Monday, October 26, 2009

Understanding Interest Rate Futures

Co-author: Satish Kumar

(Published in the Hindu BusinessLine on 26th October, 2009)

The Securities and Exchange Board of India (SEBI) and the Government had approved the launch of Interest Rate Futures (IRFs) in December 2008. Subsequently, on August 31, 2009, the National Stock Exchange of India (NSE) launched the 10 Year Government Bond IRFs.

IRFs, which are extremely popular derivative contracts around the world accounting for more than 70 per cent of the total derivatives trading, were introduced in India for the first time in 2003. However, they were soon suspended due to illiquidity and poor price discovery. Another attempt has been made by SEBI to launch them, albeit with greater preparations this time.

IRFs are instrumental in facilitating the management of interest rate risk faced by organisations and individuals while investing in floating rate debt instruments. Hence this move is being viewed as a step towards boosting the country’s debt markets. The market participants are also welcoming this move as IRFs will not only provide more depth to the market; it will also act as another instrument for investment.

IRFs are derivative contracts on a fixed income security, namely, bonds. The price of the bond changes with changes in interest rates (yield), both being inversely related.

This causes a number of organisations to incur capital losses when the interest rates drop. Investors in the bond market can now hedge against this loss if they anticipate that the interest rates might fall.

Contract specifications

Underlying: 10 Year Government Bonds with notion coupon rate of 7 per cent, semi-annual compounding;

Minimum contract size: Rs 2 lakh;

Minimum maturity period: 12 months;

Expiry and settlement: March, June, September and December.

Let’s say a trader ABC, buys 5,000 units of bonds with a face value of Rs 100, coupon rate 7 per cent, semi-annual compounding, and the yield to maturity (YTM) of the bond being 6.5 per cent. The price of this bond in the market is Rs 103.63 (calculated using discounted cash flow method). Hence, the investment for the trader will be Rs 103.63 x 5,000 units = Rs 5,18,150.

The trader would like to sell off his investment after one year. However, he is worried that the central bank might raise the interest rates by 100 basis points (1 per cent) in the coming year. If this happens, the bond will trade at around Rs 96.77 in one year’s time. This will result in the value of his portfolio going down by Rs 34,300 [(103.63-96.77)*5000].

What the trader can do is hedge for this loss using IRFs. He can go short on equivalent value of IRF contracts now and then close his position after one year when the bond prices go down.

Other tools

Other hedging tools such as interest rate swaps or forward rate agreements were available to the investors in India since long. However, they suffered from the usual problems associated with over-the-counter contracts, like illiquidity, high transaction costs, third party risks, etc.

Now, with IRFs, investors have access to a more liquid contract with almost negligible third-party risk as the clearing house of the NSE will act as the counter party to all the trades.

Most of the institutional investors, such as insurance companies, pension and provident funds, mutual funds and banks will benefit immensely from these contracts as they hold huge amounts of fixed income securities in their portfolios, either to fulfil statutory requirements or to have a desired level of risk.

There are two more instruments which have been approved but not yet introduced. They are 91-day Treasury Bill futures and short-term interest rate futures based on an index of actual call money market rates. Once these products are also introduced, the debt markets in India would have truly taken a leap forward. It would attract speculators too, making price discovery better and the debt market more complete and liquid.

(The authors are faculty member and doctoral student, respectively, at IBS Hyderabad.)

Wednesday, September 30, 2009


Glittering shirts, glittering trousers, glittering bangles, glittering shoes, glittering bags, glittering sarees, glittering kurtas, glittering showpieces, were all on sale in the Charminar area of Hyderabad, on 20th September 2009, the eve of Eid-ul-Fitr.

With odour as varied as from Mirchi Bajji to coconut oil, from axe deodorant to vanilla wafers, from coffee to itr, from leather to new cotton clothes, the nose was working overtime.
Everything under the sun was being bought and sold, with vendors vying in the most unique ways to attract attention of the customers. The most innovative slogan that I heard was, “Maalik mar gaya, rate gir gaya”.
There were heads all around. We stood at one end of Charminar and were pushed all the way to it (about one kilometer) by the crowd. We went and stood on the other end, and were pushed back to where our bike was parked.

What Brindavan is to Holi, Charminar is to Id
At eleven in the night, people were eating chaat, dosas, haleem, mirchi bajji, paneer and chicken tikka and drinking irani chai and chaach (buttermilk). White churidar, white kurta, black burkhas with black veils, dominated the crowds.

A truly unique experience.

Friday, January 2, 2009

A futures contract on real-estate?

If you are wondering why such trading hasn’t taken off in India, it is because these transactions need a lot of ground work to be put in place first.
“Why don’t we have a futures contract on real-estate to hedge the risk of land prices going down?” asked Rahul, a quiet but sharp student. Professor Nicky was taken aback by his question. Where most of the students in her class had difficulty understanding the basic concepts of hedging, this young boy was asking about an instrument which was, well, not so simple, to say the least.

Professor Nicky turned the question to the class to test how much the class knew. And she was in for a pleasant surprise. There were a few hands in the air.
Rachna: “It will be difficult to introduce real-estate futures because the valuation of the underlying product would be difficult. The real-estate market in India is highly fragmented. The prices of land differ widely based on factors such as location and usability, that is commercial, industrial, residential or agricultural”
Praveen added: “Besides, such a market would be very illiquid in India as only prime commercial and residential properties would probably be traded.”
Index of prices
“But, what is the problem here?” interposed Rajshree. “Can’t we create an index of real-estate prices? Just like we have stock indices? We can club the properties belonging to a particular city according to property types”.

Professor Nicky saw a few perplexed looking faces and decided to intervene even though she was happy with the way the discussion was proceeding. She took over from where Rajshree had left.
“See, just like we have an index for FMCG companies or IT companies or banks, similarly, we can create an index of real-estate Prices. Of course these indices will be city or region-wise indices. We would need to determine a base year”.
“Since it would be very tiresome to include all residential property transactions in the index, we take transactions that are above a minimum amount of, let’s say, Rs 25 lakh. Now we can take a weighted average of all the transactions on a weekly or a fortnightly or monthly basis to find the changes in the index.
“However, the index may not give a true and fair picture as the recorded value of these transactions with the government is generally very low to save taxes. But then, it will still be better than having nothing. And slowly, as we move ahead and learn, the issues of heterogeneity and pricing will be sorted out”.
“Ah! If I recall correctly, Chicago Mercantile Exchange and Chicago Board of Trade have such futures traded on such contracts for cities such as New York and Los Angeles. In fact, they also have futures contracts on Real Estate Investment Trusts” exclaimed Richa.
“The students have really started reading,” thought Professor Nicky. “With the job scenario being bleak, many students have become serious and are trying to read more so that they can have an edge over their batch mates in an interview”!

Benefits of futures
“Yes, both the US and the UK have real-estate futures traded on their commodity exchanges for most of the major cities in the country. But can somebody tell me what the benefits of real-estate futures are?” asked Nicky.
Before Nicky could point towards a raised hand, Rohit rattled off, “Hedging for investors and builders, diversification, price discovery, increased information availability and flow, investment tool…”.
“Okay…okay…enough…so all of you are aware of the benefits of real-estate futures. But who has heard of the London Fox?” Thankfully no hands went up this time. Nicky was almost beginning to feel that she was not required in the classroom at all as the students had answers to all her questions.

Keeping them at bay
“London Futures and Options Exchange (FOX) started trading in four property futures contracts in May 1991 and had to suspend trading in October 1991. The reasons were mainly that these contracts were not economically viable. Arbitrage was not possible as short-selling is not allowed in the underlying spot market, which is true in India also.
“Also, the housing indices for various cities would be highly dependent on each other, albeit with lagged effect, due to the cascading effect in the real-estate markets. The transaction costs were also huge, which kept the investors and hedgers at bay.
“Hence, before introducing these futures, the government will have to do a lot of ground work to ensure that they work efficiently and provide the desired benefits to investors and hedgers”.
The class looked satisfied. Everyone had contributed something and everyone had learnt something new. Nicky looked proudly at her students and called it a day.

(Praveen, Rachna, Rahul, Rajshree, Richa and Rohit are students of IBS Hyderabad, class of 2009. Nupur is an Assistant Professor of Finance at IBS Hyderabad.)