Strategies using Interest Rate Derivatives

Strategies using Interest Rate Derivatives (Part 1)

• Market Participants: The ETIRD market has three types of participants:
  • Hedgers: Traders who wish to protect themselves from the risk involved in price movements of underlying interest rates or interest rate instruments.
  • Speculators: Participants who assume interest rate risk by taking a view on the market direction and hope to make returns by taking the price risk.
  • Arbitragers: Participants who continuously hunt for profit opportunities across markets and products, seizing them by executing trades in different markets and products simultaneously.
• Hedging, Speculative and Arbitrage Transactions:
  • Hedging: Hedgers use ETIRD to remove interest rate risk, often depending on speculators to take the other side of their trades.
  • Speculative Transactions: Speculators assume price risk that hedgers attempt to lay off in the markets, adding depth and liquidity to the markets.
  • Arbitrage Transactions: Arbitragers identify mispricing in the market and use it for making profit by executing trades in different markets and products simultaneously.
• Hedging through Exchange Traded Interest Rate Derivatives:
  • Instrument: Depends on the tenor of interest rate being traded (e.g., T-Bill or GOI Bond futures/options).
  • Market Side: Depends on the expectation of the direction of rate change (e.g., sell futures contract/buy put option if expecting rates to rise).
  • Contract Month: Depends on the timing of expected rate change (e.g., choose a contract that expires in one month if expecting rate change to occur in one month).
• Key Considerations:
  • Interest Rate Risk: Exists in interest-bearing assets, such as loans or bonds, due to the possibility of a change in the asset's value resulting from the variability of interest rates.
  • Bond Prices and Interest Rates: Inversely related, meaning that when interest rates rise, bond prices fall, and vice versa.
  • Hedging with Futures: Can be implemented by undertaking a futures position as a temporary substitute for transactions to be made in the spot market at a later date.

Strategies using Interest Rate Derivatives (Part 2)

• Hedging: A risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
• Interest Rate Derivatives: Financial instruments used to manage interest rate risk, such as interest rate futures and options.

Short Hedge

• Definition: A short hedge is used to protect against a decline in the cash price of a fixed income security by selling futures contracts.
• Example: An investor holds a bond and sells a futures contract to hedge against a potential decline in the bond's price.
• Key Points:
  • The investor is long on debt securities and short on interest rate.
  • The investor is exposed to the risk of increasing interest rates.
  • To hedge the position, the investor sells bond futures.

Portfolio Based Hedging

• Definition: A hedging strategy that uses interest rate futures to hedge a portfolio of bonds.
• Key Points:
  • The hedge ratio is constructed based on the duration of the portfolio and the futures contract.
  • The maximum extent of short position that may be taken in IRFs to hedge interest rate risk of the portfolio is calculated using a formula.
  • The formula takes into account the portfolio modified duration, market value of the portfolio, futures modified duration, and futures price.

Hedging Future Borrowing

• Definition: A hedging strategy used to protect against a potential increase in interest rates when borrowing in the future.
• Example: A corporate wants to issue NCDs in the future and sells IRF contracts to hedge against a potential rise in interest rates.
• Key Points:
  • The corporate sells IRF contracts to lock in the borrowing cost at a lower rate.
  • The corporate gains from the IRF contract if the interest rate rises, which reduces the borrowing cost.

Long Hedge

• Definition: A long hedge is used to protect against a potential increase in the price of a fixed income security by buying futures contracts.
• Example: An insurance company expects to receive policy premiums in the future and buys a futures contract to hedge against a potential fall in interest rates.
• Key Points:
  • The insurance company buys a futures contract to lock in the purchase price/yield.
  • The insurance company gains from the futures contract if the interest rate falls, which increases the price of the bond.

Option Trading Strategies

• Definition: Using options to hedge a position or speculate on price movements.
• Key Points:
  • Options provide the contract buyer the right, but not the obligation, to buy or sell an asset at a fixed price.
  • The maximum risk to the buyer of an option is limited to the premium paid.
  • Options can be used to hedge a position, such as buying a call option to hedge against a potential increase in price.

Strategies using Interest Rate Derivatives (Part 3)

The limiting factor for strategies is the thought of the trader/strategy designer. As long as the trader can think of innovative combinations of various options, newer strategies will keep coming to the market. Exotic products (or ‘exotics’) are nothing but a combination of different derivative products.

• Definition: Exotic products are customized derivative products that are tailored to meet specific investment objectives or risk management needs.
• Details: They can be used to hedge against complex risks or to speculate on specific market outcomes.

Option Spreads

Option spreads involve combining options on the same underlying and of the same type (call/put) but with different strikes and maturities. These are limited profit and limited loss positions. They are primarily categorized into three sections:

• Vertical Spreads: Created by using options having the same expiry but different strike prices.
• Horizontal Spreads: Created by using options having the same strike price but different expiry dates.
• Diagonal Spreads: Created by using options having different strike prices and expiry dates.

Vertical Spreads

Vertical spreads can be further classified as:

• Bullish Vertical Spread: Created when the underlying view on the market is positive.
  • Using Calls: Involves buying a call option with a lower strike price and selling a call option with a higher strike price.
  • Using Puts: Involves buying a put option with a higher strike price and selling a put option with a lower strike price.
• Bearish Vertical Spread: Created when the underlying view on the market is negative.
  • Using Calls: Involves selling a call option with a lower strike price and buying a call option with a higher strike price.
  • Using Puts: Involves buying a put option with a lower strike price and selling a put option with a higher strike price.

Examples of Vertical Spreads

• Bullish Vertical Spread using Calls: Involves buying a call option with a lower strike price and selling a call option with a higher strike price.
• Bullish Vertical Spread using Puts: Involves buying a put option with a higher strike price and selling a put option with a lower strike price.
• Bearish Vertical Spread using Calls: Involves selling a call option with a lower strike price and buying a call option with a higher strike price.
• Bearish Vertical Spread using Puts: Involves buying a put option with a lower strike price and selling a put option with a higher strike price.

Key Characteristics of Vertical Spreads

• Limited Profit: The maximum profit is limited to the difference between the strike prices of the two options.
• Limited Loss: The maximum loss is limited to the premium paid for the option.
• Break-Even Point (BEP): The price at which the trade becomes profitable.

Strategies using Interest Rate Derivatives (Part 4)

• Introduction to Interest Rate Derivatives: The section discusses various strategies using interest rate derivatives, including limited profit and limited loss positions, and unlimited profit and limited loss positions.
• Key Concepts:
  • Horizontal Spread: Involves same strike, same type but different expiry options, also known as time spread or calendar spread.
  • Diagonal Spread: Involves combination of options having same underlying but different expiries as well as different strikes.
  • Straddle: Involves two options of same strike prices and same maturity, including long straddle and short straddle.
  • Strangle: Similar to straddle but with different strike prices, including long strangle and short strangle.

Key Strategies

• Long Straddle:
  • Definition: A strategy involving buying a call and a put option of same strike and same expiry.
  • Characteristics: Limited loss and unlimited profit strategy, with two break-even points.
  • Example: Buying a call and a put option with a strike price of 99, with premiums of 0.3 and 0.2 respectively.
• Short Straddle:
  • Definition: A strategy involving selling a call and a put option of same strike and same expiry.
  • Characteristics: Limited profit and unlimited loss strategy, with two break-even points.
  • Example: Selling a call and a put option with a strike price of 99, with premiums of 0.3 and 0.2 respectively.
• Long Strangle:
  • Definition: A strategy involving buying a call and a put option with different strike prices.
  • Characteristics: Limited loss and unlimited profit strategy, with two break-even points.
  • Example: Buying a call option with a strike price of 99.25 and a put option with a strike price of 98.75, with premiums of 0.2 and 0.15 respectively.

Important Terms

• Break-Even Point (BEP): The point at which the profit or loss of a strategy is zero.
• Premium: The price of an option contract.
• Strike Price: The price at which an option can be exercised.
• Expiry: The date on which an option contract expires.

Strategies using Interest Rate Derivatives (Part 5)

• Long Strangle: A strategy that involves buying a call option and a put option with different strike prices, but with the same expiration date. This strategy is used when the investor expects a large movement in the price of the underlying asset, but is unsure of the direction.
• Short Strangle: A strategy that involves selling a call option and a put option with different strike prices, but with the same expiration date. This strategy is used when the investor expects a small movement in the price of the underlying asset.
• Covered Call: A strategy that involves selling a call option on an underlying asset that the investor already owns. This strategy is used to generate extra income from existing holdings in bonds.
• Protective Put: A strategy that involves buying a put option on an underlying asset that the investor already owns. This strategy is used to hedge against potential losses in the value of the underlying asset.

Key points to consider:

• Strike Price: The price at which the option can be exercised.
• Premium: The price of the option contract.
• Expiration Date: The date on which the option contract expires.
• Underlying Asset: The asset on which the option contract is based.
• BEPs (Break-Even Points): The points at which the investor will break even on their investment.

Long Strangle:

• Maximum profit: Unlimited in both directions (up or down)
• Maximum loss: Limited to Rs. 0.35, which would occur if the underlying expires at any price between 98.75 and 99.25
• BEPs: 98.40 and 99.60

Short Strangle:

• Maximum loss: Unlimited in both directions (up or down)
• Maximum profit: Limited to Rs. 0.35, which would occur if the underlying expires at any price between 98.75 and 99.25
• BEPs: 98.40 and 99.60

Covered Call:

• Used to generate extra income from existing holdings in bonds
• Involves selling a call option on the underlying bond
• Maximum profit: Limited to the premium received from selling the call option
• Maximum loss: Limited to the difference between the strike price and the current market price of the bond

Protective Put:

• Used to hedge against potential losses in the value of the underlying asset
• Involves buying a put option on the underlying asset
• Maximum profit: Unlimited in the upward direction
• Maximum loss: Limited to the premium paid for the put option

Strategies using Interest Rate Derivatives (Part 6)

• Butterfly Spread: A neutral strategy that combines bull and bear spreads, with fixed risk and capped profits and losses. It involves buying and selling options with different strike prices.
• Long Call Butterfly: A strategy that involves buying one In-The-Money (ITM) Call, selling two At-The-Money (ATM) Calls, and buying one Out-The-Money (OTM) Call. The strike prices of all options should be at equal distance from the current price.
• Key Characteristics:
  • Risk: Limited to net premium paid
  • Profit: Limited to difference between adjacent strikes minus net premium debit
  • Volatility: Suitable for low volatility environments

Use of Interest Rate Derivatives for Speculative Transactions

• View Based Trading: Speculators take a view on the market with an objective to profit from it.
• Long Position in Bond: A trader buys a bond or takes a long position in bond futures, expecting interest rates to decrease and bond prices to increase.
• Short Position in Bond: A trader sells a bond or takes a short position in bond futures, expecting interest rates to increase and bond prices to decrease.
• Changing the Duration of the Portfolio: Fund managers adjust the duration of their portfolio to capitalize on their expectations of interest rate movements.

Use of Interest Rate Derivatives by Arbitragers

• Regular Arbitrage: Arbitrageurs buy a bond in the underlying market and sell futures of the same bond, capturing mispricing in the market.
• Reverse Arbitrage: Arbitrageurs sell a bond in the underlying market, lend money in the repo market, and buy futures of the same bond, capturing mispricing in the market.
• Key Characteristics:
  • Risk: Limited to the difference between the underlying price and the futures price
  • Profit: Captured by exploiting mispricing in the market
  • Volatility: Suitable for environments with mispricing opportunities

Strategies using Interest Rate Derivatives (Part 7)

• Cash Outflow: In both cases of increase or decrease in bond prices, there is a positive net pay-off, which remains the same.
• Frictions in the Market: One needs to consider frictions like brokerage, taxes, administrative costs, and funding costs.

Creating Synthetic Securities for Yield Enhancement

• Synthetic Security Creation: A cash security can be created synthetically by using a position of futures contract together with underlying bonds.
• Yield on Synthetic Security: The yield on the synthetic security should be the same as the yield on the cash market security.
• Example: An investor can take a long position in a 15-yr GOI bond in the underlying market and short three-month futures of the same bond, effectively shortening the maturity of the bond to three months.

Risks in Arbitrage

• Execution Risk: There is a possibility of a gap between the executions of both orders, leading to naked exposure of a position.
• Liquidity Risk: If either leg of the transaction is illiquid, the risk on the arbitrage deal is huge.
• Settlement Risk: Based on settlement type (cash/physical delivery), it may need reversal of trades in the respective markets, resulting in additional risk on unwinding position.
• Regulatory Risk: Regulation may not permit certain kinds of transactions, such as short selling of bonds in the underlying market.

Trading Spreads using ETIRD

• Spread Definition: Spread refers to the difference in prices of two futures/option contracts.
• Calendar Spread: A calendar spread is a contract where a trader buys/sells a particular month contract and sells/buys the same contract of a different month.
• Inter-Bond Spread: An inter-bond pair spread is a long-short position in futures on different underlying GOI bonds with the same expiry date.

Limitation of Interest Rate Derivatives for Hedgers

• Imperfect Hedging: Exchange-traded interest rate derivatives contracts are standard contracts that may lead to imperfect hedging and basis risk for hedgers.
• Maturity Mismatch: There may be a mismatch in the maturity of the exposure to be hedged and the ETIRD contract.
• Limited Availability: ETIRD are not available on all kinds of fixed income instruments and all maturity tenors.
• Correlation Risk: The movement in the underlying instrument of ETIRD and the portfolio of the participant may not be identical, leading to imperfect hedging.