banks accounted for notional principal amount of outstanding irs of rs. 40 trillion. significantly, it is disturbing to note that, day in, and day out, the irs yields trade way below yields of comparable maturity government securities. specifically, currently the 5 year irs yield is trading at a negative spread of 120 basis points to 5 year g - sec! besides, while the g - sec yield curve is almost flat, the irs yield is steeply inverted to the extent of 120 basis points defying term, credit risk and liquidity risk premia which typically characterize a normal yield curve of risk assets! a typical, but fallacious, and vacuous, rationalization offered of this counter - intuitive, warped, weird and preposterous feature is that while irs yields are influenced by expected path of future interest rates, those of g - secs are influenced by their supply!! nothing could be farther from the truth for this rationalization turns the very logic and reason on their head. for, as i said, being pure time value of money, g - secs are influenced by, and immediately price in, inflationary expectations arising from higher fiscal deficit which, in turn, is the cause of additional supply of g - secs and not the other way round. thus, here we have an irs market completely up side down and running on its head. this is completely anti - thetical to the law of one price, or the no - arbitrage argument. for, if this law held, given hugely negative spreads to govts., fixed rate receivers, who far exceed, and overwhelmingly outnumber, fixed rate payers, would have engaged in a very simple arbitrage, involving buying corresponding maturity g - sec in the cash market by financing it in the overnight repo market, and paying fixed, and receiving overnight, in the irs market! this very normal, and logical, arbitrage would have had the effect of benefiting all the three stake - holders, viz., ( a ) fixed rate receivers receiving much higher yield than they are currently, ( b ) government of india borrowing at much lower cost, and ( c ) business and industry in general, and infrastructure sector, in particular, getting long - term - fixed - rate - low - cost financing solutions. in other words, this would have been a win - win for all key stake - holders but, the fact of the matter is that, if anything, this is just not

do the opposite arbitrage if the actual cds spread is lower than the theoretical / model spread / price until the arbitrage opportunity disappears and theoretical / model and actual market prices align again. but sadly, like in a classical catch - 22, this arbitrage is just not possible simply because of its complete absence, as i said before, in the irs market and, therefore, alas, much as we would all wish, a happening corporate bond market cannot happen, inter alia, to supplement huge infrastructure funding needs of the indian economy. interest rate futures ( irfs ) if the cds was a stillborn, irf too suffered mortality in its infancy the second time round after its 2003 version which itself was almost a stillborn. for, after their second launch in august 2009, interest rate futures on 10 - year notional government bond had seen two settlements, viz. the december 2009 contract and march 2010 contract. significantly, both traded volumes and open interest ( oi ), witnessed decline over the two settlements, eventually decaying very quickly to zero permanently. in particular, the december 2009 contract, which had a peak open interest of rs. 980 million declined to a pre - settlement open interest of rs. 610 million and settled “ entirely ” by physical delivery, representing physical settlement of 62 % of the peak open interest. in contrast, the march 2010 contract, which witnessed a peak open interest of rs. 570 million declined to a pre - settlement open interest of rs. 420 million and also settled entirely by physical delivery, representing physical settlement of 72 %! both these settlements were a far cry from the hall - mark and touch - stone of an efficient, frictionless, seamlessly coupled, and organically connected, physically - settled futures market even where physical delivery typically does not exceed 1 % to 3 % of the peak open interest! this happened because of the inefficient “ disconnect ” and “ friction ” in the irf market due to only one way arbitrage viz. buying the cheapest - to - deliver ( ctd ), with the highest implied repo rate ( irr ), by financing the same at the actual repo rate and simultaneously selling futures. in fact, as ascertained from one market participant, who accounted for almost the entire rs. 600 million worth of physical delivery into the december bis central bankers ’ speeches 2009 contract, the implied repo rate of the ctd was 6. 75 % as against the