research on indian money market

Money market in India

Scope of India Money MarketThe India money market is a monetary system that involves the lending and borrowing of short-

term funds. India money market has seen exponential growth just after the globalization initiative

in 1992. It has been observed that financial institutions do employ money market instruments for

financing short-term monetary requirements of various sectors such as agriculture, finance and

manufacturing. The performance of the India money market has been outstanding in the past 20

years.

Central bank of the country - the Reserve Bank of India (RBI) has always been playing the major

role in regulating and controlling the India money market. The intervention of RBI is varied -

curbing crisis situations by reducing the cash reserve ratio (CRR) or infusing more money in the

economy.

Types of Money Market instruments in India –

Money market instruments take care of the borrowers' short-term needs and render the

required liquidity to the lenders. The varied types of India money market instruments are

treasury bills, repurchase agreements, commercial papers, certificate of deposit, and

banker's acceptance.

Treasury Bills (T-Bills) - Treasury bills were first issued by the Indian government in 1917. Treasury bills are short-term financial instruments that are issued by the Central Bank of the country. It is one of the safest money market instruments as it is void of market risks, though the return on investments is not that huge. Treasury bills are circulated by the primary as well as the secondary markets. The maturity periods for treasury bills are respectively 3-month, 6-month and 1-year. The price with which treasury bills are issued comes separate from that of the face value, and the face value is achieved upon maturity. On maturity, one gets the interest on the buy value as well. To be specific, the buy value is determined by a bidding process, that too in auctions.

Repurchase Agreements - Repurchase agreements are also called repos. Repos are short-term loans that buyers and sellers agree upon for selling and repurchasing. Repo transactions are allowed only among RBI-approved securities like state and central government securities, T-bills, PSU bonds, FI bonds and corporate bonds. Repurchase agreements, on the other hand, are sold off by sellers, held back with a promise to purchase them back at a certain price and that too would happen on a specific date. The same is the procedure with that of the buyer, who purchases the securities and other instruments and promises to sell them back to the seller at the same time.

Commercial Papers - Commercial papers are usually known as promissory notes which are unsecured and are generally issued by companies and financial institutions, at a


discounted rate from their face value. The fixed maturity for commercial papers is 1 to 270 days. The purposes with which they are issued are - for financing of inventories, accounts receivables, and settling short-term liabilities or loans. The return on commercial papers is always higher than that of T-bills. Companies which have a strong credit rating, usually issue CPs as they are not backed by collateral securities. Corporations issue CPs for raising working capital and they participate in active trade in the secondary market. It was in 1990 that Commercial papers were first issued in the Indian money market.

Certificate of Deposit - A certificate of deposit is a borrowing note for the short-term just similar to that of a promissory note. The bearer of a certificate of deposit receives interest. The maturity date, fixed rate of interest and a fixed value - are the three components of a certificate of deposit. The term is generally between 3 months to 5 years. The funds cannot be withdrawn instantaneously on demand, but has the facility of being liquidated, if a certain amount of penalty is paid. The risk associated with certificate of deposit is higher and so is the return (compared to T-bills). It was in 1989 that the certificate of deposit was first brought into the Indian money market.

Banker's Acceptance - A banker's acceptance is also a short-term investment plan that comes from a company or a firm backed by a guarantee from the bank. This guarantee states that the buyer will pay the seller at a future date. One who draws the bill should have a sound credit rating. 90 days is the usual term for these instruments. The term for these instruments can also vary between 30 and 180 days. It is used as time draft to finance imports, exports.

It depends on the economic trends and market situation that RBI takes a step forward to ease out the disparities in the market. Whenever there is a liquidity crunch, the RBI opts either to reduce the Cash Reserve Ratio (CRR) or infuse more money in the economic system. In a recent initiative, for overcoming the liquidity crunch in the Indian money market, the RBI infused more than Rs 75,000 crore along with reductions in the CRR.

Money maket is an important part of the economy. It plays very significant functions. As mentioned above it is basically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks, business corporations, non-banking financial institutions (NBFs) and other financial institutions along with investors.

The major functions of money market are given below:-

1. To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short term monetary transactions.

2. To promote economic growth. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc.

3. To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly it also provides facility of discounting bills of exchange for trade and industry.

4. To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary policy.


5. To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in generating savings and investments in the economy.

6. Money market provides non-inflationary sources of finance to government. It is possible by issuing treasury bills in order to raise short loans. However this dose not leads to increases in the prices.

Apart from those, money market is an arrangement which accommodates banks and financial institutions dealing in short term monetary activities such as the demand for and supply of money.

Definitions of Money MarketFollowing definitions will help us to understand the concept of money market.

According to Crowther, "The money market is a name given to the various firms and institutions that deal in the various grades of near money."

According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government."

According to Nadler and Shipman, "A money market is a mechanical device through which short term funds are loaned and borrowed through which a large part of the financial transactions of a particular country or world are degraded. A money market is distinct from but supplementary to the commercial banking system."

These definitions help us to identify the basic characteristics of a money market. A money market comprises of a well organized banking system. Various financial instruments are used for transactions in a money market. There is perfect mobility of funds in a money market. The transactions in a money market are of short term nature.

Functions of Money MarketMoney market is an important part of the economy. It plays very significant functions. As mentioned above it is basically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks, business corporations, non-banking financial institutions (NBFs) and other financial institutions along with investors.

The major functions of money market are given below:-


1. To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short term monetary transactions.

2. To promote economic growth. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc.

3. To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly it also provides facility of discounting bills of exchange for trade and industry.

4. To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary policy.

5. To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in generating savings and investments in the economy.

6. Money market provides non-inflationary sources of finance to government. It is possible by issuing treasury bills in order to raise short loans. However this dose not leads to increases in the prices.

Apart from those, money market is an arrangement which accommodates banks and financial institutions dealing in short term monetary activities such as the demand for and supply of money.

Indian Money Market - Features

Every money is unique in nature. The money market in developed and developing countries differ markedly from each other in many senses. Indian money market is not an exception for this. Though it is not a developed money market, it is a leading money market among the developing countries.

Indian Money Market has the following major features or characteristics :-

1. Dichotomic Structure : It is a significant aspect of the Indian money market. It has a simultaneous existence of both the organized money market as well as unorganised money markets. The organized money market consists of RBI all scheduled commercial banks and other recognized financial institutions. However, the unorganized part of the money market comprises domestic money lenders, indigenous bankers, trader, etc. The organized money market is in full control of the RBI. However, unorganized money market remains outside the RBI control. Thus both the organized and unorganized money market exists simultaneously.

2. Seasonality : The demand for money in Indian money market is of a seasonal nature. India being an agriculture predominant economy, the demand for money is


generated from the agricultural operations. During the busy season i.e. between October and April more agricultural activities takes place leading to a higher demand for money.

3. Multiplicity of Interest Rates : In Indian money market, we have many levels of interest rates. They differ from bank to bank from period to period and even from borrower to borrower. Again in both organized and unorganized segment the interest rates differs. Thus there is an existence of many rates of interest in the Indian money market.

4. Lack of Organized Bill Market : In the Indian money market, the organized bill market is not prevalent. Though the RBI tried to introduce the Bill Market Scheme (1952) and then New Bill Market Scheme in 1970, still there is no properly organized bill market in India.

5. Absence of Integration : This is a very important feature of the Indian money market. At the same time it is divided among several segments or sections which are loosely connected with each other. There is a lack of coordination among these different components of the money market. RBI has full control over the components in the organized segment but it cannot control the components in the unorganized segment.

6. High Volatility in Call Money Market : The call money market is a market for very short term money. Here money is demanded at the call rate. Basically the demand for call money comes from the commercial banks. Institutions such as the GIC, LIC, etc suffer huge fluctuations and thus it has remained highly volatile.

7. Limited Instruments : It is in fact a defect of the Indian money market. In our money market the supply of various instruments such as the Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. is very limited. In order to meet the varied requirements of borrowers and lenders, It is necessary to develop numerous instruments.

Some of the important defects or drawbacks of indian money market are :-

1. Absence of Integration : The Indian money market is broadly divided into the

Organized and Unorganized Sectors. The former comprises the legal financial institutions

backed by the RBI. The unorganized statement of it includes various institutions such as

indigenous bankers, village money lenders, traders, etc. There is lack of proper

integration between these two segments.

2. Multiple rate of interest : In the Indian money market, especially the banks, there exists

too many rates of interests. These rates vary for lending, borrowing, government

activities, etc. Many rates of interests create confusion among the investors.

3. Insufficient Funds or Resources : The Indian economy with its seasonal structure faces

frequent shortage of financial recourse. Lower income, lower savings, and lack of

banking habits among people are some of the reasons for it.


4. Shortage of Investment Instruments : In the Indian money market,

various investment instruments such as Treasury Bills, Commercial Bills, Certificate of

Deposits, Commercial Papers, etc. are used. But taking into account the size of the

population and market these instruments are inadequate.

5. Shortage of Commercial Bill : In India, as many banks keep large funds for liquidity

purpose, the use of the commercial bills is very limited. Similarly since a large number of

transactions are preferred in the cash form the scope for commercial bills are limited.

6. Lack of Organized Banking System : In India even through we have a big network of

commercial banks, still the banking system suffers from major weaknesses such as

the NPA, huge losses, poor efficiency. The absence of the organized banking system is

major problem for Indian money market.

7. Less number of Dealers : There are poor number of dealers in the short-term assets who

can act as mediators between the government and the banking system. The less number

of dealers leads tc the slow contact between the end lender and end borrowers.

Reforms made in the Indian Money Market are:-1. Deregulation of the Interest Rate : In recent period the government has adopted an

interest rate policy of liberal nature. It lifted the ceiling rates of the call money market,

short-term deposits, bills rediscounting, etc. Commercial banks are advised to see the

interest rate change that takes place within the limit. There was a further deregulation of

interest rates during the economic reforms. Currently interest rates are determined by the

working of market forces except for a few regulations.

2. Money Market Mutual Fund (MMMFs) : In order to provide additional short-term

investment revenue, the RBI encouraged and established the Money Market Mutual

Funds (MMMFs) in April 1992. MMMFs are allowed to sell units to corporate and

individuals. The upper limit of 50 crore investments has also been lifted. Financial

institutions such as the IDBI and the UTI have set up such funds.

3. Establishment of the DFI : The Discount and Finance House of India (DFHI) was set up

in April 1988 to impart liquidity in the money market. It was set up jointly by the RBI,

Public sector Banks and Financial Institutions. DFHI has played an important role in

stabilizing the Indian money market.

4. Liquidity Adjustment Facility (LAF) : Through the LAF, the RBI remains in the

money market on a continue basis through the repo transaction. LAF adjusts liquidity in

the market through absorption and or injection of financial resources.

5. Electronic Transactions : In order to impart transparency and efficiency in the money

market transaction the electronic dealing system has been started. It covers all deals in the

money market. Similarly it is useful for the RBI to watchdog the money market.


6. Establishment of the CCIL : The Clearing Corporation of India limited (CCIL) was set

up in April 2001. The CCIL clears all transactions in government securities, and repose

reported on the Negotiated Dealing System.

7. Development of New Market Instruments : The government has consistently tried to

introduce new short-term investment instruments. Examples: Treasury Bills of various

duration, Commercial papers, Certificates of Deposits, MMMFs, etc. have been

introduced in the Indian Money Market.

These are major reforms undertaken in the money market in India. Apart from these, the stamp

duty reforms, floating rate bonds, etc. are some other prominent reforms in the money market in

India. Thus, at the end we can conclude that the Indian money market is developing at a good

speed.

Indian Money Market: Market Structure, Covered Parity and Term StructIn the context of the relatively recent deregulation of interest rates in India, this

paper analyses the structure and inter-relationships of money market interest rates

and studies the extent to which covered interest parity holds in India. The paper

shows that there was a major structural break in September 1995 when in the

wake of turmoil in the foreign exchange markets, covered interest arbitrage came

into play in a big way for the first time. Even after September 1995, the forward

premia continue to violate covered parity in systematic ways. These violations are

shown to be related partly to the distortions in the foreign exchange market as

measured by the premium in the unofficial foreign exchange market. Partly,

however, covered parity violations also reflect distortions in the money market

rates and in the formation of expectations. Though the money market is free from

interest rate ceilings, structural barriers and institutional factors continue to create

distortions in the market. Apart from the overnight inter-bank (call market) rate,

the other interest rates in the money market are sticky and appear to be set in

customer markets rather than auction markets. A well defined yield curve does not

therefore exist in the Indian money marketure

It is only in the early nineties that interest rates were progressively deregulated in India, and

there

have therefore been few studies about the behaviour of interest rates in the country. Even today,


the secondary market for long term debt is highly illiquid and underdeveloped. This makes it

difficult to carry out an empirical study about long term interest rates. By comparison, the money

market is relatively more liquid making it a better candidate for empirical research (for example,

Varma, 1996, 1997). This paper seeks to study the structure and inter-relationships of money

market interest rates in India.

The money market encompasses a wide range of instruments with maturities ranging from one

day to a year, issued by the government and by banks and corporates of varying credit rating, and

traded in markets of varying liquidity. The money market is also intimately linked with the

foreign

exchange market through the process of covered interest arbitrage in which the forward premium

acts as a bridge between domestic and foreign interest rates. Thus an analysis of money market

interest rates covers four elements:

1. The term structure of interest rates (the segment of the yield curve up to a maturity of one

year).

2. The credit spread between instruments of similar maturity but differing credit risk.

3. The covered interest differential between international interest rates adjusted for the forward

premium and domestic interest rates of comparable maturity and default risk.

4. Market structure differences between continuously clearing auction markets and sticky price

customer markets.

Data

The money market instruments covered in this study include the call market, Treasury Bills

(TBills), Certificates of Deposits (CD), Commercial Paper (CP), and Inter Corporate Deposits

(ICD). On the foreign exchange side, the paper focuses on interest differentials based on dollar

LIBOR and the forward premium of the dollar at three month and six month maturities. Since the

foreign exchange market in India is not entirely free, it is also useful to look at the unofficial

(black market or havala) exchange rate of the rupee and the premium of the havala rate over the

official rate.

Official publications of the Reserve Bank of India (RBI) provide data on the call market and on

primary market auctions of T-Bills. The US Federal Reserve Board publishes data on the dollar

LIBOR rates of interest. Data on most of the others are not available in official publications, but

are often published in the business press on the basis of quotations provided by market

participants (brokers or dealers). In order to have a consistent source of data on these variables,

this study relies on the data published every quarter in the Economic and Political Weekly. This

includes weekly data on all the interest rates, forward premia and havala exchange rate (as

quoted

in Dubai) required for this study. Data for most of the variables were available from July 1994

onwards, but some key interest rates were available only from October 1994. Most of the study

however uses data only from September 1995 because of a significant structural break that was


detected during the course of the study as explained later in this paper. The study includes data

up

to the end of 1996.

As pointed out earlier, the forward premium acts as a bridge between domestic and foreign

interest rates through the process of covered interest arbitrage. A bank operating in India which

has access to borrowing abroad in dollars can convert this dollar borrowing into rupee borrowing

by taking a forward cover in the foreign exchange markets. Its total borrowing cost measured in

rupees has two components - the dollar interest rate which it pays and the forward premium that

it

pays for covering the exchange risk. If this total cost (the covered interest rate) is less than the

domestic rate at which the bank can borrow, it would prefer to borrow abroad than in India. If

enough banks make this shift, their action would push up the forward premia (as they all seek

forward cover) and would also bring down the domestic interest rate by reducing the borrowing

pressure in the domestic market. The reverse shift would take place if the covered interest rate

were higher than the domestic rate. The principle of covered interest parity says that the covered

interest rate equals the domestic interest rate for comparable maturity and default risk.

Covered interest parity holds very well when there are no restrictions on capital movements; for

example, forward premiums are virtually identical to interest differentials in the Euro-currency

markets which are completely free. Traders are known to quote forward premia by looking at

interest differentials (Deardorff, 1979). For this reason, this paper refers to the covered dollar

LIBOR as the implicit Euro-rupee rates; it is the rate that would prevail in the Euro-rupee market

if such a market existed. For example, the (implicit) three month Euro-rupee rate is defined to be

the three month dollar LIBOR plus the three month forward premium (annualized) of the dollar

against the rupee. In the absence of a readily available overnight rate in the Euro dollar markets,

the implicit overnight Euro rupee rate is defined to be the US federal funds rate plus the

cash/spot

forward premium (annualized) of the dollar against the rupee.

It is worth pointing out that since the LIBOR and federal funds rates have been quite stable

during

this period, while forward premia have been highly volatile, the Euro rupee rates behave very

much like the forward premia with a constant added. This means that, except for the intercept

terms, regression results using the implicit Euro rates are very similar to the results using the

forward premia themselves. However, in an analysis of covered parities, the intercept term (or the IJAF (The ICFAI Journal of Applied Finance) All rights reserved

3

mean of the interest differential) is quite important. Using the implicit Euro rates is therefore

preferable to working with the raw forward premia.

The interest rates used in the study are the following:


CALL The weekly average (trade weighted) call market rate published by the RBI

TBPRIM The implicit cut-off yield in the weekly auctions of 91 day T-Bills

TBSEC The yield quoted by the Discount and Finance House of India (DFHI) for

secondary market transactions in T-Bills

CDPRIM The mid rate of yields on CDs in the primary market. CDs range in

maturity up to one year, but a significant number are for three and six

month maturities.

CDSEC The yield quoted by the Discount and Finance House of India (DFHI) for

secondary market transactions in CDs.

CPPRIM The mid rate of yields on CPs in the primary market. CPs are typically for

a maturity of six months

CPSEC The yield quoted by the Discount and Finance House of India (DFHI) for

secondary market transactions in CPs.

ICDPRIM The mid rate of yields on ICDs in the primary market. ICDs are typically

for a maturity of three months

ER3MO The implicit Euro rupee rate for maturity of three months

ER6MO The implicit Euro rupee rate for maturity of six months

ERFUNDS The implicit Euro rupee rate for overnight maturity

HAVALAPR The percentage premium of the havala exchange rate over the RBI

reference rate

Market Structure

To gain an understanding of the overall structure of the money market, a factor analysis was

carried out of the various interest rates. It is well established in international markets that factor.

analysis of interest rates on government securities typically yields two major factors

(representing

the term structure of interest rates) which explain almost all the variation in yields (Litterman &

Scheinkman, 1991; Nelson & Schaefer, 1983). Since the interest rates used in this study included

a wide range of risk classes, it was expected that factor analysis may partition the rates on the

risk

dimension in addition to the time dimension. It was therefore quite surprising to find that the two

factors thrown up by the factor analysis (Table 1) had nothing to do with either maturity or risk.

The first factor included the T-Bills, CD, CP and ICD rates while the second factor included the

call rate and the (implicit) Euro rupee rates. The first factor spans the entire spectrum of the risk

dimension from sovereign to corporate. The second factor spans the time dimension ranging

from

overnight to six months.

But these two seemingly inexplicable factors have a very simple and intuitive interpretation in

terms of market structure. The second factor includes rates drawn from the call market and the


foreign exchange markets which are readily classified as auction markets. The interest rates in

this

factor are therefore continuously market clearing rates. On the other hand, as argued below, the

first factor contains sticky interest rates characteristic of customer markets.

The CD and CP markets show clear traits of customer markets. Banks often subscribe to the CP

of a large and valued customer in order to maintain the relationship. The same is true when a

large customer wishes to place a CD with the bank. The secondary rates quoted by the DFHI are

Table 1: Rotated Factor Loadings from Principal Component Analysis

Factor Loadings

Variables First Factor Second Factor

CALL 0.294 0.836

TBPRIM 0.879 0.318

TBSEC 0.856 0.331

CDPRIM 0.766 0.529

CDSEC 0.959 0.185

CPPRIM 0.766 0.458

CPSEC 0.957 0.186

ICDAVG 0.810 0.369

ER3MO 0.418 0.868

ER6MO 0.426 0.804

ERFUNDS 0.118 0.913

changed slowly and infrequently. The volume of trading done at these rates is often negligible

indicating that they are quite far from being market clearing rates. The primary T-Bills rate is set

by auction and would at first sight appear to be a market clearing rate. However, the RBI has

often let large amounts devolve upon it to prevent a rise in the cut-off yield. Moreover, during

periods of tight money, a significant portion of the T-Bills are sold through non competitive bids.

These characteristics make the T-Bills rate as sticky as it would be if it were set in a customer

market. In fact, the description of the primary T-Bill market as a customer market is not totally

inappropriate if we regard the Government as a favoured customer of the RBI. Thus all the rates

included in the first factor are set in customer markets and show evidence of stickiness.

Another piece of evidence in this direction is provided by the standard deviations of the different

rates (Table 2). All the rates in the second factor (auction markets) show much higher variability

than the rates in the first factor (customer markets). This is direct evidence on the stickiness of

the

latter. It is also possible that some of the auction market interest rates display the excess

volatility

that has been detected in other financial markets in India and elsewhere (Barua and Varma, 1994,

Shiller, 1990). This is a topic for future research.


Covered Interest Arbitrage: The Structural Break in September 1995

As indicated at the outset, there was a major structural break in the money market in September

1995 and, therefore, this paper uses data only from this point onward. The crux of this structural

break was in the inter-relationship between the money market and the foreign exchange market,

thought there were some shifts in the relationships between the domestic interest rate themselves.

Table 2: Volatility of Interest Rates in Customer Markets and Auction Markets

First Factor (Customer Markets) Second Factor(Auction Markets)

Variable Standard

Deviation

Coefficient of

Variation

Variable Standard

Deviation

Coefficient of

Variation

CDPRIM 2.74 0.19 CALL 9.23 0.68

CDSEC 1.35 0.09 ER3MO 6.45 0.36

CPPRIM 1.83 0.12 ER6MO 4.89 0.27

CPSEC 1.22 0.08 ERFUNDS 17.40 0.88

ICDPRIM 3.11 0.15

TBPRIM 1.93 0.17

TBSEC 2.27 0.21

This section studies the change that took place in September 1995 in the process of covered

interest arbitrage.

The Indian foreign exchange and money markets went through a period of turmoil in the last

quarter of 1995. After holding steady for nearly three years, the rupee started depreciating

rapidly

against the dollar. Simultaneously, the forward premia shot up to unprecedented levels. These

developments had a immediate impact on the money markets too and the call market interest rate

too rose sharply. The well known theoretical linkage between the money market and the foreign

exchange markets was witnessed in practice for the first time. The interesting fact was that even

after calm was restored in the markets, the new-found linkage persisted. This was thus a classic

case of hysterisis in financial markets: markets and arbitrage mechanisms come into being in

response to abnormally high profit opportunities; but once they have come into existence, they

do

not disappear when the profit opportunity returns to normal levels. The learning process that

markets and market participants have gone through leaves a permanent impact.

The use of the call market rate in the above analysis is not quite appropriate. Strictly speaking,


covered parity holds between instruments of similar maturity, risk and liquidity characteristics.

Since LIBOR is an inter-bank market, the comparison should ideally be with a three month or six

month inter-bank market in India. Unfortunately, an inter bank term lending market did not exist

in India during the period of the study due to excessive reserve requirements on term borrowing.

One possible comparison is with the call market which is an inter-bank market, but only for short

term funds (overnight to a fortnight). Anecdotal evidence suggests however that in deciding

whether to carry out the arbitrage, banks try to forecast the likely average of the call rate over the

next three/six months and compare that forecasted average with the implicit Euro rupee rate. A

strong case can be made for testing covered parity using a longer maturity rate like the CD rate

(CDPRIM) at which banks borrow from large non-bank lenders.

The structural break was therefore tested using CDPRIM as well as other rates like TBPRIM and

CPPRIM. as independent variables instead of CALL. These tests also confirmed the structural

break. The regression coefficients were significant at the 0.1% post-break, but not pre-break.

Covered parity was also examined using the six month rate (ER6MO) instead of the three month

rate (ER3MO) as the dependent variable. The results were similar.

Covered Arbitrage After September 1995

The above discussion indicates that covered interest arbitrage was practically non existent before

September 1995, but has become a significant factor since then. It is however necessary to

examine how effective this arbitrage has been even in this period in bringing the markets closer

to

covered interest parity.

One of the difficulties in studying covered interest parity in India is in identifying a domestic

instruments of similar maturity, risk and liquidity characteristics as LIBOR. As stated earlier,

there

is no simple solution to this because of the absence of an inter-bank term market in India. On

intuitive grounds, a strong case can be made for using the CD rate (CDPRIM) at which banks

borrow from large non-bank lenders. This comparison showed a large and highly volatile

differential between the implicit Euro rupee rate and the CD rate. The differential

(ER3MOCDPRIM) had a mean = 3.25% and a standard deviation of 4.57%; the mean is

significantly

different from zero (t = 5.96, P < 0.001). Similarly, (ER6MO-CDPRIM) had a mean of 3.15%

and a standard deviation of 3.35%; the mean is again significantly different from zero (t = 7.86, P

< 0.001). To put these magnitudes in proper perspective, it is worth noting that the mean absolute

deviations from covered interest parity of quarterly average domestic money market (three

month) interest rates in Canada, Germany, Japan, United Kingdom and the United States were

0.89% during 1974-79, 0.60% during 1980-82 and 0.26% during 1983-88 (Abaruchis, 1993).

The differential in India is therefore several times what prevailed in the developed economies

even


in the early days of floating exchange rates. In trying to understand this phenomenon, one can

identify several possible determinants of this differential:

• The slope of the term structure: It is possible that while forecasting the future average call rate,

banks may place too much reliance on the current call rate. This would be inappropriate

because it would ignore the high degree of mean reversion of the call rate (see Varma 1997).

Mean reversion implies that when the call rate is very high, it is likely to come down and vice

versa. In both cases, the call rate would revert to the mean or “normal” rate. As shown in

Varma (1997), the “normal” rate to which the call rate mean reverts is itself changing over

time. Assuming that the term rate is a proxy for the normal rate, the slope of the term structure

is a measure of the likely mean reversion in the call rate. A similar interpretation would follow

from the expectations hypothesis about interest rates also. The slope of the term structure was

defined as the difference between the T-Bills rate and the call rate (TBPRIM-CALL).

This independent variable has an alternative interpretation in terms of the difference between

sticky price customer markets and continuously clearing auction markets. As shown earlier in

this paper, the Euro rates and the call rate are market clearing rates, while the T-Bills and the

CD rate are sticky. Since the dependent variable includes a component representing the spread

between the two kinds of markets, we must have an independent variable which contains a

similar component.

• The credit spread: If the risks involved in the Euro rupee borrowing are different from that of

the CD borrowing, then the interest differential would reflect a risk premium. If this risk

premium were time varying, it is likely to be correlated with other credit spreads. Two

measures of the credit spread were tried: the difference between CDPRIM and TBPRIM (the

credit spread between the government and the banks), and the difference between ICDPRIM

and CDPRIM (the credit spread between banks and corporates).

• The Havala Premium: If the interest differential is driven by the restrictions on capital flows, it

would be strongly correlated with the havala premium (HAVALAPR) which is driven by the

same factors.

Regression analysis indicated that the credit spread was not a significant explanatory variable in

explaining the interest differential (ER3MO-CDPRIM). The regression equation was therefore

estimated using only the term structure slope and the havala premium as explanatory varaibles.

The result was as follows

ER3MO-CDPRIM = -2.018 -0.389(TBPRIM-CALL) +0.516 HAVALAPR

(-1.506) (-8.707) (3.374)

R-Square = 0.569, F(2,64) = 42.164 (P < 0.001)

It may be seen that the R-square is quite high (0.57) and both the term structure slope and the

havala premium are highly significant factors determining the covered interest differential. The

intercept term (representing that part of the mean interest differential which is not accounted for

by the independent variables) is not statistically significant at even the 5% level. These results


indicate that the covered interest differential is strongly influenced by the term structure slope

and

the havala premium, and that after these have been accounted for, the residual mean covered

interest differential is not significant. Of the two explanatory variables, the first captures the

distortions in the process of expectations formation and/ or the stickiness of prices in customer

markets, while the second represents the distortions in the foreign exchange market due to

exchange controls. These factors are therefore seen to be the principal impediments to the

process

of covered interest arbitrage in India.

The results for the six month differential were similar though the fit is not as good:

ER6MO-CDPRIM = -2.170 -0.193(TBPRIM-CALL) +0.574 HAVALAPR

(-1.836) (-4.882) (4.261)

R-Square = 0.384, F(2,64) = 19.953 (P < 0.001)

Term Structure: Expectations Hypothesis

The results earlier in this paper on stickiness of many of the interest rates raises the perturbing

possibility that much of what appears to be a term structure in interest rates only reflects the fact

that the sticky three/six month rates are adjusting slowly to changed market conditions while the

market clearing call rate has adjusted instantly. The expectations hypothesis of the term structure

provides the possibility of resolving this question. Under the expectations hypothesis, the three

month rate represents the market expectation of the average short term rate over the next three

months. In each week we can therefore compute the actual realized average of the call rate over

the three months; this is a thirteen week forward moving average (CALL13FA). Similarly, we

can

compute the six month (26 week) forward moving average (CALL26FA). We then regress these

realized averages on a three/six month rate. If the three/six month rate is excessively sticky then

1. This regression would have little explanatory power

2. The realized average would be more volatile than the three/six month rate

3. The regression coefficient would be well in excess of unity

The empirical results are mixed. In the case of CALL13FA, the best predictor turned out to be

TBPRIM with an R-square of about 0.34 which is not too low. But CALL13FA is much more

volatile than TBPRIM; the regression coefficient is close to 3, and the hypothesis that the

coefficient is unity is strongly rejected (t = 3.53, P < 0.001)

research on indian money market

Economy & Finance