| Coccinielo: the rupee options market is “going to get very deep and more liquid” |
Rupee currency options have started trading for the first time under new guidelines from the Reserve Bank of India. The move comes as part of a series of efforts to develop Indian derivatives markets.
Nine market-makers – five local and four foreign – are permitted to sell the instruments. But hedge funds need not get too excited – the new products have been tailored to serve as a useful hedge against risk for local corporates rather than as a speculative tool.
As Ravi Savur, head of structured products at market-maker Citigroup in Mumbai, explains: “The central bank has taken the view that local corporations should be allowed to be globally competitive. They should be allowed to manage risk in the same way as other companies overseas do.” One year and many consultative committee meetings later, the new cautious but effective options product was launched on the market.
Until options started trading on July 7, the only rupee hedging tools available to Indian corporates were forward contracts. These are more expensive than options – with an up-front fee when entering the contract – and are inflexible, obliging the user to deliver dollars or rupees on set dates. With options, users pay a small premium and gain the right but not the obligation to deliver the relevant currency.
The Reserve Bank of India has imposed several special restrictions on the contracts to try to limit any risks that options sometimes carry for users.
Corporates cannot sell options unless they do it as a zero-cost transaction, where they simultaneously buy them as well, so the premium earned by selling plus the premium paid by buying must be at least zero. This means that the corporates cannot assume the role of speculators.
And institutions can use the instruments only if they hold underlying rupee assets, in the form of securities investments, import or export business, capital investment and so on. That largely excludes foreign investors and hedge funds from the market. “Hedge funds don’t have the right exposure,” says Ramesh Swamy, head of derivatives marketing at JPMorgan in Mumbai. “It is only six months since the rupee started to appreciate and hedge funds really became interested in India. But it is only a matter of time.”
It is too early to assess the success of this product launch. Citigroup and JPMorgan, which are both market-makers in options, report that options transaction volumes were very high in the first few days of trading, after the banks separately spent time travelling around the country marketing the instruments and educating corporates in how to use them. After that initial surge, volumes dropped.
Banks are confident that demand for options will be maintained. “Our overall sense is that this is certainly going to grow,” says Savur at Citigroup. “We are seeing interest at all levels, from small and medium-size companies to very large corporates. And we are seeing interest across the country, not just in Mumbai and Delhi.”
This sentiment is echoed by Singapore-based Louis Coccinielo, head of foreign exchange options for non-Japan Asia, at JPMorgan. “This market is going to get very deep and more liquid,” he says. “There will be more interest in two-way flows and more market participants.”
The options market will probably always be much smaller than that for forward forex. The entire turnover volume for options is thought to be around the equivalent of $400 million a week, whereas in forwards it is closer to $1 billion a day. And as options transactions grow, so will forwards, as users frequently use one to hedge the other.
JPMorgan is focusing particularly on the long end of this new market and at the time of going to press it claims to be the only firm to have completed a five-year option transaction with a client. “That is in the spirit of what the RBI opened this market for,” says Coccinielo. “Typically, speculators never look to put on trades greater than one year. Rarely will hedge funds do trades for three weeks or less. That is why we want to focus on the back end.”
The RBI is keen to ensure that domestic banks are actively involved in the new options market, but in the short term those firms are generally selling the instruments on a back-to-back basis with foreign banks. “It will take two to three months until they are fully up to speed,” says Savur at Citigroup. “But I do not feel that this market will be dominated by the foreign banks.”
Slow but sure The development of rupee options is just one in a series of moves by the Reserve Bank of India to develop new risk management techniques for the country’s corporates and investors. Credit derivatives may be one of the next areas of focus. The pace of development does tend to be slow, with committees and consultative groups carefully considering how the new markets might work.
This long process can be frustrating. “That does become a challenge,” says Siddarth Mathur, researcher for Indian interest rates and foreign exchange at JPMorgan in Mumbai. “There is so much that is available in the rest of the world that is not immediately available here. But it is just a matter of time. That is the pervasive attitude here in India.”
In keeping with that, JPMorgan is one of the handful of banks involved in informal consultation with the national stock exchange in a consideration of how to refine the country’s interest rate derivatives market. India’s local bond market is second in size only to Korea in non-Japan Asia, but the range of available interest rate derivatives is small. The swaps market, which was launched in 1999, is quite mature, but now interest rate futures look set to develop.
In June, the national stock exchange announced that it would launch exchange-traded interest rate futures in three contracts. This sounds promising enough, but the way these contracts are valued is somewhat disappointing. “It has significant errors, it is random, and it is difficult to model,” says Mathur.
These errors stem from the fact that the futures are priced off a curve that is based on all the bond trades transacted on the exchange. “But a lot of trades are off-exchange, and what is done on exchange is not necessarily representative of the market,” explains Mathur. “We have been tracking the error in the underlying zero-coupon level, and that does not give a lot of comfort. The interest rate future is a bad hedge for existing cash positions. You cannot use it to hedge a bond and expect to be neutral.”
Interest rate futures based on physical delivery of bonds is not an appropriate approach, because the Indian bond market is dominated by a small number of large banks, which, theoretically at least, could squeeze the bond market on the day of settlement. “I can’t see why they would want to do that,” says Mathur. “In fact they would generally want to avoid it. But the outstanding volumes are small, so it would in theory be extremely easy to squeeze the market.”
The model for Indian interest rate futures is basically sound – it does provide a good basis for development. But the price-filtering clearly needs to be improved, and that is what the informal consultative group is trying to achieve along with the stock exchange.
Across the range of risk management products, the outlook for change is positive, and those banks that get involved in consultation early stand a good chance of being able to influence how the new products work. But patience is essential. “If we look at the deregulation that the central bank has made over the past several years, the direction has been clear,” says Savur. “The speed has been a little slow but the direction has been relatively uniform – there have been no sudden cutbacks.”
