Interest Rate Futures – An Update

Rama Krishna Vadlamudi vrk_100@yahoo.co.in

MUMBAI
August 28th, 2009

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 India were issued on June 17, 2009, by a committee jointly
set up by RBI and SEBI. Institutions like, banks, insurance companies, primary dealers,
pension funds, mutual funds, financial institutions, companies and provident funds are
exposed to interest rate risk on account of their huge exposure to government securities
and other fixed income securities. To mitigate the interest rate risk, RBI along with SEBI,
has introduced interest rate futures in India. This is a measure that helps in deepening
the debt market in India. (IRFs were first launched in 2003 by National Stock Exchange,
but did not find favour with market players).
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:

• 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

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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:

The salient features of NSE’s new product are:

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 GOI securities
Securities

• NSE has waived transaction charges on IRF until December 31, 2009

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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.

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