Interest Rate Futures, the new game changer in town

MUMBAI: Punters in India’s financial markets will soon have a new toy to play with. Beginning this week, day traders, banks, well-heeled investors sitting on a pile of bonds, as well as foreign portfolio managers can bet on the direction of interest rates. All this will happen on the stock exchange where the new product will be launched.

Welcome to the world of interest rate futures (or IRFs). Here the fortunes of a trader will be linked to the movement of the 10-year government of India bond – the most liquid debt paper in the country.

Bond prices rise when interest rates in the economy fall. This is because of a rise in demand for existing bonds which offer a higher return compared to new bonds which will be issued by the government and corporates to fund their activities. The reverse is also true: bond prices fall when rates rise as bonds that would be issued in the coming days and promise higher returns, look more attractive.

The country’s largest exchange National Stock Exchange (or NSE) will launch the product on Tuesday while MCX Stock Exchange (or, MCX-SX), another exchange, will launch it on Monday. IRF trading in Bombay Stock Exchange will start on January 28. The rules were issued on December 5 by Reserve Bank of India and capital market regulator Sebi.

IRFs are no different from stock and currency futures on which individual traders and institutions have honed their skills. In IRF contracts, a trader will go long when she expects the price of the 10-year underlying bond to rise; in other words, when she believes that interest rates will soften. Similarly, she would go short, when, according to her analysis, interest could harden.
Who can use it?

A person holding tax-free bonds may fear that the investment would be comparatively less valuable when interest rates go up. Under the circumstances, she can take a short position in IRF. The gains from the IRF would compensate the loss, though notional, in her bond holding.

A bank can do the same. Banks have to hold a slice of their investment in the form of government bonds as part of banking law. Since it cannot sell the bonds, it has no choice but to take a hit when interest rates go up as the price of bond it holds falls. In its books, this creeps in as mark-to-market loss – a factor that shrinks the quarterly profit number. A short position in IRF can partly offset the MTM loss.

Besides using IRF as hedging tool, traders and proprietary books of brokerages can use IRFs to take naked bets on which way they feel the interest rate would move. While there is no limit on long positions, banks will have caps on the extent to which they can go short. However, mutual funds and insurance companies are yet to get permission from respective regulators to take short positions. Thus IRF can be a hedging tool as well as a punter’s delight.

“Basically, the product is linked to a single underlying. It is easily relatable to wide reach of market…,” said Huzan Mistry, in charge of business development (currency & interest rate) at NSE. “We have designed the product taking feedback from market participants, which were also conveyed to regulators.”

Like all derivatives, IRF is a leveraged product: for every Rs 2 lakh contract, a trader has to give a margin of around 5%, which works out to Rs 10,000. If the market goes against the trader, she has chip in more funds to replenish the margin, failing which her position will be squared off. This would happen on a daily basis – something that keeps derivative traders edgy.

In most markets, IRFs contracts result in actual delivery of bonds. The underlying could be a basket of bonds, with the cheapest bond being delivered. In India, IRFs would be cash settled, a product that is prevalent in Korea. Twice in the past, IRFs structured on the delivery model were launched, but the product failed to take off due thinly traded nature of underlying bonds.

Bank, bond houses and traders are hoping that this time around it would work. “I expect the volume to be significantly higher than the past avatars,” said Sandeep Bagla, executive vice-president, ICICI Securities Primary Dealership. “As more players are ready to participant, we expect the volume as high as 50 per cent of the cash market. We are in a state of readiness to start trading.”