Interest Rate Futures. Arjun Parthasarathy Founder INRBONDS.com

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1 Interest Rate Futures Arjun Parthasarathy Founder INRBONDS.com 1

2 Interest Rate Futures Agenda Pricing How it works? 2

3 Interest Rate Futures 3

4 Ten Year Cash Settled IRF IRF on 9 to 10 year maturity (residual maturity) government bonds Coupon same as that of underlying bond On the run and off the run bonds 4

5 Theoretical Price of IRF Dirty price of bond plus financing cost minus accrued interest Example 8.83% 2023 GOI issued 25 th November 2013 Market price of 8.83% 2023 bond (2 nd Jan 2014) = Rs Accrued Interest for 37 days = Rs Dirty Price = Rs Rs = Rs

6 Theoretical Price of IRF Dirty price of bond plus financing cost minus accrued interest Dirty Price = Rs Rs = Rs Futures expiry date 31 st January 2014 Financing Cost 29 days@ 8.43% (14 day term repo rate) Rs Accrued interest on cash bond on expiry 29 days@8.83% Rs Theoretical Futures Price Rs Rs Rs = Rs

7 Ten Year GOI NDS OM 7

8 On The Run Ten Year Bond 8.83% 2023 Bond Maturity 25 th November 2023 Outstanding Issuance Rs 210 billion as of 31 st December

9 Off The Run Ten Year Bond 7.16% 2023 Bond Maturity - 20 th May 2023 Outstanding Issuance Rs 770 billion as of 31 st December

10 Why On and Off the Run RBI has an internal limit for outstanding issuances (currently around Rs 900 billion) Government stops reissuing a bond once limit is reached (or close to limit) New bond is issued to replace old one 10

11 Spread On and Off The Run Bonds New bond trades at lower yield than old bond 8.83% % 7.16% % Spread 32bps (can go up and down depending on market conditions) 11

12 Spread 8.83/

13 Spread Trade Play on widening or narrowing of new and old ten year bond spread Spread widening 32bps and trending higher Buy 8.83 IRF and Sell 7.16 IRF Spread narrowing 32bps and trending lower Sell 8.83 IRF and Buy 7.16 IRF 13

14 Yield and Price Movements on Ten Year Bonds bps Rs % bps Rs 0.06 Price change depends on time to maturity, coupon and yield 14

15 Factors That Determine Ten Year Bond Yields Government Borrowing INR and Policy Rates Domestic and Global Macro 15

16 Uses of IRF 16

17 IRF Uses ETF s, Hedging Mutual Funds Hedging, arbitraging, curve positions Traders Capturing credit spreads Traders Hedging Corporates Calendar spreads, day trading, Speculators Home loan costs, Investments in Bond funds, Tax Free Bonds Investors 17

18 Correlations? Bank Nifty USD/INR OIS (Overnight Index Swaps) 18

19 Ten Year Benchmark Bond Yield vs Bank Nifty 19

20 Ten Year Benchmark Bond Yield vs USD/INR 20

21 Ten Year Benchmark Bond Yield vs 5 Year OIS 21

22 10 Year AAA Credit Spreads Chart 22

23 Bond Market Basics 23

24 Government Securities Traded on price terms Price to YTM (Yield to Maturity) Discounted cash flow method used for price calculation Discount rate is the prevailing yield in the market Yield quoted on a semi annual basis 24

25 Nomenclature GOI 8.83% 2023 Maturity date 25 th November 2023 Semi annual interest payments 25 th May and 25 th November every year Issue date 25 th November 2013 Face value: Rs 100 Current YTM: 8.80% s.a Day count convention 30/360 25

26 YTM = 8.20% Price given YTM 10 year bond has 20 semi annual cash flows Semi annual coupon is 7.80%/2= 3.90% Price= PV of 20 semi annual cash flows + PV of maturity value using discount rate of 8.2% Excel tools- use yield function Yield(settlement date, maturity date, coupon, price, maturity value, coupon frequency,0)= Rs 97.41

27 YTM given price Price(settlement date, maturity date, coupon, yield, maturity value, coupon frequency,0)= 8.20% Annualizing yield= (1+8.2%/2)^2-1= 8.37%

28 Accrued Interest Dirty price = Clean price + Accrued Interest Accrued Interest payable = Coupon rate*principle*(no.of days from last coupn/no.of days in Year) Accrued interest payable at 8.79% for 55 days for 1 bond of face value of Rs 100= 8.79%*100*(55/365)= Rs 1.34 Excel Formula for accrued interest ACCRINT (Issue Date, First Interest Date, Settlement, Rate, Par, Frequency, Basis 28

29 Price dynamics Price increases and yield decreases and vice versa Price moves towards par/face value as the bond moves towards maturity If yield is below coupon rate bond price will be above par If yield is above coupon rate bond price will be below par

30 Thank You Information herein is believed to be reliable but Arjun Parthasarathy Editor: INRBONDS.com does not warrant its completeness or accuracy. Opinions and estimates are subject to change without notice. This information is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The financial markets are inherently risky and it is assumed that those who trade these markets are fully aware of the risk of real loss involved. Unauthorized copying, distribution or sale of this publication is strictly prohibited. The author(s) of the content published in the site inrbonds.com may or may not have investments in the assets discussed in the pages/posts. Copyright INRBONDS by Arjun Parthasarathy

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