INTRODUCTION

Definition:

“An interest rate future is a contract between the buyer and seller agreeing to the

future delivery of any interest-bearing asset. The interest rate future allows the buyer and

seller to lock in the price of the interest-bearing asset for a future date.”

- www.investopedia.com

The contract sizes of Interest Rate Futures are large in size, thus, they are not products

for less sophisticated or small traders. IRFs or Interest Rate Futures can be based on the

underlying instruments such as:

Treasury Bills in the case of Treasury Bill Futures traded on the Chicago Mercantile

Exchange Inc (CME).

Treasury Bonds traded in the case of Treasury Bond Futures traded on the Chicago

Board Of Trade (CBOT).

Other products such as CDs, Treasury Notes and Ginnie Mae's are also available to

trade as underlying assets in an Interest Rate Future (IRF).

Eurodollar futures.

History:

Interest Rate Futures contracts were first traded in the United States of America on

October 29, 1975 to meet growing need for tools that could protect against volatility in

interest rates. Since then, IRFs have become risk management tool for financial markets

worldwide. IRFs are the most widely traded derivative instruments in the world. The total

outstanding notional principal amount in Interest Rate Futures is 26 times higher than equity

index futures.

1 | P a g e

Uses:

Interest rate futures are used to hedge against the risk of that interest rates will move

in an adverse direction, causing a cost to the organization.

For example, borrowers face the risk of interest rates rising. Futures use the

inverse relationship between interest rates and bond prices to hedge against the risk of

rising interest rates. A borrower will enter to sell a future today. Then if interest rates rise

in the future, the value of the future will fall (as it is linked to the underlying asset, bond

prices), and hence a profit can be made when closing out of the future (i.e. buying the

future).

A position with existing or future interest rate risks (underlying position) is hedged by

building up a long or short position in the futures market which, in regard to its nature and

scope, corresponds as closely as possible to the underlying position. By this procedure it is

possible to fix in advance the future interest rate and makes it resistant to market variations.

Profits or losses on the underlying position are then largely compensated by an

increase or decrease in the value of the futures contract. An exact compensation will hardly

ever occur since the amounts and the maturities of the underlying position usually differ from

those of the contracts and the spot and forward market developments do not always match

exactly.

The underlying position to be hedged is the essential constituent for the excerption of

the contract. If it is to be based on a money market placement, it is advisable to choose a

contract with short-term underlying instrument, whereas if the aim is to hedge capital market

operation, a contract with a longer- term underlying security would be selected.

2 | P a g e

In note, it is important to know that a borrower can protect himself against rising

interest rates by selling interest rate futures. On the other hand, an investor can hedge against

falling interest rates by buying Interest Rate Futures.

Uses to:

Banks:

Managing duration gap with respect to change in interest rates.

Protecting against the devaluation of AFS and HFT portfolio.

Hedging against re-pricing risk related to volatility of cash flows due to

revaluation of assets and liabilities over a period of time.

Mitigating basis risk when yield on assets and cost on liabilities are based on

different benchmarks.

Primary Dealers:

Underwriting of primary issues is carried out by the primary dealers, who also

enable market making for government securities. IRFs can be used to

minimize the risk due to volatility of interest rate when primary dealers are

exposed to meeting their underwriting obligations.

With increasing government borrowings, the pressure on primary dealers to

adhere to obligations is enormous. IRFs will help to minimize the securities

portfolio risk.

Mutual Funds, Insurance Companies:

It can mitigate interest rate risk arising out of huge exposure to government

securities and corporate debt.

Optimizing the portfolio returns.

IRFs can provide another avenue to mutual funds for improving investment

income by arbitrage between cash and futures markets of the debt segment, as

well as through spread trading strategies.

Maximizing the return on investments of insurance companies in interest

bearing securities, thereby minimizing the actual risk for the insurance

companies.

Corporate Houses:

Companies can reduce their borrowing cost using IRF to manage company’s

exposure to interest rate movement.

3 | P a g e

By using IRF to manage interest rate risk companies can optimize the cost of

capital to company leading to optimal debt-equity ratio.

Improve the credit rating for a corporate by enhancing the debt-service

coverage ratio and the interest coverage ratio by better risk management using

IRF.

Corporate can convert their fixed rate borrowing into floating if view is of a

falling yield.

FIIs:

Hedging against underlying GoI securities portfolio.

FIIs having a view on long term interest rate could benefit by participating in

new asset class.

Member Brokers, Retail Investors:

Brokers can use IRF for generating income by arbitrage between cash and

futures market of the debt segment.

With increased participation in IRFs member brokers can earn additional

income in the form of brokerage fees charged to clients.

Portfolio management services to retail and corporate clients who are already

trading in equity and currency can be extended with introduction of IRF.

Small lot size provides retail investors to hedge their interest rate payment on

home loans to protect against rising interest rates.

Key Benefits:

Directional Trading:

As there is an inverse relationship between interest rate movement and

underlying bond prices, the future price also moves in tandem with the underlying

bond prices. An investor can benefit by taking a short position in IRF contracts if he

has an expectation of rise in interest rates.

Case I: A trader expects a long term interest rate to rise. He expects to sell IRFs as he

shall benefit from falling prices.

Trade Date: 12 October, 2011

Futures Delivery Date: 7 December, 2011

Current Futures Price: 93.5

Futures Yield: 8%

Trader sells 300 contracts of the December 11-12 Year futures contract on 12 October, 2011

at 93.5

4 | P a g e

Daily MTM due to change in futures price is as tabulated below:

Date Daily Settlement

Price

Calculation MTM (Rs)

12/08/2011 93.6925 300*2000*(93.5-

93.6925)

-115500

13/08/2011 93.4625 300*2000*(93.6925-

93.4625)

138000

14/08/2012 93.4575 300*2000*(93.4625-

93.4575)

3000

15/08/2012 93.1275 300*2000*(93.4575-

93.1275)

198000

Net MTM gain as on 12/08/2011 is Rs.223500

*Daily settlement price shall be weighted average price of the trades in the last half hour of

trading.

Closing out the position:

16/02/2011-futures market price-Rs.93.1125

Trader buys 300 contracts of December 2012 at 93.1125 and squares off his position.

Therefore total profit for trader 300*2000*(93.1275-93.1125) is Rs.9000

Total profit on trade is Rs.232500

Hedging:

Holders of Government of India securities are exposed to the risk of rising

interest rates which in turn reduction in the value of their portfolio. So in order to

protect against a fall in the value of their portfolio due to falling bond prices, they can

take short position on IRF contracts.

Case II: A portfolio of Government of India securities worth Rs.600 crores. Bank’s

portfolio consists of bonds with different coupon and different maturities. In view of rising

interest rates in near future, the head of treasury is concerned about the negative effect this

will have on the bank’s portfolio. The treasury head wants to hold his entire portfolio and at

the same time doesn’t want to suffer losses on account of fall in bond prices.

The head of the treasury thereby decides to take a short position and hedge the interest rate

risk in the IRFs.

Date: 12/08/2011

SPOT price of GoI security: 90.0575

5 | P a g e

Futures price of contract: 83.7925

On 12/08/2011 ABC bought 2000 Government of India securities from SPOT market at

90.0575. He anticipates that the interest rate will rise in the future. Therefore, to hedge the

exposure in underlying market he may sell Dec 2012 IRF contracts at 83.7925.

On 16/11/2011 due to increase in interest rate:

SPOT price: 87.2500

Future price: 80.1500

Loss in underlying market will be (87.2500-90.0575)*2000= (Rs.19615)

Profit in the futures market will be (83.7925-80.1500)*2000= Rs.7285

Calendar Spread Trading:

A calendar spread on inter-delivery spread, is the simultaneous purchase of

one delivery month of a given futures contract and sale of another delivery month of

the same underlying on the same exchange. Being based on different calendar months

it is referred to as calendar spread.

Case III: If a long position in a Dec 2011 IRF contract versus a short position in the Mar

2012 IRF contract is considered as calendar spread.

Since a calendar spread entails only on the basis risk, the bank runs little risk on the positions.

Trade Date: 12/08/2011

December 2011 Futures: 85.3600-85.3800

March 2012 Futures: 81.9700-82.0200

The difference between the December 2011 and March 2012 contracts is now 3.41 (after

considering bid-ask). If the trader believes that this spread is very high, he would execute a

calendar spread

Selling the March 2012 futures at 81.9700

Buying the December 2011 futures at 85.3600

10 days later

Trade Date: 22/08/2011

December 2011 Futures: 85.0050-85.0250

March 2012 Futures: 81.3000-81.3700

The difference between the December 2011 and March 2012 contracts is now Rs.3.635 (after

considering bid-ask). The trader may decide to liquidate his calendar spread by

Buying the March 2012 Futures at 81.3700

Selling the December 2011 Futures at 85.0050

Arbitrage Between Cash and Futures Market:

6 | P a g e

Arbitrage is the price difference between the bond prices in underlying bond

market and IRF contract without any view about the interest rate movement. One can

earn the risk-less profit from realizing arbitrage opportunity and entering into the IRF

contract by initiating cash and carry trade involving the following steps:

Purchase the cheapest to deliver bond.

Take short position in IRF contract

Finance the bond purchase at the current borrowing rate from the market.

Give the intention of delivery to the exchange.

Deliver the bond and receive the invoice price.

Repay the cash amount borrowed to purchase the bond.

Reduce portfolio duration:

Bonds with longer maturity are more vulnerable to interest rate changes,

therefore bond portfolio with longer duration are more exposed to sensitivity of the

movement in interest rate. By entering into an IRF contract a portfolio manager can

reduce the duration of the portfolio.

Formula:

Approximate number of contracts= {(DT – Dt)*Pt /DCTD*PCTD}*Conversion factor of

CTD bond

DT = Target duration of portfolio

Dt = Initial duration of portfolio

Pt = Initial market value of portfolio

DCTD = The duration of cheapest to deliver bond

PCTD = Value of cheapest to deliver bond (price*contract multiplier)

INTEREST RATE FUTURES IN INDIA

7 | P a g e

Interest Rate Futures (IRFs) were introduced in India in June 2003. The introduction

of trading in Interest Rate Futures in India hails the commencement of a new period in the

fixed income derivatives market. The introduction of trading in interest rate futures in India is

one more step towards consolidation of the Indian Securities Market with the rest of the

world. Globally, interest rate derivatives are very popular of the market and account for

around 70% of the total derivatives transactions across the economies.

Structure Of The Product In The Indian Market:

It was proposed that the products launched in the Indian market are futures on long

bond (10-year notional G-Secs) and T-Bills (91 days notional). Both these products were to

be settled cash based on the ZCYC (Zero Coupon Yield Curve). The final settlement of these

futures contracts would be the present value of all future cash flows from the underlying

discounted at the zero coupon rates for the corresponding maturities taken from the ZCYC.

This methodology would also be used to price the product theoretically for the Marking To

Market purpose, in case futures do not see any trade during the last half an hour of trading.

The ZCYC was proposed to be derived from the actual traded price of Government Securities

each day, reported on the Wholesale Debt Market (WDM) of the exchange or the price data

collected from the Negotiated Dealing System (NDS).

Issue With The Product:

Two major points of differentiation between the conformation of the proposed products in

India and the internationally traded interest rate futures are:

Products proposed in India are cash settled while internationally traded interest

rate futures are largely physically settled.

Methodology for cash settlement of futures contracts using ZCYC based

approach is nowhere used across the globe.

Exchange Traded Interest Rate Futures In India:

Introduction of exchange traded interest rate futures by SEBI & RBI marked a major

policy and product conception that will have significant impact on the deepening of financial

markets in India.

IRFs account for the largest volume and notional value among the financial

derivatives traded on exchange worldwide. Globally, according to data released by the Bank

for International Settlement (June 2012), the notional principal amount outstanding in

organized exchanges across all futures instruments amounts to US $21 trillion in March 2012,

of which $20 trillion pertains to IRFs. In Asia, the notional amount outstanding in Exchange

Traded IRFs is approximated at US $2.5 trillion in March 2012. Worldwide 74 million IRF

8 | P a g e

contracts are outstanding in organized exchanges as on this date. For Indian financial

markets, IRFs present a much needed opportunity for hedging and risk management by a

wide range of institutions and intermediaries, including banks, primary dealers, corporate,

AMCs, financial institutions, FIIs and retail investors. IRFs help various constituencies in

providing an effective and efficient mechanism to manage interest rate volatility.

SALIENT FEATURES:

Increased market reach enables higher liquidity.

Exchange platform ensures protection against counterparty default risk, due to

novation by clearing house of the exchange.

Greater transparency due to automated anonymous order matching system and

settlement.

Delivery of underlying asset is possible on exchange platform.

Futures contracts available on Notional 7% coupon 10- year G-SECS as the

underlying asset.

Large number of Informed Participants can participate using online electronic

trading system, leading to efficient price discovery.

Allows hedgers to efficiently transfer risk to speculators and arbitrageurs.

Exchange traded IRFs ensure robust systems for risk management and

surveillance, thereby, capable of manipulating any kind of market

manipulation.

Uniform standards and well-established procedures in IRF market allow

symmetry of treatment to various participants.

IRF expands the set of hedging tools available to financial as well as non-

financial entities to manage interest rate risk.

Simple derivative instrument and easy to understand due to its linear pay-offs.

IRFs are standardised products that allow for gauging the utility and

effectiveness of different positions and strategies.

Online real-time dissemination of prices.

Exchange traded IRF provides guarantee by the Clearing Corporation and

hence eliminates counter party risk, thereby increasing the capital efficiency of

the market participants.

EXPECTED BENEFITS TO MARKET PARTICIPANTS:

IRF will expand the scope of the financial markets in India and will further

deepen the derivatives market.

9 | P a g e

Exchange traded IRF are most transparent in terms of price discovery,

margining, risk management and settlement.

IRF will enable companies to hedge interest rate risk. Interest payments form

one of the major parts of the expenditure for companies. Volatility in the

interest rates could be better managed with the help of IRFs.

IRF will provide banks and financial institutions with an avenue for efficient

asset-liability management.

Fund managers and insurance companies can better manage asset allocation

and investments using IRF.

IRF will also help individuals in efficient management of the household

balance sheet.

MARKET PARTICIPANTS:

Banks and Primary Dealers: IRFs enable Banks and Primary Dealers to

mitigate risk, improve process efficiency.

Mutual Funds: Mutual fund managers can immensely benefit from IRF. The

Net Asset Value can be protected by hedging against interest rate volatility.

Insurance Companies: Insurance companies can benefit from IRFs in several

ways like hedging, protection against re-insurance risks, optimizing

investment portfolio returns and diversifying risk, efficient management of

asset-liability mismatch, etc.

Corporate Houses: Corporates need to identify, evaluate and mitigate risk

pertaining to interest rate volatility. IRFs provide the mechanism to contend

risk at strategic and operational level, pertaining to volatility in interest rates.

Brokers, FIIs and Retail Investors: IRFs can be beneficial to these in many

ways such as: additional source of income for brokers in the form of brokerage

fee for trading in IRFs, improved and easy access to retail and corporate

customers, wealth management advisory services, proprietary and client

trading by debt market brokers, mitigation of risk, spread trading, arbitrage

between cash and futures market of debt segment, reducing of refinancing

cost, etc.

PRODUCT DESIGN:

CRITERIA PARTICULARS

Underlying 10-year notional coupon bearing GoI security

10 | P a g e

Coupon Notional coupon 7% with semi-annual compounding

Trading Hours and Days9:00am to 5:00pm;

Monday to Friday

Lot Size of Futures

ContractRs.200000

Quotation Similar to quoted price of GoI security; Day count convention: 30/360 day basis

Tenor Maximum maturity: 12months

Contract Cycle Four quarterly contracts a year, expiring: March, June, September, December

Daily Settlement Price

i. Closing price of 10-year notional coupon bearing GoI securities futures

contract on the trading day.

ii. Closing price= weighted average price of the futures of the last half an

hour.

iii. In the absence of last half an hour trading the price as determined by the

exchanges, would be considered as daily settlement price.

Settlement

i. Settled by physical delivery of deliverable grade securities using the

electronic book entry system of the existing depositories and the Public

Debt Office of the RBI.

ii. The delivery shall take place from the first business day to the last business

day of the delivery month.

iii. The owner of a short position in an expiring futures contract shall hold the

right to decide when to initiate delivery.

iv. The short position of the holder shall have to give intimation, to the

clearing corporation, of his intention to deliver, two business days prior to

the actual delivery date.

Deliverable Grade

Securities

GoI securities maturing atleast 7.5years but not more than 15years from the first

day of the delivery month with a minimum total outstanding stock of Rs.10000

crores.

Conversion Factor

The conversion factor of the deliverable grade security would be equal to the price

of the deliverable security, on the first day of the delivery month, to yield 7%

semi-annual compounding.

Last Trading Day and

Delivery Day

Seventh business day preceding the last business day of the delivery month; and

last business day of the delivery month.

CASE EXAMPLES ON HEDGING USING IRF:

Case 1: Bank Investments In G-SECS.

11 | P a g e

XYZ Bank LTD is one of the top five public sector banks in India, in terms of deposit

mobilization. XYZ has deposited 35% of its deposits in SLR securities, well beyond the

requirements specified by the Central Bank for investment in SLR securities. 20% of these

SLR deposits are classified as Held To Maturity (HTM), and balance is classified as

Available For Sale (AFT) and Held For Trade (HFT). For the latter two categories of HFT

and AFS, XYZ bank has a risk of increase in interest rates, leading to increase in yield rates,

eventually resulting in decrease in asset value of investments in Government securities.

XYZ decides to hedge using Interest Rate Futures, for mitigating the risk of decline in

asset value of its SLR securities.

On 10th Nov. 2011:-

The yield rate of 10-year benchmark Indian Government Security, 6.19%

GS2020, was trading at 5.86%. The security is priced at Rs. 103.40.

March 2012 futures contract on the 10-year Notional 7% coupon bearing

Government security is trading at Rs. 109.34, effectively indicating a yield

rate of 5.95%.

XYZ Bank LTD. decides to hedge its exposure to SLR securities by taking a short

position in March 2012 Interest Rate Futures.

On 1st Jan. 2012:-

Expectedly, the yield rate of 10-year benchmark Indian Government Security,

6.19% GS2020, has increased to 7.66%. The security price has decreased to

Rs. 89.10.

March 2012 futures contract on the 10-year Notional 7% coupon-bearing

Government Security is trading at Rs. 95.93, effectively indicating a yield rate

of 7.49%.

XYZ Bank LTD unwinds the short hedge position by buying the futures

contract.

Thus, the long position in the cash market was effectively hedged by taking a short

futures position.

MARKET 30TH NOV.2011 1ST JAN. 2012

CASH MARKET BUY G-SEC SELL G-SEC

12 | P a g e

FUTURES MARKET SHORT FUTURES SQUARE OFF HEDGE

POSITION

Case 2: Retail Investor Who Has Invested In Long-Term Infrastructure

Bonds At Benchmark Floating Interest.

On 1st Oct. 2011, Mrs. ABC has invested Rs. 300000 of his retirement savings in

Infrastructure Bonds issued by a leading financial institution in India. The bonds provide

returns to Mrs. ABC based on a floating rate benchmark that is reset in the beginning of every

quarter. The latest benchmark rate is 9.46%.

With the credit crisis slowing the economy, the Central Bank has commenced

decreasing the repo and reverse repo rates. Thus, the floating interest rate benchmark has also

been decreasing, negating the expected returns for Mrs. ABC.

Mrs. ABC decides to hedge his risk using Interest Rate Futures. She can take a long

position in Interest Rate Futures contract, so that when interest rate decreases, the yield rate

of bonds also decrease. This results in corresponding increase in the bond prices. The bond

futures prices also increase in tandem, thereby, enabling hedge profit for Mrs. ABC.

Loss due to lower floating interest rate cash inflow, compensated by, profit from long-hedge position in futures.

FAILURE OF INTEREST RATE FUTURES IN INDIA

13 | P a g e

The IRF market has been one of the biggest riddles of India’s financial markets. It

was first started in 2003 and collapsed in a few days of trading. The Reserve Bank of India

has rolled out a series of debt hedging tools such as interest rate futures, re-purchase options

or repo in corporate bonds, credit default swaps and also securitized debt.

While the launch of a new product, the problems or issues relating to its design or

structure assume critical importance for its success. The design has to ensure that the product

serves both ends the buyers as well as the sellers and facilitates transaction with easy

comprehension and at minimal cost. In case of IRFs, it is necessary that the product design

aligns the incentives of all stakeholders- hedgers, speculators, arbitrageurs and exchanges-

with the larger public policy imperatives. The main objective of introducing the IRF is to take

a step closer to the market completion in the Arrowvian sense i.e. to expand the set of

hedging tools available to financial as well as non-financial entities against interest rate risks.

Therefore, the product must be designed as to be acceptable to, as well as beneficial for, the

target users.

Basis Of Pricing/Valuation:

It was first started in 2003 and collapsed in a few days of trading. The problem then

was that IRF was based on Zero Coupon Yield curve (ZCYC) computed by the NSE whereas

Indian bond market was based on Yield to Maturity. The apparent design flaw (which does

not exist in any major markets like the USA, the UK, the Eurozone & Japan) of using the

widget of a ZCYC for determining settlement prices were one of the reasons for the failure of

IRFs. The market was not comfortable with the complexities of ZCYC and reservations about

its lack of transparency. This problem with the IRFs was recognised in early 2004 and an

important change in the product design was introduced linking to price the YTM of a basket

of Government securities (G-Secs).

Mode Of Settlement:

Another reason for the failure of IRF products is the mode of settlement. The

evolution of futures markets indicates that settlement by physical delivery was the primal

mode. Physical settlement is when people have to give the bond at settlement (or

commodities in case of commodity derivatives) where as in cash one adjusts the differences

based on cash. IRF settled by cash as well as physical delivery co-exist in the global financial

markets. The oldest and the most well established IRF markets in terms of turnover, liquidity

and product innovation in US, UK, Eurozone and Japan use contracts based on physical

delivery where as some of the recent IRF markets like Australia, Korea, Brazil and Singapore

have cash settled contracts and have reportedly attracted sizeable volumes for reasons of

having not to deliver at all.

14 | P a g e

In 2010, it was again tried to restart this based on YTM and only for 10 year. Again

regulators kept physical settlement and again it failed to pick up. By August 2010, the

volumes had fallen by 84%.

IRF For The Money Market:

The futures contracts introduced in India in June 2003, also included a cash-settled

contract at the short end based on 91-day Treasury Bills. As in case of bond futures, banks

were allowed to transact in this product only for the purpose of hedging their exposure in the

AFS and HFT portfolios where as primary dealers were allowed to take their positions. This

product too received half-hearted response in the beginning and became illiquid

subsequently.

Finally, in 2011, the RBI introduced IRFs on 91-day Treasury Bills and then IRFs on

two-year and five-year government bonds were introduced in December, 2011.

National Stock Exchange, where IRFs on 91-day T-Bills were traded, did not show a

single trade reported in IRF segment since August 2011. Even in August, single contracts

were traded for minimum lot sizes of 2 lakhs. National Stock Exchange launched trading in

interest rate futures in 91-days T-Bills (cash settled) in July, 2011.

Initially, the IRF segment was launched with futures on 10-year government bonds.

The contracts were allowed to be settled with delivery of government securities with a tenor

between nine and 12 years. The segment, however, failed to excite market participants with

the biggest fear being that of dumping of the illiquid bonds.

Market players wanted the entire segment to be moved to cash-settlement basis, a

demand that the capital market regulator was looking into. Thereafter, in July 2011, 91-day

treasury bill futures contract were launched on cash-settlement basis that completely failed or

flopped out in just a few days.

The major reason for failure of these instruments has been the lack of hedging need

by banks, who are the largest constituents of the IRF market. Sometimes hedging can be

counterproductive and actually hurt the banks' interest income.

Bankers said interest rate risk is naturally covered or hedged by keeping floating rates

on long-term loans in alignment with short-term rates on liabilities, thus defeating the very

purpose of having IRFs in the first place, despite the RBI pushing for such products.

Investors were not interested in hedging credit or interest rate risk and this was

evident from the fact that other products like repo trading in corporate bonds or credit default

swaps did not picked up either. Only five repo trades happened in corporate debt market,

while just two deals in credit default swaps ever since they have been introduced in India.

15 | P a g e

There was an inherent problem with the structures of interest rate futures also. In case

of the interest rate futures in the ten-year government bond segment, the contracts were

settled in the form of physical delivery of bonds while in the two year and five year

government bond segment, though the contracts were cash settled, the underlying bonds

themselves were scarcely traded.

The problem with investors, such as banks, was that they didn't want to sell illiquid

papers that were held in their held-to-maturity category for high yields. These were bonds

that belonged to the basket of bonds cheapest to deliver, but held to maturity by banks.

This was one of the major reasons, why IRFs didn't work in India. In other countries

such as Malaysia, Korea and Singapore, bonds are liquid and are traded across maturities,

while in India they are held till maturity by regulation.

CONCLUSION

16 | P a g e

The primary objective in allowing the introduction if interest rate derivatives is to

make available to a broader group of economic agents an participants an effective hedging

instrument which is immune to market manipulation and systematic risk. The broader group

of economic agents comprises of banks, primary dealers, insurance companies and provident

funds which carry almost 90% of interest risk exposure of GoI securities between them. It is

the largest constituency that requires a credible institutional hedging mechanism to serve as a

“true hedge” for their interest rate risk exposure.

G- Secs yield curve being the ultimate risk free sovereign proxy for pure time value of

money, delivers all over the world, without exception, the most crucial and fundamental

public good function or role in the sense that all riskier financial assets are valued or priced

off it at a certain spread over it. Besides, but significantly, IRFs, are more liquid due to their

homogeneity unlike the underlying basket of GoI securities.

It must be noted that the OTC products had a successful reception in the Indian

markets whereas exchange traded ones like the IRFs failed to take-off. Even though

appropriate steps were taken to restart the IRF market with an objective to provide wider

aggregations of risk management tools and thereby enhance the efficiency and stability of the

financial markets, the IRFs failed several times.

The IRF market depends, for its liquidity, depth and efficiency, on significant

presence of all classes of participants, viz. hedgers, speculators and arbitrageurs. Restricting

the participation of banks only to hedging activities impairs the liquidity of the market.

Therefore, in my opinion, banks must be allowed to take trading positions in IRF subject to

prudential regulations including capital markets. Further, the current approval for banks’

participation in IRF for hedging risk in their underlying investment portfolio of G-Secs

should be extended to the interest rate risk inherent in their entire balance sheet.

Banks were allowed to classify their GoI securities portfolio held for the purpose of

meeting SLR requirements as HTM as a financial stability measure. Availability of IRFs as

hedging instruments to manage interest rate risk acts as a remedy to this situation. Therefore,

the existing dispensation should be reviewed, synchronously with the introduction of IRF.

Thus, in my opinion, the current dispensation to hold the entire SLR portfolio in Held Till

Maturity category be reviewed synchronously.

The recommended accounting practice in case of IRF, premised on the concept of

effective hedge conforms to the international best practice that in respect of IRS has been

couched in general terms and has spawned varying practices. Unless this imbalance is

addressed, market response will continue to be against IRFs. Also, in order to ensure that the

prices in spot and futures market are firmly aligned, it is necessary that the accounting

17 | P a g e

practices for derivatives as well as underlying are also aligned. In this context, it needs to be

recognized that IRF is marked-to-market daily and daily gains or losses are received or paid

through daily variation margins. This is precisely what makes IRF a zero-debt product. Thus,

the accounting method for underlying also needs to be fully aligned to reflect the character of

the hedge.

The need to reconcile the desirability of short selling in cash market symmetrically

with the futures market owing to the very persuasive rationale of cash futures arbitrage which

alone ensures the connect between the two markets throughout the contract period and also

forces convergence between cash and futures markets, at settlement. Therefore, according to

me, the time limit on short selling be extended so that term, tenure or maturity of the short

sale is co-terminus with that of the futures contract and a system of transparent and rule based

pecuniary penalty for subsidiary general ledger bouncing be put in place, in lieu of the

regulatory penalty currently in force.

The success of a physically settled IRF market depends upon a well functioning and

liquid repo market. The collateralized segment of the overnight money market is dominated

by the CBLO which is akin to tri-partite repo. Notwithstanding the efficiency of the CBLO

market as a money market instrument, the fact remains that it cannot serve the purpose of a

‘short’ that needs to borrow a specific security for fulfilling the delivery obligations.

Therefore, for the success of IRF, it would be necessary to improve the efficiency and

liquidity of the repo market.

The RBI (Amendment) Act 2006, vests comprehensive powers in the RBI to regulate

interest rate derivatives except issues relating to trade execution and settlement which are

required to be left to respective exchanges. According to me, considering the RBIs role in,

and responsibility for, ensuring efficiency and stability in the financial system, the broader

policy, including those relating to product and participants, be the responsibility of the RBI

and the micro-structure details, which evolve through interaction between exchanges and

participants, be best left to respective exchanges.

With a view to ensuring symmetry between cash market and GoI securities (and other

debt instruments) and IRF, as also imparting liquidity to the IRF market which is an

important step towards deepening of the debt market. In my opinion IRFs may be exempted

from Securities Transaction Tax (STT).

REFERENCES

18 | P a g e

Report on Interest Rate Futures- Reserve Bank Of India

IRF Brochure- National Stock Exchange India Limited

Report on Interest Rate Futures- Reserve Bank Of India and SEBI

Interest Rate Futures- MCX-SX

Interest Rate Futures- Manish Bansal (Asst. General Manager, SEBI)

Interest Rate Futures: third time lucky- Live Mint

Why are our markets averse to hedging- Economic Times

Its second death for Interest Rate Futures- Deccan Herald

Interest Rate Futures to see regulatory changes- The Indian Express

Trying to revive India’s IRFs and failing each time- Mostly Economics

Interest Rate Futures in India- A1 Investor

19 | P a g e