NISM SERIES IV – INTEREST RATE

DERIVATIVES EXAM
 NISM IV – INTEREST RATE DERIVATIVES
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NISM IV – INTEREST RATE DERIVATIVES EXAM

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I. Fixed Income and Debt Securities: Introduction

Financial markets are grouped into three super asset classes: underlying, derivative and structured finance. Besides
these three, there are collective investment schemes (e.g. mutual funds), physical assets (e.g. real estate,
commodities, art, antiques, wine, etc.) and alternative assets (e.g. ETFs, managed futures, hedge funds, private
equity, etc.).

 The underlying super asset class consists of fundamental assets and there are four of asset classes: money,
bond, equity and forex.
 The derivative super asset class is not independent but derived (whence the name “derivative”) from the
underlying super asset class. They are grouped into five asset classes: rate, credit, equity, forex and
commodity. In each derivative asset classes, there are four generic products: forward, futures swap and
option.
 The structured finance super asset class is further grouped into two asset classes: structured credit and
structured investment.
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Debt/Fixed-Income Securities: Introduction

Debt market, also known as fixed-income securities (FIS) market, consists of money and bond markets. The
difference between the two markets is the period of borrowing/lending. In money market, the period is one year or
less; and in bond market, it is more than one year. They are called “fixed-income” securities because of the following
“fixed” features.

 Their life is fixed: they will be redeemed on a specified future date because all borrow-lend transactions are
for a fixed period.
 In most cases, their cash flows are fixed, too. In other words, the timing and size of cash flows are known in
advance.

Even though everything is fixed, it is subject to certain risks;

 Credit Risk is the risk of the Company not being able to pay interest and principal on schedule.
 The sale price may be higher or lower than the initial purchase price if the holder wants to sell the security
before maturity, resulting in capital gain/loss, which is not known in advance. This is called market risk (also
known as price risk) in the bond.
 Reinvestment risk is the risk that future cash flows—either coupons (the periodic interest payments on the
bond) or the final return of principal—will need to be reinvested in lower-yielding securities

Debt/Fixed-Income Securities: Classification

 Coupon instrument pays periodic fixed amount called coupon (C), representing the interest rate; and a final
fixed amount, representing the principal (P), which is also called redemption amount.
 Annuity pays coupon and part of the principal periodically in such a manner that the cash flows are equal in
size and equally spaced in time.
 Zero-coupon bond (also called “discount” bond) does not pay any amount before maturity date. The interest
is accumulated, compounded and paid along with principal at maturity as a single bullet payment.

Based on original maturity of borrowing/lending, FIS securities are classified into money and bond instruments.
Money market instruments are those with an original maturity of one year or less; and bond market instruments
are those with original maturity of more than one year.

Money market products are further grouped into two: OTC and Exchange products. The borrowing may be against
collateral (called “secured”) or without collateral (called “clean”). All exchange-traded money market products are
clean instruments: they are unsecured promissory notes. The OTC products may be secured or unsecured; and are
privately and bilaterally negotiated contracts between two parties.

In the interbank money market, both lender and borrower are banks and the borrowing is on “clean” basis at the
interbank rate. The period of borrowing is for “standard” tenors. The overnight is the most important and liquid. It is
called call money in India and Fed Funds in the US.

Repo/Reverse repo is secured money borrowing/lending with three key features.

 First, being a money market product, it is money borrowing/lending for a period of one year or less.
 Second, it is secured lending against collateral, which is not any collateral but an actively traded, liquid and
less volatile instrument.
 Third and most important, the trade is structured not as borrow-lend trade but as buy-sell trade.

Based on the length of repo period, repos is classified into open repo (the period is one day with rollover facility and
overnight rate reset) and term repo (the period is specified in advance and the interest rate is agreed for the whole
of the term).
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 Treasury bills (TB) are issued by the central government through RBI. They are issued with original maturity
of 91-day, 182-day and 364-day and issued as zero-coupon (or discount) instruments

 CD is a negotiable, unsecured instrument issued by scheduled commercial banks and select all-India financial
institutions. The minimum and multiple of issue is Rs.1 lakh.

 CP is a negotiable, unsecured instrument issued by corporate bodies and primary dealers. The minimum and
multiple of issue is Rs.5 lakhs. The maturity of the CP should be a minimum of seven days and a maximum of
one year.

 Sovereign bonds are those issued by the governments and hence “risk-free” securities.

 Corporate bonds are those issued by corporate bodies.

Another way to classify bonds is by the interest type, based on which we can classify them into fixed-rate, floater,
and inverse floaters. If the bond’s periodic coupon is known in advance, it is called fixed-rate (or coupon) bond, and
most bonds are issued as fixed-rate bonds. If the coupon is linked to a specified market interest rate, then only its
timing but not its amount is known in advance. Such bonds are said to be floaters.

By far the most important feature of bond is its credit quality, which is specified by specialist bodies called credit
rating agencies. Examples of credit rating agencies are CRISIL, ICRA, Moody’s etc. The credit ratings above are not
numerical measures of default. They are relative measures: AAA is stronger than AA, which in turn is stronger than A,
and so on.

Some bonds have a derivative called option embedded in it, and the embedded option modifies the redemption
date or type of the bond. Three such embedded options are as follows.

Bond type Redemption feature Remark

Callable Issuer has the right to prepay the Issuer will exercise his right if the interest
bond on specified dates before rates fall so that he can refund at cheaper
maturity. rate.
Puttable Investor has the right to demand Investor will exercise his right if the interest
prepayment on specified dates before rates rise so that he can reinvest at higher
maturity. rate.
Convertible Investor has the right to convert the Investor will exercise his right only when the
bond into issuer’s equity at specified market price of equity is higher than exercise
price at maturity. price.

Debt versus Equity

As stated earlier, the capital of corporate bodies consists of debt and equity. If interest on debt is tax-
deductible, every company’s capital must have some debt. Because of this, it may seem that the
companies should fund themselves only with debt to maximize the return on equity. However, this has a
negative side because interest on debt becomes a fixed-cost and will have serious repercussions in
recession. We may say that equity is the cost of avoiding bankruptcy. For optimal results, there is always an
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optimal level of debt-to-equity ratio. The optimal ratio is such that the weighted average of cost of capital
(WACC) should be minimal. The WACC is given as follows:

Primary and Secondary Market for Debt Securities in India

Primary Market

The Reserve Bank of India acts as the issue manager for central and state government borrowing programs. The
major factors that affect the issuances of the government debt are:

 Liquidity conditions in the market

 Market Preferences for maturity versus the desired maturity
 Yields in the primary and secondary market

Apart from this, the fiscal deficit of the country also plays a major role in determining the issuances. Keeping this is
mind, the RBI releases an issuance calendar for dated securities semiannually (March and September generally). The
auctions of these securities are done in one of the following ways:

 Uniform Price Method: All participants are allotted at the same price. The price is the highest price
(corresponding to the lowest yield) that the issuer can get their entire issue subscribed.
 Multiple Price Method: All accepted are allotted at different prices and yields quoted in their individual bids.
Successful bidders get the issue at the price and yield they bid whilst the bidder at the cut off price or yield
gets the best price.

Secondary Market

CCIL provides and maintains the Negotiated Dealing System (NDS) which is the secondary market platform to trade
in government securities. CCIL has also developed and currently manages the NDS-CALL electronic trading platform
for trading in call money. It has also developed the NDS-Auction module for Treasury Bills auction by RBI. CCIL
guarantees settlements of all trades, thus eliminating counterparty risk. It is the counterparty to both the buyer and
the seller. It maintains a settlement guarantee fund (SGF) that is made up of margin contributions from each
participant with the CCIL. CCIL also provides for Repo instruments for Government Securities –termed as
Collateralized Borrowing and Lending Obligations (CBLO) and Clearcorp Repo Order Matching System (CROMS).
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II. Interest Rate: Introduction

In borrow-lend transactions, the exchange is “money for money” for different settlement dates. There is no transfer
of ownership but only use of money for a period, for which rent is charged. The rent on money is called interest rate.
Unlike the price in buy-sell trades, the rate in borrow-lend trades is not the same for all borrowers but borrower-
specific. The reason for this is that borrow-lend trades have credit-risk, which is faced only by lender against
borrower. Therefore, the price of credit risk has to be priced and incorporated into the trade, which makes the rate
borrower-specific.

Risk-Free Rate versus Risky Rate

Consider that the borrower is a sovereign government and the borrowing is in home currency. There is no possibility
of default by the borrower because the sovereign can always print money and pay off the lender. In other words,
there is no credit risk in this transaction. The interest rate applicable to such transactions is called risk-free rate, the
risk here being the credit risk. The risk-free rate is the benchmark for all valuations because it represents the return
without risk.

For borrowers other than the sovereign government, there is some chance of default. Therefore, the interest rate
applicable to such non-sovereign borrowers must be higher than the corresponding rate for sovereign borrower.
Thus the rate applicable to them is the risky rate. The difference between them is called the credit spread.

Nominal vs. Real Interest Rate

The nominal interest rate is the stated interest rate (coupon rate) of a bond. The nominal interest rate denotes the
rate that the bond issuer pays to the bond holder. However, the inflation reduces the purchasing power of money.
Therefore, the nominal interest rate has to be adjusted for the rate of inflation in order to understand the real
growth of money for the bond holder. The nominal interest rate adjusted for inflation is called Real Interest Rate.
The relationship between real and nominal interest rates can be described in the equation:
(1+r) x (1+i) = (1+R); where r is the real rate, i is the inflation rate and R is the nominal interest rate.

Term Structure of Rates: Shapes

When the interest rate (on vertical axis) is plotted against the term (on horizontal axis), it is called the term structure
of interest rates (also known as yield curve). The term structure of risk-free rate is the most important tool in
valuation because it represents the ultimate opportunity cost. It is the rate an investor can earn without any risk of
default or loss for a given term. Any other competing alternative has a risk, which has to be priced and added to the
risk-free rate for the same term as the “risk premium.” Without term structure of rates, valuation becomes
speculative rather than objective. But what determines the interest rate? The answer is demand-supply for money
for different terms.

In developed economies, central bank monitors and controls only the short-term interest rate, but in developing and
emerging economies, central bank influences long-term rates, too. The central bank uses the repo and reverse repo
with commercial banks to control the short-term rate. The term structure has different shapes but four of the
following account for most of the shapes.
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Shape Description
Normal Longer the term, the higher is the rate
Inverted Longer the term, the lower is the rate
Flat Rate is the same for all terms
Humped Rate is high for medium term and falls off on either side

Term Structure of Rates: Shifts

Term structure is a snapshot of rates at a point of time, and there are many theories and economic arguments to
explain the shapes. What is more important is, not the shape, but how it changes over time, which is called term
structure “shifts”. The shits describe the relative moves of long-term rate (LR) and short term rate (SR), and they are
grouped into three: parallel, steepening and flattening, as summarized below.

Shift Description
Steepening Difference between LR and SR rises or widens (from positive to more positive or from
negative to less negative). The curve shifts in anti-clockwise direction.
Flattening Difference between LR and SR falls or narrows (from positive to less positive or from
negative to more negative). The curve shifts in clockwise direction.
Parallel All rates move in the same direction by same extent

Conversion of Rate into Amount

The conversion requires the following parameters to be specified:

 Payment frequency: It specifies whether the payment is monthly, quarterly, semiannual, annual or at the
end of the term. For money market instruments, the market convention is to pay interest at the end of the
term.
 Compounding frequency: It specifies whether the interest is compounded or simple. If compounding is
applicable, the compounding frequency must be higher than and an integral multiple of payment frequency.
 Day count fraction (or day count basis): It specifies how to convert the payment period into year fraction
(e.g. 6M = 0.5Y). For this conversion, we must agree on counting the number of days in a year and in the
interest accrual period. It is expressed as a fraction.
 Payment timing: It specifies whether the interest amount is paid upfront (discount yield) or in arrears
(investment yield) of the payment period.
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FIMMDA rules in India

Fixed-income and Money Market Derivatives Association (FIMMDA) is the self-regulatory organization in India for
money, bond and derivatives markets. According to FIMMDA rules, the following are the market conventions.

 All interest amounts must be rounded off to the nearest whole rupee
 Price and yield quotes must be rounded to the nearest fourth decimal place when used in interest amount
calculations.
 Day count basis for all transactions is Actual/365 Fixed except for the accrued interest calculation in the
secondary market for sovereign bonds, for which is it is 30E/360.
 Yield on money market discount instruments (T Bill, CD, CP) must be quoted on true yield (Y) basis and not
on discount yield basis; and for bill rediscounting, it should be in discount yield (DY) basis.

Accrued Interest

For the secondary market trades of such bonds, there are two prices. They are clean price: the price at which the
bond is negotiated; and dirty price: the price at which the bond is settled. Dirty price is always higher than the clean
price by the amount of accrued interest rate. In other words, dirty price is clean price plus accrued interest. Accrued
interest is the interest accrual at coupon rate from the previous coupon date to the settlement date of the trade. Let
us see the timeline of different dates in the following figure:

The settlement date of the secondary market trade falls between two coupon date, which we will designate as
previous coupon date and next coupon date. Between previous coupon date and settlement date, it is the seller that
owns the bond and therefore is entitled to receive the interest accrual for this period. Similarly, it is buyer that owns
the bond between settlement date and next coupon date and therefore he is entitled to the interest accrual only for
this period.

A logical question is why not including accrued interest in the market price or clean price of the bond so that the
negotiated price recorded in the deal ticket is the same as the settlement price? If we incorporate the accrued
interest in the market price of bond itself, the result will be a periodic rise-and-fall pattern in bond price between
two coupon dates. Because the daily interest accrual is constant, the price will rise smoothly every day by daily
accrual amount from one coupon date to the next, and falls abruptly by the full coupon amount on the next coupon
date.
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III. Return and Risk measures of Debt Securities

Return on investment is the most important measure of performance. It has the following properties.
 Expressed as a rate per annum
 If there is income before the investment term, the income has to be reinvested until the term
 Compounding at less than yearly intervals, if required, is incorporated

When there is no interim income, true yield can be calculated by;

Coupon, Current Yield and Yield-To-Maturity

Coupon is the fixed payment received on the bond. It cannot be considered the return because it does not consider
the premium/discount in bond price and the capital gain/loss at redemption.

Current yield is defined as coupon divided by bond price. Current yield is better than coupon but is still
unsatisfactory.

Yield-to-maturity (YTM) is the most widely used measure is simply called “yield”. However, it is still not a true return
measure. YTM considers the premium/discount in bond price and capital gain/loss at redemption and even handles
the reinvestment in a rough way. What it does is:
 Amortizes the capital gain/loss at redemption over the bond’s life and adds it to the current yield;
 Averages the returns for all periods in a complex way; and
 Assumes that interim cash flows are reinvested at the same average return.

Spot Rate, Bond Price and YTM

 Spot rate (also known as zero rates) is the true return on investment. It considers premium/discount in bond
price, capital gain/loss at redemption and reinvestment of interim income.
 Since the zero rate is the true return, the present-value of any future cash flow will be its discounted value,
the discounting being at the zero rate relevant to the timing of the cash flow.
 The current market price of bond should be its cash flows discounted at the appropriate zero rates from the
prevailing term structure of zero rates.

The above brings in two important facts. First, the bond price is determined, not by demand-supply for bond, but by
term structure of zero rates. It should be noted that the demand-supply forces do have a play, but that is demand-
supply for money, not for bond. The demand-supply for money determines the zero rates, which in turn determine
the bond price. Second, in a coupon bond (or annuity), there is no single return measure but multiple of them.
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YTM is not a return measure but another way of quoting bond price (because it is derived from bond price).
Alternately, given YTM, the bond price can be derived from the above equation. Both bond price and its variant of
YTM cannot be used as judgment tools to determine the mispricing. For zero-coupon bond, YTM is the true measure
of return because there are no interim cash flows to be reinvested and there is a single zero rate used.

Investor may still have preference for the bonds, which is decided by factors other than price or YTM. These factors
are tax considerations and expectations about future interest rates for reinvestment.

Risk Measures

Price risk and reinvestment risk always work in the opposite way. If the market rate rises, the bond price falls but
reinvestment income rises. The bond price falls because of discounting at a higher interest rate results in lower
present value; and reinvestment income rises because the interim cash flows are reinvested at higher than the
original interest rate. Similarly, if the market interest rate falls, the bond price rises but reinvestment income falls.
The change in bond price is instant after the change in interest rate but the effect of reinvestment income is slow
over a period of time.

Maculay Duration: Macaulay was the first to measure the price risk. He proposed that bond maturity is a rough
measure of price risk. The change in the bond price is roughly proportional to the maturity. The sum of (DCF) is the
current price of the bond, of course. If we divide the sum of TDCF with the sum of DCF, what we get is T or time,
which Macaulay called it as “Duration” (D), which he considered the effective maturity of bond and a measure of
price risk.

Modified Duration: Subsequently, a better measure for price risk is derived by computing the sensitivity of bond
price to changes in YTM. This measure is called Modified Duration (MD) and is related to Macaulay Duration (D) as
follows where n is the frequency of compounding in a year.

MD gives the percentage change in bond price caused by a small change in YTM. For example, if MD is 1.71 and YTM
changes by an amount, then the bond price changes by 1.71 times the change in YTM.

 It holds good only for small changes (say, changes in YTM of 0.01% to 0.10%).
 The relationship between bond price and YTM is not linear but convex while MD assumes a linear
relationship. To capture the effect of convexity, we require a second derivative of price to yield, which is
called convexity.
 By using YTM rather than the term structure of zero rates, MD assumes flat term structure at the level of
YTM and assumes parallel shifts in term structure. If the shift is steepening or flattening, MD does not hold
good even for small changes in rates.
Senior management and risk managers are interested in change in the total market value of the bond portfolio for a
given change in the YTM. This is called rupee duration (RD). For that, they need to replace bond price with the
market value of the bond portfolio in the equation, as follows.

Change in portfolio market value = Portfolio market value × Portfolio MD × Change in YTM

The change in YTM of 0.01% (or 0.0001) is called a basis point (BP). Bond traders would like to know what would be
the change in bond price for a change in YTM of one BP, which is called price value of basis point (PVBP or PV01).
Since one BP is 0.0001 in YTM, PVBP can be derived from MD as follows.

PVBP = P × MD × 0.0001
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IV. Interest Rate Derivatives

Derivative is something that is derived from another called the underlying. The underlying is independent and the
derivative is dependent on and derived from the underlying. The derivative cannot exist without the underlying. This
is the general definition of derivative.

Accounting standards like FAS 133 (in the US), IAS 39 (in the EU) and AS 30 (in India) impose more qualifications for
derivatives. For example, IAS 39 and AS 30 require the following three criteria to be satisfied for financial derivatives.

1. Value of derivative is linked to the value of underlying

2. Trade settled on a “future” date
3. On trade date, there should be no full cash outlay
FAS 133 requires an additional qualification:
4. Trade must settle (or capable of being settled) on net basis and not on gross basis.

Forward and Futures are functionally similar and involve buying or selling of a specified underlying asset at specified
price for specified quantity for delivery on a specified later date. The difference between them is that the forward is
an OTC market instrument (i.e. privately negotiated bilateral contract) and the futures is publicly-traded Exchange
contract. Accordingly, they differ in the institutional arrangement for conducting the Trade and Settlement parts of
the transaction.

Swap is different in the sense it does not involve exchange of cash for an underlying asset: it involves exchange of
returns from the underlying against return from money. In other words, the cash-for-asset exchange is replaced with
return-for-return exchange. The return from money is interest rate and that from the underlying asset is another
interest rate (if the underlying is money or bond) or dividend and capital gains/loss (if the underlying is equity) or
foreign currency interest rate and capital gain/loss (if the underlying is currency). Swap is traded only in OTC market.

Option does not buy or sell the underlying or its returns: it involves buying or selling certain right on the underlying.
It is traded both in OTC and Exchange markets. The following table summarizes the key feature of four generic types
of derivatives.

The four asset classes and four generic types give us sixteen types of derivatives as follows, of which “bond swap”
does not exist.

Economic Role of Derivatives

The economic role of underlying markets is financing and consumption. In contrast, the economic role of derivatives
is risk management, and the risk they manage is price risk. Price risk is the uncertainty about future return. The
future return may be positive or negative. Thus, risk is a neutral concept: it does not necessarily mean loss. Risk
merely says that in future there will be either profit or loss.
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Derivatives are tools to manage price risk. How you manage risk depends on your attitude to risk, and there are two
attitudes: love and hate. When you love risk, you take risk, which is called speculation, but that word is avoided and
instead we use “trading” in banking industry and “investment” in asset management industry. When you hate risk,
you manage it one of the three ways: elimination; insurance and minimization. The following table summarizes the
approaches to market risk management.

Approach Explanation
Speculation Taking risk (more formally called “trading” or “investment”)
It results in the possibility of positive return (i.e. profit) or negative return (i.e. loss) in
future
Hedging You are already exposed to risk and hedging eliminates that risk and locks in the future
return at a known level
Insurance You are already exposed to risk and insurance selectively eliminates the negative return
but retains the positive return. It has an explicit upfront cost, unlike speculation and
hedging, which do not have any cost. It requires a particular derivative called option to
implement it.
Diversification It reduces both return and risk but in such a way that risk is reduced more than return so
that risk is minimized per unit return. It does not require derivatives to implement it.

Interest Rate Derivatives

The interest rate derivatives market is the largest derivatives market in the world. The Bank of International
Settlements estimates that the global OTC derivatives market as of December 2014 was US$ 630 trillion out of which
around US$ 500 trillion was contributed by the Interest rate derivatives market.

Feature Interest Rate Derivative Bond Derivative

Underlying Interest rate on money; and the tenor A specific instrument is issued by a
can be short term (less than 1Y) or long specific borrower
term (more than 1Y and up to 30Y)
Liquidity Very High Very Low
Settlement Compulsory for each cash settlement Maybe physical or cash

The following terms are used:

 Tenor: period of notional borrowing/lending in the contract

 Term: The distance of commencement date from trade date.
 Short: Less than one year
 Long: More than one year
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OTC versus Exchange-traded Derivatives

OTC derivatives (OTCD) are privately negotiated and settled contracts between two parties whereas Exchange-
traded derivatives (ETD) are publicly negotiated and settled contracts with the aid of Exchange (which conducts the
trade negotiation and execution) and Clearing Corporation (which conducts the settlement). OTCDs can be
customized to the specific requirements of the parties where are ETDs are “standardized” Another difference is that
OTCDs have counterparty credit risk and settlement risk (which is the risk of default by the counterparty on
settlement date), but both risks do not arise in ETDs because of “trade guarantee” by Clearing Corporation. The
trade guarantee is provided by Clearing Corporation becoming a common party . Due to increased competition
between OTC and Exchange markets, the differences between them are slowly fading.

Derivatives Market in India

Derivatives are essential for risk management, especially hedging. Though, theoretically, underlying securities can be
used for hedging, such a process is cumbersome, costly and non-optimal. In the Indian market, the OTC forex market
has had a long-history of using the forward contract for hedging currency risk by exporters and importers; and, in
recent years, currency swaps and currency options have been introduced to provide for diverse and flexible hedging
strategies. Exchanges have started in 2008 the currency futures to compete with the OTC market, and they were
received very well. In the equity market (which is predominantly an Exchange market), derivatives were introduced a
decade ago and have overtaken the cash market in daily turnover shortly after they were introduced.
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V. Contract Specification for Interest Rate

The “interest rate derivatives” traded on Exchanges in India are not truly interest rate derivatives but bond
derivatives. The underlying for interest rate derivatives is the interest rate on money, typically, the interbank money;
and the underlying for bond derivatives is a specific debt security issued by a specific borrower.

Underlying

Reserve Bank of India (RBI), whose permission is required for all derivatives on interest rate and debt instruments
(whether traded in Exchange or OTC market), has permitted futures on the specific securities. RBI has delegated
powers to further define the futures contract terms (e.g. contract amount, expiry months, etc, defined below) to
SEBI. According to SEBI guidelines, interest rate derivatives are to be traded in the Currency Derivatives segment of
Exchange. Members of Currency Derivatives segment are allowed to participate in the interest rate futures market.

Notional security does not exist and is not traded. Accordingly, for the purpose of delivery, any of the eligible
securities are allowed to be substituted for the notional underlying after adjusting the delivery quantity through a
“Conversion Factor”. However, currently no Exchange trades a notional security with physical settlement and
therefore the procedure for physical settlement is only for reference. All the three Exchanges (NSE, BSE and MSEI)
trade bond futures with actual underlying securities only.

Contract Amount (Market Lot)

Contract Amount (or Market Lot) is the minimum and multiple of trade size. In contrast, the market lot in the cash
market of wholesale debt market is Rs.5 Cr (which is equal to 250 futures contracts). The face value and market
value are linked by the market price. In both cash and futures markets, the prices are quoted for Rs.100 face value so
that the relation between face value and market value is:

Market Value = Face Value × (Market Price / 100)

Contract Expiry

Contract Month (also known as Expiry Month) is the month in which the contract ceases trading. On any trading day,
there will be multiple Contract Months that expire in different months. Expiry Date is the day in Contract Month on
which trading ceases. Settlement Day (SD) is the day on which the contract is settled. The following table shows the
particulars allowed by SEBI:
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 Price quotation refers to the style of quoting the contract price

 Tick size is the minimum change in price. The tick size for both contracts is Rs.0.0025. The price quotation for
T-bill is 100 minus the discount rate
 Trading hours are aligned with those of NDS-OM, which is currently between 9AM and 5PM.
 Daily settlement price (DSP) is the price at which margining & mark-to-market is implemented. Because of
daily mark-to-market, the carry price of the contract changes every day. DSP is the volume weighted average
price (VWAP) during the last 30 minutes of trading in the futures market. If there is no trading during the last
30 minutes, DSP will be the VWAP during the last two hours in the cash NDS-OM market.
 Final settlement price (FSP) is the price at which the contract is settled on the SD. For 91-day bill futures, FSP
is the weighted average discount yield (Y) in the auction of 91-day T-bill conducted by Reserve Bank of India
(RBI) on the expiry date. For the cash-settled 6-year or 10-year or 13-yearactual bond, FSP will be the VWAP
of the actual bond during the last two hours of trading in the cash market of NDS-OM. If less than five trades
occur during that period, FSP shall be the price determined by FIMMDA.


Delivery under Physical settlement

Currently, no Exchange trades in physically settled bond futures. Hence this discussion is for reference purpose only.
To enable physical settlement for imaginary notional bond, other bonds of the central government are to be made
eligible for delivery and are designated as Deliverable Bonds, which must satisfy specified criteria.
It is desirable to allow multiple securities for delivery because of two reasons. First, institutional investors generally
adopt buy-and-hold strategy. Since the outstanding stock of a bond is much less compared to floating stock of
equities, the bond will quickly lose liquidity in cash market, which in turn will affect the liquidity of futures. Second,
given the low outstanding stock of bonds, market manipulators can easily create squeeze by simultaneously buying
the bond in cash market and buying futures.

The delivery must be through SGL A/c or CSGL A/c and the intention to deliver must be notified on the last trading
day. The settlement amount is computed after taking into account the Deliverable Security, Conversion Factor and
accrued interest relevant to that security; and the final settlement price fixed by the Exchange.
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VI. Trading, Clearing, Settlement and Risk Management

Both the Exchange and CC do not deal with the buyers and sellers directly but through their “members”. The
members of Exchange are called Trading Members; and those of CC, Clearing Members. The following types of
memberships are permitted under current regulations.

Membership Type Explanation

Trading Member (TM) Member of Exchange but not CC so that it can only execute trades but settle
them through a designated Professional Clearing Member (PCM). Trade
execution can be for own account or for clients.
Trading-cum-Clearing Member of both Exchange and CC so that it can execute as well as settle
Member (TCM) trades. It can settle trades executed by other TMs, too.
Self-Clearing Member Same as TCM but can settle the trades of own account or its clients but not
(SCM) the trades of other TMs.
Professional Clearing Member of CC only and settles trades of TMs
Member (PCM)

The Clearing members have to meet the minimum net worth requirements set by the regulator from time to time.
Besides the regulatory minimum net worth, Exchange/CC has additional requirement of deposit to be placed with
them. The deposit is partly in cash and partly in qualified securities which are specified in advance and vary over
time.

Order Types and Execution

 Market order is an order to buy or sell at the prevailing market price.

 Limit Order is an order to buy or sell only at the specified price or better. It must be specified as a
combination of three inputs: market side + quantity + price limit.
 Immediate or Cancel (IOC) is an order to execute the trade immediately. If it cannot be executed, it should
be cancelled. Good Till Day, Also known as day order is a limit order that is kept in the market until the close
of trading hours, at which any unexecuted portion will be automatically cancelled.
 Stop-Loss Order is an order to exit from an existing trade if the market moves against the trade at a pre-
defined loss.
When the order is input, the following information is required to be specified.
1. Contract ID, which consists of the derivative and underlying, and expiry month.
2. Market sides (i.e. buy or sell)
3. Quantity (i.e. number of contracts)
4. Order type
5. Whether it is proprietary (“pro”) trade of the Trading Member or client (“cli”) trade. If it is a client trade, the
client code that is available with the Exchange.

Spread Orders

Spread order consists of simultaneous buy and sell of two different instruments. For futures, there are two kinds of
spread orders: inter-commodity spread and calendar spread. Inter-commodity spread consists of buying futures on
one underlying and selling futures on another for the same expiry month and for the same quantity.
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Calendar spread consists of buying and selling futures on the same underlying but different expiry months and for
the same quantity. Calendar spreads are more popular than inter-commodity spreads and Exchanges allow the
facility to enter calendar spread as a single order. Calendar spreads have lesser margin requirements. The margin for
both trades in the spread will not be double but less than the margin required for one of them.

Margining and Mark-To-Market

Margining and mark-to-market are tools to mitigate counterparty credit risk and settlement risk of derivatives.
Counterparty credit risk is the failure of counterparty before the trade is due for settlement; and settlement risk is
the failure of counterparty when the trade is due for settlement. Counterparty credit risk is mitigated by mark-to-
market and margining.

Mark-to-market consists of daily valuing the position at the official Daily Settlement Price. The difference between
the carry price and Daily Settlement Price is settled in cash, and the position is carried forward to the next day at the
Daily Settlement Price.

Even this reduced size of counterparty credit risk (equal to the price change over a single day) is eliminated by
collecting it upfront from each party to the trade, and this is called “initial margin”. Both buyer and seller will have to
pay initial margin upfront before the trade is initiated. Initial margin is computed through a model called “value-at-
risk” (VaR) for each trade, and the total initial margin required for all trades in an investor account is computed
through what is called SPAN margining methodology.

Value-at-risk (VaR) is a measure of maximum likely price change over a given interval and at a given confidence level.
VaR will be slightly higher for short positions than for long positions. The reason is that the price can theoretically
rise to infinity but cannot fall below zero.

SPAN margining: initial margin and variation margin. SPAN is an acronym for Standard Portfolio Analysis, which is a
margining system that is devised and owned by Chicago Mercantile Exchange (CME) Group, the largest derivatives
Exchange in the world, but is allowed to be used for free by others. Most derivatives Exchanges follow SPAN
margining today. Remember that VaR is not an exact measure but the maximum likely change at a given confidence
level.
Inter-commodity spread credit is the amount that is deducted from the portfolio-wide margin derived as above. The
credit reflects the facts that the related underlying tend to move together in the same direction.

Besides the initial margin and variation margin under SPAN margining, there are two more margins implemented by
the Clearing Corporation. They are extreme loss margin and delivery margin. Extreme loss margin is applicable to
the Clearing Member and is the amount deducted from liquid assets in real-time. It is specified as a percentage of
Open Position. Delivery margin is applicable for physical delivery of security.

Clearing and Settlement

Clearing Corporation conducts the multilateral netting of obligations for both cash and securities. The netting is
applied at the level of Clearing Member (CM). The net position (separately for cash and securities) for each Clearing
Member is called the Open Position, which is settled with the Clearing Corporation.

Settlement follows clearing and consists of payment of cash versus delivery of securities after multilateral netting in
the clearing. Physical settlement means exchange of cash for the security. Physical settlement does not mean that
every sell trade during contract’s life results in physical delivery. The seller can always square up his position with an
offsetting buy trade, but it must be done before the close of business on the Last Trading Day. In case of physical
delivery, the Open Position at the close on Last Trading Day must be settled with physical delivery of any of the
Deliverable Securities.
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Bond futures can be either cash settled or physically settled as per the current guidelines. However no exchange has
physical settlement of Bond Futures available. The Bond futures that are currently traded are all cash settled. The
profit/ loss resulting there from shall be paid to/ received from such member in accordance with the laid down
settlement procedures in this regard.

Every Clearing Member must discharge his obligation i.e.:

 In case of Physical Settlement: Deliver securities for sell trades and pay cash for buy trades before he is
entitled to receive securities or cash from the counter-party (i.e., pay-in before pay-out), and
 In case of Cash Settlement: Settle his cash obligations first before he is entitled to receive his cash
receivables (i.e., pay-in before pay-out).

This is called “pay-in” first and “pay-out” later, both occurring on the same day with few minutes or hours between
them. Thus, the settlement is not the delivery-versus-payment (DvP) type practiced for the settlement of
government securities which are settled in the SGL A/c at PDO.

Procedure for Delivery

Currently all Bond Futures are all cash settled, hence the following is only for study and reference.

Allocation to Buyer: At the client-level, Clearing Corporation will assign the intentions from the sellers to the buyers,
at the client-level, starting from longest maturity/age. If for a maturity/age, the total deliveries are less than the total
buy quantity, then the allocation is done randomly.
Clearing Corporation will finalize and announce the security delivery Open Position at the Clearing Member level.

Delivery Margin: Delivery margin is collected on the Day of Intent after the intention to deliver and allocations are
completed. The margin amount is the VaR margin computed on the invoice price plus 5% of the face value of the
security to be delivered. The delivery margin is applicable from the Day of Intention and released after the
settlement is completed, and is collected from both buyer and seller. The mark-to-market margin is applied on the
closing price of the security that is delivered.

Security Settlement: Clearing Corporation will receive and deliver Deliverable Bonds either in SGL Accounts with PDO
or through the demat accounts system of NDSL/CDSL.

Settlement of Cash Leg: Cash is settled through the Clearing Banks in the same account applicable for the currency
derivatives.

Auction Settlement: Auction settlement is a special settlement and distinguished from “normal” settlement. It
applies on two occasions. First, seller fails to notify the Intent to Deliver. Second, there is a short-delivery of
securities on the settlement day.
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VII. Regulations and Compliance

Like currency derivatives, interest rate derivatives are jointly regulated by Reserve Bank of India (RBI) and Securities
and Exchange Board of India (SEBI). Within the statutory regulations of RBI and SEBI, the Exchanges and Clearing
Corporations will frame the rules and procedures under their bye-laws.

RBI: Anything related to the government securities, both in primary and secondary market, is primarily regulated by
RBI. In addition, RBI regulates the investment in debt securities by foreign institutional investors.

 Product: The product features, deliverable bonds and settlement method are jointly defined by RBI and SEBI.
 CSGL Account: Under the Government Securities Act 2006, there are specific entities are allowed to open
Constituent Subsidiary General Ledger (CSGL) Account with Public Debt Office (PDO), RBI on behalf of their
constituents, who maintain Gilt Account.

SEBI: Within the broad regulatory framework specified by RBI, SEBI will further specify the regulations governing the
Exchange-traded interest rate futures, as follows.
 Membership Eligibility: There is no separate membership facility for interest rate futures, and membership in
the Currency Derivatives Segment of Futures & Options will automatically enable trading in interest rate
futures. The minimum net worth as of the latest balance sheet should be Rs.1 Cr for Trading Member (TM)
and Rs.10 Cr for Clearing Member (CM).
 Surveillance and Disclosure: The Exchange and Clearing Corporation will conduct the back-testing for the
effectiveness of margining method twice in a year and communicate the results to SEBI.
 Exchange and Clearing Corporation: Within the regulatory framework specified by SEBI, the Exchange and
Clearing Corporation will specify the detailed rules and procedures for trading, clearing, settlement
(including auction settlement) and risk management.

Fixed-income and Money Market Derivatives Association (FIMMDA): FIMMDA is a self-regulatory organization
for cash and derivatives markets in money and bond instruments. It publishes yield curve for bonds, which is used by
Clearing Corporation to update the SPAN margining risk parameters. It also publishes the market prices for various
bonds, which are used in calculation of theoretical prices to determine Base Price and Daily Settlement Price.
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Restrictions on Resident and Non-Resident investors

 Residents (as defined in Foreign Exchange Management Act 1999) are allowed to freely buy or sell interest
rate futures for hedging and speculation.
 RBI-supervised entities should obtain prior permission from the RBI to deal in interest rate futures; and
naked short-sale is allowed only for banks and primary dealers. Entities such as Mutual Funds, Insurance
Companies, Housing Finance Companies, NBFCs who are supervised by other regulators should similarly
obtain prior permission of the concerned regulator.
 The following exposure limits will apply to FII’s registered with SEBI
1. Purchase/Long Position: total position in cash and interest rate futures should not exceed the limit
specified for investment in government securities
2. Sold/Short Position: short position can be maintained only for hedging (and not for speculation) and
the gross short position should not exceed the total long position in government securities in cash
and interest rate futures.

Position Limit is the limit on an investor’s share in the total open interest. Under the current regulations of SEBI, the
following are the position limits for both T Bill and T Bond futures. The limits are set as a percentage of gross open
positions across all contracts.

Regulatory Reporting

For banks and all-India financial institutions, the following reports are to be submitted to the RBI at monthly
intervals.
 Outstanding futures positions and share in open interest
 Activity during the month (opening notional, notional traded, notional reversed, and notional outstanding)
 Analysis of “effective” hedges
 Analysis of “NOT effective” hedges

In addition, the following disclosures must be made as part of the notes on accounts to the balance sheet.
 Notional amount of futures traded during the year (instrument-wise)
 Notional amount of futures outstanding on balance sheet date (instrument-wise)
 Notional amount of futures outstanding and not effective for hedge (instrument-wise)
 MTM vale of futures outstanding and not effective for hedge (instrument-wise)

Role of FIMMDA in Fixed Income and Derivatives Markets in India

The Fixed Income Money Market and Derivatives Association of India (FIMMDA) is an association of Scheduled
Commercial Banks, Financial Institutions, Primary Dealers and Insurance Companies. FIMMDA is a voluntary market
body for the bond, money and derivatives markets. FIMMDA has members representing all major institutional
segments of the market. The membership includes Nationalized Banks, Private banks, Foreign Banks, Financial
institutions, Insurance Companies and all Primary Dealers. One of the main objectives of FIMMDA is to recommend
and implement healthy business practices, ethical code of conduct, standard principles and practices to be followed
by the members in their dealing of securities.

Accounting: The Institute of Chartered Accountants of India (ICAI) is a statutory body to define the accounting,
presentation and disclosures by corporations. Its accounting Standard, AS 30, specifies the accounting for all
derivative transactions.
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VIII. Trading and Hedging

What we trade with T Bill and T Bond futures is the price risk component of interest rate risk. The relationship
between changes in interest rate and the price of rate-sensitive instruments is inversely proportional. That is, of the
rate goes up, the price of rate-sensitive instrument goes down, and vice versa. For trading, we must decide three
parameters:

1. Instrument (i.e. T Bill or T Bond futures) will depend on the tenor of interest rate we want to trade. T Bill
price is determined by short-term rate of three months and T Bond price is determined by long term rate of
10 years (because the underlying is a 10Y bond).
2. Market side will depend on our expectation about the direction of rate change in future. If we expect the
rate to go up in future, then the instrument price will fall in future, implying that we should sell futures
contract now and subsequently buy it later when its price falls. Similarly, if we expect the rate to go down in
future, then the instrument price will rise in future, implying that we should buy futures contract now and
subsequently sell it later when its price rises.
3. Contract Month will depend on the timing of expected rate change. If we expect the rate change to occur in
one month, we should chose a contract that expires in one month; if we expect the rate change to occur in
three months, we should choose a contract that expires in three months; and so on. The following
summarizes the selection of these parameters.

Hedging Strategies

Hedging is the opposite of trading: eliminating the existing price risk. It is important to note that risk is defined as the
uncertainty about the future cash flows. If the futures cash flows are fixed and known (in terms of their size and
timing) at the outset, there is no risk. If you have taken a fixed-rate loan, there is no risk because you know in
advance how much you will have to pay in future. On the other hand, if you have taken a floating-rate loan, there is
risk because you do know in advance how much you will have to pay in future for the interest. Thus, converting a
floating-rate loan into a fixed-rate loan is hedging; and converting fixed-rate loan into floating-rate loan (in the
expectation that the rate in future will be lower) is speculation/trading. To understand the application of hedging
with bond futures, we must recall the concept of Modified Duration and other risk measures. Let us recall the
following definitions.

 Modified Duration is a dimensionless number that tells us the percentage change in bond’s price caused by a
given change in the yield.
 Rupee Duration (RD): it is the absolute change in the total market value of bond for a given change in the
yield.
 Price Value of a Basis Point (PVBP): it is the same as RD except that the change in yield is considered at one
basis point (or 0.01%).

To hedge a bond or bond portfolio in futures market, we must match the PVBP of both bond position and the futures
position in an offsetting manner: gain on one will be offset by the loss on the other. Bond futures derives its
Modified Duration or PVBP from the underlying Cheapest-to-delivery (CTD) bond it tracks and the link between the
PVBP of bond futures and that of CTD bond is the Conversion Factor (CF). The relation between equivalent prices in
cash and futures market is
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Adjusted futures price (or equivalent cash price) = Futures Price * CF

 Basis risk arises from standardization of futures contract for amount and expiry date. Since futures contract
can be bought or sold only in multiples of 200,000 notional, any amount that needs to be hedged but is not a
multiple of contract amount leaves a mismatch between exposure amount and hedged amount.

 Yield curve spread risk arises when the term structure shifts are not parallel (see Sec 2.5) but steepening or
flattening. This poses problem when the tenor of exposure to be hedged is different from the tenor of
futures contract.

 Market liquidity risk is the inability to quickly buy or sell futures contract without disturbing the futures
price. If there is no market liquidity, the futures price is de-linked from the price of cash markets, and
determined by demand-supply in futures market and liable for squeeze. It will be dangerous to trade in
market that has no market liquidity.

PLEASE NOTE, THESE ARE SHORT IMPORTANT NOTES EXTRACTED FROM THE NISM BOOK. ITS ADVISABLE
TO READ THE NISM BOOK TO GET FULL KNOWLEDGE.

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