Interest Rate Futures in India

Vishal M. Padole

Trainee Officer

Mittal Court ‘A’ Wing

vishalp@sebi.gov.in

Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 1
Interest Rate Futures in India

Until 1991, Indian economy was a closed economy characterized by

administered interest rate regime, which gave no reason for the
emergence of risk management tools like derivatives, as there was no
significant interest rate risk being faced by the commercial entities in
the system. Hence, various risk management instruments widely used
in international markets did not make their entry here. However, with
the deregulation of interest rate, participants were exposed to various
financial risks. Indian markets are equally or more volatile than the rest
of the world, and need depth. The derivatives, which showed their
presence in the global markets, have gradually started to find
relevance here. RBI,the policy maker realized this need and during the
‘Mid-term Review of Monetary and Credit Policy for 1998-99’ which was
announced on October 30, 1998, indicated the creation of an
environment that would favour the introduction of Over The Counter
Interest Rate Derivatives in the form of Interest Rate Swap and
Forward Rate Agreement. Let us understand the concepts of OTC
derivatives.

Concept of Interest Rate Swaps (IRS) & Forward Rate

Agreement (FRA).

Interest Rate Swaps are over the counter (OTC) derivatives contracts
wherein two parties come together for exchanging of interest
payments based on notional principal amount, for a specified period.
The notional principal is used to calculate interest payment but is not
exchanged; only interest rate payments are exchanged. Such contracts
generally involve exchange of “fixed to floating” rates of interest.
Similarly, Forward Rate Agreement is financial contract where one
party can lock in oneself in to fixed or floating rates based on notional
principal amount for specified period and on the settlement date only
differences in the predefined rate & underlying rate are exchanged.

The idea behind the introduction of OTC Interest Rate Derivatives was
to enable the market participants like banks, primary dealers (PD’s)
and All-India financial institutions (FI’s) to hedge interest rate risks and
manage their Asset-Liability in a better way. Unfortunately, the market
for IRS/FRA has not developed. The market has negligible liquidity, with
no serious impact in terms of interest-rate risk management. These
OTC derivatives remain limited to small club of market participants’ i.e.
foreign banks & Indian private sector banks
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 2
 Need was felt for hedging instrument which will cater the needs of
different segment of investors in the debt market. Moreover, if that
instrument is exchange-traded instrument, it will also take care of
default risk (i.e. counter party risk is assumed by exchange).With these
considerations and continue with the financial reforms further, Interest
Rate Future were launched on 24 th June 2003. Three products of
Interest Rate Future are available in the Indian market.

 91day Treasury bill of short-term nature.

 10 year 6% Coupon bonds of long-term nature.
 10-year Zero Coupon bond of long-term nature.
Let us quickly understand the meaning of interest rate futures and
their possible uses for the market participants.

Concept of Interest Rate Future

Interest Rate Futures are used to hedge the interest rate risk inherent
in the underlying debt instrument. If you are holding G-sec paper and
you believe yield is rising in the near future, the price of debt paper
would come down(as there is inverse relationship between yield &
price).In such a case you would sell a future, which means on the due
date there would be inflow from IRF which will neutralize the
potential losses on G-sec paper.

As the market gets mature IRF will be expected to use for numerous
reasons, some of them are,

 Asset Liability management - The deposits of a bank are mainly

short term, but advances are medium term. Similarly, borrowings
of banks are mainly on an overnight basis, but investments are
for longer maturities. When the interest rate rises, the bank will
pay for its deposits and also for overnight borrowings. However,
the interest on the loan portfolio remains the same and the
investment portfolio of banks will depreciate, (as interest rate
goes up) which would adversely affect profitability of bank.
Therefore, IRF can be used to reduce such interest rate risk.
 Modifying the Portfolio Duration – Interest Rate Futures can be used
to alter the interest rate sensitivity of the portfolio. Interest rate
sensitivity can be measured by a concept called duration, which shows
approximate percentage change in the price of bond for 100 basis
point change in the yield. If a fund manager expects rates to increase,
the value of portfolio will come down & he sells futures to protect value
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 3
 of portfolio, which means he has to decrease duration of the portfolio
in order to reduce the effects of interest rate volatility of bond in the
portfolio. If interest rates are expected to decrease, the duration will be
lengthened. This is how fund managers can adjust the duration of their
portfolio by using interest rate future.

 Reduces the spread between liquid and illiquid securities. This

spread is consists of illiquidity risk (premium) and interest rate risk
(premium). IRF takes care of interest rate risk of illiquid securities.
Thereby reduces the spread between liquid and illiquid securities to
the extent of spread caused by interest rate risk and facilitates trading
in illiquid securities.

The importance of IRF can be seen from the fact that investment
portfolios of banks are continuously swelling on account of Govt.
securities and banks are heavily depend on treasury income for
survival. Therefore, the concern for the interest rate risk is obvious to
them. Despite this, trading in IRF has been consistently falling. Let us
take look at trading volumes in IRF market.

Interest Rate Future's trading in India

Monthly traded value (cr)

200
150 Traded
Value in Cr.
100
50
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June -03 to March 04

Source: NSE

As seen from above graph they are hardly any trades in the instrument
from last few months. It becomes necessary to know the possible
reasons for non-development of Interest Rate Futures market in India.
Let us look at the some of the possible reasons as to why there is no
volume in the Interest rate Futures market in India.

Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 4
Underlying Market

The debt market in India is underdeveloped. The market is in

wholesale nature with most of the trades are being done on telephone
through broker. Though NSE provides platform for trading, it has been
used only for reporting of trade executed. So it is negotiated market.
Due to negotiated nature of the market, time sequences of the trades
are not observed. Therefore it is difficult to observe last traded price
(as trades are not being reported immediately) which results in
inefficient price discovery. Price discovery is crucial for G-sec because
it sets benchmark for rest of the market. Number of players in the
debt market is few. Banks and Primary Dealers are the main players in
the market while Financial Institutions, Mutual Funds, Pension funds &
Corporate account for just 4 - 4.5% of the total turnover of debt
market. Most of these players in the debt market have long-term
perspective of the market, and are at the long end of the yield curve
(long-term nature). G-sec is the liquid segment of debt market as it
accounts for more than 75% of total trades.

Non-SLR market i.e. market other than Govt. securities, is also

underdeveloped mainly because investor prefer bank deposits to
corporate bond , corporates also prefer bank financing as there are no
hassles of disclosure norms, ratings etc. Private placement is still
preferred way for corporate to raise money. The retail debt market
(RDM) is weak mainly because, other small saving instruments like
National Saving Certificates, Public Provident Funds etc. are
competitive in terms of rate of returns, awareness of the products etc.
Moreover, cost involved in undertaking G-sec transaction is
comparatively higher to small investor. Because of this, volume in the
Retail debt market on the NSE has been decreasing steadily with
hardly any trades since last few months.

As we, all know Derivatives derive its value from underlying cash
market and if underlying market is not developed and major securities
are illiquid, as the case with Indian debt market. It does not make
logical sense to expect the futures market (Derivatives Market) to pick
up. Therefore, the underdeveloped bond market in India is one of the
major reasons for non-taking off of Interest rate futures market.

Valuation Issues

Pricing of fixed income derivatives is complex issues. In an illiquid

market where yield curve* is not developed properly, it becomes
difficult to price future instruments. There are certain methods through
which theoretical futures settlement price can be calculated.

Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 5
  Yield to Maturity Method ( YTM Basket)
 Zero Coupon Yield Curve (ZCYC) Method &
 Cubic Spline Method.

Let us briefly understand each of these methods.

In the Yield to Maturity method, the price of the future contract can be
calculated by using price of basket of most liquid securities. The
criteria for determining the security to be part of liquid basket are
liquidity, term to maturity, amount outstanding and numbers of bonds
etc. The concept of YTM basket is, consider average YTM of three or
more, most liquid securities in the market. This average Yield to
Maturity will be considered as yield on Notional security of future
contact for calculating the future price.

ZCYC is the theoretical method of calculating term structure of the

interest rate.i.e. interest rates associated to its term to maturity. ZCYC
can be calculated either by Bootstrapping method or by Nelson- Siegel
model. ZCYC is extremely useful in illiquid market where it is difficult
to find reliable yield curve, which will provide interest rates for various
terms.

In the Cubic Spline method, the yield curve is drawn based on certain
cubic formulae. It provides interest rates for various terms. The yield
curve from Cubic Spline method is quite flexible and very smooth,
however interest rates generated may some time turn out to be
negative.

In Indian debt market, we follow ZCYC (Nelson-Siegel Model) method

to calculate theoretical future price. ZCYC provides daily estimates of
term structure of interest rate using information on secondary market
trades in G-sec from Wholesale Debt Market of NSE. This term
structure will provide basis for valuation of Interest Rate Future. Most
of the market participants believe that pricing of Interest Rate Future
using ZCYC method is not correct on the ground that underlying
market operates on YTM yield method so duration of bond based on
YTM method and on ZCYC method is not the same Therefore, two
different ways of pricing in cash and in derivatives markets result in to
anomalies and perfect hedge would not be possible. There is move to
shift from ZCYC based pricing to YTM based pricing. However, it is said
that methodology of calculating YTM itself is wrong. It assumes
reinvestment rate of all coupons of bond same for entire life of bonds,
which means the entire coupons of bonds, are reinvested in the bond
at same YTM rate. This is erroneous assumption because interest rate
changes according to its term and they cannot be same for different
maturities.
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 6
 Other serious problem associated with YTM based (basket of security)
yield calculation are,

 Firstly, in Indian G-sec market it is difficult to maintain basket of three

or more liquid securities, the reason being one security is liquid at one
point of time and other security at some other point of time.
 Secondly, reconstruction of basket of securities results in to confusion
among the market participants regarding existing contracts based on
existing basket & new contracts, which will be based on new basket
introduced.

Now let us examine some of the highly traded interest rate future
products prevalent worldwide and find out relationship between
methods of pricing of these IRF products and their tradability.

Treasury Bond Future Contract: T- Bond futures contract is the most

successful IRF product in Chicago Board of Trade (CBT). It is Notional
20 Years 6 % Treasury bond, having physical delivery based
settlement. CBT allows different kind of bonds to be delivered. They
use conversion factor for converting different qualified bonds (in to
Notional security), as if they were yielding 6 % returns. Pricing is
essentially done based on price of qualified bond plus conversion
factor.

Treasury Bill Future: T-Bill was the first contract of its kind on short-
term debt instrument on CBT. This contract is essentially Physical
delivery based and all T-bills with 3-month maturity & T-Bills with 3-
month residual maturity are eligible for settlement. Pricing is done
based on rate of three months T-bills.
Eurodollar Deposit Future: Eurodollar deposit is dollar deposit outside
United States. Eurodollar future contract is derivatives contract based
on dollar deposit. It is one of the most successful IRF product used at
the short end of the yield curve (short-term nature). The settlement
price is decided by prevailing dollar deposit rate at expiry of contract.
These are cash settled derivatives contracts.

Three-year Korean Treasury Bond (KTB) future contract, which is cash,

settled contract and is based on average YTM of basket of two- three
most liquid securities.

Other popularly traded short-term future contracts on Korean,

Australian and Singapore markets are traded on average Yield to
Maturity of basket of most liquid securities.

Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 7
It is clear from the above examples that different markets are using
different methods of pricing. All these products are doing well in their
respective markets. So it can be safely assume that there is no
relationship between method of pricing of future instrument and
tradability of the product. No single method is applicable to all the
markets. Each market is unique in itself. The point is, there is no
particular method of pricing of Interest Rate Futures, which can be
perfect or accurate. It is the level of comfort of market participants to
the method used, which will determine usefulness/ accuracy of method
of pricing. Therefore, Pricing should be done on the basis of market
conditions, ease of the methodology of pricing, etc. It has been said
that ZCYC is scientifically accurate method of calculating interest rates
for various maturities. Moreover, with new developments taking place
in the Indian debt market, the concept of ZCYC will pick up and
facilitate pricing of future contracts. Even though ZCYC would currently
result in some kind of error, I felt that the market would adjust or
discount such errors. Therefore shifting from ZCYC method of pricing to
YTM method of pricing is not the solution.

Interest Rate

Interest rates in the country pose certain issues for IRF’s trading. These
issues are structure of interest rates in the economy, acceptable
benchmark rate for the market and movements of interest rates.

Let us discuss each of these issues.

Interest rates in the country are not rationalized. Different instruments

with same maturity period are having different rates. Let us have look
at interest rates of various saving schemes in India.

Interest rates on Various Saving Schemes in India

Saving Instruments Rates* (%)

Postal Savings 6.25 -7.5
Bank Deposits 5 -5.25
National Saving Scheme 8.5
PPF 8
G-sec 4.56 -5.10
T-Bill 4.36 -4.37
Certificate of Deposit# 3.59 -5.75
Commercial Paper# 4.70 - 6.50
Call money rate 4.50 -4.80
Repo rate 4.5
Mutual Funds (Debt Funds) 12.5
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 8
 (approximate)
Source: RBI
*Rates are ranging from one year to five years. (as on 1st April 04)
#Average rates (per annum).

With such a structure of interest rates, the market for all the
instruments would not be same. Investor will prefer the instrument
where they can get maximum returns with least possible risk.
Therefore, savings are diverted more towards postal saving, NSC etc.
and they will not any takers for G-sec, Commercial Papers etc. There
would not be active trading in the market, which results in IRF not
being used by participants actively and it has been restricted towards
institutional players only. (Banks)

Acceptable benchmark rate for the market is the second issue. The
benchmark rate is the interest rate, which represents the entire
market. This rate can be used for pricing of any kind of Interest Rate
Derivative product e.g., Eurodollar Deposit rate is used for pricing of
Eurodollar Deposit Future contract. In India, there is no such
benchmark rate, represents the market rate and which can be used for
pricing derivatives products. 10-year G-sec paper is supposed to be
benchmark rate but it does not represent the entire market. Even
though NSE has developed MIBID / MIBOR rates, a few players in the
market follow these rates. Term money market(Short term) is not
illiquid so 3 months or 6 months MIBOR /MIBID rates would not solve
the purpose of benchmarking. Since there is no benchmark rate, we do
not have reliable yield curve that provides interest rates for various
term to maturity. Because of which pricing of future instrument
becomes difficult.

Third issue is related to movement of the interest rates. Interest rates

are constantly moving southwards i.e. we are witnessing downward
movement in the interest rate since last two years. This has two
implications firstly; market would not realize the need to hedge their
underlying positions as falling interest rate would result in capital
appreciation of debt security. Secondly, with the one-way movement of
interest rates, opposite views about the movements of interest rates
among the market participants are not emerging in the market
because everybody has common perception of interest rate
movements( i.e. rates are going to fall further). Therefore, one-way
movement of interest rate also affects the trading of interest rate
futures.

Other issues

Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 9
  Retail investors are likely to stay away from the retail segment of
Govt. securities, as majority of household saving end up in postal
savings, gratuity and provident fund, which have fixed rate of return.
Retail investors are also not aware about risk-return profile of the govt.
securities vis-à-vis other small saving instruments. Moreover, the
transaction cost involved in undertaking debt transaction is also
comparatively higher. Because of this Retail debt, market is not
developed and retail investor would not realize the need for interest
rate futures to hedge their positions. Therefore, Interest Rate Future
market is restricted to narrow participant’s base.

 Number of participants in the IRF market is narrow and it is just

restricted to Banks and PD’s. Diverse participant base is
important from the point of view of risk taking abilities.
Derivatives market needs players with greater risk appetite but
in India, most of participants are Banks (PSU banks), which are
basically risk averse players. Moreover, lack of adequate capital
is hindering Primary Dealer’s from developing the product with
two-way quotes, as their risk taking capacity is limited.
Therefore, we need players from diverse areas like Financial
Institutions, Mutual Funds, Pension Funds, Insurance companies,
FII, High Net worth individuals and Hedge Funds etc.with greater
risk appetite to trade in the market.

 The cash flows, duration, convexity, maturity etc. of Notional

security and underlying asset do not match as a result, Price
value of basis point (PVBP)* of notional security & underlying
security differs. Therefore, the loss on the value of underlying
security does not get perfectly match with the cash flow from
future’s (based on Notional security) sale. This phenomenon is
called basis risk*. The point is, irrespective of pricing method
used, there bound to be some basis point error (basis risk) in
calculating the perfect hedge when we use Notional security
(derivates) for hedging cash security. Therefore, ZCYC method
should not be blamed for basis point error, which we are
witnessing currently in Interest Rate Future market.

 In the current reforms phase, the role of policy maker should be more
of facilitator than of regulator. However, in India the policy maker puts
lot of restrictions on market participants. For instance, banks are not
allowed to take speculative positions in IRF market, Hedging limits
have been set up between 80% to 125% of transaction, FII’s exposure
to IRF has been limited to $100m. Such kinds of restrictions limit the
no. of players in the market.

Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 10
 The concepts of Interest Rate Swap and Interest Rate Future are new
to Indian market. There is very limited knowledge about these
instruments even among the active participants especially PSU banks.

Is there any Future for the product?

Interest Rate Future, which is one of the most sophisticated products in

Indian financial market, has bright future. An effort needs to be taken
by the policy makers to address certain regulatory issues to boost the
IRF market in India. Some of these issues are,

 Commercial banks and All India Financial institution, which are

allowed to take membership of stock exchanges for limited
purpose of proprietary trade only. They should also be permitted
to act as intermediary (broker) in the IRF transactions. It will
increase number of players in the both sides of market & will
give them additional source of fee-based income.

 If hedge is not highly effective (80%-125% range) no set off will

be allowed. Which means loss should not be adjusted and gain if
any are considered for Balance Sheet (considered as an
investment and will be taxed.).While hedging there would be a
gain from the transactions but that does not mean that intention
of participant, is to make gains out of it. Such kinds of
restrictions actually deter market participants from participating
in the market. Moreover, there should not be any limits imposed
for purpose of hedging.

 Policy makers should step in to bring awareness among the

market participants especially among investor community
regarding govt. securities, interest rate derivatives etc. by
conducting seminars etc.

Conclusion

I would like to conclude by saying that there is a market for Interest

Rate Future in India. With the introduction of Real Time Gross
Settlement, (currently SBI, Standard Chartered and Saraswat Bank are
implementing RTGS successfully) & Negotiated Dealing System (NDS),
will help in better price discovery. Private pension fund, with the
privatization of Pension Fund industry, Insurance Companies etc. will
see emergence of new players in the Interest Rate Derivatives market.
Development of retail market and rationalization of interest rate on
small saving schemes (A committee has been set up under
Dy.Governor Rakesh Mohan to look in to rationalization of interest rate
Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 11
in India) will help debt market to develop further. All theses
developments will result in to getting that, much-needed depth for the
market. Introduction of the STRIPS*-Separate Trading of Registered
Interest and Principal Securities will help in facilitating establishment of
ZCYC (Zero Coupon yield Curve) methodology, which makes pricing of
Interest Rate Futures easy. The product can be successfully traded if
market conditions in which it operates are favorable. i.e. underlying
market, interest rate structure etc.

New developments in debt market as well as regulatory issues are also

prerequisites for the development of Interest Rate Futures market.
Once theses issues are addressed, we can witness the way IRF will
revolutionize the interest rate risk management in the Indian financial
market.

Some concepts*

Duration:
Duration shows approximate percentage change in the price of bond
for 100 basis point change in the yield. It is a measure of calculating
interest rate sensitivity of bond.

Convexity:
Convexity describes the shape or curvature of price / yield
relationship of bond. It is used to measure the change in price for
small change in yield, not explained by duration.

Basis Risk:
Basis risk is caused by differences between cash bond price and
converted future’s price of the same bond. It shows difference
between hedging amount calculated & exact hedge amount possible
for particular bond.

Price Value Basis Point (PVBP):

PVBP is the absolute value of the change (in rupee terms) in the price
of the bond for a one basis point change in yield. It is another
measure of the price volatility of bond.

Yield Curve:
Yield curve shows relationship between yield (interest rates) and its
term to maturity. Usually yield curve is upward sloping, i.e. longer the
maturity greater the interest rates.

STRIPS: (Separate Trading of Registered Interest Payment)

Vishal Padule –Trainee Officer. The views expressed are of the author and not of
SEBI. 12