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Interest Rate Futures in India

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Interest Rate Futures in India 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 2 | P a g e 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. 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. 3 | P a g e Corporate Houses: Companies can reduce their borrowing cost using IRF to manage company‟s exposure to interest rate movement. 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% 4 | P a g e Trader sells 300 contracts of the December 11-12 Year futures contract on 12 October, 2011 at 93.5 Daily MTM due to change in futures price is as tabulated below: Date Daily Settlement Calculation MTM (Rs) Price 12/08/2011 93.6925 300*2000*(93.5- -115500 93.6925) 13/08/2011 93.4625 300*2000*(93.6925- 138000 93.4625) 14/08/2012 93.4575 300*2000*(93.4625- 3000 93.4575) 15/08/2012 93.1275 300*2000*(93.4575- 198000 93.1275) 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. 5 | P a g e 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: 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).
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