NISM Series IV · Chapter 5: Strategies using Interest Rate Derivatives

L1 · Foundation

Foundation — The three participants and the three decisions before any trade

Hedgers, speculators and arbitragers, and why a derivatives market needs all three; the arbitrage worked example showing why the profit is identical whichever way prices move; the three parameters every hedge or trade must fix — instrument, market side and contract month — with the full direction table; and short hedge, long hedge and hedging future borrowing.

28 min read · Worth 15% of the paper · Written from pages 157–191 of the official NISM workbook · Updated 18 September 2026

Chapter 5 — Strategies using Exchange Traded Interest Rate Derivatives

Weightage: 15%. This chapter is where Chapters 1 to 4 finally get used. It is heavy on worked examples, and the exam takes its questions straight out of them.

1. The three market participants

1.1 Hedgers

Interest rate risk exists in an interest-bearing asset such as a loan or bond, because of the possibility of a change in the asset's value resulting from the variability of interest rates. Since interest rates and bond prices are inversely related, a rise in interest rates causes bond prices to fall, and vice versa.

The workbook's illustration. An entity invests Rs 10 crore in 6.10% 10-year GOI securities, paying Rs 61,00,000 per year till maturity. If interest rates rise to 6.50%, a new bond would pay Rs 65,00,000.

Now look at the bondholder's two bad choices:

Hold the 6.10% bond to maturity → he loses out on the opportunity to earn the higher rate
Sell the 6.10% bond and buy the higher-coupon one → but he gets a lower price on the sale, because bond prices are inversely related to interest rates

Either way he is worse off. The bondholder wants to hedge the interest rate risk — he is the hedger.

1.2 Speculators

The workbook then makes a point that is easy to skip but often examined:

The wheat illustration. A farmer expects wheat prices to fall and wants to lock in a forward price for the next 3 months, so he sells futures on his expected produce. To sell, he needs a buyer — perhaps a flour mill or bakery that needs wheat in three months. But most of the time there is a demand-supply mismatch in the market, and the trader fills the gap.

Note what the trader must be thinking: he will buy only if he thinks the actual price of wheat three months hence will be HIGHER than the contract price. His profit depends on the actual price exceeding the contracted futures price at maturity — if so he makes money, otherwise he loses money.

1.3 Arbitragers

⚠️ Importantly, arbitragers generally LOCK IN their profits, unlike traders who trade NAKED contracts.

They identify mispricing in the market and use it for profit
They have neither exposure to risk nor do they take risk
They lock in a profit by simultaneously entering opposite side transactions in two or more markets
Opportunities arise where the relation between forward prices and futures prices differs, or where equilibrium prices determined by demand and supply at two different markets differ
⚠️ As more players realise the opportunity, they too implement the arbitrage, which brings the market to equilibrium and the arbitrage opportunity may cease to exist

The worked example — and why the answer is the same either way.

On 1 January 2020: market price of the underlying Rs 100; March futures Rs 110; lot size 50. The arbitrageur buys in the cash market at Rs 100 and sells futures at Rs 110, locking in Rs 10 per unit.

If on expiry the underlying is at Rs 108:

Cash market	Futures
Buy 100	Sell 110
Sell 108	Buy 108
+8	+2

Total = (8 + 2) = Rs 10 × 50 = Rs 500

If on expiry the underlying is at Rs 95:

Cash market	Futures
Buy 100	Sell 110
Sell 95	Buy 95
−5	+15

Total = (−5 + 15) = Rs 10 × 50 = Rs 500

Identical. That is the whole point of arbitrage — the profit is locked at the moment of execution and does not depend on which way the market moves. ⚠️ The workbook cautions that transaction cost, impact cost, carry cost, opportunity cost and borrowing cost have NOT been considered here, and in real life all these costs have to be considered.

1.4 The risks arbitragers actually carry

Since arbitragers execute positions in two or more markets simultaneously:

Even if the systems are seamless and electronic and both legs are liquid, there is a possibility of some GAP between the executions of both orders
⚠️ If either leg is ILLIQUID, the risk is huge — only one leg may get executed and the other may not, opening the arbitrager to NAKED exposure
If contracts are not cash settled in both or one of the markets, reversal of trades would be needed, creating additional risk on unwinding with regard to simultaneous execution
In certain cases regulation does not permit certain transactions — for example, in reverse arbitrage, short selling of bonds in the underlying market may not be allowed to all participants

2. The three decisions before any hedge or trade

2.1 Instrument — linked to the tenor of rate being traded

T-Bill price is determined by the short-term rate of three months, because the underlying has a maturity of 91 days → for a 3M rate, use T-Bill futures
GOI Bond price is mainly determined by the long-term rate (assuming a 10Y underlying) → for a 10Y rate, use 10Y GOI Bond futures/options

2.2 Market side — linked to expected direction of rate change

This is the table to memorise, and note the MIBOR row runs the opposite way to the bond rows:

Interest rate expectation	Position on interest rate	What to do
Interest rate will INCREASE	LONG on interest rate	Sell GOI bond futures<br>Buy GOI bond PUT option<br>Sell T-Bill futures<br>BUY Overnight MIBOR futures
Interest rate will DECREASE	SHORT on interest rate	Buy GOI bond futures<br>Buy GOI bond CALL option<br>Buy T-Bill futures<br>SELL Overnight MIBOR futures

Why the MIBOR row inverts. Bond and T-Bill futures are quoted on price, and price moves opposite to rate — so a rate rise means selling them. Overnight MIBOR futures are quoted on the RATE ITSELF, so if you expect the short-term rate to rise you go LONG on MIBOR futures. Get this the wrong way round and you double your exposure instead of hedging it.

In hedging specifically, the market side depends on what kind of risk the participant has and which derivative product is being used. The workbook's own example: a participant who wants to borrow money after 3 months faces the risk of interest rates increasing, so he takes a long position on interest rate. To hedge through single bond IRF he SELLS futures (because of the inverse relation between rate and bond price); to hedge through MIBOR futures he goes LONG.

2.3 Contract month — linked to when the rate change is expected

If we expect the rate change in one month, choose a contract expiring in one month; in three months, choose one expiring in three months. The timing of the expected change in rate should be the same as the contract month.

3. Hedging with futures

3.1 Short hedge

The workbook's full example. On 20 September 2021, investor X holds 6.10% G-Secs 2031 worth Rs 5 crore at Rs 100.00 (yield 6.10%). A monetary policy review is scheduled in October 2021 and he expects yields to rise, so G-sec prices to fall. He also expects new bond issuance in October at a higher coupon, and wants to switch. Three choices:

Sell the bond now and invest in a short maturity paper (T-Bills at 3.20%)
Hold the bond till 28 October 2021
Hold the bond and hedge with interest rate futures

The reasoning: as the investor holds a bond, he is long on debt securities and SHORT on interest rate. He is exposed to the risk of rising rates. So he should go LONG on interest rate by taking a SHORT position in bond futures. He sells the October 2021 expiry futures at Rs 99.95, and since one contract is a notional value of Rs 2,00,000, he sells 250 lots (Rs 5 crore / Rs 2 lakh).

On expiry, 28 October 2021, the bond price is Rs 98.36 (yield 6.32%). The three outcomes:

	Scenario 1 — sell now, buy T-Bills	Scenario 2 — hold the bond	Scenario 3 — hold and hedge
Clean price	Rs 100 (on 20 Sep)	Rs 98.36	Rs 98.36
Accrued interest	Rs 1.169167 (69 days, 30/360)	Rs 1.81306 (107 days)	Rs 1.81306 (107 days)
Underlying consideration	Rs 5,05,84,583.33	Rs 5,00,86,527.78	Rs 5,00,86,527.77 (A)
T-Bill return	Rs 1,68,522.89 (38 days @ 3.20%)	—	—
Futures profit	—	—	Rs 7,95,000 (B) = (99.95 − 98.36) × 250 × 2000
Total available on expiry	Rs 5,07,53,106.22	Rs 5,00,86,527.78	Rs 5,08,81,527.78

Scenario 3 wins. And the workbook sets out the trade-offs honestly:

	Advantage	Limitation
Scenario 1	Avoid interest rate risk by investing in short term paper	Losing on accrued interest
Scenario 2	Accrued interest on holding security; beneficial if bond price increases	Exposed to interest rate risk
Scenario 3	Accrued interest on holding security; no exposure to interest rate risk	Impact cost in IRF; matching of expiry price with trade price on expiry (as it is cash settled); opportunity loss if GOI price increases

A second short hedge situation: a fund manager knows bonds must be liquidated in 45 days to pay beneficiaries. If rates rise during the 45 days, more bonds must be liquidated at a lower price to realise the payment. To protect against this, he sells bond futures to lock the selling price.

3.2 Long hedge

Typical users: an insurance company's fund manager expecting substantial cash contributions and concerned that rates will fall, or a bond trader who knows bonds are maturing soon and expects rates to fall.

The workbook's example. Insurance company X expects policy premiums worth Rs 200 crore in March 2020 and the fund manager fears a fall in interest rates. On 12 February, the underlying 6.45% G-Secs 2029 trades at Rs 99.79 (yield 6.48%) and the March expiry future at Rs 99.60 (future yield 6.51%). He takes a long position for Rs 200 crore (10,000 lots).

On 26 March (expiry) the bond trades at Rs 101.58 (yield 6.23%).

If physically settled: the fund manager receives the bond at Rs 99.60 with a yield of 6.51%
If cash settled: profit = (101.58 − 99.60) × 10,000 lots × 2,000 units = Rs 3.96 crore, which can be invested in the bond to earn a higher interest/yield

⚠️ And the honest other side, which the exam likes. "Hedging is a risk management strategy employed to offset losses by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a REDUCTION IN POTENTIAL PROFITS."

If instead the bond had traded at Rs 99.00 (yield 6.59%) on expiry, the insurance company would have a futures loss of Rs 1.20 crore = (99.60 − 99.00) × 10,000 × 2,000 — which reduces the overall return. That is not a failure of the hedge; it is what a hedge is.

The option alternative. Since an option gives a right without an obligation, the maximum risk to the option buyer is limited to the premium paid. So:

For a long hedge, the company may buy a GOI bond CALL option
For a short hedge and for hedging future borrowing, the company hedges by buying a GOI bond PUT option

3.3 Hedging future borrowing

If a participant wants to borrow money in future and expects rates to rise, he can use bond futures to hedge.

The workbook's example. A corporate wants to issue 10-year NCDs after 1 month, and generally borrows at a 50 basis point spread over G-Secs. The institution sells IRF contracts to hedge against a rise in rates.

	14 August 20XX	24 September 20XX
IRF	7.59% GOI 20XX	7.59% GOI 20XX
Expiry date	24 September 20XX	24 September 20XX
Position	Sell	Settlement @ FSP
Futures price / FSP	Rs 95.60	Rs 94.80
Yield at futures price	7.93%	8.08%

The institution gains Rs 0.80 (= 95.60 − 94.80) per bond in the IRF. Its borrowing cost reduces to the extent of that gain, so it has effectively locked its borrowing cost at a lower rate.

⚠️ But the workbook flags the catch: "this will NOT provide a perfect hedge to market participants, as the underlying instruments are DIFFERENT and hence there will be a BASIS RISK." The corporate will issue its own NCDs; the hedge is on a GOI bond. The 50 bps spread between them can itself move.

Think of it like this

Arbitrage is the moneychanger, not the gambler

Two currency counters at Mumbai airport quote the same US dollar differently — one buys at Rs 83.00, the other sells at Rs 82.90. A person who simultaneously buys at 82.90 and sells at 83.00 makes 10 paise a dollar, and it does not matter at all what the rupee does tomorrow. He is out of the position the moment he entered it.

That is arbitrage. The workbook's own example proves the point arithmetically: whether the bond ends at 108 or at 95, the profit is exactly Rs 500. The arbitrageur locked in the profit at execution.

Contrast that with the speculator, who trades naked contracts — he is still holding a view when he goes home. The workbook's line is worth quoting: arbitragers "have neither exposure to risk and nor do they take the risk."

And note what closes the gap: as more players realise the opportunity, they implement it too, bringing the market to equilibrium — and the arbitrage opportunity may cease to exist. Which is exactly why the two airport counters eventually quote the same rate.

The speculator is not the villain — he is the counterparty

A farmer in Nashik wants to lock in an onion price for three months hence. Fine — but someone has to take the other side. If only genuine onion buyers could trade, the farmer would only find a counterparty on the days a wholesaler happened to want onions on exactly his date, in exactly his quantity.

The workbook is direct about this: "Derivatives are designed primarily to assist hedgers in managing their exposure to price risk; however, this would not be possible without the participation of speculators." Hedgers depend on speculators to take the other side of their trades and to add depth and liquidity.

And notice the speculator is not doing charity. He buys only if he thinks the actual price will be higher than the contract price at maturity. He is paid — when he is right — for carrying the risk the farmer wanted to shed. When he is wrong, he pays.

This is why the same chapter says arbitragers and traders "fetch enormous liquidity to the products traded on the exchanges," which brings better price discovery, lesser cost of transaction and lesser manipulation.

Why MIBOR futures run the opposite way — the thermometer and the ice cream

Suppose you want to bet that summer will be hotter than expected.

You could buy a thermometer reading — if it is quoted directly in degrees, you buy it and profit when the temperature rises. That is Overnight MIBOR futures, quoted in the interest rate itself: expect rates up → go LONG MIBOR futures.

Or you could sell ice-cream stock forward — ice cream gets scarce and dear in heat, so its price falls if the summer is mild. Here the thing you trade moves opposite to the temperature. That is bond and T-Bill futures, quoted in price, which moves opposite to rate: expect rates up → SELL GOI bond futures.

Same view, opposite trades, because one instrument is quoted in the variable itself and the other in something that moves inversely to it.

Get this backwards and you do not merely fail to hedge — you double your exposure. It is the single most costly confusion in this chapter.

Duration-based hedging — matching the weight, not the item

You are moving house and can only hire one standard truck. Your furniture is a mixed lot — a heavy almirah, some light chairs, a piano. You do not need a truck shaped like each item; you need enough truck capacity to match the total load.

A bond portfolio works the same way. Interest rate futures may not exist on every bond you hold, so you do not match bond-for-bond. You match interest rate sensitivity, using modified duration as the unit of weight:

$$\text{Lots} = \frac{\text{Portfolio Modified Duration} \times \text{Market Value of Portfolio}}{\text{Futures Modified Duration} \times \text{Futures Price} / \text{PAR}}$$

But the truck analogy also carries the warning. Duration measures are only accurate for SMALL changes in yield. For large moves the price-yield relationship is convex, not linear, so the hedge UNDERHEDGES in a big move — the load turns out heavier than the estimate. And the portfolio and the futures contract may not move in tandem, which is basis risk.

Covered call — renting out the flat you already own

You own a flat you intend to keep for a few years. It sits there producing nothing beyond its own appreciation. So you rent it out, collecting monthly income without selling the asset.

That is a covered call: you hold the bond and sell a call against it, earning premium and reducing your cost of acquisition. The workbook calls it "a strategy that sells volatility in return of fees."

But read the tenancy agreement. If you sign a lease with a purchase option at a fixed price, and property values then double, the tenant exercises and you lose the extra gain. Selling the call caps your upside at the strike.

Hence the workbook's guidance on strike choice: a strike close to the current price fetches a higher premium but locks the potential gain early; a far strike fetches less premium but allows a longer ride. Its neat practical rule: until the cash market price reaches your pre-determined exit price, the long cash position can be used to sell calls of that target strike. In other words, sell the call at the price you were going to sell the bond at anyway.

Key terms in this chapter

Arbitrager: A participant who identifies mispricing and simultaneously enters opposite transactions in two or more markets, locking in a profit that is the same whichever way prices move. Unlike traders, arbitragers do not hold naked contracts.
Basis risk: The risk that the hedged portfolio and the hedging contract do not move in tandem — the residual exposure that survives every imperfect hedge, and the only risk in a calendar spread.
Bearish vertical spread using calls: Short a low strike, high premium call and long a high strike call to cap the unlimited loss. It starts with a net inflow and profits when prices fall and both options go unexercised.
Bearish vertical spread using puts: Long a higher strike put, with a lower strike put sold to reduce the cost. Profits when prices fall and both options get exercised.
Bullish vertical spread using calls: Long a lower strike call and short a higher strike call. It reduces cost but remains a net cash outflow, and caps all gains beyond the higher strike.
Bullish vertical spread using puts: Short a higher strike put and long a lower strike put. A net premium receipt strategy, where the bought put is embedded insurance against the short put's otherwise unlimited loss.
Butterfly spread: A neutral strategy combining a bull and a bear spread, using four options across three equidistant strikes, with fixed risk and capped profit. The long call version buys one ITM call, sells two ATM calls and buys one OTM call.
Calendar spread trading: Buying one expiry month and selling another of the same contract. It carries no underlying price risk, only basis risk from the spread changing, so margins are much lower than normal.
Changing portfolio duration with futures: A quicker and cheaper alternative to trading cash bonds — buying GOI bond futures increases portfolio duration, selling them reduces it. Managers expecting rates to rise shorten duration (sell futures); those expecting rates to fall lengthen it (buy futures).
Covered call: Selling a call against a bond you already hold — a strategy that sells volatility in return for fees, generating income without selling the asset and reducing the cost of acquisition, at the price of capping the upside at the strike.
Diagonal spread: A combination with the same underlying but both different expiries and different strikes — much more complicated in nature and in execution, and again with no drawable pay-off.
Duration-based hedge ratio: The formula (Portfolio Modified Duration × Market Value) ÷ (Futures Modified Duration × Futures Price / PAR), used to hedge a mixed bond portfolio with a single bond future and drive the position's duration to zero.
Execution risk: The risk that prices move between the placing of two legs of a strategy. It is the arbitrager's principal danger and the reason exchanges offer spread orders.
Hedger: A participant with a real exposure to interest rate risk from his underlying business, who uses derivatives to remove it. Long-term fixed-rate bond investors are the most directly susceptible of all.
Hedging future borrowing: A prospective borrower fearing higher rates sells IRF contracts; the gain on the futures reduces the effective borrowing cost. It is never a perfect hedge, because the borrower issues its own paper while the hedge is on a GOI bond.
Horizontal (calendar or time) spread: Same strike and same type but different expiry. No pay-off chart can be drawn because the expiries differ; it is a play on the difference between the two options' time values widening or squeezing.
Impact cost: The price movement caused by your own order. Listed among the frictions — with brokerage, stamp duty, taxes and margin cost — that must be considered before any of these strategies is entered.
Imperfect hedge: The unavoidable outcome when standardised, cash-settled contracts meet a specific exposure — from last-Thursday expiry mismatches, unavailable underlyings and tenors, and timing differences on cancellation.
Inter-bond spread: A long-short position in futures on two different GOI bonds with the same expiry, used to express a view that the yield curve will steepen or flatten.
Long hedge: Buying futures to lock in a purchase price or yield, used by someone who intends to buy an asset later and fears prices rising — such as an insurer expecting large premium inflows in a falling rate environment.
Long straddle: Buying a call and a put at the same strike and expiry, for a view that the market will move significantly but in an unknown direction. Limited loss at the strike, unlimited profit, and two break-evens at strike plus and minus the total premium.
Long strangle: Buying an out-of-the-money call and an out-of-the-money put, so the premium is lower than a straddle. Maximum loss is flat across the range between the two strikes, and a larger move is needed before it pays.
MIBOR futures direction rule: Because Overnight MIBOR futures are quoted in the rate itself rather than a price, an expectation of rising short-term rates means going LONG MIBOR futures — the opposite of selling bond or T-Bill futures on the same view.
Naked contract: A derivative position with no offsetting leg — what a trader holds and an arbitrager avoids. An arbitrager ends up naked only if one leg of his trade fails to execute, which is why illiquid legs are so dangerous.
Protective put: Holding the bond and buying a put against it, so downside losses are capped at the premium while the upside stays open — unlike a short futures hedge, which removes gains along with losses.
Regular arbitrage (single bond IRF): Buying the bond in the underlying market and selling futures of the same bond, available when the futures price exceeds the theoretical futures price. The net pay-off is identical whether prices rise or fall.
Reverse arbitrage (single bond IRF): Selling the bond, lending money in the repo market against it and buying futures — available when futures trade below theoretical value. Not open to everyone, since short selling GOI securities is restricted.
Short hedge: Selling futures to protect against a decline in the cash price of a fixed income security. It fixes the future cash price and transfers the price risk of ownership to the futures buyer.
Short straddle: Selling a call and a put at the same strike and expiry, for a view that prices will stay stable. Limited profit and unlimited loss in either direction — to be undertaken with significant care.
Short strangle: Selling an out-of-the-money call and put for a view that the market will remain stable. Profit is capped at the premium across the range between the strikes; loss is unlimited in both directions.
Speculator: A participant with no real exposure who assumes interest rate risk by taking a view on direction. Hedgers depend on speculators to take the other side of their trades and to supply depth and liquidity.
Spread order facility: An exchange facility that executes both legs of a spread together, removing the execution risk of prices moving between two separately placed orders.
Synthetic security for yield enhancement: A long 15-year bond combined with a short three-month future on it behaves like a three-month riskless security. If that synthetic yield beats the cash T-Bill yield, the investor captures the difference.
Synthetic short put: The shape a covered call actually produces. If the real put at that strike trades below the premium the synthetic earns, buying it creates a risk-free profit — subject to brokerage, taxes and funding costs.
The three trade parameters: Every hedge or trade fixes an instrument (matched to the tenor of the rate), a market side (matched to the expected direction of the rate) and a contract month (matched to when the change is expected).
Underhedging: The shortfall that arises when a duration-based hedge meets a large yield move, because duration draws a straight line through a convex price-yield relationship and so understates the true price change.
Vertical spread: Options of the same type and same expiry but different strike prices, combined into a limited profit and limited loss position. It comes in four forms — bullish or bearish, using calls or using puts.

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Original explanatory writing based on the official NISM workbook for Series IV, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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