematurely. IRFs, which were launched on January 21, and flaunted as a much-needed hedging instrument, have seen a precipitous volume drop, of more than six times—from R3,080 crore on the launch day to R476 crore last Friday. (The Financial Express, February 4,

Ironically, it’s 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

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