INTEREST RATE FUTURES. "Safeguard your interest in the future. Page 1

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1 INTEREST RATE FUTURES "Safeguard your interest in the future Page 1

2 Contents NSE An Overview Interest Rate Futures A Global Perspective 04 New prospects with Interest Rate Futures...05 Interest Rate Futures : Key Concepts 07 Interest Rate Futures at NSE.12 Product Specifications 13 Uses of IRF for Market Participants Key Benefits of Interest Rate Futures 18 Case Studies Contact Us...24 Page 2

3 National Stock Exchange An Overview National Stock Exchange of India Limited (NSE) is an electronic exchange with a nationwide presence. It offers trading facility through its fully automated, screen based trading system. A variety of financial instruments, which includes, equities, debentures, government securities, index futures, index options, stock futures, stock options, currency futures, Interest Rate Futures etc. are traded on its electronic platform. NSE is the largest stock exchange in India, with a significant market share in equities,and in derivatives equities/equity indices/currency. It is also one of the leading global exchanges. NSE uses a state of the art telecommunication network to provide investors an efficient and transparent market. NSE has created new benchmarks in technology infrastructure, risk management systems, clearing and settlement systems, investor services and best market practices. It has been in the fore front offering newer products in equities and derivatives and also new asset classes for the investors to choose from. Milestones / Achievements Over the years NSE has achieved a series of milestones and landmarks, which have had a significant impact on the securities trading environment in the country. November 1992 Incorporation April 1993 Recognition as a stock exchange November 1994 Capital Market Segment goes live April 1995 Establishment of NSCCL, the first Clearing Corporation October 1995 Became the largest stock exchange in the country April 1996 Launch of S&P CNX Nifty June 1996 Establishment of Settlement Guarantee Fund December 1996 Commencement of trading/settlement in dematerialised securities February 2000 Commencement of Internet Based Trading June 2000 Commencement of Derivatives Trading (Index Futures) June 2001 Commencement of trading in Index Options July 2001 Commencement of trading in Options on Individual Securities November 2001 Commencement of trading in Futures on Individual Securities November 2006 NSE awarded 'Derivative Exchange of the Year', by Asia Risk magazine March 2008 Launch of long term option contracts on S&P CNX Nifty April 2008 Launch of Securities Lending & Borrowing Scheme April 2008 Launch of India VIX The Volatility Index June 2008 Setting up of Power Exchange India Ltd August 2008 First exchange in India to launch Currency Futures contracts August 2009 Launch of Interest Rate Futures November 2009 Launch of Mutual Fund Service System December 2009 Commencement of settlement of Corporate Bonds February 2010 Launch of Currency Futures on Additional Currency Page 3

4 Interest Rate Futures A Global Perspective Interest Rate Futures contracts were first traded in the United States on October 29, 1975 in response to a growing need for tools that could protect against sharp movements in interest rates. Since then, Interest Rate Futures have become a fundamental risk management tool for financial markets worldwide. Interest Rate Futures are the most widely traded derivatives instrument in the world. The total outstanding notional principal amount in Interest Rate Futures is times higher than equity index futures. Source: BIS The total turnover in the year 2008 for Interest Rate Futures was around USD 14,00,000 billion, which is around 10.5 times higher than equity index futures. The table given below shows the enormous contribution made by Interest Rate Futures in the global derivatives markets: Turnover USD in Billion Regions / Markets Interest Rates North America Europe Asia & Pacific Other Markets TOTAL Source: BIS Page 4

5 Interest Rate Futures in India New Prospects With the commencement of Interest Rate Futures trading under a new framework, the Indian financial markets would achieve another milestone. Interest rates are linked to a variety of economic conditions. They can change rapidly, influencing investments and debt obligations. In a market environment where long term debt issuance by the government is increasing and the demand for it is growing, there is a strong need for a cost efficient hedging instrument against interest rate risk. The last five year s government borrowings are indicated in the graph below. Source: RBI Market participants hold large amounts of GOI Securities which are impacted in value due to interest rate fluctuations. Over the last decade, the movement in the 10 year Benchmark Government of India (GOI) securities yield has shown significant movement, ranging from 5% to 12%. Page 5

6 10 Year Benchmark Government of India security Yield rate Source Reuters - INBMK Interest rate risk is the uncertainty in the movement of the interest rates. Interest rates have never been constant in the past and one can easily presume they would not remain constant in the future. The volatility of interest rates has increased manifold in the last couple of years. The annualized volatility of yield of 10 year benchmark GOI security for the calendar year 2008 has been 17.40% compared to 8.51 % in Such volatility increases risk and requires tools to manage risks. Interest Rate Futures are the product for managing the interest rate risk. Page 6

7 Interest Rate Futures Key Concepts Interest Rate Interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. They are typically noted on an annual basis, known as the annual percentage rate (APR). E.g Feb 2019 security bears an interest rate of 6.05% annually which is also referred as coupon. Does the rate of return remain same throughout the tenure of the bond? No, to measure the rate of return on your investment lets understand the concept of yield. Yield Yield is the income (return) on an investment. This refers to the income received from a security and is usually expressed as a percentage (annual return) based on the investment's cost, its current market value or its face value. Yield and price of a bond have an inverse relationship. As yield increases, the price of the bond decreases and vice-versa. Always an avid investor would be interested to know the period it takes to recover his initial investment in the bond. The concept of duration shall explain this. Duration The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for an investment in a bond to be repaid by its internal cash flows. It is an important measure because bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. Duration is expressed as the number of years (measured as a weighted average) in which the bond will pay out. Basically, duration is a weighted average of the maturity of all the income streams from a bond or portfolio of bonds. So, for a two-year bond with 4 coupon payments every six months of Rs. 50 and a Rs face value, duration (in years) is 0.5(50/1200) + 1(50/1200)+ 1.5(50/1200)+ 2(50/1200) + 2(1000/1200) = years. Page 7

8 Modified duration is a measure of the sensitivity of the price (the value of principal) of a fixedincome investment to a change in interest rates. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. The greater the duration number, the greater the interest-rate risk or reward for the bond. Modified duration does not factor the bigger change in the yield and represents linear relationship. However to measure the curvature in the relationship between bond price and yield, a concept called convexity is used. Convexity Convexity is the measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. It is used as a riskmanagement tool, and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed. Page 8

9 Price Yield Relationship Yield Change in the price is in response to change in yield which can be measured using duration and convexity. Types of Yield Curve A yield curve visually depicts the term structure of interest rates for debt instruments of the same quality (rating). Positive Yield Curve A Yield Curve in which long-term rates are higher than short-term rates. The yield curve has an upward slope, meaning longer maturities earn a higher rate of interest. It is also known as a normal yield. In a positive yield curve environment, prices of corresponding financial futures contracts decrease the more the delivery date is deferred. Page 9

10 Negative Yield Curve Yield Curve in which short-term rates are higher than long-term rates. A negative yield curve typically occurs during a period of inflation, when heavy demand for credit pushes short-term rates up in relation to long-term rates. Financial futures prices would then be lower for shorter-dated maturities relative to longer maturities. Flat Yield Curve A flat yield curve may result when there is little or no credit premium demanded for longer-term loans and investments. A flat curve may be slightly positive, slightly negative, or even slightly humped. 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." Exchange traded Interest Rate Futures are standardized contracts based on a notional coupon bearing GOI security. The contract shall be physically settled by delivering deliverable grade securities. Page 10

11 Accrued interest Accrued interest is the interest amount accrued from last coupon payment date up to the day prior to the settlement date. It is calculated using 30/360 day count convention which assumes each month has a period of 30 days. Invoice Price It will be the price paid by the Long position holder of contract to short position holder on settlement of contract. Invoice price = (Futures Settlement price * Conversion factor of the delivered bond) + Accrued Interest. Conversion Factor The conversion factor equates the deliverable security (per rupee of principal), to yield 7% with semiannual compounding. Cheapest to Deliver Bond (CTD) Bond which can be bought at cheapest price from underlying bond market and delivered against expiring futures contract is called CTD bond. It will be a bond where difference between Quoted price of Bond (Futures Settlement Price * Conversion Factor) is the most beneficial to seller. Futures Settlement Price # Quoted Price of Bond (A)# Futures Price*CF (B) Conversion Difference Security Factor (A-B) #Futures settlement price and quoted price of bonds are assumed. Page 11

12 Interest Rate Futures at NSE Robust trading systems, clearing and settlement systems and technology are the key to an efficient and effective financial market. NSE, India s largest stock exchange, has proven its ability to master the challenge of providing the best systems and practices for the markets. NSE s Interest Rate Futures offer the same reliable features as its other products. Let s understand the advantages of NSE s Interest Rate Futures : Standardization and Flexibility Interest Rate Futures contract offers market participants a standardized product which they can use conveniently for taking a view of the future direction of the market, hedging and creating income strategies. Price Transparency and Liquidity Electronic trading platform of NSE ensures transparency of prices, volumes and trade data. Trading standardized contracts results in a concentration of order flows, thus ensuring market liquidity. Leverage Effect due to a wider collateral management Due to widened scope of collateral acceptance by NSE, participants can take advantage of leverage by investing in futures contract. Also participants can benefit by using a single collateral pool for both currency and Interest Rate Futures trading. Advance trading software and technological edge Trading on NSE takes place via NEAT plus and NOW (NEAT on Web) systems through which large numbers of trading terminals have direct access to the market. Centralized clearing supported by guaranteed settlement Trades are settled through India s only AAA rated clearing corporation, the National Securities Clearing Corporation Limited (NSCCL), which acts as a central counterparty to all trades and guarantees financial settlement. Managing counterparty risk The efficient risk management system of NSCCL eliminates the risk of counterparty default due to novation of trades by its clearing corporation. Page 12

13 Product Specifications 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 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, June, Contract Cycle September & December. To start with NSE has introduced two quarterly contracts Volume Weighted average price of the contract during the time period Daily Settlement Price 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 Extreme loss 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. 0.3% of the value of the gross open positions of the futures contracts Page 13

14 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. Position Limits Position limits shall be applicable on gross open positions across all contracts. Client Level: It should not exceed 6% of the total open interest or Rs. 300 crores whichever is higher. Trading Member Level: It should not exceed 15% of the total open interest or Rs crores whichever is higher. Clearing Member Level: No separate position limit is prescribed at the level of clearing member. However, the clearing member shall ensure that his own trading position and the positions of each trading member clearing through him is within the limits specified above. FIIs: Total gross long position in the debt market and the Interest Rate Futures contract should not exceed their individual permissible limit for investment in government of India securities as prescribed from time to time. Short position in Interest Rate Futures contract should not exceed long position in the government of India securities market and in Interest Rate Futures. Page 14

15 Interest Rate Futures (IRF) and Market Participants Market Participants Banks and Primary Dealers Mutual Funds and Insurance Companies Corporate houses and Financial Institutions FIIs Member Brokers and Retail Investors How to participate in Interest Rate Futures trading at NSE Interest Rate Futures can be bought and sold through the trading members of the National Stock Exchange. To open an account with a NSE trading member you will be required to complete the formalities which include signing of member constituent agreement, constituent registration form and a risk disclosure document. The trading member will allot you a unique client identification number. To begin trading you will be required to deposit cash or collateral with your trading member as may be stipulated by them. Eligibility Criteria The members registered by SEBI for trading in currency / equity derivatives segment shall be eligible to trade in Interest Rate Derivatives also subject to meeting following criteria o Net worth of Rs. 1 crore for Trading members o Net worth of Rs. 10 crores for Clearing members Page 15

16 Uses of IRF for Market Participants Banks and Interest Rate Futures Managing duration gap with respect to change in interest rates. Protecting against the devaluation of G-sec in AFS and HFT portfolios. Hedging against re-pricing risk related to volatility of cash flows due to revaluation of assets and liabilities over a period of time. Mitigating Basis risk when yield on assets and costs on liabilities are based on different benchmarks. Primary Dealers and Interest Rate Futures Underwriting of primary issues is carried out by the primary dealers, who also enable market making for government securities. Interest Rate Futures can be used to minimize the risk due to volatility of interest rate when primary dealers are exposed to meeting their underwriting commitment. With increasing government borrowings, the pressure on primary dealers to adhere to obligations is enormous. IRF will help to minimize the securities portfolio risk. Mutual Funds, Insurance Companies and Interest Rate Futures It can mitigate interest rate risk arising out of huge exposure to government securities and corporate debt. Optimizing the portfolio returns. IRF can provide another avenue to mutual funds for improving investment income by arbitrage between cash and futures markets of the debt segment, as well as through spread trading strategies. Maximizing the return on investments of insurance companies in interest bearing securities, thereby minimizing the actuarial risk for the insurance company. Page 16

17 Corporate Houses and Interest Rate Futures Companies can reduce their borrowing cost by using IRF to manage company s exposure to interest rate movement. By using IRF to manage interest rate risk companies can optimize the cost of capital to company leading to optimal debt-equity ratio. Improve the credit rating for a corporate by enhancing the debt-service coverage ratio and the interest coverage ratio by better risk management using IRF. Corporate can convert their fixed rate borrowing to floating if view is of a falling yield. FIIs and Interest Rate Futures Hedging against underlying GOI securities portfolio. FIIs having a view on long term interest rate could benefit by participating in new asset class. Member brokers, Retail investors and Interest Rate Futures Brokers can use IRF for generating income by arbitrage between cash and futures market of the debt segment. With increased market participation in Interest Rate Futures member brokers can earn additional income in the form of brokerage fee charged to clients. Portfolio management services to retail and corporate clients who are already trading in equity and currency can be extended with introduction of IRF. Small lot size provides retail investors to hedge their interest rate payment on home loans to protect against rising interest rates. Page 17

18 Key Benefits of Interest Rate Futures Directional trading As there is an inverse relationship between interest rate movement and underlying bond prices, the futures price also moves in tandem with the underlying bond prices. If one has a strong view that interest rates will rise in the near future and wants to benefit from rise in interest rates; one can do so by taking short position in IRF contracts on NSE and benefit from the falling futures prices. Detailed example is explained in case study 1. Hedge your Portfolio Holders of the GOI securities are exposed to the risk of rising interest rates which in turn results in the reduction in the value of their portfolio. So in order to protect against a fall in the value of their portfolio due to falling bond prices, they can take short position in IRF contracts on NSE. Detailed example is explained in case study 2. Calendar Spread Trading A Calendar Spread, also known as an Inter-delivery Spread, is the simultaneous purchase of one delivery month of a given futures contract and the sale of another delivery month of the same underlying on the same exchange. This type of spread is called a "calendar spread" because it is based on different calendar months. For instance, buying a September 09 contract and simultaneously selling a December 09 contract. A market participant can profit (or lose out) as the price difference between the two contracts widens or narrows. Detailed example is explained in case study 3. Page 18

19 Reduce the duration of portfolio As the bonds with longer maturities are more sensitive to interest rate changes, bond portfolio with longer duration will be more exposed to the vulnerability of the movement in interest rate. A Portfolio manager who is concerned about the rise in short term interest rate risk would like to reduce the duration of the portfolio. By entering into an IRF contract on NSE, the portfolio manager can reduce duration of the portfolio. The below formula denotes the approximate number of contracts which needs to be entered into to achieve the desired duration (D Approximate number of contracts = T Dt ) Pt DCTD PCTD Conversion Factor of CTD Bond D T = Target duration of portfolio Dt = Initial duration of portfolio Pt = Initial market value of portfolio D CTD = The duration of cheapest to deliver bond P CTD = The value of cheapest to deliver Bond (Price * contract multiplier) Arbitraging between cash and futures market Arbitrage is the price difference between the bonds prices in underlying bond market and IRF contract without any view about the interest rate movement. One can earn the risk-less profit from realizing arbitrage opportunity and entering into the IRF contract traded on NSE by initiating cash and carry trade involving the following steps: Purchase the cheapest to deliver bond Take short position in IRF contract Finance the bond purchase at the current borrowing rate from the market. Give the intention of delivery to the exchange Deliver the bond and receive the invoice price. Repay the cash amount borrowed to purchase the bond. Detailed example is explained in case study 4. Page 19

20 Case Studies Case study 1: Directional trading A trader expects a long term interest rate to rise. He decides to sell Interest Rate Futures contracts as he shall benefit from falling future prices. Trade Date- 5 th Oct 09 Futures Delivery date 1st Dec 2009 Current Futures Price- Rs Futures Yield- 7.36% Trader sell 250 contracts of the Dec Year futures contract on NSE on 5 th Oct 2009 at Rs Daily MTM due to change in futures price is as tabulated below Date Daily Settlement Price* (Rs.) Calculation MTM (Rs) 5-Oct *2000*( ) Oct *2000*( ) Oct *2000*( ) Oct *2000*( ) Net MTM gain as on 8 th Oct 09 is Rs. 1,86,250 (I) * Daily Settlement price shall be the weighted average price of the trades in the last ½ hour of trading. Closing out the Position 9 th Oct Futures market Price Rs Trader buys 250 contracts of Dec 09 at Rs and squares off his position Therefore total profit for trader 250*2000*( ) is Rs.7,500 (II) Total Profit on the trade = INR 1,93,750 (I & II) Page 20

21 Case Study 2: Hedging A bank has a large portfolio of GOI securities worth Rs. 25 crores. Bank s portfolio consists of bonds with different coupons and different maturities. In view of rising interest rates in the near term, the treasury head is concerned about the negative effect this will have on the bank s portfolio. The treasury head wants to hold his entire portfolio and at the same time doesn t want to suffer losses on account of fall in bond prices. Should the bank go short or long on the futures contracts to establish the correct hedge? The treasury head decides to hedge the interest rate risk by taking a short position in the Interest Rate Futures on NSE. Example : Date: 05-Oct-2009 Spot price of GOI Security: Rs Futures price of IRF Contract: Rs On 05-Oct-2009 XYZ bought 2000 GOI securities from spot market at Rs He anticipates that the interest rate will rise in near future. Therefore to hedge the exposure in underlying market he may sell Dec 09 Interest Rate Futures contracts at Rs On 16-Nov-2009 due to increase in interest rate: Spot price of GOI Security: Rs Futures Price of IRF Contract: Rs Loss in underlying market will be ( )*2000 = Rs 1615 Profit in the Futures market will be ( )*2000 = Rs 1285 Page 21

22 Case Study 3: Calendar Spread Trading A long & short position in different futures contracts on the same underlying is called as a calendar spread. If a Long position in a Dec 09 IRF contract versus a Short position in the Mar 10 IRF contract on NSE is considered a calendar spread. Since a calendar spread entails only the basis risk, the bank runs little risk on the positions. Example: Trade Date : 5 th Oct 09 Dec 09 Futures (Rs.) : Mar 10 Futures (Rs.) : The difference between the Dec 09 & Mar 10 contracts is currently Rs (after considering bidask). If the trader believes that this spread is very high, he would execute a calendar spread by Selling the Mar 10 futures at Buying the Dec 09 futures at days later Trade Date : 15 th Oct 09 Dec 09 Futures (Rs.) : Mar 10 Futures (Rs.) : The difference between the Dec 09 & Mar 10 contracts is now Rs (after considering bidask). The trader may decide to liquidate his calendar spread trade by Buying the Mar 10 futures at (Profit 0.60) Selling the Dec 09 futures at (Loss 0.38) Net profit of Rs without running any interest rate risk Page 22

23 Case Study 4: Arbitrage The price differential in the underlying bond market and the future market can also provide opportunities to arbitragers. If the futures are expensive compared to the underlying,, then the arbitrager can make profit by taking long position in underlying market by borrowing funds and taking short positions in the future market. This is explained with following example. On 15 th Oct, 09 buy 6.35% GOI 20 at the current market price of Rs and conversion factor is Step 1 - Short the Dec 09 futures at the current price of Rs (7.00% Yield) Step 2 - Fund the bond by borrowing up to the delivery period (assuming borrowing rate is 4.25%) Step 3 - On 1st Dec 09, give a notice of delivery to the exchange Assuming the futures settlement price of Rs , the invoice price would be = 100 * = Rs Under the strategy, the bank has earned a return of = ( ) / * 365 / 49 = 6.86 % (implied repo rate) (Note: For simplicity accrued interest is not considered for calculation) Against its funding cost of 4.25% (borrowing rate), thereby earning risk free arbitrage The bond with the highest implied repo rate would be the cheapest to deliver (CTD) bond. The arbitrager would identify the bond with the highest implied repo rate or the CTD bond and execute the strategy with the same bond, depending on its availability in the secondary market. Page 23

24 Contact Us NATIONAL STOCK EXCHANGE OF INDIA LIMITED Exchange Plaza, Bandra Kurla Complex, Bandra (E), Mumbai , India Tel: / Fax: ird_qa@nse.co.in Web Site: 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 of action. Page 24