Exchange Traded Interest Rate Futures

Exchange Traded Interest Rate Futures (Part 1)

Definition: Exchange Traded Interest Rate Futures are standardized interest rate derivative contracts traded on a recognized stock exchange to buy or sell a notional security or any other interest-bearing instrument or an index of such instruments or interest rates at a specified future date, at a price determined at the time of the contract.
Key Features:
- Contract between two parties through an Exchange
- Centralized trading platform
- Price discovery through free interaction of buyers and sellers
- Margins are payable by both parties
- Expiry date and quantity are decided today (standardized)
Interest Rate Futures (IRF): IRF are derivatives, and their value is derived from the value/price of a certain underlying asset, such as interest rate, interest-bearing instrument, or index of interest-bearing instruments.
Futures Terminologies:
- Underlying Asset: The asset from which the IRF derives its value
- Spot Price/Rate: The price/interest rate at which the underlying asset trades in the spot market
- Futures Price/Rate: The current price/rate of the specified futures contract
- Quantity Freeze: Limits the maximum number of derivatives contracts that can be traded in a single order
- Contract Cycle: The period over which a contract trades
- Expiry Date: The day on which trading ceases in the contract
- Tick Size: The minimum move allowed in price/rate quotations
- Contract Size/Lot Size: The minimum amount of asset that has to be delivered for a single contract
- Contract Value: Calculated by multiplying the price/rate with the contract multiplier or lot size
- Base Price: Acts as a reference price for trading at the start of the day
- Price Band: The price range within which a contract can be traded for the day
- Mark to Market (MTM): The process of marking positions in futures contracts to the daily settlement price
- Daily Settlement Price (DSP): The weighted average futures price of trades, used for MTM settlement
- Final Settlement Price (FSP): The price at which all open positions are marked to on the last trading day
- Open Interest: The total number of contracts outstanding for an underlying asset
Positions in Derivatives Market:
- Long Position: An outstanding buy position in a contract
- Short Position: An outstanding sell position in a contract
- Open Position: An outstanding long or short position in various derivative contracts
- Opening a Position: Buying or selling a contract to increase a client's open position
- Closing a Position: Buying or selling a contract to reduce a client's open position
- Rollover of Position: Carrying forward a position to the next contract cycle

Exchange Traded Interest Rate Futures (Part 2)

Rollover: A process of transferring an existing position in a futures contract to the next expiry cycle, which involves closing the current month's contract and simultaneously opening a new position in the next month's contract.
Key Points of Futures:
- All open future positions are subject to Mark-to-Market (MTM).
- Future positions can be offset by taking an opposite position (Square off).
- Participants can choose to rollover the future contract if they wish to continue with the position.
- Traders need to track positions regularly.
- Traders are solely responsible for maintaining margins.
- Future trade is a ZERO sum equation, i.e., the profit of a trader is exactly equal to the loss of the opposite trader.
- Futures trade offers unlimited profit and unlimited losses.

Payoff Charts for Futures Contract

Payoff: The profit/loss that would accrue to a market participant with a change in the price of the underlying asset at expiry.
Payoff Diagram: A graphical representation showing the price of the underlying asset on the X-axis and profits/losses on the Y-axis.
Payoff for Buyer of Futures (Long Futures): The buyer makes a profit when the price of the underlying asset rises, and a loss when the price falls.
Payoff for Seller of Futures (Short Futures): The seller makes a profit when the price of the underlying asset falls, and a loss when the price rises.

Contract Specification of Exchange Traded Interest Rate Futures

Cash Settled Interest Rate Futures (IRF): Available on 6-year, 10-year, and 13-year Government of India (GOI) Security.
Underlying: A single GOI Dated Security with a residual maturity of 4-8 years, 8-11 years, or 11-15 years.
Unit of Trading: 1 Lot = 2000 bonds (notional value of Rs. 2 lakhs).
Quotation: Price-based (clean price) for a face value of Rs. 100.
Contract Value: Trade price * 2000.
Tick Size: Rs. 0.0025.
Base Price: Theoretical future price on the first day of the contract, and the daily settlement price on subsequent days.
Price Band: +/- 3% of the base price (can be expanded by 0.5% in a specific direction after 30 minutes).
Trading Hours: Monday to Friday, 9:00 a.m. to 5:00 p.m.
Trading Cycle: Three serial monthly contracts followed by three quarter-ended contracts (Mar, Jun, Sep, and Dec).
Expiry Day: The last Thursday of the month (or the previous trading day if the last Thursday is a holiday).
Mode of Settlement: Cash settlement.
Final Settlement Price: The weighted average price of the underlying bond during the last two hours of trading on the NDS-OM platform.
Daily Settlement Price: The volume-weighted average futures price of the last half hour across exchanges or the theoretical future price.
91 Day T-Bills Futures:
- Underlying: 91-day Government of India (GOI) Treasury Bill.
- Unit of Trading: One contract denotes 2000 units (face value Rs. 2 lakhs).
- Quotation: 100 minus futures discount yield (y).
- Contract Value: 2000 * (100 - 0.25 * y).
- Tick Size: Rs. 0.0025.
- Price Band: +/- 1% of the base price.
- Trading Hours: Monday to Friday, 9:00 a.m. to 5:00 p.m.
- Trading Cycle: Three serial monthly contracts and three quarter-ended contracts (Mar, Jun, Sep, and Dec).
- Expiry Day: The last Wednesday of the expiry month at 1:00 p.m. (or the previous trading day if the last Wednesday is a holiday).

Exchange Traded Interest Rate Futures (Part 3)

Definition: Exchange Traded Interest Rate Futures are financial derivatives that allow investors to hedge against interest rate risk or speculate on future interest rate movements.
Details: These contracts are traded on exchanges and are settled in cash, with the underlying asset being a notional bond or a basket of bonds.

Key Concepts

Daily Settlement: The daily settlement price is calculated using the volume-weighted average rate of trades in the last 30 minutes of trading, subject to a minimum of 5 trades. If less than 5 trades are executed, a theoretical rate is used.
Final Settlement: The final settlement price is based on the average settlement yield of the underlying bonds, which is calculated using the yields of the bonds in the basket.
Contract Specifications: Different interest rate futures contracts have varying specifications, including underlying assets, unit of trading, quotation, tick size, trading hours, and expiry days.

Interest Rate Futures Contracts

Overnight MIBOR Futures: These contracts have the daily FBIL Overnight MIBOR as the underlying, with a unit of trading based on the interest on a notional principal of Rs. 5 crores for one month.
10-Year Notional Coupon-Bearing Government of India Security Futures: These contracts have a 10-year notional coupon-bearing GOI security as the underlying, with a unit of trading of Rs. 2 lakhs.
Cash Settled Corporate Bond Index Futures: These contracts have a corporate bond index as the underlying, with a contract value of at least Rs. 2 lakhs and a tenure of up to 3 years.

Contract Specifications for Different Interest Rate Futures

2-Year and 5-Year Notional Coupon-Bearing Government of India Security Futures: These contracts have a unit of trading of Rs. 2 lakhs, with a quotation similar to the quoted price of GOI securities.
10-Year Notional Coupon-Bearing Government of India Security Futures (Cash Settlement): These contracts have a unit of trading of Rs. 2 lakhs, with a quotation similar to the quoted price of GOI securities.
Interest Rate Futures based on Corporate Bond Index: These contracts have a contract value of at least Rs. 2 lakhs, with a tenure of up to 3 years and a trading cycle of weekly, three serial monthly contracts, or one quarterly contract.

Settlement Mechanism

Daily Settlement: The daily settlement price is calculated using the volume-weighted average rate of trades in the last 30 minutes of trading.
Final Settlement: The final settlement price is based on the average settlement yield of the underlying bonds.
Settlement Day: The settlement day is the next working day after the expiry day.

Exchange Traded Interest Rate Futures (Part 4)

Definition: Exchange Traded Interest Rate Futures are financial derivatives that allow investors to hedge against interest rate risk.
Details: They are traded on a recognized stock exchange and are standardized contracts to buy or sell a notional security or interest-bearing instrument at a specified future date.

Key Concepts

Cash Settled GOI Bond Futures:
- Contract Size: Rs 200,000 of face value of GOI securities, equivalent to 2000 units.
- Tick Size: Rs. 0.0025, same as the underlying market.
- Contract Value: Calculated as Face Value × (Market Price / 100).
91 Day T-Bills Futures:
- Contract Size: 2000 units (Face Value Rs.2 lacs).
- Price Quotation: 100 minus futures discount yield (y).
- Contract Value: 2000 * (100 - 0.25 * y).
- Tick Size: Rs. 0.0025.
Overnight MIBOR Futures:
- Contract Size: Notional principal of Rs. 5 crores for one month.
- Price Quotation: Interest rate.
- Contract Value: Quoted Rate * 100 * 411.
- Tick Size: 0.0025 (0.25 basis point).

Rationale for Introducing Exchange Traded Interest Rate Derivatives

Interest Rate Risk: Affects financial, corporate, and household sectors.
Need for Hedging Mechanism: Entities need a credible institutional hedging mechanism to manage interest rate risk.
Introduction of IRF: Aims to provide a wider repertoire of risk management tools and enhance financial market efficiency and stability.

Advantages and Limitations of Future Contracts

Comparison to FRA: Futures contracts have advantages over Forward Rate Agreements (FRAs), including elimination of counterparty risk, more liquidity, and price transparency.
Key Differences:
- Operational Mechanism: FRAs are mainly bilateral OTC transactions, while futures contracts are traded on a centralized trading platform.
- Terms of Contracts: FRAs are non-standardized and customized, while futures contracts are standardized.
- Underlying: FRAs usually involve interest rates, while futures contracts can involve interest rates, instruments, or indices.
- Price Discovery: FRAs involve negotiation, while futures contracts involve free interaction of buyers and sellers on a trading platform.
- Liquidation Profile: FRAs have low liquidity, while futures contracts have high liquidity due to standardization.
- Settlement: FRAs involve bilateral settlement, while futures contracts involve clearing and settlement through a clearing corporation.
- Advantages of Futures: Price transparency, elimination of counterparty credit risk, and access to all types of market participants.

Exchange Traded Interest Rate Futures (Part 5)

Participants:
- Credit Agnostic: Participants are not concerned about the creditworthiness of the counterparty.
- Lower Liquidity Risk: Compared to Over-the-Counter (OTC) markets, exchange-traded interest rate futures have lower liquidity risk.
- Generally Lower Impact Cost: The cost of executing a trade is generally lower in exchange-traded markets.
Limitations:
- Liquidity Risk: There is still a risk that buyers and sellers may not be available at all times.
- Counterparty Risk: The risk that the counterparty may default on their obligations.
- Not Accessible for All Market Participants: Some market participants may not have access to exchange-traded interest rate futures.
- Operational Issues: Mark-to-market settlement and margin requirements can create operational issues.

Interest Rate Futures Price Computation

Forward Rate: The interest rate applicable to a financial transaction that will take place in the future.
- Definition: A forward rate can be determined using spot rates.
- Example: An investor wants to invest INR 1000 for two years and has two options: directly invest in a 2-year bond or invest in a one-year bond and reinvest the proceeds after one year.
Financing Cost/Cost of Carry: The relationship between futures prices and spot prices, measuring the interest paid to "finance" or "carry" the asset till expiry date.
Income on Cash Position: The income accrued on a daily basis, including coupon payments and interest on coupon payments.
Basis: The difference between spot price and future price.
- Negative Basis: Futures price is higher than spot price, often observed in markets experiencing contango.
- Positive Basis: Futures price is lower than spot price, often observed in markets in backwardation.

Computation of Price for Bond Futures

Formula: Future bond price = Cash Price + financing cost – income on cash position.
Example: Calculating the theoretical future dirty price and clean price of a bond future.
Assumptions: The model assumes an underlying asset is available in abundance, holding and maintaining the asset is easy, the asset can be sold short, no transaction costs, no taxes, and no margin requirements.

Expectancy Model of Futures Pricing

Definition: The expectancy model argues that futures price is the expected spot price of an asset in the future.
Characteristics:
- Futures can trade at a premium or discount to the spot price.
- Futures prices indicate the expected direction of movement of the spot price.

Price Discovery and Convergence of Cash and Futures Prices

Definition: Futures prices indicate the expected spot price of the underlying asset at the maturity of the futures contract.
Convergence: Both futures and spot prices converge at the maturity of the futures contract.

Computation of Price for 91-Day T-Bills Futures

Forward Rate Concept: Used to arrive at the price of IRF contracts, such as 91-day T-Bills futures.
Example: Calculating the 91-day yield/rate on the expiry date using the latest available treasury bills yield curve.

Exchange Traded Interest Rate Futures (Part 6)

Last Trading Day for Cash Settled 10-year Bond Futures: The correct answer is b. Two business days before the last business day of the Expiry Month.
Total Number of Derivatives Contracts Outstanding: The correct term is Open Interest, which refers to the total number of outstanding contracts in a particular futures or options contract.
Futures Contract Profit/Loss:
- If a person goes short in a futures contract at Rs.100 and on expiry the underlying price is Rs.101, they will make a loss of Rs. 1.
- This is because they sold the contract at a lower price (Rs.100) and had to buy it back at a higher price (Rs.101) to close the position.
Contract Value for Bond Futures:
- If a participant buys 10 lots of single bond futures at Rs. 99, the contract value can be calculated as follows:
  - Assuming the face value of each bond is Rs. 2,00,000 (standard for many bond futures contracts), the contract value would be Rs. 19,90,000 (10 lots * Rs. 2,00,000 * 99/100).
  - However, based on the provided options, the closest match would be Rs. 19,99,000, considering potential rounding or specific contract details not fully outlined in the question.