Interest Rate Futures

Published on May 2016 | Categories: Types, Presentations | Downloads: 49 | Comments: 0 | Views: 324
of 19
Download PDF   Embed   Report

rate futures

Comments

Content

Interest Rate Futures
Introduction
Treasury Bills are money market instruments to finance the short term requirements of the Government of India. These are discounted securities and thus are issued at a discount to face value. The return to the investor is the difference between the maturity value and issue price. Types of Treasury Bills: There are different types of Treasury bills based on the maturity period and utility of
the issuance like, ad-hoc Treasury bills, 3 months, 6 months and 12months Treasury bills etc. In India, at present, the Treasury Bills are issued for the follo in! tenor"s #1-days, 1$2-days and 36%-days Treasury bills

A contract on the future delivery of interest-bearing securities primarily Treasury bills !on the "hicago #ercantile $%change& or Treasury bonds !on the "hicago Board of Trade& although contracts on certificates of deposit Ginnie #ae certificates and Treasury notes are also available. As with other futures contracts interest rate futures permit a buyer and a seller to lock in the price of an asset !in this case a specified package of securities& for future delivery. The contracts are large in amount !'( million for bills and '()) ))) for bonds& and lend themselves to sophisticated analysis. An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. The interest rate derivatives market is the largest derivatives market in the world. The Bank for International *ettlements estimates that the notional amount outstanding in +une ,))- .(/ were 0*'123 trillion for 4T" interest rate contracts and 0*'21, trillion for 4T" interest rate swaps. According to the International *waps and 5erivatives Association 6)7 of the world8s top 9)) companies as of April ,))2 used interest rate derivatives to control their cash flows. This compares with 397 for foreign e%change options ,97 for commodity options and ()7 for options. It consists of swaps forwards and futures An interest rate swap is a derivative in which one party e%changes a stream of interest payments for another party8s stream of cash flows. Interest rate swaps can be used by hedgers to manage their fi%ed or floating assets and liabilities. 0nlike corporate bonds interest rate swaps do not involve risk on the principal amount.(/. They can also be used by speculators to replicate unfunded bond e%posures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments

Interest rate futures: Overview
The concept of interest rate futures is like that of any other derivative product e%cept for the underlying --- the underlying security here is not a stock or basket of securities but interest rates. The underlying instrument for this is a ()-year notional coupon-bearing government security. This
1

Interest Rate Futures
underlying security is assumed to pay interest !called a coupon& at a rate compounded at 37 on a halfyearly basis. Interest rate futures are primarily seen to be of use to those who have a view on how the interest rate would move and wish to benefit from it. It can also be used as a hedging mechanism for anyone who holds a large number of government securities which largely comprise banks or other such financial institutions. The introduction of trading in interest rate futures in the country heralds the beginning of a new era in the fi%ed income derivatives market. Initial hiccups with regard to the product design and variations from the global standards would settle down over a period of time and the product would emerge as a path breaker paving the way for many more initiatives on the derivatives front. The introduction of trading in interest rate futures in India is one more step towards integration of the Indian *ecurities #arket with the rest of the world. Globally interest rate derivatives are the darlings of the market and account for around 3)7 of the total derivatives transactions across the economies. In India it may be seen as a path breaking initiative because it is e%pected to pave the way for various innovations at the derivatives front in the time to come. Although market participants have unanimously appreciated the initiative there appears to e%ist certain apprehensions in their mind with regard to the product design.

Introduction to interest rate futures
Interest :ate ;utures account for the largest volume and notional value among the financial derivatives traded on e%changes worldwide. Globally according to data released by the Bank for International *ettlement !+une ,))-& the notional principal amount outstanding in organi<ed e%changes across all futures instruments amounts to 0*'(6.9 trillion in #arch ,))- of which '(3.6 trillion pertains to Interest :ate ;utures. In Asia the notional amount outstanding in $%change Traded Interest :ate ;utures is estimated at 0*'(.- trillion in #arch ,))-. =orldwide 31 million Interest :ate ;utures contracts are outstanding in organi<ed e%changes as on this date. ;or financial markets in
2

Interest Rate Futures
India Interest :ate ;utures present a much needed opportunity for hedging and risk management by a wide range of institutions and intermediaries including Banks >rimary 5ealers "orporate Asset #anagement "ompanies ;inancial Institutions ;oreign Institutional Investors and :etail Investors. Interest :ate ;utures will help various constituencies in providing an effective and efficient mechanism to manage interest rate volatility They are essentially!over-the-counter 4T"& contracts traded on one to one basis among the parties involved for settlement on a future date. The terms of these contracts are decided by the parties mutually at the time of their initiation. If a forward contract is entered into through an e%change traded on the e%change and settled through the "learing "orporation? @ouse of the e%change it becomes a futures contract. As one of the most important obAectives behind bringing the contract to the e%change is to create marketability futures contracts are standardi<ed contracts so designed by the e%changes as to ensure participation of a wide range of market participants. In other words futures contracts are standardi<ed forward contracts traded on the e%changes and settled through their clearing corporation?house. ;utures contracts being standardi<ed contracts appeal to a wide range of market participants and are therefore very liquid. 4n the other hand the clearing corporation?house in addition to settling the futures contracts becomes the counter-party to all such trades or provides unconditional guarantee for their settlement thereby ensuring financial integrity of the entire system. Therefore although futures contracts take away the fle%ibility of the parties in terms of designing the contract they offer competitive advantages over the forward contracts in terms of better liquidity and risk management. It is simple to comprehend that futures contracts on interest rates would be called interest rate futures. Bet us look at the ;orward :ate Agreements !;:As& being traded in the 4T" market. In case of ;:As contracting parties agree to pay or receive a specific rate of interest for a specific period after a specific period of time on a specified notional amount. Co e%change of the principal amount takes place among the parties at any point in time. Cow think about bringing this contract to the e%change. If we bring this ;:A to the e%change it would essentially be renamed as a futures contract. ;or instance $urodollar futures contract !most popular contract globally& is an e%change traded ;:A on 2 months $urodollar deposits rates. To comprehend the product further now think we are entering into an ;:A on an e%change. ;irst thing would be that we would trade this contract on the e%change in the form of a standard product in terms of the notional amount delivery and settlement margins etc. @aving entered into the contract we can reverse the transaction at any point of time. Indeed having reversed we can again enter into the contract anytime. Therefore these e%change traded ;:As !futures contracts& would be very liquidity. ;urther in this contract clearing corporation ? house would bear the counterparty risk. The transaction mentioned above is pretty simple. But world does not trade the interest rate futures so simply. Indeed product designs are much more complicated and they are different both at the long and short end of the maturity curve.

3

Interest Rate Futures

Interest rate futures in the global context
#ost of the global markets trade futures on two underlyings one at the long end !maturity of () years or more& and another at the short end !maturity up to one year& of the yield curve. The futures on the long end of the yield curve are called the Bong Bond ;utures and futures at the short end of the yield curve are called the T-Bill ;utures and :eference :ate ;utures. *ome markets do trade futures on underlyings with multiple maturities say of , years and 9 years as well but volumes in these products speak for their poor receptivity by market participants. In other words most of the volumes in the global markets are concentrated on derivatives with one underlying at the long end and one underlying at the short end of the yield curve. In global markets underlying for the long bond futures is a notional coupon bearing bond. These contracts are generally physically settled but some markets do have cash settled products. ;or instance *ingapore trades 9 years gilt futures which are cash settled. "hicago Board of Trade !"B4T& also trades futures on the () year #unicipal Bond Inde% which is also a cash settled product. #ethodology of the physically settled products is beyond the scope of this work. The simple thing to understand here is that there are concepts like basket of deliverable bonds conversion factors cheapest to deliver bond delivery month etc. >rice quote for long bond futures is the clean price of the notional bond across the markets.
4

Interest Rate Futures
4n the short end of the yield curve global markets have two kinds of products - T-Bill futures and reference rate futures. T-Bill futures are essentially the futures on the notional T- Bills which are physically settled. But reference rate futures are the futures on reference rates like Bondon Inter-bank 4ffer :ates !BIB4:& and are cash settled. 4ver a period of time these reference rate futures have rendered the T-Bill futures out of fashion. >ossible reasons for this phenomenon are that they are easy to comprehend have very wide participation from across the globe and are cash settled. The success of reference rate futures may be measured by the volumes they command in the international markets. Indeed all maAor markets across the globe trade them. ;or instance +apan trades futures on the +apan inter-bank offer rates !+IB4:& *ingapore trades futures on *ingapore inter-bank offer rates !*IB4:& @ong Dong trades futures on @ong Dong inter-bank offer rates !@IB4:&.

Interest :ate ;utures !I:;& is e%pected to provide the following benefits to market participantsE (& I:; will e%pand the scope of the financial markets in India and will further deepen the derivatives markets. ,&$%change Traded I:; are most transparent in terms of price discovery margining risk management and settlement. 2& I:; will enable "orporates to hedge interest rate risk. Interest payments form one of the maAor parts of the e%penditure for companies. Folatility in interest rates could be better managed with the help of Interest :ate ;utures. 1& I:; will provide banks and financial institutions with an avenue for efficient Asset-Biability #anagement. 9&;und managers and Insurance companies can better manage asset allocation and investments using I:;. G& I:; will also help individuals in efficient management of the household balance sheet.

5

Interest Rate Futures

Structure of the product in the Indian Market
>roducts proposed to be launched in the Indian #arket are futures on long bond !() year notional Gsecs& and T-bills !-( days notional&. This is in line with the international practice on the interest rate derivatives. :eference rate short end products i.e. the futures on #umbai Inter-bank 4ffer :ate !#IB4:& #umbai Implicit ;orward 4ffer :ate !#I;4:& etc. are proposed to be launched after certain legal issues related to these products are resolved. Issues like the coupon of the underlying notional long bond and the maturity of the futures contract !subAect to it being ma%imum of one year& are left to the e%changes to decide upon. Both these products Bong bond futures and T-Bill futures are proposed to be settled in cash based on the Hero "oupon Iield "urve !H"I"&. The final settlement value of these futures contract would be the present value of all future cash flows from the underlying discounted at the <ero coupon rates for the corresponding maturities taken from the H"I". This methodology would also be used to price the product theoretically for the #arking to #arket !#T#& purpose in case futures do not see any trade during the last half an hour of trading. The H"I" is proposed to be derived from the actual traded prices of the Government *ecurities each day reported on the =holesale 5ebt #arket !=5#& of the $%change or the price data collected from the Cegotiated 5ealing *ystem !C5*&. Salient Features of $%change Traded Interest :ate ;uturesE (&Increased market reach enables higher liquidity. ,& $%change platform ensures protection against counterparty default risk due to novation by "learing @ouse of the $%change. 2&Greater transparency due to automated anonymous order matching system and settlement. 1&5elivery of underlying asset is possible on $%change platform. 9& ;utures contract available on Cotional 37 coupon ()-year Government of India *ecurity as the underlying asset.
6

Interest Rate Futures
G& Barge number of Informed >articipants can trade using online electronic trading systems leading to efficient price discovery. 3& Allows hedgers to efficiently transfer risk to speculators and arbitragers. 6& $%change Traded I:; ensure robust systems for risk management and surveillance thereby capable of eliminating any kind of market manipulation. -&0niform standards and well-established procedures in I:; market allow symmetry of treatment to various participants. ()& I:; e%pands the set of hedging tools available to financial as well as non-financial entities to manage interest rate risk. ((& *imple derivative instrument and easy to understand due to its linear pay-offs. (,&I:; are standardi<ed products that allow for gauging the utility and effectiveness of different positions and strategies. (2& 4nline real-time dissemination of prices.

Trading Techniques
;or exa ple !: 4n (?(?,))2 the notional ()-year bond !from H"I"& was :s.19.12. Iou believe the long rate will go up so you short three futures contracts !(, ))) bonds& J :s.1-. 4n 2(?(?,))2 the notional ()-year bond is at :s.2-. Iou have a profit of :s.()?bond or :s.(,) ))) overall. "xa ple #: The futures contract e%pires in 2) days. 2) days from now the seller is obligated to deliver a -)-day tbill. *oE (. Buy a H" bond with (,) days to e%piry ,. *hort the -) day futures with 2) days to
7

Interest Rate Futures
e%piration This is a locked in positionK This is cash and carry arbitrage$

"xa ple % (.Get * by selling (,) day bond ,. Invest it into a 2)-day tbill gives *!( L r2)M2G9&2)M2G9 on futures e%piration. 2. Buy -)-day futures J ;. 1. 4n e%piration date INm left with *!( L r2)M2G9&2)?2G9- ; in hand. :everse cash and carry.

&ricing futures through arbitrage
=e said that the cash and carry arbitrage would be worth doing when ; O *!( L r2)M2G9&2)?2G9. :everse cash and carry arbitrage would be worth doing if ; P *!( L r2)M2G9&2)?2G9. =e get the Qfair priceR of the futures contract when there is no arbitrage ie ; M *!( L r2)M2G9&2)?2G9

8

Interest Rate Futures

Interest 'ate Futures Market &articipants !( )anks and &ri ary *ealers
Interest :ate ;utures enable Banks and >rimary 5ealers to mitigate risk improve process efficiency and increase their bottomline. ;ollowing are some of the scenarios when I:; can benefit Banks and >rimary 5eal (& #anage SIield "urve :iskS when banks are e%posed to assets and liabilities across different tenors. ,& #itigate SBasis :iskS when yield on assets and costs on liabilities are based on different benchmarks. 2& 1& @edge against Q:epricing :iskS related to volatility of cash flows due to revaluation of assets and liabilities ove a period of time. >rotect against devaluation of *B: and non-*B: securities inventory !held under Available ;or *ale and @eld ;or Trade categories& due to sudden spike in bond yield rates !and consequent decrease in bond prices&. $%posure to embedded options in structured product can lead to S4ption :iskS due to varying S4ptionalityS. ;or e%ample S>uttabilityS of mortgage !home& loans by borrowers due to home-loan refinancing in lower interest rate regime.

9&

G& Improve the financial performance by increasing theSIield on ;und AdvancesS ratio thereby decreasing the SBreakeven Iield :atioS for the bank resulting in increase in SCet Interest IncomeS. 3& 5ecrease the sensitivity of returns on bank assets and liabilities due to volatility in interest rates. 6& Banks have lower entry and e%it costs by using I:; as compared to Interest :ate *waps !I:*&. -& I:; pricing is directly dependent on the widely accepted Government of India *ecurities leading to efficient price discovery and high liquidity. ()& "learing and settlement through e%change clearing houses ensures safety for banks leading to decrease in risk capital allocation for hedged assets and better S"apital Adequacy :atioS.

9

Interest Rate Futures
((& *maller lot si<e of I:; provides avenue for banks to develop mechanism for hedging risk e%posure of retail clients. (,& Banks can pass on the hedge benefit to the borrowers products. through packaged debt

13) >rimary dealers can use I:; for interest rate risk mitigation in the process of adhering to :BI guidelines for annual minimum bidding for dated securities minimum success ratio minimum annual turnover limits and commitment to underwrite the shortfall !gap& between the subscribed accepted amount and the notified amount. (1& Banks and >rimary dealers can minimi<e portfolio volatility by using I:;.

10

Interest Rate Futures

,&Mutual Funds E#utual ;und managers can immensely benefit from I:;. The Cet Asset Falue can be protected by hedging against interest rate volatility. ;ollowing are some of the maAor benefits to these participantsE a&@edging to mitigate interest rate risk for 5ebt #arket #; b&Increasing the absolute performance of a portfolio on a risk adAusted basis over a specific time period !improved +ensen8s measure and lower drawdown as compared to unmanaged portfolios&. c& Investors can diversify their portfolio by taking positions in Interest :ate ;utures resulting in increased *harpe ratio !risk adAusted returns&. d&$asy entry into and e%it out of debt market e%posure. e&Arbitrage between cash and futures markets. f&Bow transaction costs due to higher liquidity g&*pread Trading to leverage on interest rate differentials. h&Beveraged trades using I:; i&Falue-added services for "lients using Interest :ate ;utures. A&#T# *ettlement on TL( day basis through $%change "learing @ouse. k&Innovative #utual ;und !#oney and 5ebt #arket& >roducts using Interest :ate ;utures to mitigate risk. l&4ptimi<e CAF by hedging interest rate risk m&$%change "learing "orporation provides counterparty guarantee to trades thereby minimi<ing risk. n&$fficient price discovery and greater liquidity due to wider participation o&$lectronic trading on e%change platform.

11

Interest Rate Futures

%( Insurance +o panies
;ollowing are some of the maAor benefits of Interest :ate ;utures for Insurance "ompanies both in Bife Insurance and General Insurance IndustryE a&@edgingE Insurance companies having e%posure to Government *ecurities and "orporate 5ebt can leverage on Interest :ate ;utures for mitigation against volatility of interest rate bearing assets and liabilities. b&5ecrease Boss - $%pense :atio and Increase Investment Iield of assets. c&Increasing :eturn on Investments and 5ecreasing the Insurance "laims-ratio due to foreclosures. d&$fficient management of Asset-Biability mismatch e&@edging against events such as credit crisis leading to increased claims against *ocial Insurance and Bond Insurance policies. f&>rotection against :einsurance risk g&5ecrease underwriting e%penses of insurance policies by effective and efficient management of interest rate risk. h& >rotect payment of Annuities in >ension ;unds as well as manage liquidity requirements in $ndowment Insurance policies. i& Increase the return on investments in Interest bearing securities thereby enhancing actuary numbers for the Insurance "ompany. A&@edge against interest rate risk for protection of the *um Assured. k&Increase reversionary and terminal bonus interest rate risk management. l&Innovative Insurance >roducts using Interest :ate ;utures can be structured.

12

Interest Rate Futures
1&+orporate ,ouses E"orporates need to identify measure and mitigate risk pertaining to interest rate volatility. Interest :ate ;utures !I:;& provide the mechanism to manage risk at strategic and operational level pertaining to volatility in interest rates. ;ollowing are some of the maAor benefits to "orporates by hedging using I:;E 4ptimi<ing the cost of capital to company leading to optimal Sdebt-equityS ratio based on interest rate risk management using I:;. Implementation of efficient processes and systems for improving credit terms for clients based on improved interest rate risk management. Improve the S$nterprise FalueS to S$BI5TAS ratio by better management of interest rate risk. *ophisticated management of debt and interest rate cash outflows can lead to effective use of debt as a ta%-shield. "orporate issuing bonds with Sembedded optionsS !callability and puttability& can better manage risk against volatility in interest rates leading to the e%ercise of the option by borrowers. "orporates having debt e%posure can mitigate risk against volatility in interest rates by using I:;. $%ampleE 5ebt linked to floating rate cash outflows can impact future financial performance due to adverse movement !increase& in interest rates. *maller lot si<e in I:; enables better interest rate risk management by *#$ and #*#$. @edging using I:; provides lower entry and e%it costs as compared to Interest :ate *waps !I:*& Better management of interest-rate cash outflow towards funding working capital e%penses !shortterm debt& Improve the credit rating for corporate by enhancing the Sdebt-service coverageS ratio and the Sinterest coverageS ratio !improved leverage& by better risk management using I:;.

9&Brokers ;oreign Institutional Investors and :etail >articipants

G&Banks and >rimary 5ealers

Issues with the &roduct
Two maAor points of differentiation between the configuration of the proposed products in India and the internationally traded interest rate futures areE

13

Interest Rate Futures
(. >roducts proposed in India are cash settled while internationally traded interest rate futures are largely physically settled. ,. #ethodology for cash settlement of futures contracts using H"I" based approach is nowhere used across the globe. Bet us address these issues one by one. >roducts proposed in India are cash settled while internationally traded interest rate futures are largely physically settled. Actually this is an issue of debate between the cash settled vs. physically settled derivatives. =orldwide both cash settled and physically settled derivatives are traded with equal enthusiasm for a variety of reasons. Though the physically settled products offer better hedge and better arbitrage opportunities they have their own share of competitive disadvantages in terms of the settlement risks and possibility of short squee<e. *hort squee<e occurs when the participants with short !sold& positions in the market do not find sufficient underlying in the system to buy and honor their obligations. *hort squee<e becomes a maAor issue specially when the underlying is not very liquid and?or has limited outstanding. Government *ecurities have a typical pattern of trading across the globe including in India. *ome maturity baskets like 9 years () years (9 years are pretty liquid in comparison to other maturity baskets. ;urther within a specific maturity basket only few securities !generally on-the-run securities which have yields close to the prevailing yields in the economy& command the volumes. In this environment markets either choose to have cash settled products or delivery based products linked to a basket of underlying !not a single bond&. In case of delivery based products the basket of deliverable bonds is chosen based on certain criteria such as the outstanding maturity outstanding amount etc. *till in the past there have been instances of the short squee<e with delivery based products in the global markets. >robably that is the reason why some markets have chosen to go ahead with the cash settled products which are much easier to understand and trade. ;or instance *ingapore trades 9 years gilt futures which are cash settled and are doing absolutely great. ;urther India has been trading cash settled equity derivatives !futures and options& both on indices and individual stocks. There are plans to move to the physically settled equity derivatives over the period of time. The introduction of interest rate derivatives also appear to have been planned on similar lines i.e. start with cash settlement and then move to the physically settled products over a period of time. Although physically settled products integrate both cash and derivatives market better in my opinion the decision to start with the cash settled products is a prudent one going by our own e%perience with cash settled equity derivatives and the problems linked to the delivery based products. ;urther with maturing markets accumulated e%periences and built up competencies markets can always migrate to the delivery based products. #ethodology for cash settlement of futures contracts using H"I" based approach is nowhere used across the globe. India has been trading cash settled equity derivatives for quite sometime now. Folumes in these products make me feel that market participants are comfortable with the structure of these products. Accordingly a segment of the market participants seems to have no complaint about the cash settled
14

Interest Rate Futures
interest rate futures but worried about the way these products are proposed to be finally settled. #arket participants have been voicing concerns about the H"I" based approach for the final settlement of the futures contracts. Issues raised are manyE a. Instead of H"I" based final settlement we may settle the product based on polled yields. b. #arket has been using the yield to maturity !IT#& and not H"I" for various purposes. *o better if we use IT# and not H"I". c. The H"I" based approach is comple% and difficult to understand. d. H"I" is being computed in the black bo% and transparency is an issue. e. #odelling errors with the H"I" is a maAor problem. Bet us contemplate over these issues one by one. a& The first issue is that of final settlement of the futures contracts based on polled price vs. the H"I" based approach. #arket has been demanding that the final settlement of futures contracts should be based on polled yields and not H"I". These arguments are based on the international practice on cash settled interest rate futures and the comfort of market participants with the approach. ;or instance *ingapore 9 years Gilt ;utures are cash settled based on the polled prices from the (( >rimary 5ealers appointed by the #onitory Authority of *ingapore !#A*&. ;urther as market has been trading various derivatives like swaps and ;:As on the polled prices !#IB4: and #I;4:& it would be easy for the market to understand the approach. Though it is right that the prices based on polled yields !IT#& are much easier to understand and comprehend and there is a precedent in this regard in the Global #arkets it may not be the most scientific way to settle the product. All of us would appreciate that to price a fi%ed income instrument correctly its cash flows at the different time hori<ons must be discounted at the different yields corresponding to their maturity. This may be more comple% computationally but is a more systematic approach to pricing such products. ;urther there are issues with regard to polled prices like transparency and lack of commitment on the participating agencies in the polling process. A segment of the market participants feels that polled prices are governed by the limited number of market participants and in case market participants are also trading in the market there is a possibility of conflict of interest. ;urther as there is no financial commitment on the part of these market participants their quotes may not reflect the e%pectations of the overall market. @owever some market participants still argue in favour of polled prices based cash settlement approach after addressing the issues raised above because of their comfort. This issue of polled price vs. H"I" is limited only to the cash settlement of the futures contracts and once we migrate to the physical settlement of these products there would not be any issue at all. "ommittee on the subAect has already recommended the physical settlement of the products over the period of time. b& The second issue relates to the pricing of fi%ed income instrument based on IT# vs. H"I". In my opinion as mentioned above though H"I" based approach is more difficult it is more scientific and
15

Interest Rate Futures
correct to use that to price the fi%ed income products. Cow the issue is to make a choice between an easy and practically incorrect approach or the correct and more scientific approach to the subAect. At any given point in time my sense is the we must go with later. ;urther if we look at the issue conceptually IT# is nothing but a single number !yield& representing all the points on the yield curve over the life of the bond. It is the single yield which equates the price of the bond with the present value of all its future cash flows. Therefore IT# can easily be derived from the computed theoretical price based on the H"I" and the given coupons of the notional bond. In other words first we may price the notional bond based on H"I" and then use this price with coupons to rework and find the IT#. This needs a simple piece of software. Indeed this may be done by the e%changes themselves to give comfort to the market participants. c& Third issue is the difficulty in understanding the H"I" based approach. It is undoubtedly trueT but world is becoming increasingly comple% and so also the financial products. "omple%ity is something we all need to learn to deal with. +ust to escape the comple%ities we may not continue with something which is scientifically incorrect. Indeed global markets have no way but to adopt the H"I" based approach to price the fi%ed income instruments. ;urther the whole mathematical part is to be taken care of by the computers and we need to Aust understand the way H"I" would be computed and used to price the said products. =e all would agree that the grasping power of the Indian securities market participants is phenomenal. They may have struggled with the definitions of call and put options two years ago !when equity options were first introduced & but today the same set of people state that straddle and strangle are conventional products and they need to migrate to the e%otic stuff. It is certainly proof of their growing e%perience in the derivatives markets and the resulting confidence in their abilities to use such comple% products for their own benefit. d& As regards the issue of non-transparency of computation of H"I" full computational methodology is required to be made available on the website of the e%change or the H"I" service provider. It would not be difficult for anyone in the market to create his or her own H"I" based on the given methodology. Therefore the non-transparency argument does not really hold water. ;urther argument may be whether we really know how #ibor #ifor etc. are computed. It is all the confidence in and the credibility of the service provider which is built over the period of time. It is believed that the same would happen with the H"I" as well. e& 4n modelling errors related to the H"I" I would agree with the market participants. #odelling errors create basis risk for the market participants but we need to appreciate that this error e%ists even in the markets where such contracts are settled through delivery. This happens because in all these markets traded products are the futures?options on underlying which is not a specific bond but a set of eligible bonds for the purpose. In other words this is a kind of cross hedge !one underlying being hedged by derivative on some other underlying& which always carries some basis risk. Therefore issues with the product e%ist but they would be tackled over a period of time. Indeed the H"I" providers would make sincere efforts to minimi<e the errors between the theoretical price of the actual traded bonds based on the H"I" and their actual market prices. ;urther as long as market knows that there is a possibility of certain errors it discounts for the same while pricing the products.
16

Interest Rate Futures
It is also believed that with the smoothening yield curve and its improved accuracy the market would automatically gain the confidence.

The 'oad -head Introduction of Interest :ate ;utures is an e%cellent e%ample of collaborative efforts on the part of market participants e%changes and regulators. It is a great addition to the e%isting portfolio of financial products in the Indian ;inancial #arkets. Cow we need to quickly work on the products proposed in the Technical paper prepared by the *ecurities and $%change Board of India8s !*$BI& risk management group. Availability of the large number of products always creates more and more opportunities for trading which in turn result in the better price discovery and efficiency in the system. The *$BI8s risk management group has recommended that reference rate products linked to the #IB4: and #I;4: be introduced in the market only after all related legal issues have been addressed in order to avoid the legal risk. 4nce the said issues are resolved market would see these products which are well established and e%tremely popular globally. The market participants also appear to be really looking forward to these reference rate products. Another issue is that the market participants should be given the freedom to use these products. ;ocus of regulations should be on the proper disclosures and the transparency in the operations of the market participants instead of putting the restrictions on their usage. *trategic uses of the products are discovered and rediscovered by the market participants on day to day basis and any kind of restrictions on the products8 usage hamper the market developments by containing the creativity and imagination of the market place. Therefore market participants must be given the freedom to e%plore the value creation opportunities with these products within the given framework. Introduction of $%change Traded Interest :ate ;utures by *ecurities and $%change Board of India !*$BI& U :eserve Bank of India !:BI& marks a maAor policy and product innovation that will have significant impact on the deepening of financial markets in India. .5erivatives have become a dirty word after the global financial crisis. *o why then are our regulators allowing a new type of derivativeV

17

Interest Rate Futures
;irst futures are simple standard transparent e%change traded contracts. "omple% customised 4T" products were at the heart of the implosion in the global financial system. Their impact and risk were poorly understood and there was no record of aggregate amounts outstanding. But such records are there for e%change-traded products. #oreover modern e%changes have robust risk and margining systems. 5uring the crisis although many banks became bankrupt not a single e%change had to close down. Therefore regulators worldwide now want to encourage more e%change-traded derivative products. *econd there is a myth that Indian financial institutions escaped the crisis because regulations had stifled markets. 4n the contrary development of equity and fore% markets was rapid in this decade and they survived the trial by fire. But the slow liberalisation of debt markets was a deliberate strategy. ;oreign debt liabilities have delivered severe shocks to emerging market balance sheetsT repayments often have to be made when e%change rates are also depreciating and interest rates rising in defence. But since debt markets serve needs for long-term finance developing the internal debt market remains a policy aim. Third a precondition for a hedging demand for a product is well-established two-way movement in the asset price. India has moved far from the days when interest rates were administered. :epo rates have recently changed from a peak of - per cent to a low of 1.39 per cent. The general structure of interest rates have moved with policy rates although less. The volatility of Indian interest rates has been increasing over the years and is higher now than in most countries of the world. Therefore interest risk is high for many types of transactions. ;ourth interest rate futures are part of the market deepening that will improve the transmission of monetary policy. If the impact of a change in their interest rates on bank balance sheets is lower they will be willing to change lending rates faster following a policy rate change. They will not wait as now for the bulk of deposits to be given at lower interest rates. Given these advantages why did interest rate futures fail to take off earlierV ;irst the twoway movement of policy rates was not so well established. *econd there were design issues. The theoretical <ero coupon yield curve used as the underlying created too much basis risk. This time liquid ten-year G-secs are to be used. Third only hedging transactions were allowed. This time pure trade is also to be allowed. Banks are naturally long in government securities so they are largely sellers of future contracts. *peculators and arbitrageurs create opposite position making trade possible.

18

Interest Rate Futures

19

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close