By Rajeswari Sengupta, IFMR B-school
In our previous post we discussed the development and current status of the Credit Default Swap (CDS) market in India. Any corporate debt market also suffers from an inherent interest rate risk-one of the most pervasive risks in an economy. The increasing importance of interest rate risk for the corporate sector in a deregulated interest rate environment is now widely appreciated. A way to hedge against such a risk is to use an interest rate future.
Like the CDS, an interest rate future (IRF) is a financial derivative based on an underlying security, a debt obligation that moves in value as interest rates change. Buying an interest rate futures contract will allow the buyer to lock in a future investment rate. When the interest rates scale up, the buyer will pay the seller of the futures contract an amount equal to the profit expected when investing at a higher rate against the rate mentioned in the futures contract. On the flip side when the interest rates go down, the seller will pay off the buyer for the poorer interest rate when the futures contract expires.
In other words, IRFs are an agreement to buy or sell an underlying debt security at a fixed price on a fixed day in the future, and the prices of these derivatives mirror the rise and fall in the yield of the underlying government bonds. Unlike overnight interest rate swaps, IRFs have to be traded on exchanges rather than over the counter.
IRFs account for the largest volume among financial derivatives traded on exchanges worldwide. For financial markets in India, IRFs present a much needed opportunity for hedging and risk management by a wide range of institutions and intermediaries, including banks, primary dealers, corporates, foreign institutional investors, retail investors etc.
2003 Initiative in India
As a part of the process to make Indian financial market more robust, the finance ministry and regulators like Reserve Bank of India introduced some new financial products between 2000 and 2005. Introduction of Interest Rate Futures in 2003, which allowed participants to take a call on the future movement of interest rates as a hedging tool, was once such move.
The Securities and Exchange Board of India (SEBI) group on Secondary Market Risk Management first discussed the introduction of interest rate derivatives in India at its meeting on March 12, 2003 and then the NSE first launched 10-year bond futures in June 2003. According to the RBI, it was necessary to supplement the OTC market for interest rate products by an active exchange-traded derivative market. However the initiative turned out to be a failure-in less than three months after the launch, trading in bond futures literally stopped. Among other factors, restrictions on short selling and requiring financial institutions to use derivatives only for hedging purposes could account for the inactivity of the product. In other words, the absence of speculators may have robbed the market off badly needed liquidity.
As the market for interest rate futures failed to pick up and almost vanished, it was reintroduced in August 2009 to allow participants to buy protection against and bet on interest rates changes. Trading in interest rate futures on 91 day Treasury Bills began on August 31, 2009, clocking trading volumes of Rs 276 crore on the first day of trade. The SEBI and the Reserve Bank of India have limited the maturity of IRF contracts between a minimum of three months and a maximum of 12 months. While the maximum tenor of the futures contract is 1 year or 12 months, usually it would have to be rolled over in three months making the contract cycle span over four fixed quarterly contracts.
This time around banks have been allowed to hedge interest rate risks as well as take bets on the rate trajectory. Also, foreign institutional investors have been given access to the market. This apart, a company, or a non-resident Indian or a retail investor is also eligible to trade in the IRFs market. Under normal circumstances, the weighted average price of the futures contract for the final 30 minutes would be taken as the daily settlement or closing price. Usually, the daily settlement is done on a daily marked-to-market procedural basis while the final settlement would be through physical delivery of securities. In the absence of last half an hour trading the price as determined by the exchange would be considered as daily settlement price.
The following are the advantages of this initiative:
- Interest rate futures on 91-day treasury bill can be used for hedging against volatile interest rates.
- They are cash-settled, as a result, investors can trade without the worry of being saddled with illiquid contacts, which could have been the case if the contracts were physically settled.
- No securities transaction tax (STT) is levied.
- Low margins required as compared to trading in equities and equity derivatives.
- The new product would be traded in the currency segment of the exchange so there is no requirement of any new formalities of a new account.
Some of the salient features of exchange traded IRFs are:
- Increased market reach enables higher liquidity.
- Exchange platform ensures protection against counterparty default risk.
- Greater transparency due to automated anonymous order matching system and settlement.
- Delivery of underlying asset is possible on exchange platform.
- Large number of informed participants can trade using online electronic trading systems leading to efficient price discovery.
However the 2009 initiative failed to click as well. The average daily trading turnover on NSE fell from Rs 77.5 crore in September 2009 to Rs 6 crore in January 2010. By February 2010, the average trading value dropped to a piffling Rs 3.02 crore. Since then NSE has been registering almost nil volumes for many months now. Trading in IRFs has thus slowed to a trickle as initial enthusiasm has been replaced by worries about the limited variety of players in the market and fears that the dice are loaded in favor of sellers. Bankers have said that one problem is that the underlying bonds are illiquid. In a bid to ease concerns over delivery obligations, in December 2009, SEBI allowed exchanges to set any period of time during the delivery month as the delivery period for the securities.
According to SBI officials, the product itself is defective because only the seller gains as he has the discretion of delivering either liquid or illiquid securities. Moreover, developed markets where IRFs have already taken off allow short selling and provide a good repo market. In India, short selling is not allowed beyond five days, and the repo market is not adequately developed. As a result there are mostly people who want to the sell the futures and buy bonds on spot thereby creating a situation wherein everyone sits on one side of the market.
To alleviate some of these concerns, Life Insurance Corp. of India, India’s largest insurer, and Central Bank of India in December decided to purchase government bonds from members who desire to liquidate the securities received against their interest rate derivative obligations.
Analysts have also pointed out that the three months’ tenor for the underlying asset (91- day Tbills in this case) is too short to base an interest rate futures product on. Interest rate futures seem to be on a deathbed due to complete lack of interest among the participants. In fact, in some of the trading days the volume has been as low as Rs 9 lakh. Lack of awareness among the Indian financial institutions is another major reason while the foreign financial institutions find the Indian market too small and the size of the deals tiny.
The second reason is the lack of depth because only two government securities have been introduced for future options while large number of other government bonds and corporate bonds are still out of the purview of interest rate futures. Moreover, according to market players, the prime reason for the failure of this segment is that banks are staying away from it. While the over-the-counter (OTC) market sees huge participation from foreign and private sector banks, the exchange platform has not been able to attract the same players. In order to revive this promising financial product and to make it robust, a long term planning is required. We need to create much more awareness on the efficacy of interest rate future as a hedging tool against interest rate volatility, and there should be many more securities.
In 2011, SEBI decided to introduce new products in the sagging interest rate futures segment such as derivatives based on shorter-tenure bonds that can be cash-settled.
On Dec 30, 2011, RBI and SEBI decided to introduce IRFs on notional 2-year and 5-year coupon bearing Government of India securities. The 2-year and 5-year IRF contracts shall be cash-settled and the final settlement price shall be based on the yields of the basket of securities underlying each Interest Rate Futures contract specified by the respective stock exchange. Shorter duration products that can be settled in cash are expected to attract market players.
The industry has been asking for such products and the policymakers are hoping that it will provide new life to the IRF segment. However according to skeptics, the market has totally shunned these instruments and the current environment does not guarantee any success for the new products either. No one is willing to bet on rates on account of high inflation and high borrowing.
This post concludes our Long Term Debt Markets Blog series. If you have any feedback for the authors or on the topic please do share in the comments section below or drop us a line at blog [at] ifmr.co.in