THE start of 2009 has brought in a significant development in interest rate trading.
A milestone has been achieved by the listing of Kibor Futures Contracts on National Commodity Exchange Limited (NCEL). The trading in Kibor Futures brings an innovation to the financial sector but it will take some time for key stakeholders to fully benefit from it.
The coming weeks and months will see the key market participants from financial sectors, corporates and the brokers catching up with the learning curve and actively begin to use Kibor Futures for their business planning and risk management.
Over the past two years numerous consultations were held by NCEL with SBP, SECP and FMAP for regulatory approval of Kibor Futures.
Risks: No one can escape from the interest rate risk, be it a company or an individual. A company may or may not be exposed to currency fluctuations, commodity price volatility or equity market risks but it will always be affected by interest rate movements. This is true not only for businesses that have borrowings but also for cash-rich, debt-free companies where invested funds are affected by changes in interest rates. Same goes for individuals as their savings, investments, borrowings and the value of future cash flows are impacted by variations in interest rates.
Similar to changes in prices of other assets, interest rate changes also create uncertainty for businesses. Like all other futures, interest rate futures can provide the essential service of reducing risk and uncertainty.
Benchmark: Karachi Inter-Bank Offer Rate (Kibor) represents the consensus rate at which banks are willing to lend funds to each other. It is a reference point as most lending transactions are linked to this rate. In addition to bank lending to customers, many debt instruments and commercial contracts also use Kibor as a benchmark rate. These transactions are exposed to changes in the Kibor rate. Even if someone is not directly exposed to Kibor, e.g. holder of a T-Bill is still exposed to changes in interest rates. Since Kibor rates have a correlation with other interest rate measures like yields on government T-Bills and PIBs, holders of government securities can also hedge themselves to a significant level using Kibor futures.
Benefits: Since the value of all future cash flows is affected by the changing levels of interest rates, every business either profits or loses from rising or falling interest rates, depending on whether it is receiving or paying cash in the future. Everyone needs to protect himself against adverse moves in rates and many entities, given the opportunity, may make use of available hedging instruments. Since banks are the primary participants in borrowing and lending, they are expected to be the leading providers of liquidity in the futures markets as well. However, as NCEL is a national exchange providing equal access to all, companies and individuals can go straight to the market to hedge their positions.
Interest rate spread: Numerous explanations and solutions have been put forward over the past few years regarding the huge spread between deposit and loan rates. The NCEL research shows that one of the main reasons for this huge spread is the need for banks to cushion themselves against adverse interest rate moves. In the absence of any hedging instruments, a bank will be inclined to pass on the risk of adverse movements in interest rates to its customers in the form of higher lending rates and lower deposit rates.
If a bank is able to better hedge its assets and liabilities by using the futures market, it will reduce the need to keep a huge spread without impacting the bank’s profitability.
Bank products: Interest rate futures benefit financial markets. The tradable yield curve provides information about the market’s consensus on the future path of interest rates. This information facilitates banks and other financial agencies to price, sell and hedge a variety of financing and saving products. Customers benefit from a range of better priced products suited to their needs and banks benefit by better managing their risks.
Kibor futures will enable banks to perform their lending function efficiently by taking the burden of interest rate risk away from the corporate and industrial sector. Banks are best capable of handling interest rate risk as opposed to their customers.
In the absence of good hedging instruments, borrowers are not able to fix their debt cost. This is because their banks themselves are not able to efficiently fix the price of debt for their customers.
Most debt remains floating and fully exposed to interest rate moves and the burden is borne by the end issuer. As an example, the textile sector over-invested during the low interest rate period and is now suffering due to higher rates. Ideally, banks should have structured the debt in a way which would have provided some protection to the sector. Having interest rate futures is one necessary tool for banks to be able to perform this essential risk-transfer function for the economy.
Writer is the chief operating officer of the National Commodity Exchange.