Beruflich Dokumente
Kultur Dokumente
Vishal M. Padole
Trainee Officer
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 1
Interest Rate Futures in India
Interest Rate Swaps are over the counter (OTC) derivatives contracts
wherein two parties come together for exchanging of interest
payments based on notional principal amount, for a specified period.
The notional principal is used to calculate interest payment but is not
exchanged; only interest rate payments are exchanged. Such contracts
generally involve exchange of “fixed to floating” rates of interest.
Similarly, Forward Rate Agreement is financial contract where one
party can lock in oneself in to fixed or floating rates based on notional
principal amount for specified period and on the settlement date only
differences in the predefined rate & underlying rate are exchanged.
The idea behind the introduction of OTC Interest Rate Derivatives was
to enable the market participants like banks, primary dealers (PD’s)
and All-India financial institutions (FI’s) to hedge interest rate risks and
manage their Asset-Liability in a better way. Unfortunately, the market
for IRS/FRA has not developed. The market has negligible liquidity, with
no serious impact in terms of interest-rate risk management. These
OTC derivatives remain limited to small club of market participants’ i.e.
foreign banks & Indian private sector banks
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 2
Need was felt for hedging instrument which will cater the needs of
different segment of investors in the debt market. Moreover, if that
instrument is exchange-traded instrument, it will also take care of
default risk (i.e. counter party risk is assumed by exchange).With these
considerations and continue with the financial reforms further, Interest
Rate Future were launched on 24 th June 2003. Three products of
Interest Rate Future are available in the Indian market.
Interest Rate Futures are used to hedge the interest rate risk inherent
in the underlying debt instrument. If you are holding G-sec paper and
you believe yield is rising in the near future, the price of debt paper
would come down(as there is inverse relationship between yield &
price).In such a case you would sell a future, which means on the due
date there would be inflow from IRF which will neutralize the
potential losses on G-sec paper.
As the market gets mature IRF will be expected to use for numerous
reasons, some of them are,
The importance of IRF can be seen from the fact that investment
portfolios of banks are continuously swelling on account of Govt.
securities and banks are heavily depend on treasury income for
survival. Therefore, the concern for the interest rate risk is obvious to
them. Despite this, trading in IRF has been consistently falling. Let us
take look at trading volumes in IRF market.
200
150 Traded
Value in Cr.
100
50
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Source: NSE
As seen from above graph they are hardly any trades in the instrument
from last few months. It becomes necessary to know the possible
reasons for non-development of Interest Rate Futures market in India.
Let us look at the some of the possible reasons as to why there is no
volume in the Interest rate Futures market in India.
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 4
Underlying Market
As we, all know Derivatives derive its value from underlying cash
market and if underlying market is not developed and major securities
are illiquid, as the case with Indian debt market. It does not make
logical sense to expect the futures market (Derivatives Market) to pick
up. Therefore, the underdeveloped bond market in India is one of the
major reasons for non-taking off of Interest rate futures market.
Valuation Issues
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 5
Yield to Maturity Method ( YTM Basket)
Zero Coupon Yield Curve (ZCYC) Method &
Cubic Spline Method.
In the Yield to Maturity method, the price of the future contract can be
calculated by using price of basket of most liquid securities. The
criteria for determining the security to be part of liquid basket are
liquidity, term to maturity, amount outstanding and numbers of bonds
etc. The concept of YTM basket is, consider average YTM of three or
more, most liquid securities in the market. This average Yield to
Maturity will be considered as yield on Notional security of future
contact for calculating the future price.
In the Cubic Spline method, the yield curve is drawn based on certain
cubic formulae. It provides interest rates for various terms. The yield
curve from Cubic Spline method is quite flexible and very smooth,
however interest rates generated may some time turn out to be
negative.
Now let us examine some of the highly traded interest rate future
products prevalent worldwide and find out relationship between
methods of pricing of these IRF products and their tradability.
Treasury Bill Future: T-Bill was the first contract of its kind on short-
term debt instrument on CBT. This contract is essentially Physical
delivery based and all T-bills with 3-month maturity & T-Bills with 3-
month residual maturity are eligible for settlement. Pricing is done
based on rate of three months T-bills.
Eurodollar Deposit Future: Eurodollar deposit is dollar deposit outside
United States. Eurodollar future contract is derivatives contract based
on dollar deposit. It is one of the most successful IRF product used at
the short end of the yield curve (short-term nature). The settlement
price is decided by prevailing dollar deposit rate at expiry of contract.
These are cash settled derivatives contracts.
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 7
It is clear from the above examples that different markets are using
different methods of pricing. All these products are doing well in their
respective markets. So it can be safely assume that there is no
relationship between method of pricing of future instrument and
tradability of the product. No single method is applicable to all the
markets. Each market is unique in itself. The point is, there is no
particular method of pricing of Interest Rate Futures, which can be
perfect or accurate. It is the level of comfort of market participants to
the method used, which will determine usefulness/ accuracy of method
of pricing. Therefore, Pricing should be done on the basis of market
conditions, ease of the methodology of pricing, etc. It has been said
that ZCYC is scientifically accurate method of calculating interest rates
for various maturities. Moreover, with new developments taking place
in the Indian debt market, the concept of ZCYC will pick up and
facilitate pricing of future contracts. Even though ZCYC would currently
result in some kind of error, I felt that the market would adjust or
discount such errors. Therefore shifting from ZCYC method of pricing to
YTM method of pricing is not the solution.
Interest Rate
Interest rates in the country pose certain issues for IRF’s trading. These
issues are structure of interest rates in the economy, acceptable
benchmark rate for the market and movements of interest rates.
With such a structure of interest rates, the market for all the
instruments would not be same. Investor will prefer the instrument
where they can get maximum returns with least possible risk.
Therefore, savings are diverted more towards postal saving, NSC etc.
and they will not any takers for G-sec, Commercial Papers etc. There
would not be active trading in the market, which results in IRF not
being used by participants actively and it has been restricted towards
institutional players only. (Banks)
Acceptable benchmark rate for the market is the second issue. The
benchmark rate is the interest rate, which represents the entire
market. This rate can be used for pricing of any kind of Interest Rate
Derivative product e.g., Eurodollar Deposit rate is used for pricing of
Eurodollar Deposit Future contract. In India, there is no such
benchmark rate, represents the market rate and which can be used for
pricing derivatives products. 10-year G-sec paper is supposed to be
benchmark rate but it does not represent the entire market. Even
though NSE has developed MIBID / MIBOR rates, a few players in the
market follow these rates. Term money market(Short term) is not
illiquid so 3 months or 6 months MIBOR /MIBID rates would not solve
the purpose of benchmarking. Since there is no benchmark rate, we do
not have reliable yield curve that provides interest rates for various
term to maturity. Because of which pricing of future instrument
becomes difficult.
Other issues
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 9
Retail investors are likely to stay away from the retail segment of
Govt. securities, as majority of household saving end up in postal
savings, gratuity and provident fund, which have fixed rate of return.
Retail investors are also not aware about risk-return profile of the govt.
securities vis-à-vis other small saving instruments. Moreover, the
transaction cost involved in undertaking debt transaction is also
comparatively higher. Because of this Retail debt, market is not
developed and retail investor would not realize the need for interest
rate futures to hedge their positions. Therefore, Interest Rate Future
market is restricted to narrow participant’s base.
In the current reforms phase, the role of policy maker should be more
of facilitator than of regulator. However, in India the policy maker puts
lot of restrictions on market participants. For instance, banks are not
allowed to take speculative positions in IRF market, Hedging limits
have been set up between 80% to 125% of transaction, FII’s exposure
to IRF has been limited to $100m. Such kinds of restrictions limit the
no. of players in the market.
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 10
The concepts of Interest Rate Swap and Interest Rate Future are new
to Indian market. There is very limited knowledge about these
instruments even among the active participants especially PSU banks.
Conclusion
Some concepts*
Duration:
Duration shows approximate percentage change in the price of bond
for 100 basis point change in the yield. It is a measure of calculating
interest rate sensitivity of bond.
Convexity:
Convexity describes the shape or curvature of price / yield
relationship of bond. It is used to measure the change in price for
small change in yield, not explained by duration.
Basis Risk:
Basis risk is caused by differences between cash bond price and
converted future’s price of the same bond. It shows difference
between hedging amount calculated & exact hedge amount possible
for particular bond.
Yield Curve:
Yield curve shows relationship between yield (interest rates) and its
term to maturity. Usually yield curve is upward sloping, i.e. longer the
maturity greater the interest rates.