Posts Tagged ‘bond portfolio’

Interest Rate Futures Section – Final Part :)

Interest Rate Futures Section Final Part

Interest Rate Futures Section Final Part

Hello Friends, we are here with the Final Part of our Interest Rate Futures educational section.
We would touch upon the benefits of the Interest Rate Futures and the future scenario related to it.

Here we go :

Key benefits of Interest Rate Futures:

Directional trading

As there is an inverse relationship between interest rate movement and underlying bond prices, so if one has strong view that the interest rates will rise in near future then he can take short position in IRF contracts and can be benefited from the falling futures bond prices.

Hedging portfolio

The holders of the GOI securities are exposed to risk of rising interest rates which in turn results in the reduction in the value of the portfolio.

So in order to protect against a fall in the value of the portfolio they can take short position in IRF.

Calendar spread trading

This spread is also known as an inter-delivery spread.

It 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.

For example:

Buying a September 09 and simultaneously selling a December 09 contract.
A market participant can profit as the price difference between the two contracts widens.

The either case can also be possible.

Reduce the duration of portfolio:

Bonds with longer maturities are more sensitive to interest rate changes, and bond portfolio with longer duration will be more exposed to the vulnerability of the movement in interest rate.

So portfolio manager who is concerned about the rise in the short term interest rate risk would like to reduce the duration of the portfolio.

By entering into the IRF contract to NSE, the portfolio manager can reduce duration of the portfolio.

Arbitraging between cash and futures market:

Arbitrage is the price difference between the bond 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.

Responses After launch:

After the launch of currency futures in August 2008, Interest-rate futures are the first major product to be introduced in India.

The interest rate futures began on August 31,2009 clocking trading volumes of Rs 276 crore in their first day of trade.

Market participants responded passionately to the product launch on the first day.

In around five hours of trading time available after inauguration, 1,475 trades were recorded resulting in 14,559 contracts being traded at a total value of Rs 267.31 crore.

In the beginning only two quarters has been introduced out of four, among which December 2009 was the most active with 13,789 contracts which has been traded actively.

There are nearly 638 members registered for this new product, out of which 21 are banks and there contribution to the total gross volume was 32.48 percent.

Future scenario:

BSE had received regulatory approval for interest rates futures and would launch in 8-10 weeks.

The Multi Commodity Exchange’s foreign exchange derivatives bourse has sought permission to launch trade in interest rate futures.

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However, For More latest Industry, Gyan, Stock Market and Economy News Updates, Click Here

Factors that Move the Interest Rates – Part 2 (MONETARY POLICY)

Monetary Policy

In previous Blog we have discussed about the major factors responsible for the change in interest rates and price of bonds indirectly.

All those three factors like Inflation, Currency and Liquidity have been touched upon in last blog.

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Now time to look into another major factor which causesΒ  movement in the interest rate. The factor i am talking about is Monetary Policy. πŸ™‚

Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI.

Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements.

If either of these is increased, liquidity tightens and so interest rates harden (increase).:(

Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

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(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs.

A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

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(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks.

To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

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(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities.

When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates.

When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates.

MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI.

This affects interest rates in the same manner as OMOs.

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Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in.

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If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future.

On the contrary, an expectation of a fall in interest rates means bond prices will rise.

A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above.

So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.

πŸ™‚

4 Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI. Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements. If either of these is increased, liquidity tightens and so interest rates harden (increase). Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs. A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities. When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates. When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates. MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI. This affects interest rates in the same manner as OMOs.

Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in. If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future. On the contrary, an expectation of a fall in interest rates means bond prices will rise. A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above. So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.

Factors that Move the Interest Rates – Part 1:)

Interest rates

In earlier blog we have discussed about how Bonds are different than equities and why are they considered less risky instruments. πŸ™‚

Now coming on to this blog, we would talk about the 3 major factors (other than monetary policy) which moves the interest ratesΒ  and ultimately causes a price change in the Bonds.

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To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates.

This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

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1. Inflation:

Interest rates are directly related to inflation i.e. if inflation rises, so do interest rates.

This is because lenders demand higher interest rates to compensate for the decrease in purchasing power of the money they will be repaid in the future.

This causes bond prices to fall, since bond prices are inversely related to interest rates.

Inflation itself is affected by the economy’s currency and liquidity position.

In India, inflation is measured by WPI (Wholesale Price Index), for which is released every week.

For the week ended July 25, 2009, WPI was at (-) 1.58%. This may lead one to assume that inflation has gone down, but the reason for this low figure is a high base effect from 2008, when WPI showed doubledigit growth.

Current CPI (Consumer Price Inflation) figures are in the range of 8.6-11.5% for May-June 2009.

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2. Currency: A weaker rupee causes rising inflation, which in turn results in a rise in interest rates.

This is because one’s purchasing power reduces – if one was paying $60 or Rs.2400 (Rs.40=$1) to buy 1 barrel of crude oil, a weaker rupee (Rs.45=$1) means the same 1 barrel will now cost Rs.2700 i.e. Rs.300 more.

Similarly, a stronger rupee increases one’s purchasing power and brings down inflation, causing interest rates to fall.

The latter scenario is seen as a positive for the bond market, since it leads to rising bond prices.

Since 2008, the rupee has weakened significantly to Rs.47- 48 in July-August ’09.

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3. Liquidity: Interest rates are directly related to liquidity.

A crunch in liquidity means money is not readily available, since people are not willing to part with their cash.

A lower interest rate is then offered, which increases the price of already existing bonds in the market. The vice-versa also holds true.

One way of measuring the liquidity present in the system is to check the money supply measure – M3.

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There is another factor which is responsible for the movement in interest rates that is Monetray Policy which we would discuss in next blog

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To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates. This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

Bonds… Less Risky Instruments :)

bonds risk

Bonds are considered to be less risky instruments to invest in as compared to equity.

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Therefore, it is usually the risk averse investors who trade in bonds.

But, not everyone is aware of the fact that bonds too come with their own set of risks- interest rate risk being one of the most significant ones.

It is the risk associated with interest rate changing, and this causes a movement in the price of bonds.

😦

The following is the relationship between the two – prices of bonds are inversely related to their yield.

Yield is the implied interest offered by a security over its life, given its current market price.

Therefore, a rise in interest rates decreases the price of the bond, leaving the investor trading in bonds to incur losses.

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The rationale behind this can be understood with an example.

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Assume a bond of face value Rs.100 that offers a 7% coupon. Now, another Rs.100 bond comes out in the market, which offers a higher 8% coupon.

If the investor holding the 7% coupon tries selling it, he will not be able to sell it at its face value, since a more attractive coupon-bearing bond is available in the market at present.

Therefore, he will have to settle for a lower market price, say Rs.99. This is how prices are inversely related to yields, and this very relationship forms the basis for interest rate risk.

πŸ™‚

To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates.

We would discuss the factors responsible for moving interest rates in our next Blog.

πŸ™‚

This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

πŸ™‚

Bonds are considered to be less risky instruments to invest in as compared to equity. Therefore, it is usually the riskaverse investors who trade in bonds. But, not everyone is aware of the fact that bonds too come with their own set of risks- interest rate risk being one of the most significant ones. It is the risk associated with interest rate changing, and this causes a movement in the price of bonds.

The following is the relationship between the two – prices of bonds are inversely related to their yield.

Yield is the implied interest offered by a security over its life, given its current market price. Therefore, a rise in interest rates decreases the price of the bond, leaving the investor trading in bonds to incur losses. The rationale behind this can be understood with an example. Assume a bond of face value Rs.100 that offers a 7% coupon. Now, another Rs.100 bond comes out in the market, which offers a higher 8% coupon. If the investor holding the 7% coupon tries selling it, he will not be able to sell it at its face value, since a more attractive coupon-bearing bond is available in the market at present. Therefore, he will have to settle for a lower market price, say Rs.99. This is how prices are inversely related to yields, and this very relationship forms the basis for interest rate risk.

To determine where the interest rates are headed, it is important to have an understanding of the factors that move the interest rates. This will in turn help gauge which direction bond prices are going to take, and one can make appropriate adjustments to a bond portfolio in order to maximize gains or minimize losses.

1 Inflation: Interest rates are directly related to inflation i.e. if inflation rises, so do interest rates. This is because lenders demand higher interest rates to compensate for the decrease in purchasing power of the money they will be repaid in the future. This causes bond prices to fall, since bond prices are inversely related to interest rates. Inflation itself is affected by the economy’s currency and liquidity position. In India, inflation is measured by WPI (Wholesale Price Index), for which is released every week. For the week ended July 25, 2009, WPI was at (-) 1.58%. This may lead one to assume that inflation has gone down, but the reason for this low figure is a high base effect from 2008, when WPI showed doubledigit growth. Current CPI (Consumer Price Inflation) figures are in the range of 8.6-11.5% for May-June 2009.

2 Currency: A weaker rupee causes rising inflation, which in turn results in a rise in interest rates. This is because one’s purchasing power reduces – if one was paying $60 or Rs.2400 (Rs.40=$1) to buy 1 barrel of crude oil, a weaker rupee (Rs.45=$1) means the same 1 barrel will now cost Rs.2700 i.e. Rs.300 more. Similarly, a stronger rupee increases one’s purchasing power and brings down inflation, causing interest rates to fall. The latter scenario is seen as a positive for the bond market, since it leads to rising bond prices. Since 2008, the rupee has weakened significantly to Rs.47- 48 in July-August ’09.

3 Liquidity: Interest rates are directly related to liquidity. A crunch in liquidity means money is not readily available, since people are not willing to part with their cash. A lower interest rate is then offered, which increases the price of already existing bonds in the market. The vice-versa also holds true. One way of measuring the liquidity present in the system is to check the money supply measure – M3.

4 Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI. Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements. If either of these is increased, liquidity tightens and so interest rates harden (increase). Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs. A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities. When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates. When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates. MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI. This affects interest rates in the same manner as OMOs.

Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in. If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future. On the contrary, an expectation of a fall in interest rates means bond prices will rise. A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above. So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.