INTEREST RATE FUTURES
A. V. Rajwade*
1. Interest rate futures contract have had two
“still births” in India. The first time when the
contract was introduced for trading in 2003,
the banking regulator killed the market by
stipulating that banks can use interest futures
only to hedge exposures. Since, almost by
definition, all banks are “long” in the cash
market, they could only be sellers of futures. As
the banking system is by far the largest player
in the bond market, this restriction effectively
meant that there was nobody on the other side
and the contract could not take off. More
recently, while the banking regulator removed
the restriction on use of the futures market
only for hedging, the design of the contract was
settlement by delivery, not cash settlement.
But the contract also stipulated (by a “copy
paste” of the practices in the U.S. market) that
the bond to be delivered could be any one of
ten. One wonders whether the market was
ready for the “cheapest-to-deliver“ bond
concept, given the fact that the reasonably
liquid bonds in the cash market can be counted
on the fingers of one hand. Also, there are often
“kinks” in the yield curve. Worried that they
would be landed with illiquid bonds on
settlement, participants preferred to stay away
and, once again, the market had a predictable
end.
2. Recently the Securities and Exchange Board of
India has permitted the introduction of a
futures contract on the 91-day Government of
India Treasury Bill. While the design of the
*Shri. A. V. Rajwade is a Forex and Management Consultant
contact does not suffer from any major
impractical stipulations, one also suspects that
it could have been far more user friendly. The
specifications, as they stand, are different from
the practices in the cash market in several ways:
to that extent, there is a “basis” divergence
between the cash and derivatives market. It
stands to reason that, for a derivatives contract
to become popular, it should have
specifications closely paralleling the practices
in cash market so as to readily permit
participants to move from cash to derivatives
and vice versa.
3. The major differences are as follows:
• The T-bill contract is to be quoted on a
“discount yield” basis while the cash market
typically uses the yield-to-maturity. There is a
mathematical relationship between the
discount yield and the yield-to-maturity but,
surely, it would be more useful if the cash and
derivatives market have similar practices.
THE CLEARING CORPORATION OF INDIA LTD.
• Again the cash market in T-bills uses the actual
365 day count convention, while the contract
specification specifies that “The value of 1
basis point change in the futures discount yield
would be ` 5.” By implication, this means that
the day count convention is 30/360, given the
face value of Rs 200,000. Once again, this
seems to be a “cut paste” stipulation borrowed
from the U.S. market. One wonders whether,
even in the year 2011, we need to slavishly
follow the U.S. market practices.
15
 4. Another point also occurs to me. We currently
have outstanding some floating rate bonds
where the coupon is linked to the T-bill rate.
While the coupon re-fixation is at six monthly
intervals, earlier the benchmark was the
average 364-day T-bill rate. The last issue has
changed this to the 182-day T-bill rate: this
obviously makes more sense given that coupon
refixation is at six monthly intervals.
5. There is very little liquidity in the FRB
secondary market. One reason could be a
plethora of bonds with different benchmarks,
spreads and maturities. Floating rate bonds
have obvious advantages for the banks as they
do not carry much of an interest rate risk. It is
therefore desirable that, in the interest of the
growth of a healthy market, the central bank
resorts to price auctions of the re-issues of
existing bonds, than spread auctions of new
issues with different maturities.
6. The cash and derivatives market need to grow
in tandem. It would be useful, therefore, if the
THE CLEARING CORPORATION OF INDIA LTD.
16
T-bill contract specifications are the same as
the benchmark used in the cash market in
floating rate bonds. This could be done in one
of two ways:
• The exchanges could introduce the 182-day T-
bill contract; or
• Fresh issues of FRB's could use a 91-day T-bill
yield as the benchmark, with the coupon to be
re-fixed every quarter.
Such practices would be helpful in the growth of
both the secondary market in FRBs, and a liquid T-
bill futures contract.
7. It is important to remember that, once market
practices become established, there is generally
a great deal inertia in making any changes,
howsoever logical they may be. Take our G-Sec
market which still uses the artificial 30/360 day
count convention, when the far more logical
basis is actual/actual. Hence the importance of
developing market friendly contracts from the
start.