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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.. Interest Rate Futures contracts were first traded in the United States Of
America in 1975 to protect against volatility in interest rates.
The IRFs are of large contract sizes, thus they are not products for small traders. These can be based on the underlying instruments like T- Bills,
Treasury Bonds, Treasury Notes, Eurodollar Futures, etc.
Interest rate futures are used to hedge against the risk of that interest rates will move in an adverse direction. 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 by buying the future.
IRFs were introduced in India in June 2003. 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.
Introduction of exchange traded interest rate futures by SEBI & RBI marked a major policy. For Indian financial markets, IRFs presented 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.
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.
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
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
Basis of Pricing/ Valuation: The problem 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 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: 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. In 2010, it was again tried to restart this based on YTM but again the regulators kept physical settlement and again it failed to pick up. By August 2010, the volumes had fallen by 84%. National Stock Exchange launched trading in interest rate futures in 91-days T-Bills (cash
settled) in July, 2011.
IRF For The Money Market: 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 fiveyear 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.
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 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:
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
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 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 microstructure details, which evolve through interaction between exchanges and participants, be best left to respective exchanges.
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.
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 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 coterminus 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.
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).
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