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Irf Irs

The document discusses the introduction of interest rate futures (IRFs) contracts in India. IRFs allow investors to hedge against interest rate risk when investing in floating rate debt instruments. While introduced previously, IRFs are being re-launched with greater preparation in an effort to boost India's debt markets. IRFs will provide investors tools to manage risks and allow for better price discovery than some existing hedging tools. Trading IRFs will work similarly to other derivatives, with the underlying being interest rates rather than a stock. IRFs are expected to benefit large holders of government securities like banks and pension funds.

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107 views3 pages

Irf Irs

The document discusses the introduction of interest rate futures (IRFs) contracts in India. IRFs allow investors to hedge against interest rate risk when investing in floating rate debt instruments. While introduced previously, IRFs are being re-launched with greater preparation in an effort to boost India's debt markets. IRFs will provide investors tools to manage risks and allow for better price discovery than some existing hedging tools. Trading IRFs will work similarly to other derivatives, with the underlying being interest rates rather than a stock. IRFs are expected to benefit large holders of government securities like banks and pension funds.

Uploaded by

pooja_wavhal
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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IRFs, which are extremely popular derivative contracts around the world accounting for more

than 70 per cent of the total derivatives trading, were introduced in India for the first time in
2003. However, they were soon suspended due to illiquidity and poor price discovery. Another
attempt has been made by SEBI to launch IRF in August 2009, albeit with greater preparations
this time.

IRFs are instrumental in facilitating the management of interest rate risk faced by organisations
and individuals while investing in floating rate debt instruments. Hence this move is being
viewed as a step towards boosting the country’s debt markets. The market participants are also
welcoming this move as IRFs will not only provide more depth to the market; it will also act as
another instrument for investment.

IRFs are derivative contracts on a fixed income security, namely, bonds. The price of the bond
changes with changes in interest rates (yield), both being inversely related.

This causes a number of organisations to incur capital losses when the interest rates drop.
Investors in the bond market can now hedge against this loss if they anticipate that the interest
rates might fall.

Contract specifications

Underlying: 10 Year Government Bonds with notion coupon rate of 7 per cent, semi-annual
compounding;

Minimum contract size: Rs 2 lakh;

Minimum maturity period: 12 months;

Expiry and settlement: March, June, September and December.

Let’s say a trader ABC, buys 5,000 units of bonds with a face value of Rs 100, coupon rate 7
per cent, semi-annual compounding, and the yield to maturity (YTM) of the bond being 6.5 per
cent. The price of this bond in the market is Rs 103.63 (calculated using discounted cash flow
method). Hence, the investment for the trader will be Rs 103.63 x 5,000 units = Rs 5,18,150.

The trader would like to sell off his investment after one year. However, he is worried that the
central bank might raise the interest rates by 100 basis points (1 per cent) in the coming year. If
this happens, the bond will trade at around Rs 96.77 in one year’s time. This will result in the
value of his portfolio going down by Rs 34,300 [(103.63-96.77)*5000].

What the trader can do is hedge for this loss using IRFs. He can go short on equivalent value of
IRF contracts now and then close his position after one year when the bond prices go down.

Other tools

Other hedging tools such as interest rate swaps or forward rate agreements were available to
the investors in India since long. However, they suffered from the usual problems associated
with over-the-counter contracts, like illiquidity, high transaction costs, third party risks, etc.
Now, with IRFs, investors have access to a more liquid contract with almost negligible third-
party risk as the clearing house of the NSE will act as the counter party to all the trades.

Most of the institutional investors, such as insurance companies, pension and provident funds,
mutual funds and banks will benefit immensely from these contracts as they hold huge amounts
of fixed income securities in their portfolios, either to fulfil statutory requirements or to have a
desired level of risk.

There are two more instruments which have been approved but not yet introduced. They are 91-
day Treasury Bill futures and short-term interest rate futures based on an index of actual call
money market rates. Once these products are also introduced, the debt markets in India would
have truly taken a leap forward. It would attract speculators too, making price discovery better
and the debt market more complete and liquid.

The concept of interest rate futures is like that of any other derivative product,
except 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 10-year
notional coupon-bearing government security. This underlying security is assumed
to pay interest (called a coupon) at a rate compounded at 7% on a half-yearly
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 people who are expected to be involved in the trading other than retail
investors exposed to interest rate risks are corporate houses, mutual funds, foreign
institutional investors, brokers and pension funds, besides banks and insurance
companies.

Trading can be done by signing up with a member of exchanges once they have
launched interest rate futures. Once the formalities are completed and you have
deposited the required cash or collateral with them, you are set to go.

If you believe the interest rates are headed downward, you can take a 'long'
position, or bet that the prices will head up. If you feel that the interest rates are
going to go up, then you can take the reverse or a 'short' position, thereby betting
prices will go down. Prices will change according to changes in interest rates.

Bond prices decrease with an increase in interest rates. When a higher interest rate
instrument is available in the market, the demand for one giving lower returns will
fall. Lower demand thus translates into lower prices.

Whichever way your bet goes, the daily settlement would be marked to market.
Finally, settlement would be through physical delivery of securities.

On the NSE, which is the only exchange yet to have announced the launch of the
segment, the contracts to be settled on a delivery basis would be through any one
of the 19 different government securities for a contract.

The size of the contract would be Rs 2 lakh and there would be four contracts
ending in March, June, September and December. The last trading day would be
the seventh business day prior to the last one of the delivery month.

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