Exchange Traded Interest Rate Futures

1What an interest rate future is

An interest rate future is an exchange-traded contract to buy or sell an interest-bearing instrument (in India, a Government of India security or a 91-day Treasury bill) at a price fixed today, for settlement on a future date. Like all futures, it is standardised, traded on screen, marked to market daily and guaranteed by the clearing corporation.

Because the underlying is a bond price, the direction rule is:

• Long (buy) IRF: gains when bond prices rise, that is when yields fall.
• Short (sell) IRF: gains when bond prices fall, that is when yields rise.

Exam trap "I expect interest rates to rise" means sell bond futures, not buy. Always translate a rate view into a price view first.

Remember

• IRF on a G-sec: price-based, so it moves opposite to yields.
• Rates expected up → sell futures. Rates expected down → buy futures.

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2Contract specifications in India

Indian exchanges list cash-settled IRFs on specific Government of India securities. The typical specification on NSE is:

Exchanges revise these details (expiry days, available bonds) from time to time, so always check the current contract specifications on the exchange's website.

History in brief. Earlier IRF contracts in India used a notional bond with physical delivery from a basket of deliverable bonds. The seller chose the cheapest-to-deliver (CTD) bond, and conversion factors adjusted for coupon differences. Today's contracts are on a single specified bond and are cash-settled, which removes delivery complexity.

Margins: the clearing corporation collects an initial margin (risk-based), an extreme loss margin, and settles mark-to-market profits and losses in cash every day.

Remember

• 1 lot = ₹2 lakh face value = 2,000 bonds.
• Tick = ₹0.0025.
• Cash-settled; final settlement price comes from NDS-OM trades in the bond.

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3Tick size, contract value and payoffs

Value of one tick per lot = tick size × number of bonds = 0.0025 × 2,000 = ₹5.

Contract value = futures price × 2,000. At a price of ₹98.50, one lot is worth 98.50 × 2,000 = ₹1,97,000.

Profit or loss = (selling price − buying price) × 2,000 × number of lots.

Example A trader buys 10 lots at ₹98.50 and sells at ₹99.10. Gain = 0.60 × 2,000 × 10 = ₹12,000. In ticks: 0.60 ÷ 0.0025 = 240 ticks × ₹5 × 10 lots = ₹12,000.

Payoff diagrams are straight lines, as for any futures contract:

• Long: profit rises one-for-one as the futures price rises above the entry price; the loss grows as it falls.
• Short: the mirror image.

Both sides face potentially large losses. There is no premium and no limit to the loss, unlike buying an option.

Linking price to yield: if the underlying bond has a modified duration of about 7, a 10 basis point fall in yield lifts its price by about 0.70%. On a ₹100 price, that is ₹0.70, or 0.70 × 2,000 = ₹1,400 per lot.

Remember

• Tick value per lot = ₹5.
• P&L = price change × 2,000 × lots.
• Futures payoffs are linear and symmetric.

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4Why exchange-traded rate futures, and how they compare with FRAs

Exchange-traded IRFs were introduced in India to give a transparent, liquid and safe way to hedge interest rate risk, open to a wider set of participants (banks, primary dealers, insurers, mutual funds, companies, foreign portfolio investors and individuals). Previously, hedging relied mostly on OTC contracts between banks.

Advantages over FRAs and other OTC hedges:

• Standardised and traded on screen, so prices are transparent.
• No counterparty risk, because the clearing corporation guarantees trades.
• Easy to exit before expiry by taking an opposite position.
• Low transaction cost and small lot sizes, so smaller players can hedge.
• Good price discovery for future rates.

Limitations:

• Basis risk: the hedged bond or loan may not move exactly like the futures' underlying bond.
• Fixed sizes and dates may not match the exposure exactly. An FRA can be tailored.
• Daily mark-to-market creates cash-flow (liquidity) needs even if the hedge works in the end.
• Liquidity is often concentrated in the near-month contract, so far contracts can be thin.

Remember

• Exchange IRF: transparent, guaranteed, liquid, cheap.
• Costs of standardisation: basis risk, mismatch, daily margin calls.

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5Pricing interest rate futures

Bond futures are priced by cost of carry, as for other futures. Think of an arbitrageur who borrows money, buys the bond today, holds it until the futures' expiry and delivers it then:

Futures price = spot price + financing cost − coupon income over the period

(Strictly, the calculation uses the dirty price and subtracts the accrued interest at expiry, but the principle is the same.)

• If the bond's coupon income exceeds the financing cost (positive carry), the futures price is below spot.
• If the financing cost exceeds coupon income (negative carry), the futures price is above spot.

Example A bond trades at ₹100 (clean, ignore accrued interest). It pays a 7.5% coupon, and money can be borrowed at 6% a year. For three months: coupon income = 7.5 × 3/12 = ₹1.875; financing cost = 100 × 6% × 3/12 = ₹1.50. Fair futures price = 100 + 1.50 − 1.875 = ₹99.625.

Basis = spot price − futures price. As expiry approaches, the carry period shrinks, so the basis moves towards zero and the futures price converges to the spot price. On expiry, cash-settled contracts settle against the underlying bond's price.

If the futures trade above fair value, arbitrageurs buy the bond and sell futures (cash-and-carry). If futures trade below fair value, they sell the bond and buy futures (reverse cash-and-carry).

Remember

• F = S + financing cost − income.
• Coupon yield > financing rate → futures below spot.
• Basis converges to zero at expiry.

Practise this concept (8 questions)