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Indian Financial System

Notes and/or regulating the availability in terms of quantum by adjusting the formula for
fixation of eligible limits. With the emergence of the Bank Rate as the signaling rate of
monetary policy stance, the present policy has been to keep the refinance rate linked to the
Bank Rate.

3.8 Risk Exposure in Money Market Instruments

Apart from ensuring appropriate liquidity, investors should also consider the risks present in
the money market investments. Investments in the money market are basically unsecure in
nature. While the unsecured nature does indicate a higher risk, the risks associated with money
market, however, are not necessarily due to the unsecured nature but more due to the fluctuation
in the rates. The level and the type of risk exposures that can be associated with money market
instruments/investments are discussed below.
 Market Risk/Interest Rate Risk: These risks arise due to the fluctuations in rates of the
instruments and are of prime concern in money market investments. Due to the large
quantum of funds involved in the money market deals, and the speed with which these
transactions are executed, the value of the assets are exposed to fluctuations. Further, if
these fluctuations are wide, it may lead to a capital loss/gain since the price of the
instruments, including the government securities, declines. This risk can be minimized by
enhancing liquidity since easy exit can help curb the capital loss.

 Reinvestment Risk: Reinvestment risk arises in a declining interest rate scenario. Investors
who park their funds in short-term instruments will, at the time of redemption, have to
reinvest these funds at a lower rate of interest. And since the existing securities will be
having higher coupons/YTMs, their value generally rise in such situations to bring down
the yields. All money market instruments are exposed to this risk.

 Default Risk: Lending decisions primarily focus on assessing the possibility of repayment
since the first risk that the lender will be exposed to is the default risk. Except for the
sovereign securities, all other investment/lending activities have the probability of default
by the borrower in the repayment of the principal and/or interest. It is due to the absence
of the default risk, that the government securities are considered as risk-free securities.
 Inflation Risk: Due to inflation, the average prices for all goods and services will rise,
thereby reducing the purchasing power of the lender. The risk that arises due to the
inflationary effect is known as inflation risk/purchasing power risk. All money market
instruments are exposed to this risk. Lenders will generally ensure that their contractual
rate of interest offsets this risk exposure. Though the capital market has designed
instruments to hedge against this risk, they are yet to be introduced into the money
market. However, considering the short-term nature of the money market instruments,
their level of exposure to this inflation risk can be minimal when compared with other
long-term instruments. The Capital Indexed Bond (CIB) issued by the RBI is an instrument
designed to minimize/eliminate the inflation risk. With a maturity of 5 years, these CIBs
earn a 6 per cent return on the investments. The principal amount is adjusted against
inflation for each of the years and the interest is then calculated on this adjusted principal.
Further, upon repayment, the principal amount is adjusted by the Index Ratio (IR) as
announced by the RBI.

 Currency Risk: A risk of loss is inherent in the multi-currency dealings due to the exchange
rate fluctuations. Currency risk refers to this type of risk exposure. The money market
players operating in overseas money market instruments will be exposed to this risk.
Also, when the institutional investors, like banks sell foreign currencies to play in the
money market, they may be exposed to currency risk.

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