Rama Krishna Vadlamudi, HYDERABAD

18 October 2013

www.ramakrishnavadlamudi.blogspot.in

Interest rate futures (IRF) may be relaunched for the third time in India, according to media reports widely circulated today—quoting sources in the Reserve Bank of India, India’s central bank. Exchange traded interest rate futures (ETIRF) were earlier launched by National Stock Exchange (NSE), country’s premier stock exchange, once in 2003 and again in 2009. If this financial derivative product is launched again, this will be third time that the product will be making a re-entry in the Indian market. On 31 August 2009, NSE relaunched ETIRF based on 10year Government of India (GOI) security having a notional coupon of 7 percent, with physical settlement. And on 4 July 2011, NSE launched another IRF based on 91-day Treasury Bill, with cash settlement. Initially, these two products experienced some trades from market players. Later, market interest in these products died down. According to NSE’s IRF Tracker, trades are nil in them now. Liquidity was confined to only a few government bonds. Traders were not interested in holding such illiquid bonds,

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18 October 2013

which adversely affected trading interest in this ETIRF product. The failure of this product could be attributed to a few things. The ownership of government securities in India is highly skewed towards banks and insurance companies, which keep these assets for long term and their risk appetite for trading is very low. So only a few players are in this market. Another distorting factor is that banks need not value government securities as per the market value at day’s end (mark-to-market or MTM) since bulk of their investments are allowed to be kept in held-to-maturity (HTM) category. More than 90 percent of such securities are held in this HTM category, which prompts banks not to trade them and thereby avoid any interest rate risk. Moreover, RBI is the Government’s money manager, undertaking issue of government securities, treasury bills and cash management bills. As a regulator and as a government’s fund manager, RBI exercises enormous control over banks in India—relating to reserve requirements and tweaking rules. As a Government's money manager and enforcer of reserve requirements for banks, it can be said that RBI has a conflict of interest. (However, a few studies dispute this conflict of interest argument). If this interest rate futures product is to made successful in the Indian market, both RBI and SEBI (Securities and Exchange Board of India, capital market regulator) will have to make it more attractive by allowing flexibility for exchanges to design the product and features, allow cash settlement as against physical settlement, and permit contracts in various maturities.
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18 October 2013

Time will tell whether the new RBI governor, Raghuram G Rajan, will make this product click and tick. (Please see below to know about basics of interest rate futures, their features and contract specifications). -----------------------------------------------------------------------For the benefit of readers, I reproduce my earlier article dated 28 August 2009 when NSE relauched interest rate futures.

Interest Rate Futures – An Update
Rama Krishna Vadlamudi
MUMBAI August 28th, 2009 vrk_100@yahoo.co.in

It is two months since the operational guidelines for ETIRF were issued by an RBI-SEBI Committee. Now, National Stock Exchange is re-launching trading in ‘Exchange-Traded Interest Rate Futures’ (ETIRF) from August 31, 2009. The operational guidelines for the interest rate futures (IRFs) in India were issued on June 17, 2009, by a committee jointly set up by RBI and SEBI. Institutions like, banks, insurance companies, primary dealers, pension funds, mutual funds, financial institutions, companies and provident funds are exposed to interest rate risk on account of their huge exposure to government securities and other fixed income securities. To mitigate the interest rate risk, RBI along with SEBI, has introduced interest rate futures in India. This is a measure that helps in deepening the debt market in India. (IRFs were first launched in 2003 by National Stock Exchange, but did not find favour with market players).

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18 October 2013

Exchange-Traded Interest Rate Futures (ETIRF): An IRF is a contract between two parties – a borrower and a lender – who agree to fix the rate at which they will borrow/lend on a future date. To put simply: • It is a hedging mechanism used by economic agents affected by interest rate movements • Alternatively put, it is a tool to manage interest rate risk • It is a derivative contract – providing standardization and transparency • It may be used by banks, insurers, primary dealers, provident funds, etc • Even FIIs and NRIs are allowed to take trading positions subject to norms • It will be traded on a stock exchange which bears the counterparty risk Who are permitted: • Members registered by SEBI for trading in currency/equity derivatives are eligible to trade in IRF • Even individuals who have got interest rate exposures inherent in their fixed deposits, housing and car loans can hedge their positions with the help of an IRF • The minimum net worth of a trading member should be Rs one crore • The minimum net worth of a clearing member should be Rs 10 crore The Exchange-Traded IRF product: • The IRF is based on yield-to-maturity curve • The notional coupon on the underlying 10-year Government Security would be seven per cent with semi-annual compounding • The size of the IRF contract would be Rs two lakh • Maximum maturity of the contract will be 12 months • The contract will be settled by the physical delivery of securities • The contract cycle will be at the end of March, June, September and December quarters

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18 October 2013

Gross Open Position: • The gross open position of a trading member across all contracts should not exceed 15 per cent of the total open interest or Rs 1,000 crore, whichever is higher • At the client level, the gross open position should not exceed six per cent of the total open interest or Rs 300 crore, whichever is higher • FIIs and NRIs, the gross long position in the debt market and the IRF contract should not exceed their maximum permissible debt market limit prescribed from time to time. What is not permitted as of now: • IRF based on overnight rate (based on money market rates) is not permitted • IRF based on 91-day Treasury bill is not permitted now, but may be considered later NSE’s ETIRF Product:

The salient features of NSE’s new product are:
NSE Contract Specifications
Trading unit Underlying Tick size Trading hours Contract trading cycle Last trading day Quantity Freeze Settlement One lot – equal to notional bonds of FV of Rs 2 lakhs 10 Year Notional Coupon bearing Government of India (GOI) security (Notional Coupon 7% with semi annual compounding) Rs.0.0025 paise Monday to Friday 9:00 a.m. to 5:00 p.m. Four fixed quarterly contracts for entire year ending March, June, September and December Seventh business day preceding the last business day of the delivery month 501 lots or greater Daily settlement MTM: T + 1 in cash Delivery settlement : In the delivery month i.e. the contract expiry month Daily Settlement in Cash GOI securities

Mode of settlement Deliverable Grade Securities

NSE has waived transaction charges on IRF until December 31, 2009

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18 October 2013

Till now, the only interest rate derivative available for trading is Overnight Indexed Swap (OIS) which is a type of Interest Rate Swap (IRS). Interest rate swaps are agreements where one side pays the other a particular interest rate (fixed or floating) and the other side pays the other a different interest rate (fixed or floating). However, OIS is traded in the OTC market. The new IRF is the first interest rate derivative that is being traded on an Exchange. IRF will be the first derivative product which will be settled by delivery whereas other exchange-traded derivatives (for example, stock futures, index futures, index options, etc) are settled by cash. Physical delivery will be in the demat form through the depositories NSDL, CDSL and Public Debt Office (PDO) of the Reserve Bank of India. Other Exchanges: While NSE introduces ETIRF from 31.8.09, BSE it appears would introduce the product through United Stock Exchange in which BSE took a 15 per cent stake recently. Interest Rate Scenario: The huge borrowing programme of the Indian Government has muddied the interest rate scenario. What has been exacerbating the interest rate situation is the food inflation (based on Consumer Price Index or CPI) which has been rising to alarming levels of more than 10 per cent for several months. Any pick up in credit disbursement during the oncoming festive season and credit off-take from corporate sector during the secondhalf of the fiscal year will put further pressure on the interest rates. With the benchmark 10-year Government Security yield hovering around 7.30 per cent, an increase of more than 30/35 basis points in the past one month; the bond market is jittery about further hardening of bond yields. The bond market has completely lost the appetite for new government paper with Banks’ SLR (statutory liquidity ratio) holdings higher by more than 300 basis points over and above the statutory levels. The 10-year benchmark yield is expected to touch 7.50 per cent in the next few months due to higher inflationary expectations, huge government borrowing programme, loss of agricultural output of around 20 per cent during the Kharif Season on account of monsoon failure across several states in India, rising international crude oil prices and anticipated credit demand in the second half of the fiscal. However, any revival in the
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18 October 2013

manufacturing sector and consequent rise in tax collections; usage of disinvestment proceeds that are kept in National Investment Fund (NIF) for reducing fiscal deficit; and huge resources of around Rs 35,000 crore that are expected to accrue to the Government’s exchequer from 3G spectrum auction to the Telecom Sector are likely to mitigate the crunch situation in the interest rate cycle in India. The launch by NSE is ushering in a product that seems to have been timed well in the current rising interest rate scenario so that market participants can hedge their positions.
Note: Interest rate risk: If interest rates rise, the bond prices will fall. Similarly, if interest rates fall, the bond prices will go up. As such, the movement of interest rates will have a big impact on the bondholders; be it, banks, insurance companies, mutual funds or such others, including individuals. The risk that the interest rate fluctuations will affect the prices of bonds or fixed-income investments is interest rate risk. References: RBI Report on IRF dt. Aug.8, 2008; RBI-SEBI Report on IRF dt. Jun.17, 2009; and NSE. --Disclaimer: The author is an investment analyst, equity investor and freelance writer. This writeup is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/
http://www.scribd.com/vrk100
Connect with him on twitter @vrk100

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