OIS climb hints at rate hike now, crushes hopes of a cut

One basis point is a hundredth of a percentage point.

The OIS, which is a derivative instrument using government bonds as underlying, is the main tool for hedging in India.

The levels that prevailed in early February reflected a rate cut cycle by the Reserve Bank of India (RBI) commencing from August while the current levels reflect expectations of rate hikes - of around 10-15 basis points instead.

Given the declining trajectory of local inflation - particularly core inflation - it is unlikely that the Reserve Bank of India would turn to rate hikes after maintaining a status quo on rates for more than a year. What the rise in swap rates show more than anything else is heightened risk aversion and the damage done to rate cut expectations by the abrupt ratcheting up of tensions in the Middle East.

"One-year OIS today made a high of 6.93%. Theoretically it signifies that there are chances of a rate hike, but I think it is slightly overdone. My sense is that if things cool down in the next few days, the one-year OIS should settle near 6.85%. Chances of a rate cut in this kind of a look difficult to foresee," said Abhay Garg, executive vice-president, .

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The OIS market typically prices in a spread of around 20-25 bps over where traders expect the RBI's repo rate to be at different time periods. The repo rate is currently at 6.50%

Borrowers' Woes

Apart from its predictions on interest rates, the recent hardening of OIS rates makes it costlier for financial institutions to hedge exposure to interest rate risk.

In a typical swap contract, one entity - such as a bank - agrees to pay another entity a fixed rate of interest in exchange for a floating rate of interest on a mutually agreed notional sum. The floating rate used is mostly the Mumbai Interbank Outright Rate (MIBOR).

While OIS is used by entities to hedge exposure to government bonds, by taking a counter position through swaps, it has grown to become a financial tool for institutions to punt on where interest rates are headed. OIS also provides flexibility for corporates and banks to more effectively manage their loan obligations, keeping in mind expected changes in interest rates over the medium-term horizon.

"This instrument allows financial institutions to swap the interest rates they are paying without going for a refinance or change the terms of the loans they have taken," Dipanwita Dutta, economist at , had written in a study on the Indian OIS market.