The Hindu Business Line : Islands in financial markets

As domestic financial markets open up further, it is imperative they are provided with the soundest of foundations, a key component of which is a deep and liquid interest rate market.

T. B. Kapali

One of the key features of global financial markets is the integration across various sub-segments. The money market, for instance, has well-defined relationships with the other segments such as the derivatives and foreign exchange markets. The link between the money market and the forward foreign exchange market is almost arithmetical. (Almost, as it cannot strictly be termed a purely arithmetical relationship since expectations also play a role in the determination of fo rward prices).

Rates and prices in these markets cannot remain out of kilter with each other for any length of time, as such misalignments will be arbitraged the moment they arise. A well functioning money market (the market for borrowing and lending money for up to 12 months) is also critical for the derivatives market to flourish. It is this market that provides the “risk-free” rate of interest (for various maturities) which, in turn, is the foundation for the pricing of derivatives.

The value of the simplest derivative, a forward contract on an asset — be it equity, bond or foreign exchange — is basically a function of the (forward) time period for which a price is needed and the rate of interest relevant for that period.

A three-month forward price on a stock, for instance, will be derived from the spot price (current market price) of the stock and the three-month interest rate. The stock will trade in the forward market at a price that will compensate the seller for delaying delivery for the three months.

That is, if a stock is currently quoting at Rs100 and the three-month interest rate is 10 per cent per annum, the forward price of the stock will be equal to 100*102.5/100 = Rs 102.5.

Had the seller, instead of agreeing to a three-month contract, sold the stock in the cash market, he would have got Rs 100, which he can invest for three months at 10 per cent.

Therefore, the forward price of the stock should be at such a level that the seller is compensated for agreeing to deal forward. This is a general rule in forward asset pricing.

Another rule also follows from the above. The asset that has a rate of interest lower than the asset which is to be exchanged for it will trade at a premium in the forward market.

Efficient money market

A pre-requisite for such neat forward-pricing mechanisms is the existence of a well-functioning money market, which can provide the opportunity cost of lending and borrowing for market dealers.

Globally, the inter-bank market for wholesale lending/deposits and the rates coming out of this market are accepted across all segments of the financial markets — equity, bonds, currencies, commodities — as the benchmark market/rates for pricing all derivatives.

Such widespread adoption of a particular set of interest rates ensures that arbitrage opportunities, even if they arise rarely, can remain unexploited for only fleeting moments. The London Inter-Bank Rates (LIBOR, and its counterpart LIBID) are the global standards in financial instrument pricing.

The absence of such universally accepted interest rates naturally means that various market participants use different interest rates for pricing financial instruments at varying points of time. It is apparent that misalignments in pricing are bound to occur in such a welter of rates and prices. Misalignments are then possible — for instance, one can see an inverted price curve for purely financial assets such as stocks.

The varying interest rates can also throw up arbitrage profit opportunities if some market participants have recourse to funding at lower rates of interest than that implied in ruling forward prices.

Such appears to be the case with the equity derivatives market in India. This market trades single-stock futures (or exchange-traded forward contracts), predominantly for maturities up to three months.

And the absence of a widely accepted set of benchmark money market rates means that pricing misalignments occur not only in the structure of forward market prices (an inverted forward price curve has, for instance, been noticed in certain stocks, say, in consumption commodities such as copper, oil or aluminium) but arbitrage profit opportunities also arise on account of the differential interest rates.

The market, for instance, has been pricing (short maturity — up to three months) single-stock futures at double-digit rates of interest when the inter-bank rate for overnight borrowing/lending is sub 1 per cent. There is a clear profit opportunity here for somebody who can fund a position, if not at sub 1 per cent, at something less than the 11-12 per cent implied in the forward prices. The overnight inter-bank rate of sub 1 per cent, of course, cannot be used for pricing a one-month or three-month forward contract. At the same time, the one-month contract cannot be priced at a 11-12 per cent rate of interest also.

There has to be something in between. Indeed, the overall market conditions surrounding the very low level of inter-bank overnight rates clearly indicate that the one-month or three-month rates cannot be anywhere near double digits. But such is the lack of integration between the different segments of the financial market that the level of prices/yields in one segment is not reflected in prices in the other segments.

Asset pricing in this scenario is completely out of tune with globally recognised practices.

The future

Fifteen years of financial sector reforms have not seen the emergence of a vibrant inter-bank money market (for wholesale lending / borrowing) which can provide the reference rates for the pricing of financial instruments.

A range of instruments — from simple forward contracts (which, anyway, have been around for a long time in the foreign exchange sub-segment) to more complex instruments such as futures and options, though, have been introduced in the meantime.

It has just been a case where the overall market appears to have tired of waiting for the ideal enabling environment that can help realise the efficiency gains these new financial products can generate.

It has, however, to be noted that as the local financial markets open up further, it may be imperative to provide them with the soundest of foundations. Deep and liquid interest rate markets are one of the pillars of such a foundation.

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