Interest rate futures lose charm as hedging instrument, see sharp drop in participation

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SummaryThe rise in the yield has resulted in investors making losses in IRFs.

Interest rate futures, which were launched across three bourses just a fortnight ago and touted as a much-needed hedging instrument, are seeing a sharp drop in participation already.

IRFs are contracts, which allow a bond investor to hedge against interest rates, and have the option of being settled in cash without the physical bond.

Volumes have slipped to as low as Rs 476.35 crore from Rs 3,080 crore notched on their launch day on the National Stock Exchange (NSE). Turnover on the MCX-SX and BSE have seen a fall of 74% and 70%, respectively.

In the same period, yield on the underlying 10-year benchmark 8.83%, 2023 bond has risen by 25 basis points because of the RBI’s unexpected hike in the policy on January 28. The rise in the yield has resulted in investors making losses in IRFs.

But the fall in volume of IRFs is not entirely due to these losses, dealers said.

Since Indian banks have the option of minimising their fixed income losses by holding bonds under held-to-maturity (HTM) portfolio, the incentive to hedge market risks through IRF is low, dealers said.

Banks can keep 24% of their bond portfolio under HTM and the portfolio is not required to be marked to market prices.

Banks can move their bonds from available-for-sale and held-for-trading portfolios to the HTM once in every financial year.

“There is no incentive to hedge your risks using the IRF. Banks already have the option of shifting bond holdings to HTM to minimise losses,” said Manish Wadhawan, head of rates at HSBC Bank.

There is also a lack of participation from public sector banks, the biggest market participants of the bond market.

“While PSU banks may not completely agree, most of them are wary of derivative products and are not participating in the IRFs. With whom will I trade if I cannot find enough counterparties?” said a bond trader at a private bank.

Dealers said the IRF volumes may pick up once bond yields show a sustained fall. “If there is a rally in the cash market, it would give a boost to the IRF as well,” said NS Venkatesh, head of treasury at IDBI Bank.

This is the third attempt by the RBI to introduce the interest rate hedging tool. The RBI had earlier launched IRFs in 2003 and, then again, in 2009, but both times the product failed to take off, as the contracts mandated physical delivery of the

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