Deliverable grade securities

A physically settled futures contract on a notional bond has an obvious problem: the notional bond cannot be delivered, because it was never issued. So the exchange names a list of real government securities that will do instead, and that list is the deliverable basket.

The criteria are specific. A security qualifies if it matures at least 7.5 years but not more than 15 years from the first day of the delivery month, and if there is at least Rs 10,000 crore of it outstanding. The exchange picks its own basket from the securities that clear that bar, and must disclose the basket — and each security's conversion factor — upfront, before the quarterly contract trades.

Deliberately allowing several bonds rather than one is a design choice, and the workbook gives two reasons for it.

Why multiple bonds. First, institutional investors in India buy and hold. The outstanding stock of any one bond is small compared with the floating stock of an equity, so a single named bond loses liquidity in the cash market quickly — and an illiquid cash market makes an illiquid futures contract. Second, with low outstanding stock, a manipulator can squeeze the contract by buying the bond in the cash market and the futures at the same time. A basket makes both harder.

The workbook attaches a condition to this, and it is the one candidates skip: allowing multiple securities works only when their costs of delivery are not much different. When they are, one bond becomes the cheapest to deliver and the basket collapses back to a single bond in practice.

How the basket is managed. The composition and the associated conversion factors are published upfront for each quarterly contract. Additions to the basket must be made not later than 10 business days before the first day of the delivery month, so the market has notice.

What may be delivered against one contract. A seller may not fulfil one futures contract with a mixed portfolio — Rs 1,20,000 face of one issue plus Rs 80,000 of another against a single contract is not permitted. But a seller delivering against two contracts may use two different issues, Rs 2,00,000 of one for the first and Rs 2,00,000 of another for the second.

Eligibility (physically settled 10Y notional contract):

   Residual maturity   ≥  7.5 years and ≤ 15 years
                          from the FIRST DAY of the delivery month
   Outstanding stock   ≥  Rs 10,000 crore

   Basket and conversion factors disclosed upfront per quarterly contract
   Additions made not later than 10 business days before the delivery month

Delivery unit  = Rs 2,00,000 face value per contract, one issue per contract
Delivery month = March, June, September, December

Screening the basket. A December contract is being specified, so maturities are measured from 1 December. Four candidate GOI securities:

Maturity alone is not enough; the 7.38% GS 2034 sits comfortably inside the window and still fails on stock, precisely because a thin issue is what a squeeze needs.

Delivering against it. A clearing member is short 3 contracts of the December expiry and gives notice to deliver:

Notional face value to deliver = 3 × Rs 2,00,000 = Rs 6,00,000

He may deliver Rs 6,00,000 face of the 7.26% GS 2033 across all three contracts. Or he may deliver Rs 2,00,000 of the 7.26% GS 2033 against one contract and Rs 4,00,000 of the 7.18% GS 2037 against the other two. What he may not do is split Rs 1,20,000 of one and Rs 80,000 of the other against a single contract.

And the cost of failing. If he gives notice and then fails to deliver, the clearing corporation auctions the security. On a successful auction he is debited the auction price, the shortfall against the invoice price, and a penalty of 2% of the face value short delivered — on Rs 6,00,000 that is Rs 12,000. On an unsuccessful auction the trade is closed out at the invoice price with a penalty of 5%, or Rs 30,000, and the penalty is passed on to the buying client.

Chapter 7, section 7.9 (Delivery Under Physical Settlement), sets out the eligibility criteria, the rationale for a multi-bond basket, the upfront disclosure requirement and the no-mixed-portfolio rule, then runs the delivery schedule and the failure penalties. Chapter 3, section 3.3, states the same criteria inside the contract specification for the physically settled 10-year notional bond futures. The workbook flags at the outset that all bond futures are currently cash settled, so this is study material rather than live market practice.

Questions are recall-heavy: the 7.5-to-15-year window, the Rs 10,000 crore minimum outstanding, that maturity is measured from the first day of the delivery month, and the penalty percentages.

• Maturity is measured from the first day of the delivery month, not from the trade date or the expiry date. The workbook is explicit and the exam uses it.
• Both tests must pass. A bond inside the maturity window but under Rs 10,000 crore outstanding is ineligible, and vice versa.
• One issue per contract. Mixing two securities within a single contract is prohibited; delivering different securities against different contracts is fine.
• The basket does not prevent a cheapest-to-deliver. It only works when costs of delivery are similar; when they are not, one bond dominates.
• Conversion factors are published with the basket, upfront and per quarterly contract — they are not computed by the seller at delivery.
• All bond futures in India are currently cash settled. This entire delivery apparatus is examinable but not in live use, and the workbook says so.