WEATHER DERIVATIVES – CONCEPT, CHALLENGES, AND FEASIBILITY

By  Ishan Kekre & Girish C

Introduction

A weather derivative is a tool for managing weather risk. It is a financial contract that allows a firm to hedge itself against unexpected and adverse weather. A weather derivative contract or WD derives its value from future weather conditions. Contrary to stereotypical weather insurance, the payout of this kind of derivative is based on a parametric weather index. For instance, the index could be centimeters or millimeters of rainfall. The index could also be a cumulative frequency distribution of temperatures across many locations. The underlying of WD could also be related to snowfall or hurricanes.

Origin of Weather Derivatives

The weather derivative market as compared to other financial instruments is relatively young. The first transaction in the WD market dates back to 1997. The sector developed due to the severe repercussions of El Niño. These events were forecasted correctly by the meteorological community. Firms that had their revenues linked to weather realized the importance of protecting themselves against seasonal weather risks. Many companies who were in the business of dealing with financial futures and options saw WDs as attractive tools to hedge weather risks.

The insurance sector achieved substantial financial consolidation. As a result, there was significant capital to hedge weather risks. Insurance firms started writing options with payoffs linked to weather events. This, in turn, elevated the liquidity for the development of a WD market. Thus, the WD market evolved over the years into a strong over-the-counter market.

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Development of the Indian Corporate Bond Market

By Abraham Mathew Valliyakalayil

The world GDP stood at nearly 74 trillion in 2015. The worth of the world bond markets was 100 trillion. Where was India at that time? This article attempts to juxtapose the Indian bond market with that of the world. Indian debt market is just 17% of its GDP as compared to the US which is worth 123%. We also lag behind with respect to other emerging markets such as Malaysia, Thailand, and China.

There can be a plethora of reasons for this trend. Firstly, India in contrast to these countries offers much higher interest on fixed deposits. These attractive interest rates discourage retail investment in corporate bonds as term deposits carry lesser risk. Thus, risk-averse retail investors prefer fixed deposits over debt and risk-seeking investors opt for equity. 

  Break-up of Term-Deposit & Inflation Rates of Asian Countries

Country Fixed deposit rate Headline Inflation
India 7.95 % 3.4 %
Malaysia 4.33 % 1.8 %
China 3.75 % 2.1 %
Thailand 2.8 % 1.1 %

Secondly, institutions which are the major players in the bond market shy away from investing in corporate bonds. The reason being that the secondary market is still underdeveloped, owing to the lack of demand and supply (causing market illiquidity).

Issues on the demand side:

  • The first barrier is a high SLR of 21.5% that, places restrictions on various players including banks, insurers, FPI and Provident funds. Also, only 15% of the funds is allowed to be invested in corporate bonds below AA rating. However, for mutual funds, there are no such restrictions.
  • Secondly, India lacks a well-functioning derivatives market. This hampers the ability of players to hedge credit and currency risks.
  • Lastly, a factor that banks will have to deal with is the ‘mark to market’ aspect. On the balance sheet, corporate bonds will be valued according to the market in contrast to the loans which won’t be valued similarly.

Issues on the supply side:

The institutional restrictions, preference for higher ratings (reason for higher interest rates) and the high cost of issuing (resulting in a high cost of capital, KD) has an adverse impact on number primary issues.

Conclusion: 

Analyzing the supply and demand aspects, we can say it is analogous to the chicken and egg situation. The above problems can be tackled by an effective implementation of the Insolvency and Bankruptcy Act which was passed on 5th May 2015. This can hasten the liquidation of distressed companies, thereby protecting the value of companies’ assets. It will also aid the asset reconstruction companies by attracting more participation into the NPA market. Furthermore, improved banking governance and adoption of Basel III norms mandating holding of high-quality liquid assets can also act as an elixir. Overall, these measures can improve the investors’ confidence in the corporate bond market.

Impact of The Insolvency and Bankruptcy Code,2016

By Aditya Alamuri

With the Insolvency and Bankruptcy Code 2016, Indians can finally go legally broke. The new code will step into the shoes of existing bankruptcy laws and cover individuals, companies, LLP’s, and partnership firms. The code will repair laws including those mentioned in the Companies Act, to become an overall legislation to deal with corporate insolvency. The bill now has renewed teeth to recover loans at a quicker rate.

The Bankruptcy bill has come in at a time when banks are crippled with rising NPA’s. The new code will ensure the creation of a repository of unfaltering defaulters and will result in time bound settlement of solvency.

The bill proposes the following activities to improve the banking sector:

• Creation of a database of debtors to track serial defaulters

• Usage of existing infrastructure of debt recovery and NCL tribunals, to settle individual and corporate insolvency

• Create & train a new class of insolvency professionals who will specialize in assisting sick companies

• Setting up an Insolvency and Bankruptcy Board of India, to step in as a regulator of these information utilities and professionals.

Bankruptcy code also contains provisions to deal with cross-border bungles by way of bilateral agreements with other countries. It urges shorter & aggressive intervals for every step during insolvency process.

The code also ensures that the money due to employees and workers from the 3 funds i.e. (Pension, Gratuity & Provident) is not included in the domain of either the individual or the company. Furthermore, the salaries of employees will get 1st priority up to 24 months in case of liquidation of assets of company – earlier than secured creditors.

The Bill will lead to key transformations which will ensure ease of doing business in India. Currently, as per the World Bank records, it takes more than 4 years to solve a bankruptcy case. The new code seeks to cut it down to less than a year.

The Insolvency and Bankruptcy Code 2016, on the whole, proposes a comprehensive changeover in the current Indian banking system & the way corporates function today. However, it is easier said than done. The implementation of such a vast plan will take time and we will have to wait in order to see the upshot of the same.

MASALA BONDS: Elixir to the ailing PSB’s?

By GANDHALI INAMDAR

After playing host to Yankee, Bulldog, Samurai & Dim sum, foreign bonds market witnessed the entry of a new member, “Masala Bonds”. The first Masala bond (Rs.1000 Cr.) was issued by the World Bank backed International Finance Corporation (IFC) in November 2014. In July 2016, HDFC raised Rs.3000 Cr. from Masala bonds becoming the first Indian company to issue masala bonds. NTPC, Adani Transmission, Axis Bank and Indiabulls followed suit.

Masala bond is a term used to refer to a financial instrument through which Indian entities can raise money from overseas markets through bonds issued in Indian Rupee for a minimum period of 3 years. If the dollar value appreciates, investor gets lesser amount in hand at maturity. Thus, currency risk lies with the investor.

Furthermore, the limited offshore liquidity in Rupee, the cost and availability of hedging for investor, and investors’ view of exchange rate fluctuations will affect the pricing of these bonds.

In the Indian context, there is merit in the masala bond move, since India Inc. can do good with some foreign investment minus the currency risk for their capital requirements, infrastructure financing and affordable housing projects. Masala bonds can also be considered as a step towards internationalization of the Indian rupee and can also help strengthen the Indian Financial System.

As a initiative to support Masala Bonds, the Finance minister has cut the withholding tax on interest income from 20% to 5%, making it more attractive for investors. Also, the tax from capital gain due to Rupee appreciation will also be exempted.

For foreign investment bankers, the interest rates on Masala bonds (approx. 7%) are much more attractive than their domestic bond counterparts. Furthermore, the Ratings agency S&P has predicted that Masala bonds will reach $5 billion in next two-three years.

Masala bonds are expected to bring to the Indian economy the required energy to recover from its investment slumber and the malaise of NPAs. Indian banks, especially Public Sector Banks (PSBs), need rather a lot of capital going forward. There are three reasons for this. First, banks are looking towards positive cash inflow opportunities to tackle NPAs. Second, the Indian economy is growing and this requires an increase in credit in the future. Third, there’s a general tightening up of bank capital standards under Basel III norms and this means that all banks would need more capital.

PSBs international Credit Rating (CR) derives its strength from India’s sovereign rating. Private Bank’s CR dependence on India’s sovereign rating is primarily indirect. Thus, a masala bond issued by a PSB could be considered as a proxy to India’s sovereign credit rating. This aspect can have interesting after effects on economy.

Investors would need to keenly watch the credibility of the issuer. Higher the CR of a firm, the better would be the appetite for their bonds. Since the currency risk is on the investors, they will prefer Rupee to be stable.

Having a huge growth potential, only time will tell if Masala bonds can become the penicillin to India’s current cold.

Shadow Banking

By Monica V

What is Shadow Banking? 

Paul McCulley of PIMCO coined the term “shadow bank” in 2007. The Financial Stability Board defines the shadow banking system as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”, servicing assets worth $80 trillion globally.

Components of the shadow banking system broadly include mobile payment systems, pawnshops, securitization vehicles, asset-backed commercial paper [ABCP] conduits, private equity funds, hedge funds, money market funds, markets for repurchase agreements, investment banks, and mortgage companies.

How they work? 

Shadow banks issue short-term securities and use the proceeds to buy longer-term assets. For instance, an ABCP conduit would issue commercial papers, which is bought by a money market fund, to raise funds, to purchase securitized products created by an investment bank.

What are their merits? 

* Ability to provide credit more cost-efficiently than traditional banks

* Provide funding to traditional banks

* Ensure credit growth and liquidity in the economy

* Alternative source of funding for risky borrowers

* Alternative to bank deposits for large investors

* Risk diversification

What is the risk? 

* Liabilities are liquid and assets are relatively illiquid

* Highly leveraged as their source of funding is not deposits but collateralized borrowing

* Involved in “chain of transactions”, which could lead to spillover of risk to the regulated banking sector, thus, leading to systemic risk

* Do not have safety nets, such as, Central Bank borrowing and Deposit Insurance, and no capital cushion, thus, raising concerns of run on the banks.

Conclusion: 

Shadow banks have been held responsible for the global financial crisis and the Chinese Slowdown. The Dodd Frank Act, passed by the U.S. Congress, has introduced many regulations such as moving OTC derivatives to exchanges, and registration requirements for some hedge funds. There is a need to propose regulations such that spillover effect between the banking sectors is mitigated, susceptibility of money market funds to runs is reduced, incentives associated with securitization are aligned, pro-cyclicality associated with securities financing transactions is dampened.

Argentina’s Return to International Credit Markets

By- Monica V

After 15 years of exile from the international credit markets, on 19th April, Argentina made a bond issue of $16.5bn, the largest ever for an emerging-market nation. Out of $16.5bn, $9.4 billion of the proceeds were used to pay off the holdout bondholders on 22nd April, and the remaining $7.1 billion has been earmarked for infrastructure development.

Moody’s Investors Service (“Moody’s”) has upgraded the rating of the sovereign bond issue to B3. The bonds were issued with maturities of 3 to 30 years, at yields ranging from 6.25 percent to 8 percent, much below average for similarly rated countries. This could be attributed to the positive outlook for Argentina, as a result of President Macri’s business friendly administration, which has pushed through several economic reforms, such as floating the peso to make exports more competitive, and cutting back subsidies of electricity, water, gas and transport.

Hence, there has been a robust demand for Argentina’s bonds, despite its economic woes, with inflation at 35%, unemployment at 12%, its largest trading partner, Brazil, being in deep recession, and its troubled history as a borrower, having defaulted 8 times since independence. The issue had a blockbuster reception, attracting orders of $69bn for its $16.5bn bond sale. Furthermore, the robust demand pushed down the yield allowing investors to make $597 million in profit in just two days. US investors took 66% of the sale, Europeans 25%, the Middle Easterners 5%, and Latin Americans 4%.

Argentina’s return to international credit markets will curtail reliance on central bank finances, thus, helping to reduce inflation and boost growth. Furthermore, the bonds may be included in the influential JPMorgan index of emerging market bonds. While, Macri has said that it could take time to reap the benefits, the Minister of the Economy, Alfonso, explains that this step will establish the base for more jobs, and the road to zero poverty in Argentina.