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Authored by : M. Sathya Kumar Date: 14 Feb 2008

The Indian Money Market


The money market is a mechanism that deals with the lending and borrowing of short term funds. The India Money Market has come of age in the past two decades.In order to study the money market of India in detail, we at first need to understand the parameters around which the money market in India revolves. The performance of the Indian Money Market is heavily dependent on rea interest rate that is the interest rate that is inflation adjusted. Though the money market is free from interest rate ceilings, structura barriers and other institutional factors can be held responsible for creating distortions in India Money Market. Apart from the call market rates, the other interest rates in the Indian Money Market usually do not change in the short run. It is due to this disparity between the opposite forces that is prevalent in the money market in India that a well defined income path cannot be traced.

Owing to the deregulation of the interest rate in the early nineties following the economic reforms laid down by the then finance minister Dr. Manmohan Singh, studies concerning the behavior of interest rate was restricted. However the liquidity of the market makes its a good subject for empirica research. The Indian Money Market involves a wide range of instruments. Here, maturities range from one day to a year, issued by banks and corporates of various sizes. The money market is also closely 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. To analyze the interest rates that characterize the Indian Money Market, the following elements need to be covered: The term structure of interest rate. The difference between domestic and international interest rates The market structure differences between the auction markets that clear

continuously and the. customer markets. The credit speed between instruments involving similar maturity but diverse risk factor. Such is the distortion in the Indian Money Market. The Instruments traded in the money-market are broadly classsified under Treasury Bills, Certificates of Deposits (CDs), Commercial Paper (CPs), Bills Rediscounting and other such instruments with short-term maturities (i.e. not exceeding 1 year with regard to the original maturity) 1.Treasury Bills Treasury Bills are money market instruments to finance the short term requirements of the Government of India. These are discounted securities and thus are issued at a discount to face value. The return to the investor is the difference between the maturity value and issue price. Types Of Treasury Bills : There are different types of Treasury bills based on the maturity period and utility of the issuance like, ad-hoc Treasury bills, 3 months, 12months Treasury bills etc. In India, at present, the Treasury Bills are the 91-days and 364-days Treasury bills. Benefits Of Investment In Treasury Bills No tax deducted at source Zero default risk being sovereign paper Highly liquid money market instrument Better returns especially in the short term Transparency Simplified settlement High degree of tradeability and active secondary market facilitates meeting unplanned fund requirements.

Treasury Bills - An Effective Cash Management Product Treasury Bills are very useful instruments to deploy short term surpluses depending upon the availability and requirement. Even funds which are kept in current accounts can be deployed in treasury bills to maximise returns Banks do not pay any interest on fixed deposits of less than 15 days,or balances maintained in current accounts, whereas treasury bills can be purchased for any number of days depending on the requirements. This helps in deployment of idle funds for very short periods as well. Further, since every week there is a 91 days treasury bills maturing and every fortnight a 364 days treasury bills maturing, one can purchase treasury bills of different maturities as per requirements so as to match with the respective outflow of funds. At times when the liquidity in the economy is tight, the returns on treasury bills are much higher as compared to bank deposits even for longer term. Besides, better yields and availability for very short tenors, another important advantage of treasury bills over bank deposits is that the surplus cash can be invested depending upon the staggered requirements.

2. Certificate of Deposit Certificates of Deposit ("CD") were introduced in 1989 following the acceptance of the Vaghul Working Group of Money Market. These are also usance promissory notes issued at a discount to the face value and transferable in demat form. They attract stamp duty. CDs are issued by scheduled commercial banks and it offers them an opportunity to mobilise bulk resources for better fund management. To the investors they offer better cash management opportunity with market related yield and high safety. 3. Commercial Paper It is a short term money market instrument comprising of unsecured, negotiable, short term usance promissory note with fixed maturity, issued at a discount to face value. CPs are issued by corporates to impart flexibility in raising working capital resources at market determined rates. CPs are actively traded in the secondary market since they are issued in the form of Promissory Notes and are freely transferable in demat form. 4.Bills Rediscounting The bills rediscounting scheme was introduced by RBI in November 1970 under which all licensed scheduled commercial banks were eligible to rediscount with RBI genuine trade bills arising out of sale/ purchase of goods. In November 1981 RBI stopped rediscounting bills but permitted banks to rediscount the bills with one another as well as with approved Financial institutions. To augment facilities for this activity and also make a larger pool of resources available, RBI has been progressively enlarging the number of institutions eligible for bills rediscounting including primary dealers. 5.Other instruments with short-term maturities (A) Call/ Notice/ Term Money Call money market is that part of the national money market where the day to day surplus of funds, of banks and primary dealers, are traded in. Call/ Notice/ term money market ranges between one day to 15 days borrowing and considered as highly liquid. Other key feature is that the borrowings are unsecured and the interest rates are very volatile depending on the demand and supply of the short term surplus / defeciency amongst the interbank players. The average daily turnover in the call money market is around Rs. 1200013000 cr every day and the market is active between 9.30 to 2.30 every working day and 9.30to 12.30 every Saturday (B)Repo/ Reverse Repo It is a transaction in which two parties agree to sell and repurchase the same security.

Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on which party initiated the transaction. The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions. The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills, Central/State Govt securities). Uses of Repo It helps banks to invest surplus cash It helps investor achieve money market returns with sovereign risk. It helps borrower to raise funds at better rates An SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously. RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system. (C)Inter Corporate Deposits For short term cash management of the rich corporates, the company offers to borrow through Inter corporate deposits. The company has P1+ credit rating (Highest Rating in its category) for an amount of Rs. 250 crores. The company offers two variables of the Inter Corporate Deposits: Fixed Rate ICD : the quantum/ rates/ term to maturity of the ICD are negotitaed by the two parties at the beginning of the contract and remains same for the entire term of the ICD. As per the RBI guidelines the minimum period of the ICD is 7 days and can be extended to peiod of 1 year. The rates are generally linked to Interbank Call Money Market Rates. Floating Rate ICD : Corporates interested in using the daily volatility of the call money market are offered Floating Rate ICD which may be benchmarked/ linked to either NSE Overnight Call/ Reuters Overnight Call rates. The corporates are also given Put/ Call option after 7 days for managing their funds in the event of uncertainity of availability of idle funds.

AUTHORED BY M. SATHYA KUMAR Rewards waiting for feedback at E-mail : Smarttrainee@gmail.com

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