Operation Twist

Introduction

• It  is a monetary policy operation, conducted by the RBI (First introduced  by the Federal  Reserve’s, USA in 1961) in order to influence the interest rates.
• Operation Twist focuses on lowering long term interest rates by simultaneously selling short-term securities and buying of long term securities through open market operations (OMO). 

Purpose of Operation Twist

• Whenever there is a long-term investment deficit in the country and the investors are hesitant to make long-term investments in the economy, the RBI tries to revive economic growth by lowering the interest rate for long-term investment ventures. This however makes borrowing easier for businesses, which further stimulates investment and expansion of operations.  

Functioning of Operational Twist

• RBI on behalf of the government sells and purchases government securities (for short term) or bonds or dated securities (for long term), to manage the liquidity in the market.  The major players in the market are the commercial banks, institutional investors, etc.
• RBI uses OMO (one of its monetary policy instruments) to buy or sell government securities in the open market. 
• In Operation Twist, RBI sells short term securities and purchases long term securities worth the same value. So, with the simultaneous buying and selling of government securities, yield (Interest rates) for the long term securities comes down while the yield of the short term securities goes up. 
• There is an inverse relationship between bond prices and their yields. As the RBI buys long-term securities (bonds), their demand rises which in turn pushes up their prices while pulling down yields.

How Yield varies with Bond prices?

• Yield is the return an investor gets on his (bond) holding/investment. The interest rate in an economy is determined by yield. Thus, lower long-term interest rates mean people can avail long-term loans (such as buying houses, cars or financing projects) at lower rates.
• This also results in a dip in the expected returns from long-term savings which tilts the balance from saving towards spending. Hence, cheaper retail loans can help encourage consumption spending, which is the largest GDP component in the economy.
• Suppose the face value of a 10 year government security is Rs. 100, and the coupon payment is  Rs. 5. So, while purchasing the bond the buyer has to pay the face value and in return he will receive Rs.105 after maturity. In this case, the bond yield is 5 %.
• So, with the simultaneous purchase of government securities, the demand for these securities goes up which in turn increases the price of securities. For example, if the price moves up from  Rs. 100 to Rs. 110 with a coupon rate of Rs. 5, the yield falls to 4.5 %.