On-the-run bond

Government of India securities of similar maturity are not all equally traded. Whichever one was issued most recently is usually the one the market trades most, because it best reflects current conditions. That bond is the on-the-run bond.

India's successful cash-settled interest rate futures are built around exactly this idea. Rather than settle against a basket of bonds or a theoretical security, the contract names one specific, currently on-the-run 10-year GOI bond as its underlying — and that choice of the most liquid, most recently issued security is a large part of why this design succeeded where earlier attempts failed.

India tried exchange-traded interest rate futures three times (Chapter 20, section 20.1). The first two attempts, in 2003 and 2009, used a notional 10-year bond and a "cheapest-to-deliver" physical settlement mechanism, and neither succeeded.

Based on revised SEBI and RBI guidelines from December 2013, exchanges introduced cash settled interest rate futures on 10-year Government of India Securities, based on the on-the-run 10-year GOI bond — and this design has been a success. The contract is a single bond futures contract: its underlying is one specifically named, currently most-traded bond, such as a 6.33% Central Government Security maturing in 2035, selected by the exchanges in consultation with FIMMDA.

Because the underlying is the actively traded bond of the moment, the final settlement price can be derived reliably from real trading: the weighted average price during the last two hours of trading on NDS-OM, falling back to a FIMMDA/FBIL price if fewer than five trades occurred in that window.

In 2024, the 10-year benchmark on-the-run GOI bond is the 7.10% GOI 2034. Because it is the most recently issued 10-year security, it trades far more heavily than an older 10-year bond issued five years earlier, even though both have roughly similar residual maturities.

When exchanges launch a cash-settled 10-year interest rate futures contract, they name the 7.10% GOI 2034 — the current on-the-run bond — as the underlying, not the older, thinner-trading security. A trader hedging a Rs 5 crore position in 10-year government paper can therefore rely on the futures' final settlement price being derived from genuine, liquid trading in the last two hours before expiry, rather than from a handful of stale trades in a bond nobody is actively buying or selling.

When a newer 10-year bond is issued and takes over as the most liquid security, the exchange moves the "on-the-run" designation — and, over time, the underlying of new contracts — to that newer bond.

Chapter 20 (Exchange Traded Interest Rate Futures), section 20.1, traces the three attempts at Indian interest rate futures and credits the December 2013 shift to a cash-settled, on-the-run single bond design with the market's eventual success. Expect a question on why the earlier attempts failed (cheapest-to-deliver, physical settlement) against why the current design works (on-the-run bond, cash settlement).

• On-the-run is not the same as notional. A notional bond does not exist at all; an on-the-run bond is a real, specific, currently-issued security.
• The single-bond futures contract is named after one specific bond, not a basket — which is what makes cash settlement against real trading data possible.
• The bond that is "on-the-run" changes over time as newer securities of the same maturity are issued and take over as the most liquid.
• Cheapest-to-deliver and physical settlement were the flaws of the earlier, failed designs — the current success is built on the opposite choices.