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Interest rate futures a big step forward

Interest rate futures a big step forward
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First Published: Wed, Aug 26 2009. 11 59 PM IST

Updated: Wed, Aug 26 2009. 11 59 PM IST
A significant lacuna in India’s financial markets will get fixed with the launch of interest rate futures by the National Stock Exchange next Monday.
Interest rate derivatives account for over 70% of total outstanding positions in the derivatives space on a worldwide basis, according to Bank for International Settlements (BIS) statistics. In the exchange-traded space, interest rate derivatives account for about 88% of the total turnover in value terms, again according to BIS. In the January-March 2009 quarter, turnover of exchange-traded interest rate derivatives stood at $324 trillion (Rs15,811 trillion), of the total derivatives turnover of $367 trillion.
India has missed much of the action in this space owing to weak development of the interest rate derivatives products. According to an expert in financial market infrastructure, Indian market participants are using offshore markets to hedge interest rate exposure. While the interest rate futures contract proposed by the joint committee of the Securities and Exchange Board of India (Sebi) and the Reserve Bank of India (RBI) isn’t perfect in design, experts feel that the new contract will garner decent volumes.
To start with, there’s a large need to hedge interest rate risk. Corporate borrowings, for instance, are linked to the prime lending rate of a bank, which can fluctuate. Interest rate futures can be used to fix the interest outgo over a period of time. Such companies—indeed anyone with a view that interest rates may harden—need to go short on interest rate futures.
The futures contract is essentially a notional bond, and its price will fall if interest rates head north, resulting in a profit for the seller.
Besides, with interest rate derivatives being launched on an exchange platform, securities firms, which were till now kept out of interest rate derivatives products, will be able to participate. This should enhance volumes, as they can be expected to supplement the volumes provided by banks and other institutional investors. As economist Ajay Shah points out in his blog, securities firms are the dynamic part of Indian finance. The success of the currency futures product, which now averages volumes of nearly $2 billion each day in less than a year of its launch, also indicates that the interest rate product should do well.
Having said that, Sebi and RBI would do well to be proactive in changing some of the specifications of the contract depending on the response of the market. One concern market participants have expressed is the wide range of government bonds that qualify for delivery. The fear is that buyers with outstanding positions on the expiry date could end up with illiquid bonds.
This needs to be addressed, and quickly, if there are signs that trading isn’t picking up in the initial phase and if pricing is getting affected materially.
Some experts say along with the contract based on a 10-year bond, there should also have been a short-term contract and an overnight contract.
Shah writes in his blog, “In India, the bond market is in such bad shape, that there is really only one rate. There isn’t much of a yield curve to speak of, there is no yield curve arbitrage, etc. Given the stunted Indian bond market, all that happens really is parallel shifts of the yield curve. It would be possible to trade these using interest rate futures. This will be a big step forward.”
Write to us at marktomarket@livemint.com
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First Published: Wed, Aug 26 2009. 11 59 PM IST
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