Inflation and innovations in the financial markets of India

By Vipin Agnihotri

Inflation reduces the purchasing power of money. For example, if the rate of inflation is say 10 percent per annum, the purchasing power of money declines by 10 percent per annum. In such a situation, an income increase of 10 percent per annum is needed to protect investors real income.

Likewise, if the rate of inflation is 10 percent per annum, the rate of return on investment must be at least 10 percent per year to avoid erosion in real wealth. To earn a positive real rate of return in a situation like this, the nominal rate of return must be greater than the inflation rate, namely 10 percent.

The question now arises: What innovations have occurred in financial markets in response to inflation? The following have been the important inflation-induced innovations in financial markets:

• Flexible interest rates

• Lender’s participation in equity

• Financial futures

Traditionally, lenders have offered fixed-interest loans to investors. Under this arrangement, when unanticipated inflation occurs and interest rates increase in response to it, lenders suffers and investors gain. To cope with this, lenders can opt for flexible interest rate home mortgages with interest rates based on some index of cost of funds. In addition, adjustable interest rates are also found in many kinds of debt contracts.

As compensation for bearing inflation risk, lenders may seek participation in equity. This essentially implies that lenders partake in increases (or decreases) in the value of assets financed by them. The most common type of such participation is the Shared Appreciation Mortgage (SAM) found in real estate financing.

In a typical SAM the interest rate is one-third lower than the prevailing standard mortgage loan. In return for this sacrifice, the lender gets one-third of the appreciation in the real estate when it is sold-in some arrangements, the lender can collect its share of appreciation after a certain period, even though the property may not be sold.

An agreement between two parties to exchange an asset for cash at a pre-determined future date for a price that is specified today is referred to as a futures contract. A financial futures contract represents a futures contract for financial assets like currencies, treasury bills, bonds and commercial papers. Financial futures may be used to speculate on changes in security prices caused largely by changes in interest rates.

Inflation has been a persistent feature of the Indian economy. Hence, it should be properly considered in capital investment appraisal. In practice, however, adjustment for inflation is rarely, if ever, made. The use of current price structure is deemed satisfactory and the reasoning offered runs as follows:

Inflation is expected to raise the revenues and costs of the project in a similar fashion. Hence, net revenues after adjustment for inflation would be equal to net revenues in current terms. The above argument, however, overlooks the following considerations, which cause distortion:

• The depreciation charge is based on historical costs and hence the tax advantage arising from depreciation charge does not keep pace with inflation.

• The cost of capital used for investment appraisal contains a premium for anticipated inflation.