RBI may roll out interest rate options

Reserve Bank of India on Monday said it is proposing to introduce interest rate options so that all domestic entities, including banks, having underlying interest rate risk can hedge their risk on this count.

Interest rate options (IROs) give buyers the right, but not the obligation, to pay or receive a predetermined interest rate (the strike price) over an agreed period.

An RBI working group headed by PG Apte observed that the financial entities, including banks, do not have any instruments to manage the embedded options on their balance sheets.

For example, banks are faced with the risks of prepayment of floating rate housing loans and premature withdrawal of fixed deposits. If not adequately managed, such asymmetric payoffs can pose significant risk to the entities. Thus, market participants in India, need a hedging instrument to manage interest rate option risk. “With ensuing adoption of IFRS (International Financial Reporting Standards) accounting by banks, assets and liabilities would be restated at market-determined rates and availability of interest rate option will help banks manage their risk more effectively,” the group said in its report.

Simple products initially To begin with, the group recommended that, among others, simple call and put options be permitted. Complex structures may be introduced subsequently.

The group said interest rate options may be permitted both on the currency and derivatives segment of stock exchanges as well as in the OTC (over the counter) market.

While in the OTC segment only European options may be permitted, both American and European structures may be permitted on exchanges. With a European-style option, the contract terms allow the option to be exercised only on the expiration date. This differs from an American option, which can be exercised at any point during the contract period.

FIMMDA (Fixed Income Money Market and Derivatives Association of India) and FBIL (Financial Benchmark India Pvt Ltd) will come out with the list of eligible domestic money or debt market rates as benchmarks, such as government security, treasury bills, etc.

Market makers will include banks and primary dealers. Funds, insurance companies and other regulated entities having sound financials and prudent risk management may be allowed as market makers, subject to the approval of the regulator concerned. Users will include all domestic entities having underlying interest rate risk.

The group suggested that no documentation relating to underlying exposure may be required for exposures up to ₹5 crore and large corporates may be allowed to take hedging positions for their anticipated interest rate exposures.

Minimum lot size for IROs on exchanges will be kept as ₹2 lakh. In the case of OTC, the minimum lot size will be kept at ₹5 crore and in multiples of ₹5 crore thereof among market makers. Transactions between user and market maker may not be standardised.

The group recommended standardising the tenor of contracts among market makers. The tenors may be periodically reviewed by FIMMDA in consultation with the market participants. Stock exchanges may introduce three serial monthly contracts in first phase and may consider introducing quarterly contracts up to one year in next phase.

Trading hours may be same as it is for existing derivative products — Monday-Friday, 9 am to 5 pm. Specifically for exchange traded options, last Thursday of the month shall be the expiry day. The central bank said final IRO guidelines will be issued by March-end 2016 taking into account the feedback received.

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