Notional bond

A futures contract needs an underlying. If that underlying is one specific government bond, the contract inherits that bond's problems: institutional investors buy and hold, the outstanding stock is small next to the equity market's free float, and the bond loses liquidity in the cash market — taking the futures contract down with it. Worse, a manipulator can squeeze it by buying the bond and the futures at the same time.

A notional bond sidesteps that. It is a described bond rather than an issued one: a 10-year Government of India security with a notional coupon of 7% paid semi-annually, on a face value of Rs 100. No such security exists. Its price is inferred from the market prices of real bonds that do.

So traders quote and settle a contract on a bond nobody owns, priced off a basket of bonds many people own.

India has used notional bonds three ways, and the differences are examinable.

Physically settled 10-year notional bond futures. The underlying is a notional 7% semi-annual 10-year GOI security. Because the contract cannot deliver a bond that does not exist, a basket of deliverable grade securities is specified and each is given a conversion factor that converts it into notional-bond terms. The seller chooses which to deliver, which creates the cheapest-to-deliver problem.

Cash settled notional bond futures. Same notional underlying, no delivery. The final settlement price is derived from an average settlement yield — the weighted average of the yields of the bonds in the underlying basket, each bond's yield being its weighted average yield over the last two hours of NDS-OM trading, with the FIMMDA/FBIL price used if fewer than five trades occurred. For 2-year and 5-year notional bonds the yields come from a FIMMDA polling process.

Single bond futures, which is what actually trades today, abandons the notional bond entirely for a named on-the-run security.

The lot is the same in every case: one contract equals notional bonds of Rs 2 lakh face value — 2,000 bonds of Rs 100 each.

Lot size            = notional bonds of Rs 2,00,000 face value = 2,000 units
Contract value      = Trade price × 2,000
Tick size           = Rs 0.0025   →  tick value Rs 5 per lot

Notional coupon     = 7% p.a., semi-annual  (10Y, 5Y and 2Y notional contracts)

Eligible basket     2Y notional : GOI securities maturing 1.5 – 2.5 years from expiry
                    5Y notional : GOI securities maturing 4.5 – 5.5 years from expiry
                   10Y physical : GOI securities maturing 7.5 – 15 years from the first
                                  day of the delivery month, minimum outstanding
                                  stock Rs 10,000 crore

Why the basket exists. A dealer wants to hedge Rs 10 crore of a 9-year G-Sec. If the futures were written on one named bond and that bond stopped trading, the hedge would have to be unwound at whatever price the screen showed. Written on a notional bond settled off a basket, the contract stays priced even when any one constituent goes quiet.

Trading it. A treasurer sells 50 lots of the 10-year notional bond futures at Rs 99.25:

Contract value = 99.25 × 2,000 × 50 lots = Rs 99,25,000
Face value covered = 50 × Rs 2,00,000    = Rs 1,00,00,000

Note the two are not the same number and never will be unless the price is exactly 100 — the face value is Rs 1 crore, the contract value Rs 99.25 lakh.

Rates rise and the contract settles at Rs 97.75:

Gain = (99.25 − 97.75) × 2,000 × 50 = Rs 1,50,000

That is 600 ticks of Rs 5 each, on each of 50 lots.

Settling it off the basket. Suppose the cash-settled contract's basket holds three bonds with assigned weights, and their last-two-hour weighted average NDS-OM yields on expiry day are:

Average settlement yield = 0.50 × 6.95 + 0.30 × 7.05 + 0.20 × 7.20
                         = 3.475 + 2.115 + 1.440
                         = 7.03%

The notional 7% bond is then priced to that 7.03% yield, and every open position settles against it. No single bond decided the outcome — which is exactly the design objective.

Chapter 2, section 2.5, tabulates the four possible underlyings for an interest rate derivative — interest rate, notional bond, single bond and fixed income index — and defines the notional bond as "not a physical bond but theoretical bond with fixed maturity and coupon whose price is inferred from market physically available bonds". Chapter 3, section 3.3, gives the contract specifications for the 10-year physically settled, 10-year cash settled and 2-year/5-year notional contracts, and Chapter 7, section 7.9, covers delivery against the physically settled version.

Questions ask you to identify the underlying type from a described contract, to recall the 7% notional coupon and the Rs 2 lakh lot, and to distinguish the cash-settled basket mechanism from physical delivery.

• The notional bond does not exist. No ISIN, no issuer, no holder — only a specification and a price inferred from real bonds.
• Notional bond is not the same as single bond futures. Today's live cash-settled contracts are on a named on-the-run G-Sec; the notional contracts are the earlier and the yet-to-be-introduced designs.
• The notional coupon is 7%, not the market yield. It is fixed in the specification and is also the yield at which conversion factors are computed.
• Face value and contract value are different numbers. Rs 2 lakh of face value has a contract value of price × 2,000, which equals Rs 2 lakh only at a price of exactly 100.
• The eligible baskets differ by contract. 1.5–2.5 years for the 2-year, 4.5–5.5 for the 5-year, 7.5–15 years plus Rs 10,000 crore outstanding for the physically settled 10-year.
• A basket is not an index. A fixed income securities index contract is a separate underlying type in the Chapter 2 table, settled at index value.