Why new interest rate futures contracts will be a hit among investors

The 2014 version of the IRF contract promises to succeed while the 2003 and 2009 versions failed. The contract introduced on 20 January 2014 on the MCX-SX exchange clocked volumes of Rs 930 crore. This is more than the aggregate volume this instrument has witnessed over the last 10 years.

The IRF 2014 version opened on the NSE on 21 January and is clocking volumes of over Rs 400 crore in about initial two hours of trading. The IRF will open on the BSE on 28 January. Volumes are likely to shoot up as the IRF trades on all exchanges.

The reason that the 2014 version of the IRF is doing well on the exchanges while the previous two versions failed is the simplicity of the contract. The contract is cash settled and is based on the benchmark ten-year government bond, which is the highest traded security in the fixed income markets. On good days the ten year bond, which is currently the 8.83% 2023 maturity government bond, trading volumes are around Rs 15,000 crore to Rs 20,000 crore.

The 2014 IRF contract is easy to understand as it tracks the well traded ten-year government bond, easy to trade and settle and has a host of uses. Mutual funds can hedge and rebalance portfolios, banks and primary dealers can take leveraged positions and hedge interest rate risk, speculators can carry out day trading and spread trading, corporates can hedge their borrowings and insurance companies can hedge interest rate risk. Individuals can hedge their investments in tax-free bonds and mutual funds using the IRF. FIIs can go long on interest rates or hedge their long positions through IRF.

The previous two versions of the IRF, while more tuned to bond markets with the first one tracking a zero coupon yield curve and the second one adopting a classical cheapest to deliver approach, did not find favour even with institutional participants due to the nature of the Indian government bond market. The government bond market tends to trade only a few securities that hamper the development of a vibrant yield curve and the lack of a good term repo market hampers short selling or borrowing of securities.

The features of the new IRF contract are as follows:

Underlying: 8.83% 2023 GOI / 7.16% 2023 GOI

Coupon: 8.83% / 7.16%

Unit of Trading : One IRF Contract = 2000 underlying bonds of total face value of Rs 200,000

Trading Cycle : One Month, Two Month and Three Month

Theoretical futures price = cash price + financing cost-income on cash position, where cash price of the underlying = Clean price + Accrued interest; financing cost is financing cost for the period on cash price and income on cash position is accrued interest expected to be received on expiry + Coupon payment + Interest on coupon payment.

Example of IRF pricing of 30 January 2014 contract:

8.83% 2023 GOI issued 25 November 2013

Market price of 8.83% 2023 bond (20 January 2014) = Rs 102.04

Accrued Interest for 56 days = Rs 1.3736

Dirty Price = Rs 102.04 + Rs 1.3736 = Rs 103.4136

Dirty price of bond plus financing cost minus accrued interest

Dirty price = Rs 103.4136

Futures expiry date - 30 January 2014

Financing Cost 10 days@ 8.43% (28 day term repo rate) - Rs 0.0024

Accrued interest on cash bond on expiry @8.83% - Rs 1.5943

Theoretical futures price - Rs 103.4136 + Rs 0.0024 - Rs 1.5943 = Rs 101.82

Theoretical Futures Yield - 8.55%

Arjun Parthasarathy is founder Investors are Idiots.com and INRBONDS.com. Follow him on twitter @arjunparthasara