Financial Integration and the Indian Swap Market Steven Buigut

Assistant Professor of Economics, American University in Dubai, UAE

Vadhindran K. Rao
Associate Professor of Finance, American University in Dubai. P.O Box 28282, Dubai, UAE. Email: Tel: 971-4-318-3114

Abstract: The primary objective of the study is to investigate whether the financial liberalization undertaken in India since the early nineties has resulted in financial integration of Indian markets with global (US) markets to a significant extent. To this end, we will use two approaches. First, we will investigate the relationship between the two main varieties of interest rate swaps in India, namely, the Overnight-Indexed-Swap (OIS) based on the overnight call money rate, and the MIFOR (Mumbai-Interbank-Offer Rate) swap based on the foreign exchange market. Given that the OIS rate can be interpreted as the funding cost for an Indian bank, testing for convergence between the OIS and MIFOR swap curves is a test of covered interest rate parity, and thus of financial integration of the Indian money market with the US money market. A second approach we propose to use is a Vector Error Correction Model (VECM) in order to study the dynamics of Indian swap rates, money market liquidity and US swap rates. The main question is regarding the extent of influence of US swap rates on Indian swap rates. The results have implications for monetary and exchange rate policy.
Keywords: Financial Integration, Covered Interest Parity, Swaps, India JEL Classification Codes: G15, F36, E43

the Corporate Deposit rate. and are based on testing for Covered Interest Parity (CIP). and it is generally acknowledged that Indian financial markets are now more open (refer to Patnaik and Vasudevan. although the various domestic markets (namely.e. reserve requirements for banks have been decreased. There are many studies that have investigated financial integration across borders (see Obstfeld and Taylor. foreign exchange intervention will be ineffective in integrated markets if the exchange rate targeted by authorities is inconsistent with market signals. 2005 for a good review). An assessment of the extent of financial integration is important as it has implications for monetary and exchange rate policy. Similar results were found by Takezawa (1995). The main objective of the current study is to investigate whether the financial liberalization undertaken thus far has resulted in financial integration of Indian markets with global markets to a significant extent. Varma (1997) found the CID to be several times larger than the numbers reported for OECD markets. the money market. and attributed this to market frictions. Frankel (1991) studied the CID (i. Thus. Popper (1993) based her test on no-arbitrage conditions relating long maturity currency swaps and bond yields and found support for CIP for longer maturities than a year in all the G-7 countries and the Euromarket. Similarly. the financial sector has been undergoing gradual liberalization. many of the studies set in advanced economies have found support for the CIP. For example. Thus. US and the German markets using a very long time series. Obstfeld and Taylor (2004) studied the UK. which is the rate at which banks borrow from large non-banking corporations) as the domestic borrowing rate and USD Libor as the foreign interest rate. which essentially states that under ideal conditions (such as financial integration and absence of market frictions). A few studies have also been carried out in the Indian context. 1999 and Jain and Bhanumurthy. This result was supported by Bhoi and Dhall (1998). the government bond market and the corporate bond market) appeared to 2 . suggesting that the countries were getting increasingly integrated over time.Introduction and Literature Review Indian financial markets have seen a lot of change since the nineties.e.. the lesser the scope for a country to follow an independent monetary policy. Administered rates have been abolished. Using the CD rate (i. who too concluded that Indian financial markets were far from being integrated with global markets. 2004 for a good review). foreign exchange regulations have been eased with the Rupee becoming fully convertible on the current account and partially convertible on the capital account. arbitrage activities will drive real interest rates into convergence. Batten and Szilagyi (2006) use daily time series data for the USD/JPY forward market and found that CIP deviations have been virtually eliminated since 2000. capital flows have been encouraged by removing restrictions and market-oriented reforms have been instituted including measures to protect investors. the more integrated markets are. which is the difference between the forward premium and the interest rate differential) for a group of developed economies and found that the CID showed a downward trend in about 40% of the cases. and reported that the CIDs became considerably smaller starting in the eighties. A high degree of integration means that regardless of intervention. the covered interest differential. Many of them relate to OECD countries.. the forward premium on a foreign currency would equal the interest rate differential between the two countries.

apart from testing for CIP.” However. A swap may be described as a contract between two parties to exchange cash flows based on a formula. Given that our methods of testing for financial integration are based on interest rate swaps. However. it is defined and calculated as the sum of the corresponding US dollar LIBOR (London Interbank Offer Rate) and the forward premium on the US dollar against the Indian rupee (INR). Mishra et al (2001) provide further confirmation of CIP failure. In contrast. Similarly. we take a fresh look at this question of financial integration of the Indian market with the US market.” Thus. which is a rate implied from the dollarrupee foreign exchange (FX) market. Unlike as suggested by its name. mainly because of the lack of a well-developed term interbank market in India. We believe that swap curve data are better measures of the true cost of funds for a bank in India. namely overnight MIBOR. to date. it is not directly a market-determined interbank term integrated amongst themselves. Secondly. Firstly. A plain vanilla interest rate swap (IRS) involves one party receiving a series of fixed cash flows and paying variable cash flows based on a floating interest rate applied to a notional amount. 3 . we start with a brief introduction to the Indian swap market. The concept of MIFOR rates overcomes the limitation of the lack of a developed term interbank market by exploiting the availability of currency forward premia from a highly active domestic foreign exchange market. and they cautiously conclude that Indian money markets “are getting integrated with global (US) money markets even though the integration is far from perfect. For maturities up to a year. we base our tests on the Indian swap market. In this study. using swap curves also allows us to conduct long maturity tests. and are largely based on one of two benchmarks – overnight MIBOR (Mumbai Interbank Offer Rate published by the National Stock Exchange or NSE). call money rate or T-bill rate. Swaps based on the overnight MIBOR are referred to as Overnight Indexed Swaps (OIS). As for MIFOR. the overnight call market is active and liquid and provides a credible benchmark. they do opine that the integration process is far from complete and recommend that the liberalization process should be accelerated. In this study. and those based on the six-month MIFOR are referred to as MIFOR swaps. and conclude that “the degree of integration seems to be growing. and the six-month MIFOR (Mumbai Interbank Forward Offer Rate). Interest rate swaps were first introduced in India in 1999. It is worth noting in this connection that the reason why the swap market is mostly based on one or the other of these two benchmark rates is primarily due to the lack of a well-developed term interbank market. we also propose to use a Vector Error Correction Model (VECM) to implement a direct test of the extent of the influence of US swap rates on Indian rates. US dollar LIBOR (London Interbank Offer Rate) and the dollar-rupee exchange rate. the Indian studies have found somewhat mixed results. Jain and Bhanumurthy (2005) find evidence of cointegration between the Indian call money rate. Further. this is an innovation that is perhaps unique to the Indian market. previous studies have been based either on the Indian corporate deposit rate. Bhatt and Virmani (2006) basing their regression of the US dollar forward premium on the T-bill interest rate differential between India and the US are unable to reject the CIP.

the short term MIFOR rates are artificial constructions.As stated earlier. primarily because there is no guarantee that the daily overnight MIBOR fixing on which the OIS cash flows are calculated will be the very rate at which the bank can borrow (lend) each day. It is a market-determined rate that contains the market’s expectations about the average overnight call money rate over the next two years. or more realistically (taking into account market frictions). especially given the averaging effect on the deviations over the entire life of the swap. if the Indian market is sufficiently integrated with the US market. namely the OIS curve and the MIFOR swap curve. it must be recognized that this arbitrage is not strictly riskless. the primary objective of the current study is to determine whether the financial liberalization instituted thus far has resulted in integration of the Indian financial markets with global markets. Firstly. there is an arbitrage relationship between them. But the risk is small in the sense that the uncertainty regarding cash flows as a result of this practical problem is small. Therefore. enter into a buy/sell (sell/buy) 6 month FX swap for placing (by borrowing) funds in the overseas LIBOR market. earning 6 month USD LIBOR plus the 6 month forward premium. Therefore. and enter into a 2 year pay (receive) fixed OIS thereby receiving (paying) the compounded daily overnight rate. then a bank can carry out the following transactions: enter into a receive (pay) fixed 2 year MIFOR swap. we will investigate the relationship between the two swap curves. Despite the fact that the two swap rates appear to be based on very different variables. which is of course the 6 month MIFOR. Consider for example the 2 year OIS rate. A bank in India that has access to dollar LIBOR funding can borrow dollars abroad at 6 month LIBOR and enter into a 6 month sell/buy FX swap to lock in a covered borrowing rate that is equal to the 6 month MIFOR. As may be inferred from the above. As mentioned above. arbitrage considerations should keep the two swap curves from drifting too far from each other. the same sort of transactions can also be carried out using swaps of longer maturity. The 2 year MIFOR swap rate on the other hand will reflect market expectations about future USD LIBOR rates and the forward premia on the US Dollar in the FX market. the 6 month MIFOR rate (on which MIFOR swaps are typically based) is calculated as the sum of 6 month USD LIBOR plus the 6 month dollar-rupee (USD:INR) forward premium. The net effect of these transactions is that at the end of the two years the bank will receive (pay) the 2 year MIFOR swap rate and pay (receive) the lower (higher) 2 year OIS rate. the 6 month MIFOR is essentially a covered interest rate. thereby paying (receiving) 6 month floating MIFOR. Alternatively. borrow (lend) daily on a rolling basis in the overnight call money market. We will use two approaches to answer this question. testing for stationarity/convergence of the spread between OIS and MIFOR rates of corresponding maturities is effectively a test of covered interest rate parity and financial integration. If the 2 year MIFOR swap rate is higher (lower) than the 2 year OIS rate. Of course. 4 . testing for equality between the OIS and the MIFOR swap curves. Of course. the bank can enter into a buy/sell FX swap and invest the dollar proceeds in the money market abroad thus effectively. For example.

In the presence of market frictions. 1. Following Huang and Neftci (2006). it would be of interest to test whether US swap rates have any influence on OIS rates over and above the influence they may exert through MIFOR swap rates. 5 . it can be used to confirm whether an easing of liquidity in the money market is associated with a narrowing of the swap spread. (1) ΔZ t = Γ0 + Γ1ΔZ t −1 + . Our second approach is to use a Vector Error Correction Model (VECM) to study the time series dynamics of the OIS rates. In particular. the results of this study have important implications for monetary and exchange rate policy. Impulse-response analysis will be used to determine the direction of impact of each of these variables on the others. Variance decomposition analysis can be used to determine the extent to which the forecast error variance of swap rates is explained by different factors over different horizons. the spread would be zero. the slope of the yield curve and the n year US swap rate. we would expect the spread to be contained within a band provided markets are integrated to a reasonable extent. It can thus be used (for example) to determine whether the impact of liquidity shocks is felt mostly in the near term while that of shocks from US rates is dominant over longer horizons. This is essentially a Vector Autoregression (VAR) model augmented with an error correction term in order to capture the extent of deviation of the variables from their long term equilibrium relationship. 2 and 5 (three swap maturities with ample liquidity).. MIFOR swap rates. The points of interest are a) the width of this band (or the mean and standard deviation of the spread) and b) whether the spread is either stationary or getting smaller over time. the overnight call money rate. Methodology Our first approach will be to run stationarity and regression-based tests on the spread between the OIS and the MIFOR swap curves. For example. Under ideal conditions. It would of course be necessary to confirm the appropriateness of this approach by running suitable stationarity and cointegration tests.. money market liquidity and US swap rates. the n year MIFOR rate. where n will be. overnight MIBOR (call money rates). Granger-causality tests can be used to determine whether movements in US swap rates have any impact on Indian swap rates after controlling for liquidity conditions. treasury yields of standard maturities. by turns. and US swap rates. The data will be sourced from the Reuters platform. the slope of the treasury yield curve (as measured by the difference between the 2 year yield and the 3 month rate) and the overnight call money rate are used as proxies for liquidity.Data The data to be used consist of the following time series: OIS and MIFOR swap rates. As stated previously. + Γp −1ΔZ t − p +1 + Π Z t −1 + ε t Above Z is a vector consisting of the following: the n year OIS rate.

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