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.)
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