09. Interest Rate Futures

8/16/2019 09. Interest Rate Futures

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Interest Rate

Futures

RAVI - IBA


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Interest Rate Futures

• Interest Rate Futures (IRF) are derivativeinstruments designed to enable borrowers andlenders of funds to hedge the risk arising fromchanges in interest rates.

• A coman! which is lanning of e"ansion of itsbusiness in the near future would wish to borrowfunds in the future for #nancing such e"ansion.If int. rates rise in the meantime$ the coman!su%ers a loss on account of higher int. ratea!able to borrowers. &he coman! can use int.rate futures contract to hedge the risk.


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'hat are Interest RateFutures

• A futures contract is an agreement to bu! orsell an underl!ing asset at a redeterminedrate (or rice)at a seci#ed eriod in the

future. It is method of locking in* rice for afuture transaction of bu!ing or selling anasset whose rice is +uctuating fre,uentl!.nderl!ing asset of IRF is int. rate bearing

securities such as bonds$ governmentsecurities$ commercial aers$ certi#cate ofdeosits$ treasur! bills etc.


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Introduction Interest Rate Futures

India

• 'hile the name /interest rate futures0 suggests thatthe underl!ing is interest rate$ it is actuall! bondsthat form the underl!ing instruments.

• An imortant oint to note is that the underl!ing ond

in India is a notional* government bond which ma!not e"ist in realit!. In India$ the RBI and the 12BI havede#ned the characteristics of this bond3 maturit!eriod of 45 !ears and couon rate of 67 .a.

•

It is also worthwhile noting that several othercountries have adoted the concet of notional bond$although the characteristics of the notional bondscan and do var! from countr! to countr!.


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• 8ne other salient feature of the interest ratefutures is that the! have to be h!sicall!settled unlike the e,uit! derivatives which

are cash settled in India.• 9h!sical settlement entails actual deliver! of

a bond b! the seller to the bu!er.

• But because the underl!ing notional bond

ma! not e"ist$ the seller is allowed to deliveran! bond from a basket of deliverable bondsidenti#ed b! the authorities.


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• :ike an! other #nancial roduct$ the riceof IRF is determined b! demand andsul!$ which in turn are determined b!

the individual investor0s views on interestrate movements in the future.

• If an investor is of the view that interestrates will go u$ he would sell the IRF. &his

is so$ because interest rates are inversel!related to rices of bonds$ which form theunderl!ing of IRF.


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• 1o$ e"ecting a rise in interest ratesis same as e"ecting a fall in bondrices.

• An e"ectation of rising interest rates(e,uivalentl! of falling bond rices)would therefore lead the investor to

sell the IRF. 1imilarl!$ if an investore"ects a decline in interest rates(e,uivalentl!$ a rise in bond rices)$

he would bu! interest rate futures.


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Rationale of IRFs

• It is not ;ust the #nancial sector$ butalso the cororate and householdsectors that are e"osed to interest

rate risk.

• Banks$ insurance comanies$ rimar!dealers and rovident funds bear

signi#cant interest rate risk onaccount of the mismatch in thetenure of their assets (such as loans

and


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Rationale of IRFs

• &hese entities therefore need a credibleinstitutional hedging mechanism. Interestrate risk is becoming increasingl!

imortant for the household sector as well$since the interest rate e"osure of severalhouseholds are rising on account ofincrease in their savings and investments

as well as loans (such as housing loans$vehicle loans etc.).

• =oreover$ interest rate roducts are therimar! instruments available to hedgein+ation risk$ which is t!icall! the single


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Benets of Exchangetraded IRF

• Interest rate futures rovide bene#tst!ical to an! 2"change-tradedroduct$ such as

• Standardization

• Transparency

• Counter-party Risk (Riskmitigation thro credit guarantee ofthe clearing house)


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IRF Product Features

• &he features of the roduct are as follows3

• !nderlying "ond nderl!ing bond is anotional 45 !ear$ 67 couon-bearing


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• Contract cycle @ew contracts can be introducedb! the 2"change on an! da! of a calendar month. Atthe time of introduction$ the duration of an!contract can var! from 4 month to 4? months.

• &he e"ir! has to be on one of the four specicdays of a year$ specied "y the regulator.2"ir! cannot haen on an! other date. &he set ofe"ir! dates available in a !ear constitute the e"ir!

c!cle or contract c!cle.• &he e"iries seci#ed in the current contract c!cle

are the last business da!s of %arch$ &une$Septe'"er and (ece'"er)


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• (ontracts are referred to b! their resectivee"ir! months. For e"amle$ ecember ?55Ccontract means a contract e"iring in ecember?55C.) &hese four contract e"iries have been

chosen as the! coincide with the ,uarterl!#nancial accounting closure followed b! Indiancomanies.

• &hus$ at an! given time$ a ma"imum of four

contracts can be allowed for trading on thee"change (Vi>.$ =arch$ Dune$ 1etember andecember contracts). urrentl!$ at @12 onl! twocontracts are allowed to be traded.


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Trading Aspects

• Tick size &he tick si>e of the futures contract is Rs.5.55?E. &ick si>e is the minimum rice movementallowed for a futures contract.

• Trading hours Interest Rate Futures are available

for trading from C am till E m on all business da!s.• #ast Trading (ay &he last trading da! for a futures

contract is two business da!s before the expiry date(i.e. the last business da! of the e"ir! month). For

e"amle the last trading date for ecember ?55Ccontract is ?Cth ec ?55C$ because the last businessda! of ecember ?55C is the 4st.


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Settlement Aspects

• %T% Settle'ent and *hysicalsettle'ent For IRF$ settlement isdone at two levels3

• mark-to -market (=&=) settlementwhich is done on a dail! basis and

• h!sical deliver! which haens on

an! da! in the e"ir! month.


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• Final Settle'ent (ates Final settlementwhich involves h!sical deliver! of the bond canhaen onl! the e"ir! date. If an investorwants to li,uidate his osition (i.e.$ sell if the!have bought alread! or vice versa)$ howeverthe! can do so on an! trading da! before thelast trading da!$ which has been de#ned above.

• All investors with an oen short osition as ofthe e"ir! da! are assumed to be delivering thebond on the e"ir! da!$ which is two businessda!s after the last trading da!.


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• (eli+ery Basket of "onds As statedearlier$ the underl!ing notional bond ma!not e"ist in realit! and therefore$ a basket

of bonds is identi#ed which ,ualif! fordeliver!$ an! one of which can be used fordeliver! in lieu of the notional bond.

• &he seller of the futures has the otion to

choose which articular bond todeliver.8nl! certain identi#ed bonds canbe used for deliver!.


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Settle'ent and Risk%anage'ent

• In case of exchange traded derivative contracts,the Clearing Corporation acts as a centralcounterparty to all trades. This principle is called`novationG.

• This means that for settlement, the parties enteringinto a futures contract have obligations not towardseach other $ but towards the e"change on which thecontract is traded.

•Thus the exchange becomes the seller to allcontract buyers and the buyer to all contractsellers. Novation thus entails risk of either party tocontract defaulting.


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Settle'ent and Risk%anage'ent

• &o mitigate this risk$ the e"changeimoses

• (a) margin re,uirements and (b) utsosition limits on both the arties.

• &he margin re,uirement$ the ositionlimits and settlement methods arediscussed below.


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Margin Requirement

• roadly two types of margins are re!uired from eachinvestor entering into a futures contract" namely, Initial#argin and $xtreme %oss #argin.

• 'hen the investors enter into a futures contract$ the!

have to deosit cash or li,uid assets e,ual to the totalof these two margins.

• &he initial margin is arrived at b! taking variousscenarios of market rice movements to rotect thee"change against the default risk of the arties and is

sub;ect to a minimum of ?.7 of the value of thefutures contra ct.

• 2"treme loss margin on the other hand is e,uivalent to5.7 of the contract amount.


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Margin Requirement

• 'hen an IRF contract enters into thee"ir! month$ the investors arere,uired to ost additional margin.

• &his is done because the otentialdefault amount increases during thee"ir! month and the 2"change has

to rotect itself against such rise inrisk.


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*articipants in the Interest RateFutures 'arket

&he articiants in the IRF market are broadl!classi#ed into three grous$ deending onwhat is the urose of their articiation.

Hedgers3 omanies and institutions havinge"osure to interest rates--because of theirholdings of government bonds or theirborrowing (liabilities) and lendings (assets)--

hedge the risk arising from adverse interestrate movement b! using IRF. &hese entitiesare called hedgers.


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*articipants in the Interest RateFutures 'arket

1eculators3 1eculators articiate in thefuture market to take u the rice risk$ which is

avoided b! the hedgers. &he! take calculated

risk and gain when the rices move as er theire"ectation.

Arbitrageurs3 Arbitrageurs closel! watch thebond and futures markets and whenever the!

sot a mismatch in the alignment in the ricesof the two marke ts$ the! enter to make some

ro#t in a risk-free transaction.


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,edging pplications of IR(eri+ati+es

• 8ne wa! to hedge a osition in the sot bond market is totake an oosite osition in the IRF market.

• &his ensures that a change in interest rates will not a%ectthe value of a ortfolio and this strateg! is also called

Interest rate immuni>ation) IR derivatives in general and IRfutures in articular have huge hedging alications unlikee,uit! derivatives.

• &his is because$ almost ever! economic entit! has ane"osure to interest rate +uctuation in some form or the

other. Also$ given its ver! nature$ interest rates get a%ectedb! a number of macro-economic factors. Hence$ hedgingthrough IR derivative becomes crucial. &his is articularl!so in turbulent times$ when economic uncertaint! is high.


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ses of the IR derivatives are as

mentioned below

• sset-lia"ility 'anage'ent Banks t!icall!have lot of government bonds and other long

• term assets (loans given to cororates) in theirortfolio$ while their liabilities are redominantl!

short-term (deosits made b! individuals range from4 to E !ears). &o address the risk resulting from the

asset-liabilit! mismatch$ the! generall! sell IRF andthereb!$ hedge the interest rate risk.

•

8n the other hand$ for the insurance comanies andseveral big cororates$ the tenure of their liabilitiesis longer than that of their assets. 1o$ the! bu! IRFto hedge the interest rate risk.


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ses of the IR derivatives are as

mentioned below

• In+est'ent portfolio'anage'ent =utual funds andsimilar asset classes having a

ortfolio of bonds can use IR futuresto manage their interest ratee"osure in turbulent times.


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Speculation strategies

• :et us now focus on a few simle seculationstrategies3

Long Only Strategy

•

In the view of some investors$ b! consistentl!having a long osition in assets$ articularl! inbonds$ one can achieve fair returns. &he! holdthis view for IRF also$ as IRF has the bond as

its underl!ing. &hese investors bu! IRF andreeatedl! roll them over before each e"ir!.

&his strateg! is called :ong 8nl! 1trateg!.


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Speculation strategiescontd)

• View Based Trading

• In contrast to :ong 8nl! investors$ someinvestors take both long and short ositions in

the IRF market$ deending on their views oninterest rate movements in future. If the!e"ect interest rates to go u$ the! sell IRFand if the! have the oosite e"ectation$ the

! bu! IRF. If the interest rate movement turnsout to be the wa! the investor e"ected$ hewould make ro#t otherwise$ he would makelosses.


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Illustration .ie/ Based Trading

• A trader e"ects a long term interest rate torise. 8n Eth 8ct ?55C$ the trader sells ?E5contracts of the ec ?55C 45 Jear futures on@12 at Rs. C.E5

Closing out the &osition3

• 4Eth 8ct ?55C- Futures market 9rice Rs. C?.6E

• &rader bu!s ?E5 contracts of ec ?55C at Rs.

C?.6E and s,uares o% his osition• &herefore total ro#t for trader is ?E5 " ?555 "

(C.E555 C?.6E) or Rs $6E$555.

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09. Interest Rate Futures

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