Interest rate futures and options

Interest rate futures (IRFs) are how a Debt Long-Short SIF strategy takes a short view on bonds. Shorting a G-Sec in the cash market is impractical for a fund; selling a futures contract on it is a two-minute trade. The exam wants you to know the Indian contracts, read a quote, compute profit and loss, and understand why a bond futures price moves opposite to yield.

A short history

India's first attempt at interest rate futures in 2003 failed; the contracts were priced off a zero coupon curve nobody traded and settled against it. A second attempt in 2009 used physical delivery of a notional 10-year bond with conversion factors; it was too complex for most participants. The cash-settled design launched in 2014 finally worked: a futures contract on a specific, liquid 10-year government security, settled in cash against that bond's market price. NSE and BSE both offer IRFs under SEBI regulation, with RBI oversight of the underlying government securities market.

The contracts traded in India

10-year G-Sec futures

Key specifications, as set by the exchange and revised from time to time:

• Underlying: a specified Government of India security with a residual maturity of about 10 years (the exchange names the bond, such as a 7.xx% 2034 security).
• Contract size: ₹2 lakh face value (2,000 units of ₹100 face value).
• Quotation: price per ₹100 face value, like the cash bond. A quote of 98.50 means ₹98.50 per ₹100, or a contract value of ₹1,97,000.
• Tick size: ₹0.0025, worth ₹5 per contract (0.0025 × 2,000).
• Expiry: monthly contracts, with the expiry day set by the exchange; three serial months trade at a time.
• Settlement: daily mark-to-market, and at expiry cash settlement against the weighted average price of the underlying bond in the cash market over the last two hours of trading.
• Margins: SPAN-based initial margin plus extreme loss margin; position limits for clients and trading members as notified.

Because the contract tracks a bond price, it moves inversely to yields. A trader who expects rates to rise sells the futures; one who expects rates to fall buys. This is the opposite of what a yield-based quote would do, so always check which way a contract is quoted before taking a view.

The same 0.70 move against a long position would lose ₹14,000. With margin around 3% of contract value (as notified), the position needed roughly ₹59,100 of margin, so the 0.7% move in the bond became a 24% move on capital.

91-day Treasury bill futures

The short-end contract is a cash-settled futures on the 91-day T-bill. Here the quote is 100 minus the annualised yield, so a quote of 93.50 means a yield of 6.50%. Contract size is ₹2 lakh. Contract value is computed as 2,000 × (100 − 0.25 × yield), the 0.25 reflecting the 91-day fraction of the year. At a 6.50% yield the contract is worth 2,000 × (100 − 1.625) = ₹1,96,750; if the yield falls to 6.40% the value rises to ₹1,96,800, a gain of ₹50 for the long. The contract settles against the RBI auction cut-off yield of the 91-day T-bill in the week of expiry. T-bill futures let a treasury hedge the cost of short-term borrowing or a fund lock in the yield on an upcoming liquid investment.

Pricing an interest rate futures contract

Bond futures follow the same cost-of-carry logic as equity futures, with one difference: holding the bond earns a coupon, which reduces the carry. The fair futures price is the spot (dirty) price grown at the short-term financing rate, less the future value of coupons received during the contract's life, converted back to a clean price at expiry.

When the financing rate is below the bond's running yield (the usual case in a normal curve), carry is positive and the futures trade below the spot price. When money market rates are above bond yields (an inverted curve), carry is negative and futures trade above spot. The implied repo rate is the financing rate that makes the actual futures price fair; if it is above the real repo rate, the futures are rich and a cash-and-carry (buy bond, sell futures) pays.

Interest rate options

NSE introduced interest rate options on the same 10-year G-Sec in 2019. They are European, cash settled, quoted in price terms like the futures, with strikes spaced around the current price. A fund that holds long bonds and fears a rise in yields can buy a put on the G-Sec (its price falls when yields rise, so the put pays). A fund that wants to earn income in a range-bound rate market can write calls. Premiums, moneyness and Greeks work exactly as in Chapter 7. Liquidity in interest rate options remains thin compared with the futures, so most SIF strategies use futures for the short leg and options only tactically.

Who uses IRFs and how

Banks hedge the interest rate risk of their bond portfolios; corporates lock in borrowing costs before an issue; insurers and pension funds hedge against falling yields that would hurt future reinvestment; and now SIF debt strategies use them for both hedging and directional shorts. Mutual funds may use IRFs only for hedging and portfolio rebalancing; the SIF's unhedged short up to 25% of net assets is the new freedom. For retail clients the practical appeal is that a bond view can be expressed with ₹2 lakh contracts and modest margin, but the leverage cuts both ways.