**Securities and Exchange Board of India**

**CHIEF GENERAL MANAGER**

**DERIVATIVE CELL**

SEBI/SMDRP/DC/Cir-16/2003/04/19

April 19, 2003

**To,**

**The Managing Director / Executive Director**

**of Derivative Segment of NSE & BSE**

**and their Clearing House / Corporation.**

Dear Sir,

**Sub: Scheme for introduction of Exchange Traded Interest Rate Derivative Contracts**

This circular is being issued in exercise of powers conferred by section 11 (1) of the Securities and Exchange Board of India Act, 1992, read with section 10 of the Securities Contracts(regulation) Act 1956, to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

SEBI, in consultation with the Government and the Reserve Bank of India (RBI) has decided to introduce Exchange Traded Interest Rate Derivative Contracts in the Indian Securities Market. It has also been decided that to begin with futures contracts shall be introduced on a Notional Government Security with a 10 year maturity and a Notional Treasury Bill with a maturity of 91 days or three months.

SEBI Group on Secondary Market Risk Management (RMG) considered the specification of the initial set of interest rate derivative contracts to be introduced and the risk containment measures to be adopted for such derivative contracts. The recommendations of the RMG were a part of a ‘Consultative Document’ prepared by the RMG and placed on the SEBI web site for public comments. The recommendations of the RMG as regard the derivative contract and the risk containment measures were also placed before the SEBI Board.

The risk containment measures and the scheme for introduction of futures contracts on a Notional Government Security with 10 year maturity (hereinafter referred to as a Long Bond Future) and a Notional Treasury Bill (hereinafter referred to as a Notional T-Bill Futures) are as follows-

**I) PRODUCT SPECIFICATION**

1) The Interest Rate Derivative Contracts to be traded on the derivative exchange/segment and settled through the Clearing house/corporation of the Exchange (herein after collectively referred to as Exchange) shall have prior approval of SEBI. The Contract should comply with the disclosure and other requirements, if any, specified by SEBI from time to time.

2) The minimum contract size of the Interest Rate Derivative Contract shall not be less than Rs. 2, 00,000/- at the time of its launch.

3) The Exchange shall initially introduce Long Bond Futures and Notional T-Bill Futures. The notional underlying could be a coupon bond or/and a zero coupon bond. The Exchange shall specify the coupon rate and disclose the same to the market prior to introduction of the contracts. The features of the notional bonds, including the coupon rate shall, however, be disclosed to the market in advance and form a part of the contract specification.

4) The bonds may be quoted on the basis of prices, yields or 100-yield, initially up to 2 decimal points and within two months of the introduction of the contract, up to 4 decimal places.

5) Long Bond Futures and Notional T- Bill Futures shall initially be cash settled.

6) The Exchange shall introduce futures contract on the notional bonds up to a maturity of one year. The Exchange shall decide whether to have quarterly contracts beyond the first three months, and whether the quarters should be fixed months of the year or rolling quarterly horizon from the contract introduction date.

7) The final settlement price of the Long Bond Future and the Notional T-Bill Future shall be determined using a ‘zero coupon yield curve’. The ‘zero coupon yield curve’ shall be computed from the prices of Government Securities traded on the Exchange/s or reported on the Negotiated Dealing System of RBI, or both.

8) The ‘zero coupon yield curve’ may be computed by the Exchange or by any other yield curve provider designated by the Exchange. As regard the computation of the zero coupon yield curve, the Exchange shall ensure the following:-

i) The yield curve should be computed by an objective process without any element of human judgment so that any market participant could arrive at the same yield curve by applying the published computation algorithm to publicly available data.

ii) The computation algorithm, including the source code should be fully disclosed to the public and made available on the website of the Exchange, under a GNU General Public License or under any other license that is not more restrictive than the General Public License. This requirement shall also extend to source codes and algorithm in any pre and post processing that may be carried out before or after the actual estimation itself.

iii) The Exchange shall make available on the web site a set of at least 25 trading days (i.e. one month) of data suites for the input data. Each day’s data suite shall include traded prices and other transaction data that is input into the estimation / pre-processing/post-procession algorithm.

iv) The full time-series of yield curve parameters shall be made available on the web site of the Exchange/yield curve provider, for a period extending back atleast to April 1, 1999.

v) Major changes in the estimation process shall be implemented after giving due notice to the market and providing the appropriate back tests.

vi) For the Long Bond Future, the estimation shall target, within a period of six months from the date of launch of futures contract, a mean pricing error for liquid bonds of not more that 2 basis points of yield for all liquid bonds. The mean pricing error would be calculated as the simple arithmetic mean over a one month period of the daily mean pricing errors, which in turn shall be calculated as the simple arithmetic mean of the absolute pricing errors (in basis points of yield) of the bonds that were liquid on that day. Liquid bonds may be defined as those with at least 10 trades of at least one market lot (Rs. 5 crores) on a given day.

**II) RISK CONTAINMENT MEASURES**

The present portfolio based margining approach applicable to equity derivative contracts shall also be extended to Interest Rate Derivative Contracts. The margins would be computed taking an integrated view on the risk on a portfolio of an individual client comprising positions in all Derivative Contracts including Interest Rate Derivatives Contracts. The parameters for risk containment model shall include the following-

**A) initial margin or worst scenario loss**

The Initial Margin requirements shall be based on the worst scenario loss of a portfolio of an individual client to cover 99% VaR over one day horizon across various scenarios of price changes, based on the volatility estimates, and volatility changes. The volatility estimate or standard deviation shall be calculated as per the exponentially weighted moving average methodology specified in the Prof. J. R Varma Committee Report on the Risk Containment Measures for Index Futures.

The estimate at the end of **day t** (st) (sigma) shall be estimated using the previous volatility estimate i.e. as at the end of t-1 day (st-1), and the return (rt) observed in the futures market during **day t**. The formula shall as under:

(st)2 = l (st-1)2 + (1 – l) (rt)2

where

(i) l is a parameter which determines how rapidly volatility estimates changes. The value of l is fixed at 0.94.

(ii) s (sigma) means the standard deviation of daily returns in the interest rate futures contract.

In the case of **Long Bond Futures,** the price scan range shall be 3.5 Standard Deviation (3.5 sigma) and in no case the initial margin shall be less than 2% of the notional value of the Futures Contracts. For Notional T-Bill Futures, the price scan range shall be 3.5 Standard Deviation (3.5 sigma) and in no case the initial margin shall be less than 0.2% of the notional value of the futures contract.

On the first day of interest rate futures trading, the formula given above would require a value of st-1, i.e. the estimated volatility at the end of the day preceding the first day of interest rate futures trading. This shall be obtained as follows:

(a) The standard deviation of returns of the prices of Notional Bonds, priced using the zero coupon yield curve, in the last one year shall be computed.

(b) The standard deviation shall be set as the volatility estimate at the beginning of that one year period.

(c) Move forward through the year, one day at a time, using the formula above to get the estimated volatility at the end of that day using prices of the Notional bonds computed of that days zero coupon yield curve.

(d) The estimated volatility by this method at the end of the day preceding the first day of interest rate derivative trading would be the value of st-1 to be used in the formula given above at the end of the first day of futures trading. Thereafter each day’s estimate st becomes the st-1 for the next day.

The “return” (rt) is defined as the logarithmic return: **rt = ln(It/It-1)** where It is the interest rate futures price at** time t**. The return (rt) used in the formula shall be computed using the prices of the near month interest rate futures contract.

A parallel estimation of volatility shall be done using the prices of the notional bonds computed off the zero coupon yield curve and the near month interest rate futures prices, and the higher of the two volatility measures would be used to set margins.

The Initial Margin requirement shall be netted at level of individual client and shall be calculated on a gross basis at the level of Trading / Clearing Member. The Initial margin requirement for the proprietary position of Trading/Clearing member shall be calculated on a net basis.

**B) Calendar spread charge**

The Calendar Spread Margin is charged in addition to the Worst Scenario Loss of the portfolio. For interest rate futures contracts a calendar spread margin shall be at a flat rate of 0.125% per month of spread on the far month contract subject to a minimum margin of 0.25% and a maximum margin of 0.75% on the far side of the spread with legs upto 1 year apart.

A calendar spread shall be treated as a naked position in the far month contract three trading days before the near month contract expires.

**C) Exposure Limits**

The notional value of gross open positions at any point in time in Futures Contracts on the Notional 10 year Bond shall not exceed 100 times the available liquid networth of a member. Therefore, the Exchange would be required to ensure that 1% of the notional value of gross open position in Futures Contracts on the Notional 10 year Bond is collected /adjusted from the liquid networth of a member on a real time basis.

For Futures Contracts on the Notional T-Bill, the notional value of gross open positions at any point in time in the contract shall not exceed 1000 times the available liquid networth of a member. Therefore, the Exchange would be required to ensure that 0.1% of the notional value of gross open position in Futures Contracts on the Notional T-Bill is collected /adjusted from the liquid networth of a member on a real time basis.

Exposure limits are in addition to the initial margin requirements.

**Exposure limit for calendar spreads:** As prescribed in the case of index futures contract, the Calendar Spread shall be regarded as an open position of one third (1/3rd) of the mark to market value of the far month contract. As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract three days prior to the expiry of the near month contract.

**D) Real Time Computation**

Initially, the zero coupon yield curve shall be computed at the end of the day. However, the Exchange / yield curve provider shall endeavour to compute the zero coupon yield curve on a real time basis or at least several times during the course of the day. Margins computed on the basis of the latest available yield curve shall be applied to member/client portfolios on a real time basis. Exchanges may also choose to compute the end of day margins on the basis of a provisional yield curve (for example based only on t+0 trades) because the final end of day yield curve becomes available only late in the evening. If so, exchanges shall specify and disclose the conditions under which a margin call shall be made next morning to deal with large deviations between the provisional and final yield curves. It is expected that such intra day margin calls shall be necessary only on a small number of days each year.

**E) Margin Collection and Enforcement**

As prescribed in the case of index futures contract, the mark to market settlement margin for Interest Rate Futures Contracts shall be collected before start of the next day’s trading, in cash. If mark to market margins is not collected before start of the next day’s trading, the clearing corporation/house shall collect correspondingly higher initial margin to cover the potential for losses over the time elapsed in the collection of margins. The higher initial margin shall be calculated in the same manner as specified in the Prof. J.R Varma committee reports on risk containment measures for index futures.

The daily closing price of Interest Rate Futures Contract for Mark to Market settlement would be calculated on the basis of the last half an hour weighted average price of the contract. In the absence of trading in the last half an hour the theoretical price would be taken. The exchange shall define and disclose the methodology of calculating the ‘theoretical price’ and include it as a part of the contract specification. In addition, the exchange shall also specify the detailed methodology, with examples, for arriving at the closing price at the time of expiry.

The initial margin (or the worst scenario loss) plus the calendar spread charge shall be adjusted against the available Liquid Networth of the member. The members in turn shall collect the initial margin from their clients.

**F) Position Limits**

In the case of Interest Rate Futures Contracts, positions limits shall be specified at the client level and for near month contracts. The client level position limits shall be Rs. 100 Cr or 15% of Open Interest whichever is higher.

**G) RISK CONTAINMENT MEASURES IN THE EVENT OF STRESS**

The extreme stress events are difficult to predict though the early warning signals could be noted by the clearing corporation, in which case the clearing corporation should respond on its own either by reducing positions or by raising margins to prohibitive levels

III) The Derivative Exchange/Segment shall submit their proposal for approval of the Contracts to SEBI which shall include:

a) the details of proposed derivative contract to be traded on the exchange which would include:

i) Symbol

ii) Underlying – The definition of the underlying would include the specification of the yield curve provider and the broad methodology for yield curve estimation.

iii) Multiplier

iv) Last Trading Day

v) Margins, including procedure for intra-day or beginning of day margin calls, if any.

vi) Methodology for calculating closing price for mark to market settlement.

vii) Methodology for calculating closing price at time of expiry

b) Trading Hours the economic purpose it is intended to serve,

c) likely contribution to market development,

d) the safeguards and the risk protection mechanism adopted by the exchange to ensure market integrity, protection of investors and smooth and orderly trading,

e) the infrastructure of the exchange and the surveillance system to effectively monitor trading in Interest Rate Derivative Contracts,

f) details of settlement procedures & systems with regard to Interest Rate Derivative Contracts,

g) details of the methodology used for computing the zero coupon yield curve, and

h) details of back testing of the margin calculation and the mean pricing error for a period of one year.

Yours sincerely,

N. PARAKH