Strategies using Exchange Traded Interest Rate Derivatives

Chapter 5: Strategies using Exchange Traded Interest Rate Derivatives

NISM Series IV — Interest Rate Derivatives | ~15% weightage | ~60 questions

What this chapter is about

How to use IRD futures and options to hedge, speculate, and arbitrage. Three core hedging strategies: short hedge, long hedge, and portfolio hedging using duration. The duration-based hedge ratio is unique to IRDs and heavily tested. Calendar spreads and inter-bond spreads round out the chapter.

Short Hedge — protect against rising interest rates

Who uses it: Anyone holding a fixed income security (bond portfolio, bank with loan book) who fears rates will rise → bond prices fall.

Action: SELL G-Sec bond futures (short position)

Why it works: If rates rise, bond prices fall. Short futures position profits as futures prices fall too, offsetting the loss on the bond portfolio.

Formula for hedging a bond position:

Number of contracts = (Portfolio MD × Portfolio Value) / (Futures MD × Futures price per contract)

Or more commonly:

Hedge ratio = (Change in portfolio value for 1bp) / (Change in futures value for 1bp)
            = Portfolio PVBP / Futures PVBP

Example: If a bank holds Rs 10 crore in bonds with MD = 7, and futures MD = 6, futures price = Rs 2 lakhs:

N = (7 × 10,00,00,000) / (6 × 2,00,000) = 583 contracts (approximately)

Long Hedge — protect against falling interest rates

Who uses it: Anyone planning to invest money in the future and fears rates will fall → bond prices rise → will have to pay more.

Action: BUY G-Sec bond futures (long position)

Example: A fund expects to receive Rs 5 crore in 3 months and plans to invest in bonds. It fears rates will fall (bonds get more expensive). Buy futures now — if rates fall, futures profit offsets the higher price paid for bonds.

Insurance companies: Permitted for long hedge ONLY.

Portfolio hedging using Duration

Duration-based hedge ratio = the standard approach for hedging a portfolio of multiple bonds.

Number of contracts to sell = (Target MD − Current MD) × Portfolio value / (Futures MD × Futures price)

To reduce duration of portfolio (short hedge): Target MD < Current MD → negative number = SELL contracts

To increase duration of portfolio (long hedge): Target MD > Current MD → positive number = BUY contracts

Example: Portfolio = Rs 10 crore, Current MD = 6, Target MD = 0 (fully hedged), Futures MD = 5, Futures price = 2L:

N = (0 − 6) × 10,00,00,000 / (5 × 2,00,000) = −600 contracts → SELL 600 contracts

Arbitrage strategies

Cash-and-carry arbitrage (when futures overpriced):

• Buy bond in cash market + sell bond futures simultaneously
• Profit = Futures price − (Cash price + Financing cost − Coupon income)

Reverse arbitrage (when futures underpriced):

• Sell bond in cash market + buy bond futures simultaneously
• Profit = (Cash price + Financing cost − Coupon income) − Futures price

Exchange vs OTC arbitrage: Buy in one market, sell in other to exploit price difference.

Calendar spread

Definition: Buy one month contract + sell different month contract on the SAME underlying and SAME quantity.

Also called: Time spread, horizontal spread.

Inter-commodity spread: Buy futures on one underlying + sell futures on different underlying, SAME quantity, SAME expiry month. Example: Buy March T-bill futures + sell March 10Y G-Sec futures.

Key difference from currency: IRD calendar spread = same underlying, different expiry.

Margin treatment: Calendar spreads have LOWER margin than outright positions because both contracts move in similar direction → lower net risk.

Speculation using IRDs

Speculating on LEVEL of interest rates:

• Expect rates to FALL → Buy bond futures (profit as bond prices rise)
• Expect rates to RISE → Sell bond futures (profit as bond prices fall)

Speculating on TIMING of rate change:

• Expect 3M rate to change in 1M → Use 1M expiry contract on 3M rate sensitive instrument
• Match EXPIRY DATE to WHEN rate change expected
• Match UNDERLYING to WHICH rate/tenor you're targeting

Converting floating to fixed = HEDGING (not speculation) Converting fixed to floating (expecting rates to fall) = SPECULATION

Fixed income hedging for banks and institutions

Bank asset-liability management:

• Fixed rate loans: No interest rate risk for borrower (rate locked)
• Floating rate loans: Risk for borrower — rates may rise
• Bank's risk: Borrow short-term (deposits), lend long-term (loans) → rising rates squeeze margin

Short-selling G-Sec futures:

• Banks and Primary Dealers: can do naked short sell (need prior RBI permission for PDs)
• Others: short sell only for hedging

Trap Alert

Trap 1: "Long hedge = selling futures" — FALSE Long hedge = BUYING futures. Short hedge = SELLING futures.

Trap 2: "Holding fixed rate loan = exposed to interest rate risk" — FALSE Fixed rate = NO interest rate risk. Floating rate = YES.

Trap 3: "Calendar spread = different underlyings, same expiry" — FALSE Calendar spread = same underlying, DIFFERENT expiry. Inter-commodity spread = different underlyings, same expiry.

Trap 4: "Calendar spreads have higher margin than outright" — FALSE Calendar spreads have LOWER margin (less risk because both legs move together).

Trap 5: "Converting floating to fixed is speculation" — FALSE Converting floating → fixed = HEDGING. Converting fixed → floating (expecting fall) = SPECULATION.

Must-remember rules

• Short hedge: SELL futures → protect against rising rates (bond prices falling)
• Long hedge: BUY futures → protect against falling rates (bond prices rising)
• Duration-based hedge ratio = standard for bond portfolio hedging
• Hedge ratio = Portfolio PVBP / Futures PVBP
• Insurance companies = long hedge only (not short)
• PDs need prior RBI permission for naked short sell of G-Sec futures
• Calendar spread = same underlying, different expiry, same quantity, opposite positions
• Inter-commodity spread = different underlyings, same expiry, same quantity
• Calendar spread margin < outright position margin
• Arbitrage: overpriced futures = buy cash, sell futures | underpriced = sell cash, buy futures
• Reverse arbitrage = sell cash market, buy futures (when futures underpriced)
• Fixed rate loan = no IR risk | Floating rate = yes IR risk

Quick revision — 60 second scan

• Short hedge: sell futures (fear rate rise) | Long hedge: buy futures (fear rate fall)
• Insurance: long hedge only
• Duration hedge: (Target MD − Current MD) × Portfolio value / (Futures MD × Futures price)
• Calendar spread: same underlying, different expiry | Inter-commodity: different underlying, same expiry
• Calendar spread margin < outright
• Arbitrage: buy cheap, sell expensive simultaneously
• Reverse arbitrage: sell cash, buy futures (futures underpriced)
• Fixed rate = no IR risk | Floating rate = IR risk
• Speculation: expect rate fall → buy futures | Expect rate rise → sell futures