This August 31, 2009, India successfully saw the launch of interest rate futures (IRFs) by the National Stock Exchange. Starting off with a big bang, the current level of attention is not high, but going ahead, there are a lot many advantages that stand out for investors.
At the moment, the NSE has already begun trading, the Securities and Exchange Board of India (Sebi) has already given permission to the Bombay Stock Exchange (BSE) to start trading in IRFs as well. BSE should in fact be all set to begin trading in a few more weeks, and, hot on their heels are the Multi-Commodity Exchange of India (MCX) and the United Stock Exchange (USE), both waiting for their chance to get in on the action.
This move comes one year after India saw currency futures enter into the financial markets in August 2008. Internationally, interest rate derivatives? trading has a turnover which is way higher than that, even of equity index futures. In fact, the global turnover of interest rate derivatives in 2004 was estimated to be $60 trillion! Speaking on the launch of IRFs, NSE managing director Ravi Narain said, “The launch of interest rate derivatives means a lot to the NSE, its constituency of brokers and all economic entities who face interest rate risk.”
The framework
Interest rate futures are inherently no different from other derivative products. You take a position on the underlying asset based on which way do you feel the price will move. However, in IRFs the underlying security is not stocks but a bond, a 10-year government bond to be more precise, and hence it is essentially the interest rate that you are speculating on. The underlying security is a 10-year government security, bearing a notional 7% interest rate coupon payable half yearly. An interest rate future contract is an agreement to buy or sell a debt instrument at a specified date at a fixed price. The minimum contract size for an IRF on the NSE is Rs 2 lakh.
This instrument is very useful for anyone, who wants to benefit from interest rate movements and is also a very good hedging mechanism for investors who have invested heavily in government securities, or for retail investors who have taken loans. Retail investors exposed to interest rate risks, corporate houses, mutual funds, primary dealers, foreign institutional investors, brokers, pension funds, insurance companies, banks and NRIs will comprise of the players who will in all likelihood actively play in this market space.
The contracts are to be settled in March, June, September and December and the maximum maturity period will be 12 months. Deliverable securities under the futures should mature between seven-and-half and 15 years with minimum outstanding of Rs10,000 crore. As per RBI and Sebi guidelines, commercial banks can take trading positions for themselves but not on behalf of their clients. Foreign investors can trade if they have the underlying security, but not for speculative purposes. Members registered with Sebi for trading in the currency/equity derivative segment will be eligible to trade in interest rate derivatives also, subject to meeting the balance sheet net worth requirement of Rs1 crore for a trading member and Rs10 crore for a clearing member.
The basic way to go about taking a position in this asset is to firstly figure out if you feel that interest rates will go up or down. If you believe that in the next say six months, interest rates will rise, then you would also expect that the price of the 10-year government bond will fall, and hence one will take a short position. Conversely, if you feel that the interest rate is going to drop, then it is better to take a long position on the government bond as its price will increase.
Quick start
The National Stock Exchange, which was the first to begin IRF trading, saw more than 10,000 contracts exchanging hands in less than two hours. A staggering 14,559 contracts totaling Rs 267 crore or $55 million in value were traded on the first day. Out of this, the heaviest volumes in trades were in the shortest maturity, the three-month contract maturing December 18, which ended at Rs 91.8950 to yield 8.2035%. The slightly medium term, six-month contract ended at Rs 91.2175 to yield 8.3103%.
This was truly an outstanding start for IRFs which returned to the Indian financial markets after their brief but failed appearance six years in 2003. Ironically, people are viewing this derivative instrument in two completely different manners. Some research firms are already of the opinion that trades could hit between 100-200 million contracts over the next two years.
On the other hand, mutual fund houses are approaching this new product rather cautiously. Most fund houses are in fact yet to begin trading in IRFs. One fund manager said, ?We are observing the IRF market very intently and if we feel that the market is stable enough, we will then consider entering it. As of now I agree, they have started of very well, but we need to be sure that this is not just initial excitement which may fizzle out later on.?
Then and Now
As per Ravi Narain, due to the global financial crisis, more and more regulators and markets across the world are now biasing their policies away from the OTC (over-the-counter) forward market in favour of exchange-traded market. “This is because if there is one institution that has come about unscathed in this crisis, it is the fact of a centrally counter-party guaranteed exchange-traded market,” he said.
He went on to explain that the potential risks from OTC derivatives are not measurable because they are ultimately private contracts between two parties, and hence the overall impact of such contracts becomes obvious only when an actual crisis breaks out. However, in the case of an exchange-traded derivative, the systemic risk is limited to the open position of the contracts. Since the exchange clears the trade, there is no counter party risk and further, the system of margining required by the exchanges takes care of the potential risks.
CB Bhave, chief of India’s capital market regulator, Sebi, said, ?The advantage of a guaranteed settlement and the fact that a third party makes sure that sufficient margins are posted, are important features of interest rate futures. There is a clear superiority here over OIS. First and foremost, if prices are transparent and known to the whole market, there are no doubts as to the valuation of the assets that are on your books as well, as the books of the counter party.”
Currency futures have steadily picked up, with the combined daily turnover across exchanges totalling more than $2 billion.
In 2003, when the regulators first introduced the IRFs, they failed due to a multitude of reasons. First was the overly complex pricing system. Second was the fact that banks, which are the biggest buyers of government securities, were not being allowed to trade in the segment.
Also, the 2003 contract used a zero-coupon yield curve for determining the settlement price, a process that eluded basic comprehension of most people, thanks to the complexity of the product. That product was bound to fall short, and so was eventually scrapped.
However, things could not be more different today. FIIs and speculators had been making the OTC currency markets run haywire and there was a need to regulate the market. Also bringing in more entities with Forex exposure into the foray, will only add to the clarity and transparency in the system. This move is also being seen by many as an effort to make the Indian SMEs and corporates aware and give them time to have their house in order before full capital account convertibility occurs sometime in the near future. This is a positive step in helping Indian markets achieve greater depth and be better integrated with the global financial markets. Globally interest rate derivatives, nicknamed the darlings of the financial markets, account for almost 70% of the total derivative trading done.
While there is unfortunately not a lot of historical data or trading tips one can give yet on IRFs in India, that fact remains most investors have always had an opinion or view on which way interest rate would move and so bond prices as well. This is now the perfect opportunity one has to make use of that knowledge or predictions that one has been making, and to make a worthy derivative investment in your debt portfolio.