Interest rate futures (IRF) may be relaunched for the third time in
Exchange traded interest rate futures (ETIRF) were earlier
launched by National Stock Exchange (NSE), country’s premier stock exchange,
once in 2003 and again in 2009. If this financial derivative product is
launched again, this will be third time that the product will be making a
re-entry in the Indian market.
On 31 August 2009, NSE relaunched ETIRF based on 10-year
Government of India (GOI) security having a notional coupon of 7 percent, with
physical settlement. And on 4 July 2011, NSE launched another IRF based on
91-day Treasury Bill, with cash settlement. Initially, these two products
experienced some trades from market players. Later, market interest in these
products died down. According to NSE’s IRF Tracker, trades are nil in them now.
Liquidity was confined to only a few government bonds. Traders
were not interested in holding such illiquid bonds, which adversely affected
trading interest in this ETIRF product.
The failure of this product could be attributed to a few
things. The ownership of government securities in India is highly skewed towards banks
and insurance companies, which keep these assets for long term and their risk
appetite for trading is very low. So only a few players are in this market.
Another distorting factor is that banks need not value
government securities as per the market value at day’s end (mark-to-market or
MTM) since bulk of their investments are allowed to be kept in held-to-maturity
(HTM) category. More than 90 percent of such securities are held in this HTM
category, which prompts banks not to trade them and thereby avoid any interest
rate risk.
Moreover, RBI is the Government’s money manager,
undertaking issue of government securities, treasury bills and cash management
bills. As a regulator and as a government’s fund manager, RBI exercises
enormous control over banks in India
If this interest rate futures product is to made
successful in the Indian market, both RBI and SEBI (Securities and Exchange
Board of India, capital market regulator) will have to make it more attractive
by allowing flexibility for exchanges to design the product and features, allow
cash settlement as against physical settlement, and permit contracts in various
maturities.
Time will tell whether the new RBI governor, Raghuram G
Rajan, will make this product click and tick.
(Please see below to know about basics of interest rate futures, their features and contract specifications).
(Please see below to know about basics of interest rate futures, their features and contract specifications).
For the benefit of
readers, I reproduce my
earlier article dated 28 August 2009 when NSE relauched interest rate futures.
It is two months since the operational guidelines for ETIRF were issued by an RBI-SEBI Committee. Now, National Stock Exchange is re-launching trading in ‘Exchange-Traded Interest Rate Futures’ (ETIRF) from August 31, 2009. The operational guidelines for the interest rate futures (IRFs) in
Exchange-Traded
Interest Rate Futures (ETIRF):
An IRF is a contract between two parties – a borrower and a lender – who agree to fix the rate at which they will borrow/lend on a future date. To put simply:
An IRF is a contract between two parties – a borrower and a lender – who agree to fix the rate at which they will borrow/lend on a future date. To put simply:
·
It is a hedging mechanism used by economic agents affected by
interest rate movements
·
Alternatively put, it is a tool to manage interest rate risk
·
It is a derivative contract – providing standardization and
transparency
·
It may be used by banks, insurers, primary dealers, provident
funds, etc
·
Even FIIs and NRIs are allowed to take trading positions subject
to norms
·
It will be traded on a stock exchange which bears the counterparty
risk
Who are permitted:
·
Members registered by SEBI for trading in currency/equity
derivatives are eligible to trade in IRF
·
Even individuals who have got interest rate exposures inherent in
their fixed deposits, housing and car loans can hedge their positions with the
help of an IRF
·
The minimum net worth of a trading member should be Rs one crore
·
The minimum net worth of a clearing member should be Rs 10 crore
The Exchange-Traded IRF
product:
·
The IRF is based on yield-to-maturity curve
·
The notional coupon on the underlying 10-year Government Security
would be seven per cent with semi-annual compounding
·
The size of the IRF contract would be Rs two lakh
·
Maximum maturity of the contract will be 12 months
·
The contract will be settled by the physical delivery of
securities
·
The contract cycle will be at the end of March, June, September
and December quarters
Gross Open Position:
·
The gross open position of a trading member across all contracts
should not exceed 15 per cent of the total open interest or Rs 1,000 crore,
whichever is higher
·
At the client level, the gross open position should not exceed six
per cent of the total open interest or Rs 300 crore, whichever is higher
·
FIIs and NRIs, the gross long position in the debt market and the
IRF contract should not exceed their maximum permissible debt market limit
prescribed from time to time.
What is not permitted as
of now:
·
IRF based on overnight rate (based on money market rates) is not
permitted
·
IRF based on 91-day Treasury bill is not permitted now, but may be
considered later
NSE’s ETIRF Product:
NSE Contract Specifications
|
|
Trading unit
|
One lot – equal to notional bonds of FV of Rs 2 lakhs
|
Underlying
|
10 Year Notional Coupon bearing Government of India (GOI)
security (Notional Coupon 7% with semi annual compounding)
|
Tick size
|
Rs.0.0025 paise
|
Trading hours
|
Monday to Friday
9:00 a.m. to 5:00 p.m. |
Contract trading cycle
|
Four fixed quarterly contracts for entire year ending March,
June, September and December
|
Last trading day
|
Seventh business day preceding the last business day of the
delivery month
|
Quantity Freeze
|
501 lots or greater
|
Settlement
|
Daily settlement MTM: T + 1 in cash
Delivery settlement : In the delivery month i.e. the contract expiry month |
Mode of settlement
|
Daily Settlement in Cash
|
Deliverable Grade Securities
|
|
- NSE has waived transaction
charges on IRF until December 31, 2009
Till now, the only interest rate derivative
available for trading is Overnight Indexed Swap (OIS) which is a type of
Interest Rate Swap (IRS). Interest rate swaps are agreements where one side
pays the other a particular interest rate (fixed or floating) and the other
side pays the other a different interest rate (fixed or floating). However, OIS
is traded in the OTC market. The new IRF is the first interest rate derivative
that is being traded on an Exchange.
IRF will be the first derivative product which will be settled by
delivery whereas other exchange-traded derivatives (for example, stock futures,
index futures, index options, etc) are settled by cash. Physical delivery will
be in the demat form through the depositories NSDL, CDSL and Public Debt Office
(PDO) of the Reserve Bank of India
Other
Exchanges:
While NSE introduces ETIRF from 31.8.09, BSE it
appears would introduce the product through United Stock Exchange in which BSE
took a 15 per cent stake recently.
Interest Rate Scenario:
The huge borrowing programme of the Indian
Government has muddied the interest rate scenario. What has been exacerbating
the interest rate situation is the food inflation (based on Consumer Price
Index or CPI) which has been rising to alarming levels of more than 10 per cent
for several months. Any pick up in credit disbursement during the oncoming
festive season and credit off-take from corporate sector during the second-half
of the fiscal year will put further pressure on the interest rates. With the
benchmark 10-year Government Security yield hovering around 7.30 per cent, an
increase of more than 30/35 basis points in the past one month; the bond market
is jittery about further hardening of bond yields. The bond market has
completely lost the appetite for new government paper with Banks’ SLR (statutory
liquidity ratio) holdings higher by more than 300 basis points over and above
the statutory levels.
The 10-year benchmark yield is expected to touch
7.50 per cent in the next few months due to higher inflationary expectations,
huge government borrowing programme, loss of agricultural output of around 20
per cent during the Kharif Season on account of monsoon failure across several
states in India, rising international crude oil prices and anticipated credit
demand in the second half of the fiscal. However, any revival in the
manufacturing sector and consequent rise in tax collections; usage of
disinvestment proceeds that are kept in National Investment Fund (NIF) for
reducing fiscal deficit; and huge resources of around Rs 35,000 crore that are expected
to accrue to the Government’s exchequer from 3G spectrum auction to the Telecom
Sector are likely to mitigate the crunch situation in the interest rate cycle
in India.
The launch by NSE is ushering in a product that
seems to have been timed well in the current rising interest rate scenario so
that market participants can hedge their positions.
Note: Interest
rate risk: If interest rates rise, the bond prices will fall. Similarly, if
interest rates fall, the bond prices will go up. As such, the movement of
interest rates will have a big impact on the bondholders; be it, banks,
insurance companies, mutual funds or such others, including individuals. The
risk that the interest rate fluctuations will affect the prices of bonds or
fixed-income investments is interest rate risk.
References:
RBI Report on IRF dt. Aug.8, 2008; RBI-SEBI Report on IRF dt. Jun.17, 2009; and
NSE.
- - -
Disclaimer: The author is an investment analyst, equity
investor and freelance writer. This write-up is for information purposes only
and should not be taken as investment advice. Investors are advised to consult
their financial advisor before taking any investment decisions. He blogs at:
Connect with him on twitter @vrk100
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