Derivatives - Treasury Bond Market

1. Treasury Bond Market:
The Indian Scenario
Guided By:
Dr. Santanu K Ganguli
Prepared By:
PGDM Executive Batch 11-12

2. Contents
 Government Securities Market: Introduction ................................................................................ 1
 Treasury Bills (T-bills) .................................................................................................................. 1
 Dated Government Securities ..................................................................................................... 1
 Zero Coupon Yield Curve............................................................................................................. 2
 The Bond Market ............................................................................................................................ 3
 Basic Bond Concepts ................................................................................................................... 3
 Instruments ................................................................................................................................. 3
 Importance of Interest Rates to Yield ......................................................................................... 4
 The Yield Curve ........................................................................................................................... 5
 Underdeveloped Bond Market ................................................................................................... 5
 Interest Rate Futures – A Global Perspective ................................................................................. 5
 Interest Rate Futures in India ......................................................................................................... 6
 History of Interest Rate Futures in India ..................................................................................... 7
 Features of Interest Rate Futures ............................................................................................... 8
 Benefits of Exchange Traded IRF................................................................................................. 8
 Interest Rate Futures – Key Concepts ......................................................................................... 9
 Interest Rate Futures- Contract Specification........................................................................... 14
 Product Features ................................................................................................................... 14
 Trading Aspects ..................................................................................................................... 15
 Settlement Aspects ............................................................................................................... 15
 Contract Specifications of 91 Days T-Bills ................................................................................. 16
 Contract Specifications of 10 Year GOI Securities .................................................................... 17
 Clearing & Settlement ................................................................................................................... 18
 Clearing Members ..................................................................................................................... 18
 Types of Clearing Members ...................................................................................................... 18
 Clearing Member Eligibility Norms ........................................................................................... 18
 Clearing Banks ........................................................................................................................... 18
 Clearing Mechanism.................................................................................................................. 18
 Settlement Mechanism ............................................................................................................. 19
 Daily Mark-to-Market Settlement ............................................................................................ 19
 Delivery Settlement .................................................................................................................. 19
 Intent to Deliver .................................................................................................................... 20
 Deliverable Securities............................................................................................................ 20
 Allocation to Long Positions .................................................................................................. 20
 Obligation for Delivery Settlement ....................................................................................... 20
 Settlement Schedule ................................................................................................................. 20
i

3.  Shortages Handling ................................................................................................................... 20
 Failure to Deliver Securities .................................................................................................. 20
 Failure to Provide Funds ....................................................................................................... 21
 Risk Management ..................................................................................................................... 21
 Margins ..................................................................................................................................... 21
 Initial Margin ......................................................................................................................... 21
 Extreme Loss Margin............................................................................................................. 23
 Imposition of Additional Margins ......................................................................................... 23
 Payment of Margins .................................................................................................................. 23
 Mode of Payment of Margin ..................................................................................................... 24
 Effect of Failure to Pay Margins ............................................................................................ 24
 Position Limits ........................................................................................................................... 24
 Trading Memberwise Position Limit ..................................................................................... 24
 Client Level Position Limits ................................................................................................... 24
 FII/NRI Position limits............................................................................................................ 24
 Interest Rate Futures (IRF) and Market Participants .................................................................... 25
 Major Market Participants ........................................................................................................ 25
 Uses of IRF for Market Participants .......................................................................................... 25
 Key Benefits of Interest Rate Futures ........................................................................................... 26
 Directional Trading .................................................................................................................... 26
 Portfolio Hedging ...................................................................................................................... 27
 Calendar Spread Trading ........................................................................................................... 28
 Reduce the Duration of Portfolio .............................................................................................. 28
 Arbitraging between Cash and Futures Market........................................................................ 29
 Impediments to Growth of Bond futures market in India ............................................................ 30
 Patchy Liquidity ......................................................................................................................... 30
 Further Imbalance of Liquidity .................................................................................................. 30
 Latest Developments in Bond market........................................................................................... 31
ii

4.  Government Securities Market: Introduction
The government securities market in India has witnessed significant transformation in the 1990s.
Government securities are now sold at market related coupon rates through a system of auctions
instead of earlier practice of issue of securities at very low rates just to reduce the cost of borrowing
of the government. Major reforms initiated in the primary market for government securities include
auction system (uniform price and multiple price method) for primary issuance of T-bills and central
government dated securities. Introduction of an electronic screen based trading system,
dematerialized holding, establishment of the Clearing Corporation of India Ltd. (CCIL) as the central
counterparty (CCP) for guaranteed settlement, new instruments, and changes in the legal
environment are some of the major aspects that have contributed to the rapid development of this
market.
Securities are now issued across maturities to develop a yield curve from short to long end provide
benchmarks for rest of the debt market. Innovative instruments like zero coupon bonds, floating
rate bonds, bonds with embedded derivatives, availability of full range (91-day, 182 day and 364-
day) of T-bills, etc. have added to the development of this market.
 Treasury Bills (T-bills)
Treasury bills, the money market instruments, are short term debt instruments issued by the
Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day.
Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and
redeemed at the face value at maturity. For example, a 91 day Treasury bill of Rs.100/- (face value)
may be issued at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the
face value of Rs.100/-. The return to the investors is the difference between the maturity value or
the face value (that is Rs.100) and the issue price. The Reserve Bank of India conducts auctions
usually every Wednesday to issue T-bills. Payments for the T-bills purchased are made on the
following Friday. The 91 day T-bills are auctioned on every Wednesday. The Treasury bills of 182
days and 364 days tenure are auctioned on alternate Wednesdays. T-bills of 364 days tenure are
auctioned on the Wednesday preceding the reporting Friday while 182 T-bills are auctioned on the
Wednesday prior to a non-reporting Fridays. The Reserve Bank releases an annual calendar of T-bill
issuances for a financial year in the last week of March of the previous financial year. The Reserve
Bank of India announces the issue details of T-bills through a press release every week.
 Dated Government Securities
Dated Government securities are long term securities and carry a fixed or floating coupon (interest
rate) which is paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of
dated securities can be up to 30 years.
The Public Debt Office (PDO) of the Reserve Bank of India acts as the registry / depository of
Government securities and deals with the issue, interest payment and repayment of principal at
maturity. Most of the dated securities are fixed coupon securities.
The nomenclature of a typical dated fixed coupon Government security contains the following
features - coupon, name of the issuer, maturity and face value.
For example, 7.49% GS 2017 would mean:
Coupon : 7.49% paid on face value
Name of Issuer : Government of India
Date of Issue : April 16, 2007
1

5. Maturity : April 16, 2017
Coupon Payment Dates : Half-yearly (October 16 and April 16) every year
Minimum Amount of issue/ sale : Rs 10,000
In case there are two securities with the same coupon and are maturing in the same year, then one
of the securities will have the month attached as suffix in the nomenclature. For example, 6.05% GS
2019 FEB, would mean that Government security having coupon 6.05 % that mature in February
2019 along with the other security with the same coupon, namely, 6.05% 2019 which is maturing in
June 2019.
 Zero Coupon Yield Curve
An efficient debt market needs a mechanism for valuing sovereign paper held by the market
players in their portfolio. A sound valuation tool should ideally satisfy following criteria: (a) it should
have sound conceptual basis, (b) it should provide a framework that allows consistent valuation of
similar instruments, and (c) it should be available at high frequency so as to enable market players to
constantly value and, if required, reshuffle their portfolios.
To meet these requirements NSE developed a zero coupon yield curve (ZCYC) that helps in
valuing securities across all maturities irrespective of their liquidity in the market and would create
standardisation across industry in so far as valuation of financial instruments are concerned, more
particularly the sovereign instruments. ZCYC has been developed keeping in mind the need of the
banking industry that has substantial investment in sovereign papers. The ZCYC construction is based
on the basic premise of time value of money. The rate of interest paid varies with the time period
that elapses between today and the future point of time. At any point of time therefore we would
observe different spot rates of interest associated with different terms of maturity; longer maturity
offering a ‘term spread’ relative to shorter maturity. The term structure of interest rates or ZCYC is
the set of such spot interest rates.
Fixed income instruments may be categorised by the type of their payment streams. Most fixed
income instruments pay to their holders a periodic interest payment, commonly known as the
coupon and an amount due at maturity, the redemption value. There also exist some instruments
that do not make any periodic interest payments but pay the principal amount together with the
entire accumulated interest amount as a lump sum at maturity. These instruments are known as
‘zero coupon’ instruments. Treasury bill provides an example of such an instrument. Such
instruments are sold at a discount to the redemption value, the discounted value being determined
by the interest rate payable (yield) on the instrument.
In empirical models of the ZCYC, the discount stream of cash flows gives the underlying
valuation of the bond. If the term structure is the only factor that influences the pricing of the bond,
the present value relation, as we have mentioned earlier should give us the price of the bond. With
PV relation, and with information available on ‘trade date’, ‘traded price’, ‘coupon rate’ and ‘the
date of maturity’ of a bond, this essentially leaves as unknown only the set of interest rates. The
trades on any given day provide us with information for the sample of traded bonds. Computation of
the ZCYC now involves estimation of the appropriate set of interest rates that go into deriving the
present value relation. This is done by specifying a functional form of the interest rate-maturity
relation/discount function/forward rate function.
2

6.  The Bond Market
Although less exciting than stocks, bonds play a critical role in our economy and an important role in
every well-balanced portfolio. Corporations issue bonds as a way to borrow large sums of money.
Companies have two basic ways to raise money for expansion, acquisitions, or other uses. They can
issue stock or borrow the money. Governments and governmental agencies also use bonds to raise
money. U.S. Treasury Bonds are the most secure investments in the world because the U.S.
Government backs them with its "full faith and credit."
 Basic Bond Concepts
There are four basic concepts to be remembered in bond market :
Par value - Par value, also known a face or principal value, is how much the bondholder will
receive at maturity. A $1,000 par value bond will be worth $1,000 when it matures.
Coupon - Coupon is the interest rate the bond pays. It is called the coupon rate because
bonds once came with a book of coupons, which the holder had to clip and send in to
receive an interest payment. Bond investors are still referred to sometimes as "coupon
clippers." This interest rate does not vary over the life of the bond, although there are some
bonds, which have a variable interest rate tied to an external index.
Maturity - Maturity refers to the length of time before the par value is returned to the
bondholder. It may be as short as a few months, 50 years, or more. At maturity, the
bondholder receives the par value of the bond.
Yield - The term you will hear about bonds the most is their yield and it can be the most
confusing. There are really three different types of yield to explain:
Nominal Yield - This is the coupon or interest rate. Nothing else is factored in to this number. It is
actually not very helpful.
Current Yield - The current yield considers the current market price of the bond, which may be
different from the par value and gives you a different return on that basis.
For example, if you bought a $1,000 par value bond with an annual coupon rate of 6% ($1,000 x 0.06
= $60) on the open market for $800, your yield would be 7.5% because you would still be earning
the $60, but on $800 ($60 / $800 = 7.5%) instead of $1,000.
Yield to Maturity - Yield to Maturity is the most complicated, but the most useful calculation. It
considers the current market price, the coupon rate, the time to maturity and assumes that interest
payments are reinvested at the bond's coupon rate. It is a very complicate calculation best done
with a computer program or programmable business calculator. However, when you hear the media
talking about a bond's "yield" it is usually this number they are talking about.
 Instruments
i. Fixed Rate Bonds – These are bonds on which the coupon rate is fixed for the entire life of
the bond. Most Government bonds are issued as fixed rate bonds.
For example – 8.24%GS2018 was issued on April 22, 2008 for a tenor of 10 years maturing
on April 22, 2018. Coupon on this security will be paid half-yearly at 4.12% (half yearly
payment being the half of the annual coupon of 8.24%) of the face value on October 22 and
April 22 of each year.
ii. Floating Rate Bonds – Floating Rate Bonds are securities which do not have a fixed coupon
rate. The coupon is re-set at pre-announced intervals (say, every six months or one year) by
3

7. adding a spread over a base rate. In the case of most floating rate bonds issued by the
Government of India so far,the base rate is the weighted average cut-off yield of the last
three 364- day Treasury Bill auctions preceding the coupon re-set date and the spread is
decided through the auction. Floating Rate Bonds were first issued in September 1995 in
India.
For example, a Floating Rate Bond was issued on July 2, 2002 for a tenor of 15 years, thus
maturing on July 2, 2017. The base rate on the bond for the coupon payments was fixed at
6.50% being the weighted average rate of implicit yield on 364-day Treasury Bills during the
preceding six auctions. In the bond auction, a cut-off spread (markup over the benchmark
rate) of 34 basis points (0.34%) was decided. Hence the coupon for the first six months was
fixed at 6.84%.
iii. Zero Coupon Bonds – Zero coupon bonds are bonds with no coupon payments. Like Treasury
Bills, they are issued at a discount to the face value. The Government of India issued such
securities in the nineties, It has not issued zero coupon bond after that.
iv. Capital Indexed Bonds – These are bonds, the principal of which is linked to an accepted
index of inflation with a view to protecting the holder from inflation. A capital indexed bond,
with the principal hedged against inflation, was issued in December 1997. These bonds
matured in 2002. The government is currently working on a fresh issuance of Inflation
Indexed Bonds wherein payment of both, the coupon and the principal on the bonds, will be
linked to an Inflation Index (Wholesale Price Index). In the proposed structure, the principal
will be indexed and the coupon will be calculated on the indexed principal. In order to
provide the holders protection against actual inflation, the final WPI will be used for
indexation.
v. Bonds with Call/ Put Options – Bonds can also be issued with features of optionality wherein
the issuer can have the option to buy-back (call option) or the investor can have the option
to sell the bond (put option) to the issuer during the currency of the bond. 6.72%GS2012
was issued on July 18, 2002 for a maturity of 10 years maturing on July 18, 2012. The
optionality on the bond could be exercised after completion of five years tenure from the
date of issuance on any coupon date falling thereafter. The Government has the right to
buyback the bond (call option) at par value (equal to the face value) while the investor has
the right to sell the bond (put option) to the Government at par value at the time of any of
the half-yearly coupon dates starting from July 18, 2007.
 Importance of Interest Rates to Yield
Interest rates vary based on a number of factors, including the inflation rate, exchange rates,
economic conditions, supply and demand of credit, actions of the Federal Reserve, and the activity
of the bond market itself. As interest rates move up and down, bond prices adjust in the opposite
direction; this causes the yield to fall in line with the new prevailing interest rate. By affecting bond
yields via trading, the bond market thus impacts the current market interest rate.
The simplest rule of thumb to remember when dealing in the bond market is that bond prices will
react the opposite way to interest rates. Lower interest rates mean higher bond prices, and higher
interest rates mean lower bond prices. Here's why: Your bond paying 8 percent is in demand when
interest rates drop and other bonds are paying 6 percent. However, when interest rates rise and
new bonds are paying 10 percent, suddenly your 8 percent bond will be less valuable and harder to
sell.
4

8.  The Yield Curve
The relationship between short-term and long-term interest rates is depicted by the yield curve, a
graph that illustrates the connection between bond yields and time to maturity. The yield curve
allows you to compare prices among bonds with differing features (different coupon rates, different
maturities, even different credit ratings). Most of the time, the yield curve looks normal (or “steep”),
meaning it curves upward — short-term bonds have lower interest rates, and the rate climbs
steadily as the time to maturity lengthens. Occasionally, though, the yield curve is flat or inverted. A
flat yield curve, where rates are similar across the board, typically signals an impending slowdown in
the economy. Short-term rates increase as long-term rates fall, equalizing the two. When short-term
rates are higher than long-term rates (which can signal a recession on the horizon), you get an
inverted yield curve, the opposite of the normal curve.
 Underdeveloped Bond Market
The Indian financial system is not well developed and diversified. One major missing element is an
active, liquid, and large debt market. Currently almost 98% of the secondary market transactions in
debt instruments relate to government securities, treasury bills and bonds of public sector
companies. The quality of secondary market debt trading is very poor if we compare it with the
quality of the secondary market in equities. Debt markets lack the required transparency, liquidity,
and depth. With reference to the usual standards or yardsticks of market efficiency the Indian debt
markets would not score more than 30% of the marks that the Indian equity markets would score.
In India the average daily trading in debt during the last year was about one tenth of the average
daily trading in equities. These comparisons bring out the underdeveloped nature of the Indian debt
markets.
 Interest Rate Futures – A Global Perspective
Interest Rate Futures contracts were first traded in the United States on October 29, 1975 in
response to a growing need for tools that could protect against sharp movements in interest rates.
Since then, Interest Rate Futures have become a fundamental risk management tool for financial
markets worldwide.
Interest Rate Futures are the most widely traded derivatives instrument in the world. The total
outstanding notional principal amount in Interest Rate Futures is 25.48 times higher than equity
index futures.
5

9. The total turnover in the year 2008 for Interest Rate Futures was around USD 14,00,000 billion,
which is around 10.5 times higher than equity index futures.
The table given below shows the enormous contribution made by Interest Rate Futures in the global
derivatives markets:
Turnover USD in Billion
Regions/ Markets Interest Rates
North America 774439.1
Europe 543902.3
Asia & Pacific 63811.5
Other Markets 10645.5
Total 1392798.4
 Interest Rate Futures in India
Interest rates are linked to a variety of economic conditions. They can change rapidly, influencing
investments and debt obligations. In a market environment where long term debt issuance by the
government is increasing and the demand for it is growing, there is a strong need for a cost efficient
hedging instrument against interest rate risk.
The government borrowings during financial year 2004-05 to 2008-09 are shown in the graph
below.
Market participants hold large amounts of GOI Securities which are impacted in value due to interest
rate fluctuations. Over the last decade, the movement in the 10 year Benchmark Government of
India (GOI) securities’ yield has shown significant movement, ranging from 5% to 12%.
6

10. 10 Year Benchmark Government of India security Yield rate
Interest rate risk is the uncertainty in the movement of the interest rates. Interest rates have
never been constant in the past and one can easily presume they would not remain constant in the
future. The volatility of interest rates has increased manifold in the last couple of years. The
annualized volatility of yield of 10 year benchmark GOI security for the calendar year 2008 has been
17.40% compared to 8.51 % in 2007. Such volatility increases risk and requires tools to manage risks.
Interest Rate Futures are the product for managing the interest rate risk.
 History of Interest Rate Futures in India
Post liberalization in 1991, owing to financial sector reforms interest rates have been deregulated
in India making them volatile. To hedge and manage interest rate risks as a first step in 1999, the
Reserve Bank of India (RBI) introduced over-the-counter (OTC) derivatives. Most prominent amongst
them were the Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA). The OTC trading
experiment was by and large successful when measured against the satisfactory volumes it
generated, but it seemed to suffer from shortcomings such as information asymmetries and lack of
transparency and its concentration in major institutions. As an improvement in January 2003, the
RBI committee headed by Jaspal Bindra, CEO, Standard Chartered Bank, recommended the idea of
introducing the Exchange Traded Interest Rate Futures citing advantages such as listed anonymous
trading, full transparency, lower intermediation costs and better risk management. In June 2003, the
following cash-settled variants of interest rate futures were launched:
1. Futures on 10-year notional zero-coupon Government of India (GoI) security
2. Futures on 10-year notional GoI security with 6% coupon rate
3. Futures on 91-day Treasury bill
However, the IRF market attracted very few participants and transactions and effectively failed to
take off. Two major reasons for this were:
1. Cash settled on a curve (Zero Coupon Yield Curve) was not understood by common traders.
2. Banks were prohibited from taking trading positions in these contracts, depriving early
liquidity.
7

11. The joint committee of SEBI and RBI recommended introduction of the IRF in the Indian market in a
new format. Interest Rate derivatives (IRD) introduced on NSE from 30th August 2009, offers
futures contracts on 10 Year Notional Coupon-bearing Government of India (GOI) security
(10YGS7) and the recently introduced (2011) 91-day Government of India (GOI) Treasury Bill.
 Features of Interest Rate Futures
 The underlying bond in India is a “notional” government bond which may not exist in reality. In
India, the RBI and the SEBI have defined the characteristics of this bond: maturity period of 10
years and coupon rate of 7% p.a. If futures were to be introduced on each of the government
bonds, then there would be a large number of interest rate futures contracts trading on each
bond and as a result, the liquidity would be poor for many of these futures. So a single bond
futures have been identified which pays 7% p.a. as coupon rate and has maturity of 10 years. All
bonds have been assigned a multiplier called ‘conversion factor’ which brings that bond on par
with the theoretical bond available for trading.
 IRFs have to be physically settled unlike the equity derivatives which are cash settled in India.
Physical settlement entails actual delivery of a bond by the seller to the buyer. But because the
underlying notional bond may not exist, the seller is allowed to deliver any bond from a basket of
deliverable bonds identified by the authorities. If the bond future were to be based on an actual
bond issue, it could potentially raise the activity in the futures market to such a large extent as to
cause severe shortages of this actual bond for delivery at expiry. To avoid this danger of
shortages to meet the delivery requirement, the Exchange allows a specific set of bonds -- rather
than a single bond -- with different coupons and expiry dates to be used for satisfying the
obligations of short position holders in a contract. Thus, while the purpose of a notional
underlying bond is to ensure liquidity, the purpose of having a basket of bonds is to ensure that
there delivery is not affected by short supply, which would have arisen in case of a single bond.
 Like any other financial product, the price of IRF is determined by demand and supply, which in
turn are determined by the individual investor’s views on interest rate movements in the future.
 Benefits of Exchange Traded IRF
Interest rate futures provide benefits typical to any Exchange-traded product, such as
 Standardization – Only contracts with standardized features are allowed to trade on the
exchange. Standardization improves liquidity in the market. The following features are
standardized:
- Only certain expiry dates are allowed in India viz. last working day of the months of March,
June, September and December.
- The size of contract can only be in multiples of a certain number called the lot size. The lot size
currently in India is Rs. 2 lakhs.
- Only some specific bonds can be used for delivery.
 Transparency – Transparency is ensured by dissemination of orders and trades for all market
participants. Also, competitive matching of orders of buyers and sellers boosts transparency.
Transparency improves the efficiency of the market in terms of discovery of competitive price
and liquidity.
 Counter-party Risk – Counterparty risk is mitigated by the exchange which acts as an
intermediary to all transactions. Exchange provides a platform where buyers and sellers can come
together and the orders are matched. Once the orders are matched, the Exchange becomes the
buyer to the seller and the seller to the buyer. Thus it protects both the parties to the transaction
against counterparty risk. To be able to do so, it takes initial margin from both sides as collateral.
As time passes, the margin required from the parties changes on a day to day basis depending on
8

12. the price movement of the transaction. The credit guarantee of the clearing house addresses
counter party risk thereby improving the confidence of investors leading to wider participation.
 Interest Rate Futures – Key Concepts
Interest Rate
Interest rate is the amount charged, expressed as a percentage of principal, by a lender to a
borrower for the use of assets. They are typically noted on an annual basis, known as the annual
percentage rate (APR). E.g. 6.05 Feb 2019 security bears an interest rate of 6.05% annually which is
also referred as coupon.
Does the rate of return remain same throughout the tenure of the bond? No, to measure the rate of
return on your investment lets understand the concept of yield.
Yield
Yield is the income (return) on an investment. This refers to the income received from a security and
is usually expressed as a percentage (annual return) based on the investment's cost, its current
market value or its face value. Yield and price of a bond have an inverse relationship. As yield
increases, the price of the bond decreases and vice-versa.
Always an avid investor would be interested to know the period it takes to recover his initial
investment in the bond. The concept of duration shall explain this.
Duration
The term duration has a special meaning in the context of bonds. It is a measurement of how long, in
years, it takes for an investment in a bond to be repaid by its internal cash flows. It is an important
measure because bonds with higher durations carry more risk and have higher price volatility than
bonds with lower durations.
Duration is expressed as the number of years (measured as a weighted average) in which the bond
will pay out. Basically, duration is a weighted average of the maturity of all the income streams from
a bond or portfolio of bonds. So, for a two-year bond with 4 coupon payments every six months of
Rs. 50 and a Rs. 1000 face value, duration (in years) is 0.5(50/1200) + 1(50/1200)+ 1.5(50/1200)+
2(50/1200) + 2(1000/1200) = 1.875 years.
Modified duration is a measure of the sensitivity of the price (the value of principal) of a fixed
income investment to a change in interest rates. Rising interest rates mean falling bond prices, while
declining interest rates mean rising bond prices. The greater the duration number, the greater the
interest-rate risk or reward for the bond.
Modified duration does not factor the bigger change in the yield and represents linear relationship.
However to measure the curvature in the relationship between bond price and yield, a concept
called convexity is used.
Convexity
Convexity is the measure of the curvature in the relationship between bond prices and bond yields
that demonstrates how the duration of a bond changes as the interest rate changes. It is used as a
risk management tool, and helps to measure and manage the amount of market risk to which a
portfolio of bonds is exposed.
9

13. Price Yield Relationship
Yield
8% Premium
Bond with Face Value
coupon @10% 10% (At Par)
12% Discount
Change in the price is in response to change in yield which can be measured using duration and
convexity.
10

14. Types of Yield Curve
A yield curve visually depicts the term structure of interest rates for debt instruments of the same
quality (rating).
11

15. Accrued Interest
Coupon payments occur at periodic intervals. When a bond is sold on a day that falls between two
coupon payment dates, the buyer of the bond gets the full interest payment due for the latter
coupon payment date. However the seller has a right over the interest payment for the period for
which he was holding the bond i.e. from the date of the last coupon payment he received till the
settlement date of the trade. Hence at the time of sale, the buyer pays the seller the bond's price
plus accrued interest.
Accrued Interest = Annual Coupon amount × (n/d) = Coupon rate x (n/d) x face value
The calculation of the days between two interest payment dates (n) and the number of days in a
year depend on the day count convention followed in the market. In India, 30/360 European
convention is used.
Example of convention followed in India:
Assume that a bond with a face value of Rs 100 is issued on 1st of June 2006 and matures on 1st of
June 2016. It pays 6% annualized coupon. Coupons are paid biannually on 1st June and 1st
December. As of 1st September 2009, the accrued interest can be calculated as:
AI = 6% x (90/360) x 100 = Rs. 1.5
We are using a fraction of 90/360 because of the convention, although the actual number of days
that elapsed since the last payment of coupon is 92 days and the total number of days is the year
2009 is 365 days.
Invoice Price
Following the short futures position holder’s intimation to the Exchange of his intent to give delivery
of the bond, the physical settlement of the trade is conducted. In physical settlement, the short
investor gives one of the bonds from the basket of deliverable bonds and gets cash amount from the
buyer of the bond. When futures are traded, they are quoted in clean price terms; accrued interest
is not included in the traded futures price. But for the purpose of settlement dirty price is taken into
account, which includes accrued interest.
Thus, on any given day, the futures settlement price of that day multiplied by the conversion factor
gives the clean price of the bond for that day; this value plus the accrued interest value gives the
invoice price or dirty price of the bond for that day. The buyer has to pay this price to the seller for
getting delivery of the bond.
Invoice price = (Futures Settlement price * Conversion factor of the delivered bond) + Accrued
Interest.
Example: For a futures contract on bonds with face value of Rs. 100, suppose:
Futures settlement price is Rs.90, Conversion factor for the bond to be delivered is 1.3800 and
Accrued interest on this bond at the time of delivery is Rs. 3.
The cash received by the party with the short position (and paid by the party with the long position)
is then
Invoice price = (1.3800 x 90.00) + 3.00 = Rs.127.20
Conversion Factor
As stated earlier, the Reserve Bank of India has identified a set of bonds to be allowed for delivery by
the investor having short position in the IRF to the long position holder on the settlement day. These
are called deliverable bonds. All these bonds have differing maturities and coupon rates. To facilitate
delivery, however, it is necessary to make them comparable with each other and all of them
comparable with the notional bond as of the first day of the expiry month. For achieving this, the RBI
has specified the use of conversion factor. The NSE publishes ‘conversion factor’ for each of the
12

16. deliverable bond and for each expiry at the time of introduction of the contract. For a particular
expiry month, the conversion factors do not change over time. (Excel File
“IRF_conversion_factor_calc.xls” as shown below is available on NSE website for calculation).
Conversion factor when multiplied by the futures price (whose underlying is the notional bond)
converts it to the actual delivery price for a given deliverable bond. Thus conversion factors are used
to take care of the differences between various bonds and thereby bring all the bonds at par for
settlement.
NEXT MONTH Sep
INTEREST RATE FUTURES - CONVERSION FACTOR CALCULATOR
2012
Select the Nomenclature of the Bond 8.13% 2022
Coupon 8.13%
Yield 7.00%
Maturity Date 21-Sep-22
Month Rounded down to quarter 9
Revised Year 2022
Revised Maturity 30-Sep-22
Remaining Maturity 10.00
Remaining Maturity Years (N) 10.00
Remaining Maturity Months (X) 0.00
CONVERSION FACTOR 1.0803
Cheapest to Deliver Bond (CTD)
Bond which can be bought at cheapest price from underlying bond market and delivered against
expiring futures contract is called CTD bond. It will be a bond where difference between “Quoted
price of Bond – (Futures Settlement Price * Conversion Factor)” is the most beneficial to seller.
The sellers of the IRF have to acquire bonds to deliver them to the buyers. For them, the cost of
acquiring the bonds for delivery = Quoted price of the bond + Accrued Interest. On the other hand,
when they deliver these bonds to the buyers of the IRF, the price that they receive = (Futures
settlement Price x Conversion factor) + Accrued interest.
The difference between the two accounts for the profit / loss of the seller of futures.
Profit of seller of futures = (Futures settlement Price x Conversion factor) - Quoted Spot Price of
delivered bond
Loss of seller of futures = Quoted Spot Price of delivered bond – (Futures settlement Price x
Conversion factor)
Clearly, the cheapest to deliver bond is identified by calculating the profits/losses using the formulas
given above, for each of the deliverable bonds and choosing that bond which maximizes the profit
(in case there is at least one profit making deliverable bond) or minimizes the loss (in case all
deliverable bonds are loss making).
Example: Determining Cheapest to Deliver Bond
Security Future Settlement Quoted Price Conversion Future Difference
Price # of Bond (A)# Factor Price*CF (B) (A-B)
7.46 – 2017 100 102.74 1.0270 102.7 0.04
6.05 – 2019 100 95.64 0.9360 93.60 2.04
6.35 – 2020 100 96.09 0.9529 95.29 0.80
7.94 – 2021 100 104.63 1.0734 107.34 -2.71
8.35 – 2022 100 107.02 1.1113 111.13 -4.11
13

17. 6.30 – 2023 100 89.75 0.9395 93.95 -4.20
# Futures settlement price and quoted price of bonds are assumed.
It is cleared from table that the minimum loss will occur from delivering 6.30% - 2023 bond and
therefore it is CTD bond.
Bond Basis
‘Bond basis’ provides a way to track the movement in the IRF prices relative to the movement in
CTD’s price. The bond basis is defined as the difference between a bond’s price in the cash market
and the converted futures price. The converted futures price is the current futures price multiplied
by conversion factor of the bond in consideration.
This value of bond basis is also called Gross bond basis.
Gross bond basis = Bond price – (Futures price x conversion factor for that bond)
If we add the cost of carry to the gross bond basis, we get net basis for a bond. Thus
Net Bond Basis = Gross Bond basis + Cost of Carry till the delivery date
Where Cost of Carry = Cost of financing the bond - Coupon payment receivable from the bond
Net basis for a bond is typically greater than or equal to zero. If it is lower than zero, then there is an
arbitrage opportunity.
 Interest Rate Futures- Contract Specification
The standardized IRF contracts can be traded on the Exchange. Standardization is done both in terms
of the features of the product and the mechanism of its trading and settlement.
 Product Features
- Underlying bond: Underlying bond is a notional 10 year, 7% coupon-bearing Government of India
bond or 91-day Government of India (GOI) Treasury Bill.
- Lot size: The minimum amount that can be traded on the exchange is called the lot size. All trades
have to be a multiple of the lot size. The interest rate futures contract can be entered for a minimum
lot size of 2000 bonds at the rate of Rs. 100 per bond (Face Value) leading to a contract value of Rs.
200,000.
- Contract cycle: New contracts can be introduced by the Exchange on any day of a calendar month.
At the time of introduction, the duration of any contract can vary from 1 month to 12 months. The
expiry has to be on one of the four specific days of a year, specified by the regulator. Expiry cannot
happen on any other date. The set of expiry dates available in a year constitute the expiry cycle or
contract cycle. The expiries specified in the current contract cycle are the last business days of
March, June, September and December. (Contracts are referred to by their respective expiry
months. For example, December 2009 contract means a contract expiring in December 2009.)
These four contract expiries have been chosen as they coincide with the quarterly financial
accounting closure followed by Indian companies. Thus, at any given time, a maximum of four
contracts can be allowed for trading on the exchange (Viz., March, June, September and December
contracts). Currently, at NSE only two contracts are allowed to be traded.
14

18.  Trading Aspects
- Tick size: The tick size of the futures contract is Rs. 0.0025. Tick size is the minimum price
movement allowed for a futures contract.
- Trading hours: Interest Rate Futures are available for trading from 9 am till 5 pm on all business
days.
- Last Trading Day: The last trading day for a futures contract is two business days before the expiry
date (i.e. the last business day of the expiry month). For example the last trading date for December
2009 contract is 29th Dec 2009, because the last business day of December 2009 is the 31st.
 Settlement Aspects
- MTM Settlement and Physical settlement: For IRF, settlement is done at two levels: mark-to-
market (MTM) settlement which is done on a daily basis and physical delivery which happens on any
day in the expiry month.
- Final Settlement Dates: Final settlement which involves physical delivery of the bond can happen
only the expiry dates. If an investor wants to liquidate his position (i.e., sell if they have bought
already or vice versa), however they can do so on any trading day before the last trading day, which
has been defined above. All investors with an open short position as of the expiry day are assumed
to be delivering the bond on the expiry day, which is two business days after the last trading day.
- Delivery Basket of bonds: As stated earlier, the underlying notional bond may not exist in reality
and therefore, a basket of bonds is identified which qualify for delivery, any one of which can be
used for delivery in lieu of the notional bond. The seller of the futures has the option to choose
which particular bond to deliver. Only certain identified bonds can be used for delivery. The
eligibility criteria for the basket of bonds are:
 They have to be Central Government securities,
 Maturing at least 7.5 years but not more than 15 years from the first day of the delivery
month. The Exchange can decide on any maturity basket within this period.
 With a minimum total outstanding stock of Rs 10,000 crore.
15

19.  Contract Specifications of 91 Days T-Bills
Symbol 91DTB
Market Type N
Instrument Type FUTIRT
Unit of trading One contract denotes 2000 units (Face Value Rs.2 lacs)
Underlying 91-day Government of India (GOI) Treasury Bill
Tick size 0.25 paise i.e. INR 0.0025
Trading hours Monday to Friday
9:00 a.m. to 5:00 p.m.
Contract trading 3 serial monthly contracts followed by 3 quarterly contracts of the cycle
cycle March/June/September/December
Last trading day Last Wednesday of the expiry month at 1.00 pm
In case last Wednesday of the month is a designated holiday, the expiry day
would be the previous working day
Price Quotation 100 minus futures discount yield
e.g. for a futures discount yield of 5% p.a. the quote shall be 100 - 5 = Rs 95
Contract Value Rs 2000 * (100 - 0.25 * y), where y is the futures discount yield
e.g. for a futures discount yield of 5% p.a. contract value shall be
2000 * (100 - 0.25 * 5)= Rs 197500
Quantity Freeze 7,001 lots or greater
Base price Theoretical price of the first day of the contract
On all other days, quote price corresponding to the daily settlement price of the
contracts
Price operating +/-1 % of the base price
range
Position limits Clients Trading Members
6% of total open interest or Rs.300 15% of the total open interest or
crores whichever is higher Rs.1000 crores whichever is higher
Initial margin SPAN ® (Standard Portfolio Analysis of Risk) based subject to minimum of 0.1 % of
the notional value of the contract on the first day and 0.05 % of the notional
value of the contract thereafter
Extreme loss 0.03 % of the notional value of the contract for all gross open positions
margin
Settlement Daily settlement MTM: T + 1 in cash
Delivery settlement : Last business day of the expiry month.
Daily settlement Mark to Mark (MTM) : T + 1 in cash
Daily settlement Rs (100 - 0.25 * yw) where yw is weighted average futures yield of trades during
price & Value the time limit as prescribed by NSCCL. In the absence of trading in prescribed
time limit, theoretical futures yield shall be considered
Daily Contract Rs 2000 * daily settlement price
Settlement Value
Final Contract Rs 2000 * (100 - 0.25 * yf) where yf is weighted average discount yield obtained
Settlement Value from weekly auction of 91-day T-Bill conducted by RBI on the day of expiry
Mode of settlement Settled in cash in Indian Rupees
16

20.  Contract Specifications of 10 Year GOI Securities
Symbol 10YGS7
Market Type N
Instrument Type FUTIRD
Unit of trading 1 lot - 1 lot is equal to notional bonds of FV Rs.2 lacs
Underlying 10 Year Notional Coupon bearing Government of India (GOI) security.
(Notional Coupon 7% with semi annual compounding.)
Tick size Rs.0.0025
Trading hours Monday to Friday
9:00 a.m. to 5:00 p.m.
Contract trading Four fixed quarterly contracts for entire year ending March, June, September and
cycle December.
Last trading day Two business days prior to the delivery settlement day.
Quantity Freeze 1251 lots or greater
Base price Theoretical price of the 1st day of the contract.
On all other days, DSP of the contract.
Price operating +/-5 % of the base price
range
Position limits Clients Trading Members
6% of total open interest or Rs.300 15% of the total open interest or
crores whichever is higher Rs.1000 crores whichever is higher
Initial margin SPAN Based Margin
Extreme loss 0.3% of the value of the gross open positions of the futures contract.
margin
Settlement Daily settlement MTM: T + 1 in cash
Delivery settlement : Last business day of the expiry month.
Daily settlement Closing price or Theoretical price.
price
Mode of settlement Daily Settlement in Cash
Deliverable Grade GOI securities
Securities
Conversion Factor The conversion factor would be equal to the price of the deliverable security (per
rupee of principal) on the first calendar day of the delivery month, to yield 7%
with semi-annual compounding
Invoice Price Daily Settlement price times a conversion factor + Accrued Interest
Delivery day Last business day of the expiry month
Intent to Deliver Two business days prior to the delivery settlement day.
17

21.  Clearing & Settlement
NSCCL carries out the clearing and settlement of the trades executed in the equities and derivatives
segments of the NSE. It operates a well-defined settlement cycle and there are no deviations or
deferments from this cycle. It aggregates trades over a trading period, nets the positions to
determine the liabilities of members and ensures movement of funds and securities to meet
respective liabilities.
 Clearing Members
A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals
executed by Trading Members (TM) on NSE, who clear and settle such deals through them. Primarily,
the CM performs the following functions:
1. Clearing – Computing obligations of all his TM's i.e. determining positions to settle.
2. Settlement - Performing actual settlement. Only funds settlement is allowed at present.
3. Risk Management – Setting position limits based on upfront deposits / margins for each TM.
 Types of Clearing Members
Trading Member Clearing Member (TM-CM)
A Clearing Member who is also a TM. Such CMs may clear and settle their own proprietary
trades, their clients’ trades as well as trades of other TM’s & Custodial Participants
Professional Clearing Member (PCM)
A CM who is not a TM. Typically banks or custodians could become a PCM and clear and
settle for TM’s as well as of the Custodial Participants
 Clearing Member Eligibility Norms
Net worth of at-least Rs.10 crores.
Deposit of Rs. 50 lakhs to NSCCL which forms part of the security deposit of the CM.
 Clearing Banks
NSCCL has empanelled 13 clearing banks namely Axis Bank Ltd., Bank of India, Canara Bank,
Citibank N.A, HDFC Bank, Hongkong & Shanghai Banking Corporation Ltd., ICICI Bank, IDBI Bank,
IndusInd Bank, Kotak Mahindra Bank, Standard Chartered Bank, State Bank of India and Union Bank
of India.
Every Clearing Member is required to maintain and operate clearing accounts with any of the
empanelled clearing banks at the designated clearing bank branches. The clearing accounts are to be
used exclusively for clearing & settlement operations.
 Clearing Mechanism
A Clearing Member's open position is arrived by aggregating the open position of all the Trading
Members (TM) and all custodial participants clearing through him. A TM's open position in turn
includes his proprietary open position and clients’ open positions.
1) Proprietary / Clients’ Open Position
While entering orders on the trading system, TMs are required to identify them as proprietary (if
they are own trades) or client (if entered on behalf of clients) through 'Pro / Cli' indicator provided in
the order entry screen. The proprietary positions are calculated on net basis (buy - sell) and client
positions are calculated on gross of net positions of each client i.e., a buy trade is off-set by a sell
trade and a sell trade is off-set by a buy trade.
2) Open Position
Open position for the proprietary positions are calculated separately from client position.
18

22. Example: For a CM - XYZ, with TMs clearing through him - ABC and PQR
Proprietary Position Client 1 Client 2 Net
Buy Sell Net Buy Sell Net Buy Sell Net Member
TM Security
contract contract contract contract contract contract contract contract contract position
Interest
Rate
ABC 4 2 2 3 1 2 4 2 2 Long 6
September
contract
Interest
Rate Long 1
PQR 2 3 (1) 2 1 1 1 2 (1)
September Short 2
contract
XYZ’s open position for Interest Rate September contract is:
Member Long Position Short Position
ABC 6 0
PQR 1 2
Total for XYZ 7 2
A multilateral netting procedure is adopted to determine the net settlement obligations
(delivery/receipt positions) of the clearing members. Accordingly, a clearing member would have
either pay-in or pay-out obligations for funds and / or securities separately as applicable based on
the type of settlement applicable to specific contracts.
 Settlement Mechanism
Settlement of futures contracts on interest rate
Daily Mark-to-Market Settlement
Delivery Settlement
 Daily Mark-to-Market Settlement
The position in the futures contracts for each member is marked-to-market to the daily
settlement price of the futures contracts at the end of each trade day.
The profits/ losses are computed as the difference between the trade price or the previous day’s
settlement price and the current day’s settlement price. The CMs, who have suffered a loss are
required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who
have made a profit. This is known as daily mark-to-market settlement.
Daily mark to market settlement in respect of admitted deals in Interest rate futures contracts is
cash settled by debit/ credit of the clearing accounts of clearing members with the
respective clearing bank.
All positions (brought forward, created during the day, closed out during the day) of a clearing
member in futures contracts, at the close of trading hours on a day, shall be marked to market at the
daily settlement price and settled on T+1 day basis. The settlement shall be netted with the
settlement of Currency futures.
 Delivery Settlement
Trades in interest rate futures are physically settled by delivery of Govt. securities in the expiry
month. The expiry month of the respective futures contract shall be the delivery month. This is
based on providing of intent to deliver.
19

23.  Intent to Deliver
The owner of a short position in an expiring futures contract is required to provide the intimation
to the Clearing Corporation of his intention to deliver two business days prior to the delivery
settlement day by 6.00 p.m.
The delivery settlement day for Interest Rate Futures contract shall be last business day of the
delivery month.
 Deliverable Securities
The securities which fulfill below mentioned criteria are eligible deliverable grade securities.
GoI securities maturing at least 8 years but not more than 10.5 years from the first day of the
delivery month with.
Minimum total outstanding stock of Rs 10,000 crore.
 Allocation to Long Positions
The Clearing Corporation identifies the eligible long positions for allocation and assigns the
deliveries to long position holders at client level starting with the highest vintage till the allocation is
over. For a given vintage, if the total contracts to be allocated are less than the total long positions,
the allocation to such long position holders shall be done on a ‘random’ basis.
 Obligation for Delivery Settlement
The positions intended and allocated (at client level) for delivery are netted at the clearing
member level and valued at the invoice price. The clearing members are informed of the settlement
obligation by the Clearing Corporation by 8:00 p.m. on the day of intent.
 Settlement Schedule
 Settlement of daily mark to market is carried out on T+1 day basis.
 Final Settlement for futures on 10 year GOI security is carried out on T+2 day basis.
 Final Settlement for futures on 91 day T-Bills is carried out on T+1 day basis.
Members with a funds pay-in obligation are required to have clear funds in their primary clearing
account on or before 8.30 a.m. on the settlement day. The payout of funds is credited to the primary
clearing account of the members thereafter.
 Shortages Handling
 Failure to Deliver Securities
Failure to deliver securities shall result in the following action:
For security short delivered the Clearing Corporation shall conduct a buy-in auction on T+2 day
and the settlement of the auction shall be on T+3 day (where T is the intention day).
The defaulting clearing member shall be debited the invoice price of the security as valuation
debit
In respect of successful auction, the defaulting clearing member shall be debited with the
following.
o The actual auction price (plus accrued interest till auction settlement date)
o Difference in invoice price and auction price if the auction price is less than the invoice price
o A penalty of 2% of the face value of security short delivered which shall be passed on to the
buying clearing member who shall pass it on to the buying client.
Financial close-out shall be effected in the following cases and in the manner detailed under:
o In case of unsuccessful auction, transaction shall be closed out wherein the defaulting clearing
member shall be debited by:
 Invoice price, and
 A penalty of 5% of the face value of security short delivered which shall be passed on to
the passed on to the buying clearing member who shall pass it on to the buying client.
20

24. o In case of seller in an auction failing to honour the auction obligations, the clearing member
shall be debited by:
 Invoice price, and
 A penalty of 3% of the face value of security short delivered which shall be passed on to
the passed on to the buying clearing member who shall pass it on to the buying client.
In case the clearing member fails to deliver securities on five (5) occasions in past six (6) months
then the Clearing Corporation may advise the Exchange to withdraw any or all of the membership
rights of the clearing member including the withdrawal of trading facilities of all trading members
and/ or clearing facility of custodial participants clearing through such clearing members for a
period of seven (7) days.
 Failure to Provide Funds
Non-fulfilment of delivery settlement by the scheduled date and time is treated as a violation.
In case of a settlement shortage of Rs. 5 lakhs or more the Clearing Corporation may advise the
Exchange to withdraw any or all of the membership rights of the clearing member including the
withdrawal of trading facilities of all trading members and/ or clearing facility of custodial
participants clearing through such clearing members and withhold the pay-out due to the clearing
member.
In case of settlement shortage of less than Rs. 5 lakhs the amount of shortage shall be blocked
from the effective deposits of the clearing member to the extent of funds shortage. This may lead to
the withdrawal of the trading facility of the clearing member and the associated trading member.
Further, if the clearing member is short for an amount of Rs 2 lakhs or more in six or more occasions
in the preceding three months, the Clearing Corporation may advise the Exchange to withdraw any
or all of the membership rights of the clearing member including the withdrawal of trading facilities
of all trading members and/ or clearing facility of custodial participants clearing through such
clearing members and withhold the pay-out due to the clearing member.
In case of any over-night settlement shortages penal charges of 0.07% per day of shortage shall
be levied.
 Risk Management
A sound risk management system is integral to an efficient clearing and settlement system. NSE
introduced for the first time in India, risk containment measures that were common internationally
but were absent from the Indian securities markets.
NSCCL has put in place a comprehensive risk management system, which is constantly upgraded
to pre-empt market failures. The Clearing Corporation ensures that trading member obligations are
commensurate with their networth.
Risk containment measures include capital adequacy requirements of members, monitoring of
member performance and track record, stringent margin requirements, position limits based on
capital, online monitoring of member positions and automatic disablement from trading when limits
are breached, etc.
The most critical component of risk containment mechanism for derivatives segment is the
margining system and online position monitoring, which is is carried out on-line through Parallel Risk
Management System (PRISM). PRISM uses SPAN (Standard Portfolio Analysis of Risk). SPAN system is
for the purpose of computation of on-line margins, based on the parameters defined by SEBI.
 Margins
 Initial Margin
Initial margin is payable on all open positions of Clearing Members, upto client level, and on an
upfront basis by Clearing Members in accordance with the margin computation mechanism and/ or
system.
21

25. 1) Span Margin
Initial Margin includes SPAN margins and such other additional margins. Clearing Corporation
adopts the SPAN (Standard Portfolio Analysis of Risk) system for the purpose of real time initial
margin computation. Initial margin requirements are based on 99% value at risk over a one day time
horizon. However, in the case of futures contracts, where it may not be possible to collect mark to
market settlement, before the commencement of trading on the next day, the initial margin is
computed over a two day time horizon by applying an appropriate statistical formula. The
methodology for computation of value at risk percentage is as per the recommendations of SEBI
from time to time.
Initial margin requirement:
1. For client positions – is netted at the level of individual client and grossed across all clients,
at the trading/ clearing member level, without any set-offs between clients.
2. For proprietary positions – is netted at trading/ clearing member level without any set-offs
between client and proprietary positions.
The margins so computed would be aggregated first at the trading member level and then
aggregated at the clearing member level.
Update of Risk Parameters
The risk parameters are updated 6 times in the day, based on the prices/yield at 11:00 a.m.,
12:30 p.m., 2:00 p.m., 3:30 p.m., end of the day and begin of the day. For the purpose of intra-day
update of 10 Year Notional Coupon bearing GOI security futures contract, the yield of the
benchmark 10-Year security as published by FIMMDA, from the NDS Order Matching platform, and
for 91-Day T-Bill Futures the previous day futures closing yield of 91 day GOI T-Bill futures will be
used. Risk parameters generated based on the updated parameters are provided on the exchange
website at (www.nseindia.com). Additional risk parameter file containing Interest Rate Futures and
Currency futures contracts are provided in specific format.
2) Minimum Initial Margin
The minimum initial margin for 10 Year Notional Coupon bearing GOI security futures contract is
2.33% on the first day of Interest Rate Futures trading and 1.6 % thereafter, and for 91-Day T-Bill
futures contracts minimum of 0.1% of the notional value of the futures contract on the first day of
trading and 0.05% of the notional value of the futures contract thereafter (The notional value of the
contract shall be Rs 200000) will be scaled up by look ahead period as may be specified by the
Clearing Corporation from time to time.
3) Calendar Spread Margin for 91 Day T-Bill Futures contract
91 Day T-bills futures position at one maturity hedged by an offsetting position at a different
maturity would be treated as a calendar spread position. Margin of Rs.100/- for spread of one
month, Rs 150/- for spread of two months. Rs 200/- for spread of three months and Rs 250/- for
spread of four months and beyond wiil be levied on such positions.
4) Futures Final Settlement Margin for 91 Day T-Bill Futures contract
Futures Final Settlement Margin is levied at the clearing member level in respect of the final
settlement amount due. The final settlement margin is levied from the last trading day of the
contract till the completion of pay-in towards the Final Settlement.
5) Delivery margins for 10 Year Notional Coupon bearing GOI security futures contract
Once the positions are intended for delivery and allocation has been done, the following margins are
levied
22

26. 1. Margin equal to VaR on the futures contract on the invoice price plus 5% on the face value
of the security to be delivered
2. Mark to market loss based on the underlying closing price of the security intended for
delivery.
The above margins are levied on both buyer and seller at a client level and aggregated at
clearing member level. The margins are levied from the intention day and released on completion of
the settlement. Positions for which EPI of securities is made are exempt from delivery margins.
6) Non-Intent Margins for 10 Year Notional Coupon bearing GOI security futures contract
In cases where the positions are open at end of last trading day and no intention to deliver has
been received, the following margins are levied.
1. Margin equal to VaR on the futures contract on the invoice price of the costliest to deliver
security from the deliverable basket plus 5% on the face value of the open positions
2. Mark to market loss based on the underlying closing price of the costliest to deliver security
from the deliverable basket.
The above margins are levied on both buyer and seller at a client level and aggregated at
clearing member level. The margins are levied from the last trading day till the day of receipt of
intention to deliver, following which the margins on delivery positions are levied.
 Extreme Loss Margin
Clearing members would be subjected to extreme loss margins in addition to initial margins. The
applicable extreme loss margin would for 10 Year Notional Coupon bearing GOI security futures
contract would be 0.3% of the value of the gross open positions of the futures contract and for 91-
Day T-Bill Futures contracts will be 0.03% of the notional value (Rs 200000) of the contract for all
gross open positions of the futures contract or as may be specified by the relevant authority from
time to time.
In case of calendar spread positions in 91-Day GOI T-bill futures extreme loss margin will be
0.01% of the notional value (Rs 200000) of the far month contract. The relevant authority may
specify levy of normal margins on calendar spread positions from time to time.
Extreme Loss margin requirement are computed as under:
1. For client positions - are netted at the level of individual client and grossed across all clients,
at the trading/ clearing member level, without any set-offs between clients.
2. For proprietary positions - are netted at trading/ clearing member level without any set-offs
between client and proprietary positions.
The margins so computed are aggregated first at the trading member level and then aggregated
at the clearing member level.
 Imposition of Additional Margins
As a risk containment measure, the Clearing Corporation may require clearing members to make
payment of additional margins as may be decided from time to time. This is in addition to the initial
margin and extreme loss margin, which are or may have been imposed from time to time.
 Payment of Margins
The initial margin and extreme loss margins are payable upfront by the clearing members.
Members are required to collect initial margins and extreme loss margins from their
client/constituents on an upfront basis. It is mandatory for all clearing /trading members to report
details of such margins collected to the Clearing Corporation as per the current procedure for
23

27. reporting of client margins. Clearing Corporation may levy penalty for non/short reporting/collection
of margins as may be specified from time to time.
 Mode of Payment of Margin
Clearing members are required to provide for margin in any one or more of the eligible collateral
modes as currently applicable for Currency Futures. The margins are collected /adjusted from the
liquid assets of the member on a real time basis.
 Effect of Failure to Pay Margins
Non-fulfilment of either the whole or part of the margin obligations are treated as a violation of
the Rules, Bye-Laws and Regulations of the Clearing Corporation. The violation attracts actions as
currently applicable in Currency Derivatives Segment.
 Position Limits
Clearing Members are subject to the following position limits in addition to initial margins
requirements.
Trading Memberwise Position Limit
Client Level Position Limits
FII/NRI position limits
 Trading Memberwise Position Limit
10 Year Notional Coupon bearing GOI security Futures
The gross open positions of the trading member across all contracts should not exceed 15% of
the total open interest or Rs.1000 crores whichever is higher.
91-Day T-Bill Futures
The gross open positions of the trading member across all contracts should not exceed 15% of
the total open interest or Rs.1000 crores whichever is higher.
 Client Level Position Limits
10 Year Notional Coupon bearing GOI security Futures
The gross open positions of the client across all contracts should not exceed 6% of the total
open interest or Rs.300 crores whichever is higher.
91-Day T-Bill Futures
The gross open positions of the client across all contracts should not exceed 6% of the total
open interest or Rs.300 crores whichever is higher.
The client level gross open position would be computed on the basis of PAN across all
members. Wherever the prescribed limits are crossed, alerts would be disseminated to the
respective Trading Members or Clearing Members through UCI-Online application.
 FII/NRI Position limits
10 Year Notional Coupon bearing GOI security Futures
Total gross long position in the debt market and the Interest Rate Futures would not exceed
the maximum permissible debt market limit prescribed from time to time. Short position in
Interest Rate Futures would not exceed long position in the debt market and in Interest Rate
Futures.
91-Day T-Bill Futures
In case of Foreign Institutional Investors, registered with Securities and Exchange Board of
India, the total gross long (bought) position in cash and Interest Rate Futures markets taken
together should not exceed their individual permissible limit for investment in government
securities and the total gross short (sold) position, for the purpose of hedging only, should not
exceed their long position in the government securities and in Interest Rate Futures, at any
point in time.
24

28. Client and Trading Member level position limits applicable for the next trading day are
available to members on the Exchange website (www.nseindia.com).
 Interest Rate Futures (IRF) and Market Participants
The financial sector, corporate and even households are affected by interest rate risk. Interest rate
fluctuations impact portfolios of banks, insurance companies, primary dealers, provident funds etc.
Households with loans to pay off are affected by a rise in rates. Interest rates are linked to a variety
of economic conditions. They can change rapidly, impacting investments and debt obligations.
Interest rate risk can be minimized through the use of interest rate futures.
 Major Market Participants
Banks and Primary Dealers
Mutual Funds and Insurance Companies
Corporate houses and Financial Institutions
FIIs
Member Brokers and Retail Investors
 Uses of IRF for Market Participants
Banks and Interest Rate Futures
 Managing duration gap with respect to change in interest rates.
 Protecting against the devaluation of G-sec in AFS (Available for Sale) and HFT (High Frequency
Trading) portfolios.
 Hedging against re-pricing risk related to volatility of cash flows due to revaluation of assets
and liabilities over a period of time.
 Mitigating Basis risk when yield on assets and costs on liabilities are based on different
benchmarks.
Primary Dealers and Interest Rate Futures
 Underwriting of primary issues is carried out by the primary dealers, who also enable market
making for government securities. Interest Rate Futures can be used to minimize the risk due
to volatility of interest rate when primary dealers are exposed to meeting their underwriting
commitment.
 With increasing government borrowings, the pressure on primary dealers to adhere to
obligations is enormous. IRF will help to minimize the securities portfolio risk.
Mutual Funds, Insurance Companies and Interest Rate Futures
 It can mitigate interest rate risk arising out of huge exposure to government securities and
corporate debt.
 Optimizing the portfolio returns.
 IRF can provide another avenue to mutual funds for improving investment income by
arbitrage between cash and futures markets of the debt segment, as well as through spread
trading strategies.
 Maximizing the return on investments of insurance companies in interest bearing securities,
thereby minimizing the actuarial risk for the insurance company.
25

29. Corporate Houses and Interest Rate Futures
 Companies can reduce their borrowing cost by using IRF to manage company’s exposure to
interest rate movement.
 By using IRF to manage interest rate risk companies can optimize the cost of capital to
company leading to optimal “debt-equity” ratio.
 Improve the credit rating for a corporate by enhancing the debt-service coverage ratio and the
interest coverage ratio by better risk management using IRF.
 Corporate can convert their fixed rate borrowing to floating if view is of a falling yield.
FIIs and Interest Rate Futures
 Hedging against underlying GOI securities portfolio.
 FIIs having a view on long term interest rate could benefit by participating in new asset class.
Member brokers, Retail investors and Interest Rate Futures
 Brokers can use IRF for generating income by arbitrage between cash and futures market of
the debt segment.
 With increased market participation in Interest Rate Futures member brokers can earn
additional income in the form of brokerage fee charged to clients.
 Portfolio management services to retail and corporate clients who are already trading in
equity and currency can be extended with introduction of IRF.
 Small lot size provides retail investors to hedge their interest rate payment on home loans to
protect against rising interest rates.
 Key Benefits of Interest Rate Futures
 Directional Trading
As there is an inverse relationship between interest rate movement and underlying bond prices,
the futures price also moves in tandem with the underlying bond prices. If one has a strong view that
interest rates will rise in the near future and wants to benefit from rise in interest rates; one can do
so by taking short position in IRF contracts on NSE and benefit from the falling futures price.
Example:
A trader expects a long term interest rate to rise. He decides to sell Interest Rate Futures contracts
as he shall benefit from falling future prices.
Expectation Position
Interest rates increase Short Future
Interest rates decrease Long Future
• Trade Date - 5th Oct, 2011
• Futures Delivery date - 1st Dec, 2011
• Current Futures Price - Rs 93.50
• Futures Yield - 7.36%
• Trader sell 250 contracts of the Dec 11-12 Year futures contract on NSE on 5th Oct, 2011 at Rs
93.50.
26

30. Daily MTM due to change in futures price is as tabulated below:
Date Daily settlement price* calculation MTM (Rs)
(Rs)
5-Oct-11 93.6925 250*2000*(93.5000-93.6925) -96250.00
6-Oct-11 93.4625 250*2000*(93.6925-93.4625) 115000.00
7-Oct-11 93.4575 250*2000*(93.4625-93.4575) 2500.00
8-Oct-11 93.1275 250*2000*(93.4575-93.1275) 165000.00
* Daily Settlement price shall be the weighted average price of the trades in the last ½ hour of
trading.
Net MTM gain as on 8th Oct, 2011 is Rs 1,86,250 (I).
Closing out the Position
• 9th Oct 2011 - Futures market Price – Rs 93.1125
• Trader buys 250 contracts of Dec 11 at Rs 93.1125 and squares off his position
• Therefore total profit for trader 250*2000*(93.1275-93.1125) is Rs 7,500 (II)
• Total Profit on the trade = Rs 1,93,750 (I & II)
 Portfolio Hedging
Holders of the GOI securities are exposed to the risk of rising interest rates which in turn results
in the reduction in the value of their portfolio. So in order to protect against a fall in the value of
their portfolio due to falling bond prices, they can take short position in IRF contracts on NSE.
A bank has a large portfolio of GOI securities worth Rs 25 crores. Bank’s portfolio consists of
bonds with different coupons and different maturities. In view of rising interest rates in the near
term, the treasury head is concerned about the negative effect this will have on the bank’s portfolio.
The treasury head wants to hold his entire portfolio and at the same time doesn’t want to suffer
losses on account of fall in bond prices.
The treasury head decides to hedge the interest rate risk by taking a short position in the Interest
Rate Futures on NSE.
Example:
Date: 05-Oct-2009
Spot price of GOI Security: Rs 98.0575
Futures price of IRF Contract: Rs 93.7925
On 05-Oct-2009, XYZ bought 2000 GOI securities from spot market at Rs 98.0575. He anticipates that
the interest rate will rise in near future. Therefore to hedge the exposure in underlying market he
may sell Dec 09 Interest Rate Futures contracts at Rs 93.7925.
On 16-Nov-2009 due to increase in interest rate:
Spot price of GOI Security: Rs 97.2500
Futures Price of IRF Contract: Rs 93.1500
Loss in underlying market will be (97.2500 - 98.0575)*2000 = Rs 1615
Profit in the Futures market will be (93.7925 – 93.1500)*2000 = Rs 1285
27

31.  Calendar Spread Trading
A Calendar Spread, also known as an Inter-delivery Spread, is the simultaneous purchase of one
delivery month of a given futures contract and the sale of another delivery month of the same
underlying on the same exchange. This type of spread is called a "calendar spread" because it is
based on different calendar months.
For instance, buying a September 09 contract and simultaneously selling a December 09 contract.
A market participant can profit (or lose out) as the price difference between the two contracts
widens or narrows.
Example:
A long & short position in different futures contracts on the same underlying is called as a calendar
spread. A Long position in a Dec 09 IRF contract versus a Short position in the Mar 10 IRF contract on
NSE is considered a calendar spread.
Since a calendar spread entails only the basis risk, the bank runs little risk on the positions.
Trade Date : 5th Oct ’09
Dec ’09 Futures (Rs): 93.3600 – 93.3800
Mar ’10 Futures (Rs): 91.9700 – 92.0200
The difference between the Dec 09 & Mar 10 contracts is currently Rs. 1.41 (after considering bid-
ask).
If the trader believes that this spread is very high, he would execute a calendar spread by
- Selling the Mar 10 futures at 91.9700
- Buying the Dec 09 futures at 93.3800
10 days later
Trade Date : 15th Oct ’09
Dec ’09 Futures (Rs): 93.0050 – 93.0250
Mar ’10 Futures (Rs): 91.3000 – 91.3700
The difference between the Dec 09 & Mar 10 contracts is now Rs 1.6350 (after considering bid-ask).
The trader may decide to liquidate his calendar spread trade by
- Buying the Mar 10 futures at 91.3700 (Profit 0.60)
- Selling the Dec 09 futures at 93.0050 (Loss 0.38)
Net profit of Rs 0.22 without running any interest rate risk.
 Reduce the Duration of Portfolio
As the bonds with longer maturities are more sensitive to interest rate changes, bond portfolio
with longer duration will be more exposed to the vulnerability of the movement in interest rate.
A Portfolio manager who is concerned about the rise in short term interest rate risk would like to
reduce the duration of the portfolio. By entering into an IRF contract on NSE, the portfolio manager
can reduce duration of the portfolio.
The below formula denotes the approximate number of contracts which needs to be entered into
to achieve the desired duration.
(DT - Dt) X Pt
Approximate Number of Contracts = X Conversion Factor of CTD Bond
DCTD X PCTD
28

32. DT = Target duration of portfolio
Dt = Initial duration of portfolio
Pt = Initial market value of portfolio
DCTD = The duration of cheapest to deliver bond
PCTD = The value of cheapest to deliver Bond (Price * contract multiplier)
 Arbitraging between Cash and Futures Market
Arbitrage is the price difference between the bonds prices in underlying bond market and IRF
contract without any view about the interest rate movement.
One can earn the risk-less profit from realizing arbitrage opportunity and entering into the IRF
contract traded on NSE by initiating cash and carry trade involving the following steps:
 Purchase the cheapest to deliver bond
 Take short position in IRF contract
 Finance the bond purchase at the current borrowing rate from the market.
 Give the intention of delivery to the exchange
 Deliver the bond and receive the invoice price.
 Repay the cash amount borrowed to purchase the bond.
The price differential in the underlying bond market and the future market can also provide
opportunities to arbitragers. If the futures are expensive compared to the underlying, then the
arbitrager can make profit by taking long position in underlying market by borrowing funds and
taking short positions in the future market.
Example:
On 15th Oct, 09 buy 6.35% GOI ’20 at the current market price of Rs 97.2550 and conversion factor
is 0.9815.
Step 1 - Short the Dec 09 futures at the current price of Rs 100.00 (7.00% Yield)
Step 2 - Fund the bond by borrowing up to the delivery period (assuming borrowing rate is 4.25%)
Step 3 - On 1st Dec ’09, give a notice of delivery to the exchange
Assuming the futures settlement price of Rs. 100.00, the invoice price would be
= 100 * 0.9815
= Rs 98.15
Under the strategy, the bank has earned a return of
= (98.1500 – 97.2550) / 97.2550 * 365 / 49
= 6.86 % (implied repo rate)
(Note: For simplicity accrued interest is not considered for calculation)
Against its funding cost of 4.25% (borrowing rate), thereby earning risk free arbitrage.
The bond with the highest implied repo rate would be the cheapest to deliver (CTD) bond.
The arbitrager would identify the bond with the highest implied repo rate or the CTD bond and
execute the strategy with the same bond, depending on its availability in the secondary market.
29

33.  Impediments to Growth of Bond futures market in India
There are certain hindrances to the development of bond futures market in India and these need to
be addressed by RBI. Some of them are listed below.
 Patchy Liquidity
One very important condition in India is the patchy liquidity of Indian Government Securities (G-
Secs). They show trading in some securities in different time periods. One reason for this is the major
holding by banks due to the Statutory Liquidity Requirement.
If we consider the 10 year note futures contract, which might be deliverable in June 2008 (shown in
Exhibit 3), considering the deliverable grade as 7.5 years to 15 years, a patchy basket is observed.
This is a very wide range for a 10-year futures contract. This has led to a considerably big basket. The
major liquidity lies in the two bonds - 7.49% and the 7.99% coupons. Hence, apparently there is a
huge possibility of squeeze in such a scenario.
If we remove the bonds having a very small amount of outstanding, most of the bonds would be
removed from the eligible basket. Then bonds like the 7.49% and 7.99% would mostly comprise the
liquid basket. The RBI has therefore recommended that a requirement like Rs. 20,000 crore
outstanding for the bond be imposed.
Bond Liquidity (Avg. Daily Vol. for 12 months) (Rs Million)
5.59% 2016 30.00
12.3% 2016 -
8.07% 2017 2662.5
7.49% 2017 12215.83
7.99% 2017 19594.73
7.46% 2017 23.38
6.25% 2018 57.33
8.24% 2018 Hot run
10.45% 2018 -
5.69% 2018 103.13
12.6% 2018 4.78
5.64% 2019 25.87
6.05% 2019 -
10.03% 2019 -
 Further Imbalance of Liquidity
We can easily see that the liquidity in G-Secs is very varied. When the 10-year futures contract
comes into the market, it could lead to liquidity of bonds in the basket having a little less than 7.5
year of maturity or more than 15 years of maturity to shift towards this active basket. Although the
liquidity in the spot market is bound to increase due to the futures market, it could cause some
bonds to suddenly lose their liquidity. This is an apparent risk which banks run, as they hold
considerable amount of the G-Secs.
The role of liquidity (which is defined as low transactions costs) is in making arbitrage cheap and
convenient. If transactions costs are low, then the smallest mispricing on the derivatives market will
be removed by arbitrageurs, which will make the derivatives market more efficient.
30

34.  Latest Developments in Bond market
Steps are being taken to introduce new types of instruments like STRIPS (Separate Trading of
Registered Interest and Principal of Securities). Accordingly, guidelines for stripping and
reconstitution of Government securities have been issued.
STRIPS are instruments wherein each cash flow of the fixed coupon security is converted into a
separate tradable Zero Coupon Bond and traded. For example, when Rs.100 of the 8.24%GS2018 is
stripped, each cash flow of coupon (Rs.4.12 each half year) will become coupon STRIP and the
principal payment (Rs.100 at maturity) will become a principal STRIP. These cash flows are traded
separately as independent securities in the secondary market. STRIPS in Government securities will
ensure availability of sovereign zero coupon bonds, which will facilitate the development of a market
determined zero coupon yield curve (ZCYC).
STRIPS will also provide institutional investors with an additional instrument for their asset- liability
management. Further, as STRIPS have zero reinvestment risk, being zero coupon bonds, they can be
attractive to retail/non-institutional investors. The process of stripping/reconstitution of
Government securities is carried out at RBI, Public Debt Office (PDO) in the PDO-NDS (Negotiated
Dealing System) at the option of the holder at any time from the date of issuance of a Government
security till its maturity. All dated Government securities, other than floating rate bonds, having
coupon payment dates on 2nd January and 2nd July, irrespective of the year of maturity are eligible
for Stripping/Reconstitution. Eligible Government securities held in the Subsidiary General Leger
(SGL)/Constituent Subsidiary General Ledger (CSGL) accounts maintained at the PDO, RBI, Mumbai.
Physical securities shall not be eligible for stripping/reconstitution. Minimum amount of securities
that needs to be submitted for stripping/reconstitution will be Rs. 1 crore (Face Value) and multiples
thereof.
31