Interest rate futures: The next big leap *By The Financial Express* Stock exchanges in India are gearing up for launching interest rate futures which will help deepen the country's financial markets and take the turnover and volume of the exchanges to strikingly higher levels. Interest rate futures are contractual agreements to buy or sell underlying interest bearing instruments on a specific future date at a pre-determined price and is traded on the exchange.
A recent report by IDFC-SSKI on Indian exchanges has projected an industry turnover of $10 trillion by financial year 2014 from the current level of $4 trillion. These estimates have not taken in to account trading in interest rate futures and are based on the expected turnover in commodity, equity and currency market with growth primarily spearheaded by the nascent but high-potential commodity exchanges. In organised exchanges worldwide, the notional principal amount outstanding in interest rate futures stood at $17,833.70 billion as on March 2009 which is 30 times higher than equity index futures where the amount outstanding was $592.5 billion. Similarly, the total turnover registered by interest rate futures in the organised exchanges worldwide is to the tune of $2,17,877 billion, which is 11 times higher than $19,402 billion recorded by equity index futures. But apart from bond futures traded in international exchanges, money market futures are also actively traded in exchanges like Chicago Mercantile Exchange (CME) in the US, Eurex in Europe and TFE in Japan. Given the fact that the National Stock Exchange (^NSEI<http://in.finance.yahoo.com/q?s=^NSEI>: 4571.45 +57.95) (NSE) witnesses a turnover of Rs 29,721 crore (as of July 29, 2009) in index futures, one could imagine the enormous potential of interest rate futures in turning around exchanges' volume and turnover. This will help immensely in unlocking the value for the shareholders of the exchanges when they get listed. Interest rate futures will be appealing to corporates, banks, mutual funds, foreign institutional investors, pension funds, insurance companies, and public provident funds, among others, which are exposed to risk rate risk will benefit from the product. An investor, who has invested in long-term floating rate bonds has the risk of lower return if the interest rate comes down, can hedge against that risk by taking a long position in interest rate futures. When interest rates decrease, bond yields rates also decline and, conversely, bond prices increase. Since interest rate futures contract prices follow the underlying bond prices in tandem, the investor can compensate her loss from the gain from the increase in bond prices. On the other hand, an investor, who has taken a long-tenure loan has the risk of higher cash outgo in case the interest rate increases, can hedge that risk by taking a short position or selling interest rate futures. Since the yield and price of a bond move in inverse direction, when interest rates goes up, bond yields increase and bond prices come down. Investors and companies can compensate their losses on higher cash outflow by covering their short positions when bond prices fall. Interest rate futures was, in fact, launched in early 2000s but was later withdrawn. A standing technical committee of the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) on interest rate futures submitted its report in June 2009 on product specification and is in the process of finalising the operational guidelines for the re-launch. The major challenge for exchanges as well as regulators this time is how the market participants and investors will receive the re-launch. "The key challenge for the exchanges is the acceptability of interest rate futures. There is indeed a need for such a product," said an economist. The major factor for the failure last time was the absence of a reference rate. The regulators at that time fixed the zero-coupon bond as the reference but in India this concept was not existent. This time around, the reference rate for interest rate futures will be riveted on the 10-year benchmark government of India bond with a coupon rate of 7%. This paper will be the notional underlying of the interest rate futures contract. The annualised volatility in the yield of 10-year benchmark government of India paper has increased from 8.44% in 2007 to 19.5% in 2008. In the current calendar year the annualised volatility in the benchmark index further increased to as high as 35.58%. With annualised volatility in bond yields shooting up sharply in recent times, investors as an effective tool for hedging will be more appealing to a large number of financial market participants. "There are a lot of issues that remains to be solved. The compulsory delivery on the settlement day is likely to deter investors," said C Chandrashekhar, senior vice president at Mecklai Financial Services. Another challenge before the exchanges is to educate various market participants about the benefits of the product and making them familiarise with the nuances of trading in interest rate derivatives. Exchanges have already started reaching out to various stakeholders through programmes intended to create awareness. While MCX'SX is conducting road shows in various parts of the country, National Stock Exchange (NSE) has already conducted a mock trading session for its trading members to get familiarize with the product. An official communiqu from Bombay Stock Exchange (^BSESN <http://in.finance.yahoo.com/q?s=^BSESN> : 15387.96 0) (BSE) said, "Apart from internal preparedness and planning, BSE Training Institute is organising a specialised training programme targeted both at core institutional players and retail investors." Domestic brokerages also are preparing to organise seminars and programmes targeting specific segment of clients. "We will be condicting seminars for customers including corporates, and urban and district co-operative banks as this is an attractive proposition for institutions and smaller banks. Also, we have asked our central advisory desk to do the research work to advise investment strategy to our clients," said CJ George, managing director of Geojit BNP Paribas Financial Services Ltd. Given the complex nature of the product, it will take a while for the exchanges to match the volume and turnover of other developed markets. With the Indian exchanges successfully completing the first two stages of their evolution electronic trading system that enhanced the depth and liquidity of the market, and demutualisation, or separation of ownership and trading membership, which facilitated entry of strategic foreign partners the introduction of interest rate futures would catalyse the advent of the next stage of unlocking value for their shareholders when they are listed. http://in.biz.yahoo.com/090730/50/batz16.html --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups ""GLOBAL SPECULATORS"" group. To post to this group, send email to [email protected] To unsubscribe from this group, send email to [email protected] For more options, visit this group at http://groups.google.com/group/globalspeculators?hl=en -~----------~----~----~----~------~----~------~--~---
