Basics – Trading Interest rate futures

Traders,

NSE has just relaunched Interest rate futures, and after speaking to other traders and the way the contract is designed, the feeling is that trading action on the newly launched contracts should pick up considerably even in the retail trading community. As traders, I guess we trade anything that moves. I will try to explain in this post, basics of what moves Interest rate futures, and all you need to know to put that first trade.

For starters, the positive aspect of trading Interest rate futures is that there is no STT (Security Transaction Tax), and there is a bonus of not having to pay brokerage until 31st of March 2014 at Zerodha.

Underlying?

Futures are derivative contracts, whose value is derived from an underlying. For example, the value of Nifty futures are derived from the price of Nifty Index which is the underlying.

First thing about Interest rate futures is that the underlying is not an interest rate, but the “Bond price”. NSE, MCX-SX, and BSE (launching on 28th Jan 2014) have just launched futures contract on two Government of India (GOI) Bonds: “8.83% GOI 2023 (Maturity – Nov 25, 2023)” and “7.16% GOI 2023 (Maturity – May 20, 2023)”.

 Reasons why the earlier attempts of launching Interest rate futures didn’t take off

• When they first launched trading in IRF in 2008, the underlying for Interest rate futures was a notional Government Bond of 10 years maturity with an interest (coupon) rate of 7% p.a. Since the underlying was a notional product, futures on this underlying was never accepted. With the newly launched Interest rate futures (IRF), the underlying unlike earlier is not a notional product, but are very popular and traded GOI Bonds.
• Earlier, though the Futures trading was on a notional product, it was settled with physical delivery on expiry. So if you held a contract until expiry, you would have to either buy/sell from a basket of deliverable Bonds mandated by the Exchanges. The new product has fixed the problem by making the contract completely cash settled. So similar to Nifty Futures trading, on expiry there is no exchange of underlying, but the contract is cash settled.

 What are Bonds and what causes their prices to move?

We now know, when trading Interest rate futures, we are actually trading futures of Bond prices rather than the interest rates. The next question to ask is, what makes Bond prices to move up or down, so as traders we can profit from either going long or short.

The topic of Interest rate futures is a huge discussion, and the purpose of this post is to initiate the idea and get started. I will be writing only the basic aspects, and if you are interested, a good starting point would be the NCFM module on Interest rate derivatives, which can be downloaded here. Since the discussion revolves around Interest rate futures that have GOI Bonds as their underlying, here is an introduction.

Government of India (GOI) Bond

Government of India like any business needs money for its expenses like building roads, supplying basic amenities and a lot more. In times of deficit, which is when the spending is more than the revenue, it borrows money. Like any other financial institution GOI gives an interest (also called coupon amount) on the amount borrowed, and a promise in writing (Bond) to give back the principal on maturity or end of tenure. The maximum tenure for borrowing is upto 30 years, but usually the range is between 5 to 15 years. All such government bonds having a tenure of  1 year or more are also called G-Secs (GS). All such Bonds are issued by RBI (Reserve bank of India) on behalf of GOI.

Following are examples of GOI Bonds which are also underlying for IRF (interest rate futures) – 8.83% GOI 2023 (Maturity – Nov 25, 2023), and 7.16% GOI 2023 (Maturity – May 20, 2023) Similar to this every Bond will have:

• A maturity date, Nov 25 2023 and May 20, 2023 respectively in the examples above.
• Coupon rate or Interest rate –  Yearly rate of return you get for holding the Bond, 8.83%, and 7.16% respectively.
• Name of the issuers (GOI).

As mentioned earlier, the Interest rates are fixed for the Bond as in examples above of 8.83% and 7.16%, and you can’t really trade a value which is fixed. So, I guess the next question would be :What moves which can be traded”.

Bond Prices and how they move

A Bond when issued for the first time by GOI, has a face value to it, which is basically the amount of money the issuer pays the holder of the Bond when the Bond matures. The face value of both the Bonds which are underlying in case of the IRF’s (8.83% GOI 2023 and 7.16% GOI 2023)  is Rs.100.

Along with the face value, the other component is the coupon or interest amount that the holder of the Bond gets paid either annually or semi-annually. So, if you have invested Rs 100 at face value in an 8 % GOI Bond, maturing 10 years from now with a semi-annual coupon, you get Rs 4 (Rs 8/2, Rs 8 is 8% of Rs 100 invested) every 6 months for the next 10 years, and get back the Rs.100 on maturity after 10 years.

Here are two cases for you to ponder:

• Case 1: After your investing into the 8% GOI Bond, the general interest rates in the markets are reduced by RBI to help growth of the economy. What do you think happens to the Bond price of Rs.100 that you had paid?
• Answer: The interest rates are dropping, but you are holding a Bond that yields higher interest rates. The demand for your Bond goes up and hence value of Bond prices also goes up (price discovery), so the Rs.100 goes up higher, and you can sell it if you wish at a profit.
• Case 2: After your investing into the 8% GOI Bond, the general interest rates in the economy is moving up because RBI is worried about inflation. What do you think happens to the Bond price of Rs.100 that you had paid?
• Answer: The interest rates are going up, but you are holding a Bond whose interest rate is fixed, the demand for your Bond goes down, and hence the value will go below Rs.100.
  

  Bond Price inversely related to Interest rate, like in case of a negative and a photo

In summary, Bond prices are inversely related to interest rates in the economy, so:

• If your view is that interest rates will go up, you short Bonds as the Bond prices will go down and you can profit.
• If your view is that interest rates will go down, you buy Bonds as the Bond prices will go up.

Other factors like currency movement also contribute to how Bond prices move, for example FII’s are a big community investing into GOI Bonds, and their appetite for Bonds depends on currency rates also.

Here is the most interesting aspect, GOI Bonds don’t trade on NSE, and also one of the issues trading an underlying like Bond, similar to stocks, is that you cannot profit if your view is to be short or value of Bond prices are coming down. This is the reason for introducing Interest rate futures that have the Bond prices as the underlying.

• If your view is that interest rates are going up, “Short” Interest rate futures (you profit because when interest rates go up, Bond prices come down).
• If your view is that interest rates are going down, “Buy” Interest rate futures (you profit because when interest rates go down, Bond prices go up).

The view on interest rates is dynamic, and changes every fraction of a second, and hence the Bond prices itself, as it affects many people from retail to financial institutions, from insurance companies to governments. Thus, Interest rate futures turnover is many times greater than equity futures turnover in the developed markets.

Bond yields? 

Along with Bond prices, Bond yield is a very popular way of tracking the performance of a Bond, and hence an important concept to understand.

Since the net return you make by investing into Bonds vary based on the price at which you buy, the Bond yield is a way to measure the exact % return you make by purchasing the Bond. The two most commonly used measures of yield are Coupon yield and Yield to maturity.  

Coupon Yield

                                               Coupon Yield in % = (Coupon Amount/Bond Price) x 100 

If you bought a 10% GOI Bond at a value of Rs.80 , the yield for you = (Rs.10/ Rs.80) x 100 = 12.5 %, which means in net you are actually making 12.5% even though you are buying a 10% GOI Bond. Similarly if you buy the same Bond at Rs.120 the yield = (Rs.10/ Rs.120) x 100 = 8.33%. 

Yield to Maturity (most popular way of measuring yield)

YTM (Yield to maturity) uses a complex formula to calculate the internal rate of return for the investor who buys the Bond, by using all the future cash flows (interest payments as well as ultimate principal repayment). Calculation of YTM assumes that the Bond is held to maturity. The difference between Coupon yield and YTM is that Coupon yield uses only a single coupon amount (interest amount) to calculate the yield, whereas YTM uses all the future coupon payments, and principal payment discounted to present values. If someone on TV or a bond trader is talking about yields, you can safely assume that it is measured using YTM method, the most popular way to calculate Bond yields. 

Interest Rate Futures

3 Future contracts each (present, near, and far month) on the bond prices of both the following are available on NSE,MCX-SX, and BSE (launching on 28th Jan).

• 8.83% GOI 2023 (Maturity – Nov 25, 2023)
• 7.16% GOI 2023 (Maturity – May 20, 2023)

Presently all trading activity is in futures of 8.83% GOI 2023.

Important things to know:

1. Instrument Type: FUTIRC (NSE) & FUTIRF (MCX-SX).
2. Trading symbol: Examples : 883GS202314JanFut, this is the Jan 2014 future contract for 8.83% GOI Bond (also called Gsec(GS)), and similarly 883GS202314FebFut is the Feb future.
3. Unit of trading: 1 lot , 1 lot is equal to 2000 Bonds.
4. Contract Value: If the Bond price is Rs.100, contract value is Rs 2lks (Rs.100 x 2000).
5. Tick size: Rs 0.0025 (minimum movement in Bond price).
6. Rupees made/lost for every tick change per lot: Rs 5.
7. If Bond price moves by Rs.1 which is 400 ticks, profit/loss made is Rs.2000.
8. Margin requirement: 3.3% of the contract value (SPAN margin of 2.8% + Exposure margin of 0.5 %). You can check margins for the interest rate futures under our margin calculator. So, if 883Jan future is trading at Rs.101, the contract value is around Rs 2.02 lks, and margin required to trade 1 lot would be around 3.3% of this Rs 2.02 lks, which is around Rs.6000 per lot.
9. Rs.6000 blocked as margin per lot, the profit/loss per tick (change of 0.0025) is Rs 5, and per Rs 1 movement in the bond price is Rs 2000.
10. Trading hours: Monday to Friday 9.00 AM to 5.00 PM.
11. Expiry day: Last Thursday of the month.
12. Margin requirement for Calendar Spread: Rs 800 per contract (Where you buy and sell different expiry of the same contract, lesser because it is completely hedged).
13. Product Type to be used while Trading: NRML.

Adding the contracts on the trading platform

See the picture below to know how you can add both Interest rate futures, and the underlying Bond onto the Marketwatch. Note that, you cannot trade the underlying; you can can trade only the Interest rate futures on the underlying.

If you are interested to know more,

• Read the NCFM Module
• Read the product note from NSE
• Once you have your basics right, there are tons of content available online

At Zerodha, we believe that active trading in products like Interest rate futures, and derivatives on Volatility which will most likely be launched soon, are critical for us as an exchange, and as an economy to catch up with the developed markets.

Best of luck,