The Hindu Business Line : A product to trade views on inflation

Opinion - Financial Markets
Money & Banking - Insight
Industry & Economy - Economy
Columns - Mark To Market

A product to trade views on inflation

B. Venkatesh

THE inflation data spooked the financial markets last Friday. The S&P CNX Nifty declined 1.3 per cent while bond yields increased at least 15 basis points (bps) across the yield curve. The market may not have reacted so sharply to inflation before 1999. The reason is that equity and bond prices were then ruling at levels that provided market players enough margin of safety to withstand higher-than-expected inflation. This is especially true of the bond market, which has seen a secular decline in bond yields since 1999.

The fact is that the market currently assigns great importance to inflation. It is only fitting that the market participants are offered a product to trade their views on inflation. Inflation forwards and inflation options can be structured to generate payoffs depending on the weekly numbers released by the government. Of course, such a product will be a successful only if inflation is volatile. Otherwise, the market will be unidirectional, which means there may not be counter parties to the contracts. The introduction of such a product rests on the government being more transparent in the construction of the inflation index.

Inflation risk: Fixed-income securities are worst affected by inflation. It erodes the purchasing power of these cash flows. This risk has become an important factor for bond investors because of the concave term structure, especially at the long end. The inflation risk is not so much of a concern in the equity market. The fact is weekly change in inflation is small compared to the premium that investors demand over the risk-free rate. Yet, even the stock market seemed bothered with the sharp increase in inflation levels last Friday. Market participants should, hence, be allowed to trade their views on inflation.

OTC products: . A bond investor may enter into a forward contract with a bank for a notional principal of, say, Rs 10 lakh. Suppose the benchmark inflation rate is 6.5 per cent and the actual inflation rate is 7 per cent, the bank will pay the bond investor 0.5 per cent times the notional principal divided by 52. If the actual is 6 per cent, the investor will pay the bank.

Note that such products will be successful only if the underlying is volatile. The aggressive banks may prefer to take a bet on inflation. Such players may build overnight positions depending on their Value-at-Risk models. The less aggressive ones may, perhaps, sell inflation forwards as an income-enhancing strategy against their fixed-rate deposits. Banks benefit from fixed-rate deposits when inflation levels increase because the purchasing power of such deposits will decline. Selling inflation forwards against such deposits could be compared to the covered call-write strategy in the equity options market.

Parimutuel system: Goldman Sachs and Deutsche Bank introduced options on economic derivatives in 2003. Their model is patented but a similar system can be stylised for inflation options. The IPO auction platform on the BSE and the NSE can be used for this purpose.

Suppose the auction provides an inflation range from, say, 6 per cent to 8 per cent in steps of 0.25 per cent. Those who bet on 8 per cent are essentially long on that option and short on options that range from 6 to 7.75 per cent. Assume that the total premium collected from this auction is Rs 100 crore. If actual inflation is 8 per cent and about 10 traders had bet on this number, these traders will get Rs 10 crore each. Those who bet on other numbers will concede the premium paid to the 10 traders who bet on the 8 per cent contract. This model saves the trouble of finding a counter party to each contract. If these short-term vanilla products take off, the market can consider introducing long-term contracts. Such options may be used anticipatory hedge by potential home-loan borrowers.

(Feedback can be sent to bvenky@thehindu.co.in)

More Stories on : Financial Markets | Insight | Economy | Mark To Market

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Inflation pressures

Prefer performance, not procedure

Tight world oil market ahead

Kelkar report on FRBM — Discussion at various levels a must

A product to trade views on inflation

`Engaged employees'

`On industrial front, the mood is quite positive' — Mr Sunil Kant Munjal, President, CII

After all, you get what you pay for

Independent directors