Interest rate futures, that long cherished dream of Indian bankers, bond dealers, and reformers will be launched on Monday. This is an instrument that will help a company fix its interest cost, irrespective of interest rate movements.
According to CNBC-TV18’s Gopika Gopakumar, after a long wait of six years, interest rate futures will yet again be traded on the NSE. Listed on the exchange will be a contract worth Rs 2 lakh. Each contract will comprise 10 year government securities with notional interest rate of 7%.
A potential investor like a mutual fund can open an account with a bank or brokerage already registered as trading members with the NSE. If the fund buys a 10-year government security from the spot market at Rs 101, and expects interest rates to rise by December, then it will ask its bank or broker to sell a December futures contract at say Rs.97.50. It pays a margin of 2.33% for the first day and 1.61% for subsequent days. Assume rates go up and the spot price of the government security falls to Rs100, then the futures contract will fall to Rs 96.60.
In this case, the mutual fund is making a loss in the spot market. But it is making a gain in the futures contract (Rs 97.50-96.60). Its loss is thus minimized to 10 paisa against one rupee if it was unhedged. On the other hand, if a mutual fund expects rates to fall, then the fund will go long, i.e. it will buy a futures contract to hedge itself. Note that in this product the investor has to physically deliver bonds when the contract matures. It can deliver any bond with residual maturity of 8-12 years.
According to CNBC-TV18’s Gopika Gopakumar, after a long wait of six years, interest rate futures will yet again be traded on the NSE. Listed on the exchange will be a contract worth Rs 2 lakh. Each contract will comprise 10 year government securities with notional interest rate of 7%.
A potential investor like a mutual fund can open an account with a bank or brokerage already registered as trading members with the NSE. If the fund buys a 10-year government security from the spot market at Rs 101, and expects interest rates to rise by December, then it will ask its bank or broker to sell a December futures contract at say Rs.97.50. It pays a margin of 2.33% for the first day and 1.61% for subsequent days. Assume rates go up and the spot price of the government security falls to Rs100, then the futures contract will fall to Rs 96.60.
In this case, the mutual fund is making a loss in the spot market. But it is making a gain in the futures contract (Rs 97.50-96.60). Its loss is thus minimized to 10 paisa against one rupee if it was unhedged. On the other hand, if a mutual fund expects rates to fall, then the fund will go long, i.e. it will buy a futures contract to hedge itself. Note that in this product the investor has to physically deliver bonds when the contract matures. It can deliver any bond with residual maturity of 8-12 years.
Hemant Mishr, Regional Head-Global Markets, Standard Chartered Bank, expects active participation from institutional players both financial and the non-financial institutions. "I see mutual funds, insurance players being active players." However, he does not see active retail participation at present.
B Prasanna, MD, ICICI Securities Primary Dealership Company, says though in the initial period it will probably be institutional market participants using this product, he expect quite a bit of the retail households, broking communities to enter into the particular product going forward.
Here is a verbatim transcript of the exclusive interview with Hemant Mishr and B Prasanna on CNBC-TV18. Also see the accompanying video.
Q: This looks like complex instruments, so who will be the audience or the users, it will not be as common as currency futures?
Mishr: Yes, this won’t be as common as currency futures and it’s slightly more complex than the futures that Indian investors have seen whether its equity or currency futures. In terms of the participants in this market, I would expect institutional players both financial and the non-financial institutions, I would expect the mutual funds to be an active player, I would expect the insurance players to be there. There is a thought that the retail investors run in a risk whether it is through a mortgage or a personal loan. I don’t at this point in time expect active retail participation in this. The banks would be more critical and more active counterparties for this.
Q: It does look like it is only going to be an instrument. How useful will it be for a primary dealer and for banks, will you be able to almost negate an interest rate risk?
Prasanna: This is a very good product, it is a good for all kind of market participants, things like PDs. You can run directional trades on the long as well as on the short side using futures. You can also hedge your underlying risk like when there was a devolvement in the auction or the underwriting risk that you take in auctions, so there is a bit of something for almost all market participants in it. Having said that, I would also presume that the experience of currency futures have actually told us that the retail participants have actually come in a big way in that particular product, so though I agree that in the initial period its probably going to be the institutional market participants but going forward I would also expect quite a bit of the retail households, the broking communities to kind of enter into the particular product. To start with, it would be primarily institutional but later on it could be broad based to a lot of newer participants.
Q: If it is largely for institutions, would not the OIS swaps have done the same job. Why would this be different if institutions are going to hedge, surely they were doing the same with OIS?
Mishr: That’s a good point. The interest rate swap market has seen a lot of activity ever since they were first opened up in 1999. From a bank’s perspective, it would prefer a future for a simple reason that it’s a lot more cleaner both in terms of cash outflow and in terms of the risk in that instrument. Going forward, I see a big part of the bank’s liquidity actually going to the futures market, while corporates will continue to access the OIS market. So, when a corporate speaks to a bank, they might still might be wanting to hedge in the OIS, but the bank in turn will not want to hedge in the OIS market but would access the futures market.
Q: Will the larger economy be able to read any signals from the futures contracts in the interest rate industry?
Mishr: For the constraints that have been placed on government of India bonds, that typically is an exaggerated movement when the interest rate cycle turns. We have seen that in the past couple of weeks. I would expect positive feedback from futures into the cash market at two levels. One, in terms of incremental liquidity that comes into the GoI market, but also about trading happening across the curb. I don’t expect this to happen in the next few months or even in the next one year, but a possible situation when you got a future not only on the 10-year bond but on the five year and the one year bond which will feed into incremental liquidity and trading in the five year and the one year cash markets as well.
Prasanna: Just adding one more point here which most of us seem to have missed out ‑ the ability to strip out interest rate risk to credit risk which is inherent in a corporate bond. This is an important factor which will allow the participants to do so. Hence this product will not only add some kind of liquidity to the cash market which is what the positive feedback which Mishr was referring to, but it will also galvanize the trading in bond markets. A person who wants to take an exposure in corporate bonds can strip out the interest rate risk by shorting IRF if he wants to take the credit risk.
Mishr: For the constraints that have been placed on government of India bonds, that typically is an exaggerated movement when the interest rate cycle turns. We have seen that in the past couple of weeks. I would expect positive feedback from futures into the cash market at two levels. One, in terms of incremental liquidity that comes into the GoI market, but also about trading happening across the curb. I don’t expect this to happen in the next few months or even in the next one year, but a possible situation when you got a future not only on the 10-year bond but on the five year and the one year bond which will feed into incremental liquidity and trading in the five year and the one year cash markets as well.
Prasanna: Just adding one more point here which most of us seem to have missed out ‑ the ability to strip out interest rate risk to credit risk which is inherent in a corporate bond. This is an important factor which will allow the participants to do so. Hence this product will not only add some kind of liquidity to the cash market which is what the positive feedback which Mishr was referring to, but it will also galvanize the trading in bond markets. A person who wants to take an exposure in corporate bonds can strip out the interest rate risk by shorting IRF if he wants to take the credit risk.
Q: Let me come to the product itself. The manner in which it has been launched at this point in time, does it satisfy you or do you think it needs some bit of tweaking? Are you nervous about some features?
Mishr: The process that was followed by the joint technical committee of RBI and Sebi was very comprehensive in terms of seeking market contract from a host of participants, banks, MF industry, insurance companies etc. In may ways, this is closer to what will succeed in the market place. However, it is important that we have reasonable expectation out of this. In terms of timing, this is just wonderful. With the interest rate cycle turning round and with the markets being as volatile, if I compare 2009 with 2007; the interest rate volatility on the 10 year curb at that point of time was 8% and its more like 35-40 at this point of time, so if it won’t succeed now, it won’t succeed in any point of time.
Q: How much can it neutralize the risk for say a mutual fund or bank, how much can it take out really?
Prasanna: I would still presume that the quality of the fund management team is more important because it is not a solution which is going to make you money in all kind of phases, you still have to take the right view. A derivative is something which will only make you money if you take the right view. I guess it is very important to see what kind of strategies a fund manager is employing with this product.
Q: The other problem that people or regulators rather common people will have with any derivative instrument, we know how the currency derivatives ruined or troubled the corporates and even banks, do you think this has potential for such kind of trouble, people speculating for its own sake and getting carried away because of a one way movement in the direction of trade?
Mishr: There are two points important out here. The world is migrating slowly from OTC to exchange, so there is a lot standardization happening in the OTC space that the regulators like the EUS treasury and the FSA are the few are pushing. That is the trend and trajectory, in interest rate futures. This is a relatively complex instrument compared to our currency and equity futures which is something that the investor has to keep in mind which is why I am a bit weary about proposing that to retail investors on day one. But if someone wanted to take a view on an interest rate, the exchange traded future is the best possible choice at this point in time.
Prasanna: I just wanted to make a point on what could potentially to bring this product more successful. One is the fact that there has to be a very strong linkage between the cash and the futures market for any successful derivative product launch. In that respect, I think there are a couple of things which the regulators would need to do going forward to make this product a bigger success. One is to bring about a very active inter-bank term money curb at the short end where people can really transact for lending and borrowing for 1-2-3 months which is in our market at this point of time.
The second thing is again linkages between the cash and futures means that the ability for market participants to execute arbitrage strategies both ways between the cash and futures whenever the futures deviate from the futures price. Unfortunately, even in that respect we are not able to do it on both sides because you are not having the ability to short the cash bond because there are limits as for the period which you can do it. There are very strict positional limits which would probably allow the futures deviate from its fair price for a pretty long period of time, so these are the things that the regulators need to think about going forward for this product to become a bigger success. Then, you can expect a lot of participations from corporate treasuries etc.
Q: What should be the next step in the evolution of the interest rate market?
Mishr: The next step in my opinion would be having more benchmarks to the 10-year. Whether you look at it from an institutional perspective, we run risks which are not necessarily the ten year risks. If I am running a five year risk, I think the spread and the basis risk is far too much for me to take the view on the 10 year point, so having benchmarks across the yield curve as importantly having the money market benchmark is very critical. I would see this as the first step towards non-linear products for interest rates in India.
Q: Can you explain?
Mishr: There is no reason why we shouldn’t have interest rate options in India, compared to one of the more tradable benchmarks. Once you got more liquidity in the term money market, we will have that once it is actively traded. I see this as a base market for a lot of other products which will be benchmarked and settled on this whether it’s the BSE or the NSE future’s price. We look at the LME for instance, there are lots of OTC products which the LME three month price fixes, so that in my opinion would be the next logical step.
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