Why re-introduced interest rate futures is not an old wine in new bottle

With more underlying added in future, the IRFs contract may get good trading volume. While there is a fear that like other derivative contracts, this product may also get influenced by actions of punters, multiple players and large institutions are expected to reign in that activity to a great extent

Interest rate futures (IRFs) are back in its new avatar, after having failed couple of times in the past. After Reserve Bank of India (RBI) deciding to introduce interest rate futures in the second quarter monetary policy review, and subsequently issuing a notification in this regard on 5 December 2013, all three bourses—National Stock Exchange (NSE), MCX Stock Exchange (MCX-SX) and BSE—decided to launch interest rate futures. The MCX-SX became the first stock exchange to launch this on 20 January 2014. NSE and BSE are going to shortly launch this.

Need for interest rate futures

Interest rate futures are a very actively traded derivatives contract worldwide. In fact the trading value (notional) in the interest rate futures contracts in US is as high as 80% of the total number of contracts traded. In India, till now it has been zero with earlier versions of interest rate futures having failed completely. The date below shows that trading volume in interest rate futures contracts:

The need for interest rate futures contract arises from two prime reasons: hedging and trading. Like other derivative products, interest rate futures are also a highly speculative product with most participants speculating on the interest rate movements to make money. While hedging with interest rate is also a good strategy to mitigate risk, this is used by banks and financial institutions. Since RBI has allowed banks in India to trade in these contracts, it needs to be seen what kind of depth the contract acquires in terms of trading volumes. The banks are not allowed to trade in these contracts on behalf of clients.

What has changed in the re-launched IRFs contract?

Interest rate futures contract was earlier based on a notional 10-year bond with a fixed 7% coupon rate. Investors then had no way of hedging against holdings of real 10-year bonds floated on different dates with varying coupons. Adding to the woes was physical settlement of contracts. Trading of contracts on notional bonds and delivering actual bond against these notional bonds, did not find favour with the buyers as sellers had the option to deliver what was called as ‘cheapest to deliver’ (CTD) bonds.

Now, real bonds have replaced notional bonds. The bonds allowed in interest rate futures is 8.83% Government of India (GoI) bond maturing on 25 November 2023 and 7.16% GoI bond maturing on 20 May 2023. These bonds are liquid bonds in the delivery-based market and attract lots of volume. Also, cash settlement means that there won’t be supply side pressures on these bonds. The new interest rate futures contract may help boost the volume in Negotiated Dealing System-Order Matching system (NDS-OM) where the underlying is also traded. The price differences between futures and spot, like any other market, creates arbitrage opportunities. Banks and the financial institutions will be beneficiaries of this as they have large exposure to government bonds.

Does it offer anything for retail investors?

It will be better if retail investors stay away from these contracts. However, investors knowledgeable of interest rate futures can use these contracts to hedge exposures on loans. This essentially means reducing risks arising from rising interest rates. As the exposure into home loans is generally of the large size the investors can think of mitigating risk using these contracts. As per contract specifications of MCX-SX, the initial margin and extreme loss margins are not very high and this would mean not a very investment by retail investors.

By design, the interest rate futures look more logical and should be acceptable to the market players. With more underlying added in future, the contract may get good trading volume. While there is a fear that like other derivative contracts, this product may also get influenced by actions of punters, multiple players and large institutions are  expected to reign in that activity to a great extent.

(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)

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