Illiquid nature makes interest rate futures pale

Analysts say one of the main reasons for the derivative product not taking off is the illiquid nature of the instruments. Currently,the underlying instrument for interest rate futures are two 10-year government bond bearing a notional interest rate of 7%. Bankers say they are going short on bond trades as they fear the interest rates will rise further and result in a gradual grind up in yields.

Also,the large supply of bonds has resulted in a gradual grind up in yields,making traders wary of buying any non-benchmark security. So,while the liquidity of on-the-run bonds has been quite good given the easy monetary stance,the liquidity of non-benchmark securities has been very low in recent times.

Vineet Malik,director,interest rate,Hong Kong and Shanghai Banking Corporation Ltd,India says the benchmark securities by themselves enjoy a very transient status,with new issues leading to frequent changes in the benchmark security — new securities replace existing ones as the benchmark for a given tenor. “As there is limited price discovery and liquidity in quite a few of these basket securities,pricing and liquidity of the future contract has become extremely challenging,” he says.

The solution,he says lies in fiscal consolidation,for which the budget has given encouraging signals though the actual process can be a relatively lengthy one.

IRFs were launched at the NSE to allow participants to buy protection against and bet on interest rates changes. They are an agreement to buy or sell an underlying debt security at a fixed price on a fixed day in the future. The prices of these derivatives reflect the increase or decrease in the yield of the underlying government bonds. The maturity of the contracts is fixed between a minimum of three months to a maximum of one year and the contracts have a total size of Rs 2 lakh.

Jagannadham Thunuguntla,equity head at SMC Capitals says there is lack of institutionalise of money and the awareness level for IRFs is very low. “Volume will only increase if there are more instruments and just two of them will not work in the long run.”

Globally,IRFs account for about 30% of derivatives transactions,the largest volume and notional value among all the financial derivatives traded on exchanges. Data from Bank of International Settlement show that the notional principal amount outstanding in exchange traded IRFs was $18.5 trillion. Also unlike the OTC interest rate swap market,which is an inter-bank market,exchange-traded IRFs are seen by market players as more transparent and result in better price discovery.

In India,IRF was first introduced in 2003 but it failed to evoke much response as banks,a major player in this instrument,were not allowed to hedge interest rate risks. To make the product a successful one,experts say insurance companies must be allowed to participate in IRF and there is a greater need to manage interest rate exposure efficiently for institutions and intermediaries in the financial markets.