Hedging Interest: Financial Express 19th June 2009

The direction of interest rates is a subject of conjecture as there are implications of RBI policy on one side and the market reality of high levels of liquidity and rigid interest rates on the other. Further, the bond market, comprising essentially of GSecs, has its own whims and may not always be in sync with the credit market. With a super-large government borrowing programme, interest rates tend to move in the upward direction, as interest rates and bond prices are inversely related. In such a situation, holders of GSecs such as banks are susceptible to market risk arising out of the mark-to-market principle when interest rates change. A solution out here is in an interest rate futures product. The RBI-Sebi report on interest rate futures (IRF) is quite appropriate in these circumstances and tries to address the lacunae in the earlier system that did not quite take off.
Just to illustrate how these instruments would work, we can think of players like banks or insurance companies with large GSec portfolios who can reduce their risk of loss by hedging their positions using IRF. Suppose we are expecting interest rates to decline in the near future, we can take a long position by buying a futures contract for delivery of the designated GSecs. If interest rates fall, the price of the underlying GSecs would go up, and the value of underlying GSec futures contract would also increase. The hedger then can benefit from the sale of the underlying GSec futures contract at a higher price. In the proposed scheme, the underlying bond would be a ten-year notional coupon bearing GSecs.
The opposite would occur when the market player is able to anticipate a rise in interest rates. The participant would short (sell) the bond futures contract, and when the rates of interest increase, the value of the GSec futures contract will fall. Hence, bond portfolios managers, banks, pension funds, insurance companies and individuals with such portfolios can hedge against raises in interest rates by selling short bonds that resemble the markup of the kind of bonds that are in their portfolio.
Interest rate futures are not a new concept in India and the OTC market is popular. Exchange-traded futures will have the advantages of transparency, trade guarantees and liquidity. In fact, RBI had introduced IRFs in 2003 which were traded on the NSE and were cash-settled with a maximum maturity of one-year. The settlement price was based on the zero coupon yield curve (ZCYC) method.
Though the volumes in the IRF initially were encouraging, they had disappeared by October 2003, due to inherent problems in the product design, regulations and accounting framework. Also banks, PDs and FIs were allowed to only hedge their held for trading (HFT) and available for sale (AFS) categories of their investment portfolio. Anecdotal feedback from the market indicated that the use of a ZCYC for determining the settlement and daily MTM price, resulted in large errors between zero coupon yields and underlying bond yields leading to wider basis risk between the IRF and the underlying. Or to use jargon, the linear regression for the best fit resulted in statistically significant number of outliers. Further, the prohibition on banks taking trading positions in the IRF contracts deprived the market of an active set of participants who could have provided the much needed liquidity.
The present design would hopefully take care of these issues as the notional ten-year bond with a coupon of 7% has been fixed. Further, the contracts are delivery-based and has been linked with securities with a maturity of between 7.5 and 15 years and a stock of Rs 10,000 cr. Hence, to a large extent the earlier deficiencies may be tackled.
However, to induce liquidity, trading positions should be permitted and the Report suggests that hedging should not be restricted to the AFS and HFT portfolios and should be extended to cover interest rate risk in the entire balance sheet. The success of this endeavour depends a lot on market participation and acceptance. The present success achieved in the currency futures market is reason for optimism here.