Interest rate futures and options

A bank treasury, a mutual fund or a primary dealer holding thousands of crores of G-Secs cannot sell the portfolio every time it fears a rate rise. Interest rate futures let it sell the risk instead, for a margin of a few percent. The exam wants the contract specifications, the price-yield direction, a P&L calculation and, most importantly, the duration-based hedge ratio.

Exchange-traded interest rate futures in India

After two failed designs in 2003 and 2009, the cash-settled single-bond futures launched in 2014 finally found liquidity. NSE and BSE offer futures on specified Government of India securities, typically the liquid benchmark in the 6-year, 10-year and 13-year buckets, plus a 91-day T-bill contract. Specifications, as set by the exchange:

• Underlying: a named G-Sec, for example the current 10-year benchmark. The exchange changes the underlying when a new benchmark becomes liquid.
• Contract size: ₹2 lakh face value, that is 2,000 units of ₹100.
• Quotation: clean price per ₹100 face value, to four decimals. Tick ₹0.0025, worth 0.0025 × 2,000 = ₹5 per contract.
• Expiry: monthly, with three serial months trading; last trading day as specified (the last Thursday of the month, or the previous day if a holiday).
• Settlement: daily MTM in cash; final settlement in cash against the volume-weighted average price of the underlying bond on NDS-OM in the closing period of the last trading day.
• Margins and limits: SPAN initial margin plus extreme loss margin; client, member and FPI position limits as notified.

Because the contract is quoted as a price, it moves inversely to yields. A trader who expects yields to rise sells; one who expects yields to fall buys. The 91-day T-bill futures is different: it is quoted as 100 minus the annualised yield, with contract value 2,000 × (100 − 0.25 × yield), and settles against the RBI auction cut-off yield in the week of expiry. The price still rises when yields fall, so the trading direction is the same for both contracts.

Pricing the futures

The fair price follows cost of carry, with the twist that the bond pays a coupon while you hold it. You finance the purchase at the short-term repo rate and earn coupon accrual; if the coupon exceeds the financing cost, the carry is positive and futures trade below spot.

Take the 10-year bond at a dirty price of ₹99.00 with a 7.10% coupon, repo rate 6.5%, three months to expiry. Financing cost = 99 × 0.065 × 0.25 = ₹1.609. Coupon accrual = 7.10 × 0.25 = ₹1.775. Fair futures (dirty) ≈ 99 + 1.609 − 1.775 = ₹98.83, slightly below spot because the coupon more than pays for the carry. The exchange converts this to a clean futures price by deducting accrued interest at the futures settlement date. When the repo rate exceeds the coupon, the sign flips and futures trade above spot.

Hedging a bond portfolio

A hedge must offset rupee sensitivity, not face value. The hedge ratio therefore uses modified duration on both sides: the portfolio's and the underlying bond's.

The loss and gain match closely; the small residual is rounding to whole contracts. If yields had fallen instead, the portfolio would have gained and the futures lost by the same amount: the hedge removes rate risk in both directions and leaves the fund earning the carry. Three residual risks remain. Basis risk, because the hedged bonds and the futures' underlying bond do not move one for one (a corporate bond portfolio hedged with G-Sec futures also carries credit spread risk). Duration drift, because durations change as yields move and time passes, so the ratio needs rebalancing. And cash flow, because daily MTM losses on the futures must be paid even though the portfolio's offsetting gain is unrealised.

A simpler P&L calculation is also a favourite: sell 10 contracts at 98.50, buy back at 97.80, gain = 0.70 × 2,000 × 10 = ₹14,000. Each tick is ₹5, each paisa is ₹20 per contract.

MIBOR and overnight index swaps

MIBOR, the Mumbai Interbank Offered Rate, is the overnight benchmark computed by FBIL from actual call money trades. Most rupee interest rate hedging by banks and corporates happens not on the exchange but in the OTC overnight index swap (OIS) market. In an OIS one party pays a fixed rate and receives the compounded overnight MIBOR over the period; the other does the reverse. No principal is exchanged, only the net interest difference at maturity (or periodically for longer tenors). A company with a floating-rate loan who fears rising rates pays fixed, receives floating; a bank expecting cuts receives fixed. If a one-year OIS is struck at 6.60% on ₹100 crore and compounded MIBOR averages 6.40%, the fixed payer pays net 0.20% × 100 crore = ₹20 lakh; had MIBOR averaged 6.90%, the fixed payer would receive ₹30 lakh. Forward rate agreements fix a rate for a single future period and are the one-period building block of a swap. Both are reported to CCIL's trade repository and, for standard tenors, centrally cleared.

Interest rate options

SEBI has permitted exchange-traded interest rate options on G-Sec futures or on the underlying bonds: European, cash-settled, premium-quoted, with the same lot and settlement mechanics as the futures. A put on the bond price protects against rising yields; a call benefits from falling yields. In the OTC market the equivalents are caps (a series of options that pay when a floating rate exceeds a strike), floors (pay when it falls below) and collars (buy a cap, sell a floor, to cut the premium). A borrower buys a cap; a lender or investor buys a floor. Liquidity in exchange-traded rate options remains thin, so specifications should be treated as "as specified by the exchange", but the directional logic is the same as any option on a price.