Strategies Using Exchange Traded Interest Rate Futures and Options

1Hedgers, speculators and arbitrageurs

• Hedgers already have an interest rate exposure and use derivatives to reduce it: banks, primary dealers, insurers, provident funds, mutual funds, and companies that borrow or invest.
• Speculators have no underlying exposure. They take positions to profit from an expected move in rates, accepting the risk that hedgers pass on.
• Arbitrageurs look for mispricing between related prices (futures against the bond, one contract month against another) and lock in a nearly riskless profit. In doing so they keep prices in line.

Remember

• Hedger reduces risk, speculator takes risk, arbitrageur exploits mispricing.

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2Hedging with interest rate futures

Short hedge (sell futures): used by anyone who loses if rates rise.

• A bank or fund holding bonds sells futures. If yields rise, the bonds lose value but the short futures gain.
• A company that will issue bonds or borrow at a fixed rate later sells futures to lock in today's rate.

Long hedge (buy futures): used by anyone who loses if rates fall.

• An investor who will receive cash later and buy bonds then (for example, a provident fund expecting inflows) buys futures. If yields fall before the money arrives, the futures gain offsets the higher bond prices.

How many contracts? Match the interest rate sensitivity of the exposure with that of the futures. Using duration:

Number of contracts = (Portfolio value × Portfolio modified duration) ÷ (Futures contract value × Modified duration of the futures' underlying)

Equivalently, using PVBP: Number of contracts = Portfolio PVBP ÷ PVBP of one futures lot.

Example A fund holds ₹50 crore of bonds with a modified duration of 6. One futures lot is worth ₹2 lakh (price ₹100) and the underlying bond's modified duration is 7. Contracts to sell = (50,00,00,000 × 6) ÷ (2,00,000 × 7) ≈ 2,143 lots. PVBP check: portfolio PVBP = ₹3,00,000; one lot's PVBP = 7 × 2,00,000 × 0.0001 = ₹140; 3,00,000 ÷ 140 ≈ 2,143.

Changing duration: futures can also adjust a portfolio's duration without trading the bonds. Selling futures reduces duration and buying futures increases it.

Remember

• Hurt by rising rates → short hedge. Hurt by falling rates → long hedge.
• Hedge ratio = (value × MD) ÷ (futures value × futures MD).
• Sell futures to cut duration; buy to add duration.

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3Hedging and positioning with options

• Protective put: own the bond and buy a put. This sets a floor on the bond's value if yields rise, while keeping the gain if yields fall. The cost is the premium.
• Covered call: own the bond and sell a call. You earn the premium for extra income, but give up gains above the strike if yields fall.
• Collar: own the bond, buy a put and sell a call. The call premium pays for the put, and the value is kept within a range.
• Bull call spread: buy a lower-strike call and sell a higher-strike call. This is a cheaper way to benefit from falling yields (rising prices), with the gain capped.
• Bear put spread: buy a higher-strike put and sell a lower-strike put. This benefits from rising yields, at a lower cost and with a capped gain.
• Long straddle: buy a call and a put at the same strike. It profits from a big move either way, for example around a policy announcement. The loss, limited to both premiums, comes if prices stay still.
• Long strangle: buy an OTM call and an OTM put. It is cheaper than a straddle but needs a bigger move.
• Short straddle or strangle: the seller profits if prices stay calm but faces large losses on big moves.

Example A long straddle at a strike of ₹100 costs ₹0.60 (call) + ₹0.55 (put) = ₹1.15. It breaks even if the bond settles below ₹98.85 or above ₹101.15.

Remember

• Protective put = insurance with the upside kept.
• Covered call = income, upside capped.
• Straddle = bet on volatility, not direction.

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4Speculation and arbitrage

Speculation. A trader who expects yields to fall buys futures or calls. One who expects yields to rise sells futures or buys puts. Futures give high leverage, because only a margin is paid, so small rate moves produce large gains or losses on the capital used.

Arbitrage.

• Cash-and-carry: if futures are above fair value (spot + carry), buy the bond with borrowed money and sell futures.
• Reverse cash-and-carry: if futures are below fair value, sell the bond and buy futures.
• Calendar arbitrage: if the price gap between two contract months departs from the carry cost between them, buy the cheap month and sell the dear one.

Remember

• Leverage magnifies both gains and losses.
• Arbitrage keeps futures close to their cost-of-carry fair value.

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5Spread trading

A spread is a long position in one contract and a short in a related one. It bets on the difference between them rather than on the overall direction of rates, so it carries less risk.

• Calendar spread: the same underlying bond, different expiry months (for example, buy the near month and sell the far month).
• Yield curve (inter-maturity) spread: futures on bonds of different maturities.
  • A trader expecting the curve to steepen (long yields rise relative to short yields) buys the short-maturity contract and sells the long-maturity contract.
  • A trader expecting the curve to flatten does the opposite: sells short-maturity and buys long-maturity.
  • Positions are sized by duration (PVBP) so that a parallel shift in the curve has little effect and only the change in shape matters.

Exchanges let calendar spreads be traded as a single order and give margin benefits on them, because the two legs offset much of each other's risk.

Remember

• Spread = bet on a difference, lower risk.
• Steepener: buy short end, sell long end. Flattener: the opposite.

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6Limitations for hedgers

• Basis risk: the exposure (for example, corporate bonds or a loan) may not move exactly like the futures' underlying G-sec.
• Maturity and duration mismatch: available contracts may not match the exposure, and durations change as rates and time move on, so the hedge needs rebalancing.
• Lot size rounding: the hedge ratio rarely comes to a whole number of lots.
• Liquidity: activity is concentrated in near months and a few bonds, which makes large or long-dated hedges hard.
• Mark-to-market cash flows: daily losses on futures must be paid in cash even when the hedged asset gains in value.
• Lost upside: a futures hedge removes gains as well as losses. An option hedge keeps the upside but costs a premium.

Remember

• No hedge is perfect: basis risk, mismatch and liquidity are the main gaps.

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