Hedging interest risk

The Reserve Bank of India (RBI) has done well to propose the launch of 10-year exchange-traded interest rate futures (IRF) contracts that can be settled in cash. Investors in debt securities — including banks, mutual funds, insurance companies, foreign institutional investors and individuals — have no effective instrument to hedge against interest rate risk. The downside of this was apparent over the last few months when the Indian market for government and corporate bonds went through one of its most volatile phases due to the sudden exodus of FIIs from debt assets. The plan on introducing the new product for trading in exchanges before the year-end is, therefore, timely as well.

Indian exchanges currently do offer IRF contracts — one on a 10-year government security and another on a 91-day treasury bill. But there is no trading in these. One reason is that they are not against underlying securities actually issued and traded. The 10-year sovereign paper against which IRF contracts are now tradable have a fixed notional 7 per cent coupon rate. Investors have no way, then, to hedge against holdings of real 10-year bonds floated on different dates with varying coupons. Secondly, all contracts are required to be physically settled. Since the seller has the option of choosing from a basket of 10-year securities to make the delivery, the buyer would often find himself at a disadvantage. Physical settlement also limits the universe of investors, many of whom are interested only in squaring positions through cash settlement. Poor product design apart, trading in IRFs has not taken off because of the overwhelming suspicion of regulators towards exchange-traded contracts. There is an entrenched belief that trading should only be for ‘legitimate’ hedging purposes and contracts should be bought or sold only by those investors with actual holdings in the underlying securities. This again starves the market of liquidity that ‘pure’ speculators provide.

It is good that the RBI under its new Governor is convinced about allowing cash-settled IRF trading. A change in the underlying asset for these contracts, from notional to market-traded bonds, would equally help. The regulator should further permit this segment to function in the same manner as equity derivatives, without too many trading restrictions. It will enable efficient hedging and price discovery, besides communicating market expectations of future interest rate movements that could be useful even to the central bank in formulating monetary policy. The latest RBI initiative, alongside the reported proposal to allow foreign investors to hedge their investments in currency derivative markets in India, will help prevent such risk-mitigating trades from moving overseas.

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