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