Expressing their view on Interest Rate Futures that is to be launched, Ajay Shah of NIPFP said if contract worked it would help in improving liquidity. While, Rajiv Anand feels the launch would change the dynamics of the debt market.
The Bombay Stock Exchange (BSE), on August 25, 2009 received an approval from the Securities and Exchange Board of India (SEBI) to launch Interest Rate Futures on August 31. Being a complex product the retail of Interest Rate Futures would take some time.
Expressing his view on Interest Rate Futures, Ajay Shah, Senior Fellow at NIPFP said if contract worked it would help in improving liquidity. “I think it fits in the large theme of getting more derivatives contracts, things that you can protect yourself, things where you can take a position.”
Rajiv Anand, MD & CEO, Axis AMC feels the Interest Rate Futures launch would change the dynamics of the debt market and would help in hedging banks. “As this product begins to develop we would be in a position to be able to manage, especially our long-bond portfolios a lot more dynamically, assuming that we are making the right interest rate calls.”
Here is a verbatim transcript of the exclusive interview with Ajay Shah and Rajeev Anand on CNBC-TV18. Also watch the accompanying video
Q: Would you say atleast it is some kind of a beginning to hedge interest rate risk?
Shah: Yes. I think that it is a step forward. As you know, there is already an OTC market where there is interest rate derivatives trading. There is no data but it seems that the offshore activity on the Indian yield curve today is bigger than the onshore activity. So, there is a certain development that has taken place on the OTC side. Now, we are getting an exchange traded product. So, I think it fits in the large theme of getting more derivatives contracts, things that you can protect yourself, things where you can take a position.
Q: There is an OIS market (Overnight Index Swap) as well and that is reasonably liquid. Do you think that people will wean away from that and come to the interest rate futures market nevertheless? Do you see volumes there going down or do you see the entire pie growing?
Anand: I think I see the entire pie growing. While it has taken time for the OIS or the overnight interest rate swap market to develop, especially the benchmark five-year OIS is very liquid, you can get a price, a bit of a spread of somewhere in the vicinity of about 1 or 2 bps. So, yes that is clearly the most liquid market and is actively used by especially the primary dealers and banks.
But I think this is a completely different market and therefore there will be the possibility of you being able to hedge your positions through the futures market and more importantly it will also create arbitrage opportunities between the cash market, the OIS market and the interest rate futures market, which inturn will bring in newer players as well. So, I think it is an interesting development.
Q: You have spoken many times of India just having theoretically one yield curve, so somebody has exposure across various tenures, short-term to long-term and across various bonds. Can you use this tenure as one significant benchmark to hedge most of the positions?
Shah: There are indeed many different interest rates. In a way all interest rates are different. So, if you take a AAA bond then it has its own dynamic. However, I would emphasise that from a hedging point of view, you don’t have to have a perfect hedge for it to be useful.
So, if a hedge will give you a significant risk reduction, it is better than having no risk reduction. So, the analogy, the intuition that I would make is like this. Suppose you are holding a position on the ITC stock, and for whatever reason you get uncomfortable. So, you can have a position that is long ITC plus short Nifty. Now, is the Nifty an exact hedge against ITC? But does it reduce your risk significantly? Yes, it does.
So, I think that is the way to think about it that the 10-year bond is an important source of fluctuation for everything in the interest rate world and so this is a useful product.
Q: You can deliver anything of residual maturity from 7.5-15 years against your December contract. Will this mean that it could increase the liquidity or perhaps give us a better yield curve because the tendency of a hedger or of a trader would be to buy the one where the yield is the highest or the price is the lowest? Do you see that creating liquidity or do you see that creating a problem?
Shah: There is a delicate balance that you want the range of products, the range of bonds that can be delivered to be a bit narrow because you don’t want too much uncertainty in what will be delivered. But it is also true that if the contract works then yes it is only a positive. It will improve the arbitrage, it will improve the pricing, it will reduce the liquidity premia, it will improve liquidity. So, there are lots of things that happen that are good if the contract succeeds. But we have to see whether this will really work.
Q: You have been guiding mutual funds especially the fixed interest side for quite some time now. What is your hunch? Will you as a mutual fund manager use this product?
Anand: We would certainly like to use the product. Today, what happens is that from a mutual fund perspective, we actually are able to create positions or products only for a positive interest rate environment. Perhaps as this product begins to develop we would be in a position to be able to manage, especially our long-bond portfolios a lot more dynamically, assuming that we are making the right interest rate calls, such that we would be able to create the capital appreciation in an interest rate environment, which is going up as well as going down. But of course the fact remains that you’ve got to be nimble in this environment.
It also brings up new dynamics. I think as you mentioned there is a whole basket of instruments that you can deliver and that brings about the whole dynamics of the basis risks that one needs to manage. There will be a new level of liquidity into – typically the person would want to deliver what is called the cheapest to deliver security. That inturn will create a fresh level of volatility or liquidity in what is called the cheapest to deliver securities. That inturn brings in fresh plays or trading opportunities into the market.
So, I think, like I said, it is a good development and I think all of us will need to go up the curve very quickly to be able to take advantage of this. But I think the key to success here is that the big players, which are basically the large banks, need to participate actively in this to be able to create an active two-way market.
Q: We move incrementally. So, what can be the incremental changes that you suggest to this product?
Shah: The most important incremental change is you need a short dated interest futures contract as well. You need futures on the MIBOR; you need futures on the 90-day Treasury Bill.
Q: You don’t think the OIS is good enough?
Shah: The OIS will live, it will co-exist. But if you are going to do a futures market, you have to have all three. You’ve got to have call money rate, you’ve got to have the 90-day Treasury Bill and the 10-year bond. All three have to co-exist. Then you really get a futures market that works.
Q: As a person who will use it, everybody is complaining of complications in the conversion factor. Is there anything that you can incrementally request?
Anand: I think I’d like to see not too many impediments to especially the large banks from transacting on the interest rate futures market. I think like I said they are really the key to success and will bring in liquidity into this business.
I think let’s get started. In the same manner that the OIS market really didn’t take off overnight, but it took many years for it to evolve, I am very hopeful that the interest futures market will take off and in a sense change the landscape of the interest rate market in India.
READ MORE ON Securities and Exchange Board of India, Interest Rate Futures, Bombay Stock Exchange, Ajay Shah, NIPFP, Rajiv Anand, Axis AMC
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