Interest Rate futures - Managing Interest Rate Risks


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Considering that Interest Rate Volatility can be a major cause of concern for individuals, especially the ones who have availed floating rate credit, it is important for Financial Planners to understand the hedging mechanism, evaluate its suitability and be
able to advice their clients in accordance.

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Interest Rate futures - Managing Interest Rate Risks

  1. 1. DERIVATIVE MANAGEMENT Interest Rate Futures – Managing Interest Rate Risks Considering that Interest Rate Volatility can be a major cause of concern for individuals, especially the ones who have availed floating rate credit, it is important for Financial Planners to understand the hedging mechanism, evaluate its suitability and be able to advice their clients in accordance. Amar Ranu Senior Manager, Mutual Fund Research Motilal Oswal Securities Limited W ith liberalization in 1992, a new chapter was organized exchanges across all futures instruments amounted added to the history of Indian Economy. It was the to US $ 18.5 trillion in March 2009, of which $ 17.8 trillion time India opened its gate of vast opportunities to pertained to Interest Rate Futures. In Asia, the notional domestic players as well as foreign players to participate in amount outstanding in Exchange Traded Interest Rate various financial products. Liberalization created competition Futures was estimated at US $ 1.9 trillion in March 2009. among banks, both domestic and foreign, and even among Non In India, Interest Rate Futures provide a good avenue for Banking Finance Companies (NBFCs), Asset Management different market participants such as banks, mutual funds, Companies (AMCs) etc. Capital Markets got regulated and primary dealers, insurance companies, foreign institutional many new products came into existence under the supervision investors and retail investors to hedge their risks and manage of Capital Markets regulator, Securities and Exchange them effectively. Board of India (SEBI). It was the time when products like derivatives, structured products, corporate Bonds etc., all What are Interest Rate Futures? came into existence. However, risks too multiplied too with An Interest Rate Future is a financial derivative with increased trading in financial products such as derivatives, interest rate instrument as an underlying. In India, the either as plain-vanilla or structured products. This led to underlying instrument is a 10-year notional coupon-bearing increased gyration of interest rates. To counter the increased government security. This underlying security will pay an volatility of interest rates, the Central Bank, Reserve Bank interest (coupon) at a rate compounded at 7 per cent on a half of India (RBI) introduced some hedging instruments, mainly yearly basis. The various underlying assets are Government over-the-counter (OTC) traded, such as Interest Rate Swaps of India securities with maturity ranging between 7.5 (IRS) and Forward Rate Agreements (FRA). These products years and 15 years from the first date of delivery month. were instant hit and helped all categories of traders to hedge The unique part of the new IRF is that they are settled by their risks. The success prompted the banking regulator to deliverable grade securities using the electronic book entry introduce an exchange-traded product, Interest Rate Futures system of the existing depositories (NSDL and CDSL) and (IRF), in 2003 mainly to streamline its reach to all kind of Public Debt Office (PDO) of the RBI. There are a total of investors such as banks, insurance companies, primary 11 deliverable securities from which the deliverable baskets dealers and provident funds. Let us discuss IRFs in detail, of securities are decided every month (See Table 1). Any of what prompted RBI to reintroduce it, its design issues, and these recommended securities can be delivered by the seller responses. at the end of the maturity. Here, the concept of Cheapest to Deliver (CTD) has been introduced as liquidity in bond Penetration of Interest Rate Futures products is not so deep. Out of 11 bonds chosen by the Popularly known as Bond Futures, Interest rate futures exchange, the bond having less CTD will be delivered by the globally account for the largest volume among the financial seller in the normal circumstances. derivatives traded on exchanges worldwide. As per the The minimum lot size of the contract has been specified data released by the Bank for International Settlement as Rs. 2,00,000. Hence, an entity having an interest rate (June 2009), the notional principal amount outstanding in exposure of total volume of Rs. 1 crore will have to trade MAY 2010 | FINANCIAL PLANNING JOURNAL | 42
  2. 2. DERIVATIVE MANAGEMENT into 50 contracts. The quotation is done similar to price of For example, floating home loan borrowers are subject to Government of India (GoI) security; day count convention is interest rate risk but do not hold G-Secs which may create 30/360 day basis. hurdles while delivery. Table 1: Deliverable baskets of eligible G-Secs* How it benefits the different market Near Month June 2010 contracts Next Month Sept 2010 contracts intermediaries? Nomenclature Maturity Date Nomenclature Maturity Date 5.69 % 2018 25-Sep-18 5.69 % 2018 25-Sep-18 a) Primary Dealers 12.60 % 2018 23-Nov-18 12.60 % 2018 23-Nov-18 Interest Rate Futures provides a superior tool to primary 5.64 % 2019 2-Jan-19 5.64 % 2019 2-Jan-19 dealers (PDs) to manage their interest rate risk and will support 6.05% GS 2019 (FEB) 2-Feb-19 6.05% GS 2019 2-Feb-19 their earning profiles. It also reduces the transaction costs, (FEB) and eliminates credit and settlement risks. The profitability 6.05% 2019 12-Jun-19 6.05% 2019 12-Jun-19 of PDs has always been susceptible to increased volatility in 6.90% 2019 13-Jul-19 6.90% 2019 13-Jul-19 interest rates. So, in absence of adequate hedging tools, they 6.35% 2020 2-Jan-20 6.35% 2020 2-Jan-20 *Source: NSE India are constrained to trim down their portfolio size to contain losses. Why Interest Rate Futures are required in India? b) Banks A technical advisory committee on Money, Foreign It helps banks manage basis risk, repricing risk and yield Exchange and Government Securities constituted by the curve risk. Yield curve risk arises when changes in market Reserve Bank of India (RBI) stated that banks, insurance interest rates may have different effects on similar instruments companies, primary dealers, and provident funds in India, with different maturities while repricing risk arises from who among them carry around 88 per cent of interest rate mismatches in maturity and interest rate changes in a bank’s risk on account of exposure to GoI securities, need a credible assets and liabilities. Basis risk arises when yield on assets and institutional hedging mechanism to serve as a ‘pure hedge’ costs on liabilities are based on different benchmarks. It also for their credit-risk-free interest rate-risk exposure. It is also helps in improving the capital adequacy ratio as hedged assets understood that reducing the risk of holding or trading debt will require lesser risk capital allocation. futures deepens debt markets. The IRF allows interest rate exposure to be made redundant. For example, an entity having c) Mutual Fund long positions in GoI securities can short them in future, Mutual Fund players may use IRFs in hedging to mitigate thus, cancelling out the impact of interest rate fluctuations. interest rate risk for debt market mutual fund. Taking Moreover, since, India has moved far ahead from the days positions in IRFs will diversify their portfolio which will lead when interest rates were administered, interest rate volatility to increased sharpe ratio. It will help in increasing absolute has been increasing over the years and in higher now than in performance of a portfolio on a risk adjusted basis over a most developing countries of the world. So, interest rate risk specific time period. The whole process will lead to efficient is high for many transactions. Also interest rate futures will price discovery and greater liquidity. So, the different positive help in transmitting the monetary policy in more effective may incentivize the mutual fund players to actively pursue way. If the impact of interest rate change is lower on banks’ the launch of new schemes. balance sheets, they will be willing to change the lending rates in parallel to changes in policy rates. d) Insurance Companies Insurance companies can mitigate their interest rate Why did Interest Rate Futures fail earlier? volatility bearing assets and liabilities by using IRFs. The In 2003, the zero coupon yield curve used as the use of IRF will help effective management of asset-liability underlying created too much basis risk. But now, ten-year mismatch. It will help in decreasing underwriting expenses of G-Sec, comparatively more liquid, is used. “Moreover, earlier insurance policies and expense ratio and increase investment the two-way movement of the policy rates was not so well yield of assets. It also provides hedge against interest rate risk established” said, Ashima Goyal, Professor of Economics, for protection of the sum assured. Indira Gandhi Institute of Development & Research (IGIDR). Further, earlier G-Sec biggest buyers, banks were e) Corporate Players not allowed earlier to trade in the segment. Also IRFs were IRFs provides low entry and exit costs for corporate used for hedging transactions only but in the latest issue, both as against Interest Rate Swaps (IRS). It will also help in speculators and arbitragers are to be allowed apart from pure improving the credit rating for corporate by enhancing the hedgers. Still, the issue of concern is the physical delivery, “debt-service coverage” ratio and “interest coverage” ratio. which is an operational issue as G-Secs are not widely held. Corporate issuing embedded bond options (call and put MAY 2010 | FINANCIAL PLANNING JOURNAL | 43
  3. 3. DERIVATIVE MANAGEMENT option) can manage risk against volatility in interest rates. the effective use of IRFs. f) Retail/ HNI Investors Exchanges in India where IRFs are traded Interest Rate Futures can be a good hedge against loans Currently, only National Stock Exchange (NSE) provides or fixed deposits which can be of great use for retail/HNI trading platform for Interest Rate Futures and may continue investors. It is possible to hedge loan against a rise or fall in to enjoy the first-time moving advantage. Other exchanges interest rates but the correlation between IRFs and mortgage such as Bombay Stock Exchange (BSE) and Multi-Commodity rates is not absolute. And investors will require margin money Exchange (MCX) will come out with a similar product for buying the contract and pay for transaction costs. contract in future and may see some surprised additional features. BSE may start providing trading platforms through Role of Financial Planners in making its newly-launched subsidiary, the United Stock Exchange effective use of IRFs (USE). BSE holds 15 per cent stake in USE, while the rest is Financial Planners can help Home Loan Borrowers held by 29 other investors, including 11 banks, MMTC and nullify the impact of rising interest rates on their home loans. Jaypee Capital. Let us understand how retail investors can get benefitted from IRFs. A person X is having a home loan outstanding Subdued Reponses of Rs. 50 lakh for 10 years at an adjustable floating rate of The NSE started its trading day with a turnover of Rs. 7 per cent for an EMI of Rs. 58,054. If the bank increases 267.31 crore, its highest since its launch on Aug 31, 2009 the floating rate to 8 per cent, it will affect the cash outflow and has comparatively got lukewarm responses from market of Mr. X due to increase in monthly EMI as shown in Table participants. The total contracts traded went down from 2. Therefore, he can manage his interest rate risk by entering 14,559 as on opening date to 6,101 as on Mar 31, 2010 (See into IRF contract. Table 4). Some of the public sector banks which are active in Table 2: home Loan details IRF market are State Bank of India, Bank of India and Bank initial Conditions of Baroda. Bank of America has also shown some interest home Loan Rs. 50 lakh Tenure 10 years into it. Many banks are also in the process of getting boards’ approvals to enter the IRF space, so, the market may take Interest Rate 7% EMI Rs. 58,054 around two-three quarter to see a rise in volumes. Moreover, Current Situation with BSE and MCX entering into the race, the market will Interest Rate 11% Tenure 10 years have a balanced and competitive trading. New EMi Rs. 60,664 ↑Rs. 2,609 (Monthly) Loss on home Loan Rs. 313080 (2609×120) Table 4: Trading history of iRFs - Subdued Responses Open Total Contracts Value Trade Date Interest (volume) (Rs. Crores) Mr. X sells 25 contracts of IRF (25×2,000×100) = Rs. 50 Position lakhs on April 15, 2010. The hedging details are as given in 31-Aug-09 14559 267.31 1893 Table 3. Sep-09 79648 73.67 83824 Table 3: hedging Details Oct-09 100846 93.37 203360 initial Conditions Nov-09 18134 16.84 128246 Trade Date 15-Apr-10 Interest Rate 7% Dec-09 11687 10.25 103833 Futures Price Rs. 100 Margin Paid Rs. 12,500 (2.5%) Jan-10 6443 5.94 50587 After increase in interest Rate Feb-10 3124 3.02 58255 Trade Date 25-May-10 Interest Rate 8% Mar-10 6101 5.56 61342 Futures Price Rs. 93.21 Profits on Futures (100-93.21)*2000*25 = Rs. 3,39,500 Conclusion Loss on home Loan (2609×120 months) = Rs. 3,13,080 The introduction of trading in interest rate futures aims Gross Gain (3,39,500-3,13,080) = Rs. 26,420 towards integration of the Indian Securities Market with Net Gain (26,420 - 12,500) = Rs. 13,920 outside world and also provides a competitive platform to market intermediaries to minimize different kinds of risk Similarly, if a borrower has taken a fixed rate loan, he can directly related to interest rates. The launch of interest rate convert his outstanding into floating rate by making use of futures trading will widen the country’s bond market and IRFs. Here, he will buy into IRFs. Thus, he will get into the volumes in government and corporate bond market will go benefit of reduced interest rate, if any. Thus, we see that IRFs up in near future. Moreover, the new contracts, unlike in can be a potential tool for borrowers which can hedge their 2003, have been redesigned to make them more liberal and interest rate risks and give a peace of mind. Here, Financial banks and foreign investors too have been allowed to trade. Planners can play an important role in educating borrowers MAY 2010 | FINANCIAL PLANNING JOURNAL | 44