## Monday, September 07, 2009

### How useful are the new interest rate futures?

The path to interest rate futures was afflicted by important mistakes in policy. I wrote a piece in Financial Express today about how, ironically, the damage caused by these mistakes is smaller than meets the eye, given that we have a stunted bond market in the first place.

1. Hi Ajay,

Interesting article. It probably is the case that no yield curve is a sign of a stunted bond market.

In the figure the spread seems to be about 1% point on average, that's not negligible. But this does seems small if "Interest rate risk is a real problem in India" as you say. Considering the budget deficit it must be the case that government is issuing a lot of bonds. My point being that there must be demand for the 10 year bond to keep rates closer to the short rate.

From a monetary policy perspective this might be a really good thing. How effectively can the RBI control the 90 day rate? Because if it can then they can pretty much control the long rate. This is a central banker's dream scenario. For the US graph you show the period in the early 2000s when long rates stayed high but short rates moved lower, was a cause of concern for the fed and was famously described by Greenspan as a "conundrum"

2. i guess its the Indian investors expectations rather than the taste of liquidity preference.

3. This analysis needs refinement at several levels.I would suggest a careful literature survey.

1. I posted this earlier. Since you have ignored this, I shall do it again. Please look at this classic by Litterman and Scheinkman.

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

Parallel shifts dominate world over. India is no exception.

2. I would say that you are comparing apples to I am not even sure what.

You have picked up a period in India when several structural changes were taking place.

The most obvious one was that in the early oughts long rates were probably adjusting to falling long-term inflation expectations.

So an apt comparison would be a period when a similar thing was happening in the US. Sometime in the 80s and early 90s, but certainly not in the early 2000.

3. If the elasticity of aggreagte demand to rates is low (all else unchanged). What would you expect? More parallel shifts, in my view. This is the Indian case.

US is the polar opposite where monetary policy is extremely effective.

I could go on and on as to why this comparison is bad.

4. Econlogic,

The simple correlation coefficient of the 90-day rate and the 10-year rate in the US is ~ 0.75. In India it is ~ 0.95. Yes, parallel shifts are important everywhere but the flatness of the yield curve and the domination of the parallel shift in India is kinda weird.

I took data from 1997 to 2009, i.e. 12 years. It's hard to say that this period is unusual. It's a nice long dataset of a daily observation of the zero coupon yield curve (for both countries).

Yes, this information alone does not pin down the argument that the bond market is stunted. There are many elements to that reasoning. E.g. in data for 9 Sep, the total bond market turnover was Rs.8,600 crore, of which more than half was 3 bonds. Almost everything else doesn't trade. The acute lack of analysis, speculation and liquidity at diverse points on the yield curve is unbelievable.

My main point is: under these conditions, the damage caused by banning futures on the overnight MIBOR, and futures on the 90-day rate, and all other exchange-traded derivatives, is smaller than might otherwise have been the case.

E.g. for a contrast, in the currencies context, the damage that RBI is doing by banning derivatives on INR/EUR and EUR/USD, and banning exchange-trading of currency options, is acute.

5. There is a lot that I have to say, so I will repond in parts.

There is a basic problem with comparing a global reserve currency bond market with India. That apart, there are a lot of issues.

You are comparing mostly cyclical influences in the US to cyclical+ plethora of structural changes in India. Not a good comparison by any means.

"I took data from 1997 to 2009, i.e. 12 years. It's hard to say that this period is unusual. It's a nice long dataset of a daily observation of the zero coupon yield curve (for both countries)."

My Comments: If you look carefully at the data, it is hard to make this statement.

Monetary Policy

India formally moved away from monetary targeting in I think 1998. The instability of the money demand function was recognized and the monetary strategy was changed.

Operating Procedures of Monetary Policy

India adopted LAF in 2000 and kept on refining the system subsequently.

You know that none of this happened in the US during this period.

Because India still has some combination of quantitative and rates based policy, the short rate vol is higher in India.

Vol benefits highly convex instruments such as long bonds and the market prices these at lower yields recognizing the value of convexity. This could be one reason why the curve may be flatter in regimes where the short rate vols are higher.

I am not saying this is the case in India because I have not done any study myself and have not seen any other research. Just stating one possible theoretical implication of the differences.

There could be other impacts that we do not comprehend.

2. Inflation expectations declined significantly in India in this period. You can take any measure you want, but this conclusion is undeniable.

The implication of that is that when short rates eased, long bonds rallied siginificantly recognizing this structural change. This is what happened in India in early 2001 to 2003.

Had long-term inflation expectations not declined, the long-end would not have rallied as much and the curve would have steepened.

None of that happened in the US.

6. Dear Ajay,

Pardon my ignorance. Is shorting Gsecs allowed in India.

7. For all practical purposes, shorting a government bond is infeasible.

So if you want to express a negative view about bond prices, shorting the futures is the only way.

Natural longs are the only ones who can do arbitrage since the shorting is infeasible in the hands of the smart and nimble types.

8. it help to get the investor back in the firm .thanks for such info.

9. this is really a great achievement.it will help a lot...

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