Interest rate arbitraging in treasure bills is back with a bang with interest rates ruling higher in the short end of the maturity scale.

Though there is a cap of $1 billion on foreign institutional investors' investments in the domestic debt market, players are yet again active in the treasury bills market.

Analysts' conservative estimates say arbitraging is fetching profits of 150-200 basis points.

Earlier, the Reserve Bank of India had cut the rates on various dollar-denominated deposit rates to discourage interest rate arbitraging.

Dealers said players always have the option to book profit and enter again, thereby maintaining the cap on investment.

The situation seems conducive for reaping profits this way. The interest rate on forward dollars is at premiums and without the RBI's support it is slipping into discount zone.

Even after restructuring the one-day repo to seven days, the RBI pays a 4.5 per cent interest which is considerably higher than what the market will pay.

This can be evident from the fact that repos with other parties in the market are dealt in the range of 3.40-4.25 per cent for seven days. In an attempt to bring parity with the repo rate, the cut-off rates on treasury bills are gradually increasing.

In December-January, 91-day papers fetched a yield of 4.19-4.28 per cent, while in February, it touched 4.32 per cent. The rate is expected to go up further going by the cut-off yield of 4.40 per cent seen at the 91-day bill auction this week.

Similarly, the current rate on the 364-day bill is 4.46 per cent against 4.22 per cent in January. According to dealers, even after calculating the cost of conversion from dollars to rupees in a fully covered situation, investors could make a profit of 150-200 bps.

Dealers said the treasury bill rates are going to hover around these levels as long as repo rates remain at 4.5 per cent.

With the six-month Libor (London interbank offered rate) at 1.2 per cent and the forward premium for six months rising to 0.5 per cent, the covering cost comes to around 2.5 per cent including the transaction cost.

After investments in treasury bills, one could earn returns of 4.2-4.3 per cent — a spread of 170-200 bps.

At present, forward dollars across maturities have gone down to discount territory.

Dealers, however, feel that the RBI is of the view that cutting the repo rate has wider ramifications than just discouraging forex inflows.

First, globally interest rates are set to go up. Also the dollar is gradually gaining against other currencies and the US economic data have been signalling a recovery. Base rates have been raised in most of the economies. Going by the global experience, there is hardly any reason to cut the rates.

In the domestic side, the inflation rate is ruling low but with an upward bias as prices of both oil and commodities are firming up and the base effect is slowly wearing off.

In order to support the gross domestic product growth of over 10 per cent, demand from importers may look up, putting pressure on the trade deficit.

Besides, the market also justifies a higher rate in the short-term as the supply of treasury bills is abundant under the market stabilisation scheme.

In fact, dealers feel that the tenure of the MSS instruments could not be increased as these are temporary measures to curb the liquidity arising from the sterilisation operations of the RBI in the forex market.