Participants in IRS/FRA Market: Scheduled commercial banks (excluding regional rural banks), primary dealers, and all India financial institutions are free to undertake FRA/IRS as a product for their own balance sheet management or for market making. banks/financial institutions/primary dealers can also offer these products to corporates for hedging their balances sheet exposure. Now mutual funds are permitted to undertake FRAs/IRS. The forward rate hedging facility provides fund managers an opportunity to insulate income schemes from interest rate fluctuation. This, in turn helps in protecting the returns to investors in a volatile interest rate scenario.
No specific permission from the Reserve Bank is required to undertake FRAs/IRS. However, when undertaking such transactions participants are required to inform the monetary policy department (MPD) and the Reserve Bank.
Guidelines Relating to IRS/FRA:
Banks/primary dealers/financial institutions can undertake different types of plain vanilla FRAs/IRS. Swaps having explicit/implicit option features such as caps/floors are not permitted.
NO benchmark rate, size tenor and so on have been specified in the guidelines but the Reserve Bank has left market forces to evolve a benchmark and healthy conventions and practices. The Reserve Bank has not imposed any ceiling on the minimum or maximum size of the notional principal of FRAs and IRS. The tenor of the transaction should not exceed their underlying rupee exposure. Participants are allowed, occasionally to undertake market making activity without subjecting themselves to underlying exposure. Before undertaking such an activity, they are expected to ensure that the necessary infrastructure and risk management systems are satisfactory.
The Size of Indian IRS/FRA Market:
There was an increase in the volumes of IRS/FRA during 2000-01 and 2001-02. IRS/FRA transactions, both in terms of umber of contracts and outstanding notional principal amount, rose 216 contracts amounting to Rs 4,249 crore as on March 24, 2000, to 1,521 contracts amounting to Rs 21,594 crore as on March 23, 2001, and to 4,379 contracts amounting to Rs 86,749 crore by end March 2002. The IRS has emerged at the more popular of the two instruments in the Indian market.
The participation in the market is restricted mainly to a few foreign and private sector banks, primary dealers and all India financial institutions. Most of the IRS/FRA deals have taken lace with overnight rates as benchmarks.
The IRS/FRA market is still nascent in India. The Reserve Bank has introduced some measures to bring about growth in the popularity of these instruments, the measures include allowing market participants to use interest rates implied in the foreign exchange forward market as a benchmark in addition to the existing domestic money and debt market rates.
In spite of all the measures, however, the market in these derivative instruments has not taken off as anticipated. Factors which inhibit the growth of the money market derivative instruments are as follows:
(1) Lack of awareness and perception of derivative instruments as risky away many participants from utilizing them for their own benefit.
(2) The cost of time and resources associated with the search for a suitable swap candidate and negotiating swap terms is high.
(3) Only a few private sector and foreign banks are active in this market. Most banks prefer statutory compliance in asset-liability management rather than being proactive.
(4) Lack of development of proper benchmark rates has hindered the growth of this market. Most participants rely on overnight Mibor rates as benchmark rates; this has led to a large umber of deals of maturity of less than one year and only a few deals from one or more year maturity.
(5) A vibrant term money market is a precondition of the success of this market. A developed term money market can give a series of rational benchmark but it is yet to grow.
To develop a healthy market for derivatives, there should be enough participants to provide depth and sufficient liquidity and effort should be made to develop term benchmark rates. Banks and Foreign Exchange Dealers’ Association of India (Fedai) should organize workshops to increase the awareness of the use of these products. Banks and insurance companies should be encourages to participate actively in this market.
Introduction of new derivative instruments: Exchange traded interest rate futures were launched on April 28, 2003 by NSE and BSE. Interest rate futures (IRF) contracts are tools for managing interest ate risk. The SEBI plans to introduce ten year long bond futures, futures on notional treasury bills with a maturity of 91 days and options on notional long bond and notional treasury bills.