Capstone ProjectOn

Failure Of Interest Rate Futures In India

Under the guidance of:Prof. Sabyasachi Mukherjee

Submitted By:Susmita Panda

Roll No. VAS2011PGDMFM3F042

Interest Rate Futures:

An interest rate future is a contract between the buyer and

seller agreeing to the future delivery of any interest-bearing asset. The interest

rate future allows the buyer and seller to lock in the price of the interest-bearing

asset for a future date..

Interest Rate Futures contracts were first traded in the United States Of

America in 1975 to protect against volatility in interest rates.

The IRFs are of large contract sizes, thus they are not products for

small traders. These can be based on the underlying instruments like T- Bills,

Treasury Bonds, Treasury Notes, Eurodollar Futures, etc.

Uses:

Interest rate futures are used to hedge against the risk of that

interest rates will move in an adverse direction.

For example, borrowers face the risk of interest rates rising.

Futures use the inverse relationship between interest rates and bond

prices to hedge against the risk of rising interest rates. A borrower will

enter to sell a future today. Then if interest rates rise in the future, the

value of the future will fall (as it is linked to the underlying asset, bond

prices), and hence a profit can be made by buying the future.

Interest Rate Futures In India:

IRFs were introduced in India in June 2003. It was proposed that the

products launched in the Indian market are futures on long bond (10-year

notional G-Secs) and T-Bills (91 days notional). Both these products were to be

settled cash based on the ZCYC (Zero Coupon Yield Curve). The final

settlement of these futures contracts would be the present value of all future cash

flows from the underlying discounted at the zero coupon rates for the

corresponding maturities taken from the ZCYC.

Exchange Traded IRFs In India:

Introduction of exchange traded interest rate futures by SEBI &

RBI marked a major policy. For Indian financial markets, IRFs presented a

much needed opportunity for hedging and risk management by a wide range

of institutions and intermediaries, including banks, primary dealers,

corporate, AMCs, financial institutions, FIIs and retail investors.

IRFs help various constituencies in providing an effective and

efficient mechanism to manage interest rate volatility.

Market Participants: Corporate Houses: Corporates need to identify, evaluate and mitigate risk

pertaining to interest rate volatility. IRFs provide the mechanism to contend risk at

strategic and operational level, pertaining to volatility in interest rates.

Brokers, FIIs and Retail Investors: IRFs can be beneficial to these in many ways

such as: additional source of income for brokers in the form of brokerage fee for

trading in IRFs, improved and easy access to retail and corporate customers, wealth

management advisory services, proprietary and client trading by debt market brokers,

mitigation of risk, spread trading, arbitrage between cash and futures market of debt

segment, reducing of refinancing cost, etc.

Banks and Primary Dealers: IRFs enable Banks and Primary Dealers to

mitigate risk, improve process efficiency.

Mutual Funds: Mutual fund managers can immensely benefit from IRF.

The Net Asset Value can be protected by hedging against interest rate

volatility

Insurance Companies: Insurance companies can benefit from IRFs in

several ways like hedging, protection against re-insurance risks, optimizing

investment portfolio returns and diversifying risk, efficient management of

asset-liability mismatch, etc

Market Participants:

Failure Of IRFs In India:

Basis of Pricing/ Valuation: The problem was that IRF was based on

Zero Coupon Yield curve (ZCYC) computed by the NSE whereas Indian

bond market was based on Yield to Maturity. The market was not

comfortable with the complexities of ZCYC and reservations about its lack

of transparency. This problem with the IRFs was recognised in early 2004

and an important change in the product design was introduced linking to

price the YTM of a basket of Government securities (G-Secs).

Mode of Settlement: The evolution of futures markets indicates that

settlement by physical delivery was the primal mode. Physical settlement is

when people have to give the bond at settlement (or commodities in case of

commodity derivatives) where as in cash one adjusts the differences based

on cash. IRF settled by cash as well as physical delivery co-exist in the

global financial markets. In 2010, it was again tried to restart this based on

YTM but again the regulators kept physical settlement and again it failed to

pick up. By August 2010, the volumes had fallen by 84%. National Stock

Exchange launched trading in interest rate futures in 91-days T-Bills (cash

settled) in July, 2011.

Failure Of IRFs In India:

IRF For The Money Market: As in case of bond futures, banks were

allowed to transact in this product only for the purpose of hedging their

exposure in the AFS and HFT portfolios where as primary dealers were

allowed to take their positions. This product too received half-hearted

response in the beginning and became illiquid subsequently. Finally, in 2011,

the RBI introduced IRFs on 91-day Treasury Bills and then IRFs on two-year

and five-year government bonds were introduced in December, 2011. National

Stock Exchange, where IRFs on 91-day T-Bills were traded, did not show a

single trade reported in IRF segment since August 2011. Even in August,

single contracts were traded for minimum lot sizes of 2 lakhs.

Failure Of IRFs In India:

Examples: Hedging:

A portfolio of Government of India securities worth Rs.600 crores. Bank’s portfolio consists of bonds with different coupon and different maturities. In view of rising interest rates in near future, the head of treasury 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.The head of the treasury thereby decides to take a short position and hedge the interest rate risk in the IRFs.  Date: 12/08/2011 SPOT price of GoI security: 90.0575 Futures price of contract: 83.7925

On 12/08/2011 ABC bought 2000 Government of India securities from SPOT market at 90.0575. He anticipates that the interest rate will rise in the future. Therefore, to hedge the exposure in underlying market he may sell Dec 2012 IRF contracts at 83.7925.On 16/11/2011 due to increase in interest rate: SPOT price: 87.2500 Future price: 80.1500Loss in underlying market will be (87.2500-90.0575)*2000= (Rs.19615)Profit in the futures market will be (83.7925-80.1500)*2000= Rs.7285

Calendar Spread Trading:If a long position in a Dec 2011 IRF contract versus a short position in the Mar

2012 IRF contract is considered as calendar spread.Since a calendar spread entails only on the basis risk, the bank runs little risk on the positions. Trade Date: 12/08/2011 December 2011 Futures: 85.3600-85.3800 March 2012 Futures: 81.9700-82.0200The difference between the December 2011 and March 2012 contracts is now 3.41 (after considering bid-ask). If the trader believes that this spread is very high, he would execute a calendar spreadSelling the March 2012 futures at 81.9700Buying the December 2011 futures at 85.360010 days later Trade Date: 22/08/2011 December 2011 Futures: 85.0050-85.0250 March 2012 Futures: 81.3000-81.3700The difference between the December 2011 and March 2012 contracts is now Rs.3.635 (after considering bid-ask). The trader may decide to liquidate his calendar spread by Buying the March 2012 Futures at 81.3700Selling the December 2011 Futures at 85.0050

Examples:

Suggestions: Banks were allowed to classify their GoI securities portfolio held for the

purpose of meeting SLR requirements as HTM as a financial stability

measure. Availability of IRFs as hedging instruments to manage interest rate

risk acts as a remedy to this situation. Therefore, the existing dispensation

should be reviewed, synchronously with the introduction of IRF. Thus, in my

opinion, the current dispensation to hold the entire SLR portfolio in Held Till

Maturity category be reviewed synchronously.

The RBI (Amendment) Act 2006, vests comprehensive powers in the RBI to

regulate interest rate derivatives except issues relating to trade execution and

settlement which are required to be left to respective exchanges. According to

me, considering the RBIs role in, and responsibility for, ensuring efficiency

and stability in the financial system, the broader policy, including those

relating to product and participants, be the responsibility of the RBI and the

micro-structure details, which evolve through interaction between exchanges

and participants, be best left to respective exchanges.

Suggestions:

The IRF market depends, for its liquidity, depth and efficiency, on

significant presence of all classes of participants, viz. hedgers, speculators

and arbitrageurs. Restricting the participation of banks only to hedging

activities impairs the liquidity of the market. Therefore, in my opinion, banks

must be allowed to take trading positions in IRF subject to prudential

regulations including capital markets. Further, the current approval for banks’

participation in IRF for hedging risk in their underlying investment portfolio

of G-Secs should be extended to the interest rate risk inherent in their entire

balance sheet.

Suggestions:

The recommended accounting practice in case of IRF, premised on the

concept of effective hedge conforms to the international best practice that in

respect of IRS has been couched in general terms and has spawned varying

practices. Unless this imbalance is addressed, market response will continue

to be against IRFs. Also, in order to ensure that the prices in spot and futures

market are firmly aligned, it is necessary that the accounting practices for

derivatives as well as underlying are also aligned. In this context, it needs to

be recognized that IRF is marked-to-market daily and daily gains or losses

are received or paid through daily variation margins. This is precisely what

makes IRF a zero-debt product. Thus, the accounting method for underlying

also needs to be fully aligned to reflect the character of the hedge.

Suggestions:

The need to reconcile the desirability of short selling in cash market

symmetrically with the futures market owing to the very persuasive rationale of

cash futures arbitrage which alone ensures the connect between the two markets

throughout the contract period and also forces convergence between cash and

futures markets, at settlement. Therefore, according to me, the time limit on

short selling be extended so that term, tenure or maturity of the short sale is co-

terminus with that of the futures contract and a system of transparent and rule

based pecuniary penalty for subsidiary general ledger bouncing be put in place,

in lieu of the regulatory penalty currently in force.

Suggestions:

With a view to ensuring symmetry between cash market and GoI securities

(and other debt instruments) and IRF, as also imparting liquidity to the IRF

market which is an important step towards deepening of the debt market. In my

opinion IRFs may be exempted from Securities Transaction Tax (STT).

Suggestions:

THANK YOU