IRF platform: A slew of benefits on hedging front

The recently introduced cash settled interest rate futures on stock exchanges will help market participants to hedge their exposures (lending or borrowing).

Banks, primary dealers, FIIs, mutual funds, insurers, corporates, NBFCs, individuals and brokers can buy and sell IRFs.

It will also enable them to take directional calls (bets) and benefit from movement in interest rates, exploit price discrepancy between the price of the bond and its respective bond futures contract (arbitrage) and also benefit from simultaneously buying the same instrument for one tenor and selling it for another tenor (calendar spread).

For instance, investors in Government securities such as bank treasury are lenders. As interest rates rise, bond prices go down and this causes a fall in the bank’s portfolio as bond prices and interest rates are inversely related to each other. That is, price decreases as interest rate (yield) increases and vice versa. To tackle this, the bank treasury can sell IRFs and any loss in the bond portfolio may be set off to a great extent against the profit made from selling the interest rate futures contract. This is called hedging.

Directional calls can also be taken by taking a view on the direction in which interest rates are headed. If the trader strongly expects interest rates to go up (this would mean bond prices would go down given the inverse relationship), he would sell bond futures; and in case the view is vice versa, he would go long on the bond futures. This is known as directional trading.

Riskless profit can also be made due to mis-pricing between the bond price and the bond futures price. Under normal circumstances the price of bond futures should equal the bond price plus cost of carry. If the bond futures price is greater than bond price plus cost of carry, the trader would borrow money and buy the underlying bond and sell the bond futures to make a profit. This is called arbitrage.

Traders can also benefit from an increase in the difference of futures prices of the same contract for consecutive months. If the trader feels that the difference would increase in the next few days, he can buy the near month contract while simultaneously selling the next month contract. After a few days when the gap in prices of the near and next month contracts has widened he can liquidate his position by selling the near month and buying the next month contract thereby booking a riskless profit. This is termed a calendar spread.