The Hindu Business Line : Why no future for interest rate futures

THE National Stock Exchange (NSE) recently made a presentation on how market players can use interest rate futures for hedging. This gives us an opportunity to debate on why there is no trading in these contracts on the NSE now. The reason cited is that the interest rate futures are mispriced, being priced off a theoretical spot curve.

The problem could, however, be much more than that. For one, the availability of few products in that market may actually translate into a costly trade-off between interest rate risk and basis risk. For another, there may be no counter-party for hedgers because of the largely unidirectional view on interest rates.

Spot curve: At present, interest rate futures are priced off the spot yield curve. Since the spot curve is theoretical, the argument is that the futures price is way off the actual spot price of a bond. True, but this factor can be overcome by applying error corrections methods on the spot yield curve model. To cite model error as the primary reason for a dormant interest rate futures market appears tenuous; for on the same logic, equity derivatives market should also be dormant. Perhaps, the problem in the interest rate futures market lies beyond model error.

Hedging: At present, there are three products in the market — the notional 91-day T-bill, the notional 10-year zero, and the notional 6 per cent 10-year bond. These products do not fulfil the spectrum of hedgers' needs.

Take a portfolio manager who wants to hedge her bond portfolio that has an average duration of 6. Hedging with a 10-year zero or the 10-year coupon bond will not serve the objective because the duration of the portfolio is lower than the duration of the futures contract. This means that the sensitivity of the futures contract to interest rate changes is higher than that of the underlying portfolio.

The difference in sensitivities will expose the hedged portfolio to large basis risk; this is the risk of the change in basis during the hedging horizon. This occurs primarily due to the difference in maturity of the notional instrument underlying futures contract, and the maturity of the portfolio that is being hedged. The portfolio manager may, hence, be merely substituting the interest rate risk of the portfolio with basis risk. There is, therefore, no incentive for using interest rate futures as a hedge.

This situation can be remedied by introducing more futures contract across the spot curve. That will provide hedgers more opportunities to horizon-match their portfolio with that of the futures contract, thus, lowering the basis risk; note that the basis risk may not be zero even then because a perfect hedge is rarely possible.

Of course, the NSE has to be judicious in introducing more futures contract because liquidity typically declines when more contracts are available.

Interest rate view: The market currently suffers from a unidirectional view — all market players expect the interest rate to be soft. So where then is the need for hedging? Unless the market carries different views on interest rate, there may not be active bid-ask in the futures market. Perhaps, the demand for interest rate futures will improve once the market perceives that interest rates have bottomed out; for then, two opposing factors may act on the yield curve.

On the positive side may be a perception that the high level of liquidity in the banking system will drive down bond yields. And on the flip side, the belief that RBI's need to control inflation will lead to higher yields. The opposing forces may lend volatility to the yield curve. And that may trigger demand for interest rate futures.

It will also help if the RBI permits banks to trade in the futures market. At present, banks are allowed to use interest rate futures for hedging, while primary dealers (PDs) can take position on either side of the market.

If all participants are allowed to take unrestricted bid-ask positions, higher demand-supply conditions may generate liquidity in the futures market. To sum up then, higher basis risk and unidirectional view on interest rates appear more overwhelming reasons for the dormant interest rate futures market.

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