Interest Rate Futures (IRF) were introduced in India in June 2003 on the National Stock Exchange (NSE) through launch of three contracts - a contract based on a notional 10-year coupon bearing bond, a contract based on a notional 10-year zero coupon bond and a contract based on 91-day Treasury bill. All the contracts were valued using the Zero Coupon Yield Curve (SKY). The contracts design did not provide for physical delivery.
Considering the fact that the 10-year GoI securities constitute the most liquid benchmark maturity, the Group felt that a physical delivery based contract on a 10-year notional coupon bearing GoI security would be the ideal choice. Further, it would perhaps be desirable to introduce, in the first stage, a single product at the long end to prevent fragmentation of liquidity in the early stages. Any subsequent expansion of the range of products may be left to the exchanges depending on market response. The success of a physically settled IRF market depends upon a well functioning and liquid repo market.
According to the committee report, as regards cash settlement of IRF contracts proposed earlier, the Group was of the opinion that while the money market futures may continue to be cash-settled with the 91 day T-Bills/MIBOR/ or the actual call rates serving as benchmarks, the bond futures contract/s would have to be physically-settled, as is the case in all the developed, and mature, financial markets, worldwide.
RBI has provided for physical delivery settlement in the current interest rate futures. Further the 2003 IRF was based on zero coupon yield model but the market participants prefer future contracts to be based on yield to maturity of a basket of bonds. As a result, there was poor response to the IRF 2003. In January 2007, SEBI proposed a product based on the yield to maturity model. After that RBI panel said that to begin with, futures contract based on 10-year bond and settled by physical delivery should be introduced. The panel also said that contracts based on two, five and 10-year maturity may be launched by the exchanges, depending on the market response. Finally, now RBI has started with contracts based on 10-year bond.
Review
In the wake of deregulation of interest rates as part of financial sector reforms and the resultant volatility in interest rates, a need was felt to introduce hedging instruments to manage interest rate risk. Accordingly, in 1999, the RBI took the initiative to introduce Over-the-Counter (OTC) interest rate derivatives, such as Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA). In November 2002, a Working Group under the Chairmanship of Jaspal Bindra was constituted by RBI to review the progress and map further developments in regard to Interest Rate Derivatives (IRD) in India. On the recommendation of the High Level Committee on Capital Markets (HLCC), the Bindra Group also examined the issues relating to Exchange Traded Interest Rate Derivatives (ETIRD).
In its report (January 2003), the Bindra Group discussed the need for ETIRD to create hedging avenues for the entities that provide OTC derivative products and listed anonymous trading, lower intermediation costs, full transparency and better risk management as the other positive features of ETIRD.
The Security and Exchange Board of India’s (SEBI) Group on Secondary Market Risk Management also considered introduction of ETIRD in its consultative document prepared in March 2003. Accordingly, in June 2003 IRF was launched with the following three types of contracts for maturities up to 1 year on the NSE.
Futures on 10-year notional GoI security with 6% coupon rate
Futures on 10-year notional zero-coupon GoI security
Futures on 91-day Treasury bill
While the product design issues were primarily handled by the exchanges and their regulators, RBI permitted the Scheduled Commercial Banks (SCBs) excluding RRBs & LABs, Primary Dealers (PDs) and specified All India Financial Institutions (AIFIs) to participate in IRF only for managing interest rate risk in the Held for Trading (HFT) & Available for Sale (AFS) categories of their investment portfolio. Recognizing the need for liquidity in the IRF market, RBI allowed PDs to hold trading positions in IRF subject, of course, to prudential regulations. However, banks continued to be barred from holding trading positions in IRF. It may be mentioned that there were no regulatory restrictions on banks’ taking trading positions in IRS. Thus SCBs, PDs and AIFIs could undertake IRS both for the purpose of hedging underlying exposure as well as for market making with the caveat that they should place appropriate prudential caps on their swap positions as part of overall risk management.
While Rupee IRS, introduced in India in July 1999, have come a long way in terms of volumes and depth, the IRF, ab initio, failed to attract a critical mass of participants and transactions, with no trading at all thereafter. Since both the products belong to the same class of derivatives and offer similar hedging benefits, the reason for success of one and failure of the other can perhaps be traced to product design and market microstructure. Two reasons widely attributed for the tepid response to IRF are:
The use of a Zero Coupon Yield Curve (ZCYC) for determining the settlement and daily Mark-to-Market (MTM) price, as anecdotal feedback from market participants seemed to indicate, resulted in large errors between zero coupon yields and underlying bond yields leading to large basis risk between the IRF and the underlying. Put another way, it meant that the linear regression for the best fit resulted in statistically significant number of outliers.
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 in its early stages.
In late 2003, an attempt to improve the product design was made by SEBI in consultation with RBI and the Fixed Income Money Market and Derivative Association of India (FIMMDA). Accordingly, in January 2004, SEBI dispensed with the ZCYC and permitted introduction of IRF contracts based on a basket of GoI securities incorporating the following important features:
The IRF contract was to continue to be cash-settled.
The IRF contract on a 10-year coupon bearing notional bond was to be priced on the basis of the average ‘Yield to Maturity’ (YTM) of a basket comprising at least three most liquid bonds with maturity between 9 and 11 years.
The price of the futures contract was to be quoted and traded as 100 minus the YTM of the basket.
In the event that bonds comprising the basket become illiquid during the life of the contract, reconstitution of the basket shall be attempted, failing which the YTM of the basket shall be determined from the YTMs of the remaining bonds. In case 2 out of the 3 bonds comprising the basket become illiquid, polled yields shall be used.
However, the exchanges are yet to introduce the revised product.
Recommendation
Interest rate volatility in a liberalized financial regime affects all economic agents across the board – corporate, financial institutions and individuals, underscoring the need for adequate hedging instruments to facilitate sound economic decisions. In this background, OTC instruments such as swaps and FRAs were introduced in the Indian markets in 1999. While the OTC segment of interest rate derivatives are the preponderant segment world-wide, the desirability of exchange-traded products for wider reach with an almost zero counter party, credit & settlement risks, full transparency etc., are compelling reasons for its introduction as a complementary product. It is noted that the OTC products have had a successful reception in the Indian markets whereas the exchange traded ones - the IRF failed to take off. It is imperative that appropriate steps are now taken to restart the IRF market with a view to providing a wider repertoire of risk management tools and thereby enhance the efficiency and stability of the financial markets.
The report by RBI’s technical advisory committee comes at a time of increased volatility in debt markets, with yields swinging by 100 basis points in a month. The report follows the guidelines on currency futures released on 8 August 2008.
An interest rate future is a contract where the buyer agrees to purchase a debt instrument at a future date. If the committee recommendations are accepted, RBI may disallow banks from classifying all their statutory investment in government bonds under the held-to-maturity category.
To begin with, the RBI’s technical advisory committee has recommended that futures contracts should be based on the 10-year government bond. The contracts could later cover the two-, five- and 30-year government securities, depending on the market response and appetite. It also added that the contracts should be settled through physical delivery.
RBI may impose capital requirements on the lines of what it has introduced for banks participating in currency futures, where it has prescribed a minimum net worth of Rs 500 crore and a minimum capital-to-risk assets ratio of 10%.
The technical committee has proposed that the duration for short selling must be extended, in such a manner that the tenor of the short sale transaction coincides with the futures contract. The panel feels that at least in the initial stages, only banks and bond houses should be allowed to undertake short-selling for a longer duration, but on the condition that the transaction is delivery-based.
The panel is of the view that banks were allowed to shield their bond portfolios from accounting losses to ensure stability. Since the purpose of interest rate futures is to provide stability to debt investors, the provision allowing banks to freeze their bonds in a held-to-maturity portfolio should go, the report said. A deep and liquid interest rate futures market will provide banks with a mechanism for hedging interest rate risks inherent in the SLR portfolio, it added. On the accounting regime for interest futures, it said the central bank must use its powers to mandate uniform accounting treatment for swaps and futures.
Banks should also be allowed to contract interest rate futures for trading. This recommendation goes beyond the present rule, which limits them to take use futures only for hedging against interest rate risks inherent both on and off their balance sheets. At present, banks are allowed to hedge as well as take trading positions only in swaps and forward rate agreements.
The panel further suggested that interest rate futures should be exempt from securities transaction tax. It added that once interest rate futures pick up, RBI must look at introducing options too.
The panel said RBI should be involved in designing the general framework of interest rate futures, including issues relating to the product and the market players. The nitty-gritty of the contracts should left be left to the exchanges, the panel said.
Referring to the participation of foreign institutional investors (FIIs)/non-resident Indians (NRIs), it said FIIs may be allowed to take long positions in the interest rate futures market. This is subject to the condition that the gross long position in the cash market and the futures market does not exceed the maximum permissible cash market limit, which is currently $4.7 billion.
FIIs could also take short positions in interest rate futures, but only to hedge the actual exposure in the cash market up to the maximum limit permitted. The rules prescribed to foreign investors will also apply to NRIs, it clarified.
Impact on economy
On domestic front we have huge gap in lending and borrowing rates. RBI has hiked interest rate with regular intervals to control the inflation and money supply, which is, resulted upwards treans in interest rates. The difference between domestic and global interest rates is widening as a reply to RBI’s monetary action. On this background risk profile of financial institution is on toss and to control MTM loss they need hedging instrument. RBI has now permit IRF where financial institution can manage their risk effectively. The basic purpose that IRF serve is to provide a means for hedging interest rate exposures of economic agents.
Interest rate is one of the major indicators in economy which deliver the appropriate framework of liquidity condition prevail in the economy. On the background of current global and domestic economy specially with the reference of difference interest rates IRF will be the best hedging instrument to manage interest rate risk. As the apex bank of the country RBI have strong focus on inflation however to control the excess liquidity RBI has hiked interest rate. Hard interest rate have adverse impact on bank’s NIM and its profitability. However IRF will be the practical solution for the bankers to cover the high risk prevailing in current market economy.
Outlook
Indian equity markets have developed well, but the larger debt market has dwarfed for decades together. Financial inclusion, in a different way, making trading in debt and interest instruments accessible to wider investor base is the need of the hour. Interest rate futures will be just one of such instruments which can enhance research and depth in the Indian debt market. Obviously, RBI is vested with authority to determine the policy relating to interest rate products and give directions to all market participants.
No comments:
Post a Comment