Central bank panel for interest rate options

A Reserve Bank of India (RBI)-appointed working group on Monday proposed to introduce plain-vanilla interest rate options in the market, which would help lenders manage their asset-liability mismatches better.

For example, if a bank's floating rate housing loans are prepaid and fixed deposits are withdrawn suddenly, the lender could face a grave mismatch. Derivatives instruments such as interest rate options (IROs) take care of these problems.

RBI had introduced interest rate swaps in the market, allowing an investor with fixed loan liability to swap exposure with a floating rate-exposed entity. However, to square it off, the parties have to enter into opposite transactions. Swaps entitle a series of payments over the contract period.

In case of options, the contract is though one-time payment at the start of the contract and can be cancelled easily.

SUGGESTIONS

• An RBI working group on Monday proposed to introduce plain interest rate options in the market
• This would help lenders manage their asset-liability mismatches better

The working group recommended that initially, the options should be kept simple and should include simple call and put options, caps, floors, collars (that protects both from a fall and rise in bond yields) and swaptions (options for a swap).

The options can be traded on an exchange or in an over-the-counter (OTC) market, as the latter has the advantage of being customised according to the user's requirements.

To start with, only European options should be allowed in the OTC segment, where the option can be exercised only on the date of the expiry of the contract. However, American structures, in which options can be exercised any time, can be introduced in the exchanges along with the European options, the group recommended.

The Fixed Income Money Markets and Derivatives Association (FIMMDA), will come out with the list of eligible domestic money or debt market rates as benchmarks, for which banks and primary dealers should be the market makers.

"Funds, insurance companies and other regulated entities having sound financials and prudent risk management may be allowed subject to the approval of concerned regulator," the working paper recommended, adding all domestic entities having underlying interest rate risks should be allowed as users.

While there would be no documentation required for exposure up to Rs 5 crore, large corporate firms should also be included, with due documentation process, to take hedging positions for their anticipated interest rate exposures, the working group said. The minimum lot size would be Rs 2 lakh, and all deals should be reported.