Posts Tagged ‘interest rate’

VOLATILITY (VEGA) IMPACT IN OPTION PRICING Part 1:)

Options are non linear products, volatility being an important price determinant. Volatility can be looked at as a huge potential O reward as well as risk for the option traders. So why is volatility so important for option traders? Because, it tells the possible price changes of underlying in future. In this article we will try to understand what Vega is and how change in volatility affects the option pricing.

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Vega measures the sensitivity of an option to the Volatility of the underlying. How much option should lose/gain value with a movement in implied Volatility by 1%. To understand Vega we first need to understand Implied Volatility. Implied Volatility is the estimated or expected volatility of a security’s fair price which we derive from a model such as the Black-Scholes Model.

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In addition to required factors such as market price, expiration date, interest rate and strike price, implied volatility is also used in calculating an option’s premium. The most important factor in option trading is to manage the Vega as other factors are known to the investor/trader like time to expiry, spot and strike price and interest rate.

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It means that a call option trading @ 45 and having Vega of 0.47, if the Implied Volatility rises by 1% then the option value will be 45.47. An option price rises due to the expectation that increase in Volatility rise, with the possibility for an option to get expired in favor.

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Let’s understand Vega through simple option positions. Long Call and Put have the positive Vega whereas short Call and Put have the negative Vega. There is no Vega for the stock. Here, positive Vega means that raise in Implied Volatility favor the option. Negative Vega means that fall in Implied Volatility favor the option.

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Let’s take a simple example on S&P CNX Nifty options. In Nifty a Bear call spread for the expiry Aug2010 on 16 Aug 2010 where we short 5400 Call @ 95 whose Vegais 3.18 and Long 5500 Call @36 whose Vega is 3.38. The long call Vega is positive and short call Vega is negative. So the net Vega of this position is +0.20. If theImplied Volatility rises by 1% (keeping other factors same) the net premium of 59 will rise to 59.20 and on fall by 1% it will shed to 58.80.

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Let’s Wait for the fianl part 🙂

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Interest Rate Futures Section – Final Part :)

Interest Rate Futures Section Final Part

Interest Rate Futures Section Final Part

Hello Friends, we are here with the Final Part of our Interest Rate Futures educational section.
We would touch upon the benefits of the Interest Rate Futures and the future scenario related to it.

Here we go :

Key benefits of Interest Rate Futures:

Directional trading

As there is an inverse relationship between interest rate movement and underlying bond prices, so if one has strong view that the interest rates will rise in near future then he can take short position in IRF contracts and can be benefited from the falling futures bond prices.

Hedging portfolio

The holders of the GOI securities are exposed to risk of rising interest rates which in turn results in the reduction in the value of the portfolio.

So in order to protect against a fall in the value of the portfolio they can take short position in IRF.

Calendar spread trading

This spread is also known as an inter-delivery spread.

It is the simultaneous purchase of one delivery month of a given futures contract and the sale of another delivery month of the same underlying on the same exchange.

For example:

Buying a September 09 and simultaneously selling a December 09 contract.
A market participant can profit as the price difference between the two contracts widens.

The either case can also be possible.

Reduce the duration of portfolio:

Bonds with longer maturities are more sensitive to interest rate changes, and bond portfolio with longer duration will be more exposed to the vulnerability of the movement in interest rate.

So portfolio manager who is concerned about the rise in the short term interest rate risk would like to reduce the duration of the portfolio.

By entering into the IRF contract to NSE, the portfolio manager can reduce duration of the portfolio.

Arbitraging between cash and futures market:

Arbitrage is the price difference between the bond prices in underlying bond market and IRF contract without any view about the interest rate movement.

One can earn the risk-less profit from realizing arbitrage opportunity and entering into the IRF contract traded on NSE by initiating cash and carry trade.

Responses After launch:

After the launch of currency futures in August 2008, Interest-rate futures are the first major product to be introduced in India.

The interest rate futures began on August 31,2009 clocking trading volumes of Rs 276 crore in their first day of trade.

Market participants responded passionately to the product launch on the first day.

In around five hours of trading time available after inauguration, 1,475 trades were recorded resulting in 14,559 contracts being traded at a total value of Rs 267.31 crore.

In the beginning only two quarters has been introduced out of four, among which December 2009 was the most active with 13,789 contracts which has been traded actively.

There are nearly 638 members registered for this new product, out of which 21 are banks and there contribution to the total gross volume was 32.48 percent.

Future scenario:

BSE had received regulatory approval for interest rates futures and would launch in 8-10 weeks.

The Multi Commodity Exchange’s foreign exchange derivatives bourse has sought permission to launch trade in interest rate futures.

🙂

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INTEREST RATE FUTURES – Part 2

Hello Friends, just an extension of our previous blog on interest rates futures where we touched upon the topic of interest rates future and what is it exactly.

Now we would understand that why is there need for interst rate futures and many more related aspects in this regard.

Here we go :

Why Interest rate futures?

Why Interest rate futures?

Why Interest rate futures?

The risk associated with the interest rate is uncertain and it never has been constant in the past, infact it would not remain constant in future also.

The volatility of interest rates has increased manifold in the last couple of years and recorded 17.40% in 2008 as compared to 8.51% in 2007.

This high fluctuation in volatility increases risk and requires tools to manage those risks.

Interest rate futures are the product for managing such interest rate risk.

🙂

Backbone of Interest Rate Future:

NSE, India’s largest stock exchange, began interest rate futures and offers the same reliable features as it provide to its other products with the following advantages:

Standardization and flexibility

•Price transparency and liquidity

•Leverage effect due to a wider collateral management

•Advance trading software and technological edge

•Centralized clearing supported by guaranteed settlement

🙂

Who can be a part of it?

The major market participants of interest rate futures are

•Banks and Primary Dealers

• Mutual Funds and Insurance Companies

• Corporate Houses and Financial Institutions,

•FIIs and NRIs

• Member Brokers and Retail Investors.

In Final part of this topic (which we would cover in our next blog), we would throw light on the benefits of the Interest Rate Futures and the future scenario related to Interest rate futures.

🙂

Stay Tuned 😉

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Interest Rates War Heating Up,Home Loans Rates Down!

An interest rate war led to the dip in home loan rates

An interest rate war led to the dip in home loan rates

An interest rate war is brewing in the home loans this festive season.

Development Credit Bank (DCB) and GIC Housing offering home loans below the psychological 8%.

🙂

DCB, which recently entered the segment, is offering home loans at 7.95% for loans up to Rs 5 crore at fixed interest rate for the first year and floating rates from year two.

Affordable housing is the buzzword these days, but the market would get a further boost if attractive financing options are available.

Therefore, bankers have started coming up with the attractive options for their target segments.

Central Bank of India and PNB have waived processing fee and documentation charges on certain loans.

🙂

Bankers have basically started offering a psychological pricing to get more borrowers into their fold.

According to bank observers, borrowers have started preferring low interest bearing home loan accounts of nationalised banks over private banks.

However, private sector bankers maintain that borrowers should not fall flat over the sub 8% schemes and exercise caution before signing on the dotted line.

As well as borrowers also say that such switch over is not easy.

Half way through EMI repayments, it is getting quite impossible for borrowers to get their account Shifted.

Constraints like, paying a hefty penalty and transfer fees are proving to be deterrents for them.

😦

Interest Rate War is really heating up coming Diwali. 🙂

INTEREST RATE FUTURES – What’s That?

Hello Friends,

For past weeks we have been coming up with educational and informative inputs on topics like economic indicators, Positive Undertones in the Economy etc;

In this Blog now we would throw light on “Interest rate futures.

What is Interest Rates Future?

What is Interest Rates Future?

What are interest rate futures?

An interest rate futures contract is “an agreement to buy or sell a debt instrument at a specified future date at a price that is fixed today.”

Interest rate futures are useful to those who are willing to trade in future interest rates and would like to benefit from interest rate movements.

🙂

The underlying instrument in this contract is 10 year National Coupon-bearing government of India (GOI) security, whereas the notional coupon is of 7% with semi-annual compounding interest rate.

🙂

The GOI securities are the underlying assets which should have a maturity status between seven-and-a-half years and 12 years from the first day of the delivery month.

Interest Rate Futures are the most widely traded derivatives instrument in the world.

🙂

The total outstanding notional principal amount in Interest Rate Futures is 30.09 times higher than equity index futures.

Interest rates are linked to a variety of economic conditions.

They can change rapidly, influencing investments and debt obligations.

In a market environment where long term debt issuance by the government is increasing and the demand for it is growing, there is a strong need for a cost efficient hedging instrument against interest rate.

🙂

In Next Coming parts, we would try to understand why Interest rate futures are needed, what is the backbone of interest rate futures and many more related aspects in this regard. 🙂

Stay Tuned 😉

However, For More latest Industry, Gyan, Stock Market and Economy News Updates, Click Here


Economic Indicators Part 2 :)

Hello Friends, just an extension of our yesterday’s blog on economic indicators where we talked about the categories of Economic indicators and relationship between various indicators.

ECONOMIC INDICATORS WITH A FOCUS ON STOCK MARKETS AS A LEADING INDICATOR

ECONOMIC INDICATORS WITH A FOCUS ON STOCK MARKETS AS A LEADING INDICATOR

Now in this Blog, we would look upon issues like what current economic indicators reflect about the state of Indian and global economy in coming months, factors that impact the degree of correlation and general effects of the stock maket indices(economic indicators) on the economic performance of the country.

🙂

For Indian Markets, we can refer collected data for sensex growth, GDP growth and IIP index growth for 40 quarters over the last decade i.e FY99-FY09.

On the basis of the observation, it is analyzed that there is a correlation between the indicators; however, there is a time lag of at least 3 months between the sensex performance and economic indicators performance.

🙂

Out of the 40 time periods being observed, the time lag and the correlation has been reflected in 80% of the cases.

Therefore, on the basis of the study, we can conclude that Indian economy might witness a revival over the next 3 to 6 months.

However, the Indian stock market indices are not only the reflection of the expectation of India Inc performance; the Indian markets are highly influenced by FII inflow too.

🙂

Thus, Indian markets not only indicate the future economic conditions of the country but the global liquidity conditions too.

Therefore, if the stock market improvements that started towards the end of the first quarter of 2009 can be further sustained, it may be an indication that economic activity levels might start to improve towards the end of 2009 / beginning of 2010 backed by the correlation theory and time lag of 6 months to 1 year.

The Leading effect of the stock maket indices on the economic performance of the country can be rationalized on the following basis:

1) Futuristic approach of stock prices

Current stock prices reflect the expected operational performance of industry. The price of a stock equals the present value of future dividends.

Hence, stock prices should rise because of higher expected corporate profits, giving the rate of return used by investors to discount future earnings.

🙂

Since investor’s expectations about corporate profits depend on expectations about the prospective state of the economy, then stock prices should rise or fall before the actual rise or fall of general economic activity and corporate earnings.

Thus, the stock market is forward-looking, and current prices reflect the future earnings potential, or profitability, of companies.

🙂

Since stock prices reflect expectations about profitability and since profitability is directly linked to economic activity, fluctuations in stock prices are thought to lead the direction of the economy.

If the economy is expected to enter into a recession, for example, the stock market will anticipate this by bidding down the prices of stocks.

2) Wealth Creation Effect

The “wealth effect” is also regarded as support for the stock market’s predictive ability.

Since fluctuations in stock prices have a direct effect on aggregate spending, the economy can be predicted from the stock market.

When the stock market is rising, investors’ wealth increase and they spend more.

As a result, the economy expands.

🙂

On the contrary, if stock prices are declining, investors experience a decrease in wealth levels and spend less.

This results in slower economic growth.

🙂

However, the factors that impact the degree of correlation are:

the variability in interest rate,

the money supply,

the rate of inflation and

the degree of confidence of market participants regarding the state of the economy.

🙂

Thus, although the stock market is relatively reliable as a predictor, it should be used with caution and in conjunction with other leading indicators in forecasting the turning points of business cycle.

🙂

We can also rationalize the view of 97% economists that U.S economy will be out of recession by end of CY2009.

🙂

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NRI’s Deposits Surge $1.8 Billion in Q1 :)

NRI deposits in Q1

Overseas Indians continue to set great store by deposits with banks in India due to the upward revision in the interest rate ceiling while the Non-resident Indian (NRI) deposits with banks increased by $1.8 billion in Q1 of FY2010.

However, in order to counter foreign exchange outflows, the RBI revised the ceiling rate of foreign currency non-resident deposits to LIBOR/SWAP rates plus 100 basis points for the respective currency /corresponding maturities (as against LIBOR/SWAP rates plus 25 basis points).

🙂

Moreover, in the case of repatriable NRE deposits, the ceiling rate on NRE deposits was raised to LIBOR/SWAP rates plus 175 basis points.

Further, private transfer receipts which constitutes of remittances from Indians working overseas and local withdrawals from NRI rupee deposits, remained buoyant and rose by 9.4% to $13.3 billion during Q1FY2010 from $12.2 billion in Q1FY2009.

🙂

On the other hand, during Q1FY2010, invisibles receipts, comprising services (travel, transportation, insurance, software, etc), transfers and income (investment income and compensation of employees), decreased by 0.7% to $38.684 billion due to reduction in all categories of services except insurance and financial services and a decline of 20.3% in investment income receipts.

😦

However, invisibles payments rose by 11.9% to $18.505 billion on account of growth in payments under services and income account.

The trade deficit declined to $25.986 billion and net invisibles was lower at $20.179 billion whereas merchandise exports recorded a decline of 21% in Q1FY2010 and imports declined by 19.6% as against a positive growth of 42.9% in Q1FY2009.

🙂

Factors that Move the Interest Rates – Part 2 (MONETARY POLICY)

Monetary Policy

In previous Blog we have discussed about the major factors responsible for the change in interest rates and price of bonds indirectly.

All those three factors like Inflation, Currency and Liquidity have been touched upon in last blog.

🙂

Now time to look into another major factor which causes  movement in the interest rate. The factor i am talking about is Monetary Policy. 🙂

Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI.

Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements.

If either of these is increased, liquidity tightens and so interest rates harden (increase).:(

Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

🙂

(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs.

A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

🙂

(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks.

To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

🙂

(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities.

When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates.

When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates.

MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI.

This affects interest rates in the same manner as OMOs.

🙂

Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in.

🙂

If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future.

On the contrary, an expectation of a fall in interest rates means bond prices will rise.

A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above.

So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.

🙂

4 Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI. Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements. If either of these is increased, liquidity tightens and so interest rates harden (increase). Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs. A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities. When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates. When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates. MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI. This affects interest rates in the same manner as OMOs.

Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in. If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future. On the contrary, an expectation of a fall in interest rates means bond prices will rise. A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above. So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.

Factors that Move the Interest Rates – Part 1:)

Interest rates

In earlier blog we have discussed about how Bonds are different than equities and why are they considered less risky instruments. 🙂

Now coming on to this blog, we would talk about the 3 major factors (other than monetary policy) which moves the interest rates  and ultimately causes a price change in the Bonds.

🙂

To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates.

This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

🙂

1. Inflation:

Interest rates are directly related to inflation i.e. if inflation rises, so do interest rates.

This is because lenders demand higher interest rates to compensate for the decrease in purchasing power of the money they will be repaid in the future.

This causes bond prices to fall, since bond prices are inversely related to interest rates.

Inflation itself is affected by the economy’s currency and liquidity position.

In India, inflation is measured by WPI (Wholesale Price Index), for which is released every week.

For the week ended July 25, 2009, WPI was at (-) 1.58%. This may lead one to assume that inflation has gone down, but the reason for this low figure is a high base effect from 2008, when WPI showed doubledigit growth.

Current CPI (Consumer Price Inflation) figures are in the range of 8.6-11.5% for May-June 2009.

🙂

2. Currency: A weaker rupee causes rising inflation, which in turn results in a rise in interest rates.

This is because one’s purchasing power reduces – if one was paying $60 or Rs.2400 (Rs.40=$1) to buy 1 barrel of crude oil, a weaker rupee (Rs.45=$1) means the same 1 barrel will now cost Rs.2700 i.e. Rs.300 more.

Similarly, a stronger rupee increases one’s purchasing power and brings down inflation, causing interest rates to fall.

The latter scenario is seen as a positive for the bond market, since it leads to rising bond prices.

Since 2008, the rupee has weakened significantly to Rs.47- 48 in July-August ’09.

😦

3. Liquidity: Interest rates are directly related to liquidity.

A crunch in liquidity means money is not readily available, since people are not willing to part with their cash.

A lower interest rate is then offered, which increases the price of already existing bonds in the market. The vice-versa also holds true.

One way of measuring the liquidity present in the system is to check the money supply measure – M3.

🙂

There is another factor which is responsible for the movement in interest rates that is Monetray Policy which we would discuss in next blog

🙂

To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates. This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

Bonds… Less Risky Instruments :)

bonds risk

Bonds are considered to be less risky instruments to invest in as compared to equity.

🙂

Therefore, it is usually the risk averse investors who trade in bonds.

But, not everyone is aware of the fact that bonds too come with their own set of risks- interest rate risk being one of the most significant ones.

It is the risk associated with interest rate changing, and this causes a movement in the price of bonds.

😦

The following is the relationship between the two – prices of bonds are inversely related to their yield.

Yield is the implied interest offered by a security over its life, given its current market price.

Therefore, a rise in interest rates decreases the price of the bond, leaving the investor trading in bonds to incur losses.

🙂

The rationale behind this can be understood with an example.

🙂

Assume a bond of face value Rs.100 that offers a 7% coupon. Now, another Rs.100 bond comes out in the market, which offers a higher 8% coupon.

If the investor holding the 7% coupon tries selling it, he will not be able to sell it at its face value, since a more attractive coupon-bearing bond is available in the market at present.

Therefore, he will have to settle for a lower market price, say Rs.99. This is how prices are inversely related to yields, and this very relationship forms the basis for interest rate risk.

🙂

To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates.

We would discuss the factors responsible for moving interest rates in our next Blog.

🙂

This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

🙂

Bonds are considered to be less risky instruments to invest in as compared to equity. Therefore, it is usually the riskaverse investors who trade in bonds. But, not everyone is aware of the fact that bonds too come with their own set of risks- interest rate risk being one of the most significant ones. It is the risk associated with interest rate changing, and this causes a movement in the price of bonds.

The following is the relationship between the two – prices of bonds are inversely related to their yield.

Yield is the implied interest offered by a security over its life, given its current market price. Therefore, a rise in interest rates decreases the price of the bond, leaving the investor trading in bonds to incur losses. The rationale behind this can be understood with an example. Assume a bond of face value Rs.100 that offers a 7% coupon. Now, another Rs.100 bond comes out in the market, which offers a higher 8% coupon. If the investor holding the 7% coupon tries selling it, he will not be able to sell it at its face value, since a more attractive coupon-bearing bond is available in the market at present. Therefore, he will have to settle for a lower market price, say Rs.99. This is how prices are inversely related to yields, and this very relationship forms the basis for interest rate risk.

To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates. This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

1 Inflation: Interest rates are directly related to inflation i.e. if inflation rises, so do interest rates. This is because lenders demand higher interest rates to compensate for the decrease in purchasing power of the money they will be repaid in the future. This causes bond prices to fall, since bond prices are inversely related to interest rates. Inflation itself is affected by the economy’s currency and liquidity position. In India, inflation is measured by WPI (Wholesale Price Index), for which is released every week. For the week ended July 25, 2009, WPI was at (-) 1.58%. This may lead one to assume that inflation has gone down, but the reason for this low figure is a high base effect from 2008, when WPI showed doubledigit growth. Current CPI (Consumer Price Inflation) figures are in the range of 8.6-11.5% for May-June 2009.

2 Currency: A weaker rupee causes rising inflation, which in turn results in a rise in interest rates. This is because one’s purchasing power reduces – if one was paying $60 or Rs.2400 (Rs.40=$1) to buy 1 barrel of crude oil, a weaker rupee (Rs.45=$1) means the same 1 barrel will now cost Rs.2700 i.e. Rs.300 more. Similarly, a stronger rupee increases one’s purchasing power and brings down inflation, causing interest rates to fall. The latter scenario is seen as a positive for the bond market, since it leads to rising bond prices. Since 2008, the rupee has weakened significantly to Rs.47- 48 in July-August ’09.

3 Liquidity: Interest rates are directly related to liquidity. A crunch in liquidity means money is not readily available, since people are not willing to part with their cash. A lower interest rate is then offered, which increases the price of already existing bonds in the market. The vice-versa also holds true. One way of measuring the liquidity present in the system is to check the money supply measure – M3.

4 Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI. Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements. If either of these is increased, liquidity tightens and so interest rates harden (increase). Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs. A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities. When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates. When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates. MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI. This affects interest rates in the same manner as OMOs.

Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in. If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future. On the contrary, an expectation of a fall in interest rates means bond prices will rise. A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above. So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.