The introduction of options and futures to replace the time-tested badla system effective July 2, 2001 will align interest rates in the money and equity markets, leading to a more effective monetary transmission mechanism.
At a macro level, the significance of the Securities and Exchange Board of India (Sebi) decision to ban badla and all deferral products and have only a cash and a derivatives market marks the integration of the equity and money markets.
This means the RBI's interest rate signals will be absorbed faster in the wider financial system. Currently, as Shekhar Sathe, CEO of Kotak Mahindra Mutual Fund, says, there are varying badla rates on each of the scrips eligible for carry forward. "It is like having 200 interest rates in the system," he says.
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Badla rates are derived as the sum of an equity risk premium on that particular scrip over and above the interest rate component. In effect, since the equity risk component varies from week to week and differently in different scrips, it masks the cost of money.
Thus, badla for scrip X may be 30 per cent but for scrip Y it may be only 12 per cent. The financial sector is sharply divided between the banking and the equities sector.
All this is set to change with the introduction of derivatives. At a simplified level, since operators can take a position on the spot and futures markets at the same time, the cost of money is already factored into the derivative prices. This reflects the opportunity cost of taking a forward position.
Thus, an operator who buys in spot and short sells in the futures market is actually putting up cash now in return for future gains. Since this involves a cash outlay, the operator will at least expect his returns to cover the interest costs for the period of the contract. Derivatives pricing, thus, incorporates the cost of money. Says Sebi board member J R Varma, "The system will eventually lead to a convergence of interest rates throughout the system."
Market sources said though the extent of banks' involvement in the revised trading systems will only be clarified later, there were tremendous opportunities for banks to take proprietary positions in the derivative markets. For instance, banks could play a leading role in the development of "calendar spreads" which are basically forward-to-forward contracts in the foreign exchange markets.
Thus, a bank may buy a one-month contract and sell a six-month contract. Since the price of the latter will be more than that of the one-month contract, the bank will make a net spread. But since the market rates of interest will smoothen out over all markets, this spread will typically reflect the difference between one-month and six-month money.
"Arbitrage opportunities like this will lead to a uniformity of interest rates," Varma said. Money market dealers welcomed the move saying that "equities as an asset class are a welcome addition to the limited deployment options before banks".
Acknowledging that not all banks will be comfortable with dealing in the equity derivatives markets, one dealer says, "As long as one bank is comfortable arbitraging between the money and equity markets, the rates will align as this bank can borrow in call and deploy the funds in derivative spreads. If the call money rates are higher, this bank can do a reverse arbitrage."
The second implication is that equity prices in the spot markets will respond quicker to interest rate changes. Currently, lower interest rates will to lower interest costs for companies in the coming years, thereby boosting its net profits.
This reflects in optimism on the equity price front after interest rates are cut. But with a derivatives market, a rate cut will immediately impact derivative prices and arbitrageurs will ensure that this is immediately transmitted to spot equity prices too.
"Much like in the US, we are looking at a situation where money market rates will determine the valuations of a wide spectrum of asset classes, and not just gilts," the chief dealer, of a private bank says. "This will lead to a much more responsive financial system," he adds.