Efficacy of Interest Rate Futures for Corporate The financial sector, corporate and even households are affected by interest rate risk. Interest rate fluctuations impact portfolios of banks, insurance companies, primary dealers, provident funds etc. Households with loans to pay off are affected by a rise in rates. Interest rates are linked to a variety of economic conditions. They can change rapidly, impacting investments and debt obligations. Interest rate risk can be minimized through the use of interest rate futures. An interest rate futures contract is "an agreement to buy or sell a debt instrument at a specified future date at a price that is fixed today." Interest rate futures are derivative contracts which have an notional interest bearing security as the underlying instrument. The buyer of an interest rate futures contract agrees to take delivery of the underlying debt instruments when the contract expires and the seller of interest rate futures agrees to deliver the debt instrument. The value of interest rate futures contracts rise and fall inversely to changes in interest rates. As interest rates rise, bond prices fall and consequently the futures prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding bond decreases, since investors are able to realize greater yields by buying other investments that have higher interest rates. Futures prices mirror these rise and falls of the underlying bond prices.. Overview of Interest Rate Futures Interest rate futures are derivative contracts which have an interest bearing GOI security as the underlying instrument. The buyer of an Interest Rate Futures contract agrees to take delivery of the underlying bonds when the contract expires, and the contract seller agrees to deliver the debt instrument. Most contracts are not settled by delivery, but instead are traded out before expiration. The value of the contract rises and falls inversely to changes in interest rates. For example, if Govt. bond yields rise, prices of Govt. bonds fall and hence futures contracts on Govt. bonds also fall in price. Converse also holds true.
Interest Rate Futures at NSE: Particulars Description Symbol 10YGS7 Market Type N Instrument Type FUTIRD Underlying 10 Year Notional Coupon-bearing Government of India (GOI) security Notional Coupon 7% with semi-annual Compounding Tick size 0.25 paise or INR 0.0025 Trading Hours 9:00 am to 5:00 pm (Monday to Friday) Contract Size INR 2 lakhs Quotation Similar to quoted price of GOI securities up to four decimals with 30/360 day count convention. Tenor Maximum Maturity: 12 months Four Fixed quarterly contracts for entire year ending March, Contract Cycle June, September & December. To start with NSE has introduced two quarterly contracts Volume Weighted average price of the contract during the time Daily Settlement Price period specified by the Exchange. If not traded in specified timings then the theoretical price of the contract as determined by the exchange will be the daily settlement price Daily Settlement - Marked to market daily Settlement Mechanism Final Settlement - Physical settlement on delivery day in the delivery month i.e. last working day of the month Deliverable Grade Securities GOI Securities maturing at least 8 years but not more than 10.5 years from first day of the delivery month with a minimum total outstanding of Rs 10,000 crores. The list of the deliverable grade securities will be informed by the exchange from time to time. Further any new security which meets the eligibility criteria as mentioned above shall be added to the list of deliverable grade securities. However, additions, if any, shall be made not later than 10 business days before the first business day of the delivery month Conversion Factor Invoice Price Last Trading Day Delivery Day Initial Margin The conversion factor would equate the deliverable security (per rupee of principal), to yield 7% with semiannual compounding. Futures settlement price times conversion factor plus accrued Interest Two business day preceding the last business day of the delivery month. Last business day of the delivery month. SPAN Based Margin subject to minimum 2.33% on first day and 1.6% subsequently.
Extreme loss Margin 0.3% of the value of the gross open positions of the futures contracts Physical Settlement Mechanism The Interest Rate Futures contracts at NSE would be physically settled by the delivery of deliverable grade securities. Physical delivery will be through electronic book entry system of NSDL, CDSL and SGL/CSGL Settlement through RBI PDO Settlement cycle: T+2 delivery with seller s intention to deliver two business days prior to actual delivery date. Conversion Factor System The invoice value of futures must be adjusted to reflect the specific pricing characteristics of the security that is tendered. Accordingly, bond futures utilize a "conversion factor" to reflect the value of the security that is tendered by reference to the 7% futures contract standard. Conversion factors for all the deliverable securities would be known on the first trading day of each futures contract. Say for example, following are the conversion factors for deliverable securities for a 7% 10Y GOI security future contract: Security Conversion Factor 6.90% GOI 2019 0.9931 6.35% GOI 2020 0.9545 7.94% GOI 2021 1.0713 10.25% GOI 2021 1.2465 8.20% GOI 2022 1.0949 Cheapest to Deliver
The short position holder can choose from the list of deliverable bonds, depending on which of the available bonds is the cheapest to deliver. For that we need to calculate the following for each of the deliverable bond: Current Market Price Adjusted Futures Price The bond with the lowest basis would be the cheapest to deliver (CTD) bond. Basis is equal to the difference between market price of bond and adjusted futures price (futures price multiplied by conversion factor). Financing Cost & Implied Repo Rate Financing cost is the cost of borrowing for funding the long bond position through repo. Implied repo rate is the rate of return that can be earned by simultaneously selling a bond futures contract and then buying an actual bond in the cash market using borrowed money. The bond is held until it is delivered into the futures contract and the borrowing is repaid. Applications of Interest Rate Futures Corporate can primarily use futures for trading and hedging purposes as illustrated below. Arbitrage Strategies If the implied repo rate exceeds the financing cost, then a cash-and-carry arbitrage opportunity exists Hedging for increase in interest rates (short hedge) A Corporate expecting the interest rates to go up and thus, higher cash outflows in future, can hedge the risk by going short in the interest rate futures contracts. Hedging for decrease in interest rates (long hedge) A Corporate expecting the interest rates to go down and thus, lower cash inflows in future, can hedge the risk by going long in the interest rate futures contracts.
Let us understand the use of interest rate futures for corporate with the help of following case studies. Case Study 1: Short Hedge ABC Ltd. plans to issue Rs.5,00,00,000 of 10-year bonds in June, 2010 to help finance a new project. The bonds will pay interest semiannually. It is now November, 2009, and the current cost of debt to the similar company is 12%. However, the firm's financial manager is concerned that interest rates will climb even higher in coming months and the company will be forced to borrow at higher rates. To hedge the risk, the company has decided to take a short position in the interest rate futures which has underlying 7% notional 10 year G-Sec. Currently June Futures contract is traded at Rs. 97.38. As expected, the cost of debt increases by 1.5% in June, 2010 and simultaneously the yields on Government bonds also increase by 1.14%. Cash inflows expected 50000000 Current Cost of Debt 12.00% Price of the Bond Rs 100.00 Price of June futures contract Rs 97.38 Settlement Date 01-Nov-09 Futures Expiry 22-Jun-10 Yield on futures 7.36% No. of bonds to be issued 500000 No. of futures Contracts sold 250 On 22 June, 2010 Cost of the debt 13.50% Price of the Bond Rs 91.90 Loss on bond issuance Rs 4050000 [(100 91.90)*500000] Futures yield at expiry 8.50% Price of June futures contract Rs 90.03 Profit on futures contract Rs 3675000 [(97.38-90.03)*250*2000]
Net Gain / (Loss) Rs (375000) Case Study 1: Cash and Carry Arbitrage Suppose, 8.20% 2022 G-Sec is trading at Rs 106.10. The interest rate futures which has underlying 7% Notional 10 year G-Sec is trading at Rs 96.85. Following details are available. Last Coupon was paid 164 days back Accrued Interest is Rs 3.74 Next Coupon will be paid after 16 days Futures expiry is after 34 days Conversion factor for futures is 1.0986 Accrued Interest till futures expiry will be Rs 0.36. Assume that reinvestment rate for coupon is 4% Assume that short term funding rate is 4.5% Let us find out whether there exists an arbitrage opportunity? Cash flow at the beginning = Bond s Price + Accrued Interest = 106.10+3.74 = 109.84 Cash flow at the end = Futures Price * Conversion Factor + Accrued Interest till futures expiry + Future Value of Interim Coupon = 96.85 * 1.0986 + 0.36 + 4.10*(1+4%*34/365) = 110.87 Implied repo rate = (110.87 109.84) / 109.84 * 365 / 34 Hence the annualized rate of return works out to 10.07% against the short term funding cost of 4.5% which is attractive given the fact that we have entered into a cash and carry arbitrage. The National Stock Exchange (NSE) is one of the largest and most advanced stock exchanges in the world. NSE has set up its trading system as a nation-wide, fully-
automated screen based trading system. It has written for itself the mandate to create new bench marks in world class, infrastructure, technology, risk management, clearing and settlement, investor services and best market practices. It s trading facility can be accessed through a wide network of trading terminals, across the country. The central order book with a tight bid-ask spread provides a liquid market for the investors. NSE has always taken initiatives to facilitate both investors and market participants to avail new opportunities. It has been in the forefront in offering newer products in equities and derivatives segment and also new asset class for the investors to choose from. Some Milestones: April 93 Recognition as a stock exchange November 94 Capital Market (Equities) segment goes live October 95 Became largest stock exchange in the country April 96 Launch of S&P CNX Nifty June 96 Establishment of Settlement Guarantee Fund February 00 Commencement of Internet Trading June 00 Commencement of Derivatives Trading (Index Futures) June 01 Commencement of trading in Index Options June 07 NSE launches new index derivatives January 08 Introduction of Mini Nifty derivative March 08 Introduction of long term option contracts April 08 Launch of Securities Lending & Borrowing Scheme April 08 Launch of India VIX August 08 Commencement of Currency Futures Trading August 09 Launch of Interest Rate Futures Disclaimer Market conditions can lead to substantial profit or loss. Investors are advised to seek adequate product and market knowledge as well as proper investment advice before trading. The material provided here is for general information purposes only. While care has been taken to ensure accuracy, the information furnished to reader with no warranty as to accuracy or completeness of its contents and on condition that any changes, omissions or errors shall not be made the basis for any claim, demand or cause for action.