Wednesday, August 26, 2009

Postcard from the edge

NSE has announced that on 31 August, they will trade interest rate futures. I believe BSE will also be in this fray soon thereafter.

After the Percy Mistry and Raghuram Rajan reports, there was a bad RBI committee report in August 2008. This led into a `RBI/SEBI Standing Technical Committee report' which spent ten months doing product design. This is central planning at its worst; every detail about the product is specified by the government, through a committee which has nobody from the private sector. And we went from bad to worse: while the `bad RBI committee report' talked about a short-dated interest rate futures contract, that product vanished in the RBI/SEBI Standing Technical Committee report.

With all these problems, it is a step forward. The product will trade right alongside currency futures at NSE. The glass is half full in that the government has not forced the creation of one more silo, one more separate segment.

So this long bond futures will trade in isolation, without the short-dated contract. Yet, I think it will work. The reason is that in India, the bond market is in such bad shape, that there is really only one rate. There isn't much of a yield curve to speak of, there is no yield curve arbitrage, etc. So a one-factor model -- parallel shifts of the yield curve -- captures the bulk of the action. There is relatively little else going on.

For an analogy, we know that in fledgling emerging markets, on the stock market, the market model has a high R2. In other words, there isn't much information production on a per-stock level; it's all macroeconomics and politics. As we get to a less stunted world, idiosyncratic risk surfaces, and each stock does its own thing. In similar fashion, given the stunted Indian bond market, all that happens really is parallel shifts. It would be possible to trade these using the interest rate futures at NSE/BSE. This will be a big step forward.

Economic reform in India is about winning political battles against the license-permit raj. The last time interest rate futures trading was attempted in India, RBI sabotaged this by banning bank participation. When currency futures trading started, RBI banned participation by FIIs and NRIs, while FIIs continue to have full access to the non-transparent and vulnerable OTC market. These bans continue to be in force today (!). RBI continues to ban elementary things like currency options or currency futures for non-dollar currencies on exchanges, even though these are acceptable to RBI on the (non-transparent and vulnerable) OTC market. With these kinds of mistakes starkly visible, it is generally safe to make modest assumptions about economic knowledge and sensible policy-making capability at RBI. Starting from these low expectations, it is remarkable to see that FIIs and banks will be able to trade the interest rate futures (after a fashion).

It's a halting, stumbling, bad way to make progress. But it feels nice to occasionally get progress, and progress this is.

For the domestic financial industry, this is a game changer. The dynamic part of Indian finance -- the securities firms -- have traditionally been kept out of the SGL club. They are now being given a chance to do currencies and interest rates. If you ask me which are the NSE/BSE firms which will thrive in the next ten years, my answer will be: the firms who are in the top 25 ranking by activity in currency futures and interest rate futures in 2009-10. These are the firms who will have done the most in terms of growing up beyond their equity market roots, to turn themselves into full fledged financial firms.

6 comments:

  1. I am so very elated that finally interest rate futures will be traded in the markets. I dont really know,the product specifications, but I am elated nonetheless, because its gonna give a chance for me to test the validity of some of the mean reverting models discussed in academic literature.

    In my opinion, interest rates can be much better modelled as mean reverting than equities. And of course add it with the apparent transparency of the interest rate discovery to the entire process, I am glad that this is happening.

    Soham
    P.S: You get comments with personal attacks or uses foul language??? Come on, did you bash SRK or Aamir in any one of the blog posts? :D These trollers, they absolutely love making a nuisance!

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  2. "There isn't much of a yield curve to speak of, there is no yield curve arbitrage, etc. So a one-factor model -- parallel shifts of the yield curve -- captures the bulk of the action."

    My Comments: This seems to imply that in developed markets where "yield curve arbitrage" (assuming this is the name you give to trades - which have risk - that seek to exploit rich/cheap sectors on the curve) happens, the bulk of the action is not captured by parallel shifts.

    You might want to revisit this line of thought. Please look at this classic by Litterman and Scheinkman.

    http://www.princeton.edu/~joses/pp/Common_F.pdf

    I am not against progress. Yet it should be well reasoned and thoughtful.

    Importantly, the institutional infrastructure has to support that progress. For example, you can introduce cars meant for the autobahn in India. But you know what the result would be given the current state of Indian roads.

    The first buidling block for the derivatives market is a well functioning term cash market. India does not even have reliable term money benchmarks. That is the place to start.

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  3. Its a good shot(news). But, i guess the timing is not right. With borrowing program lined ahead, RBI must be sweating. Market is already concerned about central bank's ability to handle it.
    “the year 2009-10 will be a difficult year than 2008-09.”- Mr D Subbarao at IGIDR, feb'09.
    With IRF coming he will be the most concerned.

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  4. Sir, it was great to read your post. Here someone has written a similar interesting stuff about this. Read it at your leisure:
    http://strat.in/2009/08/interest-rate-futures-connected-to-full-currency-convertibility/#more-2258

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  5. Soham:

    Q: Why do you need interest rate futures to test the validity of mean reverting interest rate models?

    ReplyDelete
  6. In my opinion, interest rates can be much better modelled as mean reverting than equities. And of course add it with the apparent transparency of the interest rate discovery to the entire process, I am glad that this is happening.

    ReplyDelete

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