True hedge

A hedge is supposed to match the risk it protects. Not every popular hedging tool actually does that.

An instrument can be hugely successful in the market. It can still be the wrong tool for one specific risk. That happens when it does not really track the exposure it is meant to cover.

The workbook makes this point about India's government bond market. Banks, insurers and pension funds carry a huge share of the interest rate risk on these bonds. Which instrument genuinely offsets that risk? Only one built around the same exposure counts as a true hedge for it.

The workbook's argument (Chapter 20, section 20.5) singles out the Overnight Index Swap (OIS) as the counter-example: OIS is "one such hugely successful and traded IRD instrument" for managing interest rate risk generally, but it "does not at all answer the description of a 'true hedge'" for the colossal outstanding stock of GOI securities specifically.

Why not: OIS references the overnight rate, which is a different point on the yield curve from the price behaviour of long-dated GOI securities. A hedge built on the overnight rate does not move in the tight relationship with a 10-year bond's price that a true hedge would need to.

By contrast, single-bond GOI interest rate futures — priced directly off a specific, named, on-the-run GOI bond — track that exact exposure far more closely, which is exactly why the workbook frames their introduction as filling the gap OIS leaves. The workbook adds that the government securities yield curve is the "ultimate risk-free sovereign proxy for pure time value of money," delivering, worldwide, the function of pricing every riskier asset at a spread over it — which is precisely the exposure a true hedge for GOI securities has to match.

A primary dealer holds Rs 500 crore of 10-year GOI securities and wants to hedge against a general rise in long-term interest rates.

Using an Overnight Index Swap referencing the overnight MIBOR would leave a large gap: the OIS moves with overnight rate expectations, while the dealer's bond portfolio's price moves with the 10-year segment of the curve. A shift concentrated at the long end of the curve, with the overnight rate barely moving, would leave the OIS hedge doing almost nothing while the bond portfolio loses value regardless.

Using single-bond GOI interest rate futures written on a comparable on-the-run 10-year bond instead ties the hedge directly to the same part of the curve the exposure actually sits on — which is the sense in which the futures qualify as a true hedge for this exposure, and the OIS, despite its own success as a product, does not.

Chapter 20 (Exchange Traded Interest Rate Futures), section 20.5 ("Rationale for Introducing Exchange Traded Interest Rate Derivatives in India"), makes the true-hedge argument directly, contrasting OIS's general success with its specific inadequacy for GOI security exposure. Expect a question testing whether OIS is described as a true hedge for GOI securities — it is explicitly not.

• A hugely successful, liquid instrument is not automatically a true hedge for every exposure. OIS is both, in the workbook's own words, at once.
• The mismatch is about which part of the yield curve the instrument references, not about OIS being a poor product in general.
• "True hedge" in this context is specific to GOI security exposure, not a general term applied loosely elsewhere in the workbook.
• Single-bond GOI futures were introduced partly to fill exactly this gap — do not treat their introduction as redundant just because OIS already existed.