Interest Rate Differentials

The universal practice appears to be to express interest rate spreads in absolute terms. Now why should that be?

Is it because interest rates are expected (guaranteed?) to lie within a narrow enough bound that the base does not make much difference? Unlikely. Both inflation and real rates are volatile enough, even over shorter periods of time, to give lie to that. Or perhaps the reasons are purely (or mostly) historical.

Or is it because spreads thus expressed are an indicator of bank profitability? If the bank is operating at a fixed spread, then it matters little what the cost of lending and borrowing are. The differential is the return on the asset base (which logically being a fixed multiple of equity) and thus the return on equity.

This explanation is slightly more credible, but fails to take into account changes to the business models of banks over the last decade as well as the involvement of players other than "banks" in the financial system. Not everyone is contrained to leverage on equity. In fact, I'd suspect that the number of players that gear up on cash flows far exceeds the former.

So if we're not to express spreads (or changes to base rates) as absolute differentials, then how else? Clearly, a purely relative change a la stocks holds less meaning than for the latter. Consider this: "The Fed today decreased its benchmark funds borrowing rate by 28.5%. The market expects further easing of between 33% adn 66% in the coming quarter", instead of: "The Fed today slashed its benchmark funds rate from 1% to 1.5%. The market expects futher easing of between 0.5 % or 1% over the next quarter".

I recently came across a passage in an article by Percy S Mistry in The Financial Express that brought out the absurdity of doing this (emphasis mine):

First, the Fed reduced rates to unprecedented levels. Then, it jacked them up
mechanically to five times the low rate over 21 months. It would be like RBI
raising rates to 30% in the next two years and not expecting trouble to arise!

Clearly Mr. Mistry is equating the tightening from 0.5% to 2.5% to RBI tighening from 6% to 30%. To me, the case under question is a lot closer to a scenario where RBI tightens from 6% to 8%. Not quite the disastrous policy that Mr. Mistry accuses the Fed of. But he does have a point: I'd expect borrowers to have been more adversely impacted by the Fed's action compared to RBI's analogous equivalent action by my definition.

Here's my proposal: express interest rates as (1 + r). This number needs a name. While I'm sure someone has already named it as well as made a similar proposal, it's hard for me to find this out (google search his not amenable to this sort of thing), besides it is an original proposal for me anyhow. So, I propose to call it "pips". A 5% interest rate is 1.05 pips, 0.5% would be 1.005 pips. Now, we can meaningfully express pips differentials as percentages. If the Fed tightens from 0.5% to 2.5%, that's a 1.9999% tightening in pips terms from 1.005 to 1.025. The equivalent RBI action would be to tighten from 5% to 7.1%, i.e. from 1.05 to 1.071 pips.

NIFTY Long Term Call Options: Tax Implication

Long term options introduced by NSE starting Mar 2008 allow one to take positions on the benchmark NIFTY 50 index over up to a three year period.

Brisk trading in select contracts. Lots of OI build up. Compared to earlier "innovations" in teh F&O space -- in CNX IT, Junior NIFTY, MINIFTY etc -- this one is clearly a hit.

Two things to notice about premiums: puts are a lot more expensive than calls and calls are often quoted at IV less than next and far month options of similar strike. So what's going on?


Clearly the call writers are writing covered calls and taking a position that NIFTY won't go below a certain level, rather than that the NIFTY will stay below the strike. The downside risk is low on the whole and it is probably quite easy to close out both positions should there be a deep correction and get away with a small loss. On the upside, the call premium goes to fund the margin now and can be taken out at expiry. But even this does not explain the low prices -- FD interest rates of 9.5% over the same period easily beats the strategy.

The real kicker is in the tax implications. The underlying that is purchased for margin, the NIFTY basket, is treated as equity investment , gains on which are tax free beyond a year. Naturally, the call writer expects to pay out the entire resulting gain to the call buyer at expiry. Now that is an income loss, offsettable against other income, and can be carried forward three years.

Here's an example scenario: I sell 1 European call contract at a strike of 5000 expiring in 25DEC2010. I receive a premium of 800 for this. NIFTY is currently at 4800, so I put in another 4000 and buy 1 NIFTY in cash and net this against the margin I need to keep for the open call. No tax implication in FY08-09. No tax implication in FY09-10 either. Now, on Dec 2010 NIFTY happens to be at 7000, say. I'm 2000 out of the money. So, I sell the 1 NIFTY that I hold, get 7000 for it, pocket 5000 and pay out 2000 to the call buyer. I book a loss of 1200 on the call.

I invested 4000. I receive 1000 at the end of 2.5 years. That's approximately 11% tax free return. But wait. That's not all. As far as the tax inspector is concerned, I made a long term capital gain of 1000 on equity which is tax free and a loss of 1200 which gives me a net 399 tax advantage. So its really as if I invested 4000 and got 1399 for it in 2.5 years. That's more than 15% post-tax return pa! The higher the NIFTY ends up, the more I stand to make (assuming I have enough other income to offset the tax loss against, of course).

And the tax free dividend (of around 2-3%) the NIFTY pays out over the 2.5 years. Now thats pure gravy!