Interest Rate Futures

Introduction

Treasury Bills are money market instruments to finance the short term requirements of the Government of India. These are discounted securities and thus are issued at a discount to face value. The return to the investor is the difference between the maturity value and issue price.

Types of Treasury Bills: There are different types of Treasury bills based on the maturity period and utility of the issuance like, ad-hoc Treasury bills, 3 months, 6 months and 12months Treasury bills etc. In India, at present, the Treasury Bills are issued for the following tenor’s 91-days, 182-days and 364-days Treasury bills

A contract on the future delivery of interest-bearing securities, primarily Treasury bills (on the Chicago Mercantile Exchange) or Treasury bonds (on the Chicago Board of Trade), although contracts on certificates of deposit, Ginnie Mae certificates, and Treasury notes are also available. As with other futures contracts, interest rate futures permit a buyer and a seller to lock in the price of an asset (in this case, a specified package of securities) for future delivery. The contracts are large in amount ($1 million for bills and $100,000 for bonds) and lend themselves to sophisticated analysis.

An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate.

The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 [1] were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cash flows. This compares with 75% for foreign exchange options, 25% for commodity options and 10% for options. It consists of swaps ,forwards and futures

An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. Unlike corporate bonds, interest rate swaps do not involve risk on the principal amount[1]. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments

Interest rate futures: Overview

The concept of interest rate futures is like that of any other derivative product, except for the underlying --- the underlying security here is not a stock or basket of securities but interest rates. The underlying instrument for this is a 10-year notional coupon-bearing government security. This

1 Interest Rate Futures underlying security is assumed to pay interest (called a coupon) at a rate compounded at 7% on a half- yearly basis.

Interest rate futures are primarily seen to be of use to those who have a view on how the interest rate would move and wish to benefit from it. It can also be used as a hedging mechanism for anyone who holds a large number of government securities, which largely comprise banks or other such financial institutions.

The introduction of trading in interest rate futures in the country heralds the beginning of a new era in the fixed income derivatives market. Initial hiccups with regard to the product design and variations from the global standards would settle down over a period of time and the product would emerge as a path breaker, paving the way for many more initiatives on the derivatives front.

The introduction of trading in interest rate futures in India is one more step towards integration of the Indian Securities Market with the rest of the world. Globally, interest rate derivatives are the darlings of the market and account for around 70% of the total derivatives transactions across the economies. In India, it may be seen as a path breaking initiative because it is expected to pave the way for various innovations at the derivatives front in the time to come.

Although market participants have unanimously appreciated the initiative, there appears to exist certain apprehensions in their mind with regard to the product design.

Introduction to interest rate futures

Interest Rate Futures account for the largest volume and notional value among the financial derivatives traded on exchanges worldwide. Globally, according to data released by the Bank for International Settlement (June 2009), the notional principal amount outstanding in organized exchanges across all futures instruments amounts to US$18.5 trillion in March 2009, of which $17.8 trillion pertains to Interest Rate Futures. In Asia, the notional amount outstanding in Exchange Traded Interest Rate Futures is estimated at US$1.9 trillion in March 2009. Worldwide, 74 million Interest Rate Futures contracts are outstanding in organized exchanges as on this date. For financial markets in

2 Interest Rate Futures

India, Interest Rate Futures present a much needed opportunity for hedging and risk management by a wide range of institutions and intermediaries, including Banks, Primary Dealers, Corporate, Asset Management Companies, Financial Institutions, Foreign Institutional Investors and Retail Investors. Interest Rate Futures will help various constituencies in providing an effective and efficient mechanism to manage interest rate volatility

They are essentially(over-the-counter OTC) contracts traded on one to one basis among the parties involved, for settlement on a future date. The terms of these contracts are decided by the parties mutually at the time of their initiation. If a forward contract is entered into through an exchange, traded on the exchange and settled through the Clearing Corporation/ House of the exchange, it becomes a futures contract.

As one of the most important objectives behind bringing the contract to the exchange is to create marketability, futures contracts are standardized contracts so designed by the exchanges as to ensure participation of a wide range of market participants. In other words, futures contracts are standardized forward contracts traded on the exchanges and settled through their clearing corporation/house.

Futures contracts being standardized contracts appeal to a wide range of market participants and are therefore very liquid. On the other hand, the clearing corporation/house, in addition to settling the futures contracts, becomes the counter-party to all such trades or provides unconditional guarantee for their settlement, thereby ensuring financial integrity of the entire system. Therefore, although futures contracts take away the flexibility of the parties in terms of designing the contract, they offer competitive advantages over the forward contracts in terms of better liquidity and risk management. It is simple to comprehend that futures contracts on interest rates would be called interest rate futures. Let us look at the Forward Rate Agreements (FRAs) being traded in the OTC market. In case of FRAs, contracting parties agree to pay or receive a specific rate of interest for a specific period, after a specific period of time, on a specified notional amount. No exchange of the principal amount takes place among the parties at any point in time. Now, think about bringing this contract to the exchange. If we bring this FRA to the exchange, it would essentially be renamed as a futures contract. For instance, Eurodollar futures contract (most popular contract globally) is an exchange traded FRA on 3 months Eurodollar deposits rates.

To comprehend the product further, now think we are entering into an FRA on an exchange. First thing would be that we would trade this contract on the exchange in the form of a standard product in terms of the notional amount, delivery and settlement, margins etc. Having entered into the contract, we can reverse the transaction at any point of time. Indeed, having reversed, we can again enter into the contract anytime. Therefore, these exchange traded FRAs (futures contracts) would be very liquidity. Further, in this contract, clearing corporation / house would bear the counterparty risk.

The transaction mentioned above is pretty simple. But, world does not trade the interest rate futures so simply. Indeed, product designs are much more complicated and they are different both at the long and short end of the maturity curve.

3 Interest Rate Futures

Interest rate futures in the global context

Most of the global markets trade futures on two underlyings - one at the long end (maturity of 10 years or more) and another at the short end (maturity up to one year) of the yield curve. The futures on the long end of the yield curve are called the Long Bond Futures and futures at the short end of the yield curve are called the T-Bill Futures and Reference Rate Futures. Some markets do trade futures on underlyings with multiple maturities say of 2 years and 5 years as well, but volumes in these products speak for their poor receptivity by market participants. In other words, most of the volumes in the global markets are concentrated on derivatives with one underlying at the long end and one underlying at the short end of the yield curve.

In global markets, underlying for the long bond futures is a notional coupon bearing bond. These contracts are generally physically settled but some markets do have cash settled products. For instance, Singapore trades 5 years gilt futures, which are cash settled. Chicago Board of Trade (CBOT) also trades futures on the 10 year Municipal Bond Index, which is also a cash settled product. Methodology of the physically settled products is beyond the scope of this work. The simple thing to understand here is that there are concepts like basket of deliverable bonds, conversion factors, cheapest to deliver bond, delivery month etc. Price quote for long bond futures is the clean price of the notional bond, across the markets.

4 Interest Rate Futures

On the short end of the yield curve, global markets have two kinds of products - T-Bill futures and reference rate futures. T-Bill futures are essentially the futures on the notional T- Bills, which are physically settled. But, reference rate futures are the futures on reference rates like London Inter-bank Offer Rates (LIBOR) and are cash settled. Over a period of time, these reference rate futures have rendered the T-Bill futures out of fashion. Possible reasons for this phenomenon are that they are easy to comprehend, have very wide participation from across the globe and are cash settled. The success of reference rate futures may be measured by the volumes they command in the international markets. Indeed, all major markets across the globe trade them. For instance, Japan trades futures on the Japan inter-bank offer rates (JIBOR), Singapore trades futures on Singapore inter-bank offer rates (SIBOR), Hong Kong trades futures on Hong Kong inter-bank offer rates (HIBOR).

Interest Rate Futures (IRF) is expected to provide the following benefits to market participants:

1) IRF will expand the scope of the financial markets in India and will further deepen the derivatives markets.

2)Exchange Traded IRF are most transparent in terms of price discovery, margining, risk management and settlement.

3) IRF will enable Corporates to hedge interest rate risk. Interest payments form one of the major parts of the expenditure for companies. Volatility in interest rates could be better managed with the help of Interest Rate Futures.

4) IRF will provide banks and financial institutions with an avenue for efficient Asset-Liability Management.

5)Fund managers and Insurance companies can better manage asset allocation and investments using IRF.

6) IRF will also help individuals in efficient management of the household balance sheet.

5 Interest Rate Futures

Structure of the product in the Indian Market

Products proposed to be launched in the Indian Market are futures on long bond (10 year notional G- secs) and T-bills (91 days notional). This is in line with the international practice on the interest rate derivatives. Reference rate short end products i.e. the futures on Mumbai Inter-bank Offer Rate (MIBOR), Mumbai Implicit Forward Offer Rate (MIFOR) etc. are proposed to be launched after certain legal issues related to these products are resolved. Issues like the coupon of the underlying notional long bond and the maturity of the futures contract (subject to it being maximum of one year) are left to the exchanges to decide upon.

Both these products Long bond futures and T-Bill futures are proposed to be settled in cash based on the Zero Coupon Yield Curve (ZCYC). The final settlement value of these futures contract 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 (MTM) purpose, in case futures do not see any trade during the last half an hour of trading. The ZCYC is proposed to be derived from the actual traded prices of the 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).

Salient Features of Exchange Traded Interest Rate Futures:

1)Increased market reach enables higher liquidity.

2) Exchange platform ensures protection against counterparty default risk, due to novation by Clearing House of the Exchange.

3)Greater transparency due to automated anonymous order matching system, and settlement.

4)Delivery of underlying asset is possible on Exchange platform.

5) Futures contract available on Notional 7% coupon 10-year Government of India Security as the underlying asset.

6 Interest Rate Futures

6) Large number of Informed Participants can trade using online electronic trading systems, leading to efficient price discovery.

7) Allows hedgers to efficiently transfer risk to speculators and arbitragers.

8) Exchange Traded IRF ensure robust systems for risk management and surveillance, thereby, capable of eliminating any kind of market manipulation.

9)Uniform standards and well-established procedures in IRF market allow symmetry of treatment to various participants.

10) IRF expands the set of hedging tools available to financial as well as non-financial entities to manage interest rate risk.

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

12)IRF are standardized products that allow for gauging the utility and effectiveness of different positions and strategies.

13) Online real-time dissemination of prices.

Trading Techniques

For example 1:

On 1/1/2003, the notional 10-year bond (from

ZCYC) was Rs.45.43.

You believe the long rate will go up, so you short three futures contracts (12,000 bonds) @ Rs.49.

On 31/1/2003, the notional 10-year bond is at Rs.39.

You have a profit of Rs.10/bond or Rs.120,000 overall.

Example 2:

The futures contract expires in 30 days.

30 days from now, the seller is obligated to deliver a

90-day tbill.

So:

1. Buy a ZC bond with 120 days to expiry

2. Short the 90 day futures with 30 days to

7 Interest Rate Futures expiration

This is a locked in position!

This is cash and carry arbitrage.

Example 3

1.Get S by selling 120 day bond

2. Invest it into a 30-day tbill, gives S(1 + r30=365)30=365 on futures expiration.

3. Buy 90-day futures @ F.

4. On expiration date, I’m left with

S(1 + r30=365)30/365- F in hand. Reverse cash and carry.

Pricing futures through arbitrage

We said that the cash and carry arbitrage would be

worth doing when F > S(1 + r30=365)30/365.

Reverse cash and carry arbitrage would be worth

doing if F < S(1 + r30=365)30/365.

We get the “fair price” of the futures contract when

there is no arbitrage, ie,

F = S(1 + r30=365)30/365

8 Interest Rate Futures

Interest Rate Futures Market Participants

1) Banks and Primary Dealers

Interest Rate Futures enable Banks and Primary Dealers to mitigate risk, improve process efficiency and increase their bottomline. Following are some of the scenarios, when IRF can benefit Banks and Primary Deal

1) Manage "Yield Curve Risk", when banks are exposed to assets and liabilities across different tenors.

2) Mitigate "Basis Risk", when yield on assets and costs on liabilities are based on different benchmarks.

3) Hedge against “Repricing Risk", related to volatility of cash flows, due to revaluation of assets and liabilities ove a period of time.

4) Protect against devaluation of SLR and non-SLR securities inventory (held under Available For Sale and Held For Trade categories) due to sudden spike in bond yield rates (and consequent decrease in bond prices).

5) Exposure to embedded options in structured product can lead to "Option Risk", due to varying "Optionality". For example "Puttability" of mortgage (home) loans, by borrowers, due to home-loan refinancing in lower interest rate regime.

6) Improve the financial performance, by increasing the"Yield on Fund Advances" ratio, thereby, decreasing the "Breakeven Yield Ratio" for the bank, resulting in increase in "Net Interest Income".

7) Decrease the sensitivity of returns on bank assets and liabilities, due to volatility in interest rates.

8) Banks have lower entry and exit costs by using IRF, as compared to Interest Rate Swaps (IRS).

9) IRF pricing is directly dependent on the widely accepted Government of India Securities leading to efficient price discovery and high liquidity.

10) Clearing and settlement through exchange clearing houses ensures safety for banks, leading to decrease in risk capital allocation for hedged assets and better "Capital Adequacy Ratio".

9 Interest Rate Futures

11) Smaller lot size of IRF provides avenue for banks to develop mechanism for hedging risk exposure of retail clients.

12) Banks can pass on the hedge benefit to the borrowers through packaged debt products.

13)Primary dealers can use IRF for interest rate risk mitigation in the process of adhering to RBI guidelines for annual minimum bidding for dated securities, minimum success ratio, minimum annual turnover limits and commitment to underwrite the shortfall (gap) between the subscribed accepted amount and the notified amount.

14) Banks and Primary dealers can minimize portfolio volatility by using IRF.

10 Interest Rate Futures

2)Mutual Funds :Mutual Fund managers can immensely benefit from IRF. The Net Asset Value can be protected by hedging against interest rate volatility. Following are some of the major benefits to these participants: a)Hedging to mitigate interest rate risk for Debt Market MF b)Increasing the absolute performance of a portfolio on a risk adjusted basis over a specific time period (improved Jensen's measure and lower drawdown as compared to unmanaged portfolios). c) Investors can diversify their portfolio, by taking positions in Interest Rate Futures, resulting in increased Sharpe ratio (risk adjusted returns). d)Easy entry into and exit out of debt market exposure. e)Arbitrage between cash and futures markets. f)Low transaction costs due to higher liquidity g)Spread Trading to leverage on interest rate differentials. h)Leveraged trades using IRF i)Value-added services for Clients using Interest Rate Futures. j)MTM Settlement on T+1 day basis through Exchange Clearing House. k)Innovative Mutual Fund (Money and Debt Market) Products using Interest Rate Futures, to mitigate risk. l)Optimize NAV by hedging interest rate risk m)Exchange Clearing Corporation provides counterparty guarantee to trades, thereby minimizing risk. n)Efficient price discovery and greater liquidity due to wider participation o)Electronic trading on exchange platform.

11 Interest Rate Futures

3) Insurance Companies

Following are some of the major benefits of Interest Rate Futures for Insurance Companies, both in Life Insurance and General Insurance Industry: a)Hedging: Insurance companies having exposure to Government Securities and Corporate Debt can leverage on Interest Rate Futures, for mitigation against volatility of interest rate bearing assets and liabilities.

b)Decrease Loss - Expense Ratio and Increase Investment Yield of assets. c)Increasing Return on Investments and Decreasing the Insurance Claims-ratio due to foreclosures. d)Efficient management of Asset-Liability mismatch e)Hedging against events such as credit crisis, leading to increased claims against Social Insurance and Bond Insurance policies. f)Protection against Reinsurance risk g)Decrease underwriting expenses of insurance policies, by effective and efficient management of interest rate risk. h) Protect payment of Annuities in Pension Funds, as well as manage liquidity requirements in Endowment Insurance policies.

i) Increase the return on investments in Interest bearing securities, thereby enhancing actuary numbers for the Insurance Company. j)Hedge against interest rate risk for protection of the Sum Assured. k)Increase reversionary and terminal bonus, interest rate risk management. l)Innovative Insurance Products using Interest Rate Futures can be structured.

12 Interest Rate Futures

4)Corporate Houses :Corporates need to identify, measure and mitigate risk pertaining to interest rate volatility. Interest Rate Futures (IRF) provide the mechanism to manage risk at strategic and operational level, pertaining to volatility in interest rates. Following are some of the major benefits to Corporates, by hedging using IRF:

Optimizing the cost of capital to company, leading to optimal "debt-equity" ratio, based on interest rate risk management using IRF.

Implementation of efficient processes and systems for improving credit terms for clients, based on improved interest rate risk management.

Improve the "Enterprise Value" to "EBIDTA" ratio, by better management of interest rate risk.

Sophisticated management of debt and interest rate cash outflows, can lead to effective use of debt as a tax-shield.

Corporate issuing bonds with "embedded options" (callability and puttability), can better manage risk against volatility in interest rates, leading to the exercise of the option by borrowers.

Corporates having debt exposure can mitigate risk against volatility in interest rates, by using IRF. Example: Debt linked to floating rate cash outflows can impact future financial performance, due to adverse movement (increase) in interest rates.

Smaller lot size in IRF enables better interest rate risk management by SME and MSME.

Hedging using IRF provides lower entry and exit costs as compared to Interest Rate Swaps (IRS)

Better management of interest-rate cash outflow towards funding working capital expenses (short- term debt)

Improve the credit rating for corporate by enhancing the "debt-service coverage" ratio and the "interest coverage" ratio (improved leverage), by better risk management using IRF.

5)Brokers, Foreign Institutional Investors and Retail Participants

6)Banks and Primary Dealers

Issues with the Product

Two major points of differentiation between the configuration of the proposed products in India and the internationally traded interest rate futures are:

13 Interest Rate Futures

1. Products proposed in India are cash settled while internationally traded interest rate futures are largely physically settled.

2. Methodology for cash settlement of futures contracts using ZCYC based approach is nowhere used across the globe.

Let us address these issues one by one.

Products proposed in India are cash settled while internationally traded interest rate futures are largely physically settled.

Actually, this is an issue of debate between the cash settled vs. physically settled derivatives. Worldwide, both cash settled and physically settled derivatives are traded with equal enthusiasm for a variety of reasons. Though the physically settled products offer better hedge and better arbitrage opportunities, they have their own share of competitive disadvantages in terms of the settlement risks and possibility of short squeeze. Short squeeze occurs when the participants with short (sold) positions in the market do not find sufficient underlying in the system to buy and honor their obligations. Short squeeze becomes a major issue specially when the underlying is not very liquid and/or has limited outstanding.

Government Securities have a typical pattern of trading across the globe including in India. Some maturity baskets like 5 years, 10 years, 15 years are pretty liquid in comparison to other maturity baskets. Further, within a specific maturity basket only few securities (generally on-the-run securities, which have yields close to the prevailing yields in the economy) command the volumes. In this environment, markets either choose to have cash settled products or delivery based products linked to a basket of underlying (not a single bond). In case of delivery based products, the basket of deliverable bonds is chosen based on certain criteria such as the outstanding maturity, outstanding amount etc. Still, in the past there have been instances of the short squeeze with delivery based products, in the global markets. Probably, that is the reason why some markets have chosen to go ahead with the cash settled products, which are much easier to understand and trade. For instance, Singapore trades 5 years gilt futures, which are cash settled and are doing absolutely great.

Further, India has been trading cash settled equity derivatives (futures and options) both on indices and individual stocks. There are plans to move to the physically settled equity derivatives over the period of time. The introduction of interest rate derivatives also appear to have been planned on similar lines i.e. start with cash settlement and then move to the physically settled products over a period of time.

Although physically settled products integrate both cash and derivatives market better, in my opinion, the decision to start with the cash settled products is a prudent one going by our own experience with cash settled equity derivatives and the problems linked to the delivery based products. Further, with maturing markets, accumulated experiences and built up competencies, markets can always migrate to the delivery based products. Methodology for cash settlement of futures contracts using ZCYC based approach is nowhere used across the globe.

India has been trading cash settled equity derivatives for quite sometime now. Volumes in these products make me feel that market participants are comfortable with the structure of these products. Accordingly, a segment of the market participants seems to have no complaint about the cash settled

14 Interest Rate Futures interest rate futures but worried about the way these products are proposed to be finally settled. Market participants have been voicing concerns about the ZCYC based approach for the final settlement of the futures contracts. Issues raised are many: a. Instead of ZCYC based final settlement, we may settle the product based on polled yields. b. Market has been using the yield to maturity (YTM) and not ZCYC for various purposes. So better if we use YTM and not ZCYC. c. The ZCYC based approach is complex and difficult to understand. d. ZCYC is being computed in the black box and transparency is an issue. e. Modelling errors with the ZCYC is a major problem. Let us contemplate over these issues one by one. a) The first issue is that of final settlement of the futures contracts based on polled price vs. the ZCYC based approach. Market has been demanding that the final settlement of futures contracts should be based on polled yields and not ZCYC. These arguments are based on the international practice on cash settled interest rate futures and the comfort of market participants with the approach. For instance, Singapore 5 years Gilt Futures are cash settled based on the polled prices from the 11 Primary Dealers appointed by the Monitory Authority of Singapore (MAS). Further, as market has been trading various derivatives like swaps and FRAs on the polled prices (MIBOR and MIFOR), it would be easy for the market to understand the approach.

Though it is right that the prices based on polled yields

(YTM) are much easier to understand and comprehend and there is a precedent in this regard in the Global Markets, it may not be the most scientific way to settle the product. All of us would appreciate that to price a fixed income instrument correctly, its cash flows at the different time horizons must be discounted at the different yields corresponding to their maturity. This may be more complex computationally, but is a more systematic approach to pricing such products.

Further, there are issues with regard to polled prices like transparency and lack of commitment on the participating agencies in the polling process. A segment of the market participants feels that polled prices are governed by the limited number of market participants and in case market participants are also trading in the market, there is a possibility of conflict of interest. Further, as there is no financial commitment on the part of these market participants, their quotes may not reflect the expectations of the overall market. However, some market participants still argue in favour of polled prices based cash settlement approach after addressing the issues raised above because of their comfort.

This issue of polled price vs. ZCYC is limited only to the cash settlement of the futures contracts and once we migrate to the physical settlement of these products there would not be any issue at all. Committee on the subject has already recommended the physical settlement of the products over the period of time. b) The second issue relates to the pricing of fixed income instrument based on YTM vs. ZCYC. In my opinion, as mentioned above, though ZCYC based approach is more difficult, it is more scientific and

15 Interest Rate Futures correct to use that to price the fixed income products. Now, the issue is to make a choice between an easy and practically incorrect approach or the correct and more scientific approach to the subject. At any given point in time, my sense is the we must go with later.

Further, if we look at the issue conceptually, YTM is nothing but a single number (yield) representing all the points on the yield curve over the life of the bond. It is the single yield, which equates the price of the bond with the present value of all its future cash flows. Therefore, YTM can easily be derived from the computed theoretical price based on the ZCYC and the given coupons of the notional bond. In other words, first we may price the notional bond based on ZCYC and then use this price with coupons to rework and find the YTM. This needs a simple piece of software. Indeed, this may be done by the exchanges themselves to give comfort to the market participants. c) Third issue is the difficulty in understanding the ZCYC based approach. It is undoubtedly true; but world is becoming increasingly complex and so also the financial products. Complexity is something we all need to learn to deal with. Just to escape the complexities, we may not continue with something which is scientifically incorrect. Indeed, global markets have no way but to adopt the ZCYC based approach to price the fixed income instruments. Further, the whole mathematical part is to be taken care of by the computers and we need to just understand the way ZCYC would be computed and used to price the said products.

We all would agree that the grasping power of the Indian securities market participants is phenomenal. They may have struggled with the definitions of call and put options two years ago (when equity options were first introduced ) but today the same set of people state that straddle and strangle are conventional products and they need to migrate to the exotic stuff. It is certainly proof of their growing experience in the derivatives markets and the resulting confidence in their abilities to use such complex products for their own benefit. d) As regards the issue of non-transparency of computation of ZCYC, full computational methodology is required to be made available on the website of the exchange or the ZCYC service provider. It would not be difficult for anyone in the market to create his or her own ZCYC based on the given methodology. Therefore, the non-transparency argument does not really hold water. Further argument may be whether we really know how Mibor, Mifor etc. are computed. It is all the confidence in and the credibility of the service provider, which is built over the period of time. It is believed that the same would happen with the ZCYC as well. e) On modelling errors related to the ZCYC, I would agree with the market participants. Modelling errors create basis risk for the market participants but we need to appreciate that this error exists even in the markets, where such contracts are settled through delivery. This happens because in all these markets, traded products are the futures/options on underlying, which is not a specific bond but a set of eligible bonds for the purpose. In other words, this is a kind of cross hedge (one underlying being hedged by derivative on some other underlying), which always carries some basis risk.

Therefore, issues with the product exist but they would be tackled over a period of time. Indeed, the ZCYC providers would make sincere efforts to minimize the errors between the theoretical price of the actual traded bonds based on the ZCYC and their actual market prices. Further, as long as market knows that there is a possibility of certain errors, it discounts for the same while pricing the products.

16 Interest Rate Futures

It is also believed that with the smoothening yield curve and its improved accuracy, the market would automatically gain the confidence.

The Road Ahead

Introduction of Interest Rate Futures is an excellent example of collaborative efforts on the part of market participants, exchanges and regulators. It is a great addition to the existing portfolio of financial products in the Indian Financial Markets. Now, we need to quickly work on the products proposed in the Technical paper prepared by the Securities and Exchange Board of India's (SEBI) risk management group. Availability of the large number of products always creates more and more opportunities for trading, which in turn result in the better price discovery and efficiency in the system.

The SEBI's risk management group has recommended that reference rate products linked to the MIBOR and MIFOR be introduced in the market only after all related legal issues have been addressed in order to avoid the legal risk. Once the said issues are resolved, market would see these products, which are well established and extremely popular globally. The market participants also appear to be really looking forward to these reference rate products.

Another issue is that the market participants should be given the freedom to use these products. Focus of regulations should be on the proper disclosures and the transparency in the operations of the market participants instead of putting the restrictions on their usage. Strategic uses of the products are discovered and rediscovered by the market participants on day to day basis and any kind of restrictions on the products' usage hamper the market developments by containing the creativity and imagination of the market place. Therefore, market participants must be given the freedom to explore the value creation opportunities with these products, within the given framework.

Introduction of Exchange Traded Interest Rate Futures by Securities and Exchange Board of India (SEBI) & Reserve Bank of India (RBI) marks a major policy and product innovation that will have significant impact on the deepening of financial markets in India.

.Derivatives have become a dirty word after the global financial crisis. So why then are our regulators allowing a new type of derivative?

17 Interest Rate Futures

First, futures are simple standard transparent exchange traded contracts. Complex customised OTC products were at the heart of the implosion in the global financial system. Their impact and risk were poorly understood, and there was no record of aggregate amounts outstanding. But such records are there for exchange-traded products. Moreover, modern exchanges have robust risk and margining systems. During the crisis, although many banks became bankrupt not a single exchange had to close down. Therefore, regulators worldwide now want to encourage more exchange-traded derivative products.

Second, there is a myth that Indian financial institutions escaped the crisis because regulations had stifled markets. On the contrary, development of equity and forex markets was rapid in this decade, and they survived the trial by fire. But the slow liberalisation of debt markets was a deliberate strategy. Foreign debt liabilities have delivered severe shocks to emerging market balance sheets; repayments often have to be made when exchange rates are also depreciating, and interest rates rising in defence. But since debt markets serve needs for long-term finance, developing the internal debt market remains a policy aim.

Third, a precondition for a hedging demand for a product is well-established two-way movement in the asset price. India has moved far from the days when interest rates were administered. Repo rates have recently changed from a peak of 9 per cent to a low of 4.75 per cent. The general structure of interest rates have moved with policy rates, although less. The volatility of Indian interest rates has been increasing over the years and is higher now than in most countries of the world. Therefore, interest risk is high for many types of transactions.

Fourth, interest rate futures are part of the market deepening that will improve the transmission of monetary policy. If the impact of a change in their interest rates on bank balance sheets is lower, they will be willing to change lending rates faster, following a policy rate change. They will not wait, as now, for the bulk of deposits to be given at lower interest rates.

Given these advantages, why did interest rate futures fail to take off earlier? First, the two- way movement of policy rates was not so well established. Second, there were design issues. The theoretical zero coupon yield curve used as the underlying, created too much basis risk. This time liquid ten-year G-secs are to be used. Third, only hedging transactions were allowed. This time pure trade is also to be allowed. Banks are naturally long in government securities, so they are largely sellers of future contracts. Speculators and arbitrageurs create opposite position, making trade possible.

18 Interest Rate Futures

19