Research on indian money market.....

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Research on indian money market.....

  1. 1. Money market in IndiaScope 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 initiativein 1992. It has been observed that financial institutions do employ money market instruments forfinancing short-term monetary requirements of various sectors such as agriculture, finance andmanufacturing. The performance of the India money market has been outstanding in the past 20years.Central bank of the country - the Reserve Bank of India (RBI) has always been playing the majorrole 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 theeconomy.Types of Money Market instruments in India –Money market instruments take care of the borrowers short-term needs and render therequired liquidity to the lenders. The varied types of India money market instruments aretreasury bills, repurchase agreements, commercial papers, certificate of deposit, andbankers 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
  2. 2. Money market in India 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. Bankers Acceptance - A bankers 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 toease out the disparities in the market. Whenever there is a liquidity crunch, the RBI optseither to reduce the Cash Reserve Ratio (CRR) or infuse more money in the economicsystem. In a recent initiative, for overcoming the liquidity crunch in the Indian moneymarket, 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. Asmentioned above it is basically a market for short term monetary transactions. Thus it hasto provide facility for adjusting liquidity to the banks, business corporations, non-bankingfinancial 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.
  3. 3. Money market in India 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 andfinancial institutions dealing in short term monetary activities such as the demand for andsupply 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 andinstitutions that deal in the various grades of near money."According to the RBI, "The money market is the centre for dealing mainly of shortcharacter, in monetary assets; it meets the short term requirements of borrowers andprovides liquidity or cash to the lenders. It is a place where short term surplus investiblefunds at the disposal of financial and other institutions and individuals are bid byborrowers, again comprising institutions and individuals and also by the government."According to Nadler and Shipman, "A money market is a mechanical device throughwhich short term funds are loaned and borrowed through which a large part of thefinancial transactions of a particular country or world are degraded. A money market isdistinct from but supplementary to the commercial banking system."These definitions help us to identify the basic characteristics of a money market. A moneymarket comprises of a well organized banking system. Various financial instruments areused for transactions in a money market. There is perfect mobility of funds in a moneymarket. 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. Asmentioned above it is basically a market for short term monetary transactions. Thus it hasto provide facility for adjusting liquidity to the banks, business corporations, non-bankingfinancial institutions (NBFs) and other financial institutions along with investors.The major functions of money market are given below:-
  4. 4. Money market in India 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 andfinancial institutions dealing in short term monetary activities such as the demand for andsupply of money.Indian Money Market - FeaturesEvery money is unique in nature. The money market in developed and developingcountries differ markedly from each other in many senses. Indian money market is not anexception for this. Though it is not a developed money market, it is a leading money marketamong the developing countries.Indian Money Market has the following majorfeatures 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
  5. 5. Money market in India 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 ofindian 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.
  6. 6. Money market in India 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.
  7. 7. Money market in India 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 stampduty reforms, floating rate bonds, etc. are some other prominent reforms in the money market inIndia. Thus, at the end we can conclude that the Indian money market is developing at a goodspeed. Indian Money Market: Market Structure, Covered Parity and TermStructIn the context of the relatively recent deregulation of interest rates in India, thispaper analyses the structure and inter-relationships of money market interest ratesand studies the extent to which covered interest parity holds in India. The papershows that there was a major structural break in September 1995 when in thewake of turmoil in the foreign exchange markets, covered interest arbitrage cameinto play in a big way for the first time. Even after September 1995, the forwardpremia continue to violate covered parity in systematic ways. These violations areshown to be related partly to the distortions in the foreign exchange market asmeasured by the premium in the unofficial foreign exchange market. Partly,however, covered parity violations also reflect distortions in the money marketrates and in the formation of expectations. Though the money market is free frominterest rate ceilings, structural barriers and institutional factors continue to createdistortions 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 incustomer markets rather than auction markets. A well defined yield curve does nottherefore exist in the Indian money marketureIt is only in the early nineties that interest rates were progressively deregulated in India, andtherehave therefore been few studies about the behaviour of interest rates in the country. Even today,
  8. 8. Money market in Indiathe secondary market for long term debt is highly illiquid and underdeveloped. This makes itdifficult to carry out an empirical study about long term interest rates. By comparison, the moneymarket 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 moneymarket interest rates in India.The money market encompasses a wide range of instruments with maturities ranging from oneday to a year, issued by the government and by banks and corporates of varying credit rating, andtraded in markets of varying liquidity. The money market is also intimately linked with theforeignexchange market through the process of covered interest arbitrage in which the forward premiumacts as a bridge between domestic and foreign interest rates. Thus an analysis of money marketinterest rates covers four elements:1. The term structure of interest rates (the segment of the yield curve up to a maturity of oneyear).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 forwardpremium and domestic interest rates of comparable maturity and default risk.4. Market structure differences between continuously clearing auction markets and sticky pricecustomer markets.DataThe 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 dollarLIBOR and the forward premium of the dollar at three month and six month maturities. Since theforeign 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 theofficial rate.Official publications of the Reserve Bank of India (RBI) provide data on the call market and onprimary market auctions of T-Bills. The US Federal Reserve Board publishes data on the dollarLIBOR rates of interest. Data on most of the others are not available in official publications, butare often published in the business press on the basis of quotations provided by marketparticipants (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. Thisincludes weekly data on all the interest rates, forward premia and havala exchange rate (asquotedin Dubai) required for this study. Data for most of the variables were available from July 1994onwards, but some key interest rates were available only from October 1994. Most of the studyhowever uses data only from September 1995 because of a significant structural break that was
  9. 9. Money market in Indiadetected during the course of the study as explained later in this paper. The study includes dataupto the end of 1996.As pointed out earlier, the forward premium acts as a bridge between domestic and foreigninterest rates through the process of covered interest arbitrage. A bank operating in India whichhas access to borrowing abroad in dollars can convert this dollar borrowing into rupee borrowingby taking a forward cover in the foreign exchange markets. Its total borrowing cost measured inrupees has two components - the dollar interest rate which it pays and the forward premium thatitpays for covering the exchange risk. If this total cost (the covered interest rate) is less than thedomestic rate at which the bank can borrow, it would prefer to borrow abroad than in India. Ifenough banks make this shift, their action would push up the forward premia (as they all seekforward cover) and would also bring down the domestic interest rate by reducing the borrowingpressure in the domestic market. The reverse shift would take place if the covered interest ratewere higher than the domestic rate. The principle of covered interest parity says that the coveredinterest 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; forexample, forward premiums are virtually identical to interest differentials in the Euro-currencymarkets which are completely free. Traders are known to quote forward premia by looking atinterest differentials (Deardorff, 1979). For this reason, this paper refers to the covered dollarLIBOR as the implicit Euro-rupee rates; it is the rate that would prevail in the Euro-rupee marketif such a market existed. For example, the (implicit) three month Euro-rupee rate is defined to bethe three month dollar LIBOR plus the three month forward premium (annualized) of the dollaragainst 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 thecash/spotforward premium (annualized) of the dollar against the rupee.It is worth pointing out that since the LIBOR and federal funds rates have been quite stableduringthis period, while forward premia have been highly volatile, the Euro rupee rates behave verymuch like the forward premia with a constant added. This means that, except for the interceptterms, regression results using the implicit Euro rates are very similar to the results using theforward premia themselves. However, in an analysis of covered parities, the intercept term (orthe IJAF (The ICFAI Journal of Applied Finance) All rights reserved3mean of the interest differential) is quite important. Using the implicit Euro rates is thereforepreferable to working with the raw forward premia.The interest rates used in the study are the following:
  10. 10. Money market in IndiaCALL The weekly average (trade weighted) call market rate published by the RBITBPRIM The implicit cut-off yield in the weekly auctions of 91 day T-BillsTBSEC The yield quoted by the Discount and Finance House of India (DFHI) forsecondary market transactions in T-BillsCDPRIM The mid rate of yields on CDs in the primary market. CDs range inmaturity up to one year, but a significant number are for three and sixmonth maturities.CDSEC The yield quoted by the Discount and Finance House of India (DFHI) forsecondary market transactions in CDs.CPPRIM The mid rate of yields on CPs in the primary market. CPs are typically fora maturity of six monthsCPSEC The yield quoted by the Discount and Finance House of India (DFHI) forsecondary market transactions in CPs.ICDPRIM The mid rate of yields on ICDs in the primary market. ICDs are typicallyfor a maturity of three monthsER3MO The implicit Euro rupee rate for maturity of three monthsER6MO The implicit Euro rupee rate for maturity of six monthsERFUNDS The implicit Euro rupee rate for overnight maturityHAVALAPR The percentage premium of the havala exchange rate over the RBIreference rateMarket StructureTo gain an understanding of the overall structure of the money market, a factor analysis wascarried 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(representingthe 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 includeda wide range of risk classes, it was expected that factor analysis may partition the rates on theriskdimension in addition to the time dimension. It was therefore quite surprising to find that the twofactors 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 thecall rate and the (implicit) Euro rupee rates. The first factor spans the entire spectrum of the riskdimension from sovereign to corporate. The second factor spans the time dimension rangingfromovernight to six months.But these two seemingly inexplicable factors have a very simple and intuitive interpretation interms of market structure. The second factor includes rates drawn from the call market and the
  11. 11. Money market in Indiaforeign exchange markets which are readily classified as auction markets. The interest rates inthisfactor are therefore continuously market clearing rates. On the other hand, as argued below, thefirst 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 CPof a large and valued customer in order to maintain the relationship. The same is true when alarge customer wishes to place a CD with the bank. The secondary rates quoted by the DFHI areTable 1: Rotated Factor Loadings from Principal Component AnalysisFactor LoadingsVariables First Factor Second FactorCALL 0.294 0.836TBPRIM 0.879 0.318TBSEC 0.856 0.331CDPRIM 0.766 0.529CDSEC 0.959 0.185CPPRIM 0.766 0.458CPSEC 0.957 0.186ICDAVG 0.810 0.369ER3MO 0.418 0.868ER6MO 0.426 0.804ERFUNDS 0.118 0.913changed slowly and infrequently. The volume of trading done at these rates is often negligibleindicating that they are quite far from being market clearing rates. The primary T-Bills rate is setby auction and would at first sight appear to be a market clearing rate. However, the RBI hasoften let large amounts devolve upon it to prevent a rise in the cut-off yield. Moreover, duringperiods 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 customermarket. In fact, the description of the primary T-Bill market as a customer market is not totallyinappropriate if we regard the Government as a favoured customer of the RBI. Thus all the ratesincluded 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 differentrates (Table 2). All the rates in the second factor (auction markets) show much higher variabilitythan the rates in the first factor (customer markets). This is direct evidence on the stickiness ofthelatter. It is also possible that some of the auction market interest rates display the excessvolatilitythat has been detected in other financial markets in India and elsewhere (Barua and Varma, 1994,Shiller, 1990). This is a topic for future research.
  12. 12. Money market in IndiaCovered Interest Arbitrage: The Structural Break in September 1995As indicated at the outset, there was a major structural break in the money market in September1995 and, therefore, this paper uses data only from this point onward. The crux of this structuralbreak 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 MarketsFirst Factor (Customer Markets) Second Factor(Auction Markets)Variable StandardDeviationCoefficient ofVariationVariable StandardDeviationCoefficient ofVariation 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 0.21This section studies the change that took place in September 1995 in the process of coveredinterest arbitrage.The Indian foreign exchange and money markets went through a period of turmoil in the lastquarter of 1995. After holding steady for nearly three years, the rupee started depreciatingrapidlyagainst the dollar. Simultaneously, the forward premia shot up to unprecedented levels. Thesedevelopments had a immediate impact on the money markets too and the call market interest ratetoo rose sharply. The well known theoretical linkage between the money market and the foreignexchange markets was witnessed in practice for the first time. The interesting fact was that evenafter calm was restored in the markets, the new-found linkage persisted. This was thus a classiccase of hysterisis in financial markets: markets and arbitrage mechanisms come into being inresponse to abnormally high profit opportunities; but once they have come into existence, theydonot disappear when the profit opportunity returns to normal levels. The learning process thatmarkets 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,
  13. 13. Money market in Indiacovered 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 sixmonth inter-bank market in India. Unfortunately, an inter bank term lending market did not existin 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 shortterm funds (overnight to a fortnight). Anecdotal evidence suggests however that in decidingwhether to carry out the arbitrage, banks try to forecast the likely average of the call rate over thenext three/six months and compare that forecasted average with the implicit Euro rupee rate. Astrong 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 andCPPRIM. as independent variables instead of CALL. These tests also confirmed the structuralbreak. 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 monthrate (ER3MO) as the dependent variable. The results were similar.Covered Arbitrage After September 1995The above discussion indicates that covered interest arbitrage was practically non existent beforeSeptember 1995, but has become a significant factor since then. It is however necessary toexamine how effective this arbitrage has been even in this period in bringing the markets closertocovered interest parity.One of the difficulties in studying covered interest parity in India is in identifying a domesticinstruments of similar maturity, risk and liquidity characteristics as LIBOR. As stated earlier,thereis no simple solution to this because of the absence of an inter-bank term market in India. Onintuitive grounds, a strong case can be made for using the CD rate (CDPRIM) at which banksborrow from large non-bank lenders. This comparison showed a large and highly volatiledifferential 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 issignificantlydifferent 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 absolutedeviations from covered interest parity of quarterly average domestic money market (threemonth) interest rates in Canada, Germany, Japan, United Kingdom and the United States were0.89% 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 economieseven
  14. 14. Money market in Indiain the early days of floating exchange rates. In trying to understand this phenomenon, one canidentify 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 inappropriatebecause 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 viceversa. In both cases, the call rate would revert to the mean or “normal” rate. As shown inVarma (1997), the “normal” rate to which the call rate mean reverts is itself changing overtime. Assuming that the term rate is a proxy for the normal rate, the slope of the term structureis a measure of the likely mean reversion in the call rate. A similar interpretation would followfrom the expectations hypothesis about interest rates also. The slope of the term structure wasdefined 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 betweensticky price customer markets and continuously clearing auction markets. As shown earlier inthis paper, the Euro rates and the call rate are market clearing rates, while the T-Bills and theCD rate are sticky. Since the dependent variable includes a component representing the spreadbetween the two kinds of markets, we must have an independent variable which contains asimilar component.• The credit spread: If the risks involved in the Euro rupee borrowing are different from that ofthe CD borrowing, then the interest differential would reflect a risk premium. If this riskpremium were time varying, it is likely to be correlated with other credit spreads. Twomeasures of the credit spread were tried: the difference between CDPRIM and TBPRIM (thecredit spread between the government and the banks), and the difference between ICDPRIMand CDPRIM (the credit spread between banks and corporates).• The Havala Premium: If the interest differential is driven by the restrictions on capital flows, itwould be strongly correlated with the havala premium (HAVALAPR) which is driven by thesame factors.Regression analysis indicated that the credit spread was not a significant explanatory variable inexplaining the interest differential (ER3MO-CDPRIM). The regression equation was thereforeestimated using only the term structure slope and the havala premium as explanatory varaibles.The result was as followsER3MO-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 thehavala premium are highly significant factors determining the covered interest differential. Theintercept term (representing that part of the mean interest differential which is not accounted forby the independent variables) is not statistically significant at even the 5% level. These results
  15. 15. Money market in Indiaindicate that the covered interest differential is strongly influenced by the term structure slopeandthe havala premium, and that after these have been accounted for, the residual mean coveredinterest differential is not significant. Of the two explanatory variables, the first captures thedistortions in the process of expectations formation and/ or the stickiness of prices in customermarkets, while the second represents the distortions in the foreign exchange market due toexchange controls. These factors are therefore seen to be the principal impediments to theprocessof 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 HypothesisThe results earlier in this paper on stickiness of many of the interest rates raises the perturbingpossibility that much of what appears to be a term structure in interest rates only reflects the factthat the sticky three/six month rates are adjusting slowly to changed market conditions while themarket clearing call rate has adjusted instantly. The expectations hypothesis of the term structureprovides the possibility of resolving this question. Under the expectations hypothesis, the threemonth rate represents the market expectation of the average short term rate over the next threemonths. In each week we can therefore compute the actual realized average of the call rate overthe three months; this is a thirteen week forward moving average (CALL13FA). Similarly, wecancompute the six month (26 week) forward moving average (CALL26FA). We then regress theserealized averages on a three/six month rate. If the three/six month rate is excessively sticky then1. This regression would have little explanatory power2. The realized average would be more volatile than the three/six month rate3. The regression coefficient would be well in excess of unityThe empirical results are mixed. In the case of CALL13FA, the best predictor turned out to beTBPRIM with an R-square of about 0.34 which is not too low. But CALL13FA is much morevolatile than TBPRIM; the regression coefficient is close to 3, and the hypothesis that thecoefficient is unity is strongly rejected (t = 3.53, P < 0.001)

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